CHAPTER 1

THE SCOPE OF MANAGEMENT ACCOUNTING

Introduction

This is Paper L2 of the ZICA Accountancy Programme. This chapter will give an
introduction to management accounting. This chapter provides definitions and the link
between management accounting and financial accounting. The chapter will go further to
explain various terminologies, which form the basis for the Management Accounting
framework which are relevant in commerce and industry whether be it Public Sector or
Private Sector.
Contents

1. The need for Management Accounting systems.

2. Definition of Management accounting.
3. Comparison of Financial accounting and management accounting.
Learning outcomes

After studying this chapter the student should be able to:

• Define Management Accounting

• Compare and contrast financial and management accounting.
• Outline the managerial process of planning, decision-making and control.

1
 1.0 MANAGEMENT ACCOUNTING

Managers need detailed information about the working of the business to enable them
plan, control and make decisions. Management accounting systems provide financial
information regarding the financial aspects of business performance needed by
management.

1.1 Management accounting

Management accounting is the application of the principles of accounting and

financial management to create, protect, preserve and increase value so as to deliver
that value to the stakeholders of Profit and Not For Profit enterprises both public and
private.

2.0 FINANCIAL ACCOUNTING AND MANAGEMENT

ACCOUNTING

2.1 Financial accounting is the classification and recording of the monetary transactions
of an entity in accordance with established concepts, principles, accounting standards
and legal requirements and their presentation by means of Profit and Loss Accounts,
Balance Sheet and Cash Flow Statements, during and at the end of an accounting
period.

2.2 Many businesses have a financial accounting system with a nominal ledger, sales
ledger and purchases ledger and books of prime entry for recording transaction that
have occurred during a given period.

2.3 Comparison of financial accounting and management accounting

Financial accounts Management accounts

• Limited companies are • There is no legal
required by law to requirement to prepare
prepare financial management accounts.
accounts.
• The law and financial • Management accounting
reporting standards formats are entirely at the
prescribe formats of discretion of
published financial management.
statements.
• Most financial • Management accounts
accounting information incorporate both

2
 is of a monetary nature. monetary and non-
monetary measures.
• Financial accounts • Management accounts are
present an essentially both historical record and
historic picture of past future planning tool.
operations.

CHAPTER SUMMARY

Under this Chapter has been covered:

• Definition of Management Accounting

• Definition of Financial Accounting
• Comparison of Management Accounting with Financial Accounting

SELF REVIEW QUESTIONS

SELF TEST QUESTIONS

1. Define management accounting

2. Highlight key differences between management accounting and financial accounting

3
 CHAPTER 2

VARIANCE ANALYSIS
INTRODUCTION

Having introduced the concept of standard costing in the previous level, this stage will deal
with the computation of cost and sales variances and explanation of the possible causes of
variances. After demonstrating the computation of cost and revenue variances, they will be
summarized in the operating statement as a basis for reconciling budgeted and actual profit.

CONTENTS

1. Variance accounting.
2. Labour variances.
3. Material variances.
4. Overhead cost variances.
5. Sales variance.
6. Operating statement.
7. Causes of variances.

LEARNING OUTCOMES

After studying this chapter you will be able to:

• Know what is meant by variance and variance analysis.

• Understand the relationship between variances.
• Calculate revenue and cost variances.
• Prepare the operating statement.
• Explain the causes of variances.

4
 1.0 VARIANCE ANALYSIS

A variance is defined as:

The difference between a planned, budgeted, or standard cost and the actual cost
incurred. The same comparison may be made for revenues.

1.1 Variance analysis is defined as:

The evaluation of performance by means of variances, whose timely reporting should

maximize the opportunity for managerial action.

C h a r t o f c o m m o n v a r ia n c e s

o p e r a t in g p r o f it v a r ia n c e

T o t a l c o s t v a r ia n c e T o t a l s a le s
T y p e t it le h e r e m a r g in v a r ia n c e

T o t a l L a b o u r v a r ia n c e T o t a l M a t e r ia l V a r ia n c e T o t a l v a r ia b le T o t a l F ix e d S a le s m a r g in S a le s m a r g in
o v e rh e d O v e rh e a d p r ic e q u a n t it y V a r ia n c e
v a r ia n c e V a r ia n c e v a r ia n c e

R a te E f f ic ie n c y P r ic e U sage E x p e n d it u r e E f f ic ie n c y V lu m e E x p e n d it u r e
v a r ia n c e V a r ia n c e V a r ia n c e V a r ia n c e V a r ia n c e V a r ia n c e V a r ia n c e V a r ia n c e

C a p a c it y E f f ic ie n c y
v a r ia n c e v a r ia n c e

When actual results are better than expected results we have a favourable variance
and when the actual results are worse than the expected results, we have an adverse
variance

1.2 Variances can be divided into three main groups

• Variable cost variance

• Fixed production overhead variances
• Sales variance

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 1.3 KEY ILLUSTRATION

The following example will be used to illustrate the computation of all variances
including the preparation of an operating statement.

Kipata Manufacturing Company produces a single product which is known as

Kiwaya. The product requires a single operation and the standard cost for this
operation is presented in the following standard costs card.

STANDARD COST CARD

Direct materials K’000
Material X 0.5kgs @ 20
K40,000/Kg

Direct Labour
Grade A 2 hours @ 40
K20,000/Hr

Variable 2 hours @ 6
Production K3,000/Hr
overhead

Fixed 2 Hrs @ 74
Production K37,000/hr
overhead

Total standard 140

cost

Standard Profit 60
Standard 200
Price

Budgeted output for June was 5,100 units. Actual results for June were as follows:

Production of 4,850 units was sold for K 1,042.75 million.

Materials consumed in production amounted to 2,300 kilos at a cost of K98.9 million
Labour hours paid amounted to 8,000 hours at a cost of K162 million
Actual variable overheads amounted to K26 million
Fixed over heads amounted to K423 million

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REQUIRED

This information will be used to define and calculate the following variances:

1.40 TOTAL DIRECT MATERIAL COST VARIANCES

The direct material cost variance is the difference between what the output actually
cost and what it should have cost in terms of materials.

Total direct material cost variances =

(Standard material cost per unit x Actual units produced) – (Actual cost of
materials)

Using the data above:

DIRECT MATERIAL VARIANCE CALCULATION

Standard material cost per unit K20,000

Number of units produced 4,850 units

Actual cost = K98,900,000

Total material variance = (4,850 x K20,000) – (98,900,000)

K 1,900, 000 (A)

1.41 DIRECT MATERIAL PRICE VARIANCE

This is the difference between the standard cost and the actual cost of the actual
quantity of materials used or purchased. In other words it’s the difference between
what the material did cost and what it should have cost.

Direct Material Price Variances = (SP - AP) x QP

where:
SP = Standard Price
AQ = Actual Quantity
QP = Quantity Purchased

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 Using the data above:

DIRECT MATERIAL PRICE VARIANCE

CALCULATION
Standard material price K20,000
per Kilo
Quantity of materials 4,850 units
purchased
Cost of materials K98,900,000
purchased
Material Price Variance [40,000 – (98,900,000/2300)] x 2,300
= (40,000 – 43,000) x 2,300
K6,900,000 (A)

1.42 DIRECT MATERIAL USAGE VARIANCE

This is the difference between the standard quantity of materials that should have
been used for the number of units actually produced and the actual quantity of
materials used valued at the standard cost per unit of material.

Direct Material Usage Variances = (SU - AU) x SP

Where:
SU = Standard Usage = Number of units produced x standard usage per unit
AU = Actual Usage
SP = Standard Price

DIRECT MATERIAL USAGE VARIANCE

CALCULATION
Standard Material price per K20,000
Kilo

8
 Actual materials used 2,300 kilos
Standard material usage per 0.5 kg
unit
Number of units produced 4,850
Material Usage Variance = [(4,850 x 0.5)- 2300] x K40,000
(2,425- 2,300) x 40,000 =
K5,000,000 (F)

1.50 TOTAL DIRECT LABOUR COST VARIANCES

The direct labour cost variance is the difference between what the output actually cost
and what it should have cost in terms of labour.

Total direct labour cost variances =

(Standard labour cost per unit x Actual units produced) – (Actual cost of labour)

Using the data above:

DIRECT LABOUR COST VARIANCE CALCULATION

Standard Labour cost K40,000
per unit
Number of units 4,850 units
produced
Actual cost = K162,000,000

Total material variance (4,850 x K40,000) – (162,000,000)

= K 32,000, 000 (F)

1.51 DIRECT LABOUR RATE VARIANCE

This is the difference between the standard cost and the actual cost of the actual
number of hours used. In other words it is the difference between what the labour did
cost and what it should have cost.

Direct Labour Rate Variances = (SR - AR) x AH

Where:

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 SR = Standard Rate
AH = Actual Hours
AR = Actual Rate

Using the data above:

DIRECT LABOUR RATE VARIANCE CALCULATION

Standard Labour rate per K20,000
hour
Labour hours used 8,000 hours
Actual Labour cost K162,000,000
Labour Rate Variance = [(K20,000 – (K162,000,000,000/8,000)]
x 8,000
(20,000 – 20,250) x 8000
K2,000,000(A)

1.52 DIRECT LABOUR EFFICIENCY VARIANCE

This is the difference between the standard of labour that should have been used for
the number of units actually produced and the actual number labour hours used
valued at the standard labour hour rate.

Direct Labour Efficiency Variances = (SH - AH) x SR

Where:
SH = Standard Hours for actual production = Number of units produced x
standard usage per unit
AH = Actual Hours taken to produce the output
SR = Standard Rate per hour

DIRECT LABOUR EFFICIENCY VARIANCE

CALCULATION
Standard Labour Hours K20,000
per unit

Actual Labour hours 8,000 Hours

used

Standard Labour hours 2 Hours

per unit

Number of units 4,850

produced
Material Usage Variance [(4,850 x 2)- 8,000] x K20,000
= (9,700- 8,000) x K20,000 =

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 K34,000,000 (F)

1.60 TOTAL VARIABLE PRODUCTION OVERHEAD VARIANCE

The difference between what the output should have cost and what it did cost in terms
of variable production overheads.

TOTAL VARIABLE PRODUCTION OVERHEAD

(Standard Variable overhead cost per unit x Actual units produced) – (Actual
cost of Variable production overheads)

Using the data above:

TOTAL VARIABLE PRODUCTION OVERHEAD COST

VARIANCE CALCULATION
Standard VOH cost per K6,000
unit
Number of units 4,850 units
produced
Actual cost = K2,600,000
Total VOH cost variance (4,850 x K6,000) – (K26,000,000)
= K 3,100, 000 (F)

1.61 VARIABLE OVERHEAD EXPENDITURE VARIANCE

This is the difference between the amount of variable overheads that should have
been incurred in the actual hours actually worked and the actual amount of variable
overheads incurred..

Variable production overhead expenditure Variances = (BVOH x AH) -

AVOH

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 Where:
BVOH = Budgeted Variable Overhead Rate
AH = Actual Hours
AVOH = Actual Variable Overhead Rate

Using the data above:

VARIABLE OVERHEAD EXPENDITURE VARIANCE

CALCULATION
Budgeted Variable overhead rate K3,000
per hour

Labour hours used 8,000 hours

Actual Variable overhead Cost K26,000,000

Variable overhead expenditure (3,000 x 8000) – K26,000,000

Variance = K24,000,000 – K26,000,000
K2,000,000 (A)

1.62 VARIABLE OVERHEAD EFFICIENCY VARIANCE

This is the difference between the standard cost of the hours that should have been
worked for the number of units actually produced and the cost for the units actually
produced.

Variable Overhead Efficiency Variances = (SH - AH) x BVOH

Where:

SH = Standard Hours for actual production = Number of units

produced x standard usage per unit
AH = Actual Hours taken to produce the output
BVOH = Budgeted Variable Overhead Rate

VARIABLE OVERHEAD EFFICIENCY VARIANCE

CALCULATION
Budgeted variable K3,000
overhead rate per hour
Actual Labour hours 8,000 Hours
used
Standard Labour hours 2 Hours
per unit

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 Number of units 4,850
produced
Variable overhead [(4,850 x 2)- 8,000] x K3,000
Efficiency Variance = (9,700- 8,000) x K3,000 = K5,100,000 (F)

1.70 TOTAL FIXED OVERHEAD VARIANCES

The difference between fixed overhead incurred and fixed production overhead
absorbed. In other words it is the under or over absorption.

TOTAL FIXED PRODUCTION OVERHEAD=

(Standard Fixed Overhead Cost per unit x Actual units produced) – (Actual
cost of Fixed Production Overheads)

Using the data above:

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 TOTAL FIXED PRODUCTION OVERHEAD COST
VARIANCE CALCULATION
Standard FOH cost per K74,000
unit

Number of units 4,850 units

produced

Actual cost = K423,000,000

Total FOH cost variance (4,850 x K74,000) – (K423,000,000)

= K64,100, 000 (A)

1.71 FIXED OVERHEAD EXPENDITURE VARIANCE

This is the difference between the budgeted fixed overhead expenditure and actual
fixed overhead expenditure.

Fixed production overhead expenditure Variances = (BFOH - AFOH)

Where:
BFOH = Budgeted Fixed Overhead
AFOH = Actual Fixed Overhead

Using the data above:

FIXED OVERHEAD EXPENDITURE VARIANCE

CALCULATION
Budgeted Fixed K74,000 x 5,100
Overhead K377,400,000

Actual Fixed Overhead K423,000,000

Cost

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 Fixed Overhead K377,400,000 – K423,000,000
Expenditure Variance = K45,600,000 (F)

1.72 FIXED OVERHEAD VOLUME VARIANCE

Fixed Overhead Volume Variance is the difference between actual and budgeted
production/volume multiplied by budgeted fixed overhead absorption rate per unit.

Fixed production overhead Volume Variances =

(BV - AV) x BFOH
Where:
BV = Budgeted Volume
AV = Actual Volume
BFOH = Budgeted Fixed Overhead per unit

FIXED OVERHEAD VOLUME VARIANCE

CALCULATION
Budgeted Volume 5,100 Units

Actual Volume 4,850 Units

Budgeted Fixed K74,000

Overhead rate per unit
Fixed Overhead Volume (4,850 – 5,100 ) x 74,000
Variance = K18,500,000 (A)

1.73 FIXED OVERHEAD VOLUME EFFICIENCY VARIANCE

This is the difference between the standard cost of the hours that should have been
worked for the number of units actually produced and the cost for the units actually
produced.

Fixed Overhead Efficiency Variances = (SH - AH) x BFOH

Where:

SH = Standard Hours for actual production = Number of units

produced x standard usage per unit
AH = Actual Hours taken to produce the output
BFOH = Budgeted Fixed Overhead Rate

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 FIXED OVERHEAD VOLUME EFFICIENCY VARIANCE
CALCULATION
Budgeted Fixed K37,000
overhead rate per hour
Actual Labour hours 8,000 Hours
used
Standard Labour hours 2 Hours
per unit
Number of units 4,850
produced
Fixed overhead [(4,850 x 2)- 8,000] x 37,000
Efficiency Variance =
(9,700- 8,000) x 37,000 =
K62,900,000 (F)

1.74 FIXED OVERHEAD VOLUME CAPACITY VARIANCE

The difference between budgeted hours of work and the actual hours worked
multiplied by the standard absorption rate.

Fixed Overhead volume capacity Variances = (AH - BH) x BFOH

Where:

BH = Budgeted hours to produce budgeted volume

AH = Actual Hours taken to produce the output
BFOH = Budgeted Fixed Overhead Rate

FIXED OVERHEAD VOLUME CAPACITY VARIANCE

CALCULATION
Budgeted Capacity 5,100 x 2
10,200 Hours
Actual Labour hours 8,000 Hours
used

Budgeted FOH rate per K37,000

Hour unit

Number of units 4,850

produced
Fixed overhead (8,000 – 10,200) x K37,000

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 Efficiency Variance =
= K81,400,000 (A)

1.80 SALES VARIANCES

1.81 SELLING PRICE VARIANCE

The effect on expected profit when the actual selling price is different from the
budgeted selling price. It is calculated as actual selling price minus budgeted selling
price multiplied by actual volume of sales units.

Sales Price Variances =

(AP - BP) x AV
Where:
AV = Actual Volume of sales
AP = Actual Price per unit
BP = Budgeted Price per unit

SELLING PRICE VARIANCE CALCULATION

Actual selling Price K215

Budgeted Selling Price K200

Actual sales volume 4,850

Selling price Variance = (K215,000 – K200,000) x 4,850

= K72,750,000 (F)

1.82 SALES VOLUME VARIANCE

Sales volume variance measures the increase or decrease in expected profit as a result
of the actual sales volume being higher or lower than the budgeted volumes.

Sales Volume Variances = (AV - BV) x BP

Where:
BV = Budgeted Volume of sales
AV = Actual Volume of sales
BP = Budgeted Profit per unit

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 SALES VOLUME VARIANCE CALCULATION
Actual sales volume 4,850 units

Budgeted sales volume 5,100 units

Budgeted Profit K60,000

Sales volume price (4,850 – 5,100) x K60,000
Variance =
= K15,000,000 (A)

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OPERATING STATEMENT
Favourable Adverse Difference
6,900
Materials Price 5,000
Usage
Labour Rate 2,000
Efficiency 34,000
Variable
OH Expenditure 2,000
Efficiency 5,100
Fixed
OH Expenditure 45,600
Capacity 81,400
Efficiency 62,900
Sales Price 72,750
Volume 15,000

Total 179,750 152,900 26,850

Budgeted Profit
(5,100 x 60) 306,000

Actual Profit
(see working below) 332,850

W1
Actual Profit
computation
K'000
Material 98,900
Labour 162,000
VOH 26,000
FOH 423,000
Total cost 709,900
Sales 1,042,750
Profit 332,850

2.0 VARIANCES IN A STANDARD MARGINAL COSTING SYSTEM

As you may recall in an earlier stage, we covered the absorption and marginal costing
techniques. In our study of standard costing, we have so far used the standard
absorption costing technique where the standard unit cost of a product has also
included fixed production overhead.

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2.1 It is possible to use standard marginal costing and this will create two differences in
the way variances are calculated:

• In marginal costing, fixed costs are not absorbed into product costs and so there
are no fixed cost variances to explain any under or over absorption of overhead.
There will be no fixed overhead volume variances. There will be a fixed overhead
expenditure variance which is calculated in the manner demonstrated above.

• The sales volume variance will be valued at standard contribution margin (sales
price per unit minus variable costs of sales per unit), not standard profit margin.

3.0 DERIVING ACTUAL DATA FROM STANDARD COST DETAILS AND

VARIANCES (working back wards)

Exam focus

From time to time, section A has included questions which have needed the working
backward technique to find missing cost details.

This section deals with working backwards using variances to get any missing cost
details. The following examples will be used to demonstrate how to work out missing
cost details given materials and labour variances.

3.1 DERIVING STANDARD MATERIAL PRICE

XY Ltd purchased 6,850 kgs of material at a total cost of K21,920,000, the material
price variance was K1,370,000 favourable.

Required

Using the price variance formula, calculate the standard price per kg.

3.2 Solution

1,370,00
(SP - K21,920,000/6,850) x 6,850 = 0
6850 6850
SP - 3,200 200

SP = K3,400

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3.3 DERIVING STANDARD MATERIAL USAGE

In a period 23,870 Kgs of material were used at a total standard cost of K907,060.
The material usage variance was K247,000 favourable.

Required
Find the total standard allowed weight of material for the period.
3.4 Solution

Material Usage Variance = (SU - AU) SP

247,000 = (SU - 23,870 ) X K907,060/23,870

247,000 = (SU - 23,870 ) 38

6500 = SU - 23,870

30,370 kg = SU

3.5 DERIVING STANDARD LABOUR HOURS

In a period 6,500 units were made and there was an adverse labour efficiency
variance of K26 million. Workers were paid K8,000 per hour and total wages paid
were K182 million. There was a nil rate variance.

Required

Find the number of standard labour hours per unit.

3.6 Solution

Labour Efficiency Variance = SR (SH - AH)

Let SH stand for standard hours per unit

-26,000,000 = K8,000 (A x 6,500 - K182,000,000/8,000)

K8,000 (SH x 6,500 -
-26,000,000 = K182,000,000/8,000)
8,000 8,000

-3,250 = 6,500SH - 22,750

-3,250 +
22,750 = 6,500SH
19500 = 6,500SH
3 hrs = SH

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3.7 DERIVING ACTUAL HOURS WORKED

In a period 5,792 units were made with a standard allowance of 6.5 hours per unit at
K5,000 per hour. Actual wages were K6,000 per hour and there was an adverse
variance of K36 million.

Required

Find the number of labour hours actually worked.

3.8 Solution

Labour Rate Variance = AH (SR - AR)

AH (5,000 -
36,000,000 = 6,000)
36,000,000 = 1000AH
1,000 1000
36,000 = AH

4.0 THE REASON FOR VARIANCES

There now follows a list of possible causes of variances. This is not an exhaustive list
and in an examination question you should review the information given and use your
imagination and common sense to suggest possible reasons for variances.

VARIANCE FAVOURABLE ADVERSE

Material Unforeseen discounts Price increase
Price received Careless purchasing
Great care in Change in material
purchasing standard
Change in material
standard
Material Material used of higher Defective material
Usage quality than standard Excessive waste
More effective use Theft
made of material errors Stricter quality
in allocating material control
to jobs Errors in allocating
material to jobs
Labour Rate Use of workers at a Wage rate increase
rate of pay lower than
standard

Idle Time The idle time variance Machine breakdown

is always adverse Non-availability of
material

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 Illness or injury to
worker

Labour Output produced more Lost time in excess

Efficiency quickly than expected, of standard allowed
because of work Output lower than
motivation, better standard set because
quality of equipment of lack of training,
or materials sub-standard
Errors in allocating material etc.
time jobs Errors in allocating
time to jobs

Overhead Saving in costs Increase in cost of

Expenditure incurred services
More economical use Excessive use of
of services services
Change in type of
services used
Overhead Production or level of Production or level
Volume activity greater than of activity less than
budgeted budgeted

Selling Price Unplanned price Unplanned price

increase reduction

Sales Additional demand Unexpected fall in

Volume demand
Production
difficulties

Chapter summary

• Variances measure the difference between actual results and expected results.

• The Direct Material Total Variance can be subdivided into the direct Material Price
Variance and the Direct Material Usage Variance. Direct Material Price Variance are
extracted at the time of receipt of materials, not time of usage

• The Direct Labour Total Variance can be subdivided into Direct Labour Rate
Variance and Direct Labour Efficiency Variance.

23
 • The Variable Production Overhead Total Variance can be sub divided into Variable
Production Overhead Expenditure Variance and the Variable Production Overhead
Efficiency Variance

• The Fixed Production Overhead Total Variance can be subdivided into expenditure
variance and volume variance. The volume variance can be subdivided into efficiency
variance and capacity variance.

• The Selling Price Variance measures the effect on profit of a different selling price to
standard selling price

• The Volume Variance measures the effect on profit of actual sales volume being
different to budgeted sales volume.

• The operating statement shows how the combination of variances reconcile budgeted
profit and actual profit

• Variances can be used to derive actual data from standard cost details

• There are two main differences between variances calculated in absorption costing
system and the variances calculated in a marginal costing system.

o In a marginal costing system the only Fixed Overhead Variance is an

Expenditure Variance
o The Sales Volume Variance is valued at standard contribution margin , not
standard profit margin.

STUDENT-SELF TESTING

SELF REVIEW QUESTIONS

1. What is variance analysis ?

2. Mention the sub components of fixed overhead variance.
3. How do variances under marginal costing differ from those under absorption costing?
4. mention some causes of variances

EXAMINATION TYPE QUESTIONS

1. C Ltd uses a standard costing system. The standard cost card for one of its products
shows that the product should uses 4Kgs of material B per finished unit and the
standard price per Kg is K4,500.

For the month of April, the budgeted production level was 1,000 units and the actual
units made were 1040 units. The actual material quantity of material B used was
4,100 Kgs. The cost of the material B which was purchased was K14.4 million.

24
 Required

Calculate Total Material Variances and analyse it into Price and Usage Variances

2. Z plc uses a standard costing system and has the following labour cost standard in
relation to one of its products:

4 hours direct labour @ K6, 000 per hour = K24,000

During October 20X5, 3,350 of these products were made which was 150 units less
than budgeted. The labour cost incurred was K79, 893,000 and the number of direct
labour hours worked was 13,450.

Required

Calculate total Labour Variances and analyse it into Rate and Efficiency variances for
the month of October.

3. A company budgets to produce 1,000 units of product E during august. The expected
time to produce a unit of E is five hours, and the budgeted fixed production overheads
is K20 million. The standard fixed production overhead cost per unit of product E
will therefore be 5 hours @ K4,000 (=K20,000). Actual fixed production overhead
expenditure in august turns out to be K20,450,000. The labour force manages to
produce 1,100 units of product E in 5,400 hours of work.

Required

Calculate the following fixed production overhead variances

a) Total Variance.

b) Expenditure Variance.

c) Volume Variance.

d) Volume Efficiency Variance.

e) Volume Capacity Variance.

25
Chapter 3

RELEVANT COSTING AND DECISION MAKING

INTRODUCTION

One of the key management tasks is decision making. Decision-making is concerned with the
future and involves making a choice between alternatives. Many factors both qualitative and
quantitative need to be considered and for many decisions, financial information is critical.
The overriding requirement of the information that should be supplied by the cost accountant
to aid decision-making, is that of relevance. This chapter starts off by looking at the decision
making process and then rules for identifying relevant costs and revenues.

CONTENTS

1. Decision making process.

2. Relevant costs.
3. Irrelevant costs.
4. Relevant costs of materials.
5. Relevant costs of Labour.
6. Relevant costs of equipment.

LEARNING OUTCOMES

After reading this chapter you should be able to:

• Outline the decision making process.

• Describe the concept of relevant costing.
• Distinguish between relevant and irrelevant costs.
• State the rule for identifying relevant costs for materials, labour and equipment.

26
 1.0 The decision-making process

The decision making process has the following steps :

• Identify objectives.
• Search for alternative courses of action.
• Collect data about the alternative courses of action.
• Select the appropriate course of action.
• Implement the decision.
• Review.

The above steps are described in detail below:

1.1 Identify objectives

The first step in decision-making is to define organization objectives which provide a

framework for assessing the appropriate courses of action to be taken by managers.
For most organizations the main objective is profit maximization.

1.2 Search for alternative

Having established the objectives, the second step is to identify a number options that
would enable an organization achieve its objectives. A profit making organization
may have the following options to enable it increase profits:

• Development of new products

• Development of new markets

1.3 Collect data about the alternative courses of action

The management accountant will need to collect data about the environment in which
the organization operates and about the organisation’s capability. If the decision is
more concerned with the short-term future of the organization, such data as the selling
prices for competing products will have to be collected.

1.4 Select the appropriate course of action

Following the data collection exercise above, the course of action, which best satisfies
the organization should be selected.

1.5 Implement the decision

The chosen decision should be implemented.

27
 1.6 Review

This is the final stage in the decision making process where the actual and planned
outcomes are compared and any needed corrective measures are taken.

2.0 RELEVANT COSTS

A relevant cost is a future incremental cash flow, which arises as a direct result of a
decision.

The definition highlights several important features of a relevant cost.

Relevant costs are future costs

A decision is about the future and it cannot alter what has already been done. Costs
that have been incurred in the past are irrelevant to the decision that is being made
now about the future.

Relevant costs are cash flows

Only cash flow information is relevant to decision making. This means costs or
charges which do reflect additional cash spending e.g depreciation and notional costs
should be ignored for the purpose of decision making

Relevant costs are incremental Costs

A relevant cost is an incremental cost this means that as a direct consequence of the
decision.

2.1 Other terms used to describe relevant costs

Avoidable costs

Avoidable costs are defined as the specific costs of an activity or sector of a business
which would be avoided if that activity or sector did not exist.

Differential cost or incremental costs

Incremental or differential costs are defined as the difference in total costs between
alternatives calculated to assist in decision making. Differential costs are relevant
costs which are simply the additional costs incurred as a consequence of a decision.

28
Opportunity costs

Relevant costs may involve incurring a cost or losing a revenue. The loss of revenue
is known as opportunity cost.

Opportunity cost is defined as the value of a benefit foregone or sacrificed when one
course of action is chosen in preference to an alternative.

2.2 Irrelevant costs

A number of terms are used to describe costs that are irrelevant for decision making
because they are either not future cash flows or they are costs which will be incurred
anyway, regardless of the decision taken.

Non-relevant costs include

• Sunk costs
• Committed costs
• Notional costs
• Historical costs
• Non cash flow costs

Sunk costs

These costs are cost of resources already acquired where the total will be unaffected
by the choice between various alternatives. These are costs that have been created by
a decision made in the past and that cannot be changed by any decision that will be
made in the future.

An example of a sunk cost is a market research. Suppose that a company has spent
K10 million in advertising a product and has discovered 4000 units can be sold at a
price of K10, 000. In deciding whether to go ahead in producing the product the
market research cost of K10m is a sunk cost and irrelevant to the decision.

Committed costs

A committed cost is a future cash outflow that will be incurred anyway, whatever
decision is taken now about alternative opportunities. Committed costs may exist
because of contracts already entered into by the organization which it cannot now
avoid.

29
 Non-cash charges

Notional costs

A notional cost is a cost used in product evaluation and performance appraisal to

represent the cost of using resources which have no conventional costs.

Examples of notional costs in cost accounting systems are:

• Notional rent.
• Notional interest on capital employed.

Unavoidable costs

If a cost is unavoidable, it cannot be relevant to a decision because it will be incurred

anyway.

2.3 THE RELEVANCE OF VARIABLE COSTS AND FIXED COSTS

The general rule is that variable costs are relevant to decision making while fixed
costs are irrelevant. However exceptions to this rule does exist as shown below.

2.4 Non relevant variable costs

There might be occasions when a variable cost is in fact a sunk cost. For example if a
computer repair shop received a one-off request from a customer which calls for
replacing a component and this component is already in stock bought in the past for
K2000. If such a component will not be replaced neither has it got scrap value, nor
alternative value approached by a customer to carry out a one off.

In deciding whether to take up this job or not, though the material cost element
represent a variable cost element, it will not be relevant in this case

2.5 Relevant fixed costs

Although fixed costs are generally irrelevant, there might be occasions when a fixed
cost is relevant.

Directly attributable fixed costs

These are fixed costs which though fixed within a relevant range of activity are
relevant for either of the following reasons:

They would increase if certain activities were undertaken. For example if an extra
supervisor was employed if a particular job was taken.

30
General fixed overhead

General fixed overheads are those fixed overheads which will be unaffected by
decisions to increase or decrease the scale of operations, perhaps because they are an
apportioned share of the fixed costs of items which would be completely unaffected
by the decision. Such fixed costs are irrelevant.

3.0 RULES FOR IDENTIFYING RELEVANT COSTS

General principles for identifying relevant costs of the following cost elements will
now be covered below:

• The relevant costs of materials

• Relevant costs of labour
• Relevant costs of machines

3.1 THE RELEVANT COSTS OF MATERIALS

The relevant cost of raw materials is generally their current replacement costs, unless
the materials have already been purchased and would not be replaced once used. In
this case the relevant cost of using the materials is the higher of:

• The current resale value; and

• The value they would obtain if they were put to alternative use.

If the materials have no resale value and no alternative use, the relevant cost of using
the material for the opportunity under consideration is nil.

