Fi32BPP Course Notes

Management Accounting
FMA/MA
Integrated Course Notes
For exams from 1 September 2020 to
31 August 2021
ISBN: 9781 5097 8611 4
VL2020
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FMA/MA Management Accounting
Study Programme
Page
Introduction to the exam and the course ................................................................................................................. 4
Skills bank ............................................................................................................................................................. 11
1 Accounting for management ....................................................................................................................... 31
2 Data and presenting information .................................................................................................................. 39
3 Cost classification and behaviour ................................................................................................................. 57
Achievement Ladder Step 1 73
4a Forecasting .................................................................................................................................................. 75
4b Summarising and analysing data ................................................................................................................. 91
5 Accounting for materials............................................................................................................................. 107
6 Accounting for labour.................................................................................................................................. 123
7 Accounting for overheads........................................................................................................................... 133
8 Process costing .......................................................................................................................................... 161
9 Costing methods ........................................................................................................................................ 179
10 Setting budgets .......................................................................................................................................... 197
11 Implementing budgets ............................................................................................................................... 215
12 Project appraisal......................................................................................................................................... 225
13 Standard costing ........................................................................................................................................ 245
14 Variance analysis ....................................................................................................................................... 257
15 Target setting ............................................................................................................................................. 281
16 Financial performance measurement ......................................................................................................... 291
17 Assessing non-financial performance......................................................................................................... 301
Achievement Ladder Step 5 311

18 Answers to Lecture Examples .................................................................................................................... 315
19 Appendix A: Overview summaries.............................................................................................................. 357
20 Appendix B: Formulae given in the exam................................................................................................... 379
Prepare for and book your CBE!

You should plan to sit your CBE within a couple of weeks of finishing ALL phases of the study programme whilst your
knowledge is still fresh. In preparation, use the Learning Media Practice & Revision Kit and i-Pass to test yourself on as
many questions as you can, revising from the Course Notes and Passcards any areas of the syllabus that cause you
problems.
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INTRODUCTION
Introduction to FMA/MA Management Accounting

The ACCA MA Management Accounting and the Foundations in Accountancy FMA Management Accounting
exam are effectively one and the same. They have an identical syllabus and students sitting either qualification
will sit an identical exam. All references to FMA within these course notes relate to the Management Accounting
syllabus and exam regardless as to whether you are sitting the ACCA MA Management Accounting or the
Foundations in Accountancy FMA Management Accounting exam.
Overall aim of the syllabus

To develop knowledge and understanding of management accounting techniques to support management in
planning, controlling and monitoring performance in a variety of business contexts.
The syllabus
The broad syllabus headings are:
A The nature, source and purpose of management information

B Data analysis and statistical techniques
C Cost accounting techniques
D Budgeting
E Standard costing
F Performance measurement
Main capabilities
On successful completion of this exam, candidates should be able to:
 Explain the nature, source and purpose of management information
 Explain and analyse data analysis and statistical techniques
 Explain and apply cost accounting techniques
 Prepare budgets for planning and control
 Compare actual costs with standard costs and analyse any variances
 Explain and apply performance measurements and monitor business performance.

INTRODUCTION
Links with other exams
SBL APM ACCA
PM
FL FMA MA
MA2
MA1
The Exam
The Applied Knowledge exams are computer-based exams (CBE).
The exam is a two hour computer-based exam. Questions will assess all parts of the syllabus and will test
knowledge and some comprehension of application of this knowledge.
The examination will consist of two sections. Section A will contain 35 two mark objective test questions. Section
B will contain three ten mark multi-task questions, each of which will examine Budgeting, Standard costing and
Performance measurement sections of the syllabus.
Format of the Exam Marks

Section A: 35 two mark questions 70
Section B: Three ten mark questions 30
100
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INTRODUCTION
Study Programme Aims

Achieving FMA/MA Study Guide Outcomes
A The nature, source and purpose of management information

A1 Accounting for management Chapter 1
A2 Sources of data Chapter 2
A3 Cost classification Chapter 3
A4 Presenting information Chapter 2
B Data analytics and statistical techniques

B1 Sampling methods Chapter 2
B2 Forecasting techniques Chapter 4a
B3 Summarising and analysing data Chapter 4b
B4 Spreadsheets Chapter 2
C Cost accounting techniques

C1 Accounting for material, labour and overheads Chapters 5-7
C2 Absorption and marginal costing Chapter 7
C3 Cost accounting methods Chapters 8-9
C4 Alternative cost accounting principles Chapter 9
D Budgeting
D1 Nature and purpose of budgeting Chapter 10
D2 Budget preparation Chapter 11
D3 Flexible budgets Chapter 11
D4 Capital budgeting and discounted cash flows Chapters 10 &12
D5 Budgetary control and reporting Chapter 11
D6 Behavioural aspects of budgeting Chapter 11
E Standard costing
E1 Standard costing systems Chapter 13
E2 Variance calculations and analysis Chapter 14
E3 Reconciliation of budgeted and actual profit Chapter 14

INTRODUCTION
F Performance measurement
F1 Performance measurement – overview Chapters 16 &17
F2 Performance measurement – application Chapters 16 &17
F3 Cost reductions and value enhancement Chapter 11
F4 Monitoring performance and reporting Chapters 16 & 17
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INTRODUCTION
Analysis of the specimen exam

Please note that the ACCA will not publish past exams for the Applied knowledge modules. The analysis of the
Specimen Exam should therefore be used as a guide to both the areas that will be examined and the mix
between narrative and computational questions. The table below shows the number of marks awarded for
each area.
Section A – 35 x 2 mark questions (70 marks)
Computational
Narrative
The nature, source and purpose of management information
Accounting for management 2
Sources of data 2
Cost classification 2 2
Presenting information 2
Data analysis and statistical techniques

Sampling methods 2
Forecasting techniques 2
Summarising and analysing data
Spreadsheets
Cost accounting techniques

Accounting for material, labour and overheads 4 8
Absorption and marginal costing 4
Cost accounting methods 8
Alternative cost accounting principles 2
Budgeting
Nature and purpose of budgeting 2
Budget preparation 2
Flexible budgets 2
Capital budgeting and discounted cash flow 2
Budgetary control and reporting
Behavioural aspects of budgeting 2
Standard costing
Standard costing system 2
Variance calculations and analysis 2 4
Reconciliation of budgeted and actual profit

INTRODUCTION
Computational
Narrative
Performance measurement
Performance measurement – overview 4
Performance measurement – application 2 2
Cost reductions and value enhancement 2
Monitoring performance and reporting 2
Total number of marks 34 36
Section B – 3 x 10 mark questions (30 marks)

Budgeting
Nature and purpose of budgeting
Budget preparation 2.
Flexible budgets
Capital budgeting and discounted cash flow 7 3
Budgetary control and reporting
Behavioural aspects of budgeting
Standard costing
Standard costing system
Variance calculations and analysis 2
Reconciliation of budgeted and actual profit 6
Computational
Narrative
Performance measurement
Performance measurement – overview
Performance measurement – application 2 8
Cost reductions and value enhancement
Monitoring performance and reporting
Total number of marks 11 19
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INTRODUCTION
Key to icons
Formula to learn
Formula given in exam
Section reference in the Study Text

Further reading is needed on this area to consolidate your knowledge.
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Key skills required to pass

Our analysis of the examining team's comments on past exams, together with our experience of preparing
students for this type of exam, suggests that to pass this exam you will need to develop a number of key skills.
1 Learning and
understanding
the syllabus
content
4 Tackling multi-task
questions
2 Time management
3 Tackling objective
test questions
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Skill 1 – Learning and understanding the syllabus content
1 What do I need to know to attempt the exam?

This exam has a broad syllabus that will be tested in Section A by 35 objective test questions worth 2 marks
each (including multiple choice questions and other means such as data entry type questions) and in Section B
by 3 multi-task questions worth 10 marks each. As all the questions are compulsory you need a broad and yet
quite detailed knowledge of the syllabus as well as an understanding of a variety of calculations to apply the
theory.
The type of knowledge that you have to acquire includes the following:
Practical application – eg calculating standard unit costs (for materials, labour or overheads); process costing
calculations; calculating variances and analysing them; producing figures to go into functional budgets and
capital budgets; project appraisal techniques; ratio calculation and interpretation; calculation of performance
measures.
Theoretical knowledge – eg sources of data; cost classification, alternative cost accounting techniques; how
budgets are prepared and the behavioural aspects of budgeting; systems of performance measurement and cost
reductions.
In this section we will look at approaches that you can take to help you learn the key elements of the knowledge
in the syllabus.
2 Practical application
Practical application requires you to do two main things:
1. Understand the principles behind a topic and be able to explain them; and
2. Apply your understanding to straightforward scenarios.
In this way you should be in a good position to answer most questions. They will either ask you to calculate a
number from some information provided, or to use the information provided to demonstrate your knowledge of
the topic in some way. You should ensure that you read the requirement carefully for these questions; further
tips on question approach will be covered under skills 3 and 4.
Principles:
For example, in the Specimen Exam, Q13 asks:
A company has recorded the following variances for a period:
Sales volume variance $10,000 adverse

Sales price variance $5,000 favourable
Total cost variance $12,000 adverse
Standard profit on actual sales for the period was $120,000.
What was the fixed budget profit for the period?
 $103,000
 $130,000
Principles
 $110,000
 $137,000
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Note that to find the correct figure you need to understand know the format of a profit reconciliation and the
relationship between the different variances. This is an example of a question which requires you to work
backwards and therefore requires greater understanding of the techniques. Watch out for the information in the
scenario which is provided but not needed to calculate the correct figure.
Application:
Another question type is Q16 from the Specimen Exam:
A company's operating costs are 60% variable and 40% fixed.
Which of the following variances' values would change if the

company switched from standard marginal costing to standard
absorption costing?
 Variable overhead efficiency variance

Application
 Sales volume variance
 Fixed overhead expenditure variance
 Direct material efficiency variance
This question requires you to have a good understanding of the differences between marginal costing and
absorption costing and the variances which vary between them. Such linkages between syllabus areas are not
uncommon.
Application – this is where question practice is key. The more practice you have in working through the
questions, the more confident you will become on using and applying the theory.
3 Theory
You will also have to answer narrative questions about theory.
You can expect questions about:
1. Fact – eg what are the rules and requirements of the accounting standards? What are the similarities and
differences between sole traders, partnerships and companies?
2. Application – eg how are the accounting concepts applied to different areas of the syllabus?
Fact:
Q2 from the Specimen Exam illustrates how knowledge of a fact might be tested:
Which of the following BEST describes target costing?
 Setting a selling price for the company to aim for in the

long run
 Setting a cost for the use in the calculation of variances
 Setting a cost by subtracting a desired profit margin from a

competitive market price
 Setting a price by adding a desired profit margin to a

Fact
production cost
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This question is testing you on a specific fact – here you need to know what target costing is. You need to make
sure you have a good breadth of knowledge of the MA syllabus.
Application:
Another question type is Q20 from the Specimen Exam
A company always 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?
Application
Higher Lower
EOQ
Annual holding cost
This type of question is about applying the theory to a theoretical situation. This can seem tricky if there are no
numbers involved – the key here is to think of some simple numbers for the EOQ formula. The formula is given to
you in the exam:
2C0 D
=
Ch
For example:
Cost of placing an order: $10
Annual demand: 1000 units
Holding cost per unit: $0.5
Therefore the EOQ = 200 units and annual holding costs = (200/2) X $0.5 = $50
Decrease the ordering cost to see what happens to both figures, for example ordering cost = $5.
Now the EOQ = 141 units (ie it falls)
The annual holding cost = (141/2) x $0.5 = $35 (ie it falls).
Although this might appear time consuming it will ensure that you get the correct answer.
There are various ways to build up this level of knowledge. Here are some suggestions:
Read Passcards Get a colleague or

regularly friend to set you
quizzes
Practice as many
questions as possible
Use annotated Produce a list of your
overviews as common mistakes and
summaries of each review it before doing
chapter (Appendix A)or question practice!
annotate your own
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Skills practice
Learn the content of the syllabus actively by:
1. Reviewing the annotated overviews for each chapter – these are available in Appendix A of
the Course Notes
2. Practising as many questions as possible, moving from using your notes to completing them
without any help
3. Using the study text/pre-recorded lectures in your learning plan to help only on areas you're
struggling with and to fill in gaps in your background knowledge
4. Know what formulae are given to you in the exam (see appendix B) and ensure that you
know how to access the formula sheet and discount tables in the exam.
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Skill 2 – Time management
It is important that you use your time wisely in the exam to gain maximum marks.
Time management
 What you SHOULD NOT do
Panic! You have two hours to answer 35 objective test questions (worth 2 marks each) in Section A and 3
multi-task questions (worth 10 marks each) in Section B. This equates to 1.2 minutes a mark. This means that
you have approximately 2.4 minutes to answer each objective test question and 12 minutes to answer each
multi-task question. In total, you should complete Section A in 84 minutes and Section B in 36 minutes. For many
questions you will get the answer straight away and so you are likely to have a bit more time to think about some
of the others. Therefore don't worry about your timing on each individual question, just keep track over a few
(eg 5).
 What you SHOULD do

It is important to start the exam positively.
Firstly:
Make a note of the finishing time for each of Sections A and B
Section A (35 objective test questions) should take approximately 84 minutes. Make a note of what time
you should finish Section A at.
Section B (3 multi-task questions) should take approximately 36 minutes. Make a note of what time you
should finish Section A at and more specifically the finishing time for each of the 3 multi-task questions.
Given the longer scenarios in Section B you must ensure you do not start this section with less than 36
minutes of the exam remaining.
Secondly:
Work through questions systematically
Start at question 1 and begin answering from there working through questions in order.
If you find a question that you don't know the answer to and want to come back to it later then put an
answer in for the moment, make a note of it and go onto the next question.
Try not to jump around questions otherwise you may leave some unanswered by the end.
Then:
Check your answers before the end of the exam
Having answered all of the questions you should look through your answers to make sure:
1. You are happy with the options selected; and
2. You have answered all questions
If you have taken this logical and systematic approach you should have given yourself the best chance of doing
well in the exam.
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Practical advice for computer based exams

STEP Before the exam
1 Make sure that you are registered with the ACCA and that your exam centre has your exam
booking. This is important because you can not sit the exam if you are not a registered student
and you need your student card as identification on the day of your exam.
Practice at least one mock exam using the computer so that you are familiar with navigating
through questions and not being able to annotate the question.
STEP At the beginning of the exam

2 You want to make the start of the exam as stress free as possible so make sure that you have
the following available:
 Photo identification and your student number – your ACCA student card is ideal for this
 Paper supplied by your exam centre, pens and a calculator
 Details of which exam you are planning to sit
STEP Starting the exam

3 To start the exam you will need to do the following:
 Login – enter your ACCA student number and your date of birth – make sure that you
have both to hand
 Select the exam – the system will ask you which exam you want to do and then you
<Confirm> that selection
 Instructions – the next three screens are instructions – read these carefully so that you
know what you have to do to complete the exam
 Launch the exam – please don't click this screen until you have been advised to by your
invigilator AND you are ready because this starts the exam and starts the timer.
STEP Answering the questions

4 The exam will start at question 1. You can progress through the questions by clicking <Next> but
you can also go back by clicking <Previous>. When you answer the questions you must follow
the following procedure:
 Enter your answer
 Click on <Submit> – you must do this otherwise as soon as you click <Next> to move to
the next question your entry will be lost and you will have to re-enter
 If you click <Next> and have not submitted your answer to a question then you will get a
reminder – clicking <OK> on the reminder does not submit your answer – you must go
back and re-enter your answer and then <Submit>
 If you are unsure of an answer then just put an answer in for now, make a note of it, and
revisit it later
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You can see that it is very important to submit your answers as you go and to keep track of what you have done.
It is probably a good idea therefore to use your pad of paper to do two things:
1. Make any notes you want to help you answer the questions; and
2. Keep a record of the status of each question
For example:
Question Status
1 
2 ?
3 
4 X
Where
 means that the question has been answered and I am reasonably confident of the answer.
? means that the question has been answered but I want to check the answer
X means that the question has not been answered and I need to go back to it
It would be most efficient to set this up at the beginning of the exam. In this way you will have a tally of which
questions really need to be checked over at the end of the exam and it reduces the chances that you will leave a
question unanswered.
STEP At the end of the exam time

5 At the end of the exam you should check your answers and ensure that you have submitted an
answer for every question as well as double checking any answers you were not sure of.
You have two ways of navigating the questions:
1. Clicking <Previous> to work back through the questions one by one; or
2. Using the drop down menu which shows all the questions 1-37 (questions 1 to 35 being
the objective test questions in Section A; questions 36 to 38 being the 3 multi-task
questions) indicating whether an answer has been submitted or not; clicking on the
question number will take you directly to that question
Remember that if you choose to change a previously submitted answer you must
<Submit> the new one otherwise your original answer will be retained instead!
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STEP Closing your exam session

6 Once you are satisfied that you are happy with your answers, if you have time left in the exam
then you have a couple of options to finish your exam session (subject to any advice you get
from the invigilators in your exam centre).
1. Let the time on the on screen clock run down to zero and the exam session will end
automatically; or
2. Click <Exit> – you will be asked to <Confirm> this so you can not accidentally end your
session early
In either case the next thing you will see will be the Results Screen that shows your mark and
whether you have passed or not.
It is important that you don't <Exit> at this stage since you have no proof of your result!
Your invigilator will ask you to <Print> two copies and will instruct you to <Exit> once these
have been printed off.
You have now finished your exam.
Final tips on timing

 Make use of the paper to make notes or to work out the answers to questions
 If you find a particularly difficult question or a long calculation, move on and come back to it later in the
remaining time – it is important that you do not run out of time leaving easier questions later in the exam
unanswered
 Keep an eye on the clock so that you can pace yourself – you will be given a 15 minute warning
15 minutes prior to the end of the 2 hour exam session
 Be well prepared for the exam day so that you can concentrate on doing the exam rather than the
administration around it
 Get to your exam venue in plenty of time so that you are relaxed when you get into the exam room.
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Skill 3 – Tackling objective test questions
Technique for multiple choice questions

There are questions were one of the four options is correct.
Narrative questions
1 What to do if you know the answer to the question

If you know the answer to a narrative question you should:
1. Read the requirement
2. Locate the correct answer
3. Check the other answers
4. Read the requirement again to ensure you're answering the correct question
5. Confirm that you have the correct answer
This systematic check will ensure that you do not throw away marks when you really do know the answer.
2 What to do if more than one answer appears plausible

Sometimes more than one option can seem to answer the question. In this case you have to firstly ensure you've
read the requirement carefully, as questions may be phrased in ways that are not what you're expecting. If you
still identify more than one likely option, select the 'most correct' answer. The approach adopted above is useful
here too but this time you have to think through the alternatives a bit more.
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For example, Q8 on the Specimen Exam asks:
Up to a given level of activity in each period the purchase price per unit
of a raw material is constant. After that point a lower price per unit
applies both to further units purchased and also retrospectively to all
units already purchased.
Which of the following graphs depicts the total cost of the raw materials
for a period?

$
0 Activity

$
0 Activity

$
0 Activity

$
0 Activity
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This is testing your understanding of cost behaviour graphically. At first sight, it may be tricky to identify the
correct answer as some of the graphs are very similar and so there seems to be more than one plausible
answer.
Here are some steps to follow:
STEP Read the requirement carefully

1 Here we need to select the graph which shows the total material cost. The key fact from the
scenario is that the lower purchase price applies retrospectively. In a different question it may
not apply retrospective which would mean the solution would be different. It is important to
analyse the information given carefully.
STEP Read each option carefully and eliminate any obviously wrong answers
2 Firstly, identify any answers that are immediately wrong. In this question, you should be able to
identify that the last graph is incorrect as it does not start at the origin, we can assume that if we
purchase zero materials then the cost would be zero, hence why the graph should begin at the
origin. You should also be able to discount the third graph as this clearly does not show the
same cost per unit for each unit purchased.
STEP Assess the remaining answers

3 We now need to consider which of the first two graphs are correct. Both show retrospective
discounts but the key here is looking at which one starts back at the origin. The first graph would
actually result in a fixed cost before any units are purchased. Therefore the second graph is
correct.
STEP Read the question again…

4 Finally, we should re-read the requirement before submitting the question to ensure we are
answering the correct question. The question could easily have stated that: 'The discount was
only for subsequent units' which would have led us to a different answer!
This systematic approach helps you to break a question down and work through to find the correct answer
logically.
Numerical questions
In the exam, you will be asked to calculate numbers based on some information provided. If it is a multiple choice
question rather than a data entry question, the temptation may be to look at the options first, and then 'fit' your
calculations to the one you think is most likely. This could lead you to answering the question incorrectly,
especially if you have not read the requirement carefully.
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For example, it would be easy to pick up the wrong answer in Q21 of the Specimen Exam:
A company which operates a process costing system had work in progress at

the start of last month of 300 units (valued at $1,710) which were 60%
complete in respect of all costs. Last month a total of 2,000 units were
completed and transferred to the finished goods warehouse. The cost per
equivalent unit for costs arising last month was $10. The company uses the
FIFO method of cost allocation.
What was the total value of the 2,000 units transferred to the finished
goods warehouse last month?
 $19,910
 $20,510
 $21,710
 $20,000
In order to answer this question correctly you needed to remember to calculate the flow of units to work out how
many units were actually started and finished during the period.

1 With numerical questions it is really important to first understand what the question is asking,
since you can easily either do too much work and waste time working out calculations that aren't
required, or answer the question you want to answer, and not the question that is actually being
asked! You needed to identify that not all units were started and finished during the period, if you
did not identify this you were likely to choose the fourth option $20,000.
STEP Think about which proforma or formula may be relevant

2 Think whether a proforma or formula may be necessary to help you calculate your answer.
Here the flow of units calculation is relevant.
STEP Calculate your answer from scratch (writing out your workings)
3 Once you're certain what the question is asking, you should calculate your answer from scratch
using the relevant proforma or formula where applicable. Write down your workings – you
will be less likely to make a mistake then and also, if you find that your answer does not match
one of the options, you can come back and check your workings for errors.
Ignore the options given, as you may arrive at an answer that matches an option but is not
what is required by the question.
Again, the fourth option is very enticing as it stands out as an easy choice.
STEP Match your answer

4 Once you've calculated your answer (using proforma or formula where relevant), match it to the
options. If you've worked carefully and answered the question, the matching option will be
available. If no option matches your calculation, re-read the requirement to ensure you've
understood what you have to do. In this situation it helps if you write down your calculations so
that you can go back and check each individual number for errors. If you still can't find the
answer, you may want to guess the answer, make a note of the question number and return to it
at the end when you can judge how much of the time remaining you can spend on it.
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What to do if you still don't know the answer (numerical and narrative questions)…
If you have been through the above 4 steps and can't identify a preferred answer then you have to guess!
 What you SHOULD NOT do

Two main things to avoid:
1. Waste excessive time – time spent dithering over a single question could leave you with insufficient time
for the rest of the exam.
2. Not answering – this is a common yet serious error – even if you make a wild guess you start with a 25%
chance of success. Your chance of getting the 2 marks if you don't offer an answer is zero!
 What you SHOULD do

Having used the step by step approaches above to narrow down your possible answers, go with the one that
feels right. And move on.
If you have a flash of inspiration later in the exam go back and revisit it – but only if you are sure.
Technique for other types of question in computer based exam
1 Data entry
You may be asked to calculate a numerical figure which you then have to enter into a box in the exam. The only
permitted characters for numerical answers are:
 Numbers
 One full stop as a decimal point if required
 One minus symbol at the front of the figure if the answer is negative.
For example: -10234.35
No other characters, including commas, are accepted.
Be very careful to follow these strict rules otherwise there is a risk that an otherwise correct answer might be
marked incorrect, if for example you insert a comma to denote thousands.
For these questions you can use steps 1 to 3 above in How to Approach Numerical Questions.
This can be illustrated with the Specimen Exam Q4:
The following budgeted information relates to a manufacturing company for

next period:
Units $
Production 14,000 Fixed production costs 63,000
Sales 12,000 Fixed selling costs 12,000
The normal level of activity is 14,000 units per period. Using absorption
costing the profit for next period has been calculated as $36,000.
What would be the profit for next period using marginal costing?
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SKILLS BANK

1 Here the question asks for the 'marginal costing profit' figure.
STEP Think about which formula may be relevant

2 Here the relevant formula is: Absorption costing profit = Marginal costing profit +/- (Change in
inventory X OAR per unit)
STEP Calculate your answer from scratch (writing out your workings)
3 Work out the difference in inventory levels (14,000 -12,000) and the calculate the OAR
(63,000/14,000 = $4.50). Remember that this is based on budgeted activity and budgeted fixed
production costs.
You then need to consider whether the marginal costing profit will be higher or lower than the
absorption costing profit. It is essential that you learn in which circumstances which one will be
higher and use the information in the question. Here inventory levels are increasing so that
absorption costing profit is highest.
STEP Enter your answer

4 Type your answer into the box, making sure that you do not include $ or commas.
2 Select more than one option

These questions are very similar to narrative multiple choice questions and the approach required is effectively
the same.
Using Q23 from the Specimen Exam:
Which TWO of the following statements are TRUE about value analysis?
It is applicable to both physical products and services
It always results in inferior products
It seeks the lowest cost method of achieving a desired function
It ignores esteem value
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1 Here we need to select two statement which are true.
STEP Read each option carefully and eliminate any obviously wrong answers
2 Here option 2 is incorrect. The word 'always' is seldom going to be true.
Option 4 is also incorrect because value analysis specifically consider esteem value as one of
the elements of value analysis.
STEP Assess the remaining answers

3 By process of elimination options 1 and 3 must be correct. Option 1 is correct because value
analysis can be applied to both physical products and services.
Option 3 is correct because value analysis looks at finding the lowest cost method to achieved
the function, so although it is considered with cost reduction it does not compromise on the
features of the product or service.
STEP Read the question again…

4 Finally, we should re-read the requirement before submitting the question to ensure we are
answering the correct question. We need to make sure that we tick on the 2 options which are
true (options 1 and 3).
Skills practice
1. Practice keeping track of the questions you have answered when doing questions from the
Practice and Revision Kit
2. Always check your answers through (if you would have time in the exam) before looking at
the solutions in the back of the book
3. Practice as many objective test questions as possible.
4. If you don't know the answer to a question – don't just go to the answer at the back or just
guess – use the step by step approach described above.
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SKILLS BANK
Skill 4 – Tackling multi-task questions

In Section B of the exam, there will be three 10 mark multi-task questions on the following three syllabus areas:
 C - Budgeting
 D - Standard costing
 E - Performance measurement
There will be a mixture of numerical and narrative requirements. It is very unlikely that one question would be
entirely numerical or discursive. The number of marks and tasks per question can also vary.
You should note that solutions from one part of a long question will not be required for the subsequent parts. This
means that you can attempt the parts in any order and that own figure rule marks will not apply.
The question requirements could include:
 Selection from drop down menu – numerical/written answers
 Completing a proforma provided
 Completing blank boxes with numerical answers
 Selecting advantages and disadvantages from a list
 Calculating ratios
You should use the same approach as in the OT questions, ensuring that you read the question carefully and
do not run out of time. It is not always necessary to answer each question in task by task order. In some cases
you may find that some later tasks are based on fact recall and would be best done first.
You should approach each task one at a time as if each one were a separate question. The same basic
technique can be applied to each task.
Cab Co own and runs 350 taxis and had sales of $10 million in the last year. Cab Co is considering introducing a
new computerised taxi tracking system.
The expected costs and benefits of the new computerised tracking system are as follows:
1. The system would cost $2,100,000 to implement.
2. Depreciation would be provided at $420,000 per annum.
3. $75,000 has already been spent on staff training in order to evaluate the potential of the new system.
Further training costs of $425,000 would be required in the first year if the new system is implemented.
4. Sales are expected to rise to $11 million in Year 1 if the new system is implemented, thereafter increasing
by 5% per annum. If the new system is not implemented, sales would be expected to increase by
$200,000 per annum.
5. Despite increased sales, savings in vehicle running costs are expected as a result of the new system.
These are estimated at 1% of total sales.
6. Six new members of staff would be recruited to manage the new system at a total cost of $120,000 per
annum.
7. Cab Co would have to take out a maintenance contract for the new system at a cost of $75,000 per
annum for five years.
8. Interest on money borrowed to finance the project would cost $150,000 per annum.
9. Cab Co's cost of capital is 10% per annum.
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SKILLS BANK
In order to determine whether a computerised tracking system should be introduced, indicate whether
each of the following is a relevant or an irrelevant cost for a net present value (NPV) evaluation.
Computerised tracking system investment of $2,100,000

Depreciation of $420,000 in each of the five years
Staff training costs of $425,000
New staff total salary of $120,000 per annum
Interest cost of $150,000 per annum
There are 5 marks available for choosing whether or not each cost is relevant or irrelevant for the NPV
evaluation. You should ensure that you consider each one separately and then select the right answer from the
drop down menu.
The technical knowledge is similar to section A, but there is a lot more information in the scenario in this section
B question and you must read it all carefully.
For example, there are two lots of staff training costs of $425,000 and $75,000. You must use the information in
the scenario to assist with each. As the $75,000 is a sunk cost as it had already been incurred and so is not
relevant, whilst the $425,000 would be spent if the project goes ahead and so it is relevant.
Another style of question in Section B could include completing a reconciliation.
Task 2 0 of 6 marks
Castilda Co uses a standard cost operating statement to reconcile budgeted contribution with actual contribution.
A standard cost operating statement for Month 1 is given below with some information missing.
Complete the reconciliation for the standard cost operating statement for Month 1 shown below.
Standard cost operating statement Month 1
£ £
Budgeted contribution 700,000
Standard contribution on actual sales

Sales price variance
711,680
Cost variances
Total direct materials variance 12,800 Adv
Direct labour rate variance 21,000 Adv
Direct labour efficiency variance 48,000 Fav
Total variable production overhead variance 10,000 Fav
24,200 Fav
735,880
In order to complete this reconciliation you need to be able to calculate the requested variances, state whether
they are favourable or adverse and also know the name of missing variance. (This will be selected from a drop
down menu and in this question there is a choice of three).
It is important therefore that you learn the layouts of the proforma documents you are taught.
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SKILLS BANK
Skills practice
1. Practice all the multi-task questions from the Specimen Exam and the Extra Bank of MTQs
and as many as possible from the Practice and Revision Kit making sure you attempt a good
spread across the three syllabus areas.
2. Adopt the steps recommended above, remembering where there are many tasks, to treat
them as a group of objective test questions but being careful not to overrun on time.
3. Rework any questions that you struggle with.
4. Know what formulae are given to you in the exam (see appendix B) and ensure that you
know how to access the formula sheet and discount tables in the exam.
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30

Accounting for management
Syllabus Guide Detailed Outcomes

Having studied this chapter you will be able to:
 Describe the purpose and role of cost and management accounting within an organisation.
 Compare and contrast financial accounting with cost and management accounting.
 Outline the managerial processes of planning, decision making and control.
 Explain the difference between strategic, tactical and operational planning.
 Distinguish between data and information.
 Identify and explain the attributes of good information.
 Explain the limitations of management information in providing guidance for managerial decision making
Exam Context
The contents of this chapter are mainly to serve as an introduction to the ACCA's Management Accounting exam.
Although this chapter is an introductory chapter it is still highly examinable. You should expect questions on every
chapter including this one.
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1: ACCOUNTING FOR MANAGEMENT
Overview
Accounting for
management
Role of management Data and information Limitations

accounting function
Qualities
Comparison with financial

accounting
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1 Accounting for management

1.1 What is management accounting?
Management accounting is concerned with the provision and the use of accounting
information. This information is used by managers of the business to assist them when
making decisions to achieve the organisation's overall objective.
1.2 What could a business have as its objective?

The assumption that will usually be made in your studies is that companies wish to
maximise the wealth of their shareholders.
Usually this will be achieved by maximising profit.
2 Role of management accountant

Main areas
Management accounting can be broken down into five main areas:
2.1 Costing
What is the cost of goods or services?
We need to know this to calculate the profit that a unit will generate, to help set prices and to
value inventory in the balance sheet.
2.2 Decision making

There are many decisions managers may have to make such as:
 What should we produce?
 How should we finance the business?
 Is a project worthwhile?
2.3 Planning
Define objectives; assessing future costs and revenues to set up a budget.
Planning is essential in assessing the purchasing/production requirements of the business.
2.4 Control
Once plans have been made, they must be reviewed to ensure the company is following
them and any identified inefficiencies must be addressed.
2.5 Performance evaluation

The performance of divisions and employees can be assessed by comparing their
performance against budgets or divisional or individual targets.
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2.6 Strategic, tactical and operational planning

R N Anthony, a leading writer on organisational control, has suggested that the activities of
planning, control and decision making should not be separated since all managers
make planning and control decisions. He has identified three types of management activity.
Chapter 1, section 2
(a) 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'.
(b) Tactical control: '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: 'the process of assuring that specific tasks are carried out
effectively and efficiently'.
Lecture example 1
What external information may the managers of a business need?
Solution
Source Information needed
Competitors
Customers
Suppliers
Government
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3 Management accounting v financial accounting

3.1 Management accounting will use the same source data as financial accounting but there are
some important differences to understand.
Lecture example 2
Complete the Comparison table to compare financial and management accounting:
Financial accounting Management accounting

Legal requirement
Users
Level of precision
Rules
Reporting
Scope
Frequency
Format
3.2 Thus it is useful to think of the two as

Financial Accounting: recording and reporting historical data
Management Accounting: deciding where the company wants to go and helping it to
realise those objectives
It is important to remember that as management accounting is forward looking, it relies
heavily on guesses and approximations, to deal with future uncertainties. We therefore have
to use reasonable approximations in all our calculations.
In your exam you should round your final answer to 2dp unless told otherwise.
4 Information
4.1 Data is the raw material for data processing.
4.2 Information is data that has been processed in some way to make it meaningful to the
person who receives it.
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Worked example 1
Bank
A bank statement provides a company with information.
What are the qualities of a bank statement which make it a good source of information?
Accurate Inaccurate figures would mislead the company as to its current bank balance.
This may result in the company exceeding its overdraft facility.
Complete The information in the bank statement will be used to reconcile and identify
transactions not included in the accounts. It is therefore essential that all
transactions are recorded that have occurred within the period of the bank
statement.
Cost A company will not be willing to pay an excessive amount to view the
beneficial transactions that a have occurred though its account. The costs of collecting
and presenting the information should therefore be evaluated.
User targeted The volume of information is kept to the minimum needed for the customer.
Details that are meaningful only to the bank are largely excluded.
Relevant The customer is not interested in all of the transactions that occurred for the
entire bank. Therefore only information relating to the user is included.
Authoritative The information within the bank statement can be used for control purposes as
the bank is considered a reliable and authoritative source.
Timely In order to be useful the information needs to be provided within a sensible time
period. Many companies have now switched to online bank statements as they
don't want to wait until the end of the month to receive information.
Easy to use It is always in the same format.
 The qualities of good information can be remembered using the mnemonic ACCURATE
Lecture example 3
Which of the following are good information?
Solution
Good information
Monthly sales figures for August received in November.
A summary provided at the front of a report to save senior managers from
having to read the whole document.
A dashboard report summarising all the key results for the last period for
use at the next management meeting.
Monthly report showing that the chocolate mixing machine was adding 1%
too much cocoa in the last period.
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5 Limitations
5.1 Cost accounting information is, in general, unsuitable for decision making because the
information required for decision making is not what is traditionally provided by conventional
cost accounts.
5.2 Information for decision making should instead by based upon relevant costs and endeavour
to incorporate uncertainty as these decisions will be made in the future.
6 Chapter summary
Topic Summary
Introduction to Purpose is to assist management in running their business to achieve
management accounting an overall objective.
Role of management Includes costing, decision making, planning, control and performance
accountant evaluation.
Financial accounting systems ensure that the assets and liabilities of a
Management accounting
business are properly accounted for. Management accounting systems
and financial accounting
provide information specifically for managers.
Information is data that has been processed to be meaningful to the
Data and information person who receives it.
ACCURATE
Information from financial accounts may not be appropriate for future
Limitations
decision making.
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END OF CHAPTER
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Data and presenting
information

 Describe sources of information from within and outside the organisation (including government statistics,
financial press, professional or trade associations, quotations and price list).
 Explain the uses and limitations of published information/data (including information from the internet).
 Describe the impact of general economic environment on costs/revenues.
 Describe the main uses of big data and analytics for organisations.
 Explain sampling techniques (random, systematic, stratified, multistage, cluster and quota).
 Choose an appropriate sampling method in a specific situation.
 Prepare written reports representing management information in suitable formats according to purpose.
 Present information using tables, charts and graphs (bar charts, line graphs, pie charts and scatter graphs)
 Interpret information presented in management reports (including the above tables, charts and graphs)
 Explain the role and features of a computer spreadsheet system.
 Identify applications for computer spreadsheets and their use in cost and management accounting.
Exam Context
As well as collecting information we also need to consider how best to present that information to users. You should
expect questions in section A of the exam on these topics.
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2: DATA AND PRESENTING INFORMATION
Overview
Effect of general economic

environment on costs /
revenues
Data and presenting information Presenting and

Spreadsheets
Interpreting Data
Tables Charts
Big data
Bar charts Pie charts Scatter graphs
Data Sampling
Primary Vs Internal Vs
Secondary External
Random Non Random
Random Systematic Stratified Multistage

Quota Cluster
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1 Data
1.1 Definition
Data is the scientific term for facts, figures, information and measurements.
1.2 Types of data

 Primary data - data collected specifically for a particular purpose.
 Secondary data - data which have already been collected elsewhere, for some other
purpose.
 Discrete data - data which can only take on a finite or countable number of values
within a given range. (eg month of birth)
 Continuous data - data which can take on any value. They are measured rather than
counted. (eg weight)
 Sample data - data arising as a result of investigating a sample. A sample is a
selection from the population.
 Population data - data arising as a result of investigating the population. A population
is the group of people or objects of interest to the data collector.
Lecture example 1
What are the key advantages and disadvantages of using primary data?
Solution
Advantages of primary data
Disadvantages of primary data
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2 Sources of data
Data may be obtained from either an internal source or from an external source.
2.1 Internal sources of data
Include: financial accounting records, payroll information, production information, time
sheets, published accounts and historical records.
2.2 External sources of data

