PART 3

LECTURE NOTES

F2 – MANAGEMENT ACCOUNTING

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 PART A – THE NATURE, SOURCE AND PURPOSE OF MANAGEMENT
INFORMATION

CHAPTER 1: ACCOUNTING FOR MANAGEMENT

Session objectives:
- Describe the purpose and role of cost and mgnt accounting within an
organization
- Compare and contrast FA with cost and MA
- Outline the managerial processes of planning, decision making and control
- Explain the difference b/w strategic, tactical and operational planning
- Distinguish b/w ‘data’ and ‘information’
- Identify and explain the attributes of good information
- Explain the limitations of mgnt information in providing guidance for
managerial decision making.
1. MANAGEMENT INFORMATION
o 3 main functions of management accounting:
- Planning
- Decision making
- Controlling
o Purpose of mgnt info: help managers to manage resources effectively
and efficiently by planning, decision making and controlling  to run
business in ways that will improve the performance of the business.
Management problems Information needed
Which products should be produced and Information about market, demand…
sold?  make plans for products
designation and development
How to determine the selling price? Cost of product
Profit margin
Other competitors
How many products should the company Sales volume per month/year
plan to make each month/year? Trends in sales volumes
Production capacity
How can the managers control Actual production volum (actual output)
production costs to make sure they are in Actual costs of raw materials, labour,
line with budget? overheads and other expenses

1.1. Data and information

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 One way of assisting management is to provide them with good information to
help them with their decisions.
The information can be provided to them in different ways, but is usually in the
form of reports. For example, a report analysing costs of producing each of several
products may assist management in deciding which products to produce.
It is the management accountant who will be expected to provide the
information, and in order to do so he/she needs to collect data.
Data consists of the facts, events or transactions that are gathered and stored.
Data has no clear meaning until it is processed – analysed and sorted – into
information.
Information is processed data which is meaningful to the person who receives
it.
DATA  Process  INFORMATION
1.2. Qualities of good information
Mnemonic “ACCURATE”
- Accuracy: Information should obviously be accurate because using incorrect
info could have serious and damaging consequences.
- Completeness (but not excessive): if users don’t have a complete picture of
the business situation they could make bad/wrong decisions.
- Cost effective (should cost less than the savings to be made or it should not
cost more to obtain the info than the benefits derived from having it): Cost vs. Benefit
- Understandable (to whoever is using it) or User – targeted.
- Relevance (to the decision being made): Info must be relevant to the purpose
for which a manager wants to use it
- Accessible ( i.e. communicated by an appropriate channel (for example, be
printed or be sent electronically). In addition, the sources of the info should be
reputable and reliable (authorization)
- Timeliness: the info must be timely
- Easy to use: Info should be clearly presented.
1.3. Types of information
 Most organizations require the following types of info:
- Financial info (quantitative): production cost, sales, financial ratio…
- Non-financial info (qualitative) : customer satisfaction, process efficiency…
- A combination of financial and non-financial info
 According to Anthony’s hierarchy:
- Strategic info:
+ It deals with the whole organization

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 + It is summarized at a high level
+ It is relevant to the long term
+ It is often prepared on an “Ad-hoc” basic
+ It is both quantitative and qualitative
- Tactical info:
+ It is primary generated internally
+ It is summarized at a lower level
+ It is relevant to the short and medium term
+ It is prepared regularly
+ It is often based on quantitative measures
- Operational info:
+ It is derived almost entirely from internal sources
+ It is highly detailed, being the processing of raw data
+ It is related to the immediate term
+ It is prepared constantly or very frequently
+ It is task – specific and quantitative
2. PLANNING, CONTROL AND DECISION MAKING
2.1. Planning
- Planning involves the following:
+ Establishing objectives: aims or goals
+ Selecting appropriate strategies to achieve those objectives: possible course of
action to achieve objectives, such as: maximize profit, minimize costs, increase market
share…
- Level of planning:
+ Strategic: covers the “big view” of the organization and its objectives. Long
term in nature
+ Tactical: planning over the short-term (usually one year), and typically in
connection with budgeting process, relates to sections, functions, departments.
+ Operational: Day-to-day decisions, implemented on-the-spot and directly
involving all levels of the organization.
- The planning process: includes 4 stages (diagram from study text):
assessment stage, objective stage, evaluation stage, corporate plan.
2.2. Control
Two stages in the control process
- The performance of the organization
- The corporate plan

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 “Effective plan is therefore not practical without planning, and planning without
control is pointless”
2.3. Decision making
- Management is decision making which involves a choice b/w alternatives.
- Decision – making process: (diagram from study text) includes 7 steps.
3. FINANCIAL ACCOUNTING AND COST AND MANAGEMENT
ACCOUNTING
Focus on comparison b/w FA and MA

Financial Management
Accounts Accounts

same invoices, clock cards, etc. analysed appropriately

Sources of data
and kept in separate departments

Results and financial

Focus position of the company at Centre by centre
a given moment in time

Used by Primarily external Internal only

Nature Financial Financial and non-financial

Historical, Current and

Time Horizon Historical
future

Information
Focus Organisation as a whole Each segment individually

Emphasis on Guidance for decision

True & Fair
precision making

Statutory and accounting

Format conventions & standards Management discretion

Statutory requirement for Internal management

Requirement
limited companies requirement

Aid for planning, control

Used for Company profitability and decision making

Value of
Must be prepared Will only be prepared if the
information to the
irrespective of cost value outweigh the costs
company

Aim To Provide Information

Notes:

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 - Cost Accounting is part of Mgnt Accounting. Cost Acc provides a bank of
data for the mgnt accountant to use.
- Cost Accounting is concerned with the following.
+ Preparing statements (eg budgets, costing)
+ Cost data collection
+ Applying costs to inventory, products and services.
- Cost Accounting, MA and FA can be separated systems or an integrated
system.
Accounting

Cost/
Financial
Management
Accounting
Accounting

Statutory
Management
Cos Acts,
Requirements
Inland
Revenue, etc.
Strategic
Tactical Financial
Operational
Type Information Nature
Non
Financial
For

Planning Decision Making Control

(Choice bewteen alternatives)

Estabishing Performance
Objectives Controls

Make/ Buy/
Pricing Cost
Hire/Repair of
Budgeting,
Efficiency Resources Effectiveness
Etc.
Variation
Pricing
of an Discount
of a new Products
existing Schemes Assets Labour Material
product
product

Variable Costs Fixed Costs

Stay fixed
Vary with
(upto certain
production
capacity)

MARGINAL
Vs
ABSORPTION
COSTING

CHAPTER 2: SOURCES OF DATA

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Session objectives:
- Describe sources of info from within and outside the organization (including
government statistics, financial press, professional or trade associations,
quotations and price list)
- Explain the uses and limitations of published info/data
- Describe the impact of the general economic environment on costs/ revenues
- Explain sampling techniques (6)
- Choose an appropriate sampling method in a specific situation
1. TYPES OF DATA
Data may be classified as follows.
- Primary and secondary data
- Discrete and continuous data
- Sample and population data
Data can also be divided into quantitative and qualitative data.
- Quantitative data: data/variables that can be measured
- Qualitative data: cannot be measured.
Sources of data:
- Internal sources of data
- External sources of data
1.1. Primary and secondary data
- Primary data are data collected especially for a specific purpose. Raw data
are primary data which have not been processed at all, and which are still just a list of
numbers.
Eg. Questionaires, interviews, participant observation
- Secondary data are data which have already been collected elsewhere, for
some other purpose, but which can be used or adapted for the survey being conducted.
Eg. Official statistics from Gov, Banks…, articles, newspapers, reports…
+ Advantage: cheaply available
+ Disadvantage: since the investigators did not collect the data, they is
therefore unaware of any inadequacies or limitations of the data.
1.2. Discrete and continuous data
- Discrete data are data which can only take on a finite or countable number of
values within a given range.
 Countable number: 0, 1, 2, 3…
- Continuous data are data which can take on any value. They are measured
rather than counted.
 Any value: 3.12313, 1.5232 m

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1.3. Sample and population data
- Sample data are data arising as a result of investigating a sample. A sample is
a selection from the population.
- Population data are data arising as a result of investigating the population. A
population is the group of people or objects of interest to the data collector.
2. SAMPLING AND SAMPLING METHODS
2.1. Sampling
- Data are often collected from a sample rather than from a population. If the
whole population is examined, the survey is called a census.
- Disadvantages of a census
+ The high cost of a census may exceed the value of the results obtained.
+ It might be out of date by the time you complete it.
- Advantages of a sample
+ It can be shown mathematically that once a certain sample size has been
reached, very little accuracy is gained by examining more items. The larger the size of
the sample, however, the more accurate the results.
+ It is possible to ask more questions with a sample.
2.2. Sampling methods
- A probability sampling method is a sampling method in which there is a
known chance of each member of the population appearing in the sample.
- Probability sampling methods
– Random sampling
– Stratified random sampling
– Systematic sampling
– Multistage sampling
– Cluster sampling
Random sampling requires the construction of a sampling frame. A sampling
frame is a numbered list of all items in a population.
- A non-probability sampling method is a sampling method in which the
chance of each member of the population appearing in the sample is not known, for
example, quota sampling.
2.2.1. Random sampling
A simple random sample is a sample selected in such a way that every item in
the population has an equal chance of being included.
- Sampling frame: is a numbered list of all items in a population
- Characteristics: Completeness, Accuracy, Adequacy (does it cover the entire
population?, Up to dateness, Convenience, Non-duplication.

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 - Drawbacks:
+ Selected items are subject to the full range of variation inherent in the
population.
+ An unrepresentative sample may result.
+ An adequate sampling frame might not exist.
+ The numbering of the population might be laborious.
+ It might be difficult to obtain the data if the selected items cover a wide area.
+ It might be costly to obtain the data if the selected items cover a wide area.
2.2.2. Stratified random sampling
Stratified random sampling is a method of sampling which involves dividing
the population into strata or categories. Random samples are then taken from each
stratum or category.
- This method ensures that a representative cross-section in a population is
obtained, not random sample
- Often used by auditors to choose a sample to confirm debtors balance (top
twenty customers)
- Advantages:
+ The sample selected will be representative
+ The structure of the sample will reflect that of the population
+ Precision is increased.
+ Inferences can be made about each stratum
- Disadvantages:
+ Requires prior knowledge of each item in the population; sampling frames do
not always contain such information.
2.2.3. Systematic sampling
Systematic samplingis a sampling method which works by selecting every nth
item after a random start.
- The first items determined by choosing randomly a number b/w 1 and 100
then the second item will be adding by 100 units.
- It is not truly random as only the first item is selected randomly
- There is danger of bias (trend) if the population has a repetitive structure
- Advantages:
+ Cheap and easy to use
- Disadvantages:
+ Biased sample might be chosen if there is a regular pattern to the population
which coincides with the sampling method.
+ Not completely random since some items have a zero chance of being

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 selected.
Example: select a sample of 20 from a population of 800, then every 40th (800 :
20) item after a random start in the first 40 should be selected. The starting point could
be found using the lottery method or random number tables. If (say) 23 was chosen,
then the sample would include the 23rd, 63rd, 103rd, 143rd ... 783rd items.
2.2.4. Multistage sampling
Multistage sampling is a probability sampling method which involves dividing
the population into a number of sub-populations and then selecting a small sample of
these sub-populations at random.
- Each sub-population is then divided further, and then a small sample is again
selected at random. This process is repeated as many times as is necessary.
- Advantages:
+ Fewer investigators are needed
+ It is not so costly to obtain a sample.
- Disadvantages:
+ Possibility of bias if, for example, only a small number of regions are
selected.
+ Not truly random. If the population is heterogeneous, the areas chosen should
reflect the full range of the diversity.
 Example: A sample of 1,000 people living in Hanoi has to be taken. We can
first divide the population into districts and select five districts. From each district, a
random sample of 200 people might be selected to interview in order to collect the
information needed.
2.2.5. Cluster sampling
Cluster sampling is a non-random sampling method that involves selecting one
definable subsection of the population as the sample, that subsection taken to be
representative of the population in question.
 For example, the pupils of one school might be taken as a cluster sample of
all children at school in one county.
- Advantages:
+ It is a good alternative to multistage sampling if a satisfactory sampling frame
does not exist.
+ It is inexpensive to operate.
- Disadvantages:
+ There is potential for considerable bias.
CHAPTER 3+4: COST CLASSIFICATION AND COST BEHAVIOUR

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(Note: summary of chapter 3 – cost classification and chapter 4 – cost behaviour in
the BBP textbook)
Session objectives:
- 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 cost – material, labour and
overheads.
- 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.
- Explain and illustrate the concept of cost objects, cost units and cost centres.
- Distinguish between cost, profit, investment and revenue centres.
1. CONCEPT OF COST OBJECTS, COST UNITS, COST CENTRES
- Cost: All expenses carried out to make one unit of a product is called a cost of
that unit.
- Cost Unit: A unit of product with which cost is attached.
Examples: Bike, Watch, etc.
- Cost Per Unit: Cost of one unit of a product is called cost per unit.
- Cost Center: A cost center is a production or service location, function,
activity or item of equipment for which costs are accumulated and analyzed.
Examples: Production department, Administration department, marketing, etc
- Cost Object: A cost object is any activity or item for which a separate
measurement of cost is desired. It could be a cost unit or cost center.
- Cost driver: Any factor whose change causes a change in the total cost of a
related cost object.
2. COST CLASSIFICATION
Cost classification
By nature By function Product and Traceability By behaviour
Period cost
- Materials - Production -Period costs: - Direct costs - Variable costs
- Labour costs salaries, selling - Indirect costs - Fixed costs
-Other -Administration expense, admin - Semi costs
expenses costs expenses…
-Distribution -Product cost:
costs manufacturing
-Selling costs costs
-Financial costs
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 -Selling costs
-R&D costs
The aim of cost classification is to find the costs incurred in the production of
a cost unit. This is important for a number of reasons:
➢ Setting the selling price (so that costs can be covered and a profit can be
earned)
➢ Decision making (for example if a company is selling two products and
has to make a decision to stop selling one of them, it will decide by
determining which of the product is making less profit; which of course is
determined after finding the cost).
➢ Planning future activities (as a company has limited resources, the
planning is done after determining costs)
➢ Reporting the results of the business (costs can only be reported if they are
known as it will have an effect on the value of stocks/shares of company
etc.)
➢ Budgeting (for the upcoming period)
2.1. Cost classification by traceability
- Direct cost: “A cost that can be directly identifiable with a specific cost unit or
cost center is called direct cost”.
Examples: Material used in production, Worker paid for making units, etc.
- Indirect cost: “A cost that cannot be directly identifiable with a specific cost
unit or cost center is called indirect cost”.
It is jointly incurred and must be shared out on an equitable basis.
Examples: Salaries, Rent of the building, etc.
+ Direct Material:
➢ Directly and easily associated/ related with a product.
➢ Traceable to a specific cost unit or cost center
➢ Form major part of the product.
Chair. Shirt.
Direct Indirect Direct Indirect
Wood Nail Fabric Thread
Iron Glue Color Buttons
Foam Paint Special buttons
Fabric Polish
Spring
+ Direct Labour:
➢ Directly and easily associated/ related with a product.
➢ Traceable to a specific cost unit or cost center.
➢ Directly involved in making a product.

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 Examples:
Direct Indirect
Carpenter Salaries of all managers and other
staff. Machine operator
Accountants in firm, etc.
+ Direct Expense:
➢ Directly and easily associated/ related with a product.
➢ Traceable with a specific cost unit or cost center.
➢ Incurred to bring raw material from point of purchase to company
premises.
Examples:
Direct: Transportation, import duties, royalty,..
Indirect : Rent fees, ...
Note : Sum of all direct production cost is called Prime costs. Total indirect
costs are overheads.
Formulae:
(1) Prime Cost = Direct Material + Direct Labour + Direct Expense.
(2) Production Cost = Prime cost + Production Overheads.
(3) Total Cost= Production Cost + Non-Production Overheads.
(4) Conversion Cost = Direct Labour + Direct Expense + Production Overheads.
2.2. Cost classification by functions
- All activities and operations of the company are called functions. In this
classification we classify cost as per activity, operation, product, individual segment,
division, department, etc.
- Functional classification may depend on the size and number of activities of
an organization.
- Functional classification could be used in following cases:
+ Cost control
+ Inventory valuation
+ Financial Statements,…
Examples:
- Production / Manufacturing Costs
Cost incurred in making the goods. There are three main elements of production
costs
➢ Cost of Material
➢ Cost of Labour
➢ Cost of Expenses

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 - Selling cost
It is an indirect cost incurred in promoting sales and retaining customers.
➢ Advertising cost
➢ Sales promotion
➢ Printing of catalogues and price list
➢ Salaries and commissions of salesmen
➢ Sales department’s costs like staff, rent, rates and insurance of
showroom
➢ Cost of free samples to customers
- Distribution cost
It is an indirect cost incurred in making the packed product ready for dispatch
and delivering it to customers
➢ Packing cost
➢ Wages of packing staff, drivers, dispatch clerks
➢ Rent and rates, insurance and depreciation of finished goods
warehouse
➢ Cost of delivery of finished goods
- Administration Costs
➢ Office Cost
➢ General manager’s salary
➢ Accountant’s salary
➢ Auditor’s fees
➢ Telephone and Postage costs
➢ Depreciation of Office Building and Equipment
- Financial Costs
Cost incurred for the arrangement of funds either through Bank or a financial
institution
➢ Interest paid on loans
- Research & Development Costs
Cost incurred before making a product like research work
2.3. Cost classification into product costs and period costs
- Product costs are costs of making or buying an item of inventory. (such as
materials, labour and other expenses)
- Period costs are costs that do not change, which remain fixed. Those costs
relate to the passage of time rather than the output of individual product or service and
often presented on Income Statement. (salaries, rent of the building, etc.)
- This type of cost classification could be used in the following.

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 + Cost control
+ Inventory valuation
+ Absorption and marginal costing, etc.
2.4. Cost classification by cost controllability
- Normally all the cost incurred by an organisation are controllable for
management. But some costs are uncontrollable for a particular manager.
- Controllable costs: costs which can be controlled by managers.
 Materials used for production, labour paid to production workers, etc. can be
controlled by production managers.
- Uncontrollable costs: costs which cannot be controlled by managers or some
specific managers.
 Production costs can be classified as uncontrollable costs for sales managers.
Or share in the rental cost of the building, share in the organisation’s bills, etc.
- Uses: for cost control, decision making.
2.5. Cost classification by behaviour
2.5.1. Variable costs, fixed costs and mixed costs
In the cost behavior we will see the effect on costs with the change in activity
level. Activity Level: is often considered as the amount of work done or the volume of
production. (numbers of products manufactured, No of machine hours, sales,…)
Costs are classified into variable costs, fixed costs, semi-fixed or semi-variable
costs.
- Variable cost: a cost which tends to vary with the level of activity.

Charts: In Total: In per unit:

$ total
cost $ Per unit

0 Activity Level 0 Activity Level.

Examples:
+ Direct material costs are variable costs because they rise as more units of a
product are manufactured.
+ Sales commission is often a fixed percentage of sales turnover, and so is a
variable cost that varies with the level of sales.

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 In case of discounts:
 If discount is applicable on only excess units:
In Total: In per unit:
$ Total $ Per unit
costs

Activity Level. Activity Level.

 If discount is applicable on all units:
In Total: In per unit:
$ Total $ Per unit
costs

Activity Level. Activity Level.

- Fixed cost is a cost which is incurred for a particular period of time and
which, within certain activity levels, is unaffected by changes in the level of activity.
Examples: The rental cost of business premises is a constant amount, at least
within a stated time period, and so it is a fixed cost. Straight-line depreciation.

Charts: In Total: In per unit:

$ Total $ Per unit
costs

Activity Level. Activity Level.

