Ma Book Revised

Sources and analysis of data 1
Table of Contents
Foreword................................................................................................................................................. 2
The nature, source and purpose of management information ............................................................ 13
Data analysis and statistical techniques ............................................................................................... 25
Sources and analysis of data ................................................................................................ 26
Summarizing and analyzing data.......................................................................................... 43
Sampling and statistical techniques ..................................................................................... 55
Cost and its analysis ............................................................................................................. 86
Cost accounting techniques .................................................................................................................. 95
Accounting for materials ...................................................................................................... 96
Accounting for labour......................................................................................................... 113
Accounting for overheads .................................................................................................. 123
Absorption and marginal costing ....................................................................................... 138
Job, Batch and Service costing ........................................................................................... 151
Process costing ................................................................................................................... 157
Alternate costing methods ................................................................................................. 172
Budgeting ............................................................................................................................................ 177
Budgeting ........................................................................................................................... 178
Capital budgeting ............................................................................................................... 208
Standard costing ................................................................................................................................. 222
Variance analysis ................................................................................................................ 223
Performance measurement ................................................................................................................ 256
Performance measurement techniques ............................................................................ 257
Foreword
‘By the ACCA, for the ACCA’
These notes are designed with a simple mission, to fill the gap for Indian students who don’t find
comfort in studying from notes that are framed in a complex manner. Our priority at Zell is to improve
the results our students achieve by providing all that they need, be it quality education, state of the
art infrastructure and techniques or the next step, the content that perfectly fits in making the trifecta
or the winning formula.
Here at Zell, we don’t worry about the background, prior knowledge or preferences someone has. The
aim is simple, by the time a student is done with a paper, they are on the same page as anyone else
and that for us, should be enough knowledge to be able to call them a professional truly.
Keeping all this in mind, we bring to you these notes, created by us, for you, to truly help make the
difference and turn your journey of ACCA into an even better one. This is just the beginning; there is
more in store.
Thank you
Credits
Authored By:
Rashesh Majithia
Shobha Lakhani
Riddhi Chheda
Designed By:
Rohan Shah
Ravi Gupta
Best way to study

Planning how to study
Before starting the preparation for any paper, you should always make a macro level plan on how to
go about preparing for the exam. Understand what is expected of you to be able to clear the exam
with high scores. It is important to set targets and stick to them, to ensure that you stay on track and
progress in your ACCA journey.
Have a plan from the beginning about where you want to be at the end of the month or two months,
then work backwards and understand what you must do to stay on track. Then, at the start of every
week, make a brief plan about how much needs to be covered every day, resulting in the timely
completion of the exam.
Break your macro plan intro studying along with the professor/recordings, examination month and
final revision. Plan how many hours can you give every day and make a schedule accordingly. Ensure
that you can give quality hours without distractions. The quantity of hours doesn’t matter.
How to approach the exam
Knowing how much importance ACCA places on application-based learning is important. You must
understand that rote learning in any exam for any concept will mostly amount to zero marks being
scored.
Further, students tend to take many days after the classes conclude for their self-preparation phase,
which tends to work negatively. The maximum time you should take after completing the classes is
21 days, after which, while you might practice more, the retention of the vast range of topics
covered in class will become faint.
The ideal approach is to watch/attend lectures and keep up with the pace, practising 40% of the
question bank alongside, to cement conceptual understanding. Once classes conclude, ensure the
remaining 60% of the question bank is solved, followed by at least three mock examinations before
attempting the main exam.
Exam month
• In the exam month, ensure that you finish the portion as soon as possible and shift all focus
to completing the question bank. Remember, completing the textbook alone is not enough,
whereas completing the question bank gives you a higher chance of clearing the exam.
• If you are done with your question bank, repeat the question bank or key questions you
marked before the exam. Only 40% of your total time should be allocated to building a
conceptual understanding, the remaining 60% to solve questions.
• Ensure you do not get into the habit of reading a question and then reading the answer. This
approach will make you seek answers in the exam and not seek solutions on your own. Read
a question, solve it on your own, check the answer. If it is incorrect, solve the question again
to get another answer, rather than reading the explanation to understand what you did
wrong. That should always be the last resort.
• Familiarise yourself with the scientific calculator, the CBE exam platform and other tools to
ensure you are comfortable with the same in the actual exam.
• Ensure you complete 100% of the portion. Do not skip anything as the exam will test you on
a range of interconnected topics, and leaving parts of the portion will guarantee you are
losing certain marks.
Exam strategy
There are certain things to be kept in mind before attempting the main exam.
1. Remain calm before the exam. Do not study at the last moment, as going into the exam with
a fresh mind will allow you to tackle the questions more easily.
2. There is no negative marketing in the exams. Ensure that you attempt 100% of the paper to
ensure that some of your educated guesses score some marks even in the worst case.
3. The examination is 2 hours long, which means you have 120 minutes for 100 marks, or simply
1.2 minutes per mark. Ensure you don’t get overboard with the time you take to solve a
question at hand.
4. Ensure you read the question very carefully. Please don’t assume that you faced a similar
question in the past and jump to solving it as the requirements can vary even in small
concepts causing you to lose easy marks.
5. The options are set up so that even answers derived using the wrong steps are available as
options. Please do not jump to the conclusion that your answer has to be correct because it is
available as an option.
6. If there is a tricky question that you can’t solve, make an educated guess by eliminating the
one’s you know are wrong, flag the question and move ahead. If you finish the paper and
have remaining time, revisit the flag questions to score full marks.
7. Do not sit and recalculate the answer you got more than twice, as you are likely to calculate it
in the same way you did previously, by repeating the same mistake if any. This is a massive
waste of your crucial time. Rather move faster and revisit key questions at the end,
recalculating your answers at that point will possibly reveal mistakes and allow you to rectify
them, thus scoring more marks.
Elements
Syllabus wise study material
The study material is curated in a manner where the syllabus provided by ACCA has been covered in
vast depth, and the order is set in a way that the flow of concepts within the material suits a
student.
Illustration
Various AYK style questions test the student on their ability to remember and understand concepts
thoroughly before moving to analytical questions.
Quiz
Further, there are primarily application-based quiz questions, introducing the student to analytical
and evaluative questions to bring the student one step closer to actual exam-style questions.
Recap
After the end of every main chapter, there is a recap page summarising all the important topics,
formulae etc., to enable ease of revision for the student.
Mind Maps
Mind maps are flowcharts that summarise the information visually, making it more likely for a
student to retain the knowledge and build upon it. These are present at the end of the book to
enable last-minute revision by simply spending time on those pages.
Nimbus™ Preparation tools
Interactive notes with gamification
The articulated version of the notes is available on the platform, allowing students to get fully
immersed in their learning and complete more in less or equivalent time they spend reading the
book.
Case studies
Case studies are specifically tailored to address the audience commonly using these notes. Having
interesting case studies based on current affairs, covering key organisations etc., contribute to
further professional development.
Technical articles
ACCA’s technical articles are placed strategically in the material, allowing students to understand
when to go through these all-important technical articles.
Exam experience
The system mimics the exam experience to ensure that the student has conceptually and technically
mastered the paper before appearing for the exam. This includes various objective questions, live
spreadsheets and word processors to practice typing, presentation and most importantly, time
management.
Question Bank & Test Series
The students have access to unit tests, half portion tests, progressive tests, mock tests and unlimited
practice tests with all performance data allowing them to know where they stand, the
improvements required before the exam day arrives.
Flashcards and Interactive mind maps for revision
Flashcards help students quiz themselves, which is more effective as a revision technique than
simply reading through pages. Interactive mind maps allow the student the power to take a detailed
glance through a whole chapter or large concept in minutes while revising at the same time.
Check the last page of this book for more information on Nimbus™ LMS by Zell
ACCA support
Examining team guidance/Exam technique & reports
The examiners’ reports are an essential study resource. Read them to learn about mistakes that
students commonly make in exams and how to avoid them.
Practice tests
Practice Tests are an interactive study support resource that will replicate the format of all the
exams available as on-demand computer-based exams (CBEs). They will help you to identify your
strengths and weaknesses before you take an exam.
As well as giving you an insight into a live exam experience, Practice Tests will also provide feedback
on your performance. Once you complete the test, you will receive a personalised feedback diagram
showing how you have performed across the different areas of the syllabus.
Specimen exams
The specimen exam indicates how the exam will be assessed, structured and the likely style and
range of questions that could be asked. Any student preparing to take this exam should familiarise
themselves with the exam style.
Technical articles
There is a range of technical articles available on ACCAs website under ‘Study support resources’.
These include a range of simplified articles on complex topics, study support videos, articles on exam
technique etc. making it an important tool to be practised when nearing the exam.
FAQs
Various commonly asked questions about the style of the examination, the coverage, computer-based
exam setup etc., are covered here to allow a student to stay up to date and ensure their understanding
is aligned with that of the ACCA body.
Syllabus
Introduction to the syllabus
The syllabus for Management Accounting (MA)/(FMA), introduces candidates to elements of

management accounting which are used to make and support decisions.
The syllabus starts by introducing the nature, the source and purpose of management information
followed by the statistical techniques used to analyse data. Then the syllabus addresses cost
accounting and the costing techniques used in business which are essential for any management
accountant.
The syllabus then looks at the preparation and use of budgeting and standard costing and variance
analysis as essential tools for planning and controlling business activities. The syllabus concludes with
an introduction to measuring and monitoring the performance of an organisation.
Main capabilities
On successful completion of this exam, candidates should be able to:
A. Explain the nature, source and purpose of management information
B. Explain and analyse data analysis and statistical techniques
C. Explain and apply cost accounting techniques
D. Prepare budgets for planning and control
E. Compare actual costs with standard costs and analyse any variances
F. Explain and apply performance measurements and monitor business performance.
ACCA Performance Objectives

Objective Chapter In Text
PO1 Ethics and professionalism Accounting for management and presenting
information
PO12 Evaluate management accounting systems Summarizing and analyzing data
PO13 Plan and control performance Performance measurement techniques
PO14 Monitor performance Performance measurement techniques
PO22 Data analysis and decision support Variance Analysis
Structure
The syllabus is assessed by two-hour computer-based examination. Questions will assess all parts of
the syllabus and will test knowledge and some comprehension or application of this knowledge. The
examination will consist of two sections. Section A will contain 35 two-mark objective test questions
(OTs). Section B will contain 3 ten-mark multi-task questions (MTQs) each of which will examine
Budgeting, Standard costing and Performance measurement sections of the syllabus
Formulae Sheet
Regression analysis
y = a + bx
∑𝑦 𝑏∑𝑥
a= −
𝑛 𝑛
𝑛 ∑ 𝑥𝑦− ∑ 𝑥 ∑ 𝑦
b=
𝑛 ∑ 𝑥2−(∑ 𝑥)2
𝑛 ∑ 𝑥𝑦− ∑ 𝑥 ∑ 𝑦
r =
√(𝑛 ∑ 𝑥2−(∑ 𝑥)2)(𝑛 ∑ 𝑦2− (∑ 𝑦)2)
Economic order quantity
2𝐶0𝐷
=√
𝐶ℎ
Economic batch quantity
2𝐶0𝐷
= √𝐶 𝐷
ℎ (1− 𝑅 )
Arithmetic mean
Ʃ𝑓𝑥
𝑥= Ʃ𝑥
𝑥 = (frequency distribution)
𝑛 Ʃ𝑓
Standard deviation
∑(𝑥−𝑥)2 ∑ 𝑓𝑥2 ∑ 𝑓𝑥 2
σ=√ σ=√ −( (frequency distribution)
𝑛 ∑𝑓
∑𝑓
)
Variance
= σ𝟐
Co-efficient of variation
σ
CV =
𝑥
Present Value Table
Present value of 1 i.e. (1 + r)-n

Where r = discount rate
n = number of periods until payment
Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 0·980 0·961 0·943 0·925 0·907 0·890 0·873 0·857 0·842 0·826 2
3 0·971 0·942 0·915 0·889 0·864 0·840 0·816 0·794 0·772 0·751 3
4 0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683 4
5 0·951 0·906 0·863 0·822 0·784 0·747 0·713 0·681 0·650 0·621 5
6 0·942 0·888 0·837 0·790 0·746 0·705 0·666 0·630 0·596 0·564 6
7 0·933 0·871 0·813 0·760 0·711 0·665 0·623 0·583 0·547 0·513 7
8 0·923 0·853 0·789 0·731 0·677 0·627 0·582 0·540 0·502 0·467 8
9 0·914 0·837 0·766 0·703 0·645 0·592 0·544 0·500 0·460 0·424 9
10 0·905 0·820 0·744 0·676 0·614 0·558 0·508 0·463 0·422 0·386 10
11 0·896 0·804 0·722 0·650 0·585 0·527 0·475 0·429 0·388 0·350 11
12 0·887 0·788 0·701 0·625 0·557 0·497 0·444 0·397 0·356 0·319 12
13 0·879 0·773 0·681 0·601 0·530 0·469 0·415 0·368 0·326 0·290 13
14 0·870 0·758 0·661 0·577 0·505 0·442 0·388 0·340 0·299 0·263 14
15 0·861 0·743 0·642 0·555 0·481 0·417 0·362 0·315 0·275 0·239 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 0·812 0·797 0·783 0·769 0·756 0·743 0·731 0·718 0·706 0·694 2
3 0·731 0·712 0·693 0·675 0·658 0·641 0·624 0·609 0·593 0·579 3
4 0·659 0·636 0·613 0·592 0·572 0·552 0·534 0·516 0·499 0·482 4
5 0·593 0·567 0·543 0·519 0·497 0·476 0·456 0·437 0·419 0·402 5
6 0·535 0·507 0·480 0·456 0·432 0·410 0·390 0·370 0·352 0·335 6
7 0·482 0·452 0·425 0·400 0·376 0·354 0·333 0·314 0·296 0·279 7
8 0·434 0·404 0·376 0·351 0·327 0·305 0·285 0·266 0·249 0·233 8
9 0·391 0·361 0·333 0·308 0·284 0·263 0·243 0·225 0·209 0·194 9
10 0·352 0·322 0·295 0·270 0·247 0·227 0·208 0·191 0·176 0·162 10
11 0·317 0·287 0·261 0·237 0·215 0·195 0·178 0·162 0·148 0·135 11
12 0·286 0·257 0·231 0·208 0·187 0·168 0·152 0·137 0·124 0·112 12
13 0·258 0·229 0·204 0·182 0·163 0·145 0·130 0·116 0·104 0·093 13
14 0·232 0·205 0·181 0·160 0·141 0·125 0·111 0·099 0·088 0·078 14
15 0·209 0·183 0·160 0·140 0·123 0·108 0·095 0·084 0·074 0·065 15
Annuity Table
1 - (1 + r)-n
Present value of an annuity of 1 i.e. r
Where r = discount rate

n=number ofperiods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3
4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6
7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10
11 10·37 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11
12 11·26 10·58 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12
13 12·13 11·35 10·63 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·00 12·11 11·30 10·56 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·87 12·85 11·94 11·12 10·38 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326 6
7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9
10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10
11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12
13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
To find the area under the normal curve between the mean and a point Z standard deviations above the
mean, use the table below. The corresponding area for a point Z standard deviations below the mean can
be found through using symmetry.
(𝒙− 𝝁)
Z=
𝝈
Standard normal distribution table
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 0·1950 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 0·4864 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 0·4931 0·4932 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
The nature, source and purpose of management information

Cost Accounting
Cost and management accounting exists to assist management in running the business in ways that
will improve the performance of the business.
Cost accounting and management accounting are terms that are used interchangably, however cost
accounting is a PART of management accounting, they are not the same thing.
Cost accounting mainly deals with:

- preparing statements (budgets)
- cost data collection
- applying costs to inventory/products/services
Whereas management accounting deals with all this and more!
Management Accounting
Management accounting is mainly concerned with providing information to managers.
5 Purposes of Management Accounting
Decision Control & Performance

Costing Planning
making Coordination measurement
1) Costing
2) Planning
3) Decision making
4) Control and coordination
5) Performance measurement/motivation
Let’s see how all these purposes are achieved with an example.
Example
Aveer Co manufactures desks and then sells them in retail stores.
Aveer is the management accountant of Aveer Co, he is responsible for:
• costing (e.g.) finding the cost of producing a desk, so that the selling price can be decided
• planning (e.g.) number of desks to produce this year
• decision making (e.g.) how much wood to purchase for the required production
• control and coordination (e.g.) control the amount of wood being used in each desk
• performance measurement (e.g.) evaluate whether more/less wood was used per desk in
comparison to the original plan. If less wood is used per desk, then the production manager has
done a great job, and he can be given a bonus! $$ = Motivation
Planning: setting of goals

Process on how to achieve the goal based on the information provided
Identify the ways in which the goals could be achieved.
Decision: Implement the decisions taken in the planning process
Control: Collect information on the actual results

Compare the actual result and the expected results, if there is a difference, investigate the
reason
Revise the original goals if necessary
Management accounting vs Financial accounting
Financial accounts are things like your balance sheet/income statement/statement of cash flows,
whereas management accounts include things like future budgets.
You need to know the differences between both for the exam, so learn this well!
Management Accounting Financial Accounting

Legally required? No Yes
Time period Looks into the past and future Only looks into the past
Users and decision makers Mainly internal use by Mainly external use by
management and employees - Shareholders/government/bank
but can be used externally also s, but can be used internally
also
Purpose of information To aid management in planning, To record the financial
decision making, control position/performance of the
business
Formats Managers will decide the According to company law
presentation that is most useful (accounting standards must be
complied with)
Nature of information Monetary and non-monetary Monetary information only
information
Differences between levels of planning
There are 3 levels of planning:
Level Purpose Management Time Examples

horizon
Strategic To formulate long term objectives Senior 3-5 New markets to
(goals) and plan (strategies) for an years enter / new
organisation as a whole. products to develop
Also known as long term or planning
horizons or corporate planning
Tactical Shorter term plans for individual areas Middle 1 year Annual budget
in the business to enable the strategic forecasts /
plan to be achieved. Productivity
measures.
Short term decision

making (e.g.)
lowering a selling
price to achieve
higher sales
Operational Involves day to day decisions about Front line Day to Department work
what to do next and how to deal with Day plan for the week
problems as they arise.
👩‍🏫 Illustration 1:
Which of the following activities is an example of tactical planning?
a) A construction company decided to launch residential property in Australia in the next 5 years.
b) A line manager delegates the responsibility of ordering materials for the next week to his juniors
c) The design team of a construction company plans to change the layouts of a building proposed
next year.
Ans: c)
Data consists of raw facts and figures gathered and stored. It has no clear meaning until it is
processed, analyzed and sorted into information.
Information is data processed in such a way so that it is meaningful to the person who uses it to
make decisions.
For example, data can be gathered on costs and revenues of producing and selling 10 products.
Information would be a report analyzing the profitability of each product to help the manager decide
which product to produce.
Quantitative Or Qualitative
Data can be either quantitative or qualitative, as can information.

• If data can be measured, it is quantitative

e.g. value of sales per day
• If it cannot be measured, then it is qualitative
It is the management accountant who is expected to provide the information to management to
assist them with their decisions.
Attributes of good information
The attributes of good information can be explained with the acronym:
Remember ACCURATE in the exam
Full form Explanation Example

A Accurate Information should be If senior managers are
accurate but not given incorrect
excessive. information about
sales revenue - this can
lead to serious and
damaging
consequences for the
business! However,
managers won’t need
each detail (e.g.) they
will need sales revenue
in thousands, they will
not need each decimal
place.
C Complete but not The information If senior management
excessive provided should be wants to decide
everything needed to whether to launch a
make the decision, not new product, they will
unnecessary need revenues and
information. costs, they will not
need details of the
number of workers
that will be hired to
make the product.
C Cost effective The information should Profit from the new
not cost more than the product if launched is
benefit it will provide. $100,000.
Information required
to arrive at a profit
figure of $120,000.
BAD IDEA!
U Understandable Information should be Many managers do not
understandable to the understand financial
people who are using jargon; therefore, it
it. should be presented in
a way that they will

understand.
R Relevant Information provided

should be relevant to
the decision being
made.
A Accessible Information provided If the manager who
should be accessible by needs the information
the person who needs is in another country,
it. send an email! Do not
the report on his desk!
T Timely Information should be A manager needs to
provided before the make a decision about
decision that needs to whether the lower the
be made, there is no selling price of his
point in the product as a new
information being competitor is entering
provided after. the market. He should
receive the information
before the competition
enters, not after!
E Easy to use Information should be Pie charts / graphs etc.
easy to use.
Mission statement
“The mission statement is a statement in writing that describes the overall aims of an organization
that is what it is trying to accomplish. In other words, it sets out the whole purpose of the business.
There are 4 key elements to the mission statement:
Purpose
Mission
Values Strategy
statement
Policies
&
Culture
1. Purpose: As to why and for whom the business exists

2. Strategy: What and how the business provides.
3. Policies and culture: A particular way in which the staff is supposed to behave
4. Values: Core principles of the business.
Example:
Mission statement of Nike:
“To bring inspiration and innovation to every athlete in the world. If you have a body, you are an
athlete.”
Mission statement of Amazon:

“To be Earth’s most customer-centric company, where customers can find and discover anything
they might want to buy online, and endeavors to offer its customers the lowest possible prices.”
Good information should be sufficiently accurate given time and cast constraints. Managers should
be made aware of the degree of accuracy of the information.
Responsibility accounting
Responsibility accounting is identifying individual parts of a business which are the responsibility of
a single manager (i.e.) he has personal responsibility for that part’s performance.
Centre Explanation Examples Manager evaluation

Cost centre This is a part of a Mixing department of Manager is only
business where costs paint responsible for the
are collected. manufacturer/service costs.
locations / purchasing
department.
Revenue centre This is a part of a Retail outlet / Sales Manager is only
business which earns department / Airline responsible for the
sales revenue. reservation revenue earned.
department
Investment centre This is a part of a Subsidiary companies Manager is responsible
business that is like a for profit and
profit center except for investment.
the fact that the Performance can be
manager here is also judged using ROCE / RI
responsible for new / ROI. (Only costs,
capital investment. revenues and capital
employed that are
actually controlled by
the manager should be
included when
calculating
performance
measures).
Profit Center This is a part of a Branch of a company Manager is responsible

business which earns for the entire P&L,
revenue and incurs both the revenue and
cost. the cosrs
The performance of a manager of a division is based on revenue, cost and investment in working
capital / noncurrent assets.
What is this manager?

a) Profit center
b) Investment center
c) Cost center
Ans: b)
Limitations of management information
Management information may fail to assist management accountants in making decisions.
Why?
Reason Explanation
Poor information If the information given to management is not ACCURATE, then
decisions will be incorrect.
Relevant costs and revenues Information that should be used when making a decision should
be relevant.
Relevant information consists of future / cash / incremental costs

and revenues.
However, many times other costs and revenues are also

considered, which do not actually affect the decision - hence
decisions being incorrect.
Non-financial information Management cannot always be correctly guided by the financial
information from internal accounting systems.
An example of non-financial information is customer satisfaction -

and these things need to be considered in order to make correct
decisions.
External environment Management accounting systems collect information from inside
the organisation, however, factors external to the organization
affect decisions also.
For example, an ice cream store is preparing its purchase order

for ice cream based on last month’s sales - however, it has
suddenly started to snow, It looks like ice cream won’t sell, but
the ice cream store is still ordering ice cream because last
month’s sales were high!
• Information for management is likely to be used for Planning, control and decision making
• Financial accounting systems ensure that the assets and liabilities of a business are properly
accounted for and provide information to shareholders while management accounting
system provides information specifically for the use of managers within an organsation, and
cost accounting information provides a bank of data for the management accountant to use.
• Anthony divides management activities into strategic planning, management control and
operational control.
• The characteristic of good information can be remembered using the acronym ‘ACCURATE’
• Cost Centres-cost identified, profit centres- cost and revenue identified, Investment centres-
profit centre with a responsibility for investment, revenue centre – accountable for revenue
only.
1) Which of the following is not a purpose of management accounting?

a) Planning
b) Reprimanding
c) Performance measurement
2) Which of the following statements are true/false?

1) The main users of financial accounting information are external to the organization.
2) Management accounting is that part of financial accounting which records the cash received
and payments made by an organization.
3) Which 3 of the following are correct about management information?

a) The format in which it is produced is provided by the government
b) Mainly intended for use by internal management
c) Forward looking and historical
d) Qualitative and quantitative terms
4) Which of the statements are correct regarding strategic planning?

i. It is concerned with quantifiable and qualitative matters
ii. It is mainly undertaken by Middle management in an organization
iii. It is concerned predominantly with the long term
a) i and ii
b) i and iii
c) ii and iii
d) i, ii and iii
5) Which of the following statements are correct?
a) Strategic planning is concerned with setting short term objectives, whereas operational
planning is concerned with setting long term objectives, and tactical planning is concerned
with a time horizon starting one year from now.
b) Strategic planning only deals with qualitative results, whereas operational and tactical
planning deal with both qualitative and quantitative results
c) Strategic planning is concerned with setting long term objectives, whereas operational
planning is concerned with setting short term objectives, and tactical planning is concerned
with a time horizon starting one year from now.
6) Aditya, the management accountant has communicated a detailed budget to ensure that cost
savings targets are achieved in the forthcoming period.
This is an example of:
a) Operational planning
b) Tactical Planning
c) Strategic planning
7) Is this statement true or false?
“Information is data that has been processed, analyzed and sorted.”
8) ------- is the raw material for data processing.

a) data
b) fact
c) information
9) What is not an attribute of good information?

a) Understandable
b) Irrelevant
c) Timely
d) Cost effective
10) The following statements refer to qualities of good information:
i. It should be communicated to the right person

ii. It should always be completely accurate before it is used
iii. It should be understandable by the recipient
Which of the above statements are correct?
a) 1 and 2 only
b) 1 and 2 and 3
c) 2 and 3 only
d) 1 and 3 only
11) Which of the following will not be controllable by a manager of a profit center?
a) Direct labour cost
b) Direct material cost
c) Investment in new machines
d) Revenue earned by the division
12) Andrew is a manager in a production department Y, he only receives information regarding

planned and actual expenditure. After completion in his department, the product goes through 3
other production departments before being dispatched to customers. He is not responsible for
decisions regarding capital investment.
What type of manager is he?

a) Profit center
b) Investment center
c) Revenue center
d) Cost center
Solutions:
1) b
2) a) True b) False
3) b), c), d)
4) b - Strategic planning is carried out by senior managers and is concerned with long term
planning. Both quantitative and qualitative information is used.
5) c
6) b
7) True
8) Data
9) b
10) d
11) c
12) d
Data analysis and statistical techniques

Sources and analysis of data
Sources of Data
Different sources of information are available to organizations, they can be from within or outside
the organization.
Internal Sources
External Sources
Internal sources of information
Name What is it? What’s good?

Accounting System This system collects data from It can be used to help managers
invoices/timesheets/journals. monitor actual costs with
budgeted costs and help them
make decisions.
Payroll System This system holds information It can be used to help managers
about labour costs. assess labour costs into
productive / non-productive
time (e.g.) idle time and sick pay.
Strategic Planning System This system holds information Only senior management have
relating to the organizations access to this as it holds
objectives and targets. sensitive information.
Benefits of Internal Data

• Readily available data
• Data can easily be sorted and analysed of use to management accountants
• Reports can easily be produced when required
• Data relates to the organization concerned
Limitation of Internal Data

• Data may need to be further analysed to be of use to management accountants
External sources of information
Name Use What’s good? What’s bad?

Government This is primarily used to It can be used in our The data is only
sources provide information organisation (e.g.) using produced in general
regarding economic inflation rates to decide terms - so it may not
planning at a national level. next year budgets. be specific to our
industry/area.
Statistics like interest rates
can also assist our
organization in raising the
right finance.
Business Customers can provide We can use information
contacts information relating to from these parties to make
product specification decisions (e.g.) production
required etc. of products that are actually
desired by
Suppliers can provide customers/purchasing in
information relating to bulk from suppliers to avail
quantity discounts etc. the discount.
Trade Most major industries have Management can use these

associations / their own trade to ensure that we are in line
trade journals association. with the required standards.
They deal with things like

codes of best practice for
the industry.
Financial press Newspapers like The Management can use these

/ business and Economic Times provide to ensure that they are up
other media statistics and financial to date with what is
reviews as well as business happening in the external
economic news and environment.
commentary.
The internet The internet is a global It’s so easy to access and This information can be
network allowing any use the information at any unreliable as anyone
computer with a point in time! can send/receive
telecommunications link to anything. The reliability
send and receive It’s pretty much free! and reputation of the
information to and from provider is very
any other computer. important!
Benefits of External Sources:

• Wide expanse of external sources of the information
• Easily accessible especially using the internet
• More general information available
• Can source specific information needs
Limitations of External Sources:

• Data may not be accurate
• Finding relevant information could be time consuming
Enough about information, let’s talk about data!