3.2 EXAMPLE

A new contract requires the use of 50 kg of material XZ41. This metal is used
regularly on the firm’s projects. There are 100 Kgs in stock at the moment, which
were bought for K20, 000 per Kg. The current purchase price is K21, 000 per Kg and
the material could be scrapped off for net scrap proceeds of K15, 000 per Kg. Assess
the relevant cost of materials for each of the cases below:

Case 1

Based on the details given above, what would be the relevant cost of the materials?

As the company would have to replace the 50 Kgs of material XZ41, the relevant cost
is the replacement cost for the materials. i.e 50 kg x K21,000 = K 1,050,000.

31
Case 2

Suppose material XZ41 that is in stock has no other use, what is the relevant cost for
the material?

The relevant cost is the opportunity of selling the material which is:

50Kg @ K15,000 = K750,000

Case 3

Suppose there is no alternative use for material XZ41 and only 25 Kgs of the material
is in stock, what would be the relevant cost?

K'000
Materials in stock (25Kg @15,000) disposal value 375
Materials to be bought (25@ K21,000) 525
Relevant costs for materials 900

Case 4

Suppose material XZ41 is in stock but it has no alternative use and has no disposal
value, what would be the relevant costs?

The relevant cost would be nil in this case.

3.3 THE RELEVANT COSTS OF LABOUR

In determining the relevant costs of labour, the key question is whether spare capacity
exists. The following guidelines can be used:

• If there is spare capacity, and employment terms are such that labour is a fixed
cost, the relevant cost is nil.

• If there is no spare capacity, two possibilities exist as follows:

o If extra labour comes from hired labour, the hire charge becomes the relevant
cost.
o If the extra labour is taken from another activity that earns a contribution for
the company, the relevant cost becomes the paid labour cost and the lost
contribution from that other activity.

32
3.4 EXAMPLE

Zacks Ltd is currently deciding whether to undertake a new contract that will require
15 hours of labour time. The standard cost per each product is as follows:

K'000
Direct Materials (10 kg @K2000) 20
Direct Labour (5 hrs@K6000) 30
Variable cost 50
Less: Selling Price 122
Contribution 22

Required

Assess the relevant costs in each of the following scenarios.

Case 1

The company has no spare capacity and decides to hire labour from outside, what is
the relevant cost for the new contract?

The relevant cost for the new product is:

15 hrs @ K6, 000 = K90,000

Case 2

Assuming the company has 5 hours spare capacity, what will be the relevant costs?

K'000
Direct Labour (10 hrs @K6000) 60
Opportunity Cost (5hrs @ 0) 00
Relevant costs for labour 60

Case 3

Assuming Zacks Ltd withdraws the required labour hours from a current activity
which earns a standard contribution, what would be the relevant cost for labour?

K'000
Direct Labour (15 hrs @K6000) 90
Opportunity Cost (22/5 * 15) 66
Relevant costs for labour 156

3.5 THE RELEVANT COSTS OF MACHINERY

33
 Only the following incremental costs of using machines should be considered:

• Repair costs arising from use

• Hire charges
• Any fall in resale value of owned assets which results from their use.

Depreciation is not a relevant cost.

3.6 EXAMPLE

A machine which originally cost K12 million with an estimated economic life of ten
years and is depreciated at a rate of K1.2 million per year. It has been unused for
sometime and there are no production orders.

A special order has now been received which would require the use of the machine
for two months.

The current net realisable value of the machine is K8 million. If it is used for the job,
its value is expected to fall to K7.5 million. The net book of the machine is K8.4
million.

Routine maintenance of the machine currently cost K400, 000 per month. With use,
the cost of maintenance and repairs would increase to K600, 000

Required

What is the relevant cost of using the machine for the order?

3.7 Solution

K'000
Fall in value of machine (K8m-K7.5m) 500
Maintenance costs (K600,000 - K400,000) x 2 400

Relevant cost of using machine 900

34
 CHAPTER SUMMARY

• This chapter has introduced the topic of Decision Making and has explained in great
details the concept of Relevant Costing. Some key points covered have been:

• Decision making has six steps which are:

o Identify objectives
o Search for alternative courses of action
o Collect data about the alternative courses of action
o Select the appropriate course of action
o Implement the decision
o Review

• Relevant Costs are future, incremental cash flows.

• An Opportunity Cost is the benefit foregone by choosing one opportunity instead of

the next best.

• Non-relevant Costs include Sunk Costs, Committed Costs, Notional Costs and
Historical Costs.

• Unless you are given an indication to the contrary, you should assume that variable
costs are relevant and that fixed costs are irrelevant for decision making

• The relevant cost of raw materials is generally their current replacement costs unless
the material have already been purchased and will not be replaced, in which case the
relevant cost of using them is the higher of their current resale value and the value
they would obtain if put to an alternative use.

• Using machinery will involve some incremental costs including

o Repair costs arising from use
o Hire charges
o Any fall in resale value of owned assets which results from use.

• The relevant costs of scarce resource is the sum of the contribution forgone from next
best opportunity for using scarce resources and the variable cost of the scarce
resource.

35
STUDENT-SELF TESTING

SELF REVIEW QUESTIONS

1. Mention the steps involved in Decision Making Process

2. Give characteristics of Relevant Costs
3. Give examples of Irrelevant Costs
4. When are labour and material costs irrelevant though variable?
5. When are fixed costs relevant in decision making?

EXAMINATION TYPE QUESTIONS

From the multiple choice questions below, choose the letter which best suits your selected
answer.

1. The costs most relevant to be used in decision making are:

A. Sunk costs
B. Current costs
C. Estimated future costs
D. Notional and full costs

2. Which of the following statements is NOT true?

A. Relevant costs change according to the decision

B. Relevant costs are always future costs
C. Fixed costs can never be relevant costs
D. Relevant costs are those specific to a decision

3. For decision-making purposes, which of the following are relevant costs?

A. Avoidable costs
B. Future costs
C. Opportunity costs
D. Differential costs

(i), (ii) , (iii) and (iv)

(i) and (iv)
(i) and (ii)
(ii) and (iii)

4. The labour requirements for a special contract are 250 skilled labour hours paid at

36
 K10, 000 per hour and 750 semi-skilled labour hours paid @ K8, 000 per hour.

At present skilled labour is in short supply, and all such labour used on this contract will
be at the expense of other work which generates a contribution of K12, 000 per hour.
There are 1,200 excess semi-skilled labour hours, but the firm has a policy of
redundancy.

The relevant cost for labour for the special contract is:

A. K3 million
B. K5.5 million
C. K8.5 million
D. K11.5 million.

5 In order to utilize some spare capacity, Chola is preparing a quotation for a special order
which requires 1,000 kilograms of material G.

Chola has 600 Kg of material G in stock (original cost K5, 000 per Kg). Material G is
used in the company’s main product Q. The resale value of material G is K4, 000 per Kg.
The present replacement price of material M is K6, 000. Material G is readily available
on the market.

The relevant cost of the 1000 Kgs of material R to be included in the quotation is :

A. K4 million
B. K5 million
C. K5.4 million
D. K6 million

37
 CHAPTER 4

SHORT TERM DECISIONS

INTRODUCTION

Having introduced the concept of relevant costing in the previous chapter, this chapter
proceeds to apply the concept to short run decision situations such as scarce resources, make
or buy, close down of business segments and minimum pricing for one-off or special orders.

CONTENTS

1. Make or buy decisions.

2. Limiting factors.
3. Close down decisions.
4. Special pricing situations.
LEARNING OUTCOMES

After studying this chapter you should be able to:

• Identify the optimal production solution when there is one limiting factor.
• Solve Make or Buy decisions when there is one limiting factor.
• Apply the concept of Relevant Costing to business decisions.
• Use relevant costing concept to solve Special Order Pricing problem.
• Use Relevant Costing to decide on closure of business segment.

38
 1.0 LIMITING FACTOR PROBLEMS

Although sales demand is a factor that often stops a company from increasing its
profits, there are sometimes situations in which some resources could be in short
supply making it impossible for a company to increase its profits.

A scarce resource is an item in short supply. In the context of decision making in

business, it is a resource in short supply and as a consequence of which the
organization is limited in its ability to provide and sell more products or services.
Such scarce resources are also called limiting factors.

1.1 Examples of scarce resources are:

• A limit on the availability of a key item of raw materials or a key component.

• A limit on the availability of a key type of labour such as skilled or qualified
labour.
• A limit on available machine time.

1.2 Decision problem

When a business has a limiting factor, a decision must be taken about how the
available resources should be used.

1.3 Approach

• Identify the scarce resources.

• Calculate contribution per unit of product.
• Calculate the units of the scarce resources used by each product.
• Rank the products based on contribution per limiting factor.
• Allocate resources according to the ranking.

1.4 QUESTION

Z Ltd makes two products which both use the same type of materials and grades of
labour but in different quantities as shown below:

Product X Product B
Labour Hours per 2 4
unit
Materials – Kg per 5 2
unit
Demand 500 250
Sales price per K30,000 K36,000
unit

39
 During each week the maximum number of labour hours available is 1,800 and the
quantity of materials available is limited to 3000Kg.The labour rate is K5,000 per
hour and materials cost K2,000 per Kg.

Required

Advise Z Ltd on a profit maximizing production plan.

1.5 SOLUTION

Step 1 Identification of limiting factor

Product Demand Labour Hours Total Hours

X 500 2 1,000
Y 250 4 1,000

Total hrs required 2,000

Available 1,800
Shortfall 200

Product Demand Materials Total kg

X 500 5kg 2,500
Y 250 2kg 500

Total 3,000

Available 3,000

Shortfall Nil

The conclusion is that only direct labour hours are a limiting factor.

40
Step 2 Contribution Computation
Product X Product Y
K000 K000
Sales Price 30 36
Labour (10) (20)
Material (10) (4)
Contribution 10 12

Step 3 Contribution per Limiting Factor

Product X Y

Contribution (K'000) 10 12
Labour hours per unit 2 4
Contribution per Hour (K'000) 5 3

Step 4 Ranking 1st 2nd

Step 5 Optimal Production Plan

Hours per
Units Unit Total Hours
Product X 500 2 1000
Product Y 200 4 800
Available Hours 1800

2.0 Make or Buy Decisions

A Make or Buy decision involves a decision by an organization about whether it

should make a product/carry out an activity with its own internal resources or whether
it should pay another organization to make the product/carry out the activity.
Examples of Make or Buy decisions would be as follows:

• Whether a company should manufacture its own components or buy components

from an outside supplier.

• Whether a company should have its own service department such as a cleaning
department or subcontract the activity to an external cleaning company

There are two situations in which the Make or Buy decisions may arise:

41
 • A business currently manufactures its own products or components and an
external supplier offers to make them instead. The choice is simply whether to
make the item in house or whether to buy them externally.

• Alternatively a company may be faced with a short fall in its own in-house
capabilities leading to a need to sub contract some work to makeup for the
shortfall. In such a situation, the business might have to decide not only whether it
should buy some units externally but which items should be purchased as well in
order to maximise profit.

2.1 Bickson Ltd makes four components A, B, Cand D for which the costs in the
forthcoming period are as follows:

Product A B C D
Units 500 1000 2000 1500
Unit marginal K’000 K’000 K’000 K’000
costs
Direct materials 8 10 4 8
Direct Labour 16 18 8 12
Variable 4 6 2 4
production
overheads

Total variable 28 34 14 24
costs

Fixed costs per annum are as shown below:

K’000
Fixed costs specific to production 2,000
of A
Fixed costs specific to production 10,000
of B
Fixed costs specific to production 12,000
of C
Fixed costs specific to production 16,000
of D
General fixed costs 30,000
Total 60,000

An external supplier has offered to supply units of A,B,C and D for

K24,000,K42,000, K20,000 and K28,000 respectively.

Required

Decide whether Bickson Ltd should make or buy the components.

42
2.2 SOLUTION AND DISCUSSION

The relevant costs in this question are the differential costs between the making and
buying options and they consist of differences in unit variable costs plus differences
in directly attributable fixed costs.

The company would save K8 million by subcontracting product A where the

purchase costs would be less than the marginal costs per unit of making internally and
the company would save K 2 million in fixed costs.

SOLUTION A B C D
Costs K'000 K'000 K'000 K'000
Unit variable cost of
buying 24 42 20 28
Unit variable cost of
making 28 34 14 24
Extra cost of buying (4) 8 6 4
Volume 2,000 4,000 8,000 6,000
Total extra cost of
buying (8,000) 32,000 48,000 24,000
Saving in fixed costs (2,000) (10,000) (12,000) (16,000)
(Net saving)/Extra
costs (10,000) 22,000 36,000 8,000

Conclusion:

The company should make products B, C and D as they have a higher relevant cost of
buying. It should make product A.

2.3 OTHER CONSIDERATIONS AFFECTING THE DECISION

Management would need to consider other factors before reaching a make or buy
decisions. Some would be quantifiable and others would be not:

• Continuity and control of supply

Can the outside company be relied upon to meet requirements in terms of
quantity, quality, delivery dates and price stability?

• Alternative use of resources

Can the resources used to make this article be transferred to another activity
which will save costs or increase revenue?

• Social/legal
Will the decision affect contractual or ethical obligations to employees or
business connections?

43
 3.0 MAKE OR BUY WITH LIMITING FACTOR

In cases where a company cannot meet orders because it has exhausted all available
capacity, it may have to subcontract some of the work in order to meet the shortfall in
the short term. The short-term decision faced by the company is to decide on which
work should be subcontracted and which one should be done in house.

In the long term management may look to such alternatives as capital expenditure.

3.1 Decision rule

The decision would be made after ranking the products according to extra purchasing
costs per unit of limiting factor.

Products with higher extra costs of buying should be made in house.

3.2 QUESTION

Gogo Ltd manufactures three components X,Y and Z used in its finished product. The
component workshop is operating at full capacity and is not able to meet the current
demand for the component. An external supplier has offered to supply the
components at a unit price of K2,500, K6,000 and K13,000 respectively. The variable
costs per product and machine requirements are as follows:

Component Component Component

X Y Z
Variable K3,000 K4,000 K7,000
costs
Machine 2 2 4
Hrs

Required

Establish the order in which products should be bought from the external supplier.

3.3 SOLUTION

SOLUTION

Compo
Component Component nent

44
 X Y Z
K'000 K'000 K'000
Outside Purchase Price 2,500 6,000 13,000
Variable Cost of Production 3,000 4,000 7,000
Extra cost of buying (500) 2,000 6,000
Machine Hours 2 2 4
Extra cost of buying per machine Hour
saved (250) 1,000 1,500

Ranking- order of buying 1st 2nd 3rd

The rule is to buy the product with the lowest extra cost of buying.

4.0 CLOSURE OF BUSINESS SEGMENT

Where part of a business appears to be unprofitable, a company is faced with a

decision whether to allow such a segment to continue or to shut it down. The segment
may be a product, a department, or channel of distribution.

In evaluating the closure the cost accountant should evaluate the following:

• Loss of contribution from the segment

• Savings in specific fixed costs
• Penalties e.g redundancy, compensation to customers
• Alternative uses of resources released

4.1 Example

Kanjombe stores comprises three department namely kitchenware, garden tools and
plumbing equipment. The company is concerned about the poor performance and is
considering whether or not to close down the plumbing tools section.

Estimated results for the store are as follows:

Kitchenware Garden tools Plumbing tools Total

K' million K' million K' million K' million

Sales 400 600 200 1,200

Direct Cost of sales 200 360 150 710
Departmental costs 50 100 30 180

45
 Apportioned Store
Costs 50 50 50 150
Total costs 300 510 230 1,040
Profit/(Loss) 100 90 (30) 160

Required

Assuming that the company cannot raise prices advise whether the section should be
closed down and comment on any other factors which should be considered in
making this decision.

4.2 Solution

As long as the section makes contribution which is higher than the specific fixed
costs, it is advisable to continue running the section in the short run. If the section was
shut down, overall profit would fall as shown below:

Plumbing
Kitchenware Garden tools tools Total
K' million K' million K' million K 'million

Sales 400 600 - 1,000

Direct Cost of sales 200 360 - 560

Departmental costs 50 100 - 150

Apportioned Store Costs 50 50 50 150

Total costs 300 510 50 860

Profit/(Loss) 100 90 (50) 140

As shown above closure of the plumbing section is not advisable in the short run as it
leads to a drop in the overall profit of K20 million due to loss in the contribution,
which the product was making to fixed costs.

Additional comments

If the plumbing section were closed down what would the do with the resources
released from the closure?

46
 For example, suppose the company could sell a new product, a computer accessory
from that space which could generate K300 million per year with direct cost of sales
of K180 million and departmental costs of K50 million, the revised results would as
shown below:

Kitchenware Garden tools Computer Total

Accessories
K' million K' million K' million K' million

Sales 400 600 300 1,300

Direct Cost of
sales 200 360 180 740
Departmental costs 50 100 50 200
Apportioned Store Costs 50 50 50 150
Total costs 300 510 280 1,090
Profit/(Loss) 100 90 20 210

In this scenario, the deletion of the plumbing tools department and the its replacement
with the computer accessories department would be the recommended course of
action.

5.0 ONE-OFF CONTRACT

This is a decision making situation where a company which is operating at below full
capacity is approached by a customer who is offering a price lower than the normal.

The relevant costs to consider in this case are the variable manufacturing costs, and if
the price being offered covers the variable costs the company should accept the
contract.

5.1 Example

BB Ltd makes a single product which sells for K20,000 it has a full cost of K15,000
which is made up as follows:

K’000
Direct material 4
Direct labour (2 6
hours)
Variable 2
overhead

47
 General 3
overhead
Total 15

The labour force is currently working at 90% of capacity and so there is capacity for
2,500 units. A customer has approached the company with a request for the
manufacture of a special order of 2,000 units for which he is willing to pay K26
million.

Required

Assess whether the order should be accepted.

The relevant cost to consider is the variable costs. Fixed costs will be incurred
regardless of whether the contract is accepted and so are irrelevant to the decision
above.

5.2 SOLUTION

K'000
Variable costs per unit 12
Order size 2,000
Total variable costs 24,000
Value of order 26,000
Profit 2,000

Conclusion

The order should be accepted because the proposed selling price covers the variable
cost.

Other factors to consider in the one-off decision include:

• The possibility of other customers asking for similar lower prices

• There could be more profitable ways of using the spare capacity
• The possibility that additional fixed costs could be incurred

STUDENT-SELF TESTING

SELF REVIEW QUESTIONS

1. What is a limiting factor?

2. Give examples of limiting factors

48
 3. What is the decision rule in limiting factor problems
4. What is the basis for choosing between the make or buy option?
5. What other factors should be considered in Make or Buy decisions
6. On what basis should the decision be made in the short run whether to close down a
loss making operation?

EXAMINATION TYPE QUESTIONS

Kalubobo Limited has 5,000 kgs of materials P in stock for which it paid K2 million. The
material is no longer in use in the company and could be sold for K150 per Kg.

Kalubobo Ltd is considering taking on a single special order which will require 8,000 kgs of
material P. The current purchase price of material P is K500 per Kg.

In the assessment of the relevant costs of the decision to accept the special order, the cost of
material P will be:-

A. A sunk cost of K2,000,000

B. A sunk cost of K2,000,000 and an incremental cost of K1,500,000
C. An opportunity cost of K750,000 and an incremental cost of K1,500,000
D. An incremental cost of K400,000.

49
Chapter 5

COST VOLUME PROFIT (CVP) ANALYSIS

INTRODUCTION

This chapter looks at a decision-making technique called cost volume profit analysis (CVPA)
commonly known as Breakeven Analysis. This concept looks at the relationship between
costs and sales and volumes in business. The chapter defines and demonstrates the breakeven
point computation in terms of sales volume and revenue. It further shows the computation of
the volumes for desired levels of profit and how to prepare breakeven charts.

CONTENTS

1. Breakeven calculation.
2. Margin of safety.
3. Target profit computation.
4. Breakeven charts.
5. Limitations of CVP analysis.

LEARNING OUTCOMES

After studying this chapter you should be able to:

• Explain the concept of Breakeven and Margin of Safety.

• Calculate Breakeven Point and Margin of Safety.
• Use CVP analysis to calculate the sales required to achieve a target profit.
• Construct a single product breakeven chart and profit volume charts.
• Explain the limitations of Breakeven Analysis concept.

50
 1.0 Major Assumptions behind CVPA

• All costs can be resolved into fixed and variable elements.

• Fixed costs will remain constant and variable costs vary proportionately with
activity.
• Over the activity range being considered costs and revenues behave in linear
fashion.
• The only factor affecting costs and revenues is volume.
• Technology, production methods and efficiency remain unchanged.
• There are no stock level changes.

1.1 Uses of CVP analysis

CVP analysis is used widely in preparing financial reports for management. It is a

simple technique that can be used to estimate profits and make decisions about the
best course of action to take. Application of CVP analysis include:

• Estimating future profits.

• Calculating the breakeven point for sales.
• Analyzing the margin of safety in the budget.
• Calculating the volume of sales required to achieve a target profit.
• Deciding on a selling price for a product.

1.2 The breakeven point

Breakeven is the volume of sales at which the business makes neither a profit nor a
loss. At breakeven point total revenue equal total costs. Breakeven shows the
minimum operating levels below which an organization should not go in order to
avoid making a loss.

1.3 Breakeven computation

Break even can be computed using three approaches which are :

• Contribution per unit

• Contribution sales ratio
• Graph method

Contribution per unit method

Break Even Point in Fixed Costs

Units =
Contribution per Unit

51
 Contribution sales ratio

Break Even Point in sales

Fixed Costs
revenue =
Contribution sales ratio

1.4 Illustration

The following details relate to a shop that currently sells 25,000 pairs of shoes
annually:

Selling price per pair K320,000

Purchase cost per pair K200,000

Total annual cost fixed costs

Salaries K800,000,000
Advertising K320,000,000
Other fixed expenses K800,000,000

Required

Calculate the breakeven point using:

a) Contribution per unit

b) Contribution sales ratio
c) Graph method

1.5 SOLUTION
a)
K'000
Break Even Point in Units 1,920,000 = 16,000 Pairs
120
b)

K'000
Unit Contribution
Contribution Sales Ratio Selling Price = K120,000 = 38%
K320,000
K'000 K'0
Fixed Costs 1,920,000 5,0
Break Even - Sales revenue CS ratio = 38%

52
BREAK EVEN CHART

c)

100
0
ue
en
ev
900 lR
o ta
TTotal Cost
800

700

600

500

400
K’000

300 Fixed Cost

200

100

2 3
0 5 10 15 20 5 0
(000
Volume )
Breakeven Point
16,000
units

2.0 MARGIN OF SAFETY

The difference between budgeted sales volume and breakeven sales is known as the
Margin of Safety. It is simply a measurement of how far sales can fall short of the
budget before the business makes a loss.

A large margin of safety indicates a low risk of making a loss where as a small
margin of safety might indicate a fairly high risk of a loss.

2.1 EXAMPLE

Margin of safety is usually expressed as a percentage of budgeted sales.

In the last example the margin of safety is as follows:

Budgeted sales 25,000

53
 Breakeven sales 16,000
Margin of safety (25,000- 16,000) Units
9,000 units or 9000/25000 = 36%

2.2 Target Profit

CVPA can be used to calculate the volume of sales that would be required to achieve
a target level of profit. To achieve a target profit, the business will have to earn
enough contribution to cover all fixed costs and then make the required amount of
profit.

Volume to make target profit ( TP) is given by:

Fixed Costs + Target

Profit
Contribution per unit

2.3 Example

Zaks Ltd has capital employed of K100 million its target profit on capital employed is
20% per annum. Zaks Ltd manufactures a standard product sigma with the following
details:

Selling Price K60, 000

Variable Cost K20, 000
Annual Fixed cost K100 million

Required

What volume of sales is required to achieve target profit?

2.4 Solution

Target profit 20% of K100 million = K20 million

Volume required to make target profit (TP) is:

K100,000,000m +
K20,000,000
K40,000

54
 3,
0
K120,000 0
,000 0
u
ni
= ts
K40,000

2.5 Sensitivity Analysis and CVP Analysis

In the context of CVP analysis sensitivity analysis answers such questions as

• What will operating profit be if the output level decreases by say 5%?
• What will operating profit be if the variable costs increased say 5%?

2.6 LIMITATIONS OF BREAK-EVEN ANALYSIS

Though break even analysis is a useful technique for managers, the techniques has
several limitations including the following:

• It can only apply to a single product or a single mix of a group of products.

• A breakeven chart may be time consuming to prepare.
• It assumes fixed costs are constant at all levels of output.
• It assumes that variable costs are the same per unit at all levels of output.
• It assumes that sales prices are constant at all levels of output.
• It assumes production and sales are the same.
• It ignores the uncertainty in the estimates of fixed costs and variable cost per unit.

55
 Chapter summary

• Cost-Volume –Profit analysis is the study of the interrelationship between costs,

volume and profits at various levels of activity.

• Breakeven point is the is the point at which profit is zero, where total revenue is equal
to total cost

• Breakeven point formula

Contribution per unit method

Break Even Point in Fixed Costs

Units =
Contribution per Unit

Contribution sales ratio

Break Even Point in Fixed Costs

Sales value
=
Contribution sales ratio

• Margin of safety is the difference in units between the budgeted sales volume and the
breakeven sales volume. It is sometimes expressed as a percentage of the budgeted
sales volume.

• A company’s target profit is achieved when the total contribution is

= Fixed costs + required profits

• The breakeven point can also be determined graphically using the simple breakeven
chart or a contribution breakeven chart.

• Breakeven analysis is a useful technique for managers as it can provide simple and
quick estimates. Breakeven charts provide a graphical representation of breakeven
arithmetic. Breakeven analysis does have a number of limitations, which are based on
the assumptions made in the analysis

56
STUDENT-SELF TESTING

SELF REVIEW QUESTIONS

1. What are the major assumptions behind CVPA

2. Mention some applications of CVPA
3. Define the break even point
4. State the formula for calculating BEP?
5. What is margin of safety?
6. What are the limitations of CVPA?

EXAMINATION TYPE QUESTIONS

The following information relates to questions 1 and 2

A business sells a single product at a selling price of K40, 000 with a contribution to sales
ratio of 30%. The fixed cost for the period is K210 million.

1. The number of units that must be sold to break even is

2. If the business wishes to make a profit of K60 million, the number of units that must
be sold is

The following information relates to question 3 and 4

K Limited’s product has the following cost and selling price structure:

K'000
Selling Price 64
Variable cost 34
Fixed Cost 10
Profit 20

Budgeted activity is 1,050 units per month

3. The budgeted margin of safety as a percentage of budgeted sales each month is

57
 %

4. To achieve a profit of K24 million in a month, the number of units that must be
sold is

5. A product has the following budgeted operating statement for the sale of 1000 units.

Sales 10,000
Variable costs 6,000
Contribution 4,000
Fixed costs 2,500
Profit 1,500

You are required to compute:

a) The C/S ratio

b) Breakeven sales and units
c) Margin of safety
d) The sales volume required to make a target profit of K2 million

58
 CHAPTER 6
PRICING DECISIONS
Introduction

Pricing is a very important type of decision that normally faces managers in organisations.
Accounting information is often an important input to pricing decisions. There are two
approaches to arriving at a price namely cost based and demand based approach. The chapter
will mainly focus on the cost basis as outlined in the syllabus.

Contents

1. Factors affecting pricing.

2. Full cost pricing approach.
3. Marginal cost based pricing.
4. Other pricing strategies.

Learning outcomes

After studying this chapter the student should be able to:

• Explain other factors affecting the price of a product or service.

• Calculate prices using full cost and marginal cost.
• Discuss advantages and disadvantages of these pricing bases.
• Discuss suitable pricing strategies for specific business situations.

59
1.0 FACTORS INFLUENCING THE PRICE OF A PRODUCT

We start by discussing factors that affect the price of products and services by looking
at basic economic analysis of demand.

Effective pricing decisions should be based on a careful consideration of the

following factors:

• Organization goals- like any other decision making process, consideration of the
organizations objectives is the first step in setting suitable prices. For example an
organization whose key objective is to maximize cash generation should set prices
that reflect this goal.

• Product Mix- an organisation which produces and sells a range of products

should set the prices for each product within the mix in a manner that maximises
cash flow generated from the whole mix.

• Price/demand relationship- for most products, at higher prices the demand for
the product is low and as the price is reduced the quantity demanded increases. It
is thus important that a price setter should have the knowledge of price/demand
relationship for his product.

• A knowledge of the price elasticity of demand- price elasticity of demand refers

to the responsiveness of changes in demand to changes in prices. The concept of
price elasticity is important when an organisation intends to adjust the current
price. They should know what the likely impact would be on demand.

• Competitors and markets – when setting selling prices it is always important to

consider the possible reaction from the competitors.

• Product life cycle- each product goes through a cycle which include,
introduction, growth, maturity, saturation and decline phases. The price must be
set with reference to the stage the product has reached in the cycle.

• Marketing strategy- selling prices should be set with reference to the overall
marketing strategy. For example, a company whose marketing strategy
emphasises heavy advertising can afford to charge higher prices.

• Costs – in the long run, all operating costs must be fully covered by the sales
revenue.

Factors affecting demand in the market as a whole include:

 The price of the good

60
  The price of other goods
 The size and distribution of household income
 Expectation
 Obsolescence
 Quality of the product
 Tastes and fashions

2.0 FULL COST-PLUS PRICING

Full-cost plus pricing is a method of determining the sales price by calculating the full
cost of the product and adding a percentage mark-up for profit. The full cost may be a
fully absorbed production cost only or it may include some absorbed administration,
selling and distribution overhead.

This pricing method is common in industries that carry out contract or jobbing work
for which quotations are regularly prepared for individual jobs or contracts. The
percentage profit is predetermined by the organization. However, the profit markup
should not be rigid and fixed, it should be varied to suit different circumstances.

2.1 EXAMPLE

Lenco Ltd has begun to produce a new product, called Sigma for which the following
cost estimates have been made:

K'000
Direct Materials 27
Direct Labour (5 hrs@K6000) 30
Variable production Overheads (5hrs at K2,500) 25
Total variable cost 82

Production fixed overheads are budgeted at K30 million per month and budgeted
direct labour hours are 25,000 per month. The absorption rate will be based on labour
hours. The company wishes to make a profit of 20% on full production cost from
product Sigma.

Required

Ascertain the full cost-plus based price.

61
2.2 SOLUTION

K'000
Direct Materials 27.00
Direct Labour (5 hrs@K6000) 30.00
Variable production Overheads (5hrs at K2,500) 25.00
Fixed overheads (K30,000,000/25,000x5) 6.00
Total cost 88.00
Mark up (20% of K88) 17.60
Selling price 105.60

2.3 Advantages of full cost-plus pricing

• It is quick, simple and cheap method of pricing.

• It gives a price which ensures that all costs are covered.

2.4 Disadvantages of full cost-plus pricing

• It causes problems of finding a suitable overhead absorption basis.

• Budgeted output volume needs to be established as it is a key factor in the
deriving of overhead absorption rate.
• It does not consider market and demand condition.
• It ignores the existence of a profit maximizing price.

3.0 Marginal cost-plus pricing

Marginal cost-plus pricing is a method of determining the sales price by adding a

profit margin on to either marginal cost of production or marginal cost of sales.

3.1 Example

A product has the following costs:

K'000
Direct Materials 5
Direct Labour 3
Variable production Overheads 7
Total variable cost 15

Fixed overheads are K10 million per month. Budgeted sales are 400 units to allow the
product to break even.