- Step fixed costs: A cost that fix for a certain level of activity, will increase and
will then remain fix again until another level of production is called stepped fixed cost
Examples: Store rent, Supervisor’s salaries,
Charts: In Total: In per unit:
$ Total cost $ per unit

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 0 Activity level 0 Activity level
- Mixed Cost/ Semi-Variable/Semi-Fixed Cost:“A cost which has both
elements fixed and variable is called semi-variable cost”.
Examples: bills, guaranteed wage, cost of running car, etc
Charts: In Total: In per unit:
$ Total cost $ per unit

Activity level Activity level

 Summary cost behavior pattern:
- If activity is increase:
+ VC per unit are constant
+ FC per unit will fall
+ TC per unit will fall
- Assumptions about cost behaviour include the following.
+ Within the normal or relevant range of output, costs are often assumed to be
either fixed, variable or semi-variable (mixed).
+ Departmental costs within an organisation are assumed to be mixed costs,
with a fixed and a variable element.
+ Departmental costs are assumed to rise in a straight line as the volume of
activity increases. In other words, these costs are said to be linear.
2.5.2. Determining the fixed and variable elements of semi-variable costs using
high-low method
- Assume that costs are linear.
- How to apply high-low method:
+ Step 1: Identify two different levels of activities: the highest and the lowest
level of activities and the corresponding costs.
+ Step 2: Calculate the variable cost per unit.
VC Total costs at highest activity level – Total costs at lowest activity level
=
per unit Total units at highest activity level – Total units at lowest activity level
+ Step 3: The fixed costs can be determined as follows.
(Total cost at high activity level) – (total units at high activity level × variable cost per
unit)
+ Step 4: Form the equation
Total Cost = Total Fixed Cost + Total Variable cost

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 Total Cost = Total Fixed Cost + (Variable cost per unit x Number of Units)
Y = a + bx
Where: - Y is the dependent variable i.e. the total cost for the period at
activity level of X
- x is the independent variable, i.e. the activity level
- a is the constant, i.e. the total fixed cost for the period
- b is also a constant, i.e. the variable cost per unit of activity
Notes:
- High low method with stepped fixed cost: Sometimes fixed costs are only
fixed within certain level of activity and increase in steps as activity increases. High-
Low method can still be used to estimate fixed and variable costs by making an
adjustment, keeping fixed cost equal at both levels.
- High low method with the change in variable cost per unit: Sometimes
there may be changes in the variable cost per unit. High-Low method can still be used
to determine the fixed and variable elements of semi-variable cost by making an
adjustment, keeping variable cost per constant at both levels. The variable cost per
unit may change because: Availability of discounts, Inflation, etc.
- Advantages of HL method:
+ It is easy to use and understand
+ It needs just two activity levels (the highest and lowest)
- Disadvantages of HL method:
+ It considers two extreme points which may be representative of normal
conditions
+ Based on two points so formula is not very accurate.
+ Based on historical data.
Example:
DG Co has recorded the following total costs during the last five years.
Year Output volume (units) Total cost ($)
20X0 65,000 145,000
20X1 80,000 162,000
20X2 90,000 170,000
20X3 60,000 140,000
20X4 75,000 160,000
Required: Calculate the total cost that should be expected in 20X5 if output is
85,000 units.

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 CHAPTER 5: PRESENTING INFORMATION
Session objectives:
- 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)

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 - Interpret information (including the above tables, charts and graphs) presented
in management reports.
5.1. PRESENTING, DISSEMINATING AND INTERPRETING INFORMATION
The management accountant is involved in the presentation, dissemination and
interpretation of information.
Information can be presented in the form of a report, or a table of figures, or as
a chart or graph.
5.2. WRITTEN REPORTS
- What is a report?
+ Variety of formats and styles of reports: single page or extensive, complex
document.
+ Routine reports are produced at regular intervals, Special reports may be
commissioned for 'one-off' planning and decision-making purposes.
+ Reports may be for professional purposes, or they may be for a wider
audience.
- Useful of report:
+ To assist management
+ As a permanent record and source of reference
+ To convey information or suggestions/ideas to other interested parties (eg in a
report for a committee)
- The reports and the report users:
+ A special 'one-off' reportwill be commissioned by a manager
+ Routine reports, such as performance reports, might be required because they
are a part of established procedures
+ Some reports arise out of a particular event, on which regulations prescribe
the writing of a report
+ Individual responsibilitiesoften include the requirement to write reports
- The four stage approach to report writing:
+ Prepare: determine the type of document required, the report users.
+ Plan: select the relevant data, produce a logical order
+ Write: determine the writing style
+ Review: ensure that it is complete and clear.
5.3. PRESENTING AND INTERPRETING INFORMATION IN TABLES,
CHARTS, GRAPHS
5.3.1. Tables
Guidelines for tabulation
(a) The table should be given a clear title.

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 (b) All columns should be clearly labelled.
(c) Where appropriate, there should be clear subtotals.
(d) A total columnmay be presented (usually the right-hand column).
(e) A total figure is often advisable at the bottom of each column of figures.
(f) Information presented should be easy to read.
(g) Sources of data/info, unit of measurement should be stated.
5.3.2. Charts
- Bar charts: is a method of presenting information in which quantities are
shown in the form of bars on a chart, the length of the bars being proportional to the
quantities.
There are three main types of bar chart.
(a) Simplebar charts
(b) Componentbar charts, including percentage componentbar charts
(c) Multiple(or compound) bar charts
- Pie chart is a chart which is used to show pictorially the relative size of
component elements of a total.
5.3.3. Scatter diagrams
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 each other.
- The x axis of a scatter diagram is used to represent the independent variable
and the y axis represents the dependent variable.
- To construct a scatter diagram or scattergraph, we must have several pairs of
data, with each pair showing the value of one variable and the corresponding value of
the other variable. Each pair is plotted on a graph.
The resulting graph will show a number of pairs, scattered over the graph. The
scattered points might or might not appear to follow a trend.

PART B – COST ACCOUNTING TECHNIQUES

CHAPTER 6 : ACCOUNTING FOR MATERIALS

Session objectives:
- Describe the different procedures and documents necessary for the ordering,
receiving and issuing of materials from inventory.

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 - 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.
- Interpret inventory control such as costs of ordering and holding inventory,
optimal reorder quantities…
- Calculate the value of closing inventory and material issues using LIFO, FIFO
and average methods.
6.1. ORDERING AND ACCOUNTING FOR INVENTORY
6.1.1. Documents used within a business for the ordering, purchasing, receiving
and issuing of goods.
 Ordering goods
When a department requires new material, they will send a purchase
requisition form to the purchasing department.
The purchasing department will then send a purchase order form to the
relevant supplier (with copies to the accounts department and to the goods receiving
department).
 Receiving goods from the supplier
When the goods are received by the goods receiving departments, they will
check the goods against the purchase order and against the delivery note (which the
supplier will have prepared and sent with the goods and which will list what is in the
delivery).
The goods receiving department will prepare a goods received note giving full
details of the goods that have been received and will send copies to the purchasing
department and to the accounting department.
The inventory records will be updated.
 Receiving the invoice from the supplier
The purchasing department will match the invoice details with the purchase
order and the goods receive note, and approve it for payment.
The approved invoice will be sent to the accounting department who will enter
it into the ledgers and later pay it.
 Issuing of inventory
When the production department requests materials for production, they will
send a material requisition note to the stores.
The stores will issue the material and update the inventory records.
Any unused material will be returned to the stores together with a materials
returned note and inventory records will be updated.

22
 If material is transferred from one production department to another, a material
transfer note is prepared.
When finished goods are despatched to customers, a goods despatch note and
a delivery note are created.

6.1.2. The valuation of inventory

There are three methods used for the valuation of closing inventory in
management accounting: FIFO, LIFO, and Weighted average (Periodic weighted

23
average pricing method, AVCO)
(1) FIFO – first in first out
FIFO assumes that materials are issued out of inventory in the order in which
they were delivered into inventory:
+ issues are priced at the cost of the earliest delivery remaining in inventory.
+ the closing inventory will consist of the most recent receipts.
Example: JM Ltd had the following material transactions during
November.
No of units Cost per unit
Opening balance 1 November 20 4.00
Receipt 8 November 140 4.40
Issues 12 November 80
Receipt 18 November 100 4.60
Issues 26 November 140
Calculate the closing inventory value at the end of November using FIFO.
- Advantages of FIFO:
+ It is a logical pricing method which probably represents what is physically
happening: in practice the oldest inventory is likely to be used first.
+ It is easy to understand and explain to Managers
+ The inventory valuation can be near to a valuation based on replacement cost.
- Disadvantages of FIFO:
+ FIFO can be cumbersome to operate because of the need to identify each
batch of material separately.
+ Managers may find it difficult to compare costs and make decisions when
they are charged with varying prices for the same materials.
+ In a period of high inflation, inventory issue prices will lag behind current
market value.
(2) LIFO – Last in first out
LIFO assumes that materials are issued out of inventory in the reverse order to
which they were delivered: the most recent deliveries are issued before earlier ones,
and issues are priced accordingly.
Example
JM Ltd had the following material transactions during November.
Numbe
Cost per
r of
unit
units

24
 Opening balance 1 November 20 4.00

Receipt 8 November 140 4.40

Issues 12 November 80
Receipt 18 November 100 4.60
Issues 26 November 140
Calculate the closing inventory value at the end of November using LIFO.
- Advantages of LIFO:
+ Inventories are issued at a price which is close to current market value.
+ Managers are continually aware of recent costs when making decisions,
because the costs being charged to their department or products will be current costs.
- Disadvantages:
+ The method can be cumbersome to operate because it sometimes results in
several batches being only part-used in the inventory records before another batch is
received.
+ LIFO is often the opposite to what is physically happening and can therefore
be difficult to explain to managers.
+ As with FIFO, decision making can be difficult because of the variations in
prices.
(3) Cumulative weighted average cost
- The cumulative weighted average pricing method (or AVCO) calculates a
weighted average price for all units in inventory. Issues are priced at this average cost,
and the balance of inventory remaining would have the same unit valuation.
The average price is determined by dividing the total cost by the total number of
units.
A new weighted average price is calculated whenever a new delivery of
materials is received into store. This is the key feature of cumulative weighted average
pricing.
- Periodic weighted average pricing method: only one weighted average cost is
calculated at the end of the period.
Example:
- Advantages of AVCO:
+ Fluctuations in prices are smoothed out, making it easier to use the data for
decision making.
+ It is easier to administer than FIFO and LIFO because there is no need to
identify each batch separately.
- Disadvantages:

25
 + The resulting issue price is rarely an actual price that has been paid, and can
run to several decimal places
+ Prices tend to lag a little behind current market values when there is gradual
inflation.
(4) Comparison of FIFO, LIFO AND AVCO
➢ The values for AVCO lie between those for LIFO and FIFO. This should
always occur because AVCO is an averaging method.
➢ Both LIFO and FIFO require records to be kept of each batch of
purchases so that the appropriate price may be attached to each issue.
➢ Price fluctuations are smoothed out with the AVCO method which
makes the data easier to use for decision-making, although the rounding
of the unit value might cause some difficulties.
➢ Many management accountants would argue that LIFO provides more
relevant information for decision-making because it uses the most up-to-
date price.
➢ However LIFO may sometimes confuse managers, since the pricing
method represents the opposite to what is happening in reality, that is,
the items in store will probably be physically issued on a FIFO basis.
➢ The prices of receipts are rising during the month. Therefore the FIFO
method, which prices issues at the older, lower prices, results in the
highest value of closing inventory and the highest profit figure. The
AVCO method produces results that lie between those for FIFO and
LIFO.
6.2. INVENTORY CONTROL
Introduction: There are many approaches in practice to ordering goods from
suppliers. For example, if a company needs a total of 12,000 units each year, then they
could decide to order 1,000 units to be delivered 12 times a year. Alternatively, they
could order 6,000 units to be delivered 2 times a year. There are obviously many
possible order quantities.
 Each company needs to consider the costs involved and thus decide on the
order quantity that minimises these costs (the economic order quantity).
6.2.1. Costs involved
The costs involved in inventory ordering systems are as follows:
• the purchase cost
• the reorder cost
• the inventory-holding cost
Purchase cost

26
 This is the cost of actually purchasing the goods. Over a year the total cost will
remain constant regardless of how we decide to have the items delivered and is
therefore irrelevant to our decision.
(Unless we are able to receive discounts for placing large orders – this will be
discussed later in this chapter)
Re-order cost
This is the cost of actually placing orders. It includes such costs as the
administrative time in placing an order, and the delivery cost charged for each order.
If there is a fixed amount payable on each order then higher order quantities
will result in fewer orders needed over a year and therefore a lower total reorder cost
over a year.
Inventory holding cost
This is the cost of holding items in inventory. It includes costs such as
warehousing space and insurance and also the interest cost of money tied up in
inventory.
Higher order quantities will result in higher average inventory levels in the
warehouse and therefore higher inventory holding costs over a year.
6.2.2. Stock control level
There are three stock control levels maintained for every proper stock control
system. The main purpose is to ensure only the right quantity of stock is held, not over
or under stocking.
- Reorder Level: It is also called replenishment order level. When stock
reaches this level, it indicates that ordering of stock is necessary. At this level, even if
usage is at maximum level and the lead-time is the longest, there will still be no stock-
out situation.
Reorder level = Maximum Usage x Maximum lead time
Lead time: Lead time is the time between placing the order and receiving the
goods.
- Maximum Level: This identifies the maximum quantity of stock to keep. It
avoids cost of over- stocking.
Maximum level = Reorder level + Reorder quantity – (Minimum usage x
Minimum lead time)
Reorder quantity: Reorder quantity is the number of units of stock ordered
each time when re-order level is reached. If it is set so as to minimize the total costs
associated with holding and ordering stock, then it is known as EOQ.
- Minimum Level: This is the lowest quantity of stock that should be kept. This
level warns the danger of stock-out. When stock reaches this level, emergency action

27
will have to be taken to avoid stock- out.
Minimum level = Reorder level – (Average usage x Average lead time)
Note: Buffer Stock/Safety Stock will also be calculated using Minimum
Level Formula.
It is also important to understand the concept of average stock for stock control
purpose:
- Average Stock: Average stock is the average between the minimum stock level
and the highest possible stock level.
Average stock = Safety stock + ½ reorder quantity
Safety stocks (or buffer stocks) are level of units maintained in case there is
unexpected demand.
6.2.3. Economic order quantity (EOQ)
- Minimising costs: One obvious approach to finding the economic order
quantity is to calculate the costs p.a. for various order quantities and identify the order
quantity that gives the minimum total cost.
In other words, it is the most economic stock replenishment order size which
minimizes stock costs.
At EOQ: Total annual holding cost = Total annual ordering cost
Assumptions/Limitations of EOQ model
➢ Demand is constant throughout the year.
➢ Lead time is constant or zero (for example suppliers are reliable)
➢ Purchase price per unit is constant (for example no bulk discounts)
➢ Holding cost per unit will be constant per annum.
➢ Ordering cost per order will be constant
➢ No safety stock
➢ Average stock concept
➢ Ignore any uncertainty.
EOQ formula is

Where,
Co: cost of placing one order
D: expected annual sale (demand)
Ch: cost of holding one item of stock for one year

Total annual costs = Total annual purchase cost + Total annual ordering
cost +Total annual holding cost
28
 No. of orders = D/EOQ
Frequency of orders = EOQ/D x 365 (if required in days) Annual ordering cost
= No. of orders x Co
Annual holding cost = (EOQ/2 + Safety stock) x Ch Annual Purchase cost = D
x Purchase Price
Quantity discounts
Often, discounts will be offered for ordering in large quantities. When bulk
discounts are available we have two options; take advantage of discount by ordering a
larger quantity or ignore the discount offer and go for economic order quantity. We
take decision based on mathematical calculation.
We choose the option under which the sum of three costs; total purchase cost,
total inventory holding cost and total inventory ordering cost, is minimised. The total
cost under two options is compared at following level:
● Pre-discount EOQ level.
● Minimum order size to earn discount
If total cost is minimised at pre-EOQ level then discount offer should be
ignored outright and vice versa.
The problem may be solved using the following steps:
• Calculate EOQ ignoring discounts
• If it is below the quantity which must be ordered to obtain
discounts, calculate total annual inventory costs.
• Recalculate total annual inventory costs using the order size
required to just obtain the discount
• Compare the cost of step 2 and 3 with the saving from the
discount and select the minimum cost alternative.
• Repeat for all discount levels
The Ways in Which Discounts Might Affect the Order Size and the Total
Costs
➢ Discounts are likely to lower the total purchase cost and it will likely to
increase order size in order to obtain discount in bulk purchases
➢ The total ordering cost will be reduced as the increase in order size will
lower the number of orders.
➢ The total holding cost will be increased or decreased. The increase is due
to the increase of the number of average stocks held annually but if the
holding cost is a percentage of purchase price, then the holding cost will
per unit per annum decrease when the purchase price decreases.
The Economic Batch Quantity

29
 Assumed that we purchased goods from a supplier who delivered the entire
order immediately.
Suppose instead that we have our own factory. The factory can produce many
different products (using the same machines). Whenever we order a batch of one
particular product then the factory will set-up the machines for the product and start
producing and delivering to the warehouse immediately.
However it will take them a few days to produce the batch and during that time
the warehouse is delivering to customers.
As a result the maximum inventory level in the warehouse never quite reaches
the order quantity, and the formula needs changing slightly.

Where: Co = cost of setting up a batch

D = Demand per period
Ch = holding cost per unit per period
R = production replacement rate/production rate per period.
6.2.4. Accounting for materials
1, Direct material issued to production
Debit Work in progress control account
Credit Material control account
2, Indirect material issued to production
Debit Production overhead control account
Credit Material control account
3, Direct material returned to stores.
Debit Material control account
Credit Work in progress control account
4, Indirect material returned to stores.
Debit Material Control account
Credit Production overhead control account
Materials Control Account
$ $
Opening balance xxx Issued to production
Direct materials Xxx
Materials bought xxx Indirect materials Xxx
Materials returned Closing Balance Xxx
Direct Materialxxx (the balancing figure)
Indirect Material xxx

30
 CHAPTER 7: ACCOUNTING FOR LABOUR
Session objectives:
- Calculate direct and indirect costs of labour
- Explain the methods used to relate input labour costs to work done.
(remuneration methods)
- 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.
7.1. LABOUR COSTS
- Labour represents the human contribution to production and is an important
cost factor requiring constant measurement, control and analysis. It can be classified
as:
● Direct Labour Cost can be specifically traced to or identified with a
particular product/service. They are directly involved in making a
product, basic pay, and any overtime premium paid for a specific job at
the customer’s request.
Examples: Wages of operative assembling parts into finished products,
Teachers, etc.
● Indirect Labour Cost not charged directly to a product.

Indirect labour costs are general overtime premiums, bonus payments,

idle time, and sick pay
Examples: Instructor’s salary, supervisor’s salary, maintenance worker’s
salary, etc.
- Recording labour costs:
Several departments are involved in the collection, recording and costing of
labour. These include:
➢ Personnel;
➢ Production planning;
➢ Timekeeping: responsible for recording the attendance time and the time

31
 spent in the factory and spent on particular job by each employee;
➢ Payroll: Labour costs paid to employees according to records;
➢ Cost accounting.
7.2. LABOUR REMUNERATION METHODS
 Remuneration methods – 3 main methods: time work, piecework, and bonus
schemes.
(1) Time work: (time related payment mode)
+ Wages are paid on the basis of hours worked
For example, if an employee is paid at the rate of $5 per hour and works for 8
hours a day, the total pay will be $40 for that day.
+ Employees paid on an hourly basis are often paid extra for working overtime.
For example, an employee is paid a normal rate of $5 per hour and works 4
hours overtime for which he is paid at time-and-a half. The amount paid for the
overtime will be 4 x 1.5 x $5 = $30.
(2) Piecework (output related payment mode)
+ Wages are paid on the basis of units produced.
For example an employee is paid $0.20 for every unit produced, with a
guaranteed minimum wage of $750 per week. In week 1, they produce 5,000 units and
so the pay will be 5,000 x $0.20 = $1,000 for the week. In week 2, they only produce
3,000 units, for which the pay would be 3,000 x $0.20 = $600. However, since this is
below the guaranteed minimum the employee will receive $750 for the week.
(3) Bonus (or incentive) schemes
There are many different ways in which a bonus scheme can operate, but
essentially in all cases the employee is paid a standard wage but in addition receives a
bonus if certain targets are achieved.
 Overtime and overtime premium
Overtime usually arise from working more than normal working hours,
including weekends and national holidays.
Overtime premium The additional / extra amount paid to the employee over
the normal rate because he/ she worked for more than the normal period of time.
Overtime payment is always more than normal hourly rate. There is two parts of
overtime payment; overtime basic pay and overtime premium.
Types of Overtime
➢ General Overtime: Extra hours worked due to general reasons like machine
breakdown, production scheduling problem etc.
➢ Specific Overtime: Overtime is done due to customer’s special request to
complete his job earlier.

