Managerial Accounting J 1 1

Managerial
Accounting
Fifth Edition
Managerial
Accounting
Fifth Edition
J Swanepoel
CA(SA)
HOD: Centre for Accounting, University of the Free State
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ISBN 978 0 409 1 2086 8

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First Edition 1999, Reprinted 2000

Second Edition 2001, Reprinted 2002, 2003, 2004
Third Edition 2005, Reprinted 2005, 2006
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Contents
Chapter 1 The meaning of management accounting ........................................................... 1

Management accounting ...................................................................................... 4
Cost behaviour ...................................................................................................... 5
Contribution ......................................................................................................... 7
The cost volume chart .......................................................................................... 14
Identifying relevant information........................................................................... 16
Key fundamental principles .................................................................................. 18
Chapter 2 Systems for recording and controlling product costs.......................................... 19
Costing terminology.............................................................................................. 20
Valuation of a single unit of production ............................................................... 23
Product valuation for financial accounting purposes ........................................... 24
Job costing ............................................................................................................ 43
Cost classification for short-term decisions .......................................................... 45
Appendix ............................................................................................................... 47
Practice questions................................................................................................. 51
Chapter 3 Process and joint product costing........................................................................ 57
Valuation of closing work-in-progress .................................................................. 57
Normal and abnormal spoilage ............................................................................ 63
Illustrative examples of typical questions ............................................................. 68
Joint product costing ............................................................................................ 76
Accounting for by-products .................................................................................. 81
Appendix ............................................................................................................... 84
Chapter 4 Variable and absorption costing .......................................................................... 101
Variable costing defined ....................................................................................... 103
Absorption costing defined................................................................................... 103
Income effect of variable costing compared to absorption costing ..................... 106
Calculating absorption profit ................................................................................ 108
Calculating variable profit ..................................................................................... 115
Reconciliation of absorption to variable profit ..................................................... 117
Reconciliation of absorption profit to absorption profit ...................................... 120
Variable costing in relation to cost-volume-profit analysis .................................. 123
Appendix ............................................................................................................... 126
Chapter 5 Activity-based costing .......................................................................................... 145
Methodology ........................................................................................................ 145
The logical error of activity-based costing ............................................................ 155
The relevance of activity-based costing ................................................................ 160
Benefits and limitations of activity-based costing ................................................ 161
Eastern vs Western management styles ............................................................... 163
Chapter 6 Cost classification and estimation ....................................................................... 175
Cost classification ................................................................................................. 175
v
vi Managerial Accounting
Linear regression analysis ..................................................................................... 179

Learning curves ..................................................................................................... 187
Appendix ............................................................................................................... 191
Chapter 7 Cost-volume-profit analysis ................................................................................. 209
Cost-volume-profit analysis and graphs ............................................................... 209
Analysing costs using cost-volume-profit principles ............................................. 218
Application of cost-volume-profit concepts ......................................................... 223
The profit-volume chart........................................................................................ 227
Multi-product break-even analysis ....................................................................... 228
Sensitivity analysis ................................................................................................ 230
Appendix ............................................................................................................... 235
Chapter 8 Budgeting and budgetary control ........................................................................ 249
Long-term planning .............................................................................................. 250
Budgeting and the human factor .......................................................................... 251
The master budget ............................................................................................... 253
The cash budget.................................................................................................... 255
Learning curve application in budgeting ............................................................... 262
Flexible budgeting ................................................................................................ 264
Zero-base budgeting ............................................................................................. 266
Appendix ............................................................................................................... 268
Chapter 9 Standard costing .................................................................................................. 283
The purpose of standard costing .......................................................................... 283
Reconciliation of budget to actual profit .............................................................. 286
Principles of standard costing ............................................................................... 290
Reconciliation of budget profit to actual profit where actual production is
higher or lower than actual sales.......................................................................... 292
Raw materials variance analysis ........................................................................... 297
Labour variance analysis ....................................................................................... 305
Variable overhead variances ................................................................................ 310
Fixed overhead variances ..................................................................................... 312
Sales variances ...................................................................................................... 315
Comprehensive example ...................................................................................... 323
Ledger accounts .................................................................................................... 334
Appendix ............................................................................................................... 337
Chapter 10 Decisions under risk and uncertainty .................................................................. 357
Evaluating a probability distribution..................................................................... 357
Risk and financial analysis ..................................................................................... 359
Probability as the area under the normal curve ................................................... 361
Decision trees ....................................................................................................... 364
Appendix ............................................................................................................... 372
Chapter 11 Relevant costs ...................................................................................................... 383
Costing terms ........................................................................................................ 383
Adding a new product .......................................................................................... 384
Dropping a product or division ............................................................................. 384
Make or buy decision............................................................................................ 385
Special orders ....................................................................................................... 386
Two alternative decisions ..................................................................................... 387
Limiting factors ..................................................................................................... 390
Appendix ............................................................................................................... 394
Contents vii
Chapter 12 Linear programming............................................................................................. 403

Linear programming model – graphic................................................................... 404
Shadow prices....................................................................................................... 407
Opportunity to buy-in or differential contribution ............................................... 408
Linear programming assumptions and limitations ............................................... 411
Appendix ............................................................................................................... 412
Chapter 13 Transfer pricing .................................................................................................... 435
Objectives ............................................................................................................. 435
Fundamentals of transfer pricing explained ......................................................... 437
Appendix ............................................................................................................... 452
Chapter 14 Performance analysis of companies and divisions .............................................. 465
Strategic planning ................................................................................................. 466
Divisional performance measurement ................................................................. 468
Return on investment ........................................................................................... 470
Residual income.................................................................................................... 476
Economic value added .......................................................................................... 477
Performance of divisional managers .................................................................... 479
Comparing inter-divisional performance .............................................................. 483
Appendix ............................................................................................................... 486
Chapter 15 Examination techinique ....................................................................................... 495
The meaning of
management accounting
The objective of financial accounting is to provide information that external users can use to make
decisions about their investment in a particular company and analyse how the company is
performing.
Financial accountants produce financial statements that are useful to financial analysts. These are
produced in accordance with a system known as absorption costing, which means that all production
costs, including the value of work in progress, finished goods, and product and period costs (such as
rent) are incorporated in the closing inventory valuation.
IAS 2 on Inventories states the following:

The costs of conversion of inventories include costs directly related to the units of production,
such as direct labour. They also include a systematic allocation of fixed and variable production
overheads that are incurred in converting material into finished goods. Fixed production
overheads are those indirect costs of production that remain relatively constant regardless of the
volume of production, such as depreciation maintenance of factory buildings and equipment, and
the cost of factory management and administration.
Variable production overheads are those indirect costs of production that vary directly, or nearly
directly, with the volume of production, such as indirect materials and indirect labour.
As a result of this financial accounting definition, the valuation of inventory is carried out on an
absorption costing basis, using the FIFO or weighted average basis. LIFO is strictly prohibited and will
not be covered in the text.
Cost accounting developed out of the need that financial accountants have for financial information,
and gathers and analyses costs for the purposes of:
l product costing
l job costing
l inventory valuation.
A typical financial accounting costing exercise will involve the following:
Financial accounting system
Absorption costing
Product costing
Allocate costs to production and service departments
Allocate costs from service to production departments

Select an activity base
Calculate an overhead recovery rate
Figure 1
1
2 Managerial Accounting
Using a pre-determined overhead recovery rate will result in either an

under-recovery of overheads
or an
over-recovery of overheads.
It is important to note that absorption costing exists for the sole benefit of the financial accountant.
Management accounting does not concern itself with absorption costing.
Example
A Company manufactures a product and presents you with the following information:
Production 1 000 units
Sales 800 units
Selling price per unit R1 000
Company cost structure

R’000
Raw materials 200
Labour cost 180
Production costs 140
Packaging costs 20
Administration 70
Computer costs 10
Marketing 60
Accounting 50
Rental 20
Maintenance 50
800
Required:
1 How much profit did the company make?
2 What is the cost per unit manufactured?
Solution
1 As we can see from the information provided, the company manufactured 1 000 units and sold
800. 200 units are therefore unsold and represent closing inventory.
How do we arrive at the value for the closing inventory?

Is the cost per unit R800 000 / 1 000 = R800 per unit?
Or, should the cost per unit represent the manufacturing costs only?
R’000
Raw materials 200
Labour cost 180
Packaging costs 20
Rental 20
Maintenance 50
610
Therefore cost per unit R610 000 / 1 000 = R610

Chapter 1: The meaning of management accounting 3
Income and expenditure account

R’000 R’000
Sales 800 @ R1 000 800
Production costs:
Raw materials 200
Labour cost 180
Packaging costs 20
Rental 20
Maintenance 50
610
Closing inventory 200 × R610 (122)
Cost of sales 488 488
Gross profit 312
Administration 70
Computer costs 10
Marketing 60
Accounting 50
Profit 122
Financial accounting would agree with the above calculations and the resultant profit of
R122 000. The accounting system used is called “absorption costing”; it represents all
manufacturing costs divided by the number of units produced.
The closing inventory valuation is shown at R610 per unit.
The company may now choose to establish a pre-determined value per unit of production, at
R610, and use this value as the forecast/budget cost to be used in the following accounting
period. If it did so, we would call the system a “fully-integrated absorption costing system”.
Obviously, production costs are likely to change in the following accounting period; therefore the
pre-determined cost of R610 is likely to be different to the actual cost. If it is, we would raise a
charge called an “under-” or “over-recovery” of overheads.
2 What is the cost per unit?
The answer to this question is R610, if you are a financial accountant. Is this incorrect?
If the cost is R610, does it mean that the profit per unit is R1 000 – R610 = R390 before allowing
for non-manufacturing costs?
One would have to say “Yes”, as long as production/sales did not exceed 1 000 units. But what if
the company had produced 1 200 units? In what way would this change the cost per unit of
production?
Answer – Cost of producing 1 200 units
R’000
Raw material 200 × 1 200 / 1 000 240
Labour – variable 180 × 1 200 / 1 000 216
Packaging – variable 20 × 1 200 / 1 000 24
Production – fixed 140
Rental – fixed 20
Maintenance – fixed 50
690
Cost per unit R690 000 / 1 200 = R575
As you can see, we have a problem. Although the company’s cost structure has not changed, the
cost per unit produced has dropped from R610 to R575. This means that, if we use the financial
accounting cost definition of absorption costing, ie all manufacturing costs of production (both
fixed and variable) must be included when assessing the cost per unit, then the cost will change
every time the production level changes.
Is there a different/better method of determining production cost?

Yes there is. It is called “variable costing” and is used by management accountants.
Management accounting
Management accountants require information that will assist them in decision-making and
performance evaluation activities, which involve:
l demand estimation
l relative product profitability
l relevant costing
l product and market expansion
l product performance evaluation
l estimation of selling prices.
The shift in emphasis from “cost accumulation” for financial accounting reasons to “relevant
information” for better profitability reasons has led to the emergence of management accounting as
a discipline. “Cost accounting” thus refers to cost-gathering for external financial accounting
purposes while “management accounting” refers to information-gathering for internal decision-
making purposes.
Management accounting can best be defined as follows:
Management accounting
system
Variable costing
Performance analysis
Relevant costing
Contribution
Cost volume profit
Limiting factors
Probability estimates
Cost estimates
Figure 2
Management accounting measures profit in terms of contribution; sets budgets, and analyses the
performance of a company by comparing the budgeted to the actual results.
Management accounting is
Relevant
costing
Contribution
Standard Cost
variable Budgets volume
costing Performance profit
Variable
costing
Figure 3
Note: Cost volume profit (CVP) analysis is a variable costing system that analyses expected
performance based on a changing level of sales activity. CVP answers the “what if?” question
on changes in sales level, and is the yard-stick for comparing the budget to flexed-budget to
actual results.
Cost behaviour
Managerial accounting is a very simple discipline used by companies to maximise profit. It requires
the analysis of costs into two simple categories, namely variable and fixed.
Variable costs
A variable cost is a cost that will be incurred every time a company increases or decreases the
production of an item.
Example: Company “A” purchases T-shirts which it dyes and then sells for R70 each. The cost of
the T-shirt is R40, while the cost of dyeing the T-shirt is R10 each.
In this example the R40 material cost is a variable cost, as is the cost of converting the T-shirt into the
saleable product.
We therefore have the following analysis:

R
Selling price 70
Material cost 40
Conversion cost – variable 10
Profit/Contribution 20
Every time the company sells a T-shirt it will make a “profit” or “contribution” of R20. The word
“contribution” is the word used by management accountants to describe the incremental profit that
a company will make as the company sells one more unit of production.
What is wrong with the word “profit”?

Profit = Selling price – variable costs – fixed costs
As a company sells one more unit, the total sales value will increase, as will the total variable costs.
The fixed costs will, however, remain unchanged. This means that the profit per unit will change as
sales volume changes. This happens because fixed costs (by their very nature) do not change, but the
production volume does. The fixed cost per unit will therefore increase or decrease as production
drops or increases. “Contribution”, however, will remain the same.
On the basis of the example above, we can draw a profitability graph as follows:
3 500 Sales
2 500 Variable costs
Units 50
Figure 4
The difference between the sales and variable costs represents profit or (more correctly),
contribution.
Profitability can therefore be calculated as follows:
Sales – units 1 10 20 50
R R R R
Sales 70 700 1 400 3 500
Material 40 400 800 2 000
Conversion 10 100 200 500
Profit (Contribution) 20 200 400 1 000
Fixed costs
Fixed costs are expenses incurred by a company that do not change as production increases or
decreases. A good example is rent. A company may pay rent for the premises it uses. Rent is a cost of
production but it is not dependent on sales. In the previous example, let us assume that our T-shirt
company rents space, for which it pays R200 rent per month.
1 What profit will the company make if it sells either 1, 10, 20 or 50 T-shirts in a single month?
2 How much profit does the company make per unit sold?
Profit statement
R R R R
Sales 70 700 1 400 3 500
Material 40 400 800 2 000
Fixed cost 200 200 200 200
Profit (180) – 200 800
Profit per unit (180) – 10 16
As you can see, the profit per unit changes every time sales change. It is therefore impossible to say
what the profit per unit is. In fact, the concept of profit per unit is meaningless. Management
accounting, however, describes the contribution per unit, and it is this measure that is used to
describe profit.
Contribution
“Contribution” is the selling price of a product less all variable costs. Contribution describes the
concept of profitability as used by management accountants. It correctly describes the increase or
decrease in total profit as sales increase or decrease by 1 unit.
In the example above we get
R R R R
Sales 70 700 1 400 3 500
Material 40 400 800 2 000
Contribution 20 200 400 1 000
Contribution per unit 20 20 20 20
In this example, an increase in sales from 1 to 10 units will result in a profit increase of
9 × R20 = R180
An increase in sales from 20 to 50 units will result in an increase in profit of
30 × R20 = R600
Diagrammatic representation
Sales
Profit
Total cost
Break even
700
200 Fixed costs

Loss
10 50
Units
(Diagram not to scale)
Figure 5
The above diagram shows that the difference between “Sales” and “Total costs” equals “Profit”. The
increase in profit is however equal to the “Contribution”, ie R20 × increase in sales. At a sales level of
10 units, the company breaks even. An increase in sales by 40 units to 50 units will result in an
increase in profit equal to the contribution, ie 40 × R20 = R800, represented as
Units 1 10 20 50
R R R R
Contribution 20 200 400 1 000
Fixed cost 200 200 200 200
Profit (180) – 200 800
Increase 9 × R20 10 × R20 30 × R20
= Contribution 180 200 600
What would you expect from a person who is employed as a management accountant?
A management accountant is a person who is predominantly involved in setting budgets and
evaluating the company or product performance once the actual results are available. The
performance analysis requires a reconciliation of the budget profit to the actual profit, using the
variable costing system.
Illustrative example – Variable costing

The management accountant produced the following budget at the beginning of the financial
year:
Sales 10 000 units
R’000
Sales 23 000
Less:
Material 8 000
Labour 5 000
Variable manufacturing overhead 2 000
Fixed manufacturing overhead 3 000
Variable selling 2 000
Fixed selling 2 000
Profit R1 000
At the end of the financial year, the financial accountant produced the following profit
statement.
Sales 15 000 units
R’000
Sales 33 750
Production costs:
Material 12 600
Labour 8 100
Variable overheads 3 000
Fixed overheads 3 000
Gross profit 7 050
Fixed selling 2 000
Profit R2 650
continued
You are required to:

(a) Explain how well the company has performed by reconciling the budget profit to the
actual profit.
(b) Produce a budget income statement for the forthcoming year on a variable costing basis
with production of 15 000 units and sales of 13 000 units. Assume that the cost structure
for the forthcoming year is the same as the actual variable and fixed costs incurred
above.
Solution
(a) Management Accounting is about corporate planning and maximising profit. It starts with a
budget and then moves on to analyse the actual results to see whether the budget expectations
have been met. It thus determines where problems have occurred and how management can
plan for the future. A reconciliation of the budget profit to the actual profit should always be
carried out.
The process is therefore to reconcile
Budget profit – 10 000 units
To expected profit – 15 000 units
To actual profit – 15 000 units
Expected profit represents the profit the company would expect if it had correctly forecast the
actual sales volume.
There are two ways of arriving at the expected profit
l Do a budget for 15 000 units
OR
l Increase the original budget of 10 000 units by adding the contribution for the increase in
sales of 5 000 units.
Budget method – income statement for 15 000 units
Profit Contribution
R’000 R’000
Sales 34 500 34 500
Production costs:
Material 12 000 12 000
Labour 7 500 7 500
Variable overhead 3 000 3 000
Fixed overhead 3 000
Gross profit 9 000
Variable selling 3 000 3 000
Fixed selling 2 000 –
Budget profit R4 000 R9 000
Units 15 000
Contribution per unit R600
Alternative method
Budget profit 10 000 units R1 000 000

Increased sales 5 000 units × Contribution R600 R3 000 000
Expected profit 15 000 units R4 000 000
Explanation of actual profit
R
10 000 Budget profit 1 000 000
Sales volume variance (5 000 × 600) 3 000 000
15 000 Expected profit 4 000 000
Sales price variation – 750 000
Materials – 600 000
Labour – 600 000
Manufacturing variable overhead –
Manufacturing fixed overhead –
Variable selling + 600 000
Fixed selling –
15 000 Actual profit 2 650 000
(b) A variable costing system is one where the fixed manufacturing costs for a particular period are
charged to the income statement as an expense for that period. Closing inventory is therefore
valued on manufacturing variable costs only, ie the valuation excludes all manufacturing fixed
costs. This system is representative of managerial accounting for decision-making.
Budget method – income statement
Production – 15 000 units
Sales – 13 000 units
Closing inventory – 2 000 units
R’000 R’000
Sales 29 250
Production costs:
Material 12 600
Labour 8 100
Variable overhead 3 000
Closing inventory (3 160)
Variable cost of sales 20 540 (20 540)
Fixed overheads (3 000)
Gross profit 5 710
Variable selling (2 400 × 13 / 15) 2 080
Fixed selling 2 000
Budget profit R1 630
Closing inventory valuation:

(12 600 + 8 100 + 3 000) × 2 000 / 15 000 = 3 160.
The absorption costing dilemma

In a perfect world, we would ditch the financial accounting idea of absorption costing and use
variable costing in the financial statements. Unfortunately, we do not live in a perfect world;
therefore, as a management accountant, you need to understand how absorption costing
works. You also need to know how to prepare absorption costing statements; how to reconcile
the budget to absorption costing profit, and (more importantly) to explain why and where there
is a difference between variable costing and absorption costing.
Please note: We are not compromising the variable costing values; nor are we accepting a
system that produces misleading information. We are simply studying both
methods, holding on to the accounting truth – variable costing – and explaining
the error of absorption costing. In order to explain the error, it is necessary to
understand how absorption costing is applied in the financial statements.
The following example is intended as an overview of what happens when absorption costing is
used in the financial statements. You need to see the fundamental issues of absorption costing.
Illustrative example – Absorption costing

The management accountant produced the following budget at the beginning of the financial
year:
Sales 10 000 units
R’000
Sales 23 000
Less:
Material 8 000
Labour 5 000
Fixed selling 2 000
Profit R1 000
At the end of the financial year, the financial accountant produced the following two profit
statements.
Sales 12 000 units
R’000 R’000 R’000 R’000
Sales 27 000 27 000
Production costs:
Material 12 12
600 600
Labour 8 100 8 100
Variable overheads 3 000 3 000
Fixed overheads 3 000 4 500
26 28
700 200
Less: Closing inventory 5 400 5 400
Cost of sales 21 21 300 22 – 22 800
300 800
Fixed cost over-recovery + 1 500
Gross profit 5 700 5 700
Variable selling 2 200 2 200
Fixed selling 2 000 2 000
Profit R1 500 R1 500
The managing director is pleased that the actual profit has exceeded budget and has asked you
to prepare a report giving your views on how well the company has performed.

Explain how you would go about preparing a report on the company’s performance, showing
the relevant financial information that you would present to management.
Solution
Background information
The fundamental difference between absorption costing and variable costing is the valuation
method used to value closing inventory.
Closing inventory can be valued as follows:
Variable costing
1 Budget variable cost of production
In the above example, the value of the closing inventory would be calculated as follows:
R’000
Material 8 000
Labour 5 000
R15 000
Units 10 000
Cost per unit R1 500
This method is used where actual costs approximate the budget costs, or the company uses a
standard variable costing system.
2 Actual variable cost of production

In the above example, the value of the closing inventory would be calculated as follows:
R’000
Material 12 600
Labour 8 100
R23 700
Units 15 000
This value represents the actual cost and is equally acceptable, as long as the company does not
have a standard costing system. You will find that in most instances in this text book, the budget
cost method is used, rather than the actual cost method.
Absorption costing
1 Budget total cost of production method
Where the company uses the budget cost of production as the valuation method, it may have a
fully-integrated absorption costing system, or not.
The above actual results were prepared using the budget cost of production where the first set of
figures is not fully-integrated while the second set is a fully-integrated absorption costing
system.
R’000
Material 8 000
Labour 5 000
R18 000
Units 10 000
Where the closing inventory is valued at budget absorption costing, the closing inventory is valued
as
3 000 × R1 800 = R5 400 000
However, where the company has a fully-integrated absorption costing system (per the second
set of figures) you will always have an under- or over-recovery balancing figure.
Explanation:
Fully integrated absorption costing means that all manufacturing fixed costs are treated as if they
were variable costs and are charged to production at the rate of (R3 000 000 / 10 000) R300 per
unit every time a unit is manufactured.
In this example, as we have produced 15 000 units, the fixed cost charged to production will be
15 000 × R300 = R4 500 000.
This is the reason for the fixed cost appearing as R4 500 000 in the financial accounts. The actual
fixed cost incurred was in fact R3 000 000, as can be seen from the first set of figures. This means
that we have over-charged R1 500 000 fixed cost into the financial statements; hence the
adjustment of R1 500 000 as an over-recovery.
Note: In both of the statements above, the value of the closing inventory is the same, ie closing
inventory × budget cost per unit = R1 800 × 3 000 = R5 400 000.
The reason for the adjustment of R1 500 000 in the second column is the fact that the
fixed cost is shown as R4 500 000 whereas the actual fixed cost is R3 000 000.
2 Actual total cost of production method

R’000
Material 12 600
Labour 8 100
R26 700
Units 15 000
Conclusion:
For variable costing, there are two ways of valuing inventory – budget or actual variable cost of
production.
For absorption costing, there are also two ways of valuing closing inventory – budget or actual
variable plus fixed cost of production. There are, however, three possible ways of presenting the
information in the financial statements:
l Fully-integrated absorption costing (budget cost)
l Non-integrated absorption costing (budget cost)
l Actual cost absorption costing.
Is absorption costing acceptable?

One may wish to argue that if a company has chosen to use absorption costing as the method of
valuing closing inventory (which is acceptable), then why not evaluate performance using absorption
costing? The reason why it is not acceptable to evaluate performance using an absorption costing
system is because you cannot carry a fixed cost such as rent, which is a period cost, as part of your
closing inventory valuation. It will distort the true company profit and show excessive profits when
inventory holding is rising.
Why does one statement have an over-recovery of R1 500 000 while the other one does not?
The adjustment (under- or over-recovery) occurs because the company is using a fully-integrated
absorption costing system where the fixed cost has been charged to production at a pre-determined
rate of R300 per unit (ie budget R3 000 000 ÷ by 10 000 units).
Thus, there will always be an under- or over-recovery, due to:
(i) Actual volume being different to budget volume
(ii) Actual manufacturing overhead being different to budget overhead
Does this mean that a company can have an absorption costing system without a
pre-determined absorption rate?
It does. All that is needed for an absorption costing system to be in operation is simply to value the
closing inventory at a value that includes fixed overhead costs. Refer to the chapter on variable/
absorption costing.
The cost volume chart

When the original budget was prepared, the following CVP relationships were established:
Sales
R’000
Total
costs
5 000 Fixed
costs
Units 8 333 10 000
Figure 6
On the basis of the above chart, we can draw the following conclusions:
(i) The fixed costs over the relevant range are R5 000 000, representing R3 000 000
manufacturing overhead and R2 000 000 fixed selling costs
(ii) The break-even point is 8 333 units (based on budget information)
(iii) Profits will increase by R600 per unit, above the budget level of 10 000 units.
The profit increase per unit is determined on the basis of contribution per unit, as follows:
R
Selling price per unit 2 300
Less: Material cost 800
Labour cost 500
Variable overhead 200
Variable selling 200
When the original budget was prepared, the management accountant would have pointed out that
at the budget sales and cost structure profit should increase or drop by R600 per unit above or below
the 10 000 unit sales budget.
Flexed budget if sales had been anticipated to be as high as 12 000 units:

R
Contribution 12 000 × R600 7 200 000
Fixed manufacturing overhead 3 000 000
Fixed selling costs 2 000 000
Budget profit R2 200 000
Our report to management must start with the budgeted profit and explain what the profit should
have been at a sales level of 12 000 units. We must then reconcile to the actual profit and explain
what deficiencies or improvements have taken place.
Actual profit on a variable costing basis

Management accounting is based on variable costing. The CVP chart represents a variable costing
system; therefore actual profit should also be based on variable costing, if we want to show the true
performance of the company.
Actual production 15 000 units
Actual sales 12 000 units
R’000 R’000
Sales 27 000
Production costs:
Material 12 600
Labour 8 100
Variable 3 000
23 700
Closing inventory (1 500 x 3 000) (4 500)
Cost of sales 19 200 19 200
Fixed selling 2 000
Actual profit R600
Note: The closing inventory has been valued by taking the budget variable costs ÷ budget
production × 3 000 units.
We now need to explain to management how well the company has performed by reconciling the
budget profit to the actual profit of R600 000.
Units R’000
10 000 Budget profit 1 000
2 000 Increased sales (2 000 x 600) 1 200
12 000 Expected profit 2 200
Selling price decrease (600)

Material cost increase (600)
Labour cost increase (600)
Variable overhead –
Fixed overhead –
Variable selling saving + 200
Fixed selling –
Actual profit R600
A report should now be prepared explaining:

(i) the budget profit of R1 000 000
(ii) the expected increase in profit for the increased sales of 2 000 units, being the contribution of
R600 × 2 000 = R1 200 000 increased revenue
(iii) what we mean by expected profit with reference to the CVP chart at the 12 000 sales unit level
(iv) the current year’s problems in relation to the budget sales and cost structure
(v) the actual profit on a variable costing basis.
The report must show that the company has in fact performed worse than the budget profit of
R1 million. Absorption costing distorted the profit to R1,5 million. Hence, variable costing is superior
to absorption costing.
Identifying relevant information

Since financial accountants use absorption costing as a financial accounting method of valuing
inventory, we are often blinded by the true facts of a situation when evaluating performance.
Remember: The information provided to you has been prepared using one of the following
methods:
(i) a non-integrated absorption costing system
(ii) a fully-integrated absorption costing system
(iii) a variable costing system.
You cannot evaluate performance if the information has been prepared on an absorption costing
basis; it is necessary to convert the information to variable costing. Once you understand this, you
will never have a problem understanding what is required of you. Students often complain that
examiners are trying to trick them as the information is given on an absorption costing basis yet the
solution is done on a variable costing basis. “Why”, they ask, “do examiners not just tell us to use
variable costing so that there is no confusion?”
The fact of the matter is that you should know that you must use a variable costing basis – imagine
being called upon to evaluate the performance of a company on the basis of the income statement
prepared by the financial accountant – you do not ask management to give you a hint about the
system they use; you immediately re-calculate the figures on a variable costing basis!
Illustrative example
You have been given the following income statement:
Actual results of Power Plus Ltd
R R
100 000
Sales 1 000 units
Variable costs 90 000

Fixed costs 45 000
135 000
Less: Closing inventory 45 000
Profit R10 000
continued
You are required to discuss:

(a) how the company has performed
(b) what other aspects you would consider when evaluating performance
(c) what the future prospects for this company are.
Solution
The above information is obviously incomplete; there are many other facts that you would need to
ascertain in order to answer the above questions.
What is the most important line in the above example?

The most important line is the closing inventory of R45 000, because the company either uses an
absorption costing system or a variable costing system. Determining how the R45 000 was arrived at
will tell us whether part of the fixed costs are being carried in the closing inventory figure.
Closing inventory R45 000 ÷ 500 units = R90

Absorption cost per unit:
Variable costs R90 000
Fixed costs R45 000
R135 000 ÷ 1 500 = R90
Variable cost per unit:
Variable cost R90 000 ÷ 1 500 = R60
The company is clearly using absorption costing, which will distort the true picture of the company’s
performance.
To analyse the performance more accurately, the figures will have to be re-calculated using variable
costing.
Variable costing statement
R R
Sales 1 000 units 100 000
Contribution 40 000
Fixed costs (45 000)
Loss R(5 000)
The company has in fact performed poorly, which indicates that we need to analyse the problem
areas carefully.
The questions we need to investigate are:
(i) Was a budget prepared, and how does it compare to the actual results?
(ii) Why were 500 more units produced than were sold?
(iii) What is the competition like?
(iv) What is the future demand for the product?
(v) In terms of CVP relationships:

l What is the expected break-even?
l What is the expected margin of safety?
(vi) Are there any limiting factors of production?
(vii) Does the company produce other products?
(viii) What is the result of an analysis of the business and financial risks?
Students often struggle to understand managerial accounting, because they are taught the subject in
modules, which means that they cannot see the bigger picture when all the topics are integrated.
This chapter is an attempt to give you that bigger picture. As you study the individual topics, keep
referring to this chapter to remind you how the pieces fit together.
At this point, you probably have difficulty understanding the concepts of “absorption costing” and
“variable costing” and “pre-determined recovery rates”. However, as you get into the next few
chapters, you will gain the necessary knowledge, and can come back to this chapter, which should
always point you in the right direction.
The important concept is that financial accountants use absorption costing, while management
accountants concern themselves with variable costing, because profitability is based on contribution
per unit; not profit per unit.
Key fundamental principles

1 Financial accounting is based on absorption costing, ie closing inventory is valued at the lower of
cost and net realisable value.
2 Absorption costing means that closing inventory includes fixed manufacturing overheads.
3 There are three methods of producing an income statement using absorption costing:
(i) Fully-integrated absorption costing
l Closing inventory is valued at budget manufacturing costs
l There will always be an under- or over-recovery of fixed costs
l The under- or over-recovery is the difference between actual fixed cost incurred and the
fixed cost charged to the accounts
(ii) Non-integrated absorption costing, where closing inventory is valued at budget total cost. In
this situation there is no under- or over-recovery reconciliation figure
(iii) Closing inventory is valued at actual manufacturing costs incurred in the current period.
4 Variable costing is superior to absorption costing because it uses the contribution concept when
determining profit, and it correctly charges fixed cost incurred in the current year to the current
income statement. No fixed cost is carried to the balance sheet.
5 Variable costing is consistent with cost volume profit (CVP) analysis, ie fixed costs are treated as
period costs.
Systems for recording and
controlling product costs
After studying this chapter you should be able to:

l explain the meaning of each of the terms listed in this chapter
l differentiate between management accounting and financial accounting
l explain the basic difference between short-term and long-term decision-making
l identify and allocate costs for product costing under absorption costing
l explain and apply the principle of pre-determined overhead recovery rate, calculate the
under- or over-recovered overhead and explain the two components of the over- or under-
absorbed overhead
l calculate the accounting cost of a product for job costing purposes
Important fundamental principle. Trace this principle through this chapter and link it to other
chapters and tutorial questions. You must understand this principle.
Companies analyse costs for inventory valuation, product analysis, decision-making and planning.
Before we go any further, however, it is very important that we answer the following questions:
1 Is it important that a company know what a product costs?
2 How should a company arrive at the selling price for a product?
The answer to the first question appears to be obvious. We need to know what a product costs so
that we can see whether we are making a profit. But what is meant by “profit”? The obvious answer
is “selling price per unit minus cost per unit, which is arrived at by dividing total production cost by
units produced”.
Well then, if a company produced 1 000 units, is the following correct?
Production/Sales 1 000 units
Per unit
Sales R12 000 R12
Material costs R4 000 R4
Variable labour R2 000 R2
Fixed costs R4 000 R4
Profit R2 000 R2
The cost per unit is R10, while the profit per unit is R2. Can one say that the company is making R2
profit per unit sold? No, certainly not. It is only correct to say that the profit is R2 per unit if the
company manufactures and sells 1 000 units. What happens if only 500 units were manufactured and
sold?
The fixed cost per unit is now R8, ie R4 000 divided by 500 units. The total cost is
R8 + R4 + R2 = R14.
Therefore, if the selling price is R12, the company makes a loss of R2 per unit!
Conclusion: For decision-making purposes, the accounting profit of R2 per unit determined on the
basis of the original data is meaningless. Wanting to know the full or total cost of a
product is equally meaningless for decision-making, because the cost per unit changes
every time production changes. However, the one thing that does not change as
production changes is a management accounting concept called contribution.
19
Contribution is the difference between the selling price and all variable costs. In the
above example, it would be
Selling price R12
Material R4
Labour R2
Contribution R6
What does “contribution” mean?

Contribution is the term used by management accountants to define profit. It means that for every
unit sold, the company will make an increased profit of R6 per unit. Does that mean that fixed costs
can be ignored? No, they cannot – it is very important that a company first covers its fixed cost
before it starts to account for the profit. As management accountants analysing the above
information, we should first ask, “How many units do we have to sell to break even?”
Answer: R4 000 / R6 = 667 units
Now it can be said that the company must sell 667 units to break even; thereafter it will make a
profit of R6 for each additional unit sold. Management accountants place an emphasis on maximising
sales which will maximise contribution and therefore profit, and not on minimising costs. Costs are
important, but sales are more important.
The second question we should ask is, “How do we determine the selling price?” Selling price for a
product should stem from the economics of supply and demand, not from a “cost plus mark-up”
idea. A company should attempt to identify the best selling price/demand that maximises
contribution, not “cost plus a profit”. A company that uses a cost + formula to derive selling price will
soon go out of business, as its competitors will maximise their profits by selling in bulk at a lower
price.
Conclusion: The cost of a product is meaningless if used for future decision-making or to
determine selling price. Product cost is only useful when comparing actual costs to
budget, in order to analyse performance.
This chapter concerns itself to a large extent with the analysis of costs for the purpose of arriving at
inventory valuation when a financial accounting “fully-integrated” absorption costing system is used.
Do not assume that every company allocates fixed costs as shown in this chapter in order to arrive at
the cost of a product. Only companies that have a “job costing” environment require a pre-
determined fixed cost to allocate to future production. Very few companies will allocate overhead
costs to production and service departments, followed by a re-allocation from service departments
to production departments.
Costing terminology
Opportunity cost – The value of an opportunity foregone. Opportunity costs are important
because if we are confronted with a choice that requires giving up some
other opportunity, then the choice must compensate us for what we are
giving up. For example: A company currently sells a product that yields a
profit of R10. They now want to sell a new product, but if they do they will
have to stop selling the old product. The opportunity cost is therefore R10
and the new product will have to generate a profit higher than R10 if the
company is to make the change.
Sunk cost – A cost that has been incurred as a result of a past decision and which has a
zero value when making future decisions. For example, a company
purchased a car for R50 000, but now realise that it made a mistake and
want to sell it. The cost of R50 000 is a sunk cost, and the selling price is
dependent on what a buyer is willing to pay, which may or may not be
greater than R50 000.
Administration costs – Treated as a manufacturing overhead only if it relates to work being carried
out in the manufacturing process. In most instances, it is written off as a
period cost.
Chapter 2: Systems for recording and controlling product costs 21
Controllable and Costs that allow a company to make a choice that will influence the
non-controllable outcome. For example, a company could have the choice of manufacturing
costs – equipment, rather than being given a machine, whether they like it or not.
Conversion costs – All costs other than direct material costs that are incurred in manufacturing
a product. The word “conversion” is normally associated with process
costing and refers to all costs other than material that are directly related
to the manufacturing process.
Fixed costs – Costs such as rent, depreciation, leasing charges, salaries etc that are
incurred by a company and do not increase or decrease as production or
sales change. A high proportion of costs are fixed.
Marginal, incremental Additional costs incurred in the production of one extra unit. These costs
or differential costs – are usually variable only.
Non-relevant costs – Costs that will not change, regardless of the production or sales decisions
taken.
Overhead costs or May be variable or fixed, but are not directly linked to the product
manufacturing manufactured. It may vary, but not necessarily with production. In an
overhead costs – absorption costing system, these costs are allocated to a unit of
production. Only manufacturing overheads may be included in the
valuation of closing inventory in an absorption costing system. Variable
costing would treat the cost as a period cost and write it off in the period
that it is incurred. Administration overheads or selling overheads must
never be associated with production.
Period costs – All costs that are not carried as part of inventory valuation and are written
off in the period that they are incurred.
Prime costs – All costs that can be directly identified with a unit of production. In reality,
the only prime cost is direct material. We do, however, tend to treat direct
labour as a prime cost, but only if the labour cost is truly variable. It is
possible, but exceptional, to treat other variable costs such as power as
prime costs.
Product costs – All costs that are identified with products manufactured. These costs are
used to value a product for inventory valuation purposes. It will differ
between variable and absorption costing.
Relevant costs – Costs that will be incurred in the future and are required for decision-
making purposes. It is dependent on future decisions.
Selling costs – May be variable or fixed, relate to sales and are written off in the period in
which it is incurred.
Semi-fixed costs – Costs that are fixed over a range of activity, but increase by a fixed amount
as production increases beyond a particular level, for example, the leasing
cost of a machine where 1 machine can only manufacture 1 000 units. If the
required production is 2 800 units, then the fixed cost will be three times
the fixed leasing cost of one machine (because three machines will be
needed). Also known as a “stepped cost”.
Semi-variable costs – Costs that have a fixed element as well as a variable element. Rent could be
classified as semi-variable in instances where the monthly rental is (say)
R10 000 plus 10% of gross sales revenue. Sometimes referred to as a
“mixed cost”.
Variable costs – May be related to production or to units sold. It refers to costs that are
incurred at a fixed amount per unit of output. If production increases, then
variable costs also increase in direct proportion. Manufacturing variable
costs may consist of material, labour or any other cost that increases as
production increases. Variable selling costs are also incurred at a fixed rate
but per unit sold; not per unit produced. A sales commission would be a
typical example of a variable cost.
Absorption costing – The method used to value closing inventory that includes all manufacturing
costs, ie both variable and fixed. Financial accounting uses absorption
costing as the only method of inventory valuation. The fixed cost element
may be derived from actual fixed cost incurred, or it may be allocated as a
budget amount. If the fixed element is pre-determined, the system is called
fully-integrated absorption costing. In a fully-integrated absorption costing
system, the actual cost will differ from the allocated cost and a balancing
amount known as the under- (or over-)recovered fixed overhead must be
calculated.
Job costing – The accumulation of all costs incurred in doing a job such as building a
house. The cost will include direct, indirect and overhead costs. The
overhead costs are allocated on a pre-determined basis. This method is
referred to as a fully-integrated absorption costing system, where the costs
are allocated from budgeted or expected costs.
Process costing – The method used to value inventory when a company manufactures a
product and at the end of a period some of the closing inventory is partially
manufactured. The valuation of this inventory may be done using variable
or absorption costing principles.
Standard costing – Another method of valuing closing inventory, but at a pre-determined rate
for both variable and fixed costs. When only pre-determined variable costs
are used, it is known as a standard variable costing system. When fixed
costs are also included, it is known as a standard absorption costing system.
Variable costing – The method used to value closing inventory using variable manufacturing
costs only (also referred to as direct or marginal costing). Fixed costs are
written off as period costs.
Cost centre – The area (or department) for which a person or manager is responsible.
Investment centre – This term defines the accountability for profit generation and also for
choices in what will/will not be purchased by way of capital expenditure in
running a business.
Profit centre – This term defines the accountability for the maximisation of profits from
assets placed under a manager’s control.
Direct labour – The cost of employees who work exclusively on a product being
manufactured. The most important characteristic is that direct labour, like
direct material, can be identified as a specific amount of time or cost per
unit. In other words, the cost varies with each unit produced.
Note: In practice, labour costs are generally fixed, and should not be
treated as a variable cost per unit. We do, however, tend to treat labour as
a direct cost of production in tutorial and examination questions. Tread
with caution.
Indirect labour – The cost of employees (such as supervisors) that cannot be directly traced
or linked to a specific unit of production. Such costs are treated as
manufacturing overhead costs. They may be variable, fixed or a mix of the
two.
Direct material – represents the Rand value of material that is used in the manufacture of a
product. The quantity of material used in each unit of product output is
always the same.
Indirect material – The cost of the materials required for the manufacture of a product that are
not identified with the finished product, for example, cleaning materials,
materials required to repair production machinery, etc.
High-low cost Refers to the analysis of semi-variable costs where the variable and fixed
analysis – cost elements are arrived at by analysing the increase in cost in comparison
to the increase in production volume.
Relevant range – A limited level of activity under which costs are analysed as either fixed or
variable. For example, if I plan to manufacture at a level between 10 000
and 15 000 units only, the relevant range under which I would analyse how
costs behave would be costs incurred at a production level of between
10 000 and 15 000 units.
Valuation of a single unit of production

Product costs include direct costs such as material, labour and other costs that are not directly
traceable to a specific product (and are therefore known as “indirect costs”). Product costing is
necessary for financial accounting, in order to arrive at the annual manufacturing costs and inventory
valuation and also to provide relevant information for decision-making.
Financial accountants are keen to allocate all manufacturing costs, both variable and fixed, to the
manufacturing process and closing inventory, as they believe that all costs incurred in producing a
product should be reflected in the product cost. The appropriate system that does this is called
absorption costing. However, absorption costing distorts the true performance of companies,
divisions and products, as fixed manufacturing costs are allocated to closing inventory instead of
being written-off in the period they are incurred.
For decision-making purposes, the correct way to measure performance is to use a variable-costing
system, where fixed costs are written-off in the period they are incurred. Variable costing focuses on
relevant manufacturing costs, thus enabling management to make decisions that are congruent with
company objectives of “profit maximisation”.
The allocation (or recovery) of all costs that relate directly or indirectly to a specific product differs
from company to company, depending on the objective of the company. For example, some
companies allocate management expenses such as general and administrative overheads to the
manufacturing department and absorb the cost to the unit of production, while others do not.
There is no “correct” system of indirect or non-production cost allocation that will suit every
company. The following examples therefore only serve to examine some of the problems caused by
the need for costs to be allocated to departments and absorbed by products.
Financial Management
accounting accounting
External reporting Internal decision
Absorption
Short-term Long-term
costing
decision decision
Relevant costs
Relevant long-
Opportunity term costs
costs
Sunk costs Recovery of

fixed costs
Replacement
costs
Return on
investment
Controllable
costs
Figure 1
It is important to understand that the system used to classify a cost is dependent on the objective of
the cost classification.
When we require a product cost for accounting purposes, or to value closing inventory, it is
customary to use an absorption costing system to determine such costs. This chapter concerns itself
with a fully-integrated financial accounting costing system that allows for the determination of a full
product cost, as well as a inventory valuation model. This model is known as a “fully-integrated
absorption costing system” in which all manufacturing costs, both variable and fixed, are allocated to
the cost of a product.
The problem of cost allocation to a product is that a company will have several production and
related service departments that require cost allocation. How, then, do we determine the cost of a
product that passes through several production departments? In addition, how do we allocate the
costs of the service departments to the production departments so that they may in turn be
allocated to a specific product?
The answer is to allocate the service costs to the production departments on a basis that closely
reflects the usage of the service cost by the specific production department. Costs are normally
allocated to a product on the basis of the most common activity in a particular production
department, for example labour hours, or machine hours.
Product valuation for financial accounting purposes

Fully-integrated absorption costing system
Note: Fully-integrated absorption costing is only used when it is necessary to allocate a fixed cost
element to production in order to determine a job cost. The cost is then used to determine
the selling price, or the profit made on a job. The system is a job costing exercise. Do not
assume, therefore, that a company will analyse the costs as described in this section in every
situation for the purpose of arriving at an overhead allocation basis for units produced.
Definitions
Cost allocation
To assign an item of direct or indirect cost to a specific manufacturing or non-manufacturing
department based on a particular cost objective, eg, allocation of rent between manufacturing and
non-manufacturing departments.
Cost objective
The accumulation of costs relating to a specific department, organisation or job function that require
measurement, eg central warehousing costs of a retail outlet.
A company will have several cost objectives, such as:
1 Central warehousing cost
2 Redistribution of warehousing costs to various production departments
3 Redistribution of production department costs to individual products
Direct cost
A cost that can be specifically identified as belonging to a specific department or product
Indirect cost
A cost that is incurred by several departments or products, but is not directly identified with a single
cost objective, eg rent of a building that houses productive and non-productive departments.
Cost absorption rate

A cost rate used to charge a group of costs, such as machine hours or labour hours, to a specific
product on a pre-determined cost basis, eg Department A incurs a total cost of R50 000 direct and
indirect costs, which are allocated to the manufacture of the end product on the basis of the
machine hours used by each product.
The allocation of manufacturing overheads to products in order to determine a full product cost for
decision-making purposes will always give incorrect product costs, as the overheads are usually
allocated on a labour or machine hour activity basis. It has been argued that the activity-based
costing (ABC) system (which identifies more than one activity base) is a more accurate cost allocation
method. ABC tends to allocate a more proportionate value of overheads to products that are
manufactured in short production runs and use up a higher proportion of overhead costs than it
allocates to long production run products.
In any event, whether the traditional absorption costing is less accurate than the ABC method is
discussed in the chapter on ABC; we need only state at this stage that financial accountants use
absorption costing as a basis for allocating fixed costs for inventory valuation purposes.
Note: For internal management accounting decision-making requirements, both absorption costing
and ABC are inappropriate.
The aim of this chapter is to show how we would allocate overheads to a product for the purpose of
determining a full absorption cost per unit of production.
The International Statement on Inventories states that:

The cost of inventories should comprise all costs of purchase, costs of conversion and other costs
incurred in bringing the inventories to their present location and condition. The costs of conversion
of inventories include costs directly related to the units of production, such as direct labour. They
also include a systematic allocation of fixed and variable production overheads.
The allocation of fixed production overheads to the costs of conversion is based on the normal
capacity of the production facilities. Normal capacity is the production expected to be achieved on
average over a number of periods or seasons under normal circumstances, taking into account the
loss of capacity resulting from planned maintenance. The actual level of production may be used if it
approximates normal capacity. The amount of fixed production overheads allocated to each unit of
production is not increased as a consequence of low production or idle plant. Un-allocated
overheads are recognised as an expense in the period in which they are incurred. In periods of
abnormally high production, the amount of fixed production overheads allocated to each unit of
production is decreased so that inventories are not measured above cost.
Cost allocation procedure

Step 1
Allocate relevant production overheads to the production and service departments.
Identify all overheads that are incurred by the company and allocate them to the departments on an
appropriate basis as follows:
Depreciation – Asset values in each department
Insurance – Asset values in each department
Rent – Area occupied
Salaries – Staff in each department
Water and electricity – Area occupied
Employee costs – Number of employees
Step 2
Reallocate service department costs to the production departments.
Service departments, such as maintenance, exist to support the manufacturing departments;
therefore we need to identify an appropriate basis to allocate the costs according to % of usage by
the production departments.
Some appropriate methods used are

l direct cost allocation method
l step cost allocation method
l reciprocal allocation method.
Step 3
Identify the activity most common to a specific production department and use that activity to
determine the cost recovery rate.
Illustrative example 1
A company manufactures three products, A, B and C. The manufacturing costs for the year
ended 20X1 were as follows:
Products A B C
Actual production [units] 1 000 2 000 4 000
Direct costs R R R
Material 15 000 36 000 84 000
Labour (variable) 5 000 8 000 24 000
20 000 44 000 108 000
Other manufacturing costs: R
Rent 20 000
Depreciation 10 000
Other overheads 20 000
R50 000
The three products are manufactured in two separate production departments, X and Y. There
are also two service-related departments that support the manufacture of the three products.
The costs incurred by the company in the departments are as follows:
Production Service Total
X Y 1 2
Labour 6 000 12 000 4 000 5 000 27 000
Indirect material 6 000 4 000 4 000 2 000 16 000
Manufacturing overheads 3 000 4 000 – – 7 000
Service overheads – – 4 000 3 000 7 000
15 000 20 000 12 000 10 000 57 000

(a) Discuss whether it is important for a company to determine the cost for each product
that it manufactures.
(b) Calculate the cost per unit for products A, B, and C.
Solution
(a) If you can grasp the answer to this requirement, then you can start to understand and
appreciate what management accounting is all about and how a company can plan to increase
profit.
Why is it necessary to know the cost of a product? Is it to
(i) determine the selling price?
(ii) value closing inventory?
(iii) determine the profit of a product?
(i) No. The selling price of a product is dependent on demand, not on accounting cost. Do not
waste your time calculating the cost in order to arrive at a fair selling price. If you do, you
will eventually go bankrupt. The correct business equation is:
Selling price – required profit = Maximum cost
Not: Cost + Mark-up = Selling price
(ii) No. Closing inventory does not determine profit. The correct method of arriving at the value
of a product should be a system called variable costing (you will learn about it later). At
the moment, we are using absorption costing, which is required for financial accounting
statements only.
(iii) It is very important for a company to know which of its products is the most profitable and
which one is likely to yield the highest profit in the future. Companies should also discontinue
products that are making a loss. However, is this the reason why a company must determine
the cost of a product?
What do we mean when we talk about the “cost” of a product?
Illustrative example – “cost” of a product

A company produces a single product. The income statement is as follows:
Production/Sales 1 000 units R Per unit
Sales 10 000 10,00
Cost of sales:
Material – variable 4 000 4,00
Labour – variable 1 000 1,00
overheads – fixed 3 000 3,00
2 000 2,00
Required:
What is the cost per unit and the profit per unit?
Solution
Is the cost R8 per unit?
Is the profit R2 per unit?
Answer: No.
The cost of R8 per unit and profit of R2 per unit is only correct if we manufacture and sell 1 000
units.
What if we manufactured and sold 1 200 units? In that case, the income statement would be as
follows:

R Per unit
Sales 12 000 10,00
Cost of sales:
Material – variable 4 800 4,00
Labour – variable 1 200 1,00
Overheads – fixed 3 000 2,50
3 000 2,50
Now it appears that the cost per unit has dropped to R7,50, while the profit has increased to
R2,50.
Conclusion: There is no such thing as “cost per unit” or “profit per unit” for a product. Both
the cost and the profit change every time production quantities change.
The important concept that you will learn in future chapters is that there is a profit which is
constant (called “contribution”) and there is also a constant production cost known as “variable
cost”. In the above example the important information is:
Selling price R10
Variable costs R5
Contribution R5
This means that if a company produces 1 more (or 1 less) unit of production it will incur a cost
(or a saving) of R5 per unit and make a profit (or a loss) of R5 per unit. In the above example, we
conclude that, as sales have increased by 200 units, profit has increased by
200 units × contribution = 200 × R5 = R1 000
Therefore, the cost that is important is “variable cost” and the profit that is important is
“contribution”.
To answer the question “Is it important for a company to determine the cost for each product
that it manufactures” one must first ask the question, “For what purpose do you need to know
the cost?”
If the answer to the second question is “to value the closing inventory in the income
statement”, then the answer to the first question is “yes”, and we must use the appropriate
financial accounting method, namely absorption costing.
If the cost is required in order to determine the selling price, then the answer to the first
question is “no”, as the selling price is determined by the demand.
If the cost is required to determine the profitability of a product, then we should calculate the
“variable cost” of the product and the profit should be defined as “contribution”.
(b) Calculate the cost per unit of products A, B, and C

Let me say one more time that there is no such thing as the “cost of a product”. The definition
of cost depends on the purpose for which we want to use the information.
In this example, if the purpose is to make future profitability decisions, then the relevant cost
per unit is “variable cost”. In this example we have:
A B C
Production – units 1 000 2 000 4 000
Direct variable costs R20 000 R44 000 R108 000
Variable cost per unit R20 R22 R27
How do we allocate the other costs?
Under a variable costing system, we would not allocate any of the costs directly to the three
products. The costs would simply be written-off in the income and expenditure account.
If, however, we want the cost per unit for financial accounting purposes, we need to somehow
find a way of allocating the indirect costs and overheads to the three products.
Step 1
Allocate the rent, depreciation and other overheads to the two production departments and
two service departments.
Step 2
Allocate the service department costs to the two production departments.
Step 3
Based on the predominant activity of the two production departments, allocate costs to the
three products.
Illustrative example 1 – continued

Assume that the following additional information was given:
Production Service
X Y 1 2
Area occupied (rent) 50% 30% 10% 10%
Asset value (depreciation) 40% 60% – –
Direct (other overheads) 30% 30% 20% 20%
The service department costs are allocated to the production departments on an equal basis.
The predominant activity for department X is labour hours. There were 24 000 labour hours in
this department.
Product A requires 4 hours per unit
Product B requires 6 hours per unit
Product C requires 2 hours per unit
The predominant activity for department Y is machine hours. There were 40 000 machine
hours in this department.
Product A requires 2 hours per unit
Product B requires 5 hours per unit
Product C requires 7 hours per unit
Solution – absorption costing

Production Service Total
X Y 1 2
Rent 10 000 6 000 2 000 2 000 20 000
Depreciation 4 000 6 000 – – 10 000
Other overheads 6 000 6 000 4 000 4 000 20 000
Labour 6 000 12 000 4 000 5 000 27 000
Indirect material 6 000 4 000 4 000 2 000 16 000
Manufacturing overheads 3 000 4 000 – – 7 000
Service overheads – – 4 000 3 000 7 000
35 000 38 000 18 000 16 000 107 000
Allocate service 17 000 17 000 (18 000) (16 000)
52 000 55 000
Labour hours 24 000
Machine hours 40 000
Rate per hour R2,167 R1,375
Cost per unit – absorption costing
Products A B C
Direct material 15 18 21
Direct labour 5 4 6
Overheads 11,42 19,88 13,96
Cost per unit R31,42 R41,88 R40,96
Direct materials
Product A R15 000 / 1 000 = R15
B R36 000 / 2 000 = R18
C R84 000 / 4 000 = R21
Direct labour
Product A R5 000 / 1 000 = R5
B R8 000 / 2 000 = R4
C R24 000 / 4 000 = R6
Overheads
Product A [ 2,167 × 4 ] + [ 1,375 × 2 ] = R11,42
B [ 2,167 × 6 ] + [ 1,375 × 5 ] = R19,88
C [ 2,167 × 2 ] + [ 1,375 × 7 ] = R13,96
The costs calculated above can be used for financial accounting inventory valuation purposes, and
as a pre-determined rate to charge to production in the forthcoming year. See next section.
Factory X has 3 production departments and two service departments, ie maintenance and
administration. The annual manufacturing-related costs are as follows:
Materials: R R
Production Department A 60 000
Production Department B 50 000
Production Department C 100 000
Maintenance 30 000
Administration 10 000 250 000
Salaries and wages:
Production Department A 120 000
Production Department B 60 000
Production Department C 40 000
Maintenance 40 000
Other overhead costs:
Water and electricity 40 000
Rent 160 000
Depreciation 60 000
Insurance 30 000
Security 80 000 370 000
R980 000
The company will allocate the non-direct costs as follows:
Cost Apportionment basis
Water and electricity Area occupied
Rent Area occupied
Depreciation Value of machinery
Insurance Value of machine
Security Area occupied
The values of the machinery and the area occupied by each department has been
determined as:
Dept A Dept B Dept C Maint Admin
Area occupied 30% 25% 25% 10% 10%
Value of machinery 50% 33,3% 16,6% – –
The benefits derived by the three production departments and the inter-service benefits are
as follows:
Production
Service Dept Dept A Dept B Dept C Maint Admin
Maintenance 30% 40% 25% – 5%
Administration 20% 40% 30% 10% –
Allocate all costs to production departments A, B and C.
Solution
Step 1
Allocate indirect costs to the production and service departments
The above table of costs allocates the material and labour costs to specific departments because they
are directly identifiable with the department. Those costs that cannot be allocated directly to specific
departments, because they are incurred in respect of various departments, must be apportioned on
a common basis.
Overhead analysis sheet

Item of Basis of Production Service
expenditure apportionment A B C Maint Admin
Materials Actual 60 000 50 000 100 000 30 000 10 000
Salaries and wages Actual 120 000 60 000 40 000 40 000 100 000
Water and electricity Area 12 000 10 000 10 000 4 000 4 000
Rent Area 48 000 40 000 40 000 16 000 16 000
Depreciation Machine value 30 000 20 000 10 000 – –
Insurance Machine value 15 000 10 000 5 000 – –
Security Area 24 000 20 000 20 000 8 000 8 000
309 000 210 000 225 000 98 000 138 000
Step 2
Allocate service department costs to production departments
The allocation of service costs to production departments is done on the basis of the benefits they
have received.
Methods of allocating service department costs:
(a) direct allocation
(b) step allocation
(c) reciprocal allocation.
(a) Direct allocation

This method of allocation means that service department costs are allocated directly to producing
departments. No service department costs are allocated to other service departments, even though
they may perform work for other service departments.
In the above example, the allocation is as follows:
Production
Cost Total A B C
Maintenance 30 / 95 40 / 95 25 / 95
Administration 20 / 90 40 / 90 30 / 90
Maintenance 98 000 30 947 41 263 25 790
Administration 138 000 30 667 61 333 46 000
R236 000 R61 614 R102 596 R71 790
(b) Step allocation

This method accounts for the inter-service department cost allocation. The technique used is to
allocate the cost of the service department which services the greatest number of other service
departments first. If you have a situation in which two service departments service each other, as in
the above example, then the allocation starting point is the service department that has the highest
cost to be allocated.
Service Production
Administration Maintenance A B C
Cost 138 000 98 000 309 000 210 000 225 000
Allocation (138 000) 13 800 27 600 55 200 41 400
– 111 800
Allocation (111 800) 35 305 47 074 29 421
Total overhead 371 905 312 274 295 821
(c) Reciprocal allocation (linear algebra)

The reciprocal allocation method takes into account the inter-service department work. In other
words, you apportion the costs backwards and forwards between the departments until all costs
have been allocated.
Service Production
Administration Maintenance A B C
138 000 98 000 309 000 210 000 225 000
(138 000) 13 800 27 600 55 200 41 400
111 800
5 590 (111 800) 33 540 44 720 27 950
(5 590) 559 1 118 2 236 1 677
28 (559) 168 224 139
(28) 3 6 11 8
(3) 1 1 1
– – 371 433 312 392 296 175
The total costs allocated by the service departments were as follows:

Administration 138 000 + 5 590 + 28 = 143 618
Maintenance 98 000 + 13 800 + 559 + 3 = 112 362
Being:
Total A B C
Administration 20% 40% 30%
Maintenance 30% 40% 25%
Cost 309 000 210 000 225 000
Administration 143 618 28 724 57 447 43 085
Maintenance 112 362 33 709 44 945 28 090
371 433 312 392 296 175
The above long-winded calculations can be simplified by using linear algebra equations:
Let total allocated cost of Administration =a
Let total allocated cost of Maintenance =b
a = 138 000 + 0,05b
b = 98 000 + 0,10a
a = 138 000 + 0,05 (98 000 + 0,1a)
a = 138 000 + 4 900 + 0,005a
a = 143 618
b = 112 362
Allocation A B C
Administration 143 618 28 724 57 447 43 085
Maintenance 112 362 33 709 44 945 28 090
62 433 102 392 71 175
Step 3
Allocate the total manufacturing department costs to the units of production manufactured
The four common bases for allocating the overhead production are:
(a) direct labour hours
(b) machine hours
(c) direct labour cost
(d) material cost.
Many overhead costs are time-related; consequently, the more common allocation method is the
“direct labour hours” or “direct machine hours” basis.
Assume in the above example that you are given the following additional information:
Manufacturing departments:
A B C
Total direct labour hours 100 000 50 000 200 000
Total machine hours 80 000 80 000 120 000
The company manufactures two products, ie Alpha and Beta. Both products pass through all
three manufacturing departments and require the following machine and labour hours.
Manufacturing department: A B C
Product Alpha
Labour hours 5 2 3
Machine hours 1 3 4
Product Beta
Labour hours 4 1 6
Machine hours 2 4 1
The company uses the reciprocal allocation method, and recovers the overheads in
departments A and C on the basis of labour hours, and in department B on the basis of
machine hours.

Calculate the overhead cost allocation to products Alpha and Beta for a batch of 20 units of
Alpha and 50 units of Beta.
Solution
Overhead recovery rates
Departments A B C
Overhead costs 371 433 312 392 296 175
Direct labour hours 100 000 200 000
Recovery rate per hour R3,7143 R3,9049 R1,4809
Overhead allocation
Product Alpha – 20 units
R R
Department A 20 × 5 (labour) × 3,7143 = 371,43
Department B 20 × 3 (machine) × 3,9049 = 234,29
Department C 20 × 3 (labour) × 1,4809 = 88,85
694,57
Product Beta – 50 units

R R
Department A 50 × 4 (labour) × R3,7143 = 742,86
Department B 50 × 4 (machine) × R3,9049 = 780,98
Department C 50 × 6 (labour) × R1,4809 = 444,27
1 968,11
The purpose of allocating manufacturing overhead to a product can be:

l to arrive at the value of closing inventory. When an absorption costing system is used to value
closing inventory, it may be necessary to determine the value of the manufacturing overhead to
be allocated to closing inventory.
l to arrive at a pre-determined recovery rate that can be used to allocate overhead costs to a
product in the forthcoming year. Overhead costs are only charged to a product in the
forthcoming year if the company operates a job-costing system and is required to determine the
value of the job at a particular point in time.
Pre-determined overhead rates

There are certain types of manufacturing companies that manufacture a product only when an order
is placed. A good example is a printing company.
Let us assume that an order for 10 000 books is placed with a printing company. To manufacture the
books, the company will incur direct costs such as data capture, paper and direct labour cost. It will
also incur many indirect costs and manufacturing overheads such as machine time, machine repairs,
rental, depreciation of machinery, electricity, etc.
Although the selling price of a job is based on what the market will bear, it is common for a company
to estimate both the direct and the overhead costs, and then charge a mark-up in order to arrive at
the selling price. The company will incur material, labour and overhead costs which will be recorded
in the company accounting books in the normal financial accounting method. The company,
however, wants to know how much profit it makes on each individual job. To do this it becomes
necessary to charge all manufacturing (and sometimes also some non-manufacturing) costs directly
to the specific job.
The problem associated with allocating the indirect overhead costs to a job is that the actual costs
can only be calculated long after the job has been completed. Clearly, we need to know the costs
now. We cannot wait until the end of the year to calculate an appropriate allocation of costs to a
particular job.
The Chicago Printing Company produced the following abridged income statement for the
financial year ended February 20X3.
R
Sales 80 000
Cost of sales:
Direct material 18 000
Direct labour 12 000
Manufacturing overheads 30 000
Profit 20 000
continued
During the financial year, three jobs were completed, as follows:

A B C Total
Sales 10 000 20 000 50 000 80 000
Direct material 2 000 6 000 10 000 18 000
Direct labour 3 000 3 000 6 000 12 000
Manufacturing overheads ? ? ? 30 000
Profit ? ? ? 20 000

Calculate the actual profit achieved by each of the three jobs completed.
Solution
There is no one single method of determining the profit for each of the three jobs.
In fact, at best, the company should calculate the contribution (see chapter on cost-volume-profit
and variable costing later) for each job and leave it at that. It should then treat the manufacturing
overheads as general company costs.
Unfortunately, the fact is that most companies want the overheads to be allocated and a profit for
each job determined, however meaningless that figure may be.
Well then, if we must do it, we need to decide somehow what method to use to allocate the
manufacturing overheads to the three jobs.
Manufacturing overheads
As has been previously discussed in this chapter, if we want to allocate overhead costs to a particular
product or job we need to:
1 allocate costs to production and service departments
2 transfer the service department costs to the production departments
3 determine the most common activity in each production department (eg machine hours)
4 allocate costs to the products on the basis of activity consumption.
Illustrative example – continued

Chicago Printing has two manufacturing departments, X and Y. Department X is labour-
intensive, while department Y is machine-intensive.
X Y Total
Overhead costs R14 000 R16 000 R30 000
Labour hours 7 000
Recovery rate per hour R2 R1
All three jobs passed through the two departments as follows:
X Y
Labour hours Machine hours
Job A 1 000 3 000
Job B 2 000 4 000
Job C 4 000 9 000
7 000 16 000

Calculate the profit for each job.
Solution
A B C Total
Sales 10 000 20 000 50 000 80 000
Direct materials 2 000 6 000 10 000 18 000
Direct labour 3 000 3 000 6 000 12 000
Manufacturing overheads 5 000 8 000 17 000 30 000
Profit R– R3 000 R17 000 R20 000
Cost allocation
Job A Labour 1 000 × R2 = R2 000
Machine 3 000 × R1 = R3 000
R5 000
Job B Labour 2 000 × R2 = R4 000
Machine 4 000 × R1 = R4 000
R8 000
Job C Labour 4 000 × R2 = R 8 000
Machine 9 000 × R1 = R 9 000
R17 000
Timing – One problem with what we have done above is that the overhead costs have been
allocated at the end of the year. In other words, we can only determine the profit on each
job at the end of the year. Clearly this is unacceptable, as we want to allocate the costs as
the jobs are completed. We cannot wait until the end of the financial year.
Pre-determined recovery rate

To overcome this problem we calculate the allocation rate at the beginning of the accounting period,
ie a pre-determined rate.
In the above example, we may decide that next year as a job passes through the manufacturing
department X, we will charge R2 per labour hour and R1 per machine hour for the manufacturing
department Y.
By doing so, we are in effect saying that we expect the total manufacturing cost to equal R30 000, and
activity levels of 7 000 labour hours for department X and 16 000 machine hours for department Y.
In adopting this system, we will almost certainly be wrong on two counts:
1 The overhead charged will not equal the actual overhead.
2 The actual machine/labour hours will be different to the anticipated or budgeted hours.
We will therefore either over-charge or under-charge the overhead cost.
Chicago printing has decided that in 20X4 it will charge the overhead to all future jobs on the
basis of a pre-determined rate. The company has estimated that next year’s overhead is likely
to increase to R40 000 (budget cost). It has also estimated that there will be an increase in
activity for both production departments as follows:
Budget overheads:
Production departments X Y Total
Anticipated activity
Labour hours 10 000 10 000
Machine hours 20 000 20 000
Allocated (budget) cost: R18 000 R22 000 R40 000
Pre-determined recovery rate R1,80 R1,10
continued
Actual results
The following jobs were completed in 20X4
Jobs D E
Sales value R50 000 R60 000 R110 000
Direct materials R10 000 R15 000 R25 000
Direct labour R7 000 R8 000 R15 000
Jobs D E Total
Labour hours 7 000 5 000 12 000
Machine hours 10 000 15 000 25 000
Actual overhead cost incurred: R45 000

(a) Calculate the profit for each job
(b) Produce the actual income statement for 20X4
Solution
(a) Profit calculation
Job D E
Sales 50 000 60 000
Direct material 10 000 15 000
Direct labour 7 000 8 000
Overhead 23 600 25 500
Profit 9 400 11 500
Overhead allocation
Job D
Machine hours 10 000 × 1,10 = R11 000
Labour hours 7 000 × 1,80 = R12 600
R23 600
Job E
Machine hours 15 000 × 1,10 = R16 500
Labour hours 5 000 × 1,80 = R9 000
R25 500
(b) This is where students start to have difficulties

When a company allocates overhead costs to jobs at a pre-determined rate, the cost allocated
will never equal the actual cost incurred.
Two things will go wrong:
1 The actual cost incurred will be higher or lower than the budget cost. In this example, the
budget cost is R40 000, while the actual cost is R45 000.
2 The actual activity levels will be higher or lower than the budget activity levels. In this
example, we expected 10 000 labour hours and 20 000 machine hours. The actual activity
was 12 000 labour hours and 25 000 machine hours.
By allocating the overheads to jobs D and E at a pre-determined rate we will end up with an under-
or over-allocated overhead amount. In a job-costing system, both direct and allocated costs are
charged to the jobs. The jobs are then transferred to the income statement. As overhead has been
charged to the jobs at a pre-determined rate, the actual overhead account must be transferred to
the applied overhead account and the difference charged to the income statement.
Overhead account
Actual overhead 45 000 Job D overhead charged 23 600
Over-recovery 4 100 Job E overhead charged 25 500
(To income statement) 49 100 49 100
20X4 income statement
R
Sales 110 000
Cost of sales:
Direct materials 25 000
Allocated overheads 49 100
89 100 89 100
Gross profit 20 900
Over-recovered overhead + 4 100
Actual profit R25 000
Conclusion
The allocation of overhead costs to the manufacturing and service departments and then to the
products is done for the purposes of
1 Calculating the profit on an individual job
OR
2 Calculating the value of closing inventory in the income statement where a fully-integrated
absorption costing system is used.
Note: In the above example, the over-recovered overhead of R4 100 occurred because the actual
fixed cost was R45 000 but we recovered R49 100 in the income statement.
Important – students always forget this:
The under- or over-recovery balancing figure in the income statement will always represent the
difference between the actual fixed overhead cost incurred and the amount of fixed cost charged to
the income statement.
“Only the fixed cost”. In other words, the pre-determined recovery rate is for fixed-costs only and
does not apply to any other cost.
Application of pre-determined overhead rates

When a company has a job costing system, and it wishes to charge the fixed overhead to production
as a product passes through a particular production department, it will:
(a) Do a budget for the forthcoming period.
(b) Determine an overhead rate based on the budget fixed overhead and budget production
activity, eg budget production 10 000 units using 20 000 machine hours; budget cost R100 000
The pre-determined overhead cost will be:
(i) On a unit basis R100 000 ÷ 10 000 = R10 per unit
(ii) On a machine hour basis R100 000 ÷ 20 000 = R5 per machine hour.
(c) Apply the pre-determined overhead to production by debiting the work-in-progress (WIP)
account and crediting the overhead account.
(d) Calculate the under-/over-recovered overhead from the Overhead (O/H) account and write it
off to the income and expenditure account.
Explaining the under-/over-recovery

It is necessary at this point to fully understand the implications of the under-/over-recovery, as it will
appear again and again from now on.
Under- or over-recovery only occurs when we have a fully-integrated absorption costing system.
The under- or over-recovery figure in the income statement is there to adjust the allocated
overhead back to the actual overhead incurred.
The under-or over-recovery is caused by:

(a) actual overhead incurred being different to budget overhead
(b) the actual activity volume being different to the budget activity volume.
Gole Company uses a fully-integrated absorption costing system for recording overhead costs
and produced the following budgeted costs for a production level of 10 000 units:
Total Cost per unit
R R
Raw materials 80 000 8
Direct labour 70 000 7
Fixed manufacturing costs 50 000 5
R200 000 R20
The actual results for the period showed that 12 000 units were produced. The actual costs
incurred were:
Raw materials R96 000
Direct labour R84 000
Fixed manufacturing costs R65 000

Show the overhead and manufacturing accounts and explain the reasons for the under- or
over- recovered overhead.
Solution
Overhead account
Actual overhead 65 000 Manufacturing 60 000
Under-recovery 5 000
65 000 65 000
Manufacturing account
Raw material 96 000 Finished goods 240 000
Overheads 60 000
240 000 240 000
The under-recovery of R5 000 can be explained as follows:
Volume
The actual volume was 2 000 units greater than budget, resulting in an over-recovery of
2 000 × R5 = R10 000
Expenditure
The budget expenditure was R50 000, compared to the actual expenditure of R65 000. This has given
rise to an under-recovery of R15 000.
Volume over-recovered + R10 000

Expenditure under-recovered – R15 000
Net under-recovered – R5 000
Note: In the above example, the actual variable costs were the same as the budget variable costs.
What if they had been different? Does a change in variable costs affect the under-/over-
recovery of overheads?
No
The reason why it does not affect the income statement is because we charge the actual variable
cost, not the budget cost, to the income statement. We do this because we know what the variable
cost is at the time of production. So, there is no reconciling amount in the statements for variable
costs. The company will however wish to analyse how well it has performed in relation to the budget.
The reconciliation between the budget profit and the actual profit will explain any difference that
may exist in the variable cost expenditure.
If we charge the actual variable cost to production, why do we not do the same with fixed
overheads? Because we do not know what the fixed overhead is going to be, nor do we know what
the actual production is going to be, until we get to the end of an accounting period.
That is why we use a pre-determined fixed cost amount. In doing this, we know that at the end of the
accounting period, we will have to put through a reconciling figure.
Gole Company uses a fully-integrated absorption costing system for recording overhead costs and
values the closing inventory at the standard cost, per the budget.
Budget
R
Sales 10 000 units 250 000
Cost of sales:
Material 80 000
Labour – variable cost 70 000
Profit R50 000
Actual results
The company manufactured 12 000 units and sold 10 000 at the budget selling price of R25 per unit.
Actual cost of production

Material R84 000
Labour R90 000
Fixed manufacturing overhead R65 000

(a) Calculate the under-/over-recovery of fixed overhead.
(b) Prepare the actual income statement.
(c) Reconcile the budget to actual profit using absorption costing principles.
Solution
(a) As stated before, the under-/over-recovery represents the difference between the overhead
charged to the income statement and the actual overhead incurred, not “the difference
between the budget and the actual cost”.
Overhead charged
R
12 000 units × R5 = 60 000
Actual – 65 000
Under-recovery – 5 000
Recovery rate = R50 000 / 10 000 units = R5 per unit
The under-recovery can be explained as follows:

R
Expenditure 50 000 – 65 000 = – 15 000
Volume + 2 000 × R5 = + 10 000
Under-recovered by – 5 000
(b) Actual income statement

R R
Sales 10 000 × R25 250 000
Production costs – 12 000 units:
Material 84 000
Fixed overhead (12 000 × R5) 60 000
234 000
Closing inventory (2 000 × R20) (40 000)
Cost of sales 194 000 194 000
Profit 56 000
Under – recovery – 5 000

Material 80 000
200 000
Budget units 10 000
Cost per unit R20
Note 1
The value of closing inventory of R40 000 does not comply with IAS 2, as the cost is not at the
lower of cost and net realisable value. At the year end, an adjustment would be made to reflect
the IAS 2 requirement. The value charged in the income statement does, however, comply with
a standard absorption costing system.
The value of the closing inventory could have been shown at actual cost rather than at the
budget cost for material and labour – this is perfectly acceptable. As you will discover later,
there are different, but equally acceptable methods of valuing closing inventory.
Note 2
The under-recovery of R5 000 is shown as a negative of R5 000, because the fixed cost charged
was R60 000, although it should have been R65 000. The extra R5 000 will reduce the profit.
The R5 000 adjustment could have been shown above the profit line, however, ie as an
adjustment to the R60 000 charged. In this instance, the R5 000 would have been shown as an
increase of + R5 000 to the cost of sales. In other words, you can either increase the costs, or
decrease the profit.
(c) Reconciliation of budget to actual profit

R
Budget profit 50 000
Material saving + 12 000
Labour increase – 6 000
Fixed cost – expenditure – 15 000
Fixed cost – volume + 10 000
Material saving
R
Actual cost 84 000
Budget 12 000 × R8 96 000
= Saving + 12 000
Labour increase
R
Actual cost 90 000
Budget 12 000 × R8 84 000
= Increase – 6 000
Fixed cost
Expenditure
R
Budget cost 50 000
Actual cost 65 000
= Increase – 15 000
Volume
+ 2 000 units × R5 = + R10 000
As you can see, the under-recovery of R5 000 is explained in the reconciliation statement with
reference to the expenditure and the volume variation.
Important: When we have a standard absorption costing system, the under- or over-
recovered overhead is shown as a volume variance (the difference between budget volume
and actual volume) and an expenditure variance, which is the difference between the
budget and actual cost. Refer to the chapter on standard costing.
Job costing
Job costing is essentially a bookkeeping exercise and is used by companies such as printing, furniture,
auditing and auto-repair firms, where the products or services are readily identified by individual
units receiving material, labour and overhead charges. Job costing is associated with a fully-
integrated absorption costing system.
A company has the following opening balances:
Work-in-progress R200 000
Finished goods –
Salaries (accounts payable) CR R10 000
Work-in-progress is as follows:
Job No Materials Labour Overhead Total
1 50 000 60 000 10 000 120 000
2 45 000 30 000 5 000 80 000
R95 000 R90 000 R15 000 R200 000
During the current year the following took place:
(a) Purchase of raw material R200 000
(b) Started work on Jobs 3, 4 and 5
(c) Indirect labour cost for the year R20 000
(d) Factory overheads R60 000
(e) Direct labour cost
Job No Cost Hours
1 R10 000 5 000
2 R30 000 17 000
3 R20 000 8 000
4 R60 000 32 000
5 R30 000 16 000
(f) Salaries and wages paid during the current year amounted to R160 000
(g) Raw material issues
Job No Cost
1 R30 000
2 R10 000
3 R20 000
4 R50 000
5 R40 000
(h) Factory overhead is applied at the rate of R1,50 per direct labour hour
(i) Jobs 1 and 2 have been completed and invoiced for R250 000 and R200 000 respectively.
The other Jobs are still work-in-progress.

Set up ledger accounts for the current year’s transactions and produce the income statement.
Solution
Note: Only the relevant job costing accounts are shown.
Raw materials
Balance 50 000 5 WIP 150 000
1 Purchases 200 000 Balance c/f 100 000
Salaries and wages

Cash 160 000 Balance 10 000
Balance c/f 20 000 2 Overhead 20 000
4 WIP 150 000
Work-in-progress
Balance 200 000 8 Cost of sales 313 000
4 Labour 150 000 Balance c/f 304 000
5 Materials 150 000
6 Overhead applied 117 000
Over-/Under-applied overhead
Income and expenditure A/C 37 000 7 Overhead control 37 000
Overhead control
2 Indirect labour 20 000 6 Overhead applied 117 000
3 Overhead 60 000
7 Over-applied (balance) 37 000
Sales
Debtors 450 000
Cost of sales
8 WIP 313 000
Job 1
Balance 120 000 Job completed 167 500
Labour 10 000
Materials 30 000
Overhead 7 500
Job 2
Balance 80 000 Job completed 145 500
Labour 30 000
Materials 10 000
Overhead 25 500
Job 3
Labour 20 000 Balance c/f 52 000
Materials 20 000
Overhead 12 000
Job 4
Materials 50 000
Overhead 48 000
Job 5
Materials 40 000
Overhead 24 000
Note: Indirect labour is treated as an overhead. Total overheads are applied to production at the
rate of R1,50 per direct labour hour.
R R
Sales 450 000
Opening inventory:
Raw materials 50 000
Work-in-progress 200 000
Current costs:
Labour 150 000
Overheads 117 000
Closing inventory
Raw materials (100 000)
Work-in-progress (304 000)
Cost of sales 313 000 313 000
Gross profit 137 000
Over-applied overhead + 37 000
Cost classification for short-term decisions

Note: This section is introduced here to show you that there is another, more important method of
analysing costs when we are making decisions. This concept is explored fully in the chapter
entitled “Relevant costs”. You may, if you wish skip this section for the time being.
When we are attempting to determine whether a specific product should be discontinued, or
whether a special order should be accepted, we are concerned with costs and incomes that are
specifically relevant to that short-term decision.
We are not concerned with the financial historical costs incurred, sunk costs or any other financial
cost that is not relevant to a specific short-term decision.
A company manufactures several products. The following budget has been prepared for one
of the products for the forthcoming year:
Sales R600 000
Manufacturing costs:
Labour 200 000
Fixed costs 300 000
Loss (200 000)
continued
The raw material can be used in another product produced by the company. The current
replacement cost is R300 000. If the raw material is disposed of, it will cost the company
R50 000. If the product is discontinued, fixed labour costs of R20 000 will continue to be
incurred.

(a) Calculate whether the product should be discontinued in the short-term.
(b) Determine whether the product should be discontinued in the long-term.
Solution
(a) Short-term decision
The short-term decision must be based on current relevant costs, and is carried out by comparing the
available options and choosing the one with the lowest loss (or highest profit).
Shut-down Continued
Sales – 600 000
Raw material – 300 000
Labour 20 000 200 000
Variable costs – 100 000
Fixed costs 300 000 300 000
Loss (320 000) (300 000)
The relevant raw material cost is R300 000, as this material would be used in some other product if
this product were discontinued. The material would therefore have to be purchased at a cost of
R300 000. In this case, the disposal value is not relevant, as there is a better opportunity of using it
within the company.
This simple example shows that it is better to continue with the product in the short-term as the
company will make a greater loss if the product is discontinued. The assumption in this situation is
that the fixed costs of R300 000 will continue to be incurred. Refer to the chapter on “relevant
costing” for a detailed study of management accounting short-term decisions.
(b) Long-term decision

In the long-term, a company must produce not only a positive contribution; it must also be able to
cover a fair proportion of fixed costs and yield a return commensurate with both the business and
financial risks of the company.
The relevant costs will therefore be the long-term expected cash-flows that will yield a positive net
present value (NPV) at the company’s required return. Refer to the chapter on “capital budgeting”
for a detailed discussion of the relevant costs.

1 The cost of a product in closing inventory can be reflected as:
l variable cost
OR
l variable plus fixed costs.
When the cost is variable cost plus fixed cost, it is called “absorption costing”.
2 The absorption cost of a product is useful for valuing closing inventory as per IAS 2 only. If the
production level changes, the resultant cost of the product will also change.
3 Overhead cost allocation is carried out for the purpose of determining the full cost of a
manufactured product only. It is not a management accounting requirement that costs be
allocated to a product; it is a financial accounting requirement.
4 A pre-determined fixed-cost recovery rate is required when a company has an absorption costing
system that wishes to charge the overhead cost to a product as it is manufactured or completed.
5 The under-/over-recovery of an overhead represents the difference between the overhead
charged to the financial accounts (ie actual production × pre-determined recovery rate), less the
actual cost incurred.
Note: Fixed costs only.
6 The under-/over-recovery can be broken down to represent both the expenditure and volume
elements. The expenditure is the difference between the budget fixed cost and the actual fixed
cost. The volume represents the difference between the budget volume and the actual volume
produced × the pre-determined recovery rate.
Appendix
The following questions are intended to reinforce the important concepts that have been
introduced in this chapter. Do not proceed to the next chapter until you have grasped these
questions.
Question 1
A company manufactures three products in two production departments. The company also has two
service departments. The company wishes to arrive at a pre-determined recovery rate for each of the
two production departments and has presented you with the following budget information which is
based on last year’s actual results, adjusted for inflation.
Products 1 2 3
Budget production units 12 000 5 000 8 000
Direct materials per unit R20 R40 R30
Direct labour per unit R10 R20 R20
Machine hours per unit – Dept A 10 20 15
Labour hours per unit – Dept B 20 8 5
Overheads: Manufacturing Service
Dept A Dept B X Y Total
Direct overheads R50 000 R80 000 R20 000 R10 000 R160 000
Other overheads:
Rent 40 000
Depreciation 20 000
Labour – indirect costs 30 000
R250 000
Additional information:
Value of machinery R110 000 R60 000 R20 000 R10 000
Employees 10 12 2 6
Floor-space 30% 50% 5% 15%
The company has a policy of allocating the service department costs on a step down basis. Service
department X will allocate its overheads on the basis of 50% to Department A, 30% to Department B
and 20% to Service Department Y. Service Department Y allocates 30% of its overheads to
Department A and the balance to Department B.

(a) Allocate the overheads to the two production departments and determine the overhead
recovery rate for each of the two departments.
(b) Calculate the budgeted manufacturing overhead cost per unit of the three products.
(c) The actual production and sales in the forthcoming year were:
Product 1 10 000 units at a selling price of R40
The actual total overhead manufacturing cost was R270 000. All other costs were per budget.
Prepare the actual income statement

(d) Explain the causes for the under- or over-recovery of manufacturing overhead costs.
Solution
(a) The general overheads will be allocated as follows:
Rent – Floor-space
Depreciation – Value of machinery
Indirect labour – Number of employees
Department A is machine-intensive. The recovery rate is therefore on the basis of machine
hours.
Total machine hours = (12 000 × 10 + 5 000 × 20 + 8 000 × 15) = 340 000
Department B is labour-intensive. The recovery rate is therefore based on labour hours.
Total labour hours = (12 000 × 20 + 5 000 × 8 + 8 000 × 5) = 320 000
Departments A B X Y
Direct overheads 50 000 80 000 20 000 10 000
Rent (floor-space) 12 000 20 000 2 000 6 000
Depreciation (machine value) 11 000 6 000 2 000 1 000
Labour (employees) 10 000 12 000 2 000 6 000
83 000 118 000 26 000 23 000
Allocate Department X 13 000 7 800 (26 000) 5 200
96 000 125 800 – 28 200
Allocate Department Y 8 460 19 740 (28 200)
104 460 145 540 – –
Department A machine hours 340 000
Rate per hour = 0,30723
Department B labour hours 320 000
Rate per hour = 0,45481
(b) Budget manufacturing recovery rate per unit

Products 1 2 3
Machine hours 10 20 15
x rate × 0,30723 × 0,30723 × 0,30723
= 3,0723 6,1446 4,6085
Labour hours 20 8 5
x rate × 0,45481 × 0,45481 × 0,45481
= 9,0962 3,6385 2,2741
Total overhead
cost per unit R12,1685 R9,7831 R6,8826
Say R12,17 R9,78 R6,88
(c) Actual overhead recovery
1 10 000 units × R12,17 = 121 700

2 8 000 units × R9,78 = 78 240
3 14 000 units × R6,88 = 96 320
296 260
Allocated overhead R296 260
Actual overhead R270 000
Over-recovery R26 260
Actual income statement
Products 1 2 3 Total
Sales 400 000 640 000 980 000 2 020 000
Cost of sales:
Materials 200 000 320 000 420 000 940 000
Labour 100 000 160 000 280 000 540 000
Overheads 121 700 78 240 96 320 296 260
Gross profit – 21 700 81 760 183 680 243 740
Overhead over-recovered + 26 260
Profit R270 000
(d) Explanation of over-recovered overhead

There are two possible reasons why an under- or over-recovery of overheads occurs:
– Expenditure
– Volume
Expenditure –
Budget R250 000
Actual R270 000
Under-recovery R20 000
Volume Products 1 2 3
Budget production 12 000 5 000 8 000
Actual 10 000 8 000 14 000
– 2 000 + 3 000 + 6 000
× rate 12,17 9,78 6,88
= – 24 340 + 29 340 + 41 280
Over-recovery = + R46 280
Expenditure under-recovery – 20 000
Volume over-recovery + 46 280
Rounding off – 20
Income – statement over-recovery R26 260
Question 2
Company A manufactured 2 000 units and incurred the following costs:
Raw material R40 000
Variable overheads R60 000
Fixed overheads R60 000
1 200 units were sold at a price of R100 each.

(i) Prepare a variable costing income statement.
(ii) Prepare an absorption costing income statement.
(iii) Prepare an absorption costing income statement assuming:
l that the company used a fully-integrated absorption costing system
l that the pre-determined recovery rate for fixed overheads was set at R35 per unit
l a production run of 1 500 units.
Solution
(i) Variable costing income statement
Sales R120 000

R160 000
Closing inventory R40 000 [ R100 000 / 2 000 × 800 ]
Cost of sales R120 000 R120 000
Profit –
(ii) Absorption costing income statement
Sales R120 000

R160 000
Closing inventory R64 000 [ R160 000 / 2 000 × 800 ]
Profit R24 000
(iii) Fully-integrated absorption costing income statement
Sales R120 000

R170 000
Closing inventory R68 000
Gross profit R18 000
Over-recovered fixed costs R10 000
Profit R28 000
Why is the closing inventory valued differently in (ii) and (iii)?

Although they are both done on an absorption costing basis, (ii) above values closing inventory at the
current fixed cost per unit incurred, ie R60 000 / 2 000 units = R30 per unit. By contrast, (iii) above is
a fully-integrated absorption costing system that uses the pre-determined value of R35 per unit.
Hence the difference of R5 × 800 units = R4 000.
Question 3
Using the information given in Question 2, show the overhead and manufacturing accounts, and
indicate how the under-/over-recovery can be explained.
Solution
Overhead account
Actual overhead 60 000 Manufacturing 70 000
Over recovery 10 000
70 000 70 000
Manufacturing account
Raw material 40 000 Finished goods 170 000
Overheads 70 000
170 000 170 000
The over-recovery of R10 000 can be explained as follows:
Volume
The actual volume was 500 units greater than budget, resulting in an over-recovery of
500 × R35 = R17 500
Expenditure
The budget expenditure was R52 500, compared to the actual expenditure of R60 000. This has given
rise to an under-recovery of R7 500.
Reconciliation
Volume over-recovered + R17 500

Expenditure under- – R7 500
recovered
Net over-recovered + R10 000
Practice questions
Question 2 – 1 25 marks 38 minutes
Fancy Dude Limited operates a factory consisting of three production departments (A, B and C),
together with four ancillary service departments (maintenance, steam supply, central stores and
transport). Department A covers 2 000 square metres and comprises three machines – a band-saw, a
lathe and a drill. There is no annual close-down.
You are given the following information from the cost records for the year ended 31 March 19X4.
Direct labour: (Department A)

Band-saw R180 000
Lathe R200 000
Drill R95 000
Band-saw:
Cost R450 000
Estimated life 5 years
Scrap value R50 000
Floor area 400 square metres
Hours clocked in the period 180 000
Idle time 20 000 hours
Therefore operating hours = 160 000 hours
Power consumed R25 000 (estimated)
Overheads for the entire factory for the period
Department A Department B Department C

R’000 R’000 R’000
Foreman’s wages 28 20 25
Cleaner’s wages 5 15 5
Indirect materials 13 5 16
Insurance 7 8 5
Water – 10 15
Rent 50 40 37
103 98 103
Service departments
Maintenance Steam Stores Transport
R’000 R’000 R’000 R’000
Foreman’s wages 32 10 30 45
Cleaner’s wages 16 5 26 18
Indirect materials 70 7 – 5
Insurance 2 15 28 72
Coal – 125 – –
Rent 10 5 15 20
130 167 99 160
Service department costs are to be apportioned to other departments as follows:
A B C Stores Transport
Maintenance 30% 25% 25% 10% 10%
Steam – 60% 40% – –
Stores 40% 20% 20% – 20%
Transport 20% 25% 25% 30% –

1 Apportion the service department overheads to the production departments on the repeated
distribution basis.
2 Calculate to the nearest cent a machine-hour rate for the band-saw in department A.
Solution
1 Let a, b, c and d represent the total overheads of maintenance, steam, stores and transport
respectively.
(R’000)
Therefore a = 130
b = 167
c = 99 + 0,1a + 0,3d
d = 160 + 0,1a + 0,2c
Therefore c = 99 + 13 + 0,3d
d = 160 + 13 + 0,2C
Therefore c = 174,362
d = 207,872
Allocation of total service department overheads to production departments
Dept A Dept B Dept C

R R R
Direct overheads 103 000 98 000 103 000
Maintenance (130 000) 39 000 32 500 32 500
Steam (167 000) 100 200 66 800
Stores (174 362) 69 745 34 872 34 872
Transport (207 872) 41 574 51 968 51 968
253 319 317 540 289 140
2 Calculation of machine hour rate for band-saw in department A

Estimated annual costs
450 000 – 50 000
Depreciation = 80 000
5
400
Rent × 50 000 = 10 000
2 000
Power = 25 000
It is assumed that all overheads, excluding rent, apply equally to each of the three machines in
the department; therefore
(253 319 – 50 000)
Overheads = 67 773
3
Total annual cost = 182 773
Hours worked per year 180 000 – 20 000 = 160 000
Therefore the machine hour rate is 182 773 divided by 160 000 = R1,14

The Isis Engineering Company operates a job order costing system which includes the use of pre-
determined overhead absorption rates. The company has two service cost centres and two
production cost centres. The production cost centre overheads are charged to jobs via direct labour
hour rates which are currently R3,10 per hour in Production cost centre A, and R11,00 per hour in
Production cost centre B. The calculations involved in determining these rates have excluded any
consideration of the services that are provided by each service cost centre to the other.
Notes: The bases used to charge general factory overhead and service cost centre expenses to the
production cost centres are as follows:
(i) General factory overhead is apportioned on the basis of the floor area used by each of the
production and service cost centres.
(ii) The expenses of Service cost centre 1 are charged out on the basis of the number of personnel
in each production cost centre,
(iii) The expenses of Service cost centre 2 are charged out on the basis of the usage of its services
by each production cost centre.
The company’s overhead absorption rates are revised annually, prior to the beginning of the year,
using an analysis of the outcome of the current year and the draft plans and forecasts for the
forthcoming year. The revised rates for next year are to be based on the following data:
General factory Service cost Production cost
overhead centres centres
1 2 A B
Budgeted overhead for next
year (before any re-allocation) R210 000 R93 800 R38 600 R182 800 R124 800
% of factory floor area – 5 10 15 70
% of factory personnel – 10 18 63 9
Estimated usage of services of
Service cost centre 2 in
forthcoming year – 1 000 hrs – 4 000 hrs 25 000 hrs
Budgeted direct labour hours
for next year (to be used to
calculate next year’s
absorption rates) – – – 120 000 hrs 20 000 hrs
Budgeted direct labour hours
for current year (these figures
were used in the calculation
of this year’s absorption – – – 100 000 hrs 30 000 hrs
rates)

(a) Ignoring the question of reciprocal charges between the service cost centres, calculate the
revised overhead absorption rates for the two production cost centres. Use the company’s
established procedures. (10 marks)
(b) Comment on the extent of the differences between the current overhead absorption rates and
those you have calculated in your answer to (a). Set out the likely reasons for these differences.
(8 marks)
(c) Each service cost centre provides services to the other. Recalculate next year’s overhead
absorption rates, recognising the existence of such reciprocal services and assuming that they
can be measured on the same bases as those used to allocate costs to the production cost
centres.
(14 marks)
(d) Assume that:
(i) General factory overhead is a fixed cost.
(ii) Service cost centre 1 is concerned with inspection and quality control with its budgeted
expenses (before any re-allocations) being 10% fixed and 90% variable.
(iii) Service cost centre 2 is the company’s plant maintenance section with its budgeted
expenses (before any re-allocations) being 90% fixed and 10% variable.
(iv) Production cost centre A is labour-intensive, with its budgeted overhead (before any re-
allocation) being 90% fixed and 10% variable.
(v) Production cost centre B is highly-mechanised, with its budgeted overhead (before any
re-allocations) being 20% fixed and 80% variable.
In the light of these assumptions, comment on the cost apportionment and absorption
calculations made in (a) and (c) and suggest any improvements that you would consider
appropriate.
(8 marks)
Solution
(a) General Overhead analysis Production cost
factory (ignoring reciprocal centres
overhead allocations)
Service cost centres
1 2 A B
R R R R R
Primary allocation 210 000 93 800 38 600 182 800 124 800
Apportionment of general
factory over-head (Note 1) (210 000) 10 500 21 000 31 500 147 000
– 104 300 59 600 214 300 271 800
Charges by Service cost centre 1 (Note 2) (104 300) – 91 262 13 038
– 59 600 305 562 284 838
Charges by Service cost centre 2 (Note 3) (59 600) 8 221 51 379
– 313 783 336 217
Budgeted direct labour hours 120 000 20 000
Absorption rates R2,61 R16,81
Notes:
1 General factory overhead is apportioned to service cost centres before re-allocation to
production centres, as indicated in Note (i) of the question.
2 Because reciprocal allocations are not made, the costs allocated to Service cost centre 1 are
re-allocated as follows:
R91 262 (63 / 72 × R104 300) to Production cost centre A
R13 038 (9 / 72 × R104 300) to Production cost centre B
3 Reciprocal charges are not made. Therefore the allocation is as follows:
4 000 / 29 000 × R59 600 = R8 221 to Production cost centre A
25 000 / 29 000 × R59 600 = R51 379 to Production cost centre B
(b) The difference may be due to the following:
(i) Changes in projected overhead expenditure compared with expenditure that was used
to determine the current year’s overhead rate.
(ii) Budgeted activity for the next year is greater than the current year for Production cost
centre A. If this is not matched by a corresponding increase in overhead expenditure,
then the hourly overhead rate will decline. Budgeted activity for Production cost centre
B is lower than the current year, thus resulting in an increase in the overhead rate.
Because fixed overheads do not change in relation to activity, the hourly overhead rate
will fluctuate whenever changes in activity occur.
(c) This question can be answered by using the simultaneous equation method, which is
illustrated below:
Let X = Total overhead of Service cost centre 1
Y = Total overhead of Service cost centre 2
â X = 104 300 + 1/30Y
(ie 1 000 / 30 000 hours of Service cost centre 2 overheads)
Y = 59 600 + 1/5X
(ie 18% out of a total of 90% of Service cost centre 1 overheads)
Rearranging the above equations
X – 1/30Y = 104 300 (1)
– 1/5X + Y = 59 600 (2)
Multiply equation (1) by 1 and equation (2) by 5
X – 1/30Y = 104 300
–X + 5Y = 298 000
Adding the above equations together we have

149Y
= 402 300
30
402 300 × 30
âY= = R81 000
149
Substituting for Y in equation (1) results in the following equation:
X – 1/30 (81 000) = 104 300
âX = 107 000
The service cost centre overheads of R107 000 (Service cost centre 1) and R81 000 (Service cost
centre 2) are now apportioned to the production cost centres as follows:
General factory Service cost Production cost
overhead centres centres
1 2 A B
R R R R R
Primary allocation 210 000 93 800 38 600 182 800 124 800
Apportionment of general
factory over-head (210 000) 10 500 21 000 31 500 147 000
– 104 300 59 600 214 300 271 800
Charges by Service cost centre 1
(Note 1) (107 300) 21 400 74 900 10 700
(2 700) 81 000 289 200 282 500
Charges by Service cost centre 2
(Note 2) 2 700 (81 000) 10 800 67 500
– – 300 000 350 000
Budgeted direct labour hours 120 000 20 000
Absorption rates R2,50 R17,50
Notes:
1 18 / 90 × R107 000 = R21 400 to Service cost centre 2 (18% out of 90%)
63 / 90 × R107 000 = R74 900 to Production cost centre A
9 / 90 × R107 000 = R10 700 to Production cost centre B
2 1 000 / 30 000 × R81 000 = R2 700 to Service cost centre 1
4 000 / 30 000 × R81 000 = R10 800 to Production cost centre A
25 000 / 30 000 × R81 000 = R67 500 to Production cost centre B
(d) The answer should include the following points:
(i) The overhead rate calculations do not distinguish between fixed and variable elements.
Such an analysis is necessary for decision-making purposes.
(ii) The majority of Service cost centre 1 costs are variable. It is preferable to determine an
activity measure which exerts most influence on the variable costs and apportion the
costs on the basis of this measure. The present method of apportionment appears to be
inappropriate.
(iii) Service cost centre 2 is the maintenance department and the majority of costs are fixed,
suggesting that preventive maintenance is undertaken. The question does not make it
clear which hourly base (ie direct labour hours or machine hours) is used for allocating
overheads. Machine hours should be used for allocating variable costs, since these costs
are likely to vary with this activity base. Preventive maintenance should be apportioned
on the basis of the planned hours which the maintenance staff intends to allocate to
each department.
(iv) Production cost centre B is highly mechanised, suggesting that a machine hour rate
might be preferable to the present direct labour hour rate.
Process and joint
3 product costing
l understand the principle that process costing is about valuing closing WIP
l calculate normal spoilage, abnormal spoilage and abnormal gain units
l determine equivalent units produced under FIFO and Weighted average methods
l allocate normal spoilage between closing WIP and units transferred out on a physical units
basis
l differentiate between process costing and joint product costing
l calculate the value of WIP, transferred out production and abnormal loss using FIFO and
weighted average methods
l understand the principle that normal spoilage should be allocated to inspected units only
l value inventory and calculate the product profit for joint products using the physical
allocation method and relative sales value method of joint cost allocation
l explain the advantages and disadvantages of using different methods of joint cost
apportionment
The valuation of products manufactured in a process is covered under IAS 2, as is the treatment of
joint product costs. However, when the costs are required for a short- or long-term decision, the
correct method is relevant costing under a variable costing system.
IAS 2 Paragraph 14 states:

A production process may result in more than one product being produced simultaneously. This is
the case, for example, when joint products are produced or when there is a main product and a by-
product. When the costs of conversion of each product are not separately identifiable, they are
allocated between the products on a rational and consistent basis. The allocation may be based, for
example, in the relative sales value of each product either at the stage in the production process
when the products become separately identifiable, or at the completion of production. Most by-
products, by their nature, are immaterial. When this is the case, they are often measured at net
realisable value and this value is deducted from the cost of the main product. As a result, the carrying
amount of the main product is not materially different from its cost.
In a process costing system products are manufactured in one department, transferred to a second,
and possibly subsequent, departments and finally transferred to finished goods. During the process,
material and overhead costs are added to the production cost.
Valuation of closing work-in-progress

It becomes necessary at the end of an accounting period to value the good production, abnormal
spoilage or abnormal gain, and closing work-in-progress. Note that in all the examples in this chapter
it is the closing work-in-progress that is valued. The value of the good output is always the balancing
figure.
57
IAS 2 Paragraph 16 states:

Examples of costs excluded from the cost of inventories and recognised as expenses in the period in
which they are incurred are:
(a) abnormal amounts of wasted materials, labour, or other production costs
(b) storage costs, unless those costs are necessary in the production process prior to a further
production stage
(c) administrative overheads that do not contribute to bringing inventories to their preset location
and condition, and
(d) selling costs.
The most common methods used to value the closing work-in-progress are first-in, first-out (FIFO)
and weighted average.
However, for external reporting purposes, IAS 2 states:
The cost of inventories should be assigned by using the first-in, first-out (FIFO) or weighted average
cost formulas.
The FIFO formula assumes that the items of inventory that were purchased first are sold first;
consequently the items remaining in inventory at the end of the period are the most recent products
purchased or produced. Under the weighted average cost formula, the cost of each item is
determined from the average cost of similar items at the beginning of a period and the cost of similar
items purchased or produced during the period. The average may be calculated on a periodic basis,
or as each additional shipment is received, depending upon the circumstances of the enterprise.
Illustrative example – FIFO and weighted average finished inventory valuation

The opening inventory of finished goods of Green Ltd consists of 1 000 units valued at R100
each. During the current year, Green manufactured 8 000 units at a cost of R120 per unit. The
closing inventory of finished goods at the end of the year was 800 units.