Sources of Data
Transactional
Machine/sensor Human
Sources of
Data
There are 3 main sources of data:
1. Machine or sensor data:

Machine or sensor data refers to the information collected from various devices, machines,
or sensors that are equipped with sensors to monitor and measure specific physical or
environmental conditions. These sensors can capture data from the surrounding
environment or the internal state of the device itself. The data collected is typically in the
form of raw measurements or readings.
For example, in industrial settings, sensors monitor machinery performance, temperature,
and production processes to ensure efficiency and safety.
2. Transactional data:
Transactional data refers to the information generated and recorded during various
transactions or interactions between individuals, businesses, or organizations. These
transactions can involve the exchange of goods, services, money, or data, and the data
captured during these interactions is usually structured and organized for specific business
or operational purposes.
For example, sales transactions, financial transactions, travel bookings, inventory
transactions, etc.
3. Human data:
Human data encompasses information derived from various sources directly involving
humans, such as social media posts, handwritten letters, phone calls, questionnaires, and
surveys. It includes any data generated, shared, or provided by individuals in these
interactions, and it often reflects human attributes, preferences, sentiments, and behaviors.
This type of data is widely used in market research, sentiment analysis, customer feedback
analysis, and social studies, among other fields. However, it's essential to handle human
data ethically and ensure data privacy and confidentiality in accordance with relevant
regulations and best practices.
For example, user generated content, academic and research data, location based data, etc.
Types of Data
Data has 2 classifications:
Primary & Secondary

Discrete & Continuous
1) Primary & secondary

2) Discrete & continuous
Primary & Secondary Data
Primary data is data collected specially for a specific purpose. For example, collecting the material
cost of last year so that we can budget for this year, or collecting data outside of a polling station to
determine voter’s choices.
Secondary data is data that has already been collected for a purpose and is now being used by us.
For example, government statistics on inflation will be used by our organization for project feasibility
in the future, or information from a trade association to choose the cheapest supplier in the
industry.
Discrete & Continuous Data
Discrete data is data that will have a specific (integer value), for example, you can have either 1 or 2
people, you cannot have 1/2 a person!
Continuous data is data that can have any value, for example, we can be 50.2348 kg!
Which of the following are pieces of external information that can be used in a management
accounting system?
a) Government statistics
b) Customer returns
Solution: Government statistics
Customer returns are internal to the organization.
It will carry an integer value; it must be collected from outside of the organization and is being
collected for a specific purpose.
Direct and Indirect Data Capture Costs
Direct data is collected directly from the source or subject, providing reliable information. Examples
include surveys, interviews, and observational studies.
Indirect data is obtained from secondary sources or methods not involving the primary source.
Examples include social media data mining and web scraping. It can be useful for obtaining large
datasets and identifying trends but may be less accurate and subject to biases.
Direct costs of information

The primary cost categories related to management accounting data and information are as follows:
1. Data Capture and Processing Costs: These are the direct costs associated with capturing,
processing, analyzing, and utilizing data. For instance, maintaining systems that collect and process
customer data from e-commerce purchases or running reporting platforms that organize and
present data in useful formats like charts and dashboards.
2. Storage Costs: These costs pertain to storing data securely and efficiently. They include expenses
for maintaining on-site storage servers, subscribing to cloud storage services, and managing
database systems that handle data storage and retrieval.
The most significant direct costs in this context are those related to data capture and processing.
Direct Data Capture Costs

Direct data capture costs refer to the expenses incurred specifically for collecting and recording data
directly from the source or primary data generation process. These costs are associated with the
methods, tools, and resources used to capture and input data into a system or database.
Direct data capture methods include a variety of techniques for collecting data directly from the
source. These methods involve:
• Use of Data Forms: Data can be captured through various forms, including manual data
entry into systems, digitalized forms with pre-set fields, and automated processes using
optical character recognition (OCR).
• Machine-Readable Codes: Data can be captured using machine-readable barcodes, QR
codes, or RFID tags, enabling quick and accurate data retrieval.
• Artificial Intelligence (AI) and Algorithmic Processing: AI algorithms can process and codify
non-standardized data captures, such as facial recognition or physical item identification, by
adding associated tags and metadata.
• Large-Scale Data Capture: For extensive data collection, other machines, workforce, and
systems can be employed, including measuring devices and associated systems, laboratory
work, sensors on manufacturing lines, survey drones, and more.
Indirect Data Capture Costs

Indirect data capture costs refer to the expenses incurred in obtaining data from secondary sources
or through methods that do not directly involve the primary data source. These costs are associated
with acquiring data that has been previously collected or generated by others for different purposes.
Indirect data might have a transactional cost, meaning it was purchased directly from another entity,
such as a research firm or university.
There might also be costs in verifying the reliability of the data, such as establishing sources, cross-
referencing with data of known veracity, etc.
Similarly to direct data, indirect data may need to be processed into an appropriate format and
structure before it can be used; this process may also incur costs.
Impact of economic environment on costs/revenue
The economic environment affects firms in a variety of ways.
Specific Factors
Inflation – The impact of inflation will be faced by both the business and the consumer. Increasing
inflation increases costs, hence businesses suffer as profit margins get less. Revenue also decreases
as customers cannot afford all goods during inflation as their purchasing power decreases.
Interest rates – If a business holds debt with variable interest rates, a rise in interest rates would
increase interest payments which in turn will decrease profit.
Exchange rates – These will have an effect on businesses operating internationally. Fluctuations will
lead to gains or losses, which will affect the business if not avoided.
Government Spending- Suppliers to the government (e.g. construction firms ) are affected by
spending.
State of the economy
Boom – The spending power increases; therefore, a company will produce more - even if costs are
high.
Recession – A company will focus on being cost effective and competitive.
In which economic time does consumer demand increase?

Recession
Boom
Solution: Boom
Big data
Big Data refers to data sets which are of high volume and variety, relating to the consumers.
Such data can help identify and analyze patterns and trends of consumer behavior and further help
the user to exploit such data to influence the choices of the end consumer.
By examining any activity of a user, several data points are plotted, and such data points help build a
frame of how the consumer behaves, how the consumer buys etc. Data sets are sets of consumers
having similar data points.
Big data is used by various industries, including healthcare, weather forecasting, hospitality, banking
etc. It helps a company improve its efficiency in marketing their product, design and develop new
products, analyze and eliminate risks, make accurate forecasts which in turn lead to profit to the
society as a whole.
Example:
Facebook was recently heavily criticized for harvesting data points of millions of users without
consent and using and selling such Big Data, which was misused as a tool to influence the decisions
of the masses in many significant political events around the world.
Big Data is characterized using the 3V’s
Volume
Variety
Velocity
3 V's of Big Data
1. Volume
Volume refers to the quantity of the data that’s generated. Businesses, especially those
having an online presence, hold huge volumes of data. Facebook claims to have 5000 data
points on each of its users, which is huge. They use such data collected from our activity on
the website to show us ads they think would be relevant to us.
2. Variety
Variety refers to the range of the data that’s generated. Only data of financial nature is not
helpful, operational data such as efficiency, time taken, customer choices form a larger part
of big data. Facebook has access to the user’s private information, access to photos and
videos uploaded and, in some instances, chats.
Data can be structured or unstructured.

Structured: Such data is easily available, as it is mostly in text form, such as date, amounts,
items purchased. Such data does not form a major part of Big Data.
Unstructured: Such data is difficult to store and analyze, as it includes drawing assumptions
based on other forms, such as audio, video, images. Such data is more useful.
3. Velocity
Velocity refers to the speed of the data. Data needs to be converted into information, and
the quicker the better as the information received late will not help in decision making.
Too much volume and variety lead to decreased velocity, as more data needs to be
processed before it can be turned into useful information. Companies such as Facebook,
invest heavily in the development of software that can sort data quickly!
Two additional Vs have been developed which are:
4. Veracity:
Veracity refers to the reliability and trustworthiness of the data. It involves assessing the
quality of the data, including its accuracy, consistency, and credibility. In Big Data,
information can come from various sources and may exhibit varying levels of quality.
Veracity challenges arise when dealing with data that is incomplete, inconsistent, or
potentially unreliable. Poor data quality can lead to incorrect analyses and flawed decision-
making. Therefore, ensuring data veracity is crucial for maintaining the integrity of analytical
processes and obtaining trustworthy insights.
5. Value:
Value represents the end goal of Big Data initiatives, emphasizing the extraction of
meaningful insights and actionable information from the vast datasets. The primary
objective of handling Big Data is to derive value that contributes to informed decision-
making, improved processes, and strategic business outcomes. Organizations invest in Big
Data analytics to uncover patterns, trends, and correlations that can drive innovation,
enhance efficiency, and gain a competitive edge. The value derived from Big Data can
manifest in various forms, such as cost savings, revenue growth, improved customer
experiences, and enhanced operational efficiency.
Benefits of Big data analytics:

• Examine vast quantities of data relatively quickly
• Improves organizational decision making
• Greater focus on the individual customer
• Cost reduction
Risks associated with Big Data:

• Data, if not held securely, can lead to a security concern, as a breach of data can lead to the
private information of various individuals being handed to unsafe users.
• Incorrect data can lead to incorrect conclusions being made.
• Poor handling of Big Data can lead to issues for both parties, as breaches will lead to misuse,
which will affect the subject. This in turn, will attract fines and penalties, plus reputational
damage for the business.
• Data that may be of no use to the company is collected and stored together with other
important data, thus making it more difficult to identify useful data.
Example:
Big data is widely used to understand customer preferences by various websites offering hotel
bookings, effectively showing exactly what the customer is looking for, thus saving their time. The
customer will keep visiting such websites more than generic ones where more manual work needs
to be put, which benefits the website offering such personalization.
Report writing
Accountants rely on reports for various business proceedings and hence report writing is a key tool a
management accountant must have.
Reports must be well planned, structured, written in an appropriate style and reviewed before being
used. Any facts used must be checked and sourced, any calculations must be correct, and general
formatting must be clear.
Steps to follow to write a report:

1) Prepare
2) Plan
3) Write
4) Review
The structure of an ordinary report is as follows:
Title: A suitable heading that gives an idea of what the report is about, usually a date is also included
in the title.
Introduction: An introduction should set the ground for the report, why the report was drafted,
what is included in the report, and how was the information acquired.
Analysis: Presenting the information in proper paragraphs with similar or continuous information
being drafted together.
Conclusion: New information must not be introduced, a conclusion should summarize the report,
and wherever necessary, provide recommendations.
Appendices: Any significant calculations, tables of data etc., must be shown here. References to the
appendix must be shown wherever appropriate.
A common problem faced by a person preparing reports is how to present data. Since there is
always a huge volume of data available and being used, such data needs to be summarized.
Data can be summarized using tables, charts and graphs.
Tables, Graphs and Charts
Tables
A table simply represents data using rows and columns, so it is presented in a more
understandable way.
A typical table would look like this:

Column 1 Column 2
Row 1
Row 2
Graphs and Charts

Graphs and charts are frequently used to summarize and present information in a manner
meaningful to the management. A good graph should be clear and unambiguous. Knowing how to
prepare a graph or chart is extremely important. Sales, finance, marketing departments heavily rely
on such summarized means.
The types of graphs and charts you are required to know are:
1. Bar charts
2. Line graphs
3. Scatter graphs
4. Pie charts
Bar charts
Bar charts are a type of graph that are used to display and compare various items and their costs,
sales etc. They are useful for displaying data classified into categories.
1. Simple bar chart
Sedan sales in $m
5
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
Qtr 1 Qtr 2 Qtr 3 Qtr 4
Sales in $m
A simple bar chart is where only one variable is being illustrated. The chart above displays how
many sedan vehicles were sold in each quarter.
2. Component bar chart

Car sales for the month of

January 2019 in millions
14
12
10
8
6
4
2
0
Asia Europe North Australia
America
Sedan Hatchback SUV
A component bar chart is often used when there are more categories involved. Here, the company
operates in various markets and has various types of vehicles to offer. Such a chart is useful as it can
be used to analyze the performance in each geographic location and which type has performed well.
3. Percentage component bar chart

January 2019
100%
80%
60%
40%
20%
0%
Asia Europe North Australia
America
Sedan Hatchback SUV
A percentage component bar chart is a component bar chart, but each category is displayed as a
percentage. This means that each category can be properly compared as the percentages show a
more comparable picture. The graph above shows sales of three types of vehicles in a month at
various geographical locations. In Asia, 50% of total car sales, were due to Sedans, whereas in
Europe, 45% of all car sales were due to Hatchbacks.
4. Compound bar chart


January 2019 in millions
6
0
Asia Europe North America Australia
Sedan Hatchback SUV
A compound bar chart shows the same information as a component bar chart, but instead of the
data being displayed in one column, it shows it in multiple columns. The chart above displays how
each type of vehicle performed in each market, which can help more in decision making. However,
care must be taken that such graphs don’t include too much information making the graph difficult
to interpret.
Line Graphs
1. Single line graph
Sedan sales in 2019 in $m

5
0
Sedan sales in $m
A single line graph is used to show the trend or performance of a particular item over a span of time.
Like the graph above displays how many sedan vehicles were sold in each quarter of 2019, in a
manner where it can be compared with previous performance and predictions can be drawn based
on visible trends.
2. Multiple line graph

Car sales for the year in

millions
6
0
Sedan Hatchback SUV
A multiple line graph is exactly like a line graph, but it is used to provide more information together
for the purpose of comparability. In the graph above, the performance over the year for various
types of vehicles is shown.
Scatter diagram
Relation between output and

cost
3.5
3
Costs in million
2.5
2
1.5
1
0.5
0
0 0.5 1 1.5 2
Output in '000 (units)
A scatter diagram is widely used to show a relationship between two variables in a quantitative
manner. The chart above shows that there is a positive relationship between output and costs, i.e. as
output increases, costs increase.
Pie Chart
Sales in Q1
Sedan Hatchback SUV
A pie chart is a circular graph which shows how much different types contribute to a particular item.
In the graph above, the total sales of the first quarter are divided by their contributors, i.e. types of
cars.
Pie charts are good for displaying data around 5-6 groups, after which it becomes difficult to analyze
the chart. Every 1% contribution by a group equals 3.6 degrees in the pie chart.
The following formula is used to calculate the angle on a pie chart:

Variable/Total x 360
This is further explored in the Illustration below.
Pizza Co is preparing a pie chart to analyze customer choices in various markets of their offerings.
The following sales information relates to the Asian market:
$000
Cheese pizza 850
Veggie delight 710
Tangy tomato 1050
House special 290
Total 2900
What will be the angle of Veggie delight pizza in its representation in a pie chart? (To the nearest
whole degree)?
Solution:
Pizza type sales/Total sales x 360

710/2900 x 360
=88o
• Data may be primary or secondary

• Discrete data can only take a countable number of values. Continuous data can only take
value
• Two sources of gathering information- internal and external
• The main characteristics of big data are 3V’s, that is volume, velocity and variety.
• Big data involves the collection and analysis of a large amount of data to find trends,
understand customer needs and help an organization to focus resources more effectively
and to make better decisions.
• The purpose of a report must be clear, and certain general principles should be followed in
the planning and giving structure to a report.
• Tables are simple way of presenting information about two values.
• Bar charts often convey the meaning or significance of data more clearly than would a table.
There are three types of bar charts: simple, component and multiple.
1. Which of the following are examples of primary and internal data?
a) The number of pieces of bread produced in a factory each week

b) The number of pieces of bread produced in India each week
c) The average wage paid to our employees each week
2. Which of the following is an example of an external information that could be used in a

management accounting system?
a) Consumer price index statistics
b) Price list for the products sold by the business
c) Production volume achieved by the production department
d) Discounts given to customers
External information is obtained from sources outside the organization Statistics relating to
customer price index comes from the government. Information about price lists, production volumes
are discounts to customers comes from sources within the organization.
3. The local council is carrying out a survey on of the number of traffic signals which need
repair.
What type of data is this?
a) Discrete, external and primary

b) Continuous, external and secondary
c) Discrete, internal and primary
d) Continuous, internal and secondary
4. Last month the total sales for ABC Co. were $1,000,000. A pie chart is used to show the
breakdown of sales by division for the month. The screws division is represented by 90
degrees on the pie chart.
What are the sales for the month for the screw’s division?
5. The following bar chart shows the total contribution made by the business for each month
of 20X1
What was the extra contribution earned in June over February?
$ ________________
6. Is each of the following statements about scatter diagrams true or false:
Scatter diagrams are graphs which shows the relation between pairs of quantitative measurements
The x axis on a scatter diagram is used to represent the dependent variable
Solutions:
1)
1) a and c
Both these are examples of primary and internal data
2)
2) a
3) a
4-
4) $250,000
The total pue represents 360 degrees. The screws division represents 90/360, hence
90/360*$1,000,000 = $250,000
5) $100,000
In June, contribution was $400,000. In Feb, it was $300,000. The excess was therefore $400,000 -
$300,000 = $100,000.
6) Scatter diagrams are graphs which shows the relation between pairs of quantitative
measurements: True
The x axis on a scatter diagram is used to represent the dependent variable: False
Summarizing and analysing data
Mean, Median and Mode
Moving on, it is not always possible for businesses to consider all data points and make a
decision, hence they often take an average. Let’s see how these averages are calculated.
The most common ones, are Mean, Median and Mode. We’ll be learning how to calculate these, one
by one.
1. Mean
Arithmetic mean, is known as the simple average and is calculated by adding all the values,
and dividing them by ‘n’, which stands for a total number of values.
Example: The mean of the data: 15, 18, 25, 28, 31 would be (15+18+25+28+31)/5 =23.4
∑𝑥
Mean is denoted as 𝑥 = 𝑛
When we have a frequency of data, meaning multiple data points, we solve it using the
frequency method.
Example:
Output Number
unit’s of such
production days (f)
(x)
5 4
7 15
9 6
11 2
∑ 𝑓𝑥
Here, the mean would be calculated as 𝑥 = ∑𝑓
Output Number (fx)

unit’s of such
production days (f)
(x)
5 4 20
7 15 105
9 6 54
11 2 22
27 201
Mean: 201/27 =7.44
Lastly, the mean can get complicated when we have grouped data. Let us demonstrate how
to calculate mean with grouped data, in the following Illustration.
Number Number
of of such
absent days (f)
kids (x)
0- 5
under 4
4- 16
under 8
8- 9
under
12
12- 3
under
16
We simply convert the grouped data into ungrouped, by taking the midpoint value, and then
solve the some using the frequency method. To do this, add the high and low values, and
divide them by 2.
Solution:
Number Number (fx)

of of such
absent days (f)
kids (x)
Mid
value
2 5 10
6 16 96
10 9 90
14 3 42
33 238
Mean: 238/33 =7.21
2. Median
The mean can give a high average when one or two values are extremely high or low. Hence,
we can also use the median.
The median is defined as the exact middle value, when data is arranged in an ascending or
descending order. This is as simple to calculate as it is to say.
Example: The median for the data: 87, 68, 99, 54, 75 can be found when the data is arranged
in an order. This is: 54, 68, 75, 87, 99. Hence, the median is the middle value, being 75.
It’s a little more complicated when the median is to be found for even numbers of data.
Here, we simply add the two median points, and divide it by 2. It is shown in the Illustration
below:
Find the median for the following data:

1500, 1450, 1325, 1750, 1675, 1575
Solution:
Data arranged in ascending order:
1325, 1450, 1500, 1575, 1675, 1750
Two midpoints: 1500, 1575
Median: (1500+1575)/2 =1537.
3. Mode
Mode or modal value of data is the value that occurs more frequently than others. Simply,
the most found value.
Find the mode for the following:

2, 4, 2, 5, 4, 6, 2, 4, 2, 6, 5, 2, 6
Solution:
Data Frequency
2 5
4 3
5 2
6 3
The modal value or mode is 2.
Measures of dispersion
Having discussed how averages work, and a common flaw being one value influencing the
average, it is important to see how far the total data is spread. To do so, we have a few
measures:
1. The range
2. The standard deviation and variance
3. The coefficient of variance
1. The range
The range of any data is simply the difference between the highest value and lowest value of
the data set.
The formula for calculating range for ungrouped data, is:
Highest value – lowest value +1
When data is grouped, it is simply:

Upper most interval – lowest interval
An accountant earned the following fees from clients in the month of April:
$1600, $1850, $900, $500, $2250, $750, $1200
What is the range of the fees received?
Solution:
Range: Highest value – lowest value +1

= 2250-500+1 =1751
2. The standard deviation and variance
The standard deviation is simply a way of finding out how far the data points are from the
mean on average.
Example: Say we have two observations, 50 and 100. The mean will be 75, and both data
points will be 25 points away from the mean.
∑(𝒙−𝒙̅) 𝟐
For more complex calculations, we use the formula: 𝝈 = √ 𝒏
The variance is simply the square of standard deviation, the variance is used in more
complex discussions.
∑ 𝒇𝒙𝟐 ∑ 𝒇𝒙
For grouped data, the following formula is more commonly used: 𝝈 = √ ∑ − ( ∑ )𝟐
𝒇 𝒇
Continuing with the Illustration for mean:

Output Number
unit’s of such
production days (f)
(x)
5 4
7 15
9 6
11 2
Calculate the standard deviation from the mean.
Solution:
Output X2 Number (fx) (fx2)

unit’s of such
production days (f)
(x)
5 25 4 20 100
7 49 15 105 735
9 81 6 54 486
11 121 2 22 242
27 201 1563
∑ 𝑓𝑥 2 ∑ 𝑓𝑥
The standard deviation or 𝜎 = √ ∑ 𝑓 − ( ∑ 𝑓 )2
1563 201
𝜎=√ 27
− ( 27 )2
𝜎 = √57.9 − 55.42
𝜎 = 1.58
3. Coefficient of variation
The coefficient of variation is the ratio of the standard deviation to the mean, and it is a
useful statistic for comparing the degree of variation from one data series to another, even if
the means are very different from one another.
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜
Coefficient of variation =
𝑀𝑒𝑎𝑛
A company has operations in two countries and have obtained the following statistics on the
basic weekly wages of its manufacturing units:
Country A mean: 100 standard deviation 60

Country B mean: 70 standard deviation 55
Can we conclude that the company has a wider spread of wages in country A?
Solution:
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛
Coefficient of variation = 𝑀𝑒𝑎𝑛
Coefficient of variation in country A: 60/100 =60%
Coefficient of variation in country B: 55/70 =78.57%
Hence, we can see that country B has higher variations in weekly wages for the
company.
Expected value analysis
Probability is known as the likelihood of an event happening.

Example: The event that the dice rolls a 4 is 1/6th as there are 6 possible dice rolls, 4 is one of them.
Hence, the probability is calculated as No. of favorable outcome/Total outcomes.
The probability of any event happening always lies between 0 and 1, with 1 being the event
happening with certainty, and 0 being the event not happening.
The higher the probability, the more likelihood of the event happening.
Expected Values
Expected values are averages that will happen in the long run. Simply put, as further explained in the
example, an expected value will always be an average situation when we look at an event that is
happening continuously.
EV =∑PX
Where, X is the outcome, and P is the probability of such outcome.
Example:
An ice cream seller sells ice cream worth:

$100 on a hot day, with the probability of the day being hot at 60%
$50 on a cold day, with the probability of the day being hot at 40%
The expected value of this would be (100x0.6) + (50x0.4) =$80
Now, it is important to understand, in no single day, will the ice cream seller earn $80 dollars, as
either the sales would be $100 or $50. But, if the probabilities pan out correctly, and out of 10 days,
6 days were hot, and 4 cold, the ice cream seller will earn $600 + $200 in total, which when
averaged, comes to $80.
A company must decide between the following three investments: P, Q, R.
Investment P: Profit of $10000 with probability of 75%, profit of $2500 with probability of 25%
Investment Q: Profit of $12000 with probability of 50%, profit of $10000 with probability of 30% and
loss of $5000 with probability of 20%
Investment R: Profit of $25000 with probability of 50% and loss of $7500 with probability of 50%
Using EV, which of the following projects must be chosen?
Solution:
EV(P): (10000x0.75) + (2500x0.25) =$8125

EV(Q): (12000x0.5) + (10000x0.3) + (-5000x0.2) =$8000
EV(R): (25000x0.5) + (7500x0.5) =$8750
Based on EV analysis alone, Investment R must be chosen. However, it must be understood that it is
possible that the company won’t be able to afford a $7500 loss, which has a 50% probability. In this
case, the second alternative with guaranteed profits can be selected.
Disadvantages of Expected Value analysis

1. Subjective Calculation
Expected value highly depends on the probability, which is a subjective thing. It means no
accurate probabilities can be calculated; different people would give you different
expectations (probabilities of outcome).
2. Average Value
Expected value gives you an average result and not the actual outcome. It means that results
of expected can only be tele with an actual result by chance.
3. Only useful for repetitive outcome
Expected value concept has more usefulness, where the outcome is repeated. In the case of
a onetime activity (project analyses), it has little usefulness.
Normal distribution
Data is said to have normal distribution when:

• It is spread in a symmetrical manner.
• Where the curve is bell shaped,
• The mean, median, and mode are all be equal.
Essentially, a normal distribution graph will look like:
When we draw a line around the distribution, we see what is known as the bell curve, a smoothed-
out histogram.
Examples of normal distributions usually include:

• Height
• Shoe size
• IQ
• Birth weight
This bell curve is used to represent a normal distribution.

The mean point represents the center, with 50% being above the mean and 50% below the mean.
The curve spreading out represents the standard deviation.

The total area under the curve is equal to 1.
Use of normal distribution in decision making
Example:
If the manufacturer of biscuit company wants to know how many packets have an extra biscuit
packed inside, such probability can be found. However, as it is a normal distribution curve, the same
probability also applies to biscuit packs with one biscuit less. Think of it like a balance.
If 0.5% of packages contain an extra biscuit, then 0.5% of other packages will also have one less
biscuit.
To calculate probability percentage, we need to convert the normal distribution into a standard
normal distribution and then refer to the normal distribution table given to you in the exam, to find
out the probabilities.
A standard normal distribution has the mean of 0 and standard deviation of 1.
Such special distribution is denoted by ‘z’ and can be calculated as:

𝑥−𝜇
z=
𝜎
Here, z is the z score

x is the value being considered
µ is the mean
𝜎 is the standard deviation
Money Co is an investment firm with a project in question, the returns from a project are normally
distributed with a mean of $1000 and a standard deviation of $200.
If the project loses more than $800, it would be an issue for Money Co.
What is the probability of this happening?

Calculate the z score.
Solution:
𝑥−𝜇
z= 𝜎
z= (800-1000)/200 = -1
Looking up distribution tables

Once we’ve found our Z score, we can look it up in our normal distribution table, to find out the
probability of the event. Note: The normal distribution table only shows positive values.
In a normal distribution chart, the values are provided in the first column, with each row showing
the exact value to that decimal. So, z score of 2.04 would have a probability under 2 and 0.04.
👩‍🏫 Illustration:
Continuing with the Money Co example, find out the probability of the event.
Since a normal distribution curve is symmetrical, the probability at -1 and 1 would be the same.
Let’s find out the probability at 1.
This means, that the chance of the project losing more than $800 would have a probability of 0.3413
or 34.13%
The area from 0 to 1 represents 34.13. And likewise, 0 to -1 represents the 34.13%. This means that
68.26% of data fall under 1 standard deviation. (-1 to 1)
Find the probability of the shaded area.

Probability of z score higher than -1.96 will be the same as a positive 1.96. The probability of a z
score of 1.96 is 0.4750 or 47.5%. However, this represents the probability from 0 to -1.96, we need
the probability of z score being higher than -1.96. This will simply be 50%-47.5% =2.5%
(50% because each curve below and above the mean at 0 represents 50% probability)
Find the probability of the shaded area.
Solution:
The shaded area represents the probability from -1.2 to 2.8. or P (-1.2 < z <2.8). This can be found
out by finding the probabilities of z score being from 0 to 1.2 and 0 to 2.8 and then adding them
together.
In the table, the entry for 1.2 is 0.3848 and 2.8 is 0.4974.
Hence, P (-1.2 < z <2.8) = 0.3848+0.4979 =0.8823 or 88.23%
Spreadsheets
A spreadsheet is a computer software that can process numerical data. Companies commonly use
spreadsheets to maintain various elements of their businesses, as spreadsheets make it easy to
make calculations with the use of formulae. Any spreadsheet will have a rows and columns format,
shown below:
The rows are represented by numbers, and the columns by alphabets. The data input areas are
known as a cell, and referenced by their column and row. The selected cell, for example, will be A1.
Key features:
• Formulae such as sum, average etc., can be input using an ‘=’ sign.
• Spreadsheets allow quick analysis of data
• They reduce calculation errors, only errors are due to incorrect input
• Data can be corrupted easily
• Sharing and editing data from various sources is very difficult in one file
Uses in management accounting:

• ‘What if?’ analysis
Spreadsheets can reapply formulae and recalculate numbers if data is changed, allowing for
what if analysis, such as what if sales increased by 5%?
• Budgeting and forecasting
Preparing budgets and forecasts is a well-known use, estimates can be applied easily in a
spreadsheet, and with proper formulae, it can automatically show budgets with changed
values.
• Reporting performance
Ratio calculation is easy with the help of excel, and comparisons with other statements is
possible in a spreadsheet.
• Variance analysis
Variances are differences between budgets and actual figures, spreadsheets make such
comparisons extremely manageable.
• Inventory valuation methods such as FIFO, AVCO (that we’ll learn in latter chapters) can be
kept updated using spreadsheets.
• Methods of averaging data include: mean, median and mode.

