FL086 Management Accounting Study Manual 2015

FOUNDATION EXAM
MANAGEMENT ACCOUNTING
STUDY MANUAL
Foundation exam
Management Accounting
ii |
Fifth edition 2015

First edition 2010
ISBN 9781472714565
Previous ISBN 9781 4453 6875 7
British Library Cataloguing-in-Publication Data
A catalogue record for this book
is available from the British Library.
Published by BPP Learning Media Ltd
All rights reserved. No part of this publication may be
reproduced or transmitted in any form or by any means or
stored in any retrieval system, electronic, mechanical,
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permission of the publisher.
The contents of this book are intended as a guide and not
professional advice. Although every effort has been made to
ensure that the contents of this book are correct at the time of
going to press, BPP Learning Media, the Editor and the Author
make no warranty that the information in this book is accurate
or complete and accept no liability for any loss or damage
suffered by any person acting or refraining from acting as a
result of the material in this book.
Every effort has been made to contact the copyright holders of
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We are grateful to CPA Australia for permission to reproduce
the Learning Objectives, the copyright of which is owned by
CPA Australia.
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BPP Learning Media Ltd 2015
INTRODUCTION | iii
FOUNDATION EXAMS
International Education Standards
CPA Australia is a member of the International Federation of Accountants (IFAC). All foundation exam
education materials are developed in line with IFACs International Education Standards. These
standards provide guidance in establishing the content of professional accounting education
programs together with the associated assessment. The standards also assist in developing the
required passing standard for accounting education and competence of a professional accountant.
The foundation exams provide you with the opportunity to demonstrate your competence in areas
required for Associate membership of CPA Australia. By demonstrating this entry level knowledge you
will be well positioned to succeed at the CPA Program and ultimately attaining the CPA designation.
YOU AND YOUR STUDY PLAN

This study manual is designed to give you an understanding of what to expect in your exam as a well
as covering the fundamentals that you need to know. Exams will be based on the contents of this
study manual.
There are no specifically recommended hours of study. Each candidate brings their own level of
experience and knowledge to the foundation exams. The number of study hours required is entirely
dependent on your prior knowledge of the subject. You will need to develop your own study plan.
Refer to Preparing for foundation exams on page viii.
ADDITIONAL LEARNING SUPPORT

If you feel you have gaps in your knowledge after reviewing the study manual, there is a range of
optional additional support to assist in your exam preparation. Additional learning support caters for
different learning styles and budgets.
Please check the CPA Australia website for more information www.cpaustralia.com.au/learningsupport
STANDARDS AND LEGISLATION

The material in this study manual has been prepared based upon standards and legislation in effect as
at 1 September 2013. Candidates are advised that they should confirm effective dates of standards
and legislation when using additional study resources. Exams are based on the learning objectives
outlined within this study manual.
iv | MANAGEMENT ACCOUNTING
INTRODUCTION | v
CONTENTS
Page
INTRODUCTION
Foundation exams
iii
Chapter features
vi
Preparing for your foundation exam

Chapter summary
Learning objectives
viii
x
xii
CHAPTER
1
The nature and purpose of management accounting
Decision making and relevant costing
39
Budgeting
63
Cost behaviour and CVP analysis
99
Overheads, absorption and marginal costing
135
Overhead costing activity-based costing
171
Process and job costing
191
Standard costing
233
Variance analysis
247
10
Capital expenditure
273
11
Inventory and pricing decisions
297
12
Performance measurement and evaluation
323
Revision questions
353
Answers to revision questions
377
Before you begin questions: answers and commentary
395
Glossary of terms
415
Index
423
vi | MANAGEMENT ACCOUNTING
CHAPTER FEATURES
Each chapter contains a number of helpful features to guide you through each topic.
Learning
objectives
Show the referenced CPA Australia learning objectives.
Topic list
Tells you what you will be studying in this chapter.
Introduction
Presents a general idea of what is covered in this chapter.
Chapter summary
diagram
Summarises the content of the chapter, helping to set the scene so that you
can gain the bigger picture.
Before you begin
This is a small bank of questions to test any pre-existing knowledge that you
may have of the chapter content. If you get them all correct then you may
be able to reduce the time you need to spend on the particular chapter.
There is a commentary section at the end of the Study Manual called Before
you begin: answers and commentary.
Section overview
This summarises the key content of the particular section that you are about
to start.
Learning objective
reference
This box indicates the learning objective covered by the section or

paragraph to which it relates.
LO
1.2
Definition
Definitions of important concepts. You really need to know and understand

these before the exam.
Exam comments
These highlight points that are likely to be particularly important or relevant

to the exam. (Please note that this feature does not apply in every
foundation exam study manual.)
exam
Worked example
This is an illustration of a particular technique or concept with a solution or

explanation provided.
Question
This is a question that enables you to practise a technique or test your

understanding. You will find the solution at the end of the chapter.
Key chapter points
Review the key areas covered in the chapter.
Quick revision
questions
A quick test of your knowledge of the main topics in this chapter.

The quick revision questions are not a representation of the difficulty or
style of questions which will be in the exam. They provide you with an
opportunity to revise and assess your knowledge of the key concepts
covered in the materials so far. They are not a practice exam, but rather a
means to reflect on key concepts and not as the sole revision for the exam.
INTRODUCTION | vii
Revision questions
The revision questions are not a representation of the difficulty or style of

questions which will be in the exam. They provide you with an opportunity
to revise and assess your knowledge of the key concepts covered in the
materials so far. They are not a practice exam but rather a means to reflect
on key concepts and not as the sole revision for the exam.
Case study
This is a practical example or illustration, usually involving a real world

scenario.
Formula to learn
These are formulae or equations that you need to learn as you may need to
apply them in the exam.
Bold text
Throughout the Study Manual you will see that some of the text is in bold
type. This is to add emphasis and to help you to grasp the key elements
within a sentence and paragraph.
viii | MANAGEMENT ACCOUNTING
PREPARING FOR YOUR FOUNDATION EXAM

STUDY PLAN
Review all the learning objectives thoroughly. Use the topic exam weightings listed at the end of
the learning objectives to develop a study plan to ensure you provide yourself with enough time to
revise each learning objective.
Dont leave your study to the last minute. You may need more time to explore learning objectives
in greater detail than initially expected.
Be confident that you understand each learning objective. If you find that you are still unsure after
reading the study manual, seek additional information from other resources such as text books,
supplementary learning materials or tuition providers.
STUDY TECHNIQUES
In addition to being able to complete the revision and self-assessment questions in the study
manual, ensure you can apply the concepts of the learning objectives rather than just memorising
responses.
Some exams have formulae and discount tables available to candidates throughout the exams. My
Online Learning lists the tools available for each exam under "Useful Resources".
Check My Online Learning on a weekly basis to keep track of announcements or updates to the
study manual.
TIPS FOR EXAMS

Plan to arrive at the exam centre at least 15 minutes before your exam. Allow for possible delays
with public transport or traffic.
You have three hours and fifteen minutes to complete the exam. As soon as you commence the
exam your exam clock in the top right hand corner of the screen begins to count down. Watch your
time carefully.
ANSWERING MULTIPLE CHOICE QUESTIONS

Foundation exams are a series of 100 multiple choice questions. Each question will contain four
possible options.
Step 1
Attempt every question. Read the question thoroughly. You may prefer to work out the
answer before looking at the options, or you may prefer to look at the options at the
beginning. Adopt the method that works best for you.
Step 2
Read the four options and see if one matches your own answer. Be careful with
numerical questions, as some options are designed to match answers that incorporate
common errors. Check that your calculation is correct. Have you followed the
requirement exactly? Have you included every step of the calculation?
Step 3
You may find that none of the options matches your answer.
Re-read the question to ensure that you understand it and are answering the
requirement
Eliminate any obviously wrong answers
Consider which of the remaining answers is the most likely to be correct and select the
option
INTRODUCTION | ix
Step 4
If you are still unsure, you can flag the question and continue to the next question. Some
questions will take you longer to answer than others. Try to reduce the average time per
question, to allow yourself to revisit problem questions at the end of the exam.
Revisit unanswered questions. A review tool is available at the end of the exam, which
allows you to Review Incomplete or Review Flagged questions. When you come back to a
question after a break you often find you are able to answer it correctly straight away. You
are not penalised for incorrect answers, so never leave a question unanswered!
COMPUTER-BASED EXAM NAVIGATION

Your computer-based exam has the following functions:
Navigation
You can select your answer by: clicking on the circle to the left of the option, or typing the letter
corresponding to the option.
To move through the exam, you use the 'Next' or 'Previous' buttons on the bottom of the
screen. The function of each button is selected by your mouse, or with a combination of
keyboard keys. For example, you can select the 'Next' button by clicking it with the mouse, or
by typing ALT + N.
The 'Next' button moves you from one screen to the next screen. If you wish to go back and
view the screen you just viewed, click the 'Previous' button or type ALT + P.
Select for review
There is a flag in the upper right corner of your exam screen labelled 'Fag for Review'. You mark
an exam question to review at a later time by clicking on this flag. The flag will appear filled-in
once it is selected. You may mark any exam question for later review, whether you select an
answer or not.
Review Screen
After finishing the last exam question, you will see a review screen. This lists every exam
question. If you clicked the 'Flag for Review' flag on a question screen, that question appears on
the Review Screen marked with the flag filled in.
If you skipped any exam questions, these will be labelled as 'Incomplete' even if you did not
select them for review.
From the Review Screen you can choose to:
1. review all of the questions in the exam by clicking 'Review All';
2. individually select more questions for review (click on the flags corresponding to the
questions);
3. review all questions marked as incomplete by clicking 'Review Incomplete';
4. begin reviewing the selected questions by clicking 'Review Flagged'; or
5. exit by clicking 'End Review' this will also end your exam.
x | MANAGEMENT ACCOUNTING
CHAPTER SUMMARY
This summary provides a snapshot of each of the chapters, to help you to put the Study Manual into
perspective.
CHAPTER 1 THE NATURE AND PURPOSE OF MANAGEMENT

ACCOUNTING
This introductory chapter sets the scene for your forthcoming studies of Management Accounting. It
explains the differences between financial, cost and management accounting and explains the role of
the management accountant.
It also introduces two key activities of the management accountant: decision making and performance
measurement and evaluation.
CHAPTER 2 DECISION MAKING AND RELEVANT COSTING

One of the most important things that a management accountant does is to provide the information
that enables a business to make decisions about its activities. This involves ascertaining the relevant
costs of the business, which are its future costs and cash flows. The chapter goes on to consider
choice of product (product mix) decisions, make or buy decisions and outsourcing.
CHAPTER 3 BUDGETING
A budget is a quantitative statement, for a defined period of time (often a year) which usually includes
planned revenues, expenses, assets, liabilities and cash flows. When organisations draw up budgets
they have stated objectives and intentions, and the actual results can then be compared with the
budget and differences identified and analysed. This chapter explains the background of budgeting
and then teaches you how to prepare and operations budget and a cash budget.
CHAPTER 4 COST BEHAVIOUR AND CVP ANALYSIS

This chapter introduces the different types of cost and also discusses cost behaviour. It then moves on
to cost-volume-profit analysis, which is based on cost behaviour principles; this is necessary so that the
appropriate decision-making information can be provided to management.
CHAPTER 5 OVERHEADS, ABSORPTION AND MARGINAL COSTING

There are some costs incurred by organisations that have to be allocated out to the various units
produced, so that a cost per unit can be produced. This chapter examines the different types of
overheads and introduces two methods of accounting for them: absorption and marginal costing. It
ends with a comparison between the two.
CHAPTER 6 OVERHEAD COSTING ACTIVITY-BASED COSTING

Activity-based costing (ABC) has been developed relatively recently to suit modern business and
accounting practices. It provides a modern alternative to traditional methods such as absorption
costing, which tend to allocate too great a proportion of overheads to high volume products. ABC
involves the identification of those factors, known as cost drivers, which cause the costs of an
organisations major activities.
CHAPTER 7 PROCESS AND JOB COSTING

Costing systems are used to cost goods or services, and the method used depends on the way in
which the goods or services are produced. Within the context of your syllabus, the two most important
are process costing, used when it is not possible to identify separate units of production, and job
costing, where work is undertaken to a particular customers specific requirements.
INTRODUCTION | xi
CHAPTER 8 STANDARD COSTING

In business, standards are applied to the costs of products and services. An organisation will expect
the standards that it sets (for example for the amount of materials to be used in production, or for the
amount of workforce time involved) to be met. If they are not, a variance analysis will be carried out,
which identifies where they have not been met.
CHAPTER 9 VARIANCE ANALYSIS

The actual results achieved by an organisation during the reporting period are frequently different
from those expected. Variance analysis identifies where these differences from the expected occur. It
is important to realise that in some situations a favourable (ie positive) variance on one aspect of
production will be cancelled out by an adverse (ie negative) variance on another aspect. Hence
businesses produce operating statements, which reconcile the expected and the actual results, by
means of all the variances, so management can see the complete picture.
CHAPTER 10 CAPITAL EXPENDITURE

Decisions about capital expenditure require different thought processes from those about revenue
expenditure. Capital expenditure often involves the expenditure of larger sums of money, and this
usually happens over a longer period of time. Because of this, there are sometimes elements of
uncertainty, such as interest rates or the revenue to be gained from a project, and this chapter
introduces the different means of assessing the value of capital expenditure.
CHAPTER 11 INVENTORY AND PRICING DECISIONS

Manufacturing businesses in particular are very concerned to retain the right amount of stock, or
inventory. They do not want to tie too much cash up in the purchase and holding of stocks of goods or
components, but nor do they want to run the risk of not being able to fulfil an order from a customer
because they do not have the stock or cannot get it quickly enough. This chapter examines systems
for maintaining inventory and controlling its levels, and also looks at different approaches to pricing.
CHAPTER 12 PERFORMANCE MEASUREMENT AND EVALUATION

This chapter is concerned with performance indicators, i.e. the ways of assessing how a business, or a
division, or a particular product within a catalogue, is performing. The central theme here is
responsibility accounting, the system of accounting that divides revenue and costs into area of
personal responsibility in order to monitor and assess the performance of each part of an
organisation.
xii | MANAGEMENT ACCOUNTING
LEARNING OBJECTIVES
MANAGEMENT ACCOUNTING
CPA Australia's learning objectives for this Study Manual are set out below. They are cross-referenced
to the chapter in the Study Manual where they are covered.
This exam covers an understanding of developments in management accounting and the tools
management accountants use to cost products and services, and to develop and manage budgets. It
also covers performance management and control; planning and assessment of project alternatives;
and an understanding of the nature, functions, structures and operations of management.
CHAPTER(S)
WHERE
COVERED
Topics
LO1. Conceptual issues and behavioural implications
LO1.1
Explain the historical development of management accounting
LO1.2
Analyse the key differences between financial, cost and management

accounting
LO1.3
Describe how management accounting creates value
LO1.4
Analyse the current influences on management accounting
LO1.5
Explain the range of theories that underpin management accounting

and how they have an influence on practice
LO1.6
Outline the core parts of management accounting systems and how

they enable strategic management
LO1.7
Analyse the roles of management accountants in cross-functional

teams
LO1.8
Identify and explain appropriate internal controls for management

and accounting systems in a range of situations
12
LO1.9
Explain how organisational behaviour can impact the creation of

organisational value
LO1.10
Describe the increasing awareness of sustainability and its relationship

to management accounting
LO2. Decision making

LO2.1
Apply the steps in the decision making process
2.1.1 define the problem

2.1.2 identify the decision making criteria
2.1.3 develop alternatives
2.1.4 analyse alternatives
2.1.5 select an alternative
LO2.2
Apply relevant information guidelines for short-term alternative choice

operating decisions
LO2.3
Identify the quantitative and qualitative criteria involved in accepting a

project
10
LO2.4
Analyse the challenges posed by differences between a project and

an organisations risk profiles
10
LO2.5
Explain the impact of cash flows and risks on project decision making
2, 10
INTRODUCTION | xiii
CHAPTER(S)
WHERE
COVERED
Topics
LO3. Budgeting
LO3.1
Identify and analyse the human behavioural challenges to the

budgeting process in organisations
LO3.2
Explain the nature of budgets and the reasons that organisations use
budgets
LO3.3
Prepare an operations budget
LO3.4
Prepare a cash budget
LO4. Cost behaviour

LO4.1
Describe the nature of costs and their behaviour
2, 4
LO4.2
Apply relevant techniques to separate costs into their fixed and

variable components
3, 4
LO4.3
Apply the principles of cost-volume-profit analysis in organisations
LO5. Overhead costing product and service costing

LO5.1
Explain key methods of departmental overhead allocation
LO5.2
Explain the concepts underpinning product costing in organisations
LO5.3
Develop different product costing statements involving production

resource costs
LO5.4
Evaluate the difference between direct production costs and indirect

overhead costs
LO5.5
Apply the principles of absorption and variable costing to product

costing analysis
LO6. Overhead costing activity based costing

LO6.1
Identify and apply the principles of activity based costing to allocate

overheads in organisations
LO7. Process and job costing

LO7.1
Explain the differences between job and process costing techniques
LO7.2
Apply costing principles to job costing and process costing

organisations
LO8. Standard costing

LO8.1
Explain how standard costing can be used to assist in cost control and
efficient resource allocation
LO9. Variance analysis

LO9.1
Define and describe a variance
LO9.2
Explain the causes of variances and associated corrective actions
LO9.3
Calculate a variance
xiv | MANAGEMENT ACCOUNTING
CHAPTER(S)
WHERE
COVERED
Topics
LO10. Capital expenditure
Analyse capital expenditure decisions in organisations using relevant
tools and techniques
Apply capital expenditure analysis to project planning and managing
LO10.2
uncertain scenarios through scenario analysis
LO11. Inventory and pricing decisions
LO10.1
LO11.1
Evaluate the principles of just-in-time
Apply the economic order quantity formula to determine order

quantities for inventory management
Establish and apply the appropriate approach for long-term pricing
LO11.3
decisions
LO12. Performance measurement and evaluation
LO11.2
10
10
11
11
11
LO12.1
Explain the characteristics and purpose of performance measurement

systems
12
LO12.2
Analyse the different types of financial performance measures and

their limitations
12
LO12.3
Describe the key characteristics of the Balanced Scorecard and its

advantages over traditional performance measurement systems
12
LO12.4
Outline the characteristics of reward systems and the circumstances in

which they can be tied to performance measures
12
Exam topic weightings

1
Conceptual issues and behavioural implications
7%
Decision making
13%
Budgeting
10%
Cost behaviour
15%
Overhead costing product and service costing
13%
5%
5%
Standard costing
5%
Variance analysis
5%
10
Capital expenditure
5%
11
Inventory and pricing decisions
5%
12
12%
TOTAL
100%
CHAPTER 1
THE NATURE AND PURPOSE
OF MANAGEMENT
ACCOUNTING
Learning objectives
Reference
LO1
Explain the historical development of management accounting
LO1.1
Analyse the key differences between financial, cost and management accounting
LO1.2
Describe how management accounting creates value
LO1.3
Analyse the current influences on management accounting
LO1.4
Explain the range of theories that underpin management accounting and how they
have an influence on practice
LO1.5
Outline the core parts of management accounting systems and how they enable
strategic management
LO1.6
Analyse the roles of management accountants in cross-functional teams
LO1.7
Explain how organisational behaviour can impact the creation of organisational value
LO1.9
Describe the increasing awareness of sustainability and its relationship to management

accounting
LO1.10
Decision making
LO2
Apply the steps in the decision making process
LO2.1
define the problem
LO2.1.1
identify the decision making criteria
LO2.1.2
develop alternatives
LO2.1.3
analyse alternatives
LO2.1.4
select an alternative
LO2.1.5
Topic list
1
2
3
4
5
6
7
8
The management accounting function

Financial accounting and management and cost accounting
Planning, control and decision-making
Information
Management accounting systems
Design of management accounting systems
Developments in management accounting
Sustainability and management accounting
2 | MANAGEMENT ACCOUNTING
INTRODUCTION
This chapter provides an introduction to Management Accounting.
We begin this first chapter by looking at the role of the management accounting function.
We then examine the differences between management accounting and financial accounting and
introduce cost accounting.
The chapter goes on to look at the importance of information provided by the management
accountant in planning, control and decision making. It also briefly looks at the design and
development of management accounting systems.
This chapter discusses the limitations of some of the traditional methods of management accounting,
and considers how recent developments in management accounting attempt to overcome these
limitations.
Finally we examine the management accountant's role in the creation of organisational value and the
relationship between sustainability and management accounting.
The chapter content is summarised in the diagram below.
The nature and

purpose of
management accounting
Information
Presentation of
information to
management
Planning, control
and decision
making
Management
accounting
systems
Financial accounting and cost

and management accounting
Design of management
accounting systems
Developments in management
accounting
The management
accounting function
THE NATURE AND PURPOSE OF MANAGEMENT ACCOUNTING | 3
If you have studied these topics before, you may wonder whether you need to study this chapter in
full. If this is the case, please attempt the questions below, which cover some of the key subjects in the
area.
If you answer all these questions successfully, you probably have a reasonably detailed knowledge of
the subject matter, but you should still skim through the chapter to ensure that you are familiar with
everything covered.
There are references in brackets indicating where in the chapter you can find the information, and you
will also find a commentary at the back of the Study Manual.
1 What are the differences between financial accounts and management accounts?
(Section 2.2)
2 What are the differences between cost accounting and management accounting?
(Section 2.3)
3 Explain the link between an organisation's objectives and its strategy.

4 Identify steps involved in the decision making process.
(Section 3.2)
(Section 3.6.1)
5 What are the three types of management activity identified by Anthony

(Management Control Systems, 1972)?
(Section 3.7)
6 What are the basic elements of a management control system?
(Section 3.8)
7 What is the difference between data and information?
(Section 4.1)
8 List the qualities of good information.
(Section 4.2)
9 What are the main features of a report?
(Section 4.5)
10 What are the risks of using traditional management accounting methods?
(Section 5.4)
11 What are the components of a management accounting system?
(Section 5.2)
12 Define and explain Just-In-Time (JIT).
(Section 7.1)
13 Define and explain Total Quality Management (TQM).
(Section 7.2)
14 Define and explain Kaizen.
(Section 7.3)
CHAPTER 1
BEFORE YOU BEGIN
1 THE MANAGEMENT ACCOUNTING FUNCTION

Section overview
The role of the management accounting function as an information provider has developed
with advances in technology. To assess the effectiveness of the management accounting
function, a clear understanding is needed of its objectives and activities, so that
appropriate measures of performance can be determined.
We will now look at the role and objectives of the management accounting function and how its
performance should be measured.
1.1 ROLE OF THE MANAGEMENT ACCOUNTING FUNCTION

The role of the management accountant is to provide information to decision makers, and to provide
advice based on that information. The information provided by management accounting covers all
areas of strategy and operations, and includes information to assist with planning, control and
decision-making by management.
The role of the management accountant today is more concerned with providing complex analysis
and information to support business management than with providing routine reports, since much
routine work is now computerised. At the same time the areas covered by management accounting
have extended to include strategic information and non-financial information, and information to
support risk management. Developments in technology have also made it easier to provide
accounting information to non-financial managers.
1.1.1 THE DEVELOPMENT OF MANAGEMENT ACCOUNTING INFORMATION

LO
1.1
In the 1950s Simons identified three attributes of what could by now be called management
accounting information:
It should be useful for scorekeeping to see how well the organisation is doing overall and to
monitor performance.
It should be attention-directing to indicate problem areas that need to be investigated.
It should be useful for problem-solving to provide a means of evaluating alternative responses
to the situations in which the organisation finds itself.
Management accounting information is therefore used by managers for a number of purposes:
To make decisions.
To plan for the future. Managers have to plan and they need information to do this. Much of this is
provided by management accounting systems.
To monitor the performance of the business. Managers need to understand how they are
performing against goals and targets.
To measure profits and put a value on inventory.
To implement processes and practices that focus on effective and efficient use of organisational
resources to support managers to enhance customer and stakeholder value (IFAC 2002)
LO
1.7
In some organisations, the cost and management accounting function may be organised as a
functional section or department within the organisation. However, because management accountants
provide information to other managers, it has become fairly common to include management
accountants within cross-functional teams, or to assign them to work with non-accounting functions. A
cross-functional team is a small group of individuals, with different expertise, taken from many
different parts and levels of an organisation, which comes together to work towards a common
purpose or goal. The size of each team will vary according to the scale and complexity of the project.
Cross-functional teams are typically formed on the assumption that a small group is better for a
particular task than either individuals acting alone or in a large, permanently structured group.
Benefits of cross-functional teams include:
improved coordination and integration of systems or activities
problem-solving across traditional functional or organisational boundaries
facilitate innovation and product/service development
In addition to contributing their technical expertise as accounting and finance experts and their
functional expertise as information providers, management accountants have a key role to play in
helping maximise the potential of a cross-functional team by:
providing, collecting and assessing critical team information;
helping establish goals and set priorities;
assisting with problem-solving and decision-making, through the application of decision-making
models and other techniques
ensuring the team maintains an organisation-wide perspective.
1.3 DEFINING OBJECTIVES OF THE MANAGEMENT ACCOUNTING

FUNCTION
The objectives of the management accounting function should depend on the information needs of
the 'internal customers' the managers within an organisation who need information to help them to
run the business. The overall objective should be the provision of quality service and decision making
information. This broad objective can be analysed into a number of sub-objectives.
SUB-OBJECTIVE
DETAIL
The provision of good

information
This requires supplying information that fulfils the following criteria.

Information must be relevant to the needs of users. This involves identifying
the users of information and the reasons why they need it. Information can
only ever be relevant if it has a purpose and a use.
Information should be reliable. It should be sufficiently accurate for its
purpose. For example it should be free from material error and should not be
taken from an unreliable source. Unless information is reliable, management
will not have sufficient confidence to use it.
Information should be timely, which means that it should be provided in time
for the purpose for which it is intended. Information has no value if it is
provided too late. Some information, such as information provided for control
purposes, may lose value with time.
Information should be clear, comprehensible and appropriately
communicated, since it will lose its value if it is not clearly communicated to
the user in a suitable format and medium. A large amount of management
accounting information should be accessible immediately and on-line to
authorised managers.
The provision of a value-formoney service
The costs of management accounting should be justified by the benefits that

the function provides to the organisation, and the level of service and the
quality of information provided.
The availability of informed

personnel
Users will expect management accounting staff to be available to answer

queries and resolve problems as and when required.
CHAPTER 1
1.2 ROLE OF THE MANAGEMENT ACCOUNTANT IN CROSSFUNCTIONAL TEAMS
1.4 MANAGEMENT ACCOUNTING FUNCTION ESTABLISHING

ACTIVITIES
Once the objectives have been defined, the activities that the function should carry out to achieve its
objectives must be established. This is why it is necessary to answer the question:
'What information do we want, or might we want?'
The specific information that a management accounting system needs to provide (and the timing or
accessibility of this information) will vary between organisations, according to factors such as the
nature of their business and their size. The management accounting function should be organised and
staffed so that it is able to provide the information expected from it.
A follow-up question is:
'What type and size of function do we need to provide this information, and what will it cost?'
Management, as users of information, should therefore understand what information they are getting,
and what it is costing to get it.
1.5 MANAGEMENT ACCOUNTING FUNCTION IDENTIFYING

PERFORMANCE MEASURES
The performance of the management accounting function should be measured according to its
objectives and its specified activities. Suitable specific performance measures might be as follows:
a. Measures relating to the quality of the information provided. Quality measures may be based on
the judgement of users, such as opinions about whether the information provided is useful, timely
and reliable.
b. Measures relating to value for money. The cost of the function should be measurable. It may be
possible to compare the cost with other information provision services within the organisation or in
different organisations. The benefits are not so easy to assess, but management need to be
satisfied that they are getting value for money.
c. Measures relating to the availability of accounting staff to assist management, such as the
amount of time the accounting staff spend with managers in other functions, and the speed of
their response to requests for information, advice or assistance.
d. Measures relating to flexibility, such as delivery in accordance with the service levels agreed with
business units to meet needs for ad-hoc reporting.
e. Ratings provided from user satisfaction surveys would provide extremely useful measures of
performance. 'Users' are the 'internal customers' for the management information.
f. Measure of management accounting service:
i. Timeliness of reports
ii. Attendance/contribution at management meetings/forums
iii. Management accounting involvement in strategic projects
Section overview
Financial accounting systems ensure that the assets and liabilities of a business are properly
accounted for, and provide information about profits and historical financial performance to
shareholders and to external stakeholders such as ATO and ASIC; and other interested
parties including interest groups, potential shareholders, unions and NGOs.
Management accounting systems provide information specifically for the use of managers
within an organisation. Corporate Performance Management (CPM) software and Business
Intelligence (BI) software are management accounting tools used by management
accountants.
Cost accounting is part of management accounting. The purpose of cost accounting is to
determine the cost of products and services.
2.1 FINANCIAL ACCOUNTS AND MANAGEMENT ACCOUNTS

LO
1.2
accounted for. They are used to provide information to shareholders and other interested parties in
the form of (published) financial statements. Management accounting systems provide information
specifically for the use of managers within an organisation.
Management information provides a common source from which information for two groups of
people is drawn.
a. Financial accounts are prepared for individuals external to an organisation: for example
shareholders, customers, suppliers, regulatory authorities, employees.
b. Management accounts are prepared for internal use by managers of the organisation.
Much of the data used to prepare financial accounts and management accounts are the same but
differences between the financial accounts and the management accounts arise because the data are
analysed differently. In addition, management accounting systems draw on a wider range of data,
including non-financial data, data from external sources, and data relating to the future.
2.2 FINANCIAL ACCOUNTS VERSUS MANAGEMENT ACCOUNTS

Management accountants and financial accountants perform different parts of the accounting
function. The table below shows the differences between the two areas of accounting.
FINANCIAL ACCOUNTS
MANAGEMENT ACCOUNTS
Financial accounts detail the performance of an

organisation over a defined period and the state of
affairs at the end of that period. Financial accounts
provide information to third parties.
Management accounts are used to aid management

record, plan and control the organisation's activities and
to help the decision-making process. The information in
management accounts can measure the organisation's
activities against its strategic objectives.
Limited liability companies must, by law, prepare

financial accounts.
There is no legal requirement to prepare management

accounts.
The format of published financial accounts is

determined by local law, by International Accounting
Standards and International Financial Reporting
Standards. In principle the accounts of different
organisations can therefore be easily compared.
The format of management accounts is entirely at

management discretion: no strict rules govern the way
they are prepared or presented. Each organisation can
devise its own management accounting system and
format of reports.
Financial accounts concentrate on the business as a

whole, aggregating revenues and costs from different
operations, and are an end in themselves.
Management accounts can focus on specific areas of an

organisation's activities. Information may be produced
to aid a decision rather than as the end product of a
decision.
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2 FINANCIAL ACCOUNTING AND MANAGEMENT

AND COST ACCOUNTING
FINANCIAL ACCOUNTS
MANAGEMENT ACCOUNTS
Most financial accounting information is of a

monetary nature.
Management accounts incorporate non-monetary

measures. Management may need to know, for example,
tons of aluminium produced, monthly machine hours, or
miles travelled by sales staff.
Financial accounts present an essentially historic

picture of past operations.
Management accounts are both an historical record and

a future planning tool.
Question 1: Management accounts

Which of the following statements about management accounts is/are true?
I There is a legal requirement to prepare management accounts
II The format of management accounts is largely determined by law
III They serve as a future planning tool and are not used as a historical record
A III only
B I and II only
C II and III only
D none of the statements are correct
(The answer is at the end of the chapter)
2.3 COST ACCOUNTS

The terms 'cost accounting' and 'management accounting' are often used interchangeably. It is not
correct to do so. Cost accounting is part of management accounting. Cost accounting provides
source data for the management accountant to use.
Cost accounting is concerned with:
Preparing cost estimates of new and current products
Cost data collection
Measuring inventory costs including raw materials, work-in-progress and finished goods, and the
costs and profitability of products and services.
Management accounting on the other hand is concerned with:
Interpretation and assessment of financial, accounting and operational data, and communicating
it as information to users, for example as financial targets or performance measurements.
2.3.1 USES OF COST ACCOUNTS

Cost accounting is used to measure:
a. The cost of goods produced or services provided.
b. The cost of a department or business unit.
c. The revenues earned from a product, service, department or business unit, or the organisation in
total.
d. The profitability of a product, a service, a department, or the organisation in total.
e. Selling prices with some regard for the costs of sale.
f. The value of inventories of goods (raw materials, work in progress, finished goods) that are still
held in store at the end of a period, thereby aiding the preparation of a statement of financial
position of the company's assets and liabilities.
g. Future costs of goods and services, based on given assumptions about what will happen in the
future. Costing is an integral part of budgeting, because budgets are detailed financial plans.
h. How actual costs compare with budgeted costs. If an organisation plans for its revenues and
costs to be a certain amount, but they actually turn out differently, the differences (variances) can
be measured and reported. Management can use these reports as a guide to whether corrective
action, or 'control' action, is needed to sort out a problem. This system of control is often referred
to as budgetary control or variance analysis.
3 PLANNING, CONTROL AND DECISION-MAKING

Section overview
Management information is used for planning, control and decision making.
Long-term planning, also known as corporate or strategic planning, involves selecting
appropriate strategies to prepare a long-term plan to attain the organisation's objectives.
Robert N Anthony (Management Control Systems, 1972) has categorised management
activities and decision-making into strategic planning, management control and
operational control.
A management control system is a system which measures and corrects the performance of
activities of subordinates.
Information within an organisation can be analysed into the three levels of Anthony's
hierarchy: strategic; tactical; and operational information.
3.1 PLANNING
LO
1.9
Planning forces management to think ahead systematically in both the short term and the long term.
Planning involves the following:
Establishing overall objectives.
Selecting appropriate strategies to achieve those objectives.
Setting targets for each strategy.
Formulating detailed plans for achieving those targets.
When expected changes are gradual, planning occurs in a fairly stable environment, and routine
budget planning procedures may be used.
3.2 OBJECTIVES OF ORGANISATIONS

Definitions
A vision is a succinct statement of an organisation's future aspirations.
A mission statement sets out an organisation's fundamental purpose.
An objective is the aim or goal of an organisation.
A strategy is a possible course of action that might enable an organisation to achieve its objectives.
Organisations often start by setting out their vision. This is a succinct statement of the organisation's
future aspirations e.g. Microsoft's vision is 'to help people and businesses throughout the world
realise their full potential'.
A mission statement is then created, setting out the organisation's fundamental purpose and
including references to its strategy, standards of behaviour and values.
The mission sets the overall direction of the organisation and the organisation's goals and more
detailed objectives then follow from this. The strategies identified as a result of the planning process
are designed to achieve these objectives.
CHAPTER 1
Cost accounting systems are not restricted to manufacturing operations, although they are probably
more fully developed in this area. Service industries, government departments and non-profit making
organisations all make use of cost accounting information. Within a manufacturing organisation, the
cost accounting system should be applied not only to manufacturing but also to administration, selling
and distribution, research and development and all other departments and functions.
Note that in practice, the terms objective, goal and aim are often used interchangeably.
The two main types of organisation that you are likely to come across in practice are as follows:
Profit making
Non-profit making
It is often assumed that the main objective of profit making organisations is to maximise profits. A
secondary objective of profit making organisations might be growth, for example by increasing the
output and sales of its goods/services. Instead of maximising profit, an organisation may seek to
maximise the wealth of its shareholders. Unfortunately, the aim of profit maximisation may encourage
decisions that compromise the long term viability of the business in the attempt to maximise
immediate profit outcomes.
The main objective of non-profit making organisations is usually to provide goods and services. A
secondary objective of these organisations might be to minimise the costs involved in providing the
goods/services.
The stated objectives of an organisation might include one or more of the following:
Maximise profits
Maximise revenue
Maximise shareholder value
Increase market share
Minimise costs
Management accounting techniques often assume one of these objectives when recommending a
course of action to management. Remember however that decisions have consequences for the
longer term as well as the short term, and decisions to maximise profit may have high associated risks.
3.3 LONG-TERM STRATEGIC PLANNING

Management accounting contributes to long-term strategic planning. Long-term planning, also known
as corporate planning, involves selecting appropriate strategies to attain the organisational
objective, and integrating these strategies into an overall long-term corporate or strategic business
plan.
The time span covered by a long-term plan depends on the organisation, the industry in which it
operates and the particular environment involved. Typical periods for a strategic business plan are 2,
5, 7 or 10 years although longer planning periods may be used.
Long-term strategic planning consists of four basic elements:
assess the organisation and its environment
determine the corporate objectives
devise strategies for achieving these objectives
create a corporate plan
The diagram below provides an overview of the process and shows the link between short-term and
long-term planning.
3.4 SHORT-TERM TACTICAL PLANNING

The corporate or strategic plan serves as the long-term framework for the organisation as a whole.
For operational purposes it is necessary to convert the corporate (strategic) plan into a series of shortterm plans, usually covering one year, which relate to business units, functions or departments. The
annual process of short-term planning should be seen as stages in the progressive fulfilment of the
corporate plan. Each short-term plan steers the organisation towards its long-term objectives. It is
therefore vital that, to obtain the maximum advantage from short-term planning, some form of longterm plan exists.
The management accounting function supports the short-term planning process, for example by
providing information for setting targets and standards, and helping to establish the assumptions on
which the short-term plan is based, such as growth rates, costs, efficiency savings and cost inflation.
The planning process

Assess the
external
environment
Assess the
organisation
Assess the
future
Assess
expectations
CHAPTER 1
THE
ASSESSMENT
STAGE
Evaluate
corporate
objectives
THE
OBJECTIVE
STAGE
THE
EVALUATION
STAGE
Consider
alternative
ways of achieving
objectives
THE
CORPORATE
PLAN
Agree a
corporate
plan
Production
planning
Resource
planning
Product
planning
LONGTERM
STRATEGY
PLANNING
Research and
development
planning
SHORTTERM
PLANNING
Detailed operation plans which implement the corporate plan on a monthly,

quarterly or annual basis. Operational plans include short-term budgets,
standards and objectives.
3.5 CONTROL
As well as providing information for planning, management accounting also provides information to
assist with monitoring and control. There are two stages in the control process.
a. The planned performance of the organisation (set out as targets or expectations in the detailed
operational plans) is compared with the actual performance of the organisation on a regular and
continuous basis. Significant deviations from the plans can then be identified and appropriate
corrective action can be taken where possible.
b. The corporate (strategic) plan is reviewed in the light of the comparisons made and any changes
in the parameters on which the plan was based, (such as new competitors, government instructions
and so on), to assess whether the objectives of the plan can be achieved. The plan is modified to
ensure the organisation's future success.
Effective control is not practical without planning, and planning and control are interrelated. Targets
and objectives will not be achieved without monitoring and control measures when needed.
An established organisation should have a system of management reporting that produces control
information in a specified format at regular intervals.
Smaller organisations may rely on informal information flows or ad-hoc reports being produced as
required.
3.6 DECISION-MAKING
LO
2.1
A function of management is decision-making. Managers at all levels within an organisation make

decisions, both long term and short term, and routine and occasional. It is the role of the
management accountant to provide information so that management can reach an informed decision.
Decision making always involves a choice between alternative courses of action. For example, when
comparing actual results against a target, if actual results are poor, management needs to decide
whether corrective action should be taken. This may involve considering the different ways in which
control may be applied, and choosing the preferred course of action from the available alternatives.
Budgeting decisions involve a choice between different ways of using the organisation's scarce
resources (such as cash, equipment and manpower).
It is vital that management accountants understand the decision-making process so that they can
supply the appropriate type of information.
3.6.1 DECISION-MAKING PROCESS

It is possible to analyse the decision-making process into a sequence of steps. These apply whether
the decision is taken immediately, or whether the matter is carefully considered before a decision is
reached. These steps are shown below:
LOs
2.1.1
2.1.2
2.1.3
2.1.4
2.1.5
Define the problem
Identify decision-making criteria

(goals & objectives)
Develop alternative solutions/

opportunities which might
contribute towards achieving
them.
PLANNING
Collective and analyse relevant

data about each alternative.
Select an alternative
State the expected outcome
and check that the expected
outcome is in keeping with
the overall goals or objectives.
Implement the decision.
The sequence of steps can be applied to form decision making. Note the role of relevant and reliable
information is critical to the decision making process.
Define the problem. A decision is made only when a problem is recognised. If a manager is
unaware that a problem exists, they will not feel the need to make any decision. A workflow for
decision making has been set out above.
Identify the decision-making criteria. Having recognised that there is a problem for which a
decision must be made, the next step is to recognise the decision-making criteria. What are we
trying to achieve? In the planning process, the criteria may be to maximise profits over the next 12
months, given the available resources and subject to limitations on the risks that should be taken.
The criterion for control decisions may be to reduce excessive spending. In management
accounting, the decision-making criterion is often to maximise profitability, but as explained
earlier, consideration must be given to the longer term and risk.
Analyse the alternatives. Each of the alternatives should be analysed and evaluated. If the
decision-making criterion is to maximise short-term profit, each alternative should be evaluated
financially, to estimate the profit that would result from choosing that alternative. Although a
management decision is often based on financial considerations, other non-financial factors may
also be considered if they are a part of the decision-making criteria.
Select an alternative. A decision involves selecting one alternative from the two or more that have
been analysed. The recommended choice should satisfy the goals of the organisation.
These steps in the decision-making process should be apparent in later chapters, when specific
management accounting techniques for analysis are described.
3.7 ANTHONY'S (1972) VIEW OF MANAGEMENT ACTIVITY

LO
1.5
Author Robert N Anthony (Management Control Systems, 1972) divided management activities into
three levels: strategic planning, management control and operational control. This is sometimes
known as the Anthony hierarchy.
a. Strategic planning is 'the process of deciding on the objectives of the organisation, on changes in
these objectives, on the resources required to attain these objectives, and on the policies that are
to govern the acquisition, use and disposition of these resources'.
b. Management control is 'the process by which managers assure that resources are obtained and
used effectively and efficiently in the accomplishment of the organisation's objectives'.
c. Operational control is 'the process of assuring that specific tasks are carried out effectively and
efficiently'.
A management accounting system provides information to management for strategic planning and
management control, and for some aspects of operational control.
3.7.1 STRATEGIC PLANNING

Strategic plans are those which set or change the objectives, or strategic targets, of an
organisation. They would include such matters as the selection of products and markets, the required
levels of company profitability and the purchase and disposal of subsidiary companies or major noncurrent assets.
3.7.2 MANAGEMENT CONTROL

While strategic planning is concerned with setting objectives and strategic targets, management
control is concerned with decisions about the efficient and effective use of an organisation's
resources to achieve these objectives or targets.
(a) Efficiency in the use of resources to achieve optimum output from the input resources used. It
relates to the combinations of labour, land and capital (for example, how much production work
should be automated) and to the productivity of labour, or material usage.
(b) Effectiveness in the use of resources to create the outputs that are in line with the intended
objectives or targets.
CHAPTER 1
Develop alternatives. The next step is to recognise different ways in which the problem might be
resolved in a way that is consistent with the decision-making criteria. For a simple decision, there
may be just two alternatives 'Do it', or 'Don't do it.' However there may be a number of different
alternatives, and the process of developing alternatives involves:
recognising the range of possible options and
from these, selecting a small number of alternatives for evaluation.
3.7.3 OPERATIONAL CONTROL

The third, and lowest tier, in Anthony's hierarchy of decision making, consists of operational control
decisions. Operational control is about ensuring that specific tasks are carried out effectively and
efficiently. Just as 'management control' plans are set within the guidelines of strategic plans,
'operational control' plans are set within the guidelines of both strategic planning and management
control. Consider the following:
a. Senior management may decide that the company should increase sales by five per cent per
annum for at least five years a strategic plan.
b. The sales director and senior sales managers will make plans to increase sales by five per cent in
the next year, with some provisional planning for future years. This involves planning direct sales
resources, advertising, sales promotion and so on. Sales quotas are assigned to each sales territory
a tactical plan (management control).
c. The manager of a sales territory specifies the weekly sales targets for each sales representative.
This is operational planning. Individuals are given tasks which they are expected to achieve.
Although we have used an example of selling to describe operational control, it is important to
remember that this level of planning occurs in all aspects of an organisation's activities, even nonstandard activities, such as repair work or answering customer complaints.
The scheduling of unexpected or ad-hoc work must be done at short notice, which is a feature of
much operational planning. In the repairs department, for example, routine preventive maintenance
can be scheduled, but breakdowns occur unexpectedly and unplanned repair work must be done 'on
the spot' by a repairs department supervisor.
3.8 MANAGEMENT CONTROL SYSTEMS

A management control system is a system which measures and corrects the performance of activities
of subordinates in order to make sure that the objectives of the organisation are being met and the
plans devised to attain them are being carried out.
The basic elements of a management control system are as follows:
Planning what to do and identifying the desired results.
Recording the plan which should incorporate standards of efficiency or targets.
Carrying out the plan and measuring actual results achieved.
Comparing actual results against the plans.
Evaluating the comparison, and deciding whether further action is necessary.
Where corrective action is necessary, this should be implemented.
Information to assist with this process is needed for recording the plan, comparing actual results
against the plan and evaluating the comparison. The information is often financial or partially financial
in nature, although it will include non-financial information too. This is why management accounting,
by providing information of both a financial and non-financial nature, should be an integral part of a
management control system.
3.9 TYPES OF INFORMATION

Information within an organisation can be analysed into the three levels assumed in Anthony's
hierarchy: strategic; tactical; and operational information.
3.9.1 STRATEGIC INFORMATION

Strategic information is used by senior managers to plan the objectives of their organisation, and to
assess whether the objectives are being met in practice. Examples of such information include overall
profitability, the profitability of different segments of the business, capital equipment needs and so
on.
Strategic information therefore has the following features:

It is derived from both internal and external sources.
It is summarised at a high level, and is directed at senior management.
It is relevant to the long term.
It is often prepared on an ad-hoc basis.
It is both quantitative and qualitative.
It cannot provide complete certainty, given that the future cannot be predicted.
3.9.2 TACTICAL INFORMATION

Tactical information is used by middle management to decide how the resources of the business
should be employed, and to monitor how they are being and have been employed. Such information
includes productivity measurements (output per direct labour hour or per machine hour), budgetary
control or variance analysis reports, and cash flow forecasts.
Tactical information has the following features:
It is primarily generated internally.
It is summarised at a lower level and is directed at middle management as well as more senior
management.
It is relevant to the short and medium term.
It describes or analyses activities or departments.
It is prepared routinely and regularly.
It is based largely on quantitative measures.
It allows the monitoring of business performance against goals.
3.9.3 OPERATIONAL INFORMATION

Operational information is used by 'front-line' managers, such as foremen and supervisors, to ensure
that specific tasks are planned and carried out properly. In the payroll office, for example, information
at this level will relate to day-rate labour and will include the hours worked each week by each
employee, the rate of pay per hour, details of deductions, and for the purpose of wages analysis,
details of the time each person spent on individual jobs during the week. In this example, the
information is required weekly, but more urgent operational information, such as the amount of raw
materials being input to a production process, may be required daily, hourly, or in the case of
automated production, second by second.
Operational information has the following features:
It is derived almost entirely from internal sources.
It is highly detailed, being the processing of raw data.
It relates to the immediate term, and is prepared constantly, or very frequently.
It is task-specific and largely quantitative.
4 INFORMATION
Section overview
Data is the raw material for data processing. Data relates to facts, events and transactions.
Information is data that has been processed so as to be meaningful.
Good information is relevant, complete, accurate and clear. It inspires confidence, is
appropriately communicated, its volume is manageable, it is timely to produce and it costs
less to produce than the benefits it provides.
CHAPTER 1
It deals with the whole organisation.
4.1 DATA AND INFORMATION

Definitions
Data is the raw material for data processing. Data relates to facts, events and transactions.
Information is data that has been processed so as to be meaningful to the person who receives it.
Information is knowledge communicated or received concerning facts or circumstances.
Information is sometimes referred to as processed data. The terms 'information' and 'data' are often
used interchangeably. It is important to understand the difference between these two terms.
For example, researchers who conduct market research surveys might ask members of the public to
complete questionnaires about a product or a service. These completed questionnaires are data; they
are processed and analysed in order to prepare a report on the survey. This resulting report is
information and may be used by management for decision-making purposes.
Management accounting systems provide information, and the quality of the management accounting
system depends on the quality of the information that it provides.
4.2 QUALITIES OF GOOD INFORMATION

Good information is relevant, complete, accurate and clear. It inspires confidence, is appropriately
communicated and its volume is manageable. It is timely and its cost to produce is less than the
benefits it provides.
Let us look at those qualities in more detail.
a. Relevance. Information should have a purpose; otherwise there is unlikely to be sufficient benefit
from processing data to justify the cost of providing it. Information must be relevant to the purpose
for which a manager wants to use it.
b. Completeness. Information users should have all the information they need to do the job properly.
If they do not have a complete picture of the situation, they might well make bad decisions.
c. Reliability. Information should be reliable. This means that it should be sufficiently accurate for its
purpose. Using incorrect information could have serious and damaging consequences. However,
there is no need to go into unnecessary detail. Where there is some uncertainty about the accuracy
or reliability, for example when making forecasts about the future, the nature of the uncertainty
should be fully understood, so that the information is used and treated with caution.
d. Clarity. Information must be clear to the user. If the user does not understand it properly they will
not be able to use it properly. Lack of clarity is one of the causes of a breakdown in
communication. It is therefore important to choose the most appropriate presentation medium or
channel of communication.
e. Confidence. Information must be trusted by the managers who are expected to use it. However
not all information is certain. Some information has to be certain, especially operating information,
for example, related to a production process. Strategic information, especially relating to the
environment, is uncertain. However, if the assumptions underlying it are clearly stated, this might
enhance the confidence with which the information is perceived. Having confidence in information
depends on other qualities of the information reliability, relevance and clarity.
f. Communication. Within any organisation, individuals are given the authority to do certain tasks,
and they must be given the information they need to do them. For example, an office manager
might be made responsible for controlling expenditure in the office, and given a budget
expenditure limit for the year. As the year progresses, they might try to keep expenditure in check
but unless they are told throughout the year what current total expenditure is to date, they will find
it difficult to judge whether they are keeping within budget or not.
g. Volume. There are physical and mental limitations to what a person can read, absorb and
understand properly before taking action. An inappropriate amount of information, even if it is all
relevant, cannot be handled. Reports to management must therefore be clear and concise and in
h. Timing. Information should be timely. If it is not available until after a decision is made, it will be
useful only for comparisons and longer-term control. Information prepared too frequently can be a
serious disadvantage. If, for example, a decision is taken at a monthly meeting about a certain
aspect of a company's operations, information to make the decision is only required once a month,
and weekly reports would be a time-consuming waste of effort.
i. Channel of communication. Information should be communicated or should be accessible
through appropriate channels of communication. There are occasions when using one particular
method of communication will be better than others. Some internal memoranda may be better
sent by 'electronic mail'. Some information is best communicated informally by telephone or
word-of-mouth, whereas other information ought to be formally communicated in writing or
figures. Electronic methods of data transmission, data storage and data access are integral parts of
most management accounting systems.
j. Cost. Information should have some value, otherwise it would not be worth the cost of collecting
and filing it. The benefits obtainable from the information must also exceed the costs of acquiring
it. Whenever management is trying to decide whether or not to produce information for a
particular purpose, for example, whether to computerise an operation or to build a financial
planning model, a cost/benefit analysis ought to be undertaken.
k. Comparability. Information needs to be measured and reported in a similar manner so that
meaningful comparisons can be made over time.
Question 2: Value of information
Managers receive a monthly performance report indicating that costs in the previous month were 15%
more than expected. Which one of the following would be the most appropriate response by
management to this information?
A Control action should be taken to deal with the problem and reduce costs by 15%.
B The overspend indicates that planning targets will not be met, and forecasts should be revised.
C The reasons for the overspend may be controllable; therefore they should be investigated with a
view to reducing the overspend as much as possible.
D The reasons for the overspend may be controllable or uncontrollable; therefore they should be
investigated with a view either to reducing the overspend as much as possible or revising forecasts
or targets.
4.3 WHY IS INFORMATION IMPORTANT?

Information is important for management because it provides awareness and understanding of an
issue. By helping management to make better-informed decisions, information should contribute
significantly to better-quality decision-making. Consider the following problems and what
management needs to solve these problems.
a. A company wishes to launch a new product. The company's pricing policy is to charge cost plus
20%. What should the price of the product be?
b. An organisation's widget-making machine has a fault. The organisation has to decide whether to
repair the machine, buy a new machine or hire a machine. What does the organisation do if its aim
is to control costs?
c. A company is considering offering a discount of 2% to those customers who pay an invoice within
seven days of the invoice date and a discount of 1% to those customers who pay an invoice within
eight to fourteen days of the invoice date. How much will this discount offer cost the company?
CHAPTER 1
many systems, control action works basically on the 'exception' principle, with reports only being
produced if there is an issue that needs to be brought to management attention or investigated
further .
In solving these and a wide variety of other problems, management needs information.
a. In problem (a) above, management would need information about the cost of the new product.
b. Faced with problem (b), management would need information on the cost of repairing, buying and
hiring the machine.
c. To calculate the cost of the discount offer described in (c), information would be required about
current sales settlement patterns and expected changes to the pattern if discounts were offered.
The successful management of any organisation depends on information: organisations in the public
sector, such as hospitals and local authorities and other non-profit making organisations such as
charities and clubs need information for decision making and for reporting the results of their activities
just as multi-nationals do. For example, a local government authority needs to know what resources
are being used to deliver services to residents. A tennis club needs to know the cost of undertaking its
various activities so that it can determine the amount of annual subscription it should charge its
members.
4.4 WHAT TYPE OF INFORMATION IS NEEDED?

Managers require a mixture of financial and non-financial information.
Worked Example: Financial and non-financial information
Assume that the management of ABC Co have decided to provide a cafeteria for their employees.
a. The financial information required by management might include cafeteria staff costs, costs of
subsidising meals, capital costs, costs of heat and light and so on.
b. The non-financial information might include comment on the effect on employee morale of the
provision of cafeteria facilities, details of the number of meals served each day, meter readings for
gas and electricity and attendance records for cafeteria employees.
ABC Co could now combine financial and non-financial information to calculate the average cost to
the company of each meal served, thereby enabling them to predict total costs depending on the
number of employees in the work force.
4.4.1 NON-FINANCIAL INFORMATION

Management accounting is mainly concerned with the provision of financial information to aid
planning, control and decision making. However, the management accountant cannot ignore nonfinancial influences and should qualify the information provided with non-financial matters as
appropriate.
Non-financial information may relate to matters such as quality, speed, flexibility, creativity, motivation,
customer satisfaction and competitive advantage.
4.5 PRESENTATION OF INFORMATION TO MANAGEMENT

Reports
Information may be communicated by word of mouth, but in many organisations, especially larger
organisations, formal reports are an important method of communication. Financial information in
particular is often presented in the form of reports, because managers cannot always easily and
quickly understand financial details, and need to have the information presented to them in a
structured way. Management accountants need to be skilled in writing and presenting formal reports.
Main features of a report

TITLE
Most reports are usually given a heading to show that it is a report.
WHO IS THE REPORT INTENDED FOR?

It is vital that the intended recipients of a report are clearly identified. For example, if you are
writing a report for Joe Rafter, it should be clearly stated at the head of the report.
If the recipients of the report have any comments or queries, it is important that they know who to
contact.
DATE
We have already mentioned that information should be communicated at the most appropriate
time. It is also important to show this timeliness by giving your report a date.
SUBJECT: REPORT HEADING
What is the report about? Managers are likely to receive a great number of reports that they need
to review. It is useful to know what a report is about before you read it! A report should therefore
have a clear heading or title.
SUB-HEADINGS
Unless they are very brief, reports should be divided into sections, each with a clear sub-heading.
The first heading may be an introduction (explaining the purpose of the report), followed by an
executive summary (setting out both the purpose and the findings of the report). The final subheading may be for a summary, conclusion or recommendation.
APPENDIX
In general, information is summarised in a report and the more detailed calculations and data are
included in an appendix at the end of the report.
5 MANAGEMENT ACCOUNTING SYSTEMS

Section overview
Management accounting systems developed from cost accounting systems. They are used
for scorekeeping, directing management attention and problem solving.
LO
1.1
We start this section by briefly looking at how management accounting systems have developed, and
we consider the implications of systems not developing quickly enough to keep pace with changes in
the business world.
5.1 THE DEVELOPMENT OF MANAGEMENT ACCOUNTING

Management accounting has developed gradually over time, and has changed in nature. Originally,
cost accounting systems were used to record costs and report costs to management in manufacturing
industries, so that product costs and profitability could be better managed. Historically manufacturing
costs were a larger proportion of total costs, and a larger proportion of total manufacturing costs
consisted of direct materials and direct labour costs, than is found in many modern manufacturing
industries. Manufacturing costs were 'driven' by direct labour hours worked or machine hours
operated.
Cost and management accounting information was also used for planning, particularly for annual
budgeting. Budgetary control reports were produced regularly, typically every month, to inform
management about actual performance and how this compared against the budget targets.
Some industries produced standard products in large quantities, so that standard costing systems
could be operated for budgeting and also for control reporting (standard costing variance reports).
CHAPTER 1
WHO IS THE REPORT FROM?
A significant development in management accounting was the use of marginal costing, and the
separation of costs into fixed and variable costs. Marginal costing concepts were applied to planning
and other aspects of decision-making. Management accounting systems became more relevant and
reliable in providing information to management for decision-making, through the application of
concepts and techniques such as relevant costs and discounted cash flow analysis.
More recently, management accounting systems have developed quite rapidly, in a variety of different
ways. Service industries and non-manufacturing activities became more important for many
companies, and management accounting systems were developed within service industries, and also
for activities such as marketing and distribution.
Management accounting techniques have also been developed to analyse costs in different ways,
particularly overhead costs, and techniques such as activity based costing and customer profitability
analysis have emerged.
The importance of information for strategic planning has also been recognised, and management
accounting has expanded from the provision of information at the management control level to
information provision for strategic planning and control. Management accounting systems must now
gather non-financial as well as financial information, and information from external as well as internal
sources. Corporate Performance Management (CPM) and Business Intelligence (BI) software are
examples of such systems.
There have also been changes in manufacturing techniques, such as Total Quality Management and
Just-in-Time (JIT) production. As manufacturing management has changed, the information to
support management management accounting has also had to change so that it remains relevant
and useful.
The expansion and increased sophistication of many management accounting systems would not have
been possible without technological change, and enormous improvements in the capabilities of IT
systems.
5.2 WHAT IS A MANAGEMENT ACCOUNTING SYSTEM (MAS)?

LO
1.6
A management accounting system (MAS) can be defined by its tangible components:

a. People with accounting knowledge (management accountants).
b. The technology they use.
c. Paper or computer records of financial transactions.
d. The cost accounting system on which it is based.
e. The management accounting techniques that are used to provide information: there are a wide
variety of simple and complex mathematical techniques for analysing data.
f. The reports that are produced by the system, or the nature of the information that is accessible online.
g. The users of the information the managers for whom the reports are prepared.
In summary, a management accounting system is an information system that produces information
required by managers to manage resources and create value for customers and shareholders.
5.3 RISKS IN USING MANAGEMENT ACCOUNTING SYSTEMS

In practice, management accounting systems may not provide information of sufficient quality, and
this will affect the quality of decision-making within the organisation. Typical weaknesses in some
management accounting systems are explained briefly below.
Management information may be unduly focused on financial costs and short-term profits that can
easily be measured. Non-financial information may be overlooked. At a strategic level, for example,
the objective of a company may be to increase profitability, but in order to grow the business and its
profits, it may be necessary to consider factors such as quality, flexibility, customer satisfaction and
employee skills.
5.3.2 INTERNAL ORIENTATION

Management accounting systems may use data and information from internal sources, and fail to
make use of external sources. A business needs an external orientation. It operates in a competitive
and regulated environment, and management cannot ignore what is happening in the business
environment. There should be some focus on customers and competitors, suppliers and perhaps
other stakeholders.
5.3.3 LACK OF GOAL CONGRUENCE

Management accounting systems may encourage a lack of goal congruence within the organisation,
i.e. managers may be encouraged to concentrate on their own part of the company operations,
without regard for other aspects of the business. Managers may pursue targets that are in their
departmental interests but not in the best interests of the organisation as a whole. Often this may
reflect poor overall design of the system, with potential conflicts between short and long-term
objectives being ignored and incompatible targets being set for different parts of the organisation.
5.3.4 LACK OF FUTURE PERSPECTIVE

The management accounting systems may highlight historical financial costs and report on past
performance. There is a requirement to provide information for management to make decisions about
the future. Financial information for decision-making should consist of relevant costs (which we will
discuss below). However, management accounting systems may fail to provide relevant cost
information for management.
5.3.5 FAILURE TO ADAPT PERFORMANCE MEASURES TO CHANGING CIRCUMSTANCES

A particular problem with management accounting systems is that they may remain 'stuck' in
traditional methods of reporting and analysis, when new approaches may be much more appropriate
and valuable for management.
5.4 RISKS OF TRADITIONAL MANAGEMENT ACCOUNTING METHODS

A serious risk with using traditional management accounting methods and reports is that the
information they provide may be inappropriate for management's changing needs. Changes in the
business environment call for changes in information systems for management. Changes in the
business environment have included:
Globalisation and increased competition.
Information technology changes resulting in changes in production methods and information
flows.
Changes in organisation structures, such as internal reorganisations and external mergers.
Increasing awareness of sustainability and environmental issues.
Traditional management accounting systems may be inadequate for advanced manufacturing
technology and a modern business environment that focuses on marketing, customer satisfaction,
employee involvement and total quality ('getting things right first time').
CHAPTER 1
5.3.1 EXCESSIVE EMPHASIS ON FINANCIAL MEASURES
5.4.1 TIMING
In trying to improve profitability, management will often look for ways of reducing costs. However, as
we will see later, the cost of a new product is substantially determined when it is being designed, not
at the time it goes into production. The materials that will be used, the machines and labour required,
are largely determined at the design stage. In the car industry, 85 per cent of all future product costs
are determined during the design stage and by the end of the testing stage. Target costing is a
management accounting technique that draws attention to control of product costs at the design
stage. Traditional management accounting, however, continues to direct its attention to the
production stage.
5.4.2 CONTROLLABILITY
Traditionally, management accounting systems have provided more information about direct costs of
operations (material and labour) than about indirect costs (overheads), for example, by the
preparation of cost cards. This may result in an organisation focussing on controlling direct labour and
direct material costs and directing insufficient attention to overheads. However for many modern
organisations the controllable element of overhead costs, such as power, may be more significant and
offer more scope for savings than the direct costs of material or labour. There are techniques for
analysing overhead costs more closely, such as activity based costing and customer profitability
analysis, but traditional management accounting systems do not provide information of this quality.
5.4.3 NON-FINANCIAL ASSETS

Traditional management accounting measures do not deal with intangible assets, such as knowledgebased assets. Management information systems need to be able to provide information about the
resources that drive value, how knowledge-based assets help the organisation to improve its strategic
value and develop performance indicators that will help determine resource allocation and strategic
development.
5.4.4 CUSTOMER COSTS AND PROFITABILITY

Many costs are driven by customers such as delivery costs, discounts and after-sales service but
traditional cost and management accounting systems do not recognise this. Companies may be
trading with certain customers at a loss but not realise it because costs are not analysed in a way that
would reveal it.
6 DESIGN OF MANAGEMENT ACCOUNTING

SYSTEMS
Section overview
A management accounting system comprises people with accounting knowledge,
technology, records, processes, mathematical techniques, reports and the users for whom
those reports are prepared. The key components of the system are: inputs, processes and
outputs. It is used for strategic decision making, performance measurement, operational
control and costing.
LO
1.6
In this section we focus on the factors determining the design of management accounting systems,
and assessing the adequacy of existing management accounting systems. The most important factor
is for the output to meet the needs of management, for various decision making purposes.
6.1 DESIGNING A MANAGEMENT ACCOUNTING SYSTEM

FACTOR
DETAIL
Information and timing
A starting point for design or assessment should be the output from the
management accounting system. For what purposes do management need
the information? The management accountant must identify the information
needs of managers making planning and control decisions, and monitoring
progress. Levels of detail and accuracy of output must be determined in each
case, and also the speed or frequency with which the information should be
provided or made available.
Sources of input data
A management accounting system should be capable of gathering the data

that is needed to provide the information. This involves obtaining data from
both internal and external sources. It also involves specifying the methods
that should be used to obtain and store the data.
Processing involved
Decisions should be made about how the data will be processed to provide
the information, and how frequently it should be provided (for example, in
monthly routine reports, continuously accessible online, or prepared in
response to specific requests from management). Decisions should also be
made about which methods or techniques of management accounting should
be used to process the data.
Response required
An important issue is how managers should be expected to respond to the

information provided. This will depend to some extent on how the
information is presented to them. Ultimately the information is meant to result
in decision making.
Question 3: Information
Management accounting information should be relevant to the user's needs, and should be reliable. It
should also be timely, appropriately communicated and cost-effective.
Which one of the following best describes the consequences if management accounting information
does not have these qualities?
A
B
C
D
The quality of decision making will be poor.

None of the information will be used by management.
Management will be forced to rely more on external information.
Management will be forced to rely more on financial accounting statements.
6.2 STRATEGIC, TACTICAL AND OPERATIONAL INFORMATION

LO
1.6
A management accounting system should be capable of providing information at a strategic, tactical

(management control) and operational level for management.
6.2.1 STRATEGIC INFORMATION

Definition
Strategic Management Accounting is a form of management accounting in which emphasis is
placed on information which relates to factors external to the entity, as well as to non-financial
information and internally-generated information.
CHAPTER 1
The following factors should be considered when designing a management accounting system:
Some examples of strategic information that may be provided by a management accounting system
are found in the table below.
ITEM
COMMENT
Competitors' costs
What are they? How do they compare with ours? Can we beat them?
Are competitors vulnerable because of their cost structure?
Financial effect of competitor response
Have sales fallen?
Product profitability
A company should want to know not just what profits or losses are
being made by each of its products, but why one product is making
good profits whereas another equally good product might be
making a loss.
Customer profitability
Some customers or groups of customers are worth more than others.
Pricing decisions
Accounting information can help to analyse how profits and cash

flows will vary according to price and prospective demand.
Value of market share
A company ought to be aware of what it is worth to increase the

market share of one of its products.
Capacity expansion
Should the company expand its capacity, and if so by how much?

Should it diversify into a new area of operations, or a new market?
Brand values
How much is it worth investing in a 'brand' which customers will

choose over competitors' brands?
Shareholder wealth
Future profitability determines the value of a business.
Cash flow
A loss-making company can survive if it has adequate cash resources,

but a profitable company cannot survive unless it has sufficient
liquidity.
6.2.2 MANAGEMENT CONTROL INFORMATION

The information required for management control embraces the entire organisation. It is provided
for budgeting and planning, monitoring and other decision-making purposes at a management
control level within the organisation. The information is often quantitative, such as labour hours,
quantities of materials consumed, volumes of sales and production, and is commonly expressed in
money terms, but (as indicated previously) tactical information as well as strategic information may
include non-financial elements.
Examples of management control information might include profit forecasts, variance analysis reports,
and productivity statistics.
Some tactical information is prepared regularly, perhaps weekly, or monthly, in the form of regular
reports.
6.2.3 OPERATIONAL CONTROL INFORMATION

Operational information is information which is needed for the conduct of day-to-day
implementation of plans. It will include much 'transaction data' such as data about customer orders,
purchase orders, cash receipts and payments.
The amount of detail provided in information is likely to vary with the purpose for which it is needed.
Operational information is likely to go into much more detail than management control information,
which in turn will be more detailed than strategic information. Operational information, although
quantitative, is more often expressed in terms of units, hours and quantities of material. The extent
to which management accountants are involved in providing information at the operational level will
depend on the nature of the information and the responsibility structure within the organisation.
6.3 PERFORMANCE MEASUREMENT IN DIFFERENT SECTORS

An important aspect of management accounting systems is the provision of information about
performance. The nature of the performance measures used will depend largely on the nature of the
organisation's business and the type of industry in which it operates. The information will be both
financial and non-financial in nature.
Management accounting information is provided for management in service industries, not just
manufacturing industries. The management accountant must take into account the characteristics of
the service businesses, including the fact that (unlike manufacturing) production and consumption of
services occur at the same time and there are no finished goods inventories. Customer satisfaction
may be difficult to measure in service businesses, and there may also be problems with identifying
which parts of the service the customer values most, and providing relevant information about
meeting customer needs.
In the service sector, performance evaluation (and information about performance) may have several
dimensions:
Flexibility
Excellence
Innovation
Financial performance
Resource utilisation
Competitiveness
6.3.2 PERFORMANCE MEASUREMENT IN THE NOT-FOR-PROFIT SECTOR

In the public sector/government, performance may be judged in terms of inputs and outputs, which
tie into the idea of 'value for money', based on:
Economy obtaining suitable inputs at the lowest cost.
Efficiency the process working as expected.
Effectiveness achieving goals.
Management accounting information in the not-for-profit sector may therefore focus on all three of
these aspects of performance.
7 DEVELOPMENTS IN MANAGEMENT
ACCOUNTING
Section overview
Management accountants have responded to developments such as JIT, TQM and lean
management accounting by using techniques such as target costing, life cycle costing and
Kaizen.
LOs
1.4
1.5
In this section we look at changes in the business environment and manufacturing methods, and how
management accounting techniques have been developed in response to them. Many of the
'modern' manufacturing methods are grouped around the concept of World-Class Manufacturing
(WCM), which sets as its objective achieving and sustaining competitive advantage in an environment
of strategic cost reduction. We shall revisit these concepts of manufacturing management, and the
associated management accounting techniques, in more detail later in the Study Manual.
7.1 JUST-IN-TIME (JIT)

JIT encompasses a commitment to continuous improvement and the search for excellence in the
design and operation of the production management system. Just-in-time manufacturing systems
seek to eliminate waste and 'get things right first time' in production operations. Waste is anything
that incurs costs without adding value holding inventories is one example of waste and JIT systems
seek to minimise inventory holding. To do this, materials must be supplied at exactly the time they are
needed to meet production requirements, and production must be completed exactly at the time that
output is needed to meet customer demand.
CHAPTER 1
6.3.1 PERFORMANCE MEASUREMENT IN THE SERVICE SECTOR
Definition
Just-in-time (JIT) is a system whose objective is to produce or to procure products or components
as they are required by a customer or for use, rather than for inventory. A JIT system is a 'pull'
system, which responds to demand, in contrast to a 'push' system, in which stocks act as buffers
between the different elements of the system, such as purchasing, production and sales.
Just-in-time production is a system which is driven by demand for finished products whereby each
component on a production line is produced only when needed for the next stage.
Just-in-time purchasing is a system in which material purchases are contracted so that the receipt
and usage of material, to the maximum extent possible, coincide.
The implications of JIT for the management accounting systems is that they have to be reorganised to
include or highlight items that are seen as costs under JIT but are not included in traditional systems.
Systems must highlight excessive inventory levels, machinery set ups and long lead times. The
changes in organisation resulting from JIT, such as the regroupings of workings, will also result in
changes in accounting systems to adjust to new demands and changed sources of information.
JIT is considered in more detail in chapter 11.
7.2 TOTAL QUALITY MANAGEMENT

Definition
Total Quality Management (TQM) is a culture of management and operations, rather than a specific
technique. The culture is one of achieving continuous improvements, no matter how small each
individual improvement may be, so that customer needs and expectations are met with increasing
success. The approach (like JIT) has a zero defects philosophy.
Total Quality Management (TQM) originated in Japanese manufacturing companies, notably Toyota,
from the end of the 1940s. The following 'requirements of quality' could be seen as the characteristics
of TQM programs and the TQM philosophy:
a. Organisation wide there must be acceptance that the only thing that matters is the customer.
b. There should be recognition of the all-pervasive nature of the customer-supplier relationship,
including internal customers; passing sub-standard material to another division is not acceptable.
c. Instead of relying on inspection to a predefined level of quality, the cause of the defect should be
prevented. (Defects should be eliminated and operations should be 'right first time'.)
d. Each employee or group of employees must be personally responsible for defect-free production
or service in their domain.
e. There should be a move away from 'acceptable' quality levels. Any level of defects is
unacceptable.
f. All departments should strive for perfection; this applies to misdirected phone calls and typing
errors as much as to production.
g. Quality certification programs should be introduced.
h. The cost of poor quality should be emphasised; good quality generates savings.
Key costs in a TQM system include:
a. Conformance costs, those costs incurred to prevent problems and to appraise quality.
b. Non-conformance costs, internal failures such as waste, and external failures selling faulty
goods to customers and as a result suffering claims from customers because products or services
supplied have been faulty. The emphasis will be on minimising or, preferably, eliminating nonconformance costs as these tend to be much larger than conformance costs.
Total quality management and continuous improvement tie in with risk management. Constant
review of processes to identify what went wrong, systems to input feedback from within the
organisation and from the customer, and procedures to ensure the organisation responds successfully
may reduce exposure to certain types of risk.
7.3 KAIZEN
Definition
The Kaizen method is applied during the production process when it is difficult to make really big
changes. Kaizen focuses on the key elements of operations: production, purchasing and distribution.
Kaizen aims to achieve a specified cost reduction, but to do so through continuous improvements
rather than one-off changes.
Though managers may set the targets, employees working in the production process will ensure that
those targets are met. The logic of this approach is that those involved in production will be best able
to see how to achieve the necessary economies effectively but with minimum disruption. Often these
targets will be achieved in collaboration with suppliers.
7.4 LEAN MANAGEMENT ACCOUNTING

Lean management accounting has a lot in common with the other techniques outlined above. Its
emphasis is on the elimination of waste and continuous improvement. Customer demand
determines the flow of products or services, and emphasis is on processes and value streams rather
than departments.
In a lean system, management accounting systems need to be refocused to provide the information
necessary to drive improvement, and highlight waste. Distortions such as reduced unit costs arising
from producing large batches at a time need to be removed.
7.5 LIFE CYCLE COSTING

Life cycle costing is based on the view that the costs and profitability of products should be planned
and monitored over the entire life cycle of the products, from the design stage to the end of its
commercial life. Life cycle costing tracks and accumulates actual costs and revenues attributable to
each product or project over the entire product/project life cycle. The total profitability of any given
product / project can therefore be determined.
Traditional management accounting systems usually total all non-production costs and record them as
a period expense. Under life cycle costing such costs are traced to individual products over complete
life cycles.
Some organisations find that approximately 90% of a product's life cycle cost is determined by
decisions made early within the cycle at the design stage. Life cycle costing is therefore particularly
suited to innovative organisations and products, incurring high spending and commitments to spend
during the early stages of a product's life cycle.
In order to compete effectively in today's competitive market, many organisations need to continually
redesign their products with the result that product life cycles have become much shorter. The
planning, design and development stages of a product's cycle are therefore critical to an
organisation's cost management process. Cost reduction at this stage of a product's life cycle,
rather than during the production process, is one of the most important ways of reducing product
cost.
7.5.1 ADVANTAGES OF LIFE CYCLE COSTING

The life cycle costing approach emphasises the importance of development and design costs by
placing them in the context of the product's whole history. This may sway organisations away from
under-expenditure initially on design and development that results in problems later. The approach
deals well with other costs that may vary over a product's life cycle, for instance advertising. The life
cycle approach also highlights the importance of time to market; the success of a product may
depend on whether it gets to market quicker than its rivals.
CHAPTER 1
Kaizen is a Japanese term for continuous improvement in all aspects of an entity's performance at
every level. Kaizen is a feature of Total Quality Management.
7.5.2 PROBLEMS OF LIFE CYCLE COSTING

The biggest challenge is estimating product life costs over a number of years and how realistic they
will be in the light of the information available at the start of its life. When circumstances change, life
cycle costs have to change and management accounting systems may not be flexible enough to be
able to cope. Customer information may be important as customers may be prepared to pay a higher
price for a product that has lower lifetime costs.
7.6 TARGET COSTING

Target costing requires managers to change the way they think about the relationship between cost, price
and profit.
a. The traditional approach is to develop a product, determine the expected standard production
cost of that product and then set a selling price with a resulting profit or loss. Costs are controlled
through variance analysis at monthly intervals.
b. The target costing approach is to develop a product concept and the primary specifications for
performance and design and then to determine the price customers would be willing to pay for
that concept. The desired profit margin is deducted from the price leaving a figure that
represents total cost. This is the target cost and the product must be capable of being produced
for this amount otherwise the product will not be manufactured.
7.6.1 ADVANTAGES OF TARGET COSTING

The biggest advantage of target costing is that it brings market information into the management
accounting system rather than the accounting system being internally focused. It also encourages
continual product and production improvements and provides a structured approach for dealing
with those improvements.
7.6.2 PROBLEMS OF TARGET COSTING

The most significant challenge is setting a target, as it will be very difficult to forecast the market
price. It will partly depend on assumptions made about the future market situation including
behaviour of competitors, and technological and customer preferences.
A number of other problems may undermine the use of target costing as a means of control. These
include whether to use one target cost or several target costs, what costs to include and on what level
of production to base the target.
7.7 ORGANISATIONAL BEHAVIOUR

LO
1.9
Organisational behaviour is about the impact that individuals, groups and organisational structure
have on behaviour within an organisation and on that organisation's effectiveness or ability to create
value.
It is possible to identify three components that have an impact on organisational behaviour:
People
Structure
Technology and systems
To realise its full potential, an organisation needs to exploit the potential of its individual employees
and ensure that their goals are aligned with those of the organisation. The way that an organisation is
structured and its systems for planning, control and decision-making will affect the motivation of its
staff and hence the achievement of its results.
In today's fast-changing environment, a successful company is often one that is outward looking and
always looking to the future towards new markets, innovative products or services, better designs, new
processes, improved quality and increased productivity.
To create and improve value, organisations need to:

Recruit and retain the best talent.
Create a culture that supports individual and team abilities and promotes and rewards the drivers
of organisational success.
Recognise the power and value of knowledge and ensure that this is captured and then shared to
improve competitive advantage, eg through the use of knowledge management systems.
Implement a management style and organisational structure that is consistent with all of the above.
Develop and maintain an information system to support management.
The management accountant plays a vital role in organisational behaviour.
7.8 ROLE OF THE MANAGEMENT ACCOUNTANT IN CREATING VALUE

LO
1.3
Earlier in this chapter we examined the role of the management accounting function and the
contribution of management accounting to strategic management.
Management accounting is a value added process. This value added process:
Guides management action
Motivates behaviour
Supports and creates the cultural values required to achieve the organisation's objectives
The management accountant plays a key role in providing relevant and timely information to the
management of the organisation, explaining the impact of that information and participating in the
managerial decision-making process.
The information provided by management accountants and the management accounting system:
supports the strategic planning process which ensures the organisation adapts to its competitive
environment (planning)
helps senior management to evaluate performance (control) and
provides timely and accurate information about activities required for success (decision making)
and
helps maximise the effective use of resources over time
Thus the management accountant helps create organisational value by:
providing relevant information for planning and decision making
assisting management in direction and control activities
motivating managers and other employees towards organisational objectives
measuring the performance of the activities of managers and other employees
assessing the organisation's competitive position
8 SUSTAINABILITY AND MANAGEMENT

ACCOUNTING
Section overview
Sustainability is about considering the future as well as the present. Management
accountants have a role in ensuring that this aim is recognised, relevant objectives are set,
performance measured and corrective action taken.
CHAPTER 1
Get the best from their employees.
LO
1.10
In this section we examine one of the newer concepts in management accounting, that of
sustainability and sustainability accounting. In recent years there has been an increasing awareness of
sustainability. The section begins by looking at what is meant by sustainability both on a global scale
and at an organisational level. The objectives of sustainability are then considered and its relationship
to management accounting.
Definition
In relation to the development of the world's resources, sustainability has been defined as
ensuring that development meets the needs of the present without compromising the ability of
future generations to meet their own needs.
For organisations, sustainability involves developing strategies so that the organisation only uses
resources at a rate that allows them to be replenished (in order to ensure that they will continue to
be available). At the same time emissions of waste are confined to levels that do not exceed the
capacity of the environment to absorb them.
(Brundtland report)
The concept of sustainability should not be confused with environmental protection and the scarcity of
natural resources, although for many industries there is a direct connection between these. The
concept of sustainable business applies to all types of business banks and retail businesses as well as
mining and oil companies.
8.1 THE OBJECTIVES OF SUSTAINABILITY

Sustainability is about ensuring that an industry will be able to continue into the foreseeable future.
To do this, it needs to identify any risks that may exist to its continued existence, and develop
strategic objectives to protect itself against those risks. For many companies, sustainability involves
considering how to achieve a sustainable business that does not deplete natural resources below a
sustainable level, and does not create excessive pollution that endangers the future well-being of
society. It may be argued that sustainability is concerned with ensuring a better quality of life for
everyone, now and for generations to come, whilst meeting the following four objectives:
Social progress that recognises the needs of everyone

Effective protection of the environment
Prudent use of natural resources
Maintenance of high and stable levels of economic growth or employment
However it is important to recognise that business organisations do not exist primarily to benefit
society as a whole. It is all too easy to become nave and unrealistic when thinking about sustainability!
8.2 SUSTAINABILITY AND MANAGEMENT ACCOUNTING

There is clearly a growing interest in providing information to management that will help to support
decision-making within the context of setting and achieving sustainability objectives. Many
organisations now produce social and environmental reports or sustainability reports. There is also a
growing understanding that accountants have an important role to play, demonstrated by the work
that is being done by the leading accountancy bodies to engage the profession in sustainability
issues.
Definition
The term 'sustainability accounting' encompasses a range of new accounting and reporting tools
and approaches which are part of a transition towards a different kind of organisational decisionmaking, focused not just on economic rationality, but consistent with ecological and social
sustainability.
The role of the management accountant in sustainability accounting includes:

producing public reports of an organisation's carbon emissions, energy use, and impact on the
local economy (sometimes called physical, environmental or social accounting);
According to the International federation of Accountants (IFAC), 'a sustainability or (environmental)
management system can help an organisation:
Define its sustainability objectives, and ensure their alignment to business objectives;
Identify sustainability challenges, risks, and opportunities; and
Ensure that management and operational practices respond to these challenges, risks, and
opportunities.'
the reporting of initiatives which demonstrate that an organisation is taking its social and
environmental impacts into account in its decisions (such as in Corporate Social Responsibility
reporting);
the reporting of such initiatives together with an organisation's financial accounts; and
the reporting of information within key performance indicator criteria, reflecting progress towards
the sustainability of an organisation.
the reporting of costs organisations incur to prevent, monitor and report environmental impacts.
8.3 SUSTAINABILITY REPORTING

The term 'sustainability reporting' refers to the concept of organisations reporting to stakeholders not
only on their economic performance, but also on their performance in relation to the environment and
society. This has led to the emergence of frameworks to encompass reporting on social and
environmental performance.
8.3.1 GLOBAL REPORTING INITIATIVE (GRI)

The Global Reporting Initiative (GRI), founded in 1997, is an international not-for-profit organization. It
is the world-wide standard setter in sustainability reporting and its reporting guidelines are a global
voluntary code which provide a framework for organisations to measure their economic,
environmental and social performance. Reporting on these three aspects of performance is
sometimes called 'triple bottom line reporting'.
Economic: concerns the organisation's impacts on the economic conditions of its stakeholders and on
economic systems at local, national, and global levels.
Environmental: concerns an organisation's impacts on living and non-living natural systems, including
ecosystems, land, air, and water.
Social: concerns the impacts an organisation has on the social systems within which it operates.
Examples of GRI core performance indicators include:
ECONOMIC
ENVIRONMENTAL
SOCIAL
Revenues and costs
Materials used
Employee turnover and

absenteeism
Wages, pensions, other

employee benefits
Energy consumption
Diversity of workforce, incidents

of discrimination
Retained earnings and payments

to providers of capital
Water use
Employee health and safety
Taxes paid, subsidies and

grants received
Greenhouse gas emissions
Child labour
Geographic analysis of key

markets
Effluents and waste produced
Training undertaken
CHAPTER 1
the use of such reports as part of an environmental or sustainability management system;
ECONOMIC
ENVIRONMENTAL
SOCIAL
Return on capital employed
Significant spillages
Bribery and corruption
Fines and penalties
Community relations
Impact of activities on
biodiversity
Complaints re breaches of
customer privacy
Standard of Product labelling
(Source: GRI 2006)
The GRI Reporting Framework sets out the principles and Performance Indicators that organisations
can use to measure and report their economic, environmental, and social performance. There are
Sustainability Reporting Guidelines for different industries. The third version of the Guidelines known
as the G3 Guidelines - was published in 2006.
Many organisations around the world have declared their use of the GRI Guidelines as the basis for
sustainability reporting, including companies such as Coca Cola, Bayer, British American Tobacco,
Dell, and MTR Corporation. There are GRI guides for different industries, because the nature of
sustainability information differs according to the nature of the industry.
8.3.2 SUSTAINABILITY REPORTING IN AUSTRALIA

In October 2008 GRI Focal Point Australia was set up as a collaborative initiative by GRI and the St
James Ethics Centre. It is funded by the Federal Government's Treasury, CPA Australia and GRI. Its
goal is to increase the uptake of responsible business practice and make reporting on economic,
environmental and social performance by all organizations as routine and comparable as financial
reporting.
According to GRI Focal Point Australia, sustainability reporting in Australia is gaining momentum with
GRI reports almost doubling between 2007 and 2009. The establishment of the Focal Point has led to
an increased number of organisations considering GRI in their reporting and Australia is now the
fourth largest reporter against GRI, after Spain, USA and Brazil.
By 2010, 70 organisations in Australia, including Corporate Express Australia, Australia and New
Zealand Banking Group Ltd, Australia Post, and Telstra, had registered their use of GRI's reporting
guidelines and sustainability framework.
(http://www.globalreporting.org)
Case study
People, Productivity and Planet - Attitudes to Sustainability Reporting in Australia
The Nossal Institute for Global Health at the University of Melbourne, in partnership with Beaton and
Wellmark Perspexa undertook an Australia - wide survey on business sustainability, capturing the
attitudes of over 5000 business leaders.
The following is an extract of their key finding, published in 2011:
The strongest message emerging from the study is the huge latent potential in sustainability reporting
in Australia the will is there, but a substantial proportion of organisations are yet to find the way.
Snapshot of sustainability reporting in Australian organisations:
35% of leaders say their organisation currently produces sustainability reports
54% of those have been producing reports for less than three years
Huge business community support for sustainability reporting:
Reputation management, minimised environmental impacts, employee satisfaction and more
healthy workplaces are considered the major benefits of committing formally to sustainability
reporting
44% believe the benefits of sustainability reporting outweigh the costs

47% believe that in five years' time the majority of businesses will be producing sustainability
reports
Supply chain pressures will be a critical driver in the near future:

57% of leaders from reporting organisations would give preference to suppliers who can
demonstrate their commitment to sustainability
80% of leaders in reporting organisations agree it is likely that their organisation will require
suppliers to meet certain sustainability standards in the future
20% of leaders in non-reporting organisations in manufacturing, utilities, engineering and
architecture have been asked by clients about their sustainability reporting
If relevance can be demonstrated, most organisations have the will:
42% of leaders say they are not doing sustainability reporting because they don't feel it is relevant
to their organisation
20% of leaders say it is only a matter time before they start they are already talking about it
73% of leaders would personally like to see their organisation start sustainability reporting
Despite this, 25% of employees blame a lack of leadership commitment and interest for their
organisation not producing sustainability reports
53% of employees haven't done anything to encourage their organisation to start sustainability
reporting but have thought about it.
The employee attraction, satisfaction and retention case for sustainability reporting is strong:
54% of employees say that as a result of their organisation tackling sustainability issues, they feel
more proud of their organisation
70% of employees in non-reporting organisations say they would feel they were promoting a
healthier and more productive workplace if their organisation made a commitment to sustainability
41% of employees in reporting organisations said if they changed jobs they wouldn't want to work
somewhere that doesn't tackle sustainability issues
(http://www.sustainabilityatwork.com.au/2011/05/16/a-snapshot-of-sustainability-in-australia/)
8.3.3 SOCIALLY RESPONSIBLE INVESTMENT INDEXES

The two leading global Socially Responsible Investment (SRI) indexes are the Dow Jones Sustainability
Index World (DJSI World) and the FTSE4Good Global.
These indexes are designed to measure the performance of companies that meet globally recognised
corporate responsibility standards, and to facilitate investment in those companies. They include
companies that meet the selection criteria, but exclude those in certain sectors such as tobacco,
weapons and nuclear power.
Launched in February 2005, the Australian SAM Sustainability Index (AuSSI) tracks the performance
of Australian companies that lead their industry in terms of corporate sustainability. It comprises
companies from a range of industry sectors, including National Australia Bank Ltd, David Jones Ltd,
Foster's Group Ltd, Macquarie Group Ltd, and Energy Resources of Australia Ltd.
CHAPTER 1
47% of leaders in reporting organisations say there was no pressure to commence sustainability
reporting it was deemed to be the right thing to do
KEY CHAPTER POINTS