62
 Required

Determine the profit margin which needs to be added to marginal costs to allow the
product to break even.
3.2 SOLUTION

At breakeven point , fixed cost = Total contribution

; K10, 000,000 = 400 (Price - 15,000)
25,000 = Price - 15,000
Price = K40,000

3.3 Advantages of marginal cost-plus pricing

• It is a simple and easy method to use.

• It draws management attention to contribution, a concept which is important to
decision making.

3.4 Disadvantages of marginal cost-plus pricing

• It does not pay sufficient attention to demand conditions, competitors prices and
profit maximization.
• It ignores fixed overheads in the pricing decisions, but pricing decisions must be
sufficiently high to ensure that a profit is made after covering fixed costs.

4.0 OTHER PRICING POLICIES

4.1 Special orders

A special order is a one-off revenue earning opportunity. The basic approach in such
a situation is to determine the price at which the company breaks even or the
minimum price it would charge. This is the price at which the company covers the
incremental costs of producing and selling the product and the opportunity costs of
the resources consumed.

4.2 Market penetration pricing

Market penetration pricing is a policy of low prices when the product is first launched
in order to obtain sufficient penetration into the market. Penetration prices aim to
secure a substantial total market.

Circumstances in which penetration policy may be appropriate include:

• Where a firm wishes to discourage new entrants into the market.

63
 • where there are significant economies of scale to be achieved from high volume
of output.
• where demand is highly elastic and so would respond well to low prices.

4.3 Market skimming pricing

Market pricing involves charging high prices when a product is first launched and
spending heavily on advertising and sales promotion to obtain sales.

The aim of market skimming is to gain high unit profits early in the products life.
High unit prices make it more likely that competitors will enter the market than if
lower prices were charged.

Circumstances in which market skimming policy may be appropriate include:

• Where the product is new and different, so that customers are prepared to pay
high prices.
• Where the strength of demand and the sensitivity of demand is unknown.
• Where the product has a shorter life cycle and so there is need to recover the
development costs and make profit relatively quickly.

64
 Chapter summary

• This chapter has considered the last topic in the decision-making area of the syllabus,
namely, pricing. The following are some of the key points highlighted.

• Several factors including the following should be considered in making pricing

decisions:

o Product life cycle.

o Marketing strategy.
o Organization goals.
o Product Mix.
o Price/demand relationship.
o Knowledge of the price elasticity of demand.
o Competitors and markets.

• In full cost plus pricing the sales price is determined by calculating the full cost of the
product and then adding a percentage mark-up for profit.

• Marginal cost cost-plus pricing involves adding a profit margin to the marginal cost
of production/sales

• The most important criticism of cost plus pricing is that it fails to recognize the
relation between price and demand.

• The basic approach to pricing special orders is to establish the relevant cost of the
order and this becomes the minimum price that can be charged.

• Three alternative pricing strategies for new products are market penetration pricing,
market pricing and premium pricing.

STUDENT-SELF TESTING

SELF REVIEW QUESTIONS

1. Mention factors that should be considered in pricing decisions?

2. What is full cost-plus pricing?
3. What are some disadvantages of full cost-plus pricing?
4. What is market penetration
5. What is market skimming pricing strategy ?

65
 CHAPTER 7

INTRODUCTION TO BUDGETING

Introduction

One of the functions of the standard costing technique is to assist in budgeting. We now turn
our attention to budgeting starting with this chapter that will introduce the concept and
illustrate the preparation of functional budgets. As you progress through the chapters you will
notice that budgeting is a very important tool used by accountants in the planning and control
of a business.

CONTENTS

1. Definition of a Budget.
2. Objectives of Budgeting.
3. Responsibility accounting.
4. Feedback.
5. Feed forward.
6. Preparation of Functional Budgets.

LEARNING OUTCOMES

After studying this chapter you should be able to:

• Define a Budget.
• Understand the objectives of Budgeting.
• Understand the Budget preparation process.
• Explain typical problems faced in Budgeting.
• Prepare Functional Budgets.

66
1.0 DEFINITION

A budget is a quantitative expression of a plan of action prepared in advance of the

period to which it relates.

A budget may be prepared for the business as a whole, for departments, for functions
such as sales and production or for financial and resource items such as cash, capital
expenditure, manpower and purchases.

1.1 OBJECTIVES OF BUDGETING

The key objectives of a budgeting process are:

• Communication
• Control
• Coordination
• Planning
• Motivation
• Performance evaluation
• Resource allocation

67
 OBJECTIVE COMMENT
Planning Annual budgeting gives management an opportunity to
prepare detailed plans which are required to implement
the corporate strategic plans.

Coordination The budget serves as a vehicle through which actions of

the different parts of an organization are brought together
and reconciled into a common plan. Without a budget
managers may be making conflicting decisions.

Communication Through the budget, the top management communicates

its expectations to lower level management, so that all
members of the organization may understand these
expectations. Additionally it is not just the budget itself
that facilitates communication; there is a lot of exchange
of vital information during the planning process itself.

Motivation The interest and commitment of employees can be

retained via a system of feedback of actual results which
lets them know how well or badly they are performing.

Control A budget is a yardstick against which actual performance

is measured and assessed. Control is provided by
comparing the actual with the budget after which
corrective actions are taken to eliminate the variances.

Performance A manager’s performance is often evaluated by

evaluation measuring his or her success in meeting the budget. The
budget provides a useful means of informing managers
of how well they are performing in meeting targets that
they previously helped in setting.
Resource Budgets are used to allocate resources to various section
allocation of an organisation

2.0 HOW BUDGETS ARE PREPARED

2.1 Budget centre

A budget centre is a clearly defined part of an organisation for which a budget is

prepared for budgetary control purposes.

The selection of budget centre in an organisation is an important step in the budgeting

system.

68
2.2 Budget period

The budget period is the period for which a budget is prepared and used, which may
then be subdivided into shorter control periods.

The length of the budget period is affected by the following factors:

• The nature of the business – power supply companies may have longer budget
period of up to 20 years, while clothing industry would be better off with shorter
periods.

• The nature of the cost items – budget period for capital cost items is normally
longer than that for revenue cost items.

• The basis of control – a company with a quarterly reporting system is likely

should have quarterly budget period.

2.3 Budget committee

A typical budget committee comprises the chief executive, the management

accountant who is the budget officer and functional heads. The functions of the
committee are to:

• Coordinate budget preparation.

• Issue timetables for budget preparation.
• Allocate responsibilities for the preparation of functional budgets.
• Provide information for the preparation of budgets.
• Suggest amendments to budgets.
• Approve budgets after amendments.
• Assess the budgeting and planning process.

2.4 Budget manual

The budget manual is a collection of instructions governing the responsibilities of

persons and the procedures, forms and records relating to the preparation and use of
budgetary data.

The management accountant is responsible for the preparation of the budget manual
and the manual normally include the following:

• Explanation of the objectives of the budgeting process.

• Organizational structure highlighting budget holders.
• Outline principal budgets.
• Administrative details including details for budget time table for budget
preparation.

69
 • Procedural matters such as specimen forms, account codes and specimen reports.

2.5 BUDGET PREPARATION PROCESS

The budget preparation process is as follows:

• Communicating details of the budget policy and budget guidelines.

• Determining the factor that restricts output.
• Preparation of the sales budget.
• Preparation of functional budgets.
• Negotiation of budgets with superiors.
• Coordination and review of budgets.
• Final acceptance of budgets.
• Budget review.

2.61 COMMUNICATING DETAILS OF THE BUDGET POLICY AND BUDGET

GUIDELINES

Strategic details should be communicated to the managers responsible for preparing

budgets.

Managers should also be provided with important guidelines for wage rate increases,
changes in productivity as well as information about industry demand and output.

2.62 DETERMINING THE FACTOR THAT RESTRICTS OUTPUT

Before any plans could be prepared, management should identify the limiting factor
also known as principal budget factor. This is a factor that restricts or limits an
organisation’s performance for a given period.

For many organizations sales demand happens to be the limiting factor. However, the
principal budget factor could also be machine capacity, distribution and selling
resources, the availability of key raw materials or cash.

2.63 PREPARATION OF THE SALES BUDGET

As sales demand is a common limiting factor, the initial plan to be prepared is the
sales budget. Some factors that are considered in preparing a budget are:

• Past sales pattern

• The economic environment
• Results of market research
• Anticipated advertising

70
 • Pricing policies and discounts.

In addition to the above factors, management may use forecasting techniques such as
time series and linear regression to estimate future sales demand.

2.64 PREPARATION OF FUNCTIONAL BUDGETS

Based on the sales budget, the following functional budgets can be prepared:
• Finished goods stock budget
• Production budget
• Material usage budget
• Machine utilisation budget
• Labour budget
• Raw material purchases budget
• Overhead cost budget

2.65 NEGOTIATION OF BUDGETS WITH SUPERIORS

Once managers have prepared their draft budgets, they present it to their superiors for
discussion after which the superior consolidates their budgets.

2.66 COORDINATION AND REVIEW OF BUDGETS

The whole budgeting process is fairly complex and functional budgets may be
reviewed several times before final approval. Such reviews may imbalance one
budget against another hence the need for the budget officer to coordinate the whole
process.

2.67 FINAL ACCEPTANCE OF BUDGET

When all functional budgets have been completed, they are summarized into a Master
Budget consisting of a Budgeted Profit and Loss account Budgeted Balance Sheet and
Cash Budget.

2.68 BUDGET REVIEW

Budgeting process does not end for the current year once the budget period has
begun; budgeting is a continuous process. During the budget period the actual results
are compared with budget. Corrective measures are taken to eliminate negative
variances. If variances have occurred due to unrealistic budgets, then the budgets are
revised.

71
 Chapter summary

In introducing the concept of budgeting, the following have been covered:

• A budget is a quantitative expression of a plan of action prepared in advance of the

period to which it relates.

• The key Objectives of a budgeting process are:

o Communication
o Control and
o Coordination
o Planning
o Motivation
o Performance evaluation
o Resource allocation

• A typical Budget Committee comprises the chief executive, the management

accountant who is the budget officer and functional heads.

• The Budget Manual is a collection of instructions governing the responsibilities of

persons and the procedures, forms and records relating to the preparation and use of
budgetary data.

• The budget preparation process is as follows:

o Communicating details of the budget policy and budget guidelines
o Determining the factor that restricts output
o Preparation of the sales budget
o Preparation of functional budgets
o Negotiation of budgets with superiors
o Coordination and review of budgets
o Final acceptance of budgets
o Budget review

• A Budget Centre is a clearly defined part of an organisation for which a budget is

prepared for budgetary control purposes.

• The Budget Period is the period for which a budget is prepared and used, which may
then be subdivided into control periods.

72
STUDENT-SELF TESTING

SELF REVIEW QUESTIONS

1. Define the term Budget.

2. What are the objectives of Budgeting?
3. What are the functions of the Budget Committee?
4. Outline the budget preparation process.

EXAMINATION TYPE QUESTIONS

End of chapter questions

1. Which of the following are aims of budgeting? (Tick all that apply)

Planning

Coordinating

Delegating authority

Maximising sales demand

Controlling

Increasing output

Communication

2. Which of the following are functions of the Budget Committee? (Tick all that
apply)

Coordinate budget preparation

Agree policy with regard to budgets

Prepare budgets for sales demand

73
 CHAPTER 8

PREPARATION OF FUNCTIONAL AND CASH

BUDGETS

Introduction

Having introduced the concept of budgeting in the previous chapter, this chapter will
demonstrate how to prepare functional budgets and the cash budget. This chapter covers a
topic that has frequently been subject of the examinations.

CONTENTS

1. Budget preparation.
2. Sales budgets.
3. Production budgets.
4. Raw material usage budget.
5. Labour budgets.
6. Overheads budget.
7. Purchases budget.
8. Master budget.
9. Cash budgets.
LEARNING OUTCOMES

After studying this chapter you should be able to:

• Prepare Functional Budgets

• Prepare Cash Budgets
• Prepare a Master Budget

74
 THE STEPS IN BUDGET PREPERATION

Step 1 Sales Budget

Step 2 Production Budget

Step 3 Raw material Labour Budget Factory overhead

Cost of goods budget

Selling and Genera and

Distribution administration
Step 4 budget budget
MASTER BUDGET

Budgeted profit and

Step 5 loss

Capital expenditure
Step 6 Cash budget budget

Budgeted balance
Step 7 sheet

75
 1.2 PREPARATION OF FUNCTIONAL BUDGETS

Functional budgets are the budgets for the various functions and department of an
organisation. They therefore include Production Budgets, Marketing Budgets, Sales
Budgets, Personnel Budgets, Purchasing Budgets and Research and Development
Budget.

1.3 EXAMPLE – FUNCTIONAL BUDGETS

The following example will be used to illustrate the preparation of functional budgets:

Metallurgical Enterprise manufactures two products known as Alpha and Sigma.

Alpha is manufactured in department 1 and Sigma in department 2. The following
information is available for 20X5.

Balance sheet for the accounting year 20X5

Fixed assets K'000 K'000

Land 85,000
Buildings and Equipment 646,000
Less depreciation 127,500 518,500
603,500

Current Assets

Finished goods 49,538

Raw materials 94,600
Debtors 144,500
Cash 17,000
305,638

Less current liabilities

Creditors 124,400
Net Current assets 181,238
Net assets 784,738

Share Capital and reserves

Ordinary shares K1000 each 600,000

Reserves 184,738
784,738

76
Standard costs per unit

Alpha Sigma
K K

Material X 10 kg@K180 1,800 8 kg@K180 1,440

Material Y 5 kg@K400 2,000 9 kg@K400 3,600

10 hrs@K300 per 15 hrs@K300
Labour Hr 3,000 per Hr 4,500
Variable
Production
overhead Dept 1 10 hrs@K80 per Hr 800
15 hrs@K70
Dept 2 per Hr 1,050

Total variable
cost 7,600 10,590

Other relevant information for 20X6

Department 1 Department 2
Budgeted Fixed
Overhead K14, 280 K 7,160

Stocks Finished goods

Alpha Sigma
Forecast Sales (units) 8,500 1,600
Selling price K10,000 K14,000
Closing Stocks (units) 1,870 90
Opening stocks (units) 170 85

Raw materials
Material X Material Y
Closing stocks (Kg) 8,500 8,000
Opening stocks (Kg) 10,200 1,700

Other Fixed costs K13.8 million

REQUIRED

Prepare the following budgets.

77
 i) Sales budget.
ii) Production budget.
iii) Raw materials.
iv) Labour budget.
v) Overhead budget.

1.31 The Sales budget

Selling Total
Product Volume price (K'000)
Alpha 8,500 K10,000 85,000
Sigma 1,600 K14,000 22,400

Total revenue 107,400

1.32 The Production Budget

The production budget is usually expressed in quantity and represents the sales being
adjusted for opening and closing stocks as shown below:

Sigm
Product a Alpha
Sales 1,600 8,500
Add closing Stock 90 1,870
Less opening stock (85) (170)
Production 1,605 10,200

1.33 The raw materials usage budget

Materials Materials
X Y
Product Kg kg
Sigma 1,605 x 8Kg 12,840 1,605 x 9Kg 14,445
Alpha 10,200 x 10Kg 102,000 10,200 x 5Kg 51,000
Total 114,840 65,445

1.34 The raw materials Purchases budget

Material Material
X Y
Production 114,840 65,445
Add closing Stock 10,200 1,700
Less opening stock (8,500) (8,000)
Production 116,540 59,145
Purchase Price K180 K 400
Total Cost(K'000) 20,977.2 23,658

78
 1.35 The Labour Budget

Hrs
per Total
Product Volume unit Hrs
Sigma 1,605 15 24,075
Alpha 10,200 10 102,000
Total hrs 126,075
Rate per Hour K300
Total Labour cost 37,823

1.36 The factory overhead budget

Department Department
1 1
Labour Hours 10,200.00 1,605.00
Overhead rate K 80.00 K 70.00
Total Variable OH (K'000) 816.00 112.35
Fixed production overhead 14,280.00 7,159.80
Total overheads 15,096.00 7,272.15

1.37 Master budget

When all the functional budgets have been prepared, they are summarized and
consolidated into a Master budget which consists of the budgeted profit and loss
account, budgeted balance sheet and cash budget which provides the overall picture
of the planned performance for the budget period.

79
STUDENT-SELF TESTING

SELF REVIEW QUESTIONS

1. Define the term Budget.

2. What are the objectives of Budgeting?
3. What are the functions of the Budget Committee?
4. Outline the Budget preparation process.

EXAMINATION TYPE QUESTIONS

QUESTION ONE

You are presented with the following budgeted Cash Flow data for your organisation for the
period November 20X4 to June 20X5. It has been extracted from the functional budgets that
have already been prepared.

Nov X4 Dec X4 JanX5 Feb X5 Mar X5 Apr X5

K'0 K'0
K'000 K'000 K'000 00 00 K'000
65,0 70,
Sales 40,000 50,000 55,000 00 000 75,000
45,0 55,
Purchases 20,000 30,000 40,000 00 000 65,000
10,0 12,
Wages 5,000 6,000 8,000 00 000 14,000
7,50 7,5
Overheads 5,000 5,000 7,500 0 00 10,000
Dividends 10,000
Capital
Expenditure 15,000 20,000

You are also told the following:

(a) Sales are 40% cash and 60% credit. Credit sales are paid two months after the
month of sale
(b) Purchases are paid the month following the purchases
(c) 75% of wages are paid in the current month and 25% the following month
(d) Overheads are paid the month after they are incurred
(e) Dividends are paid three months after they are declared
(f) Capital expenditure is paid two months after they are incurred
(g) The opening cash balance is K7.5 million.

Required

Prepare a cash budget for the six month period January to June 20X5

80
QUESTION TWO

The following information is relevant to questions 2, 3 and 4

A business is preparing its Production Budget, Material Usage and Material Purchases
Budget for the forth-coming period. Each unit of the product uses 6 Kgs of material X. Other
known information is as follows:

Relevant details
Budgeted Sales of Sigma 4,600 units
Current stock of finished goods 800 units
Required closing stock of finished 1,100 units
goods
Current stock of raw materials 2,400 Kgs
Required closing stock of raw 3,000 Kgs
material

Required

Calculate the following:

a) Budgeted production for the period

b) Budgeted material usage
c) Budgeted material purchases

81
QUESTION THREE

GM engineering

GM engineering Ltd produces two product called A and B using two raw materials, X and Y.
The work is done in two departments, machining and assembly. Estimates collected for the
forth coming period for the two products and the relevant resources are as shown below.

Product A B
Demand for the company’s products 8,500 1,600
Selling Price per unit 4,000 5,600
Ending Inventory 1,870 90
Beginning inventory 170 85

Raw Materials requirements

Material X 1.5 kilos 0.5 kilos
Material Y 2.0 kilos 4.0 kilos

Material Material
X Y
Raw material stocks
Beginning inventory 500 500
Closing inventory 490 480
Raw material cost per kilo (K’000) K1.5 K1.0
Direct labour hours per unit 6hrs 9hrs
Labour rate per hour (K’000) K1.6 K1.6
Machining Assembly

Production overheads 45,000 23,000

Machine Hours 3,000hrs 2,300hrs

Required

From the above information prepare the following functional budgets:

a) Sales Budget
b) Production Budget
c) Material Usage
d) Purchases Budget
e) Plant utilisation Budget
f) Labour Budget
g) Production Overhead Budget
h) Total production cost Budget

82
CHAPTER 9

BUDGETARY CONTROL AND BEHAVIOURAL

IMPLICATIONS OF BUDGETING

INTRODUCTION

You should by now have a full grasp of the budgeting process and be able to prepare
functional budgets and consolidate them into a Master Budget. This chapter looks at the use
of budgets for control by using the Flexible Budgeting technique. The chapter further looks
at the impact of budgets on staff motivation.

CONTENTS

1. Budgetary control.
2. Fixed budgets.
3. Flexible budgets.
4. Behavioural implications of budgeting.

LEARNING OUTCOMES

After studying this chapter, the student should be able to:

• Explain the concept of Budgetary control.

• Define fixed and Flexible Budgets.
• Apply Flexible Budgets for control.
• Assess the behavioural implications of budget control and performance evaluation,
including participation in budget setting.

83
1.0 FIXED BUDGET

A fixed budget is a budget which is designed to remain unchanged regardless of the

volume of output or sales achieved.

When the actual volumes of production are different from the budget in a control
period, a fixed budget is not adjusted to the new levels of activity.

The major purpose of a fixed budget is at the planning stage, when it is used to define
the broad objectives of the organization.

1.1 FLEXIBLE BUDGETS

A budget which by recognizing different cost behavior patterns, is designed to change

as volume of output changes.

Flexible budgets may be used in two ways:

• At the planning stage- Where an organization expects a wide range of output and
sales, the flexible budgeting technique may be used to prepare contingency plans
for the various possible output levels.

• At the end of the period- In order to carry out effective budgetary control,
flexible budgeting technique can be used to adjust the original budget in line with
the actual level of output.

1.2 BUDGETARY CONTROL

Definition

Budgetary control involves drawing up budgets for the areas of responsibility for
individual mangers and of regularly comparing actual results against expected results.
The difference between actual results and expected results are called variances and
these are used to provide guideline for control action by individual managers.

84
1.3 It is wrong to use fixed budgets as a basis for control action within an
organization as shown below:

Comment on
Budget Actual Variance Variances
Production and sales
units 2000 3000
K'000 K'000 K'000
Sales 200,000 300,000 100,000 Favourable
Direct Materials 60,000 85,000 (25,000) Adverse
Direct Labour 40,000 45,000 (5,000) Adverse
Maintenance 10,000 14,000 (4,000) Adverse
Depreciation 20,000 22,000 (2,000) Adverse
Rent and rates 15,000 16,000 (1,000) Adverse
Other Costs 36,000 50,000 (14,000) Adverse

Total cost 181,000 232,000 (51,000) Adverse

Profit 19,000 68,000 151,000 Favourable

1.4 Using the variances contained in the above statement for control purposes is
meaningless. Costs were higher because the output volume was also higher.

1.5 The correct approach to budgetary control is as follows:

• Identify fixed and variable costs

• Produce a flexible budget using marginal costing technique.

1.6 The following assumptions will be used to prepare a Flexible Budget base on the
budget above:

Cost Cost behavior

Direct material, direct labour, Variable
maintenance

Depreciation Fixed
Rent and rates
Other costs Semi-variable
Fixed component = K16
million
Variable = K 1000 per
unit

85
 1.7 Converting the original fixed budget into flexible budget

Original Adjustment to flex

Budget original budget Flexed budget
Flexing sales revenue
Sales 200,000 200000/2000 x 3000 300,000
Flexing Variable costs
Direct Materials 60,000 60,000/2000 x 3000 90,000
Direct Labour 40,000 40,000/2000 x 3000 60,000
Maintenance 10,000 10,000/2000 x 3000 15,000
Fixed costs
Depreciation 20,000 No adjustment 20,000
Rent and rates 15,000 No adjustment 15,000
Semi variable costs
Other Costs 36,000 16000+ 3000 x 10 46,000
Total cost 181,000 246,000

1.8 Budgetary control statement based on flexed budget

Flexed Comment on
Budget Budget Actual Variance Variances
Production and
sales units 2000 3000
K'000 K'000 K'000 K'000

Sales 200,000 300,000 300,000 100,000 Favourable

Direct
Materials 60,000 90,000 85,000 5,000 Favourable
Direct
Labour 40,000 60,000 45,000 15,000 Favourable
Maintena
nce 10,000 15,000 14,000 1,000 Favourable
Depreciati
on 20,000 20,000 22,000 (2,000) Adverse
Rent and
rates 15,000 15,000 16,000 (1,000) Adverse
Other
Costs 36,000 46,000 50,000 (4,000) Adverse

Total cost 181,000 246,000 232,000 14,000 Adverse

Profit 19,000 54,000 68,000 86,000 Favourable

The variances based on the revised budgets are more meaningful. Management
can take corrective measures based on the above budget.

86
2.0 BEHAVIOURAL IMPLICATIONS OF BUDGETING

In designing and using budgets for planning and control, the management accountant
should consider the impact of budgets on people’s behaviour. In the past behavioural
scientists have complained that accountants have not given sufficient consideration to
the impact of control systems such as budgetary control.

2.10 In particular we shall examine the following behavioral aspects of budgeting.

• Goal congruence
• The use of budgets as targets
• Communication
• Motivation
• Budget bias or slack variable
• Participation
• Using budgets for performance evaluation

2.11 GOAL CONGRUENCE

The ideal budgeting system is one which encourages goal congruence. This simply
means that the goals of individuals and groups should coincide with the goals and
objectives of the organization as a whole. Although goal congruence is difficult to
achieve, recognition must be given to the fact that organizations objective cannot be
imposed through a budget with no regard to individual objectives.

2.12 THE USE OF BUDGETS AS TARGETS

Research studies have provided substantial evidence that existence of a defined

quantitative goal or target is likely to motivate higher levels of performance than
would be achieved if no such targets were set. Ideally such targets should coincide
with personal goals. A good budgeting system should ensure that targets are clearly
defined agreed and accepted by individuals concerned.

2.13 COMMUNICATION

Communication between and across layers in the organization is an important factor

in any planning and control system. Lack of communication is likely to lead to non
acceptance by users of such systems; they could even hamper the operation of such
systems.

Research has shown that frequent up to date communication of budgetary planning

and control information to a manager has a motivating effect.

87
2.14 BUDGETARY SLACK

Budgetary slack is the difference between the minimum necessary costs and the costs
built into the budget or actually incurred. In the process of preparing budgets
managers might deliberately overestimate costs or under estimate revenue so that they
will not be blamed in the future for overspending and poor results.

In controlling operations managers must then ensure that their spending rises to meet
their budgets otherwise they will be blamed for careless budgeting.

2.15 MOTIVATION

Motivation is what makes people behave in the way they do. It comes from individual
attitude, or groups attitudes. Individuals will be motivated by personal desires and
interests. These may be in line with objectives of the organization and some people
live for their organization. For others they may consider their job as a chore and their
motivation may be unrelated to the organization objectives.

It is therefore vital that the goals of management and employees harmonise with the
goals of the organization as a whole. This is known as goal congruence. Although
goal congruence is a behavioral issue, it is possible to design and run a budgetary
control system which will go some way towards ensuring that the goal congruence is
achieved. Managers and employees must be therefore must be favorably disposed
towards budgetary control system for it to operate efficiently.

2.2 PARTICIPATION

In relation to participation there are three possible styles namely

• Top down (imposed)

• Bottom up (participatory)
• Negotiated style

2.21 TOP DOWN (IMPOSED)

In this approach to budgeting top management prepares a budget with little or no

input from operating personnel which is then imposed upon employees who have to
implement the budget.

This style is good in the following circumstances:

• In newly formed organizations.

• In very small businesses.
• During period of economic hardship.
• When operational managers lack budgeting skills.

88
2.22 Advantages and disadvantages of the imposed style are:

2.23 Advantages of Imposed Management Style

• Time taken to finalise budgets is reduced.

• High quality budgets due to reduce input from inexperienced people.
• Budgets are likely to include all strategic issues.
• Realistic to the extent.

2.24 Disadvantages of Imposed Management Style

• Defensiveness and low morale amongst staff.

• Does not support team spirit.
• Limited acceptance of organization goals and objectives.
• Lower level management not given sufficient planning skills.

2.25 PARTICIPATIVE STYLE OF BUDGETING

In this budgeting approach budgets are developed by lower managers who then
submit the budgets to the superiors for review and consolidation,

Participative budgets are suitable in the following circumstances:

• Well established organization.

• Large organizations.
• When operational managers have budgeting skills.
• When the organization different units enjoy a measure of autonomy.

2.26 Advantages and disadvantages of the above approach include:

2.27 Advantages of Participative Management Style

• Morale and motivation is likely to be improved.

• They likely to be more realistic.
• They are based on information from employees with relevant knowledge.
• Coordination between units is improved.

2.28 Disadvantages of Participative Management Style

• They consume more time.

• Slack may be built in by managers.
• Changes made by senior managers may cause dissatisfaction.
• Low level managers may lack budgeting skills.

89
2.29 NEGOTIATED STYLE OF BUDGETING

The above two styles are two extremes. In practice different levels of management
often agree budgets by a process of negotiation. The budgeting process is a
bargaining process and this process is vital to making the budget more effective.

Chapter summary

Some key concepts covered in the chapter have included the following:

• Fixed budgets are budgets that have been designed to remain unchanged
regardless of the level of activity.

• Flexible budgets are budgets that have been designed to vary with changes in the
level of activity.

• Budgetary control involves the setting up of budgets and using them as a basis for
taking control actions. The concept of flexible budgeting is useful to budgetary
control.

• There are basically two ways in which a budget can be set from the top- imposed
style or from the bottom – participatory. Each system has its own advantages and
disadvantages.

• Used correctly a budgetary control system can motivate, but it can also produce
undesirable negative reactions.

• Factors that affect people in the process of setting up, implementing and using
budgets include the following:

o The use of budgets as targets

o Motivation
o Participation
o Goal congruence
o Using budgets for performance evaluation
o Communication
o Budget bias or slack variable

90
STUDENT-SELF TESTING

SELF REVIEW QUESTIONS

1. What is a Fixed Budget?

2. What is a Flexible Budget?
3. What is Budgetary control?
4. Outline some behavioural implications of budgeting.
5. What is budgetary slack?
6. What are the advantages of Top-down approach to budgeting?

EXAMINATION TYPE QUESTIONS

1 A Fixed Budget is:

A. A budget for a single level of activity

B. Used when the mix of products is fixed in advance of the budget period
C. A budget which ignores inflation
D. Used only for fixed costs

2. The term budget slack refers to:

A. Extended lead-time between the preparation of the functional budgets and the
master budget.
B. Difference between the budgeted output and the breakeven output
C. Additional capacity available which can be budgeted for
D. Deliberate over-estimation of costs and under-estimation of revenues in a budget.

3. Green plc makes two products, the X and the Y. The following extract is taken from
the production cost budget of Green plc:

Product X Product Y
Production (units) 4,000 10,000 8,000 15,000
Production cost budget
(K'000) 30,000 60,000 202,000 377,000

Required

Calculate:

91
a) Budget cost allowance for an activity level of 5000 units of X
b) Budget cost allowance for an activity level of 10,000 units of Y

92
CHAPTER 10

ALTERNATIVE BUDGETING SYSTEMS

Introduction

In this chapter, we examine various methods which can be used as a basis for the preparation
of budgets either as principles on which all the budgets are based or particularly for
functional budgets such as Administration budget. The student will note that budgeting
approaches covered in this chapter are very useful to functional departments within the
organization and Non Profit Making Organizations as their operations are not sales demand
driven.

CONTENTS

1. Incremental budgeting.
2. Zero Base Budgeting.
3. Rolling budgets.
4. Activity based budgeting.
5. Program planning based budgeting.

LEARNING OUTCOMES

After studying this chapter the student should be able to:

• Describe and evaluate Incremental Budgeting.

• Describe and evaluate the main features of Zero Based Budgeting.
• Describe and evaluate periodic and continuous budgeting.
• Understand the concept of planned program based budgeting.

93
1.0 The alternative budgeting approaches which an organization can adopt include:

• Incremental budgeting
• Zero Based Budgeting
• Rolling budgets
• Activity based budgeting

1.1 INCREMENTAL BUDGETING

Incremental budgeting is a traditional approach to budgeting, widely used in

commercial organizations and the public sector. Incremental budgeting means:

Basing on next years budget on current year’s results plus extra amount for
estimated growth or inflation.

Specific changes, such as planned expansion or reduction in activities would be

allowed for.