Include: market research, interviews, postal questionnaires (primary external data), data
from governments such as statistics and indices, banks, newspapers, trade journals,
reference manuals, consultancies, the internet, libraries, advice and information bureaux
(secondary external data).
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3 The impact of the general economic environment on

costs/ revenues
3.1 The general economic environment will affect the costs and revenues of a business.
Worked example 1
Accountancy Co
Consider an accountancy training business and state how it might be affected by the current
recession (ie the general economic environment.)
Change Impact
Decline in GDP Less money in the economy meaning less disposable
income may create fall in demand for courses.
The firm operates in a city which has a A higher proportion of students coming from an area
high proportion of financial service firms less affected by the recession may stave off the
which seem to be bucking the overall expected fall in demand due to the national recession.
recession well. (eg of a Local economic
trend)
Increased inflation High inflation in prices of utilities and food costs mean
that students will have less disposable income and
therefore may not be able to afford fees.
Staff and facility costs may also increase.
Low Interest rates Will make it easier for the business to raise debt
finance to finance its business.
From the point of view of the students low interest
rates should keep down mortgage repayments and
thus combat the high price inflation to help maintain
disposable income levels, or make it cheaper to
borrow the course fees.
Increases in tax rates Will reduce the post tax profits made by the business
which could cause a reduction in either the dividends
paid to investors or a reduction in reinvestment within
the business.
Reductions in government spending Any contracts with government agencies could be at
risk due to local cutbacks.
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4 Big Data
Big Data refers to the mass of data that society creates each year, extending far beyond the
traditional financial and enterprise data created by companies. Sources of Big Data include
social networking sites, internet search engines, and mobile devices.
4.1 The main characteristics of Big Data are volume, velocity and variety.
Volume The scale of information which can now be created and stored is staggering.
Advancing technology has allowed embedded sensors to be placed in everyday
items such as cars, video games and refrigerators. Mobile devices have led to an
increasingly networked world where people's consumer preferences, spending
habits, and even their movements can be recorded.
Advances in data storage technology as well as a fall in price of this storage has
allowed for the captured data to be stored for further analysis.
Velocity The speed at which 'real time' data is being streamed into the organisation.
Timeliness is a key factor in the usefulness of financial information to decision
makers, and it is no different for the users of Big Data. One source of high-
velocity data is Twitter.
Variety Modern data takes many different forms. Structured data may take the form of
numerical data whereas unstructured data may be in the format of images, video,
location information, call centre recordings, email, and social media posts.
Processing these sources may require significant investment in people and IT.
4.2 The uses of Big Data

There are numerous uses of Big Data in the business context. At this stage we shall
consider how it is relevant to businesses' decision making.
A business makes all kinds of decisions every day; for example, should it enter a new
market, redesign its packaging, reorganise the sales team or launch a new product. Such
decisions are often more complicated than they first appear because many factors will
come into play to determine whether or not the decision will be successful. In very complex
decisions, some factors are beyond the knowledge of those taking them.
The key role of Big Data is to analyse all relevant information and to generate a
predictive model of what the outcome of the decision will be.
4.2.1 Big Data and business value

Business value is measured in many ways, such as profit, shareholder value, brand value
and intellectual value. Big Data can be used to analyse opportunities to increase revenue
and reduce costs, thereby increasing profit. For example, a holiday company can use Big
Data to analyse trends in where tourists are visiting in order to improve the range of holiday
locations that it offers. It can reduce its offering in unpopular areas and increase its offering
of popular areas and increase its revenue.
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4.2.2 Big Data and the customer

Understanding the customer is a key benefit of Big Data analytics. By understanding the
customer, the business can respond to their needs and tailor the customer experience to be
more personal and therefore improve customer loyalty.
4.2.3 Big Data and corporate strategy

To be successful, Big Data must fit into the organisation's overall aims and objectives. After
identifying how business value can be improved, and the requirements of the customer,
business priorities can be determined – for example, which markets or customers are the
most important in terms of increasing business value.
Big Data is a key source of innovation, helping to create new products and services. Volume
and velocity of data helps speed up decision making. This means that Big Data can help
create new sources of income for a business and contribute to an improvement in the
organisation's competitive advantage.
4.3 Effect of Big Data on decisions

The key effects of Big Data on decisions can be summarised as follows:
(a) Decisions can be made quickly.
(b) Businesses can respond earlier to environmental changes and be more flexible in
their response.
(c) Decisions can be based on current situation but also have an element of taking
potential future situations into account.
(d) Decisions are made on hard data evidence that can be quantified.
(e) Decisions can be made on a collaborative basis because data is easily shared and
converted from one form into another.
(f) 'Outside the box' decisions are more likely because all factors are taken into account,
not just the ones managers think of.
5 Sampling
Sample versus census
Data are often collected from a sample rather than from a population. If the whole population is
examined, the survey is called a census.
Due to the high costs and time consuming nature of a census often a sample is used. It is
therefore important that the sample chosen covers all areas of the population and is non-biased.
There are many different techniques for selecting a sample:
5.1 Random sampling

A sample selected in such a way that every item in the population has an equal chance of
being included and should therefore be free from bias.
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5.1.1 Random numbers

Random numbers can be generated from a computer program or a book of random numbers.
The items, which correspond to the chosen random numbers then form the sample.
5.1.2 Drawbacks of random sampling

 The selected items are subject to the full range of variations inherent in the population
 Sample may be unrepresentative
 Sample may be scattered over a large geographical area
 An adequate sampling frame may not exist
 The numbering of the population may be laborious
 Expensive
5.2 Quasi-random sampling

The three main methods of quasi-random sampling are as follows:
 Systematic sampling
 Stratified sampling
 Multistage sampling
5.3 Systematic sampling

Designed to give a good approximation to random sampling: It works by selecting every nth
item after a random start. The gap between every nth item is known as the sampling
interval.
5.3.1 Advantages of systematic sampling

(i) It is easy to select the sample items given a sampling frame.
(ii) It is reasonably random, providing that there is no pattern to the distribution of items.
5.3.2 Disadvantages of systematic sampling

 It requires a sampling frame.
 It requires access to the whole population.
 If there is a regular pattern to the distribution of items, the sample may be biased.
 It may be expensive to select the required sample (every nth item).
5.4 Stratified sampling

The population is put into groups known as strata. A random sample is taken from each
group proportional to the size of that group.
5.4.1 Advantages of stratified sampling

 Samples are representative as all important groups will have elements in the final
sample.
 The sample structure reflects the population as the same proportion of individuals
should be chosen from each strata.
 Each stratum is represented by a randomly chosen sample.
 Increased precision.
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5.4.2 Disadvantages of stratified sampling

 Prior knowledge required of each item in the population (to determine strata).
 Time consuming to divide population into strata.
5.5 Multistage sampling

The population is divided into groups and a small sample of these is selected at random.
These groups are sub-divided into smaller groups and again, a smaller number of these are
selected at random. This process can be repeated many times.
5.5.1 Advantages of multistage sampling

 Approximates to a random sample.
 It does not require a sampling frame.
 Suits very large populations.
 Relatively cheap as samples may be collected quickly.
5.5.2 Disadvantages of multistage sampling

 It is not truly random.
 The sample may be biased if only a small number of regions are selected.
6 Non random sampling

There are two main methods of non random sampling. They are used when a sampling
frame cannot be established and random sampling can therefore not be used.
 Quota sampling
 Cluster sampling
6.1 Quota sampling

This method is most commonly used by market researchers and involves stratifying the
population and restricting the sample to a fixed number in each stratum on a 'first come first
served' basis.
6.1.1 Advantages of quota sampling

 Cheap and administratively easy
 Large samples can be studied
 No sampling frame required
 May be the only approach to use
 Yields sufficiently accurate information for market research
6.1.2 Disadvantages of quota sampling

 Bias may exist (first come first serve basis could attract keenest members of the
population)
 Not ultimately satisfactory if theoretically valid results required
 Cannot estimate sampling error
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6.2 Cluster sampling

This involves selecting one definable subsection of the population for the sample that is
deemed to be representative of the population in question.
6.2.1 Advantages of cluster sampling

 No sampling frame required
 Good alternative to multistage sampling
 Quick and cheap to administer
6.2.2 Disadvantage of cluster sampling

Potential for considerable bias.
Worked example 2
Stratified Sampling
Calculate the number of customers to be interviewed from each area of the country to obtain a
representative response from 5,000 questionnaires.
Region North East South West Total

Number of
75,000 36,500 90,000 98,500 300,000
customers
Sample
Do not show decimals. Round to the nearest whole number.
Region North East South West Total

Number of
75,000 36,500 90,000 98,500 300,000
customers
Sample 1,250 (W1) 608 1,500 1,642 5,000
(W1) (75,000/300,000)  5,000 = 1,250
Lecture example 2
Which TWO of the following statements are true?
If a sample is selected using random sampling, it will be free from bias
A sampling frame is a numbered list of all items in a sample
Multistage sampling is a non-random sampling method
In quota sampling, investigators are told to interview all the people they meet up to a certain
quota
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Solution
7 Presenting information
7.1 Writing a report
7.1.1 Purpose and contents

The purpose of a report is usually to initiate a decision or action by the reader(s) of the
report. The decisions or actions might be the following types:
 Control actions
 Planning decisions
Reports can be routine (such as budgetary control reports, sales reports or progress
reports) or non-routine (market research report, report on a proposed project).
The likely contents will be:
 Information
 Narrative or description
 Analysis
 Evaluation
These should be presented in an unbiased way as possible and be tailored to the users'
needs.
7.2 Tables and diagrams
7.2.1 Ways of presenting data:

 Tables
 Charts
 Graphs
Before these methods are used the data may have to be summarised in some way.
Ways of doing this include:
 Calculation of averages
 Construction of time series
 Calculation of ratios
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7.2.2 Tables
A table is a matrix of data in rows and columns with the rows and columns being titled. It is
two dimensional so shows two variables.
Table guidelines
 Title
 Label all columns/rows
 Subtotals where appropriate
 Total column at right/bottom
7.2.3 Charts
Charts are a more visual display than tables. Using them depends on:
(i) What the data is intended to show;
(ii) Who is going to use the data.
7.2.4 Bar charts
(a) Simple bar charts – are charts consisting of a set of non-joining bars. A separate bar
is drawn for each class with a height proportional to the class frequency. The widths
of the bars drawn for each class are always the same.
Example
Thousands
40
20
0 20X8 20X9 20Y0 20Y1
Profits per annum
(b) Component bar charts – have each bar representing a class and split up into
constituent parts (components). Within each bar, components are always stacked in
the same order.
Example
Thouands
250
200
150
100
50
20X8 20X9 20Y0 20Y1
Product A Product B Product C
50

(c) Multiple Bar charts – have a set of bars for each class, each bar representing a
single constituent part of the total. Within each set, the bars are physically joined and
always arranged in the same sequence. Sets of bars should be separated.
Example
Thouands
80
60
40
20
0
20X8 20X9 20Y0 20Y1
(d) % Bar charts – have each bar representing a class but all drawn to the same height,
representing 100% (of the total). The constituent parts of each class are then
calculated as percentages of the total and shown within the bar accordingly. Within
each bar, components are stacked in the same order.
Example
20X8
20X9
20Y0
20Y1
0% 25% 50% 75% 100%
7.2.5 Pie charts

Pie charts show the relative size of the components of a total
Example
Employment – Destination of UK graduates in 20X9
LONG-TERM CAREER
65%
16% is then
multiplied by 360 to
give us 58, which is
this segment of the
TEMPORARY JOB circle
16%
TRAVEL
FURTHER STUDY 7%
12%
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7.2.6 Scattergraphs
Scattergraphs (or scatter diagrams) are graphs which are used to exhibit data, (rather than
equations) in order to compare the way in which two variables vary with another.
Lecture example 3
A company has four regional divisions whose sales for the last quarter are as follows:
Sales
$m
North 320
South 120
East 180
West 100
If the figures were displayed in a pi e chart how many degrees would the South division
represent?
Solution
 90 degrees
 60 degrees
 120 degrees
 75 degrees
8 Spreadsheets
The use of spreadsheets has been commonplace for over twenty years and is the basic tool
of accountants to record and manipulate management information.
This section is intended only as a summary, we recommend that you work through Chapter
15 of the Study Text with Microsoft Excel open on a computer to ensure you are familiar with
the basic functions of a spreadsheet.
8.1 Definition
A spreadsheet is an electronic piece of paper divided into rows and columns. The
intersection of a row and a column is known as a cell. Cells can be used to hold numerical
data. Data can be processed by defining a relationship between cells, to derive output.
Some common applications of spreadsheets by management accountants are:
 Preparation of management accounts
 Cash flow analysis, budgeting and forecasting
 Account reconciliation
 Revenue and cost analysis
 Comparison and variance analysis
 Sorting, filtering, categorising large volumes of data.
52

8.2 Features and functions

Cell contents can include:
Text – words, abbreviations, descriptions, references, key words, decision summary
Values – A number which can be used as part of a calculation
Formulae – A definition of a mathematical relationship between cells. For example, if we
multiply the contents of two cells A1 and B1 the formula required is =A1 * B1.
The formula bar allows you to see and edit contents of the active cells. It also shows the
'cell address', which is the location of the current highlighted cell
8.3 Preparing formulae

Always remember in an exam to write the formula as you would actually see it in Excel. Do
not forget the equals sign at the beginning.
Lecture example 4
Provide the required formulae for the following spreadsheet computations given the following:
A B C
1 Sales value
2 January 150
3 February 120
4 March 100
5 Total
6 VAT
7 Gross Sales
Solution
(a) In cell B5 calculate total sales value (150 + 120 +100). Formula
(b) In cell B6 calculate the VAT payable at a rate of 17.5% on the sum calculated in
B5. Formula
(c) Calculate the gross sales value to invoice in Cell B7. Formula
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8.3.1 Absolute cell referencing

When copying a formula we sometimes want one of the cell references to remain the same.
By using $ (absolute cell referencing) we can do this.
The following VAT calculation uses absolute cell referencing. A $ sign either side of the
column letter anchors the formula to this cell. The formula can now be copied.
Lecture example 5
A B C D
1
2 VAT 0.175
3
4 Price (excl VAT) VAT Price (incl VAT)
5 12 = B5+C5
6 15.5 = B6+C6
7 35 = B7+C7
What formula will be typed into C5 to calculate the VAT (using absolute cell referencing)?
Solution
8.3.2 Rounding
Simple rounding uses the following formula:
=ROUND(cell ref, decimal places required)
eg =ROUND(C4,2) This will round everything in cell C4 to 2 decimal places
8.3.3 Formulae with conditions

Where statements are used in conditional formulae and follow the following structure:
= IF (logical_test, value_if_true, value_if_false)
For example:
= IF (A5>500,'HURRAY', 'MORE SALES PLEASE')
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Note the following symbols which can be used in formulae with conditions
< less than
<= less than or equal to
= equal to
> greater than
>= greater than or equal to
<> not equal to
Lecture example 6
Given cell C4 contains the monthly sales revenue, devise the conditional formula to prompt the
payment of a bonus. Bonuses are paid if monthly revenues are equal to or exceed $200,000.
Solution
8.4 Spreadsheets and 'What if' analysis

Spreadsheets can be very helpful for 'what if' analysis. Once a forecast cash flow has been
prepared the formulae used in assumptions to create the spreadsheet can easily be
tweaked to see the results of different scenarios. For example once a cash flow forecast has
been prepared, the assumption that cost of sales is 60% of revenue could be altered to see
the impact of it rising to 64% or the impact of receivables taking two months to pay rather
than one month could be seen quickly.
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9 Summary
Topic Summary
Data Data is term for facts, figures, information and measurements. If
collected for a specific purpose it is known as primary data and if
collected for another purpose it is known as secondary.
Sources of data Data can be internal (accounting records, payroll information, product
information, published accounts or historic records) or external (market
research, interviews, questionnaires, data from government, banks,
newspapers or the internet).
Impact of the general The economic environment will impact the costs and revenues of a
economic environment business. Think about how businesses are suffering in the current
on costs/ revenues recession.
Big Data Refers to the mass of data created by society.
There are three Vs of Big Data:
 Volume
 Velocity
 Variety
Sampling A sample is where data is only collected from a sample of the population
whereas a census collects information from the whole population.
Random sampling The sample is selected in such a way that each item has an equal
chance of being selected. Often done using random numbers. Quasi
random sampling can also be used.
Non random sampling Where a random sample cannot be used non random sampling can be a
solution. Both quota and cluster sampling can be used.
Reports Should be presented in an unbiased way as possible and be tailored to
the users' needs.
Tables and diagrams A table is a matrix of data in rows and columns.
Charts are a more visual display than tables.
Bar charts are charts consisting of a set of non-joining bars with the
height proportional to the class frequency.
A pie chart shows the relative size of the components of a total.
Spreadsheets A spreadsheet is an electronic piece of paper divided into rows and
columns.
A wide range of formulae and functions are available in Excel.
END OF CHAPTER
56

Cost classification and
behaviour

 Explain and illustrate production and non production costs.
 Describe the different elements of non-production costs – administrative, selling, distribution and finance.
 Describe the different elements of production costs – materials, labour and overheads.
 Explain the importance of the distinction between production and non-production costs when valuing output and
inventories.
 Explain and illustrate with examples classifications used in the analysis of the product/service costs including by
function, direct and indirect, fixed and variable, stepped fixed and semi variable costs.
 Describe and illustrate graphically different types of cost behaviour.
 Use high/low analysis to separate the fixed and variable elements of total cost including situations involving semi
variable and stepped fixed costs and changes in the variable cost per unit.
 Explain the structure of linear functions and equations.
 Explain and illustrate the concepts of cost objects, cost units and cost centres.
 Explain and illustrate the use of codes in categorising transactions.
Exam Context
Cost classification is one of the key areas of the syllabus and as well as providing you with key terminology for many of
the following chapters, is also very examinable in section A of the examination.
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3: COST CLASSIFICATION AND BEHAVIOUR
Overview
Cost behaviour
Variable cost Fixed cost Stepped fixed cost

(VC) (FC)
$ $
Output Output Output
Mixed cost
Output
Cost estimation
High/low method
58

Cost classification
Cost object
Cost unit
Classification by function
Cost centre
Production costs Non production costs
Materials Materials
Labour Further Labour

classification by
nature
Overheads
Overheads
Direct cost Indirect cost
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1 Cost classification
Cost classification is the arrangement of cost items into logical groups for example by their
function (administration, production etc) or by their nature (materials, wages etc).
The eventual aim of costing is to determine the cost of producing a product or service.
1.1 Classification by function

A company may first arrange cost items into groups by function. At the highest level there
could be groups of production costs and groups of non production costs.
Pool of total costs

Costs associated with the All other costs incurred
production of goods and in the business
services, from the supply of
raw materials up to the
end of the production process
Production costs can then be broken down further by their nature.
Production costs
Materials Labour Overheads

Cost of materials that Cost of the workforce Cost of any
are used in making the used in making overheads required to
product or service the product support the
production process
Lecture example 1
Give an example production costs under each of the three headings below.
Solution
Materials
Labour
Overheads
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1.2 Classification by nature

Non production costs can also be broken down further by their nature to aid analysis.
Non production costs
Administration Selling Distribution Finance
All other costs All costs incurred All costs incurred All costs incurred
incurred in in promoting and in making the to finance the
managing the retaining packed product business
organisation customers ready for despatch
and delivery to the
customer
Lecture example 2
Give an example of non-production costs under each of the four headings below.
Solution
Administration
Selling
Distribution
Finance
Remember the eventual aim of costing is to determine the cost of producing a product or service.
This information is important to management for many reasons, the three most important being:
(1) Profitability analysis
(2) Selling price determination
(3) Inventory valuation purposes
2 Direct and indirect costs

Production costs can be split into direct costs and indirect costs of production.
2.1 Direct Costs

A direct cost is a cost that can be traced in full to the product, service or department that is
being costed.
Total direct costs = Prime costs.
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2.2 Indirect costs

Indirect production costs are those costs which are incurred in the course of making a
product/service but which cannot be identified with a particular cost unit.
Indirect production costs are often referred to as production overheads.
Lecture example 3
Identify and group the costs involved in the production of a CD.
Solution
Total production costs
Direct Indirect
Identify any direct or indirect non manufacturing costs associated with the production and sale of a
CD.
Direct Indirect
In summary the cost of producing a CD could be broken down as follows:

Cost Card
Production costs Materials

Direct production costs X Labour
Prime cost X Expenses
Indirect production costs
(production overheads) X Materials
X Labour
Expenses
Non production cost
Administration cost X
Selling and distribution cost X
Total product cost X
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3 Cost behaviour and output

A business needs to know how costs behave as production volumes either increase or
decrease so that predictions of costs can be made.
It is expected that costs will increase as production increases but, the exact way costs
behave as output changes will depend on the nature of the cost.
We first classify costs according to how they behave as output changes.
3.1 Cost diagrams
Lecture example 4
Types of cost behaviour
(a) Fixed cost – (FC) A fixed cost is a cost which tends to be unaffected by increases or
decreases in the volume of output. It would be represented graphically as follows:
Total cost $
Output (units)
Examples include:
(b) Stepped fixed cost – A stepped fixed cost is a cost which is fixed in nature but only within
certain levels of activity. It would be represented graphically as follows:
Total cost $
Output (units)
Examples include:
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(c) Variable cost (VC) – A variable cost is a cost which tends to vary directly with the volume of
output. The variable cost per unit is the same amount for each unit produced. It would be
represented graphically as follows:
Total cost $
Output (units)
Examples include:
(d) Mixed cost (semi-variable cost) – A mixed cost is a cost which contains both fixed and
variable components and so is partly affected by a change in the level of activity. It would be
represented graphically as follows:
Total cost $
Output (units)
Examples include:
The total costs of a business are likely to have a variable cost and a fixed cost element.
y
Total cost TC
TC
VC
FC
FC
x
Output
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3.2 Equation of a line

If there is a linear relationship between output and total cost then the relationship can be
within this form:
y = a + bx
Where y is the dependent variable (eg total cost)
x is the independent variable (eg output)
a is the intercept on the y axis (eg fixed cost)
b is the gradient on the line (eg variable costs per unit).
Therefore TC = FC + VC per unit  output
Lecture example 5
Up to a given level of activity in each period one purchase price of a unit of raw material is
constant. After that point a lower price per unit applies both to further units purchased and also
retrospectively to all units already purchased.
Which of the following graphs depicts the total cost of the raw materials for a period?
A B
$ $
0
C D
$ $
Solution
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4 Collecting cost information

4.1 Cost objects, cost units and cost centres
4.1.1 A cost object is anything for which cost data is desired eg products, product lines, jobs,
customers or departments and divisions of a company.
4.1.2 A cost unit is a unit of product or service in relation to which costs may be ascertained. The
cost unit should be appropriate to the type of business. For example:
Business Appropriate cost unit

Car manufacturer Car
Ball bearing manufacturer Batch of ball bearings
Builder Job / Contract
Management consultant Project
4.2 A cost centre is a location, function or item of equipment in respect of which costs may be
ascertained and related to cost units for control purposes.
Each cost centre acts as a 'collecting place' for certain costs before they are analysed
further. Note:
 Cost centres may be set up in any way the business thinks appropriate.
 Usually, only manufacturing costs are considered and hence we will focus on factory
cost centres.
We need to distinguish between factory cost centres that are:
 Production cost centres, through which cost units actually flow;
 Service cost centres, which support/service the production cost centres.
Lecture example 6
Suggest three examples of production cost centres and service cost centres within a clothes
manufacturing factory.
Solution
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5 Cost estimation
To help with analysis and planning for the future it is necessary to determine the fixed and
variable elements of the total costs.
5.1 High/low method

A method known as 'high/low' can be used to estimate the fixed and variable elements of a
given cost.
The high/low method is a four-step method.
Worked example 1
The total costs of a business for differing levels of output are as follows:
Output Total costs
(units) ($'000)
500 70
200 30
300 50
800 90
1,000 110
What are the fixed and variable elements of the total cost using the High/Low method?
 Y = $30,000 + $100x
 Y = $30,000 + $110x
 Y = $10,000 + $110x
 Y = $10,000 + $100x
Solution
Workings
Step 1  Review the cost records from previous periods.
Select highest and lowest activity level and associated cost.
Units produced (output) Total costs $
Highest level of output 1,000 110,000
Lowest level of output 200 30,000
Step 2  Find the change in cost resulting from the change in output.
Units Total costs $
Highest 1,000 110,000
Lowest 200 30,000
Difference 800 80,000
Step 3  Calculate the VC/unit.

$80,000
=$100per unit
800
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Step 4  Substitute back into formula of line.

Total cost = fixed cost + variable cost  output
$110,000 = FC + ($100  1,000)
Therefore FC = $10,000
Equation for total costs = $10,000 + $100X
TC y
x
100 -
50 -
x
x
500 1,000
What we have done 
 Plotted a line between the highest and lowest points.
 Calculated formula of that line
We can now use that formula for planning.
Lecture example 7
Using the equation for total costs = $10,000 + $100X
If production next year is expected to be 780 units what is the estimated total cost?
Solution
Workings
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5.2 Assumptions about cost behaviour

The assumptions that have been made include the following:
 Within the normal range of output costs are assumed to be either fixed, variable or
semi variable.
 Variable costs per unit are constant.
Lecture example 8
LMN Co has a manufacturing capacity of 100,000 units. The production cost of the company is as
follows:
Capacity 65% 100%
Total production costs $290,500 $378,000
What is the budgeted total production cost if it operates at 80% capacity?
Solution
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Lecture example 9
The following data has been collected from Steps Inc:
Units produced 5,000 7,500 10,000
Total costs 54,500 76,500 90,000
Total costs are made up of two elements, a stepped fixed cost that changes when the units exceed
7,000 and some variable costs, which remain constant.
What are the total fixed cost at production levels below and above 7,000 units?
What is the variable cost per unit?
Solution
$ below 7,000 units and $ above 7,000 units.
The variable cost per unit $
Workings
The same methodology could be applied if fixed costs were constant and variable costs changed
above a certain level of output.
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6 Costs codes
Once the costs have been classified then a coding system could be put in place to make it
easier to manage the cost data.
Each individual cost should be identifiable by its code. This is done by building up the
individual characteristics of the code. The characteristics are normally identified as follows:
 The nature of the cost (eg material/ labour/ overhead) which is known as a subjective
classification
 The type of cost (eg indirect/ direct)
 The cost centre to which the cost should be allocated which is known as an objective
classification; and
 The department which the particular cost centre is in.
An example of a coding system might be a composite code. For example let's consider a
composite code number of 413.375. The first three digits might indicate the nature of the
expenditure (subjective classification) and the last three digits might indicate the cost centre
to be charged (objective classification.)
So the digits 413 might refer to:
4 Materials
1 Raw materials
3 Plastic sheeting
So anyone familiar with the coding system would know that 413 indicates expenditure on
plastic sheeting.
The digits 375 might refer to
3 Direct cost
7 Factory Beta
5 Finishing department
This would indicate the expenditure was to be charged as a direct material cost to the
finishing department in factory beta.
6.1 Advantages of coding system

 A code is usually briefer than a description thus saving time and storage space
 A code is more precise and reduces ambiguity
 Coding facilitates data processing
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7 Chapter summary
Topic Summary
Cost estimation The fixed and variable element of a mixed cost can be determined by the
high/low method.
Classification Cost classification is the arrangement of cost items into logical groups by
their function or by their nature.
The eventual aim of costing is to determine the cost of producing a
product/service.
Production and Costs can be split by their function into production and non production
non production costs costs.
Production costs can be split further by their nature into material, labour
and overhead costs.
Direct and indirect Direct costs are costs that can be directly traced to a cost unit.
costs Indirect costs are costs incurred in production but cannot be directly
linked to a cost unit.
A cost card can be built up for an individual cost unit.
Cost objects, cost units Costs can be calculated and analysed at different levels within an
and cost centres organisation's structure.
Cost behaviour and Cost behaviour is the way in which costs are affected by changes in
output volume of output.
A fixed cost will be unaffected by an increase or decrease in volume of
output.
A step cost is a cost which is fixed in nature within certain volumes of
output.
A variable cost is a cost that will vary with output. The variable cost per
unit is the same amount for each unit produced.
Codes A coding system can save time and reduce ambiguity when recording
items of expenditure.
END OF CHAPTER
72

Achievement Ladder Step 1
You have now covered the Topics that will be assessed in Step 1 of your Achievement Ladder.
It is vital in terms of your progress towards ‘exam readiness’ that you attempt this Step in the near future.
You will receive feedback on your performance, and you can use the wide range of online resources and
ongoing BPP support to help address any improvement areas. This will help you to tailor your learning
exactly to your own individual requirements.
Course notes
Topic name Subtopic/Chapter name
chapter

Management information Data and presenting information 2
Cost classification and behaviour 3
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ACHIEVEMENT LADDER
74

Forecasting

 Explain the advantages and disadvantages of using the high/low method to estimate the fixed and variable
element of costing.
 Construct scatter diagrams and lines of best fit.
 Explain the concept of correlation coefficient and coefficient of determination.
 Calculate and interpret correlation coefficient and coefficient of determination.
 Establish a linear function using regression analysis and interpret the results.
 Use linear regression coefficients to make forecasts of costs and revenues.
 Adjust historical and forecast data for price movements.
 Explain the advantages and disadvantages of linear regression.
 Describe the product life cycle and explain its importance in forecasting.
 Explain the principle of time series analysis (cyclical, trend, seasonal variation and random elements).
 Calculate moving averages.
 Calculation of trend, including the use of regression coefficients.
 Use the trend and seasonal variation (additive and multiplicative) to make budget forecasts.
 Explain the advantages and disadvantages of time series analysis.
 Explain the purpose of index numbers.
 Calculate simple index numbers for one or more variables.
Exam Context
This important topic forms part of both the cost behaviour and budgeting sections of the syllabus and it is vital that you
are able to understand forecasting techniques and able to apply the numerical techniques within this chapter as they
could be tested in section A of the examination.
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4a: FORECASTING
Overview
Forecasting
Cost Prediction Time Series
High/Low Scatter graphs Linear

Method regression
Additive Multiplicative
Correlation Coefficient (r) Coefficient of determination

(r2)
Index Number
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4a: FORECASTING
1 Statistical forecasting techniques

1.1 Linear regression
In order for a business to be able to plan and make decisions, it needs to be able to
accurately predict costs at differing output levels.
If we can identify the relationship between the output level and the cost at that level from
observation then it is possible to construct a model to predict costs at all future output levels.
If this relationship exists there is said to be a correlation between output levels and total
costs.
Other examples of variables that may be correlated are:
 A person's height and weight
 The distance of a journey and the time it takes to make it.
1.1.1 Scatter graph

Plotting a scatter graph is the best way of ascertaining a correlation between two variables,
(nowadays computer packages make this easy even for large amounts of data).
For example total costs at different levels of output could be plotted as:
Total
costs
Output
Output in this case would be the 'independent variable' and is plotted on the x axis.
Total cost is the 'dependent variable' and is plotted on the y axis.
The scatter graph seems to show a linear relationship, ie a correlation between the two
variables.
We can estimate the line of best fit for this data, and use this information to help predict the
total cost at future levels of output.
Two main techniques for estimating this information are
(a) High/low. This method forms a linear relationship between the highest and lowest
point plotted.
(b) Linear regression. This method finds the line of best fit mathematically.
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4a: FORECASTING
Example
y
X Y = a + bx
X
X
X X
b
X
a X
X
The formula for a basic linear relationship as seen in Chapter 3 is:
y = a + bx
where
y is the dependent variable (eg costs)
x is the independent variable (eg output)
a is the intercept on the vertical axis (y axis) (eg fixed costs)
b is the slope (gradient) of the line (eg variable cost per unit).
For example, if the information is related to costs then:
Total cost = Fixed cost + Variable cost per unit × output.
Linear regression finds mathematically the line of best fit, by minimising the squares of the
vertical differences.
Formulae:
n xy   x  y
b =
2
n x 2    x 
y 
a = y  bx = –b
n n
Note. This technique can be applied to any pairs of data not just cost and output.
78

4a: FORECASTING
Lecture example 1
Wigwam Ltd makes high quality tents for outdoor festivals. The company accountant has observed
costs at different production levels as follows:
Output Total Costs
(units) $
280 46,500
350 49,100
200 36,700
160 32,000
240 44,500
These costs could be plotted on a scattergraph as follows:
Costs
$
50,000 X
X
40,000
X
30,000
100 200 300 400 Output
(units)
The costs appear to follow an approximately linear pattern.
Required
(a) Calculate the regression line.
(b) Use the line to estimate costs for output of 240 units and 700 units.
Note. The answers will be expressed in $'000 as the values for Y are given in $'000.
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4a: FORECASTING
Solution
80

4a: FORECASTING
1.1.2 Reliability of regression line

The formula applied will find a value for a and b and hence a formula for the line.
The usefulness of this formula for predicting results in the future depends on how strong the
correlation between the two variables is.
1.1.3 Correlation coefficient (r): indicates the strength of the linear relationship between x and y.
Examples of correlation coefficients
No correlation r = 0 No correlation r = 0
Perfect negative Perfect positive

correlation r = –1 correlation r = +1
Formula
r=
n xy  -  x y 
 2 2  2 2 
 n x   x   n y   y  
  
where r = correlation coefficient.
The value of the correlation coefficient must be between -1 and 1.
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4a: FORECASTING
Lecture example 2
What is the correlation coefficient for the data in Lecture example 1 - Wigwam?
Solution
Workings
1.1.4 Coefficient of determination (r2)

r2 indicates the proportion of change in y which would be explained by change in x. It does
not prove cause and effect relationship. It merely suggests a possible link.
The value must be between 0 and 1.
Lecture example 3
What is the coefficient of determination for the data in Lecture example 1 – Wigwam?
Solution
Workings
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4a: FORECASTING
Lecture example 4
The following data regarding a company Y's costs have been collected:
x = 440, y = 330, x2 = 17,986, y2 = 10,366, xy = 13,467 and n= 11.
Solution
(a) Find the value for 'b' – the gradient of the line:
 1.45
 2.40
 -0.69
 0.69 (2 marks)
(b) Find the value for 'a' – the point of intersection with the y axis:
 57.6
 19.3
 2.4
 26.4 (2 marks)
(c) Find the value for the correlation coefficient, to two decimal places is:
 0.98
 0.63
 0.96
 0.59 (2 marks)
Workings
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4a: FORECASTING
1.1.5 Advantages and disadvantages of linear regression analysis

Advantages
 Gives a definitive line of best fit.
 Makes efficient use of data and good results can be obtained with relatively small
amounts of data.
 Many processes are linear and so are well described by regression analysis.
Disadvantages
 Assumes linearity between x and y.
 The observations used may be atypical.
 Historic data is used and patterns may change in future.
 Each observation should be independent from the others.
 Forecasting usually involves extrapolation outside the given range of observations
where working conditions and therefore cost patterns may change.
2 Time series analysis

A time series is a series of figures or values recorded over time. The analysis of time series
allows historical aspects of data to be monitored so that observations can be made as to
how a variable has performed over a period of time.
Examples – output at a factory each day for the last month
– total costs per annum for last ten years
– monthly sales over last five years.
2.1 Components of a time series (TS)

Trend (T)
The general movement of a time series over a long period of time (ie growth, inflation). It
generally expected to be a smooth line/curve. It can be found using moving averages.
Seasonal variations (SV)
A recurring pattern in recorded values, due to repetitive events, over a shorter but fixed
period of time (weekly, quarterly).
Cyclical variations (CV)
Recurring patterns over a longer period of time, not generally of a fixed nature (ie
recession/depression/economic growth).
Random variations (RV)
Irregular/unpredictable variations, due to rare/chance occurrences (hurricanes, floods,
nuclear war).
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4a: FORECASTING
2.2 Time series models

The four components of variation are assumed to combine together in two ways. Thus we
have two mathematical models of the variable, TS.
The additive model
The additive model in which the components are assumed to add together to give TS.
TS = T + SV + CV + RV.
This is valid only if the components are independent.
The multiplicative model
The multiplicative model in which the components are considered as multiplying to give TS.
TS = T × SV × CV × RV.
In the exam, you will only be required to do calculations involving the trend (T) and seasonal
variations (SV).
2.3 Moving averages

This is the main method for calculating a trend from a time series. This technique averages
all of the results of a fixed number of periods and relates to the mid-point of the overall
period.
The most appropriate number of periods for a moving average will depend on the
circumstances and the nature of the time series. For example, a time series of output over a
5 day week should use a 5 period moving average whereas a time series of sales per
quarter would use a 4 period moving average.
Sales
$000s
Trend
0 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4
20X0 20X1 20X2 20X3
In the above example, there would appear to be a large seasonal variation in demand, but
there is also a basic upwards trend.
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4a: FORECASTING
2.4 Calculating seasonal variations

Once the trend has been established, the seasonal variation can be determined using the
models above.
Additive model: SV = TS – T
TS
Multiplicative model: SV =
T
(Ignoring CV and RV as this will not be in calculations in the exam.)
Note. When predicting values, an average of all seasonal variations for a particular period is
used.
Lecture example 5
Using moving averages, determine the trend given a three-period recurring seasonal
variation. Rearranging the equation for TS, determine the SV by subtracting the trend from
the time series. ie using the additive model.
Solution
Additive model
SV = TS– Trend
Time Series 3/Period Seasonal
(TS) Moving Average Variation
2
5
5
5
8
8
8
11
Under the additive time series, the sum of seasonal variations must equal zero. Adjustments need
to be made where this is not the case.
Under the multiplicative time series, the sum of the seasonal variations must equal the number of
periods over which seasonality occurs prior to repeat ie the sum of a quarterly seasonal variation
should equal 4.
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4a: FORECASTING
Lecture example 6
Adjust the following seasonal variation where necessary.
Solution
Adjustment Adjusted SV
Q1 SV = +6
Q2 SV = -3
Q3 SV = +5
Q4 SV = -6
SV =
Lecture example 7
You are given the regression equation of how the sales trend varies with time:
y = 400 + 20x
where:
x = quarter (x increases by one for each new quarter)
y = unit sales.
Forecast sales for year 6 for each quarter using the seasonal variations below.
Solution
Quarter Q1 Q2 Q3 Q4
SV -5% +10% +20% -25%
Prediction
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4a: FORECASTING
Lecture example 8
If budgeted fixed overheads = $120,000 per annum and the following seasonal variations have
been observed:
Q1 Q2 Q3 Q4
+10% -20% +15% -5%
What would be the budgeted fixed overheads per quarter for the coming year?
Solution
Quarter 1
Quarter 2
Quarter 3
Quarter 4
3 Forecasting problems
All forecasts are subject to error, but the likely errors vary from case to case:
 The further into the future the forecast the more unreliable it's likely to be
 The less data available on which to base the forecast the less reliable the forecast
 The pattern of trend and seasonal variation cannot be guaranteed to continue
 There is always the danger of random variations upsetting the pattern of trend and
seasonal variation
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4a: FORECASTING
4 Index numbers
An index measures over time the average changes in the values, prices or quantities of a
group of items.
An index can either be a price or a quantity index for an item or a group of items.
We can get a feel for how a time series is changing over time by plotting a trend line.
Another simple and convenient method of doing this is to convert the actual figures into a
series of index numbers.
This is done by firstly determining a base period which is the period for which the actual
figure is equated to an index of 100.
Each subsequent period's figure is converted to the equivalent index using the following
formula:
Current Period's figure
Index = × 100
Base Period figure
Lecture example 9
Suppose a cost of living index is to be calculated from the following three items: beer, pizza and
chocolate and that prices for 20X1 and 20X2 were as follows.
X1 X2
Beer $2.00 $2.10
Pizza $3.50 $3.55
Chocolate $0.55 $0.60
What is the cost of living index for X2, assuming X1 as a base year? (give your answer to
one decimal place)
%
Solution
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4a: FORECASTING
4.1 Retail price index (RPI) or 'cost of living' index