32
 Overtime premium of direct labour force is treated as indirect cost except:
+ If overtime is worked at the specific request (specific overtime) to complete
customer’s order  treat as direct cost.
+ If overtime is regular basic in normal course of operation, overtime corporate
with average of direct labour hourly rate.
 Idle Time / Down Time
➢ Time that is paid for but in which no work was done (so it is non-
productive time)
➢ It is always treated as an indirect labour cost (both for direct and
indirect workers)
➢ There is no idle time in overtime but general overtime may arise due to
idle time.
➢ Idle time hours are deducted from normal basic hours
Reasons of idle time
▪ Production disruption
▪ Machine breakdown
▪ Shortage of material
▪ Inefficient scheduling
▪ Poor labour supervision
▪ Payments for tea break
▪ Payments for rest periods
▪ Sudden fall in demand of a product
▪ Strike at supplier’s business
Note:
- Total hours paid = Productive hours + Non-productive hours
- Total hours worked = only Productive hours
7.3. LABOUR RATIOS
(1) Idle time ratio
Idle time Idle hrs
= X 100 %
ratio Total hrs

 The idle time ratio is useful because it shows the proportion of available
hours which were lost as a result of idle time.
(2) Labour turnover: is the rate at which employees leave a company and this
rate should be kept as low as possible. The cost of labour turnover can be divided into
preventative and replacement costs.
= Replacements X 100 %

33
 Labour
Avrg No. of employees in period
turnover rate
Example: Revolving Doors Inc had a staff of 2,000 at the beginning of 20X1
and, owing to a series of redundancies caused by the recession, 1,000 at the end of the
year. Voluntary redundancy was taken by 1,500 staff at the end of June, 500 more than
the company had anticipated, and these excess redundancies were immediately
replaced by new joiners.
The labour turnover rate is calculated as follows.
Rate = 500/ [(2,000 + 1,000): 2] * 100% = 33%
(3) Efficiency ratio
This ratio measures the efficiency of the labour force by comparing equivalent
standard hours for product produced and actual hours worked. The benchmark of
efficiency is 100%.
 This measures whether the labour are working faster or slower than
expected.
Standard hours for actual output
Efficiency ratio
= (or expected hours to make output) X 100 %
Actual hours worked/taken
(4) Capacity ratio
This ratio measures the extent of worker's capacity by their working hour has
been achieved in a period with the planned labour hours utilization.
 This measures whether the labour were able to obtain more or less working
hours than we originally budgeted on being available

Capacity ratio Actual hours worked/taken

= X 100 %
Hours budgeted

(5) Production volume ratio/ Activity ratio

This ratio measures how the overall production compares to planned levels. It
compares the number of standard hours equivalent to the actual work produced and
budgeted hours.
 This measures whether we were able to produce more or less than we
expected to produce based on the budgeted hours available.
Production Standard hours for actual output
= X 100 %
volume ratio Hours budgeted
Note: Relationship between the three ratios:
 Activity ratio = Efficiency ratio x capacity ratio

34
  Standard hours for actual output = Standard hours per unit x Actual
output.
 Standards hours per Unit = Budgeted hours ÷ Budgeted units produced
7.4. ACCOUNTING FOR LABOUR COSTS
1, Charging Direct Wages to production department
Debit Work in progress account
Credit Wages control account
2, Charging Indirect Wages to production department
Debit Production overhead account
Credit Wages control account
3, Charging Indirect Wages to non-production department
Debit Non-production overhead control account
Credit Wages control account
Wages control account
$ $
Bank xxx WIP(direct labour) xxx
Production overhead:
Indirect labour xxx
Overtime premium xxx
Idle time xxx
Shift allowance xxx
Sick pay xxx
Xxx Xxx

35
 CHAPTER 8: ACCOUNTING FOR OVERHEADS
Session objectives:
- Explain the different treatment of direct and indirect expenses.
- Describe the procedures involved in determining production overhead
absorption rates.
- Allocate and apportion production overheads to cost centres using an
appropriate basis.
- Reapportion service cost centre costs to production cost centres (methods used
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.
8.1. OVERHEADS
Overhead is the cost incurred in the course of making a product, providing a
service or running a department, but which cannot be traced directly and in full to the
product, service or department.

Indirect Clearly Production cost centre

materials identifiable
with cost Service cost centre
centres Administration, selling,
Indirect distribution centres
Indirect
labour costs Not clearly
(overheads) identifiable
with General OH cost centres
Indirect particular
expenses cost centres

In cost accounting there are two schools of thought as to the correct method of
dealing with overheads:
Absorption costing
Marginal costing
8.2. ABSORPTION COSTING: AN INTRODUCTION

36
 - The objective of absorption costing is to include in the total cost of a product
an appropriate share of the organisation's total overhead. An appropriate share is
generally taken to mean an amount which reflects the amount of time and effort that
has gone into producing a unit or completing a job.
- Why do we need absorptions?
+ Theoretical justification: all production OH incurred in the production of
outputs and therefore should be charged to each unit of output
+ Practical reason:
o Stockk valuation (in BS and COS), Absorption costing is recommended
in financial accounting by the statement of standard accounting practice
on stocks
o Pricing decision: Many companies fix the selling price of a product by
calculating the full cost of production and then add a margin for profit.
This is known as “full cost plus pricing”.
o Establishing the profitability of different products: When a company
sells more than one product, overhead costs must be shared on a fair
basis to each product to judge the profitability of each product.
- Under Absorption costing system there are four steps of charging overhead
costs to cost centres and cost units.
1 Allocation.
2 Apportionment.
3 Re-apportionment.
4 Absorption
+ Step 1 - Allocation is the charging or distributing of cost directly to the cost
centres or cost units. Costs that relate to a single cost centre are allocated to that cost
centre.
Examples: Direct labour will be charged to a production cost centre. The cost of
a warehouse security guard willbe charged to the warehouse cost centre.
+ Step 2 – Apportionment is where an overhead is common, combined or joint
to more than one cost centre (they are indirect costs) and therefore it needs to be shared
out amongst the relevant cost centres based on benefit received by each cost centre.
Formula of OH apportionment:
OH Department base
apportionment = X Production overheads
Total base
Sharing out common cost: identify all OH costs as production, administration, selling
and distribution overhead. So the shared costs (rent, heat, lighting…) initially allocated to a
single cost center must now be shared b/w the other cost centers.

37
 Costs Basis of apportionment
- Rent and rates - Floor area / space occupied
- Light and heat - Floor area / space occupied
- Power - Kilowatt hour / capacity of machines
- Employee related costs - Number of employees / wages cost
- Depreciation of plant and machinery - Value of machinery
- Insurance of plant and machinery - Value of machinery
- Canteen costs - Number of employees

+ Step 3 – Re-appointionment. Service departments are cost centres, which

exist to provide services to other departments. The canteen is a common example,
having allocated and apportioned the costs to the production and service departments,
the totals of service cost centres, the latter need to be reapportioned to the production
cost centres.
 In order to calculate a correct of each product, we must determine the total
cost of producing each unit, not just the cost of the materials and the labour that are
directly used in production but also the indirect costs of services provided by service
departments.
 Two methods are available for reapportionment:
(1) Direct method is used when service centers do not exchange services with
each other, means they only provide services to production centers.
(2) Indirect method is used when service centers exchange services with each
other. Means service centers provide services to production centers and to each others
as well. Indirect method further sub divided into 2 methods:
o Step Down method (one-way method)
One service department provides services to other service departments
but others do not. Service department which provides service to other
service center is reapportioned first. This is the only method in which
sequence of re-apportionment matters.
o Reciprocal method (two-way method)
Service departments provide services to each other. It may be solved
algebraically by simultaneous equation or through repeated
distribution.
+ Step 4 – OH absorption is the process whereby overhead costs allocated and
apportioned to production cost centres are added to unit, job or batch costs. Overhead
absorption is sometimes called overhead recovery.
Calculation of overhead absorption rates (OAR):

38
 o Estimate the overhead likely to be incurred during the coming period.
o Estimate the activity level for the period. (total units, hours, etc.)
o Divide the estimated overhead by the budgeted activity level
o Absorb the overhead into the cost unit by applying the calculated absorption
rate
OAR Budgeted OH
=
Budgeted Activity
Note: There are blanket absorption rate and separate absorption rate:
o Blanket absorption rate: refers to a situation where single OAR is used
for the whole factory or organization.
o Separate absorption rate (departmental rate) is used for each department
or cost center. Charging of OH will be fair and the full cost of production
of items will represent the amount of the effort and resources put into
making them.
- Over and under absorption of overheads
Predetermined absorption rate or Overhead absorption rate (OAR) is based on
budgeted overheads and budgeted activity levels. The absorbed overheads will differ
from actual overheads incurred.
+ Absorbed overheads = Absorption rate x actual activity level
Absorbed overheads are compared with actual overheads incurred in a period;
the difference is either under absorption or over absorption.
+ Absorbed OH < Actual OH  UNDER absorption
(add to Cost of goods sold or deduct from profit)
+ Absorbed OH > Actual OH  OVER absorption
(deduct from Cost of goods sold or add in profit)
Note:
+ If actual overheads incurred are not given then an assumption can be taken
that Budgeted overheads = Actual overheads
+ Under or over absorption of overheads will occur if:
(a) Actual overheads are different from the budgeted overheads
(b) Actual activity level different from the budgeted activity level
(c) Or both situations arise
8.3. NON-PRODUCTION OVERHEAD
Non-production overheads (non-manufacturing OH) may be allocated by
choosing a basis for overhead absorption rate which fairly reflects the non-production
overheads.
For external reporting purposes non-manufacturing costs are required to be

39
treated as period cost but for internal reporting purposes it may be included into
product cost.

Basis for apportionment of non-manufacturing overheads

There are two options available for apportioning non-manufacturing costs to
cost units:
● Method 1: Choose a basis for apportioning non-manufacturing overheads
which fairly reflects non- manufacturing overhead such as direct labour
hour, machine hour etc.
● Method 2: Allocate non-manufacturing overheads to product on the basis
of products ability to bear such cost. For example manufacturing cost may
be used to apportion non-manufacturing cost to product.
Other possible bases for allocating overhead costs are as follows:
Overhead Possible absorption bases
Administration Production cost
Selling overhead Sales value
Distribution overhead Sales value

40
 CHAPTER 9: ABSORPTION AND MARGINAL COSTING
Session objectives:
- 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
9.1. MARGINAL COST AND MARGINAL COSTING
- Marginal cost is the variable cost of one unit of product or service.
- The marginal production cost per unit of an item usually consists of the
following.
+ Direct material
+ Direct labour
+ Variable production OH
- Marginal costing: is an alternative method of costing to absorption costing. In
marginal costing:
+ Only variable costs are charged as a cost of sale
+ Closing inventories of work in progress or finished goods are valued at
marginal
(variable) production cost.
+ Fixed costs are treated as a period cost, and are charged in full to the profit
and loss account of the accounting period in which they are incurred.
- Contribution: is calculated as the difference between sales value and
marginal or variable cost of sales.
Contribution = Total Sales Revenue – Total Variable Cost
Contribution = Total Fixed Cost + Total Profit
 Profit will increase by the amount of contribution earned from the extra
item.
- The principles of marginal costing
+ Period fixed costs are the same, for any volume of sales and production
+ Profit measurement should therefore be based on an analysis of total
contribution

41
 + The additional costs (marginal cost) to produce an additional item are variable
costs and therefore the closing stock should be valued at variable production cost.
9.2. DIFFERENCE B/W MARGINAL COSTING AND ABSORPTION COSTING
Marginal costing Absorption costing
- Closing inventories are valued at - Closing inventories are valued at full
marginal production cost.
production cost.
- Fixed costs are period costs. - Fixed costs are absorbed into unit costs.
- Cost of sales does not include a share of - Cost of sales does include a share of
fixed overheads. fixed
Overheads.
9.3. RECONCILING PROFITS
9.3.1. Comparison of total profits
- If production is equal to sales, there will be no difference in calculated profits
using the costing methods.
- If there are changes in stocks during the period (opening and closing stocks
are different), the profits reported under two costing systems will be different.
- In the long run, the total profits generated under two costing systems are the
same.
CASES:
1/ Opening stock units < Closing stock units  High profit under Absorption
costing
2/ Opening stock units > Closing stock units  High profit under Marginal
costing
3/ Opening stock units = Closing stock units  Same profit under Both
9.3.2. Reconciling profits
Difference in profits = change in inventory level × OAR per unit
Change in INV level = Closing INV – Opening
* Arguments in favour of Absorption costing:
- Fixed production costs are incurred in order to make output, it is therefore fair
to charge all outputs with a share of these costs.
- Closing stock values, by including a share of fixed production overhead, will
be valued on the principle of IAS 2, as required by financial accounting purpose.
- Including fixed cost in the value of closing stock allows the fixed cost to be
charged only in the period of which revenue is earned, thus following the cost -
revenue matching concept.
* Arguments in favour of Marginal costing:
- It is simple to operate as we do not have to determine fixed overhead

42
absorption rate.
- Writing off fixed cost immediately in the period it is incurred follows the
prudence concept of accounting.
- Fixed cost are irrelevant cost for decision making, thus highlighting
contribution in profit statement provides better information for decision making
purposes.
- Profit will not be distorted through fluctuation in stock level and production
level as the contribution calculated is based on sales volume.

43
 CHAPTER 10 : JOB, BATCH AND SERVICE COSTING
Session objectives:
- 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.
10.1. JOB COSTING
- A job is a cost unit which consists of a single order or contract. It consists of a
single order undertaken to customers’ special requirements and is usually for a short
duration.
 It relates to a costing system where each unit of batch of output is unique.
This creates the need for the cost of each unit to be calculated separately.
- Procedure for the performance of jobs:
+ Customer approaches the supplier and indicates the requirementsof the job.
+ Details are confirmed and agreed with the customer as to the precise
dimensions, quality of materials, quality of finished goods, required delivery date, etc.
+ A cost estimate is prepared based on the requirement of the customer.
+ A profit markup or margin will be added to the total estimated cost in order to
calculate a quotation (selling price) for the job.
+ If the estimate is accepted the job can be scheduled. All the material, labour or
equipment required will be arranged.
+ After the completion of the job, actual cost of the job will compare with the
estimated selling price for the calculation of actual profit.
- Job Sheet/Job Card
Cost of each job is recorded on a job sheet or job card. It is separately prepared
for each job because each job is different from another job.
- Collection of Job cost information:
+ Dir Material cost (estimates and actual)
+ Dir labour cost (estimates and actual)
+ Dir expenses (estimates and actual)
+ Production OH (estimates and actual)
+ Administration, selling and distribution OH

44
 - Treatment of rectification work.
Rectification cost is the cost incurred in rectifying sub-standard outputs.
Rectification is necessary where defects are discovered during the job or after
completion of the job which requires additional work to be done. Sub-standard output
returned to that department where the fault arises.
Rectification cost can be treated in two ways:
➢ If rectification work is not a frequent occurrence and can be identified with
a specific job, then rectification costs should be charged as a direct cost to
the job concerned.
➢ If rectification work is regarded as a normal part of the work, then
rectification cost should be treated
as production overheads and absorbed into the cost of all jobs for the
period using overhead
absorption rate.
- Work In Progress: At the period end, the value of work in progress is simply
the sum of cost incurred on incomplete jobs (charged as closing work in progress).
- Pricing the job:
+ Cost plus pricing means that a desired profit margin is added tototal costs to
arrive at the selling price
+ The final price quoted will, of course, be affected by what competitors charge
and what the customer will be willing to pay.
+ In general terms, the profit earned on each job should conform to the
requirements of the organisation's overall business plan.
+ Profit on a job maybe expressed in two different ways:
 As a percentage of job cost, such as 25% mark up (total cost per unit =
$80, cost mark up 25%  price = 80 + 80*25% = $100)
 As a percentage of price, such as 20% margin (total cost per unit = $80,
profit = 25% of selling price  Price = 80 + 25%*price = 107)
10.2. BATCH COSTING
- Batch costing is very much similar to that of job costing. A batch of identical
products is treated as an individual job.
A batch is a cost unit where a quantity of identical items is manufactured. It
consists of a separate, readily identifiable group of product units which maintains their
separate identity throughout the production process.
- Batch costing is essentially a variation of job costing. Instead of a single job, a
number of product units are manufactured as a batch. Batches may be made

45
specifically to customer requirements or produced for holding in stock prior to sale.
The procedures for costing batches are very similar to job costing.
Once the batch is completed, the cost per unit can be calculated.
Cost per unit Total batch cost
=
Number of units
10.3. SERVICE COSTING
- Service costing is a costing method concerned with establishing the cost, not
for items of production, but the cost of services provided. It is also called operation or
function costing.
Service organisations do not make or sell tangible goods. Profit seeking service
organisations include accountancy firms, law firms, transport companies, hair salons,
banks and hotels. Non-profit organisations include hospitals, schools and libraries.
- Features of services: (SHIP)
+ Intangibility: Output is ‘intangible’ rather than a tangible product.
+ Perishability: Services are not ‘storable’ and cannot be bought in bulk.
+ Simultaneity: Service is performed and consumed simultaneously.
+ Heterogeneity: Nature and output is never standardized as human input is a
major element of a service
- Features of cost:
+ Cost nature: In a service industry sector a higher proportion of costs
incurred are indirect as compared to direct
+ Composite cost units: More than one cost units like cost per patient/night,
cost per passenger/mile.
- Difference with product costing:
+ Labour element in service costing is more prominent than material used
+ There is no standardized process for recording of material, labour and other
expenses. These all vary subject to nature of service
+ Not all services are revenue generating; customer service centres, distribution
facility, libraries etc are main examples. So purpose of service costing may not,
necessarily, be establishing a profit or loss attributable to that service but rather to
provide the management with costs associated and efficiency and effectiveness of
service being provided.
- The unit cost measurement
Typical unit cost are as follows:
Services Cost unit
Transport company Passenger/kilometer ton/mile or kilometer
Education Student/subject
Hospital Patient/night
Canteen meals served
46
 Cost per Total service costs for the period
service unit = Number of services provided in the period

CHAPTER 11 : PROCESS COSTING

Session objectives:

47
 - 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 unit of process outputs
- 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.
11.1. INTRODUCTION OF PROCESS COSTING
- Process costing is a costing method used where it is not possible to identify
separate units of production, or jobs, usually because of the continuous nature of the
production processes involved.
- Features of process costing:
+ The output of one process becomes the inputto the next until the finished
product is made in the final process.
+ There will usually be closing work in progress which must be valued.
+ There is often a loss in processdue to spoilage, wastage, evaporation and so
on.
+ Output from production may be a single product, but there may also be a by-
product (or by-products) and/or joint products.
- Framework for dealing with process costing: The exact work done at each
step will depend on whether there are normal losses, scrap, opening and closing work
in progress.
Step 1 - Determine output and losses, including:
+ Determining expected output
+ Calculating normal losses, abnormal losses and gain.
+ Calculating equivalent units if there is opening and closing WIP
Step 2 - Calculate cost per unit of output, losses and WIP
Cost per unit Input cost
=
Expected output
Step 3 - Calculate total cost of output, losses and WIP
Step 4 - Complete accounts
11.2. LOSSES AND GAINS IN PROCESS COSTING
11.2.1. Losses in process costing
During production process, a loss may occur.
- If the loss is not more than the expected loss then it is called as NORMAL
Loss (ignored in the calculation).
- If the loss is more than the expected loss, then it is called as ABNORMAL