The role of management accounting as an information provider has developed with advances in
technology. To measure an organisation's performance effectively, clear understanding is needed
of its objectives and activities, and appropriate measures developed based on these.
accounted for, and provide information about profits and so on to shareholders and to other
interested parties. Management accounting systems provide information specifically for the use of
managers within the organisation.
Cost accounting and management accounting are terms which are often incorrectly used
interchangeably. Cost accounting is part of management accounting. Cost accounting provides a
bank of data for the management accountant to use.
Information provided by management accountants is likely to be used for planning, control and
decision making.
Anthony (1972) divided management activities into strategic planning, management control and
A management control system is a system which measures performance against a target or
benchmark, and indicates where control action may be required to make sure that the objectives of
an organisation are being met and the plans devised to attain them are being carried out.
Management accounting systems are management information systems. Information is data that
has been processed in such a way as to be meaningful to the person who receives it. Information is
anything that is communicated.
Good information should be relevant, complete, accurate and clear. It should inspire confidence, it
should be appropriately communicated and its volume should be manageable. It should be timely
and its cost should be less than the benefits it provides.
Information within an organisation can be analysed into the three levels assumed in Anthony's
hierarchy: strategic; tactical; and operational.
Management accounting developed from cost accounting. It is used for scorekeeping, directing
management attention and problem solving. It has since branched out into behavioural aspects.
A management accounting system comprises people with accounting knowledge, technology,
records, processes, mathematical techniques, reports and the users for whom those reports are
prepared. The key components of the system are: inputs, processes and outputs. It is used for
strategic decision making, performance measurement, operational control and costing.
Management accountants have responded to developments such as JIT, TQM and lean
management accounting by using techniques such as target costing, life cycle costing and Kaizen.
Organisational behaviour is about the impact that individuals, groups and organisational structure
have on behaviour within an organisation and on that organisation's effectiveness or ability to
create value.
Management accounting is a value added process which guides management action, motivates
behaviour and supports the cultural values required to achieve an organisation's objectives
For companies in many industries, sustainability involves developing strategies so that the
organisation only uses resources at a rate that allows them to be replenished. At the same time
emissions of waste are confined to levels that do not exceed the capacity of the environment to
absorb them.
CHAPTER 1
The term 'sustainability accounting' encompasses a range of new accounting and reporting tools
and approaches which are part of a transition towards a different kind of organisational decisionmaking focused not just on economic rationality, but consistent with ecological and social
sustainability.
QUICK REVISION QUESTIONS

1 Which of the following is not an essential quality of good information?
A
B
C
D
It should be timely
It should be completely accurate
It should be relevant for its purposes
It should be communicated to the right person
2 The sales manager has prepared a direct labour plan to ensure that sales targets for the year are
achieved. This is an example of
A tactical planning.
B strategic planning.
C corporate planning.
D operational planning.
3 Which of the following statements is/are correct?
I Information is data that has been processed into a form meaningful to the recipient.
II An objective is a course of action that an organisation might pursue in order to achieve its strategy.
III A management control system is a term used to describe the hardware and software used to drive a
database system which produces information outputs that are easily assimilated by management.
A
B
C
D
I only
I, II and III
I and II only
I and III only
4 Monthly variance reports are an example of which of the following types of management
information?
A Tactical only
B Strategic only
C Operational only
D Tactical, strategic and operational
5 The three main types of accounting are management accounting, financial accounting and cost
accounting. Which of the following sequences is correct?
A Management accounting: immediate; financial accounting: quick; cost accounting: delayed
B Financial accounting: immediate; cost accounting: quick; management accounting: delayed
C Management accounting: immediate; cost accounting: quick; financial accounting: delayed
D Cost accounting: immediate; management accounting: quick; financial accounting: delayed
6 Which of the following describes a Just-in-time system?
A Sustaining a culture of continuous improvement
B Aiming to produce goods when required by customers or for use
C Using resources to create outputs that are in line with the intended objectives or targets
D Developing a product concept and determining the price customers would be willing to pay for
that concept
7 Which one of the following statements is not correct?
A Financial accounting information can be used for internal reporting purposes.
B Cost accounting can only be used to provide inventory valuations for internal reporting.
C Routine information can be used to make decisions regarding both the long term and the short term.
D Management accounting provides information relevant to decision making, planning, control
and evaluation of performances.
1 B The reliability of information depends on its accuracy. Information should be sufficiently

accurate for its purpose. Relevance and clarity are different qualities of good information, and
information that is not provided in a timely way loses relevance.
2 A Tactical planning is used by middle management to decide how the resources of the business
should be employed to achieve specific objectives in the most efficient and effective way.
Strategic planning (option B) is planning for the achievement of long-term objectives, and
corporate planning (option C) is another name for this.
Operational planning (option D) is concerned with the very short term, day to day planning that
is carried out by 'front line' managers such as supervisors and head clerks.
3 D An objective is a target for achievement, not a course of action.
4 A Variance reports are an example of tactical management information. They have the key
features outlined in section 3.9.2.
5 C Management accounting information is generally needed and provided immediately and
responsively; cost accounting information is provided quickly and responsively, but not
necessarily immediately. The provision of financial accounting information is usually delayed.
6 B Just-in-time is a system whose objective is to produce or to procure products or components as
they are required by a customer or for use.
Option A (sustaining a culture of continuous improvement) is a general principle and not
specific to Just-in-time.
Option C (using resources to create outputs that are in line with the intended objectives or
targets) describes effectiveness in the context of management control.
Option D (developing a product concept and determining the price customers would be willing
to pay for that concept) describes target costing.
7 B Cost accounting has a variety of uses.
CHAPTER 1
ANSWERS TO QUICK REVISION QUESTIONS
ANSWERS TO CHAPTER QUESTIONS

1 D Statement I is incorrect. Limited liability companies must, by law, prepare financial accounts.
The format of published financial accounts is determined by law, but not the format of
management accounts. Statement II is therefore incorrect.
Management accounting information is sometimes used as a planning tool, for example in
budgeting. Therefore management accounts do serve as a future planning tool, but they are
also useful as a historical record of performance for example in monthly performance reports.
Management accounting information is used for control and one-off decision-making purposes,
as well as for planning purposes. Therefore, all three statements are incorrect and D is the
correct answer.
2 D Management accounting information has identified that costs were 15% more than expected.
Where actual performance is compared against a target, the problem could be with the actual
performance or the target may have been inappropriate Control information should lead to
investigation of the reasons for differences or variances. In this case the variance could suggest
that there has been unnecessary overspending or that there are reasons for the overspending
that is outside management's control. Where appropriate, control action should be taken to
reduce excess spending. Alternatively, if the overspend is caused by factors outside
management control it may be necessary to revise forecasts about what will happen in the
future.
3 A Management accounting information is used, even when its quality is poor. For example,
organisations prepare budgets, even when there is a lack of confidence in the quality of the
forecasts and other assumptions in the budget. Using external information is not a substitute for
internal information. Financial statements are for external publication and are not produced
frequently enough for management purposes. This suggests that the correct answer must be
answer A. The information will be used, even if there is a lack of confidence in it, but the quality
of decision-making will be adversely affected.
39
CHAPTER 2
DECISION MAKING AND
RELEVANT COSTING
Learning objectives
Reference
Decision making
LO2
Apply relevant information guidelines for short-term alternative choice operating

decisions
LO2.2
LO2.5
Cost behaviour
LO4
LO4.1
Topic list
1
2
3
4
Relevant costs
Choice of product (product mix) decisions
Make or buy decisions
Outsourcing
INTRODUCTION
Management at all levels within an organisation take decisions. The overriding requirement of the
information that should be supplied by the cost/management accountant to aid decision making is
that of relevance. This chapter therefore begins by looking at the concept of relevant costing, and
explains how to decide which costs need taking into account when a decision is being made.
We then go on to see how to apply relevant costing to product mix decisions, and make or buy
decisions.
Finally, the important area of outsourcing is considered.
Decision making
and
relevant costing
Relevant
costs
Choice of product
(product mix) decisions
Outsourcing
Make or buy
decisions
DECISION MAKING AND RELEVANT COSTING | 41
BEFORE YOU BEGIN

area.
everything covered.
1 What is a relevant cost?
(Section 1.1)
2 What are avoidable costs?
(Section 1.2)
3 Define differential and opportunity costs.
(Section 1.3)
4 What is a sunk cost?
(Section 1.5)
5 What is deprival value?
(Section 1.9)
6 A limiting factor is anything which limits the activity of an entity. What are the
possible limiting factors for an organisation?
(Section 2.1)
CHAPTER 2
1 RELEVANT COSTS
Section overview
Relevant costs are future cash flows arising as a direct consequence of a decision.
Decisions should be based on future incremental cash flows.
1.1 RELEVANT COSTS

Definition
LO
4.1
Relevant costs are future cash flows arising as a direct consequence of a decision and which are
therefore pertinent to the decision making process.
Decision making should be based on relevant costs. Relevant costs are:

a. Future costs. A decision is about the future and it cannot alter what has been done already. Costs
that have been incurred in the past are totally irrelevant to any decision that is being made 'now'.
Such costs are past costs or sunk costs.
Costs that have been incurred include not only costs that have already been paid, but also costs
that have been committed. A committed cost is a future cash outflow that will be incurred
regardless of future decisions.
LO
2.5
b. Cash flows. Only cash flow information is required. This means that costs or charges which do not
reflect additional cash spending, such as depreciation or arbitrarily apportioned costs, should be
ignored for the purpose of decision-making.
c. Incremental costs. Incremental costs are additional costs incurred due to particular decision or
alternative course of action. For example, an employee is expected to have no work to do next
week, but will continue to be paid the basic wage, of $100 per week for attending. A manager
wants to decide whether to give the employee a job which earns the organisation $40 revenue. The
$100 is irrelevant to the decision because although it is a future cash flow, it will be incurred anyway
whether the employee is given work or not. Therefore the job would generate a net gain of $40
and should be given to the employee.
1.2 AVOIDABLE COSTS

Definition
Avoidable costs are costs which would not be incurred if the activity to which they relate did not exist.
One situation in which it is necessary to identify avoidable costs, is in deciding whether to discontinue
a product. The only costs which would be saved are the avoidable costs which are usually the
variable costs and some specific costs. Costs which would be incurred whether or not the product is
discontinued are known as unavoidable costs.
1.3 DIFFERENTIAL COSTS AND OPPORTUNITY COSTS

Relevant costs also include differential costs and opportunity costs:
Differential cost is the difference in total cost between alternatives.
An opportunity cost is the value of the benefit sacrificed when one course of action is chosen in
preference to an alternative.
For example, if decision option A costs $300 and decision option B costs $360, the differential cost is
$60.
Worked Example: Differential costs and opportunity costs

Assume for example, that there are three options, A, B and C, only one of which can be chosen. The
net profit from each would be $80, $100 and $70 respectively.
Since only one option can be selected, option B would be chosen because it offers the biggest
benefit.
Profit from option B
Less opportunity cost (i.e. the benefit from the next most profitable alternative, A)
Differential benefit of option B
$
100
80
20
The decision to choose option B would not be taken simply because it offers a profit of $100, but
because it offers a differential profit of $20 in excess of the next best alternative.
Controllable costs are items of expenditure which can be directly influenced by a given manager
within a given time span.
As a general rule, committed fixed costs such as rental costs arising from the possession of plant,
equipment and building, are largely uncontrollable in the short term because they have been
committed by long term decisions.
Discretionary fixed costs, for example, advertising and research and development costs can be
thought of as being controllable because they are incurred as a result of decisions made by
management and can be increased or decreased at fairly short notice.
1.5 SUNK COSTS

Definition
A sunk cost is a past cost which is not directly relevant in decision making.
The principle underlying decision making is that management decisions can only affect the future. In
decision making, managers therefore require information about future costs and revenues which
would be affected by the decision under review. Managers must consider decisions in light of future
costs and avoid incorporating sunk costs when comparing alternatives.
Sunk costs are irrelevant to decision-making because the expenditure has already been incurred.
Worked Example: Sunk costs
An example of a sunk cost is development costs which have already been incurred. Suppose that a
company has spent $250 000 in developing a new service for customers, but the marketing
department's most recent findings are that the service might not gain customer acceptance and could
be a commercial failure. The company needs to decide whether to abandon the development of the
new service, but the $250 000 spent so far should be ignored by the decision makers because it is a
sunk cost.
1.6 FIXED AND VARIABLE COSTS

Unless you are given an indication to the contrary, in general you should assume the following:
Variable costs, which are costs that are constant per unit but can change as production or service
volume changes, will be relevant costs.
Existing Fixed costs, which are costs that are constant but decrease per unit output as activity
increases, will be incurred in any event, regardless of the decision, so are non-relevant.
CHAPTER 2
1.4 CONTROLLABLE AND UNCONTROLLABLE COSTS
This is not always the case, however, and you should analyse variable and fixed cost data carefully. Do
not forget that 'fixed' costs may only be fixed in the short term.
1.6.1 NON-RELEVANT VARIABLE COSTS

There might be occasions when a variable cost is in fact a sunk cost and therefore a non-relevant
variable cost. For example, suppose that a company has some units of raw material in inventory. They
have been paid for already, and originally cost $2 000. They are now obsolete and are no longer used
in regular production, and they have no scrap value. However, they could be used in a special job
which the company is trying to decide whether to undertake. The special job is a 'one-off' customer
order, and would use up all these materials in inventory.
a. In deciding whether the job should be undertaken, the relevant cost of the materials to the special
job is nil. Their original cost of $2 000 is a sunk cost, and should be ignored in the decision.
b. However, if the materials did have a scrap value of, say, $300, then their relevant cost to the job
would be the opportunity cost of being unable to sell them for scrap, i.e. $300.
1.6.2 ATTRIBUTABLE FIXED COSTS

There might be occasions when a fixed cost is a relevant cost, and you must be aware of the
distinction between specific or directly attributable fixed costs, and general fixed overheads.
Directly attributable fixed costs are those costs which, although fixed within a relevant range of
activity levels are relevant to a decision for either of the following reasons:
a. They could increase if certain extra activities were undertaken. For example, it may be necessary to
employ an extra supervisor if a particular order is accepted. The extra salary would be an
attributable fixed cost.
b. They would decrease or be eliminated entirely if a decision were taken either to reduce the scale of
operations or shut down entirely.
General fixed overheads are those fixed overheads which will be unaffected by decisions to increase
or decrease the scale of operations. Unless there is an incremental element, general fixed overheads
are not a relevant cost.
1.6.3 ABSORBED OVERHEAD

Absorbed overhead is a notional accounting cost and hence should be ignored for decision-making
purposes. Only incremental overheads arising as a result of the decision are relevant.
1.7 THE RELEVANT COST OF MATERIALS

If additional materials need to be acquired for a job/contract, the relevant cost of the materials is their
current purchase price.
If the raw materials required are already in inventory then the relevant cost is generally their current
replacement cost, unless the materials would not be replaced once used. In this case the relevant
cost of using them is the higher of the following:
Their current resale value and
The value they would obtain if they were put to an alternative use.
If the materials have no resale value and no other possible use, then the relevant cost of using them
for the opportunity under consideration would be nil.
Question 1: Relevant cost of materials I

O'Reilly has been approached by a customer who would like a special job to be done for him, and
who is willing to pay $22 000 for it. The job would require the following materials:
Material
Total units
required
A
B
C
D
1 000
1 000
1 000
200
Units already
in inventory
0
600
700
200
Book value of
units in inventory
$/unit
2
3
4
Realisable
value
$/unit
2.50
2.50
6.00
Replacement
cost
$/unit
6
5
4
9
Materials C and D are in inventory as the result of previous excessive-buying, and they have a
restricted use.
No other use could be found for material C. The units of material D could be used in another job as
substitute for 300 units of material E, which currently costs $5 per unit (of which the company has no
units in inventory at the moment).
Calculate the relevant costs of material for deciding whether or not to accept the contract.
Question 2: Relevant cost of materials II

A company regularly uses a material. It currently has 100kg in inventory for which it paid $200. If it were
sold it could be sold for $3 per kg. The market price is now $4 per kg. A customer has placed an order
that will use 200kg of the material. The relevant cost of the 200 kgs is
A $500.
B $600.
C $700.
D $800.
1.8 THE RELEVANT COST OF LABOUR

The relevant cost of labour, in different situations, is best explained by means of an example.
Worked Example: Relevant cost of labour
LW is currently deciding whether to undertake a new contract. 15 hours of labour will be required for
the contract. LW currently produces product L, the standard cost details of which are shown below:
STANDARD COST
PRODUCT L
Direct materials (10kg @ $2)
Direct labour (5 hrs @ $6)
Selling price
Contribution
$/unit
20
30
50
72
22
a. What is the relevant cost of labour if the labour must be hired from outside the organisation?
b. What is the relevant cost of labour if LW expects to have five hours' spare capacity?
c. What is the relevant cost of labour if labour is in short supply?
CHAPTER 2
Material B is used regularly by O'Reilly, and if units of B are required for this job, they would need to
be replaced to meet other production demand.
Solution
a. Where labour must be hired from outside the organisation, the relevant cost of labour will be the
variable costs incurred.
Relevant cost of labour on new contract = 15 hours @ $6 = $90
b. It is assumed that the five hours spare capacity will be paid anyway, and so if these five hours are
used on another contract, there is no additional cost to LW.
Relevant cost of labour on new contract
$
60
0
60
Direct labour (10 hours @ $6)

Spare capacity (5 hours @ $0)
c. Contribution earned per unit of product L produced = $22

If it requires five hours of labour to make one unit of product L, the contribution earned per labour
hour = $22/5 = $4.40
Relevant cost of labour on new contract
Direct labour (15 hours @ $6)
Contribution lost by not making product L ($4.40 15 hours)
$
90
66
156
It is important that you are able to identify the relevant costs which are appropriate to a decision.
Check your understanding by attempting the following question.
Question 3: Customer order
A company has been making a machine to order for a customer, but the customer has since gone into
liquidation, and there is no prospect that any money will be obtained from the winding up of the
company.
Costs incurred to date in manufacturing the machine are $50 000 and progress payments of $15 000
had been received from the customer prior to the liquidation.
The sales department has found another company willing to buy the machine for $34 000 once it has
been completed.
To complete the work, the following costs would be incurred:
a. Materials: these have been bought at a cost of $6 000. They have no other use, and if the machine
is not finished, they would be sold for scrap for $2 000.
b. Further labour costs would be $8 000. Labour is in short supply, and if the machine is not finished,
the work force would be switched to another job, which would earn $30 000 in revenue, and incur
direct costs of $12 000 and absorbed (fixed) overhead of $8 000.
c. Consultancy fees $4 000. If the work is not completed, the consultant's contract would be cancelled
at a cost of $1 500.
d. General overheads of $8 000 would be added to the cost of the additional work.
Assess whether the new customer's offer should be accepted.
1.9 THE RELEVANT COST OF AN ASSET

The relevant cost of an asset represents the amount of money that a company would have to receive if
it were deprived of the asset in order to be no worse off than it already is. We can call this the deprival
value.
The deprival value of an asset is best demonstrated by means of an example.
Worked Example: Deprival value of an asset

A machine cost $14 000 ten years ago. The machine is expected to generate future revenues of $10
000. Alternatively, the machine could be scrapped for $8 000. An equivalent machine in the same
condition would cost $9 000 to buy now.
What is the deprival value of the machine?
Solution
First, let us think about the relevance of the costs given to us in the question.
Cost of machine = $14 000 = past/sunk cost
Future revenues = $10 000 = revenue expected to be generated
Net realisable value (NRV) = $8 000 = scrap proceeds
Replacement cost = $9 000
When calculating the deprival value of an asset, use the following diagram.
REPLACEMENT
COST
($9 000)
CHAPTER 2
LOWER OF
HIGHER OF
($10 000)
NRV
($8 000)
REVENUES
EXPECTED
($10 000)
Therefore, the deprival value of the machine is the lower of the $9 000 replacement cost and the $10
000 future revenues. The deprival value is therefore $9 000.
2 CHOICE OF PRODUCT (PRODUCT MIX)

DECISIONS
LO
2.2
Section overview
A limiting factor is any factor which limits the organisation's activities. In a limiting factor
situation, contribution will be maximised by earning the biggest possible contribution per
unit of limiting factor.
2.1 THE LIMITING FACTOR

A limiting factor is anything which limits the activity of the entity. This could be the level of demand for
its product or it could be one or more scarce resources which limit production to below the level of
demand.
Possible limiting factors are:
a. Sales. There may be a limit to sales demand.
b. Labour. There may be a limit to total quantity of labour available or to labour having particular
skills.
c. Materials. There may be insufficient available materials to produce enough units to satisfy sales
demand.
d. Manufacturing capacity. There may not be sufficient machine capacity for the production required
to meet sales demand.
One of the more common decision-making problems is a situation where there are not enough
resources to meet the potential sales demand. A decision has to be made about what mix of products
to produce, to ensure the available resources are used as efficiently as possible.
It is assumed in limiting factor decision making that management wishes to maximise profit and that
profit will be maximised when total contribution is maximised and that there is no change in fixed cost
expenditure incurred. Contribution is equal to sales revenue less variable costs.
Contribution will be maximised by earning the biggest possible contribution from each unit of
limiting factor. For example, if grade A labour is the limiting factor, contribution will be maximised by
earning the biggest contribution from each hour of grade A labour worked.
The limiting factor decision therefore involves the determination of the contribution earned by
each different product from each unit of the limiting factor.
Worked Example: Profit-maximising production mix
Colour makes two products, the Red and the Blue. Unit variable costs are as follows:
Red
$
1
6
1
8
Direct materials
Direct labour ($3 per hour)
Variable overhead
Blue
$
3
3
1
7
The sales price per unit is $14 per Red and $11 per Blue. During July 20X2 the available direct labour is
limited to 8 000 hours. Sales demand in July is expected to be 3 000 units for Reds and 5 000 units for
Blues.
Determine the profit-maximising production mix, assuming that monthly fixed costs are $20 000, and
that opening inventories of finished goods and work in progress are nil.
Solution
Step 1
Confirm that the limiting factor is something other than sales demand.
Labour hours per unit
Sales demand
Labour hours needed
Labour hours available
Shortfall
Reds
2 hrs
3 000 units
6 000 hrs
Blues
1 hr
5 000 units
5 000 hrs
Total
11 000 hrs
8 000 hrs
3 000 hrs
Labour is the limiting factor on production.
Step 2
Identify the contribution earned by each product per unit of limiting factor, that is per
labour hour worked.
Sales price
Variable cost
Unit contribution
Contribution per labour hour (= unit of limiting factor)
Reds
$
14
8
6
2 hrs
$3
Blues
$
11
7
4
1 hr
$4
Although Reds have a higher unit contribution than Blues ($8 versus $7), two Blues can be
made in the time it takes to make one Red. Because labour is in short supply it is more
profitable to make Blues than Reds.
Determine the optimum production plan. Sufficient Blues will be made to meet the full
sales demand, and the remaining labour hours available will then be used to make Reds.
(a)
Hours
required
5 000
6 000
11 000
Sales
Demand
5 000
3 000
Product
Blues
Reds
Hours
available
5 000
3 000(bal)
8 000
Hours
Needed
(b)
Product
Units
Blues
Reds
5 000
1 500
Contribution
per unit
$
4
6
5 000
3 000
8 000
Less fixed costs

Profit
Priority of
manufacture
1st
2nd
Total
$
20 000
9 000
29 000
20 000
9 000
In conclusion:
a. Unit contribution is not the correct way to decide priorities.
b. Labour hours are the scarce resource, and therefore contribution per labour hour is the correct
way to decide priorities.
c. The Blue earns $4 contribution per labour hour, and the Red earns $3 contribution per labour hour.
Blues therefore make more profitable use of the scarce resource, and should be manufactured first.
Question 4: Limiting factor 1

The following details relate to three products made by DSF Co:
V
$ per unit
120
30
20
10
20
80
Selling price
Direct materials
Direct labour
Variable overhead
Fixed overhead
Profit
40
A
$ per unit
170
40
30
16
32
118
52
L
$ per unit
176
60
20
20
40
140
36
All three products use the same direct labour and direct materials, but in different quantities.
In a period when the direct labour used on these products is in short supply, the most profitable and
least profitable use of the direct labour is:
A
B
C
D
Most profitable
L
L
V
A
Least profitable
V
A
A
L
CHAPTER 2
Step 3
Question 5: Limiting factor 2

Jam Co makes two products, the K and the L. The K sells for $50 per unit, the L for $70 per unit. The
variable cost per unit of the K is $35, that of the L $40. Each unit of K uses 2 kg of raw material. Each
unit of L uses 3 kg of raw material.
In the forthcoming period the availability of raw material is limited to 2,000 kg. Jam Co is contracted to
supply 500 units of K. Maximum demand for the L is 250 units. Demand for the K is unlimited.
What is the profit-maximising product mix?
A
B
C
D
K
250 units
625 units
750 units
1 250 units
L
625 units
250 units
1 250 units
750 units
3 MAKE OR BUY DECISIONS
LO
2.2
3.1 INTRODUCTION
Section overview
A make or buy problem involves a decision by an organisation about whether to make a

product with its own internal resources, or to pay another organisation to make the
product.
In deciding whether to make internally or buy externally, and assuming no scarce resources,
the relevant costs for the decision will be the differential costs between the two options.
One example of a make or buy decision is whether a company should manufacture its own
components, or buy the components in from an outside supplier.
The 'make' option should give management more direct control over the work, but the 'buy' option
often has the benefit that the external organisation has a specialist skill and expertise in the work.
Make or buy decisions should not be based exclusively on cost considerations. The following should
also be considered:
a. How can spare capacity freed up by the 'buy' option be used most profitably?
b. Could the decision to use an outside supplier cause an industrial dispute?
c. Would the subcontractor be reliable with delivery times and product quality?
d. Does the company wish to be flexible and maintain better control over operations by making
everything itself?
Where the organisation has a choice about whether to make internally or buy externally, and scarce
resources are not a factor, the relevant cost is the differential cost between sourcing internally and
sourcing externally.
The organisation will need to consider differences in both variable and fixed costs. For example the
variable cost per unit of buying externally may be higher than the variable cost of making in-house,
but the use of an outside supplier may give rise to savings in directly attributable fixed costs. As a
result, if only a small number of units are required, it may be cheaper overall for an organisation to buy
externally, because the saving in fixed costs may outweigh the additional variable costs incurred.
Worked Example: Make or buy

An organisation makes four components, W, X, Y and Z, for which costs in the forthcoming year are
expected to be as follows:
Production (units)
Unit marginal costs
Direct materials
Direct labour
Variable production overheads
W
1 000
$
4
8
2
14
X
2 000
$
5
9
3
17
Y
4 000
$
2
4
1
7
Z
3 000
$
4
6
2
12
Directly attributable fixed costs per annum and committed fixed costs are as follows:
CHAPTER 2
$
1 000
5 000
6 000
8 000
30 000
50 000
Incurred as a direct consequence of making W

Incurred as a direct consequence of making X
Incurred as a direct consequence of making Y
Incurred as a direct consequence of making Z
Other fixed costs (committed)
A subcontractor can supply units of W, X, Y and Z for $12, $21, $10 and $14 respectively.
Decide whether the organisation should make or buy the components.
Solution
a. The relevant costs are the differential costs between making and buying. They consist of
differences in unit variable costs plus differences in directly attributable fixed costs. Buying will
result in some fixed cost savings.
Unit variable cost of making

Unit variable cost of buying
Annual requirements (units)
Extra variable cost of buying (per annum)
Fixed costs saved by buying
Extra total cost of buying
W
$
14
12
$(2)
X
$
17
21
$4
Y
$
7
10
$3
1 000
(2 000)
1 000
(3 000)
2 000
8 000
5 000
3 000
4 000
12 000
6 000
6 000
Z
$
12
14
$2
3 000
6 000
8 000
(2 000)
b. The company would save $3 000 pa by buying component W, where the purchase cost would be
less than the marginal cost per unit to make internally. It would save $2 000 pa by subcontracting
component Z. This is because of the saving in fixed costs of $8 000.
c. Important further considerations would be as follows:
i. If components W and Z are subcontracted, the company will have spare capacity. How should
that spare capacity be profitably used? Are there hidden benefits to be obtained from
buying? Would the company's workforce resent the loss of work to an outside supplier, and
might such a decision cause an industrial dispute?
ii. Would the supplier be reliable with delivery times, and would they supply components of the
same quality as those manufactured internally?
iii. Does the company wish to be flexible and maintain better control over operations by making
everything itself?
iv. Are the estimates of fixed cost savings reliable? In the case of product W, buying is clearly
cheaper than making in-house. In the case of product Z, the decision to buy rather than make
would only be financially beneficial if the fixed cost savings of $8,000 could really be 'delivered'
by management.
4 OUTSOURCING
LO
2.2
Section overview
An organisation's value chain refers to the sequence of activities by which inputs are
converted into outputs and includes its supply chain and distribution network.
An organisation should concentrate on retaining those core activities that enhance its
competitive advantage and should consider outsourcing all other activities where it cannot
achieve benchmarked levels of performance.
To minimise the risks associated with outsourcing, organisations generally build close longterm partnerships or alliances with a few key suppliers.
4.1 INTRODUCTION
A significant trend in recent years has been for organisations and government bodies to concentrate
on their core competences, what they are really good at, and turn other activities over to specialist
contractors. Facilities management companies have grown in response to this. An organisation that
earns its profits from manufacturing bicycles does not also need to have expertise in mass catering or
office cleaning.
Definition
Outsourcing is the use of external suppliers as a source of finished products, components or services.
This is also known as contract manufacturing or sub-contracting.
4.2 REASONS FOR THIS TREND

a. Frequently an outsourcing decision is made on the grounds that specialist contractors can offer
superior quality and efficiency. If a contractor's main business is making a specific component, it
can invest in the specialist machinery and labour and knowledge skills needed to make that
component. However, this component may be only one of many needed by the contractor's
customer, and the complexity of components is now such that attempting to keep internal facilities
up to the standard of specialists detracts from the main business of the customer. For example,
Dell Computers buys the Pentium chip for its personal computers from Intel because it does not
have the know-how and technology to make the chip itself.
b. Contracting out manufacturing frees capital and management time that can then be invested in
core activities such as market research, product definition, product planning, marketing and sales.
c. Contractors generally have the capacity and flexibility to start production very quickly to meet
sudden variations in demand. In-house facilities may not be able to respond as quickly, because
of the need to redirect resources from elsewhere.
4.3 INTERNAL AND EXTERNAL SERVICES

In administrative and support functions, too, organisations are increasingly likely to use specialist
companies. Decisions such as the following are now common.
a. Whether the design and development of a new computer system should be entrusted to inhouse data processing staff or whether an external software house should be hired to do the work.
b. Whether maintenance and repairs of certain items of equipment should be dealt with by in-house
engineers, or whether a maintenance contract should be entered into with a specialist
organisation.
A familiar example is office cleaning being done by contractors.
4.4 CHOOSING THE ACTIVITIES TO OUTSOURCE

In deciding whether to outsource an activity, an organisation must consider whether:
Within the value chain, both primary activities and support activities are candidates for outsourcing,
although many can be eliminated from the list immediately either because the activity cannot be
contracted out or because the organisation must control it to maintain its competitive position. For
instance, Coca Cola does not outsource the manufacture of its concentrate to safeguard its formula
and retain control of the product.
Of the remaining activities, an organisation should carry out only those that it can deliver on a
level comparable with the best organisations in the world. If the organisation cannot achieve
benchmarked levels of performance, the activity should be outsourced so that the organisation is only
concentrating on those core activities that enhance its competitive advantage.
4.5 ADVANTAGES AND DISADVANTAGES

The advantages of outsourcing are as follows:
a. It frees up time of existing staff on the contracted-out activities. It also frees up time spent
supporting the contracted-out services by staff not directly involved, for example, supervisory staff,
personnel staff.
b. It allows the company to take advantage of specialist expertise and equipment rather than
investing in these facilities itself and underutilising them.
c. It may be cheaper, once time savings and opportunity costs are taken into account.
d. It is particularly appropriate when an organisation is attempting to expand in a time of uncertainty
as it is a way of gaining all the benefits of extra capacity without having to fund the full cost.
However there are also a number of disadvantages:
a. Without monitoring there is no guarantee that the service will be performed to the organisation's
satisfaction.
b. There is a chance that contracting out will be more expensive than providing the service in-house.
c. By performing services itself the organisation retains or develops skills that may be needed in the
future and will otherwise be lost.
d. Contracting out any aspect of information-handling carries with it the risk that commercially
sensitive data will get into the wrong hands.
e. There may be some ethical considerations, such as exploitation of staff and inadequate pay and
working conditions.
f. There will almost certainly be opposition from employees and their representatives if contracting
out involves redundancies.
To minimise the risks associated with outsourcing, organisations generally enter into long-run
contracts with their suppliers that specify costs, quality and delivery schedules. They build close
partnerships or alliances with a few key suppliers, collaborating with suppliers on design and
manufacturing decisions, and building a culture and commitment for quality and timely delivery.
CHAPTER 2
retaining control of the activity is vital to maintain its competitive position and
the activity can be delivered internally on a level comparable with the best organisations in the
world.
An organisation's value chain refers to the sequence of activities by which inputs are converted into
outputs and includes its supply chain and distribution network. The concept of a value chain was
suggested by Michael Porter (1985) to demonstrate how value for the customer is added to the
products or services produced by an organisation. The chain consists of primary activities (such as
inbound logistics, operations, outbound logistics, marketing and service) and secondary activities
(such as infrastructure, human resources, technology and procurement).
Case study
Albright and Davis ('The Elements of Supply Chain Management') describe the extreme outsourcing
approach adopted by Mercedes.
Instead of contracting with suppliers for parts, Mercedes outsourced the modules making up a
completed M-class to suppliers who purchase the subcomponents and assemble the modules for
Mercedes.
This has led to a reduction in plant and warehouse space needed, and a dramatic reduction in the
number of suppliers used (from 35 to one for the cockpit, for example).
At the beginning of the production process Mercedes maintained strict control in terms of quality and
cost on both the first tier suppliers, who provide finished modules, and the second tier suppliers, from
whom the first tier suppliers purchase parts. As the level of trust grew between Mercedes and the first
tier suppliers, Mercedes allowed them to make their own arrangements with second tier suppliers.
Benefits of this approach for Mercedes
i. Reduction in purchasing overhead.
ii. Reduction in labour and employee-related costs.
iii. Higher level of service from suppliers.
iv. Supplier expertise in seeking ways to improve current operations.
v. Suppliers working together to continuously improve both their own module and the integrated
product.
KEY CHAPTER POINTS

Relevant costs are future cash flows arising as a direct consequence of a decision.
Decisions should be based on future, incremental cashflows.
Relevant costs also include differential costs and opportunity costs:
Differential cost is the difference in total cost between alternatives.
An opportunity cost is the value of the benefit sacrificed when one course of action is chosen in
A sunk cost is a past cost which is not directly relevant in decision making.
In general, variable costs will be relevant costs and fixed costs will be irrelevant to a decision.
A limiting factor is any factor which limits the organisation's activities. In a limiting factor situation,
contribution will be maximised by earning the biggest possible contribution per unit of limiting
factor.
In deciding whether to make internally or buy externally, and assuming no scarce resources, the
relevant costs for the decision will be the differential costs between the two options.
An organisation's value chain refers to the sequence of activities by which inputs are converted into
outputs and includes its supply chain and distribution network.
An organisation should concentrate on retaining those core activities that enhance its competitive
advantage and should consider outsourcing all other activities where it cannot achieve
benchmarked levels of performance.
To minimise the risks associated with outsourcing, organisations generally build close long-term
partnerships or alliances with a few key suppliers.
CHAPTER 2
The relevant cost of an asset represents the amount of money that a company would have to
receive if it were deprived of an asset in order to be no worse off than it already is. We can call this
the deprival value.

1 You are currently employed as a management accountant in an insurance company, but you are
contemplating starting your own business. In considering whether or not to take this action your
current salary level would be
A a sunk cost.
B an irrelevant cost.
C an incremental cost.
D an opportunity cost.
2 Your company regularly uses material X and currently has in inventory 500 kgs for which it paid
$1 500 two weeks ago. If this were to be sold as raw material, it could be sold today for $2.00 per
kg. You are aware that the material can be bought on the open market for $3.25 per kg, but it must
be purchased in quantities of 1,000 kgs.
You have been asked to determine the relevant cost of 600 kgs of material X to be used in a job for
a customer. The relevant cost of the 600 kgs is
A
B
C
D
$1 325
$1 825
$1 950
$3 250
3 A company is considering its option with regard to a machine which cost $60 000 four years ago.
If sold, the machine would generate scrap proceeds of $75 000. If kept, this machine would
generate net income of $90 000.
The current replacement cost for this machine is $105 000.
What is the relevant cost of the machine?
A
B
C
D
$60 000
$75 000
$90 000
$105 000
4 A company manufactures and sells two products (X and Y) both of which utilise the same skilled
labour. For the coming period, the supply of skilled labour is limited to 2,000 hours. Data relating
to each product are as follows:
Product
Selling price per unit
Variable cost per unit
Skilled labour hours per unit
Maximum demand (units) per period
X
$20
$12
2
800
Y
$40
$30
4
400
In order to maximise profit in the coming period, how many units of each product should the
company manufacture and sell?
A
B
C
D
200 units of X and 400 units of Y

5 In the short-term decision-making context, which one of the following would be a relevant cost?
A Specific development costs already incurred
B The cost of special material which will be purchased
C The cost of a report that has been carried out but not yet paid for
D The original cost of raw materials currently in inventory which will be used on the project
6 A company manufactures and sells a single product. The variable cost of the product is $2.50 per
unit and all production each month is sold at a price of $3.70 per unit. A potential new customer
has offered to buy 6,000 units per month at a price of $2.95 per unit. The company has sufficient
spare capacity to produce this quantity. If the new business is accepted, sales to existing customers
are expected to fall by two units for every 15 units sold to the new customer.
What would be the overall increase in monthly profit which would result from accepting the new
business?
A
B
C
D
$1 740
$2 220
$2 340
$2 700
7 A company is evaluating a project that requires two types of material (T and V). Data relating to the
material requirements are as follows:
T
V
Quantity
needed for
project
kg
500
400
Quantity
currently in
inventory
kg
100
200
Original cost
of quantity in
inventory
$/kg
40
55
Current
purchase
price
$/kg
45
52
Current
resale price
$/kg
44
40
Material T is regularly used by the company in normal production. Material V is no longer in use by
the company and has no alternative use within the business.
What is the total relevant cost of materials for the project?
A
B
C
D
$40 400
$40 900
$43 400
$43 900
8 A machine owned by a company has been idle for some months but could now be used on a one
year contract which is under consideration. The net book value of the machine is $1 000. If not used
on this contract, the machine could be sold now for a net amount of $1 200. After use on the
contract, the machine would have no saleable value and the cost of disposing of it in one year's
time would be $800.
What is the total relevant cost of the machine to the contract?
A
B
C
D
$400
$800
$1 200
$2 000
9 A company has just secured a new contract which requires 500 hours of labour.
There are 400 hours of spare labour capacity. The remaining hours could be worked as overtime at
time and a half or labour could be diverted from the production of product X. Product X currently
earns a contribution of $4 in two labour hours and direct labour is currently paid at a rate of $12 per
normal hour.
What is the relevant cost of labour for the contract?
A
B
C
D
$200
$1 200
$1 400
$1 800
CHAPTER 2
Material type
10 A company uses limiting factor analysis to calculate an optimal production plan given a scarce
resource.
The following applies to the three products of the company:
Product
Direct materials (at $6/kg)
Direct labour (at $10/hour)
Variable overheads ($2/hour)
Maximum demand (units)
Optimal production plan
I
$
36
40
8
84
II
$
24
25
5
54
III
$
15
10
2
27
2 000
2 000
4 000
1 500
4 000
4 000
How many kg of material were available for use in production?

A
B
C
D
15 750 kg
28 000 kg
30 000 kg
38 000 kg

1 D An opportunity cost is the value of the benefit sacrificed when one course of action is chosen, in
preference to another.
A sunk cost (option A) is a past cost which is not relevant to the decision.
An incremental cost (option C) is an extra cost to be incurred in the future as the result of a
decision taken now.
The salary cost forgone is certainly relevant to the decision therefore option B is not correct.
Option B values the inventory items at their original purchase price, but this is a sunk or past
cost.
Option D is the cost of the 1 000 kgs that must be purchased, but since the material is in
regular use the excess can be kept in inventory until needed.
3 C When calculating the relevant cost of an asset, use the following diagram.
LOWER OF = $90 000
REPLACEMENT
COST
($105 000)
HIGHER OF
= ($90 000)
NRV
($75 000)
REVENUES
EXPECTED
($90 000)
4 D
Product

Contribution per unit
Contribution per skilled labour hour required
Ranking
X
$
20
12
8
4
1st
Y
$
40
30
10
( 4)
2.5
2nd
Manufacture and sell: 800 units of Product X (using 800 2 hours = 1 600 hours); 100 units of
Product Y (using the remaining 400 hours* (2 000 1 600).
* 400 hours 4 hours skilled labour per unit = 100 units.
5 B The cost of special material which will be purchased is a relevant cost in a short-term decisionmaking context.
CHAPTER 2
2 C The material is in regular use and so 1,000 kgs will be purchased. 500 kgs of this will replace the
500 kg in inventory that is used, 100 kgs will be purchased and used and the remaining 400 kgs
will be kept in inventory until needed. The relevant cost is therefore 600 $3.25 = $1,950.
If you selected option A you valued the inventory items at their resale price. However, the items
are in regular use therefore they would not be resold.
6 A
$
1.20
0.45
$
2 700
(960)
1 740
Contribution per unit current $(3.70 2.50)

Contribution per unit revised $(2.95 2.50)
Total contribution new business (6 000 $0.45)
Lost contribution current business (6 000/15 2 $1.20)
Increase in monthly profit
7 B Total relevant cost of materials

$
Material T
500kg $45
Material V
200kg $40
200kg $52
Total relevant cost of materials
22 500
8 000
10 400
40 900
8 D
$
1 200
800
2 000
Opportunity cost (net realisable value)

Cost of disposal in one year's time
Total relevant cost of machine
9 C
500
400
100
Hours are required

Hours are available as spare labour capacity
Hours are required but not available as spare capacity
1 If the 100 hours are from worked overtime, then the cost
= 100 hours 1.5 $12 = $1 800
2 If labour is diverted from the production of Product X, then the cost
= 100 hours $12 + (100/2 $4)
= $1 200 + $200
= $1 400
Option 2 is cheaper and therefore the relevant cost of labour for the contract is $1 400.
10 B
Optimal production plan (units)
Kgs required per unit
Kgs material available
I
2 000
6
12 000
II
1 500
4
6 000
III
4 000
2.5
10 000
Total
28 000

1 Material A is not yet owned. It would have to be bought in full at the replacement cost of $6 per
unit.
Material B is used regularly by the company. There are existing inventories (600 units) but if these
are used on the contract under review a further 600 units would be bought to replace them.
Relevant costs are therefore 1 000 units at the replacement cost of $5 per unit.
The required units of material D are already in inventory and will not be replaced. There is an
opportunity cost of using D in the contract because there are alternative opportunities either to sell
the existing inventories for $6 per unit ($1 200 in total) or avoid other purchases (of material E),
which would cost 300 $5 = $1 500. Since substitution for E is more beneficial, $1 500 is the
opportunity cost.
Summary of relevant costs
Material A (1 000 $6)
$
6 000
Material B (1 000 $5)
5 000
Material C (300 $4) plus (700 $2.50)

Material D
Total
2 950
1 500
15 450
2 D The material is in regular use and so 200 kg will be purchased. The relevant cost is therefore
200 $4 = $800.
3 Costs incurred in the past, or revenue received in the past, are not relevant because they cannot
affect a decision about what is best for the future. Costs incurred to date of $50 000 and revenue
received of $15 000 are not relevant and should be ignored.
Similarly, the price paid in the past for the materials is irrelevant. The only relevant cost of
materials affecting the decision is the opportunity cost of the revenue from scrap which would be
forgone $2 000.
Labour costs
Labour costs required to complete work
Opportunity costs: contribution forgone by losing
other work $(30 000 12 000)
Relevant cost of labour
$
8 000
18 000
26 000
The incremental cost of consultancy from completing the work is $2,500.

Cost of completing work
Cost of cancelling contract
Incremental cost of completing work
$
4 000
1 500
2 500
Absorbed overhead is a notional accounting cost and should be ignored. Actual overhead
incurred is the only overhead cost to consider. General overhead costs and the absorbed overhead
of the alternative work for the labour force should be ignored.
CHAPTER 2
1 000 units of material C are needed and 700 are already in inventory. If used for the contract, a
further 300 units must be bought at $4 each. The existing inventories of 700 will not be replaced. If
they are used for the contract, they could not be sold at $2.50 each. The realisable value of these
700 units is an opportunity cost of sales revenue forgone.
Relevant costs may be summarised as follows.

$
Revenue from completing work
Relevant costs
Materials: opportunity cost
Labour:
basic pay
opportunity cost
Incremental cost of consultant
$
34 000
2 000
8 000
18 000
2 500
30 500
3 500
Extra profit to be earned by accepting the order
4 B As direct labour is in short supply the contribution per $ of direct labour is used to rank the
products:

Variable cost per unit (materials, labour and variable
overhead)
Labour cost per unit
Contribution per $ of labour
Ranking
V
$
120
A
$
170
L
$
176
60
60
20
3
86
84
30
2.80
100
76
20
3.80
5 B
Contribution per unit of limiting factor
Ranking
Production plan
Contracted supply of K (500 2 kg)
Meet demand for L (250 3 kg)
Remainder of resource for K (125 2 kg)
K
$15
$15/2 = $7.50
L
$30
$30/3 = $10
1
Raw material used
kg
1 000
750
250
2 000
63
CHAPTER 3
BUDGETING
Learning objectives
Reference
Budgeting
LO3
Identify and analyse the human behavioural challenges to the budgeting process in
organisations
LO3.1
Explain the nature of budgets and the reasons that organisations use budgets
LO3.2
Prepare an operations budget
LO3.3
Prepare a cash budget
LO3.4
Cost Behaviour
LO4
Apply relevant techniques to separate costs into their fixed and variable components
LO4.2
Topic list
1
2
3
4
5
6
7
8
9
10
The purposes and benefits of a budget

Steps in the preparation of a budget
Preparing functional operating budgets
Cash budgets
Budgeted financial statements
Flexible budgets
Cost estimation
Incremental and zero-based budgeting systems
Budgeting, performance and motivation
Budgeting and quality
INTRODUCTION
This chapter begins by explaining the reasons why an organisation might prepare a budget and goes
on to detail the steps in the preparation of a budget. The method of preparing, and the relationship
between the various functional budgets is then set out.
The chapter also considers the construction of cash budgets and the budgeted statement of
comprehensive income and statement of financial position, which make up what is known as a master
budget. Two different budgeting systems are described: the more traditional incremental approach,
and a more recent development zero-based budgeting (ZBB). The first builds on the previous year's
budgets, while ZBB begins from scratch each time the budget is prepared.
Finally, we will look at the way in which budgets can affect the behaviour and performance of
employees, for better and for worse.
Budgeting
Purposes and
benefits
Preparation
Flexible
budgets
Performance
and motivation
Functional
budgets
Cost
estimation
Budgeting
and quality
Cash
budgets
Statement of
comprehensive
income
Statement of
financial position
Incremental budgeting
and ZBB
BUDGETING | 65
BEFORE YOU BEGIN

area.
everything covered.
1 What is a budget?
(Section 1)
2 What are the functions of the budget committee?
(Section 2.1)
3 Why is the principal budget factor important?
(Section 2.5)
5 Explain the difference between a fixed and a flexible budget.
(Section 6)
6 Explain the difference between incremental and zero-based budgeting systems.
(Section 8)
7 What are four types of performance standard?
(Section 9.2)
8 What are the advantages of participative budgets?
(Section 9.5)
9 What are the disadvantages of participative budgets?
(Section 9.5)
10 What is the aim of Total Quality Management (TQM)?
(Section 10.1)
11 Explain the link between TQM and budgeting
(Section 10.2)
CHAPTER 3
4 What is an appropriate management action when an organisation has a short-term surplus?

(Section 4.1)
1 THE PURPOSES AND BENEFITS OF A BUDGET

Section overview
The main purpose and benefit of using a budget is to assist with the achievement of the
organisation's objectives.
Definition
LO
3.2
A budget is a quantitative statement, for a defined period of time, which may include planned
revenues, expenses, assets, liabilities and cash flows.
1.1 PURPOSES AND BENEFITS

The main purpose and benefit of using a budget is:
To assist with the achievement of the organisation's objectives
The organisation's objectives are quantified and drawn up as targets to be achieved within the
timescale of the budget.
Using a budget has seven further purposes/benefits, all of which contribute to the main purpose,
listed above:
To compel planning
Planning forces management to look ahead, to set out detailed plans for achieving targets for each
department, operation and (ideally) each manager. It should also help to anticipate problems.
To communicate ideas and plans
A formal system is necessary to ensure that each person involved is aware of what he or she is to
do. Communication may be one-way, where managers give instructions to staff, or there might be
a two-way dialogue where the staffs feedback their suggestions to management which may be
incorporated into the formal plan.
To co-ordinate activities
The activities of different departments need to be co-ordinated to ensure maximum integration of
effort towards common organisation goals. For example, the purchasing department should base
its budget on production requirements and the production budget should be based on sales
expectations.
To provide a framework for responsibility accounting
Budgets require that managers are made responsible for the achievement of budget targets for
the operations under their control.
To establish a system of control
Control over actual performance is provided by the comparisons of actual results against the
budget. Departures from budget can then be investigated and the reasons for the departures can
be found and acted on.
Motivate employees to improve their performance
The interest and commitment of employees can be retained if there is a system which lets them
know how well or badly they are performing. The identification of controllable reasons for
departures from budget with managers responsible provides an incentive for improving future
performance.
BUDGETING | 67
Allocation of resources
Allocation of scarce resources among competing uses.
The remainder of the chapter explain further how budgets are used to achieve these benefits. We will
begin by looking at the planning and control aspects of budgeting.
1.2 BUDGETS IN THE CONTEXT OF PLANNING AND CONTROL

Planning involves making choices between alternatives and is primarily a decision-making activity. The
control process involves measuring and correcting actual performance to ensure that the strategies
that are chosen and the plans for implementing them are carried out. The link between these two is
the budget.
The diagram below represents the planning and control cycle:
Planning
process
Control
process
Step 1
Identify objectives
Step 1
Identify alternative courses of action

(strategies) which might contribute
towards achieving the objectives
Step 2
Evaluate each strategy
Step 3
Choose alternative
courses of action
Step 4
Implement the long-term

plan in the form of
the annual budget
Step 5
Measure actual results

and compare with the plan
Step 6
Respond to
divergences from plan
Step 7
Identify objectives
Objectives establish the direction in which the management of the organisation wish it to
be heading. Typical objectives include the following:
To maximise profits.
To increase market share.
To produce a better quality product than anyone else.
Objectives answer the question: 'where do we want to be?'.
Step 2
Identify alternative courses of action

Once an organisation has decided 'where it wants to be', the next step is to identify a
range of possible courses of action or strategies that might enable the organisation to
get there.
The organisation must therefore carry out an information-gathering exercise to ensure
that it has a full understanding of where it is now. This is known as a position audit or
strategic analysis. It involves looking both inwards and outwards.
The organisation must gather information from all of its internal parts to find out what
resources it possesses: what its manufacturing capability is, what is the state of its
technical know-how, how well it is able to market itself, how much cash it has in the
bank, how much it could borrow, and any other relevant data available from its own
records.
CHAPTER 3
The planning and control cycle
It must also gather external information so that it can assess its position in the
environment. Just as it has assessed its own strengths and weaknesses, it must do
likewise for its competitors (threats). Its current market must be analysed. It must also
analyse any other markets that it is intending to enter, to identify possible new
opportunities. This process is known as SWOT analysis: Strengths, Weaknesses,
Opportunities and Threats. The state of the world economy must be considered. Is it
in recession or is it booming? What is likely to happen in the future and over what
timescale? This is known as assessing the business cycle.
Having carried out a strategic analysis, alternative strategies can be identified.
Step 3
Evaluate strategies
The strategies must then be evaluated in terms of suitability, feasibility and
acceptability in the context of the strategic analysis. Management should select those
strategies that have the greatest potential for achieving the organisation's objectives.
One strategy may be chosen or several.
Step 4
Choose alternative courses of action

The next step in the process is to collect the chosen strategies together and coordinate them into a long-term plan, commonly expressed in financial terms.
Typically a long-term financial plan would show the following (not in any particular order):
Step 5
Projected cash flows

Projected long-term profits
Capital expenditure plans
Statements of financial position forecasts
A description of the long-term objectives and strategies in words
Implement the long-term plan

The long-term plan should then be broken down into smaller parts. It is unlikely that
the different parts will fall conveniently into successive time periods. For example
Strategy A may take two and a half years, while strategy B may take five months, but not
start until year three of the plan. It is usual, however, to break down the plan as a whole
into equal time periods (usually one year). The resulting short-term plan is the budget.
Steps 6
Measure actual results and compare with plan. Respond to divergences from plan
and 7
At the end of the year actual results should be compared with those expected under the
long-term plan. The long-term plan should be reviewed in the light of this comparison
and the progress that has been made towards achieving the organisation's objectives
should be assessed. Management can also consider the feasibility of achieving the
objectives in the light of circumstances which have arisen during the year. If the plans are
now no longer attainable then alternative strategies must be considered for achieving the
organisation's objectives, as indicated by the feedback loop (the arrowed line) linking
step 7 to step 2. This aspect of control is carried out by senior management, normally on
an annual basis.
The control of day-to-day operations is exercised by lower-level managers. At frequent
intervals they must be provided with performance reports which consist of detailed
comparisons of actual results and budgeted results. Performance reports provide
feedback information by comparing planned and actual outcomes. Such reports should
highlight those activities that do not conform to plan, so that managers can devote their
scarce time to focusing on these items. Effective control requires that corrective action is
taken so that actual outcomes conform to planned outcomes, as indicated by the
feedback loop linking steps 5 and 7. Isolating past inefficiencies and the reasons for them
will enable managers to take action that will avoid the same inefficiencies being repeated
in the future. The system that provides reports that compare actual performance with
budget figures and holds managers responsible is known as responsibility accounting.
We will return to this topic below.
BUDGETING | 69
2 STEPS IN THE PREPARATION OF A BUDGET

Section overview
Ideally budget preparation begins towards the end of the strategy planning stage once
objectives and strategies have been decided upon. While the mechanics of budget
preparation is the focus of your immediate study, it is important to appreciate how
important budgets are in co-ordination and control.
It is not uncommon for the responsibility of administration and coordination of the budget
to sit with a Budget committee.
You will see how the activities of all aspects of the business are brought together in the budget.
2.1 BUDGET COMMITTEE

The co-ordination and administration of budgets may be the responsibility of a budget committee,
consisting of senior executives. The budget committee is assisted by a budget officer who is usually
an accountant. Every part of the organisation should be represented on the committee, so there
should be a representative from sales, production, marketing and so on. Functions of the budget
committee include the following:
Co-ordination and allocation of responsibility for the preparation of budgets
Issuing of the budget manual
Timetabling
Provision of information to assist in the preparation of budgets
Monitoring the budgeting and planning process by comparing actual and budgeted results
2.2 RESPONSIBILITY FOR BUDGETS

The responsibility for preparing the budgets should, ideally, lie with the managers who are
responsible for implementing them. For example, the preparation of particular budgets might be
allocated as follows:
The sales manager should draft the sales budget and the selling overhead cost centre budgets.
The purchasing manager should draft the material purchases budget.
The production manager should draft the direct production cost budgets.
2.3 THE BUDGET MANUAL

Definition
The budget manual is a collection of instructions on how to use the tools, systems and software
related to the budgeting process.
A budget manual may contain the following:

a. An explanation of the objectives of the budgetary process including the following:
The purpose of budgetary planning and control.
The objectives of the various stages of the budgetary process.
The importance of budgets in the long-term planning and administration of the organisation.
b. Organisational structures, including the following:
An organisation chart
A list of individuals holding budget responsibilities
CHAPTER 3
Communication of final budgets to the appropriate managers
c. An outline of the principal budgets and the relationship between them.

d. Administrative details of budget preparation such as the following:
Membership, and terms of reference of the budget committee
The sequence in which budgets are to be prepared
A timetable
e. Procedural matters such as the following:
Sample forms and instructions for their completion. (Note: many budgets are now prepared in
budget models, such as spreadsheet models).
Sample reports.
Account codes or a chart of accounts.
The name of the budget officer to whom enquiries must be directed.
2.4 STEPS IN BUDGET PREPARATION

The procedures for preparing a budget will differ from organisation to organisation but the steps
described below will be indicative of the steps followed by many organisations. The preparation of a
budget may take weeks or months and the budget committee may meet several times before the
master budget (budgeted statement of comprehensive income and budgeted statement of financial
position) is finally agreed.
Functional budgets (such as sales budgets, production budgets and direct labour budgets), which
are amalgamated into the master budget, may need to be amended many times as a consequence of
discussions between departments and changes in market conditions during the course of budget
preparation.
2.5 IDENTIFYING THE PRINCIPAL BUDGET FACTOR

Definition
The principal budget factor is the factor which limits the activities of an organisation.
The first task in the budgetary process is to identify the principal budget factor. This is also known as
the key budget factor or limiting budget factor.
The principal budget factor is usually sales demand. A company is usually restricted from making
and selling more of its products because there would be no sales demand for the increased output at
a price which would be acceptable/profitable to the company. The principal budget factor may also
be machine capacity, distribution and selling resources, the availability of key raw materials or the
availability of cash.
Once the principal budget factor is defined then the remainder of the budgets can be prepared. For
example, if sales are the principal budget factor then the production manager can only prepare the
production budget after the sales budget is complete.
A useful assumption for preparing the first draft of the functional budgets is to assume that sales
demand is the principal budget factor. If it then becomes apparent that a scarce resource is the
principal budget factor, the functional budgets can be revised and new drafts prepared.
The stages involved in the preparation of a budget with sales as the limiting factor can be summarised
as follows.
a. The sales budget (revenue budget) is prepared by calculating units of product (volume) multiplied
by sales price. The finished goods inventory budget can be prepared at the same time. This
budget decides the planned increase or decrease in finished goods inventory levels.
b. With the information from the sales and inventory budgets, the production budget can be
prepared. This is, in effect, the sales budget in units plus (or minus) the increase (or decrease) in
finished goods inventory. The production budget will be stated in terms of units.
c. This leads on to budgeting the resources for production. This involves preparing a materials
usage budget, machine usage budget and a labour budget.
BUDGETING | 71
d. In addition to the materials usage budget, a materials inventory budget will be prepared, to
decide the planned increase or decrease in the level of inventories held. Once the raw materials
usage requirements and the raw materials inventory budget are known, the purchasing department
can prepare a raw materials purchases budget in quantities and value for each type of material
purchased.
e. During the preparation of the sales and production budgets, the managers of the cost centres of
the organisation will prepare their draft budgets for the department overhead costs. (A cost
centre is any division, department, or subsidiary of a company that has expenses but is not directly
producing revenues). Such overheads will include maintenance, stores, administration, selling and
research and development.
f. From the above information a budgeted statement of comprehensive income can be produced.
g. In addition several other budgets must be prepared in order to arrive at the budgeted statement
of financial position. These are the capital expenditure budget (for non-current assets), the
working capital budget (for budgeted increases or decreases in the level of receivables and
payables as well as inventories), and a cash budget.
3 PREPARING FUNCTIONAL OPERATING BUDGETS

Section overview
A functional (or departmental) budget is a budget forecasting income and expenditure for
a particular department or process. It could be a production budget, a sales budget or
purchasing budget depending on the function and the nature of its activities.
LO
3.3
ECO Ltd manufactures two products, S and T, which use the same raw materials, D and E. One unit of
S uses 3 litres of D and 4 kilograms of E. One unit of T uses 5 litres of D and 2 kilograms of E. A litre of
D is expected to cost $3 and a kilogram of E $7.
The sales budget for 20X2 comprises 8,000 units of S and 6,000 units of T; finished goods in stock at 1
January 20X2 are 1 500 units of S and 300 units of T, and the company plans to hold inventories of 600
units of each product at 31 December 20X2.
Inventories of raw material are 6,000 litres of D and 2,800 kilograms of E at 1 January and the company
plans to hold 5,000 litres and 3,500 kilograms respectively at 31 December 20X2.
The warehouse and stores managers have suggested that a provision should be made for damages
and deterioration of items held in store, as follows:
Product S:
Product T:
Material D:
Material E:
loss of 50 units
loss of 100 units
loss of 500 litres
loss of 200 kilograms
Prepare a material purchases budget for the year 20X2.
CHAPTER 3
Worked Example: Preparing a materials purchases budget
Solution
To calculate material purchases requirements first it is necessary to calculate the material usage
requirements. That in turn depends on calculating the budgeted production volumes.
Product S
Units
Production required
To meet sales demand
To provide for inventory loss
For closing inventory
Product T
Units
8 000
50
600
8 650
1 500
7 150
Less inventory already in hand

Budgeted production volume
6 000
100
600
6 700
300
6 400
Material D
Litres
Usage requirements
To produce 7 150 units of S
To produce 6 400 units of T
To provide for inventory loss
For closing inventory
Less inventory already in hand
Budgeted material purchases
Unit cost
Cost of material purchases
Total cost of material purchases
Material E
Kgs
21 450
32 000
500
5 000
58 950
6 000
52 950
28 600
12 800
200
3 500
45 100
2 800
42 300
$3
$7
$158 850
$296 100
$454 950
The basics of the preparation of each functional budget are similar to the above.
4 CASH BUDGETS
Section overview
The cash budget is one of the most important planning tools that an organisation can use.
It shows the cash effect of all plans made within the budgetary process.
Definition
A cash budget is a statement in which estimated future cash receipts and payments are tabulated
in such a way as to show the forecast cash balance of a business at defined intervals.
Worked Example: Cash position

LO
3.4
In December 20X2 an accounts department might wish to estimate the cash position of the business
for the following months, January to March 20X3. A cash budget might be drawn up in the following
format:
Estimated cash receipts

From credit customers
From cash sales
Proceeds on disposal of non-current assets
Total cash receipts
Jan
$
Feb
$
Mar
$
14 000
3 000
16 500
4 000
2 200
22 700
17 000
4 500
17 000
21 500
BUDGETING | 73
Estimated cash payments

To suppliers of goods
To employees (wages)
Purchase of non-current assets
Rent and rates
Other overheads
Repayment of loan
Net surplus/(deficit) for month
Opening cash balance
Closing cash balance
Jan
$
Feb
$
Mar
$
8 000
3 000
7 800
3 500
16 000
10 500
3 500
1 200
2 500
14 700
1 200
1 000
1 200
28 500
16 200
2 300
1 200
3 500
(5 800)
3 500
(2 300)
5 300
(2 300)
3 000
In the example above, where the figures are purely for illustration, the accounts department has
calculated that the cash balance at the beginning of the budget period, 1 January, will be $1 200.
Estimates have been made of the cash which is likely to be received by the business (from cash and
credit sales, and from a planned disposal of non-current assets in February). Similar estimates have
been made of cash due to be paid out by the business - payments to suppliers and employees,
payments for rent, rates and other overheads, payment for a planned purchase of non-current assets in
February and a loan repayment due in January.
The last part of the cash budget above shows how the business's estimated cash balance can then be
rolled along from month to month. Starting with the opening balance of $1 200 at 1 January a cash
surplus of
$2 300 is generated in January. This leads to a closing January balance of $3 500 which becomes the
opening balance for February. The deficit of $5 800 in February puts the business's cash position into
overdraft and the overdrawn balance of $2 300 becomes the opening balance for March. Finally, the
healthy cash surplus of $5 300 in March leaves the business with a favourable cash position of $3 000 at
the end of the budget period.
4.1 THE USEFULNESS OF CASH BUDGETS

The cash budget is one of the most important planning tools that an organisation can use. It shows
the cash effect of all plans made within the budgetary process and hence its preparation can lead
to a modification of budgets if it shows that there are insufficient cash resources to finance the
planned operations.
It can also give management an indication of potential problems that could arise and allows them
the opportunity to take action to avoid such problems. A cash budget can show four positions.
Management will need to take appropriate action depending on the potential position. This is part of
the process of the management of working capital.
CASH POSITION
APPROPRIATE MANAGEMENT ACTION
Short-term surplus
Short-term deficit
Pay suppliers early to obtain discount

Attempt to increase sales by increasing receivables
and inventories
Make short-term investments
Increase payables
Reduce receivables
Arrange an overdraft
CHAPTER 3
From these estimates it is a simple step to calculate the excess of cash receipts over cash payments in
each month. In some months cash payments may exceed cash receipts and there will be a deficit for
the month; this occurs during February in the above example because of the large investment in noncurrent assets in that month.
CASH POSITION
APPROPRIATE MANAGEMENT ACTION
Long-term surplus
Make long-term investments

Expand
Diversify
Replace/update non-current assets
Pay dividends, repay debt capital, buy back and
cancel shares
Long-term deficit
Raise long-term finance: borrow or raise equity

finance through a new share issue
Consider shutdown/disinvestment opportunities
Worked Example: Petra Blair cash budget

Petra Blair has worked for some years as a sales representative, but has recently been made
redundant.
She intends to start up in business on her own account, using $15 000 which is currently invested with a
building society. Petra maintains a bank account showing a small credit balance, and plans to approach the
bank for the necessary additional finance. Petra asks you for advice and provides the following additional
information:
a. Arrangements have been made to purchase non-current assets costing $8 000. These will be paid
for at the end of September 20X3 and are expected to have a five-year life, at the end of which
they will possess a nil residual value.
b. Inventories costing $5 000 will be acquired on 28 September and subsequent monthly purchases
will be at a level sufficient to replace forecast sales for the month.
c. Forecast monthly sales are $3 000 for October, $6 000 for November and December, and $10 500
from January 20X4 onwards.
d. Selling price is fixed at the cost of inventory plus 50%.
e. Two months' credit will be allowed to customers but only one month's credit will be received from
suppliers of inventory.
f. Running expenses, including rent but excluding depreciation of non-current assets, are estimated
at $1 600 per month.
g. Petra intends to make monthly cash drawings of $1 000.
Prepare a cash budget for the six months to 31 March 20X4.
Solution
The opening cash balance at 1 October will consist of Petra's initial $15 000 less the $8 000 expended
on non-current assets purchased in September. In other words, the opening balance is $7 000. Cash
receipts from credit customers arise two months after the relevant sales.
Payments to suppliers are a little more tricky. We are told that cost of sales is 100/150 sales.
Therefore for October cost of sales is 100/150 $3 000 = $2 000. These goods will be purchased in
October but not paid for until November. Similar calculations can be made for later months. The initial
inventory of $5 000 is purchased in September and consequently paid for in October.
Depreciation is not a cash flow and so is not included in a cash budget.
The cash budget can now be constructed.
BUDGETING | 75
CASH BUDGET FOR THE SIX MONTHS ENDING 31 MARCH 20X4
Payments
Suppliers (W1)
Running expenses
Drawings
Receipts
Debtors (W1)
Surplus/(shortfall)
Opening balance
Closing balance
Workings
W1 Suppliers
Purchased
Paid for in
W2 Receipts
Sales made
Cash received
Oct
$
Nov
$
Dec
$
Jan
$
Feb
$
Mar
$
5 000
1 600
1 000
7 600
2 000
1 600
1 000
4 600
4 000
1 600
1 000
6 600
4 000
1 600
1 000
6 600
7 000
1 600
1 000
9 600
7 000
1 600
1 000
9 600
(7 600)
7 000
(600)
(4 600)
(600)
(5 200)
3 000
(3 600)
(5 200)
(8 800)
6 000
(600)
(8 800)
(9 400)
6 000
(3 600)
(9 400)
(13 000)
10 500
900
(13 000)
(12 100)
Sept
Oct
Nov
Dec
Jan
Feb
Mar
5000
0
2000
5000
4000
2000
4000
4000
7000
4000
7000
7000
7000
7000
0
0
3000
0
6000
0
6000
3000
10500
6000
10500
6000
10500
10500
Question 1: Your organisation

You are presented with the budgeted data shown in the table below (Annex A). This will be used to
prepare a budget for the period January to June 20X5. The data has been extracted from the other
functional budgets that have been prepared.
a. Sales are 40% cash, 60% credit. Credit sales are paid two months after the month of sale.
b. Payments for purchases are made in the month following purchase.
c. 75% of wages are paid in the current month and 25% the following month.
d. Depreciation charges were $2 000 in each month in November and December 20X4. Depreciation
increases by $500 in each month from January 20X5 and by another $500 per month from April
20X5 (when the new capital expenditure occurs). All other overheads are cash expenditure items.
e. Cash expenditure items of overhead are paid the month after they are incurred.
f. Dividends are paid three months after they are declared.
g. Capital expenditure is paid two months after it is incurred.
h. The opening cash balance on 1 January 20X5 is $15 000.
The managing director is pleased with these figures as they show sales will have increased by more
than 100% in the period under review. In order to achieve this the MD has arranged a bank overdraft
with a ceiling of $50,000 to accommodate the increased inventory levels and wage bill for overtime
worked.
Sales
Purchases
Wages
Overheads
Dividends
Capital
expenditure
Nov X4
$
80 000
40 000
10 000
10 000
Dec X4
$
100 000
60 000
12 000
10 000
20 000
Jan X5
$
110 000
80 000
16 000
15 500
30 000
Annex A
Feb X5
Mar X5
$
$
130 000
140 000
90 000
110 000
20 000
24 000
15 500
15 500
Apr X5
$
150 000
130 000
28 000
20 000
40 000
May X5
$
160 000
140 000
32 000
20 000
Jun X5
$
180 000
150 000
36 000
20 000
CHAPTER 3
You are also told the following.
Requirements:
a. How much cash will be received from sales in February 20X5?
A
B
C
D
$100 000
$112 000
$118 000
$130 000
b. What is the budgeted cash balance at the end of January 20X5?

A
B
C
D
($6 000) overdraft

$9 000
$19 000
$24 000
c. What is the total budgeted cash spending on overheads in the six month period January June
20X5?
A
B
C
D
$81 000
$87 000
$95 000
$99 000
d. What is the total budgeted receipts from sales in the six month period January to June 20X5?
A
B
C
D
$666 000
$742 000
$774 000
$822 000
e. What are the total budgeted payments for purchases in the six month period January to June
20X5?
A
B
C
D
$610 000
$690 000
$700 000
$790 000
f. If the cash budget indicates a large bank overdraft at the end of June, which one of the following
measures might be the most practical for reducing the budgeted cash deficit?
A Postpone the capital expenditure
B Increase the speed of debt collection
C Take on extra staff to reduce the amount of overtime working.
D Persuade staff to work at a lower rate in return for an annual bonus or a profit-sharing
agreement
(The answers are at the end of the chapter)
4.2 OTHER WORKING CAPITAL BUDGETS

It may also be useful for a business monitoring its cash situation to look at other components of
working capital: inventory, receivables and payables. Inventory usually gets detailed consideration
when the functional budgets are prepared. Receivables budgets and payables budgets depend on
patterns of payment to suppliers and from customers, which are considered for the purpose of
preparing the cash budget.
BUDGETING | 77
5 BUDGETED FINANCIAL STATEMENTS
LO
3.3
Section overview
As well as wishing to forecast its cash position, a business might want to estimate its
profitability and its financial position for a coming period. This would involve the
preparation of a budgeted statement of comprehensive income and statement of financial
position, both of which form the master budget.
Worked Example: Budgeted financial statements
Using the information in the previous example involving Petra Blair (section 4.1) you are required to
prepare Petra's budgeted statement of comprehensive income for the six months ending on 31 March
20X4 and a budgeted statement of financial position as at that date.
Solution
The statement of comprehensive income is straightforward. The first figure is sales, which can be
computed very easily from the information in paragraph (c) in the original question. It is sufficient to
add up the monthly sales figures given there; for this statement there is no need to worry about any
closing receivables. Similarly, cost of sales is calculated directly from the information on gross margin
contained in the example above.
$
46 500
Sales (3 000 + (2 6 000) + (3 10 500))
31 000
Cost of sales (100/150 $46 500)

Gross profit
Expenses
Running expenses (6 $1 600)
Depreciation ($8 000 20% 6/12)
Net profit
15 500
9 600
800
10 400
5 100
a. Inventory will comprise the initial purchases of $5 000.

b. Receivables at the end of March will comprise sales made in February and March, not paid until
April and May respectively.
c. Payables at the end of March will comprise purchases made in March, not paid for until April.
d. The bank overdraft is the closing cash figure computed in the cash budget.
CHAPTER 3
INCOME STATEMENT
FORECAST TRADING AND COMPREHENSIVE INCOME STATEMENT
FOR THE SIX MONTHS ENDING 31 MARCH 20X4
FORECAST STATEMENT OF FINANCIAL POSITION AT 31 MARCH 20X4

$
Non-current assets $(8 000 800)
Current assets
Inventories
Receivables (2 $10 500)
$
7 200
5 000
21 000
26 000
Current liabilities
Bank overdraft
Trade payables (March purchases)
Net current assets
Total assets
Proprietor's interest
Capital introduced
Profit for the period
Less drawings
Retained loss
Total equity
12 100
7 000
19 100
6 900
14 100
15 000
5 100
6 000
(900)
14 100
Budget questions are often accompanied by a large amount of sometimes confusing detail. This
should not blind you to the fact that many figures can be entered very simply from the logic of the
trading situation described. For example, in the case of Petra Blair you might feel tempted to begin a
T-account to compute the figure for closing receivables. This kind of working is rarely necessary, since
you are told that credit customers take two months to pay. Closing receivables will equal total credit
sales in the last two months of the period.
Similarly, you may be given a simple statement that a business pays rates at $1 500 a year, followed by
a lot of detail to enable you to calculate a prepayment at the beginning and end of the year. If you are
preparing a budgeted comprehensive income statement for the year do not lose sight of the fact that
the rates expense can be entered as $1 500 without any calculation at all.
6 FLEXIBLE BUDGETS
LO
3.2
3.3
Section overview
A flexible budget is a budget which is designed to change as volume of activity changes.
Definitions
A fixed (static) budget is a budget which is set for a single activity level.
A flexible budget is a budget which, by recognising different cost behaviour patterns, is designed to
change as volume of activity changes.
Master budgets are based on planned volumes of production and sales but do not include any
provision for the event that actual volumes may differ from the budget. In this sense they may be
described as fixed (static) budgets.
A flexible budget has two advantages:
a. At the planning stage, it may be helpful to know what the effects would be if the actual outcome
differs from the prediction. For example, a company may budget to sell 10 000 units of its product,
but may prepare flexible budgets based on sales of, say, 8 000 and 12 000 units. This would enable
contingency plans to be drawn up if necessary.
b. At the end of each month or year, actual results may be compared with the relevant activity level in
the flexible budget as a control procedure.
BUDGETING | 79
Flexible budgeting uses the principles of marginal costing. In estimating future costs it is often
necessary to begin by looking at cost behaviour in the past. For costs which are wholly fixed or wholly
variable no problem arises. But you may be presented with a cost which appears to have behaved in
the past as a semi-variable cost (partly fixed and partly variable). A technique for estimating the level
of the cost for the future is called the high-low method. This is discussed in more detail in Chapter 4,
section 4.2
Worked Example: High-low method
The cost of factory power has behaved as follows in past years:
Units of output produced
20X1
20X2
20X3
20X4
7 900
7 700
9 800
9 100
Cost of factory power

$
38 700
38 100
44 400
42 300
Budgeted production for 20X5 is 10 200 units. Estimate the cost of factory power which will be
incurred. Ignore inflation.
Solution
20X3 (highest output)
20X2 (lowest output)
Units
9 800
7 700
2 100
$
44 400
38 100
6 300
The variable cost per unit is therefore $6 300/2 100 = $3.

$
44 400
29 400
Total cost of factory power in 20X3

Less variable cost of factory power (9 800 $3)
Fixed cost of factory power
15 000
An estimate of costs in 20X5 is as follows.

$
15 000
30 600
Fixed cost
Variable cost of budgeted production (10 200 $3)
Total budgeted cost of factory power
45 600
We can now look at a full example of preparing a flexible budget:

Worked Example: Preparing a flexible budget
a. Prepare a budget for 20X6 for the direct labour costs and overhead expenses of a production
department at the activity levels of 80%, 90% and 100%, using the information listed below:
The direct labour hourly rate is expected to be $3.75.
100% activity represents 60,000 direct labour hours.
Variable costs
Indirect labour
Consumable supplies
Other staff expenses
$0.75 per direct labour hour

$0.375 per direct labour hour
6% of direct and indirect labour costs
CHAPTER 3
The level of fixed cost can be calculated by looking at any output level.
Semi-variable costs are expected to relate to the direct labour hours in the same manner as for
the last five years.
Direct labour
hours
Year
20X1
20X2
20X3
20X4
20X5
Semi-variable
costs
$
20 800
19 800
18 600
17 800
16 000 (estimate)
64 000
59 000
53 000
49 000
40 000 (estimate)
Fixed costs
$
18 000
10 000
4 000
15 000
25 000
Depreciation
Maintenance
Insurance
Rates
Management salaries
Inflation is to be ignored.
b. Compile a flexible manufacturing budget for 20X6 assuming that 57,000 direct labour hours are
worked.
Solution
a.
Direct labour ($3.75/DLH)

Other variable costs
Indirect labour ($0.75/DLH)
Consumable supplies ($0.375/DLH)
Other staff expenses
Total variable costs ($5.145 per hour)
Semi-variable costs (W)
Fixed costs
Depreciation
Maintenance
Insurance
Rates
Management salaries
Total manufacturing costs
80% level
48 000 hrs
$ 000
90% level
54 000 hrs
$ 000
100% level
60 000 hrs
$ 000
180.00
202.50
225.00
36.00
18.00
12.96
246.96
17.60
40.50
20.25
14.58
277.83
18.80
45.00
22.50
16.20
308.70
20.00
18.00
10.00
4.00
15.00
25.00
336.56
18.00
10.00
4.00
15.00
25.00
368.63
18.00
10.00
4.00
15.00
25.00
400.70
Working
Using the high/low method:
$
20 800
16 000
4 800
Total cost of 64 000 hours

Variable cost of 24 000 hours
Variable cost per hour ($4 800/24 000)
$0.20
$
20 800
12 800

Variable cost of 64 000 hours ( $0.20)
Fixed costs
8 000
Semi-variable costs are calculated as follows:

60 000 hours
54 000 hours
48 000 hours
(60 000 $0.20) + $8 000

(54 000 $0.20) + $8 000
(48 000 $0.20) + $8 000
=
=
=
$
20 000
18 800
17 600
BUDGETING | 81
b. The budget manufacturing cost for 57,000 direct labour hours of work would be as follows:
$
293 265
Variable costs
(57 000 $5.145)
Semi-variable costs
($8 000 + (57 000 $0.20))
Fixed costs
19 400
72 000
384 665
6.1 BUDGETARY CONTROL

Budgetary control is a system of management control that is based on feedback comparisons of
actual results with the budget. Where actual results differ significantly from budget, the cause is
investigated and control action taken where appropriate. Control reports are prepared regularly,
typically every month, and budgetary control reports may be prepared for each responsibility centre
(cost centre or profit centre that is an areas of responsibility for an individual manager) as well as for
the organisation as a whole.
The most important method of budgetary control is variance analysis, which involves the comparison
of actual results achieved during a control period, usually a month, or four weeks, with a flexible
budget. The differences between actual results and expected results are called variances and these
are used to provide a guideline for control action by individual managers.
A less desirable approach to budgetary control is to compare actual results against a fixed (static)
budget. Consider the following example.
Worked Example: Windy Ltd: actual results compared to fixed (static) budget
Production and sales of the cloud (units)

Sales revenue (a)
Direct materials
Direct labour
Maintenance
Depreciation
Rent and rates
Other costs
Total costs (b)
Profit (a) (b)
Budget
2 000
$
20 000
6 000
4 000
1 000
2 000
1 500
3 600
18 100
1 900
Actual results
3 000
$
30 000
8 500
4 500
1 400
2 200
1 600
5 000
23 200
6 800
Variance
1 000F
$
10 000 (F)
2 500 (U)
500 (U)
400 (U)
200 (U)
100 (U)
1 400 (U)
5 100
4 900 (F)
Note. (F) denotes a favourable variance and (U) an unfavourable variance. Unfavourable variances are
sometimes denoted as (A) for 'adverse'.
a. In this example, some of the variances calculated above are not useful for the purposes of control.
Windy Ltd has earned $10 000 more revenue than budgeted but spent $5 100 more on costs.
However actual revenue and costs would inevitably be expected to be higher than the original
budget because the volume of output was also 50% higher. For example, even if the unit costs
were as budgeted, total variable costs such as direct material and direct labour would be expected
to increase by 50% above the budgeted costs in the fixed (static) budget, whereas fixed costs such
as rent and rates would be unaffected by the volume change.
b. For control purposes, it is necessary to adjust the original budget to ascertain the answers to
questions such as the following:
Were actual costs higher than they should have been to produce and sell 3 000 clouds? As
explained above, the unfavourable direct materials variance of $2 500 is misleading. It would be
more meaningful to compare the actual material cost of $8 500 to a restated budget figure of
$9 000 ($6 000 x 3 000/2 000), resulting in a favourable variance of $500 which implies that Windy
Ltd has in fact saved money on materials.
CHAPTER 3
Windy Ltd manufactures a single product, the cloud. Budgeted results and actual results for June 20X2
are shown below:
Was actual revenue satisfactory from the sale of 3 000 clouds? The budgeted selling price is $10
per cloud ($20 000/2 000 units), so budgeted revenue for 3 000 clouds would be $30 000
indicating that Windy Ltd has performed exactly as expected.
A more desirable approach to budgetary control which helps an organisation to identify where
corrective action needs to be taken can be seen in the worked example below:
a. Identify fixed and variable costs.
b. Produce a flexible budget using marginal costing techniques.
c. Ascertain the variances by comparing the actual result with the flexible budget.
Worked Example: Windy Ltd: actual results compared to flexible budget

Using the previous example of Windy Ltd, let us assume that we have the following estimates of cost
behaviour:
Direct materials, direct labour and maintenance costs are variable.
Rent and rates and depreciation are fixed costs.
Other costs consist of fixed costs of $1 600 plus a variable cost of $1 per unit made and sold.
Solution
The budgetary control analysis should be as follows:
Production & sales (units)

Sales revenue
Variable costs
Direct materials
Direct labour
Maintenance
Semi-variable costs
Other costs
Fixed costs
Depreciation
Rent and rates
Total costs
Profit
Fixed
(static)
budget
(a)
2 000
Flexible
budget
(b)
3 000
Actual
results
(c)
3 000
Budget
variance
(b) (c)
$
20 000
$
30 000
$
30 000
6 000
4 000
1 000
9 000
6 000
1 500
8 500
4 500
1 400
500 (F)
1 500 (F)
100 (F)
3 600
4 600
5 000
400 (U)
2 000
1 500
18 100
1 900
2 000
1 500
24 600
5 400
2 200
1 600
23 200
6 800
200 (U)
100 (U)
1 400 (F)
1 400 (F)
Note. (F) denotes a favourable variance and (U) an unfavourable variance.