The RPI measures the changes in the costs of items of expenditure of the average
household.
4.1.1 Characteristics
(a) Baskets of goods with which prices and sales volumes are compared. The RPI (Retail
Price Index) for example is made up of a large variety of items, including bread,
butter, meat, rent, insurance etc.
(b) Base year – a point in time with which current prices/quantities are compared.
(c) Weightings are used and they give the relative importance of each item.
(d) Index numbers may be used to deflate costs for comparison.
5 Chapter summary
Topic Summary
Correlation Two variables are correlated if a change in the value of one variable is
accompanied by a change in the value of another variable.
Scattergraphs Observations of the behaviour of two variables can be plotted on a
scattergraph.
Linear regression Linear regression is a mathematical technique that finds the line of best
fit that defines the relationship between two variables.
Correlation coefficient The degree of correlation is measured by the correlation coefficient 'r'.
Coefficient of The coefficient of determination, r2, measures the proportion of the total
determination variation in the value of one variable that appears to be explained by
variations in the value of the other variable.
Time series There are four components of a time series: trend, seasonal variations,
cyclical variations and random variations.
Additive model
TS = T + SV + RV + CV
Multiplicative model
TS = T  SV  RV  CV
Moving averages
One method of finding a trend is by the use of moving averages.
Index numbers An index is a measure, over time, of the average changes in value (price
or quantity) of a group of items relative to the situation at some point in
the past.
Forecasting problems All forecasts are subject to error and this impacts on their use.
END OF CHAPTER
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Summarising and
analysing data

 Calculate the mean, mode and median for grouped and ungrouped data.
 Calculate measures of dispersion including the variance, standard deviation and coefficient of variation for both
grouped and ungrouped data.
 Calculate expected values for use in decision making.
 Explain the properties of normal distribution.
 Interpret normal distribution graphs and tables.
Exam Context
This important topic forms part of the data analysis and statistical techniques section of the syllabus and it is important
that you are able to understand data analysis and apply the statistical techniques within this chapter as they could be
tested in section A of the examination.
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4b: SUMMARISING AND ANALYSING DATA
Overview
Expected Summarising and Standard deviation

Dispersed
values analysing data data
 (x x)2
=
n
Or
Typical  fx2 2
-x
attributes f
Mean Median Mode

 Ungrouped  Ungrouped/  Occurring
 Grouped Grouped most
x=
Σfx  Odd/Even frequently
Σf
Normal
distribution
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1 Grouped and ungrouped data

1.1 Grouped Data: Where the frequency is shown in terms of a range. Known as continuous
data
Ungrouped Data: Discrete data, where the frequency is shown in terms of a specific
measure/value.
If there is a large set of data or if every (or nearly every) data item is different, it is often
convenient to group frequencies (how often data occurs) together into bands or classes.
2 Averages
2.1 The example below will be used throughout the chapter in order to calculate the three
averages; the mean, median and mode; the following data will be used to illustrate each.
In the small town of Brum Brum in the West Midlands, a survey of 1,600 out of 100,000 car
owners was performed to find out about annual mileage travelled. The results were as
follows:
Midpoint Number of
mileage cars Mileage
x f fx
< 2,000 1,000 * 10 10,000
2,000 – < 4,000 3,000 14 42,000
4,000 – < 6,000 5,000 154 770,000
6,000 – < 8,000 7,000 292 2,044,000
8,000 – < 10,000 9,000 493 4,437,000
10,000 – < 12,000 11,000 404 4,444,000
12,000 – < 14,000 13,000 164 2,132,000
14,000 – < 16,000 15,000 48 720,000
 16,000 17,000 * 21 357,000
1,600 14,956,000
* assume same size as adjacent intervals.
2.2 Mean
Definition – the MEAN is the average value and is calculated by adding all the observations
and dividing by the number of observations.
Ungrouped Data:
x
x=
n
Grouped Data:
Σfx
x= (frequency distribution)
Σf
where x = value
f = frequency
Where the frequency is a grouped distribution ie a range of values, we use the ‘midpoint’ for
x to calculate the mean.
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Lecture example 1
Required
Using the information in 2.1 calculate the mean annual mileage for these 1,600 cars.
Solution
2.3 Mode
Definition – the MODE is the most frequently occurring item.
Ungrouped Data: the most frequently occurring item in the list.
Grouped Data: we cannot say what the most frequently occurring item is, however, we can
estimate the mode using the following method.
To find the mode using a histogram
(i) Draw the frequency histogram and identify the highest frequency class.
(ii) Draw a diagonal line from the top of the block either side of the highest class.
(iii) The intercept is the estimated modal value, read from the x axis.
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Finding the mode using a histogram (using the data from the previous example)
No. of cars
500 Estimated modal value

read from the x axis.
400
300
200
100
0
1,000 3,000 5,000 7,000 9,000 11,000 13,000 15,000 17,000
Mileage
Reading from the histogram the mode is approximately 9,250 miles.
Lecture example 2
A group of shoppers were interviewed and asked how many loaves of bread they would need to
buy from the bakers over a one-week period. The results are as follows.
Number of loaves Number of shoppers
0 2
1 22
2 32
3 2
4 34
5 6
6 12
Required
What is the mode of the number of loaves needed per shopper in a one-week period?
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Solution
2.4 Median
(a) Definition: the Median is the value of the middle item.
Ungrouped Data (Odd number)
(i) Arrange data in order
(ii) Calculate middle (median) rank -
n  1 
nth item in the list
2
(iii) Median value = the entry corresponding to the median rank
Ungrouped Data (Even number)
(i) Arrange the data in order
(ii) Calculate the MEAN of the two median ranks.
n n
The mean of th and  1 th
2 2
(b) Grouped Data
(i) Arrange data in order
(ii) Calculate middle (median) rank (note whether even or odd)
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Lecture example 3
In a supermarket, the number of employees and the annual earnings per employee are shown as
follows.
Annual earnings Number employed
$
6,000 3
7,000 5
10,000 3
11,000 1
12,000 2
15,000 1
Required
What is the median value of annual earnings?
Solution
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2.5 Advantages and disadvantages

2.5.1 Mean ( x )
Advantages
(a) used most frequently
(b) most commonly understood
(c) uses all data
Disadvantages
(a) may not be a value in the distribution
(b) distorted by extreme high/low values
(c) ignores dispersion
2.5.2 Mode
Advantages
(a) most popular item
(b) not distorted by high/low values
(c) corresponds to an actual value in the distribution
Disadvantages
(a) ignores dispersion
(b) does not take into account all data
2.5.3 Median
Advantages
(a) not distorted by high/low values
(b) corresponds to an actual value in the distribution
Disadvantages
(a) ignores dispersion
(b) limited use
2.5.4 Limitations
The averages we have calculated do not explain very much about the distribution itself. We
cannot determine whether the data lies close to the central point (the mean) or is scattered
around the entire range of possible values. This is called dispersion.
Graphical methods enable us to see what is happening within the distribution, but there is a
need for a more statistical measure. This is known as the standard distribution and it
measures dispersion.
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3 Dispersion
3.1 Measures of dispersion give some indication of the spread of data about the central point
(mean).
3.2 Standard deviation is one of the most important measures of dispersion.

Formulae
 (x x)2
=
n
For a frequency distribution the formula becomes
 fx2 2
= -x
f
where  = standard deviation
x = value
x = mean
f = frequency
n = f
Advantages
(a) uses all data
(b) gives ‘weight’ to values that lie far away from mean
Lecture example 4
Required
Complete the following table and calculate 
Mid point No.
mileage of cars
x f fx x2 fx2
('000s)
<2 1 10
2 –< 4 3 14
4 –< 6 5 154
6 –< 8 7 292
8 –< 10 9 493
10 –< 12 11 404
12 –< 14 13 164
14 –< 16 15 48
 16 17 21
1,600
x = 9,347.5 miles
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Solution
3.3 Coefficient of variation

Measures the standard deviation as a percentage of the mean. Particularly useful when
comparing two distributions.
Key learning - the higher the percentage, the higher the dispersion.
σ
Formula – Coefficient of variation =
x
Lecture example 5
Required
Calculate the co-efficient of variation for Lecture Example 4.
Solution
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3.4 Variance is defined as the square of the standard deviation (2). Watch out for questions
where you are given a variance but need a standard deviation for your calculation
Variance =  2
Standard Deviation   var iance
4 Probabilities and expected values

Expected values
4.1 Introduction
An expected value (EV) is a weighted average, based on probabilities.
Expected Value (EV) = px
where  = sum of
p = probability of outcome occurring
x = outcome/results
4.2 Expected value can be used in situations where there are a number of possible outcomes
from a single event and it is not known with certainty what will actually happen. Each
outcome is assigned a probability.
Lecture example 6
A gambler has placed a bet on a horse. From past form, the probability distribution relating to its
chances in the race is as follows.
Place Winnings Probability
1st £100 5%
2nd £50 15%
3rd £25 10%
No place Nil 70%
Required
What is the expected value of the gambler's winnings?
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Solution
4.3 There are limitations with using expected values:

(a) Expected Value is a long-run average result therefore it is inappropriate for one-off
decisions.
(b) It is heavily dependent on probability distribution.
(c) EV ignores risk where risk is the spread or variability of outcomes.
5 Normal distribution
The normal distribution (or probability distribution) is a frequency distribution and it is
important because it arises frequently in ‘real life’.
For example, if we take the population of Britain and look at the distribution of the height of
all adults it would almost certainly follow a normal distribution. In fact, most data distributions
follow a normal distribution where the majority of items lie near to the average.
5.1 Shape
The normal distribution is often described as a ‘bell-shaped’ curve. The normal curve for
the height of adults might look like this.
 = 10 cm
50 50
 = 1.7 metres
102

When using the normal distribution we will use the  to define the mean and  to define
standard deviation.
Here  = 1.7 metres and standard deviation,  = 10 cm
5.2 Reason for shape

As the majority of people's heights lie on or near to the average height (the mean), there is a
higher concentration of occurrences the closer we get to the mean.
As you get further away from the mean, the number of people with these heights gets
smaller and smaller, hence the curve gets lower and lower.
5.3 Symmetry
When attempting questions, it is important to note the normal distribution is always
symmetrical around the mean. Consequently, the area either side of the mean represents
50%.
5.4 Properties of normal distribution

(a) The curve is symmetrical centred on  (mean).
In our example, 50% of people are taller than 1.7 metres and 50% are shorter than
1.7 metres.
Standard =  = 10 cm
deviation
50% 50%
 = 1.7 metres
(b) The total area under the curve = 1 or 100% of the population.
(c) The width of the curve is measured in terms of the standard deviation ().
(d) For practical purposes the range of the normal distribution is six standard deviations
ie heights of adults range between
 - 3 = 1.7 metres - (3  10 cm) = 1.4 metres
and  + 3 = 1.7 metres + (3  10 cm) = 2 metres
There will be occasional exceptions but on the whole heights will be in this range.
(e) The most useful feature of the normal curve is that at a point a certain number of
standard deviations from the mean, the area under the curve will always represent the
same % of the population (no matter what normal curve is being considered).
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5.5 Some examples are given below.

(a)
Standard =  = 10 cm
deviation
50% 47½%
1.96 
In the height example this would mean that 2½% of the population are taller than
1.7 metres + (1.96  10 cm) = 1.896 metres.
(b)
50% 34.13%
1
Here we are measuring a range one standard deviation from the mean ie 1.7 metres
+ (1  10 cm) = 1.8 metres
This would mean that 84.13% of the population are shorter than 1.8 metres and
15.87% of the population are taller than 1.8 metres.
(c)
50% 47.72%
2
Here we are measuring a range two sds from the mean ie 1.7 metres + (2  10 cm) =
1.9 metres.
This would mean that 97.72% of the population are shorter than 1.9 metres and
2.28% of the population are taller than 1.9 metres.
We need a method to translate distances from the mean into probabilities ie areas
under the curve. We do this with a combination of Z-scores and normal distribution
tables.
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5.6 Z-scores
Distances from the mean in the normal distribution are always measured by the number of
standard deviations they represent. This is known as a Z-score.
Number of standard deviations from the mean
x 
Z= (formula on normal distribution table)

5.7 Normal Distribution Tables

These are tables which give the relationship between % of population and Z-score for any
Z-score. You will be provided with these in the formulae sheet given in the exam.
Lecture example 7
The average number of bottles of beer consumed in three months by accountancy students is 251.
The standard deviation is 15 bottles.
Assume a normal distribution.
Required
What is the likelihood that a student will drink:
(a) more than 285 bottles?
(b) between 220 – 255 bottles?
Solution
5.8 It is important to recognise that you may need to manipulate the Z-score calculation to
answer questions.
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Lecture example 8
Required
A normal distribution has a mean of 150 and a standard deviation of 20.
80% of the population is therefore below what?
Solution
6 Chapter summary
Topic Summary
Grouped and ungrouped Grouped Data: Where the frequency is shown in terms of a range.
data
Ungrouped Data: Discrete data, where the frequency is shown in terms
of a specific measure/value.
Averages
Sum of values of item
Mean =
number of items
Mode –the most frequently occurring item.

Median - the value of the middle item.
Dispersion The standard deviation, which is the square root of the variance, is the
most important measure of spread used in statistics. The spreads of two
distributions can be compared using the coefficient of variation.
Expected values An expected value (EV) is a weighted average, based on probabilities.
Normal distribution The normal distribution is a probability distribution which applies to

continuous variables.
END OF CHAPTER
106

Accounting for
materials

 Describe the different procedures and documents necessary for the ordering, receiving and issuing of materials
from inventory.
 Describe the control procedures used to monitor physical and 'book' inventory and to minimise discrepancies and
losses.
 Interpret the entries and balances in the material inventory account.
 Identify and explain the costs of ordering and holding inventory (including buffer inventory)
 Calculate and interpret optimal reorder quantities.
 Calculate and interpret optimal reorder quantities when discounts apply.
 Produce calculations to minimise inventory costs when inventory is gradually replenished.
 Describe and apply appropriate methods for establishing reorder levels where demand in the lead time is
constant.
 Calculate the value of closing inventory and material issues using LIFO, FIFO and average methods.
Exam Context
Materials cost is a key cost within a manufacturing environment. This is an important part of the syllabus and you need
to be happy with all relevant calculations and formulae for section A of the examination.
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5: ACCOUNTING FOR MATERIALS
Overview
Accounting for Materials
Ordering, receipt and issue of

raw material Monitoring of inventory Value inventory using
levels FIFO, LIFO and
average methods
Recording purchases in Inventory control levels

accounts
Reorder level EBQ

Minimum level
Maximum level
EOQ
Discounts
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1 Accounting for materials

Inventory control includes the processes of:
(1) Ordering
(2) Purchasing
(3) Receiving goods into store
(4) Storing
(5) Issuing inventory
(6) Controlling levels of inventory.
We will begin with processes 1-5 before considering how and why levels of inventory are
controlled.
1.1 Ordering, receipt and issue of raw material

Every movement of material should be documented in order to keep a proper physical
record and so that the correct entries can be entered in the 'books' of the company.
Inventory control process:
Purchase requisition Purchase requisition

Job Number
 When the stores department need Supplier Date
more materials they issue a Requested by
purchase requisition which is sent to
Quantity Code Description Cost
the purchasing department
Authorised:
Purchase order (PO) Purchase order No

To Date
 The purchasing department raise a Order ref
PO which is sent to: Address
Quantity Code Description Cost
– Supplier
– Accounts departments
Subtotal
– Stores
VAT @ 20%
Total
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When the goods arrive at stores:

Goods received note
Delivery note/goods received note
(GRN) Date No
Time
Out order no.
Supplier no.
 Received with the goods
Quantity No./Code Description
into the stores department
 Signed off to confirm
quantity and quality Received in good condition………………………
 Sent to:
– Purchasing department
– Accounts department
The accounts department should match the PO to the GRN and the invoice when it arrives
from the supplier.
Materials purchased will be recorded in the accounting books of a company as follows.
(1) When a purchase is made or an invoice received
Dr Materials inventory Dr Materials inventory
Cr Cash account Cr Creditors account
(2) When an issue is made to a production process
Dr Production process/work-in-process (WIP)
Cr Materials inventory
Materials inventory
(1) Materials (2) Issues to
purchased X Production X
C/f closing
Inventory X
X X
B/f closing
inventory X
1.2 Monitoring of inventory levels

One of the objectives of storekeeping is to maintain accurate records of inventory levels.
This involves accurately monitoring inventory movements in order that the physical inventory
is reflected in the company's books.
A company will carry out inventory counts to check that the physical inventory matches that
shown in the inventory records.
This count can be carried out on a periodic or continuing basis.
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1.3 Free inventory

Managers need to know the free inventory balance in order to obtain a full picture of the
current inventory position of an item. Free inventory represents what is really available for
future use and is calculated as follows:
Materials in inventory X
Add: Materials on order from suppliers X
Less: Materials requisitioned but not yet issued (X)
Free inventory balance X
Lecture example 1
(a) What are the reasons for holding inventory?
(b) What are the costs of holding inventory?
(c) What are the costs of ordering inventory?
Solution
(a) Reasons:
(b) Costs of holding:
(c) Costs of ordering inventory:
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2 Control levels
Three control levels can be calculated from historic records:
2.1 Reorder level

This indicates the inventory level when a new order should be made.
It is set so that in theory it is not possible to run out of inventory, based on the maximum
usage of inventory and the maximum delivery days or lead time.
Reorder level = Max usage per day  Max lead time
2.2 Minimum level

This indicates an inventory level below which inventory should not normally fall below.
It acts as a warning sign to management that inventory is very low and that there is an
increased risk of stockouts.
Minimum level = Reorder level – (Ave usage per day  Ave lead time)
2.3 Maximum level

This indicates an inventory level above which inventory should not normally rise.
It acts as a warning sign to management that too much stock is held which may be
uneconomical.
Maximum level = Reorder level + Reorder Quantity – (Min usage per day  Min lead
time)
2.4 Additional terminology:

Average inventory = minimum inventory + ½ reorder quantity
The average inventory formula assumes that inventory levels fluctuate evenly between the
minimum (or safety or buffer) inventory level and the highest possible inventory level (the
amount of inventory immediately after an order is received).
Reorder quantity
The quantity of inventory which is to be ordered when inventory reaches the reorder level.
This can be calculated as the Economic Order Quantity (EOQ) formula.
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Lecture example 2
Data for a component part with stock number B1422 is as follows:
Minimum usage 1,000 units
Maximum usage 2,250 units
Lead time (delivery time) 8-16 days
Reorder Quantity 14,500 units
(a) What is the reorder level?
 8,000 units
 36,000 units
 18,000 units
 27,000 units (2 marks)
(b) The Minimum inventory holding below which inventory should not fall (in units) is
(2 marks)
(c) What is the maximum inventory holding above which inventory should not rise?
 32,500 units
 34,500 units
 42,500 units
 58,500 units (2 marks)
Solution
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3 Costs involved with inventory

(a) Purchase: unaffected by stock policy unless bulk discounts are available.
Purchase costs = purchase price  annual demand = P  D
(b) Ordering: if a fixed amount per order is charged this will be affected by inventory
policy. If an amount per unit is charged, the cost will be fixed per annum
since it only depends on sales level (assumed constant).
D
Ordering costs = cost per order  number of orders pa = Co 
Q
(where Q = order quantity per order)

(c) Holding: will consist of some costs which are fixed per annum (ie warehouse
rental) and therefore irrelevant to inventory policy and those which vary
with the number of units held in inventory and are thus relevant to any
decision (ie, per unit insurance costs).
Holding costs = cost of holding one unit for one year  average
inventory throughout the year =
Q
CH  ( + minimum inventory)
2
A particular holding cost to look out for is the cost of capital tied up in
inventory
Worked example 1
When the purchase price of a unit is $10, the delivery cost per unit is $2 and the cost of capital is
15% p.a.
The total cost of putting one unit into inventory is $12.
If unit is held in inventory for 1 year, the holding cost = 15%  $12 = $1.80
4 The economic order quantity model

4.1 Introduction
Economic order quantity (EOQ) is a mathematical tool to calculate the amount of
inventory to order in each order and minimise the holding costs, ordering costs and
purchase costs.
4.2 Terms
P = purchase price
D = annual demand in units
CO = fixed cost per order
CH = cost of holding one unit for one year
Q = number of units ordered
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4.3 Assumptions
 Demand is constant
 Delivery is instantaneous or lead time is constant
 Purchase costs are constant (no discounts)
4.4 EOQ formulae

Annual inventory costs
Total inventory costs = ordering costs + purchase costs + holding costs
CQ
 total costs (TC) = CoD + PD+ H
Q 2
The total cost is minimised when
Q = EOQ = 2CoD
C
H
Lecture example 3
Demand 150 units per month
Cost per unit $25
Order cost $32
Holding cost 18% pa. of inventory value.
(a) What is the economic order quantity (in units)?
(b) What is the total cost associated with this order quantity?
(c) What are the holding and order costs for order quantities of 200, 600 and 1,000 units?
Solution
Workings
(a) EOQ
(b) Total cost
(c)
Quantity Holding costs Order costs
200 $ $
600 $ $
1,000 $ $
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4.5 Discounts
Discounts may be available if the order quantity is above a certain size. This needs to be
considered in determining the best order quantity.
The economic order quantity will give us the optimal order quantity to minimise holding,
ordering and purchase costs but it does not take into account bulk discounts available.
We therefore need to calculate total costs at discount levels to find the lowest total cost.
Steps
(1) Calculate EOQ in normal way.
(2) Recalculate EOQ if it falls within a discount band; Ch will have changed as it is a % of
purchase price.
(3) Calculate the total annual costs using the formula at the EOQ.
(4) Calculate annual costs at the lower boundary of each discount band above the EOQ.
(5) Select order quantity that minimises costs.
Lecture example 4
Using the same information as used in Basic EOQ, calculate the minimum total cost assuming the
following discounts apply:
Discount of 1% given on orders of 150 and over
The minimum total costs are: $
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Solution
Workings
Revised EOQ:
Number of
Discount units ordered Purchase cost Ordering cost Holding cost Total cost
$ $ $ $
1%
2%
4%
5 Economic batch quantity (EBQ)

The EBQ is a modification of the EOQ and is used when inventory is replenished gradually
to match production rates, rather than instantaneously.
This approach is used in order to minimise administration, reduce inventory holding costs
and to guarantee future inventory supplies where a company is manufacturing inventory for
its own use rather than ordering from an external supplier. Alternatively EBQ is used if the
external supplier is willing to deliver gradually.
For example, a company may wish to order a batch of 500,000 (Q) components to secure
supply whilst receiving delivery to match the weekly production demand for the components
of 50,000 (R) due to the limited availability of warehouse space.
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5.1 Terms
Q = The amount ordered per batch
D = Demand in the time period
CO = Set up cost of one batch/cost of making one order
CH = Holding cost per unit per time period
R = Production rate/delivery rate per time period
The EOQ formula is amended to reflect that Q units are never all held in inventory.
 EBQ = 2CoD
C  1  D 
 
H  R
Total holding costs = Q  1  D  C

 
2 R H
Lecture example 5
Berry Ltd has capacity to manufacture 800 cakes in a week. The cakes are demanded at a rate of
600 per week.
Set up costs for each production run are $5.40 and the holding cost of each unit is 5 cents per
week.
Required
(a) What is the EBQ (in units)?
(b) What are the total weekly holding and set up costs associated with inventory if the
Firm's aim is to minimise costs?
Solution
Workings
(a) EBQ units
(b) Holding costs $
Set up costs $
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Lecture example 6
Dixon always determines its order quantity for raw material R by using the Economic Order
Quantity (EOQ) model.
What would be the effects on the EOQ and the total annual holding cost of an increase in
the cost of ordering a batch of raw material R?
Solution
EOQ Annual Holding Costs
 Higher Lower
 Higher Higher
 Lower Higher
 Lower Lower
6 Inventory valuation methods

(a) FIFO (First in first out) assumes that unit purchased first are issued/sold before those
purchased later.
(b) LIFO (Last in first out) assumes the most recently purchased items are issued/sold
before those already in stock.
(c) AVCO(Average cost) calculates a cumulative weighted average of all the units in
inventory to value those issued/sold.
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Worked example 2
1 March
(Opening inventory) : 100 units bought at $2 each
2 March : bought 300 units at $2.10 each
5 March : sold 50 units for $5 each
17 March : bought 100 units at $2.30 each
20 March : sold 150 units for $5 each
Required
(a) Calculate the value of closing inventory at the end of March using:
(i) FIFO
Units Cost Value
1 March 100 2 200
2 March 300 2.10 630
5 March (50) (2) (100)
17 March 100 2.30 230
20 March (50) (2) (100)
(100) (2.10) (210)
300 650
(ii) LIFO
Units Cost Value
1 March 100 2 200
2 March 300 2.10 630
5 March (50) (2.10) (105)
17 March 100 2.30 230
20 March (100) (2.30) (230)
(50) (2.10) (105)
300 620
(iii) AVCO
Units Cost Value
1 March 100 200
2 March 300 630
5 March 400 2.075 830
(50) (2.075) (103.75)
17 March 100 230
450 2.125 956.25
20 March 150 (2.125) (318.75)
300 637.50
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(b) Calculate the gross profit for March using each of the methods:
FIFO LIFO AVCO
Sales (50  5) 250 250 250
(150  5) 750 750 750
1,000 1,000 1,000
Less: cost of sales (410) (440) (422.50)
FIFO: 100 + 100+ 210
LIFO: 105 + 230 + 105
AVCO: 103.75 + 318.75
590 560 577.50
(c) If prices are rising method of inventory valuation will give the
highest closing inventory value and will give the highest gross profit.
Workings
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7 Chapter summary
Topic Summary
Inventory control Inventory control includes the functions of inventory ordering and
purchasing, receiving goods into store, storing and issuing inventory and
controlling the level of inventories.
Ordering, receipt and Documents record the movements of raw materials.
issue of raw material
Monitoring of inventory Inventory should be counted on a periodic or perpetual basis in order to
levels match physical and book quantities.
Inventory control levels Inventory control levels can be calculated in order to maintain inventories
at the optimum level.
The three critical control levels are:
 Recorder level
 Minimum level
 Maximum level
Costs involved with Inventory costs include purchase costs, holding costs, ordering costs and
inventory stock-out costs.
The economic order The economic order quantity (EOQ) is the order quantity that minimises
quantity model inventory costs.
Discounts Discounts may be available if the order quantity is above a certain size.
This needs to be considered in determining the best order quantity.
Economic batch The economic batch quantity (EBQ) is a modification of the EOQ and is
quantity (EBQ) used when re-supply is gradual instead of instantaneous.
Inventory valuation 3 methods: FIFO, LIFO and AVCO.
END OF CHAPTER
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Accounting for labour

 Calculate direct and indirect costs of labour.
 Explain the methods used to relate input labour costs to work done.
 Prepare the journal and ledger entries to record labour cost inputs and outputs.
 Describe different remuneration methods: time-based systems, piecework systems and individual and group
incentive schemes.
 Calculate the level, and analyse the costs and causes of labour turnover.
 Explain and calculate labour efficiency, capacity and production volume ratios.
 Interpret the entries in the labour account.
Exam Context
As with materials costs in Chapter 5, the labour cost within a manufacturing or a service environment is a key area of the
syllabus. You can expect to see questions on this topic in section A of your examination.
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6: ACCOUNTING FOR LABOUR
Overview
Methods of remuneration Labour turnover
Measuring labour activity
Accounting for labour costs
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1 Introduction
The principle of recording and controlling costs incurred by a business, may also be applied
to labour costs. Businesses will normally require a system capable of analysing both labour
times and costs.
2 Method of remuneration
2.1 Time-based systems
Wages are determined by the number of hours worked. If an employee works more than
their basic hours, then an overtime payment might be made.
2.2 Piecework systems

In this case wages are calculated on the number of units/items produced. It is usual for
pieceworkers to be guaranteed a minimum wage.
2.3 Bonus/incentive schemes

Eg benefits-in-kind, profit sharing schemes and bonuses. These schemes were introduced
to compensate workers paid under a time-based system, who unlike pieceworkers, could
not increase their pay by being more efficient. The main aim of all these schemes is to
increase productivity.
Bonuses could be paid if an individual target is exceeded or if the output of a group exceeds
a target.
Lecture example 1
Normal working day 8 hours
Basic rate of pay $6 per hour
Standard time allowed to produce 1 unit 2 minutes
Premium bonuses 75% of time saved at basic rate
What is the cost of producing 340 units in one day?
Solution
$
Workings
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Lecture example 2
A company pays its employees using a piecework scheme. The rates are as follows:
0-100 units per week $4 per unit
101-150 units per week $4.50 per unit
151-200 units per week $5 per unit
201 + units per week $5.50 per unit
If an employee produces 163 units in week 48, what would their pay be for that week?
Solution
$
Workings
3 Measuring labour activity

3.1 Production is the quantity of output produced.
3.2 Productivity is a measure of the efficiency with which output has been produced. An
increase in productivity is likely to reduce unit costs.
3.3 A standard hour of production is the pre-determined output from one worker for one hour.
In other words a standard hour is a 'quantity of work' not a period of time.
Standard labour hours = actual units output  standard time per unit.
Lecture example 3
An employee makes 200 units of product A, 350 units of product B and 300 units of product C. The
standard time allowed per unit was:
A 4 minutes
B 2 minutes
C 3 minutes
What are the standard hours produced by the employee (in hours)?
126

Solution
Workings
4 Efficiency, capacity and production volume
Efficiency ratio = Standard hours to

make actual output
 100%
Actual hours worked
Capacity ratio = Actual hours worked
 100%
Budgeted hours
Production volume ratio = Standard hours to
make actual output
 100%
Budgeted hours
Measures of labour activity include the following:
Efficiency  Capacity = Production volume
Ratio ratio ratio
Lecture example 4
Barnes Ltd budgeted to make 13,000 standard units of output during a budgeted period of 26,000
hours (each unit should take two hours).
During the period, the company actually made 14,000 units which took 35,000 hours.
Required
(a) What is the efficiency ratio?
(b) What is the capacity ratio?
(c) What is the production volume ratio?

Give your answers to one decimal place.
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Solution
5 Labour turnover
Labour turnover is the rate at which employees leave a company and should ideally be kept
as low as possible.
5.1 Reasons for labour turnover include:
Controllable causes Uncontrollable causes

 Demotivated staff  Company recruit staff as trainees,
 Work not interesting / challenging therefore once qualified they have
more options open to them
 Staff not appropriately rewarded
 Staff leave to work for a competitor
5.2 Labour turnover can be calculated as follows:
Labour turnover rate = Replacements  100%

Average number of employees in period
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Lecture example 5
A company has 1,000 staff at the start of 20X3 and at the end this had reduced to 920 due to
redundancies being made.
100 staff took voluntary redundancy which was 20 more than the company had anticipated and
these 20 employees were replaced.
What is the labour turnover rate per year?
Give your answer to one decimal place.
Solution
Workings
5.3 Costs associated with labour turnover can be split into two categories
Replacement costs Preventative costs

 Cost of selection and placement  Costs to maintain good relationships
 Inefficiency of new labour  Costs of welfare
 Training Eg sports facilities; canteens; social
 Timing problems events
 Employee benefits
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6 Direct vs indirect costs

Labour costs can be broken down into both direct and indirect costs according to the type of
worker and the work done as follows:
Direct Workers Indirect Workers

Normal Basic Pay Direct Cost Indirect Cost
General Production: Overtime Direct Cost Indirect Cost
– Basic pay element
General Production: Overtime Indirect Cost Indirect Cost
– O/T Premium
General Non Production: Overtime Indirect Cost Indirect Cost
– Basic pay element
General Non Production: Overtime Indirect Cost Indirect Cost
– O/T Premium
Specific Overtime – Basic pay element Direct Cost Direct Cost
Specific Overtime – O/T Premium Direct Cost Direct Cost
Lecture example 6
Busy bees employs two types of labour: skilled workers, considered to be direct workers, and
semi-skilled workers considered to be indirect workers. Skilled workers are paid $10 per hour and
semi-skilled $7.50 per hour. All employees work a standard 35 hour week. There are seven skilled
workers and four semi-skilled workers.
The skilled workers have worked 50 hours of overtime this week, 20 hours on a specific order and
30 hours on general production.
The semi-skilled workers have worked 20 hours of overtime, 10 hours on a specific order at a
customer's request and the remaining 10 hours to meet general production requirements.
All overtime is paid at time and a half.
Required
(a) What are the total direct labour costs for the week? $
(b) What are the total indirect labour costs for the week? $
Give your answers to one decimal place.
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Solution
Workings
7 Ledger accounting
When gross wages are paid to employees they are accounted for as:
Dr: Wages control account
Cr: Bank/PAYE control account/NIC control account
Note. PAYE (pay-as-you-earn) is a withholding tax on income payments to employees and
NIC (National Insurance contributions) is a UK tax paid by employers and employees
to contribute to state benefits for the working population.
When labour is used within a particular production process, the direct labour costs are
transferred from the wages control account using:
Dr: Work in progress account
Cr: Wages control account
Indirect labour costs are transferred from the wages control account to be grouped with
other indirect costs using:
Dr: Production overhead account
Cr: Wages control account
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Wages control account

(1) Bank etc (2) WIP
(actual wages) X (direct labour) X
(3) Production overheads X
(indirect labour)
Income Statement  X
X X
Worked example 1
Using the data from the Busy Bee's activity construct a wages control account
Wages control account
$ $
Bank – net pay 3,580.00 Work in progress account
Deductions – PAYE/NIC 895.00 – direct labour 3,162.50
Production overheads
– indirect labour 1,312.50
4,475.00 4,475.00
8 Chapter summary
Topic Summary
Methods of Methods of remuneration for production staff include
remuneration  Time based systems
 Piecework systems
 Bonus/incentive systems
Measuring labour Labour productivity is a measure of the efficiency with which output has
activity been produced.
Companies will monitor productivity as part of their cost control
procedures. You need to be able to calculate
 Efficiency ratios
 Capacity ratios
 Production volume ratios
Labour turnover High labour turnover will cause increased cost to a business.
Accounting for labour Labour costs will be split between direct and indirect costs and double
costs entry will be used to record these costs.
END OF CHAPTER
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Accounting for
overheads

 Explain the different treatment of direct and indirect expenses.
 Allocate and apportion production overheads to cost centres using an appropriate basis.
 Reapportion service cost centre costs to production cost centres (including using the reciprocal method where
service cost centres work for each other).
 Select, apply and discuss appropriate bases for absorption rates.
 Prepare journal and ledger entries for manufacturing overheads incurred and absorbed.
 Calculate and explain the under and over absorption of overheads.
 Explain the importance of, and apply, the concept of contribution.
 Demonstrate and discuss the effect of absorption and marginal costing on inventory valuation and profit
determination.
 Calculate profit or loss under absorption and marginal costing.
 Reconcile the profits or losses calculated under absorption and marginal costing.
 Describe the advantages and disadvantages of absorption and marginal costing.
Exam Context
Overhead apportionment and absorption is one of the most important topics in your Management Accounting studies
and is almost certain to appear in section A of the examination you will be facing.
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7: ACCOUNTING FOR OVERHEADS
Overview
Marginal and absorption

costing
Cost card under AC Cost card under MC
Contribution
Profit/loss under AC Profit/Loss under MC
Reconciliations
Advantages/disadvantages of
AC and MC
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Absorption costing
Allocating overheads to units to Predetermine

find the full production cost OAR
3-step approach to absorption

costing
(1) Allocate & (2) Reapportion (3) Absorb

apportion
Under and over absorption of

overheads
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1 Absorption costing
1.1 Overview
Businesses need to be able to ascertain the cost of making their product or service for three
main reasons:
(1) Profitability analysis
(2) Determining the selling price
(3) Inventory valuation purposes
1.2 Cost card

A cost card can be built up for an individual unit.
For example:
Cost/unit
$
Direct materials 4 kg @ $2/kg 8
Direct labour 3 hours @ $7/hr 21
Direct expenses 4
Prime cost 33
Indirect costs (overheads) 10
Total cost 43
1.3 Production overheads

An overhead is a cost incurred in the course of production that can't be traced directly to the
product or service, hence they are often referred to as indirect costs.
Worked example 1
For example
Indirect materials Oil, grease, paper towels
Indirect labour Supervisors salary
Indirect expenses Rent, rates, insurance, depreciation
Ascertaining the direct costs of a cost unit to get the prime cost is usually quite straightforward.
However, since overheads are not identified with specific cost units we need a method to charge a
share of the total production overhead to each cost unit.
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2 The Absorption costing process

The objective of AC is to calculate the full production cost for a unit of output. It does this
by including an appropriate share of the organisation's overheads in the total cost of each
product.
2.1 Absorption costing overview
Total Production Costs
Direct Costs Indirect Costs

(overheads)
Should be easy to link directly More difficult to link

to unit and put in cost card to unit so we need a
methodology
Absorption Costing
Step 1 Cost Centres
Production 1 Production 2 Service
Step 2
Production 1 Production 2
Step 3
COST UNIT
Direct materials X
Direct labour X
Prime cost X
Indirect costs X
Full production cost/unit X
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2.2 Steps
Step 1 Allocate AND apportion production overheads to cost centres
Allocate – whole cost items are charged to a cost centre.
Apportion – cost items are divided between several cost centres.
Step 2 Reapportion overheads in service cost centres to production cost centres
Step 3 Absorb overheads into cost units
3 Step 1 – Allocation and apportionment of production

overheads to cost centres
The first stage in valuing the overhead cost of a cost unit is to allocate and apportion
overheads between the cost centres.
Lecture example 1
Overhead allocation and apportionment
Mars Ltd has the following overheads in the year ended 31 December 20X5:
Overhead: $
Rent and rates 90,000
Insurance of machinery and equipment 40,000
Stores costs (wages and salaries) 75,000
Heating costs 57,000
262,000
Additional information includes:
Mixing Stirring Stores Canteen Total
Floor space (square metres) 9,000 3,000 1,000 2,000 15,000
NBV of machinery and
Equipment $'000 2,000 1,000 600 400 4,000
Required
After allocating and apportioning overhead costs, calculate the total cost in the mixing dept, stirring
dept, stores and canteen:
Mixing department $ Store department $
Stirring department $ Canteen department $
138