1.1 PRACTICAL EXAMPLE

Quench Zambia Ltd is a water bottling company. Transport cost for last year
amounted to K12 million. Planned expansion is expected to result in K1million
additional transport costs (estimated at current prices). Inflation is expected at 3%

The transport budget for next year will be:

= 103% x (K12m + K1m)

Advantages of Incremental budgeting method are:

 It is an easy and straightforward approach to budgeting

 It is appropriate for such elements of costs as rent and salaries because they are
increased based on the previous year’s figures.

The major disadvantage to incremental budgeting is that:

 It tends to carry forward past inefficiencies into the future.

 It does not encourage improvement on the past performance.

94
1.2 ZERO BASED BUDGETING (ZBB)

Zero Based Budgeting is defined as:

‘A method of budgeting which requires each cost element to be specifically justified

as though the activities to which the budget relates were being undertaken for the first
time. Without approval the budget allowance is zero’
CIMA Official Terminology

ZBB thus rejects assumptions inherent in incremental budgeting that this year’s
activities will continue at the same level or volume and that next year’s budget can be
based on this year’s costs.

ZBB is a cost benefit approach whereby it is assumed that the cost allowance for an
item is zero, and will remain so until the manager responsible justifies the existence
of the cost item and the benefits the expenditure brings

1.3 Where can ZBB be applied?

• ZBB can be applied both in profit seeking and non-profit seeking

organizations.

• In a manufacturing firm ZBB is best applied to service and support functions

including finance, administration production planning and so on.

• ZBB can also be useful to service industries and a wide range of

organizations.

1.4 STAGES IN IMPLEMENTING ZBB

The implementation of ZBB involves a number of steps but of greater importance is

the development of a questioning attitude where the following questions are asked to
evaluate each activity:

• Should the activity or function be performed at all?

• What would be the consequence if the activity were not carried out?
• At what level should it be performed?
• Is it being performed in the optimum manner?
• How much will it cost?

95
1.5 The rest of the stages are stated below

Definition of packages

A decision package is a comprehensive description of a facet of the organisation’s

activities or functions which can be individually evaluated.

Evaluation and ranking of packages

When the decision packages have been prepared, management will the rank all the
packages on the basis of their benefits to the organization.

Resources allocation

When the overall budgeted expenditure level is decided upon the package would be
accepted in the ranked priority sequence up to the agreed expenditure level.

1.6 The advantages and limitations of implementing ZBB

Advantages of ZBB

It is possible to identify and remove inefficient operations.

It forces employees to avoid wasteful expenditure.
It challenges the status quo.
It should result in more efficient allocation of resources.

Disadvantages of ZBB

It increases volume of paper work.

It may emphasise short-term benefits at the expense of long-term benefits.
The ranking of packages may be difficult.

2.0 ROLLING OR CONTINOUS BUDGETS

A rolling budget is a budget continuously updated by adding a further period say a

month or a quarter and deducting the earliest period.

2.1 WHY ROLLING BUDGET?

A Rolling Budget is an attempt to prepare targets and plans which are more realistic
and certain particularly with regard to price levels by shortening the period between
preparing budgets.

96
 Actual conditions may differ from those anticipated when the budget was drawn up
for a number of reasons including the following:-

• Change in organization structure.

• Introduction of new technology.
• Economic changes such as inflation.
• Changes in the levels of activity.

Any of these changes may invalidate the original budgets and they would require
revision.

2.2 OPERATION OF A ROLLING BUDGET SYSTEM

A three-month rolling budget would operate as follows:

A budget is prepared for the coming year, say January to December broken down into
quarters. The first quarter budget that is January to March will be prepared in greater
detail and the remaining three quarters in less detail. Towards the end of the first
quarter a much more detailed budget will be prepared for the second quarter and in
less detail for the remaining quarters. In addition a new quarterly budget, which is
also in less detail covering the first quarter of the subsequent year, is added.

2.3 Advantages of continuous budgeting:

• Budgets are more realistic and achievable.

• The annual disruption associated with the preparation of an annual budget is
removed.
• The pressures placed on managers to achieve unrealistic budget targets are
eased.
• Variance feed back is more meaningful.
• They force managers to reassess budgets regularly.

2.4 Disadvantages of continuous budgeting:

 Managers will be faced with greater workload and additional staff may be
required
 Managers may devote insufficient attention to preparing budgets which they
know will be shortly revised.
 The organization may be required to operate annual budgets as opposed to
short term budgets

97
3.0 PROGRAMMING PLANNING BASED BUDGETING SYSTEMS (PPBS)

Traditional budgeting approach which is department based is not very suitable for
Non-Profit Making Organizations such as Government Ministries.

A major criticism of the traditional approach is its lack of information on the

activities actually being performed by the ministries. Costs are analysed by their
nature rather than purpose.

PPBS are intended to overcome such criticisms. The aim of PPBS is to enable the
management of a Non-Profit Making Organization to make more informed decisions
about the allocation of resources to meet overall objectives of organisations.

3.1 Stages in the implementation of PPBS

• Review of objectives of the activities undertaken by an organization

• Identification of programmes which should be undertaken to achieve the
organisations objectives
• Identification and evaluation of various methods of the objectives of the various
programmes.
• Selection of appropriate programmes on the basis of cost-benefit principles

3.2 Advantages of PPBS

• Forces management to identify activities or programmes to be provided,

thereby establishing the basis for evaluating their worthiness.
• Provides information that enable management to assess the effectiveness of
their plans.
• More efficient allocation of resources.

Chapter summary

• Incremental budgeting is the traditional approach to budgeting where next year’s

budgets are based on the current year’s results plus an extra amount for estimated
growth and inflation for next year. It encourages slack and wasteful spending to creep
into budgets.

• The principle behind Zero Base Budgeting is that the budget for each cost centre
should be made from the scratch or zero. Every item of expenditure must be justified
in its entirety in order to be included in the next year’s budget

• There is a three-step approach to ZBB

o Define decision units

98
 o Evaluate and rank packages
o Allocate resources

• Continuous budgets (rolling budgets) are budgets which are continuously updated by
adding a further period (say a month or quarter) and deducting the earliest period.

99
STUDENT-SELF TESTING

SELF REVIEW QUESTIONS

1. Explain the term Incremental Budgeting.

2. Explain the term Zero Based Budgeting.
3. What questioning approach should be followed in the ZBB approach?
4. Explain the term Rolling Budgets.
5. What is PPBS?

EXAMINATION TYPE QUESTIONS

1. Incremental budgeting is:

A. A method of setting budgets where each item of expenditure must justify its
inclusion
B. The setting of a budget which is challenging but attainable
C. The setting of a budget by adjusting the previous period’s budget for changes in
activity and inflation
D. A method of determining the principal budget factor.

2. What might be the base package and incremental packages for a personnel
department cover?

BASE INCREMENTAL

A. Recruitment Training
B. Dismissal Recruitment
C. Training Pension administration
D. Pension administration Recruitment

100
1 CHAPTER 11
FORECASTING TECHNIQUES IN BUDGETING
Introduction

This chapter involves the number crunching aspect of budgeting. The preparation of a budget
calls for preparation of forecasts of costs and revenues. This chapter aims to provide an
understanding of various forecasting techniques though more attention will be given to
Linear Regression and Time Series.

Contents

1. Scatter diagram.
2. The high-low method.
3. Regression analysis.
4. Linear regression analysis.
5. Time series.
Learning outcomes

After studying this chapter, the student should be able to:

• Draw a scatter diagram and use it for forecasting.

• Estimate costs using the high-low method.
• Derive the linear regression equation.
• Forecast business variables using the linear regression.
• Describe the use of time series in forecasting.
• Perform computations using the time series model.

101
1.0 COST PREDICTION

Three methods that can be used to forecast costs are:

• Scatter diagram
• The high-low method
• Linear regression analysis

1.1 SCATTER DIAGRAM

This is a method of cost estimation where past costs at different activity levels are
plotted on a graph. A line of best fit is then drawn. This line should be drawn through
the middle of the plotted points as closely as possible so that the distance of the points
above the line are equal to distances below the line. Where necessary costs should be
adjusted to the same indexed price level to allow for inflation.

1.2 Example

The following table shows the number of units of a good produced and the total costs
incurred:

Units
Produced Total Costs
K'000
100 80
200 90
300 100
400 130
500 140
600 140
700 160

Required

a) Draw a scatter diagram including a line of best fit

b) Forecast total costs at 750 units

SCATTER DIAGRAM
TOTAL COSTS (K'000)

200

150

100

50

0
0 200 400 600 800
UNITS
102
1.3 SOLUTION

At 750 units total costs are estimated at K180, 000

2.0 HIGH- LOW METHOD

This method involves the splitting of the total cost into its fixed and variable
components. The identified fixed and variable components become the basis for
forecasting. The specific steps involved are:

• Selection of periods of highest and lowest activity levels and their costs.
• Identification of total variable costs.
• Computation of variable cost per unit.
• Estimation of fixed cost.
• Forecasting total cost.

2.1 Example

Maintenance costs for the six months to 31st December 20X8 are as follows

Total
cost
Month Units K’000
July 340 2,260
August 300 2,160
September 380 2,320
October 420 2,400
November 400 2,300
December 360 2,266

Required

a) Use the high-level method to calculate the fixed costs per month and the
variable cost per unit.

b) Forecast total cost at 450 units.

103
Solution
Cost –
Units K’000
Step 1 High 420 2,400
Low 300 2,160
Step 2 Variable costs 120 240

Step 3 Variable cost/unit 240/120 = K2,000

Fixed Costs = Total cost - variable cost

Step 4 Fixed costs = 2400 - (K2,000 x 420)

K1,560,000

Step 5 Forecast cost at 450 units = K1,560,000 + (K2,000 x 450)

= K 2,460,000

2.2 LINEAR REGRESSION

Linear Regression Analysis also known as the Least Squares technique is a statistical
method of estimating values of a business variable such as production cost using
historical data.

In the budgeting process, Linear Regression analysis is usually used to predict costs
and in the rest of this section the technique will be used to demonstrate how to predict
costs.

Linear regression is used to derive the formula for the line of best fit whose general
form is:

Y = a + bx
where,
y is the dependent variable = total cost
x is the independent variable = the level of activity
a is the intercept of the line on the y-axis = fixed costs
b is the gradient of the line = the variable costs per unit of activity

Where:
n ∑XY - ( ∑X) ( ∑Y)
b =
n ∑X 2 - ( ∑X) 2

a = ΣY - bΣX
n n

104
 Historical data is collected from the previous periods and adjusted to a common price
level to remove inflationary differences. This provides a number of readings for
activity levels X and their associated costs Y. Then by substituting these readings into
the formulae below for ‘a’ and ‘b’, estimates of the fixed costs and variable cost per
unit are provided.

2.21 QUESTION

Answer the question in paragraph 1.2 above using the Linear Regression method.

SOLUTION

Notes to the calculations

Step 1 Tabulate the data and determine which variable is the dependent variable, y,
and which is the independent variable, x.

Step 2 Calculate ΣX, ΣY, ΣX², and ΣXY

Step 3 Substitute results of step 2 into the formulae below to find b and a in that
order

n ∑XY - ( ∑X) ( ∑Y)

b=
n ∑X 2 - ( ∑X) 2

a= n ΣY - b ΣX
n n

Step 4 Substitute in the regression equation.

Steps 1 and 2

X Y XY X²
1 80 80 1
2 90 180 4
3 100 300 9
4 130 520 16
5 140 700 25
6 140 840 36
7 160 1120 49

28 840 3740 140

105
Step 3

(7 x 3740 ) - (28 x
840)
7 x 140 – 28²

b=

a=
7 x 3740 - 28*) -
(28 x 840)
7 x 140 - 28 ^2

25,372

2.3 TIME SERIES

A time series is a name given to a set of observations taken at equal intervals of time
e.g daily, weekly, monthly, etc.

The following are examples of Time Series:

• Daily output at a factory for one month
• Monthly sales over a year
• Total annual exports

2.31 Time series Graph

A graph of Time Series is called a Historigram.

EXAMPLE:

1st 2nd 3rd 4th

quarte quarte quarte quarte
r r r r
20X2 92 91 95 94
20X3 99 100 98 96
20X4 108 102 106 110
20X5 124 131 128 130

The above time series will be plotted on a graph so that the overall picture of sales
could be clearly observed.

The horizontal axis is always chosen to represent time, and the vertical axis represents
the values of the data recorded such as sales.

106
 Historigram

140
120
100
Sales

80 Time
60 Variable
40
20
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Time- quarters

The above historigram shows an upward trend or growth in sales.

2.32 COMPONENTS OF A TIME SERIES

A time series has four components namely:

• Trend
• Seasonal variation
• Cyclical variation
• Residual or random variation

2.33 Trend

This is the way in which the graph of a time series appears to be moving over along
interval of time when the short-term fluctuations have been smoothed out.

2.34 Observed trend pattern could be:

• Down ward, where the values are steadily declining.

• Upward, where the values are steadily increasing over the observed time period.
• No clear movement, where the values are going neither up nor downward.

2.35 Seasonal variation

Seasonal variations are short term fluctuations in recorded values due to different
circumstances which affect results at different times of the year, on different days of
the week, at different times of day or any other time period.

107
2.36 Here are examples of seasonal variations:

• Sales of swimming costumes will be higher in summer than winter

• Sales of alcoholic beverages may be higher over the weekend compared to the
week days

2.37 Cyclical variation

This is the wavelike appearance of a Time series graph when taken over a number of
years. Such fluctuations are caused by circumstances which repeat in cycles. In
business, cyclical variations are associated with economic cycles i.e successive
booms and slumps.

2.38 Residual or random variations

This covers any other variations which cannot be associated with the trend, seasonal
variation or cyclical variations dealt with above. These are events which happen
randomly and are due to unpredictable causes, e.g strikes, fires, sudden changes in
taxes.

2.4 ANALYSIS OF TIME SERIES

In order to use a Time series as a basis for forecasting, it’s necessary to disentangle
the various influences and measure each one separately.

2.41 Additive and multiplicative model

In order to separate the various components of a Time series its necessary to make an
assumption about how the four components are combined to give the total effect. Two
possibilities are the additive model and multiplicative model.

A = Actual value for the period

T = Trend component
S = Seasonal component
C = Cyclical component
R = Residual component

2.42 Additive model

A=T+C+S+R

Multiplicative model

A=TxCxSxR

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2.43 For the purpose of forecasting in the preparation of budgets, we shall ignore the
random factor which is not easy to forecast. The cyclical factor will be assumed to be
common to the figures under a forecast and so will be ignored. This leaves us with
two variables, trend and seasonal factors and we will begin by looking at how to find
the trend in a time series.

2.44 IDENTIFYING THE TREND

Three methods could be used namely:

• Graphical method
• Linear regression
• Moving averages

Of the above methods we shall focus on how to use the Moving Averages in
establishing the trend.

2.45 MOVING AVERAGES

A Moving Average is an average of the results of a fixed number of periods. Since a

moving average is an average of several time periods, it relates to the mid-point of the
overall period.

Moving averages of an odd number of time periods results

Year Sales
20XO 390
20X1 380
20X2 460
20X3 450
20X4 470
20X5 440

Required

Compute a moving average of the annual sales over a three year period.

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2.46 Solution

Moving Averages
Year Sales Moving Total of 3 years
of 3 year Sales
20X0 390
20X1 380 1230* 410
20X2 460 1290** 430
20X3 450 1380 460
20X4 470 1360 453
20X5 440 1410 470

*(390+380+460)/3
**(380+460+450)/3

There is an upward trend in sales which is more noticeable from the Moving Average
than the original series of figures.

2.50 MOVING AVERAGES OF EVEN NUMBER OF RESULTS

Where the moving average is calculated for an even set of numbers e.g. values
collected on a quarterly basis a special problem arises in that the average does not
relate to any specific time period as shown below:

1st
quarte
r
20X2 92
20X3 99
105.75
20X4 108
20X5 124

This average is falling between 20X3 and 20X4the average needs to relate to
a particular time period otherwise seasonal variation cannot be calculated

To overcome this difficulty, we take a moving average of the moving average as

shown below:

The following is a Time Series for sales collected over a four year time period for a
company in the retail sector.

1st 2nd 3rd 4th

quarte quarte quarte quarte

110
 r r r r
20X2 92 91 95 94
20X3 99 100 98 96
20X4 108 102 106 110
20X5 124 131 128 130

Required

Determine the trend and the quarterly seasonal factors

2.51 SOLUTION

A moving average of four will be used, since the volume of sales would appear to
depend on the season of the year and each year has four quarterly results. The moving
average of four does not relate to any specific period of time and as such a second
moving average of two will be calculated on the first moving averages.

111
Year Sale
Quarter s 4 Quarterly 4 Quarterly Mid point of 2
(000) moving totals moving average moving average
X2 1 92 Trend

X2 2 91
372 93
X2 3 95 94
379 95
X2 4 94 96
388 97
X3 1 99 98
391 98
X3 2 100 98
393 98
X3 3 98 100
402 101
X3 4 96 101
404 101
X4 1 108 102
412 103
X4 2 102 105
426 107
X4 3 106 109
442 111
X4 4 110 114
471 118
X5 1 124 120
493 123
X5 2 131 126
513 128
X5 3 128

X5 4 130

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2.52 Discussion of the solution

By taking a mid-point (a moving average of two) of the original moving

averages, we can relate the results to specific quarters, e.g the first trend value
of 94 relates to quarter 3 of 20X2.

The upward trend in the sales values is more visible in the trend values
compared to the original values.

2.60 FINDING THE SEASONAL VARIATIONS

Once the trend has been found, we can now establish the quarterly seasonal variations
using either the Additive model or the Multiplicative model. We shall illustrate the
calculation of seasonal variations using both models.

2.61 SEASONAL VARIATIONS USING THE ADDITIVE MODEL

As earlier discussed, if we ignored the random factor (r) and the cyclical factor (c) the
additive model can be stated as:

Y=T+S
→ re-arranging the formula in terms of S:
S = Y – T →this expression is now used below to establish the seasonal factor.

Solution

Year Sales Seasonal

(000) Trend factor
Y T T = Y-T

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 20X2Q1 92
20X2Q2 91
20X2Q3 95 94 1
20X2Q4 94 96 -2
20X3Q1 99 97 2
20X3Q2 100 98 2
20X3Q3 98 99 -1
20X3Q4 96 101 -5
20X4Q1 108 102 6
20X4Q2 102 105 -3
20X4Q3 106 109 -3
20X4Q4 110 114 -4
20X5Q1 124 121 3
20X5Q2 131 126 5
20X5Q3 128
20X5Q4 130

2.62 In order to find the quarterly factors, the figures are summarized in a table below:

Q1 Q2 Q3 Q4 Total
20X2 1 -2 -1
20X3 2 2 -1 -5 -2
20X4 6 -3 -3 -4 -4
20X5 3 5 8
Total 11 4 -3 -11 1
Average 3.67 1.33 (1.00) (3.67) 0.33

Variations around the basic trend line should cancel each other out and add up to
zero. Looking at the table above they do not cancel out as yet, they give a total of
0.33. We therefore spread the total variation equally to all quarters as shown below:

Q1 Q2 Q3 Q4 Total
Estimates of quarterly
variations 3.67 1.33 (1.00) (3.67) 0.33
Adjustment to
reduce variation
to zero (0.33 / 4) -0.0825 -0.0825 -0.0825 -0.0825 -0.33
Final estimates of
quarterly
variations 3.58 1.25 (1.08) (3.75) 0.00

2.63 SEASONAL VARIATIONS USING THE MULTIPLICATION MODEL

As earlier discussed, if we ignored the random factor ( r ) and the cyclical factor ( c )
the additive model can be stated as:

Y=Tx S

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 → re-arranging the formula in terms of S:
S = Y/ T →this expression is now used below to establish the seasonal factor.

Computation of the trend

Year Sales Seasonal

(000) Trend factor
Y T T = Y/T
92
20X2Q1
91
20X2Q2
20X2Q3 95 94 1.0106
20X2Q4 94 96 0.9792
20X3Q1 99 97 1.0206
20X3Q2 100 98 1.0204
20X3Q3 98 99 0.9899
20X3Q4 96 101 0.9505
20X4Q1 108 102 1.0588
20X4Q2 102 105 0.9714
20X4Q3 106 109 0.9725
20X4Q4 110 114 0.9649
20X5Q1 124 121 1.0248
20X5Q2 131 126 1.0397
128
20X5Q3
130
20X5Q4

2.64 Computation of seasonal variations

In order to find the quarterly factors, the figures are summarized in a table below:

115
 Q1 Q2 Q3 Q4 Total
20X2 1.0106 0.9792 1.9898
20X3 1.0206 1.0204 0.9899 0.9505 3.9814
20X4 1.0588 0.9714 0.9725 0.9649 3.9676
20X5 1.0248 1.0397 2.0645
Total 3.1042 3.0315 2.9730 2.8946 12.0033
Average 1.0347 1.0105 0.9910 0.9649 4.0011

Whilst under the Additive model, the average should come to zero, under the
Multiplication model the total should come to 4, 1 for each quarter.

The total is actually 4.0011 so 0.000275 has to be deducted from each total as shown
below:

Q1 Q2 Q3 Q4 Total
Estimates of
quarterly
variations 1.0347 1.0105 0.9910 0.9649 4.0011
Adjustment to
reduce variation
to zero -0.000275 -0.000275 -0.000275 -0.000275 -0.0011
Final estimates of
quarterly
Variations 1.0345 1.0102 0.9907 0.9646 4.00

Rounded off
values 1.03 1.01 0.99 0.96 4.00

2.65 TIME SERIES ANALYSIS AND FORECASTING

Forecast of future values are found by finding the trend using the graphical method,
Linear Regression or Moving Average and then making an adjustment for seasonal
variation.

Example

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 Using the seasonal factors calculated above and the following trend values for 20X6
prepare the quarters 1, 2 3, and 4 of 2006 forecasts using additive and multiplication
model.

Year Quarters
2006 1 2 3 4
Trend Values 130 136 133 135

2.66 ADDITIVE MODEL FORECAST

Year Quarters
2006 1 2 3 4
Trend Values 130.00 136.00 133.00 135.00
Seasonal factor 3.58 1.25 (1.08) (3.75)
Forecast 133.58 137.25 131.92 131.25

2.67 MULTIPLICATIVE MODEL FORECAST

Year Quarters
2006 1 2 3 4
Trend Values 130.00 136.00 133.00 135.00
Seasonal factor 1.03 1.01 0.99 0.96
Forecast 134.48 137.39 131.77 130.22

2.68 FINDING TREND BY MATHEMATICAL EXTRAPOLATION

Future Trend can also be found by extrapolating past trend into the future as shown in
the example which follows:

Trend values for sales by Zam House over the last three years have been as follows

Year 1st 2nd 3rd 4th

Quarte Quarte Quarte Quarter
r r r
1 7,490 7,661 7,889 8,124
2 8,395 8,498 8,709 8,880
3 9,096 9,297 9,495 9,706

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 Average seasonal variations for the four quarters have been:

Quarter 1st
Quarter
1 + 53
2 + 997
3 + 1,203
4 - 2,253

Solution

Average increase in trend = (9,706 - 7,490)/11

= 201

Future trend for the next year

Year 4 Estimate of Trend Trend Seasonal Forecast

values for year 4 factors
1st Quarter 9706 + 201 9,907
53 9,960
nd
2 Quarter 9706 + (2 x 201) 10,108
997 11,105
rd
3 Quarter 9706 + (3 x 201) 10,309
1,203 11,512
4th Quarter 9706 + (4 x 201) 10,510
-2,253 8,257

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CHAPTER SUMMARY

• This chapter has considered statistical techniques which an accountant can use to
obtain information for inclusion in budgets.

• Methods for forecasting costs include:

o Scatter diagram
o The high-low method
o Linear regression analysis

• Scatter diagrams can be used to estimate the fixed and variable components of costs,
which can be used forecast total costs.

• The High low Method is a relatively simple way of determining the fixed and variable
costs elements of variable costs.

• The linear regression analysis model is used formulate the equation for the Line of
Best Fit which can be used to estimate values of a given variable.

• A Time Series is a series of figures or values recorded overtime.

• A Time Series has 4 components :

o Trend
o Seasonal variation
o Cyclical variation
o Random factors
• The four components can be combined using either a Multiplicative or an Additive
model.

• Forecasts can be made by calculating the trend line and adjusting these using the
seasonal factors.

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STUDENT-SELF TESTING

1. Mention three methods used to predict costs.

2. What is a scatter diagram?
3. Mention steps are involved in the High-Low method.
4. State the formula for Linear Regression Analysis.
5. What is meant by trend?
6. What is Seasonal Variation?
7. What is Cyclical Variation?
EXAMINATION TYPE QUESTIONS

1. The total maintenance costs and machine hours for the past ten accounting years were
as follows:

Year Machine Maintenance

Hours cost (K)
1 400 960
2 240 880
3 80 480
4 400 1200
5 320 800
6 240 640
7 160 560
8 480 1200
9 320 880
10 160 440

Required

a) Derive the Regression equation from the above data.

b) Estimate the maintenance cost for the following year when 250 maintenance
hours will be worked.

2. William owns a small corner shop and his sales over a three week period were as
follows:

Week Week Week

Day 1 2 3

120
 Monday 560 574 588
Tuesday 840 875 910
Wednesday 728 770 812
Thursday 658 679 700
Friday 434 448 462

William has used Regression Analysis to calculate a trend line for the sales of:
y = 2.94x + 648.9

Required

a) Find the seasonal variation for each of the 15 days, and the average seasonal
variation for the week using the following models:-

i) The Additive model

ii) The Multiplicative model

b) Forecast sales using both models above.

121
 CHAPTER 12
BUDGETING IN THE PUBLIC SECTOR

Introduction

Like in the private sector, planning is an important management function in the public sector.
Control is equally important to ensure that plans are achieved. The budget provides the link
between the two activities. The budget expresses what is to be undertaken in the next year
and authorizes the financial resources that will be needed. Two important budgets in the
context of public sector budgeting process are capital and revenue expenditure.

Contents

1. Definition of a budget
2. Objectives of budgeting
3. Revenue budgets
4. Capital budgets
5. Budgetary approaches
Learning outcomes

After reading this chapter, the student should be able to:

• Define a Budget.
• Outline the objectives of Public Sector Budgeting.
• Distinguish Revenue Budgets from Capital Budgets.
• Describe the key approaches to Public Sector Budgeting.

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 1.0 BUDGETING IN THE PUBLIC SECTOR

A budget plays a very important role in the managerial planning and control of public
sector organisations. Although Long-term and medium term plans are important in
well run organisations, they are only an expression of intentions. It is only when these
intentions are incorporated into annual budgets that they become firm commitments
with funds being allocated to enable their achievement.

The annual budget expresses what is to be undertaken during the next year and
authorizes the financial resources that will be needed. Budgets are invariably
expressed in financial terms, although other measures should ideally be incorporated.

It is also important to make a clear distinction between capital income/expenditure

and revenue income/ expenditure and to prepare separate annual revenue budgets and
annual capital budgets.

2.0 THE OBJECTIVES OF ANNUAL BUDGET PREPARATION

The objectives of the annual budgetary process within the public sector are discussed
below.

2.1 The establishment of the required income levels.

The income in the public sector comes from taxation, fees and charges levied by the
Government. Budgeted income for the forth coming year is arrived at by examining
the current levels of income and by looking at the levels of expenditure planned for
the coming year. The desire to minimize tax increases, while increasing quality and
quantity of services, provide the dynamics and stresses of the budgetary process.

2.2 Planning service expenditure levels

One of the most important objectives of Public Sector Budgeting is to assist in the
planning of service expenditure levels and the levels of service provision. The total of
service expenditure has to be accommodated within the total income raised; but
within this total, choices have to be made between expenditure on various items.

2.3 Authorization of expenditure

The budget authorizes the expenditure of public funds on those services and to the
total of those service expenditure levels which are agreed in the budget. Money
should be spent on what has been authorised in the annual budget; and one guideline
for subsequent decisions is to enquire whether an item of expenditure is included
under a budget expenditure head

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2.4 The control of expenditure

The budget provides a basis for control of expenditure. At its crudest total annual
expenditure should not be exceed the budget. This philosophy can be applied
throughout the organisation, to the expenditure of services and within services, to
expenditure on sub services and to detailed heads.

2.5 A communication device

The budget is an excellent communication device; service managers are informed

through out the budget not just of the annual expenditure allocation but also of service
level proposed.

2.6 Focus attention

The budget process focuses attention on the future; it thus forces a consideration by
managers of the objectives, methods and costs of service delivery.

2.7 Motivation of managers

Though the link between budgeting and motivation is complex it is possible that
managers are well motivated and form an attachment to the budget, when they have
played a role in helping to formulate it.

3.0 BUDGETS PREPARED IN THE PUBLIC SECTOR

• Revenue income budget

• Revenue expenditure budget
• Capital income budget
• Capital expenditure budget

For most public sector bodies income and expenditure of a revenue nature is usually
much greater than the capital income and expenditure in any given year.

3.1 REVENUE BUDGETS

Annual budgets have been developed as attempt by the Parliament to exercise control
over the activities of the Central Government. It is an established practice that the
total Government and the appropriations of expenditure for particular purposes have
to be approved for each financial year by Parliament.

The most compelling reason for a revenue budget is to determine the levels of income
and expenditure. For tax funded services this would enable the Government fix levels
of taxation and for the charges funded services, the Government would be able to set
the level of charges.

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3.2 Line-Item Budget

Line budgets are budgets which place considerable emphasis on the nature of the
income and expenditure e.g income from grants, fees, sales or expenditure on salaries,
materials traveling etc.

At its most extreme, a line budget would appear as shown below:

3.3 Example of summarised line item budget

Local Authority Budget for Year Ended 31 March

Expenses K'000
Employees XXX
Premises costs XXX
Transport costs XXX
Supplies and services XXX
Support services XXX
Capital financing costs XXX
Total Costs XXX

Income
Government grants XXX
Sales XXX
Fees and charges XXX
Rent XXX
Interest XXX
Miscellaneous income XXX
Total Income XXX
Balance to be met from council tax XXX

The main disadvantage with the above approach is that the statement cannot identify
the amount allocated to each individual service and would therefore fail to reflect the
planned level of activity for each service.

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3.4 PROGRAMME BUDGET STRUCTURE

This is a budget approach which places emphasis on the purpose of the expenditure
such as crime prevention, mental health care, refuse disposal etc.
It is argued that the programme budgeting approach as illustrated below should lead
to better managerial planning and control because resources could be allocated more
precisely to specific activities and actual achievements could be monitored more
effectively.

3.5 An example of a programme budget for a police authority

Police Authority Budget

K'000
Crime control and detection XXX
Crime prevention advice XXX
Traffic control XXX
Crowd control XXX
Police training XXX
court work XXX
Prison duties XXX
Rehabilitation of offenders XXX
Administration XXX
Research and planning XXX

Total XXXX

4.0 CAPITAL BUDGETING

If a public sector organisation is to be successful in achieving its fundamental aims

and objectives it is necessary to give careful consideration to the planning of capital
expenditure requirements.

4.1 THE FORM OF CAPITAL BUDGETING

Although capital budgets may be prepared for one year only, the long term nature of
capital schemes suggest that budgets for several years a head will usually be more
appropriate.

A useful approach to the problem of planning and controlling capital expenditure is to

develop capital programmes which express the overall plan of short, medium and
long term capital schemes, and reveal the allocation of priorities between different
parts of the organisation.