We can analyse the above as follows:
a. In selling 3 000 units the expected profit should have been, not the fixed (static) budget profit of $1
900, but the flexible budget profit of $5 400. Instead, actual profit was $6 800 i.e. $1 400 more than
we should have expected. The reason for this $1 400 improvement is that, given output and sales
of 3 000 units, overall costs were lower than expected and sales revenue was exactly as expected.
For example, the direct material cost was $500 lower than expected.
BUDGETING | 83
b. Another reason for the improvement in profit above the fixed (static) budget profit is the sales
volume. Windy Ltd sold 3 000 clouds instead of 2 000 clouds, with the following result:
$
Budgeted sales revenue increased by
Budgeted variable costs increased by
direct materials
direct labour
maintenance
variable element of other costs
Budgeted fixed costs are unchanged
Budgeted profit increased by
$
10 000
3 000
2 000
500
1 000
6 500
3 500
Budgeted profit was therefore increased by $3 500 because sales volumes increased. This can be
calculated by comparing the fixed (static) budget to the flexible budget (5 400 1 900 = 3 500).
c. A full variance analysis statement would be as follows:
$
Fixed (static) budget profit
Variances
Sales volume (as calculated in (b) above)
Direct materials cost
Direct labour cost
Maintenance cost
Other costs
Depreciation
Rent and rates
Actual profit
$
1 900
3 500 (F)
500 (F)
1 500 (F)
100 (F)
400 (U)
200 (U)
100 (U)
4 900
6 800
(F)
Question 2: Fixed cost and variance reporting

A manufacturing organisation budgeted to produce 16 000 units in the budget period. The budgeted
variable cost per unit was $2.75. When output was 18 000 units, total expenditure was $98 000 and it
was found that fixed overheads were $11 000 over budget, while variable costs were in line with
budget.
What was the amount budgeted for fixed costs?
A $37 500
B $43 000
C $59 500
D $65 000
CHAPTER 3
If management believes that any of these variances are large enough to justify it, they will
investigate the reasons for them to see whether any corrective action is necessary.
7 COST ESTIMATION
LO
4.2
Section overview
The production of a budget calls for the preparation of cost estimates and sales forecasts.
Cost estimation involves the measurement of historical costs to predict future costs.
In this section we will consider various cost estimation techniques.
7.1 COST ESTIMATION METHODS

Cost estimation involves the measurement of historical costs to predict future costs. Some
estimation techniques are more sophisticated than others and are therefore likely to be more reliable.
In practice, the simple techniques are more commonly found and should give estimates that are
sufficiently accurate for their purpose. It is these simple techniques which we will be examining here.
7.2 ACCOUNT-CLASSIFICATION METHOD

By this method, the manager responsible for estimating costs will go through a list of the individual
expenditure items which make up the total costs. Each item will be classified as fixed, variable or
semi-variable, and values will be assigned to these, probably by reference to the historical cost
accounts with an adjustment for estimated cost inflation.
This, in rough terms, is how the direct cost items (materials and labour costs) might be built-up when a
budgeted direct cost per unit of output is estimated. It is also commonly used by cost centre
managers in budgeting overhead costs and is quick and inexpensive. The technique does, however,
depend on the subjective judgment of each manager and his/her skill and realism in estimating
costs, and so only an approximate accuracy can be expected from its use.
7.3 HIGH/LOW METHOD

This method was introduced in section 6 of this chapter. The high/low method is used to calculate the
amount of variable and fixed cost within a semi variable cost. It involves the following steps:
Step 1
Take the highest and lowest output levels
Step 2
Find the difference
Step 3
Calculate the variable cost /unit

(Cost at highest level Cost at lowest level)/Difference in output level
Variable cost per unit =
Step 4
Total cost at high activity level _ total cost at low activity level
_
Total units at high activity level total units at low activity level
Calculate the fixed cost

Fixed costs = (total cost at high activity level ) (total units at high activity level variable
cost per unit)
The major drawback to the high/low method is that only two historical cost records from previous
periods are used in the cost estimation. Unless these two records are a reliable indicator of costs
throughout the relevant range of levels of activity, which is unlikely, only a 'loose approximation' of
fixed and variable costs will be obtained. The advantage of the method is its relative simplicity.
7.4 THE SCATTER GRAPH METHOD

A graph can be plotted of the historical costs from previous periods, and from the resulting scatter
diagram, a line-of-best-fit can be drawn by visual estimation.
BUDGETING | 85
The advantage of the scatter graph over the high/low method is that a greater quantity of historical
data is used in the estimation, but its disadvantage is that the cost line is drawn by visual judgment
and so is a subjective approximation.
A more accurate technique for plotting a line of best fit is to use regression analysis. This statistical
technique uses data from past periods to establish the relationship between costs and level of activity
as the equation of a straight line:
y = a + bx,
where a = fixed costs, b= variable cost per unit and x = volume of output.
The regression line can then be used to forecast costs for future periods.
8 INCREMENTAL AND ZERO-BASED BUDGETING

SYSTEMS
LOs
3.1
3.2
Section overview
Incremental budgeting is concerned mainly with the increments in costs and revenues
which will occur in a coming period.
Zero-based budgeting involves preparing a budget for each cost centre from a zero base.
The traditional approach to budgeting is to base next year's budget on the current year's results
plus an extra amount for estimated growth or inflation next year. This approach is known as
incremental budgeting since it is concerned mainly with the increments in costs and revenues which
will occur in the coming period.
Incremental budgeting is a reasonable procedure if current operations are as effective, efficient and
economical as they can be, and the organisation and the environment are largely unchanged.
In general, however, it is an inefficient form of budgeting as it encourages slack and wasteful spending
to creep into budgets: managers will spend to budget, even if the amount added for inflation proved
not to be necessary, so that the level of next year's budget is maintained. The result is that past
inefficiencies are perpetuated because cost levels are rarely subjected to close scrutiny.
To ensure that inefficiencies are not concealed, alternative approaches to budgeting have been
developed. One such approach is zero-based budgeting (ZBB).
8.2 THE PRINCIPLES OF ZERO-BASED BUDGETING

Zero-based budgeting rejects the assumption inherent in incremental budgeting that next year's
budget can be based on this year's costs. Existing practices and expenditures must be challenged.
ZBB requires each cost centre to justify all planned activities. Every aspect of the budget is examined
in terms of its cost and the benefits it provides and the selection of better alternatives is encouraged.
Definition
Zero-based budgeting involves preparing a budget for each cost centre from a zero base. Every item
of expenditure has to be justified in its entirety in order to be included in the next year's budget.
CHAPTER 3
8.1 TRADITIONAL (INCREMENTAL) BUDGETING
The basic approach of ZBB has three steps.
Step 1
Define decision packages

A decision package is a comprehensive description of a specific organisational activity, its
objectives, costs and benefits.
Step 2
Evaluate and rank packages

Using the decision packages, each activity is evaluated and ranked on the basis of its
benefit to the organization, in order of priority against other activities.
The ranking process provides managers with a technique to allocate scarce resources
between different activities. Minimum work requirements (those that are essential to get
a job done) will be given high priority and so too will work which meets legal obligations.
In the accounting department these would be minimum requirements to operate the
payroll, accounts receivable and accounts payable systems, and to maintain and publish a
set of accounts which satisfies the external auditors and regulatory authorities (e.g. tax
returns).
Step 3
Allocate resources
Resources in the budget are then allocated according to the funds available and the
evaluation and ranking of the competing packages.
8.3 THE ADVANTAGES OF IMPLEMENTING ZBB

It is possible to identify and remove inefficient or obsolete operations.
Cost reductions are possible.
It forces employees to avoid wasteful expenditure.
It can increase motivation if, as a result of preparing the decision packages, staff become more
involved in the budgeting process
It provides a budgeting and planning tool for management which responds to changes in the
business environment; 'obsolescent' items of expenditure are identified and dropped.
The documentation required provides all management with a coordinated, in-depth appraisal of
an organisation's operations.
It challenges the status quo and forces an organisation to examine alternative activities and
existing expenditure levels.
In summary, ZBB should result in a more efficient allocation and utilisation of resources to an
organisation's activities and departments.
8.4 THE DISADVANTAGES OF ZBB

The major disadvantage of zero-based budgeting is the time and energy required. The assumptions
about costs and benefits in each package must be continually updated and new packages developed
as soon as new activities emerge. The following problems might also occur:
Short-term benefits might be emphasised to the detriment of long-term benefits.
The false idea that all decisions have to be made in the budget might be encouraged.
Management must be able to meet unforeseen opportunities and threats at all times, and must not
feel restricted from carrying out new ideas simply because they were not approved by a decision
package, cost benefit analysis and the ranking process.
It may require management skills both in constructing decision packages and in the ranking
process which the organisation does not possess. Managers may therefore have to be trained in
ZBB techniques so that they can apply them sensibly and properly.
It may be difficult to 'sell' ZBB to managers as a useful technique for the following reasons:
costs and benefits of alternative courses of action are hard to quantify accurately.
Employees or trade union representatives may resist management ideas for changing the ways
in which work is done.
BUDGETING | 87
The organisation's information systems may not be capable of providing suitable cost and
benefit analysis.
The ranking process can be difficult. Managers face three common problems:
A large number of packages may have to be ranked.
There is often a conceptual difficulty in having to rank packages which managers regard as
being equally vital, for legal or operational reasons.
It is difficult to rank completely different types of activity, especially where activities have
qualitative rather than quantitative benefits, such as spending on staff welfare and working
conditions, where ranking must usually be entirely subjective.
In summary, perhaps the most serious drawback to ZBB is that it requires a lot of management
time and effort. One way of obtaining the benefits of ZBB and overcoming the drawbacks, is to apply
it selectively on a rolling basis throughout the organisation. For example, this year it applies to the
finance department, next year marketing department, the year after personnel department and so on.
In this way all activities will be thoroughly scrutinised over a period of time.
8.5 USING ZERO-BASED BUDGETING

ZBB can be used by both profit-making and non-profit-making organisations.
In manufacturing organisations, ZBB is best applied to expenditure incurred in departments that

support the essential production function. These include marketing, finance, quality control, repairs
and maintenance, production planning, research and development, engineering design, personnel,
data processing, sales and distribution. In many organisations, these expenses make up a large
proportion of the total expenditure. These activities are less easily quantifiable by conventional
methods and are more discretionary in nature.
ZBB can also be successfully applied to service industries and public sector organisations such as
local and central government departments, educational establishments, hospitals and so on. This is
because ZBB is a useful technique for identifying the cause of excess spending in administrative
activities, and eliminating wasteful and non-value-adding activities.
ZBB can be applied in any organisation where alternative levels of provision for each activity are
possible and where the costs and benefits are separately identifiable.
Some particular uses of ZBB are:
a. Budgeting for discretionary cost items, such as advertising, R & D and training costs. The
priorities for spending money could be established by ranking activities and alternative levels of
spending or service can be evaluated on an incremental basis. For example, is it worth spending $2
000 more to increase the number of employees to be trained on one type of training course by
10%? If so, what priority should this incremental spending on training be given, when compared
with other potential training activities?
b. Rationalisation measures. 'Rationalisation' means cutting back on production and activity levels,
and cutting costs. ZBB can be used to make rationalisation decisions when an organisation is
forced to make spending cuts. As indicated above, it is also a useful approach to eliminating
unnecessary and wasteful spending.
8.6 ROLLING BUDGETS

A rolling budget is a budget that always extends a set number of financial periods into the future, for
example four quarters. As the current period ends, a new period is added to the budget.
The advantages of rolling budgets include:
The forecast represented by the budget will be more accurate as managers are forced to reassess
the budget regularly and adjust for current conditions
CHAPTER 3
The procedures of ZBB do not lend themselves easily to direct manufacturing costs where standard
costing, work study and the techniques of management planning and control have long been
established as a means of budgeting expenditure.
Planning and control is based on a more recent, up-to-date plan

The budget will prompt managers to look further into the future than the traditional annual budget
The rolling budget can help to provide an early warning of whether the organisation is on track to
meet its goals.
Disadvantages include:
The budget preparation process may be more costly
Managers may be de-motivated by the additional volume of work involved, for example if standard
costs or stock valuations need to be revised.
9 BUDGETING, PERFORMANCE AND MOTIVATION

Section overview
Human behaviour affects the budgeting process, the resulting budgets and the
performance of managers and employees alike.
LO
3.1
In this chapter we have concentrated on the importance of the budgeting process for planning and
control by management. A further aspect of the budgeting process is the human behavioural aspect,
the effect that the budgeting process and resulting budgets has on the performance of managers and
other employees alike.
9.1 BUDGETS AND MOTIVATION

The motivational effect of the budgeting process on managers in a business is much written-about
and there are many conflicting views. It is well recognised that the budgetary process has the potential
to be a powerful motivating tool, but conversely it may also have a de-motivating effect.
The effect of the budget on the motivation of managers is largely due to the level of difficulty of the
targets set, and the manner in which they are set. Are the budgets imposed or have the managers
taken part in the budgeting process?
9.2 BUDGETS AND STANDARDS AS TARGETS

Once decided, budgets become targets. But how difficult should the targets be? And how might
people react to targets which are easy to achieve, or difficult to achieve?
The quantity of material and labour time included in the budget will depend on the level of
performance required by management. Four types of performance standard might be set:
Ideal standards are based on perfect operating conditions: no wastage, no spoilage, no
inefficiencies, no idle time, no breakdowns. Employees will often feel that the goals are
unattainable, become de-motivated and not work so hard.
Attainable standards are based on the hope that a standard amount of work will be carried out
efficiently, machines properly operated or materials properly used. Some allowance is made for
wastage and inefficiencies. If well-set they provide a useful psychological incentive by giving
employees a realistic, but challenging target of efficiency.
Current standards are based on current working conditions (current wastage, current
inefficiencies). They do not attempt to improve on current levels of efficiency.
Basic standards are kept unaltered over a long period of time, and may be out of date. They are
used to show change in efficiency or performance over a long period of time. They are perhaps the
least useful and least common type of standard in use.
Management must decide which of the four types of standard is most appropriate as a benchmark for
measuring performance.
BUDGETING | 89
Standards can be used as aspirational targets to drive improvements in performance, but when
benchmarking actual performance against such standards, management need to be aware that this
may result in de-motivated employees:
The impact on employee behaviour of budgets based on these different standards is summarised in
the table below:
TYPE OF STANDARD
IMPACT
Ideal standards
Some say that they provide employees with an incentive to be more efficient
even though it is highly unlikely that the standard will be achieved. Others
argue that they are likely to have an unfavourable effect on employee
motivation because the differences between standards and actual results will
always be adverse. The employees may feel that the goals are unattainable and
so they will not work so hard.
Attainable standards
Might be an incentive to work harder as they provide a realistic but challenging

target of efficiency.
Current standards
Will not motivate employees to do anything more than they are currently doing.
Basic standards
May have an unfavourable impact on the motivation of employees. Over time

they will discover that they are easily able to achieve the standards. They may
become bored and lose interest in what they are doing if they have nothing to
aim for.
Similar comments apply to budgets.
The various research projects into the behavioural effects of budgeting have given conflicting views on
certain points. However, there appears to be general agreement that a target must fulfil certain
conditions if it is to motivate employees to work towards it:
It must be sufficiently difficult to be a challenging target.
It must not be so difficult that it is not achievable.
It must be accepted by the employees as their personal goal.
9.3 PARTICIPATION
There are basically two ways in which a budget can be set: from the top down (imposed budget) or
from the bottom up (participatory budget).
9.4 TOP-DOWN STYLE OF BUDGETING

In this approach to budgeting, top management prepare a budget with little or no input from
operating personnel. This budget is then imposed upon the employees who have to work to the
budgeted figures.
The times when imposed budgets are effective are as follows:
In newly-formed organisations, because of employees' lack of knowledge.
In very small businesses, because the owner/manager has a complete overview of the business.
When operational managers lack budgeting skills.
When the organisation's different units require precise co-ordination.
When budgets need to be set quickly.
There are, of course, advantages and disadvantages to this style of setting budgets.
Advantages
The aims of long-term plans are more likely to be incorporated into short-term plans.
They improve the co-ordination between the plans and objectives.
CHAPTER 3
Budgets and standards are more likely to motivate employees if employees accept that the budget or
standard is achievable. If it can be achieved too easily, it will not provide sufficient motivation. If it is too
difficult, employees will not accept it because they will believe it to be unachievable. In extreme
circumstances, if employees believe a budget is impossible to achieve, they might be so de-motivated
that they attempt to prove that the budget is wrong. This is obviously the completely opposite effect to
that intended.
They use senior management's overall awareness of the organisation.

There is less likelihood of input from inexperienced or uninformed lower-level employees.
Budgets can be drawn up in a shorter period of time because a consultation process is not
required.
Disadvantages
Dissatisfaction, defensiveness and low morale amongst employees who have to work to meet the
targets. It is hard for people to be motivated to achieve targets set by somebody else. Employees
might put in only just enough effort to achieve targets, without trying to beat them.
The feeling of team spirit may disappear.
Organisational goals and objectives might not be accepted so readily and/or employees will not
be aware of them.
Employees might see the budget as part of a system of trying to find fault with their work: if they
cannot achieve a target that has been imposed on them they may be punished.
If consideration is not given to local operating and political environments, unachievable budgets
for overseas divisions could be produced.
Lower-level management initiative may be stifled if they are not invited to participate.
9.5 BOTTOM-UP STYLE OF BUDGETING

In this approach to budgeting, budgets are developed by lower-level managers who then submit
the budgets to their superiors. The budgets are based on the lower-level managers' available data
and forecasts of what is achievable and the associated necessary resources.
The advantages of participative budgets are as follows:
They are based on information from employees most familiar with the department. Budgets should
therefore be more realistic.
Knowledge spread among several levels of management is pulled together, again producing more
realistic budgets.
Because employees are more aware of organisational goals, they should be more committed to
achieving them.
Co-ordination and co-operation between those involved in budget preparation should improve.
Senior managers' overview of the business can be combined with operational-level details to
produce better budgets.
Managers should feel that they 'own' the budget and will therefore be more committed to the
targets and more motivated to achieve them.
Participation will broaden the experience of those involved and enable them to develop new skills.
Overall, participation in budget setting should give those involved a more positive attitude towards
the organisation, which should lead to better performance.
There are, on the other hand, a number of disadvantages of participative budgets:

They consume more time.
Any changes made by senior management to the budgets submitted by lower-level management
may cause dissatisfaction.
Budgets may be unachievable if managers are not qualified to participate.
Managers may not co-ordinate their own plans with those of other departments.
Managers may include budgetary slack (padding the budget) in their budgets. This means they
have over-estimated costs or under-estimated income. Actual results are then more likely to be
better than the budgeted target results.
An earlier start to the budgeting process could be required.
The research projects do not appear to provide definite conclusions about the motivational effects of
budgeting. The attitudes of the individuals involved have an impact.
BUDGETING | 91
Some managers may complain that they are too busy to spend time on setting standards and
budgeting.
Others may feel that they do not have the necessary skills.
Some may think that any budget they set will be used against them.
In such circumstances participation could be seen as an added pressure rather than as an opportunity.
For such employees an imposed approach might be better.
9.6 NEGOTIATED STYLE OF BUDGETING

At the two extremes, budgets can be dictated from above or simply emerge from below but, in
practice, different levels of management often agree budgets by a process of negotiation.
In the imposed budget approach, operational managers will try to negotiate with senior managers
the budget targets which they consider to be unreasonable or unrealistic.
Likewise senior management usually review and revise budgets presented to them under a
participative approach through a process of negotiation with lower level managers.
Final budgets are therefore most likely to lie between what top management would really like and
what lower level managers believe is feasible.
9.7 PADDING THE BUDGET

In the process of preparing budgets, managers might deliberately overestimate costs and
underestimate sales, so that they will not be blamed in the future for overspending and poor results.
A typical situation is for a manager to pad the budget and waste money on non-essential expenses so
that all the budget allowances are used. The reason behind this action is the fear that unless the
allowance is fully spent it will be reduced in future periods, making the future budget more difficult to
attain. If inefficiency and slack are allowed for in budgets, achieving a budget target means only that
costs have remained within the accepted levels of inefficient spending.
Budget bias can work in the other direction too. It has been noted that, after a run of mediocre
results, some managers deliberately overstate revenues and understate cost estimates, no doubt
feeling the need to make an immediate favourable impact by promising better performance in the
future. They may merely delay problems, however, as the managers may well be censured when they
fail to hit these optimistic targets.
9.8 GOAL CONGRUENCE AND DYSFUNCTIONAL DECISION MAKING

Individuals are motivated by personal desires and interests. These desires and interests may tie in with
the objectives of the organisation after all, some people 'live for their jobs'. Other individuals see
their job as a chore, and their motivations will have nothing to do with achieving the objectives of the
organisation for which they work.
It is therefore important that some of the desires, interests and goals motivating employees
correspond with the goals of the organisation as a whole. This is known as goal congruence. Such a
state would exist, for example, if the manager of department A worked to achieve a 10% increase in
sales for the department, this 10% increase being part of the organisation's overall plan to increase
organisational sales by 20% over the next three years.
On the other hand, dysfunctional behaviour can occur if a manager's goals are not in line with those
of the organisation as a whole. Attempts to enhance his or her own situation or performance (typically
'empire building' employing more staff, cutting costs to achieve favourable variances but causing
quality problems in other departments) will be at the expense of the best interests of the organisation
as a whole. Participation is not necessarily the answer. Goal congruence does not necessarily result
from allowing managers to develop their own budgets.
CHAPTER 3
In controlling actual operations, managers must then ensure that their spending rises to meet their
budget, otherwise they will be 'blamed' for careless budgeting.
A well designed standard costing and budgetary control system can help to ensure goal congruence.
Continuous feedback prompting appropriate control action should steer the organisation in the right
direction.
Question 3: Eskafield
Eskafield Industrial Museum opened ten years ago and soon became a market leader with many
working exhibits. In the early years there was a rapid growth in the number of visitors but with no
further investment in new exhibits, this growth has not been maintained in recent years.
Two years ago, John Derbyshire was appointed as the museum's chief executive. His initial task was to
increase the number of visitors to the museum and, following his appointment, he had made several
improvements to make the museum more successful.
Another of John's tasks is to provide effective financial management. This year the museum's Board of
Management has asked him to take full responsibility for producing the 20X3 budget. He has asked
you to prepare estimates of the number of visitors next year.
Shortly after receiving your notes, John Derbyshire contacts you. He explains that he had prepared a
draft budget for the Board of Management based on the estimated numbers for 20X3. This had been
prepared on the basis that:
Most of the museum's expenses such as salaries and rates are fixed costs;
The museum has always budgeted for a deficit;
The deficit in the draft budget for 20X3 is $35 000.

At the meeting with the Board of Management, John was congratulated on bringing the deficit down
from $41 000 in 20X1 to $37 000 (latest estimate) in 20X2. However, the Board of Management raised
two issues:
1. They felt that the planned deficit of $35 000 for 20X3 should be reduced to $29 000 as this would
represent a greater commitment.
2. They also queried why the budget had been prepared without any consultation with the museum
staff, i.e. a top down approach.
Requirements:
a. Which one of the following factors is LEAST likely to influence the views of John Derbyshire about
whether the further reduction in the deficit is achievable?
A
B
C
D
Variable cost estimates in the budget

The amount of padding in the budget
The morale and commitment of museum staff
The amount of discretionary costs in the budget
b. Which of the following factors would affect whether or not a top-down approach to budgeting is
appropriate for the museum?
I Financial awareness of the management team
II The level in the management hierarchy where spending decisions are made
III The size and culture of the organisation
A I only
B I and III only
C II and III only
D I, II and III
BUDGETING | 93
10 BUDGETING AND QUALITY

Section overview
Many businesses, both manufacturing and service businesses, are wholly concerned with
quality.
The concept behind quality control is the principle of 'get it right first time'.
10.1 TOTAL QUALITY MANAGEMENT (TQM)

As discussed in Chapter 1, Total Quality Management (TQM) is a management approach that means
that quality is the aim of every part of the organisation. The aim is to 'get it right first time' which
means striving for continuous improvement in order to eliminate faulty work and prevent mistakes. It
must apply to every part of the business and every activity that the business undertakes, whether it is
in making the product, providing the service, selling the product or general administration. Under
TQM each person, in every function of the business, has to recognise that s/he has customers. In some
cases, these are external customers but in many cases these are internal customers, the employees'
colleagues and managers.
10.2 BUDGETING AND TQM

The budgeting process is about setting standards or targets for all aspects and functions of the
business to meet. If the budgeting process is successful it can help in this continuous process of
improvement by setting targets that eventually eliminate all unnecessary waste and mistakes.
CHAPTER 3
However, since TQM seeks continuous improvement, it is not altogether consistent with a budget
approach to planning that uses current or attainable standards as a target.
KEY CHAPTER POINTS

A budget is a quantitative statement, for a defined period of time, which may include planned
revenues, expenses, assets, liabilities and cash flows.
The main purpose and benefit of using a budget is to assist with the achievement of the
organisation's objectives.
Towards the end of the strategy planning stage, the budget will be prepared. While the mechanics
of budget preparation is the focus of your immediate study, it is important to appreciate how
important budgets are in co-ordination and control.
The co-ordination and administration of budgets is usually the responsibility of a budget
committee.
The budget manual is a collection of instructions governing the responsibilities of persons, and the
procedures, forms and records relating to the preparation and use of budgetary data.
The principal budget factor is the factor which limits the activities of an organisation.
A functional operating or departmental budget is a budget forecasting income and expenditure
for a particular department or process. It could be a production budget, a sales budget or a
purchasing budget depending on the function and the nature of its activities.
A cash budget is a statement in which estimated future cash receipts and payments are compiled
in such a way as to show the forecast cash balance of a business at defined intervals.
A budget is one of the most important planning tools that an organisations can use. It shows the
cash effect of all plans made within the budgetary process.
In addition to forecasting its cash position, a business may want to estimate its profitability and its
financial position for a coming period.
Budgeted statements of comprehensive income and financial position form the master budget.
A fixed (static) budget is a budget which is set for a single activity level, whereas a flexible budget
is a budget which is designed to change as volume of activity changes.
Cost estimation involves the measurement of historical costs to predict future costs.
Incremental budgeting is concerned mainly with the increments in costs and revenues which will
occur in a coming period.
Zero-based budgeting involves preparing a budget for each cost centre from a zero base.
Human behaviour affects the budgeting process, the resulting budgets and the performance of
managers and employees alike.
BUDGETING | 95

1 Which of the following is a definition of feedback?
A The planning and control cycle within a budgetary system
B Control action on the basis of comparing actual results with a plan or budget
C Information gathered internally for comparing actual results against a plan or budget
D Information gathered internally and externally for comparing actual results against a plan or
budget
2 Which of the following is not a functional budget?
A Cash budget
B Production budget
C Selling cost budget
D Distribution cost budget
3 The principal budget factor is normally assumed to be
A cash.
B sales demand.
C production capacity.
D skilled labour resources.
5 In comparing a fixed budget with a flexible budget, what is the reason for the difference between
the profit figures in the two budgets?
A
B
C
D
Different levels of activity

Different levels of spending
Different levels of efficiency
The difference between actual and budgeted performance
6 When budget allowances are set without the involvement of the budget owner, the budgeting
process can be described as
A
B
C
D
top down budgeting.

negotiated budgeting.
zero based budgeting.
participative budgeting.
7 For which of the following would zero based budgeting be most suitable?
A
B
C
D
Building construction
Mining company operations
Transport company operations
Government department activities
CHAPTER 3
4 When preparing a production budget, the quantity to be produced equals

A sales quantity + opening inventory of finished goods + closing inventory of finished goods
B sales quantity opening inventory of finished goods + closing inventory of finished goods
C sales quantity opening inventory of finished goods closing inventory of finished goods
D sales quantity + opening inventory of finished goods closing inventory of finished goods

1 C Feedback is information for control purposes. It is not the control system itself, nor is it control
action. Feedback is collected as output from the system and so is internally-obtained
information.
2 A A functional budget is a budget prepared for a particular function or department. A cash
budget is the resultant cash balance of the planning decisions included in all the functional
budgets. It is not a functional budget itself. Therefore the correct answer is A.
The production budget (option B), the distribution cost budget (option D) and the selling cost
budget (option C) are all prepared for specific functions, therefore they are functional budgets.
3 B Unless there are good reasons for suspecting anything different, sales demand is assumed to
be the principal or limiting budget factor when the first draft budgets are prepared. The first
draft budget to prepare is therefore the sales budget.
4 B Any opening inventory available at the beginning of a period will reduce the additional quantity
required from production in order to satisfy a given sales volume. Any closing inventory
required at the end of a period will increase the quantity required from production in order to
satisfy sales and leave a sufficient volume in inventory. Therefore, we need to deduct the
opening inventory and add the required closing inventory.
5 A The difference in profit between the fixed budget and a flexible budget is due to differences in
the activity levels, resulting in differences in both costs and revenues.
6 A The budget is imposed by senior management at the top.
7 D Zero based budgeting, when used, is most suitable for activities that are away from front line
production or operating activities, where standards of performance can be set to plan and
monitor performance. ZBB is therefore best suited for back office operations, or administrative
work. It may therefore be appropriate for budgeting for government departments, especially
when the government is trying to reduce expenditure.
BUDGETING | 97

1 (a) B
Cash sales: (40% $130 000)
From credit sales in December: (60% $100
000)
Total cash receipts in February
$
52 000
60 000
112 000
(b) D
$
Cash sales: (40% $110 000)
From credit sales in November: (60% $80 000)
Total cash receipts in January
Payments for Decembers purchases
Payments for wages (Dec: 25% 12 000) + (Jan:
75% 16 000)
Payments for Decembers overheads (10 000
2 000)*
Total cash payments in January
Excess of cash receipts over payments
Cash balance at beginning of January
Cash balance at end of January
$
44 000
48 000
92 000
60 000
15 000
8 000
83 000
9 000
15 000
24 000
(c) A Overheads are paid the month after they are incurred so payments in January-June 20X5
relate to overheads incurred in December-May. Depreciation is not a cash cost and
therefore needs to be excluded:
Payments in:
January (10 000 2 000)
February April: [3 (15 500 2 500)]
May June: [2 (20 000 3 000)]
Total payments
$
8 000
39 000
34 000
81 000
(d) C
Receivables at 1 January: 60% (80 000 + 100
000)
Sales January to June
Less
Receivables at 30 June: 60% (160 000 + 180
000)
Cash receipts from sales
$
108 000
870 000
978 000
(204 000)
774 000
CHAPTER 3
* Depreciation is not a cash cost and therefore needs to be excluded:
(e) A
Payables at 1 January
Purchases January to June
Less Payables at 30 June
Cash payments for purchases
$
60 000
700 000
760 000
(150 000)
610 000
Alternatively since purchases are paid in the month after they are incurred, cash payments
Jan-June relate to purchases from Dec-May: (60+80+90+110+130+140) = 610 000
(f) A Budgeted wages costs are expected to rise substantially, but extra staff should not be taken
on unless they are expected to do simple casual work, or unless they are expected to remain
with the organisation for a long time. Otherwise training costs would be high. It would take
too long to re-negotiate wages and salary arrangements, and it will not be easy to speed up
collections from customers unless customers are in breach of their credit arrangements and
paying later than they should. Deferring some or all of the capital expenditure is likely to be
the easiest and most practical option.
2 A
Total expenditure
Variable cost, as expected (18 000 $2.75)
Actual fixed costs incurred
Unfavourable fixed overhead expenditure variance
Budgeted fixed costs
$
98 000
49 500
48 500
11 000
37 500
3 (a) A If John is aware of padding in the budget, he will be able to cut budgeted expenditure
without too much trouble simply by reducing the amount of padding. He may need to
consider the attitudes of staff and whether they are likely to have the commitment to cut
costs further. Most costs are fixed costs: some of these may be discretionary, and so
controllable. Since variable costs are small, they are unlikely to be a key factor in trying to
reduce the deficit, since potential savings in variable costs will not be significant.
(b) D If the management team is financially aware, they should be more capable of drafting
bottom-up budgets. However, responsibility for budgeting expenditures should not go
lower in the management hierarchy than the managers who make the spending decisions. If
John Derbyshire makes most of the spending decisions himself, and has the responsibility
for expenditures, he should retain the responsibility for budgeting. The approach to
budgeting, top-down or bottom-up, also depends on the culture and size of the
organisation. Very small organisations and large bureaucratic organisations are likely to have
a strong top-down culture.
99
CHAPTER 4
COST BEHAVIOUR AND
CVP ANALYSIS
Learning objectives
Reference
Cost behaviour
LO4
LO4.1
Apply relevant techniques to separate costs into their fixed and variable components
LO4.2
Apply the principles of cost-volume-profit analysis in organisations
LO4.3
Topic list
1 Fixed costs and variable costs

2 Introduction to cost behaviour
3 Cost behaviour patterns
4 Determining the fixed and variable elements of semi-variable costs
5 CVP analysis and break-even point
6 The contribution to sales (C/S) ratio
7 The safety margin
8 Break-even calculations and profit targets
9 Break-even graphs, contribution charts and profit/volume charts
10 Limitations of CVP analysis
INTRODUCTION
This chapter introduces the concept of the separation of costs into those that vary directly with
changes in activity levels (variable costs) and those that do not (fixed costs). This chapter examines
further this two-way split of cost behaviours and explains the high-low method as one method of
splitting semi-variable costs into these two elements.
The cost accountant, must also be fully aware of cost behaviour because, to be able to estimate
costs, he or she must know what a particular cost will do given particular conditions.
The application of cost-volume-profit analysis, which is based on the cost behaviour principles and
marginal costing ideas, is sometimes necessary so that the appropriate decision-making information
can be provided to management. This chapter is going to conclude with that very topic, cost-volumeprofit analysis or break-even analysis.
Cost behaviour
and
CVP analysis
Fixed and
variable costs
Cost behaviour
patterns
CVP
analysis
Contribution to Sales
(C/S) ratio
Safety margin
Breakeven
COST BEHAVIOUR AND CVP ANALYSIS | 101
BEFORE YOU BEGIN

area.
everything covered.
1 What is a fixed cost?
(Section 1)
2 What is a variable cost?
(Section 1)
3 Draw graphs to show fixed, variable and step-fixed costs
(Section 3)
4 What are the steps to follow to estimate the fixed and variable elements
of semi-variable costs?
(Section 4.2)
5 What is CVP analysis?
(Section 5.1)
(Section 6)
7 What is the formula for target profits?
(Section 8.1)
8 Draw and label a break-even chart
(Section 9.1)
9 What are the limitations of CVP analysis?
(Section 10)
CHAPTER 4
6 What is the C/S ratio (or P/V ratio)?
1 FIXED COSTS AND VARIABLE COSTS
LO
4.1
Section overview
Costs may be classified into fixed costs and variable costs. Many items of expenditure are
part-fixed and part-variable and are so termed step-fixed or semi-variable (or mixed)
costs.
Definitions
Cost is a measure of the resources given up to achieve an objective.
A fixed cost is a cost which is incurred for a particular period of time and which, within certain activity
levels, is unaffected by changes in the level of activity.
A variable cost is a cost which varies with the level of activity. Variable costs tend to be constant per
unit but total variable costs will increase or decrease with changes in production or service volume.
A semi-variable (or mixed) cost is a cost that contains both a fixed cost and a variable cost
component.
A step-fixed cost is a cost that is fixed for a certain range of activity but increases to a new fixed level
once a critical level of activity is reached.
1.1 EXAMPLES OF FIXED AND VARIABLE COSTS

a. Direct material costs (cost of materials consumed in the manufacturing process) are variable costs
because they rise as more units of a product are manufactured.
b. Sales commission is often a fixed percentage of sales turnover, and so is a variable cost that varies
with the level of sales.
c. Telephone call charges are likely to increase if the volume of business expands, but there is also a
fixed element of line rental, and so they are a semi-variable overhead cost.
d. The rental cost of business premises is a constant amount, at least within a stated time period, and
so it is a fixed cost.
e. The salary paid to a factory supervisor might be considered a step-fixed cost. For example the
factory may be able to produce up to 20,000 product units with one supervisor, but needs a second
supervisor once this level of activity is exceeded.
2 INTRODUCTION TO COST BEHAVIOUR
LO
4.1
2.1 COST BEHAVIOUR AND DECISION-MAKING

Section overview
The basic principle of cost behaviour is that as the level of activity rises, costs will usually
rise.
Definition
Cost behaviour is the way in which costs are affected by changes in the level of activity.
Management decisions will often be based on how costs and revenues vary at different activity levels.
Examples of such decisions are as follows:
What should the planned activity level be for the next period?
Should the selling price be reduced in order to sell more units?
Should a particular component be manufactured internally or bought in?
Should a contract be undertaken?
There are many factors which may influence costs. The major influence is volume of output, or the
level of activity. Examples of cost drivers or level of activity may include one of the following:
Number of units produced.
Number of invoices issued.
Number of units of electricity consumed.
Value of items sold.
Number of items sold.
An understanding of cost behaviour is useful for:
Cost control - the level of costs incurred, will in part, be a result of an organisation's activities.
Budgeting - knowledge of cost behaviour is essential for the tasks of budgeting, decision making
and management control.
2.2 COST BEHAVIOUR PRINCIPLES

The basic principle of cost behaviour is that as the level of activity rises, costs will usually rise. It will
cost more to produce 2 000 units of output than it will cost to produce 1 000 units.
This principle is common sense. The challenge for the accountant, however, is to be able to analyse
each item of cost, in terms of the factors that drive the cost and to determine the amount by which the
cost increases as the level of activity changes. For our purposes here, the level of activity for
measuring cost will generally be taken to be the volume of production.
Worked Example: Cost behaviour and activity level
Bart Hurst has a fleet of company cars for sales representatives. Running costs have been estimated as
follows:
a. Cars cost $12 000 when new, and have a guaranteed trade-in value of $6 000 at the end of two
years. Depreciation is charged on a straight-line basis (in equal annual amounts over the life of the
car).
b. Petrol and oil cost 15 cents per km.
d. Routine maintenance costs $325 per annum per car.
e. Repairs are thought to vary with mileage. The average car travels 25 000 kms per annum and incurs
annual repair costs of $200.
f. Tax, insurance, and membership of motoring organisations cost $400 per annum per car.
Calculate the total annual cost of a car which travels 15 000 kms per annum and a car which travels 30
000 kms per annum.
Solution
Costs may be analysed into variable, fixed, and step-fixed elements. A step-fixed cost being a cost
which is fixed in nature but only within a certain level of activity.
a. Variable costs
Petrol and oil
Repairs ($200 25 000 km)
Cents per km
15.0
0.8
15.8
CHAPTER 4
c. Tyres cost $300 per set to replace; replacement occurs every 15 000 kms.
b. Fixed costs
$ per annum
3 000
325
400
3 725
Depreciation $(12 000 6 000) 2

Routine maintenance
Tax, insurance etc
c. Step-fixed costs are tyre replacement costs, which are $300 after every 15 000 kms.
The estimated costs per annum of cars travelling 15 000 kms per annum and 30 000 kms per annum
would therefore be:
Variable costs (15.8c per km 15 000/30 000)

Fixed costs
Step-fixed costs
Cost per annum
15 000 kms
per annum
$
2 370
3 725
300
6 395
30 000 kms
per annum
$
4 740
3 725
600
9 065
3 COST BEHAVIOUR PATTERNS

3.1 FIXED COSTS
Section overview
A fixed cost is a cost which tends to be unaffected by increases or decreases in the volume
of output. A step-fixed cost is a cost which is fixed in nature but only within certain levels of
activity, while a variable cost is cost which tends to vary directly with the volume of output.
The variable cost per unit is the same for each unit produced. Many costs contain both a
fixed and variable element a semi-variable cost and are partly affected by changes in
the level of activity.
LO
4.1
Fixed costs are a period charge, in that they relate to a span of time; as the time span increases, so
too will the fixed costs (which are sometimes referred to as period costs for this reason). It is important
to understand that fixed costs always have a variable element, since an increase or decrease in
production may also bring about an increase or decrease in per unit fixed costs.
A sketch graph of fixed cost would look like this:
$
Total cost
Total fixed cost
Volume of output (level of activity)
Examples of a fixed cost would be:

The rent of a single factory building (per month or per annum)
Straight line depreciation of a single machine (per month or per annum)
3.2 STEP-FIXED COSTS

A step-fixed cost is a cost which is fixed in nature but only within a certain range of activity. It is fixed
for a certain range of activity but increases to a new fixed level once a critical level of activity is
reached.
Consider the depreciation of a machine which may be fixed if production remains below 1 000 units
per month. If production exceeds 1 000 units, a second machine may be required, and the cost of
depreciation (on two machines) would go up a step. A sketch graph of a step-fixed cost could look like
this:
Graph of step-fixed cost
$
Cost
Volume of output
Other examples of step-fixed costs are:

a. Rent is a step-fixed cost in situations where rental space requirements increase as output levels get
higher.
b. Basic pay of employees is nowadays usually fixed, but as output rises, more employees (direct
workers, supervisors, managers and so on) are required.
c. Royalties e.g. fees of $10 000 payable if sales are below 5 000 units. Fees increase to $15 000 if
sales exceed this.
3.3 VARIABLE COSTS

A variable cost is a cost which varies directly with the volume of output. The variable cost per unit is
the same amount for each unit produced but the total variable cost of production increases/decreases
as the volume of output (activity) increases/decreases.
Graph of variable cost (1)
Volume of output
A constant variable cost per unit implies that the price per unit of say, material purchased is constant,
and that the rate of material usage is also constant.
a. The most important variable cost is the cost of raw materials (where there is no discount for bulk
purchasing since bulk purchase discounts reduce the cost of purchases).
b. Direct labour costs are most often classed as a variable cost even though basic wages are usually
fixed.
c. Sales commission is variable in relation to the volume or value of sales.
CHAPTER 4
$
Cost
d. Bonus payments for productivity to employees might be variable once a certain level of output is
achieved, as the following diagram illustrates.
$
Cost
nu
Bo
Volume of output
Up to output A, no bonus is earned.
3.4 NON-LINEAR OR CURVILINEAR VARIABLE COSTS

If the relationship between total variable cost and volume of output can be shown as a curved line on
a graph, the relationship is said to be curvilinear.
Two typical relationships are as follows:
a.
b.
$
Cost
$
Cost
Volume of output
Volume of output
Each extra unit of output in graph (a) causes a less than proportionate increase in cost whereas in
graph (b), each extra unit of output causes a more than proportionate increase in cost.
The cost of a piecework scheme for individual workers with differential rates could behave in a
curvilinear fashion if the rates increase by small amounts at progressively higher output levels.
3.5 SEMI-VARIABLE COSTS (OR MIXED COSTS)

A semi-variable/mixed cost is a cost which contains both fixed and variable components and so is
partly affected by changes in the level of activity.
Examples of these costs include the following:
a. Electricity and gas bills
i. Fixed cost = rental charge
ii. Variable cost = charge per unit of electricity used
b. Salesman's salary
i. Fixed cost = basic salary
ii. Variable cost = commission on sales made
c. Costs of running a car
i. Fixed cost = registration, insurance
ii. Variable costs = petrol, oil, repairs (which vary with km travelled)
3.6 OTHER COST BEHAVIOUR PATTERNS

Other cost behaviour patterns may be appropriate to certain cost items. Examples of two other cost
behaviour patterns are shown below:
a.
Cost behaviour pattern (1)
b.
$
Cost
Cost behaviour pattern (2)

$
Cost
Maximum
cost
Minimum
charge
Volume of output
Volume of output
Graph (a) represents an item of cost which is variable with output up to a certain maximum level of
cost.
Graph (b) represents a cost which is variable with output, subject to a minimum (fixed) charge.
3.7 THE RELATIONSHIP BETWEEN TOTAL COSTS AND UNIT COSTS

The following example relates to different levels of production of a product zed. The variable cost of
producing a zed is $5. Fixed costs are $5 000.
1 zed
$
5
5
5 000
5 000
5 005
5 005
Total variable cost

Total fixed cost
Fixed cost per unit
Total cost (fixed and variable)
Total cost per unit
10 zeds
$
50
5
5 000
500
5 050
505
50 zeds
$
250
5
5 000
100
5 250
105
What happens when activity levels rise can be summarised as follows:

The variable cost per unit remains constant
The fixed cost per unit falls
The total cost per unit falls
This may be illustrated graphically as follows:
Fixed cost
Cost per
unit
$
Number of units
Total cost
Cost per
unit
$
Number of units
Question 1: Fixed, variable and mixed costs

Are the following likely to be fixed, variable or mixed costs?
a. Telephone bill
b. Annual salary of the chief accountant
c. The company accountant's annual membership fee (paid by the company)
d. Cost of materials used to pack 20 units of product X into a box
e. Wages of warehouse employees
CHAPTER 4
Variable cost
Cost per
unit
$
Number of units
3.8 ASSUMPTIONS ABOUT COST BEHAVIOUR

Assumptions about cost behaviour include the following.
a. Within the normal or relevant range of output (the range of activity over which a particular cost
behaviour pattern is assumed valid), costs are often assumed to be either fixed, variable or semivariable (mixed).
b. Departmental costs within an organisation are assumed to be mixed costs, with both a fixed and a
variable element.
c. Departmental costs are assumed to rise in a straight line as the volume of activity increases. In
other words, these costs are said to be linear.
The high-low method of determining fixed and variable elements of mixed costs relies on the
assumption that mixed costs are linear. We shall now go on to look at this method of cost
determination.
4 DETERMINING THE FIXED AND VARIABLE

ELEMENTS OF SEMI-VARIABLE COSTS
4.1 ANALYSING COSTS
Section overview
The fixed and variable elements of semi-variable costs can be determined by the high-low
method.
LO
4.2
It is generally assumed that costs are one of the following:

Variable
Semi-variable
Fixed
Cost accountants tend to separate semi-variable costs into their variable and fixed elements. They
therefore generally tend to treat costs as either fixed or variable.
There are several methods for identifying the fixed and variable elements of semi-variable costs (for
example regression analysis). Each method is only an estimate, and each will produce different results.
One of the principal methods is the high-low method.
4.2 HIGH-LOW METHOD

Follow the steps below to estimate the fixed and variable elements of semi-variable costs:
Step 1
Review records of costs in previous periods:

Select the period with the highest activity level.
Select the period with the lowest activity level.
Step 2
Determine the following:
Step 3
Total cost at high activity level.

Total costs at low activity level.
Total units at high activity level.
Total units at low activity level.
Calculate the following:
= variable cost per unit (v)
_
Step 4
The fixed costs can be determined as follows:

(Total cost at high activity level ) (total units at high activity level variable cost per unit)
The following graph demonstrates the high-low method:

$
Total cost
Demonstration of high-low
method
st
tal co
d to
sume
As
Variable costs
Fixed costs (same at all

levels of output)
Low
High
Level of activity
a = Total cost at high activity level - Total cost at low activity level.
Note. As only two data points are used to estimate the cost behaviour, we have no assurance that it
accurately represents cost behaviour across or within the relevant range
Worked Example: The high-low method
DG Co has recorded the following total costs during the last five years:
Year
Output volume
Units
65 000
80 000
90 000
60 000
75 000
20X0
20X1
20X2
20X3
20X4
Total cost
$
145 000
162 000
170 000
140 000
160 000
Required
Calculate the total cost that should be expected in 20X5 if output is 85 000 units.
Solution
Step 1
Period with highest activity = 20X2
Step 2
Total cost at high activity level = 170 000

Total cost at low activity level = 140 000
Total units at high activity level = 90 000
Total units at low activity level = 60 000
Step 3
Step 4

=
_
170 000 14 0000 30 000

= $1
90 000 60 000
30 000
Fixed costs = (total cost at high activity level) (total units at high activity level variable
cost per unit)
= 170 000 (90 000 $1) = 170 000 90 000 = $80 000
CHAPTER 4
Period with lowest activity = 20X3
Therefore the costs in 20X5 for output of 85 000 units are as follows:
$
85 000
80 000
165 000
Variable costs = 85 000 $1

Fixed costs
Worked Example: The high-low method with step-fixed costs
The following data relate to the overhead expenditure of contract cleaners (for industrial cleaning) at
two activity levels.
Square metres cleaned 12 750
Overheads
$73 950
15 100
$83 585
When more than 14 000 square metres are industrially cleaned, there will be a step up in fixed costs of
$4 700.
Required
Calculate the estimated total cost if 14 500 square metres are to be industrially cleaned.
Solution
Before we can compare high activity level costs with low activity level costs in the normal way, we must
eliminate the part of the high activity level costs that are due to the step up in fixed costs:
Total cost for 15 100 without step up in fixed costs = $83 585 $4 700 = $78 885
We can now proceed in the normal way using the revised cost above.
Units
15 100
12 750
2 350
High activity level

Low activity level
Variable cost
Total cost
Total cost
$
78 885
73 950
4 935
$4 935
2 350
= $2.10 per square metre

Before we can calculate the total cost for 14 500 square metres we need to find the fixed costs. As the
fixed costs for 14 500 square metres will include the step up of $4 700, we can use the activity level of
15 100 square metres for the fixed cost calculation:
Total cost (15 100 square metres) (this includes the step up in fixed costs)
Total variable costs (15 100 x $2.10)
Total fixed costs
$
83 585
31 710
51 875
Estimated overhead expenditure if 14 500 square metres are to be industrially cleaned:

Fixed costs
Variable costs (14 500 $2.10)
$
51 875
30 450
82 325
Worked Example: The high-low method with a change in the variable cost
per unit
Same data as the previous example.

Additionally, assume wage negotiations have just taken place which will cost an additional $1 per
square metre.
What is the revised estimated total cost of cleaning 14 500 square metres?
Solution
Estimated overheads to clean 14 500 square metres.

Per square metre
$
2.10
1.00
3.10
Variable cost
Additional wages cost (variable)
Total variable cost
Cost for 14 500 square metres:

$
51 875
44 950
96 825
Fixed
Question 2: High-low method
The valuation department of a large firm of surveyors wishes to develop a method of predicting its
total costs in a period. The following costs have been previously recorded at two activity levels:
Number of valuations
(V)
420
515
Period 1
Period 2
Total cost
(TC)
82 200
90 275
The total cost model for a period could be represented as follows:

A TC = $42 000 + 95V
B TC = $46 500 + 85V
C TC = $46 500 85V
D TC = $51 500 95V
5 CVP ANALYSIS AND BREAK-EVEN POINT
Section overview
Cost-volume-profit (CVP)/break-even analysis is the study of the interrelationships between
costs, volume and profit at various levels of activity.
LO
4.3
The management of an organisation usually wishes to know the profit likely to be made if the
budgeted/target production and sales for the year are achieved. Management may also be interested
to know:
a. The break-even point which is the activity level at which there is neither profit nor loss.
b. The amount by which actual sales can fall below anticipated sales, without a loss being incurred
(the safety margin).
CHAPTER 4
5.1 INTRODUCTION
5.2 BREAK-EVEN POINT

Formula to learn
Break-even point
Total fixed costs

Contribution required to break-even
=
= Number of units to be sold to break even
Please note, contribution per unit = sales price per unit variable cost per unit
Worked Example: Break-even point
Expected sales
Variable cost
Fixed costs
10 000 units at $8 = $80 000

$5 per unit
$21 000
Required
Compute the break-even point.

Solution
The contribution per unit (sales price - variable costs) is $(85)
= $3
Contribution required to break even
= fixed costs = $21 000
Break-even point (BEP)
= 21 000 3
= 7 000 units
In revenue, BEP
= (7 000 $8) = $56 000
Sales above $56 000 will result in profit of $3 per unit of additional sales and sales below $56 000 will
mean a loss of $3 per unit for each unit by which sales fall short of 7 000 units. In other words, profit
will improve or worsen by the amount of contribution per unit.
Revenue
Less variable costs
Contribution
Less fixed costs
Profit
7 000 units
$
56 000
35 000
21 000
21 000
0
7 001 units
$
56 008
35 005
21 003
21 000
3
6 THE CONTRIBUTION TO SALES (C/S) RATIO

Section overview
The C/S ratio (or Profit/Volume ratio) is a measure of how much contribution is earned from
each $1 of sales. It provides an alternative way of calculating the break-even point in terms
of sales revenue.
Formula to learn
Fixed costs
Contribution required to break-even
=
= Break-even point in terms of sales revenue
C / S ratio
C / S ratio
(The contribution/sales (C/S) ratio is also sometimes called a profit/volume or P/V ratio.)
An alternative way of calculating the break-even point in terms of sales revenue.

In the example in Paragraph 5.2 the C/S ratio is
Break-even is where sales revenue equals
$3
= 37.5%
$8
$21 000
= $56 000
37.5%
At a price of $8 per unit, this represents 7 000 units of sales.

The C/S ratio (or P/V ratio) is a measure of how much contribution is earned from each $1 of
sales.
The C/S ratio of 37.5% in the above example means that for every $1 of sales, a contribution of 37.5c is
earned. Thus, in order to earn a total contribution of $21 000 (fixed costs) and if the contribution
increases by 37.5c per $1 of sales, sales must be:
$1
$21 000 = $56 000
37.5c
Worked Example: Break-even point
Assume the C/S ratio of product W is 20%. IB, the manufacturer of product W, wishes to make a
contribution of $50 000 towards fixed costs. How many units of product W must be sold if the selling
price is $10 per unit?
Solution
Required contribution
$50 000
=
= $250 000
C / S ratio
20%
Therefore the number of units = $250 000 $10 = 25 000
Worked Example: C/S ratio
A company manufactures a single product with a variable cost of $44. The contribution to sales ratio is
45%. Monthly fixed costs are $396 000. What is the break-even point in units?
Solution
Contribution per unit = $80 0.45

= $36
Break-even point
= Fixed costs/contribution per unit

= $396 000/$36
= 11 000 units
7 THE SAFETY MARGIN

Section overview
The safety margin is the difference in units between the budgeted sales volume and the
break-even sales volume. It is sometimes expressed as a percentage of the budgeted sales
volume. The safety margin may also be expressed in sales revenue rather than volume
terms.
CHAPTER 4
Contribution/sales ratio = 45%

Therefore Variable cost/sales ratio = 55%
Therefore sales price = $44/0.55 = $80
Worked Example: Safety margin
Mal de Mer makes and sells a product which has a variable cost of $30 and which sells for $40.
Budgeted fixed costs are $70 000 and budgeted sales are 8 000 units.
Calculate the break-even point and the safety margin.
Solution
a. Break-even point
Total fixed costs

$70 000
=
$(40 30)
= 7 000 units
b. Safety margin
= 8 000 7 000 units = 1 000 units
which may be expressed as
1000 units
100% = 12.5% of budget
8 000 units
c. The safety margin indicates to management that actual sales can fall short of budget by 1 000 units
or 12.5% before the break-even point is reached and no profit at all is made.
8 BREAK-EVEN CALCULATIONS AND PROFIT

TARGETS
Section overview
At the break-even point, sales revenue equals total costs and there is no profit. At the
break-even point total contribution = fixed costs.
The target profit is achieved when sales revenue equals total variable costs plus total fixed
costs, plus required profit.
Formula to learn
S=V+F
where
S = break-even sales revenue
V = total variable costs
F = total fixed costs
Subtracting V from each side of the equation, we get:
S V = F, that is, total contribution = fixed costs
Worked Example: Break-even calculation
Butterfingers makes a product which has a variable cost of $7 per unit.

If fixed costs are $63 000 per annum, calculate the selling price per unit if the company wishes to break
even with a sales volume of 12 000 units.
Solution
Fixed costs (F)
= $63 000
Total variable costs (V)
= 12 000 units $7
= $84 000
A business will breakeven when total contribution (S V) = total fixed costs (F)
SV
=F
S $84 000
= $63 000
S
S
= $63 000 + $84 000
Breakeven sales revenue per unit
= $147 000 / 12 000 units
= $147 000
= $12.25 per unit
8.1 TARGET PROFITS

The target profit is achieved when S = V + F + P (where P= required profit). Therefore, the total
contribution required for a target profit = fixed costs + required profit
A similar formula may be applied where a company wishes to achieve a certain profit during a period.
To achieve this profit, sales must cover all costs and leave the required profit.
Formula to learn
The target profit is achieved when: S = V + F + P,

where
P = required profit
Subtracting V from each side of the equation, we get:

SV
= F + P, so
Total contribution required
=F+P
Worked Example: Target profit
Riding Breeches makes and sells a single product, for which variable costs are as follows:
$
10
8
6
24
Direct materials
Direct labour
Variable production overhead
The sales price is $30 per unit, and fixed costs per annum are $68 000. The company wishes to make a
profit of $16 000 per annum.
Solution
Required contribution = fixed costs + profit = $68 000 + $16 000 = $84 000
Required sales can be calculated in one of two ways:
(a)
$84 000
= 14 000 units, or $420 000 in revenue
$(30 24)
(b)
C / S ratio
$84 000
= $420 000 of revenue, or 14 000 units
20% *
* C/S ratio =
$30 $24
$6
=
= 0.2 = 20%
$30
$30
CHAPTER 4
Determine the sales required to achieve this profit.
Question 3: Target profit
Seven League Boots wishes to sell 14 000 units of its product, which has a variable cost of $15 to make
and sell. Fixed costs are $119 000 and the required profit is $70 000.
Required
What sales price per unit is required to achieve this target profit?
A
$13.50
B
$20.00
C
$23.50
D
$28.50
8.2 DECISIONS TO CHANGE SALES PRICE OR COSTS

You may come across a problem in which you have to work out the effect of altering the selling price,
variable cost per unit or fixed cost. Such problems are slight variations on basic break-even
calculations.
Worked Example: Change in selling price
Stomer Cakes bake and sell a single type of cake. The variable cost of production is 15c and the
current sales price is 25c. Fixed costs are $2 600 per month, and the annual profit for the company at
current sales volume is $36 000. The volume of sales demand is constant throughout the year.
The sales manager, Ian Digestion, wishes to raise the sales price to 29c per cake, but considers that a
price rise will result in some loss of sales.
Ascertain the minimum volume of sales required each month to raise the price to 29c.
Solution
The minimum volume of sales which would justify a price of 29c is one which would leave total profit at
least the same as before, ie $3 000 per month. Required profit should be converted into required
contribution, as follows:
Monthly fixed costs
Monthly profit, minimum required
Current monthly contribution
Contribution per unit (25c 15c)
Current monthly sales
$
2 600
3 000
5 600
10c
56 000 cakes
The minimum volume of sales required after the price rise will be an amount which earns a
contribution of $5 600 per month. The contribution per cake at a sales price of 29c would be 14c.
Required sales =
$5 600
required contribution
= 40 000 cakes per month.
=
14c
contribution per unit
Worked Example: Change in production costs
Close Brickett makes a product which has a variable production cost of $8 and a variable sales cost of
$2 per unit. Fixed costs are $40 000 per annum, the sales price per unit is $18, and the current volume
of output and sales is 6 000 units.
The company is considering hiring an improved machine for production. Annual hire costs would be
$10 000 and it is expected that the variable cost of production would fall to $6 per unit.
a. Determine the number of units that must be produced and sold to achieve the same profit as is
currently earned, if the machine is hired.
b. Calculate the annual profit with the machine if output and sales remain at 6 000 units per annum.
Solution
The current unit contribution is $(18 (8+2)) = $8

a.
$
48 000
40 000
8 000
Current contribution (6 000 $8)

Less current fixed costs
Current profit
With the new machine fixed costs will go up by $10 000 to $50 000 per annum. The variable cost
per unit will fall to $(6 + 2) = $8, and the contribution per unit will be $10.
$
8 000
50 000
58 000
Required profit (as currently earned)

Fixed costs
Sales required to earn $8 000 profit
$10
5 800 units
b. If sales are 6 000 units

$
Sales (6 000 $18)
Variable costs:
production (6 000 $6)
sales (6 000 $2)
Contribution (6 000 $10)
Less fixed costs
Profit
$
108 000
36 000
12 000
48 000
60 000
50 000
10 000
Alternative calculation
Profit at 5 800 units of sale (see (a))
Contribution from sale of extra 200 units ( $10)
Profit at 6 000 units of sale
$
8 000
2 000
10 000
Given no change in fixed costs, total profit is maximised when the total contribution is at its maximum.
Total contribution in turn depends on the unit contribution and on the sales volume.
An increase in the sales price will increase unit contribution, but sales volume is likely to fall because
fewer customers will be prepared to pay the higher price. A decrease in sales price will reduce the unit
contribution, but sales volume may increase because the goods on offer are now cheaper. The
optimum combination of sales price and sales volume is arguably the one which maximises total
contribution.
Worked Example: Profit maximisation
High Ladders has developed a new product which is about to be launched on to the market. The
variable cost of selling the product is $12 per unit. The marketing department has estimated that at a
sales price of $20, annual demand would be 10 000 units.
However, if the sales price is set above $20, sales demand would fall by 500 units for each 50c increase
above $20. Similarly, if the price is set below $20, demand would increase by 500 units for each 50c
stepped reduction in price below $20.
Determine the price which would maximise High Ladder's profit in the next year.
CHAPTER 4
8.3 SALES PRICE AND SALES VOLUME
Solution
At a sales price of $20 per unit, the unit contribution would be $(20 12) = $8. Each 50c increase (or
decrease) in price would raise (or lower) the unit contribution by 50c. The total contribution is
calculated at each sales price by multiplying the unit contribution by the expected sales volume.
Unit price
$
20.00
Unit contribution
$
8.00
Sales volume
units
10 000
7.50
7.00
10 500
11 000
Total contribution
$
80 000
a. Reduce price
19.50
19.00
78 750
77 000
b. Increase price
Unit price
$
20.50
21.00
21.50
22.00
22.50
Unit contribution
$
8.50
9.00
9.50
10.00
10.50
Sales volume
units
9 500
9 000
8 500
8 000
7 500
Total contribution
$
80 750
81 000
80 750
80 000
78 750
The total contribution would be maximised, and therefore profit maximised, at a sales price of $21 per
unit, and sales demand of 9 000 units.
Question 4: Break-even output level
Betty Battle manufactures a product which has a selling price of $20 and a variable cost of $10 per
unit. The company incurs annual fixed costs of $29 000. Annual sales demand is 9,000 units.
New production methods are under consideration, which would cause a $1 000 increase in fixed costs
and a reduction in variable cost to $9 per unit. The new production methods would result in a superior
product and would enable sales to be increased to 9 750 units per annum at a price of $21 each.
If the change in production methods were to take place, the break-even output level would be
A 100 units higher.
B 100 units lower.
C 400 units higher.
D 400 units lower.
9 BREAK-EVEN CHARTS, CONTRIBUTION CHARTS

AND PROFIT/VOLUME CHARTS
9.1 BREAK-EVEN CHARTS
Section overview
The break-even point can also be determined graphically using a break-even chart or a
contribution break-even chart. These charts show approximate levels of profit or loss at
different sales volume levels within a limited range.
The profit/volume (P/V) chart is a variation of the break-even chart which illustrates the
relationship of costs and profits to sales and the safety margin. It shows clearly the effect on
profit and break-even point of any change in selling price, variable cost, fixed cost and/or
sales demand.
A break-even chart has the following axes:

A horizontal axis showing the sales/output (in value or units)
A vertical axis showing $ for sales revenues and costs
The following lines are drawn on the break-even chart:
a. The sales line
i. Starts at the origin
ii. Ends at the point signifying expected sales
b. The fixed costs line
i. Runs parallel to the horizontal axis
ii. Meets the vertical axis at a point which represents total fixed costs
c. The total costs line
i. Starts where the fixed costs line meets the vertical axis
ii. Ends at the point which represents anticipated sales on the horizontal axis and total costs of
anticipated sales on the vertical axis
The break-even point is the intersection of the sales line and the total costs line.
The distance between the break-even point and the expected (or budgeted) sales, in units,
indicates the safety margin.
Worked Example: A break-even chart
The budgeted annual output of a factory is 120 000 units. The fixed overheads amount to $40 000 and
the variable costs are 50c per unit. The sales price is $1 per unit.
Construct a break-even chart showing the current break-even point and profit earned up to the
present maximum capacity.
Solution
We begin by calculating the profit at the budgeted annual output.

Sales (120 000 units)
Variable costs
Contribution
Fixed costs
Profit
$
120 000
60 000
60 000
40 000
20 000
Break-even chart (1) is shown on the following page.

The chart is drawn as follows:
a. The vertical axis represents money (costs and revenue) and the horizontal axis represents the level
of activity (production and sales).
b. The fixed costs are represented by a straight line parallel to the horizontal axis (in our example, at
$40 000).
c. The variable costs are added 'on top of' fixed costs, to give total costs. It is assumed that fixed
costs are the same in total and variable costs are the same per unit at all levels of output.
The line of costs is therefore a straight line and only two points need to be plotted and joined up.
Perhaps the two most convenient points to plot are total costs at zero output, and total costs at the
budgeted output.
At zero output, costs are equal to the amount of fixed costs only, $40 000, since there are no
variable costs.
At the budgeted output of 120 000 units, costs are $100,000.
Fixed costs
Variable costs 120 000 50c
Total costs
$
40 000
60 000
100 000
CHAPTER 4
LO
4.3
d. The sales line is also drawn by plotting two points and joining them up.
i. At zero sales, revenue is nil.
ii. At the budgeted output and sales of 120 000 units, revenue is $120 000.
-
$000
120
es
l
Sa
Budgeted profit
100
Break-even point
80
60
a
Tot
Budgeted variable costs
ts
cos
Fixed costs
40
Safety
margin
20
20
40
60
80
100
120
Units
The break-even point is where total costs are matched exactly by total revenue. From the chart,
this can be seen to occur at output and sales of 80 000 units, when revenue and costs are both $80
000. This break-even point can be proved mathematically as:
$40 000
Required contribution (= fixed costs)
= 80 000 units
=
50c per unit
The safety margin can be seen on the chart as the difference between the budgeted level of activity
and the break-even level.
9.2 THE VALUE OF BREAK-EVEN CHARTS

Break-even charts are used as follows:
To plan the production of a company's products
To plan the marketing of a company's products
To give a visual display of break-even calculations
Worked Example: Variations in the use of break-even charts
Break-even charts can be used to show variations in the possible sales price, variable costs or fixed
costs. Suppose that a company sells a product which has a variable cost of $2 per unit. Fixed costs are
$15 000. It has been estimated that if the sales price is set at $4.40 per unit, the expected sales volume
would be 7 500 units; whereas if the sales price is lower, at $4 per unit, the expected sales volume
would be 10 000 units.
Draw a break-even chart to show the budgeted profit, the break-even point and the safety margin at
each of the possible sales prices.
Solution
Workings
Sales price $4.40 per unit
$
15 000
15 000
(10 000 $2.00)
30 000
Fixed costs
Total costs
Budgeted revenue (7 500 $4.40)
33 000
Sales price $4 per unit

$
15 000
20 000
35 000
(10 000 $4.00)
40 000
Break-even chart (2)
$000
Profit
40
Revenue ($4.00)
Profit
35
Break-even point A
Total costs
Revenue ($4.40)
30
Break-even point B
25
20
Fixed costs
15
10
5
8
Safety
margin A
10
Units
(000s)
Safety
margin B
(check:
$15 000
Required contribution to break - even
= 6 250 units)
$2.40 per unit
The safety margin (A) is 7 500 units 6 250 units = 1 250 units or 16.7% of expected sales.
b. Break-even point B is the break-even point at a sales price of $4 per unit which is 7 500 units or
$30 000 in costs and revenues.
(check:
Required contribution to break - even $15 000

= 7 500 units)
$2 per unit
The safety margin (B) = 10 000 units 7 500 units = 2 500 units or 25% of expected sales.
Since a price of $4 per unit gives a higher expected profit and a wider safety margin, this price will
probably be preferred even though the break-even point is higher than at a sales price of $4.40 per
unit.
CHAPTER 4
a. Break-even point A is the break-even point at a sales price of $4.40 per unit, which is 6 250 units or
$27 500 in costs and revenues.
9.3 CONTRIBUTION (OR CONTRIBUTION BREAK-EVEN) CHARTS

As an alternative to drawing the fixed cost line first, it is possible to start with variable costs. This is
known as a contribution chart. An example is shown below using the data in Paragraph 9.2.
Contribution chart
$000
120
Profit
Break-even point
Contribution
Fixed
costs
80
al
Tot
ts
cos
ue
n
ve
40
e
sr
e
al
t
cos
ble
Safety
margin
ia
Var
Fixed
costs
0
40
80
120
Units
One of the advantages of the contribution chart is that is shows clearly the contribution for different
levels of production (indicated here at 120 000 units, the budgeted level of output) as the 'wedge'
shape between the sales revenue line and the variable costs line. At the break-even point, the
contribution equals fixed costs exactly. At levels of output above the break-even point, the
contribution is larger, and not only covers fixed costs, but also leaves a profit. Below the break-even
point, the loss is the amount by which contribution fails to cover fixed costs.
9.4 THE PROFIT/VOLUME (P/V) CHART

The profit/volume (P/V) chart is a variation of the break-even chart which illustrates the relationship of
costs and profits to sales and the safety margin.
A P/V chart is constructed as follows (look at the graph in the example that follows as you read the
explanation).
a. 'P' is on the y axis and actually comprises not only 'profit' but contribution to profit (in monetary
terms), extending above and below the x axis with a zero point at the intersection of the two axes,
and the negative section below the x axis representing fixed costs. This means that at zero
production, the company is incurring a loss equal to the fixed costs.
b. 'V' is on the x axis and comprises either volume of sales or value of sales (revenue).
c. The profit-volume line is a straight line drawn with its starting point (at zero production) at the
intercept on the y axis representing the level of fixed costs, and with a gradient of contribution/unit
(or the P/V ratio if sales value is used rather than units). The P/V line will cut the x axis at the breakeven point of sales volume. Any point on the P/V line above the x axis represents the profit to the
company (as measured on the vertical axis) for that particular level of sales.
Worked Example: P/V chart
Let us draw a P/V chart for our example (Paragraph 9.1). At sales of 120 000 units, total contribution
will be
120 000 $(1 0.5) = $60 000 and total profit will be $20 000.
P/V chart (1)
Profit/loss
$000
20
PROFIT
Budgeted
profit
Sales volume
(units)
10
BREAK-EVEN
120,000
Break-even point
10
LOSS
Budgeted
contribution
Fixed
costs
20
30
40
9.5 THE ADVANTAGE OF THE P/V CHART

The P/V chart shows clearly the effect on profit and break-even point of any changes in selling
price, variable cost, fixed cost and/or sales demand.
If the budgeted selling price of the product in our example is increased to $1.20, with the result that
demand drops to 105 000 units despite additional fixed advertising costs of $10 000. At sales of
105 000 units, contribution will be 105 000 $(1.20 0.50) = $73 500 and total profit will be $23 500
(fixed costs being $50 000).
Profit/loss
$000
30
P/V chart (2)
20
PROFIT
10
Break-even point 2
Sales volume
000 (units)
BREAK-EVEN
10
LOSS 20
30
40 x
50 x
105
Break-even point 1
120
CHAPTER 4
The diagram shows that if the selling price is increased, the break-even point occurs at a lower level of
sales revenue (71 429 units instead of 80 000 units), although this is not a particularly large increase
when viewed in the context of the projected sales volume. It is also possible to see that for sales
above 50 000 units, the profit achieved will be higher (and the loss achieved lower) if the price is $1.20.
For sales volumes below 50 000 units the first option will yield lower losses.
The P/V chart is the clearest way of presenting such information; two conventional break-even charts
on one set of axes would be very confusing.
Changes in the variable cost per unit or in fixed costs at certain activity levels can also be easily
incorporated into a P/V chart. The profit or loss at each point where the cost structure changes should
be calculated and plotted on the graph so that the profit/volume line becomes a series of straight lines.
For example, suppose that in our example, at sales levels in excess of 120 000 units the variable cost
per unit increases to $0.60 (perhaps because of overtime premiums that are incurred when production
exceeds a certain level). At sales of 130 000 units, contribution would therefore be 130 000 $(1 0.60)
= $52 000 and total profit would be $12 000.
P/V chart (3)
Profit/loss
$000
20
PROFIT 10
Sales volume
000 (units)
Break-even point
BREAK-EVEN
120
10
Fixed
costs
LOSS 20
30
40
Question 5: Profit/volume chart
The profit/volume chart for a single product company is as follows:

Profit
($ 000)
140
500
Sales revenue ($ 000)
(60)
What is the product's contribution to sales ratio (expressed as a %)?

A 16%
B 28%
C 40%
D 72%
130
10 LIMITATIONS OF CVP ANALYSIS

Section overview
Break-even analysis is a useful technique for managers as it can provide simple and quick
estimates. Break-even charts provide a graphical representation of break-even calculations.
Break-even analysis does, however, have number of limitations.
The limitations of break-even analysis are described in the list that follows:
It can only apply to a single product or a group of products that are produced and sold in a fixed
mix. Firms generally do not produce a single product or products in a fixed mix.
A break-even chart may be time-consuming to prepare.
It assumes fixed costs are constant at all levels of output.
It assumes that variable costs are the same per unit at all levels of output.
It assumes that sales prices are constant at all levels of output.
It assumes production and sales are the same (inventory levels are ignored).
CHAPTER 4
It ignores the uncertainty in the estimates of fixed costs and variable cost per unit.
KEY CHAPTER POINTS

Costs may be classified into fixed costs and variable costs. Many items of expenditure are partfixed and part-variable and are termed step-fixed or semi-variable costs.
Cost behaviour is the way in which costs are affected by changes in the levels of activity.
The basic principle of cost behaviour is that as the level of activity rises, costs will usually rise. It will
cost more to produce 2 000 units of output than it will to produce 1 000 units.
A fixed cost is a cost which tends to be unaffected by increases or decreases in the levels of
activity.
A step-fixed cost is a cost which is fixed in nature but only within certain levels of activity.
A variable cost is a cost which tends to vary directly with the levels of activity.
The variable cost per unit is the same amount for each unit produced.
If the relationship between total variable cost and levels of activity can be shown as a curved line
on a graph, the relationship is said to be curvilinear.
A semi-variable (mixed) cost is a cost which contains both fixed and variable components and so is
The fixed and variable elements of semi-variable costs can be determined by the high-low method.
Cost-volume-profit (CVP)/break-even analysis is the study of the interrelationships between costs,
volume and profits at various levels of activity.
Break-even point in terms of sales volume
Total fixed costs
Contribution required to break - even
=
Break-even point in terms of sales revenue

Fixed costs
Contribution required to break - even
=
C / S ratio
C / S ratio
The C/S ratio (or P/V ratio) is a measure of how much contribution is earned from each $1 of sales.
C/S ratio
= Total Contribution/Sales Revenue or

= Contribution per unit/Sales price per unit
The safety margin is the difference in units between the budgeted sales volume and the breakeven sales volume. It is sometimes expressed as a percentage of the budgeted sales volume. The
safety margin may also be expressed in sales revenue terms.
At the break-even point, sales revenue = total costs and there is no profit. At the break-even point
total contribution = fixed costs.
The target profit is achieved when S = V + F + P. Therefore the total contribution required for a
target profit = fixed costs + required profit.
The break-even point can also be determined graphically using a break-even chart or a
contribution break-even chart. These charts show approximate levels of profit or loss at different
sales volume levels within a limited range.
The profit/volume (PV) chart is a variation of the break-even chart which illustrates the relationship
of costs and profits to sales and the safety margin.
The P/V chart shows clearly the effect on profit and break-even point of any changes in selling
price, variable cost, fixed cost and/or sales demand.
CHAPTER 4
Break-even analysis is a useful technique for managers as it can provide simple and quick
estimates. Break-even charts provide a graphical representation of break-even calculations. Breakeven analysis does, however, have a number of limitations.

THE FOLLOWING INFORMATION RELATES TO QUESTIONS 1 TO 3
$
Level of activity
Level of activity
Graph 1
$
Graph 2
$
Level of activity
Graph 4
Level of activity
Graph 3
$
Level of activity
Graph 5
Level of activity
Graph 6
Which one of the above graphs illustrates the costs described in questions 1 to 3?
1 A linear variable cost when the vertical axis represents cost incurred.
A graph 1
B graph 2
C graph 4
D graph 5
2 A fixed cost when the vertical axis represents cost incurred.
A graph 1
B graph 2
C graph 3
D graph 6
3 A step fixed cost when the vertical axis represents cost incurred.
A graph 3
B graph 4
C graph 5
D graph 6
4 A company manufactures a single product. The total cost of making 4 000 units is $20 000 and the
total cost of making 20 000 units is $40 000. Within this range of activity the total fixed costs remain
unchanged.
What is the variable cost per unit of the product?
A
B
C
D
$0.80
$1.20
$1.25
$2.00
5 A production worker is paid a salary of $650 per month, plus an extra 5 cents for each unit
produced during the month. This labour cost is best described as
A a fixed cost.
B a variable cost.
C a step-fixed cost.
D a semi-variable cost.
THE FOLLOWING DATA RELATES TO QUESTIONS 6 AND 7
Data concerning a company's single product is as follows:

Selling price
Variable production cost
Variable selling cost
Fixed production cost
Fixed selling cost
$ per unit
6.00
1.20
0.40
4.00
0.80
Budgeted production and sales for the year are 10 000 units.
6 What is the company's break-even point, to the nearest whole unit?
A
B
C
D
8 000 units
8 333 units
10 000 units
10 909 units
7 It is now expected that the variable production cost per unit and the selling price per unit will each
increase by 10%, and fixed production costs will rise by 25%.
What will be the new break-even point, to the nearest whole unit?
A
B
C
D
8 788 units
11 600 units
11 885 units
12 397 units
8 Which of the following statements about profit-volume graphs is/are correct?

I The profit-volume line starts at the origin.
II The profit-volume line crosses the x axis at the break-even point.
A
B
C
D
I and II only
I and III only
II and III only
I, II and III
9 A company's break-even point is 6 000 units per annum. The selling price is $90 per unit and the
variable cost is $40 per unit. What are the company's annual fixed costs?
A
B
C
D
$120
$240 000
$300 000
$540 000
10 A company makes a single product which it sells for $16 per unit. Fixed costs are $76 800 per
month and the product has a profit/volume ratio of 40%. In a period when actual sales were
$224 000, the company's safety margin, in units, was
A 2 000.
B 12 000.
C 14 000.
D 32 000
.
CHAPTER 4
III Any point on the profit-volume line above the x axis indicates the profit (as measured on the
vertical axis) at that level of activity.

1 B Graph 2 shows that costs increase in line with activity levels
2 A Graph 1 shows that fixed costs remain the same whatever the level of activity
3 A Graph 3 shows that the step fixed costs go up in 'steps' as the level of activity increases
4 C Using the high-low method:
Units
Cost
$
40 000
20 000
20 000
20 000
4 000
16 000
$20 000
= $1.25
16 000 units
5 D The salary is part fixed ($650 per month) and part variable (5 cents per unit). Therefore it is a
semi-variable cost and answer D is correct.
If you chose option A or option B you were considering only part of the cost.
Option C, a step cost, involves a cost which remains constant up to a certain level and then
increases to a new, higher, constant fixed cost.
6 D Breakeven point =
=
Fixed costs
Contributi on per unit
10000 ($4.00 0.80)

$48 000
=
= 10 909 units
$6.00 ($1.20 $0.40)
$4.40
If you selected option A you divided the fixed cost by the selling price, but the selling price
also has to cover the variable cost.
Option B ignores the selling costs, but these are costs that must be covered before the
breakeven point is reached.
Option C is the budgeted sales volume, which happens to be below the breakeven point.
7 C
New selling price ($6 1.1)
New variable cost ($1.20 1.1) + $0.40
Revised contribution per unit
$ per unit
6.60
1.72
4.88
New fixed costs ($40 000 1.25) + $8 000 = $58 000

Revised breakeven point =
$58 000
= 11 885 units
$4.88
If you selected option A you divided the fixed cost by the selling price, but the selling price
also has to cover the variable cost.
Option B fails to allow for the increase in variable production cost
Option D increases all of the costs by the percentages given, rather than the production costs
only.
8 C Therefore the correct answer is C, statements II and III are correct.

Statement II is correct. The point where the profit-volume line crosses the x axis is the point of
zero profit and zero loss, ie the breakeven point.
Statement III is correct. The profit can be read from the y axis at any point beyond the
breakeven point.
Statement I is incorrect. The starting point of the profit-volume line is the point on the y axis
representing the loss at zero activity, which is the fixed cost incurred.
9 C Contribution per unit = $90 $40 = $50. The sale of 6 000 units just covers the annual fixed
costs, therefore the fixed costs must be $50 6 000 = $300 000.
If you selected option A you calculated the correct contribution of $50 per unit, but you then
divided the 6 000 by $50 instead of multiplying.
Option B is the total annual variable cost.
Option D is the annual revenue.
10 A Breakeven point =
Fixed costs
$76 800
= $192 000
=
P/V ratio
0.40
Actual sales =
Margin of safety in terms of sales value
selling price per unit
Margin of safety in units
$224 000
$32 000
$16
2 000
If you selected option B you calculated the breakeven point in units, but forgot to take the next
step to calculate the margin of safety.
Option C is the actual sales in units.
CHAPTER 4
Option D is the margin of safety in terms of sales value.

1 (a) mixed
(b) fixed
(c) fixed
(d) variable
(e) variable
2 B
Valuations
V
515
420
95
Period 2
Period 1
Change due to variable cost
Total cost
$
90 275
82 200
8 075
Variable cost per valuation = $8 075/95 = $85.

Period 2: fixed cost= $90 275 (515 $85) = $46 500
You should have managed to eliminate C and D as incorrect options straightaway. The variable
cost must be added to the fixed cost, rather than subtracted from it. Once you had calculated
the variable cost as $85 per valuation (as shown above), you should have been able to select
option A without going on to calculate the fixed cost (we have shown this calculation above for
completeness).
3 D
Required profit
Fixed costs
$
70 000
119 000
189 000
Required contribution per unit = $189 000/14 000 = $13.50

$
Required contribution per unit
Required sales price per unit
13.50
15.00
28.50
4 D
Selling price
Variable costs
Current
$
20
10
10
Revised
$
21
9
12
Fixed costs
Break-even point (units)
$29 000
2 900
$30 000
2 500
Break-even point =
Total fixed costs

Current BEP =
$29 000
= 2 900 units
$10
Revised BEP =
$30 000
= 2 500 units
$10
Difference
400 lower
5 C The profit/volume graph shows levels of profit at different levels of sales. In order to answer the
question, you must determine contribution for $500 000 sales revenue.
Remember that profit = contribution fixed costs.
When sales revenue = 0, contribution = 0 and the graph shows a loss of $60 000 at zero sales
revenue. This means that fixed costs must be $60 000.
Contribution at $500 000 sales revenue = $140 000 (profit) + $60 000 (fixed costs)
= $200 000
CHAPTER 4
Contribution to sales ratio = contribution/sales revenue = ($200 000/$500 000) = 0.4 or 40%
135
CHAPTER 5
OVERHEADS, ABSORPTION
AND MARGINAL COSTING
Learning objectives
Reference
Overhead costing product and service costing
LO5
Explain key methods of departmental overhead allocation
LO5.1
Explain the concepts underpinning product costing in organisations
LO5.2
Develop different product costing statements involving production resource costs
LO5.3
Evaluate the difference between direct production costs and indirect overhead costs
LO5.4
Apply the principles of absorption and variable costing to product costing analysis
LO5.5
Topic list
1
2
3
4
5
6
7
8
9
10
Cost classification
Overheads
Absorption costing: an introduction
Overhead allocation
Overhead apportionment
Overhead absorption
Blanket absorption rates and departmental absorption rates
Marginal cost and marginal costing
The principles of marginal costing
Marginal costing, absorption costing and the calculation of profit
INTRODUCTION
The classification of costs, as either direct or indirect for example, is essential to determine the cost of
a unit of product or service.
Absorption costing is a method of accounting for overheads. It is basically a method of sharing out
overheads incurred amongst units produced.
This chapter explains why absorption costing might be necessary and then provides an overview of
how the cost of a unit of product is built up under a system of absorption costing. A detailed analysis
of this costing method is then provided, covering the three stages of absorption costing: allocation,
apportionment and absorption.
This chapter concludes when it defines marginal costing and compares it with absorption costing.
Whereas absorption costing recognises fixed costs, usually fixed production costs, as part of the cost
of a unit of output and hence as product costs, marginal costing treats all fixed costs as period costs.
Two such different costing methods obviously each have their supporters and detractors so we will be
looking at the arguments both in favour of and against each method. Each costing method, because
of the different inventory valuation used, produces a different profit figure and we will be looking at
this particular point in detail.
Overheads, absorption
and marginal costing
Cost
classification
Overhead
allocation
Overheads
Overhead
apportionment
Overhead
absorption
Blanket absorption rates and

departmental absorption rates
Marginal cost
and marginal
costing
Principles of
marginal costing
Marginal costing, absorption

costing and the calculation of profit
OVERHEADS, ABSORPTION AND MARGINAL COSTING | 137
BEFORE YOU BEGIN

area.
everything covered.
1 What is a direct cost?
(Section 1.2)
2 What is an indirect cost?
(Section 1.2)
3 What are direct wages?
(Section 1.2)
(Section 2)
5 What are the practical reasons for using absorption costing?
(Section 3.2)
6 What are the three stages of absorption costing?
(Section 3.4)
7 What are the steps involved in the calculation of overhead absorption rates?
(Section 6.2)
8 What is a marginal cost?
(Section 8)
9 What are the principles of marginal costing?
(Section 9)
CHAPTER 5
4 What is an overhead?
1 COST CLASSIFICATION
Section overview
Materials, labour costs and other expenses can be classified as either direct costs or
indirect costs.
Classification by function involves classifying costs as production/manufacturing costs,
administration costs or marketing and distribution costs.
1.1 TOTAL PRODUCT/SERVICE COSTS

LO
5.2
The total cost of making a product or providing a service consists of the following:
a. Cost of materials.
b. Cost of the wages and salaries (labour costs).
c. Cost of other expenses such as:
i. Rent and rates.
ii. Electricity and gas bills.
iii. Depreciation.
1.2 DIRECT COSTS AND INDIRECT COSTS

1.2.1 MATERIALS, LABOUR AND EXPENSES
Definitions
A direct cost is a cost that can be traced in full to the product, service, or department.
LO
5.4
An indirect cost, or overhead is a cost that is incurred in the course of making a product, providing a
service or running a department, but which cannot be traced directly and in full to the product, service
or department.
Materials, labour costs and other expenses can be classified as either direct costs or indirect costs.
a. Direct material costs are the costs of materials that are known to have been used in making a
product, or providing a service.
b. Direct labour costs are the specific costs of the labour used to make a product or provide a
service. Direct labour costs are established by measuring the time taken for a job, or the time taken
in 'direct production work'.
c. Other direct expenses are those expenses that have been incurred in full as a direct consequence
of making a product, or providing a service, or running a department.
Examples of indirect costs include supervisors' wages, cleaning materials and buildings insurance.
1.2.2 ANALYSIS OF TOTAL COST

Materials
+
Labour
+
Expenses
Total cost
=
=
=
=
Direct materials
+
Direct labour
+
Direct expenses
Direct cost
+
+
+
+
Indirect materials
+
Indirect labour
+
Indirect expenses
Overhead
1.2.3 DIRECT MATERIAL

Direct material is all material consumed in the manufacture of the product or the provision of the
service.
Direct material costs are charged to the product as part of the prime cost. Examples of direct material
are as follows:
Component parts, specially purchased for a particular job, order or process.
Part-finished work which for example is transferred from department 1 to department 2. It
becomes finished work of department 1 and a direct material cost in department 2.
Primary packing materials like cartons and boxes.
1.2.4 DIRECT LABOUR

Definition
Direct wages are all wages paid for labour, either as basic hours or as overtime, expended on work on
the product itself.
Direct wages costs are charged to the product as part of the prime cost. Prime costs are the total of
all direct costs.
Examples of groups of labour receiving payment as direct wages are as follows:
Workers engaged in altering the condition or composition of the product.
Inspectors, analysts and testers specifically required for such production.
Supervisors, shop clerks and anyone else whose wages are specifically identified as working on a
particular product.
As production becomes more capital intensive:
The ratio of direct labour costs to total product cost falls as the use of machinery increases, and
hence depreciation charges increase.
Skilled labour costs and sub-contractors' costs increase as direct labour costs decrease.
Question 1: Labour costs
Which of the following labour costs are normally treated as indirect labour costs?
I
II
III
IV
V
Overtime premium paid to direct workers

Bonus payments to direct workers
Payroll taxes
Idle time of direct workers
Work on installation of equipment
A I, II and IV only
B I, IV and V only
C II, III and IV only
D III, IV and V only
1.2.5 DIRECT EXPENSES
Direct expenses are any expenses which are incurred on a specific product other than direct material
cost and direct labour.
Direct expenses are charged to the product as part of the prime cost. Examples of direct expenses
are as follows:
The hire of tools or equipment for a particular job.
Maintenance costs of tools, fixtures and so on.
CHAPTER 5
Definition
Direct expenses are also referred to as chargeable expenses.
1.2.6 PRODUCTION OVERHEAD

Definition
Production (or factory) overhead includes all indirect material costs, indirect wages and indirect
expenses incurred in the factory to facilitate the order completion.
Production overhead includes the following:

Indirect materials which cannot be traced to the finished product.
Consumable stores, e.g. material used in negligible amounts.
Indirect wages, meaning all wages not charged directly to a product.
Wages of personnel in the production department not directly involved in the manufacture of the
product, e.g. supervisors.
Indirect expenses, other than material and labour, not charged directly to production.
i. Rent, rates and insurance of a factory.
ii. Depreciation, fuel, power, maintenance of plant, machinery and buildings.
1.2.7 ADMINISTRATION OVERHEAD

Definition
Administration overhead is all indirect material costs, wages and expenses incurred in the direction,
control and administration of a business.
Examples of administration overhead are as follows:

Depreciation of office buildings and equipment.
Office salaries, including salaries of directors, support staff and accountants.
Lighting, cleaning and telephone charges.
1.2.8 MARKETING OVERHEAD

Definition
Marketing overhead is all indirect materials costs, wages and expenses incurred in promoting
products and services and retaining customers.
Examples of marketing overhead are as follows:

Printing and stationery, such as catalogues and price lists.
Salaries and commission of sales representatives and sales department staff.
Advertising and sales promotion, market research.
Rent, rates and insurance of sales offices and showrooms.
1.2.9 DISTRIBUTION OVERHEAD

Definition
Distribution overhead is all indirect material costs, wages and expenses incurred in making the
packed product ready for despatch and delivering it to the customer.
Examples of distribution overhead are as follows:

Cost of packing cases
Wages of packers, drivers and despatch clerks
Insurance charges, rent, rates
Question 2: Direct labour cost
A direct labour employee's wage in week 5 consists of the following:
a.
b.
c.
d.
Basic pay for normal hours worked, 36 hours at $4 per hour =

Pay at the basic rate for overtime, 6 hours at $4 per hour =
Overtime shift premium, with overtime paid at time-and-a-quarter
6 hours $4 per hour =
A bonus payment under a group bonus (or 'incentive') scheme bonus for the month =
Total gross wages in week 5 for 42 hours of work
$
144
24
6
30
204
What is the direct labour cost for this employee in week 5?

A $144
B $168
C $198
D $204
1.3 FUNCTIONAL COSTS

1.3.1 CLASSIFICATION BY FUNCTION
Classification by function involves classifying costs as production/manufacturing costs, administration
costs or marketing and distribution costs.
In a 'traditional' costing system for a manufacturing organisation, costs are classified as follows:
a. Production or manufacturing costs. These are costs associated with the factory.
b. Administration costs. These are costs associated with general office departments.
c. Marketing and distribution costs. These are costs associated with sales, marketing, warehousing
and transport departments.
Classification in this way is known as classification by function. Expenses that do not fall fully into one
of these classifications might be categorised as general overheads or even listed as a classification on
their own, for example, research and development costs and financing costs.
1.3.2 FULL COST OF SALES

In costing a small product made by a manufacturing organisation, direct costs are usually restricted to
some of the production costs.
A commonly found build-up of costs is therefore as follows:
$
Production costs
Direct materials
Direct wages
Direct expenses
Prime cost
Production overheads
Full factory cost
Administration costs
Distribution costs
Full cost of sales
A
B
C
A+B+C
D
A+B+C+D
E
F
A+B+C+D+E+F
CHAPTER 5
LO
5.3
1.3.3 FUNCTIONAL COSTS

a. Production costs are the costs which are incurred by the sequence of operations beginning with
the supply of raw materials, and ending with the completion of the product ready for warehousing
as a finished goods item. Packaging costs are production costs where they relate to 'primary'
packing (boxes, wrappers and so on).
b. Administration costs are the costs of managing an organisation, but only insofar as such
administration costs are not related to the production, sales, distribution or research functions.
c. Marketing costs are the costs of creating demand for products and securing firm orders from
customers.
d. Distribution costs are the costs associated with the sequence of activities commencing with the
receipt of finished goods from the production department and making them ready for despatch.
e. Research costs are the costs of searching for new or improved products, whereas development
costs are the costs incurred between the decision to produce a new or improved product and the
commencement of full manufacture of the product.
f. Financing costs are costs incurred to finance the business, such as loan interest.
Question 3: Cost classification
Within the costing system of a manufacturing company the following types of expense are incurred:
Reference number
1. Cost of oils used to lubricate production machinery
2. Motor vehicle licences for trucks
3. Depreciation of factory plant and equipment
4. Cost of chemicals used in the laboratory
5. Commission paid to sales representatives
6. Salary of the secretary to the finance director
7. Trade discount given to customers
8. Holiday pay of machine operators
9. Salary of security guard in warehouse stocked with raw material
10. Fees to advertising agency
11. Rent of finished goods warehouse
12. Salary of scientist in laboratory
13. Insurance of the company's premises
14. Salary of supervisor working in the factory
15. Cost of toner cartridges for printers in the general office
16. Protective clothing for machine operators
Complete the following table by placing each expense in the correct cost classification.
COST CLASSIFICATION
REFERENCE NUMBER
Production costs
Marketing and distribution costs
Research and development costs
Each type of expense should appear only once in your response. You may use the reference numbers
in your response.
2 OVERHEADS
Section overview
Overhead is the cost incurred in the course of making a product, providing a service or
running a department, but which cannot be traced directly and in full to the product,
service or department.
Overhead is actually the total of the following:
Indirect materials
Indirect labour
Indirect expenses
The total of these indirect costs is usually split into the following categories:
Production
Marketing and distribution
Administration
In cost accounting there are two schools of thought as to the correct method of dealing with
overheads:
Absorption costing
Marginal costing
3 ABSORPTION COSTING: AN INTRODUCTION

Section overview
The objective of absorption costing is to include in the total cost of a product an
appropriate share of the organisation's total overhead. An appropriate share is generally
taken to mean an amount which reflects the amount of time and effort that has gone into
producing a unit or completing a job.
LO
5.5
An organisation with one production department that produces identical units will divide the total
overheads among the total units produced. Absorption costing is a method for sharing overheads
between different products on a fair basis.
3.1 IS ABSORPTION COSTING NECESSARY?