Value the closing inventory of finished goods on a FIFO and weighted average basis.
Solution
(a) First-in, first-out
Under a FIFO valuation, the first unit in is the first out. The remaining units in closing inventory will
therefore have a value equal to the value of units manufactured in the current year.
Closing inventory value: 800 × R120 = R96 000
FIFO process costing principle

To value the closing inventory under a process costing system, we need to determine the current
period’s production and the current period’s cost. The current period’s production will include:
(i) completed units in beginning work-in-progress
(ii) units that were started from scratch in the current period and completed in the current period
(iii) completed units in the closing work-in-progress.
Chapter 3: Process and joint product costing 59
(b) Weighted average

Under a weighted average valuation method, the closing inventory is valued at the average cost of
opening inventory and current period’s production.
Units Value
Opening inventory 1 000 R100 000
Manufacturing 8 000 R960 000
9 000 R1 060 000
Average unit cost R1 060 000 ÷ 9 000 = R117,78
Closing inventory value: 800 × R117,78 = R94 224
Weighted average process costing principle

To value the closing inventory under a weighted average process costing system, we need to
determine:
(i) equivalent units of beginning work-in-progress
(ii) equivalent units of completed beginning work-in-progress
(iii) units started and completed in the current period
(iv) work completed from closing work-in-progress.
The value will be the total of beginning work-in-progress, plus current costs.
The allocation of costs

In a manufacturing process, costs are incurred as a product passes through the production line. Some
costs are incurred at the beginning of the process, some at a specific point in the process, while
others such as labour (conversion costs) are incurred throughout the process.
A company manufactures a product that requires raw Material A at the beginning of the
process and Material B when the product is 70% complete and incurs conversion costs evenly
throughout the process.
Opening inventory –
Started production on 1 000 units during the period.
700 units were completed, while 300 units are 60% complete.
Material A cost R1 000
Material B cost R2 000
Conversion costs R4 000
(a) Calculate the value of the closing WIP and the value of the completed output.
(b) Calculate the value of the closing WIP, assuming that it was 80% complete, as well as the
completed production.
Solution
(a) As there is no beginning work-in-progress, the FIFO and weighted average methods of
determining the value of closing work-in-progress are one and the same.
The correct method of valuing closing WIP is to analyse the production into 3 categories,
Beginning WIP, Started and completed and Closing WIP.
Started and completed refers to those units that were started and completed in the current
period.
Equivalent unit calculation
Total Material Material Conversion
A B costs
Beginning WIP – – – –
Started and completed 700 700 700 700
Closing WIP 300 300 – 180
1 000 1 000 700 880
Beginning costs – – –
Current costs R1 000 R2 000 R4 000
Total costs R1 000 R2 000 R4 000
+ equivalent units 1 000 700 880
Equivalent cost per unit R1 R2,86 R4,55
Value of closing WIP

R
Material A 300 × R1 300
Conversion costs 180 × R4,55 819
1 119
Completed production (balancing figure) 5 881
R7 000
(b) Equivalent unit calculation

A B costs
Beginning WIP – – – –
Closing WIP 300 300 300 240
1 000 1 000 1 000 940
+ equivalent units 1 000 1 000 940
Equivalent cost per unit R1 R2 R4,26

R
Material A 300 × R1 300,00
Material B 300 × R2 600,00
Conversion costs 240 × R4,26 1 022,40
1 922,40
Completed production (balancing figure) 5 077,60
R7 000
A company manufactures a product that requires raw Material A at the beginning of the
process and Material B when the product is 70% complete, and incurs conversion costs evenly
Opening inventory 500 units 40% complete
Value – Material A R400
Started production on 1 000 units during the period.
700 units were completed, while 300 units are 30% complete.
Current costs:
Material A cost R1 000
Material B cost R2 000
(a) Using the FIFO method, value the Closing WIP as well as the completed production.
(b) Using the weighted average method, value the Closing WIP as well as the completed
production.
(c) Assuming that the closing WIP was 300 units, 80% complete, value the Closing WIP using,
FIFO and weighted average.
Solution
Process diagram
Conversion costs
Mat A Mat B
30% 40% 70%
Beginning WIP
Closing WIP
Figure 1
(a) FIFO valuation

A B costs
Beginning WIP 500 – 500 300
1 500 1 000 1 200 1 090
Equivalent units 1 000 1 200 1 090
Cost per unit R1 R1,67 R3,67
Note: FIFO valuation is concerned with current period production and current period costs.
Work done in the previous period and costs associated with the previous period
are therefore ignored when calculating the equivalent cost per unit to value closing
work-in-progress. Units completed and transferred out are made up of Beginning WIP +
Started and completed.
ie Beginning WIP 500
Started and completed 700
Total 1 200
Valuation of closing WIP R
Material A 300 × R1,00 = 300,00
Conversion costs 90 × R3,67 = 330,30
630,30
Completed units (1 200 ) Balance 7 809,70
Total [ 400 + 1 040 + 1 000 + 2 000 + 4 000 ] R8 440,00
(b) Weighted average valuation

A B costs
Beginning WIP 500 500 500 500
1 500 1 500 1 200 1 290
Beginning costs R400 – R1 040
Note: Weighted average valuation is concerned with current period production plus
production completed in the previous period. Costs are also current period costs plus
previous period costs. Units completed and transferred out are once again made up of
Beginning WIP + Started and completed.
Value of closing WIP: R
Material A 300 × R,93 279,00
Conversion costs 90 × R3,91 351,90
630,90
Completed units (1 200 ) Balance 7 809,10
Total [ 400 + 1 040 + 1 000 + 2 000 + 4 000 ] 8 440,00
(c) Closing work-in-progress now 80% complete

Process diagram
Conversion costs
Mat A Mat B
40% 70% 80%

Beginning WIP
Closing WIP
Figure 2
FIFO valuation
A B costs
Beginning WIP 500 – 500 300
Closing WIP 300 300 300 240
1 500 1 000 1 500 1 240
Cost per unit R1 R1,33 R3,23
Valuation of closing WIP
Material A 300 × R1,00 = R300,00
Material B 300 × R1,33 = R399,00
Conversion costs 240 × R3,23 = R775,20
R1 474,20
Weighted average valuation

A B costs
Closing WIP 300 300 300 240
1 500 1 500 1 500 1 440
Beginning costs R400 R– R1 040
Valuation of closing WIP
Material A 300 × R0,93 = R279,00
Material B 300 × R1,33 = R399,00
Conversion costs 240 × R3,50 = R840,00
R1 518,00
Normal and abnormal spoilage

Normal spoilage is a loss that is inherent in the production process and cannot be eliminated. It is
therefore common to allow a certain percentage of total input as spoilage. Sometimes the allowance
is too high; therefore, if the losses are not as high as allowed for, we get abnormal gain. Abnormal
spoilage is defined as losses in excess of those allowed.
Most manufacturing processes have an inspection point where actual spoilage is measured. It is
common to have an inspection point at the end of a process, but it would not be unusual to have the
inspection point at some other point, eg half way. Multiple inspection points, although unusual, are
also encountered. Although spoilage is inherent in a process and can occur at any point in the
process, it is nevertheless identified and accounted for at the inspection point.
Allocation of spoilage costs

Normal spoilage costs must be allocated to all units that have been inspected, as the loss is inherent
in the process. For example, a company manufactures Kicker boards for swimmers. It purchases
specially manufactured material 2 meters by 1 meter, from which it manufactures 10 boards 400 mm
by 250 mm. Approximately half the material is wasted. What is the cost of the 10 boards?
It must be the cost of the raw material divided by 10. In other words, the value of the normal
spoilage is included in the value of the good output.
Example – Allocation of spoilage costs to WIP where

(a) the closing WIP has gone past inspection, and
(b) it has not gone past inspection.
A company incurs material costs only. These are added at the beginning of a manufacturing
process. 800 units were started at the beginning of the period at a total cost of R8 000.
Inspection takes place at the 50% complete stage and the closing work-in-progress is currently
75% complete. The production details are as follows:
Normal spoilage 200
Completed units 400
Closing WIP 200

(a) Calculate the value of the closing WIP and the good units completed.
(b) Calculate the value of the closing WIP and the good units completed assuming that the
Closing WIP is 25% complete and has not gone past inspection.
Solution
(a) Total units Equivalent units
Normal spoilage 200 200
Started and completed 400 400
Closing WIP 200 200
800 800
Total cost R8 000
Cost per unit R10
Value of closing WIP: 200 × R10 + (2/6 × 200 × 10) = R2 666
Value of output (balancing figure): R8 000 – R2 666 = R5 334
It is important to note that as closing WIP has gone past inspection it must receive a
proportionate allocation of the spoilage value.
(b)
As closing WIP has not gone past inspection it cannot receive an allocation of normal spoilage.
Total units Equivalent units

Closing WIP 200 200
800 800
Total cost R8 000
Cost per unit R10
Value of closing WIP: 200 × R10 = R2 000

Value of output (balancing figure): R8 000 – R2 000 = R6 000
(a) Always calculate the normal spoilage and include the correct spoilage figure in the
“Equivalent units” column.
(b) Never allocate spoilage to closing work-in-progress if it has not gone past the
inspection point.
Calculation of normal and abnormal spoilage
Only one calculation is required, and that is for normal spoilage. If the good units are known, and the
normal spoilage is calculated, then the abnormal loss will be the balance of the input units.
Assume that the normal loss is 20% of input. This means that from 100 units input
80 = Good output
20 = Normal spoilage
OR
if 8 000 units are introduced then
8 000 units = 6 400 Good output
= 1 600 Normal spoilage
Suppose the 8 000 units introduced produce only 6 000 good output units. What is the calculation of
normal spoilage?
Calculation
8 000 units input = 6 000 Good output
= 1 600 Normal spoilage (20% of 8 000 units)
= 400 Abnormal spoilage
There are two methods that can be used to determine the normal spoilage:
1 Use the % of input method.
2 Use the % of good output method.
Example 1 – Using the % of input method

A company expects 10% of input to be spoiled. This means that it expects 90% to be good
output. More correctly, it expects to spoil one unit for every nine good units.
Input 2 000 units
Normal spoilage 10% of input
Output 1 440 units

Calculate normal spoilage
Solution:
2 000 × 10% = 200
Total loss = 560
Abnormal loss = 360 (2000 – 1440)
Example
8 000 units started, produced 6 000 good units and had costs of R80 000. Normal loss is
calculated as 20% of input.

Determine the value of the good units produced
Solution
Calculation
R
Good units (6 000 × R10) 60 000
Normal spoilage (1 600 × R10) 16 000
Total cost inventoried 76 000
R76 000
Cost per unit = R12,67
6 000
Abnormal loss (400 × R10) 4 000
Spoilage costs allocated according to physical units, not equivalent units

The allocation of normal spoilage must be split between good output and closing WIP where closing
WIP has gone past inspection. The problem is that the “Equivalent units” column will always be less
than the total unit column; thus a dilemma arises as to whether the allocation should be done on a
total units basis or equivalent units basis.
The important question to ask is whether the closing WIP that has gone past inspection is likely to
incur further spoilage. The answer is “No, unless there is a second inspection point”. In that case, if
1 000 units have gone past inspection, then the allocation must be on the basis of the 1 000 units,
not the equivalent units of (say) 800.
Example
Assume that in a given process all costs (conversion) are incurred evenly throughout the process.
Spoilage is discovered at the 25% completed stage and closing WIP is 25% complete and has
gone past inspection (no further spoilage).
Physical Conversion costs
units equivalent units
Transferred out 400 400
Closing WIP 200 50
800 500
Conversion costs incurred equal R12 000

Calculate the value of the Closing WIP.
Solution
In this illustration, spoilage is discovered when the closing WIP has reached the stage where 25% of
the process is completed. Obviously, as units transferred out and closing WIP have both contributed
to the spoilage, each should be charged with a proportion of the spoilage costs, but a question arises,
namely “What is the correct method of allocating the normal spoilage value?” Is it to be based on the
total good output of 600 units, or should it be based on the equivalent units of output, ie 450 units?
Correct allocation
Unit cost R24 (R12 000 ÷ 500)
Transferred out 9 600 (400 × R24)
Spoilage 800 (50 × R24 = 1 200 × 4 / 6)
R10 400
Closing WIP 1 200 (50 × R24)
Spoilage 400 (1 200 × 2 / 6)
R1 600
In other words, the normal spoilage of R1 200 cannot be allocated to transferred out units in the
ratio of 400 : 450 because the number of physical units in the WIP will not incur any further spoilage.
The 200 units have been inspected and as there will be no further inspection, all 200 units will
eventually be transferred out.
How to deal with abnormal spoilage cost

Basically, there are two methods of dealing with the costs of abnormal spoilage.
1 Decrease the gross profit immediately.
2 Assign these costs to an overhead account to be allocated to all units produced over the financial
period.
The rationale for the first method is that abnormal spoilage cost represents wasted effort, for which
no benefit accrues. It is akin to a loss, not an expense, and therefore should decrease income in the
period of occurrence. Note, however, that this system is unique, compared with a non-standard
costing system, in that it does not use all production costs as inventoriable amounts. In a non-
standard job costing system, all production costs (both beneficially used and wasted) are
inventoriable. The separation of the wasted costs in process costing seems to imply that these are
period losses, hence the term “abnormal loss” is more appropriate than “abnormal spoilage”.
The second method implies that the operator will randomly cause a certain amount of wastage, ie
the operators have abnormal spoilage too. Such wastage should not be identified with specific units
of production, but should be spread over all units. This argument is less persuasive than the previous
one, and failure to let a loss fall in the period of occurrence is an attempt to average costs. If the first
method is unacceptable, then it would seem more reasonable to use the actual costs of production
for inventory purposes.
Recommended layout for a process costing question

Equivalent units
Total Materials Conversion
Opening work-in-progress xxx – xx
Started and completed xxx xxx xxxx
Normal spoilage xx xx xx
Abnormal spoilage/gain x x x
Closing work-in-progress xxxx xxx xxxx
xxxxx xxxx xxxxx
Application of costs to products

Total costs Equivalent units Unit cost
Beginning work-in-progress xxxx – x
Current costs:
Materials xxx xxxx x
Conversion costs xxx xxxx x
Total costs to account for xxxx xx
Summary of costs
R
Closing work-in-progress:
Materials xxx
Conversion costs xx xxx
Abnormal spoilage xx
Completed and transferred (balancing figure) xxxx
Total costs accounted for xxxx
Note: Opening work-in-progress plus production started and completed in the current period
equals the total units transferred out.
Production started and completed, plus normal spoilage, plus abnormal spoilage/(gain), plus closing
work-in-progress equals total production units put in to production in the current period.
Illustrative examples of typical questions

Calculation of normal spoilage, transferred in costs and valuation of
abnormal spoilage – FIFO and weighted average
Example
The following details relate to Department B:
Beginning WIP 10 000 units (40% complete).
40 000 units transferred in from Department A.
Material is added at the end of the process in Department B.
Conversion costs are incurred evenly.
Closing WIP 4 000 units (75% complete).
Completed and transferred out to finished goods 35 100 units. Spoilage is discovered at the
end of the process, just prior to the material being added.
A spoilage factor of 10% of normal input is acceptable.
Costs R
Beginning WIP Conversion 4 000
Transferred in 10 000
Current period Conversion 40 000
Transferred in 50 000
Material 100 000
R204 000

Calculate the value of the closing WIP and units transferred out to finished goods on a FIFO
and weighted average basis.
Solution
Note: Always have a good look at the method used to calculate the normal spoilage. If you are told
that normal spoilage is calculated as (say) “10% of good units completed”, all you have to do
is determine how many units were completed and multiply the figure by 10%.
In this example it would be 35 100 units × 10% = 3 510 units. The key phrase is “Spoilage as a % of
good output”. In all other situations, the spoilage must be calculated on a normal input basis as in this
example.
Process diagram
Transferred in costs Material
Conversion costs
Beginning WIP 40% Closing WIP 75% Spoilage

Figure 3
The above diagram reveals that beginning WIP went through 60% of the process in the current
period (from 40% complete to end) and only incurred part of the conversion costs and all of the
material costs. Closing WIP went through 75% of the process in the current period (from beginning to
75% complete) and only incurred part of the conversion costs and all of the transferred in costs.
First-in, first-out
Calculating normal spoilage:
Spoilage must be based on the number of input units inspected. Care must be taken regarding the
position of opening and closing inventory. If inventory passed the inspection point during the period
it will form part of the input units.
Units inspected
Units in opening inventory 10 000
Input units 40 000
Units in closing inventory
(did not pass the inspection point) 4 000 36 000
Input units that contributed to spoilage 46 000
Normal loss is 10% of 46 000 = 4 600 units

Abnormal loss 10 000 + 40 000 – 35 100 – 4 600 = 6 300 units
First-in, first-out Equivalent units

Total Transferred in Conversion Material
Beginning WIP 10 000 – 6 000 10 000
Started and completed 25 100 25 100 25 100 25 100
Normal spoilage 4 600 4 600 4 600 –
Abnormal spoilage 6 300 6 300 6 300 –
Closing WIP 4 000 4 000 3 000 –
50 000 40 000 45 000 35 100

Beginning WIP 14 000
Current costs: Transferred in 50 000 40 000 R1,25
Conversion 40 000 45 000 R0,89
Material 100 000 35 100 R2,85
Total costs to account for 204 000 R4,99
Summary of costs
R
Transferred in 4 000 × R1,25 5 000
Conversion costs 3 000 × R0,89 2 670
7 670
Abnormal spoilage 6 300 × R2,14 13 482
Completed and transferred
(balancing figure) 182 848
204 000
Weighted average Equivalent units

Total Transferred in Conversion Material
Beginning WIP 10 000 10 000 10 000 10 000
Normal spoilage 4 600 4 600 4 600 –
Abnormal spoilage 6 300 6 300 6 300 –
Closing WIP 4 000 4 000 3 000 –
50 000 50 000 49 000 35 100

Transferred in 60 000 50 000 R1,20
Conversion 44 000 49 000 R0,90
Material 100 000 35 100 R2,85
Summary of costs
R
Transferred in 4 000 × R1,20 4 800
Conversion costs 3 000 × R0,90 2 700
7 500
Abnormal spoilage 6 300 × R2,10 13 230
Completed and transferred (balancing figure) 183 270
204 000
Allocation of normal spoilage on a physical units basis, where closing WIP has
gone past inspection – FIFO and weighted average
Example
One department only
Beginning WIP 10 000 units 60% completed
Started work on 55 000 units
Transferred out 50 000 units
Normal spoilage 5 000 units 10% of good output
Closing WIP 80% complete

Inspection point at 50% stage
All material and conversion costs are incurred evenly
Beginning costs R10 000
Current costs R150 000
Calculate the value of the closing WIP and units transferred out of finished goods on a FIFO
and weighted average basis.
Solution
FIFO basis
Equivalent units: Total Conversion costs
Normal spoilage 5 000 2 500
Closing WIP 10 000 8 000
65 000 54 500
Total cost R150 000
Cost per unit R2,75
Allocation of spoilage
Value of spoilage 2 500 × 2,75 = 6 875
To be allocated between started and completed units and closing WIP
Started and completed 6 875 × 40 000 / 50 000 = R5 500
Closing WIP 6 875 × 10 000 / 50 000 = R1 375
Summary of costs
Closing WIP R
Conversion costs 22 000
Spoilage costs 1 375
23 375
Transferred out (balancing) 136 625
Total costs R160 000
Weighted average basis

Equivalent units: Total Conversion costs
Normal spoilage 5 000 2 500
65 000 60 500
Total cost R160 000
Cost per unit R2,65
Value of normal spoilage 2 500 × 2,65 = 6 625
Allocation: Completed units 40 000 / 50 000 × 6 625 = 5 300
Closing WIP 10 000 / 50 000 × 6 625 = 1 325
Summary of costs
Closing WIP R
Conversion costs 21 200
Spoilage costs 1 325
22 525
Transferred out (balancing) 137 475
R160 000
Sale of spoilage or scrap

In certain situations, the normal or abnormal lost units can be sold at a reduced value. The resulting
sales revenue should be offset against:
(a) the work-in-progress account in the case of normal spoilage
(b) the abnormal spoilage account if the losses are considered abnormal.
Calculation and treatment of abnormal gain – FIFO and weighted average
Abnormal gain occurs because normal spoilage was lower than expected.
Example
A company expects a normal spoilage of 400 units from an input of 2 000 units, ie normal spoilage is
20% of input. If good output was (say) 1 800 units, then we have the following:
Output 1 800
Normal spoilage 400 (20% of 2 000)
Abnormal gain (200)
2 000
The calculated abnormal gain of 200 is just a book entry to balance the WIP account and recognise
the abnormal gain in the income and expenditure account.
It is also important to note that the calculated abnormal gain must be treated as having gone all the
way to completion. The abnormal gain could not have been thrown out at the 50% stage if that is
where the inspection point is.
Example
Beginning WIP 10 000 units 40% completed
Transferred to finished goods 60 000 units
Spoilage 5 000 units
Closing WIP 30 000 units 80% complete
Units started in current period 85 000 units
Inspection point 50% stage
Material is added at the beginning of the process and conversion costs are incurred evenly
The expected spoilage factor is 10% of input
Beginning WIP costs:
Material R10 000
Current costs:
Material R102 000
Using the FIFO method of valuing inventory, show the WIP account as well as the abnormal
gain or loss account.
Solution
Process diagram
Material
Conversion costs
Beginning WIP 40% Inspection 50% Closing WIP 80%

Figure 4
Normal spoilage = 10% of input

Units inspected:
Input 85 000
Closing WIP (Passed inspection) –
Contributed to spoilage 95 000
Normal spoilage (10%) = 9 500

Therefore, abnormal gain = (4 500) units
Equivalent units – FIFO
Total Materials Conversion costs
Beginning WIP 10 000 – 6 000
Started and completed 50 000 50 000 50 000
Normal spoilage 9 500 9 500 4 750
Abnormal gain (4 500) (4 500) (4 500)
Closing WIP 30 000 30 000 24 000
95 000 85 000 80 250

Total Equivalent cost Unit cost
Current costs: Materials 102 000 85 000 R1,20
Conversion 150 000 80 250 R1,869
Value of normal spoilage

9 500 × R1,20 = 11 400
4 750 × R1,869 = 8 878
R20 278
Allocation to closing WIP

30 000
× 20 278 = R6 759
90 000
Materials 30 000 × R1,20 = 36 000
Conversion 24 000 × R1,875 = 44 856
Spoilage = 6 759
R87 615
Work-in-progress
Opening balance 18 000 Finished goods 196 195
Materials 102 000 (Balancing figure)
Conversion 150 000 Closing balance 87 615
Abnormal gain 13 810
(4 500 × R3,069) R283 810 R285 375
Balance b/d 87 615
Abnormal gain
Income and expenditure 13 810 Work-in-progress 13 810
Calculating normal and abnormal losses where spoilage occurs through

evaporation – FIFO and weighted average
Losses through evaporation are difficult to deal with as there is no specific inspection point at which
they can be identified. You could say that inspection takes place throughout the process and losses
are incurred at every point in the process. Very often, evaporation losses are expressed within a
range as follows: “The manufacturing process will result in evaporation losses of between 10% and
20%”
In such cases, it is appropriate to calculate the loss at the maximum allowed of 20%. If the losses are
less than 20% but greater than 10%, no abnormal loss or gain is allowed and the losses are said to be
normal.
Example
Beginning WIP 9 024 liters (40% complete)
Transferred out at the end of the period 49 860 liters
Liters added at the beginning of the period 68 000
Closing WIP 9 964 liters (60% complete)
Normal loss through evaporation is 10% of input
Material is added at the beginning of the period
Conversion costs are incurred evenly
Beginning WIP costs:
Materials R10 000
Current costs:
Materials R50 000

Calculate the value of the closing WIP and units transferred out to finished goods on the First-
in, first-out basis.
Solution
The calculation of spoilage through evaporation is difficult because spoilage does not occur at a
specific point in the process but throughout the process.
Calculation of normal spoilage
Beginning WIP 9 024 liters 40% complete

For every 100 liters input, output is 90 liters, normal loss 10 liters
Output is 40% completed, loss =
40
= × 10 = 4%
100
WIP = 96%
9 024
Original input × 100 = 9 400 liters
96
Spoilage 9 400 × 10% = 940
Therefore expected output 9 400 – 940 = 8 460
Normal spoilage 9 024 – 8 460 = 564 liters
Liters transferred out = 49 860
Less: Beginning WIP 8 460
Output 90% 41 400
41 400
Therefore 100% = × 100 = 46 000
90
Normal input 46 000 liters
Normal spoilage 46 000 × 10% = 4 600 liters
Closing WIP 9 964 liters = 60% complete
100
Therefore: Original amount 9 964 × = 10 600 liters
94
Therefore: Normal spoilage 10 600 – 9 964 = 636 liters
Total normal spoilage 564 + 4 600 + 636 = 5 800 liters

Total Material costs Conversion
Beginning work-in-progress 9 024 – 5 414
Abnormal gain 11 400 11 400 5 700
Closing work-in-progress 9 964 9 964 5 978
77 024 68 000 60 828

Total Equivalent units Unit cost
Beginning WIP R15 000
Current costs:
Material R50 000 68 000 R0,74
Conversion R20 000 60 828 R0,33
R85 000 R1,07
Value of normal spoilage
Material 5 800 × R0,74 = 4 292

Conversion 2 900 × R0,33 = 957
R5 249
Value of closing WIP R

Materials 7 373
Conversion 1 973
9 964 874
Spoilage × 5 249 =
59 824 R10 220
Summary of costs
R
Closing work-in-progress 10 220
Abnormal spoilage
Material 11 400 × 0,74 = 8 436
Conversion 5 700 × 0,33 = 1 881 10 317
Transferred out (balancing figure) 64 463

R85 000
Joint product costing

Joint product costing occurs when a company produces more than one product simultaneously from
a given production process. A joint cost therefore represents the total cost of a process that must be
allocated to two or more products that are manufactured. In many manufacturing processes, such as
in the dairy industry, the production of one main product inevitably produces other products known
as joint products, by-products or waste.
Example – Mining industry

Output
Gold (Joint product)
Mining Silver (Joint product)
Process Uranium (By-product)
Residue (Waste product)
At split-off, where the products become distinguishable, gold and silver are considered joint products
as they have a high value, while uranium may be considered a by-product if the saleable value is low.
Residue often results in disposal costs being incurred and it is thus called a waste product.
Definitions
Joint costs – Joint costs are costs that are incurred in the production of 2 or more joint
products that cannot be linked to any specific joint product (costs incurred
simultaneously). Joint costs are not allocated to by-products or to waste.
Separable costs – These are costs that can be identified or allocated to an individual product and are
incurred after split-off.
By-product – A product that is manufactured from a joint product process but has a relatively
low sales value. Joint production costs are not generally allocated to by-products.
Waste/Scrap – Product manufactured in a joint product process but with a low or zero saleable
value. Companies sometimes incur costs to get rid of waste or scrap.
Note: It is possible that over time the marketability of a product may change; therefore, the
classification of joint product/by-product or waste can change. It is possible that a product
that is considered waste today could, with technological changes, become a product with
high saleable value and hence be re-classified as a joint product.
Context of allocating joint product costs

The main reason for allocating joint product costs to two or more products is for the purpose of
inventory valuation.
Joint costs are sometimes allocated for the purposes of determining selling prices and product
profitability. This cost allocation objective is incorrect, as selling prices should be market-related, not
cost plus. Profitability of each joint product is also erroneous, as the profit is strongly influenced by
the basis used to allocate the joint costs. As the products are common and cannot be separated,
profitability per product should not be determined for managerial accounting decision-making.
It is regrettable that companies often make cost allocations in order to determine the profitability of
a product.
Basis for joint cost allocation

There are four generally accepted methods of allocating joint costs:
(a) Physical
Costs are allocated in proportion to the physical volume or weight of each joint product.
(b) Sales value method
Joint costs are allocated in proportion to the sales values of the joint products. Profit margins
are the same for each joint product.
(c) Net realisable value method
Joint costs are allocated in the proportion of the relative sales value of each joint product after
deducting the separable costs.
(d) Gross profit method
Costs are allocated on the basis of total gross profit percentage.
The net realisable value method is the generally accepted method of allocating costs.
Example
Company A produces three joint products from a common process.
Joint costs = R140 000
Product X yields 4 000 units and sells at R12 per unit at split-off.
Product Y yields 8 000 units, incurs R50 000 separable costs, and sells for R20 per unit.
Product Z yields 2 000 units, incurs R20 000 separable costs, and sells for R25 per unit.

Calculate the allocation of the R140 000 joint cost to the three products on the following
bases:
(a) Physical units method
(c) Net-realisable value method
Solution
(a) Physical units method
Units Joint cost allocation
Product X 4 000 40 000
Product Y 8 000 80 000
Product Z 2 000 20 000
14 000 R140 000
Profit calculation:
Product Sales units Sales value Total costs Profit GP%
R R R R
X 4 000 48 000 40 000 8 000 17
Y 8 000 160 000 130 000 30 000 19
Z 2 000 50 000 40 000 10 000 20
R48 000

Sales value Joint cost allocation
Product X 48 000 26 047
Product Y 160 000 86 822
Product Z 50 000 27 131
R258 000 R140 000
Profit calculation
R R R R
X 4 000 48 000 26 047 21 953 46
Y 8 000 160 000 136 822 23 178 14
Z 2 000 50 000 47 131 2 869 6
R48 000
(c) Net realisable value

Product Sales value Separable cost Net realisable value Joint cost allocation
X 48 000 – 48 000 35 745
Y 160 000 50 000 110 000 81 915
Z 50 000 20 000 30 000 22 340
258 000 70 000 188 000 R140 000
Profit calculation
R R R R
X 4 000 48 000 35 745 12 256 26
Y 8 000 160 000 131 915 28 085 18
Z 2 000 50 000 42 340 7 660 15
R48 000

Total sales value R258 000
Total costs R140 000 + R50 000 + R20 000 = R210 000
% of cost allocation 210/258 = 81,40%
Product Sales value Total cost Separable cost Allocated joint cost Profit
X 48 000 39 072 – 39 072 8 928
Y 160 000 130 240 50 000 80 240 29 760
Z 50 000 40 688 20 000 20 688 9 312
R258 000 R210 000 R48 000
GP% for all products is 18,6%.
Joint product costing and short-term decisions

When you are considering the desirability of producing a particular product, or whether to process
the product further, joint cost allocations should not be used. Consider only the relevant costs, ie the
additional costs which a product will incur (or cost savings if a product is not processed further).
Company A manufactures two joint products, X and Y.
The joint product cost of manufacture is R10 000 and 1 000 units of product X together with
4 000 units of product Y are manufactured.
The company can sell both products at the split-off point. Product X has a saleable value of R10
per unit and product Y a value of R5 per unit. Alternatively, the company can process both
products beyond split-off point as follows:
Product X Incremental/Separable costs
Labour R5 per unit
Materials R2 000
Product X can then be sold at R14 per unit
Product X Incremental/Separable costs
Labour R10 000
Materials R30 000
continued
The manufacturing process for product Y will produce two new products:
Product Y1 3 000 units will be produced and sold at R20 per unit
Product Y2 1 000 units will be produced and sold at R12 per unit

Determine whether the company should sell its products at split-off point or process the
products further.
Solution
The company is faced with the following options:
Sell at split-off:
Income Product X 1 000 × R10 = R10 000
Product Y 4 000 × R5 = R20 000
Total income R30 000
The joint product costs of R10 000 are not relevant to the decision.
OR:
The company may choose to process either or both products X and Y in order to increase the
incremental income.
We therefore need to calculate the incremental expenditure and income which will be compared to
the income at the split-off point.
R
Product X – process further:
Sales value 1 000 × 14 14 000
Incremental costs:
Labour 1 000 × 5 – 5 000
Materials – 2 000
Net profit R7 000
As we can sell the product at split-off for R10 000, we should not process it further as we will be
worse off.
Alternative calculation for product X R
Incremental revenue [ 14 000 – 10 000 ] + 4 000
Incremental costs – 7 000
Net decrease in profit – R3 000
Conclusion: If we process product X beyond split-off point we will be R3 000 worse off.
Product Y – process further

Product Y can be sold at split-off for R20 000 or it can be processed further into two separate
products, Y1 and Y2
R
Sell beyond split-off
Sales Y1 3 000 × 20 60 000
Y2 1 000 × 12 12 000
R72 000
Separable costs:
Labour – 10 000
Conversion costs – 30 000
Net income R32 000
Income at split off – 20 000
Differential increase + R12 000
Product Y should therefore be processed further as the company will be better off by R12 000.
Alternative analysis:
R
Incremental income [ 72 000 – 20 000 ] 52 000
Incremental labour – 10 000
Incremental conversion costs – 30 000
Incremental profit R12 000
Accounting for by-products

By definition, a by-product is one that has a relatively low sales value and is not allocated any portion
of the joint costs. Consequently, the amounts involved are not likely to be material and a simple
system of accounting for the costs or revenues should be used.
The two more widely used methods are:
(a) Recognise the income and expenditure of the by-product in the income and expenditure
account as a separate item.
(b) Allocate the revenue and costs attributable to the by-product to the joint products.
The accounting for by-products can be a difficult task as there are many accounting methods that can
be adopted when we have a closing inventory of the main (joint products) as well as a inventory of
the by-product.
Example – Situation where the by-product is sold in its entirety

Company A incurs R100 000 joint costs of production and produces 3 products as follows:
Product X (joint product) 10 000 units
Product Y (joint product) 5 000 units
Product Z (by-product) 2 000 units
Sales of products:
Product X 5 000 units at R20 per unit (Closing inventory 5 000 units)
Product Y 4 000 units at R15 per unit (Closing inventory 1 000 units)
Product Z 2 000 units at R2 per unit (Closing inventory nil)

Allocate the joint product costs to products X and Y and calculate the value of the closing
inventory.
Solution
The value of the by-product is 2 000 × R2 = R4 000
There are two acceptable methods of treating the value of the by-product.
1 As a reduction to the joint product costs
2 As a separate income item
1 Reduction in joint product costs

Joint costs R100 000
Sale of by-product – 4 000
Net joint product R96 000
Allocation to joint products X and Y

The allocation can be made on the basis of physical units or net-realisable basis.
Physical basis
Products Total X Y
Joint cost 96 000 64 000 32 000
Closing inventory (38 400) (32 000) (6 400)
Cost of sales R57 600 R32 000 R25 600
Closing inventory of X R64 000 × 5 000 / 10 000 = R32 000
Closing inventory of Y R32 000 × 1 000 / 5 000 = R6 400
Net realisable value basis

We have a problem in allocating the joint product costs to the two products as only part of the
production has been sold. The only practical way of getting round this problem is to assume that
the entire production will be sold at the current selling price of R20 for product X and R15 for
product Y.
X Y
Selling price R20 R15
units 10 000 5 000
Sales/realisable value R200 000 R75 000
Joint costs – total R96 000

Allocate X 96 000 × 200/275 = R69 818
Allocate Y 96 000 × 75/275 = R26 182
Closing inventory
Product X 69 818 × 5 000/10 000 = R34 909
Product Y 26 182 × 1 000/ 5 000 = R5 236
Products
Total X Y
Joint cost 96 000 69 818 26 182
Cost of sales R55 855 R34 909 R20 946

In this instance, the sales value of the by-product is shown as a sales item and the joint product
costs remain at R100 000. The allocation to the joint products is then carried out as above on a
physical or net-realisable sales value.
Physical basis
Products Total X Y
Joint cost 100 000 66 667 33 333
Cost of sales R60 000 R33 334 R26 666

Allocate X 100 000 × 200 / 275 = R72 727
Allocate Y 100 000 × 75 / 275 = R27 273
Closing inventory
Product X 72 727 × 5 000 / 10 000 = R36 364
Product Y 27 273 × 1 000 / 5 000 = R5 455
Products Total X Y
Joint cost 100 000 72 727 27 273
Cost of sales R58 181 R36 363 R21 818
Example – Where there is a closing inventory of the by-product

Company A incurs R100 000 joint costs of production and produces 3 products as follows:
Product X (joint product) 10 000 units
Product Y (joint product) 5 000 units
Product Z (by-product) 2 000 units
Sales of products:
Product X 5 000 units at R20 per unit (Closing inventory 5 000 units)
Product Y 4 000 units at R15 per unit (Closing inventory 1 000 units)
Product Z 1 000 units at R2 per unit (Closing inventory 1 000 units)

Allocate the joint product costs to products X and Y and calculate the value of the closing
inventory.
Solution
Applying the same principle as in the above example, we need to decide whether the value of the by-
product should be treated as a reduction in the joint-product cost, or whether it should be treated as
a sales item only.
1 Reduction to joint product costs

Regrettably, there are several ways of dealing with the treatment of the by-product value. As only
half of the by-product has been sold we can either:
(a) Treat the value of the by-product as R4 000 (ie we assume that it was sold in its entirety).
The journal entry would be to credit sales with R4 000 (which gets transferred to joint
product costs and debit cash and unrealised profit with R2 000 each). Inventory valuations
would be per the example above, ie
Physical basis
Products Total X
Closing inventory R32 000 R6 400
Products X Y
Closing inventory R34 909 R5 236
(b) Assuming that only the R2 000 sold is accounted for, we then have
Physical basis
Products Total X Y
Joint cost 98 000 65 333 32 667
Cost of sales R58 800 R32 666 R26 134
The closing inventory of the by-product, ie 1 000 units, may in this situation be shown as zero
or at its net realisable value of R2 000.
X Y
Sales value R200 000 R75 000

Allocate X 98 000 × 200 / 275 = R71 273
Allocate Y 98 000 × 75 / 275 = R26 727
Closing inventory
Product X 71 273 × 5 000 / 10 000 = R35 637
Product Y 26 727 × 1 000 / 5 000 = R5 345
Products Total X Y
Joint cost 98 000 71 273 26 727
Cost of sales R57 018 R35 636 R21 382
The closing inventory of by-product Z is again shown at zero value or at a net realisable value
of R2 000.

This solution is exactly the same as that of the example where all of the by-product was sold. The
closing inventory of the by-product Z is shown as zero as it is only recognised in the financial
statements when it is sold.
Appendix
introduced in this chapter. Do not proceed to the next chapter until you have grasped the following
questions.
Question 1
A company manufactures a product which passes through two production departments.
Department 1
Material is added at the beginning of the process. Conversion costs are incurred evenly.
Beginning WIP 400 units 40% complete
Value of Beginning WIP – Material R800
Conversion costs R640
In the current period 1 200 new units were started.
Current costs incurred

Material R3 000
In total, 1 400 units were transferred to Department 2. Closing WIP in Department 1 was 20%
complete.
Department 2
Production from Department 1 is introduced at the beginning of the process in Department 2.
Further material is added at the 30% stage. Conversion costs are incurred evenly.
Beginning WIP 300 units 60% complete
Value of Beginning WIP – Transferred in costs R1 860
Material R900
Conversion costs R720
R3 480
Current period costs

Material R4 900
Transferred in ?
Closing WIP: 250 units, 50% complete.

Value the Closing WIP in each of the two departments and the completed production of Department
2 using the FIFO method.
Solution
Department 1 – Equivalent units
Total Materials Conversion
Beginning WIP 400 – 240
Closing WIP 200 200 40
1 600 1 200 1 280
Beginning WIP = 400, started production on a further 1 200 new units. Total units must therefore be
1 600. Transferred out, 1 400 units. 400 must have come from Beginning WIP. Started and completed
must therefore be 1 000 units. Closing WIP is the balancing figure.
Costs Total Materials Conversion
Current R8 760 R3 000 R5 760
R10 200
Equivalent units 1 200 1 280

Cost per unit R2,50 R4,50
Closing WIP
Material 200 × R2,50 = 500
Conversion costs 40 × R4,50 = 180
R680
Transferred out (balancing figure) R9 520
Total cost R10 200
Department 2 – Equivalent units

Total Transferred in Materials Conversion
Beginning WIP 300 – – 120
Closing WIP 250 250 250 125
1 700 1 400 1 480 1 395
In this case the Started and completed units are the balancing figure
Beginning WIP = 300. We transferred 1 400 units, Therefore total units is 1 700
Closing WIP = 250. Therefore Started and completed is the balancing figure of 1 150 units
Costs Total Transferred in Materials Conversion
Current R21 420 R9 520 R4 900 R7 000
R24 855
Closing WIP
Transferred in 250 × R6,80 = 1 700,00
Material 250 × R3,50 = 875,00
Conversion costs 125 × R5,02 = 627,50
3 202,50
Completed (balancing figure) 21 697,50
R24 900,00
Question 2
A company operates a FIFO process costing system. Raw Material A is added at the beginning of the
process, Material B is added at the end and conversion costs are incurred evenly throughout the
process.
Normal spoilage is 10% of input and is discovered at the 50% stage.
Beginning WIP 20 000 units 40 % complete
Started work on 200 000 units
Spoilage 40 000 units
Closing WIP 50 000 units 60 % complete
Required: Show the equivalent unit calculation for the current period.
Solution
A B
Beginning WIP 20 000 – 20 000 12 000
Normal spoilage 20 000 20 000 – 10 000
Abnormal spoilage 20 000 20 000 – 10 000
Closing WIP 50 000 50 000 – 30 000
220 000 200 000 130 000 172 000
Transferred out = 20 000 + 200 000 – 40 000 – 50 000 = 130 000 units
Started and completed = 130 000 – 20 000 = 110 000
Normal spoilage 20 000 + 110 000 + 50 000 = 180 000 = 90%
100% = 200 000
Normal spoilage is therefore 200 000 – 180 000 = 20 000

Abnormal spoilage is the balancing figure
Question 3
Assume the figures above, except for spoilage, which was only 13 000 units.
Required: Show the equivalent unit calculation for the current period.
Solution
A B
Beginning WIP 20 000 – 20 000 12 000
Normal spoilage 23 000 23 000 – 11 500
Abnormal spoilage – 10 000 – 10 000 – 10 000 – 10 000
Closing WIP 50 000 50 000 – 30 000
220 000 200 000 147 000 172 000
Transferred out = 20 000 + 200 000 – 13 000 – 50 000 = 157 000 units
Started and completed = 157 000 – 20 000 = 137 000
Normal spoilage 20 000 + 137 000 + 50 000 = 207 000 = 90%
100% = 230 000
Normal spoilage is therefore 230 000 – 207 000 = 23 000
Abnormal gain is the balancing figure
Practice questions
Topstar Ltd uses a FIFO process costing system to value its production and you have been given the
following information for the month of May:
Beginning work-in-progress 60% complete 5 000 units
Value of Beginning work-in-progress
Materials R50 000
During the current period 50 000 new units were started. At the end of the month 40 000 units were
complete and transferred to finished goods.
Closing work-in-progress 70% complete 8 000 units
Current period costs:
Material R750 000
Conversion costs R1 115 000
The manufacturing process is inspected when the product is 50% complete and a normal spoilage
factor of 20% of normal input is allowed.
Material is added at the beginning of the process while conversion costs are incurred evenly

(a) Calculate the equivalent units of production.
(b) Show the work-in-progress ledger account for the month of May.
Solution
(a) Equivalent units
Total Material Conversion
Opening WIP 5 000 – 2 000
Abnormal spoilage – 3 000 – 3 000 – 3 000
Closing WIP 8 000 8 000 5 600
55 000 50 000 44 600
(b) Work-in-progress account

Opening inventory 90 000 Finished goods 1 763 837
Input costs
Material 750 000
Conversion 1 115 000 Closing inventory 311 163
Abnormal gain 120 000
R 2 075 000 R 2 075 000
Workings
i Calculation of Normal spoilage

Units inspected
Opening WIP –
Input 50 000
Closing WIP – 50 000
Units inspected 50 000
Normal spoilage 20% 10 000
ii Units that contributed to spoilage

Opening WIP –
35 000
Closing WIP 8 000
To carry cost of NL 43 000
iii Cost to Account for Total Material Conversion

Opening WIP R 90 000 R – R –
Current period costs R 1 865 000 R 750 000 R 1 115 000
R 1 955 000 R 750 000 R 1 115 000
Cost per equivalent unit R 15,00 R 25,00
iv Allocated normal spoilage R 275 000 R 150 000 R 125 000
v Allocated abnormal spoilage R – 120 000 R – 45 000 R – 75 000
vi Allocated to closing WIP R 260 000 R 120 000 R 140 000

Share of Normal spoilage 51 163
Total cost of Closing WIP R 311 163
vii Allocated to units transferred out R 1 450 000 R 525 000 R 925 000
Share of Normal Spoilage R 223 837
Value of opening WIP R 90 000
R 1 763 837
Total costs R 1 955 000
Note: The proportion of normal spoilage allocation is based on physical units, ie Started and
complete plus closing WIP. The Beginning WIP is ignored as it went past inspection in the
last period.

Sacks Ltd manufactures several pharmaceutical products. One of its products is processed in two
separate departments. In the first department, several chemicals are added at the beginning of the
process and conversion costs are incurred evenly throughout the process. The product manufactured
in Department 1 is inspected at the 60% stage of completion.
The completed product is then transferred from Department 1 to Department 2 where more
material is added at the beginning of the process to the transferred in product. Production in
Department 2 is inspected when the project is 45% complete.
The following information relates to the month of June 19X1
Department 1 Department 2
Beginning work-in-progress at 1/6/X1
Percentage of process completed 40% 70%
Physical units 2 000 1 300
Materials cost R36 000 R12 900
Conversion costs R11 200 R19 350
Transferred in costs – R45 150
During the month of June 19X1
Units started 28 000 ?
Materials added R560 000 R201 000
Variable overheads R134 200 R219 115
Fixed overheads (actual) R300 000 R100 000
Closing work-in-progress at 30/6/X1
Physical units in process 4 000 2 300
Completed units not transferred 2 000 –
1 Sacks Ltd values closing inventory on a first in first out basis.

2 The company uses a fully-integrated accounting system and fixed overheads are charged to
production at the rate of R10 per equivalent unit completed in Department 1 and R5 per
equivalent unit completed in Department 2.
3 Normal losses in Department 1 are allowed up to 10% of input. 3 900 units were found to be
spoiled in Department 1 during the month of June 19X1.
4 Normal losses in Department 2 are allowed up to 20% of input.
5 15 000 good units were completed in Department 2 during the month of June, transferred out
and sold.

(a) Prepare an equivalent unit tabulation for Department 1. (8 marks)
(b) Value the closing work-in-progress and the good production for Department 1. (7 marks)
(c) Prepare an equivalent unit tabulation for Department 2. (11 marks)
(d) Value the closing work-in-progress for Department 2. (5 marks)

(e) Determine the total amount of under- or over-recovery that will be shown in the
income statement of Sacks Ltd for the month of June 19X1. (4 marks)
Solution
Variable Fixed
(a) Equivalent units – Dept 1 Total Material overhead overhead
Opening WIP 2 000 – 1 200 1 200
Normal spoilage 3 000 3 000 1 800 1 800
Abnormal spoilage 900 900 540 540
Closing WIP 4 000 4 000 3 200 3 200
30 000 28 000 26 840 26 840
(b) Closing work in progress – Dept 1

Allocated to closing WIP R 128 000 R 80 000 R 16 000 R 32 000
Good production
Allocated to units transferred out R 721 500 R 402 000 R 106 500 R 213 000
R 842 367
Variable Fixed
(c) Equivalent units – Dept 2 Total Trf in Material overhead overhead
Opening WIP 1 300 – – 390 390
Started and completed 13 700 13 700 13 700 13 700 13 700
Normal spoilage 3 560 3 560 3 560 1 602 1 602
Abnormal spoilage 540 540 540 243 243
Closing WIP 2 300 2 300 2 300 920 920
21 400 20 100 20 100 16 855 16 855
(d) Closing work in progress – Dept 1

Allocated to closing WIP R 127 227 R 87 667 R 23 000 R 11 960 R 4 600
(e) Under- or over-recovery

Fixed overhead (Dept 1)
Actual costs 300 000 Allocated to WIP 268 400
– Under-recovery 31 600
R 300 000 – R 300 000
Fixed overhead (Dept 2)

R 100 000 R 100 000
Total under-recovery is R47 325

Workings
i Calculation of Normal spoilage – Dept 1
Units inspected
Opening WIP 2 000
Input 28 000
Closing WIP (Deduct if not inspected) – 28 000
ii Units that contributed to spoilage – Dept 1

Opening WIP 2 000
22 100
Closing WIP 4 000
iii Cost to Account for – Dept 1

Opening WIP R 47 200 R – R – R –
Current period costs R 962 600 R 560 000 R 134 200 R 268 400
R1 009 800 R 560 000 R 134 200 R 268 400
Cost per equivalent unit R 20,00 R 5,00 R 10,00
iv Allocated normal spoilage – Dept 1 R 87 000 R 60 000 R 9 000 R 18 000
v Allocated abnormal spoilage – Dept 1 R 26 100 R 18 000 R 2 700 R 5 400
vi Calculation of Normal spoilage

Units inspected
Opening WIP –
Input 20 100
Closing WIP (Not inspected) 2 300 17 800
vii Units that contributed to spoilage

Opening WIP –
13 700
Closing WIP –
viii Cost to Account for

Opening WIP R 77 400 R – R – R – R –
Current period costs R1 270 524 R 766 134 R201 000 R219 115 R 84 275
R1 347 924 R 766 134 R201 000 R219 115 R 84 275
Cost per equivalent unit R 38,12 R 10,00 R 13,00 R 5,00
ix Allocated normal spoilage R 200 129 R 135 693 R 35 600 R 20 826 R 8 010
x Allocated abnormal spoilage R 30 357 R 20 583 R 5 400 R 3 159 R 1 215

xi Allocated to units
transferred out R 912 811 R522 191 R137 000 R183 170 R 70 450
R1 190 341

Smacks Ltd manufactures several pharmaceutical products. One of its products is processed in two
separate departments. In the first department, several chemicals are added at the beginning of the
process and conversion costs are incurred evenly throughout the process. The product manufactured
in Department 1 is inspected at the 50% stage of completion.
The completed product is then transferred from Department 1 to Department 2 where more
material is added at the beginning of the process to the transferred in product. Production in
Department 2 is highly technical; as a result there are several inspection points throughout the
process. The company accounts for losses in Department 2 in the same way as accounting for losses
through evaporation.
The following information relates to the month of June 19X1
Beginning work-in-progress at 1/6/X1
Physical units 3 000 1 400
Materials cost R46 000 R18 600
Transferred in costs – R65 100
During the month of June 19X1
Units started 38 000 ?
Materials added R560 000 R305 800
Variable overheads R128 250 R251 100
Fixed overheads (actual) R420 000 R210 000
Closing work-in-progress at 30/6/X1
Physical units in process 6 000 2 500
Completed units not transferred 3 000 –
1 Sacks Ltd values closing inventory on a first in first out basis.
2 The company uses a fully-integrated accounting system and fixed overheads are charged to
production at the rate of R14 per equivalent unit completed in Department 1 and R8 per
equivalent unit completed in Department 2.
3 Normal losses in Department 1 are allowed up to 15% of normal input. 4 200 units were found to
be spoiled in Department 1 during the month of June 19X1.
4 Normal losses in Department 2 are allowed up to 10% of normal input.
5 23 200 good units were completed in Department 2 during the month of June, transferred out
and sold.

(a) Prepare an equivalent unit tabulation for Department 1. (8 marks)
(b) Value the closing work-in-progress and the good production for Department 1. (7 marks)
(c) Prepare an equivalent unit tabulation for Department 2. (16 marks)
(d) Value the closing work-in-progress for Department 2. (5 marks)
(e) Determine the total amount of under- or over-recovery that will be shown in the
income statement of Sacks Ltd for the month of June 19X1. (4 marks)
Solution
Variable Fixed
(a) Equivalent units – Dept 1 Total Material overhead overhead
Opening WIP 3 000 – 900 900
Normal spoilage 4 800 4 800 2 400 2 400
Abnormal spoilage – 600 – 600 – 600 – 600
Closing WIP 6 000 6 000 1 800 1 800
41 000 38 000 32 300 32 300
(b) Closing WIP – Dept 1

Allocated to closing WIP R 120 768 R 88 421 R 7 147 R 25 200
Allocated to units
transferred out R 925 440 R 409 684 R113 956 R401 800
R1 106 506
Trans- Variable Fixed

(c) Equivalent units – Dept 2 Total ferred in Material overhead overhead
Opening WIP 1 400 – – 560 560
Started and completed 21 800 21 800 21 800 21 800 21 800
Normal spoilage 2 593 2 593 2 593 1 296 1 296
Closing WIP 2 500 2 500 2 500 1 000 1 000
29 200 27 800 27 800 25 110 25 110
(d) Closing WIP – Dept 2

Allocated to closing WIP R 135 314 R 89 814 R 27 500 R 10 000 R 8 000
Allocated to units transferred

out R1 425 457 R783 177 R239 800 R223 600 R178 880
R1 668 344
(e) Recovery of overhead

Fixed overhead – Dept 1
Over-recovery 32 200
R 452 200 – R 452 200
Fixed overhead – Dept 2

R 210 000 – R 210 000
Total over-recovery (32200 – 9120) = R23 080
Workings
i Calculation of Normal spoilage – Dept 1
Units inspected
Opening WIP –
Input 38 000
ii Units that contributed to spoilage – Dept 1
Opening WIP –
27 800
Closing WIP –
iii Cost to Account for – Dept 1

Opening WIP R 67 200 R – R – R –
Current period costs R1 140 450 R 560 000 R 128 250 R 452 200
R1 207 650 R 560 000 R 128 250 R 452 200
Cost per equivalent unit R 14,74 R 3,97 R 14,00
iv Allocated normal spoilage – Dept 1 R 113 866 R 70 737 R 9 529 R 33 600
v Allocated abnormal spoilage – Dept 1 R – 19 624 R – 8 842 R – 2 382 R – 8 400
vi Calculation of Normal spoilage Good

– Dept 2 Started NL output
With evaporation spoilage is
derived from
Opening WIP 1 400 60 1 340
Started and Completed 24 288 2 429 21 860
Closing inventory 2 604 104 2 500
Total normal spoilage 2 593 25 700
vii Loss from Opening WIP – Dept 2

As losses occur evenly throughout the process Opening WIP already contributed an amount
equally to the percentage completion in the previous period. The remainder part of the
normal spoilage will occur in the current period and will be equal to the percentage still to
complete the units.
Normal spoilage 10%
Percentage already recognised
in previous period 60% 6%
Still to recognise 4%
Opening WIP as a percentage of

original input 100% 94%
Opening WIP as a percentage of

original input 1 489 1 400
Total expected spoilage 149
Less: Recognised in previous
period 89
To recognise in current period 60
Loss from Started and completed

These units were started at
100% and finished with the net
volume after spoilage
Original Input 24 288
Normal spoilage for the period 2 429
Loss from Closing WIP

As losses occur evenly throughout the process Closing WIP also contributed an amount equally
to the percentage completion in the period. The remainder part of the normal spoilage will
occur in the following period and will be equal to the percentage still to complete the units.
Normal spoilage 10%

Percentage to recognise in this
period 40% 4%
Still to recognise 6%
Closing WIP as a percentage of

original input 100% 96%
Original input therefor 2 604 2 500
Total expected spoilage 260
Recognise in this period
(2604 – 2500) 104
To recognise in next period 156
Trans- Variable Fixed

viii Cost to Account for – Dept 2 Total ferred in Material overhead overhead
Opening WIP R112 000 R – R – R – R –
Current period costs R1 756 510 R998 730 R305 800 R251 100 R200 880
R1 868 510 R998 730 R305 800 R251 100 R200 880
Cost per equivalent unit R 35,93 R 11,00 R 10,00 R 8,00
ix Allocated normal spoilage R 144 992 R 93 140 R 28 518 R 12 963 R 10 370
x Allocated abnormal spoilage R 50 748 R 32 599 R 9 982 R 4 537 R 3 630

Alpha Limited manufactures a variety of plastic products and uses a variable costing system.
Department B receives a special plastic (Alphex) from Department A which it moulds into two joint
products known as Bistro and Poplen.
The ratio in physical units of Bistro to Poplen is 1:2.
Poplen is sold at the split-off point for R20 per unit while Bistro is further processed in Department C
where it incurs conversion costs during the process, and is then sold for R30 per unit.
Spoilage in Department B is detected at the 50% stage and is based on 20% of normal input. All
spoiled units (ie normal and abnormal) are sold for R5 each.
The basis of allocating the joint costs from Department B to the joint products is on the net realisable
value basis.
Department B units Department C units
Beginning work-in-progress 60% complete 5 000 –
Transferred in 45 000 10 000
Closing work-in-progress 80% complete 10 000 –
Costs:
Beginning work-in-progress:
Transferred in costs R50 000 –
Conversion costs R10 000 –
Current:
Transferred in costs R450 000 ?
Department B’s conversion costs are 2/3 variable. Department C’s conversion costs are all variable.
(a) Show the calculation of equivalent unit cost for Department B using the FIFO method.
(15 marks)
(b) Determine the value of the closing work-in-progress for Department B, the abnormal spoilage
value, and the costs allocated to Bistro and Poplen at split-off. (15 marks)
(c) Discuss the arguments in favour of variable costing and those in favour of absorption costing. Why
do the profits of an entity increase when inventory holdings are increasing under absorption
costing, in comparison to variable costing? (10 marks)
Solution
(a) Calculation of Normal spoilage
Units inspected
Opening WIP –
Input 45 000
Closing WIP – 45 000
Units that contributed to spoilage

Opening WIP –
25 000
Closing WIP 10 000
Transferred Conversion
Equivalent units Total in costs
Opening WIP 5 000 – 2 000
Closing WIP 10 000 10 000 8 000
50 000 45 000 40 000
(b) Cost to account for

Opening WIP 60 000 – –
Current period costs R 550 000 R 450 000 R 100 000
Less: Sale of Spoilage R – 50 000
R 560 000 R 450 000 R 100 000
Cost per equivalent unit R 10,00 R 2,50
Allocated normal spoilage R 101 250 R 90 000 R 11 250

R 56 250
Allocated abnormal spoilage R 11 250 R 10 000 R 1 250

R 6 250
Allocated to closing WIP R 120 000 R 100 000 R 20 000

Allocated to units transferred out R 317 500 R 250 000 R 67 500

R 417 679
Total costs R 560 000
(c) Direct costing

(1) Direct costing is felt to be more useful for management decision-making because it
separates fixed costs which do not change with volume. The impact of management
decisions which change volume is more evident.
(2) Fixed factory overhead is more closely related to the capacity to produce than to the
production of specific units. Fixed costs should therefore be reported as a period cost.
Absorption costing
(1) Fixed factory overhead is a necessary cost of production and units produced should bear all
such costs. It is consistent with the concept that the cost of an asset should consist of all
necessary costs to get it into the proper form, location and working condition.
(2) Absorption costing is required by generally accepted accounting principles.
Increase in profits
If production is greater than sales, ie inventory holdings are increasing, then (under absorption
costing) we will carry forward certain fixed costs to the next accounting period. This has the
effect of decreasing the total cost of sales and thus increasing profits. Under variable costing,
we write-off all fixed costs in the period incurred. Therefore, in relation to absorption costing,
profits recorded will be lower when inventory value increases.

A chemical company has a contract to supply annually 3 600 tonnes of Product A at R24 a tonne and
4 000 tonnes of Product B at R14,50 a tonne. The basic components for these products are obtained
from a joint initial distillation process. From this joint distillation a residue is produced which is
processed to yield 380 tonnes of By-product Z. By-product Z is sold locally at R5 a tonne and the net
income is credited to the joint distillation process.
The budget for the year ending 30 June 19X1 includes the following data:
Joint Separable cost
Process Product Product By-product
A B Z
Variable cost per tonne of input (R) 5 11 2 1
Fixed costs for year (R) 5 000 4 000 8 000 500
Evaporation loss in process (% of input) 6 10 20 5

Since the budget was compiled it has been decided that an extensive five-week overhaul of the joint
distillation plant will be necessary during the year. This will cost an additional R17 000 in repair costs
and reduce all production in the year by 10%. Supplies of the products can be imported to meet the
contract commitment at a cost of R25 a tonne for Product A and R15 a tonne for Product B.
Experiments have also shown that the joint distillation plant operations could be changed during the
year such that either:
(i) The output of distillate for Product A would increase by 200 tonnes with a corresponding
reduction in Product B distillate. This change would increase the joint distillation variable costs
for the whole of that operation by 2%.
OR:
(ii) The residue for By-product Z could be mixed with distillate for the production of Products A
and B proportionate to the present output of these products. By intensifying the subsequent
processing for Products A and B, acceptable quality could be obtained. The intensified
operation would increase Product A and B’s separable fixed costs by 5% and increase the
evaporation loss for the whole operation to 11% and 21% respectively.

(a) Calculate on the basis of the original budget:
(i) The costs of products A and B; and
(ii) The total profit for the year.
(b) Calculate the change in the unit costs of products A and B based on the reduced production.
(c) Calculate the profit for the year if the shortfall of production is made up by imported products.
(d) Advise management whether either of the alternative distillation operations would improve the
profitability calculated under (c) and whether you recommend the use of either.
Solution
(a) A B C Total
Final production 3 600 4 000 380
Production % 90% 80% 95%
Therefore joint product input 4 000 5 000 400 9 400
Joint product % 94%
Therefore distillation input 10 000
The cost of the joint distillation process is as follows:
R
10 000 tonnes at R5 variable cost 50 000
Fixed cost 5 000
55 000
By-product Z sales: 380 tonnes at R5 1 900
Variable cost: 400 tonnes at R1 (400)
Fixed cost (500)
Profit 1 000 1 000
R54 000
The question is silent as to how the joint product costs are to be allocated to Products A and B.
Joint costs will be apportioned on the net realisable value and on a units-produced basis.
Net realisable basis
(i) and (ii)
A B Total
Sales 86 400 58 000 144 400
Separable variable costs 44 000 10 000 54 000
Separable fixed costs 4 000 8 000 12 000
Realisable value 38 400 40 000 78 400
Joint costs 26 449 27 551 54 000
Profit R11 951 R12 449 R24 400
Units produced basis

(i) and (ii)
A B Total
Sales 86 400 58 000 144 400
Joint costs 24 000 30 000 54 000
Profit R14 400 R10 000 R24 400
(b) A B C Total
Previous output 3 600 4 000 380
Previous joint product yield 4 000 5 000 400 9 400
Less: 10% = – 400 – 500 – 40 – 940
New joint product yield (ie reduce by 10%) 3 600 4 500 360 8 460
Input ÷ 94% 9 000
The calculation of the revised joint costs is as follows:
R
Variable costs (9 000 × R5) 45 000
Fixed costs 5 000
Plant overhead 17 000
67 000
Joint product costs 67 000
By-product Z sales: 342 tonnes at R5 1 710
Variable cost: 360 tonnes at R1 (360)
Fixed cost (500)
Profit 850 850
R66 150
The joint cost of R66 150 is now apportioned to Products A and B on the physical basis
A B Total
Joint costs 29 400 36 750 66 150
Total costs R73 000 R53 750 R126 750
Joint cost A: 66 150 × 3 600 / 8 100 = 29 400
Joint cost B: 66 150 × 4 500 / 8 100 = 36 750
(c) A B
(tonnes) (tonnes)
Revised yield from joint process 3 600 4 500
Evaporation beyond split-off point 360 (10%) 900 (20%)
Revised output of final product 3 240 3 600
Original production 3 600 4 000
Lost output imported 360 400
Imported cost
A 360 tonnes × R25 = 9 000
B 400 tonnes × R15 = 6 000
A B
Production costs per (b) above 73 000 53 750
Imported cost 9 000 6 000
Revised total costs 82 000 59 750
Sales 86 400 58 000
Profit R4 400 R(1 750)
Net profit = R2 650
(d) (i) Comparing proposal (i) with the answers to (b) and (c), the differential costs are calculated
as follows:
A B C Total
Yield from joint process 3 800 4 300 360 8 460
Final output 3 420 3 440
Sales demand 3 600 4 000
Required imports 180 560
Differential costs
Additional variable cost in joint process (2% × 45 000) 900
Additional variable cost after split-off point (A = 200 × 11) 2 200
(B = 200 × 2) (400)
Savings in imports of A (180 – 360 at R25) (4 500)
Additional import cost of B (560 – 400 at R15) 2 400
Additional costs 600
Therefore proposal (i) should be rejected.
(ii) With proposal (ii), the by-product residue is apportioned to Products A and B in proportion
to their output from the joint process (ie A = 360 × 3 600 / 8 100 = 160; B = 360 × 4 500 / 8 100
= 200)
A B
Revised yield from joint process 3 760 4 700
Final output 3 346 3 713
Sales demand 3 600 4 000
Required imports 254 287
Previous imports in (c) 360 400
Saving in imports 106 113
The differential costs are as follows:
Increase in fixed costs (5% × 4 000) + (5% × 8 000) – 600
Increase in variable costs (A = 160 × 11) – 1 760
(B = 200 × 2) – 400
Loss of contribution from By-product Z (1 710 – 360 per part (b)) – 1 350
Savings in import costs (A = 106 × 25) 2 650
(B = 113 × 15) 1 695
Net gain from the proposal R235
Variable and
absorption costing
l explain the difference between variable and absorption costing
l prepare an income statement using variable and absorption costing, and explain why
the profits are different
l reconcile an absorption costing income statement from one year to the next
l explain the arguments for and against variable and absorption costing
l account for under- and over-recovered overheads
l calculate the fixed cost for a period using the under- or over-recovered overhead as a
reconciling figure
This chapter takes a look at the two methods used to value closing inventory of production, and the
effect that they have on the financial statements.
Variable costing is sometimes called “marginal” or “direct” costing while absorption costing is
sometimes more correctly referred to as “full” costing.
Variable costing has for a long time been accepted as a technique of internal reporting to
management. However, absorption costing has been more widely accepted for external reporting to
shareholders, creditors and other outside interest groups, as it reflects the total cost of production,
not just the variable costs.
The most fundamental point of controversy between variable and absorption costing is the question
of whether fixed manufacturing costs are costs of the product produced, or of the period in which
they are incurred. Variable costing treats the fixed manufacturing costs as period costs, while
absorption costing treats them as product costs.
The product cost approach method assigns the fixed costs to the product, instead of allocating the
costs to the period, because it is the product that generates the revenue. The time period is purely
incidental to the operations of the firm – the only important time factor is “When did the sale take
place?” The production costs are therefore matched with the revenue in the period of the sale.
Arguments in favour of variable costing
(a) Variable costing is more useful to internal management decision-making as it does not include
fixed costs which do not change with volume. Thus, the impact of management decisions is
more correctly observed where volume is changing.
(b) Fixed factory cost is more closely related to the ability to produce than to the production of
specific units. Since fixed cost would be incurred regardless of production, and since it relates to
the capacity to produce for a period of time, it should be charged to the income and
expenditure account as a period cost.
Arguments in favour of absorption costing
(a) Fixed costs are a necessary cost in producing any product and as such should be charged to
production.
(b) Absorption costing is required by generally accepted accounting principles as well as the
Commissioner of Inland Revenue.
101
It has been argued by the proponents for absorption costing that external reporting must be
consistent and that absorption costing is the only system that gives this consistency. They argue that,
if a company changed its method of valuing inventory from year to year, this consistency would be
lost.
I contend that variable costing is in fact more consistent, as closing inventory is always valued at
variable cost from year to year.
A further argument in favour of absorption costing is that it allows for inter-company comparisons.
This statement is very controversial; I believe that we should never compare two companies that
produce the same product, because of the following possible differences:
(i) One may be labour-intensive while the other may be capital-intensive.
(ii) One may rent or lease its assets while the other may own its assets.
(iii) The age of assets used may be different.
(iv) Cost structures may be different due to the physical location of the company.
(v) The companies may have different trading markets.
(vi) Capital structure may be different.
(vii) Management is different.
A further contention by the advocates for absorption costing is that the users of financial statements
need to be assured that the statements have been prepared in accordance with generally accepted
accounting standards. This would imply that absorption costing is generally accepted while variable
costing is not. Perhaps to the blind, it is.
Any system that reports inconsistent profits when sales remain the same should be
discarded
Absorption costing is certainly inconsistent in its profit reporting while variable costing is consistent
(see example below). The absorption costing experts would also contend that variable costing
understates the true value of inventory, while absorption costing reflects the true value more
accurately. That would of course depend on what the definition of value is. One could for example
argue that the selling price reflects the true value more accurately.
Nevertheless, if the argument is that the balance sheet value must be correct, then I would question
why share values, debt values and fixed assets all reflect values that have no resemblance
whatsoever to their true market values.
Then there is the question of the matching concept. Absorption costing states that the expenses
incurred in the normal course of business in bringing the product or service to its present location
and condition should be matched to the revenue received when the inventory is sold. The debate
here is whether fixed overheads such as rent have been incurred for the purpose of producing a
particular product or because we have chosen to be in a line of business that requires the payment
of rental for the premises. The point is that we cannot control the rental cost according to units
produced. It is a period cost that must be paid in the period incurred. Imagine telling the landlord
that he can only have half of his rent as the other half is sitting in inventory, so he can only have the
balance when we are able to match that cost to the revenue! Ridiculous!
Accounting Statement on Inventories – IAS 2

l A primary issue in accounting for inventories is the amount of cost to be recognised as an asset
and carried forward until the related revenues are recognised.
l The cost of inventories should comprise all costs of purchase, costs of conversion and other costs
incurred in bringing the inventories to their present location and condition.
l The costs of conversion of inventories include costs directly related to the units of production,
such as direct labour. They also include a systematic allocation of fixed and variable production
overheads that are incurred in converting materials into finished goods.
l The process of recognising as an expense the carrying amount of inventories sold results in the
matching of costs and revenues.
Chapter 4: Variable and absorption costing 103
Variable costing defined

Variable costing recognises fixed manufacturing overheads as a period cost and values inventory at
the variable cost of production.
Example
A company manufactured 2 000 units and sold 1 000 units.
Per unit
Selling price R100
Production costs:
Material R20
Labour R20
Variable overheads R10
Total fixed overheads R40 000

Produce an income statement showing the company profit using variable costing.
Solution
R R
Labour 40 000
100 000
Contribution 50 000
Profit R10 000
Absorption costing defined

Absorption costing is a financial accounting system that incorporates both the variable and fixed
costs in arriving at its inventory valuation. The system matches the costs to revenues received.
Example
(Information per above example)

Produce an income statement showing the company profits using absorption costing.
Solution
R R
Labour 40 000
140 000
Profit R30 000
Is absorption costing consistent in profit-reporting?
The biggest argument against absorption costing is that it is inconsistent in the profit that it reports,
even when sales remain constant over a two-year period.
Example
A company manufactures a product with the following selling and cost structure:
Per unit
Selling price R100
Production costs:
Material R20
Labour R20
Total fixed overheads R40 000
Over a three-year period the production and sales of the product are as follows:
19X1 19X2 19X3
Production 2 000 1 000 2 000
Sales 1 000 2 000 2 000

Produce the income statement over the three-year period under absorption costing.
Solution
19X1 19X2 19X3
R R R
Sales 100 000 200 000 200 000
Production costs:
Opening inventory – 70 000 –
Material 40 000 20 000 40 000
Labour 40 000 20 000 40 000
Variable costs 20 000 10 000 20 000
Fixed costs 40 000 40 000 40 000
140 000 160 000 140 000
Closing inventory (70 000) – –
Cost of sales 70 000 160 000 140 000
Profit R30 000 R40 000 R60 000
The above statements show that a shareholder has no consistent basis for analysing his company’s
performance. When sales double, the profit only increases by R10 000, yet in the following year
when the sales are exactly the same, the profit increases by R20 000. The argument of matching the
expenses to the income clearly yields inconsistent profit figures that are totally meaningless to the
shareholder. Any kind of ratio analysis performed using the above figures would yield misleading
information.
Is variable costing consistent in profit-reporting?
Variable costing looks at the increase or decrease in profit as a result of the increase or decrease in
contribution over a relevant range. The reported contribution will always be consistent with units
sold and the bottom line profit is shown as contribution less fixed costs.
Example
Information per above example under absorption costing.
Produce the income statement over the three-year period under variable costing.
Solution
19X1 19X2 19X3
R R R
Sales 100 000 200 000 200 000
Production costs:
Opening inventory – 50 000 –
Material 40 000 20 000 40 000
Labour 40 000 20 000 40 000
Variable costs 20 000 10 000 20 000
Closing inventory (50 000) – –
Cost of sales 50 000 100 000 100 000
Contribution 50 000 100 000 100 000
Fixed costs 40 000 40 000 40 000
Profit R10 000 R60 000 R60 000
The above statement shows that the contribution per unit sold is R50 per unit. When sales increase
from 1 000 units to 2 000 units, the profit increases by R50 000, regardless of the value of closing
inventory. Variable production costs are matched to sales as these can be reduced if we produce less.
The fixed costs are written-off in the period incurred, as they represent period costs that will be
incurred regardless of production levels. Variable costing is more clearly illustrated in the diagram
below, where profit is seen to increase due to an increase in contribution.
Sales
Rand
value Increase in profit
= Contribution
Total
costs Variable
costs
Fixed
costs
Units 800 2 000

Figure 1
Income effect of variable costing compared to absorption costing

Comparing variable to absorption profit where company inventory-holding is
increasing
Example
Company Zeta has the following information:
Sales 5 000 units
Selling price R120 per unit
Variable R400 000
Fixed R300 000
Calculate the variable and absorption profit
Solution
Variable costing profit statement
R R R
Sales 600 000
Production costs:
Variable 400 000
Fixed 300 000 700 000
Cost of sales 500 000 500 000
Profit R100 000
Accounting period
Inventory
Variable costs R200 000 R200 000
Fixed costs R300 000
Absorption costing profit statement
R R R
Sales 600 000
Production costs:
Variable 400 000
Fixed 300 000 700 000
Cost of sales 350 000 350 000
Profit R250 000
Accounting period
Inventory
Fixed costs R150 000 R150 000
R350 000
Conclusion: If production is greater than sales, then absorption profit is greater than variable
profit.
Comparing variable to absorption profit where company inventory-holding

is decreasing
Example
Company Zeta has the following information:
Opening inventory 5 000 units
Value at variable costing R200 000
Value at absorption costing R350 000
Sales 10 000 units
Selling price R120 per unit
Cost of production:
Calculate the variable and absorption profit
Solution
Variable costing profit statement
R R
Sales 1 200 000
Production costs:
Variable 200 000
Fixed 300 000
Opening inventory 200 000
Cost of sales 700 000 700 000
Profit R500 000
Absorption costing profit statement
R R
Sales 1 200 000
Production costs:
Variable 200 000
Fixed 300 000
Opening inventory 350 000
Cost of sales 850 000 850 000
Profit R350 000
Conclusion: If production is less than sales, then absorption profit is less than variable profit.
Comparing variable and absorption profit where production equals sales

If production equals sales, then absorption profit will equal variable profit. The only exception to this
rule occurs when the company is holding inventory of finished goods at a cost different to the
current period’s cost per unit.
Calculating absorption profit

There are three different methods of presenting information on an absorption costing basis.
(a) Fully-integrated absorption costing system

A fully-integrated absorption costing system is used when a company runs a job costing accounting
system and it wishes to determine the full cost of a particular job once it has been completed.
Full job cost will equal – Direct materials used – Actual cost
– Direct labour cost – Actual cost
– Other variable costs – Actual cost
– Overhead costs – Allocated
As the company cannot determine the exact amount of fixed cost that it needs to allocate to a
particular job, it will have to use some other method of estimating this cost. The most logical method
would be to prepare a budget of the overhead cost at the beginning of the financial year and
determine how the cost will be recovered in the forthcoming year.
Most companies recover the overhead cost on the basis of labour hours, machine hours or units of
production.
Example
A printing company has budgeted on an overhead cost for the forthcoming financial year of
R1,5 million. The company recovers the overhead on the basis of machine hours. Budget machine
hours for next year have been set at 10 000 hours.
The pre-determined recovery rate will therefore be

R1 500 000 / 10 000 machine hours = R150 per hour
The cost allocation for each printing job will be

Direct material incurred +
Direct labour incurred +
R150 overhead × actual machine hours
At the end of the financial year, the company will charge all completed jobs to the income statement
and carry the uncompleted jobs as closing inventory. The valuation of the closing inventory of
uncompleted printing jobs will represent all variable costs charged at actual cost, plus the overhead
cost charged at the budget pre-determined value.
As the actual fixed costs incurred for the financial year will be different to the allocated fixed
overhead, we will need to make a journal entry that corrects the allocated cost in order to represent
the actual cost incurred. The other side of the journal entry will reflect the under- or over-recovered
fixed cost.
Example
Company Zee budgeted on incurring fixed manufacturing costs of R1,5 million. Machine hours were
budgeted at 10 000 hours. The company recovers the fixed overhead on the basis of machine hours.
Actual results
The company completed 10 jobs that used up 9 500 machine hours. A further 3 jobs used up 1 500
machine hours, but were incomplete at the end of the year.
Sales value of completed jobs R4 300 000
Materials purchased R1 800 000
Labour cost R1 000 000
Manufacturing overhead – fixed R1 450 000
Closing inventory
Incomplete jobs:
Material R350 000
Labour R240 000
Overhead R225 000
R865 000
Required:
Prepare the income statement
Solution
Pre-determined recovery rate R1 500 000 / 10 000 = R150 per machine hour
Overhead allocated R150 × (9 500 + 1 500) = R1 650 000
Actual overhead R1 450 000
Over-recovered R1 650 000 – R1 450 000 = R200 000
Income statement
R R
Sales 4 300 000
Costs incurred:
Material 1 800 000
Labour 1 000 000
Overheads charged 1 650 000
4 450 000
Closing inventory 865 000
Cost of sales 3 585 000 3 585 000
Plus: Over-recovery adjustment 200 000
Profit R915 000
The over-recovery adjustment has been made after the gross profit figure as an increase to gross
profit.
Alternative solution
R R
Sales 4 300 000
Costs incurred:
Material 1 800 000
Labour 1 000 000
Overheads charged 1 650 000
Less: Over-recovery adjustment – 200 000
4 250 000
Cost of sales 3 385 000 3 385 000
Profit R915 000
Note:
We have assumed that the pre-determined overhead rate is based on the fixed manufacturing
overhead only. What if the company was unable to distinguish between the variable and the fixed
overheads?
Per the above example, assume the following situation:

The budget manufacturing overheads of R1 500 000 represents both variable and fixed costs. The
pre-determined recovery rate of R150 per hour represents both fixed and variable overheads.
You are then told that the actual overhead of R1 450 000 is 40% variable and 60% fixed.
Solution: Same as above. The over-recovery of R200 000 is however due to the fixed overhead only.
(b) Closing inventory is valued at budget absorption cost – ie standard absorption costing system
The standard absorption costing system is very similar to the fully-integrated absorption costing
system, and the fixed overhead is charged to the actual income statement in exactly the same way.
The main difference is that the actual cost of overhead is charged to the income statement. The
closing inventory is valued using the budget cost structure for both variable and fixed costs. Refer to
the chapter on “Standard costing”.
Example
Company Zee budgeted on incurring fixed manufacturing costs of R1,5 million. Machine hours were
budgeted at 10 000 hours. The company recovers the fixed overhead on the basis of machine hours.
Actual results
Closing inventory
Raw materials R50 000 Standard cost R45 000
Incomplete jobs
Material R350 000 Standard cost R315 000
Labour R240 000 Standard cost R200 000
Overhead 1 500 machine hours
Required:
Prepare the actual income statement
Solution
Pre-determined recovery rate R1 500 000 / 10 000 = R150 per machine hour
Closing inventory value – overhead = R150 × 1 500 = R225 000
Income statement
R R
Sales 4 300 000
Costs incurred:
Material 1 800 000
Labour 1 000 000
Actual overheads 1 450 000
4 250 000
Cost of sales 3 465 000 3 465 000
Profit R835 000
Closing inventory value = R45 000 + R315 000 + R200 000 + R225 000 = R785 000
(c) Closing inventory is valued at the actual absorption cost

Absorption costing means that the closing inventory must include fixed manufacturing costs. The
closing inventory can therefore represent the actual cost of production, not the budget cost.
Example
Company Zee values the closing inventory at actual absorption costs.
Actual results
Closing inventory
Incomplete jobs
Material R350 000
Labour R240 000
Overhead 1 500 machine hours
Required:
Prepare the income statement.
Solution
Actual overhead R1 450 000
Actual production 11 000 machine hours
Overhead value of closing inventory = R1 450 000 / 11 000 × 1 500 = R197 727
Income statement
R R
Sales 4 300 000
Costs incurred:
Material 1 800 000
Labour 1 000 000
Actual overheads 1 450 000
4 250 000
Cost of sales 3 412 273 3 412 273
Profit R887 727
Closing inventory = 50 000 + 350 000 + 240 000 + 197 727 = R837 727
You are given the following information:
Budget production 1 000 units
Budget sales 1 000 units
R R
Budget sales 500 000
Raw material 80 000
Labour: Variable 80 000
Manufacturing costs 260 000 260 000
Manufacturing profit 240 000
Fixed administration costs 20 000
Variable selling costs 80 000
Actual results for the period

Actual sales 800 units
R R
Actual sales 480 000
Raw material 120 000

(a) Prepare the actual income statement using a fully-integrated absorption costing system.
(b) Prepare the actual income statement on an absorption costing basis where the closing
inventory is valued at actual cost.
(c) Prepare the actual income statement on a standard absorption costing basis and reconcile the
budget profit to the actual profit.
Solution
(a) Fully-integrated absorption costing
The valuation of closing inventory in a fully-integrated absorption costing system is
Actual variable costs of production × closing inventory in units + pre-determined recovery rate
× closing inventory in units
Fixed cost in the income statement is shown as applied overhead cost. An adjustment is made
for the under- or over-recovered overhead.
Some may argue that all costs should be at budget cost. Where all costs are shown at budget
cost, you have a standard absorption costing system.
Pre-determined recovery rate
R100 000 / 1 000 units = R100 per unit
Applied overhead = R100 × 1 200 = R120 000
Actual fixed overhead = R132 000
Under recovered overhead = R132 000 – R120 000 = R12 000
Closing inventory valuation

Raw material R120 000 / 1 200 = R100 per unit × 400 = R 40 000
Labour R108 000 / 1 200 = R90 per unit × 400 = R 36 000
Manufacturing overhead = R100 per unit × 400 = R 40 000
Income statement
R R
Applied manufacturing overhead 120 000
348 000
Cost of sales 232 000 232 000
Under-recovered overhead – 12 000
236 000
(b) Absorption costing

Raw material R120 000 / 1 200 = R100 per unit × 400 = R40 000
Labour R108 000 / 1 200 = R 90 per unit × 400 = R36 000
Manufacturing overhead R132 000 / 1 200 = R110 per unit × 400 = R44 000
Income statement
R R
Manufacturing overhead 132 000
360 000
Cost of sales 240 000 240 000
(c) Standard absorption costing

Raw material R80 000 / 1 000 = R 80 per unit × 400 = R32 000
Income statement
R R
360 000
Cost of sales 256 000 256 000
Reconciliation of budget to actual profit (Absorption)

Units R
– 200 Sales volume (– 200 × R160 (Profit)) – 32 000
800 Standard profit 108 000
Sales price + R100 × 800 + 80 000
Material variance (80 × 1 200) – 12 000 – 24 000
Labour variance (80 × 1 200) – 10 800 – 12 000
Overhead – volume + 200 × 100 + 20 000
Overhead – expenditure 100 000 – 132 000 – 32 000
Fixed administration 20 000 – 25 000 – 5000
Variable selling (80 × 800) – 80 000 – 16 000
800 Actual profit R119 000
Note: The explanation of standard costing is done in depth in a later chapter; nevertheless a
few explanatory notes are in order.
1 The reconciliation between the budget profit and the actual profit is a very useful
explanation of how well the company has performed. The problem, however, is that an
absorption costing system will result in the fixed manufacturing cost being treated as a
variable cost. As a result, you will have an under-/over-recovery of fixed manufacturing cost
which is shown in the reconciliation as an overhead volume and expenditure variance.
2 The sales volume represents the difference between the budget volume and the actual
volume of units sold. In this case it is – 200 units. It is multiplied by the budget profit per unit
which is arrived at by taking the manufacturing profit minus all other variable non-
manufacturing costs divided by budget units sold.
ie R240 000 – R80 000 = R160 000 / 1 000 units = R160
3 The expenditure variances reflect the difference between the actual costs incurred and the
expected costs at a production level equal to units produced multiplied by the budget rate
per unit. They do not reflect the difference between the budget cost and the actual cost. A
full explanation of variance analysis is carried out in the chapter on “Standard costing”.
Calculating variable profit

Variable costing is the only system that accurately reflects the profits of a company, as fixed
manufacturing costs are correctly written-off in the year incurred, not carried forward to the balance
sheet. It is regrettable that financial accounting in terms of IAS standards is obsessed with capitalising
fixed manufacturing costs by including them in the value of closing inventory.
Variable costing only includes variable manufacturing costs when valuing closing inventory. There are
only two methods of valuing inventory on a variable costing basis.
(a) Closing inventory is valued at actual variable costs incurred in the current year.
(b) Closing inventory is valued at the budget variable cost – standard costing.
R R
Raw material 80 000
Manufacturing costs 260 000 260 000
Manufacturing profit 240 000
Actual results for the period

Actual sales 800 units
R R

(a) Prepare the actual income statement on a variable costing basis where the closing inventory is
valued at actual cost.
(b) Prepare the actual income statement on a standard variable costing basis and reconcile the
budget profit to the actual profit.
Solution
(a) Variable costing system
Income statement
R R
360 000
Cost of sales 284 000 284 000
Gross profit R196 000
(b) Standard variable costing

Labour R80 000 / 1 000 = R80 per unit × 400 = R32 000
Income statement
R R
360 000
Cost of sales 296 000 296 000
Reconciliation of budget to actual profit (Variable)
Units R
– 200 Sales volume (– 200 × R260 (Contribution)) – 52 000
800 Standard profit 88 000
Sales price + R100 × 800 + 80 000
Material variance (80 × 1 200) – 120 000 – 24 000
Labour variance (80 × 1 200) – 108 000 – 12 000
Manufacturing overhead – 32 000
Fixed administration 20 000 – 25 000 – 5 000
Variable selling (80 × 800) – 80 000 – 16 000
800 Actual profit R79 000
Note: The difference between the reconciliation done under a standard variable costing system,
compared to an absorption costing system, lies in the sales volume variance and the fixed
manufacturing cost variance only.
The sales volume variance is multiplied by the budget contribution, ie sales minus all variable costs
(manufacturing and non-manufacturing).
The fixed manufacturing cost variance for variable costing is simply the difference between the
budget and the actual cost. Once again – we will deal with standard variable costing systems when
we get there.
Reconciliation of absorption profit to variable profit

The difference between the absorption and variable profit is ALWAYS the increase or decrease in
closing inventory multiplied by the fixed manufacturing cost per unit.
Example:
Absorption Variable
R R R R
Sales 1 000 units 100 000 100 000
Opening inventory 200 units 16 000 8 000
Production 1 200 units 96 000 96 000
Closing inventory 400 units (32 000) 80 000 (16 000) 88 000
Administration and selling costs 10 000 10 000
Profit R10 000 R2 000
Cost structure
Variable manufacturing R40
Fixed manufacturing R40
Reconciliation
Absorption profit R10 000
Increase in inventory:
200 units × R40 (R8 000)
Variable profit R2 000
Note: In the above example, it has been assumed that the cost structure has not changed. It is
however possible that the cost structure from one accounting period to the next does in fact
change.
Where cost structures have changed, the difference between absorption profit and variable
profit is the increase or decrease in the fixed cost component of opening inventory,
compared to closing inventory.
Example
Absorption Variable
R R R R
Sales 1 000 units 100 000 100 000
Opening inventory 200 units 14 000 8 000
Production 1 200 units 96 000 96 000
Closing inventory 400 units (32 000) 78 000 (16 000) 88 000
Administration and selling costs 10 000 10 000
Profit R12 000 R2 000
Opening fixed cost R30 / unit

Closing fixed cost R40 / unit
Valuation of closing inventory on a FIFO basis

Reconciliation
R
Absorption profit 12 000
Fixed inventory in opening inventory (200 × 30) + 6 000
Fixed inventory in closing inventory (400 × 40) (16 000)
Reconciling absorption to variable profit from the previous section

In the previous Illustrative example, we determined the absorption and variable profits where the
closing inventory valuation was valued at actual cost as follows:
Income statement
Absorption Variable
R R R R
Actual sales 480 000 480 000
Raw material 120 000 120 000
Labour: Variable 108 000 108 000
Manufacturing overhead 132 000 132 000
360 000 360 000
Closing inventory (120 000) (76 000)
Cost of sales 240 000 240 000 284 000 284 000
Gross profit 240 000 196 000
Fixed administration costs 25 000 25 000
Variable selling costs 80 000 80 000
Actual profit R135 000 R91 000
You will notice that all the figures are exactly the same, except for the closing inventory valuation.
Under absorption costing, the closing inventory was valued as follows:
Closing inventory valuation – absorption costing
Raw material R120 000 / 1 200 = R100 per unit × 400 = R 40 000
Labour R108 000 / 1 200 = R 90 per unit × 400 = R 36 000
Manufacturing overhead R132 000 / 1 200 = R110 per unit × 400 = R 44 000
Under variable costing, the closing inventory was valued as follows:
Closing inventory valuation – variable costing
The only difference is the fixed cost of R4 400 in the absorption costing figures.
The reconciliation between the two statements is as follows:

Less: Fixed cost in closing inventory – R44 000
Similarly, we have the following for a comparative standard absorption costing and a standard
variable costing system:
Absorption Variable
R R R R
Actual sales 480 000 480 000
Raw material 120 000 120 000
Labour: Variable 108 000 108 000
360 000 360 000
Cost of sales 256 000 256 000 296 000 296 000
Gross profit 224 000 184 000
Fixed administration costs 25 000 25 000
Variable selling costs 80 000 80 000
Actual profit R119 000 R79 000
Closing inventory valuation for standard absorption costing

Raw material R 80 000 / 1 000 = R 80 per unit × 400 = R32 000
Labour R 80 000 / 1 000 = R 80 per unit × 400 = R32 000
Standard variable costing shows a value of R64 000, ie it excludes the R40 000 manufacturing
overhead.
The reconciliation between the two statements is as follows:
Less: Fixed cost in closing inventory – R40 000
Reconciliation of absorption profit to absorption profit

When a company recovers the fixed overheads at a pre-determined rate, ie by using fully-integrated
systems, the profit is shown as normal gross profit before adjusting the under-/over-recovery.
Normal gross profit treats the fixed cost as if it were a variable cost. Changes in sales from year to
year will result in normal gross profit increasing or decreasing by the number of units sold above the
previous year multiplied by the profit per unit.
Note: The under-/over- fixed cost recovery adjustment is there to restore the fixed cost to the true
actual cost. A fully-integrated absorption costing system treats the fixed costs as variable per
unit, resulting in a fixed charge that will be lower or greater than the true fixed cost.
Actual fixed cost = Fixed cost charged

+ overhead under-/over-recovery
Reconciliation example
Ace Ltd uses a fully-integrated absorption costing system. Fixed costs have been budgeted at
R500 000 for the forthcoming months and production is budgeted at 10 000 units per month.
The pre-determined overhead recovery rate has been set at R50 per unit.
Actual results for the months of May and June 20X1
May June
Units sold 8 000 12 000
Units produced 12 000 9 000
Production costs:
Variable R600 000 R450 000
Fixed overheads R500 000 R500 000
Unit selling price R120 R120

Prepare accounts for the month of May and June using absorption costing and reconcile the
May profit to the June profit.
Solution
May June
R R
Sales 960 000 1 440 000
Production costs:
Opening inventory – 400 000
Variable cost 600 000 450 000
Fixed overhead 600 000 450 000
Cost of sales 800 000 1 200 000
Normal gross profit 160 000 240 000
(Under-)/over-recovered 100 000 (50 000)
Profit R260 000 R190 000
Reconciliation
R
May profit 260 000
Over recovery (100 000)
Normal gross profit 160 000
Sales increase:
4 000 × R20 unit profit 80 000
June normal gross profit 240 000
Under-recovery (50 000)
June profit R190 000
Accounting for a change in the valuation basis of inventories and recovery of

fixed overheads
Example
Northwood Corporation is considering changing its method of inventory valuation from
absorption costing to direct costing and has engaged you to determine the effect of the
proposed change on the 20X4 financial statements.
The Corporation manufactures a Gink which is sold for R200 per unit. Production capacity is
budgeted at 100 000 units of Gink annually. At this level of production, the costs per unit are:
Material R30,00
Labour R50,00
Variable manufacturing overhead R10,00
Fixed manufacturing overhead R10,00
Selling expenses at the 100 000 unit level:
Variable R10,00
Fixed (advertising) R5,00
Units
Opening inventory 1st April 20X3 5 000
Production in current year 80 000
Sales 60 000

(a) Prepare an income statement on the absorption cost basis.
(b) Prepare an income statement on a variable cost basis with a prior year adjustment for
the change in inventory valuation.
Solution
(a) Absorption costing
Northwood Corporation – Income statement for the year ended 1st April 20X4
R R
Sales (60 000 × 200) 12 000 000
Beginning inventory (5 000 × R100) 500 000
Production (80 000 × R100) 8 000 000
Available 8 500 000
Ending inventory (25 000 × R100) 2 500 000
Cost of goods sold 6 000 000
Adjustment for under-recovery of fixed costs (20 000 × R10) 200 000 6 200 000
Gross margin 5 800 000
Variable selling expenses 600 000
Fixed (100 000 × R5) 500 000
Profit R4 700 000
(b) Variable costing

R R
Sales 60 000 × 200 1 200 000
Beginning inventory (5 000 × R90) 450 000
Production (80 000 × R90) 7 200 000
Available 7 650 000
Ending inventory (25 000 × R90) 2 250 000
5 400 000
Fixed costs 1 000 000
Selling expenses:
Variable 600 000
Fixed 500 000 7 500 000
4 500 000
Prior year adjustment – opening inventory (50 000)
Profit R4 450 000
Variable costing in relation to cost-volume-profit analysis

Cost-volume-profit (CVP) analysis is a mirror reflection of the variable costing system because:
(a) Fixed costs in both systems are treated as period costs.
(b) Internal management decision analysis is based on contribution, which is characteristic of both
variable costing and CVP analysis.
In other words, cost-volume-profit analysis is a variable costing system.
Example
Company A’s budget for the forthcoming year is as follows:
R R
Sales 100 000 units 4 000 000
Cost of sales:
Materials 500 000
Depreciation 300 000
Labour 800 000
Overheads 400 000 2 000 000
A cost-volume-profit graph was also produced, showing the following relationships between
total costs and production volume.
Volume (units) Total costs
80 000 R1 800 000
100 000 R2 000 000
120 000 R2 200 000

Assuming that Company A produced 100 000 units and sold 80 000 units, prepare the income
and expenditure account in a form consistent with the cost-volume-profit graph.
Solution
The cost-volume-profit graph has not been prepared in this example, but we have sufficient
information to enable us to calculate the fixed costs over the relevant range as well as the variable
cost per unit.
The question requires that an income and expenditure account be prepared in a form that is
consistent with the CVP graph. This raises the question “What is the format or the underlying
principle of CVP graphs?”
The underlying principle is that fixed costs are treated as period costs and profit increases on a per
unit basis equal to the difference between the selling price and the variable costs per unit, ie profit
increases by the contribution per unit.
To be consistent with the CVP graph, you must calculate the profit on a
variable costing basis.
The cost of sales expenses does not tell us which costs are variable, fixed or semi-variable. However,
the information relating to the volume and total costs gives us the following answer:
Volume Costs
120 000 R2 200 000
80 000 R1 800 000
Difference 40 000 R 400 000
Variable cost per unit R10, fixed costs R1 000 000, ie depreciation is a fixed cost plus a proportion of
the other costs.
R’000
Sales
5 000
4 000
3 000
Total
Costs
2 000
1 000 Fixed
Costs
80 100 120
’000 units
Figure 2

R R
Sales 80 000 units 3 200 000
Production costs: 100 000 units 1 000 000
Cost of sales 800 000 800 000
Profit R1 400 000
Not required
Absorption costing basis
R R
Sales 80 000 units 3 200 000
Production costs:
Materials 500 000
Depreciation 300 000
Labour 800 000
Overheads 400 000
2 000 000
Cost of sales 1 600 000 1 600 000
Profit R1 600 000

1 Absorption costing capitalises period costs such as rent to the balance sheet. As a result, profit in
the income statement will be distorted as follows:
(i) When closing inventory is greater than opening inventory, profit is over-stated
(ii) When closing inventory is lower than opening inventory, profit is under-stated
2 Variable costing charges manufacturing fixed costs to the income statement in the period that
they are incurred.
As a result, profit in the income statement is measured as contribution, which will always increase
or decrease as sales increase or decrease. Changes in closing inventory do not distort profit.
3 A fully-integrated absorption costing system means that fixed costs are charged to the income
statement at a rate that is determined at the beginning of the year. The rate is: budget fixed
manufacturing costs divided by expected (or budget) production.
In a fully-integrated absorption costing system, you will always have an under- or over-recovery of
fixed overheads.
Under- or over-recovery is always the difference between the actual fixed manufacturing cost and
the fixed cost charged to the income statement (actual production × pre-determined rate).
4 There are two other absorption costing methods:
(i) Where closing inventory is valued at actual costs incurred
(ii) Where closing inventory is valued at standard cost
In both of these systems, there is no under- or over-recovery of overhead when calculating the
actual profit.
5 The reconciliation of absorption profit to variable profit is due to the difference in the valuation of
inventory between variable and absorption costing.
Where the value of the fixed cost per unit in the opening and closing inventory is the same, the
reconciliation figure is the increase or decrease in inventory multiplied by the fixed cost per unit.
Example: Opening inventory: 1 000 units R100 000
Value is based on: Material R35 000
Labour R25 000
Fixed overhead R40 000
Closing inventory: 500 units R80 000
Labour R38 000
In this example, both the opening fixed cost per unit and the closing fixed cost per unit are the
same. Therefore the reconciliation of absorption to variable profit will be:
Absorption profit R xx xxx
Plus: 500 × R40 R20 000
Variable profit R xx xxx
Note: If inventory is decreasing, then variable profit will be greater than absorption profit.
Where the value of the fixed cost per unit in the opening and closing inventory is different, the
reconciliation figure is the increase or decrease in the value of the fixed cost itself.
Example: Opening inventory: 1 000 units R100 000
Labour R25 000
Closing inventory 500 units R80 000
Labour R38 000
In this example, the opening fixed cost per unit is valued at R50 per unit, while the closing
inventory is valued at R40 per unit.
Therefore the reconciliation of absorption to variable profit will be:
Absorption profit R xx xxx
Plus: 500 × R60 R30 000
Variable profit R xx xxx
Once again, notice that the value of fixed cost in the absorption costing accounts is decreasing –
therefore the variable profit will be higher than absorption profit.
6 The CVP graph shows that fixed costs do not change as production/sales increases – fixed cost is
the same over the relevant range. As sales increase, total sales value, as well as all variable costs,
increases.
Sales – variable costs = contribution
An increase in sales will lead to an increase in contribution. Profit is therefore measured as
contribution.
CVP analysis is therefore the same as a variable costing system.
Appendix
The following question is intended to reinforce the important concepts that have been introduced
in this chapter. Do not proceed to the next chapter until you have grasped the following question.
A company budgeted on producing and selling 10 000 units. At this level, profit was budgeted at
R300 per unit as shown below.
R
Cost per unit:
Direct material 220
Direct labour 80
Fixed production overhead 300
Variable selling 100
Fixed selling 200
Profit R300
The actual results were as follows:

Year 1 Year 2
Produced 15 000 units Produced 9 000 units
Sold 12 000 units Sold 11 000 units

(a) Produce an income statement for Years 1 and 2 using a fully-integrated absorption costing
system. You are to assume that all costs and selling price were as budgeted.
(b) Produce an income statement for both years using variable costing.
(c) Reconcile the absorption profit to the variable profit for both years.
Solution
(a) Year 1 Year 2
Sales 14 400 000 13 200 000
Opening inventory – 1 800 000
Direct materials 3 300 000 1 980 000
Direct labour 1 200 000 720 000
Fixed production overheads 4 500 000 2 700 000
Closing inventory – 1 800 000 7 200 000 – 600 000 6 600 000
Gross profit 7 200 000 6 600 000
ದ Under-/+ Over-recovery + 1 500 000 – 300 000
Variable selling – 1 200 000 – 1 100 000
Fixed selling – 2 000 000 – 2 000 000
Profit 5 500 000 3 200 000
(b) Year 1 Year 2
Sales 14 400 000 13 200 000
Direct labour 1 200 000 720 000
Closing inventory – 900 000 3 600 000 – 300 000 3 300 000
Contribution 10 800 000 9 900 000
Fixed production overheads – 3 000 000 – 3 000 000
Variable selling – 1 200 000 – 1 100 000
Fixed selling – 2 000 000 – 2 000 000
Profit 4 600 000 3 800 000
(c) Reconciliation Year 1 Year 2

Absorption profit 5 500 000 Absorption profit 3 200 000
Variable profit 4 600 000 Variable profit 3 800 000
Difference 900 000 Difference – 600 000
Increase in inventory – units 3 000 Decrease in inventory – 2 000
Fixed cost per unit × 300 Fixed cost per unit × 300
Total 900 000 Total – 600 000
Practice questions
PART A
A company produced the following budget:
Sales value R300 000
Cost of sales:
Profit R40 000
Actual results:
Produced 4 500 units, sold 3 800
Sales R304 000
Cost of sales:
Fixed costs 90 000
Less: Closing inventory (45 500) 233 500
Profit R70 500

(a) Discuss the type of accounting system the company is using.
(b) Re-produce the actual results using:
(i) Current cost, absorption costing system
(ii) Current cost, variable costing system
(iii) Standard variable costing system.
(c) Reconcile the budget profit to the actual profit using a standard variable costing system
and comment on how well the company has performed.
PART B
Absorption/variable costing
A company budgeted on producing and selling 10 000 units. At this level, the profit was budgeted at
R
Selling price per unit 100
Cost per unit:
Direct material 30
Direct labour 35
Fixed overheads 15
Profit 20
Sales 12 000 units at R90 per unit
Cost of production:
Direct materials R450 000

Reconcile the budget profit to actual profit
(a) On a variable standard costing basis.
(b) On an absorption standard costing basis.
PART C
Use the same information as in PART B, except that the actual results were
Cost of production:

Reconcile the budget profit to actual profit on a variable costing basis.
Solution
PART A
(a) Current accounting system
The company is currently operating on a standard absorption costing system. In any accounting
statement, you must always look at the closing inventory value and ask how the value was
arrived at.
In this instance, the value is R65 per unit.
R45 500 / 700 units (closing inventory) = R65 per unit
This value is determined by absorption costing, variable costing, or standard absorption/variable
costing.
If it is absorption costing, then (189 000 + 90 000) / 4 500 = R62
Therefore, it is not absorption costing. It cannot be variable costing either, as the value would
be even lower.
Therefore, it must be standard absorption costing = (160 000 + 100 000) / 4 000 = R65
(b) (i) Fully-integrated absorption costing

Value of closing inventory: Fixed cost 100 000 / 4 000 = R25
Variable cost 189 000 / 4 500 = R42
Inventory value R67
Income statement
R R
Sales 304 000
Cost of sales:
Fixed overheads (4 500 × 25) 112 500
301 500
Less: Closing inventory – 46 900
Cost of sales 254 600 254 600
49 400
Plus: Over-recovered overhead 22 500
Profit 71 900
Closing inventory = R67 × 700 = R46 900

Over-recovered overhead = R112 500 – R90 000 = R22 500
(ii) Current cost absorption costing

Value of closing inventory – (189 000 + 90 000) / 4 500 = R62
R R
Sales 304 000
Cost of sales:
279 000
Cost of sales 235 600 235 600
Profit 68 400
(iii) Current cost variable costing

Value of closing inventory – 189 000 / 4 500 = R42
R R
Sales 304 000
Cost of sales:
279 000
Cost of sales 249 600 249 600
Profit 54 400
(iv) Standard variable costing

Value of closing inventory – 160 000 / 4 000 = R40
R R
Sales 304 000
Cost of sales:
279 000
Cost of sales 251 000 251 000
Profit 53 000

(c) Reconciliation of budget profit to actual profit

4 000 Budget profit R40 000
– 200 Sales volume variance – 200 × R35 – R7 000
3 800 Standard profit R33 000
Selling price + R19 000
Variable costs – R9 000
Fixed costs + R10 000
3 800 Actual profit R53 000
Contribution = (300 000 – 160 000) / 4 000 = R35
Selling price = R300 000 / 4 000 = R75 × 3 800

= R285 000 – R304 000 = R19 000
Variable cost = R160 000 / 4 000 = R40 × 4 500

= R180 000 – R189 000 = – R9 000
Fixed cost = R100 000 – R90 000 = R10 000

The budget profit was R40 000, with a sales volume of 4 000 units. Sales were down by
200 units, which has resulted in a R7 000 reduction in profit. The drop in the budget sales
was probably caused by the increase of R5 per unit in the actual selling price. This
resulted in a positive increase in revenue of R19 000.
A saving of R10 000 was also made in the fixed costs. The only expenditure above budget
was the variable cost, which exceeded the budget cost per unit by R2 per unit. The
resultant increase in expenditure = R2 × 4 500 = R9 000.
Overall, the company has performed very well, because of the policy of increasing the
selling price. There are however 700 units in closing inventory. I assume that the company
will be able to sell these units in the forthcoming year. One other concern is that the
increased selling price may lead to existing customers reducing future orders.
PART B
(a) Variable costing
Budget profit 10 000 × R20 = R200 000
Actual profit: R
Sales 1 080 000
Cost of sales:
Fixed cost 160 000
Profit R110 000
Reconciliation: R
Plus: Sales volume variance (2 000 × R35) 70 000
Standard profit 270 000
Variances:
Sales price (120 000)
Direct materials –
Direct labour (30 000)
Fixed overhead expenditure (10 000)

Actual profit: R
Sales 1 080 000
Cost of sales:
Fixed cost 160 000
Actual profit R 155 000
Reconciliation: R
Variances:
Fixed overhead volume (R15 × 5 000) 75 000
PART C
Variable costing basis
Actual profit: R
Sales 1 080 000
Cost of sales:
Inventory transfer (4 000 × 65) 260 000 796 000
Fixed cost 140 000
Reconciliation: R
Variances:
Direct materials (16 000)
Fixed cost 10 000

Cockroach Ltd manufactures a single product at a unit cost of R18. The R18 cost can be broken down
as follows:
Variable manufacturing 30%
Fixed manufacturing 60%
Selling and distribution 10%
The selling and distribution costs are 50% fixed and 50% variable.
At a management meeting held at the beginning of the financial year, the accountant produced a
cost-volume-profit graph for the year showing that the company should make a profit of R200 000 if
it produced at its normal activity level of 110 000 units and sold 100 000 units. The increased
production is necessary to raise current inventory holding.
Cockroach Ltd operates a full absorption costing system. All under- or over-recovery of fixed
overheads is written-off to the income and expenditure account at the end of the first half of the
year and at the end of the financial year. Overhead recovery is based on normal activity of 55 000
units for each six-monthly period. The company’s manufacturing and trading results for the first and
second half of the current financial year, showing the quantities of production and sales in units, are
summarised below.
1st 6 months 2nd 6 months
Opening inventory 10 000 25 000
Production 60 000 40 000
70 000 65 000
Sales 45 000 45 000
The managing director is unhappy as reported profits show a positive profit for the first six months
and a loss for the second six months, yet 45 000 units were sold in each period. He also believes that
profit should have been 90% of R200 000 as the company sold 90% of budgeted sales.