126
 4.2 INFORMATION IN A CAPITAL PROGRAMME

• Title of capital scheme

• The committee, department and officer responsible
• A description of the scheme
• The priority rating
• The schemes in progress- cost to-date Plus estimated future costs

5.0 APPROACHES TO THE BUDGETARY PROCESS

We now consider different models of the budgetary process within the public sector.
We shall particularly consider four models that may be regarded as paradigms that
any public sector organisation can choose from.

5.1 Incremental/ departmental

Under this approach, the budget for each year takes as the starting point the budget
for the previous year and adds or subtracts marginally from the base. Such systems
tend to emphasize the objectives of the individual services and departments.

5.2 Rational/ corporate

These approaches are less concerned with the budget base and the past but are more
concerned with using resources to meet currently established objectives. In addition
these approaches foster a corporate view, taking into account inter service aspects and
the objectives of the whole organisation.

We now move on to consider two models within the incremental model and two
models within the rational model.

5.3 The bid system

Stage 1- separate estimate preparation

Separate departments or services prepare next years estimates in isolation adopting as

a starting point the current years expenditure and service levels (the base budget).

Stage 2 - Aggregation and comparison

The separate estimates, or bids (similar to an auction) are then aggregated and the
total is compared with what can be raised via taxation and charges. More often than
not total estimated expenditure exceeds total estimated income.

127
 Stage 3 - reductions in estimated expenditure levels

At this stage proposals are made to marginally increase the income from taxes, fees
and charges in order to reduce the gap between income and expenditure. However the
gap is reduced mainly by reducing the proposed expenditure by a given percentage.

Stage 4 – detailed estimate reduction

Faced by the prospects to make substantial cuts in proposed expenditure, the

following guidelines are often used:

Proposed Capital expenditure is dealt with first where measures taken may include:
• Cutting out new projects
• Delaying progress on part completed projects
• Postpone start of projects

Revenue expenditure is reduced by:

• New services are cut before existing services

• New services are delayed
• Level of service reduced
• Service deferred to following year

5.4 CRITICISM OF THE BID SYSTEM

5.41 Little review of the base budget

Within the bid system there is little review of the base budget. This is not desirable
because any public sector organisation is faced with a complex network of changing
needs and problems which should be incorporated in the budgeting process.

5.42 A departmental orientation

The system views the departmental estimates and allocations as the focus of the
budgetary process. The problem created by this approach is that the interest of a
group, say old people may not be thoroughly addressed by a single department.

5.43 Outcomes are ignored

The system places more emphasis on the financial control of inputs with little attempt
to relate these to the outputs that emanate from the expenditure.

5.44 Single year emphasis

The system emphasises the annual budget yet one year is too short for effective
planning.

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 6.0 FINANCIAL PLANNING SYSTEMS

Features which distinguish financial planning systems from the bid systems include:
• Their multi- year nature
• The issue of expenditure guideline
• The joint consideration of capital and revenue budgets
• A more helpful specification and classification in the budget document.

6.1 MULTI- YEAR NATURE

Under this system in addition to the annual budgets are considered, medium term
plans say 2-3 years commitments and forecasts are considered. The annual budget is
seen as the first year of a rolling budget in which each year, one additional year is
added on as the past year is dropped off.

6.2 EXPENDITURE GUIDELINE

An expenditure guideline, a target growth percentage or even an expenditure limit is

established for each service prior to the preparation of detailed estimates for a
department.

6.3 JOINT CONSIDERATION OF CAPITAL AND REVENUE BUDGETS

There is a simultaneous consideration of capital and revenue estimates due to the fact
that estimates are considered for several periods.

6.4 DETAILED SPECIFICATION AND CLASSIFICATION

Much greater specificity is introduced into the budget process. In place of a bid
system’s base expenditure plus incremental we now have:

Base expenditure + Inflation – Reductions + committed growth + new growth

6.7 WEAKNESSES OF THE FINANCIAL PLANNING SYSTEMS

• No justification of the base budget

• Emphasis placed not on objectives but department
• Emphasis is on input and not output

6.8 PLANNING PROGRAMMING BUDGETING SYSTEMS (PPBS)

PPBS was introduced into the Federal Government of the United States of America
by president Jonson in 1965.

129
 The goals of the PPBS are:

• The careful identification and examination of goals and objectives in each area of
government activity

• Analysis of the output of a given programme in terms of its objectives

• Measurement of the total cost of specific programmes not just for one year but for
several years into the future.

• The formation of objectives and programmes extending beyond one year to relate
a annual budgets to long term objectives.

• Analysis of alternatives to find the most efficient ways of reaching programme

objectives for least cost

• The objectives of analytical procedures to serve as a systematic part of the budget

reviews process

6.9 Programme defined

A programme is a set of activities which encompasses all organisational efforts to

achieve a specific objective. A programme such as care for the elderly would have
cross departmental boundaries.

6.10 Limitations of PPBS approach

The attraction of the PPBS has faded due to:

• Complexity of programme structures- technical problems are encountered in

constructing programme structures.

• The benefits of incremental policy making- PPBS completely ignores incremental

approach which is key to reducing conflict- the base or stating point is objective.

• Pressure on participants in the process.

• Participants should need to have knowledge of several specialized areas and this
tends to create pressure on them.

6.20 ZERO BASED BUDGETING (ZBB)

ZBB is a technique whereby the total cost of every item included in a proposed
budget must be justified and approved. No bare or minimum expenditure level should

130
 be accepted for any activity. The approach is to require to a re-evaluation of all
expenditure and of all activity; activities start from zero base.
In reality many Government organisations may retain functions or goals which have
lost their usefulness as the environment has changed. ZBB seeks to expose such
expenditure.

6.21 Although ZBB is an appealing concept, it is difficult to appraise all activities due to:

• Time factor
• Some expenditure are politically motivated
• Some expenditure are as a result of past commitments which are supported by
some legislation.
• May generate too much information which decision makers cannot comfortably
handle.

6.22 Despite these draw backs it is clear that there is need to expose public sector
expenditure to systematic review. This can be achieved by:

• Ad hoc efficiency studies

• The use of virement policy
• Option budgets

6.23 AD HOC EFFICIENCY and effectiveness STUDIES

Such studies which scrutinizes the effectiveness of current operations may be

motivated by internal reviews or the may be sparked by the activities of external
review agents such as the auditors.

6.24 THE USE OF VIREMENT POLICY

Virement is a policy which allows discretionary savings to be switched by service by

service managers to expenditure heads according to the department’s priorities. This
system is attractive as it is an inducement to those for those closest to the service
delivery who are most likely to be able to deliver efficiency savings to search out
those savings. Where savings are lost there may be little incentive to search for them.

6.25 OPTION BUDGETS

Under this system the priorities of a department are evaluated by testing the effect on
a department when the budget allocation is increased e.g what is the effect on the
service if:

• 10% cut in expenditure?

• 5% cut in expenditure?
• 1% cut in expenditure?

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 Such options force a service to consider policies and operating procedures.
Chapter Summary

This chapter dealt with the following topics:-

• Objectives of Annual Budget preparation
• Types of Budgets prepared in the Public Sector
• Revenue Budgets
• Programme Budget structure
• Capital Budgeting
• Approaches to Budgeting Process
• Criticism of the Bid System
• Financial Planning Systems
• Planning Programming Budgeting Systems (PPBS)
• Zero Based Budgeting
• The Virement Policy

132
 CHAPTER 13
BUDGET PREPARATION IN THE PUBLIC SECTOR

Introduction

Having discussed the various approaches and types of budgets in the public sector, this
chapter will proceed to demonstrate the preparation of a budget under the Public Sector..
Contents

1. Estimated out-turn
2. Next years estimate
Learning out come

After studying this chapter, he student should be able to:

• Prepare forecast for the remainder of the current year

• Prepare a budget for the forth-coming year

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1.0 TWO STEPS IN BUDGET PREPARATION

The preparation of a budget in the public sector involves the following two stages:

• Estimated out-turn for the current year

• Estimate for the next year

1.1 PROBABLE OR ESTIMATED OUT-TURN

The first step involves forecasting the out turn for the current year which forms the
budgetary base for the construction of the budget for next year.

1.2 ESTIMATE FOR NEXT YEAR

The next step is to project the expenditure and income for the forth coming year
based on the probable or estimated out-turn.

2.0 DETERMINING THE PROBABLE OUT-TURN FOR THE CURRENT

FINANCIAL YEAR.

The process involved in calculating the probable out-turn for the current year is as
follows:-
• Establishing the actual to date.
• Adding estimated expenditure for the remainder of the current year.

2.1 In estimating the expenditure for the remainder of the year, the following should be
considered:

• The proportion of the year remaining.

• The anticipated inflation for the remainder of the year.
• Impact of pay awards on staff costs.
• Cost of new products to be commenced in the current year.

EXAMPLE:

PREPERATION OF OUT-TURN FOR THE YEAR

The following information relates to costs of a government funded Prisoners’

Rehabilitation Centre for a nine month period ending 31st December 2004.

134
 Former Prisoners Rehabilitation Centre
K’000
Income 94,500

Employees 91,800
Running expenses 272,500
Asset rents and capital charges 37,500
Total Expenditure 401,800

Net Expenditure 307,300

The following assumptions is the basis for preparing estimated out-turns

Income

No changes are expected in the pattern of income in the next three months

Employees

Employees will receive an increment of 4% in the next quarter

Running expenses

25% of the running cost is expected to be fixed while and the variable component is
expected to rise by 6%.

Asset rents and capital charges

Asset rents and capital charges is the actual payments made to 30th September 2005

Required

Prepare a statement of the estimated out-turn as at 31st march 2005.

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 2.21 Solution

Estimated out-
Prisoners Rehabilitation Centre turn
K'000 Workings K'000
Income 94,500 94500/3x4 126,000

Employees 91,800 91800+ (91800/3x1.04) 123,624

Running expenses 272,500 see working below 367,421
Asset rents and capital charges 37,500 37500/2x4 75,000
Total Expenditure 401,800 566,045

Net Expenditure 307,300 440,045

Estimated
Working out-turn
Running cost 272,500
Fixed 25% 68,125 90,833
Variable 75% 204,375 276,588
367,421

2.3 DETERMINING THE ESTIMATE FOR THE NEXT YEAR

Preparing expenditure for the coming year involves the following:

Take the probable expenditure prepared in step (2.2 above) one above

Add the following:

i) The full-year effect of any expenditure, notably employee costs, where

a part-year effect in the current year is to be converted into a full year
effect for next year; for example the pay increase for step one above
would now be for the whole year.

ii) The part year effect of next years estimated pay award. Estimated price
inflation for consumables, energy, transport, etc

iii) Any committed growth for next year; whether this be due to salary
increments, the full year effect of completed schemes and so on.

iv) Finally, add in new or discretionary growth.

Deduct the following:

136
 i) Any non-recurring expenditure in the current year which will not be
repeated next year.

ii) Any savings which are estimated to accrue next in the next year

Additional requirements for the question above

Charges
i) Charges to residents are expected to increase by 10% with effect from
1st April 2005

Employees
ii) It is expected that a wage award of 6% will be made with effect from
1st October 2005

Running expenses
iii) The fixed costs are expected to increase by 10% p.a with exception of
500

iv) Variable costs are expected to increase by 7.5% with effect from 1st
March 2005

Asset rents and capital charges

v) The expected amount for the whole year is K12 million

Required

Using this information prepare a budget for the next year.

Solution

Prisoners Rehabilitation Centre Budget for

31st March 2006
K'000
Income 138,600

Employees 133,636
Running expenses 397,248
Asset rents and capital charges 120,000
Total Expenditure 650,885

Net Expenditure 512,285

Workings
K’000

137
Income 126000x1.1 138,600

Employee 91800/3x1.06x2 64,872

64872x1.06 68,764
Total 133,636
Running expenses
Fixed costs 1.1x90833 99,916
Variable 1.075 x 276588 297,332
Total 397,248

138
End of chapter questions

The following information relates to a police authority for the six months to 30 September
19X9:

Malu Province Criminal Records office

K'000
Employees 235,500
Premises 48,000
Supplies and services 29,750
Transport 7,600
Central department and technical support 35,300
Miscellaneous expenses 27,500
Asset rents and capital charges 15,000
Total 398,650

Note:

a) Employees received a pay award of 5% during the first half of the year and payable
with effect from 30 June 19X9
b) Half of premises costs for the first half-year comprises space heating costs; space
heating costs in the last 4 months of the year are expected to equal total costs for the
first 8 months of the year.
c) Asset rents and capital charges are payable on 30 September and 31st March.
d) Due to increase in the price of fuel, transport costs will be 2.5% higher in the second
half of the year.
e) Supplies and services includes a non-recurring payment of K5 million made in June
19X9

Required

Prepare a statement giving the estimated out-turn for the year ended 31st March 19X0

139
SOLUTION

WORKINGS

W1 Employees
X + 1.05x = 235 500
2.05x = 235 500
X = 114 878
Pay in quarter 2 = 1.05 x 114 878 = 120 622

W2 Premises
Non space heating costs = 1/2 x 48 000 24 000
Six months 24 000
Next 3 months = 24 000/6 x 2 8 000
Estimate for the 8 months 32 000
Estimate for the next 4 months 32 000
Total space heating cost 64 000
Total Premises costs 88 000

W3 Supplies and Services

Recurring = (29750-500)/6x12 58 500
Non recurring 500

Total 59 000

W4 Transport
Six months 7 600
Next six months 1.025 x 7600 7 790
Total 15 390

W5 Central department and technical support

Six months to 30th September 35 300
Six months to 31st March 35 300
Total
70 600
W6 Asset and Capital Charges
Six months to 30th September 15 000
Six months to 31st March 15 000
Out Turn 30 000

W7 Miscellaneous Expenses
27 500/6 x 12 55 000

140
 Malu Province Criminal Records office

K’000

Employees 120 622

Premises 88 000
Supplies and Services 59 000
Transport 15 390
Central department and technical support 35 300
Miscellaneous Expenses 55 000
Asset rents and capital charges 30 000
Estimated out-turn 403 312

Chapter Summary
Under this chapter, the following have been covered:

• Steps in Budget preparation process

• Probable or Estimated out-Turn
• Estimates for the Next Year

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CHAPTER 14
MODERN MANAGEMENT ACCOUNTING TECHNIQUES
________________________________________________________
Learning Outcomes

After studying this chapter students should be able to:-

• Appreciate the various developments in the modern manufacturing scenario

• Demonstrate strong knowledge of throughput accounting
• Discuss Target costing
• To show understanding of Life Cycle Costing
__________________________________________________________________________
_

Throughput Accounting

Introduction

The CIMA Official Terminology defines ‘Throughput’ as:

‘The rate of production of a defined process over a stated period of time. Rates may be
expressed in terms of units of products, batches produced, turnover, or other meaningful
measurements (CAM-I)’.

The term ‘Throughput’ is defined by Goldratt and Cox (1989) by means of the following
equation:

Throughput = sales revenue less direct material cost.

The aim of Throughput Accounting is to maximise this measure of throughput.

The direct material cost referred to in the above definition relates to all material purchased
during a particular period, and not simply to material used. The principle behind throughput
accounting is that all costs other than material are effectively fixed; even those costs which
are seen as variable in the traditional sense, or costs which would normally be split into fixed
and variable elements, are treated as entirely fixed.

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The focus of throughput:

As the equation shows, throughput is dependent on four elements:

1) Unit selling price ;

2) Sales volume;
3) Purchase of usage of direct material.
4) Usage of direct materials

A focus on throughput necessarily focuses management attention on these four areas. There
are strong interrelationship between the above four items, particularly between 1, 2and 4. If a
company were to reduce its selling price, if faced with a downward sloping demand curve, it
would expect to see an increase in its sales volume, and might also see an increase in the
speed of use of raw materials, particularly when the new sales are satisfied from stock. The
throughput approach is therefore in sympathy with the JIT approach. Material held in raw
material, work-in-progress or finished goods increases direct material cost, but does not
increase throughput. Throughput is only increased when finished goods are sold, and the
value of the sales feeds through into sales revenue in the throughput equation. However, the
throughput approach does not go as far as the JIT philosophy in its attitude to stock. In
throughput accounting, it is recognized that it may sometimes be necessary to maintain stock,
in order to alleviate a resource constraint and therefore increase the speed of throughput.

Constraints on throughput

The idea of ‘constraint’ is central to the throughput approach. It asks: ‘what are the factors –
market, organisational and production – which are preventing the company from expanding
at the present time?’

These factors might include:

(i) Inadequately trained sales force;

(ii) Poor reputation for meeting delivery dates;
(iii) Poor physical distribution system;
(iv) Unreliability of material suppliers, delivery and/or quality;
(v) Inadequate production resources;
(vi) Inappropriate management accounting system.

Once the constraints have been identified, management attention and action can be focused
on alleviating them. Some of the constraints may be interrelated: a poor reputation for
meeting delivery dates could be associated with inadequate production resources, which in
turn may be related to the signals generated by the management accounting system. For
example, if a company operates a traditional standard costing system, interrupting the
production schedule of a particular work station, so that goods can be completed to satisfy a
customer’s rush order, will result in an adverse direct labour efficiency variance being

143
reported, if the interruption in work requires the machine to be stopped and reset to meet this
rush demand. A stoppage of this kind is not necessarily undesirable, despite the signal sent
out from the accounting system, but it needs to be noted that such a stoppage would always
be discouraged if efficiency variances were based on keeping 100 per cent utilization of
particular resources, a philosophy which traditional accounting systems have tended to
encourage.

Bottleneck Resources

Throughput accounting is most associated with the management of production resources. The
ultimate aim of many modern manufacturing approaches – CIM, JIT etc. – is to enable
production to take place in a complete balanced manner, so that productive resources are an
exact match for the demand placed upon them. This means that there are no constraints –
known as bottleneck resources – within a factory. However, the throughput approach
recognizes that this will rarely be the case when there is a healthy demand for the changes in
demand by the consumer.

The throughput approach is dedicated to the identification and subsequent elimination of

bottleneck resources. Where elimination is not possible, it seeks to ensure that bottleneck
resources are utilized for 100 per cent of their availability. A reassessment of the measures
traditionally employed to record the efficiency of surrounding resources may sometimes be
required. For example, if the output of machine A becomes the input to machine B, and
machine B is a bottleneck resource, it would make more sense in terms of the overall
efficiency of the facility if machine A were to limit its production to the capacity of machine
B, in order to avoid the output of machine A simply becoming work-in-progress, which
would increase neither the throughput of the organisation nor its profit.

As noted above, once a bottleneck has been identified, it is the aim of the throughput
approach to eliminate it. This can sometimes be done with existing resources: it may be
possible, for example, to modify other machinery in such a way that it can perform the
operations of the bottleneck resource, and thereby eliminate the problem. However, the
almost invariable result of this is simply to move the bottlenecks to some other part of the
plant, and management’s attention would then have to focus on the elimination of this second
constraint.

If reorganization of existing resources cannot get rid of a bottleneck, and alternatives such as
buying in particular components are not available or are rejected, a company must consider
investing in new equipment in order to alleviate it. The throughput may thus lead to a better
allocation of capital investment funds than would be possible under traditional system.

The throughput approach should therefore be viewed as a search for continuous

improvement, rather than another technique which simply reports on the status quo.

144
Throughput measures

The role of the accountant in a throughput environment is to devise measures which will;
help production staff to achieve greater throughput volume. Attention should be drawn to the
financial effects of bottlenecks. For example, if a particular machine which is a bottleneck
resource fails to operate for one single hour as a whole, it will readily be appreciated that
dividing this figure by total production time available results in a rate per throughput hour
dramatically in excess of the cost of operating the bottleneck machine as measured by
traditional accounting methods, thus highlighting the problem.

Consistency between Throughput as so far defined and traditional financial reporting are
helpful in analyzing performance.

The reader will have noted that ‘direct material cost’ in the definition of ‘throughput’ given
earlier related to the cost of material purchased in a period, rather than the cost of the
material actually used. The behavioural impact of this definition is to encourage managers to
minimize stockholdings, an aim frequently found in modern manufacturing environments.

However, if an attempt is being made to integrate throughput measure with traditional

accounting systems, the measure of throughput would obviously need to be modified to
reflect the more traditional approach. However, the authors wish to point out that a debate as
to which is the right measure of throughput is sterile. As noted earlier, throughput is an
approach to managing a business and management should select the measure which is most
appropriate to the particular circumstances. A throughput report that deals with direct
material in a manner which is consistent with traditional accounting measures is shown
below:

Throughput report

Sales x
Direct material cost of sales (x)
Throughput x
Direct labour (x)
Production overhead (x)
Administration costs (x)
Selling expenses (x)
(x)
Operating profit x

(The reader will note that the ‘throughput’ in this report is an absolute measure in financial
terms. This may be surprising as the English word ‘throughput’ contains connotations of
movement or flow. However, ‘throughput’ emphasises flow in the management of the
production process, and as reiterated above, it is process management rather than accounting
which reflects the true focus of the throughput approach.

145
In this second ‘version’ of throughput accounting, direct materials are treated in precisely the
same way as in traditional accounting systems, i.e. direct material costs are associated with
raw materials, work-in-progress, finished goods and cost of sales. However, both ‘versions’
of throughput accounting differ from conventional accounting in their treatment of direct
labour costs and production overheads. In throughput accounting, these are regarded as
period costs, to be expensed in the period in which they are incurred and are thus treated in
exactly the same way as selling, distribution and administrative costs (which, of course, will
receive the same treatment under both throughput accounting and traditional systems).
Clearly, these results in all stocks in a throughput accounting system being held at raw
materials cost only. Horngren et al (1997) refer to throughput accounting as an example of
‘super- variable costing’.

Throughput and contribution

When making short –term judgments as to the relative profitability of particular product
lines, it has been conventional to look at the contribution – selling price less direct costs and
variables production overheads – and to give priority to producing those items which show
the highest contribution per unit. Certainly, this measure is often used as the basis for
encouraging salesmen to push particular products.

In a throughput environment, the attractiveness of particular products is related to their

consumption of bottleneck resources. The production scheduling process would result in
priority being given to those products which were best able to generate throughput. For
example, product A, with a unit contribution of K 80 000 but a requirement of two minutes
of a bottleneck resource, would be preferred to product B, with a unit contribution of K 160
000, but a requirement for five minutes of the bottleneck resource. In this respect, we should
note, the throughput approach is simply employing the common short term decision –making
technique of maximizing contribution per limiting factor.

It must be stressed that such product ranking are relevant for short-term production
scheduling only, and their use should not be extrapolated to determine longer term sales
effort. When adopting a throughput approach, it would be expected that bottlenecks will be
alleviated, so that the ranking can be expected to change –possibly very quickly – over period
of time. Indeed, as indicated above, any change in the mix of products demanded by
customers can have the effect of immediately switching the bottleneck resource within a
production capacity, and hence altering the relative attractiveness of particular products.

The relationship between the traditional accounting technique of maximising contribution per
unit of scare resource and throughput accounting

The relationship between the traditional accounting technique of maximising contribution per
unit of scare resource and the throughput approach is illustrated by the simple example given
below.

146
Example
A company produces two products, A and B, the production costs of which are shown below:
A B
K K
Direct material cost 10 10
Direct labour material cost 5 9
Variable overhead 5 9
Fixed overhead 5 9
Total production cost 25 37

Fixed overhead is absorbed on the basis of direct labour cost.

The products pass through two processes, Y and Z, with associated labour costs of K40 000
per direct labour hour in each. The direct labour associated with the two products during
these processes is shown below:

Process Time Taken

Product A Product B

Y 10 mins. 39 mins.
Z 20 mins. 15 mins.

Selling prices are set by the market, the current market price for A being K65 and that for B
K25. At these prices, the market will absorb as many units of A and B as the company can
produce. The ability of the company to produce A and B is limited by the capacity to process
the products in Y and Z. The company operates a two-shift system, giving 16 working hours
per day. Process Z is a single–process line, and for technical reasons this line can only be
operated for a maximum of 12 hours per day. Process Y is a dual process line, and thus two
units can be processed simultaneously, although this doubles the requirement for labour.
Process Y operates for the full 16 working hours each day.

Question

Based on the above information, what production plan should the company follow in order to
maximise profits?

Solution

In order to find the profit-maximising solution in any problem, the constraints which prevent
the profit from being infinite must be identified; the greater the number of constraints the
more difficult the problem is to solve. In the most simple case, where there is only one
binding constraint, the profit maximising solution is found by maximising the contribution
per unit of the scare recourse, i.e. the binding constraint.

147
Linear programming may be used to solve the problem where more than one constraint is
binding for some, but not all, feasible solutions. Where the number of products is limited to
two, and such constraints are relatively few in number, the problem can easily be expressed
graphically to reveal the profit –maximising solution, and/or the problem can be expressed in
the form of a set of simultaneous equations. As the number of potentially binding constraints
increase, the use of a computer becomes the only feasible way to solve the necessary number
of simultaneous equations.

Maximum process time Y = 2 x 16 x 60 =1,920 minutes

Maximum process time Z = 12 x 60 =720 minutes

So the maximum number which could be produced of each of the two products is:

Products A Product B
Max units Max units

Y 1,920 = 192 1,920 = 49.23

10 39

Z 720 = 36 720 = 48
20 15

In the case of both products, the maximum number of units which can be produced in process
Y exceeds the number which can be produced in process Z, and thus the capacity of process
Y is not a binding constraint; the problem, therefore becomes one of deciding how to allocate
the scare production capacity of process Z in such a way as to maximise profit.

Traditional approach – maximizing the contribution per minute in process Z

Contribution of A =K65 (selling price) less K20 (variable cost) = K45

Contribution of B =K52 (selling price) less K28 (variable cost) = K24

Contribution of A per minute in process Z = K45 = K2.25

20

Contribution of B per minute in process Z = K24 = K1.60

15
The profit–maximising solution is therefore to produce the maximum possible number of
units of A, 36 giving a contribution of K45 x 36 =K1,620.

Profit maximization

It is clear, given their different solutions that the two approaches cannot both lead to profit
maximization. A comparison of the two – the ‘traditional’ approach and the ‘throughput’
approach – shows that the former indicates that profits will be maximised by producing A
only, while the latter indicates that product B alone should be produced.

148
This dichotomy of prescription arises solely because the traditional method holds that in
addition to materials, some other costs are also variable, whereas the throughput approach
treats all costs, other than materials, as fixed. If these ‘other’ costs that are identified as
variable under the traditional approach really are variable in the short term, the profits will be
maximized by producing A only, and the throughput solution is sub-optimal. The calculation
below shows this:

Traditional method = 36 units of A, with a contribution of K1, 620

K1, 620 – fixed costs = profit

Throughput method = 48 units of B yielding K2, 016

K2, 016 – (variable labour cost + overhead) – fixed cost = profit
K2, 016 – 48 (K9 + K9) – fixed cost = profit
K2, 016) – fixed cost = profit

The fixed cost is common to both cases. Thus the throughput solution is sub-optimal where
there are costs, other than material, which are variable – and identifiable with particular
products – in the short run.

The throughput approach is, in fact, a special case of the ‘traditional’ method of maximising
contribution per unit of scarce resource in short–term decision making. It is a special case in
as much as contribution is measured after material cost only. But, as has been pointed out, if
this is an accurate representation of reality, the contribution should be measured in this way.

If all costs other than material are, in fact, fixed, the traditional approach could be reworked
to recognize this fact. The traditional approach would then be identical to the throughput
approach, and the profit-maximising output would be recognized as the production of B only.

Provision of additional resources to bottleneck

The aim of throughput management is to focus attention on bottleneck resources, with the
immediate aim of ensuring that such resources are utilized for 100 per cent of their capacity,
and the further aim of alleviating the constraint. In this example, Z is the bottleneck resource.
If management is able to find a way to enable this machine to work for one extra hour, the
maximum number which could be produced of the two products becomes:

Products A Product B
Max units Max units

Y 1,920 = 192 1,920 = 49.23

10 39

Z 780 = 39 720 = 52
20 15

149
Whether a particular constraint is binding now depends on the production plan. The capacity
of Y limits production of B, whilst the capacity of Z limits production of A.

Adoption of a linear programming approach reveals that the profit maximising output, if
labour and variable overhead are truly variable, is to produce units of A only; if the only
variable cost is material, the profit maximising output is to produce 48.57 units of B and 2.57
units of A. Thus, if one extra hour is provided to relieve the bottleneck at Z, the above
analysis suggests that, where no costs other than material are variable (i.e. as assumed in the
throughput approach), the effect is to alter the optimal production plan so that both A and B
would be produced, rather than B alone. However, Y and Z both become bottlenecks in this
case, as they are both utilized to 100 per cent of their capacity.

Y: [48.57 x 39] + 2.57 = 1896.8

Z: [48.57 x 15] + [2.57 x 20] = 728.6 + 51.4 = 780mins

If costs other than material are variable (i.e. as assumed in the traditional approach), the
provision of one extra hour at Z does alter the optimal production plan, except insofar as
additional units of A can now be produced. Z remains a bottleneck, being used to 100 per
cent of its capacity, whilst spare capacity continues to exist in Y. The quality of the decision
regarding the appropriate production schedule to follow is thus crucially dependant upon the
quality of the assumption on which the decision is based.

Throughput accounting as a technique of production management

The example above focused on the choice of product to product. It was shown that this
choice is dependent on the assumptions that are made about the behaviour of costs. The
actual profits which a company makes are clearly dependent on the accuracy of the data on
which decisions are based. The throughput approach has been shown to be a specific
application of the ‘contribution per unit of limiting resource’ approach. It can therefore be
argued that throughput accounting does not add anything to the accountant’s existing set of
techniques. However, the example above is trivial in many respects. It relates to a company
producing only two standard products, requiring only two production processes, and with a
stable demand for the products is largely unpredictable.

The contribution of the throughput accounting approach may lie in the insights it can offer in
such chaotic, but realistic, production conditions. A global measure of throughput at the
factory level may give a clear signal as to the efficacy of factory management. With a given
level of resources, premises, machinery, employees etc., an increase in the throughput of the
manufacturing unit period by period would give a simple measure improvement in the flow
of goods through the factory and to the customer. By drawing attention to impediments to
that flow- the bottleneck resources – management will focus on alleviating problems which
are inhibiting the profitability of the factory as a whole, rather than sub-units or particular
product lines. Managing the throughput of a factory reflects the philosophy of ‘management
by walking about’, i.e. bottleneck machines or processes are generally much more easily
identified by direct observation than by relying on the output of conventional accounting

150
reports. Traditional variance reporting may encourage the attainment of high levels of local
efficiency at the expense of overall efficiency.

Criticisms of Throughput Accounting

Throughput accounting has been criticised as not representing a profit–maximising approach.

The classical approach is illustrated below.

For single-product firms as we have, a company has a range of products produced from
common facilities. Advocates of throughput accounting would suggest that, by operating
under the aegis of traditional techniques, which have as their objective profit maximization, it
is impossible to realise that objective because output is invariably lower than the level which
can be achieved using the throughput approach if we assume that output will generally not
exceed 90 per cent of the profit-maximising output, owing to the problems associated with
production scheduling, it can readily be imagined that the throughput approach will actually
lead to the profit-maximising output being achieved in many cases, whereas adoption of the
profit-maximising approach would result in lower level of profit. Furthermore, it has often
been pointed out that maximisation of profit is a largely theoretical concept, and does not
detract from the attractions of the throughput approach, which has been shown in a number
of organisations to result in increasing profit from period to period.