Suppose that a company makes and sells 100 units of a product each week. The prime cost per unit is
$6 and the unit sales price is $10. Production overhead costs $200 per week and administration,
marketing and distribution overhead costs $150 per week.
The weekly profit could be calculated as follows:
$
Sales (100 units $10)
Profit
600
200
150
950
50
CHAPTER 5
Prime costs (100 $6)

Administration, marketing and distribution costs
$
1 000
In absorption costing, overhead costs will be added to each unit of product manufactured and
sold.
Prime cost per unit
Production overhead ($200 per week for 100 units)
Full factory cost
$ per unit
6
2
8
The weekly profit would be calculated as follows:

Sales
Less factory cost of sales
Gross profit
Less administration, marketing and distribution costs
Net profit
$
1 000
800
200
150
50
Sometimes, but not always, the overhead costs of administration, marketing and distribution are also
added to unit costs, to obtain a full cost of sales.
Prime cost per unit
Factory overhead cost per unit
Administration costs per unit ($150 per week for 100 units)
Full cost of sales
$ per unit
6.00
2.00
1.50
9.50
The weekly profit would be calculated as follows:

Sales
Less full cost of sales
Profit
$
1 000
950
50
It may already be apparent that the weekly profit is $50 no matter how the figures have been
presented.
So, how does absorption costing serve any useful purpose in accounting?
The theoretical justification for using absorption costing is that all production overheads are incurred
in the production of the organisation's output and so each unit of the product receives some benefit
from these costs. Each unit of output should therefore be charged with some of the overhead costs.
3.2 PRACTICAL REASONS FOR USING ABSORPTION COSTING

The main reasons for using absorption costing are for inventory valuations, pricing decisions, and
establishing the profitability of different products.
a. Inventory valuations. Inventory on hand must be valued for two reasons:
i. For the closing inventory figure in the statement of financial position
ii. For the cost of sales figure in the statement of comprehensive income
The valuation of inventory will affect profitability during a period because of the way in which the
cost of sales is calculated.
The cost of goods produced (extract)
+ the value of opening inventories
the value of closing inventories
= the cost of goods sold
In our example, (under Section 3.1), closing inventories might be valued at prime cost, $6, but in
absorption costing, they would be valued at a fully absorbed factory cost, $8 per unit. They would
not be valued at $9.50, the full cost of sales, because the only costs incurred in producing goods
for finished inventory are factory costs.
b. Pricing decisions. Many companies attempt to fix selling prices by calculating the full cost of
production or sales of each product, and then adding a margin for profit. In our example, the
company might have fixed a gross profit margin at 25% on factory cost, or 20% of the sales price, in
order to establish the unit sales price of $10. 'Full cost plus pricing' can be particularly useful for
companies which do contract work, where each job or contract is different, so that a standard unit
sales price cannot be fixed. Without using absorption costing, a full cost is difficult to ascertain.
c. Establishing the profitability of different products. This argument in favour of absorption costing
is more contentious. If a company sells more than one product, it will be difficult to judge how
profitable each individual product is, unless overhead costs are shared on a fair basis and charged
to the cost of sales of each product.
3.3 INTERNATIONAL ACCOUNTING STANDARD 2 (IAS 2)

Absorption costing is recommended in financial accounting by IAS 2 Inventories. IAS 2 deals with
financial accounting systems. The cost/management accountant is, in theory, free to value inventories
by whatever method seems best, but where companies integrate their financial accounting and cost
accounting systems into a single system of accounting records, the valuation of closing inventories will
be determined by IAS 2.
IAS 2 states that costs of all inventories should comprise those costs which have been incurred in the
normal course of business in bringing the inventories to their 'present location and condition'.
These costs incurred will include all related production overheads, even though these overheads may
accrue on a time basis. In other words, in financial accounting, closing inventories should be valued at
full factory cost, and it may therefore be convenient and appropriate to value inventories by the same
method in the cost accounting system.
3.4 ABSORPTION COSTING STAGES

The three stages of absorption costing are:
Allocation
Absorption
Apportionment
We shall now begin our study of absorption costing by looking at the process of overhead allocation.
4 OVERHEAD ALLOCATION
4.1 INTRODUCTION
Section overview
Allocation is the process by which whole cost items are charged direct to a product unit or
cost centre.
Cost centres may be one of the following types:
a. A production department, to which production overheads, such as the wages of factory
supervisor, are charged.
b. A service department, such as quality control or maintenance, to which overheads incurred in
providing that service are charged.
c. An administrative department, to which administration overheads are charged.
d. A marketing or a distribution department, to which marketing and distribution overheads are
charged.
e. An overhead cost centre, to which items of expense, such as rent and rates, heating and lighting,
which will ultimately be shared by a number of departments, are charged.
CHAPTER 5
LO
5.1
Where a cost is specifically attributable to a cost centre, it is allocated directly to the cost centre that
caused the cost to be incurred, for example:
Direct labour for the packing staff will be allocated to the packing department (production) cost
centre.
The cost of a warehouse security guard will be charged to the warehouse cost centre.
Paper (recording computer output) will be charged to the computer department.
Worked Example: Overhead allocation
Consider the following costs of a company.
Wages of the foreman of department A
Wages of the foreman of department B
Indirect materials consumed in department A
Rent of the premises shared by departments A and B
$200
$150
$50
$300
The cost accounting system might have the below three overhead cost centres.
Cost centre:
101
102
201
Department A
Department B
Rent
Solution
Overhead costs would be allocated directly to each cost centre, i.e. $200 + $50 to cost centre 101,
$150 to cost centre 102 and $300 to cost centre 201. The rent of the factory will be subsequently
shared between the two production departments, but for the purpose of day to day cost recording,
the rent will first of all be charged in full to a separate cost centre (201).
5 OVERHEAD APPORTIONMENT
Section overview
Apportionment is a procedure whereby indirect costs are spread fairly between cost
centres. Service cost centre costs may be apportioned to production cost centres by using
the reciprocal method.
The following data will be used to illustrate the overhead apportionment process.
Worked Example:
Cups Inc has two production departments (A and B) and two service departments (maintenance and
stores). Details of next year's budgeted overheads are shown below:
Total
$
19 200
9 600
54 000
38 400
9 000
25 000
Heat and light

Building repair costs
Machinery depreciation
Rent and rates
Cafeteria
Machinery insurance
Details of each department are as follows:

Floor area (m2)
Machinery book value ($ 000)
Number of employees
Allocated overheads ($ 000)
A
6 000
48
50
15
B
4 000
20
40
20
Maintenance
3 000
8
20
12
Stores
2 000
4
10
5
Total
15 000
80
120
52
Service departments' services were used as follows:

Maintenance hours worked
Number of stores requisitions
A
5 000
3 000
B
4 000
1 000
Maintenance
-------
Stores
1 000
----
Total
10 000
4 000
5.1 STAGE 1: APPORTION GENERAL OVERHEADS

Overhead apportionment follows on from overhead allocation. The first stage of overhead
apportionment is to identify all overhead costs as production department, production service
department, administration or marketing and distribution overhead. These costs may include
expenses such as heat and light, rent and rates and cafeteria, i.e. costs allocated to general overhead
cost centres, must therefore be shared out between the other cost centres.
5.1.1 BASES OF APPORTIONMENT

Overhead costs should be shared out on a fair basis. You will appreciate that because of the
complexity of items of cost it is rarely possible to use only one method of apportioning costs to the
various departments of an organisation. An example of some of the bases of apportionment for
common overhead expenses are given below:
OVERHEAD TO WHICH THE BASIS APPLIES
BASIS
Rent, rates, heating and lighting, repairs and

depreciation of buildings
Floor area occupied by each department (cost centre)
Depreciation of equipment, insurance of equipment
Cost or book value of equipment held by a particular

department/cost centre
Personnel costs, cafeteria costs, superannuation
Number of employees, or labour hours worked in each

cost centre
Note that heating and lighting may also be apportioned using volume of space occupied by each cost
centre.
Worked Example:
Using the Cups question above, show how overheads should be apportioned between the four
departments.
Solution
Item of cost
Heat and light

Building repair costs
Machine depn
Rent and rates
Cafeteria
Machine insurance
Total
Basis of apportionment
Floor area
Floor area
Book value of machinery
Floor area
No of employees
Book value of machinery
A
$
7 680
3 840
32 400
15 360
3 750
15 000
78 030
Department
B
Maintenance
$
$
5 120
3 840
2 560
1 920
13 500
5 400
10 240
7 680
3 000
1 500
6 250
2 500
40 670
22 840
Stores
$
2 560
1 280
2 700
5 120
750
1 250
13 660
Workings
Overhead apportioned to department =
Floor area occupied by department

total overhead
Total floor area
For example:
Heat and light apportioned to dept A =
6 000
19 200 = $7 680
15 000
CHAPTER 5
Overhead apportioned by floor area
Overheads apportioned by machinery value
Overheads apportioned to department
Value of department'smachinery
total overhead
Total value of machinery
Overheads apportioned by number of employees
Overheads apportioned to department
No of employees in department
total overhead
Total no of employees
Question 4: Apportionment
Match the following overheads with the most appropriate basis of apportionment.
OVERHEAD
Cafeteria costs
Heat and light costs
Insurance of computers
Depreciation of equipment
A
B
C
D
I
II
III
IV
BASIS OF APPORTIONMENT
Floor area
Number of employees
Book value of computers
Book value of equipment
5.2 STAGE 2: APPORTION SERVICE DEPARTMENT COSTS

Only production departments produce goods that will ultimately be sold. In order to calculate a
correct price for these goods, we must determine the total cost of producing each unit that is, not
just the cost of the labour and materials that are directly used in production, but also the indirect
costs of services provided by such departments as maintenance and stores.
Our aim is to apportion all the service department costs to the production departments, in one of
three ways.
a. The direct method, where the service centre costs are apportioned to production departments
only.
b. The step-down method, where each service centre's costs are not only apportioned to production
departments but initially to some, but not all, of the other service centres that make use of the
services provided. The costs of the service centres are then apportioned to the production
departments.
c. The repeated distribution (or reciprocal) method, where service centre costs are apportioned to
both the production departments and service departments that use the services. The service
centre costs are then gradually apportioned to the production departments. This method is used
only when service departments work for each other that is, service departments use each
other's services. For example, the maintenance department will use the cafeteria, while the
cafeteria may rely on the maintenance department to ensure its equipment is functioning properly
or to replace bulbs, plugs, etc.
The difference between the step down and reciprocal method is that step-down only partially
recognises the relationships between service departments, whereas the reciprocal method
recognises these fully.
5.2.1 BASIS OF APPORTIONMENT

Whichever method is used to apportion service cost centre costs, the basis of apportionment must
be fair. A different apportionment basis may be applied for each service cost centre. This is
demonstrated in the following table:
SERVICE COST CENTRE
POSSIBLE BASIS OF APPORTIONMENT
Stores
Number or cost value of material requisitions
Maintenance
Hours of maintenance work done for each cost centre
Production planning
Direct labour hours worked in each production cost centre
Although both the direct and step-down methods are not in your syllabus, the following illustration
will give you an idea of how to carry out simple apportionments before we move onto the more
complex reciprocal method.
Worked Example: Simple apportionment using the step-down method
Using the information contained in the Cups Worked Example regarding allocated overheads (section
5) and the results of the overhead apportionment calculations in 5.2 above, apportion the
maintenance and stores departments' overheads to production departments A and B and calculate
the total overheads for each of these production departments.
Solution
1. Decide how the service departments' overheads will be apportioned. The table above tells us that
maintenance overheads can be apportioned according to the hours of maintenance work done,
while we can use the number or cost value of stores/material requisitions for apportioning stores.
The question gives us information about maintenance hours worked and the number of stores
requisitions.
2. Apportion the overheads of the service department whose services are also used by another
service department (in this case, maintenance). This allows us to obtain a total overhead cost for
stores.
Total overheads for maintenance department
$
22 840
12 000
General overheads
Allocated overheads
(see section 5.2 above)

(from information given in worked example
section 5 above)
34 840
Apportioned as follows:
Maintenance hours worked in department
$34 840
Total maintenance hours worked
Production department A =
5 000
$34 840 = $17 420
10 000
Production department B =
4 000
$34 840 = $13 936
10 000
Stores department =
1 000
$34 840 = $3 484
10 000
3. Apportion stores department's overheads.

Total overheads for stores
$
13 660
5 000
General overheads
Allocated overheads
Apportioned from maintenance
3 484
22 144

(from information given in worked example
section 5 above)
(see above)
Apportioned as follows:
Production department A =
3 000
$22 144 = $16 608
4 000
Production department B =
1 000
$22 144 = $5 536
4 000
CHAPTER 5
Number of stores requisitions for department

$22 144
Total number of stores requisitions
4. Total overheads for each production department
General overheads
Allocated overheads
Maintenance
Stores
A
$
78 030
15 000
B
$
40 670
20 000
17 420
16 608
127 058
13 936
5 536
80 142

(from information in worked
example section 5 above)
5.3 THE RECIPROCAL (REPEATED DISTRIBUTION) METHOD OF

APPORTIONMENT
Now that we have looked at the 'simple' scenario of only one service department making use of the
other service department's services, we can move onto the more complicated situation of 'reciprocal'
servicing. This is where each service department makes use of the other service department. In the
Cups example, stores services would use maintenance services and maintenance services would use
stores services.
Worked Example: using repeated distribution method
Assume the usage of Cups's service departments' services were amended to be as follows:
Maintenance hours used
Number of stores requisitions
A
5 000
3 000
B
4 000
1 000
Maintenance
1 000
Stores
1 000
Total
10 000
5 000
Show how the maintenance and stores departments' overheads would be apportioned to the two
production departments and calculate total overheads for each of the production departments.
Solution
Remember to apportion both the general and allocated overheads (see above). The bases of
apportionment for maintenance and stores are the same as for the example above, that is,
maintenance hours worked and number of stores requisitions.
A
$
B
$
Maintenance
$
Stores
$
Total overheads (general and

allocated)
Apportion maintenance (note (a))
93 030
17 420
60 670
13 936
Apportion stores (note (b))
13 286
4 429
2 215
1 772
332
126 283
110
80 917
34 840
(34 840)
NIL
4 429
4 429
(4 429)
NIL
NIL
NIL
18 660
3 484
22 144
(22 144)
NIL
442
442
(442)
NIL
Apportion maintenance (note (c))

Apportion stores (note (d))
Total overheads
Notes
a. It does not matter which department you choose to apportion first. Maintenance overheads were
apportioned using the calculations illustrated above.
b. Stores overheads are apportioned using the same formula as used above but with the amended
number of stores requisitions given above. For example A = 3 000/5 000 $22 144 = $ 13 286
c. Then the new figure for maintenance overheads is reapportioned. For example
A= 5 000/10 000 $4 429 = $2 215
d. The problem with the repeated distribution method is that you can keep performing the same
calculations many times. When you are dealing with a small number (such as $442 above) you can
take the decision to apportion the figure between the production departments only. In this case,
we ignore the stores requisitions for maintenance and base the apportionment on the total stores
requisitions for the production departments, that is, 4 000. The amount apportioned to production
department A was calculated as follows:
Stores requisitions for A
3 000
stores overheads =
$442 = $332
Total stores requisitions (A + B)
4 000
5.4 THE RECIPROCAL (ALGEBRAIC) METHOD OF APPORTIONMENT

The results of the reciprocal method of apportionment may also be obtained using algebra and
simultaneous equations.
Worked Example: Cups using the algebraic method of apportionment
Whenever you are using equations you must define each variable.
Let M = total overheads for the maintenance department
S = total overheads for the stores department
Remember that total overheads for the maintenance department consist of general overheads
apportioned, allocated overheads and the share of stores overheads (1 000/5 000 = 20%).
Similarly, total overheads for stores will be the total of general overheads apportioned, allocated
overheads and the 1 000/10 000 (10%) share of maintenance overheads.
M = 0.2S + $34 840
S = 0.1M + $18 660
1
2
($34 840 was calculated above)

($18 660 was calculated above)
We now solve the equations.

Multiply equation 1 by 5 to give us
5M = S + 174 200
S = 5M 174 200
3, which can be rearranged as

4
Subtract equation 2 from equation
S = 5M 174 200
S = 0.1M + 18 660
0 = 4.9M 192 860

4.9M = 192 860
M=
192 860
= $39 359
4.9
Substitute M = 39 359 into equation 2

S = 0.1 39 359 + 18 660
S = 3 936 + 18 660 = 22 596
Overhead costs
Apportion maintenance
Apportion stores
Total
A
$
93 030
19 680
13 558
126 268
B
$
60 670
15 743
4 519
80 932
Maintenance
$
34 840
(39 359)
4 519
Nil
Stores
$
18 660
3 936
(22 596)
Nil
You will notice that the total overheads for production departments A and B are the same regardless
of the method used (minor difference is due to rounding).
CHAPTER 5
These overheads can now be apportioned to the production departments using the proportions in
Section 5.2.1 above.
Question 5: Reapportionment
Sandstorm is a contracting engineering company which has three production departments (forming,
machines and assembly) and two service departments (maintenance and general).
The following analysis of overhead costs has been made for the year just ended.
$
Rent and rates
Power
Light, heat
Repairs, maintenance:
Forming
Machines
Assembly
Maintenance
General
$
8 000
750
5 000
800
1 800
300
200
100
3 200
Departmental expenses:
Forming
Machines
Assembly
Maintenance
General
1 500
2 300
1 100
900
1 500
7 300
Depreciation:
Plant
Fixtures and fittings
Insurance:
Plant
Buildings
Indirect labour:
Forming
Machines
Assembly
Maintenance
General
10 000
250
2 000
500
3 000
5 000
1 500
4 000
2 000
15 500
52 500
Other available data are as follows:
Forming
Machines
Assembly
Maintenance
General
Floor
area
Plant
value
sq. ft
2 000
4 000
3 000
500
500
10 000
$
25 000
60 000
7 500
7 500
100 000
Fixtures
& fittings
value
$
Effective
horsepower
1 000
500
2 000
1 000
500
5 000
40
90
15
5
150
Direct
Labour
cost for
Hours
year
Worked
$
20 500
14 400
30 300
20 500
24 200
20 200
75 000
Machine
hours
worked
12 000
21 600
2 000
55 100
35 600
Service department costs are apportioned as follows:
Forming
Machines
Assembly
General
Maintenance
Maintenance
%
20
50
20
10
100
General
%
20
60
10
10
100
Using the data provided prepare an analysis showing the distribution of overhead costs to
departments. Reapportion service cost centre costs (maintenance and general) using the repeated
reciprocal method.
6 OVERHEAD ABSORPTION
Section overview
Overhead absorption is the process whereby overhead costs allocated and apportioned to
production cost centres are added to unit, job or batch costs. Overhead absorption is
sometimes called overhead recovery.
6.1 INTRODUCTION
Having allocated and/or apportioned all overheads, the next stage in the costing treatment of
overheads is to add them to, or absorb them into the cost of the product.
Overheads are usually added to the cost of the product using a predetermined overhead
absorption rate, which is calculated using figures from the budget.
6.2 CALCULATION OF OVERHEAD ABSORPTION RATES

Step 1
Step 2
Estimate the overhead likely to be incurred during the coming period.
Step 3
Divide the estimated overhead by the budgeted activity level. This produces the
overhead absorption rate.
Step 4
Absorb the overhead into the product cost by applying the calculated overhead
absorption rate.
Estimate the activity level for the period. This could be total labour hours, units, or direct
costs or whatever basis is to be used for the overhead absorption rates.
Worked Example: The basics of absorption costing
Athena Co makes two products, the Greek and the Roman. Greeks take 2 labour hours each to make
and Romans take 5 labour hours. Athena Co budgets its total overhead for the coming year at $50
000, and estimates that 100 000 labour hours will be worked. What is the overhead cost per unit for
Greeks and Romans respectively if overheads are absorbed on the basis of labour hours?
Solution
Step 1
Estimate the overhead likely to be incurred during the coming period.

Athena Co estimates that the total overhead will be $50 000.
Step 2
Estimate the activity level for the period.

Athena Co estimates that a total of 100 000 direct labour hours will be worked.
Divide the estimated overhead by the budgeted activity level.
Absorption rate =
$50 000
= $0.50 per direct labour hour
100 000hrs
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Step 3
Step 4
Absorb the overhead into the product cost by applying the calculated absorption rate.
Absorption rate per labour hour
Overhead absorbed per unit
Greek
2
$0.50
$1
Roman
5
$0.50
$2.50
It should be obvious that, even if a company is trying to be 'fair', there is a great lack of precision
about the way the absorption base is chosen and overhead is absorbed.
This arbitrariness is one of the main criticisms of absorption costing. If absorption costing is to be
used, because of its other virtues, then it is important that the methods used are kept under regular
review where necessary. Changes in working conditions should lead to changes in the way in which
work is accounted for.
For example, a labour intensive department may become mechanised. If a direct labour hour rate of
absorption had been used prior to the mechanisation, it would probably now be more appropriate to
change to using a machine hour rate.
6.3 CHOOSING THE APPROPRIATE ABSORPTION BASE

Some bases of absorption, or 'overhead recovery rates', are as follows:
A percentage of direct materials cost.
A percentage of direct labour cost (note a).
A percentage of prime cost.
A rate per machine hour (note b).
A rate per direct labour hour.
A rate per unit of product (note c).
A percentage of factory cost - for administration overhead.
A percentage of sales or factory cost - for marketing and distribution overhead.
The choice of an absorption basis is a matter of judgment. What is required is an absorption basis
which realistically reflects the characteristics of a given cost centre and which avoids undue anomalies.
Many factories use a direct labour hour rate or machine hour rate in preference to a rate based on a
percentage of direct materials cost, wages or prime cost.
a. A direct labour hour basis is most appropriate in a labour intensive environment.
b. A machine hour rate would be used in departments where production is controlled or dictated by
machines.
c. A rate per unit of product would be effective only if all units were identical.
Worked Example: Bridge Cottage
The budgeted production overheads and other budget data of Bridge Cottage are as follows:
Budget
Overhead cost
Direct materials cost
Direct labour cost
Machine hours
Direct labour hours
Units of production
Production
dept A
$36 000
$32 000
$40 000
10 000
18 000
Production
dept B
$5 000
1 000
Calculate the absorption rate for Department A using the bases of apportionment below:
Percentage of direct materials cost.
Percentage of direct labour cost.
Percentage of prime cost.
Rate per machine hour.
Rate per direct labour hour.

Units of production
Calculate an absorption rate for Department B using units of output as the absorption rate.
Solution
Department A
i. Percentage of direct materials cost
$36 000
100% = 112.5%
$32 000
ii. Percentage of direct labour cost
$36 000
100% = 90%
$40 000
iii. Percentage of prime cost
$36 000
100% = 50%
$72 000
iv. Rate per machine hour
$36 000
= $3.60 per machine hour
10 000 hrs
v. Rate per direct labour hour
$36 000
= $2 per direct labour hour
18 000 hrs
The department B absorption rate based on units of output:

$5 000
= $5 per unit produced
1 000 units
6.4 BASES OF ABSORPTION

The choice of the basis of absorption is significant in determining the cost of individual units, or jobs,
produced. Using the previous example, suppose that an individual product has a material cost of $80,
a labour cost of $85, and requires 36 labour hours and 23 machine hours to complete. The overhead
cost of the product would vary, depending on the basis of absorption used by the company for
overhead recovery.
a. As a percentage of direct material cost, the overhead cost would be
112.5% $80
= $90.00
b. As a percentage of direct labour cost, the overhead cost would be

90% $85
= $76.50
c. As a percentage of prime cost, the overhead cost would be 50% $165

d. Using a machine hour basis of absorption, the overhead cost would be
23 hrs $3.60
= $82.50
= $82.80
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e. Using a labour hour basis, the overhead cost would be 36 hrs $2

= $72.00
In theory, each basis of absorption would be possible, but the company should choose a basis which
seems to it to be the 'fairest'.
7 BLANKET ABSORPTION RATES AND

DEPARTMENTAL ABSORPTION RATES
7.1 INTRODUCTION
Section overview
A blanket overhead absorption rate is a single absorption rate, that is used throughout a
factory.
For example, if total overheads were $500 000 and there were 250 000 direct machine hours during the
period, the blanket overhead rate would be $2 per direct machine hour and all jobs passing through
the factory would be charged at that rate.
Blanket overhead rates are not appropriate in the following circumstances:
Products or jobs pass through more than one department, and
products/jobs do not spend an equal amount of time in each department.
If a single factory overhead absorption rate is used, some products will receive a higher overhead
charge than they ought 'fairly' to bear, whereas other products will be under-charged.
If a separate absorption rate is used for each department, charging of overheads will be more fair
and the full cost of production of items will more closely represent the amount of the effort and
resources used to make them.
Worked Example: Stoakley
Stoakley Ltd has two production departments, for which the following budgeted information is
available:
Budgeted overheads
Budgeted direct labour hours
Department A
$360 000
200 000 hrs
Department B
$200 000
40 000 hrs
Total
$560 000
240 000 hrs
If a single factory overhead absorption rate is applied, the rate of overhead recovery would be:
$560 000
240 000 hours
If separate departmental rates are applied, these would be:
Department A =
Department B =
$360 000
200 000 hours
$200 000
= $5 per direct labour hour
40 000 hours
Jobs using Department B would get charged a higher overhead rate in terms of cost per hour worked
than department A.
Now let us consider two separate jobs.
Job X has a prime cost of $100, takes 30 hours in department B and does not involve any work in
department A.
Job Y has a prime cost of $100, takes 28 hours in department A and 2 hours in department B.
What would be the factory cost of each job, using the following rates of overhead recovery?
a. A single factory rate of overhead recovery
b. Separate departmental rates of overhead recovery
Solution
a. Single factory rate
Prime cost
Factory overhead (30 $2.33)
Factory cost
b. Separate departmental rates

Prime cost
Factory overhead:
department A
department B
Factory cost
(30 $5)
Job X
$
100.00
69.90
Job Y
$
100.00
69.90
169.90
169.90
$
100.00
0
150.00
$
100.00
50.40
10.00
(28 $1.80)
(2 $5)
250.00
160.40
Using a single factory overhead absorption rate, both jobs would cost the same. However, since job X
is done entirely within department B where overhead costs are higher, whereas job Y is done mostly
within department A, where overhead costs are lower, it is arguable that job X should cost more than
job Y. This will occur if separate departmental overhead recovery rates are used to reflect the work
done on each job in each department separately.
If all jobs do not spend approximately the same time in each department then, to ensure that all jobs
are charged with their fair share of overheads, it is necessary to establish separate overhead rates for
each department.
Question 6: Single factory rate
What is the problem with using a single factory overhead absorption rate?
8 MARGINAL COST AND MARGINAL COSTING

Section overview
Marginal cost is the variable cost of one unit of product or service.
Marginal costing is an alternative method of costing to absorption costing. In marginal costing, only
variable costs are charged as a cost of sale and a contribution is calculated (sales revenue minus
variable cost of sales). Closing inventories of work in progress or finished goods are valued at marginal
(variable) production cost. Fixed costs are treated as a period cost, and are charged in full to the
statement of comprehensive income in the accounting period in which they are incurred.
The marginal production cost per unit of an item usually consists of the following:
Direct materials
Direct labour costs might be excluded from marginal costs when the work force is a given number of
employees on a fixed wage or salary. Even so, it is not uncommon for direct labour to be treated as a
variable cost, even when employees are paid a basic wage for a fixed working week. If in doubt, you
should treat direct labour as a variable cost unless given clear indications to the contrary. Direct labour
is often a step-fixed cost, usually with sufficiently short steps to make labour costs act in a variable
fashion.
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Direct labour
The marginal cost of sales usually consists of the marginal cost of production adjusted for inventory
movements plus the variable marketing costs, which would include items such as sales commission,
and possibly some variable distribution costs.
8.1 CONTRIBUTION
Contribution is an important measure in marginal costing, and it is calculated as the difference
between sales price and marginal or variable cost of sales.
Contribution is of fundamental importance in marginal costing, and the term 'contribution' is really
short for 'contribution towards covering fixed overheads and making a profit'.
9 THE PRINCIPLES OF MARGINAL COSTING

Section overview
Period fixed costs are the same, for any volume of sales and production.
The principles of marginal costing are as follows:

a. Period fixed costs are the same, for any volume of sales and production (provided that the
level of activity is within the 'relevant range'). Therefore, by selling an extra item of product or
service the following will happen:
i. Revenue will increase by the sales value of the item sold.
ii. Costs will increase by the variable cost per unit.
iii. Profit will increase by the amount of contribution earned from the extra item.
b. Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution
earned from the item.
c. Profit measurement can be based on an analysis of total contribution. Since fixed costs relate
to a period of time, and do not change with increases or decreases in sales volume, it is misleading
to charge units of sale with a share of fixed costs. Absorption costing can therefore be misleading,
and it is more appropriate to deduct fixed costs from total contribution for the period to derive a
profit figure.
d. When a unit of product is made, the extra costs incurred in its manufacture are the variable
production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when
output is increased. Using marginal costing the valuation of closing inventories is the
variable production cost (direct materials, direct labour, direct expenses (if any) and variable
production overhead) because these are the only costs properly attributable to the product.
Worked Example: Marginal costing principles
Rain Until September Co makes a product, the Splash, which has a variable production cost of $6 per
unit and a sales price of $10 per unit. At the beginning of September 20X0, there were no opening
inventories and production during the month was 20 000 units. Fixed costs for the month were $45 000
(production, administration, sales and distribution). There were no variable marketing costs.
Calculate the contribution and profit for September 20X0, using marginal costing principles, if sales
were as follows:
a. 10 000 Splashes
b. 15 000 Splashes
c. 20 000 Splashes
Solution
The stages in the profit calculation are as follows:

To identify the variable cost of sales, and then the contribution.
Deduct fixed costs from the total contribution to derive the profit.
Value all closing inventories at (marginal) production cost ($6 per unit).
Sales (at $10)

Opening inventory
Variable production cost
Less value of closing
inventory (at marginal cost)
Variable cost of sales
Contribution
Less fixed costs
Profit/(loss)
10 000 Splashes
$
$
100 000
0
120 000
120 000
60 000
Profit (loss) per unit

15 000 Splashes
$
$
150 000
0
120 000
120 000
20 000 Splashes
$
$
200 000
0
120 000
120 000
0
30 000
60 000
40 000
45 000
(5 000)
90 000
60 000
45 000
15 000
120 000
80 000
45 000
35 000
$(0.50)
$1
$1.75
$4
$4
$4
The conclusions which may be drawn from this example are as follows:
a. The profit per unit varies at differing levels of sales, because the average fixed overhead cost per
unit changes with the volume of output and sales.
b. The contribution per unit is constant at all levels of output and sales. Total contribution, which is
the contribution per unit multiplied by the number of units sold, increases in direct proportion to
the volume of sales.
c. Since the contribution per unit does not change, the most effective way of calculating the
expected profit at any level of output and sales would be as follows:
i. First calculate the total contribution.
ii. Then deduct fixed costs as a period charge in order to find the profit.
d. In our example the expected profit from the sale of 17 000 Splashes would be as follows:
$
Total contribution (17 000 $4)
Less fixed costs
Profit
68 000
45 000
23 000
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i. If total contribution exceeds fixed costs, a profit is made.

ii. If total contribution exactly equals fixed costs, no profit or loss is made.
iii. If total contribution is less than fixed costs, there will be a loss.
Question 7: Mill Stream
Mill Stream makes two products, the Mill and the Stream. Information relating to each of these
products for April 20X1 is as follows:
Opening inventory
Production (units)
Sales (units)
Mill
Nil
15 000
10 000
Sales price per unit
$20
Unit costs
Direct materials
Direct labour
Variable sales overhead
Fixed costs for the month
Production costs
Sales and distribution costs
$
8
4
2
2
Stream
Nil
6 000
5 000
$30
$
14
2
1
3
$
40 000
15 000
25 000
Using marginal costing principles, what was the profit in April 20X1?
A $10 000
B $40 000
C $45 000
D $70 000
9.1 PROFIT OR CONTRIBUTION INFORMATION

The main advantage of contribution information, rather than profit information, is that it allows an easy
calculation of profit if sales increase or decrease from a certain level. By comparing total contribution
with fixed overheads, it is possible to determine whether profits or losses will be made at certain sales
levels. Profit information, on the other hand, does not lend itself to easy manipulation but note how
easy it was to calculate profits using contribution information in the Worked Example Marginal costing
principles. Contribution information is also more useful for decision making than profit information.
10 MARGINAL COSTING, ABSORPTION COSTING

AND THE CALCULATION OF PROFIT
Section overview
In marginal costing, fixed production costs are treated as period costs and are written off as
they are incurred. In absorption costing, fixed production costs are absorbed into the cost
of units and are partially carried forward in inventory to be charged against sales for the
next period. Inventory values using absorption costing are greater than those calculated
using marginal costing.
Marginal costing as a cost accounting system is significantly different from absorption costing. It is an
alternative method of accounting for costs and profit, which rejects the principles of absorbing fixed
overheads into unit costs.
MARGINAL COSTING
ABSORPTION COSTING
Closing inventories are valued at marginal production

cost.
Closing inventories are valued at full production cost.
Fixed costs are period costs.
Fixed costs are absorbed into unit costs.
Cost of sales does not include a share of fixed

overheads.
Cost of sales does include a share of fixed overheads

(see note below).
Note. The share of fixed overheads included in cost of sales are from the previous period (in opening
inventory values). Some of the fixed overheads from the current period will be excluded by being
carried forward in closing inventory values.
In marginal costing, it is necessary to identify the following:

Variable costs.
Fixed costs.
Contribution.
In absorption costing (sometimes known as full costing), it is not necessary to distinguish variable
costs from fixed costs.
Worked Example: Marginal and absorption costing compared
This example will lead you through the various steps in calculating marginal and absorption costing
profits, and will highlight the differences between the two techniques.
Big Possum Ltd manufactures a single product, the Bark, details of which are as follows:
Per unit
Selling price
Direct materials
Direct labour
Variable overheads
$
180.00
40.00
16.00
10.00
Annual fixed production overheads are budgeted to be $1.6 million and Big Possum Ltd expects to
produce 1 280 000 units of the Bark each year. Overheads are absorbed on a per unit basis. Actual
overheads are $1.6 million for the year.
Budgeted fixed marketing costs are $320 000 per quarter.
Actual sales and production units for the first quarter of 20X8 are given below:
January March
240 000
280 000
Sales
Production
There is no opening inventory at the beginning of January.

Prepare a statement of comprehensive income for the quarter, using
a. Total cost per unit (marginal costing).
b. Total cost per unit (absorption costing).
Solution
Calculate the overhead absorption rate per unit.

Remember that overhead absorption rate is based only on budgeted figures.
Overhead absorption rate =
Budgeted fixed overheads

Budgeted units
Also be careful with your calculations. You are dealing with a three-month period but the
figures in the question are for a whole year. You will have to convert these to quarterly
figures.
Budgeted overheads (quarterly) =
$1.6 million
= $400 000
4
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Step 1
Budgeted production (quarterly) =
1280 000
= 320 000 units
4
Overhead absorption rate per unit =
Step 2
$400 000
= $1.25 per unit
320 000
Calculate total cost per unit.

Total cost per unit (marginal costing) = Variable cost per unit
= (40 + 16 + 10) = $66
Total cost per unit (absorption costing)
Step 3
= Variable cost + fixed production cost

= $66 + 1.25
= $67.25
Calculate closing inventory in units.

Closing inventory = Opening inventory + production sales
Closing inventory = 0 + 280 000 240 000 = 40 000 units
Step 4
Calculate under/over absorption of overheads.

This is based on the difference between actual production and budgeted production.
Actual production = 280 000 units
Budgeted production = 320 000 units (see step 1 above)
Under-production = 40 000 units
As Big Possum Ltd produced 40 000 fewer units than expected, there will be an underabsorption of overheads of 40 000 x $1.25 (see step 1 above) = $50 000. This will be
added to production costs in the statement of comprehensive income.
Step 5
Produce statements of comprehensive income.
Sales (240 000 x $180)

Less Cost of sales
Opening inventory
Add Production cost
280 000 x $66
280 000 x $67.25
Less Closing inventory
40 000 x $66
40 000 x $67.25
Marginal costing
$ 000
$ 000
43 200
0
18 480
18 830
(2 640)
(2 690)
16 140
50
Add Under absorbed O/H

(15 840)
27 360
Contribution
Gross profit
Less
Fixed production O/H
Fixed marketing O/H
Net profit
Absorption costing
$ 000
$ 000
43 200
(16 190)
27 010
400
320
Nil
320
(720)
26 640
(320)
26 690
Question 8: Marginal and absorption
A company makes a single product. Its budgeted data for a period is as follows.
Opening inventory
Variable production cost per unit of opening
inventory
Production
Sales
Variable production cost per unit produced in
the period
Variable selling cost per unit
Sales price per unit
Production fixed costs
Other fixed overhead costs
3 000 units
$6
16 000 units
17 000 units
$7
$1
$20
$80 000
$60 000
The company uses marginal costing, but is considering whether to use absorption costing instead. If
absorption costing were to be used, the fixed production overhead in the opening inventory would
have been $4 per unit. Inventory is valued using the FIFO (first in, first out) method.
a. Using marginal costing principles, what is the budgeted profit for the period?
A
B
C
D
$55 000
$64 000
$67 000
$69 000
b. If absorption costing were to be used instead of marginal costing, by how much would the
reported profit for the period be higher or lower?
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A $2 000 lower
B $2 000 higher
C $10 000 lower
D $10 000 higher
KEY CHAPTER POINTS

Materials, labour costs and other expenses can be classified as either direct costs or indirect costs.
Classification by function involves classifying costs as production/manufacturing costs,
administration costs or marketing and distribution costs.
Overhead is the cost incurred in the course of making a product, providing a service or running a
department, but which cannot be traced directly and in full to the product, service or department.
The objective of absorption costing is to include in the total cost of a product an appropriate share
of the organisation's total overhead. An appropriate share is generally taken to mean an amount
which reflects the amount of time and effort that has gone into producing a unit or completing a
job.
Allocation is the process by which whole cost items are charged direct to a product's cost.
Apportionment is a procedure whereby indirect costs are spread fairly between cost centres.
Service cost centre costs may be apportioned to production cost centres by using the reciprocal
method.
Overhead absorption is the process whereby overhead costs allocated and apportioned to
production cost centres are added to unit, job or batch costs. Overhead absorption is sometimes
called overhead recovery.
A blanket overhead absorption rate is an absorption rate used throughout a factory and for all jobs
and units of output irrespective of the department in which they were produced.
Marginal cost is the variable cost of one unit of product or service.
Period fixed costs are the same, for any volume of sales and production.
In marginal costing, fixed production costs are treated as period costs and are written off as they
are incurred. In absorption costing, fixed production costs are absorbed into the cost of units and
are partially carried forward in inventory to be charged against sales for the next period. Inventory
values using absorption costing are therefore greater than those calculated using marginal costing.

1 A company has to pay a 20c per unit royalty to the inventor of a device which it manufactures and
sells.
The royalty charge would be classified in the company's accounts as a/an
A
B
C
D
direct expense.
marketing expense.
production overhead.
administrative overhead.
2 Which of the following would be classed as indirect labour?

A A stores assistant in a factory store
B Plasterers in a construction company
C Assembly workers in a company manufacturing televisions
D Employees responsible for packaging the product at the end of the production line
3 A manufacturing company is very busy and overtime is being worked.
The amount of overtime premium contained in direct wages would normally be classed as
A
B
C
D
part of prime cost.

factory overheads.
direct labour costs.
administrative overheads.
4 The following extract of information is available concerning the four cost centres of EG Limited.
Number of direct employees

Number of indirect employees
Overhead allocated and apportioned
Production cost centres

Machinery
Finishing
Packing
7
6
2
3
2
1
$28 500
$18 300
$8 960
Service cost
centre
Cafeteria
4
$8 400
The overhead cost of the cafeteria is to be re-apportioned to the production cost centres on the
basis of the number of employees in each production cost centre. After the re-apportionment, the
total overhead cost of the packing department, to the nearest $, will be
$1 200.
$9 968.
$10 080.
$10 160.
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A
B
C
D
THE FOLLOWING INFORMATION RELATES TO QUESTIONS 5 AND 6
Budgeted information relating to two departments in a company for the next period is as follows:
Department
1
2
Production
overhead
$
27 000
18 000
Direct
material cost
$
67 500
36 000
Direct
labour cost
$
13 500
100 000
Direct
Labour hours
2 700
25 000
Machine
hours
45 000
300
Individual direct labour employees within each department earn differing rates of pay, according to
their skills, grade and experience.
5 What is the most appropriate production overhead absorption rate for department 1?
A $0.60 per machine hour
B $10 per direct labour hour
C 40% of direct material cost
D 200% of direct labour cost
6 What is the most appropriate production overhead absorption rate for department 2?
A $0.72 per direct labour hour
B 18% of direct labour cost
C 50% of direct material cost
D $60 per machine hour
7 Which of the following statements about predetermined overhead absorption rates are true?
I Using a predetermined absorption rate offers the administrative convenience of being able to
record full production costs sooner.
II Using a predetermined absorption rate avoids fluctuations in unit costs caused by abnormally
high or low overhead expenditure or activity levels.
III Using a predetermined absorption rate avoids problems of under/over absorption of overheads
because a constant overhead rate is available.
A
B
C
D
I, II and III
I and II only
I and III only
II and III only
8 A direct labour hour basis is most appropriate in which of the following environments?
A Labour-intensive
B Machine-intensive
C When all units produced are identical
D When there are several production departments

1 A The royalty cost can be traced in full to the product, i.e. it has been incurred as a direct
consequence of making the product. It is therefore a direct expense. Options B, C and D are
all overheads or indirect costs which cannot be traced directly and in full to the product.
2 A The wages paid to the stores assistant cannot be traced in full to a product or service, therefore
this is an indirect labour cost.
The wages paid to plasterers in a construction company can be traced in full to the contract or
building they are working on (option B). This is also a direct labour cost. The assembly workers'
wages can be traced in full to the televisions manufactured (option C), therefore this is a direct
labour cost. The same is true of the packaging employees (option D).
3 B Overtime premium is always classed as factory overheads unless it is:
worked at the specific request of a customer to get the order completed.
worked regularly by a production department in the normal course of operations, in which
case it is usually incorporated into the direct labour hourly rate.
4 D Number of employees in packing department = 2 direct + 1 indirect = 3

Number of employees in all production departments = 15 direct + 6 indirect = 21
Packing department overhead
Cafeteria cost apportioned to packing department
Original overhead allocated and apportioned

Total overhead after apportionment of cafeteria costs
=
=
=
$8 400
3
21
$1 200
$8 960
$10 160
If you selected option A you forgot to include the original overhead allocated and apportioned
to the packing department.
If you selected option B you included the four cafeteria employees in your calculation, but the
question states that the basis for apportionment is the number of employees in each
production cost centre. If you selected option C you based your calculations on the direct
employees only.
5 A Department 1 appears to undertake primarily machine-based work, therefore a machine-hour
rate would be most appropriate.
$27 000
= $0.60 per machine hour
45 000
Therefore the correct answer is A.

Option C is not the most appropriate because it is not time-based, and most items of overhead
expenditure tend to increase with time.
Options B and D are not the most appropriate because labour activity is relatively insignificant
in department 1, compared with machine activity.
$18 000
25 000
Option B is based on labour therefore it could be suitable. However differential wage rates
exist and this could lead to inequitable overhead absorption.
Option C is not the most appropriate because it is not time-based.
Option D is not suitable because machine activity is not significant in department 2.
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6 A Department 2 appears to be labour-intensive therefore a direct labour-hour rate would be most

appropriate.
7 B Statement (I) is correct because a constant unit absorption rate is used throughout the period.
Statement (II) is correct because 'actual' overhead costs, based on actual overhead
expenditure and actual activity for the period, cannot be determined until after the end of the
period. Statement (III) is incorrect because under/over absorption of overheads is caused by
the use of predetermined overhead absorption rates.
8 A A direct labour hour absorption rate is most appropriate for labour-intensive work when output
consists of non-standard units.

1 A The cost of overtime premiums paid to direct workers is treated as an indirect labour cost
unless the overtime is worked specifically at the request of a customer, in which case the
overtime premium becomes a direct cost of the job. Bonus payments to direct workers may be
paid annually, and are normally treated as an indirect cost. The cost of idle time is also an
indirect labour cost. Payroll taxes are part of the total cost of employing either direct or indirect
workers, however they do not normally feature in management accounting analysis and are
therefore not a relevant issue for management accounting purposes. The labour cost of work to
install capital equipment is normally included in the cost of the capital asset.
2 B The correct answer is B because the basic rate for overtime is a part of direct wages cost. It is
only the overtime premium that is usually regarded as an overhead or indirect cost.
3
COST CLASSIFICATION
REFERENCE NUMBER
Production costs
14
Marketing and distribution costs
10
11
13
15
Research and development costs
12
Maint.
$
General
$
Total
$
4 D IV
A II
BI
16
C III
5 Analysis of distribution of actual overhead costs

Basis
Directly allocated overheads:
Repairs, maintenance
Departmental expenses
Indirect labour
Apportionment of other
overheads:
Rent, rates
Power
Light, heat
Depreciation of plant
Depreciation of F and F
Insurance of plant
Insurance of buildings
1
2
1
3
4
3
1
Forming Machines
$
$
Ass
$
800
1 500
3 000
1 800
2 300
5 000
300
1 100
1 500
200
900
4 000
100
1 500
2 000
3 200
7 300
15 500
1 600
200
1 000
2 500
50
500
100
11 250
3 200
450
2 000
6 000
25
1 200
200
22 175
2 400
75
1 500
750
100
150
150
8 025
400
25
250
750
50
150
25
6 750
400
0
250
0
25
0
25
4 300
8 000
750
5 000
10 000
250
2 000
500
52 500
Basis of apportionment:
1 floor area
2 effective horsepower
3 plant value
4 fixtures and fittings value
Overheads
Forming
$
11 250
1 350
Machines
$
22 175
3 375
Assembly
$
8 025
1 350
995
99
10
1
13 705
2 985
249
30
3
28 817
498
99
5
1
9 978
Maintenance
$
6 750
(6 750)
497
(497)
5
(5)
0
General
$
4 300
675
4 975
(4 975)
50
(50)
Total
$
52 500
52 500
CHAPTER 5
Apportionment of service department overheads to production departments, using the repeated

reciprocal method.
6 The problem with using a single factory overhead absorption rate is that some products will receive
a higher overhead charge than they ought 'fairly' to bear and other products will be undercharged.
7 A
$
Contribution from Mills (unit contribution = $20 $16 = $4 10 000)
Contribution from Streams (unit contribution = $30 $20 = $10 5 000)
Total contribution
Fixed costs for the period
Profit
40 000
50 000
90 000
80 000
10 000
8 (a) C
$
18 000
112 000
Opening inventory (3 000 $6)

Variable production costs (16 000 $7)
130 000
(14 000)
Closing inventory (2 000 $7)

Variable production cost of sales
116 000
17 000
Variable selling costs (17 000 $1)

Total variable costs
133 000
340 000
Sales (17 000 $20)

Contribution
Fixed costs (80 000 + 60 000)
Profit
207 000
(140 000)
67 000
(b) A Absorption costing: fixed production cost per unit in the period $80 000/16 000 = $5.
Therefore value of closing inventory (per unit) = $7 + $5 = $12.
Opening inventory (3 000 $6)

Closing inventory (2 000 $7)
Reduction in inventory
Marginal
costing
Absorption
costing
$
18 000
14 000
$
30 000
24 000
4 000
(3 000 $10)
(2 000 $12)
6 000
The reduction in inventory is an addition to the cost of sales in the period; therefore with
absorption costing the cost of sales in the period would be $2 000 higher, and reported
profit $2 000 lower.
171
CHAPTER 6
OVERHEAD COSTING
ACTIVITY BASED COSTING
Learning objectives
Reference
LO6
Identify and apply the principles of activity-based costing to allocate overheads in

organisations
LO6.1
Topic list
1
2
3
4
5
6
The reasons for the development of ABC

Outline of an ABC system
Absorption costing versus ABC
Marginal costing versus ABC
Introducing an ABC system into an organisation
Advantages and disadvantages of ABC
INTRODUCTION
In this chapter we look at a costing system that has been developed to suit modern practices: activity
based costing.
Basically, activity based costing (ABC) is the modern alternative to traditional absorption costing.
Overhead costing
activity based
costing
Reasons for
development
Introducing
ABC
Absorption costing
versus ABC
Outline of
ABC system
Merits and
criticisms
Marginal costing
versus ABC
OVERHEAD COSTING ACTIVITY BASED COSTING | 173
area.
everything covered.
1 What are the reasons for the development of ABC?
2 Define ABC.
3 Explain the concept of cost drivers.
(Section 1)
(Section 2.1)
(Sections 2.2, 3.2)
4 When should an ABC system be introduced?
(Section 5.1)
5 What are product-sustaining activities?
(Section 5.2)
6 What are facility-sustaining activities?
(Section 5.2)
7 List the advantages of ABC.
(Section 6.1)
8 Define customer profitability analysis.
(Section 6.1)
9 List the disadvantages of ABC.
(Section 6.2)
CHAPTER 6
BEFORE YOU BEGIN
1 THE REASONS FOR THE DEVELOPMENT OF ABC

Section overview
Traditional costing systems assume that all products consume all resources in proportion to
their production volumes. The use of a predetermined overhead absorption rate tends to
allocate too great a proportion of overheads to high volume products, which use relatively
fewer support services, and too small a proportion of overheads to low volume products,
which use relatively more support services. Activity based costing (ABC) attempts to
overcome this problem by identifying core activities involved in the production of a product
and charging overheads on the basis of each product's consumption of those
activities/support services, rather than based on volume of production.
LO
6.1
The traditional system of absorption costing was developed when cost accounting systems were
used mainly for manufacturing organisations that produced only a narrow range of products and
when overhead costs were only a very small fraction of total costs. Direct labour and direct
material costs accounted for the largest proportion of the costs. Production overhead costs were not
too significant, and were usually considered to be 'driven' by direct labour hours worked. Similarly
selling and distribution costs were relatively small, and were considered to be 'driven' by the volume
of sales activity.
Nowadays, however, with the advent of advanced manufacturing technology (AMT), production
overheads are a much more significant proportion of total production costs. Direct labour costs in
a highly automated production system may account for as little as 5% of a product's cost. There are
now many different ways of delivering products to different types of customer, and selling and
distribution costs depend on factors such as the channel of distribution used and the type of customer,
not just on sales volumes.
It may therefore now be difficult to justify the use of direct labour or direct production cost as the
basis for absorbing production overheads.
Many resources are used in support activities that are not directly related to production (or selling)
volume. The increase in costs of non-volume-related activities is due to AMT: they include costs
relating to setting-up production runs, production scheduling, customer order handling, inspection
and data processing. These support activities assist the efficient manufacture of a wide range of
products (necessary if businesses are to compete effectively) and are not, in general, affected by
changes in production volume. They tend to vary in the long term according to the range and
complexity of the products manufactured rather than the volume of output.
The wider the range and the more complex the products, the more support services will be required.
Consider, for example, factory X which produces 10 000 units of one product, the Alpha, and factory Y
which produces 1 000 units each of ten slightly different versions of the Alpha. Support activity costs in
the factory Y are likely to be a lot higher than in factory X but the factories produce an identical
number of units. For example, factory X will only need to set-up once whereas Factory Y will have to
set-up the production run at least ten times for the ten different products. Factory Y will therefore
incur more set-up costs for the same volume of production.
Activity based costing is a system of costing that analyses overhead costs in a different way. Overhead
costs are allocated initially to activities, and the key factors that 'drive' each of these activities are also
identified. Costs are then attributed to products (or services or customers) on the basis of the use they
make of each of these activities.
2 OUTLINE OF AN ABC SYSTEM
Activity based costing (ABC) is an alternative to the traditional method of accounting for
costs - absorption costing. ABC divides production into core activities which drive the
need for resources, assigns costs to those activities based on the resources they use, and
then allocates those costs to products based on their consumption of the activities.
2.1 THE CONCEPT OF ABC

Definition
Activity based costing (ABC) is an approach to the costing and monitoring of activities and the
costing of final outputs which involves tracing an activity's resource consumption.
The cost of the various resources consumed by an activity are collected by way of activity cost pools.
Each activity cost pool is then assigned to individual products based on the product's consumption of
that activity. This is done using cost drivers.
The major ideas behind activity based costing are as follows:

a. Activities cause an organisation to consume resources and incur costs.
For a manufacturing organisation, activities might include ordering, materials handling, production
scheduling, machine set-up, assembly, quality testing, and product despatch.
Activities are seen as driving the need for resources and are known as resource drivers. For
example the ordering of materials will consume a variety of resources including labour, office
space, utilities and technology.
b. Making and selling products/services is what creates demand for the various activities. The product
or service is known as a cost object.
c. The costs of all the resources used in an activity are collected into an activity cost pool.
e. The organisation needs to ascertain the causes of the costs behind each activity known as the
cost drivers. For example the cost driver for quality control costs might be the number of product
inspections carried out; the cost driver for material ordering might be the number of orders placed.
f. Using the cost drivers, the costs of each activity are then assigned to the cost objects (products)
that demand that activity on the basis of each product's consumption of the activity.
Definition
Activity based management (ABM) uses the information provided by an activity based cost analysis
to identify ways to improve an organisation's profitability through performing certain activities more
efficiently or eliminating activities that do not add value. ABM attempts to ensure customer needs are
satisfied whilst reducing the demand on an organisation's resources.
2.2 THE OPERATION OF AN ABC SYSTEM

Definitions
A resource driver is an activity that causes an organisation to consume resources and incur costs.
A cost driver is a factor influencing the level of cost. Often used in the context of ABC to denote the
factor which links activity resource consumption to product outputs, for example, the number of
purchase orders would be a cost driver for procurement cost.
CHAPTER 6
Section overview
An activity cost pool is a grouping of costs relating to a particular activity in an activity based costing
system.
An ABC system operates as follows:
Step 1
Identify an organisation's major activities.

Unit-level activities are those activities that have a one-to-one relationship with a unit
of output. For example, a manufacturer may have to perform a final quality control
check on each unit of finished product, so quality inspection might be a unit level
activity.
Batch-level activities are those activities that must be performed, but can relate to
one or more units of output. Despatch of orders by an online retailer of DVDs is an
example of a batch-level activity. In each case the customer's order must be boxed
and shipped, requiring the same activity regardless of the number of items being
packaged in the box.
Product-level activities are carried out at the product level, regardless of the number
of units or batches produced. Product design/development and marketing are
examples of activities that may relate to the existence of a particular product.
Other levels of activity which do not relate to products may also be used. For example
some organisations consider customer-level activities which relate to the number of
customers e.g. activities such as operating a technical support help line; or the
production and distribution of product catalogues.
Step 2
Identify the factors which determine the size of the costs of an activity/cause the
incurrence of costs of an activity. These are known as cost drivers.
Look at the following examples:
COSTS
POSSIBLE COST DRIVER
Ordering costs
Number of orders
Materials handling costs
Number of production runs
Production scheduling costs
Despatching costs
Number of despatches
Quality control costs
Number of product inspections
For those costs that vary with production levels in the short term, ABC uses volumerelated cost drivers such as labour or machine hours. The cost of oil used as a lubricant
on the machines would therefore be added to products on the basis of the number of
machine hours, since oil would have to be used for each hour the machine ran.
Overheads that vary with some other activity, and not volume of production, should be
traced to products using transaction-based cost drivers such as production runs or
number of orders received.
Step 3
Collect the costs of the resources associated with each activity into what are known as
activity cost pools.
Step 4
Charge the costs of each cost pool to products on the basis of their usage of the
activity, measured by the number of the activity's cost driver a product generates, using
a cost driver rate (total costs in cost pool/number of cost drivers).
Question 1: Cost drivers

Which of the following definitions best describes a cost driver?
A A cost that varies with production levels
B Any activity which causes an increase in costs
C A collection of costs associated with a particular activity
D Any factor which causes a change in the cost of an activity
An organisation has estimated that the resources incurred in the production set-up activity will cost
$200 000 for a particular period. The machinery for production has to be set-up each time a batch of a
particular product is manufactured and there are expected to be 40 machine set-ups in total. In the
period the company expects to manufacture 150 000 units of Product X (in batches of 5 000 units) and
500 000 units of Product Y (in batches of 50 000 units).
Calculate the production set-up costs to be assigned to a single unit of Product X and Y, using Activity
based costing.
Solution
Step 1
The resource driver (activity) is production set-up
Step 2
The appropriate cost-driver is the number of machine set-ups, which is 40.
Step 3
The activity cost pool for production set-ups is $200 000.
Step 4
The cost driver rate is therefore $200 000/40 = $5 000 per machine set-up.
The production set-up costs can then be assigned to the products based on the number of machine
set-ups each requires (which because production set-up is a batch level activity is driven by the
number of batches of each product that are made):
a. Number of units produced
b. Units per batch
c. Total number of batches = (a)/(b) (each
batch requires one machine set-up)
d. Total machine set-up costs assigned to
product
= No. of machine set-ups (c)x $5 000
cost per set-up
Production set-up cost per unit of
product = (d)/(a)
Product X
150 000
5 000
30
Product Y
500 000
50 000
10
$150 000
$50 000
$1.00
$0.10
The production set-up costs determined above would then form part of the overhead cost of each
product.
3 ABSORPTION COSTING VERSUS ABC

Section overview
The principle difference between absorption costing and activity based costing is the way
in which overheads are absorbed into products.
Absorption costing commonly uses either a labour hour or machine hour basis to charge
overheads to products. ABC attempts to absorb the costs of the various activities involved
in the production of a product according to that product's demand for/usage of each
activity.
The principle difference between the two approaches is the way in which overheads are absorbed into
products.
Under absorption costing, overheads are typically charged to products using either labour hours or
machine hours. As a result, the more time spent on production of a product, the greater the absorbed
overhead per unit and the more units produced, the greater the share of total overhead that that
product receives.
CHAPTER 6
Worked Example: Activity based costing
ABC uses multiple cost drivers to absorb costs and by considering each activity separately, attempts
to more closely link the absorption rate to the actual cause of the overhead. When using ABC, for
costs that vary with production levels in the short term, the cost driver will be volume related (labour or
machine hours). Overheads that vary with some other activity, and not volume of production, should
be traced to products using transaction-based cost drivers such as production runs or number of
orders received.
The following example illustrates the point that traditional cost accounting techniques may result in a
misleading and inequitable division of costs between low-volume and high-volume products, and that
ABC can provide a more meaningful allocation of costs.
Worked Example: Absorption costing vs Activity based costing
Suppose that Cooplan manufactures four products, W, X, Y and Z. Output and cost data for the period
just ended are as follows:
Number of
production
runs in the
period
Output units
W
X
Y
Z
10
10
100
100
2
2
5
5
14
Direct labour cost per hour
$5
Overhead costs
Short run variable costs
Set-up costs
Scheduling costs
Materials handling costs
Material cost
per unit
$
20
80
20
80
Direct labour
hours per unit
Machine
hours per unit
1
3
1
3
1
3
1
3
$
3 080
10 920
9 100
7 700
30 800
Prepare unit costs for each product using conventional absorption costing and ABC.
Solution
Using a conventional absorption costing approach and an absorption rate for overheads based on
either direct labour hours or machine hours, the product costs would be as follows:
Direct material
Direct labour
Overheads *
Units produced
Cost per unit
W
$
200
50
700
950
10
$95
X
$
800
150
2 100
3 050
Y
$
2 000
500
7 000
9 500
Z
$
8 000
1 500
21 000
30 500
10
$305
100
$95
100
$305
Total
$
44 000
* $30 800 440 hours = $70 per direct labour or machine hour.
Using activity based costing and assuming that the number of production runs is the cost driver for
set-up costs, scheduling costs and materials handling costs and that machine hours are the cost driver
for short-run variable costs, unit costs would be as follows:
Units produced
Cost per unit
10
$428
X
$
800
150
210
1 560
1 300
1 100
5 120
Y
$
2 000
500
700
3 900
3 250
2 750
13 100
Z
$
8 000
1 500
2 100
3 900
3 250
2 750
21 500
10
$512
100
$131
100
$215
Total
$
44 000
Workings
1
2
3
4
$3 080 440 machine hours =

$10 920 14 production runs =
$7 per machine hour

$780 per run
$650 per run
$550 per run
Summary
Product
W
X
Y
Z
Conventional costing
Unit cost
$
95
305
95
305
ABC
Unit cost
$
428
512
131
215
Difference per
unit
$
+ 333
+ 207
+ 36
90
Difference in
total
$
+3 330
+2 070
+3 600
9 000
The figures suggest that the traditional volume-based absorption costing system is flawed.
a. It under-allocates overhead costs to low-volume products (here, W and X) and over-allocates
overheads to higher-volume products (here Z in particular).
b. It under-allocates overhead costs to smaller-sized products (here W and Y with just one hour of
work needed per unit) and over allocates overheads to larger products (here X and particularly Z).
3.1 ABC VERSUS TRADITIONAL COSTING METHODS

Both traditional absorption costing and ABC systems adopt the two stage allocation process.
3.1.1 ALLOCATION OF OVERHEADS

ABC establishes separate cost pools for support activities such as despatching. As the costs of
these activities are assigned directly to products through cost driver rates, reapportionment of
service department costs is avoided.
3.1.2 ABSORPTION OF OVERHEADS

The principal difference between the two systems is the way in which overheads are absorbed into
products.
(a) Absorption costing most commonly uses two absorption bases, labour hours and/or machine
hours, to charge overheads to products. There may be a different absorption rate for each
production department.
(b) ABC uses many cost drivers as absorption bases; number of orders, number of despatches and so
on. There is an absorption rate for each activity.
Absorption rates under ABC should therefore be closely linked to the causes of overhead costs.
3.2 COST DRIVERS

The principal idea of ABC is to focus attention on what causes costs to increase, i.e. the cost
drivers.
CHAPTER 6
Direct material
Direct labour
Short-run variable overheads (W1)
Set-up costs (W2)
Scheduling costs (W3)
Materials handling costs (W4)
W
$
200
50
70
1 560
1 300
1 100
4 280
a. Those costs that do vary with production volume, such as power costs, should be traced to
products using production volume-related cost drivers as appropriate, such as direct labour hours
or direct machine hours. Such costs tend to be short-term variable overheads.
Overheads which do not vary with output but with some other activity should be traced to products
using transaction-based cost drivers, such as number of production runs and number of orders
received. Such costs tend to be long-term variable overhead (overhead that traditional accounting
would classify as fixed).
b. Traditional costing systems allow overhead to be related to products in rather more arbitrary ways
producing, it is claimed, less accurate product costs.
Question 2: ABC versus traditional costing
A company manufactures two products, L and M, using the same equipment and similar processes.
An extract of the production data for these products in one period is shown below:
L
5 000
1
3
10
15
Quantity produced (units)

Direct labour hours per unit
Machine hours per unit
Set-ups in the period
Orders handled in the period
M
7 000
2
1
40
60
Production overhead costs

Relating to machine activity
Relating to production run set-ups
$
209 000
25 000
Relating to handling of orders
51 000
285 000
a. What is the amount of production overhead to be absorbed by one unit of product M using a
traditional absorption costing approach, with a direct labour hour rate to absorb overheads?
A
B
C
D
$15.00
$17.50
$22.00
$30.00
b. What is the amount of production overhead to be absorbed by one unit of product M using an
activity based costing approach, with suitable cost drivers to trace overheads to products?
A
B
C
D
$12.95
$18.19
$32.57
$37.57
(The answers are at the end of the chapter)
4 MARGINAL COSTING VERSUS ABC

Section overview
The main criticism of using marginal costing to provide decision making information is that
marginal costing analyses cost behaviour patterns according to the volume of production.
However, although certain costs may be fixed in relation to the volume of production, they
may in fact be variable in relation to some other cost driver.
The problem with marginal costing is that it analyses cost behaviour patterns according to the volume
of production. However, although certain costs may be fixed in relation to the volume of
production, they may in fact be variable in relation to some other cost driver. A failure to allocate
such costs to individual products could result in incorrect decisions concerning the future
management of the products.
The advantage of ABC is that it spreads costs across products according to a number of different
bases. For example, an ABC analysis may show that one particular activity which is carried out
primarily for one or two products is expensive. A correct allocation of the costs of this activity may
reveal that these particular products are not profitable. If these costs are fixed in relation to the
volume of production then they would be treated as period costs in a marginal costing system and
written off against the marginal costing contribution for the period.
The marginal costing system would therefore make no attempt to allocate these 'fixed' costs to
individual products and a false impression would be given of the long run average cost of the
products.
Therefore, marginal costing may provide incorrect decision making information, particularly in a
situation where 'fixed' costs are vary large compared with 'variable' costs.
5 INTRODUCING AN ABC SYSTEM INTO AN

ORGANISATION
Section overview
ABC should only be introduced if the additional information it provides will result in action
that will increase the organisation's overall profitability.
ABC identifies four levels of activities: product level, batch level, product-sustaining level
and facility-sustaining level.
5.1 WHEN SHOULD ABC BE INTRODUCED?

ABC should only be introduced if the additional information it provides will result in action that will
increase the organisation's overall profitability. This is most likely to occur in situations such as the
following, when the ABC analysis differs significantly from the traditional absorption costing analysis:
Production overheads are high in relation to direct costs, especially direct labour.
Overhead resource consumption is not just driven by production volume.
There is wide variety in the product range.
The overhead resource input varies significantly across the product range.
5.2 ANALYSIS OF ACTIVITIES

ABC attempts to relate the incidence of costs to the level of activities undertaken. A hierarchy of four
levels of activity has been suggested.
Definition
The hierarchy of activities is a classification of activities by level of organisation, for example, unit,
batch, product-sustaining and facility-sustaining.
CHAPTER 6
One view is that only marginal costing provides suitable information for decision making but this is not
true. Marginal costing provides a crude method of differentiating between different types of cost
behaviour by splitting costs into their variable and fixed elements. However, such an analysis can be
used only for short-term decisions and usually even these have longer-term implications which ought
to be considered.
TYPE OF ACTIVITIES
COSTS ARE DEPENDENT ON .
EXAMPLES
Product level
Volume of production
Machine power
Batch level
Number of batches
Set-up costs
Product-sustaining
Existence of a product group/line
Product management
Facility-sustaining
Organisation simply being in business
Rent and rates
Definitions
Product-sustaining activities are activities undertaken to develop or sustain a product or service.
Product sustaining costs are linked to the number of products or services, not to the number of units
produced.
Facility-sustaining activities are activities undertaken to support the organisation as a whole, and
which cannot be logically linked to individual units of output.
The difference between a unit product cost determined using traditional absorption costing and one
determined using ABC will depend on the proportion of overhead cost which falls into each of the
categories above.
a. If most overheads are related to unit level and facility level activities, the unit product costs
generated by each method will be similar.
b. If the overheads tend to be associated with batch or product level activities the unit product cost
generated by ABC will be significantly different from traditional absorption costing.
Consider the following example.
Worked Example: Batch level activity
XYZ produces a number of products including product D and product E and produces 500 units of
each of products D and E every period at a rate of ten of each every hour. The overhead cost is $500
000 and a total of 40 000 direct labour hours are worked on all products. A traditional overhead
absorption rate would be $12.50 per direct labour hour and the overhead cost per product would be
$1.25.
Production of D requires five production runs per period, while production of E requires 20. An
investigation has revealed that the overhead costs relate mainly to 'batch-level' activities associated
with setting-up machinery and handling materials for production runs.
There are 1,000 production runs per period and so overheads could be attributed to XYZ's products at
a rate of $500 per run.
Overhead cost per D = ($500 5 runs)/500 = $5
Overhead cost per E = ($500 20 runs)/500 = $20
These overhead costs are activity based and recognise that overhead costs are incurred due to batch
level activities. The fact that E has to be made in frequent small batches, perhaps because it is
perishable, means that it uses more resources than D. This is recognised by the ABC overhead costs,
not the traditional absorption costing overhead costs.
In the modern manufacturing environment, production often takes place in short, discontinuous
production runs and a high proportion of product costs are incurred at the design stage. An
increasing proportion of overhead costs are therefore incurred at batch or product level.
Such an analysis of costs gives management an indication of the decision level at which costs can
be influenced. For example, a decision to reduce production costs will not simply depend on making
a general reduction in output volumes: production may need to be organised to reduce batch
volumes; a process may need to be modified or eliminated; product lines may need to be merged or
cut out; facility capacity may need to be altered.
5.3 ABC IN SERVICE AND RETAIL ORGANISATIONS
ACTIVITIES
EXAMPLES
Unit level
Accept cash
Processing of cash by bank
Number of transactions
Number of transactions
Batch level
Cash desk closed by clerk (close out) and

reviewed by supervisor
Deposits
Review and transfer of funds
Number of 'close outs'

Number of deposits
Number of accounts
Product level
Maintenance charges for bank accounts

Reconciling bank accounts
Number of accounts
Number of accounts
An important aspect of ABC in non-manufacturing operations is to identify the items for which the
costing system is intended to provide cost information. In the case of cash processing above, ABCrelated costs can be established for customer accounts and also for cash processing transactions.
Costs can also be established for 'close outs' and fund transfers.
Having identified the items for which unit costs are needed, at a unit, batch or product level, activity
costs should be assigned to each cost item on the basis of their 'use' of each activity.
Question 3: ABC and retail organisations
List five activities that might be identified in a department store and state one possible cost driver for
each of the activities you have identified.
6 ADVANTAGES AND DISADVANTAGES OF ABC

Section overview
ABC has a range of uses and has many advantages over more traditional costing methods.
However, the system does have its critics and it does not solve all costing problems.
6.1 ADVANTAGES OF ABC

Once the necessary information has been obtained ABC is similar to traditional absorption costing.
This simplicity is part of its appeal. Further merits of ABC are as follows:
a. The complexity of manufacturing has increased, with wider product ranges, shorter product life
cycles and more complex production processes. ABC recognises this complexity with its multiple
cost drivers.
b. In a more competitive environment, companies must be able to assess product profitability
realistically. ABC facilitates a good understanding of what drives overhead costs.
c. In modern manufacturing systems, overhead functions include a lot of non-factory-floor activities
such as product design, quality control, production planning and customer services. ABC is
concerned with all overhead costs and so it takes management accounting beyond its
'traditional' factory floor boundaries.
d. By facilitating and enabling the control of the incidence of the cost driver, the level of the cost can
be controlled.
CHAPTER 6
ABC was first introduced in manufacturing organisations but it can equally well be used in other types
of organisation. For example, the management of the Post Office in the US introduced ABC. They
analysed the activities associated with cash processing as follows:
e. The costs of activities not included in the costs of the products an organisation makes or the
services it provides can be considered to be not contributing to the value of the
product/service. The following questions can then be asked:
What is the purpose of this activity?
How does the organisation benefit from this activity?
Could the number of staff involved in the activity be reduced?
f. ABC can help with cost management. For example, suppose there is a fall in the number of orders
placed by a purchasing department. This fall would not impact on the amount of overhead
absorbed in a traditional absorption costing system as the cost of ordering would be part of the
general overhead absorption rate. The reduction in the workload of the purchasing department
might therefore go unnoticed and the same level of resources would continue to be provided,
despite the drop in number of orders. In an ABC system, however, this drop would be immediately
apparent because the cost driver rate would be applied to fewer orders.
g. Many costs are driven by customers, delivery costs, discounts, after-sales service and so on, but
traditional absorption costing systems do not account for this. Organisations may be trading with
certain customers at a loss but may not realise it because costs are not analysed in a way that
reveals the true situation. ABC can be used in conjunction with customer profitability analysis to
determine more accurately the profit earned by servicing particular customers.
Definition
Customer profitability analysis is the analysis of the revenue streams and service costs associated
with specific customers or customer groups.
h. Many service businesses have characteristics similar to those required for the successful
application of ABC:
A highly competitive market.
Diversity of products, processes and customers.
Significant overhead costs not easily assigned to individual 'products'.
Demands placed on overhead resources by individual 'products' and customers, which are not
proportional to volume.
If ABC were to be used in a hotel, for example, attempts could be made to identify the activities
required to support each guest by category and the cost drivers of these activities. The cost of a onenight stay midweek by a businessman could then be distinguished from the cost of a one-night stay by
a teenager at the weekend. Such information could prove invaluable for Customer profitability
analysis.
6.2 DISADVANTAGES OF ABC

It has been suggested by critics that activity based costing has some serious flaws.
a. Some measure of (arbitrary) cost apportionment may still be required at the cost pooling stage for
items like rent, rates and building depreciation.
b. Can a single cost driver explain the cost behaviour of all items in its associated pool?
c. On the other hand, the number of cost pools and cost drivers cannot be excessive otherwise an
ABC system would be too complex and too expensive.
d. Unless costs are caused by an activity that is measurable in quantitative terms and which can be
related to production output, cost drivers will not be usable. What drives the cost of the annual
external audit, for example?
e. ABC is sometimes introduced because it is fashionable, not because it will be used by
management to provide meaningful product costs or extra information. If management is not
going to use ABC information, an absorption costing system may be simpler to operate.
f. The costs of ABC may outweigh the benefits.
6.3 OTHER USES OF ABC

The information provided by analysing activities can support the management functions of planning,
control and decision making, provided it is used carefully and with full appreciation of its implications.
Before an ABC system can be implemented, management must analyse the organisation's activities,
determine the extent of their occurrence and establish the relationships between activities,
products/services and their cost.
The information database produced from such an exercise can then be used as a basis for forward
planning and budgeting. For example, once an organisation has set its budgeted production level,
the database can be used to determine the number of times that activities will need to be carried out,
thereby establishing necessary departmental staffing and machine levels. Financial budgets can then
be drawn up by multiplying the budgeted activity levels by cost per activity.
This activity based approach may not produce the final budget figures but it can provide the basis for
different possible planning scenarios.
6.3.2 CONTROL
The information database also provides an insight into the way in which costs are structured and
incurred in service and support departments. Traditionally it has been difficult to control the costs of
such departments because of the lack of relationship between departmental output levels and
departmental cost. With ABC, however, it is possible to control or manage the costs by managing
the activities which underlie them by monitoring cost driver usage.
6.3.3 DECISION MAKING

Many of ABC's supporters claim that it can assist with decision making in a number of ways:
Provides accurate and reliable cost information
Establishes a long-run product cost
Provides data which can be used to evaluate different ways of delivering business
It is therefore particularly suited to the following types of decision:
Pricing
Promoting or discontinuing products or parts of the business
Redesigning products and developing new products or new ways to do business
Note, however, that an ABC cost is not a true cost, it is simply a long run average cost because some
costs such as depreciation are still arbitrarily allocated to products. An ABC cost is therefore not a
relevant cost for all decisions. For example, even if a product/service ceases altogether, some costs
allocated to that product/service using an activity based approach, such as building occupancy costs
or depreciation, would not disappear just because the product/service had disappeared.
Management would need to bear this in mind when making product deletion decisions.
6.4 ACTIVITY BASED MANAGEMENT (ABM)

Although the terms are sometimes used interchangeably, ABM is a broader concept than ABC, being
likely to incorporate ABC and activity based budgeting (ABB).
Activity based budgeting is where resources are allocated to individual activities depending on their
inter-relationships. A detailed knowledge of this is not required in this unit.
Definitions
Optimal ABM are actions, based on activity driver analysis, that increase efficiency, lower costs and/or
improve asset utilisation.
Strategic ABM are actions, based on activity based cost analysis, that claim to change the demand for
activities so as to improve profitability.
CHAPTER 6
6.3.1 PLANNING: ACTIVITY BASED BUDGETING (ABB)
KEY CHAPTER POINTS

Traditional costing systems assume that all products consume all resources in proportion to their
production volumes. The use of a predetermined overhead absorption rate tends to allocate too
great a proportion of overheads to high volume products, which use fewer support services and
too small a proportion of overheads to low volume products, which use more support services.
Activity based costing (ABC) attempts to overcome this problem by identifying core activities
involved in the production of a product and charging overheads on the basis of each product's
consumption of those activities/support services, rather than based on volume of production.
Activity based costing (ABC) is an alternative to the traditional method of accounting for costs absorption costing. ABC divides production into core activities which drive the need for resources,
assigns costs to those activities based on the resources they use, and then allocates those costs to
products based on their consumption of the activities.
A resource driver is an activity that causes an organisation to consume resources and incur costs.
An activity cost pool is a grouping of costs relating to a particular activity in an activity based
costing system.
A cost driver is a factor influencing the level of cost.
Activity based management (ABM) uses the information provided by an activity based cost analysis
to identify ways to improve an organisation's profitability through performing certain activities
more efficiently or eliminating activities that do not add value. ABM attempts to ensure customer
needs are satisfied whilst reducing the demand on an organisation's resources.
ABC involves the identification of the factors (cost drivers) which cause the costs of an
organisation's major activities. Support overheads are charged to products on the basis of their
usage of an activity.
When using ABC, for costs that vary with production levels in the short term, the cost driver will be
volume related (labour or machine hours). Overheads that vary with some other activity, and not
volume of production, should be traced to products using transaction-based cost drivers such as
production runs or number of orders received.
The principle difference between absorption costing and activity based costing is the way in which
overheads are absorbed into products. Absorption costing commonly uses either a labour hour or
machine hour basis to charge overheads to products. ABC attempts to absorb the costs of the
various activities involved in the production of a product according to that product's demand
for/usage of each activity.
The main criticism of using marginal costing to provide decision making information is that
marginal costing analyses cost behaviour patterns according to the volume of production.
However, although certain costs may be fixed in relation to the volume of production, they may in
fact be variable in relation to some other cost driver.
ABC should only be introduced if the additional information it provides will result in action that will
increase the organisation's overall profitability.
ABC identifies four levels of activities: product level, batch level, product sustaining level and
facility sustaining level.
ABC has a range of uses and has many advantages over more traditional costing methods.
However, the system does have its critics and it does not solve all costing problems.

A ABC can be used for customer profitability analysis.
B A single cost driver may not explain the level of expenditure on an activity.
C In manufacturing, ABC is more appropriate than traditional absorption costing when the
consumption of resources on overhead activities is not related to production volumes.
D Traditional costing systems tend to allocate too small a proportion of overheads to high volume
products and too great a proportion of overheads to low volume products.
2 For which of the following costs might the number of machine hours worked be a cost driver?
A
B
C
D
Set-up costs
Product development costs
Short-run variable overhead costs
Materials handling and despatch costs
3 Which of the following is most likely to be the cost driver for production scheduling costs?
A
B
C
D
Volume of output
Number of orders
Volume of materials handled
4 In ABC, brand management might be an example of a

A
B
C
D
batch level activity.

product level activity.
facility-sustaining activity.
product-sustaining activity.
5 In ABC, general factory administration costs might be an example of a

A
B
C
D
batch level activity.

product level activity.
facility-sustaining activity.
product-sustaining activity.
6 Which one of the following statements is incorrect?

A ABC may be used for cost and management accounting by service organisations.
B In ABC, direct labour hours or direct machine hours may be used to trace costs to products.
C The cost driver for quality inspection is likely to be number of hours worked on the product.
D In ABC, activity costs are absorbed into product costs using an activity cost per unit of cost
driver as the absorption rate.
CHAPTER 6

1 D Traditional costing systems tend to allocate too great a proportion of overheads to high volume
products and too small a proportion of overheads to low volume products. Note that a
weakness of the ABC method is that for some activities, there may be several cost drivers for
cost.
2 C Short-run variable costs (such as repairs costs) are generally driven by production activity
(machine hours or direct labour hours).
3 C Production scheduling costs are likely to be driven by the number of production runs. Set-up
costs may be included in the general activity: 'production scheduling'.
4 D In ABC, activities are identified at different levels. At a product-sustaining level, activities are
generally related to product or brand management,
5 C General factory administration costs are incurred to keep the factory in operation, and so would
be classified as a facility-sustaining activity
6 C The cost driver for quality inspection is likely to be number of inspections carried out. In ABC,
direct labour hours or direct machine hours may be used to trace some costs to products
typically short-run variable costs. ABC can be applied to any operations where resources are
consumed by activities, including service organisations.
2 (a) D
Traditional absorption costing approach
Direct
labour
hours
5 000
Product L = 5 000 units 1 hour
14 000
Product M = 7 000 units 2 hours
19 000
Therefore Overhead absorption rate =
$285 000
= $15 per hour
19 000
Overhead absorbed by one unit of product M would be as follows:

Product M
2 hours $15
$30 per unit
(b) B
ABC approach
Product L
= 5 000 units 3 hours
Machine
hours
15 000
Product M
= 7 000 units 1 hour
7 000
22 000
Using ABC the overhead costs are absorbed according to the cost drivers.
Machine-hour driven costs
Set-up driven costs
Order driven costs
209 000 22 000 m/c hours

25 000 50 set-ups
51 000 75 orders
$
= $9.50 per m/c hour
= $500 per set-up
= $680 per order
Overhead costs are therefore as follows:

Product M
$
66 500
Machine-driven costs
(7 000 hrs $9.50)
Set-up costs
(40 $500)
20 000
Order handling costs
(60 $680)
40 800
127 300
Units produced
Overhead cost per unit of Product M
7 000
$18.19
These figures suggest that product M absorbs an excessive amount of overhead using a direct
labour hour basis. Overhead absorption should be based on the activities which drive the costs,
in this case machine hours, the number of production run set-ups and the number of orders
handled for each product. Most overhead costs are driven by machine activity, but Product M
requires much less machine time than Product L.
CHAPTER 6
1 D A cost driver is best described as any factor which causes a change in the cost of an activity.
3
ACTIVITIES
Quoting prices (curtains, carpets etc)
Number of requests for quotations
Purchasing and receiving goods
Number of orders
Returned goods
Number of returns
Operating a department
Number of departments/floor space
Check-out activity
Number of customers/check-outs
Home deliveries
Number of orders (or possibly the distance

travelled to deliver)
191
CHAPTER 7
PROCESS AND JOB
COSTING
Learning objectives
Reference
LO7
Explain the differences between job and process costing techniques
LO7.1
Apply costing principles to job costing and process costing organisations
LO7.2
Topic list
1
2
3
4
5
6
7
8
The distinguishing features of process costing

The basics of process costing
Dealing with losses in process
Accounting for scrap
Valuing closing work in process
Valuing opening work in process
Joint products and by-products
Job costing
INTRODUCTION
This chapter looks at costing systems. Costing systems are used to cost goods or services. The
method used depends on the way in which the goods or services are produced.
The chapter begins by considering process costing. Process costing is applied when output consists of
a continuous stream of identical units. We will begin with the basics and look at how to account for the
most simple of processes. We will then move on to how to account for any losses which might occur,
as well as what to do with any scrapped units which are sold. Next we will consider how to deal with
closing work in process before examining situations involving closing work in process and losses. We
will then go on to have a look at situations involving opening work in process and how to deal with
situations where we have both opening and closing work in process and losses. This is followed with
an outline discussion of joint products and by-products.
This chapter will conclude by covering job costing.
Process and
job costing
Process
costing
Basics
Accounting
for scrap
Work in
process
Joint products
and by-products
Job
costing
PROCESS AND JOB COSTING | 193
BEFORE YOU BEGIN

area.
everything covered.
1 When is process costing used?
(Section 1)
2 Define process costing.
(Section 1)
3 What is on the left hand side of the process account?
(Section 2.1)
4 What is on the right hand side of the process account?
(Section 2.1)
5 What are the four key steps involved in process costing?
(Section 2.2)
6 Define normal loss, abnormal loss and abnormal gain.
(Section 3.1)
7 How is normal loss valued?
(Section 3.1)
8 How is work in process valued?
(Sections 5, 6)
9 What is a joint product? Give examples.
(Section 7.1)
10 What is a by-product ? Give examples.
(Section 7.2)
11 Define job costing.
(Section 8)
CHAPTER 7
1 THE DISTINGUISHING FEATURES OF PROCESS

COSTING
Section overview
Process costing is a costing method used when it is not possible to identify separate units
of production, or jobs, usually because of the continuous nature of the production
processes involved.
LO
7.1
7.2
Process costing is used where there is a continuous flow of identical units and it is common to
identify it with continuous production such as the following:
Oil refining
The manufacture of soap
Paint manufacture
Food and drink manufacture
Concrete/cement production
Magazine printing
Definition
Process costing is a cost accounting system used where products or services are mass produced in a
continuous flow of production. Process costs are attributed to the number of units produced. This may
involve estimating the number of equivalent units in stock at the start and end of the period under
consideration.
We will discuss 'equivalent units' later in this chapter.

The features of process costing which make it different from other methods of costing such as job or
batch costing are as follows:
a. The continuous nature of production in many processes means that there will usually be closing
work in process which must be valued. In process costing it is not possible to build up cost
records of the cost of each individual unit of output because production in progress is an
indistinguishable homogeneous mass.
b. There is often a loss in process due to spoilage, wastage, evaporation and so on.
c. The output of one process becomes the input to the next until the finished product is made in the
final process.
d. Output from production may be a single product, but there may also be a by-product (or byproducts) and/or joint products.
e. Costs are accumulated by department instead of by job with average cost per unit calculated
by total costs divided by number of units produced.
2 THE BASICS OF PROCESS COSTING
LO
7.2
Section overview
Costs incurred in processes are recorded in what are known as process accounts. A process
account has two sides, and on each side there are two columns, one for quantities (of raw
materials, work-in-process and finished goods) and one for costs.
There is a four step approach for dealing with process costing questions.
2.1 PROCESS ACCOUNTS

A process account has two sides (Debit and Credit), and on each side there are two columns one
for quantities (of raw materials, work in process and finished goods) and one for costs.
a. On the left hand side of the process account we record the inputs to the process and the cost of
these inputs. So we might show the quantity of material input to a process during the period and
its cost, the cost of labour and the cost of overheads.
b. On the right hand side of the process account we record what happens to the inputs by the end
of the period.
i. Some of the input might be converted into finished goods, so we show the units of finished
goods and the cost of these units.
ii. Some of the material input might evaporate or get spilled or damaged, so there would be
losses. So we record the loss units and the cost of the loss.
The quantity columns on each side of the account should total to the same amount. Why? For
instance if we put 100 kgs of material in to a process, which we record on the left hand side of the
account, we should know what has happened to those 100 kgs. Some would be losses maybe, some
would be WIP, some would be finished units, but the total should be 100 kgs.
Likewise the cost of the inputs to the process during a period (i.e. the total of the costs recorded on
the left hand side of the account) is the cost of the outputs of the process. If we have recorded
material, labour and overhead costs totalling $1 000 and at the end of the process we have 100
finished units (and no losses or WIP), then that output cost $1 000.
Here's a simple example of a process account:
PROCESS ACCOUNT
Material
Labour
Units
1 000
Overhead
1 000
$
11 000
4 000
Closing WIP
Finished goods
inventory
3 000
18 000
Units
200
800
$
2 000
16 000
1 000
18 000
As you can see, the quantity columns on each side balance (i.e. they are the same), as do the
monetary columns. Don't worry at this stage about how the costs are split between WIP and finished
units.
Worked Example: Basics of process costing
Suppose that Purr and Miaow Co make squeaky toys for cats. Production of the toys involves two
processes, shaping and colouring. During the year to 31 March 20X3, 1 000 000 units of material worth
$500 000 were input to the first process, shaping. Direct labour costs of $200 000 and production
overhead costs of $200 000 were also incurred in connection with the shaping process. There were no
opening or closing inventories in the shaping department. The process account for shaping for the
year ended 31 March 20X3 is as follows:
PROCESS 1 (SHAPING) ACCOUNT
Direct materials
Direct labour
Units
1 000 000
1 000 000
$
500 000
200 000
200 000
900 000
Output to Process 2
Units
1 000 000
$
900 000
1 000 000
900 000
When preparing process accounts, balance off the quantity columns (i.e. ensure they total to the same
amount on both sides) before attempting to complete the monetary value columns since they will
help you to check that you have not missed something. This becomes increasingly important as more
complications are introduced into questions.
CHAPTER 7
iii. At the end of a period, some units of input might be in the process of being turned into finished
units so would be work in process (WIP). We record the units of WIP and the cost of these units.
When using process costing, if a series of separate processes is needed to manufacture the finished
product, the output of one process becomes the input to the next until the final output is made in
the final process. In our example, all output from shaping was transferred to the second process,
colouring, during the year to 31 March 20X3. An additional 500 000 units of material, costing $300 000,
were input to the colouring process. Direct labour costs of $150 000 and production overhead costs of
$150 000 were also incurred. There were no opening or closing inventories in the colouring
department.
The process account for colouring for the year ended 31 March 20X3 is as follows:
PROCESS 2 (COLOURING) ACCOUNT
Materials from process 1
Added materials
Direct labour
Production overhead
Units
1 000 000
500 000
1 500 000
$
900 000 Output to finished
300 000 goods
150 000
150 000
1 500 000
Units
1 500 000
1 500 000
1 500 000
1 500 000
In some cases, the figures for direct labour and production overhead may not be given separately in
an assessment question, but instead grouped together as one figure and called 'conversion cost'.
Added materials, labour and overhead in process 2 are usually added gradually throughout the
process. Materials from process 1, in contrast, will often be introduced in full at the start of the second
process.
2.2 FRAMEWORK FOR DEALING WITH PROCESS COSTING

There is a suggested four-step approach when dealing with process costing questions.
The exact work done at each step will depend on the circumstances of the question, but the approach
can always be used.
Step 1
Determine output and losses.