Solution
Workings
Apportioned costs are apportioned to cost centre on 'some fair basis'. You will need to identify
relevant information from the question and think about why the cost is being generated, to decide
on the most appropriate basis.
4 Step 2 – Reapportionment of service cost centre

overheads
Factory cost centres can be broken down into two types:
(a) Production cost centres – through which cost units actually flow – these make the
cost units.
(b) Service cost centres – which support/service the production cost centres and each
other
Unit Mixing Stores Canteen
Production cost centres Service cost centres

Finished goods store
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We therefore need to transfer all service cost centre overheads to the production centres so
that all production overheads for the period are shared between the production cost centres
alone – as it is through these cost centres that cost units flow.
The reapportionment becomes a little more complicated where there is:
 More than one service cost-centre, and
 The service centres do work for one another (inter-service department work), for
example the canteen feeds employees in stores and stores holds materials for
canteen.
To reapportion service cost centre overheads to production cost centre there are three
methods.
Direct Step down Reciprocal
method method method
Inter-service Some inter-service All inter-service

department department work is department work
work is ignored recognised is recognised
or there is no inter– (sometimes called the
service work repeated distribution method)
(a) The direct method
All the inter-service department work is ignored and service centre overheads are
reapportioned directly to production cost centres. Mainly used when there is only one
service centre or the service centres do not work for each other.
A simple but inaccurate method.
(b) The step down method
A method best used when some service cost centres provide services to other service
cost centres, but these services are not reciprocated. For example when maintenance
employees eat in the canteen, but kitchen equipment is not serviced by the
maintenance department.
The service department that serves most other service centres should be
reapportioned first. We then 'step down' to the service centre that provides the second
most service, and so on.
This method provides a simple approximation.
(c) The reciprocal method (repeated distribution)
This method recognises all inter-service department work and is therefore more
accurate. This accuracy is more time consuming to calculate. If the examiner wants
this method used it will ask for a method that 'fully reflects the reciprocal services
involved'.
The reciprocal method can be carried out in two ways:
(i) Repeated distribution/continuous apportionment
or (ii) Algebraic method. (Most efficient use of time in the exam).
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Lecture example 2
Service cost re-apportionment
Production Depts. Service Centres
Mixing Stirring Stores Canteen
$ $ $ $
Allocated and apportioned
overheads
From Mars Ltd 108,200 39,400 90,800 23,600
Estimated work done by the

service centres for other
departments:
Stores 50% 30% – 20%
Canteen 45% 40% 15% –
Required
After the apportionment of the service departments to the production department, the total
overhead costs for the production departments using the different methods will be:
Mixing Stirring
(a) Direct $ $
(b) Step down $ $
(c) Repeated distribution $ $
(d) Algebraic $ $
Solution
Workings
(a) Direct method
Prod depts. Service centres
Mix Stir Stores Canteen
$ $ $ $
Overheads 108,200 39,400 90,800 23,600
(b) Step down method

$ $ $ $
Overheads 108,200 39,400 90,800 23,600
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(c) Reciprocal method

$ $ $ $
Overheads 108,200 39,400 90,800 23,600
Reapportion
Stores (50:30:20) 45,400 27,240 (90,800) 18,160
– 41,760
Reapportion
Canteen (45:40:15) 18,792 16,704 6,264 (41,760)
6,264 –
Reapportion
Stores (50:30:20) 3,132 1,879 (6,264) 1,253
– 1,253
Reapportion
Canteen (45:40:15) 564 501 188 (1,253)
188 –
Reapportion
Stores (50:30:20) 94 56 (188) 38
– 38
Reapportion
Canteen (45:40:15) 17 15 6 (38)
6 –
Reapportion
Stores (50:30:20) 3 2 (6) 1
– 1
Reapportion
Canteen (45:40:15) 1 – – (1)
176,203 85,797 – –
(d) Algebraic method
$ $ $ $
Overheads 108,200 39,400 90,800 23,600
Workings
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Lecture example 3
A Co has two production cost centres (A and B) and two service cost centres (C and D). The
following overheads have been apportioned and allocated to the cost centres.
Cost Centre A B C D
Allocated and apportioned overhead $ 12,000 16,000 8,000 10,000
The company has calculated the following usage of C and D's services.
A B C D
Use of C's services 60% 30% Nil 10%
Use of D's services 80% 20% Nil Nil
How much would A's total overhead cost be if the company used the step-down method to
reapportion service cost centre overheads?
 $16,800
 $20,000
 $24,800
 $25,440
Solution
5 Step 3 – Absorption of overheads into production

(cost units)
All of the production overhead costs have now been apportioned to the production cost
centres. We now need to charge these to the cost units passing through the production cost
centres. This is termed absorption. We are going to absorb an element of total production
overhead into each cost unit.
Production overhead
OAR (overhead absorption rate) =
Activity level
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5.1 Choosing the activity

Ideally, the basis chosen for the activity should be the one which most accurately reflects
the way in which the overheads are in fact being incurred:
For example:
 Per unit
 Per labour hour Main methods used in exam
 Per machine hour
 % of direct labour cost
 % of direct materials cost
 % of prime cost
5.2 Process of absorption into cost units
Where the OAR has been calculated using an activity other than units some extra
calculation will be required to get the cost for the cost card.
(a) Calculate the overhead absorption rate using an appropriate activity level (eg
machine hours).
Production overhead
OAR =
Activity Level (eg machine hours)
(b) Find the activity level per unit (eg machine hours per unit) and then apply the OAR
calculated to the specific unit.
OAR per unit = OAR per machine hour  machine hours per unit
(c) Repeat for all production cost centres.
Remember each production cost centre may absorb overhead on a different basis.
These steps complete the process described in the diagram.
Lecture example 4
Mars Ltd has decided to use the direct method to re-apportion service centre costs to its two
production departments, mixing and stirring.
As calculated previously this resulted in allocated overheads of $177,444 and $84,556 to the
mixing and stirring departments respectively.
During the year the following data has been collected:
Mixing Stirring
Direct labour hours 12,500 4,000
Direct machine hours 2,000 10,000
Number of batches of Mars bars 2,500 2,500
(each batch consists of 1,000 bars)
Direct materials cost $75,000 $30,000
Direct labour cost $62,500 $20,000
Note that Mars Bars are just one of many products produced by Mars Ltd in this factory.
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Required
(a) Decide which basis you think is most appropriate for the absorption of overheads in each
department and state why.
(b) Using the bases chosen in (a), calculate the overhead absorption rate per batch
(i) in the mixing department.
(ii) in the stirring department.
Solution
Workings
6 Under and over absorption of overheads

Under and over absorption of overheads occurs because the predetermined overhead
absorption rates are based on estimates.
Over absorption means that the overheads charged to the cost of sales are greater than
the overheads actually incurred.
Under absorption means that insufficient overheads have been included in the cost of
sales.
It is almost inevitable that at the end of the accounting year there will have been an over
absorption or under absorption of the overhead actually incurred.
The under/over absorption of overheads can be calculated as follows:
$
Actual overhead incurred X
Overhead absorbed (OAR x actual units) (X)
Under/over absorption of overheads X/(X)
If the actual overhead incurred is greater than the absorbed overhead, then overheads are
under absorbed
If the actual overhead incurred is less than the absorbed overhead, then overheads are over
absorbed
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Lecture example 5 Exam standard 2 marks
A company uses an overhead absorption rate of $2.50 per machine hour, based on 32,000
budgeted machine hours for the period. During the same period the actual total overhead
expenditure amounted to $78,875 and 30,000 machine hours were recorded on actual production.
By how much was the total overhead under or over absorbed for the period?
 Over absorbed by $3,875

 Under absorbed by $5,000
 Over absorbed by $ 5,000
 Under absorbed by $3,875
Solution
7 Marginal costing
Some businesses only want to know the variable costs of the units they make, regarding
fixed costs as period costs.
Marginal costing (MC) includes only the variable cost of a product or a service. That is a
cost which would be avoided if the unit was not produced or provided.
Cost card – marginal costing
$/unit
Direct materials X
Direct labour X Used to value
Variable overhead X inventory
under MC
Marginal cost X
Used to value
Fixed overheads X inventory
under AC
Full production cost X
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7.1 Calculating a profit or loss under marginal costing

$ $
Sales X
Less: Variable cost of sales:
Opening inventory X
Production costs:
– Variable X
X
Less: closing inventory (X)
(X)
X
Less: Variable selling, distribution and (X)
administration costs
CONTRIBUTION X
Less Fixed costs:
Production X
Selling and distribution X
Administration X
(X)
NET PROFIT X
Note. Inventories are valued at variable production costs only.
Lecture example 6
Goodtime Ltd manufactures cheap watches which it sells to wholesalers for $25.
The cost card for each watch is as follows:
$
Direct materials 7
Direct wages 8
Variable production overheads 5
20
There is a variable selling cost per unit of $0.50.
Additional information:
Year 1 Year 2
units units
Normal/budgeted production 12,000 12,000
Actual production 14,000 11,500
Actual sales 13,000 12,500
Actual fixed production overheads $11,000 $11,000
Actual fixed selling costs $5,000 $5,000
There is no opening inventory. All variable costs were as per budget for the two years.
Required
Set out a profit and loss account under marginal costing for both years 1 and 2.
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Solution
Year 1 Year 2
$ $ $ $
Sales
Less: Variable cost of sales
Opening inventory
Production costs – variable
Less closing inventory
Less variable selling costs
Contribution
Less: Fixed costs

– Production
– Selling
Net profit
Workings
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8 Contribution
Contribution is a fundamental concept in marginal costing. Contribution is an abbreviation of
'contribution towards fixed costs and profit'.
It is the difference between selling price and all variable costs (including non-production
variable costs), usually expressed on a per unit basis.
$ $
Selling price X
Less: Variable production costs X
Variable non-production costs X
(X)
Contribution X
Note. Contribution takes account of all variable costs. Marginal costing takes account of
variable production costs only and inventory is valued at marginal cost.
Lecture example 7
Parsons has budgeted to produce 5,000 units of Product E per month. The opening and closing
inventories of Product E for next month are budgeted to be 400 units and 900 units respectively.
The budgeted selling price and variable production costs per unit for Product E are as follows:
$ per unit
Selling price 20.00
Direct costs 6.00
Variable production overheads 3.50
Total budgeted fixed production overheads are $29,500 per month.
What is the budgeted profit for Product E next month under marginal costing?
$
Solution
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9 Advantages and disadvantages of marginal costing

9.1 Advantages
 Appropriate for decision making as it highlights contribution. (It is useful for short-
term pricing decisions or decisions on one-off or ad-hoc contracts.)
 Fixed costs are treated in accordance with their nature, ie as period costs.
 Profit depends on sales and efficiency not on production levels.
9.2 Disadvantages
 There is a danger that products will be sold on an ongoing basis at a marginal
contribution which fails to cover fixed costs.
 Does not comply with IAS 2, thus necessitating year-end adjustments for the
preparation of published accounts.
 Mixed costs must be split into fixed and variable elements.
10 Calculating a profit or loss under absorption costing

$ $
Sales X
Less: Cost of sales:
Opening inventory X
Production costs:
Variable costs X
Fixed overhead absorbed X
Adjustment Fixed overhead under/(overhead absorbed) X/(X)
Less: Closing inventory (X)
(X)
Gross profit X
less: Non production costs (selling, administration etc) (X)
Net profit X
Note. Inventory is valued at full production cost.
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Worked example 2
Goodtime decides that it wishes to implement absorption costing
Selling price $25.
Cost card per unit:
$
Direct materials 7
Direct wages 8
Variable production overheads 5
Fixed production overheads 0.90
20.90
There is also a variable selling cost per unit of $0.50
Year 1 Year 2
units units
Normal/budgeted production 12,000 12,000
Actual production 14,000 11,500
Actual sales 13,000 12,500
Actual fixed production overheads $11,000 $11,000
Actual fixed selling costs $5,000 $5,000
There is no opening inventory. All variable costs were as per budget for the two years.
Required
Calculate the total budgeted fixed production overhead
(a) OAR = $0.90
Budgeted fixed production overheads
OAR =
Normal activity
Budgeted fixed production overheads
 $0.90 =
12,000
Budgeted fixed production overhead = 12,000  $0.90
= $10,800
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(b) Calculate the profit/(loss) under absorption costing for years 1 and 2.
Absorption profit and loss
Year 1 Year 1 Year 2 Year 2
$ $ $ $
Sales @ $25 325,000 312,500
Less: CoS:
Opening inventory – 20,900
(1,000  $20.90)
Production costs
– variable
(14,000  $20) 280,000
(11,500  $20) 230,000
– fixed (absorbed)
(14,000  $0.90) 12,600
(11,500  $0.90) 10,350
Adjustment for (Over)/under
absorption (see Ch 13) (1,600) 650
291,000 261,900
Less: closing inventory
(1,000  $20.90) (20,900) –
271,700 261,900
(270,100) (261,900)
Gross profit 54,900 50,600
Less: selling costs

– variable
(13,000  $0.50) (6,500)
(12,500  $0.50) (6,250)
– fixed (5,000) (5,000)
Net Profit 43,400 39,350
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11 Absorption vs Marginal costing

costing
CONTRIBUTION
Profit/loss under AC
Profit/Loss under MC
Reconciliations
AC and MC
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Worked example 3
Year 1 Year 2 Total
$ $ $
Absorption costing 43,400 39,350 82,750
Marginal costing 42,500 40,250 82,750
900 (900) –
 Overall the same profit is recognised
 The difference arises from different inventory valuations. (Absorption costing inventory
valued at $20.90 per unit and marginal costing inventory valued at $20 per unit.)
11.1 Reconciling profits

Profits generated using AC and MC can also be reconciled as follows:
Difference in the profit = Change in inventory in units × OAR per unit
To work out which profit figure is greatest remember when:
Production > Sales

Closing inventory > Opening inventory
AC profit > MC profit
Lecture example 8
The following budgeted information relates to a manufacturing company, Perry, for the next period:
Units $
Production 35,000 Fixed production costs 157,500
Sales 30,000 Fixed selling costs 30,000
The normal level of activity is 35,000 units per period.
Using absorption costing the profit for next period has been calculated as $90,000.
What would be Perry's profit for the next period using marginal costing?
$
Solution
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11.2 Advantages and disadvantages of absorption costing and marginal costing
Absorption costing Marginal costing

Advantages
 Recognises that selling price must cover  Highlights contribution so appropriate for
all costs. decision making.
 Complies with IAS 2.  Fixed costs treated in accordance with
their nature.
 Profit depends on sales and efficiency not
production levels.
Drawbacks
 Profits can be manipulated by changing  Danger that contribution fails to cover
production levels. fixed costs.
 Based on the assumption that overheads  Does not comply with IAS 2
are volume related.
 Necessitates analysis of mixed costs
between fixed and variable
12 Working backwards
Exam questions may give you the movement in inventory and the difference in profits and the ask
you to work backwards in order to calculate the OAR:
Worked example 4
In a period, opening inventories were 12,600 units and closing inventories 14,100 units. The profit,
based on marginal costing, was $50,400 and profit using absorption costing was $60,150. The
fixed overhead absorption rate per unit is:
Units
Opening inventory 12,600
Closing inventory 14,100
Increase in inventory level 1,500
$
Absorption costing profit 60,150
Marginal costing profit 50,400
Difference in profit 9,750
Difference in the profit = Change in inventory in units x OAR per unit
Therefore OAR = Difference in the profit/ Change in inventory in units
OAR =$9,750/1,500 = $6.50 per unit
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Lecture example 9
In a period, opening inventories were 10,000 units and closing inventories 11,000 units. Profits,
based on marginal costing, were $100,000 and profit under absorption costing was $105,000.
What is the fixed overhead absorption rate per unit?
Solution
 $0.50
 $5.00
 $4.50
 $5,000
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12 Chapter summary
Topic Summary
Overheads Overheads are costs incurred in the course of making a product that
can't be directly linked to a unit.
Absorption costing The objective of absorption costing is to include a share of the
(AC) overheads in the total cost of the product.
Step 1 – Allocation and The first stage in valuing the overhead cost of a cost unit is to allocate
apportionment and apportion overheads between the cost centres.
Step 2 – The second stage is to transfer all service cost centre overheads to the
Reapportionment production centres – as it is through these cost centres that cost units
flow.
Step 3 – Absorption The final stage is to charge the overheads to the cost units passing
through the production cost centres using an overhead absorption rate
(OAR).
Under and over If actual overhead incurred less absorbed overhead = NEGATIVE, then
absorption of overheads are over absorbed
overheads If actual overhead incurred less absorbed overhead = POSITIVE, then
overheads are under absorbed
Marginal costing The marginal cost is the variable production cost of one unit.
Contribution Contribution is the amount that a unit contributes towards fixed costs
when it is sold. It is calculated as selling price less all variable costs.
Calculating a profit or In marginal costing fixed costs are treated as period costs and are
loss under marginal deducted from total contribution
costing
Calculating a profit or In absorption costing fixed costs are absorbed into the units of
loss under absorption production and carried forward in closing inventory. (Which is valued at
costing the full production cost)
Absorption costing vs. AC recognises that all costs must be covered in the long run, whilst MC
marginal costing is better for short-term decision making.
Reconciliation of The different inventory valuations in AC and MC can lead to different
absorption and profits being reported.
marginal costing profits The difference can be reconciled by multiplying the change in the
inventory by the OAR.
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END OF CHAPTER
158

You have now covered the Topics that will be assessed in Step 2 of your Achievement Ladder. This
mainly focuses on the shaded topics below but will also include some recap questions on earlier
topics.
Course notes
chapter
Forecasting 4
Fundamentals of costing Accounting for materials 5
Accounting for labour 6
Accounting for overheads Accounting for overheads 7
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ACHIEVEMENT LADDER
160

Process costing

 Describe the characteristics of process costing.
 Describe the situations where the use of process costing would be appropriate.
 Explain the concepts of normal and abnormal losses and abnormal gains.
 Calculate the cost per units of process outputs.
 Prepare process accounts involving normal and abnormal losses and abnormal gains.
 Calculate and explain the concept of equivalent units.
 Apportion process costs between work remaining in process and transfers out of a process using the weighted
average and FIFO methods.
 Prepare process accounts in situations where work remains incomplete.
 Prepare process accounts where losses and gains are identified at different stages of the process.
Note. Situations involving WIP and losses in the same process are excluded.
Exam Context
Process costing has historically been a common examination question. In section A you might be required to do
calculations for completion of a process account. Make sure that you can deal with losses, gains, scrap and WIP,
however losses and WIP will not be examined in the same question.
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8: PROCESS COSTING
Overview
Process costing
General principles of process Abnormal loss or gain Work in progress (WIP)

costing
Normal losses
Closing WIP Opening WIP
Without scrap With scrap

value value
Subsequent/previous processes
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8: PROCESS COSTING
1 Introduction
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
involved. Process costing involves the averaging of the total costs of each process over the
total output of that process.
Examples of processes where process costing may be used are:
 Oil refining
 Paper production
 Food and drink production
 Chemical production
Inputs Process 1 Good output
Input costs
Cost per unit =
Units
1.1 Process costing no losses
Worked example 1
Input to Process I during a period was 1,000 units of raw materials, which cost $40,000.
Other costs were: labour $50,000 and overheads $20,000.
All of the output was transferred to Process II.
Required
Complete the process account.
Solution
Unit calculation
Input units = Good output
1,000 = 1,000
Process I
Units $ Units $
Raw materials 1,000 40,000 To Process II 1,000 110,000
Labour 50,000
Overheads 20,000 –
1,000 110,000 1,000 110,000
Costs 110,000
Cost/unit = = = $110 / unit
Output 1,000
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8: PROCESS COSTING
2 Normal loss – with no scrap value

2.1 Definition
Normal loss is the loss that is expected from a businesses experience of the process eg
wastage or evaporation.
Good output
Inputs Process 1 Normal loss – expected
Worked example 2
Input and costs same as in Process I.
Additional we have discovered that losses normally account for 10% of input.
Actual output was 900 units.
Required
Prepare the Process I ledger account
Solution
Unit calculation
Input units = Good output + Normal loss
1,000 = 900 100
Process I
Units $ Units $
Raw materials 1,000 40,000 Normal loss 100 –
Labour 50,000 To Process II 900 110,000
Overheads 20,000
1,000 110,000 1,000 110,000
Costs $110,000
Cost/unit = = = $122.22 / unit
Normal Output 900
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8: PROCESS COSTING
3 Normal loss – with a scrap value

Any proceeds we receive for the normal loss can be used to reduce the processing costs.
Input cost - scrap value of normal loss
Cost per unit =
Input units - normal loss units
Normal loss can be calculated in several ways, depending on the normal expectation of the
process:
 % of input (most common) – this means materials input only not opening WIP;
 % of throughput = opening WIP + materials input – closing WIP;
 % of good output
 % of total output = good output + losses.
Worked example 3
Required
Prepare the Process and Scrap ledger accounts for the following situations using the data from
Process I.
All scrapped units have a scrap value of $20 each.
Solution
Unit calculation
Input units = Good output + Normal loss
1,000 = 900 100
Process I
Units $ Units $
Raw materials 1,000 40,000 Normal loss 100 2,000
Overheads 20,000
1,000 110,000 1,000 110,000
cost  scrap value of normal loss 110,000  2,000

Cost/unit = = = $120 / unit
input units  normal loss units 1000  100
Scrap Account
Units $ Units $
Normal loss 100 2,000 Cash 100 2,000
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8: PROCESS COSTING
4 Abnormal loss or gain

An abnormal loss or gain occurs when the actual loss is different to expected loss.
Good output (hopefully!)
Inputs Process 1 Normal loss Expected

Abnormal loss
Or NOT
Abnormal gain expected
4.1 Abnormal loss

This is the excess of actual spoilage over normal spoilage. The abnormal loss should be
valued at the same cost per unit as a good unit and any losses or gains taken to the
income statement for the period.
Worked example 4
As before, but output to Process II is 880 units not 900 units as expected.
Required
Prepare appropriate ledger accounts.
Solution
Unit calculation: Input units = Good output + Normal loss +/– Abnormal loss/(gain).
Unit calculation
Input units = Good output + Normal loss +/– Abnormal loss/(gain)
1,000 = 880 + 100 + 20
Abnormal loss
Process I
Units $ Units $
Overheads 20,000 Abnormal loss 20 2,400
1,000 110,000 1,000 110,000
Input costs – scrap value of normal loss

Cost/unit =
input units – normal loss units
$110,000  $2,000
=
1,000  100
= $120/unit
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8: PROCESS COSTING
Scrap Account
Units $ Units $
Normal loss 100 2,000 Cash 120 2,400
Abnormal loss 20 400
120 2,400 120 2,400
Abnormal Losses Account
Units $ Units $
Abnormal loss 20 2,400 Scrap 20 400
P&L a/c – 2,000
20 2,400 20 2,400
4.2 Abnormal gains

This is the shortfall of actual spoilage from normal spoilage. It is treated in the same way as
the abnormal loss. (Actual loss is less than the normal loss expected.)
Worked example 5
As before but output to process II is 920 units, not 900 units as expected.
Required
Prepare appropriate ledger accounts.
Solution
Unit calculation
1,000 = 920 + 100 – 20
Abnormal gain
Process I
Units $ Units $
Overheads 20,000
Abnormal gain 20 2,400
1,020 112,400 1,020 112,400
Scrap Account
Units $ Units $
Normal loss 100 2,000 Abnormal gain 20 400
Cash 80 1,600
100 2,000 100 2,000
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8: PROCESS COSTING
Abnormal Gains Account

Units $ Units $
Scrap 20 400 Abnormal gain 20 2,400
P&L account 2,000
20 2,400 20 2,400
Cost/unit =
Input units – normal loss units
$110,000  $2,000
=
1,000  100
= $120/unit
Lecture example 1
Information relating to two processes (J and K) was as follows:
Process Normal loss as % of input Input (kg) Output (kg)

J 3 85,000 82,400
K 7 47,000 44,000
For each process was there an abnormal loss or an abnormal gain?
Process J Process K
Abnormal gain Abnormal gain
Abnormal gain Abnormal loss
Abnormal loss Abnormal gain
Abnormal loss Abnormal loss
5 Subsequent processes
Costs in each process include the full cost of material inputs from previous processes.
Good output Process 2
Inputs Process 1 Normal loss (to scrap a/c)

Abnormal
loss/gain (to abnormal gains/losses a/c)
Labour and overhead costs together are called conversion costs.
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8: PROCESS COSTING
Lecture example 2
The output from process I 920 units with a value of $110,400 forms the input to process II.
Normal loss in process II is 10% of good output (from process II) and has no scrap value. Output
from process II is 900 units.
Other inputs to process II are:
Added materials $20,600
Conversion $35,000
Required
Prepare an appropriate ledger account given the above information.
Solution
Unit calculation
Process II
Units $ Units $
6 Work in progress
At the end of the accounting period we may have two types of output from the process:
(a) Fully completed good output
(b) Output that has not yet been finished
This partially completed output is known as work in progress (WIP).
6.1 Valuing WIP

If we compare the value of one unit of WIP with the value of one unit of good output the
value of the unit of WIP will be less than the value of one unit of good output. This is
because WIP is only partially completed. To make comparison easier we restate partially
completed units in terms of equivalent whole units.
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8: PROCESS COSTING
Lecture example 3
Finished goods
200 units
Input costs $250

PROCESS
Input units 300
WIP 50%
complete
100 units
Required
(a) (i) Using the usual cost per unit calculation, what would the cost per unit be?
$
(ii) What would the value of WIP be ? $
(iii) What would the value of finished goods be? $
(b) (i) Using equivalent units, what would the cost per equivalent be?
$
(ii) What would the value of WIP be? $
(iii) What would the value of finished goods be? $
Solution
Workings
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8: PROCESS COSTING
7 Closing WIP (no opening WIP)
Lecture example 4
Finish It does not manage to get all of its WIP processed before the end of the period.
The following are introduced into Process I.
Raw materials 1,500 units $12,000
Labour $8,880
Overheads $2,930
Closing WIP: 50 units – completed as below
Raw materials 100% complete
Labour 60% complete
Overheads 30% complete
There were no losses.
Required
Prepare appropriate ledger accounts given the information above.
(a) Unit calculation: Input units = Good output + Normal +/– Abnormal + Closing
Loss Loss / (gain) WIP
Process I
Units $ Units $
Raw materials Output to Process II
Labour
Overheads
(b) Complete the statement of equivalent units

Actual Equivalent units
units Materials Labour Overheads
Finished output
Closing WIP
(c) Cost per cost type

Input costs
(d) Calculate the cost per equivalent unit.
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8: PROCESS COSTING
Workings
(e) Valuations
The value of finished goods is
The value of closing WIP is
Workings
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8: PROCESS COSTING
Lecture example 5
Henleaze Co operates a process in which no losses are incurred. The process account for last
month, when there was no opening work-in-progress, was as follows:
Process account
Units $ Units $
Costs arising 12,000 385,000 Finished output 7,000 245,000
Closing WIP 5,000 140,000
Rounding
12,000 385,000 12,000 385,000
The closing work-in-progress was complete to the same degree for all elements of cost.
What was the percentage degree of completion of the closing work-in-progress?
Solution
 20%
 42%
 70%
 80%
Workings
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8: PROCESS COSTING
8 Opening and closing WIP

The closing WIP from one accounting period will become the opening WIP in the next.
There are two methods that we can use when there is opening WIP.
8.1 FIFO
 Assumes that opening WIP is completed first;
 Spreads costs incurred in the period over work done in that period;
ie (i) FG/output (started and finished)
(ii) Opening WIP (finished)
(iii) Closing WIP (started)
and then add on the opening WIP costs to the sum of (i) and (ii) to give the total costs of
finished output.
8.2 Weighted average

 All items are equally likely to be completed;
 Spread all costs (including those b/fwd in opening WIP) over all units
Unit calculation:
Opening + Input = Good output + Normal + / – Abnormal + Closing WIP
WIP Units loss loss/(gain)
Note. Exam questions will not contain both WIP and losses
Worked example 6
If there was closing WIP at the end of the previous period this becomes opening WIP for the
following period:
Raw materials 2,050 units $22,550
Labour $16,304
Overheads $8,212
Opening WIP: 50 units
Output from Process I : 2,020 units
Closing WIP: 80 units complete as below
Raw materials 100% complete
Labour 60% complete
Overheads 60% complete
There were no losses.
Required
Prepare a Process I ledger account using (a) FIFO and (b) weighted average methods.
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8: PROCESS COSTING
Solution
(a) FIFO
Op WIP + Input = Good + Normal +/– Ab + Cl WIP
units output loss loss/gain
50 + 2,050 = 2,020 + 0 + 0 + 80
Process I
Units $ Units $
Opening WIP 50 610 To Process II 2,020 46,220
Raw materials 2,050 22,550
Labour 16,304
Overheads 8,212 Closing WIP 80 1,456
2,100 47,676 2,100 47,676

Statement of equivalent units
Equivalent units
Actual units Materials Labour Overheads
Opening WIP 50 – 20 35
(completed)
Started & finished 1,970 1,970 1,970 1,970
Output 2,020 1,970 1,990 2,005
Closing WIP (started) 80 80 48 48
2,100 2,050 2,038 2,053
Costs per equivalent unit

$ $ $
Costs 22,550 16,304 8,212
Cost/EU $11.00 $8.00 $4.00
Total cost/EU $23.00
Valuations
Good output $
Costs b/f in opening WIP 610
Materials (1,970  $11.00) 21,670
Labour (1,990  $8.00) 15,920
Overheads (2,005  $4.00) 8,020
46,220
Closing WIP $
Materials (80  $11.00) 880
Labour (48  $8.00) 384
Overheads (48  $4.00) 192
1,456
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8: PROCESS COSTING
(b) Weighted average

Process I
Units $ Units $
Opening WIP 50 610 To Process II 2,020 46,238
Raw materials 2,050 22,550 Closing WIP 80 1,448
Labour 16,304
Overheads 8,212 Rounding (10)
2,100 47,676 2,100 47,676
Statement of equivalent units
Equivalent units
Actual units Materials Labour Overhead
Good output 2,020 2,020 2,020 2,020
Closing WIP 80 80 48 48
2,100 2,100 2,068 2,068
Cost per equivalent unit

Materials Labour Overhead
$ $ $
Costs – b/f 400 180 30
– incurred 22,550 16,304 8,212
22,950 16,484 8,242

Cost/EU $10.93 $7.97 $3.99
Total Cost/EU $22.89
Valuations
$
Good output
(2,020  $22.89) 46,238
Closing WIP $
– materials (80  $10.93) 874.40
– labour (48  $7.97) 382.56
– overheads (48  $3.99) 191.52
1,448.48
8.3 FIFO or weighted average?

Questions will not always state which method to use. You can make this choice by looking
at how the opening WIP is quoted.
Information about opening WIP includes:
(1) % complete – materials  FIFO Method
% complete – conversion
Total cost brought forward
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8: PROCESS COSTING
(2) Not given %s complete information  Weighted Average Method

Total cost brought forward broken down into:
$ materials
$ conversion
Lecture example 6
A company which operates a process costing system had work-in-progress at the start of last
month of 750 units (valued at $6,375) which were 60% complete in respect of all costs. Last month
a total of 5,000 units were completed and transferred into the finished goods warehouse. The cost
per equivalent unit for costs arising last month was $15. The company uses the FIFO method of
cost allocation.
What was the total value of the 5,000 units transferred to the finished goods warehouse last
month?
Solution
 $68,250
 $74,625
 $75,000
 $82,625
9 Previous processes
The output from one process may undergo further processing in a subsequent process.
Say we have Process I and Process II. The output from Process I becomes an input into
Process II. So in Process II we may have:
 Opening WIP
 Materials from Process I
 Added materials
 And conversion costs
All WIP in Process II must by definition be 100% complete in terms of Process I inputs
(the Process I material).
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10 Chapter summary
Topic Summary
Process costing Process costing can be used in a situation where it is not possible to
identify separate units of production.
Normal loss Expected losses are called normal losses.
Abnormal loss or gain During the process abnormal gains or losses may occur, when the actual
loss differs to the expected loss.
Subsequent processes Costs in each process include the full cost of material inputs from
previous processes.
Work in progress Opening and closing WIP can be accounted for using either the FIFO or
weighted average method.
Question approach:
 Determine output/losses and WIP units.
 Set up account and fill out easy parts. ie units and value of normal
loss
 Calculate the cost per equivalent unit.
 Complete accounts
FIFO Use if opening WIP given in %
Weighted Average Use if opening WIP given in $
Previous processes The output from one process may undergo further processing in a
subsequent process. It must be fully complete before it can be
processed further.
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Costing methods

 Describe the characteristics of job and batch costing.
 Describe the situations where the use of job or batch costing would be appropriate.
 Prepare cost records and accounts in job and batch costing situations.
 Establish job and batch costs from given information.
 Identify situations where the use of service/operation costing is appropriate.
 Illustrate suitable unit cost measures that may be used in different service/operation situations.
 Carry out service cost analysis in simple service industry situations.
 Distinguish between by-products and joint products.
 Value by-products and joint products at the point of separation.
 Prepare process accounts in situations where by-products and/or joint products occur
 Explain activity based costing (ABC), target costing, life cycle costing and total quality management (TQM) as
alternative management techniques.
 Differentiate ABC, Target costing and life cycle costing from the traditional costing techniques (note calculations
are not required).
Exam Context
This is a popular topic for questions. Make sure that you are able to deal with basic calculations for section A of the
examination.
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Overview
Costing methods
Job and Service industry Joint products &

batch costing by-products
Joint products By-products
Composite cost
units
Cost card
Accounting
treatments
Service Method of allocating costs

department
costing
Alternative costing principles
Activity Based Total Quality Life Cycle Target

Costing(ABC) Management(TQM) Costing Costing
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9: COSTING METHODS
1 Job and batch costing

Job and batch
1.1 A job is a cost unit that consists of a single order or contract. Each job is separately
identifiable and costs can be attributed to each job eg construction of a rail link.
1.2 A batch is a cost unit that consists of a separate, readily identifiable group of units, eg
production of 10,000 disposable razors. Here the cost of a single unit is too small to be
measured in $'s.
Lecture example 1
Suggest three examples of businesses that use job costing.
Solution
(1)
(2)
(3)
1.3 Cost cards

A cost card can be drawn up for each job or batch using absorption costing or marginal
costing techniques in the same way as for individual products.
A job cost card would look like:
Job XYZ
$
Direct materials X
Direct labour (hrs  $/hr) X
Direct Expenses X
PRIME COST X
Variable overheads (hrs  $/hr) X
Fixed overheads X
TOTAL COST X
The organisation may also absorb non-production overheads and include these in the
estimate of the total jobs cost.
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Lecture example 2
A company is preparing for job X112. The job requires materials worth $1,350 and 150 hours of
labour.
Labour is paid at $6 per hour, variable overheads are absorbed at a rate of $2 per labour hour and
fixed overheads at a rate of $3 per labour hour.
What is the total cost of job X112?
Solution
$
Workings
1.4 Rectification costs

If the finished output is found to be substandard, it may be possible to rectify the fault.
Rectification costs can be split into two categories:
 Rectification work that is not a frequent occurrence
 is charged as a direct cost to the job
 Rectification work that is a frequent occurrence
 is treated as a production overhead
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2 Service industry costing
Lecture example 3
(a) Suggest three examples of service organisations:
(1)
(2)
(3)
(b) Consider how service organisations differ from manufacturing organisations?
Service Manufacturing
Product
Types of cost
Cost unit
Heterogeneous/homogenous
2.1 Differences between service organisations and manufacturing

Simultaneous
The production and consumption of a service are simultaneous, and therefore it cannot be
inspected for quality in advance.
Heterogeneous
A service is heterogeneous. The service received will vary each time. Services are more
reliant on people. People are not robots, so how the service is delivered will not be identical
each time.
Intangible
A service is intangible. The actual benefit being bought cannot be touched.
Perishable
Services are perishable, that is, they cannot be stored. For example a hairdresser cannot do
haircuts in advance and keep them stocked away for when demand increases.
This can be remembered using SHIP.
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Lecture example 4
Suggested cost units that might be used by the service industry companies listed below.
Solution
Service Cost unit
Hotels
Education
Hospitals
Catering establishments
2.2 Cost per unit

Total costs for period
Cost per unit =
Number of service units in the period
2.3 Charging customers for services

The procedure for charging customers for services is similar to that which applies in job
costing. A mark up will be added to the cost per unit to give a selling price which will provide
the required level of profit.
The choice of the cost unit by the organisation is important to ensure that an equitable
charge is made to the users of the service.
2.4 Composite cost units

These are used when a single measure would not be appropriate.
The charge for excess baggage on an airline might be based on:
(a) How far in km baggage has to be transported.
(b) How heavy the baggage is.
Both of these will impact on the airline's fuel cost so it would be inappropriate to base the
charge on either distance or weight alone. Clearly taking 10 kg 100 km will cost less than
taking 10 kg 10,000 km.
To take account of this, a composite cost unit is derived ie cost per kg per km. This will
provide a method of comparing costs for any weight travelling any journey.
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9: COSTING METHODS
Worked example 1
In the last year the following information was collected:
Total kg of excess baggage carried 32,000 kg
Total miles excess baggage carried 25,000 km
Total cost incurred (eg extra fuel) $6m
What is the cost of carrying an extra 2 kg an extra 5,000 km?
Solution
Workings
Step 1 – work out the cost per kg per km
6,000,000
= $0.0075
 32,000×25,000 
Step 2 – work out cost for extra 2 kg transported an extra 5,000 km
$0.0075  2  5,000 = $75.00
2.5 Service department costing

Service department costing is used to establish a specific cost for an 'internal service' that
is a service provided by one department for another, rather than one sold externally to
customers. Service departments therefore include canteens and data processing
departments.
Service department costing has two basic purposes:
 To control the costs and efficiency in the service department.
 To control the costs of the user departments, and prevent the unnecessary use of
services.
2.6 The bases for charging service costs to user departments

The 'cost' of support services charged to user departments could be based on any of the
following.
 No charge at all
 Total actual cost
 Standard absorption cost
 Variable cost
 Opportunity cost
 Cost plus a margin for profit
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3 Joint and by-products

Chapter 12
sections 3 and 4
Joint
products
Forestry
By-
product
3.1 Joint products

Joint products are two or more products which are output from the same processing
operation, but which are indistinguishable from each other up to their point of separation.
They each have a substantial sales value either immediately or after further processing.
3.2 By-product
These are products produced at the same time and in the same process as the joint
products but are recognised by a relatively low sales value compared to the main product or
joint products and are produced in much smaller volumes. They are secondary to the main
products / processes.
Lecture example 5
State three examples of either joint products or by-products.
Solution
(1)
(2)
(3)
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9: COSTING METHODS
3.3 Treatment
3.3.1 By-products
 Do not allocate joint costs to them.
 If usual occurrence then calculate net proceeds of by-products and reduce process
costs by this amount.
 If one-off then calculate net proceeds and treat as miscellaneous income.
3.3.2 Joint products

Cannot be identified until separation point.
Therefore common costs incurred up to separation point need to be apportioned on some
basis to the joint products.
Method of apportionment:
 Physical units
 Relative sales value
Physical units
Apportioning common costs on the basis of the proportion that the output of each product be
as by weight or volume of output.
Relative sales value
Apportioning common costs on the basis of the proportion of the total sales value.
Lecture example 6
(a) A process involves incorporating 2,000 units input of material costing $2,000 with labour
costs of $2,000 and overheads of $1,000.
The output of the process is two joint products: 600 units P1, 1,200 units P2; and 200 units
of by-product. The by-product will be able to be sold for $50 in total.
Allocate the joint costs on a physical units basis.
Solution
(a)
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(b) Assuming now that both products can be sold immediately.