(a) Prepare a cost-volume profit graph as presented by the financial accountant at the beginning of
the year, and calculate the break-even point.
(b) Produce revenue accounts for the two six-monthly periods in accordance with company policy.
(c) Explain the reasons for the reduction in reported profits between the two periods.
(d) Calculate the profits for both periods on a variable costing basis.
(e) Explain the difference in reported profits between (b) and (d) above.
Solution
(a) Cost-volume-profit and break-even point
Cost analysis: Variable Fixed
Manufacturing cost 5,40 10,80
Selling cost 0,90 0,90
6,30
Fixed manufacturing cost 10,80 × 110 000 = R1 188 000
Fixed selling and distribution 0,90 × 100 000 = R90 000
Calculating selling price

R
Profit 200 000
Fixed selling and distribution 90 000
Fixed manufacturing cost 1 188 000
Variable selling 90 000 (100 000 × 0,90)
Variable manufacturing 540 000 (100 000 × 5,40)
Sales 2 108 000
divided by 100 000 = R21,08 selling price per unit

Contribution per unit R 21,08 – R 6,30 = R 14,78
Break-even point
Fixed costs R1 278 000
Contribution R14,78
R1 278 000
Break-even = 86 468 units
R14,78
R’000 Sales
2 108
Total costs
1 908
1 278
600
100 000
Units 86 468
Figure 3
(b) Absorption costing statement

First half Second half
R R R R
Sales (45 000 × 21,08) 948 600 948 600
Cost of sales:
Cost of production 972 000 648 000
Cost of sales 729 000 729 000 729 000 729 000
Normal profit 219 600 219 600
(Under-)/Over-absorbed
Fixed overhead 54 000 (162 000)
Selling variable cost 40 500 40 500
Selling fixed cost 45 000 45 000
Profit 188 100 (27 900)
Workings
Cost of opening inventory, closing inventory and production
Variable manufacturing cost R5,40
Fixed manufacturing cost R10,80
R16,20
Under-/(over-)absorbed fixed overhead

Period 1 Period 2
Fixed overheads charged (60 000 × 10,80) 648 000 (40 000 × 10,80) 432 000
Fixed overheads incurred 594 000 594 000
Over-/(under-)recovered 54 000 (162 000)
(c) The profits shown above were calculated using absorption costing. The difference of R216 000 is
explained by the under- and over-recovery of fixed costs.
Note: If the sales in Period 1 had been different to those in Period 2, the reconciliation
between Period 1’s reported profits and Period 2’s would be:
Reported profit: Period 1 R......
Less: Over-recovery R......
Normal profit: Period 1 R......
Difference in sales from Period 1 to Period 2 × profit per unit R......
Normal profit: Period 2 R......
Less: Under-recovery R......
Reported profit: Period 2 R......
(d) Variable profit calculation
Period 1 Period 2
Sales (units) 45 000 45 000
R R
Contribution (45 000 × 14,78) 665 100 665 100
Fixed manufacturing overheads (594 000) (594 000)
Fixed selling and distribution (45 000) (45 000)
Profit 26 100 26 100
(e) Difference in reported profits
The difference between the profits shown in (b) and (d) above is due to the increase/decrease
in inventory.
Period 1 Period 2
R R
Absorption profit 188 100 (27 900)
Increase in inventory (15 000 × 10,80) (162 000)
Decrease in inventory (5 000 × 10,80) 54 000
Variable profit 26 100 26 100

Rumbles Ltd manufactures a single product, with a variable manufacturing cost of R12 per unit and a
selling price of R20 per unit. Fixed production overheads are R90 000 per period. The company
operates a full absorption costing system and the fixed overheads are absorbed into the cost of
production, on the basis of a normal activity of 15 000 units per period, at a rate of R6 per unit. Any
under- or over-absorbed overheads are written-off to the profit and loss account at the end of each
period. It may be assumed that no other expenses are incurred.
The company’s manufacturing and trading results, showing quantities only, for Periods 2 and 3 are
summarised below:
Period 2 Period 3
(units) (units)
22 000 24 000
Sales 11 000 18 000
The managing director of Rumbles Ltd, who has recently returned from a course on marginal costing,
has calculated that as sales have increased by 7 000 units in Period 3, the company’s profits should
increase by R56 000. However, the results produced by the accountant show that profits in Period 2
were R34 000, while those of Period 3 were R24 000. The managing director is somewhat surprised!

(a) Produce columnar revenue accounts for both periods, showing how the profits of R24 000 and
R34 000 were obtained.
(b) Carefully explain, with supporting calculations:
(i) the reasons for the reduction in reported profits between the two periods
(ii) how the managing director has calculated that profits should increase by R56 000 in
Period 3
(iii) why profits have not increased by R56 000 in Period 3.
ACCA
Solution
(a) Absorption costing statement
Period 2 Period 3
R R R R
Sales 220 000 360 000
Cost of sales:
Cost of production 306 000 234 000
Cost of sales 198 000 198 000 324 000 324 000
Normal profit 22 000 36 000
(Under-) /over-absorbed fixed overhead 12 000 (12 000)
Profit 34 000 24 000
Workings
Cost of opening inventory, closing inventory and production
Variable cost R12 (90 000 / 15 000)
Fixed cost R6
R18
Under-/(over-)absorbed fixed overhead

Period 1 Period 2
Fixed overhead charged (17 000 × 6) 102 000 (13 000 × 6) 78 000
Fixed overhead incurred 90 000 90 000
Over-/(under-)recovered 12 000 (12 000)
(b) (i) The profits shown in (a) above were calculated using absorption costing. The difference of
R10 000 is explained by:
1 Increase in sales × profit per unit (7 000 × R2 = R14 000)
2 Under- and over-recovery of fixed costs
Reconciliation of Period 2 and Period 3 profits
Period 2 Period 3
Normal profit 22 000 (7 000 × 2) 36 000
´ ´ ´ ´ ´ ´ ´
(Under-)/over-absorbed fixed overhead 12 000 K L (12 000)
Profit 34 000 K L 24 000
(ii) The managing director is using variable costing techniques. An increase in sales of 7 000
units should yield an increase in contribution of R 56 000 (7 000 × R8).
Variable profit calculation
Period 1 Period 2
Sales (units) 11 000 18 000
R R
Contribution 88 000 144 000
Fixed cost 90 000 90 000
Profit/(Loss) (2 000) 54 000
(iii) Profits have not increased by R56 000 because absorption costing charges a fixed cost of
R6 per unit to inventory. In Period 1, inventory increased by 6 000 units; as a result,
absorption costing overstated its inventory value and resultant profit by R36 000 in
comparison to the values shown by variable costing.
In Period 2, inventory levels decreased by 5 000 units. Absorption costing in this period
reduced the value of the inventory by R30 000 (R6 × 5 000) and thus reduced profit by
R30 000 in comparison to the values shown by variable costing.
Period 1 Period 2
Absorption profit 34 000 24 000
Fixed cost included in inventory (36 000) 30 000
Variable profit (2 000) 54 000

The Management Accountant of Ndileka (Pty) Ltd produced the following budget for the month of
May 19X0.
Income statement of Ndileka (Pty) Ltd for the month ending 31 May 19X0
Products Abes Babes Total
Sales quantity 2 000 1 000
R’000 R’000 R’000
Sales value 600 400 1 000
Production costs:
Material 160 100 260
Labour 80 50 130
Overheads 180 70 250
Gross profit 180 180 360
Selling expenses 200
Profit 160
You are given the following additional information:

(a) The production overheads allocated to each of the two products are both fixed and variable.
20% of the total overheads of R250 000 are variable.
(b) 70% of the total production fixed costs have been allocated to product Abes. It is company
policy to allocate 70% of production fixed overhead to Abes, regardless of the production levels
of the two products.
(c) The selling expenses are both fixed and variable. The variable portion is 10% of the sales value
of each product sold.
The Managing Director is not happy with the budget produced above and has requested you to
produce a budget where the sales for Abes and Babes are set at 1 500 units each. He is also of the
opinion that it is prudent to hold a buffer inventory of 250 units of Abes and 200 units of Babes.

(a) Produce a new budget as requested by the Managing Director on an absorption costing basis.
Note: The company does not use a fully-integrated system.
(b) Show how the profit calculated in (a) can be adjusted to reflect the variable profit.
Note: You are not required to re-do the income statement on a variable costing basis.
Solution
Cost analysis
Total overhead – R250 000
Variable 20% R50 000
Fixed 80% R200 000
Abes – Overhead R180 000

Fixed overhead = R200 000 × 70% = R140 000
Therefore variable = R180 000 – R140 000 = R40 000
or R40 000 / 2 000 units = R20 per unit
Babes – Overhead R70 000

Fixed overhead = R200 000 × 30% = R60 000
Therefore variable = R70 000 – R60 000 = R10 000
or R10 000 / 1 000 units = R10 per unit
Material
Abes: R160 000 / 2 000 = R80 per unit
Babes: R100 000 / 1 000 = R100 per unit
Labour
Abes: R80 000 / 2 000 = R40 per unit
Babes: R50 000 / 1 000 = R50 per unit
Sales
Abes: R600 000 / 2 000 = R300 per unit
Babes: R400 000 / 1 000 = R400 per unit
Selling expenses
Variable 10% of R1 000 000 = R100 000
Fixed (R200 000 – R100 000) = R100 000
(a) Absorption costing

Overheads
Abes: 1 750 × 20 = R35 000 + R140 000 = R175 000
Babes: 1 700 × 10 = R17 000 + R 60 000 = R 77 000

Abes: (R140 000 + R70 000 + R175 000) / 1 750 units = R220
Inventory: 250 × R220 = R55 000
Babes: (R170 000 + R85 000 + R77 000) / 1 700 units = R195,29
Inventory: 200 × R195,29 = R39 058
Income statement for the month ending 31 May 19X0

Products Abes Babes Total
R’000 R’000 R’000
Sales value 450 600 1 050
Production costs:
Labour 70 85 155
Overheads 175 77 252
385 332 717
Less: Closing inventory – 55 – 39,058 – 94,058
Cost of sales 330 292,942 622,942
Gross profit 120 307,058 427,058
Selling variable expenses 105
Selling fixed expenses 100
Profit 222,058
(b) Reconciliation to variable costing

Inventory adjustment: Abes R20 000
Inventory adjustment: Babes R7 058
Inventory: Abes Closing inventory 250 units × fixed cost in inventory
Fixed inventory = R140 000
Production = 1 750 units
Value per unit R140 000 / 1 750 = R80
Closing inventory = 250 × R80 = R20 000
Inventory: Babes Closing inventory 200 units × fixed cost in inventory
Fixed inventory = R60 000
Production = 1 700 units
Value per unit R60 000 / 1 700 = R35,29
Closing inventory = 200 × R35,29 = R7 058

Eagle-Eye (Pty) Ltd operates a full absorption costing system which incorporates a pre-determined
overhead absorption rate per unit produced. Direct costs of production include material and variable
labour costs, which are charged to the production account while indirect variable and fixed
overhead costs are charged at a pre-determined rate of R6 per unit.
The established selling price procedure is to add a profit mark-up of 50% to the full factory cost of
the company’s products. In 20X2, Eagle-Eye experienced a considerable drop in the demand for its
products due to a down-turn in the economy. This resulted in a higher under-absorption of fixed
factory overheads and a resultant loss. The actual selling price of the company’s products and all
costs of production incurred were according to the budget. The budget and actual fixed cost of
production for 20X2 was R800 000.
The summarised income and expenditure account for 20X2 is shown below:
Actual income and expenditure account 20X2
Units R R
90 000 Sales revenue 1 620 000
10 000 Opening inventory of finished goods 120 000
Direct costs 600 000
100 000 Factory overhead 600 000
1 320 000
20 000 Less: Closing inventory of finished goods 240 000
Factory cost of goods sold 1 080 000 1 080 000
Less: Fixed factory overhead under-absorbed 400 000
140 000
Administrative costs: Fixed 120 000
Selling costs: Variable per unit sold 180 000
Loss (160 000)
You are provided with the following information for the 20X3 financial year:
1 In 20X3 all variable production costs increased by 10%.
2 Fixed factory overhead and administrative fixed costs remained unchanged.
3 Variable selling costs increased by 5% per unit.
4 Eagle-Eye took the decision to increase the factory fixed overhead absorption rate to R6 per unit.
This decision was taken as management was of the opinion that a major cause of the loss in 20X2
was the low overhead absorption rate which led the company to quote selling prices which were
uneconomic.
5 The selling prices for 20X3 were varied in line with the established procedures so as to reflect a
mark-up of 50% on full factory cost. The new selling prices were also charged on the inventory of
finished goods held at the beginning of 20X3.
6 Closing inventory was valued on a FIFO basis.
The sales for 20X3 were 5 000 units lower than for 20X2 but management was happy that a profit,
which was attributed to the increase in the absorption rate, was achieved. Closing inventory,
however, increased to 40 000 units, which is a concern to management. Management has now
decided to reduce the inventory levels at the end of the 20X4 financial year to the physical level held
at the beginning of 20X2.
The Managing Director has instructed the Accountant to prepare a budget for 20X4 on the
assumption that all costs and recovery rates as well as unit sales and selling price per unit remain at
the 20X3 level. The Accountant prepared a budget statement based on full absorption costing as
shown in the statement above which the Managing Director refuses to accept, saying:
“How is it possible that we are showing a loss for 20X4 when we plan to sell the same number of
units next year as were sold in 20X3?”

(a) Prepare the actual income statement for the year ended 20X3 using a full absorption costing
system.
Note: Use the same format as presented above.
Briefly give your opinion on how well the company has performed. (20 marks)
(b) Prepare the budget for 20X4 as presented to the Managing Director as well as a comparative
budget done on a variable costing basis.
Note: For the comparative budget you are required to show the opening inventory on a
variable costing basis. Do not show any adjustment in the income statement for the
change in the opening inventory value.
Reconcile the absorption costing budget to the variable costing budget for 20X4. (15 marks)
(c) Calculate the break-even point and profit volume ratio for 20X4.
Calculate the sales volume required in 20X4 if the selling price and all costs remained at the
20X3 level and the company achieved a profit of R110 000. (5 marks)
Solution
(a) 20X2 cost analysis
Direct costs per unit = R600 000 / 100 000 = R6
Variable overhead per unit
R
Factory overhead 600 000
Fixed cost under-recovery 400 000
Total 1 000 000
Fixed cost 800 000
Variable cost 200 000
Divided by number of units 100 000
= R2 per unit
Selling variable costs = R180 000 / 90 000 = R2
20X3 costs:
Direct costs R6 × 1,1 = R6,60
Variable overhead R2 × 1,1 = R2,20
Selling variable cost R2 × 1,05 = R2,10
Selling price R
Direct costs 6,60
Variable overhead 2,20
Fixed factory 6,00
Factory cost 14,80
Mark-up × 50% 7,40
Selling price 22,20
Units produced in 20X3

Sales 85 000
Plus: Closing inventory 40 000
Less: Opening inventory – 20 000
Production 105 000
Actual income and expenditure account 20X3

Units R R
85 000 Sales revenue × R22,20 1 887 000
Direct costs (105 000 × R6,60) 693 000
105 000 Factory overhead × (2,20 + 6) 861 000
1 794 000
40 000 Less: Closing inventory × (R14,80) 592 000
515 000
Administrative costs – fixed 120 000
Selling costs – 85 000 × R2,10 178 500
Profit 216 500
Fixed cost recovery

105 000 × R6 = 630 000
Budget 800 000
Company performance
The company has shown a profit of R216 500 on an absorption costing basis. However, as
closing inventory has increased by 20 000 units, R120 000 (ie R6 × 20 000) fixed cost
expenditure has been capitalised.
On a variable costing basis, the profit would have been shown as R96 500 ie
R216 500 – R120 000.
(b) Budget income and expenditure account 20X4 – absorption costing

Units R R
85 000 Sales revenue × R22,20 1 887 000
Direct costs (55 000 × R6,60) 363 000
55 000 Factory overhead × (2,20 + 6) 451 000
1 406 000
10 000 Less: Closing inventory × (R14,80) 148 000
159 000
Administrative costs – fixed 120 000
Selling costs – 85 000 × R2,10 178 500
Profit – 139 500
Budget income and expenditure account 20X4 – variable costing

Units R R
85 000 Sales revenue × R22,20 1 887 000
40 000 Opening inventory of finished goods × 8,80 352 000
Direct costs (55 000 × R6,60) 363 000
55 000 Factory variable overhead × 2,20 121 000
Factory fixed overhead 800 000
1 636 000
10 000 Less: Closing inventory × R8,80 88 000
Administrative costs: Fixed 120 000
Selling costs: (85 000 × R2,10) 178 500
Profit 40 500
Reconciliation
Absorption profit – R139 500
Variable profit + R 40 500
Difference R180 000
The difference in recorded profit is due to the inventory holding decreasing by 30 000 units.
Inventory decrease 30 000 units
Fixed cost per unit × R6
Fixed cost w/o in income statement R180 000
Workings
Production
Sales 85 000
Closing inventory + 10 000
Production 55 000
Fixed cost recovery
55 000 × R6 = 330 000
Budget 800 000
(c) Break-even
Fixed costs:
Factory overhead 800 000
Administration 120 000
920 000
Contribution:
Sales 22,20
Direct costs 6,60
Variable selling 2,10
Contribution 11,30
Break-even: R920 000 / 11,30 = 81 416 units

PV ratio: 11,30 / 22,20 = 51%
Sales volume at a profit of R110 000

110 000 + 920 000
=
11,30
= 91 150 units
Activity-based
costing
l explain why using only unit-based cost drivers to assign overheads may produce distorted
costs
l explain the advantages and disadvantages of activity-based costing (ABC)
l explain why ABC is preferable to absorption costing but may be inappropriate for decision-
making purposes
l compute product costs using activity-based costing
Activity-based costing is a system of allocating production overheads to products manufactured in a

manner that is more equitable than the traditional method of using a single allocation base such as
labour hours. ABC recognises that manufacturing techniques have moved away from labour-
intensive production to capital-intensive in recent years. As a result there has been a significant shift
away from direct variable costs of manufacturing to indirect fixed costs.
Another significant change in the modern-day production process is the shift away from single
product manufacturing to multi-product manufacture. ABC recognises that low-volume products
require a higher proportion of manufacturing support costs such as machine set-up costs, inspection,
packaging, ordering, selling etc than high-volume products do.
The system of activity-based costing analyses costs in order to reflect the higher manufacturing costs
of low-volume products, in comparison to the traditional method that would simply smooth over all
overhead costs on an equal basis to all products manufactured. The result is that low-volume
products tend to be under-costed, while high-volume products are over-priced. A direct consequence
of allocating overheads evenly to all product lines is that a company quoting on a cost-plus basis may
out-price itself on the high-volume products and sell low-volume products that make a loss.
Empirical evidence suggests that companies require accurate product costing information and use
full costing systems to arrive at product costs for decision-making purposes. ABC is a more
sophisticated technique than the traditional absorption costing system, but is it subject to the same
limitations as the traditional absorption costing system?
Methodology
ABC takes the view that all costs are variable in the long-term and links the activity that causes the
variability to the cost. ABC recognises that there are many activities or “cost-drivers” causing costs to
be incurred. The system has a framework that is similar to that of a conventional absorption costing
system.
ABC involves two stages:

(a) Overhead costs are pooled according to the activities which cause the costs.
(b) Each cost activity is then linked by a cost driver to the product output.
145
Overheads are allocated to products by dividing the activity cost by the period cost driver volume
and then multiplying the determined rate by the units of activity used by a product. A typical ABC
cost system will involve the following steps:
Step 1 Determine the activities that relate to the overheads
Step 2 Quantify the activity cost
Step 3 Determine the cost drivers associated with the activity
Step 4 Determine the cost driver rates by dividing the activity cost by the cost driver volume
Step 5 Apply the rates determined in step 4 to a product
Certain activities within a production department will be related to a specific volume of production
and will be recovered in the same way as a conventional absorption costing system, eg labour or
machine hours.
Example
Activities Cost drivers
Purchase requests Number of requests
Material procurement Number of supplier orders
Number of items
Material handling Number of movements
Set-up Number of set-ups
Maintenance Number of maintenance hours
Machinery Number of machine hours
Fitting Number of labour hours
Quality control Number of inspections
Pricing Number of orders
Number of customers
Customer vetting Number of customers
Size of orders
Expediting delivery Number of deliveries
Administration Number of staff
ABC focuses attention on the underlying causes of costs; consequently, it not only is used to calculate
a more accurate product cost; it also provides a method of managing overhead costs. By identifying
the activities such as marketing, manufacturing and invoicing it becomes easier to understand why a
cost is being incurred and how best to control it.
ABC treats the volume-related overheads in exactly the same way as a conventional absorption
costing system but differs in the treatment of non-volume-related overheads. Benefits will therefore
only be derived where the non-volume-related overheads are substantial. While it can be said that
there is a high similarity between the conventional absorption costing and ABC systems, ABC is
superior as the cost allocation to the underlying products is more relevant.
Conventional absorption costing
Production Volume-based
departments overhead rates
Overhead
cost +
Products
Service
department
cost
Figure 1 Conventional absorption costing

Chapter 5: Activity-based costing 147
Activity-based costing
Activity
Activity-based cost driver
cost pools rates
Overhead Products
costs
Figure2 Activity-based costing
A company manufactures two products, King and Queen. You are given the following information:
King Queen
Production – units 10 000 10 000
Closing inventory – units 4 000 2 000
R R
Selling price per unit 1 000 750
Material cost per unit 100 300
Variable cost per unit 300 200
Overhead costs
Manufacturing – total R3 000 000
Other – total R2 000 000
The company has three accountants, ie a variable costing accountant, an absorption costing
accountant and an ABC accountant.
The variable costing accountant values the closing inventory at variable cost and charges the
overheads in total to the income statement.
The absorption costing accountant allocates 1/3 of the manufacturing overhead costs to product King
and the balance to product Queen. The other overheads are allocated equally to the two products.
The ABC accountant has identified the following activities:
King Queen Overhead
cost
Machine hours 160 000 80 000 R1 200 000
Labour hours 120 000 60 000 R1 800 000
R3 000 000
Other overheads
King Queen Overhead
cost
Activity A 250 000 50 000 R1 500 000
Activity B 25 000 25 000 R500 000
R 2000 000

(a) Calculate the cost per unit for the two products for each accountant.
(b) Determine the most profitable product for each accountant and indicate, giving reasons,
whether they would recommend that the company discontinue either of the two products.
(c) Prepare an income statement for each of the three accountants.
Solution
King Queen
R R
Cost per unit 400 500
Absorption costing
King Queen Total
R R
Manufacturing overhead 1 000 000 2 000 000 3 000 000
Other overheads 1 000 000 1 000 000 2 000 000
2 000 000 3 000 000
Production – units 10 000 10 000
Allocation per unit R200 R300
King Queen
R R
Overhead 200 300
The problem with absorption costing is that the cost will not remain the same as production
changes. An increase in production will lead to a decrease in cost per unit. If production is
reduced the cost per unit will increase.
ABC costing
Recovery rates
Machine hours R1 200 000 / 240 000 = R5 per hour
Labour hours R1 800 000 / 180 000 = R10 per hour
Activity A R1 500 000 / 300 000 = R5 per activity
Activity B R500 000 / 50 000 = R10 per activity
King Queen Total

R R R
Machine hours @ R5 800 000 400 000 1 200 000
Labour hours @ R10 1 200 000 600 000 1 800 000
Activity A @ R5 1 250 000 250 000 1 500 000
Activity B @ R10 250 000 250 000 500 000
Total overhead R3 500 000 R1 500 000 R5 000 000
Units 10 000 10 000
Cost per unit R350 R150
King Queen
R R
Overhead 350 150
Activity-based costing is exactly the same as absorption costing as the cost calculated above will
change as production increases or decreases. ABC will give you the incorrect cost per unit for
decision-making purposes.

King Queen
R R
Selling price 1 000 750
Contribution per unit 600 250
The product that generates the highest contribution is the best product. The accountant is of
the opinion that both products are profitable and should be retained as long as there are no
limiting factors of production.
If there are limiting factors of production, the accountant will recommend that the company
maximise the contribution per limiting factor (or factors) and may recommend that one of the
products be discontinued, or that neither product be discontinued. The important factor is that
contribution is maximised.
Absorption costing
King Queen
R R
Overhead cost 200 300
Profit per unit 400 – 50
The best product is King. The accountant will recommend that product Queen be discontinued
as it makes a loss.
Activity-based costing
King Queen
R R
Overhead cost 350 150
Profit per unit 250 100
The best product is King. The accountant will recommend that the company continue to sell
both products.
If there are limiting factors of production, the accountant will recommend that the company
maximise the profit per limiting factor (or factors) and may recommend that one of the
products be discontinued or that neither product be discontinued. ABC is only concerned with
maximising profit per limiting factor.
This logic is incorrect, because if there are limiting factors of production, using the profit per
unit concept in making decisions will always lead to incorrect and unprofitable conclusions,
because overhead costs are not variable and do not move with the relevant activity.
Consequently, the cost per unit will change as production levels change. If there are limiting
factors of production, the production levels will change and so will the cost per unit.
(c) Variable costing – income statement

King Queen Total
R R R R
Sales 6 000 000 6 000 000 12 000 000
Production costs:
Material 1 000 000 3 000 000
Variable costs 3 000 000 2 000 000
4 000 000 5 000 000
Less: Closing inventory 1 600 000 1 000 000
Cost of sales 2 400 000 2 400 000 4 000 000 4 000 000 6 400 000
Gross profit 3 600 000 2 000 000 5 600 000
Manufacturing overhead – 3 000 000
Other costs – 2 000 000
Profit R600 000
Absorption costing – income statement

King Queen Total
R R R R
Sales 6 000 000 6 000 000 12 000 000
Production costs:
Material 1 000 000 3 000 000
Variable costs 3 000 000 2 000 000
Manufacturing overhead 1 000 000 2 000 000
Other 1 000 000 1 000 000
6 000 000 8 000 000
Cost of sales 2 400 000 3 600 000 6 400 000 6 400 000 10 000 000
Profit 2 400 000 – 400 000 R2 000 000
Activity based costing – income statement

King Queen Total
R R R R
Sales 6 000 000 6 000 000 12 000 000
Production costs:
Material 1 000 000 3 000 000
Variable costs 3 000 000 2 000 000
Overheads 3 500 000 1 500 000
7 500 000 6 500 000
Cost of sales 4 500 000 4 500 000 5 200 000 5 200 000 9 700 000
Profit 1 500 000 800 000 R2 300 000
Megapede Ltd manufactures three products which pass through two production departments,
ie A and B. The company also has three service departments, namely Receiving, Packing and
Maintenance. The overhead costs for the two production sections and three service
departments are as follows:
Production Service
A B Receiving Packing Maintenance
R380 000 R450 000 R210 000 R190 000 R420 000
Production Department A has been identified as being labour-intensive while Department B is
machine-intensive. Overheads are traditionally recovered in Department A on the basis of
labour hours and in Department B on the basis of machine hours. The overheads are allocated
to the production departments on the basis of estimated usage as follows:
Department A Department B
Receiving 40% 60%
Packing 55% 45%
Maintenance 30% 70%
Details of product usage time and related inputs are as follows:
Total Total
Product Annual output labour hours machine hours
X 5 000 10 000 20 000
Y 20 000 40 000 60 000
Z 40 000 80 000 160 000
130 000 240 000
Megapede Ltd is interested in analysing the overhead cost per unit of product manufactured
on an ABC basis and has extracted the following information:
Manufacturing cost analysis
Labour-related R130 000 –
Machine-related – R120 000
Set-up-related R80 000 R270 000
Inspection-related R170 000 R60 000
R380 000 R450 000
Cost driver analysis
Annual cost driver volume per product
Cost driver: X Y Z
Set-ups 20 60 10
Number of inspections 90 90 120
Maintenance hours 1 000 2 000 3 000
Number of raw material orders 40 80 80
Number of external orders 120 80 20

Complete the unit cost per unit of products X, Y and Z, using:
(a) the traditional method
(b) the ABC costing method.
Solution
(a) Traditional method – absorption costing
In an absorption costing system as shown in chapter 2, overhead costs are allocated to the
production departments on a basis that the accountant feels is equitable. In this example,
production costs have already been allocated. The only other overhead costs that need to be
allocated are the Service Department costs.
The basis of allocation has been determined on an appropriate percentage basis according to
each Service Department cost. Once the costs have been allocated to the Production
Department, the accountant determines the basis of recovering the overhead costs. As
Department A is labour-intensive, the company will allocate overhead costs on the basis of
labour hours. Department B is machine-intensive; therefore overhead costs will be allocated on
the basis of machine hours.
Production departments A B Total
R R R
Manufacturing costs 380 000 450 000 830 000
Receiving 40 : 60 84 000 126 000 210 000
Packing 55 : 45 104 500 85 000 190 000
Maintenance 30 : 70 126 000 294 000 420 000
Total overhead allocated 694 500 955 500 1 650 000
Recovery basis:
Labour hours 130 000
Recovery rate per hour R5,34 R3,98
We now need to allocate the overheads on the pre-determined basis to each of the three
products as follows:
Products X Y Z
Labour hours per unit 2 2 2
Machine hours per unit 4 3 4
Cost per unit:
Product X (2 × R5,34) + (4 × R3,98) = R26,60
Product Y (2 × R5,34) + (3 × R3,98) = R22,62
Product Z (2 × R5,34) + (4 × R3,98) = R26,60
In a fully-integrated absorption costing system, the overhead costs would be recovered in the
forthcoming year on the basis calculated above. This means that next year, once we know the
actual overhead costs, we would have an under- or an over-recovery of overheads.
(b) Activity-based costing system
An activity-based costing system is exactly the same as a traditional absorption costing system,
apart from the fact that the overhead costs are allocated to each product on the basis of
multiple activities or cost drivers.
Cost analysis
Cost driver Department A Department B Total activity
manufacturing manufacturing cost
Labour 130 000 R130 000
Machine 120 000 R120 000
Set-up 80 000 270 000 R350 000
Inspection 170 000 60 000 R230 000
380 000 450 000
Receiving R210 000
Packing R190 000
Maintenance R420 000
Total overhead costs R1 650 000
Cost allocation to each product

Products X Y Z
Labour R130 000 10 : 40 : 80 10 000 40 000 80 000
Machine R120 000 20 : 60 : 160 10 000 30 000 80 000
Set-up R350 000 20 : 60 : 10 77 778 233 333 38 889
Inspection R230 000 90 : 90 : 120 69 000 69 000 92 000
Receiving R210 000 40 : 80 : 80 42 000 84 000 84 000
Packing R190 000 120 : 80 : 20 103 636 69 091 17 273
Maintenance R420 000 1 : 2 :3 70 000 140 000 210 000
Total overhead cost 382 414 665 424 602 162
Note: Costs have been allocated to each product on the basis of activity usage. For example –
the total labour hours are 130 000. The labour hour usage per product is – Product X :
10 000 hours, Product Y : 40 000 hours, Product Z : 80 000 hours.
Allocation is therefore 10 : 40 : 80
Allocated cost per unit

Products X Y Z
Total overhead cost R382 414 R665 424 R602 162
Units 5 000 20 000 40 000
Comparative traditional absorption cost per unit R26,60 R22,62 R26,06
As you see, there is a substantial difference in the cost per unit depending on which method you
use. However, the main reason for the difference is because of the recovery methods used. Is
one method better than the other method?
Yes, ABC more accurately reflects the cost per unit. But, the question you need to ask is: “Do we
need to know the cost per unit?” For decision-making purposes, the answer is “NO.” Only
variable costing gives the correct costing data to make decisions.
Can we use this cost data to decide which products are making a loss and should be
discontinued? Again, the answer is “NO.” Only variable costing can give you the correct data to
decide which products are unprofitable.
As ABC is exactly the same as absorption costing, it suffers from the same problem as traditional
absorption costing when used in a fully-integrated absorption costing system.
Continuation of Illustrative example 2
The actual results for Megapede Ltd in the following year are as follows:
The company produced 10 000 units of product X, 30 000 units of product Y and 30 000 units of
product Z.
Closing inventory at the year-end was 2 000 units of X; 5 000 units of product Y, and 5 000 units of
product Z.
Actual overhead costs incurred by the company
Department A manufacturing overheads R480 000
Department B manufacturing overheads R450 000
Receiving department R170 000
Packing department R160 000
Maintenance department R550 000
R1 810 000

(a) Produce a fully-integrated traditional absorption costing statement reflecting the actual results.
(b) Produce a fully-integrated activity-based costing statement reflecting the actual results.
Solution
(a) Absorption costing – cost statement
Actual overheads recovered
Product X 10 000 × R26,60 = R260 600
Product Y 30 000 × R22,62 = R678 600
Product Z 30 000 × R26,06 = R781 800
R1 721 000
Actual overheads incurred R1 810 000

Under-recovered overhead R89 000
Cost statement
Allocated overhead
Product X R260 600
Product Y R678 600
Product Z R781 800
R1 721 000
Closing inventory
Product X 2 000 × R26,60 = R53 200
Product Y 5 000 × R22,62 = R113 100
Product Z 5 000 × R26,06 = R130 300
R296 600 (R296 600)
Cost of sales R1 424 400
Actual cost of sales R1 513 400
(b) Activity based costing – cost statement

Actual overheads recovered
Product X 10 000 × R76,48 = R764 800
Product Y 30 000 × R33,27 = R998 100
Product Z 30 000 × R15,05 = R451 500
R2 214 400
Actual overheads incurred R1 810 000

Over-recovered overhead R404 400
Cost statement
Allocated overhead
Product X R764 800
Product Y R998 100
Product Z R451 500
R2 214 400
Closing inventory
Product X 2 000 × R76,48 = R152 960
Product Y 5 000 × R33,27 = R166 350
Product Z 5 000 × R15,05 = R75 250
R394 560 (R394 560)
Cost of sales R1 819 840
Actual cost of sales R1 415 440
The logical error of activity-based costing

Activity-based costing has been sold as a “product” that companies can use to make better product-
selling decisions. ABC in a sense is similar to “zero-based budgeting” or “zero-based costing”. The
idea is to re-think the cost structure of a product so that a better “cost” for the product is arrived at.
The question is: “Why do you want to know the cost of a product?” or rather: “Is it important to
know the cost of a product?” The answer would appear to be “Yes”, as without it we do not know
whether a product is profitable or not. ABC would go further, saying that you need to know the cost
of a product so that you can arrive at the selling price. Now there lies an interesting question – “Do
you need to know the cost of a product to arrive at the selling price? What comes first, the selling
price of a product or the cost of the product?”
The logical answer is that the selling price should be market-related to demand and not to the cost of
the product. The greater the competition, the more the selling price is a given and costs are a by-
product of selling a product. Decision-makers must therefore maximise contribution and the costs
will look after themselves. That does not mean that we must ignore “costs”, but it does mean that
our minds must be focused on maximising sales and contribution and therefore minimising costs
without compromising the quality of the product.
How ABC uses cost information for decision-making purposes

Company A manufactures blue pens only and the monthly cost information is as follows:
Manufacture 1 000 blue pens
Sell 1 000 blue pens @ R6,50 each
Unit costs:
Variable R2 per unit
Fixed R3 per unit
The company is at full capacity.
From the above information we ascertain the following:
Monthly profit (R6,50 – R5) = R1,50 × 1 000 = R1 500
Monthly fixed cost R3 × 1 000 = R3 000
Mark up = R1,50 / R5 = 30%
The fixed cost per unit of R3 is only correct at a production level of 1 000 pens. If production should
drop to (say) 500 pens per month, then the fixed cost per pen would be R6 and at a selling price of
R6,50 per pen the company will make a loss of R1,50 per pen sold.
A second company, Company B, also has a monthly capacity to manufacture 1 000 pens per month
but it manufactures blue pens plus a variety of other colours. The fixed costs for the company are
higher than that for Company A as it has to work overtime, because it is more time-consuming to
manufacture various colours of pens instead of just blue pens. It also incurs higher set-up costs,
cleaning costs and wastage.
The accounting information for a normal month is

Blue pens Other
Quantity produced 600 400
Sales 600 400
Variable cost R2 R3
Fixed cost R5 R5
Selling price R6,50 R10
The fixed cost of R5 000 is recovered on a traditional absorption costing basis by dividing the total
cost by units produced.
Management is concerned that the company is making a loss on blue pens and wants to know if it
should stop producing blue pens.
The ABC answer

How does ABC uses cost data for decision making purposes? The answer is that ABC analyses the
overhead costs into cost pools and then allocates the costs to the products using cost drivers. The
assumption is that costs vary according to the usage of the cost driver.
Once the costs have been allocated, the selling price is arrived at by adding a mark-up to cost. Where
the selling price is a given, ABC advocates the maximisation of profit per unit.
Profit is defined as selling price – variable costs – allocated “cost driver” overheads. What if there is
a production constraint? ABC would advocate the maximisation of profit per limiting factor.
Getting back to Company B: ABC would re-allocate the fixed cost on the basis of cost drivers which
would result in a higher overhead cost allocation to the “other” products, as these are the ones that
are causing more set-ups and higher overhead costs.
Assume the following ABC cost allocation:
Blue pens Other pens Total
Production 600 400
Variable cost R2 R3
Fixed cost R4 R6,50 R5 000
Total cost R6 R9,50
The R5 000 fixed cost has been allocated according to cost drivers, which shows that “Other pens”
cost more to manufacture than blue pens. The blue pens have been allocated a cost of R4 which is R1
higher than Company A’s cost because the blue pens are more expensive to manufacture as a result
of the additional set-ups, overtime and wastage.
Now, ABC would tell management that if its policy is to mark up by 30%, then it must sell the blue
pens at R7,80 and the “others” at R12,35. Proponents of ABC make the point that ABC is quick to
identify products that are being sold at too low a price. In the above example, they would argue that
a selling price of R10 for “Other pens” was clearly too low and that the price should be increased to
R12,35.
The above argument is fine if Company B can sell blue pens at R7,80 and “Other pens” at R12,35.
What if it cannot? What if it can only sell 200 blue pens at a selling price of R7,80? Is the cost of R6
and R9,50 per unit correct? Yes, but only at a level of 600 blue pens and 400 “Other pens”. If the
production level changes, then so will the cost per activity driver. And there lies the problem with
ABC. The costs that are fixed do not vary with production; therefore as production changes so does
the cost per unit.
At a production level and sales of 200 blue pens and 400 “Other pens” the following would happen:
R
Sale of blue pens 200 × R7,80 1 560
Sale of “Other pens” 400 × R12,35 4 940
Less:
Variable cost ([ 200 × 2 ] + [ 400 × 3 ]) (1 600)
Fixed cost (5 000)
Loss (R100)
Conclusion: ABC can and will give the incorrect decision when the selling price is determined by
supply and demand, and cannot be derived from cost alone. The only time that ABC
may give the correct information for decision-making is when a cost-plus formula gives
a selling price that is less than the market is prepared to pay for the product.
The correct cost analysis

It is quite clear that Company A will always be in a position to produce blue pens more cheaply than
Company B, and, if we look at total cost as a basis for arriving at the selling price, Company A will
always have a strategic advantage. Clearly, Company B has a market for “Other pens” that it could
capitalise on.
The correct method to adopt when looking at product decision-making is as follows:

1 Identify the main or flag-ship product that the company manufactures.
2 Maximise the profit on the main product by maximising production, sales and contribution.
3 Sell other products manufactured by the company only if there is spare capacity.
4 Sell other products at a price higher than variable cost.
In our example, the answer for Company A is to sell as many blue pens as possible at a price that
maximises contribution.
Company B
1 The company’s main product is “Other pens”. The company should establish the selling price that
will result in the highest possible profit up to a sales level of 1 000 pens.
2 If it cannot use up all the available production capacity, it should sell blue pens at a selling price
higher than R2. Company B can in fact compete with Company A in the blue pen market at a
selling price less than the current market price of R6,50.
Adams Ltd manufactures three products. The latest financial statements show the following:
Product X Product Y Product Z
Production/Sales 8 000 10 000 12 000
Machine hours 6 000 3 000 6 000
Selling price/unit R20 R15 R10
Variable cost/unit R10 R8 R4
Fixed cost/unit R7,50 R3 R5
Profit R2,50 R4 R1
The fixed costs have been allocated to each product on the basis of machine hours. Demand
for next year at current selling prices is
X 10 000 units
Y 12 000 units
Z 18 000 units
continued
The machines are currently operating at full capacity. ABC consultants have determined that
the fixed cost for the current year should have been
X R9
Y R5,40
Z R2
(a) Produce a budget for the forthcoming year using ABC.
(b) Produce a budget for the forthcoming year that will accurately maximise profit.
Solution
As previously stated, a company should never calculate the total cost per unit in order to make profit
maximising decisions. Regrettably, in practice many companies do, and as a result they end up
making very bad decisions.
When a company sells more than one product and wants to maximise profit, it should firstly
determine the optimal selling price, followed by the variable costs of production. In most instances,
the variable cost of production will be the direct material costs, as all other costs, even labour, tend
to be fixed. To maximise profit, the company must choose the products that yield the highest
contribution.
If the company has one or more limiting factors of production, it will maximise the contribution per
limiting factor in order to maximise company profit.
What if a company uses an absorption or an activity-based costing system and it wishes to
maximise profit?
No company should use these two systems, they should use variable costing. If, however, the
company believes that only full-costing gives it the correct profit-maximising answer, then it will
attempt to maximise profit per unit.
What if there is a limiting factor?
Then the company will (in error) attempt to maximise profit per limiting factor. The reason why the
company is comfortable with this is because it believes that all costs vary with some activity – this is
particularly true of ABC costing.
(a) Activity-based costing
Product X Y Z
Sell R20 R15 R10
Variable cost R10 R8 R4
Fixed cost R9 R5,40 R2
Profit R1 R1,60 R4
ABC would encourage the company to maximise the sale of product Z, followed by Y, and finally
X. As “machine hours” is a limiting factor, ABC would now calculate the profit per machine hour.
X Y Z
Profit R1,00 R1,60 R4,00
Hours 0,75 0,3 0,5
Profit per hour R1,33 R5,33 R8,00
Maximise 3 2 1
Product X hours = 6 000 / 8 000 = 0,75
Product Y hours = 3 000 / 10 000 = 0,3
Product Z hours = 6 000 / 12 000 = 0,5
Maximise ABC production

Hours
Product Z 18 000 units × 0,5 9 000
Product Y 12 000 units × 0,3 3 600
Product X 3 200 units 2 400 Balance
15 000
Income statement
Product X Y Z
Sales – units 3 200 12 000 18 000
R R R Total
Sales – value 64 000 180 000 180 000 424 000
Variable costs 32 000 96 000 72 000 200 000
Fixed costs 28 800 64 800 36 000 129 600
Profit 3 200 19 200 72 000 94 400
Under-recovered fixed cost (150 000 – 129 600) 20 400
Note: Actual fixed cost is arrived at as
8 000 × 7,50 = 60 000 or 8 000 × 9,00 = 72 000
10 000 × 3,00 = 30 000 10 000 × 5,40 = 54 000
12 000 × 5,00 = 60 000 12 000 × 2,00 = 24 000
150 000 150 000
Note: Assume that the actual fixed cost incurred was the same as the budget cost, ie
R150 000.
Product X Y Z
Sell R20 R15 R10
Variable cost R10 R8 R4
Contribution R10 R7 R6
Hours 0,75 0,3 0,5
Contribution/hour R13,33 R23,30 R12
Maximise 2 1 3
Hours
Product Y 12 000 units × 0,3 3 600
Product X 10 000 units × 0,75 7 500
Product Z 7 800 units 3 900 balance
15 000
Income statement
Product X Y Z
Sales – units 10 000 12 000 7 800
R R R Total
Sales – value 200 000 180 000 78 000
Variable costs 100 000 96 000 31 200
Contribution 100 000 84 000 46 800 230 800
Fixed costs 150 000
Profit R80 800
Note: Actual fixed cost is arrived at as
8 000 × 7,50 = 60 000 or 8 000 × 9,00 = 72 000

10 000 × 3,00 = 30 000 10 000 × 5,40 = 54 000
12 000 × 5,00 = 60 000 12 000 × 2,00 = 24 000
150 000 150 000
The relevance of activity-based costing

ABC takes a relatively new look at the treatment, disclosure and accounting for overhead costs. The
first articles were written by Cooper and Kaplan in 1988, and have since then received much acclaim,
as well as arousing much controversy.
Much of the criticism of ABC can be summed up as follows:
l ABC treats the cost allocation to an activity as absolute, certain and linear.
l It uses a small sample of historical data and extrapolates the information for long-term costing
and decision-making requirements.
l ABC is a sophisticated absorption costing system and suffers from the same limitations as the
traditional method:
– choice of absorption base
– changing volume of production.
l ABC costs will vary significantly according to the choice of cost drivers and activities.
ABC has been criticised by many authors, who have suggested that the system is not a profound
development in our understanding of cost behaviour but an in-vogue management technique. Some
argue that the “allocation of indirect overhead is arbitrary, time-consuming and the resultant cost [is]
unlikely to be appropriate for decision-making.” They also question whether ABC has been oversold
and “hyped” to benefit the consultancies with their expensive seminars and training programmes.
An example supporting ABC used by Cooper and Kaplan is given below:
Two identical companies manufacture ballpoint pens. Company A only manufactures blue pens
and produces 1 000 000 pens per annum.
Company B also produces 1 000 000 ballpoint pens but specialises in manufacturing various
colour variations and as a result only produces 100 000 blue pens. Company B manufactures up
to 1 000 different colours or product variations and as a result incurs higher scheduling, set-up,
inspection, purchasing, receiving, material handling and administration costs.
Cooper and Kaplan conclude that a traditional product costing system will smooth the manufacturing
costs equally over all products, and as a result the pricing of Company B’s blue pens will be
uncompetitive. An ABC costing system will however recognise that the exotic colour variations incur
higher manufacturing costs due to the complexity of operations, and will allocate production costs
accordingly.
The exotic colour ballpoint pens will therefore be allocated higher production costs and be sold at a
higher price. The blue pens will only be allocated costs incurred in manufacture and will remain price
competitive.
The above logic cannot be faulted when we compare ABC to the so called traditional “absorption
costing” system. However, does the same logic hold true when we compare ABC to a decision-based
“variable costing” system?
I would dispute the contention that Company B will (on an ABC basis) arrive at a cost per unit for blue
pens equal to Company A’s cost. Company A specialises in the manufacture of blue pens, while
Company B specialises in the manufacture of exotic colours and can therefore not produce blue pens
at the same cost as Company A, even on an ABC basis.
The logical business decision would be for Company A to manufacture blue ballpoint pens, and for
Company B to manufacture the exotic colour variations, and so maximise profit. Does that mean that
Company B should not manufacture blue pens?
Whether Company B should manufacture blue pens or not will depend on its spare capacity. If it is
able to manufacture the exotic colours using up 100 % of available capacity, then it should not
manufacture blue pens. If, however, it is manufacturing below full capacity, then it should
manufacture blue pens as long as the Company is able to generate a positive contribution. The
opportunity cost of buying from a supplier such as Company A should also be considered.
Variable costing will always be superior to ABC as it is decision-based and seeks to maximise
contribution, which in turn will maximise corporate profit. ABC ignores opportunity costs and will
therefore lead to invalid decisions where other contribution-maximising options exist.
In the example quoted above, the important question that needs to be asked is: “What will the
marginal cost of one additional blue pen be?” ABC cannot answer that question, as the system
operates on a batch costing system that gives the average absorption unit cost per batch.
Benefits and limitations of activity-based costing

Many of the real and perceived benefits of ABC stem from the historical business environment and
the inability of historical accounting systems to control the activities of companies which operate in
an advanced manufacturing environment. The main criticisms of accounting and management
accounting systems are:
l Conventional accounting systems do not address the modern competitive business environment.
l Absorption costing systems provide inaccurate information for decision-making.
l Management accounting is simply accommodating and becoming the slave of financial
accounting.
Benefits of activity-based costing

Proponents of ABC state that the following benefits are derived from its use:
l When a high proportion of overhead costs are non-volume-related, and a company produces a
variety of products, the resultant product cost is more accurate than that obtained using
traditional methods.
l The flexibility of ABC allows the extension of cost analysis to areas such as customer costing and
internal management costs.
l Product costs reflect the long-run variable product cost, which is important for strategic decision-
making.
l ABC improves cost estimation, as cost behaviour understanding is improved.
l ABC improves strategic decision-making in
– the pricing of products
– improving the product range by discontinuing old products and promoting new ones, and
– assists in the costing of new products.
Many of the above benefits are questionable in the light of changing production volumes, where the
cost per activity will inevitably change as the overhead cost remains constant. It is future marginal or
differential costs (not historical costs) that are relevant for short- and long-term decisions. ABC
costing can only provide a starting point for the determination of decision-based cost information.
Any costing system that is based on historical technology, production methods and products must be
used with caution. In support of ABC, one must acknowledge that ABC costs provide a useful starting
point for the preparation of future cost information that is required for decision-making purposes.
Limitations of activity-based costing

l There is no real evidence that ABC improves company profits.
l ABC is based on absorption costing techniques, which are only valid at a single historical level of
production.
l ABC is historic and lacks relevance for future strategic decisions.
l The selection of cost drivers is difficult and in some instances has little relevance to activity.
l Costs such as rent, rates, depreciation, power, insurance still have to be apportioned
l ABC assumes that a single cost driver within a cost pool fully explains the cost behaviour of the
pool. It is doubtful that detailed segregation of costs achieves perfect cost homogeneity within a
cost pool.
l ABC requires an activity whose cost is measurable and can be related to a product. Some costs
such as general advertising, audit fees, finance costs, and goodwill have no meaningful cost driver
and cannot be linked to a specific product.
Operational benefits of activity-based costing

The most favourable benefits of ABC have been in the areas of improvement in the management of
business operations, and the motivation to improve business methods.
By breaking down the production operation into many activities that cause costs to be incurred, ABC
forces management to look at the products being manufactured in the light of the overheads being
incurred. It also makes management look at better methods for improving the manufacturing
process and business efficiency. In addition, it improves cost awareness and in many instances results
in cost reduction and improved methods of buying, setting-up, manufacturing and selling.
Activity-based costing and strategic decisions

Traditional absorption costing has been used for a long time by companies to arrive at a product cost,
which is then used for decision-making purposes. The fact that the underlying principle of arriving at
an overhead rate for each unit of production is fundamentally flawed has generally been accepted.
ABC uses the same fundamental technique to allocate overheads. It is more sophisticated than
traditional absorption costing, but its use is limited for decision-making purposes. ABC looks at all
costs and allocates them to the products according to the activity identified. The problem with using
this system to make the strategic decision about what product should be produced is clearly
illustrated in the following example:
John purchased a cow from a farmer for R2 500. He sold the meat for R2 300 and the hide for
R300. How much profit did he make on the hide?
ABC will attempt to allocate costs according to cost-drivers in the above example, in order to show a
profit for the meat and hide sales. A more accurate assessment of the above problem would be to
ask “What is John’s main line of business? Is it selling meat, or hides, or both?”
If his main activity is selling meat, then he should attempt to maximise his contribution on meat sales
and evaluate the sales of hide on a marginal or opportunity cost basis. If he is not in the market for
hides, then he should sell them at split-off point, if there is a market for the raw product. He may,
however, evaluate the hide option on a joint product basis, in which he would compare the
incremental costs to the incremental revenues. The strategic decision nevertheless remains
identifying what you are in the market for, and maximising those incomes. Spare capacity should
then be evaluated on a marginal contribution basis, not on an absorption costing profit basis.
Japanese businessmen determine the selling price for a product on the basis of what the market will
bear. Having decided on the selling price, they then focus on the costs of producing the product in
the long-term, and make their strategic decision on the basis of cost reduction. Any decision made on
a cost-plus basis will invariably give the wrong signal. The problems identified in using ABC for pricing
and strategic decision-making can be listed as follows:
l Overhead costs change from one period to another for a multiplicity of reasons and cannot be
defined as being static. Yet, ABC treats the cost consumption as constant.
ABC ignores the differential marginal overhead cost of manufacturing a product when a company
is working at full capacity, compared to the overhead cost of one that is operating below
capacity. In practice, a company operating at near full capacity will incur considerable marginal
costs to manufacture the marginal unit, whereas companies operating below capacity will incur
low or zero incremental overhead costs.
l ABC does not differentiate between costing for internal and public use.
The ABC cost+ basis of arriving at a product selling price is appropriate for “cost-plus” contracts
such as are used by building contractors, where detailed costing information is necessary. For
internal costing, management should be more concerned with the competitor’s cost structures.
If we assume that all competitors have identical plant layouts and efficiencies, then all companies
should be quoting at the same price. If they are not, then an ABC system may assist them to
improve their quotes, ie by ensuring that low-volume products are allocated a higher proportion
of overhead costs. In practice however, company structures and efficiencies, investment bases,
plant layout, organisational structure, degree of specialisation and size of business all differ from
business to business.
Eastern vs Western management styles

The technological advances made in the 1980s have dramatically changed production processes in
many companies. Modern product manufacturing requires the production of innovative products of
high quality at a low cost, coupled with strong customer service. These changes have called for the
modernising of the “traditional absorption costing“ system, and a mini-revolution in management
accounting. Modern automated manufacturing techniques require greater emphasis to be placed on
quality control, production flow and improvement of set-up times. The western style of management
in the mass-production era has long been one of rigid, hierarchical organisational structures with the
line of responsibility well defined. The adoption of automated manufacturing technologies requires a
change in this style, and a move away from highly-structured management. The distinction between
planning and execution must be eliminated, so that management can respond to changes in product
specifications and customer demand.
Western management styles have traditionally concentrated on the costs of individual responsibility
centres, rather than on the costs of the company’s strategic activities, which requires the co-
ordination of the activities of many departments. These requirements are seldom found in the
traditional accounting set-up, which does not focus on determining the costs of providing product
characteristics and, in the end, value to the customer. The use of cost-plus techniques to arrive at the
selling price of a product is incompatible with modern technological changes in the manufacturing
environment. Activity-based costing has gone a long way towards re-focusing management’s
attention on a new style of thinking that improves the manufacturing process, and a strategic
management style. ABC has encouraged managers to move away from their desire to determine
product costs, towards concentrating on the activities that make up a company. Yet, there is little
evidence that ABC has increased the profitability of companies. There is, however, strong evidence
that ABC has changed management’s approach to decision-making, thereby indirectly increasing
company profitability and improving their understanding of their businesses, competitors and
customers.
The success of the Japanese is, to a large extent, due to their strategic management style, which
focuses on product strategies. Japanese managers are concerned firstly with a target selling price
that will ensure a desired market share. From the selling price, they work backwards, to determine
maximum allowed costs that will yield the desired profits. Future market share is planned for and a
strong customer service is established. Companies establish a strong cost-reduction policy that
ensures long-term survival and expansion.
Bhimani and Bromwich say the following:

Whereas many firms in the West are said to rely on cost accuracy in pricing products, in Japan
product prices are often set according to a calculus determined primarily by the potential
customer’s utility for the product, the desired market positioning of the producer and internal
estimates of resource inputs to manufacture the product. Target pricing for instance, relies on
the price a product can command on the market, the perceived benefits of being an early market
entrant and reaping the advantages of the relationships between large-scale volume and
experience effects, as well as the coordinated effects of accountants, designers and engineers to
obtain the predetermined target cost.
Conclusion
The fact that ABC is superior to a traditional absorption costing system is without doubt. The relevant
question, however, is whether ABC is superior to decision-based or opportunity-based systems.
ABC has contributed to improving operational efficiencies by focusing on production methods and on
the gap between theory and practice. Its ideas have broadened our understanding of cost behaviour,
and it remains to be seen how acceptable the system will become. Management needs to recognise
that business decisions are complex, and that costs should not be determined by using a mechanical
system such as ABC to make major strategic decisions about pricing and the choice of products to be
manufactured.

1 Activity-based costing is exactly the same as absorption costing, and suffers from the same problem
as traditional absorption costing, because the cost per unit is only correct at one level of
production. Any increase or decrease in the production of a product will change the cost per unit.
2 The allocation of overhead costs using the ABC method requires the identification of multiple
activities that cause (or are believed to cause) the cost. In other words, ABC believes that all costs
are variable and that they vary with some activity.
3 When a cost is determined from the budget and applied to the forthcoming financial year, as in
absorption costing, an under- or over-recovery of overheads will result.
When ABC costs are used as a pre-determined recovery rate, it is easier to use the cost per unit
rather than the cost for each activity.
4 For decision-making purposes, variable costing is superior to both traditional absorption costing
and ABC. Profit per unit should never be used for decision-making; contribution per unit should be
used.
5 The only advantage of activity-based costing lies in the fact that it enables a better understanding
of operations in companies that have complex operations with many products being
manufactured. ABC is similar to zero-based budgeting.
Practice questions
(a) In the context of activity-based costing (ABC), it was stated in “Management Accounting –
Evolution not Revolution”, by Bromwich and Bhimani, that “Cost drivers attempt to link costs to
the scope of output rather than the scale of output thereby generating less arbitrary product
costs for decision making”.
You are required to explain the terms “activity-based costing” and “cost drivers”. (20 marks)
(b) XYZ Ltd manufactures four products, namely A, B, C and D, using the same plant and processes.
The following information relates to a production period:
Material Direct Machine Labour
cost labour time cost
Product Volume per unit per unit per unit per unit
A 500 R5 ½ hour ¼ hour R3
B 5 000 R5 ½ hour ¼ hour R3
C 600 R16 2 hours 1 hour R12
D 7 000 R17 1½ hours 1½ hours R9
Total production overhead recorded by the cost accounting system is analysed under the
following headings:
Factory overhead applicable to machine-oriented activity is R37 424
Set-up costs are R4 355
The cost of ordering materials is R1 920
Handling materials R7 580
Administration for spare parts R8 600
These overhead costs are absorbed by products on a machine hour rate of R4,80 per hour,
giving an overhead cost per product of:
A = R1,20 B = R1,20 C = R4,80 D = R7,20
However, investigation into the production overhead activities for the period reveals the
following totals:
Number Number Number
Number of material of times material of spare
Product of set-ups orders was handled parts
A 1 1 2 2
B 6 4 10 5
C 2 1 3 1
D 8 4 12 4

(i) compute an overhead cost per product using activity-based costing, tracing overheads to
production units by means of cost drivers. (10 marks)
(ii) comment briefly on the differences disclosed between overheads traced by the present
system and those traced by activity-based costing. (10 marks)
Solution
(a) Activity-based costing is a system of allocating production overheads to products manufactured
in a manner that is more equitable than the traditional method of using a single allocation base
such as labour hours. ABC recognises that manufacturing techniques have moved away from
labour-intensive production to capital-intensive production, in recent years. As a result, there
has been a significant shift away from direct variable costs of manufacturing to indirect fixed
costs.
Another significant change in the modern-day production process is the shift away from single
product manufacturing to multi-product manufacture. ABC recognises that low-volume
products require a higher proportion of manufacturing support costs such as those for machine
set-up, inspection, packaging, ordering, selling etc than high-volume products.
The system of activity-based costing analyses costs in order to reflect the higher manufacturing
costs of low-volume products, in contrast to the traditional method that would simply smooth
over all overhead costs on an equal basis to all products manufactured, which results in a
tendency to under-cost low-volume products, and over-price high-volume products. A direct
consequence of allocating overheads evenly to all product lines is that a company quoting on a
cost-plus basis may out-price itself on the high-volume products and sell low-volume products
that make a loss.
When a product is manufactured, costs will be incurred as value is added to the manufacturing
process. If one had to break down the manufacturing process into the different activities that
are taking place, each activity would constitute a “cost centre”. A “cost driver” is the event that
causes a cost to be incurred and charged to an activity or cost centre.
For example, if a company manufactures paint, product scheduling is very important as the
machines need to be cleaned and re-set every time a new colour is manufactured. In this
instance, the number of set-ups becomes the cost driver for scheduling the production of paint.
Other examples of cost drivers are:
the number of purchases in a purchasing department
the number of customer orders in a dispatch department
the number of inspections in a quality control department.
(b) Machine-related costs

Machine hours for the period:
A = 500 × ¼ = 125
B = 5 000 × ¼ = 1 250
C = 600 × 1 = 600
D = 7 000 × 1½ = 10 500
12 475
Machine hour rate = R3 per hour (R37 424 / 12 475 hours)
Set-up-related costs
Cost per set-up = R256,18 (R4 355 / 17)
Set-up cost per unit of output

Product A (1 × R256,18) / 500 = R0,51
B (6 × R256,18) / 5 000 = R0,31
C (2 × R256,18) / 600 = R0,85
D (8 × R256,18) / 7 000 = R0,29
Material ordering-related costs

Cost per order = R1 920 / 10 orders = R192 per order
Material ordering cost per unit of output:
Product A (1 × R192) / 500 = R0,38
B (4 × R192) / 5 000 = R0,15
C (1 × R192) / 600 = R0,32
D (4 × R192) / 7 000 = R0,11
Material handling-related costs

Cost per material handling = R7 580 / 27 = R280,74
Material handling cost per unit of output

Product A ( 2 × R280,74) / 500 = R1,12
B (10 × R280,74) / 5 000 = R0,56
C ( 3 × R280,74) / 600 = R1,40
D (12 × R280,74) / 7 000 = R0,48
Spare parts
Cost per part = R8 600 / 12 = R716,67
Administration of spare parts cost per unit of output

Product A (2 × R716,67) / 500 = R2,87
B (5 × R716,67) / 5 000 = R0,72
C (1 × R716,67) / 600 = R1,19
D (4 × R716,67) / 7 000 = R0,41
Overhead cost per unit of output

Product A B C D
ABC overhead cost: R R R Total
Machine overheads 0,75 0,75 3,00 4,50
Set-ups 0,51 0,31 0,85 0,29
Material ordering 0,38 0,15 0,32 0,11
Material handling 1,12 0,56 1,40 0,48
Spare parts 2,87 0,72 1,19 0,41
5,63 2,49 6,76 5,79
Present system 1,20 1,20 4,80 7,20
Difference + 4,43 + 1,29 + 1,96 + 1,41
The current pre-determined recovery rate is based on machine hours, and assumes that all costs
are incurred on the basis thereof. The information given in the question indicates that there are
five cost drivers. Costs can easily be grouped into the five cost drivers, and then allocated to the
four products according to the cost driver activity level.
ABC recognises that high-volume products are often unfairly valued, as costs are allocated on a
uniform basis. When ABC is used, a more accurate cost allocation will lower the cost of high-
volume products. Thus, Product D, a high-volume product, is allocated a lower level of cost
when ABC is used. Products A and B are both low-volume products; as such, they should be
charged with a higher cost as they consume a higher proportion of overhead costs due to the
low volumes produced.

Having attended a CIMA course on activity-based costing, you decide to experiment by applying the
principles of ABC to the four products currently made and sold by your company. Details of the four
products and relevant information are given below for one period:
Product A B C D
Output in units 120 100 80 120
Cost per unit R R R R
Direct material 40 50 30 60
Direct labour 28 21 14 21
Machine hours (per unit) 4 3 2 3
The four products are similar and are usually produced in production runs of 20 units and sold in
batches of 10 units.
The production overhead is currently absorbed by using a machine hour rate, and the total of the
production overhead for the period has been analysed as follows:
R
Machine departmental costs (rent, business rates, depreciation and supervision) 10 430
Set-up costs 5 250
Stores receiving 3 600
Inspection/quality control 2 100
Materials handling and dispatch 4 620
You have ascertained that the “cost drivers” to be used are as listed below for the overhead costs
shown:
Cost Cost driver
Set up costs Number of production runs
Stores receiving Requisitions raised
Inspection/quality control Number of production runs
Materials handling and dispatch Orders executed
The number of requisitions raised on the stores was 20 for each product and the number of orders
executed was 42, each order being for a batch of 10 of a product.

(a) Calculate the total costs for each product if all overhead costs are absorbed on a machine hour
basis (8 marks)
(b) Calculate the total costs for each product, using activity-based costing (14 marks)
(c) Calculate and list the unit product costs from your figures in (a) and (b), to show the differences
and to comment briefly on any conclusions which may be drawn which could have pricing and
profit implications (8 marks)
Solution
(a) Overhead costs
R
Machine departmental costs 10 430
Set up costs 5 250
Store receiving 3 600
Inspection/quality control 2 100
Materials handling 4 620
R26 000
Machine hours
Product Machine hours Total hours
A 120 × 4 480
B 100 × 3 300
C 80 × 2 160
D 120 × 3 360
1 300
Cost per machine hour: R26 000 / 1 300 = R20
Total costs
Product A B C D
Direct cost per unit R68 R71 R44 R81
Overhead cost per unit R80 R60 R40 R60
R148 R131 R84 R141
× number of units 120 100 80 120
R17 760 R13 100 R6 720 R16 920
Overhead costs arrived as follows:
Products A B C D
Cost per hour 20 20 20 20
Hours 4 3 2 3
80 60 40 60
(b) Total cost per product using ABC

Machine department
The machine department’s costs are all fixed and do not vary with any cost driver. Costs will be
recovered on the basis of machine hours.
Therefore R10 430 / 1 300 hours = R8,023 per machine hour
Cost per unit Total cost
A = 4 hrs × 8,023 = R32,09 × 120 = R3 850,80
B = 3 hrs × 8,023 = R24,07 × 100 = R2 407,00
C = 2 hrs × 8,023 = R16,06 × 80 = R1 284,00
D = 3 hrs × 8,023 = R24,07 × 120 = R2 888,40
R10 430,20
Set-up costs
Set-ups Cost Total cost
A 120 / 20 = 6 × 250 = 1 500
B 100 / 20 = 5 × 250 = 1 250
C 80 / 20 = 4 × 250 = 1 000
D 120 / 20 = 6 × 250 = 1 500
21 5 250
Cost per set-up R5 250 / 21 = R250
Stores receiving
Stores requisitions 20 × 4 = 80
Cost per requisition R3 600 / 80 = R45
Each product had 20 requisitions, therefore total cost per product
= 20 × R45
= R900
Or simply R3 600 / 4 = R900 per product
Inspection/quality control
Same as set-ups; therefore R2 100 / 21 = R100 per production run
A 6 × 100 = 600
B 5 × 100 = 500
C 4 × 100 = 400
D 6 × 100 = 600
21 R2 100
Handling and dispatch costs

Cost per order R4 620 / 42 = R110
Units Orders Cost Total cost
A 120 / 10 = 12 × 110 = 1 320
B 100 / 10 = 10 × 110 = 1 100
C 80 / 10 = 8 × 110 = 880
D 120 / 10 = 12 × 110 = 1 320
42 4 620
Total cost per product

A B C D
Direct costs 8 160 7 100 3 520 9 720
Machine department 3 851 2 407 1 284 2 888
Set-ups 1 500 1 250 1 000 1 500
Stores receiving 900 900 900 900
Inspection 600 500 400 600
Handling 1 320 1 100 880 1 320
16 331 13 257 7 984 16 928
Units 120 100 80 120
Per unit R136,10 R132,60 R99,80 R141,07
(c)
A B C D
Cost from (a) 148,00 131,00 84,00 141,00
Cost from (b) 136,10 132,60 99,80 141,07
– 11,90 + 1,57 + 15,80 + 0,07
Based on an absorption costing system, ABC shows a higher cost for products B, C and D, while a
simple absorption costing system shows a higher cost for product A. Use of either one or the
other absorption costing system will impact on inventory valuation and on sales price if the
cost+ method is used. Selling prices should be based on demand/price relationships, not cost
price. It must be remembered that where a cost price system is used, the cost is only correct at
one specific production level. If that production level changes, the cost per unit will also change,
even in an ABC system.

Lewis (Pty) Ltd manufactures three products. The latest financial statements reveal the following for
the quarter ended 30 June 19X0:
Products X Y Z
Production/Sales – units 8 000 10 000 12 000
Machine hours 6 000 3 000 6 000
R R R
Variable cost/unit 10 8 4
Fixed cost/unit 8,50 4 6
Profit 2,50 4 –

1 The variable cost per unit includes variable selling costs of R2 per unit for X, Y and Z.
2 The fixed cost per unit as shown above includes both selling and production fixed costs. The
selling fixed costs have been allocated at R1 per unit, while the manufacturing fixed costs were
allocated to production on the basis of machine hours.
3 The demand for the next quarter at the current selling prices is:
Product X 12 000 units
Product Y 15 000 units
Product Z 20 000 units
4 The machines are currently operating at 80% of maximum capacity.
5 All costs and selling prices for the three products will remain unchanged in the next quarter.
The managing director is concerned that product Z is only breaking-even, and is of the opinion that it
should be dropped as the demand for the other two products has increased and there is no point in
carrying a product that is only breaking-even.
The accountant is not so sure that product Z should be dropped; he has analysed the manufacturing
cost allocation to the three products. Based on activity-based costing, he has determined that the
correct manufacturing fixed cost allocation for the quarter ended 30 June 19X0 should have been:
Product X R9
Product Y R5,40
Product Z R2

(a) Determine the break-even volume for each product for the quarter ended 30 September 19X0,
assuming that the current sales mix is maintained.
(b) Produce a budget income statement for the quarter ending 30 September 19X0 that will
maximise profit on an ABC basis.
(c) Produce an income statement for the quarter ending 30 September 19X0 that will maximise
profit on a variable costing basis.
(d) Reconcile the profit determined in (b) to the profit as shown in (c).
Solution
(a) Break-even
Selling fixed costs
X R1 × 8 000 = 8 000
Y R1 × 10 000 = 10 000
Z R1 × 12 000 = 12 000
30 000
Production fixed costs

X R7,50 × 8 000 = 60 000
Y R3 × 10 000 = 30 000
Z R5 × 12 000 = 60 000
150 000
Contribution
X Y Z
Variable costs 10 8 4
Contribution 11 8 6
Average contribution
X 11 × 8 / 30 = 2,933
Y 8 × 10 / 30 = 2,666
Z 6 × 12 / 30 = 2,400
8,00
Break-even point
Fixed cost 180 000
= = 22 500 units
Contribution 8
or – X 6 000 units
Y 7 500 units
Z 9 000 units
(b) ABC income statement

Capacity required
X 12 000 × 0,75 (6 000 / 8 000) = 9 000
Y 15 000 × 0,30 (3 000 / 10 000) = 4 500
Z 20 000 × 0,50 (6 000 / 12 000) = 10 000
23 500
Capacity available
15 000 = 80%
18 750 = 100% machine hours
“Machine hours” is a limiting factor of production
Maximum ABC profit
X Y Z
Selling price 21,00 16,00 10,00
Variable costs 10,00 8,00 4,00
Fixed costs 9,00 5,40 2,00
ABC profit 2,00 2,60 4,00
Machine hours 0,75 0,30 0,50
Profit per hour 2,66 8,67 8,00
Maximise 3 1 2
Hours
Produce Y 15 000 units × 0,3 4 500
Z 20 000 units × 0,5 10 000
X 5 666,7 units × 0,75 4 250
18 750
Income statement for the quarter ending 30 September 19X0

X Y Z Total
Sales – units 5 666 15 000 20 000
R R R R
Sales 118 986 240 000 200 000
Production –
Variable costs @ 8 45 328 @ 6 90 000 @ 2 40 000
Fixed costs @ 9 50 994 @ 5,4 81 000 @ 2 40 000
Gross profit 22 664 69 000 120 000 211 664
Over-recovered overhead + 21 994
Variable selling 40 666 × 2 – 81 332
Fixed selling – 30 000
Profit R122 326
Fixed cost recovered

X 5 666 × 9 = 50 994
Y 15 000 × 5,4 = 81 000
Z 20 000 × 2 = 40 000
171 994
Budget 150 000
Over recovered 21 994
(c) Variable costing

X Y Z
Contribution 11 8 6
Machine hours 0,75 0,30 0,50
Contribution per hour 14,66 26,67 12
Maximise 2 1 3
Hours
Produce X 12 000 units × 0,75 9 000
Y 15 000 units × 0,3 4 500
Z 10 500 units × 0,50 5 250
18 750
Income statement for the quarter ending 30 September 19X0

X Y Z Total
Sales – units 12 000 15 000 10 500
R R R R
Sales 252 000 240 000 105 000
Production –
Variable costs @8 96 000 @6 90 000 @2 21 000
156 000 150 000 84 000 390 000
Variable selling 37 500 × 2 – 75 000
Contribution 315 000
Fixed production – 150 000
Fixed selling – 30 000
Profit R135 000
(d) Reconciliation
ABC profit R122 326
12 674
Variable ABC Total

Contribution
X 12 000 – 5 666 = 6 334 × 11 + 69 674
Y 15 000 – 15 000 = 0
Z 10 500 – 20 000 = – 9 500 × 6 – 57 000
12 674
Cost classification and
6 estimation
l define cost behaviour and explain the concepts of variable, fixed and mixed costs
l calculate fixed and variable costs using the high-low and least squares methods
l calculate and interpret the co-efficient of correlation, standard error of the estimate and
significance of a relationship
l discuss the steps required when analysing data using the least squares method
l discuss the limitations of cost behaviour analysis
l calculate costs using learning curve data
l understand the application of learning curve costs
l calculate average cost per unit of cumulative production and marginal cost for the
incremental order using the learning curve concept
Cost classification
Costs are often classified on a functional basis or on a behavioural basis. Functional cost classification
refers to a cost allocation to departments such as manufacturing and administration. This type of
cost classification is used for external reporting.
Behavioural cost classification refers to the way costs change in relation to changes in the volume of
activity, eg fixed and variable costs. This type of classification is necessary for internal decision-
making, such as the evaluation or elimination of a product division. Management will want to know
which costs will be eliminated in total, partially, or will remain unchanged, in order to evaluate the
effect on the company of closing down an unprofitable division or product. Although costs behave in
many different ways, the main classification categories are:
1 Fixed
2 Variable
3 Semi-fixed
4 Semi-variable
5 Mixed.
Fixed costs
Fixed costs are costs that do not change with increases or decreases in activity level (production)
within the “relevant range”. For example, rent is a fixed cost whether production is increasing or
decreasing. It is important to note that the relevant range criteria must be applied. In other words, as
soon as production exceeds the current capacity, it becomes necessary to increase the production
facilities, which will result in increased rent.
175
Cost
R
Total fixed costs
Activity level
Relevant range
Figure 1
The total fixed cost may be related to the cost per unit of production. In such a situation, the cost per
unit will decrease as activity increases.
Production (units) 10 000 20 000 25 000
Fixed cost R100 000 R100 000 R100 000
Cost per unit R10 R5 R4
Variable costs
Variable costs are costs that increase directly and proportionately with the level of activity. The ratio
between the change in the cost and the change in the level of activity is always constant.
Cost
R
Total
variable
cost
Activity level
Figure 2
The total variable cost will increase as activity increases, while the variable cost per unit will remain
unchanged.
Production (units) 10 000 20 000 25 000
Variable cost R50 000 R100 000 R125 000
Cost per unit R5 R5 R5
Semi-fixed costs
Semi-fixed costs increase with increased levels of production, but by intermittent (or stepped) jumps
rather than continuously.
Cost
Activity level
Figure 3
Chapter 6: Cost classification and estimation 177
Semi-variable costs
Semi-variable costs are costs that increase with production, but not on a proportionate basis. They
can be classified into costs that increase at a decreasing rate and costs that increase at an increasing
rate. Semi-variable costs that increase at a decreasing rate are often referred to as learning curve
costs.
Cost Total Total

cost cost
R
Activity Activity
Figure 4
Mixed costs
Mixed costs are often referred to as semi-variable costs. Mixed costs cannot be described by a single
cost behaviour pattern and include elements of fixed and variable costs. It is necessary to
differentiate between the fixed and variable cost element for decision-making purposes.
Cost
R Total cost
Variable
Fixed
Activity level
Figure 5
Most indirect costs, as well as labour costs, exhibit mixed cost characteristics.
Many examination questions bring mixed costs into a question by showing the cost structure at two
different levels of activity. Never assume that certain costs are variable simply because the name
thereof (such as labour) implies that they are variable.
Example
You are given the following cost budget at two different levels of activity.
Units Units
60 000 80 000
R R
Direct materials 600 000 800 000
Labour 400 000 500 000
Production overheads 380 000 440 000
Rent 120 000 120 000
Power 200 000 260 000

Determine the fixed and variable cost structure.
Solution
Differential Variable
Units Units units unit cost
60 000 80 000 20 000
R R R R
Direct materials 600 000 800 000 200 000 10
Labour 400 000 500 000 100 000 5
Production overheads 380 000 440 000 60 000 3
Rent 120 000 120 000 – –
Power 200 000 260 000 60 000 3
Direct materials
Variable cost R10 per unit
At 60 000 unit level variable costs = R10 × 60 000 = R600 000 no fixed cost
Labour
Fixed cost R400 000 – (R5 × 60 000) = R100 000
Production overheads
Fixed cost R380 000 – (R3 × 60 000) = R200 000
Rent
Fixed cost of R120 000
Power
Fixed cost R200 000 – (R3 × 60 000) = R20 000
Identification of fixed and variable components

High/low method
The high/low method of cost estimation is a simple and widely-used method of identifying the fixed
and variable cost elements for given cost data.
Example

Month Cost Activity
(units produced)
1 R120 000 20 000
2 R150 000 30 000
3 R140 000 26 000
4 R90 000 15 000
5 R100 000 18 000
6 R130 000 25 000
Calculate the fixed and variable costs
Solution
Month Cost Activity
2 R150 000 30 000
4 R90 000 15 000
Difference R60 000 15 000
R60 000 divided by 15 000 = R4 per unit
Fixed cost = R150 000 – (30 000 × 4)
= R30 000
Assuming that in month 7 we expect the activity level to be 32 000 units, the estimated total costs
are:
R
Variable 32 000 × R4 128 000
Fixed 30 000
Total cost R158 000
There are two problems associated with the high/low shown in the example above.
(i) The highest and lowest values may not necessarily be representative of the population.
(ii) The two values taken are extremes and may fall outside the average cost expectation.
Linear regression analysis

Regression analysis is fundamentally a method of using a sample of past cost behaviour information
to estimate how the entire population of costs actually behave. The technique establishes the fixed
cost value of the population within a relevant range and estimates the variable cost per unit.
A linear regression analysis exercise can only be carried out within a relevant range where:
(a) Future circumstances are likely to be similar to those under which the historical data was
recorded.
(b) All cost data has been adjusted to current prices.
(c) The error terms are normally distributed around the regression line.
Remember, we are trying to obtain a linear relationship of a non-linear cost function over the
relevant range.
Regression analysis compares cost to volume of output, or costs to an identifiable resource input
such as labour hours.
The cost is dependent on the volume of output.
Example
Output 1 000 units = Total cost R5 000
Output 2 000 units = Total cost R8 000
An increase in volume has a resultant increase in cost, not vice-versa.
Therefore:
Output = independent variable
Total cost = dependent variable
It is possible that costs are affected not only by an increase in output but also by an increase in
labour hours, in which case
Output = independent variable
Labour hours = independent variable
Total cost = dependent variable
When the relationship between a dependent variable and one independent variable is analysed, the
analysis is called a “simple linear regression”. If more than one independent variable is considered,
the analysis is called “multiple regression”. This chapter will examine simple linear regression only.
Usually the independent variable is denoted by x and the dependent variable by y.
The general least squares linear equation is denoted as:
y = a + bx
where:
y = calculated value of the dependent variable
a = intercept of the regression line (fixed cost)
x = independent variable
b = slope of the regression line (variable cost)
a and b are constants
For multiple regressions, the equation would look as follows:
y = a + b1x1 + b2x2 + b3x3
where b1 could represent the variable cost for labour hours x1
b2 could represent machine hours
b3 could represent units of production
The objective of a regression analysis is to determine from a sample of data the cost structure (ie
variable and fixed costs) that best fits our sample.
The true regression line could deviate from our estimate because:
(i) the fixed cost could be different
(ii) the slope or variable cost could be different.
We would therefore draw a normal curve from a sample as follows:
Cost Estimate1
Activity
Figure 6
In the above diagram, Estimate1 represents the regression equation from the given data. The dotted
lines represent possible deviations around the mean estimate.
The following example illustrates the steps required to do a regression analysis of cost data from a
given sample.
Example
Month Direct labour Production Overtime
cost (units) (hours)
1 R100 000 490 120
2 R70 000 250 300
3 R130 000 650 60
4 R110 000 600 50
5 R120 000 550 200
6 R110 000 450 200
7 R90 000 320 100
8 R100 000 350 80
9 R90 000 380 50
10 R78 000 190 150
Assuming the above data is within the relevant range.
Show the steps you would take in analysing the information using simple linear regression
analysis methods.
Solution
Step 1
Economic plausibility
The first criterion that must be satisfied before a regression analysis is carried out is that of economic
plausibility. In our example, we must ask “Is it plausible that the direct labour costs vary with
production?” If so, then an analysis of the correlation may be carried out. “Is it plausible that labour
costs vary with the number of overtime hours?” In our example it is highly unlikely, therefore we
should not use overtime hours as a possible independent variable.
A high correlation between the dependent variable and the independent variable merely indicates
that the two variables move together. No conclusions about cause and effect are warranted.
Knowledge of the production operation will help to identify possible independent variables. The
regression analysis will then support or refute our observations, based on the degree of correlation
between the dependent and independent variables.
Step 2
Scatter diagram
A scatter diagram is plotted once you have determined the independent measure to be used in the
regression analysis. In our example, the independent variable is units of production. A graph is then
drawn plotting the direct labour costs on the y axis and the production activity on the x axis.
The scatter diagram should give a visual confirmation of whether a linear or non-linear relationship
exists. It also helps to identify data which may be discarded as exceptional.
Cost Cost
R R
linear relationship Non-linear

Activity Activity
(Independent variable)
Figure 7
Note: If you are given the scatter diagram in an examination look out for stepped costs, a definite
change in the slope of the variable costs, and the relevant range.
Step 3
Using simultaneous equations, determine the fixed and variable costs
The objective is to find the values of a and b in the prediction equation, y = a + bx. The value of a =
fixed cost and of b = variable cost is determined by substituting in the following normal equations.
1 y = na + bx
2 xy = ax + bx2
Where n = number of observations
The line of best fit y = a + bx found by this method is called the regression line of y on x.
Tabulation
Units Direct labour cost
x y xy x2
’000 ’000
490 100 49 000 240 100
250 70 17 500 62 500
650 130 84 500 422 500
600 110 66 000 360 000
550 120 66 000 302 500
450 110 49 500 202 500
320 90 28 800 102 400
350 100 35 000 122 500
380 90 34 200 144 400
190 78 14 820 36 100
4 230 998 445 320 1 995 500
Substituting into the two simultaneous equations we get:
998 000 = 10a + 4 230b (1)
445 320 000 = 4 230a + 1 995 500b (2)
a = 99 800 – 423b (1)
445 320 000 = 4 230 (99 800 – 423b) + 1 995 500b (2)
b = 112,34178
a = 52279,42
Within the relevant range the fixed costs are R52 279 and the variable cost is R112,34178 per unit.
If the company is budgeting to produce 580 units in the forthcoming month, then the estimated
costs can be calculated as follows:
Total costs = 52 279 + (580 × R112,34178)
= R117 437,23
Step 4
Correlation or goodness of fit
Regression analysis is not a technique that can be used in any situation. One must be careful that the
assumptions underlying the regression are valid for the particular cost analysis.
It is important to state once again that “We are trying to obtain a linear relationship of a non-linear
cost function over the relevant range”. In other words, we can only obtain an approximation of how
the costs should behave over the relevant range.
Cost
y
R Regression line
Mean
Activity (Production)
Figure 8
Perfect correlation
The above diagram shows a situation where all observed total costs in relation to increased activity
lie on the regression line. They are perfectly correlated with a zero variation. The difference in costs
between the observed cost y and the mean cost of the population y is explained by the variation in
production. In other words, the mean is a constant figure regardless of activity level, while the actual
costs will be above or below the mean as activity increases or decreases.
Regression line
y y1
Cost y
R
y1
Mean
y
Activity (production)
Figure 9
Correlation less than 1

The above diagram depicts a typical scatter diagram of observed cost points where a calculated
regression line has been fitted. We now observe that the points on the diagram do not lie on the
regression line itself. The further away from the regression line, the less reliability we can place on
the estimated regression. How accurate is the regression line as a basis for prediction?
The explained variation (as mentioned previously) is the difference between the mean and the
computed regression point y1. The unexplained variation is the difference between y and y1.
y–y = (y – y1) + (y1 – y )
Total Unexplained Explained
Variation Variation Variation
The above relationship is employed to evaluate the goodness of fit of the regression line using the
following equation:
(y1 – y)2 / N Explained sum of squares
r2 = 2
=
(y – y) / N Total sum of squares
r2 is called the co-efficient of determination.
r2 is at its maximum when all values of y1 equal y (as in diagram 1).
r2 is the percentage of variation in total costs explained by variation in activity. The square root
of r2 is called the co-efficient of correlation and the sign is the same as the regression co-
efficient b.
Tabulation
y y y1
100 000 99 800 107 326
70 000 99 800 80 364
130 000 99 800 125 301
110 000 99 800 119 684
120 000 99 800 114 067
110 000 99 800 102 833
90 000 99 800 88 228
100 000 99 800 91 598
90 000 99 800 94 969
78 000 99 800 73 624
Substituting in the equation
(y1 – y)2 / N
r2 =
(y – y)2 / N
we get
r2 = 0,844
r = 0,919
The co-efficient of determination is actually the ratio of the variance of the regression line about the
mean value of R99 800 to the total variance of the actual data points about the mean.
The co-efficient of determination of 0,844 indicates that of the total variance of direct labour costs
about the mean of R99 800, 84% of the fluctuation can be explained by knowing the number of units
produced during a particular month.
Step 5
Standard error of estimate
We have calculated the estimated fixed costs for future predictions, but we also know that in
calculating the fixed and variable costs we used a sample of data. If we duplicated the exercise using
different sample data, we would get a different fixed and variable cost estimate.
The values of a and b are estimates based on a sample. In statistical analysis we compute the
standard deviation and the co-efficient of variation to help indicate the degree of dispersion about
the mean. In the same way we need to compute the dispersion of the observed values of y around
the regression line.
The measure of the dispersion is termed the standard error of estimate and is calculated using one of
the two following equations.
(y – y1)2
Se =
n–2
OR:
y2 – a y – b xy
Se =
n–2
The denominator n – 2 is called the “degrees of freedom”. The figure 2 is subtracted because, based
on our sample of observations, we estimated the values of the a and b regression co-efficients.
From our example we get Se = 7 758
The standard error of the estimate can be used to make probabilistic estimates about future costs.
For example, the estimated total cost for a production run is calculated as
52 279 + (580 × R112,34178)
= R117 437,23
To help gauge our confidence in the above prediction, we adjust our value by the standard error.
Approximately 68% of the points should lie within the band plus/minus one standard error.
Therefore total cost = R117 437,23 plus/minus R7 758
If we require a 95% confidence of the estimate, then from t- value tables the adjustment is
determined as follows:
Number of observations 10
Constants 2
Therefore n – 2 = 8
From t- value tables t.025 (95% confidence) column and reading across at 8 observations, we get a
factor of 2,306.
Therefore 95% confidence for a production of 580 units
= R117 437,23 plus/minus (2,306 × R7 758)
= R117 437,23 plus/minus R17 890
Thus we can be 95% confident that total cost will lie in a band of R99 547 to R135 327.
Step 6
Significance of a relationship
The variable cost estimate of R112,34178 per unit implies that, for every unit of output produced,
the total cost increases by R112,34. It is possible that the relationship represented occurs by chance
and that there in fact is no relationship. If there is no relationship then the slope of the regression
line would be zero.
To test for the significance of a relationship, we determine if the value of “b” (the variable cost) is
significantly different to zero. If it is significantly different to zero, then we infer that a relationship
between the independent and the dependent variables exists.
Test that B =/ 0 (null hypothesis)
Calculate the standard error of the “b” co-efficient
Se
Sb =
x2 – x x
where Se = standard error of estimate. The denominator describes the dispersion of x values around
their mean.
In our example
7758
Sb =
1995 500 – 423 × 4 230
Sb = 17,08421
We now use our calculated Sb to compute the number of standard errors our sample value “b” is
from zero.
b 112,34
= = 6,58 = t – value
Sb 17,08
Therefore, “b” is 6,58 standard errors from B = 0, and we conclude that the deviation does not occur
by chance and that the co-efficient is a good estimate of the population. A deviation greater than
two standard errors is usually regarded as representing a significant relationship between the
variables.
Conclusion
Most examination questions do not require you to calculate the figures in steps 3 and 4 above as it is
very time consuming and the calculations too repetitive.
The more likely type of question is that in which you are given all the statistical information and are
required to comment on the significance of the information. In such cases the steps to be followed as
detailed above are
(a) test for economic plausibility
(b) does the scatter graph show a linear relationship?
(c) test for correlation
(d) test for significance of a relationship.
Values of t
Degrees of 80% 90% 95% 98% 99%
freedom
df t.100 t.050 t.025 t.010 t.005 df
1 3,078 6,314 12,706 31,821 63,657 1
2 1,886 2,920 4,303 6,965 9,925 2
3 1,638 2,353 3,182 4,541 5,841 3
4 1,533 2,132 2,776 3,747 4,604 4
5 1,476 2,015 2,571 3,365 4,032 5
6 1,440 1,943 2,446 3,143 3,707 6
7 1,415 1,895 2,365 2,998 3,499 7
8 1,397 1,860 2,306 2,896 3,355 8
9 1,383 1,833 2,262 2,821 3,250 9
10 1,372 1,812 2,228 2,764 3,169 10
11 1,363 1,796 2,201 2,718 3,106 11
12 1,356 1,782 2,179 2,681 3,055 12
13 1,350 1,771 2,160 2,650 3,012 13
14 1,345 1,761 2,145 2,624 2,977 14
15 1,341 1,753 2,131 2,602 2,947 15
16 1,337 1,746 2,120 2,583 2,921 16
17 1,333 1,740 2,110 2,567 2,898 17
18 1,330 1,734 2,101 2,552 2,878 18
19 1,328 1,729 2,093 2,539 2,861 19
20 1,325 1,725 2,086 2,528 2,845 20
21 1,323 1,721 2,080 2,518 2,831 21
22 1,321 1,717 2,074 2,508 2,819 22
23 1,319 1,714 2,069 2,500 2,807 23
24 1,318 1,711 2,064 2,492 2,797 24
25 1,316 1,708 2,060 2,485 2,787 25
26 1,315 1,706 2,056 2,479 2,779 26
27 1,314 1,703 2,052 2,473 2,771 27
28 1,313 1,701 2,048 2,467 2,763 28
29 1,311 1,699 2,045 2,462 2,756 29
inf 1,282 1,645 1,960 2,326 2,576 inf
df t.100 t.050 t.025 t.010 t.005 df
The t-value describes the sampling distribution of a deviation from a population value divided by the
standard error.
Degrees of freedom (df) appear in the first column. The probabilities indicated as sub-values of t in
the heading refer to the sum of a one-tailed area under the curve that lies outside the point t.
For example, in the distribution of the means of samples of size n = 20, df = n – 2 = 18, then 0,010 of
the area under the curve falls in one tail outside the interval t± 2,552.
Learning curves
“Learning” in individuals performing a task takes place when workers continuously perform a
repetitive task. Efficiency increases as the same task is performed repetitively and the time required
to do the job decreases exponentially. Learning will continue at the same rate until conditions
change or a steady state condition is reached. The rate of learning is specified as a percentage
associated with the learning curve. This rate of learning is usually related to average times to produce
units at a doubling of output.
Learning is calculated on the average time of cumulative production, not on the total time.
See example below.
Example
Assume it takes 40 hours to assemble a computer, and it has been determined that an 80%
learning curve is appropriate for estimating assembly time when output doubles.
Calculate the average unit time and the marginal unit time for the assembly of 16 computers.
Solution
Tabulation
Average and total times at doubling points
Marginal
Production Cumulative Average Total Total Average
production time time time unit time
1 1 40 40 40 40
1 2 32 64 24 24
2 4 25,6 102,4 38,4 19,2
4 8 20,48 163,84 61,44 15,4
8 16 16,384 262,14 98,3 12,3
Calculations
Average time : Previous average × 80%
Total time : Average time × Cumulative production
Marginal total time : Current total time – Previous total time
Marginal average unit time : Marginal total time ÷ Production
The above tabulation can be expressed graphically as follows:
40
Average
hours per
unit of
cumulative
production
32
25,6
Steady state
1 2 4
Figure 10 Cumulative quantity. In units
Learning curve
While the doubling points help to explain learning curves, practicality requires that the information
should be available at any level of output.
Note: Learning is often measured in batches of production; it is therefore important that you do the
calculations based on batches and not in single units.
Illustrative examples
Example 1
1st batch of production took 70 hours to manufacture.

2nd batch of production took 28 hours to manufacture.
What is the learning curve % ?
Solution
Learning is measured in the average production line.
Cumulative Marginal Total Average
1 70 70 70
2 28 98 49
70%
The average is based on a 70% learning curve.
Example 2
1st batch of production took 70 hours to manufacture.

1st two batches of production took 126 hours to manufacture.
What is the learning curve % ?
Solution
Cumulative Total Average Marginal
1 70 70 70
2 126 63 56
90%
The learning curve is 90%.
Example 3
A company manufactures a product and a budget has been prepared on the assumption that
the company will produce and sell 300 units.
Unit selling price R200
Costs per unit:
Variable labour R100
Fixed R50
The budget assumes that production will take place in batches of 100 units and the average
production time per unit is 5 hours. No learning has been assumed.
continued
The managing director believes that the budget does not reflect the correct cost structure as
he believes that learning does take place and that an 80% learning curve should be applied.