Determine expected output.
Calculate loss or gain.
Calculate equivalent units if there is closing work in process.
Step 2
Calculate cost per unit of output, losses and WIP.

Calculate cost per unit or cost per equivalent unit.
Step 3
Calculate total cost of output, losses and WIP.

In some examples this will be straightforward. In cases where there is work in process, a
statement of evaluation will have to be prepared. This will be covered later in the
chapter.
Step 4
Complete accounts.
Complete the process account and any other accounts required.
3 DEALING WITH LOSSES IN PROCESS
LO
7.2
Section overview
Losses may occur in a process. If a certain level of loss is expected, this is known as normal
loss. If losses are greater than expected, the extra loss is abnormal loss. If losses are less
than expected, the difference is known as abnormal gain.
3.1 LOSSES
During a production process, a loss may occur.
Definitions
The normal loss is expected loss, allowed for in the budget, and normally calculated as a percentage
of the good output, from a process during a period of time. Normal losses are generally either valued
at zero or at their disposal values.
Abnormal loss is any loss in excess of the normal loss budgeted.
Abnormal gain is the outcome from improvements associated with production activity.
Losses may occur due to wastage, spoilage, evaporation, and so on.
Units associated with abnormal loss and gain are valued at the same unit rate as 'good' units.
Abnormal events do not therefore affect the cost of good production. Their costs are analysed
separately in an abnormal loss or abnormal gain account.
3.1.1 ACCOUNTING FOR ABNORMAL GAINS AND LOSSES

a. In an abnormal loss account, the debit entry shows the units (and their value) from the process
account. The credit entry shows the impact on the statement of comprehensive income.
b. In an abnormal gain account, the debit entry shows the effect on the statement of comprehensive
income, while the credit entry shows the units (and their value) from the process account.
Worked Example: Abnormal losses and gains
Assume that input to a process is 1 000 units at a cost of $4 500. Normal loss is 10% and there are no
opening or closing inventories. Determine the accounting entries for the cost of output and the cost
of the loss if actual output were as follows:
(a) 860 units (so that actual loss is 140 units)
(b) 920 units (so that actual loss is 80 units)
Solution
Before we demonstrate the use of the 'four-step framework' we will summarise the way that the losses
are dealt with:
a. Normal loss is given no share of cost.
b. The cost of output is therefore based on the expected units of output, which in our example
amount to 90% of 1 000 = 900 units.
c. Abnormal loss is given a cost, which is written off to the statement of comprehensive income via an
abnormal loss/gain account.
d. Abnormal gain is treated in the same way, except that being a gain rather than a loss, it appears as
a debit entry in the process account (as it is a type of input, being additional unexpected units),
whereas a loss appears as a credit entry in this account (as it is a type of output).
(a) Output is 860 units.
Step 1

If actual output is 860 units and the actual loss is 140 units:
Actual loss
Normal loss (10% of 1 000)
Abnormal loss
Units
140
100
40
CHAPTER 7
Since normal loss is not given a cost, the cost of producing these units is borne by the 'good' units of
output.
Step 2
Calculate cost per unit of output and losses.

The cost per unit of output and the cost per unit of abnormal loss are based on expected
output.
Costs incurred
$4 500
=
= $5 per unit
Expected output
900 units
Step 3
Calculate total cost of output and losses.

Normal loss is not assigned any cost.
$
4 300
0
200
4 500
Cost of output (860 $5)

Normal loss
Abnormal loss (40 $5)
Step 4
Complete accounts.
PROCESS ACCOUNT
Cost incurred
Units
1 000
1 000
$
4 500
Normal loss
Output (finished
goods a/c)
Abnormal loss
4 500
Units
100
860
40
1 000
ABNORMAL LOSS ACCOUNT

Process a/c
Units
40
$
200
Statement of
comprehensive
income
Units
40
$
0
( $5)
( $5)
4 300
200
4 500
$
200
(b) Output is 920 units.
Step 1

If actual output is 920 units and the actual loss is 80 units:
Actual loss
Normal loss (10% of 1 000)
Abnormal gain
Step 2
Units
80
100
20

The cost per unit of output and the cost per unit of abnormal gain are based on
expected output.
Costs incurred
$4 500
=
= $5 per unit
Expected output
900 units
Whether there is abnormal loss or gain does not affect the valuation of units of output.
The figure of $5 per unit is exactly the same as in the previous paragraph, when there
were 40 units of abnormal loss.
Step 3

Cost of output (920 $5)
Normal loss
Abnormal gain (20 $5)
$
4 600
0
(100)
4 500
Step 4
Complete accounts.
PROCESS ACCOUNT
Cost incurred
Abnormal gain a/c
( $5)
Units
1 000
20
$
4 500
100
1 020
4 600
Normal loss
Output
(Finished goods a/c)
( $5)
Units
100
920
$
0
4 600
1 020
4 600
ABNORMAL GAIN
Statement of
comprehensive
income
Units
20
$
100
Process a/c
Units
20
$
100
During a four-week period, period 3, costs of input to a process were $29 070. Input was 1 000 units,
output was 850 units and normal loss is 10%.
During the next period, period 4, costs of input were again $29 070. Input was again 1 000 units, but
output was 950 units.
There were no units of opening or closing inventory.
Prepare the process account and abnormal loss or gain account for each period.
Solution
Step 1

Period 3
Actual output
Normal loss (10% 1 000)
Abnormal loss
Input
Units
850
100
50
1 000
Period 4
Actual output
Abnormal gain
Input
Step 2

For each period the cost per unit is based on expected output.
Cost of input
$29 070
=
= $32.30 per unit
Expected units of output
900
Units
950
100
(50)
1 000
CHAPTER 7
Worked Example: Abnormal losses and gains
Step 3
Step 4

Period 3
Cost of output (850 $32.30)
Normal loss
Abnormal loss (50 $32.30)
$
27 455
0
1 615
29 070
Period 4
Cost of output (950 $32.30)
Normal loss
Abnormal gain (50 $32.30)
$
30 685
0
(1 615)
29 070
Complete accounts.
PROCESS ACCOUNT
Units
Period 3
Cost of input
Period 4
Cost of input
Abnormal gain a/c
( $32.30)
1 000
$
29 070
1 000
29 070
1 000
50
29 070
1 615
1 050
30 685
Normal loss
Finished goods a/c
( $32.30)
Abnormal loss a/c
( $32.30)
Normal loss
Finished goods a/c
( $32.30)
Units
100
850
0
27 455
50
1 615
1 000
29 070
100
950
0
30 685
1 050
30 685
ABNORMAL LOSS OR GAIN ACCOUNT

$
Period 3
Abnormal loss in process a/c
1 615
$
Period 4
Abnormal gain in process a/c
1 615
There is a zero balance on this account at the end of period 4.
Question 1: Full cost
Charlton Co manufactures a product in a single process operation. Normal loss is 10% of input. Loss
occurs at the end of the process. Data for June are as follows:
Opening and closing inventories of work in process
Cost of input materials (3 300 units)
Direct labour and production overhead
Output to finished goods
The full cost of finished output in June was
A $74 250.
B $81 000.
C $82 500.
D $89 100.
Nil
$59 100
$30 000
2 750 units
Question 2: Abnormal gain
Zed Co makes product Emm which goes through several processes. The following information is
available for the month of June:
Opening WIP
Closing WIP
Input
Normal loss
Transferred to finished goods
kg
5 200
3 500
58 300
400
59 900
What was the abnormal gain in June?
4 ACCOUNTING FOR SCRAP

LO
7.2
Section overview
The valuation of normal loss is either at scrap value or nil. It is conventional for the scrap
value of normal loss to be deducted from the cost of materials before a cost per equivalent
unit is calculated.
Definition
Scrap is discarded material having some value.
4.1 BASIC RULES FOR ACCOUNTING FOR SCRAP

a. Revenue from scrap is treated, not as an addition to sales revenue, but as a reduction in costs. The
valuation of normal loss is either at scrap value or nil. It is conventional for the scrap value of
normal loss to be deducted from the cost of materials before a cost per equivalent unit is
calculated.
b. The scrap value of normal loss is therefore used to reduce the material costs of the process
with the scrap value of the normal loss.
DEBIT
CREDIT
Scrap account
Process account
Abnormal losses and gains never affect the cost of good units of production. The scrap value of
abnormal losses is not credited to the process account, and the abnormal loss and gain units
carry the same full cost as a good unit of production.
c. The scrap value of abnormal loss is used to reduce the cost of abnormal loss with the scrap
value of abnormal loss, which therefore reduces the write-off of cost to the statement of
comprehensive income.
DEBIT
CREDIT
Scrap account
Abnormal loss account
CHAPTER 7
A 260 kgs
B 300 kgs
C 400 kgs
D 560 kgs
d. The scrap value of abnormal gain arises because the actual units sold as scrap will be less than
the scrap value of normal loss. Because there are fewer units of scrap than expected, there will be
less revenue from scrap as a direct consequence of the abnormal gain. The abnormal gain account
should therefore be debited with the scrap value of the abnormal gain.
DEBIT
CREDIT
Abnormal gain account

Scrap account
e. The scrap account is completed by recording the actual cash received from the sale of scrap with
the amount received from the sale of the actual scrap.
DEBIT
CREDIT
Cash at bank/Receivables
Scrap account
The same basic principle therefore applies that only normal losses should affect the cost of the good
output. The scrap value of normal loss only is credited to the process account. The scrap values of
abnormal losses and gains are analysed separately in the abnormal loss or gain account.
Worked Example: Scrap and abnormal loss or gain
A factory has two production processes. Normal loss in each process is 10% and scrapped units sell for
$0.50 each from process 1 and $3 each from process 2. Relevant information for costing purposes
relating to period 5 is as follows:
Direct materials added:
Units
Cost
Direct labour
Production overhead
Output to process 2/finished goods
Actual production overhead
Process 1
2 000
$8 100
$4 000
150% of direct labour cost
1 750 units
$17 800
Process 2
1 250
$1 900
$10 000
120% of direct labour cost
2 800 units
Prepare the accounts for process 1, process 2, scrap and abnormal loss or gain.
Solution
Step 1
Output
Normal loss (10% of input)
Abnormal loss
Abnormal gain
Process 1
Units
1 750
200
50
2 000
Process 2
Units
2 800
300
(100)
3 000*
* 1 750 units from process 1 + 1 250 units added.
Step 2

Process 1
$
Cost of input
material
from process 1
labour
overhead
(150% $4 000)
Less: scrap value of

normal loss
(200 $0.50)
Expected output
90% of 2 000
90% of 3 000
Cost per unit
$18 000 1 800
$40 500 2 700
Process 2
$
8 100
4 000
6 000
18 100
(1 750 $10)
(100)
18 000
(300 $3)
(120% $10 000)
1 900
17 500
10 000
12 000
41 400
(900)
40 500
1 800
2 700
$10
$15
Note. Calculate the cost per unit of output for process 1 prior to attempting to calculate the cost of
process 2.
Step 3

Process 1
$
17 500
100
500
18 100
18 100
Output (1 750 $10)

Normal loss (200 $0.50)*
Abnormal gain
Process 2
$
42 000
900
42 900
(1 500)
41 400
(2 800 $15)
(300 $3)*
(100 $15)
* Remember that normal loss is valued at scrap value only.

Complete accounts.
PROCESS 1 ACCOUNT
Direct materials
Direct labour
Production
overhead a/c
Units
2 000
$
8 100
4 000
Scrap a/c (normal loss)

Process 2 a/c
Abnormal loss a/c
6 000
18 100
2 000
Units
200
1 750
50
$
100
17 500
500
2 000
18 100
PROCESS 2 ACCOUNT
Units
Direct materials
From process 1
Added materials
Direct labour
Production overhead
1 750
1 250
17 500
1 900
10 000
12 000
41 400
1 500
42 900
3 000
100
3 100
Abnormal gain
Units
Scrap a/c (normal loss)
Finished goods a/c
300
2 800
900
42 000
3 100
42 900
ABNORMAL LOSS ACCOUNT

$
500
Process 1 (50 units)
$
Scrap a/c: sale of scrap of
extra loss (50 units)
Statement of comprehensive
income
500
25
475
500
ABNORMAL GAIN ACCOUNT

$
Scrap a/c (loss of scrap
Revenue due to abnormal
gain, 100 units $3)
Statement of
comprehensive income
$
Process 2 abnormal gain
(100 units)
1 500
300
1 200
1 500
1 500
SCRAP ACCOUNT
$
Scrap value of normal loss
Abnormal loss a/c (process 1)
100
900
25
1 025
$
Cash at bank/Receivables
Loss in process 1 (250 units)
Loss in process 2 (200 units)
Abnormal gain a/c (process 2)
125
600
300
1 025
CHAPTER 7
Step 4
Question 3: Process accounts
Parks Co operates a processing operation involving two stages, the output of process 1 being passed
to process 2. The process costs for period 3 were as follows:
Process 1
Material
Labour
3 000 kg at $0.25 per kg

$120
Process 2
Material
Labour
2 000 kg at $0.40 per kg

$84
General overhead for period 3 amounted to $357 and is absorbed into process costs at a rate of 375%
of direct labour costs in process 1 and 496% of direct labour costs in process 2.
The normal output of process 1 is 80% of input and of process 2, 90% of input. Waste from process 1 is
sold for $0.20 per kg and that from process 2 for $0.30 per kg.
The output for period 3 was as follows:
Process 1
Process 2
2 300 kgs
4 000 kgs
There was no inventory of work in process at either the beginning or the end of the period and it may
be assumed that all available waste had been sold at the prices indicated.
Show how the above would be recorded in process, scrap and abnormal loss/gain accounts by
completing the proformas below. (Hint. Not all boxes require entries.)
PROCESS 1 ACCOUNT
Kg
kg
Material
Normal loss to scrap a/c
Labour
Production transferred to
process 2
General overhead
Abnormal loss a/c
Abnormal gain account
PROCESS 2 ACCOUNT
Kg
Transferred from process 1
Material added
Labour
finished inventory
General overhead
Abnormal loss
kg
kg
Abnormal gain
SCRAP ACCOUNT
kg
Normal loss (process 1)
Abnormal gain (process 1)
Abnormal loss (process 1)
Cash
Abnormal loss (process 2)
ABNORMAL LOSS AND GAIN ACCOUNT

kg
kg
Process 1 (loss)
Scrap value of abnormal
Process 2 (loss)
loss
Scrap value of abnormal gain
Process 1 (gain)
Statement of comprehensive
income
Process 2 (gain)
5 VALUING CLOSING WORK IN PROCESS

Section overview
When units are partly completed at the end of a period, i.e. when there is closing work in
process, it is necessary to calculate the equivalent units of production in order to determine
the cost of a completed unit.
In the examples we have looked at so far we have assumed that opening and closing inventories of
work in process have been nil. We must now look at more realistic examples and consider how to
allocate the costs incurred in a period between completed output, i.e. finished units, and partly
completed closing inventory.
Some examples will help to illustrate the problem, and the techniques used to share out (apportion)
costs between finished output and closing work in process.
Worked Example: Valuation of closing inventory
Trotter Co is a manufacturer of processed goods. In March 20X3, in one process, there was no
opening inventory, but 5,000 units of input were introduced to the process during the month, at the
following cost:
Direct materials
Direct labour
Production overhead
$
16 560
7 360
5 520
29 440
Of the 5 000 units introduced, 4 000 were completely finished during the month and transferred to the
next process. Closing inventory of 1 000 units was only 60% complete with respect to materials and
conversion costs.
Solution
a. The problem in this example is to divide the costs of production ($29 440) between the finished
output of 4 000 units and the closing inventory of 1 000 units. It is argued, with good reason, that a
division of costs in proportion to the number of units of each (4 000:1 000) would not be 'fair'
because closing inventory has not been completed, and has not yet 'received' its full amount of
materials and conversion costs, but only 60% of the full amount. The 1 000 units of closing
inventory, being only 60% complete, are the equivalent of 600 fully worked units.
b. To apportion costs fairly and proportionately, units of production must be converted into the
equivalent of completed units, i.e. into equivalent units of production.
CHAPTER 7
LO
7.2
Definition
Equivalent units are the notional number of whole units that could have been fully produced in the
period. They represent the sum of the proportion of incomplete units that have been completed.
Equivalent units are used to apportion costs between work in process and completed output.
Step 1
Determine output.
For this step in our framework we need to prepare a statement of equivalent units.
STATEMENT OF EQUIVALENT UNITS
Total
units
4 000
1 000
5 000
Fully worked units

Closing inventory
Step 2
Completion
100%
60%
Equivalent
units
4 000
600
4 600
Calculate cost per unit of output, and WIP.

For this step in our framework we need to prepare a statement of costs per equivalent
unit because equivalent units are the basis for apportioning costs.
STATEMENT OF COSTS PER EQUIVALENT UNIT
Total costs
$29 440
=
Equivalent units
4 600
Cost per equivalent unit $6.40
Step 3
Calculate total cost of output and WIP.

For this step in our framework a statement of evaluation may now be prepared, to show
how the costs should be apportioned between finished output and closing inventory.
STATEMENT OF EVALUATION
Equivalent
units
Item
Fully worked units
Closing inventory
Step 4
Cost per equivalent

unit
4 000
600
4 600
Valuation
$
25 600
3 840
29 440
$6.40
$6.40
Complete accounts.
The process account would be shown as follows:
PROCESS ACCOUNT
Direct materials
Direct labour
Production o'hd
Units
5 000
5 000
$
16 560
7 360
5 520
29 440
Output to next process

Closing inventory c/f
Units
4 000
1 000
$
25 600
3 840
5 000
29 440
5.1 A FEW HINTS ON PREPARING ACCOUNTS

When preparing a process account, it might help to make the entries as follows:
a. Enter the units first. The units columns are simply memorandum columns, but they help you to
make sure that there are no units unaccounted for, for example, as loss.
b. Enter the costs of materials, labour and overheads next. These should be given to you.
c. Enter your valuation of finished output and closing inventory next. The value of the credit
entries should, of course, equal the value of the debit entries.
5.2 DIFFERENT RATES OF INPUT

In many industries, materials, labour and overhead may be added at different rates during the course
of production.
a. Output from a previous process, for example, the output from process 1 to process 2, may be
introduced into the subsequent process all at once, so that closing inventory is 100% complete in
respect of these materials.
b. Further materials may be added gradually during the process, so that closing inventory is only
partially complete in respect of these added materials.
c. Labour and overhead may be 'added' at yet another different rate. When production overhead is
absorbed on a labour hour basis, however, we should expect the degree of completion on
overhead to be the same as the degree of completion on labour.
When this situation occurs, equivalent units, and a cost per equivalent unit, should be calculated
separately for each type of material, and also for conversion costs.
Suppose that Shaker Co is a manufacturer of processed goods, and that results in process 2 for April
20X3 were as follows:
Opening inventory
Material input from process 1
Costs of input:
nil
4 000 units
$
6 000
1 080
1 720
Material from process 1

Added materials in process 2
Conversion costs (direct labour and manufacturing overhead)
Output is transferred into the next process, process 3.

Closing work in process amounted to 800 units, complete as follows:
%
100
50
30
Process 1 material
Added materials
Conversion costs
Required
Prepare the account for process 2 for April 20X3.

Solution
Step 1

STATEMENT OF EQUIVALENT UNITS (OF PRODUCTION IN THE PERIOD)
Input
Units
4 000
4 000
Output
Completed
production
Closing inventory
Total
Units
3 200
800
4 000
* 800 50% ** 800 30%
Equivalent units of production

Process 1
Added
Conversion
material
materials
costs
Units
%
Units
%
Units
%
3 200
100
3 200
100
3 200
100
800
4 000
100
400*
3 600
50
240**
3 440
30
CHAPTER 7
Worked Example: Equivalent units and different degrees of completion
Step 2

STATEMENT OF COST (PER EQUIVALENT UNIT)
Input
Cost
$
6 000
1 080
1 720
8 800
Process 1 material
Added materials
Conversion costs
Step 3
Equivalent production
in units
Cost per
unit
$
1.50
0.30
0.50
2.30
4 000
3 600
3 440

STATEMENT OF EVALUATION (OF FINISHED WORK AND CLOSING INVENTORIES)
Production
Completed production
Closing inventory:
Cost element
process 1 material
added material
Conversion cots
Number of
equivalent
units
3 200
800
400
240
Cost per
equivalent
unit
$
2.30
1.50
0.30
0.50
Total
$
Cost
$
7 360
1 200
120
120
1 440
8 800
Step 4
Complete accounts.
PROCESS ACCOUNT
Process 1 material
Added material
Conversion costs
Units
4 000
4 000
$
6 000
1 080
1 720
8 800
Process 3 a/c
(finished output)
Units
3 200
$
7 360
800
4 000
1 440
8 800
5.3 CLOSING WORK IN PROCESS AND LOSSES

The previous sections have dealt separately with the following:
a. The treatment of loss and scrap.
b. The use of equivalent units as a basis for apportioning costs between units of output and units of
closing inventory.
We must now look at a situation where both problems occur together. We shall begin with an
example where loss has no scrap value.
The conventions are as follows:
a. Costs should be divided between finished output, closing inventory and abnormal loss/gain using
equivalent units as a basis of apportionment.
b. Units of abnormal loss/gain are often taken to be one full equivalent unit each, and are valued
on this basis, i.e. they carry their full 'share' of the process costs.
c. Abnormal loss units are an addition to the total equivalent units produced but abnormal gain
units are subtracted in arriving at the total number of equivalent units produced.
d. Units of normal loss are valued at zero equivalent units, i.e. they do not carry any of the process
costs.
Worked Example: Changes in inventory level and losses
The following data have been collected for a process:

Opening inventory
Input units
Cost of input
Normal loss
none
2 800 units
$16 695
10%; nil scrap value
Output to finished goods 2 000 units

Closing inventory
450 units, 70% complete
Total loss
350 units
Prepare the process account for the period.

Solution
Step 1
Total units
2 000
Completely worked units
( 100%)
Equivalent units
of work
done this
period
2 000
Closing inventory
450
( 70%)
315
Normal loss (10% 2800)

Abnormal loss (350 280)
280
70
( 100%)
0
70
2 800
Step 2
2 385

STATEMENT OF COST (PER EQUIVALENT UNIT)
Costs incurred
$16 695
=
Equivalent units of work done
2 385
Cost per equivalent unit = $7
Step 3

Equivalent
units
2 000
315
70
2 385
Completely worked units

Closing inventory
Abnormal loss
Step 4
$
14 000
2 205
490
16 ,695
Complete accounts.
PROCESS ACCOUNT
Units
Opening inventory
Input costs
2 800
16 695
2 800
16 695
Normal loss
Finished goods a/c
Abnormal loss a/c
Units
280
2 000
70
450
2 800
$
0
14 000
490
2 205
16 695
5.4 CLOSING WORK IN PROCESS, LOSS AND SCRAP

When loss has a scrap value, the accounting procedures are the same as those previously described.
However, if the equivalent units are a different percentage (of the total units) for materials, labour and
overhead, it is a convention that the scrap value of normal loss is deducted from the cost of
materials before a cost per equivalent unit is calculated.
CHAPTER 7
Question 4: Closing work in process
Complete the process account below from the following information. (Hint. Not all boxes require
entries.)
Opening inventory
Nil
Input units
10 000
Input costs
Material
Labour
$5 150
$2 700
Normal loss
5% of input
Total loss
1 000 units
Scrap value of units of loss
$1 per unit
8 000 units
Closing inventory
1 000 units
Completion of closing inventory
80% for material

50% for labour
PROCESS ACCOUNT
Units
Units
Material
Labour
Closing inventory
Abnormal gain
Normal loss
Abnormal loss
6 VALUING OPENING WORK IN PROCESS

LO
7.2
Section overview
The weighted average cost method of valuing opening WIP makes no distinction between
units of opening WIP and new units introduced to the process during the current period.
6.1 WEIGHTED AVERAGE COST METHOD

The weighted average cost method of inventory valuation is an inventory valuation method that
calculates a weighted average cost of units produced from both opening inventory and units
introduced in the current period.
With the weighted average cost method no distinction is made between units of opening WIP and
new units introduced to the process during the current period. The cost of opening WIP is added to
costs incurred during the period, and completed units of opening WIP are each given a value of one
full equivalent unit of production.
Worked Example: Weighted average cost method
Magpie Co produces an item which is manufactured in two consecutive processes. Information

relating to Process 2 during September 20X3 is as follows:
Opening inventory 800 units
Degree of completion:
Process 1 materials
Added materials
Conversion costs (direct labour and manufacturing overhead)
%
100
40
30
$
4 700
600
1 000
6 300
During September 20X3, 3,000 units were transferred from process 1 at a valuation of $18 100. Added
materials cost $9,600 and conversion costs were $11 800.
Closing inventory at 30 September 20X3 amounted to 1,000 units which were 100% complete with
respect to process 1 materials and 60% complete with respect to added materials. Conversion cost
work was 40% complete.
CHAPTER 7
Magpie Co uses a weighted average cost system for the valuation of output and closing inventory.
Prepare the process 2 account for September 20X3.
Solution
Step 1

Opening inventory units count as a full equivalent unit of production when the weighted
average cost system is applied. Closing inventory units are assessed in the usual way.
Total
Output to finished goods*

Closing inventory
Process 1
units
2 800
1 000
3 800
(100%)
(100%)
material
2 800
1 000
3 800
(60%)
Equivalent units
Added
Conversio
n
material
costs
2 800
2 800
600 (40%)
400
3 400
3 200
* 3 000 units from process 1 minus closing inventory of 1 000 units plus opening inventory
of 800 units.
Step 2
Calculate cost per unit of output and WIP.

The cost of opening inventory is added to costs incurred in September 20X3, and a cost
per equivalent unit is then calculated.
Opening inventory
Added in September 20X3
Total cost
Process 1
material
$
4 700
18 100
22 800
Equivalent units
Cost per equivalent unit
Step 3
Added
materials
$
600
9 600
10 200
3 800 units
$6
3 400 units
$3
Conversion
costs
$
1 000
11 800
12 800
3 200 units
$4
Calculate total cost of output and WIP.

Process 1
Material
$
(2 800 units)
Closing inventory
16 800
6 000
Added
materials
$
8 400
1 800
Conversion
costs
$
Total
cost
$
11 200
1 600
36 400
9 400
45 800
Step 4
Complete accounts
PROCESS 2 ACCOUNT
Opening inventory b/f
Process 1 a/c
Added materials
Conversion costs
Units
800
3 000
3 800
$
6 300
18 100
9 600
11 800
45 800
Finished goods a/c
Units
2 800
$
36 400
1 000
3 800
9 400
45 800
6.2 A FINAL QUESTION

The following question involves the following process costing situations:
Normal loss with and without sale of scrap.
Abnormal loss.
Abnormal gain.
Opening work in process.
Closing work in process.
Take some time to work through this question carefully and to check your workings against the answer
given below. This question should help consolidate all of the process costing knowledge that you
have acquired while studying this chapter.
Question 5: Watkins Ltd
Watkins Ltd has a financial year which ends on 30 April 20X0. It operates in a processing industry in
which a single product is produced by passing inputs through two sequential processes. A normal loss
of 10% of input is expected in each process. Total loss for process 1 was 1 200 units.
The following account balances have been extracted from its ledger at 31 March 20X0:
Process 1 (Materials $4 400; Conversion costs $3 744)

Process 2 (Process 1 $4 431; Conversion costs $5 250)
Abnormal loss
Abnormal gain
Overhead control account
Sales
Cost of sales
Finished goods inventory
Debit
$
8 144
9 681
1 400
Credit
$
300
250
585 000
442 500
65 000
Watkins Ltd uses the weighted average method of accounting for work in process.
During April 20X0 the following transactions occurred:
Process 1
Process 2
Materials input (kg $)

Labour cost
Transfer to process 2
Transfer from process 1

Labour cost
Transfer to finished goods
Overhead costs incurred amounted to
Sales to customer were
4 000 kg
$22 000
$12 000
2 400 kg
2 400 kg
$15 000
2 500 kg
$54 000
$52 000
Overhead costs are absorbed into process costs on the basis of 150% of labour cost.
The losses which arise in process 1 have no scrap value: those arising in process 2 can be sold for $2 per
kg.
Details of opening and closing work in process for the month of April 20X0 are as follows:
Process 1
Process 2
Opening
3 000 kg
2 250 kg
Closing
3 400 kg
2 600 kg
In both processes closing work in process is fully complete as to material cost and 40% complete as to
conversion cost.
Inventories of finished goods at 30 April 20X0 were valued at cost of $60 000.
You are required to fill in the blank boxes.
a. In an account for process 1, the monetary and quantity values for:
kgs at $
transfers to process 2 are
ii normal loss are
kgs at $
iii. abnormal loss are
kgs at $
iv. abnormal gain are
kgs at $
v. WIP materials are
kgs at $
kgs at $
vi. WIP conversion costs are
b. In an account for process 2, the monetary and quantity values for:

i. finished goods are
kgs at $
ii. normal loss are
kgs at $
iii. WIP from process 1 are
kgs at $
iv. WIP from process 2 are
kgs at $
7 JOINT PRODUCTS AND BY-PRODUCTS
LO
7.2
Section overview
Joint products are two or more products produced by the same process and separated in
processing, each having a sufficiently high saleable value to merit recognition as a main
product.
A by-product is an incidental product from a process which has an insignificant value
compared to the main product(s).
7.1 JOINT PRODUCTS

Joint products
are produced in the same process.
are indistinguishable from each other until the separation point.
have a substantial sales value after further processing, if necessary.
may require further processing after the separation point.
For example, in the oil refining industry the following joint products all arise from the same process:
Diesel fuel
Petrol
Paraffin
Lubricants
CHAPTER 7
7.2 BY-PRODUCTS
A by-product is an incidental product from a process which has an insignificant value compared to
the main product(s).
Definition
A by-product is output of some insignificant value produced incidentally while manufacturing the
main product. By products are not separately identifiable as individual products until separation point.
A by-product is a product which is similarly produced at the same time and from the same common
process as the 'main product' or joint products. The distinguishing feature of a by-product is its
relatively low sales value in comparison to the main product. In the timber industry, for example, byproducts include sawdust, small off cuts and bark.
7.3 DISTINGUISHING JOINT PRODUCTS FROM BY-PRODUCTS

The answer lies in management attitudes to their products, which in turn is reflected in the cost
accounting system.
a. A joint product is regarded as an important saleable item, and so it should be separately costed.
The profitability of each joint product should be assessed in the cost accounts.
b. A by-product is not important as a saleable item, and whatever revenue it earns is a 'bonus' for the
organisation. It is not worth costing by-products separately, because of their relative
insignificance. It is therefore equally irrelevant to consider a by-product's profitability. The only
question is how to account for the 'bonus' net revenue that a by-product earns.
7.4 ACCOUNTING FOR JOINT AND BY-PRODUCTS

The point at which joint and by-products become separately identifiable is known as the split-off
point or separation point. Costs incurred up to this point are called common costs or joint costs.
Common or joint costs need to be allocated (apportioned) in some manner to each of the joint
products. In the example below there are two different split-off points.
(1) Split-off point
Input
raw materials
A
roduct
Joint p
Joint p
roduc
tB
Process 1
(2) Split-off point
roduct
Process 2
Joint p
Joint
By-product X
produ
ct D
By-product Y
Example of two split-off points
7.5 APPORTIONING COMMON COSTS

Reasons for apportioning common costs to individual joint products are as follows:
a. To put a value to closing inventories of each joint product.
b. To record the costs and therefore the profit from each joint product. This is of limited value
however, because the costs and therefore profit from one joint product are influenced by the share
of costs assigned to the other joint products. Management decisions should not be based on the
apparent relative profitability of the products which has arisen due to the arbitrary apportionment
of the joint costs.
c. Perhaps to assist in pricing decisions.
Here are some examples of common costing problems.
a. How to spread the common costs of oil refining between the joint products made petrol,
naphtha, kerosene and so on.
b. How to spread the common costs of running the telephone network between telephone calls in peak
rate times and cheap rate times, or between local calls and long-distance calls.
7.5.1 METHODS OF APPORTIONING COMMON COSTS

The main methods that might be used to establish a basis for apportioning or allocating common
costs to each product are as follows:
Physical measurement, e.g. weight of output.
Relative sales value apportionment method 1; sales value at split-off point.
Relative sales value apportionment method 2; sales value of end product less further processing
costs after split-off point, i.e. the net realisable value of each product at the split-off point.
Despite the fact that the by-product has a small value relative to that of the main product, it does have
some commercial value and its accounting treatment usually consists of one of the following:
a. Income (minus any post-separation further processing or selling costs) from the sale of the byproduct may be added to sales of the main product, thereby increasing sales revenue for the
period.
b. The sales of the by-product may be treated as a separate, incidental source of income against
which are offset only post-separation costs (if any) of the by-product. The revenue would be
recorded in the statement of comprehensive income as 'other income'.
c. The sales income of the by-product may be deducted from the cost of production or cost of sales
of the main product.
d. The net realisable value of the by-product may be deducted from the cost of production of the
main product. The net realisable value is the final saleable value of the by-product minus any
post-separation costs.
The choice of method will be influenced by the circumstances of production and ease of calculation,
as much as by conceptual correctness. The most common method is method (d). Notice that this
method is the same as the accounting treatment of a normal loss which is sold for scrap.
Question 6: Split off point
Butter
Milk
Cream
Yoghurt
Mark the split-off point on the diagram above.

8 JOB COSTING
Section overview
Job costing is the costing method used where work is undertaken to customers' special
requirements and each order is of comparatively short duration.
The usual method of fixing prices within a company involved in contracting is cost plus
pricing.
CHAPTER 7
7.6 ACCOUNTING FOR BY-PRODUCTS
LO
7.2
7.2
The work relating to a job is usually carried out within a factory or workshop and moves through
processes and operations as a continuously identifiable unit.
Definitions
A job is a customer order or task of relatively short duration. It can be an individual product, a small
unique batch of products, a project, a case or even a client project.
Job costing is a form of specific order costing where costs are attributed to individual jobs.
8.1 PROCEDURE FOR THE PERFORMANCE OF JOBS

The normal procedure which is adopted in companies involved in contract work involves the following:
a. Customer and supplier discuss and agree parameters and scope of job, for example, the quantity,
quality, size and colour of the goods, the date of delivery and any special requirements.
b. The estimating department of the organisation then prepares an estimate for the job. This will
include the cost of the materials to be used, the wages expected to be paid, the appropriate
amount for factory, administration, selling and distribution overhead, the cost where appropriate of
additional equipment needed specially for the job, and finally the supplier's profit margin. The
total of these items will represent the quoted selling price.
c. At the appropriate time, the job will be 'loaded' on to the factory floor. This means that as soon as
all materials, labour and equipment are available and subject to the scheduling of other orders, the
job will be started. In an efficient organisation, the start of the job will be timed to ensure that it will
be ready for the customer by the promised date of delivery. The job should not be loaded too
early, otherwise storage space will have to be found for the product until the date it is required by
the customer.
8.2 RECORDING JOB COSTS

A separate record must be maintained to show the details of individual jobs. In manual systems, these
are known as job cost cards or job cost sheets. In computerised systems, job costs will be collected
in job accounts.
8.2.1 JOB ACCOUNTS

Job accounts are very much like the process accounts we encountered in Section 1. Inputs to a job are
recorded on the left-hand side of the account, outputs on the right-hand side.
8.2.2 COLLECTING JOB COSTS

Key points on the process of collecting job costs are as follows:
a. Some labour costs, such as an overtime premium, might be charged either directly to a job or else
as an overhead cost, depending on the circumstances in which the costs have arisen.
b. The relevant costs of materials issued, direct labour performed and direct expenses incurred are
charged to a job account in the work in process ledger, the work in process ledger recording the
cost of all WIP.
c. The job account is allocated with the job's share of the factory overhead, based on the absorption
rate(s) in operation. If the job is incomplete at the end of an accounting period, it is valued at
factory cost in the closing statement of financial position, where a system of absorption costing is
in operation.
d. On completion of the job, the job account is charged with the appropriate administration, selling
and distribution overhead, after which the total cost of the job can be ascertained. The job is then
transferred to finished goods.
e. The difference between the agreed selling price and the total actual cost will be the supplier's
profit (or loss).
f. When delivery is made to the customer, the costs become a cost of sale.
Question 7: Job costing
Twist and Tern Co is a company that carries out contracting work. One of the jobs carried out in
February was job 1357, to which the following information relates:
Direct material Y: 400 kilos were issued from stores at a cost of $5 per kilo.
Direct material Z: 800 kilos were issued from stores at a cost of $6 per kilo.
60 kilos were returned.
Department P:
320 labour hours were worked, of which 100 hours were done as overtime.
Department Q:
200 labour hours were worked, of which 100 hours were done as overtime.
Overtime work is not normal in department P, where basic pay is $8 per hour plus an overtime
premium of $2 per hour. Overtime work was done in department Q in February because of a request
by the customer of another job to complete that job quickly. Basic pay in department Q is $10 per
hour and the overtime premium is $3 per hour.
Overhead is absorbed at the rate of $3 per direct labour hour in both departments.
a. The direct materials cost of job 1357 is $
c. The full production cost of job 1357 is $
.
.
8.3 COST PLUS PRICING

The usual method of setting prices within a company involved in contract work is cost plus pricing.
Cost plus pricing is where a desired profit margin is added to total costs to arrive at the selling price.
The disadvantages of cost plus pricing are as follows:
a. There are no incentives to control costs as a profit is guaranteed.
b. There is no motive to tackle inefficiencies or waste.
c. It does not take into account any significant differences in actual and estimated volumes of activity.
Since the overhead absorption rate is based upon estimated volumes, there may be under-/overabsorbed overheads not taken into account.
d. Because overheads are apportioned in an arbitrary way, this may lead to under and over pricing.
The cost plus system is often adopted where one-off jobs are carried out to customers' specifications.
Advantages are:
a. It is relatively simple to determine the appropriate price once overheads have been allocated.
b. For a one-off contract it ensures that the contractor's costs will be covered and a profit realised,
hence reducing the risk of losses on the contract.
c. It may help the supplier justify the price to the customer e.g. if supplier can point to an increase in
the cost of raw materials as a reason for the price increase.
d. It may help promote price stability because it limits the ability of the sales department to adopt a
discretionary approach to pricing.
In a competitive market however the margin added to cost would need to take into account
competitor prices or the company may price itself out of the market.
CHAPTER 7
b. The direct labour cost of job 1357 is $
Question 8: Selling prices
The total cost of job 259 is $4 200.

a. When profit is calculated as 25 per cent of sales, the correct selling price for the job is $
b. When profit is calculated as 25 per cent of cost, the correct selling price for the job is $
Worked Example: Job costing example
An example may help to illustrate the principles of job costing.

FM Co is a contract company. On 1 June 20X2, there was one uncompleted job in the factory. The job
card for this work is summarised as follows:
Job card, job no 6832
Costs to date
Direct materials
Direct labour (120 hours)
Factory overhead ($2 per direct labour hour)
Factory cost to date
$
630
840
240
1 710
During June, three new jobs were started in the factory, and costs of production were as follows:
Direct materials
Issued to:
Job 6832
Job 6833
Job 6834
Job 6835
$
2 390
1 680
3 950
4 420
Material transfers
Job 6832 to Job 6834
Job 6834 to Job 6833
$
620
250
Materials returned to store

From Job 6832
From Job 6835
$
870
170
Direct labour hours recorded

Job 6832
Job 6833
Job 6834
Job 6835
Hours
430
650
280
410
The cost of labour hours during June 20X2 was $8 per hour, and production overhead is absorbed at
the rate of $2 per direct labour hour. Completed jobs were delivered to customers as soon as they
were completed, and the invoiced amounts were as follows:
Job 6832
Job 6834
Job 6835
$8 500
$9 000
$9 500
Administration and marketing overheads are added to the cost of sales at the rate of 20% of factory
cost.
Required
a. Prepare the job accounts for each individual job during June 20X2. (Remember inputs to the job go
on the left-hand side of the account, outputs on the right-hand side.)
b. Prepare the summarised job cost cards for each job, and calculate the profit on each completed
job.
Solution
a. Job accounts
JOB 6832
Balance b/f
Materials (stores a/c)
Labour (wages a/c)
Production overhead (o'hd a/c)
$
1 710
2 390
3 440
860
8 400
$
620
Job 6834 a/c

(materials transfer)
To stores (materials returned)
Cost of sales (balance)
870
6 910
8 400
JOB 6833
$
1 680
5 200
1 300
250
8 430
$
8 430
Balance c/f
8 430
JOB 6834
Labour (wages a/c)
Job 6832 a/c (materials transfer)
$
3 950
2 240
560
620
7 370
$
250

7 120
7 370
JOB 6835
Labour (wages a/c)
$
4 420
3 280
820
8 520
$
170
To stores (materials returned)

8 350
8 520
Note that the accounts to which the double entry is made are shown in brackets.
b. Job cards, summarised
Materials
Labour
Production overhead
Factory cost
Admin & marketing o'hd (20%)
Cost of sale
Invoice value
Profit/(loss) on job
Job 6832
$
1 530*
4 280
1 100
6 910
1 382
8 292
8 500
208
Job 6833
$
1 930
5 200
1 300
(c/f) 8 430
* $(630 + 2 390 620 870) ** $(3 950 + 620 250)
Job 6834
$
4 320**
2 240
560
7 120
1 424
8 544
9 000
456
Job 6835
$
4 250
3 280
820
8 350
1 670
10 020
9 500
(520)
CHAPTER 7

Labour (wages a/c)
KEY CHAPTER POINTS

Process costing is a costing method used where it is not possible to identify separate units of
production, or jobs, usually because of the continuous nature of the production processes
involved.
Costs incurred in processes are recorded in what are known as process accounts.
A process account has two sides, and on each side there are two columns one for quantities (of
raw materials, work in process and finished goods) and one for costs.
A suggested four-step approach when dealing with process costing questions is:
Step 1
Step 2
Step 3
Step 4
Determine output and losses

Calculate cost per unit of output, losses and WIP
Calculate total cost of output, losses and WIP
Complete accounts
Losses may occur in a process. If a certain level of loss is expected, this is known as normal loss. If
losses are greater than expected, the extra loss is abnormal loss. If losses are less than expected,
the difference is known as abnormal gain.
The valuation of normal loss is either at scrap value or nil. It is conventional for the scrap value of
normal loss to be deducted from the cost of materials before a cost per equivalent unit is
calculated.
Abnormal losses and gains never affect the cost of good units of production. The scrap value of
abnormal losses is not credited to the process account, and the abnormal loss and gain units carry
the same full cost as a good unit of production.
When units are partly completed at the end of a period, i.e. when there is closing work in process,
it is necessary to calculate the equivalent units of production in order to determine the cost of a
completed unit.
The weighted average cost method of valuing opening WIP makes no distinction between units of
opening WIP and new units introduced to the process during the current period.
Joint products are two or more products separated in a process, each of which has a significant
value.
A by-product is an incidental product from a process which has an insignificant value compared to
the main products(s).
Job costing is the costing method used where work is undertaken to customers' special
requirements and each order is of comparatively short duration.
The usual method of fixing prices within a company involved in contract work is cost plus pricing.

A company manufactures chemical X in a single process. At the start of the month there was no workin-process. During the month 300 litres of raw material were input into the process at a total cost of
$6 000. Conversion costs during the month amounted to $4 500. At the end of the month 250 litres of
chemical X were transferred to finished goods inventory. The remaining work-in-process was 100%
complete with respect to materials and 50% complete with respect to conversion costs. There were no
losses in the process.
A
B
C
D
Material
25 litres
25 litres
50 litres
50 litres
Conversion costs
25 litres
50 litres
25 litres
50 litres
2 If there had been a normal process loss of 10% of input during the month the value of this loss
would have been
A nil.
B $450.
C $600.
D $1 050.
3 In a process account, abnormal losses are valued

A at zero.
B at their scrap value.
C at the cost of raw materials.
D the same as good production.
4 A company needs to produce 340 litres of chemical Y. There is a normal loss of 10% of the material
input into the process. During a given month the company did produce 340 litres of good
production, although there was an abnormal loss of 5% of the material input into the process.
How many litres of material were input into the process during the month?
A
B
C
D
357 litres
374 litres
391 litres
400 litres
CHAPTER 7
1 The equivalent units for closing work-in-process at the end of the month would have been
A company produces a certain food item in a manufacturing process. On 1 November, there was no
opening inventory of work in process. During November, 500 units of material were input to the
process, with a cost of $9 000. Direct labour costs in November were $3 840. Production overhead is
absorbed at the rate of 200% of direct labour costs. Closing inventory on 30 November consisted of
100 units which were 100% complete as to materials and 80% complete as to labour and overhead.
There was no loss in process.
5 The full production cost of completed units during November was
A $10 400.
B $16 416.
C $16 800.
D $20 520.
6 The value of the closing work in process on 30 November is
A $2 440.
B $3 720.
C $4 104.
D $20 520.
A company makes a product in two processes. The following data is available for the latest period, for
process 1.
Opening work in process of 200 units was valued as follows:
Material
Labour
Overhead
$2 400
$1 200
$400
No losses occur in the process.

Units added and costs incurred during the period:
Material
Labour
Overhead
$6 000 (500 units)

$3 350
$1 490
Closing work in process of 100 units had reached the following degrees of completion:
Material
Labour
Overhead
100%
50%
30%
The company uses the weighted average method of inventory valuation.

7 How many equivalent units are used when calculating the cost per unit in relation to overhead?
A 500
B 600
C 630
D 700
8 The value of the units transferred to process 2 was
A $7 200.
B $13 200.
C $14 840.
D $15 400.
9 A company manufactures two joint products, P and R, in a common process. Data for June are as
follows:
$
1 000
10 000
12 000
3 000
Opening inventory
Direct materials added
Conversion costs
Closing inventory
Production
Units
4 000
6 000
P
R
Sales
Units
5 000
5 000
Sales price
$ per unit
5
10
A
B
C
D
$1.25
$2.22
$2.50
$2.75
10 How is revenue from scrap treated?

A As a bonus to all employees
B As an addition to sales revenue
C As a reduction in costs of processing
D As a bonus to production employees
CHAPTER 7
If costs are apportioned between joint products on a sales value basis, what was the cost per unit
of product R in June?

1 C Work in progress = 300 litres input 250 litres to finished goods
= 50 litres
Equivalent litres for each cost element are as follows:
Material
Equiv.
litres
100
50
Conversion costs
%
Equiv.
litres
50
25
50 litres in progress
Option A is incorrect because it assumes that the units in progress are only 50 per cent
complete with respect to materials.
Option B has transposed the information concerning the two cost elements.
If you selected option D you calculated the correct number of litres in progress but you did not
take account of their degree of completion.
2 A There is no mention of a scrap value available for any losses therefore the normal loss would
have a zero value. The normal loss does not carry any of the process costs therefore options B,
C and D are all incorrect.
3 D Abnormal losses are valued at the same unit rate as good production, so that their occurrence
does not affect the cost of good production. They are not valued at zero, so option A is
incorrect.
The scrap value of the abnormal loss (option B) is credited to a separate abnormal loss account;
it does not appear in the process account.
Option C is incorrect because abnormal losses also absorb some conversion costs.
4 D The total loss was 15% of the material input. The 340 litres of good output therefore represents
85% of the total material input.
Therefore, material input =
340
= 400 litres
0.85
Options A and B are incorrect because they represent a further five per cent and ten per cent
respectively, added to the units of good production.
If you selected option C you simply added 15 per cent to the 340 litres of good production.
However, the losses are stated as a percentage of input, not as a percentage of output.
5 C
Step 1

Input
Units
500
500
Step 2
Output
Finished units (balance)
Closing inventory
Total
Units
400
100
500
Equivalent units
Materials
Labour and overhead
Units
%
Units
%
400
100
400
100
100
100
80
80
500
480
Calculate the cost per equivalent unit.
Input
Materials
Labour and overhead
Cost
$
9 000
11 520
Equivalent
production
in units
500
480
Cost per
unit
$
18
24
42
Step 3
Calculate total cost of output.

Cost of completed units = $42 400 units = $16 800
If you selected option A you omitted the absorption of overhead at the rate of 200
per cent of direct labour.
If you selected option B you did not allow for the fact that the work in progress
was incomplete.
Option D is the total process cost for the period, some of which must be allocated
to the work in progress.
6 B Using the data from answer 5 above, extend step 3 to calculate the value of the work in
progress.
Work in progress:
Number of
equivalent units
Materials
Labour & overhead
100
80
Cost per
equivalent unit
$
18
24
Total
$
1 800
1 920
3 720
If you selected option A you omitted the absorption of overhead into the process costs. If you
selected option C you did not allow for the fact that the work in progress was incomplete.
Option D is the total process cost for the period, some of which must be allocated to the
completed output.
7 C STATEMENT OF EQUIVALENT UNITS
Output to process 2*
Closing WIP
Total
Units
600
100
700
Equivalent units
Labour
Materials
(100%)
600
100
700
(50%)
600
50
650
Overheads
600
30
630
(30%)
*500 units input + opening WIP 200 units closing WIP 100 units.
Option A is incorrect because it is the number of units input to the process, taking no account
of opening and closing work in progress.
Option B is the completed output, taking no account of the work done on the closing
inventory. Option D is the total number of units worked on during the period, but they are not
all complete in respect of overhead cost.
8 B STATEMENT OF COSTS PER EQUIVALENT UNIT
Opening stock
Added during period
Total cost
Equivalent units
Cost per equivalent unit
Materials
$
2 400
6 000
8 400
700
$12
Labour
$
1 200
3 350
4 550
650
$7
Overheads
$
400
1 490
1 890
630
$3
Total
$22
Value of units transferred to process 2 = 600 units $22 = $13 200

Option A is incorrect because it represents only the material cost of the units transferred.
Option C is all of the costs incurred in the process during the period, but some of these costs
must be allocated to the closing work in progress.
Option D is the value of 700 completed units: but only 600 units were transferred to the next
process.
CHAPTER 7
Cost
element
9 C Total production inventory

$
1 000
10 000
12 000
23 000
3 000
20 000
Opening inventory
Conversion costs
Less closing inventory
Total production cost
P
R
Production
Units
4 000
6 000
( $5)
( $10)
Sales value
$
20 000
60 000
80 000
($20 000 20/80)

($20 000 60/80)
Apportioned
cost
$
5 000
15 000
20 000
Product R cost per unit = $15 000/6 000 = $2.50 per unit.
Option A is the cost per unit for product P, and if you selected option B you apportioned the
production costs on the basis of units sold. If you selected option D you made no adjustment
for inventories when calculating the total costs.
10 C Revenue from scrap is treated as a reduction in costs of processing.

1 C
Step 1

Units
2 750
330
220
3 300
Actual output
Abnormal loss
Step 2

= Cost per expected unit of output
Step 3

$
82 500
0
6 600
89 100
Cost of output (2 750 $30)

Normal loss
Hence cost of 2 750 finished units output is $82 500

Option A is incorrect because it results from allocating a full unit cost to the normal loss:
remember that normal loss does not carry any of the process cost.
Option B is incorrect because it results from calculating a 10% normal loss based on output of 2
750 units (275 units normal loss), rather than on input of 3 300 units.
Option D is simply the total input cost, with no attempt to apportion some of the cost to the
abnormal loss.
2 B
DR
Opening WIP
Input
PROCESS ACCOUNT
CR
5 200
Output
58 300
Normal loss
59 900
400
Closing WIP
3 500
Abnormal gain
63 800
63 800
The abnormal gain is the balancing figure: 63 800 5 200 58 300 = 300
3
Step 1
Output
Normal loss (20% of 3 000 kgs)
Abnormal loss
Abnormal gain
Process 1
kgs
2 300
600
100
3 000
* From process 1 (2 300 kgs) + 2 000 kgs added
(10% of 4 300)
Process 2
kgs
4 000
430
(130)
4 300*
CHAPTER 7
Cost of input
$89 100
=
= $30 per unit
Expected units of output
3 300 330
Step 2

Process 1
$
750
120
450
Material (3 000 $0.25)

From process 1
Labour
Overhead (375% $120)
Less: scrap value of normal loss
(600 $0.20)
Expected output
3 000 80%
Cost per unit $ $1320 $120
3 000 600
Step 3
(2 000 $0.40)
(2 300 $0.50)
(496% $84)
(120)
1 200
(430 $0.3)
(129)
2 322
2 400
$0.50
4 300 90%
3 870
$0.60
$2 451 $129
4 300 430

Process 1
$
1 150
Output (2 300 $0.50)

Normal loss (scrap)
(600 $0.20)
Abnormal loss (100 $0.50)
120
50
1 320
1 320
Abnormal gain
Step 4
Process 2
$
800
1 150
84
417
Process 2
$
2 400
(4 000 $0.60)
(430 $0.30)
129
2 529
(78)
2 451
(130 $0.60)
Complete accounts.
PROCESS 1 ACCOUNT
Material
Labour
General overhead
kg
3 000
3 000
$
750
120
450
kg
(20%)
process 2
Abnormal loss a/c
1 320
600
120
2 300
100
3 000
1 150
50
1 320
kg
PROCESS 2 ACCOUNT
kg
Transferred from
process 1
Material added
Labour
General overhead
Abnormal gain
2 300
2 000
4 300
130
4 430
$
1 150
800
84
417
2 451
78
2 529

(10%)
finished inventory
430
129
4 000
2 400
4 430
2 529
kg
130
1 000
$
39
230
1 130
269
SCRAP ACCOUNT
Abnormal loss
(process 1)
kg
600
430
$
120
129
100
1 130
20
269

Cash/Receivables
ABNORMAL LOSS AND GAIN ACCOUNT

Process 1 (loss)
Scrap value of abnormal
Gain
Statement of
comprehensive income
kg
100
50
130
39
9
230
98
Scrap value of
abnormal loss
Process 2 (gain)
kg
100
130
20
78
230
98
(Note. In this answer, a single account has been prepared for abnormal loss/gain. It is also possible
to separate this single account into two separate accounts, one for abnormal gain and one for
abnormal loss.)
Step 1 Determine output and losses.

Total
Units
8 000
1 000
500
500
10 000
Closing inventory
Normal loss
Abnormal loss
Equivalent units
Material
Labour
%
Units
%
Units
100
8 000
100
8 000
80
800
50
500
100
500
9 300
100
500
9 000
Step 2 Calculate cost per unit of output, losses and WIP.

STATEMENT OF COST PER EQUIVALENT UNIT
Equivalent
units
Cost
$
4 650
2 700
7 350
Material ($(5 150 500))*

Labour
9 300
9 000
Cost per
equivalent
unit
$
0.50
0.30
0.80
* The scrap value of the normal loss is used to reduce the material costs of the process.
Step 3 Calculate total cost of output, losses and WIP.
Equivalent
units
Closing inventory: material
Labour
8 000
800
500
Abnormal loss
500
Cost per
equivalent
unit
$
0.80
0.50
0.30
Total
$
6 400
400
150
550
400
7 350
0.80
Step 4 Complete accounts.

PROCESS ACCOUNT
Material
Labour
Units
10 000
$
5 150
2 700
10 000
7 850
Closing inventory
Normal loss
Abnormal loss
Units
8 000
1 000
500
500
10 000
$
6 400
550
500
400
7 850
CHAPTER 7
5 (a) Process 1
Equivalent units
Conversion
Material costs
costs
2 400
2 400
(100%) 3 400
(40%) 1 360
0
0
800
800
6 600
4 560
Total units
2 400
3 400
400
800
7 000
Transfers to process 2
Closing WIP
Abnormal loss

Costs incurred
= Cost per equivalent unit
Equivalent units
Therefore Materials cost per equivalent unit =
$4 400 $22 000

$26 400
=
= $4
6 600
6 600
therefore Conversion costs per equivalent unit
$3 744 $12 000 $18 000

$33 744
=
=
4 560
4 560
$7.40
Materials
$
9 600
3 200
13 600
26 400
Transfers to process 2
Abnormal loss
Closing WIP
Conversion costs
$
17 760
5 920
10 064
33 744
Total
$
27 360
9 120
23 664
60 144
PROCESS 1 ACCOUNT
WIP materials
(opening)
WIP conversion costs
Materials
Labour
Overhead
Kg
3 000
$
4 400
4 000
7 000
3 744
22 000
12 000
18 000
60 144
Process 2
Normal loss
Abnormal loss
WIP materials (closing)
The monetary and quantity values for:

(i) transfer to process 2 are
(ii) normal loss are
2 400
kgs at $ 27 360
kgs at $
400
(iii) abnormal loss are
800
kgs at $
9 120
(iv) abnormal gain are
kgs at $
(v) WIP materials are
3 400
(vi) WIP conversion costs are
kgs at $ 13 600
0
kgs at $ 10 064
Kg
2 400
$
27 360
400
800
3 400
7 000
9 120
13 600
10 064
60 144
(b) Process 2
Total units
2 500
240 *
(690) *
2 600*
4 650
Finished goods
Normal loss
Abnormal gain
Closing WIP
* Total input units
Process 1
2 500
0
(690)
2 600
4 410
Conversion costs
2 500
0
(690)
1 040**
2 850
= opening WIP + input = 2 250 + 2 400 = 4 650
Normal loss = 2 400 * 10% = 240

Expected transfer to finished goods = total input 4 650 normal loss 240 closing WIP 2 600 =
1 810.
Actual transfer to finished goods = 2 500, hence abnormal gain = 2 500 1 810 = 690
= finished goods + closing WIP + normal loss abnormal gain
= 2 500 + 2 600 + 240 690
= 4 650
CHAPTER 7
Total output units
** 2 600 40% = 1 040

Process 1 =
$4 431 27 360 480

= $7.10
4 410
Conversion costs =
$5 250 $15 000 $22 500

= $15.00
2 850
Process 1
$
17 750
4 899
18 460
41 109
Finished goods
Abnormal gain
Closing WIP
Conversion
costs
$
37 500
10 350
15 600
63 450
Total
$
55 250
15 249
34 060
104 559
PROCESS 2 ACCOUNT
Kg
2 250
2 400
690
5 340
WIP Process 1
Process 1
Labour
Overhead
Abnormal gain
$
4 431
5 250
27 360
15 000
22 500
15 249
89 790
Finished goods
Normal loss
WIP process 1
The monetary and quantity values for:

(i) finished goods are
(ii) normal loss are
kgs at $ 55 250
2 500
240
kgs at $
480
(iii) WIP from process 1 are
2 600
kgs at $ 18 460
(iv) WIP from process 2 are
kgs at $ 15 600
Kg
2 500
240
2 600
$
55 250
480
18 460
15 600
5 340
89 790
6
Butter
Milk
Cream
Yoghurt
Split off point
7 (a) The direct materials cost is $
6 440
Workings
$
2 000
Direct material Y (400 kilos $5)

Direct material Z (800 60 kilos $6)
Total direct material cost
(b) The direct labour cost is $
4 440
6 440
4 560
Workings
$
2 560
Department P (320 hours $8)
2 000
Department Q (200 hours $10)

Total direct labour cost
4 560
In department P, overtime premium will be charged to overhead. In department Q, overtime

premium will be charged to the job of the customer who asked for overtime to be worked.
(c) The full production cost is $ 12 560
Workings
Direct material cost
Direct labour cost
Production overhead (520 hours $3)
$
6 440
4 560
1 560
12 560
8 If you have difficulty working out the correct amount, simply jot down the cost and selling price
structures as percentages in each case.
(a) The correct selling price is $ 5 600 .
Workings
Profit is calculated as a percentage of sales, so selling price must be written as 100%.

%
75
25
100
Cost
Profit
Selling price
Selling price = $4 200 100/75 = $5 600

(b) The correct selling price is $
5 250
Workings
Profit is calculated as a percentage of cost, so cost must be written as 100%.

Cost
Profit
Selling price
Selling price = $4 200 125/100 = $5 250
%
100
25
125
233
CHAPTER 8
STANDARD COSTING
Learning objectives
Reference
Standard costing
LO8
Explain how standard costing can be used to assist in cost control and efficient resource
allocation
LO8.1
Topic list
1 What is standard costing?

2 Setting standards
INTRODUCTION
Just as there are standards for most things in our daily lives (cleanliness in restaurants, educational
achievement of students, number of trains running on time), there are standards for the costs of
products and services. Also, just as the standards in our daily lives are not always met, the standards
for the costs of products and services are not always met. We will be looking at standards for costs,
what they are used for and how they are set.
In the next chapter we will see how standard costing forms the basis of a process called variance
analysis, a vital management control tool.
Standard
costing
What is it?
Setting
standards
STANDARD COSTING | 235
BEFORE YOU BEGIN

area.
everything covered.
1 What is a standard cost?
(Section 1)
2 State two principal uses of standard costing.
(Section 1.2)
3 What is the difference between actual and standard costs called?
(Section 1.3)
4 What are the four types of performance standards?
(Section 2.1)
CHAPTER 8
5 Which element of Direct material standards are the purchasing department most likely to estimate
and what knowledge will they use to do this?
(Section 2.3)
1 WHAT IS STANDARD COSTING

Section overview
A standard cost is a predetermined estimated unit cost, used for inventory valuation and
control.
The standard cost of a product is a detailed list of the expected costs required to produce
a completed unit of that product. Differences between actual and standard costs are called
variances.
1.1 STANDARD COST

Definition
A standard cost system is a cost accounting system that uses standard cost of input and standard
quantities to measure the final cost of a product or service.
LO
8.1
The standard cost of a product provides a detailed breakdown of all the expected costs required to
produce a completed unit of that product
The standard cost of product 1234 is set out below:
STANDARD COST PRODUCT 1234
$
Direct materials
Material X 3 kg at $4 per kg
Material Y 9 litres at $2 per litre
12
18
30
Direct labour
Grade A 6 hours at $1.50 per hour
Grade B 8 hours at $2 per hour
Standard direct cost
Variable production overhead 14 hours at $0.50 per hour
Standard variable cost of production
Fixed production overhead 14 hours at $4.50 per hour
Standard full production cost
Administration and marketing overhead
Standard cost of sale
Standard profit
Standard sales price
9
16
25
55
7
62
63
125
15
140
20
160
Notice how the total standard cost is built up from standards for each cost element: standard
quantities of materials at standard prices, standard quantities of labour time at standard rates and so
on. It is therefore determined by management's estimates of the following:
The expected prices of materials, labour and expenses.
Efficiency levels in the use of materials and labour.
Budgeted overhead costs and budgeted volumes of activity.
We will see how management arrives at these estimates below.
But why should management want to prepare standard costs? Obviously to assist with standard
costing, but what is the point of standard costing?
1.2 THE USES OF STANDARD COSTING

Standard costing has a variety of uses but its two principal ones are as follows:
To value inventories and measure the cost of production for cost accounting purposes.
To act as a control device by establishing standards (planned costs), highlighting (via variance
analysis which we will cover in the next chapter) activities that are not conforming to plan and
therefore alerting management to areas which may be out of control and in need of corrective
action.
Worked Example: Standard cost
Bloggs makes one product, the joe. Two types of labour are involved in the preparation of a joe,
skilled and semi-skilled. Skilled labour is paid $10 per hour and semi-skilled $5 per hour. Twice as
many skilled labour hours as semi-skilled labour hours are needed to produce a joe, four semi-skilled
labour hours being needed.
A joe is made up of three different direct materials. Seven kilograms of direct material A, four litres of
direct material B and three metres of direct material C are needed. Direct material A costs $1 per
kilogram, direct material B $2 per litre and direct material C $3 per metre.
Variable production overheads are incurred at Bloggs at the rate of $2.50 per direct labour (skilled)
hour.
A system of absorption costing is in operation at Bloggs. The basis of absorption is direct labour
(skilled) hours. For the forthcoming accounting period, budgeted fixed production overheads are $250
000 and budgeted production of the joe is 5 000 units.
Administration, selling and distribution overheads are added to products at the rate of $10 per unit.
Using the above information calculate a standard cost for the joe.
Solution
STANDARD COST PRODUCT JOE
$
7
8
9
Direct materials
A 7 kgs $1
B 4 litres $2
C 3 m $3
24
Direct labour
Skilled 8 $10
Semi-skilled 4 $5
80
20

Variable production overhead 8 $2.50
Standard variable cost of production
Fixed production overhead 8 $6.25 (W)
Standard full production cost
Administration, selling and distribution overhead
Standard cost of sale
Standard profit (25% 204)
Working
$250 000
= $6.25 per skilled labour hour
5 000 8
100
124
20
144
50
194
10
204
51
255
CHAPTER 8
A mark-up of 25% is made on the joe.
Worked Example: Marginal costing system
What would a standard cost for product joe show under a marginal system?
Solution
STANDARD COST PRODUCT JOE

Direct materials
Direct labour
Standard variable production cost
Standard contribution
$
24
100
124
20
144
255
111
Although the use of standard costs to simplify the keeping of cost accounting records should not be
overlooked, we will be concentrating on the control and variance analysis aspect of standard costing.
Standard costing is a control technique which compares standard costs with actual results to obtain
variances which are used to improve performance.
Notice that the above definition highlights the control aspects of standard costing.
1.3 STANDARD COSTING AS A CONTROL TECHNIQUE

Differences between actual and standard costs are called variances.
Standard costing involves:
The establishment of predetermined estimates of the costs of products or services
The collection of actual costs
The comparison of the actual costs with the predetermined estimates
The predetermined costs are known as standard costs and the difference between standard and
actual cost is known as a variance. The process by which the total difference between standard and
actual results is analysed is known as variance analysis.
Standard costing can be used in a variety of costing situations:
Batch and mass production
Process manufacture
Job production where there is standardisation of parts
Service industries if a realistic cost unit can be established
However, the greatest benefit from its use can be gained if there is a degree of repetition in the
production process. It is therefore most suited to mass production and repetitive assembly work.
2 SETTING STANDARDS
Section overview
The standard cost of a product, or service, is made up of a number of different standards,
one for each cost element, each of which has to be set by management.
Performance standards are used to set efficiency targets. There are four types: ideal,
attainable, current and basic. We have divided this section into two: the first part looks at
setting the monetary part of each standard, whereas the second part looks at setting the
resources requirement part of each standard.
LO
8.1
Standard costs may be used in both absorption costing and in marginal costing systems. We shall,
however, confine our description to standard costs in absorption costing systems.
2.1 TYPES OF PERFORMANCE STANDARD

Performance standards are used to set efficiency targets. There are four types: ideal, attainable,
current and basic.
TYPE OF STANDARD
DESCRIPTION
Ideal
These are based on perfect operating conditions: no wastage, no spoilage, no

inefficiencies, no idle time, no breakdowns. Variances from ideal standards are
useful for pinpointing areas where a close examination may result in large savings
in order to maximise efficiency and minimise waste. However ideal standards are
likely to have an unfavourable motivational impact because reported variances
will always be adverse. Employees may feel unmotivated by the perception of
having unattainable targets.
Attainable
These are based on the hope that a standard amount of work will be carried out
efficiently, machines properly operated or materials properly used. Some
allowance is made for wastage and inefficiencies. If well set they provide a useful
psychological incentive by giving employees a realistic, but challenging target of
efficiency. The consent and co operation of employees involved in improving the
standard are required. Also sometimes called 'practical standards' or 'target
standards'.
Current
These are based on current working conditions (current wastage, current

inefficiencies). The disadvantage of current standards is that they do not attempt
to improve on current levels of efficiency.
Basic
T These are kept unaltered over a long period of time, and may be out of date
because of changes within the organisation or changes in the environment in
which the organisation operates. They are used as a 'benchmark standard'
against which to measure changes in efficiency or performance over a long
period of time. Basic standards are perhaps the least useful and least common
type of standard in use.
Ideal standards, attainable standards and current standards each have their supporters and it is by no
means clear which of them is preferable.
Question 1: Performance standards
Which of the following statements is not correct?

A Basic standards may provide an incentive to greater efficiency even though the standard cannot be
achieved.
B Variances from ideal standards are useful for pinpointing areas where a close examination might
result in large cost savings.
C Current standards or attainable standards are a better basis for budgeting, because they represent
the level of productivity which management will wish to plan for.
D Ideal standards cannot be achieved and so there will always be adverse variances. If the standards
are used for budgeting, an allowance will have to be included for these 'inefficiencies'.
CHAPTER 8
The setting of standards raises the problem of how demanding the standard should be. Should the
standard represent a perfect performance or an easily attainable performance? The type of
performance standard used can have behavioural implications. There are four types of standard.
2.2 METHODS OF STANDARD SETTING

Standards for each resource required to produce the product need to be set in terms of both the
physical quantity of that resource (e.g. labour hours) and its cost (e.g. wage rate per hour).
The standard can be derived using historic data, although this may result in past inefficiencies being
incorporated. Methods of estimating costs from past information were considered in Chapter 3,
Section 7.
If new methods of working are being introduced, standards based on historical data may not be
appropriate. In this case, new standards will need to be calculated based on an analysis of working
practices, using methods such as engineering studies.
2.3 DIRECT MATERIAL STANDARDS

The standard cost of direct material for a unit of product =
standard price per unit of material x standard quantity of the material
Direct material price standards will be estimated by the purchasing department from their knowledge
of the following:
Purchase contracts already agreed.
Pricing discussions with regular suppliers.
The forecast movement of prices in the market.
The availability of bulk purchase discounts.
Price inflation can cause difficulties in setting realistic standard prices. Suppose that a material costs
$10 per kilogram at the moment and during the course of the next twelve months it is expected to go
up in price by 20% to $12 per kilogram. What standard price should be selected?
The current price of $10 per kilogram
The average expected price for the year, say $11 per kilogram
Either would be possible, but neither would be entirely satisfactory.
a. If the current price were used in the standard, the reported price variance will become adverse as
soon as prices go up, which might be very early in the year. If prices go up gradually rather than in
one big jump, it would be difficult to select an appropriate time for revising the standard.
b. If an estimated mid-year price were used, price variances should be favourable in the first half of
the year and adverse in the second half of the year, again assuming that prices go up gradually
throughout the year. Management could only really check that in any month, the price variance did
not become excessively adverse / favourable and that the price variance switched from being
favourable to adverse around month six or seven.
To estimate the materials required to make each product (material usage), technical specifications
must be prepared for each product by production experts in the production department. The
'standard product specification' for materials must list the quantities required per unit of each
material in the product. These standard input quantities must be made known to the operators in the
production department so that control action by management to deal with excess material wastage
will be understood by them.
2.4 DIRECT LABOUR STANDARDS

The standard cost of direct labour for a unit of product = standard labour rate per hour x standard
quantity of hours required by that particular labour type
Direct labour rates per hour will be set by discussion with the personnel department and by reference
to the payroll and to any agreements on pay rises with trade union representatives of the employees.
a. A separate hourly rate or weekly wage will be set for each different labour grade/type of employee.
b. An average hourly rate will be applied for each grade, even though individual rates of pay may vary
according to age and experience.
Similar problems when dealing with inflation to those described for direct material standards can be
encountered when setting labour standards.
To estimate the labour hours required (labour efficiency), technical specifications must be prepared
for each product by production experts in the production department. The 'standard operation
sheet' for labour will specify the expected hours required by each grade of labour in each department
to make one unit of product. These standard times must be carefully set and must be understood by
the labour force. Where necessary, standard procedures or operating methods should be stated.
2.5 OVERHEAD ABSORPTION RATES

When standard costs are fully absorbed costs, the absorption rate of fixed production overheads will
be predetermined, usually each year when the budget is prepared, and based in the usual manner on
budgeted fixed production overhead expenditure and budgeted production.
For selling and distribution costs, standard costs might be absorbed as a percentage of the standard
selling price.
CHAPTER 8
Standard costs under marginal costing will, of course, not include any element of absorbed
overheads.
KEY CHAPTER POINTS

A standard cost is a predetermined estimated unit cost, used for inventory valuation and control.
The standard cost of a product shows full details of the expected costs required to produce a
completed unit of that product.
Differences between actual and standard cost are called variances.
Performance standards are used to set efficiency targets. There are four types: ideal, attainable,
current and basic.

1 Which of the following would not be directly relevant to the determination of direct labour
standards per unit of output?
A Skills of the work force
B the type of performance standard to be used
C the volume of output from the production budget
D technical specifications of the proposed production methods
2 What is an attainable standard?
A A standard which is kept unchanged, to show the trend in costs.
B A standard which is based on currently attainable operating conditions.
C A standard which includes no allowance for losses, waste and inefficiencies. It represents the
level of performance which is attainable under perfect operating conditions.
D A standard which includes some allowance for losses, waste and inefficiencies. It represents the
level of performance which is attainable under efficient operating conditions.
3 A control technique which compares standard costs and revenues with actual results to obtain
variances, which are used to stimulate improved performance, is known as
A budgeting.
B standard costing.
C variance analysis.
D budgetary control.
A Printing
B Fashion design
C Postal services
D Mobile phone manufacture
CHAPTER 8
4 For which one of the following is standard costing most likely to be appropriate?

1 C The volume of output would influence the total number of labour hours required, but it would
not be directly relevant to the standard labour time per unit.
The type of performance standard (option B) would be relevant. For example, if an ideal
standard is used there would be no extra time allowed for inefficiencies.
Option D would be relevant because it would provide information about the tasks to be
performed and the time that those tasks should take.
Similarly Option A would be relevant because the skills of the workforce will affect the way the
task is performed and the time that the task should take.
2 D An attainable standard assumes efficient levels of operation, but includes allowances for normal
loss, waste and machine downtime.
Option A describes a basic standard.
Option B describes a current standard.
Option C describes an ideal standard.
3 B Standard costing is a control technique comparing standard costs with actual costs. When the
differences between standard costs and actual costs are analysed, this is known as variance
analysis.
4 D Standard costing may be suitable when an organisation produces a large quantity of standard
products, or provides standard services. This applies to mobile phone manufacture. It does not
apply to postal services, since delivery costs vary with size and distance. It does not apply to
fashion design, which by its nature is non-standard work. It does not apply to printing, which is a
type of jobbing industry where each printing 'job' may be different.
CHAPTER 8
1 A Statement A is describing ideal standards, not basic standards.
247
CHAPTER 9
VARIANCE ANALYSIS
Learning objectives
Reference
Variance analysis
LO9
Define and describe a variance
LO9.1
Explain the causes of variances and associated corrective actions
LO9.2
Calculate a variance
LO9.3
Topic list
1
2
3
4
5
6
7
8
9
Variances
Direct material cost variances
Direct labour cost variances
Variable production overhead variances
Fixed production overhead variances
The reasons for cost variances
The significance of cost variances
Sales variances
Operating statements
INTRODUCTION
The actual results achieved by an organisation during a reporting period (week, month, quarter, year)
will, more than likely, be different from the expected results. The expected results are the standard
costs and revenues which we looked at in the previous chapter. Such differences may occur between
individual items, such as the cost of labour or the volume of sales, and between the total expected
profit and the total actual profit.
Management will have spent considerable time and trouble setting standards. When actual results
differ from the standards, the reasons for the differences need to be considered and the results used
to assist in attempts to attain the standards. The wise manager will use variance analysis as a method
of control.
This chapter examines variance analysis and sets out the method of calculating the variances.
We will then go on to look at the reasons for, and significance of, cost variances.
The chapter concludes by building on the basics set down in this chapter by introducing sales
variances and operating statements.
Variance
analysis
Cost
variances
Sales
variances
Direct material
cost variances
Operating
statements
Direct labour
cost variances
Variable production
overhead variances
Fixed production
overhead variances
Reasons for
cost variances
Significance of
cost variances
VARIANCE ANALYSIS | 249
BEFORE YOU BEGIN

area.
everything covered.
1 What is a variance?
(Section 1)
2 What is a direct material total variance?
(Section 2)
3 What effect do opening and closing inventories have on material variances?
(Section 2.2)
4 The direct labour total variance can be subdivided into which two variances?
(Section 3)
5 The variable production overhead total variance can be subdivided into which two variances?
(Section 4)
6 In an absorption costing system, the fixed production overhead total variance can be subdivided
into which two variances?
(Section 5)
7 State reasons for cost variances arising.
(Section 6)
8 Explain the relevance of materiality and controllability when deciding whether or not a variance
should be investigated.
(Section 7)
9 How is selling price variance calculated?
(Section 8.1)
10 How is sales volume profit variance calculated?
(Section 8.2)
(Section 9)
CHAPTER 9
11 Draw a proforma operating statement reconciling budgeted profit and actual profit.
1 VARIANCES
Section overview
A variance is the difference between a planned, budgeted, or standard cost and the actual
cost incurred. The same comparisons may be made for revenues. The process by which the
total difference between standard and actual results is analysed is known as variance
analysis.
LO
9.1
When actual results are better than expected results, we have a favourable variance (F). If, on the
other hand, actual results are worse than expected results, we have an unfavourable variance (U).
Variances can be divided into three main groups:
Variable cost variances
Sales variances
Fixed production overhead variances
2 DIRECT MATERIAL COST VARIANCES

2.1 INTRODUCTION
Section overview
The direct material total variance can be subdivided into the direct material price variance
and the direct material usage variance.
Direct material price variances are usually extracted at the time of the receipt of the
materials, rather than at the time of usage.
LO
9.1
The direct material total variance The direct material total variance is the difference between what
the output actually cost and what it should have cost, in terms of material. is the difference between
what the output actually cost and what it should have cost, in terms of material.
2.1.1 THE DIRECT MATERIAL PRICE VARIANCE

This is the difference between the standard cost and the actual cost for the actual quantity of material
used or purchased. In other words, it is the difference between what the material did cost and what it
should have cost.
2.1.2 THE DIRECT MATERIAL USAGE VARIANCE

This is the difference between the standard quantity of materials that should have been used for the
number of units actually produced, and the actual quantity of materials used, valued at the standard
price per unit of material. It is the difference between how much material should have been used and
how much material was used, valued at standard price.
Worked Example: Example name
Product X has a standard direct material cost as follows:
LO
9.3
10 kilograms of material Y at $10 per kilogram = $100 per unit of X.

During period 4, 1 000 units of X were manufactured, using 11 700 kilograms of material Y which cost
$98 600.
Calculate the following variances:

a. The direct material total variance
b. The direct material price variance
c. The direct material usage variance
Solution
a. The direct material total variance
This is the difference between what 1 000 units should have cost and what they did cost.
1 000 units should have cost ( $100)
but did cost
Direct material total variance
$
100 000
98 600
1 400 (F)
The variance is favourable because the units cost less than they should have cost.
Now we can break down the direct material total variance into its two constituent parts: the direct
material price variance and the direct material usage variance.
b. The direct material price variance
This is the difference between what 11 700 kgs should have cost and what 11 700 kgs did cost.
11 700 kgs of Y should have cost ( $10)
but did cost
Material Y price variance
$
117 000
98 600
18 400 (F)
The variance is favourable because the material cost less than expected.
c. The direct material usage variance
This is the difference between how many kilograms of Y should have been used to produce 1 000
units of X and how many kilograms were used, valued at the standard cost per kilogram.
1 000 units should have used ( 10 kgs)
but did use
Usage variance in kgs
standard price per kilogram
Usage variance in $
10 000 kgs
11 700 kgs
1 700 kgs (U)
$10
$17 000 (U)
The variance is unfavourable because more material than the standard quantity was used.
Price variance
Usage variance
Total variance
$
18 400 (F)
17 000 (U)
1 400 (F)
2.2 MATERIALS VARIANCES AND OPENING AND CLOSING INVENTORY

Direct material price variances are usually extracted at the time of the receipt of the materials rather
than at the time of usage. .
Suppose that a company uses raw material P in production, and that this raw material has a standard
price of $3 per metre. During one month 6 000 metres are bought for $18 600, and 5 000 metres are
used in production. At the end of the month, inventory will have been increased by 1 000 metres. In
variance analysis, the problem is to decide the material price variance. Should it be calculated on the
basis of materials purchased (6 000 metres) or on the basis of materials used (5 000 metres)?
The answer to this problem depends on how closing inventories of the raw materials will be valued.
a. If they are valued at standard cost, (1 000 units at $3 per unit) the price variance is calculated on
material purchases in the period.
CHAPTER 9
d. Summary
b. If they are valued at actual cost (FIFO) (1 000 units at $3.10 per unit) the price variance is calculated
on materials used in production in the period.
A full standard costing system is usually in operation and therefore the price variance is usually
calculated on purchases in the period. The variance on the full 6 000 metres will be written off to the
costing income statement, even though only 5 000 metres are included in the cost of production.
There are two main advantages in extracting the material price variance at the time of receipt.
a. If variances are extracted at the time of receipt they will be brought to the attention of managers
earlier than if they are extracted as the material is used. If it is necessary to correct any variances
then management action can be more timely.
b. Since variances are extracted at the time of receipt, all inventories will be valued at standard
price. This is administratively easier and it means that all issues from inventory can be made at
standard price. If inventories are held at actual cost it is necessary to calculate a separate price
variance on each batch as it is issued. Since issues are usually made in a number of small batches
this can be a time-consuming task, especially with a manual system.
The price variance would be calculated as follows:
6 000 metres of material P purchased should cost ( $3)
but did cost
Price variance
$
18 000
18 600
600 (U)
3 DIRECT LABOUR COST VARIANCES

Section overview
The direct labour total variance can be subdivided into the direct labour rate variance and
the direct labour efficiency variance.
If idle time arises, it is usual to calculate a separate idle time variance, and to base the
calculation of the efficiency variance on active hours, when labour actually worked, only. It is
always an unfavourable variance.
LO
9.1
The direct labour total variance is the difference between what the output should have cost and
what it did cost, in terms of labour.
The direct labour rate variance. This is similar to the direct material price variance. It is the difference
between the standard rate and the actual rate for the actual number of hours paid for.
It is the difference between what the labour did cost and what it should have cost.
The direct labour efficiency variance is similar to the direct material usage variance. It is the
difference between the hours that should have been worked for the number of units actually
produced, and the actual number of hours worked, valued at the standard rate per hour.
It is the difference between how many hours should have been worked and how many hours were
worked, valued at the standard rate per hour.
The calculation of direct labour variances is very similar to the calculation of direct material variances.
Worked Example: Direct labour variances

The standard direct labour cost of product X is as follows:
LO
9.3
2 hours of grade Z labour at $5 per hour = $10 per unit of product X.

During period 4, 1 000 units of product X were made, and the direct labour cost of grade Z labour was
$8 900 for 2 300 hours of work.
a. The direct labour total variance.
b. The direct labour rate variance.
c. The direct labour efficiency (productivity) variance.
Solution
a. The direct labour total variance
This is the difference between what 1 000 units should have cost and what they did cost.
1 000 units should have cost ( $10)
but did cost
Direct labour total variance
$
10 000
8 900
1 100 (F)
The variance is favourable because the units cost less than they should have done.
Again we can analyse this total variance into its two constituent parts.
b. The direct labour rate variance
This is the difference between what 2 300 hours should have cost and what 2 300 hours did cost.
2 300 hours of work should have cost ( $5 per hr)
but did cost
Direct labour rate variance
$
11 500
8 900
2 600 (F)
The variance is favourable because the labour rate was less than the standard rate.
c. The direct labour efficiency variance
1 000 units of X should have taken ( 2 hrs)
but did take
Efficiency variance in hours
standard rate per hour
Efficiency variance in $
2 000 hrs
2 300 hrs
300 hrs (U)
$5
$1 500 (U)
d. Summary
Rate variance
Efficiency variance
Total variance
$
2 600 (F)
1 500 (U)
1 100 (F)
4 VARIABLE PRODUCTION OVERHEAD VARIANCES

Section overview
The variable production overhead total variance can be subdivided into the variable
production overhead expenditure variance and the variable production overhead efficiency
variance (based on actual hours).
CHAPTER 9
The variance is unfavourable because more hours were worked than should have been worked.
Worked Example: Variable production overhead variances

Suppose that the variable production overhead cost of product X is as follows:
2 hours at $1.50 = $3 per unit
LO
9.3
During period 6, 400 units of product X were made. The labour force worked 820 hours, of which
60 hours were recorded as idle time. The variable overhead cost was $1 230.
a. The variable overhead total variance..
b. The variable production overhead expenditure variance.
c. The variable production overhead efficiency variance.
Solution
Since this example relates to variable production costs, the total variance is based on actual units of
production. (If the overhead had been a variable selling cost, the variance would be based on sales
volumes.)
400 units of product X should cost ( $3)
but did cost
Variable production overhead total variance
$
1 200
1 230
30 (U)
In many variance reporting systems, the variance analysis goes no further, and expenditure and
efficiency variances are not calculated. However, the unfavourable variance of $30 may be explained
as the sum of two factors:
a. The hourly rate of spending on variable production overheads was higher than it should have been,
that is there is an expenditure variance.
b. The labour force worked inefficiently, and took longer to make the output than it should have
done. This means that spending on variable production overhead was higher than it should have
been, in other words there is an efficiency (productivity) variance. The variable production
overhead efficiency variance is exactly the same, in hours, as the direct labour efficiency variance,
and occurs for the same reasons.
It is usually assumed that variable overheads are incurred during active working hours, but are not
incurred during idle time (for example, the machines are not running, therefore power is not being
consumed, and no indirect materials are being used). This means in our example that although the
labour force was paid for 820 hours, they were actively working for only 760 of those hours and so
variable production overhead spending occurred during 760 hours.
The variable production overhead expenditure variance is the difference between the amount of
variable production overhead that should have been incurred in the actual hours actively worked, and
the actual amount of variable production overhead incurred.
a.
760 hours of variable production overhead should cost ( $1.50)
but did cost
Variable production overhead expenditure variance
$
1 140
1 230
90 (U)
The variable production overhead efficiency variance. If you already know the direct labour
efficiency variance, the variable production overhead efficiency variance is exactly the same in
hours, but priced at the variable production
b. In our example, the efficiency variance would be as follows

400 units of product X should take ( 2hrs)
but did take (active hours)
Variable production overhead efficiency variance in hours
Variable production overhead efficiency variance in $
800 hrs
760 hrs
40 hrs (F)
$1.50
$60 (F)
c. Summary
Variable production overhead expenditure variance
Variable production overhead efficiency variance
Variable production overhead total variance
$
90 (U)
60 (F))
30 (U)
5 FIXED PRODUCTION OVERHEAD VARIANCES

Section overview
The fixed production overhead total variance can be subdivided into an expenditure
variance and a volume variance. The fixed production overhead volume variance can be
further subdivided into an efficiency and capacity variance.
LO
9.1
You may have noticed that the method of calculating cost variances for variable cost items is
essentially the same for labour, materials and variable overheads. Fixed production overhead
variances are very different. In an absorption costing system, they are an attempt to explain the
under- or over-absorption of fixed production overheads in production costs.
The fixed production overhead total variance (i.e. the under- or over-absorbed fixed production
overhead) may be broken down into two parts as usual:
An expenditure variance.
A volume variance.
You will find it easier to calculate and understand fixed overhead variances, if you keep in mind the
whole time that you are trying to 'explain' (put a name and value to) any under- or over-absorbed
overhead.
5.1 UNDER OR OVER-ABSORPTION

Budgeted fixed overhead

Budgeted activity level
The budgeted fixed overhead is the planned or expected fixed overhead and the budgeted activity
level is the planned or expected activity level.
If either of the following budget estimates are incorrect, then we will have an under- or overabsorption of overhead.
The numerator (number on top) = Budgeted fixed overhead.
The denominator (number on bottom) = Budgeted activity level.
CHAPTER 9
The absorption rate is calculated as follows:
5.2 THE FIXED OVERHEAD EXPENDITURE VARIANCE

The fixed overhead expenditure variance occurs if the numerator is incorrect. It measures the underor over-absorbed overhead caused by the actual total expenditure on fixed overhead being different
from the budgeted total expenditure on fixed overhead.
Therefore
Fixed overhead expenditure variance = Budgeted (planned) expenditure Actual Expenditure.
5.3 THE FIXED OVERHEAD VOLUME VARIANCE

The fixed overhead volume variance arises if the denominator (i.e. the budgeted activity level or
volume) is incorrect.
The fixed overhead volume variance measures the under- or over-absorbed overhead caused by the
actual activity level being different from the budgeted activity level used in calculating the
absorption rate.
There are two reasons why the actual activity level may be different from the budgeted activity level
used in calculating the absorption rate.
a. The workforce may have worked more or less efficiently than the standard set.
b. The hours worked by the workforce could have been different to the budgeted hours, regardless of
the level of efficiency of the workforce, because of overtime, strikes and so on.
5.4 HOW TO CALCULATE THE VARIANCES

LO
9.3
In order to clarify the overhead variances which we have encountered in this section, consider the
following definitions which are expressed in terms of how each overhead variance should be
calculated.
Definition
Fixed overhead total variance is the difference between fixed overhead incurred and fixed overhead
absorbed.
Fixed overhead expenditure variance is the difference between budgeted fixed overhead
expenditure and actual fixed overhead expenditure.
Fixed overhead volume variance is the difference between actual and budgeted (planned) volume
multiplied by the standard absorption rate per unit.
You should now be ready to work through an example to demonstrate all of the fixed overhead
variances.
Worked Example: Fixed overhead variance
Suppose that a company plans to produce 1 000 units of product E during August 20X3. The expected
time to produce a unit of E is five hours, and the budgeted fixed overhead is $20 000. The standard
fixed overhead cost per unit of product E will therefore be as follows:
5 hours at $4 per hour = $20 per unit
Actual fixed overhead expenditure in August 20X3 turns out to be $20 450. The labour force manages
to produce 1 100 units of product E in the month.

a. The fixed overhead total variance.
b. The fixed overhead expenditure variance.
c. The fixed overhead volume variance.
Solution
All of the variances help to assess the under- or over absorption of fixed overheads.
a. Fixed overhead total variance
Fixed overhead incurred
Fixed overhead absorbed (1 100 units $20 per unit)
Fixed overhead total variance
(= under-/over-absorbed overhead)
$
20 450
22 000
1 550 (F)
The variance is favourable because more overheads were absorbed than budgeted.
b. Fixed overhead expenditure variance
Budgeted fixed overhead expenditure
Actual fixed overhead expenditure
Fixed overhead expenditure variance
$
20 000
20 450
450 (U)
The variance is unfavourable because actual expenditure was greater than budgeted expenditure.
c. Fixed overhead volume variance
The production volume achieved was greater than expected. The fixed overhead volume variance
measures the difference at the standard rate.
$
Actual production at standard rate (1 100 $20 per unit)
Budgeted production at standard rate (1 000 $20 per unit)
Fixed overhead volume variance
22 000
20 000
2 000 (F)
The variance is favourable because output was greater than expected.

i. The labour force may have worked efficiently, and produced output at a faster rate than
expected. Since overheads are absorbed at the rate of $20 per unit, more will be absorbed if
units are produced more quickly.
ii. The labour force may have worked longer hours than budgeted, and therefore produced more
output.
Expenditure variance
Volume variance
Over-absorbed overhead (total variance)
$
450 (U)
2 000 (F)
$1 550 (F)
In general, a favourable cost variance will arise if actual results are less than expected results. Be
aware, however, of the fixed overhead volume variance which gives rise to favourable and
unfavourable variances in the following situations:
A favourable fixed overhead volume variance occurs when actual production is greater than
budgeted (planned) production.
An unfavourable fixed overhead volume variance occurs when actual production is less than
budgeted (planned) production.
Do not worry if you find fixed production overhead variances more difficult to grasp than the other
variances we have covered. Most students do. Read over this section again and then try the following
practice questions.
CHAPTER 9
The variances may be summarised as follows:
Question 1, 2 and 3: Common information
The following information relates to the questions shown below.