P1 sells at $2/unit
P2 sells at $5/unit
Required
What is the profit on each under:
(i) Physical measurement apportionment? P1 $ P2 $
(ii) Relative sales value apportionment? P1 $ P2 $
Workings
3.4 Relative sales value vs Physical units

Physical units basis is useful where:
 The joint products are in the same form eg both solids or both liquids
 The joint products are components in another product and therefore have no relevant
sales value.
Relative sales value basis is useful where:
 Products are to be sold immediately with no further costs being incurred (such as
selling costs);
 Joint products are not in the same form of output.
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9: COSTING METHODS
Lecture example 7
Two products S and T are created from a joint process. S can be sold immediately after split-off. T
requires further processing into product TT before it is in a saleable condition. There are no
opening inventories and no closing work-in-progress of products S,T or TT. The following data is
available for the last period:
$
Total joint processing costs 262,500
Further processing costs of product T 49,500
Product Production units Closing inventory
S 315,000 15,000
TT 247,500 22,500
Using the physical unit method for apportioning joint production costs, what was the total
value of the closing inventory of product TT for the last period?
Solution
 $12,480
 $13,969
 $15,000
 $16,200
Workings
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4 Alternative costing principles

4.1 Activity based costing (ABC)
ABC is a modern alternative to absorption costing which attempts to overcome the problems
of costing in a modern manufacturing environment.
4.2 Traditional absorption costing

Traditional absorption costing uses a single basis for absorbing all overheads into cost
units for a particular production department cost centre.
A business will choose the basis that best reflects the way in which the overheads are being
incurred, eg in an automated business much of the overhead cost will be related to
maintenance and repair of the machinery. It is likely that this will vary to some extent with
machine hours worked so we would have used a machine hour absorption rate.
PRODUCTION SET-UP COSTS
MACHINE OIL PRODUCTION OAR =

DEPARTMENT MACHINE
SUPERVISOR SALARY A HOURS
MACHINE REPAIRS
Activity based costing

Production overheads are by no means all volume-related and hence a single basis for
absorption, eg labour hours, would not adequately reflect the complexity of producing
certain products/cost units as opposed to others.
ABC is an extension of absorption costing specifically considering what causes each type of
overhead category to occur, ie what the cost drivers are. Each type of overhead is absorbed
using a different basis depending on the cost driver.
Activities Cost drivers
PRODUCTION NUMBER OF
SET UP COSTS PRODUCTION SET UPS
MACHINE OIL AND TOTAL

MACHINE REPAIRS MACHINE HOURS
SUPERVISOR TOTAL
SALARY LABOUR HOURS
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9: COSTING METHODS
4.3 Steps in ABC

(a) Group overheads into activities, according to how they are driven. These are known
as cost pools.
(b) Identify the cost drivers for each activity, ie what causes the activity cost to be
incurred.
(c) Calculate a cost per unit of cost driver.
(d) Absorb activity costs into production based on usage of cost drivers.
Absorption costing vs. Activity based costing
Overhead absorption rates using ABC should be more closely linked to the causes of
overhead costs.
The modern business environment has much wider product ranges than seen before,
complex production process and decreasing product lifecycles. ABC recognises these
factors by using multiple cost drivers when absorbing overheads.
5 Total Quality Management (TQM)

Total quality management (TQM) is a business philosophy aimed at improving quality.
The process of the management of quality involves
(a) Establishing standards of quality for a product/ service
(b) Establishing procedures or production methods to ensure these standards are met in
a suitably high proportion of cases
(c) Monitoring actual quality; and
(d) Taking control action when actual quality is below standard.
TQM has two key philosophies
 Get it right, first time
– The cost of preventing mistakes is less than the cost of correcting them if they
occur
 Continuous improvement
– Never be satisfied with current achievement. It is always possible to improve
performance.
Performance measures for TQM should not simply be confined to the production process as
quality should be embraced in every activity of the organisation. Measures should also cover
the work of the sales, distribution and administration departments and often non-financial
performance measures are most useful. Eg no of complaints. no of warranty claims, no of
defective products rejected as deliveries accepted.
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6 Life cycle costing

Life cycle costing aims to cost a product, service, customer or project over its entire lifecycle
with the aim of maximising the return over the total life while minimising costs.
Traditionally the costs and revenues of a product are assessed on a financial year or period
by period basis.
Product life cycle costing considers all the costs that will be incurred from design to
abandonment of a new product and compares these to the revenues that can be generated
from selling this product at different target prices throughout the product's life.
6.1 Product life cycle

The product life cycle (PLC) can be divided into five stages.
Sales and
profits
Sales
revenue
Profit
Time
Development Introduction Growth Maturity Decline
6.2 Characteristics of the PLC
Stage Sales Volume Costs

Development None Research & development
Introduction Very low levels Very high fixed costs (eg Fixed
(non-current) assets, advertising)
Growth Rapid increase Increase in variable costs
Some fixed costs increase
(eg Increase number of fixed (non-current)
assets)
Maturity Stable Primarily variable costs
High volume
Decline Falling demand Primarily variable costs
(now decreasing)
Some fixed costs
(eg decommissioning costs)
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7 Target costing
In a modern environment with shortening product lifecycles, organisations have to
continually redesign their products. It is essential that they try to achieve a target cost during
the product's development.
7.1 Cost plus pricing

Under traditional approaches to pricing, businesses calculate the cost of manufacturing and
selling a product, and then add mark up, to give the profit element. These methods are
known as 'cost plus pricing'.
A major criticism of cost plus pricing techniques is that they do not consider any external
factors (eg demand for product; no. of competitors, etc). They are therefore unlikely to
maximise the profits that a business will generate.
7.2 Target costing

As product life cycles have become much shorter, the planning, development and design stage
of a product is critical to an organisation's cost management process. Cost reduction must be
considered at this stage of a product's life cycle, rather than during the production process.
Target costing involves setting a selling price for your product by reference to the market.
From this your desired profit margin is deducted leaving you with a target cost.
7.2.1 Deriving a target cost
Traditionally:
mark-up
(2nd)
selling price
cost (3rd)
(1st)
Target Costing:
margin
(2nd)
selling price
target (1st)
cost
(3rd)
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7.2.2 Implementing target costing

(a) Define product specification and estimate anticipated sales volume.
(b) Set a target selling price at which the company will be able to achieve the desired
market share.
(c) Required profit is estimated based on profit margins or return on investment.
(d) Target cost is calculated as:
$
Target selling price X
Less: target profit (X)
Target cost X
(e) The estimated cost of the product is calculated based on the product specification
and current cost levels.
(f) Estimated Product Cost – Target Cost = Cost Gap
(g) Efforts are made to close the cost gap. Aim to 'design out' costs before production
starts.
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8 Chapter summary
Topic Summary
Job and batch Job costing is a costing method applied where work is undertaken to
costing customers' special requirements and each order is of comparatively short
duration.
Batch costing is similar to job costing in that a separately identifiable group of
units are produced (often to order) and are treated as a single cost unit (like
a job).
Service industry Service costing is used by companies operating in a service industry. The
costing main difficulty is defining an appropriate cost unit.
Charging customers Service companies often use composite cost units to work out cost per unit
for services on which to base their prices.
Service department This is used to determine costs for 'internal services' such as canteens or IT
costing support.
Joint products and Joint products are two or more products separated after a process, each of
by-products which has a significant value.
A by-product is an incidental product from a process which has an
insignificant value compared to the main product.
Treatment of by- By-products are not allocated any of the joint costs.
products Joint products need to be apportioned a fair share of the joint costs at the
split off point.
Apportioning joint The main methods of apportioning joint costs are by physical measurement
costs and by relative sales value.
ABC  ABC groups overheads into activities. These are referred to as cost
pools. The item that causes the costs to be incurred is known as the
cost driver and the overheads are absorbed into products using the
cost driver.
 Overheads absorbed using ABC should be more reliable than those
using traditional absorption costing giving a more meaningful product
cost.
TQM TQM is a business philosophy aimed at improving quality with two main
ideas
 Get it right, first time
 Continuous improvement
Life cycle costing Life cycle costing considers all costs and revenues of a product throughout
its life rather than on a periodic basis.
Target costing A target cost is derived by setting a selling price for a product and deducting
a desired profit margin to arrive at the target cost.
Costs are then designed out of the product to ensure the target cost is
achieved.
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END OF CHAPTER
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Setting budgets

 Explain why organisations use budgeting.
 Describe the planning and control cycle in an organisation.
 Explain the administrative procedures used in the budgeting process.
 Describe the stages in the budgeting process (including sources of relevant data, planning and agreeing draft
budgets and the purpose of forecasts and how they link to budgeting).
 Define and distinguish between capital and revenue expenditure.
 Outline the issues to consider and the steps involved in the preparation of a capital expenditure budget.
 Explain the importance of principal budget factor in constructing the budget.
 Prepare sales budgets.
 Prepare functional budgets (production, raw materials usage and purchases, labour, variable and fixed
overheads).
 Prepare cash budgets
 Prepare master budgets (statement of profit or loss and statement of financial position).
Exam Context
Budgeting is one of the key roles that a management accountant may perform and essential for planning and control
within a business. You should expect to see questions on this topic in section A and/or B of your examination.
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Overview
Setting budgets
Planning & control Responsibility Budgetary Process Preparing Budgets

cycle Accounting
Functional Cash Capital Expenditure
Sales Budget
Production Budget
Overhead Budget
Labour Budget
Material Usage Budget
Material Purchases Budget
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1 Planning and control cycle

There are seven steps in the planning and control cycle.
Identify objectives Step 1
Identify alternative courses of action

(strategies) which might contribute Step 2
towards achieving the objectives
Planning Evaluate each strategy Step 3

process
Choose alternative
courses of action Step 4
Implement the long-term

plan in the form of the Step 5
annual budget
Measure actual results Step 6

and compare with the plan
Control
process
Respond to
divergences from plan Step 7
1.2 Budgetary planning and control systems

A budget is a quantified plan of action for a forthcoming accounting period.
A budget is a plan of what the organisation is hoping to achieve whereas a forecast is an
estimate of what is likely to occur in the future.
The objectives of a budgetary planning and control system are as follows:
P – Planning – forces management to plan ahead in detail
R – Responsibility – clarifies what the budget holder can control
I – Integration and co-ordination – between departments / divisions
M – Motivation – employee behaviour will be affected by the budget
E – Evaluation and control – compare actual performance to budget targets
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2 Responsibility accounting and its significance in

control
If a manager is to bear responsibility for the performance of a division he will need
information about its performance. To this end, different areas of the business are divided
into responsibility centres.
Centre Responsible for

Cost Costs only
Profit Costs and revenues
Investment Costs, revenues and investment
Lecture example 1
Which of the following is not a purpose of a budget?
Solution
 To establish a basis of control of operations
 To communicate targets to managers
 To formulate strategic plans
 To coordinate the organisation's activities
3 Preparation of budgets
3.1 The budget period is commonly the accounting year and is usually split up into 12 or 13
control periods. (ie 13 four week periods).
3.2 The budget manual is a collection of instructions governing the budgetary process. It is
likely to contain:
 An explanation of the objectives of the budget
 Organisational structures
 Principal budgets
 Administrative detail
 Procedural matters
The Budget Committee is the co-ordinating body in the preparation and administration of
budgets.
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10: SETTING BUDGETS
3.3 The budget preparation timetable
Step Description
1 Communicating details of the budget policy and budget guidelines
 Start point for budget is the long term plan
 Managers also require guidelines on wage rate increases, changes in productivity
etc
2 Determining the factor that restricts output (the limiting factor) (see section 4.1)
3 Preparation of the sales budget (assuming this is the limiting factor) (see section 4.3)
4 Initial preparation of budgets (see section 4.3)
5 Negotiation of budgets with superiors
 Each budget submitted to superior for approval
 Budgets then incorporated into others and passed on to next superior and so on
until final budget presented to budget committee for approval
 Each step involves negotiation until agreement between parties
6 Co-ordination and review of budgets
 Budget officer reviews all budgets to identify inconsistencies and ensure revisions
of any budgets which require attention.
 Budgeted income statement, statement of financial position and cash budgets
prepared
7 Final acceptance of the budgets.
It is at this point that the budgets are pulled together into a master budget (see
below)
8 Budget review
 Actual results compared to budget
 Variance analysis performed
 Budget committee meet periodically to review performance and revise budget
 Budget process should be seen as a continuous and dynamic process
3.4 Master budget

Once the functional budgets have all been prepared and have been reviewed to ensure they
are all consistent then they are pulled together into a master budget. This comprises of a
budgeted income statement, statement of financial position and cash budget which provide
an overall picture of the planned performance for the budget period.
You should be aware of the format of an income statement and statement of financial
position and understand that they are produced on an accruals concept. A cash budget, in
contrast, is simply a budget of both cash inflows and outflows incorporating both capital and
revenue items.
Review your Study Text for a comprehensive example of producing a master budget.
However, note given the nature of the FMA exam you would never be asked to complete the
full statements in the exam. You could, however, be asked about one particular number.
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4 Preparing functional budgets

4.1 Principal budget factor (or limiting budget factor)
This is the factor which prevents an organisation from expanding at present beyond a
certain point. The principal budget factor is usually sales demand.
Other factors could include:
 Availability of raw material
 Availability of labour supply
 Machine capacity
 Availability of cash
 Distribution and selling resources
Lecture example 2
Magic Ltd's production process requires 3.5 kg of material per unit of production. For the first three
months of next year only 54,600 kg of material will be available each month. Assume production is
spread evenly over the three months.
What will be the maximum monthly production level?
Solution
units
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10: SETTING BUDGETS
4.2 Setting up a budget

Step 1 is to identify the principal budget factor.
Step 2 is to work the budgets around it.
4.3 Initial preparation of budgets
SALES BUDGET
units/value
(1) Consider op/cl inventory FG
Sales X
Op. inventory (X)
Cl. inventory X
Production required X
LABOUR BUDGET (2) Losses incurred/damaged
hours/value goods
PRODUCTION BUDGET
units
OVERHEADS BUDGET Units produced x kg

value per unit from CC
Material USAGE Budget

Kg/litres etc
(1) Consider op/cl inventory RM

Production usage X
Op inventory (X)
Cl inventory X
Materials required X
(2) Losses incurred
Material PURCHASE
Budget Think about
Kg/litres/value discounts
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Worked example 1
Functional budgets
Bun plc makes a range of cakes. When producing the budget for 20X1 the company realises that
its principal budget factor is sales, and forecasts the following sales:
Product Name: Sponge cake Jam cake Cream cake
Sales (number of batches) 2,400 4,800 1,200
Selling price per batch $150 $175 $200
The unit direct costs of producing a batch of each type of cake are:
Sponge cake Jam cake Cream cake
Materials
Flour (@ 50c/kg) 5 kg 6 kg 7 kg
Milk (@ 70c/litre) 4 litres 5 litres 6 litres
Labour
Mixers (@ $2/hr) ½ hr ¾hr 1 hr
Cooks (@ $3/hr) ½ hr ½hr 1 hr
The company has inventory levels of completed batches of cakes as follows: 480 Sponges, 480
Jams and 240 Creams and raw materials inventory of 1,000 kg of flour and 500 litres of milk.
Management feel that 20X1's sales figures could well be repeated in 20X2 and wishes to have
sufficient inventory of finished batches to cope with 10% of this demand and raw materials to cope
with 20% of the demand for the finished product.
Required
Complete the functional budgets for Bun plc
SALES BUDGET
Sponge Jam Cream Total
Sales (number of batches) 2,400 4,800 1,200 8,400
Selling price per batch $150 $175 $200
Revenue $360,000 $840,000 $240,000 $1,440,000
PRODUCTION BUDGET
Sponge Jam Cream
Sales 2,400 4,800 1,200
Closing stock 240 480 120
2,640 5,280 1,320
Opening stock (480) (480) (240)
Production 2,160 4,800 1,080
MATERIALS USAGE
Sponge Jam Cream Total
Flour – (kg) 10,800 28,800 7,560 47,160
Milk – (litres) 8,640 24,000 6,480 39,120
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MATERIALS PURCHASES
Flour Milk Total
Kg $ Litres $ $
Usage 47,160 23,580 39,120 27,384 50,964
Closing stock (W) 9,840 4,920 8,160 5,712 10,632
57,000 28,500 47,280 33,096 61,596
Opening stock (1,000) (500) (500) (350) (850)
Purchases 56,000 $28,000 46,780 32,746 60,746
W: Closing Stock – Flour: (20%  2,400 sales  5 kg) + (20%  4,800 sales  6 kg) + (20% 
1,200  7 kg)
= 9,840 kg
Milk: (20%  2,400 sales  4l) + (20%  4,800 sales  5l) + (20%  1,200  6l)
= 8,160 litres
LABOUR UTILISATION BUDGET
Mixers Cooks Total
(Hours) (hours) (hours)
Sponge (2,160 units) 1,080 1,080 2,160
Jam (4,800 units) 3,600 2,400 6,000
Cream (1,080 units) 1,080 1,080 2,160
5,760 4,560 10,320
Hourly rate $2 $3
Total cost $11,520 $13,680 $25,200
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Lecture example 3
Suppose a company currently holds 100 units of inventory but it wishes to increase its inventory
holding to 150 units during the next month. Sales are expected to be 850 units. Each unit requires
5 kg of material. Of units produced 10% have to be discarded because they are defective. No
inventories of raw materials are held.
What should the raw materials purchases for next month be? (give your answer to the nearest
whole kg)
kg
Solution
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5 Capital v Revenue Expenditure

5.1 Definition
Capital expenditure is the acquisition of non-current assets or an improvement in their
earning capacity. Non-current assets will be acquired and retained by the business with a
view to earning profits and not merely turning it into cash.
Revenue expenditure is usually incurred for the purpose of the trade of the business or to
maintain the existing earning capacity of non-current assets.
Lecture example 4
Brum Brum Ltd is a second hand car dealer. The bookkeeper has a list of items of expenditure for
the last month, but cannot decide if they are capital or revenue, and has asked for your help.
Select the correct box for each item of expenditure.
Solution
Expenditure Capital Revenue
Purchase of envelopes for the office
Extension to the sales office
Purchase of new delivery van
Road tax & insurance for new delivery van
Purchase of 10 new cars for resale
Repair of broken window in the workshop
Purchase of 5 new laptops for the sales men (previously they
recorded sales leads in a notebook)
5.2 Recording transactions

Capital expenditure is not charged as an expense in the income statement of the business,
although a depreciation charge will usually be made to write off the capital expenditure over
the assets' useful economic life. This depreciation charge will be debited to the income
statement.
There will be a debit to the statement of financial position to show the purchase of a
non-current asset.
Revenue expenditure will be charged to the income statement of the period, provided that it
relates to trading activity and sales of that particular period.
It is essential that the type of transactions is correctly identified and treated as incorrect
classification will result in incorrect levels of profit being reported.
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Lecture example 5
An error has been identified in the accounts of Hawk Co.
The purchase of new machinery has been treated as revenue expenditure.
What would be the impact on the financial statements of this error?
Solution
Profit reported Machinery asset value
Too high Too high
Too high Too low
Too low Too high
Too low Too low
5.3 Capital income v Revenue income

Capital income is the proceeds from the sale of non-trading assets (ie proceeds from the
sale of non-current assets, including investments. The profits (or losses) from the sale are
included in the income statement for the accounting period in which the sale takes place.
Revenue income is derived from the following sources:
 The sale of trading assets
 Interest and dividends received from investments held by the business
5.4 Other capital transactions

The categorisation of capital and revenue items above does not mention raising additional
capital from the owner(s) of the business or raising and repaying loans. These are entirely
reflected on the statement of financial position and would not be shown in the income
statement.
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5.5 Preparing capital expenditure budgets

Capital expenditure often involves spending large sums of money. Companies therefore
need to appraise decisions to invest in new capital expenditure carefully and make sure that
they have the funds available at the correct time.
We will see how to appraise projects in chapter 11.
Planning for capital expenditure should form part of the business' longer term plans, and so
should be drawn up for the short, medium and long term.
6 Cash budgets
6.1 Overview
The level of cash held by a business is important. A cash budget shows how the balance will
change over several months.
6.2 Presentation
XYZ Ltd: CASH BUDGET FOR THE THREE MONTHS ENDED 31 MARCH 20X3
Jan Feb Mar
Cash receipts
Sales receipts (W1) X X X
Loan _ X X
X X X
Cash payments
Purchase payments (W2) X X X
Wages X X X
Overheads X X X
Non-current assets X _ _
X X X
Net cash flow X (X) X

Opening balance X X (X)
Closing balance X (X) X
6.3 Approach
Fill in the easy figures first.
(a) Sundry receipts and payments: for example the purchase of non-current assets.
(b) Wages and salaries: usually paid when due.
(c) Sales receipts. Check the timing of the cash receipt – some sales may be for cash
others for credit.
(d) Payments to payables. Again the timing of the payment needs to be considered
carefully.
Cash budgets consider the cash element of business transactions, whereas the income
statement records all transactions on an accruals basis regardless of when cash is received
or paid.
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Lecture example 6
Select the correct boxes to show which of the following should be included in a cash
budget.
Solution
Include Do not include
Purchase of new machinery
Payment of tax
Bad debts written off
Depreciation of delivery van
Road tax for delivery van
Payment to supplier
6.4 Cash effect

You may need to work out the cash effect of a transaction from Income statement and
statement of financial performance information as follows.
(a) Receivables receipts – sales recorded in January will not usually be cash receipts for
January.
$
Receivables b/fwd X
Sales (on credit) X
Receivables c/fwd (X)
CASH RECEIVED X
(b) Purchase payments
$
Payables b/fwd X
Purchases (on credit) X
Payables c/fwd (X)
CASH PAID X
6.5 Potential cash surpluses or shortages

Cash budgets can give management an indication of any cash surpluses or shortages
expected.
Management can then make decisions on financing any expected cash shortage or
investing any cash surpluses.
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Lecture example 7
Kookaburra have prepared the following budgeted data.
March April May June July
Sales 4,250 4,600 5,000 5,350 5,400
Purchases 1,200 1,300 1,500 1,600 1,750
Wages 800 800 850 850 850
Other overheads 650 650 675 675 675
Capital expenditure 3,000 1,000
Additional information:
 30% sales are for cash. The remaining sales are on credit and customers pay 1 month later
 Purchases are paid for after 1 month
 Wages and other overheads are paid in the current month. Other overheads includes $400
of depreciation each month.
Required
Prepare a monthly cash flow forecast for quarter 2.
Solution
April May June Total Qtr 2
Receipts
Cash Sales
Credit Sales
Total Receipts
Payments
Purchases
Wages
Other overheads
Capital expenditure
Total payments
Net Cash
Opening cash balance 750
Closing cash balance
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Workings
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7 Chapter summary
Topic Summary
Planning and control There are seven stages in the planning and control cycle.
cycle
Budgetary planning A budget is a quantified plan of action for a forthcoming period.
Responsibility Divisions are divided into types of responsibility centres: cost, revenue and
accounting profit centres. These represent the level of control exercised by that
division on costs, revenues and investment.
Preparation of The budget committee co-ordinates the preparation and administration of
budgets budgets.
Master budget This pulls together all the individual budgets and is usually comprised of a
budget income statement, statement of financial position and cash budget.
Capital v revenue Items of income and expenditure should be correctly classified. Capital
transactions expenditure is when new non-current assets are acquired, where as
revenue expenditure occurs for the purposes of trade or improving assets.
Principal budget The principal budget factor should be identified at the start of the process,
factor and the overall budget constructed around this limiting factor. This is often
sales demand.
Preparation of Care must be taken to ensure that all the components of a full operating
budgets budget are consistent with one other. Always start with sales budget.
Cash budgets Cash planning is important to businesses as it helps forecast cash
surpluses or shortages.
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END OF CHAPTER
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Implementing budgets

 Explain the importance of motivation in performance management
 Identify factors in a budgetary planning and control system which influence motivation
 Explain the impact of targets upon motivation
 Discuss managerial incentive schemes
 Discuss the advantages and disadvantages of a participative approach to budgeting
 Explain top down, bottom up approaches to budgeting
 Define the concept of responsibility accounting and its significance in control.
 Explain the concepts of controllable and uncontrollable costs.
 Discuss the relationship between short-term and long-term performance
 Compare cost control and cost reduction
 Describe and evaluate cost reduction methods
 Describe and evaluate value analysis
Exam Context
This chapter looks at how to put budgets into action. Questions on this topic are unlikely to include calculations and
would be most likely in Section A of the examination.
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11: IMPLEMENTING BUDGETS
Overview
Cost control & cost

Budgets and people Hopwood
reduction
Approaches Methods
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1 Budgets and people

The purpose of budgetary control system is to assist management in planning and
controlling the resources of their organisation by providing appropriate control information.
This information is only valuable if it is interpreted correctly and used purposefully by
managers and employees.
1.1 Motivation
A well designed budgetary process should encourage goal congruence.
'Goal congruence is the state which leads individuals or groups to take actions that are in
their self interest and also in the best interest of the organisation' CIMA official terminology
Maintaining motivated managers is an important aspect of setting and achieving targets.
To do this managers should be involved in the planning process when budgets are set, so
that they are not set at unachievable levels.
Challenging and achievable targets should be set that can lead to acceptable rewards.
Managers should be kept informed of any changes in strategic plans and understand the
part they play in budget preparation.
1.2 Behavioural problems

The correct use of the control information depends on the behaviour of recipients. Problems
can arise because:
 The managers who set the budget are not responsible for achieving it
 Lack of goal congruence
 Poor attitudes when setting budget
 Poor attitudes when putting plans into action
 Control is applied at different stages by different people
1.3 Participation
Participation in the budgeting process will improve motivation and therefore the quality of the
budget decisions. There are two different approaches to generating and managing budgets:
 Top down
 Bottom up (Departmental budgeting)
Top down
 This style of budgeting involves senior management laying down the budget with little
or no employee involvement.
 This is also known as imposed budgeting.
Appropriateness of top down budgeting
(i) Newly formed organisations
(ii) Very small businesses
(iii) During times of economic hardship
(iv) When operational managers lack budgeting skills
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Bottom up
 This method involves participation of the work force who then submits the budgets to
their superiors.
 This is also known as participative budgeting. This type of budget may also be
called departmental budgeting.
Advantages
(i) Staff doing the work have the most accurate knowledge of operations
(ii) More achievable targets based on local knowledge
(iii) Morale and motivation improved as people working towards their own budgets
(iv) Reduces work load of top management
Disadvantages
(i) Time consuming
(ii) Staff may set targets which are too easy and lack consistency (budgetary slack)
(iii) May never get agreement if too many conflicting views
(iv) Staff may lack skills/knowledge required
Negotiated budgeting
In practice, the different levels of management often agree budgets by a process of
negotiation.
1.4 Performance evaluation

Employees should be kept informed about how actual results are progressing and how
these compare with targets.
We introduced the qualities of good information in Chapter 1 (ACCURATE). Feedback
should follow the same principles. The key features of feedback:
 Clear and comprehensive reports
 Identify controllable costs and revenues
 Timely
 Accurate
The impact of an accounting system on managerial performance depends on how the
information is used.
Hopwood identified 3 ways of using budgetary information to evaluate managerial
performance:
Style of evaluation Comment

Budget constrained Managers' performance is measured on ability to meet budget
Profit conscious Manager's focus is on increasing the effectiveness of a unit's
operations. The goal is to generate a positive return to shareholders
Non-accounting Manager's focus is non-financial. Measures such as feedback from
colleagues is how performance is measured
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1.5 Budgetary slack

When managers set their own budgets they may be tempted to deliberately overestimate
costs and underestimate sales so that they will not be blamed in the future for overspending
and poor results.
In controlling actual operations the managers then ensure that their spending rises to meet
the budget.
Slack or manipulation of accounting reports is more likely to occur if the manager is under
pressure to achieve short-term budget targets.
Lecture example 1
Which of the following is an example of budget bias?
Solution
 A manager uses his best estimate of likely costs when setting the budget.
 A manager's advertising budget is disproportionately large in comparison with the budgeted
revenue to be generated.
 A manager underestimates revenues when setting the budget to ensure that the budget
target can be easily exceeded.
 A manager will consult with his team to try to establish an appropriate sales volume target.
1.6 Controllable vs uncontrollable costs

A manager should only be held accountable for costs over which they have some influence.
(ie a controllable cost)
Mangers should not be held accountable for costs over which they have no control.
2 Cost control and cost reduction

2.1 Definition
Cost control is concerned with regulating the costs of operating a business and keeping
costs within acceptable limits. The process involves comparing planned cost with actual
costs and implementing control action if there is a significant difference.
Cost reduction is a planned and positive approach to reducing expenditure. This starts with
the assumption that current cost levels are too high even though cost control might be good.
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2.2 Approaches to cost reduction

There are two basic approaches to cost reduction:
 Crash programmes to cut spending levels – often a reaction to cash flow or
profitability problems, a company may decide on an immediate programme to reduce
spending.
 Planned programmes to reduce costs – this involves a continual assessment of the
organisation even during times of prosperity, to ensure that crash programmes are
not needed.
2.2.1 Scope of cost reduction programmes

A cost reduction campaign should embrace the activities of the entire company.
A cost reduction campaign should have long-term and well as short-term objectives:
 In the short term only variable costs can usually be susceptible to cost reduction
efforts. Fixed costs, eg rent cannot easily be changed.
 Some fixed costs are avoidable in the short term (eg advertising) these are known
discretionary fixed costs.
 In the long term most costs can be either reduced or avoided.
2.3 Methods of cost reduction

Improving efficiency
One way of reducing costs is to improve the efficiency of materials usage, the productivity of
labour or the efficiency of machinery and other equipment.
2.3.1 Value Analysis

Value analysis is a planned, scientific approach to cost reduction, which reviews the
materials used in the manufacture of the product as well as considering the design of the
product, so that modifications and improvements can be made which do not reduce the
value of the product to the customer or user.
This means that the value of the product must be kept the same or else improved at a
reduced cost.
2.3.2 Value engineering

Is the application of value analysis techniques to new products, so that the products are
designed and developed to a given value at minimum cost.
There are four aspects of value:
 Cost value – the cost of producing and selling an item
 Exchange value – the market value of the product or service
 Use value – what the item does, ie the purpose it fulfils
 Esteem value – the prestige the customer attaches to the product.
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3 Chapter summary
Topic Summary
Behavioural implications Motivation
Goal congruence
Behaviour problems
Budgetary slack
Participation Top down v bottom up
Negotiated budgets
Performance evaluation Essential to inform employees how actual results are
progressing.
Hopwood – 3 ways to evaluate managerial performance.
Cost reduction and Make sure you understand the difference – cost control links
control to variances identified and cost reduction is a planned
approach
Approaches to cost Crash programmes to cut spending levels
reduction Planned programmes to decrease costs
Scope of cost reduction Whole company
programme Short term and long term objectives
Methods of costs Improved efficiency:
reduction Material efficiency
Labour productivity
Machinery efficiency
Value analysis Planned scientific approach to cost reduction. There are four
aspects of value:
Cost value
Exchange value
Use value
Esteem value
The value of the product may therefore be kept the same or
else improved at a reduced cost.
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topics.
Course notes
chapter
Forecasting 4
Process costing 8
Cost accounting methods
Costing methods 9
Setting budgets 10
Budgeting
Implementing budgets 11
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Project appraisal

 Explain and illustrate the difference between simple and compound interest, and between nominal and effective
interest rates.
 Explain and illustrate compounding and discounting.
 Discuss the importance of capital investment planning and control.
 Explain the distinction between cash flow and profit and the relevance of cash flow to investment appraisal.
 Identify and evaluate relevant cash flows for individual decisions.
 Explain and illustrate net present value (NPV) and internal rate of return (IRR) methods of discounted cash flow.
 Calculate present value using annuity and perpetuity formulae.
 Calculate NPV, IRR and payback (discounted and non-discounted) .
 Interpret the results of NPV, IRR and payback calculations of investment viability .
Exam Context
This chapter helps us to appraise whether the capital investment projects identified should be undertaken. It is an
important chapter and you should expect it to be examined in either section A and/or section B of your examination.
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Overview
Project appraisal
Payback NPV IRR
Simple Discounted
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1 Compounding and discounting

Introduction
1.1 Compounding
1.1.1 Definition
How much an investment made now will be worth in the future if you earn a certain
percentage rate of interest.
1.1.2 Notation
So = initial investment/principal
Sn = investment at the end of n years
time 0 = now (31.12.X0 or 1.1.X1)
time 1 = end of year 1 or the start of year 2 ie one year from now (31.12.X1 or 1.1.X2)
1.1.3 Compound interest

Compound interest is where interest is calculated and paid on capital plus any interest paid
or payable earned up to that point.
Sn = So (1 + r)n
Where n = number of periods investment is held for
r = interest rate as decimal
Worked example 1
Example
If $100 was invested in an account, which paid 10% compound interest, how much would be in the
account after four years?
T0 T1 T2 T3 T4
$100
Interest $10 $11 $12 $13
ie S1 = $100 (1 + 0.1)
S2 = S1 + 0.1S1 = S1 (1 + 0.1) = 100 (1 + 0.1) (1 + 0.1)
= 100 (1 + 0.1)2
S3 = S2 + 0.1S2 = S2 (1 + 0.1) = 100 (1 + 0.1) (1 + 0.1) (1 + 0.1)
= 100 (1 + 0.1)3
S4 = S3 + 0.1S3 = S3 (1 + 0.1) = 100 (1 + 0.1) (1 + 0.1) (1 + 0.1) (1 + 0.1)
= 100 (1 + 0.1)4
Or in summary the value at T4 = 100 x 1.14

= $146.41
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Lecture example 1
B invests $500 in a building society account earning compound interest of 10% p.a.
How much will the investment be worth in five years time? (give your answer to two decimal
places)
$
Solution
1.1.4 Equivalent rates – non-annual compounding

Watch how often interest is compounded – make sure 'n' relates to the number of periods
for which 'r' is compounded.
Lecture example 2
$1,000 is invested at 6% six-monthly interest rate.
What is the value of the investment after one year and how much interest is earned? (give
your answer to two decimal places)
$
Solution
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1.1.5 Equivalent rates – effective annual interest rate (EAR)

An effective annual rate of interest is the corresponding annual rate when interest is
compounded at intervals shorter than a year.
The non-annual compounding interest rate can be converted into an annual equivalent using
the following formula.
(1+R) = (1+r)n
where R = effective annual rate
r = period rate
n = number of periods in a year.
The EAR is also called the APR (annual percentage rate) by banks, building societies and
credit companies.
Lecture example 3
$300 initial investment, 2% monthly interest rate.
Required
(a) What is the value of the investment after two years? (give your answer to two decimal
places)
$
(b) What is the effective annual rate of interest? (give your answer to two decimal places)
Solution
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1.1.6 Nominal rate

Sometimes the annual rate of interest is quoted as a nominal rate rather than an effective
rate.
For example, a credit card may have a 1% monthly interest rate. This may be quoted as a 12%
annual rate.
Nominal rates should never be used as an annual rate, they should always be converted to
an annual percentage rate (APR).
Lecture example 4
$1,000 is invested now at nominal interest rate of 15%, interest compounded monthly.
How much has the investment grown to at the end of the first year? (give your answer to the
nearest $)
$
Solution
2 Discounted Cash flows

Discounting is the opposite of compounding. Discounted cash flow techniques take account
of the time value of money – the fact that money received now is worth more because it
could be invested to become a greater sum at the end of a year.
2.1 Present Value

Rather than calculating the terminal value of an investment here we are calculating an
equivalent value of money at an earlier point in time. This is known as the present value.
Sn
Rearranging the compounding formula the present value is given by S 0 
1  r n
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Lecture example 5
We need $1,610 at the end of five years from now.
Assuming we could earn 10% p.a. how much should be invested now? (give your answer to
the nearest $)
$
Solution
$1,000 is the present value (PV) of $1,610 @ 10% in five years.