(a) Re-draft the budget based on an 80% learning curve.
(b) If a further order for 100 units is received, should the company accept a price of R50/
unit, and how much profit will it make?
X Y
1,0 100%
1,5 87,6%
2,0 80,0%
2,5 74,9%
3,0 70,7%
3,5 66,4%
4,0 64,0%
Solution
(a) Batch of 100 units takes 500 hours
Average time if 300 units (3 batches) are produced = 70,7%
Average time for 300 units is: 500 × 70,7% = 353,5 hours
Total time for 300 units: 353,5 × 3 = 1060,5 hours
Variable labour cost 1060,5 × 20 = R21 210
Fixed cost R50 × 300 = R15 000
Profit statement
R
Sales 60 000
Production costs
Variable 21 210
Fixed 15 000
Profit 23 790
(b) Incremental order of 100 units

Average time 500 × 64% = 320 hours
Total time for 400 units: 320 × 4 = 1 280
Total time for 300 units: 1 060,5
Marginal time 219,5
Marginal cost 219,5 × R20 = R4 390
Marginal revenue 100 × R50 = R5 000
Marginal profit R610
Mathematical method
Note: It is not necessary at most educational institutions to calculate aspects of the learning curve
using mathematical methods. Before you proceed, find out if you need to study this section.
The mathematical learning curve relationship can be expressed as:
y = axb
Where:
y= cumulative average time per unit when x units are produced
a= time required to produce the first unit
x= cumulative number of units produced
b= measure of learning
The log transformation of the above equation is
log y = log a + b.log x
log (learning %)
b is determined as b =
log 2
Using the information given in our example, and assuming we want to compute the cumulative
average time to produce three units, the calculation is carried out as follows:
log 0,80 9,9031 – 10
b = = = – 0,322
log 2 0,301
substituting in y = axb we get

log y = log 40 + (– 0,322).log 3
log y = 1,6021 + (– 0,322 × 0,4771) = 1,4485
y = 28,1
Tabulation: Average and total times per unit

Production Cumulative Average Total Marginal
production time time time
1 1 40 40 40
1 2 32 64 24
1 3 28,1 84,3 20,3
1 4 25,6 102,4 18,1
1 5 23,86 119,3 16,9
1 6 22,46 134,8 15,5
1 7 21,40 149,7 14,9
1 8 20,48 163,8 14,1
1 9 19,71 177,4 13,6
1 10 19,06 190,6 13,2
The mathematical calculation can only give us average time per unit. If we want to know how long it
will take to produce the 10th unit, then we must calculate the total time taken for 10 units as well as
for 9 units and subtract the difference.
Example
Calculate the estimated labour cost to assemble the 15th computer at an hourly cost of R20.
Solution
Using the equation y = axb
Average time for 14 units y = 17,1
Average time for 15 units y = 16,73
Total time for 14 units: 14 × 17,1 = 239,4 hours
Total time for 15 units: 15 × 16,73 = 250,95 hours
Actual time for unit 15: 250,95 – 239,4 = 11,55 hours
at a cost of R20 per hour, the assembly cost for computer 15 is computed as:
R20 × 11,55 = R231
Calculating the rate of learning

Assume that the following information is given:
Assembly of 4 computers took 129,6 hours
Assembly of 10 computers took 282 hours
What is the rate of learning ?
Step 1
Average time for 4 computers = 32,4
Average time for 10 computers = 28,2
Step 2
Solve 2 simultaneous equations where
log y = log a + b log x
log (32,4) = log a + b log(4) (1)
log (28,2) = log a + b log(10) (2)
1,5105 = log a + b.6021 (1)
1,4502 = log a + b (2)
Subtracting 0,0603 = – 0,3979 b
Therefore b = – 0,1515
Step 3
log (learning %)
Substituting in the equation b =
log 2
log x
– 0,1515 =
0,301
– 0,0456 = log x
9,9544 – 10 = log x
0,9 = x
or 90% learning curve
The learning effect as discussed in this chapter only applies to direct labour costs and those variable
overhead costs which use a direct function of labour hours of input.
Refer to the chapter on “Budgeting” for an example of the application of learning curves on
manufacturing budgets and cash budgets.
Appendix
A company manufactures a product and a budget has been prepared on the assumption that the
company will produce and sell 300 units.
Unit selling price R200
Costs per unit:
Variable labour R60
Fixed R50
The budget assumes that production will take place in batches of 100 units. No learning has been
assumed.
The managing director believes that the budget does not reflect the correct cost structure as he
believes that learning does take place in batches of 100 units and that an 80% learning curve should
be applied. The variable overheads vary directly with labour hours.

(a) Re-draft the budget based on 80% learning curve.
(b) If a further order for 100 units is received, indicate whether the company should accept a price
of R50/unit and how much profit it will make.
X Y X Y
1,0 100% 3,0 70,7%
1,5 87,6% 3,5 66,4%
2,0 80,0% 4,0 64,0%
2,5 74,9%
Solution
(a) Batch of 100 units will cost
Variable labour R60 × 100 = 6 000
Variable overhead R60 × 100 = 6 000
R12 000
Learning curve factor for 3 batches of production = 70,7%
Average cost for 300 units is: R12 000 × 70,7% = R8 484
Total cost for 300 units (3 batches): R8 484 × 3 = R25 452
Fixed cost R50 × 300 = R15 000
Profit statement
R
Sales 60 000
Production costs
Variable 25 452
Fixed 15 000
Profit 19 548
(b) Incremental order of 100 units

Average cost R12 000 × 64% = R7 680
Total cost for 400 units: R7 680 × 4 = R30 720
Total cost for 300 units: R25 452
Marginal cost R5 268
Marginal revenue 100 × R50 = 5 000
Marginal profit R268
Practice questions
Kinetics Ltd manufactures a product used in the motor industry, but has found that monthly demand
for the product fluctuates greatly, depending on the demand for motor vehicles. The company
manufactures to order and it is sometimes necessary to have extra machines when demand is
particularly high.
Kinetics Ltd is machine-intensive but also has a very large labour force. The company is concerned
about manufacturing costs and has asked you to analyse the cost structure and report on the
manufacturing cost per unit. Your initial analysis has produced the following data:
Machine hours Labour hours
Sample size 21 28
Co-efficients of regression equation:
Constant R125 000 R186 000
Independent variable R7,65 R15,80
Co-efficient:
of correlation 0,90 0,86
of determination 0,81 0,74
Standard error of estimate (Se) 18 265 26 280
Standard error of regression
Co-efficient for independent variable (Sb) 2,50 1,98
True t statistic for 90%confidence interval (n – 2)d / f 1,729 1,706

R’000
500
R’000
375
350
325
300
250 250
200
175
150
125
100
50
5 10 15 20 25 30 35 40 45 50 1 2 3 4 5 6 7 8 9 10
Machine hours ’000 Labour hours ’000
Figure 11
The above figures are based on a monthly production run at different levels of production. Orders
have been placed for the forthcoming quarter as follows:
Quarter 3
Month Units Machine hours Labour hours
1 4 000 6 000 4 000
2 18 000 24 000 6 000
3 32 000 45 000 10 000
Kinetics Ltd is interested in taking on a special order in months 1 and 2, and has requested that you
advise them on the estimated cost per unit on the special orders.
Special order
Month Units Machine hours Labour hours
1 12 000 17 000 5 000
2 4 000 6 000 4 000

(a) Compare the statistical evidence available and give an opinion on which activity best describes
the cost behaviour. (18 marks)
(b) Prepare a statement for Quarter 3 showing the expected cost structure at a 90% confidence
level for:
(i) normal orders
(ii) special orders.
Comment on how you arrived at your estimated cost structure. (17 marks)
Solution
(a) Comparison of statistical evidence
Regression analysis is fundamentally a method of using a sample of past cost behaviour information
to estimate how the entire population of costs actually behaves. The technique establishes the fixed
cost value of the population within a relevant range and estimates the variable cost per unit.
A linear regression analysis exercise can only be carried out within a relevant range where:
(a) Future circumstances are likely to be similar to those under which the historical data was
recorded.
(b) All cost data has been adjusted to current prices.
(c) The error terms are normally distributed around the regression line.
Regression analysis compares cost to volume of output, or costs to an identifiable resource input
such as labour hours.
The cost is dependent on the volume of output.
Step 1 – Economic plausibility

The first criterion that must be satisfied before a regression analysis is carried out is that of economic
plausibility. On the basis of the data given in the question, it is plausible that costs vary with either
machine hours or labour hours.
Step 2 – Scatter diagram

A scatter diagram should give a visual confirmation of whether a linear or non-linear relationship
exists. On the basis of the above “Machine hours” diagram, it would appear that there is a linear
relationship for machine hours up to 20,000 machine hours. At this level, all costs increase by
approximately R75 000, which suggests that fixed costs are incurred at this level. When demand is
high, the company hires extra machines. This seems to take place at the 20 000 machine hour level.
From 20 000 machine hours through to 40 000 hours (the relevant range), there continues to be a
linear relationship.
There also appears to be a linear relationship for labour hours.
Step 3 – Determination of fixed and variable costs

Machine Labour
Fixed cost R125 000 R186 000
Variable cost per hour R7,65 R15,80
Step 4 – Goodness of fit

To determine how reliable a chosen activity is in predicting costs, we must determine the total
dispersion of the observations and compare this with the dispersion that occurs when hours of
activity are used in predicting costs. The degree of association between two variables such as cost
and activity is normally referred to as “correlation”. The correlation co-efficient r is the square root of
the co-efficient of determination. If the degree of association between the two variables is very
close, it will be almost possible to plot the observations on a straight line, and r and r2 will be near
to 1. In the given data, “Machine hours” shows a better correlation than “Labour hours” and is
therefore a better predictor.
Step 5 – Standard error of the estimate

The co-efficient of determination gives us an indication of the reliability of the estimate of total cost
based on the regression equation, but it does not give us an indication of the absolute size of the
probable deviations from the line. This information is obtained from the standard error of the
estimate. As expected, “Labour hours” has a higher standard error than “Machine hours”.
Step 6 – Significance of a relationship

The variable cost estimate implies that for every unit of output produced, the total cost increases by
the variable cost. It is possible that the relationship represented occurs by chance and that there is,
in fact, no relationship. If there is no relationship, then the slope of the regression line would be zero.
To test for the significance of a relationship, we determine if the value of “b” is significantly different
to zero. If it is, we infer that a relationship exists between the independent and the dependent
variables.
Test that B does not equal zero
7,65 15,80
2,50 1,98
= 3,06 = 7,98
“Labour hours” has a higher standard error factor, which indicates that the variable cost factor for
“Labour hours” is a better predictor than “Machine hours”.
In conclusion, I believe that the “Machine hour” analysis is superior, but it is necessary to re-analyse
the cost structure before and after the 20 000 machine hours level, as fixed costs increase at this
point.
(b) Cost estimation

From the scatter diagram the estimated cost behaviour is as follows:
From 0 machine hours to 20 000 hours:
Machine hours Cost
0 175 000
20 000 250 000
Fixed cost = R175 000
250 000 – 175 000
Variable cost = = R3,75
20 000
From 20 000 hours to 40 000 hours

Incremental fixed costs (325 000 – 250 000) = 75 000
Machine hours Cost
20 000 325 000
40 000 375 000
Increased hours 20 000 – Increased cost R50 000
50 000
Variable costs above 20 000 hours = = R2,50
20 000
R3,75 also acceptable
Final cost structure

0 – 20 000 hours Fixed costs R175 000 Variable costs R3,75
20 000 – 40 000 hours incremental Fixed costs R75 000 Variable costs R2,50
The standard error for the above calculation will be lower than the R18 265 given in the
question. I will assume a standard error of R10 000.
Variability = +/– 10 000 × 1,729 = +/– 17 290
For a 90% confidence interval, the predicted costs are as follows:
Normal order
Month 1 175 000 + ( 6 000 × 3,75) = 197 500 +/– 17 290
Month 2 250 000 + (20 000 × 3,75) + ( 4 000 × 2,50) = 335 000 +/– 17 290
Month 3 250 000 + (20 000 × 3,75) + (25 000 × 2,50) = 387 500 +/– 17 290
The estimated cost for month 3 is outside the relevant range of 40 000 machine hours and
assumes that there will be no incremental fixed costs and that variable costs will continue at the
level of R2,50 per hour.
Special order
Month 1 75 000 + (14 000 × 3,75) + (3 000 × 2,50) = 135 000
Month 2 6 000 × 2,50 = 15 000

PART A
Learning curves
Direct labour needed to make the first machine is 1 000 hours.
Learning curve is 80%.
Direct labour cost is R3 per hour.
Direct materials cost is R1 800 per machine.
Fixed cost for any size order is R8 000.

Calculate the expected average unit cost of making 1 machine, 4 machines and 8 machines.
PART B
Learning curves
The first machine took 800 hours to manufacture; the second machine took 320 hours to
manufacture. What is the learning %?
PART C
Learning curves
The first machine took 1 000 hours to manufacture. The first two machines took 1 800 hours to
manufacture. What is the learning %?
Solution
PART A
Machines Average Hours
1 1 000 1 000
2 1 000 × 0,8 800
4 800 × 0,8 640
8 640 × 0,8 512
Costs 1 machine 4 machines 8 machines

R R R
Labour 3 000 7 680 12 288
Materials 1 800 7 200 14 400
Fixed costs 8 000 8 000 8 000
Total 12 800 22 880 34 688
Average cost per machine R12 800 R5 720 R4 336
PART B
Average 1st machine 800 hours
Total 2 machines 1 120 (800 + 320)
Average 2 machines 560
Learning curve 70%
ie 800 × 70% = 560
PART C
Average 1st machine 1 000 hours
Average 2 machines 900 (1 800 / 2)
Learning curve 90%

A company has to quote for a special order to be made in its two departments, R and S.
Details are as follows:
Department R Department S
Standard direct wage rate (per hour) R50 R30
Standard variable overhead (Per hour) R25 R20
Standard fixed overhead (per hour) R60 R40
Direct labour hours per unit (for first 100 units) 12 6
Direct labour hours available (per period) 4 000 3 000
Expected rate of learning curve (applied per block of 100 units) 80% 70%
You are to assume that learning is applicable to both labour and variable overheads. Fixed overheads
are recovered on a labour hour basis.
Cost of direct materials used in Department R:
Level of output Cost per unit of output
100 R360
200 R324
800 R270
No overtime premium has been included in the calculation of overhead but, when necessary,
overtime is paid at time and a half.
The special order involves special tooling to be used in department R at a total cost of R6 000,
chargeable to the customer.
In arriving at selling prices, the company adds profit margins of:
25% of total cost in Department R
15% of total cost in Department S
5% of total cost on any sub-contractor’s work
No profit margins are added to direct materials or to special tooling.
If the order is for 200 units or fewer, it will need to be done during period 5, which already has a
work-load of:
Department R 2 560 direct labour hours
Department S 1 400 direct labour hours
For this order, a sub-contractor has quoted R160 per unit for the work that would be done by
Department S.
Because of the sub-contractor’s apparently competitive prices and the fact that Department S has
been operating at rather low levels, the company is wondering whether it should close Department S
and have the sub-contractor do the work that Department S normally does.

(a) Recommend the price to be charged for units made entirely within the company for an order of
(i) 100 units (4 marks)
(ii) 200 units (10 marks)
(b) Assuming an order for 200 units has been placed as in (a)(ii) above, recommend the lowest
price the company could charge for an additional order of 600 units under the following
conditions:
l The company wished to treat this as an incremental order but did not wish to make a loss on
it, and
l the additional work would be done when there were no capacity constraints for either
department, and
l the materials supplier would charge the required 600 units at R270 per unit. (15 marks)
(c) Recommend in what circumstances
(i) the sub-contractor should be used for this order (5 marks)
(ii) you would agree to the idea of closing Department S and having its work done by the
sub-contractor. (6 marks)
Solution
1 Workings
Department R Department S
Normal labour hours available 4 000 3 000
Existing work load 2 560 1 400
Special order
(100 units) 100 × 12 1 200 100 × 6 600
Total 3 760 2 000
Special order (200 units) 200 × 6 × 70%
200 × 12 × 80% 1 920 840
Less 100 order 1 200 720 Less 100 order 600 240
Total 4,480 2,240
Overtime hours
480 × R50 × 50% = R12 000
R12 000 ÷ 200 = R60 per unit premium
Note: Normal time has already been charged. The above calculation is just the premium.
(a) Cost statement

(i) (ii)
100 units 200 units
R R
Department R
Direct labour 12 × R50 600 at 80% 480
Variable overhead 12 × R25 300 at 80% 240
Fixed overhead 12 × R60 720 9,6 × R60 576
Overtime premium 60
1 620 1 356
Department S
Direct labour 6 × R30 180 at 70% 126
Variable overhead 6 × R20 120 at 70% 84
Fixed overhead 6 × R40 240 4,2 × R40 168
Overtime premium
Special tools R6 000 / 100 60 at 50% 30
960 732
Total 2 580 2 088
Profit:
Department R 25% of R1 620 405 of R1 356 339
Department S 15% of R540 81 of R378 56,70
Selling price per unit R3 066 R2 483,70
Recommended price
(i) 100 units at R306,60 each
(ii) 200 units at R248,37 each.
(b) Order for 600 units incremental to, but combined with, the order for 200 units, making 800
units in all.
Basis: No capacity restraints, fixed overheads already recovered and no profit on the 600 units.
200 units per
(a)(ii) 800 units
R R
Department R 480 R720 × 0,8 × 0,8 460,80
Direct labour 240
Variable overhead
Department S
Direct labour 126 R210 × 0,7 × 0,7 102,90
R930 R563,70
R
Cost of 800 units as above at R563,70 450 960
Cost of 200 units as above at R930 186 000
Therefore 600 units 264 960
Material @ R270 × 600 162 000
426 960
An incremental order for 600 units with no capacity restrictions, fixed overhead already
recovered and no profit could be charged at R711,60 each or R426 960 for the 600 units.
(c) (i) When the sub-contractor should be used for this order instead of Department S
R per unit
Sub-contractor’s price 160
Department S’ variable cost:
Direct labour 6 × R30 180
Variable overhead 6 × R20 120
300
First 100 units 300
200 units R300 × 0,7 210
400 units R210 × 0,7 147
800 units R147 × 0,7 102,9
For the present order the sub-contractor would be cheaper, and therefore could be used
on the 100 or 200 units orders but not on the 800 unit order.
(ii) Circumstances warranting closing Department S and using the sub-contractor
l if the fixed costs of R120 000 (R40 × 3 000) could be eliminated
l if the contribution from Department S is less than R120 000 per year (3 000 hours ×
R40 per hour fixed overhead)
l if normal orders are for 200 units or less for work similar to the special order
l if the contractor is willing to enter into a long-term contract based on the R160 per
unit or its equivalent, his quality of work is good and his delivery is reliable.

Babel Ltd produces a single product. The company’s directors want to explore new markets, and
require an accurate analysis of the firm’s cost structure for both forecasting and pricing purposes. An
attempt to provide this analysis from the aggregation of individual costs has produced a poor
correspondence between actual and predicted costs. You are an accountant employed by Babel Ltd,
and have been asked to provide a statistical approach to the problem.
The financial director has given you the following data:
Month Output Average unit cost
units (000’s) R
January 9 12,80
February 14 13,00
March 11 11,40
April 8 12,00
May 6 13,00
June 12 11,70
You obtain the following further information:

1 The costs from which the averages have been computed consist of the firm’s entire costs for the
relevant months.
2 Fixed costs can be assumed to be unaffected by seasonal factors, except for winter heating. In
January and February, a supplementary heating system was employed; this cost R10 000 per
month to operate.
You are asked to transform the original data in any way that may be necessary. Work to the nearest
R100 for total costs and to the nearest 10c for unit cost calculations.

(a) Estimate Babel Ltd’s normal fixed and variable cost of production using linear regression,
showing full workings. (12 marks)
(b) Draw a graph of Babel Ltd’s costs versus output to provide a better analysis of costs than
regression estimates in (a), estimate the point at which variable costs change and estimate the
linear cost relationships over the relevant ranges (8 marks)
(c) Use your answer from (b) to provide an analysis of costs from January to June, set out in
spreadsheet format (ie rows and columns). Divide the rows into relevant cost categories to
explain observed costs, and treat any residual amounts as unexplained differences. (10 marks)
(d) Discuss the difficulties which may be encountered in preparing and using statistical cost
estimation in practice. (10 marks)
Solution
(a) Units Cost
6 000 78 000
9 000 105 200
Marginal 3 000 27 200
Variable costs – 27 200 / 3 000 = R9,07
Fixed costs – 78 000 – (6 000 × 9,07) = R23 580
Normal
total
costs 180
’000
160
140
120
100
80
60
40
20
0 2 4 6 8 10 12 14
Output (’000) units 10,7
Figure 12
Normal total
Month Output units Costs
(000’s) R’000
January 9 105,2 (115,2 – 10)
February 14 172,0 (182,0 – 10)
March 11 125,4
April 8 96,0
May 6 78,0
June 12 140,4
Linear regression analysis

Let x = output in 000’s units
y = normal total costs in R’000
n = 6
x y x2 xy
9 105,2 81 946,8
14 172,0 196 2 408,0
11 125,4 121 1 379,4
8 96,0 64 768,0
6 78,0 36 468,0
12 140,4 144 1 684,8
60 717,0 642 7 655,0
y = na + bx
xy = ax + bx2
717 = 6a + 60b (1)
7 655 = 60a + 642b (2)
a = 119,5 –10b (1)
7 655 = 60(119,5 – 10b) + 642b (2)
485 = 42b
b = 11,55
a = 4,5 or R4 500
Estimates: Normal fixed costs R4 500 per month
Normal variable costs R11,50 per unit
(b) From the graph

For output levels 0 – 10 800 units (W1) y = 23,7 + 9,1x
For output levels 10 800 – 14 000 units (W2) y = – 45,4 + 15,5x
Variable costs per unit change at output of 10 800 units.
Note: The 10 800 units is arrived at where the two lines cross, ie substitute in the equations.
23,7 + 9,1x = – 45,4 + 15,5x
x = 10 800
Workings
(W1) R’000 Units (000’s)
January 105,2 9
May 78,0 6
27,2 3
27,2
Variable costs = = 9,06 per unit ie R9,10
3
Fixed costs = 105,2 – (9,06 × 9) = 23,66 ie R23 700
(W2) R’000 Units (000s)
February 172,0 14
March 125,4 11
46,6 3
46,6
Variable costs = = 15,53 per unit ie R15,50
3
Fixed costs = 172 – (15,53 × 14) = – 45,42 ie – R45 400
(c) Analysis of costs in spreadsheet format

January February March April May June
Output (units) 9 000 14 000 11 000 8 000 6 000 12 000
Normal variable costs 81 900 127 400 100 100 72 800 54 600 109 200
Premium variable costs 20 480 1 280 7 680
Normal fixed costs 23 700 23 700 23 700 23 700 23 700 23 700
Heating costs 10 000 10 000
Rounding off – 400 420 320 – 500 – 300 – 180
Total costs 115 200 182 000 125 400 96 000 78 000 140 400
Notes
(i) Normal variable cost = R9,10 per unit.
(ii) Premium variable cost = R15,50 – R9,10 = R6,40 per unit on all output in excess of
10 800 units.
(d) If an organisation wishes to use statistical cost estimation there are several difficulties which
may be encountered.
(i) The data collected and used in the analysis must be truly representative of the
production processes employed. Any unusual or rogue data will distort the analysis.
(ii) The effects of inflation will, over a period of time, increase costs without there being an
increase in activity. These effects should be adjusted for in the analysis of costs.
(iii) The use of historical data to estimate future costs assumes that conditions have
remained unchanged between the periods concerned. If any new factors have entered
the picture, then the analysis should be adjusted to take them into account.
(iv) Estimation or forecasting should be made only within the relevant range of activity, ie
those activity levels for which the cost data had been collected.
(v) The dependence of variables needs to be clearly established for valid relationships to be
obtained. Linear regression analysis assumes that there are only two variables involved.
If this is not so, then multiple regression analysis may be necessary.

A company is asked to quote for a contract taking account of an 80% learning curve which is normal
for its industry.
There are three variations to the contract:

Variation 1: A single order for 200 units.
Variation 2: An initial order for 200 units, followed by a succession of orders totaling 600 units
altogether (including the initial order).
Variation 3: A first order for 200 units.
A possible second order for 100 units.
A possible third order for 100 units.
A possible fourth order for 80 units.
There is no obligation on the customer to place the second, third or fourth orders, but
he requires a separate price quotation for each of them now.
Based on standards for comparable work, the company’s cost estimates per unit for variation 1 of
the contract are:
Direct materials: 15 meters at R80 per meter
Direct labour:
Dept AR 8 hours at R30 per hour
Dept AS 100 hours at R36 per hour
Dept AT 30 hours at R24 per hour
Variable overhead: 25% of direct labour
Fixed overhead absorption
Dept AR R50 per direct labour hour
Dept AS R30 per direct labour hour
Dept AT R20 per direct labour hour
The three departments differ in their work composition. Dept AR is highly automated and its output,
predominantly machine-controlled, is little influenced by operator efficiency. By contrast, output in
Departments AS and AT is almost exclusively influenced by operator skills.

(a) Calculate prices per unit for each of the three variations to the contract, allowing a profit margin
of 3% on direct materials cost and 10% on conversion cost. (30 marks)
Note: Variation 3 calls for four separate prices.
(b) List three major factors that would influence you against taking account of the learning curve
when setting labour standards in a standard costing system. (5 marks)
Note: An 80% learning curve on ordinary graph paper would show the following relationship
between the x axis (volume) and the y axis (cumulative average price of elements
subject to the learning curve):
x y x y
(%) (%)
1,0 100 2,1 78,9
1,1 96,9 2,2 77,8
1,2 93,3 2,3 76,8
1,3 91,7 2,4 76,0
1,4 89,5 2,5 74,9
1,5 87,6 2,6 74,0
1,6 86,1 2,7 73,2
1,7 84,4 2,8 72,3
1,8 83,0 2,9 71,5
1,9 81,5 3,0 70,7
2,0 80,0 3,1 70,0
Solution
(a) Variation 1
Assumption: The number of labour hours is given per unit, based on an initial order of 200
units. It is assumed that learning is based on the initial batch of 200 units.
Cost and selling price per unit

R R R
Direct material cost (15 meters × R80) 1 200
Conversion costs:
Direct labour:
AR ( 8 hours × R30) 240
AS (100 hours × R36) 3 600
AT ( 30 hours × R24) 720 4 560
Variable overhead 25% × R4 560 1 140
Fixed overhead:
AR ( 8 hours × R50) 400
AS (100 hours × R30) 3 000
AT ( 30 hours × R20) 600 4 000 9700
10 900
Profit (3% on direct materials of R1 200) 36
(10% on conversion cost of R9 700) 970
Variation 2
Cumulative
Batches Batches x y%
Initial order 200 units 1 1 1,0 100
Subsequent order 200 units 1 2 2,0 80
200 units 1 3 3,0 70,7
Total 600 units
As the total number of batches ordered is 3, the average time per unit is 70,7% of the labour
time per cost category.
Cost and selling price per unit
R R R
Direct material cost 1 200,00
Conversion cost:
Direct labour:
AR ( 8 hours × R30) 240
AS (100 hours × 70,7% = 70,7 × R36) 2545,20
AT ( 30 hours × 70,7% = 21,21 × R24) 509,04 3 294,24
Variable overhead 25% × 3 294,24 823,56
Fixed overhead:
AR ( 8 hours × R5) 400,00
AS (70,70 hours × R3) 2 121,00
AT (21,21 hours × R2) 424,20 2945,20 7 063,00
8 263,00
Profit (3% on direct materials of R120) 36,00
(10% on conversion cost of R706,30) 706,30
Selling price per unit R9 005,30
Variation 3
Cumulative
Batches Batches x y%
Initial order no 1 200 units 1 1 1,0 100
Subsequent order no 2 100 units 0 ,5 1,5 1,5 87,6
Subsequent order no 3 100 units 0,5 2 2,0 80
Subsequent order no 4 80 units 0 ,4 2,4 2,4 76
The solution will be carried out by calculating the cumulative selling prices as the order size
increases, and then subtracting the selling price for the previous order.
Order no 1
Unit selling price = R11 906 per unit (see variation 1).
Order no 2
Cumulative orders 300 × R10 678,40 = R3 203 520
Previous order 200 × R11 906,00 = R2 381 200
Order 2 100 R822 320
Selling price per unit R822 320 ÷ 100 units = R8 223,20 per unit
Order no 3
Cumulative orders 400 × R 9 926,00 = R3 970 400
Previous orders 300 × R10 678,40 = R3 203 520
Order 3 100 R766 880
Selling price per unit R766 880 ÷ 100 units = R7 668,80 per unit
Order no 4
Cumulative orders 480 × R 9 530,00 = R4 574 400
Previous orders 400 × R 9 926,00 = R3 970 400
Order 4 80 R604 000
Selling price per unit R604 000 ÷ 80 units = R7 550 per unit
Workings
Order no 2 Order no 3 Order no 4
cumulative 300 cumulative 400 cumulative 480
Conversion costs R R R
Direct labour
AR × R30 240,00 240,00 240,00
AS 87,6hrs × R36 3 153,60 (80 hrs) 2 880,00 (76 hrs) 2 736,00
AT 26,28hrs × R24 630,72 (24 hrs) 576,00 (22,8 hrs) 547,20
4 024,32 3 696,00 3 523,20
Variable overhead 25% 1 006,08 924,00 880,80
Fixed overhead
AR at R50 400,00 400,00 400,00
AS at R30 2 628,00 2 400,00 2 280,00
AT at R20 525,60 480,00 456,00
8 584,00 7 900,00 7 540,00
Direct materials cost 1 200,00 1 200,00 1 200,00
Profit 3% on R1200 36,00 36,00 36,00
10% on R8584 858,40 (R7900) 790,00 (R754) 754,00
10 678,40 9 926,00 9 530,00
(b) (i) A standard costing system sets a uniform time and labour cost that will enable
management to compare the original budget and flexed budget to the actual cost.
Introducing the effect of the learning curve into the standard would mean that unit costs
would keep changing, which would frustrate those responsible for meeting the
budgeted costs. Implementation would also be difficult.
(ii) Changing standards would cause workers to have a negative attitude as they may
interpret the system as a way of making them work harder to meet a standard that they
may feel is unfair. Future budgeted input information from the workers could also be
negative when easy standards are set, as they fear that management will tighten
standards anyway.
(iii) Learning curve applications are inappropriate where the labour cost per hour is low and
labour turnover is high. It must be remembered that once a steady state is attained, no
further reduction in costs will occur.
Cost-volume-profit
7 analysis
l define what is meant by cost-volume-profit (CVP) analysis including break-even analysis
l explain the difference between the economist’s and accountant’s cost-volume-profit graph
l calculate the break-even point, margin of safety and incremental contribution
l reconcile budget profit to actual profit and discuss why CVP represents a variable costing
system
l carry out multi-product break-even analysis and sensitivity analysis
Cost-volume-profit analysis is useful to management as costs often increase or decrease as the

activity in production/sales increases or decreases. The economist’s view of CVP relationships is
different from that of the accountant for the following reasons:
(a) (i) Economists look at the whole range of activity from zero to maximum output to derive
the range of profit volume relationships.
(ii) Accountants limit the range of activity to the relevant range which is a smaller area
where costs tend to behave on a linear relationship over the area considered.
(b) (i) Economists assume that information about prices, costs and volumes is available at all
levels of activity.
(ii) Accountants assume linearity over the relevant range as well as limited cost, sales and
volume information.
(c) The accountant’s use of CVP is practical while the economist’s is expositional.
Cost-volume-profit analysis and graphs

Assumptions of the economist’s cost-volume-profit graph
(a) Total revenue line is curvilinear
The firm cannot increase the sales volume by holding the selling price constant. Increased sales
can only be achieved by dropping the selling price. The effect is that total revenue will be
maximised at a point where the slope is zero or the marginal revenue from the nth sale is zero.
The adverse effect of overall price reductions outweighs the benefits from increased sales volume.
(b) Increasing and decreasing returns to scale
As can be seen from the graph, the total cost line runs fairly steeply between A and B, levels off
between B and C and rises sharply beyond C. The economist’s fixed cost point is shown as A. The
reason for the curve being shaped this way is the fact that the assumption is made that variable
cost per unit decreases as bulk purchases are made and division of labour benefits are gained.
This situation is referred to as increasing returns to scale. Between B and C, unit variable costs
level out as the firm operates at its most efficient output. Beyond point C, the firm experiences
decreasing returns to scale as output per direct labour hour decreases due to bottlenecks and
production beyond normal capacity. Note that for the economist’s CVP graph there are two
break-even points, while profit is maximised at an activity level where the difference between
total revenue and total cost is at its greatest.
209
The economist’s cost-volume-profit graph

Total
costs
R
Costs
and
C
revenue
B Total
revenue
A
0 Activity (units)
Figure 1
The accountant’s cost-volume-profit graph

Sales Total
costs
R
Total Variable
costs costs
and
revenue
Fixed costs
0 Activity (production and sales)
Figure 2
(a) Constant fixed cost line

The assumption that fixed costs are constant at all levels of activity within the relevant range is
valid as the range is normally small.
(b) Constant variable costs and selling price per unit
The variable cost per unit and selling price per unit are regarded as fixed, as short-run prices are
inflexible over the relevant range of output. Increased sales may also be achieved without
decreasing the selling price by increasing product promotion.
The graphical representation is useful to management as it gives an overview of the company’s
profitability as volume is increased or decreased.
It is important to note that profit increases on a unitary basis by the difference between the
selling price and variable cost per unit. It is representative of a variable costing system.
Chapter 7: Cost-volume-profit analysis 211
Key ratios
Contribution
Profit Volume (PV) ratio =
Sales
Fixed expenses
Break-even sales (B/E sales) revenue =
PV ratio
Fixed expenses
Break-even sales volume =
Contribution per unit
Sales – B/E sales
Margin of safety ratio =
Sales
Profit
Profit ratio =
Sales
Break-even analysis
The number of units needed to be sold in order to “break-even” will be the total costs divided by the
contribution required to break-even. This must be an amount which equals the fixed costs.
Target profit
When a company wishes to achieve a certain profit during a period, we need to consider whether the
profit required is fixed or varies with each unit sold. If the profit required is fixed, we treat it in the
same way as we would a fixed cost. If the profit required is variable, we treat it in the same way as
we would a variable cost.
Margin of safety
The margin of safety is a measure by which the budgeted volume of sales is compared with the
volume of sales required to break-even. It is the difference in units between:
(a) budgeted sales volume, and
(b) break-even sales volume,
and it is sometimes expressed as a percentage of the budgeted sales volume. (It may also be
expressed as the difference between the budgeted sales revenue and break-even sales revenue,
expressed as a percentage of the budgeted sales revenue.)
The contribution concept

Management accountants are interested, not in the increase in profit, but in the increase in
contribution. The reason for this is that, as the sales volume increases, the incremental profit is
always equal to the increase in contribution where fixed cost is constant.
The relationship between the contribution and sales is therefore of vital importance as profit should
be viewed as:
Sales
– Variable costs
= Contribution
– Fixed costs
= Profit
per the cost-volume-profit chart.
Profit = (Selling price – Variable costs) x Sales volume – Fixed costs

PART A
A company has produced the following budget information:
R
Sales 5 800 000
Direct materials 2 000 000
Labour costs 1 000 000
Overhead costs 500 000
Manufacturing profit 2 300 000
Non-manufacturing costs:
Rent 400 000
Accounting 200 000
Marketing 300 000
Salaries 500 000
Other costs 100 000
Profit R800 000
Budgeting information
Manufacturing labour costs are 80% variable.
Overhead costs are 40% variable.
Marketing costs are 40% variable.
Other costs are 20% variable with production units.
All other costs are fixed, except for direct materials.

(a) Analyse the company’s cost structure and show all the key ratios.
(b) Prepare an income statement that shows the company contribution separately.
(c) Draw a cost-volume-profit diagram that shows all the information as determined in (a).
(d) Calculate the effect that each of the following independent scenarios will have on company
profits:
(i) Sales units are increased by 10%
(ii) Selling price is increased by 10%
(iii) All variable costs are decreased by 10%
(iv) All fixed costs are decreased by 10%.
PART B
The actual results for the company are as follows:
The company produced 120 000 units and sold 110 000 units at the budget selling price.
Variable manufacturing costs, including materials, are 5% higher.
Fixed manufacturing costs are 10% higher.
All other costs were per the budget cost structure.

(a) Produce the actual income and expenditure account. You are to value the closing inventory on a
variable costing basis at budget cost.
(b) Using the actual cost information, calculate all relevant key ratios.
Solution
PART A
(a) Analysis of cost structure
Variable per unit Fixed R
Sales 58 5 800 000
Labour costs 8 200 000 1 000 000
Overhead costs 2 300 000 500 000
Rent 400 000 400 000
Accounting 200 000 200 000
Marketing 1 ,20 180 000 300 000
Salaries 500 000 500 000
Other costs 0 ,20 80 000 100 000
Contribution R26 ,60
Profit R800 000
Labour – Fixed cost 1 000 000 × 20% = 200 000

Variable cost 1 000 000 × 80% = 800 000
Units 100 000
Cost per unit R8
Overhead – Fixed cost 500 000 × 60% = 300 000

Variable cost 500 000 × 40% = 200 000
Units 100 000
Cost per unit R2
Marketing – Fixed cost 300 000 × 60% = 180 000

Variable cost 300 000 × 40% = 120 000
Units 100 000
Cost per unit R1,20
Other – Fixed cost 100 000 × 80% = 80 000

Variable cost 100 000 × 20% = 20 000
Units 100 000
Cost per unit R0,20
Contribution: R
Sales 58
Direct materials 20
Labour costs 8
Overhead costs 2
Marketing 1 ,20
Other costs 0 ,20
Contribution 26 ,60
Contribution
Profit Volume ratio: =
Sales
26,60 × 100 000
= = 0,4586 or 45,86%
5 800 000
Fixed expenses
Break-even sales revenue: =
PV ratio
1 860 000
= = R4 055 822
0,4586
Fixed expenses
Break-even sales volume: =
1 860 000
= = 69 925 units
26,60
Sales – B/E sales
Margin of safety ratio: =
Sales
5 800 000 – 4 055 822

=
5 800 000
= 0,30 or 30%
Profit
Profit ratio: =
Sales
800 000
= = 0,1379 or 13,79%
5 800 000
(b) Profit statement showing contribution

R
Sales 5 800 000
Variable costs:
Labour costs 800 000
Marketing – variable 120 000
Other – variable 20 000
Contribution R2 660 000
R
Fixed costs:
Labour 200 000
Rent 400 000
Accounting 200 000
Marketing 180 000
Salaries 500 000
Other costs 80 000
Profit R800 000
(c) Cost-volume-profit diagram

Rand
’000
5 800 Sales value
Increase in
5 000 profit / contribution
Break-even
4 055 Total costs
Decrease in
profit / contribution
Variable costs
1 860
Fixed costs
Units 69 925 100 000
Margin of safety
Figure 3
(d) (i) Sales units increase by 10%

Sales = 100 000 × 110% = 110 000 units
Contribution 110 000 × 26,60 = R2 926 000
Profit R1 066 000
(ii) Selling price increases by 10%
Selling price increase = R58 × 10% = R5,80
Current contribution = R26,60
Increase in selling price R5,80
New contribution R32,40
Contribution 100 000 × 32,40 = R3 240 000

Profit R1 380 000
Note: Any increase in the selling price will always increase the contribution by the price
increase. In fact, profit will increase by the exact increase in sales value. The best
way to increase profit is always to increase the selling price where possible.
(iii) Variable costs decrease by 10%
Variable costs = R31,40 × 10% = R3,14
Current contribution = R26,60
Decrease in variable costs R3,14
New contribution R29,74
Contribution 100 000 × 29,74 = R2 974 000
Profit R1 114 000
Note: A decrease in variable costs is also a very powerful method of increasing profit, as
contribution will increase by the decrease in variable costs, as will the profit.
(iv) Fixed costs decrease by 10%
Fixed costs = R1 860 000 × 10% = R186 000

Current profit R800 000
Decrease in fixed costs R186 000
Profit R986 000
Note: A decrease in fixed costs has very little effect on profit and should be resisted, as
fixed costs often represent an investment in the company’s infrastructure. A
decrease in fixed costs will often hamper its ability to trade efficiently.
PART B
(a) Actual income statement
R R
Sales 110 000 × 58 6 380 000
Labour costs 1 208 000
4 310 000
Closing inventory – 300 000
Cost of sales 4 010 000 (4 010 000)
Manufacturing profit 2 370 000
Non-manufacturing costs:
Rent 400 000
Accounting 200 000
Marketing 312 000
Salaries 500 000
Other costs 104 000
Profit R854 000
Direct materials:
120 000 × R20 × 105% = 2 520 000
Labour:
Variable 120 000 × R8 × 105% = 1 008 000
Fixed 200 000
1 208 000
Manufacturing overheads:
Variable 120 000 × R2 × 105% = 252 000
Fixed 300 000 × 110% = 330 000
582 000
Marketing:
Variable 110 000 × R1,20 = 132 000
Fixed 180 000
312 000
Other:
Variable 120 000 × R0,20 = 24 000
Fixed 80 000
104 000
Closing inventory:
10 000 × (20 + 8 + 2) = R300 000
(b) Relevant key ratios – at actual values

Contribution
R
Sales 58
Direct materials 21
Labour costs 8 ,40
Overhead costs 2 ,10
Marketing 1 ,20
Other costs 0 ,0
Contribution 25 ,10
Contribution
Profit Volume ratio: =
Sales
25,10 × 110 000
= = 0,4328 or 43,28%
6 380 000
Fixed expenses
Break-even sales revenue: =
PV ratio
Fixed costs: = 200 000 + 330 000 + 400 000 + 200 000 + 180 000 + 500 000 +
80 000 = 1 890 000
1 890 000
= = R4 366 913
0,4328
Fixed expenses
1 890 000
= = 75 299 units
25,10
Sales – B/E sales
Margin of safety ratio: =
Sales
6 380 000 – 4 366 913
=
6 380 000
= 0,316 or 31,6%
Profit
Profit ratio: =
Sales
854 000
=
6 380 000
= 0,1339 or 13,39%
Analysing costs using cost-volume-profit principles

To make business decisions, it is important that a company has a firm understanding of its cost
structure. In other words, a company needs to know which costs are fixed and which ones are
variable. This is more easily said than done, as most costs, with the exception of material costs, have
a mix of both variable and fixed cost.
A good example is labour costs as they tend to be fixed on a monthly basis. Although there is some
latitude to hire on the basis of production requirements, it is still essentially a fixed cost. A simple
and effective way of determining the split between variable and fixed cost would be to analyse the
costs on a high/low basis.
Example 1
You have been given the following cost analysis:
20X1 20X2
R R
Sales 1 000 000 1 200 000
Material cost 170 000 204 000
Labour 100 000 104 000
Rent 50 000 50 000
Salaries 100 000 100 000
Marketing 180 000 198 000
Profit 100 000 208 000

(a) Calculate the cost structure for the company, the contribution per unit and the break-even
point, assuming that the company manufactured 1 000 units in 20X1 and 1 200 units in 20X2.
(b) Calculate the cost structure for the company, the contribution ratio and the break-even point,
assuming that you are not given the sales units.
(c) Determine by how much the company profits will increase if sales increase by 10% for 20X3.
Solution
(a) Sales units given
20X1 20X2 Marginal Variable
Units 1 000 1 200 200 per unit
R R R R
Sales 1 000 000 1 200 000 200 000 1 000
Material cost 170 000 204 000 34 000 170
Labour 100 000 104 000 4 000 20
Manufacturing overhead 300 000 336 000 36 000 180
Rent 50 000 50 000
Salaries 100 000 100 000
Marketing 180 000 198 000
Profit 100 000 208 000 18 000 90
Contribution R108 000 R540
The increase in sales revenue must be for the incremental sales of 200 units. Any increase in
costs incurred in 20X2 must be an increase in variable costs, as all fixed costs remain the same
by nature. In practice, it is possible that there has also been an increase in the general price
levels. The calculations above assume that the cost structure for 20X2 is the same as the 20X1
cost structure.
Cost analysis for 20X1

20X1 Variable cost Variable Fixed
Units 1 000 per unit cost cost
R R R R
Total
Material cost 170 000 [ 170 × 1 000 ] 170 000
Labour 100 000 [ 20 × 1 000 ] 20 000 80 000
Manufacturing overhead 300 000 [ 180 × 1 000 ] 180 000 120 000
Rent 50 000 50 000
Salaries 100 000 100 000
Marketing 180 000 [ 90 × 1 000 ] 90 000 90 000
Total cost R900 000 R460 000 R440 000
The cost analysis for 20X2 is the same as that for 20X1 and there is no need to duplicate the
figures. In other words, when analysing the cost structure, you can do it for either one of the
two years.
For illustrative purposes only – 20X2

20X2 Variable cost Variable Fixed
Units 1 200 per unit cost cost
R R R R
Total
Material cost 204 000 [ 170 × 1 200 ] 204 000
Labour 104 000 [ 20 × 1 200 ] 24 000 80 000
Manufacturing overhead 336 000 [ 180 × 1 200 ] 216 000 120 000
Rent 50 000 50 000
Salaries 100 000 100 000
Marketing 198 000 [ 90 × 1 200 ] 108 000 90 000
Total cost R992 000 R552 000 R440 000
Contribution per unit: R108 000 / 200 = R540
Fixed expenses
440 000
=
540
= 815 units
(b) Sales units not given

If we do not know the number of units sold, we do exactly the same analysis, except that,
instead of calculating the per unit cost or contribution per unit, we calculate ratios.
20X1 20X2 Marginal
R R R
Sales 1 000 000 1 200 000 200 000
Material cost 170 000 204 000 34 000
Labour 100 000 104 000 4 000
Manufacturing overhead 300 000 336 000 36 000
Rent 50 000 50 000
Salaries 100 000 100 000
Marketing 180 000 198 000 18 000
Profit 100 000 208 000
Contribution R108 000
Contribution ratio 108 000 / 200 000 = 54%

Variable cost ratio = 46%
Sales 200 000

Therefore, for 20X1
R
Sales 1 000 000 Given
Variable costs 460 000 [ 1 000 000 × 46% ]
Fixed costs 440 000 Balancing figure
Profit R100 000 Given
Fixed expenses
PV ratio
440 000
=
0,54
= R814 815
(c) Increase in sales by 10% for 20X3

This section can be done whether you know the number of units per (a) or not.
Contribution for 200 units = R108 000
Therefore contribution for a 10% increase in sales equals
1 200 × 110% = 1 320 / 200 × R108 000 = R712 800
Fixed costs = R440 000
Profit = R712 800 – R440 000 = R272 800
If you did not know the number of units, then

20X2 sales value = R1 200 000
20X3 sales value = R1 200 000 × 110% = R1 320 000
Contribution = R1 320 000 × 54% = R712 800
Profit = R712 800 – R440 000 = R272 800
Example 2
A company produced a CVP chart at its monthly meeting showing that the company would
break-even at a sales level of R400 000. At a sales level of R600 000, the company will make a
profit of R80 000.

Determine the current variable and fixed cost structure of the company and determine the
loss that the company will incur if sales drop to R350 000.
Solution
It is very important to be aware of the profit volume ratio, or ratio of contribution to sales. Bear in
mind that, as sales change and fixed costs remain constant, only “contribution” will change. The
following relationship is important:
Marginal
Sales 400 000 600 000 200 000 100%
Variable costs ? ? 120 000 60% K
Contribution ? ? 80 000 40% K
Fixed costs ? ? – –
Profit – 80 000 80 000 40% K
The above tabulation shows that as sales increase by R200 000, so the contribution and resultant
profit will increase by R80 000.
From the diagram below, we note that the shaded area represents the increase in company profit. As
fixed costs have not changed, the profit has in fact increased by the contribution per unit. This is why
management accountants always show contribution as profit.
The PV ratio is constant at all sales levels and is calculated as
80 000
= 40%
200 000
Sales
Profit =
R’000 increase in
contribution
600
500 Total
costs
400
300
200
160
Sales value or
‘000 400 600 sales in units
Figure 4
At break-even
Sales 400 000 100%
Variable costs 240 000 60%
Contribution 160 000 40%
Fixed costs 160 000 (balancing figure)
Profit –
If sales drop to R350 000, the contribution will be R140 000 and, as fixed costs are R160 000, the
company will make a loss of R20 000.
Example 3
The budget income statement of Company Z is as follows:
Sales 20 000 units R’000
Sales 1 800
Manufacturing costs 1 100
Gross profit 700
Administration and selling costs 400
Profit 300
30% of the administration and selling costs are variable. The company has a break-even point
of 12 500 units.

Calculate the budget profit that Company Z could achieve if sales increase to 24 000 units.
Solution
Administration and selling costs
Fixed – R400 000 × 70% = R280 000
Variable – R400 000 × 30% = R120 000 / 20 000 = R6 per unit
At break-even, profit equals zero
Therefore change in sales = 7 500 units [ 20 000 – 12 500 ]
change in profit = R300 000 = contribution [ 300 000 – 0 ]
contribution per unit = R300 000 / 7 500 = R40 per unit
total variable cost = [ R1 800 000 / 20 000 ] – R40 = R50
manufacturing variable cost = R50 – R6 (selling) = R44
Cost analysis at 20 000 units
Total per unit
Sales 1 800 000 90
Variable manufacturing 880 000 44
Fixed manufacturing 220 000 n/a Balancing figure
Variable administration and selling 120 000 6
Fixed administration and selling 280 000 n/a
Profit 300 000 R40 Contribution
Budget at 24 000 units
Sales 2 160 000 [ R90 × 24 000 ]
Variable manufacturing 1 056 000 [ R44 × 24 000 ]
Variable administration and selling 144 000 [ R6 × 24 000 ]
Contribution 960 000 [ R40 × 24 000 ]
Fixed manufacturing 220 000
Fixed administration and selling 280 000
Profit 460 000
OR: Increased sales = 4 000 units
Contribution × R40
Increased contribution R160 000
Current profit R300 000
Alternative solution
Current B/even Marginal
Sales – units 20 000 12 500 7 500
R’000 R’000 R’000
Sales 1 800 1 125 675
Manufacturing costs 1 100
Gross profit 700
Administration and selling costs 400
Profit 300 – 300
Break-even sales = R1 800 000 / 20 000 × 12 500 = R1 125 000
Marginal increase in profit represents contribution.

PV ratio = 300 / 675 = 44,44%
Variable costs = 55,56%
Therefore variable costs for 20 000 units = R1 800 000 × 55,56% = R1 000 000
Therefore fixed costs = R1 800 000 – R300 000 – R1 000 0000 = R500 000
Administration and selling costs = 30% variable, 70% fixed
Therefore fixed costs = R400 000 × 70% = R280 000
Therefore manufacturing fixed costs = R500 000 – R280 000 = R220 000
Therefore cost analysis at 20 000 units

Current
Sales – units 20 000
R’000
Sales 1 800
Manufacturing costs – variable 880 [ 1 100 – 220 ] = 880
Manufacturing costs – fixed 220
Gross profit 700
Administration and selling – variable 120 [ 400 × 30% ]
Administration and selling – fixed 280 [ 400 × 70% ]
Profit 300
Application of cost-volume-profit concepts

The following illustrative example is used to show the concepts of break-even, profit-targets and
pricing decisions.
Example
A company manufactures a single product, and the management accountant has produced the
following budget:
Production and sales are expected to be 1 000 units.
R
Sales @ R500 each 500 000
Fixed costs 100 000
Profit 100 000
(a) Break-even (i) Determine the break-even volume.
(ii) Determine the margin of safety.
(b) Profit targets
(i) Determine how many units must be sold to earn a profit of R160 000.
(ii) Determine how many units must be sold to earn a profit equal to 20% of sales
revenue.
(iii) Determine how many units must be sold to earn an after-tax profit of R55 000,
assuming that the tax rate is 45%.
(iv) Determine how many units must be sold to earn an after-tax profit of R22 000 plus
11% of sales after tax, assuming that the tax rate is 45%.
(c) Pricing decisions
The company has recently conducted a market survey that revealed three possible
outcomes.
(i) If advertising was increased by R20 000, sales would increase from 1 000 units to
1 200 units.
(ii) A selling price decrease to R450 would increase sales by 300 units. Fixed costs
would, however, increase by R20 000.
(iii) A decrease in selling price by R60 and an increase in advertising by R20 000 will
increase sales by 500 units.
Fixed costs will, however, increase by R20 000.
Should the company maintain its current price and advertising policies or should it select one
of the three alternatives described above?
Solution
(a) Break-even
Fixed costs
(i) The break-even point is determined as
Contribution per unit = R200 000 ÷ 1 000 = R200
Break-even R100 000
= = 500 units
R200
(ii) Margin of safety

Margin of safety = Sales – Break-even sales
Sales
= 500 000 – 250 000
= 50%
500 000
(b) Profit targets

(i) Required contribution = R160 000 + R100 000
unit sales required R260 000
= = 1 300 units
R200
(ii) As the required profit is variable, the adjustment must be made to the contribution figure.
Sales 500
– Variable costs 300
– Desired profit 100
= Contribution 100
Fixed costs 100 000

Unit sales = = = 1 000 units
Contribution R100
Important: When a required profit is calculated as a variable percentage or a variable
opportunity cost, the required return is treated as if it were a variable cost.
However, where the required profit is fixed, such profit is treated as if it were a
fixed cost.
(iii) Required profit is R55 000 after tax
55 000
or = R100 000 before tax
0,55
100 000 + 100 000
Required sales = = 1 000 units
200
(iv) Required profit is R22 000 after tax plus 11% of sales
22 000
= R40 000 before tax
0,55
Sales = R500 × 11% = R55 after tax
Before tax = R55 / 0,55 = R100
100 000 + 40 000
Required sales = = 1 400 units
200 – 100
(c) Pricing decisions

(i) Current profit is R100 000
R
New sales (1 200 × R500) 600 000
Fixed costs (100 000 + 20 000) 120 000
120 000
New policy is better as long as estimates are accurate

(ii) R
Sales 1 300 × 450 585 000
Variable costs 1 300 × 300 390 000
Fixed costs 120 000
Profit 75 000
This alternative is not acceptable, as previous profit was R100 000

(iii) R
Sales 1 500 × 440 660 000
Variable costs 1 500 × 300 450 000
Fixed costs (100 000 + 20 000 + 20 000) 140 000
Profit 70 000
Not acceptable
Reconciling budget profit to actual profit

The cost-volume-profit chart represents the expected profit at different sales levels. The change in
profit as sales increase is in turn represented by the change in contribution.
Does the CVP graph represent a variable or an absorption costing system?

The fixed costs do not change with increased sales as is represented on CVP charts. This means that
the graphical representation of CVP must be on a variable cost basis.
Following from the CVP chart, it is important to understand that the information given represents the
new profit as sales levels change. It stands to reason then, that if we budgeted to sell 10 000 units
but the actual sales were 12 000 units, we need to have a look at the expected profit at that level in
order to evaluate performance (variable costing concept)
Example
Company A produced a CVP graph at its monthly meeting showing that the company expected
a profit of R90 000 at a sales level of 9 000 units for the month of May.
Budget profit per unit:
R
Sales 40
Variable cost 20
Fixed cost 10
Profit 10
The actual production and unit sales for the month of May was 10 000, showing an actual
profit of R98 000.

Determine how well the company performed.
Solution
Performance analysis should always be done on a variable costing basis, and it is important to
reconcile the budget profit to expected profit at the actual sales level, and then to actual profit.
Budget profit at 9 000 units:
R Per unit
Sales 360 000 40
Contribution 180 000 20
Fixed costs 90 000
Profit 90 000
Reconciliation:
R
Sales variance 20 000 (+ 1 000 × R20)
Standard/Expected profit 110 000
Unfavourable performance (12 000)
We conclude that the company has outperformed expectations in terms of sales levels and bottom-
line profit.
We however also report that there is an unfavourable performance of R12 000 that requires
investigation. According to the CVP chart, the company should have made a profit of R110 000 if it
sold 10 000 units. The reason for the unfavourable performance of R12 000 could be any one of the
following: a lower selling price, higher costs or inefficiencies of production.
The profit-volume chart

The PV (profit/volume) chart is a variation of the break-even chart which provides a single illustration
of the relationship of costs and profit to sales, and of the margin of safety. A PV chart is constructed
as follows:
(a) The horizontal axis comprises either sales volume in units, or sales value.
(b) The vertical axis comprises contribution in value, extending above and below the horizontal axis
with a zero point at the intersection of the two axes, and the negative section below the
horizontal axis representing fixed costs. This means that at zero production, the firm is incurring
a loss equal to the fixed costs.
(c) The profit-volume line is a straight line drawn with its starting point (zero production) at the
intercept on the vertical axis, representing the level of fixed cost and with a gradient of
contribution/unit (or the PV ratio in sales value is used rather than units). The PV line will cut
the horizontal axis at the break-even point of sales volume. Any point on the PV line above the
horizontal axis represents the profit to the firm (as measured on the vertical axis) for that
particular level of sales.
Example
Company B produces a product whose variable cost is R6 per unit; its selling price is R10 per unit.
Fixed costs are R20 000 over a relevant range of 4 000 to 10 000 units.
The above example can be illustrated by drawing a Profit Volume diagram as illustrated below. The
break-even position is where the company sells 5 000 units, while the margin of safety is the excess
sales above break-even sales. The distance between the PV line and the x axis represents the
contribution. For every marginal unit sold, the Company’s profit increases by the incremental
contribution gained. Conversely, for every unit of sale lost, the Company’s profit will decrease by an
amount equal to the contribution. The PV graph could be described as the Contribution Volume
Graph.
40
Profit
R’000 30
20 Relevant range
10
Margin of safety
0
Loss 2 4 6 8 10 1
R’000
10
B/E point
20
Figure 5
Multi-product break-even analysis

Cost-volume-profit analysis is carried out where a single product is manufactured. When a company
manufactures multiple products, you can carry out an analysis per product as long as the fixed costs
incurred are identifiable with each individual product, ie the fixed costs are specific to each product
manufactured. However, when the fixed costs are not directly attributable to each product, we need
to present the information on a conglomerate basis. In other words, we must pre-determine a sales
mix that will not change, and assume that future sales will be made in accordance with the
predetermined mix.
Example
Company A sells three products with the following selling prices, costs and sales mix.
A B C
Unit sales 1 000 2 000 3 000
Unit selling price R20 R15 R10
Unit variable costs R10 R8 R6
Specific fixed costs R8 000 R7 000 R5 000
General fixed costs amount to R14 000

(a) Produce a budget income statement.
(b) Calculate the break-even point for each product and advise on product viability.
(c) Determine the overall break-even point if the company must sell all products at the
budget ratio.
Solution
(a) Budget income statement
A B C Total
R R R R
Sales 20 000 30 000 30 000
Variable costs 10 000 16 000 18 000
Contribution 10 000 14 000 12 000
Specific fixed costs 8 000 7 000 5 000
Product profit 2 000 7 000 7 000 16 000
General fixed costs 14 000
Company profit R2 000
(b) A B C
Selling 20 15 10
Variable cost 10 8 6
Contribution 10 7 4
Specific fixed costs R8 000 R7 000 R5 000
Break-even units 800 1 000 1 250

Current unit sales 1 000 2 000 3 000
All three products are generating a contribution towards general fixed costs, therefore we
should continue to produce them. What would happen if we allocated the general fixed costs to
each product on an equal basis?
Product A would now show a loss of R2 700, and one might argue that it is therefore not viable.
Whether we should be producing product A or not will depend on several factors, such as
capacity constraints and customer demand. Nevertheless, we do have a problem in determining
the overall company break-even point on a per product basis.
Note: Although we have calculated a break-even per product, we have done so based on
specific fixed costs only, and have ignored the general fixed costs. In practice, you will
probably not have the specific fixed cost, in which case you have to calculate the overall
break-even per (c) below.
(c) A B C
Sales mix 1 : 2 : 3
1 2 3
Equivalent unit contribution = (10 × ) + (7 × ) + (4 × )
6 6 6
= R6
Total fixed costs R20 000 + R14 000 = R34 000

Break-even R34 000 ÷ 6 = 5 667 units
Sales in units: Product ratio

A 1 / 6 × 5 667 = 945 units
B 2 / 6 × 5 667 = 1 889 units
C 3 / 6 × 5 667 = 2 833 units
5 667 units
Alternative solution:
A R10 × 1 = 10
B R7 × 2 = 14
C R4 × 3 = 12
Total contribution 36
34 000
Break-even = = 944,4
36
Sales in units: Product ratio

A 1 × 944,4 = 945
B 2 × 944,4 = 1 889
C 3 × 944,4 = 2 833
5 667
Sensitivity analysis
The variable inputs of cost-volume-profit analysis are sales volume, selling price, variable cost and
fixed costs (production, administration and selling). Any change of any of these inputs will have a
direct effect on profitability. If, for example, the selling price of a product were to drop by (say) R1
per unit, the effect could have a major impact on profitability. Management is therefore interested in
determining which variable or combination of variables will have the biggest impact on profitability.
In practice, companies would use a computer programme to simulate changes in the variables and
analyse their effect on profitability. The following example illustrates the technique, but has its
limitations on multi-variable manipulation.
Example
The following budget was produced by the accountant for the forthcoming year:
Sales – units 100 000
R
Sales value 1 800 000
Variable cost 800 000
Fixed cost 400 000
Profit 600 000
The company desires a minimum profit of R400 000 for the following year.
Required:
(a) Calculate the sensitivity of the budget profit to changes in the input variables, ie sales
volume, selling price, variable costs and fixed costs.
(b) Assuming that the minimum profit requirement of R400 000 was not given in the
example, re-calculate the sensitivity on all the variables.
Solution
(a) Sales volume
Set the profit and fixed cost. Determine the contribution, followed by the sales, at the budget
profit volume ratio (or contribution per unit).
Sales 1 440 000 [ 800 000 / 10 × 18 ]
Variable costs 640 000 [ 800 000 / 10 × 8 ]
Fixed costs 400 000 K Given
Profit 400 000 K Given
Selling price per unit R1 800 000 / 100 000 = R18
Variable cost per unit R800 000 / 100 000 = R8
Contribution per unit = R18 – R8 = R10
Unit sales = R1 440 000 / 18 = 80 000 units
Expected volume 100 000 units
Potential decline 20 000 units
As a percentage of current sales = 20 000 / 100 000 = 20%
Selling price
Keep all variables static, except for selling price. Start with minimum profit of R400 000.
Sales volume 100 000
Sales 1 600 000 (Balancing figure)
Variable costs 800 000 K (Per budget)
Contribution 800 000 K
Fixed costs 400 000 K (Per budget)
Profit 400 000 K Given
Selling price per unit = R1 600 000 / 100 000 = R16
Existing selling price = R18
Percentage potential decline 2/18 = 11,1%
Variable cost
Sales 1 800 000 L (Per budget)
Variable costs 1 000 000 (Balancing figure)
Profit 400 000 K
Variable cost per unit R1 000 000 / 100 000 = R10

Existing variable cost = R8
Budget fixed cost R400 000
Percentage potential increase is 2 / 8 = 25%

Fixed cost
Sales 1 800 000 L (Per budget))
Variable costs 800 000 L (Per budget)
Contribution 1 000 000 L (Per budget)
Fixed costs 600 000 (Balancing figure)
Profit 400 000 K
Budget fixed cost = R400 000
Percentage potential increase in fixed cost 200 000 / 400 000 = 50%
(b) Where a comparative profit is not given
Use break-even as the required minimum profit, ie profit = zero
Sales volume
Required volume?
Sales 720 000 [ 400 000 / 10 × 18 ]
Variable costs 320 000 [ 400 000 / 10 × 8 ]
Fixed costs 400 000 K
Profit – K
Unit sales = R720 000 / 18 = 40 000 units

Expected volume 100 000 units
Potential decline 60 000 units
As a percentage of current sales = 60 000 / 100 000 = 60%
Selling price
Sales 1 200 000 (Balancing figure)
Variable costs 800 000 K (Per budget)
Profit – K
Selling price per unit = R1 200 000 / 100 000 = R12
Existing selling price = R18
Percentage potential decline 6 / 18 = 33,3%
Variable cost
Variable costs 1 400 000 (Balancing figure)
Profit – K
Variable cost per unit R1 400 000 / 100 000 = R14

Existing variable cost = R8
Percentage potential increase is 6 / 8 = 75%

Fixed cost
Variable costs 800 000 L (Per budget)
Contribution 1 000 000 L (Per budget)
Fixed costs 1 000 000 (Balancing figure)
Profit – K
Percentage potential increase in fixed cost 600 000 / 400 000 = 150%
A manufacturing company has the following cost structure:
Variable cost per unit R8
Annual fixed costs:
Production Fixed costs
1 – 20 000 R320 000
20 001 – 60 000 R380 000
60 001 – 80 000 R400 000
80 001 – 100 000 R500 000
Required:
(a) Production is set at 50 000 units per year, and selling price at R15 per unit. An order has
been received from America at a required selling price of R10 per unit. How many units
have to be sold for the company to show an overall profit of R6 000 per annum?
(b) Current sales is 60 000 units per year. By how much may advertising costs be increased to
bring sales up to 80 000 units and still earn a net profit of 10% of total sales if the selling
price is held at R15 per unit?
Solution
(a) Current Required increase
Sales 750 000 180 000 100% R10
Variable cost 400 000 144 000 80% R8
Contribution 350 000 36 000 20% R2
Fixed costs 380 000 ?
Profit (30 000) 36 000
The required contribution to yield a net profit of R6 000 is a marginal increase of R36 000. At a
contribution of R2 per unit, sales will have to increase by 18 000 units. This means that sales will
increase to 68 000 units and fixed cost will increase by a further R20 000.
Required sales R36 000 ÷ 2 = 18 000 units
Increased fixed costs R20 000 ÷ 2 = 10 000
Increased sales 28 000
Current 50 000
Total units 78 000
No further increase in fixed costs.
The required American sales is 28 000 units.
(b) At a sales level of 80 000 units, total sales will equal R1 200 000 and the required net profit will
be R120 000.
Sales 1 200 000
Fixed costs 400 000
Profit 160 000
Required profit 120 000
Maximum advertising 40 000
Variable costs for a particular product are as follows:
R
Materials 40,00
Labour 15,00
60,00
Selling price is R80 each, and the expected total annual sales revenue is R1 200 000. Budgeted
fixed costs are R150 000. In the forthcoming year, labour costs will increase by 10%; material
by 5%; variable overhead costs by 4%, and fixed costs by 2% from the beginning of the year.
(a) Calculate the new selling price if the PV ratio is to be maintained.
(b) Calculate the sales volume required in the forthcoming year if the selling price remains
the same and profit is to be maintained.
Solution
20
(a) PV ratio = = 25%
80
Revised variable costs
R
Material 42,00
Labour 16,50
Variable overheads 5,20
R63,70
100
Revised selling price = 63,70 ×
75
= R84,93
(b) Revised contribution per unit
R80 – R63,70 = R16,30
Current profit (15 000 × 20) – 150 000 = R150 000
150 000 + 153 000

Therefore, required volume =
16,30
= 18 589 units
Appendix
introduced in this chapter. Do not proceed to the next chapter until you have grasped the following
questions.
Question 1
You are given the following information pertaining to a company:
Variable expenses R30 000
Profit volume ratio 0,40
Profit ratio 0,10
Units sold 5 000
You are required to calculate the following:

– Sales value
– Contribution
– Fixed expenses
– Profit
– Break-even value and volume
– Margin of safety value and ratio
Solution
Contribution
PV ratio =
Sales
40 Contribution
=
100 Sales
Sales = 100
Variable cost = 60
Contribution = 40
Sales = 50 000
Contribution = 20 000
Profit is 10% 50 000 × 10% = 5 000

Fixed expenses = 15 000
15 000
B/E value = = 37 500
0,40
Contribution per unit = R4
15 000
B/E volume = = 3 750
4
50 000 – 37 500
Margin of safety ratio = = 0,25
50 000
Margin of safety value = 50 000 × 0,25 = 12 500

Question 2
Fixed expenses R135 000
Profit R90 000
Break-even value R300 000
Margin of safety ratio 0,40
Units sold 20 000

– Sales value
– Variable expenses
– Contribution
– PV ratio
– Break-even volume
– Margin of safety value
– Profit ratio
Solution
Contribution = 135 000 + 90 000 = 225 000
40
Margin of safety ratio =
100
40 Sales – 300 000
=
100 Sales
Sales = 500 000

Variable expenses = 275 000
225 000
PV ratio = = 0,45
500 000
Contribution per unit = 225 000 divided by 20 000 = R11,25
135 000
Break-even volume = = 12 000
11,25
Profit ratio = 18%
Question 3
Sales R500 000
Margin of safety ratio 0,20
Profit ratio 0,06
Units sold 200 000

– Contribution
– Fixed expenses
– Profit
– PV ratio
– Break-even value and volume
– Margin of safety value
Solution
Profit ratio = 0,06

Profit 500 000 × 0,06 = 30 000
Margin of safety ratio = 0,20
500 000 – B/E sales

0,20 =
500 000
B/E sales = 400 000
Extra sales of 100 000

Profit 30 000
At a sales level of 500 000

Variable costs = 5 × 70 000 = 350 000
PV ratio 150 000

= = 0,30
500 000
400 000
B/E volume = = 160 000
2,5
Question 4
Contribution R1 800
Profit volume ratio 0,18
Break-even volume 36 800
Units sold 40 000
– Sales
– Fixed expenses
– Profit
– Break-even value
Solution
PV ratio 18
=
100


Sales = 10 000
Variable expenses = 8 200
10 000
Selling price per unit = = 0,25
40 000
Break-even value 36 800 × 0,25 = 9 200
At this level variable costs = 7 544

Profit = 144
Margin of safety value = 10 000 – 9 200 = 800
= 800
10 000
Profit ratio = 0,0144
Question 5
Profit R660
Break-even volume 40 000
Profit ratio 0,33
Units sold 100 000

– Sales
– Contribution
– Fixed expenses
– Profit volume ratio
– Break-even value
Solution
33
Profit ratio =
100
Sales = 2 000
660 33
=
Sales 100
Sales price per unit 2 000 divided by 100 000 = 2 cents

B/E value = 40 000 × 0,02 = 800
Sales 2 000 – 800 = 1 200 Sales

540 Variable costs
660 Profit
Variable costs are R900 at a sales level of R2 000

Fixed expenses = 440
PV ratio = 0,55
Margin of safety value = 1 200
Practice questions
Berrow Ltd is in the process of preparing budgets for the next financial year. The company sells two
products, the Exe and the Axe. The following budgets have been drawn up for the two products:
Axe Exe
R R
Sales revenue 160 000 200 000
Variable material and labour costs (120 000) (124 000)
Fixed production overheads (allocated on labour hours) (19 800) (36 000)
Fixed administration overheads (allocated on sales value) (3 200) (4 000)
Profit R17 000 R36 000
The products are manufactured using identical processes; therefore, all production facilities are
readily interchangeable. The fixed administration overheads can only be avoided if neither product is
produced. Avoidable fixed production overheads are estimated to be R15 000 for Axe and R24 000
for Exe. As Exe has been more difficult to promote during recent years, the company plans to
continue with the policy of allowing an average of three months’ credit to its customers. Axe is sold
entirely on a cash basis. Bad debts for Exe are expected to amount to 2% of sales revenue. Berrow
does not hold inventories, and has a cost of capital of 24% per annum.

(a) Calculate break-even in sales units for each product separately. (5 marks)
(b) Calculate the break-even in sales units for Berrow Ltd, assuming Axe and Exe are sold in the
ratio 2:1 respectively. (6 marks)
(c) Re-compute the budgeted sales mix on the assumptions that:
(i) Total sales of both products (currently 12,000 units) should remain at this level and both
must be sold.
(ii) Prices and costs are unaffected by changes to the mix.
(iii) The minimum total profit required is R60 000. (6 marks)
(d) Assuming that the original budget was adopted, draw up a brief report on performance using a
marginal costing approach, given that the actual results were:
Axe: 6 250 units
Exe: 4 750 units
All price and cost budgets were achieved. (13 marks)
Solution
Berrow Ltd
Workings
1 Axe Exe
R R
Selling price 20 50
Less: Variable costs:
Material and labour (15) (31)
Finance costs – (3)
Bad debts – (1)
Contribution per unit R5 R15
Finance costs: The finance cost of R3 per unit has been included because Axe is sold for cash
whereas it takes 3 months to receive the cash from sales of Exe. There is therefore
an opportunity cost due to the timing, equal to 24% of selling price per unit over 3
months.
= R50 × 24% × 3 / 12 = R3
Note: Working capital costs are not usually included in management accounting
decisions. In this case, they have been included only because they are
mentioned in the question.
Bad debts: As for finance costs, bad debts constitute is a working capital problem. They have
only been included because they are mentioned in the question. As all of Axe is
sold for cash, there are no bad debts. For Exe, however, the cost is R50 × 2% per
unit = R1.
2 Average weighted contribution

Axe R5 × 2/3 = R3,333
Exe R15 × 1/3 = R5,00
R8,333
3 Total fixed costs

R19 800 + R36 000 + R3 200 + R4 000 = R63 000
(a) Break-even analysis – individual products
Based on avoidable fixed costs
R15 000
Axe: = 3 000 units
R5
R24 000
Exe: = 1 600 units
R15
(b) Break-even analysis – product mix

R63 000
= 7 560 units
8,333
This implies sales of: Axe: 5 040

Exe: 2 520
7 560
(c) Sales level for R60 000 target profit

Note: This requirement is very unusual and certainly not something you must spend too
much time on.
Fixed cost + Fixed profit
Break-even in units =
Average contribution per unit
63 000 + 60 000
12 000 =
Average contribution
Average contribution = 123 000 / 12 000 = R10,25

What mix of Axe and Exe will yield an average contribution of R10,25?
Let proportion of Axe = a% proportion of Exe = 1 – a%
Therefore [R5 × a%] + [R15 × (1 – a%)] = R10,25
5a + 15 – 15a = 10,25
10a = 4,75
a = 0,475 or 47,5% of Axe
Exe = 100 % – 47,5%
= 52,5 %
Axe = 12 000 × 47,5% = 5 700 units
Exe = 12 000 × 52,5% = 6 300 units
(d) Comparison with actual results

Original budget
R
Sales Axe 8 000 × 20 160 000
Exe 4 000 × 50 200 000
Material and labour costs 244 000
Finance costs 4 000 × 3 12 000
Bad debts 4 000 × 1 4 000
Separable fixed costs 39 000
Joint fixed costs 24 000
Profit R37 000
Actual R
Sales Axe 6 250 × 20 125 000
Exe 4 750 × 50 237 500
Material and labour costs 241 000
[ 6 250 × 15 + 4 750 × 31 ]
Finance costs 4 750 × 3 14 250
Bad debts 4 750 × 1 4 750
Separable fixed costs 39 000
Joint fixed costs 24 000
Profit R39 500
Reconciliation
8 000 Axe Budget profit 37 000
4 000 Exe
Sales volume + 2 500
– 1 750 Axe × R5 = – 8 750
+ 750 Exe × R15 = + 11 250
Expected profit 39 500
6 250 Axe
4 750 Exe Actual profit 39 500
The sales volume can be broken down into a sales quantity variance as well as a sales mix variance,
per standard costing.
Not required
Budget Standard mix Actual
Axe 8 000 7 333 6 250
Exe 4 000 3 667 4 750
12 000 11 000 11 000
1 The quantity variance is

Axe – 667 × R5 = – 3 335
Exe – 333 × R15 = – 4 995
– R8 330
2 The mix variance is

Axe – 1 083 × R5 = – 5 415
Exe + 1 083 × R15 = + 16 245
+ R10 830

At a Board meeting held on 02/01/19X1, the Accountant presented the following budgeted income
and expenditure account together with a cost-volume profit chart:
Production time
Budget income and expenditure account for the year ended 31/12/19X1
R
Sales 160 000 units 1 600 000
Manufacturing cost of sales:
Indirect labour 80 000
Overhead costs (fixed and variable) 560 000 1 200 000
Selling expenses (variable) 160 000
Budget margin of safety ratio: 0,25 (25%)

Inventory value per unit: R7,50
Opening inventory: nil
The actual results for the financial year ended 31/12/19X1 revealed the following:
(a) Sales volume increased to 180 000 units at an average selling price of R9,80.
(b) A special order was received at a selling price of R6 per unit. No selling expenses were incurred
in filling the order of 30 000 units.
(c) Raw materials were purchased at a discount of 5% due to the bulk purchases made.
(d) All other expenses incurred were as budgeted.
At a Board meeting, the Accountant produced the following abridged income and expenditure
account:
Actual income and expenditure account for the year ended 31/12/19X1
R
Sales 210 000 units 1 944 000
Production 250 000 units 1 625 000
Less: closing inventory (40 000 × R7,50) 300 000 1 325 000
Selling expenses 180 000
R359 000
The Managing Director was somewhat surprised to see such a high reported profit and comments
“Something is very wrong with this statement. We budgeted on a profit per unit of R1, the selling
price was less than budgeted and the special order sales were made at a below cost price of only R6.
How is it possible that the profits have sky-rocketed to R 359 000? I want a full explanation of these
vast differences.”

Write a report to the Managing Director explaining the difference between the original budget and
the reported profit of R359 000. Your report must include:
(a) Calculations showing the assumptions underlying the original cost-volume-profit statement.
(b) The original break-even point and expected profit per unit.
(c) A re-statement of the income and expenditure statement on a basis consistent with the original
cost-volume profit graph.
(d) An explanation of the difference between the profit calculated in (c) and the reported profit of
R 359 000.
Solution
Report to the Managing Director
From:
The original budget presented at the meeting held on 02/01/19X1, together with the cost-volume-
profit graph was based on the following:
R
Manufacturing variable costs 5
Selling expenses 1
Fixed costs: R
Overheads 400 000
R480 000
Break-even value R1 200 000

Break-even in units 120 000
From the above calculations, the profit per unit above break-even is R4 per unit (contribution). At a
sales level of 40 000 units above break-even (ie 160 000 units), the profit is 40 000 × R4 = R160 000.
Sales in units have increased from 160 000 to a total of 210 000 units. The expected profit at this
level is therefore 90 000 × R4 = R360 000. This figure must be adjusted for the decreased sales price
and lower cost of raw materials.
R
Budgeted profit at 210 000 unit level per CVP 360 000
Less:
Sales 180 000 × (10 – 9,80) price reduction – 36 000
Sales 30 000 × (10 – 6) price reduction – 120 000
Add:
Raw materials – discount 25 000
250 000 × (R2 × 5%)
Selling expenses on special order
Not incurred (30 000 × R1) 30 000
Expected profit R259 000
The above profit is consistent with the original cost-volume-profit graph, given the adjustments to
the sales, raw materials and selling expenses.
The above statement may be re-stated as follows (not required)

R
Sales
180 000 @ R9,80 1 764 000
30 000 @ R6,00 180 000
1 944 000
Production costs:
Raw materials (250 000 × R1,90) 475 000
Direct labour (250 000 × R1,50) 375 000
Indirect labour (250 000 × R0,50) 125 000
Variable overheads (250 000 × R1,00) 250 000
1 225 000
Less: Closing inventory (40 000 × R5,00) – 200 000 1 025 000
Manufacturing overheads (fixed) 400 000
Selling expenses (180 000 × R1,00) 180 000
The reported profit of R359 000 has been determined on an absorption costing basis, which means
that all manufacturing costs inclusive of fixed costs have been capitalised into the inventory
valuation. As a result, the closing inventory of 40 000 units has been valued at R7,50 per unit (R5
variable, R2,50 fixed). The cost-volume-chart shows the performance of the Company given that
fixed costs will be written-off in the period they are incurred. In other words, any closing inventories
will be valued at variable costs only of R5.
R
Reported profit R359 000
Less: Fixed costs included in inventory (40 000 × R2,50) 100 000
Workings:
Margin of safety = 0,25
Sales – B/E sales
0,25 =
Sales
0,25 = 1 600 000 – B/E sales
1 600 000
B/E sales = R1 200 000 or 120 000 units
Difference
Sales units 120 000 160 000 40 000
Value 1 200 000 1 600 000 400 000
Total costs 1 200 000 1 440 000 240 000
Profit – 160 000 160 000
The differential total costs of R240 000 are variable, as there is no change in fixed costs when
production/sales changes.
Variable costs = 240 000 ÷ 40 000 = R6
R
Material 2,00
Direct labour 1,50
Indirect labour (assumed variable) 0,50
Variable overheads 1,00
Selling expenses 1,00
R6,00
Fixed costs
At 160 000 units
R
Total cost 1 440 000
Variable cost (960 000) (6 × 160 000)
Fixed cost 480 000

PART A
Delta Enterprises Ltd manufactures three products (Alpha, Beta and Gamma) and the
standard cost per unit of each product is as follows:
Alpha Beta Gamma
R R R
Materials 40,250 2,100 48,125
Direct labour: Grade A 13,125 9,625 4,375
Grade B 2,625 7,875 23,625
For the year ending 30 June 19X5, budgeted fixed overheads are R1 050 000.
Grade A labour is paid at R8,75 per hour, while Grade B labour is paid at R5,25 per hour.
The sales department has produced the following sales budget for the year ending 30 June 19X5:
Sales price
Units per unit
Alpha 16 000 R98,00
Beta 28 000 R54,25
Gamma 15 000 R89,25
Upon seeing the draft sales budget, the Works Manager draws attention to the fact that a maximum
of 50 000 hours of Grade A labour and 120 000 of Grade B labour will be available, and overtime will
not be possible.

(a) Calculate how many units of each product should be produced to enable Delta Enterprises Ltd
to maximise profits. (20 marks)
(b) Prepare a budgeted profit statement for the year ending 30 June 19X5 based on your answer
to (a). (5 marks)
PART B
The Directors decide that the sales targets set in the draft sales budget should be accepted, provided
that it is profitable to do so. To achieve this, the company will (where necessary) sub-contract work
to maximise profits. The following quotations were obtained from an outside supplier who is
prepared to sub-contract the manufacture of completed units: Alpha R61,25 per unit; Beta R27,30
per unit, and Gamma R81,375 per unit.

Calculate how many units of each product should be produced and sub-contracted to enable the
company to maximise profits, and calculate the budgeted profit which would result for the year
ending 30 June 19X5. (15 marks)
Solution
PART A
Alpha Beta Gamma
R R R
Selling price 98,00 54,25 89,25
Variable cost 56,00 19,60 76,125
Contribution 42,00 34,65 13,125
Production time
Grade A (hours) 1,5 1,1 0,5
Grade B (hours) 0,5 1,5 4,5
Total
Grade A 62 300 24 000 30 800 7 500
Grade B 117 500 8 000 42 000 67 500
Limiting factor – Grade A labour only.
Contribution per limiting factor
Alpha R42 divided by 1,5 = R28
Beta R34,65 divided by 1,1 = R31,50
Gamma R13,125 divided by 0,5 = R26,25
maximise Beta, followed by Alpha, then Gamma
(a) Production schedule Grade A hours

Beta 28 000 units 30 800
Alpha 12 800 units 19 200
50 000
(b) Budget profit statement for year ending 30 June 19X5
R
Sales Beta 28 000 × R54,25 1 519 000
Alpha 12 800 × R98 1 254 400
Variable costs
Beta 28 000 × R19,60 548 800
Alpha 12 800 × R56 716 800
Profit R457 800
PART B
Alpha Beta Gamma
Variable cost of in-house manufacture 56,00 19,60 76,125
Cost of sub-contracting 61,25 27,30 81,375
Extra cost 5,25 7,70 5,25
Hours saved by sub-contracting 1,5 1,1 0,5
Extra cost per hour saved 3,5 7 10,5
Priority for buying out 1st 2nd 3rd
manufacture in-house 3rd 2nd 1st

OR Alpha Beta Gamma
Selling 98 54,25 89,25
Cost 61,25 27,30 81,375
Profit 36,75 26,95 7,875
Hours saved per unit if you buy out 1,5 1,1 0,5
maximise hours saved by manufacturing next best 1,5 × 31,50 1,1 × 28 0,5 × 31,50
Equals 47,25 30,8 15,75
Total 84,00 57,75 23,625
Contribution per hour ÷ 1,5 ÷ 1,1 ÷ 0,5
Equals R56 R52,50 R47,25
buy out 1st 2nd 3rd
In-house production Units Grade A hours
Gamma 15 000 7 500
Beta 28 000 30 800
Alpha 7 800 11 700
50 000
Buy from outside
Alpha 8 200 units
Budgeted profit
Contribution Alpha 7 800 units R327 600
Beta 28 000 units R970 200
Gamma 15 000 units R196 875
Contribution on Alpha bought out R301 350
Fixed costs R(1 050 000)
Profit R746 025
Budgeting and
budgetary control
l define budgeting and discuss its role in planning, control and decision-making
l identify and discuss the key features that a budgeting system should have to encourage
managers to engage in behavior that is in line with company objectives
l describe the various stages of the budget process
l prepare the master budget components, including the cash budget
l discuss the link between budgetary control and variance analysis
l discuss the need for flexible budgeting, and calculate the necessary income and expenditure
for specific flexed budgets
l describe zero-base budgeting
Budgets are accounting plans that normally serve the purpose of quantifying the objectives of the
firm and provide a basis for control and performance evaluation.
Budgets form a basis for quantifying company plans, which fall into three categories:
(a) Operating plans: Operating plans are directed at the production and investment objectives of
the firm.
(b) Administrative plans: These form the objectives of the development and maintenance of the
company’s structure.
(c) Strategic plans: These plans deal with the long-term company objectives in relation to
competitors, company growth and philosophy.
Reasons for budgeting

1 Periodic planning: The budgeting process creates a formal planning framework that provides
specific deadlines for each phase of the planning process.
2 Co-ordination of company activities and quantification of objectives: The budgeting framework
provides opportunities for the exchange of ideas among various company segments. Budgeting
also helps management to quantify the cost and benefit of different available alternatives. Costs
and revenues of every product and department are compared in order to choose the most
profitable course of action.
3 Performance evaluation: Budgets are estimates of future events; consequently, they form the
basis for evaluating performance. Budgets help to indicate to management what is expected of
them. The comparison of actual results to the original or flexed budget assists in highlighting
potential problems.
4 Cost awareness: Production managers, marketing managers and other line managers tend to
ignore costs and related benefits as they are concerned with efficient production or innovative
marketing techniques. Budgeting creates a cost-awareness in managers, with budget
responsibilities highlighted. Budgets also provide common ground for communication.
249
5 Goal orientation: Budgets should reflect plans to achieve company goals, rather than
departmental goals which are in conflict with overall company profitability. This problem is often
highlighted in the inter-departmental transfer of products or services.
Financial and management budgeting

It is necessary to define the objectives of the budgetary system to avoid a conflict of interest
between financial managers on the one hand and non-financial or operating managers on the other.
All too often, budgets are seen by line managers as a battle of wills, and they attempt to achieve the
maximum expenditure that they can get away with, or to achieve the minimum result that will keep
the financial managers happy.
Companies should recognise the two separate budgetary functions that form the overall corporate
objectives. These are:
l financial control
l management control.
The financial control is reflected in the master budget incorporating all the financial budgets from
sales to cash-flow, debt collection and the long-term financial planning. These functions are carried
out by the financial and management accountants.
Management control is concerned with the day-to-day physical operations of the company in line
with company objectives and goals. Management control is carried out by line managers from
general managers down to lower level management, and is expressed in physical measures of output
rather than in financial terms. The importance of management control is that the system will allow
for greater freedom of action by line management, thereby improving the attitude of workers. The
control will vary from specific details to more general target specifications.
Long-term planning
Long-term planning is concerned with defining the company objectives, which may be profit
maximisation; increase in market share of products sold, or increase in shareholder wealth. The
company objectives may also incorporate non-financial aspects such as employee job satisfaction;
improving company image, or environmental issues.
Long-term planning involves the identification of resources such as available finance generated from
operations or from shareholders and money-lenders, and the strategic use of those resources. A
strategic long-term plan will require the company to review past performance and identify its
strengths and weaknesses. Management will need to take a forward look, say five to ten years
ahead, and decide where it wants to be in terms of asset base, labour force and market share, as well
as non-financial issues such as staff training and corporate image.
Strategic planning is a complex process which involves taking a view of the company, the future it
is likely to encounter and then attempting to organise the structure and resources of the company
accordingly.
Strategic planning requirments

(a) The review of the expectations of external and internal company participants
(b) The establishment of data banks to provide past and current information for planning
(c) The establishment of preliminary long-term forecasts
(d) The evaluation of the strengths and weaknesses of the company, and the opportunities and
threats to the business from factors in its environment.
A full discussion of strategic planning and appraisal is beyond the scope of this book
The most common problem encountered in long-term planning is the short-term implementation of
such plans. When managers are motivated and remunerated on the basis of short-term
performance, they will be reluctant to take on a project that will yield short-term losses, even though
the project may be very profitable in the long-term. Management may see the long-term plans as
Chapter 8: Budgeting and budgetary control 251
vague and therefore seek to maximise short-term profits. (Refer to Divisional performance analysis).
Another problem encountered in long-term planning is the assumption that historical data can be
extrapolated to the future. Unknown economic and political changes often make future strategies
void within a short time.
Important: Refer to the chapter on Performance analysis of companies and divisions.
Defining the budget process

Budgets are long- and short-term plans expressed in quantitative terms, which can be financial or
physical. A budgeting system translates organisational goals and strategies into operational terms.
It is important that the budgeting system is followed up by comparing the actual results to the
budget, so that corrective action can be taken in future budgets and strategic plans.
The diagram below shows the relationship between planning and control. The strategic plan should
be based on, at least, a 5-year plan, or longer.
Planning Control
Monitoring of
Strategic plan actual activity
Long-term objectives Long-term budget
Short-term objectives
Short-term plan
Financial
Budgets Comparison to actual
control
Investigation
Management
control
Short-term plan Corrective action
Budgets
Figure 1
Budgeting and the human factor

Meeting of long- or short-term budgets is dependent on employees understanding the company
goals and acting in such a manner as to meet them. Sometimes companies will attempt to coerce the
employees to achieve budget by either offering a bonus or threatening to take action if budget is not
met. How the employees react is of vital importance, as lack of consultation may lead to industrial
disputes. The danger of strict performance evaluation is that management may distrust the purpose
of the budgetary system and see it as a pressure device.
Line management may develop innumerable devious means to beat the system, rather than use it as
an aid to the management of operations. One method often used by line management is to ensure
that the budget is not bettered, as future budgets will be even more stringent.
When line management resists the budget imposed on them, they may reduce overall efficiency,
resulting in dysfunctional behaviour. This will lead to a manager trying to find ways around the
budget, as he may feel that the controls set are too tight and performance is difficult. Managers may,
at times, manipulate the accounting data in order to improve the accounting measure of
performance such as return on investment, without actually improving the department or division’s
effectiveness.
Positive aspects of budgeting

l Budgeting forces management to plan.
l It provides resource information that can be used to improve decision-making.
l It sets benchmarks for resource use that can be used for future performance evaluation.
l It improves the process of communication and co-ordination.
The budgeting process should, where possible, be structured in such a manner that it
l sets appropriate standards of performance
l defines good performance and provides a means of measuring such performance, and
l stipulates how rewards are to be linked to results.
Defined, quantitative targets are more likely to motivate management to perform well, even if they
are difficult, as long as they are accepted by management. Budgets will motivate workers if they
represent a set of definite, quantitative goals, together with regular feedback on the attainment of
the standards. It is therefore essential that management is involved in setting standards and budgets.
Behavioural considerations
Companies often use budgets to motivate workers by offering bonuses based on actual managerial
performance in making budget or beating it. It follows that budgets can and do have a significant
behavioural effect and it is important that the budgeting systems are structured in such a way that
the effect is largely positive.
Aligning company and worker goals will produce a positive motivational force and cause corporate
goal-congruence. If the budgeting system creates a negative reaction in workers, who may see the
system as unfair and inequitable, you will create a subversive spirit leading to dysfunctional
behaviour in conflict with corporate goals. Companies should strive for a budgetary system that will
achieve complete goal-congruence between the workers and the company. How the ideal budgetary
system should be created is debatable, but the system should (where possible) have the following
characteristics:
l communication of corporate objectives and budgetary guidelines to all people responsible for
budget preparation
l determination of the success factors of the company
l full participation by all line management, with a commitment to meet corporate goals
l preparation of the sales budget
l preparation of budgets for all major operating activities
l negotiation of budgets and standards
l co-ordination and review of budgets
l acceptance and communication of all budgets by managers who will bear responsibility
l frequent feedback of actual performance against budget targets
l flexible budgeting capabilities
l monetary and non-monetary incentives.
The master budget

The master budget is the total budget package for a company; It is the end product of the budget
preparation process. The master budget consists of all the individual budgets for each part of the
company aggregated into one overall budget for the entire company. The development of the master
budget is a sequential process, in which information from one budget is carried forward to another
budget. Some elements, such as the capital expenditure budget, are independent.
Master budget
Sales budget Marketing budget
Inventory budget Production budget
Direct materials budget

Direct labour budget Manufacturing O/H budget
Cost of goods sold budget
Marketing expense budget
Admin expense budget
Budgeted net income
Capital expenditure budget Cash budget Budgeted balance sheet
Figure 2
Components of the master budget

Operating budget
l Sales budget
l Budget of ending inventories
l Production budget:
– Materials budget
– Direct labour budget
– Manufacturing overhead budget.
l Budgeted cost of goods sold
l Administrative expense budget
l Marketing expense budget
l Budgeted net income from operations
l Budgeted non-operating items
l Budgeted net income
Financial budget
l Capital expenditure budget
l Budgeted statement of financial position (balance sheet)
l Budgeted statement of changes in financial position
Operating budget
The operating budget is composed of the income statement elements. A manufacturing business
budgets for both manufacturing and non-manufacturing activities. We will discuss the various
elements of the operating budget of a manufacturing firm shortly.
Sales budget
The sales budget is the first budget to be prepared, and it is usually considered the most important
budget because so many other budgets are directly related to sales and are therefore largely derived
from the sales budget.
Factors that are taken into account

(a) Decisions made by competitors
What the competitors are doing is important, as we need to consider whether we are likely to
gain or lose market share. Perhaps we should even consider diversifying.
(b) State of local and world economy
We need to consider our current markets as well as the potential for export. Local and world
trends are important, especially as the two begin to merge as technological advances improve.
We need to consider inflation rates, exchange rates and cost of debt.
(c) International markets
These must be considered from both the exporting side and the effect that imported goods will
have on our projected sales.
(d) Effectiveness of advertising and promotion policies
The effect that advertising will have on our product needs to be considered. Where necessary,
surveys should be carried out to ascertain consumer tastes. Demand elasticity should also be
ascertained in setting a pricing strategy.
(e) Effects of seasonal fluctuations
We need to ascertain if there are any seasonal or cyclical trends that should be considered in
creating our objective or subjective forecasts.
(f) Stability of supplies
Consideration of supply lines is important, as disruption will cause production bottlenecks that
will affect sales.
(g) Historical data
In preparing forecasts, it is always important to analyse historical data to ascertain trends and
determine whether future expectations are likely to mirror historical trends.
Production budget
The production budget is dependent on the expected sales, together with required inventory levels
of finished goods. The production plan must take the opening inventory levels into account, and
specify the timing of production.
Direct materials budget

Purchases will be determined by opening inventory levels, desired closing inventory levels, and
production requirements. We need to consider:
(a) quantity discounts
(b) storage capacity
(c) inventory and re-order levels
(d) delivery times from suppliers
(e) liquidity constraints.
Direct labour budget

The direct labour budget is useful for production planning as well as for personnel management.
Consideration must be given to any changes in the type of labour talent needed as a result of
changes in the mix of products manufactured and sold. Significant swings in production during the
year cause much greater problems in planning for labour than for materials and manufacturing
overheads.
Factors requiring consideration

(a) establish general requirements for skilled and unskilled labour
(b) training needs
(c) staff turnover
(d) wage negotiating policies.
The cash budget

The cash budget is one of the most important budgets as it shows how liquid the company is at any
point in time. Cash budgets are normally prepared weekly or monthly, as they are required for
management information.
Key factors in preparing a cash budget

1 Establish opening cash balance
2 Estimate cash from operations, ie net income after adjusting for non-cash items such as
depreciation
3 Estimate timing of debtor cash receipts taking into account customer payment behaviour
4 Include all non-operating cash items such as capital purchases, repayment or advances on loans,
etc.
5 Estimate the amount and timing of credit payments, salaries and wages
The difference between the net income figure and net cash flow is explained to a large extent by the
changes in working capital.
Principal budget factors

The key to budgeting lies in the recognition of the sales market as well as the production limitations.
These may be listed as:
(a) expected sales levels of products
(b) production capacity dictated by space, machine output, availability of labour and material
(c) financial resources, both short- and long-term.
The following illustration is used to show you that there are several inter-dependent budgets that a
company is required to complete, such as
l sales budget
l finished goods budget
l production budget
l direct materials inventory budget
l direct materials purchase budget
l labour budget.
A company is also required to prepare budgets for manufacturing overhead, marketing expenses,
and administration expenses, as well as any other cost that it is likely to occur in a particular
budgeting period. In most examination questions however, you will only be exposed to the income
and expenditure budget as shown below, and (on the odd occasion) to the cash budget.
In practice, a budget is not only prepared on an annual basis but also on a bi-annual, quarterly or
even on a monthly basis. The following illustration is for a company that prepares a budget every six
months.
You have been presented with the following information for a company that manufactures and sells
two products, the Mondi and the Hilton.
Sales budget
1st half of the year – Sell 1 000 units of Mondi and 2 000 units of Hilton
2nd half of the year – Sell 1 500 units of Mondi and 1 200 units of Hilton
1st half of the following year – Sell 1 200 units of Mondi and 2 500 units of Hilton
Selling price is R120 per unit of product Mondi and R150 for product Hilton
Production requirements
Quantity per unit of product
Resource Price Mondi Hilton
Material A R2/kg 20 kgs
Material B R5/kg 10 kgs
Direct labour R20/hour 2 hours 2,5 hours
The company has a policy of holding sufficient opening inventory of finished products to meet 50% of
the sales for the following six months.
Direct materials
The company has a policy of holding sufficient opening inventory of Material A and Material B to
meet 50% of the material required for the production of both Mondi and Hilton in the following six
months. You are to assume that the production in the 1st half of the following year is 1 500 units of
Mondi and 2 000 units of Hilton.
You are required to prepare the following budgets for each half of the current year, as well as for
the whole year:
l sales budget
l finished goods budget
l production budget
l raw materials inventory budget
l raw materials purchases budget
l labour budget
l budget income statement.
Solution
Sales budget
First half Units Price Value
Mondi 1 000 R120 R120 000
Hilton 2 000 R150 R300 000
R420 000
Second half Units Price Value
Mondi 1 500 R120 R180 000
Hilton 1 200 R150 R180 000
R360 000
Whole year Units Price Value
Mondi 2 500 R120 R300 000
Hilton 3 200 R150 R480 000
R780 000
Finished goods budget

Policy – to keep sufficient inventory on hand to meet 50% of sales in the next six-month period.
Opening inventory at beginning of year
Cost Value
Mondi 50% × 1 000 = 500 R80 R40 000
Hilton 50% × 2 000 = 1 000 R100 R100 000
R140 000
Inventory at beginning of second half of the year
Cost Value
Mondi 50% × 1 500 = 750 R80 R60 000
Hilton 50% × 1 200 = 600 R100 R60 000
R120 000
Inventory at end of year
Cost Value
Mondi 50% × 1 200 = 600 R80 R48 000
Hilton 50% × 2 500 = 1 250 R100 R125 000
R173 000
Cost per unit of Mondi = Material R2 × 20 Labour R20 × 2
= R40 + R40 = R80
Cost per unit of Hilton = Material R5 × 10 Labour R20 × 2,5
= R50 + R50 = R100
Production budget
Mondi 1st half 2nd half Total
Required closing inventory 750 600 600
Less: Opening inventory 500 750 500
250 (150) 100
Add: Sales 1 000 1 500 2 500
Hilton 1st half 2nd half Total

Required closing inventory 600 1 250 1 250
Less: Opening inventory 1 000 600 1 000
(400) 650 250
Add: Sales 2 000 1 200 3 200
Note: The above figures have been calculated on the basis of 50% of the sales for the next six
months, eg opening inventory for Mondi for the 1st half of the year is 1 000 × 50% = 500.
Raw materials inventory budget

Policy – to keep sufficient inventory of Material A and B on hand to meet 50% of production in the
next six-month period.
Opening inventory at beginning of year
Cost Value
Material A 50% × 1 250 × 20 = 12 500 R2 R25 000
Material B 50% × 1 600 × 10 = 8 000 R5 R40 000
R65 000
Inventory at beginning of second half of the year
Cost Value
Material A 50% × 1 350 × 20 = 13 500 R2 R27 000
Material B 50% × 1 850 × 10 = 9 250 R5 R46 250
R73 250
Inventory at end of year
Material A 50% × 1 500 × 20 = 15 000 R2 R30 000
Material B 50% × 2 000 × 10 = 10 000 R5 R50 000
R80 000
Raw material purchases budget
1st half 2nd half Total
Material A
Required closing inventory 13 500 15 000 15 000
Less: Opening inventory 12 500 13 500 12 500
1 000 1 500 2 500
Materials for production 25 000 27 000 52 000
Current period purchases 26 000 28 500 54 500
Cost R2 R2 R2
Total cost R52 000 R57 000 R109 000
Material B
Required closing inventory 9 250 10 000 10 000
Less: Opening inventory 8 000 9 250 8 000
1 250 750 2 000
Materials for production 16 000 18 500 34 500
Current period purchases 17 250 19 250 36 500
Cost R5 R5 R5
Total cost R86 250 R96 250 R182 500
Labour budget
Mondi
Direct labour hours 2 2 2
Total hours 2 500 2 700 5 200
Hourly rate R20 R20 R20
Direct labour cost R50 000 R54 000 R104 000
Hilton
Direct labour hours 2,5 2,5 2,5
Total hours 4 000 4 625 8 625
Hourly rate R20 R20 R20
Direct labour cost R80 000 R92 500 R172 500
Budget income statement – 1st half of year
R
Sales 420 000
Opening inventory – Finished product 140 000
Opening inventory – Materials 65 000
Material purchases 138 250
Labour 130 000
473 250
Closing inventory – Finished product (120 000)
Closing inventory – Materials (73 250)
Cost of sales 280 000 (280 000)
Profit 140 000
Budget income statement – 2nd half of year
R
Sales 360 000
Labour 146 500
493 000
Cost of sales 240 000 (240 000)
Profit 120 000
Budget income statement for the year
R
Sales 780 000
Labour 276 500
773 000
Cost of Sales 520 000 (520 000)
Profit 260 000
The cash budget

The cash budget is normally the more complex budget to complete, especially in an examination
situation, as non-cash items appearing in previous budgets must be adjusted for. The receipt of
income and payment of expenses also tends to lag behind the actual period in which they are
incurred, which can create problems.
Hint: Before you attempt a cash budget, draw a diagram to determine where the cash-flows take
place.
Budgeted sales for a company are as follows:
January 10 000 @ R10 per unit
February 12 000 @ R10 per unit
March 16 000 @ R10 per unit
20% of all sales are for cash. The balance of sales is on credit. 20% of credit sales are paid for in the
month of sales, 50% the following month, and 25% the month thereafter. Bad debts are budgeted at
5% of credit sales.