Barbados has prepared the following standard cost information for one unit of Product Zeta.
Direct materials
Direct labour
Fixed overheads
4kg @ $10/kg
2 hours @ $4/hour
3 hours @ $2.50
$40.00
$8.00
$7.50
The fixed overheads are based on a budgeted expenditure of $75 000 and budgeted activity of 30 000
hours.
Actual results for the period were recorded as follows:
Production
Materials 33 600 kg
Labour 16 500 hours
Fixed overheads
9 000 units
$336 000
$68 500
$70 000
Question 1: Material variances Question here
The direct material price and usage variances are:
A
B
C
D
Material price
$
24 000 (F)
24 000 (U)
Material usage
$
24 000 (F)
24 000 (U)
Question 2: Labour variances
The direct labour rate and efficiency variances are:
A
B
C
D
Labour rate
$
2 500 (U)
2 500 (F)
6 000 (U)
6 000 (F)
Labour efficiency
$
6 000 (F)
6 000 (U)
2 500 (F)
2 500 (U)
Question 3: Overhead variances
The total fixed production overhead variance is

A $2 500 (U).
B $2 500 (F).
C $5 000 (U).
D $5 000 (F).
6 THE REASONS FOR COST VARIANCES

Section overview
There are many possible reasons for cost variances arising, including changes in the price
or use of material, the availability of labour and the efficiency of machinery.
LO
9.2
VARIANCE
FAVOURABLE
UNFAVOURABLE
Material price
Unforeseen discounts received
Price increase
Discounts obtained in purchasing
Careless purchasing
Change in material standard
Change in supply and demand of raw

materials (supply exceeds demand)

materials (demand exceeds supply)
Material used of higher quality than

standard
Defective material
More effective use made of material
Theft
Errors in allocating material to jobs
Stricter quality control
Material usage
Excessive waste

Labour rate
Use of apprentices or other workers at a

rate of pay lower than standard.
Idle time
Wage rate increase.

Use of higher grade labour.
Machine breakdown
Non availability of material
Illness or injury to worker
Under-utilisation of assets
Labour efficiency
Output produced more quickly than

expected because of work motivation,
better quality of equipment or materials,
or improved processes.
Errors in allocating time to jobs.
Higher asset utilisation than planned.
Lost time in excess of standard

allowed.
Output lower than standard set
because of deliberate restriction, lack
of training, or sub standard material
used.
Errors in allocating time to jobs.
Overhead expenditure
Savings in costs incurred
Increase in cost of services used.
More economical use of services.
Excessive use of services.
Labour force working more efficiently

(favourable labour efficiency variance).
Labour force working overtime.
Labour force working less efficiently

(unfavourable labour efficiency
variance).
Machine breakdown, strikes, labour
shortages.
This is not an exhaustive list and in a question you should review the information given in order to
analyse possible reasons for variances.
7 THE SIGNIFICANCE OF COST VARIANCES

Section overview
Materiality, controllability, the type of standard being used, the interdependence of
variances and the cost of an investigation should be taken into account when deciding
whether to investigate reported variances.
CHAPTER 9
Change in type of services used.

Overhead volume
LO
9.2
Once variances have been calculated, management have to decide whether or not to investigate their
causes. It would be extremely time consuming and expensive to investigate every variance, therefore
managers have to decide which variances are worthy of investigation.
There are a number of factors which can be taken into account when deciding whether or not a
variance should be investigated.
a. Materiality. A standard cost is an average expected cost and is not a rigid specification. Small
variations either side of this average are therefore bound to occur. The problem is to decide
whether a variation from standard should be considered significant and worthy of investigation.
Tolerance limits can be set and only variances which exceed such limits would require
investigating.
b. Controllability. Some types of variance may not be controllable even once their cause is
discovered. For example, if there is a general worldwide increase in the price of a raw material
there are limited actions that can be taken to mitigate the impact on costs. If a central decision is
made to award all employees a 10% increase in salary, staff costs in division A will increase by this
amount and the variance is not controllable by division A's manager. Uncontrollable variances call
for a change in the plan, not an investigation into the past.
c. The type of standard being used.
i. The efficiency variance reported in any control period, whether for materials or labour, will
depend on the efficiency level set. If, for example, an ideal standard is used, variances will
always be unfavourable.
ii. A similar problem arises if average price levels are used as standards. If inflation exists,
favourable price variances are likely to be reported at the beginning of a period, to be offset by
unfavourable price variances later in the period as inflation pushes prices up.
d. Interdependence between variances. Individual variances should not be looked at in isolation.
One variance might be inter-related with another, and much of it might have occurred only
because the other, inter-related, variance occurred too. We will investigate this issue further in a
moment.
e. Costs of investigation. The costs of an investigation should be weighed against the benefits of
correcting the cause of a variance.
The investigation of variances and the need for control action is discussed further in Chapter 12.
7.1 INTERDEPENDENCE BETWEEN VARIANCES

When two variances are interdependent (interrelated) one will often be unfavourable and the other
one favourable.
7.2 INTERDEPENDENCE MATERIALS PRICE AND USAGE VARIANCES

It may be decided to purchase cheaper materials for a job in order to obtain a favourable price
variance. This may lead to higher materials wastage than expected and therefore, unfavourable usage
variances occur. If the cheaper materials are more difficult to handle, there might be some
unfavourable labour efficiency variance too.
If a decision is made to purchase more expensive materials, which perhaps have a longer service life,
the price variance will be unfavourable but the usage variance might be favourable.
7.3 INTERDEPENDENCE LABOUR RATE AND EFFICIENCY VARIANCES

If employees in a workforce are paid higher rates for experience and skill, using a highly skilled team
should incur an unfavourable rate variance at the same time as a favourable efficiency variance. In
contrast, a favourable rate variance might indicate a high proportion of inexperienced workers in the
workforce, which could result in an unfavourable labour efficiency variance and possibly an
unfavourable materials usage variance, due to high rates of rejects.
Question 4: Causes of variance
A large unfavourable direct labour efficiency variance has been reported. Which TWO of the following
might be causes of the variance?
I
Using expensive skilled labour
II Using poor quality direct materials

III Using a target standard cost for the labour efficiency standard
IV Working overtime
A I and III only
B I and IV only
C II and III only
D II and IV only
Question 5: Investigation of variances
List the factors which should be taken into account when deciding whether or not a variance should be
investigated.
8 SALES VARIANCES
Section overview
The selling price variance is a measure of the effect on expected profit of a different selling
price to standard selling price. The sales volume profit variance is the difference between
the actual units sold and the budgeted (planned) quantity, valued at the standard profit per
unit.
8.1 SELLING PRICE VARIANCE
LOs
9.1
9.3
The selling price variance is a measure of the effect on expected profit of a different selling price to
standard selling price. It is calculated as the difference between what the sales revenue should have
been for the actual quantity sold, and what it was.
Suppose that the standard selling price of product X is $15. Actual sales in 20X3 were 2 000 units at
$15.30 per unit.
The selling price variance is calculated as follows:
Sales revenue from 2 000 units should have been ( $15)
but was ( $15.30)
Selling price variance
$
30 000
30 600
The variance calculated is favourable because the price was higher than expected.
600 (F)
CHAPTER 9
Definition
8.2 SALES VOLUME PROFIT VARIANCE

Definition
LOs
9.1
9.3
The sales volume profit variance is the difference between the actual units sold and the budgeted
(planned) quantity, valued at the standard profit per unit. In other words, it measures the increase or
decrease in standard profit as a result of the sales volume being higher or lower than budgeted
(planned).
Suppose that a company budgets to sell 8,000 units of product J for $12 per unit. The standard full
cost per unit is $7. Actual sales were 7,700 units, at $12.50 per unit.
The sales volume profit variance is calculated as follows:
8 000 units
7 700 units
300 units (U)
$5
Budgeted sales volume

Actual sales volume
Sales volume variance in units
standard profit per unit ($(127))
Sales volume variance
$1 500 (U)
The variance calculated above is unfavourable because actual sales were less than budgeted
(planned).
Question 6: Selling price variance
Jasper Co has the following budget and actual figures for 20X4:
Budget
600
$30
Sales units
Actual
620
$29
Standard full cost of production = $28 per unit.

What are the selling price variance and the sales volume profit variances?
A
B
C
D
Sales price
$
600 (U)
600 (U)
620 (U)
620 (U)
Sales volume
$
20 (F)
40 (F)
20 (F)
40 (F)
8.3 THE SIGNIFICANCE OF SALES VARIANCES

The following table suggests some possible causes for the existence of sales variances:
VARIANCE
FAVOURABLE
UNFAVOURABLE
Sales price
Price increase to cover unforeseen costs.
Price cut to stimulate demand due to

increase in competition.
Price increase following increased

demand.
Price increase to reflect increased
product/service quality
Sales volume
Increased sales resulting from a new

advertising campaign or a change in
perception of the product by the public.
Unexpected slump in the economy/demand

for the product.
The possible interdependence between sales price and sales volume variances should be obvious to
you. A reduction in the sales price might stimulate bigger sales demand, so that an unfavourable sales
price variance might be counterbalanced by a favourable sales volume variance. Similarly, a price rise
would give a favourable price variance, but possibly at the cost of a fall in demand and an
unfavourable sales volume variance.
It is important in analysing an unfavourable sales variance that the overall consequence should be
considered, for example, has there been a counterbalancing favourable variance as a direct result of
the unfavourable one?
9 OPERATING STATEMENTS
Section overview
Operating statements show how the combination of variances reconcile budgeted profit
and actual profit.
So far, we have considered how variances are calculated without considering how they combine to
reconcile the difference between budgeted profit and actual profit during a period. This reconciliation
is usually presented as a report to senior management at the end of each control period. The report is
called an operating statement or statement of variances.
Definition
An operating statement is a regular report for management of actual costs and revenues, usually
showing variances from budget.
An extensive example will now be introduced, both to revise the variance calculations already
described, and also to show how to combine them into an operating statement.
Worked Example: Example name
Sydney manufactures one product, and the entire product is sold as soon as it is produced. There are
no opening or closing inventories and work in progress is negligible. The company operates a
standard costing system and analysis of variances is made every month. The standard cost card for the
product, a boomerang, is as follows:
Direct materials
Direct wages
Variable overheads
Fixed overhead
Standard cost
Standard profit
Standing selling price
0.5 kilos at $4 per kilo

2 hours at $2.00 per hour
$
2.00
4.00
0.60
7.40
14.00
6.00
20.00
Selling and administration expenses are not included in the standard cost, and are deducted from
profit as a period charge.
CHAPTER 9
STANDARD COST CARD BOOMERANG
Budgeted (planned) output for the month of June 20X7 was 5 100 units. Actual results for June 20X7
were as follows:
Production of 4 850 units was sold for $95 600.
Materials consumed in production amounted to 2 300 kgs at a total cost of $9 800.
Labour hours paid for amounted to 8 500 hours at a cost of $16 800.
Actual operating hours amounted to 8 000 hours.
Variable overheads amounted to $2 600.
Fixed overheads amounted to $42 300.
Selling and administration expenses amounted to $18 000.
Calculate all variances and prepare an operating statement for the month ended 30 June 20X7.
Solution
a.
b.
2 300 kg of material should cost ( $4)

but did cost
Material price variance
4 850 boomerangs should use ( 0.5 kgs)
but did use
Material usage variance in kgs
standard price per kg
Material usage variance in $
c.
d.
8 500 hours of labour should cost ( $2)

but did cost
Labour rate variance
4 850 boomerangs should take ( 2 hrs)
but did take (active hours)
Labour efficiency variance in hours
Labour efficiency variance in $
e.
f.
g.
Idle time variance 500 hours (U) $2

8 000 hours incurring variable o/hd expenditure should cost ( $0.30)
but did cost
Variable overhead expenditure variance
Variable overhead efficiency variance in hours is the same as the
labour efficiency variance:
1 700 hours (F) $0.30 per hour
h.
Budgeted fixed overhead (5 100 units 2 hrs $3.70)

Actual fixed overhead
i.
Actual production at standard rate (4 850 $3.70 2)

Budgeted production at standard rate (5 100 $3.70 2)
Fixed overhead volume variance in $
j.
Revenue from 4 850 boomerangs should be ( $20)

but was
Actual sales volume
Sales volume profit variance in units
k.
standard profit per unit

Sales volume profit variance in $
$
9 200
9 800
600 (U)
2 425 kgs
2 300 kgs
125 kg (F)
$4
$ 500 (F)
$
17 000
16 800
200 (F)
$
9 700 hrs
8 000 hrs
1 700 hrs (F)
$2
$3 400 (F)
$1 000 (U)
$
2 400
2 600
200 (U)
$ 510 (F)
$
37 740
42 300
4 560 (U)
$
35 890
37 740
1 850 (U)
$
97 000
95 600
1 400 (U)
5 100 units
4 850 units
250 units
$6 (U)
$1 500 (U)
There are several ways in which an operating statement may be presented. Perhaps the most
common format is one which reconciles budgeted profit to actual profit. In this example, sales and
administration costs will be introduced at the end of the statement, so that we shall begin with
'budgeted profit before sales and administration costs'.
Sales variances are reported first, and the total of the budgeted profit and the two sales variances
results in a figure for 'actual sales minus the standard cost of sales'. The cost variances are then
reported, and an actual profit before sales and administration costs calculated. Sales and
administration costs are then deducted to reach the actual profit for June 20X7.
SYDNEY OPERATING STATEMENT JUNE 20X7
$
Budgeted (planned) profit before sales and administration costs
Sales variances:
price
volume
1 400 (U)
1 500 (U)
2 900 (U)
27 700
Actual sales minus the standard cost of sales

(F)
$
(U)
$
600
500
200
3 400
1 000
200
510
4 610
Actual profit before sales and
administration costs
Sales and administration costs
Actual profit, June 20X7
Check:
Sales
Materials
Labour
Variable overheads
Fixed overhead
Sales and administration
Actual profit
4 560
1 850
8 210
3 600 (U)
24 100
18 000
6 100
95 600
9 800
16 800
2 600
42 300
18 000
89 500
6 100
CHAPTER 9
Cost variances
Material price
Material usage
Labour rate
Labour efficiency
Labour idle time
Variable overhead expenditure
Variable overhead efficiency
Fixed overhead expenditure
Fixed overhead volume
$
30 600
KEY CHAPTER POINTS

A variance is the difference between a planned, budgeted, or standard cost and the actual cost
incurred. The same comparisons can be made for revenues. The process by which the total
difference between standard and actual results is analysed is known as variance analysis.
The direct material total variance can be subdivided into the direct material price variance and the
direct material usage variance.
Direct material price variances are usually extracted at the time of receipt of the materials, rather
than at the time of usage.
The direct labour total variance can be subdivided into the direct labour rate variance and the
direct labour efficiency variance.
If idle time arises, it is usual to calculate a separate idle time variance, and to base the calculation
of the efficiency variance on active hours, when labour actually worked, only. It is always an
unfavourable variance.
The variable production overhead total variance can be subdivided into the variable production
overhead expenditure variance and the variable production overhead efficiency variance, based on
active hours.
In an absorption costing system, the fixed production overhead total variance can be subdivided
into an expenditure variance and a volume variance.
There are many possible reasons for cost variances arising, including changes in the price or use of
material, the availability of labour and the efficiency of machinery.
Materiality, controllability, the type of standard being used, the interdependence of variances and
the cost of an investigation should be taken into account when deciding whether to investigate
reported variances.
The selling price variance is a measure of the effect on expected profit of a different selling price to
standard selling price.
The sales volume profit variance is the difference between the actual units sold and the budgeted
(planned) quantity, valued at the standard profit per unit. In other words, it measures the increase
or decrease in standard profit as a result of the sales volume being higher or lower than budgeted
(planned).
Operating statements show how the combination of variances reconciles budgeted profit and
actual profit.

THE FOLLOWING INFORMATION RELATES TO QUESTIONS 1 TO 3
A company expected to produce 200 units of its product, the Bone, in 20X3. The actual number
produced was 260 units. The standard labour cost per unit was $70 (10 hours at a rate of $7 per hour).
The actual labour cost was $18 600 and the number of hours worked was 2 200 hours although 2 300
hours were paid.
1 What is the direct labour rate variance for the company in 20X3?
A $400 (U)
B $2 500 (F)
C $2 500 (U)
D $3 200 (U)
2 What is the direct labour efficiency variance for the company in 20X3?
A $400 (U)
B $2 100 (F)
C $2 800 (U)
D $2 800 (F)
3 What is the idle time variance?
A $700 (F)
B $700 (U)
C $809 (U)
D $809 (F)
4 A company has budgeted to make and sell 4 200 units of product X during a period.
The standard fixed overhead cost per unit is $4.
During the period covered by the budget, the actual results were as follows:
Production and sales
Fixed overhead incurred
5 000 units
$17 500
A
B
C
D
Fixed overhead
expenditure variance
$700 (F)
$700 (F)
$700 (U)
$700 (U)
Fixed overhead
volume variance
$3 200 (F)
$3 200 (U)
$3 200 (F)
$3 200 (U)
5 A company has a budgeted material cost of $125 000 for the production of 25 000 units per month.
Each unit is budgeted to use 2 kgs of material. The standard cost of material is $2.50 per kg.
Actual materials in the month cost $136 000 for 27 000 units and 53 000 kgs were purchased and
used.
What was the favourable material usage variance?
A $2 500
B $4 000
C $7 500
D $10 000
CHAPTER 9
The fixed overhead variances for the period were:
A company operating a standard costing system has the following direct labour standards per unit for
one of its products:
Last month when 2 195 units of the product were manufactured, the actual direct labour cost for the 9
200 hours worked was $110 750.
6 What was the direct labour rate variance for last month?
A $4 250 favourable
B $4 250 unfavourable
C $5 250 favourable
D $5 250 unfavourable
7 What was the direct labour efficiency variance for last month?
A $4 250 favourable
B $4 250 unfavourable
C $5 250 favourable
D $5 250 unfavourable
8 PQ Limited currently uses a standard absorption costing system. The fixed overhead variances
extracted from the operating statement for November are:
Fixed production overhead expenditure variance
Fixed production overhead volume variance
$
5 800 unfavourable
2 800 favourable
PQ Limited is considering using standard marginal costing as the basis for variance reporting in
future. What variance for fixed production overhead would be shown in a marginal costing
operating statement for November?
A No variance
B Volume variance: $2 800 favourable
C Total variance: $3 000 unfavourable
D Expenditure variance: $5 800 unfavourable

1 C
$
16 100
18 600
2 500 (U)
2 300 hours should have cost ( $7)

but did cost
Rate variance
Option A is the total direct labour cost variance.

If you selected option B you calculated the correct dollar value of the variance but you
misinterpreted its direction.
If you selected option D you based your calculation on the 2 200 hours worked, but 2 300 hours
were paid for and these hours should be the basis for the calculation of the rate variance.
2 D
2 600 hrs
2 200 hrs
400 hrs (F)
$7
$2 800 (F)
260 units should have taken ( 10 hrs)

but took (active hours)
Efficiency variance in hours
Efficiency variance in $
Option A is the total direct labour cost variance. If you selected option B you based your
calculations on the 2,300 hours paid for; but efficiency measures should be based on the active
hours only, i.e. 2 200 hours.
If you selected option C you calculated the correct dollar value of the variance but you
misinterpreted its direction.
3 B Idle time hours (2 300 2 200) standard rate per hour
= 100 hrs $7
= $700 (U)
If you selected option A you calculated the correct dollar value of the variance but you
misinterpreted its direction. The idle time variance is always unfavourable.
If you selected options C or D you evaluated the idle time at the actual hourly rate instead of
the standard hourly rate.
4 C Fixed overhead expenditure variance
$
16 800
17 500
700 (U)
The variance is unfavourable because the actual expenditure was higher than the amount
budgeted.
Actual production at standard rate (5 000 $4 per unit)
Budgeted production at standard rate (4 200 $4 per unit)
$
20 000
16 800
3 200 (F)
The variance is favourable because the actual volume of output was greater than the budgeted
volume of output.
If you selected an incorrect option you misinterpreted the direction of one or both of the
variances.
CHAPTER 9
Budgeted fixed overhead expenditure (4 200 units $4 per unit)

Actual fixed overhead expenditure
5 A
27 000 units should use ( 2 kg)
but did use
Material usage variance
$
54 000 kg
53 000 kg
1 000 kg (F)
2.5
2 500 (F)
6 A
9 200 hours should have cost ( $12.50)
but did cost
$
115 000
110 750
4 250 (F)
7 D
2 195 units should have taken ( 4 hours)
but did take
Direct labour efficiency variance (in hours)
standard rate pre hour
8 780 hours
9 200 hours
420 hours (U)
12.50
5 250 (U)
8 D The only fixed overhead variance in a marginal costing statement is the fixed overhead
expenditure variance. This is the difference between budgeted and actual overhead
expenditure, calculated in the same way as for an absorption costing system.
There is no volume variance with marginal costing, because under or over absorption due to
volume changes cannot arise.

1 A Material price variance
33 600 kg should have cost ( $10/kg)
and did cost
$
336 000
336 000
Material usage variance

9 000 units should have used ( 4kg)
but did use
standard cost per kg
36 000 kg
33 600 kg
2 400 kg (F)
$10
24 000 (F)
2 A
16 500 hrs should have cost ( $4)
but did cost
$
66 000
68 500
2 500 (U)
Direct labour efficiency variance

9 000 units should have taken ( 2 hrs)
but did take
standard rate per hour ( $4)
18 000 hrs
16 500 hrs
1 500 (F)
$4
6 000 (F)
3 A
Fixed production overhead absorbed ($7.50 9 000)
Fixed production overhead incurred
$
67 500
70 000
2 500 (U)
Materiality, controllability, type of standard being used, interdependence between variances

and costs of investigation.
6 D
Sales revenue for 620 units should have been ( $30)
but was ( $29)
Actual sales volume
Sales volume variance in units
standard profit per unit ($(30 28))
Sales volume profit variance
$18 600
$17 980
$620 (U)
600 units
620 units
20 units (F)
$2
$40 (F)
CHAPTER 9
4 C If a target standard rather than a current standard is used, unfavourable variances will occur until
the target is achieved. Poor quality materials may slow down work, and possibly increase
wastage/rejection rates. This will cause labour inefficiency. Using expensive skilled labour
should be expected to result in favourable efficiency variances. There should be no connection
between labour efficiency and whether work is done in normal time or overtime.
273
CHAPTER 10
CAPITAL EXPENDITURE
Learning objectives
Reference
Capital expenditure
LO10
Analyse capital expenditure decisions in organisations using relevant tools and

techniques
LO10.1
Apply capital expenditure analysis to project planning and managing uncertain

scenarios through scenario analysis
LO10.2
Decision making
LO2
Identify the quantitative and qualitative criteria involved in accepting a project
LO2.3
Analyse the challenges posed by differences between a project and an organisation's

risk profiles
LO2.4
LO2.5
Topic list
1
2
3
4
5
The process of investment decision making

Post-completion audit
The payback method
The accounting rate of return method
Risk and uncertainty in decision making
INTRODUCTION
This chapter is an introduction to the appraisal of projects which involve the outlay of capital.
Capital expenditure differs from day-to-day revenue expenditure for two reasons:
Capital expenditure often involves a bigger outlay of money.
The benefits from capital expenditure are likely to accrue over a long period of time, usually well
over one year and often much longer. In such circumstances the benefits cannot all be set against
costs in the current year's income statement.
For these reasons any proposed capital expenditure project should be properly appraised, and found
to be worthwhile, before the decision is taken to go ahead with the expenditure.
We begin the chapter with an overview of the investment decision-making process, before moving on
to examine two capital investment appraisal techniques, the straightforward payback method and the
slightly more involved accounting rate of return method.
We conclude by looking at uncertainty and risk. Decision making involves making decisions now about
what will happen in the future. Ideally, the decision maker would know with certainty what the future
consequences would be for each choice faced. But, in reality, decisions must be made in the
knowledge that their consequences, although perhaps probable, are rarely totally certain.
Capital
expenditure
The process
Payback
method
Post audit
ARR method
Risk and
uncertainty
CAPITAL EXPENDITURE | 275
BEFORE YOU BEGIN

area.
everything covered.
1 A typical model for investment decision making has a number of distinct stages.
(Section 1.2)
What are they?

3 What is a post-completion audit?
(Section 1.5)
(Section 2)
4 Why perform a post-completion appraisal?
(Section 2.1)
5 Which projects should be audited?
(Section 2.2)
6 Who should perform a post-completion audit (PCA)?
(Section 2.4)
7 Define the payback method of investment appraisal.
(Section 3)
8 What are the disadvantages of the payback method?
(Section 3.2)
9 What are the advantages of the payback method?
(Section 3.3)
10 What are the formulae that can be used for ARR?
(Section 4)
11 What are the drawbacks and advantages to the ARR method of project appraisal?
(Section 4.2)
12 What are risk and uncertainty?
(Section 5.1)
CHAPTER 10
2 What are steps involved in the analysis stage of investment decision making?
1 THE PROCESS OF INVESTMENT DECISION

MAKING
Section overview
A typical model for investment decision making has a number of distinct stages:
Origination of proposals
Project screening
Analysis and acceptance
Monitoring and review
During the project's progress, project controls should be applied.
1.1 CREATION OF CAPITAL BUDGETS

LO
10.1
The capital budget will normally be prepared to cover a longer period than sales, production and
resource budgets, from three to five years, although it should be broken down into periods matching
those of other budgets. It should indicate the expenditure required to cover capital projects already
underway and those it is anticipated will start in the three to five year period of the capital budget.
The budget should therefore be based on the current production budget, future expected levels of
production and the long-term development of the organisation, and industry, as a whole.
Budget limits or constraints might be imposed internally (soft capital rationing) or externally (hard
capital rationing).
Projects can be classified in the budget into those that generally arise from top management policy
decisions or from sources such as mandatory government regulations (health, safety and welfare
capital expenditure) and those that tend to be appraised using the techniques covered in this chapter.
a. Cost reduction and replacement expenditure.
b. Expenditure on the expansion of existing product lines.
c. New product expenditure.
The administration of the capital budget is usually separate from that of the other budgets. Overall
responsibility for authorisation and monitoring of capital expenditure is, in most large organisations,
the responsibility of a committee.
1.2 THE INVESTMENT DECISION MAKING PROCESS

LO
2.3
Capital expenditure often involves the outlay of large sums of money, and expected benefits may
take a number of years to accrue. For these reasons it is vital that capital expenditure is subject to a
rigorous process of appraisal and control.
Origination of proposals
Project screening
Analysis and acceptance
Monitoring and review
We will look at these stages in more detail below.
1.3 ORIGINATION OF PROPOSALS

Investment opportunities must be sought where appropriate to ensure an organisation either gains or
maintains competitive advantage. An organisation must set up processes to ensure that the
environment is scanned for potential opportunities and gives an early warning of future
problems. Such processes may include seeking external professional advice, carrying out scenario
planning and holding regular internal meetings where interested parties can bring suggestions. A
technological change that might result in a drop in sales might be picked up by this scanning process,
and steps should be taken immediately to respond to such a threat.
Ideas for investment might come from those working in technical positions. A factory manager, for
example, could be well placed to identify ways in which expanded capacity or new machinery could
increase output or the efficiency of the manufacturing process. Innovative ideas, such as new product
lines, are more likely to come from those in higher levels of management, given their strategic view of
the organisation's direction and their knowledge of the competitive environment.
The overriding feature of any proposal is that it should be consistent with the organisation's overall
strategy to achieve its objectives.
1.4 PROJECT SCREENING

Each proposal must be subject to detailed screening. A qualitative evaluation may occur, using
questions such as those below, before any financial analysis is undertaken. Only if the project passes
this initial screening will more detailed financial analysis begin.
a. What is the purpose of the project?
b. Does it 'fit' with the organisation's long-term objectives?
c. Is it a mandatory investment, for example, to conform with safety legislation?
d. What resources are required and are they available, e.g. money, capacity, labour?
e. Do we have the necessary management expertise to guide the project to completion?
f. Does the project expose the organisation to unnecessary risk?
g. How long will the project last and what factors are key to its success?
h. Have all possible alternatives been considered?
1.5 ANALYSIS AND ACCEPTANCE

Step 1
Complete and submit standard format financial information as a formal investment

proposal.
Step 2
Classify the project by type to separate projects into those that require more or less
rigorous financial appraisal, and those that must achieve a greater or lesser rate of return
in order to be deemed acceptable.
Step 3
Carry out financial analysis of the project. We look at this in more detail below.
Step 4
Compare the outcome of the financial analysis to predetermined acceptance criteria.
Step 5
Consider the project in the light of the capital budget for the current and future
operating periods.
Step 6
Make the decision accept/reject. This is considered in more detail below.
Step 7
Monitor the progress of the project (covered below).
The approval hierarchy for an investment will be dependent on the level of investment i.e. its
cost/value and complexity (see section 1.5.3).
Steps 1 to 6 above can be seen in the context of the decision-making process that was described in
chapter 1, section 3.7. After all, investing in capital projects involves a decision about whether to
spend, and how much to spend. Using the approach from chapter 1:
CHAPTER 10
The analysis stage can be broken down into a number of steps.
Step 1
Define the problem. The problem that leads to capital expenditure decisions may be
that existing assets are getting old and less reliable, and management want to decide
how to improve reliability and efficiency in production. The problem may be that the
organisation wants to expand the scale of its operations or diversify into a new line of
business, and to do this it needs to invest in new assets.
Step 2
Identify the decision-making criteria. There are several different ways of evaluating
investment options. As we shall see later, the decision-making criteria may be that any
new investment should earn a minimum return on capital invested, or should add value to
the business, or that any amount invested should be recovered within a given number of
years.
Step 3
Develop alternatives. With capital investment decisions, the alternatives may be

presented simply as 'Invest in a specific asset' or 'Do not invest'. However there may be
other options to consider, such as whether to buy Asset 1 or Asset 2 (which may be a
bigger and more expensive item). There may also be different options about when to
invest whether to invest now or whether to defer the spending until a later time. In the
exam, the options are likely to be either to invest or not to invest 'now'.
Step 4
Analyse the alternatives. Each of the alternatives should be analysed and evaluated,
using the chosen decision-making criterion. If the alternatives are simply either to invest
or not to invest, the analysis is carried out by evaluating the decision to invest.
Step 5
Select an alternative. If investing is worthwhile, the 'don't invest' option is rejected. If

investing seems worthwhile, the 'don't invest' option is rejected.
1.5.1 FINANCIAL ANALYSIS

The financial analysis will involve the application of the organisation's preferred investment
appraisal techniques. In many projects some of the financial implications will be extremely difficult to
quantify, but every effort must be made to do so, to have a formal basis for planning and controlling
the project.
Here are examples of the type of question that will be addressed at this stage:
a. What cash flows/profits will arise from the project and when?
b. Has inflation been considered in the determination of the cash flows?
c. What are the results of the financial appraisal?
d. Has any allowance been made for risk, and if so, what was the outcome?
Some types of project, for example, a marketing investment decision, may give rise to cash inflows
and returns which are so intangible and difficult to quantify that a full financial appraisal may not be
possible. In this case more weight may be given to a consideration of the qualitative issues.
1.5.2 QUALITATIVE ISSUES

Financial analysis of capital projects is obviously vital because of the amount of money involved and
the length of time for which it is tied up. A consideration of qualitative issues is also relevant to the
decision i.e. factors which are difficult or impossible to quantify. We have already seen that qualitative
issues would be considered in the initial screening stage, for example, in reviewing the project's 'fit'
with the organisation's overall objectives and whether it is a mandatory investment. There is a very
wide range of other qualitative issues that may be relevant to a particular project.
a. What are the implications of not undertaking the investment, e.g. adverse effect on staff morale,
loss of market share?
b. Will acceptance of this project lead to the need for further investment activity in future?
c. What will be the effect on the company's image?
d. Will the organisation be more flexible as a result of the investment, and better able to respond to
market and technology changes?
1.5.3 APPROVAL HIERARCHY

'Invest' or 'Don't invest' decisions on projects may be made at different levels within the
organisational hierarchy, depending on three factors:
a. The type of investment.
b. Its perceived riskiness.
c. The amount of expenditure required.
For example, a divisional manager may be authorised to make decisions up to $25 000, an area
manager up to $150 000 and a group manager up to $300 000, with board approval for greater
amounts.
Once the 'Invest' or 'Don't invest' decision, or accept/reject, decision has been made, the
organisation is committed to the project, and the decision maker must accept that the project's
success or failure reflects on his or her ability to make sound decisions.
1.6 MONITORING THE PROGRESS OF THE PROJECT

During the project's progress, project controls should be applied to ensure the following:
Capital spending does not exceed the amount authorised
The implementation of the project is not delayed
The anticipated benefits are eventually obtained
The first two items are easier to control than the third, because the controls can normally be applied
soon after the capital expenditure has been authorised, whereas monitoring the benefits will span a
longer period of time.
1.6.1 CONTROLS OVER EXCESS SPENDING

There are a number of controls which organisations can implement to ensure that capital spending
does not exceed the amount authorised.
a. The authority to make capital expenditure decisions must be formally assigned.
b. Capital expenditure decisions should be documented. Approval of the project should specify the
manager authorised to carry out the expenditure, and hence responsible for the successful
implementation of the project, the amount of expenditure authorised and the period of time in
which the expenditure should take place.
c. Some overspending above the amount authorised by 5% or 10% might be allowed. If the
required expenditure exceeds the amount authorised by more than this amount, a fresh
submission for reauthorisation of the project should be required.
d. A total capital budget monitors total spending. Any additional capital expenditure in excess of the
original budget would require approval via a structured capital expenditure approach.
1.6.2 CONTROL OVER DELAYS

If there is a delay in carrying out the project and the capital expenditure has not taken place before
the stated deadline is reached, the project should be resubmitted for fresh authorisation, and the
proposer should be asked to explain the reasons for the delay.
1.6.3 CONTROL OVER THE ANTICIPATED BENEFITS
A difficulty with control measurements of capital projects is that most projects are 'unique' with no
standard or yardstick to judge them against other than their own appraisal data. Therefore if actual
costs were to exceed the estimated costs, it might be impossible to tell just how much of the variance
is due to bad estimating and how much is due to inefficiencies and poor cost control.
CHAPTER 10
Further control can be exercised over capital projects by ensuring that the anticipated benefits do
actually materialise, the benefits are as big as anticipated and running costs do not exceed
expectation.
In the same way, if benefits are below expectation, is this because the original estimates were
optimistic, or because management has been inefficient and failed to get the benefits they should
have done?
Many capital projects such as the purchase of replacement assets and marketing investment decisions
do not have clearly identifiable costs and benefits. The incremental benefits and costs of such
schemes can be estimated, but it would need a very sophisticated management accounting system to
be able to identify and measure the actual benefits and many of the costs. Even so, some degree of
monitoring and control can still be exercised by means of a post-completion appraisal or audit
review.
2 POST-COMPLETION AUDIT
Section overview
A post-completion audit cannot reverse the decision to incur the capital expenditure,
because the expenditure has already taken place but it can assist with the implementation
and control of future investments.
Definition
A post-completion audit (PCA) is an objective independent assessment of the success of a capital
project in relation to plan. It covers the whole life of the project and provides feedback to managers to
aid the implementation and control of future projects. A post-completion audit is often referred to as
post-implementation audit in some countries.
The PCA is therefore is therefore a forward-looking rather than a backward-looking technique. It

seeks to identify general lessons to be learned from a project.
2.1 WHY PERFORM A POST-COMPLETION APPRAISAL (PCA) OR AUDIT?

a. The possibility of the PCA can motivate managers to work to achieve the promised benefits from
the project.
b. If the audit takes place before the project life ends, and if it finds that the benefits have been less
than expected because of management inefficiency, steps can be taken to improve efficiency.
Alternatively, it will highlight those projects which should be discontinued.
c. PCA may be incorporated into individual performance reviews for the project manager.
d. It might identify weaknesses in the forecasting and estimating techniques used to evaluate
projects, and so should help to improve the discipline and quality of forecasting for future
investment decisions.
e. Areas where improvements can be made in methods which should help to achieve better results
in general from capital investments might be revealed.
f. The original estimates may be more realistic if managers are aware that they will be monitored,
but post-completion audits should not be unfairly critical.
Research by Neale and Homes (1990) found that managers see the following advantages to PCAs:
a. They improve the quality of decision making.
b. They improve organisational performance.
c. They improve control and guidance.
d. They encourage a more realistic approach to new investment project decision making.
e. They help to identify critical success factors.
f. They enable changes to be made more quickly to projects that are not doing very well.
g. They encourage (when relevant) project termination.
2.2 WHICH PROJECTS SHOULD BE AUDITED?

A reasonable guideline might be to audit all projects above a certain size, and a random selection
of smaller projects.
A PCA does not need to focus on all aspects of an investment, but should concentrate on those
aspects which have been identified as particularly sensitive or critical to the success of a project. The
most important thing to remember is that post-completion audits are time-consuming and costly, so
careful consideration should be given to the cost-benefit trade-off arising from the post-completion
audit results.
2.3 WHEN SHOULD PROJECTS BE AUDITED?

If the audit is carried out too soon, the information may not be complete. On the other hand, if the
audit is too late then management action will be delayed and the usefulness of the information is
greatly reduced.
There is no correct answer to the question of when to audit, although research suggests that in
practice most companies perform the PCA approximately one year after the completion of the
project.
2.4 WHO PERFORMS A PCA?

Because it can be very difficult to evaluate an investment decision completely objectively, it is
generally appropriate to separate responsibility for the investment decision from that for the PCA.
Line management involved in the investment decision should therefore not carry out the PCA. To
avoid conflicts of interest, outside experts could be used.
2.5 PROBLEMS WITH PCA

a. There are many uncontrollable factors which are outside management control in long-term
investments, such as environmental changes.
b. It may not be possible to identify separately the costs and benefits of any particular project.
c. PCA can be a costly and time-consuming exercise, although 'contrary to what is often thought,
conducting a PCA does not appear to be an expensive business' reported Brantjes, von Eije,
Eusman and Prins in Management Accounting (Post-completion auditing with Heineken) in April
1999.
d. Applied punitively, post-completion audit exercises may lead to managers becoming over
cautious and unnecessarily risk averse.
e. The strategic effects of a capital investment project may take years to materialise and it may in
fact, never be possible to identify or quantify them effectively.
Despite the growth in popularity of post-completion audits, you should bear in mind the possible
alternative control processes:
a. Teams could manage a project from beginning to end, control being used before the project is
started and during its life, rather than at the end of its life.
b. More time could be spent choosing projects rather than checking completed projects.
A 1999 Management Accounting article looked at post completion auditing at Heineken (the Dutch
beer producer) and how it was applied to a project to replace a 20-year old bottling line. The
following table shows the planned objectives of the investment and the actual situation at the time a
PCA was carried out on the investment. (Guilders were the Dutch currency prior to the euro.) This
should give you an idea of the type of objectives that can be monitored with a PCA.
CHAPTER 10
Case study
OBJECTIVES
PLAN
ACTUAL
Efficiency
Increase from 65% to 80%
No increase yet
Staff savings
From 13 to 7 per shift
Achieved
Forklift savings
1 vehicle less
1 and possibly 2 vehicles less
Savings on overhaul of
old bottling line
1.3 million guilders of savings
Savings achieved, but as a result of

reusing part of the old bottling line
another 1.8 million guilders was spent in
additional overhaul costs
Savings on
maintenance
Savings of 0.4 million guilders annually
Savings estimated at 0.3 million guilders

annually
Quality
50% reduction in damage
Achieved
Working conditions
Level of noise
All much improved, but not quantified
Accessibility
Safety
Attainability
Now that we have discussed all the stages involved in the capital budgeting process, we will return to
study in detail the stage that many managers consider to be the most important: the financial
appraisal. A decision about whether to invest is often made on financial considerations, and the
decision criterion is related to financial return. We will begin with what is probably the most
straightforward appraisal technique: the payback method.
3 THE PAYBACK METHOD

Section overview
The payback method looks at how long it takes for a project's net cash inflows to equal the
initial investment. It is often used as a first screening method because it helps focus
attention on liquidity.
Definition
Payback is the time required for the cash inflows from a capital investment project to equal the cash
outflows, so that the returns from the investment pay back the initial outlay.
Payback is often used as a 'first screening method' because it helps focus attention on liquidity. By
this, we mean that when a capital investment project is being subjected to financial appraisal, the first
question to ask is: 'How long will it take to pay back its cost?' The organisation might have a target
payback, and so it would reject a capital project unless its payback period were less than a target
maximum number of years.
When deciding between two or more competing projects, management may prefer the one with the
shortest payback.
If payback were the only method of evaluation used, the decision criterion would be to recover the
initial capital outlay as quickly as possible.
However, a project should not be evaluated on the basis of payback alone. If a project gets through
the payback test, it ought then to be evaluated with a more sophisticated project appraisal technique.
Payback is a cash based measure. Ideally it is based on the project's cash inflows versus its cash
outflows. It does not consider profit. In the absence of cash flow information however, profits before
depreciation can be used as a very rough approximation of annual cash flows.
With some methods of capital expenditure appraisal, it is commonly assumed that cash flows in each
period occur on the last day of the period. However with the payback method, either of two different
assumptions may be used:
a. that the cash flows in each period do occur at the end of the period: this means that capital
expenditure at the beginning of the first year are assumed to occur in 'Year 0', which is the year
that has just ended. When this assumption is used, payback will occur at the end of a particular
year.
b. that the cash flows occur at an even rate throughout each time period. When this assumption is
used, payback will normally occur at some time during a particular year, not at the end of a year.
When it is assumed that cash flows occur at an even rate throughout the year (with the exception of
any cash from the disposal of a capital asset, which happens at the very end of the project), the
payback period is calculated as follows.
a. Calculate the cumulative cash flows at the end of each year. The initial capital outlay is a cash
outflow, so the cumulate cash flow will remain negative until payback is achieved.
b. Payback is achieved during the year that the cumulative cash flows change from negative to
positive.
c. The time in the payback year that payback occurs is found by calculating the proportion:
(Extra cash inflow needed for payback at the start of the year/Cash flow during the year)
d. Multiply this proportion by 12 months to get the payback month in the year.
For example, suppose that the cumulative cash flow for a project at the end of Year 3 is - $15 000 and
the cash flow in Year 4 is $36 000. The payback period will be 3 years + [(15 000/36 000) 12 months]
= 3 years 5 months.
3.1 WHY IS PAYBACK ALONE AN INADEQUATE PROJECT APPRAISAL

TECHNIQUE?
Look at the figures below for two mutually exclusive projects (this means that only one of them can be
undertaken).
Capital cost of asset
Profits before depreciation
Year 1
Year 2
Year 3
Year 4
Year 5
Project P
$60 000
$20 000
$30 000
$40 000
$50 000
$60 000
Project Q
$60 000
$50 000
$20 000
$5 000
$5 000
$5 000
Project P pays back in year 3. If we assume that cash flows occur at the end of the year, payback occurs
at the end of year 3. If we assume that cash flows occur at an even rate throughout each year, Project P
will pay back one quarter of the way through year 3 (after 2 years 3 months).
Using payback alone to judge projects, project Q would be preferred. But the returns from project P
over its life are much higher than the returns from project Q. Project P will earn total profits before
depreciation of $200 000 on an investment of $60 000, whereas project Q will earn total profits before
depreciation of only $85 000 on an investment of $60 000. Making the choice between the projects on
payback alone would be inappropriate: total return must also be considered.
CHAPTER 10
Project Q pays back in year 2. If we assume that cash flows occur at the end of the year, payback
occurs at the end of year 2. If we assume that cash flows occur at an even rate throughout each year,
Project Q will pay back half way through year 2 (after 1 year 6 months).
Question 1: Payback
An asset costing $120 000 is to be depreciated over ten years to a nil residual value. Profits after
depreciation for the first five years are as follows:
Year
1
2
3
4
5
$
12 000
17 000
28 000
37 000
8 000
How long is the payback period to the nearest month, assuming that cash flows occur at an even rate
during each year?
A 3 years
B 3 years 6 months
C 3 years 7 months
D The project does not payback in five years
3.2 DISADVANTAGES OF THE PAYBACK METHOD

There are two serious drawbacks to the payback method:
a. It ignores the timing of cash flows within the payback period, the cash flows after the end of the
payback period and therefore the total project return.
b. It ignores the time value of money which is a concept incorporated into more sophisticated
appraisal methods. This means that it does not take account of the fact that $1 today is worth more
than $1 in one year's time. An investor who has $1 today can either consume it immediately or
alternatively, can invest it at the prevailing interest rate, say 10%, to get a return of $1.10 in a year's
time.
There are also other disadvantages:
a. The method is unable to distinguish between projects with the same payback period.
b. The choice of any cut-off payback period by an organisation is arbitrary.
c. It may lead to excessive investment in short-term projects.
d. It takes account of the risk of the timing of cash flows but does not take account of the variability of
those cash flows.
3.3 ADVANTAGES OF THE PAYBACK METHOD

The use of the payback method does have advantages, especially as an initial screening device:
a. Assesses period for which capital is tied up.
b. Focus on early payback can enhance liquidity.
c. Investment risk is increased if payback is longer.
d. Shorter-term forecasts are likely to be more reliable.
e. The calculation is quick and simple.
f. Payback is an easily understood concept.
4 THE ACCOUNTING RATE OF RETURN METHOD

Section overview
Like the payback method, the accounting rate of return method is popular despite its
limitations, because it involves a familiar concept of a percentage return.
The accounting rate of return (ARR) method of appraising a project is to estimate the accounting
rate of return that the project should yield. If it exceeds a target rate of return, the project will be
undertaken. The accounting rate of return (ARR) is also called the return on capital employed
(ROCE) method or the return on investment (ROI) method.
Profits rather than cash flows are used to measure the size of returns.
Formula to learn
Unfortunately there are several different definitions of ARR.
ARR =
Average annual profit from investment

100%
Average investment
ARR =
Estimated total profits

100%
Estimated initial investment
Or ARR =
Estimated average profits

100%
The measurement of ARR is different according to whether 'average annual profit' or 'total profits over
the asset life' is the figure above the line. Similarly, ARR differs according to whether 'average
investment' or 'initial investment' is used below the line.
Note: Average investment = [(Initial cost + Estimated residual value)/2].
Whichever method of measuring ARR is selected (assuming that the ARR method is used as a decision
criterion) the method selected should be used consistently. For examination purposes we
recommend the first definition (average profit as a percentage of average investment) unless the
question clearly indicates that some other one is to be used.
Note that this is the only appraisal method that we will be studying that uses profit instead of cash
flow. If you are not provided with a figure for profit, assume that net cash inflow minus depreciation
equals profit.
Worked Example: Target accounting rate of return
A company has a target accounting rate of return of 20%, using the first definition above, and is now
considering the following project.
$80 000
4 years
$20 000
$25 000
$35 000
$25 000
The capital asset would be depreciated by 25% of its cost each year, and will have no residual value.
Assess whether the project should be undertaken.
CHAPTER 10
Capital cost of asset

Estimated life
Estimated profit before depreciation
Year 1
Year 2
Year 3
Year 4
Solution
The annual profits after depreciation, and the mid-year net book value of the asset, would be as
follows.
Year
1
2
3
4
Profit after
depreciation
$
0
5 000
15 000
5 000
Mid-year net
book value
$
70 000
50 000
30 000
10 000
ARR in the
year
%
0
10
50
50
As the table shows, the ARR is low in the early stages of the project, partly because of low profits in
Year 1 but mainly because the NBV of the asset is much higher early on in its life. The project does not
achieve the target ARR of 20% in its first two years, but exceeds it in years 3 and 4. Should it be
undertaken?
When the ARR from a project varies from year to year, it makes sense to take an overall or 'average'
view of the project's return. In this case, we should look at the return over the four-year period.
$
105 000
25 000
6 250
80 000
40 000
Total profit before depreciation over four years

Total profit after depreciation over four years
Average annual profit after depreciation
Original cost of investment
Average net book value over the four-year period ((80 000 + 0)/2)
The project would not be undertaken because its ARR is (6 250/40 000) 100% = 15.625% and so it
would fail to yield the target return of 20%.
4.1 THE ARR AND THE COMPARISON OF MUTUALLY EXCLUSIVE

PROJECTS
The ARR method of capital investment appraisal can also be used to compare two or more projects
which are mutually exclusive. The project with the highest ARR would be selected, provided that the
expected ARR is higher than the company's target ARR.
Question 2: The ARR and mutually exclusive projects
Arrow wants to buy a new item of equipment. Three models of equipment are available, differing
according to cost, size, reliability and supplier. The expected costs and profits of each item are as
follows:
Equipment item
Capital cost
Life
Profits before depreciation
Year 1
Year 2
Year 3
Year 4
Year 5
Disposal value
X
$80 000
5 years
$
50 000
50 000
30 000
20 000
10 000
0
Y
$150 000
5 years
$
50 000
50 000
60 000
60 000
60 000
0
Z
$200 000
5 years
$
60 000
70 000
90 000
70 000
60 000
50 000
ARR is measured as the average annual profit after depreciation, divided by the average net book
value of the asset. The investment with the highest ARR will be selected, provided that its expected
ARR is more than 30%.
Which of these items of equipment should be purchased?

A Item X
B Item Y
C Item Z
D None of them
4.2 THE DRAWBACKS AND ADVANTAGES TO THE ARR METHOD OF

PROJECT APPRAISAL
The ARR method has the serious drawback that it does not take account of the timing of the profits
from a project. Whenever capital is invested in a project, money is tied up until the project begins to
earn profits which pay back the investment. Money tied up in one project cannot be invested
anywhere else until the profits come in. Management should be aware of the benefits of early
repayments from an investment, which will provide the money for other investments.
There are a number of other disadvantages:
a. It is based on accounting profits which are subject to a number of different accounting
treatments.
b. It is a relative measure rather than an absolute measure and hence takes no account of the size of
the investment.
c. It takes no account of the length of the project.
d. Like the payback method, it ignores the time value of money.
There are, however, advantages to the ARR method:
a. It is quick and simple to calculate.
b. It involves a familiar concept of a percentage return.
c. Accounting profits can be easily calculated from financial statements.
d. It looks at the entire project life.
e. Managers and investors are accustomed to thinking in terms of profit, and so an appraisal method
which employs profit may therefore be more easily understood.
Question 3: Payback and ARR
A company is considering two capital expenditure proposals.

The following information is available:
Depreciation is charged on the straight line basis. Profits and cash flows are assumed to occur at an
even rate within each year. The maximum acceptable payback period is 3 years and the minimum
acceptable ARR is 23%.
a. What is the payback period for each investment?
A Proposal A 2 years 6 months, Proposal B 2 years 11 months
B Proposal A 2 years 6 months, Proposal B 3 years 1 month
C Proposal A 2 years 8 months, Proposal B 2 years 11 months
D Proposal A 2 years 8 months, Proposal B 3 years 1 month
CHAPTER 10
Initial investment
Year 1
Year 2
Year 3
Year 4
Estimated scrap value at the end of year 4
Profit/(loss) after depreciation

Proposal A
Proposal B
$
$
46 000
46 000
6 500
4 500
3 500
2 500
13 500
4 500
(1 500)
14 500
4 000
4 000
b. What is the ARR for each investment, using average profit and average investment to measure
ARR?
A Proposal A 22%, Proposal B 26%
B Proposal A 22%, Proposal B 28.3%
C Proposal A 23.5%, Proposal B 26%
D Proposal A 23.5%, Proposal B 28.3%
c. On the basis of these two performance criteria (payback and ARR) which project or projects should
be undertaken?
A Proposal A only
B Proposal B only
C Both Proposal A and Proposal B
D Neither proposal
5 RISK AND UNCERTAINTY IN DECISION MAKING

5.1 WHAT ARE RISK AND UNCERTAINTY?
Section overview
Risk and uncertainty are not the same. Risk can be quantified and relates to the potential
variability in an outcome. Uncertainty is the inability to predict an outcome due to a lack of
information. An example of a risky situation is one in which we may say that there is a 70%
probability that returns from a project will be in excess of $100 000 but a 30% probability
that returns will be less than $100 000. If no information can be provided on the returns
from the project, we are faced with uncertainty.
People may be risk-seekers, risk neutral or risk averse.
Scenario planning, involves asking 'what if?' and 'what is the effect of?' questions about the
future.
Definition
LOs
2.5
10.2
Risk involves situations or events which may or may not occur, but whose probability of occurrence
can be calculated statistically and the frequency of their occurrence predicted from past records.
Therefore insurance deals with risk.
Uncertain events are those whose outcome cannot be predicted with statistical confidence.
In everyday usage the terms risk and uncertainty are not clearly distinguished. In the context of capital
investment however the difference relates to whether sufficient information is available to allow the
lack of certainty surrounding costs or revenues to be quantified.
5.2 RISK AND CAPITAL INVESTMENT DECISIONS

In general, risky projects are those which have future cash flows, and hence project returns, that are
likely to be variable. The greater the variability, the greater the risk.
The problem of risk is more acute with capital investment decisions for the following reasons:
a. Estimates of capital expenditure might be for several years ahead, such as those for major
construction projects. Actual costs may well escalate well above budget as the work progresses.
b. Estimates of benefits will be for several years ahead, sometimes 10, 15 or 20 years ahead or even
longer, and such long-term estimates can at best be approximations.
5.3 RISK PREFERENCE

People may be risk averse, risk neutral or risk seekers.
Definition
A risk averse investor requires compensation for risk and will avoid risk unless the expected return
adequately compensates for it. If two investments have the same expected return, they would choose
the one with the lowest risk. However, a risk averse decision maker may be prepared to invest in a
more risky project, provided that the expected return is higher.
LO
2.5
An investor is risk neutral if they are indifferent to the level of risk involved in an investment and only
concerned about the expected return. A risk neutral decision maker would be indifferent between
investments that offered the same expected return, regardless of the risk with each investment.
A risk seeker is an investor who is attracted to risk. They would choose an investment that offers the
possibility of a higher level of return, even when there is a high probability of a much lower return. For
example a risk seeker might choose to invest in something that offers a 10% chance of a return of $20
000 and a 90% chance of $0 in preference to an investment that is 100% certain to provide a return of
$5 000.
This has clear implications for managers and organisations. A risk seeking manager working for
an organisation that is characteristically risk averse is likely to make decisions that are not
congruent with the goals of the organisation. There may be a role for the management
accountant here, who could be instructed to present decision-making information in such a way
as to ensure that the manager considers all the possibilities, including the worst.
Case study
What constitutes an acceptable amount of risk will vary from organisation to organisation. For large
public companies it is largely a question of what is acceptable to the shareholders. A 'safe' investment
will attract investors who are to some extent risk averse, and the company will therefore be obliged to
follow relatively 'safe' policies. A company that is recognised as being an innovator or a 'growth'
company in a relatively new market, like Yahoo!, will attract investors who are looking for high
performance and are prepared to accept some risk in return. Such companies will be expected to
make 'bolder' decisions.
The risk of an individual strategy should also be considered in the context of the overall 'portfolio' of
investment strategies adopted by the company.
a. If a strategy is risky, but its outcome is not related to the outcome of other strategies, then
adopting that strategy will help the company to spread its risks.
b. If a strategy is risky, but is inversely related to other adopted strategies, so that if strategy A does
well, other adopted strategies will do badly and vice versa, then adopting strategy A would actually
reduce the overall risk of the company's investment portfolio.
CHAPTER 10
LO
2.4
5.4 SCENARIO PLANNING

Scenario planning can be useful in providing a long-term view of a strategy, where a few key factors
may influence success. It is designed to improve decision making by considering the impact of
possible future situations that may occur and their likely implications. These may be favourable or
unfavourable changes for the business concerned.
Scenario planning can be used:
To develop contingency plans to cope with specific threats or risks e.g. the likelihood of an oil
spillage for a petroleum company
As a technique to predict the possible future operating environment for the company and to
identify appropriate actions e.g. a financial services company may forecast the likely impact on its
business of differing states of the economy (recession, growth etc.)
Scenario planning, involves asking 'what if?' and 'what is the effect of?' questions about the future.
KEY CHAPTER POINTS

Origination of proposals.
Project screening.
Analysis and acceptance.
Monitoring and review.
During the project's progress, project controls should be applied to ensure the following:
Capital spending does not exceed the amount authorised.
The implementation of the project is not delayed.

The anticipated benefits are eventually obtained.
A post-completion audit cannot reverse the decision to incur the capital expenditure, because the
expenditure has already taken place, but it can assist with the implementation and control of future
investments.
The payback method looks at how long it takes for a project's net cash inflows to equal the initial
investment. It is often used as a first screening method because it helps focus attention on liquidity.
Like the payback method, the accounting rate of return method is popular despite its limitations,
because it involves a familiar concept of a percentage return.
Risk and uncertainty are not the same. Risk can be quantified and relates to the potential variability
in an outcome. Uncertainty is the inability to predict an outcome due to a lack of information. An
example of a risky situation is one in which we may say that there is a 70% probability that returns
from a project will be in excess of $100 000 but a 30% probability that returns will be less than
$100 000. If no information can be provided on the returns from the project, we are faced with
uncertainty.
People may be risk seekers, risk neutral or risk averse.
CHAPTER 10
Scenario planning, involves asking 'what if?' and 'what is the effect of?' questions about the future.

1 Mutually exclusive capital expenditure options may arise as a consequence of
A project control.
B a capital budget.
C capital rationing.
D post completion audit.
2 If a machine with annual running costs of $100 000 was diverted from producing output selling for
$50 000 to producing a special order worth $70 000, what would be the relevant costs of what has
happened?
A $20 000
B $50 000
C $100 000
D $170 000
3 Project control for a major capital expenditure project is needed to ensure that overspending on
the project is avoided and
A there is a post-completion audit.
B expenditures are properly authorised.
C the project cost estimates were realistic.
D the project implementation is not delayed
4 Which of the following can be used to calculate the return on capital employed?
I

100%
II
Estimated average annual profits

100%
Estimated average investment
III

100%
A I, II and III
B I and II only
C I and III only
D II and III only
5 The ARR method of investment appraisal is primarily criticised because
A there are different ways of calculating ARR.
B investment is about cash returns on cash investments.
C depreciation rates are arbitrary when calculating profit.
D it does not consider the full expected life of the project.
6 Which one of the following statements is correct?
A Earlier payback improves profitability.
B Investment risk is lower if payback is longer.
C A risk averse investor wants to avoid risk entirely.
D Shorter term forecasts are likely to be more reliable.

A The payback method does not consider total project returns.
B The ARR method of investment appraisal ignores the time value of money.
C The payback method ignores the timing of cash flows within the payback period.
CHAPTER 10
D The ARR method of investment appraisal uses accounting profits before depreciation charges.

1 C Any form of capital rationing means that the capital available for investment will be less than the
total value of projects in which investment could be made. A choice has to be made between
the projects that are competing for the scarce capital.
2 A $50 000 is the opportunity cost of the lost sales revenue. Options C and D are incorrect because
they include the $100 000 running costs which would be incurred anyway and so are not
relevant.
In the absence of any further information, Option A $20 000 would be the net benefit
($70 000 $50 000).
3 D Project control is to keep control over costs, try to ensure that implementation is not delayed
and (although this may not be practical) try to ensure that the anticipated benefits are obtained.
The proper authorisation of expenditures is a necessary financial control, but this is linked to the
aim of keeping costs under control and avoiding overspending.
4 A All three could be used, although (II)

100% is probably the
Estimated average investment
most commonly used.

5 B Investments, like short-term decision, should be assessed using relevant costs cash flows and
opportunity costs. ARR is an accounting measure that ignores cash flows, and so is very
unsatisfactory as a decision making criterion.
6 D Shorter term forecasts are likely to be more reliable than longer term forecasts, because
differences between forecast and what happens can increase with time. Risk-averse investors do
not wish to avoid risk entirely: investment without risk is not possible in the business world.
However, for additional risk, they will expect the prospect of higher returns. Investment risk is
higher when payback is longer. Early payback improves liquidity, not profitability.
7 D The ARR method uses accounting profits, which is after deducting depreciation charges. Both
the ARR and payback methods ignore the time value of money. Payback ignores cash returns
after the payback point, and does not consider the timing of cash flows within the period up to
payback.

1 C
Profits before depreciation should be used.
Profit after
depreciation
$ 000
12
17
28
37
8
Year
1
2
3
4
5
Depreciation
$ 000
12
12
12
12
12
Profit before
depreciation
$ 000
24
29
40
49
20
Cumulative
profit
$ 000
24
53
93
142
(120 - 93)
Payback period = 3 years +

12 months
(142 - 93)
= 3 years 7 months
2 A
Total profit over life of equipment

Before depreciation
After depreciation
Average annual profit after depreciation
Average investment = (capital cost + disposal value)/2
ARR
Item X
$
Item Y
$
Item Z
$
160 000
80 000
16 000
40 000
40%
280 000
130 000
26 000
75 000
34.7%
350 000
200 000
40 000
125 000
32%
All three projects would earn a return in excess of 30%, but since item X would earn the biggest
ARR, it would be preferred to item Y and item Z, even though the profits from Y would be
higher by an average of $10 000 a year and the annual profit from Z would be $24 000 higher.
3 Workings:
Depreciation must first be added back to the annual profit figures, to arrive at the annual cash
flows.
Depreciation
Initial investment $46 000 scrap value $4 000

4 years
= $10 500 pa
Adding $10 500 per annum to the profit figures produces the cash flows for each proposal.
0
1
2
3
4
4
Proposal A
Cumulative
cash flow
$
(46 000)
(29 000)
(15 000)
9 000
18 000
22 000
Annual
cash flow
$
(46 000)
15 000
13 000
15 000
25 000
4 000
Proposal B
Cumulative
cash flow
$
(46 000)
(31 000)
(18 000)
(3 000)
22 000
26 000
15 000
a. D Proposal A payback = 2 +
12 months = 2 years 8 months
24 000
3 000
Proposal B payback = 3 +
12 months = 3 years 1 month
25 000
CHAPTER 10
Year
Annual
cash flow
$
(46 000)
17 000
14 000
24 000
9 000
4 000
b. A The return on capital employed (ROCE) is calculated using the accounting profits given in
the question.
Proposal A
Proposal B
Average profit
$(6 500 + 3 500 + 13 500 1 500)/4
$22 000/4 = $5 500
Average investment
$(46 000 + 4 000)/2 = $25 000
ARR
$5 500
100% = 22%
$25 000
Average profit
$(4 500 + 2 500 + 4 500 + 14 500)/4
$26 000/4 = $6 500
$6 500
100% = 26%
$25 000
ARR
c. D Project Y takes just over 3 years to pay back. Project X earns less than 23% return, measured
as ARR. Applying the decision criteria strictly, neither proposal is acceptable.
297
CHAPTER 11
INVENTORY AND PRICING
DECISIONS
Learning objectives
Reference
Evaluate the principles of just-in-time
LO11.1
Apply the economic order quantity formula to determine order quantities for inventory
management
LO11.2
Establish and apply the appropriate approach for long-term pricing decisions
LO11.3
Topic list
1 Just-in-time (JIT) systems

2 Inventory control levels
3 Pricing
INTRODUCTION
This chapter examines two separate topics inventory and pricing.
Within the area of inventory two areas will be examined Just-in-time systems and inventory
management.
In recent years there have been significant changes in the business environment in which both
manufacturing and service organisations operate. Organisations have therefore adopted new
management approaches and have changed their manufacturing systems. One such type of system is
just-in-time (JIT) systems.
The investment in inventory is a very important one for most businesses, both in terms of monetary
value and relationships with customers. It is therefore vital that management establish and maintain an
effective inventory control system.
This chapter will concentrate on a inventory control system for materials, but similar problems and
considerations apply to all forms of inventory.
The chapter concludes by looking at pricing. Finding the cost of a product or service means, among
other things, that you have a basis for setting a selling price that will earn the business the profit it
wants. Recently, however, some businesses have approached the problem from the opposite side:
they have decided what the selling price should be in order for the product to sell, and then they
deduct the profit they want, which leaves the target cost. In this chapter we look at methods of pricing
that are based on cost, as well as target costing. Finally, there is a brief discussion on transfer pricing
this is where internal transfers of goods or services are made between different units of the same
business and management must decide on the appropriate price at which such transfers should be
charged.
Inventory and
pricing decisions
Inventory
JIT systems
Value added
Inventory
control levels
Economic
order quantity
Full cost
pricing
Pricing
Market-based
approaches
Target
costing
Transfer
pricing
INVENTORY AND PRICING DECISIONS | 299
area.
everything covered.
1 What is JIT?
(Section 1)
2 Explain the link between value-added costs and JIT.
(Section 1.3)
3 What are the problems associated with JIT?
(Section 1.4)
4 What are the reasons for holding inventory?
(Section 2.1.1)
5 How can the EOQ be calculated?

6 What is the EOQ formula?
7 Identify and explain four systems of stores control and reordering other than EOQ.
(Section 2.3)
(Section 2.3.1)
(Section 2.4)
8 What is full cost-plus pricing?
(Section 3.1.1)
9 What are the four stages of the product life cycle?
(Section 3.2.1)
10 What is PED?
(Section 3.2.8)
11 What is target costing?

12 What is transfer pricing?
(Section 3.3)
(Section 3.3.3)
CHAPTER 11
BEFORE YOU BEGIN
1 JUST-IN-TIME (JIT) SYSTEMS

1.1 'TRADITIONAL' SYSTEMS OF INVENTORY MANAGEMENT AND
PRODUCTION
Section overview
JIT aims for zero inventory and perfect quality and operates by demand-pull. It consists of
JIT purchasing and JIT production and results in lower investment requirements, space
savings, greater customer satisfaction and increased flexibility.
LO
11.1
'Just-in-time' systems (which were introduced in chapter 1, section 8) are systems of purchasing,
inventory management and production planning and control that differ from so-called 'traditional'
systems.
In a traditional system, production quantities are planned to meet expected sales demand.
Management try to avoid running out of inventories of raw materials and finished goods, so that the
entity can meet demand for production and sales out of inventories. Inventory management therefore
involves deciding what levels of inventories should be held, and in what locations. Inventory managers
may try to maintain inventory levels at a number of weeks' supply.
'Efficient' management in a traditional system involves trying to minimise production costs through
long production runs (reducing set-up time and costs). 'Efficient' purchasing and inventory
management might involve buying materials and parts from suppliers in economic order quantities, in
order to minimise the combined costs of purchase orders and holding inventory.
Purchasing managers or buyers deal with immediate suppliers, but not suppliers at earlier stages in
the supply chain. The general view about suppliers is that they cannot be trusted to supply the correct
quantities of supplies or to supply items to the quality standards required and specified. Consequently
it is necessary to check all deliveries from suppliers for quantity and quality.
'Traditional' responses to the problems of improving manufacturing capacity and reducing unit costs
of production might therefore be described as follows:
Longer production runs
Economic batch quantities for purchasing and production runs
Fewer products in the product range
Reduced time on preventive maintenance, to keep production flowing
In general terms, longer production runs and large batch sizes should mean less disruption, better
capacity utilisation and lower unit costs.
1.2 INTRODUCTION TO JUST-IN-TIME

Just-in-time systems challenge such 'traditional' views of manufacture.
Definitions
Just-in-time (JIT) is a system whose objective is to produce or to procure products or components as
they are required by a customer or for use, rather than for inventory. A JIT system is a pull system,
which responds to demand, in contrast to a push system, in which stocks act as buffers between the
different elements of the system, such as purchasing, production and sales.
Just-in-time production is a production system which is driven by demand for finished products
whereby each component on a production line is produced only when needed for the next stage.
Just-in-time management involves trying to eliminate non-value adding activities, where costs are
incurred for little or no benefit. One aspect of this is the elimination of waste, and 'getting things right
first time'. Another is the elimination of (or reduction in) inventory levels, because items held in
inventory have a cost but are not earning anything.
Although often described as a technique, JIT is more of a philosophy or approach to management
since it encompasses a commitment to continuous improvement and the search for excellence in
the design and operation of the production management system.
JIT has the following essential elements:
JIT purchasing
Parts and raw materials should be purchased as near as possible to the time they are
needed, using small frequent deliveries against bulk contracts.
Close relationship
with suppliers
In a JIT environment, the responsibility for the quality of goods lies with the supplier, who
must operate within the 'right first time' environment that JIT operations demand. In a
traditional system, deliveries from suppliers are verified for quality and quantity when they
are received. With JIT there is minimal checking of deliveries, which means that there must
be trust between the entity and the supplier. To achieve this, the relationship between
them cannot be seen as short-term. A long-term commitment between supplier and
customer should be established: as a key supplier, the supplier is guaranteed demand and
is able to plan to meet the customer's production schedules. If an organisation has
confidence that suppliers will deliver material of 100% quality, on time, so that there will be
no rejects or returns and hence no consequent production delays, usage of materials can
be matched with delivery of materials and inventories can be kept at near zero levels.
Suppliers are also chosen because of their close proximity to an organisation's plant.
Uniform loading
All parts of the productive process should be operated at a speed which matches the rate
at which the final product is demanded by the customer. Production runs will therefore be
shorter and there will be smaller inventories of finished goods because output is being
matched more closely to demand, and so storage costs will be reduced.
Set-up time
reduction
Machinery set-ups are non-value-added activities (see below) which should be reduced or
even eliminated.
Machine cells
Machines or workers should be grouped by product or component instead of by the type

of work performed. The non-value-added activity of materials movement between
operations is therefore minimised by eliminating space between work stations. Products
can flow from machine to machine without having to wait for the next stage of processing
or returning to stores. Lead times and work in progress are therefore reduced.
Quality
Production management should seek to eliminate scrap and defective units during
production, and to avoid the need for reworking of units since this stops the flow of
production and leads to late deliveries to customers. Product quality and production
quality are important 'drivers' in a JIT system.
Pull system (Kanban) A Kanban, or signal, is used to ensure that products / components are only produced
when needed by the next process. Nothing is produced in anticipation of need, to then
remain in inventory, consuming resources. It is important to monitor usage, so that new
production or supply can be arranged to meet demand. In supermarkets, for example, the
sale of stores items is monitored 'just in time' through the use of bar codes and automatic
scanners at the check-out points.
Preventative
maintenance
Production systems must be reliable and prompt, without unforeseen delays and
breakdowns. Machinery must be kept fully maintained, and so preventative maintenance is
an important aspect of production.
Employee
involvement
Workers within each machine cell should be trained to operate each machine within that
cell and to be able to perform routine preventative maintenance on the cell machines, i.e.
to be multiskilled and flexible.
The supply chain
Because it is important that suppliers should be able to deliver materials and parts when
they are needed, it is often necessary to monitor the supply chain along its entire length,
and not just to establish a close relationship with immediate suppliers. Inventory
management may therefore involve monitoring supplies throughout the supply chain, and
there are software systems that can help companies to do this.
CHAPTER 11
Just-in-time purchasing is a purchasing system in which material purchases are contracted so that the
receipt and usage of material, to the maximum extent possible, coincide.
Question 1: JIT system

A company is considering changing to a JIT system. Which of the following changes in their working
practices are likely to be necessary?
I
II
III
IV
V
More frequent revision of inventory control levels and of the economic order quantity
Increase in the number of raw material suppliers in order to guarantee supply
Selection of suppliers close to the company's manufacturing facility
Increased focus on the accurate forecasting of customer demand
Increased quality control activity
A I and II only
B III, IV and V only
C II, III, IV and V only
D I, II, III, IV and V
1.3 VALUE ADDED

JIT aims to eliminate all non-value-added costs. Value is only added while a product is actually being
processed. While it is being inspected for quality, moving from one part of the factory to another,
waiting for further processing and held in store, value is not being added. Non value-added activities,
or diversionary activities, should therefore be eliminated.
Definition
A value-added cost is incurred for an activity that cannot be eliminated without the customer's
perceiving a deterioration in the performance, function, or other quality of a product.
'The costs of those activities that can be eliminated without the customer's perceiving deterioration in
the performance, function, or other quality of a product are non-value-added. The costs of handling
the materials of a television set through successive stages of an assembly line may be non-valueadded. Improvements in plant layout that reduce handling costs may be achieved without affecting
the performance, function, or other quality of the television set.'
(Horngren)
Question 2: Value-added activity
Which of the following is a value-added activity?
A
B
C
D
Storing materials
Repairing faulty production work
Painting a car, if the organisation manufactures cars
Setting up a machine so that it drills holes of a certain size
Case study
The following extract from an article in the UK's Financial Times illustrates how 'just-in-time' some
manufacturing processes can be.
'Just-in-time manufacturing is down to a fine art at Nissan Motor Manufacturing (UK). Stockholding of
some components is just ten minutes - and the holding of all parts bought in Europe is less than a day.
These manufacturers do not even receive an order to make a component until the car for which it is
intended has started along the final assembly line. Seat manufacturer Ikeda Hoover, for example, has
about 45 minutes to build seats to specification and deliver them to the assembly line a mile away. It
delivers 12 sets of seats every 20 minutes and they are mounted in the right order on an overhead
conveyor ready for fitting to the right car.
Nissan has close relationships with a dozen or so suppliers and deals exclusively with them in their
component areas. It involves them and even their own suppliers in discussions about future needs and
other issues. These companies have generally established their own manufacturing units close to the
Nissan plant.
Other parts from further afield are collected from manufacturers by Nissan several times at fixed times.
This is more efficient than having each supplier making individual haulage arrangements.'
1.4 PROBLEMS ASSOCIATED WITH JIT

JIT should not be seen as a cure for all the problems associated with traditional approaches to
manufacturing.
It might not even be appropriate in all circumstances.
a. It is not always easy to predict patterns of demand.
b. JIT makes the organisation far more vulnerable to disruptions in the supply chain.
c. JIT, originated by Toyota, was designed at a time when all of Toyota's manufacturing was done
within a 50 km radius of its headquarters. Wide geographical spread, however, makes this difficult.
Case studies
The Kobe earthquake in Japan in 1995 severely disrupted industry in areas unaffected by the actual
catastrophe. Plants that had not been hit by the earthquake were still forced to shut down
production lines less than 24 hours after the earthquake struck because they held no buffer stocks
which they could use to cover the shortfall caused by non delivery by the Kobe area suppliers.
Supply chains in the automotive industry are extremely complex, with a single car requiring up to
20 000 parts and involving a wide range of different global suppliers. Many US automotive
manufacturers that operate JIT strategies, were severely affected by the 2011 Japanese tsunami.
Companies such as General Motors had to halt production of vehicles at several plants because of
the resulting parts shortages from Japanese suppliers.
CHAPTER 11
Nissan has moved beyond just-in-time to synchronous supply for some components, which means
manufacturers deliver these components directly to the production line minutes before they are
needed.
Question 3: Batch sizes within a JIT manufacturing environment

Batch sizes within a JIT manufacturing environment may well be smaller than those associated with
traditional manufacturing systems.
What costs might be associated with this feature of JIT?
I
Increased set-up costs
II Opportunity cost of lost production capacity as machinery and the workforce reorganise for a
different product
III Additional materials handling costs
IV Increased administrative costs
A I only
B II and III only
C I, II, III and IV
D none of the above
1.5 MODERN VERSUS TRADITIONAL INVENTORY CONTROL SYSTEMS

There is no reason for the newer approaches to supersede the old entirely. A restaurant, for example,
might find it preferable to use the traditional economic order quantity approach for staple nonperishable food items, but adopt JIT for perishable and 'exotic' items. In a hospital a stock-out could,
quite literally, be fatal, and JIT would be unsuitable.
2 INVENTORY CONTROL LEVELS

2.1 INVENTORY COSTS
Section overview
Inventory costs include purchase costs, holding costs, ordering costs and costs of running
out of inventory.
The costs of purchasing inventory are usually one of the largest costs faced by an organisation and,
once obtained, inventory has to be carefully controlled and checked.
2.1.1 REASONS FOR HOLDING INVENTORIES

To ensure sufficient goods are available to meet expected demand
To provide a buffer between processes
To meet any future shortages
To take advantage of bulk purchasing discounts
To absorb seasonal fluctuations and any variations in usage and demand
To allow production processes to flow smoothly and efficiently
As a necessary part of the production process such as when maturing cheese
As a deliberate investment policy, especially in times of inflation or possible shortages
2.1.2 HOLDING COSTS

If inventories are too high, holding costs will be incurred unnecessarily. Such costs occur for a number
of reasons:
a. Costs of storage and stores operations. Larger inventories require more storage space and
possibly extra staff and equipment to control and handle them.
b. Interest charges. Holding inventories involves the tying up of capital (cash) on which interest must
be paid.
c. Insurance costs. The larger the value of inventories held, the greater insurance premiums are likely
to be.
e. Deterioration. When materials in store deteriorate to the extent that they are unusable, they must
be thrown away with the likelihood that disposal costs would be incurred.
2.1.3 COSTS OF OBTAINING INVENTORY

On the other hand, if inventories are kept low, small quantities of inventory will have to be ordered
more frequently, thereby increasing the following ordering or procurement costs:
a. Clerical and administrative costs associated with purchasing, accounting for and receiving goods.
b. Transport costs associated with delivery of inventory.
c. Production run costs, for inventory which is manufactured internally rather than purchased from
external sources.
2.1.4 STOCK OUT COSTS (RUNNING OUT OF INVENTORY)

An additional type of cost which may arise if inventory are kept too low is the type associated with
running out of inventory. There are a number of causes of stockout costs:
Lost contribution from lost sales
Loss of future sales due to disgruntled customers
Loss of customer goodwill
Cost of production stoppages
Labour frustration over stoppages
Extra costs of urgent, small quantity, replenishment orders
2.1.5 OBJECTIVE OF INVENTORY CONTROL

The overall objective of inventory control is, therefore, to maintain inventory levels so that the total of
the following costs is minimised:
Holding costs
Stock out costs
Ordering costs
2.2 INVENTORY CONTROL LEVELS

Section overview
Inventory control levels can be calculated in order to maintain inventories at the optimum
level. The three critical control levels are reorder level, minimum level and maximum level.
Based on an analysis of past inventory usage and delivery times, inventory control levels can be
calculated and used to maintain inventory at their optimum level (in other words, a level which
minimises costs). These levels will determine 'when to order' and 'how many to order'.
2.2.1 REORDER LEVEL

When inventories reach this level, an order should be placed to replenish inventories. The reorder
level is determined by consideration of the following:
The maximum rate of consumption
The maximum lead time
The maximum lead time is the time between placing an order with a supplier, and the inventory
becoming available for use.
CHAPTER 11
d. Risk of obsolescence. The longer a inventory item is held, the greater is the risk of obsolescence.
Formula to learn
Reorder level = maximum usage maximum lead time
2.2.2 MINIMUM LEVEL

This is a warning level to draw management attention to the fact that inventories are approaching a
dangerously low level and that stockouts are possible.
Formula to learn
Minimum level = reorder level (average usage average lead time)
2.2.3 MAXIMUM LEVEL

This also acts as a warning level to signal to management that inventories are reaching a potentially
wasteful level.
Formula to learn
Maximum level = reorder level + reorder quantity (minimum usage minimum lead time)
Question 4: Maximum inventory level
A large retailer with multiple outlets maintains a central warehouse from which the outlets are
supplied. The following information is available for Part Number SF525.
Average usage
Minimum usage
Maximum usage
Lead time for replenishment
Re-order quantity
Re-order level
350 per day

180 per day
420 per day
11-15 days
6 500 units
6 300 units
a. Based on the data above, what is the maximum level of inventory?

A 5 250
B 6 500
C 10 820
D 12 800
b. Based on the data above, what is the approximate number of Part Number SF525 carried as buffer
inventory?
A 200
B 720
C 1 680
D 1 750
2.2.4 REORDER QUANTITY

This is the quantity of inventory which is to be ordered when inventory reaches the reorder level. If it is
set so as to minimise the total costs associated with holding and ordering inventory, then it is known
as the economic order quantity.
2.2.5 AVERAGE INVENTORY

The formula for the average inventory level assumes that inventory levels fluctuate evenly between the
minimum (or safety) inventory level and the highest possible inventory level (the amount of inventory
immediately after an order is received, i.e. safety inventory + reorder quantity).
Formula to learn
Average inventory = safety inventory + reorder quantity
A component has a safety inventory of 500, a re-order quantity of 3 000 and a rate of demand which
varies between 200 and 700 per week. The average inventory is approximately
A
B
C
D
2 000.
2 300.
2 500.
3 500.
2.3 ECONOMIC ORDER QUANTITY (EOQ)

Section overview
The economic order quantity (EOQ) is the order quantity which minimises inventory costs.
The EOQ can be calculated using a table, graph or formula. EOQ can be used to calculate
the optimum size of orders.
There are a number of other systems of stores control and recording, such as order cycling,
two-bin system, classification and Pareto distribution.
LO
11.2
Economic order theory assumes that the average inventory held is equal to one half of the reorder
quantity. Although, as we saw in the last section, if an organisation maintains some sort of buffer or
safety inventory then average inventory = buffer inventory + half of the reorder quantity. We have
seen that there are certain costs associated with holding inventory. These costs tend to increase with
the level of inventories, and so could be reduced by ordering smaller amounts from suppliers each
time.
On the other hand, as we have seen, there are costs associated with ordering from suppliers:
documentation, telephone calls, payment of invoices, receiving goods into stores and so on. These
costs tend to increase if small orders are placed, because a larger number of orders would then be
needed for a given annual demand.
The EOQ can be calculated using a table, or a graph, or a formula. This is illustrated in the three
worked examples below:
Worked Example: Method 1 Economic order quantity table
Suppose a company purchases raw material at a cost of $16 per unit. The annual demand for the raw
material is 25 000 units. The holding cost per unit is $6.40 and the cost of placing an order is $32.
We can tabulate the annual relevant costs for various order quantities as follows:
Order quantity (units)
Average inventory (units) (a)
Number of orders
(b)
Annual holding cost
Annual order cost
Total relevant cost
(c)
(d)
100
50
250
$
320
8 000
8 320
200
100
125
$
640
4 000
4 640
300
150
83
$
960
2 656
3 616
400
200
63
$
1 280
2 016
3 296
500
250
50
$
1 600
1 600
3 200
600
300
42
$
1 920
1 344
3 264
Notes
a. Average inventory = order quantity 2 (i.e. assuming no safety inventory)
b. Number of orders = annual demand order quantity
c. Annual holding cost = average inventory $6.40
800
400
31
$
2 560
992
3 552
1 000
500
25
$
3 200
800
4 000
CHAPTER 11
Question 5: Average inventory
d. Annual order cost = number of orders $32

You will see that the economic order quantity is 500 units. At this point the total annual relevant costs
are at a minimum.
Worked Example: Method 2 Economic order quantity graph

We can present the information tabulated in Paragraph 2.3 in graphical form. The vertical axis
represents the relevant annual costs for the investment in inventories, and the horizontal axis can be
used to represent either the various order quantities or the average inventory levels; two scales are
actually shown on the horizontal axis so that both items can be incorporated. The graph shows that, as
the average inventory level and order quantity increase, the holding cost increases. On the other
hand, the ordering costs decline as inventory levels and order quantities increase. The total cost line
represents the sum of both the holding and the ordering costs.
Economic order quantity graph
Annual costs
($)
9 000
8 000
7 000
6 000
5 000
Total costs
4 000
Holding costs
3 000
2 000
1 000
Ordering costs
Order quantity (units)
0
100
200 300
400 500 600
700 800 900 1 000
Average inventory level (units)

100
200
300
400
500
Note that the total cost line is at a minimum for an order quantity of 500 units and occurs at the point
where the ordering cost curve and holding cost curve intersect. The EOQ is therefore found at the
point where holding costs equal ordering costs.
2.3.1 EOQ FORMULA

Formula to learn
EOQ =
where CH
CO
D
2C D
0
C
H
=
=
=
cost of holding one unit of inventory for one time period

cost of ordering one consignment from a supplier
demand during the time period
The formula calculates the order quantity that minimises the total annual holding and ordering costs
(the lowest point of the total cost curve).
Worked Example: Method 3 Economic order quantity formula
CH
CO
D
EOQ
=
=
=
cost of holding one unit of inventory for one year = $6.40

cost of ordering one consignment from a supplier = $32
demand during the time period = 25 000 units per annum
2 $32 25 000
$6.40
250 000
500 units
Question 6: EOQ and holding costs
A manufacturing company uses 25 000 components at an even rate during a year. Each order placed
with the supplier of the components is for 2 000 components, which is the economic order quantity.
The company holds a buffer inventory of 500 components. The annual cost of holding one
component in inventory is $2.
What is the total annual cost of holding inventory of the component?
A $2 000
B $2 500
C $3 000
D $4 000
2.4 OTHER SYSTEMS OF STORES CONTROL AND REORDERING

2.4.1 ORDER CYCLING METHOD
Under the order cycling method, quantities on hand of each stores item are reviewed
periodically (every 1, 2 or 3 months). For low-cost items, a technique called the 90-60-30 day
technique can be used, so that when inventories fall to 60 days' supply, a fresh order is placed for a 30
days' supply so as to boost inventories to 90 days' supply. For high-cost items, a more stringent stores
control procedure is advisable so as to keep down the costs of inventory holding.
2.4.2 TWO-BIN SYSTEM

The two-bin system of stores control, or visual method of control, is one whereby each stores
item is kept in two storage bins. When the first bin is emptied, an order must be placed for resupply; the second bin will contain sufficient quantities to last until the fresh delivery is received. This is
a simple system which is not costly to operate but it is not based on any formal analysis of inventory
usage and may result in the holding of too much or too little inventory.
2.4.3 CLASSIFICATION OF MATERIALS

Materials items may be classified as expensive, inexpensive or in a middle-cost range. Because of
the practical advantages of simplifying stores control procedures without incurring unnecessary high
costs, it may be possible to segregate materials for selective stores control.
a. Expensive and medium-cost materials are subject to careful stores control procedures to minimise
cost.
b. Inexpensive materials can be stored in large quantities because the cost savings from careful stores
control do not justify the administrative effort required to implement the control.
CHAPTER 11
Instead of using a table or graph we can calculate the EOQ using the formula based on the
information in Paragraph 2.3
This selective approach to stores control is sometimes called the ABC method whereby materials are
classified A, B or C according to their expense-group: A being the expensive, group B the mediumcost and group C the inexpensive materials.
2.4.4 PARETO (80/20) DISTRIBUTION

A similar selective approach to stores control is the Pareto (80/20) distribution which is based on the
finding that in many stores, 80% of the value of stores is accounted for by only 20% of the stores items,
and inventories of these more expensive items should be controlled more closely.
3 PRICING
3.1 COST-BASED APPROACHES TO PRICING
Section overview
Many firms base price on simple cost-plus rules.
3.1.1 FULL COST-PLUS PRICING

Definition
Full cost-plus pricing is a method of determining the sales price by calculating the full cost of the
product and adding a percentage mark-up for profit.
In practice cost is one of the most important influences on price. Many firms base price on simple
cost-plus rules (costs are estimated and then a mark-up is added in order to set the price). A
traditional approach to pricing is full cost-plus pricing.
The 'full cost' may be a fully absorbed production cost only, or it may include some absorbed
administration, selling and distribution overhead.
A business might have an idea of the percentage profit margin it would like to earn, and so might
decide on an average profit mark-up as a general guideline for pricing decisions. This would be
particularly useful for businesses that carry out a large amount of contract work or jobbing work, for
which individual job or contract prices must be quoted regularly to prospective customers. However,
the percentage profit mark-up does not have to be rigid and fixed, but can be varied to suit the
circumstances. In particular, the percentage mark-up can be varied to suit demand conditions in the
market.
Question 7: Full cost
A product's full cost is $4.70 and is sold at full cost plus 70%.
What is the selling price?
Worked Example: Full cost-plus pricing
Markup has begun to produce a new product, Product X, for which the following cost estimates have
been made:
Direct materials
Direct labour: 4 hrs at $5 per hour
Variable production overheads: machining, hr at $6 per hour
$
27
20
3
50
Fixed production overheads are budgeted at $300 000 per month and, because of the shortage of
available machining capacity, the company will be restricted to 10 000 hours of machine time per
month. The absorption rate will be a direct labour rate, however, and budgeted direct labour hours
are 25 000 per month.
What is the full cost-plus based price?
Solution
$
27.00
20.00
Direct materials
Direct labour (4 hours)
3.00
Fixed production overheads

$300 000
(at
= $12 per direct labour hour)
25 000
Full production cost
Profit mark-up (20%)
Selling price per unit of product X
48.00
98.00
19.60
117.60
There are several serious problems with relying on a full cost approach to pricing:
a. It fails to recognise that demand may be determining price. For many products, the price set will
determine the quantity sold. The price we set using this method may not lead to selling the
quantity that gives us the biggest profit. In other words, the price we set might not be competitive.
b. There may be a need to adjust prices to market and demand conditions.
c. Budgeted output volume needs to be established. Output volume is a key factor in the overhead
absorption rate.
d. A suitable basis for overhead absorption must be selected, especially where a business produces
more than one product.
However, it is a quick, simple and cheap method of pricing which can be delegated to junior
managers, which is particularly important with jobbing work where many prices must be decided and
quoted each day and, since the size of the profit margin can be varied, a decision based on a price in
excess of full cost should ensure that a company working at normal capacity will cover all of its fixed
costs and make a profit.
3.1.2 MARGINAL COST-PLUS PRICING

Definition
Marginal cost-plus pricing/Mark-up pricing is a method of determining the sales price by adding a
profit margin on to either marginal cost of production or marginal cost of sales.
Whereas a full cost-plus approach to pricing draws attention to net profit and the net profit margin, a
variable cost-plus approach to pricing draws attention to gross profit and the gross profit margin, or
contribution.
Question 8: Mark up on cost
A product has the following costs:

Direct materials
Direct labour
Production variable overheads
Sales variable overheads
$
5
3
7
2
Fixed overheads are $10 000 per month. Budgeted sales per month are 400 units.
CHAPTER 11
The company wishes to make a profit of 20% on full production cost from product X.
What is the mark up on marginal cost if the selling price is $20?