• Measures of dispersion answer how far apart data is. They include: range, standard
deviation and variance, and coefficient of variance.
• The standard deviation is calculated using a formula, and it finds out how far the values are
from the mode.
• Coefficient of variance calculates the degree of variation from one data set to another. It is
found out by dividing standard deviation with mean.
• Expected value is the value we expect based on probability analysis. It is calculated by
weighting all the possible outcomes to its probabilities and adding the outcomes.
• Normal distribution has the following characteristics
• It is spread in a symmetrical manner.
• Where the curve is bell shaped,
• The mean, median, and mode are all be equal.
• A spreadsheet is an electronic piece of paper divided into rows and columns. The
intersection of a row and a column is known as a cell.
• Formulae in Microsoft Excel follow a specific syntax.
1. A company has developed three strategies to make profits, however, the sales are not in
control of the company. You are provided with the profits/losses in each of the strategy with
probabilities of each scenario given.
High sales Medium sales Low sales
0.3 0.5 0.2
Strategy X $5000 $3500 -$1000
Strategy Y $4000 $4000 $500
Strategy Z $3000 $4500 $0
Which of the following strategies would you select based on EV analysis?

a) Strategy X
b) Strategy Y
c) Strategy Z
d) None
Ans: 1-b) Strategy Y

EV(X): (5000x0.3) + (3500x0.5) + (-1000x0.2) =$3050
EV(Y): (4000x0.3) + (4000x0.5) + (500x0.2) =$3300
EV(Z): (3000x0.3) + (4500x0.5) + (0x0.2) =$3150
Sampling and statistical techniques 55
Sampling and statistical techniques
Sampling techniques
In the real world, it is often the case that when decisions are to be made, examining all the data
available is too time consuming and costly. Sampling is a technique used to solve this problem.
Sampling is basically picking some data out of all data or more technically, a proportion of the
whole population as a sample. By population, we mean the total data available, and by proportion,
the part of data that represents a sample of the total data.
Example: If a filmmaker wants to find out which of his previous films was most liked by viewers, he
can’t go about finding out what each individual viewer thought about the films. Instead, he can take
a sample by asking a few people from various different backgrounds and try to find out their
opinion.
The obvious question that one will have now is, how will such a sample truly give the same answer
the full data would. Well, that’s actually a drawback of sampling, and hence it is recommended that
the larger the sample, the better. However, the costs should not exceed the benefit of taking a
larger sample.
The sample being chosen, must be an accurate representation of the entire population.
Example: If a research study wants to test out a vitamin drug before selling it, it can take a sample
based on the entire population to test its drug on. If it is reported that there are 60% men and 40%
women living in the city, and the research can only test with 100 people, 60 men and 40 women
would accurately represent the entire population.
The objective of a sample is to collect data upon which an opinion can be formed, a conclusion can
be drawn.
Example: Amazon, being an international company, cannot go around checking every user’s data
before introducing a new feature that it thinks would be beneficial for the company and its
consumers. Instead, it will take various samples that it thinks would accurately represent the whole
population and take a decision based on analyzing such samples.
The question that now arises is, how will Amazon decide its sample population?
Answer, there are various techniques that Amazon can consider using, in order to arrive at a sample.
Let’s look into these techniques one by one, understand what they are, how they’re used and their
benefits and problems.
Sampling Methods
1. Random sampling
As the name suggests, random data is selected such that every data piece has an equal
chance of being selected. Random samples are taken until the sample size is met. Amazon
would pick random users with no particular order to meet its sample requirement.
As correctly guessed, this method has obvious limitations, as the sample won’t mostly
represent the whole population accurately. Hence, this method is used when such issues
don’t matter.
A variation of the random sampling method is stratified random sampling.Its a method of

sampling which involves dividing the population into strata or categories. Random sampling
are then taken from each stratum or category.
2. Systematic sampling
Systematic sampling is simply picking every nth data until the sample size is met. Amazon,
for example, can select every 100th user profile and examine it. It can do so by starting from
the 5th user too. So, it would check 5th, 105th, 205th and onwards.
The issue with this method is, it can potentially avoid items that would’ve otherwise been
always considered. If such a method is known beforehand, bias can come into the picture
also this method is cheap. This method of sampling is also called quasi random sampling
technique.
3. Stratified sampling
If the population has various layers, known as strata, such as age, gender, size etc., then
sample sizes can be set for each strata and samples be picked from each strata/group.
Samples are taken such that the total samples represent the total population.
If for amazon, 25% population is below 18, 55% population is from 18-55years of age and
the remaining 20% above 55, it can take a sample in a similar ratio, i.e. 25:55:20 or 5:11:4.
This method ensures that all sections of the data are selected, auditors use this method to
take samples based on values.
4. Multi-stage sampling
This method is often used when the population size is large. As the name says, the
determination of samples would be done in multiple stages.
Amazon would first divide its customers by countries, and pick a random country.
It would then divide the country into cities and towns, and take a random sample from each.
The cities and then divided into main localities, and analyze users randomly from such
localities.
5. Cluster sampling
Here, the researcher divides the population into separate groups, called clusters. Then, a
simple random sample of clusters is selected and analyzed completely. The sample size
becomes this selected cluster.
Amazon would follow a similar process to the one followed in multi-stage, but rather than
analyzing users randomly from various localities, it would analyze all users from a few
localities. This would save significant costs, as samples are taken from a few clusters only.
6. Quota sampling
In this method of sampling, a specific target is given to the data selector, and any method
can be used to meet this target or quota. For example, if the sample needs 60 men and 40
women, this target is given to the interviewer, who then has the freedom to collect it
anyhow.
Amazon can select quotas, such as at least 1000 user’s data from Mumbai, 1000 from New
York etc. Then, any method can be used to meet such a sample size. It is possible, however
that such samples include some bias.
Remember that, sampling method is always selected based on the benefit received. If it
doesn’t matter what the sample is, it is likely that detailed methods are not required. If the
sample is of a very important use, detailed methods that achieve accurate representations
would be selected.
👩‍🏫 Illustration 1: (Multi-stage sampling)

Your research objective is to evaluate online spending patterns of households in the US through
online questionnaires. You can form your sample group comprising 120 households in the following
manner:
Choose 6 states in the USA using simple random sampling (or any other probability sampling).
Choose 4 districts within each state using a systematic sampling method (or any other probability
sampling).
Choose 5 households from each district using simple random or systematic sampling methods. This
will result in 120 households to be included in your sample group.
👩‍🏫 Illustration 2: (Cluster sampling)

If the same situation required cluster sampling, instead of choosing 5 households, the following
would be done:
Choose 6 states in the USA using simple random sampling (or any other probability sampling).
Choose 2 districts within each state using a systematic sampling method (or any other probability
sampling).
The two districts can now be analyzed until the sample group is met.
High/low method
Earlier, as we understood that costs can be fixed, variable or semi-variable, it is important to know
how to arrive at such costs.
Fixed cost is simply fixed, and in any budget, the same amount would be taken regardless of the
level of activity.
Variable cost, on the other hand, varies depending upon the activity, and so is simple to calculate as
well. Just multiply total units with cost per unit.
Semi-variable costs though, include both a fixed and a variable element, and it is necessary to
understand how these are calculated, as for any level of activity, the variable element will change
and the fixed element will not.
Example:
You recently received your mobile bill, which was due next week for $150, and according to the bill,
your usage was 3gb. You are now wondering, how was your bill $90 when you had used only 1gb on
last month’s bill. You’ve come across, what is a semi-variable cost. Later, we’ll find out the fixed
element you were charged, and also your variable cost per Gb.
As you might’ve correctly guessed, what if we simply find out the fixed and variable elements, and
then simply calculate them normally to arrive at a semi variable cost for any activity level. Well,
that’s exactly what we need to do!
The question here is, how?
The answer is known as the high/low method
The total cost of a semi-variable cost is Total fixed cost + (Variable cost per unit x level of activity)
Basically, by using the high/low method, we compare two semi-variable costs for two activity levels,
to find out the variable cost element. Then we simply subtract this from the total cost to arrive at
the fixed cost element. This is explained in more detail using the following steps and Illustration.
Step 1
Select the highest and lowest data levels, and their respective costs. In our example, since we have
only two data levels, our highest data level will be 3gb, and our lowest data level will be 1gb.
Step 2
Calculate the VC per unit:

VC per unit: Cost at high level of activity-cost at low level of activity
High level of activity-low level of activity
The variable cost per Gb is therefore, $150-90 = 60/2 = 30.
3-1
You are charged $30 per additional Gb you use.

Step 3
We now use this variable cost to find out the fixed cost by substituting it in any one data level.
Using the formula, Total fixed cost + (Variable cost per unit x level of activity)
We get, 150 = Fc + (3 x 30) i.e. 150-90 = Fc

Therefore, the fixed cost in this situation is $60.
You can also check this out by putting it in another data level,
90 = Fc + (1 x 30) i.e. 90-30 = Fc i.e. $60
Step 4
Similarly, after you have found out the fixed cost and variable cost elements, by making a cost
equation, you can estimate costs for different data levels.
For our example, our equation therefore is, TC = 60 + (Gb used x 30)
So, if in a month our usage is 5gbs, our estimated cost is $210.
Let’s try and apply this to another example, with various data points.
The following costs have been incurred by a factory in various production runs.
Output Total cost

(Production) ($)
600 71000
400 64000
900 81000
700 74400
500 67600
Using high/low method, analyses the total cost into fixed cost and variable cost elements and
estimate the cost if production to satisfy demand is 1200 units.
Solution:
Remember to pick the highest and lowest activity levels, not the highest and lowest costs nor the
first and last levels.
VC per unit = (81000-64000) / (900-400)

=17000/500 =34
FC per unit = 81000 – (34 x 900)

= 81000 – 30600 = 50400
Estimated cost for 1200 units: 50400 + (34 x 1200) i.e. 50400 + 40800 i.e. $91200.
Assumptions of the high/low method are as follows:

• the only thing causing any change in cost is the change in activity
• the cost under consideration is potentially semi-variable (i.e. it has both fixed and variable
elements)
• the linear model of cost behaviour is valid, i.e. y = a + bx
High/low method with stepped fixed costs
Like we learned previously, fixed costs can also be fixed only to a certain level, after which the fixed
cost changes are known as a stepped fixed cost.
In such cases, choose the two activity levels where the fixed cost remains unchanged based on the
given information, and calculate costs normally using the high/low method.
To estimate costs at another level, include the change in fixed cost.
The following costs at three activity levels are as follows:
Activity
level (units) 10000 14000 16000
$ $ $
Total cost 21,500 27,500 29,200
There is a step down of 20% in the total fixed costs when the activity exceeds 15000 units.
Solution:
Using the high/low method, we take the activity levels below 15000 in order to correctly find out the
variable cost.
VC per unit = (27500-21500) / (14000-10000) i.e. 6000/4000 i.e. $1.5

Substituting the VC in one activity level, we find out the fixed cost.
FC = 27500 – (14000 x 1.5) i.e. 27500-2100 =6500
Activity
level (units) 900 1200 1500
$ $ $
Total cost 13,100 17,300 20,000
The fixed cost increases by 1500 when the volume exceeds 1000 units.
Estimate the cost at the activity level of 950.
Solution:
Using the high/low method, we take the activity levels above 1000 in order to correctly find out the
variable cost.
VC per unit = (20000-17300) / (1500-1200) i.e. 2700/300 i.e. $9

Substituting the VC in one activity level, we find out the fixed cost.
FC = 20000 – (1500 x 9) i.e. 20000-13500 =6500
Therefore, the fixed cost of up to 1000 units would be $5000. (6500-1500)
Total cost for 950 units: 5000 + (950 x 9) = 5000 + 8550 = 13550
High/low method with changes in the variable cost per unit:
Sometimes there may be changes in the variable cost per unit, and the high/low method can still be
used to determine the fixed and variable elements of semivariable costs. As with the stepped fixed
costs – choose activity levels where the variable costs per unit remain unchanged.
Advantages of high/low method

Simple to calculate
Easy to explain
Disadvantages of high/low method

Relies on historical data
It only uses two values, hence random variations are ignored
Bulk discounts etc. distort the calculations
Cost Equations
What we just learnt above, is known as a cost equation.
Total Cost = Total fixed cost + (Variable cost per unit x level of activity)
Can be restated as,
y = a + bx
Here,
‘y’ represents the total cost (Dependent on the activity level)

‘a’ represents fixed cost (Intercept)
‘b’ represents the variable cost per unit (Gradient/slope)
‘x’ represents the activity level (Independent variable)
Let’s check a graph of the line: y = 1000 +2x
The intercept (a) represents the point at which the line y = a + bx cuts the axis or intercepts the axis.
The gradient or slope (b) represents the change in y when x is changed by 1 unit.
Scatter diagrams
As we learnt previously, a scatter diagram is used to show the relationship between pairs of two
variables. Just understanding and being able to interpret a scatter diagram is not enough, as being
able to construct a diagram is also important for a management accountant.
However, it is unlikely that a construction question appears in your MA exam.
On a scatter diagram, both the x and y-axis have scales. Dots are plotted representing each data set
with reference to both axes. After all dots are plotted, we analyse the pattern of dots that make up
the diagram and find out if a pattern exists. If there exists a pattern, it would be known as a positive
correlation, and we draw a line of best fit to represent such a relationship.
Let’s take the following data of a factory where the total costs and output is provided.
Output (units) Total cost ($)

40 5100
44 5250
49 5500
55 6000
60 6100
63 6150
If this data is plotted on a scatter diagram, and a line of best fit is drawn, it would look like this.
It is clear that a positive correlation exists between the output and cost. As the output increases, so
does the total cost.
You might be wondering what we mean by the term positive correlation, so let’s go ahead and
discuss various degrees of correlation.
Positive correlation simply means that when one variable increases, the other one increases
too, meaning they move together.
Negative correlation is the opposite of this, as one variable increases, the other one decreases,
meaning the two move in a negative manner.
If all the pairs of data form a straight line of best fit, it means that the data have a perfect
correlation.
This is illustrated in the diagram below, where a perfect negative correlation is shown.
When a line of best fit can still be drawn, but all the data points are not exactly on the line, it is said
that the data has a partial correlation. In the diagram below, we illustrate a partial positive
correlation.
Lastly, if it is not possible to draw a line of best fit due to the data points being scattered, it is said
that no correlation exists between the data variables.
You might be thinking, is drawing a scatter diagram the only way of finding out correlation? Isn’t
there a mathematical way of finding out if a correlation exists? Let us introduce you to a concept
called as regression analysis in the next part of the syllabus to answer this question.
Like we discussed, a scatter diagram is not the only way to find out if a relationship exists between
two variables. Other methods include high/low analysis, which we’ve studied previously and
regression analysis, which we’re going to look into now.
Least squares regression analysis
This method finds out the line of best fit mathematically instead of estimating a line on a graph,
hence we know it’s built around the same equation.
y = a + bx
The formulae to find out ‘a’ and ‘b’ are:
𝑛 ∑ 𝑥𝑦− ∑ 𝑥 ∑ 𝑦
b= 2
𝑛 ∑ 𝑥 2 −(∑ 𝑥)
∑𝑦 𝑏∑𝑥
a= 𝑛
− 𝑛
or 𝑦̅ − 𝑏𝑥
Where ‘n’ is number of pairs of data.
John’s bookstore is a small chain of bookstores having 5 stores. Each store advertises in their area’s
billboards, and the marketing director is interested in finding if the revenue is actually affected by
the advertising, by how much. The following information is provided:
Store Advertising Revenue

expenditure (y)
(x)
1 100 400
2 230 700
3 50 275
4 170 620
5 25 150
∑x = 575
∑y = 2145
∑xy = 323900
∑x2 = 94925
∑y2 = 1132525
Calculate the line of best fit using regression analysis.
Solution:
𝑛 ∑ 𝑥𝑦− ∑ 𝑥 ∑ 𝑦
b= 2
𝑛 ∑ 𝑥 2 −(∑ 𝑥)
5∗323900−575∗2145
b= 5∗94925−5752
b = 2.68
a = 𝑦̅ − 𝑏𝑥
2145 575
a = 5 − 2.68 ∗ 5
a = 120.8
Line of best fit: y = 120.8 + 2.68x
This means that if no money is spent on advertisements, the revenue would still be $120.8, then
for every additional $1 of advertisement expense, the revenue would increase by $2.68.
Linear regression in budgeting
Continuing on what we’ve learnt so far, next we’ll understand how this helps us in budgeting.
Once we establish the line of best fit equation, we can use it for estimation purposes. Simply put, the
equation y = 120.8 +2.68x can be used to find out what revenue (y) would be at any other
advertisement cost (x).
We can predict the value of ‘y’ for any given ‘x’ value.
When we take an ‘x’ value that is included in the given original data, the prediction is known as
Interpolation.
When we take an ‘x’ value that is not included in the given original data, the prediction is known as
Extrapolation. In general, interpolation is much safer than extrapolation.
Angela, a graduate has decided to open her own ice cream and smoothie store in the city
centre. She has conducted a research study and found out that if no money is spent on advertising,
the minimum revenue she will earn is $500. For every $1 she spends on ads, she will earn $3 in
revenue.
She came to this conclusion by researching other local shops, where she calculated this using data
where advertisement costs ranged from $50-$250.
She wants to know what her revenue would be if she spent

a) $150 on advertising expenditure.
b) $300 on advertising expenditure.
Comment on the reliability of the forecast.
Solution:
The equation formed is y = 500 +3x

a) y = 500 + 3x150 = 500 + 450 = $950
b) y = 500 + 3x300 = 500 + 900 = $1400
When Angela will spend $150 on ads, she will earn $950 as revenue, and when Angela will spend
$300 on ads, she will earn $1400 as revenue, however, the first forecast is more reliable, as the
estimate is made using the Interpolation technique, meaning the prediction is based on data it is
based upon.
Benefits of simple linear regression

Explains the basic relationship between two sets of data.
Simple and easy to explain
Can be used for forecasting and budgeting purposes
Limitations of simple linear regression

Assumes a linear relationship exists. (Assumes costs move in a pattern)
Does not consider more than one variable affecting the main variable.
Only interpolated prediction can be relied upon advertising.
Based on historical data.
The correlation coefficient
As we understand various things related to the relationship between data, we need to understand
how strong is the correlation. Like a scatter diagram can also be calculated mathematically, the
correlation can be calculated too.
By correlation, we mean whether the relationship is perfect, partial, or there is no correlation.
Such degree of correlation can be calculated using the Pearsonian correlation coefficient known as
‘r’
𝑛 ∑ 𝑥𝑦−∑ 𝑥 ∑ 𝑦
r=
√(𝑛 ∑ 𝑥 2 −(∑ 𝑥)2 )√(𝑛 ∑ 𝑦 2 −(∑ 𝑦)2 )
‘r’ must always be between -1 and +1

If r = +1, there is perfect positive correlation.

If r = 0, there is no correlation.
If r = -1, there is negative positive correlation.
For other values, a partial correlation can be said to exist, however, if it’s above 0.8 or -0.8, only then
it’s said to be strong.
If ∑x = 720, ∑y = 4075, ∑x2 =139950, ∑y2 =4161325, ∑xy =743150 and n is 4, then the value of ‘r’ to a
two decimal place is:
𝑛 ∑ 𝑥𝑦−∑ 𝑥 ∑ 𝑦
r=
√(𝑛 ∑ 𝑥 2 −(∑ 𝑥)2 )√(𝑛 ∑ 𝑦 2 −(∑ 𝑦)2 )
4∗743150−720∗4075
r=
√(4∗139950−7202 √(4∗4161325−40752 )
r = 0.95
The coefficient of determination
Lastly, let’s understand the coefficient of determination, r2. This is calculated to find out how much
of the change in y is due to the change in x. Basically, if the coefficient of determination is 95%, it
means that 95% of changes in y were due to changes in x.
Let us calculate the coefficient of determination for the Illustration above:

r = 0.95
r2 =90.25%
This means that 90.25% changes in ‘y’ are caused by ‘x’.
And for regression analysis, that’s a wrap! For more practice, do the few quizzes given below:
Learning regression calculations on a scientific calculator
Now we’ll learn how to do regression analysis by using a scientific calculator. This is a useful trick
which eliminates the need to remember and apply proper formulae with those messy brackets. It is
recommended that one knows how to apply those formulae, but in the real world, the calculation is
what matters.
ACCA will provide you with the formulae in the exam, however, to gain an edge by saving significant
time and ensuring you’re left with an accurate answer, learning how to do it over a scientific
calculator is beneficial.
Note: The calculator that we’ve used for demonstration purposes is allowed in an Acca exam, and
similar scientific calculators will also have functions helping out with regression analysis.
Model: Casio fx-991es plus
Step 1: The first thing we need to do, is input our data into the calculator, for
this particular demonstration, let’s input the following table of data into the
calculator:
x y
- 0
1
0 2
1 4
2 5
Turn on your calculator by pressing the button ‘ON’ on the top right corner,
and press the ‘MODE’ button besides it.
Step 2:
On pressing mode, the following will pop up on your display. Here,

we select the ‘STAT’ option, by pressing the numeric key, 3.
At this point, the following display will be displayed.
Here, we’ll select the second

option, ‘A+BX’, which represents
our cost equation y=a+bx, by
pressing the numeric key, 2.
Step 3:
Now, what should hopefully pop up is an empty table, with two columns, headed as ‘x’ and ‘y’, as
shown in the picture below.
Here, we fill our data, as provided in step 1, by simply entering the

numbers in the relevant boxes. To navigate across the table, we use
the arrow keys provided at the center of the calculator.
Once, this is done, your table should look like this:
Once, you’ve inputted the data, simply press the ‘AC’ button, and
your data will be saved until you clear the data.
This brings us to the end of data entry, and also, 90% of the work is
done, wasn’t it simple?
Step 4:
All that’s left now, is to check the regression values.
Simply press ‘SHIFT’ and then ‘1’ to move to the STAT menu, as
shift enables you to move to the areas written in yellow on your
calculator. The screen will now display the following:
Here is where all your answers lie.

Press 2 to edit the data in the table,
Press 3 to find out values such as ∑x, ∑y, ∑xy etc.
Press 5 to find out regression data, such as ‘A’,’B’ and ‘r’
In the next step, we’ll demonstrate how to do it.
Step 5:
Let’s try and find out the value of ‘A’ in this particular scenario. By pressing 5, the following options
will show up:
Here, to find out the value of ‘A’, we simply press the number
denoting it, 1. After this, press the ‘=’ sign to find out the value of ‘A’.
It’s that simple. It should be displayed as:
In our example, the answer to A is 1.9. This can be cross verified by

manual calculations; however, it is safe to say that the powerful
calculator would always be correct. With practice, regression
questions can be solved in less than a minute, where as they’re
allocated 2 ½ minutes or more. If you receive a Section B question, half
your work will be done on the calculator. If you’re one who double
checks a regression question, when done manually would take 5
minutes, whereas rechecking the calculator answer is not necessary,
one can check the data for correct inputs.
Time series analysis
A time series analysis, as the name suggests, is a series of figures recorded over time. Figures such as
revenue, staff turnover etc.
It is used to identify any trends or patterns, which are then used to then make forecasts by
extending such patterns.
Why are these forecasts so important? Because a company has to reliably estimate how much
output it will require to meet demand, or how many employees will stay to help achieve this etc. If
an accurate and reliable forecast is in place, a company can plan their activities accordingly.
We need to understand 4 Components of time series analysis.
1. The trend
All events faced by a company, usually follow some trend, in the long run, if such pattern can
be found out, it can be used to benefit the company. The trend can be found out by
inspecting a graph, by regression analysis, or by moving average calculation, which we’ll
learn later in the course.
2. Seasonal variations
These variations occur due to the regular rise and fall over shorter periods of time.
For example, umbrella sales are likely to be higher than average every winter and lower than
average every summer.
3. Cyclical variations
These variations are long term in nature and happen due to changes in the economy. To
accurately make a forecast, data of at least 6-7 cycles would be required, each cycle being of
uncertain long periods. Hence, it is unlikely that cyclical variations are analyzed.
4. Residual or random variations
These variations happen due to random or unexpected events, hence cannot be predicted.
There are two models that can be used to forecast figures, including the seasonal variations.
1. Additive model:
Here the seasonal variation is expressed as an absolute amount to be added on to the trend to
find the actual result, e.g. ice cream sales in summer are expected to be $200,000 above the
trend.
Forecast =Trend + Seasonal variation
2. Multiplicative model:
Here the seasonal variation is expressed as a ratio/proportion/percentage to be multiplied
by the trend to arrive at the actual figure, e.g. ice cream sales are expected to be 50% more
than the trend
Forecast =Trend x Seasonal variation
Let’s see how each of these models are applied with the help of this following Illustration.
The following are the results of a business in the year.

Year Quarter Units
sold
20X9 1 45
20X9 2 65
20X9 3 65
20X9 4 70
The trend is expected to increase by 10 units per month and is estimated to be 50 units at the start
of Q1.
Make forecasts for all quarters of 20Y0 using
a) Additive model
b) Multiplicative model
Solution:
We can draw the following table:

Year Quarter Units Trend a) b)
sold Variation Variation
20X9 1 45 50 -5 10%
20X9 2 65 60 +5 -8.33%
20X9 3 65 70 -5 -7.14%
20X9 4 70 80 -10 -12.5%
These variations can be applied to trend projections for 20Y0. Forecasts using both methods are:
Year Quarter Trend Forecast Forecast (b)

(a)
20Y0 1 90 90+5=95 90x1.1=99
20Y0 2 100 100- 100x0.92=92
5+95
20Y0 3 110 110- 110x0.93=102
5=105
20Y0 4 120 120- 120x0.875=105
10=110
Note: The factor for Q2 of 0.92 in (b) is 1-0.0833 as the trend is negative. The factors for Q3 and Q4
have been calculated similarly.
Moving averages
In reality, it would be unlikely that trends are easily obtained or set, hence we use moving averages,
to find out trends. A moving average is a series of averages calculated from historical time series
data.
A moving average can be of 3-point, 4 point or 5 point. In the Illustration below, we use a 3-point
moving average.
Let us look into this Illustration and learn how a moving average is calculated.
A business is forecasting the sales value of the first quarter of the coming year, using moving
averages. Current year values are:
Month Sales
Revenue
June 851
July 771
August 916
September 935
October 855
November 1000
December 1019
Solution:
Step 1: Calculate 3 month moving average.

Simply add the sale revenues of three months, and divide them by 3 to arrive at a moving average
trend.
Month Sales Moving Trend
Revenue average $
total
June 851
July 771 2538 846

August 916 2622 874
September 935 2706 902
October 855 2790 930
November 1000 2874 958
December 1019
Step 2: Compare the trend to the sales revenue, and find the variation.
Month Sales Trend Variation
Revenue $
June 851
July 771 846 -75
August 916 874 42
September 935 902 33
October 855 930 -75
November 1000 958 42
December 1019
Step 3: Extrapolate the trend. Like in this example, the trend is increasing by $28 each month.
Then apply the seasonal variations to arrive at the forecast values
Month Trend Seasonal Forecast
$ Variation Sales
Value
September 902 33
October 930 -75
November 958 42
December 986 33
January 1014 -75 939
February 1042 42 1084
March 1070 33 1103
That’s how forecasts are estimated using moving averages in time series analysis.
Time series analysis can also be done using regression analysis, that’s right, what we learnt
previously does indeed have practical applications.
The period or quarter represents the independent variable, and the dependent variable usually
represents the output. Let’s take a look at this Illustration to understand this:
A company uses a multiplicative time series model to forecast sales. The trend in sales is linear and is
described by the following equation:
Trend = 250 + 20T
Where T = 1 denotes the first quarter of 20X0
T = 2 denotes the second quarter of 20X0 etc.
The average seasonal variations are as follows:
Quarter 1 2 3 4
% - +6 +15 -
Variation 19 2
What is the sales forecast for Quarter 3 of 20X2?

Solution:
First, we find out which quarter in a period no. is Q3 of 20X2, that represents T
T = 11 (4 quarters in 20X0 plus 4 quarters in 20X1 plus 3 quarters in 20X2)
The trend therefore, by using regression analysis is 250 + (20x11) =470 units.
Multiplicative variation for quarter 3 = + 15%
Sales forecast = 540 units (470 x 1.15)
Advantages of time series analysis

Forecasts are based on clearly understood assumptions.
Accuracy can be improved with experience.
Trend lines can be updated and compared to improve reliability.
Disadvantages of time series analysis

Past events may not be a true guide for future events.
Assumes that a straight-line trend exists.
Assumes seasonal variations are constant, hence predictable.
Index numbers
Index numbers are commonly used in various situations to measure change.

Index numbers are also a tool that measure inflation. Countries across the world maintain their
index records, which usually have a base year and each year, an index number is provided, showing
how much inflation has occurred.
Example:
In the UK, the year 1987 is treated as the base year, and every month, a relevant index number is
published, showing how much inflation has been suffered. The index rate in 1987 January was 100,
as this is the base year. The index number for comparison in December 2018, was 285.6.
In theory, for sales to actually or really grow, it has to beat the inflation. It is said to be healthy even
if real sales stay constant, moving upwards with inflation.
There are various ways index numbers are used, and we’ll be discussing the following:
Chain based
indices
Multi-items or
Simple Indices weighted
indices
Index
Numbers
1. Simple indices
A simple index is used to measure the changes in either price or quantity of a single item.
Therefore, the two types of indices are,
Simple price index- shows the change in the price of an item from the base year
p1/p0x100
Simple quantity index- shows a change in quantity or volume sold from the base year
q1/q0x100
Where: p0 is price at time 0

p1 is price at time 1
q0 is quantity at time 0
q1 is quantity at time 1
A company sold 5000 units in the year 20X2 compared to 4500 units in 20X1. Calculate a simple
quantity index for 20X3 using 20X2 as the base year.
Solution:
Simple quantity index =q1/q0x100
=5000/4500x100
=111.11
Using index numbers for any period, can help estimate the variables for those periods.
The cost of buying 1kg of Material A is $2325 in the year 20X8. The index number for this year is 155.
The index number for the year 20X1 was 120. How much would’ve 1kg of Material A cost in 20X1?
Solution:
The cost in 20X1 would be: 2325/155x120 =$1800.
In a longer calculation, it can be calculated as 2325/155x100 to bring it to its base year value at 1500.
Then normally, 1500x120/100 would equal to $1800.
2. Chain based indices

A chain-based index is similar to a simple index, with the only difference being that instead
of the comparison being with the base year, we take it with the previous year.
Let’s consider these in more detail in the following Illustration.

P.T.O.