Produce the cash receipts budget for January, February and March.
Solution
Tabulation
January February March
January – cash (20%) 100%
January – credit (80%) 20% 50% 25%
February – cash (20%) 100%
February – credit (80%) 20% 50%
March – cash (20%) 100%
March – credit (80%) 20%
Cash budget
January – cash 20 000 20 000
January – credit 80 000 16 000 40 000 20 000
February – cash 24 000 24 000
February – credit 96 000 19 200 48 000
March – cash 32 000 32 000
March – credit 128 000 25 500
Total cash receipts 36 000 83 200 125 500
Further information
70% of production requirements for any particular month are manufactured in the month required,
while the balance is manufactured in the previous month.
Material cost per unit is R5. 60% of the material required for production in a particular month is
purchased in the previous month. Material purchased is paid for as follows:
70% in the month acquired, and the balance the following month. Assume that sales for April and
May will be 20 000 units.
Solution
1 Production budget – units
January February March April May
Sales 10 000 12 000 16 000 20 000 20 000
Production 70%J + 30%F 70%F + 30%M 70%M + 30%A 70%A + 30%M
January 7 000
February 3 600 8 400
March 4 800 11 200
April 6 000 14 000
May 6 000
Production required 10 600 13 200 17 200 20 000
2 Material purchases budget
December January February March April
Production – units ? 10 600 13 200 17 200 20 000
Value – R 53 000 66 000 86 000 100 000
December January February March
January purchases 60% 40%
31 800 21 200
February purchases 60% 40%
39 600 26 400
March purchases 60% 40%
51 600 34 400
April purchases 60% 40%
60 000 40 000
R31 800 R60 800 R78 000 R94 400
3 Payments budget
Payment: 70 / 30
December N/A 9 540
January 42 560 18 240
February 54 600 23 400
March 66 080
Cash out-flow R52 100 R72 840 R89 480
Final cash budget
Sales 36 000 83 200 125 500
Materials (52 100) (72 840) (89 480)
Balance b/f – (16 100) (5 740)
(16 100) (5 740) 30 280
Learning curve application in budgeting

An order has been received to supply cell phones in batches of 50 over the eight quarters in
two years as follows:
Batches Cumulative
required batches
20.1 Q1 1 1
Q2 1 2
Q3 2 4
Q4 4 8
20.2 Q1 4 12
Q2 4 16
Q3 4 20
Q4 2 22
The labour and variable overhead costs are R40 per hour. Raw material is R200 per cell phone.
Fixed costs are R20 000 per quarter.
Planning and set-up costs of R22 000 will be incurred in quarter 1 and will be charged over the
total batches. The first batch hours are 2 000 and a learning curve of 80% will apply on
cumulative output up to and including the eighth batch; thereafter the learning curve levels
out and does not operate on any further batches.
The sales price per cell phone is R1 200.
Assume the following:
(a) Each quarter is self-contained and there is no work-in-progress or inventory carry-over to
the next quarter.
(b) Raw material is ordered and paid for a quarter in advance of production.
(c) Labour and variable overhead are paid for in the quarter in which they are incurred.
(d) Fixed overhead is paid in the quarter in which it is incurred.
(e) Planning and set-up costs are paid for in quarter 1.
(f) Sales are paid for in the quarter following that in which they are produced and sold. Sales
for Q4 in year 2 are received in the same quarter.

Prepare the income and expenditure accounts for 20.1 and 20.2, as well as the cash-flow
statement over the same period.
Solution
Labour and variable overhead – learning curve
Quarter 1
Batch 1 2 000 × R40 = R80 000
Quarter 2
Cost of one batch R80 000
Learning curve 80% × 80%
Average cost R64 000 2 batches – cumulative
2 batches – cumulative cost ×2
= R128 000
Less: Batch 1 cost R80 000
Therefore cost of second batch R48 000
Quarter 3
= R204 800
Less: 2 batches – cumulative cost R128 000 R64 000 × 2
Therefore for quarter 3 R76 800
Quarter 4
= R327 680
Less: 4 batches – cumulative cost R204 800 R51 200 × 4
Therefore for quarter 4 R122 880
Thereafter the price stabilises, therefore the cost per batch is R122 880 / 4 = R30 720
Income and expenditure account 20.1
Q1 Q2 Q3 Q4 Total
R’000 R’000 R’000 R’000 R’000
Sales 60 60 120 240 480
Costs:
Labour and variable 80 48 76,8 122,88 327,68
Material 10 10 20 40 80
Fixed 20 20 20 20 80
Planning and set-up 1 1 2 4 8
Total 111 79 118,8 186,88 495,68
Profit/(Loss) (51) (19) 1,2 53,12 (15,68)

Income and expenditure account 20.2
Q1 Q2 Q3 Q4 Total
R’000 R’000 R’000 R’000 R’000
Sales 240 240 240 120 840
Costs:
Labour and variable 122,88 122,88 122,88 61,44 430,08
Material 40 40 40 20 140
Fixed 20 20 20 20 80
Planning and set-up 4 4 4 2 14
Total 186,88 186,88 186,88 103,44 664,08
Profit 53,12 53,12 53,12 16,56 175,92

Cash-flow statement 20.1

Q1 Q2 Q3 Q4 Total
R’000 R’000 R’000 R’000 R’000
Opening balance (10) (142) (170) (246,8) (10)
Sales 60 60 120 240
Balance (10) (82) (110) (126,8) 230
Less: Costs
Labour and variable 80 48 76,8 122,88 327,68
Material 10 20 40 40 110
Fixed 20 20 20 20 80
Planning 22 22
Closing balance (142) (170) (246,8) (309,68) (309,68)
Note: The negative opening balance of R10 000 is the result of material being paid one quarter
in advance.
Cash-flow statement 20.2
Q1 Q2 Q3 Q4 Total
R’000 R’000 R’000 R’000 R’000
Opening balance (309,68) (252,56) (195,44) (118,32) (309,68)
Sales 240 240 240 360 1080
Balance (69,68) (12,56) 44,56 241,68 770,32
Less: Costs
Labour and variable 122,88 122,88 122,88 61,44 430,08
Material 40 40 20 – 100
Fixed 20 20 20 20 80
Closing balance (252,56) (195,44) (118,32) 160,24 160,24
Flexible budgeting
The master budget is constructed on the basis of a particular level of expected sales and inventory
policies. The actual sales and production more often than not are different to budget, which makes a
comparison of the original budget to the actual results invalid. When the original budget was
constructed and presented to the company managers, the management accountant would also have
presented the financial consequences for a range of alternative scenarios.
A good example of a change in the actual sales compared to budget is the Cost-Volume-Profit (CVP)
graph. The CVP graph shows the cost structure for the company within the relevant range and the
expected increase or decrease in profits if the actual sales are different to budget. If we wish to
compare the actual performance to budgeted performance, we would construct a flexible budget in
accordance with the company cost structure and compare it to the actual results.
Note: The CVP chart and performance analysis are variable costing concepts and cannot be done on
an absorption costing basis. However, if we wish to analyse the actual results on an
absorption costing basis we can do so, but the results will not be consistent with CVP
assumptions and will not reflect a correct analysis of performance.
If we compare the flexible budget to the actual results when analysing performance, does that
mean that the original budget is irrelevant?
The original budget is very important, as it is based on the expected sales and if the actual sales are
different to the expected sales we would want to know why. A correct analysis of performance must
start with the original budget, reconcile to the flexible or standard budget followed by analysis of
variances to arrive at actual profit.
Example
The XYZ Company produced the following budget at the beginning of the financial year:
Budget production and sales in units 10 000
R
Sales 900 000
The actual results for the year were as follows:
Actual production and sales in units 11 000
R
Sales 957 000

Prepare a statement comparing the budget to the actual profit.
Solution
Budget Flexed budget Actual Variances
Sales units 10 000 11 000 11 000
R R R R
Sales 900 000 990 000 957 000 –33 000
Direct materials 300 000 330 000 341 000 –11 000
Direct labour 200 000 220 000 209 000 +11 000
Variable overheads 100 000 110 000 122 000 –12 000
Fixed overheads 200 000 200 000 190 000 +10 000
Profit R100 000 R130 000 R95 000 R–35 000
Reconciliation statement
R
Sales volume variance 30 000
Variances (35 000)
The above statement shows that the expected profit for a sales level of 11 000 units is R130 000;
thus a total variance of R35 000 requires explanation. A complete variance analysis and reconciliation
is shown in the Standard Costing chapter.
Caution is required in preparing a flexible budget where the production is either higher or lower than
actual sales. This aspect, as well as absorption costing systems, is dealt with in detail in the Standard
Costing chapter.
Zero-base budgeting
Zero-base budgeting (ZBB) is an integration and formalisation of the underlying financial planning
techniques such as management team development, incremental cost-benefit analysis, and project
accountability through compulsory and systematic reviews.
In operation, the program centres on creating and evaluating “decision packages”. These documents
are self-contained, detailed descriptions of activity-level operating systems.
Conventional budgeting weakness

(a) Budgeting is usually carried out by financial or management accountants, with little or no
involvement of non-financial managers. The result is that management tends to operate with
little regard for budgeted costs or operating techniques, and fails to be cost-efficient.
(b) Conventional budgeting tends to be little more than an exercise aimed at updating the previous
year’s budgets, with little thought given to improving existing weaknesses or looking at cost/
benefit comparisons. Better alternatives in manufacturing, marketing or efficiency of current
operations are seldom considered.
(c) The budgeting formula used is:
Budget sales – budget costs = Profit.
Zero-base budgeting takes the view that the emphasis should be placed on minimising costs and
changes the formula to:
Budget sales – Profit = Maximum costs.
Defining zero-base budgeting

Zero-base budgeting is a procedure that requires every manager to justify in detail the nature and
level of his entire budget, relative to the functions required for the effective achievement of specified
objectives.
A company needs to identify

(a) The objectives of the firm and how they tie in with the objectives of each department.
(b) Each department, cost or profit centre and their goals. It also needs to decide whether more
departments are needed or whether some can be eliminated.
(c) The minimum level of resource (men, equipment and expenditure allowance) required to
provide any service whatsoever from each department.
(d) The additional resources that would be necessary to provide a limited but regularly available
service.
(e) The minimum requirement needed to enable a department to provide the customary level of
service.
(f) The improvements that could be made to the departments’ operations if additional resources
were available, justifying the increase or decrease in benefit derived for every incremental level
of cost.
The overall goal in zero-base budgeting is to identify and define the functions required, as well as
alternative levels of performance. The technique identifies and costs all alternatives, rates them
according to priority, and progressively implements them in the company.
How to implement zero-base budgeting

The following is an example of how zero-base budgeting could be implemented; it is not necessarily
the only way of carrying out the procedure.
1 Involve all managers who are responsible for spending and controlling money. Each should be
capable of being designated as a cost centre.
2 Give them guidance about what is involved in creating a workable budget. If they have never been
involved before, they will need to know what goes into the existing budget. Some basic training is
essential to avoid the whole exercise getting out of hand.
3 Have all necessary basic information available so that managers do not have to re-invent the
wheel.
4 Invite each manager to consider three ways of running his cost centre and provide a justification
for each, with priority ratings.
5 The first level must be the minimum that he believes is necessary to carry out the job at all. For
example, a buying department might simply place orders without ever seeking quotations of any
sort. The function would be accomplished, although the cost would be higher. Against this, the
cost of the buying department itself would be reduced.
6 The second level constitutes the standard operating level, ie the level at which the manager has
been (or would be) operating if he were at his “normal” level of staffing.
7 The third level is the expansion and diversification level. This gives the manager the opportunity
of saying what he would like to do if he were given the resources to do it. He would almost
certainly have to be able to show that the benefits of an expanded service would be of greater
value than the cost involved in providing them. To take the same example as above, the buyer
who is fighting for his life to place orders and has no time to seek quotations might well justify an
expansion in order to make greater net savings.
8 In every case where a manager wants to make a change, whether upwards or downwards, he
must interact with other related managers and comment meaningfully on the impact that such
changes would have on other cost centres. One great advantage of this is that managers would
have a greater understanding of the way in which the whole organisation works in an integrated
manner.
9 Each manager at the next level would review the three propositions of his subordinate managers
and add his report to each one. He, of course, would have the benefit of being able to see how
each relates to the other as well as to cost centres outside his own control.
Advantages of zero-base budgeting

1 Zero-base budgeting has the potential to develop a more vibrant and interactive management
team.
2 The decentralisation of budgeting formulation to line management has the advantage of tapping
the expertise of those closest to a problem or opportunity.
3 The participation of line management generates a greater degree of commitment on their part.
4 Since zero-base budgeting requires that detailed proposals and alternatives be provided to the
top decision-makers, the knowledge and experience of upper level managers can be more
appropriately applied.
5 Zero-base budgeting improves the planning function, as it requires that company and operational
objectives be clearly defined.
6 Excessive program appropriations and wasteful perpetuation of “pet projects” are less likely to
occur in the face of detailed planning and a comparison of accomplishments against previously
established standards.
7 Compulsory formal review of departmental functions generates a systematic method for judging
the adequacy of performance.
8 Zero-base budgeting highlights weaknesses in the company’s planning procedures.
9 It focuses attention on priority areas and unnecessary expenditure within the whole company.
Disadvantages/problems of zero-base budgeting

1 The yearly budget cycle requires continual management attention and updating, thus creating an
additional administrative cost.
2 The major difficulty is securing co-operation from employees at the inception stage.
3 Conversion to ZBB may have to be handled by a team of outside consultants, which could create
problems.
4 Abrupt imposition of ZBB can arouse panic, as certain managers fear evaluation and drastic
procedural change to their job.
5 Start-up costs are likely to be high in both time and value, as training sessions are necessary.
6 Inadequate training of line management.
7 Identification of departments where the technique can be used.
8 Fear that jobs within a department may be lost or departmental status may be reduced.
9 Defining the minimum or lowest practical level of operating.
10 Evaluating and priority-rating functions or departments that have little or no similarity.
Appendix
The working capital of Twinmate at the end of June 19X1 shows the following:
R
Finished production 43 200
Debtors (includes bad debts) 79 200
173 280
Creditors 26 880
Bank overdraft 40 000
Net working capital 106 400
The cost structure based on current selling prices is

% %
Sales price 100
Variable – inventory value
Materials 40
Variable costs 20
Total variable costs 60 60
Contribution 40
1 The selling price per unit is R120. All sales are made on credit. 50% of debtors pay their accounts
in the month the purchase is made and receive a 10% discount for early settlement. 30% of
debtors pay their account the month after the purchase, and the balance 2 months later. Bad
debts are 5% of monthly sales.
2 Sales data
Actual Budget
May June July August September October
800 1 000 1 000 1 200 1 200 800
3 It is company policy to have a closing monthly inventory of finished production equal to 60% of
the following month’s sales. Assume that November sales are 800 units.
4 50% of raw material required for production each month is purchased one month in advance of
production, and the balance in the month required. Raw material is paid in full in the month after
purchase.
5 All variable manufacturing costs are paid in the month incurred.

6 Monthly fixed costs are R24 000(inclusive of depreciation, which amounts to R6 000 per month).

Prepare the cash budget for the months of July, August and September.
Solution
Sales
Sales – units 800 1 000 1 000 1 200 1 200 800
Sales – value 96 000 120 000 120 000 144 000 144 000
May 45% 30% 15%
June 45% 30% 15%
July 45% 30% 15%
August 45% 30%
September 45%
(45% represents 50% of debtors less 10% for discount)
(15% represents the balance net of bad debts {100 – 50 – 30 – 5 = 15})
Debtors – May (15%) 14 400
Debtors – June 36 000 18 000
July 54 000 36 000 18 000
August 64 800 43 200
September 64 800
Sales cash-flow 104 400 118 800 126 000
Production
Closing inventory (next month) (Note 1) 600 720 720 480 480
Current month (Note 2) 400 400 480 480 320
Production 1 000 1 120 1 200 960 800
Notes:
1 Closing inventory is represented by 60% of next month’s sales.
2 Current month represents 40% of current month’s sales.
Material cash-flow
Material required
(R120 × 40% × production) 48 000 53 760 57 600 46 080 38 400
Purchased Total payment
June 24 000 + 26 880 = 50 880
July 26 880 + 28 800 = 55 680
August 28 800 + 23 040 = 51 840
September 23 040 + 19 200 = 42 240
R50 880 is purchased in June, paid in July.
R55 680 is purchased in July, paid in August.
R51 840 is purchased in August, paid in September.
R42 240 is purchased in September, paid in October.
Variable costs
May June July August September
Production 1 120 1 200 960
Value: Production × R120 × 20% 26 880 28 800 23 040
Cash-flow statement
July August September
Opening balance (40 000) (31 360) (15 040)
Sales 104 400 118 800 126 000
Material (50 880) (55 680) (51 840)
Variable costs (26 880) (28 800) (23 040)
Fixed costs (18 000) (18 000) (18 000)
Closing balance (31 360) (15 040) 18 080
Practice questions
John Berger, Managing Director of Siberian Instruments Ltd, feels that the time has come for a price
increase of R10,00 on the company’s only product, the “Tech-Mouse”. “Our costs have gone up 32%
since our last price increase,” he said, “and I think that justifies a price hike now. We’re almost down
to the break-even level and for the first time in 20 years we can’t pay a dividend to the
shareholders.”
The product is sold directly to industrial users at a price of R172. The factory cost estimates at the
time of the last price increase and at present are shown in the following table:
Then Now
R R
Materials 17,50 20,40
Direct labour 32,50 40,00
Factory overhead 65,00 91,60
Total factory cost R115,00 R152,00
The product specifications have not been changed since the previous price increase. Wage rates have
gone up by 30%, but some labour has been saved as a result of method changes that have been
effected during this period. The raw material is available in abundant supply and the cost increases
have been kept low by using multiple suppliers.
Factory overhead is recovered on the basis of total labour cost, and reflects estimated costs at
current volume. The rate is brought up to date once a year. The overhead cost files at the time of the
increase and at present show the following:
Then Now
Overhead rate (per R1 of direct labour cost) R2,00 R2,29
Estimated monthly direct labour cost R120 000 R110 000
Estimated monthly variable overhead cost R36 000 R31 900
All of the company’s sales people are on salary and all selling and administrative costs are regarded
as fixed. Even so, they have gone up in total from R40 000 a month to R50 000 a month.
Dave Pierce, Siberian’s Sales Manager, is against any price increase. “We have a tough enough time
now,” he said. “Our competitors’ list prices are about the same as ours, but my guess is that they’re
doing a little unofficial price-cutting. Our market share on this product has fallen from about 50% to
maybe 40%. If anything, we should be offering a few deals of our own, not raising prices.”
The factory is currently under-utilised at a level that represents 55% of direct labour capacity. If
required, the company can employ factory workers at the current hourly rate to bring the factory to
full labour capacity, which cannot be extended.
Dave Pierce has done a market survey on available opportunities which reveals the following
information:
Current product sales

A drop of R10 in the sales price will increase the sales volume by 30%.
An increase in the sales price by R10 will reduce the sales volume by 20%.
Export sales
A market exists for the sale of up to 2 000 units per month of the existing product on the overseas
market at a reduced selling price of R120, which will not affect the local customers.
New product
Dave believes that the company has the expertise to manufacture a new product that uses raw
material that is available in abundant supply. The product can be sold on the lucrative do-it-yourself
market. He has estimated the following selling price demand relationships per month:
Selling price Demand
R180,00 1 000 units
R160,00 2 000 units
R145,00 4 000 units
The costs of manufacture are estimated as follows:

Material: R35 per unit
Labour: R40 per unit on the manufacture of the first 12 000 units. A learning curve of
80% is considered appropriate for estimating labour time when output
doubles per batch of 12 000 units, up to a maximum production of 48 000
units. Thereafter learning levels off.
Variable overhead: R10 per unit.
Fixed overhead costs will increase by R10 000 per month if the new product is manufactured above a
monthly sales level of 2 000 units. Management is of the opinion that if the new product is sold, the
company must be committed to selling it for at least one year.

Write a report to the Managing Director proposing a monthly sales-plan that will maximise short-
term company profit for the next financial year. Your report must include:
l current monthly break-even in units (8 marks)
l current monthly margin of safety (2 marks)
l sales plans for different products/markets that will maximise profits (27 marks)
l associated risks or problems that the company may encounter, given your sales plan. (8 marks)
Solution
Report to Managing Director of Siberian Instruments Ltd
From:
Having examined the current operations of your company, as well as potential opportunities, I
believe that the profitability of the company can be improved as shown below.
Current break-even point and margin of sales

Analysis of costs: R
Direct materials 20,40
Direct labour 40,00
Variable overheads (Note 1) 11,60
Total variable costs 72,00
Selling price 172,00
Contribution 100,00
Note 1: Monthly labour 110 000,00
Labour cost per unit 40,00
Sales in units 110 000 ÷ 40 = 2 750 units
31 900 ÷ 2 750 = 11,60
Alternative
Total overhead 110 000 × 2,29 = 251 900
31 900
Variable overhead × 91,60 = 11,60
251 900
Total fixed costs
R
Total overheads (2 750 × R91,60) 251 900
Less: Variable overheads 31 900
Administrative and selling costs 50 000
Total fixed costs 270 000
270 000
Monthly break-even = 2 700 units
100
Margin of safety
2 750 – 2 700
= 1,82%
2 750
At the current level of sales, the company is financially vulnerable and must consider other
opportunities.
Labour is a limiting factor of production. The total available labour in Rand value is
R110 000 ÷ 0,55 = R200 000.
The company should therefore attempt to maximise the contribution per the limiting factor (labour
cost).
Analysis of current market sales

At a selling price of R172, contribution = R100
Contribution per R1 of labour (limiting factor)
R100 ÷ R40 = R2,50 Total labour usage R110 000
Increase of selling price by R10

Current sales = 2 750 units
Reduction by 20%
New sales 2 750 × 80% = 2 200 units
Total labour usage ( R40 × 2 200) = R88 000
Contribution = R100 + R10 = R110
Contribution per limiting factor = 110 ÷ 40 = R2,75
Decrease of selling price by R10
Current sales = 2 750 units
Increase by 30%
New sales 2 750 × 130% = 3 575 units
Total labour usage = R143 000
Contribution = 100 – 10 = R90
Contribution per limiting factor = 90 ÷ 40 = R2,25
Export market
Selling price R120
Variable costs R72
Contribution R48
Contribution per limiting factor = R48 ÷ 40 = R1,20
Total labour usage – up to = R80 000
New product (based on the average monthly demand over a 12-month period)
Demand 1 000 2 000 4 000
R R R
Material cost 35 35 35,00
Labour cost 40 32 25,60
Variable cost 10 10 10,00
Total variable cost 85 77 70,60
Selling price 180 160 145,00
Contribution 95 83 74,40
Limiting factor 40 32 25,60
Contribution per limiting factor 2,375 2,594 2,91
Labour usage 40 × 1 000 32 × 2 000 25,6 × 4 000
= 40 000 = 64 000 = 102 400
Note that the contribution per limiting factor at a level of demand of 4 000 units taking the increased
fixed cost of R10 000 per month into account is
R10 000 ÷ 4 000 ÷ 25,60 = 0,10 less or R2,81
Order of preference
Contribution Sales Labour
per limiting units usage
factor
R R R
New product 2,91 4 000 102 400
Existing product at increased selling price to R182,00 2,75 2 200 88 000
190 400
Balance export market 1,20 240 9 600
Given that the estimated demand versus selling price structure is correct, the company will maximise
its profits as follows:
Sales Contribution Total
units per unit contribution
R R
New product 4 000 74,40 297 600
Existing product at R182 2 200 110,00 242 000
Export 240 48,00 11 520
551 120
Fixed costs – 270 000
New fixed costs – 10 000
Total profit per month 271 120
Annual profit × 12 = R3 253 440
Based on the above calculations, the monthly profit has increased from R5 000 per month to
R271 120. I am of the opinion that the estimated statistics on the new product could be over-
optimistic and I would recommend that in the short-term the company should continue to sell at the
current selling price and explore sales of the new product by initially entering the market at the 1 000
unit level; thus minimising the risk of loss due to incorrect market assessments. In the short-term,
any sales on the export market will generate a positive contribution and such contribution should be
maximised given the available capacity.
In the medium- to long-term, the company should pursue its increased sale of the new product as a
high contribution of R2,91 per limiting factor is attainable due to the learning effect. A risk in this
strategy is the possible error in the estimation of the learning, which will reduce the contribution per
R1 of labour.
The recommended increase in the selling price of the existing product is also very risky as market
share will be further reduced. This may play into the hands of the competitors. It does, however,
offer a high contribution per R1 labour cost. A reduction in the sales price will increase market share
and may be a good strategy in the short-term.

You have been requested by Burling Ltd to assist one of its subsidiaries, Burtie Ltd, with the
preparation of a budget for the year ending 28 February 20X2.
Burtie Ltd uses an imported raw material in its production process. It also has a large interest
commitment which is expected to amount to R281 000 for the year ending 28 February 20X2. The
company uses specialised skilled labour, which is not freely available.
You obtain the following information regarding Burtie Ltd:

1 The company produces two products which are used in the manufacturing industry, namely Exe
and Zet.
2 Details of production factors available for the year ended 28 February 20X1 are as follows:
(a) Normal annual production capacity: 78 000 machine hours, which represents 80% of the
maximum production capacity, which can be utilised at 100% if required.
(b) Labour hours available: 54 000 hours. The same hours will be available in 20X2.
(c) Imported raw material available: 630 000 kilograms.
3 The following are the actual production costs for the year ended 28 February 20X1 at 78 000
hours (80% of maximum capacity):
Exe Zet
R per unit R per unit
Imported raw material: R2,50 per kg 3,75 6,25
Labour: R20 per hour 5,00 4,00
Production overheads: R7,50 per machine hour 1,50 3,00
Total production costs 10,25 13,25
Production overheads, of which 40% are fixed, are not expected to increase during the year
ending 28 February 20X2.
4 All foreign exchange arrangements regarding the group’s import requirements are made by the
corporate head office, which then allocates the available foreign currency to the companies in the
group.
Enquiries made at corporate head office indicated that the foreign currency allocated to Burtie
Ltd for the year ending 28 February 20X2 could be as follows:
Probability
Increase of 26% on last year 0,50
Same amount as last year 0,20
Decrease of 10% on last year 0,30
5 Changes in costs and sales for the year ending 28 February 20X2 are expected to be as follows:
(a) Imported raw materials: 20% increase in landed cost per kilogram compared to 20X1.
(b) Wages: 25% increase in hourly rate compared to 20X1.
(c) Administrative overheads: 2,5% increase on 20X1 cost of R80 000.
(d) The demand for the products for the year is estimated to be as follows:
l Exe: 80 000 units at a selling price of R17,15 per unit.
l Zet: 180 000 units at a selling price of R18,55 per unit.
6 The marketing division prepared the following variable budget with regard to the monthly selling
expenditure for the year ending 28 February 20X2:
Combined sales Selling expenses
Units R
15 000 41 250
20 000 45 000
24 000 48 000
7 Burtie Ltd was asked to tender for a government department order for a product which is the
same as product Zet, with the exception of a slightly different final finishing. Although this is only
a once-off order, it could pave the way for further orders in the future. The Managing Director
would therefore like the tender to be successful and wants the company to tender at the lowest
price possible without adversely affecting the company’s net income.
The tender has the following implications:
(a) 20 000 units of the product will have to be delivered evenly throughout the year.
(b) An additional machine costing R17 000 will have to be purchased for the final finish of the
product.
(c) An existing foreman earning R50 000 per year will have to supervise the production of the
product. It is estimated that, although he will spend 30% of his time on supervision of the
government contract, his total hours will remain the same as at present.
8 The company has an effective tax rate of 50%.
9 Burtie Ltd is confident that it will be exempt from the surcharge on imported raw materials.

(a) Prepare a budgeted income statement for the year ending 28 February 20X2, showing:
l budgeted net income for the year without the government contract
l budgeted net income for the year should the tender be successful.
Show the following as part of your answer:
l the quantity of each of Exe and Zet that must be produced in each case
l the tender price for the delivery of the product to the government department. (40 marks)
(b) Discuss any other qualitative factors that may be taken into account in determining the final
tender price. (5 marks)
SAICA (Adjusted)
Solution
(a) Possible limiting factors
(i) Machine hours: Maximum capacity 78,000 divided by 80% = 97 500 hours
Required for 20X2 production
Hours
Exe 0,2 × 80 000 = 16 000
Zet 0,4 × 180 000 = 72 000
88 000
Machine hours not a limiting factor
(ii) Labour hours

Maximum available 54 000 hours
Hours
Exe 0,25 × 80 000 = 20 000
Zet 0,2 ×180 000 = 36 000
56 000
Labour is a limiting factor
(iii) Raw material

Kgs
Exe 1,5 × 80 000 = 120 000
Zet 2,5 × 180 000 = 450 000
570 000
Assuming a continuous probability distribution, the foreign currency available will be –
Probability
126% × 0,50 = 63%
100% × 0,20 = 20%
90% × 0,30 = 27%
110%
20X1 foreign currency

630 000 × 2,50 = R1 575 000
Increase of 10% for 20X2 on above amount = R1 732 500
Raw material cost in 20X2 = R2,50 + 20% (R2,50)
= R3,00
Raw material available in 20X2 = R1 732 500 divided by R3
= 577 500 kgs
Therefore raw material is not a limiting factor
Contribution per limiting factor – labour
Exe Zet
R R
Sell 17,15 18,55
Variable costs:
Material 4,50 7,50
Labour 6,25 5,00
Variable o/h 0,90 1,80
Variable selling 0,75 0,75
Contribution 4,75 3,50
divided by labour hrs 0,25 0,20
Contribution per labour hour = 19,00 = 17,50
Labour hours
Therefore sell and produce: 80 000 Exe 20 000
170 000 Zet 34 000
54 000
Budgeted income statement for the year ended 28 February 20x2

Exe Zet Total
Sales (units) 80 000 170 000
R R R
Sales value 1 372 000 3 153 500 4 525 500
Material (W1) (360 000) (1 275 000) (1 635 000)
Labour (W2) (500 000) (850 000) (1 350 000)
Variable costs (W3) (72 000) (306 000) (378 000)
Fixed costs (W4) – – (234 000)
Interest (281 000)
Administrative overheads (82 000)
Selling expenditure (W5) (547 500)
Net income before taxation 18 000
Tax (9 000)
Net profit after tax 9 000
Workings
1 R2,50 × 20% + R2,50 = R3,00
Exe usage 20X1: R3,75 divided by R2,50 = 1,5
Zet usage 20X1: R6,25 divided by R2,50 = 2,5
20X2 Exe 1,5 × 3 × 80 000 = 360 000
20X2 Zet 2,5 × 3 × 170 000 = 1 275 000
2 R20 × 25% + R20 = R25

Exe usage 20X1: R5 divided by R20 = 0,25
Zet usage 20X1: R4 divided by R20 = 0,2
20X2 Exe 0,25 × R25 × 80 000 = 500 000
20X2 Zet 0,2 × R25 × 170 000 = 850 000
3 Variable costs 60%
therefore Exe R1,50 × 60% = 0,90
Zet R3,00 × 60% = 1,80
Exe usage 20x1: R0,90 divided by 4,50 = 0,2
Zet usage 20x1: R1,80 divided by 4,50 = 0,4
20x2 Exe 0,2 × 4,50 × 80 000 = 72 000
20x2 Zet 0,4 × 4,50 × 170 000 = 306 000
4 Fixed costs R7,50 × 40% = R3
Annual R3 × 78 000 hours = R234 000
5 Units R
High 24 000 48 000
Low 15 000 41 250
9 000 R6 750
Therefore R6 750 divided by 9 000 units = 0,75 variable per unit
Fixed = R30 000
Annual fixed costs = R360 000
20X2 sales 250 000 units
therefore 250 000 × 0,75 = R187 500
Total selling costs R187 500 + R360 000 = R547 500
Tender price
Reduction in income R
Zet 20 000 × 18,55 – 371 000
Reduction in costs
Variable selling 20 000 × 0,75 + 15 000
Increased costs
Additional machine – 17 000
Minimum tender price 373 000
Budgeted income statement for the year ended 28 February 20X2
Exe Zet Contract Total
Units 80 000 150 000 20 000
R R R R
Sales value 1 372 000 2 782 500 373 000 4 527 500
Material (1 635 000)
Labour (1 350 000)
Variable costs (378 000)
Fixed costs (234 000)
Interest (281 000)
Selling expenditure (532 500)
Additional machine (17 000)
Tax (9 000)
(b) 1 By accepting the special order, we will have to drop the sales of Zet by 20 000 units. The
future effect on our current Zet customers must therefore be considered.
2 The marketing expenses will be reduced by R15 000. If this amount represents commission
payments, then the company must consider the effect on its employees.
3 The company is at full capacity with regard to labour hours. If labour hours cannot be
increased, then the company should consider quoting a high tender price as its profits will
not be affected if the tender is lost. The company is only just above break-even and it would
be advisable to attempt to increase selling price.

The chief executive of your organisation has recently seen a reference to zero-base budgeting. He
asked for more details of the technique.
You are required to prepare a report for him explaining:

(a) What zero-base budgeting is, and to which areas it can best be applied.
(b) What advantages the technique has over traditional-type budgeting systems.
(c) How the organisation might introduce such a technique.
(d) What problems might be met in introducing zero-base budgeting.
Solution
(a) Zero-base budgeting is a procedure that requires every manager to justify in detail the nature
and level of his entire budget, relative to the functions required for the effective achievement of
specified objectives. It also entails defining a minimum level of expenditure, below which a
function cannot be performed adequately or at all (often between 55% – 75% of current levels)
and justifying in terms of cost-benefit the incremental levels requested (hence the name “zero-
base budgeting”). Thus, every manager is forced to examine possibilities of lower levels of
expenditure than the current ones. The key to zero-base budgeting lies in:
(a) Identification and definition of functions required.
(b) Definition of objectives of each function.
(c) Effective costing of each function.
(d) Identification, formulating and costing of alternatives and different levels of performance.
(e) The priority-rating of these.
(f) Progressive implementation.
The major problem with zero-base budgeting is that it is very time- consuming. However, it does
not have to be applied throughout the organisation. It can be applied selectively to those areas
about which management is most concerned.
(b) The benefits of this method over traditional methods of budgeting are claimed to be:
1 Traditional budgeting tends to extrapolate the past by adding a percentage increase to
current year costs. This becomes very much a preservation of the status quo, as the
relationship between costs and benefits for a particular activity is rarely questioned. Zero-
base budgeting represents a move towards allocation of resources by need and benefit.
2 Zero-base budgeting creates a questioning attitude rather than one which assumes that
current practice represents value for money.
3 Zero-base budgeting focuses attention on outputs in relation to value for money.
4 Zero-base budgeting leads to increased staff involvement, which may lead to improved
motivation and greater job interest.
(c) It is preferable to introduce zero-base budgeting selectively rather than introducing it “across
the board”. The approach should initially be applied to those activities where immediate
benefits are likely. This might lead to a greater acceptance by the users. Care should be taken in
selecting the activities to which zero-base budgeting is to be applied. It is best suited to non-
manufacturing activities and non-profit making organisations. When the system is introduced,
meetings and seminars should be arranged explaining the principles of zero-base budgeting.
Because zero-base budgeting is costly and time-consuming, there are strong arguments for
selective ad hoc applications which are likely to yield benefits. It is unlikely that a universal
application of zero-base budgeting in an organisation can be justified.
(d) The problems that might be met in introducing zero-base budgeting include:
(i) The implementation of zero-base budgeting might be resisted by staff. Traditional
incremental budgeting tends to protect the empire that a manager has built. Zero-base
budgeting challenges this empire; therefore there is a strong possibility that managers
might resist the introduction of such a system.
(ii) There is a need to combat a feeling that current operations are efficient.
(iii) The introduction of zero-base budgeting is time-consuming.
(iv) Lack of top management support.

The directors of Abe Trading Company Limited have been concerned about the problems of cash
shortages and have asked you to assist them in the preparation of a cash budget for each of the next
three months.
The company sells on both cash and credit terms. Customers who pay their accounts within 15 days
are given a cash discount of 5%. Likewise, Abe Company always pays cash on receipt of purchases in
order to obtain 4% discount.
Forecast sales for the next three months are as follows:
June July August
R R R
Credit sales 80 000 80 000 90 000
Cash sales 20 000 25 000 27 000
Total sales 100 000 105 000 117 000
The profit mark-up on sales gives a gross profit margin of 50% on gross cost. It is estimated that the
above sales will require an inventory of goods of R90 000 sales value to be maintained.
An analysis of customer accounts discloses that 80% of credit customers pay in time to take
advantage of the cash discount, while the remainder pays within 15 to 60 days. There are no bad
debts in this business. On average, 25% of credit sales made during a particular month will be in
debtors at the end of that month (ie sales take place on an even basis, therefore certain sales are still
within the 15-day discount period at the end of the month). The ratio of this figure with regard to
those customers paying within 15, 30 and 60 days is always 80% : 10% : 10% respectively.
The estimated other expenses payable monthly are as follows:

Fixed R14 000 per month
Variable 10% of gross sales
Included in the fixed expense is a depreciation charge of R3 000. A capital payment of R20 000 is
required to be made during July.
The balances at the beginning of June are as follows:

Cash R6 000
Inventory R50 000
Debtors R18 000
Credit sales for May – a low sales month – were R56 000, of which R14 000 was still outstanding at
the end of the month. The remainder of the debtors represent April sales.

Prepare a cash budget for the months of June, July, and August.
Solution
Abe Trading Company: cash budget
June July August
Opening balance 6 000 5 040 (2 460)
Cash sales 20 000 25 000 27 000
Credit sales (see Workings) 73 640 76 200 84 000
99 640 116 240 108 540
Purchases 73 600 67 200 74 880
Fixed costs 11 000 11 000 11 000
Variable costs 10 000 10 500 11 700
Capital expenditure 20 000
Balance 5 040 (2 460) 10 960
Workings
June July August
April debtors 4 000
May debtors
80% R11 200 (less 5%) 10 640
10% 1 400 1 400
10% 1 400 1 400
R14 000
June credit sales

Discount portion R48 000 (less 5%) 45 600
Paid within 30 days 12 000 12 000
60 000
80% 16 000 (less 5%) 15 200
10% 2 000 2 000
10% 2 000 2 000
R80 000
July credit sales

Discount portion R48 000 (less 5%) 45 600
80% 16 000 (less 5%) 15 200
10% 2 000 2 000
10% 2 000
R80 000
August credit sales

Discount portion 54 000 (less 5%) 51 300
Other (25%) 22 500
R90 000
Total 73 640 76 200 84 000
Purchases
June July August
R R R
Sales 100 000 105 000 117 000
Cost of sales 66 667 70 000 78 000
Opening inventory 50 000 60 000 60 000
Closing inventory 60 000 60 000 60 000
Increase inventory 10 000 – –
Purchases 76 667 70 000 78 000
Less: 4% 3 067 2 800 3 120
73 600 67 200 74 880
If sales = 100% then cost of sales = 66% profit 33%

100 – x = 0,5x
Therefore 100 = 1,5x
Therefore x = 66,666%
x = Cost of sales
Standard
costing
l discuss the need for a standard costing system and the different types of standards
l understand the principle of reconciling the budget profit to actual profit
l reconcile the budget profit to actual profit where actual production is higher or lower than
actual sales
l calculate material, labour, overhead and sales variances
l identify and discuss the causes for variances and possible remedies
l distinguish between standard variable and standard absorption systems
The purpose of standard costing

The need for a standard costing system has to be seen in the context of budgeting in general. A
budget is a quantitative analysis of a plan or a corporate action. It is intended that production and
sales be co-ordinated by all departments in order to achieve the expectations about future income,
cash-flows, financial position and supporting plans.
The individual budgets are seen as approximations to the company’s objectives, inputs and outputs.
Standard costing then is a system that enables management to analyse deviations from budget so
that future costs can be controlled more effectively. Standard costs are predetermined target costs
which should be incurred in production.
When a company prepares a budget, it is making a statement about expected sales, costs and profits.
The budget is, in a sense, a map showing the final destination, plus the route we need to follow to
reach it. It is therefore vital that the budget is never discarded and it is equally vital that we compare
it to the actual results, so that we can see where we went wrong or how we can do better in the next
accounting period.
Example – Budget
R
Cost of sales:
Material 2 000
Labour – variable 1 800
Selling – variable 700
Selling – fixed 1 000
Profit 2 000
The key elements in the above budget are the sales units/value and the profit. Any change in sales
will have an effect on profit. To maximise profit, a company should attempt to maximise sales units
where sales price is a given, or maximise a combination of sales/contribution, where the market is
price-sensitive.
283
While preparing the budget, the management accountant would have considered what effect actual
sales of both a greater and a smaller number of units than the budget sales of 1 000 units would have
on the budgeted profit. He would also have asked the question “What if sales are as low as 800 units
or as high as 1 200 units?”
Based on the “budget standards” the expected profit would be as follows:

Sales 800 units Sales 1 200 units
R R
Sales 8 000 12 000
Material 1 600 2 400
Labour 1 440 2 160
Fixed overheads 2 500 2 500
Selling – variable 560 840
Selling – fixed 1 000 1 000
Profit 900 3 100
On the basis of the original budget, the management accountant would state that the contribution
per unit is R5,50. He would also state that, if actual sales were 200 units less than budget, then the
expected profit will be R1 100 less than budget, and that if actual sales were 200 units more than
budget, he would expect a profit R1 100 higher than budget.
Having prepared the budget, the company will now wish to evaluate the actual performance of the
company. The management accountant would do this by obtaining the actual results and reconciling
the budget profit to the actual profit.
Why start with the budget profit?

The budget profit is the expectation or “destination”. If the budgeted profit was not achieved it
should be investigated and the difference between budgeted and actual profit explained. Therefore,
the starting point is always the budget profit.
If actual sales differ from budget, the company’s performance will immediately be affected in every
respect, both sales revenue and costs. The second point of reference must therefore be actual sales
units. Without actual sales you cannot measure performance.
Note: Actual production costs are irrelevant to the assessment of initial expected profit.
Continuing with the above example, if the company actually sold 1 200 units, can the company’s
performance be analysed?
Solution
R
1 000 units Budget profit 2 000
200 × R5,50 Sales volume variance 1 100
1 200 units Expected profit (or standard profit) 3 100
Based on the budget or “standard”, the expected actual profit would be equal to R3 100. In terms of
performance the sales department has done well to sell 200 units more than budgeted, which should
lead to an increase in profit of R1 100. It could be asked why the sales budget was not set at 1 200
units, because, although there is a favourable sales variance, it could be indicative of poor or
conservative budgeting.
The first “standard costing variance” ie the “sales volume variance” has now been identified, but at
this point a logical explanation of expected profit based on the budget was given. The same
reconciliation will be done when reporting on the performance of a company that does not have a
standard costing system.
Chapter 9: Standard costing 285
What if the actual income statement is as follows and a report explaining how the company
performed is required?
Sales 1 200 units R
Sales 10 800
Material 2 280
Labour 2 400
Selling – variable 1 080
Selling – fixed 1 200
Profit 1 240
Procedure – reconciliation of budget to actual profit

R
200 × R5,50 Sales volume variance 1 100
1 200 units Expected profit 3 100
Sales price variance – 1 200
Materials variance + 120
Labour variance – 240
Fixed variance – 100
Sales – variable cost variance – 240
Sales – fixed cost variance – 200
1 200 units Actual profit 1 240
The above statement analyses performance by looking at the original budget profit of R2 000 and
comparing it to the actual profit of R1 240. This is not a standard costing reconciliation. It is a simple
statement that looks at the performance for each category of cost and sales without doing an in-
depth analysis. Every company should do the above analysis, even if it does not operate a standard
costing system. The reconciliation above is based on a standard variable costing system.
Note: Later on a standard absorption costing system will be explained.
So, what is standard costing and what is its purpose?

Standard costing is a system that analyses performance in detail. The purpose is to look at each
category of variance and do an in-depth analysis of what went wrong or right, and establish how,
given this information, we can do better in the next accounting period.
Elements used in setting standards

A standard is a performance target against which actual costs are compared. This means that the
target can be set to varying levels depending on management participation and employee aspiration
levels. For a standard costing system to be successful, individual standards must be both meaningful
and attainable.
Standards should not be optimal levels of performance but company goals which assist in motivating
employees. This means that standards must be varied to take account of different manufacturing
methods and different work groups.
Basic cost standards

Basic cost standards represent an attainment value which does not change over long periods of time.
It is used as a basis from which current standards can be developed, as well to compare actual results
over a period of years. A trend is developed over time, showing improved efficiencies. The main
problem with using cost standards is that they do not represent current attainable standards, and for
this reason are seldom used.
Current attainable standards

Current attainable standards are most frequently used, as they are based on current operating
conditions and take account of machine breakdowns, substitute materials etc. They are also a fair
base from which to evaluate the performance that employees are accountable for.
Variance analysis based on current standards identifies deviations from expected performance in the
short-term, based on attainable goals.
Ideal standards
Ideal standards reflect the minimum operating costs under ideal conditions. Such standards seldom
represent a target as they are seen as being impossible to achieve and so demotivate workers.
Ideal standards can provide long-term goals where performance improvements are seen as an
objective to be achieved over a longer period.
Effect of learning curves in standard costing

In many production situations, the labour efficiency is improved over time due to the learning effect.
This aspect is dealt with under separate heading.
Reconciliation of budget to actual profit

The annual (or quarterly) budget refers to the total revenue or total cost expected for a given period.
From the budget statement, “unit” standards are calculated to obtain the standard unit cost of a
product.
Example
Annual budget
Sales units 100 000
Production 100 000
R R
Sales 500 000
Cost of sales:
Labour 100 000
Fixed costs 100 000
On the basis of the above budget statement, the standards are

Standard selling price: R5 per unit.
Standard cost per unit:
Material R1,50
Labour R1,00
Variable overheads R0,80
Total variable cost R3,30
Fixed cost per unit at a level of production of 100 000 units is R1. (The treatment of fixed costs under
a variable costing system instead of an absorption costing system is discussed later.)
In standard costing, the fundamental issue is not that the total variable costs should be R330 000 but
that each unit produced should have a variable cost of R3,30.
Assuming that actual production and actual sales are 80 000 units, the first step is to reconcile the
budgeted profit to the standard profit.
Standard profit statement

The standard profit statement calculates the profit the company should expect from known sales
units and production units. It forms the basis for calculating performance variances. For example, if a
company budgeted to spend R100 000 on producing 500 units, it would be ridiculous to say that the
company has overspent if the actual production of 600 units cost R110 000. The only acceptable cost
comparison would be to compare the actual cost of R110 000 to what it should cost to produce 600
units. Put another way, had we known that production was going to be 600 units, what would the
budget cost have been? Although it is important to establish why production was more or less than
budgeted, manufacturing performance can only be compared to the standard, and not to the budget.
Comparison of a static budget to a flexed budget

Example
Assume that a Company’s actual production is 80 000 units.
Annual Standard profit
budget statement
(static) (flexed)
Sales units 100 000 80 000
Production units 100 000 80 000
R R
Sales 500 000 400 000
Costs of sales:
Raw material 150 000 120 000
Labour 100 000 80 000
Variable costs 330 000 264 000
Fixed costs 100 000 100 000
Total costs 430 000 364 000
Profit R70 000 R36 000

Reconcile the budget profit to the standard profit.
Solution
Reconciliation of budget profit to standard profit
R
Less: Cost of sales 430 000
Less: Volume variance 34 000 (20 000 units × contribution R1,70)
Standard profit R36 000
In other words, the difference between the budget and the standard profit is due to a drop in
production/sales of 20 000 units (a sales volume variance of R34 000 calculated on a profit basis).
Selling price R5
Variable cost of sales R3,30
Contribution/profit R1,70
Therefore, R1,70 × 20 000 units = R34 000

Alternative reconciliation
R
Less: Volume variance 100 000
Standard sales 400 000
The above reconciliation calculates the sales volume variance to be R100 000, based on sales value
rather than sales profit, ie 20 000 units × R5 = R100 000.
The first step in reconciling the budget profit to actual profit is to reconcile the budget profit to the
standard profit.
Standard profit is
actual units sold × standard selling price per unit, minus
actual units sold × standard cost per unit
Two alternative reconciliation methods:

Budget sales Standard sales
– Budget cost of sales – Standard cost of sales
Budget contribution Standard contribution
– Budget fixed cost – Standard fixed costs
Budget profit Standard profit
Reconcile budget sales to budget profit to standard profit
Reconcile budget sales to standard sales to standard profit

Note: It is more meaningful and easier if you always reconcile the budget profit to the standard
profit and then to the actual profit. Do not go from budget sales to standard sales.
Figure 1
Actual results
Now let us consider the actual results and complete the reconciliation of standard profit to actual
profit.
Actual profit statement
Sales/Production 80 000 units
R R
Sales 410 000
Cost of sales:
Labour 100 000
Fixed costs 100 000
Comparative statements
Actual Standard Variance
Sales/Production 80 000 80 000
R R R
Sales 410 000 400 000 + 10 000
Cost of sales:
Raw materials 130 000 120 000 – 10 000
Labour 100 000 80 000 – 20 000
Variable costs 70 000 64 000 – 6 000
Fixed costs 100 000 100 000
Profit R10 000 R36 000 – R26 000
At a sales level of 80 000 units, the company should expect a profit of R36 000. As the profit was only
R10 000, the total variance is a negative R26 000.
Important:
The variance calculated above, with the exception of the sales variance of R10 000, represents the
total variance per cost category. In other words, it is not necessary to use a formula to calculate the
variances. All standard questions require the above comparison.
Reconciliation of budget to actual profit – variable costing

Less: Sales volume variance 34 000
80 000 units Standard profit R36 000
Variances Favourable Unfavourable
Sales price 10 000
Material 10 000
Labour 20 000
10 000 36 000 (26 000)
80 000 units Actual profit R10 000
The only detail outstanding from the above reconciliation is the individual variances that make up the
category total.
Reconciliation of budget to actual profit – absorption costing

R
Less: Sales volume variance (20 000 × profit R0,70) 14 000
80 000 units Standard profit R56 000
Sales price 10 000
Material 10 000
Labour 20 000
10 000 56 000 (46 000)
80 000 units Actual profit R10 000
The profit of R0,70 in the sales volume variance above comes from the original budget of 100 000
units where the profit is shown as R70 000. Profit per unit is therefore R70 000 / 100 000 = 70c.
Note: When reconciling under an absorption costing system, all variances are the same as variable
costing, except sales volume variance and fixed production overheads. If actual production
were different to actual sales, the actual profit would also be different.
Why is there a difference in the sales volume and fixed cost variance?
The difference exists because, if the company operates an absorption standard costing system, it is
(in effect) operating a “fully-integrated absorption costing system” which means that the fixed
manufacturing cost per unit is charged to production at the “standard rate”. Fixed cost is therefore
treated in essence as a “variable” cost which leads to profit per unit varying with every unit sold. The
difference between budgeted fixed cost and actual fixed cost is adjusted by the under- /over-
recovered fixed cost, which in standard costing is shown as
Fixed volume variance
Fixed expenditure variance
Note: Revise chapter 2 to fully understand the effect of under-/over-recovery and how it breaks
down into a volume and expenditure reconciliation of budget cost to actual cost.
Principles of standard costing

Standard costing is a system that sets detailed standards of production and sales performance so
that the company can easily analyse what is going wrong and rectify the problem in the following
accounting period.
A standard represents the expectation of how costs should be incurred.
Example – Material standard

1 unit = 2 kg
1 kg = R10
The above material standard is stating that every kilogram of material purchased should cost R10
(price standard) and that two kilograms of raw material should yield one unit of output. The standard
cost of a unit of production is therefore R20.
If the actual cost was found to be R30 per unit, rather than the standard cost of R20 per unit, I would
want to know why. There are two possible reasons:
1 The actual price of raw material was higher than budget.
2 The input usage per unit was higher than budget.
Very important:
If a company uses a standard costing system (variable or absorption) then all inventory
accounts must be at a standard value all the time.
The following inventory accounts must be at standard value always:

Raw material inventory Work-in-progress Finished goods
At std At std
Actual
cost Actual
Variances
Variances production
costs
c/s std value c/s std value c/s std value
Figure 2
Example
Budget 1 000 units
R Standard/unit
Material 5 000 R5 (at say R2 per kg)
Variable costs 20 000 R20
Fixed costs 10 000 R10 (absorption costing only)
R35 000
Now, if the actual results were

Purchase of raw material 4 000 kg @ R2,10/kg
Fixed costs R12 000
Closing inventory Raw materials 1 000 kg
WIP 100 units 1/2 complete (all costs are incurred evenly)
Finished goods 100 units
The company had no opening inventory of raw material, WIP or finished goods. The company sold
1 200 units.
What was the actual cost of sales?
Solution – Variable costing

Actual costs: R
Raw material 4 000 × 2,10 8 400
Fixed costs 12 000
44 700
Less: Closing inventory:

Raw materials 1 000 × R2 (2 000)
WIP (100 × 50% = 50 × 25) (1 250)
Finished goods (100 × 25) (2 500)
Actual cost of sales R38 950
Solution – Absorption costing

Actual costs: R
Raw material 4 000 × 2,10 8 400
Fixed costs 12 000
44 700
Less: Closing inventory:

Raw materials 1 000 × R2 (2 000)
WIP (100 × 50% = 50 × 35) (1 750)
Finished goods (100 × 35) (3 500)
Actual cost of sales R37 450
Changes in standard costs

From time to time, standard values must be adjusted to be in line with future expectations. This
means that all inventory accounts must be adjusted to reflect the new standard if the change in
standard resulted from permanent variances. If the change only reflects new estimations, then
future inventory values will automatically be adjusted as costs are transferred to the different
inventory accounts. Adjustments to standards could happen at any time during the year but will
normally happen if permanent changes to the standard occurred. An annual revision is common
practice in order to consider future cost.
Inventory value should always resemble current costs as close as possible. Inventory may not be
valued at future expected costs. In terms of IAS 2, inventory must be valued at the lowest of cost or
net realisable value.
Reconciliation of budget profit to actual profit where actual

production is higher or lower than actual sales
Higher production
The situation often arises where actual production is higher or lower than actual sales. The
reconciliation in such situations is simple, but requires greater care.
Example
A Company produced the following budget:
Budget sales/production 100 000 units
R
Sales 500 000
Cost of sales:
Labour 100 000
Fixed costs 100 000
Profit 70 000
Actual results:
Sales 80 000 units
Actual costs:
Labour R150 000
(i) under variable costing; and
(ii) under absorption costing.
Solution
(i) Variable costing
Assuming that there are no opening inventory of WIP or finished inventory, the company has
transferred 40 000 units from WIP to unsold finished inventory.
Standard costing systems require that all ledger accounts be at standard at all times.
Therefore, one cannot say that the actual cost for 80 000 units is 2/3 of total actual cost. The
first step is to calculate the value of 40 000 units at the standard unit cost of R3,30 (assuming a
variable costing system, ie fixed costs are written-off in the period in which they occur). The
balancing figure then becomes the actual cost of goods sold.
It may be argued that the resultant cost is not a true actual cost of sales, but remember that
standard costing systems do not allow for apportionment of variances or extra costs to the
forthcoming period.
Work-in-progress account
R R
Material 195 000 To finished goods 396 000
Labour 150 000 (120 000 × R3,30)
Variable costs 105 000 Variances 54 000
450 000 450 000
Finished goods
R R
WIP 396 000 COS 264 000
C/F 132 000
396 000 396 000
B/F 132 000
R R
Sales (80 000 units) 410 000
Cost of sales:
Labour 150 000
450 000
Cost of sales 318 000 318 000
Contribution 92 000
Fixed costs – 100 000
Actual loss – R8 000
Reconciliation of budget profit to actual profit

R
Budget profit 100 000 units 70 000
Less: Sales volume variance (20 000 × 1,70 contribution) 34 000
Standard profit 80 000 units R36 000
Sales price 10 000
Material 15 000
Labour 30 000
10 000 54 000 (44 000)
Actual profit 80 000 units (R8 000)
Calculating the total cost variances

As the production was 120 000 units, all cost variances must be based on a flexible budget of
120 000 units.
Units 120 000 120 000
R R R
Material 195 000 180 000 – 15 000
Labour 150 000 120 000 – 30 000
Variable costs 105 000 96 000 – 9 000
Fixed costs 100 000 100 000 –
Note: The above comparison of actual to standard has been done for illustrative purposes
only. Later, a much easier method of calculating the variances will be discussed.
(ii) Absorption costing

Work-in-progress account
R R
Material 195 000 To finished goods 516 000
Labour 150 000 (120 000 × R4,30)
Variable costs 105 000 Variances 34 000
Fixed costs 100 000
550 000 550 000
Finished goods
R R
WIP 516 000 COS 344 000
C/F (40 000 × 4,30) 172 000
516 000 516 000
B/F 172 000
R R
Sales (80 000 units) 410 000
Cost of sales:
Labour 150 000
Fixed costs 100 000
550 000
Cost of sales 378 000 378 000

Budget profit 100 000 units 70 000
Less: Sales volume variance (20 000 × 0,70 profit) 14 000
Standard profit 80 000 units R56 000
Sales price 10 000
Material 15 000
Labour 30 000
Fixed costs 20 000
30 000 54 000 24 000
Actual profit 80 000 units R32 000
Note: Under standard absorption costing, the fixed cost variance is due to the difference
between the budget and actual fixed cost as well as the difference between the budget
and actual volume of production.
Cost variance analysis

Units 120 000 120 000
R R R
Material 195 000 180 000 – 15 000
Labour 150 000 120 000 – 30 000
Variable costs 105 000 96 000 – 9 000
Fixed costs 100 000 120 000 + 20 000
Note: The standard fixed cost is shown as 120 000 because, in a fully-integrated absorption
costing system, the fixed cost is charged to actual production at the rate of R1 per unit.
As 120 000 units were produced, the standard cost charged will be R1 × 120 000 =
R120 000.
Lower production
When production is lower than units sold, the comparison of standard or budget to actual results is
very simple.
Example
Assume the same information given in the previous example with the following actual costs:
Sales 80 000 units
Costs:
Labour R75 000

Reconcile the budgeted profit to actual profit
(i) under variable costing
(ii) under absorption costing.
Solution
(i) Variable costing
The difference between sales and production is 20 000 units. As all accounts are at standard,
the extra sales came from inventory at standard cost.
R R
Sales (80 000 units) 410 000
Cost of sales:
Opening inventory (20 000 × R3,30) 66 000
Raw material 97 500
Labour 75 000
Cost of sales 291 000 291 000
Fixed costs 100 000

Units R
Sales volume variance (20 000 × 1,70) 34 000
Sales price 10 000
Material 7 500
Labour 15 000
10 000 27 000 (17 000)
80 000 Actual profit R19 000
Comparative costs
Production 60 000 60 000 –
R R R
Raw material 97 500 90 000 – 7 500
Labour 75 000 60 000 – 15 000
Variable costs 52 500 48 000 – 4 500
R198 000
Per unit R3,30
(ii) Absorption costing

R R
Sales (80 000 units) 410 000
Cost of sales:
Opening inventory (20 000 × R4,30) 86 000
Raw material 97 500
Labour 75 000
Fixed costs 100 000
Cost of sales 411 000 411 000
Actual profit – R1 000

R
Sales volume variance (20 000 × 0,70) 14 000
Sales price 10 000
Material 7 500
Labour 15 000
Fixed cost 40 000
10 000 67 000 – 57 000
80 000 Actual Loss – R1 000
Comparative costs
Production 60 000 60 000 –
Raw material 97 500 90 000 – 7 500
Labour 75 000 60 000 – 15 000
Variable costs 52 500 48 000 – 4 500
Fixed costs 100 000 60 000 – 40 000
Raw materials variance analysis

The analysis of direct materials variances can be shown diagrammatically as follows:
(Total)
Materials cost variance
Price Usage
Mix Yield
Figure 3
The standards
(i) Material cost per unit of input – The price
(ii) Material required per unit of output – The usage
(iii) Cost per unit of output – The cost per unit
eg Cost of raw Material A = R10 per kg
One unit of output requires 2 kg of Material A
Cost per unit = R10 × 2 = R20
(iv) When more than one raw material is required in the production process, the usage is analysed
into the mix and the yield.
eg Two raw materials are used in the production of Product Z.
2 kg of Raw Material A
3 kg of Raw Material B
l The mix = 2 kg A + 3 kg B
l The yield = 5 kg = 1 unit of Product Z
The variances
The variances consist of an analysis of the actual results compared to the original budget. They
represent what can go wrong.
(i) The material price variance
The material price variance analyses the difference between the budget cost of the material
input and the actual cost.
(ii) The material usage variance
The material usage variance analyses the difference between the budget material required per
unit of output and the actual usage of material.
(iii) The material mix variance
Where two or more raw materials are used in production, the material mix variance measures
the financial effect of changing the budget mix to a new actual mix.
(iv) The material yield variance
Where two or more raw materials are used in production, the material yield variance
measures the actual product output from the total input of the materials used, compared to
the expected output from the same actual input of raw materials.
The direct materials cost variance or (total materials cost variance) is the difference between the
total ACTUAL cost of materials charged to production and the standard cost of the direct materials
specified for such production.
Example
Budget Actual
Production 100 000 units 80 000 units
Direct materials R150 000 R130 000
Standard per unit R1,50
On the basis of the above budget, we calculate the standard cost per unit as R1,50 (R150 000 /
100 000).
As previously indicated, you cannot compare the budget cost of R150 000 to the actual cost of
R130 000, because the production volume is different.
The standard cost of actual production, or the “flexed budget” is
80 000 units × R1,50 = R120 000
Materials cost variance

Standard cost of actual production – actual cost, ie:
R120 000 – R130 000 = – R10 000
In other words, if we had known that the actual production was going to be 80 000 units, then we
would have budgeted for a cost of R120 000
Note: Invariably the inventory of raw material actually purchased is higher or lower than that used
in production. This occurs when the control and purchase of raw materials is in a separate
department, servicing production. The accounting records then represent two separate
departments as follows:
Inventory – “raw material” “Production” – WIP
Purchases at Transfers at standard cost Finished goods
actual at standard
When the above situation occurs, there are two ways of dealing with the cost variances:
1 Only calculate a materials price variance which is based on actual purchases and a materials usage
variance which is based on actual usage.
OR:
2 Calculate the total materials variance by making an adjustment to the increase/decrease in
inventory at the standard cost.
Example
A Company purchased 100 000 kg raw materials at a cost of R180 000. The Company used 75 000 kg
of material purchased to produce 80 000 units.
Company standards
Cost per unit R1,50
Usage per unit 0,75 kg
Therefore 1 kg = Standard cost of R2,00
Input (kg) × Price (kg) = Cost per unit
0,75 × R2,00 = R1,50
Method 1
Ledger accounts
Inventory
Purchases (Note 1) 180 000 (Note 2) WIP 150 000

Variance (Note 3) 20 000 (Note 4) c/f 50 000
200 000 200 000
b/f 37 500
WIP
Inventory 150 000 (Note 5) Finished inventory 120 000

(Note 6) Variance 30 000
150 000 160 000
Notes:
(1) Actual purchases at actual price.
(2) Transfer of 75 000 kg of inventory to production at a standard price of R2,00 per kg. You cannot
transfer actual purchases to WIP at actual price, because ALL accounts must be at standard and
ALL transfers must be at standard.
(3) Price variance due to a difference between actual purchase price of R1,80 and a standard price
of R2,00. This variance can also be arrived at as the balancing figure in the inventory account.
(4) Balance of inventory carried forward 25 000 kg × R2,00 = R50 000 AT STANDARD.
(5) Finished inventory, and once again the transfer must be at a standard value of R1,50 (ie 80 000
units manufactured) 80 000 × R1,50 = R120 000.
(6) Balancing figure in this account of R30 000 is the usage variance.
Method 2
Actual purchases 100 000 kg @ R180 000
Actual usage 75 000 kg
Value R180 000 – (25 000 × 2,00) = R130 000
Total variance
Standard cost 120 000
Less: Actual cost (130 000)
Total variance + 10 000
Price variance + 20 000
Usage variance – 30 000
Direct materials variance

The direct materials price variance must always be calculated on the basis of the actual materials
purchased, regardless of whether all purchases are used in production, ie the direct materials price
variance takes place in the raw materials inventory account.
Up to now, we have looked at standard cost based on a unitary measure only. We have said that if
the material budget of R150 000 is for the production of 100 000 units then the standard is R1,50 per
unit of production.
It is now necessary to look further into the production process and show not only the cost per unit
but also the material usage per unit and the cost thereof.
Example
Budget:
Raw materials cost R150 000
Raw materials usage 80 000 kg
Standard:
Cost per unit R1,50
Usage per unit 0,75 kg
Cost per kg R2,00
Actual results:
Purchases 100 000 kg
Cost of purchases R220 000
Usage 110 000 kg

Calculate the material price variance
Solution
In this example there has been a run-down of inventory (ie 110 000 kg transferred from inventory to
WIP). The total transfer of 110 000 kg at standard was made at a value of R220 000.
Price variance
The standard cost per kg of raw material is R2,00
Therefore, 100 000 kg should cost R200 000
Actual cost R220 000
Unfavourable price variance R20 000
Important:
As closing inventory must always be stated at standard cost, the actual cost of producing 110 000
units is
Cost of materials R220 000
From opening inventory R 20 000
R240 000
Not required
Total variance
Actual cost (220 000 + 20 000) = R240 000
Standard R165 000
Total variance – R75 000
Usage variance:
Used 110 000
Should use 75 / 100 × 110 82 500
– 27 500
× 2,00
– R55 000
Why calculate price variances?

1 To improve the purchasing performance of the buying department, thus resulting in control of
material costs.
2 To evaluate the opportunity for substituting current raw materials for alternative raw materials.
Causes of material price variances

The purchasing department is responsible for price variances. However, as purchasing of raw
materials is directly related to production requirements, variances could be due to poor production
planning and efficiency problems outside the control of the purchasing manager.
Major reasons for price variances

1 A general increase in market prices or an increase in price from the company’s own supplier.
2 Not taking advantage of discounts, buying in small quantities.
3 Bad planning/budgeting.
4 Change in specified quality when usual raw material is not available.
Materials usage variance

The material usage variance indicates a deviation from expected materials used in comparison to the
quantities required for actual production. It indicates a problem in converting input materials to
output of production.
As previously noted, the price variance is calculated when raw materials are purchased, therefore the
usage variance when expressed in terms of a Rand value must be at a standard value.
Example
Budget raw material cost R250 000
Raw material usage
“A” 100 000 kg R150 000
“B” 50 000 kg R100 000
Actual results:
Raw materials purchased and used:
“A” 90 000 kg at the standard cost per kg
“B” 30 000 kg at the standard cost per kg
(There is no price variance as actual purchases were made at the standard cost per kg)

Calculate the materials usage variance
Solution
From the budget, the standards are as follows:
Cost: Raw material “A” R1,50 per kg
Raw material “B” R2,00 per kg
Usage: “A” 1 kg per unit of output
“B” ½kg per unit of output
Unit cost = R2,50
Usage variance
If we hade known that the production was going to be 80 000 units the budget would have been:
Usage Standard cost Total cost
R
Material “A” 80 000 kg × R1,50 120 000
Material “B” 40 000 kg × R2,00 80 000
200 000
Usage variance in terms of kg, input is
Standard usage Actual usage
“A” 80 000 – 90 000 = – 10 000 kg
“B” 40 000 – 30 000 = + 10 000 kg
In terms of value
“A” – 10 000 × R1,50 = – R15 000
“B” + 10 000 × R2,00 = + R20 000
Total usage variance + R5 000
Without using equations the question that must be asked when calculating the materials usage
variance is:
Knowing the actual output in units, what should the material input have been to achieve that
output?
Compare the calculated “standard input” to the actual usage, which then indicates whether the
variance is favourable or unfavourable in terms of raw material input. To quantify the variance, it
must be multiply by the standard unit cost, because the price variance has been eliminated.
Reasons for a usage variance

1 When a favourable usage variance occurs, the reason could be that a better quality of raw
material has been used (expect an unfavourable price variance).
2 Improved labour efficiency could result in better material utilisation.

3 Poor quality raw material would cause an unfavourable usage variance but favourable price
variance, and could also have an impact on the unfavourable labour efficiency variance.
4 Improvements in machinery and tooling used could improve material usage. The reverse would
result in an unfavourable usage variance.
5 Overtime or second shift could result in material usage deviation from standard.
6 Technological changes; however, these should have been budgeted for in the short-term.
Materials mix and yield variances

As previously mentioned, the usage variance can be subdivided into two variances, ie the material
mix variance and the material yield variance. Two conditions must exist before one can calculate a
material mix and yield variance:
(a) Direct materials must be physically mixed.
(b) Material substitution must be possible.
These conditions tend to occur in plastic- or chemical-related industries.
A mix variance will occur when the actual mix used is different from the standard (most optimal mix)
resulting in increased costs or a lower quality end product.
The assumption is that an optimal mix exists which can be identified, ie costs are minimised and
quality improved to specification when the correct mixture is used.
The yield variance refers to that part of the total usage variance which represents the standard input
to output relationship. If a budgeted total usage of (say) 10 kg (comprising various raw materials) is
expected to produce 5 units of output, then the yield variance expresses the actual usage in terms of
the number of units that should have been produced above or below standard. So if the actual usage
was 10 kg but only 4 units were produced, then an unfavourable yield variance of 1 unit exists.
Example
You are given the following budget information:
Inputs Quantity % Total cost
A 2 000 kg 10 8 000
B 6 000 kg 30 6 000
C 12 000 kg 60 6 000
20 000 kg R20 000
Actual results:
Inputs Quantity
A 2 000 kg at R4,10 per kg
B 4 400 kg at R0,90 per kg
C 8 000 kg at R0,40 per kg
14 400 kg
Total cost: R15 360

Calculate the material usage, mix and yield variances.
Solution
Standards from budget information
Standard cost per unit R2
Usage 2 kg
Input costs
A R4 per kg
B R1 per kg
C R0,50 per kg
Usage per unit
A 0,2 kg
B 0,6 kg
C 1,2 kg
2,0 kg
Usage variance
The usage variance is calculated by asking the question: “Knowing that the actual production was
going to be 8 000 units, what would the budget cost have been?”
Answer: R16 000 (R2 × 8 000 units)
As the price variance is eliminated in the raw material account the actual input must be re-calculated
at standard:
ie 2 000 × R4 = 8 000
4 400 × R1 = 4 400
8 000 × R0,50 = 4 000
R16 400
Usage variance R16 000 – R16 400 = – R400
Mix variance
This requires a comparison of how the raw materials were mixed with how they should have been
mixed.
The reconciling figure is total actual usage of 14 400 kg
Standard usage Actual Standard cost
10% A 1 440 – 2 000 = – 560 × R4 = – 2 240
30% B 4 320 – 4 400 = – 80 × R1 = – 80
60% C 8 640 – 8 000 = + 640 × R0,50 = + 320
14 400 14 400 – – R2 000
Total mix variance: – R2 000
Yield variance
The actual total input of 14 400 kg yielded an output of 8 000 units.
In terms of unitary standard, a total input of 14 400 kg should have yielded
14 400 / 2 = 7 200 units
Therefore, production was 800 units more than budgeted. To express the favourable variance in
monetary terms simply multiply 800 units by the standard cost per unit of R2, ie
800 × R2 = + R1 600
Labour variance analysis

Total labour variance
Rate Efficiency Capacity usage
Figure 4
The standards
(i) Labour cost per hour – The rate
(ii) Labour required per unit of output – The efficiency
eg Cost of labour = R30 per hour
One unit of output requires 5 hours of labour
(iv) When a company measures the hours that a worker clocks in versus the hours that he is
actually operating (productive hours) we have a time usage standard.
l The capacity usage
The variances
The variances represent an analysis of the actual results compared to the original budget. They
(i) The rate of pay variance
The rate of pay variance analyses the difference between the actual cost of labour and the
expected cost for the same number of actual hours at the budget rate.
(ii) The efficiency variance
The efficiency variance measures the cost of the actual productivity in comparison to the
expected productivity cost for the actual hours worked.
Note: Do not compare the budget production cost to the actual labour production cost.
(iii) The capacity usage variance
This variance is seldom calculated as it requires a recording of the clocked-in hours as well as
the recording of the operating or productive hours. The clocked-in hours represent the time a
worker is physically at work, while the operating hours represent the productive hours.
Note: The capacity usage variance is not a measure of inefficiency, it is a measure of
operating time, which may or may not have been avoidable. The capacity usage
variance measures the financial cost of lost productive hours or unplanned hours
lost, when the actual productivity ratio was lower or greater than the budget
productivity ratio.
Labour variances are similar to material variances as the rate variance (price for material) and the
efficiency variance (yield for material) is evaluated. The capacity usage variance is seldom calculated
in practice, due to the difficulty in differentiating between clocked-in hours (total hours expected to
be at work) and operating hours (hours physically involved in production). For example, an employee
may be expected to clock in for an 8-hour day, but he is only productive for 7 hours due to tea
breaks, setting up and cleaning time. When the capacity usage variance is not calculated, the
efficiency standard of (say) 2 hours per unit of output will contain an element of non-productive
time.
Example
The following labour budget was produced based on budget sales of 10 000 units:
Labour hours 100 000
Rate R20 per hour
Actual results:
Actual labour hours 95 000
Actual cost R1 520 000

(a) Calculate all labour variances.
(b) Calculate all labour variances, assuming that there was a machine breakdown that
resulted in non-productive labour time of 10 000 hours for which the workers were paid.
Solution
(a) Standards
Hours per unit = 100 000 / 10 000 = 10 hours
Budget cost per unit = 10 × R20 = R200
Total variance
The company produced 8 000 units at a labour cost of R1 520 000. In producing 8 000 units,
what should the budgeted labour cost be?
Answer: 8 000 × R200/unit = R1 600 000
Therefore total variance = R1 600 000 – R1 520 000
= + R80 000
Rate of pay variance
Actual cost = R1 520 000
Expected cost = 95 000 × R20/hour = R1 900 000
Therefore favourable variance of R1 900 000 – R1 520 000 = R380 000
Efficiency variance
Produced 8 000 units in 95 000 hours
How many units should have been produced in 95 000 hours?
Answer –95 000 / 10 hours = 9 500 units
The company has under-produced by 9 500 – 8 000 = 1 500 units
Efficiency variance therefore = – 1 500 × R200/unit
= Unfavourable R300 000 variance
(b) Total variance – Per (a) above + R80 000

Rate of pay variance – Per (a) above + R380 000
Capacity usage variance

The capacity usage variance represents the number of hours that workers did not produce
through no fault of their own. In this example, the company did not budget for non-productive
time; they expected the workers to clock-in and be productive during all clocked-in hours, ie
clocked-in hours = operating hours
As there were 10 000 non-productive hours, it would be more accurate to show the capacity
usage variance and the efficiency variance as follows:
Capacity usage 10 000 non-productive hours

Budget cost per hour = R20
Therefore capacity usage variance = – 10 000 × R20 = – R200 000
Efficiency variance
Actual operating hours 95 000 – 10 000 = 85 000 hours
How many units should have been produced in 85 000 hours?

Expected production = 85 000 / 10 hours = 8 500 units
Therefore efficiency = – 500 units × R200 = – R100 000
Capacity usage variance explained further

In the above example, if the budget had been stated as follows:
Budget 10 000 units
Labour hours 100 000 @ R20 per hour
Capacity usage 80 %
and the actual results were stated as follows:
Labour hours 95 000
Non-productive hours 10 000
how would the variances be calculated?
Standards
Clock hours 100 000 @ R20
Operating hours 80 000 @ R25 (R20 × 100 000 / 100 000 × 80%)
Operating hours per unit 80 000 / 10 000 = 8 hours
Cost per unit R200 (8 × 25)
Total variance
Expected cost R1 600 000 (200 × 8 000 units)
Actual cost – R1 520 000
+ R80 000
Rate of pay: + R380 000, per above.

The budget capacity usage ratio of 80% represents the number of hours that the company
expects to be productive, ie for every 10 hours clocked-in, the company expects 8 hours of
productive time.
Actual clocked-in hours = 95 000
Expected operating hours = 95 000 × 80% = 76 000
Actual operating hours = 95 000 – 10 000 = 85 000
The company produced more hours than expected. The capacity usage variance is therefore
favourable.
85 000 – 76 000 = 9 000 × R25 = + R225 000
Note: The 9 000 favourable hours, represent operating (not clock) hours. The rate is
therefore R25 per operating hour (not R20 per clocked-in hour).
Efficiency
Actual productive hours 85 000 hours
How many units could be produced in 85 000 hours?
Answer – 85 000 / 8 = 10 625 units
Variance 8 000 – 10 625 = – 2 625 units
Value – 2 625 × R200/unit = – R525 000
Reconciliation
Rate of pay + 380 000
Capacity usage + 225 000
Efficiency – 525 000
Total + 80 000
Example – multiple categories of labour

Labour Hours Rate Cost
Skilled 5 000 R50 250 000
Semi-skilled 3 000 R40 120 000
Unskilled 10 000 R20 200 000
18 000 R310 ,66 R570 000
Budget capacity usage 80%
Actual results
Labour Hours Rate Cost
Skilled 4 000 R51,00 204 000
Semi-skilled 4 000 R41,00 164 000
Unskilled 12 000 R18,00 216 000
20 000 R29,20 R584 000
Actual capacity usage 70%

Calculate all labour variances.
Solution
Total labour variance
Once again, the first step is to express the original budget in terms of a standard for the actual
production of 80 000 units.
If it was known that the actual production was going to be 80 000 units, then the budget cost or
standard cost would be:
80 000 units × R5,70 = R456 000
Therefore, total variance is: 456 000 – 584 000 = – 128 000
Rate variance
The rate variance is calculated by comparing the average standard cost per clocked-in hour.
Standard cost per average clocked-in hour = R31,66
Actual clocked-in hours 20 000
Therefore, standard cost 20 000 × R31,66 = R633 333
Variance: 633 333 – 584 000 = + R49 333
Labour capacity usage variance

It is important at this stage to differentiate between clocked-in hours and operating hours. In the
above example, it is stated that there is a budget capacity usage of 80%. This means that on average
for every 10 hours that a worker is present at work he is expected to be productive for 8 hours. If, for
instance, there is a machine breakdown and the employee is only productive for 5 hours during the
10-hour period, then a capacity usage variance of 3 hours exists.
In other words, the employee is expected to be productive for eight hours instead of five. The
capacity usage variance is sometimes called an idle time variance. A negative capacity usage variance
or idle time variance does not mean that the employee has been idle or inefficient. It simply means
that, due to some factor, he was not productive for a certain period of time within or outside of his
control. Idleness or inefficiency is reflected in the efficiency variance.
The original budget can be expressed as follows:

Budget clocked-in hours 18 000 cost R570 000
Budget operating hours 14 400 cost R570 000 (18 000 × 80%)
Standard cost per operating hour R39,583
It is necessary to calculate the operating hourly rate as the capacity usage variance is calculated in
terms of operating hours.
Actual operating hours 14 000 (20 000 × 70%)
Budgeting for an 80% capacity usage or standard usage, the expected operating hours are:
20 000 × 80% = 16 000
Therefore, capacity usage variance
14 000 – 16 000 = – 2 000 × R39,583
= – R79 166.
Efficiency variance
The efficiency variance is an expression of how well or badly the workers have performed during the
actual operating hours. The concern is not with how many hours they were physically at work, but
with their productivity during actual operations.
The actual results show that in total the workers clocked 20 000 hours. However, these 20 000
clocked-in hours are irrelevant. Of the 20 000 clocked-in hours, they were productive for 14 000
operating hours, during which time they produced 80 000 units.
Therefore, Actual operating hours 14 000
The efficiency variance then is calculated by asking the question, “Knowing that the actual operating
hours would be 14 000, how many units should have been produced?”
From the budget the following is obtained:

Clocked-in hours 18 000
Operating hours 14 400
Therefore, 14 000 operating hours should result in a production of

14 000 100 000
× = 97 222,22 units
14 400 1
Actual production 80 000 units.
Variance
80 000 units –97 222,22 = – 17 222,22 × R5,70 (Standard unit cost) = – R98 167
Reconciliation
Rate variance + 49 333
Efficiency variance – 98 167
Capacity usage variance – 79 166
The above example could also be done by calculating the variances for each category of labour.
There would therefore be three variances, ie rate, efficiency and capacity variances.
Note that as there are three different categories of labour and the actual labour mix is different from
the standard, a further variance, ie the labour mix variance can be calculated. This variance leads to
undue complication, especially where there is a different capacity usage ratio to that budgeted.
Reasons for labour variances

Labour rate
1 Hiring wrong grade of labour eg using unskilled workers for semi-skilled work.
2 Unexpected labour disputes resulting in increased rates.
3 Bad planning.
4 Overtime payments.
Labour efficiency
1 The quality of raw materials used differed from the specification, resulting in excessive operating
time.
2 The labour mix was different to budget.
3 Poor training and lack of supervision.
4 Machine inefficiencies.
5 Operations not being performed in accordance with standard procedures.
Labour capacity usage

Idle time stoppage due to:
(a) Machine breakdowns
(b) Labour disputes, eg strikes.
Variable overhead variances

Variable with operating hours
Total variance
Expenditure Efficiency
Figure 5
The standards
(i) Variable cost per hour or per unit – The rate
(ii) Hours required per unit of output – The efficiency
eg Cost of variable overhead = R20 per hour
One unit of output requires 4 hours of variable overhead
The variances
(i) The expenditure variance
The expenditure variance analyses the difference between the actual cost of variable overhead
and the expected cost for the same number of actual hours at the budget rate.
Note: Where the variable cost is a function of units produced, ie the expenditure is incurred
only where the specific product is manufactured, then the variance is the difference
between actual cost and expected cost for the actual production.
(ii) The efficiency variance
The efficiency variance measures the cost of the actual productivity in comparison to the
expected productivity cost for the actual variable hours worked.
Note: As with labour, one does not compare the budget production cost to the actual
variable production cost.
Variable with production – expenditure variance only

The treatment of variable overhead variances is similar to that of labour as the expenditure variance
represents the difference between a budget rate and an actual rate, multiplied by the activity. The
efficiency variance is calculated on exactly the same basis as the labour efficiency variance. Where a
variable cost is based on the cost per unit, rather than an hourly cost, there can only be an
expenditure variance.
Example

Hours Cost
Indirect labour 5 000 R50 000
Packaging costs – R10 000
Indirect labour is paid on the basis of actual operating hours, while packaging costs are based
on cost per unit of output.
Actual results:
Hours Cost
Indirect labour 6 500 R58 500
Packaging costs – R10 000

Calculate all relevant variances.
Solution
Total variable overhead variance
On the basis of the budget, we establish that the standard cost per unit is:
Indirect labour R10
Packaging costs R2
Indirect labour
R
Standard cost (R10 × 6 000) 60 000
Less: Actual cost 58 500
Total variance + R1 500
Packaging costs
R
Standard cost (R2 × 6 000) 12 000
Total variance – expenditure 2 000
variance
Analysis of indirect labour variances

Expenditure
R
Standard cost (6 500 hours × R10) 65 000
Expenditure variance + R6 500
Efficiency variance
The company produced 6 000 units in 6 500 hours. The budget sets a standard production rate of 1
unit per hour, so the expected actual production would be 6 500 units.
Therefore, Actual production 6 000 units
– Standard production – 6 500 units
Variance – 500 units
× Standard rate R10
Efficiency variance – R5 000
Fixed overhead variances

The important factor to consider when looking at fixed overhead variances is whether the company
uses a standard variable costing system or a standard absorption costing system.
Variable standard costing system

Under a variable standard costing system, the fixed costs are treated as period costs and are written-
off in the accounting period in which they are incurred. They are not allocated to the cost of
production on a unitary basis but on a lump-sum basis. Unsold production will not contain any
element of fixed cost.
Example
Original budgeted production 10 000 units
Budget fixed costs R100 000
Budget operating hours 5 000
Actual fixed cost R130 000
Actual operating hours 6 000

Solution
As fixed cost under a variable costing system is treated as a period cost, the standard cost for a
production level of 12 000 units does not change, ie standard cost R100 000.
There is only one variance, namely the expenditure variance
Standard cost R100 000
Expenditure variance – R30 000
Absorption standard costing system

Under an absorption standard costing system, fixed costs are charged to production at a standard
rate per unit (calculated from the budget). It is necessary to allocate fixed costs to production on a
per unit basis because of management’s need to value inventory and assess individual departmental
profitability. It must be noted that the unit allocation basis is often arbitrary; therefore one must be
very careful in interpreting the resultant variances. The immediate effect is that profit will be over- or
under-stated, depending on whether unsold inventory has increased or decreased. If a company
overproduces in comparison to budget, then it will over-recover and have a positive volume variance.
If actual production is below budget, then it will have a negative volume variance.
Total fixed cost variance
Expenditure Volume
Figure 6
The standards
(i) Fixed cost for the period – The period cost
(ii) Budget units of output – The volume
(iii) The pre-determined recovery rate – The budget cost per unit
eg Budget fixed cost = R3 000
Budget production volume = 1 000 units
Cost per unit = R3 000 / 1 000 = R30
The variances
The variances represent an analysis of the actual results compared to the original budget, ie they
(i) The expenditure variance

The expenditure variance is always the difference between the budget cost and the actual
cost.
Note: The variable cost expenditure variance is not calculated on the same basis as the fixed
cost expenditure variance. Also note that this variance is determined in exactly the
same way whether a variable costing system or an absorption costing system is
operated.
(ii) The volume variance
The volume variance quantifies the difference between the budget units of production and the
actual units produced at the pre-determined recovery rate.
Note: This variance only occurs in an absorption costing system.
Example
Budget
Actual

Solution
The total variance is calculated in exactly the same manner as any cost variance. It is the difference
between the standard cost at the actual production level and the actual cost.
Standard cost (120 000 × R1,50) R180 000
Expenditure variance
When considering the expenditure variance under a variable or absorption standard costing system,
the calculation of the expenditure variance is the same. It is simply the difference between the
budget fixed cost and the actual fixed cost.
Actual fixed cost R160 000
Volume variance
The volume variance represents the under- or over-absorption of fixed costs, ie if actual production is
above budget, then there has been an over-absorption of fixed costs which needs to be adjusted as
the recovery rate was based on a lower production volume.
(over absorbed) Volume variance + 20 000 units
Standard unit cost × R1,50
Volume variance + R30 000
Reconciliation
Volume variance + R30 000
Other fixed cost variances

Volume variance
Efficiency Clock hour Capacity usage Calendar
Figure 7
The above sub-variances of the volume variance are to a large extent obsolete as they are
meaningless and serve no purpose in improving productivity and budget control.
As the practical usage of the sub-variances is negligible in a real world situation, the calculation and
discussion of these variances is not considered necessary.
Reasons for fixed overhead variances

The reasons for an expenditure variance are directly related to the basis on which the expenditure
was originally based. As one does not purchase fixed overheads in bulk and by nature they are not
expected to change, the expenditure variance is often due to unforeseen circumstances. It is also
possible that production exceeds the RELEVANT range criteria on which the budget was determined;
as a result there could have been a stepped increase in fixed costs.
The volume variance has a very low information content as it only indicates capacity utilisation and is
only calculated to balance the books after an under- or over-recovery of fixed costs.
Sales variances
The major difference between cost variance analysis and sales analysis is that for cost variances the
comparison is between the standard costs (revised or flexed budget) and the actual costs, while for
sales variance analysis the comparison is between the original budget and the actual results.
The analysis is carried out either on a sales value (turnover) basis or net profitability (contribution)
basis.
Total sales variance
Price Volume
Quantity Mix
Figure 8
The standards
(i) The budget selling price per unit – The price
(ii) The budget sales in units – The volume
(iii) When a company sells more than one product the sales volume is further analysed.
l The quantity
l The mix
eg budget sales
Product F 1 000 R50 000
Product G 2 000 R200 000
3 000
The price is R50 for product F and R100 for product G
The volume is 3 000 units
The quantity is 3 000 units at the budget mix
The mix is 1F : 2G
The variances
(i) The price variance
The price variance analyses the difference between the actual selling price for a product and
the budget selling price for the actual units sold in total.
(ii) The volume variance
When only one product is being sold, the volume variance represents the difference between
the budget units to be sold and the actual units sold, valued at the budget contribution per
unit (variable costing) or budget profit per unit (absorption costing).
(iii) The quantity variance
When more than one product is sold by the company, the quantity variance represents the
difference between the budget sales units and the actual units at the budget mix. The value is
calculated at the budget contribution per unit (variable costing) or budget profit per unit
(absorption costing).
(iv) The mix variance
Where more than one product is sold by the company, the mix variance represents the
difference between the actual units sold at the budget mix and the actual units sold at the
actual mix. The value is calculated at the budget contribution per unit (variable costing) or
budget profit per unit (absorption costing).
The volume variance is sub-divided into a quantity and mix variance only when a company sells more
than one product. The reason why it is important to calculate the sub-variances is that such analyses
show which individual product sales have improved or decreased compared to budget expectations.
Example
Budget: Sales 100 000 units
Cost of sales R400 000
Actual: Sales 80 000 units
Cost of sales R280 000
Calculate all relevant sales variances.
Solution
Sales variances on the basis of sales value
Total sales variance R
– R60 000
Price variance
Standard selling price R5 per unit
Standard value R400 000
Actual value R440 000
As we have derived a greater total revenue, we have a positive variance of R40 000.
Volume variance
Due to the actual volume being different from the budgeted volume,
Budgeted sales 100 000 units
Variance – 20 000 units
Value × R5
= – R100 000
Reconciliation of budget sales to actual profit

R
Standard sales 400 000
Less: Standard cost of sales 320 000
Plus: Favourable variances
Sales price 40 000
Sales variances on the basis of profit/contribution

The sales variances when calculated on the basis of contribution are the same as those calculated
above, except for the volume variance. The reason is that the cost deducted from standard selling
price is the same as the cost deducted from the actual selling price (cost variances are analysed
separately), so the resultant price variance is the same as calculated under the sales value basis.
With regard to the volume variance, in terms of units there is no difference, ie 20 000 units, but the
standard contribution per unit is obviously different from the standard selling price per unit.
Information per previous example

Price variance
Standard profit R5 × 80 000 = 400 000
Actual profit 440 000
+ R40 000
Therefore, price variance R0,50 × 80 000 units = + R40 000
Volume variance
Actual volume 80 000 units
Budget volume 100 000 units
Variance – 20 000 units × R1 = – R20 000
R
Plus: Favourable variances
Sales price 40 000
Note: The budget sales to standard profit can be reconciled in two different ways, ie:
1 Budget sales to standard sales. This method requires an adjustment of a volume variance on
the basis of sales value, because costs have not been deducted.
2 Budget sales to budget profit to standard profit. This method requires that costs based on
budget sales level be deducted to arrive at the budget profit. This means that any adjustment
following the budget profit figure for the volume variance can only be done on the volume/
contribution basis.
Introducing sales mix and quantity variances

You can only have a sales mix and quantity variance if you are selling more than one product.
Example
Sales: R
“A” 1 000 units at R5 5 000
“B” 4 000 units at R4 16 000
R21 000
Costs: (all variable)
“A” 1 000 units at R3 3 000
“B” 4 000 units at R2 8 000
Profit R10 000
Actual profit statement R
Sales:
“A” 4 000 units at R6 24 000
“B” 6 000 units at R3 18 000
R42 000
Costs:
“A” 4 000 units at R2 8 000
“B” 6 000 units at R3 18 000
Profit R16 000

Calculate all relevant sales variances.
Solution
Variances on a value basis
Price variance
“A” (6 – 5) 4 000 = + 4 000
“B” (3 – 4) 6 000 = – 6 000
– 2 000
Volume variance
“A” 4 000 – 1 000 = + 3 000 × R5 = + R15 000
“B” 6 000 – 4 000 + 8 000
= + 2 000 × R4 =
+ R23 000
Mix variance
“A” 4 000 – 2 000 = + 2 000 × R5 = + R10 000
“B” 6 000 – 8 000 = – 2 000 × R4 = – 8 000
10 000 10 000 + R2 000
Quantity variance
“A” 2 000 – 1 000 = + 1 000 × R5 = + R5 000
“B” 8 000 – 4 000 = + 4 000 × R4 = + R16 000
10 000 5 000 + R21 000
Profit basis
Price variance
“A” (6 – 5) × 4 000 = + 4 000
“B” (3 – 4) × 6 000 = – 6 000
– 2 000
Volume variance
“A” + 3 000 × R2 = + R6 000
“B” + 2 000 × R2 = + R4 000
+ R10 000
Mix variance
“A” + 2 000 × R2 = + R4 000
“B” – 2 000 × R2 = – R4 000
–
Quantity variance
“A” + 1 000 × R2 = + R2 000
“B” + 4 000 × R2 = + R8 000
+ R10 000
The quantity variance is the same as the volume variance, except that the mix variance element is
not taken into account. In other words, the assumption is that the total actual sales were made on
the basis originally budgeted for, in this example a 1:4 ratio.
Or:
Budget Standard Actual
1 000 2 000 4 000

4 000 8 000 6 000
5 000 10 000 10 000
Quantity Mix
Volume
Figure 9

Value basis Profit basis
Budget sales R Budget sales R
“A” 5 000 “A” 5 000
“B” 16 000 “B” 16 000
21 000 21 000
Quantity variance 21 000
Mix variance 2 000 Less: Cost of sales 11 000
Standard sales 44 000 Budget profit 10 000
Less standard cost of sales Quantity variance 10 000
“A” 4 000 × R3 12 000 Mix variance –
“B” 6 000 × R2 12 000 Standard profit 20 000
Less: Cost of sales variance 2 000 Less: Cost of sales variance 2 000
Less: Sales price variance 2 000 Less: Sales price variance 2 000
Actual profit R16 000 Actual profit R16 000
Reasons for sales variances

The selling price will have a direct impact on sales volume and in turn on production. There are
however, problems associated with the identification of causes and the person responsible for the
problem.
The following are the major difficulties:

1 Changes in selling prices are both controllable and non-controllable; differentiating between the
two is often difficult.
2 Changes in volume are either due to an increase or decrease in the sales price, competitors’
marketing strategy or internal marketing strategy. It is difficult to assess the relative impact of
these factors.
3 Profit can be affected by miscalculated market demand.
4 New competition or elimination of previous competitors.
5 Production problems resulting in lower and/or inferior output.
6 Effects of advertising.
7 The mix and quantity variances are justified where the products are substitutes for one another.
8 A change in mix could indicate that a less profitable product is being sold because it is either
easier to sell or commissions can be earned more easily at the expense of company profits.
Standard absorption/variable costing

The difference between a standard variable costing system and a standard absorption costing system
was discussed under fixed costs. The only aspect that needs highlighting is the relationship between
a cost-volume-profit analysis and a standard costing system.
When a company produces a budget for a particular period, it will invariably also look at a break-
even analysis or a cost-volume-profit graph.
Example
Assume that a company has produced a budget as well as a cost-volume-profit graph which
highlights the following relationships:
Sales/Production (units) 5 000 10 000 15 000
R R R
Sales 50 000 100 000 150 000
Cost “A” 10 000 20 000 30 000
Cost “B” 20 000 20 000 20 000
Cost “C” 15 000 20 000 25 000
Profit R5 000 R40 000 R75 000
Question: Does a cost-volume-profit depict a typical variable system or absorption system?