In purely monetary terms we would be indifferent between receiving $1,000 now or $1,610
in five years. In order to maintain the same purchasing power, we would require $1,610 in
five years' time to purchase goods costing $1,000 now.
2.2 Discount factor formula

1
is known as a discount factor (DFn)
1+ r 
n
Therefore PV = Sn  DFn
We can take any future cash flow and discount it back to what its equivalent worth today.
2.3 Tables
Present value tables will be available in the exam. These tables give discount factors of
between 1% – 20% and between 1 and 15 periods. (Should interest rates or periods fall
outside these ranges then use the formula to derive the answer).
Worked example 2
We need $5,000 at the end of three years.
Assuming we could earn interest at 8% pa, how much should we invest now?
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Solution
Option 1: Using the tables
Look up the DF8%1-3 = 0.794
PV = $5,000  0.794 = $3,970
Option 2: Using the formula
1
Discount factor = = 0.794
1+ 0.08
3
PV = $5,000  0.794 = $3,970

Note that the answer is the same regardless of the method used.
3 Annuities
An annuity is a constant sum of money paid or received each and every period for a given
number of periods.
Worked example 3
Invest $100 now and at the end of the next three years at 10% compound annual interest.
Using the timeline method, what will the terminal value be? (ie the value at the end of year 3
after the last payment has been made.)
Solution
0 1 2 3
$100
$100
$100
$100
Yr 0 Yr 1 Yr 2 Yr 3
S3 = $100 (1.1)3 + $100 (1.1)2 + $100 (1.1)1 + $100 (1.1)0
= $464.1
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3.1 Loan repayments

The techniques for calculating the terminal value of an annuity can be used to calculate loan
repayments.
(a) Calculate the terminal value of the loan (Sn)
(b) Calculate the equal annual instalments (A)
Note. the terminal value you calculate in (1) will be equal to the annuity payments plus
interest, NOT simply the annuities.
Present value of an annuity (Discounting)
Now we will look at the present value of an annuity.
Lecture example 6
Imagine we invested $100 now and at the end of each of the next three years at 10% per annum.
What is the present value of this investment? (give your answer to two decimal places)
$
Solution
3.2 Cumulative discount factors

To make the calculations easier we can use cumulative discount factors to calculate the
present value of an annuity.
$100  (1 + DF1 + DF2 + DF3)
The cumulative discount factor is a sum of the annual discount factors for the period
concerned.
CDF1-3 = DF1 + ...... + DF3
A selection of these is given in the tables provided in the exam.
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3.3 Perpetuities
Perpetuity is an annuity, commencing at T1 which continues to be paid/received at regular
intervals forever. Perpetuity therefore has no end. For example, you might receive an entry
to a competition offering you $1,000 per year for the remainder of your life.
Formula
a
PV of a perpetuity starting at time 1 =
r
For these formulae to work, the timing of the first cash flow must be in one year's time
(ie at T1).
Lecture example 7
If the interest rate is 10%, what would you pay for a perpetuity of $1,000 starting in one
year's time? (give your answer to the nearest $)
$
Solution
4 Investment appraisal techniques

To determine whether a future investment opportunity (project) is worthwhile a number of
appraisal methods may be used:
 Payback period
 Net present value (NPV)
 Internal rate of return (IRR)
4.1 Cost of capital

For long term decision making an important factor is the time value of money. This is the
idea that money today is worth more than the same amount of money in the future.
Compensation for this difference is known as the cost of capital.
We use the discount factor to approximate the cost of capital.
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5 Payback period (PP)

5.1 Definition
The number of years necessary for the cash flows of the project to payback the initial
investment.
5.2 Decision rules

 Accept projects with a PP of less than the company's required payback period.
 When deciding between two projects the one with the shorter payback period is
preferred.
Lecture example 8
Kirby plc is considering a five year project that requires an initial cash outlay of $550,000 on
equipment. At the end of the project the equipment is expected to have a scrap value of $25,000.
The equipment will produce annual cash operating revenues of $150,000 for five years.
Kirby has a cost of capital of 10%.
Kirby has a required payback period of five years.
Should Kirby plc go ahead with the project on the basis of payback period?
Solution
Year Cash flow Cumulative cash flow
0
1
2
3
4
5
5.3 Advantages of payback period

 Quick, simple calculation
 Easily understood concept
 Considers liquidity, ie cash flow
5.4 Disadvantages of payback period

 The maximum period set is arbitrary
 Ignores timing of flows within the payback period
 Ignores any cash flows after the end of the payback period
 Ignores the time value of money
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Discounted payback period overcomes some of these disadvantages. The payback period is
calculated in the same way, but there is an extra step to discount the cash flows.
6 Net present value (NPV)

6.1 Definition
The net total of the discounted cash flows of the project.
NPV: difference between
The sum of the discounted Amount initially

cash flows expected from invested
the investment
6.2 Method
(1) Calculate/list the expected cash flows (per year) that result from the investment or
decision.
(2) Discount each cash flow for the cost of capital to find the PV of the cash flows.
(3) Total up the present value of cash flows adding present value of cash inflows and
subtracting present value of cash outflows.
6.3 Purpose
The purpose of Net Present Value is to establish the maximum amount that an investor
would be willing to pay for a given set of future cash flows, given the investor's cost of
capital. This takes into account the time value of money.
6.4 Decision rule

Accept projects with a NPV greater than zero.
In deciding between two projects accept the one with the higher NPV.
NPV is the superior investment appraisal technique. If the NPV of a project is negative you
would always reject the project even when all other appraisal methods are favourable.
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Lecture example 9
Calculate the NPV of Kirby's project and advise Kirby whether to proceed.
Solution
Time Cash flow DF @ 10% PV
0 1
1 0.909
2 0.826
3 0.751
4 0.683
5 0.621
6.5 Advantages
 Correctly accounts for the time value of money (discounting of future cash flows gives
greater 'weight' to earlier cash flows)
 Uses relevant cash flows
 Absolute measure
 It is consistent with the objective of maximising shareholders' wealth
6.6 Disadvantages
 Need to estimate cost of capital
 Tricky concept
 Does not allow for the risk of the project
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7 Internal rate of return (IRR)

7.1 Definition
The internal rate of return (IRR) is the discount rate that gives a NPV of zero. It is also the
actual return that the project generates.
To calculate the IRR we use the following formula:
 NPVa  b  a  
IRR = a   
 NPVa  NPVb 
Where a = lower discount rate
b = higher discount rate
7.2 Decision rule

Accept all projects with an IRR greater than the company's cost of capital or minimum
acceptable rate of return.
7.3 Advantages
 Readily understood concept of % return
 Does not require an exact cost of capital
7.4 Disadvantages
 Relative return – not absolute.
 May rank projects incorrectly
Lecture example 10
Calculate the IRR of Kirby's project.
Solution
Time Cash flow DF @ 10% PV DF @ 15%
$ $ $
0 (550,000) 1 (550,000)
1 150,000 0.909 136,350
2 150,000 0.826 123,900
3 150,000 0.751 112,650
4 150,000 0.683 102,450
5 175,000 0.621 108,675
NPV $34,025
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Lecture example 11
Transco is considering a new project with expected returns at the following two costs of capital:
Cost of capital NPV
10% 4,645
15% (2,190)
What is the IRR of the project? (give your answer to one decimal place)
%
Solution
Lecture example 12
Using an interest rate of 10% per year the net present value (NPV) of a project has been correctly
calculated as $250. If the interest rate is increased by 1% the NPV of the project falls by $50.
What is the internal rate of return (IRR) of the project? (give your answer to the nearest
whole number)
%
Solution
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Lecture example 13
Crispin Co wishes to maximise the wealth of its shareholders. It has a cost of capital of 12% per
annum and it has correctly calculated the following measures for the new project it is considering:
 The internal rate of return (IRR) is 16%
 The return on average capital employed (ROCE) is 21% and
 The payback period is three years
Which of the following is true?
Solution
 The project is worthwhile because the IRR is a positive value
 The project is worthwhile because the IRR is greater than the cost of capital
 The project is not worthwhile because the IRR is less than the ROCE
 The project is not worthwhile because the payback is less than four years
8 Relevant costing
8.1 Definition
A relevant cost is a future cash flow arising as a direct consequence of a decision.
These are the costs which should be used for decision making.
8.2 Criteria
In order for a cost to be relevant it must fulfil the following criteria:
(a) Future
It cannot change the past.
A cost that has been incurred is irrelevant to any decision being made now. It is a
sunk cost.
Costs that have been incurred include not only costs that have already been paid, but
also costs that are the subject of legally binding contracts, even if payments due
under the contract have not yet been made. These are committed costs.
(b) Incremental
A relevant cost is one which arises as a direct consequence of a decision. Only costs
which will differ under some or all of the available opportunities should be
considered.
(c) Cash flow
Costs or charges which do not reflect additional cash inflows or spending should be
ignored for the purpose of decision making.
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These include the following.

 Depreciation, as a fixed overhead incurred.
 Notional rent or interest, as a fixed overhead incurred.
 All overheads absorbed. Fixed overhead absorption is always irrelevant since it
is overheads to be incurred which affect decisions.
This means that all avoidable, differential and opportunity costs will be relevant.
8.3 Non relevant costs

The following are not relevant costs:
 Sunk costs
 Committed costs
 Notional costs
Lecture example 14
A company is calculating the relevant cost of undertaking a special contract, which requires 300
litres of material A and 200 litres of material B.
The following data is available:
In inventory Historic Cost Current purchase price

Litres $ per litre $ per litre
A 100 3 4
B 200 8 7.50
Both materials are held in inventory as they are regularly used by the company for normal
production.
What is the relevant cost of A and B to be included in the contract cost?
Solution
Relevant cost of A = $
Relevant cost of B = $
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Lecture example 15
Pizza Co is a pizza restaurant, in a busy town centre, with sales of $500,000 in the last year. It is
considering replacing its ovens with new modern ones in anticipation of growth in customers.
The expected costs and benefits of the new ovens are as follows:
(i) The new ovens would cost $350,000
(ii) Depreciation would be provided at $70,000 per annum
(iii) $7,000 has already been spent on staff training to evaluate the potential of the new ovens.
Further training costs of $10,000 would be required in the first year if the new system is
implemented.
(iv) Sales are expected to rise to $600,000 in Year 1 if the new ovens are purchased, thereafter
increasing by 10% per annum. If the ovens are not purchased sales are expected to rise by
$10,000 per annum.
(v) Despite increased sales, cleaning costs are expected to fall as a result of the new ovens.
These are estimated at 1% of total sales.
(vi) Three new staff members will be recruited to deal with additional demand at a total cost of
$45,000 per annum. Their training is included in the estimate above.
(vii) A new maintenance contract would be undertaken at a cost of $2,000 per annum for five
years.
(viii) Interest of money borrowed to finance the project would cost $10,000 per annum.
(ix) Pizza Co's cost of capital is 10% per annum.
Required
(a) Select whether each of the following items are relevant or irrelevant cash flows for a net
present value (NPV) evaluation of whether to purchase the new ovens.
Relevant Irrelevant
Purchase cost of the new ovens of $350,000
Depreciation of $70,000 in each of the five years
New staff salaries of $45,000
Interest costs of $10,000 per annum
(b) Calculate the following values if the new ovens are installed.
(i) Incremental sales in Year 1 $
(ii) Savings in cleaning costs in Year 1 $
(iii) Present value of the maintenance costs over the life of the contract
$
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Solution
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9 Chapter summary
Topic Summary
Cost of capital Compensation for the time value of money, recognising that $ today is
worth more than $ in the future, due to inflation, interest and risk.
Compounding Earning interest on interest already received, Considered non annual
rates of interest – equivalent rates (EAR) .
Discounted cash flows Opposite of compounding, using tables or formula.
Annuities A constant sum of money for a fixed period of time, the present value is
calculated using the cumulative discount tables.
Loan repayments, which included the annuities and the interest.
Perpetuities – annuity paid or received forever.
Payback Period (PP) Time taken for cash flows to repay the initial investment.
Net Present Value (NPV) The net total of the discounted cash flows of the project.
Internal Rate of Return The discount rate that gives a NPV of zero.
(IRR) Calculated using the formula:
 NPVa  b  a 
IRR = a   
 NPVa  NPVb  
Relevant costing A relevant cost is a future, incremental cash flow.
END OF CHAPTER
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Standard costing

 Explain the purpose and principles of standard costing.
 Explain and illustrate the differences between standard, marginal and absorption costing.
 Establish the standard cost per unit under absorption and marginal costing.
 Explain and illustrate 'what-if' analysis and scenario planning.
 Explain the importance of flexible budgets in control.
 Explain the disadvantages of fixed budgets in control.
 Identify situations where fixed or flexible budgetary control would be appropriate.
 Flex a budget to a given level of volume.
 Calculate simple variances between flexed budget, fixed budget and actual sales, costs and profits.
Exam Context
Standard costing is a popular part of the syllabus and has been regularly examined. This chapter gives you an
understanding of key terminology to be used in Chapter 14 on basic variance analysis. It is likely to best tested in section
A and/or B of the examination.
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13: STANDARD COSTING
Overview
Standard costing
Definition Setting standards
Use in cost card Uses in business
Flexible budgets
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1 Standard setting
A standard is prepared by management in advance, and details their expectations of the
future.
Standards are not just for items of production in manufacturing businesses. They exist in
many different spheres. Standard times for repairing cars, standard punctualities for train
companies and standard response times for ambulances are just some of the many
examples encountered.
A standard cost is a predetermined estimated unit cost and is calculated using
management expectations of:
 Efficiency levels in the use of materials and labour;
 The expected price of materials, labour and expenses;
 Budgeted overhead costs and activity levels.
A standard cost card will usually be prepared for each product manufactured by the
business.
Worked example 1
Direct materials 4 kg @ $3/kg $12.00
Direct labour 3 hrs @ $10/hr $30.00
Standard direct cost $42.00 Under
Variable production o/h 3 hrs @ $1.50/hr $4.50 MC
Standard variable cost of production $46.50
Fixed production cost 3 hr @ $4.50/hr $13.50 Under
Standard cost $60.00 AC
1.1 Types of standard

There are four types of performance standard.
Ideal standards
These are based on perfect operating conditions ie no wastage, no idle time, therefore,
representing very difficult targets to achieve in practice.
Their effect is to demotivate staff because staff are never able to reach the targets which
have been established.
Current standards
These are based on current performance levels therefore including current inefficiencies etc.
No attempt is made to aim for improved future performance thereby leading to stagnation
and under performance.
Basic standards
These standards are left unaltered over long periods of time and are likely to become out
dated quickly.
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These are used to measure long-term performance and are least useful as a means of
indicating strengths and weaknesses in production performance.
Expected standards
These are based on hope for improved operating performance but not perfect performance
ie what should be practically possible.
If they are well set, these types of standard should motivate employees to improved levels of
performance because they know the standards can be achieved.
1.2 The uses of standard costing are as follows:

 Prediction of costs and times for decision making, eg for allocating resources.
 Standard costing is used in setting budgets – an accurate standard will increase the
accuracy of the budget.
 Variance analysis is a control technique which compares actual with standard costs
and revenues.
 Performance evaluation systems make use of standards as motivators and also as
a basis for assessment.
 Inventory valuation – this is often less time consuming than alternative valuations
methods such as FIFO or weighted average.
1.3 Advantages and disadvantages of setting standards
Advantages Disadvantages
(a) Facilitates budgetary control (a) Difficult to forecast accurately
(b) Leads to more accurate budgeting (b) Time consuming
(c) Assists performance measurement (c) Regular revision required
(d) Assists in target setting for staff (d) Demotivating if wrong
(e) Assists in price setting (e) Includes existing inefficiencies
(f) Simplifies bookkeeping
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2 Pre-determined overhead absorption rates

Businesses need to cost their production throughout the year, not at the end of an
accounting period. Therefore they predetermine or estimate their absorption rates for the
year.
Budgeted overhead
Pre-determined OAR =
Budgeted activity level
Note. Activity level refers to production activity not sales
2.1 Absorption into production
During the year: Business will record overheads regularly.
Overhead = Actual Activity  Predetermined
Absorbed (eg labour hours) OAR
End of the year: actual overheads will be known and it is likely that
Overhead ≠ Actual
Absorbed Overhead
Overheads absorbed may differ from actual overhead costs incurred for either or both of the
following two reasons:
(1) Actual expenditure was more or less than budget (expenditure variance).
(2) Actual units produced (ie volume) were more or less than budget (volume variance).
The difference between the overhead absorbed and the actual overhead is known as the
over or under absorption.
It is shown in the I/S so that in total the actual overhead is charged. The actual overhead is
equal to the amount absorbed plus an adjustment for under absorption or minus an
adjustment for over absorption.
Actual overhead X
Overhead absorbed (X)
Under/(over) absorption X/(X)
Under / (over) absorption can be broken down into an expenditure and a volume variance.
$
Actual overhead X
Overheads absorbed (X)
Adjustment for under/(over) absorption X/(X)
Expenditure variance Volume variance

$ Units
Budgeted expenditure X Budgeted production volume X
Actual expenditure X Actual production volume X
FOH expenditure variance X Difference X
Valued @ Std OAR per unit $ X
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Lecture example 1
Pre-determined overhead absorption rates.
Gurney Halleck limited had the following budgeted and actual figures for units of production and
overheads.
Budget Actual
Units of production 20,000 24,000
Overheads $100,000 $117,000
Required
Complete the following calculations:
=
Pre-determined absorption rate
Overhead absorbed for period =
Actual overhead =
Under/(over) absorption =
3 Fixed and flexible budgets

The fixed budget is the master budget prepared before the beginning of the budget period. It
is based on budgeted volumes, costs and revenues.
The flexible budget is a budget which is designed to change as volume of activity changes.
This can be done by recognising the behaviour of different costs (fixed or variable).
3.1 Purpose of flexible budgets
 Designed to cope with different activity levels to keep the budget meaningful and
hence preserve the relevance of variances for effective control.
 Useful at planning stage to show different results from possible activity levels,
sometimes known as 'what-if analysis'. Spreadsheets will be very useful tools when
considering potential results for different scenarios
 Necessary as control device because we can meaningfully compare actual results
with relevant flexible budget, ie budgetary control.
 Differences between the flexible/flexed budget figures and actual results are called
variances.
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Worked example 2
Suppose W Co manufactures a single product, the CL. Budgeted results and actual results for
June 20X2 are shown below.
Actual
Budget results Variance
Production and sales of the CL (units) 2,000 3,000
$ $ $
Sales revenue (a) 20,000 30,000 10,000 (F)
Direct materials 6,000 8,500 2,500 (A)
Direct labour 4,000 4,500 500 (A)
Maintenance 1,000 1,400 400 (A)
Depreciation 2,000 2,200 200 (A)
Rent and rates 1,500 1,600 100 (A)
Other costs 3,600 5,000 1,400 (A)
Total costs (b) 18,100 23,200 5,100 (A)
Profit (a) – (b) 1,900 6,800 4,900 (F)
Why, in this example, are the variances meaningless for purposes of control?
The correct approach to control

The correct approach to control is as follows.
 Identify fixed and variable costs.
 Produce a flexible budget based on the actual activity level.
If we now have the following estimates of cost behaviour:
(a) Direct materials, direct labour and maintenance costs are variable.
(b) Rent and rates and depreciation are fixed costs.
(c) Other costs consist of fixed costs of $1,600 plus a variable cost of $1 per unit made and
sold.
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The control analysis should therefore be based on a flexible budget as follows.

Fixed Flexed Actual Budget
budget budget results variance
(a) (b) (c) (c)-(b)
Production & sales (units) 2,000 3,000 3,000
$ $ $ $
Sales revenue 20,000 30,000 30,000
Variable costs
Direct materials 6,000 9,000 8,500 500 (F)
Direct labour 4,000 6,000 4,500 1,500 (F)
Maintenance 1,000 1,500 1,400 100 (F)
Semi-variable costs
Other costs 3,600 4,600 5,000 400 (A)
Fixed costs
Depreciation 2,000 2,000 2,200 200 (A)
Rent and rates 1,500 1,500 1,600 100 (A)
Total costs 18,100 24,600 23,200 1,400 (F)
Profit 1,900 5,400 6,800 1,400 (F)
$3,500 (F) $1,400 (F)

Volume variance Expenditure variance
$4,900 (F)
Total variance
Notice that the total variance has not altered. It is still $4,900 (F) as before. The flexible budget
comparison merely analyses the total variance into two separate components.
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Lecture example 2
Wine Co manufactures a single product and has drawn up the following flexible budget for the
year.
Flexible budgets
Bottles produced: 10,000 12,000 14,000

Production costs: $ $ $
Materials 30,000 36,000 42,000
Labour 27,000 31,000 35,000
Overhead 20,000 20,000 20,000
77,000 87,000 97,000
Required
If actual production was 12,350 what is the flexed budget production cost?
Solution
Bottles produced: 12,350
Production costs: $
Materials
Labour
Overhead
Total
Workings
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Lecture example 3
Which of the following describes aspects of a flexible budget?
Solution
 A budget comprising variable production costs only.
 A budget which is updated with actual costs and revenues as they occur during the budget
period.
 A budget which shows the costs and revenues at different levels of activity.
 A sales revenue budget which is changed to reflect the actual unit sales price.
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4 Chapter summary
Topic Summary
Standards A standard is prepared by management in advance, and details their
expectations of the future
A standard cost is a predetermined estimated unit cost used for
inventory valuation and control.
A standard cost card shows full details of the standard cost of each
product.
Standard setting Standards can be set at based on different assumptions. There are four
types: ideal, current, basic and expected.
Uses of standard costs Standards can be used to assess and control actual performance
through the analysis of variances.
Pre-determined Under or over absorption of overheads occurs due to the difference
overhead absorption between the budgeted and the actual expenditure and/or the budgeted
rates and actual activity levels.
Flexible budgets Restating the original budget based on the actual production volume so
that meaningful comparisons can be made.
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END OF CHAPTER
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Variance analysis

 Calculate materials total, price and usage variance.
 Calculate labour total, rate and efficiency variance.
 Calculate variable overhead total, expenditure and efficiency variance
 Calculate fixed overhead total, expenditure and, where appropriate, volume, capacity and efficiency variance.
 Calculate sales price and volume variance.
 Interpret the variances.
 Explain factors to consider before investigating variances, explain possible causes of the variances and
recommend control action.
 Explain the interrelationships between the variances.
 Calculate actual or standard figures where the variances are given.
 Discuss the relative significance of variances.
 Explain potential action to eliminate variances.
 Prepare control reports suitable for presentation to management (to include recommendation of appropriate
control action).
 Reconcile budgeted profit with actual profit under standard absorption costing.
 Reconcile budgeted profit or contribution with actual profit or contribution under standard marginal costing.
Exam Context
Variance calculations are a very important part of your Management Accounting studies and it is vital that you are able
to calculate all of the different types of variance included in the syllabus as this will appear in section A of your
examination and could also appear in section B.
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14: VARIANCE ANALYSIS
Overview
Variance
analysis
Variable cost variances Fixed cost variances Sales variance
Calculation Calculation Calculation

 Materials – price  Fixed o/h – expenditure  Sales – price
– usage – Volume variance
 Labour – rate – sales
– efficiency efficiency capacity volume
variance
 Variable o/h – expenditure
– efficiency
Using variances
Interpretation/ Operating Backward

interdependence statements variances
AC MC
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1 Cost Variances
Variance analysis is used when evaluating performance as part of the control process.
Variances explain the difference between actual results and expected results.
Variances will either be:
 Favourable (F), ie when performance was better than expected;
 Adverse (A), ie when performance was worse than expected.
Each standard cost is made up of both a quantity element and an expenditure element.
Differences in quantities are known as efficiency, usage or volume variances. Differences in
expenditure are known as rate, price or expenditure variances.
We must first calculate the standard cost for actual production – ie the flexed budget
element.
1.1 Material
Total: based on actual production – What should the actual production use and what
should that material cost? What did it cost?
$
'Should' Actual units should cost X
'Did' Actual materials used did cost (X)
X
This will measure whether the material cost more or less than standard cost.
Price: based on cost per kg – What should materials have cost? What did they cost?
'Should' Actual kg purchased should cost X
'Did' Actual kg purchased did cost (X)
X
This will measure whether the actual materials paid for cost more or less than standard.
Usage: based on actual production – How much did it use? How much should it have
used?
Kgs
'Should' Actual production should use X
'Did' Actual production did use (X)
X
Difference valued at standard cost per kg $X
This will measure the cost of production using more or less materials than the standard
allows.
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Worked example 1
A company operates a standard costing system. It purchases and uses 35,464 kg of material at a
cost of $4.75 per kg.
The standard cost card per unit:
Direct materials 4 kg @ $4.50/kg $18.00
Budgeted production: 8,000 units
Actual production: 8,900 units
Required
Calculate the material price and usage variance
Materials
(a) Price-based on actual purchases
 What should they have cost?:
Actual quantity material purchased  standard cost of material/kg $
35,464 kg  $$4.50/kg 159,588
 What did they cost?:
Actual quantity material purchased  actual cost of material/kg (168,454)
(35,464 kg  $4.75)
(8,866) A
(b) Usage-based on actual production.
 What should actual production have used?:
Actual production (units)  standard usage/unit
8,900 units  4 kg 35,600 kg
 What did it use?:
Actual production (units)  actual usage/unit 35,464 kg
136 kg F
Valued at standard cost of material/kg $4.50 $612 F
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Lecture example 1
News Co operates a standard costing system. It purchases and uses 53,000 kg of material at a
cost of $2.38 per kg.
The budgeted production was 25,000 units which requires 50,000 kg of material at a total standard
cost of $125,000. The actual production was 27,000 units.
Required
(a) Calculate the total materials variance:
(b) Calculate the material price variance:
(c) Calculate the material usage variance:
Solution
Workings
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1.2 Labour
Total: based on actual production – What should the actual production use and what
should that labour cost? What did it cost?
$
'Should' Actual units should cost X
'Did' Actual labour used did cost (X)
X
This will measure whether the labour cost more or less than standard cost.
Rate: based on hours paid – What should they have cost? What did they cost?
'Should' Actual hours paid should cost X
'Did' Actual hours paid did cost (X)
X
This will measure whether the actual hours paid for cost more or less than standard.
Efficiency: based on actual production – How long did it take? How long should it have
taken?
Hrs
'Should' Actual production should take X
'Did' Actual production did take (X)
X
Difference valued at standard rate per hour $X
This will measure the cost of production taking more or less time than the standard allows.
Idle time: difference between hours paid and worked.
Hrs
'Should' Hours paid X
'Did' Hours worked (X)
X
Difference valued at standard rate per hour $X
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Lecture example 2
Yard Co operating a standard costing system expects to produce 3,000 units of Y using 12,000 hours
of labour. The standard cost of labour is $12.50 per hour.
Last month the company actually made 2,195 units. The actual labour cost was $110,750 for the
9,200 hours worked.
Required
(a) Calculate the total labour variance:
(b) Calculate the labour rate variance:
(c) Calculate the labour efficiency variance:
Solution
Workings
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Lecture example 3
Flight Co expected to produce 200 units of its product. Actual production was 260 units. The
standard labour cost of a unit was $70 (10 hours at a rate of $7 per hour).
The actual labour cost for 2,300 hours was $18,600. The labour force worked 2,200 hours.
What is the idle time variance?
Solution
 $700
 $400
 $2,100
 $100
1.3 Variable overheads

Expenditure: based on actual hours worked. Calculated as difference between:
 What should they have cost?
$X
Actual hours worked  standard variable overhead cost/hour
 What did they cost?
$(X)
Actual hours worked  actual variable overhead cost/hour
$XF/(X)A
Efficiency: based on actual production. Calculated as difference between:
 How long should it have taken?
X hrs
Actual production  standard hours/unit
 How long did it take?
(X) hrs
Actual production  actual hours/unit
XF/(X)A hrs
$XF/(X)A
Difference valued at standard variable overhead cost/hour
Note. This assumes variable overheads are incurred per labour hour. Hours part of
calculation the same as for the Labour Efficiency Variance.
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1.4 Fixed overheads
1.4.1 Absorption costing

Remember that:
Overheads absorbed (OAR  actual activity) x
Actual overheads (x)
Over / (under) absorption x/(x)
The over / (under) absorption of fixed overheads can be split further as follows:
Fixed overhead volume variance Fixed overhead expenditure variance

Budgeted production volume X Budgeted expenditure $X
Actual production volume X Actual expenditure $X
X $X
Value at OAR / Unit $X
When overheads are absorbed on a labour hour or machine hour basis the volume
variance can be split further into:
Volume efficiency variance Volume capacity variance

Based on actual production
 How long did it take?  Budgeted hours of work
 How long should it have taken?  Actual hours of work
Value at standard OAR/hour Value at standard OAR / hour
1.4.2 Marginal costing

When using marginal costing there is only a fixed overhead expenditure variance, this is
calculated as the difference between the budgeted and actual levels of fixed overhead
expenditure.
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Lecture example 4
Armour Ltd has budgeted to make 1,100 units of a product called Soul during the month of
April 20X3. The budgeted fixed overhead cost is $33,000 and the standard time to make a unit of
Soul is three hours.
The actual fixed overhead cost during the month turns out to be $33,980. 1,000 units of Soul were
produced and the labour force worked for 3,500 hours.
Required
Calculate the following variances:
(i) Fixed overhead total variance
(ii) Fixed overhead expenditure variance
(iii) Fixed overhead volume variance
(iv) Fixed overhead efficiency variance
(v) Fixed overhead capacity variance
Solution
Workings
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2 Sales variances
Sales variances measure the effect on expected profit of a different selling price to the
standard and a different volume of sales to the original budget. The total variances can be
split as follows:
Price: based on actual units sold. Calculated as difference between:
 What revenue should have been achieved?
Actual units sold  standard selling price $X
 What revenue was achieved?
Actual units sold  actual selling price $(X)
$XA/(X)F
Volume: difference between budgeted and actual sales volume. Value at standard
contribution (marginal costing) or standard profit (absorption costing).
Budget volume X units
Actual volume (X) units
XA/(X)F units
Valued @ Standard contribution per unit (MC)
or Standard profit per unit (AC) $XA/(X)F
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Lecture example 5
The following data is available with regard to a product
Period Period
actual budget
Sales (Units) 10,100 10,000
$ $
Total sales value 52,520 51,000
Total manufacturing costs at standard 43,430 43,000
Manufacturing profit 9,090 8,000
Solution
What was the sales price variance?
 $1,010 adverse
 $510 favourable
 $520 favourable
 $1,010 favourable
What is the sales volume variance?
 $80 favourable
 $90 favourable
 $510 favourable
 $520 favourable
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3 Applying variance analysis

3.1 Operating statements
An operating statement shows how the combination of variances that reconcile the original
budget to the actual profit.
Worked example 2
Canary Inc a manufacturer of mobile phone car kits has the following financial data:
BUDGET Unit Total
$ $
Sales (8,000 units) 75 600,000
Production (8,700 units)
Materials 4 kg @ $4.50 18 156,600
Labour 5hrs @ $5 25 217,500
Variable overheads 5 hrs @ $2 10 87,000

53 461,100
Closing inventory (700 units @ $53/unit) (37,100)
424,000
Budgeted contributions 176,000
Budgeted fixed overheads 130,500
ACTUAL $
Sales (8,400 units) 613,200
Production (8,900 units)
Materials purchased 35,464 kgs for $163,455 (used 34,928 kgs) 161,043
Labour (45,400 hours paid and worked) 224,515
Variable overheads 87,348
472,906
Closing inventory (500 units @ $53/unit)) (26,500)
446,406
Actual contribution 166,794
Actual fixed overheads 134,074
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Operating Statement under marginal costing

$
Budgeted contribution (8,000 units at $22/unit) 176,000
Sales volume variance 8,800
Flexed contribution 184,800
Sales price variance (16,800)

168,000
Cost variances: F A
Materials – price 3,867
– usage 3,024
Labour – wage rate 2,485

– efficiency 4,500
Var. O/head – expenditure 3,452

8,961 10,167 (1,206)
 Actual contribution 166,794
Less: Fixed costs:

Budgeted 130,500
Expenditure variance 3,574 (A) (134,074)
Actual profit 32,720
3.2 Differences between the treatment of variances under absorption costing and
marginal costing
Absorption costing Marginal costing

Sales volume variance Valued at standard profit per Valued at standard
unit contribution per unit
Treatment of FOH variances FOH Expenditure variance FOH Expenditure variance
FOH Volume variance: only
 Capacity
 Efficiency
In addition, when you are preparing an operating statement under absorption costing you
reconcile budgeted profit to flexed budgeted profit to actual profit.
270

Lecture example 6
Using the same data used in Canary Inc worked example 2 produce an operating statement that
reconciles budgeted profit to actual profit under absorption costing principles. Remember the
budgeted and actual profit under absorption costing will not be the same as those calculated under
marginal costing.
Solution
Operating statement for period ended 31/12/XX (under absorption costing)
$
Budgeted profit
Sales volume variance
Flexed profit
Sales price variance
Cost variances (as before) $F $A

Materials Price
Usage
Labour Rate
Efficiency
Variable overheads
Expenditure
Efficiency
Fixed overheads:
Expenditure variance
Efficiency variance
Capacity variance
Actual profit
Workings
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3.3 Interpretation of variances

Care must be taken when interpreting variances, especially when they are being used to
assess the performance of employees. Remember to use the scenario in the question to
give you ideas.
The following table may help you to think about some of the operational causes of
variances.
Variance Favourable Adverse

Material price Unforeseen discounts received Price increase
Greater care in purchasing Careless purchasing
Change in material standard Change in material standard
Material usage Material used of higher quality Defective material
than standard Excessive waste or theft
More efficient use of material Stricter quality control
Errors in allocating material to Errors in allocating material to
jobs jobs
Labour rate Use of workers at a rate of pay Wage rate increase
lower than standard
Labour efficiency Output produced more quickly Lost time in excess of standard
than expected because of Output lower than standard set
worker motivation, better because of lack of training,
quality materials etc sub-standard materials etc
Errors in allocating time to jobs Errors in allocating time to jobs
Higher grade of labour than
originally planned
Fixed overhead Savings in costs incurred Increase in cost of services
expenditure More economical use of used
services Excessive use of services
Change in type of service used
Overhead expenditure variances ought to be traced to the individual cost centres where the
variances occurred.
Fixed overhead Production or level of activity Production or level of activity
volume greater than budgeted less than budgeted
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3.4 Interdependence of variances

In order to interpret variances effectively any interdependence between variances must be
identified, ie it is not always possible to look at individual variances in isolation.
When two variances are interdependent one will usually be adverse and the other
favourable.
Eg (a) Cheaper materials Favourable price variance
Adverse usage variance and

Inferior quality perhaps adverse efficiency
variance (labour and overheads)
(b) Higher rate for labour Adverse price (rate) variances
Favourable efficiency variances.

Higher efficiency Favourable usage variances
(materials)
It is therefore important in analysing any variance that the overall consequence should be
considered. An unfavourable variance may give concern by itself, but a favourable variance
may have unfavourable interdependent variances.
3.5 When to investigate

Once variances have been calculated, which variances need investigating must be decided.
General factors for consideration would be:
 Size of variance
 Controllability of variance
 Cost of investigation
 Interrelationships with other variances
 Level of standard
 Trend emerging
3.6 Control action

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, but not simply due to chance, it will
be necessary to review forecasts of expected results and maybe revise the budget.
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Lecture example 7
Sweatshop Ltd has found that it has had an increasing adverse labour efficiency variance for the
last 3 months. You learn that the company is using lots of temporary workers in a bid to keep up
with increased demand for its single product, the Z.
Which two of the following control actions could be implemented by the company to try to
eliminate this?
Solution
Increase the hourly rate paid to temporary workers
Offer paid overtime to the company's existing skilled employees
Implement training for the temporary employees
Reduce the number of supervisors.
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3.7 Backwards variances

Sometimes an exam question may be set which requires you to work from a set of variances
back to actual or budgeted data.
Lecture example 8
The direct labour cost data relating to last month was as follows:
Actual hours worked 28,000
Total direct labour cost $117,600
Direct labour rate variance $ 8,400 (adverse)
Direct labour efficiency variance $ 3,900 (adverse)
To the nearest thousand (in hours), what are the total standard labour hours last month?
Solution
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Lecture example 9
A company uses standard marginal costing. Last month the standard contribution on actual sales
was $23,000 and the following variances arose:
$
Total variable costs variance 3,250 Adverse
Sales price variance 4,000 Favourable
Sales volume contribution variance 7,500 Adverse
What was the actual contribution for last month?
Solution
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4 Chapter summary
Topic Summary
Variances Variances show the differences between actual results and expected
results and provide information for performance evaluation and control
purposes.
Cost variances Cost variances can be calculated for materials, labour and overheads.
Fixed overheads Using marginal costing there is just a FOH expenditure variance.
Using absorption costing a FOH volume variance can be calculated, this
can be further sub-divided into capacity and efficiency.
Sales variances Sales price variance and sales volume variance measure the effect on
profit of different selling prices and volumes to the standard.
Interpretation of The interpretation of variances is a crucial element of the control
variances process. Variances are often interdependent and this must be taken into
account when deciding on the control action to implement.
When to investigate Before deciding whether to investigate a variance factors such as size,
trend and controllability should be considered.
The interdependencies between variances should also be considered.
Operating statements Operating statements show how the combination of variances reconcile
budgeted profit and actual profit. Be prepared to produce part of the
operating statement only, for example budgeted materials cost to actual
materials cost.
Absorption costing v The differences in variance calculations between using absorption and
marginal costing marginal costing include:
variances Under marginal costing
 Only the fixed overhead expenditure variance is needed
 Sales volume variance calculated based on standard contribution
 Operating statement reconciles budgeted contribution to actual
contribution and then to actual profit.
Backwards variances Sometimes an exam question may be set which requires you to work
from a set of variances back to actual or budgeted data.
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END OF CHAPTER
278

topics.
It is vital in terms of your progress towards 'exam readiness' that you attempt this Step in the near future.
Course notes
chapter
Forecasting 4
Process costing 8
Costing methods 9
Setting budgets 10
Budgeting
Project appraisal Project appraisal 12
Standard costing Standard costing 13
Variance analysis Variance analysis 14
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ACHIEVEMENT LADDER
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Target setting

 Discuss the purpose of mission statements and their role in performance measurement.
 Discuss the purpose of strategic and operational and tactical objectives and their role in performance
measurement.
 Discuss the role of benchmarking in performance measurement.
 Discuss critical success factors and key performance indicators and their link to objectives and mission
statements
 Establish critical success factors and key performance indicators in a specific situation
 Discuss the impact of economic and market conditions on performance measurement.
 Explain the impact of government regulation on performance measurement.
Exam Context
This chapter links to the organisational objectives and goals covered in chapter 1. It is most likely to be tested in section
A of the examination.
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15: TARGET SETTING
Overview
Target setting
Mission
Calibr Objectives Critical success Benchmarking External
factors conditions
Strategic
Tactical
Operational
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15: TARGET SETTING
1 Mission and Objectives

1.1 Mission
This represents the vision of top management: what is it that they are trying to achieve?
A good mission statement should contain the following characteristics:
 Brevity
 Flexibility
 Distinctiveness
Lecture example 1
Which of the following statements would not be expected to appear within a mission
statement for a cafe?
Solution
 The cafe believes in paying a fair price to its suppliers and only serves fair trade tea and
coffee.
 The cafe serves homemade food.
 The cafe exists to provide a return for its investors and refreshments for visitors to the park.
 The cafe aims to attract 200 customers this week.
1.2 Objectives
Most organisations will set themselves quantified objectives in order to enact their mission.
There should be goal congruence within the goals set for different parts of the organisation.
Characteristics of objectives:
S pecific
M easureable
A ttainable
R elevant
T ime-bounded
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15: TARGET SETTING
Lecture example 2
Your mission is to become the Finance Director of a FTSE 100 company. What is a suitable
objective to set regarding studying this course?
Solution
1.3 Primary and secondary objectives

Some objectives are more important than others. There is a primary corporate objective
and other secondary objectives which are strategic objectives which should combine to
ensure the achievement of the primary corporate objective.
Lecture example 3
If a company sets its primary objective to be growth in profits, what secondary objectives might it
use?
Solution
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15: TARGET SETTING
2 Planning, control and decision making

Information for management accounting is likely to be used for planning, control and
decision making.
Planning  establishing objectives.
 selecting appropriate strategies to achieve those objectives.
2.1 The objectives of a firm may be:
The objectives of a firm may be:
Profit making firm Non-profit making firm

 Increase market share  User satisfaction
 Increase sales revenue  Level of service provision
 Increase profits  Value for money
 Reduce costs
2.2 Levels of objectives
Strategic
Tactical
Operational
Different objectives will be required at different levels in the organisation to enable the
company to achieve its primary objective.
Management should ensure that there is consistency between objectives horizontally as well
as vertically.
Long-term strategic planning (corporate plan) involves determining an organisation's long-
term goals and then selecting appropriate strategies to attain those objectives.
Shorter term planning involves developing tactical and operational plans in order to
achieve the goals of the corporate plan.
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15: TARGET SETTING
Lecture example 4
Buster sells vacuum cleaners.
Which TWO of the following are suitable measures of performance at the strategic level?
Solution
Number of vacuum cleaners sold
Return on investment
Market share
Number of vacuum cleaners returned
Control  There are two key mechanisms within the control process.
(1) Actual performance is compared with planned performance of the
organisation as set out in the detailed operational plan and
adjusted in response.
(2) The corporate plan is reviewed to reflect significant new
information.
Decision Making  Managers at all levels within an organisation make decisions.