The philosophy underpinning throughput accounting is that the goal of manufacturing is to

make money. Critics suggest that the approach is excessively short-term, in that all costs
other than direct material are regarded as fixed. A further criticism suggests that the approach
is excessively short-term in that all costs other than direct material are regarded as fixed. This
approach may not be realistic, even in the short term. A further criticism is that, in
concentrating only on direct material, it says nothing about why other costs are incurred, and
therefore can do nothing to help their control. Nevertheless, it is an approach which focuses
very clearly on measures designed to ensure that the production facility is responsive to the
needs of the marketplace, and therefore fits in well with modern manufacturing creeds.

In focusing on direct materials costs, the throughput approach could be argued to be either
the direct opposite of, or the perfect complement to, the Activity Based Costing approach
with the latter’s focus labour and overhead costs.

Target Costing

SOME VIEWS OF TARGET COSTING

The CIMA Terminology defines ‘target cost’ as follows:

‘A product cost estimate derived from a competitive market price. Used to reduce costs
through continuous improvement and replacement of technologies and processes’.

The term ‘target cost’ is not included in the terminology, and may be regarded as a
misnomer. It is not a costing system as such, but rather refers to an activity whose aim,

151
consistent with the Terminology definition of target cost, is that of reducing cost. The most
widely held view of target costing can be summarised as follows:

View 1
An activity whose aim is that of reducing the life cycle cost of new products, through the
examination of all ideas for cost reduction of the product at the pre-production stage. The aim
is to meet customer requirements, such as quality and reliability, at the minimum possible
cost.

This interpretation of target costing emphasis an important point made that is, namely that
the ability to influence cost is greater at the product planning, research and development
stage, rather than the production stage itself. View 1 sees target costing as moving the focus
of cost-reduction efforts from the production phase of the life cycle to earlier phases in the
cycle, where the opportunities for cost reduction efforts are greatest. However, it has been
argued that this view of target costing is too restrictive and an alternative interpretation may
be expressed as follows:

View 2
Target cost is an approach to cost reduction which can be applied to the production phase of
the life cycle for both new and existing products.

These different interpretations are in no way contradictory and could be applied in tandem.
The reason for making the distinction between them is to clarify what may or may not be
included in a particular discussion of target costing.

Agreed target costs are final; they are never expected to change, other things being equal.
However, different targets may be set for different phases of the development process, as the
figure below shows:-

Figure: Target Costing

Target
cost Stepped strategy

o
Single-target strategy

Concept Design Testing Process Prod’n

planning

152
Although target costing is most commonly applied to product costs, it can also be applied to
other areas.

Calculating Target Costs

There are three ways of arriving at a target cost, and these are listed below in order of
increasing sophistication:

1) The Additional method, which is based on existing technology and cost data, and uses
the current of existing or similar components or products to set a target cost for the
new product.

2) The Integrated method, which is a mixture of the addition method – and thus derives
some parts of the target cost from existing cost data- and the deductive/subtraction
method (see below)

3) The Deductive/subtraction method, which is based on the price of competitor’s

products, and works backwards from the market price to derive the target cost.

We shall limit our discussion to the last of these, which is the method most frequently
encountered. The deductive /subtraction method is –called because the target cost is simply
the residual figure arrived at by deducting the target profit from the expected sales price, as
follows:

Expected sales price – target profit = target cost (allowable cost)

The starting point in this method will obviously be the establishment of an expected selling
price.

Establishing an Expected Sales Price

New brands of existing product types, or minor varieties of existing products, will enter
established market with knowledge of the relevant existing product market, and the place of
the new good within it, should enable a competitive price to be set. However, in the case of a
totally new product, by definition there will be no established market for it and therefore no
existing market price that can be used as a guide. For companies, which are first to market,
establishing an appropriate selling price is much harder than for those that follow. However,
the potential profits are much greater for the former than the latter. To help with the pricing
decision in such situations, many Japanese companies employ functional analysis and
employ ‘pricing by function’.

As we saw earlier, this approach views any product as a collection of individual functions,
with the consumer being willing to pay a price for each of them. By decomposing the new
product into its separate functions- appearance, reliability, ease of operation and maintenance
etc. – and placing a value on each of this particular collection of functions can be established.
This information can then be used in conjunction with the company’s strategic plan for the

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product in terms of desired sales volume and market position, to establish an expected selling
price.

Establishing a Target Profit

It is at this point that target costing provides a mechanism whereby the company’s product
planning can be fully integrated into the strategic plans of the organisation. The strategy of a
business in the short, medium or long term will be reflected in its short-medium and long–
term profit plans, and the target profit for any individual product will be a function of its
place within those plans.

The Residual: Target Cost

The deduction of the target profit from the expected selling price will give the target cost. As
the process described above makes clear, this cost will have been determined primarily by
looking outward to the market. No estimate of the actual cost which will be incurred in the
manufacture of the product will have been made up to this stage, and this must now be done.
The costing should be based on the most cost-effective design, materials, and production
processes, irrespective of whether the company currently has the capacity to put into practice
the plans on which the costing is based.

In the case of a modification of an existing product, management will obviously have the
benefit of ‘on-going’ cost data in building up the target cost. This cost will always be greater
than the target profit, as opportunities for cost reduction will usually have been identified
during the life of the existing product. As we noted earlier, once production has commenced,
it is rarely possible to implement all the potentially benefited changes that come to
management’s attention, but companies should be able to calculate the cost that would reflect
the position if the changes where incorporated in the design and production process. Even
when this is done, the initial estimate will almost invariable be higher that the target post, the
difference between the two representing the so-called ‘cost gap’, which must be bridged
without sacrificing any of the ructions that were included in setting the expected selling
price. Value analysis and functional analysis can fruitfully be employed to assist this
estimating process.

In the case of the totally new product, by definition the costing will be based on internal
information relating to previously experience costs, and the historic costing records are thus
limited in use in supplying the required data. In Japan, these data, and indeed data to support
modified versions of the existing products, are often provided by ‘cost tables’.

Cost Tables

Sato (1965) defines a ‘cost table’ as follows:

‘...a measurement to decide cost and to be able to evaluate the cost of not only existing
products but also the future products at the very beginning of the design processes.

The purpose of cost tables is implicitly in the definition:

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 i. To help reduce cost
ii. To minimise the cost of new products.

Their use is thus consistent with the general principle of cost reduction, and a specific
requirement to achieve a target cost. The ‘measurement’ of the definition is derived from a
comprehensive database of detailed cost information on alternative materials, labour,
equipment and production costs, including those not currently used or experienced by the
company. This database enables companies to establish ‘state–of-the-art’ costs for new or
existing products, even though these costs are not necessarily attainable with current
facilities. Cost tables are very widely used in Japanese industry, and autonomous agencies
exist to provide the relevant data for various industrial sectors, in the absence of sufficient in-
house information. They can be assumed to play no small part in the ability of Japanese
companies to estimate the final unit cost of a product at the planning stage to an accuracy of
+ 12 per cent.

The integration of cost tables with a company’s CAD system and the incorporation of
functional analysis into the manipulation of the database, ensure that the cost implications of
changes in basic design and functions can be readily determined at the earliest stages of a
product’s life. Cost tables thus allow Japanese companies to perform a vast number of ‘what
if? Calculations on all aspects of a product before it enters the production stage. This greatly
enhances the likelihood of its acceptability to the consumer and its efficient manufacture- and
hence its profitability. The dictates of world-class manufacturing mean that cost tables
continue to be used throughout the life of an individual product, to test the validity of design
modifications, whether internally or externally driven.

Service Costing

Service costing is cost accounting for specific services or functions e.g. canteens,
maintenance, personnel, departments or functions.

Therefore the services provided may be for sale e.g. public transport, hotel accommodation,
restaurants, power generation etc or they may be provided within the organization e.g.
maintenance, library and stores.

A particular difficulty is to define a realistic cost unit that represents a suitable measure of the
service provided.

Frequently a composite cost unit is deemed the more relevant, for example, the hotel industry
may use the ‘occupied bed per night’ as an appropriate unit for cost.

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 ASCERTAINMENT AND COST CONTROL

Typical cost units used in service costing are shown below:

2 Service Possible Cost Units

Transport Tonne per kilometer, Passenger per kilometer

Hospitals Patient per day, Number of Operations.
Electricity Kilowatt per hour
Hotels Occupied bed per night
Restaurants Meals served
Colleges Full time equivalent student

Each organization will have to determine what cost is most appropriate for use according to
the nature of the business.

Whatever cost unit is decided upon, the calculation of the cost per unit is done in a similar
fashion to output costing i.e.

Cost per service = Total cost per period

Unit Number of service units supplied in the period

It will be realized that the calculations shown above are similar to the calculation of cost
driver rates using activity based costing. Service costing using homogenous service centres
or function and cost units that are a good measure of the service provided is a form of
Activity Based Costing.

Example
Information has been collected about two hospitals over the last year:

Hilltop Copme

Hospital Hospital

Number of beds 780 500

Number of in- patients 23,472 8,165
Average stay 7 ½ days *
Number of out patients visits 216,500 63,920

*Not recorded but bed occupation percentage was 85%.

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 COST BREAKDOWN

Hilltop Hospital Copmed Hospital

In- patients Out-patients In-patients Outpatients

K’000 K’000 K’000 K’000
Direct Patient
Care

Supplies, drugs 1,821,520 693,600 1,551,350 285,450

Medical stores 8,729,100 3,308,950 6,832,700 1,975,050
Support services 2,210,500 2,563,700 1,845,380 1,591,620
Indirect Costs
General services 3,524,470 1,721,800 1,937,410 635,600

16,285,590 8,288,050 12,166,840 4,487,720

Required:

Calculate:
(a) Average length of stay in Copmed hospital
(b) Bed occupation percentage in Hilltop hospital
(c) Cost per in patient day for both hospitals
(d) Cost per out- patient attendance for both hospitals and comment on the results.

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Solutions:

(a) Average stay in Copmed hospital.

Potential in- patient days in a year;

500 beds x 365days = 182,500.

Therefore; 85% occupancy = 182,500 x 0.85

= 155,125 in- patient days

Therefore, average stay = 155,125

8,165
= 19 days.

(b) Bed occupation percentage in hilltop;

= Actual in- patient days x 100%

Potential in- patient days

= 23,472 x 7.5 x 100%

780 x 365

= 176,040
284,700

= 62%

(c) Costs per in- patient day = Costs for in- patients
November of in- patient days

Hilltop Hospital Copmed Hospital

K16,285,590,000 K12,166,840,000
23,472 x 7.5 8,165 x 19

= K92,510 = K78,430

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(d) Cost per out- patient attendance

= Costs for out- patients

Number of out patient attendances

Hilltop Copmed
Hospital Hospital

=K 8,288,050 K4,487,720
216,500 63,920

= K38,280 K70,210

It will be seen that a composite cost unit (i.e. in patient days) is used to calculate the
costs.

Use of Unit Costs In The Public Sector

The public sector organizations cover an enormous range. Examples include primary and
secondary state education, local authorities, the national health services, police and so on.

Costs are collected, related to some measure of throughput or output and a unit cost
calculated as described above.

These unit costs have three main uses. They serve as:

(a) As indicators of relative frequency e.g. cost per pupil in different education
authorities.
- Cost per patient per day at various hospitals.
- Cost per night in police cells.

(b) As measures of efficiency over time. These can help to indicate whether
efficiency is increasing or decreasing over time.

(c) As an aid to cost control. The regular production of unit costs and comparison
with the costs of other establishments in the same field helps to control costs and
engenders a more cost conscious attitude.

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Limitations of The Cost Units

(a) Quality of performance is usually ignored.

(b) Throughputs are used rather than outcomes. Throughputs are numeric indicators
where as outcomes are the impact which the activity has on the recipient of the
service.

(c) The throughput mix is likely to differ.

For instance, the local authority’s costs to cater for the children’s home catering services for
disturbed and disabled children will differ greatly to those homes catering for normal
children. Like must be compared with like for the comparison to be fair.

Life Cycle Costing

THE NATURE AND PURPOSE OF LIFE CYCLE COSTING

In the section on pricing, the reader will find a description of the product life, whereby
products or services entering a market go through four stages: introduction, growth, maturity
and decline. From the suppliers point of view, the life cycle will obviously begin before the
product is introduced to the marketing and distribution before the first unit of product is sold
or the first service is delivered.

The initial expenditure will invariably be lower in absolute terms than the manufacturing
costs to produce and support the product, and thus the absolute level of cost incurred on a
product will rise over its life, with a tendency for costs to follow the sales pattern- as sales
increase, costs will increase, being largely the manufacturing and support costs mentioned
above. The aim of any business must be to ensure that these costs rise at a rate which is less
than proportionate to the actual increase in sales revenue.

The interactions of the revenue curve and the cost curve measures the profitability of the
product over its life. Although a relative decline in cost per unit may be expected from
economics of scale and the experience curve once production commences. The actual profit
associated with any individual product will have been largely determined before it is
introduced to the market. We make no apology for reiterating that as much as 90 per cent of
the future cost that will be incurred throughout the remaining life of the product is actually
dictated by the fundamental decisions taken at the pre-introduction stage regarding functions,
materials, components and the method of manufacture.

Life cycle costing has much with value analysis and target costing ,in that it recognises
(albeit indirectly) the importance of understanding cost throughout the whole life of a
product, and emphasises, as do the other techniques, the importance of early decisions in
determining what these costs will be. Indeed, as was the case with value analysis, life cycle
costing was taken up in the early 1960s by the American Department of Defence as part of a
drive to increase the effectiveness of government procurement.

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However, as students of accounting are well aware, the mere recording of financial
information does not of itself impact on the transactions which are undertaken, and it can
only influence cost if it results into action. This reported association with increased
effectiveness clearly indicates that Life Cycle Costing is a process which goes beyond the
simple recording of information. The Terminology definition of ‘life cycle costing’ creates
some confusion in this context, by defining it as:

‘The practice of obtaining, over their lifetimes, the best use of physical assets at the lowest
total cost to the entity (terotechnology)’.

It is not clear how a costing method can itself be a practice that results in something being
obtained, but clarification is fortunately provided in an explanatory sentence that appears
after the definition, via:

‘This is achieved through a combination of management, financial, engineering and other

disciplines’.

This indicates to the authors that Life Cycle Costing of itself does not result in the reduction
of cost, but when used in combination with other techniques, such as Value Analysis, its
recognition of the changing cost structure of products over time provides a valuable tool; for
management in gaining control over the firm’s activities.
Horngren et al (1994) state that:

‘Life cycle costing tracks and accumulates the actual costs attributable to each product from
its initial research and development to its final customer servicing and support in the market
place’.

When used in this sense, it can be seen that Life Cycle Costing supplies the means whereby a
company can establish whether the lower costs which were expected through the application
of cost reduction techniques, both prior to and following a product’s introduction, have
actually been delivered.

The expected costs against which the actual costs are compared reflect the careful analysis
and planning which should take place before the production stage of a product and the cost
reductions expected during the production phase through the application of the firm’s
decision – making and control structure of these expected product cost changes throughout
the product’s life is achieved by the process known as ‘Life Cycle Budgeting’.

As life cycle budget relates specifically to products or services, it can be appreciated that a
life cycle budget cost for a product has much in common with a target cost, particularly in
companies where different targets are established for different phases of the product’s life
cycle. As costing terms have no legal validity, they do not necessarily require the precision of
terms relating to financial (i.e. statutory) accounting, and no offence is committed if two
companies follow exactly the same set of procedures and attach a different title to their
common activities; a semantic debate as to the exact boundaries, if any, of life cycle costing,

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life cycle budgeting, not only will the production cost of a product be forecast, but those
costs attributable to the product in respect of non-production overheads, such as marketing,
distribution and customer service, will also be considered.

Life Cycle Budgeting and Resource Allocation

The breakdown of the production costs predicted to occur over the life of a product will form
the basis for the budgeted production cost of each period. However, a life cycle approach can
also help managers in allocating resources to non-production activities: for example, a
mature product requires less marketing support than a product in the introductory phase, and
support may be withdrawn almost entirely from a product in the introductory phase, and
support required by a product, based on an understanding of its individual life cycle, can lead
to a more effective allocation of resources, and represents an improvement of the traditional
incremental approach to budgeting. Indeed, it could be used in support of decision packages
in zero-base budgeting.

The life cycle costing/budgeting approach can thus be seen to allow the integration and
expression within the traditional accounting system of a number of approaches to, and
techniques for cost reduction, such as the learning curve and value analysis. However, life
cycle costing reports require the tracking of costs and revenues throughout the entire life of a
product, which represents a significant change to traditional accounting reporting, such in
terms of focus and timing. For example, in traditional systems, many overhead costs are
budgeted, recorded and reported by function – customer service, research and development
etc. – and no attempt is made to attribute these costs particular products. In contrast, with life
cycle costing, this identification of costs with particular products forms the whole basis of the
system – it is only by tracking these costs throughout the life of a product that the overall
product profitability can be ascertained. Life cycle cost reports will thus normally be an
addition to, rather than a substitute for, traditional accounting reports and practice. Reports
produced in this way can be seen to have four clear benefits:

1) The costs of pre-production activities e.g. research, development and design and
post production activities e.g. distribution, marketing and customer service are
highlighted on a product–line basis, a useful format which is not seen in traditional
systems.

2) An understanding of the cost commitment/cost incurrence relationship is gained for

different products.

3) The relationship between different cost areas/categories is highlighted. For

example, reducing cost at the customer service stage. This may have been known
implicitly, but life cycle costing makes the knowledge explicit.

4) The existence of life cycle reports facilities the conduct of post-completion product
audits, along the same lines as capital expenditure post-completion audits. The
knowledge gained from such audit reports can be fed into the company’s decision
making processes to improve future product decisions.

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Most companies are operating in a manufacturing environment are finding that about 90% of
a product’s life cycle cost is determined by decisions made early in the cycle. Management
accounting systems should therefore be developed that aid the planning and control of
product life cycle costs and monitor spending at the early stages of the life cycle.

Exercise
Required:

a) Explain the nature of the Product Life Cycle concept and its impact on businesses
operating in an advanced manufacturing environment.

b) Explain life cycle costing and state what distinguishes it from more traditional
management accounting practices.

c) Compare and contrast life cycle budgeting with Activity-Based Management identify
and comment on any themes that two practices have in common.

Solutions:

(a)The product life cycle (PLC) is shown in the diagram below:

When a product is first successfully introduced for the market, suggested by an expensive
advertising campaign it will only achieve a relatively low sales volume. In an Advance
Manufacturing Technology (AMT) environment, a very large amount of fixed costs will
already have been incurred in designing the product and building or re-equipping the
production line.

In the growth stage sales increase and unit costs fall as the high fixed costs per unit
decrease although new entrants may start to complete at this stage. This is the most
profitable stage of the product life cycle.

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Product Life Cylce

Illustration of product life cycle

Sales
revenue

Introduction growth maturity decline sales

No of Years

The product is said to be mature when sales demand levels off. In a static market price
competition will reduce the profitability of each firm. Firms seek to differentiate their
product at this stage. Eventually, the product will become obsolete and falling sales will
ensure. This is the decline phase of the Plc. Firms will begin to pull out of the market will
have developed a replacement product, thereby incurring further large fined costs for
R&D, design and new production facilities.

In Advanced Manufacturing Techniques environments the time period for the product life
cycle is decreasing.

(b)Life Cycle Costing (LCC) involves collecting cost data for each product from
inception through its useful life and including any end cost. These data are compared
with the life cycle budgeted cost for the product. This comparison will show if the
expected savings from using new technology or production methods etc.

The recognition of the total support required over the life of the product whereas
traditional costing by function e.g. Research & Development, production, marketing and
so on. This for manufacturers LCC makes explicit the relationship between design choice
and production and marketing costs. The insights gained from company budgeted and
actual life cycle costs may be used to refine future decisions.

Consumers as well as producers may use LCC. A recent analysis has shown that the life
cycle cost of purchasing a personal computer (PC) is around six times the purchase cost.

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 Staff the training and extra software will cost three times the cost of the PC and
maintenance will cost twice the purchase cost over the life of the PC.

It has been recognized in Advanced Manufacturing Techniques environment that up to

90% of the costs incurred throughout a product life cycle will be determined before the
product reaches the market. Thus the early decisions regarding product design and
production method are paramount and LCC attempts to recognize this situation.

The high fixed costs of introducing a new product compared with reduced life cycle
periods is a major challenge to profitability in AMT environments. LCC is used to
improve management decision making in breach conditions.

(c)Activity Based Management (ABM) uses the understanding of cash drivers found
fromAactivity Based Costing (ABC) to make more informed decisions. In particular, this
approach yields a better understanding of overhead costs in AMT environments
compared to traditional absorption methods. ABM aims to improve performance by:

(b) Eliminating waste

(c) Minimizing cost drivers

(d) Emulating best practice

(e) Considering how the use of resources supports both operational and strategic
decisions.

This ABM seeks to consider all activities performed by the organisation in order to serve a
customer or produce a product.

Results of ABM in an AMT environment include:

(i) Increased production efficiency

(ii) Reduced production costs

(iii) Increase throughput

(iv) Increased quality assurance

These gains may be realized by:

i. Simplified product designs

ii. More use of common sub – assembly

iii. Reduced set-up times

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 iv. Reduced material handling

v. Better use of the workforce e.g.. Multi – skilling

Their ABM is very similar to LCC in some respects.

For example:

i. Both attempt to increase management understanding of overhead costs

ii.Both consider how the use of resources supports strategic decisions, that is, both look at
how resources inputs are used to obtain the required organizational outputs.

In an AMT environment both methods focus management attention on the need to produce
simplified products using common components and common sub-assemblies and to
maximize the output from expensive capital instruments.

Exercise

Target costing

Nsonsi Ltd is a company that manufactures mobile phones.

This market is extremely volatile and competitive and achieving adequate product
profitability is extremely important.

Nsunsi is a mature company that has been producing electric equipment for many years and
has all the costing system in place that one would expect of such a company. These include a
comprehensive overhead absorption system, annual budgets and monthly variance respects
and the balanced scorecard for performance measurements.

The company is considering introducing.

d) Target costing: and
e) Life cycle costing systems.

What are the benefits of introducing the Costing Systems?

Solution

The modern business encouragement terms to be an instant one and is rapidly changing in
terms of customer requirement, economic factors, technology and so on.

Nsunsi is in a particularly versatile business because technology is changing rapidly as digital

telephones take over and tent messaging develops. Both target costing and life cycle costing
are systems, which should help the company, lope with this. These systems help Nsunsy to

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complete in terms of cost to product development in the competitive telecommunicating
market.

Their specific advantages are as follows:

1.Target costing

Target costing may replace and is often compared with traditional standard costing/variance
analysis, which has long been in place in the historical world. Nuns may wish to replace
standard costing/variance analysis with target costing for cost control and reduction for the
following reasons:

a) It puts pressure on cost it can be used as a cost reduction technical unlike standard
costing and can incorporate a leaving effect. This is likely to be important in the
manufacture of phones.
b) Traditional standards may be too rigid for cost control in reduction purpose for a
company such as Nsunsy as they usually need to be set for a year at a time. Target
costing is more flexible and target can charge/reduce from years to months.
c) It considers the market to price customers are prepaid to pay so it forces an
originating to be outward rather than inward looking. Nsunsi needs to consider the
final customer as well as the system supplier.
d) It should motivate staff if used contently and help. Break down any artificial
functional barriers as it involves staff at all levels and in most functions and forces
them to communicate.
e) It leads towards the use of other techniques, such as value analysis and value
engineering, which should supply production methods and reduce costs. This is
particularly important in an industry with shunt produce life cycles.

2.Life cycle costing

a) The life cycle of Nsunsu’s products are likely to be shunt because of charging
technology, therefore, it is vital that the product begin to generate profits quickly.
b) Estimating life cycle costs and revenue will highlight this
c) Research and development costs are likely to be quite high and must be recovered in
a short period.
d) Many of Nsunsi’s costs are likely to be “looked in” during the design stage, say 94%,
so it is important to control cash initially in order to maximize the profit over the
product’s life.
e) It focuses on the time as well as money. Time to the market is often a key as money
factor is generally profited. It is more important to measure time than money/cost it
may be vital for Nsunsi to bring new products to market quickly and on time in order
to achieve a product.
f) Monitoring a costs and benefits over the life cycle helps to stop a project early if
events have changed or not turned out as planned.
g) It presents a different perspective that could be advantageous to Nsuni as it is not tied
to period reporting.

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 Because of the above it would be advantage for the company to adopt both of these
techniques.

Information technology

During 1990 a printing company defined and installed a management system that met the
business news of a commercial environment which was characterized at that time by:

(i) To unitary structure with one profit center.

(ii) Central education from senior managers.
(iii) 100% internal resoucing of ancihary seniors.

Management information system

Backflush Accounting

In traditional accounting systems, the physical flow of materials and conversion costs is
exactly mirrored in the costing system: the product flow beings with raw materials and other
prime manufacturing costs, proceeds through work-in-progress to finished goods and finally
ends with costs – indeed, the traditional system has been referred to as one of sequential
tracking. Such a system has two main benefits:

i. Stock valuation. Companies may have stocks of raw materials, work-in-progress

and finished costs through these accounts, a valuation period. By tracking material
and conversion costs through these accounts, a valuation can easily be placed on
each for financial accounting purposes. This facility is important: although the
disposition of the costs between the first two of these stock categories is of little
consequence, financial accounting is concerned to draw a clear distinction between
goods that have been sold in an accounting period, and the finished goods still
remaining in stock at the end of the period. The reason for this concern is obvious:
the latter will simply remain in the balance sheet.

ii. Control of costs. Detailed tracking of costs allow a considerable level of control to
be exercised, not only over costs in total, but also over the costs incurred by
individual products or jobs. This benefit applies most obviously to situations in
which job costing, rather than batch or process costing is the norm.

However, the traditional system is time-consuming and expensive to operate as it requires

large volumes of documentation, such as material requisitions and time tickets, to support it.
Furthermore, the benefits associated with it are less obvious in the modern manufacturing
environment, in which low stock levels are becoming the general rule. In such a situation, all
but an insignificant amount of any one period’s costs of production will end up in cost of
sales on the income statement, and thus the need to distinguish between the goods sold
during a period and those on hand at the period end becomes largely redundant. Backflush

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costing is a system that has been developed in response to these concomitants of the
traditional method and the change in the environment.

The primary benefit offered by backflush costing is the considerable reduction in the clerical
effort required to maintain it, both in terms of the number and frequency of entries to the
accounting system, and the level of supporting data and documentation. It must be stressed
from the start that it is not a more accurate system of costing than those traditionally
employed. Indeed, it can be criticized as being less accurate. However, against the general
background of low stock levels mentioned above, this reduction in accuracy is regarded by
the system’s advocates as relatively unimportant, and more than outweighed by the cost
savings to be gained from its operation.

A further point must be stressed: as backflush costing does not attach conversion costs to
products until they are completed, or even sold, it follows that the system cannot be
successfully operated in situations in which work-in-progress is significant and/ or fluctuates
from period to period. In such situations (and, as we shall see, when the same situation
applies to raw materials and finished goods in some variants), the use of backflush costing
would lead to different results than would have been obtained under the traditional tracking
systems, and would be inconsistent with the reporting requirements of financial accounting.

Distinguishing features of backflush costing

The Terminology defines backflush costing as follows:

‘A method of costing associated with a JIT production system, which applies cost to the
output of a process. Costs do not mirror the flow of products through the production
process, but are attached to output produced (finished goods, stock and cost of sales), on
the assumption that such backflushed costs are a realistic measure of the actual costs
incurred’.

The recognition of the costs to be associated with products in the backflush system and thus
their point of entry into the cost accounts is triggered by certain events. Different ‘triggers’ or
‘trigger points’ can be employed in backflush accounting and therefore a number of variants
of the system exist. However, the feature which distinguishes it from other systems, whatever
variant is being considered, is that its focus is on output: costs are associated with output, and
then ‘flushed back’ through the system to attach to particular products. Although the
treatment of material costs in backflush accounting differs from variant to variant, a further
common feature, noted therefore, the identification of conversion costs with particular
products cannot be used as an effective control mechanism during production. It follows
from this that another prerequisite for successful introduction of backflush system is that
management control of the production process is capable of being carried out effectively in
the absence of costing information.

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In a modern manufacturing environment, it can be argued that effective operational control
could be maintained through computer monitoring of the process, by the use of non-financial
measures expressed in physical quantity terms and by direct observation of the operations
themselves (for example, in the JIT environment in which backflush costing is most likely to
be employed, a lack of raw materials would cause the production line to come to a standstill,
and thus problems would be immediately evident to all concerned and solutions rapidly
sought).

Accounting entries in backflush costing

Horngren et al (1997) describe three variants of a backflush costing system. The variant
which differs least from traditional sequential accounting (method 1) has the following two
trigger point- the purchase of raw materials or components and the completion of good
finished units of product. The purchase of materials triggers a debit to the initial stock
account and a credit to creditors for the cost of the materials purchased. The authors call this
initial stock account ‘raw and in process’, rather than ‘raw material’, as it combines both the
traditional raw material and work-in-progress accounts.

The next trigger point is the production of finished goods: a debit is made to the finished
goods account equal to the standard cost of the produced, and credits are made to the raw and
in-process and conversion costs accounts, showing respectively the standard material value
and conversion costs of the completed goods. The above text and Drury (1996) have
qualified examples of this and the following variant.

The simplest and most extreme version (method 2) has only one trigger point: the completion
of finished goods for the actual produced and conversion costs. This variant not only
excludes from costing record any raw materials purchased but not yet used to produce a
finished good, but also fails to record a creditor for material until the production process has
been completed. It is not clear how this latter point can be reconciled with the financial
account requirement to recognize liabilities.

Presumably, it would be feasible only where the throughput time of the manufacturing
process is so fast that stocks of raw materials and work-in-process are non-existent – a highly
improbable situation. Further, when the liability is eventually recognized, it appears to be
recorded at standard rather than actual cost, and the mechanics for recording actual costs and
calculating variances are also unclear.

The third variant (method 3) again has a similar initial trigger point to the first (i.e. the
purchase of raw materials or components), but takes as its second trigger point the sale,
rather than the manufacture, of finished units and expenses all conversion costs immediately
on sale. There is only one stock account – merely called ‘inventory’- which contains only the
outstanding material costs of raw materials, work-in-progress and finished goods. By
charging all conversion costs to the income statements, this variant is intended to focus
management attention on selling the products, as profit can no longer be bolstered by simply
producing for stock. The analogy with throughput accounting should be obvious.

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Example of accounting for backflush costing (method 1)

As 31 December a widget manufacturer has no stocks.

The standard cost of a widget is:
K
Materials: 2kg at K10 per kg 20
Labour: 10minutes at K24 per hour 4
Overheads: K6 per kg of material 12
Total cost 36

Budgeted monthly production is 1,000 units.

During January:

Materials purchased and used: 2,100kg 20,580

Labour: 175 hours 4,410
Overheads incurred 11,500

Finished goods produced 1,050 units

Finished goods sold 1,000 units

The triggers for entry into the cost accounting ledgers are the purchase of materials and the
completion of finished goods. The entries to record these transactions are as follows.

• When materials are purchased:

DEBIT Raw and in process account
CREDIT Creditors or cash with the actual cost of the materials.

• When the goods are completed:

DEBIT Finished goods account with the standard cost of finished goods.
CREDIT Raw and in process account with the
standard cost of material
CREDIT Conversion cost account with the
standard cost of labour and overheads.
DEBIT Conversion cost account
with the actual cost of labour and overheads.
CREDIT Creditors or cash
With the actual cost of labour and overheads.

• When the goods are sold:

DEBIT Cost of sales account
CREDIT finished goods account
with the standard cost of goods sold.