Under a variable system, fixed costs do not change with production. Under an absorption system,
fixed costs are charged at a certain level per unit produced.
A cost-volume-profit graph shows the fixed costs as being constant at all levels of production within a
relevant range.
The above costs show that:
Cost “A” – Variable cost of R2 per unit
Cost “B” – Fixed
Cost “C” – R10 000 fixed and R1 variable per unit.
If required to reconcile the budget profit at a level of 10 000 units to the actual profit of (say) 15 000
units in a manner that is consistent with the CVP graph, then a variable costing reconciliation must be
done:
Variable costs = R3 per unit
ie reconcile the budget profit of R40 000 to the standard profit of R75 000 to actual profit.
Process costing aspects relevant to standard costing

When a process standard costing system is in operation, remember that the standard per unit of
production includes an element of normal spoilage.
Example
The production of one unit requires the following:
Input Output
Raw material 5 kg 3 kg
Labour 5 hours 4 hours
(1 hour idle-time)
If the input cost is R5 per kg of raw material and R30 per labour hour, then the output standard cost
is R25 for raw material and R150 for labour.
Important:
When calculating the equivalent units of production under a process standard costing system only
the actual production matters. Normal spoilage and abnormal spoilage are not important.
Example
The budget for Company A states the following:
1 unit of output for product X requires the following inputs:
Raw material 5 kg standard cost R5 per kg
Conversion costs 5 hours standard cost R30 per hour
The material is added at the beginning of the process and conversion costs are incurred evenly
throughout the process. The inspection point is at the 50% complete stage.
Beginning WIP 1 000 units 50% complete
Started and completed 2 000 units
Normal spoilage 500 units
Abnormal spoilage 400 units
Closing WIP 1 000 units 80% complete
Actual material cost R97 500 Input 19 500 kg
Actual conversion costs R555 000 Input 18 500 hours

Calculate the actual units produced and compare the actual cost of production to the standard
cost
Solution
Units Material Conversion costs
Beginning WIP 1 000 – 500
Normal spoilage 500 – –
Abnormal spoilage 400 – –
Closing WIP 1 000 1 000 800
4 900 3 000 3 300
The variances are calculated on the production of 3 000 units for materials and 3 300 units for
conversion costs.
Note: Standard costing represents a FIFO system, as standard costing represents current costs only.
The normal and abnormal units spoiled are calculated as shown in the chapter on process
costing. However, the equivalent units for each cost category column are always zero.
Why?
They are always zero because the equivalent actual production of good units only is
calculated. Normal spoilage has already been included in the unit standard cost. Abnormal
spoilage will be shown in the variances. Part of the material usage and labour efficiency can
be explained by referring to the number of units abnormally spoiled.
In this example, all variances are based on actual production of 3 000 for material and 3 300
for all other costs.
Standard cost Actual cost

Material (3 000 × 5 × 5) R75 000 R97 500
Conversion (3 300 × 5 × 30) R495 000 R555 000
The variances are due primarily to the abnormal spoilage, which you can quantify as:
Material 400 × 5 × R5 = R10 000
Conversion costs 400 × 5 × R30 = R60 000
Remember: A process standard costing system can only operate on a FIFO system, because
standard costing implies current costs at current attainable standards.
Changes in standards
Standard costing, by its nature, implies current attainable standards or current costing. When
standards are revised, it becomes necessary to update the raw material inventory account, WIP
account and the finished goods account. These adjustments must however be carefully considered. If
the adjustments in standard reflect future changes, then no adjustment should be made to
inventory. If the standard must be changed because of changes in the current period and inventory is
therefore under- or over-valued, the necessary adjustments must be made against the variance
account and the inventory accounts, so that inventory will be reflected at close to its actual cost.
Example
Company A has the following inventory-holding:
Raw materials Standard price
A 1 000 units R4
B 500 units R2
Work-in-progress: 500 units ½ complete at a standard cost of R10 per unit
Finished goods: 1 000 units at a standard cost of R10 per unit
Standard costs have recently been revised as follows:

Raw materials
A: R5 per unit
B: R3 per unit
Each unit produced has a current standard cost of R12

Show the adjustments required to account for the change in standards.
Solution
The following adjusting journal entry must be made:
Raw material Dr 1 500
Work-in-progress Dr 500
Finished goods Dr 2 000
Variance account Cr 4 000
Adjustment due to a change in standards.
Raw materials:
A 1 000 × R1 = R1 000
B 500 × R1 = R500
R1 500
WIP: 500 × ½ × R2 = R500
Finished goods: 1 000 × R2 = R2 000
The variance account is to be written off in the current year’s income and expenditure account.
Comprehensive example
The best way of dealing with journal entries and ledger accounts is to go through a comprehensive
example.
Maranatha Limited produces rubber sandals and employs a standard costing system. The budget for
the forthcoming year as presented by the Management Accountant is as follows:
Production Expenditure Average month
Product Kg Annual budget Kg Value
A 1 200 R36 000 100 R3 000
B 6 000 R540 000 500 R45 000
C 2 400 R168 000 200 R14 000
Labour
– Dept A R38 592 R3 216
– Dept B R67 200 R5 600
Fixed overheads – unit based R86 400 R7 200
Variable overheads:
– Related per unit R54 000 R4 500
– Related to operating hours R64 800 R5 400
Total cost R1 054 992 R87 916
Total units to be produced: 60 000 per annum, ie 5 000 per month
The budget is based on – (i) working 240 days in the year
(ii) 8 clocked-in hours per day
(iii) non-productive time of 10%
Sales
The total units produced represent 3 different types of sandals, each type being identical in respect of
cost and production time.
Budgeted production Type X 12 000
Type Y 18 000
Type Z 30 000
Total budget production 60 000
The budgeted sales schedule is as follows:

Average month
Units Price Annual Units Value
Type X 12 000 R24,00 R288 000 1 000 R24 000
Type Y 18 000 R21,00 R378 000 1 500 R31 500
Type Z 30 000 R19,00 R570 000 2 500 R47 500
Total 60 000 R1 236 000 5 000 R103 000
Less: Budget costs R1 054 992 R87 916
Budget profit R181 008 R15 084
As at the year ended 31 December 19X1, the relevant accounts showed the following balances:
Kg Value
Raw material in inventory R
Product A 30 900
Product B 310 27 900
Product C 105 7 350
Work-in-progress Units Value
Type X 500 (All 50% complete in R4 396
Type Y 500 respect of materials, R4 396
Type Z 1 000 labour and overheads) R8 792
Total 2 000 R17 583
Finished goods Units Value

Type X 200 R3 517
Type Y 200 R3 517
Type Z 600 R10 550
Total 1 000 R17 583
Actual results for the month of January 19X2

Purchases Kg Price Value
Product A 90 R33 R2 970
Product B 350 R80 R28 000
Product C 130 R85 R11 050
570 R42 020
Actual raw material used in January production
Kg
Product A 75
Product B 485
Product C 200
Total 760
Maranatha worked for 22 days in January, clocking 8 hours per day. Idle time amounted to 44 hours
due to the machine breaking down.
Labour costs:
Employees in Dept A R3 696
Employees in Dept B R6 248
Variable overheads:
– Related to each unit R3 850
– Related to operating hours R4 825
At the end of January, the following sandals had been completed and transferred to closing inventory:
Type X 1 500
Type Y 1 500
Type Z 2 000
Work-in-progress as at 31 January 19X2
Type X 25% complete 400
Type Y 50% complete 200
Type Z 75% complete 400
1 000
Sales in January
Price Value
Type X 1 600 25,00 40 000
Type Y 1 500 21,50 32 250
Type Z 2 000 19,50 39 000
5 100 R111 250

1 Calculate all variances on an absorption standard costing basis.
2 Journalise all entries.
3 Reconcile the budget sales to the actual profit.
Solution
Calculation of actual units produced
Equivalent units
Closing WIP 1 000 500
6 000 4 500
Total units produced in January 4 500
Calculation of material variances for January 19X2

Price variance
(Standard cost – actual cost) × actual quantity purchased
Standard price – Actual price Actual quantity Price variance
Product A 30,00 – 33,00 × 90 = – 270

Product B 90,00 – 80,00 × 350 = + 3 500
Product C 70,00 – 85,00 × 130 = – 1 950
+ 1 280
Total variance/usage variance

Standard costs
Standard Kg Standard price Value
Product A 100 × 30,00 = 3 000
Product B 500 × 90,00 = 45 000
Product C 200 × 70,00 = 14 000
800 62 000
Standard cost per unit R12,40
Budget 5 000 units
Actual Kg Price Value
Product A 75 × 30,00 = 2 250
Product B 485 × 90,00 = 43 650
Product C 200 × 70,00 = 14 000
760 59 900
Actual units produced 4 500
The price variance has been eliminated, therefore total variance is calculated as follows:
Units produced 4 500

× standard cost × 12,40 R55 800
Actual cost – 59 900
Total variance – R 4 100
Usage variance
The usage variance is due to the difference between the actual usage to produce 4 500 units and the
budget usage to produce 4 500 units.
800 kg at standard gives us 5 000 units
Therefore 720 kg at standard will give us 4 500 units
Actual kg used 760
(Standard quantity in standard mix to produce actual production – actual quantity in actual mix) ×
standard price.
Standard Actual Variance Standard price Variance
Product A 90 – 75 = + 15 × 30,00 = + 450
Product B 450 – 485 = – 35 × 90,00 = – 3 150
Product C 180 – 200 = – 20 × 70,00 = – 1 400
720 760 – 4 100
Mix variance
(Standard cost of actual mix in standard proportions at standard prices – standard cost of actual mix
in actual proportions at standard prices)
Standard Actual
Product A 1 95 – 75 = 20 × 30,00 = 600
B 5 475 – 485 = – 10 × 90,00 = – 900
C 2 190 – 200 = – 10 × 70,00 = – 700
760 760 – 1 000
Yield variance (due to actual yield differing from standard yield)

Actual input of 760 kg yielded 4 500 units
At standard, an input of 760 kg will yield 4 750 units
Therefore, unfavourable yield variance of (250) units
Therefore, yield variance: – 250 × 12,40 = – R3 100
Reconciliation
R
Mix variance – 1 000
Yield variance – 3 100
Usage variance – 4 100
Price variance + 1 280
Total – R2 820
Journal entries
Accounts payable Cr 42 020
(being 360 kg of raw material purchased)
Material price variance Cr 1 280
(being favourable price variance on purchase of 360 kg raw material)
Work-in-progress Dr 59 900
Raw material Cr 59 900
(being transfer of 760 kg of raw material used in January production)
Finished goods (inventory) Dr 62 000
Mix variance Dr 1 000
Yield variance Dr 3 100
Work-in-progress – Variances Cr 4 100
Work-in-progress – Cost Cr 62 000
Being transfer of finished output of 5 000 units.
Labour variances
Actual Hours Rate Total
Dept A Dept B
Clock 176 21,00 35,50 56,50

Idle 44
Operating 132 28,00 47,33 75,33
Actual pay for January R9 944
Total variance
Standard cost of producing 5 000 units = R8 816
Therefore, cost per unit R1,7632
Therefore, cost of actual production at standard cost 4 500 × R1,7632 = 7 934

Actual cost 9 944
Unfavourable variance – R2 010

(Standard rate of pay per clocked-in hour – actual rate of pay per clocked-in hour) × actual clocked-in
hours
(55,10 – 56,50) × 176
= – 1,400 × 176
= – R246
(Standard rate = R8 816 ÷ 160 hours)
Efficiency variance
(Standard hours produced – actual operating hours) × standard labour cost rate
OR:
(Actual units produced – units we should have produced for the given operating hours) × standard cost
rate per unit.
We produced 4 500 units
According to the budget, 5 000 units should have been produced in 144 hours
OR:
5 000
per hour = 34,72 units per hour
144
Therefore, standard hours produced = 4 500 ÷ 34,72 = 129,6
Number of units we should have produced
5 000
= 132 × = 4583,33 units
144
Therefore, (129,6 – 132) × 61,22 = – R147
OR:
(4 500 – 4583,33) × 1,7632 = – R147

(actual operating hours – expected operating hours) × standard labour cost rate
Per budget
Idle 44 17,6 10%
Operating 132 158,4
Therefore, (132 – 158,4) × 61,22 = – R1 616
Reconciliation
Rate of pay variance – 246
Efficiency variance – 147
Capacity usage variance – 1 616
Journal entries
Labour (accounts payable) Cr 9 944
(being cost of labour for the months of January 19X2)
Labour variance Dr 2 010
Work-in-progress Cr 2 010
(being total variance for the month of January)
Rate of pay variance Dr 246
Efficiency variance Dr 147
Capacity usage variance Dr 1 616
Labour variance Cr 2 010
(being analysis of total variances)
(being transfer of finished output of 5 000 units × 0,894)
Variable overhead variances

If variable costs are related to a unit of output there can only be an expenditure variance
If variable costs are related to operating hours there will be an efficiency and expenditure variance
Actual variable overhead related to production R4 175
Actual variable overhead related to operating hours R5 925
Per budget variable overheads related per unit R4 500 for 5 000 units
Therefore, standard R0,90 per unit
Variable overheads related to operating hours R5 400 per 5 000 units
Therefore, standard R1,08 per unit
OR:
5 400 ÷ 144 operating hours = R37,50 per operating hour
Total variance
Related to Related to
units operating hours
Recovered (allowed) costs 4 050 4 860 (129,60 × R37,50)
Actual costs 3 850 4 825
Variance R200 R36
Variable overheads related to units

Expense variance
Actual output at standard cost = 4 500 × R0,90 (recovered costs) = 4 050
Actual cost – 3 850
Unfavourable variance R200
Variable overheads related to operating hours

Efficiency variance
(Standard hours produced – actual operating hours) standard cost rate
4 500
( – 132) × 37,50 = (129,6 – 132) × 37,50 = – R90
34,72
Expense variance
(Actual operating hours × standard cost rate) – actual cost
(132 × 37,50) – 4 825 = 4 950 – 4 825 = R125
Reconciliation of variances
Expenditure variance + R200
Expenditure variance + R125
Efficiency variance – R90
Total variance + R235
Journal entries
Variable overheads payable Cr 8 675
(being variable overheads for the month of January 19X2 charged to
work-in-progress)
Variable overhead variance Cr 235
(being total variance for the month of January 19X2)
Variable overhead variance Dr 235
Efficiency variance Dr 90
Expenditure variance Cr 325
(being transfer of finished goods output at standard)

Budget cost R7200
Actual production for January 4 500 units cost R6 100
Total variance
Standard cost 4 500 × 1,44 = R6 480
Actual cost – R6 100
Variance + R380
Budget – Actual
R7 200 – R6 100 = + R1 100
Volume variance
Actual volume 4 500 units
Budget volume 5 000 units
– 500 units
– 500 units × 1,44 = – R720
Journal entries
Fixed overhead (accounts payable) Cr 6 100
(being fixed overheads for the month of January 19X2 charged to
work-in-progress)
Fixed overhead variance Cr 380
(being total variance for the month)
Fixed overhead variance Dr 380
Fixed overhead volume Dr 720
Expenditure variance Cr 1 100
(being transfer of finished goods output of 5 000 units × 0,144)
Sales variances
Calculation of total variances
Budget
Sales standard Sales Standard Total Standard
Type Quantity price value cost cost profit
X 1 000 24,00 24 000 17,583 17 583 6 417
Y 1 500 21,00 31 500 17,583 26 375 5 125
Z 2 500 19,00 47 500 17,583 43 958 3 542
5 000 103 000 87 916 15 084
Actual
Sales actual Actual Standard Total Actual
Type Quantity price value cost cost profit
X 1 600 25,00 40 000 17,583 28 133 11 867
Y 1 500 21,50 32 250 17,583 26 375 5 875
Z 2 000 19,50 39 000 17,583 35 166 3 834
5 100 111 250 89 674 21 576
Total sales value variance

= Actual sales – budgeted sales
= 111 250 – 103 000
= + R8 250
Total sales profit variance

= Calculated profit – standard profit
= 21 576 – 15 084
= + R6 492
Analysis of total sales value variance

Price variance
Actual Standard
quantity Actual price price Variance Value
Type X 1 600 25,00 – 24,00 = + 1,00 + 1 600
Type Y 1 500 21,50 – 21,00 = + 0,50 + 750
Type Z 2 000 19,50 – 19,00 = + 0,50 + 1 000
5 100 + 3 350
Volume variance
(Standard value for actual sales at standard prices) less (standard value for standard sales at
standard prices)
Actual Standard
Type X 1 600 × 24,00 1 000 × 24,00
Type Y 1 500 × 21,00 – 1 500 × 21,00 = + R4 900
Type s 2 000 × 19,00 2 500 × 19,00
-Mix variance
Standard value for actual sales at standard price and actual mixture less standard value for actual
sales at standard price and standard mixture.
Actual mix Actual at standard
proportions
Type X 1 600 – 1 020 = + 580 × 24,00 = 1 450
Type Y 1 500 – 1 530 = – 30 × 21,00 = – 78
Type Z 2 000 – 2 550 = – 550 × 19,00 = – 1 100
5 100 5 100 + 2 840
Quantity variance
Standard value of actual sales in standard proportions and price less standard sales at standard
prices.
Actual at Standard Standard
standard mix sales price
Type X 1 020 – 1 000 = + 20 × 24,00 = + 480
Type Y 1 530 – 1 500 = + 30 × 21,00 = + 630
Type Z 2 550 – 2 500 = + 50 × 19,00 = + 950
5 100 5 000 + 2 060
Analysis of total sales profit variance

Actual Actual
mix profit
Type X 1 600 × 7,4168 = 11 867
Type Y 1 500 × 3,9168 = 5 875
Type Z 2 000 × 1,9168 = 3 834
5 100 21 576 A
Actual Standard
mix profit
Type X 1 600 × 6,4138 = 10 267
Type Y 1 500 × 3,4168 = 5 125
Type Z 2 000 × 1,4168 = 2 834
5 100 18 226 B
Actual at Standard
standard mix profit
Type X 1 020 × 6,4168 = 6 545
Type Y 1 530 × 3,4168 = 5 228
Type Z 2 550 × 1,4168 = 3 613
5 100 15 386 C
Standard Standard
sales profit
Type X 1 000 × 6,4168 = 6 417
Type Y 1 500 × 3,4168 = 5 125
Type Z 2 500 × 1,4168 = 3 542
5 000 15 084 D
Price variance A –B
= 21 576 – 18 226 = + R3 350
Volume variance B –D
= 18 226 – 15 084 = + R3 142
Mix variance B –C
= 18 226 – 15 386 = + R2 840
Quantity variance C – D
= 15 386 – 15 084 = + R302
Reconciliation Profit Price

Price variance + 3 350 + 3 350
Mix variance + 2 840 + 2 840
Quantity variance + 302 + 2 060
Total variance + 6 492 + 8 250
Journal entries
Cost of sales Dr 89 674
Finished foods Cr 89 674
(being 5 100 units sold in January at standard cost )
Debtors Dr 111 250
Sales Cr 111 250
(being budgeted sales of 5 000 units for January)
Sales Dr 8 250
Sales variance account Cr 8 250
Total variance for the month of January
Sales variance account Dr 8 250
Price variance Cr 3 350
Quantity variance Cr 2 840
Mix variance Cr 2 060
(being analysis of total variances on a sales value basis)
Ledger accounts
Raw materials
Balance 36 150 Work-in-progress 59 900
Accounts payable 42 020 Balance c/d 19 550
Price variance 1 280
79 450 79 450
Balance b/d 19 550
Work-in-progress
Balance 17 583 Finished goods and variance 62 000
Raw materials 59 900 Finished goods and variance 9 900
Labour 9 944 Finished goods and variance 7 200
Variable overhead 8 675 Finished goods and variance 8 816
Fixed overhead 6 100 Material variance 4 100
Variable overhead variance 235 Labour variance 2 010
Fixed overhead variance 380 Balance c/d 8 792
102 817 102 817
Balance b/d 8 792
Finished goods
Units Value Units Value
Balance 1 000 17 583 Cost of sales 5 100 89 674
Work-in-progress 5 000 62 000 Balance c/d 900 15 825
105 499 105 499
Balance b/d 900 15 825
Accounts payable
Labour (WIP) 9 944
Fixed overhead (WIP) 6 100
Variable overhead (WIP) 8 675
66 739
Price variance
Raw materials 1 280
Mix variance
Finished goods 1 000
Variance yield
Labour variance
Accounts payable 2 010 Variances 2 010
Labour variance 246
Efficiency variance
Labour variance 147
Expenditure variance 90
237
Labour variance 1 616
Fixed overhead volume variance
Fixed overhead 720
Fixed overhead variance
Variances 380 Work-in-progress 380
1 425
Variable overhead variance
Variances 235 Work-in-progress 235
Cost of sales
Debtors
Sales 111 250
Sales
Debtors 111 250
Preferred method:
Income and expenditure reconciliation statement
Sales volume variance
Sales mix 302
Sales price variance 3 350
21 576
Plus: Favourable cost variances
Expenditure variance 1 425
Materials price variance 1 280 2 705
Less: Unfavourable cost variances 24 281
Volume variance 720
Capacity usage variance 1 616
Efficiency variance 237
Rate of pay variance 246
Yield variance 3 100
Mix variance 1 000 6 919
R17 362
Alternative (not recommended):

Income and expenditure reconciliation statement
Plus:
Sales mix variance 2 840
Sales quantity variance 2 060
Actual sales at standard 107 900
Less:
Standard cost of sales 89 674
Sales price variance 3 350
21 576
Plus: Favourable cost variances
Expenditure variance 1 425
Materials price variance 1 280 2 705
Less: Unfavourable cost 24 281
variances
Volume variance 720
Capacity usage variance 1 616
Efficiency variance 237
Rate of pay variance 246
Yield variance 3 100
Mix variance 1 000 6 919
R17 362
Actual Income and expenditure statement (not required)

Sales 111 250
Less:
Cost of sales
Opening inventory
Material 36 150
Work in progress 17 583
Finished goods 17 583 71 316
Current period costs
Materia purchased 42 020
Labour 9 944
Fixed overhead 6 100 66 739
Closing inventory
Material 19 550
Work in progress 8 792
Finished goods 15 825 (44 167) (93 888)
R17 362
Appendix
The following question is intended to reinforce the important concepts that have been introduced in
this chapter. Do not proceed to the next chapter until you have grasped the following question.
You have been given the following information:

Budget sales/Production 10 000 units
Cost and selling prices per unit are budgeted at
R
Sales price 100
Raw material (1 kg) 20
Labour (2 hours) 30
Fixed cost 20
Profit 30
Actual results
The company produced 12 000 units and sold 8 000 units. The following expenses were incurred:
Raw material 13 000 kg cost R234 000
Labour 25 200 hours cost R390 600
Selling price per unit was R105

(a) Calculate the actual profit on a
(i) variable costing basis
(ii) absorption costing basis.
(b) Reconcile the budget profit to the actual profit on a
(i) variable costing basis
(ii) absorption costing basis.
Solution
(a) (i) Actual profit – absorption costing
Sales 8 000 units R840 000
Cost of sales: Production 12 000 units
Materials R234 000
Labour R390 600
Fixed cost R180 000
R804 600
Closing inventory 4 000 units R280 000
(ii) Actual profit – variable costing

Sales 8 000 units R840 000
Cost of sales: Production 12 000 units
Materials R234 000
Labour R390 600
Fixed cost R180 000
R804 600
Closing inventory 4 000 units R200 000
(b) (i) Reconciliation of budget profit to actual profit – absorption costing
Sales volume variance – R60 000
Sales price 40 000
Material price 26 000
Material usage 20 000
Labour rate 12 600
Labour efficiency 18 000
Fixed – volume 40 000
Fixed – expenditure 20 000
126 000 50 600 75 400
(ii) Reconciliation of budget profit to actual profit – variable costing
Sales volume variance – R100 000
Sales price 40 000
Material price 26 000
Material usage 20 000
Labour rate 12 600
Fixed – expenditure 20 000
86 000 50 600 35 400
Variances
Sales volume – absorption 2 000 units × R30 = R60 000
Sales volume – variable 2 000 units × R50 = R100 000
Sales price R5 × 8 000 = R40 000
Material price (R20 × 13 000) – R234 000 = + R26 000
Material usage (12 000 – 13 000) × R20 = – R20 000
Labour rate 25 200 × R15 – R390 600 = – R12 600
Labour efficiency [ (12 000 × 2) – 25 200 ] × R15 = – R18 000
Fixed volume + 2 000 × R20 = R40 000
Fixed expenditure R200 000 – R180 000 = R20 000
Practice questions
PART A
Absorption/Variable costing
A company budgeted on producing and selling 10 000 units. At this level, the profit was budgeted at
R
Cost per unit:
Direct material 30
Direct labour 35
Fixed overheads 15
Profit 20

Cost of production:

(a) On a variable standard costing basis.
(b) On an absorption standard costing basis.
PART B
Same information as for PART A, except that the actual results were:
Cost of production:

Reconcile the budget profit to actual profit on a variable costing basis.
Solution
PART A
Budget profit 10 000 × R20 = R200 000
Actual profit: R
Sales 1 080 000
Cost of sales:
Fixed cost 160 000
Profit R110 000
Reconciliation
R
Variances

Actual profit
R
Sales 1 080 000
Cost of sales:
Fixed cost 160 000
Reconciliation
R
Plus sales volume variance (2 000 × R20) 40 000
Variances
Fixed overhead volume (R15 × 5 000) 75 000
PART B
Variable costing basis
Actual profit
R
Sales 1 080 000
Cost of sales:
Inventory transfer (4 000 × 65) 260 000 796 000
Fixed cost 140 000
Reconciliation
R
Plus: Volume variance (2 000 × R35) 70 000
Variances
Direct materials – 16 000
Sales price – 120 000
Fixed cost 10 000

Datar manufactures a single product which it sells on the South African and Australian markets. In
19X0, the company manufactured and sold 100 000 units. Management is confident that sales in the
forthcoming year can be increased by 20%, as the company has the production-capacity required and
demand for the product has continued to show steady growth. Management has further set a target
of sales to Australia at 25% of total sales.
The Management Accountant has produced the following budget information per unit based on the
anticipated production and sales as forecast by management for 19X1.
Budget information for the 19X1 financial year

Selling price South Africa R160 per unit
Australia R130 per unit
Production costs per unit

Material 6 kg @ R8 per kg
Labour 5 hours @ R10 per hour
Variable overheads 5 hours @ R4 per hour
Fixed R10 per unit
All sales made in South Africa are paid a 10% commission based on the selling price. Sales to Australia
are subject to a transport cost of R4 per unit.
Actual results for 19X1

Production
Materials purchased 760 000 kg R6 042 000
Materials used in production 715 000 kg
Labour 515 000 hours R5 665 000
Variable overheads 495 000 hours R2 106 000
Fixed R1 000 000
Commission paid 10% of sales value
Transport cost – Australia R250 000
Datar experienced production problems, which resulted in a loss of 20 000 non-productive labour
hours, which were paid at normal rates. The 20 000 non-productive labour hours have been included in
the 515 000 labour hours listed above. Variable production costs are incurred on the basis of
productive labour hours.
Actual production for the 19X1 financial year

110 000 units were completed and transferred to finished inventory
Opening inventory nil
Closing inventory
Raw materials 45 000 kg
Finished production 10 000 units
All units in South Africa were sold at R10 per unit above budget. The Australian sales were made at the
budget selling price. 50% of all units sold were exported to Australia. Datar operates a standard variable
costing accounting system.

(a) Calculate the budget combined target sales required for South Africa and Australia that will give
the company a profit of R300 000 plus R6,50 per unit sold. (8 marks)
(b) Produce a detailed budget and actual income statement for the year ending 19X1. (10 marks)
(c) Reconcile the budget profit to the actual profit determined in (b). Your reconciliation must show
the sales mix and quantity variance, as well as the production cost variances in as much detail as
possible. (22 marks)
Solution
(a) Budget production/Sales
100 000 × 120% = 120 000
South Africa = 120 000 × 75% = 90 000 units
Australia = 120 000 × 25% = 30 000 units
Fixed costs
120 000 × R10 = R1 200 000
Contribution South Africa Australia
Sales R160 R130
Material 6 × 8 48 48
Labour 5 × 10 50 50
Variable 5 × 4 20 20
Commission 160 × 10 % 16 –
Transport – 4
Contribution R26 R8
Target sales/contribution assumption

South Africa 75% × 26 = R19,50
Australia 25% × 8 = R2,00
Average contribution R21,50
Fixed costs + Fixed profit

Required sales:
Contribution – variable profit
1 200 000 + 300 000

=
21,50 – 6,50
= 100 000 units

South Africa = 75 000 units
Australia = 25 000 units
(b) Budget
Sales South Africa 90 000 × 160 = 14 400 000
Australia 30 000 × 130 = 3 900 000
18 300 000
Costs:
Material 120 000 × 48 = 5 760 000
Labour 120 000 × 50 = 6 000 000
Variable 120 000 × 20 = 2 400 000
Fixed 120 000 × 10 = 1 200 000
Commission 90 000 × 160 × 10% = 1 440 000
Transport 30 000 × 4 = 120 000
Budget income statement for year ending 19X1

R’000
Sales 18 300
Variable costs:
Material 5 760
Labour 6 000
Variable 2 400
Commission 1 440
Transport 120
Contribution 2 580
Fixed cost 1 200
Profit 1 380
Actual
Materials closing inventory – 760 000 – 715 000 = 45 000 × R8 = R360 000
Finished production – 10 000 × (R48 + R50 + R20) = R1 180 000
Actual income statement for year ending 19X1

R’000
Sales South Africa 50 000 × 170 8 500
Australia 50 000 × 130 6 500
15 000
Production costs:
Material 6 042
Labour 5 665
Variable 2 106
Less: Closing inventory
Material 360
Finished units 1 180
Fixed costs 1 000
Commission 850
Transport 250
Actual profit 627
(c) Reconciliation of budget to actual profit

Variances
Sales quantity/mix
Actual Standard Budget
South Africa 50 000 75 000 90 000
Australia 50 000 25 000 30 000
100 000 100 000 120 000
Mix Quantity
Sales mix
50 000 – 75 000 = – 25 000 × 26 = – 650 000
50 000 – 25 000 = + 25 000 × 8 = + 200 000
– 450 000
Sales quantity
75 000 – 90 000 = – 15 000 × 26 = – 390 000
25 000 – 30 000 = – 5 000 × 8 = – 40 000
– 430 000
Sales price
South Africa + R10 × 50 000 = + 500 000
Material price
Actual cost – R6 042 000
Standard 760 000 × R8 + R6 080 000
+ R38 000
Material usage
715 000 kg produced 110 000 units
715 000 kg / 6 kg should yield 119 166,66 units
– 9 166,66 units
× R48
– R440 000
Labour rate
Actual – R5 665 000
Standard 515 000 × R10 + R5 150 000
– R515 000
Labour capacity usage

– 20 000 hours × R10 = – R200 000
Labour efficiency
Standard (515 000 – 20 000) / 5 99 000 units
+ 11 000 units
× R50
+ R550 000
Variable expenditure
Actual – R2 106 000
Standard 495 000 × 4 + R1 980 000
– R126 000
Variable efficiency
Standard 495 000 / 5 99 000 units
+ 11 000 units
× R20
+ R220 000
Fixed cost Actual + R1 000 000
Budget – R1 200 000
+ R200 000
Commission
Actual 50 000 × 170 × 10% – R850 000
Standard 50 000 × 16 + R800 000
– R50 000
Transport
Actual – R250 000
Standard 50 000 × 4 + R200 000
– R50 000
Reconciliation
R’000
Budget profit 1 380
Sales mix – 450
Sales quantity – 430
Standard profit 500
Sales price 500
Material price 38
Material usage 440
Labour rate 515
Labour capacity usage 200
Labour efficiency 550
Variable expenditure 126
Variable efficiency 220
Fixed cost expenditure 200
Commission 50
Transport 50 + 127
Actual profit 627

Tardy Creek Ltd is a divisionalised company that allows its divisions full autonomy in preparing their
budgets, but final target profits set by the divisions must be approved by head office.
The KwaZulu-Natal division produces and sells a product to external customers at R300 per unit.
Internal sales to other divisions in the group are made at R270 per unit, but are limited to a
maximum demand of 5 000 units. The reduction in selling price of R30 for internal divisional sales is
made possible as no selling and distribution costs are incurred on divisional sales.
The KwaZulu-Natal division operates a standard absorption costing system and has produced the
following product cost specification for the year based on a production level of 15 000 units. Budget
sales to internal divisions was set at 5 000 units, while external sales were budgeted at 10 000 units.
Standard product cost per unit

R
Raw material 5 kg 45
Direct labour 4 operating hours 40
Variable manufacturing overhead
4 operating hours 20
Fixed manufacturing overhead 45
Head office cost 30
Selling and distribution costs 30
Standard unit cost 210
The selling and distribution costs apply to external sales only and include a variable cost of R10 per
unit, together with a fixed element. The head office cost relates to a fixed monthly charge made to a
division to cover all costs of administration carried out by head office. Unsold inventory is carried at a
full absorption rate as determined in the budget.
There was no opening inventory at the beginning of the financial year.

During the current financial year a dispute arose between the KwaZulu-Natal division and a division
in Gauteng. The Gauteng division found a supplier for the same product at a price of R250, and, as
the KwaZulu-Natal division was unwilling to lower the transfer price, the order for 3 000 units was
cancelled.
The actual sales and costs incurred by the KwaZulu-Natal division for the current year were as
follows:
External sales 11 000 units @ R295
Internal sales 2 000 units @ R270
Current year costs incurred

R
Raw materials 72 800 kg 720 720
Raw materials used 67 200 kg
Head office cost 450 000
Selling and distribution costs 440 000
R3 132 220
The direct labour was paid for 52 500 operating hours.

The variable manufacturing overhead was incurred per direct labour operating hour.

(a) Show the budget profit statement and the actual profit statement for the current year.(5 marks)
(b) Reconcile the budget profit to the actual profit calculated in (a). Show the sales volume variance
only, plus all cost variances in detail. (30 marks)
(c) Comment on the transfer pricing method used by the KwaZulu-Natal division and discuss the
lowest and highest possible transfer price. (5 marks)
Solution
(a) Budget profit
R
External sales 10 000 × R300 3 000 000
Less: Selling and distribution 10 000 × R30 300 000
Net external sales 2 700 000
Internal sales 5 000 × R270 1 350 000
Total sales 4 050 000
Cost of sales 15 000 × 150 2 250 000
Head office 15 000 × 30 450 000
Actual profit
R
External sales 11 000 × R295 3 245 000
Internal sales 2 000 × R270 540 000
3 785 000
continued
Manufacturing costs
Material 720 720
Labour 577 500
2 191 820
Less: Closing inventory
Finished inventory 1 000 × R150 150 000
Raw materials 5 600 × 9 50 400 2 041 820
1 743 180
Head office costs 450 000
Selling/distribution 440 000
(b) Reconciliation of budget profit to actual profit
R
Budget profit 1 350 000
External sales volume + 1 000 × 140 (Note 1) 140 000
Internal sales volume – 3 000 × 120 (Note 1) (360 000)
Standard profit 1 130 000
Sales price variance (55 000)
Raw material price (65 520)
Raw material usage 25 200
Labour rate (52 500)
Variable expenditure 3 500
Variable efficiency 17 500
Fixed volume (45 000)
Fixed expenditure (10 000)
Head office –
Selling and distribution (130 000)
Sales price: 11 000 × – R5 = – R55 000

Raw material price:
Actual R720 720
Standard R9 × 72 800 R655 200
– R65 520
Raw material usage
14 000 × 5 = 70 000 – 67 200 = + 2 800 × R9 = + R25 200
Labour rate
Actual operating hours 52 500
Expected cost 52 500 × R10 per operating hour = R525 000
Variance 525 000 – 577 500 = – R52 500
Labour efficiency
Actual operating hours 52 500 hours
Units produced 14 000
Expected production 52 500 ÷ 4 13 125
+ 875 × R40
= + 35 000
Variable expenditure 52 500 × R5 = 262 500 – 259 000 = + 3 500

Variable efficiency + 875 × R20 = + R17 500
Fixed overhead
Volume – 1 000 × R45 = – 45 000
Expenditure 675 000 685 000 = – 10 000
Head office costs 450 000 – 450 000 = –
Selling and distribution
Standard Fixed 20 × 10 000 = 200 000
Variable 10 × 11 000 = 110 000
310 000
Actual 440 000
– 130 000
Note 1:
The external sales volume value of R140 is arrived at as follows:
R
External
Sales 300
Production cost 150
Selling cost 10
Profit 140
Internal
Sales 270
Production cost 150
Profit 120
Where an absorption costing system is in operation, the sales volume variance is equal to the
difference between the budget and actual units sold multiplied by the profit per unit.
However: The profit per unit is arrived at as

Sales – Variable production costs
– Fixed production costs
= Normal gross profit
– Variable non-manufacturing cost
= Absorption profit
The fixed non-manufacturing costs cannot be charged as a unit cost, ie non-manufacturing costs
are not inventoriable.
Therefore, in this example the sales value on external sales equals
R300 – R150 – R10 = Normal gross profit of R140
(c) The transfer price is based on the market price rule, with an allowance to reflect the fact that
selling and distribution costs are not incurred on internal transfers. The manager of the
supplying division may find that using a market-related price may not be in the best interests of
the company when he cannot sell all that he produces in the open market. In this situation, the
manager of the KwaZulu-Natal division has lost sales of 2 000 units.
The variable cost of manufacturing the product is
Raw materials 45
Labour 40
Variable production 20
R105
Any price above R105 will generate a positive contribution. Negotiation should take place
between a price of R105 and the current price of R270. At an average selling price of R187,50
the contribution generated would be
5 000 × 82,50 = 412 500
compared to the current 2 000 × 165 = 330 000
The KwaZulu-Natal division should at least drop its price to meet that of the outside supplier, as
long as the price is above R187,50 (which is likely to be considering that the KwaZulu-Natal
division is selling 11 000 units at R295 each).

Mr Warrick chairman of Kowloon Manufacturing Company gave his son full responsibility for the
operations of one of the businesses as from the 1st September 20X2. The company manufactures
metal frames.
Mr Warrick is however very concerned about his son’s ability to run the operation, as the income
statement for the month ended 30th September 20X2 reveals that he has failed to meet the
budgeted profit target of R6 000 even though he has exceeded the sales volume by 200 frames and
the selling price by R1,00 per unit.
Budget income statement for the month of September 20X2
R R
Sales:
2 000 frames at R36 72 000
Production costs:
Material 18 000
Labour – variable 22 000
56 000 56 000
Gross profit 16 000
Selling and administration (40% variable) 10 000
Profit R6 000
Budget break-even = 1 400 units
Standard cost per unit at the budget level of 2 000 sales units
R
Material: Metal 3 units @ R2,00 6
Welding 1 unit @ R3,00 3
Labour: 30 minutes @ R22 per hour

Prime cost 11
Manufacturing overhead 20
Total cost of manufacture 8
R28
Mr Warrick explained that at the beginning of the year his son had prepared a “Profit graph” which
showed what his plant sales revenue, various categories of expense and profit should be for various
levels of volume, saying “It appears to me that an increase above the budget sales of 2 000 units should
have increased the profit substantially. As you can see, he has managed to exceed the budgeted sales
volume and raise the selling price on the frames by R1. Not only that, he looked around until he found a
fellow who would sell us welding rods at a lower price. Regardless of these facts he still has not
managed to achieve the target profit.”
Actual results for the month of September

Opening inventory 400 units
Actual costs for September

Raw materials R
Metal 6 500 units 13 000
Welding 3 250 units 7 475
Labour 1 200 hours 25 200
Manufacturing overhead
Variable 10% higher than budget cost
Fixed 5 000
Selling and administration 11 500
The company operates a standard variable costing system. The opening inventory of 400 units of
finished product was valued at current standards.
There was no opening or closing inventory of raw material in the month of September.

(a) Prepare a statement showing the actual profit for the month of September. (10 marks)
(b) Reconcile the budget profit to the actual profit as calculated by you in (a). Your reconciliation
must show the variances in as much detail as possible. (22 marks)
(c) Comment, with supporting figures, on how the variances have affected the profit and whether
Mr Warrick’s son has performed well. (8 marks)
Solution
(a) Valuation of opening inventory of 400 units
The company uses a variable standard costing system. We therefore need to analyse the
manufacturing costs to determine the variable cost per unit.
Budget cost analysis:
Sales 1 400 units 2 000 units
Profit – R6 000
Differential sales of 600 units has resulted in an increase in profit of R6 000.
Contribution therefore equals R6 000 / 600 = R10 per unit
At a budget level of 2 000 units we have

Budget contribution 2 000 × 10 R20 000
Budget profit 6 000
Fixed costs R14 000
Fixed selling and administration ( 10 000 × 60%) 6 000
Fixed manufacturing cost R8 000
Variable manufacturing overhead [ 16 000 – 8 000 ] = 8 000
Variable cost per unit R8 000 / 2 000 = R4
continued
Variable manufacturing cost per unit:

R
Material 9
Labour 11
Variable manufacturing overhead 4
R24
Actual profit for September
R R
Sales 2 200 @ R37 81 400
Opening inventory 400 × 24 9 600
Production costs –2 000 units:
Material 20 475
Labour 25 200
Manufacturing overhead:
Variable R8 000 × 1,1 8 800
Fixed 5 000
69 075
Less: Closing inventory 200 × 24 4 800
Selling and administration costs 17 125
Profit 11 500
5 625
(b) Reconciliation of budget to actual profit
Standard contribution
Sales – variable manufacturing – variable selling
R36 – 24 – ([ 10 000 × 40% ] / 2 000) = R10
R
Budget profit 6 000
Sales volume variance 200 × 10 + 2 000
Sales price 2 200
Metal price –
Welding price 2 275
Material mix 812,50
Material yield 3 937,50
Labour rate 1 200
Variable 800
Fixed 3 000
8 675 11 050 – 2 375
Actual profit 5 625
Sales price variance

2 200 units × R1 = R2 200
Material variances
Price
Metal 6 500 × R2 = 13 000 – 13 000 = nil
Welding 3 250 × R3 = 9 750 – 7 475 = + 2 275
Mix Actual Budget Variance Price
Metal 6 500 3 7 312 ,5 + 812,5 ×2 = + 1 625
Welding 3 250 1 2 437 ,5 – 812,5 ×3 = – 2 437 ,50
9 750 9 750 – 812 ,50
Yield
Budget 4 input units = 1 output unit
Actual output 2 000 units from an input of 9 750
Input of 9 750 should yield 9 750 / 4 = 2 437,5 units
Yield variance: 2 000 – 2 437,5 = – 437 ,5
× unit cost (6 + 3) ×9
= –3 937 ,5
Labour variances
Rate:
Standard 1 200 × 22 = 26 400
Actual – 25 200
+ 1 200
Efficiency
Standard 2 000 × 0,5 hours = 1 000 hours
Actual 1 200 hours
Variance – 200 hours
Rate × R22
Variance – R4 400
Variable Standard 2 000 × 4 = 8 000
Actual 8 800
– 800
Fixed Budget 8 000
Actual 5 000
3 000
Selling and administration

Standard cost [2 200 × 2 + 6 000] = R10 400
Actual cost – R11 500
Variance – R1 100
(c) Sales
He seems to be doing well as a sales manager, although we know nothing about how sales are
expected to respond to changes in seasonal or other variables. He has boosted the volume by
200 units and the selling price by R1 which has resulted in a positive selling price variance of
R2 200, and a sales volume variance of R2 000.
Materials
The decision to buy the welding rods at a cheaper price has resulted in a saving of R2 275 on the
price, but the negative mix and yield variance strongly suggests that the quality of the welding
rods has had a huge detrimental effect on profits. The negative yield of almost R4 000 requires
investigation as it could be due to the poor quality of raw materials.
Labour
The significant negative efficiency variance once again raises serious questions about the quality
of raw materials used, as the efficiency and material yield variances are often related. It is
unusual to see a favourable labour variance which requires an explanation.
The negative expenditure variance of R3 000 may have been outside the control of Mr Warrick’s
son.
Selling and administration
As with the manufacturing overhead, it is possible that the unfavourable variance could be due
to the fixed cost element which could have been out of his control.

The Jackson Company Ltd operates a standard absorption costing system. The standard figures for
one of its products (known as Castel) are as follows:
Standard revenue and cost per unit of Castel
R R
Selling price 8,00
Direct material cost 2,20
Direct labour cost 1,70
Direct fixed overhead cost 1,00 4,90
Standard profit R3,10
It is the company’s practice to value finished goods inventory at full standard cost. During the four-
week period under review there was no opening inventory because of exceptional sales in the
previous period. To rectify this position, although it was estimated that sales would only be 8 000
units during the period, it was decided to produce 10 200 units. It was on the basis of this production
level that the fixed overhead unit cost of R1,00 was calculated. During the period, the actual
production was 9 500 units, while sales reached 7 000 units, for which the income and costs were as
follows:
Sales income R58 000
Direct material cost R24 772
Direct labour cost R19 941
Fixed overhead cost R10 928
Notes:
1 The supplier of the raw material for the Castel raised prices by 10% during the period under review.
The company uses a FIFO pricing system and 6 600 units of output were manufactured from raw
material bearing the increased price.
2 The company operates a five-day, 42,5 hour week. In the second week of the period, the direct
workforce withdrew its labour for three days. No wages were paid to the 60 members of the
direct labour force during this period. However, to make up for lost production, an extra two
Saturdays and one Sunday were worked, at double-time rates.
3 The proceeds from the sale of waste amounted to R1 500, which is included in the sales income
figure. Normally waste has no sales value and is ignored in the standard revenue/cost calculations.

Prepare a report for management, explaining the significance of the actual results for the four-week
period and in particular reconciling the difference between the budget profit of R24 800 and the
actual profit of R14 609. Your report should include a detailed original budget statement and actual
income and expenditure statement.
Solution
Workings
Sales variances
Volume variance 56 000 – 64 000 = – R8 000
Price variance R2 000
(of which R1 500 is due to the sale of waste)
Direct materials variance

Total variance 20 900 – 24 772 = – R3 872
Price variance 6 600 units × 10% of R2,20 = – R1 452
Usage variance
Actual production at standard usage and cost R20 900
Actual production at actual usage and standard (24 772 – 1 452) R23 320
cost
– R2 420
Direct labour variances

Total variance 16 150 – 19 941 = – R3 791
Rate variance
Due to overtime 60 × 3 × 8,5 = 1 530 hours
It is assumed that an equal number of hours
were worked at overtime rates
Therefore 1 530 hours × R1,70 = – R2 601
Efficiency variance
Standard production for normal operating hours
42,5 × 60 × 4 = 10 200 units
Therefore efficiency variance = –700 units
Therefore 700 × R1,70 = – R1 190

Total variance 9 500 – 10 928 = – R1 428
Budgeted – Actual 10 200 – 10 928 = – R728
Volume 700 units × R1 = – R700
Report to Management
Income and expenditure statement for four weeks ended . . .
Original Revised Actual
budget units budget units results units
Production 10 200 9 500 9 500
Sales 8 000 7 000 7 000
Closing inventory 2 200 2 500 2 500
R R R
Sales value 64 000 56 000 58 000
Cost of production:
Direct labour 17 340 16 150 19 941
Fixed overhead 10 200 9 500 10 928
49 980 46 550 55 641
Cost of sales 39 200 34 300 43 391
Profit R24 800 R21 700 R14 609
The above statement shows that there was a drop in sales volume amounting to 1 000 units, which
gave rise to a drop in profit of R3 100, ie 1 000 units × standard profit of R3,10. The purpose of the
revised budget shown in the statement is to eliminate the effect of the reduction in volume so that a
more realistic appraisal of performance may be made.
The performance variance, being the difference between the revised budget and the actual results,
and amounting to – R7 091 profit, is reconcilable as follows:
Sales price variance + R2 000
Direct materials price variance – R1 452
Direct materials usage variance – R2 420
Direct labour rate variance – R2 601
Direct labour efficiency variance – R1 190
Fixed overhead expenditure variance – R728
Fixed overhead volume variance – R700
– R7 091
The sales price variance is attributable to the sale of waste, which brought in R1 500, and to an
increase of R500 in the sales value. The direct materials price variance is attributable to the 10%
increase in the price of raw materials, while the rate of pay variance was due to the three days
worked at overtime or double-time rates. It must be noted that, as the company is using an
absorption costing system, we have a volume variance amounting to – R700, as actual production
was less than budget. There is insufficient information to analyse the material usage variance and the
labour efficiency variance.
Decisions under
10 risk and uncertainty
l calculate and explain the meaning of expected values
l define certainty, uncertainty and risk
l calculate the standard deviation and co-efficient of variation
l explain the meaning of the expected value criterion and conditions required
l calculate the value of perfect and imperfect information
l calculate the probability as area under the curve
l draw a decision tree and evaluate the expected value
Context of risk, uncertainty and decision trees

All business endeavours require management to make choices. The consequences of these choices
result in events which are uncertain. The purpose of this chapter is to provide a framework within
which you can analyse choices and consequences which are given as probability distributions.
Note on examination questions

Most (if not all) examination questions that give information in the form of a probability
distribution require that you produce a budget or budget-related information. All probability
distributions, even if there is only one probability distribution given in a question, require that
you analyse the information in the form of a decision tree.
If a budget must be compiled, but the quantity of material available is uncertain and the following
are given
Material available 100 000 kg probability 30%
150 000 kg probability 50%
180 000 kg probability 20%
the budget should be compiled at each level of material available. Once all three budgets are
complete, multiply the three budget amounts by the probability given above to arrive at the
expected budget. Regrettably this is seldom done. Most of the time an expected value of material
availability is calculated based on the probabilities given and one budget is constructed at that level.
Evaluating a probability distribution

A given probability distribution will gives a point estimate that is only correct if the operation is
repeated many times over. In other words, it is a long-term predictor.
357
Example
Company A is attempting to predict future profit from a new project and the following probability
distribution has been prepared:
State Probability Profit
1 0,10 – R150 000
2 0,40 – R20 000
3 0,40 R40 000
4 0,10 R 300 000
Expected value R23 000
Required: Should the company accept the new project?
The answer to the above example depends on the company’s attitude to risk. The expected value of
R23 000 is a long-term expectation and assumes that the returns remain the same over a long period
of time. The short-term returns will range from the negative return of R150 000 to the high positive
of R300 000. There are three identifiable attitudes to risk:
(i) risk aversion
(ii) indifference towards risk
(iii) risk taker.
If the company is averse to risk, it may take the view that, as there is a 50% chance that the project
will yield a negative return, it will not accept the project. In fact, the company may have a policy that
it will only accept projects that have a minimum of 80% probability of yielding a positive return.
If the company is indifferent to risk, it will look at the expected return of R23 000 and make a
decision on whether the return is reasonable. Given two projects with the same expected return but
different risk profiles, an indifferent investor will not take the risk into account.
If the company is a risk taker it will look at the highest possible return and assess whether the risk is
acceptable in terms of the return. The above project has a 10% chance of yielding a return of
R300 000. The company may well feel that it is worth taking a risk for such a high return.
A risk taker will be more concerned with the possibility of making a profit of R300 000 rather than
the long-term expected return of R23 000.
Discrete vs continuous distribution

When analysing probability distributions, it is important to assess the information and determine
whether the probability distribution is discrete or whether the outcome lies under the area of a
normal curve.
Discrete Continuous
Probability Probability
Value Value
Figure 1
When a probability distribution is discrete, one cannot calculate a mean value or area under a curve.
Chapter 10: Decisions under risk and uncertainty 359
Example
You have won a car and there is a 40% chance that it will be red, a 30% chance that it will be white
and a 30% chance that it will be blue. Clearly the outcome is discrete and you cannot get a “mean”
colour.
It is important that you analyse information given to determine whether a continuous distribution is
possible. Sometimes it is difficult to assess, in which case you must form an opinion about whether
you believe that the information could be interpreted as continuous.
Example
You have applied for a foreign currency allocation to purchase imported raw materials and are
uncertain of the amount that will be allocated; however, you have been given the following possible
outcomes:
Probability Outcome
30% R 80 000
50% R160 000
20% R220 000
Is the outcome discrete or continuous? Given the nature of the information, the distribution can be
viewed as continuous, as the allocated amount could be between R80 000 and R220 000. The mean
value of R148 000 is therefore a long-term possibility. What about in the short-term? In the short-
term, the expected value of R148 000 is an acceptable estimate, but the standard deviation as well as
the probability as measured by the area under the curve must be determined.
Risk and financial analysis

Risk is associated with project variability. Risk exists where we do not know exactly what will happen
in the future, but the various possibilities are weighted by their assumed probability of occurrence.
Risk can be measured as long as statistical evidence exists.
Uncertainty exists where there is no statistical evidence relating to outcomes; therefore, the
decision-maker has little or no guidance in predicting them. Probabilities cannot be assigned to
uncertain events. Under conditions of uncertainty, there is no statistical evidence and no probability
distribution.
Any investment decision, or any business decision, implies a forecast of future events that is either
explicit or implicit.
Example
Company A estimates that the annual cash-flow for the next three years is R1 000 000 annually. How
good is this point estimate, or how confident is the forecaster of a R1 000 000 return?
The degree of uncertainty can be defined and measured in terms of the forecaster’s probability
distribution (the probability estimates associated with each possible outcome), eg:
Return
Given an upswing in the economy R1 200 000
Normal economic conditions R1 000 000
Downturn in economy R800 000
If estimates of the probabilities of these events were known, a weighted average cash-flow estimate
and a measure of the degree of confidence in this estimate can be determined.
Measuring risk
Risk can be defined in terms of probability distributions as:
The tighter the probability distribution of expected future returns, the smaller the risk of a given
project.
Probability
of
occurrence Project A
Project B
Cash-flows: R
Figure 2
According to this definition, Project A (above) is less risky than Project B, because the actual return
for Project A should be closer to the expected return than is true for Project B.
Standard deviation
Standard deviation is the conventional measure of the dispersion of a probability distribution and is
calculated as follows:
(a) Calculate the expected value of the distribution:
n
Expected value R = (RiPi)
i=1
Where: Ri = return associated with i’th outcome

Pi = probability of occurrence of i’th outcome
R, the expected value, is a weighted average of the various possible outcomes, each weighted
by the probability of its occurrence (MEAN).
(b) Subtract the expected value from each possible outcome to obtain a set of deviations about the
expected value:
Deviation i = Ri – R
(c) Square each deviation.
(d) Multiply the squared deviation by the probability of occurrence for its related outcome and sum
these products to obtain the variance of the probability distribution:
n
2
Variance = = (Ri – R)2 Pi
i=1
(e) The standard deviation is found by obtaining the square root of the variance:
n
Standard deviation = = (Ri – R)2 Pi
i=1
(f) The co-efficient of variation

When the risk structure and returns for two independent projects are different, it is necessary
to calculate the weighted average risk per R1 of return. This statistical measure is called the co-
efficient of variation (CV), which is calculated as follows:

CV =
Mean
The co-efficient of variation helps us to compare the risk of one project to that of another. If
there is only one project being considered, the co-efficient of variation simply reflects the risk
per Rand of return. It does not give a conclusive decision on whether the investment under
consideration is risky or not.
Example
Project A has an expected return of R100 000 and a standard deviation of R18 900. Project B has an
expected return of R180 000 and a standard deviation of R38 000. Calculate the co-efficient of
variation.
18 900
Co-efficient of variation for A = = 0,1890
100 000
38 000
Co-efficient of variation for B = = 0,2111
180 000
Conclusion
Project A has a lower risk profile than Project B. Does that mean that Project A is a better investment
than B? Not necessarily. Project A offers a lower expected return than Project B. Assuming that the
invested amount was the same for both projects, Project B appears to be a better investment as it
offers a higher return. Project B however also has a higher risk (although it is marginal). An investor
may conclude that the marginal extra risk offered by B is more than compensated for by a far higher
average (or mean) return.
The important factor is to understand that the co-efficient of variation expresses the risk per Rand of
return which is helpful in comparing two projects but not conclusive in deciding which one is better.
The missing piece in the puzzle is the investor’s attitude to risk.
Probability as the area under the normal curve

1 When the returns from an investment are normally distributed, the mean and standard deviation
describe the entire probability distribution, facilitating risk measurement and comparison.
2 By calculating the area under a normal curve, we can find the probability that an outcome will be
between any two points. Standardised statistical tables are available to calculate this area without
tedious integration.
3 To use the tables, the probability distribution to be investigated is calculated as follows:
X–u
Z =

Where u = the mean of the distribution
= the standard deviation of the distribution
X = the point in question
Z = the number of standardised standard deviations an observation lies from the
mean of the normal curve.
68,26% of all observations fall within +/– 1 standard deviation of the mean;
95,46% fall within +/– 2 standard deviations; and
99,74% fall within +/– 3 standard deviations.
The above equation is simple to understand. If you look at the diagram below, you can see that there
are 3 standard deviations to the left and right of the mean.
50%
50%
3 standard
3 standard deviations
deviations
Mean
Figure 3
50% of the area under the curve lies to the left of the mean and 50% to the right. This means that
there is a 50% chance that the profit will be higher or lower than the mean.
X–u
The equation Z =

calculates the number of standard deviations that a particular point lies from the mean.
Example
The mean value of a distribution is R8 000. The standard deviation is R1 600. What is the probability
that the profit will be greater than R10 000?
50%
8 000 10 000
Figure 4
The answer is represented by the shaded area under the curve that shows a value greater than
R10 000. The equation is, however, restricted to analysing a point in question in comparison to the
mean. That does not pose a problem, because we know that there is a 50% probability that profit will
be greater than R8 000.
If, for example, we determine that the probability of profit lying between R8 000 and R10 000 is (say)
30%, then the probability of profit being greater than R10 000 is 20%.
Solution
X–u 10 000 – 8 000
Z = = = 1,25
1 600
This means that the area between 8 000 and 10 000 represents 1,25 standard deviations. The next
step is to convert the 1,25 standard deviations to a percentage (%). Reading from the tables of area
under the curve (see end of chapter) we get a value of 0,3944 which means that the area under the
curve from 8 000 to 10 000 is 39,44%.
Therefore, the probability that profit will be greater than R10 000 is
50% – 39,44% = 10,56%
4 The assumption of normality also permits us to calculate the probability that an outcome will be
greater or less than a certain amount, through use of cumulative probability distributions.
5 Normal distribution is widely assumed because many distributions do fit this pattern.
Example
Dixy Hats expects to make the following profits next year:
State Probability Profit (R’000)
1 0,1 4 000
2 0,2 5 000
3 0,4 6 500
4 0,2 8 000
5 0,1 9 000
continued

(a) Calculate the mean, standard deviation and co-efficient of variation of the probability
distribution.
(b) Determine the probability that profit will exceed R6 900 000, fall below R4 750 000, and
fall between R4 750 000 and R6 900 000.
(c) Determine the probability of profit falling between R6 500 000 and R8 000 000.
Solution
(a) State Profit × P Profit – Mean (Profit – Mean)2 P(Profit – Mean)2
’000
1 400 – 2 500 6 250 625 000
2 1 000 – 1 500 2 250 450 000
3 2 600 0 0 0
4 1 600 1 500 2 250 450 000
5 900 2 500 6 250 625 000
Mean 6 500 2 = 2 150 000
= 1 466,3
If the above activity is undertaken a sufficient number of times, it will be expected to produce
(on average) a profit of R6 500 000. However, if the company was going to undertake this
activity once only, it will run the risk of making a profit of only R4 000 000 (10% probability) or
R5 000 000 (20% probability). Whether it is prepared to take the chance will depend on the
company’s attitude to risk.
In the case of non-recurring decisions, the expected value represents the best single figure
estimate of the outcome that can be made on the basis of subjective probabilities. It will be
useful for a preliminary assessment of the project, but it cannot be considered a result that will
be attained in the form of a long-run average.
Standard deviation 1 466,3
Co-efficient of variation = = = 0,2256
Expected sales 6 500
Companies with low CVs have less risk perRand of sales than companies with high CVs.
(b) Exceed R6 900 000
X–u 6 900 – 6 500
Z = = = 0,2728
1 466,3
From the table of normal values, Z = 0,2728 represents a probability of 0,1075 from the mean,
therefore 0,5 – 0,1075 = 0,3925 or 39,25%.
Fall below R4 750 000
4 750 – 6 500
Z = = 1,1935
1 466,3
Per tables: 0,3837 from the mean
Therefore: 0,5 – 0,3837 = 0,1163 or 11,63%
Fall between R4 750 and R6 900 = 100 – 39,25 – 11,63 = 49,12%
(c) Between R6 500 000 and R8 000 000
8 000 – 6 500
Z = = 1,0230 per tables = 0,3468 or 34,68%
1 466,3
Decision trees
A decision tree is a diagram that starts by showing the choices available, followed by consequences
that have a probability distribution. Choices do not have a probability distribution.
Example – On your way to work you come to a set of traffic lights. You may choose to go straight or
you may choose to go an alternative route by turning left. As a result of your choice
there will be certain consequences.
If you go straight there is a 60% probability that you will encounter a traffic jam. If there
is no traffic jam, there is a 90% chance that you will get to work on time. There is,
however, a 10% probability that a taxi will cut in front of you, causing an accident.
If you turn left at the robot, there is a 50% probability that there will be road works.
There is a 40% probability that there will be no road works, in which case you will get to
work on time. There is a 10% probability that there will be no road works, but there will
be a traffic jam.
Drawing the above decision tree requires that you
1 identify choices (no probability distribution)

2 identify consequences as a result of the choice.
Traffic jam
0,60
Consequence
0,40 0,90 Work on time

Straight
No jam
0,10
Choice
Accident
Turn left 0,50 Road works

Consequence
0,04
Work on time
0,11
Traffic jam
Figure 5
The second part of analysing probability distributions in the form of a decision tree is to evaluate the
values of the outcome (ie the probabilities). Most business questions require that you analyse cost
data, ie variable and fixed costs, and arrive at a Rand value for the final outcome.
Finally, you need to integrate the outcome value and the probability in order to arrive at a value for
the choices available at the beginning of the decision tree. This is called “backward induction”, which
simply means the evaluation of each option.
Many decisions in practice involve multi-alternatives with varied probability distributions. The
outcomes become possible depending on the previous states or decision points. Decision tree
analysis is a useful analytical tool for clarifying alternative courses of action, with a multitude of
outcomes. A decision tree is a diagram showing decision points, alternatives and possible outcomes
with assigned probabilities.
1
0,3
Alternative 1
Event 2
0,3
3
0,4
Decision
point
4
0,2
Alternative 2
Event
5
Decision trees 0,8
Figure 6
The decision point box represents a choice available to a decision-maker. For example, if we have an
opportunity to expand our business, we would draw a box with two alternative choices, ie expand or
not expand. Alternatives flowing from a decision point do not have a probability distribution.
If we decide to expand our business, we will be faced with expected profit outcomes that may be
described in the form of a probability distribution.
Probability distributions are represented by drawing a circle with different probability distributions,
as shown in the diagram above. Circles represent points where different states may affect the
consequences of prior decisions.
The advantage of using decision trees and the expected value technique is that it recognises that
there are several possible outcomes and evaluates them separately, allowing the different outcomes
to be considered. The calculations are also simple, and we are able to choose the optimising
alternative by discarding those alternatives that have a lower value.
There are, however, several disadvantages to using this technique, as follows:
l The expected value as calculated from the probability distribution is only correct if the project is
repeated many times. Expected values do not represent the financial once-off outcome.
l The mechanical expected value calculation ignores the decision-makers’ attitude towards risk.
The investors may be risk-takers or risk-averse, which is ignored in a decision tree.
l The forecasting technique requires an estimate of the outcomes which are subject to a high
degree of error. The probability distributions are also very subjective and inaccurate.
l The expected value ignores the dispersion of possible outcomes about the mean.
A company is considering drilling for oil in the Cape. The probability of finding oil is dependent
on whether or not an initial exploration study is undertaken.
If no study is undertaken, and the company decides to drill, there is a 12% chance that oil will
be discovered, generating a total income of R50 million. The cost of drilling will be R8 million.
If a study is undertaken at a cost of R200 000, there is a 10% chance that the study will be
favourable. Should the study show favourable results, the probability of finding oil is 95%. The
total income generated from the discovery of oil is R50 million at an R8 million cost of drilling.
If the study is undertaken, and the results show that there is a low likelihood of oil existing,
the company may choose to drill, but the probability of discovering oil is only 5%.

Advise the company on what course of action it should take.
Solution
0,95 Oil
+ R50m
Drill
(R8)
0,05 No oil
Positive 3 nil
0,10 R39,5
0,05 Oil
+ R50m
Study Drill
(R8)
(R0,2m) 0,95 No oil
nil
Negative 4 Abandon
1 nil
0,90 R0
0,12 Oil
+ R50m
Drill
(R8) 0,88 No oil
nil
No study 2
R0
Abandon
nil
Figure 7
The decision tree shown above has the outcome values at every point. It is acceptable (and I would
recommend) that you do not clutter the diagram with values. Show the values separately with a
conclusion in the final value.
1 Decision Point 2: No study
Expected return R50m × 0,12 = R6m
Cost – R8m
Net return – R2m
2 Decision Point 3: Positive study
Expected return R50m × 0,95 = R47,5m
Cost – R8,0m
Net return R39,5m
3 Decision Point 4: Negative study
Expected return R50m × 0,05 = R2,5m
Cost – R8,0m
Net return – R5,5m
Choice available: Abandon with an expected return of zero or drill with an expected loss of
– R5,5m. Therefore select the zero value.
4 Decision Point 1: Should the study be undertaken?
Expected return Probability Expectation
(2) above R39,5 0,1 3,95
(3) above (abandon) R0 0,9 –
3,95
Less: Cost 0,20
Expected return 3,75
Conclusion
The study should be carried out and drilling should be done if the study results are positive. The
procedure used is referred to as “backward induction” or “roll-back”, where we start at the right-
hand side and roll back towards the left. The sequence of decisions is to choose the option that yields
the highest positive or zero return and move back to account for the probability distribution that
gave rise to that choice.
One factor that has not been considered is the investor’s attitude to risk. It is possible that the
probability expectations are too low in terms of his aversion to risk.
Illustrative example 2 – using net present values (NPV)

A company is considering whether to develop and market a particular product. There is a 40%
probability that the research and development department will come up with a viable
product, and a 60% probability that the product will be scrapped. The cost of undertaking the
research and development is R200 000.
If the product development is successful, the company will build a plant. The product demand
is unknown and the company has the choice of building a large or small plant. The expected
demand and net present value is shown below:
High demand Low demand
Action probability 0,75 probability 0,25
Large plant R1 600 000 R400 000
Small plant R1 000 000 R1 000 000

Advise the company on the most beneficial course of action.
Solution
0,75 High
1 600 000
Large plant
R1 300 000
400 000
0,25 Low
0,4 ’000
2
R1 300 0,75 High
1 000 000
Invest Small plant

R1 000 000
1 000 000
0,25 Low
Project fails
(200 000)
’000 0,6
1
R400
Do not
invest
1,0
0
Figure 8
Note: The R200 000 research and development cost is already included in the terminal present
value figures.
The analysis proceeds by working backwards from the final outcomes through each of the decision
points.
Decision 1: Should the company invest or not?
Decision 2: Should the company build a large or small plant?
Proceeding backwards, we find the net present value of investing in the product development is
R400 000.
Conclusion
The project is desirable.
Note: This example is different to the previous example as the expected values are given as NPV.
This means that the cost of undertaking the research has already been accounted for in
arriving at the NPV.
Illustrative example 3 – a double decision tree

Company Dandy can produce Product A, Product B or Product C; it cannot, however, produce more
than one product.
If it chooses to manufacture Product A, it can sell it to a company that has given an undertaking to
order either 5 000 units or 8 000 units, depending on the order size that maximises its own company
profit.
An order for 5 000 units will yield a profit of R3 million for Dandy, while an order for 8 000 units will
result in a profit of R4 million.
Dandy’s selling price to the customer is R1 000 per unit if 5 000 units are ordered, and R900 per unit
if 8 000 units are ordered. The customer will sell the product for R2 000 per unit, while unsold
inventory can be exported at R500 per unit.
The market demand for the product is expected to be

2 000 units with a probability estimate of 30%
The purchasing company has analysed the available information and has made a decision on the
purchase size. Dandy may, however, pass the order on to another manufacturer if it so chooses.
If Dandy decides to manufacture Product B, it has a 40% chance of making a profit of R5 million and a
60% chance of making only R2 million.
Product C can be sold either on the local market or on the overseas market. If Dandy decides to sell
on the local market it has a 70% chance of making a R5 million profit and a 30% chance of making a
loss of R1 million. If, however, it decides to export, there is a 70% probability that it will encounter
competition, in which case the profit will be only R1,5 million. If it turns out that there is no
competition, then the profit will be as high as R12 million.

Evaluate the options available to Dandy and advise on what course it should take.
Solution
There are two decision trees to be evaluated. The first one is to calculate how many units the
customer is likely to order. We have no control over how the customer will make his decision. All we
know is that if he orders 5 000 units, our profit will be R3 million, while an order for 8 000 units will
result in a profit of R4 million.
Customer order
Order size: 5 000 units
2 000 – 2 000 × [ 2 000 – 1 000 ] + 3 000 × [ 500 – 1 000 ] = + 500 000
5 000 – 5 000 × [ 2 000 – 1 000 ] = + 5 000 000
8 000 – 5 000 × [ 2 000 – 1 000 ] = + 5 000 000
+ 500 000 × 0,3 = 150 000
+ 5 000 000 × 0,5 = 2 500 000
+ 5 000 000 × 0,2 = 1 000 000
3 650 000
Order size: 8 000 units

2 000 – 2 000 × [ 2 000 – 900 ] + 6 000 × [ 500 – 900 ] = – 200 000
5 000 – 5 000 × [ 2 000 – 900 ] + 3 000 × [ 500 – 900 ] = + 4 300 000
8 000 – 8 000 × [ 2 000 – 900 ] = + 8 800 000
– 200 000 × 0,3 = – 60 000
+ 4 300 000 × 0,5 = 2 150 000
+ 8 800 000 × 0,2 = 1 760 000
3 850 000
0,3 + 500 000
0,5
+ 5 000 000
3,65
5 000
0,2
+ 5 000 000
3,85
0,3 – 200 000
8 000
0,5
3,85 + 4 300 000
0,2
+ 8 800 000
Figure 9
The customer will therefore order 8 000 units as it maximises his profit
Company Dandy – decision

Product A
+ R4mil
+ R5mil
0,4
Product B
4,65 3,2 0,6
+ R2mil
0,7 + R5mil
3,2 0,3
– R1mil
4,65 Product C
0,7 + R1,5mil
4,65 0,3
+ R12mil
Figure 10
Product A
The demand for product A from the customer is 8 000 units.
The profit is therefore R4 million.
Product B
Expected value
5 000 000 × 40% = R2 000 000
2 000 000 × 60% = R1 200 000
R3 200 000
Product C
Expected value
Local market
5 000 000 × 70% = R3 500 000
– 1 000 000 × 30% = – R 300 000
R3 200 000
Export market
1 500 000 × 70% = R1 050 000
12 000 000 × 30% = R3 600 000
R4 650 000
The options are evaluated using the backward induction method. The highest value is Product C,
export market.
However, in practice it would be very foolish to choose this option, as the company will either make
a profit of R1 500 000 or a profit of R12 000 000, but the probability of making a profit of R12 million
is only 30%.
If we are, however, looking at the long-term and the information is the same every year, only then
would we choose Product C, export market.
A better short-term option is Product A as it has a guaranteed profit of R4 million.
Table of areas under the normal curve

Values of the standard normal distribution function
Z 0,00 0,01 0,02 0,03 0,04 0,05 0,06 0,07 0,08 0,09
0,0 0,0000 0,0040 0,0080 0,0120 0,0160 0,0199 0,0239 0,0279 0,0319 0,0359
0,1 0,0398 0,0438 0,0478 0,0517 0,0557 0,0596 0,0636 0,0675 0,0714 0,0753
0,2 0,0793 0,0832 0,0871 0,0910 0,0948 0,0987 0,1026 0,1064 0,1103 0,1141
0,3 0,1179 0,1217 0,1255 0,1293 0,1331 0,1368 0,1406 0,1443 0,1480 0,1517
0,4 0,1554 0,1591 0,1628 0,1664 0,1700 0,1736 0,1772 0,1808 0,1844 0,1879
0,5 0,1915 0,1960 0,1985 0,2019 0,2054 0,2088 0,2123 0,2157 0,2190 0,2224
0,6 0,2257 0,2291 0,2324 0,2357 0,2389 0,2422 0,2454 0,2486 0,2517 0,2549
0,7 0,2580 0,2611 0,2642 0,2673 0,2704 0,2734 0,2764 0,2794 0,2823 0,2852
0,8 0,2881 0,2910 0,2939 0,2967 0,2995 0,3023 0,3051 0,3078 0,3106 0,3133
0,9 0,3159 0,3186 0,3212 0,3238 0,3264 0,3289 0,3315 0,3340 0,3365 0,3389
1,0 0,3413 0,3438 0,3461 0,3485 0,3508 0,3531 0,3554 0,3577 0,3599 0,3621
1,1 0,3643 0,3665 0,3686 0,3708 0,3729 0,3749 0,3770 0,3790 0,3810 0,3830
1,2 0,3849 0,3869 0,3888 0,3907 0,3925 0,3944 0,3962 0,3980 0,3997 0,4015
1,3 0,4032 0,4049 0,4066 0,4082 0,4099 0,4115 0,4131 0,4147 0,4162 0,4177
1,4 0,4192 0,4207 0,4222 0,4236 0,4251 0,4265 0,4279 0,4292 0,4306 0,4319
1,5 0,4332 0,4345 0,4357 0,4370 0,4382 0,4394 0,4406 0,4418 0,4429 0,4441
1,6 0,4452 0,4463 0,4474 0,4484 0,4495 0,4505 0,4515 0,4525 0,4535 0,4545
1,7 0,4554 0,4564 0,4573 0,4582 0,4591 0,4599 0,4608 0,4616 0,4625 0,4633
1,8 0,4641 0,4649 0,4656 0,4664 0,4671 0,4678 0,4686 0,4693 0,4699 0,4706
1,9 0,4713 0,4719 0,4726 0,4732 0,4738 0,4744 0,4750 0,4756 0,4761 0,4767
2,0 0,4772 0,4778 0,4783 0,4788 0,4793 0,4798 0,4803 0,4808 0,4812 0,4817
2,1 0,4821 0,4826 0,4830 0,4834 0,4838 0,4842 0,4846 0,4850 0,4854 0,4857
2,2 0,4861 0,4863 0,4868 0,4871 0,4875 0,4878 0,4881 0,4884 0,4887 0,4890
2,3 0,4893 0,4896 0,4898 0,4901 0,4904 0,4906 0,4909 0,4911 0,4913 0,4916
2,4 0,4918 0,4920 0,4922 0,4925 0,4927 0,4929 0,4932 0,4934 0,4934 0,4936
2,5 0,4938 0,4940 0,4941 0,4943 0,4945 0,4946 0,4948 0,4949 0,4951 0,4952
2,6 0,4953 0,4955 0,4956 0,4957 0,4959 0,4960 0,4961 0,4962 0,4963 0,4964
2,7 0,4965 0,4966 0,4967 0,4968 0,4969 0,4970 0,4971 0,4972 0,4973 0,4974
2,8 0,4974 0,4975 0,4976 0,4977 0,4977 0,4978 0,4979 0,4979 0,4980 0,4981
2,9 0,4981 0,4982 0,4982 0,4983 0,4984 0,4984 0,4985 0,4985 0,4986 0,4986
3,0 0,4987 0,4987 0,4987 0,4988 0,4988 0,4989 0,4989 0,4989 0,4990 0,4990
Appendix
Terminology
l Subjective probabilities
A subjective probability is one where the decision-maker has no basis from past experience on
which to estimate the probabilities of various outcomes. The assignment of probabilities is
therefore a matter of individual judgement, which varies from person to person.
l Objective probabilities
Objective probabilities are based on historical evidence or experience. Tossing a coin is an
objective probability.
l Unconditional probabilities (Marginal probabilities
The outcome of any event is in no way conditioned or affected by the preceding event.
l Mutually exclusive events
Where one, and only one, outcome can occur at a time. The probabilities of events that are
mutually exclusive can be added and must always total 1.
l Collectively exhaustive events
A list which contains all of the possible outcomes for a given action is said to be collectively
exhaustive. Events may be both mutually exclusive and collectively exhaustive. The sum of the
probabilities must be 1.
l Statistical independence
The occurrence of one event will not affect the probability of the occurrence of the second event.
l Statistical dependence
Statistical dependence is present if the probability of one event is affected by or dependent upon
the happening of some other event.
Addition of probabilities
The probability of one event occurring in a given set of mutually exclusive events is:
P(X or Y) = P(X) + P(Y)
Example 1
Event X has a probability of 30% and Event B has a probability of 50%. Both events are mutually
exclusive.
The probability that either A or B will occur is:
0,30 + 0,50 = 0,80 or 80%
Example 2 – Where events are not mutually exclusive

Event A has a probability of 30%, while Event B has a probability of 40%. There is a 20% probability
that both A and B will occur simultaneously.
The probability that either A or B will occur is denoted by:
P(A or B) = P(A) + P(B) – P(A and B)
= 0,30 + 0,40 – 0,20
= 0,50 or 50%
Multiplication rule or joint probability

Independent
When two events are independent, the occurrence of one in no way affects the occurrence of the
other. The probability that both of two independent events will occur is defined as:
P(A and B) = P(A) P(B)
Example
What is the probability of throwing a dice twice and getting a 5 followed by a 3?
1
Event A = 5 on first throw = P(A) =
6
1
Event B = 3 on second throw = P(B) =
6
1 1 1
P(A) and(B) = × =
6 6 36
Dependent events
When two events are dependent on each other, their joint probability is influenced by the way in
which the first probability affects the second probability.
Example
Given a pack of cards, what is the probability of drawing two consecutive aces, assuming that the first
card drawn is not returned to the pack?
4
The probability of drawing the first ace is
52
3
The probability of drawing a second ace is
51
(as there are now only three aces because the first is not returned to the pack, which also affects the
total available cards in the pack)
4 3 12
Solution: = × =
52 51 2 652
The above probability is often called a conditional probability and is written P(B/A), ie Probability of
B, given A.
Under conditional probabilities, the distribution of Event A and Event B or both occurring is denoted
as:
P(A and B) = P(A) P(B/A)
The formula P(A and B) = P(B) P(A/B) is equivalent to the above equation.
Practice question: I recommend that you attempt Question 12 – 3 PART B before proceeding.
Practice questions
PART A
Bermuda Ltd is to quote for a contract to supply 10 000 units of a certain product to a large group
with branches throughout the country.
It knows that the group will accept the lowest bid and, from past experience and good intelligence
within the industry, estimates the following probabilities of bids at various levels (in multiples of R5
only).
Price bid Probability of bids at
R that price
45 0,05
50 0,10
55 0,20
60 0,25
65 0,25
70 0,10
75 0,05
1,00
Bermuda Ltd expects its out-of-pocket costs for these items to be R32 per unit.

Calculate the price that Bermuda Ltd should bid for this contract if it wishes to maximise its expected
profit margin. (6 marks)
PART B
In arriving at its out-of-pocket costs, Bermuda Ltd has estimated an amount per unit for servicing the
items for one year, as required by the terms of the contract.
If it obtains the contract, there are a number of ways in which it can satisfy this servicing
requirement:
(i) It could sub-contract to AB Limited, which is willing to undertake the work in all areas or any
individual area and has quoted the prices shown in the table below.
Area No of units to be Price quoted
serviced under the
contract R
Gauteng 3 000 18 000
Western Cape 4 500 20 000
KwaZulu-Natal 2 500 13 500
(ii) For the Western Cape area only, it could sub-contract to CD Limited, which has quoted
R18 000 plus a charge for service calls above a certain level.
These charges and the assessed probability of their occurrence are
Calls made CD limited charge Probability of
R occurrence
750 or fewer – 0,40
751 – 900 900 0,30
901 – 1050 2 200 0,20
1 051 or more 3 500 0,10
1,00
(iii) For the KwaZulu-Natal area only, it can use its own organisation, but would need to take on
extra staff.
The cost of this staff and the probability of needing each level of extra staff are assessed as:
Cost of extra staff Probability of needing
R that level
4 500 0,20
7 000 0,35
11 000 0,45
1,00
If sub-contractors are used, they will buy spares from Bermuda Ltd at an average price of R2
per unit to be serviced.
The out-of-pocket cost of these spares to Bermuda Ltd is R1,50 per unit.

Calculate which combination of servicing arrangements will involve Bermuda Ltd in the minimum
cost; calculate the total net cost to the company, and discuss the other factors that should be taken
into account before a final decision about the servicing arrangements is reached. (24 marks)
Solution
Tutorial note: This is a fairly straightforward question involving the use of expected values for
decision making. In PART A, cumulative probabilities should be used. The company will not get the
contract if there are lower bids; the probability of not getting the contract is therefore the
cumulative probability of there being bids at a lower price, and the probability of getting the contract
is 1 minus this figure. In PART B, the expected net cost of each option must be determined (after
allowing for the contribution on spares purchased by outside contractors.) but for the final part, you
need to be aware of the limitations of expected values.
PART A
It has been assumed that if Bermuda Ltd and another company both bid the same price, the former
will be awarded the contract.
Price bid Probability of acceptance Contribution Expected
(1 – cumulative probability per unit contribution per unit
(R) of bids at lower prices) (R) (R)
45 1,00 13 13,00
50 0,95 18 17,10
55 0,85 23 19,55
60 0,65 28 18,20
65 0,40 33 13,20
70 0,15 38 5,70
75 0,05 43 2,15
The expected contributions will be greatest if a price of R55 is bid. It must be borne in mind, of
course, that at this price there is an estimated 15% chance of not getting the contract. There is also a
good chance that if a higher price were bid, the contract would still be obtained.
PART B
Examine the three areas in turn
Gauteng
The only alternative is AB Limited, at a cost of R18 000 less the contribution Bermuda will earn on the
spares, ie R1 500 (3 000 units × R2 – R1,50).
Western Cape
The choice is between AB Limited and CD Limited and, initially, the contribution from spares can be
ignored.
AB Limited R
Fixed charge of 20 000
CD Limited:
Expected additional charge
Charge Prob R
900 0,3 270
2 200 0,2 440
3 500 0,1 350 1 060
19 060
From the above, it can be seen that the contract should be given to CD Limited, at an expected cost
of R19 060 less the R2 250 contribution on spares.
KwaZulu-Natal
Here the choice is between AB Limited and the company’s own staff.
R
AB Limited
Less: Contribution from
sale of spares (2 500 @ 50c) 1 250
12 250
Own staff
Expected cost of extra staff
Cost Prob R R
4 500 0,20 900
7 000 0,35 2 450
11 000 0,45 4 950
8 300
Variable cost of required spares
(2 500 @ R1,50) 3 750
12 050
The company should therefore use its own staff.
The net overall expected cost will be
R
North (AB) 16 500
South (CD) 16 810
KwaZulu-Natal (own staff) 12 050
45 360
The following points should be borne in mind:

(i) Expected values are averages and their use for decision-making depends, ideally, on the same
decision being taken an infinitely large number of times. In practice this is not the case, and
the decision-maker should consider the range of values around the average. In the present
situation, there is a 0,30 probability of CD Limited being more expensive than AB Limited in the
Western Cape, and a 0,45 probability of the company’s own staff being more expensive in
KwaZulu-Natal.
(ii) The quality of service obtainable from AB, CD and the company’s own staff and (in particular)
the more direct control over the latter.
(iii) The financial stability of AB and CD and hence their ability to complete the year’s contract.
(iv) The ability of the company to dispense with any extra staff taken on in the KwaZulu-Natal area
or use them elsewhere in the organisation.
(v) The timing of the relevant cash-flows.

PART A 20 marks
The management of Lota Ltd used discounted cash-flow techniques to evaluate capital expenditure
projects. They recognise that budgeting several years ahead is subject to estimating probabilities.
They therefore estimate not only the likely cash-flows but also the probabilities of different cash-
flows.
They are contemplating the acquisition of a machine at a cost of R234 000.
The probabilities of its life expectancy are as follows:

10 years 0,2
11 years 0,5
12 years 0,3
For a premium which will be payable in addition to the purchase price, the supplier of the machine is
prepared to guarantee that the machine will last at least 11 years.
The machine produces a single product with a selling price of R12 per unit and variable cost of
production of R7 per unit.
The probabilities of the following production volumes are:

5 000 units per annum 0,1
The present value of R1 per annum at the company’s screening rate for capital projects is as follows:
10 years R6,71
11 years R7,13
12 years R7,52

(a) Advise the management of Lota Ltd on whether they should acquire the machine. (14 marks)
(b) Calculate how much Lota Ltd can afford to pay by way of a premium in the first year for a
guarantee that the machine will last 11 years. (6 marks)
PART B 20 marks
Cilic Gardens Ltd is contemplating the manufacture of pool equipment and must decide whether to
build a large or a small plant.
There is a 0,6 probability that the demand for the equipment will be strong and a 0,4 probability that
the demand will be weak. If demand is strong and a large plant is built, a profit or R10 million will
result. However, if demand is weak but the plant large, profits will amount to R1 million. If Cilic
Gardens Ltd builds a small plant and demand is weak, profits of R4 million will be made.
If demand is strong and Cilic Gardens Ltd has a small plant, the likelihood of competition is greater. It
is estimated that there is a 75% chance that the company will come up against competition under
these circumstances. In such a case, Cilic Gardens Ltd could either build another separate small plant
in a different area, or expand the existing plant. If Cilic Gardens Ltd decides not to invest in further
plant, profits of R6 million are expected, regardless of whether there any competition.
If there is competition, however, either form of expansion is expected to yield a 0,7 probability of a
profit of R8 million and a 0,3 probability of no change in the status quo. If there is no competition,
building the separate plant would yield a profit of R9 million with a 0,8 probability and a profit of
R7 million with a 0,2 probability. Expanding the existing plant is expected to result in a profit of
R7,5 million.

(a) Draw a decision tree for Cilic Gardens Ltd. (10 marks)
(b) Determine the optimal strategy by means of backward induction. (10 marks)
Solution
PART A
(a) Outcome 10 years 11 years 12 years
Production 5 000 × 0,1
6 000 × 0,3 6 500 6 500 6 500
7 000 × 0,6
Contribution ×5 ×5 ×5
Total contribution 32 500 32 500 32 500
P.V. factor 6,71 7,13 7,52
Value 218 075 231 725 244 400
Probability 0,2 0,50 0,30
Present value expectation 43 615 115 862,50 73 320
Net present value (NPV) 232 797,50 – (234 000) = – R1 202,50
Lola Ltd should not acquire the machine.
Probability of machine lasting eleven years = 70%
Probability of machine lasting twelve years = 30%
Present value of expected returns

11 years 12 years
Units 6 500 6 500
Contribution ×5 ×5
32 500 32 500
P.V. Factor 7,13 7,52
Value 231 725 244 400
Probability 0,70 0,30
R162 207,50 R73 320
NPV R235 527,50 – R234 000 = R1 527,50
Lota Ltd would be prepared to pay a premium of R1 527,50
Note: The question says that the company will guarantee that the machine will last at least 11
years. This statement in no way increases the probability that the machine will last 12 years,
therefore the 30% probability cannot be increased.
PART B
Strong demand (0,6) + 10
Weak demand (0,4)

6,4 +1
Large
plant Weak demand (0,4)
+4
6,4 Small
plant +8
6,22 0,7
0,3 +6
7,4
Build
Strong
separate
demand +8
(0,6) plant 0,7
Expand 0,3 +6
7,4
7,4
Competition No expand
No +6
(0,75)
expand
7,7 Build +9
8,6 separate 0,8
No
competition 0,2 +7
8,6
(0,25)
Expand
+ 7,5
No expand
+6
Conclusion
The company should choose to build the large plant. Had the question required an analysis of the risk
factors, one would argue in favour of the small plant, as the returns carry a lower risk.

The Alternative Sustenance Company is considering introducing a new franchised product,
Wholefood Waffles.
Existing ovens now used for making some of the present “Half-Baked” range of products could be
used for baking the Wholefood Waffles instead. However, new special batch-mixing equipment
would be needed. This cannot be purchased, but can be hired from the franchiser in three alternative
specifications, for batch sizes of 200, 300 and 600 units respectively. The annual cost of hiring the
mixing equipment would be R5 000, R15 000 and R21 000 respectively.
The “Half-Baked” product that would be dropped from the range currently earns a contribution of
R90 000 per annum, which it is confidently expected could be continued if the product were retained
in the range.
The company’s marketing manager considers that, at the market price for Wholefood Waffles of
40 cents per unit, it is equally probable that the demand for this product could be 600 000 or
1 000 000 units per annum.
The company’s production manager has estimated the variable costs per unit of making Wholefood
Waffles, and the probabilities of those costs being incurred, as follows:
Batch size: 200 units 300 units 600 units 600 units
Probability if Probability if Probability Probability
annual sales are annual sales are if annual if annual
either 600 000 either 600 000 sales are sales are
Cost per unit or 1 000 000 or 1 000 000 600 000 1 000 000
(cents) units units units units
20 0,1 0,2 0,3 0,5
25 0,1 0,5 0,1 0,2
30 0,8 0,3 0,6 0,3

(a) Draw a decision tree setting out the problem faced by the company. (15 marks)
(b) Show which size of mixing machine, if any, the company should hire to maximise the expected
value of contribution per annum. (8 marks)
(c) Briefly outline the strengths and limitations of the methods of analysis which you have used in
part (a) above. (5 marks)
Solution
(a)
(b) Expected value

Using the contributions and probabilities from the tree:
Half-Baked waffles: Annual contribution R90 000
Wholefood waffles: batch size 200
xi = contribution pi = probability xi pi
R’000 R’000
195 0,05 9,75
145 0,05 7,25
95 0,4 38,00
115 0,05 5,75
85 0,05 4,25
55 0,4 22,00
(contribution) R87,00
Note: The probability of achieving a contribution greater than R100 000 is arrived at as
follows:
R’000 pi
195 0,05
145 0,05
115 0,05
0,15 or 15%
Therefore the probability of achieving less than R100 000 contribution is 85%.

R’000 R’000
185 0,1 18,50
135 0,25 33,75
85 0,15 12,72
105 0,1 10,50
75 0,25 18,75
45 0,15 6,75
(contribution) R101,00

R’000 R’000
178,8 0,25 44 625
128,5 0,10 12 850
78,5 0,15 11 775
98,5 0,15 14 775
68,5 0,05 3 425
38,5 0,30 11 550
(contribution) R99 000
Therefore, to maximise the expected value of contribution, the company should
produce waffles in batch sizes of 300 as this provides the highest contribution.
(c) Introduction
Most business decisions take place in an uncertain environment. The impact of this uncertainty
in decision-making involves two distinct aspects, ie:
(i) The decision-maker’s estimation of the uncertainty of various outcomes.
(ii) The attitude of the decision-maker to risk-taking.
The methods of analysis referred to in (a) deal with these aspects in the following ways:
(i) Expected values
Strengths
All outcomes are considered.
Each outcome is given an importance in proportion to its likelihood.
Weaknesses
The results are averages and are therefore unlikely to be achieved if the project is only
repeated a small number of times.
It is assumed that the probabilities and data used in calculations are known with
certainty, when in fact they are likely to be subjectively determined.
(ii) Minimising the probability of low contribution

Strengths
This is, again, a risk-averse technique since it reduces the probability of a low return as
far as possible.
It does consider the likelihood of the outcomes.
Weaknesses
The technique only considers one extreme of the probability distribution of possible
outcomes, and does not consider the likelihood of high returns.
Very risky high-return projects are likely to be rejected.
Relevant
costs
l define and explain the concept of relevant costs
l apply relevant costing to decision-making
l explain the importance of qualitative factors
l use the relevant-costing decision model as an aid in choosing among competing
alternatives
l identify management accounting situations in which relevant costing is appropriate
l apply relevant costing to make or buy decisions, starting a new department or closing
down an existing department, sell or process further
l choose the optimal product mix when faced with one constraint
Context of relevant costs

Managerial accounting is primarily concerned with producing budgets, setting performance
standards and evaluating performance from an overall perspective, or from a detailed analysis such
as standard costing.
The setting of standards or budgets requires the analysis of current or future costs, and therefore
requires the analysis of relevant costs. You should already have a good understanding of relevant
costs; therefore the purpose of this chapter is not to revise relevant costs but to look at special
situations that arise when preparing a budget that requires special attention.
In particular you must have a sound understanding of special orders, two alternative decisions and
limiting factors in the context of budget preparation. Every company is faced with limiting factors of
production and one cannot do a budget without firstly assessing the production/sales limitations
facing the company. When attempting tutorial questions and examinations, you must always look
out for potential limiting factors. Special orders are also very important, as every company should
look at other alternatives of selling its products that will increase contribution without affecting
current markets. Finally, and we shall start with this topic, it is necessary to evaluate the production
options available and choose the method that optimises short-term (and where possible) long-term
profit.
Costing terms
(a) Relevant cost
A relevant cost is a future cash-flow arising as a direct consequence of the decision under review.
Only relevant costs should be considered in decision-making, because it is assumed that in the long
run future profits will be maximised if the “cash profits” of the company, ie the cash earned from
sales minus the cash expenditures incurred to sell the goods, are also maximised.
Costs which are not relevant include:
(i) past sunk costs, or money already spent
(ii) future spending already committed by separate decisions
383
(iii) costs which are not of a cash nature, eg depreciation

(iv) absorbed overheads (only cash overheads incurred are relevant to a decision).
The relevant cost of a unit of production is usually the variable cost of that unit plus (or minus) any
change in the total expenditure on fixed costs.
(b) Differential cost
A differential cost is the difference in cost of alternative choices. If Option A costs an extra R300 and
Option B costs an extra R360, the cost differential is R60, with Option B being more expensive. A
differential cost is the difference between the relevant costs of each option.
(c) Incremental cost
The differential cost of an extra unit of production is the extra cost required to make that unit, ie it is
the difference in cost between making the unit and not making it. This type of cost is also called an
incremental cost. Incremental costs are relevant costs.
(d) Opportunity cost
An opportunity cost is the benefit foregone by selecting one alternative in preference to the most
profitable alternative. If, for example, a company is currently making a cash-flow of R100 000 from
the use of a machine and it now has an opportunity of investing in a new machine, the choices
available are:
continue with the existing machine
replace with the new machine
sell existing machine (opportunity cost).
(e) Sunk costs
A sunk cost in decision-making terms is a past expenditure which:
(i) Has been charged as a cost of sale in a previous accounting period
OR
(ii) Will be charged in a future accounting period, although the expenditure has already been
incurred (or the expenditure decision irrevocably taken). An example of this type of cost is
depreciation. If the fixed asset has been purchased, depreciation may be charged for several
years but the cost is a sunk cost about which nothing can now be done.
Adding a new product

When deciding whether to introduce a new product, a company must consider costs such as
advertising, incremental marketing costs, commissions and incremental administrative costs.
Working capital must also be considered, as cash invested in inventory and debtors will no longer be
available.
The opportunity cost must also be taken into account, as the current production of a new product
could mean that the opportunity to produce some other product in the future is foregone. Decisions
involving the addition of new products are essentially capital budgeting problems.
Dropping a product or division

When a company is considering dropping an unprofitable product or division, the following factors
must be considered:
1 The production capacity taken up by the product under consideration.
If the company is operating in conditions of under-utilisation of capacity, the product should not
be dropped as long as it is contributing towards fixed costs. If the company is at full capacity or
close to full capacity and there is an alternative product that could be manufactured, strong
consideration should be given to dropping the existing product.
Chapter 11: Relevant costs 385
2 Long-term prospects for recovery of demand.

3 Market competition.
4 The cash break-even point.
The cost-volume-profit chart shows the profit break-even point below which a company is said to be
making a loss. It is at this point that consideration is given to dropping a product or division.
The cash break-even chart is an analysis based on receivable cash from sales minus the outflow of all
cash payable. This analysis ignores all costs that are non-cash outlays and takes account of time lags
in accounts receivable and payable. Where the depreciation charge is high, the break-even point is
considerably reduced. The cash break-even analysis does not fully represent cash-flows, unlike the
cash budget, but it is useful because it provides a picture of the flow of funds from operations. If cash
outlays are relatively low, the firm may continue to operate above the cash break-even point, even if
the company is incurring financial losses. Thus, the risks of insolvency are low, as cash obligations are
met.
Note that the cash break-even point is only a short-term solution where long-term prospects for
recovery are good.
Make or buy decision

A common business decision is the “make or buy” decision, in which a manager chooses between
buying an item, or manufacturing it. The item can be a part used in production or a cost such as a
computer service cost. Regardless of the type of product or service involved in the make or buy
decision, relevant costs are essential in the analysis. The company must evaluate both the qualitative
matters (discussed below) as well as the quantitative matters dealing with cost, eg what is the cost of
production compared to the cost of buying?
Qualitative aspects
1 Consideration of competitors’ economies of scale
2 Consideration of inhibited future expansion due to the tying-up of available capacity
3 Reduction in dependence on outside supplier
4 Internal quality control, rather than relying on outside suppliers to control standards
5 Risk of destroying long-term relationships with suppliers, which may prove to be harmful and
disruptive
6 Technology change often makes internal production more costly than purchasing from outside.
Example
Company A produces a component used in the production of one of the company’s main
products. The costs are budgeted as follows:
R R
Per unit 10 000 units
Materials 3 30 000
Labour 8 80 000
Variable overhead 6 60 000
Depreciation 3 30 000
Allocated general overhead 8 80 000
R28 R280 000
The components can be purchased from an outside supplier at a cost of R20 per unit.

Determine whether the company should make or buy the component.
Solution
Cost analysis: Production Differential cost Total differential cost
cost per per unit per 10 000 units
unit Make Buy Make Buy
Materials 3 3 30 000
Labour 8 8 80 000
Variable overhead 6 6 60 000
Depreciation 3 –
Allocated general overhead 8 –
Outside purchase price 20 200 000
Total cost R28 R17 R20 R170 000 R200 000
Difference in favour of
continuing to make: R3 R30 000
Depreciation is not a relevant cost; it is a sunk cost.
On a quantitative analysis, it is more beneficial to manufacture internally than it would be to
purchase from outside.
Special orders
A special order is one that will not affect a company’s current sales to its regular customers. Special
orders are often seen as sales on the export market. The problem of defining a special order as an
export is that if the sale is made at a low selling price, the product may yet find itself back on the
local market at a cheaper price than the local product.
Special orders take place when a buying company wishes to buy a product below full cost. At first
glance, it may appear that accepting a special order at less than full cost can only contribute a loss to
the company’s overall profitability. However, under certain conditions, special orders in fact increase
the company’s overall profitability.
The following qualitative aspects must be considered:
(a) The potential effect of the special-order sales on the firm’s sales at normal prices, eg if a
manufacturer sells 10 000 washing machines to a chain of discount stores in order to use up
excess capacity, the sales to regular dealers may fall because the ultimate customers buy from
the discount chain instead of the regular dealers.
(b) Special orders may require capacity in excess of existing available time. The fulfilling of the
special order may result in the more profitable regular orders being turned away. The issue is
that potential lost sales must be incorporated into the analysis of the special order.
(c) Special order for a market that does not compete with the firm’s regular sales. The special order
may be packaged under a private label that does not compete with the firm’s brand name, or it
may be sold in a foreign market where the product is not sold.
(d) Price must cover variable costs, costs associated with production and shipping the special order,
plus some contribution margin.
(e) Opportunity cost of tying up the plant must be considered.
(f) Effect on commissions paid to company staff.
(g) The accommodation of sales to existing customers.
(h) Future long-term contracts from the company requesting a special-order price.
(i) Market factors – how will the special order affect our competitor’s attitude to pricing?
Example
The following budgeted income statement is for a manufacturer who has received a special
order to sell 30 000 units of a product at R11 per unit. Existing planned sales are 80 000 units.
Plant capacity is 100 000 units and there is no inventory of finished goods.
Budget income statement
Per unit Total
Sales (80 000 units) R16 R1 280 000
Materials 5 400 000
Overhead (half variable) 6 480 000
Total manufacturing costs 13 1 040 000
Selling, general and administrative costs (half variable) 80 000
Net income R160 000
The variable portion of selling, general and administrative expenses is for commission.
Commission would not have to be paid for the special order.

Evaluate the special-order offer.
Solution
Incremental analysis Per unit Total
Revenue (30 000 units) R11 R330 000
Materials 5 150 000
Variable overhead 3 90 000
10 300 000 R300 000
Profit 30 000
Loss in sales:
10 000 units contribution 60 000
Less: Commission 5 000 (R55 000)
Net loss (R25 000)
By accepting the special offer, sales to existing customers would have to be reduced by 10 000 units
due to limiting factors of production. The resultant loss of R55 000 makes the acceptance of the
special offer unattractive.
Two alternative decisions

“Two alternative decisions” is about comparing a capital-intensive business with a labour-intensive
business. We often hear “Company overheads are too high” What does this mean? If you were
starting a new business, what costs would you try to minimise?
When you start a new business and you are operating under a chosen cost structure, what is the first
milestone you wish to overcome? Having arrived at this milestone, what should the medium- and
long-term objectives be? If you want to increase profit, what type of cost should you target?
When evaluating a business decision or when answering an examination question that requires your
opinion on how a business should be structured you should consider the following:
Business cost structure

Business is about maximising contribution and minimising “overheads”. Overheads are fixed costs.
The lower the fixed costs, the faster a business is able to generate a positive contribution or profit.
When starting a company it is therefore better to start small and not “too flashy” in order to
minimise the fixed costs. If the business does not work, your losses will be restricted to the fixed
costs. Variable costs are easily minimised by simply not producing. Low fixed costs, however, tend to
go hand in hand with high variable costs. The contribution per unit for new companies will tend to be
relatively low.
First milestone
The first objective of a business should be to break even. If a company cannot break even in the
short- to medium-term, it is probably a bad investment. You should therefore always determine the
break-even point and the margin of safety. Companies with a low fixed cost structure or low
overheads will be less risky than companies with high fixed costs. In an examination question asking
for advice on how a company is performing, focus your answer on an analysis of its cost structure, ie
its fixed costs and contribution per unit.
Medium-/Long-term objective
Once a company has established itself and has passed the break-even point, the company will look to
changing its cost structure so that the contribution per unit increases.
Invariably, this means moving from a “low fixed cost, high variable cost” cost structure to a “high
fixed cost, low variable cost” cost structure. It therefore becomes important at this point to
determine the production point of indifference, ie where the total cost of a capital-intensive
company = the total cost of a labour-intensive company.
“Two alternative decisions” focuses on companies calculating the point of indifference between
these two cost structures. In the long-term, a company will aim at minimising the variable costs of
production, and therefore maximise contribution.
Long-term objective
The long-term objective should be to maximise return on investment. Companies should therefore
aim at increasing sales and reducing variable costs. Targeting fixed costs is counter-productive. Fixed
costs are the engine-room of the company and represent the manufacturing assets that generate
sales/profit. If the overheads are too high, it is because the sales are too low. Target sales, and the
costs will look after themselves. Most companies, when faced with difficult times, tend to target
fixed costs such as salaries and the infrastructure of the company, which often leads to a slow death.
It is better to target variable costs which will increase contribution and sales rather than a cost
reduction. Always focus on sales.
The example below evaluates two production options, high fixed costs, low variable costs vs the
option of low fixed costs and high variable costs. In examinations, you must focus on the overall
discussion.
1 Effects of different cost structure
2 Break-even point
3 Point of indifference
4 Long-term cost structure
Example
Company X is planning to produce a product and may choose a manual method or an
automated method. The costs of production are as follows:
Manual Automated Differential
Fixed costs:
Equipment lease 15 000 42 000 27 000
Rent 10 000 10 000 –
Maintenance contract 5 000 8 000 3 000
R30 000 R60 000 R30 000
Manual Automated Differential
Variable costs per unit:
Materials 4 4 –
Labour 6 5 1
Overheads 2 1 1
R12 R10 R2
Selling price is R15 per unit.