A
B
C
D
15%
17.6%
25%
33.3%
There are several advantages of a marginal cost-plus approach to pricing:

a. It is a simple and easy method to use.
b. The mark-up percentage can be varied, and so mark-up pricing can be adjusted to reflect demand
conditions.
c. It draws management attention to contribution, and the effects of higher or lower sales volumes on
profit. In this way, it helps to create a better awareness of the concepts and implications of
marginal costing and cost-volume-profit analysis. For example, if a product costs $10 per unit and a
mark-up of 150% is added to reach a price of $25 per unit, management should be clearly aware
that every additional $1 of sales revenue would add 60 cents to contribution and profit.
d. In practice, mark-up pricing is used in businesses where there is a readily-identifiable basic variable
cost. Retail industries are the most obvious example, and it is quite common for the prices of
goods in shops to be fixed by adding a mark-up (20% or 33.3%, say) to the purchase cost.
There are, of course, drawbacks to marginal cost-plus pricing:
a. Although the size of the mark-up can be varied in accordance with demand conditions, it does not
ensure that sufficient attention is paid to demand conditions, competitors' prices and profit
maximisation.
b. It ignores fixed overheads in the pricing decision, but the sales price must be sufficiently high to
ensure that a profit is made after covering fixed costs.
3.1.3 COST-PLUS PRICING AND INVENTORY VALUATION

Many retail businesses price their goods by applying a fixed mark up to their cost. It is therefore very
convenient to take the selling price of the goods as shown on the price ticket or the price list, and
deduct the profit element to arrive at the cost of the goods for inventory valuation purposes.
3.2 MARKET-BASED APPROACHES TO PRICING

Section overview
Many firms base price on what consumers demand rather than simple cost-plus rules.
3.2.1 PRODUCT LIFE CYCLE

LO
11.3
The product life concept is relevant to pricing policy. The concept states that a typical product moves
through four stages:
a. Introduction
The product is introduced to the market. Heavy capital expenditure will be incurred on product
development and perhaps also on the purchase of new non-current assets and building up stocks
for sale.
On its introduction to the market, the product will begin to earn some revenue, but initially
demand is likely to be small. Potential customers will be unaware of the product or service, and the
organisation may have to spend further on advertising to bring the product or service to the
attention of the market.
b. Growth
c. Maturity
Eventually, the growth in demand for the product will slow down and it will enter a period of
relative maturity. It will continue to be profitable. The product may be modified or improved, as a
means of sustaining its demand.
d. Saturation and decline
At some stage, the market may reach 'saturation point'. Demand will start to fall. For a while, the
product will still be profitable in spite of declining sales, but eventually it will become a loss-maker
and this is the time when the organisation should decide to stop selling the product or service, and
so the product's life cycle should reach its end.
Remember, however, that some mature products may never decline: staple food products such as
milk or bread are the best example.
Not all products follow this cycle, but it remains a useful tool when considering decisions such as
pricing. The life cycle concept is relevant when considering what pricing policy will be adopted.
3.2.2 MARKETS
The price that an organisation can charge for its products will also be influenced by the market in
which it operates.
Definitions
Perfect competition: many buyers and many sellers all dealing in an identical product. No individual
or group of sellers or buyers can influence the market price.
Monopoly: one seller who dominates many buyers. The monopolist can use this market power to set
a profit-maximising price.
Oligopoly: relatively few competitive companies dominate the market. While each large firm has the
ability to influence market prices, the unpredictable reaction from the other giants makes the final
industry price indeterminate.
3.2.3 COMPETITION
In established industries dominated by a few major firms, a price initiative by one firm will usually be
countered by a price reaction by competitors. In these circumstances, prices tend to be stable.
If a rival cuts its prices in the expectation of increasing its market share, a firm has several options:
a. It will maintain its existing prices if the expectation is that only a small market share would be lost,
so that it is more profitable to keep prices at their existing level. Eventually, the rival firm may drop
out of the market or be forced to raise its prices.
b. It may maintain its prices but respond with a non-price counter-attack. This is a more positive
response, because the firm will be securing or justifying its current prices with a product change,
advertising, or better back-up services.
c. It may reduce its prices. This should protect the firm's market share so that the main beneficiary
from the price reduction will be the consumer.
d. It may raise its prices and respond with a non-price counter-attack. The extra revenue from the higher
prices might be used to finance an advertising campaign or product design changes. A price increase
would be based on a campaign to emphasise the quality difference between the firm's own product
and the rival's product.
CHAPTER 11
The product gains a bigger market as demand builds up. Sales revenues increase and the product
begins to make a profit. The initial costs of the investment in the new product are gradually
recovered. However competitors enter the market, increasing competition, which can cause prices
to drop. Also additional investment in manufacturing capacity may be required to meet demand.
3.2.4 PRICE LEADERSHIP

Given that price competition can have disastrous consequences in conditions of oligopoly, it is not
unusual to find that large corporations emerge as price leaders. The price leader indicates to the
other firms in the market what the price will be, and competitors then set their prices with
reference to the leader's price.
3.2.5 MARKET PENETRATION PRICING

This is a policy of low prices when the product is first launched in order to obtain sufficient
penetration into the market. A penetration policy may be appropriate:
If the firm wishes to discourage new entrants into the market.
If the firm wishes to shorten the initial period of the product's life cycle in order to enter the growth
and maturity stages as quickly as possible.
If there are significant economies of scale to be achieved from a high volume of output, so that
quick penetration into the market is desirable in order to gain unit cost reductions.
If demand is likely to increase as prices fall.
3.2.6 MARKET SKIMMING PRICING

In contrast, market skimming involves charging high prices when a product is first launched and
spending heavily on advertising and sales promotion to obtain sales. As the product moves into the
later stages of its life cycle (growth, maturity and decline) progressively lower prices will be charged.
The profitable 'cream' is therefore skimmed off in stages until sales can only be sustained at lower
prices.
The aim of market skimming is to gain high unit profits early in the product's life. High unit prices
make it more likely that competitors will enter the market than if lower prices were to be charged.
Such a policy is appropriate:
Where the product is new and different, so that customers are prepared to pay high prices so as to
be one up on other people who do not own it. Games systems are a good example.
Where the strength of demand and the sensitivity of demand to price are unknown. It is better
from the point of view of marketing to start by charging high prices and then reduce them if the
demand is insufficient.
Where products may have a short life cycle, and so need to recover their development costs and
make a profit quickly.
3.2.7 DIFFERENTIAL PRICING

In certain circumstances the same product can be sold at different prices to different customers.
There are a number of bases on which such prices can be set.
BASIS
EXAMPLE
By market segment
A cross-Tasman airline would market its services at different prices in Australia and New
Zealand, for example. Services such as cinemas and hairdressers are often available at
lower prices to senior citizens and/or juveniles.
By product version
Many car models have 'add on' extras which enable one brand to appeal to a wider
cross-section of customers. The final price need not reflect the cost price of the add on
extras directly: usually the top of the range model would carry a price much in excess of
the cost of provision of the extras, as a prestige appeal.
By place
Theatre seats are usually sold according to their location so that patrons pay different
prices for the same performance according to the seat type they occupy.
By time
This is perhaps the most popular type of price discrimination. Railway companies, for
example, are successful price discriminators, charging more to rush hour rail
commuters whose demand remains the same whatever the price charged at certain
times of the day.
3.2.8 PRICE AND THE PRICE ELASTICITY OF DEMAND
An important concept in this context is price elasticity of demand (PED).

Definition
The price elasticity of demand () measures the extent of change in demand for a good following a
change to its price.
Formula to learn
Price elasticity () is measured as:
% change in sales demand

% change in sales price
Demand is said to be elastic when a small change in the price produces a large change in the quantity
demanded. The PED is then greater than 1. Demand is said to be inelastic when a small change in the
price produces only a small change in the quantity demanded. The PED is then less than 1.
There are two special values of price elasticity of demand:
Demand is perfectly inelastic ( = 0). There is no change in quantity demanded, regardless of the
change in price.
Demand is perfectly elastic ( = ). Consumers will want to buy an infinite amount, but only up to
a particular price level. Any price increase above this level will reduce demand to zero.
An awareness of the concept of elasticity can assist management with pricing decisions.
In circumstances of inelastic demand, prices should be increased because revenues will increase
and total costs will reduce (because quantities sold will reduce).
In circumstances of elastic demand, increases in prices will bring decreases in revenue and
decreases in price will bring increases in revenue. Management therefore have to decide whether
the increase/decrease in costs will be less than/greater than the increases/decreases in
revenue.
In situations of very elastic demand, overpricing can lead to a massive drop in quantity sold and
hence a massive drop in profits, whereas underpricing can lead to costly stock outs and, again, a
significant drop in profits. Elasticity must therefore be reduced by creating a customer
preference which is unrelated to price (through advertising and promotional activities).
In situations of very inelastic demand, customers are not sensitive to price. Quality, service,
product mix and location are therefore more important to a firm's pricing strategy.
3.2.9 THE DEMAND-BASED APPROACH TO PRICING

Price theory or demand theory is based on the idea that a connection can be made between price,
quantity demanded and sold, and total revenue. Demand varies with price, and so if an estimate can
be made of demand at different price levels, it should be possible to derive either a
profit-maximising price or a revenue-maximising price.
The theory is dependent on realistic estimates of demand being made at different price levels.
Making accurate estimates of demand is often difficult as price is only one of many variables that
influence demand.
Some larger organisations go to considerable effort to estimate the demand for their products or
services at differing price levels by producing estimated demand curves.
CHAPTER 11
Economists argue that the higher the price of a good, the lower will be the quantity demanded. We
have already seen that in practice it is by no means as straightforward as this (some goods are bought
because they are expensive, for example), but you know from your personal experience as a consumer
that the theory is essentially true.
For example, a large transport authority might be considering an increase in bus fares or underground
fares. The effect on total revenues and profit of the increase in fares could be estimated from a
knowledge of the demand for transport services at different price levels. If an increase in the price per
ticket caused a large fall in demand, because demand was price elastic, total revenues and profits
would fall whereas a fares increase when demand is price inelastic would boost total revenue, and
since a transport authority's costs are largely fixed, this would probably boost total profits too.
Many businesses enjoy something akin to a monopoly position, even in a competitive market. This is
because they develop a unique marketing mix, for example, a unique combination of price and
quality. The significance of a monopoly situation is:
a. The business does not have to 'follow the market' on price. In other words it is not a 'price-taker',
but has more choice and flexibility in the prices it sets.
(i) At higher prices, demand for its products or services will be less.
(ii) At lower prices, demand for its products or services will be higher.
b. There will be a selling price at which the business can maximise its profits.
3.3 TARGET COSTING

Section overview
Target costing requires managers to change the way they think about the relationship
between cost, price and profit. The traditional approach is to develop a product, determine
the expected standard production cost of that product and then set a selling price
(probably based on cost), with a resulting profit or loss.
The target costing approach is to develop a product concept and then to determine the
price customers would be willing to pay for that concept. The desired profit margin is
deducted from the price, leaving a figure that represents total cost. This is the target cost.
3.3.1 THE TARGET COSTING APPROACH

Japanese companies developed target costing as a response to the problem of controlling and
reducing costs over the entire product life cycle, but especially during the design and development
stages. It has been used successfully by car manufacturers in particular, including Toyota and
Mercedes Benz.
Target costing requires managers to change the way they think about the relationship between cost,
price and profit. The traditional approach is to develop a product, determine the expected standard
production cost of that product and then set a selling price, probably based on cost, with a resulting
profit or loss. Costs are controlled through variance analysis at monthly intervals.
The target costing approach is to develop a product concept and the primary specifications for
performance and design and then to determine the price customers would be willing to pay for
that concept. The desired profit margin is deducted from the price, leaving a figure that represents
total cost. This is the target cost. The product must be capable of being produced for this amount
otherwise it will not be manufactured.
During the product's life the target cost will be continuously reviewed and reduced so that the price
can fall. Continuous cost reduction techniques must therefore be used.
3.3.2 ACHIEVING THE TARGET COST

If the anticipated product cost, based on the design specifications is above the target cost, the
product must be modified so that it is cheaper to produce.
The total target cost can be split into broad cost categories such as development, marketing,
manufacturing and so on. A team of designers, engineers, marketing and production staff, as well as
the management accountant, should then try to produce a product with planned development,
marketing, manufacturing (and so on) costs below the target costs.
If any of the target costs cannot be achieved given the product design, other individual targets must
be reduced, the product redesigned or scrapped.
3.3.3 TRANSFER PRICING
Where internal transfers of goods or services are made between different units of the same
business, management must decide on the appropriate price at which such transfers should be
charged.
Transfer prices are a way of promoting divisional autonomy, ideally without prejudicing the
divisional performance measurement or discouraging overall profit maximisation.
Definition
A transfer price is the price at which goods or services are transferred between different units of the
same company. The extent to which the transfer price covers costs and contributes to (internal) profit
is a matter of policy.
When there are transfers of goods or services between divisions, the transfers could be made free to
the division receiving the benefits. For example, if a garage and car showroom has two divisions, one
for car repairs and servicing and the other for car sales, the servicing division will be required to
service cars before they are sold. The servicing division could do the work without making any record
of the work done. However, unless the cost or value of such work is recorded, management cannot
keep a check on the amount of resources, such as time, that has been required for new car servicing.
For planning and control purposes, it is necessary that some record of inter-divisional services or
transfers of goods should be kept.
Inter-divisional work can be given a cost or charge, and this is its transfer price. The transfer price is
revenue to the division providing the goods or service, and a cost to the division receiving the benefit.
3.3.4 PROFIT CENTRES AND TRANSFER PRICING

An organisation might be divided into a number of profit centres. The manager of each profit centre is
required to make a profit from the activities for which he or she is responsible, and the performance of
the centre is measured in terms of profit.
A profit centre might be a division within the company, or a separate subsidiary company within the
group. The activities of a profit centre might be fairly autonomous, and separate from the activities of
other profit centres within the organisation. Alternatively, the activities of profit centres might be fairly
closely inter-related, with some profit centres providing products or services to others.
When one profit centre provides products or services to another profit centre, its manager will expect
to make a profit from these transactions, and so will charge the other profit centre a price for the work
that is in excess of the costs it incurred.
An issue that arises in such situations is how to fix a price for the work that is acceptable to both profit
centres.
CHAPTER 11
Section overview
Worked Example: Transfer pricing
Suppose that profit centre A supplies goods to profit centre B, and the cost to profit centre A is, say,
$10 000. Any price in excess of $10 000 will result in a profit for profit centre A. Now suppose that
profit centre B then re-sells the goods for $18 000 without doing any further work on them.
a. The total profit to the company is $8 000 ($18 000 $10 000).
b. If the price charged by profit centre A to profit centre B is $12,000, profit centre A will make a profit
of $2 000 ($12 000 $10 000) and profit centre B will make a profit of $6 000
($18 000 $12 000).
c. If the price charged by profit centre A to profit centre B is $17 000, profit centre A will make a profit
of $7 000 ($17 000 $10 000) and profit centre B will make a profit of $1 000 ($18 000 $17 000).
The overall profit is the same, whatever price profit centre A charges to profit centre B, but the price
charged affects the share of the total profit enjoyed by each profit centre.
The purpose of having a profit centre organisation is to provide an incentive for improving profitability
within each part of the organisation. However, setting prices for work done by one profit centre for
another is a potential source of disagreement, since one profit centre can improve its profits at the
expense of another, by charging higher prices.
In theory since the transfer price represents a cost to one party and income to the other, overall
corporate profits should be the same regardless of the transfer price. In practice however, the transfer
pricing policy has behavioural implications, which may cause managers to take decisions in the
interests of their profit centre but which reduce the profits of the organisation as a whole. For
example, if profit centre A charges $18 000 or more, B will not be encouraged to take the transfer
despite it being worthwhile for the company as a whole. This will lead to unused capacity.
3.3.5 BASES FOR SETTING A TRANSFER PRICE

A transfer price may be based on either the market price, the cost of production or it may be
negotiated.
If the market price is used as a basis for a transfer price then it may be either based on the full market
price or a discounted market price. If it is based on cost then it may be based on either marginal cost,
or full cost. A profit margin may be added to cost and is then referred to as cost-plus.
JIT aims for zero inventory and perfect quality and operates by demand-pull. It consists of JIT
purchasing and JIT production and results in lower investment requirements, space savings,
greater customer satisfaction and increased flexibility.
JIT aims to eliminate all non-value-added costs.
Inventory costs include purchase costs, holding costs, ordering costs and costs of running out
inventory.
Inventory control levels can be calculated in order to maintain inventories at the optimum level.
The three critical control levels are reorder level, minimum level and maximum level.
The economic order quantity (EOQ) is the order quantity which minimises inventory costs.
The EOQ can be calculated using a table, graph or formula.
There are a number of other systems of stores control and reordering, such as order cycling, twobin, classification and Pareto distribution.
Under the order cycling method, quantities on hand of each stores item are reviewed
periodically.
item is kept in two storage bins.
Materials items may be classified as expensive, inexpensive or in a middle-cost range.
Pareto (80/20) distribution which is based on the finding that in many stores, 80% of the value of
stores is accounted for by only 20% of the stores items.
Many firms base price on simple cost-plus rules.
Full cost-plus pricing is a method of determining the sales price by calculating the full cost of
the product and adding a percentage mark-up for profit.
Marginal cost-plus pricing/mark-up pricing is a method of determining the sales price by
adding a profit margin on to either marginal cost of production or marginal cost of sales.
Many firms base price on what consumers demand rather than simple cost-plus rules.
Target costing requires managers to change the way they think about the relationship between
cost, price and profit. The traditional approach is to develop a product, determine the expected
standard production cost of that product and then set a selling price (probably based on cost), with
a resulting profit or loss.
The target costing approach is to develop a product concept and then to determine the price
customers would be willing to pay for that concept. The desired profit margin is deducted from the
price, leaving a figure that represents total cost. This is the target cost.
Transfer prices are a way of promoting divisional autonomy, ideally without prejudicing the
divisional performance measurement or discouraging overall corporate profit maximisation.
Transfer prices may be based on market price where there is an external market.
CHAPTER 11
KEY CHAPTER POINTS

1 Features of a Just-in-Time production system include
A
B
C
D
longer production runs.

less preventive maintenance work.
producing only to meet known customer demand.
more movement of materials within the production area.
2 Which of the following may be reasons for holding inventory?

I When the production process is very long.
II To take advantage of bulk purchase discounts
III To smooth out production volumes when sales demand is seasonal
A
B
C
D
I, II and III
I and II only
I and III only
II and III only
3 A company determines its order quantity for a raw material by using the Economic Order Quantity
(EOQ) model.
What would be the effects on the EOQ and the total annual holding cost of a decrease in the cost
of ordering a batch of raw material?
A
B
C
D
EOQ
Higher
Higher
Lower
Lower
Total annual holding cost

Lower
Higher
Lower
Higher

A Cost plus pricing is a pricing method to ensure maximum profits.
B Marginal cost plus pricing is more appropriate when marginal costs are a small proportion of
total costs.
C For differential pricing to succeed, it must be possible to keep the different price markets
segregated.
D Market skimming pricing is appropriate if a small cut in the selling price of the product will lead
to a large increase in the quantity demanded.
5 At which stage of a product's life cycle are profits the lowest?
A
B
C
D
Introduction
Growth
Saturation and decline
It could be any of these
6 Which of the following statements regarding transfer pricing is/are correct?

I Negotiated transfer prices will always maximise total profit.
II Market based transfer prices will always encourage internal transfers.
A
B
C
D
I only
II only
I and II
Neither I nor II
1 C Features of JIT production systems are shorter production runs, more preventive maintenance
work (to prevent production hold-ups) and less movement of materials within the production
area (with production based around work cells). The organisation produces only to meet known
customer demand.
2 A To take advantage of bulk purchase discounts, it may be necessary to buy larger quantities, but
the cost of holding more inventory is justified by the saving in purchase costs. When sales
demand is seasonal, a manufacturer may schedule even production flows through the year (to
reduce overtime costs, avoid excessive production capacity, etc) and this means building up
inventories during the low sales seasons. When the production process is long, for example in
wine-making, it is necessary to hold large quantities of work-in-progress.
3 C If there is a decrease in the cost of ordering a batch of raw material, then the EOQ will also be
lower (as the numerator in the EOQ equation will be lower). If the EOQ is lower, then average
inventory held (EOQ/2) with also be lower and therefore the total annual holding costs will also
be lower.
4 C Market skimming pricing is appropriate when customers will pay high prices to own a new
product. Cost plus pricing cannot ensure maximum profits, because profitability depends on
sales demand. Marginal cost plus pricing is more appropriate when marginal costs are a large
proportion of total costs, for example in retailing. For differential pricing to succeed, it must be
possible to keep the different price markets segregated: for example separate prices for
children and people over 70. Unless the markets can be kept segregated, customers will buy in
the lower-priced market and re-sell in the higher-priced market, or will move to the lower-priced
market to buy the product or service.
5 D Net profits are revenues minus costs. In the introductory stage, high prices can be charged, but
fixed costs may be high and development costs may be charged against profits. In the growth
phase, sales volume is rising, but prices are falling and additional capital investment may add to
total costs. In the saturation and decline phase, sales volumes and probably also prices are
falling, and losses may be incurred. So for a given product, any of these phases of the life cycle
could be the least profitable.
6 D Negotiated transfer prices may result in maximum profit and market-based transfer prices may
encourage internal transfers, but not 'always'.
CHAPTER 11

1 B (I) Revision of inventory control levels would not be necessary because the control level system
would be abandoned completely. Parts and raw materials would be purchased in small
frequent deliveries against bulk contracts.
(II) is not correct because the number of suppliers would be reduced in a JIT environment.
There may be a long-term commitment to a single supplier.
(III) is correct. Suppliers may be chosen because of their close proximity so that they can
respond quickly to changes in the company's demands.
(IV) is correct. Accurate forecasting of demand reduces the need for inventories.
(V) is correct. Production management will aim to eliminate the occurrence of rejects and
defective materials since these situations stop the flow of production.
2 C The other activities are non-value-adding activities.
3 C All are potential limitations of JIT systems. Smaller batch sizes mean more batch production
runs. This results in higher set-up costs, administration costs and materials handling costs. There
is also more non-productive time spent getting ready for the next batch; therefore an
opportunity cost of productive labour is also incurred.
4 (a) C Maximum inventory level = reorder level + reorder quantity (min usage min lead time)
= 6 300 + 6 500 (180 11)
= 10 820
Using good MCQ technique, if you were resorting to a guess you should have eliminated
option A. The maximum inventory level cannot be less than the reorder quantity.
(b) D Buffer inventory
Minimum level
= minimum level
= reorder level (average usage average lead time)
= 6 300 (350 13) = 1 750
Option A could again be easily eliminated. With minimum usage of 180 per day, a buffer
inventory of only 200 would not be much of a buffer!
5 A Average inventory = safety inventory + reorder quantity
= 500 + (0.5 3 000)
= 2 000
6 C [Buffer inventory + (EOQ/2)] Annual holding cost per component
= [500 + (2 000/2)] $2
= $3 000
$7.99 ($4.70 170%)
7
8 B
Selling price
Marginal (variable) cost (5 + 3 + 7 + 2)
Mark up =
Profit
100%
Marginal cost
3
100%
17
= 17.6%
=
Note that the fixed overheads are not included in marginal cost.
$
20
17
323
CHAPTER 12
PERFORMANCE
MEASUREMENT AND
EVALUATION
Learning objectives
Reference
LO12
Explain the characteristics and purpose of performance measurement systems
LO12.1
Analyse the different types of financial performance measures and their limitations
LO12.2
Describe the key characteristics of the Balanced Scorecard and its advantages over
traditional performance measurement systems
LO12.3
Outline the characteristics of reward systems and the circumstances in which they can
be tied to performance measures
LO12.4
LO1
Identify and explain appropriate internal controls for management and accounting
systems in a range of situations
LO1.8
Topic list
1
2
3
4
5
6
Responsibility centres
Investigating variances
Control action
Performance measures
The balanced scorecard
Reward systems
INTRODUCTION
In Chapter 9 we learnt the mechanics of calculating variances and preparing operating statements.
But, for the purposes of operating a budgetary control system, this is not the end of the matter. The
information must be given to the people responsible for the parts of the organisation that are
experiencing variances, so that they can take action to bring the situation under control. A system
which gives this responsibility to managers is known as responsibility accounting.
Variances provide one way of highlighting a possible problem area to managers, and are therefore a
type of performance indicator. We will have a look at other performance indicators, which can be used
to monitor the performance of individual departments in the organisation and the organisation as a
whole.
The chapter then moves on to a discussion about the key characteristics of the balanced scorecard
and its advantages over traditional performance measurement systems.
Finally, we consider reward systems.
Performance
measurement
and evaluation
Responsibility
centres
Investigating
variances
Performance
measures
Control action
Balanced
scorecard
Reward
systems
PERFORMANCE MEASUREMENT AND EVALUATION | 325
BEFORE YOU BEGIN

area.
everything covered.
will also find a commentary at the back of the study manual.
1 What is a responsibility centre?
(Section 1)
3 Explain the concept of interdependence between variances and why this is relevant when
considering control action.
(Section 3)
4 Give examples of performance measures.
(Section 4.1)
5 Explain how indices can be used to measure activity within an organisation.
(Section 4.4.3)
6 Outline performance measures for an investment centre.
(Section 4.10)
7 What are the four perspectives of the balanced scorecard?
(Section 5.1)
8 What are the limitations of using the balanced scorecard?
(Section 5.2)
9 Define the term 'reward'.
(Section 6)
CHAPTER 12
2 What factors should be considered when deciding whether or not to investigate the reasons for the
occurrence of a particular variance?
(Section 2)
1 RESPONSIBILITY CENTRES
Section overview
Responsibility accounting is a system of accounting that segregates revenue and costs into
areas of personal responsibility to monitor and assess the performance of each part of an
organisation.
A responsibility centre is a function or department of an organisation that is headed by a
manager who has direct responsibility for its performance.
There are a number of different bases for control:
A cost centre is any unit of an organisation to which costs can be separately attributed.
A profit centre is any unit of an organisation to which both revenues and costs are
assigned, so that the profitability of the unit may be measured.
An investment centre is a profit centre whose performance is measured by its return on
capital employed.
Definitions
Responsibility accounting is a system of accounting that makes revenues, costs and assets the
responsibility of particular managers so that the performance of each part of the organisation can be
monitored and assessed. It is the accounting system that measures the performance of managers
against their budgets.
A responsibility centre is a section of an organisation that is headed by a manager who has direct
responsibility for its performance.
LO
12.1
A budget will be prepared for each responsibility centre, and its manager will be responsible for
achieving the budget targets of that centre. The performance of the centre will be monitored, and the
manger will be expected to take appropriate action if there are significant variances or other targets
are not met.
Responsibility centres are usually divided into different categories. Here we shall describe cost
(expense), revenue, profit and investment centres.
1.1 COST CENTRES

Definition
A cost, or expense, centre is any part of an organisation which incurs costs. A cost centre is a
responsibility centre where the manager has authority and influence over the costs but not over
revenue.
Cost centres can be quite small, sometimes one person or one machine or one expenditure item.
They can also be quite big, for example, an entire department. An organisation might establish a
hierarchy of cost centres. For example, within a transport department, individual vehicles might each
be made a cost centre, the repairs and maintenance section might be a cost centre, there might be
cost centres for expenditure items such as rent or building depreciation on the vehicle depots, vehicle
insurance and road tax. The transport department as a whole might be a cost centre at the top of this
hierarchy of sub-cost centres.
To charge actual costs to a cost centre, each cost centre will have a cost code, and items of
expenditure will be recorded with the appropriate cost code. When costs are eventually analysed,
there may be some apportionment of the costs of one cost centre to other cost centres.
Information about cost centres might be collected in terms of total actual costs, total budgeted
costs and total cost variances. In addition, the information might be analysed in terms of ratios, such
as cost per unit produced (budget and actual), hours per unit produced (budget and actual) and
transport costs per tonne/ kilometre (budget and actual).
1.2 REVENUE CENTRES

Definition
A revenue centre is a section of an organisation which raises revenue but has no responsibility for
production. A sales department is an example.
1.3 PROFIT CENTRES

Definition
A profit centre is any section of an organisation, for example, a division of a company, which earns
revenue and incurs costs. The profitability of the section can therefore be measured. A profit centre is
a responsibility centre where the manager has authority and influence over costs and revenue of that
centre
Profit centres differ from cost centres in that they account for both costs and revenues. The key
performance measure of a profit centre is therefore profit. The manager of the profit centre must be
able to influence both revenues and costs, in other words, have a say in both sales and production
policies.
A profit centre manager is likely to be a fairly senior person within an organisation, and a profit centre
is likely to cover quite a large area of operations. A profit centre might be an entire division within the
organisation, or there might be a separate profit centre for each product, brand or service or each
geographical selling area. Information requirements need to be similarly focused.
In the hierarchy of responsibility centres within an organisation, there are likely to be several cost
centres within a profit centre.
1.4 INVESTMENT CENTRES

Definitions
An investment centre is a responsibility centre where the manager has authority and influence over
costs, revenues and investments of that centre.
An investment centre manager has some say in investment policy in their area of operations as well
as being responsible for costs and revenues.
Several profit centres might share the same capital items, for example, the same buildings, stores or
transport fleet, and so investment centres are likely to include several profit centres, and provide a
basis for control at a very senior management level, like that of a subsidiary company within a group.
The performance of an investment centre is measured by the return on capital employed. It shows
how well the investment centre manager has used the resources under their control to generate profit.
CHAPTER 12
The term 'revenue centre' is often used in non-profit-making organisations. Revenue centres are
similar to cost centres, except that whereas cost centres are for costs only, revenue centres are for
recording revenues only. Information collection and reporting could be based on a comparison of
budgeted and actual revenues earned by that centre.
Question 1: Freeways Minibreak Limited

Freeways Minibreak Limited owns a chain of motels situated at strategic points alongside major
freeways in Australia. It is a high-volume, low-margin business which operates a strict system of
budgetary control, central to which is a hierarchy of responsibility centres. Bookings can be made
directly with the hotels, or via a central call centre. Each hotel has a restaurant which is open to the
public as well as guests. The hotel manager has a capital expenditure budget, although the Head
Office makes all decisions regarding the purchase of new hotels.
Which one of the following responsibility centres would be categorised as a profit centre?
A
B
C
D
The Melbourne Minibreak Hotel

The central bookings call centre
The Bridgeview Restaurant at the Sydney Minibreak Hotel
The domestic services (cleaning and maintenance) function in the Kalgoorlie Minibreak Hotel
2 INVESTIGATING VARIANCES
Section overview
Materiality, controllability and variance trend should be considered before a decision about
whether to investigate a variance is taken.
One way of deciding whether to investigate a variance is to only investigate those variances
which exceed pre-set tolerance limits.
Control limits may be illustrated on a control chart.

There are a number of factors which should be considered when deciding whether to investigate the
reasons for the occurrence of a particular variance.
2.1 MATERIALITY
Small variations in a single period between actual and standard are bound to occur and are unlikely to
be significant. Obtaining an 'explanation' of the reasons why they occurred is likely to be timeconsuming and irritating for the manager concerned. For such variations further investigation is not
worthwhile.
Management will only want to spend time investigating meaningful or material variances. A variance is
material or significant if it is likely to influence the actions and decisions of management. An
assessment of materiality may be linked to the size, relative amount and nature of the variance. e.g. a
50% saving in sundry costs which total less than $500 (a favourable variance of $250) may not be
material for a large company, but the cause of a 10% increase in capital expenditure compared to the
budget of $10million (an unfavourable variance of $1 million) would need to be investigated. One
approach is to set tolerance limits and investigate the cause of variances which fall outside these
limits.
2.2 CONTROLLABILITY
Managers of responsibility centres should only be held responsible for costs over which they have
some control. These are known as controllable costs - items of expenditure which can be directly
influenced by a given manager within a given time span.
If there is a general worldwide price increase in the price of an important raw material there is nothing
that can be done internally to control the effect of this. If a central decision is made to award all
employees a 10% increase in salary, staff costs in division A will increase by this amount and the
variance is not controllable by division A's manager. Uncontrollable variances call for a change in the
standard, not an investigation into the past.
2.3 VARIANCE TREND
a. If a labour efficiency variance is $1 000 unfavourable in month 1, this could indicate that the
production process is out of control and that corrective action must be taken to improve
productivity. This may be correct, but what if the same variance is $1 000 unfavourable every
month? The trend may indicate that the process is in control but that the standard has been
wrongly set. The unfavourable labour efficiency variance may reflect an ongoing operational
decision to use lower skilled labour which might otherwise have been idle. Alternatively it could
reflect the purchasing department's decision to acquire cheaper but lower quality material which is
proving more time-consuming to work with.
b. Suppose, though, that the same labour efficiency variance is consistently $1 000 unfavourable for
each of the first six months of the year but that production has steadily fallen from 100 units in
month 1 to 65 units by month 6. The variance trend in absolute terms is constant, but relative to the
number of units produced, labour efficiency has got steadily worse. Hence an investigation into the
cause of the inefficiency and the decline in production is almost certainly required, in order for
corrective action to be taken.
Individual variances should therefore not be looked at in isolation; variances should be scrutinised
for a number of successive periods if their full significance is to be appreciated.
Variances also need to be considered in the light of the type of standards being used, cost drivers for
the relevant expenditure, any known operational decisions and the interdependence between
variances. The possible causes of variances were examined in more detail in Chapter 9.
Question 2: Variance trend information
Which of the following trends in variances might indicate a learning curve effect?
A
B
C
D
Gradually improving labour efficiency variances.

Gradually improving fixed overhead expenditure variances.
A rapid, large increase in unfavourable material price variances.
Regular, perhaps fairly slight, increases in unfavourable labour rate variances.
2.4 THE SIGNIFICANCE OF VARIANCES

A variance can be considered significant if it will influence management's actions and decisions.
Significant variances usually need investigating.
Variances which are simply random deviations, in other words fluctuations which have arisen by
chance, are uncontrollable. This is because a standard cost is really only an average expected cost and
is not a rigid specification. Some variances either side of this average must be expected to occur and
are hence outside management's control.
The accountant should analyse the cause and effect of any variances. The problem for management is
to decide whether a variation from standard is attributable to chance and hence not significant or
whether it is due to a controllable cause and therefore significant.
CHAPTER 12
Although small variations in a single period are unlikely to be significant, small variations that occur
consistently may need more attention. Variance trend is more important than a single set of variances
for one accounting period. The trend provides an indication of whether the variance is fluctuating
within acceptable control limits or becoming out of control.
2.5 CONTROL LIMITS AND CONTROL CHARTS

Because standard costs are only estimates of average costs, it would be incorrect to treat them as
being rigid. Tolerance limits should be set, and only variances which exceed these limits should be
reported as being significant and investigated. The following variances would lie within the tolerance
limits:
Normal variations around average performance, with variations above and below the average
(unfavourable and favourable variances) cancelling each other out in the course of time.
Minor operational variances which are too small to justify the cost of investigation and control
action by management. Small variances might 'sort themselves out' in time, and only if they persist
and grow larger should investigative action be worthwhile.
A minor planning error in the standard cost for the year.
The control limits may be illustrated on a variance control chart as follows:
Variance control chart

Variances
Favourable
Control limit
Inner warning limit

100% = Standard
Adverse
Inner warning limit

Control limit
*Notify as an exception
There are several ways of establishing control limits:
Management might establish a rule that any variance should be deemed significant if it exceeds a
certain percentage of standard, for example, if it exceeds 10% of standard in any one period based
on judgment or experience.
Management can use statistics, and estimate not only the standard cost, but the expected
standard deviation, a measure of the spread or dispersion, of actual costs around the standard.
Variances would then be deemed significant if actual costs were significantly different from
standard.
Not all variances which are outside the control limits require detailed investigation. Often the cause is
already known. A variance will only be investigated if the expected value of benefits from investigation
and any control action exceed the costs of investigation.
For example, it may be known from past experience that the cost of investigating a particular variance
is $150 and that cost savings amounting to $1 200 can be made if the variance is corrected
successfully. However it is also known that there is only a 30% possibility of the variance being
corrected once the cause is found.
Expected value of an investigation = ($1 200 0.3) $150 = $210
In this particular case it is worth investigating the variance.
Question 3: Jefferson Ltd
Every month for the past eight months, the operating statement of Jefferson Ltd has shown an
unfavourable direct material efficiency variance of between $1 500 and $2 500 relating to a product
that is only to be produced for a further six months. The company management accountant believes
that if the variance is investigated, there is a 70% chance that its cause can be eliminated. The cost of
the investigation to find out the cause of the variance would be $2 000 and the expected cost of
corrective action, if the cause is found to be controllable, would be an additional $5 000.
What is the best estimate of the net benefit from investigating the cause of this variance?
A
$1 400
B
$2 000
C
$2 500
D
$2 900
The variance in each period is added to the total of the variances that have occurred over a longer
period of time. If the variances are not significant, the total will simply fluctuate in a random way above
and below the average (favourable and unfavourable variances), to give an insignificant total or
cumulative sum. If the cumulative sum develops a positive or negative drift, it may exceed a set
tolerance limit. Then the situation must be investigated, and control action will probably be required.
The cumulative sum of variances over a period of time can be shown on a cusum chart.
Cumulative sum of variances

Control limit
Inner warning limit
Time
Inner warning limit
Control limit
*
* Control action required
The advantage of the multiple period approach is that trends are detectable earlier, and control
action can be introduced sooner than might have been the case if only current-period variances were
investigated.
3 CONTROL ACTION
Section overview
If a variance is assessed as significant then the responsible manager may need to take
control action.
If the cause of a variance is controllable, action can be taken to bring the system back
under control in future. If the variance is uncontrollable, but not simply due to chance, it will
be necessary to review forecasts of expected results, and perhaps to revise the budget.
LO
1.8
Since a variance compares historical actual costs with standard costs, it is a statement of what has
gone wrong (or right) in the past. By taking control action, managers can do nothing about the past,
but they can use their analysis of past results to identify where the 'system' is out of control. If the
cause of the variance is controllable, action can be taken to bring the system back under control in
future. If the variance is uncontrollable, on the other hand, but not simply due to chance, it will be
necessary to revise forecasts of expected results, and perhaps to revise the budget.
It may be possible for control action to restore actual results back on course to achieve the original
budget. For example, if there is an unfavourable labour efficiency variance in month 1 of 1 100 hours,
control action by the production department might succeed in increasing efficiency above standard
by 100 hours per month for the next 11 months.
CHAPTER 12
Another approach is to look at the variances over a number of accounting periods, instead of just
looking at variances in a single period.
It is also possible that control action might succeed in restoring better order to a situation, but the
improvements might not be sufficient to enable the company to achieve its original budget. For
example, if for three months there has been an unfavourable labour efficiency in a production
department, so that the cost per unit of output was $8 instead of a standard cost of $5, then control
action might succeed in improving efficiency, so that unit costs are reduced to $7, $6 or even $5, but
the earlier excess spending means that the profit in the master budget will not be achieved.
Depending on the situation and the control action taken, the action may take immediate effect, or it
may take several weeks or months to implement. The effect of control action might be short-lived,
lasting for only one control period; but it is more likely to be implemented with the aim of long-term
improvement.
3.1 POSSIBLE CONTROL ACTION

The control action which may be taken will depend on the reason why the variance occurred. Some
reasons for variances and their implications for control action are outlined in the paragraphs below.
a. Measurement errors
In practice it may be extremely difficult to establish that 1 000 units of product A used 32 000 kg of
raw material X. Scales may be misread, the pilfering or wastage of materials may go unrecorded,
one material may have been incorrectly substituted for another or items may be wrongly classified,
for example, as material X3 when material X8 was used in reality.
An investigation may show that control action is required to improve the accuracy of the recording
system so that measurement errors do not occur.
b. Poor planning out of date standards of measurement
Price standards are likely to become out of date when changes to the costs of material, power,
labour and so on occur, or in periods of high inflation. In such circumstances an investigation of
variances is likely to highlight a general change in market prices rather than efficiencies or
inefficiencies in acquiring resources.
Standards may also be out of date where operations are subject to technological development or if
learning curve effects have not been taken into account. Investigation of this type of variance will
provide information about the inaccuracy of the standard and highlight the need to frequently
review and update standards.
c. Random or chance fluctuations
A standard is an average figure. It represents the midpoint of a range of possible values and
therefore actual results are likely to deviate unpredictably within the predictable range.
As long as the variance falls within this range, it will be classified as a random or chance fluctuation
and control action will not be necessary.
d. Efficient or inefficient operations
Spoilage and better quality material/more highly skilled labour than standard are all likely to affect
the efficiency of operations and hence cause variances. Investigation of variances in this category
should highlight the cause of the inefficiency or efficiency and will lead to control action to
eliminate the inefficiency being repeated or action to compound the benefits of the efficiency. For
example, stricter supervision may be required to reduce wastage levels. The possible reasons for
the occurrence of variances were discussed in Chapter 9.
3.2 INTERDEPENDENCE BETWEEN VARIANCES

The cause of one variance may be wholly or partly explained by the cause of another variance.
Examples could be as follows:
a. If the purchasing department buys a cheaper material which is poorer in quality than the expected
standard, the material price variance will be favourable, but this may cause material wastage and
an unfavourable usage variance.
b. Similarly, if employees used to do some work are highly experienced, they may be paid a higher
rate than the standard wage per hour, but they should do the work more efficiently than
employees of 'average' skill. In other words, an unfavourable rate variance may be compensated by
a favourable efficiency variance.
c. An unfavourable efficiency variance may be reported following the purchase of cheaper material
(favourable material price variance) because operatives find difficulty in processing the cheaper
material.
d. A rise in selling price very often leads to a fall in the volume of goods sold, so sales price and
volume variances can be interdependent.
Question 4: Variance report
VARIANCE REPORT: SEPTEMBER 20X5
Material
Usage
Price
Labour
Efficiency
Rate
Fixed production overhead
Expenditure
Volume
Variance
(Favourable)
$
Total
variance
$
2 000
5 500
3 500
1 500
3 000
1 500
500
4 500
5 000
Actual costs for September 20X5 were as follows:

Materials
Labour
Overheads
Total
$
100 000
80 000
75 000
255 000
Which one of the following statements is appropriate?

A
The fixed overhead expenditure variance could be caused by some expenditures being
deferred to a later month.
The total unfavourable variance of $4 000 is just 1.57% of total costs; therefore the variances do
not justify investigation.
The fixed overhead volume variance indicates that the production operation worked at above
budgeted capacity during the period.
The materials usage variance and materials price variance are interdependent; and the two
components of the materials variance therefore do not justify separate investigation.
4 PERFORMANCE MEASURES
Section overview
Performance measurement aims to establish how well something or somebody is doing in
relation to a planned activity.
Ratio and percentages are useful performance measurement techniques.
CHAPTER 12
Variance
(Unfavourable)
$
LO
12.1
Management measure the performance of an organisation in a number of areas to see whether

objectives or targets are being met
in the organisation as a whole.

in each of the main sub-divisions of the organisation.
in individual activities.
in relationships with customers, the market, suppliers and competitors.
The process of performance measurement is carried out using a variety of performance indicators,
which are individual measurements. We look at performance indicators in general below before
moving on to look at performance indicators derived from the statements of income and financial
position. As well as being of use to management, parties external to the organisation can use these as
a guide to how well the organisation is performing.
4.1 PERFORMANCE INDICATORS

In the previous section we looked at the analysis of variances. Cost variances are examples of
performance indicators and can provide assistance to management in a number of ways:
Monitoring the use of resources

Controlling the organisation
Planning for the future
In this section we will look at a wide variety of performance indicators. Let's have a look at some
examples and the possible uses they could have:
The direct labour efficiency variance, which could identify problems with labour productivity.
Distribution costs as a percentage of turnover, which could help with the control of costs.
Number of hours during which labour are idle, which could indicate how well resources are being
used.
Profit as a percentage of turnover, which could highlight how well the organisation is being
managed.
Number of units returned by customers, which could help with planning production and finished
inventory levels.
Given this wide range of uses, you should be able to appreciate the importance of performance
indictors and their value to managers in allowing them to see where improvements in organisational
performance can be made.
A performance indicator is only useful if it is given meaning in relation to something else. Here is a list
of yardsticks against which indicators can be compared so as to become useful.
Standards, budgets or targets what was expected or hoped for.

Trends over time comparing last year with this year, say. An upward trend in the number of
rejects from a production process, say, would indicate a problem that needed investigating. The
effects of inflation would perhaps need to be recognised if financial indicators were being
compared over time.
The results of other parts of the organisation. Large manufacturing companies may compare the
results of their various production departments, supermarket chains will compare the results of
their individual stores, while a college may compare pass rates in different departments.
The results of other organisations. For example, trade associations or the government may
provide details of key indicators based on averages for the industry.
As with all comparisons, it is vital that the performance measurement process compares 'like with
like'. There is little to be gained in comparing the results of a small supermarket in a high street with a
huge one in an out-of-town shopping complex. We return to the importance of consistency in
comparisons later in this chapter.
4.2 QUALITATIVE AND QUANTITATIVE MEASURES

LO
12.2
It is possible to distinguish between quantitative data, which is capable of being expressed in

numbers, and qualitative data, which can only be expressed in numerical terms with difficulty.
Qualitative data refers to the character, attribute or property of the item or action being measured.
An example of a quantitative performance measure is 'You have been late for work twice this week
and it's only Tuesday!'.
An example of a qualitative performance measure is 'My bed is very comfortable'.
The first measure is likely to find its way into a staff appraisal report. The second would feature in a
bed manufacturer's customer satisfaction survey. Both are indicators of whether their subjects are
doing as good a job as they are required to do.
Consider the statement 'Seven out of ten customers think our beds are very comfortable'. This is a
quantitative measure of customer satisfaction as well as a qualitative measure of the perceived
performance of the beds. (But it does not mean that only 70% of the total beds produced are
comfortable, nor that each bed is 70% comfortable and 30% uncomfortable: 'very' is the measure of
comfort.)
4.3 PRODUCTIVITY, EFFICIENCY AND EFFECTIVENESS

In general, performance indicators are established to measure productivity, efficiency and
effectiveness.
Effectiveness is about meeting targets and objectives.
Productivity or efficiency is a measure of output relative to some form of input.
4.4 PERFORMANCE MEASURES FOR COST CENTRES

4.4.1 PRODUCTIVITY
This is the quantity of the product or service produced (output) in relation to the resources put in
(input). For example, so many units produced per hour, or per employee, or per tonne of material.
It measures how efficiently resources are being used.
4.4.2 COST PER UNIT

For the manager of a cost centre which is also a production centre, one of the most important
performance measures will be cost per unit. This is simply the total costs of production divided by the
number of units produced in the period.
Worked Example: Cost per unit
The total costs and number of units produced for a production cost centre for the last two months are
as follows:
Production costs
Units produced
May
$128 600
12 000
June
$143 200
13 500
Cost per unit
$128 600
$143 200
12 000
= $10.72
13 500
$10.61
CHAPTER 12
Qualitative measures are by nature subjective and judgmental but this does not mean that they are
not valuable. They are especially valuable when they are derived from several different sources.
4.4.3 INDICES
Indices can be used in order to measure activity.
Indices show how a particular variable has changed relative to a base value. The base value is
usually the level of the variable at an earlier date. The 'variable' may be just one particular item, such
as material X, or several items may be incorporated, such as 'raw materials' generally.
In its simplest form an index is calculated as (current value base value) 100%.
Therefore if materials cost $15 per kg in 20X0 and now (20X3) cost $27 per kg the 20X0 value would be
expressed in index form as 100 (15/15 100) and the 20X3 value as 180 (27/15 100). If you find it
easier to think of this as a percentage, then do so. The current cost is 180% of the base cost.
Worked Example: Work standards and indices
Standards for work done in a service department could be expressed as an index. The budget forms
the base value. For example, suppose that in a sales department, there is a standard target for sales
representatives to make 25 customer visits per month each. The budget for May might be for ten sales
representatives to make 250 customer visits in total. Actual results in May might be that nine sales
representatives made 234 visits in total. Performance could then be measured as:
Budget
Actual
100
104
(Standard = index 100)
(234 (9 25)) 100)
This shows that 'productivity' per sales representative was actually 4% over budget.
4.5 PERFORMANCE MEASURES FOR REVENUE CENTRES

Traditionally sales performance is measured against price and volume targets. Other possible
measures include revenue targets and target market share. They may be analysed in detail: by
country, by region, by individual products, by salesperson and so on.
In a customer-focused organisation the basic information 'Sales revenue is up by 14%' can be
supplemented by a host of other indicators.
a. Customer rejects/returns: total sales. This ratio helps to monitor customer satisfaction, providing
a check on the efficiency of quality control procedures.
b. Deliveries late: deliveries on schedule. This ratio can be applied both to sales made to
customers and to receipts from suppliers. When applied to customers it provides an indication of
the efficiency of production and production scheduling.
c. Flexibility measures indicate how well able a company is to respond to customers' requirements.
Measures could be devised to measure how quickly and efficiently new products are launched,
and how well procedures meet customer needs.
d. Number of people served and speed of service, in a shop or a bank for example. If it takes too
long to reach the point of sale, future sales are liable to be lost.
e. Customer satisfaction questionnaires, for input to the organisation's management information
system.
4.6 PERFORMANCE MEASURES FOR PROFIT CENTRES

4.6.1 PROFIT MARGIN
Definition
The profit margin (profit to sales ratio) is calculated as (profit sales revenue) 100%.
The profit margin provides a simple measure of performance for profit centres. Investigation of
unsatisfactory profit margins enables control action to be taken, either by reducing excessive costs or
by raising selling prices.
Profit margin is usually calculated using operating profit.

Worked Example: The profit to sales ratio
A company compares its year 2 results with year 1 results as follows:
Profit
Profit to sales ratio
Year 1
$
120 000
40 000
40 000
22 000
42 000
144 000
20 000
30 000
20 000
35 000
105 000
16 000
15 000
16 000
100%
160 000
15 000
100%
120 000
10%
12%
The above information shows that there is a decline in profitability in spite of the $1 000 increase in
profit, because the profit margin is less in year 2 than year 1.
4.6.2 GROSS PROFIT MARGIN

The profit to sales ratio above was based on a profit figure which included non-production overheads.
The pure trading activities of a business can be analysed using the gross profit margin, which is
calculated as (gross profit sales revenue) 100%.
For the company in the above example the gross profit margin would be:
16 000 42 000
Year 1:
100% = 36.25%
160 000
15 000 35 000
Year 2:
100% = 41.67%
120 000
4.6.3 COST/SALES RATIOS

When target profits are not met, further ratios may be used to shed some light on the problem:
Production cost of sales sales revenue
Distribution and marketing costs sales revenue
Administrative costs sales revenue
Subsidiary ratios can be used to examine problem areas in greater depth. For example, for production
costs the following ratios might be used:
Material costs sales value of production
Works labour costs sales value of production
Production overheads sales value of production
CHAPTER 12
Sales revenue
Cost of sales
Direct materials
Direct labour
Production overhead
Marketing overhead
Year 2
$
160 000
Worked Example: Cost/sales ratios
Look back to the previous example. A more detailed analysis would show that higher direct materials
are the probable cause of the decline in profitability.
Year 2
Material costs/sales revenue
40 000
100%
160 000
Year 1
25%
20 000
100%
120 000
16.7%
Other cost/sales ratios have remained the same or improved.
Question 5: Margin
Use the following summary income statement to answer the questions below.
Sales revenue
Cost of sales
Selling and distribution expenses
Administrative expenses
Operating profit
$
3 000
1 800
1 200
300
200
700
Calculate
(a) the profit margin.
(b) the gross profit margin.
4.7 RESOURCES
Traditional measures for materials compare actual costs with expected costs, looking at differences
(or variances) in price and usage. Many traditional systems also analyse wastage. Measures used in
modern manufacturing environments include the number of rejects in materials supplied, and the
timing and reliability of deliveries of materials.
Labour costs are traditionally measured in terms of standard performance (such as ideal or attainable)
and rate and efficiency variances.
Qualitative measures of labour performance concentrate on matters such as ability to communicate,
interpersonal relationships with colleagues, customers' impressions and levels of skills attained.
Managers can expect to be judged to some extent by the performance of their staff. High profitability
or tight cost control are not the only indicators of managerial performance!
For variable overheads, differences between actual and budgeted costs, i.e. variances, are traditional
measures. Various time based measures are also available, such as:
a. Machine down time: total machine hours. This ratio provides a measure of machine usage and
efficiency.
b. Value added time: production cycle time. Value added time is the direct production time during
which the product is being made. The production cycle time includes non-value-added times such
as set-up time, downtime, idle time and so on. The 'perfect' ratio is 100%, but in practice this
optimum will not be achieved. A high ratio means non-value-added activities are being kept to a
minimum.
4.8 MEASURES OF PERFORMANCE USING THE STANDARD HOUR

Sam Ltd manufactures plates, mugs and eggcups. Production during the first two quarters of 20X5 was
as follows:
Quarter 1
1 000
1 200
800
Plates
Mugs
Eggcups
Quarter 2
800
1 500
900
The fact that 3 000 products were produced in quarter 1 and 3 200 in quarter 2 does not tell us
anything about Sam Ltd's performance over the two periods because plates, mugs and eggcups are
so different. The fact that the production mix has changed is not revealed by considering the total
number of units produced. The problem of how to measure output when a number of dissimilar
products are manufactured can be overcome, however, by the use of the standard hour.
The standard hour (or standard minute) is the quantity of work achievable at standard
performance, expressed in terms of a standard unit of work done in a standard period of time.
Standard time
1
/2 hour
1
/3 hour
1
/2 hour
Plate
Mug
Eggcup
By measuring the standard hours of output in each quarter, a more useful output measure is obtained:
Product
Plate
Mug
Eggcup
Standard hours
per unit
1/2
1/3
1/4 hour
Quarter 1
Standard
Production
hours
1 000
500
1 200
400
200
800
1 100
Quarter 2
Standard
Production
Hours
800
400
1 500
500
225
900
1 125
The output level in the two quarters was therefore very similar.
4.9 EFFICIENCY, ACTIVITY AND CAPACITY RATIOS

Standard hours are useful in computing levels of efficiency, activity and capacity. Any management
accounting reports involving budgets and variance analysis should incorporate control ratios. The
three main control ratios are the efficiency, capacity and activity ratios.
a. The capacity ratio compares actual hours worked and budgeted hours, and measures the extent
to which planned utilisation has been achieved.
b. The activity or production volume ratio compares the number of standard hours equivalent to
the actual work produced and budgeted hours.
c. The efficiency ratio measures the efficiency of the labour force by comparing equivalent standard
hours for work produced and actual hours worked.
Worked Example: Ratios and standard hours
Given the following information about Sam Ltd for quarter 1 of 20X5, calculate a capacity ratio, an
activity ratio and an efficiency ratio and explain their meaning.
Budgeted hours
Standard hours produced
Actual hours worked
1 100 standard hours

1 125 standard hours
1 200
CHAPTER 12
The standard time allowed to produce one unit of each of Sam Ltd's products is as follows:
Solution
Capacity ratio =
Activity ratio =
Actual hours worked

1200
100% =
100% = 109%
Budgeted hours
1100

1125
100% =
100% = 102%
Budgeted hours
1100
The overall activity or production volume for the quarter was 2% greater than forecast. This was
achieved by a 9% increase in capacity.
Efficiency ratio =

1125
100% =
100% = 94%
Actual hours worked
1200
The labour force worked 6% below standard levels of efficiency.
Question 6: Ratio conundrum
If
X = Actual hours worked

Y = Budgeted hours
Z = Standard hours produced
what is
Z
?
Y
A Capacity ratio
B Activity ratio
C Efficiency ratio
D Standard hours produced ratio
4.10 PERFORMANCE MEASURES FOR INVESTMENT CENTRES

4.10.1 RETURN ON INVESTMENT (ROI)
Definition
Return on investment (ROI), also called Return on capital employed (ROCE), is calculated as (profit
before interest and tax/capital employed) 100% and shows how much profit has been made in
relation to the amount of resources invested.
ROI is generally used for measuring the performance of investment centres; profits alone do not
show whether the return is sufficient when different values of assets are used. Therefore if company A
and company B have the following results, company B would have the better performance.
Profit
Sales revenue
Capital employed
ROI
A
$
5 000
100 000
50 000
10%
B
$
5 000
100 000
25,000
20%
The profit of each company is the same but company B only invested $25 000 to achieve that profit
whereas company A invested $50 000.
ROI may be calculated in a number of ways, but profit before interest and tax is usually used.
Similarly all assets of a non-operational nature, for example, trade investments and intangible assets
such as goodwill, should be excluded from capital employed.
Profits should be related to average capital employed. In practice, many companies calculate the ratio
using year-end assets. This can be misleading. If a new investment is undertaken near to the year end,
the capital employed will rise but profits will only have a month or two of the new investment's
contribution.
What does the ROI tell us? What should we be looking for? There are two principal comparisons that
can be made:
The change in ROI from one year to the next.

The ROI being earned by other entities.
4.10.2 RESIDUAL INCOME (RI)

An alternative way of measuring the performance of an investment centre, instead of using ROI, is
residual income (RI). Residual income is a measure of the centre's profits after deducting a notional or
imputed interest cost, and depreciation on capital equipment.
Residual income (RI)is 'Pre-tax profits less a notional interest charge for invested capital'.
Question 7: Residual Income
A division with average capital employed of $400 000 currently earns a ROI of 22%. It expects this
average investment and ROI to continue next year for its current operations. It has decided to make
an additional investment of $50 000 at the beginning of the year in a new operation generating an
annual net profit of $12 000 after depreciation of $4 000 on the capital equipment. A notional interest
charge amounting to 15% of the average capital invested is to be charged to the division each year.
What is the expected residual income of the division in the first year of the new investment?
A
B
C
D
28 500
28 800
32 500
32 800
5 THE BALANCED SCORECARD

Section overview
The balanced scorecard approach to the provision of information focuses on four
different perspectives: customer, financial, internal, and learning and growth.
5.1 INTRODUCTION
LO
12.3
So far in our discussion we have focused on performance measurement and control from a financial
point of view. Another approach, originally developed by Kaplan and Norton, is the use of what is
called a 'balanced scorecard' consisting of a variety of indicators, both financial and non-financial.
CHAPTER 12
Definition
Definition
The balanced scorecard is an approach to the provision of information to management to assist

strategic policy formulation and achievement. It emphasises the need to provide the user with a set of
information which addresses all relevant areas of performance in an objective and unbiased fashion.
The information provided should include both financial and non-financial elements, and cover areas
such as profitability, customer satisfaction, internal efficiency and innovation.
The balanced scorecard focuses on four different perspectives, as follows:
PERSPECTIVE
QUESTION
EXPLANATION
Financial
How do we create value for

our shareholders?
Covers traditional measures such as growth, profitability

and shareholder value but set through talking to the
shareholder or shareholders direct.
Customer
What do existing and new

customers value from us?
Gives rise to targets that matter to customers: cost,

quality, delivery, inspection, handling and so on.
Internal
What processes must we excel

at to achieve our financial and
customer objectives?
Aims to improve operational and administrative

processes and decision making.
Learning and
growth
Can we continue to improve

and create future value?
Considers the business's capacity to maintain its

competitive position through the acquisition of new
skills and the development of new products.
Performance targets are set once the key areas for improvement have been identified, and the
balanced scorecard is the main monthly report.
The scorecard is 'balanced' in the sense that managers are required to think in terms of all four
perspectives, to prevent improvements being made in one area at the expense of another.
The types of measure which may be monitored under each of the four perspectives include the
following. The list is not exhaustive but it will give you an idea of the possible scope of a balanced
scorecard approach. The measures selected, particularly within the internal perspective, will vary
considerably with the type of organisation and its objectives.
PERSPECTIVE
MEASURES
Financial
Return on capital employed

Cash flow
Revenue growth
Earnings per share
Customer
New customers acquired

Customer complaints
On-time deliveries
Returns
Internal
Quality control rejects

Average set-up time
Speed of producing
management information
Learning and growth
Labour turnover rate

Percentage of revenue generated by new products and services
Average time taken to develop new products and services
Broadbent and Cullen (in Berry, Broadbent and Otley, eds, Management Control, 1995) identify the
following important features of this approach:
It looks at both internal and external matters concerning the organisation.

It is related to the key elements of a company's strategy.
Financial and non-financial measures are linked together.
The balanced scorecard approach may be particularly useful for performance measurement in
organisations which are unable to use simple profit as a performance measure. For example, the
public sector has long been forced to use a wide range of performance indicators, which can be
formalised with a balanced scorecard approach.
5.2 PROBLEMS
PROBLEM
EXPLANATION
Conflicting measures
Some measures in the scorecard such as research funding and cost

reduction may naturally conflict in the short term. It is often difficult to
determine the balance which will achieve the best results.
Selecting measures
The ultimate objective for commercial organisations is to maximise profits

or shareholder wealth. Other targets should offer a guide to achieving this
objective and not become an end in themselves. Not only do appropriate
measures have to be devised but the number of measures used must be
agreed. Care must be taken that the impact of the results is not lost in a
sea of information.
Interpretation
Even a financially-trained manager may have difficulty in putting the

figures into an overall perspective.
6 REWARD SYSTEMS
Section overview
Employment is an economic relationship: labour is exchanged for reward. Extrinsic rewards
derive from job context and include remuneration and benefits. Intrinsic rewards derive
from job content and satisfy higher level needs. reward interacts with many other aspects of
the organisation. Reward policy must recognise these interactions, the economic
relationship and the psychological contract.
LO
12.4
Employment is fundamentally an economic relationship: the employee works as directed by the

employer and, in exchange, the employer provides reward. The relationship inevitably generates a
degree of tension between the parties, since it requires co-operation if it is to function, but it is also
likely to give rise to conflict since the employee's reward equates exactly to a cost for the employer.
Definition
Reward is 'all of the monetary, non-monetary and psychological payments that an organisation
provides for its employees in exchange for the work they perform'.
(Bratton)
Rewards may be seen as extrinsic or intrinsic.

a. Extrinsic rewards derive from the job context: such extrinsic rewards include remuneration and
other material benefits as well as matters such as working conditions and management style.
b. Intrinsic rewards derive from job content and satisfy higher-level needs such as those for self
esteem and personal development.
The organisation's reward system is based on these two types of reward and also includes the policies
and processes involved in providing them.
Reward is a fundamental aspect of HRM and of the way the organisation functions. It interacts with
many other systems, objectives and activities:
It should support the overall strategy.

It is a vital part of the psychological contract.
It influences the success of recruitment and retention policies.
It must conform with law.
It consumes resources and must be affordable.
It affects motivation and performance management.
CHAPTER 12
As with all techniques, problems can arise when it is applied.
It must influence employees to behave in a goal congruent manner.

It must be administered efficiently and correctly.
The dual nature of reward mentioned earlier a benefit for the employee, a cost for the employer
means that the parties in the relationship have differing views of its purposes and extent. Employees
see reward as fundamental to their standard of living: inflation, comparisons with others and rising
expectations put upward pressure on their notion of what its proper level should be. Employers, on
the other hand, seek both to control their employment costs and to use the reward system to
influence such matters as productivity, recruitment, retention and change.
6.1 AN EFFECTIVE REWARD SYSTEM

The effective reward system should facilitate both the organisation's strategic goals and also the
goals of individual employees.
An organisation has to make three basic decisions about monetary reward:
a. how much to remunerate.
b. whether monetary rewards should be paid on an individual, group or collective basis.
c. how much emphasis to place on monetary reward as part of the total employment relationship.
However, there is no single reward system that fits all organisations.
6.2 THE STRATEGIC PERSPECTIVE

Contingency theory as applied to management suggests that techniques used should be appropriate
to the circumstances they are intended to deal with: there is unlikely to be a single best option that is
appropriate to any context.
A contingency approach to reward accepts that the organisation's strategy is a fundamental
influence on its reward system and that the reward system should support the chosen strategy.
Therefore, for example, cost leadership and differentiation based on service will have very different
implications for reward strategy and, indeed, for other aspects of HRM. This is because each strategy
needs a reward which is appropriate for it. The closer the alignment between the reward system and
the strategic context, the more effective the organisation.
6.3 REWARD OBJECTIVES

The reward system should pursue three behavioural objectives:
a. It should support recruitment and retention.
b. It should motivate employees to high levels of performance. This motivation may, in turn, develop
into commitment and a sense of belonging, but these do not result directly from the reward
system.
c. It should promote compliance with workplace rules and expectations.
6.4 REWARD OPTIONS

Material reward may be divided into three categories:
a. Base remuneration is a simply established reward for the time spent working. It is salary/wages
paid at an agreed/set rate.
b. Performance-related remuneration is normally added to base remuneration and is intended to
reward performance learning or experience.
c. Indirect remuneration is made up of benefits such as health insurance, child care, and so on, and
is provided in addition to base remuneration or performance-related remuneration.
6.4.1 BASE REMUNERATION

Base remuneration is usually related to the value of the job, as established by a simple estimate, a
scheme of job evaluation or reference to prevailing employment market conditions. It is easy to
administer and shows a commitment by the employer to the employee that goes beyond simple
compensation for work done. A distinction may be made between hourly or weekly paid wages and
monthly paid salary. The latter is normally expressed as an annual rate.
6.4.2 PERFORMANCE-RELATED REMUNERATION
Performance-related remuneration differs from base remuneration in that it can be designed to

support team working and commitment to organisational goals. Team working is supported by a
system of bonuses based on team rather than individual performance; the size of the team may vary
from a small work group to a complete office or factory. Overall organisational performance is
supported by various schemes of profit sharing, including those that make payments into pension
funds or purchase shares in the employing company.
However, the extent to which an organisation emphasises performance-related remuneration will
depend on whether this type of reward supports its strategy.
6.4.3 INDIRECT REMUNERATION

Indirect remuneration is often called 'employee benefits'.
Benefits can form a valuable component of the total reward package. They can be designed so as to
resemble either base remuneration or, to some extent, performance-related remuneration. A benefit
resembling base remuneration, for example, would be use of a subsidised staff canteen, whereas the
common practice of rewarding high-performing sales staff with holiday packages or superior cars
looks more like performance-related remuneration. Again though, the extent to which an organisation
offers indirect remuneration should reflect whether this type of reward supports its strategy.
There is a trend towards a cafeteria approach to benefits. Employees select the benefits they require
from a costed menu up to the total value they are awarded. This means that employees' benefits are
likely to match their needs and be more highly valued as a result.
Types of indirect remuneration include:
Private health care.

Discounted insurance.
Private dental care.
Extra vacation days.
Pension plans.
Child care.
Car allowance.
Shopping/entertainment vouchers.
6.4.4 LEVELS OF REWARD

The level of rewards an organisation offers will inevitably be subject to factors external to the
organisation.
a. The labour market as it exists locally, nationally and perhaps globally, as relevant to the
organisation's circumstances.
b. The pressure for cost efficiency in the relevant industry or sector.
c. Legislation such as the level of any applicable minimum wage.
d. Governments influence remuneration levels by means other than outright legislative prescription
e.g. their fiscal and monetary policies can lead them to exert downward pressure on public sector
wage rates.
CHAPTER 12
Performance-related remuneration takes many forms, including commission, merit remuneration and
piecework remuneration. In addition to bonus plans tied to short-term performance measures, a
company may also offer executive incentive plans linked to longer term financial performance and
shareholder returns. These will often consist of shares and/or share options.
KEY CHAPTER POINTS

Responsibility accounting is a system of accounting that segregates revenue and costs into areas of
personal responsibility to monitor and assess the performance of each part of an organisation.
A responsibility centre is a function or department of an organisation that is headed by a manager
who has direct responsibility for its performance.
There are a number of different bases for control:
A cost centre is any unit of an organisation to which costs can be separately attributed.
A profit centre is any unit of an organisation to which both revenues and costs are assigned, so
that the profitability of the unit may be measured.
An investment centre is a profit centre whose performance is measured by its return on capital
employed.
Controllable costs are items of expenditure which can be directly influenced by a given manager
within a given time span.
Materiality, controllability and variance trend should be considered before a decision about
whether to investigate a variance is taken.
One way of deciding whether to investigate a variance is to only investigate those variances which
exceed pre-set tolerance limits.
Control limits may be illustrated on a control chart.
If the cause of a variance is controllable, action can be taken to bring the system back under
control in future. If the variance is uncontrollable, but not simply due to chance, it will be necessary
to review forecasts of expected results, and perhaps to revise the budget.
Performance measurement aims to establish how well something or somebody is doing in relation
to a planned activity.
Ratios and percentages are useful performance measurement techniques.
The profit margin (profit to sales ratio) is calculated as (profit sales revenue) 100%.
The gross profit margin is calculated as gross profit sales revenue 100%.
Return on investment (ROI) or return on capital employed (ROCE) shows how much profit has
been made in relation to the amount of resources invested.
Residual income (RI) is an alternative way of measuring the performance of an investment
centre. It is a measure of the centre's profits after deducting a notional or imputed interest cost.
Cost per unit is total costs number of units produced.

Performance measures for materials and labour include differences between actual and expected
(budgeted) performance. Performance can also be measured using the standard hour.
The balanced scorecard approach to the provision of information focuses on four different
perspectives: customer, financial, internal, and learning and growth.
Employment is an economic relationship: labour is exchanged for reward. Extrinsic rewards derive
from job context and include remuneration and benefits. Intrinsic rewards derive from job content
and satisfy higher level needs. Reward interacts with many other aspects of the organisation.
Reward policy must recognise these interactions, the economic relationship and the psychological
contract.

1 An airline company has an operations centre in an international airport. The airport is owned and
managed by a separate group of companies. If the airline company operates a responsibility
accounting system, the operations centre at the airport is likely to be
A
B
C
D
a cost centre.
a profit centre.
a revenue centre.
an investment centre.
2 Which of the following statements are correct?

I
There may be several cost centres within a profit centre.
A
B
C
D
I only
II only
I and II
Neither statement

A A cusum chart provides a visual record of monthly variances for a particular type of variance.
B The possible significance of a variance can be assessed by its size relative to the actual total
cost.
C Control action to deal with an unfavourable variance of $3 000 in a month should be expected
to save $3 000.
D A large variance in one month is not a matter of concern if the size of variances in previous
months has been insignificant.
4 Which one of the following is the most likely cause of an unfavourable overhead expenditure
variance?
A
B
C
D
Theft of materials
Change in type of services used
Unexpected slump in sales demand
Direct labour inefficiency, taking longer than the standard time to do work
5 Which one of the following is the least appropriate performance measure for a revenue centre?
A
B
C
D
Profitability
Customer satisfaction
Speed of customer service
% of customer deliveries on time
6 A common basis for measuring the volume of output of different products is

A
B
C
D
efficiency ratio.
standard hours.
value added time.
cost/sales revenue ratio.
CHAPTER 12
II There may be several profit centres within an investment centre.
7 The following information relates to a manufacturing unit:

Budgeted hours
Actual hours worked
5 200
5 600
5 800
What is the activity ratio for the period?

A
B
C
D
96.6%
103.6%
107.7%
111.5%
8 In calculating the ROI for an investment centre, the most commonly-used measure of return is
A
B
C
D
profit after tax.

profit before tax.
profit before interest and tax.
profit before interest, tax, depreciation and amortisation.
9 The four perspectives of performance using the balanced scorecard are financial, customer,
internal and
A
B
C
D
external.
value chain.
competitive.
learning and growth.

1 A The operations centre is unlikely to have revenues over which it has control; therefore it is most
likely to be a cost centre.
2 C A profit centre may contain several cost centres. For example, if a factory and its associated
selling operations is treated as a profit centre, each functional department in the factory could
be a cost centre. Similarly an investment centre such as a large subsidiary company within a
group may contain several profit centres.
4 B A change in the type of services used will change spending patterns, and this could mean
unfavourable spending variances. Labour inefficiency will cause efficiency variances. Material
theft will result in a usage variance when a shortfall in materials is discovered. An unexpected
slump in sales demand will cause a sales volume variance.
5 A Profitability is an inappropriate performance measure for a revenue centre since it is only able
to control revenue.
6 B A common basis for measuring the volume of output of different products is standard hours.
7 C
Standard hours
produced
Budgeted hours
5 600
100%
= 107.7%
5 200
8 C In calculating the ROI for an investment centre, the most commonly-used measure of return is
profit before interest and tax
9 D The four perspectives of performance using the balanced scorecard are financial, customer,
internal and learning and growth
CHAPTER 12
3 B The significance of a variance can be assessed initially by means of its size relative to the actual
costs incurred. A large variance in one month should be investigated, even when there have
been no significant variances in the past, because it is important to find out what the reasons for
the variance are and to try to ensure that it does not happen again. A cusum chart shows
cumulative variances over time, not the variances each month.

1 C A is an investment centre, responsible for investment in some non-current assets, as well as
hotel expenses and income.
B is a revenue centre, responsible for revenue from centrally made room bookings only.
C is a profit centre. The restaurant manager will be responsible for the income and costs of the
restaurant
D is a cost centre, since there will only be costs in relation to cleaning and maintenance.
2 A A learning curve effect means that average times to complete an item of work fall as the work
force becomes more skilled. This may lead to improvements in labour efficiency, and also
machine time running (machine usage efficiency) and materials handling efficiency (so
favourable material usage variances). A learning curve effect is less likely to have an effect on
price, rate or expenditure variances.
3 D The best estimate of the monthly unfavourable variance is the average variance for the past 8
months, which is $2 000.
Cost of investigation
Expected value of cost of corrective action (70% $5 000)
Expected value of benefits if the cause can be corrected:
(70% 6 months $2 000)
Expected value of net benefit from investigation
$
2 000
3 500
5 500
8 400
2 900
A more cautious estimate would be to assume minimum monthly savings of $1 500 rather than
$2 000 if the cause is controllable, This would reduce the expected value of benefit by (70% 6
months $500) $2 100 to just $800. However this was not one of the answer options.
4 A Note that the cause of the favourable expenditure variance, which represents 6% of the total
overhead costs for the month, should be encouraged if it is a genuine reduction in costs.
However some fixed overhead costs may simply slip from one month to the next, so
expenditure variances cannot be judged on the basis of one month's figures alone.
Option B: The purpose of analysing variances into sub-variances is to enable each separate
sub-variance to be investigated if its seems significantly large. The total variance may only be
1.57% of total costs but this total disguises a number of significant unfavourable and favourable
variances which need investigating.
Option C: The unfavourable fixed overhead volume variance is more likely to indicate that the
production operation worked at below budgeted capacity during the period, because the
unfavourable variance indicates under-absorption of fixed overheads.
Option D: Similarly, the materials price and usage variance should be considered separately,
even though the fact that there is a favourable price variance and an unfavourable usage
variance could indicate interdependence between them. The purchasing department may have
bought cheap materials but these cheaper materials may have been more difficult to work with
so that more material was required per unit produced. The possibility of such an
interdependence should be investigated. Whether or not there is an interdependence, both
variances do require investigation since they represent 5.5% (usage) and 3.5% (price) of the
actual material cost for the month.
5 (a)
700
100% = 23%
3 000
The profit margin usually refers to operating profit/sales revenue.
(b)
1200
100% = 40%
3 000
The gross profit margin is the gross profit/sales revenue ratio.
6 B Standard Hours produced/Budgeted hours = Activity ratio

7 D
verage capital
Original investment: assume no change
New investment: 50% of (50 000 + 46 000)
Average capital employed
Notional interest (448 000 0.15)
Residual income
$
100 000
400 000
48 000
448 000
67 200
32 800
Note: Depreciation on the new investment will be $4 000 therefore the average investment for
the year is half-way between the initial investment of $50 000 and the year-end net book value
of $46 000.
CHAPTER 12
Divisional profit with project ((400 000 22%) + 12 000)
353
REVISION QUESTIONS
REVISION QUESTIONS | 355
CHAPTER 1
1 Possum Ltd is now engaged solely in a service industry having previously been involved in
manufacturing. Its chief accountant is considering which of the following management accounting
processes the company needs to retain:
I Capacity planning
II Inventory valuation
III Production planning
IV Workforce planning
A
B
C
D
IV only
I and III only
II and III only
II and IV only
2 Consider the following statements in relation to management information:

I It should always be provided regardless of its cost
II It should not be provided until it is as detailed as possible
III It is data that has been processed so as to be meaningful to the recipient
Which of the above statements is/are true of good management information?
A
B
C
D
I only
III only
I and II only
II and III only
3 Which of the following are characteristics of management accounting information?

I Not legally required
II Used by all stakeholders
III Non-financial as well as financial
IV Concerned with cost control only
A
B
C
D
I and III only

II and IV only
I, II and III only
I, III and IV only
4 Which of the following statements about cost and management accounting are true?
I
II
III
IV
There is a legal requirement to prepare management accounts

The format of management accounts may vary from one business to another
Management accounting provides information to help management make business decisions
Cost accounting cannot be used to provide information for inventory valuations for external
financial reporting
A
B
C
D
I and II only
I and IV only
II and III only
III and IV only
5 A management control system is

A a system that controls and maximises the profits of an organisation.
B a collective term for the hardware and software used to drive a database system.
C a possible course of action that might enable an organisation to achieve its objectives.
D a system that measures and corrects the performance of activities of subordinates in order to
make sure that the objectives of an organisation are being met and their associated plans are
being carried out.
6 Which of the following statements is/are true?
I Information is the raw material for data processing.
II External sources of information include an organisation's financial accounting records.
III The main objective of a non-profit making organisation is usually to provide employment to its
staff.
A
B
C
D
I and III only

II and III only
I, II and III
None of the above
7 Wateraid is a charity providing relief for victims of drought in Africa. A fund-raising brochure
produced by the charity contains the following statement: 'Wateraid aspires to be the largest
charitable provider of clean water services for Africa.' The statement is an example of the charity's
A vision.
B mission.
C strategy.
D objective.
8 Genzyme Ltd operates its business in four geographical regions. The sales director has decided
that the company needs to increase its market share in the next five years and as a result has
decided to establish a sales quota for next year which is to be achieved by each of the regions. The
setting of a quarterly sales target for each sales representative is an example of
A a tactical plan.
B a strategic plan.
C an operational plan.
D a management control plan.
CHAPTER 2
1 A machine which originally cost $12 000 has an estimated life of ten years and is depreciated at the
rate of $1 200 a year. It has been unused for some time, as expected production orders did not
materialise.
A special order has now been received which would require the use of the machine for two
months.
The current net realisable value of the machine is $8 000. If it is used for the special order, its value
is expected to fall to $7 500. The net book value of the machine is $8 400.
Routine maintenance of the machine currently costs $40 a month. With use, the cost of
maintenance and repairs would increase to $60 a month for the months that the machine is being
used.
Ignore the time value of money.
What is the relevant cost of using the machine for the special order?
A
B
C
D
$240
$520
$540
$620
2 The total relevant cost of a scarce resource is equal to the sum of the variable cost of the scarce
resource and
A the fixed cost absorbed by a unit of the scarce resource.
B the price that the resource would sell for in the open market.
C the price that would have to be paid to replace the scarce resource.
D the contribution forgone from the next-best opportunity for using the scarce resource.
3 Which of the following is not an assumption typically made in relevant costing?
A Decisions should be based on future incremental cash flows.
B Absorbed overheads should be included for decision making purposes.
C Sunk costs are irrelevant to decision making because the expenditure has already been
incurred.
D Opportunity costs need to be considered when one course of action is chosen in preference to
an alternative.
4 Keyboards Pty Ltd is in the process of deciding whether or not to accept a special order. The order
will require 100 litres of liquid X. Keyboards Pty Ltd has 85 litres of liquid X in inventory but no
longer produces the product which required liquid X. It could therefore sell the 85 litres and
receive net proceeds of only $2 per litre, if it rejected the special order. The low net proceeds are
because of high selling costs. The liquid was purchased three years ago at a price of $8 per litre
but its replacement cost is $10 per litre. What is the relevant cost of liquid X to include in the
decision-making process?
A $200
B $320
C $800
D $1 000
5 A company is considering accepting a one-year contract which will require four skilled employees.
The four skilled employees could be recruited on a one-year contract at a cost of $40 000 per
employee. The employees would be supervised by an existing manager who earns $60 000 per
annum. It is expected that supervision of the contract would take 10% of the manager's time.
Instead of recruiting new employees the company could retrain some existing employees who
currently earn $30 000 per year. The training would cost $15 000 in total. If these employees were
used they would need to be replaced at a total cost of $100 000.
The relevant labour cost of the contract is:
A
B
C
D
$115 000
$135 000
$166 000
$275 000
6 A company is considering its options with regard to a machine which cost $120 000 four years ago.
If sold, the machine would generate scrap proceeds of $150 000. If kept, this machine would
generate net income of $180 000.
The current replacement cost for this machine is $210 000.
The relevant cost of the machine is:
A
B
C
D
$120 000
$150 000
$180 000
$210 000
CHAPTER 3
1 Which one of the following is the budget committee not responsible for?
A Preparing functional budgets
B Monitoring the budgeting process
C Timetabling the budgeting operation
D Allocating responsibility for the budget preparation
2 Which of the following may be considered to be objectives of budgeting?
I Expansion
II Co-ordination
III Communication
IV Resource allocation
A
B
C
D
I and II only
I, II, III and IV
I, III and IV only
II, III and IV only
3 What does the statement 'For company XYZ Ltd, sales is the principal budget factor' mean?
A If the company gets its sales level correct then nothing else matters.
B The company's activities are limited by the level of sales it can achieve.
C The level of sales will determine the level of cash at the end of the period.
D The level of sales will determine the level of profit at the end of the period.
4 A production process uses Material M to make Product P. At the beginning of a budget period, it
is expected that the opening inventory of Material M will be 16 000 kg, but the plan will be to
reduce the inventory level to 14 000 kg by the end of the year. During the year, the budgeted
production of Product P is 36 000 kg. The loss or wastage in production is 10% of the quantities of
material input.
What should be the materials purchases budget for Material M?
A 34 000 kg
B 37 600 kg
C 38 000 kg
D 42 000 kg
5 Budgeted sales for a company in three months of the year are as follows:
March
April
May
$
500 000
600 000
700 000
All sales are invoiced and invoices are sent out on the last day of each month. An early settlement
discount of 2% is offered to customers who pay within 7 days. 20% of customers are expected to
take the discount, another 30% are expected to pay within one month after the invoice date and all
other payments are expected in the following month. Irrecoverable debts are expected to be 1% of
the total sales invoiced.
What will be the budgeted cash receipts from customers in May?
A $542 600
B $547 600
C $562 200
D $641 200
6 The following information is available about the costs of producing a single item of product in a
manufacturing operation:
Production
units
36 000
29 000
Cost
$
370 200
291 800
It is known that fixed costs increase by $49 000 when output volume exceeds 30 000 units.
Using this data and the high/low method, what should be the budgeted cost of producing 31
000 units?
A
B
C
D
$300 200
$314 200
$347 200
$349 200
CHAPTER 4
1 The following information for advertising expenditure and sales revenue has been established over
the past six months:
Month
Sales revenue
$ 000
155
125
200
175
150
225
1
2
3
4
5
6
Advertising expenditure
$ 000
3.0
2.5
6.0
5.5
4.5
6.5
Using the high-low method which of the following is the correct equation for linking advertising
expenditure and sales revenue from the above data?
A
B
C
D
Advertising expenditure = 4 750 + (0.05 sales revenue)

Advertising expenditure = 2 500 + (0.04 sales revenue)
Sales revenue = 62 500 + (25 advertising expenditure)
2 A company incurs the following costs at various activity levels:

Total cost
$
250 000
312 500
400 000
Activity level
units
5 000
7 500
10 000
Using the high-low method what is the variable cost per unit?
A
B
C
D
$25
$30
$35
$40
3 The total cost of production for two levels of activity is :

Production (units)
Total cost ($)
Level 1
3 000
6 750
Level 2
5 000
9 250
The variable production cost per unit and the total fixed production cost both remain constant in
the range of activity shown.
What is the level of fixed costs?
A
B
C
D
$2 000
$2 500
$3 000
$3 500
4 A company generates a 12 per cent contribution on its weekly sales of $280 000. A new product, Z,
is to be introduced at a special offer price in order to stimulate interest in all the company's
products, resulting in a 5 per cent increase in weekly sales of the company's other products.
Product Z will incur a variable unit cost of $2.20 to make and $0.15 to distribute. Weekly sales of Z,
at a special offer price of $1.90 per unit, are expected to be 3 000 units.
The effect of the special offer will be to increase the company's weekly profit by
A
B
C
D
$330.
$780.
$12 650.
$19 700.
5 A company manufactures one product which it sells for $40 per unit. The product has a
contribution to sales ratio of 40%. Monthly total fixed costs are $60 000. At the planned level of
activity for next month, the company has a profit target of $25 600.
What is the planned activity level (in units) for next month?
A
B
C
D
3 100
4 100
5 350
7 750
6 A company manufactures a single product, P. Data for the product is:

Selling price
Direct material cost
Direct labour cost
Variable production overhead cost
Variable selling overhead cost
Fixed overhead cost
Profit per unit
The profit/volume ratio for product P is

A
B
C
D
25%.
50%.
55%.
60%.
$ per unit
20
4
3
2
1
5
5
CHAPTER 5
1 Which of the following items would be treated as an indirect cost?
A Wood used to make a chair
B Metal used for the legs of a chair
C Fabric to cover the seat of a chair
D Staples to fix the fabric to the seat of a chair
2 Spaced Out Ltd has two production departments (F and G) and two service departments (Cafeteria
and Maintenance). Total allocated and apportioned general overheads for each department are as
follows:
F
$125 000
G
$80 000
Cafeteria
$20 000
Maintenance
$40 000
Cafeteria and Maintenance perform services for both production departments and Cafeteria also
provides services for Maintenance in the following proportions:
% of Cafeteria to
% of Maintenance
F
60
65
G
25
35
Cafeteria
Maintenance
15
What would be the total overheads for production department G once the service department's
costs have been apportioned?
A
B
C
D
$90 763
$99 000
$100 050
$100 500
3 The following data relates to one year in department A.