48
Loss of the process. It should be treated in the calculation.
- In some industries, there might be a chance of joint and By-products. By-
products should be treated as NORMAL LOSS.
- Loses might have a certain resale value, that value is called the “Scrap
Value”.
+ The scrap value of normal loss is usually deducted from the cost of materials.
+ The scrap value of abnormal loss (or abnormal gain) is usually set off against
its cost, in an abnormal loss (abnormal gain) account.
- Losses might have to dispose of at some cost to company, that cost is called
“Disposal value”.
- Cost of one unit of abnormal loss = cost of one unit of good output from the
process = Prodution cost / expected quantity of output
- Cost of abnormal cost is treated as a charge against profit in the period it
occurs.
11.2.2. Abnormal gain in process costing
- If the output units are greater than the expected output, then the extra units
produced are called as ABNORMAL GAIN.
ABNORMAL GAIN = Actual Output – Expected output = Normal loss –
Actual loss
- Treatment:
Abnormal gain is recorded in abnormal gain Account  taken to Income
Statement as an item of profit.
11.3. VALUING CLOSING WORK IN PROGRESS
- When units are partly completed at the end of a period (and hence there is
closing work in progress), it is necessary to calculate the equivalent units of production
in order to determine the cost of a completed unit.
- Equivalent units are notional whole units which represent incomplete work,
and which are used to apportion costs between work inprocess and completed output.
- Assumptions when calculating equivalent units.
+ Material is completely added at the start of the process and therefore a unit is
assumed to be 100% complete with respect to material unless stated otherwise.
+ Labour and overheads are assumed to be incurred evenly over the production
process. So when a unit is referred to be 50% complete with respect to labour and
overhead that means that unit is half complete with respect to labour and overheads
although it might be 100% complete for material.
11.4. VALUING OPENING WIP
Units left partially completed at the end of the period are treated as Opening

49
WIP for the next period. They can be valued by using two methods for inventory
valuation: FIFO and weighted-average method.
+ FIFO inventory valuation technique is normally used and should be used in
examination unless specifically stated otherwise.
+ If degree of completion of each cost element is not provided in the question
but just the value of each cost element, use weighted average method.
+ If, on the other hand, degree of completion is provided for each cost element
but not the value of each cost element, use FIFO method
11.5. ILLUSTRATIVE EXAMPLES
Example 1: During a 2-week period, period 1, costs of input to a process were
$30,000. Input was 2,000 units, output was 1,700 units and a normal loss is 10%, with
a scrap value of $1.5 per unit. During the next period, period 2, costs of input were
again $30,000. Input was again 2,000 units, normal loss is 10%, with scrap value of
$1.5 per unit but output was 1,900 units. There were no units of opening or closing
inventory.
Required: Prepare process account.
Solution:
Period 1: Process Account
units $ units $
Input 2,000 30,000 Finished goods 1,700 28,050
Normal loss 200 300
Abnormal loss 100 1,650
Total 2,000 30,000 Total 2,000 30,000
Normal loss: 2,000 x 10% = 200 units
Expected output = 2,000 – 200 = 1,800 units > Actual output = 1,700 units.
Process cost = 30,000 – 200 x $1.5 = $29,700
Cost per unit: $29,700 / 1,800 = $16.5 per unit
Cost of output (cost of finished goods): 1,700 x 16.5 = $28,050
Cost of normal loss: 0
Cost of abnormal loss: (2,000 – 1,700 – 200) x 16.5 = 100 x 16.5 = $1,650
Period 2: Process Account
units $ units $
Input 2,000 30,000 Finished goods 1,900 31,350
Normal loss 200 300
Abnormal gain 100 1,650
Total 2,100 31,650 Total 2,100 31,650
Normal loss: 2,000 x 10% = 200 units
Expected output = 2,000 – 200 = 1,800 units < Actual output = 1,900 units.
 Abnormal gain = 100 units

50
 Process cost = 30,000 – 200 x $1.5 = $29,700
Cost per unit: (30,000 – 300) / 1,800 = $16.5 per unit
Cost of output: 1,900 x 16.5 = $31,350
Cost of abnormal gain: 100 x 16.5 = $1,650
Example 2: BR Ltd makes a product requiring several successive processes. Details of the
first process are as follows:
Opening WIP 400 units
Degree of completion:
- Material (valued at $19,880) 100%
- Conversion (valued at $3,775) 25%
Units transferred to process 2 1700 units
Closing WIP 300 units
Degree of completion:
- Materials 100%
- Conversion 50%
Costs incurred in the period
- Material $100,000
- Conversion $86,000
There were no process losses.
Required: Prepare the process account for august using:
(a) Weighted average method.
(b) FIFO method.

CHAPTER 12 : PROCESS COSTING – JOINT PRODUCTS AND BY-

PRODUCTS
Session objectives:
- 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.

51
12.1. JOINT PRODUCTS AND BY-PRODUCTS
- Joint products are two or more products separated in a process, each of which
has a significant value compared to the other.
A joint product is regarded as an important saleable item, and so it should be
separately costed.
- A by-productis an incidental product from a process which has an insignificant
value compared to the main product.
A by-productis not important as a saleable item, and whatever revenue it earns
is a 'bonus' for the organization.
12.2. DEALING WITH COMMON COSTS
Problems in accounting for joint productsare basically of two different sorts.
(a) How common costs should be apportioned between products, in order to put
a value to closing inventories and to the cost of sale (and profit) for each product
(b) Whether it is more profitable to sell a joint product at one stage of
processing, or to process the product further and sell it at a later stage
The joint cost of the joint products is distributed according to these methods:
(1) Physical measurement/volume at point of separation.
The common cost is apportioned to the joint products on the basis of the
proportion that the output of each product bears by weight or volume to the total
output.
(2) Sales value at point of separation.
The cost is allocated according to the product's ability to produce income.
(assumes that all products achieve the same profit margin)
(3) Net realizable value at point of separation.
12.3. ACCOUNTING FOR BY-PRODUCTS
The most common method of accounting for by-products is to deduct the net
realisable valueof the by-product from the cost of the main products.
In process costing, by-products are treated as normal losses and the sales value
of by-product is treated as scrap value of normal loss.
- Income from by-product added to sales of main product
- Income from by-product treated as a separate source of income
- Sales income of by-product deducted from the cost of production
- Net realisable value of by product deducted from the cost of production 
This is the most likely examinable method.

52
 CHAPTER 13 : ALTERNATIVE COSTING TECHNIQUES
Session objectives:
- Explain activity based costing (ABC), target costing, life cycle costing and
total quality management (TQM) as alternative cost management techniques.
- Differentiate ABC, target costing and life cycle costing from the traditional
costing techniques (calculations are not required).
13.1. ACTIVITY BASED COSTING

53
13.1.1. The reasons for the development of activity based costing
Activity-based costing (ABC) is an alternative approach to the traditional
method of absorption costing.
+ The traditional method of overhead absorption effectively absorbs on a
production volume basis and may be misleading for costs where the behaviour is not
directly related to production volume.
+ ABC involves the identification of the factors (cost drivers) which cause the
costs of an organisation's major activities. Support overheads are charged to products
on the basis of their usage of an activity.
+ Cost pool: A cost pool is an activity that consumes resources and for which
overhead costs are identified and allocated. For each cost pool, there should be a cost
driver. A group of costs having the same cost driver
+ Cost drivers: Any factor which causes a change in the cost of an activity. A
cost driver is a unit of activity that consumes resources. An alternative definition of a
cost driver is a factor influencing the level of cost.
Cost pool Cost driver
Purchasing department costs number of purchase orders made
Maintenance costs number of machine breakdowns
Production control costs number of production runs
Quality control costs number of inspections carried out
Ordering costs number of purchase orders

Dispatch costs number of customer orders

Material handling cost number of production runs

- Reasons behind the development of ABC
+ Traditional method of absorption costing was developed in a time when most
organizations produce only a narrow range of products (which produced in similar
operations and consumed similar proportions of overheads) and overheads costs were
only a small part of total cost.
+ ABC was first developed in the US where, in the 1950’s – 60’s, attempts were
made to establish more accurate allocation and absorption of selling and distribution
overheads, based on value adding activities which consume resources and the cost
drivers which generate cost.
+ There had been a general agreement that traditional method of dealing with
overheads had weaknesses.
+ Business processes are now more complicated and automated which
includes a more diverse product range requiring wide support functions. Service
providers have become a more significant feature in many economies. With this shift,

54
overheads have become an increasingly larger proportion of total cost, with wide
ranging activities and drivers generating such costs. With this change competition has
come increased and the need to develop models which enable management to
determine more accurate product cost.
+ Activity based costing could provide much more meaningful information
about product costs and profits when:
 Indirect costs are high relative to direct costs
 Products or services are complex
 Products or services are tailored to customer specifications
 Some products are sold in large numbers and others in small numbers.
+ Different products result in different levels of activities and resource
consumption.
13.1.2. Calculating product costing using ABC
-Step 1: Identify an organisation's major activities.
-Step 2: Identifythe factors which determine the size of the costs of an activity /
cause the costs of an activity. These are known as cost drivers.
-Step 3: Collect the costs of each activity into what are known as cost
pools(equivalent to cost centres under more traditional costing methods).
-Step 4: Charge support overheads to products on the basis of their usage of the
activity. A product's usage of an activity is measured bythe number of the activity's
cost driver it generates
 Examples:
13.1.3. ABC vs. Traditional Absorption Costing
- Allocation of overheads: Absorption costing allocates overheads to
production departments where ABC assigns overheads to each major activity (cost
pool), under ABC reapportionment of service department costs is avoided.
- Absorption of overheads: The major difference between the two methods is
the way in which overheads are absorbed into products. Traditional method usually use
two absorption bases (labour hours or machine hours) whereas ABC uses many cost
drivers as absorption bases (number of orders, number of dispatches)
- Cost drivers and absorption rates: ABC focus attention on what causes cost to
increase, the cost drivers. Whereas in traditional system no rule is available for
selecting a base.
13.1.4. Advantages and disadvantages of ABC
- Advantages:
+ Allotment of overhead is fairer and therefore product costs are more
accurate.

55
 + There is a better understanding of what causes cost.
+ The company can concentrate on producing the most profitable items.
+ Control of overheads is easier, as responsibility for incoming costs must be
given.
+ Performance appraisal is more meaningful.
+ Cost driver rates can be monitored and used to identify areas of weakness or
inefficiency.
+ Budget setting and sensitivity analysis are more accurate.
+ Activity based budgeting (ABB) can be used.
+ More accurate use of resources in making a product.
+ By focusing attention on cost drivers it will help managers understand and
manage overhead cost.
+ An understanding of cost driver rates can help in budgeting overhead
expenditure.
+ ABC concerns itself with all overhead costs, and as a consequence it has
proved very useful in service industries.
+ ABC is concerned with all overhead costs (production related and non-
production)
- Disadvantages:
+ ABC may be based on historic information but could be used for future
strategic decisions.
+ Selection of cost drivers may not be easy.
+ Additional time and cost of setting up and administering the system.
+ Cost measurement may not be easy.
+ Assessing the degree of completion of work in progress with respect to each
cost driver is difficult.
+ Variance analysis is complicated.
+ Implementation of ABC is often problematic.
+ Many judgmental decisions still required in the construction of an ABC
system.
13.2. TOTAL QUALITY MANAGEMENT
Total Quality Management (TQM) is the process of applying a zero defect
philosophy to the management of all resources and relationships within an
organization as a means of developing and sustaining a culture of continuous
improvement which focuses on meeting customer expectations.
Quality means
+ How well a product is made or service is performed

56
 + How well it fulfills its purpose
+ How it measures up against its rivals
Importance of quality: In modern business environment, there are some
changes in customers’ behaviour
+ Now customer emphasis on quality rather than quantity.
+ Customer prefers timely deliveries
+ It prefers reliable product with best quality
Costs of quality

Quality management becomes total when it applies on process of TQM

+ Step 1: Establish standards of quality for a product or service
+ Step 2: Determine procedures or methods through which required standards
of quality can meet
+ Step 3: Monitor actual quality achieved and compare it with required
standards
+ Step 4: Take control actions if the required standards are not met.
Principles of TMQ
+ Get it right, first time: Cost of preventing mistake is always less than cost of
correcting. So the basic aim is to get things right first time
+ Continuous improvement: Second principle of TQM is continuous
improvement in quality. It means get it more right next time.

57
 + Customer focused: The product should meet all the requirements of the
customer.
13.3. LIFE CYCLE COSTING
13.3.1. Introduction of Life cycle costing
Life cycle costing tracks and accumulates costs and revenues attributable to
each product over the entire product life cycle.
A product life cycle can be divided into four phases: Introduction, Growth, Maturity, and
Decline.
The product life cycle
(Not all products follow this cycle, but it remains useful tool when considering
decisions such as pricing)
1 - Introduction - Product introduce in market
- Heavy capital expenses on product development
- Potential customers will be unaware
- Very low demand
- Start earning some revenue
- More spending on advertisement
- Try to gain market share
2 – Growth - Gaining market
- Create demand
- Increase in sales revenue
- Start gaining profit
- Initial costs of investment are gradually recovered
3 – Maturity - Stable demand
- Continue to be profitable
- To sustain demand modification or improvement is required
4 - Decline - Saturation point
- Fall in demand
- May be become loss maker
- At this time organization stop selling the product
Advantages of Life Cycle Costing
- Full understanding of individual product profitability
- More accurate feedback information
- Cost reduction and revenue expansion opportunities more apparent
- Increased visibility of non-production costs
13.3.2. Life cycle costing versus traditional absorption costing
- Traditional costing system is based on financial accounting year and it divides
product lifecycle into a series of 12 month period. It assesses profitability of a product
on a periodic basis whereas life cycle costing tracks and accumulates actual costs and
58
revenue to each product over the entire product life.
- Traditional costing system does not relate research costs to the products that
caused them. Instead they write off these costs on annual basis against the revenue
generated by existing products. Through which the existing products seems to be less
profitable than they actually are. Whereas in life cycle costing research cost is charged
to the product which actually causes it.
- Traditional costing system charge non-production cost as period cost but life
cycle costing charge non-production to which it relates.
13.4. TARGET COSTING
Target costing involves setting a cost by subtracting a desired profit margin
from a competitive market price. To compete in current competitive market,
organisation must continually redesign the process so profit life cycles have become
much shorter. Now days many costs are committed at planning and designing stage of
a product. Target costing have great impact on design stage to reduce cost.
Steps involved in implementing target costing system
- Step 1: Determine a product specification for which sales volume is
estimated.
- Step 2: Set a selling price at which market share can be achieved
- Step 3: Estimate the organisation’s required profit
- Step 4: Calculate target cost = target selling price – target profit
- Step 5: Determine estimated cost of that product based on defined
specifications
- Step 6: Calculate cost gap = estimated cost – target cost
- Step 7: Make efforts to close the gap. Try to close the gap at planning stage
rather than controlling cost after arising gap.
When a product is manufactured, its target cost may be very low as compared to
currently attainable cost. Management have to reduce costs through:
- Reducing number of components
- Proper training
- Use new technology
- Remove any non-value adding activity
- Using different materials
- Use low paid staff
These techniques are known as value engineering.
Even if the product can be produced within target cost, target costing can be
applied to throughout the entire life cycle. Once target cost is achieved, it gradually
reduces and reduction is incorporated into budget process (continuous cost saving).

59
 PART C – BUDGETING
CHAPTER 14: FORECASTING
Session objectives:
- 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.
- Analysis of cost data
- Use linear regression coefficients to make forecasts of costs and revenues
- Explain the advantages and disadvantages of linear regression analysis,
principles of time series analysis.

60
 - Calculation of trend, including the use of regression coefficients.
- Use trend and seasonal variation (additive and multiplicative) to make budget
forecasts.
14.1. FORECAST
- Forecast: A forecast is an estimate of what might happen in the future.
Forecast is based on some assumptions about the conditions that are expected to apply.
- Budget: A budget is a plan of what the organization is aiming to achieve and
what it has set as a target. Budgets are more realistic because management will try to
establish some control over the conditions that will apply in the future.
- Forecasting methods:
▪ High – low method
▪ Scatter graph method
▪ Time series analysis
▪ Linear regression analysis
▪ Product life cycle models
 We can use HL method, scatter graph and regression analysis to forecast
costs.
 and use scatter diagrams, regression analysis , time series analysis and life
cycle models to forecast revenue.
14.2. HIGH – LOW METHOD
▪ It is simple forecasting technique based on historical data.
▪ High – low method is already discussed in part A.
▪ Principles: analyse cost behavior into fixed costs and variable costs. We
apply the technique by using four steps (…)
Advantages:
▪ It is easy to use and understand
▪ It needs just two activity levels (highest and lowest)
Disadvantages:
▪ It considers two extreme points which may be representative of normal
conditions
▪ Based on two points so formula is not very accurate.
▪ Based on historical data.
Example:
14.3. SCATTER DIAGRAM METHOD
This is graphical way of forecasting.
Steps involved in forecasting under scattergraph method are:
▪ Collect data of past volumes of output and the associated cost of

61
 producing that output.
▪ Plot the data on the graph which has cost on vertical axis and volume of
output on the horizontal axis.
▪ Draw the line of best fit through the middle of the plotted points so that
the distance of points above the line is the same as the distance of points
below the line.
The intersection of the line of best fit on the vertical axis is the fixed cost and
slope of the line represents variable costs.
It is a method of visual judgments that is a disadvantage of this method.
14.4. TIME SERIES ANALYSIS
14.4.1. The components of time series
A time series is a series of figures relating to the changing value of a variable
over time. The data often conforms to a certain pattern over time. It is use to forecast
sales. Graph of time series called a histogram. (horizontal axis always represents time,
vertical axis represents the values of data recorded)
This pattern can be extrapolated into the future and hence forecasts are possible.
Time periods may be any measure of time including days, weeks, months and quarters.
Examples
▪ Annual cost for last ten years.
▪ Number of people employed in each last 10 years
▪ Output per day of last month
▪ Sales per month of last 3 years.
The four components of a time series are:
▪ The trend this describes the long term general movement of the data
recorded.
▪ Seasonal variations are short term fluctuations in recorded values, a
regular variation around the trend over a fixed time period, usually one
year.
▪ Cyclical variations are long term fluctuations in recorded values,
economic cycle of booms and slumps. It takes several years to complete.
▪ Random variations irregular, random fluctuations in the data usually
caused by factors specific to the time series. They are unpredictable.
(In examination problems there is generally insufficient data to evaluate the
cyclical and random variations, hence, they are ignored).
14.4.2. Trends
- Trend: Long term movement over time in the value of data recorded
Downward trend Upward trend No clear movement/static

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 Years Output/hour(units) Cost/unit ($) Number of employees
4 30 1 100
5 24 1.08 103
6 26 1.20 96
7 22 1.15 102
8 21 1.18 103
9 17 1.25 98
- Finding a trend
One method of finding the trend is by the use of moving averages. (Take
moving averages which covers a cycle)

Remember that when finding the moving average of an even number of result, a
second moving average has to be calculated so that values can relate to specific actual
figures. This method attempts to remove seasonal (or cyclical) variation from a time
series by a process of averaging so as to leave a set of figures representing the trend.
Moving average figure relate to midpoint of overall period.
Example (*): Moving average of an even number of results
Year Quarter Volume of sales (‘000 units)
2005 1 600
2 840
3 420
4 720
2006 1 640
2 860
3 420
4 740
2007 1 670
2 900
3 430
4 760
Required: Calculate the trend using moving average?
Solution:
Actual volume of Moving average of 4 Midpoint of 2 moving
sales quarters’ sales averages trend line
Year Quarter
(‘000 units) (‘000 units) (‘000 units)
(A) (B/A) (C)
2005 1 600