Evaluate the two production methods and advise the company which method to choose.
Solution
Break-even point Manual Automated
Fixed costs 30 000 60 000
Contribution R3 R5
B/E units 10 000 12 000
The manual production method only contributes R3 towards profit after break-even, compared to R5
for the automated system. However, a lower break-even point favours the manual method.
The next step is to determine the production level at which we are indifferent between the manual
and automated methods.
Let x = number of units.
Indifference point
Total cost of manual method = total cost of automated method.
Total fixed cost of manual + total variable cost of manual = total fixed cost of automated + total
variable cost of automated.
30 000 + 12x = 60 000 + 10x
30 000 = 2x
15 000 = x
Indifference point is 15 000 units
The calculation can also be carried out as follows:
Differential fixed costs

= Indifference point
Differential variable costs
= 30 000
= 15 000 units
2
At 15 000 units, both methods incur identical production costs and therefore yield the same profit.
The lower fixed costs make the manual method more profitable up to 15 000 units. Beyond 15 000
units, the automated method is more profitable.
R’000
Automated
60
30
Manual
Unit 10 000 12 000 15 000

Figure 1
Limiting factors
Production constraints are often imposed upon a firm by inadequate supplies of raw materials,
skilled labour, machine time or factory space. When sales demand exceeds production capacity, it is
necessary to identify which product maximises profits on the basis of contribution per limiting factor.
Note: Always look out for potential limiting factors in an examination question and document your
findings. Decision-related questions often ask for production advice and have limiting factors
of production as a constraint.
How to evaluate management accounting information for all questions and in particular
where there is a limiting factor
Step 1
Sort out the information given by evaluating fixed costs and variable costs, both budget and actual.
Virtually all questions require an analysis of the cost structure. Have headings, eg fixed costs, variable
costs, high/low, absorption costing, variable costing. You will invariably be given information on a
variable costing or absorption costing basis that requires you to sift through the information and
show the costs as variable costs or fixed costs.
Step 2
Identify maximum production capacity for machinery or labour and show whether there is a limiting
factor. Headings should read “Potential limiting factor – machine hours”, (or labour hours or
material, etc). You must also conclude whether there is a limiting factor for each cost analysed.
Step 3
When there is a limiting factor, you must determine the contribution per unit, followed by the cost
per limiting factor.
Step 4
Do the budget.
Step 5
Evaluate possible alternative information that may change the contribution per unit determined in
Step 3 above.
Contribution per limiting factor where buying in is an option
Where buying-in is an option, the contribution per limiting factor must be evaluated slightly
differently.
Consider the following:

A company manufactures 3 products; the contribution per unit is
A B C
Assuming that the contribution per unit = contribution per limiting factor, it is very clear that the
company will maximise profit by producing (first) product A, followed by product B, followed by
product C. In fact, product A yields a contribution which is double that of B.
Now, what if product A and product B can be bought-in and sold such that the company will make
the following contribution?
A B C
Contribution from buy-in R35 R5 N/A
If you look at product A, you can see that the difference between producing the product ourselves
instead of buying it in is marginal. If we make the product ourselves, we will make a contribution of
R40; if we buy in, we still make a very good contribution of R35. The difference is only R5.
However, when you look at product B you will notice that there is a big difference between
manufacturing the product and buying it in. There is a R15 difference; therefore a company would
prefer to manufacture product B and buy in product A.
Conclusion
When there is an option to buy in, the correct method of calculating the contribution per limiting
factor on the internal production decision is to calculate the contribution per differential limiting
factor.
A B C
Internal contribution R40 R20 R10
Buy-in contribution R35 R5 –
Differential contribution R5 R15 R10
Now the correct decision is to manufacture B, followed by C, followed by A.
Example
A company manufactures three products as follows:
Product costs per unit
A B C
Labour 200 180 300
Variable overheads 100 50 100
Total variable costs R400 R430 R550
continued
A B C
Selling price: R600 R800 R900
Demand (units) 1 000 500 600
Material usage (kg) 2 4 3
Labour time (hours) 10 9 15
Material available: 4 000kg
Labour time: 25 000 hours
The products can also be imported from America at the following prices:
A B C
Cost R450 R600 R700

(a) Ignoring the possibility of importing any of the products, determine the most profitable
production mix.
(b) Determine the most profitable production mix if the company has taken the decision to
meet the shortfall by importing products as required from America.
Solution
(a) Step 1 – Identify the limiting factor or factors.
Material required to meet demand:
(1 000 × 2) + (500 × 4) + (600 × 3) = 5 800kg
Therefore, material is a limiting factor.
Labour hours required to meet demand:
(1 000 × 10) + (500 × 9) + (600 × 15) = 23 500 hours
Therefore, labour is not a limiting factor.
Step 2 – Calculate the contribution per limiting factor.
Products
A B C
Less: Variable costs 400 430 550
Limiting factor – material

Material usage 2kg 4kg 3kg
Contribution per limiting factor R100 R 92,50 R116,60
Produce in the order 2 3 1
Step 3 – Maximise contribution by producing to maximum demand in the order determined in
Step 2.
Material available
4 000 kg
Produce 600 units of C (1 800)
2 200
Produce 1 000 units of A (2 000)
200
Produce 50 units of B (200)
–
When multiple limiting factors exist (say raw material and labour hours) the solution is
determined using linear programming techniques.
Profit
R
600 units C × 350 210 000
1 000 units A × 200 200 000
50 units B × 370 18 500
Total contribution 428 500
(b)
Current contribution 200 370 350
Outside contribution 150 200 200
Differential contribution 50 170 150
Material usage 2 4 3
Differential contribution per kg R25 R42,50 R50
Produce in order 3 2 1
Material available
4 000 kg
Produce 600 units of C (1 800)
2 200
Produce 500 units of A (2 000)
200
Produce 100 units of B (200)
–
Import 900 units of A
Profit
R
600 units C × 350 210 000
500 units B × 370 185 000
100 units A × 200 20 000
415 000
Import 900 units A × 150 135 000
Total contribution R550 000
Note: If you took the solution to (a) as optimal, and purchased 450 units of B from America,
the profit would be
R
Contribution (a) 428 500
Import 450 B × 200 90 000
Total contribution R518 500
Appendix
A company produces two products, the standard costs of which are as follows:
Product A B
R R
Material A at R5/kg 10 15
Material B at R10/kg 30 10
Labour grade 1 at R1/hr 6 12
Labour grade 2 at R3/hr 18 24
Unit cost R98 R81
Fixed overhead of R4 000 per month is allocated to products on the estimated demand (and
therefore sales and production) during the month.
Monthly demand for each product is 200 units.
The selling price of the products is

A : R110
B : R100
As a result of a shortage of supply of experienced (ie grade 2) labour, the total hours of this labour
available to the company is 2 000 hours monthly.
The company has also been approached by N C Machines, which has developed a machine that will
halve grade 1 labour time. As this machine is new on the market, N C Machines are prepared to hire
the machine to the company on a monthly basis.
No inventory is kept.

1 State what product mix the company should produce to maximise profits if the company does not
acquire the new machine, and state what those profits will be.
2 Calculate the maximum hire charge that the company could afford, to ensure that profit equals
the amount calculated in 1.
3 Calculate the minimum price the company could charge for a new product if, having hired the
machine, it received an order for 20 units of the new product which has the following cost:
R
Material 30
Labour – grade 1 12
Labour – grade 2 45
Unit cost R97
Solution
1 Product A B
Selling price 110 100
Contribution 22 29
Grade 2 labour hours 6 8
Contribution/hour 3,66 3,625
To maximise profits
Produce and sell 200A × 22 = 4 400 using 1 200 hours
100B × 29 = 2 900 using 800 hours
7 300 2 000
Less: Fixed costs 4 000
3 300
2 If grade 1 labour time is halved, new contributions are
Product A B
Contribution 25 35
Grade 2 labour hours 6 8
Contribution/hour 4,16 4,375
To maximise profits
Produce and sell 200B × 35 = 7 000 using 1 600 hours
66A × 25 = 1 650 using 396 hours
8 650 1 996
Profit before hire charge 4 650
Maximum hire charge 1 350
Original profit 3 300
3 Special order will require 300 hours of grade 2 labour, ie will produce 50 less units of A.
Contribution lost on A – 50 units × R25 = R1 250
Minimum charge is
Variable cost R97,00
1 250
Profit required 62,50
20
R159,50
Practice questions
The Lennox Company manufactures a single product. The following summarised income statement
representing the current year’s results has been presented at a management meeting:
Income statement for the year ended 30 August 19X2
R’000 R’000
Opening inventory 60 000 units 2 100
Material 600
Labour 400
Fixed overhead 900
4 200
Less: Closing inventory 20 000 units 700
3500 3 500
Fixed administration costs 500
Profit 500
The managing director is very disappointed with the results, because the company sold the same
number of units as in the previous year yet the profits are down. “How is it possible that profit has
dropped, yet the selling price and all costs have remained at the same level as last year?” he asked.
In the current year ended 30 August 19X2, Lennox produced at a level that represented 80% of
maximum capacity. Management wishes to increase company profitability in the forthcoming year
and is considering a strategy that will increase sales by up to 20%. The marketing department is of
the view that a 10% decrease in selling price will result in a 20% increase in sales.
Two options are available to create sufficient production capacity:
Option 1 Replace the existing machinery with new machinery; this will double the current
maximum production capacity. All production and administration costs will remain
unchanged, except for fixed production costs, which will increase by R400 000.
Option 2 Work an extra shift. Production capacity will increase to double the number of units
produced in the 19X2 financial year. Labour costs will however increase by R3 per unit
on ALL units produced.
The production manager is concerned that the proposed changes may not have the desired effect
and believes that the company should consider a third option, namely that no production changes
should be made. “The selling price should remain unchanged and the company should operate at
100% of capacity”. He also believes that the Financial Accountant should have another look at the
financial statements presented at the meeting, as he does not believe that they are a true reflection
of profitability.
Lennox has also been approached by an overseas company requesting a quote for a specialised
product that is similar to the product manufactured by Lennox but requires specialised labour input.
The company has requested two separate quotes, one for 2 000 units and the other for 4 000 units.
The overseas order will be manufactured in batches of 1 000 units and Lennox believes that there
will be labour savings equal to an 80% learning curve based on the production of the first batch. The
labour cost for the first batch will be five times the normal labour cost per unit. All other costs per
unit will remain unchanged. Lennox has a pricing policy of charging 150% of incremental costs on
special orders. You may assume that the special order will not affect current production as it will be
carried out after hours.

(a) Comment on the statement made by the production manager that the actual results for the
year ended 30 August 19X2 are not a true reflection of profitability. (5 marks)
(b) Calculate the break-even point as well as the maximum production capacity for each of the two
new production options. (10 marks)
(c) Determine the production point at which you would be indifferent in terms of profit between
production Option 1 and Option 2. (5 marks)
(d) Prepare a projected income statement for each of the three options on a CVP basis that will
maximise profit. Assume a closing inventory of 5 000 units for each option, based on a FIFO
valuation method. (15 marks)
(e) Prepare the two quotes as required for the overseas order. (5 marks)
Solution
(a) Valuation of closing inventory R700 000 ÷ 20 000 = R35 per unit
Current production costs
600 000 + 400 000 + 200 000 + 900 000 = R2 100 000
Current production
Sales 100 000
Closing inventory + 20 000
Production 60 000
Production cost per unit R2 100 000 ÷ 60 000 = R35

The closing inventory has been valued on an absorption costing basis.
Value of opening inventory R2 100 000 ÷ 60 000 = R35 per unit
There has been a decrease in inventory holding by 40 000 units, which means that fixed costs of
R600 000 (40 000 × 15) pertaining to last year have been written-off in the current year. The
profit is therefore understated by R600 000. If the accounts had been prepared on a variable
costing basis, the profit would have been R1 100 000. The production manager is correct in
stating that the true profitability has not been shown.
(b) Break-even point – new machine option 1

Fixed costs
Manufacturing 900 000
Extra production 400 000
1 800 000
Contribution
Selling price 40,50 (4 500 000 ÷ 100 000) × 90%
Material 10,00 (600 000 ÷ 60 000)
Labour 6,67 (400 000 ÷ 60 000)
Variable O/H 3,33 (200 000 ÷ 60 000)
Contribution 20,50
Break-even 1 800 000 ÷ 20,50 = 87 805 units
Maximum production
Current production = 60 000 = 80%
Maximum production 75 000 = 100%
New production 75 000 × 2 = 150 000 units
Break-even point – 2 shifts option 2
Fixed costs
Manufacturing 900 000
1 400 000
Contribution
R
Selling price 40,50
Material 10,00
Labour 6,67
Variable 3,33
Extra labour 3,00
Contribution 17,50
Break-even 1 400 000 ÷ 17,50 = 80 000 units
Maximum production
Current production = 60 000 units
New production 60 000 × 2 = 120 000 units
(c) Indifference point between machine-intensive and labour-intensive

Machine-intensive
Fixed costs = R1 800 000
Variable costs = R20
Labour-intensive
Fixed costs = R1 400 000
Variable costs = R23
Indifference point is where total cost for machine-intensive equals the total cost for labour-
intensive.
Let x = number of units
1 800 000 + 20x = 1 400 000 + 23x
3x = 400 000
x = 133 333
As production using a second shift is restricted to 120 000 units, we conclude that labour-
intensive is preferable up to 120 000 units. Between 120 000 and 133 000 units, the company
will reduce its profit, and thereafter capital-intensive will increase profits.
(d) Income statement – new machine for year ending 30 August 19X3
R’000 R’000
Sales 120 000 @ R40,50 4 860
Opening inventory 20 000 units @ R20 400
Material @ R10 1 050
Labour @ R6,67 700
Variable overhead @ R3,33 350
Less: Closing inventory 5 000 units @ R20 (100) 2 400
Contribution 2 460
Fixed manufacturing 900 000 + 400 000 1 300
Administration 500
Profit 660
Opening inventory: Variable costs (600 000 + 400 000 + 200 000) / 60 000 = R20
Closing inventory: R10 + R6,67 + R3,33
Income statement – two shifts for the year ending 30 August 19X3
R’000 R’000
Sales 120 000 @ R40,50 4 860
Material @ R10 1 050
Labour @ R9,67 1 015
Contribution 2 160
Fixed manufacturing 900
Administration 500
Profit 760
Continue as is
Production is limited to 75 000 units at 100% capacity.
Opening inventory = 20 000
Closing inventory = 5 000
sell = 15 000
+ production 75 000
Total sales 90 000
Income statement – as is for year ending 30 August 19X3

R’000 R’000
Sales 90 000 @ R45 4 050
Material @ R10 750
Labour @ R6,67 500
Contribution 2 250
Fixed manufacturing 900
Administration 500
Profit 850
(e) Incremental costs: Average Average Average

Material 1st 1 000 2nd 1 000 Next 2 000
Labour R10,00 R10,00 R10,00
Variable overheads R33,35 R26,68 R21,34
R3,33 R3,33 R3,33
R46,68 R40,01 R34,67
Learning curve average labour cost

1st 1 000 R33,35
next 1 000 R33,35 × 80% = R26,68
next 2 000 R26,68 × 80% = R21,344
Total cost 2 000 units R

2 000 × R40 80 000
Mark up 50% 40 000
Quote R120 000
Total cost 4 000 units R

4 000 × R34,674 138 696
Mark up 50% 69 348
Quote R208 044
Quote for 2 000 units R120 000
Quote for 4 000 units R208 044

Rotaquip (Pty) Ltd manufactures three products used in the electronics industry. As a result of the
high technical expertise required in the manufacture of the products and the shortage of skilled
labour, only 2 700 labour operating hours were available during February 20X9.
The standard cost per unit of production is as follows:

Alpha Beta Zeta
R R R
Raw materials
Components 76 36 28
Microchips 144 108 72
Direct labour (at R15 per hour) 90 90 90
Fixed costs (at R5 per labour hour) 30 30 30
Standard cost of sales 340 264 220
Standard selling price 550 480 440
Standard profit 210 216 220
Material usage in units per product Alpha Beta Zeta

R R R
Components 38 18 14
Microchips 16 12 8
The same microchip is used in all three products.
The budgeted income statement for February 20X9 was prepared on a standard variable costing
basis and showed the sales mix in the proportion of Alpha = 1: Beta = 2: Zeta = 3 as follows:
Budgeted income statement: February 20X9
Alpha Beta Zeta Total
Units 75 150 225 450
R R R R
Sales 41 250 72 000 99 000 212 250
Variable costs
Raw materials:
Components 5 700 5 400 6 300 17 400
Microchips 10 800 16 200 16 200 43 200
Direct labour 6 750 13 500 20 250 40 500
Contribution 18 000 36 900 56 250 111 150
Fixed costs 13 500
Budgeted net income 97 650
During January 20X9, import restrictions were imposed on the company; as a result Rotaquip (Pty)
Ltd imported only 75% of the quantity of microchips originally budgeted for. As a consequence, the
company has decided to prepare a revised budget for February 20X9 and at the same time abandon
the plan of selling its products in the proportion of 1:2:3. Rotaquip (Pty) Ltd will, however, remain
subject to a lower sales limit of 30 Alpha, 30 Beta and 50 Zeta, and an upper sales limit of 255 units of
Zeta.
The actual selling prices and production and sales volumes for February 20X9 were in accordance
with the optimal usage of the new limiting factor microchips. Other relevant cost data for February
20X9 were as follows:
R
Material cost
Components (total) 11 500
Microchips (total) 38 000
Labour cost (total) 34 125 (2 625 operating hours)
Fixed costs 14 000
There was no opening or closing inventory of raw materials, work-in-progress or finished goods.

(a) Prepare the revised budget for February 20X9, in accordance with the optimal usage of the new
limiting factor microchips. (25 marks)
(b) Calculate the actual net income for February 20X9 and reconcile it to the revised budgeted net
income as calculated in (a). (10 marks)
PAAB (Adjusted)
Solution
(a) Revised budget for February 20X9
R
Sales Alpha 16 500
Beta 43 200
Zeta 112 200
Total sales 171 900
Cost of sales:
Raw materials:
Components 12 660
Microchips 32 400
Labour 33 750
Fixed costs 13 500
Standard cost of sales 92 310 92 310
(b) Actual net income

R
Sales 171 900
Cost of sales:
Material costs:
Components 11 500
Microchips 38 000
Labour cost 34 125
Fixed cost 14 000 97 625
Reconciliation of revised profit to actual profit
R
Revised standard profit 79 590
R R
Components 1 160
Microchips 5 600
Direct labour 375
Fixed costs 500
1 160 6 475 5 315
Note – Not required
The direct labour variance of R375 could be shown as:

Direct labour rate + R5 250
Direct labour efficiency – R5 625
Workings
(i) Budgeted quantity of microchips
Alpha Beta Zeta Total
Microchips per unit 16 12 8
Budgeted production × 75 × 150 × 225
Total required 1 200 1 800 1 800 4 800
Maximum available 4 800 × 75% = 3 600
(ii) Calculation of contribution per microchips per product

Alpha Beta Zeta
Contribution total R18 000 R36 900 R56 250
Units of production 75 150 225
Contribution per unit R240 R246 R250
Microchips required per unit ÷ 16 ÷ 12 ÷8
Contribution per unit R15 R20,50 R31,25
Therefore, produce in order 3 2 1
Subject to minimum 30 30 50
(iii) Revised production schedule

Units Usage Total
Minimum Alpha 30 × 16 480
Beta 30 × 12 360
Zeta 50 × 8 400
1 240
Maximise Zeta 205 × 8 1 640
2 880
Total available 3 600
Balance 720
Beta 60 × 12 720
Therefore produce and sell Alpha 30 units

Beta 90units
Zeta 225 units
375
Note:
The previous production budget was based on 450 units.
At that level, the labour utilisation was 450 × 6 = 2 700 hours, which is the maximum labour
time available.
Clearly, at a level of 375 units, labour will not be a limiting factor.
Linear
12 programming
l use linear programming to find the optimal solution to a problem of multiple constraints
l formulate the linear programming equations and draw a diagram to solve for optimal
solution
l apply the concept of shadow pricing
l construct the initial tableau using the simplex method and interpretation of the final tableau
l discuss the deficiencies of linear programming
Every company has one or more factors of production that are in limited supply, as well as sales
constraints.
Example of possible limiting factors

(a) Production capacity cannot exceed (say) 10 000 units due to size of machine.
(b) Skilled labour may be limited thus curtailing production.
(c) Factory space may inhibit production above a certain level.
(d) Demand for a particular product may be limited to a certain level.
(e) Raw materials used in production may be in short supply.
Scarce resource situations are normally defined as circumstances in which, because of a restriction
on the availability of one or more resources, the firm is unable to accept all opportunities.
The aim of a company is to maximise profit. To achieve this aim, it must maximise contribution on
the line of products manufactured.
The choice between the products that it should or should not manufacture is often made by choosing
those products that maximise contribution. As discussed in the chapter on “Relevant costs”, when
there is one limiting factor of production or sales, the company will maximise profit by choosing
those products that yield the highest contribution per the limiting factor.
Most limiting factor problems, however, involve a situation where more than one limiting factor exists
and therefore interacts with more than one product.
Example
A company produces two products, A and B, with unlimited demand. Production is, however, limited
by machine hours and the raw material used in the manufacture of the two products:
Input per unit of output
Product Machine hours Raw material (kg) Contribution per unit
A 5 3 R4
B 2 6 R5
Maximum available: 3 000 hours 6 000 kg
403
On the basis of contribution alone, the company should manufacture Product B as it yields a higher
contribution per unit.
However, as we have previously discussed, when limiting factors exist, the decision must be based on
contribution per the limiting factor. In the above example, both machine hours and raw materials are
limiting factors.
Contribution per machine hour

Product A Product B
Contribution R4 R5
Machine hours 5 2
Contribution per hour R0,80 R2,50
Product B is favoured if machine hours are the limiting factor.
Contribution per raw material

Product A Product B
Contribution R4 R5
Raw material 3 6
Contribution per kilogram R1,33 R0,83
Product A is favoured if raw material is the limiting factor.
This example requires a mathematical formulation known as linear programming, which produces
the following final solution:
250 units of Product A
875 units of Product B
Linear programming model – graphic

Linear programming can be solved using either the graphic method or the simplex method. Although
computer programmes exist to facilitate the determination of the optimal solution where more than
one limiting factor exists, the graphic method illustrates the logic behind optimal solutions,
sensitivity analysis and shadow prices more clearly.
The graphic method can, however, only be carried out when only two decision variables exist (ie only
two products are manufactured: two-dimensional diagram; x and y axes).
The following steps must be carried out under the graphic linear programming method:
1 Identify the objective function. The objective will be to either maximise profit or minimise cost.
2 Identify all the limiting factors. These are known as constraints. They are represented on the
graph as straight lines between the maximum x axis production and the maximum y axis
production. Any number of limiting factors may exist.
3 Plot all limiting constraints on the graph and identify the feasible region, ie the area or points
showing a possible optimal solution.
4 Draw the objective function on the graph to identify the point where the optimal solution exists.
5 Read the number of units to be produced as identified under step 4 above off the graph, or solve
the equations identified as forming part of the optimal solution.
Chapter 12: Linear programming 405
Example 1
A company has two departments, Machining and Finishing. The company produces two pro-
ducts, A and B, each of which requires processing in each department.
The daily capacities of the Machining department is 1 200 minutes and the Finishing
department is 1 400 minutes. 10 units of A, or 5 units of B, can be processed each hour in the
Machining department. 6 units of A, or 12 units of B, can be processed each hour in the
Finishing department. In addition, the supply of raw material used only in Product B (3 kg per
unit) is limited to 270 kg per day.
The contribution per unit for Product A is R2,00, while for Product B it is R2,50.

Specify the product mix that will maximise daily contribution.
Solution
1 Determine what the goals/objectives are in this decision situation. In this case, it is maximisation
of the daily contribution.
2 Isolate the variables relevant to the achievement of the objective. These are:
(a) the number of units of Product A produced daily (say A)
(b) the number of units of Product B produced daily (say B).
Note that these variables, known as the decision variables, are both
(i) controllable, and
(ii) result in a plan of action when their values are known.
3 Develop the functional relationships that will relate the variables to the objective function. This is
the actual model or method.
Steps
(a) The objective function
Maximise profit: 2A + 2,50B
The objective function is seldom given in an examination as the contribution for products A
and B as given in this example. You will be required to analyse the cost information into the
variable cost and fixed cost components and from there determine the contribution. It is
possible that a question will present the production costs on an absorption costing basis and
you will be required to analyse the costs to arrive at the contribution per unit.
(b) The constraints
Machining department : 6A + 12B 1 200
Finishing department : 10A + 5B 1 400
Materials : 3B 270
The formulation of the limiting factor equations must be in terms of the limiting quantity of time
or kilograms for material. The equation must be formulated in terms of the limit.
Example: If the limiting factor is Machining hours and there are 2 products (A and B) being
manufactured, the equation will read
Hours per unit of A + hours per unit of B = maximum hours
Never: Units of A + units of B = maximum hours
In the above example, the question states that there are only 1 200 minutes available in the
Machining department and that 10 units of A or 5 units of B can be processed each hour.
The equation cannot be 10A + 5B = 1 200

units units minutes
The correct equation is 6A + 12B = 1 200
minutes minutes minutes
(c) Draw diagram
Product B
300
280
250
200 Finishing
150
Materials
100
Final solution
50
Objective Machining
0
0 50 100 150 200 250
Product A
Figure 1
(d) The area bounded by the inequality lines and the axes is known as the area of feasible solutions.
The optimal solution always lies on one of the corners of the feasible area polygon.
The dashed lines on the graph represent the iso-profit lines or the objective function. The line
may be plotted in one of two ways.
1 Assume that the profit is (say) R200
We have: 2A + 2,5 B = 200
Therefore: if B = 0, A = 100, and
if A = 0, B = 80
Therefore, on the Product A axis, plot a point at a production level of 100 units, and on the
Product B axis, a point at a production level of 80 units. Draw a line connecting the two
points. Any line parallel to the derived iso-profit line will maximise the profit where it crosses
the last point on the feasible area.
2 Product A has a contribution of R2,00 while Product B has a contribution of R2,50 per unit. The
slope of the iso-profit line must therefore favour Product B. The ratio in units of Product A to
Product B where profits are equal is 2,5 units of A to 2 units of B. Therefore, any multiple
multiplied by 2,5 units of A and 2 units of B will result in the same profit, ie
25 units of A to 20 units of B
Note: The slope is always in reverse. In the above example it will be
2,50 units of A to 2 units of B
It is interesting to note that the slope of the limiting equations is also in reverse.
ie for the Machining department, the equation reads 6A + 12B
The ratio of A units to B units is 12 : 6, or 2 to 1 (see diagram, 200 units of A to 100 units of B).
Final solution
In the above graph, the iso-profit line last touches the point where the Finishing and Machining
constraints meet, therefore the equations providing the final solution are:
10A + 5B = 1 400
6A + 12B = 1 200
Solving, we get (long-term solution): A = 120 units
B = 40 units
Contribution: (120 × 2) + (40 × 2,5) = R340
Note: The contribution is R314,28569 when no rounding-up takes place.
Shadow prices
In the context of linear programming, the shadow price of a scarce resource is the increase in value
of the objective function if one more unit of the resource were made available. More generally, it is
the marginal contribution which each scarce resource can make towards the recovery of fixed costs
and profit.
In the above example, assume that one additional minute of machine capacity becomes available.
The effect would be that the Machining limiting factor line would move away from the origin, thus
increasing the production of both products A and B, as follows:
Limiting factor solution equations

6A + 12B = 1 201
10A + 5B = 1 400
A = 119,94
B = 40,11
Total contribution: R310,1667
Marginal contribution: R0,1667
Conclusion
The shadow price of the limiting factor (machine time) is R0,1667.
Similarly, the shadow price for finishing time is R0,10.
In this example, material is not a limiting factor; therefore it cannot have a shadow price or marginal
contribution. In other words, if one more kilogram of material were made available, it would have no
effect on the total contribution, as the material is currently under-utilised.
Non-critical resources have a zero shadow price
Alternative method of calculating the shadow price

Machining time and Finishing time are both limiting factors for the production of Products A and B.
Product A requires 6 minutes of Machining time plus 10 minutes of Finishing time to yield a
contribution of R2. The relationship for the required resources can therefore be shown as:
6 machining minutes + 10 finishing minutes = R2
For Product B, the relationship is

12 machining minutes + 6 finishing minutes = R2,50
Solving: 1 machining minute = R0,1667
1 finishing minute = R0,10
This means that, if one more minute of Machining time became available, the contribution would
increase by R0,1667, and if 1 more minute of Finishing time became available, the contribution
would increase by R0,10.
Note: If we had more Finishing time, the limiting factor line would move to the right, parallel to the
existing line. The profit-maximising point would move down and more units of product A (and
fewer units of product B) would be produced.
The input times, limiting factors and contribution per unit may be described as follows:
Critical equations
Product A Product B Limit
Machining time 6 12 1 200 Shadow
Finishing time 10 5 1 400 price
Contribution R2 R2,50 equations
Limiting equations for optimal solutions

The marginal contribution or shadow price is expressed as the increase in contribution if one more
unit of the limiting factor resource is made available. The formulation of the shadow price equation
must therefore be in terms of machining time and finishing time equating to the contribution per
unit as follows:
Let M = Machining time, and F = Finishing time
6M + 10F =2
12M + 5F = 2,5
Solving we get:
M = R0,1667 per minute
F = R0,10 per minute
The shadow price equation is sometimes referred to as the DUAL PROBLEM.
Opportunity to buy-in, or differential contribution

In the previous chapter the situation in which there was only one limiting factor, with several
products manufactured, and the opportunity to purchase a product or products from another
supplier was discussed. It was stated that, when the opportunity of buying-in is available, it is
necessary to calculate the differential contribution per limiting factor.
The principle is exactly the same for a linear programming system. Calculate the new differential
objective function and place it on the diagram to find the new optimal point.
Example 2
Assume that Products A and B can be bought-in at a price that will yield a contribution of
R1,50 for Product A and R1,00 for Product B. The existing limiting factors do not change.
Demand equals 200 units for Product A and 150 units for Product B.
Determine the new product mix, given the above information, and the total contribution.
Solution
The internal contribution for Products A and B is R2,00 and R2,50 respectively.
The slope of the objective function therefore favours internal production of Product B. Outside
purchases yield a lower contribution, with a preference for Product A.
The differential contribution is calculated as:

Product A Product B
Current contribution R2,00 R2,50
Outside contribution R1,50 R1,00
Differential contribution R0,50 R1,50
Prior to there being an opportunity to buy-in, Product B was favoured over Product A in the ratio of
R2,50 to R2. Now that there is an outside opportunity to buy-in both products, the new differential
objective function favours Product B in the ratio of R1,50 for product B to R0,50 for Product A.
Conclusion
Production will favour Product B over Product A.
Objective function: Product B R1,50 to Product A R0,50
Product B
200
Finishing
150
New solution
100
Materials
0,50A + 1,50B
50
New objective function
Machining
50 100 150 200

Product A
Figure 2
Drawing the new iso-profit lines on the graph above reveals that the optimal point has moved to
where the following two equations meet:
3B = 270
6A + 12B = 1 200
B = 90 units
A = 20 units
Product Internal production × Contribution Total
A 20 2,00 = 40
B 90 2,50 = 225
External purchase
A 180 1,50 = 270
B 60 1,00 = 60
R595
Other shadow price implications

Note: The concepts introduced below are difficult to understand and often confusing to students.
Your University or Technikon may not require you to understand the following examples.
The shadow price can also be interpreted as the internal opportunity cost of the resource. This
implies that if a new product opportunity became available, it would only be acceptable if its selling
price could cover both the market prices of the inputs plus the shadow prices, representing the
contribution sacrificed if one unit of the input is transferred to the new product. Therefore, where
resources are scarce, the total cost of consuming the resource is equal to the external opportunity
cost, ie market price plus the shadow price. This combined value also represents the maximum
amount which should be paid for additional amounts of the scarce resource at the margin.
Example of a special offer

Assume the same information as in Example 1, and a production level of 120 units of Product
A and 40 units of Product B.
The company now receives an order for 100 units of a special product requiring the following
inputs:
Raw material: 90 kg – total cost R900
Machine time: 200 minutes
Finishing time: 140 minutes
Assume that: 1 minute of machine time costs R5
1 minute of finishing time costs R10

Calculate the lowest selling price that the company should quote on the special order.
Solution
Current contribution is R340. Ninety-nine kilograms of raw material are available. As the special
order only requires 90 kg, raw material is not a limiting factor.
The optimal solution remains at the intersection of the Machining and Finishing time constraints
equation.
The shadow price of Machining time is R0,1667 per minute
The shadow price of Finishing time is R0,10 per minute
Lost contribution
Machine 200 × 0,1667 = R33,34
Finishing 140 × 0,10 = R14,00
R
Loss of contribution 47
Material costs 900
Machining time 1 000
Finishing time 1 400
Minimum selling price R3 347
Linear programming assumptions and limitations

Certainty
Linear programming analysis assumes certainty of information. In most cases, however, the
information is a “best estimate”.
Product independence
The assumption that products are independent means that the demand for one product will not
affect the demand for another product.
However, when the products are complementary, the increase or decrease in demand for one
product will directly affect the demand for the second product.
When the products are substitutes, the increase in demand for one product will have the opposite
effect on the substitute product.
Linearity
Linear programming models assume that the product variable can be sold at the same price up to the
demand constraint. It is more likely that demand is related to selling price, other than in a perfect
market. It is further assumed that the input costs per unit of product output are the same, regardless
of the level of production. It is common for certain unit costs, such as labour, to change with
production levels. The classification of costs into fixed and variable costs also changes with increased
levels of production. This means that the contribution per unit will change as the output increases.
Divisibility
The assumption that products and resources are divisible seldom holds true. The production of a
fraction of a unit is often impossible and creates a problem when a “product” represents a major
contract with a high fractional value. The acquisition of input costs, such as labour or raw materials,
are seldom divisible, as labour cannot be timed or fixed at will.
Accuracy of information
The final solution is as accurate as the information for the model.
Appendix
Lumaret (Pty) Ltd manufactures two products, Alpha and Beta. The current selling and cost structure
for the two products is as follows:
Alpha Beta
Selling price R39 R37
Direct materials:
Material X 5 kg R16
Material Y 2 kg R10
Direct labour at R4 per hour R8 R12
Fixed overheads R5 R29 R5 R27
Profit per unit R10 R10
The fixed overhead recovery rate of R5 per unit of Alpha and R5 per unit of Beta is based on the
company producing and selling 1 800 units of each of the two products, which is the maximum sales
volume that the market can absorb. Due to the current economic import restrictions, Lumaret has
been allocated an import quota amounting to R40 000 for the purchase of raw materials. Both of the
raw materials used in the manufacture are imported. The size of the premises used by Lumaret
places a restriction on the maximum annual labour hours available; amounting to 6 000 hours per
annum.
Lumaret (Pty) Ltd is considering certain options available to enable the company to improve its trading
position. The following opportunities are being considered at present:
1 The company could purchase a machine with a life of 5 years for R75 000, which would reduce the
labour time per unit of production by half. The machine would be purchased by paying 5 equal
annual installments free of interest.
2 The company could purchase Alpha from an outside supplier for R33 per unit. There is no restriction
on the number of units of Alpha that can be purchased from the local supplier. (Assume the
machine mentioned in 1 is not purchased.)

Analyse the three options available to Lumaret (Pty) Ltd and state whether the company should
continue as is, purchase the machine, or purchase Alpha from another supplier in order to maximise
company profit.
Note: Ignore taxation and the present value of future cash-flow considerations.
Solution
Let A = Alpha units
B = Beta units
Option 1 (continue as is)

Objective function 15A + 15B
Limiting factors 16A + 10B = 40 000
2A + 3B = 6 000
A = 1 800
B = 1 800
4
Iso-profit line for
’000
Option 2: 19A + 21B
3,5
Iso-profit line for
Option 1: 15A + 15B
3
2A + 3B = 6 000 Iso-profit line for
B = 1 800 Option 3: 9A + 15B
2,5
A 2 A = 1 800
1,5
1
16A + 10B = 40 000
0,5
0
0,5 1 1,5 2 2,5 3 3,5 4
’000 B
Figure 3
Solution: intersection of
A = 1 800
2A + 3B = 6 000
Therefore A = 1 800 units
B = 800 units
Contribution for A = R10 + FC R5
= R15
B = R10 + FC R5
= R15
Total fixed costs = R5 × 3 600 units
= R18 000
Profit statement
R
Product A 1 800 × R15 = 27 000
Product B 800 × R15 = 12 000
Contribution 39 000
Profit R21 000
Option 2 (buy machine)

Labour is no longer a limiting factor as you can produce 6 000 units of Alpha and 4 000 units of Beta.
The objective function changes to 19A + 21B
As labour time is halved, the contribution of A increases by R4, while the contribution of B increases by
R6.
Solution
ISO-profit line of 19B + 21B shows that the solution occurs where
16A + 10B = 40 000
B = 1 800
Therefore: Produce 1 800 units of B, and
1 375 units of A
Profit statement
R
Product A 1 375 × R19 = 26 125
Product B 1 800 × R21 = 37 800
Contribution 63 925
Cost of machinery 15 000
Profit R30 925
Option 3 (purchase from outside)

The purchase of raw material is not a limiting factor.
Product A B
Current contribution 15 15
Outside contribution –6 –
Differential contribution 9 15
Th objective function is now 9A + 15B

As we can purchase Product A from outside suppliers, the lost contribution is R9. In other words, the
opportunity cost is R9 for Product A, compared to R15 for Product B.
Solution
2A + 3B = 6 000
B = 1 800
Therefore B = 1 800
A = 300
Purchase A = 1 500
Profit statement
R
Product B 1 800 × R15 = 27 000
Product A 300 × R15 = 4 500
Product A 1 500 × R6 = 9 000
Contribution 40 500
Profit R22 500
Conclusion
The company will maximise profits by purchasing the machine.
Practice questions
Casting Ltd produces two products, the B2 and the A40. Budgeted data relating to these products on
a unit basis for January 19X0 is as follows:
B2 A40
R R
Materials 60 30
Direct labour 20 25
The selling and administration costs are 50% variable. The fixed portion has been calculated based on
last month’s sales of 300 units of B2 and 400 units of A40.
Each unit of product incurs costs of machining and assembly. The total capacity available has recently
been increased by modifications made to the machinery. In January 19X0, the capacity is budgeted to
be 1 000 hours of machining and 1 500 hours of assembly.
The capacity cost is fixed at R12 000 and R20 000 respectively for the month, regardless of the level
of usage attained.
The number of hours required in each of these departments to complete one unit of output is as
follows:
B2 A40
Machining 1,0 2,0
Assembly 2,5 2,0
In terms of special controls recently introduced by the Government, selling prices are fixed at the
above prices. The maximum demand for either product in January 19X0 is 500 units.

(a) Calculate Casting Ltd’s optimal production plan for January 19X0, and the profit earned.
(20 marks)
(b) Calculate the effect on the profitability of Casting Ltd if the machine or assembly capacity were
increased. (8 marks)
(c) Calculate by how much the price of Product B2 would have to increase or decrease before there
would be a change to the optimal production plan calculated in (a). (8 marks)
(d) State the principal assumptions underlying your calculations in (a) and (b). (4 marks)
Solution
(a) Let B = Number of units of B2 produced and sold
Let A = Number of units of A40 produced and sold
The LP model is as follows:
Contribution
B A
Sales 200 190
Variable costs:
Material 60 30
Labour 20 25
Selling 20 15
Maximise contribution subject to:

B + 2A < 1 000 (Machining capacity)
2,5B + 2A < 1 500 (Assembly capacity)
B < 500 (Maximum output of B2 constraint)
A < 500 (Maximum output of A40 constraint)
The constraints are plotted on the graph as follows:

Machining constraint: Line from B = 1 000 A = 500
Assembly constraint: Line from B = 600 A = 750
Output of/B2 constraint: Line from B = 500
Output of/A40 constraint: Line from A = 500
1 000
B2
units 900
B + 2A < 1 000
800
A < 500
700
600
A B E
500
B < 500
400
C
300
Objective
F
200
2,5B + 2A < 1 500
100
D
0
100 200 300 400 500 600 700 800 900 1 000
A40 units
Figure 4
At the optimum point (C on the graph) the output mix is calculated as follows:
B + 2A = 1 000
2,5B + 2A = 1 500
B = 333,3
A = 333,3
R
333 units of B2 at a contribution of R100 per unit = 33 300
333 units of A40 at a contribution of R120 per unit = 39 960
Total contribution 73 260
Selling and administration (20 × 300 + 15 × 400) 12 000
Less: fixed costs (R12 000 + R20 000) 32 000
Profit 29 260
(b) If we obtain additional machine hours, the line B + 2A = 1 000 will shift to the right. Therefore, the
revised optimum point will increase along the line 2,5B + 2A = 1 500 up to point F on the graph.
Similarly, if assembly capacity is increased, the line 2,5B + 2A = 1 500 will move upwards along
the line B + 2A = 1 000 until point E on the graph is reached.
Calculation of shadow prices
Limiting constraints – Assembly 2,5 B + 2 A= 1 500 L
Machining B + 2 A= 1 000 L
Objective 100 B + 120 A L
New limiting equations
Let A = Assembly time
Let M = Machine time
2,5A + M = 100
2 A + 2M = 120
A = R26,67
M = R33,33
If the assembly time is increased, the contribution will increase by R26,67 per hour.
If the machine time is increased, the contribution will increase by R33,33 per hour.
Limitation
The assembly time can be increased by a maximum of 250 hours. At this level, the limiting factor
will reach point E, which becomes the new contribution maximising point.
At E: Units Assembly hrs Total hrs
B = 500 × 2,5 = 1 250
A = 250 × 2 = 500
1 750
Existing – 1 500
Hours 250
The machine time can be increased by a maximum of 200 hours. At this level, the limiting factor
will reach point F, which becomes the new contribution maximising point.
At F: Units Assembly hrs Total hrs
B = 200 × 1 = 200
A = 500 × 2 = 1 000
1 200
Existing – 1 000
Hours 200
(c) A change in the selling price of B2 will lead to a change in the contribution of B2 and a resultant
change in the slope of the objective function.
Increase in price of B2
An increase in the selling price of B2 will cause the slope of the objective function to move in
line with the slope of the assembly capacity constraint.
Current objective function: 100B + 120A
Slope of assembly constraint: 2,5B + 2A
A change in the objective function to a slope equal to the assembly constraint will cause the
optimal solution to lie between B and C on the above graph.
Objective function must change to

120
× 2,5B + 120A = 150B + 120A
2
At a value of 151B + 120A, the solution will be at point B on the graph.
Conclusion
An increase in the sales price of Product B2 by R51 will shift the optimal solution to point B on
the graph.
Similarly, a downward change in the selling price of B2 in line with the slope of the machine
constraint will change the solution from point C to point D.
120
× B + 120A = 60B + 120A
2
Conclusion
A drop in the selling price of B2 by just under R40 will move the optimal solution to D.
(d) The assumptions underlying the calculations in (a) and (b) are:
1 linearity over the whole output range for costs, revenues and quantity of resources used
2 divisibility of products (it is assumed that products can be produced in fractions of units)
3 divisibility of resources (supplies of resources may only be available in specified multiples)
4 the objectives of the firm (it is assumed that the single objective of a firm is to maximise
short-term contribution)
5 all of the available opportunities for the use of the resources have been included in the LP
model.

D Electronics produces three satellite dish models – Alpha, Beta and Gamma – which have
contributions per unit of R400, R200 and R100 respectively.
There is a two-stage production process, and the number of hours per unit for each process is:
Alpha Beta Gamma
Process 1 2 3 2,5
Process 2 3 2 2
There is an upper limit of 1 920 process hours per period for Process 1 and 2 200 for Process 2.
The Alpha dish was designed for a low-power satellite which is now fading and the Sales Manager
thinks that sales will be no more than 200 per period.
Fixed costs are R40 000 per period.

(a) Formulate the data into a linear programming model using the following notation:
X1 : number of Alphas
X2 : number of Betas
X3 : number of Gammas (7 marks)
(b) Formulate (but do not attempt to solve) the initial simplex tableau using
X4 : as slack for Process 1
X5 : as slack for Process 2
X6 : as slack for any sales limit
Describe the meaning of “slack”. (7 marks)
(c) Interpret the final simplex tableau below:
X1 X2 X3 X4 X5 X6 Solution
X2 0 1 0,83 0,33 0 – 0,67 506,7
X5 0 0 0,33 – 0,67 1 – 1,67 586,7
X1 1 0 0 0 0 1 200
Z 0 0 66,67 66,67 0 266,7 181 333,8
(8 marks)
(d) Investigate the effect on the solution of each of the following:

(i) an increase of 20 hours per period in Process 1
(ii) an increase of 10 units per period in the output of Alpha
(iii) receiving an order, for 10 units of Gamma, which must be met.
CIMA (8 marks)
Solution
(a) Objective function: 400X1 + 200X2 + 100X3
Limiting equations
2X1 + 3X2 + 2,5X3 1 920 Process 1
3X1 + 2X2 + 2X3 2 220 Process 2
X1 200 Alpha sales
(b) X1 X2 X3 X4 X5 X6 Solution
X4 2 3 2,5 1 0 0 1 920
X5 3 2 2 0 1 0 2 200
X6 1 0 0 0 0 1 200
– 400 – 200 – 100 0 0 0 0
Slack variables represent unused resources and unused sales potential.
(c) The optimal solution shows that

506,7 units of Betas should be produced
200 units of Alphas should be produced
586,7 hours of Process 2 hours remain
Contribution is R181 333,80
Interpretation of columns X4 and X6
(i) X4
66,67 represents the shadow price of Process 1 time. If one more hour of Process 1 time
became available, the company would:
Manufacture an extra 0,33 units of Beta
Use up 0,67 hours of Process 2 capacity
(ii) X6
266,7 represents the shadow price of Alpha sales units (variable). If one more unit of
Alpha (above the 200 limit) were sold, contribution would increase by R266,70.
Manufacture an extra unit of Alpha
Manufacture 0,67 less units of Beta
Use up 1,67 hours of Process 2 capacity
Interpretation of column X3
Column X3 refers to product Gamma for which production is zero.
However, if the company decides to produce a unit of Gamma, the consequences will be
as follows:
Produce 0,83 units of Beta less and thus decrease contribution by
R200 × 0,83 = R166,67
Produce one unit of Gamma and increase contribution by R100
The net effect is to reduce the overall contribution by R66,67
Process 2 time would increase by 0,33 hours
(d) (i) Increase in contribution by R66,67 × 20 = R1 333,40
Increase production of Beta by 20 × 0,33 = 6,6 units
Use up 20 × 0,67 = 13,4 hours of Process 2 time
(ii) Increase in contribution by R266,70 × 10 = R2 667
Reduce Beta output by 0,67 × 10 = 6,7 units
Use up 10 × 1,67 = 16,7 hours of Process 2 time
(iii) Reduce contribution by R66,67 × 10 = R666,70
Reduce production of Beta by 0,8333 × 10 = 8,3 units
Increase Process 2 time by 0,33 × 10 = 3,3 hours

A company produces two products, Alpha and Beta, details of which are as follows:
Alpha Beta
Material X at R5/kg 10 20
Labour at R2/hour 20 10
Variable machine costs at R3/hour 12 9
Variable costs 6 6
48 45
Selling price 60 60
Demand 1 000 1 000
Material is restricted, owing to import restrictions, to 5 000 kg monthly.
The machine hour capacity of the company is 6 000 hours monthly.
There is no opening or closing inventory.
You are required to show, with reasons:

1 The production plan the company should follow to maximise profits, and the contribution so
arising.
2 The minimum selling price the company could quote on a special which required the
undermentioned costs:
Material X R1 000
Labour R1 000
Machine time R150
Variable costs R400
3 If Alpha and Beta can be bought-in a price of R52 and R55 respectively, the optimum production
and purchasing strategy that the company should follow to maximise profits.
Solution
1 Let A = No of Alpha, and B = No of Beta
Constraints
(i) Material 2A + 4B = 5 000
(ii) Machine 4A + 3B = 6 000
(iii) A < 1 000
(iv) B < 1 000
Objective: Maximise 12A + 15B

Optimum must be at the intersection of
From (i) 4A + 8B = 10 000
(ii) 4A + 3B = 6 000
Therefore 5B = 4 000
Therefore B = 800
A = 900
Contribution: 10 800 + 12 000 = 22 800
’000
2,0
A = 1 000
B 4A + 3B = 6 000
B = 1 000
1,0
12A + 15B
4A + 10B
2A + 4B = 5 000
0
0,5 1,0 1,5 2,0 2,5 3,0
’000
A
Figure 5
2 New constraints
(i) Material 2A + 4B = 4 800
(ii) Machine 4A + 3B = 5 950
The intersection will remain unchanged for the optimum solution
From (i) 4A + 8B = 9 600
(ii) 4A + 3B = 5 950
A = 940
B = 730
Contribution: 11 280 + 10 950 = 22 230

Therefore, loss of contribution 570
Minimum selling price R3 120
3 Existing objective function

12A + 15B
New objective function due to outside purchases
4A + 10B
(See graph for change of slope)
New optimum point
2A + 4B = 5 000
B = 1 000
Therefore, A = 500

Panorama Ltd manufactures two washing powders known as Cloud White and Sky Blue. The total
available manufacturing capacity for an average month is 400 hours of labour and 300 hours of
machine time.
The amount of time required to produce a kilogram pack of each soap powder is as follows:
Cloud White Sky Blue

Labour 10 minutes 5 minutes
Machine time 5 minutes 12 minutes
Any fraction of a kilogram can be produced for either product but sales are made in kilogram packs
only. The profit per kilogram of washing powder is calculated as follows:

R R
Sales 5,80 4,80
Cost of sales:
Raw material A 1,50 2,10
Raw material B 1,10 0,70
Labour 1,00 0,50
(50% variable, 50% fixed) 1,40 0,80
Profit 0,80 0,70
Raw material A costs R3,00 per kilogram and is restricted in supply to 3 500 kilograms per month.
There are no restrictions on the supply of raw material B. Fixed costs have been apportioned to the
two products in accordance with the instructions of the Managing Director. Total budgeting fixed
costs are R3 000 per month.
The Production Manager believes that Sky Blue is not as profitable as a substitute product, Jeena,
which does not require any additional fixed cost investment and has the following cost structure per
kilogram pack:
Jeena
R
Sales 7,25
Cost of sales:
Raw material A 1,50
Raw material B 1,40
Labour 1,00
Variable manufacturing overhead 1,50
Contribution 1,85
The production of a kilogram pack of Jeena requires ten minutes of labour and ten minutes of
machine time.
The Managing Director has rejected the Production Manager’s suggestion on the grounds that fixed
costs of R1,50 per kilogram pack must be allocated to Jeena, thus making it a poor alternative.

(a) Draw a graph to illustrate the optimum output mix of Cloud White and Sky Blue, and calculate
algebraically the maximum profit that Panorama Ltd can make in an average month if it
produces Cloud White and Sky Blue only. (25 marks)
(b) Describe briefly the significance of shadow prices of resources where a new product
opportunity becomes available. (5 marks)
(c) Evaluate and comment on the proposal made by the Production Manager to substitute Jeena
for Sky Blue. (10 marks)
PAAB
Solution
1 Calculation of contribution

R R
Selling 5,80 4,80
Raw material A 1,50 2,10
Raw material B 1,10 0,70
Labour 1,00 0,50
Manufacturing overhead 0,70 0,40
Contribution 1,50 1,10
Objective function
Let Cloud White = x
Let Sky Blue = y
Objective function = 1,50 x + 1,10 y
Limiting factors
Labour 10x + 5y 24 000
Machine 5x + 12y 18 000
Material 0,5x + 0,7y 3 500
7 000
Cloud
White
6 000
0,5x + 0,7y = 3 500

5 000
4 000
3 000 5x + 12y = 18 000
2 000
10 x + 5y = 24 000
1 000
Objective
0
1 000 2 000 3 000 4 000 5 000
Sky Blue
Figure 6
Optimum output mix is at intersection of
10x + 5y = 24 000
5x + 12y = 18 000
x = 2 084,21 units
y = 631,58 units
Monthly profit Contribution
Cloud White 2 084 × R1,50 3 126,00
Sky Blue 631 × R1,10 694,10
3 820,10
Less: Fixed cost 3 000,00
Profit R820,10
2 In the context of linear programming, the shadow price of a scarce resource is the increase in
value of the objective function if one more unit of the resource were made available. It is the
marginal contribution which each scarce resource can make towards the recovery of fixed costs
and profit. If a new product opportunity became available, eg Jeena in the question, it would only
be accepted if its selling price could cover both the market prices of the inputs plus the shadow
prices, representing the contribution sacrificed if one unit of the input is transferred to the new
product.
3 Calculation of shadow prices per minute of labour and machine time (ie the limiting factors).
Let S1 = shadow price per labour minute
Let S2 = shadow price per machine minute
Therefore 10S1 + 5S2 = 1,50
5S1 + 12S2 = 1,10
Solving S1 = 0,131578
S2 = 0,0368421
Substitute product Jeena makes a contribution of R1,85 per the question.
Cost of marginal utilisation of scarce resources
Labour 10 × 0,131578 = 1,31578

Machine 10 × 0,0368421 = 0,36842
1,68420
As the contribution of Jeena is greater than the marginal cost of time given up by Sky Blue, it
would be more profitable to produce Jeena. When one is looking at production alternatives, the
important factor is the contribution yielded per limiting factor, not the overall profit of a product
as suggested by the Managing Director.

You are the Management Accountant of Patch (Pty) Ltd and have been requested to prepare a
budget for the forthcoming financial year that will maximise company profit. The company
manufactures two products, Yam and Kite, and the demand for the two products has been increasing
significantly over the past 3 years. The income statement for the current year just ended shows the
following:
Yam Kite Total
R’000 R’000 R’000
Sales – value 1 200 800 2 000
Material costs 360 200 560
Variable manufacturing 360 440 800
Fixed manufacturing 120 120 240
Fixed costs over-recovered + 40
Selling costs – 200
Profit 240
The following additional information on the actual results presented above is available:
1 Material costs
Yam requires a raw material that is imported from Brazil and is available in limited quantities. The
cost of the raw material is R10 per kg. The cost allocated to Yam in the current year was R200 000.
Patch has been advised that next year the imported raw material will be increased by 10 000 kg.
2 Variable manufacturing
Yam is machine-intensive, while Kite is more labour-intensive.
Yam Kite
Labour hours per unit 10 20
Machine hours per unit 18 9
Total manufacturing labour hours can be increased by a maximum of 60%. Machine hours have
been operating at 80% of available capacity.
3 Selling costs
The selling costs represent both a fixed and a variable component. In the current year, the fixed
component was 40%. Yam incurred twice as much variable cost per unit as Kite.
In preparing the budget for the forthcoming year, you have been given the following information:
1 All variable costs and selling prices for both products will remain unchanged. Fixed manufacturing
costs will increase by 10% while fixed selling costs will decrease by 40%.
2 The production department has changed the manufacturing process for both the Yam and the
Kite as follows:
(a) The labour time for Yam will increase by 2 hours while the labour time for the Kite will
decrease by 4 hours.
(b) The machine time for Yam will decrease by 3 hours.
3 The demand for both products is expected to increase by 100%.

(a) Prepare a budget for the forthcoming year that will maximise company profit. You are required
to solve by drawing a linear programming diagram. (32 marks)
(b) Determine by how much company profits would increase if one additional unit of limiting
factors became available. (8 marks)
Solution
(a) 1 Materials
Yam – current imported raw material used
R200 000 / 10 = 20 000 kg
Increase 10 000 kg
Available 30 000 kg
Usage per unit 20 000 / 4 000 = 5 kg

Required next year 8 000 units (ie 100% increase)
× 5 kg
40 000 kg
Raw material is a limiting factor of production.
2 Variable overheads
Labour
Current labour hours (10 × 4 000) + (20 × 4 000) = 120 000
Increase + 60% 72 000
Available next year 192 000
Required labour hours

Production will double. Therefore Yam = 8 000 units, Kite = 8 000 units
Labour time per unit – Yam 10 + 2 = 12
Kite 20 – 4 = 16
Therefore 12 × 8 000 = 96 000
16 × 8 000 = 128 000
224 000
Available: 192 000 hours. Therefore, labour is a limiting factor.

3 Variable overheads
Machine hours
Current machine hours (18 × 4 000) + (9 × 4 000) = 108 000 = 80% capacity
Therefore 100% capacity equals 108 000 / 80% = 135 000 hours
Required machine hours
Machine time per unit – Yam 18 – 3 = 15
Kite 9 – 0 = 9
Therefore 15 × 8 000 = 120 000
9 × 8 000 = 72 000
192 000
Available: 135 000 hours. Therefore, machine time is a limiting factor.
4 Selling costs
Fixed 200 000 × 40% = 80 000
Variable 200 000 × 60% = 120 000
Ratio
Yam 80 000 2
Kite 40 000 1
120 000
Variable cost per unit

Yam 80 000 / 4 000 = R20
Kite 40 000 / 4 000 = R10
5 Objective function – Contribution

Yam Kite
Selling price 300 200 (Budget/units)
Material 90 50 (Budget/units)
Variable – manufacturing 90 110 (Budget/units)
Contribution 100 30
6 Limiting factors
Material 5Y = 30 000
Labour time 12Y + 16K = 192 000
Machine time 15Y + 9K = 135 000
’000
16 Labour
time Objective function
15 100Y + 30K
14 Machine time
13 15Y + 9K = 135 000
Demand
12 limited Labour time
to 8 000 12Y + 16K = 192 000
11 units
10 Material
Machine 5Y = 30 000
9
time Demand limited to 8 000 units
Yam
8
7
Material
6
5
4
3
Objective function
2
1
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 ’000
Kite
Figure 7
7 Profit is maximised per the diagram at the intersection of the machine time and raw material
limiting factors.
Machine time 15Y + 9K = 135 000
Yam = 6 000 units
Kite = 5 000 units
8 Income statement of Patch (Pty) Ltd

Yam Kite Total
R’000 R’000 R’000
Sales – value 1 800 1 000 2 800
Material costs 540 250 790
Variable manufacturing 540 550 1 090
Variable selling 120 50 170
Contribution 600 150 750
Fixed manufacturing (240 000 – 40 000) × 110% 220
Fixed Selling (80 000 – 40%) 48
Profit 482
(b) Shadow prices

Machine 15Y + 9K = 135 000
Objective 100 + 30
Let Material = M
Machine = A
Solving 5M + 15A = 100
9A = 30
Therefore A (machine time shadow price) = R3,33
Therefore M (material shadow price) = R10
The two limiting factors are raw material and machine time. Therefore, if one extra kilogram of
raw material became available, profit would increase by R10. If one additional hour of machine
time became available, profit would increase by R3,33.

You have recently been appointed as Management Accountant to a manufacturing company called
Kohlberg (Pty) Ltd. One of its divisions manufactures two products and has been making a loss for the
last six months. The company now wishes to turn the situation around and is of the opinion that the
quality of the two products can be greatly improved by using higher quality raw materials. A strong
advertising campaign is also planned to improve product sales.
The Financial Accountant of the company is assisting you and has compiled the following actual
information for the month of October 19X1.
Product Product
Alto Beet
Production/Sales – units 400 400
R R
Sales 128 000 80 000
Labour 26 000 28 000
Overheads 50 000 20 000
Administration expenses 15 000 15 000
Selling and distribution 10 000 8 000
Profit (13 000) (11 000)
1 Both products are manufactured in separate departments which have their own labour forces.
The labour cost per unit varies depending on the level of production.
In the month of September, the production levels and labour costs were as follows:
Alto: 350 units R24 000
Beet 500 units R30 000
2 The overhead costs relate to two machines used in the production of both the Alto and Beet. 20%
of overhead costs are fixed for Alto and 50% for Beet. Manufacturing time required per unit of
output for each product is:
Machine 1 Machine 2
Alto 15 minutes 24 minutes
Beet 19 minutes 11 minutes
3 Administration costs are fixed and have been allocated on the basis of occupied space.
4 Selling and distribution costs are fixed for Alto but variable for Beet.
The following information relates to the month of November 19X1:

1 In view of the volatility in the market, it is difficult to project sales for either product for the
month of November. Sales volumes are, however, limited to a maximum of 800 units for Alto and
1 300 units for Beet.
2 The maximum machine manufacturing capacity is 475 hours per month for Machine 1 and 440
hours per month for Machine 2.
3 Material costs will increase by 40% per unit for Alto and 60% for Beet. Raw material is freely
available.
4 The advertising campaign will cost a total of R30 000 per month.
5 The selling price for Alto will be increased by 25% per unit and by 12,5% for Beet.
6 All other costs will remain unchanged.
7 Labour is freely available.

(a) Prepare a budget for the month of November 19X1 that will maximise company profit. You are
required to determine the maximum profit by drawing a linear programme diagram. (32 marks)
(b) Assuming that the division of Kohlberg (Pty) Ltd continues as is without any product, cost or
selling price changes, determine the break-even point for each product. You are to assume that
Alto and Beet must be sold in the ratio of 1 : 1. (5 marks)
(c) You have been given the following hypothetical final production/sales tableau for Kohlberg (Pty)
Ltd.
A B S1 S2 S3 S4 Z
A 1 0 0 0 1 0 800
S1 0 0 1 – 1,52 – 7,8 0 4 063,55
S4 0 0 0 – 0,08 + 1,2 1 645,55
B 0 1 0 0,08 – 1,2 0 654,55
0 0 0 6,4 24 0 28 364,00
Where: A = units of Alto
B = units of Beet
S1 = Machine 1
S2 = Machine 2
S3 = Alto demand
S4 = Beet demand
You are required to interpret all figures appearing in columns S2 and Z. (8 marks)
Solution
(a) 1 Labour High – Low
Alto Production Cost
400 26 000
350 24 000
Marginal 50 2 000
Variable cost = 2 000 / 50 = R40
Fixed cost = R26 000 – (400 × 40) = R10 000
Beet Production Cost

400 28 000
500 30 000
Marginal 100 2 000
Variable cost = 2 000 / 100 = R20
Fixed cost = R28 000 – (400 × 20) = R20 000
2 Overheads
Alto Beet
Overhead cost 50 000 20 000
Fixed cost 20% 10 000 50% 10 000
Variable cost 40 000 10 000
Units 400 400
Variable cost per unit R100 R25
3 Selling and distribution

Variable cost – Beet R8 000 / 400 = R20 per unit
4 Machine hours for both machines are limiting factors of production.

(Show workings)
5 Material costs
Alto Beet
Current 40 000 20 000
Units 400 400
Cost per unit R100 R50
+ 40% R140 + 60% R80
6 Selling prices
Alto Beet
Current 128 000 80 000
Units 400 400
Price per unit R320 R200
+ increase 25% R80 +12,5% R25
R400 R225
7 Contribution – objective function

Alto Beet
Costs:
Material 140 80
Labour 40 20
Overheads 100 25
Selling – 20
Contribution 120 80
8 Limiting factors Let A = Alto

B = Beet
Sales A = 800
B = 1 300
Machine 1 15A + 19B = 475 × 60
A = 1 900 B = 0
B = 1 500 A = 0
Machine 2 24A + 11B = 440 × 60
A = 1 100 B = 0
B = 2 400 A = 0
Alto
1 900
Machine 1
15A + 19B = 28 500 Sales Beet
B = 1 300
Profit maximising point

1 100
Sales Alto
800
A = 800
Objective
function Machine 2
120 A + 80 B 24A + 11B = 26 400
1 200 1 500 2 400

Beet
Figure 8
The diagram above indicates that the profit maximising point is where the two machine
limiting factors intersect.
15A + 19B = 28 500
24A + 11B = 26 400
Solving, we get
A = 646,39 units or 646 units
B = 989,69 units or 990 units
Budget income statement November 19X1

Sales Alto 646 units × 400 258 400
Beet 990 units × 225 222 750
481 150
Material – Alto 646 × 140 90 440
Beet 990 × 80 79 200
Labour – Alto 646 × 40 25 840
Beet 990 × 20 19 800
Fixed costs – 10 000 + 20 000 30 000
Overheads – Alto 646 × 100 64 600
Beet 990 × 25 24 750
Fixed costs – 10 000 + 10 000 20 000
354 630 354 630
Selling and distribution Fixed 10 000
Variable – 990 × 20 19 800
Advertising 30 000
Profit 36 720
(b) Products Alto and Beet both made a loss in the month of October. The important factors for
October are:
1 Contribution
Alto Beet
Material 100 50
Labour 40 20
Overheads 100 25
Selling – 20
Contribution 80 85
Average contribution = R80 + R85 / 2 = R82,50
2 Fixed costs
Alto Beet
Labour 10 000 20 000
Overheads 10 000 10 000
Selling 10 000 –
45 000 45 000
Total fixed costs = R90 000
3 Break-even
90 000
= 1 090 units
82,50
or 545 units of each product.
(c) Column Z
800 represents production and sales of Alto
4 063,55 represents Machine 1 excess time
645,45 represents unsatisfied Beet demand
654,55 represents production and sales of Beet
28 364 represents contribution at production maximisation point
Column S2
– 1 ,52 represents Machine 1 time required
– 0 ,08 represents Beet demand satisfied from the 645,45 units
0 ,08 represents units of Beet produced
6 ,4 represents shadow price of Machine 2 time
Transfer
pricing
l describe the objectives of transfer pricing
l describe how to set a transfer price where the transferring division sells to an external
market, and where it sells to a receiving division only
l calculate the lowest and highest transfer price that is in line with overall company
objectives
l explain why cost-plus transfer pricing will not maximise group profits
l discuss the main objectives of setting a transfer price
Where goods or services are transferred between divisions, a transfer-pricing system is required to
allow for the profit independence of each division. One of the primary obstacles to meaningful
divisional performance measurement is the transfer of goods or services between divisions. Many
products transferred between divisions are not readily marketable and, as a result, it becomes
difficult to establish a fair price that ensures company-wide maximisation of profit as well as
divisional autonomy. If inter-divisional transfers are minimal, the transfer price has little effect on the
measurement of segment performance. However, if the transfers are substantial, the transfer price
will have a dramatic effect on reported performance.
Objectives
The main objectives of establishing a transfer price should be to
l Ensure that divisional performance assessments are not affected by a transfer price that will
disadvantage a division.
l Encourage a division to make decisions that will maximise divisional profits as well as overall
company profits, ie be in line with company objectives.
l Promote divisional autonomy without prejudice to the group.
It is difficult to establish a transfer price that will allow for divisional autonomy and at the same time
be in line with group profit maximisation, as the two objectives often work against one another. A
further problem in arriving at an equitable transfer price is that some products produced cannot be
sold on an open market while others can. When a company is able to sell its products on the open
market it will be faced with a perfect or imperfect price structure.
The general rule in recommending a suitable transfer price should be to arrive at the lowest
and highest transfer price that will be in line with overall group objectives.
There are many methods of arriving at a transfer price, and only the more important methods are
mentioned below:
(a) Market price
A market price is considered ideal where a market exists for the product being transferred. The
transfer price becomes the going market price. The nature of the market (competitive or
imperfect) will determine whether a unique market price exists. When there is an appropriate
outside market, the market price is sometimes reduced to make allowances for the reduced
selling effort.
435
(b) Cost price

May take the form of:
l direct cost
l full absorption cost
l standard cost
l full cost + profit margin
l direct cost + opportunity cost.
Actual cost bases may allow the transferring division to pass on its cost inefficiencies. Historical
cost transfer prices are limited by the fact that a profit centre cannot be evaluated on a profit
basis if its revenue is merely a recovery of cost.
(c) Negotiated price

Flexibility may be introduced by requiring the transferring segments to negotiate their own
transfer prices. This may have the advantage of allowing a division to avoid sub-optimal
decisions being made. A negotiated price suggests an arm’s-length bargaining process such as
one would encounter when dealing with entities external to the firm.
(d) Target profit

Target profit transfers are based on a fixed percentage, where standard or actual costs form the
base for the calculation. Target profit transfer prices attempt to provide a reasonable or desired
profit level for divisions when a market price is not available or when transfer pricing methods
would yield unsatisfactory results.
Transfer pricing complexities

Transfer pricing has for a long time been hotly debated, with many opinions offered but few
solutions found. The situation where most disputes arise is where no clear market prices exist to
assist in setting transfer price guidelines. It is important to understand that the central theme in
establishing an acceptable transfer price is the recognition that there must be a fair profit
distribution from transactions that result in inter-divisional trading.
The problems of inter-divisional transfer pricing may be reduced to three situations:
(a) where a competitive market exists
(b) where there are no clear market guidelines
(c) where production constraints restrict output.
(a) Competitive market

Where a market exists for a product, a company will focus its production and sales strategy on
short-term profit maximisation. It will produce and sell up to the point where marginal revenue
equals marginal cost. As the marginal cost exceeds marginal revenue, a company will cease
selling to the market. In this situation, the correct transfer price is the price for the
“intermediate product” in the outside market.
(b) No clear market guidelines

Where there is no outside market (or a less than perfect market), problems will exist. The
optimal transfer price in this situation gravitates towards variable production costs. This price is
usually unacceptable to the transferring division when it is operating as a profit or investment
centre.
(c) Production constraints

The use of variable cost as an appropriate transfer price falls away where production constraints
exist. The correct transfer price for this type of problem is often expressed as the opportunity
cost foregone, ie the value that can be obtained by a product from its next best use. Although
Chapter 13: Transfer pricing 437
correct in theory, the practical use has lead to much controversy in its application. This chapter
will nevertheless look at resolving the transfer pricing problem where production constraint
exists on an opportunity cost basis.
Fundamentals of transfer pricing explained

A company has a departmental structure, manufactures a single product that passes through two
production departments (A and B) and is then sold. Department A incurs a variable manufacturing
cost of R5 per unit, then transfers the product to Department B which in turn incurs variable
manufacturing costs of R8 per unit. The company then sells the product at a price of R20 per unit.
Company X
Variable Variable
manufacturing manufacturing
cost R5 cost R8
Transfer
Selling price R20
Figure 1
Does the product yield a profit? Yes, the company will make a profit of R7 per unit.
At this point there is no transfer price problem as the company is not divisionalised.
What if Company X sold its product on an imperfect market and was faced with the following
demand/selling price relationships?
Demand Selling price
5 000 R24
7 000 R22
10 000 R20
12 000 R18
15 000 R15
The company would now evaluate the above combinations of Demand/Selling price, determine the
profit-maximising selling price and sell at that price.
Demand Selling Variable Contribution Total
price cost contribution
5 000 R24 R13 R11 R55 000
7 000 R22 R13 R9 R63 000
10 000 R20 R13 R7 R70 000
12 000 R18 R13 R5 R60 000
15 000 R15 R13 R2 R30 000
Company X will choose to sell 10 000 units at a selling price of R20 per unit. Once again, there is no
transfer price problem as the company is not divisionalised.
What if the company was divisionalised?

If Company X now decides to make Department A a Division in Cape Town while Department B
remains a Division in Johannesburg, we now have two separate companies operating in an
environment that requires them to maximise profits.
Refer to Chapter 14 – Divisional performance measurement

– Advantages of divisionalisation
– Disadvantages of divisionalisation
As far as the group structure is concerned, nothing has changed. The cost structure remains the same
and the total profit remains the same. This means that the decisions about how many units to sell
and the selling price have not changed, and the Division in Johannesburg should sell 10 000 units at
R20 each.
Divisionalisation does however create the problem of deciding how to split the profit between the
two divisions. Note once again that the total profit does not change.
In the first example above, where there is only one selling price, ie R20, and assuming that the
company sells 10 000 units and makes a profit of R70 000 (10 000 × [ 20 – 13 ]) the problem that we
have to resolve is how much of the R70 000 goes to Division A and how much goes to Division B.
When you are called to give an opinion on a transfer price, you are in fact required to determine:
(a) how many units should be sold to maximise group profits
(b) the lowest transfer price in line with objectives
(c) the highest transfer price in line with objectives
(d) your opinion on a fair transfer price.
Assuming that the final product is sold in a perfect market and that the two divisions have decided to
transfer and sell 10 000 units, the overall group profit will be 10 000 [20 – 8 – 5] = R70 000. The
lowest transfer price will be set at R5. The highest transfer price will be when Division A gets all the
profit, ie R70 000 / 10 000 = R7 + incremental cost of Division A = R12.
A transfer price “in line with objectives” refers to the transfer price that will ensure that the optimal
number of units is sold in order to maximise group profits.
At the lowest transfer price, Division B makes all the profit while at the highest transfer price,
Division A makes all the profit. We may therefore recommend a transfer price of (say) R8,50.
Situation where the final product is sold in an imperfect market (per the example above)
(a) Establish how many units the group should sell.
Answer: As in the above calculations, the answer is 10 000 units.
(b) Lowest transfer price in line with objectives.
Answer: R5
(c) Highest transfer price in line with objectives
Unlike our previous example of simply taking the profit of R70 000 divided by 10 000 units and
adding it to the variable cost of Division A, ie R70 000 / 10 000 = R7 + R5 = R12, the technique is
different, because, as the selling price from Division A increases it is possible that the number of units
that Division B decides to sell will not be in line with objectives of the group.
Example – If Division A chose to set a transfer price of R10 per unit, the following decision would be
made by Division B:
Quantity Selling TP + VC = Total profit to
price Division B
5 000 24 – (10 + 8) = 30 000
7 000 22 – (10 + 8) = 28 000
10 000 20 – (10 + 8) = 20 000
12 000 18 – (10 + 8) = –
15 000 15 – (10 + 8) = – 45 000
At a transfer price of R10, Division B will choose to sell only 5 000 units, which is the worst possible
choice from a group perspective.
How then do we arrive at the correct transfer price?
Calculate the differential contribution, ie look at the “next best scenario” if Division B does not sell
10 000 units.
Maximum contribution 70 000 10 000 units
Next best 63 000 7 000 units
Differential contribution 7 000 3 000 units
R7 000 / 3 000 units = Maximum contribution of R2,3333
Maximum transfer price is therefore R5 + R2,3333 = R7,3333
Transfer pricing and selling markets

The transferring division will either have a market for its product or not. If it can sell in the open
market then it will be faced with either a perfect (competitive) or imperfect selling market. The
receiving division will also be faced with a perfect or imperfect selling market. The possible
permutations are illustrated in the following diagram.
Transferring division
External market No external market
Receiving division
Perfect Imperfect
market market
Perfect Imperfect
Receiving division Receiving division
market market
Perfect Imperfect Perfect Imperfect

market market market market
Figure 2
From the identified options we need to establish:

l the optimal production strategy
l the lowest transfer price in line with objectives
l the highest transfer price in line with objectives.
Illustrative examples
Example 1
Transferring division has no external market, receiving division sells product in an imperfect
market.
Establishing a solution methodology for transfer price questions
Examples 1, 3 and 4 are very typical of examination questions. Note that the cost information in
these examples is very simple; you can expect the cost data in exams to be more complex.
The following strategy for establishing a transfer price will work for all questions. It is however
possible that some steps are not relevant for a given situation. Remember that the first objective is
to determine the number of units that should be sold in line with group objectives.
Step 1
Look at the transferring division and establish how many units it would like to sell in its normal
outside market (if it has one) and how many units it would like to sell to the receiving division.
Step 2
From the perspective of the receiving division, establish how many units they would like to sell to
maximise profit.
Step 3
If the transferring division has enough production capacity to satisfy its requirements as well as those
of the receiving division, move to calculate the lowest and highest transfer price in line with group
objectives.
If it does not have sufficient production capacity, establish the production/sales combinations that
are available from a group perspective.
Step 4
Establish the transfer price. This step is different for every scenario (see examples below).
Division A processes product Beta at a variable cost of R4 per unit. No incremental fixed costs
or opportunity costs are incurred. Division B completes the production of product Beta at a
variable cost of R6 per unit and fixed cost of R200 000.
Market demand for the product is as follows:
Price per unit (R) Quantity (units)
50 8 000
43 10 000
33 15 000
28 18 000
25 20 000

Calculate the lower and upper limit of a transfer price that will maximise overall company
profit.
Solution
Step 1 – Transferring division
The transferring division does not have an external market for the product and would like to sell as
many units as possible above the variable cost of R4 per unit.
Step 2 – Receiving division
Sales Selling Variable cost Contribution Total

quantity price Div A + Div B contribution
8 000 50 – (4 + 6) = 40 320 000
10 000 43 – (4 + 6) = 33 330 000
15 000 33 – (4 + 6) = 23 345 000
18 000 28 – (4 + 6) = 18 324 000
20 000 25 – (4 + 6) = 15 300 000
Division B will choose to sell 15 000 units which is in line with group sales.
Step 3 – Transfer price

Lowest transfer price = variable cost = R4
Highest transfer price – Differential contribution

Units Contribution
15 000 345 000
10 000 330 000
Differential 5 000 15 000
Differential contribution R15 000 / 5 000 = R3
Therefore, the highest transfer price R4 + R3 = R7
Why is it necessary to arrive at the marginal revenue between the optimal production plan and the
next best?
It would seem logical that the highest transfer price is VC plus Profit ÷ Optimal production units.
Applying this logic we get
R
Division A variable cost 4,00
Division B profit R145 000 ÷ 15 000 9,67
Transfer price 13,67
If we used this as the transfer price, the choices available to Division B would be as follows:
Sales Total Division A Division B Net

quantity revenue transfer price cost profit
8 000 400 000 109 360 248 000 42 640

10 000 430 000 136 700 260 000 33 300
15 000 495 000 205 050 290 000 (50)
18 000 504 000 246 060 308 000 (50 060)
20 000 500 000 273 400 320 000 (93 400)
Division B would, in this situation choose to sell 8 000 units rather than the optimal 15 000 units.
At a transfer price of R7, we have the following:
Sales Total Division A Division B Net

quantity revenue transfer price cost profit
8 000 400 000 56 000 248 000 96 000

10 000 430 000 70 000 260 000 100 000
15 000 495 000 105 000 290 000 100 000
18 000 504 000 126 000 308 000 70 000
20 000 500 000 140 000 320 000 40 000
As can be seen, Division B is indifferent between selling 15 000 units or 10 000 units at a R7 transfer
price. The correct highest transfer price would be R6,99.
Example 2
The transferring division sells its products in a perfect market, while the receiving division sells in
an imperfect or perfect market.
When a perfect market exists for a product, the selling division is a price-taker and cannot influence
the market price by either dumping its product on the market or refusing to supply the market.
In this situation, the correct transfer price is the market price less any saving that the transferring
division may make in selling directly to a receiving division.
Example 3
The transferring division sells its product in an imperfect market, while the receiving division sells
its product in a perfect market.
Division A sells product Zeta on the open market and incurs a variable production cost of R5
per unit. The division has the capacity to produce 22 000 units only.
The market demand at different selling prices is as follows:
Price per unit (R) Demand
13 5 000
10 10 000
8 15 000
Assume that demand between 5 000 and 10 000 units can be sold at R10, and in excess of
10 000 units at R8 per unit.
Division B manufactures a product that requires 1 unit of Zeta in the manufacturing process to
produce product Gamma. Division B incurs further variable manufacturing costs of R10 per
unit and fixed costs of R20 000.
One unit of Gamma is sold for R20.

Determine the optimal production plan that will maximise company profits, and calculate the
minimum and maximum transfer price for Division A.
When the transferring division sells in an imperfect market, the transfer price must be such that the
transferring division is no worse off if it transfers some of its product to the receiving division or sells
it on the open market. However, it is important that the sales strategies of the two divisions
maximise overall group profit.
Solution
Step 1 Desired external sales by Division A
Selling price Demand Cost Sales Profit/Cont
13 5 000 25 000 65 000 40 000
10 10 000 50 000 100 000 50 000
8 15 000 75 000 120 000 45 000
Division A will choose to sell 10 000 units to the external market as it makes the highest contribution
at this level. Division A would like to transfer 12 000 units to Division B.
Step 2 Desired sales by Division B

As Division B sells its product in a perfect market, it will maximise its profit by selling as many
units as Division A is able to transfer. Division B would like to sell 22 000 units.
Step 3 Identify the options available to the group

Division A will never wish to sell more than 10 000 units on the external market. The options
available are therefore as follows:
(i) Division A sells 5 000 units on the open market and 17 000 units to Division B.
(ii) Division A sells 10 000 units on the open market and 12 000 units to Division B.
(iii) Division A sells 22 000 units to Division B.
Evaluating option (i)

Division A Division B Company
R R R
Division A cost 110 000 – 110 000
Transfers (85 000) 85 000 –
Division B cost – 190 000 190 000
Total cost 25 000 275 000 300 000
Sales 65 000 340 000 405 000
Profit 40 000 65 000 105 000
Evaluating option (ii)

R R R
Division A cost 110 000 – 110 000
Transfers (60 000) 60 000 –
Division B cost – 140 000 140 000
Total cost 50 000 200 000 250 000
Sales 100 000 240 000 340 000
Profit 50 000 40 000 90 000
Evaluating option (iii)

R R R
Division A cost 110 000 – 110 000
Transfers (110 000) 110 000 –
Division B cost – 240 000 240 000
Total cost – 350 000 350 000
Sales – 440 000 440 000
Profit – 90 000 90 000
The group will maximise profits by allowing Division A to sell 5 000 units on the open market at R13
and transferring 17 000 units to Division B. The manager of Division A would prefer to sell 10 000
units on the open market as he maximises his profit at this level. To ensure that he is not prejudiced
by the optimal decision, he must be compensated for lost profit.
Step 4 Minimum and maximum transfer price

Division A must be in no worse a position than if it simply sold 10 000 units on the external market at
a profit of R50 000.
Selling only 5 000 units on the external market means that it will make a profit of only R40 000.
Division B must therefore compensate Division A for the lost profit of R10 000 as follows:
Lost profit compensation as a result of selling 5 000 less units on external market
Variable cost R5
Plus: Lost profit R2 (R10 000 ÷ 5000)
R7
Lost profit is calculated as R50 000 – R40 000
Note:
At a transfer price of R7 for the first 5 000 units transferred, Division A will show a profit as follows:
5 000 units sold on outside market R40 000
5 000 units transferred to Division B R10 000 (R2 × 5 000)
R50 000
Balance of 12 000 units

Lower limit – Variable cost R5
The upper limit is determined by the differential profit method
Division B sells 17 000 units profit R65 000

Less: Profit foregone 5 000 units profit R10 000
Actual profit 12 000 units R55 000
Next best – units –
Differential profit 55 000

= R4,5833
Differential units 12 000
Highest transfer price: R5 + R4,5833 = R9,5833

Highest transfer price assumes that the first 5 000 units are transferred at R7 per unit and the last
12 000 units at R9,5833.
Better alternative solution

Highest transfer price on 17 000 units = R65 000 / 17 000 = R3,8235 + R5 = R8,8235 per unit
This method averages out the profit of R65 000 over the transfer of 17 000 units. Both methods yield
the same profit to Division A, ie
5 000 × R7 = 35 000
12 000 × R9,5833 = 115 000
R150 000
Compared to - 17 000 × R8,8235 = R150 000

Note: The negotiated price is more likely to be closer to R5, as Division A cannot improve its profit
on the open market.
Example 4
Transferring and receiving divisions sell their products in an open imperfect market
Information per above example, except that Division B can sell on the open market as follows:
Price per unit (R) Demand
27 8 000
25 10 000
22 12 000

Determine the optimal selling strategy as well as the minimum and maximum transfer prices
for Division A.
Solution
Step 1 Establish the profit-maximising sales strategy for Division A
As previously calculated, Division A wishes to sell 10 000 units as it will maximise its external
profit at this level.
Step 2 Establish the profit-maximising sales strategy for Division B

Unit Selling Total Division A Division B Contribution
sales price revenue variable variable
costs costs
8 000 27 216 000 40 000 80 000 96 000
10 000 25 250 000 50 000 100 000 100 000
12 000 22 264 000 60 000 120 000 84 000
Division B will wish to sell 10 000 units to remain in line with the company’s policy of maximising
profits. Division A wishes to sell 10 000 units to the outside market, and given that its production
capacity is 22 000 units, it has sufficient capacity to meet the needs of both divisions.
Step 3 Establish the minimum and maximum transfer prices

Minimum price: The lower limit transfer price for Division A will be the variable cost of R5.
Maximum price: The correct method of arriving at the highest transfer price is to determine the
differential contribution or profit.
R
Division B Total contribution for 10 000 units 100 000
Division B Total contribution for 8 000 units 96 000
Differential contribution 4 000
Differential units 2 000
Differential contribution per unit = R2
Maximum transfer price R5 VC + R2 = R7
The upper limit will be R7
What if the production capacity for Division A was only 15 000 units?
Step 1 Establish desired sales level for Division A
Step 2 Establish desired sales level for Division B
Step 3 Establish the profit-maximising sales strategy for the group
Step 3 Options available

Division A wishes to sell 10 000 units on the external market and only 5 000 units to Division B
Division B wants to sell 10 000 units
The options available to the group are:
Division A Division B
Sell 5 000 10 000
Sell 10 000 5 000
assuming that Division B can sell 5 000 units at R27.
Test 1 Division A sells 5 000 units on the open market and 10 000 units to Division B.
Division A
(open market) Division B Profit
Units 5 000 10 000
Sales R65 000 R250 000
Transfer costs (variable) – R50 000
Fixed costs – R20 000
Profit R40 000 R80 000 R120 000
Test 2 Division A sells 10 000 units on the open market and 5 000 units to Division B.
Division A
(open market) Division B Profit
Units 10 000 5 000
Sales R100 000 R135 000
Transfer costs (variable) – R25 000
Fixed costs – R20 000
Profit R50 000 R40 000 R90 000
The company will therefore choose to sell 5 000 units on Division A’s open market and 10 000 units
to Division B.
Lower limit transfer price

Minimum transfer price for first 5 000 units
R5 variable cost plus (R10 000 ÷ 5 000 units) = R7
Minimum transfer price for second 5 000 units is R5
Upper limit transfer price for all 10 000 units

Division B will increase its contribution from R96 000 to R100 000 by selling the extra 2 000 units.
Incremental contribution R4 000
Incremental units 2 000
Incremental contribution per unit R2
Variable cost R5
Transfer price R7
Example 5
The transferring division has no external market, while the receiving division sells the final product
on a perfect market.
This example is quite tricky as there are opportunity costs, as well as incremental fixed costs.
This situation may occur when a division manufactures a partly processed product, or a specialist
product. I have introduced opportunity costs and stepped costs into this example, which you would
not normally encounter in a transfer price question.
Note: Most transfer price questions give the information in a manner that requires you to separate
the fixed cost from the variable cost. You may, for instance, be given the information in an
absorption costing format where you are required to determine the contribution before you
can decide on an appropriate transfer price.
Product Alpha is sold by Division B at a price of R130 per unit on a perfectly competitive
market. The product is processed in Division A, then transferred to Division B where it is
completed and sold.
Division A’s monthly manufacturing costs are as follows:
Volume (units)
0 – 100 101 – 300 301 – 600
Variable cost per unit R25 R25 R30
Fixed cost – R3 500 –
Opportunity cost – R50 R80
Variable costs increase due to overtime.
continued
Opportunity cost relates to losses of contribution from not producing other products.
The fixed cost increase of R3 500 relates to any production above 100 units. Division A cannot
produce above 600 units.
Division B’s manufacturing costs:
Division B would have to invest R8 000 monthly on fixed equipment. The variable cost to
complete each unit of production is R15.

(a) Calculate the lowest and highest transfer price assuming 100, 300 and 600 units are sold
monthly.
(b) Calculate the optimal production level for Division A.
Solution
Company-wide decision computation
Volume
0–100 101–300 301–600
R R R
Division A direct costs 25 25 30
Division B direct costs 15 15 15
Division A opportunity costs – 50 80
40 90 125
Contribution per unit R90 R40 R5
Sales volume
Incremental 100 200 300
R R R
Total contribution 9 000 8 000 1 500
Division A fixed costs (3 500)
Division B fixed costs (8 000)
Incremental net profit 1 000 4 500 1 500
Net profit for 100 units: R1 000
Net profit for 300 units: R1 000 + R4 500 = R5 500
Net profit for 600 units: R1 000 + R4 500 + R1 500 = R7 000.
(a) Lowest and highest transfer price

At 100 units of production, the lowest transfer price is the variable cost of production, ie R25.
The highest transfer price is net profit divided by production, ie
R1 000 ÷ 100 = R10
Plus: Division A’s variable cost R25
R35
Lowest transfer price at 300 units
Opportunity cost 50 × 200 R10 000
Fixed cost R3 500
R13 500
÷ Total units produced 300 R45,00

Plus: Variable cost R25,00
R70,00
Highest transfer price at 300 units
Lowest transfer price R70,00
Plus: (R5 500 ÷ 300) R18,33
R88,33
Lowest transfer price at 600 units
Opportunity cost 50 × 200 R10 000
80 × 300 R24 000
Fixed cost R3 500
Variable costs (300 × 25) + (300 × 30) R16 500
Total costs R54 000
÷ Units produced 600
Highest transfer price at 600 units
Plus: (R7 000 ÷ 600) R11,67
R101,67
The problem in this type of situation is that the lowest transfer price gives all the profit to the
receiving division, while the highest transfer price gives all the profit to the transferring division.
Both situations are unacceptable, and it is impossible to suggest an equitable transfer price that
can be applied consistently. The only solution we can offer is that the two divisions must arrive
at an equitable solution that is in line with company objectives, or Head Office must set an
equitable transfer price.
Perhaps the best advice would be that the transferring division should not be evaluated as a
profit centre as no clear arm’s-length pricing mechanism can be established.
(b) The optimal production level for Division A will be the level that maximises overall company
profits, ie 600 units.
Example 6
Assume the same information as in the above example, except that Division B has the
following selling price/demand relationships:
R140 100
R138 300
R130 600

Determine the company optimal sales level and the lowest transfer price that will be in line
with company objectives.
Solution
Company-wide decision computation
Selling price R140
Division A cost
R
Direct cost (R25 × 100) = R2 500
Division B costs
Direct cost (R15 × 100) 1 500
Fixed cost 8 000
Total cost 12 000
Sales value 14 000
Profit R2 000
Selling price R138

Division A cost
R
Direct cost (R25 × 300) 7 500
Opportunity cost R50 × 200 10 000
Fixed cost 3 500
Total cost 21 000
Division B cost
Direct cost (R15 × 300) 4 500
Fixed cost 8 000
Total cost 33 500
Sales value R138 × 300 41 400
Profit R7 900
Selling price R130

Profit per the example above in situation 1 is R7 000.
The profit-maximising point that is in line with the objectives of the company is at a level of 300 units
and a selling price of R138. At this level the lowest transfer price will be the relevant opportunity cost
plus the fixed cost, divided by 300 units, plus a variable cost of R25.
(10 000 + 3 500) / 300 + 25 = R70
Example 7
When both the transferring and the receiving divisions sell on an imperfect market and the
divisions’ cost structures change with incremental production
Note: This type of question is seldom (if ever) examined.
Assume that two divisions have the following manufacturing costs and sales revenue:
Total Total
manufacturing Total manufacturing Total
Units cost revenue cost revenue
10 10 20 50 75
20 16 36 100 140
30 22 50 150 203
40 30 60 200 265
50 39 69 250 326
60 49 77 300 381
70 60 84 350 435
80 72 92 400 488
90 85 95 450 540
Division A can either sell to the external market or transfer to Division B who will sell to the
external market. The total costs of Division B exclude the manufacturing costs of Division A.

(a) Determine how many units Division A should sell in the external market and how many it
should sell to Division B.
(b) Calculate the upper and lower transfer price for Division A.
Solution
(a) The problem with this type of question is that as the costs of Division A are increasing at a
disproportionate rate to production, you cannot determine the optimal strategy as before.
The correct method is to analyse the overall marginal cost to the company versus the marginal
revenue as follows:
Division A Division A Division B
Production marginal marginal net marginal
cost revenue revenue
10 10 20 25
20 6 16 15
30 6 14 13
40 8 10 12
50 9 9 11
60 10 8 5
70 11 7 4
80 12 6 3
90 13 5 2
The net marginal revenue of Division B is arrived at by subtracting the total revenue from the
manufacturing costs and calculating the marginal increase.
On the basis of the above tabulation, the desired sales strategy is:
Marginal revenue Marginal cost
1 Sell 10 to Division B 25 10
2 Sell 10 to Division A’s outside market 20 6
8 Cease production 11 12
9 Cease production 10 13
The company would desire to produce only 70 units, as above this level, marginal costs are
higher than marginal revenue.
At a production level of 70 units, 40 should be sold to Division B, and 30 left for Division A to sell
on the outside market.
(b) Transfer price

Division A would prefer to sell 40 units to the outside market in order to maximise profits.
Division A would not go beyond 40 units on the outside market as incremental sales would not
increase profits. At the 50 unit sales level, profits will be the same as at the 40 unit level. Beyond
50 units, profit will decrease.
The group however would like Division A to sell only 30 units to the outside market and 40 units
to Division B.
At 40 units Division A’s profit would be:
Total revenue R60
Total costs R30
Profit R30
At 30 units Division A’s profit would be:
Total revenue R50
Total costs R22
Profit R28
Division A is foregoing R2 profit by not selling 40 units on the external market.
The minimum transfer price must therefore cover the lost profit of R2.
Incremental cost of 40 units R38 (60 – 22)
Lost contribution R2
Minimum transfer price R40
The R60 represents the cost of 70 units (10 + 6 + 6 + 8 + 9 + 10 + 11)
The R22 represents the cost of the first 30 units (10 + 6 + 6)
Maximum transfer price
Taking the transfer costs from Division A to be R40, Division B will make the following profit:
Total revenue R265
Division B costs R200
Division A transfer costs R40
Profit R25
Net profit of R25 is the maximum that could be transferred to Division A.

This would yield a transfer price of
Net profit R25
Transfer costs R40
R65
However, the argument once again is that Division A cannot sell its product on the open market
to yield a profit of R27 (R65 – R38).
The upper limit should therefore be slightly above R40.
It may be argued that the highest transfer price that allows for divisional autonomy should be at
an average price equal to the lowest incremental profit. In the above situation this would be
R12 × 4 = R48.
Conclusion
Transfer prices should be based on marginal cost + opportunity cost to the company. Where an
intermediate market exists, the market price should be used (less internal cost savings).
Where a division’s marginal costs and opportunity costs change with the level of production, a
schedule must be completed for the differing levels of output.
If the divisions are decentralised with full autonomous decision-making powers, the company may
produce at sub-optimal levels. It is recommended that in situations where inter-divisional transfers
are substantial, top management should arbitrate on transfer pricing decisions between divisions to
ensure maximum company profit.
Appendix
Z Limited is a company that is organised into two profit centres, P and Q. At the moment, both profit
centres sell all their output to external customers.
Monthly data for both profit centres is as follows:
P Q
Output per month 9 000 units 4 000 units
Sales price per unit R40 R80
Material costs per unit R20 R18
Other variable costs per unit R5 R12
Fixed costs per month R120 000 R180 000
P and Q are both working at full capacity. The Manager of Q has become worried about the variable
costs of units produced in the department, and is aware that it would be possible to receive the
output of department P instead of buying raw materials from outside suppliers at a cost of R18. One
unit of output from P would be further processed, at an incremental cost of R1 per unit of P’s output,
and used as a substitute material for 2 units of Q’s output.
The Manager of P has suggested that the transfer price for 2 000 units of P should be the market
price of R40 per unit. The Manager of Q objects, because this is higher than the cost of raw materials
purchased from outside suppliers. As an arbitrator from Head Office, you are aware that if P
withdrew 2 000 units from sales to the outside market, the outside market price for the remaining
output would rise to R43 per unit.

(a) Indicate whether you agree that P should transfer 2 000 units to Q each month, stating your
reasons.
(b) Suggest a possible range for a transfer price which should be satisfactory to the managers of
both divisions.
(c) List three main objectives managers should consider when establishing a transfer price and
describe why the objectives often conflict with each other.
Solution
(a) The incremental cost of transfer would be as follows:
R
Sales revenue to P from 9 000 units (× R40) 360 000
Sales revenue to P from 7 000 units (× R43) 301 000
Loss of contribution from transferring 2 000 units 59 000
Purchase costs saved by Q (4 000 × R18) 72 000
13 000
Costs of conversion of P’s output (2 000 × R1) 2 000
Marginal contribution per month R11 000
The transfer of 2 000 units is justified because it will increase total company profits by R11 000
per month.
Alternative
P Q
9 000 7 000 R
R R Variable cost 2 000 × 25 = 50 000
Sales 360 000 301 000 Variable cost 2 000 × 1 = 2 000
Variable cost 225 000 175 000 52 000
Contribution 135 000 126 000 Outside contribution 72 000
Saving + 20 000
Company point of view

Saving 20 000
Lost contribution 9 000
Net increase 11 000
(b) The transfer price should not be R40, because the Manager of Q would prefer to pay
R18 × 2 = R36 on external purchases rather than R40 plus R1 on transfers from P.
The lower limit of transfers from P is the lost revenue of R59 000 for 2 000 units transferred, ie
R29,50 per unit. Alternatively: Lost contribution R9 000 / 2000 = R4,50 + Variable costs R25 =
R29,50. The cost of Q must not exceed R18 × 2 minus R1, ie R36 – 1 = R35 per unit, if Q is to
profit from the transfer arrangement. A negotiated price above R29,50 but less than R35 per
unit of P’s output is recommended, as this will divide the marginal contribution of R5,50 per unit
(R11 000 / 2 000 units) between the profit centres P and Q.
(c) The main objective of establishing a transfer price should be to

l Ensure that divisional performance assessments are not affected by a transfer price that will
disadvantage a division.
l Encourage a division to make decisions that will maximise divisional profits as well as overall
company profits.
l Promote divisional autonomy without prejudice to the group.
It is difficult to establish a transfer price that will allow for divisional autonomy and at the same
time be in line with the objective of maximising group profits, as the two objectives often work
against one another. A further problem encountered when attempting to arrive at an equitable
transfer price is that some products produced cannot be sold on an open market, while others
can. When a company is able to sell its products on the open market, it will be faced with a
perfect or imperfect price structure.
The general rule in recommending a suitable transfer price should be to arrive at the lowest and
highest transfer price that will be in line with overall group objectives.
Practice questions
Klooftrim is a large divisionalised company selling a variety of catering products. Division A, a
company within the Klooftrim Group, manufactures a single product which it sells on the open
market and to Division B.
The agreed transfer price policy within the group is market price where such price is determinable, or
a negotiated price that will maximise the overall group profit. The production capacity of Division A is
50 000 units per annum. Division A sells its product on a market that is price-sensitive, and the
average annual budget for 19X4 is as follows:

Unit selling price and costs for Division A
R
Sale price 65
Costs:
Direct material 12
Direct labour 8
Manufacturing overheads 20
Administration cost 5
Selling and packing expense 5
Profit R15
The manufacturing overheads are 40% variable. Administration costs are fixed, while selling and
packing expenses are 80% variable.
Customer demand at various selling prices for Division A
Selling price R80 R65 R52 R44
Demand 15 000 30 000 40 000 50 000
Division A is currently negotiating with Division B to sell its excess production at the current market
price. There are no internal savings on sales to Division B.
Division B can incorporate the transferred-in product into a more advanced product. The unit costs of
this product at a sales level of 50 000 units are as follows:
R
Material 10
Transferred-in product ?
Manufacturing overheads 16
Administration/Selling costs 9
The management of Division B has found that the cost structure tends to vary at different levels of
production as follows:
Units 10 000 50 000
Material R100 000 R500 000
Manufacturing overheads R400 000 R800 000
Administration/Selling R250 000 R450 000
Division B’s manager is unhappy with the suggested transfer price, and has requested that Head
Office intervene in order to set a more reasonable transfer price.
Customer demand for Division B’s products is also price-sensitive and the demand/price relationships
per annum are as follows:
Demand 10 000 20 000 35 000 50 000
Head Office has appointed you to evaluate the effect that the proposed transfer price has on the
overall group profits, and recommend a transfer price.

Write a report to the Directors of Klooftrim evaluating whether the proposed transfer price is fair and
recommend a transfer price or prices acceptable to both Divisions A and B.
Solution
Workings
Division A cost analysis
R Variable Fixed
Direct material 12 12 –
Direct labour 8 8 –
Manufacturing overhead 20 8 12
Administration cost 5 – 5
Selling and packing expense 5 4 1
50 32 18
Budget fixed costs R18 × 30 000 = R540 000

Sales to outside market
Units sales 15 000 30 000 40 000 50 000
R’000 R’000 R’000 R’000
Sales 1 200 1 950 2 080 2 200
Variable costs 480 960 1 280 1 600
Fixed costs 540 540 540 540
Profit * 180 450 260 60
Division A will maximise its profit by selling 30 000 units.

Division B cost analysis
Costs
Variable Fixed
Units 10 000 50 000
R R
Material 100 000 500 000 10
Manufacturing overheads 400 000 800 000 10 300 000
Administration/Selling 250 000 450 000 5 200 000
25 500 000
Division B incurs incremental variable costs of R25 per unit, and fixed costs of R500 000.
Desired sales to outside market

Unit sales 10 000 20 000 35 000 50 000
R’000 R’000 R’000 R’000

Sales 1 350 2 140 3 325 3 800
Transfer costs 320 640 1 120 1 600
Variable costs 250 500 875 1 250
Fixed costs 500 500 500 500
Profit 280 500 830 450
Division B will wish to sell 35 000 units.
As production capacity is limited to 50 000 units, the options available to Klooftrim in order to
maximise profits are:
Division A Division B Total profit
R’000
Option 1: Sell 15 000 units 35 000 units 1 010
Option 2: Sell 30 000 units 20 000 units 950
Option 3: Sell 40 000 units 10 000 units 540
The most favourable sales mix that will maximise overall company profit is for Division A to sell
15 000 units to the external market and 35 000 units to Division B.
Transfer price
First 15 000 units
R450 000 – R180 000 = R270 000 ÷ 15 000
= R18
R18 + variable cost R32 = R50
Balance of 20 000 units

Lower limit
The lower limit will always be variable cost, which is R32.
Upper limit
Differential Differential
profit units
R830 000 35 000
R500 000 20 000
R330 000 15 000
R330 000 ÷ 15 000 = R22

Variable cost R32
R54
Profit at a transfer price of R65

Sales (units) 10 000 20 000 35 000 50 000
R’000 R’000 R’000 R’000
Incremental transfer costs (330) (660) (1 155) (1 650)
Profit (see * above) 280 500 830 450
Revised profit (50) (160) (325) (1 200)
Report:
To: Chairman of the Board
From:
The current company policy is to allow a division to set its own transfer price at market price when
such a price is available, or to set a transfer price that is in line with maximising group profit.
When a division such as Division A sells its product on an imperfect market, it is difficult to arrive at a
market price because such prices will vary with demand.
Division A should establish the market selling price that will maximise its external sales. At the
moment, Division A will maximise its profit by selling 30 000 units at a market price of R65 per unit.
At this level of sales, Division A can only transfer 20 000 units to Division B.
Should Division A transfer at the market price of R65, Division B will not purchase any units. Division
A cannot use the R65 as a market price as it cannot increase its sales at R65. Any selling price above
R32 will increase Division A’s profits.
My investigation has however revealed that the optimal sales split between Divisions A and B is for
Division A to sell 15 000 units and Division B to sell 35 000 units. To encourage Division A to sell
35 000 units to Division B we must ensure that Division A’s profits are, at worst, R450 000.
The suggested transfer price that is in line with company objectives is as follows:
First 15 000 units R50
Balance of 20 000 units between R32 and R54
At these transfer prices, Division A will make a profit of R450 000 on the first 30 000 units sold. For
the balance of 20 000 units, I would suggest a price above the variable costs, but only marginally so,
as the company cannot sell on the external market. A mark up of 20% to +/– R38 should be
acceptable. At this price, the divisional and company profits would be as follows:
External sales units) 15 000 35 000
Internal sales (units) 35 000 –
R’000 R’000 R’000
Sales external 1 200 3 325 4 525
Sales internal 1 510 – 1 510
2 710 3 325 6 035
Variable costs 1 600 875 2 475
Transfer costs – 1 510 1 510
Fixed costs 540 500 1 040
Profit 570 440 1 010
Yours faithfully

Games Ltd has a wide range of manufacturing activities within South Africa. The company operates
on a divisionalised basis, with each division being responsible for its own manufacturing, sales,
marketing and working capital management. Divisional managers are expected to achieve a target
return of 15% on sales.
A disagreement has arisen between two divisions which operate on adjacent sites. Arima has the
opportunity to manufacture an industrial vacuum cleaner using a motor which has recently been
developed by the Motos division. Currently there is no other source of supply for an equivalent
motor in the required quantities.
The Motos division currently sells its motors on the open market, which has the following demand/
price relationship for a normal month:
Quantity supplied Market price per unit
500 R360
700 R360
1 000 R305
Motos can manufacture up to 1 200 motors when manufacturing at full production capacity. The
division’s cost structure at two different production levels are as follows:
Production 500 units 900 units
Manufacturing costs: R’000 R’000
Materials 75 135
Labour 35 55
Packaging 5 7
Total manufacturing costs 115 197
Sales and distribution 5 7
Total costs 130 214
Arima’s incremental variable cost for each vacuum cleaner over and above the cost of each motor is
R150. If the project is undertaken, the division will also incur fixed costs of R40 000 per month. Arima
has received an order for the supply of 700 vacuum cleaners per month at a selling price of R560 per
cleaner. The buyer is prepared to purchase a reduced number of 500 vacuum cleaners per month in
the short-term at R580 each, but has suggested that it will look for alternative suppliers if it is unable
to purchase 700 cleaners per month in the long-term.
Motos has communicated to the manager of Arima that it is prepared to sell as many motors as it
wishes at the present market selling price of R360. Arima has suggested that Motos is far too greedy
and that it is prepared to pay relevant variable costs plus 20% for the purchase of 700 units. Motos
will not incur any sales and distribution costs on sales made to Arima.