It is the role of management accountants to provide information so
that management at whatever level can reach an informed
decision.
3 Critical success factors

A critical success is a performance requirement that is fundamental to competitive
success.
These are examples of 'critical success factors'.
 Profitability
 Market share
 Productivity
 Product leadership goals
 Personnel development
 Employee attitudes
 Public responsibility
Critical success factors can be set and used by identifying objectives and goals,
determining which factors are critical for accomplishing each objective and then
determining a small number of performance measures for each factor.
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15: TARGET SETTING
4 Short termism
As well as conflict between objectives, there can also be conflict between time frames.
Managers performance is often measured on short-term results, trying to achieve these may
involve the sacrifice of longer-term objectives.
For example, trying to maximise profit in the short term may involve postponing R&D
expenditure, advertising or other investment which would contribute to growth in profits in
long term.
4.1 Methods to encourage a long-term view:
 Making short term targets realistic
 Providing sufficient management information
 Evaluating manager's performance
 Link rewards to share price
 Set quality based targets
5 Benchmarking
A business will attempt to seek the best available performance against which it can measure
its own performance. By adopting what is regarded as best practice as a target, the
business attempts to improve its own performance. In this way, the business can be as good
as, or better than, the best in class in the most important areas of operation.
Benchmarking uses a challenging target for improving the operations of the business. It can
benefit from the knowledge and practices of other businesses, without having to make all its
own mistakes, and it can obtain a competitive advantage.
Benchmarking is now widely used in not for profit organisations, because there are less
issues with confidentiality and sharing best practice.
5.1 Types of benchmarking:

 Internal benchmarking: a method of comparing one operating unit or function with
another within the same organisation.
 Competitive benchmarking: in which information is gathered about other direct
competitors, using techniques including reverse engineering.
 Functional benchmarking: where internal functions are compared regardless of
industry, this may occur when non competing businesses have similar processes.
 Strategic benchmarking: this is a type of competitive benchmarking aimed at
strategic action and organisational change.
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15: TARGET SETTING
Lecture example 5
Read zone is an online book store that wants to undertake an external benchmarking exercise in
order to evaluate its delivery processes. Which of the following would be the most suitable
organisation to approach with a view to sharing data?
Solution
 The market leader in online book retailing
 An online tie retailer.
 A high street book seller
 A take away Pizza company
6 External conditions
Chapter 23
section 8 External conditions can also affect performance. An organisation must be aware of the
following external conditions when measuring performance:
 Market conditions: the entry of a new competitors to the market is likely to impact on
performance.
 General economic conditions: overall demand and supply will be impacted by
changes in interest and inflation rates.
 Government influence: taxation, legislation and a government's economic policy will
affect a business's performance.
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15: TARGET SETTING
7 Chapter summary
Topic Summary
Mission Top management's vision
Objectives SMART
Primary v secondary
Strategic, tactical, competitive
Critical success factors Goals which are fundamental to competitive success
Benchmarking Internal
Competitive
Functional
Strategic
External conditions Market conditions, general economic conditions and government
influence can impact on performance measurement.
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15: TARGET SETTING
END OF CHAPTER
290

Financial performance
measurement

 Discuss and calculate measures of financial performance (profitability, liquidity, activity and gearing)
 Distinguish between cost, profit, investment and revenue centres.
 Describe the differing needs for information of cost, profit, investment and revenue centre managers.
 Discuss measures that may be used to assess managerial performance and the practical problems involved.
 Calculate return on investment and residual income.
 Explain the advantages and limitations of return on investment and residual income.
Exam Context
This chapter looks at how to evaluate financial performance. You should expect questions assessing financial
performance in both section A and B of the examination and must ensure that you learn all of the ratios.
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16: FINANCIAL PERFORMANCE MEASUREMENT
Overview
Financial performance measurement
Ratios
Profitability Liquidity Gearing
Responsibility
centres
ROI RI
292

1 Performance measures
Performance measure can be divided into two groups.
 Financial performance measures
 Non-financial performance measures (chapter 17)
1.1 Profitability
PBIT
(a) Return on capital employed ( ROCE) = %
TALCL
PBIT = Profit before interest and tax. It is often referred to internationally as IBIT
(Income before interest and tax)
TALCL = Total assets less current liabilities. It is equal to the capital invested in the
business (equity plus non-current liabilities).
PBIT
(b) Return on sales (profit margin) = %
Revenue
Revenue
(c) Asset turnover =
TALCL
PAT and preference dividends
(d) Return on equity = %
Equity shareholders' funds
1.2 Liquidity
Current assets
(a) Current ratio =
Current liabilities
Current assets  inventories

(b) Quick ratio (or acid test) =
Current liabilities
Cost of sales Inventories

(c) Inventory turnover/days = or × 365 days
Inventories Cost of sales
Trade receivables
(d) Receivables collection period = × 365 days
Credit turnover
Trade payables
(e) Payables payment period = × 365 days
Credit purchases
1.3 Gearing
Debt
(a) Gearing =
Debt + Equity
PBIT
(b) Interest cover =
Interest charges
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Lecture example 1
The following figures are extracted from the accounts of Big Bond plc.
20X9 20X8
Total production cost $3,269,000 $2,541,000
Gross profit for the year $1,503,000 $1,291,000
Net profit for the year before interest and taxation $295,000 $287,000
Total assets less current liabilities $3,005,500 $2,861,000
Average number of employees in the year 260 248
Number of books produced 29,361 27,498
Required
Calculate the following ratios:
Return on sales (net profit percentage)
Gross profit margin
Return on capital employed
Sales per employee

Average production cost per book
Average number of books produced per employee
Solution
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1.4 Limitations
 On their own, they do not provide information to enable managers to gauge
performance or make control decisions.
 The ratios used must be carefully defined.
 Measures compared over a period of time at historical cost will not be properly
comparable where inflation in prices has incurred during the period, unless an
adjustment is made to the measures to make allowance for price level differences.
 The performance of different companies cannot be properly compared where each
company uses different accounting policies.
2 Responsibility centres
2.1 Divisionalisation
As companies grow, and possibly also spread geographically, it is likely to need some form
of Divisionalisation. Divisional managers are then given the authority to make decisions
concerning the activities of their divisions.
2.2 Responsibility accounting

Responsibility accounting is the term used to describe decentralisation of authority, with the
performance of the decentralised units or responsibility centres measured in terms of
accounting results.
Lecture example 2
Within a system of responsibility accounting there are four main types of responsibility centre:
cost centre, revenue centre, profit centre and investment centre.
Identify for each of the responsibility centres below, one example of a decision which
managers can control and a principle performance measure.
Solution
Type of Example of Manager has Principal
responsibility responsibility centre control over performance
centre measures
Cost centre Design department
Revenue centre Car dealer
Profit centre Canteen car factory
Investment centre New overseas sales outlet
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3 Appraisal of Investment centres

Where a manager of a division is allowed some discretion about the nature of the
investment undertaken by the division, assessment of results by profit alone (as for a profit
centre) is inadequate. The profit earned must be related to the amount of capital
invested. Such divisions are sometimes called investment centres for this reason.
Performance can be measured by return on investment (ROI) and by residual income (RI).
The amount of capital employed attributed to an investment centre should consist only of
directly attributable non-current assets and working capital (net current assets).
3.1 Return on investment (ROI)
ROI is often used as a measure to monitor the performance of an investment centre. It
shows how much profit has been earned in relation to the amount of capital invested in the
centre.
Controllable divisional profit
ROI =  100%
Divisional capital employed
The main reason for the widespread use of ROI is that it ties in directly with the
accounting system and is identifiable from the income statement and balance sheet.
Return on Capital Employed (ROCE) provides the same relative profit/capital employed
measure, but for the entire company.
Lecture example 3
News Inc. has two publications which it treats as separate investment centres, Real News and
Tabloid Trash, which show results for the year as follows.
R.N T.T
$000 $000
Profit 6,000 3,000
Capital employed 40,000 12,000
Which investment centre has been more successful?
Solution
296

3.2 ROI and goal congruence

In certain circumstances the use of ROI as a performance measure might not lead to
goal congruent decisions.
Lecture example 4
E-Wheels is an investment centre of a bicycle retailer Cycle Corp. Its current divisional profit is
$300,000 which has been generated on investments of $1m. The target return on investment is
20%.
The divisional manager of E-Wheels has the opportunity to upgrade the web servers at a cost
$100,000. It is expected that as a result of the ability to handle increased internet traffic an
additional $25,000 of profits could be earned.
Would the manager proceed with the upgrade if they were paid a bonus based on ROI?
Solution
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3.3 Residual income (RI)

An alternative way of measuring the performance of an investment centre is residual income
(RI). RI is an absolute measure of the centre's profits after deducting a notional or
imputed interest charge based on the total invested in the division multiplied by the
company's cost of the capital.
RI can avoid some of the behavioural problems of dysfunction decision making that arise
with the use of ROI.
Residual Income = Controllable profit – (controllable investment  cost of capital)
Worked example 1
Residual income and goal congruence

Returning to the E-wheels activity, would the divisional manager accept the proposed upgrade
project if the bonus was based on RI?
$'000
Divisional RI without the project:
Divisional profit 300
Imputed interest charge (20%  $1m) 200
100
Divisional RI with the project:

Divisional profit 325
Imputed interest charge (20%  $1,100,000) 220
105
The RI would increase therefore the manager would accept the project. In this particular
circumstance, RI would lead to a goal congruent decision since the project ROI of 25% is
acceptable to the company.
Note. that the ROI and the RI are both based on the same figures for profits and capital employed.
The difference is that ROI is a relative measure whereas RI is an absolute measure.
298

Lecture example 5
Fizz Co is a soft drinks manufacture with two divisions. Shareholders are expecting a return of at
least 15%.
Profit Investment
$m $m
Cola 64 320
Tropical 16 64
Which manager will receive a bonus for the best performance if ROI or RI is used to
measure performance.
Solution
ROI RI
A Cola Tropical
B Cola Cola
C Tropical Tropical
D Tropical Cola
Lecture example 6
Atwell Ltd has a capital employed of $300,000. It has a cost of capital of 13% per year and its
residual income is $6,000.
What is the company's return on investment?
 2%
 10%
 13%
 15%
Solution
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3.4 The advantages and disadvantages of RI compared with ROI

The advantages of using RI
 Acceptable projects increase the RI of a division giving a simpler decision rule
 Goal congruent decisions more likely to occur.
 RI can be more flexible as different costs of capital can be applied to investments with
different risk characteristics
The disadvantages of using RI
 Comparisons between divisions and projects are more difficult
 RI does not relate the size of a centre's income to the size of the investment
 Requires a cost of capital
3.5 RI versus ROI: marginally profitable investments

RI will increase if a new investment is undertaken which earns a profit in excess of the
imputed interest charge on the value of the asset acquired. This means that 'marginally
profitable' investments are likely to be undertaken by the investment centre manager.
In contrast, when a manager is judged by ROI, a marginally profitable investment would be
less likely to be undertaken because it would reduce the average ROI earned by the centre
as a whole.
4 Chapter summary
Topic Summary
Quantitative evaluation via ratios. Ensure you have learnt the
Financial performance
ratios.
Responsibility centres Return on Investment
performance measurement Controllable  traceable  profit
(ROI)= × 100%
Controllable  traceable  investment
Residual Income (RI) =
Controllable profit – (controllable investment  cost of capital)
END OF CHAPTER
300

Assessing non-financial
performance

 Discuss the importance of non-financial performance measures .
 Discuss and calculate non-financial measures.
 Discuss the relationship between short-term and long-term performance
 Discuss the advantages and limitations of the balanced scorecard.
 Describe the performance indicators for financial success, customer satisfaction, process efficiency and growth.
 Discuss the measurement of performance in non-profit seeking and public sector organisations.
 Explain the concepts of economy, efficiency and effectiveness.
 Describe performance indicators for economy, efficiency and effectiveness.
 Establish performance indicators for economy, efficiency and effectiveness in a specific situation.
 Discuss the meaning of each of the efficiency, capacity and activity ratios.
 Calculate the efficiency, capacity and activity ratios in a specific situation.
 Establish measures of resource utilisation in a specific situation.
 Describe performance measures which would be suitable in contract and process costing environments.
 Describe measures of performance utilisation in service and manufacturing environments.
 Distinguish performance measurement issues in service and manufacturing industries
 Describe performance measures appropriate for service industries
 Discuss the measurement of performance in service industry situations
 Produce reports highlighting key areas for management attention and recommendations for improvement.
Exam Context
This chapter considers ways of assessing non-financial performance, there are lots of techniques you need to learn and
be prepared to apply in section A and B of the examination.
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17: ASSESSING NON-FINANCIAL PERFORMANCE
Overview
performance
Labour Balanced NPMOs Contract and Service and

Performance scorecard process costing manufacturing
industries
302

1 Non-financial indicators
Financial measures do not convey the full picture of a company's performance, especially in
a modern business environment. Today, organisations are competing in terms of product
quality, delivery, reliability, after-sales service and customer satisfaction. Successful
execution of these variables is essential for success but none of these are directly measured
by a traditional accounting system.
Many companies are therefore using of quantitative and qualitative non-financial
indicators (NFIs) such as the following.
 Quality
 Number of customer complaints
 Number of warranty claims
 Lead times
 Rework
 Delivery to time
 Non-productive hours
 System (machine) down time, and so on
Unlike traditional variance reports, measures such as these can be provided quickly for
managers, per shift or on a daily or even hourly basis as required. They are likely to be easy
to calculate, and easier for non-financial managers to understand and therefore to use
effectively to take action.
The beauty of non-financial indicators is that anything can be compared if it is
meaningful to do so.
Worked example 1
If a company wanted to see how efficient an invoice clerk was they could review invoices
generated per day. What this fails to show is how accurately they are working.
Therefore miscalculations per 1,000 invoices would be a better indicator.
2 Problems with NFPI's

 Too many measures can lead to information overload for managers, providing
information which is not truly useful.
 May lead managers to pursue detailed operational goals at the expense of overall
corporate strategy.
 Need to be developed and refined over time to ensure remain relevant.
 Need to be linked with financial measures.
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3 Efficiency, capacity and activity (production volume)

ratio
The following ratios can be used to assess labour performance. They are referred to as
control ratios and use standard hours.
Note that these ratios were covered in Chapter 6 Accounting for labour.
Standard hour = standard hour/unit  actual number of units made.
The standard hour 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.
Efficiency ratio = Standard hours produced  100%

Actual hours worked
This measures the efficiency of the labour force.
Actual hours worked
Capacity ratio =  100%
Budgeted hours
This measures the extent to which planned utilisation has been achieved.
Standard hours produced
Activity (production volume) ratio =  100%
Budgeted hours
Lecture example 1
Barnes Ltd budgeted to make 12,000 standard units of output during a budget period of
36,000 hours (each unit should take 3 hours each).
During the period, the company actually made 14,000 units which took 40,000 hours.
Calculate the efficiency, capacity and activity ratios.
Solution
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4 The Balanced Scorecard

A popular approach in current management thinking to performance measurement (for
service and non-service organisations) is the use of a 'balanced scorecard', consisting of a
variety of indicators both financial and non-financial.
The balanced scorecard focuses on four different perspectives and aims to establish goals
for each together with measures which can be used to evaluate whether these goals have
been achieved.
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Perspective Question
Customer What do existing and new customers value from us? This perspective
satisfaction gives rise to targets that matter to customers: cost, quality and so on
Process efficiency What processes must we excel at to achieve our financial and
customer objectives? This perspective aims to improve internal
processes and decision making.
Growth Can we continue to improve and create future value? This perspective
considers the business's capacity to maintain its competitive position
by acquiring new skills and developing new products
Financial success How do we create value for our shareholders? This perspective covers
traditional measures, such as growth, profitability and shareholder
value, but these are set by talking to the shareholder or shareholders
direct
4.1 Features
 Traditional measures are mainly inward looking and narrow in focus with over
emphasis on financial measures and short term goals.
 The Balanced Scorecard focuses on both internal and external factors and links
performance measures to key elements of a company's strategy.
 It requires a balanced consideration of both financial and non-financial measures and
goals to prevent improvements being made in one area at the expense of another.
 It attempts to identify the needs and concerns of customers to identify new products
and markets and focuses on comparison with competitors to establish best practice.
Lecture example 2
For each of the following performance indicators, for a general insurance company, identify one
balanced scorecard perspective being measured.
(a) % of policies renewed
(b) Staff training days
(c) Return on capital employed
(d) % revenue from new products
(e) % of premiums paid out as claims
(f) % of policy documents sent out within 5 working days
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5 Performance measures for non-profit-making

organisations (NPMOs)
NPMOs includes organisations such as charities and much of the public sector. By
definition, NPMOs can't be judged by profitability, nor do they generally have to be
successful against competition, so other methods of assessing performance have to be
used.
Performance is usually judged in terms of 'value for money'. Using the 3 E's:
Economy is concerned with the inputs of an organisation. The idea is to attain the
appropriate quantity and quality of inputs at the lowest cost.
Effectiveness looks at the outputs of the organisation specifically in relation to its objectives
and the requirements of its stakeholders.
Efficiency is the relationship between inputs and outputs and can be viewed in two ways.
 Maximising output for a given input
 Achieving the minimum input for a given output.
Lecture example 3
Using the 3 Es suggest a range of performance measures for a public sector library.
Solution
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Lecture example 4
The Travelwise bus service is government owned. The government requires it provide local bus
services for the rural and urban residents of Angloland at low prices, which are set by the
government. Best Buses Co is a privately owned bus company that also operates in Angloland. It
is not subject to government regulation and most of its journeys are in the large cities of Angloland
where customer numbers are high.
Which of the following factors should NOT be allowed for when comparing the ROCE of the
two organisations to assess the efficiency of their management?
Solution
 Differences in objectives pursued
 Differences in prices
 Differences in geographic area served
 Differences in customer complaints
6 Performance measurement in contract and process

costing environments
Chapter 24 section 2
In a contract environment each contract undertaken is unique. Products are made to the
specific requirements of individual customers. Detailed planning should be undertaken and
performance targets set.
Suppliers may be different for each contract, making it harder to set standards for
quality, speed of delivery and so on.
Customer satisfaction measures are particularly important in this environment
The high degree of standardisation in a process costing environment means that it is ideal
for setting performance standards. However, costs, materials usage/wastage, labour
inefficiencies, machine breakdowns and so on cannot be traced to a specific item. These
features can only be measured on an average per unit basis. A measure like 'cost per unit'
in a processing environment reflects average performance over a period of time. It may
therefore be more difficult to improve on existing performance standards, as inefficiencies
may not be easily identifiable.
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7 Performance measurement in service and

manufacturing industries
The key to performance measurement in service industries is to ensure that what you are
measuring has been clearly enough defined. Performance measures covering the following
six dimensions have been suggested for service organisations:
Chapter 24 section 3
 Competitive performance
 Financial performance
 Quality of service
 Flexibility
 Resource utilisation
 Innovation
Performance measurement in manufacturing is increasingly using non-financial measures.
Malcolm Smith identifies four overarching measures for manufacturing environments.
Chapter 24  Cost
section 1 and 2
 Time
 Quality
 Innovation
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8 Chapter summary
Topic Summary
Non-financial performance More useful in modern environment with multiple factors
measures
Efficiency, capacity and activity Control ratios used for management reports.
ratios
Balanced Scorecard 4 dimensions:
Financial success
Customer satisfaction
Process efficiency
Growth
Performance is often evaluated using the 3 Es
Economy
3Es
Effectiveness
Efficiency
Contract and process costing In a contract environment each contract undertaken is unique.
Detailed planning should be undertaken and performance
targets set.
The high degree of standardisation in a process costing
environment means that it is ideal for setting performance
standards.
Service and manufacturing The key to performance measurement in service industries is to
industries ensure that what you are measuring has been clearly enough
defined.
Performance measurement in manufacturing is increasingly
using non-financial measures.
END OF CHAPTER
310

You have now covered the Topics that will be assessed in Step 5 in your Achievement Ladder. This
topics.
It is vital in terms of your progress towards 'exam readiness' that you attempt this Step in the near future.
Course notes
chapter
Forecasting 4
Process costing 8
Costing methods 9
Setting budgets 10
Budgeting
Target setting 15
Performance measurement (1)
Financial performance measurement 16
Performance measurement (2) Assessing non-financial performance 17
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ACHIEVEMENT LADDER
312

In the final run up to your exam, you should attempt Step 6 as the final check that you are fully prepared
for your real CBE exam.
It covers all the Topics in your course. As ever, you will receive feedback on your performance, and you
can use the wide range of online resources to help address any final areas where you need to fine tune
your knowledge or technique.
Course notes
chapter
Forecasting 4
Process costing 8
Costing methods 9
Setting budgets 10
Budgeting
Target setting 15
Performance measurement (1)
Financial performance measurement 16
Performance measurement (2) Assessing non-financial performance 17
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ACHIEVEMENT LADDER
314

Answers to
Lecture Examples
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18: ANSWERS TO LECTURE EXAMPLES
Chapter 1
Answer to Lecture Example 1
Source Information needed
Competitors Prices, product specifications, markets
Customers Needs and wants of product, price prepared to pay
Suppliers Products, prices, quality of supplies, financial position, delivery time
Government Tax rates, minimum wage and other legislation.

Financial accounting Management accounting
Legal requirement  X
Users External and internal Internal
Precision True and fair As accurate as possible for the
users needs
Rules Generally accepted accounting No rules govern them but some
principles established techniques used
Reporting Past data Past and present data to make
decisions about future
Scope Whole organisation Segments/divisions or whatever
is needed by the business
Frequency Annual As required
Format Governed by Companies Act No set format

Good information
Monthly sales figures for August received in November.
A summary provided at the front of a report to save senior manager's 
from having to read the whole document.
A dashboard report summarising all the key results for the last period 
for use at the next management meeting.
Monthly report showing that the chocolate mixing machine was
adding 1% too much cocoa in the last period.
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Chapter 2
Advantages of primary data
 Known source
 Known collection method
 Awareness of limitations
 Tailor-made to requirements
 Up-to-date
Disadvantages of primary data
 Expensive to collect
 Time consuming

The correct answers are:
If a sample is selected using random sampling, it will be free from bias
In quota sampling, investigators are told to interview all the people they meet up to a
certain quota
A sampling list is a numbered list of all items in a population not a sample
At each stage in multistage a sample is picked at random

The correct answer is 60 degrees
120/720  360 = 60 degrees

(a) = B2 + B3 + B4 or = SUM(B2 : B4)
(b) = B5* 0.175
(c) = B5 + B6 or = B5* 1.175

Absolute cell referencing: = B5*$C$2

= IF (C4>=200000, 'BONUS', 'NO BONUS')
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Chapter 3
Production costs
 Glue  Supervisor  Rent
 Grease for machine  Factory cleaner  Rates
 Paper towels  Insurance of machinery

Non production costs
Administration Selling Distribution Finance
 Depreciation of  Sales staff  Packing  Overdraft interest
office equipment salaries
 Office salaries  Cars for sales  Driver salaries  Loan interest
directors etc staff
 Advertising  Van insurance  Dividends
Total production costs
Direct Indirect
Materials Labour Expenses Material Labour Expenses
CD Factory Royalties Oil/grease Supervisor Rent

Box staff for Rates
machine Insurance
Direct Indirect
 Selling cost per CD ie Sales commission  Admin department
 Distribution cost per CD ie Post &  Finance department
packaging
 Head office
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Types of cost behaviour
(a) Fixed cost (b) Stepped fixed cost

$ $
Total Total
cost cost
0 0
eg rent, rates, insurance eg rent if further production space is
required
(c) Variable cost (d) Mixed cost

$ $
Total Total
cost cost
0 0
eg material, labour eg telephone bill, labour on minimum
wage or total cost

Graph D
Production cost centres  Machining

Finishing
Pressing
Packing
Service cost centre  Canteen
Maintenance
Stores
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Answer to Worked Example 1

The correct answer is:
Y = $10,000 + $100x
Units Costs
$
Highest 1,000 110,000
Lowest 200 30,000
800 80,000
 variable cost per unit = $80,000 = $100

800
Fixed cost element:
TC = FC + VC/unit  output
Substitute at the highest level:
$110,000 = FC + $100  1,000
FC = $10,000

y = 10,000 + 100x
y = 10,000 + 100  780
TC = $88,000

Units $
100,000 378,000
65,000 290,500
35,000 87,500
87,500
Variable cost = = $2.50
35,000
Fixed cost = 378,000 – (100,000 × 2.50)
= 128,000
80% capacity = 80,000 units
Flexible budget allowance for 80,000 units = $128,000 + (80,000 × $2.50) = $328,000.
320


High/low method above volume of 7,000 units.
Output Total cost
$
Lowest 7,500 76,500
Highest 10,000 90,000
2,500 13,500
VC/unit = $13,500 = $5.40/unit

2,500
Note: This is constant at all volumes of output
Substitute at lowest (or highest) level:
$76,500 = FC + $5.40  7,500
FC = $36,000 above output of 7,000 units.
So at 5,000 units
$54,500 = FC + $5.40  5,000
FC = $27,500 below output of 7,000 units.
Chapter 4a
(a)
x y xy x2 Y2
(units) ($000) ($000) ($000)
280 46.5 13,020 78,400 2,162.25
350 49.1 17,185 122,500 2,410.81
200 36.7 7,340 40,000 1,346.89
160 32.0 5,120 25,600 1,024.00
240 44.5 10,680 57,600 1,980.25
1,230 208.8 53,345 324,100 8,924.20
Remember b represents the gradient of the line ie $92.02 per unit
b
5  53,345  1,230  208.8  9,901  0.092 (in 000' s)
5  324,100  1,2302 107,600
208.8 1,230
a  0.092   19.128 (in 0000' s)
5 5
Remember a represents the fixed costs ie $19,128 in total
y = $19,128 + $92x
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(b) Interpolation, when output is 240 units

Cost predicted = $19,128 + $92  240 = $41,208
Extrapolation, when output is 700 units
Cost predicted = $19,128 + $92  700 = $83,528

9,901
r
107,600 5  8,924.2   208.8 2 
9,901

107,600  1,023.56
 0.94

r2 = 0.8836

(a) The correct answer is 0.69
n xy   x  y
b= = 2,937 / 4,246
n x 2  (  x) 2
= 0.69
(b) The correct answer is 2.4

y x
a= b = (330 / 11) – (0.69  440/11)
n n
= 2.4
(c) The correct answer is 0.63

n  xy     y
r=
(n  x 2  (  x)2 )(n  y 2  (  y)2 )
(11 13,467)  (440  330)
=
((11 17,986)  (440) 2 ((11 10,366)  (3302 ))
2937
 0.63
(4,246  5,126)
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SV = TS – Trend
Time Series 3/Period Seasonal
(TS) Moving Average Variation
2
5 4 1
5 5 0
5 6 -1
8 7 1
8 8 0
8 9 -1
11

Adjustment Adjusted SV
Q1 SV = +6 -1/2 +5 ½
Q2 SV = -3 -1/2 -3 ½
Q3 SV = +5 -1/2 +4 ½
Q4 SV = -6 -1/2 -6 ½
SV =
SV = +2 therefore need to adjust by -2

Trend SV Forecast
sales sales
Q1 (W1) 820 -5%  779
Q2  840 +10%  924
Q3  860 +20%  1,032
Q4  880 -25%  660
W1: y = 400 + (21  20)
y = 820

Q1 33,000
Q2 24,000
Q3 34,500
Q4 28,500
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$120,000
= $30,000/qtr
4
SV  Budget
Q1 30,000 +10% 33,000
Q2 30,000 -20% 24,000
Q3 30,000 +15% 34,500
Q4  30,000 -5% 28,500

ΣPn
Price index = × 100
ΣPo
X1 X2
Beer $2.00 $2.10
Pizza $3.50 $3.55
Chocolate $0.55 $0.60
∑Po 6.05 ∑Pn 6.25
6.25
Price index = × 100
6.05
= 103.3
Prices have therefore inflated by 3.3% in a year.
Chapter 4b
Mid point No of cars Mileage
xf f fx
< 2,000 1,000 10 10,000
2,000 –< 4,000 3,000 14 42,000
4,000 –< 6,000 5,000 154 770,000
6,000 –< 8,000 7,000 292 2,044,000
8,000 –< 10,000 9,000 493 4,437,000
10,000 –< 12,000 11,000 404 4,444,000
12,000 –< 14,000 13,000 164 2,132,000
14,000 –< 16,000 15,000 48 720,000
 16,000 17,000 21 357,000
1,600 14,956,000
 fx
Mean =
f
14,956,000
=
1,600
= 9,347.5
The mean annual mileage of these car owners is 9,347.5 miles.
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The correct answer is 4
The mode is the most frequently occurring number of loaves required by a shopper,
ie 4 loaves.

The correct answer is $7,000
Firstly, we need to calculate the cumulative frequency of earnings.
Annual earnings Frequency Cumulative frequency
$
6,000 3 3
7,000 5 8
10,000 3 11
11,000 1 12
12,000 2 14
15,000 1 15
(15 + 1)
The median is the = 8th item which has a value of $7,000.
2

Mid point No. of cars
Mileage x f fx x2 fx2
('000s) ('000s)
<2 1 10 10 1 10
2 –< 4 3 14 42 9 126
4 –< 6 5 154 770 25 3,850
6 –< 8 7 292 2,044 49 14,308
8 –< 10 9 493 4,437 81 39,933
10 –< 12 11 404 4,444 121 48,884
12 –< 14 13 164 2,132 169 27,716
14 –< 16 15 48 720 225 10,800
 16 17 21 357 289 6,069
1,600 14,956 151,696
2
 fx
σ=  x2
f
151,696
=  9.34752 NB. Calculations using 000's of miles.
1,600
= 2.72658 (measured in 000's)
ie standard deviation = 2,727 miles (nearest mile)
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σ
Coefficient of variation =
x
2,727
=
9,347.5
= 0.292 (3 dp)
ie 29.2%

Winnings Probability EV
£
100  0.05 = 5
50  0.15 = 7.5
25  0.10 = 2.50
Nil  0.70 = Nil
15
x = 25
 = 15
(a)
x 2.27
285  251  (0.5 - 0.4884)
Z(285) =  2.27
15  0.0116
 probability of a student drinking more than 285 bottles is 0.0116 or 1.16%.
326

(b)
–2.07 0.27
x
220  251
Z(220) =  2.07  0.4808
15
225  251
Z(255) =  0.27  0.1064
15
 probability that a student will drink between 220 and 255 bottles in three months =
0.4808 + 0.1064 = 0.5872 or 58.72%.

50% are below 150
Need to find 30% (30% from the tables gives a z of 0.84)
x  150
 0.84  x = 166.8
20
80% of the population is under 166.8
Chapter 5
(a) Reasons for holding inventory
 Ensure goods are available to meet demand ie no stockout
 Provide a buffer between processes
 Meet future shortages
 Take advantage of bulk discount
 Absorb seasonable fluctuations in usage and demand
 Investment if expecting shortages/inflation
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(b) Costs of holding inventory

 Cost of storage
 Interest charges
 Insurance
 Risk of obsolescence
 Deterioration
(c) Costs of ordering inventory
 Clerical and administration
 Transport

(a) The correct answer is 36,000 units
Reorder level = max usage per day  max number of days' delivery time. (2,250*16)
= 36,000 units
(b) The correct answer is 16.500
Minimum level = Re-order level – (Ave. usage * Ave lead time)
36,000 – ( (2,250 + 1,000)/2 *(8 + 16)/2) = 16,500 units
(c) The correct answer is 42,500 units
Maximum level = Re-order level + Re-order quantity – (Min usage * Min lead time)
36,000 + 14,500 – (1,000 * 8) = 42,500 units
2  32  150  12
(a) EOQ = =160 units
25  0.18
(b) Total cost = COD +PD+ CHQ

Q 2
= (32)(150  12) + (25)(150  12)+ (25  0.18)(160)

160 2
= 360 + 45,000 + 360
= $45,720
(c)
CH
Q CO  D
2 Q
Order quantities Holding costs Order costs
units $ $
18%  25  200 = 450 (150 × 12)
32  = 288
200 2 200
600 1,350 96
1,000 2,250 57.6
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Steps:
2CoD 2  32  150  12
EOQ = =
CH 25  18%
= 160 units per order
2  32  150  12
Recalculate = = 160.8 units/order ie 161 units
25  99%  18%
Discount Number of Purchase Ordering Holding Total
units cost cost cost cost
ordered $ $ $ $
1% 161 44,550 357.76 358.63 45,266.39
$25  0.99 32  150  12 (25  0.99  0.18)  161
 1800 161 2
2% 300 44,100 192 661.5 44,953.50

$25  0.98 32  150  12 (25  0.98  0.18)  300
 1800 300 2
4% 800 43,200 72 1,728 45,000

$25  0.96 32  150  12 (25  0.96  0.18  800)
 1800 800 2
Order 300 units at a time
(a) EBQ = 2  5.40  600

0.05  1 600 
 
 800 
= 720 units
(b) Set up costs = 600  $5.40 = $4.50
720
 600 
Holding costs = 720   1  0.05 = $4.50
2  800 

EOQ – Higher
Annual Holding Costs – Higher
Answer to Worked Example 2

(c) FIFO=Highest closing inventory
FIFO=Highest gross profit
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Chapter 6
Standard time 340  2 mins 680 mins
Actual time 8 hrs  60 mins 480 mins
Time saved 200 mins
Bonus 75%  (200 mins/60)  $6/hr $15
Basic 8 hr  $6 $48
$63

$
100 units
1st (100  $4) 400
Next 50 units (50  $4.50) 225
Remaining 13 units (13  $5) 65
Week 48 pay 690

Standard hours produced:
A 200  4 = 800
B 350  2 = 700
C 300  3 = 900
2,400 mins
 60 = 40 hours
14,000  2
(a) Efficiency ratio =  100 = 80%
35,000
35,000
(b) Capacity ratio =  100 = 134.6%
26,000
14,000  2
(c) Production volume ratio =  100 = 107.7%
26,000

20
Labour turnover =  100 = 2.08%
(1,000 + 920) ÷ 2
330


$ $
Skilled workers:
Basic pay for normal hours worked
(7  35  $10) 2,450
Basic pay for general overtime
(30  $10) 300
Specific overtime
(20  $10  1.5) 300
Overtime premium for general overtime
(30  $10  0.5) 150
Semi-skilled workers:
Basic pay for normal hours
(4  35  $7.50) 1,050
Specific overtime
(10  $7.50  1.5) 112.50
General overtime
(10  $7.50  1.5) 112.50
3,162.50 1,312.50
Chapter 7
Mixing Stirring Stores Canteen Total
$ $ $ $ $
Stores cost – – 75,000 – 75,000
Rent & Rates
(9:3:1:2) 54,000 18,000 6,000 12,000 90,000
Insurance
(2:1:0.6:0.4) 20,000 10,000 6,000 4,000 40,000
Heat and light
(9:3:1:2) 34,200 11,400 3,800 7,600 57,000
108,200 39,400 90,800 23,600 262,000
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(a) Direct method
$ $ $ $
Overheads 108,200 39,400 90,800 23,600
Reapportion
Stores (50:30) 56,750 34,050 (90,800) –
Reapportion
Canteen (45:40) 12,494 11,106 – (23,600)
177,444 84,556 – –
(b)
$ $ $ $
Overheads 108,200 39,400 90,800 23,600
Reapportion
Stores (50:30:20) 45,400 27,240 (90,800) 18,160
Reapportion
Canteen (45:40) 22,108 19,652 – (41,760)
175,708 86,292 – –
(c) Reciprocal method
$ $ $ $
Overheads 108,200 39,400 90,800 23,600
Reapportion
Stores (50:30:20) 45,400 27,240 (90,800) 18,160
– 41,760
Reapportion
Canteen (45:40:15) 18,792 16,704 6,264 (41,760)
6,264 –
Reapportion
Stores (50:30:20) 3,132 1,879 (6,264) 1,253
– 1,253
Reapportion
Canteen (45:40:15) 564 501 188 (1,253)
188 –
Reapportion
Stores (50:30:20) 94 56 (188) 38
– 38
332


$ $ $ $
Reapportion
Canteen (45:40:15) 17 15 6 (38)
6 –
Reapportion
Stores (50:30:20) 3 2 (6) 1
– 1
Reapportion
Canteen (45:40:15) 1 – – (1)
176,203 85,797 – –
(d) Algebraic method
Let S be total amount reapportioned out of stores
C be total amount reapportioned out of maintenance
 S = 90,800 + 0.15C
C = 23,600 + 0.2S
Solve for S and C
S = 90,800 + 0.15 (23,600 + 0.2S)
S = 90,800 + 3,540 + 0.03S
0.97S = 94,340
S = 97,258
Substitute
97,258 = 90,800 + 0.15C
C = 43,053
Production depts. Service centres
M S S C
$ $ $ $
Overheads 108,200 39,400 90,800 23,600
Stores (50:30:20) 48,629 29,177 (97,258) 19,452
Canteen (45:40:15) 19,374 17,221 6,458 (43,053)
176,203 85,797 – –

A B C D
$ $ $ $
Allocated and apportioned 12,000 16,000 8,000 10,000
overheads
Reapportion
C (60:30:10) 4,800 2,400 (8,000) 800
Reapportion
D (80:20) 8,640 2,160 – (10,800)
25,440 20,560 – –
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(a) The most appropriate activity for the mixing department is labour hours as it is a
labour intensive department.
The most appropriate activity for the stirring department is machine hours as it is a
machine intensive department.
(b)
Mixing Stirring
Mars $177,444 $84,556
= $14.20 per = $8.46 per mach hr
bars 12,500 labour hr 10,000 mach hr
labour hr
 5 labour hr per batch = $70.98  4 machine hr per batch = $33.82
Total overheads = $70.98 (mixing) + $33.82 (stirring) = $104.80 per batch of mars bars.