A freelance agent received the following amounts from his freelance works:
Year $
20X1 1000
20X2 1200
20X3 1440
20X4 1728
20X5 2073.6
Calculate the change in sales using simple indices and chain-based indices
Solution:
Year Sales Simple Indices Chain based indices

($)
20X1 1000 100 100
20X2 1200 1200/100x100=120 1200/1000x100=120
20X3 1440 1440/1000x100=144 1440/1200x100=120
20X4 1728 1728/1000x100=172.8 1728/1440x100=120
20X5 2073.6 2073.6/1000x100=207.36 2073.6/1728x100=120
Hence, the sales in numbers have increased each year, but the sales haven’t grown when compared
to the previous year and have remained static.
3. Multi-item or weighted indices
A multi-item index measures the change in the overall quantity or price of a number of
different items together.
Basically, we find out the simple index for the separate items, and then based on the
assigned weights, we apply the indices to find out the multi-item index.
Let’s understand this in more detail, using an Illustration.
A production process uses 25 batches of Product X and 35 batches of Product Z each year. The costs
are as follows:
Item 20X7 20X8
Product 7.25 7.75
X
Product 3.5 4
Z
Using 20X7 as the base year, calculate the weighted price index using production quantity as the
weighting.
Solution:
Step 1: Calculate the simple price index

Product X =$7.75/7.25x100=106.89
Product Z=$4/$3.5x100=114.28
Weights to be used:
X 25
Z 35
60
Applying weights to price indices

Product Quantity Index Total
weight price
index x
quantity
X 25 106.89 2672.25
Z 35 114.28 4000
60 6762.25
Weighted price index = 6762.25/60 =111.20
Now let’s dig deeper into the weighted indices by learning two specific indices given by Laspeyre and
Paasche. These indices are named after the individuals that developed them.
Laspeyre index numbers
Laspeyre index numbers are used to see the change in only one element, where the other basically is
taken as the same. So, if we’re discussing quantity indices, current year quantity is compared with
base year quantity. However, the comparison will use base year prices. By this, we mean:
∑(𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑐𝑒 𝑥 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦) ∑ 𝑝1𝑞0
𝑃𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 = ∑(𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑐𝑒 𝑥 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦)
or ∑
𝑝0𝑞0
∑(𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑥 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑐𝑒) ∑ 𝑞1𝑝0
Quantity 𝑖𝑛𝑑𝑒𝑥 = ∑(𝐵𝑎𝑠𝑒 or ∑
𝑦𝑒𝑎𝑟 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑥 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑐𝑒) 𝑞0𝑝0

20X2 20X2 20X3 20X3
Product Quantity Unit Quantity Unit
price price
$ $
A 20 5 15 5.5
B 50 3 60 4
The base year is 20X2
Solution:
∑ 𝑝1𝑞0
Laspeyre price index = ∑ 𝑝0𝑞0
Product 20X2 20X3 20X2 p1q0 p0q0
Price Price Quantity
p0 p1 q0
A 5 5.5 20 110 100
B 3 4 50 200 150
Total 310 250
Laspeyre price index =310/250 =124

∑ 𝑞1𝑝0
Laspeyre quantity index =∑ 𝑞0𝑝0
Product 20X2 20X3 20X2 q1p0 q0p0
Quantity Quantity Price
q0 q1 p0
A 20 15 5 75 100
B 50 60 3 180 150
Total 255 250
Laspeyre quantity index= 255/250 =102

Paasche index numbers
Paasche index numbers are used to see the change in only one element as well, where the other
stays the same. So, if we’re discussing quantity indices, current year quantity is compared with base
year quantity, however, the comparison will use current year prices. By this, we mean:
∑(𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑐𝑒 𝑥 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦) ∑ 𝑝1𝑞1

𝑃𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 = ∑(𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑐𝑒 𝑥 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦)
or ∑ 𝑝0𝑞1
∑(𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑥 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑐𝑒) ∑ 𝑞1𝑝1

Quantity 𝑖𝑛𝑑𝑒𝑥 = ∑(𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑥 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑐𝑒)
or ∑ 𝑞0𝑝1

20X2 20X2 20X3 20X3
Product Quantity Unit Quantity Unit
price price
$ $
A 20 5 15 5.5
B 50 3 60 4
The base year is 20X2
Solution:
∑ 𝑝1𝑞1
Paasche price index = ∑ 𝑝0𝑞1
Product 20X2 20X3 20X3 p1q1 p0q1
Price Price Quantity
p0 p1 q1
A 5 5.5 15 82.5 75
B 3 4 60 240 180
Total 322.5 255
Paasche price index =322.5/255= 126.5

∑ 𝑞1𝑝1
Paasche quantity index =∑
𝑞0𝑝1
Product 20X2 20X3 20X3 q1p1 q0p1
Quantity Quantity Price
q0 q1 p1
A 20 15 5.5 82.5 110
B 50 60 4 240 200
Total 322.5 310
Paasche quantity index= 322.5/310 =104
Advantages of index number:

They aid the management understanding of information presented to them.
• Indices present changes in data or information over time in percentage terms.
• They make comparison between items of data easier and more meaningful – it is relatively easy to
make comparisons and draw conclusions from figures when you are starting from a base of 100.
Disadvantages of index number:

There may be no single correct way of calculating an index, especially the more sophisticated index
numbers. The user of the information should bear in mind the basis on which the index is calculated
. • The overall result obtained from multi-item index numbers are averages.
• They should only be applied to the items which are included in the index calculation
Life cycle of a product
It is said that all products move through five stages in what is called a products life cycle.
All important decisions relating to the product are taken in a manner which takes advantage of the
stage the product is in.
The five stages are explained in detail below, but first, let’s look at the stages in this diagram:
1. Development
At this stage, costs are incurred, but no revenue is generated, a large investment is
required to finish development and hence, during this stage, the company makes losses.
2. Introduction
After development is completed, the product is introduced into the market, initially, it
struggles as people are not aware about it. High costs are incurred to market the product
successfully.
3. Growth
In the growth stage, the product has been accepted by customers, and companies are
looking to increase market share. The company starts making profits.
4. Maturity
At the mature stage, sales will hit their peak. Competition increases, so product features
may need to be improved. Production costs also tend to decline at this stage because of
more efficiency in the manufacturing process.
5. Decline
This stage is associated with declining revenue, due to various reasons, mainly that the
product is no more required by customers. Companies often try to delay this stage by trying
to introduce improvements.
• Data are often collected from a sample rather than from a population. If the whole
population is examined, the survey is called a census.
• A probability sampling method is a sampling method in which there is a known chance of

each member of the population appearing in the sample
• Probability sampling:
– Random
– Stratified
– Systematic
– Multistage
– Cluster
• Two variables are said to be correlated if a change in the value of one variable is
accompanied by a change in the value of another variable. This is what is meant by
correlation.
• A time series is a series of figures or values recorded over time.
• A index is a measure over time of the average changes in value (price or quantity) of a group
of items relative to the situation at some period in the past.
• The product life cycle model shows how sales of a product can be expected to vary with the
passage of time.
1) An accountant has to check a sample of invoices. The invoices are divided into 3 groups, by value
as follows; ‘under $250’,’$250 - $700’and ‘over 700’. Samples are then selected randomly from each
group.
What is this approach to sampling known as?
a) Cluster sampling
b) Stratified sampling
c) Systematic sampling
d) Quota sampling
Accountant first Stratified the invoices according to the value and then selects randomly.
2) A firm which sells soft drinks will select some filled bottles for examination. The procedure used is
to select fifty bottles in no particular order.
What is the type of sampling known as?
a) Multistage
b) Random
c) Systematic
d) Stratified
3) The essence of systematic sampling is that:
a) each element of the population has an equal chance of being chosen

b) members of various strata are selected by the interviewers up to predetermined limits
c) every nth member of the population is selected
d) every element of one definable subsection of the population is selected.
4) An organization has the following total costs at two activity levels:
Activity 18,350 35,850

level
(units)
Total 76,500 127,750
costs
($)
Variable cost per unit is constant within this range of activity levels, and there is a step-up in the
total fixed costs of $7,500, when the activity level exceeds 30,000 units.
What are the total costs at an activity level of 32,000 units?
$ ____________
5) Using the gradient of the line on a graph of semi variable cost, we can determine:
a. Total semi variable cost

b. Semi variable cost per unit
c. Total fixed cost
d. Semi variable cost per unit
6) Which of the following is not a valid value for ‘r’?

a) 0.9
b) -1
c) 0
d) 1.3
7) y = a + 0.92x with six pairs of data.

Preliminary calculations have established that ∑x = 120 and ∑y = 240.
What is the value of a in the equation?
a) 12.60
b) 13.80
c) 21.60
d) 16.20
8) Which of the following are correct with regards to regression analysis?
a) In regression analysis the n stands for the number of pairs of data.

b) Σx2 is the same as (Σx)2
c) Σxy is calculated by multiplying the total value of x and the total value of y
9) Which of the following is NOT a feasible value for the correlation coefficient?
a) +1.2
b) +0.6
c) 0
d) –0.9
10) A company uses an additive time series model to forecast sales. The trend in sales is linear and is
described by the following equation:
Trend = 1000 + 120T
Where T = 1 denotes the first quarter of 20X0
T = 2 denotes the second quarter of 20X0 etc.
The average seasonal variations are as follows:
Quarter 1 2 3 4
Variation - +60 +115 -
190 75
What is the sales forecast for Quarter 4 of 20X1?
a) 1885
b) 2035
c) 1405
d) 2365
11) B company is preparing its forecast sales information for the end of the current year. The actual
sales information for the first nine months of 20X7 is given below:
Month Sales Volume (units)
January 95000
February 69100
March 58750
April 85250
May 74800
June 107500
July 81600
August 71250
September 97750
What is the monthly trend when using a 5-point moving average?
a) 250
b) 25000
c) 2500
d) 25
12) 5 years ago, the price index appropriate to the cost of material X had a value of 220. It now has a
value of 130. If material X costs $14,950 per kg today, what would it cost per kg have been two
years ago?
Solutions:
1) a) Stratified sampling - Accountant first Stratified the invoices according to the value and then
selects randomly.
2) b
3) c
4) $118,125
Variable cost using high-low method:
(Total cost at high activity - step-up in fixed cost - total cost at low activity) /
(total units at high activity - total units at low activity)
= $2.50 ((127,750 - 7,500 - 76,500) / (35,850 - 18,350))
Total fixed cost = $38,125 (127,750 - (35,850 x 2.5))
Total cost at 32,000 units of activity:
Fixed cost = $38,125
plus, variable cost = $80,000 (32,000 x $2.50)
Total cost at 32,000 units of activity = $118,125 (38,125 + 80,000)
5) b) On a graph of a semi-variable cost, the intercept shows the fixed element, and the gradient
gives the variable cost per unit.
6) d) ‘r’ can only be between -1 and +1
7) c) 21.6
∑𝑦 𝑏∑𝑥
Using the least squares method, the value of a equals: −
𝑛 𝑛
In the question there are six pairs of data and b = 0.92
Therefore: a = 21.6 (240 / 6) - (0.92 x (120 / 6))
8) a)
9) a)
10) a) 1885
First, we find out which quarter in a period no. is Q4 of 20X1, that represents T
T = 8 (4 quarters in 20X0 plus 4 quarters in 20X1)
The trend therefore, by using regression analysis is, 1000 + (120x8) =1960 units.
Additive variation for Q4 = -75
Sales forecast = 1885 (1960-75)
11) c) 2500
Month Sales Volume (units) 5 point moving average Trend

January 95000
February 69100
March 58750 382900 76580
April 85250 395400 79080
May 74800 407900 81580
June 107500 420400 84080

July 81600 432900 86580
August 71250 382900 76580
September 97750
As we can notice, the trend each month is increasing by 2500 units. (79080-76580=2500)
12) $25,300
The material has a current index of 130, but previously it had an index of 220. To calculate the
previous cost, we divide the current cost by the index and multiply it by the previous index.
($14,950 / 130) x 220 = $25,300
Cost and its analysis 86
Cost and its analysis
Classification of Costs
Costs can be classified in 4 ways:
Element
Classification of Costs
Behaviour Nature
- on the basis of
Function
Classification of Costs – on the basis of Element
Costs can be classified into different categories based on the elements they represent. Here are
some common elements used to classify costs:
• Material - Materials bought for production or non-production activities.

Eg: Raw materials, components, maintenance materials, etc.
• Labour – All staff related costs.
Eg: Salaries, wages, etc.
• Expenses – All other costs that are not material or labour costs.
Eg: Factory rent, Office rent, Depreciation, etc.
Classification of Costs – on the basis of Nature
Costs can be classified into two categories on the basis of how they are related to production:
• Direct costs – Direct relation to production, also called Prime cost.

Eg: Direct materials, direct labour, direct expenses.
• Indirect costs – Indirectly related to production, also called Overheads.
Eg: Indirect materials, indirect labour, indirect expenses.
Classification of Costs – on the basis of Function

Costs are classified on the basis of their function, into production and non-production costs.
Such classification is important as inventory it helps in proper reporting of the cost of inventory in
the balance sheet.
1. Production costs
Production costs are basically costs that are incurred directly in the products manufacturing
process inside the factory. Such as direct materials and labour. These are the costs that are
included in the valuation of inventory.
Eg: Direct materials, direct labour, direct expenses, variable production overheads, fixed
production overheads.
2. Non-production costs
These costs are simply costs that incur outside the factory, such as admin, selling and
distribution costs. These are the costs that are not included in the valuation of inventory.
Eg: Administration cost, Selling and distribution cost, Finance cost, etc.
Classification of Costs – on the basis of Behaviour
This classification of cost is done on the basis of the behaviour of cost in relation to changes in the
level of activity.
• Variable cost
• Fixed Cost
• Stepped Fixed Cost
• Semi Variable Cost
1. Variable costs
Variable costs are costs that increase or decrease depending on the activity level.
Example: An additional battery is required to make an additional unit of a cellphone. Hence,
the costs to buy/manufacture a battery are variable costs in the production of a cellphone.
As shown above, the total variable cost will increase as activity increases, however,
variable cost per unit will remain constant.
2. Fixed costs
A Cost is deemed to be fixed when it is incurred regardless the level of activity.
Example: In the production of the said cellphones, rent paid for machinery while remain
fixed regardless of how many units of cellphones are produced using the machine.
As shown in the graph, the total cost is unaffected by the level of activity, however, cost per
unit will decrease as the activity level increases.
3. Stepped Fixed costs

Such costs are similar to fixed costs, but up to a certain level of activity. After the upper limit
is reached, the fixed costs suffer a step up.
Example: Continuing with the cellphone manufacturer, if one storage unit can store 1 million
cell phone boxes, another facility will be required as soon as the upper limit of 1 million is
crossed, leading to a step up.
4. Semi Variable costs

Semi variable costs contain both fixed and variable elements and therefore are partly
affected by change in activity.
Example: Cellphones are usually sold with network plans, which often include a base
rental(fixed) and usage dependent costs(variable).
Here, the cost will have a minimum, however usage will result in the total cost increasing
with the level of activity.
Discounts are often offered when purchases exceed a set quantity in the year, which reduces the
variable costs.
However, purchases are made in parts, and hence discount criteria can be met later.
When this happens, discounts can be received in two ways:
When discounts offered only apply to the extra units.

Example: Purchases over and above 10,000 units will receive a 5% discount
Here, if the cost to the company was $10 per unit, purchases after 10,000 units will be made at a
price of $9.5, thus reducing the additional cost. If, say, a 10% discount is received after purchases
above 15,000 units, such units will be made at $9.
Here, if for example 12,000 units are purchased, total price would be, 10000 x $10 = $100000 and
2000 x $9.5 = $19000, making the total price $11900
When discounts offered apply to all units purchased.
Example: A 5% discount will be received if the annual purchases exceed 10,000.
In this case, discounts received are applied to all purchases, i.e. all 10,000 units will be priced
at $9.5 since the discount criteria was met, therefore if 12000 units are purchased, the total
purchase price would be 12000 x $9.5= $114000.
Since the company would have paid 10000 x $10 = $100,000 already, for the additional units, they
will only pay the balance of $14,000, which represents the total discount for all 12,000 units.
The thing to understand here is that in the first case, the graph line deviates from the origin as it
becomes steeper, this is due to costs being reduced only for the latter purchases.
Whereas in the second case, the new line represents the cost line that would’ve been if the discount
existed from the very beginning, i.e. from the origin.
Cost Card
$ per unit
Direct materials X
Direct labour X
PRIME COST XX
Variable production overheads X
TOTAL VARIABLE PRODUCTION COST XX

Fixed production overheads X
TOTAL PRODUCTION COST XX

Non-production overheads:
-Administration X
-Selling X
-Distribution X
TOTAL COST XX
Elements of a Cost Card
1. Material
Materials are visible items used in production. Materials can be direct or indirect.
Direct materials: for the cellphone industry, batteries and LED displays.
Indirect materials: cleaning fluids, oils for machines.
2. Labour
Labour includes employees working in production or non-production activities.
Direct labour: Labour involved in the assembly of the units.
Indirect labour: Employees working in the sales department.
3. Expenses
All expenses are other than material or labour. Direct expenses can be associated with the
production, whereas indirect costs can’t. Indirect expenses are also called as overheads.
Overheads are of two types:
Fixed overheads: Factory rent
Variable overheads: Electricity costs incurred by a plant
4. Administration costs
An expense incurred in controlling and directing an organization as a result of general
administration is called as an administration cost.
5. Selling costs
These costs are expenses incurred in the marketing and distribution of a product.
6. Distribution costs
Cost or expense incurred in moving goods from the point of production to the point of
consumption.
7. Finance costs
These are the costs that arise as a result of the company’s financing. Example: Bank interest.
Cost Codes
A code is a system of symbols designed to be applied to a classified set of items, to give a brief
accurate reference, which helps entry into the records, collation and analysis.
A cost code is a code used in a costing system.
The cost centre to which the cost relates has to be determined and then that cost has to be
allocated the correct cost centre code.
Cost codes are of two basic categories:

1. Generic or functional codes:
• An expense for a particular cost centre will be coded with a specific number.
• For eg, for cost centre head office, code could be 01 and for canteen could be 67. Canteen
expenses for head office will then be coded as 0167.
2. Specific codes:
• A specific item of cost will be given a specific or special code.
• For eg, if the wages are coded as 22, the wages of the head office canteen will be coded as
016722.
Types of codes
Codes or reference codes are frequently used in costing to classify costs into segments using
designated short forms with the use of symbols.
1. Sequential code
This is a basic form of coding, where all codes are assigned in a numerical or alphabetical
sequence. It is likely that codes are unstructured and set randomly.
For example, if we are making a list of revenues, codes could be as follows:
Code Item of revenue
001 Sales
002 Commission income
003 Interest income
This will allow us to have 999 different types of codes of expenses considering we are using a
3-digit sequential code.
2. Block code
Each accounting item block is assigned a block code, such as 1000 for Assets, 2000 for
Liabilities, where each asset or liability can be further classified using a code number in the
block. Here, Land can be 1001, Machinery can be 1002 etc.
Following is an example of different types of items being coded:
Code Item
00 Expenses
01 Revenue
02 Current assets
03 Current liabilities
04 Non-current assets
05 Long term liabilities
06 Equity
3. Hierarchical code
Codes in this system follow a hierarchy or an order from left to right, usually getting into
more detail with more subsets.
Code Account Code Location

1 Revenue 0.1 India
2 Purchases 0.2 Australia
3 Expenses 0.3 China
Here, Revenue from China will be recorded as 1.3, Purchases from India will be recorded as
2.1.
A more exhaustive example is given in the quiz below.
4. Significant digit code

Here a significant code is assigned to an item, and numbers represent different elements of
that item.
Example: If 5000 is assigned to all beverages, then numbers representing beverage
quantities can be 5008 for an 8 pack, 5003 for a pack of 3.
5. Faceted code
This type of coding uses various fields as bases, representing one segment of information.
Such as alphabets representing countries, (E=Europe, NA=North America) and numbers for
other information, (01=Sales, 02=Purchases). Therefore, purchases made from Europe would
be represented as E02. There can be more fields or segments.
6. Mnemonic code
This type of coding is alphabetical, it uses abbreviations of the subject as codes. INC can be
used for income, while NCL for non-current liabilities. However, such coding is often limited
by abbreviations.
Cost objects, cost units and cost centers
A cost object is any activity for which a separate measurement of cost is undertaken. For example,
the cost of a product/service / particular department.
A cost unit is a unit of a product or service in relation to which costs may be ascertained. The cost
unit should be appropriate to the type of business.
Business Cost unit

Car manufacturer Cost per car
Cigarette manufacturer Cost per pack of cigarettes, not 1 cigarette!
Builder Cost per square foot
Audit company Cost per hour
A cost centre is a location, function, activity or specific equipment for which costs can be identified.
Such as sales area, stores, vehicle, machine etc.
When you think of cost units, you need to think of one standard unit that costs can be ascertained to
- that can be used when selling all the goods/services of that business.
Direct Data Capture Costs:
The expenses associated with obtaining data initially for system integration are referred to as direct
data capture costs. These costs encompass various methods, including:
1. Manual entry or digitalization of data forms, either through human input, digital forms with
predefined fields, or automated processes using optical character recognition (OCR).
2. Utilization of machine-readable elements like barcodes, QR codes, or RFID tags.
3. Application of artificial intelligence (AI) or algorithmic processes for categorizing and tagging non-
standardized data captures, such as facial recognition or physical item identification.
Indirect Data Capture Costs:
Indirect data acquisition may involve transactional costs, indicating the purchase of data directly from
external entities like research firms or universities. Additionally, there could be expenses associated
with validating data reliability, including efforts to establish sources and cross-reference data with
known verifiable information.
• Production cost-=prime cost-plus overheads and Non-production cost= admin, selling,

distribution and finance.
• Types of cost behavior: 1. Fixed- does not vary with the level of activity
2. Variable – vary with the level of activity
• Direct cost is the cost which is directly involved in the production, whereas indirect cost is
not directly involved in the production.
1) Which is true of the prime cost of a product?

a) Material + Labor Cost = Prime Cost
b) Direct costs are those which are directly involved with the making of a product or service.
The sum of the direct costs is equal to the prime cost.
c) Indirect costs are those which are incurred for other reasons (e.g.) wages of a supervisor.
The sum of the indirect costs is equal to the prime cost.
2) Which two of the following will be indirect materials for a furniture company?
a) Disposable tools
b) Wood
c) Cleaning supplies
d) Fabric
3) Bad Shoe Co uses hierarchical coding to account for its shoe inventory.
The following codes are used.
Code Color Code Material Code Size

1 Black 0.1 Leather 0.0.9 US 9
2 Blue 0.2 Synthetic 0.0.10 US 10
3 Brown 0.3 Rubber 0.0.11 US 11
Which code will Bad Co use to record its remaining units of US 10 Brown Leather shoes?
a) 1.2.10
b) 3.1.10
c) 1.3.10
d) 2.1.10
Solutions:
1) a)
2) a), c)
3) b)
Cost accounting techniques

Accounting for materials 96
Accounting for materials
Documentation for materials
Accounting is only possible with proper documentation, and any such documents commonly used in
accounting practices must be known and understood by an accountant. Since we’re learning
management accounts, let’s learn about commonly used documents in the inventory process.
The inventory process is divided into the following stages:
Ordering Receiving Receiving Issue of Returns of

goods goods invoice inventory inventory
1. Ordering goods
When any department requires material, they issue a purchase requisition form, which is
simply a list of goods they require and send it to the purchasing department.
The purchasing department uses this document and chooses a supplier to order the
necessary materials from, then issue a purchase order form.
Usually, goods are ordered in advance when the stock reaches its buffer limit, as the orders
are not received immediately. While the goods get delivered, buffer inventory is used, so
production is not halted. This difference between order time and delivery time is known as
lead time.
2. Receiving goods (from supplier)

The chosen supplier will prepare a delivery note which specifies the materials being sent,
which they will later match against the bill.
The department receiving the goods will check the goods received against delivery note and
purchase order, and if all matches, issue a goods received note (GRN) which includes details
of goods received.
If goods are sent to customers, a goods dispatch note (GDN) and a delivery note are
created.
3. Receiving invoice (from supplier)

The invoice is a document the supplier will send as a means of processing payment, such
invoice will be matched to GRN and purchase order before approval.
After approval, an invoice will be sent to the accounting department, who will enter it into
the ledgers and process payment.
4. Issue of inventory
The department that requires material, will send a material requisition note to the stores
department. Only authorized personnel can issue materials from any department.
Material will be provided, and records will be maintained.
5. Returns of inventory
When the department has excess materials, it may return them to the storage, and a
material returned note will be used to record it.
Similarly, if the business returns any goods to the supplier, a goods returned note is issued,
and in exchange, the supplier issues a credit note which gives the business credit for future
purchases in exchange of goods returned.
Stocktaking
It is very important to maintain a record of the actual stock, which should match to the stock we
show in our accounts. This process is known as ‘stocktaking’. If stocktaking is not done, the real
position of the stock will not be known, and it may be possible that several incorrect stock records
are maintained.
There are two ways of taking or counting stock:
Periodic Stock-
taking Continuous Stock-
taking
1. Periodic stocktaking
We carry out stocktaking once, periodically, most likely at the end of the year. Any items
that don’t match, are adjusted and investigated as to why.
2. Continuous stocktaking
Here, we check different items throughout the year, eventually checking all items at least
once as we near the year end. Higher value items can be checked more than once also. This
way, the burden of year end check is reduced.
There is no point of stocktaking if any discrepancies or issues found are not investigated. Finding out
why losses are incurred and taking actions to avoid them in the future is necessary.
Examples of common issues and controls:

• Delivery should be accepted and signed by the accepting authority, so the person can be
held initially accountable.
• Security procedures must be implemented, such as CCTV cameras, so any theft would be
recorded, and action be taken.
• Purchasing, delivery, ordering departments should not be controlled by the same people, so
fake inventory purchases, known as fictitious purchases, don’t pass through.
Material inventory account

Inventory held by a company is an asset, and must be accounted for like on.
Other names for such account include bin ledger, stores ledger.
Usually in factories, they have a storehouse, or a storage area, commonly known as stores. When
something needs to be produced, the production team will request the stores to issue them
inventory, which will be an outflow for the storekeeper. The storekeeper handles inventory ins and
outs, so the production solely focuses on production.
Material inventory account (Storekeeper)

Any increase in the inventory, will be debited. Any decrease in the inventory, will be
credited.
Opening balance
Purchases made Materials issued to production (WIP)
Materials returned by production to stores Materials returned to suppliers by
stores
Closing balance
Just-In-Time (JIT)
Just-in-time (JIT) inventory is a supply chain management strategy where businesses hold minimal
inventory and receive goods or materials only when they are needed in the production process or to
meet customer demand. The primary goal of JIT inventory is to reduce inventory carrying costs,
minimize waste, and increase efficiency in production and distribution.
In essence, JIT reduces the Cash Conversion Cycle of a business, by using a Pull mode manufacturing
and Lean manufacturing mechanism instead of Push mode manufacturing.
Cash Conversion Cycle (CCC) or Net Working Capital Cycle is calculated as Inventory Holding Period
(IHP) + Debtors Collection Period (DCP) – Payment Deferral Period (PDP), where
IHP = 360/ Inventory Turnover Ratio

Inventory Turnover Ratio = Cost of Goods Sold (COGS)/ Average Inventory
COGS = Sales – Gross Profit
Average Inventoy = (Opening Inventory + Closing Inventory)/2
Debtors Collection Period (DCP) = 360/ Debtors Turnover Ratio

Debtors Turnover Ratio = Net Credit Sales/ Average Debtors
Net Credit Sales = Credit Sales – Sales Returns
Average Debtors = (Opening Debtors + Closing Debtors)/2
Payment Deferral Period (PDP) = 360/ Creditors Turnover Ratio

Creditors Turnover Ratio = Net Credit Purchases/ Average Creditors
Net Credit Purchases = Credit Purchases – Purchase Returns
Average Creditors = (Opening Creditors + Closing Creditors)/2
Key features and concepts of just-in-time inventory include:

• Demand-Driven: Aligns inventory levels with customer demand.
• Lean Production: Focuses on eliminating waste and improving efficiency.
• Continuous Replenishment: Suppliers deliver materials as needed.
• Reduced Lead Times: Shortens production lead times.
• Quality Control: Emphasizes high product quality.
• Kanban System: Uses visual signaling for replenishment.
Benefits of using just-in-time inventory system:

• Lower Holding Costs
• Minimized Obsolescence
• Enhanced Efficiency
• Faster Response to Demand
• Space Savings
Inventory costs
Depending on the size of the business, inventory needs will differ. Even relationships with suppliers
and other factors are considered before deciding on how inventory will be managed.
We’ll be focusing on fixed inventories or fixed demand for this section. For example, a company may
need 1200 units in a year to satisfy demand. Depending on their need, they can order 100 units, 12
times
a year, or even 400 units 3 times a year.
However, one thing that is common amongst all businesses is that inventory ordering policies will
always be in ways where costs are minimized.
To understand how to do this we first have to understand what costs are incurred by a business in
relation to inventory, and how are they calculated.
Every business incurs the following costs:
1. Purchase cost
This is an obvious cost, the cost of purchasing 1 unit of inventory is known as purchase cost.
Total purchase cost = PC x Demand
2. Holding cost
Holding cost is a cost the business incurs because they hold inventory with them. Holding
costs basically include costs such as administration costs, insurance cost, opportunity cost as
capital is tied up etc.
Total annual holding cost = Ch x Quantity/2
Quantity is divided by 2 to come to an average, because all inventory won’t be held
throughout the year.
3. Ordering cost
Ordering costs are costs incurred as a result of placing an order. Delivery costs,
administration costs etc., are examples of ordering costs.
The less orders we place, the less ordering costs we incur, but we end up holding more
inventory. So as one decreases, the other increases.
If we hold less inventory, we may not be able to satisfy all customer orders in time.
Total annual ordering cost = Co x Demand/Quantity

Annual demand divided by quantity ordered per order, will give us the number of orders to
be placed. We simply multiply it with ordering cost per order.
Therefore, Total cost = PC+HC+OC or
= (PC x Demand) + (Ch x Quantity/2) + (Co x Demand/Quantity)
Cost of buffer inventory:
Buffer inventory allows you to meet unpredictable peaks in demand, and it allows you to
protect your customers from production breakdowns, supplier failures, or delays in
deliveries from suppliers. It can also reduce the cost of purchasing as inventory levels should
never get to a critical level. However, buffer inventory ties up cash that could be better
invested in other parts of the business. It costs money in terms of the opportunity cost (what
else the cash could be being used for), the cost to insure the inventory, the cost to store the
product, and the cost of theft or damage. Buffer inventory could also end up being a huge
liability if the demand falls or the product becomes obsolete before you can use the
inventory
4. Inventory recording systems cost

The cost of recording inventory into the system involves its own cost.
Though this is low as compared to the previous three costs, it is not low enough to be
ignored.
Disadvantages of low inventory:
To keep the holding costs low, it may be possible to reduce the volume of inventory that is
kept, but this can cause some problems:
• Customer demand cannot always be satisfied; this may lead to loss of business if
customers become dissatisfied.
• In order to fulfil commitments to important customers, costly emergency
procedures (e.g. special production runs) may become necessary in an attempt to
maintain customer goodwill
• Stock out costs need to be borne – which include loss of sales, damage to reputation
and production stoppages.
Disadvantages of high inventory levels :
To reduce the problems mentioned above management may consider holding high levels of
inventory, but again this can have issues:
• Storage or holding costs are very high; such costs will usually include rates, rent, labour,
heating, deterioration, etc.
• The cost of the capital tied up in inventories, i.e. the cash spent to buy the inventory, is
not available to pay other bills.
• If the stored product becomes obsolete, a large inventory holding of that item could, at
worst, represent a large capital investment in an unsaleable product whose cash value is
only that of scrap
The following costs are incurred by a company when purchasing Material X:

Purchase price: $5 per unit
Ordering cost: $25 per order placed
Holding cost: 20% of purchase price
The company orders 1250 units.
What will be the total cost if the annual demand is 11250 units?
Solution:
PC = $5 x 11250 =$56250
Ch = 20% of $5 =$1
HC = Ch x Q/2 =$1 x 1250/2 =$625
OC = Co x D/Q =$25 x 11250/1250 =$225
TC =PC+HC+OC =$56250+$625+$225 =$57100
Economic order quantity (EOQ)
As we discussed, the main objective for all companies is to minimize cost. The EOQ model is an
approach which finds a balance between ordering and holding cost, thus minimizing total cost.
We only focus on holding and order costs, minimizing them by using the EOQ model, as purchase
cost per unit remains the same regardless of how much we buy or when we buy.
The formula to calculate EOQ is:

2𝐶𝑜 𝐷
EOQ = √ 𝐶ℎ
Where:
D = Annual demand
Co = Cost of placing one order
Ch = Cost of holding one unit for one year
This formula is provided in your exam.
For EOQ to work, the following assumptions are made:

• Demand and lead time are known
• Purchase price does not change
• No buffer inventory is held, if buffer inventory is held, it will increase holding costs.
Find out the EOQ and total cost for:

Annual demand: 11250 units
Solution:
Ch = 20% of $5 =$1
2𝐶𝑜 𝐷
EOQ = √
𝐶ℎ
2𝑥25𝑥11250
EOQ = √ 1
EOQ = 750 units
Total cost under EOQ
PC = $5 x 11250 =$56250
Ch = 20% of $5 =$1
HC = Ch x Q/2 =$1 x 750/2 =$375
OC = Co x D/Q =$25 x 11250/750 =$375
TC =PC+HC+OC =$56250+$375+$375 =$57000
Therefore, using EOQ will save the company $100 when compared with the previous Illustration.
EOQ with discounts
There is one way where total costs are less than costs calculated using EOQ. This is when a discount
is negotiated with the supplier on bulk quantity purchases.
A bulk purchase will reduce the purchase price, increase holding cost, decrease ordering costs.
The approach for such sums is simple, calculate EOQ and total cost using EOQ and calculate the total
cost using quantity where we receive a discount. Compare the two and choose the one with the
minimum cost.
This is demonstrated in the Illustration below:
The following costs are incurred by a company when purchasing Material X:

Annual demand: 11250 units
The supplier offers a 5% discount on the purchase price, if more than 1875 units are ordered. The
current EOQ is 750 units.
Calculate and comment on whether the company should accept the discount.
Solution:
Total cost using EOQ: Total cost on purchase of 1875 units:

PC = $5 x 11250 =$56250 PC = $4.75 x 11250 =$53437.5 (New purchase
price with 5% discount is $4.75)
Ch = 20% of $5 =$1 Ch = 20% of $4.75 =$0.95
HC = Ch x Q/2 =$1 x 750/2 =$375 HC = Ch x Q/2 =$0.95 x 1875/2 =$890.625
OC = Co x D/Q =$25 x 11250/750 OC = Co x D/Q =$25 x 11250/1875 =$150
=$375
TC =PC+HC+OC =$56250+$375+$375 TC =PC+HC+OC =$53437.5+$890.5+$150 =$54478
=$57000
Therefore, the business should opt for the discount as it leads to cost savings of $2522
Reorder level
Once it’s decided how much to order, it is also important to know when to order. If you order too
late, due to lead time, you might run out of inventory until the new stock arrives. Hence, it is
important to calculate at what level should inventory be re ordered, known as reorder level or ROL.
ROL = Maximum usage x Maximum lead time.
The logic behind this is how much inventory/material be used in a week at max multiplied by how
many weeks will be taken for the delivery. Hence, running out of inventory becomes very unlikely.
Example:
A company having a lead time of 3 weeks, and using 2000 units per week, will have a ROL of 6000
units. So, once the order is placed, in these 3 weeks, enough units will be held.
Maximum and Minimum Inventory:

Minimum level = Re-order level – (Average usage × Average lead time)
Maximum level = Re-order level + Re-order quantity – (Minimum usage × Minimum lead time)
Economic Batch Quantity (EBQ)
Not all businesses order externally, some also produce their inventory internally. They have to
determine how much to produce or replenish per batch or simply, batch size.
EBQ is calculated to minimize set up costs of the machinery.
Businesses keep producing units while also constantly selling units in some quantities. Here, the
average quantity is batch quantity /2 x (1-D/R)
2𝐶𝑜 𝐷
EBQ = √ 𝐷
𝐶ℎ (1− )
𝑅
Where:
D = Annual demand
Co = Cost of setting up one batch
Ch = Cost of holding one unit for one year
R = Rate of production p.a.