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 2 840
645
3 420 650
655
4 720 657.50
660
2006 1 640 660
660
2 860 662.50
665
3 420 668.75
672.50
4 740 677.50
682.50
2007 1 670 683.75
685
2 900 687.50
690
3 430
4 760
14.4.3. Seasonal variations
- Seasonal variations: Short term fluctuations due to change in season. For
example, seasonal businesses like ice-cream manufacturing.
- Finding the seasonal variation: There are two models use to find out
seasonal variations: (1) additive model and (2) multiplicative model.
(1) Additive model: Seasonal variations are the difference between actual
and trend figures. An average of the seasonal variations for each time period within
the cycle must be determined and then adjusted so that the total of the seasonal
variations sums to zero.
Here Y = T + R + S
Time series (actual sales) = trend + seasonal variation
Seasonal variation = actual sales – trend
- Drawbacks of additive model: When there is a steeply arising or a steeply
declining trend, the trend will either get ahead of a fall behind the real trend. So,
▪ The trend is not a good representation of actual figures
▪ The trend is probably unsuitable for forecasting.
Example: continue example (*)
Actual volume of sales Trend Seasonal variation
Year Qtr
‘000 units ‘000 units ‘000 units
2005 1 600
2 840
3 420 650 -230

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 4 720 657.50 62.50
2006 1 640 660 -20
2 860 662.50 197.50
3 420 668.75 -248.75
4 740 677.50 62.50
2007 1 670 683.75 -13.75
2 900 687.50 212.75
3 430
4 760
The variation between the actual result for any particular quarter and the trend
line average is not the same from the year to year, but an average of these variations
can be taken.
Q1 Q2 Q3 Q4
2005 -230 62.50
2006 -20 197.50 -248.75 62.50
2007 -13.75 212.50
Total -33.75 410 -478.75 125
Average (divided by 2) -16.875 205 -239.375 62.50
Estimate of the seasonal or quarterly variation is almost done, but there is one
more important step to take. Variations around the basic trend line should cancel each
other out, and add to the ‘zero’. At the moment they do not. Therefore spread the total
of the variations (11.25) across the four quarters (11.25/4) so that the final total of the
variations sum to zero.
Q1 Q2 Q3 Q4 Total
Estimated quarterly variations -16.875 205 -239.375 62.50 11.25
Adjusted to reduce variations to 0 -2.8125 -2.8125 -2.8125 -2.8125 -11.25
Final estimates of quarterly -19.6875 202.1875 - 59.6875 0
variations 242.1875
These might be rounded as Q1 = -20 Q2 = 202 Q3 = Q4 = 60 Total = 0
follows: -242
(2) Multiplicative model: This model assumes that the components of the
series are independent of each other. In this model, each actual figure is expressed as a
proportion of the trend. Time series Y= T x S x R
Seasonal variation = actual sales / trend
The trend component will be same in both models but the seasonal and random
component will vary according to the model. In our example, we assume that random
component is small and so ignore it. So: Y = T x S
Then: S = Y/T
Example: continue example (*)
Year Quarter Actual volume of Trend (T) Seasonal
sales (Y) ’000 units variation (Y/T)

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 ‘000 units ‘000 units
2005 1 600
2 840
3 420 650 0.646
4 720 657.50 1.095
2006 1 640 660 0.970
2 860 662.50 1.298
3 420 668.75 0.628
4 740 677.50 1.092
2007 1 670 683.75 0.980
2 900 687.50 1.309
3 430
4 760
An average of these variations can be taken.
Q1 % Q2 % Q3 % Q4 %
2005 0.646 1.095
2006 0.970 1.298 0.628 1.092
2007 0.980 1.309
Total 1.950 2.607 1.274 2.187
Average (divided by
0.975 1.3035 0.637 1.0935
2)
Instead of summing to zero, average should sum to 4 or 1 for each of the four
quarters
Q1 Q2 Q3 Q4 Total
Estimated quarterly variations 0.975 1.3035 0.637 1.0935 4.009
Adjusted to reduce variations to 4 -0.00225 -0.00225 -0.00225 -0.00225 -0.009
Final estimates of quarterly 0.97275 1.30125 0.63475 1.09125 4
variations
These might be rounded as Q1 = 0.97 Q2 = Q3 = Q4 = 1.09 Total = 4
follows: 1.30 0.64
- De-seasonalise: This means that seasonal variations have been taken out, to
leave a figure which might be taken as indicating the trend
14.5. INDEX NUMBERS/ INDICES
Index is a measure of change over time by making some base. It provides
standard way of comparing the values.

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14.6. CORRELATION
14.6.1. Correlation
Two variables are said to be correlated if a change in the value of one variable is
accompanied by a change in the value of another variable. For example:
▪ Total variable cost and production units
▪ Selling price of a product and its demand.
The purpose of correlation analysis is to measure and interpret the strength of
linear relationship between two variables.
- Degrees of correlation: Two variables might be perfectly correlated, partly
correlated or uncorrelated. Correlation can be positive or negative. The differing
degrees of correlation can be illustrated bt scatter diagrams.
+ Perfectly correlation
All the pairs of values lie on a straight line. An exact linear relationship exists
between the two variables.

+ Partial correlation:
In (a), although there is no exact relationship, low values of X tend to be
associated with low values of Y, and high values of X with high values of Y.
In (b) again, there is no exact relationship, but low values of X tend to be

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associated with high values of Y and vice versa.

+ Non-correlation:
The values of these two variables are not correlated to each other.
Positive and negative correlation: Correlation can be positive or negative.
Positive correlation means that the low values of one variable are associated
with low values of other, and high values of one variable are associated with high
values of other.
Negative correlation means that the low values of one variable are associated
with high values of other, and high values of one variable are associated with low
values of other.

14.6.2. Correlation coefficient

Correlation coefficient (r): it express degree of linear correlation between two
variables. It is from +1 to -1. Two variables are perfectly or partially correlated and if
they are partially correlated ,they there may be high or low degree of correlation.

Correlation in time series: The correlation coefficient is calculated with time

as X variable, the independent variable and other variable as Y, the dependent variable.
It is recommended that when analysing correlation in a time series it is more
convenient to replace years (time) with digits, i.e. X variable having time values of
year 2001,2002,2003,2004 and so on should be replaced with 0, 1, 2, 3 and so on. Note
that first year is replaced with 0 not 1. You can use whatever figure for years but using

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0, 1, 2, 3… is most simplified.
The coefficient of determination (r2): The coefficient of determination, r2, is
simply the square of correlation coefficient, r. it is useful because it gives the
proportion of variance (fluctuation) of one variable that is predictable from the other
variable. In other words r2 expresses the proportion of total variance in the value of one
variable that can be fully explained by the other variable.
The coefficient of determination is such that 0 ≤ r 2 ≤ +1, i.e. it cannot be a
negative value. The coefficient of determination denotes the strength of linear
association between X and y. If r = -0.99 so coefficient of determination is +0.98,
which means that 98% of variation in a variable is explained by other variable.
14.7. LINEAR REGRESSION
Regression analysis is the study of the relationship between variables. It is one
of the most commonly used business analysis tool and easy to use.
Line of best fit: Although correlation coefficient is used to trace out that
whether there is any linear relationship between any two variables but correlation
coefficient solely cannot be used to predict the value of dependent variable Y based on
independent variable X. Once it is found that two variables are correlated we can use
the line of best fit. We can use this equation for forecasting; putting a value for
variable X and deriving a forecast value for dependent variable Y.
Dependent variable is the single variable is being explained/predicted by
regression model.
Independent variable is the explanatory variable used to predict dependent
variable.
Estimating line of best fit: The line of best fit is a cost equation and is of the
form: Y = a + bx
Where,
a = total fixed cost,
b = gradient/slope of line or variable cost per unit
Regression analysis uses following formulas for estimating line of best fit:

Where n is the number of data pairs used in analysis.

Regression line and time series analysis: Regression line can also be used in
time series analysis. Time to be taken as independent variable and years to be replaced
with 0,1,2,3 and so on correlation coefficient is calculated.
The reliability of regression model in forecasting

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 As is the case with any other model, results from regression analysis will not be
accurate or reliable. There are a number of limitations of this model which cast doubt
on its results:
▪ This model assumes that there exists a linear relationship but this is not
always true, there might be a non-linear relationship. The model is only
appropriate if there is a linear relationship between two variables.
▪ The model assumes that that there are only two variables. Value of one
variable, the dependent variable Y, is predicted from value of one other
variable, the independent variable X. This is quite unrealistic as the
value of Y might be affected by many other factors not considered at all.
▪ Past behavior is used to forecast future. The model assumes that past
movement pattern of two variables will continue in the future. Again,
this is an unrealistic assumption.
▪ Linear regression model is limited to predicting numeric output only. It
cannot be used to predict any other sort of information.
▪ A lack of explanation about what has been learned can be a problem.
Prediction of a figure not that is all desired.
▪ The model is only appropriate if used to predict value of dependent
variable within relevant range. Predicted results are not reliable if model
is used for extrapolation.
▪ Interpolation means using a line of best fit to predict a value within the
two extreme points of the observed range.
▪ Extrapolation means using a line of best fit to predict a value outside the
two extreme points.
▪ There must be sufficient number of data pairs. Even if correlation is high
between two variables and have less than ten pairs of data any forecast
value should be regarded as somewhat unreliable.
We can still use the forecast produced by the model with high confidence if
correlation coefficient between two variables is high. Coefficient of determination tells
us that how much of the variation in cost can be explained by volume level. Higher the
coefficient of determination the higher the reliance that could be placed on predicted
result.
Advantages of regression analysis:
▪ It gives definitive line of best fit after taking account of all the given
data.
▪ It produces good forecasting results.
▪ Many processes are linear so they are well defined by regression

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 analysis.
14.8. FORECASTING PROBLEMS
All forecasting methods are subject to have errors but it varies from case to
case. Some main problems are:
▪ Future is always unpredictable or uncertain.
▪ Less data is available so less reliable forecasts.
▪ Pattern of forecasts and seasonal variations cannot be guaranteed to be
continued in future.
▪ There is always a danger of random variations.
Other changes which affects future forecasts:
▪ Political and economic changes: (It creates uncertainty for example
change in interest rates, exchange rates or inflation).
▪ Environmental changes: (Changes in market will affect other company’s
market)
▪ Technological changes
▪ Technological advances
▪ Social changes

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 CHAPTER 15: BUDGETING AND THE BUDGETATY PROCESS
Session objectives:
- Explain why organisations use budgeting.
- Describe the planning and control cycle in an organisation.
- Prepare a budget (functional budgets and master budget preparation) explain
and illustrate 'what if' analysis and scenario planning.
- Explain the importance of flexible budgets in control, 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.
- Define the concept of responsibility accounting and its significance in control.
- Explain the concept of controllable and uncontrollable costs.
- Prepare control reports suitable for presentation to management.
15.1. THE PLANNING AND CONTROL CYCLE
Most organizations have long term goals which can be divided into objectives
and action plan.
- Objective: Measurable steps towards achieving the goals.
- Action plan: Detailed steps for achieving the objectives. Action plans are often
express in money terms and usually called budget.
Budget: An organization’s plan for a forthcoming period, expressed in monetary
terms. Forecasts and budgets are not the same thing. Forecast is a prediction of what is
likely to happen. A budget is a target, not a prediction, which has to be achieved. Any
difference between the planned results and the actual results are called variances.

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15.2. THE MAIN PURPOSES OF BUDGETING
Budget generally refers to a list of all planned expenses and revenues. The
purpose of budgeting is to:
● Provide a forecast of revenues and expenditures i.e. construct a model of
how our business might perform financially speaking if certain strategies,
events and plans are carried out.
● Enable the actual financial operation of the business to be measured against
the forecast.
Department managers in a business are responsible for making decisions on
daily basis that affect the profitability of the business. In order to make effective
decisions and coordinate the decisions and actions of the various departments, a
business needs to have a plan for its operations. Planning the financial operations of a
business is called budgeting. A budget is a written financial plan of a business for a
specific period of time, expressed in currency and units. Each area of a business’s
operations typically has a separate budget. For example, a business might have a
marketing budget, a production budget, a sales budget, a purchase budget, a research
and development budget, and a cash budget.
The main aims of preparing budgets include:
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 ▪ To ensure the fulfillment of organization’s objectives.
▪ A framework for responsibility accounting.
▪ Planning for the future.
▪ Best utilization of resources.
▪ Cost controlling.
▪ To ensure proper co-ordination.
▪ To motivate employees.
▪ Performance appraisals.
▪ Defining authorities.
Budgets are therefore set in consultation with all the stakeholders in order to
ensure that budget setting objectives are achieved.
15.3. THE BUDGET SETTING PROCESS
Before budget setting process is commenced, long-term goals of the
organization must be considered. Budget is always set taking account of organizational
goals. Budgets are steps towards the achievement of long term goals of the
organization and hence budgets ensure the progress towards the ultimate goal of the
organization.
15.3.1. Administration of Budget
(1) Budget manual: It is a collection of instructions governing the
responsibilities of persons. It is usually prepared by management accountant.
It includes:
▪ Object of budgets
▪ Organisation structure
▪ Guide line regarding making budgets
▪ Formats and layouts of budgets
▪ Interdependence of budgets
▪ Budget Deadlines
(2) Budget period: Budget period is a time period to which budget relates.
(3) Responsibilities of preparing budgets: Managers responsible for preparing
budgets ideally be the managers who are responsible for carrying out the budget.
(4) Budget committee: Budget committee is usually responsible for
coordination and administration of budgets.
Members of budget committee are:
 Managing directors as chairman
 Accountant as budget officer (for assistance)
 Representatives from each department (sales, production, marketing).
Functions of budget committee:

74
 ▪ Coordination for budget preparation
▪ Issue timetables for functional budgets
▪ Assign responsibilities of budget preparation
▪ Provide information which is required for budget
▪ Communicate final budget to appropriate managers
▪ Variance calculation and investigation
▪ Continuous assessment of budgetary process.
15.3.2. Budget Preparation
(1) Communicate budget details and guidelines to responsible person.
(2) Determine Principal Budget Factor.
▪ Principal budget factor is the factor that limits an organization’s
activity for a given period.
▪ It is often the starting point in budget preparation.
▪ It is also known as key budget factor or limiting budget factor.
▪ Usually it is Sales demand or any Limiting Factor.
▪ All the other budgets are dependent upon it.
(3) Prepare budget of principal budget factor.
(4) Prepare functional budgets dependent upon Principal budget. Functional
budgets include:
▪ Production cost budget
▪ Resources budget
▪ Machine utilization
▪ Material usage budget
▪ Purchasing budget
▪ Labour budget
▪ Overhead budget
▪ Marketing cost budget
▪ Personnel budget
▪ Research and development budget
(5) Prepare Master Budget. It includes:
▪ Cash budget: This shows anticipated sources and uses of cash for the
forthcoming budget period. Short run deficits and surpluses are
identified to enable the appropriate action to be taken.
▪ Budgeted income statement
▪ Budgeted balance sheet
(6) Negotiate budgets with seniors for approval.
(7) Coordination of budgets because some budgets are out of balances with

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others and need modifications.
(8) Final acceptance of budgets.
(9) Budget reviews.
15.4. FUNCTIONAL BUDGET
(1) Sales budget
Sales figure is subject to market demand so it is mostly principal budget factor
and hence sales budget is prepared before any other budget.
= expected sales demand (units) x selling price per unit
(2) Production budget
Production budget is prepared based on sales budget. But if production capacity
is principal budgeting factor then production budget factor is prepared first. To find out
whether production is principal budget factor consider the following:
▪ Availability of materials
▪ Availability of labour
▪ Machine capacity
= Budgeted sales units + Closing stock – Opening stock
(3) Material Budget
Material budget are of two types:
▪ Material usage budget:
=Budgeted number of units for production x material quantity required
per unit
▪ Material purchase budget; it equals to
=Material usage budget + Closing inventory of material – Opening
inventory of material
(4) Labour budget
Labour budget is calculated simply by multiplying number of hours required for
production to labour rate per hour.
▪ Budgeted labour hours = budgeted production units x standard hours per
unit
▪ Budgeted labour cost = Budgeted labour hours x standard hourly rate
Labour budget based on standard hour
Productivity is often described in terms of standard hour. A standard hour
describes the amount of work that is achievable at standard efficiency level. This
concept is particularly useful when dissimilar units are being produced in a factory and
management is interested to determine the production level of each product.
If there is a shortfall of labour hours, management can take a number of steps to
address the problem:

76
 ▪ Recruit more workers
▪ Offer better overtime rates
▪ Offer incentives for labour force for achieving production targets
▪ Address the causes of scrap output
▪ Reduce closing inventory requirement
(5) Production overheads budget:
Unlike non-production overheads budget for production overheads can be set
quite comfortably as production overheads are directly related to production.
(6) Non-production overheads:
As non-production overheads are not related to production but rather fixed in
nature like administration overheads and research overheads. Fixed costs can be
predicted in advance but the costs that incur subject to management decisions are
harder to predict at the start of the period.
15.5. MASTER BUDGET
The master budget is the budget into which all subsidiary budgets are
consolidated. The master budget normally comprises:
▪ Budgeted income statement
▪ Budgeted balance sheet
▪ Budgeted cash flow statement (cash budget).
The master budgets will be drawn up after all the functional budgets have been
approved.
➢ Budgeted income statement: The budgeted income statement is prepared
by summarising the functional budgets.
➢ Budgeted balance sheet: The budgeted balance sheet will show the likely
financial position at the end of the budget period.
➢ Cash budget: ‘A cash budget is a detailed budget of cash inflows and
outflows incorporating both revenue and capital items.’
▪ Consider only cash items
▪ Ignore non-cash items like depreciation, provisions etc
▪ Take cash flows at the time of receipt and payment not at transaction
time
The cash budget shows the cash position as a result of all plans made during the
budgetary process and gives management the opportunity to take appropriate control
action. Cash budget is an important part of the budgeting process and an important
working capital management tool. These, produced on a monthly basis, will allow a
firm to identify when cash surpluses or deficits are likely to arise so that suitable steps
(investing or borrowing) can be planned.