The correct answer is Under absorbed by $3,875
Actual overhead expenditure $78,875
Overhead absorbed (30,000 hours  $2.50) $75,000
Under absorption $3,875

Year 1 Year 1 Year 2 Year 2
$ $ $ $
Sales @ $25 325,000 312,500
Less: COS
Opening inventory
(1,000  $20) – 20,000
Production costs
– variable
(14,000  $20) 280,000
(11,500  $20) 230,000
280,000 250,000
Less: Closing inventory
(1,000  $20) (20,000) –
(260,000) (250,000)
65,000 62,500
Less: Variable selling costs (6,500)
(13,000  $0.50)
(12,500  $0.50) (6,250)
Contribution 58,500 56,250
Less: Fixed costs

– Production 11,000 11,000
– Selling 5,000 5,000
(16,000) (16,000)
Net profit 42,500 40,250
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$ $
Sales price 20
Less: direct costs (6)
Variable production overheads (3.50)
Contribution per unit 10.50
X units sold 4,500
Total contribution 47,250
Less: fixed production overheads (29,500)
MC Profit 17,750

$157,500
Budget OAR  $4.50/unit
35,000
$4.50  5,000 units = $22,500 difference in profits.
Since inventory levels are increasing, absorption costing profit will be higher than marginal.
MC profit = $90,000 – $22,500 = $67,500

The correct answer is $5.00
The difference in profits is due to fixed overheads in opening/closing inventory. 1,000 extra
units of inventory led to a $5,000 difference in profits. Therefore, each unit of inventory has
$5 of fixed overheads.
Chapter 8
Process J – Abnormal loss
Process K – Abnormal gain
Normal loss Actual loss Abnormal loss Abnormal gain
Process J 2,550 2,600 50 –
Process K 3,290 3,000 290

920 = 900 + 90 – 70
Abnormal gain
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Process II
Units $ Units $
Input from process 920 110,400 Output to finished
Added materials 20,600 goods 900 180,000
Conversion 35,000 Normal loss 90 –
Abnormal gains  70 14,000
990 180,000 990 180,000
Scrap Account
Units $ Units $
Normal loss 90 – Abnormal gain 70 –
Scrap 20
90 – 90 –
Abnormal Gains Account
Units $ Units $
Scrap 70 – Abnormal gain 70 14,000
P&L a/c – 14,000
70 14,000 70 14,000
Cost/unit =
Input units – normal loss units
$166,000
=
920 – 90
= $200/unit

Total cost $250
(a) Cost per unit = = = $0.83 per unit
Total units 300 units
Hence valuations:
Finished goods 200 units @ $0.83 each = $166
WIP 100 units @ $0.83 each = $83
(b) WIP 100 units 50% complete = 50 equivalent units

$250
 cost per equivalent unit: = $1 per equivalent unit
250 units
Hence valuations:
Finished goods 200 equivalent units @ $1 each = $200
WIP 50 equivalent units @ $1 each = $50
336


(a)
Abnormal
Input units = Good output + Normal loss +/– loss/(gain) + CI WIP
1,500 = 1,450 + 0 + 0 + 50
Process I
Units $ Units $
Raw materials 1,500 12,000 To Process II 1,450 23,200
Labour 8,880 Closing WIP c/d 50 610
Overheads 2,930
1,500 23,810 1,500 23,810

(b) Statement of equivalent units
Actual Equivalent units
units Materials Labour Overheads
Finished output 1,450 1,450 1,450 1,450
Closing WIP 50 50 30 15
1,500 1,500 1,480 1,465

(c)&(d) Cost per equivalent unit
$ $ $
Costs 12,000 8,880 2,930
Cost/EU $8.00 $6.00 $2.00
Total cost/EU $16.00
(e) Valuations
Finished goods (1,450  $16.00) $23,200
$
Closing WIP
Materials (50  $8.00) 400
Labour (30  $6.00) 180
Overheads (15  $2.00) 30
610

The correct answer is 80%
Cost per equivalent unit (245,000/7000) = $35
Degree of completion ((140,000/35)/5000) = 80%
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$
4,250 units  $15 63,750
750 units  0.4  $15 4,500
Opening WIP value 6,375
Total value 74,625
Chapter 9
Job costing may be used by:
Plumbers
Builders
Engineering company

Job X112
$
Direct materials 1,350
Direct labour (150  $6) 900
Variable overheads (150  $2) 300
Prime cost 2,550
Fixed overheads (150  $3) 450
Total cost 3,000

(a) Accountancy firm
Advertising agency
Law firm
Government agency
Charity
(b)
Service Manufacturing
Product Intangible Tangible
Types of cost High proportion High proportion
Indirect Direct
Cost unit Difficult to identify Easy to identify
Can't be stored Can build up stock
(not always - perishable)
Heterogeneous/ Composite Homogenous
homogenous Heterogeneous
338

Service Cost unit

Hotel Occupied bed nights
Education Full time students/tutor
Hospital Patient/day
Catering establishment Meals served

Joint products
Oil refinery (diesel, petrol, paraffin)
Chicken farm (legs, wings) Saw mill (timber vs. sawdust)
By-product
Saw mill (sawdust)
600
(a) P1 :  (5,000  50)  $1,650
1,800
1,200
P2 :  (5,000  50)  $3,300
1,800
Process II
Units $ Units $
Material 2,000 2,000 Output P1 600 1,650
Labour 2,000 P2 1,200 3,300
Overheads 1,000 By-product 200 50
2,000 5,000 2,000 5,000
(b)(i)
Sales Costs* Profit
$ $ $
P1 1,200 1,650 (450)
P2 6,000 3,300 2,700
7,200 4,950 2,250
*from (a)
(b)(ii)
Sales Costs Profit
$ $ $ Margin
P1 1,200 825 375 31.25%
P2 6,000 4,125 1,875 31.25%
7,200 4,950 2,250
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Joint costs apportioned to TT ((247,500/(315,000 + 247,500))  262,500 = $115,500
Closing inventory valuation (22,500/247,500)  (115,500 + 49,500) = $15,000
Chapter 10
To formulate strategic plans
The budget is set within the framework of the organisation's strategic plan, converting it into
a shorter term action plan for the forthcoming period. The budget does not in itself act as a
means of formulating the strategic plan

54,600 kgs = 15,600 units per month
3.5

5,000 kg
Workings
Good
units
Sales 850
less: opening inventory (100)
Closing inventory requirement 150
Production 900
900 good units required, but 10% of production defective.
900
 need to produce  100  1,000 units
90
ie 900 good and 100 defective
 materials required = 1,000  5 kg = 5,000 kg
No inventories of raw materials are held
 5,000 kg needs to be purchased
340


Expenditure Capital Revenue
Purchase of envelopes for the office √
Extension to the sales office √
Purchase of new delivery van √
Road tax & insurance for new delivery van √
Purchase of 10 new cars for resale √
Repair of broken window in the workshop √
Purchase of 5 new laptops for the sales men (previously they √
recorded sales leads in a notebook)

Profit reported – Too low
Machinery asset value – Too low
The profits will be too low as they will include the full cost of the asset instead of the
depreciation charge for the period and the asset value will exclude the assets altogether.

Include Do not
include
Purchase of new machinery √ 
Payment of tax √
Bad debts written off √
Depreciation of delivery van √
Road tax for delivery van √
Payment to supplier √

April May June Total
Qtr 2
Receipts
Cash Sales 1,380 1,500 1,605 4,485
Credit Sales 2,975 3,220 3,500 9,695
Total Receipts 4,355 4,720 5,105 14,180
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April May June Total

Qtr 2
Payments
Purchases 1,200 1,300 1,500 4,000
Wages 800 850 850 2,500
Other overheads 250 275 275 800
Capital expenditure – 3,000 1,000 4,000
Total payments 2,250 5,425 3,625 11,300
Net Cash 2,105 (705) 1,480 2,880

Opening cash balance 750 2,855 2,150 750
Closing cash balance 2,855 2,150 3,630 3,630
Chapter 11
A manager underestimates revenues when setting the budget to ensure that the budget
target can be easily exceeded.
Chapter 12
S5 = 500(1 + 0.1)5
= $805.26

0 6 months 1
$60 $63.6
$1,000 $1,060 $1,123.6
Alternative
S2 = S0(1+r)n
= $1,000(1.06)2
= $1,123.6
Interest received is $123.60

(a) S24 = S0(1 + r)n
= 300 (1.02)24
= $482.53
342

(b) 1+R = (1+r)n

R = (1+r)n-1
R = (1+0.02)12-1
= 26.82%

Nominal rate 15%
15%
Monthly rate =  1.25%
12
 at the end of the first year (12 compound periods)
investment = $1,000 (1.0125)12
= $1,161

$1,610
S0 =  $1,000
(1.1)5

$100 + $100 × 2.487 = $348.70

1,000
 $10,000
0.1

Simple payback
Year cash flow Cumulative cash flow
$ $
0 (550,000) (550,000)
1 150,000 (400,000)
2 150,000 (250,000)
3 150,000 (100,000) Payback between 3 and 4 years
4 150,000 50,000
5 175,000 225,000
If cash flows arise at the year end the payback period is 4 years.
If cash flows accrue evenly over the year the payback period is 3 years and 8 months
 100 
 150  12
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Time Cash flow DF @ 10% PV
$ $
0 (550,000) 1 (550,000)
1 150,000 0.909 136,350
2 150,000 0.826 123,900
3 150,000 0.751 112,650
4 150,000 0.683 102,450
5 175,000 0.621 108,675
NPV $34,025
Kirby should proceed with the project because it has a positive NPV.

Given that the NPV was positive $34,025 in example 12, we need to choose a higher
discount rate to appraise the project.
Time Cash flow Discount factor 15% Present value
$ $
0 (550,000) 1 (550,000)
1 150,000 0.87 130,500
2 150,000 0.756 113,400
3 150,000 0.658 98,700
4 150,000 0.572 85,800
5 175,000 0.497 86,975
NPV = (34,625)
34,025
IRR = 10 + [ (15 - 10)] = 12.5%
34,025 + 34,625

4,645
IRR = 10% + (15% - 10%)
4,645 + 2,190
= 13.4%

Df10% NPV = $250
Df11% NPV = $200
 NPVa 
IRR = a +   b  a 
 NPVa  NPVb 
 250 
= 10 +   11  10
 250  200 
= 15%
344


The project is worthwhile because the IRR is greater than the cost of capital
The IRR is greater than the cost of capital which means that the project will have a positive
NPV at 12% and should therefore be accepted.

$
A 300 litres  $4 1,200
B 200 litres  $7.50 1,500
2,700

(a) NPV evaluation of whether to purchase the new ovens.
Relevant Irrelevant
Purchase cost of the new ovens of $350,000 x
Depreciation of $70,000 in each of the five years x
Staff training costs of $10,000 x
New staff salaries of $45,000 x
Staff training costs of $7,000 x
Interest costs of $10,000 per annum x
Depreciation is not a cash flow
Staff training costs of $7,000 are a sunk cost
The cost of capital includes compensation for interest therefore interest costs should
not be included.
(b) (i) Increase in sales = ($600,000 – $500,000) = $100,000
Increase due to the project = $100,000 – $10,0000 = $90,000
(ii) Total sales in Year 1 = $600,000
Savings ($600,000  0.01) = $6,000.
(iii) Annuity factor for five years at 10% =3.791
Present value = ($2,000  3.791) = $7,582
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Chapter 13
$100,000
Pre-determined overhead absorption rate = = $5/unit
20,000 units
Overheads absorbed = 24,000 (actual units produced)  $5/unit = $120,000
Actual overhead = $117,000
Under/(over) absorption = $(3,000)

Bottles produced: 12,350
Production costs: $
Materials (w1) 37,050
Labour (w2) 31,700
Overhead 20,000
Total 88,750
Workings
1 Materials
This is a variable cost: ($30,000/10,000) = $3 per unit
For 12,350 units = 12,350  $3 = $37,050
2 Labour
This is a semi-variable cost, use the high low method.
Units $
High 14,000 35,000
Low 10,000 27,000
Difference 4,000 8,000
Therefore the variable cost = ($8,000/4000) = $2 per unit
Substitute to find fixed costs:
$
Total cost for 10,000 27,000
Less variable costs ($2  10,000) (20,000)
Fixed costs 7,000
For 12,350 units = 7,000 + ($2  12,350) = $31,700.
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A budget which shows the costs and revenues at different levels of activity.
A flexible budget recognises sales and cost behaviour patterns and is designed to change
as the volume of sales or production activity changes.
Chapter 14
(a) Total material variance
$
Actual units should cost (27,000  2 kg  $2.50) 135,000
Actual material used did cost (53,000 kg  $2.38) (126,140)
8,860 (F)
(b)
Price variance $
Actual purchases should cost (53,000  $2.50) 132,500
Actual purchases did cost (53,000 kg  $2.38) (126,140)
6,360 (F)
(c)
Usage variance kg
Actual production should use (27,000  2 kg) 54,000
Actual production did use (53,000)
1,000 F
@ std cost $2.50 $2,500 F

(a)
Total labour variance $
Actual units should cost (2,195  4 hrs  $12.50) 109,750
Actual labour used did cost (110,750)
(1,000) A
(b)
Rate variance $
Actual hours paid should cost (9,200  $12.50) 115,500
Actual hours paid did cost (110,750)
4,250 F
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(c)
Efficiency variance hrs
Actual production should use (2,195  4 hrs) 8,780
Actual production did use (9,200)
(420) A
@ std cost $12.50 $5,250 A

hours
Actual hours worked 2,200
Actual hours paid (2,300)
(100) A
@ std cost $7/hour ($700) A

The standard fixed overhead cost of a Soul is 3 hours at $10 per hour = $30 per unit
(i) The fixed overhead total variance
$
Amount of overhead absorbed (1,000 units  $30 per unit) 30,000
Fixed overhead incurred (33,980)
FIXED OVERHEAD TOTAL VARIANCE (under absorbed) (3,980) (A)
(ii) The fixed overhead expenditure variance
$
Budgeted fixed overhead expenditure 33,000
Actual fixed overhead expenditure 33,980
FIXED OVERHEAD EXPENDITURE VARIANCE 980 (A)
(iii) The fixed overhead volume variance
Budgeted production 1,100 units

Actual production 1,000 units
(100) units (A)
 standard absorption rate per unit  $30
FIXED OVERHEAD VOLUME VARIANCE ($3,000) (A)
Or
Budgeted labour hours (3 hrs  1,100 units) 3,300 hrs

Standard hours produced (3 hrs  1,000 units) 3,000 hrs
300 hrs (A)
 standard OAR per hour  $10
FIXED OVERHEAD VOLUME VARIANCE $3,000 A
348

(iv) The fixed overhead efficiency variance
1,000 units of Soul should take ( 3 hrs) 3,000 hours

But did take 3,500 hours
500 hours (A)
 standard absorption rate per hour ( $10)  $10
FIXED OVERHEAD VOLUME EFFICIENCY VARIANCE $5,000 (A)
(v) The fixed overhead capacity variance
Budgeted hours of work (3 hrs  1,100 units) 3,300 hours

Actual hours of work 3,500 hours
200 hours (F)
 standard absorption rate per hours ( $10)  $10
FIXED OVERHEAD VOLUME CAPACITY VARIANCE $2,000 (F)
$ Fav $ Ad $
Overhead absorbed 30,000
Expenditure variance 980
Efficiency variance 5,000
Capacity variance 2,000
Total variances 2,000 5,980 3,980
Actual overhead 33,980

Sales price variance: $1,010 favourable
$
10,100 units should sell for ( $5.10) 51,510
did sell 52,520
$1,010 F
Sales volume variance: $80 favourable
Actual volume 10,100 units
Budget 10,000
100 F
at standard profit $0.80 [$8,000/10,000 units] $80 F

Operating statement under absorption costing
$
Budgeted profit 56,000
Sales volume variance 2,800
Flexed profit 58,800
Sales price variance (16,800)
42,000
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$(F) $(A)
Cost variances:
Materials – price 3,867
– usage 3,024
Labour – rate 2,485
Variable overheads
– expenditure 3,452
Fixed overheads – expenditure 3,574
– capacity 5,700
14,661 16,441 (1,780)
Actual profit 40,220
Workings
Sales volume variance
Units
Budgeted sales 8,000
Actual sales 8,400
400 units F
Valued at standard profit/unit ($7) $2,800

Offer paid overtime to the company's existing skilled employees
Implement training for the temporary employees
Offer paid overtime to the company's existing skilled employees - would mean that the
company's existing workforce complete the work and they are likely to be quicker as they
have more experience.
Implement training for the temporary employees - increased training should also improve the
efficiency of production.
Incorrect answers:
Increase the hourly rate paid to temporary workers - There is no evidence that increasing
their salary will make them worker faster
Reduce the number of supervisors - reducing the amount of supervision is likely to have the
opposite effect, ie increasing the time taken to make each unit rather than decreasing it.
350


(a) Labour rate variance
$
Actual hours should cost  109,200
28,000  standard cost
Actual hours did cost 117,600
$8,400 A
109,200
Therefore, Standard cost = = $3.90/hour
28,000
(b) Labour efficiency variance
Hours
Actual units should take  27,000
Actual units did take 28,000
1,000 hours (A)
Value @ standard cost (from (1)) $3.90/hour

$
Standard contribution on actual sales (flexed contribution) 23,000
Sales price variance 4,000 Favourable
Total variable costs variance 3,250 Adverse
Actual contribution 23,750
The sales volume variance reconciles from the budget contribution to the flexed contribution
and therefore is not required in this calculation.
Chapter 15
The cafe aims to attract 200 customers this week – this is a specific objective.

Pass CBT within 6 weeks of finishing the course.

Secondary objectives might then be concerned with sales growth, continual technological
innovation, customer service, product quality, efficient resource management (eg labour
productivity) or reducing the company's reliance on debt capital.
Conflict: There may be conflict between objectives. For example, growth in sales volumes
might result in higher levels of bad debts.
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Return on investment
Market share
Number of vacuum cleaners sol and returned would be used lower down the hierarchy.

An online tie retailer.
 although the product is not the same there are many similarities in terms of size of
packaging and required delivery lead times.
It is unlikely that a direct competitor will willingly share information
352

Chapter 16
Gross profit margin = gross profit  100%

sales
20X9 20X8
$ $
Total production cost 3,269,000 2,541,000
Gross profit 1,503,000 1,291,000
Sales 4,772,000 3,832,000
Gross profit margin = 1,503,000 1,291,000
4,772,000 3,832,000
= 31.5% 33.7%
Net profit margin = net profit
 100%
revenue
Net profit margin = 295,000 287,000
4,772,000 3,832,000
= 6.2% 7.5%
ROCE = PBIT
TALCL
= 295,000 287,000
3,005,500 2,861,000
= 9.8% =10.0%
Sales per employee = Sales
No E'ees
= 4,772,000 3,832,000
260 248
= $18,354 $15,452
Production costs per book = Total prod'n cost
No Books
= 3,269,000 2,541,000
29,361 27,498
= $111 $92
No books per employee = No Books
No E'ees
= 29,361 27,498
260 248
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Type of responsibility Example of Manager has control Principal
centre responsibility centre over performance
measures
Cost centre Design department Costs only Variance analysis
Revenue centre Car dealer Revenue only Sales revenue
Profit centre Canteen car factory Costs and revenues Profit
Investment centre New overseas sales Costs, revenues and Return on investment
outlet investments

R.N T.T
ROI 15% 25%
Tabloid Trash is more successful as it has generated a better return on the capital invested.

£300,000
Divisional ROI without the project =  100%
£1m
= 30.0%
Divisional ROI with the project = £325,000

 100%
£1.1m
= 29.5%
Although the project ROI is acceptable to the company (25%), the manager would not be
motivated to accept a project which lowers divisional ROI.

D Tropical ROI Cola RI
Cola Tropical
ROI 64m/320m  100% 16m/64m  100%
20.0% 25.0%
Bonus
RI 64m – (320m  15%) 16m – (64m  15%)

= 16m 6.4 m
Bonus
354


The correct answer is 15%
Residual Income $
Profit  45,000
Less: imputed interest (300,000  13%) (39,000)
RI 6,000
45,000
Therefore: = 15%
300,000
Chapter 17
(14,000 × 3) hours
Efficiency ratio =  100% = 105%
40,000 hours
40,000 hours
Capacity ratio =  100% = 111%
36,000 hours
(14,000 × 3) hours
Production volume ratio =  100% = 117%
36,000 hours
E  C = PV ie 105%  111% = 117%
The production volume ratio of 117% (more output than budgeted and more standard hours
produced then budgeted), is explained by the 111% capacity working, and by good
efficiency of 105%.

(a) Customer satisfaction
(b) Growth
(c) Financial success
(d) Growth
(e) Financial success
(f) Process efficiency
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Economy = cost of inputs
Value for money in sourcing library staff of appropriate quality
Competitive tendering for computers, security, cleaning
Efficiency = input to output ratio
Cost per loan (cost of book/number of times loaned out)
Effectiveness = compared to objective
Number of active members
Number of overview due books returned

Differences in customer complaints
END OF ANSWERS TO LECTURE EXAMPLES

356

Appendix A:
Overview Summaries
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19: APPENDIX A
Chapter 1: Overview summary
Accounting for
management
Role of management Data and information Limitations

accounting function
 Data = Raw Material  Financial accounting
 Assist management in  Info = Processed data information may not be
running business suitable for decision
– Costing making
– Decision making  Instead use relevant costs
– Planning
– Control
– Performance evaluation
Qualities
A ccurate
Comparison with financial C omplete
accounting C ost beneficial
U ser targeted
R elevant
 Financial accounting A uthoritative
– Recording and T imely
reporting historical data E asy to use
358

19: APPENDIX A

Effect of general economic
environment on costs /
revenues
Data and presenting information Presenting and

Spreadsheets
Interpreting Data
 Prepare basic formulae

 Absolute call referencing Tables Charts
 Formulae with conditions
Big data Bar charts Pie charts Scatter graphs
 Volume
 Velocity
 Variety
Data Sampling
Primary Vs Internal Vs
Secondary External
Primary= data Internal includes financial
collected for specific accounting records, payroll
purpose info, product info, published
Secondary= data accounts. external includes
collected elsewhere market research, interviews,
for some other data from government, Random Non Random
purpose newspapers, internet,
libraries
Random Systematic Stratified Multistage

Quota Cluster
Random Selects every Population Population divided
numbers nth item after a grouped into into groups. Stratify Select one
generated by random start strata. Random Sample of these population and definable
computer to sample from selected at restrict sample subsection of
choose sample each strata random. These to fixed number population that
proportional to groups again in each stratum is deemed to be
its size subdivided and on first come representative.
random sample first send basis
taken. Repeat
VL2020
359

19: APPENDIX A
Cost behaviour
Group costs together according to how they

behave when output volume changes
Variable cost Fixed cost Stepped fixed cost

(VC) (FC)
 Varies directly with the volume of  Unaffected by changes in volumes  Fixed within certain levels of output
output of output
$ $
Output
Output Output
Mixed cost
 Contains a fixed and variable element
Total cost = FC + (VC/unit  Output)

Output
Cost estimation
 Businesses need to estimate costs in the future

 To do so they need to break down a historic cost into a VC and FC element
High/low method
(1) Select highest and lowest activity (output) and associated total cost
(2) Find the change in activity and cost
Change in cost
(3) Calculate VC/unit
Change in activity
(4) Substitute back into: TC = FC + VC/unit  output
360

19: APPENDIX A
Cost classification
Cost Codes
Something for
which cost data Cost object
is desired
Terminology for Costing Finding the cost of one unit
Unit of production  Profitability
or service in  Selling price
relation to which Cost unit  Inventory valuation
costs may be
ascertained
Location, function
or item of
Classification by function
Cost centre
equipment where
costs can be
collected Arrange costs into logical
groups for analysis
 Associated with the  All other costs in a business

production of goods and
services
Materials Materials
 Cost of material used in  Cost of material used

production elsewhere in business
Labour Further Labour

classification by
nature
 Cost of workforce used in  Cost of workforce used
production elsewhere in business
Overheads
Overheads
 Cost of overhead required

to support production  Cost of overhead required
to support function
 Directly traced to product  Incurred as a result of

making a product but not
directly traceable
VL2020
361

19: APPENDIX A
Chapter 4a: Overview summary

Forecasting
Cost Prediction Time Series
 Using historical information to  Trend (Moving average)

predict future cash flows  Seasonal Variation
High-Low Scatter graphs Linear

Method regression
Additive Multiplicative
Chapter 3 To establish visually if Mathematical line of best fit
a correction exists Formula y= a + bx
Mathematically finds value
for a + b
TS = T + SV + RV + CV TS = T  SV  CV  RV
Correlation Coefficient (r) Coefficient & determination

(r2)
 Gives indication of reliability of regression line  Indicates proportion & changing which would be
 Strength of relationship between x + y explained by change in x
 -1 ≤ r ≤ 1  Does not prove cause and effect
Index Number
 Average changes, over time, in values, prices or

quantities of a group of items
Current period's figure

Index = ×100
Base period figure
362

19: APPENDIX A
Chapter 4b: Overview summary
Expected Summarising and Standard deviation

Dispersed
values analysing data data
 (x x)2
A weighted =
The standard n
average based on
probabilities. deviation is the most Or
important measure
of spread used in
Typical statistics.  fx2 2
attributes -x
f
Mean Median Mode

Sum of values of item The value of the The most frequently
number of items middle item occurring item
 Ungrouped/
 Ungrouped Grouped
 Grouped  Odd/Even Normal
Σfx distribution
x=
Σf
A probability
distribution which
applies to continuous
variables.
VL2020
363

19: APPENDIX A
Accounting for Materials
Ordering, receipt and

Monitoring of inventory Value inventory using
issue of raw material
levels FIFO, LIFO and
average methods
Purchase requisition
OBJECTIVE maintain  FIFO- Assumes
Purchase order accurate records of inventory levels materials issued
in order they were
Goods received note delivered
 LIFO- Assumes
materials issued
Recording purchases Inventory control levels in the reverse
in accounts order in which
they are delivered
 AVCO- Calculates
Buy material
Reorder level EBQ a weighted
DR Materials
Minimum level average price for
CR Cash/creditors
all inventory.
Use material in production Maximum level
DR Production/WIP  EOQ when inventory is
CR Materials  Theoretical ways of replenished gradually
managing stock levels
LEARN
– Reorder level EOQ
– Minimum level
– Maximum level
Theoretical model:
 Quantity of units to order each
Materials inventory order to minimise
– Purchase costs (= P  D)
Actual materials Issued to production X – Order costs (= Co  D/Q)
purchased X – Holding costs (= CH  Q/2)
c/d Closing inventory X
X X
B/d Closing Discounts
inventory X
 EOQ does not take into account bulk discounts

at certain order quantities
(1) Calculate EOQ
(2) If EOQ falls in discount band recalculate
EOQ
(3) Calculate total cost at new EOQ
(4) Calculate total costs at each discount band
boundary
(5) Select option with minimal cost
364

19: APPENDIX A
Systems of recording and analysing labour time

and costs
Methods of remuneration Labour turnover
 Time based system  Controllable causes/Uncontrollable causes

 Piecework system  Replacement costs/Preventative costs
 Bonus/incentive scheme
Measuring labour activity
 Production/productivity
– Efficiency ratio
– Capacity ratio
– Production volume ratio
Accounting for labour costs
Direct Indirect
Dr WIP Dr Production o/h
Cr Wages control a/c Cr Wages control a/c
VL2020
365

19: APPENDIX A

costing
Calculating the cost per unit

 Profitability
 Selling price
 Inventory valuation
 EXCLUDES any overheads

 Includes element of
overheads (see below)
Contribution
 Contribution towards fixed costs

and profit = SP – ALL VC
Including non production VC
Profit/loss under AC Profit/Loss under MC
Above contribution = VARIABLE costs

Above gross profit = PRODUCTION costs Format Below contribution = FIXED costs
Below gross profit = NON PRODUCTION costs
Value at marginal cost ie from cost card

Value at full production cost ie from cost card Inventory excluding overheads
including overheads
(1) Overheads absorbed

Fixed overheads Include actual fixed overhead
(estimate of overheads)
= OAR  actual activity
(2) Adjustment for under or over absorption
Reconciliations
Difference is due to the valuation of inventory
AC MC
 Recognises that selling price must  Highlights contribution so appropriate
cover all costs for decision making
 Complies with IAS2  Treats FC in accordance with their
 Profits can be manipulated by
AC and MC nature
changing production levels  Danger that contribution fails to cover
 Assumes FC are volume related FC
366

19: APPENDIX A
Absorption costing
Allocating overheads to units to Predetermine

find the full production cost OAR
 OAR calculated at the start of the

year based on budgeted figures
 Predetermined OAR used to
3-step approach to absorption estimate overheads during the
costing year to calculate a profit or loss
figure.
 Getting the production overhead cost
into the cost card
(1) Allocate & (2) Reapportion (3) Absorb

apportion
 Overheads from service cost

 Overheads to cost centres on
centres to production cost
some fair basis
centres on some fair basis
– Production cost centres
– Direct method Under and over absorption of
– Service cost centres
– Step down method overheads
– Reciprocal method
– Algebraic method
 Overheads from production cost
centres to individual units using
an overhead absorption rate
(OAR).
Budgeted overhead
OAR =
Budgeted activity
(1) Calculate OAR using
appropriate activity
(2) Calculate the activity for a
single unit and apply OAR
VL2020
367

19: APPENDIX A

Process costing
Costing  where goods/services are produced

in a series of processes
General principles of process Abnormal loss or gain Work in progress (WIP)

costing
At end of accounting period partially
Inputs Process 1 Good  Unexpected losses or gains during completed units are called WIP units
output process
 For comparison purposes restate WIP
Good
units in terms of equivalent whole units
Output
(EU)
Inputs Process 1 Normal loss
Abnormal loss/
Normal losses gain
 Abnormal loss or gain valued at CPU
 Losses expected in the process
Good
Inputs Process 1 output
Closing WIP Opening WIP
Normal
loss
(no opening WIP) (and closing WIP)
(1) Unit calculation Same steps
(2) Set up T account
Without scrap With scrap (3) Statement of EU Which method?
value value (4) Valuations
(5) Complete T account
 No proceeds from  Income generated
scrapped units from scrapping loss
FIFO Weighted Average
Assumes opening WIP All units equally likely to be
Value good output at cost per unit (CPU)
completed first, need: completed, need: cost b/f
Input cost  scrap value of normal loss % complete materials broken down into materials
CPU =
Input units  normal loss units % complete conversion and conversion
Total cost b/f
Opening WIP + Input units = Good output + Normal loss +/- Abnormal loss/gain + Closing WIP
Losses and WIP will not be tested in the

same question in the exam
Subsequent/previous processes
 Output from process 1 becomes input into process 2

 All WIP in process 2 is 100% complete in terms of process 1 costs
368

19: APPENDIX A

Costing methods
Job and Service industry Joint products &

batch costing S imultaneous
by-products
JOB – single areas or H eterogeneous
contract I ntangible
BATCH – lots of identical P erishable
items that make Joint products
up one cost unit
By-products
Composite  Two or more products which are  Produced in the same process
output from the same process as the joint products but have
cost units  Each with substantial sales value low sales value
Cost card  Quite often a single

measure is not enough
eg excess baggage:  No joint cost allocated
Direct materials X calculate cost per
 Common (joint)  If usually occur use any
Direct labour X additional kg per km
costs split Accounting income to offset against
carried
Prime cost X between products treatments joint costs before allocating
Overheads X to joint products
Total cost X  If one off treat as
miscellaneous income
Service Method of allocating costs
department
costing
Physical units Relative sales value
 Cost of an internal service
 A business will want to
Control cost of department Control usage of service in

providing service company
Alternative costing principles
Activity Based Total Quality Life Cycle Target

Costing (ABC) Management (TQM) Costing Costing
 Absorb overheads  Focus on quality  Consider all costs  Target cost derived
according to cost  Get it right first time and revenues of by deducting
drivers  Continuous improvement product required margin
 Fairer cost allocation throughout its life from selling price
not just on a  Cost designed out
periodic basis. and close cost gap
VL2020
369

19: APPENDIX A

Setting budgets
Planning & control Responsibility Budgetary Process Preparing Budgets

cycle Accounting
P lanning  Cost centre  Timetable

R esponsibility  Profit centre  Master budget
I ntegration & co-ordination  Investment centre
M otivation
E valuation
Functional Cash Capital Expenditure
 Identify principal  Cash v profit  Capital v revenue

budget factor transactions
Sales Budget
Production Budget
Overhead Budget
Labour Budget
Material Usage Budget
Material Purchases Budget
370

19: APPENDIX A
Cost control & cost

Budgets and people Hopwood
reduction
 Motivation Styles
 Goal congruence  Budget constrained
 Participation  Profit conscious
– topdown v bottomup  Non-accounting
 Performance evaluation
– slack
Approaches Methods
 Crash programme  Improved efficiency

 Planned programme  Rationalisation
 Value engineering
– cost value
– exchange value
– use value
– esteem value
VL2020
371

19: APPENDIX A
Project appraisal
Payback NPV IRR
 Time taken for project to  Discount rate that gives

payback initial investments NPV=0
 Accept projects with PBP < Difference between  Accept all projects with
target PBP IRR> company's cost of
capital
Simple Discounted
Sum of discounted cash Amount initially invested

flows expected from
investment
 Accept all projects with

positive NPV
372

19: APPENDIX A
Standard costing
Definition Setting standards
Budgeted or expected costs  Ideal standard

eg standard unit cost based on  Current standard
– expected efficiency  Basic standard
– expected prices  Expected standard
Use in cost card Uses in business
 Inventory valuation
 Control device
Cost card prepared at start of
period and includes standard costs
and efficiencies to make up
standard unit cost. Flexible budgets
Restating original budget based on

actual production so meaningful
comparisons can be made
VL2020
373

19: APPENDIX A

Variance
analysis
Analysis of difference between actual results

and expected results
Variable cost variances Fixed cost variances Sales variance
Should cost/use X  Under MC  expenditure  Impact on profit of differences

Did cost/use X variance only between budgeted and actual
Variance X  Under AC  all variances below selling prices and sales volumes
Calculation Calculation Calculation

 Materials – price  Fixed o/h – expenditure  Sales – price variance
– usage – Volume – sales volume
 Labour – rate variance
– efficiency efficiency capacity
 Under MC  Sales volume
 Variable o/h – expenditure variances valued at
 Volume variance broken down into standard contribution
– efficiency efficiency and capacity when OAR per unit
originally calculated using activity  Under AC  Sales volume variance
other than units valued at standard
profit per unit
Using variances
Interpretation/ Operating Backward

interdependence statements variances
 Operational cause  Reconciliation between budgeted profit  Type of exam question to

 Incorrect standard and actual profit using variances really test your
 Interdependence understanding ie given
 Controllable/uncontrollable variance and asked to
 When to investigate calculate something else
AC MC
 Budgeted profit  Budgeted contribution
 
Flexed budget profit Flexed budget contribution
 
Actual profit Actual contribution

Actual profit
374

19: APPENDIX A
Target setting
Mission Objectives Critical success Benchmarking External

factors conditions
Top management's vision. To achieve mission. Fundamental to  Internal

Characteristics: Characteristics: competitive success in  Competitive
 Brevity S pecific short and long term  Functional
 Flexibility M easurable  Strategic
 Distinctiveness A ttainable
R elevant
T ime bound
Levels of
objectives
strategies
tactical
operational
VL2020
375

19: APPENDIX A
Financial performance measurement
Ratios
Profitability Liquidity Gearing
 ROCE  Current ratio  Gearing

 Profit margin  Quick ratio  Interest cover
 Asset turnover  Inventory turnovers
 Return on equity  Receivables
convention period
 Payables payment
period
Responsibility
centres
ROI RI
Controllable division profit ×100% RI

ROI =
Controllable divisional investment $
controllable divisional point x
less: controllable profit – (controllable
divisional investment  cost of capital) (x)
X
376

19: APPENDIX A
performance
NPMOs
VL2020
377

19: APPENDIX A
END OF APPENDIX A
378

Appendix B: Formulae
given in the exam
VL2020
379

19: APPENDIX B: FORMULAE GIVEN IN THE EXAM
Regression analysis
y = a  bx
y bx
a= 
n n
nxy  xy
b
nx 2   x 
2
nxy  xy
r
nx   x  ny   y 
2 2 2 2
2CoD
Economic order quantity 
Ch
2CoD
Economic batch quantity 
 D
Ch  1  
 R
Arithmetic mean
x fx
x x  frequency distribution
n f
Standard deviation
 
2
 xx fx 2  fx 
2
     frequency distribution
n f  f 
Variance  2
Co-efficient of variation

CV 
x
Expected value
EV  px
380

VL2020
381

382

VL2020
383

END OF APPENDIX B
384

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Management Accounting

ISBN: 9781 5097 8611 4

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Copyright © IFRS Foundation

Improving study material and removing errors

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Achievement Ladder Step 6 313

Prepare for and book your CBE!

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Introduction to FMA/MA Management Accounting

Overall aim of the syllabus

A The nature, source and purpose of management information

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Links with other exams

SBL APM ACCA

Format of the Exam Marks

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Study Programme Aims

A The nature, source and purpose of management information

B Data analytics and statistical techniques

C Cost accounting techniques

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Analysis of the specimen exam

Section A – 35 x 2 mark questions (70 marks)

Data analysis and statistical techniques

Cost accounting techniques

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Section B – 3 x 10 mark questions (30 marks)

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Formula given in exam

Section reference in the Study Text

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Key skills required to pass

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Skill 1 – Learning and understanding the syllabus content

1 What do I need to know to attempt the exam?

A company has recorded the following variances for a period:

Sales volume variance $10,000 adverse

Standard profit on actual sales for the period was $120,000.

What was the fixed budget profit for the period?

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A company's operating costs are 60% variable and 40% fixed.

Which of the following variances' values would change if the

 Variable overhead efficiency variance

 Sales volume variance

 Fixed overhead expenditure variance

 Direct material efficiency variance

Which of the following BEST describes target costing?

 Setting a selling price for the company to aim for in the

 Setting a cost for the use in the calculation of variances

 Setting a cost by subtracting a desired profit margin from a

 Setting a price by adding a desired profit margin to a

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A company always determines its order quantity for a raw material

Read Passcards Get a colleague or

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Skill 2 – Time management

 What you SHOULD do