This formula is provided in your exam.
The following information relates to a company which produces Material X:
Production rate: 200 units per month.
Demand: 1500 units p.a.
Set-up cost: $500 per batch.
Storage costs: $4 per unit for a year
Calculate the EBQ:
Solution:
R = 200 x 12 =2400 p.a.

2𝐶𝑜 𝐷
EBQ = √ 𝐷
𝐶ℎ (1− )
𝑅
2𝑥500𝑥1500
EBQ = √ 1500
4(1− )
2400
EBQ = 1000
Valuation of closing inventory
When there is a continuous inflow and outflow of ready inventory, a business will need ways to
value inventory in a way that accounts for the minor changes in the cost of inventory.
The continuous inflow and outflow is what is known as Perpetual inventory.
Example: Say you bought 50 units of baking powder for $2.5 each at the start of month 1, and a
further 50 units at the start of month 3 at $2.7 each. If a sale at month 4 for 80 units takes place,
what should ideally be the cost of inventory?
For this, essentially, we have four inventory valuation techniques:

1. FIFO: Tells you that inventory that is received first, will be sold and accounted for first.
2. LIFO: Tells you that inventory that is received last, will be sold and accounted for first.
3. AVCO (Continuous): An average cost of inventory is created, and inventory is sold and
accounted for using this continuous average.
4. AVCO (Periodic): Inventory cost is calculated periodically, and such cost is used.
Keep in mind, closing inventory in all cases would be valued at the remaining inventory and its value.
Let’s understand each one in more detail below:
FIFO
This method is known as the first in first out method, simply FIFO.
It is commonly used in practice, think of it as, you will sell the inventory you received first, before
they reach their expiry dates, first in so first out.
So, if our example was answered using FIFO method, the 80 units sold would’ve included the first 50
units at $2.5 and 30 units at $2.7, the remaining inventory would be the remaining 20 units at $2.7.
Advantages of FIFO:
• Logical – reflects the most likely physical flow.
• Easily understood.
• Inventory values at up-to-date prices.
• Acceptable to HM Revenue and Customs and IAS2.
Disadvantages of FIFO:
• Issues may be at out-of-date prices.
• In times of rising prices, reported profits are high (‘high’ closing inventory valuations).
• Cost comparisons between jobs are difficult.
On 1 January, there were 1,000 units of inventor units valued at a price of $10 each. The following
receipts and issues were recorded during January:
5 January Receipts 3,000 units at $11 per unit

11 January Issues 2,500 units
18 January Receipts 4,500 units at $12 per unit
25 January Issues 4000 units
Calculate the value of closing inventory using FIFO method.
Solution:
The following format is known as a store card, commonly known as a ‘bin card’ which tracks all ins in
the first column, titled as ‘Receipts’ and outs in the middle column, titled as ‘Issues’ while the
balance is shown in the third.
Date Receipts Issues Balance
Unit Cost $ Total Unit Cost Total Unit Cost $ Total
$ $ $ $
Opening 1000 10 10000 1000 10 10000
Jan 5 3000 11 33000 1000 10 10000
3000 11 33000
4000 43000
Jan 11 1000 10 10000 1500 11 16500
1500 11 16500
2500 26500
Jan 18 4500 12 54000 1500 11 16500

4500 12 54000
6000 70500
Jan 25 1500 11 16500 2000 12 24000
2500 12 30000
4000 46500
Closing 2000 12 24000
As we can notice, the units that first came, were issued first, hence applying FIFO. Any issues made,
will follow the order of receipts. Further receipts will simply be added to the balance.
Hence, in a time of rising prices, FIFO method would give you a higher closing inventory value and
hence a higher profit.
LIFO
This method is known as the last in first out method, simply LIFO.
Consider that you are selling sand, will it matter if you sold sand that came first or last? No.
In a bucket, if you store sand, the sand on the top would’ve been added last, but to remove sand,
you will ideally remove it from the top. That’s LIFO. However, this method barely has any practical
uses.
So, if our example was answered using LIFO method, the 80 units sold would’ve included the last 50
units at $2.7 and 30 units at $2.5, the remaining inventory would be the remaining 20 units at $2.5.
Advantages of LIFO:
• Issue prices are up-to-date.

• In times of rising prices, reported profits are reduced (as in this example where closing inventory is
valued at ‘lower’ cost).
Disadvantages of LIFO:
• Not usually acceptable to the HM Revenue & Customs and accounting standards.
• Inventory values may become very out-of-date.
• Cost comparisons between jobs are difficult
5 Receipts 3,000 at
January units $11
per
unit
11 Issues 2,500
January units
18 Receipts 4,500 at
January units $12
per
unit
25 Issues 4000
January units
Calculate the value of closing inventory using LIFO method.
Solution:

Unit Cost $ Total Unit Cost Total Unit Cost $ Total
$ $ $ $
Opening 1000 10 10000 1000 10 10000

Jan 5 3000 11 33000 1000 10 10000
3000 11 33000
4000 43000
Jan 11 2500 11 27500 1000 10 10000
500 11 5500
1500 15500
Jan 18 4500 12 54000 1000 10 10000
500 11 5500
4500 12 54000
6000 69500
Jan 25 4000 12 48000 1000 10 10000
500 11 5500
500 12 6000
2000 21500
Closing 2000 12 21500
So effectively, the goods brought in first, stay until enough quantity is sold where they are sold as
well, before any purchases.
Hence, in a time of rising prices, LIFO method would give you a lower closing inventory value and
hence a lower profit.
AVCO (Continuous)
This method is known as the continuous average cost method, simply AVCO.
This approach is more practical, as inventory value is constantly averaged out.
So, if our example was answered using AVCO method, the average cost would be calculated as
follows: (50x2.5) + (50x2.7)/100 = $2.6
Therefore, the 80 units sold would’ve been at $2.6, and the remaining inventory of 20 units would
be valued at $2.6 as well
Advantages:
• Acceptable to Accounting Standards and HM Revenue & Customs.
• Logical because units all have the same value.
Disadvantages:
• Issue prices and inventory values may not be an actual purchase price.
• Inventory values and issue prices may both lag behind current values.
5 Receipts 3,000 at
January units $11
per
unit
11 Issues 2,500
January units
January units $12
per
unit
25 Issues 4000
January units
Calculate the value of closing inventory using AVCO method.
Solution:

Unit Cost $ Total Unit Cost $ Total Unit
Total Cost $
$ $ $
Opening 1000 10 10000 1000 10 10000
Jan 5 3000 11 33000 1000 10 10000
3000 11 33000
4000 10.75 43000
Jan 11 2500 10.75 26875 1500 10.75 16125
Jan 18 4500 12 54000 1500 10.75 16125
4500 12 54000
6000 11.6875 70125
Jan 25 4000 11.6875 46750 2000 11.6875 23375
Closing 2000 11.6875 23375
So, the timing of the purchase is not considered, the costs are constantly averaged out, and such
average is used to issue inventory.
The average cost in the balance is calculated as Total cost/Units. So, for Jan 5, 43000/4000 = $10.75
Inventory values and issue prices may both lag behind current values (e.g. issue on 5 March is at
$2.244/unit whereas most recent purchase price = $2.30/unit).
AVCO (Periodic)
Another average cost method, commonly known as Periodic AVCO.
Here, again we simply calculate an average, but do it in an even simpler way. Rather than
continuously averaging rates, we find one common average rate at the end of the month, and then
charge all issues at that rate.
Let’s directly look into the Illustration to understand it better.
5 Receipts 3,000 at
January units $11
per
unit
11 Issues 2,500
January units
January units $12
per
unit
25 Issues 4000
January units
Calculate the value of closing inventory using the Periodic AVCO method.
Solution:
Periodic average = Total receipts/total units

(1000𝑥10)+(3000𝑥11)+(4500𝑥12)
= 8500
= $11.41
Closing inventory = 2000units x $11.41 = $22820
If the issue cost needs to be calculated, it will also be at $11.41. For example, the issues made on Jan
11 would be 2500 x $11.41 = $28525
• Ordering: Purchase requisition, Purchase order form

• Receiving: delivery note, Goods received a note
• Issuing: Material requisition note, material returned note, Material transfer note
• Valuation of inventory: LIFO, FIFO, AVCO
o Any increase in materials inventory will result in a debit entry, while any reductions
in
o Materials inventory will be shown as a credit entry.
• Control procedures: Re order level, maximum and minimum inventory levels
• Stocktaking: Periodic and continuous
• Holding cost: interest on capital, storage, insurance, stock outs
• Ordering: administrative, clerical, delivery.
1) The following statements refer to documents used in the material procurement procedures of
ABC Co.
Is each of these statements true or false?
1) Purchasing requisitions are sent by the department that is requesting the material to the
purchasing department. The purchasing department then places the order with the supplier.
2) Goods received notes are prepared by the goods received department and sent to the
department that ordered the materials to advise them that their order has arrived.
A stores ledger account records details of the receipts and issues
A stores requisition will record the quantity required
Lead time is the time between placing an order and receiving it
2) Which of the following statements, which refer to documents used in the material procurement
procedures of a company, correct?
a) A stores ledger account will be updated from a goods received note only
b) A stores requisition will only detail the type of product required by a customer
c) The term ‘lead time’ is best used to describe the time between receiving an order and
paying for it.
d) To make an issue from stores authorization should be required
3) The following information relates to a company which produces inventory:

Production rate: 1000 units per month.
Demand: 8000 units p.a.
Set-up cost: $2000 per batch.
Storage costs: $4 per unit for a year
Calculate the EBQ:
4) Which of the following is least relevant to the simple economic model for inventory?
a) Safety inventory
b) Annual demand
c) Holding cost
d) Ordering cost
5) A company uses the EOQ Model, and no holds buffer inventory.
It’s the cost of placing one order has decreased, and its annual cost of holding one unit in inventory
has increased.
What is the effect, if any, of the decrease in ordering cost and increase in holding cost on the EOQ?
6) On 1 June, there were 1,500 units of inventory component H valued at a price of $5 each. The
following receipts and issues were recorded during June:
7 June Receipts 3,200 units at $3.30 per unit
23 June Receipts 6,000 units at $3.50 per unit
25 June Issues 7,000 units
Using the first-in first-out (FIFO) method, what is the total value of the units issued on 25 June?
a) $24,500
b) $23,860
c) $26,110
d) $24,300
Solutions:
1) 1-True 2-True.
2) 1-d)
3) R = 1000 x 12 =12000 p.a.

2𝐶𝑜 𝐷
EBQ = √ 𝐷
𝐶ℎ (1− )
𝑅
2𝑥2000𝑥8000
EBQ = √ 8000
4 (1− )
12000
EBQ = 4899
4) The EOQ calculation does not include safety inventory
5) EOQ will decrease.

This is because – the cost of placing one order has decreased (therefore, more orders can be placed
more frequently without effect on the cost), and the cost of holding inventory has increased (so less
items can be held for the same cost).
Therefore, less items will be ordered more frequently – resulting in a lower EOQ.
6) c) $26,110
The FIFO method uses the price of the oldest batches first. The issues of 7,000 units will be valued as
follows:
$
1,500 x $5 = 7,500
3,200 x $3.30 = 10,560
2,300 x $3.50 = 8,050
7,000 26,110
Accounting for labour 113
Accounting for labour
Costs of labour
It is very important to distinguish between direct and indirect labour, as the two are treated
differently.
Direct labour: Direct labour is the labour involved in making or manufacturing the product or
providing the service. Example: Construction workers in a construction company.
Indirect labour: Any labour cost that is not directly involved in the good or service is classified as
indirect labour. These include maintenance, supervisors, canteen workers. These also include bonus
payments, idle time, sick pay.
Overtime and overtime premium: Employees are paid overtime when they work beyond their
contracted hours. For example, if you are supposed to work for 8 hours, but work for 12 hours, the
extra 4 hours of work qualifies as overtime. The payment above basic pay is known as an overtime
premium.
Example: Brian is paid a basic salary of $10 per hour, and overtime being time and a half of his basic
pay. Therefore, his overtime pay would be $15, out of which $10 relates to basic pay and $5 relates
to overtime premium.
Continuing the example, calculate the total pay if Brian works for 36 hours a week, out of which 6
hours are overtime.
Solution:
Basic pay for 36 hours (Direct cost): $10 x 36 = $360

Overtime premium for 6 hours (Indirect cost): $5 x 6 = $30
Total pay: $390
Alternatively, Basic pay for 30 hours can be calculated as $300, and total overtime pay can be
calculated as $90, but remember, only overtime premium is an indirect cost. The basic pay for all
hours worked is classified as direct labour.
*When extra hours are worked only at the specific request of a customer, they may be classified as
direct labour.
Last month an organization’s direct workers were paid $10,000 for normal working. In addition, they
were paid a total of $5,500 for overtime working. Overtime hours which were required due to a
general shortage of labour, relate to $2500. $3000 worth of labour was due to a specific request of a
customer. Overtime was paid at twice the basic pay.
What was the total direct labour cost for last month?
Solution:
In this situation, direct labour cost only includes pay at normal rate and specific overtime and not a
premium for overtime.
Direct labour cost for normal working = $10,000
Basic pay in overtime = $1250 (2500/2)
Specific overtime pay (Classified as direct cost) =$3000
Total direct labour cost = $14,250
Methods of determining time spent by labourers:

• Time sheets
A timesheet is a record of the amount of time an employee has spent at work, on a
particular job, project or working for a specific client.
• Timecards
Like a time sheet, a card is provided to the worker where time is stamped to maintain a
record.
• Job sheets
A time sheet provided to track the time taken for a particular job is known as a job sheet.
1. Last month an organization’s direct workers were paid $50,000 for normal working. In
addition, they were paid a total of $15,000 for overtime working. Overtime hours which
were required due to a general shortage of labour, were paid at time and a half.
What was the total direct labour cost for last month?
Answer: 1-$60,000
In this situation, direct labour cost only includes pay at normal rate and not a premium for overtime.
Direct labour cost for normal working = $50,000
Overtime working at normal pay rate = $10,000 (15,000 / 1.5)
Total direct labour cost = $60,000
Remuneration methods
There are two main remuneration methods; time related and output related.
Time related Output related
Remunerati
on methods
1. Time related system

Simply paying wages based on the number of hours worked by an employee, including basic pay
and overtime. Here there is no incentive for an employee to be more efficient. If an employee
makes 8 units in 8 hours or 6, he still will be paid the same.
Total wages = (total hours worked x basic rate pay) + (overtime hours x overtime premium)
2. Output related system

This is commonly known as piecework system. Employees are paid variably based on how much
they produce. For example, $2 per unit. They have an incentive to work well, however they may
let quality suffer. Usually, the minimum wage is set in accordance with laws.
Total wages = (units produced x rate of pay per unit)
Howard is working at a factory where he is paid on a piecework basis. The minimum guaranteed
wage per eight-hour day is $100. A unit takes 10 minutes to produce (standard time), and employees
are paid $15 per standard hour on a piecework basis.
Calculate the gross pay if Howard produced 54 units on a particular day.
Solution:
Standard hours worked: 54 x 10 = 540 minutes i.e. 9 hours.

Gross pay: $15 x 9 =$135
Minimum guaranteed wage = $100
Howard will be paid $135 since this is higher than the minimum guaranteed wage.
Types of piecework system

There are two main piecework systems that you need to know about:
• Straight piecework systems – the same rate per unit is paid no matter how many units are
produced. These systems are almost extinct today as employees are more likely to be paid a
guaranteed minimum wage within a straight piecework system.
• Differential piecework systems – these systems are the most widely used piecework systems and
involve different piece rates for different levels of production.
Incentive schemes
Like we discussed, employees have no incentive in a time-based pay to be efficient.

To overcome this, many companies offer their employees bonus schemes, and have their own ways
of paying such bonuses.
These bonuses only help if the employees are informed about them, they agree to them and are
simple to calculate.
Bonus schemes act like overtime, as they are paid above basic pay. Rate and pay are decided by the
company.
Some commonly used bonus schemes that you need to know are:
• Halsey
𝑇𝑖𝑚𝑒 𝑎𝑙𝑙𝑜𝑤𝑒𝑑−𝑡𝑖𝑚𝑒 𝑡𝑎𝑘𝑒𝑛
Bonus = 2
𝑥 𝑇𝑖𝑚𝑒 𝑟𝑎𝑡𝑒
• Rowan
𝑇𝑖𝑚𝑒 𝑡𝑎𝑘𝑒𝑛
Bonus = 𝑇𝑖𝑚𝑒 𝑎𝑙𝑙𝑜𝑤𝑒𝑑 𝑥 𝑇𝑖𝑚𝑒 𝑟𝑎𝑡𝑒 𝑥 𝑇𝑖𝑚𝑒 𝑠𝑎𝑣𝑒𝑑
• Measured day work – the concept of this approach is to pay a high time rate, but this rate is
based on an analysis of past performance. Initially, work measurement is used to calculate
the allowed time per unit. This allowed time is compared to the time actually taken in the
past by the employee, and if this is better than the allowed time, an incentive is agreed, e.g.
suppose the allowed time is 1 hour per unit and that the average time taken by an employee
over the last three months is 50 minutes. If the normal rate is $12/hour, then an agreed
incentive rate of $14/hour could be used.
• Share of production – share of production plans are based on acceptance by both

management and labour representatives of a constant share of value added for payroll.
Thus, any gains in value added – whether by improved production performance or cost
savings – are shared by employees in this ratio.
In the exam, the scheme that needs to be used will be given, or you will be informed on how to
calculate the bonus with another formula.
B company is deciding on which bonus scheme to adopt and has asked you to calculate gross pay
using both Halsey and Rowan schemes from the following:
Basic rate: $10 per hour

Expected time for 1 unit: 45 minutes
Time taken: 30 minutes
Solution:
Basic pay = $10 x 30/60 = $5
Halsey scheme
𝑇𝑖𝑚𝑒 𝑎𝑙𝑙𝑜𝑤𝑒𝑑−𝑡𝑖𝑚𝑒 𝑡𝑎𝑘𝑒𝑛

Bonus = 𝑥 𝑇𝑖𝑚𝑒 𝑟𝑎𝑡𝑒
2
45−30 10
Bonus = 2
𝑥 60
Bonus = $1.25
Total pay = $5 + $1.25 = $6.25
Rowan scheme
𝑇𝑖𝑚𝑒 𝑡𝑎𝑘𝑒𝑛
Bonus = 𝑇𝑖𝑚𝑒 𝑎𝑙𝑙𝑜𝑤𝑒𝑑 𝑥 𝑇𝑖𝑚𝑒 𝑟𝑎𝑡𝑒 𝑥 𝑇𝑖𝑚𝑒 𝑠𝑎𝑣𝑒𝑑
30 10
Bonus = 45 𝑥 60
𝑥 15
Bonus = $1.67
Total pay = $5 + $1.67 = $6.67
A company operates a piecework system of remuneration, but also guarantees its employees 75% of
a time-based rate of pay which is based on $19 per hour for an eight hour working day. Each unit
should take 3 minutes to produce (standard time). Employees are paid based on the number of
hours their output should have taken (standard hours). Piecework is paid at the rate of $18 per
standard hour. If an employee produces 200 units in eight hours on a particular day, what is the
employee gross pay for that day?
Solution:
200 units × standard time of 3 minutes per unit = 600 minutes, or 10 hours.
Employee gross pay = 10 hours × $18 = $180 Guaranteed ($19 × 8 hours) × 75% = $152 × 75% = $114
As gross pay exceeds the guaranteed amount, the answer is $180
Labour Ratios
The following ratios help the management manage labour. The ratios are:
Labour turnover
Labour turnover helps management measures the rate at which employees leave the company.
It is important to measure labour turnover as the higher this number is, the worse for the company.
More leavers lead to more replacements, which cost the company. Selection, training etc.
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑙𝑒𝑎𝑣𝑒𝑟𝑠 𝑤ℎ𝑜 𝑟𝑒𝑞𝑢𝑖𝑟𝑒 𝑟𝑒𝑝𝑙𝑎𝑐𝑒𝑚𝑒𝑛𝑡
Labour turnover = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑒𝑠
𝑥100
Labour efficiency
This ratio measures whether labour is working faster or slower than expected.
Simply put, if we are given 1 hour to make a unit of inventory, but we do it in 45 minutes, we are
efficient. If we take 75 minutes, we are not efficient.
If the efficiency is 100, the labour is working at the expected speed, if the ratio is above 100, the
labour is more efficient, and below 100 means the labour is less efficient.
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 ℎ𝑜𝑢𝑟𝑠 𝑓𝑜𝑟 𝑎𝑐𝑡𝑢𝑎𝑙 𝑜𝑢𝑡𝑝𝑢𝑡
Labour efficiency = 𝐴𝑐𝑡𝑢𝑎𝑙 ℎ𝑜𝑢𝑟𝑠 𝑤𝑜𝑟𝑘𝑒𝑑 𝑡𝑜 𝑝𝑟𝑜𝑑𝑢𝑐𝑒 𝑜𝑢𝑡𝑝𝑢𝑡 𝑥100
Idle time ratio
At times, there is simply no work for labourer’s, but they still need to be paid. This time is known as
‘idle’ time. For example, machine breakdown leads to employees being unable to work.
This ratio calculates how idle were the employees as a percentage.
𝐼𝑑𝑙𝑒 ℎ𝑜𝑢𝑟𝑠
Idle time ratio = 𝑇𝑜𝑡𝑎𝑙 ℎ𝑜𝑢𝑟𝑠 𝑥100
Labour capacity ratio
This ratio helps the management find out whether they were able to get more out of the labour than
originally planned.
𝐴𝑐𝑡𝑢𝑎𝑙 ℎ𝑜𝑢𝑟𝑠 𝑤𝑜𝑟𝑘𝑒𝑑 𝑡𝑜 𝑝𝑟𝑜𝑑𝑢𝑐𝑒 𝑜𝑢𝑡𝑝𝑢𝑡

Labour capacity ratio = 𝑇𝑜𝑡𝑎𝑙 𝑏𝑢𝑑𝑔𝑒𝑡𝑒𝑑 ℎ𝑜𝑢𝑟𝑠
𝑥100
Labour production volume ratio (‘activity’ ratio)
This ratio tells the management whether they produced more or less in the given budgeted hours.
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 ℎ𝑜𝑢𝑟𝑠 𝑓𝑜𝑟 𝑎𝑐𝑡𝑢𝑎𝑙 𝑜𝑢𝑡𝑝𝑢𝑡
Activity ratio = 𝑇𝑜𝑡𝑎𝑙 𝑏𝑢𝑑𝑔𝑒𝑡𝑒𝑑 ℎ𝑜𝑢𝑟𝑠
𝑥100
In the last period, an organization budgeted to work 100,000 hours manufacturing 40,000 units.
Actual output last period was 25,000 units which took 80,000 hours to manufacture.
What was the labour efficiency ratio for the last period (expressed as a % correct to zero decimal
place)?
Solution:
Budgeted hours per unit = 2.5 (100,000 / 40,000)

Actual hours per unit = 3.2 (80,000 / 25,000)
Labour efficiency ratio = 78% (2.5 / 3.2)
👩‍🏫 Illustration:
A company had 2500 employees at the start of the year and 2750 employees at the end of the year.
During the year, 500 employees left that needed replacement in the company.
What was the labour turnover for the year?
Solution:
Average number of employees in the year = 2625 (2500+2750/2)

Labour turnover rate = 19% (500/2625x100)
Journal entries for labour accounts
All costs relating to labour are debited to the labour account as they are an expense.
Then, expenses relating to direct and indirect labour are treated differently.
Direct costs: These costs are what eventually are included in inventory; hence they are removed
from the labour account by crediting them. They are debited to WIP account as that will eventually
make the finished goods.
Indirect costs: These costs are expensed out in the form of production overheads. Hence the labour
account is credited, and the production overheads account is debited. These include indirect labour,
overtime premium, sick pay, idle time etc.
Hence, the labour account looks like:
Labour account
Particulars $ Particulars $
By Cash To WIP
To Production overheads
To Overtime Premium
To Idle Time
To Sick pay
• There are three basic groups of remuneration methods: time work, piecework schemes and
bonus/incentive schemes.
• Labour attendance time is recorded on, for example, an attendance record or clock card. Job
time may be recorded on daily timesheets, weekly timesheets or job cards, depending on
the circumstances. The manual recording of times on timesheets or job cards is, however,
liable to error or even deliberate deception and may be unreliable. The labour cost of
pieceworkers is recorded on a piecework ticket/operation card.
• Idle time has a cost because employees will still be paid their basic wage or salary for these
unproductive hours, and so there should be a record of idle time.
• Labour turnover is the rate at which employees leave a company, and this rate should be
kept as low as possible.
• Production is the quantity or volume of output produced. Productivity is a measure of the

efficiency with which output has been produced. An increase in production without an
increase in productivity will not reduce unit costs
1) At 1 January, a company employed 3,641 employees, and at 31 December, employee numbers

were 3,735. During the year, 624 employees chose to leave the company.
What was the labour turnover rate for the year? Enlist the causes of labour turnover.
2) In the last period, an organization budgeted to work 120,000 hours manufacturing 31,000 units.
Actual output last period was 28,000 units which took 110,000 hours to manufacture.
What was the labour efficiency ratio for the last period (expressed as a % correct to one decimal
place)?
3) The following information is available for H Co for quarter two:

Budgeted hours 10,400 standard hours
Standard hours produced 9,375 standard hours
Actual hours worked 9,765
What is the efficiency ratio?
a) 98%
b) 96%
c) 104%
d) 102%
4) Last period an organization budgeted to work 40,000 hours manufacturing 7,000 units. Actual
output last period was 9,360 units which took 54,135 hours to manufacture.
What was the labour efficiency ratio for the last period (to one decimal place)?
a) 95.1%
b) 96.4%
c) 103.7%
d) 98.2%
5) A hotel has 180 identical bedrooms. It uses labour efficiency percentages to compare the
performance of four groups of workers (A, B, C and D) employed to clean the bedrooms. The
standard time to clean a bedroom is 1 hour.
The following data for last week is available:
Group A B C D
Actual hours worked 162 192 210 186
Actual number of bedrooms cleaned 247 297 310 279
Which group of workers was the most efficient last week?
a) Group D
b) Group C
c) Group B
d) Group A
Solutions1) Labour turnover rate =
Number of leavers who require replacement

Average number of employees × 100
Average number of employees in the year = (3,641 + 3,735) ÷ 2 = 3,688
Labour turnover rate = 624 3,688 × 100% = 16.9%
Causes It is important to try to identify why people leave an organisation and to distinguish between
avoidable and unavoidable causes of labour turnover.
• Causes of labour turnover –
avoidable:
– poor remuneration
– poor working conditions
– lack of training opportunities
– lack of promotion prospects
– bullying in the workplace.
• Causes of labour turnover –

unavoidable:
– retirement
– illness/death
– family reasons (e.g. pregnancy)
– relocation.
2) 98.5%
Budgeted total hours = 108387 (120,000 / 31,000*28000)

Actual hours = 110,000
Labour efficiency ratio = 98.5% (108,387 / 110,000)
3) 96%
Efficiency ratio =9375/9765x100

=96%
4) 103.7%
Budgeted hours per unit = 6 (40,000 / 7,000)

Budgeted hours for units actually produced = 56,160 (6 x 9,360)
Labour efficiency ratio = 103.7% ((56,160 / 54,135) x 100)
5) Group B
Total number of bedrooms cleaned per hour:
(1) Group A: 1.52 (247 / 162)

(2) Group B: 1.54 (297 / 192)
(3) Group C: 1.47 (310 / 210)
(4) Group D: 1.50 (279 / 186)
Group B cleaned more bedrooms per hour than the other groups and is therefore the most efficient.
Accounting for overheads
Types of expenses
As we saw with material and labour, even expenses are classified as either direct or indirect.
Direct expenses
Indirect expenses
Direct expenses are expenses that specifically happen while making the product and can be
identified to a specific cost centre.
These are part of the prime cost of a product.
Example: Hire of tools for a specific production requirement.
Indirect expenses cannot be specifically related to a product, hence are known as overheads.
Overheads can be grouped into production, administration, selling etc.
For example: Rent of the factory is a production overhead. It simply can’t be allocated to one
product, hence it’s indirect in nature.
Usually, production overheads take place across the factory, and must be allocated accordingly into
cost centres and service centres.
Production overheads = Indirect expenses + Indirect materials + Indirect labour
In this chapter, we’ll be dealing with production overheads and not administration and selling
overheads. For that, we need to know:
A cost centre is where costs are incurred, but the costs relate to production. Like assembly,
machining, finishing etc.
A service centre is where costs are incurred to provide service to cost centres. Like maintenance,
canteen etc.
Overhead accounting
In accordance with IAS 2, inventory value should include all costs incurred while making the
inventory. Using absorption costing, we follow this by absorbing all production costs into the
inventory.
Absorption costing is a way in costing where we recover overheads in a way that properly shows
how much overhead relates to the inventory.
In this section, we will learn how to
• Allocate and apportion overheads to different cost centres