The balance on the accounts are then:

Cost variances written off to the Profit and Loss Account;

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 The value of closing stock at standard cost (permitted by the International Accounting
Standards).

Raw and in process account

K K
(1) Creditors/cash 20,580 (2) Standard cost of materials
(5) Profit & loss A/C 420 (1,05 x £20) 21,000
21,000 21,000

Finished goods account

K K
(2) Standard cost of (4) Cost of sales
production (1,000 x K36) 36,000
(1,050xK36) 37,800
(5) Profit & loss account 420 Stock c/d 1,800
37,800 37,800
(6) Stock b/d 1,800

Conversion account
K K
(3) Creditors/ cash 15,910 (2) Standard cost of labour
(5) Profit and loss account and overheads (1,050x (4 ÷12))
890 16,800
16,800 16,800

Cost of sales account

K K
(4) Finished goods (1,000 x 36)
36,000

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Criticism of Backflush

As the introductory remarks to part of the appendix made clear, the virtue of backflush
accounting is its sheer simplicity. However, it is axiomatic that simple systems provide rather
less information than more complex systems. Several criticisms of backflush costing have
been made passim, but a detailed critique can be found in Calvasina et al (1989).

‘In a true JIT manufacturing system with a JIT purchasing system, material also goes
directly into the production process and there is no need for a separate raw material
inventory account. While this goal is achievable theoretically, raw material inventories
never actually reach zero. Typically, the company at a minimum will receive items in a
cost –effective delivery size. For example, it will receive a truckload or a railcar load.
Thus, a small but very real raw material inventory exists in an ideal situation. The name
RIP is at best a cosmetic change. If there is no raw material inventory on hand, except
what is needed to complete the work in progress, it would seem that the new situation is
identical to the old situation when the appropriate title was work-in-process’.

They object to the late appearance of entries in the accounting system when backflush
costing is used, and conclude their criticisms with the following remarks:

‘Because of no reports from accounting on inventory, managers have to take a physical

count. A job that contradicts one of the basic objectives of the JIT philosophy – the
elimination of wasteful, non-value- adding functions. The physical inventory counts not
only increase overhead costs directly but also disrupt production that reduces efficient use
of plant resources. The backflush system looks very similar to what used to be called a
periodic system. In this system, accountants waited until the end of the fiscal period to
take a physical count of the inventory. At that time, the appropriate numbers were derived
from the ending inventory count. While the JIT presents management with less
accounting and less information on which to base its decisions’.

One might be forgiven for a measure of puzzlement and confusion at all this. After all,
traditional accounting has always ‘backflushed’ costs from work-in-progress to finished
goods when products are completed. On the other hand, traditional systems require the
identification of products at different stages of completion in work-in-progress, which would
involve considerably more physical stock counting then the envisaged in a backflush system.

While backflush costing will reduce the documentation flow-most obviously from raw
materials to work-in-progress – the combination of raw materials and work-in-progress in
backflush’s ‘raw and in- process’ account does not allow the important distinction to be made
between raw materials that are still available for use and those that have already been built
into unsold products. However, if the manufacturing circumstances are such that high levels
of stock are unavoidable, backflush costing becomes an impossibility anyway.

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The reader looking for prescriptive advice on the use and usefulness of backflush costing will
be disappointed: the present authors must fall back on the truism that the circumstances of
the particular operation under consideration will determine

ACTIVITY BASED COSTING (ABC)

Activity based costing (ABC) can be defined as‘an approach to the costing and monitoring of
activities which involves tracing resource consumption and costing final outputs. Resources
are assigned to activities and activities to cost objects based on consumption estimates. The
latter utilise cost drivers to attach activity costs to outputs’.

From the above terminology it is clear that ABC looks at activities as the causes of costs
(cost drivers). Cost drivers are activities which give rise to costs. These may include, number
of orders made (for ordering costs), number of production runs (for material handling costs).

In addition ABC acknowledges the fact that by producing products, demand is created for the
activities. Costs should therefore be allocated to products based on the activities that the
products have consumed.

Need for ABC

The development of ABC was due to the limitations in the traditional product costing
systems. The traditional product costing systems were established at a time when a number
of firms were producing a narrow range of products. In addition the main cost elements were
made up of direct materials and direct labour, as compared to overhead costs. Therefore
distortions arising from overhead allocations were not as significan

In contrast, firms today produce a range of products which do not need significant labour.
Instead overhead costs are considerable. This means that the traditional approach of overhead
allocation using direct labour basis does not reflect a true picture. Therefore a more accurate
cost allocation system becomes necessary and this was made possible with advancements in
the cost information systems which reduced the cost of operating a more complex system.

Establishing an Activity-Based-Costing System

There are basically FOUR steps involved:

1. Identifying the major activities that take place in an organization;

2. Determining the cost driver for each major activity;
3. Create a cost pool for each activity;
4. Assigning the cost of activities to products according to the products demand for
activities.

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Traditional Vs ABC Systems

In a typical traditional cost system there will be the usual two-stage cost allocation process.
In the first stage the system allocates overheads to production and service departments and
then reallocates service department costs to the production departments.

In an ABC system overhead costs are assigned to each major activity instead of departments.
A number of activity-based cost centres (cost pools) will therefore need to be established.
Activities in an ABC system will be made up of a number of tasks. Such activities may
include, set-up machines, materials purchasing, product inspections and production
scheduling. Even though activity cost centres may be identical to traditional cost centres,
ABC systems tend to have more activity cost centres.

In a traditional cost system overheads are traced to products using a limited number of
allocation bases which vary in direct proportion with production volume. The common bases
used are direct labour hours and machine hours.

For ABC systems, a number of cost drivers which will include non-production volume
related are used. These will include, number of purchase orders and number of production
runs.

In addition traditional systems normally allocate service/support costs to production centres.

These costs are added to the production cost centres . However, in ABC systems separate
cost driver rates for support centres are established and support activities costs re assigned to
cost objects without any reallocation to production centres.

It is therefore evident from the above that by having a number of cost centres and cost
drivers, ABC systems can more accurately measure the resources consumed by cost objects.

In contrast traditional cost systems tend to produce less accurate costs as most allocation
bases used are not related to the cost objects.

Other Considerations

The cost/benefit of implementing an ABC system should be analysed. It is quite obvious that
the more complex the ABC system is the more beneficial it will be in the organization.

It is however a fact that, such a detailed and complex system will be more costly to a
traditional costing system. Costs associated with an ABC system will include software and
staff training which may be prohibitive.

Consideration must be given to the poor decisions that will be made as a result of having an
inaccurate traditional costing system. Poor decisions may relate to having to having
unprofitable products and dropping profitable products.

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However it is not always that an ABC system will greatly improve the quality of cost
allocation nor is it the case that a traditional cost system will produce inaccurate cost reports.
Therefore ABC must meet the cost/benefit criterion and improvements should be made in the
level of sophistication of the costing system up to the point where the marginal cost of
improvement equals the marginal benefit from improvement.

Drawbacks of ABC Systems

The following pitfalls of ABC Systems can be noted:

a) The calculation of unit of costs under ABC faces the same

disadvantages of the traditional cost system. This is so because to calculate unit costs
of products, the batch level activity costs are divided by the number of units in the
batch. This unitising approach is an allocation which yields a constant average cost
per unit of output which vary depending on the level of activity. For decision-making
there is a danger that what started out as a non-volume related.

b) It is not all costs which will be caused by activities that are measurable in quantitative
terms and which can be related to production output. In such situations cost drivers
can not be used.

c)The behaviour of cost items in a cost pool cannot be explained by single cost driver.

EXAMPLE

Chiatu Plc manufactures three products A, B and C. The following data is available for the
month of February:
A B C
Output (units) 800 800 2000
Production runs 20 20 100
Direct Labour hrs per unit 2 6 2
Machine hrs per unit 2 4 2
Material cost per unit (K) 1000 4000 1000

Labour cost per hour is K 8000

The following overheads were also incurred:

K’000
Production Scheduling 7 280
Material Handling 6 160
Set-up Costs 8 736
22 176

Required:
Calculate the cost of each Product using ABC and traditional cost system.

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Solution:

Under ABC system the overheads will be allocated to the Products using the number of
production runs as the cost-driver.
A B C
K’000 K’000 K’000
Raw Materials 800 3200 2000
Direct Labour 12800 38400 32000
Production Scheduling 1040 1040 5200
Material Handling 880 880 4400
Set-up 1248 1248 6240

Cost per unit 16768 44768 49840

800 800 2000

= K20.96 = K55.96 = K24.92

Traditional System:
A B C
K’000 K’000 K’000
Raw Material 800 3200 2000
Direct Labour 12800 38400 32000
Overheads 3412 10235 8529
17012 51835 42529

Workings:

1. Production Scheduling = K 7,280,000 = K 52,000 per run

140

2. Materials Handling = K 6160000 = K 44,000 per run

140

3. Set-up = K 8736000 = K 62,400 per run

140

4. Overheads absorption = K 2217600= K 2132.3

10400

NOTE: It can be seen that under ABC the allocation of overheads is more reflective of the
actual activities in production since Product C, because of the many production

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 runs, consumes more of those activities (Set-ups, Production runs and Production
scheduling), than Products A and B.

Under the traditional system Product B has been over-allocated with the overheads
since the allocation is based on the number of labour hours. However, as stated
earlier on, most modern firms have automated operations therefore the use of labour
hours like in the case does not reflect the causes of the overheads.

Other aspects of ABC

Further approaches which revolve around ABC have been developed. Activity-Based
Management (ABM): Activity-Based Management (ABM) is a system of management
which uses activity-based cost information for variety of purposes including cost reduction,
cost modelling and customer profitability analysis.

Activity-Based Budgeting (ABB), this is a method of budgeting based on the activity

framework and utilizing cost driver data in the budget-setting and variance feedback
processes.

MANUFACTURING RESOURCE PLANNING (MRPII)

Is an expansion of Material Requirements Planning (MRPII) to give a broader approach

than MRPI to the planning and scheduling of resources, embracing areas such as finance,
logistics, engineering and marketing.

MRPI evolved into MRPII and MRPII plans production jobs and also calculates resource
needs such as labour and machine hours. It therefore attempts to integrate materials
requirement planning, factory capacity planning, shop-floor and even marketing into single
complete (and computerised) manufacturing control system. Most MRPII systems are a
collection of computer programs that permit the sharing of information with and between
departments in an organisation.

MRPII is used by many companies for manufacturing planning but with the advent of JIT
manufacturing, it has been identified as a planning system. Even so MRPII has advantages
as a controlling system for planning and controlling manufacturing systems, especially
when JIT methods are unsuitable.

ENTERPRISE RESOURCE PLANNING (ERP)

ERP systems are accounting oriented information systems for identifying and planning the
enterprise-wide resources needed to take, make, distribute and account for customer orders.
ERP has been described as an umbrella term for integrated business software systems that
empowers a corporate information structure, thus helping companies to control their
inventory, purchasing, manufacturing, finance and personnel operators.

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Originally, ERP systems were simple extensions of MRPII systems, but their scope has now
widened. They allow an organization to automate and integrate most of its business
processes, share common data and practices across the whole enterprise and produce and
access information in a real-time environment. ERP may also incorporate transactions with
organisations supplies.

They help large national and multi-national in particular to manage geographically dispersed
and complex operations. For example, an organisation in Zambia e.g. TATA sales office may
be responsible for marketing, selling and servicing a bus assembled in India using parts from
China. ERP enables the organisation to understand and mange demand placed on the plan in
China.

There are two groups of applications within an ERP:

1. CORE APPLICATIONS

The applications that need to work in the organisation will be unable to function.
They include production, sales, distribution and planning. These are fully integrated
within the ERP system

2. Business analysis applications

Examples include modelling, decision support, information retrieval, accounting,

simulation and “what if” analysis. Some ERP software includes these. Some provide
links into ERP system to third party software that performs tasks.

Some advantages of ERP systems

The advantage of ERP systems compared to traditional system architectures include:

a)Increased data consistency

b)Reduced data redundancy
c) Greatly enriched data, including access to qualitative data by functions that do not
typically have access to it.
d) Greatly increased depth and breadth of data analysis
e) Reduced response times to information requests
f) Reduced need for manual intervention in data access and analysis
g) Reduced risk of errors in data or in its analysis
h) Greatly reduced Lead Times in report generation
i) Greatly increased efficiency in materials ordering, requisition and deployment

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 Questions

1. What is Enterprise Resource Planning?

2. What are the advantages of a ERP system?

3. Why will those organisations that integrate their ERP systems with supply chain
management benefit more than those that introduce only one of the other, or these
two concepts?

Chapter Summary

The following have been covered under this chapter

• Throughput Accounting
• Target Costing
• Service Costing
• Product Life Cycle Cost
• Backflush Accounting
• Activity Based Costing (ABC)

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CHAPTER 15
CAPITAL INVESTMENT APPRAISAL
__________________________________________________________________________
_
Learning outcomes

After studying this chapter candidates must be able to:

Demonstrate knowledge of key investment, regarding appraisal methods and the following.

• The concept of the time value of money

• Net present value (NPV)
• Real and normal interest rates
• Payback
• Internal rate of return
• Multiple IRRs
• Unequal
• Project appraisal & Audit
__________________________________________________________________________
_

Introduction

Capital Budgeting involves the assessment of how much should be spent on assets or project
and which assets should be acquired.

Before deciding which project/assets to invest in, corporations must compare the benefits to
be derived from the acquisition/investment against the costs involved in the investment.

The investment will not purely depend upon financial aspects but to a large extent, the
strategic direction of the business. Remember the financial decisions fall with the long-term
corporate strategy formulation process.

Appraisal Methods

The main methods of investment appraisal, which are normally in use, are:
a) Payback
b) Internal rate of return
c) Net present value
d) Accounting rate of return.

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The investment appraisal methods can be divided into traditional and scientific methods. The
traditional methods ignore the fine value of money whilst the scientific methods recognise
the fine value of money in the evaluation.

Net Present Value (NPV)

The Net Present Value of a project is the difference between the sum of the project
discounted cash inflows and outflows attributable to a capital investment or other long-term
project.

The Net Present Value approach holds that cash received in the future is less valuable than
cash received today.

In the Net Present value computations, all cash flows are expressed in present day values by
the cash flows, which are realised in the future.

A comparison is then made, in present day terms of the total costs of the investment (cash
outflows) and the total receipts from the investment (cash inflows).

When the present value of the inflows exceeds that of outflows (which includes any relevant
taxation liabilities, as well as the more obvious initial investment outlay), the net present
value is positive and purely on financial grounds, the investment should be accepted. In
contrast, if the present value of the outflows exceeds the present value of inflows, the net
present value is negative and the investment should be rejected.

Discount Factors/ Interest Rate

The interest rate, at which investors can borrow or lend money, is key to the Net Present
Value model (NPV). The model is based on the assumption that an investor may invest
money in the financial market at an interest rate prevailing or invest money in real assets,
undertake a combination of the two options, or borrow in order to invest in real asset.

Real assets will only be attractive to a rational investor if they offer a rate of return in excess
of the cost of money (the rate at which the money has been borrowed).

By discounting the financial costs and benefits associated with real assets at this rate, the
investor can determine whether a return in excess of discount rate ‘r’ is available from the
real asset in question.

NPV and The Agency Theory

Senior managers of an organisation normally save the interests of shareholders and they are
thereby employed to maximise the wealth of shareholders.

Since Net present Value models decision rule advocates that a project whose financial
benefits outweigh its financial cost, henceforth having a positive net present value should be

182
accepted and be pursued and vice versa. The net present value upholds the thenetical sole
objective of business of maximisation of shareholder’s wealth through maximisation of
returns from the project.

Assumption in Net Present Value

The Net Present Value technique is based on the following assumption.

 The Discount rate must be a measure of the opportunity cost of funds for wealth
maximisation to result.
 Perfect capital market and perfect information exists
 The model assumes that a single rate which reflects the opportunity cost for all
individuals and companies.
 All Shareholders have an objective of wealth maximisation

Net Present Value, Risk and Uncertainty

Risk management does not leave out project appraisal and evaluation process.
Past experiences can be new, is a guide in assigning specific possible outcomes for the action
currently proposed.

This can also be used as the basis for assigning probabilities to these outcomes what we can
use to calculate the expected cashflows of a project for our NPV computations.
In the absence of past experience, we would have no basis upon which we can base our
probability on.

Advanced risk analysis and management are outside the scope of the text.

Example

Chaswe engineering consultants have been engaged in developing four (4) projects on
behalf of their client, Ninsh Corporation.

However, the project sponsors, Ninsh Corporation have asked their management Accountant
to evaluate the 4 projects for their viability before it commits its finances to the projects.

The cost of funds for NINSH Corporation is 5%.

Required:

In your capacity as Management Accountant of NINSH Corporation, evaluate the viability of

the four (4) projects given that the cash inflows and cash outflows of the projects are as
shown below on the Net Present Value basis.

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Project: A B C D

Capital K’000 K’000 K’000 K’000

(Outlay) year 0 (40,000) (40,000) (20,000) (20,000)

Cash Inflows 1 20,000 400 12,800 0

2 20,000 400 12,800 0
3 100 32,000 400 0
4 100 32,000 400 36,000

Solution:

Since the company’s cost of capital is 5%, thus will serve as the discount rate at which the
project cashflow will be discounted.

Project A

Discount
Year factor @5% Cash flows Present Value
K’000 K’000
0 1.0000 (40,000) (40,000.00)
1 0.9524 20,000 19,048.00
2 0.9070 20,000 18,140.00
3 0.8638 100 86.38
4 0.8227 100 82.27
Net Present Value (2,643.35)

Project B

Discount
Year factor @5% Cash flows Present Values
K’000 K’000
0 1.0000 (40,000) (40,000.00)
1 0.9524 400 380.96
2 0.9070 400 362.50
3 0.8638 32,000 27,641.60
4 0.8227 32,000 26,326.40
Net Present Value 14,711.76

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Project C

Discount
Year factor @ 5 % Cash flow Present Values
K’000 K’000
0 1.0000 (20,000) (20,000.00)
1 0.9524 12,800 12,190.72
2 0.9070 12,800 11,609.60
3 0.8638 400 245.52
4 0.8227 400 329.08
Net Present Value 4,474.92

Project D
Discount
Year factor @ 5% Cash flows Present Values
K’000 K’000
0 1.0000 (20,000) (20,000.00)
1 0.9524 0 0
2 0.9070 0 0
3 0.8638 0 0
4 0.8227 36,000 29,617.20
Net Present Value 9,617.20

ANALYSIS AND CONCLUSION

Project B, C, & D are giving positive present values indicating that purely on financial
information, they are viable and hence management of Ninsh Corporation should undertake
the projects in order to maximize shareholder wealth.

Project A is yielding a negative net present value and hence, purely on financial grounds, the
project should not be undertaken as it is posed to destroy value of Ninsh Corporation.

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Internal Rate of Return (IRR)

Internal rate of return is achieved by a project at which the sum of the discounted cash
inflows over the life of the projects is equal to the sum of the discounted cash flow.

In other terms, the IRR of an investment is that rate which when used to discount the cash
flows of the investment will result in a rate present value of zero.

The IRR of a project with conventional cashflows can be calculated using a process of trial
and error.

The following steps represent a systematic, methodical trial and error approach to the
calculation of project IRR.

1. The net present value of the project at zero interest rate needs to be established. This
must be a positive figure if an investment with conventional cashflows is to have a
positive IRR.

2. A positive discount rate should be selected and the Net Present value of the project at
this rate is calculated.

3. The procedure under (2) should be repeated for one or more additional discount rates.
The Net Present Value profiles should be sketched and an approximate IRR
estimated.

Example

Suppose a company has project Y with the following cashflows to evaluate. Estimate the IRR
of project Y using the data given at a cost of capital of 14%.

2.1 Project Y Cash flows

Year K’000

0 (20,000)
1 200
2 200
3 160,000
4 160,000

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Solution:

Years Cashflows Discount Present Values

Factors (14%)
K’000 K’000
0 (20,000) 1.000 (20,000.00)
1 200 0.877 178.40
2 200 0.769 153.80
3 160,000 0.675 108,000.00
4 160,000 0.592 94,920.00
Net Present Value 183,252.20

Decision Criteria In Internal Rate of Return

In case the IRR, the decision rule is to compare opportunity cost of funds and accept the
project if the IRR is greater than the company’s cost of money and reject it if it is not i.e.
purely on financial grounds.

This decision rule would always lead to the selection of an identical set of projects as the
application of NPV rule given the assumptions that have been made so far namely; certainty,
conventional cashflows and perfect capital markets and the additional assumption of
independent projects.

The Reinvestment Assumptions

The Net Present Value technique assumes that all cash flows from a project will be re-
invested at the discount rate used in the calculation of the project’s net present value, which
in a real/free world is the prevailing base interest rate.

This assumption is realistic as application of the NPV rule means that all projects offering a
return in excess of the discount rate will be accepted and the marginal funds are invested at
the prevailing interest rate.

In contrast IRR assumes that all cash flows will be reinvested at the projects own IRR.There
are not practical supporting reasons for this assumption though.

This assumption will lead to favour projects with concentrated cash flows in the early years
of the project running than those with low cash flows in the early years of running.

187
This can be illustrated by using an example of 2 projects M & K and calculations of their
terminal values. In the early years of the project running than those with low cash flows in
the early years of running.

The terminal value of an investment is the total value of the cashflows generated by an
investment at the end of its life.

In calculating the terminal values, interim cash flows must be projected forward to the end of
the investment’s life by the application of a particular reinvestment rate.

The Net terminal value is calculated by subtracting the terminal value of the initial
investment from the terminal value of the cashflows.

It’s assumed below that the interim cashflows will be reinvested at 5%.

Projects M K
Years cash flows cash flows
K’000 K’000
0 (18,000) (16,000)
1 14,000 1,250
2 12,000 12,000
3 8,000 12,000
4 1,000 12,000

Projects M Terminal values

Years Cashflows Reinvestment rate terminal values

K’000 5% K’000
4
0 (18,000) (1.05) 65,340
1 14,000 (1.05)3 38,122
2 12,000 (1.05)2 22,404
3 8,000 (1.05)1 7,616
4 1,000 1.00 1,000

Conclusion and Analysis

By definition, the IRR is the discount rate of zero and you should not be surprised to see that
it is also the discount rate which gives a net terminal value of zero. This is clearly seen in the
case of project K; the small positive NTV of M arises because 49% is a slight under estimate
of the IRR as perusal of the above analysis.

Example

Seakwe Ltd is considering which of two mutually inclusive projects it should undertake. The
finance director thinks that the project with the higher net present value should be chosen

188
 where the managing director thinks that one with the higher IRR should be undertaken
especially as both projects have the same initial outlay and length of life. The company
anticipates a cost of capital of 10% and the cashflows of the projects are as follows:

Years Project X Project Y

K’000 K’000

0 (400) (400)
1 70 436
2 160 20
3 180 20
4 150 8
5 40 6

Required:

1. Calculate the Net Present Value and internal rate of return of each project.
2. Recommend with reasons, which project you would undertake.
3. Explain the inconsistency in ranking of the two projects in the light of the remarks of the
two directors.
4. Identify the cost of capital at which your recommendation in (2) would be reversed.

Solution

(1).

Y Factor Factor Project Present Present Project Present Present

10% 20% X value value Y value 10% value
10% 20% 20%
0 1.000 1.000 (400) (400) (400) (400) (400) (400)
1 0.909 0.833 70 63.63 58.31 436 396.32 363.19
2 0.826 0.694 160 132.16 111.04 20 16.52 13.88
3 0.751 0.579 180 135.18 104.22 20 15.02 11.58
4 0. 683 0.482 150 102.45 72.30 8 5.46 3.85
5 0.621 0.402 40 24.84 16.08 6 3.72 2.41
58.28 (38.05) 37.04 (5.08)

Therefore as it has been noticed in the calculations.

At 10% the NPV of Project X = K58,280,000

At 10% the NPV of project Y = K37,040,000

189
At 20% the NPV of Project X = (K38,050,000)

At 20% the NPV of project Y = (K5,080,000)

The IRR of the two projects are as follows:

Project X

1NPV1
IRR = Ra + [1NPV11+1NPV21 x (Rb – Ra)]

K58, 280,000
IRR = 10% + [K58, 280,000 + K38, 050,000 x (20%- 10%)]

= 10% + 6.050036333%
= 16.05%

Project Y

1NPV1
IRR = Ra + [1NPV11+1NPV21 x (Rb – Ra)]

K37,040,000
IRR = 10% + [K37,040,000 + 5,080,000 x (20%- 10%)]

IRR= 10% + 8.793922127

IRR= 18.7939%
IRR=18.79%
(2)

The recommendation should be to undertake Project X for the following reasons:

• Project X has a positive Net Present Value, showing that it exceeds the
company’s cost of capital.

• In addition, assuming that the company’s object is to maximise the Present

Value of future cashflows Project X offers the higher Net Present Value.

• Project X indicates a higher NPV, whereas project Y offers a higher

internal rate of return where such conflicting indications appear, it is
generally appropriate to accept the Net Present Value result, net present

190
 value being regarded as technically more sound than internal rate of
return.

• The two projects have radically different time profiles. Projects X’s
cashflows are grouped in the three middle years of the project, while
nearly 90% of Y’s inflows come in the first year of the project, leading to
a situation where project Y shows a higher internal rate of return.

Risk, uncertainty and timing if cashflows may be considered by the Directors in making the
final investment decisions.

+
100
+
80
+
60
+
40
+
20
0 1 2 3 4 6
0 0 0 0 0
-
20 Discou
nt rate; %
-
40

Although in the above illustration we have shown the graphical representation using straight
lines, the true relationship between the Net Present Value and discount rate is a cumulative
one.

Multiple IRR (Multiple Yields)

At this point in time, we would want to appreciate that in cases where a project does not have
conventional cashflows, there is a possibility of having multiple IRR in the project whose
cashflows are unconventional.

By a project having conventional cashflows, we mean that there will be a cash outflow
followed by a stream of inflows.

A project with non- conventional cashflows may have a cash outflow followed by an inflow
or inflows then followed by a further outflow or by further outflows.

As a result of these cashflows coming in and out of the project at different times, the IRR
computation might give rise to two or more internal rate of return rates.

191
 Example

Lunga Plc is proposing making a machine it will use in its manufacturing process, the cost of
which will be paid in two stages. Revenue can be expected from its demonstration, although
it will be expensive to break up and dispose of at the end of its useful life. The cashflows
associated with the project are as follows.

Years Cash flows

K’000
0 (7,820)
1 (20,000)
2 80,000
3 (53,020)

The appropriate discount rate is 15%.

Solution:

This project has two internal rates of return as shown below.

Years Cash flows Discount PV

K’000 Factor (6%) K’000
0 (7,820) 1.0000 (7,820)
1 (20,000) 0.9434 (18,868)
2 80,000 0.8300 71,200
3 (53,020) 0.8396 (46,906)
Net Present Value 16,000

Years Cash flows Discount PV

K’000 Factors (30%) K’000
0 (7,820) 1.0000 (7,820)
1 (20,000) 0.9434 15,384
2 80,000 0.8300 47,336
3 (53,020) 0.8396 24,034
Net Present Value 78,934

192
2.2 Graphical Representation

NPV Investment

NPV 200
£
100

0
(100) 5 10 15 20 25 30
Discount rate, %
(200)

(300)

(400)

Conclusion, Interpretation and Analysis

As both IRRs are equally valid, the decision whether or not to accept this investment cannot
be made by reference to these rates alone. Therefore, NPV method can be used to get a
clearer result.

If NPV shows that the NPV of the same project lower consideration is positive, then the
project should be accepted as it shows that the net financial benefits far outweigh the
financial costs of the project and hence demonstrating financial viability of the project.

Internal Rate of Return for Projects With Unequal lines

When two projects or more mutually exclusive investments with unequal lives are being
evaluated and compared, consideration must be given to the time period over which a
comparison of the investments is to be made.

193
 Example

Consider two projects

Years 0 1 2
K’000 K’000 K’000
Project P (60,000) 40,000 40,000

Q (60,000) 75,100 -

Compute the IRRs of the two projects assuming a cost of capital of 10%.

A comparison can be made over an equal time span for both investments; the lives of P and
Q can be equalised by assuming that the company can invest in another project like Q at the
end of year 1. The cashflows of two consecutive investments in Q would be as follows:

Year 0 1 2
K’000 K’000 K’000
Project Q (60,000) 75,100 -
Project Q repeated (60,000) 75,100
Total Cashflow (60,000) 15,100 75,100

(1) Using unadjusted K’000 IRR

Cash flows NPVP = 4,711 22%
(I.e. P over 2 yrs
And Q over 1 yr) NPVQ = 4,090 25%

(2) Cashflow adjusted to K’000 IRR

Equalise project lives NPVP = 4,711 22%
(i.e. P over 2 yrs and
Q over 2years) NPVQ = 7,810 25%

Conclusion and analysis

Ranking project P and Q on an IRR basis makes project Q the superior choice, irrespective of
the period over which the comparison is made.

194
In conclusion, regardless of the project lives, the project with a higher IRR should be chosen
as the IRR does not seem to be affected by the length of the project life or repeated
reinvestment of the cash flows.

TRADITIONAL APPROACHES TO PROJECTS/ CAPITAL INVESTMENT

APPRAISAL

As you can remember, from the outset of the chapter, the payback period and accounting rate
of return are the commonly used traditional methods of appraising capital investments.

Payback Period Method

Computation of payback period of a project is the time required for the cash inflows from a
capital investment project to equal the cash outflows.

If we assume that cashflows are received at the end of each year, the payback period for the
four projects below will be:

Projects: Years A B C D
K’000 K’000 K’000 K’000

Initial capital outlay 0 (20,000) (20,000) (10,000) (10,000)

Cash inflows 1 10,000 400 6,400 0
2 20,000 400 12,800 0
3 20,500 16,400 13,000 0
4 21,000 32,400 13,200 18,000

The pay back period for the projects is as follows:

Project Payback period

A 2 years
B 4years
C 2years
D 4years

In practice corporations will have a benchmark of the payback period, which is going to be
adopted in their company policy as the threshold or cut off point for appraising and assessing
the payback periods of projects.

For instance if the company above has a corporate policy of only accepting project with
payback period of 3 years only project A and C promise to payback a three year period.

Hence only project A and C would be accepted and be undertaken in this instance.

195
Decision rule:

Only projects with short payback periods are preferred.

Limitations of Payback Period Method

The payback period method has a limitation not taking the time value of money into
consideration and it ignores the future cashflows beyond the payback threshold as per
company policy no matter how healthy the cashflows might be.

Discounted Payback Period

In order to go round the problem of the lack of recognition of the time value of money some
evaluators opt to use discounted pay back where the payback of the project is deferred using
discounted cash flows as opposed to simple cashflows.

Exercise

Compute the present values of the cashflows from the above 4 projects A, B, C and D at a
cost of capital of 5% and you will discover that the discounted payback (year) will be as
follows:

Project Discounted payback (years)

A No Payback
B 4 years
C 2 years
D 4 years

This is a slightly more comprehensive evaluation that the crude simple method of using
simple cash flows.

The Accounting Rate Of Return (ARR)

Computing Accounting Rate of Return

A mathematical expression of;

Average annual profit from an investment x 100

Average Investment

196
Defines the accounting rate of return as;

The model that employs accounting profits rather than cash flows from the project as the
input data to the model. To find the ARR of an investment, the average profit over the life of
the investment is calculated. This is then expressed as a return on either the initial or the
average investment in the project. An acceptable ARR must be specified by the decision
maker in advance and projects exceeding this return will be accepted and those falling short
of the return will be rejected.