Budgeted machine hours
25 000
Actual machine hours
21 875
Budgeted overheads
$350 000
Actual overheads
$350 000
Based on the data above, what is the machine hour absorption rate as conventionally calculated?
A
B
C
D
$12
$14
$16
$18

Cost and selling price details for product Z are as follows:
Direct materials
Direct labour
Variable overhead
Fixed overhead absorption rate
Profit
Selling price
$ per unit
6.00
7.50
2.50
5.00
21.00
9.00
30.00
Budgeted production for the month was 5 000 units although the company managed to produce 5
800 units, selling 5 200 of them and incurring fixed overhead costs of $27 400.
4 The profit under the marginal costing method for the month is
A $45 400.
B $46 800.
C $53 800.
D $72 800.
5 The profit under the absorption costing method for the month is
A $45 200.
B $45 400.
C $46 800.
D $48 400.
6 Which of the following are acceptable bases for absorbing production overheads?
I Per unit
II Machine hours
III Direct labour hours
IV As a percentage of the prime cost
A I and IV only
B II and III only
C I, II, III and IV
D II, III and IV only
CHAPTER 6
1 Consider the following statements about Activity Based Costing (ABC):
I Introducing ABC will always reduce costs in the short term;
II If the cost of a product or service using both ABC and absorption costing is the same, there will
be no benefit to be gained from adopting ABC.
Which of the statements is/are correct?
A
B
C
D
I only
II only
I and II
neither I nor II
2 Studley Ltd uses activity based costing.

The budgeted distribution costs for the next year are:
Transport costs
Order processing
Total distribution costs
$2 631 200
$1 573 000
$4 204 200
It is estimated that in the next year, 325 000 orders will be processed, and that the delivery vehicles
will travel 1 495 000 km.
A customer has indicated that 138 orders, each of which will require a journey of 122 km for each
order will be placed next year.
To the nearest $, what is the distribution cost for this customer?
A
B
C
D
$1 785
$30 299
$38 891
$47 342
3 The directors of Wiltshire Ltd are considering the introduction of activity based costing (ABC). A
trainee manager has asked which of the following comments about the calculation of overhead
cost using ABC are not correct:
I The volume of activity has no influence on cost
II Each individual cost will have a unique, identifiable, cost driver
III The overhead cost calculated using ABC will always be significantly different from the overhead
cost calculated using absorption costing
A
B
C
D
I, II and III
I and II only
I and III only
II and III only
4 The budgeted overheads of Coleman Ltd for the next year have been analysed as follows:
Machine running costs
Purchase order processing costs
Production run set up costs
$ 000
640
450
180
In the next year, it is anticipated that machines will run for 32 000 hours, 6 000 purchase orders will
be processed and there will be 450 production runs.
One of the company's products is produced in batches of 500. Each batch requires a separate
production run, 30 purchase orders and 750 machine hours.
Using Activity Based Costing, what is the overhead cost per unit of the product?
A
B
C
D
$0.99
$1.59
$35.30
$495.00
CHAPTER 7
1 A chemical process has a normal wastage of 10% of input. In a period, 2 500 kgs of material were
used and there was an abnormal loss of 75 kgs.
What quantity of finished goods output was achieved?
A
B
C
D
2 175 kgs
2 250 kgs
2 325 kgs
2 425 kgs
2 In a particular process, the input for the period was 2 000 units. There were no inventories at the
beginning or end of the process. Normal loss is 5 per cent of input. In which of the following
circumstances is there an abnormal gain?
I Actual output = 1 800 units
II Actual output = 1 950 units
III Actual output = 2 000 units
A
B
C
D
I only
II only
I and II only
II and III only
3 A company uses process costing to establish the cost per unit of its output.
The following information was available for the last month:
Input units
10 000
Output units
9 850
Opening inventory
300 units, 100% complete for materials and

70% complete for conversion costs
Closing inventory
450 units, 100% complete for materials and

30% complete for conversion costs
The company uses the weighted average method of valuing inventory.

What were the equivalent units for conversion costs?
A
B
C
D
9 505 units
9 715 units
9 775 units
9 985 units
4 A company uses process costing to value its output. The following was recorded for the period:
Input materials
Conversion costs
Normal loss
Actual loss
2 000 units at $4.50 per unit

$13 340
5% of input valued at $3 per unit
150 units
There were no opening or closing inventories.

What was the valuation of one unit of output to one decimal place?
A
B
C
D
$11.8
$11.6
$11.2
$11.0
5 A company manufactures two joint products, P and R, in a common process. Data for June are as
follows:
$
1 000
10 000
12 000
3 000
Opening inventory
Conversion costs
Closing inventory
Production
Units
4 000
6 000
P
R
Sales
Units
5 000
5 000
Sales price
$ per unit
5
10
If costs are apportioned between joint products on a physical unit basis, what was the total cost of
product P production in June?
A
B
C
D
$8 000
$8 800
$10 000
$12 000
6 Which of the following costing methods is most likely to be used by a company involved in the
manufacture of liquid soap?
A Job costing
B Batch costing
C Service costing
D Process costing
CHAPTER 8
1 Information on standard rates of pay would be provided by
A a newspaper
B a trade union
C a payroll manager
D a production manager
2 For which of the following is an attainable standard (target standard) inappropriate?
I Inventory valuation
II Planning
III Control
A
B
C
D
I only
II only
III only
I and III only
3 Standard costing provides which of the following?

I Actual future costs
II Information for budgeting
III Targets and measures of performance
IV Simplification of inventory control systems
A
B
C
D
I, II and III only

I, II and IV only
I, III and IV only
II, III and IV only
4 Which of the following statements is correct?

A The operating standards set for production should be the minimal level.
B The operating standards set for production should be the maximum level.
C The operating standards set for production should be the attainable level.
D The operating standards set for production should be the most ideal possible.
5 Which of the following best describes management by exception?
A Recruiting exceptionally good managers and being prepared to pay over the market rate for
their services.
B Sending management reports only to those managers who are able to act on the information
contained within the reports.
C Focusing management reports on areas which require attention and ignoring those which
appear to be performing within acceptable limits.
D Using management reports to highlight exceptionally good performance, so that favourable
results can be built upon to improve future outcomes.
6 A unit of product L requires 9 active labour hours for completion. The performance standard for
product L allows for 10 per cent of total labour time to be idle, due to machine downtime. The
standard wage rate is $9 per hour. What is the standard labour cost per unit of product L?
A $72.90
B $81.00
C $89.10
D $90.00
CHAPTER 9
1 A company manufactures a single product L, for which the standard material cost is as follows:
$ per unit
42
Material 14 kg $3
During July, 800 units of L were manufactured, 12 000 kg of material were purchased for $33 600, of
which 11 500 kg were issued to production.
The company values all inventory at standard cost.
The material price and usage variances for July were:
A
B
C
D
Price
Usage
$2 300 (F)
$2 300 (F)
$2 400 (F)
$2 400 (F)
$900 (U)
$300 (U)
$900 (U)
$840 (U)
2 Which of the following would help to explain a favourable direct labour efficiency variance?
I Employees were of a lower skill level than specified in the standard.
II An innovation in production which reduces materials handling requirements.
III Suggestions for improved working methods were implemented during the period.
A
B
C
D
I and II only
I and III only
II and III only
I, II and III
3 Which of the following statements is correct?

A An unfavourable direct material cost variance can be a combination of a favourable material
price variance and a favourable material usage variance.
B An unfavourable direct material cost variance can be a combination of a favourable material
price variance and an unfavourable material usage variance.
C An unfavourable direct material cost variance will always be a combination of an unfavourable
material price variance and an unfavourable material usage variance.
D An unfavourable direct material cost variance will always be a combination of an unfavourable
material price variance and a favourable material usage variance.
4 A company has a budgeted material cost of $125 000 for the production of 25 000 units per month.
Each unit is budgeted to use 2 kgs of material. The standard cost of material is $2.50 per kg.
Actual materials in the month cost $136 000 for 27 000 units and 53 000 kgs were purchased and
used.
What was the unfavourable material price variance?
A
B
C
D
$1 000
$3 500
$7 500
$11 000
5 A company purchased 6 850 kgs of material at a total cost of $21 920. The material price variance
was $1 370 favourable. The standard price per kg was
A $0.20.
B $3.00.
C $3.20.
D $3.40.
6 Which of the following situations is most likely to result in a favourable selling price variance?
A Fewer customers than expected took advantage of the early payment discounts offered.
B Competitors charged lower prices than expected, therefore selling prices had to be reduced in
order to compete effectively.
C The sales director decided to change from the planned policy of market skimming pricing to
one of market penetration pricing.
D Demand for the product was higher than expected and prices could be increased without
unfavourable effects on sales volumes.
CHAPTER 10
1 Which of the following is not an example of soft capital rationing?
A The company is debt-averse.
B The company's credit rating prevents it from borrowing further.
C The company will only use retained earnings to finance new investment.
D Management does not want to issue more shares to raise capital, in order to avoid dilution of
control.
2 The following statements have been made in relation to the advantages of a Post Completion
Audit (PCA).
I It encourages a more realistic approach to new investment project decision making.
II It enables an assessment of project success and may highlight projects that should be
discontinued.
III It encourages (when relevant) project termination.
Which of the statements are true?
A
B
C
D
I and II only
I and III only
II and III only
I, II and III
3 A company has carried out an investigation into a new capital investment project, paying $10 000
for a consultants' report. The consultants have reported that the project would require an outlay of
$90 000 on new equipment. The expected net cash inflows from the project would be:
Year
25 000
35 000
40 000
40 000
60 000
What is the project's payback period?

A
B
C
D
2.25 years
2.5 years
2.75 years
3.0 years
4 James Ltd is considering a capital expenditure project which requires an investment of $46 000 in a
machine that will have a four year life, after which it will be sold for $6 000. Depreciation is charged
in equal instalments over the life of the machine. The expected profits after depreciation to be
generated by the project are as follows:
Year 1
$20 500
Year 2
$23 000
Year 3
$13 500
Year 4
$1 500
What is the payback period and Accounting rate of return (ARR calculated as average annual
profits/initial investment)?
Payback period
A
B
C
D
ARR
1.47 years
1.47 years
2.19 years
2.19 years
31.79%
36.54%
20.65%
36.54%
5 Consider the following two statements concerning investor attitudes towards risk:
I A risk-neutral investor will only be prepared to invest in a project with the prospect of high
returns if there are no risks involved.
II A risk-seeking investor will readily invest in a project with prospects of high returns, even if it
means carrying substantially high risk.
Which one of the following combinations relating to the above statements is correct?
Statement
I
II
A
B
C
D
True
True
False
False
The following statements have been made in relation to investment decisions.

In making investment decisions, qualitative issues should be ignored.
True
False
True
False
II To ensure effective risk management, all investment decisions should be taken at board level
within an organisation.
III Project controls can be applied to monitor the extent of the benefits achieved from an
investment decision.
Which of the statements are true?
A
B
C
D
III only
I and III only
I, II and III
None of them
CHAPTER 11
1 Which of the following is not a feature of Just in Time (JIT)?
A Pull system
B Zero inventory
C Employee involvement
D Increased lead times
A The size of the Economic Order Quantity depends on the supply lead time.
B In a Just-in-Time purchasing system, the maximum inventory is the Economic Order Quantity.
C If a large order discount is offered for purchases above a certain quantity of units, the EOQ may
fall in size.
D When the EOQ formula is used to decide the purchase quantity average total inventory holding
costs will be equal to the average total annual ordering costs.
A If the profit margin on a product is 60% of the sales price, the mark-up is 150% on cost.
B An objective of Just-in-Time production is the elimination of bottlenecks and hold-ups in
production.
C For a Just-in-Time purchasing system to be successful there must be complete trust between a
company and its supplier.
D When inventory control involves re-order levels and minimum and maximum inventory levels,
inventory should never fall below the minimum level.
4 When a system of target costing is employed, the product concept is devised first. What should be
decided next?
A
B
C
D
Price
Full cost
Profit margin
Production cost
5 A company may price a new product fairly high initially, in order to recover as much of the
development costs as possible. Prices may then be lowered as demand for the product increases
and may then stabilise, or possibly fall further, when market saturation is reached. This is an
example of the application of which pricing policy?
A
B
C
D
Target pricing
Life cycle pricing
Differential pricing
Market penetration
CHAPTER 12
1 A company uses a range of performance measures, including units produced per tonne of material
and Return on Capital Employed (ROCE). What do these measures assess?
Units produced
per tonne of material
ROCE
A
B
C
D
Efficiency
Efficiency
Effectiveness
Efficiency
Capacity
Efficiency
Effectiveness
Effectiveness
2 When measuring performance, for which of the following costs could the manager of a production
department in a manufacturing company be held responsible?
I Indirect labour employed in the department
II Direct materials consumed in the department
III Indirect materials consumed in the department
IV A share of the costs of the maintenance department
A
B
C
D
II only
I and III only
II and IV only
I, II, III and IV
3 Which one of the following is most likely to be the explanation for an unfavourable material usage
variance?
A Rates of pay have been increased
B Quality standards have been increased
C Unforeseen material price rises have been incurred
D A major supplier of material has reduced the rate of trade discount
4 Tasmin Ltd has many divisions which it evaluates using Return on Investment (ROI) and Residual
Income (RI) measures. The Melbourne division has net assets of $24m at 31 December 20X1. In the
year to 31 December 20X1 it earned profit before interest and tax of $3.6m and paid interest of
$0.6m. Its cost of capital is 12%.
What is the correct combination of ROI and RI for the year to 31 December 20X1?
A
B
C
D
ROI
RI
12.5%
12.5%
15.0%
15.0%
$0.72m
$3.0m
$0.72m
$3.0m
5 Marcham Ltd is a building company. Recently there has been a concern that too many quotations
have been sent to clients either late or containing errors, partly as a result of understaffing in the
responsible department.
Which of the following non-financial performance indicators would not be an appropriate measure
to monitor and improve performance of the quotations department?
A Actual number of quotations issued as a percentage of budget.
B Percentage of quotations found to contain errors when checked.
C Percentage of quotes not issued within company policy of 5 working days.
D Actual number of department staff as a percentage of the department's planned number of
staff.
6 In the context of a balanced scorecard approach to the provision of performance management

information, which of the following measures would be appropriate for monitoring the learning and
growth perspective?
I Labour turnover rate
II Training days per employee
III Percentage of revenue generated by new products and services
A
B
C
D
I, II and III
I and II only
I and III only
II and III only
377
ANSWERS TO REVISION
QUESTIONS
ANSWERS TO REVISION QUESTIONS | 379
CHAPTER 1
1 A A service company will concentrate on workforce planning and labour allocation. It will neither
engage in production planning (as there is no physical product), nor capacity planning (again, as
there is no physical product) nor in inventory valuation (as there is no inventory of physical
items).
2 B Statement I is not true as the benefit and cost of management information should be
compared. Statement II is not true because many managers require summarised, high level
information rather than very detailed information. Statement III is true. Remember that,
information is data that has been processed so as to be meaningful to the person who receives
it.
3 A Management accounting information is not legally required and therefore I is true. It is used
only by management, therefore II is false. It is information that is communicated concerning
facts or circumstances. It can comprise non-financial (eg employee numbers) as well as financial
information, so III is true. It is concerned with planning and with revenues, ie much more than
just cost control, so IV is false. Thus I and III are true and Option A is correct.
4 C Management accounts are not legally required, so I is false. There is no set format for
management accounts, so II is true. III is the essence of management accounting so is
immediately true. Cost accounting can be used to provide information to value inventory for
internal and external reporting so IV is false. Thus II and III are true, so Option C is correct.
5 D A management control system is a system by which assurance is sought that organisational
goals are being achieved and procedures are being adhered to, or if not, that appropriate
remedial action is taken. Thus Option D is correct.
6 D Data, not information, is the raw material for data processing, so I is false. An organisation's
financial accounting records are an internal source of information, so II is false. The main
objective of a non-profit making organisation (eg, a charity) is to deliver some stated objective
which will not usually be employment of staff, so III is false. Thus none of I, II or III are true, so
Option D is correct.
7 A Vision concerns the charitys future aspirations. Mission would go further and set out the
charitys fundamental purpose together with reference to its strategy, behaviour and values.
Objectives are the specific goals of the charity and strategy is a course of action that might
enable it to achieve its objectives.
8 C The desire to increase market share is a strategic plan. The annual sales quotas are part of a
tactical plan to help achieve this. The quotas will be broken down into individual quarterly sales
targets for each sales representative (operational plans). Management control is concerned with
decisions about the efficient and effective use of resources to achieve the organisations
objectives or targets.
CHAPTER 2
1 C
$
Loss in net realisable value of the machine
through using it on the special order $(8 000 7 500)
Costs in excess of existing routine maintenance costs $(120 80)
Total marginal user cost
500
40
540
If you selected option A you incorrectly included the depreciation cost. Depreciation is not
relevant because it is not a future cash flow.
Option B is incorrect because it allows for only one month's increased maintenance cost. The
special order will take two months.
Option D is incorrect because it includes all of the maintenance cost to be incurred. $40 per
month would be incurred anyway so it is only the incremental $20 that is relevant.
2 D Total relevant cost needs to include the opportunity cost.
3 B This is not an assumption in relevant costing. Absorbed overhead is a notional accounting cost
hence should be ignored for decision making purposes. Only incremental overheads arising as
a result of the decision are relevant.
4 B
Relevant cost of 85 litres in inventory
(Realisable value = 85 $2)
Relevant cost of 15 litres to be bought
(Purchase cost = 15 $10)
$170
$150
$320
5 A
$ 000
160
Cost of recruiting skilled employees

(4 $40 000)
Cost of retraining
Training cost
Additional labour costs
15
100
115
It would be cheapest to retrain existing staff, so the relevant cost is $115,000.

6 C The relevant cost (deprival value) of the machine is:
LOWER OF
NET INCOME
($180 000)
HIGHER OF
REPLACEMENT
COST
($210 000)
NRV
($150 000)
REVENUES
EXPECTED
($180 000)
CHAPTER 3
1 A Option A is correct because it is the manager responsible for implementing the budget that
must prepare it, not the budget committee.
2 D Expansion Item I is not in itself an objective of budgeting. Although a budget may be set
within a framework of expansion plans, it is perfectly normal for an organisation to plan for a
reduction in activity.
Co-ordination Item II is an objective of budgeting. Budgets help to ensure that the activities
of all parts of the organisation are co-ordinated towards a single plan.
Communication Item III is an objective of budgeting. The budgetary planning process
communicates targets to the managers responsible for achieving them, and it should also
provide a mechanism for lower level managers to communicate to more senior staff their
estimates of what may be achievable in their part of the business.
Resource allocation Item IV is an objective of budgeting. Most organisations face a situation
of limited resources and an objective of the budgeting process is to ensure that these resources
are allocated among budget centres in the most efficient way.
3 B The principal budget factor is the factor which limits the activities of an organisation.
Although cash and profit are affected by the level of sales (options C and D), sales is not the
only factor which determines the level of cash and profit. It does not mean that nothing matters
other than the sales level (option A).
4 C Output = 36 000 kg
Wastage = 10% of input
Therefore input = 36 000/0.90 = 40 000 kg
Closing inventory
Used in production
Less Opening inventory
Purchases
kg
14 000
40 000
54 000
(16 000)
38 000
5 A All invoices are sent out at the end of the month; therefore payments within 7 days occur in the
following month. In May, 20% of April sales customers will pay within 7 days and take the
settlement discount; another 30% of April sales customers will pay before the end of May.
Irrecoverables are 1%; therefore 49% of March sales will be collected in May
Cash receipts
Customers taking 2% discount: 20% $600 000 98%
Other customers paying within one month of invoice: 30% $600 000
Receipts from March sales: 49% $500 000
Total receipts
$
117 600
180 000
245 000
542,600
6 D The high-low method can be used to estimate fixed and variable costs
Total cost of 36 000 units
Total cost of 29 000 units, adding $49 000 to remove fixed cost difference
Variable cost of 7 000 units
$
370 200
340 800
29 400
Variable cost per unit = $29 400/7 000 = $4.20

Variable cost of 36 000 units ( $4.20)
Fixed costs (above 30 000 units of output)
Fixed costs
Variable cost of 31 000 units ( $4.20)
$
370 200
151 200
219 000
$
219 000
130 200
349 200
CHAPTER 4
1 C Independent Variable x = advertising expenditure
Dependent variable y = sales revenue
Highest x = month 6 = $6 500
Highest y = month 6 = $225 000
Lowest x = month 2 = $2 500
Lowest y = month 2 = $125 00
Using the high-low method:
Highest
Lowest
Advertising expenditure
$
6 500
2 500
4 000
Sales revenue generated for every $1 spent on advertising =
Sales revenue
$
225 000
125 000
100 000
$100 000
= $25 per $1 spent.
$4 000
If $6 500 is spent on advertising, expected sales revenue = $6 500 $25 = $162 500
Sales revenue expected without any expenditure on advertising = $225 000 $162 500 = $62
500
2 B
Activity level
$
10 000
5 000
5 000
Highest
Lowest
Cost
$
400 000
250 000
150 000
$150 000
= $30
5 000 units
3 C
Level 2
Level 1
Production
Units
5 000
3 000
2 000
$2 500
2 000 units
= $1.25 per unit

Fixed overhead = $9 250 ($1.25 5 000) = $3 000
Total cost
$
9 250
6 750
2 500
4 A Currently weekly contribution = 12% $280 000 = $33 600

Extra contribution from 5% increase in sales = 5% $33 600
Loss on product Z each week 3 000 $(1.90 2.20 0.15)
Weekly increase in profit
$
1 680
(1 350)
330
If you selected option B you forgot to allow for the variable cost of distributing the 3 000 units
of Product Z. Option C is based on a five per cent increase in revenue from the other products;
however extra variable costs will be incurred, therefore the gain will be a five
per cent increase in contribution.
If you selected option D you made no allowance for the variable costs of either product Z or
the extra sales of other products.
5 C At planned activity level, Total contribution target = Fixed costs + Profit target
Total contribution target = $60 000 + $25 600 = $85 600
Contribution per unit = Sales Price x Contribution/Sales ratio = $40 0.4 = $16.00
Budgeted/planned activity level
$85 600
$16
= 5 350 units
6 B P/V ratio

$(20 _ 4_3 _2_1)
=
100% = 50%
$20
=
If you selected option A you calculated profit per unit as a percentage of the selling price per
unit.
Option C excludes the variable selling costs from the calculation of contribution per unit.
Option D excludes the variable production overhead cost, but all variable costs must be
deducted from the selling price to determine the contribution.
CHAPTER 5
1 D Indirect costs are those which cannot be easily identified with a specific cost unit. Although the
staples could probably be identified with a specific chair, the cost is likely to be relatively
insignificant. The expense of tracing such costs does not usually justify the possible benefits
from calculating more accurate direct costs. The cost of the staples would therefore be treated
as an indirect cost, to be included as a part of the overhead absorption rate.
Options A, B and C all represent significant costs which can be traced to a specific cost unit.
Therefore they are classified as direct costs.
2 C The correct answer is C.
Total Maintenance overheads
= $40 000 + 15% of Cafeteria overheads

= $40 000 + 15% of $20 000
= $43 000
Of which 35% are apportioned to G = $15 050

Cafeteria costs apportioned to G = 25% of $20 000 = $5 000
Total overheads for G = $80 000 + 15 050 + 5 000 = $100 050
3 B The correct answer is B.
4 A Contribution per unit
Budgeted overheads
$350 000
=
= $14 per machine hour
Budgeted machine hours
25 000
= $30 $(6.00 + 7.50 + 2.50)

= $14
= $14 5,200 units

= $72 800
Less fixed costs incurred = $27 400
Contribution for month
Marginal costing profit
= $45 400
If you selected option B you calculated the profit on the actual sales at $9 per unit. This utilises
a unit rate for fixed overhead which is not valid under marginal costing.
If you selected option C you used the correct method but you based your calculations on the
units produced rather than the units sold.
If you selected option D you calculated the correct contribution but you forgot to deduct the
fixed overhead.
5 D
$
Sales (5 200 at $30)
Materials (5 200 at $6)
Labour (5 200 at $7.50)
Variable overhead (5 200 at $2.50)
Total variable cost
Fixed overhead ($5 5 200)
Over-absorbed overhead (*)
Absorption costing profit
*Working
Overhead absorbed (5 800 $5)
Overhead incurred
Over-absorbed overhead
$
156 000
31 200
39 000
13 000
(83 200)
(26 000)
1 600
48 400
$
29 000
27 400
1 600
If you selected option A you calculated all the figures correctly but you subtracted the overabsorbed overhead instead of adding it to profit.
Option B is the marginal costing profit.
If you selected option C you calculated the profit on the actual sales at $9 per unit, and forgot
to adjust for the over-absorbed overhead.
6 C All of the methods are acceptable bases for absorbing production overheads. However, the
percentage of prime cost (item IV) has serious limitations and the rate per unit (item I) can only
be used if all cost units are identical or very similar.
CHAPTER 6
1 D Neither statement is correct. Statement I is incorrect because although ABC will lead to a
greater understanding of cost drivers, it will only reduce costs if action is taken. Statement II is
incorrect because there will be a benefit of a greater understanding of cost drivers.
2 B Order processing costs
$1 573 000/325 000 orders
$4.84 per order
Transport costs
=
=
$2 631 200/1 495 000 km

$1.76 per km
Customer cost
(138 $4.84) + (122 138 $1.76)
$30 299.28
3 A None of the statements are correct. Statement I is not correct because some costs will be driven
by volume, for example, machine running costs may depend upon the volume of production.
Statement II is not correct because some costs may be driven by more than one cost driver, for
example, energy costs may depend upon the volume of production as well as the physical size
of a production department. Finally, statement III is not correct because although overhead cost
calculated using ABC will often be significantly different from the overhead cost calculated
using absorption costing, it is not always so.
4
Cost
description
Purchase order
processing
Cost
amount
$
450 000
Production run set up
180 000
Machine running
640 000
Cost
driver
Activity
level
Purchase
orders
6 000
Overhead
Allocation
Rate
(OAR)
$
75
450
32 000
Production
runs
Machine
hours
Product
activity
30
Cost
$
2 250
400
400
20
750
15 000
Cost per batch =
17 650
Cost per unit = 17 650/500 =
35.30
CHAPTER 7
1 A Finished good production
= input normal loss abnormal loss

= (2 500 (2 500 10%) 75) kg
= 2 500 250 75
= 2 175 kgs
2 D Expected output = 2 000 units less normal loss (5%) 100 units = 1 900 units
In situation I there is an abnormal loss of 1 900 1 800 = 100 units
In situation II there is an abnormal gain of 1 950 1 900 = 50 units
In situation III there is an abnormal gain of 2 000 1 900 = 100 units
3 D
Equivalent units
Total
Opening inventory
Fully worked units*
Closing inventory
* Fully worked units
Units
300
9 55
9 85
(100%)
450
10 300
Material
s
Units
300
9 550
9 850
450 (30%)
10 300
Conversion costs
Units
300
9 550
9 850
135
9 985
= input closing inventory

= (10 000 450) units
= 9 550 units
4 B Input costs = 2 000 units $4.50 = $9 000

Conversation costs = $13 340
Normal loss = 5% 2 000 units $3 = $300
Expected output = 2 000 units 100 units = 1 900 units
Cost per unit of output
Input costs
Expected output
$9 000 + $13 340 - $300

1 900 units
$22 040
1 900 units
= $11.6 (to one decimal place)

5 A Total production cost for June to be apportioned
= $1 000 + $10 000 + $12 000 $3 000
= $20 000
Production
Units
P
R
4 000
6 000
10 000
Apportioned cost
$
($20 000 4/10)
($20 000 6/10)
8 000
12 000
20 000
If you selected option B you made no adjustment for inventories when calculating the total
costs.
If you selected option C you apportioned the production costs on the basis of the units sold.
Option D is the total cost of product R.
6 D Process costing is a costing method used where it is not possible to identify separate units of
production, or jobs, usually because of the continuous nature of the production process. The
manufacture of liquid soap is a continuous production process.
CHAPTER 8
1 C A payroll manager would usually keep information concerning the expected rates of pay for
employees with a given level of experience and skill.
A newspaper (option A) may provide information regarding average rates of pay for an industry
sector but this would not necessarily reflect the standard pay rate for particular employees.
Option B is also incorrect because although the trade union is involved in negotiating future
rates of pay for their members, they do not take decisions on the standard rate to be paid in the
future.
A production manager (option D) would provide information concerning the number of
employees needed and the skills required, but they would not have the latest information
concerning the expected rates of pay.
2 A An attainable standard cost is an inappropriate basis for measuring inventory values, unless the
standard is actually attained. Attainable standards are much more relevant to planning and
control.
3 D Item I is incorrect because standard costs are an estimate of what will happen in the future, and
a unit cost target that the organisation is aiming to achieve. Standard costing provides the unit
cost information for evaluating the volume figures contained in a budget (item II). Standard
costing provides targets for achievement, and yardsticks against which actual performance can
be monitored (item III). Inventory control systems are simplified with standard costing. Once
the variances have been eliminated, all inventory units are valued at standard price (item IV).
4 C It is generally accepted that the use of attainable standards has the optimum motivational
impact on employees. Some allowance is made for unavoidable wastage and inefficiencies, but
the attainable level can be reached if production is carried out efficiently.
Option B and option D are not correct because employees may feel that the goals are
unattainable and will not work so hard.
Option A is not correct because standards set at a minimal level will not provide employees
with any incentive to work harder.
5 C When management by exception is adopted within a standard costing system, only the
variances which exceed acceptable tolerance limits need to be investigated by management
with a view to control action. Option A has nothing to do with management by exception.
Unfavourable and favourable variances alike may be subject to investigation, therefore option
D is incorrect.
Any efficient information system would ensure that only managers who are able to act on the
information receive management reports, even if they are not prepared on the basis of
management by exception. Therefore option B is incorrect.
100
$9 = $90
90
You should have been able to eliminate option A because it is less than the basic labour cost of
$81 for 9 hours of work. Similar reasoning also eliminates option B. If you selected option C
you simply added 10% to the 9 active hours to determine a standard time allowance of 9.9
hours per unit. However the idle time allowance is given as 10% of the total labour time.
6 D Standard labour cost per unit = 9 hours
CHAPTER 9
1 C Since inventories are valued at standard cost, the material price variance is based on the
materials purchased.
12 000 kgs material purchased should cost ($3)
but did cost
$
36 000
33 600
2 400 (F)
800 units manufactured should use ( 14 kg)

but did use
Usage variance in kg
Usage variance in $
11 200 kgs
11 500 kgs
300 kg (A)
$3
$900 (A)
If you selected options A or B you based your calculation of the material price variance on the
material actually used. If you selected option B you forgot to evaluate the usage variance in kg
at the standard price per kg.
If you selected option D you evaluated the usage variance at the actual price per kg, rather
than the standard price per kg.
2 C Statement I is not consistent with a favourable labour efficiency variance. Employees of a lower
skill level are likely to work less efficiently, resulting in an unfavourable efficiency variance.
Statement II is consistent with a favourable labour efficiency variance. Time would be saved in
processing if the material was easier to handle.
Statement III is consistent with a favourable labour efficiency variance. Time would be saved in
processing if working methods were improved.
3 B Direct material cost variance = material price variance + material usage variance.
The unfavourable material usage variance could be larger than the favourable material price
variance. The total of the two variances would therefore represent a net result of an
unfavourable total direct material cost variance.
Option A is incorrect because the sum of the two favourable variances would always be a larger
favourable variance.
Option C will sometimes be correct, as unfavourable price and usage variances will lead to an
overall unfavourable direct material cost variance. However it will not always be correct as
Option B and/or D could sometimes arise.
The situation in option D would sometimes arise depending on the relative size of the variances,
but not always, because of the possibility of the situations described in options B and C.
4 B
53 000 kgs should cost ( $2.50)
but did cost
$
132 500
136 000
3 500 (A)
5 D Total standard cost of material purchased actual cost of material purchased = Price variance
Total standard cost
= $21 920 + $1 370
= $23 290
Standard price per kg
$23 290
6 850
$3.40
=
Option A is the favourable price variance per kg. This should have been added to the actual
price to determine the standard price per kg. If you selected option B you subtracted the price
variance from the actual cost. If the price variance is favourable then the standard price per kg
must be higher than the actual price paid. Option C is the actual price paid per kg.
6 D Raising prices in response to higher demand would result in a favourable selling price variance.
Early payment discounts, option A, do not affect the recorded selling price.
Reducing selling prices, option B, is more likely to result in an unfavourable selling price
variance.
Market penetration pricing, option C, is a policy of low prices. This would result in an
unfavourable selling price variance, if the original planned policy had been one of market
skimming pricing, which involves charging high prices.
CHAPTER 10
1 B Soft capital rationing is a limit on capital investment imposed from within the company. Options
A, C and D are all restrictions imposed internally, whereas B is an external constraint and
represents hard capital rationing.
2 D All the statements are advantages of carrying out a PCA.
3 C The consultancy fee of $10 000 has already been incurred and is irrelevant.
Payback
Year
Cash flow
$
(90 000)
25 000
35 000
40 000
0
1
2
3
Cumulative
$
(90 000)
(65 000)
(30 000)
10 000
Payback is after 2 years plus 30 000/40 000 of Year 3, i.e. after 2.75 years.
4 A Payback
Add back depreciation to annual profits to get cashflows.
Depreciation = 46 000 6 000/4 = 10 000 pa
Cash flow
Cumulative
Initial investment = (46 000)
(46 000)
Year 1 20 500 + 10 000 = 30 500
(15 500)
Year 2 23 000 + 10 000 = 33 000
(17 500)
Year 3 13 500 + 10 000 = 23 500

Year 4 1 500 + 10 000 = 11 500
Payback period = 1 year + 15 500/33 000 = 1.47 years

ARR
Average profit = (20 500 + 23 000 + 13 500 + 1 500)/4 = 14 625
ARR = 14 625/ 46 000 = 31.79%
5 C A risk neutral investor does not require a zero risk - they are indifferent to the level of risk
involved in an investment and only concerned about the expected return. A risk- seeking
investor is an investor who is attracted to risk. They would choose an investment that offers the
possibility of a higher level of return, even when there is a high probability of a much lower
return.
6 A Whilst it is easier to apply project controls to ensure spending is within authorised limits and
that the implementation of the investment is not delayed, longer term controls can help ensure
the anticipated benefits are eventually obtained. So item III is correct. Financial analysis of an
investment decision is obviously vital however qualitative issues should also be considered in
the initial screening stage. Item I is therefore incorrect. Investment decisions may be made at
different levels within the organisational hierarchy depending on the type and amount of
investment and the level of risk. Therefore item II is incorrect.
CHAPTER 11
1 D Just in time (JIT) features machine cells which help products flow from machine to machine
without having to wait for the next stage of processing or returning to store. Lead times and
Work in Progress (WIP) are therefore reduced.
2 D Total holding costs and total ordering costs each year are the same when inventories are
purchased in the EOQ size. The EOQ purchasing system is incompatible with JIT, and the size
of the order quantity does not depend on the lead time for re-ordering and re-supply. If
discounts for bulk purchases are offered, the EOQ may increase (since the value of the holding
cost H may fall).
3 D The inventory level control system is designed to avoid a situation where there is no inventory
when it is needed. The minimum inventory level acts as a warning sign that inventory levels are
getting low. It is possible however that inventory levels may fall below this, for example if there
is maximum demand in the supply lead time period, and the supply lead time is at its longest.
JIT purchasing does depend on complete trust between buyer and supplier, for example so
that the supplier is aware of what quantities the buyer will need and when, and the buyer is
aware of the state of the suppliers production and inventory. JIT production has elimination of
waste as an objective: this includes the elimination of bottlenecks and hold-ups in production.
4 A After the product concept has been created, the first step is to set a price that customers are
likely to pay for it. After price, a target profit margin is established, so that the target cost can
be identified.
5 B It could be argued that there is market skimming at the beginning of the products life cycle,
but the changes in prices as the product goes through the stages of its life cycle is an example
of life cycle pricing.
CHAPTER 12
1 B Both relate outputs to inputs and are therefore measures of efficiency.
2 D Managers should be held responsible for costs over which they have some influence. Although
it is the responsibility of the maintenance department manager to keep maintenance costs
within budget, their costs will be partly fixed and partly variable, and the variable cost element
will depend on the volume of demand for the service. If the production department staff don't
use their equipment appropriately we might expect higher maintenance costs. The production
department manager should be made accountable for the costs that his department causes the
maintenance department to incur on its behalf.
3 B If higher quality standards are required, more material may be used as wastage rates will likely
be higher.
4 C Return on investment
Residual income
(Profit/capital employed) 100%
'Pre-tax profits less a notional interest charge

for invested capital'
(3.6/24) 100 = 15.0%
3.6 (24m 12%) = 0.72m
5 A Improving performance is concerned with quality of output, whereas A is measuring quantity.

B would detect any improvement in accuracy. C would assess timeliness and D would consider
staffing levels which are thought to be the cause of the problem.
6 A All of the measures would be appropriate for monitoring the learning and growth perspective.
It could be argued that the higher the labour turnover rate (measure (I)), the more fresh ideas
are being brought into the organisation as new employees join. This measure would need to be
interpreted with care, however, as a high labour turnover rate may indicate dissatisfaction
among employees, for example if they feel there is a lack of opportunity for training and further
advancement.
The higher the number of training days per employee (measure (II)), the more the organisation
is focusing on learning, and improving the employees' skills.
The higher the percentage of revenue generated by new products and services (measure (III)),
the more innovative the organisation is being, rather than relying on established products and
services.
395
BEFORE YOU BEGIN

QUESTIONS:
ANSWERS AND
COMMENTARY
BEFORE YOU BEGIN: ANSWERS AND COMMENTARY | 397
CHAPTER 1
1
FINANCIAL ACCOUNTS
MANAGEMENT ACCOUNTS
Financial accounts detail the performance of an

organisation over a defined period and the state of
affairs at the end of that period.
Management accounts are used to aid management

record, plan and control the organisation's activities
and to help the decision-making process.
Limited liability companies must, by law, prepare

financial accounts.
There is no legal requirement to prepare management

accounts.
The format of published financial accounts is

determined by local law and by International Financial
Reporting Standards. In principle, the accounts of
different organisations can therefore be easily
compared.
The format of management accounts is entirely at

management discretion: no strict rules govern the way
they are prepared or presented. Each organisation can
devise its own management accounting system and
format of reports.
Financial accounts concentrate on the business as a

Management accounts can focus on specific areas of
whole, aggregating revenues and costs from different an organisation's activities. Information may be
operations, and are an end in themselves.
produced to aid a decision rather than to be an end
product of a decision.
Most financial accounting information is of a monetary Management accounts incorporate non-monetary
nature.
measures. Management may need to know, for
example, tons of aluminium produced, monthly
machine hours, or miles travelled by sales staff.
Financial accounts present an essentially historic
picture of past operations.
Management accounts are both an historical record

and a future planning tool.
2 Cost accounting and management accounting are terms which are often used interchangeably. It is
not correct to do so. Cost accounting is part of management accounting. Cost accounting provides
a bank of data for the management accountant to use.
Cost accounting is concerned with the following:
Preparing statements (e.g. budgets, costing).
Cost data collection.
Applying costs to inventory, products and services.
Management accounting is concerned with the following:
Using financial data and communicating it as information to users.
3 An objective is the aim or goal of an organisation (or an individual) whereas is strategy is a possible
course of action that might enable an organisation (or an individual) to achieve its objectives.
Step 1
Define the problem
Step 2
Identify decision-making criteria

(goals & objectives)
Step 3
Develop alternative solutions/

opportunities which might
contribute towards achieving
them.
Step 4
Collective and analyse relevant

data about each alternative.
Step 5
Select an alternative
State the expected outcome
and check that the expected
outcome is in keeping with
the overall goals or objectives.
Step 6
Implement the decision.
PLANNING
5 Anthony divides management activities into strategic planning, management control and
6
Planning: deciding what to do and identifying the desired results.

Recording the plan which should incorporate standards of efficiency or targets.
Carrying out the plan and measuring actual results achieved.
Comparing actual results against the plans.
Evaluating the comparison, and deciding whether further action is necessary.
Where corrective action is necessary, this should be implemented.
7 Data is the raw material for data processing. Data relates to facts, events and transactions whereas
information is data that has been processed in such a way as to be meaningful to the person who
receives it. Information is anything that is communicated.
8 Good information should be relevant, complete, accurate, clear, it should inspire confidence, it
should be appropriately communicated, its volume should be manageable, it should be timely and
its cost should be less than the benefits it provides.
9 Title
Who is the report intended for?
Who is the report from?
Date
Subject
Appendix
10 Globalisation and increased competition.
Information technology changes resulting in changes in production and information flows.
Changes in organisations including internal reorganisations and external mergers.
11 A management accounting system is an information system that produces information required by

managers to manage resources and create value for customers and shareholders. It includes:
(a) Staff with accounting knowledge (management accountants).
(b) The equipment they use, including technology.
(c) Paper or computer records of financial transactions.
(d) The cost accounting system - Codes or titles describing the purpose of the financial transaction
(for example, 'Rent') and who it was incurred on behalf of (for example,
'Factory A').
(e) The management accounting techniques that are used to provide information - records of the
usage of resources other than money, such as time, physical materials, energy and so on.
(f) A large variety of simple and complex mathematical techniques for arranging and analysing (c)
in terms of (d) and (e).
(g) Reports that are produced by the people in (a), using (b) to (f), and the nature of information
available on-line. Also, prescribed formats for reports, at least in larger, more bureaucratic
organisations.
(h) Managers, to whom the reports are given (the users of the information).
12 Just-in-time (JIT) is a system whose objective is to produce or to procure products or components
as they are required by a customer or for use, rather than for inventory. A JIT system is a 'pull'
system, which responds to demand, in contrast to a 'push' system, in which inventories act as
buffers between the different elements of the system, such as purchasing, production and sales.
13 Total quality management (TQM) is the process of applying a zero defects philosophy to the
management of all resources and relationships within an organisation as a means of developing
and sustaining a culture of continuous improvement which focuses on meeting customers'
expectations.
14 Kaizen is a Japanese term for continuous improvement in all aspects of an organisation's
performance at every level. Kaizen aims to achieve a specified cost reduction, but to do so through
continuous improvements rather than one-off changes.
CHAPTER 2
1 Relevant costs are future cash flows arising as a direct consequence of a decision. Remember
decisions should be made based on relevant costs.
2 Avoidable costs are costs which would not be incurred if the activity to which they relate did not
exist.
3 Differential cost is the difference in total cost between alternatives. An opportunity cost is the value
of the benefit sacrificed when one course of action is chosen in preference to an alternative.
4 A sunk cost is a past cost which is not directly relevant in decision making.
5 The relevant cost of an asset represents the amount of money that a company would have to
receive if it were deprived of an asset in order to be no worse off than it already is. We can call this
the deprival value.
6 An easy way to generate ideas here is to think about an organisation that you know and what
factors stop it making more revenue.
(a) Sales. There may be a limit to sales demand.
(b) Labour. There may be a limit to total quantity of labour available or to labour having particular
skills.
(c) Materials. There may be insufficient available materials to produce enough products to satisfy
sales demand.
(d) Manufacturing capacity. There may not be sufficient machine capacity for the production
required to meet sales demand.
CHAPTER 3
1 A budget is a quantitative statement, for a defined period of time, which may include planned
revenues, expenses, assets, liabilities and cash flows, or non-monetary items such as staff numbers
2
Co-ordination and allocation of responsibility for the preparation of budgets.

Issuing of the budget manual.
Timetabling.
Provision of information to assist in the preparation of budgets.
Communication of final budgets to the appropriate managers.
Monitoring the budgeting and planning process by comparing actual and budgeted results.
3 The principal budget factor is the factor which limits the activities of an organisation and is
therefore the starting point for the creation of budgets.
4 Pay creditors early to obtain discount.
Attempt to increase sales by increasing debtors and inventories.
Make short-term investments.
5 A fixed budget is a budget which is set for a single activity level whereas a flexible budget is a
budget which, by recognising different cost behaviour patterns, is designed to change as volume
of activity changes.
6 Incremental budgeting is concerned mainly with the increments in costs and revenues which will occur
whereas zero based budgeting involves preparing a budget for each cost centre from a zero base.
7 Ideal standards, attainable standards, current standards and basic standards.
8 They are based on information from employees most familiar with the department operations.
Budgets should therefore be more realistic.
Knowledge spread among several levels of management is pulled together, again producing
more realistic budgets.
Because employees are more aware of organisational goals, they should be more committed to
achieving them.
Co-ordination and cooperation between those involved in budget preparation should improve.
Senior managers' overview of the business can be combined with operational-level details to
produce better budgets.
Managers should feel that they 'own' the budget and will therefore be more committed to the
targets and more motivated to achieve them.
Participation will broaden the experience of those involved and enable them to develop new skills.
9 They consume more time.
Budgets may be unachievable if managers are not qualified to participate.
Managers may not co-ordinate their own plans with those of other departments.
Managers may include budgetary slack (padding the budget) in their budgets. This means they
have over-estimated costs or under-estimated income. Actual results are then more likely to be
better than the budgeted target results.
An earlier start to the budgeting process could be required.
10 The aim is to 'get it right first time' which means that there is a striving for continuous improvement
in order to eliminate faulty work and prevent mistakes.
11 The budgeting process is about setting standards or targets for all aspects and functions of the
business to meet. If the budgeting process is successful it can help in the continuous process of
improvement (Total Quality Management) by setting targets that eventually eliminate all
unnecessary waste and mistakes.
CHAPTER 4
1 A fixed cost is a cost which is incurred for a particular period of time and which, within certain
activity levels, is unaffected by changes in the level of activity.
2 A variable cost is a cost which tends to vary with the level of activity.
3
Graph of fixed cost

$
Cost

$
Cost
Fixed cost
$
Cost
Volume of output
Graph of step-fixed cost
Step 1 Review records of costs in previous periods.
Select the period with the highest activity level.

Select the period with the lowest activity level.
Step 2 Determine the following:
Total cost at high activity level

Total costs at low activity level
Total units at high activity level
Total units at low activity level
Step 3 Calculate the following:

= variable cost per unit (v)
_
Step 4 Determine the fixed costs.

Fixed costs = (total cost at high activity level ) (total units at high activity level variable cost per unit)
5 Cost-volume-profit (CVP) / breakeven analysis is the study of the interrelationships between costs,
volume and profit at various levels of activity.
6 The C/S ratio (or P/V ratio) is a measure of how much contribution is earned from each $1 of sales.
7 The target profit is achieved when S = V + F + P.

where:
S = Sales revenue
V = Total variable costs
F = Total fixed costs
P = Required profit
8
-
$000
120
le
Sa
Budgeted profit
100
Break-even point
80
60
a
Tot
Budgeted variable costs
ts
cos
Fixed costs
40
Safety
margin
20
20
40
60
80
100
120
Units
It can only apply to a single product or a single mix of a group of products.

A breakeven chart may be time-consuming to prepare.
It assumes fixed costs are constant at all levels of output.
It assumes that variable costs are the same per unit at all levels of output.
It assumes that sales prices are constant at all levels of output.
It assumes production and sales are the same - inventory levels are ignored.
It ignores the uncertainty in the estimates of fixed costs and variable cost per unit.
CHAPTER 5
1 A direct cost is a cost that can be traced in full to the product, service, or department that is
causing the cost to be incurred.
2 An indirect cost, or overhead, is a cost that is incurred in the course of making a product,
providing a service or running a department, but which cannot be traced directly and in full to the
product, service or department.
3 Direct wages are all wages paid for labour, either as basic hours or as overtime, expended on work
on the product.
4 Overhead is the cost incurred in the course of making a product, providing a service or running a
department, but which cannot be traced directly and in full to the product, service or department.
5 The main reasons for using absorption costing are for inventory valuations, pricing decisions, and
establishing the profitability of different products.
6 The three stages of absorption costing are allocation, absorption and apportionment.
7
Step 1 Estimate the overhead likely to be incurred during the period.

Step 2 Estimate the activity level for the period. This could be total hours, units, or direct costs
or whatever the basis on which the overhead absorption rates are to be based.
Step 3 Divide the estimated overhead by the budgeted activity level. This produces the
overhead absorption rate.
8 Marginal cost is the variable cost of one unit of product or service.
9 (a) Period fixed costs are the same, for any volume of sales and production provided that the
level of activity is within the 'relevant range'.
(b) Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution
earned from the item.
(c) Profit measurement should therefore be based on an analysis of total contribution.
(d) When a unit of product is made, the extra costs incurred in its manufacture are the variable
production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when output
is increased.
CHAPTER 6
1 The major reason is the failure of traditional costing systems to adapt to changes in organisations
and their environments.
2 Activity based costing (ABC) is an approach to the costing and monitoring of activities which
involves tracing resource consumption and costing final outputs. Resources are assigned to
activities and activities to cost objects based on consumption estimates. The latter utilise cost
drivers to attach activity costs to outputs.
3 The principal idea of ABC is to focus attention on what causes costs to increase, i.e. the cost
drivers.
4 ABC should only be introduced if the additional information it provides will result in action that will
increase the organisation's overall profitability.
5 Product-sustaining activities are activities undertaken to develop or sustain a product or service.
Product sustaining costs are linked to the number of products or services, not to the number of
units produced.
6 Facility-sustaining activities are activities undertaken to support the organisation as a whole, and
which cannot be logically linked to individual units of output, batches or products.
7 (a) The complexity of manufacturing has increased, with wider product ranges, shorter product life cycles
and more complex production processes. ABC recognises this complexity with its multiple cost
drivers.
(b) ABC facilitates a good understanding of what drives overhead costs.
(c) ABC is concerned with all overhead costs and so it takes management accounting beyond its
'traditional' boundaries.
(d) By controlling the incidence of the cost driver, the level of the cost can be controlled.
(e) The costs of activities not included in the costs of the products an organisation makes or the
services it provides can be considered to be not contributing to the value of the product or
service (that is non-value adding).
(f) ABC can help with cost management.
(g) Many costs are driven by customers, delivery costs, discounts, after-sales service and so on, but
traditional absorption costing systems do not account for this.
(h) Simplicity is part of its appeal.
8 Customer profitability analysis is the analysis of the revenue streams and service costs associated
with specific customers or customer groups.
9 (a) Can a single cost driver explain the cost behaviour of all items in its associated pool?
(b) The number of cost pools and cost drivers cannot be excessive otherwise an ABC system would
be too complex and too expensive.
(c) Unless costs are caused by an activity that is measurable in quantitative terms and which can be
related to production output, cost drivers will not be usable. What drives the cost of the annual
external audit, for example?
(d) The costs of ABC may outweigh the benefits.
(e) Some measure of (arbitrary) cost apportionment may still be required at the cost pooling stage
for items like rent, rates and building depreciation.
CHAPTER 7
1 Process costing is a costing method used when it is not possible to identify separate units of
production, or jobs, usually because of the continuous nature of the production processes involved.
2 Process costing is a form of costing applicable to continuous processes where process costs are
attributed to the number of units produced.
3 On the left hand side of the process account the inputs to the process and the cost of these inputs
are recorded.
4 On the right hand side of the process account we record what happens to the inputs by the end of
the period.
5
Step
Step
Step
Step
1
2
3
4

Calculate cost per unit of output, losses and Work in Progress (WIP).
Complete accounts.
6 The normal loss is expected loss, allowed for in the budget, and normally calculated as a
percentage of the good output, from a process during a period of time. Normal losses are
generally either valued at zero or at their disposal values.
Abnormal loss is any loss in excess of the normal loss allowance.
Abnormal gain is improvement on the accepted or normal loss associated with a production activity.
7 The valuation of normal loss is either at scrap value or nil.
8 Equivalent units are used to apportion costs between closing work in process and completed
output. These are the notional number of whole units that could have been fully produced in the
period. They represent the sum of the proportion of incomplete units that have been completed.
(e.g. 1,000 units of WIP which are 60% complete equates to 600 Equivalent units and would attract
600 units worth of value)
In many industries, materials, labour and overhead may be added at different rates during the
course of production. In this case, equivalent units, and a cost per equivalent unit, is calculated
separately for each type of material, and also for conversion costs.
If the weighted average cost method of valuing opening Work in Progress (WIP) is used, it makes
no distinction between units of opening WIP and new units introduced to the process during the
current period. The cost of opening WIP is added to costs incurred during the period, and
completed units of opening WIP are each given a value of one full equivalent unit of production.
9 Joint products are two or more products produced by the same process and separated in
processing, each having a sufficiently high saleable value to merit recognition as a main product.
For example, in the oil refining industry the following joint products all arise from the same
process.
Diesel fuel.
Petrol.
Paraffin.
Lubricants.
10 A by-product is output of some value produced incidentally while manufacturing the main
product. Meat processing produces meat for human consumption as well as dog bones, glue and
so on.
11 Job costing is the method used when work is undertaken to a customer's special requirements
and each order is of comparatively short duration.
CHAPTER 8
1 A standard cost is a predetermined estimated unit cost, used for inventory valuation and control.
2 To value inventories and cost production for cost accounting purposes.
To act as a control device by establishing standards (planned costs), highlighting (via variance
analysis which we will cover in the next chapter) activities that are not conforming to plan and
therefore alerting management to areas which may be in need of corrective action.
3 A variance.
4 Ideal, attainable, current and basic.
5 The purchasing department are most likely to be involved in estimating the standard price of
materials.
They will do this using:
Purchase contracts already agreed.

Pricing discussions with regular suppliers.
The forecast movement of prices in the market.
The availability of bulk purchase discounts.
CHAPTER 9
1 A variance is the difference between a planned, budgeted, or standard cost and the actual cost
incurred. Basically it is a just a difference.
2 The direct material total variance can be subdivided into the direct material price variance and
the direct material usage variance.
3 The way inventory is valued will change the value of the variance.
4 The direct labour rate variance and the direct labour efficiency variance.
5 The variable production overhead expenditure variance and the variable production overhead
efficiency variance.
6 The expenditure variance and the volume variance.
7 The reasons for cost variances arising are summarised in the table that follows.
FAVOURABLE
(a) Material price
Unforeseen discounts received

Discounts obtained in purchasing
ADVERSE
Price increase
Careless purchasing

Change in supply and demand of
raw materials (supply exceeds
demand)

materials (demand exceeds supply)
(b) Material usage
Material used of higher quality than

standard
More effective use made of
material
Defective material
Excessive waste
Theft
Stricter quality control
(c) Labour rate
Use of apprentices or other workers

at a rate of pay lower than standard
Wage rate increase

Use of higher grade labour
(d) Idle time
The idle time variance is always

adverse
Machine breakdown
Non-availability of material
Illness or injury to workers
Under-utilisation of assets
(e) Labour efficiency
Output produced more quickly

than expected because of work
motivation, better quality of
equipment or materials, or better
methods.
Errors in allocating time to jobs
Lost time in excess of standard allowed

Output lower than standard set because
of deliberate restriction, lack of training,
or sub-standard material used
Errors in allocating time to jobs
Higher asset utilisation than

planned.
(f) Overhead
expenditure
Savings in costs incurred

More economical use of services
Increase in cost of services used

Excessive use of services
Change in type of services used
(g) Overhead volume
Labour force working more

efficiently (favourable labour
efficiency variance)
Labour force working less efficiently

(adverse labour efficiency variance)
Labour force working overtime
Machine breakdown, strikes, labour

shortages
8 Variances should only be investigated where the amount is material, i.e. significant to decision
makers and when the reasons for the variance can be controlled through management action.
9 The difference between what the sales revenue is and should have been for the actual quantity
sold.
10 The difference between the actual units sold and the budgeted (planned) quantity, valued at the
standard profit per unit. In other words, it measures the increase or decrease in standard profit as a
result of the sales volume being higher or lower than budgeted (planned).
11 A proforma operating statement reconciling budgeted profit and actual profit.
Budgeted (planned) profit before sales and administration costs
Sales variances:
price
volume
X
X
X
X
X
Actual sales minus the standard cost of sales

Cost variances
Material price
Material usage
Labour rate
Labour efficiency
Labour idle time
Variable overhead expenditure
Variable overhead efficiency
Fixed overhead expenditure
Fixed overhead volume
Actual profit before sales and
administration costs
Sales and administration costs
Actual profit
(F)
$
X
X
X
X
X
X
X
X
X
(A)
$
X
X
X
X
X
X
X
X
X
X
X
X
X
X
CHAPTER 10
1 Origination of proposals; project screening; analysis and acceptance; and monitoring and review.
2
Step 1
Complete and submit standard format financial information as a formal investment

proposal.
Step 2
Classify the project by type to separate projects into those that require more or less
rigorous financial appraisal, and those that must achieve a greater or lesser rate of
return in order to be deemed acceptable.
Step 3
Step 4
Step 5
Carry out financial analysis of the project.
Step 6
Step 7
Compare the outcome of the financial analysis to predetermined acceptance criteria.

Consider the project in the light of the capital budget for the current and future
operating periods.
Make the decision accept/reject.
Monitor the progress of the project.
3 A post-completion audit (PCA) is an objective independent assessment of the success of a capital

project in relation to plan. It covers the whole life of the project and provides feedback to
managers to aid the implementation and control of future projects. A post-completion audit is
often referred to as post-implementation audit in some countries.
4 (a) The possibility of the PCA is likely to motivate managers to work to achieve the promised
benefits from the project.
(b) If the audit takes place before the project life ends, and if it finds that the benefits have been
less than expected, steps can be taken to improve efficiency. Alternatively, it will highlight those
projects which should be discontinued.
(c) It can help to identify managers who have been good performers and those who have been
poor performers.
(d) It might identify weaknesses in the forecasting and estimating techniques used to evaluate
projects, and so should help to improve the discipline and quality of forecasting for future
investment decisions.
(e) Areas where improvements can be made in methods which should help to achieve better
results in general from capital investments might be revealed.
(f) The original estimates may be more realistic if managers are aware that they will be monitored,
but post-completion audits should not be unfairly critical.
5 A reasonable guideline might be to audit all projects above a certain size, and a random selection
of smaller projects.
6 It is generally appropriate to separate responsibility for the investment decision from that for the
PCA.
7 Payback is the time required for the cash inflows from a capital investment project to equal the
cash outflows.
8 (a) It ignores the timing of cash flows within the payback period, the cash flows after the end of the
payback period and therefore the total project return.
(b) It ignores the time value of money which is a concept incorporated into more sophisticated
appraisal methods.
(c) The method is unable to distinguish between projects with the same payback period.
(d) The choice of any cut-off payback period by an organisation is arbitrary.
(e) It may lead to excessive investment in short-term projects.
(f) It takes account of the risk of the timing of cash flows but does not take account of the
variability of those cash flows.
9 (a) Assesses period for which capital is tied up.
(b) Focus on early payback will encourage strong liquidity.
(c) Investment risk is increased if payback is longer.
(d) Shorter-term forecasts are likely to be more reliable.
(e) The calculation is quick and simple.
(f) Payback is an easily understood concept.
10
Average annual profit from investment

100%
Average investment
or
100%
or
Estimated average profits
100%
11 The ARR method has the serious drawback that it does not take account of the timing of the profits
from a project
There are a number of other drawbacks:
(a) It is based on accounting profits which are subject to a number of different accounting
treatments.
(b) It is a relative measure rather than an absolute measure and hence takes no account of the size
of the investment.
(c) It takes no account of the length of the project.
(d) Like the payback method, it ignores the time value of money.
Advantages of the ARR method:
(a) It is quick and simple to calculate.
(b) It involves a familiar concept of a percentage return.
(c) Accounting profits can be easily calculated from financial statements.
(d) It looks at profits throughout the entire project life.
(e) Managers and investors are accustomed to thinking in terms of profit, and so an appraisal
method which employs profit may therefore be more easily understood.
12 Risk involves situations or events which may or may not occur, but whose probability of occurrence
can be calculated statistically and the frequency of their occurrence predicted from past records.
Uncertain events are those whose outcome cannot be predicted with statistical confidence.
CHAPTER 11
1 Just-in-time (JIT) is a system whose objective is to produce or to procure products or components
as they are required by a customer or for use, rather than for inventory. A JIT system is a pull
system, which responds to demand, in contrast to a push system, in which inventories act as buffers
between the different elements of the system, such as purchasing, production and sales.
2 JIT aims to eliminate all non-value-added costs. Value is only added while a product is actually
being processed. While it is being inspected for quality, moving from one part of the factory to
another, waiting for further processing and held in store, value is not being added. Non valueadded activities, or diversionary activities, should therefore be eliminated.
3 (a) It is not always easy to predict patterns of demand.
(b) JIT makes the organisation far more vulnerable to disruptions in the supply chain.
(c) Wide geographical spread of suppliers and manufacturing makes JIT difficult.
4
To ensure sufficient goods are available to meet expected demand.

To provide a buffer between processes.
To meet any future shortages.
To take advantage of bulk purchasing discounts.
To absorb seasonal fluctuations and any variations in usage and demand.
To allow production processes to flow smoothly and efficiently.
As a necessary part of the production process such as when maturing cheese.
As a deliberate investment policy, especially in times of inflation or possible shortages.
5 The EOQ can be calculated using a table, graph or formula.

6 EOQ =
2C D
0
C
H
where:
CH = cost of holding one unit of inventory for one time period
C0 = cost of ordering a consignment from a supplier
D = demand during the time period
7 1 Order cycling method
Under the order cycling method, quantities on hand of each item are reviewed periodically
(every 1, 2 or 3 months).
2 Two-bin system
item is kept in two storage bins.
3 Classification of materials
Materials items may be classified as expensive, inexpensive or in a middle-cost range.
(a) Expensive and medium-cost materials are subject to careful stores control procedures to
minimise cost.
(b) Inexpensive materials can be stored in large quantities because the cost savings from careful
stores control do not justify the administrative effort required to implement the control.
This selective approach to stores control is sometimes called the ABC method whereby
materials are classified A, B or C according to their expense-group A being the expensive,
group B the medium-cost and group C the inexpensive materials.
4 Pareto (80/20) distribution

A similar selective approach to stores control is the Pareto (80/20) distribution which is based on
the finding that in many stores, 80% of the value of stores is accounted for by only 20% of the
stores items, and inventories of these more expensive items should be controlled more closely.
8 Full cost-plus pricing is a method of determining the sales price by calculating the full cost of the
9 Introduction; Growth; Maturity; and Saturation and Decline.
10 The price elasticity of demand (PED) measures the extent of change in demand for a product
following a change to its price.
11 The target costing approach is to develop a product concept and then to determine the price
customers would be willing to pay for that concept. The desired profit margin is deducted from the
price, leaving a figure that represents total cost. This is the target cost.
12 A transfer price is the price at which goods or services are transferred between different units of
the same company. The extent to which the transfer price covers costs and contributes to (internal)
profit is a matter of policy.
CHAPTER 12
1 A responsibility centre is a section of an organisation (a function or department) that is headed by a
manager who has direct responsibility for its performance.
2 Materiality, controllability and variance trend.
3 Interdependence refers to the fact that the cause of one variance may be wholly or partly explained
by the cause of another variance. For example, if the purchasing department buys a cheaper
material which is poorer in quality than the expected standard, the material price variance will be
favourable, but this may cause material wastage and an unfavourable usage variance. It may also
have a negative impact on labour variances as the cheap material may be harder to work with. Thus
individual variances must not be considered in isolation. Investigation of variances should highlight
the underlying cause of the inefficiency or efficiency, in this case the poor quality material and lead
to control action to avoid the purchasing decision being repeated. This may remove the favourable
material price variance but will also address the unfavourable material usage and labour efficiency
variances.
4 The direct labour efficiency variance, which could identify problems with labour productivity.
Distribution costs as a percentage of turnover, which could help with the control of costs.
Number of hours for which labour was idle, which could indicate how well resources are being
used.
Profit as a percentage of turnover, which could highlight how well the organisation is being
managed.
5 Indices show how a particular variable has changed relative to a base value.
6 The two key measures are Return on investment (ROI) and Residual income (RI). Both these show
how well resources are being used in that centre.
7 Customer; Internal; Learning and growth; and Financial.
8 Conflicting measures, selecting measures, expertise, interpretation and the possibility of too many
measures.
9 Reward is 'all of the monetary, non-monetary and psychological payments that an organisation
provides for its employees in exchange for the work they perform'. Bratton
415
GLOSSARY OF TERMS
GLOSSARY OF TERMS | 417
Absorption costing. A method for sharing overheads between different products on a fair basis.
Activity Based Costing (ABC). An approach to the costing and monitoring of activities which involves
tracing resource consumption and costing final outputs. Resources are assigned to activities and
activities to cost objects based on consumption estimates.
Administration costs. The costs of managing an organisation.
Allocation. The process by which whole cost items are charged direct to a unit or cost centre.
Apportionment. A procedure whereby indirect costs are spread fairly between cost centres.
Avoidable costs. Costs which would not be incurred if the activity to which they relate did not exist.
Balanced scorecard approach. An approach to the provision of information to management to assist
strategic policy formulation and achievement. It emphasises the need to provide the user with a set of
information which addresses all relevant areas of performance in an objective and unbiased fashion.
The information provided may include both financial and non-financial elements, and cover areas such
as profitability, customer satisfaction, internal efficiency and learning and growth.
Break-even analysis. See Cost-volume profit analysis.
Budget. A quantitative statement, for a defined period of time, which may include planned revenues,
expenses, assets, liabilities and cash flows.
Budget manual. A collection of instructions governing the responsibilities of persons and the
procedures, forms and records relating to the preparation and use of budgetary data.
By-product. Output of some value produced incidentally while manufacturing the main product.
Cash budget. A statement in which estimated future cash receipts and payments are tabulated in
such a way as to show the forecast cash balance of a business at defined intervals.
Contribution. The difference between the selling price and the variable cost of a product.
Controllable costs. Items of expenditure which can be directly influenced by a given manager within
a given time span.
Cost behaviour. The way in which costs are affected by changes in the volume of output.
Cost centre. Any part of an organisation which incurs costs.
Cost driver. A factor influencing the level of cost. Often used in the context of ABC to denote the
factor which links activity resource consumption to product outputs.
Cost pool. A grouping of costs relating to a particular activity in an activity-based costing system.
Cost, or expense, centre. Any part of an organisation which incurs costs.
Cost-volume-profit (CVP) analysis. The study of the interrelationships between costs, volume and
profit at various levels of activity. Also known as break-even analysis.
Customer profitability analysis (CPA). The analysis of the revenue streams and service costs
associated with specific customers or customer groups.
Cusum chart. A chart which shows the cumulative sum of variances over a period of time.
Data. The raw material for data processing. Data relates to facts, events and transactions.
Development costs. The costs incurred between the decision to produce a new or improved product
and the commencement of full manufacture of the product.
Differential cost. The difference in total cost between alternatives.
Direct cost. A cost that can be traced in full to the product, service, or department that is incurring
the cost.
Direct labour costs. The specific costs of the workforce used to make a product or provide a service.
Direct labour costs are established by measuring the time taken for a job, or the time taken in 'direct
production work'.
Direct labour efficiency variance. The difference between the hours that should have been worked
for the number of units actually produced, and the actual number of hours worked, valued at the
standard rate per hour.
Direct labour rate variance. The difference between the standard cost and the actual cost for the
actual number of hours paid for.
Direct material costs. The costs of materials that are known to have been used in making and selling
a product, or providing a service.
Direct material price variance. The difference between the standard cost and the actual cost for the
actual quantity of material used or purchased.
Direct material total variance. The difference between what the output actually cost and what it
should have cost, in terms of material used.
Direct material usage variance. The difference between the standard quantity of materials that
should have been used for the number of units actually produced, and the actual quantity of materials
used, valued at the standard cost per unit of material.
Economic Order Quantity (EOQ). The order quantity which minimises inventory costs. The EOQ can
be calculated using a table, graph or formula.
Facility-sustaining activities. Activities undertaken to support the organisation as a whole, and which
cannot be logically linked to individual units of output.
Financing costs. Costs incurred to finance a business such as loan interest.
Fixed budget. A budget which is set for a single activity level.
Fixed cost. A cost which is incurred for a particular period of time and which, within certain activity
levels, is unaffected by changes in the level of activity.
Fixed overhead expenditure variance. The difference between the budgeted fixed overhead
expenditure and actual fixed overhead expenditure.
Fixed overhead total variance. The difference between fixed overhead incurred and fixed overhead
absorbed. In other words, it is the under or over-absorbed fixed overhead.
Fixed overhead volume capacity variance. The difference between budgeted (planned) hours of
work and the actual hours worked, multiplied by the standard absorption rate per hour.
Fixed overhead volume efficiency variance. The difference between the number of hours that actual
production should have taken, and the number of hours actually taken (that is, worked) multiplied by
the standard absorption rate per hour.
Fixed overhead volume variance. The difference between actual and budgeted (planned) volume
multiplied by the standard absorption rate per unit.
Flexible budget. A budget which, by recognising different cost behaviour patterns, is designed to
change as volume of activity changes.
Full cost-plus pricing. A method of determining the sales price by calculating the full cost of the
Indirect cost, or overhead. A cost that is incurred in the course of making a product, providing a
service or running a department, but which cannot be traced directly and in full to the product, service
or department.
Information. Data that has been processed in such a way as to be meaningful to the person who
receives it.
International Accounting Standard 2 (IAS 2). States that costs of all inventories should comprise
those costs which have been incurred in the normal course of business in bringing the inventories to
their 'present location and condition'.
Investment centre. A section of an organisation whose manager has some say in investment policy in
their area of operations as well as being responsible for costs and revenues.
Job analysis. The 'systematic process of collecting and evaluating information about the tasks,
responsibilities and the context of a specific job' (Bratton).
Job costing. The costing method used where work is undertaken to customers' special requirements
and each order is of comparatively short duration.
Job evaluation. 'A systematic process designed to determine the relative worth of jobs within a single
work organisation' (Bratton).
Job. A customer order or task of relatively short duration.
Joint products. Two or more products produced by the same process and separated in processing,
each having a sufficiently high saleable value to merit recognition as a main product.
Just-in-time (JIT). A system whose objective is to produce or to procure products or components as
they are required by a customer or for use, rather than for inventory. A JIT system is a 'pull' system,
which responds to demand, in contrast to a 'push' system, in which inventories act as buffers between
the different elements of the system, such as purchasing, production and sales.
Just-in-time production. A system which is driven by demand for finished products whereby each
component on a production line is produced only when needed for the next stage.
Just-in-time purchasing. A system in which material purchases are contracted so that the receipt and
usage of material coincide to the maximum extent possible.
Kaizen. A Japanese term for continuous improvement in all aspects of an entity's performance at
every level.
Limiting factor. Anything which limits the activity of the entity.
Management accounting systems. Provide information specifically for the use of managers within an
organisation.
Management control. The process by which managers assure that resources are obtained and used
effectively and efficiently in the accomplishment of the organisation's objectives.
Margin of safety. The difference in units between the budgeted sales volume and the breakeven
sales volume. It is sometimes expressed as a percentage of the budgeted sales volume.
Marginal cost. The variable cost of one unit of product or service.
Market penetration pricing. Adopting a policy of low prices when a product is first launched in order
to obtain sufficient penetration into a market.
Market skimming. Involves charging high prices when a product is first launched and spending
heavily on advertising and sales promotion to obtain sales.
Monopoly. One seller who dominates many buyers. The monopolist can use their market power to set
a profit-maximising price.
Objective. The aim or goal of an organisation (or an individual).
Oligopoly. Relatively few competitive companies dominate the market. While each large company
has the ability to influence market prices, the unpredictable reaction from the other large competitors
makes the final industry price indeterminate.
Operating statement. A regular report for management of actual costs and revenues, usually
showing variances from budget.
Operational control. The process of assuring that specific tasks are carried out effectively and
efficiently.
Opportunity cost. The value of the benefit sacrificed when one course of action is chosen in
Outsourcing. The use of external suppliers as a source of finished products, components or services.
This is also known as contract manufacturing or sub-contracting.
Overhead absorption. The process whereby overhead costs allocated and apportioned to
production cost centres are added to unit, job or batch costs. Overhead absorption is sometimes
called overhead recovery.
Payback. The time required for the cash inflows from a capital investment project to equal the cash
outflows.
Perfect competition. Many buyers and many sellers all dealing in an identical product. Neither
producer nor user has any market power and both must accept the prevailing market price.
Post-Completion Audit (PCA). An objective independent assessment of the success of a capital
project in relation to plan. It covers the whole life of the project and provides feedback to managers to
aid the implementation and control of future projects
Price Elasticity of Demand. Measures the extent of change in demand for a product following a
change to its price.
Prime costs. The sum of all the direct costs.
Principal budget factor. The budgeted factor which limits the activities of an organisation.
Process costing. A form of costing applicable to continuous processes where process costs are
attributed to the number of units produced.
Production costs. The costs which are incurred by the sequence of operations beginning with the
supply of raw materials, and ending with the completion of the product ready for warehousing as a
finished goods item.
Product-sustaining activities. Activities undertaken to develop or sustain a product or service.
Product sustaining costs are linked to the number of products or services, not to the number of units
produced.
Profit centre. Any section of an organisation, for example, a division of a company, which earns
revenue and incurs costs. The profitability of the section can therefore be measured.
Relevant cost of an asset. Represents the amount of money that a company would have to receive if
it were deprived of an asset in order to be no worse off than it already is.
Relevant costs. Future cash flows arising as a direct consequence of a decision.
Research costs. The costs of researching new or improved products.
Residual income (RI). Pre-tax profits less a notional interest charge for invested capital.
Responsibility accounting. A system of accounting that makes revenues and costs the responsibility
of particular managers so that the performance of each part of the organisation can be monitored and
assessed.
Responsibility centre. A section of an organisation that is headed by a manager who has direct
responsibility for its performance.
Return on capital employed (ROCE). Also called Return on investment (ROI). Is calculated as
(profit/capital employed) x 100% and shows how much profit has been made in relation to the amount
of resources invested.
Revenue centre. A section of an organisation which creates revenue but has no responsibility for
production. A sales department is an example.
Reward. 'All of the monetary, non-monetary and psychological payments that an organisation
provides for its employees in exchange for the work they perform'. (Bratton)
Risk averse. Decision maker acts on the assumption that the worst outcome might occur and requires
compensation for risk in the form of higher returns.
Risk. Involves situations or events which may or may not occur, but whose probability of occurrence
can be calculated statistically and the frequency of their occurrence predicted from past records
Risk neutral. Decision maker is indifferent to the level of risk in an investment and only concerned
about the level of expected return.
Risk seeker. A decision maker who is interested in the best outcomes no matter how small the chance
that they may occur, and is attracted to risk.
Sales volume profit variance. The difference between the actual units sold and the budgeted
(planned) quantity, valued at the standard profit per unit. In other words, it measures the increase or
decrease in standard profit as a result of the sales volume being higher or lower than budgeted
(planned).
Scrap. Discarded material having some value.
Selling costs. Sometimes known as marketing costs, are the costs of creating demand for products
and securing firm orders from customers.
Selling price variance. A measure of the effect on expected profit of a different selling price to
standard selling price. It is calculated as the difference between what the sales revenue should have
been for the actual quantity sold, and what it was.
Semi-variable/mixed cost. is a cost which contains both fixed and variable components and so is
Standard cost. A predetermined estimated unit cost, used for inventory valuation and control.
Step-fixed cost. A cost that is fixed for a certain range of activity but increases to a new fixed level
once a critical level of activity is reached.
Strategic information. Used by senior managers to plan the objectives of their organisation, and to
assess whether the objectives are being met in practice.
Strategic Management Accounting. A form of management accounting in which emphasis is placed
on information which relates to factors external to the entity, as well as to non-financial information
and internally-generated information.
Strategic planning. The process of deciding on objectives of the organisation, on changes in these
objectives, on the resources used to attain these objectives, and on the policies that are to govern the
acquisition, use and disposition of these resources.
Strategy. A possible course of action that might enable an organisation (or an individual) to achieve its
objectives.
Sunk cost. A past cost which is not directly relevant in decision making.
Tactical information. Used by middle management to decide how the resources of the business
should be employed, and to monitor how they are being and have been employed
Target costing approach. A process that begins with the development of a product concept and
then determination of the price customers would be willing to pay for that concept. The desired profit
margin is deducted from the price, leaving a figure that represents total cost. This is the target cost.
Total Quality Management (TQM). A philosophy that means that quality management is the aim of
every part of the organisation. The aim is to 'get it right first time' which means that there is a striving
for continuous improvement in order to eliminate faulty work and prevent mistakes.
Uncertain events. Those events whose outcome cannot be predicted with statistical confidence.
Value-added cost. Costs incurred for an activity that cannot be eliminated without the customer's
perceiving a deterioration in the performance, function, or other quality of a product.
Variable cost. A cost which tends to vary with the level of activity.
Variable production overhead expenditure variance. The difference between the amount of
variable production overhead that should have been incurred in the actual hours actively worked, and
the actual amount of variable production overhead incurred.
Variance. The difference between a planned, budgeted, or standard cost and the actual cost incurred.
Weighted average cost method of inventory valuation. An inventory valuation method that
calculates a weighted average cost of units produced from both opening inventory and units
introduced in the current period.
Zero based budgeting (ZBB). Involves preparing a budget for each cost centre from a zero base.
Every item of expenditure has to be justified in its entirety in order to be included in the next year's
budget.
423
INDEX
INDEX | 425
A
ABC method of stores control, 310
Abnormal gain, 197
Abnormal loss, 197
Absorption base, 154
Absorption costing, 143, 177
Absorption costing and marginal costing
compared, 161
Account-classification method, 84
Accounting rate of return (ARR) method, 285
Activity based costing (ABC), 174, 175
Activity based management (ABM), 175, 185
Activity cost pool, 176
Activity ratio, 339
Administration overhead, 140
Advanced manufacturing technology, 174
Advantages of ABC, 183
Allocation, 145
Assumptions about cost behaviour, 108
Attainable standard, 88, 239
Attributable fixed costs, 44
Average inventory, 307
Avoidable costs, 42
B
Balanced scorecard, 341
Balanced scorecard approach, 342
Base remuneration, 344, 345
Bases of absorption, 155
Basic standard, 88, 239
Berry, Broadbent and Otley, 342
Blanket absorption rates, 156
Blanket overhead absorption rate, 156
Bottom up, 89
Bottom up (participatory budget), 89
Break-even analysis, 111
Break-even charts, 118
Break-even point, 112, 114
Budget, 66, 68
Budget variance, 81
Cash, 72
Fixed, 78
Incremental, 85
Master, 77
Responsibility for, 69
Budget bias, 91
Budget committee, 69
Budget manual, 69
Budgetary slack, 90
Budgeting and TQM, 93
By-product, 214
C
Capacity ratio, 339
Capital budgets, 276

Cash budget, 72
Usefulness of, 73
Common costs, 214
Contract manufacturing, 52
Contribution, 158
Contribution chart, 118, 122
Contribution/sales (C/S) ratio, 112
Control, 11, 67
Control charts, 330
Control limits, 330
Control ratios, 339
Controllability, 260, 328
Controllable costs, 43, 328
Corporate planning, 9, 10
Cost accounts, 8
Cost behaviour, 102
Cost behaviour principles, 103
Cost centre, 326
Cost driver, 175, 179
Cost estimation
Account-classification method, 84
High-low method, 84
Scatter graph method, 84
Cost management, 184
Cost plus pricing, 217
Cost/sales ratios, 337
Cost-volume-profit analysis (CVP), 111
Current standard, 88
Curvilinear variable costs, 106
Customer profitability analysis (CPA), 184
Cusum chart, 331
D
Data, 15, 16
Decision-making problems, 48
Demand-based approach to pricing, 315
Deprival value, 47
Deprival value of an asset, 46
Designing a management accounting system,
23
Development of managing accounting
information, 4
Differential costs, 42
Differential pricing, 314
Direct cost, 138
Direct expenses, 139
Direct labour costs, 138
Direct labour efficiency variance, 252
Direct labour rate variance, 252
Direct labour total variance, 252
Direct material, 139
Direct material costs, 138
Direct material total variance, 250
Direct wages, 139
Disadvantages of ABC, 184
Discretionary cost items, 87
Distribution overhead, 140

Dysfunctional decision making, 91
E
Effectiveness, 13, 335
Efficiency, 13, 335
Efficiency ratio, 339
Elastic demand, 315
Empire building, 91
EOQ formula, 308
Equivalent units, 206
Expense centre, 326
Expenses, 138
Extrinsic rewards, 343
Indirect cost, 138

Indirect expenses, 140
Indirect materials, 140
Indirect remuneration, 344
Indirect wages, 140
Inelastic demand, 315
Information, 15, 16
Interdependence between variances, 332
International Accounting Standard 2 (IAS 2),
145
Intrinsic rewards, 343
Introduction, 312
Inventory control, 304, 305
Inventory control levels, 304
Investment appraisal techniques, 278
Investment centre manager, 327
Investment decision, 276
F
Facility-sustaining activities, 182
Factory overhead, 140
Favourable variance, 250
Features of a report, 18
Feedback Information, 68
Feedback loop, 68
Financial accounts, 7
Financial analysis of long-term decisions, 278
Financial information, 18
Fixed budget, 78
Fixed cost, 43, 102, 104
Fixed overhead expenditure variance, 256
Fixed overhead total variance, 256
Fixed overhead volume variance, 256
Fixed production overhead variances, 255
Flexible budget, 78
Full cost-plus pricing, 310
Functional costs, 141
J
Job, 216
Job accounts, 216
Job costing, 216
Joint costs, 214
Joint products, 213
Just-in-time (JIT), 26, 300
Just-in-time production, 26, 300
Just-in-time purchasing, 26, 301
Just-in-time systems (JIT), 300
K
Kaizen, 27
Kanban, 301
Key budget factor, 70
L
G
Goal congruence, 91
Gross profit margin, 337
Growth, 313
H
Hierarchy of activities, 181
High-low method, 79, 84, 108
Holding costs, 304
I
Ideal standard, 88, 239
Imposed budget, 89
Incremental costs, 42
Indices, 336
Labour, 138
Lean management accounting, 27
Life cycle costing, 27
Limiting budget factor, 70
Limiting factor, 47
Long-term financial plan, 68
Long-term plan, 68
Long-term planning, 9, 10
Long-term strategic planning, 10
M
Machine cells, 301
Management accounting
Development of managing accounting
information, 4
Management accounting function, 4
Management accounting system, 20
Designing, 23
INDEX | 427
Management control, 13
Management control information, 24
Management control system, 9, 14
Margin of safety, 113
Marginal cost, 157
Marginal costing, 157, 160
Marginal costing and absorption costing
compared, 161
Marginal costing principles, 158
Marginal cost-plus pricing, 311
Market penetration pricing, 314
Market skimming pricing, 314
Marketing overhead, 140
Mark-up pricing, 311
Master budget, 77, 78
Materiality, 260, 328
Materials, 138
Materials variances and opening and closing
stock, 251
Maturity, 313
Maximum level, 306
Minimum level, 306
Mission, 9
Mixed cost, 106
Monopoly, 313
Mutually exclusive projects, 286
N
Negotiated style of budgeting, 91
Non-financial information, 18
Non-linear variable costs, 106
Non-relevant variable costs, 44
Non-value-added costs, 302
Normal loss, 197
O
Objective, 9
Objectives of organisations, 9
Oligopoly, 313
Operating statement, 263
Operational control, 14
Operational control information, 24
Operational information, 15, 24
Opportunity costs, 42
Optimal ABM, 185
Optimum production plan, 49
Order cycling method of stores control, 309
Ordering costs, 305
Origination of proposals, 277
Other direct expenses, 138
Outsourcing, 52
Overhead, 138, 143
Overhead absorption, 153
Overhead absorption rate, 156, 157, 255
Overhead allocation, 145
Overhead apportionment, 147

Overhead recovery, 153
Overtime, 139
P
Padding the budget, 90
Pareto (80/20) distribution, 310
Participation, 89
Participatory budget, 89
Payback, 282
Payback method, 282
Perfect competition, 313
Performance indicators, 334
Performance measurement, 24
Performance measures, 333
Performance measures for cost centres, 335
Performance measures for investment centres,
340
Performance measures for profit centres, 336
Performance measures for revenue centres,
336
Performance standards, 239
Performance-related remuneration, 344
Planning, 9, 67
Planning and control cycle, 67
Position audit, 67
Post-completion audit (PCA), 280
Predetermined overhead absorption rate, 153
Price elasticity of demand (PED), 315
Price leadership, 314
Principal budget factor, 70
Process accounts, 195
Process costing, 194
Procurement costs, 305
Product life cycle, 312
Production overhead, 140
Production volume ratio, 339
Productivity, 335
Product-sustaining activities, 182
Profit centre, 327
Profit margin, 336
Profit targets, 114
Profit/volume (P/V) chart, 118, 122
Profit/volume (P/V) ratio, 112
Project screening, 277
Q
Qualitative issues in long-term decisions, 278
Qualitative performance measure, 335
Qualities of good information, 16
R
Reciprocal (repeated distribution) method of
apportionment, 150
Relevant cost of labour, 45

Relevant cost of materials, 44
Relevant costs, 42
Reports, 18
Residual income (RI), 341
Residual income (RI), 341
Resource driver, 175
Responsibility accounting, 66, 326
Responsibility centre, 326
Return on capital employed (ROCE), 340
Return on capital employed (ROCE)
method, 285
Return on investment (ROI), 340
Return on investment (ROI) method, 285
Revenue centre, 327
Reward, 343
Risk, 288
Risk averse, 289
Risk neutral, 289
Risk seeker, 289
Target costing, 28
Target profit, 115
Top down, 89
Top down (imposed budget), 89
Total cost, 316
Total Quality Management (TQM), 26, 93
Transfer price, 317
Transfer price, 317, 318
Transfer pricing, 318
Two-bin system of stores control, 309
U
Uncertain events, 288
Uncertainty, 288
Uncontrollable costs, 43
Unfavourable variance, 250
Uniform loading, 301
V
S
Sales variances, 261
Sales variances significance, 262
Sales volume profit variance, 261, 262
Saturation, 313
Scatter graph method, 84
Scrap, 201
Selling price variance, 261
Semi-variable cost, 106
Short-term tactical planning, 10
Spend to budget, 85
Standard cost system, 236
Standard costing, 236, 238
Standard hour, 339
Standard operation sheet, 241
Standard product specification, 240
Step-fixed cost, 105
Stockout costs, 305
Strategic ABM, 185
Strategic analysis, 67
Strategic information, 14
Strategic Management Accounting, 23
Strategic planning, 13
Strategy, 9
Sub-contracting, 52
Sunk cost, 43
Sustainability, 30
Sustainability accounting, 30
T
Tactical information, 15, 24
Value-added, 302
Variable cost, 43, 102, 105
Variable overhead total variance, 254
Variable production overhead expenditure
variance, 254
Variable production overhead variance, 254
Variance, 250, 334
Control chart, 330
Control limits, 330
Significance of, 329
Variances
Interdependence between, 332
Vision, 9
W
Weighted average cost method, 210
World-Class Manufacturing (WCM), 25
Y
Yardsticks, 334
Z
Zero base budgeting (ZBB), 85
Advantages of, 86
Disadvantages of, 86
Using, 87
NOTES | 429
430 | NOTES

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FOUNDATION EXAM

Fifth edition 2015

BPP Learning Media Ltd 2015

YOU AND YOUR STUDY PLAN

ADDITIONAL LEARNING SUPPORT

STANDARDS AND LEGISLATION

Preparing for your foundation exam

The nature and purpose of management accounting

Decision making and relevant costing

Cost behaviour and CVP analysis

Overheads, absorption and marginal costing

Overhead costing activity-based costing

Process and job costing

Inventory and pricing decisions

Performance measurement and evaluation

Answers to revision questions

Before you begin questions: answers and commentary

Show the referenced CPA Australia learning objectives.

Tells you what you will be studying in this chapter.

Presents a general idea of what is covered in this chapter.

Before you begin

This box indicates the learning objective covered by the section or

Definitions of important concepts. You really need to know and understand

These highlight points that are likely to be particularly important or relevant

This is an illustration of a particular technique or concept with a solution or

This is a question that enables you to practise a technique or test your

Key chapter points

Review the key areas covered in the chapter.

A quick test of your knowledge of the main topics in this chapter.

The revision questions are not a representation of the difficulty or style of

This is a practical example or illustration, usually involving a real world

viii | MANAGEMENT ACCOUNTING

PREPARING FOR YOUR FOUNDATION EXAM

TIPS FOR EXAMS

ANSWERING MULTIPLE CHOICE QUESTIONS

COMPUTER-BASED EXAM NAVIGATION

CHAPTER 1 THE NATURE AND PURPOSE OF MANAGEMENT

CHAPTER 2 DECISION MAKING AND RELEVANT COSTING

CHAPTER 4 COST BEHAVIOUR AND CVP ANALYSIS

CHAPTER 5 OVERHEADS, ABSORPTION AND MARGINAL COSTING

CHAPTER 6 OVERHEAD COSTING ACTIVITY-BASED COSTING

CHAPTER 7 PROCESS AND JOB COSTING

CHAPTER 8 STANDARD COSTING

CHAPTER 9 VARIANCE ANALYSIS

CHAPTER 10 CAPITAL EXPENDITURE

CHAPTER 11 INVENTORY AND PRICING DECISIONS

CHAPTER 12 PERFORMANCE MEASUREMENT AND EVALUATION

xii | MANAGEMENT ACCOUNTING

Explain the historical development of management accounting

Analyse the key differences between financial, cost and management

Describe how management accounting creates value

Analyse the current influences on management accounting

Explain the range of theories that underpin management accounting

Outline the core parts of management accounting systems and how

Analyse the roles of management accountants in cross-functional

Identify and explain appropriate internal controls for management

Explain how organisational behaviour can impact the creation of

Describe the increasing awareness of sustainability and its relationship

LO2. Decision making

Apply the steps in the decision making process

2.1.1 define the problem

Apply relevant information guidelines for short-term alternative choice

Identify the quantitative and qualitative criteria involved in accepting a