• Reapportion non-production (Service) overheads into cost centres
• Absorb overheads into the products (In the next syllabus area)
Allocation and apportionment of overheads

To allocate means to simply charge the cost to whatever caused the cost. In simple language,
directly assign costs to specific departments. If a cost is arising specifically due to a department, such
cost will be fully allocated to that department. Example: A supervisor hired to supervise one cost
centre, that overhead cost will be allocated to that cost centre.
When more than one department is causing overhead costs, the costs need to be apportioned
between the departments or divided between them using an appropriate basis.
Examples of appropriate bases include:
• Floor area – rent
• Number of employees – canteen costs
• Machine value – depreciation
• kW consumed – electricity
A base can be selected if it justifies the cost.
👩‍🏫 Illustration 1: (Apportionment)

Major manufacturers Co have two production departments and two service departments and incur
the following overheads:
Rent: $49500
Electricity $12000
The following information is available:
Assembly Finishing Maintenance Canteen Total
Area (sq meters) 5000 2500 250 500 8250
kW consumed 1000 3500 1200 300 6000
Apportion the overheads with use of relevant basis:
Solution:
Rent will be apportioned on the basis of area and electricity on the basis of kW consumed.
Rent per square meter = $49500/8250 =$6
Electricity per kW consumed = $12000/6000 =$2
Apportionment:
Assembly Finishing Maintenance Canteen Total
Rent $30000 $15000 $1500 $3000 $49500
(Working) ($6 x 5000) ($6 x 2500) ($6 x 250) ($6 x 500) Tally
Electricity $2000 $7000 $2400 $600 $12000
(Working) ($2 x 1000) ($2 x 3500) ($2 x 1200) ($2 x 300) Tally
Reapportionment of service cost centre costs to production cost centres.
As we saw, overheads are apportioned to service cost centres as well, and these service costs need
to be reapportioned to cost centres in order to absorb them in the end.
It is likely that the service cost centres will serve other service centres. For example, a canteen will
serve those employees working for the maintenance department. Hence reapportionment methods
need to reapportion the costs accordingly.
Reapportionment can be done using
1. Direct method
2. Step down method
3. Reciprocal method
4. Reciprocal method (Algebraic)
These are discussed in detail below:
1. Direct method
In this method, service costs are apportioned directly to production cost centres and not to
other service centres. This might not give the most accurate result; however, this method is
useful when there are no service centres serving another centre or when the reapportionment is
not very significant.
Direct Method Cost Centres
👩‍🏫 Illustration 2: (Direct method)

The following are the overheads for a business.
$
C1 55200
C2 34500
S1 14850
S2 18300
There are 25 employees in the C1 department, 18 in the C2 department, 12 in the S1
department and 5 in the S2 department. The S1 department serves all employees in C1 and C2
departments only.
The S2 department spends 70% of their time for C1 and 30% of their time for the C2
department.
Reapportion the service centre costs to cost centres using the direct method.
Solution:
The costs of S1 will be reapportioned to the cost centres using employees as a ratio. Therefore,
in the ratio of 25:18
The costs of S1 will be reapportioned to the cost centres using time spent as a ratio. Therefore,
in the ratio of 70:30 or 7:3
The following format can be used to reapportion costs.
Basis C1 C2 S1 S2 TOTAL
Overhead 55200 34500 14850 18300 122850
costs
Reapportion Employees 8634 6216 (14850) - -
S1 25:18
Reapportion Time 12810 5490 - (18300) -
S2 spent
7:3
Total 76644 46206 - - 122850
Working:
S1 to C1: 14850/43x25 = 8634
Similarly, the other costs are reapportioned using the direct method.
2. Step down method
In this method, service costs are apportioned to other service cost centres, where applicable and
then to production cost centres. This method is useful when there is one service centres serving
another centre but not otherwise.
Step Down Method Service costs
Service Centres
Cost Centres
👩‍🏫 Illustration 3: (Step down method)

$
C1 55200
C2 34500
S1 14850
S2 18300
department and 5 in the S2 department. The S1 department serves employees in C1 and C2
departments only.
department.
Reapportion the service centre costs to cost centres using step down method.
Solution:
As we can see, S1 serves S2 along with the cost centres, whereas S2 only serves cost centres.
Hence, we apportion S1 costs to all three centres using the ratio 25:18:5
The costs of S2 will be reapportioned the same way, to the cost centres using time spent as a
ratio. Therefore, in the ratio of 70:30 or 7:3
The following format will be used again.
Overhead 55200 34500 14850 18300 122850
costs
Reapportion Employees 7734 5569 (14850) 1547 -
S1 25:18:5
S2 spent
7:3
Total 76827 46023 - - 122850
Working:
The only difference here is that instead of reapportioning 18300, we reapportion 19847.
Remember, the total costs at the service centres have to be zero at the end.
3. Reciprocal method
The need for a reciprocal method arises when both service cost centres serve each other as well
as serve cost centres. Here we keep reapportioning the costs to the other three until we reach
zero. For example: The maintenance centre maintains electronic equipment, vents and air
conditioners in the canteen, and the canteen serves the employees of the maintenance
department.
Service Centres
Cost Centres
👩‍🏫 Illustration 4: (Reciprocal method)

$
C1 55200
C2 34500
S1 14850
S2 18300
departments only.
department, and 10% of their time for the S1 department.
Reapportion the service centre costs to cost centres using the reciprocal method.
Solution:
The S1 department will serve all three departments in the ratio 25:18:5
The costs of S2 will be reapportioned to the cost centres and S1 using time spent as a ratio.
Therefore, in the ratio of 60:30:10 or 6:3:1
The following format will be used again.
Overhead 55200 34500 14850 18300 122850
costs
S1 25:18:5
Reapportion Time 11908 5954 1985 (19847) -
S2 spent
6:3:1
S1* 25:18:5
Reapportion Time 124 62 21 (207) -
S2 spent
6:3:1
S1 25:18:5
S2** spent
Round off
Total 76012 46838 - - 122850
Working:
*Now that 1985 has been apportioned to S1, we will reapportion it to the three cost centres. We
keep doing this until we reach zero.
**At the end, rounding off can be done logically, without following the ratios. 2 could’ve been
assigned to C1 as well.
4. Reciprocal method (Algebraic)
The same reciprocal method calculation can be done using algebraic equations. We need to
understand how to form such linear equations, and then solving those equations would give us
amounts to apportion to cost centres.
Service Centres
Cost Centres
Using the same Illustration, let’s understand how the algebraic calculation is done.
👩‍🏫 Illustration 5 : (Reciprocal method-algebraic)

$
C1 55200
C2 34500
S1 14850
S2 18300

departments only.
department, and 10% of their time for the S1 department.
Reapportion the service centre costs to cost centres using the reciprocal method.
Solution:
Simply put, we have to form a relation between the two service cost centres, in a way that the
equation shows the actual scenario.
If we see S1, its overhead cost is 14850 and 10% of the cost from S2.
Hence, the equation formed will be S1 =14850 + 0.1S2
For S2, we will convert the ratio 25:18:5 in percentage.
25/48x100 =52%
18/48x100 =37.5%
5/48x100 =10.5%
So, the overhead cost for S2 is 18300 and 10.5% from S1
Hence, the equation formed will be S2 =18300 + 0.105S1
The two equations therefore are:
S1 =14850 + 0.1S2 (1)
S2 =18300 + 0.105S1 (2)
We can solve these equations using any method.
Multiply (1) by 10
10S1 =148500 + S2 (3)
Compare (2) and (3)
-S2 =148500 – 10S1
S2 =18300 + 0.105S1
We get,
9.895S1 =166800
S1 =16857
Substitute the value of S1 in (2)
S2 =18300 +0.105 x 16857
S2 =18300 +1770
S2 =20070
Using these, we arrive at the total overhead for the cost centres.
C1 =55200 + 0.6S1 + 0.52S2
Substitute the values
C1 =55200 +(0.6 x 16857) +(0.52 x 20070)
C1 =55200 +10114 +10436
C1 =75750
C2 =34500 +(0.3 x 16857) +(0.375 x20070)
C2 =34500 +5057 +7526
C2 =47083
Absorption of overheads
As we know, inventory is valued at production cost. These include:

• Direct materials (Variable)

• Direct labour (Variable)
• Direct expenses (Variable)
• Production overheads (Variable)
• Production overheads (Fixed)
As the first four are variable, they can be easily identified. However, the fixed production overheads
do not change based on production and hence need to be absorbed into (Added to) the units of the
product.
This can be done by using a base and dividing costs upon the base, examples like:
• Units produced
• Labour hours
• Machine hours
• Percentage of prime cost
• Percentage of direct wages
As companies need to assign fixed overheads to particular units before determining selling price,
they are decided in the beginning. An overhead absorption rate is hence found out.
Budgeted production overhead

OAR =
Total base (Units,machine hours,labour hours)
It is possible for different overheads in the same factory to have different bases for calculating OAR.
If an overhead is labour intensive, it can use labour hours as base. Similarly, if an overhead is
machine intensive, it can use machine hours as base.
The following overheads are estimated for the next month:

$
Power 10000
Heating 5000
Maintenance 4000
19000
The company produces and sells 5000 units a month and absorbs overheads based on the number of
units produced.
Calculate the overhead cost to be allocated to each unit.
Solution:
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑
OAR = 𝑇𝑜𝑡𝑎𝑙 𝑏𝑎𝑠𝑒 (𝑈𝑛𝑖𝑡𝑠,𝑚𝑎𝑐ℎ𝑖𝑛𝑒 ℎ𝑜𝑢𝑟𝑠,𝑙𝑎𝑏𝑜𝑢𝑟 ℎ𝑜𝑢𝑟𝑠)
19000
OAR = 5000
OAR = $3.8
Therefore 0$3.8 will be added to the cost of each unit as overhead allocation.
Wendy Co makes two products, P and Q. Each passes through two departments, Machining and
finishing.
The following budgets are provided:

Units Machining Finishing
Product P 5000 2 hrs 1 hr
Product Q 2500 1.5 hrs 1.5 hrs
Budgeted overheads are as follows:

Machining: $75000
Finishing: $125000
Calculate OAR for both machining and finishing with relevant bases and find out the total overhead
absorbed by product Q using the rates.
Solution:
1. Machining OAR
Total machine hours = (2x5000) + (1.5x2500) =13750
Machining overheads = $75000
OAR = 𝑇𝑜𝑡𝑎𝑙 𝑚𝑎𝑐ℎ𝑖𝑛𝑖𝑛𝑔 ℎ𝑜𝑢𝑟𝑠
75000
OAR =
13750
OAR = $14.29
2. Finishing OAR
Total finishing hours = (1x5000) + (1.5x2500) =8750
Finishing overheads = $125000
OAR = 𝑇𝑜𝑡𝑎𝑙 𝑓𝑖𝑛𝑖𝑠ℎ𝑖𝑛𝑔 ℎ𝑜𝑢𝑟𝑠
125000
OAR = 8750
OAR = $5.45
3. Overhead absorbed by one unit of product Q

Finishing OAR =$5.45 per hour
Finishing hours used by Q: 1.5 hours
Overhead =$8.175 ($5.45 x 1.5)
Machining OAR =$14.29

Machining hours used by Q: 1.5 hours
Overhead =$21.435 ($14.29 x 1.5)
Total overhead for one unit of Q = $29.61 ($8.175 + $21.435)
Under/Over absorption
So, we’ve learnt how to calculate OAR, but we don’t know how it is actually absorbed.
We take this calculated OAR and multiply it with the actual activity (Units or hours) as demonstrated
in the formula below:
Overheads actually absorbed = OAR x Actual activity level
But we need to understand that this absorption is done based on budgeted overheads, and the
actual overheads incurred by the factory might be different.
This will lead to under or over absorption.
When:
Absorbed overheads > Incurred overheads = Over absorption (We’ve absorbed more cost than
actually incurred).We simply add back the over absorbed amount, (or remove the expense), thus
increasing our profit.
Absorbed overheads < Incurred overheads = Under absorption (We’ve absorbed less cost than
actually incurred).
We add more expense for the under absorbed amount, thus decreasing our profit.
Overabsorption =
Absorbed OH > Incurred OH
Underabsorption =
Absorbed OH < Incurred OH
Fancy Co has the following budgets for the month of October:

Budgeted overheads: $90000
Budgeted machine hours: 30000
However, the actual hours and expenses were as follows:
Actual overheads: $85000
Actual machine hours: 29000
Calculate the under/over absorption.
Solution:
Do not get confused and simply compare the budgeted overheads with the actual overheads and
conclude that the overheads were under absorbed by $5000.
Remember to calculate the OAR and apply it to the actual hours to arrive at the answer.
OAR = $90000/30000 =$3
Absorbed overheads = $3 x 29000 =$87000
Actual overheads = $85000
Over absorption =$2000 ($87000 - $85000)
Working backwards
In the exam, you might be provided with information about the under or over absorption and may
have to work backwards to find other information. This is demonstrated in the Illustration below.
The following information is provided for a business using labour hours as a base for overhead
absorption.
Budgeted fixed overhead $50000
Budgeted labour hours 12500
Actual fixed overhead $54000
The overheads were under absorbed by $2000.
Find out the actual labour hours worked.
Solution:
Remember, because there is an under absorption, the total absorbed overheads will be less than
actual overheads.
Hence, absorbed overheads =$54000 - $2000 =$52000
OAR =$50000/12500 =$4
The formula to find overheads actually absorbed can be restated as:

Actual activity = Overheads absorbed/OAR
=$52000/4 =13000
Actual labour hours worked are, therefore, 13000 hours.
You can always recalculate using your answer in the normal calculation to arrive at an under
absorption of $2000 to be sure that your answer is correct.
As long as you remember the basic calculation involved in identifying an under/over-absorption,

you should not have any problems.
• The main thing to remember is that if actual overheads are greater than absorbed overheads, then
we have under-absorption and any under-absorption need to be deducted from actual overheads
incurred in order to calculate the overheads absorbed.
• Similarly, if over-absorption occurs, the over-absorption needs to be added to actual overhead in
order to calculate the overheads absorbed

A firm absorbs overheads on a machine hour basis. In one period, machine hours worked were 3500.
Actual overheads were $54000, and overheads were under absorbed by $5000.
Find out the OAR.
Solution:
Actual overhead: $54000

Under absorption: $5000
Absorbed overhead: $49000
Actual activity (machine hours worked): 3500
OAR = $49000/3500 =$14
Accounting entries for overheads
Overheads are treated exactly like the labour account. Where all expenses are initially debited to the
overheads account.
Then all production costs that are absorbed are credited in the overheads account and debited to
WIP.
Any under or over absorption out of absorbed overheads is taken to P/L.
All non-production costs are credited in the overheads account and debited to P/L wherever
relevant.
Overheads account
Indirect WIP
labour Under
Indirect absorption
materials (P/L)
Indirect
expenses
Over
absorption
(P/L)
• Overhead is the cost incurred in the course of making a product, providing a service or
running a department, but which cannot be traced directly and in full to the product, service
or department.
• Recap of indirect and direct expenses:

Direct expenses are a part of a prime cost of a product
Indirect expenses are known as overheads
• Allocation and apportionment

Allocation charges overheads directly to specific departments
Apportioned fixed production overheads includes: rent, rates, heating and electricity cost.
• Reapportionment involves sharing out the fixed production overheads of services cost
centre between production cost centre.
• Appropriate bases for absorption

• Machine hour rate
• Labour hour rate
• Percentages of prime cost
• Percentage of direct wages
If either or both of the estimate for budgeted overheads or budgeted level of activity are
difference from actual results, then this will lead to under or over absorbed (recovery ) of
overheads.
1) A business absorbs its fixed production overhead on the basis of machine hours. The
budgeted machine hours were 5000 hours. However, actual machine hours ended up being
5500. The overheads incurred by the business was $9000. The overhead was over absorbed
by $2000.
What was the budgeted fixed overhead?
a) 11000
b) 9000
c) 10000
d) 7000
2) There are $100,000 of standard overheads to be applied and 2,000 hours of direct labour are
to be incurred in the period, however, the number of actual hours was 1,900 hours.
Which of the following statements are correct?
a) It would cause an over absorption of $2.6

b) It would cause an under absorption of $5.2
c) It would cause an under absorption of $2.6
d) It would cause an over absorption of $5.2
3) A company absorbs production overheads on a machine hour basis. The following

data relates to last year:
Budget Actual
Machine hours 1,500 1,200
Total production overheads ($) 34,500 36,600
What was the total over or under absorption of production overheads last year?
a) $9,000 under absorbed
b) $2,100 over absorbed
c) $2,100 under absorbed
d) $9,000 over absorbed
4) A company uses an overhead absorption rate of $18 per machine hour, which was calculated
using 60,000 budgeted machine hours for the period. During the same period, the actual
total overhead expenditure was $1,250,000, and 63,000 machine hours were recorded on
actual production.
By how much was the total overhead under or over absorbed in the period?
a) $116,000 under absorbed

b) $170,000 over absorbed
c) $170,000 under absorbed
d) $116,000 over absorbed
5) What is an absorption rate used for?

a) Share out common costs over benefiting cost centres
b) Find the total overheads for a cost centre
c) Charge overheads to products
d) Control overheads
6) A factory consists of two production cost centres (production1 and Production 2) and two
service cost centres (Service1 and Service 2). The total allocated and apportioned overhead
for each centre is as follows:
P1 P2 S1 S2
$500,000 300,000 $200,000 $400,000
The work done by the service cost centres can be represented as follows:
PC1 PC2 SC1 SC2

% of SC1 costs to other cost centres: 70 30 - -
% of SC2 costs to other cost centres: 60 30 10 -
After the full reapportionment of service cost centre overheads, what is the total overhead
for production cost centre P1?
a) $690,000
b) $880,000
c) $750,000
d) $908,000
7) A factory consists of two production cost centers (M and N) and one service cost center (O).
The total allocated and apportioned overhead for each center is as follows:
M ($) N ($) O ($)

15,400 37,800 56,000
The service cost center overhead is reapportioned to the production cost centers based on
the number of employees. The number of employees in each cost center is as follows:
M N O
35 21 14
After the reapportionment of service cost center overhead, what is the total overhead for
production cost center M?
$__________________
Solutions:
1 c) $10000
Absorbed overheads =$9000 + $2000 =$11000
OAR = $11000/5500 =$2
Budgeted overheads = OAR x Budgeted hours
Budgeted overheads = 2 x $5000 = $10000
2 c) It would cause an under absorption of $2.6
Overheads will be under absorbed if the actual activity is less than what was budgeted because
there is not enough activity when multiplied by the absorption rate to cover the overheads.
3 a) $9,000 under absorbed
Budgeted absorption rate = $23 per machine hour (34,500 / 1,500)

Amount of overhead absorbed = $27,600 (23 x 1,200)
Total production overheads = $36,600
Therefore, overheads were over absorbed by $9,000 (27,600 - 36,600).
4 a) $116,000 under absorbed
Total overhead absorbed = $1,134,000 (18 x 63,000)
Actual total overhead = $1,250,000
Under absorbed overhead = $116,000 (1,250,000 – 1,134,000)
5 c) Charge overheads to products
An absorption rate is used to determine the full cost of a product or service. Answer A describes
overheads allocation and apportionment. Absorption does not control overheads, so answer D is not
correct
Absorption and marginal costing 138
6 d) $908,000
Reapportionment of SC2
To PC1 = $240,000 (400,000 x 60%)

To PC2 = $120,000 (400,000 x 30%)
To SC1 = $40,000 (400,000 x 10%)
Reapportionment of SC1
Total costs to be reapportioned = $240,000 (200,000 + 40,000)

To PC1 = $168,000 (240,000 x 70%)
To PC2 = $72,000 (240,000 x 30%)
Total costs for PC1
Overhead = $500,000
SC2 reapportioned = $240,000
SC1 reapportioned = $168,000
Total = $908,000
7) $50,400
Total employees at profit centers M and N = 56 (35 + 21)
Profit center M's proportion of employees = 62.5% (35 / 56)
Profit center O's overheads allocated to profit center M = $35,000 (56,000 x 0.625)
Profit center M's total overhead = $50,400 (15,400 + 35,000)
Absorption and marginal costing
Introduction
As we know, we need the cost per unit first to add the profit and find out the selling prices of a
product. Such cost per unit can be found out using two methods: Absorption costing and marginal
costing.
1. Absorption costing
This is the method that we’ve been using so far. Let’s take a look at how the costing of a product
would be done using absorption costing:
Cost Card $
Direct materials X
Direct labour X
Direct expenses X
Variable production overhead X
Fixed production overhead (OAR) X
Full production cost XX
As we can see, we value our inventory at full production cost. Note that non-production costs
such as selling and administration expenses are excluded from the inventory valuation, and are
added later when calculating profit. That’s simply because we want to know how much it costs
us to produce the inventory.
This full production cost is what is used to value closing inventory, if any, at the end of the year.
Now, remember how we learnt to absorb overheads in the previous section? That’s what comes
here. It is important to remember that overheads absorbed and actual overheads incurred are
different. Hence, once we have actual overheads, we need to account for them.
This is how a cost statement looks when we use absorption costing:

$ $
Sales X
Less: Cost of sales
Opening inventory X
Variable cost of production X
Fixed overhead absorbed X
Less: Closing inventory (X) (X)
X
(under)/over absorption (X)/X
Gross profit X
Less: Non production costs (X)
Profit/Loss X
You might be wondering, why do we remove under absorption? Doesn’t under absorption mean
we absorbed less than the actual cost? You are correct. What you need to understand is we’re
removing it from the profit. A decrease in profit or increase in expense is the same thing.
To summarize;
Under absorption (which means we spent more than we budgeted/absorbed) is removed or
deducted from the profit.
Actual overhead > Absorbed overhead = Under absorption = -Profit

Over absorption (which means we spent less than we budgeted/absorbed) is added to the profit
as we spent less.
Actual overhead < Absorbed overhead = Over absorption = +Profit
👩‍🏫 Illustration 1: (Absorption costing)
Chair Co produces chairs:

Direct materials 3kg ($5/kg)
Direct labour 5 hours ($2/hour)
Variable prod. Overhead $4/unit
Budgeted activity level 15,000 units/month

Budgeted fixed production overhead $30000/month
Actual fixed production overhead for the month $27000
Selling price $50/unit

Variable non production cost $1/unit
Fixed non production cost $2500/month
For March:
Production 16000 units
Sales 14000 units
There is no opening inventory

Prepare the following:
a) Cost card
b) Profit/loss statement for the month of March
Solution:
a) The cost card under absorption costing will be:
Cost Card $
Direct materials ($3 x 5kg) 15
Direct labour ($2 x 5hours) 10
Variable production overhead (Given) 4
Fixed production overhead (OAR) 2
Full production cost 31
OAR = Budgeted fixed production/budgeted activity level

OAR = $30000/15000 =$2
b) Profit/Loss statement under Absorption costing
$ $
Sales ($50 x 14000) 700000
Less: Cost of sales
Opening inventory -
Variable cost of production ($29 x 16000) 464000
Fixed overhead absorbed ($2 x 16000) 32000
Less: Closing inventory ($31 x 2000) (62000) (434000)
266000
Over absorption (Note) 5000
Gross profit 271000
Less: Non production costs (2500 + ($1 x 14000)) (16500)
Profit/Loss 254500
Notes:
Actual fixed overhead =$27000
Overhead absorbed =$32000
More overhead is absorbed than actually incurred, meaning there is over absorption. Profit will
increase as we removed 5000 more earlier, now we add it back.
Over absorption =$32000-$27000 =$5000
2. Marginal costing
This is a new concept. As the word itself says, marginal costing means only taking the marginal
cost or additional cost that we incur to value inventory. Now, what is this additional or marginal
cost? Simple, the total variable cost.
Variable cost increases as units increase, meaning it’s an additional cost that we incur. Total
variable cost of production includes direct material, direct labour, direct expenses and variable
production overheads.
Absorption costing values inventory at full production cost, marginal costing values inventory at
marginal or variable production cost.
Before we dig deeper, we need to understand the concept of contribution.
Contribution
As we understood, marginal cost takes into account all variable costs, but not fixed costs.
Obviously, what remains can’t be termed as profit. Profit is calculated after all costs are
deducted. Hence, the term contribution.
Contribution = Sales price – all variable costs (production & non-production)
Simply put, the contribution is the amount that the product will contribute towards the recovery
of fixed costs.
How much ‘money’ do we have to ‘contribute’ towards paying for the fixed costs.
If this money, (known as contribution) is more than fixed costs, we have a profit. If it is less, it
means we did not earn enough to recover fixed costs, and hence made a loss.
Contribution per unit,, therefore, remains constant, profit varies as the more we sell the more
total contribution we’ll have to recover fixed costs from.
This can be demonstrated in the cost statement below:
$ $
Sales X
Less: Cost of sales

Opening inventory X
Variable cost of production X
Less: Closing inventory (X) (X)
X
Less: Other variable costs (X)
Contribution X
Less: Fixed costs (X)
Profit/Loss X
As we can see, we directly deduct the actual fixed cost as a period cost in the end. Hence, the
complicated under or over absorption issues don’t arise here.
👩‍🏫 Illustration 2: (Marginal costing)
Chair Co produces chairs:

Direct materials 3kg ($5/kg)
Direct labour 5 hours ($2/hour)
Variable prod. Overhead $4/unit
Budgeted activity level 15,000 units/month

Budgeted fixed production overhead $30000/month
Actual fixed production overhead for the month $27000
Selling price $50/unit

Variable non production cost $1/unit
Fixed non production cost $2500/month
For March:
Production 16000 units
Sales 14000 units
There is no opening inventory
Prepare the following:

a) Cost card
b) Profit/loss statement for the month of March
Solution:
a) Cost card under marginal costing

Cost Card $
Direct materials ($3 x 5kg) 15
Direct labour ($2 x 5hours) 10
Variable production overhead (Given) 4
Variable production cost 29
b) Profit/Loss statement under marginal costing

$ $
Sales ($50 x 14000) 700000
Less: Cost of sales
Opening -
inventory
Variable cost of 464000
production ($29 x
16000)
Less: Closing (58000) (406000)
inventory ($29 x 2000)
294000
Less: Other variable (14000)
costs ($1 x 14000)
Contribution 280000
Less: Fixed costs (29500)
(Actual=$27000+$2500)
Profit/Loss 250500
Note:
Contribution can also be calculated by calculating contribution per unit
Sales $50
Variable production costs $29
Variable non production costs $1
Contribution $20
Sales units 14000

Total contribution 280000
As we can see, when we compare the same question solution under absorption and marginal
costing. The profit figures are different. Let us now understand why this is the case.
Profit reconciliation
The reason behind the difference in profits is the valuation of closing inventory. Absorption costing
values inventory at $2 more than marginal costing. Since we have a closing inventory of 2000 units,
the difference of $4000 ($2 x 2000)
Difference in the inventory levels are the change in opening and closing inventory.
If the inventory levels increase, absorption costing gives higher profit
Example:
If opening inventory is 2000 units and closing inventory is 4000 units, absorption costing will give a
higher profit.
If the inventory levels decrease, marginal costing gives higher profit

Example
If an opening inventory is 4000 units and closing inventory is 2000 units, marginal costing will give a
higher profit.
We can directly calculate the difference by multiplying the inventory level with OAR. That is the only
cost which causes the difference as it is included in inventory valuation in absorption costing but not
in marginal costing. If we are provided with either of the profits, we can also find out the profit on
using another method.
Let us understand this better with the help of an Illustration.
In our previous Illustration, there was no opening inventory and a closing inventory of 2000 units.
This means the inventory levels have increased. This means that profit by absorption costing will be
higher.
What will be the difference in profits?
Solution:
The difference in profits is OAR x Difference in inventory level

Therefore, $2 x 2000 =$4000
A company has profit using absorption costing of $525000 and OAR of $15. In a month, the opening
inventory was 15000 units, and the closing inventory was 12000 units.
What will be the profit using marginal costing?
Solution:
Difference in inventory levels =3000 (15000-12000)

The inventory levels have decreased, hence profits by marginal costing will be higher.
Profit using absorption costing =$525000

Difference in profits =$45000 ($15 x 3000)
Profit using absorption costing =$570000
Finding production units

Similarly, we can find what was the production last when given the required information. This can be
done by working backwards. Let us understand it with the help of an Illustration.
👩‍🏫 Illustration 5 :
Absorption costing profit: $5750
Marginal costing profit: $1250
OAR =$3
In the month of January, there was no opening inventory, and sales were 7000 units.
Find out the production units.