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 Appropriate control actions for cash:
+ Short term surplus: Pay payables early to obtain discount or make short
term investments
+ Short term deficit: Increase payables, reduce receivables, and arrange an
overdraft
+ Long term surplus: Expand, diversify, replace /update fix assets
+ Long term deficit: Issue share capital, consider shutdown /divestment
opportunities
The production of this budget in practices and in exam questions will follow a
similar pattern:
▪ Forecast sales
▪ Identify debtor payment patterns
▪ Calculate cash receipts
▪ Produce functional budgets to determine production, materials usage,
materials purchases, labor requirements, and other costs.
▪ Calculate cash payments
▪ Find net cash flow
▪ Calculate surplus /deficit and closing cash balances
15.6. FIXED AND FLEXIBLE BUDGETS
- Fixed budget: A budget which remains unchanged regardless of activity level
is called fixed budget.
▪ A fixed budget is prepared based on an estimated production plan at the
start of a period.
▪ It does not give like with like comparison.
▪ Commonly used in service industries where most costs is fixed.
▪ It does not give fair performance evaluation.
▪ Fixed budget is normally prepared for planning purpose.
- Flexible or flex Budgets: A budget that flexes the budgeted level of costs and
revenues according to the level of activity actually achieved.
▪ Budget is initially prepared at the anticipated level of activity.
▪ The budgeted production level and the actual production level may not
be the same.
▪ Budgets may need to be adjusted to reflect the actual production level
▪ The new budget, flexed to the actual production level is called the flexed
budget.
▪ The budget prepared on different activity levels is called flexible budget.
▪ For variance reporting, actual costs are compared with the flexed budget

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 for the same volume of production and sales.
▪ Variance can be either favourable or adverse. Appropriate control
action is then taken to control variances.
▪ Its gives like with like comparison.
▪ It determines cost behaviour patterns.
▪ It gives realistic performance evaluation.
- Variance Reporting: It is the reporting of differences between budgeted and
actual performance
Variance = Actual – Budget (flex budget)
Variances are:
+ Favourable if the business has more money as a result
+ Unfavourable (Adverse) if the business has less money as a result
Favourable variances are NOT always good for the organisation. For example if
the essential staff is not hired the labour variance will be favourable but this may also
mean that the production targets will not be met.
15.7. BEHAVIOURAL ASPECTS OF BUDGETING
It is very easy for the budgetary process to cause dysfunctional activity. For
example, if junior management believe that a budget imposed upon them is not
attainable, their aim may well be to ensure that the budget is not achieved, thereby
proving themselves to be correct. This needs to be avoided, and therefore an
understanding of the behavioural aspects is necessary.
Managers may be involved in setting budget targets or these may be imposed by
senior management without consultation.
15.7.1. Top-down approach / Imposed style of budgeting
It is a budget, which is set without allowing the ultimate budget holders to have
the opportunity to participate in the budgeting process. It is also called ‘imposed’
budget, or non-participative.
Features
▪ Senior management prepare budgets
▪ Imposed on junior management
▪ Quicker than bottom up approach
▪ Time saving
The time when imposed budgets are effective
▪ New organization
▪ Small businesses
▪ In period of economic hardship
▪ When operational personnel have lack of budgeting skills

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 ▪ When different organization’s unit require precise coordination
Advantages
▪ Strategic plans are incorporated in budgets
▪ Increased coordination between plans and long-term objectives of the
division
▪ Involvement of senior management in operational decisions
▪ Decreased input from inexperienced employees
▪ Time saving
Disadvantages
▪ low employees morale (hard for people to be motivated to achieve
targets set by someone else)
▪ acceptance of organizational goals & objectives could be limited
▪ operational managers are likely to have a better understanding of day by
day operations
▪ unachievable budgets (may be for local operations)
▪ The feeling of team spirit may disappear.
▪ Lower-level management initiative may be stifled.
15.7.2. Bottom-up approach / Participative style of budgeting
Bottom-up budgeting system of budgeting in which budget holders have the
opportunity to participate in setting their own budgets.
Features
▪ Junior management prepare budgets
▪ Senior management review to ensure consistent with organization
objectives
▪ Risk of budget bias/slacks
Advantages
▪ Increased morale and motivation
▪ Should contain better information, especially in a fast-moving or diverse
business
▪ Increases managers’ understanding and commitment
▪ Better communication
▪ Senior managers can concentrate on strategy.
▪ In general they are more realistic.
▪ Individual managers' aspiration levels are more likely to be taken into
account.
Disadvantages
▪ Senior managers may resent loss of control

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 ▪ Bad decisions from inexperienced managers
▪ Budgets may not be in line with corporate objectives
▪ Budget preparation is slower and disputes can arise
▪ They may cause managers to introduce budgetary slack and budget bias.
▪ An earlier start to the budgeting process could be required.
▪ They can support 'empire building' by subordinates.
▪ Figures may be subject to bias if junior managers either try to impress or
set easily achievable targets
▪ Certain environments may preclude participation, e.g. sales manager
may be faced with long- term contracts already agreed.
Whilst bottom-up is generally seen as preferable, there are situations where
top-down is applicable.
15.7.3. Negotiated style of budgeting
A budget in which budget allowances are set largely on the basis of
negotiations between budget holders and those to whom they report.
At the two extremes, budgets can be dictated from above or simply emerge
from below but, in practice, different levels of management often agree budgets by a
process of negotiation. In the imposed budget approach, operational managers will try
to negotiate with senior managers the budget targets which they consider to be
unreasonable or unrealistic. Likewise senior management usually reviews and revises
budgets presented to them under a participative approach through a process of
negotiation with lower level managers.
Final budgets are therefore most likely to lie between what top
management would really like and what junior managers believe is feasible. The
budgeting process is hence a bargaining process and it is this bargaining which is of
vital importance, determining whether the budget is an effective management tool
or simply a clerical device.
15.7.4. Budgetary slacks
Budgetary slack is the difference between the minimum necessary costs and the
costs built into the budget or actually incurred.
▪ In the process of budgeting, managers might deliberately overestimate cost
and understate sales, so that they will not be blamed in the future for
overspending and poor results.
▪ Manager of profit centre might understate budgeted sales and/or overstate
budgeted expenditure (budgetary slack).
Reasons
▪ Reward systems may be linked to performance compared with budget. This

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 encourages the manager to build slack into the budget to maximize personal
gain.
▪ To reduce work related stress by having easier targets.
▪ “Gaming” – some individuals enjoy trying to beat the system.
15.8. BEHAVIOURAL IMPLICATIONS OF BUDGETING
“Used correctly a budgetary control system can motivate but it can also
produce undesirable negative reactions”. The purpose of a budgetary control system
is to assist management in planning and controlling the resources of their organization
by providing appropriate control information. The information will only be valuable,
however, if it is interpreted correctly and used purposefully by managers and
employees.
Their attitude to control information will colour their views on what they should
do with it and a number of behavioral problems can arise.
▪ The managers who set the budget or standards are often not the managers
who are then made responsible for achieving budget targets.
▪ The goals of the organization as a whole, as expressed in a budget, may
not coincide with thepersonal aspirations of individual managers.
▪ Control is applied at different stages by different people. A supervisor
might get weekly control reports, and act on them; his superior might get
monthly control reports, and decide to take different control action.
Different managers can get in each other’s way and resent the interference
from others.
- Motivation:
Motivation is what makes people behave in the way that they do. It comes from
individual attitudes, or group attitudes. Individuals will be motivated by personal
desires and interests. It is therefore vital that the goals of management and the
employees harmonise with the goals of the organization as a whole. This is known as
goal congruence.
The management accountant should therefore try to ensure that employees have
positive attitudes towards setting budgets, implementing budgets. (that is, putting the
organization's plans into practice) and feedback of results (control information). If
this desirable state of affairs does not exist the organization is at risk of under-
performing as a result of dysfunctional decision-making.
▪ 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
organization.
▪ Dysfunctional decision making occurs when goal congruence does not

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 exist or is impaired. Managers and others take decisions that promote their
self-interest at the expense of the interest of the organization.
- Poor attitudes when setting budgets
If managers are involved in preparing a budget, poor attitudes or hostile
behaviour towards the budgetary control system can begin at the planning stage.
▪ Managers may complain that they are too busy to spend much time on
budgeting.
▪ They may build 'slack' into their expenditure estimates.
▪ They may argue that formalizing a budget plan on paper is too
restricting and that managers should be allowed flexibility in the decisions
they take.
▪ They may set budgets for their budget centre and not coordinate their own
plans with those of other budget centres.
▪ They may base future plans on past results, instead of using the
opportunity for formalized planning to look at alternative options and new
ideas.
- Poor attitudes when putting plans into action
Poor attitudes also arise when a budget is implemented.
▪ Managers might put in only just enough effort to achieve budget targets,
without trying to beat targets.
▪ A formal budget might encourage rigidity and discourage flexibility.
▪ Short-term planning in a budget can draw attention away from the
longer-term consequences
of decisions.
▪ There might be minimal cooperation and communication between
managers.
▪ Managers will often try to make sure that they spend up to their full
budget allowance, and do not overspend, so that they will not be accused
of having asked for too much spending allowance in the first place.

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 CHAPTER 16: CAPITAL EXPENDITURE BUDGETING
Session objectives:
- Discuss the importance of capital investment planning and control.
- 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.
16.1. INTRODUCTION
16.1.1. Capital expenditure and revenue expenditure
Capital expenditure:
▪ Expenditure incurred in acquisition of non-current assets.
▪ It is not charged to income statement although a depreciation charge will
usually be made to write off the capital expenditure gradually overtime.
▪ Capital expenditure appears in statement of financial position.
Revenue expenditure:
▪ Expenditure incurred for the purpose of trade off the business or to maintain
the existing earning capacity of non-current assets.
▪ It is charged to income statement.
16.1.2. Capital income and revenue income
Capital income:
▪ Income from the sale of non-current assets.
Revenue income:
▪ Income from the sale of trading assets. It also includes interest and dividend
received from investment held by the business.
16.2. PREPARING CAPITAL EXPENDITURE BUDGETS
▪ Capital expenditure budget is a long term plan and is considered very
important for the business.
▪ Major expenses are required for it so most projects are considered
individually and are fully appraised.
▪ Suitable finance must be arranged for capital expenditure.
▪ Capital expenditure should have a positive value for the business.

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 CHAPTER 17: METHODS OF PROJECT APPRAISAL
Session objectives:
- Explain and illustrate the difference between simple and compound interest,
and between nominal and effective interest rates.
- Explain and illustrate compounding and discounting.
- Explain the distinction between cash flow and profit and the relevance of cash
flow to capital investment appraisal.
- Identify and evaluate relevant cash flows for individual investment decisions.
- Explain and illustrate the 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.
17.1. INTRODUCTION
Investment appraisal techniques are required to determine:
▪ whether a new project should be accepted
▪ which of two (or more) projects to accept
▪ whether to lease or buy a new asset
▪ How to raise finance for the purchase of an asset
Relevant and irrelevant costs: The cost which is useful for decision making is
known as relevant cost. Relevant costing is used in long term decision making and
investment decisions. The relevant costs are:
▪ Only cash items
▪ Future cash flows
▪ Incremental cash flows
The key methods of project appraisal are:
+ The payback period
+ Net present value
+ Discounted payback period
+ Internal rate of return (IRR)
17.2. RELEVANT AND IRRELEVANT COSTS
➢ Past or Sunk Cost or Historical cost: Costs that have been incurred to date
are past costs or sunk costs, irrecoverable costs. These are irrelevant for
decision making because we cannot change the past.
➢ Committed cost: Costs that are already committed to be incurred regardless

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 of the decision made. Committed costs are irrelevant to decision. Mostly
fixed costs are committed cost.
➢ Apportioned cost: All costs or charges being allocated but without the
responsible manager’s control or not actual cost are irrelevant for decision
making. For example absorbed overheads, fixed overheads.
➢ Notional cost: A notional cost or imputed cost is a hypothetical accounting
cost to reflect the use of a benefit for which no actual cash expense is
incurred. For example Notional rent, notional interest, depreciation,
provisions. These are non-cash items and irrelevant for decision making.
➢ Incremental Cost: Costs which are additional due to only one specific
decision are incremental cost and they are relevant.
➢ Controllable Cost: Costs that can be controlled because of one particular
decision are controllable costs and they are relevant for decision making.
➢ Uncontrollable Cost: Costs which cannot be controlled because of a
specific decision are uncontrollable cost and they are irrelevant for
decision making.
➢ Avoidable Cost: Costs that can be avoided because of one specific decision
are avoidable costs and they are relevant.
➢ Unavoidable Cost: Costs that cannot be avoided because of one specific
decision are unavoidable costs and they are irrelevant for decision making.
➢ Fixed cost: Fixed costs are generally irrelevant to decision making
because they do not change but the incremental fixed costs are always
relevant.
➢ Variable cost: Variable costs are normally relevant for decision making.
➢ Opportunity Cost: Opportunity cost is the benefit which has been given up,
by choosing one option instead of another. Opportunity costs only apply to
the use of scarce resources. Where resources are not scarce, no sacrifice
exists from using these resources.
➢ Differential/ incremental cost: Differential cost is the difference in total
costs between alternatives. Incremental costs are similar in principle to the
economist’s concept of marginal cost.
Example: Relevant cost of using machines: Use of machinery will incur some
incremental costs:
▪ Repair cost
▪ Hire charges
▪ Fall in resale value
(Note: depreciation is irrelevant cost)

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 Cost Behaviour
▪ Variable costs are usually relevant costs.
▪ Fixed costs which do not change when the activity level changes irrelevant
cost. Fixed cost may only be fixed in the short term.
▪ Incremental fixed cost is relevant cost.
❖ Additional fixed cost are incurred in a decision to increase an extra
activity or
❖ Fixed cost will decrease if the scale of an operation is reduced.
17.3. INVESTMENT APPRAISAL METHODS
There are mainly two methods to appraise any prospective investment.
1. Non-discounted cash flow methods (traditional methods)
➢ Accounting rate of return
➢ Simple payback period
2. Discounted cash flow methods (DCF methods)
➢ Discounted payback period
➢ Net present value
➢ Internal rate of return
17.3.1. The time value of money
- Interest:
Money earned or paid for the use of money is called interest. Interest cost is
always on outstanding balance. The two types of interest are:
+ Simple interest: Interest calculated on principal amount is Simple interest
Simple Interest = Principal amount x r x n
+ Compound interest: Compound interest is calculated on principle amount as
well as any previous outstanding interest.
Compound Interest = Principal amount (I + r)n
Where: r = Interest rate
n = Number of years
- Future value:
Future value is defined as the value or sum of money at a future date at a
particular interest rate. Future value is calculated by multiplying present value with a
compound factor.
FV = PV (1 + r)n
Where: = Present value

PV
FV = Future value
r = interest rate / discount rate
n = number of time periods
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 The method of converting present value into future value is called as
compounding.
- Present value:
Present value is the value which refers to the value of money at today which is to be received
in future. The present value of a future sum tells us what a future sum is worth today.
PV = FV (1 + r)-n
Where: = Present value

PV
FV = Future value
r = interest rate / discount rate
n = number of time periods
The method of converting future value into present value is called as
discounting.
- Time value of money concept:
There is a time preference for receiving the same sum or money sooner rather
than later. Conversely, there is a time preference for paying the same sum of money
later rather than sooner.
Reasons for Time Preference for Money
There are three very important reasons why money has a time preference.
▪ Consumption Preference – money received now can be spent on
consumption
▪ Risk preference – risk disappears once money is received.
▪ Investment preference – money received can be invested in the
business, or invested externally.
17.3.2. Non-discounted cash flow methods
(1) Accounting rate of return or Return on capital employed (ARR or
ROCE)
This method of appraising the viability of a project over its several years life is
similar to the method of assessing the financial performance of a business over a single
year.

- Decision rules
+ If accounting rate of return > Target  Accept the project

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 + If accounting rate of return < Target  Reject the project
- Advantages of Accounting rate of return
▪ Quick to calculate
▪ Simple to use and understand
▪ Familiar concept for managers
▪ Commonly used by external analysts
- Disadvantages of Accounting rate of return
▪ Accounting profits might not be objectives of the organization
▪ Different methods of calculation are possible
▪ It ignores the time value of money
▪ It considers accounting profits rather than cash flows
(2) Simple payback period
- This is the time taken to recover the initial cash flows from the cash inflows of
the project. Payback period is the amount of time that is expected to take for the cash
inflows from a capital investment project to equal the cash outflows. It is particularly
useful if there are liquidity problems or if distant forecasts are very uncertain.
Simple payback period = Initial investment ÷ annual cash inflows
(in case of annuity)
- Decision rules:
+ If Simple payback period < Target  Accept the project
+ If Simple payback period > Target  Reject the project
- Advantages of simple payback period
▪ It is easy to calculate and understand.
▪ It is widely used in practice as a first screening method.
▪ Its use will tend to minimize the effects of risk and help liquidity,
because greater weight is given to earlier cash flows which can probably
be predicted more accurately than distant cash flows.
▪ It is based on cash flows rather than profits.
- Disadvantages of simple payback period
▪ Total profitability is ignored.
▪ The time value of money is ignored.
▪ It ignores any cash flows that occur after the project has paid for itself. A
project that takes time to get off the ground but earns substantial profits
once established might be rejected if the payback method is used, where
as a smaller project, paying back more quickly, may be accepted.
17.3.3. Discounted cash flow methods (DCF methods)
Principles behind DCF methods

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 ▪ It recognize the “time value of money” (having the use of money has a
cost for example interest)
▪ People would prefer to receive money sooner rather than later
▪ Investors don’t attach equal values to equal sums of money receivable at
different times
▪ In investment appraisal calculations, reduce (discount) later cash flows
▪ The discounting process is sometimes thought of as compound interest
in reverse
(1) Discounted payback period
Discounted payback period is same as simple payback period with the
difference that cash flows are discounted cash flows. Simple payback period is always
shorter than discounted payback period.
(2) Net present value (NPV)
- Net present value is the net of present values of cash flows.
Net present value = PV of cash inflows – PV of cash outflows.
- Decision rules:
+ If Net present value = Positive  accept the project
+ If Net present value = Negative  reject the project
Advantages of Net present value
▪ Shareholder wealth is maximized.
▪ It considers time value of money.
▪ It takes into account the time value of money.
▪ It is based on cash flows which are less subjective than profit.
▪ Shareholders will get benefits if a project with a positive net present
value is accepted.
▪ It considers cash flows after payback period
Disadvantages of Net present value
▪ It can be difficult to identify an appropriate discount rate.
▪ For simplicity, cash flows are sometimes all assumed to occur at year
ends: this assumption may be unrealistic.
▪ Some managers are unfamiliar with the concept of net present value.
(3) Internal rate of return
- Internal rate of return is the point where the present value of cash inflows is
exactly equal to the present value of cash outflows. It refers to the discount rate where
net present value is zero. It is calculated as.
NPVA
IRR = A+ x (B – A)
NPVB – NPVA
Where: A = Lower discount rate
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 B = Higher discount rate
NPVA = NPVA at A
NPVB = NPVB at B
- IRR is more accurate if:
A = Lower discount rate at which NPV is positive &
B = Higher discount rate at which NPV is negative
But these two should be closest
- Decision rules:
+ If internal rate of return > cost of capital => Accept the project (in this NPV
would be positive)
+ If internal rate of return < cost of capital => Reject the project (in this NPV
would be negative)
+ If internal rate of return = cost of capital => Project is gearing no return
Advantages of Internal rate of return
▪ It takes into account the time value of money, unlike other
approaches such as simple payback period.
▪ Results are expressed as a simple percentage, and are more easily
understood than some other methods.
▪ It indicates how sensitive calculations are to changes in interest rates.
Disadvantages of Internal rate of return
▪ Projects with unconventional cash flows can produce negative or
multiple internal rates of return.
▪ Internal rate of return may be confused with accounting rate of return
or return on capital employed (ROCE), since both give answers in
percentage terms.
▪ It may give conflicting recommendations with mutually exclusive
projects, because the result is given in the relative terms
(percentages), and not in absolute terms ($) as with net present value.
▪ Some managers are unfamiliar with the internal rate of return
method.
▪ It cannot accommodate the changing interest rates.
▪ It assumes that funds can be re-invested at a rate equivalent to the
internal rate of return, which may be too high.
17.3.4. ANNUITY AND PERPETUITIES
(1) Annuity
Whenever a project is expected to earn equal amount of cash flows in equal
interval of time for a defined time period, then the cash flows are said to be an

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Annuity. Constant cash inflows or outflows for a defined time period is called annuity.

(2) Perpetuities
Perpetuity is, in which equal cash flows are generated for unlimited time period.
When a project has expected to earn equal amount of cash flows in equal interval of
time but for unlimited time period is called perpetuity.
If the perpetuity situation arises, the present value of perpetuity will be
calculated as:

17.3.5. Nominal rate and effective rate

- Nominal rate is the interest rate which is quoted by the financial institutions
and effective rate is the actual rate of interest earned that a company charge. Nominal
rate is used when interest is compounded only once in a period.
- Effective rate is use when interest is compounded more than once in a period.
Interest may be compounded daily, weekly, monthly or quarterly.
Effective rate is greater than nominal rate when compounding is done for less
than one year.
Effective rate is equals to the nominal rate if compounding is done at the end of
year.
Effective rate is calculated as:
Effective Rate = [(1 + r)n – 1] x 100
Where:

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 r = nominal rate of interest per compounding
n = number of times compounding is done in a period.
Effective rate is also called Annual Percentage Rate (APR) or compound annual
rate (CAR).