(a) Determine the optimal sales for Motos and Arima divisions that will maximise the overall
company profit. (22 marks)
(b) Calculate the minimum and maximum transfer prices that are in line with overall company
policies. (10 marks)
(c) Discuss whether the transfer prices suggested by the management of Motos and Arima are
acceptable, and give your opinion on an appropriate transfer price. (8 marks)
Solution
(a) Motos costs
Marginal
500 units 900 units 400 units V/C F/C
R’000 R’000 R’000

Materials 75 135 60 150 –
Labour 35 55 20 50 R10 000
Packaging 5 7 2 5 R2 500
Sales and distribution 5 7 2 5 R2 500
Administration 10 10 – – R10 000
R210 R25 000
Step 1 – Motos’ sales to external market

Sales Selling Total Motos Profit
demand price revenue costs
500 R360 180 000 130 000 50 000
700 R360 252 000 172 000 80 000
1 000 R305 305 000 235 000 70 000
Variable costs R210 per unit
Fixed costs R25 000
Motos will maximise its profits by selling 700 units, and make a profit of R80 000.
Step 2 – Arima
Sales Selling Total Arima Motos Profit
demand price revenue costs costs
R R R R R R
500 580 290 000 115 000 102 500 72 500
700 560 392 000 145 000 143 500 103 500
Arima costs: R150 variable per unit + R40 000
Motos’ costs charged to Arima are taken as variable incremental costs only
Material R150
Labour R50
Packaging R5
R205
Conclusion: Arima will wish to sell 700 units to maximise its profits.
Games Ltd will wish to maximise sales and profit and will attempt to maximise the revenues of
both Arima and Motos.
Step 3
If Motos sells 700 units on the external market, it will only have 500 units available to sell to
Arima.
Choices available
1 Motos: Sell 500 external Profit 50 000
Arima: Sell 700 units Profit 103 500
Total 153 500
2 Motos: Sell 700 external Profit 80 000
Arima: Sell 500 units Profit 72 500
Total 152 500
The best combination that maximises company profits is for Motos to sell 500 units to the
external market and 700 units to Arima.
(b) The minimum transfer price

The minimum transfer price is determined as the variable marginal cost incurred by the
transferring division, or the market price if the transferring division can sell on the external
market.
In this question, Motos would wish to sell 700 units in the external market in order to maximise
its profits.
As it would be in the interests of Games Ltd that Motos sells 500 units on the external market,
the correct minimum transfer price would be:
First 200 units R355 (market price less R5 sales and distribution)
Balance 500 units R205 (variable cost)
Or: Profit lost R80 000 – R50 000 = R30 000 which must be made up
Therefore R30 000 ÷ 200 = R150 + Variable costs R205 = R355
The upper limit is determined by looking at the differential profit of Arima.
R
Profit at 700 units 103 500
Profit at 500 units 72 500
Difference 31 000
= 31 000 ÷ 200 = 155 per unit
Upper limit
First 200 units R355
Balance 500 units R155 + R205 = R360
(c) Motos has asked for a transfer price of R360 per unit as this is the market price. Clearly this
price is not acceptable beyond 700 units, as Motos is unable to sell more than 700 units at that
price. Any price above variable cost will increase Motos’ profit, which should be pointed out to
the management of Motos.
Arima has suggested a transfer price of cost + 20%, based on average cost of 500 unit
production. This suggestion will yield the following cost structure:
Variable cost of production R205
Mark-up 20% 41
Suggested transfer price R246
The transfer price suggested by Arima appears reasonable. An attempt should be made to
increase the manufacturing capacity of Motos as the company will (on current demand) have a
problem meeting future market requirements. Consideration should also be given to what
effect a drop in sales by Motos will have on its clients.
The recommended transfer price in my opinion should be based on
1 Market price up to 700 units
ie R360 for the first 200 units.
2 The 15% required return on sales should be dropped for internal transfers and a negotiated
price between R205 and R355 (possibly a mid-price of R280) accepted.

Brooks is a division of Brooks and Dunn Incorporated. The division manufactures standard solar
panels used for lighting. Dunn is another division of Brooks and Dunn Inc, and manufactures solar
geysers. Both divisions are fully autonomous and sell their products in imperfect markets.
Dunn has in the past manufactured both the solar panels and the geysers used in its product. There
has, however, been a substantial increase in the demand for its product and the division has now
reached the point where the production facilities cannot meet the required demand. Management
has therefore approached Brooks requesting that they manufacture all of Dunn’s solar panel
requirements so that Dunn can concentrate on manufacturing the geysers only.
You have been requested to recommend a transfer price and have been given the following
information:
Brooks
1 Last year, Brooks manufactured and sold 10 000 solar units at a profit of R300 each.
R
Selling price 1 000
Cost:
Direct material 370
Direct labour 80
Variable manufacturing overhead 80
Fixed manufacturing overhead 100
Variable selling 20
Fixed selling 50
Profit R300
2 The production capacity of Brooks is 25 000 solar units, if it works an overtime shift.
3 All variable costs for the forthcoming year will remain at the same level as last year.
4 Fixed manufacturing overhead and fixed selling costs will be the same at a production level of
10 000 units, 10% lower if production is 8 000 units and 10% higher if production is 13 000 units.
5 All units produced for Dunn will incur no selling costs. All other costs will remain the same.
6 The external market selling price/demand relationship for the forthcoming year is as follows:
R920 13 000
R1 000 10 000
R1 050 8 000
7 If Brooks’ production exceeds 13 000 units, it will have to work an overtime shift which will
increase the cost per unit manufactured during overtime hours by R90 per unit.
Dunn
1 The manufacturing costs of the geyser (excluding the solar panel to be manufactured by Brooks)
depend on the number produced. At a production level of 10 000 units per annum, the cost per
geyser is R800. At a lower production level of 5 000 units per annum the cost is R1 100 per unit.
2 The final product for the forthcoming year will consist of one solar unit manufactured by Brooks
plus one geyser manufactured by Dunn.
3 The selling price/demand relationship for each solar-geyser is as follows:
R1 700 8 000
R1 600 10 000
R1 450 12 000
Note: Sales for Brooks and for Dunn can only be made at the demand levels shown above.

(a) Calculate how many units Brooks should sell on the open market and how many should be
transferred to Dunn in order to maximise group profits.
Calculate the lowest and highest transfer prices that Brooks could charge Dunn in order to
maximise group profits. (30 marks)
(b) “Return on Investment” (ROI) is defined as Earnings/Total funds invested.

l Explain how a company should calculate earnings and total funds invested.
l List four possible methods of how a company can improve ROI.
l Explain the meaning of “Economic Value Added”. (10 marks)
Solution
(a) Brooks’ cost analysis
Variable costs
Up to 10 000 units Above 13 000 units
Direct labour 80 80
Overtime – 90
Total variable 550 640
Fixed cost
R
Manufacturing overhead 100 × 10 000 = 1 000 000
Fixed selling 50 × 10 000 = 500 000
1 500 000 at 10 000 units
8 000 units R1 500 000 × 90% = R1 350 000
13 000 units R1 500 000 × 110% = R1 650 000
Profit maximising position for Brooks

At 13 000 units
R
Contribution (920 – 550) = 370 × 13 000 = 4 810 000
Less: Fixed costs 1 650 000
Profit 3 160 000
At 10 000 units
R
Contribution (1 000 – 550) = 450 × 10 000 = 4 500 000
Profit 3 000 000
At 8 000 units
Contribution (1 050 – 550) = 500 × 8 000 = 4 000 000
Profit 2 650 000
Brooks should sell 13 000 units to the outside market

Dunn’s cost analysis
Total costs at 10 000 units 10 000 × 800 = 8 000 000
Total costs at 5 000 units 5 000 × 1 100 = 5 500 000
High/Low
Units Costs
10 000 8 000 000
5 000 5 500 000
Differential 5 000 2 500 000 variable cost
Variable cost per unit

R2 500 000 / 5 000 = R500 per unit
Fixed cost: At 5 000 units

Total cost 5 500 000
Less: Variable cost 2 500 000
Fixed cost 3 000 000
Dunn’s profit
Note: Variable cost from Brooks excludes the variable selling but includes the overtime cost of
R90 per unit, assuming Brooks will sell 13 000 units on the outside market.
Variable cost = R640 – 20 = 620
At 8 000 units Or contribution
Variable cost R500 + R620 = R1 120
Selling price R1 700
Contribution R580
R
Total contribution 580 × 8 000 = 4 640 000 4 640 000
Less: Fixed cost 3 000 000
Profit 1 640 000
At 10 000 units
Variable cost R500 + 620 = R1 120
Contribution R480
R
Total contribution 480 × 10 000 = 4 800 000 4 800 000
Profit 1 800 000
At 12 000 units
Variable cost R500 + R620 = R1 120
Contribution R330
R
Total contribution 330 × 12 000 3 960 000 3 960 000
Less: Fixed cost 3 000 000
Profit 960 000
Dunn will maximise its profit by selling 10 000 units

Brooks can produce up to 25 000 units; the desired production is

Brooks 13 000 units to outside market
Brooks 10 000 units to Dunn
23 000
Minimum transfer price

The minimum transfer price is Brooks’ variable cost, which is R620, assuming that all units
manufactured in overtime are transferred to Dunn.
Maximum transfer price

Or
R R
Dunn profit at 10 000 units 1 800 000 4 800 000
Dunn profit at 8 000 units 1 640 000 4 640 000
Differential profit 160 000 160 000
Differential units 2 000 2 000
Maximum increase on Brooks division’s variable cost R160 000 divided by 2 000 = R80
Maximum transfer price R620 + R80 = R700
(b) Calculation of earnings for ROI

l Earnings represents the profit from the main line of business
l It excludes income from investments
l It also excludes interest paid (source of finance) and received
l In addition, it excludes tax
Calculation of total funds invested

l Funds invested should be property, plant and equipment plus net current assets
l This excludes assets not employed in the main line of business, ie investment assets
l The assets should be equal to the average net assets employed during the year
l Market or replacement value can also be used
Improving ROI
l Increase sales volume
l Increase selling price
l Reduce costs
l Reduce total assets (do not replace PPE)
“Economic Value Added”

“Economic Value Added” is another term for “Residual Income”. To arrive at residual income, a
cost equal to the company’s weighted average cost of capital (WACC) is multiplied by the
operating asset value and charged against earnings. A positive figure shows that the company is
yielding a return above WACC, which will satisfy both debt providers and shareholders.
Performance analysis of
14 companies and divisions
l discuss the difference between functional and divisionalised structures
l explain why companies choose to decentralise
l discuss the factors that should be considered when designing measures for performance
evaluation of both the manager and the division
l calculate the “return on investment” and “residual income”/EVA
l explain the advantages and disadvantages of using “return on investment” and “residual
income” as performance measures
l explain how performance measures may conflict with the concept of “net present value”
l make inter-divisional performance comparisons and discuss the problems of making such
comparisons
The purpose of this chapter is to provide a framework and ideas that will enable you to evaluate the
performance of a company or division and form an opinion of how well a particular company has
performed.
Performance evaluation cannot take place in a vacuum; it must be preceded by a company or
division setting a standard of performance against which performance can be evaluated. This
performance standard is known as a “budget”. The budget is a short-term plan that comes from
management’s assessments of its long-term objectives in terms of a strategic plan. It is not my
intention to do a detailed study of strategic planning; nevertheless, it is necessary to examine some
aspects of strategic planning so that you have an idea of what a company should be attempting to
achieve in terms of a budget and subsequent performance analysis. Before we look at what strategic
planning entails, I want to once again set the foundation for “performance analysis”.
The underlying theme of this text book is the analysis of performance by

l preparing a budget
l calculating the actual profit
l reconciling the budget profit to the actual profit.
The performance analysis which highlights the positive and negative sales and production attributes
is done on a variable costing basis (it is less acceptable to use absorption costing) and looks at the
following:
Budget profit
Plus/less sales volume
= Expected profit
+/– Sales price variance
+/– Cost variances
= Actual profit
The above analysis evaluates the performance of sales and expenditure and can be done in detail
when standard costing analysis is used. The budget defines corporate objectives which are attainable
465
and meaningful, while the financial reconciliation focuses on internal performance over a relevant
period.
Strategic planning
Strategic planning is a process of evaluating a company’s strengths, weaknesses, opportunities and
threats (SWOT) from an external and internal perspective. By defining the strengths, weaknesses,
opportunities and threats facing a company, management is able to define the long-term objectives,
which can be translated into short-term plans.
From an internal perspective, a company will look at its strengths and weaknesses, ie those
attributes that the company is good at or bad at.
Weaknesses
Strengths
Products
Quality
Management
Manufacturing – capital/labour
Employees
Figure 1
Company strengths can at the same time represent potential weaknesses.

Products A company should look at its range of products and identify which products
are strong and which ones are weak, as well as the reasons for the strengths
and weaknesses.
Quality How do our products compare to competitive products or overseas products?
Management Is the management team or style of management a strength or a weakness?
Manufacturing Is the company under consideration capital- or labour-intensive? If it is
capital-intensive, is that a strength or a weakness? Are similar companies
better or worse than ours in terms of manufacturing processes? Is there
anything we can learn from them?
Employees Are our employees a strength or a weakness in terms of the value they
contribute to the company? Are they unionised? If so, does this present a
problem?
From an external perspective, a company will look at the opportunities and threats facing the
company.
Threats
Opportunities
Competition
Suppliers
Customers
Market
Technology
Economic environment
Figure 2
Political considerations
Chapter 14: Performance analysis of companies and divisions 467
External opportunities and threats are important as they help a company to evaluate its position in
the market without becoming complacent or arrogant.
Competition Are there any competitors? If not, what is the threat of new entrants into our
market? If there is no competition, have we become complacent and in doing so
have we invited competition? What is the existing level of competition?
Suppliers What kind of negotiating power do we have with our suppliers? Do we have a
single or multiple suppliers? Do we import? If so, how reliable are the suppliers?
Customers Do we have a market niche? Do we sell on an open competitive market? What
negotiating strengths do our customers have?
Market What kind of market? Do we export? Is that an opportunity or a threat? What
substitute or competing products are available in the market?
SWOT analysis is an aid to highlight opportunities and limitations in an organisation in terms of its
long-term goals and objectives. It can be used to re-direct the company in terms of a changing
environment. Within the context of unprecedented technological changes, it is vital that companies
regularly reassess “how they do business” and modify operations as the business world, customers,
markets and suppliers change.
How to answer questions on company performance analysis

Measurement and evaluation of performance requires a clear distinction between short-term and
long-term performance evaluation.
Long-term performance should be related to the long-term return on investment, ie the
discounting of future cash-flows at the target WACC.
Short-term performance should analyse the return on assets employed.
Long-term Short-term
Analytical: Strengths Strengths

Internal Internal
Weaknesses Weaknesses
Threats Threats
External External
Opportunities Opportunities
Financial: Discounted cash-flows Reconciliation of budget to actual

Return on investment
Residual income
Market share
Sales analysis
Contribution
Comparative analysis
Figure 3
Step 1: Read the question and identify all information that can be classified as a strength,
weakness, opportunity or threat to the company, either in the short- or in the long-term.
Step 2: Within the context of the question, state the objective of performance analysis and your
initial assessment of the company in terms of its strengths, weaknesses, opportunities or
threats (both short- and long-term).
Step 3: Evaluate the numerical information, calculate and explain the relevance of
Residual income
Other measures, such as:

l market share
l increase in sales
l comparative analysis.
Step 4: Conclusion (very important). State your opinion of the company, incorporating both
numerical and analytical data given in the question under two headings, ie long-term and
short-term. List the weaknesses and strengths.
The type of question could differ significantly, for example, you may be given the budget and actual
information and asked to assess the performance. In such a situation you must state the importance
of a budget, why and how it is prepared, reconcile to actual and comment on performance.
Financial measurements of return on investment and residual income are shown later in this chapter.
The principles are the same for a company as for a division.
Divisional performance measurement

Divisionalisation of a company takes place when divisions or operations are segmented, with
decision-making powers decentralised to the divisions. Autonomy may be given to the manager to
make decisions on selling prices, costs, sales levels and asset investment. Depending on the degree of
autonomy delegated, a division may be classed as a cost, profit or investment centre.
There are various reasons put forward in favour of decentralised decision-making, such as:
l increased size of firms, necessitating the creation of smaller business units where decision-
making is improved
l changing economic environment requiring specialisation in aspects of the business that should be
managed by experts
l creation of an environment that is more self-fulfilling to management who are given greater
responsibility.
The measurement of divisional performance in decentralised companies is often done on an
exclusive profit test basis such as:
l divisional net profit
l divisional controllable profit
l return on investment.
Accounting systems have been designed around the profit goal of the firm which tends to represent
a single divisional profit measure. The fundamental assumption of these systems is that individuals
accept top management goals as their personal goals; therefore goal-congruence is achieved. It is
questionable whether such accounting systems are in fact in line with company objectives and, given
that divisions may have different business objectives, control based on a single accounting return is
unrealistic. A single measure is also in conflict with the ideal of divisional autonomy, as it will be seen
by the divisional manager as a top management control mechanism which inhibits creativity and
growth. The more acceptable alternative is to create multiple qualitative and quantitative standards
particular to each division which can then be used to evaluate overall performance.
Management seems to prefer a single measure so that it can compare inter-divisional performance
or carry out inter-company comparisons. This antiquated desire for comparative assessment
produces no meaningful performance assessment, as no two divisions or companies are identical.
No accounting system is able to reflect or measure the multi-faceted aspects of managerial
behaviour. Accounting systems conflict with other performance indices, such as:
l creating customer loyalty
l product improvement
l establishing good employee relationships.
Advantages of divisionalisation
l Improvement in the quality of decision-making and management. The chain of command is
reduced and decisions are specific.
l Business units become more responsible, because decisions are made by people more familiar
with the problems.
l Most businesses operate under conditions of active competition, high inflation and employee
strikes, in which decisions have to be made timeously. Decentralised decision-making ensures
that problems are resolved as they occur.
l Decentralisation frees management from the day-to-day running of the business and enables it
to devote more time to long-term planning.
l Management is more motivated and achieves a higher level of self-fulfillment.
l Divisional managers can be encouraged to act as entrepreneurs and to exercise initiative.
l Participation in decision-making is likely to be greater, with important team-building spin-offs.
l Unprofitable activities will quickly be identified and eliminated or turned around.
Disadvantages of divisionalisation
l Divisionalisation inevitably results in duplication of activities such as computer systems,
purchasing departments, etc.
l Divisionalised decision-making often leads to managers making decisions which are not
congruent with overall company policy.
l It is difficult to design performance measures based on divisional profit, especially where
divisions are inter-dependent of one another.
l Divisions may compete against each other to the detriment of the company.
l Inexperienced managers may make mistakes that could otherwise be avoided.
l Greater staff numbers may result.
l A divisional structure may create unwanted competition between the divisions that could create
friction.
Types of divisional responsibility centres

Cost centre – functional
A “cost centre” is a segment of an organisation in which managers are held responsible for the costs
incurred in the segment. Cost centre managers are responsible for some or all costs in their segment,
but are not responsible for revenues. Cost centres are widely used, because many different types of
segments such as the marketing department, sales region or a sales representative can be identified
as a cost centre.
Profit centre – divisionalised

A “profit centre” is a segment of a business where managers are responsible for both costs and
revenues. The main concern of the manager is to run his segment as profitably as possible. Profit
centre maximisation of profit does not necessarily mean that the business as a whole will maximise
profit, because inter-divisional activities may impair the overall company profitability.
Investment centre – divisionalised

An “investment centre” is a segment of a business in which managers are held responsible for the
return on the resources invested in the segment. Investment centres are widely accepted as being
superior to profit centres, as the return on assets invested becomes the performance criterion. The
comparison of divisional profitability is not made on the bottom-line profit figure, but on the return
on assets invested.
Performance analysis
Performance Performance Inter-company /
of division of manager -division comparisons
Long-term Internal – Strengths – Strengths Type of business
Analytical – Weaknesses – Weaknesses Labour-/Capital-intensive
Products
Finance –
External – Threats – Threats Debt/Equity
– Opportunities – Opportunities
Short-term – ROI – Controllable ROI Comparative ROI
Financial – Residual Inc – Controllable RI Comparative RI
– Net profit % – Net profit % Comparative market share
– Market share – Market share Comparative sales growth
– Sales growth – Sales growth Comparative NP %
Short-term financial analysis of a company or division

When examining the performance of a company or division, you must follow the steps highlighted
above.
“Return on investment” (ROI) is a financial accounting measure used to compare companies in the
same business class or for inter-divisional comparisons. Return on investment is defined as a
measure of operating profit divided by assets employed in deriving the profit.
Earnings 100
Return on investment = Investment × 1
The equation can be expanded to show that

Profitability is a function of sales, earnings and cost of sales
Turnover is a function of sales, property, plant and equipment and working capital
Turnover Profitability
Sales revenue Earnings
Expanded: = ×
Investment Sales revenue
The objective of ROI is to evaluate how well a company has performed, based on the assets that it
has at its disposal.
The definition of return on investment shown above is not a constant; you will find that an
examination or tutorial question may change the definition of ROI. For example, a question may say
that the investment is defined for ROI purposes as “current assets + Property, plant and equipment
at replacement value”. The question could also say that earnings are “company earnings after tax”.
There are many variations on the calculation, so read the question carefully.
If a question does not define ROI, you need to consider which assets must be included and also which
income and expenditure items must be included or excluded from the calculation.
Investment
“Investment” should be equal to “property, plant and equipment plus current assets less assets not
employed in the main line of business”. Investment assets are clearly excluded. Investment should
reflect the operating assets directly related to the main line of business only. Most text books and
analysts do not include current liabilities as part of investment. I believe that current liabilities should
be included as they form part of net operating assets, but for the purposes of this text book, I will
exclude current liabilities. However, when an exam question defines investment as net assets, you
must include current liabilities.
Definition of assets
Assets must relate to those assets that appear in the Statement of Financial Position and that are
used in the normal line of business.
Possible assets appearing in the Statement of Financial Position

Property, plant and equipment – Use opening balance/closing balance or average
Current assets – Include
Current liabilities – Exclude
Goodwill – Asset or expenditure?
Investments – Required to generate operating earnings?
Deferred tax – Negative asset or expenditure?
Research and development – Asset or expenditure?
Marketing costs – Asset or expenditure?
Property, plant and equipment

Use average investment over the year. There could be exceptions to this rule, for example where a
company purchased property, plant and equipment at the end of the year and the assets were not
used in the year being evaluated to generate earnings. Those assets must be excluded. You are not
likely to see this “trick” in an exam question.
Example
Net assets at beginning of year R100
Depreciation R20
Net assets at end of year R80
Net assets for the year would be shown as ½ (100 + 80) = R90
Current liabilities
Some companies include current liabilities in the definition of assets, while other companies leave
them out. There are good arguments for inclusion, as well as for exclusion. I suggest that in
examination questions where investment is not defined, you should state in your answer that you
are defining investment as property, plant and equipment plus current assets.
Goodwill
Goodwill is an asset and it has value. As with any other asset, we need to ask the question: “Does the
asset loses value?” If the asset is clearly losing value, then it should be written down to its fair value
and the impairment loss recognised in the period it originated.
Investments (simple)
If the investments were not used to generate the earnings, then the investment must not be
included.
Research and development/marketing costs

Treat as you would treat goodwill. If it is an asset that has a long-term benefit, then it must be
written-off over the period pertaining to that benefit. If, however, it is not losing value as an “asset”
then it must not be written-off. Realistically, the asset should be written-off as an expense over a
period of time.
Deferred tax
Normal taxation is never included, as the ROI is based on earnings before tax. Deferred tax must
therefore also be excluded.
Definition of earnings
“Earnings” represents the income from the main line of business. It excludes income from
investments, but includes non-cash-flow items that represent assets losing value. Interest paid is also
excluded, as interest is incurred as a result of a finance decision. In other words, a company can
avoid incurring interest cost by simply using equity as a finance option.
Tax is also excluded, as it makes comparisons from one year to the next difficult, because tax rates
change.
Note: If the question says that the company calculates ROI on the basis of earnings after tax, then
you must clearly follow the instructions.
Earnings from operations
Depreciation – Include
Goodwill impairment – Include
Research and development – Include
Marketing – Include
Foreign exchange gain/loss – Include
Note: Goodwill, research and development and marketing must be included as expenses only if we
believe that the asset has lost value equal to the write-off.
The biggest problem associated with ROI is that we show an asset base “investment” at carry
value, which may or may not have a bearing on the true market or replacement value of the
asset.
Taxation Must be ignored

Interest income and dividend income Also ignore
Interest expenditure Must also be ignored as it is not a cost of operations. It is
a finance cost. Interest expenditure can be avoided by
choosing equity finance.
Example
You have been presented with the following statement of financial position and income
statement:
Statement of Financial Position
R
Ordinary share capital 100 000
Retained income 30 000
Ordinary shareholders equity 130 000
Long-term debt 120 000
Current liabilities 40 000
290 000
Represented by:
Property, plant and equipment 150 000
Goodwill 30 000
Investments 30 000
Current assets 80 000
290 000
continued
Income statement
R
Turnover 150 000
Cost of sales (67 500)
Gross profit 82 500
Interest income 3 000
Interest expenditure (12 000)
Depreciation (20 000)
Income before tax 53 500
Taxation (15 000)
Income after tax 38 500
No assets were purchased or sold during the current year. Goodwill was raised at the
beginning of the current financial year and has been valued at R30 000.

Calculate the return on investment (ROI) and discuss how the company could increase the ROI
in future years.
Solution
To calculate the ROI, we need to evaluate the assets and liabilities of the company to assess which
assets must be included and at what value. We also need to determine the income before tax that
reflects the earnings from normal business operations.
Assets
Property, plant and equipment: As we have not been told the basis used by the company to
determine the appropriate asset value for the ROI calculation, we will use the average asset basis.
The closing value of property, plant and equipment is R150 000. Depreciation of R20 000 has been
written-off during the financial year. As there were no purchases or sales of any other assets, we
must use the average asset value for the year.
Closing balance R150 000
Depreciation for the year R20 000
Therefore opening balance R170 000
Therefore average asset value is (R170 000 + R150 000) / 2 = R160 000
Note: When a company does not replace its property, plant and equipment on a regular basis, we
find that the “net asset value” will decrease substantially over time, which will lead to an
increase in ROI even if the company is performing poorly, because the denominator drops as
asset values decrease. It is therefore appropriate to compensate for this problem by using
the market value, or the replacement value or historical cost as an alternative value. If, for
example, an exam question tells you that the company uses the replacement value of assets
to determine ROI, the R160 000 would not have been appropriate.
Investments
Assuming that the investment of R30 000 is not part of normal operations, ie it is an investment
outside the normal business operations, such as Treasury bills or share investments in another
industry, they will not be included.
Long-term liabilities
Long-term liabilities are part of the capital structure of the company. Long-term liabilities and
ordinary shareholders equity are interchangeable. Assets are financed from debt and equity. The
assets are then used to derive operating income.
Investment
R
Property, plant and equipment 160 000
Goodwill 30 000
Current assets 80 000
Total Assets 270 000
Earnings
Income before tax 53 500
Interest expense + 12 000
Interest income – 3 000
Operating income 62 500
Earnings
Return on investment =
Investment
62 500
= = 23,15%
270 000
How to improve ROI

Sales Earnings
ROI = ×
Investment Sales
150 000 62 500
= ×
270 000 150 000
Turnover Profitability
ROI can be expanded into two equations that represent turnover and profitability. By focusing on
each of the two inputs, one can easily determine how to improve overall ROI.
150 000
Current turnover ratio = = 56%
270 000
To increase the ratio we need to increase sales or decrease investment. The company must therefore
either sell more, or increase the selling price of current sales, or decrease investment.
An increase in sales to (say) R170 000 will have the following effect
170 000
= 63%
270 000
A decrease in investment can easily be achieved by simply not increasing the property, plant and
equipment from year to year. As depreciation continues to be charged annually, the overall
investment figure will decrease by R20 000. The long-term effects for the company will however be
very bad, as assets become run down. A general decrease in working capital, ie better asset
utilisation, will also improve the ROI.
62 500
Current profitability ratio = = 42%
150 000
When sales remain unchanged, the company can target the cost of sales in order to improve the
earnings from operations. At the moment, the cost of sales is 67 500 / 150 000 = 45% of sales. A
decrease in cost of sales to R60 000, ie 5% of turnover, will result in earnings increasing to R70 000,
while the profitability ratio increases to 47%.
70 000
= = 47%
150 000
If sales increase as a result of a drop in the selling price, the profitability ratio may still improve, as
long as the contribution ratio has a favourable effect on the overall earnings.
An increase in sales should result in an improvement in the ratio, because fixed costs will remain
unchanged and a sales increase will result in an increase in contribution.
Assume current
R
Sales 150 000 100%
Fixed costs 30 000
Gross profit 82 500
If sales increase to R170 000, we get

R
Sales 170 000 100%
Fixed costs 30 000
Gross profit 97 500
Gross profit has improved by R15 000
The profitability ratio will change as follows

Was Now
[ 82 500 – 20 000 ] [ 97 500 – 20 000 ]
= =
150 000 170 000
= 42% = 45,6%
We therefore conclude:
To increase return on investment a company must target
l increase in sales value
l increase selling price
l reduce cost of sales
l reduce assets employed.
The return on investment can be further broken down into the Du Pont analysis as follows:
Du Pont analysis Sales
Profitability Earnings Minus

Cost of
Earnings Divided sales
% of sales
Sales
ROI Multiplied
by
Sales
Turnover Divided Working

capital
Total
assets Fixed
assets
Figure 4
Problems associated with inter-company or -divisional comparisons

l No two companies operate in exactly the same way. Some are labour-intensive while others are
machine-intensive.
l The products manufactured and sold are not identical.
l The nature and age of the assets is different. This means that both the depreciation charge and
the net carry asset value can in no way be compared.
l Market value of assets are ignored. Carry values are a very poor substitute for market or
realisable values.
l Accounting policies and inventory valuation methods differ across companies.
l The financial structure of companies is different.
l Income may be derived from other investments not related to the main business of the company.
Divisional return on investment

If the company we are examining consists of (say) two divisions, how then do we calculate the ROI
for the divisions?
If we are looking at divisional performance, rather than divisional manager performance, it is
appropriate to allocate all company assets, income and expenditure to the two divisions.
It is also acceptable to leave out the assets, income and expenditure that are directly attributable to
Head Office. Follow the instructions given in the question.
If we are, however, evaluating the performance of the manager, we should only allocate those assets
that he is responsible for, plus income and expenditure that he personally generates.
Residual income
“Residual income” (RI) is a profitability measure that looks at the earnings derived from operations
per ROI above, and then charges a notional charge for the assets utilised against the earnings.
The notional charge represents the company’s required return for the assets utilised.
Example
Investment R1 000
Earnings R120
ROI = 120 / 1 000 = 12%
Assuming that the company requires a return of 20% for assets utilised, the residual income would
be calculated as
Earnings 120
Notional interest charge (200) [ 1 000 × 20% ]
Residual income (80)
We therefore say that the company has performed poorly, as it has a negative residual income. In
other words, it has not yielded the required return of 20%.
Is the notional interest charge the weighted average cost of capital?

This is a difficult question to answer. The WACC of a company is the company’s required return after
tax. The earnings used in the ROI calculation are, however, profit before tax. It therefore seems
inappropriate to use the WACC as the notional return required, as the rate charged is an after-tax
rate. One could argue that the notional interest should be the required return before tax.
In practice, the notional interest rate used is often the WACC. Because of this confusion, it has
become fashionable to use a new term, called “economic value added” or EVA, when calculating the
residual income.
Economic value added

“Economic value added” was first introduced in 1993 and is simply a different name for residual
income; however, it uses earnings after tax as the performance measure before charging notional
interest. EVA uses the long-term discounted cash-flow technique in the short-term scenario. EVA is in
effect a year-by-year discounted cash-flow analysis. EVA takes a cost equal to the company’s WACC
multiplied by the operating asset value and charges it against after-tax earnings. A positive figure
shows that the company is yielding a return above WACC, which will satisfy both the debt providers
and the shareholders.
Example
A company invested in a new machine at a cost of R150 000. The life of the machine is 3 years
and the market value at the end of that period is zero. Wear-and-tear is allowed by the
Receiver at R50 000 per annum. Depreciation will also be allowed in equal amounts over
3 years.
The income and expenditure account over the next 3 years is projected as follows:
Year 1 Year 2 Year 3
Operating income 100 000 130 000 170 000
Interest – 20 000 – 12 000 – 10 000
Depreciation – 50 000 – 50 000 – 50 000
Earnings before tax 30 000 68 000 110 000
Tax 9 000 20 400 33 000
Earnings after tax 21 000 47 600 77 000
The tax rate is 30%
WACC is 18%
Required return before tax is 30%

(a) Determine whether the company should invest in the project.
(b) Calculate the year-by-year ROI and the average ROI over the 3-year period.
(c) Calculate the annual residual income.
(d) Calculate the annual EVA and the present value (PV) of the EVA values.
Solution
(a) NPV calculation
NPV Tax 18%
calculation effect Cash-flow PV PV
Year 0 Investment – 150 000 1 – 150 000
Year 1 Cash-flow 100 000 0,7 70 000 0,8475 59 325
Year 2 Cash-flow 130 000 0,7 91 000 0,7182 65 356
Year 3 Cash-flow 170 000 0,7 119 000 0,6086 72 423
Year 1 Wear-and-tear 50 000 0,3 15 000 0,8475 12 713
Net present value 79 719
The investment yields a positive net present value (NPV) and is therefore a good investment.
(b) Return on investment

Earnings before interest and taxation
Operating income 100 000 130 000 170 000
Depreciation (50 000) (50 000) (50 000)
Earnings 50 000 80 000 120 000

(150 + 100) (100 + 50) (50 + 0)
Average assets
2 2 2
= 125 75 25
50 000 80 000 120 000
ROI =
125 000 75 000 25 000
= 40% 107% 480%

Average ROI = 209%
(c) Residual income

Earnings 50 000 80 000 120 000
30% required return (45 000) (30 000) (15 000)
Residual income 5 000 50 000 105 000
Note: The notional interest has been based on the value of investment at the beginning of the
financial year. It could be argued that the average investment amount per the ROI
calculation is equally (or more) appropriate.
(d) Economic value added

Earnings 50 000 80 000 120 000
Tax (15 000) (24 000) (36 000)
Earnings after tax 35 000 56 000 84 000
18% WACC charge (27 000) (18 000) (9 000)
Economic value added 8 000 38 000 75 000
Note: The 18% notional interest is charged against the asset value at the beginning of the year.
Present value of EVA

PV 18% NPV
Year 1 8 000 0,8475 6 780
Year 2 38 000 0,7182 27 292
Year 3 75 000 0,6086 45 645
79 717
Performance of divisional managers

Forms of divisional profit measurement
External sales xxx
Inter-divisional sales xxx
xxx
Less: Variable cost of internal
and external sales xx
Variable divisional expenses xx
Controllable contribution xxx
Less: Controllable divisional overhead xx
Depreciation on controllable property, xx
plant and equipment
Expenses related to controllable
property, plant and equipment (leases) xx
Controllable operating profit xxx
Less: Interest on controllable

investments xx
Controllable residual income xxx
Less: Depreciation on non- Less: Depreciation on non-
controllable property, plant and controllable property, plant xxx
equipment xxx and equipment
Allocated Head Office costs xx Allocated Head Office costs xx
Interest on non-
controllable
investments xx
Net profit before tax xxx Net residual income before tax xxx
Short-term performance measurements are required to evaluate the personal performance of
management and are often used to determine salary and bonus payments. The problem with this
type of assessment is that a manager may concentrate on short-term operating decisions that will
enhance his performance, to the detriment of long-term objectives.
When evaluating short-term performance, it is important to use more than one measure to ensure
that management remains in line with company objectives. The following measurements help to
focus on overall performance, not only on financial measures:
l increase in sales volume
l market share of product sales
l manufacturing efficiency
l product quality and customer satisfaction
l new products
l employee relations.
It is important that no division should employ a short-term profit-maximising strategy to the
detriment of the company as a whole. An example would be where a division charges a transfer price
that will decrease the overall company profitability. Where possible, the performance of the
autonomous division should be evaluated on all income and expenditure under the direct control of
the manager. Allocated costs and decisions should be isolated when determining divisional
management performance.
Head Office should set divisional/manager objectives that are in line with overall objectives of the
company/group.
Managers will structure their divisions in order to maximise the objectives set by Head Office as it is
in their personal interest to achieve the targets set by Head Office. Managers are motivated to
achieve targets, which will in turn lead to personal rewards. It is therefore up to Head Office to
ensure that all performance targets are in line with the company’s overall long-term objectives.
Because it is important that long-term goals are targeted, divisional managers should not be
evaluated on a single ratio alone. Performance measures should include several key indicators, both
financial and non-financial in nature. Secondly, managers should be evaluated for those expenditures
which are under their control only.
Important: Assessment of managerial performance must also take into account economic factors.
A target of (say) 15% ROI may not be appropriate in recessionary times while in boom
times it may be too low.
A distinction is necessary between a “profit centre” and an “investment centre” when evaluating
performance.
There is general agreement that controllable contribution and controllable profit are appropriate
means of performance for a profit centre, as the principal financial measure is profit itself. The
controllable contribution is useful for short-term decision-making as it looks at costs and revenues
that respond to short run volume changes. It is unsatisfactory from a performance evaluation
viewpoint, as it excludes fixed costs. Controllable operating profit is a better measure of the
divisional manager’s performance, while net profit is a good measure of divisional performance. One
of the problems of evaluating a manager on the basis of controllable contribution or profit is that he
may develop the skill of “playing the game” by improving short-term returns at the expense of long-
term company profit.
In an attempt to counteract non-congruent managerial interests, companies have devised the return
on investment (ROI) measure and the residual income (RI) measure.
ROI offers a valuable investment performance measure as it considers the employment of assets as
well as the profit generated from those assets. It is also used extensively to compare inter-divisional
performance which is generally questionable.
The return on investment performance measure takes account of all assets invested in the division.
The accounting information is the same as conventional financial reporting, and the objective of
maximising return on investment is consistent with profit maximisation where investment is a fixed
constant.
Residual income shows the excess of income after charging the cost of investment. It is an absolute
profit performance (controllable residual income) and divisional performance (net residual income
before or after tax).
Residual income provides a better management target than ROI, as the measure is neutral and does
not cause managers to make decisions that will be detrimental to the group. This is due to the fact
that residual income states a profit figure, not a rate of return.
Whether RI or ROI is used as the predominant performance measure, both are equally problematic in
setting standards.
Return on controllable investment

In circumstances where a division does not have full control over its income and expenses or the
assets under its control, the ROI equation should be adjusted to allow for performance evaluation on
controllable income and controllable assets.
When a manager is evaluated on the basis of
Controllable operating profit 100
×
Controllable investment 1
he may make decisions which are not in the best interests of the company. If, for example, his
current return percentage on the basis of the above calculation is, (say) 15%, he will increase his
controllable investment base as long as the resultant return will improve the overall 15% return. A
new investment yielding a return of 18% would be accepted by the manager as it will improve the
current return.
The company cost of capital may well be above 18%, in which case the investment should in fact
have been rejected. The reverse may also happen where the current return is above the cost of
capital screening rate, but a new investment would be rejected if it lowered the existing return. The
rejection would be detrimental to the company if the projected return is above the cost of capital.
In the event of ROI being used as a performance measure, we need to be aware of its limitations. We
must be aware that ROI will fluctuate over time and that a more appropriate measure would be to
evaluate performance over time. It is also very dangerous to compare the ROI of divisions within the
group, as their operations and assets employed are unlikely to be comparable. When a division is
defined as an “investment centre”, performance should be monitored over a long period, and not on
an annual basis.
Advantages of ROI
l It is generally accepted.
l The measure is understood and measurable.
l It encourages managers to expand or take on projects that will increase ROI and discard those
that reduce ROI.
Disadvantages of ROI
l Profit is affected by accounting policies which may be outside of the control of the divisional
manager, such as
(a) depreciation policy
(b) transfer price policy
(c) allocation of Head Office overheads
(d) control over creditors and debtors.
l Net profit measure includes arbitrary allocations of corporate overheads, which are beyond the
control of divisional managers.
l The use of “contribution measure” instead of “net profit” is acceptable as it does not include
fixed costs. The contribution measure is disadvantageous in situations where the divisional
manager can influence the capital investment input amount. By increasing capital expenditure,
rather than labour input, the division would in effect be reducing the variable cost input base and
increasing the contribution (ie depreciation is not included in the contribution calculation).
l Maximising return on investment may lead to divisional managers disregarding the interests of
the company as a whole, and selecting projects which will increase the divisional return on
investment.
l Lack of consensus in defining net income and investment.
l Long-term profitability can be adversely affected, as ROI can be increased by avoiding projects
that yield a return that is lower than current ROI yet higher than the cost of capital.
l ROI ignores non-financial criteria.
Residual income performance measure

Residual income is the divisional profit measure stated after the deduction of a notional interest
charge for the utilisation of divisional assets.
Residual income performance attempts to concentrate on a measure which is free of all costs which
are beyond the control of the divisional manager. To identify those expenses which are controllable
by the divisional manager, it is necessary to ascertain whether the division is free to purchase the
required product or service from any source. If it can, then that category of expense is controllable.
When a division must purchase a particular product from a division, but has control over the
quantity, then the expense should be classified as controllable, if the charge is at standard cost. If the
division controls the investment in the division, the depreciation charge must be included.
The controllable residual income measure is a preferable measure, as an interest charge equal to the
cost of capital multiplied by controllable investment is charged against the controllable operating
profit. When applying this measure, managers are encouraged to act in the best long-term interests
of the company. Residual income measures encourage goal-congruence.
When evaluating a divisional manager, you cannot allocate all corporate income and expenditure to
the divisions. Only the income and expenditure that the manager is directly responsible for should be
allocated. The same applies to assets; only those that the manager is directly responsible for should
be accounted for. Clearly this is difficult, and the analysis of a division is therefore often done,
instead of the analysis of the divisional manager.
Advantages of using residual income

l Wealth-maximising corporate objectives are consistent with residual income and are more useful
than ROI in evaluating performance.
l The notional interest charge can be changed to match different divisional risk levels.
l Residual income is consistent with the NPV measure, which looks at long-term evaluation.
Disadvantages of using residual income

l It is difficult to make comparative performance evaluations as residual income gives an absolute
amount, ie a division may be twice the comparative size, yet it may have the same residual
income amount.
l As the value of the assets decreases due to depreciation, the interest charge will also decrease.
This presents the same problem as return on investment.
Division A is currently achieving a ROI of 38%, while Division B is achieving a ROI of 10%. The target
WACC for both divisions is 25%. You have been requested to evaluate the following new investment
proposals:
New investment required R2 million R1 million
Controllable earnings 520 000 200 000
Return on project 26% 20%
Required:
Discuss the advantages and disadvantages of evaluating the divisional managers of Divisions A and B
on a ROI basis.
Solution
Division A
Division A has a current return on investment of 38%. If the divisional manager is evaluated on ROI,
he will reject the investment, as it will have the effect of reducing his current ROI of 38%. The ROI of
the new investment is 520 000 / 2 million = 26%. (Note: You could argue that the assets should be
less than R2 million if taken as average investment over the year and that the return would in fact be
higher than 26%.)
The project should, however, be accepted, as it offers a return above WACC of 25% and therefore
has a positive NPV.
If the manager’s performance is evaluated on a residual income basis, we get
Controllable earnings 520 000
Less: (R2 million × 25%) interest (500 000)
Residual income 20 000
and the manager would be encouraged to accept the investment.

Division B
Division B has a current return on investment of only 10%. If the manager wishes to improve his ROI,
he will accept the project, as it offers a ROI of 20% (or higher), which improves the current ROI of
10%.
Based on residual income, we get

Controllable earnings 200 000
Less: (R1 million × 25%) interest (250 000)
Residual income (50 000)
and the manager will reject the investment
Conclusion
Residual income is more in line with overall group objectives than ROI, and managers will act in their
personal best interests as well as those of the group/company when performance is evaluated on
residual income basis.
The same conclusion is obtained when evaluating the disposal of assets against taking on new
investments.
Comparing inter-divisional performance

The comparison of inter-divisional performance is also a dangerous practice, as no two divisions are
structured identically, own the same assets, or necessarily sell the same products. Performance
comparisons will be meaningless when
l the age of the assets is different and hence the depreciation allowance will be different
l one division is labour-intensive while another is capital-intensive
l one division owns its production or building facilities while another leases or rents
l products are sold in different markets with different pricing strategies
l different inventory valuation methods are used
l different expenditure accrual bases are used.
When comparing the performance of two or more divisions, it is necessary to look at all group assets
as well as group income and expenditure in order to establish how to distribute them to the
divisions. It most instances, we find that some of the assets as well as part of the income and
expenditure belong to Head Office; consequently, they should not be allocated to the divisions.
When calculating divisional residual income or divisional EVA, it is necessary to evaluate each
division’s business and financial risk if the divisions are not in the same industry. You cannot apply
the same required return or WACC in charging the notional interest if the business activities are
different. It is therefore possible that two divisions of a particular company are evaluated at different
required returns.
The following information relating to two divisions in the same industry has been made
available:
R’000 R’000
Land and buildings 29 000 20 890
Plant and equipment 15 000 3 000
Vehicles 900 600
Inventory 2 000 5 000
Debtors 3 000 500
Cash 100 10
Investment 50 000 30 000
Income statement
Revenue 17 500 9 300
Production overhead 3 000 2 000
Depreciation 1 000 300
Leases – 1 000
Head Office allocated costs 500 500
Profit 11 000 4 500
l Division A purchased the land and buildings in 19X0

l Division B purchased the land and buildings in 19Y0
l Division A uses variable costing while Division B uses absorption costing. Fixed costs
included in inventory amount to R3 000 000
l Division A’s plant, equipment and vehicles are 10 years old. The replacement value is
estimated to be double the carry value. Division B’s assets (plant, equipment and vehicles)
are new, but it leases half its asset requirement
l The cost of capital is 20%
Consumer index
19X0 100
19Y0 130
19Y6 150

(a) Determine the ROI for Divisions A and B on a net assets basis.
(b) Determine the residual income for both divisions.
(c) Calculate the ROI for both divisions on a net realisable basis making adjustments as
required to place both divisions on an equal comparative basis.
Solution
(a) Division A Division B
R’000 R’000
Profit 11 000 4 500
Add back: H/O allocation 500 500
Controllable profit 11 500 5 000
Controllable investment 50 000 30 000
11 500 5 000
ROI = × 100 × 100
50 000 30 000
= 23% 16,67%
OR: 11 500 5 000

× 100 × 100
50 500 30 150
= 22,77% 16,58%
(b) Division A Division B
R’000 R’000
Controllable profit 11 500 5 000
Notional interest
50 000 × 20% 10 000
30 000 × 20% 6 000
Residual income 1 500 – 1 000
(c) Inter-divisional comparisons require that all assets and income are placed on the same basis so
that like is compared to like. Clearly, whatever adjustments are carried out, the resultant
comparative figures will always be questionable.
Statement of Financial Income statement
Position
Division A Division B Division A Division B
R’000 R’000 R’000 R’000
Closing balance 50 000 30 000 11 500 5 000
Adjustment to land
and buildings:
Division A + 14 500
(29 000 × 150 / 100) – 29 000 + 3 214
Division B
(20 890 × 150 / 130) – 20 890
Adjustment to Division B from
absorption to variable costing – 3 000 – 3 000
Fixed asset at replacement
value + 15 900 – 1 000
Equivalent asset value
from leasing + 3 600
Replacement value 80 400 33 814 10 500 2 000
Notional interest (16 080) (6 763)
Residual income (5 580) (4 763)
10 500
ROI Division A × 100 = 13,1%
80 400
2 000
ROI Division B × 100 = 5,9%
33 814
Conclusion
Both ROI and RI have been criticised for, amongst other things,
l an overemphasis on short-term results
l a concern with quantitative aspects only
l questionable choice of investment basis
l incorrect inter-divisional comparisons
l encouraging dysfunctional objectives.
An emphasis on short-term goals will lead to a lack of long-term planning, which could have
disastrous consequences for the division and, indeed, the group. It is unfortunate that managers are
rewarded for their short-term successes and are seldom around to see the inevitable long-term
consequences. It must once again be emphasised that both qualitative and quantitative reasons are
necessary to create a balance assessment of performance.
In terms of broad principles one would, however, conclude that in the event that a divisional
manager is not authorised to make capital investment decisions, or cannot influence the investment
in working capital, return on investment is a satisfactory performance measure. When divisional
managers can significantly influence the investment in working capital, the residual income method
is more appropriate. In situations in which divisional managers are aware of the opportunity cost of
corporate funds, the use of residual income measures means that divisional profits and company
profits are maximised.
Appendix
in this chapter.
J plc’s business is organised into divisions. For operating purposes, each division is regarded as an
investment centre, with divisional managers enjoying substantial autonomy in their selection of
investment projects. Divisional managers are rewarded via a remuneration package which is linked to
a return on investment (ROI) performance measure. The ROI calculation is based on the net carry
value of assets at the beginning of the year. Although there is a high degree of autonomy in
investment selection, approval to go ahead has to be obtained from group management at the Head
Office in order to release the finance.
Division X is currently investigating three independent investment proposals. If they appear
acceptable, it wishes to assign each a priority in the event that funds may not be available to cover all
three. Group finance staff assesses the cost of capital to the company at 15%.
The details of the three proposals are

Project A Project B Project C
R’000 R’000 R’000
Initial cash outlay on
property, plant and equipment 60 60 60
Net cash inflow in year 1 21 25 10
Ignore tax and residual values.
Depreciation is straight-line over asset life, which is four years in each case.

(a) Give an appraisal of the three investment proposals from a divisional and from a company point
of view. (20 marks)
(b) Explain any divergence between these two points of view and demonstrate techniques by which
the views of both the division and the company can be brought into line. (15 marks)
Solution
(a) Divisional viewpoint – Return on investment
Project A Years
1 2 3 4
Net asset value at beginning of year 60 45 30 15
Net cash-flow 21 21 21 21
Depreciation 15 15 15 15
Net profit 6 6 6 6
ROI 10% 13,33% 20% 40%
Project B Years
1 2 3 4
Net profit 10 5 5 0
ROI 16,67% 11,1% 16,67% –
Project C Years
1 2 3 4
Net profit (5) 5 15 25
ROI (8,3%) 11,1% 50% 166,67%
As the divisional managers are rewarded on the basis of return on investment, they will choose
the investment that gives them the highest ROI, in order to maximise their remuneration
package.
Divisional managers will have to decide whether they are looking for short- or long-term
rewards. In the short-term, managers would choose Project B as this gives them the highest
ROI. Project C would be rejected as it has a negative ROI of 8,3% in the first year.
However, if the managers are looking to long-term rewards, they will choose Project C, because
of its high returns in Years 3 and 4.
Residual income (not required)

Project A Years
1 2 3 4
Net profit 6 6 6 6
Cost of capital (15% of NAV) 9 6,75 4,5 2,25
RI (3) (0,75) 1,5 3,75
Project B Years
1 2 3 4
Net profit 10 5 5 0
RI 1 (1,75) 0,5 (2,25)
Project C Years
1 2 3 4
Net profit (5) 5 15 25
RI (14) (1,75) 10,5 22,75
If divisional managers were evaluated on the basis of residual income, it is likely that the
manager would choose Project B in the short-term and Project C in the long-term.
Company viewpoint – Net present value evaluation
Discount rate 15%
Project A Investment – R60 000
Cash-flow 21 000 × 2,855 + R59 955
+ R45
Project B Investment – R60 000
Cash-flow 25 000 × 0,87 + R21 750
Cash-flow 20 000 × 0,76 + R15 200
Cash-flow 20 000 × 0,66 + R13 200
Cash-flow 15 000 × 0,57 + R8 550
– R1 300
Project C Investment – R60 000
Cash-flow 10 000 × 0,87 + R8 700
Cash-flow 20 000 × 0,76 + R15 200
Cash-flow 30 000 × 0,66 + R19 800
Cash-flow 40 000 × 0,57 + R22 800
+ R6 500
The company would prefer Project C, as it yields the highest positive net present value of
R6 500.
(b) Measurement and evaluation of divisional performance requires a clear distinction between
short-and long-term performance evaluation. The long-term divisional performance should be
related to the long-term return on investment, ie the discounting of future cash-flows at the
target weighted average cost of capital.
management and are often used to determine salary and bonus payments. The problem with
this type of assessment is that managers may concentrate on short-term operating decisions
that will enhance their performance to the detriment of long-term objectives.
When evaluating short-term performance, it is important to use more than one measure
to ensure that management remains in line with corporate objectives. The following
measurements help to focus on overall performance, not only financial measures:
l new products
Reconciling the short-term decision to the long term NPV method is difficult, and conflict is
inevitable. Attempts have been made to devise a system that yields short-term results that are
not in conflict with their long-term counterparts, but all have associated problems.
The residual income approach does in fact equal the NPV method when looked at over the life
of the project, but in the short-term managers are likely to make decisions that are not
congruent with overall company objectives.
Practice questions
Kruise (Pty) Ltd is the Head Office of four divisions known as Lorton, Lever, Morley and Zareena.
Lorton and Lever operate in the home appliances sector, but Lever is more capital-intensive. Morley
and Zareena operate in the chemical industry, which is more risky than the home appliances sector.
All finance requirements are raised by Head Office, which in turn charges the divisions with interest
as appropriate. Head Office also does the invoicing, debt collection and payments for all divisions.
Kruise (Pty) Ltd has recently paid a dividend of R160 per share. There are 100 000 shares in issue,
currently trading at a price of R800 per share. The ordinary shareholders equity is R4,8 million. Long-
term debt in the Statement of Financial Position amounts to R20 million and Head Office pays
R3,6 million after tax annually for long-term interest. Kruise (Pty) Ltd has recently raised long-term
debt for Lorton at a rate of 12% per annum after tax.
The results for the divisions for the year ended 31 August 19X1 are as follows:
Division
Lorton Lever Morley Zareena
R’m R’m R’m R’m
Sales 44,2 26,0 70,0 22,6
Cost of sales 24,3 10,0 49,0 11,3
Gross profit 19,9 16,0 21,0 11,3
Exchange loss – – 1,4 –
Depreciation 6,5 7,0 2,0 2,5
Interest 4,2 1,0 2,0 –
Head Office charge 1,2 1,2 2,4 ,8
Profit before tax 8,0 6,8 13,2 8,0
Taxation 4,0 3,4 6,6 4,0
Profit after tax 4,0 3,4 6,6 4,0
Net assets (at year end) 52 28 14 5

1 The exchange losses are due to export sales. Morley has, over the last few years, developed a
good foreign market for its products by selling at a discount price.
2 Head Office charges each division R400 000 for a share of Head Office overheads plus a direct
charge for work done on their behalf.
3 Head Office compares and rewards the performance of each divisional manager by calculating the
return on net average assets. Profit is taken as divisional profit after tax. The division with the
highest return is also given a large bonus.

1 Briefly outline how a company should evaluate divisional performance as well as the problems of
comparing one division to another. (8 marks)
2 Discuss the problems of inter-divisional comparisons as carried out by Kruise (Pty) Ltd.
Note: You are not required to do any calculations. (12 marks)
3 Evaluate the performance of each division by calculating the return on average assets and residual
income.
Your calculations must include or exclude those items that you consider to be appropriate. You do
not have to apply the criteria used by Head Office unless it is correct to do so in your opinion.
(15 marks)
Solution
1 Measurement and evaluation of divisional performance requires a clear distinction between
short- and long-term performance evaluations. Long-term divisional performance should be
related to the long-term return on investment, ie the discounting of future cash-flows at the
target weighted average cost of capital.
managers, and are often used to determine salary and bonus payments. The problem with this
type of assessment is that managers may concentrate on short-term operating decisions that will
enhance their performance to the detriment of long-term objectives.
When evaluating short-term performance, it is important to use more than one measure to
ensure that management remains in line with corporate objectives. The following measurements
help to focus on overall performance and not only financial measures:
l new products
The comparison of inter-divisional performance is also a dangerous practice, as no two divisions
are structured identically, own the same assets or necessarily sell the same products.
Performance comparisons will be meaningless when
l the age of the assets is different, thus the depreciation allowance will be different
l one division is labour-intensive, while another is capital-intensive
l one division owns its production or building facilities, while another leases or rents
l products are sold in different markets with different pricing strategies
l different inventory valuation methods are used
l different expenditure accrual bases are used.
It is important that no division employ a short-term profit-maximising strategy to the detriment of
the company as a whole. An example would be where a division charges a transfer price that will
decrease the overall company profitability. Where possible, the performance of the autonomous
division should be evaluated on all income and expenditure under the direct control of the
manager. Allocated costs and decisions should be isolated when determining division
performance.
2 Head Office evaluates performance based on return on average assets only.

Problems associated with return on average assets:
l The definition of what constitutes “profit” is very debatable. The inclusion of depreciation,
interest on debt, Head Office costs and taxation could distort the return on assets measure, as
well as performance evaluation.
l Depreciation used by the division could be over- or understated, depending on the life of the
assets.
l Interest is a finance cost and should not be included when calculating return on assets. In the
case of Kruise, it is a particular problem, as some divisions may be more adversely affected
than others if most of their investments were financed using debt.
l Allocated Head Office costs should not be included as they are not controllable by the
division.
l Kruise evaluates return on assets by looking at net average assets. This is a major problem, as
the value of the assets will decrease from year to year, causing return on assets to increase
substantially in nominal terms. Where assets are not replaced regularly, the return will tend
towards infinity.
l Taxation may have different timing differences which will distort performance evaluation.
Inter-divisional comparisons
1 Lorton and Lever are in the same industry and could, within limits be compared to one another.
Problems
l Comparative size of divisions.
l Gross profit percentages are different due to sales in different markets.
l Lorton has a higher interest charge.
l Lever’s assets are much older than Lorton’s.
l Lever is more capital-intensive than Lorton.
2 Morley and Zareena can also (within limits) be compared one to another.
Problems
l Morley exports, Zareena does not.
l Gross profit and cost structure are different.
l Morley’s assets appear to be financed by debt, while Zareena has been financed via equity.
l Head Office does more work for Morley than for Zareena.
l Comparative size of divisions.
l Zareena’s assets are much older than Morley’s.
3 Return on average assets

Division
Profit after tax 4,0 3,4 6,6 4,0
Add back:
Head Office charge 0,4 0,4 0,4 0,4
Interest 4,2 1,0 2,0 –
Controllable profit 8,6 4,8 9,0 4,4
Average assets:
Net assets (at year-end) 52,00 28,0 14,0 5,00
Plus: ½ depreciation 3,25 3,5 1,0 1,25
Average assets 55,25 31,5 15,0 6,25
Return 8,60 4,8 9,0 4,40
55,25 31,5 15,0 6,25
= 15,6% 15,24% 60% 70,4%
Exchange loss has been included in the calculations above as Morley exports regularly – exchange
losses are therefore a normal business cost.
Residual income
WACC Equity value R800 × 100 000 = R80 000 000
160
Ke = = 20%
800
Market value of debt = 3,6 / 12% = R30 million
Kd = 12%
80 30
WACC = × 20 + × 12 = 17,82%
110 110
Division
Controllable profit 8,6 4,8 9,0 4,4
55,25 × 17,82 (9,8)
31,50 × 17,82 (5,6)
15,00 × 17,82 (2,7)
6,25 × 17,82 (1,1)
Residual income (1,2) (0,8) 6,3 3,3
Note: As Morley and Zareena are more risky than Lorton and Lever, the WACC should be adjusted
to reflect business risk, to (for example) 14% for Lorton and Lever and (say) 20% for Morley
and Zareena.
Remaining life of assets
Lorton 52 / 6,5 = 8 years Morley 14 / 2 = 7 years
Lever 28 / 7 = 4 years Zareena 5 / 2,5 = 2 years
Lorton has marginally outperformed Lever, based on return on investment. However, considering
that Lever is more capital-intensive and that the average age of its assets is only 4 years, its return on
assets is very flattering. We note, however, that based on residual income, which represents long-
term performance, both divisions have failed to yield a return above WACC. One should also argue in
favour of a WACC below 17,82% as both divisions have lower business risk than the other two
divisions in the group.
We would expect the return on assets of both Morley and Zareena to be higher than that of Lorton
and Lever, due to higher business risk. Although Zareena has performed better than Morley on the
basis of return on assets, we again note that the average age of the assets is only 2 years in
comparison to 7 years for Morley. There is no doubt that Morley has done far better than Zareena in
real terms.

Two divisions (A and B) have the following financial statements:
19X2 19X1 19X0 19X2 19X1 19X0
R’000 R’000 R’000 R’000 R’000 R’000
Fixed plant 1 200 1 000 1 000 300 200 200
Equipment 300 400 500 60 80 100
Debtors 200 180 160 100 120 100
Inventory 400 350 320 200 180 160
Cash – 40 – 30 – 30 20 10 15
Creditors – 200 – 200 – 200 – 220 – 180 – 200
Long-term liabilities 500 500 500 600 600 600
Income and expenditure
Market sales 2 800 2 500 2 000 10 000 9 000 8 000
Division sales 1 500 1 200 800 1 000 880 800
Costs:
Material 250 220 140 300 280 270
Labour 200 140 120 180 160 150
Depreciation 150 140 130 25 20 20
Equipment rental – – – 100 100 100
Factory rental – – – 100 100 100
Maintenance 140 130 120 25 20 15
H/O allocated costs 220 220 220 100 100 100
Net profit 540 350 70 170 100 45
The required rate of return for both divisions is 20%.

(a) Calculate the following for each division
(i) return on investment
(ii) residual income
(iii) market share
(iv) annual sales growth
(v) net profit percentage
(vi) asset turnover.
(b) Determine which division is performing better.
Solution
(a) Division A Division B
19X2 19X1 19X0 19X2 19X1 19X0
R’000 R’000 R’000 R’000 R’000 R’000
Property, plant and equipment 1 500 1 400 1 500 360 280 300
Net current assets 360 300 250 100 130 75
Net assets 1 860 1 700 1 750 460 410 375
Net profit 540 350 70 170 100 45
H/O costs 220 220 220 100 100 100
760 570 290 270 200 145
Interest (20%) – 372 – 340 – 350 – 92 – 82 – 75
Residual income 388 230 60 178 118 70
(i) Return on investment

19X2 19X1 19X0 19X2 19X1 19X0
R’000 R’000 R’000 R’000 R’000 R’000
760 570 290 270 200 145
1 860 1 700 1 750 460 410 375
= 41% = 34% = 17% = 59% = 49% = 39%
Note: The above figures have been calculated on the basis of asset value at the end of
the year. Asset value is normally based on the average value during the year or
the value at the beginning of the year. As carry values are incorrect in times of
inflation, as long as the comparisons between divisions are done on the same
basis for each division, the above figures are acceptable.
(ii) Residual income (see above)
(iii) Market share
19X2 19X1 19X0 19X2 19X1 19X0
R’000 R’000 R’000 R’000 R’000 R’000
1 500 1 200 800 1 000 880 800
2 800 2 500 2 000 10 000 9 000 8 000
= 54% = 48% = 40% = 10% = 9,8% = 10%
(iv) Annual sales growth

19X0 – 19X1 19X1 – 19X2 19X0 – 19X1 19X1 – 19X2
400 300 80 120
800 1 200 800 880
= 50% = 25% = 10% = 14%
(v) Net profit percentage (based on profit before Head Office costs)
19X2 19X1 19X0 19X2 19X1 19X0
R’000 R’000 R’000 R’000 R’000 R’000
760 570 290 270 200 145
1 500 1 200 800 1 000 880 800
= 51% = 48% = 36% = 27% = 23% = 18%
(vi) Asset turnover
19X2 19X1 19X0 19X2 19X1 19X0
R’000 R’000 R’000 R’000 R’000 R’000
1 500 1 200 800 1 000 880 800
1 860 1 700 1 750 460 410 375
0,8 0,7 0,5 2,2 2,1 2,1
(b) Division B is doing better on ROI and asset turnover. The advantage that Division B has over
Division A is that it appears to own few assets and therefore has a low asset base. This has the
effect of distorting performance and highlights the problems that arise with ROI (and residual
income) when the asset base is low. Division A appears to be in a strong position with reference
to sales growth, market share and net profit percentage. This example shows that, when various
measures are taken into account, a clearer picture of comparative performance emerges.
Examination
technique
What is the biggest problem you encounter when writing exams?
Students all give the same answer, ie:
l lack of time to answer the questions
l poor examination technique.
Time management
You seldom have enough time in an examination. The problem, however, is not a lack of time. In fact,
if you were given an extra hour or two, the chances are that you could still do with more time.
Let us agree – There is never going to be enough time to complete the exam. Now that this is resolved,
what becomes important is to know how you can manage your exam time better, in order to
MAXIMISE your mark.
Why do examiners not give you more time? Because the examiner assumes that you are very well
prepared and if you are, then time is not a problem. But (as you know) you will never be as prepared as
you would like to be, so lack of time will always be a problem. Secondly, examinations, particularly
accounting-related exams, try to place a certain amount of time pressure on the student, as in a work
environment you do not have all the time in the world to do the work and you are therefore required to
perform in the exam with a certain amount of time constraint.
Given our experience in setting examination questions for nearly 20 years, you can be assured that ALL
reasonably prepared students should pass a 60-minute question within 40 minutes. If you cannot pass
a question within 40 minutes, you will never pass it, not even if you had 120 minutes. You either know
how to do it or you do not. If your knowledge of a particular topic is very good, it is impossible to get
less than 75% because of a lack of time.
“Rubbish!”, you may say. Well, read on!
Examination technique
Let me ask you – Do you have poor exam technique?
– What is exam technique?
– If you do have poor exam technique, how long have you known this?
– If you have known this for a long time, then why have you not done something
about it?
Most university students have been writing exams for at least 10 years, so how is it possible that they
have poor exam technique?
It is easy to tell you what you should or should not do when writing exams, but you will never get it
right if you go through the whole exercise of good exam technique just before the exam. Why not?
Assume that you have never driven a car, and that you went to the best driving instructor in the
world and said to him: “I have a driving exam in a few hours’ time. Please show me how to drive the
car and give me all the tips that I require to pass the exam.” He can certainly sit you in the car and
show you how the pedals work and how to change gears, etc., but – guess what? You will still fail.
What is missing? Practice.
Most students practice how to write exams when they sit down and the examiner says, “You may start
writing”. You have no chance if you have not practised examination technique. The art of practicing is
far more than just sitting down with a time constraint and practising writing an exam. Practice starts
495
with study methods, tutorial questions, learning from tutorial solutions, etc. When you eventually sit
down to write your final exam, you should know in advance
l how to read a question
l how to identify what scores marks
l how to plan your answer
l how to answer the question.
Good examination technique should start at the beginning of the year.
What are the elements that lead to maximising your final mark and developing better study
methods?
1 How examiners set exam questions

If you know in advance what the objective of an examiner is when setting examination questions,
you can style your learning habits in order to ensure that the knowledge you gain is in line with the
type of question you will get in the exam.
When an examiner sets a question, he does not write the first thing that comes into his head and at the
end of the process say “Wow, look what has come out! It is a relevant costing question!” Setting a
question is very much like baking a cake. First, you choose the type of cake you want to bake, eg. “a
Milk Tart”. Then you identify all the ingredients required to bake the cake and, as each cook has his
own style of baking, he will add or take away certain ingredients in order to make his own style of “Milk
Tart”. And so it is with setting examination questions.
First, an examiner will choose the “topic” to be examined – let us say “relevant costing”. An
examiner may in fact decide that he wants to examine relevant costing with cost structure
implications.
Next, he will choose the principles (ingredients) that will be examined in the question. In
composing the question, the examiner will have a very definite plan of how many fundamental
principles, such as fixed cost per unit, total fixed costs, fixed costs when absorption rate is given,
overheads, variable costs, absorption costs, limiting factors, probabilities, etc., he wants to
examine.
It is these fundamental principles that the examiner wants to question you about. Maximising
marks is not about getting the bigger picture right; it is about getting the detail right. The
examiner structures a question with seven or eight different principles within the context of
relevant costing. The question will now be worded in a manner that contains all eight principles
and you are now required to identify them, sort them out, explain, and show that you
understand each principle.
Now that you know that the examiner focuses on several fundamental principles, you must study
in a manner that enables you to identify and learn these principles. After all, that is where the
marks are.
Note: The question requirement will not state: “Using the information given above, identify the
following eight principles and explain what you know about each of them.” All that the
question will state is that “You are required to prepare a budget income statement.” It is very
possible that the words “relevant costing” do not appear in the question at all.
Now: If you were given a question on relevant costing in the exam, where must you concentrate
your efforts to maximise your marks?
l The relevant costing identification?
l The income statement?
l Or none of the above?
Answer – None of the above.

If you want to score marks, you must know that the question is about the underlying fundamental
principles such as limiting factors, contribution, calculation of fixed costs, etc., and not necessarily
about the relevant costing topic or the income statement required in the question.
Chapter 15: Examination technique 497
Knowing this, when you attend lectures, or when you study, you MUST
l identify the fundamental principles
l UNDERSTAND the logic of the principles.
Do not simply learn how to do the correct solution to a question. Rather try to understand the logic
behind the solution. Always ask, “What is the principle in this solution and WHY is it done this way?”
Sometimes it appears that the solution is done one way in a particular question and in a different
way in another question. Ask yourself “Why?”, because there must be a logical reason.
Examiners ask underlying principles, not topics.

KNOW THE PRINCIPLES – SCORE MARKS
2 What you should listen out for in lectures, and how you should read a text book
The key to good learning methods is not knowing how to do a question but understanding why a
particular topic exists and understanding the logic behind the topic. Consider “absorption costing”. You
already know what absorption costing is about. Does that mean that you fully understand the
fundamental principle of absorption costing? Not necessarily. Very often, you will read a statement and
say to yourself, “Yes, I understand that, I see how it works.”
The reality, however, is that you have a very superficial understanding of the principle; a very single
dimensional understanding. Your limited understanding is soon exposed when you get a tutorial
question and all of a sudden you have no idea how to do it. Why can you not do it? You cannot do it
because a single principle is very often multi-faceted.
The only way to fully understand a principle is to do several tutorial questions that expose the different
facets of the underlying principle. Until you have questioned the logic of a principle by studying (in
depth) the text books and tutorial questions, you have zero knowledge.
When doing a tutorial question, play Devil’s advocate. Ask yourself how the solution would change if
the information was changed to “such and such”. For example, if, instead of giving you fixed cost per
unit, what if you got the total under-recovered overhead, how would you determine the total fixed
cost?
Step 1: When you read or go to a lecture, keep asking “WHY?”
Step 2: Ask “WHY?”
Step 3: Ask “WHY?”
Never learn from a book or solution without asking “WHY?” If you do not ask “WHY?” you could
easily fall into the trap of looking at a solution and saying “Oh, I see how it is done. Next time I see
this I know what to do”. REALLY? What if the information has been changed slightly next time you
see it? Will you still know what to do, or will you say, “This is not fair! I have never seen it done this
way”?
When you see an example in a book or lecture, ask yourself “Why is it like this? What is the purpose
of this topic?” Once you can answer these questions and understand the principles, then you are on
the right track. Regrettably, at school you were taught to learn without understanding. NOW you
need to start learning with understanding. You will find that it is more time-consuming to learn with
a critical mind but (on the plus side) if you understand the principles, you will never forget how to do
it.
Do you want to be an accountant? If your answer is “Yes”, then the requirement for a good
accountant is one that can think, can see the bigger picture, has an enquiring mind and is always
thinking of other ways to solve a problem. DEVELOP LATERAL VISION. A lousy accountant is one that
memorises as much as possible and fills his or her head with mush!! The more you learn, and the
more you memorise without understanding, the bigger your problem and the lower your exam
result.
Difficult or unfair questions:

Has it ever happened to you that you learn a particular topic and you know it well, it comes up in the
exam, but it is so difficult that you have little idea of what to do?
It is possible to get a question on a topic that you have learned very well, and it is equally possible that
the question is very difficult or very different to what you are accustomed to. However, the underlying
principles have not changed; therefore, if you know how to look for them and how to do them, you will
do well. It is not getting the question right that matters, it is applying as many principles as possible that
matters.
If the question is unfair, difficult, too long, or (horrors of horrors!) the examiner has messed up, what
are your chances of passing? It sometimes happens that an examiner has not been entirely fair, or the
question is ambiguous or there is a major error in the question. When the examiner marks the scripts,
he will have to sort out the problem somehow. He will not fail everyone because of the problem, but
will be more generous in awarding marks for the easy sections, or will award bonus marks. If you make
sure you get the easy principles correct, you will maximise your mark.
Remember, the name of the game is to accumulate as many easy marks as possible and not necessarily
to get the question right. See below on how to answer a question.
So, when all is said and done, what must you do to have a good study technique?
l Read a chapter to get an overall view of what it is about.
l Read it again to identify the underlying or fundamental principles.
l List the principles.
l Learn the principles and keep asking “WHY?”, “WHY?”, “WHY?”.
Note: You will always find that, when you have finished studying a topic, think that you know it and
try to do a tutorial question, you just cannot succeed. This will be addressed under the next
heading.
3 How you should do tutorial questions

The real “practising of examination questions” starts here. Most students will tell you that most of the
learning comes from doing tutorial questions and studying solutions. And so it should be. Regrettably, a
lot of that learning is done incorrectly by looking at a question and its solution without first attempting
the question. If that is how you learn, all you are doing is memorising a question and hoping that
exactly the same question will come up in an exam. I have news for you: it will not. But what will come
up is the same underlying principles that were identified in your tutorials.
In the previous section, it was stated that you should identify the fundamental principles and
understand how they work before attempting a tutorial question. Does that mean that you should
know how to do the tutorial question after reading the text book? Unfortunately, not really. Why
should that be? Well, when you studied the text and when a principle was explained to you in a lecture,
the example used was a simple one so that you would not get confused by too much detail. The tutorial
question you are now attempting is more difficult, has a lot more information, and (more importantly)
contains other principles that have been grouped together. If effective learning is to take place, it is
important that you do tutorial questions as follows:
l Read the question and identify what topic or topics are being examined. The “required” will
obviously give you a good idea.
l Break the question down by paragraph or sentence and see if you can identify the underlying
principles. You see, when an examiner writes a paragraph, the chances are that the paragraph
has information about an underlying principle. In other words, break the question down into a
series of short questions.
l Write down the principles that you have identified and try to see into the examiner’s mind to
determine what he was thinking about when he composed the paragraph.
l Now start the tutorial question. But, where should you start?
Another good examination tip:

Questions at this level cloud the information to some extent with unnecessary information. The
objective is to break down the question into small manageable parts and do them one at a time. You
must distinguish between relevant and irrelevant information.
l A 60-minute question will take you about 120 to 150 minutes to complete, so do not worry about
the fact that it takes you so long to complete a tutorial question. However, you must spend as
much time as possible trying to do the question.
Do not wait for the solution to learn how to do it. The reason why it is so important to do a tutorial
question properly and spend a lot of time studying the solution is because it is very possible that the
principles you thought you understood when you read the text book actually went over your head, or
you missed the point altogether.
The tutorial question has exposed your lack of knowledge, so you must now go back to the text and
determine why you missed the boat. In other words, go back to the text to understand more clearly
what the principle really is.
Remember: If you do not attempt tutorial questions in “examination mode” ie neatly, with proper
headings and workings, you will never have good exam technique.
4 How to read a tutorial solution

The solution shows the logical sequence that the examiner had in mind when he was setting the
question. It is therefore very important that you study the solution and learn from it. The most
important page of the solution is the first. If the solution has been done “correctly”, it will start
where the examiner would have expected you to have started and it should follow a logical
sequence. Any other sequence will lead to a lousy answer that is lengthy and hard to follow.
1 Identify the sequence in which the information given in the question was used in the solution.
Does it follow a logical sequence? Did you start there? If not, why not?
2 Identify the principles in the solution. Each one should have a heading, eg fixed costs, followed by
the analysis and workings of fixed costs.
3 Keep asking “Why was it done like this? What is the principle?” Learn “why”? NOT “HOW?”
4 Go through your attempted solution and learn from your mistakes.
5 List the principles that have come out in the tutorial question and make sure you understand
them.
When learning for exams it is obviously very important to go through all the tutorial questions
thoroughly. I suggest you do the following:
(i) Read the question as if you were writing the exam.
(ii) Write down the headings you would have used in the exam.
(iii) Very briefly, write down what you would have done and why you would have done it.
(iv) Look at the solution, heading by heading, and verify that your sequence is the same as the
solution’s, and that everything you would have done is there. If there is anything in the
solution that you did not have in your rough solution, or is done differently, and you have it
wrong.
YOU MUST –
Spend time studying that portion of the solution. Go back to the text. Re-learn. Look for the
same principle in other questions and look out for variations of that principle. Look for the
same principle worded differently elsewhere, particularly in other questions. Learn to cross-
reference a principle to another question, or start a list that tells you where that principle
appeared. For example, “Limiting factors: Q2 – 4, Q2 – 6, Q7 – 3, Q8 – 2”.
Building up a good cross-referencing system should enable you to cover all the possible
permutations. Do not look at the solution and think to yourself “But of course, silly me, in the
exam I will not make that mistake!” Watch out. You will make that mistake!!!!!
Never look at a question and solution side-by-side for the first time.
Never read a question and give up without trying to answer it. Do not think that it will be a waste
of time trying those that you think you cannot do. Often when you look at the solution, you will
say “Of course, silly me for not seeing it. In the exam I will get it right”. The problem is that in the
exam you will not get a question worded exactly the same way as the tutorial question. It may be
similar, and examine the same principles, but it will be worded differently. In the exam you
cannot say “OK, you got me, I give up! Now can I have a look at the solution?”
Important – Learn from the solution, particularly in respect of the

l headings used
l workings done
l style of solution.
If your solution does not look like the official solution, you are in trouble.
Examination day – how to read examination questions

The name of the game is to score as many marks as possible and not necessarily to get the right
answer. There are no extra marks awarded for getting the right answer. Marks are awarded for
getting the underlying workings or principles correct.
Answering an examination question is like doing a puzzle. When you do a puzzle, you do not just pick
up a piece and position it on a table. First, you sort the pieces by colour and shape, then you do the
border, followed by a colour section at a time. So it is with exam questions. You do not start writing
as soon as the gun goes off, so to speak. First, you need to sort out the information, plan, and then
you start to answer. For a 60-minute question, you should read/sort/plan for 10–15 minutes. It is not
a waste of time. A waste of time is when you start in a rush and you are forever crossing-out and
putting yourself under pressure.
1 Read the information handed out to get an overview of the situation. Do not attempt to guess
what is in the required. Remember, the purpose of reading time is for you to calmly acquaint
yourself with the information supplied. Look at possible links or breaks in the information.
2 On receiving the “Required” section, read the requirement to get an idea of the topic being
examined and what it is that is required of you. Reread the given information now and then
analyse the information to highlight the principles.
A word of caution – The “Required” in the question sometimes gives you little idea of where the
marks are. For example, a 40-mark question could ask for the “Budget income statement” (see
illustrative example at the end). Many students immediately start with the income statement. The
problem is that the marks awarded for the income statement may be as little as 5 out of 40
marks. The other 35 marks will be awarded for your workings and underlying principles.
3 Every time you identify a principle in the question, write it down in the margin of the question.
For example: Potential limiting factor; or high/low; or overhead cost analysis.
4 For every principle identified in Step 3, write down how many marks you think you will get for the
workings required.
5 Add up the identified easy marks. On a 40-mark question you should have identified at least 15
easy marks before you start answering the question.
5 How to answer a question in the exam

1 Plan. Organise your thoughts and decide where you are going to start, the order in which you
will do the workings and the headings you will use. You will normally find that the best place to
start your answer is to use the information given in the question, near the beginning. In fact,
your solution should follow the order in which the information was given in the question.
Think about it, if the question was done in a logical manner, ie, first a principle with the
applicable information, followed by a second principle with the applicable information, etc., it is
only logical that your solution should follow the same order. When a question has (say) 3
requirements, you will very often find that requirement 1 only requires the information given in
the first half of the question. Requirement 2 will then require the second half of the information
and requirement 3 probably asks for your opinion or forecast of projected results.
2 Do the workings first – ie, analyse the principles. This is where the marks are.
Use headings.
In other words, tell the examiner what you are about to do. Make it clear.
Often your answer is such that the examiner marks many figures and has no idea what you are
doing because you have not communicated what you are doing and why.
Often markers will remark that they get the impression that a student thinks that it is up to the
examiner to sort his workings out for him. “After all,” the student seems to think, “I am under
pressure.”
3 Do not make mistakes in the first page of your solution. If you write 3 pages and you get 21/40,
the chances are that most of the 21 marks (about 15) appear in the first page of the solution.
That is why it is so important that the first page is perfect.
All the easy/obvious marks are awarded for simple workings. Do not make a mistake on the
first page. If you get something that is very simple wrong, you will be heavily penalised, and the
chances are that you will fail the question.
When marking a script, the examiner wants to know if a student wrote neatly, in a manner that
anybody can follow and if he or she got the easy workings correct. If the student got the easy
marks, then examiners tend to find themselves wanting to pass that student and doing
everything to award extra marks.
4 If you have been asked to give an opinion about something, it is important that you first state
the underlying principle before giving your opinion.
For example, if a question asks you, “Do you think that activity-based costing is appropriate for
this company?”, your answer should first explain what activity-based costing is about, why some
companies may choose to use the system, followed by whether or not it is appropriate for the
company in question.
In other words, the examiner wants to know what knowledge you have about ABC – he is
actually not particularly bothered about your opinion!
5 Does your work look professional?
If you want to become an accountant, you had better make sure that your work looks
professional. Is it neat, logical, easy to read? If the answer is “No”, quit now, do not waste your
time. You must project a professional image. Learn how to do this by practising.
Important: When doing tutorial assignments do them and present them as you would in an
examination. Be neat, use headings, be logical. What your tutorials look like is what your exam
paper will look like.
6 Create a good impression:
Have you ever seen a person walk through a door and found yourself liking or disliking that
person without even saying a word to them? Yes? Well, guess what? When an examiner opens
your script, he immediately takes a liking or a dislike to it. If your work looks like a dog’s
breakfast, the examiner will give you the least possible marks. Believe it, it is true! It is all about
projecting a positive impression about your knowledge.
If, on the other hand, your script creates a good impression, you are going to get extra marks
that you probably do not fully deserve, and you will always be given the benefit of the doubt.
So, do yourself a favour and neaten up your solution.
“But I do not have time to be neat!” Take some good advice – concentrate on presenting a neat
script and do not necessarily try to complete a question. Just make sure that what you have
written is neat, presentable and correct. Better to do only 2/3 of a question correctly than to
finish a question that is full of errors.
7 Answer all the questions:
You must (as much as it is humanly possible) attempt all the questions. Remember – the first
page of your solution scores more marks than the last page. This being so, it is better to leave a
question unfinished and start a new question rather than finish a question and leave out the last
question. You can get +/– 18/40 for half a solution. Finishing a question seldom brings huge
rewards. How many times have you finished a question and got 80% or better? Hardly ever?
Well, was it worth spending so much extra time on the question?
8 How to deal with “lemons”:

What do you do if you know how to do a question, but there is a piece of information you do
not know how to use?
Answer – Do not waste your time on it. Either you know it, or you do not. Worrying about it will
not help you. If you have an idea, but you are not entirely sure, answer on the basis of the first
idea you had, or leave out that section altogether. Above all, once you have made a decision, do
not worry about it. It is water under the bridge. Do not waste time thinking. Besides, the
chances are that it is only worth 4 or so marks, so why lose the next 10 minutes worrying about
it?
I suggest that you first try to answer the question that appears to be the easiest, and try to save
+/– 5 minutes on each question. In other words, try to build up about 15 free minutes, so that at
the end of the exam you can spend those 15 minutes in the most productive manner. There is
nothing worse than going over time on several questions, only to discover that the question you
have left out altogether is in fact the easiest question and that you could have passed it if you
had had a few extra minutes!
9 What if the paper is very difficult?
Do not panic. If you have done your work and know it, it does not matter whether the paper is
difficult or easy. You are, in a sense, competing against all the other students writing the paper.
If it is difficult for you, it is difficult for them. An easy paper will be marked strictly, while a
difficult paper will be marked leniently, and at times extra marks will be awarded. This is even
more reason to make sure you do all the easy sections in a difficult paper clearly and correctly. If
extra marks are awarded, they will be for the easy sections.
10 How to answer a discussion question:
How many times have you answered a discussion question thinking that you have done well,
and then found that you have actually failed? When you get the solution, you think “I knew
that. If that is what they wanted why did they not say so?” Well, it happens, and unfortunately
far more often than one would like. Try this:
Step 1 Identify the topic being examined. The “required” should tell you, or give you a hint. The
information should confirm the area being examined or provide enough evidence about
what is required. “What if I think that the required is asking one thing but the information
suggests something different?” Well, are you sure the requirement is clear or are you
reading something into the “required” that was not intended? In most instances, you will
find that the information given in the question is more important than the requirement.
Think about it, why would they give you the information if it is not required? To trick you?
Not likely.
Step 2 Plan your answer. If you know what topic is being examined and if you give them the
information pertaining to that topic, you will pass. Write down key words or BUZZ words.
First state the principle of a topic, even if they did not directly ask for it, followed by your
opinion.
Step 3 Use headings to convey the importance of what you are about to write.
Step 4 Try to always write in point form. Alternatively, write only one or two sentences per
paragraph and leave a line gap after every valid point. Each point or sentence should
contain a principle and must be worth a mark. If you know you are waffling, stop wasting
your time.
Step 5 Very important – use as much of the information given in the question as possible. The
longer the question, the more you must use the information given as part of your answer.
Either comment on the information given, or use it to illustrate the principle. It is
commonly found that students tend to avoid the information given. Do not be a fool, USE
IT! For example, assume that in the examination you are given the following information:
Joe is thinking of purchasing a company in the shoe industry which is capital-intensive and
exports to Japan . . . etc.
Required – give advice on whether he should purchase the company.
The solution must deal with:

Shoe industry – good/bad industry? What do you know about it?
Capital-intensive – should the company be capital-intensive? Discuss advantages and
disadvantages of capital-intensive vs labour-intensive.
Exports – is that good or bad? Use of capacity, selling at a profit/loss, etc. . . .
Conclusion
Read the information provided carefully.
Read the “Required” section.
Choose which question you will answer first.
Reread the information relating to that question.
Identify the items in the question that will score marks.
Plan your answer in order to maximise marks.
Do not Do influence the marker

Write a book Keep your answer short
Write out laundry lists Write neatly
Repeat yourself Use a ruler
Go off the subject Cross out neatly (do not use Tippex)
Be positive
Write the obvious
Be aware of time
Do not leave out a question
Write in point form or short paragraphs
Sample Question (45 marks 80 minutes)

Burtie Ltd is a subsidiary of Burling Ltd. Burling is a well-diversified group with operations in different
sectors. One of the company’s stronger investments was in Burtie Ltd. The investment was made about
5 years ago and to date has rendered a good return on investment.
Burtie Ltd operates as a manufacturer producing two products which are well set in the market.
However, expectations are that sales may still increase in the near future as there are few competitors
in the market.
All the raw material for the production process is imported by Burtie Ltd. It also has a large interest
commitment which is expected to amount to R2 810 000 for the year ending 28 February 2013. Where
necessary, Burling Ltd takes out forward cover to hedge the expenses and make planning easier. In the
past, Burling incurred heavy losses when forward cover was not taken. All currency deals are approved
by Head Office, in their sole discretion. The CFO makes an allocation to companies in the group, based
on their past performance.
WHAT DO WE DO ABOUT INTEREST?
Due to the specialised nature of the manufacturing process, the company uses highly-skilled labour
which is not freely available. Management has a permanent workforce that it nurses to ensure
production does not suffer from strikes or inefficiencies.
The following information regarding Burtie Ltd was gathered by a junior accountant and presented to
you. The inexperienced lad only made rough notes on certain areas and did not bother to fully highlight
all aspects.
1 The company produces two products which are used in the manufacturing industry, namely Exe
and Zet.
Exe is sold to retailers in the pharmaceutical sector. Exe is used as part of the manufacturing
process of chemotherapy drugs and is in a high demand.
Zet is sold to tyre manufacturers and serves as a bonding and sealing agent to make a more
durable tyre. Several manufactures have enquired about future supply, but Burtie has current
agreements which restrict supplies to other tyre manufacturers.
2 Details of production factors available for the year ended 28 February 2012 are as follows:
CALCULATE MAX CAPACITY 9

Normal annual production capacity is 78 000 machine hours, which represents 80% of the
maximum production capacity, which can be utilised at 100% if required.
POSSIBLE
Labour hours available are 54 000 hours. The same hours will be available in 2013. LIMITING
Due to restrictions on imports, the imported raw material availability was expected FACTORS
not to exceed 630 000 kilograms per annum.
3 The junior accountant summarised the actual production costs for the year ended 28 February
2012 at 78 000 machine hours. This represented usage of 80% of maximum capacity:
CAPACITY GIVEN AGAIN ; MUST BE A LIMITING FACTOR
Exe Zet
R per unit R per unit
WORK OUT
Imported raw material: R25 per kg 37,50 62,50 Kg
Labour: R200 per hour 50,00 40,00 Hrs 99
Production overheads: Hrs
R75 per machine hour 15,00 30,00
Total production costs 102,50 132,50
WORK OUT FIXED and VARIABLE COSTS 9999

Production overheads, of which 40% are fixed, are not expected to increase during the year
ending 28 February 2013.
4 As stated earlier, all foreign exchange arrangements regarding the group’s import requirements
are made by the corporate Head Office, which then allocates the available foreign currency to the
companies in the group.
Enquiries made at corporate Head Office indicated that the foreign currency LIMITING
allocated to Burtie Ltd for the year ending 28 February 2013 could be as follows: FACTOR?
Probability
Increase of 26% on last year 0,50 EXPECTED
Same amount as last year 0,20 VALUE 9
Decrease of 10% on last year 0,30
5 Estimations of changes in costs and sales for the year ending 28 February 2013 are expected to be
as follows:
(a) The costs of imported raw materials are expected to increase by 20% on
the landed cost per kilogram compared to 2012 INCREASE
VALUE
(b) The labourers are constantly receiving offers from other manufacturing
companies. To incentivise them not to leave, management indicated that
99
hourly wage rates would increase by 25% compared to 2012
(c) The administrative overheads should increase by 2,5% on the 2012 cost of
R80 000. This is a small increase resulting from proper planning
(d) The sales team has reviewed the marketing strategy and the demandC A L C U L A T E
for the products for 2013 is estimated to be as follows: CONTRIBUTION
PER LIMITING
M U S T• B E
LIMITING
• Exe: 80 000 units at a selling price of R171,50 per unit FACTOR 9999
FACTOR • Zet: 180 000 units at a selling price of R185,50 per unit
6 The marketing division prepared the following variable budget with regard to the monthly selling
expenditure for the year ending 28 February 2013:
Combined sales Selling expenses
(units) (R)
15 000 412 500
HIGH / LOW 999
20 000 450 000
24 000 480 000
7 Burtie Ltd was asked to tender for a government department order for a
product which is the same as product Zet, with the exception of a slightly NOT IN
different final makeup. Although this is only a once-off order, it could pave the 1ST
REQUIREMENT
way for further orders in the future. The managing director would therefore
like the tender to be successful.
The tender has the following implications:
(a) 20 000 units of the product will have to be delivered evenly throughout the year.
(b) An additional machine, costing R170 000, will have to be purchased for the final finish of the
product.
(c) An existing foreman earning R50 000 per year will have to supervise the production of the
product. It is estimated that, although he will spend 30% of his time on supervision of the
government contract, his total hours will remain the same as at present.
8 The company has an effective tax rate of 28%.
9 Burtie Ltd is confident that it will be exempt from the surcharge on imported raw materials.
SO?
Required
(a) Prepare a budgeted income statement for the year ending 28 February 2013 showing:
1 Budgeted net income for the year without the government contract (34) MOST
M ARKS
2 Budgeted net income for the year should the tender be successful (6)
Show the following as part of your answer:
The quantity of each of Exe and Zet that must be produced in each case.
The tender price for the delivery of the product to the government department,
where the tender is at the lowest price possible without adversely affecting the
company’s net income.
(b) Discuss any other qualitative factors that may be taken into account in determining
the final tender price. (5)
NOTE: THIS QUESTION REQUIRES ABOUT 100 10 0 MINUTES TO COMPLETE UNDER EXAM
CONDITIONS; HOWEVER; IT IS EASY TO GET ± 28 MARKS
Suggested solution
(a) 1 (from note 2 in question)
Machine hours
Maximum capacity 78 000 divided by 80% = 97 500 hours 99
2 (from note 3 in question)
Calculation of usage and hours
Raw material
Exe usage (2012: R37,50 divided by R25 = 1,5 kg) 9
Zet usage (2012: R62,50 divided by R25 = 2,5 kg)
Labour hours
Exe usage (2012: R50 divided by R200 = 0,25 hours) 9
Zet usage (2012: R40 divided by R200 = 0,2 hours)
Machine hours
Exe usage (2012: R15 divided by R75 = 0,2 hours) 9
Zet usage (2012: R30 divided by R75 = 0,4 hours)
(From note 2 in question)
Potential limiting factors
Machine hours
Required for 2013 production
Hours
Exe: 0,2 × 80 000 = 16 000
Zet: 0,4 × 180 000 = 72 000
88 000 99
Machine hours available = 97 500 hours; therefore machine hours is not a limiting factor.
Labour hours
Maximum available 54 000 hours
Hours
Exe 0,25 × 80 000 = 20 000
Zet 0,2 × 180 000 = 36 000
56 000 999
Labour is a limiting factor
Raw material
Kg
Exe: 1,5 × 80 000 = 120 000
Zet: 2,5 × 180 000 = 450 000
570 000 99
Assuming a continuous probability distribution, the foreign currency available will be

Probability
126% × 0,50 = 63%
100% × 0,20 = 20%
90% × 0,30 = 27%
110%
2012 foreign currency

630 000 × 25 = R15 750 000 9
Increase of 10% for 2013 on above amount = R17 325 000 9
Raw material cost in 2013 = R25 + 20% of R25 = R30 9
Raw material available in 2013
= R17 325 000 divided by R30 = 577 500 kg
Therefore raw material is not a limiting factor 9
3 Cost analysis
(From notes 3 and 5 in question)
Fixed costs: R75 × 40% = R30
Annual R30 × 78 000 hours = R2 340 000 999
Material – increase by 20%
Exe R37,50 × 120% = R45
Zet R62,50 × 120% = R75 9
Labour – 25% increase
Exe R50 × 125% = R62,50
Zet R40 × 125% = R50,00 9
Variable cost
Exe R15 × 60% = R9
Zet R30 × 60% = R18 99
4 Selling expenses
Units R
High 24 000 480 000
Low 15 000 412 500
9 000 R67 500 99
Therefore R67 500 divided by 9 000 units = R7,50 variable per unit 9
Fixed = R480 000 – (24 000 × 7,50) = R300 000
Annual fixed costs =R300 000 × 12 = R3 600 000 99
5 Contribution per limiting factor – Labour

Exe Zet
R R
Sell 171,50 185,50
Variable costs:
Material 45,00 75,00
Labour 62,50 50,00
Variable O/H 9,00 18,00
Variable selling 7,50 7,50
99 Contribution 47,50 35,00
divided by labour hrs 0,25 0,20
99 Contribution per labour hour = 190,00 = 175,00
Labour
hours
99 Therefore sell and produce: 80 000 Exe 20 000
170 000 Zet 34 000
54 000
Budgeted income statement for the year ended 28 February 2013

Exe Zet Total
Sales (units) 80 000 170 000
R R R
Sales value 13 720 000 31 535 000 45 255 000
Material (W1) (3 600 000) (12 750 000) (16 350 000)
Labour (W2) (5 000 000) (8 500 000) (13 500 000)
Variable costs (W3) (720 000) (3 060 000) (3 780 000)
Fixed costs (W4) – – (2 340 000)
9 Interest (2 810 000)
99 Selling expenditure (W5) (5 475 000)
Tax (50 400)
Workings
(W1) 2013 Exe 45 × 80 000 = 360 000
2013 Zet 75 × 170 000 = 1 275 0000
(W2) 2013 Exe 62,50 × 80 000 = 500 000
2013 Zet 50 × 170 000 = 850 000
(W3) 2013 Exe 9 × 80 000 = 72 000
2013 Zet 18 × 170 000 = 306 000
(W4) Fixed costs R2 340 000 (see above)
(W5) Variable costs 250 000 × 7,50 = R1 875 000
Total selling costs R1 875 000 + R3 600 000 = R5 475 000
Tender price
Reduction in income R
Zet 20 000 × 185,50 (3 710 000)
Reduction in costs
Variable selling 20 000 × 7,50 + 150 000 999
Increased costs
Minimum tender price 3 730 000
Budgeted income statement for the year ended 28 February 2013

Exe Zet Contract Total
Units 80 000 150 000 20 000
R R R R
99Sales value 13 720 000 27 825 000 3 730 000 45 275 000
Material (16 350 000)
Labour (13 500 000)
Variable costs (3 780 000)
Fixed costs (2 340 000)
Interest (2 810 000)
Selling expenditure (5 325 000)
Tax (50 400)
(b) 99999
1 Accepting the special order means that the company will have to drop the sales of Zet by
20 000 units. The future effect on its current Zet customers must therefore be considered.
2 Marketing expenses will be reduced by R150 000. If this amount represents commission
payments, then the company must consider the effect on its employees.
3 The company is at full capacity in terms of labour hours. If labour hours cannot be increased,
then the company should consider quoting a high tender price, as its profits will not be
affected if the tender is lost. The company is only just above break-even and it would be
advisable to attempt to increase the selling price.

Managerial Accounting J 1 1

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Managerial

ISBN 978 0 409 1 2086 8

First Edition 1999, Reprinted 2000

Editor: Beryl Kirsten

Technical Editor: Liz Bisschoff

Printed in South Africa by Interpak Books Pietermaritzburg

Chapter 1 The meaning of management accounting ........................................................... 1

Linear regression analysis ..................................................................................... 179

Chapter 12 Linear programming............................................................................................. 403

IAS 2 on Inventories states the following:

Financial accounting system

Allocate costs to production and service departments

Allocate costs from service to production departments

Calculate an overhead recovery rate

Using a pre-determined overhead recovery rate will result in either an

Company cost structure

How do we arrive at the value for the closing inventory?

Therefore cost per unit R610 000 / 1 000 = R610

Income and expenditure account

Is there a different/better method of determining production cost?

Management accounting can best be defined as follows:

Cost volume profit

We therefore have the following analysis:

What is wrong with the word “profit”?

2 500 Variable costs

In the example above we get

200 Fixed costs

Illustrative example – Variable costing

You are required to:

Budget profit 10 000 units R1 000 000

Explanation of actual profit

Closing inventory valuation:

The absorption costing dilemma

Illustrative example – Absorption costing

You are required to:

Closing inventory can be valued as follows:

2 Actual variable cost of production

2 Actual total cost of production method

Is absorption costing acceptable?

The cost volume chart

Units 8 333 10 000

Flexed budget if sales had been anticipated to be as high as 12 000 units:

Actual profit on a variable costing basis

Selling price decrease (600)

A report should now be prepared explaining:

Identifying relevant information

Variable costs 90 000

You are required to discuss:

What is the most important line in the above example?

Closing inventory R45 000 ÷ 500 units = R90

Variable costing statement

(v) In terms of CVP relationships:

Key fundamental principles

After studying this chapter you should be able to:

What does “contribution” mean?

Valuation of a single unit of production

External reporting Internal decision

Sunk costs Recovery of

Product valuation for financial accounting purposes

Cost absorption rate