Solution
First, we find out the difference in profits

This is $4500 ($5750-$1250)
If a change in inventory x OAR = difference in profits,
Then the difference in profits/OAR =change in inventory
Next, we find out change in inventory, this is,

$4500/$3 =1500 units.
As we know, profits using absorption costing are higher if inventory levels increase. Hence, closing
inventory is more than opening inventory. Since we have no opening inventory, the closing inventory
is 1500 units.
Last step here is to find out the production units.
The only way we have closing inventory is if we sold less than what we produced, right?
If not with this logic, we can even find it out using the formula.
Opening + Production – Sales = Closing
This can be restated as,
Production = Closing + Sales – Opening
Hence, production units = 1500 + 7000 = 9500 units.
Last month a manufacturing company's profit was $15,750, calculated using marginal costing
principles. If absorption costing principles had been used, a loss of $2,500 would have occurred. The
company's fixed production cost is $10 per unit. Sales last month were 15,000 units. Opening
inventory was 3000 units.
What was last month's production (in units)?
Solution:
Profit using marginal costing: $15750
Loss using absorption costing $(2500)
Difference in profits =$18250 (15750- (-2500))
Change in inventory = $18250/10 =1825 units

As profit using marginal costing is more, inventory levels have decreased.
Using the formula,

Opening + Production – Sales = Closing
Which can be restated as,
Production = Closing + Sales – Opening
Production = 1825 + 15000 – 3000
Production units = 13825
Advantages and disadvantages of absorption and marginal costing.
Advantages of absorption costing Advantages of marginal costing

Complies with IAS 2 Inventories Contribution per unit is constant over different
sales volumes
Better control due to under/over absorption No over/under absorption
Recognises that selling price must cover all costs Highlights contribution so appropriate for
decision making
Simple to operate
Disadvantages of absorption costing Disadvantages of marginal costing

Profits can be manipulated by changing Contribution may not cover fixed costs
production levels
It assumes that overheads are volume related Does not comply with IAS 2 Inventories
Fixed production overheads are not shared

between production units, they are written off in
full.
• Marginal cost is the variable cost of one unit of product or service.
• Contribution is an important measure in marginal costing, and it is calculated as the

difference between sales value and marginal or variable cost of sales.
• In marginal costing, fixed production costs are treated as period costs. In absorption costing,
fixed production costs are absorbed into the cost of units. Inventory values using absorption
costing are therefore greater than those calculated using marginal costing.
• Reported profit figures using marginal costing or absorption costing will differ if there is any
change in the level of inventories in the period.
• Absorption costing is most often used for routine profit reporting and must be used for
financial accounting purposes. Marginal costing provides better management information
for planning and decision making. There are a number of arguments both for and against
each of the costing systems.
1) For absorption costing, are the following statements true or false?
a) Over absorption occurs when the actual activity level is less than the budgeted activity level -
therefore, overheads are over absorbed.
b) Under absorption occurs when the actual overhead expenditure is less than the budgeted
overhead expenditure - therefore, overheads are under absorbed.
2) Last month a manufacturing company's profit was $1,750, calculated using absorption
costing principles. If marginal costing principles had been used, a loss of $3,500 would have
occurred. The company's fixed production cost is $3.5 per unit. Sales last month were 10,000
units.
What was last month's production (in units)?
a) 9,500
b) 11,500
c) 10,500
d) 12,500
3) A company manufactures and sells a single product. Next year the budgeted total fixed
production costs are $276,000, the budgeted sales are 92,000 units, and the budgeted
production is 110,400 units. The budgeted profit for next year using absorption costing
principles is $73,600
What is the budgeted profit for next year using marginal costing principles?
a) $18,400
b) $119,600
c) $27,600
d) $128,800
4) The following information relates to a manufacturing company for the next period:
Units $
Production 33,000 Fixed production costs 495,000
Sales 30,000 Fixed selling costs 60,000
Using absorption costing, the budgeted loss for next period is $58,000.
What would be the budgeted loss for next period using marginal costing?
a) $67,600
b) $13,000
c) $10,400
d) $65,000
5) Last month the opening inventory was 8,000 units, and the closing inventory was 6,000
units. Using absorption costing, this closing inventory was valued at $39,000. Using marginal
costing, last month’s profit was $60,000 and using absorption costing, it was $51,000.
What was the variable production cost per unit last month?
$______
6) Last month the opening inventory of a company was 1,800 units, and the closing
inventory was 4,050 units. Using absorption costing, this closing inventory was valued
at $26,325. Using marginal costing, last month's profit was $22,500 and using
absorption costing, it was $30,600.
What was the variable production cost per unit last month?
a) $2.90
b) $2.00
c) $3.60
d) $4.50
7) A company manufactures and sells a single product.
Next year the budgeted total fixed production costs are $500,000, budgeted sales are 26,000 units,
and budgeted production is 27,000 units.
The budgeted profit for next year using the absorption costing principle is $60,000.
What is the budgeted profit for next year using marginal costing principles?
$______
Solutions:
1) a) True
b) True
Explanation:
If the actual activity level is less than the budgeted activity level - the OAR is being multiplied by a
smaller amount, therefore under absorption
If the actual overhead is less than the budget overhead expenditure - then we have absorbed too
much - therefore over absorption.
2) -b) 11,500
In marginal costing, all fixed costs are written off in the financial period they occur, but in absorption
costing, they are absorbed in the cost per unit and are carried forward to future financial periods
within the inventory figure.
The marginal costing loss of $3,500 is $5,250 lower than the absorption costing's profit of 1,750
(1,750 - (- 3,500)). Therefore, the fixed cost held in inventory under absorption costing principles is
$5,250.
As fixed cost is $3.5 per unit, the total units in inventory is 1,500 (5,250 / 3.5).
Therefore, total production for the month must have been 11,500 (10,000 sales + 1,500 units carried
forward in inventory).
3) - c) $ 27,600
The difference between profits calculated under absorption costing and marginal costing principles
is due to the treatment of fixed costs.
In absorption costing, fixed costs are allocated to units produced. Therefore, fixed costs will move
from one financial period to another where not all units are sold but are carried forward as
inventory.
In marginal costing, all fixed costs are set off against revenue in the period they are incurred. No
fixed costs are carried forward.
Fixed cost per unit of production = $2.5 (276,000 / 110,400)
Closing inventory = 18,400 (110,400 - 920,000)
Fixed cost held in closing inventory = $46,000 (2.5 x 18,400)
As the $46,000 of the fixed cost would have been written off in the period under marginal costing,
but carried forward under absorption costing, the absorption costing profit will be higher than under
marginal costing principles by $46,000.
Therefore, the profit using marginal costing principles is $27,600 (73,600 - 46,000).
4) -b) $13,000
Losses under marginal costing can be different to those under absorption costing because of the
treatment of fixed costs. In marginal costing, all fixed costs are written off in the financial period
they occur, but in absorption costing, they are absorbed in the cost per unit and may be carried
forward to future financial periods within the inventory figure.
However, where inventory levels fall during a period, marginal costing will show a lower loss than
under absorption costing as less fixed cost is carried forward as inventory.
Fixed cost per unit of production = $15 (495,000 / 33,000)
Reduction in inventory during the period = 3,000 (33,000 - 30,000)
Reduction in fixed cost held in inventory = $45,000 (15 x 3,000)
Loss under marginal costing = $13,000 (58,000 - 45,000).
5) $2
Inventory value per unit: (39,000/6,000) = $6.50

This value is made up of variable and fixed costs as it was calculated under the absorption costing
method.
The difference between marginal and absorption costing profit is fixed cost.
Fixed cost per unit = ($60,000 - $51,000)/2,000 = $4.50
Variable cost per unit $6.50 - $4.50 = $2
6) -a) $2.90
Variable cost per unit = Total cost per unit - Fixed cost per unit
Total cost per unit = $6.50 (26,325 / 4,050)
Fixed cost per unit = $3.60 ((30,600 – 22,500) / (4,050 – 1,800))
Variable production cost per unit = $2.90 (6.50 - 3.60)
7) $41,480
Budgeted fixed production cost per unit = $18.52 (500,000 / 27,000)

Marginal costing profit = $41,480 (60,000 - (27,000 - 26,000) x 18.52)
Job, Batch and Service costing
Job costing
Job costing is basically costing for a specific job. Jobs like designing a client’s house etc., are unique
in nature. Hence, each job is costed separately.
It enables us to price each job differently based on estimated costs and an added profit margin.
Let’s see how this is done with the help of an Illustration.
A business operates a job costing system and prices its jobs by adding 5% to the total cost of the job.
The prime cost of a job was $750, and it had used 20 direct labour hours. The fixed production
overheads are absorbed on the basis of direct labour hours. The budgeted overhead absorption rate
was based upon a budgeted fixed overhead of $500 and total budgeted direct labour hours of 100.
What price should be quoted for this job?
Solution:
As we can see, the business adds 5% to total cost to arrive at a selling price.
This can be done as follows:
Prime cost $750
Overhead ($500/100 x 20) $100
Total cost $850
Profit (5% of 850) $42.5
Price $892.5
Note: Until the job is completed, all costs incurred, such as material and labour, will be part of WIP,
i.e. Work-in-progress. When the job gets completed, final costs are added to WIP to arrive at the
total costs incurred.
Batch costing
Batch costing is exactly like job costing, only instead of one single job, a batch is produced having
multiple identical units. To arrive at the cost per unit, we divide the total costs by units produced.
That is:
Total production cost of batch

Cost per unit in batch =
Number of units in a batch
WeWool is a woolen cloth manufacturer producing identical white woolen shirts. The following are
the costs for a batch of 100 shirts.
Wool $85
Machine set up 2 hours @$15 per hour
Other materials $25
Wages (20 hours per 100 shirts) $5 per hour
Generally, fixed overheads are $6000 per period, during which a total of 2000 labour hours are
expected to be worked.
Calculate cost per shirt using batch costing.
Solution:
Batch cost for 100 shirts $
Wool 85
Machine costs ($15 x 2) 30
Other materials 25
Wages ($5 x 20) 100
Overheads ($3 x 20) 60
Total cost A 300
No. of shirts B 100
Cost per shirt (A/B) $3
Service costing
So far, we’ve looked at costing for different products. Services also get provided in exchange for
money with a motive of profit. Hence, costing for services is necessary.
Remember, a service will always be provided by someone, hence the indirect costs are always in a
higher proportion.
The main idea of service costing is the same, cost of service plus profit required gives us the price to
be charged. The issue is that we don’t easily arrive at the cost of service due to the following
reasons:
1. Simultaneous- A service is provided and consumed at the same time. Costing is usually done
before the activity; hence it gets complicated with services. A massage parlour will not know
how much oil will be used in a massage, and hence cannot pre budget for oil per massage.
2. Heterogeneity -This means each service is different. Costing is done for identical units, but
each service will be slightly different than the other. Like we said, the amount of oil used will
be more or less.
3. Intangibility- A service is intangible, meaning it can’t be seen or touched. You don’t go home
with a service in your hand. You receive a service, and it’s gone. Costing for something like
this is difficult.
4. Perishability- This means that services we receive can’t be stored. Costing for something that
will only arise when required and is unique is hence difficult.
Composite cost unit
One of the main difficulties is finding out a correct cost unit. Take the example of a hospital. Do you
cost per patient, or do you cost per room or per day? Due to this, we have composite cost units.
They are simply costs per two variables. For the hospital, therefore, an appropriate cost unit would
be cost per patient per day.
Cost per service unit = Total costs for providing the service
Number of service units used to provide the service
For travel provider companies, such as public transport buses, an appropriate composite cost per
unit is passenger-miles.
Let’s take an Illustration to understand the composite cost unit.
A hospital calculates its basic costs using a composite cost unit: cost per bed per day.
The following information is available for the month of June:

Number of patients in period 2500
Average admission period 4 days
Nurse costs $25000
Cost of cleaning supplies $3000
Other costs $12000
What will the cost per bed per day be?
Solution:
First, we find out our total cost, which is:

$25000 + $3000 + $12000 = $40000
Next, we divide it by the number of patients, to find out the cost per patient.
Cost per patient = $40000/2500 =$16
But this cost is for an average period of 4 days.

Cost per patient per day is therefore, $16/4 = $4
This way of calculation is explained for understanding purposes.

It is recommended to find out the composite unit first.
As follows:
Patient-days = 2500 x 4 =10000

(10000 patient days represent the fact that 2500 patients were admitted for a combined 10000 days,
on average 4 each)
Cost per patient per day = $40000/10000 =$4

• A costing method is designed to suit the way goods are processed or

o manufactured or the way services are provided
• Job costing is a costing method applied where work is undertaken to customers' special
requirements, and each order is of comparatively short duration.
• Costs for each job are collected on a job cost sheet or job card.
• The usual method of fixing prices within a jobbing concern is cost plus pricing.
• Batch costing is similar to job costing in that each batch of similar articles is separately
identifiable. The cost per unit manufactured in a batch is the total batch cost divided by the
number of units in the batch.
• Service costing can be used by companies operating in a service industry or by companies

wishing to establish the cost of services carried out by some of their departments. Service
organizations do not make or sell tangible goods.
• Specific characteristics of services:

o Simultaneity
o Heterogeneity
o Intangibility
o Perishability
• The main problem with service costing is the difficulty in defining a realistic cost unit that
represents a suitable measure of the service provided. Frequently, a composite cost unit
may be deemed more appropriate. Hotels, for example, may use the 'occupied bed-night' as
an appropriate unit for cost ascertainment and control.
• Service department costing is also used to establish a specific cost for an internal service
which is a service provided by one department for another, rather than sold externally to
customers, e.g. canteen, maintenance.
1) Which of the following is not a performance measures for service industries?

a) % of return customers
b) % market share
c) % of services returned
2) Which of the following is NOT a characteristic of job costing?

a) Homogenous products.
b) Customer- driven production.
c) Production that can be completed within a single accounting period.
3) A company operates a job costing system. Job number 1300 requires $90 of direct materials
and $150 of direct labour. Direct labour is paid at a rate of $15 per hour. Direct expenses for
the job are $60. Production overheads are absorbed at a rate of $50 per direct labour hour,
and non-production overheads are absorbed at a rate of 130% of prime cost.
What is the total cost of job number 1300?
$________?
Solutions:
1) c) Services cannot be returned
2) a) Each job is unique.

Job costing is customer driven with customers ordering a specific job to be done. It is also possible
for production to be completed within a single accounting period
3) - $1,190
Prime cost = $300 (90 + 150 + 60)
Overheads = $890 ((150 / 15) x 50) + (1.3 x 300)
Total cost = $1,190 (300 + 890)
Process costing 157
Process costing
Introduction to process costing
Process costing is useful for companies that mass produce products that go through a series of
processes before completion.
Example: Manufacturing a car is done through various processes. The main body is built, painted,
parts individually fitted, interior crafted, and finally, finishing touches and electric components
added. Often, the process of manufacturing takes a long time and hence accounting for the
unfinished product is necessary.
This unfinished product is known as WIP.
Process costing tracks all input process costs, such as material, labour, overheads. Such total cost is
then divided by the total no. of expected units of output to arrive at an average cost per unit.
Net cost of inputs

Cost per unit =
Expected output
Average cost per unit= Total Cost of inputs – scrap value of normal loss
Input unit- normal loss unit
Process 1 Process 2 Process 3
• Inputs: • Additional • Additional

• Material inputs: inputs:
• Labour • Materials • Materials
• Overheads • Labour • Labour
• Overheads • Overheads
We simply assume that at the end of each process, every unit that comes out takes an equal share of
the total cost, to calculate cost per unit.
The following costs were incurred in Process 2
Materials transferred from Process 1: 100 units at $90 per unit

Labour costs: $5000
Overheads: $2000
Materials transferred to Process 3: 100 units
Prepare Process 2 account and calculate an average cost per unit.

Solution:
Process 2
Particulars Units $ Particulars Units $
Process costing 158
Materials 100 9000 Materials 100 16000

from P1 5000 transferred
Labour 2000 to P3
Overheads
100 16000 100 16000
All inputs are debited, all outputs are credited.

Therefore, each unit is valued at $160, i.e. $16000/100
Like in normal accounts, ledgers need to tally. In costing, even the unit’s columns will always tally.
Normal loss and Scrap value
It is necessary to understand, input units and output units will not always be equal. That’s what is
known as loss in process costing. For example, a process involving milk may input 100ltrs to start
with but may only end up with 98ltrs. That may be due to evaporation, milk left behind in drums etc.
Physical products may get damaged too.
Basically, a normal loss is the loss that every company will face while making the product. It is hence
termed as ‘normal’ or unavoidable. We usually know how much loss will we make based on past
process information. This will be given to us as a %age in the exam questions.
Let’s understand how this will impact our process account.

Starting with the unit’s column, the two litres of milk lost will now be shown as a normal loss on the
credit side, with the output being the remaining 98 litres, thus tallying the unit’s column.
Remember that, normal loss will change our cost per unit. Remember, the formula says expected
units. When we’re expecting 98litres, we will only assign total costs to those 98litres.
The units we lose will have no value, and hence their value in the account will be $0.
In some cases, when we can sell off normal loss units for scrap, the sale amount will be credited in
the process account.
When there is scrap involved, we deduct the income from our total cost before calculating the total
cost per unit. Remember, the formula says the Net cost of inputs. I.e. Total costs – Income from
scrap.
To understand what we mean, let’s dive into a few Illustrations.
👩‍🏫 Illustration 2: (Normal loss- no scrap)


Normal loss is 5% of the input
Labour costs: $5000
Overheads: $2000

Solution:
Process 2
Process costing 159
Materials 100 9000 Normal 5 -

from P1 5000 loss 95 16000
Labour 2000 Materials
Overheads transferred
100 16000 to P2 100 16000
Normal loss is calculated as 5% of 100, i.e. 5 units.
Now, our cost per unit becomes $168.42 ($16000/95)
👩‍🏫 Illustration 3 : (Normal loss- no scrap)


Normal loss is 10% of the output
Labour costs: $1000
Overheads: $750
Solution:
Process 2
from P1 1000 loss 250 4500
275 4500 to P2 275 4500
Normal loss is 10% of output not input

Output + Normal loss = Input
If the output is 100, the normal loss is 10, making input 110.
100+10=110
We can find normal loss from the given input; therefore as,
275 x 10/110 = 25 units.
To cross check, the normal loss is 10% of output which is true as 25 units are 10% of 250 units
Now, our cost per unit becomes $18 ($4500/250)
👩‍🏫 Illustration 4: (Normal loss- scrap value)

Scrap from the process can be sold at $27 per unit.
Labour costs: $5000
Overheads: $2000
Solution:
Process 2
Process costing 160
Materials 100 9000 Normal 5 135

from P1 5000 loss 95 15865
100 16000 to P2 100 16000
Normal loss is calculated as 5% of 100, i.e. 5 units. These units are sold at a scrap value of $27 each,
therefore, the total scrap income is $135.
The balancing figure is, therefore, $16865, which will be distributed to the 95 units.
𝑁𝑒𝑡 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑖𝑛𝑝𝑢𝑡

Cost per unit = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑜𝑢𝑡𝑝𝑢𝑡
16000−135
Cost per unit = 95
$15865
Cost per unit = 95
Cost per unit = $167 per unit.
Abnormal loss and gains

Normal loss is a prediction of how much loss will be faced by the company.
The actual loss, however, may be different,
If the actual loss is more than the normal loss, the additional amount is an abnormal loss.
Example: A company’s normal loss was at 50 units; however, the actual loss was 60 units. 10
additional units lost are abnormal losses.
If the actual loss is less than the normal loss, meaning the company did not lose as many units as
they thought they would, the difference in units leads to an abnormal gain.
Example: A company’s normal loss was at 50 units; however, the actual loss was only 45 units. 5
units that were expected to be lost, but aren’t, are abnormal gains.
Abnormal losses and gains and the process account:
• The costs associated with producing abnormal losses or gains are not absorbed into the cost of
good output.
• Abnormal loss and gain units are valued at the same cost as units of good output in the process
account.
Abnormal losses and gains:

Losses and gains are transferred from the process account to the abnormal loss/gain account. If
there is no scrap value, the losses or gains are transferred to the statement of profit or loss at the
value given in the process account.
Simply put,
Actual loss > Normal loss = Abnormal loss
Actual loss < Normal loss = Abnormal gain
Now, how do we value these units? Remember, these were not expected, and the cost per unit
valuation should not change based on these. Hence, these too are taken at full cost per unit. You
will understand what we mean in the next Illustration. The loss incurred or gain received will simply
be taken to the P/L statement.
👩‍🏫 Illustration 5: (Abnormal loss- no scrap)


Labour costs: $5000
Process costing 161
Overheads: $2000
Solution:
Process 2
from P1 5000 loss 5 842
Labour 2000 Abnormal 90 15158
Overheads loss
100 16000 Materials 100 16000
transferred
to P2
As the output is 90 units, 10 units were lost. 5 units were expected and accounted for as normal loss;
hence the remaining units are an abnormal loss. This can also be found as the balancing figure in the
unit’s column.
The cost per unit stays at $168.42 ($16000/95) as the formula states expected units which still were
95.
Cost for materials transferred = $168.42 x 90 =$15158
Cost for abnormal loss = $168.42 x 5 =$842
👩‍🏫 Illustration 6: (Abnormal gain- no scrap)


Labour costs: $5000
Overheads: $2000
Solution:
Process 2
Materials from P1 100 9000 Normal loss 5 -
Labour 5000 Materials transferred 97 16337
Overheads 2000 to P2
Abnormal gain 2 337
102 16337 102 16337

The company expected to produce 95 units, but they ended up producing 97 units. This is known as
abnormal gain. 2 units will be shown on the credit side.
Remember, the unit’s column has to tally, with normal loss at 5 units and materials transfer at 97
units, 2 units less are on the Dr side. These are the abnormal gain units.
Process costing 162
Another way of thinking is, if 5 units were credited as loss, but the actual loss was only 3 units, we
credit 2 units to have a net credit impact.
This might sound complicated but is extremely simple to account for.
Cost per unit stays at $168.42 ($16000/95) as expected units are used.
97 finished units will be valued at $168.42 x 97 = $16337
And 2 abnormal gain units will be valued at $168.42 x 2 = $337
If the sum does not tally, you might’ve made a mistake in allocating the cost to abnormal gain.
Recheck :)
With scrap value, accounting for abnormal losses and gains becomes a little tricky. But again,
remember the cost per unit will not change after taking scrap value for the normal loss. Additional
scrap generated from abnormal loss units will directly be taken to P/L, and abnormal gain will
reverse scrap proceeds in P/L as well. This is illustrated below:
👩‍🏫 Illustration 7: (Abnormal loss- scrap value)

Labour costs: $5000
Overheads: $2000
Solution:
Process 2
from P1 5000 loss 5 835
Labour 2000 Abnormal 90 15030
Overheads loss
100 16000 Materials 100 16000
transferred
to P2
As the output is 90 units, 10 units were lost. 5 units were expected and accounted for as normal loss;
hence the remaining units are an abnormal loss. This can also be found as the balancing figure in the
unit’s column.
The cost per unit is $167 ($16000-135/95) as we deduct scrap proceeds from normal loss units only.
Cost for materials transferred = $167 x 90 =$15030
Cost for abnormal loss = $167 x 5 =$835
Remember, abnormal loss units will be shown at cost per unit and not at scrap value. The scrap will
be accounted separately as follows:
Abnormal loss Account

Process 2 5 835 Scrap 5 135
P/L 700
Process costing 163
As abnormal loss is credited to Process 2, Process 2 will be debited in the Abnormal loss account.
These 5 units as well, will be sold for a scrap value of $27 each unit, totalling $135. The remaining
$700 is the actual loss and will be taken to P/L.
Scrap Account
Process 5 135 Cash 10 270
2(Normal) 5 135
Abnormal 10 270
loss
A total of 10 units are sold for scrap, and we receive $27, our total scrap received is $270. 5 units are
from normal loss, and 5 units are from abnormal loss.
👩‍🏫 Illustration 8: (Abnormal gain- scrap value)


Labour costs: $5000
Overheads: $2000
Solution:
Process 2
from P1 5000 loss 97 16199
Overheads 2 334 transferred
Abnormal to P2 102 16334
gain 102 16334
As the output is 97 units, 3 units were lost. As we produced more than we expected, we have an
abnormal gain of 2 units. These units are debited.
The cost per unit is $167 ($16000-135/95) as we deduct scrap proceeds from normal loss units only.
Cost for materials transferred = $167 x 97 =$16199
Cost for abnormal loss = $167 x 2 =$334
Remember, abnormal gain units will be shown at cost per unit. The scrap will be reversed separately
as follows:
Abnormal gain Account

Scrap 2 54 Process 2 2 334
P/L 280
2 334 2 334
Process costing 164
As the abnormal gain is debited to Process 2, Process 2 will be credited in the Abnormal gain
account.
Remember, only 3 units will be scrapped. But we accounted for 5 units in our normal loss. Hence,
scrap for 2 units will be reversed. Our real income from abnormal gain,therefore, is $280.
Scrap Account
Process 5 135 Cash 3 81
2(Normal) Abnormal 2 54
5 135 gain 5 135
As total 3 units are sold for scrap at $27 each, total scrap is $81. Previously we expected 5 units to be
scrapped, shown on the debit side. The 2 units are therefore reversed by crediting abnormal gain.
Joint products v/s By-products
Sometimes in production, more than one product can be made out of one process. These are known
as joint products. Joint products are products with full market value.
Example: Milk can be processed to make cream, cheese and butter.
Byproducts are also products made with other products, but the only difference is they have a lower
value when compared with the other product. They are more of a residual product that comes out.
Costing for the two is different and needs to be understood.
Example: Woodcutters wood is the main product, but the sawdust generated by cutting the wood
can also be sold at a lower value, making it a by-product.
Joint product costing
Joint products usually have a split-off point, after which they incur separate costs. Like milk will be
processed the same way initially, but the WIP will be split-off at some point to then make cheese
and butter.
All costs after the split-off point have simple calculations as they are directly assigned to the specific
cost. The costs before the split-off point need to be allocated.
The allocation can be done using various ways, some methods include:
• Market value
• Production units
• NRV (Net realizable value)
These methods are demonstrated in the Illustration below:
Wendy Co produces two products, W and Y, in a single joint process. The following information is
provided:
Joint costs incurred $25000
Production units:
W 5000
Process costing 165
Y 7500
Additional processing costs:
W $15000
Y $10000
Selling price:
W $15
Y $10
Allocate the joint costs.
Solution: (Production units’ method)
Production units:
W 5000
Y 7500
Total 12500
Therefore, joint costs will be allocated in the ratio 5000:7500 or 2:3
Joint costs:
W $25000 x 2/5 $10000
Y $25000 x 3/5 $15000
Total $25000
Solution: (Market value method)
Market value:
W $15 x 5000 75000
Y $10 x 7500 75000
Total 150000
Joint costs:
W $25000 x 1/2 $12500
Y $25000 x 1/2 $12500
Total $25000
Solution: (Net realizable value method)
Net realizable value: (MV- Additional costs)

W $75000-$15000 $60000
Y $75000-$10000 $65000
Joint costs:
W $25000 x 12/25 $12000
Y $25000 x 13/25 $13000
Total $25000
Process costing 166
By-products
The treatment for by-products is varied. What to do with the income will always be given in the
exam question. Some commonly used methods are:
• Other income: Where by products are not allocated any costs and are recorded as other
income.
• Income deduction: The income is deducted from the total costs, and then the net cost is
distributed to the other products.
• Pro rata: Allocate cost to by-products like done for joint products. Rarely used method
practically.

A company produces two products, V and W and one by-product that is product U. Joint costs are
allocated between V and W using the production units method.
The following information is relevant:

Production Units:
V 1000
W 1500
U 500
Selling prices
V $50
W $45
U $1
Joint costs: $45500
Allocate joint costs to V and W if sales revenue from U is deducted from total costs.
Solution:
Revenue from U: $1 x 500 =$500

Total costs: $45500
Joint costs: $45000 ($45500 - $500)
Production units:
V 1000
W 1500
Total 2500
Therefore, joint costs are apportioned in the ratio 2:3
Joint costs:
V $45000x2/5 $18000
W $45000x3/5 $27000
Total $45000
A company produces two products along with a single by-product. The joint process costs a total of
$200,000. Product A can be sold for $450,000 after additional processing of $250,000; Product B can
Process costing 167
be sold for $600,000 after additional processing of $200,000. The by-product BP can be sold for
$25,000 after packaging costs of $5,000. The by-product is accounted for using the by-product
revenue deducted from the main product cost approach.
Required:
What would be the joint cost allocation using the net realisable value method?
A B
A $60,000 $120,000
B $66,667 $133,333
C $77,143 $102,857
D $85,714 $114,286
Further processing viability
Further processing viability refers to the analysis of whether it is economically feasible and beneficial
to continue processing a product or semi-finished goods beyond their current stage of production. It
involves evaluating the costs and potential benefits associated with additional processing to make
informed decisions about whether to proceed with the next stage of production or stop the process
at its current stage.
Incremental revenues XX
Less: Further processing costs (XX)
Incremental profit or loss XX
If there is an incremental profit, only then it is worthwhile to process further.

Joint products R and S are outputs of a single manufacturing process. Each product could be sold at
the split-off point or processed further into RR and SS. The following information about the two
products is available:
Product R S
Number of units manufactured at 5,000 units 4,500 units
split-off point of R and S
Selling price at the split-off point $55.00 per unit $75.00 per unit
Cost of further processing $127,000 $300,000
Number of units of RR and SS 6,000 units 5,500 units
manufactured
Selling price after further 78.00 115.00
processing
Solution
R or RR S or SS
Revenue from RR and SS 468,000 632,000
(6,000 x 78) (5,500 x 115)
Less: Revenue from R and S 302,500 337,500
(5,000 x 55) (4,500 x 75)
Incremental revenue from further processing 165,500 294,500
Process costing 168
Less: Incremental cost of further processing (127,000) (300,000)

Incremental Profit/Loss 38,500 (5,500)
Process further? Yes No
Process costing 169
• Process costing is a costing method used where it is not possible to identify separate units of
production, or jobs, usually because of the continuous nature of the production processes
involved.
• Process costing is centred around four key steps. The exact work done at each step will
depend on whether there are normal losses, scrap, opening and closing work in progress.
– Step 1 Determine output and losses

– Step 2 Calculate cost per unit of output, losses and WIP
– Step 3 Calculate total cost of output, losses and WIP
– Step 4 Complete accounts
• Losses may occur in the process. If a certain level of loss is expected, this is known as normal
loss. If losses are greater than expected, the extra loss is an abnormal loss. If losses are less
than expected, the difference is known as abnormal gain.
• The scrap value of the normal loss is usually deducted from the cost of materials.
• The scrap value of abnormal loss (or abnormal gain) is usually set off against its cost, in an
abnormal loss (abnormal gain) account.
• The point at which joint products and by-products become separately identifiable is known
as the split-off point or separation point. Costs incurred up to this point are called common
costs or joint costs.
1) An organization operates a process that creates two joint products (M and B). Last month, joint
costs of $15,000 were incurred, and the organization apportioned these to the joint products using
the sales value method. Data relating to last month were as follows:
Product Production (litres) Selling price per litre ($)

M 12,000 4
B 8,000 1.5
What was the apportionment of joint costs to product B for last month?
2) A company manufactures two main products - A, B and the by-product C. The by-product has an
NRV of $1.5 per litre. The following information relates to last month, when there were no opening
inventories.
Product A B C
Prod. (L) 60,000 50,000 20,000
Sales 50,000 35,000 20,000
Process costing 170
Joint costs last month were $400,000. Company policy is to apportion joint costs on a physical
measure basis and to treat the net realizable value of the by-product as a deduction from the cost of
the main products.
What was the cost value of last month’s closing inventory of product A?
$_______
3) An organization operates a process that creates two joint products (A and B). Product A has a
selling price of $14 per litre, and product V has a selling price of $82 per litre. Last month joint costs
of $420,000 were incurred, and the completed production was as follows:
Product Litres
T 12,600
V 6,300
The organization uses the sales value method of apportioning joint costs.
How much of the joint costs were apportioned to product B last month?
a) $200,000
b) $240,000
c) $447,000
d) $450,000
4) Data relating to two processes (Q and T) are as follows:
Process Normal Input Output

loss as (litres) (litres)
% of
input
Q 18 630,000 520,000
T 18 560,000 455,000
For each process, was there an abnormal gain or an abnormal loss?
5) The following data for last month relates to a production process in which no WIP is held:
Input 14,000 litres
Normal loss 5% of input
Output 13,000 litres
What was the abnormal loss or abnormal gain for last month?
$_______
6) A process operates with a normal loss of 10% of input. All losses have a net realizable value of
$7.50 per litre. Last month 127,500 litres were input into the process, and the output of good
production was 110,500 litres. Costs arising last month were $841,500.
What was the valuation of the 110,500 litres of output in the process account? $____________
Solutions:
1) $1,200
Total sales value of product M produced = $48,000 (12,000 x 4)

Process costing 171
Total sales value of product B produced = $12,000 (8,000 x 1.5)

Total sales value of products M and B produced = $60,000 (48,000 + 12,000)
Proportion of product B produced = 20% (12,000 / 60,000)
Joint costs allocated to product B = $3,000 (15,000 x 20%)
2) $33,600
NRV of by-product C: (20,000 * $1.5) = $30,000

Joint costs of products A and B: ($400,000 - $30,000) = $370,000
Costs allocated to product A: ((60,000/50,000+60,000)) *$370,000) = $201,818
Production of A: 60,000 litres
Costs allocated to A: $201,818/60,000 = $3.36 per litre
Cost value in product A inventory at the end of the month: 10,000 litres * $3.36 = $33,600
3) c) $447,000
Sales value of product T = $176,400 (12,600 x 14)
Sales value of product V = $516,600 (6,300 x 82)
Total sales = $693,000 (176,400 + 516,600)
Product V proportion of sales = 74.5% (516,600 / 693,000)
Product V proportion of joint costs = $447,000 (600,000 x 74.5%)
Process accounts for joint and by-products:
Process costs and -Scrap value of normal loss-Sales value of by-product
Expected number of units output (Input units – Normal loss units – By product units)
4)
Process Q Abnormal gain of 3,400 litres

Process T Abnormal loss of 4,200 litres
For each product, expected output is 82% of input (100% - 18%)
Expected output for product Q = 516,600 litres (630,000 x 82%)
Actual output for product Q = 520,000
Abnormal gain = 3,400 litres
Expected output for product T = 459,200 litres (560,000 x 82%)
Actual output for product T = 455,000 litres
Abnormal loss = 4,600 litres
5) Abnormal gains and losses occur where the output of a process is greater or less than
what would be expected after normal losses are applied to inputs.
Actual output: 13,000 litres
Expected output (14,000 * 0.95) = 13,300 litres
Abnormal loss: (13,000 – 13,300) = 300 litre
6) $718,250, The value of a unit of output from a process is calculated as:
(Cost of process – Scrap value of normal loss) / Expected output.