PART D – STANDARD COSTING

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CHAPTER 18: STANDARD COSTING
Session objectives:
- Explain the purpose and principles of standard costing.
- Explain and illustrate the difference between standard, marginal and
absorption costing.
- Establish the standard cost per unit under absorption and marginal costing.
18.1. WHAT IS STANDARD COSTING
18.1.1. Standard costing
- Standard cost: The planned unit cost of a product, component or service.
- Standard costing: A system of accounting based on predetermined costs and
revenue per unit, which are compared to actual performance to provide useful
feedback information to management.
The predetermined cost is known as standard cost and the difference between
standard and actual cost is called variance. The process through which differences are
analysed is known as variance analysis. Although standard costing can be used in
manufacturing as well as service industries, its greatest benefits are realised where
mass production and repetitive work is undertaken.
- Performance Standards
Performance standards are used to set efficiency targets. There are four types of
standards:
+ Ideal Standards
▪ These standards are based on perfect or ideal situations i.e. no wastage,
no idle time, no efficiencies.
▪ These standards are likely to be de-motivating because reported variance
is always adverse.
▪ Employees will often feel that standards are unattainable so they will not
feel the need to work hard.
+ Attainable Standards
▪ These standards are based on efficient situations to make them
attainable.
▪ Some allowances are made for wastage or inefficiencies.
▪ They are realistic however challenging targets for employees.
▪ These standards are motivating for employees.
+ Current Standards
▪ These are based on the current situation.
▪ Prepared for short term (just for current situations)

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 ▪ When the current situation ends, standards are restated.
▪ These standards do not attempt to improve current level of efficiency.
+ Basic Standards
▪ These standards are kept unaltered over long periods of time.
▪ These standards are likely to be outdated.
▪ They are the least useful for variance analysis.
- Use of standard costing:
▪ Stock valuation. For internal or external use.
▪ As a basis for pricing decisions i.e. cost plus pricing.
▪ For budget preparation/business planning.
▪ For budgetary control, reporting deviations from plan (reporting by
exception)
▪ Use in variance analysis
▪ For performance measurement.
▪ Motivating staff by using standards as targets.
18.1.2. Standard cost card
A standard cost cardshows full details of the standard cost of each product.
(1) Standard cost card under Absorption costing
Product XYZ
$ per unit $ per unit
- Selling price 100
- Production cost:
+ Material (2 kgs @ $20/kg) 40
+ Labour (1.5 hrs @ $2/hr) 3
+ Variable overheads (1.5 hrs @ $6/hr) 9
+ Fixed overheads (1.5hrs @ $10/hr) 15
- Standard cost (67)
- Standard profit per 33
unit
(2) Standard cost card under Marginal costing
Product XYZ
$ per unit $ per unit
- Selling price 100
- Production cost:
+ Material (2 kgs @ $20/kg) 40
+ Labour (1.5 hrs @ $2/hr) 3
+ Variable overheads (1.5 hrs @ $6/hr) 9
-Standard variable (52)
cost
-Standard 48
contribution per unit

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18.2. SETTING STANDARDS
Standards are set for each element of cost in the production of a unit of output.
It involves estimating the quantity of the resource used and its associated costs. In
addition a standard selling price is set.
- Direct materials
▪ Materials standard is like: 5 kgs/unit x $10/kg = $50/unit
▪ Quantity standards are recorded, for example, as a bill of materials.
▪ Standard prices are obtained from the purchasing department which
researches alternative suppliers and selects those which can provide:
o Required quantity
o Sound quality
o Most competitive price
- Direct labour
▪ Labour standard is like: 3 hrs/unit x $8/hr = $24/unit
▪ Time measurements determine standard hours for the average worker to
complete a job.
▪ Wage rates are determined by company policy/negotiations between
management and unions.
- Variable overheads
▪ Variable overheads standard is like: 3 hrs/unit x $5/hr = $15/unit
▪ Variable overheads rate is often based upon labour hours or machine
hours.
▪ A standard variable overhead rate per unit of activity is calculated.
▪ If there is no observable direct relationship between resources and
output, past data is used to predict.
▪ The activity measure that exerts the greatest influence on costs is
investigated– usually direct labour hours.
- Fixed overheads
▪ Fixed overheads standard is like: 3 hrs/unit x $2/hr = $6/unit
▪ This standard is developing by using fixed overhead absorption rate.
▪ Because fixed costs are largely independent of changes in activity, they
are constant over wide ranges in the short term.
▪ Therefore, for control purposes, a fixed overhead rate per unit of activity
is inappropriate.
▪ For inventory valuation purposes IAS 2 requires standard fixed overhead
rates.
- Selling price and margin

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 ▪Sales standard is like: $30/unit x 100 units sold
▪ Anticipated market demand
▪ Competitive production and competitor’s action
▪ Manufacturing costs
▪ Inflation estimates
* ADVANTAGES & DISADVANTAGES OF STANDARDS
Advantages
▪ Annual examination of costs and revenues.
▪ Provides a yardstick to judge performance.
▪ Helps management by exception.
▪ Helps bookkeeping.
Disadvantages
▪ Waste important resources like time and costs.
▪ Standard developed may be outdated.
▪ De-motivating effect if system is poor.
18.3. BUDGET AND STANDARD COMPARISON
Budgets and standard are very similar and interrelated, but there are important differences
between them.
Budget Standards
 Gives planed and aggregate  Shows the planned unit resources usage for a
costs for a function of cost single task, for example the standard labour
centre hours for a single units of production
 Can be prepared for all  Limited to situation where representative
functions, even when output action are performed and output can be
cannot be measured measured
 Need not be expressed in money terms. For
 Mostly expressed in money
example a standard rate of output does not
terms
need a financial value put on it

CHAPTER 19: COST VARIANCES

Session objectives:
- Calculate materials total, price and usage variance.
- Calculate labour total, rate and efficiency variance.
- Calculate variable overhead total, expenditure and efficiency.

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 - Calculate fixed overhead total, expenditure and, where appropriate, volume,
capacity and efficiency 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 simple variances between flexed budget, fixed budget and actual
sales, costs and profits.
- Discuss the relative significance of variances.
- Explain potential action to eliminate variances.
19.1. VARIANCE
- Variance: A variance is ‘the difference between a planned, budgeted or
standard cost and the actual cost incurred’. The same comparisons may be made for
revenues.
- Variance analysis: The process by which the total difference between
standard and actual results is analyzed is known as variance analysis.
- Finally three figures arise
▪ Original budget (standard costs/revenues at expected activity level)
It is calculated as standard cost/revenue per unit x budgeted units
▪ Flexed budget (standard costs/revenues at actual activity level) It is
calculated as standard cost/revenue per unit x actual units
▪ Actual results
It is calculated as actual cost/revenue per unit x actual units
19.2. DIRECT MATERIAL COST VARIANCES
Direct material total variance refers to the total difference between what the
output quantity should have cost and what it did cost (in terms of material)
- Direct material total variance can be computed as:
Actual output x standard cost per unit XX
Actual output at actual cost (XX)
Direct material total variance XX
- The direct material total variance is made up of:
● Direct material price variance; and
● Direct material usage variance
+ Direct material price variance represents the difference between the
standard cost and actual cost for the material purchased or used.
Standard cost of actual quantity XX
Actual cost of actual quantity (XX)

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 Material price variance XX
+ Direct material usage variance is the difference between the standard
quantity of materials that should have been used for the number of units actually
produced, and the actual quantity of materials used, valued at the standard cost per unit
of material.
= (actual quantity used – standard quantity that should have been used) x
standard cost per unit
- Cases of Material: If material purchase quantity and used quantity is different
then:

19.3. DIRECT LABOUR COST VARIANCES

Direct labour cost variance is the difference between the standard cost for actual
production and the actual cost in production. Direct labour total variance can be
subdivided into labour rate variance and labour efficiency variance.
- Direct labour total variance can be computed as:
Actual output x standard cost per unit XX
Actual output at actual cost (XX)
Direct labour total variance XX
- Direct labour rate variance is the difference between the standard cost and
the actual cost paid for the actual number of hours worked.
Actual hours at standard rate XX
Actual hours at actual rate (XX)
Labour rate variance XX
- Direct labour efficiency variance is the difference between the standard
labour hour that should have been worked for the actual number of units produced and
the actual number of hours worked when the labour hours are valued at the standard
rate.
= (actual hours taken for job – standard hours for job) x standard rate per hour
NOTE: Idle time is not considered in calculation of this variance.
- Idle Time Variance: Company may operate a costing system in which any
idle time is recorded. Idle time may be caused by machine breakdowns or not having
worked to give to employees, perhaps because of limited resources or a shortage of
orders from customers. When idle time occurs, the labour force is still paid wages for

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time at work, but no actual work is done. Time paid for without any work being done
is non-productive and therefore inefficient. In variance analysis, idle time is an adverse
efficiency variance.
In case of idle time:

19.4. PRODUCTION OVERHEAD VARIANCES

19.4.1. Variable production OH variance
Variable production overhead variance is divided into variable production
overhead expenditure variance and variable production efficiency variance.
- Variable overheads total variance can be computed as:
Actual output x standard cost per unit XX
Actual output at actual cost (XX)
Variable overheads total variance XX
- Variable overhead expenditure variance is the difference between amount of
variable production overhead that should have been incurred in actual hours worked
and the amount of variable production overhead actually incurred.
Actual hours at standard rate XX
Actual hours at actual rate (XX)
Variable overheads expenditure variance XX
- Variable overhead efficiency variance is very much similar to labour
efficiency variance. It is difference between the standard labour hour that should have
been worked for the actual number of units produced and the actual number of hours
worked when the labour hours are valued at the standard variable production overhead
rate.
= (actual hours taken for job – standard hours for job) x standard variable
OAR per hour
19.4.2. Fixed production OH variance
Fixed production overhead variance is the difference between the incurred cost
of fixed production overhead and the amount of overhead actually absorbed. The
amount of overhead absorbed is calculated by using the overhead rate which, at the
time of absorption, is based on budgeted figures. In absorption costing system under or
over absorption of overheads is almost inevitable. Recall the overhead absorption rate:
Budgeted fixed overheads
Overhead absorption rate =
Budgeted activity level
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 Both, numerator and denominator are budgeted or planned. If either of two
changes, it will result in over or under absorption of overheads. Fixed production
overhead variance is divided and analyzed into:
▪ Expenditure variance
▪ Volume variance
● Volume efficiency variance
● Volume capacity variance
- Fixed overheads total variance can be computed as: It is same as under/over
absorption of overheads.
Actual output x standard cost per unit XX
Actual output at actual cost (XX)
Fixed overheads total variance XX
- Fixed overhead expenditure variance: Fixed production overhead
expenditure variance is simply the difference between the actual fixed production
overhead expenditure and the budgeted fixed production overhead expenditure.
- Fixed overhead volume variance: Fixed overhead volume variance arises
due to difference between actual and budgeted activity level. To compute the volume
variance difference between actual and budgeted activity level is multiplied by
budgeted absorption rate per unit.
- Fixed overhead volume efficiency variance is the difference between the
actual number of hours worked to produce a set amount of units and the standard hours
for actual units. This figure is then multiplied by the overhead rate for an hour of
labour.
- Fixed overhead volume capacity variance is the difference between the
actual number of hours worked and the budgeted number of hours. This figure is then
multiplied by the overhead rate for an hour of labour.

However, if absorption rate is calculated on the basis of production units.

There are only three variance:

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  Fixed production overhead total variance.
 Fixed production overhead expenditure variance.
 Fixed production overhead volume variance.
19.5. REASONS FOR VARIANCES
Variance Favourable Adverse
 Defective material.
 Material used of higher quality than
 Excessive waste or theft.
Material standard.
 Stricter quality control.
Usage  More efficient use of material.
 Errors in allocating material to
 Errors in allocating material to jobs.
jobs.
 Use of workers at a rate of pay lower  Wage rate increases.
Labour rate
than standard.  Use of high grade labour.
 The idle time variance is always  Machine breakdown.
Idle time
adverse.  Illness or injury to worker.
 Output produced more quickly than  Lost time in excess of standard.
expected because of worker  Output lower than standard set
Labour
motivation, better quality materials because of lack of training, sub-
efficiency
etc. standard materials etc
 Errors in allocating time to jobs.  Errors in allocating time to jobs.
Fixed  Increase in cost of services used
 Savings in costs incurred.
overhead  Excessive use of services.
 More economical use of services.
expenditure  Change in type of services used.
Fixed
overhead  See labour efficiency.  See labour efficiency.
efficiency
Fixed
 Actual time worked greater than  Excessive idle time.
overhead
budget (e.g. overtime working).  Shortage of plant capacity.
capacity
19.6. SIGNIFICANCE OF VARIANCE
A variance can be considered significant if it will influence management’s
actions and secedes. Significant variances usually need investigating. If actual results
are different from planned and consequently resulted in variances, management need
to consider a number of factors in order to decide whether to investigate it or not.
Variances are inevitable in routine processes and therefore investigating each and
every variance would not be worth-while.
Factors that should be considered as to whether to investigate a variance or not
include:
- The size of variance: If variance is immaterial then it needs not to be
investigated.
- Controllability: Some investigations are not controllable by nature. An
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increase in price of material or shortage of material and skills are major examples as
opposed to material usage variance which is controllable by management. In case of
uncontrollable variance, plan should be changed for the next period.
- Cost of investigation: Cost of investigating a variance must be weighed
against the benefits of correcting the cause of a variance.
- Interdependence of variances: Sometimes adverse variance in one area is
linked with a favorable variance in some other area. For example if sub-standard
material is purchased, it would result in favorable material price variance but at the
same time would result in adverse material usage variance and adverse labour
efficiency variance. So while investigating an adverse variance, all relevant factors
should be taken into account.
- Standard type used: at the start of this chapter, you studied about different
types of standards. If a standard was set which was not suitable to working conditions,
adverse variances are inevitable. Standards should be set at ‘normal’ level and not at an
ideal level.

CHAPTER 20: SALES VARIANCES AND OPERATING STATEMENTS

Session objectives:
- Calculate sales price and volume variance.
- Calculate actual or standard figures where the variances are given.
- Calculate sales price and volume variance.
- Calculate actual or standard figures where the variances are given.
20.1. SALES VARIANCES
Sales variance is the difference between actual sales and budget sales. Sales
variance arises from two reasons; either the sale price varies from planned or the
volume of sales vary from budgeted. Sales variance can, therefore, be divided in
following two main areas:
▪ Price variance
▪ Volume variance

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 - Sales price variance: Sales price variance is a measure of effect on profit of a
change in sales price. Sales price variance is difference between what the revenue
should have been from sale of actual quantity and what the actual revenue was.
- Sales volume variance: Sales volume variance measures the effect on profit
of change in volume of sales. Volume variance calculates the difference between
budgeted quantity and actual quantity sold, valued at standard profit per unit or
standard contribution per unit.
+ Std profit / unit =Standard selling price/unit – standard all cost / unit
+ Std contribution/unit = standard selling price/unit – standard all variable
cost/unit
20.2. OPERATING STATEMENTS
Operating statements show how the combination of variances reconcile
budgeted profit and actual profit.
An operating statement is a regular report for management of actual costs and
revenues, usually showing variances from budget.
(1) Operating Statements under absorption costing:

(2) Operating Statements under marginal costing

- In the marginal costing system the only fixed overhead variance is an
expenditure variance.

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 - The sales volume variance is valued at standard contribution margin (sales
price per unit minus variable costs of sale per unit), not standard profit margin.
- Stock should be valued at standard marginal cost, rather than standard total
absorption cost.

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 PART E – PERFORMANCE MEASUREMENT

CHAPTER 21: ACCOUNTING FOR MANAGEMENT

Session objectives:
- Discuss the purpose of mission statements and their role in performance
measurement, and the purpose of strategic and operational and tactical objectives and
their role in performance measurement.
- Discuss the impact of some factors on performance measurement, such as
economic and market conditions or government regulations.
- Apply some techniques of performance measurements.
21.1. PERFORMANCE MEASUREMENT AND MISSION STATEMENTS
(1) Performance measurement
Performance measurement is a vital part of control and aims to establish how
well something or somebody is doing in relation to a planned activity. Control is to
compare actual results with the plan. Strategic management must decide what they
want the business to be and how to get there.
Performance measure can be divided in two groups:
(a) Financial performance measures (used to measure the performance of
Profit Seeking Organizations)
It includes:
▪ Ratio analysis - Several profitability and liquidity measures can be
applied to divisional performance reports.
▪ Variance analysis - is a standard means of monitoring and controlling
performance; care must be taken in identifying the controllability of and
responsibility for each variance. (already studied in standard costing)
▪ Benchmarking (financial + non-financial)
▪ Balanced scorecard (financial + non-financial)
(b) Non-financial performance measure (used to measure the performance of
Profit Seeking Organizations and Not For Profit Organizations)
▪ Benchmarking (financial + non-financial)
▪ Balanced scorecard (financial + non-financial)
(2) Mission
Mission should identify the purpose of the business and what is it trying to

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achieve and just as importantly what the business does not do. The managers of the
business will contribute their views of the desired position of the business in the future.
For this reason, the mission has also become known as the vision due to the
requirement of being able to look into the future.
- Purpose of mission: It shows why the company exists
▪ To create wealth for shareholders
▪ To satisfy all stakeholders
- Mission provides the commercial logic for the organisation like products or
services it offers & its competitive position. It also defines its competence by which it
hopes to prosper.
- Mission statement: A mission statement is a formal, short, written
statement of the purpose of a company or organization. The mission statement
should guide the actions of the organization, spell out its overall goal, provide a sense
of direction, and guide decision-making. It provides "the framework or context” within
which the company's strategies are formulated. It should possess certain
characteristics:
▪ Brevity Easy to understand and remember
▪ Flexibility To accommodate change
▪ Distinctiveness To make the firm stand out
+ Mission statement can play an important role in the planning process.
▪ Plans should outline the fulfilment of the organization’s mission.
▪ Evaluate and screening (mission helps to ensure consistency in decisions)
▪ Implementation (mission also affects the implementations of a planned
strategy, in the culture and business practice of the firm)
(3) Goals:
The goals set for different parts of the organization should be consistent with
each other (goal congruence).
There are two types of goals:
+ Operational goals: Can be expressed as objectives. It can be measurable. For
example, cut cost, objective reduce budget by 10%.
+ Non-operational goals: Not all the goals can be measured. For example, a
university goal might be to seek the truth, this goal cannot be measured.
- Distinguish between goals and objectives Goals:
▪ Goals will support the mission.
▪ This is primary long term objective of the organisation
▪ Goals are the main purpose of the organization.
▪ This is at overall organizational level.

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 ▪ Goals are decided at corporate planning stage by strategic management.
(4) Objectives:
▪ Objectives are sub-division of goals.
▪ Objectives are at departmental level.
▪ If the departments achieve their objectives, the organization will achieve its
goal.
Objectives usually are smart
▪ Specific
▪ Measurable
▪ Attainable
▪ Result orientated
▪ Time bounded
Some objectives are primary corporate objectives (goals) and some are
secondary objectives. Both should combine to ensure the achievement of the overall
corporate objective. For example a company sets its Primary objective as to
maximize profit, for this it has Secondary objectives like cost reduction, sales growth,
customer satisfaction etc.
Objectives may be long term and short term. A company that suffering from
losses in short term might continue to have a long term primary objective of achieving
a growth in profits, but in short term its primary objective might be survival.
Strategic, tactical and operational objectives: Objectives can also be
classified as strategic, tactical or operational.
♦ Strategic objectives would include matters such as required level of
company profitability.
♦ Tactical objectives would concern with efficient and effective use of
organizational resources.
♦ Operation objectives would include guidelines for ensuring that specific
tasks are carried out.
Trade-off between the objectives: When there is number of objective, some
might be achieved on the expense of others. For example, a company’s objective of
achieving good profits and profit growth might have adverse consequences for the cash
flows of the business, of the quality of the firm’s products.
Short-termism is when there is a bias towards short-term rather than long-term
performance. It is often due to the fact that managers' performance is measured on
short-term results.