To illustrate the mechanics of the method, the following illustration can be used.

Consider four projects A, B, C, & D with the following data.

Example

Project Name: A B C D

Project life: 4 4 4 4

Cash –Inflows: K21, 000,000 K32, 400,000 K13, 200, 000 K18, 000,000

Deprecation: K20, 000,000 K20, 000,000 K10, 000,000 K10, 000,000

Profit: K1, 000,000 K12, 400,000 K3, 200,000 K8, 000,000

In the above figures, we are assuming that the deprecation and profit figures shown are for
total (aggregate) figures over the lives of the projects.

Average profits for the projects

Total Profit over 4 years = Profit per year

Project life years

Projects: A B C D
K1, 000,000 K12, 400,000 K3, 200,000 K8, 000,000
4yrs 4yrs 4yrs 4yrs

= K250, 000 K3, 100,000 K800, 000 K2, 000,000

197
Computation of average capital investment:

Assuming that all the resources invested in the project will be consumed and hence the
investment at the end of the project life will reduce to zero (0), the Average investments are
calculated as a simple mathematical mean.

Project A Project B

K21, 000,000 + K0 K32, 400,000 + K0

2 years 2 years

K10, 500,000 K16, 200,000

Project C Project D

K13,200,000 + K0 K18,000,000 + K 0
2 years 2 years

K6, 600,000 K9, 000,000

The Accounting Rate of return:

Projects A: K250, 000 = 2.38%

K10, 500,000

Projects B: K3, 100,000 = 19.14%

K16, 200,000

Projects C: K800, 000 = 12.12%

K6, 600,000

Projects D: K2, 000,000 = 22.22%

K9, 000,000

For the technique to find use, the decision maker needs to specify a required rate of return
when ARR is used as the project evaluation method.

As mentioned under the payback period method, corporations need to establish and choose as
a policy, an accounting rate of return percentage.

198
ANNUALISED EQUIVALENT COSTS

Example

Mpose Plc is considering the purchase of a new track, which will be required to travel 50,000
kilometers per year. Two suitable models are available details of which are as follows:

The Kenworth having a life of four (4) years and a price of K200, 000,000 the running cost is
initially K2000 per kilometer but this will rise by K300 per kilometer for each year the truck
is in service.

Scania will incur the following cost over 6 years

Years K’000
0 350,000
1 75,000
2 90,000
3 105,000
4 120,000
5 135,000
6 150,000

The cost of capital for Mpose Plc is 12%

Required:

Explain which truck (between the Kenworth and the Scania) should be purchased.

Solution:

As we can see the comparison of the two projects is complicated by their unequal lines. We
are going to use annualized costs to compare the two projects.
Therefore the annualized cost of the Kenworth is:

Year Costs
K’000

0 200 000
1 100 000
2 115 000
3 130 000
4 145 000

199
The annualized cost of the Kenworth Truck
Year Costs 12% DCF Present value
K’000 K’000
0 200,000 1.000 200,000

1 100,000 0.8930 89,300

2 115,000 0.7970 91,655

3 130,000 0.7120 92,560

4 145,000 0.6360 92,220

Totals: 3.038 565,735

The annualized equivalent of K 565,735

K 565,735
3.038
= K186,219.552

This is determined by calculating the Net Present Value of acquiring and operating a
Kenwork truck over four years and converting it an equal annual equivalent cost by dividing
the Net Present Value by 3.037.

The annualized cost of the Scania truck is;

Year Costs 12% DCF Present value

K’000 K’000
0 350,000 1.0000 350,000

1 75,000 0.8930 66,980

2 90,000 0.7970 71,230

3 105,000 0.7120 74,760

4 120,000 0.6360 76,320

5 135,000 0.5670 76,550

6 150,000 0.5070 76,050

200
 Totals: 4.112 791,890
The annualized equivalent of K791, 890,000 is

K 791,890,000
4.112

= K192, 580,252.90

Therefore in conclusion, the Kenworth Truck is the best option with a lower annualized cost.

PREFERENCE FOR APPRAISAL METHOD

Investment Appraisal method

Advantages and disadvantages of Investment Appraisal Methods

PAYBACK PERIOD METHOD

Advantages

(a) It is easily understood and interpreted, especially to non-financial managers, and its
implications for liquidity are clear.
(b) It can be used as preliminary project appraisal screening method, before scientific
methods (discounted cash flows are applied for the appraisal process).

Disadvantages

(a) It ignores cash flows beyond the payback period and it does not take into account of
the time value of money.

NET PRESENT VALUES

Advantages

(a) It takes account the timing of cash flows.

(b) It takes proper account of the size and duration of projects.
(c) It takes into account the greater uncertainty of later years’ cash flow by using a higher
discount rate for these years.

Disadvantages

(a) It produces a number which is less familiar to management than a rate of return.
(b) It's complex in its mechanics.

201
 (c) Not easily understood by non-financial managers.

INTERNAL RATE OF RETURN

Advantages

(a) It takes into account of the timing of the cash flow.

(b) It is easily compared to a given return, which project owners are looking for, in
assessing a project’s viability.

Disadvantages

(a) It does not take account of the size of the project, so a small project with a high return
looks better than a large project with a lower return, even through the latter will
contribute more to earnings.

(b) The Internal Rate of Rate (IRR) cannot evaluate properly the duration of projects.
This is because IRR takes no account of what happens to the returns after they are
achieved.

(c) Another potential difficulty, which may sometimes arise, is the possibility of two or
more solutions to the IRR calculation. This usually happens when a project has
unconventional cash flows, meaning that cash flows with negative and positive signs
may come through during the life of the project.

Chapter Summary

The following have been covered under this chapter:-

• Net Present Value (NPV)

• Internal Rate of Return (IRR)
• Pay Back Period (PBP)
• Accounting Rate of Return (ARR)

202
ANSWERS TO END OF
CHAPTER QUESTIONS

203
Chapter 1

Question 1 C

Question 2 B

Chapter 2

Chapter 3

Cost(K’000)
Activity
High activity 42 6,700
Low activity 33 6,052
Change 9 648

Variable cost per unit 648 = 72

9

Fixed costs = Total cost - variable cost

K’000
= 6700 - (72 x 42) = 3,676

Total cost at 75 units

= 3676 + (72 x 75) = 9,076

Total cost at 90 units

= 3676 + (72 x 75) = 10,156

204
 Chapter 4

QUESTION 1 : B QUESTION 2 : C

Cost of issues under the FIFO method

Issue Value
500 1,250
1,000 2,750
1,600 4,480
800 =800/1200 x 3480 2,320
3,900 10,800

Cost of issues under the LIFO method

K'000
Total Receipts 16,310

Less Issues

1,200 3,480
900 =900/1600 x 4480 2,520
2,100

1,500 4,350
300 =300/1600 x 4480 840
11,190

Closing Stock 5,120

QUESTION 3 : D

Cost of issues under the AVCO method

Units Average price Value
K'000
Receipts 500 2.50 1,250

205
Receipts 1,000 2.75 2,750
Receipts 1,600 2.80 4,480
Receipts 1,200 2.90 3,480
Total 4,300 2.78 11,960
Issue (2,100) 2.78 (5,841)
Balance 2,200 2.78 6,119
Receipts 1,500 2.90 4,350
Total 3,700 2.83 10,469

206
 Chapter 5

Question : 1 C

Reorder level = maximum Usage x maximum lead time

420 x 15 = 6,300

3 Maximum stock = reorder level + reorder quantity – (minimum usage x minimum

lead time)

6,300 + 7,000 – (180 x 11) = 11,320

Question : 2 B

Minimum stock level = Reorder level – (average usage x average lead time)

6,300 – (350 x 13) = 1,750

Question : 3 B
4

2 x 55,000x

√ 4000
200 + 10% x 200

440000000
√ 220

1,414

207
 Chapter 6

Question 1a

Chila
Basic (45 x 920) 41,400
Over time Premium - first 3 Hrs (3 x 1/3 x 920) 920
Over time Premium - next 2 Hrs (2 x 1/2 x 920) 920

Total 43,240

Bonus
standard Time allowed (40 min x 72) 48
Actual Time 45
Saving 3
Bonus Pay (3 x 920 x 75%) 2,070

Total Pay 45,310

Cheta
Basic (46 x 960) 44,160
Over time Premium - first 3 Hrs (3 x 1/3 x 960) 960
Over time Premium - next 3 Hrs (3 x 1/2 x 960) 960

Total 46,080

Bonus
standard Time allowed (40 min x 188) 47
Actual Time 46
Saving 1
Bonus Pay (1 x 960 x 75%) 2,160

Total Pay 48,240

Chulu
Basic (44 x 940) 41,360

208
Over time Premium - first 3 Hrs (3 x 1/3 x 940) 940
Over time Premium - first 2 Hrs (2 x 1/2 x 940) 940

Total 43,240

Bonus
standard Time allowed (40 min x 432) 50.4
Actual Time 44
Saving 6.4
Bonus Pay (6.4 x 960 x 75%) 4,512

Total Pay 47,752

Question 1b

Net pay computation Chila Cheta Chulu

Gross Pay 45,310 48,240 47,752
PAYE (13,593) (14,472) (14,326)
NAPSA (3,000) (3,000) (3,000)
Mukuba Pension (2,500) (2,500) (2,500)

Net Pay 26,217 28,268 27,926

Question 1c

Journal Entry
DR CR
Wages Account 141,302

PAYE 42,391
NAPSA 9,000
Mukuba Pension 7,500
Salaries Control 82,411

Total 141,302 141,302

Being wages cost for the month

209
 Chapter 7

Question 1.1

Answer is C

Question 1.2

Answer is C

Question 1.3

Answer is A

Question 1.4

Answer is B

Question 2a

Overhead Analysis Sheet

Overhead Basis of apportionment Total overhead Production departm

Machining A
Indirect Material Direct 245,000 100,000
Indirect Wages Direct 275,000 90,000
Managers Salaries No of employees 70,000 21,000
Depreciation of machinery Value of Machinery 150,000 120,000
Heating and Lighting Area 50,000 1,250
Building insurance Area 25,000 625
Insurance of Machinery Value of Machinery 100,000 80,000
Rent and rates Area 75,000 1,875

Totals 990,000 414,750

210
Question 2b

Overhead Analysis Sheet

Overhead Basis of apportionment Total overhead Production departments
Machining Assembly
K'000 K'000 K
Totals 990,000 414,750 274
Maintenance - 52,785 50
Stores - 141,269 56

Total 990,000 608,804 381

Machining Assembly
K'000 K'000
Over heads 608,804 Over heads 381,196
Machine hours 100,000 Machine hours 80,000

K 6.09
OHAR per hour OHAR K4.76 per hour

Question 2c

Total costs for Job X

K'000
Direct Materials 2,000
Direct Labour
Machining (K5,000 x 1000 hrs) 5,000
Assembly (K5,000 x 800 hrs) 4,000
Overheads
Machining (400hrs x K 6.09) 2,436
Assembly (800hrs x K 4.76) 3,808

Total 17,244

Chapter 10

211
Part (a) Part (b)

Absorption Cost Statement

K'000
Sales (9,000 X K20) 180,000

Opening Stock -
Production cost (11,000 x K12) 132,000
Closing Stock (2,000 x K12) (24,000)
Cost of Sales 108,000
Gross Profit (K180,000 - K108,000) 72,000
Other Expenses
Variable selling costs (K1 X 9,000) (9,000)
Fixed selling costs (K2 x 10,000) (20,000)
Under absorption (see working) 4,000

Net Profit 47,000

Marginal Cost Statement
K'000
Sales (9,000 X K20) 180,000

Opening Stock -
Production cost (11,000 x K8) 88,000
Closing Stock (2,000 x K8) (16,000)
Variable Cost of Sales 72,000
Variable selling costs (9,000 x 1) 9,000
Total Variable costs 81,000
Contribution (K180,000-K99,000) 99,000
Fixed costs
Production (10,000 x 4) (40,000)
Selling (10,000 x 2) (20,000)
Net Profit 39,000

Under/Over absorption

Fixed Production OH K'000

Absorbed overheads 44,000
Actual overheads 40,000
Over absorption 4,000

Part (c)

Profit Reconciliation
K'000
Absorption Cost Profit 47,000

212
Less : F/costs in C/stock (8,000)
Profit as per marginal costing 39,000

Chapter 11

Question 1 K
Salary cost per consulting hour (senior) K2,000 x 86hrs 172,000
Salary cost per consulting hour (Junior) K1,500 x 220hrs 330,000
Total Labour cost 502,000
Overhead absorption rate per consulting
hour K1,250 x 306hrs 382,500
Total cost 1,386,500

Profit Mark up 40 % of 1,386,500 554,600

Price for the assignment 1,941,100

Question 2
a) Job X124 Job X125
Material costs
Job X124 Job X125
Direct Material issued from stores 697,800 1,899,400
Direct returned to stores (700,000)
Direct Material transfers 86,000
Material Cost 697,800 1,285,400
Month 6 costs 722,000
Total material costs 1,419,800 1,285,400
Labour costs
Direct Labour hours 780 2,364
Rate Per hour 700 700
Labour cost 546,000 1,654,800
Month 6 costs 600,760
Total labour cost 1,146,760 1,654,800

Production overhead
Direct Labour hours 780 2,364
Overhead absorption Rate Per hour 1,200 1,200

213
 Labour cost 936,000 2,836,800
Month 6 costs 1,041,600
Total labour cost 1,977,600 2,836,800

b) Total costs and profits Job X124 JobX125

Total Production costs 4,544,160 5,777,000
Distribution, selling & admin costs 908,832 1,155,400
Total costs 5,452,992 6,932,400
Sales invoices 6,000,000 7,900,000
Profit 547,008 967,600
Chapter 12

SOLUTION

K’
0
0
K'000 0
450,00
Contract Price 0
295
,00
Cost to date 0
Estimated 70,
future costs 000
Estimated (365,00
total costs 0)
Estimated
total profit 85,000

6
8,
( 295 X 6
a ,00 85,000 9
) Cost to date 0 = 9
365
Estimated ,00
total costs 0

5
6,
( 300 X 6
b ,00 85,000 6
) Work certified 0 = 7
450
,00
Contract Price 0

214
 Chapter 13

4.1 Solution

Cost Item K'000

Depreciation of vehicles [(500,000- 20,000)/10 ] / 4 7,500
Road fund licence and insurance 11,450
Tyres (80,000/40,000) x 8 x 1050 16,800
Servicing (80,000)/16,000 x 3250 16,250
Fuel (80,000/10) x 5 40,000
Drivers 36,000
128,000
Total

Kilometres per year 80,000

Cost per Kilometre 1.60

Chapter 14

PROCESS ACCOUNT
Units K’000 Units K’000
Direct 50,00 24,80 Finishe 36,00
materials 0 0 d goods 30,00 0
0
Direct 17,60 Closing 11,00
Labour 0 WIP 12,00 0
0
A/Loss 7,200
6,000
Production 12,60 N/Loss
overheads 0 2,000 800
Totals 50,00 55,00 Totals 55,00
0 0 50,00 0
0

215
 ABNORMAL LOSS ACCOUNT
Units K’000 Units K’000
Process 6,00 7,200 Cash/Bank 6000
account 0 2,400
P&L
4,800

Totals 100 7,200 Totals 100

7,200

Workings
W1
Total
Cost
Cost Per
s Unit
K’000 K’000
Cost 4.1.1.1 Equivalent Units
Elem Finished A/Los Closin
ent Output s g WIP Total
6,000
Mater 12,00 48,00 24,0
ial 30,000 0 0 00** 0.50
6,000
Labo 44,00 17,6
ur 30,000 8,000 0 00 0.40
6,000
Over
head 42,00 12,6
s 30,000 6,000 0 00 0.30

Total 1.20

** K24,800- 800 beings scrap value of normal loss

W2
Valuation of Closing Work-In-Progress

Cost Element Equivalent Units – WIP Cost per unit Value

K’000 K’000
Material 12,000 0.5 6,000
Labour 8,000 0.4 3,200
Overheads 6,000 0.3 1,800

Total 11,000

Valuation of Finished Goods

Cost Element Equivalent Units – WIP Cost per unit Value

216
 K’000 K’000
Material 30,000 0.5 15,000
Labour 30,000 0.4 12,000
Overheads 30,000 0.3 9,000

Total 36,000

W3

Valuation of abnormal Loss

Cost Element Equivalent Units – WIP Cost per unit Value

K’000 K’000
Material 6,000 0.5 3,000
Labour 6,000 0.4 2,400
Overheads 6,000 0.3 1,800

Total 7,200

Chapter 15

U
n C
i o
t st
s s
K'
0
0
Process costs 0

4
,
0 6,
0 4
0 0
Direct materials 0

5,
2
0
Direct Labour 0

1
1,
6
0
Total Prime Costs 0

217
 1
7,
4
Factory overhead (150% of 0
K11.6m) 0

2
9,
0
0
Total Process Costs 0

(
6
0 (9
0 0
Less By-product sales** ) 0)

3
, 2
4 8,
0 1
Joint costs to be 0 0
apportioned 0

** Note the treatment of the sales value of the by-product which has been deducted from the
process costs.

a)

Apportionment of joint costs using Volume

K'000
X 2500 X 39,700 = 29,191
3,400

Y 400 X 39,700 = 4,671

3,400

Z 500 X 39,700 = 5,838

3,400

Total costs apportioned 39,700

218
 Workings for sales values at the split-off-point

Product Quantities in Kg Selling price per Kg K'000

Kwacha
X 2,500 10,160 25,400
Y 400 12,645 5,058
Z 500 6,740 3,370
Total sales value at split-off-point 33,828

b)

Apportionment of joint costs using relative sales values at split-

off
K'000
X
K28
25,40 ,10 20,66
X 0 0= 2
33,82
8

X
K28
,10
Y 5,058 0= 3,306
33,82
8

X
K28
,10
Z 3,370 0= 4,132
33,82
8

28,10
Total costs apportioned 0

219
 Chapter 16

Question 1 : Answer is C

Question 2 : Answer is C

Question 3 : Answer is A

Question 4 : Answer is B

Working

250kg x K10,000 K2,500

250kg x 12,000 K3,000
Total K5,500

Question 5 : Answer is D

Working

1,000kg x K6,000 = K6 million

Chapter 17

Answer is : C

Relevant cost for material P would be

Opportunity Cost 5,000 kg x K150 750,000

Extra material required 3,000kg x K500 1,500,000

Total cost 2,250,000

220
 Chapter 18

Q1. BEP = Fixed cost/CS ratio

= K210,000,000/0.3 = K700,000,000/40,000 = 17,500 units

Q2. (K210,000,000+K60,000,000)/0.3 = K900,000,000/40,000 = 22,500 units

Q3 Contribution = K64,000 – K34,000 = K30,000

F/cost = 1,050 units x K10,000 = K10,500,000
BEP = K10,500,000/K30,000 = 350 units
Margin of safety = 1,050 – 350 = 700 units
MOS as a % = 700/1050 x 100 = 66.67%

Q4 Volume to achieve a profit of K24million

(K24,000,000 + 10,500,000)/30,000 = 1150 units

Q5 (a) C/S ratio = 4,000/10,000 x 100 = 40%

(b) BEP = K2,500,000/4,000 = 625 units
(c) MOS = 1,000 – 625 = 375 units
(d) (K2,000,000 + K2,500,000)/4,000 = 1,125 units

221
 Chapter 20

Standard Cost Card

Direct materials Costs

K K
10kg of material X @K1,600 per kg 16,000
7.5kg of material Y @ K2,500 per Kg 18,750
Material cost 34,750

Direct Labour:
Preparation 14 hours @ K3,750 per hour 52,500
Assembly 5 hours @ K5,000 per hour 25,000
77,500
Prime Cost 112,250
The budgeted total overheads for one year are:

Variable Overheads
Preparation 14 hours @ K3,150 per hour 44,100
Assembly 5 hours @ K4,250 per hour 21,250
65,350
Variable Production Costs 177,600
Fixed Overheads
Preparation 14 hours @ K1,250 per hour 17,500
Assembly 5 hours @ K2,000 per hour 10,000
27,500

Total Production Cost 205,100

222
WORKINGS
Total Fixed OH Variable
Preparation 88,000,000 25,000,000 63,000,000
Assembly 150,000,000 48,000,000 102,000,000

Fixed Production OH Cost Hours OH rate per Hour

Preparation 25,000,000 20,000 1,250
Assembly 48,000,000 24,000 2,000

Variable Production OH Cost Hours OH rate per Hour

Preparation 63,000,000 20,000 3,150
Assembly 102,000,000 24,000 4,250

Chapter 21

SOLUTIONS

One

Total material cost variance

K'000
Actual units 1,040
Standard cost per unit (4,500 x 4) 18,000
Standard material cost 18,720
Actual material cost 14,400
Variance 4,320 F

Material Price variance = (SP - AP)AQ

K'000
(4,500 - 14,400,000/4,100) x 4,100 = 4050 F

Material Usage Variance = (SQ - AQ) x SP

[(1040x 4) - 4,100] x 4,500 270 F

SOLUTION – TWO

Total labour cost variance

223
 K'000
Actual units 3,350
Standard cost per unit 24,000
Standard labour cost 80,400
Actual labour cost 79,893
Variance 507 F

Labour Rate variance = (SR - AR)AH

K'000
(6,000 - 79,893,000/13,450) 13,450 = 807 F

Labour efficiency Variance = (SH - AH) x SR

[(3,350x 4) - 13,450] x 6,000 -300 F

SOLUTION- THREE

Total Fixed overhead variance

K'000
Actual units 1,100
Standard cost per unit 20,000
Standard labour cost 22,000
Actual labour cost 20,450
Variance 1,550 F

Expenditure Variance
K,000
Budgeted Expenditure 20,000
Actual Expenditure 20,450
Expenditure Variance (450) A

Volume Variance

Actual Volume (Units) 1,100

Budgeted Volume (Units) 1,000
Budgeted Rate per unit (K'000) 20
Variance (K'000) 2,000 F

Volume Variance Efficiency

Standard Hours = 1100 units @5 hours 5,500

Actual Hours 5,400
Standard Rate per Hour (K'000) 4

224
Variance (K'000) 400 F

Volume Capacity Efficiency

Actual Hours 5,400

Budgeted Hours = 1000 units @5 hours 5,000
Standard Rate per Hour (K'000) 4
Variance (K'000) 1,600 F

Chapter 23

Question one

WORKING FOR RECEPTS FROM DEBTORS

F J
J e u
a b n
n Ma
X X Mar Apr y X
5 5 X5 X5 X5 5
K K
K’ ’ ’
Mont 0 0 0
h of 0 0 K’0 K’0 K’0 0
sale 0 0 00 00 00 0
2
4,
0
Nov 40,000 0
X4 x 60% 0
3
0
,
0
Dec 50,000 0
X4 x 60% 0
JanX 55,000 33,
5 x 60% 000
Feb 65,000 39,
X5 x 60% 000
Mar 70,000 42,
X5 x 60% 000
4
5
,
0
Apr 75,000 0
X5 x 60% 0
May 80,000

225
X5 x 60%
Jun 90,000
X5 x 60%
3 4
2 0 5
4, , ,
0 0 0
0 0 33, 39, 42, 0
Total 0 0 000 000 000 0

226
The six-month cash Budget

SOLUTION
Cash inflow JanX5 Feb X5 Mar X5 Apr X5
K'000 K'000 K'000 K'000
Cash sales 22,000 26,000 28,000 30,000
Debtors receipts 24,000 30,000 33,000 39,000

Total inflow 46,000 56,000 61,000 69,000

Creditors 30,000 40,000 45,000 55,000

Wages 7,500 9,500 11,500 13,500
Overheads 5,000 7,500 7,500 7,500
Dividends 10,000
Capital Expenditure 15,000

Total Outflows 42,500 57,000 89,000 76,000

Opening Balance 7,500 11,000 10,000 (18,000)

Net cash flow 3,500 (1,000) (28,000) (7,000)
Closing Balance 11,000 10,000 (18,000) (25,000)

Question 2
a) Production Budget

Product Sigma
Sales 4,600
Add closing Stock 1,100
Less opening stock ( 800)
Production 4,900

b) Material Usage Budget

Product
Units of production 4,900
Materials per unit 6
Material usage 29,400Kg

c) Material Purchases Budget

Material X
Production 29,400
Add closing Stock 3,000
Less opening stock (2,400)
Purchases 30,000

227
 Question 3

GM engineering
Sales
Budget

Product Volume Selling Price Total Revenue

Units K'000 K'000
A 8,500 4.00 34,000
B 1,600 5.60 8,960

Total 42,960

Production
Budget

Product A B

Sales 8,500 1,600

Add Closing Stock 1,870 90
Less Opening stock (170) (85)

Production 10,200 1,605

Material Usage Budget

Material Usage X Usage Y

To Product A (10,200 x 1.5) 15,300 (10,200 x 0.5) 5,100
To Product B (1605 x 2) 3,210 (4X1605) 6,420

Total 18,510 11,520

Material Purchases Budget

Material X Y
Production 18,510 11,520
Add Closing stock 490 480
Less Opening Stock (500) (500)

Total 18,500 11,500

Purchase Price (K'000) 1.5 1

Total material cost (K'000) 27,750 11,500

228
Labour Budget

Product Volume Hours per unit Total Hours Rate/Hour (K000) Total Co
A 10,200 6 61,200 1.60 97
B 1,605 9 14,445 1.60 23

Total 121

Production Overhead Rate

Assembl
Department Machining y

Budgeted Overheads (K'000) 45,000 23,000

Budgeted Activity - Machine Hours 3,000 2,300

Production overhead absorption rate (K'000) 15 10

Production Overhead Budget

Product Machining Asse

Time Hrs Rate (K'000) Total (K'000) Time Hrs Rate (K
A (10200 units) 3,400 15 51,000 2,550 10
B (1605 units) 1,070 15 16,050 668.75 10

Total 67,050

Chapter 24

Solution 1 : answer is A

Solution 2 : answer is D

Solution 3

Product X

High Volume Volume (units) Cost (K’000)

High 10,000 60,000
Low 4,000 30,000
Variation 6,000 30,000

Variable Cost per unit (K’000) 30,000 5

6,000

Fixed cost = Total cost - Variable cost

229
@10,000 units= K60,000 -( K5 x 10,000) = K10,000

Total cost @ 5,000 units K’000

Variable cost = 5,000 x K 5 25,000
Fixed costs 10,000
Total cost 35,000

Product Y

High Volume Volume Cost

High 15,000 377,000
Low 8,000 202,000
Variation 7,000 175,000

Variable Cost per unit 175,000 25

7,000

Fixed cost = Total cost - Variable cost

@ 8,000 units= 202,000 -( 25 x 8,000) = 2000

Total cost @ 10,000 units

Variable cost = 10,000 x 5 250,000
Fixed costs 2,000
Total cost 252,000

Chapter 25

Solution 1 : answer is C

Solution 2 : answer is A

230
 Chapter 26

Assume Monday of the first week is 0, Friday of the third week is 14

Question 1a

b n ∑XY - ( ∑X) ( ∑Y)

= n ∑X 2 - ( ∑X) 2

= (10 x 2,540,800 - (2,800)

x (8040)
(10 x 928,000) - (2,800)^2

2,8
b
96,
00
= 0
1,4
40,
00
0

b 2.
0
= 1

a
Σ b
Σ
= Y - X
n n

8 2.0
0 1x
4 2,8
0 - 00
1
0 10

8
0 562
4 - .8

231
 241.2

Question 1b

5 Y = 7,477.2 + 2.01 x ,
Where x = 250; Y =241.2 + 2.01 x 250
= 743.7

Question 2a

X Y Trend S= T- Y

Week 1 Monday - 560 649 89

Tuesday 1 840 652 (188)

Wednesday 2 728 655 (73)

Thursday 3 658 658 (0)

Friday 4 434 661 227

Week 2 Monday 5 574 664 90

Tuesday 6 875 667 (208)

Wednesday 7 770 669 (101)

Thursday 8 679 672 (7)

Friday 9 448 675 227

Week 3 Monday 10 588 678 90

Tuesday 11 910 681 (229)

Wednesday 12 812 684 (128)

Thursday 13 700 687 (13)

Friday 14 462 690 228

Monday Tuesday Wednesday Thursday Friday

Week 1 88.9 -188.16 -73.22 -0.28 226.66

232
Week 2 89.6 -208.46 -100.52 -6.58 227.36

Week 3 90.3 -228.76 -127.82 -12.88 228.06

Total 268.8 -625.38 -301.56 -19.74 682.08

Average 89.6 -208.46 -100.52 -6.58 227.36

Adjustment -0.28 -0.28 -0.28 -0.28 -0.28

Final estimate 89.32 -208.74 -100.8 -6.86 227.08

Question 2 b- Forecast sales For week 4

Period Trend Seasonal Forecast

Day X T factor Y

Week 4 Monday 15 693.00 89.32 782.32

Tuesday 16 695.94 (208.74) 487.20

Wednesday 17 698.88 (100.80) 598.08

Thursday 18 701.82 (6.86) 694.96

Friday 19 704.76 227.08 931.84

233
INDEX Causes of variances, 20
Committed costs, 27
CVP Analysis, 49
A
D
Accounting Rate of Return (ARR), 193
Activity Based Costing (ABC), 171 Decision making process, 25
Annualised Equipment costs, 196 Differential costs, 26
Avoidable costs, 26 Direct labour efficiency variance, 10
Direct labour rate variance, 9
B Direct material price variance, 7
Direct material usage variance, 8
Backflush accounting, 165 Directly attributable fixed costs, 28
Break-even point, 49
Budget centre, 66 E
Budget committee, 67
Budget manual, 67 Enterprise Resource Planning, (ERP), 175
Budget period, 67
Budget, 65
Budgetary control, 83
Budgetary slack, 87
F
C
Financial Accounting, 2
Capital Budgeting, 123, 180 Financial planning system, 126

234
Fixed budget, 83
Fixed overhead volume capacity variance, 15 O
Fixed overhead volume efficiency variance, 13
Fixed overhead volume variance, 13 One-off contract, 45
Flexible budget, 83 Opportunity costs, 27
Full cost-plus pricing, 59 Option budgets, 128
Functional budgets, 74
P
G
Payback period method, 192
Goal congruence, 86 Pproduct life cycle, 58, 161
Product mix, 58
H Programming planning based budgetary
system, 97, 127
High-low method, 103
R
I
Relevant costs, 26
Incremental budgeting, 93 Revenue budgets, 121
Incremental costs, 26 Rolling or continuous budgets, 95
Internal Rate of Return (IRR), 183
Irrelevant cost,27 S

L Sales volume variance, 16

Scarce resource, 37
Life cycle budgeting, 159 Scatter diagram, 101
Life cycle costing, 157 Selling price variance, 15
Linear regression, 103 Service costing, 152
Line-item budget, 122 Sunk costs, 27

M T

Make of buy decisions, 39 Target costing, 148

Management Accounting, 2 Target profit, 52, 151
Manufacturing Resource Planning (MRP), 175 The bid system, 124
Margin of safety, 51 Throughput accounting, 139
Marginal cost-plus pricing, 60 Time series, 105
Market penetration pricing, 61
Market skimming pricing, 62 U
Marketing strategy, 58
Master budget, 77 Unavoidable costs, 28
Moving averages, 108
N
V
Net Present Value (NPV), 179
Notional costs, 28 Variance analysis, 5

235
Variable overhead efficiency variance, 11
Variable overhead expenditure variance, 11
Virement policy, 128

Zero based budgeting, 94,127

236