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 Organizations often have to make a trade-off between short-term and long-term
objectives. Decisions which involve the sacrifice of longer-term objectives include
the following.
▪ Postponing or abandoning capital expenditure projects, this would
eventually contribute to growth and profits, in order to protect short term
cash flow and profits.
▪ Cutting R&D expenditure to save operating costs, and so reducing the
prospects for future product development.
▪ Reducing quality control, to save operating costs (but also adversely
affecting reputation and goodwill).
▪ Reducing the level of customer service, to save operating costs (but
sacrificing goodwill).
▪ Cutting training costs or recruitment (so the company might be faced with
skills shortages).
Managers may also manipulate results, especially if rewards are linked to
performance. This can be achieved by changing the timing of capital purchases,
building up inventories and speeding up or delaying payments and receipts.
Methods to encourage a long-term view: Steps that could be taken to
encourage managers to take a long-term view, so that the 'ideal' decisions are taken,
include the following:
▪ Making short-term targets realistic. If budget targets are unrealistically
tough, a manager will be forced to make trade-offs between the short and
long term.
▪ Providing sufficient management information to allow managers to see
what trade-offs they are making. Managers must be kept aware of long-term
aims as well as shorter-term (budget) targets.
▪ Evaluating managers' performance in terms of contribution to long-term
as well as short-term objectives.
▪ Link managers' rewards to share price. This may encourage goal
congruence.
▪ Set quality based targets as well as financial targets. Multiple targets can
be used.

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 The link between mission statements and key performance indicators

21.2. FINANCIAL PERFORMANCE MEASURES (measuring profitability and

productivity)
Ratio Analysis
Financial ratios quantify many aspects of a business and are an integral part of
the financial statement analysis. Financial ratios are categorized according to the
financial aspect of the business which the ratio measures.
Financial ratios allow for comparisons:
▪ Between companies
▪ Between industries
▪ Between different time periods for one company
▪ Between a single company and its industry average
21.2.1. Profitability ratio
It measures the firm's use of its assets and control of its expenses to generate an
acceptable rate of return. Management is always keen to measure its operating
efficiency. Owners / shareholders invest their funds in the expectation of reasonable
returns. The operating efficiency of a firm and its ability to ensure ample returns to its
owners / shareholders depends basically on the profits earned by it.
(1) Operating profit margin:
Operating profit is an income of the company that is generated from its own
operations. It excludes income from investment in other businesses. The ratio
illustrates what proportion of sales revenue was retained in the form of profit before
the deduction of interest and tax. The operating profit ratio measures the operating
efficiency and pricing efficiency through cost control. If profit margin unsatisfactory
means excessive cost or low selling price.

Profit before interest and tax = Total Sales - Cost of Goods Sold – Non
manufacturing overheads (except tax and interest)

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 Total sales = Cash Sales + Credit Sales
Note: if no information about interest and tax is given then take NET PROFIT
instead of Profit before interest and tax
Investors can measure the quality of the company’s operations looking at the
operating profit margin ratio over the period of time and comparing it with other
competitors in the industry.
Typical implication/observation
▪ It indicate the profit per $1 of sales (but not the volume of sales)
▪ If it increases during the period it is satisfactory
▪ Might be useful to compare the budget to assess expectations
▪ The possible causes of low or reducing profit margin are :
♦ Costs are high /increasing
♦ Sale price are low/reducing (but the result may be that turnover is
increasing)
♦ A worse of the sale mix (by selling low margin product in the
place of high margin product)
(2) Gross profit margin:
Gross profit margin ratio indicates how efficiently the material, labour and
expenses related to production are used by an organization in order to produce a
product at a lower cost. Higher percentage shows better control over the costs and
reasonable profit on sales.

Gross Profit = Total Sales - Cost of Goods Sold

Total sales = Cash Sales + Credit Sales
Comparison of the business ratios to those of similar businesses will reveal the
relative strengths or weaknesses in the business.
(3) Cost of goods sold to sales ratio
When profit targets are not met, cost to sales ratios are calculated to determine
in which area of cost does the problem lie

The ratio has measured the efficiency with which the company has acquired and
used resources to generate sales. Generally the lower the ratio, the better the cost
efficiency is. The ratio does however need to be considered in context with quality,
which influences the volume of sales revenue. The ratio can be sub analysed by
different costs: material, labour and expenses.

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 (4) Earning per share (EPS)
The earnings per share ratio are widely used to measure the profitability of the
shareholders’ investment. EPS represents the amount of profits attributable to each
ordinary share or, what each share has generated in terms of profits. Investors compare
the EPS of the company with the industry average and with the EPS of other
companies before taking investment decisions.

(5) Price earnings ratio (P/E ratio)

Price earnings ratio compares current market price of each share with the per
share earnings in order to assess the company’s performance. It reflects investors’

expectations about the increase in the firm’s earnings. A high P/E ratio indicates that
investors are expecting higher growth in future compared to companies with low P/E
ratio. It is more useful to compare one company’s P/E ratio with that of the other
companies in the same industry or the market in general and with the company’s own
P/E ratio of preceding years.

(6) Return on capital employed (ROCE)

ROCE is probably the most popular ratio for measuring general management
performance in relation to the capital invested in the business. Also known as Return
on investment (ROI). ROI is normally used for divisional or investment centre
performance appraisal. This ratio expresses profits earned as a proportion of capital
employed. It illustrates how efficiently the company is using its capital to generate
profits.

(7) Asset turnover

This ratio indicates the efficiency with which company is able to use all its (net)
assets to gearing $1 sales. Generally, the higher a company’s total net asset turnover,
the more efficiently its assets have been used. The total net asset turnover is probably
of greatest interest to management, however, other parties, such as creditors and
prospective and present shareholder, will also be interested in the measure.
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 The return on investment is widely used by external analysts of company
performance when the primary ratio is broken down into its two secondary ratios:

21.2.2. Liquidity ratios

Liquidity refers the state of an asset’s nearness to cash. Nearness to cash has
been defined in terms of the time and effort needed to sell an asset. Liquidity is vital to
the financial health of any company too much liquidity is a misuse of money, and too
little leads to severe cash problems.
(1) Current ratio
Current ratio measures the short-term solvency of a firm. It shows the
availability of current assets for every one dollar of current liability. The higher the
current ratio, the larger is the amount of current assets in relation to current liabilities
and the company’s ability to meet its current obligations is greater too. If the current
ratio is 2:1 or more, the company is generally considered to have good short-term
financial strength. If the current ratio is less than 1 (liabilities exceed current assets),
the company may face difficulties in meeting its short term obligations.

(2) Quick ratio or acid test ratio

Quick ratio determines the relationship between liquid assets and current
liabilities. Liquid assets are the assets that can be easily and immediately converted
into cash without loss of value. A quick ratio of 1 to 1 or more represents a satisfactory
current financial position of a firm.
21.3. NON-FINANCIAL PERFORMANCE MEASURES
These are the qualitative measures which are not expressed in numeric. Due to
Changes in cost structure, more competitive environment and competitive
manufacturing environment have led to an increased use of non-financial indicators.
▪ In modern businesses, a major investment is required for new technology
and product life cycle have got shorten. Mostly costs are committed at
planning stage so it is too late to control cost in further stages
▪ Financial measures do not convey full picture of the company’s
performance. In competitive environment companies are competing in terms

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 of customer satisfaction, quality, product features, quality deliveries, after
sales services etc.
▪ New competitive process of making a product focuses on reducing time of
production, less machine setups, more efficient labour and machine,
increase in productivity etc.
Non-financial Key performance indicators
measures
Competitiveness  Sales growth by product or service.
 Measures of customer base.
 Relative market share and position.
Quality of service  Quality measures in every unit.
 Evaluate suppliers on the basis of quality.
 Number of customer complaints received.
 Number of new accounts lost or gained.
 Rejections as a percentage of production or sales.
Customer satisfaction  Speed of response to customer needs.
 Informal listening by calling a certain number of customers
each week.
 Number of customer visits to the factory or workplace.
 Number of factory and non-factory manager visits to
customers.
Quality of working  Days absence
life  Labour turnover
 Overtime
 Measures of job satisfaction
21.4. BALANCED SCORECARD
The balanced scorecard measures performance in four different perspectives. It
employs a variety of financial and non-financial indicators.
➢ Financial perspective (financial success)–how do we create value for
our shareholders?
➢ Customer perspective (customer satisfaction)–how do existing and new
customers value from us?
➢ Internal business perspective (process efficiency)–what must process
we excel at?
➢ Innovation and learning perspective (growth)–can we continue to
improve and create future value?
In balanced scorecard these four perspectives are act as Critical Success
Factors (CSF). A critical success factor is a performance requirement that is

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fundamental (critical) to competitive success. These critical success factors have
number of Key Performance Indicators (KPI). These are the indicators used to measure
performance.
There are two types of key performance indicators.
▪ Financial key performance indicators( in monetary terms)
▪ Non-Financial key performance indicators(in non-monetary terms)
(1) Financial perspective: This considers how the organisation can create
value for its stakeholders. Performance measures are likely to include traditional
financial measures of profitability, cash flow and sales growth. This focuses on
satisfying shareholder value. Examples;
▪ Return on capital employed
▪ Profit margins
(2) Customer perspective: This looks at how existing and potential customers
see the organisation. Performance measures could include number of customer
complaints, new customers acquired, on- time deliveries etc. This is an attempt to
measure customers’ view of the organization by measuring customer satisfaction.
Examples;
▪ Customer satisfaction with timeliness
▪ Customer loyalty.
(3) Internal business perspective: This considers the processes at which an
organisation must excel if it is to achieve customer satisfaction and financial success.
Measures might include the speed of innovation, the quality of after sales service or
manufacturing time. This aims to measure the organization’s output in terms of
technical excellence and consumer needs. Examples;
▪ Unit cost
▪ Quality measurement
(4) Innovation and learning perspective: This looks at the organisation’s
capacity to maintain its competitive position through the acquisition of new skills and
the development of new products and services. This focus on the need for continual
improvement of existing products and techniques and developing new ones to meet
customers’ changing needs. Examples;
▪ A measure would include % of turnover attributable to new products.
The following important features of this approach have been identified:
▪ It looks at both internal and external matters concerning the
organization.
▪ It is related to the key elements of a company's strategy.
▪ Financial and non-financial measures are linked together.

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 The balanced scorecard approach may be particularly useful for performance
measurement in organizations which are unable to use simple profit as a performance
measure. For example the public sector has long been forced to use a wide range of
performance indicators, which can be formalized with a balanced scorecard
approach.
Advantages
▪ All four perspectives considered by manager: Managers need to look at
both internal and external matters affecting the organization. They also need
to link together financial and non-financial measures. Therefore they can
see how factors in one area affect all other areas.
▪ Consistency between objectives, control systems and staff: It can be
difficult to incorporate objectives into control systems such as budgets. So
targets set by a budget may conflict with objectives. Moreover, staff may
put their own interpretation on objectives against the actual intention of the
original objective. The balanced scorecard should improve communication
between different levels of the organization. The balanced scorecard strives
to keep all of these factors in balance.
Disadvantages
▪ Conflicting measures: Some measures in the scorecard such as research
funding and cost reduction may naturally conflict. It is often difficult to
determine the balance which will achieve the best results.
▪ Selecting measures: Not only do appropriate measures have to be devised
but the number of measures used must be agreed. Care must be taken that
the impact of the results is not lost in a sea of information.
▪ Expertise: Measurement is only useful if it initiates appropriate action.
Non-financial managers may have difficulty with the usual profit
measures. With more measure to consider this problem will be
compounded.
▪ Interpretation: Even a financially-trained manager may have difficulty in
putting the figures into an overall perspective.
21.5. BENCHMARKING
Benchmarking involves the establishment, through data gathering, of targets
and comparators, through whose use relative levels of performance (and particularly
areas of underperformance) can be identified. By the adoption of identified best
practices the performance of the organisation should be improved.
Types of benchmarking
▪ Internal benchmarking: This involves the comparison of different

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 departments or divisions within an organisation. Data for this is easy to
obtain and conditions are often comparable. Learning may be limited as
comparisons are only being made within the same company.
▪ Competitive benchmarking: This involves comparing performance
with that of direct competitors. The potential for learning is improved
but data may be difficult to obtain. For commercial reasons firms are
often unwilling to divulge information to direct competitors. The growth
of benchmarking clubs and trade associations has reduced the problems
of competitive benchmarking
▪ Functional benchmarking: Various functions in the business are
compared with those recognised as the best external practitioners of the
function. A manufacturing company could compare its invoice
preparation time with that of a credit card company, its delivery time
with a firm of couriers etc. The potential for learning how to improve
performance is very high, but comparability problems sometimes exist.
(This is sometimes referred to as operational or generic benchmarking)
▪ Strategic benchmarking: This involves comparison of performance
with competitors at the strategic level. Areas such as market share and
return on capital employed could be considered. Such comparisons are
important in designing competitive strategy.
Why use benchmarking?
✓ For setting standards: Benchmarking allows attainable standards to be
established following the examination of both external and internal
information. If these standards are regularly reviewed in the light of
information gained through benchmarking exercises, they can become
part of a program of continuous improvement by becoming
increasingly demanding.
✓ Its flexibility means that it can be used in both the public and private
sector and by people at different levels of responsibility.
✓ Cross comparisons (as opposed to comparisons with similar
organisations) are more likely to expose radically different ways of
doing things.
✓ It is an effective method of implementing change, people being involved
in identifying and seeking out different ways of doing things in their
own areas.
✓ It identifies the processes to improve.
✓ It helps with cost reduction.

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 ✓ It improves the effectiveness of operations.
✓ It delivers services to a defined standard.
✓ It provides a focus on planning.

CHAPTER 22: APPLICATIONS OF PERFORMANCE MEASUREMENT

Session objectives:
- Discuss performance measures for different kind of businesses
- Compare cost control and cost reduction.
- Describe and evaluate cost reduction methods.
- Describe and evaluate value analysis.
22.1. PERFORMANCE MEASURES
22.1.1. Performance mearures for manufacturing business
- Performance measures for sales
- Performance measures for material
- Performance measures for labour
- Performance measures for OH
- Performance measures of labour using standard hour
- Performance measures through cost per unit
22.1.2. Performance measures for services
There are 6 key dimensions to performance in the service sector
▪ Competitive Performance
▪ Financial Performance
▪ Quality
▪ Resource utilization
▪ Flexibility
▪ Innovation
Together these areas influence the competitiveness of the business and
ultimately its profitability.
22.1.3. Performance measurement in Non-profit Making Organisations
Performance cannot be judged by Profitability rather than it is judged in terms
of inputs and outputs which ties in with the Value for Money criteria.
▪ Economy

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 ▪ Efficiency
▪ Effectiveness
Problems with Non-profit Making Organisations:
▪ NFMOs tend to have multiple objectives
▪ Outputs can seldom be measured
Performance can be measured by
▪ Input – Output Relation
▪ Judgments
▪ Comparisons
▪ Unit cost Measurement
Performance measurement in Public Sector Organisations: Large volume of
information on performance and value for money is produced. This information is for
internal and external use. Performance can be measured against:
▪ Financial Performance Targets
▪ Volume of Output Targets
▪ Quality of Service Targets
▪ Efficiency Targets
22.2. COST CONTROL AND COST REDUCTION
Cost can be managed by:
▪ Reducing cost
▪ Controlling cost
- Cost reduction
▪ Cost reduction is a planned and positive approach to reduce expenditure.
▪ Its aim is to reduce cost to below budget.
▪ By changing working method, cost can be reduced to below current budget
or standards.
- Cost control
▪ Cost control is concerned with regulating the costs of operating a business
and keeping costs within acceptable limits.
▪ Acceptable limits mean standards or budgets.
▪ If actual cost varies from budgeted cost then cost action will be required.
▪ It means actual cost should be below the budget.
▪ Cost control actions lead to reduction in excessive spending.
22.2.1. Approaches of cost reduction
- There are two approaches used to reduce cost:
(1) Crash programme to cut spending levels
▪ Immediate plan to reduce spending without any proper planning like:

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 ✓ Some projects might be abandoned
✓ Deferred some expenses
✓ Stop new recruitments
✓ Redundant unnecessary employees.
▪ It might create a panic situation
▪ Poor planning may lead to poor efficiency
▪ May be cost reduced in short term but increase in long term.
▪ May be useful in time of crisis.
(2) Planned Programme to reduce cost
▪ It involves continual assessments of organization products, methods,
services and so on
▪ It is a planned approach
▪ It reduces the cost for long term
- Problems in introducing cost reduction programmes
▪ Resistance from employees
▪ To overcome this problem, proper communicate the programme through
some campaign
▪ If the programme introduced in one area may lead extra cost in other
area
▪ Not properly planned programme create panic situation
- Managers’ responsibilities in reducing cost
▪ They should have a positive approach
▪ They should do cost benefit analysis
▪ Investigate area of potential cost reduction and identify unnecessary
costs
▪ Cost reduction should be planned, agreed, implemented and monitored
by managers
- Scope of cost reduction
▪ Cost reduction should be applied to whole organization through
campaigns
▪ Cost reduction campaigns should have a long term aim as well as short
term objectives
▪ In short term only variable cost can reduce easily. Fixed cost remains
unchanged like rent
▪ Some fixed costs can be avoided in short term like advertising or sales
promotions. These are called discretionary fixed costs
▪ In long term variable and fixed costs both can be either avoided or

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 reduced
22.2.2. Methods of cost reduction
✓ Improving efficiency
✓ Improving efficiency includes:
▪ Improving efficiency of material usage
▪ Low level of wastage
▪ Better quality checks
✓ Improving labour productivity
▪ Pay incentives
▪ Change working methods
▪ Improving coordination between departments
▪ Give challenging standards
▪ Improving efficiency of equipment usage
▪ Better use of equipment resources
▪ Provide proper maintenance to avoid down time
✓ Material costs
▪ Avail bulk purchase discounts
▪ Introduce EOQ
▪ Use Cheap substitute material
▪ Improve store controls
✓ Labour cost
Work study is a mean of raising the productivity of an operating unit by
reorganization of work.
✓ Organization and methods (O&M)
It is a term for techniques, including method study and work measurement
that are used to examine clerical, administrative and management
procedures for improvements.
Critical examination of existing and proposed ways of doing work in order
to improve it through alternative cost reduction methods and establishing
the time for a skilled worker to carry out a specified job at specified level of
performance
✓ Finance Cost
▪ Avail cash discounts from suppliers
▪ Reassessed cash discounts offered to credit customers
▪ Borrow at low interest rates
▪ Improve foreign exchange dealings
✓ Rationalization

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 When organizations grow, especially through mergers and takeovers, there
is a tendency for work to be duplicated in different parts of the organisation.
The elimination of unnecessary duplication and concentration of resources
is a form of rationalisation.
✓ Expenses
▪ Authorised expenses
▪ Evaluate capital expenditure
▪ Continually questions about expense items
NOTE: ANOTHER APPROACH TO COST REDUCTION
Value analysis: It is a planned, scientific approach to cost reduction, which
reviews the material composition of a product and product’s design so that
modifications and improvements can be made which do not reduce the value of the
product to the customer or user. This means the value of the product remains same
with reduced cost.
Value engineering: It is the application of similar technique on new products
so that new products are designed and developed to a given value at minimum cost.
Values: There are four types of values:
- Cost value: It is a cost of producing and selling an item
- Exchange value: It is the market value of the product or service
- Use value: It is what the item does, what the purpose it fulfils
- Esteem value: It is the prestige the customer attaches to the product. It is
the value which is given by customer
Steps of value analysis
▪ Reduce unit cost so cost value is the only value which we try to reduce
▪ Value analysis try to provide same or improved use value in a low cost
▪ Value analysis try to maintain or enhance the esteem value at low cost
Role of senior management in value analysis
Value analysis programmes must have the full backing of senior management.
Management must therefore do the following:
▪ Provide support like acting as a member of Value analysis programs,
attend training sessions
▪ Establish goals for Value analysis programs to be achieved
▪ Select the personnel for value analysis
▪ Provide sufficient budget
▪ Insist on continual audit
▪ Give rewards

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