Number of units input = 127,500
Normal loss = 12,750 (10% x 127,500)
Expected output = 114,750 (127,500 – 12,750)
Scrap value of normal loss = $95,625 (12,750 x 7.5)
Cost per expected unit = $6.5 ((841,500 – 95,625) / 114,750)
Value of output = $718,250 (110,500 x 6.5)
Alternate costing methods 172
Alternate costing methods
Modern production environments have evolved significantly in recent years with the advent of
advanced technologies and methodologies. These are very different from the traditional production
environments and following are some key aspects of modern production environments:
1. Automation and Robotics streamline processes and reduce errors.
2. IoT devices monitor real-time data for maintenance and efficiency.
3. Data Analytics and AI optimize processes and improve product quality.
4. Cloud and Edge Computing provide scalable resources and real-time data processing.
5. Agile and Lean Manufacturing enhance flexibility and efficiency.
6. Collaborative Robotics (Cobots) work safely with humans, improving productivity and safety.
7. Additive Manufacturing (3D Printing) enables rapid prototyping and on-demand production.
8. Supply Chain Integration and Visibility ensure coordination and traceability across the supply
chain.
Besides absorption and marginal costing, there are other cost accounting techniques which are
improvements to the traditional techniques. In this area, we have to understand what they are, and
how they are used. Calculations are not part of the syllabus. These include:
1. Activity based costing (ABC)

Earlier, we learned how overheads are assigned to products using overhead absorption rates.
This traditional method does not take it into account various reasons why overheads occur.
There may be more than one reason or driver that leads to costs. This is known as a cost driver.
Example: Floor space occupied is a more accurate cost driver to allocate factory rent which is a
production overhead, rather than using labour or machine hours, which do not affect rent
allocation in any manner.
ABC allocates costs to cost pools rather than cost centres like in traditional methods and then
absorb them using cost drivers. A cost pool is an area where costs can be identified. For
example, machine set up is a cost pool where all costs relating to machine set up are allocated.
Example: A business may use machine hours as a base for allocating costs which may be correct
for machine related costs such as electricity. However, costs like rent would not be correctly
allocated using machine hours. ABC simply assigns different drivers to different costs and helps
overcome this problem.
ABC provides a more accurate cost per unit. As we see what drives costs, we can understand and
better analyze costs and eliminate costs which are unnecessary.
However, it is complex to calculate as some costs simply won’t have drivers to allocate. The
costs of using ABC may not justify the benefit received.
Advantages of ABC:
• It provides a more accurate cost per unit. As a result, pricing, sales strategy, performance
management and decision making should be improved.
• It provides much better insight into what causes overhead costs.
• ABC recognises that overhead costs are not all related to production and sales volume.
Disadvantages of ABC:
• ABC will be of limited benefit if the overhead costs are primarily volume related or if the
overhead is a small proportion of the overall cost.
• It is impossible to allocate all overhead costs to specific activities.
• The choice of both activities and cost drivers might be inappropriate.
• ABC can be more complex to explain to the stakeholders of the costing exercise.
2. Target costing
Target costing is a costing method useful when a new product is about to be launched. In
traditional costing methods, we find out the cost per unit, add our profit and arrive at a selling
price. This may be an acceptable method, but the price at which we reach would not always be a
price at which the product will sell successfully in the market.
Target costing simply finds out the market selling price first. This may be the competitor’s price,
price at which the customers want the product etc. Value analysis is the process of finding out
why and how customer’s value a product. The company’s required profit is deducted from such
an estimated price to arrive at the target cost.
Then, the cost per unit is calculated based on current costing and is compared with the target
cost. The difference is known as the cost gap. The company will try to reduce this cost gap by
various cost cutting techniques.
This method can be considered as a top-down or a reverse method to understand the idea. We
start from the selling price instead of the cost price.
BB Co wants to introduce a new printer in the market and is using the target costing approach.
On conducting a market survey, they found out that the maximum customers would be willing to
pay is $250 for the printer. The company has a policy of having a 25% margin on all products.
Currently, the printer is in the prototype stage, and it is estimated that the total cost will be
$195.
Calculate the cost gap, if any, for the printer.
Solution:
Selling price: $250
Margin: 25%
Target cost =$250x75/100 =$187.5
Current cost =$195
Cost gap =$7.5
3. Life cycle costing

Life cycle costing tries to take into consideration the complete life of a product and the cost for it
accordingly. Traditional costing methods are usually more short term and look for short term
profit. However, as we’ve learnt previously that initially, sales would be less, which would make
it difficult to recover costs and make a profit. That doesn’t mean that the product won’t be
profitable in the long run. Many product ideas are shut down because of initial losses. Life cycle
costing would avoid this.
Life cycle costing simply includes the entire cost from start to end of the products life cycle.
Decisions will be made keeping in mind this cost and prices would be decided accordingly. A
price may be set that may not recover the initial high costs, but due to sales growing over time
at a low price, costs may be eventually recovered, and profits would be made.
Stage Sales volume Sales Explanation

Development Not applicable Not Company makes a loss as only development
applicable costs are being incurred, without any sales.
Introduction Low Low Product has just been launched in the market.
Customers take time to shift from their
existing preferences.
Growth Rising Rising Customers become aware of the product and
start buying in more quantities.
Maturity Highest Highest No growth in sales. However, this is the best
stage at which the product could reach. The
company needs to make modifications in the
product to avoid reaching the decline stage.
Decline Falling Falling Product becomes outdated, sales start falling
at an increasing pace as new products from
competitors enter the market.
The advantages of life cycle costing are:

• Before initiating production, the projected profitability of a product throughout its entire
lifecycle is assessed and determined.
• For planning and control purposes, it is possible to compare the accumulated costs at each
stage with the budgeted costs for the product’s entire lifecycle on a product-by-product basis.
• By considering all costs associated with a product, life cycle costing improves accuracy in
budgeting and forecasting. It provides a more realistic and comprehensive view of future costs,
allowing for better financial planning, risk assessment, and contingency measures.
In summary, life cycle costing provides a holistic view of costs, enables informed decision
making, identifies long-term cost savings, incorporates sustainability considerations, enhances
budgeting accuracy, improves relationships, and ensures compliance with regulations.
4. Total quality management(TQM)

Simply put, total quality management focuses on involving everyone that is in the production
chain and making the production effective.
TQM operates on the following principles:

1. Get it right the first time:
Costs that are incurred to correct what goes wrong should be completely eliminated. The
aim is to reach 100% quality and have 0 rejects.
2. Continuous improvement:
It may not be possible to have a perfect production state, however continuously improving
and aiming to reach there is the idea. The team should never be satisfied with current levels
of efficiency.
3. Customer focus:
The main aim always is to meet customer needs. Production is designed in a way that quality
is not poor and it meets the customer’s requirements.
A quality-related cost is the ‘cost of ensuring and assuring quality’ as well as the loss incurred when
quality is not achieved. Quality related costs include:
1. Prevention costs
These costs are due to any actions taken to prevent or reduce defects or failures. Field trials,
using improved machinery, quality engineering etc.
2. Appraisal costs
Appraisal costs are costs that are incurred to ensure that the product meets the quality
requirements. Such as testing costs, quality audits etc.
3. Internal failure costs
Failure cost is a cost that occurs due to the product having a problem. Internal failure cost is
when this happens before the product is sold. These include rework costs, disposal of
defective products etc.
4. External failure costs
External failure costs occur when the failure takes place after the product is sold by the
supplier. Warranty costs, product recalls etc.
Conformance costs and non-conformance costs

Appraisal and prevention costs may also be referred to as conformance costs, whilst
internal and external failure costs may be referred to as non-conformance costs.
• An alternative to absorption costing is activity-based costing (ABC). ABC involves the

identification of the factors (cost drivers) which cause the costs of an organisation’s major
activities. Support overheads are charged to products on the basis of their usage of an
activity.
• When using ABC, for costs that vary with production levels in the short term, the cost driver
will be volume related (labour or machine hours).
• Total quality management (TQM) is the process of applying a zero-defect ideology to the
management of all resources and relationships within an 176rganization as a means of
developing and sustaining a culture of continuous improvement which focuses on meeting
customer expectations.
• Life cycle costing tracks and accumulates costs and revenues attributable to each product
over the entire product life cycle.
• A product life cycle can be divided into four phases.
• Introduction – Maturity
• Growth – Decline
• Target costing involves setting a target cost by subtracting a desired profit margin from a
competitive market price.
1) Which of the following methods of costing describes target costing?
a) A process where we target a specific type of job and minimize the cost incurred for that same job.
b) A process where we target a specific process to minimize our cost in that department.
c) A process where we target cost by subtracting a desired profit margin from a competitive market
price
d) A process where we target a specific share of sale in the market so we can maximize our profits
Ans: 1-c) A method that sets a target cost by subtracting a desired profit margin from a competitive
market price
Target costing involves deciding on a competitive price for a product and then deducting a desired
profit margin from it. The balance is the target cost.
Budgeting
Budgeting 178
Budgeting
Introduction to budgeting
To budget means to plan out costs and revenues for a period in the future. This planning or
budgeting is done based on forecasts and estimates about expected costs and incomes. They take
into account any plans to reduce costs and increase sales etc. At the end of the month or any other
period, the budget is compared with the actual numbers, and the changes, known as variances, are
investigated.
Purposes of budgeting
• Budgeting is part of the overall planning process, meant to achieve objectives of the
company.
• It is a plan for the future, so the people know what to do and what is expected. Costs are
predetermined, and if costs are going above budget, steps are taken to control the costs.
• A challenging budget (but not unachievable) will act as a motivator to the manager and the
employees.
• Targets are communicated across the department, such as production, marketing, sales etc.,
and each department co-ordinates with one another to achieve the same goal stated in the
budget.
• Manager performance can be judged based on actual performance compared with the
budget.
Planning and control cycle

1. The very first step is to formulate plans. This means that based on the missions and
objectives of the organization, plans must be made to achieve them with the resources
available.
2. Various courses of action can be considered, and the most suitable option can be selected,
with alternatives being carefully checked before eliminating them.
3. After the course of action is selected, it will be implemented. Short term plans are plans that
link long term objectives are moved to the implementation process.
4. Monitoring outcomes is a key part of the control cycle. Outcomes need to be compared with
budgets, and any changes will be investigated, and the future budgets will take into account
any variations in the outcomes.
Stages of budgeting:
Identification
Budget Budget Budget
of limiting
Committee Manual Preparation
factor
1. Budget committee:
Senior management usually form the budget committee. Based on the long-term objectives
of the company, relevant personnel are included in the committee. For example, the sales
director will be involved in setting the sales budget.
2. Budget manual:
Budgeting 179
A budget manual sets out the instructions and guidelines to be considered before preparing
a budget. It gives details about who is responsible for what in the budget. An organizational
chart is drafted to assist with the process.
3. Limiting factor is identified
Usually, as resources are limited, something or the other will limit the budget. It may be the
capacity, the capital requirement etc. Mostly, it is sales that limit the budget. So, this needs
to be found out, and the budget will always try and get the most out of the limiting factor.
4. Budget preparation:
Once the main budget is made, other budgets follow. All budgets are based on the main
budget. These are made based on forecasts of existing conditions as simply planning to
achieve something which isn’t possible will not benefit the company. A forecast is a trend of
what has happened in the past and what is likely to happen. With reasons, a budget around
the forecast is drafted. Draft budgets are prepared, then approved and finally accepted and
implemented. The budgets are regularly reviewed and revised whenever necessary.
Types of Budgets
The process of budgeting usually starts with the sales budget (Unless there’s another limiting
factor). We forecast our sales and accordingly plan our production.
Hence after that, we prepare our production budget.
Budgeting 180
Based on our production estimate, we prepare budgets for our costs, such as material budgets,
labour budgets and overhead budgets.
Finally, that is followed by a cash budget. We will discuss why a cash budget is important later when
we discuss that.
Lastly, to summarize all our budgets, we prepare a master budget.
Let’s look at each budget one by one and understand how these functional budgets are prepared.
Sales budget
Preparing a sales budget is very simple. We estimate our sale quantity and the price we will sell the
units at, which gives us our sales budget. Let’s look at an Illustration to understand it clearly.
It is calculated as:
Sales budget = Sales unit x Selling price
High Co makes three products, A, B and C. A is their premium product and sells at $90 per unit. The
company estimates that 12750 units of A will be sold in the next year. B is their most selling product.
The company estimates that it will sell 35000 units of B at a price of $25. C is a product whose
market is declining, and hence it is sold at a low price of $15. The company expects to sell 10000
units of C.
Prepare a sales budget for High Co
Solution:
Sales budget for High Co

$ A B C Total
Sales 12750 35000 10000 57750
units
Sales 90 25 15
price
Total 1147500 875000 150000 2172500
Production budgets
A production budget is to budget how many units to produce. Remember, we may have some
opening inventory with us already that will reduce the new production quantity. Similarly, we may
need closing inventory at the end of the month to be used if we end up selling more than our
budget, which increases our production budget.
The formula for production budget is:

Production budget = Sales units – Opening inventory + Closing inventory
High Co makes three products, A, B and C. A is their premium product and sells at $90 per unit. The
company estimates that 12750 units of A will be sold in the next year. B is their most selling product.
The company estimates that it will sell 35000 units of B at a price of $25. C is a product whose
market is declining, and hence it is sold at a low price of $15. The company expects to sell 10000
units of C.
Budgeting 181
The company has the following opening and required closing inventory levels.
A B C
Opening inventory 2250 units 500 units 6000 units
Closing inventory 2000 units 750 units 1000 units
Calculate the production budget for High Co.
Solution:
Production budget (units) A B C

Sales units 12750 35000 10000
- Opening inventory 2250 500 6000
+ Closing inventory 2000 750 1000
Production units 12500 35250 5000
So, if we already have 2250 units of A and we produce 12500 units, we will have 14750 units. Out of
which we will sell 12750 units and remain with 2000 units.
Material budget
We need to calculate how much material we will use, and how much material we produce.
• Material usage budget: This is simply the production units x material quantity per unit. If
we are to produce 10000 units and we require 3kg material to produce one unit, we will use
30000 kgs. Simple!
• Material purchase budget: This is exactly like the production budget. If we already have
some kgs in inventory (opening inventory), we will purchase less, if we need closing
inventory, we will purchase more. Giving us the formula:
Material purchases = material usage – opening inventory + closing inventory

Material usage =
Budgeted production x Quantity required to produce one unit
High Co has a product A. They intend to produce 12500 units. Each unit requires 9kg of material A3c.
The company already has 10750kgs of material A3c in inventory. They require 10% of this month’s
material usage requirement as opening inventory for next month.
Prepare the material usage and purchase budget.
Solution:
Material usage budget: A3c

Production units =12500 units
Material requirement =9kgs
Material usage = 112500 units.
Material purchase budget: A3c

Budgeting 182
Material usage = 112500 (Calculated above)

Opening inventory = 10750 (Given)
Closing inventory = 11250 (10% of 112500)
Material purchase = 113000 (112500 – 10750 + 11250)
Labour budget
Since we can’t have an opening or closing labour hours, calculating the labour cost budget is really
simple. We simply multiply the number of hours required by the labour rate. Remember, the no. of
hours required will include idle time as we will actually pay for it.
Labour cost budget = Total labour hours x labour rate per hour
High Co manufactures 3 products, A, B, and C. Product A takes 12 hours to manufacture. B takes 5
hours to manufacture, and C takes 4 hours to manufacture. Production for the month is as follows:
A 12500
B 35250
C 5000
Labour is paid at a rate of $6 per hour. Prepare the labour cost budget.
Solution:
Labour cost budget Hours $

A 12500 x 12 150000
B 35250 x 5 176250
C 5000 x 4 20000
Total 346250 x $6 2077500
Bottle Co produces a single product, bottle. In a month, Bottle Co requires 5670 actual hours to
produce 100000 bottles. 10% of the time of workers is idle time. Labour is paid at a rate of $7.5 per
hour.
Prepare total labour cost budget.
Solution:
Hours needed =5670

Idle time = 10%
5670 hours represent 90% as out of total hours (100%), 10% will be idle time. Since we will have to
pay for the idle hours too, we need to find 100%. This can be done with the help of cross
multiplication.
Hours payable = 6300 (5670 x 100/90)
Labour rate = $7.5
Labour cost budget = $47250
Overhead budget
Overhead budgets are exactly like labour budgets. We calculate the total hours required (machine or
labour) and multiply it with the overhead absorption rate.
Budgeting 183
High Co has budgeted to produce 12500 units of product A, 35250 units of product B and 5000 units
of product C in the next period. The variable overhead absorption rate is $0.6 per machine hour.
Machine hours are as follows:
A 7 hours
B 3 hours
C 2 hours
Prepare the overhead budget for the next period.
Solution:
Overhead budget Hours $

A 12500 x 7 87500
B 35250 x 3 105750
C 5000 x 2 10000
Total 203250 x $0.6 121950
Cash budget
In any business, no matter how profitable or well planned, if cash runs out, everything is halted.
Hence, it is very important to prepare accurate cash forecasts/budgets to avoid this.
A cash forecast will include all the likely cash inflows and all the likely cash outflows in the upcoming
period, and predict the surplus or shortfall of cash. We might already have some cash balance with
us, so that is taken into account as well. If, at the end, we need more cash, we can arrange it
beforehand to avoid running out of cash.
A cash budget is similar to other budgets. We budget something that we want to achieve. Preparing
a cash budget means aiming to get the expected receipts and taking appropriate steps to do so.
Basically, to take any action necessary to meet the budget.
A cash forecast will consider every inflow and outflow of actual cash in the business. Saying we
made a sale today and will receive cash 3 months later, will not mean we have a cash inflow today.
In our cash forecast, we will add cash in the third month. Non-cash expenses will not be included at
all.
Tip: Use simple logic in a cash forecast. If say we will be buying a machine in march, there will be an
expense in march, hence a cash outflow. Similarly, if we receive a loan from the bank this month,
this will give us cash; hence it is a cash inflow.
To prepare a cash forecast, we start with the opening balance, add all receipts, deduct all payments
and arrive at a closing balance. This closing balance becomes the opening balance of the next month.
We will understand this more clearly with the help of an Illustration.
WeMake Co is a manufacturer of boxes. They want your help to prepare the cash forecast for their
next quarter (January to March). Relevant information is provided below:
Month Sales and production units

Budgeting 184
November 11000
December 15000
January 12800
February 13500
March 11500
April 10750
Sales information:
Each box is sold for $5.
20% of all sales are for cash, 40% are received in the next month, 35% two months after, and 5% are
bad debts.
Production information:
Each box takes 2kg of wood to produce. WeMake has 4500kg of wood in stock at 1st December. It
has a policy to keep 15% of next month’s production requirements as closing stock to avoid
stockouts. 1kg wood can be purchased at $0.3. Suppliers are paid a month after the purchase.
Other information:
In March, WeMake plans to purchase a wood cutting machine for $12500.
Cash balance on 1st January is $2500
Prepare cash forecast.
Solution:
Particulars January February March

Opening 2500 6108 11435
cash
balance
Receipts:
Cash from 12410 13070 12180
sales
Payments:
Purchases -8802 -7743 -7902
Purchase -
of NCA 12500
Closing 6108 11435 3213
balance
Working:
The closing cash balance of January will be the opening cash balance of February.
Cash from sales:

In January we receive 20% of January, 40% of December and 35% of November.
I.e. (0.2 x 12800) + (0.4 x 15000) + (0.35 x 11000) = $12410
In February we receive 20% of February, 40% of January and 35% of December.
I.e. (0.2 x 13500) + (0.4 x 12800) + (0.35 x 15000) = $13070
In March we receive 20% of March, 40% of February and 35% of January.
I.e. (0.2 x 11500) + (0.4 x 13500) + (0.35 x 12800) = $12180
Budgeting 185
Note: Remember to carefully read the explanation for cash receipts. If the question read 40% of
remaining credit sales, it would be 40% of the remaining 80%which is credit. Here it is a breakdown
for 100%.
Purchases:
To find out purchases, we need to calculate production.
Production December January February March

Material 30000 25600 27000 23000
required (15000 x (12800 (13500 x (11500
(kgs) Units 2) x 2) 2) x 2)
x per
-Opening -4500 -3840 -4050 -3450
inventory
+closing 3840 4050 3450 3225
inventory (15% x
(15% of 10750
next x 2)
month)
Purchases 29340 25810 26400 22775
Purchase $0.3 $0.3 $0.3 $0.3
price
Purchase $8802 $7743 $7920 $6833
amount
Payment $8802 $7743 $7920
in cash
The closing balance of December, becomes the opening balance of January etc. The payment is
made in the month after the purchases. Therefore, we pay for the purchases of December, in
January.
Master budget
A master budget is the final budget. It includes all our budgets that we previously calculated and
present them together. In a master budget, we include a budgeted statement of profit or loss, a
budgeted statement of financial position and a cash budget. In your MA examination, a master
budget is rarely tested.
We have already learnt how to prepare a cash budget, let’s go ahead and understand how our
statement of profit or loss and statement of financial position will be calculated using the help of this
table.
Head Description
Cost per We need to find out the cost per unit as an addition to preparing all the budgets. Cost
unit per unit is simply the total of direct materials per unit + direct labour per unit and
overhead per unit.
Profit or
loss:
Revenue The figure for revenue is simply the sales budget total.
Cost of Cost of sales is calculated as opening inventory + production – closing inventory. We
sales have all these figures in our production budget, and we value them at the cost per unit
calculated above.
Budgeting 186
Financial
position:
Inventory Closing inventory will be the same figure that is included in cost of sales.
Cash The cash figure will be the final figure of our cash budget.
‘What if’ analysis
At the end of the day, budgets are forecasts, and they may not go as planned. Hence, it is necessary
to check if changes in one or two variables will affect the budget severely. This is known as
sensitivity analysis. How sensitive is a budget to one variable?
‘What if’ analysis is a form of sensitivity analysis. It is commonly found in spreadsheet processors,
where a budget is prepared. It shows the budget when a variable is changed. For example, what if
the variable cost was $6 instead of $4? The answer would present a budget where the variable cost
is $6 and its effect on the profit.
“What-if” analysis is a technique used to evaluate the potential outcomes of different scenarios by
making changes to key variables or assumptions. It helps businesses assess the impact of various
factors on their plans, decisions, and outcomes. Here are some implications and benefits of
conducting what-if analysis:
1) Decision Making: What-if analysis allows businesses to explore different options and make
more informed decisions. By altering variables or assumptions, organizations can assess the
potential outcomes and risks associated with each scenario, aiding in selecting the most
favorable course of action.
2) Risk Assessment: Businesses can use what-if analysis to evaluate potential risks and
uncertainties. By considering different scenarios and their outcomes, organizations can
identify vulnerabilities and develop contingency plans to mitigate or respond to risks
effectively.
3) Financial Planning: What-if analysis is valuable for financial planning and budgeting. By
adjusting key variables such as sales volumes, pricing, costs, or market conditions,
organizations can evaluate the financial impact on revenues, expenses, cash flow, and
profitability. This helps in developing realistic financial projections and setting achievable
targets.
4) Sensitivity Analysis: What-if analysis helps determine the sensitivity of outcomes to changes
in specific variables. By varying individual factors and observing the resulting changes,
businesses can identify the key drivers that significantly impact their plans or financial
performance. This insight guides decision making and resource allocation.
5) Scenario Planning: What-if analysis facilitates scenario planning, which involves creating
multiple plausible future scenarios and assessing their potential outcomes. By examining
different scenarios, businesses can better prepare for uncertainties and adapt their
strategies accordingly, fostering agility and resilience.
6) Resource Optimization: Organizations can use what-if analysis to optimize resource

allocation. By simulating different scenarios, businesses can identify the most efficient
Budgeting 187
allocation of resources such as manpower, equipment, or inventory based on changing

conditions or demand patterns.
7) Performance Evaluation: What-if analysis enables businesses to assess the performance of

various strategies or initiatives. By comparing different scenarios against predefined metrics
or targets, organizations can identify the most effective approach and refine their plans to
improve performance.
8) Investment Analysis: What-if analysis is helpful in evaluating investment opportunities. By

varying assumptions related to costs, revenues, market conditions, or other relevant factors,
organizations can assess the potential returns, risks, and feasibility of different investment
options.
In summary, what-if analysis is a valuable tool for decision making, risk assessment, financial
planning, scenario planning, resource optimization, performance evaluation, and investment
analysis. It provides insights into the potential outcomes of different scenarios, allowing businesses
to make more informed decisions and adapt to changing circumstances.
Scenario planning
Scenario planning is a process where we take into consideration various different scenarios and plan
for them from the beginning. So, if something goes off budget, the scenario closest to it can be
adopted. It basically means preparing the budget to be flexible to more uncertainties.
Scenario planning is a useful tool in forecasting
, strategic planning and business modelling. However, since it is a subjective process, qualified
personnel are involved in generating scenarios over software.
Steps in Scenario Planning:

1. Identify high-impact, high-uncertainty factors in the environment.
2. Rank factors by importance and uncertainty.
3. Develop different possible futures for each factor.
4. Cluster factors into consistent future scenarios (around 7-9 mini scenarios).
5. Conduct a detailed analysis of the most important scenarios, considering financial and strategic
implications.
6. Identify and assess possible courses of action for each scenario.
7. Monitor reality to identify unfolding scenarios.
8. Revise and adjust scenarios and strategic options as needed.
Pros of Scenario Planning:
• Focuses management attention on the future and possibilities

• Encourages creative thinking
• Can be used to justify a decision
• Encourages communication via the participation process
• Can identify the sources of uncertainty
• Encourages companies to consider fundamental changes in the external environment.
Cons of Scenario Planning:

• Costly and inaccurate – uses up substantial resources and time
• Tendency for cultural distortion and for people to get carried away
Budgeting 188
• The risk of the self-fulfilling prophecy, i.e. thinking about the scenario may be the cause of it
• Many scenarios considered will not actually occur
Fixed and flexed budgets
A fixed budget is a budget that is set for a fixed level of volume. It is a budget that is prepared at the
beginning of the year and not changed until it’s time to make a new one at the start of the next year.
For example, a budget for producing 10000 candy bars in a week.
A flexible budget is a budget made in such a way that if the volume is different than what was
budgeted, it can be adjusted to the actual volume. For example, if the actual production was 9750
candy bars, the budget if adjustable as if it was always based on 9750 units is known as a flexible
budget.
Actual results are compared with the relevant section of the flexible budget, which corresponds to
the actual level of activity. This is usually referred to as the flexed budget
In the simplest comparisons, actual costs are compared with fixed budgets. However, this is not very
helpful. If a lower volume was produced, it is likely that costs are lower. Hence, such a comparison
would give a positive answer, whereas the actual situation might not be the same. We’ll see how this
is overcome later.
Importance of flexible budgets (Disadvantages of fixed budgets)

• Takes advantage of changes. If an opportunity to increase sales arises, but more costs would
be incurred, a fixed budget would give negative differences, which would look poor even
though the decision is beneficial. A flexible budget will take into consideration the costs that
will increase.
• A lot can change in a year. If there is a rapid fall or increase in the price of a resource, such as
labour, the fixed budget will be a useless comparison, whereas a flexible budget will be a
realistic comparison.
• Fixed budgets simply provide a guideline of costs to follow over the year. However, as more
data is available of current costs throughout the year, that data becomes more useful.
Flexing of a budget
To flex a budget means to remake the budget at a different level of activity. This is very simple. If our
variable costs where budgeted to be $20000 when production was 10000 units, we can correctly say
the costs should be $24000 when the production is 12000 units. This cost can then be compared
with the actual costs. How do we calculate $24000? If we have a $2 cost per unit, then at 12000
units, our costs should be $24000. Simple!
Remember, fixed costs should remain the same even in a flexed budget, as they do not change when
activity levels change.
For semi variable costs, we use the high/low method, which we’ve learnt previously, and calculate
the cost at another level of activity.
Let’s look at an Illustration to see how a budget is flexed.
Budgeting 189
A ltd has a production capacity of 75000 units. In the last three months, the following activity levels
were seen, and the flexible budgets are as follows:
Level of activity (units) 70000 74000 72000

$ $ $
Direct material 210000 222000 216000
Direct labour 364000 384800 374400
Production overheads 400000 412000 406000
Fixed overheads 100000 100000 100000
1074000 1111800 1096400
Flex the budget for a level of activity of 69000 units.
Solution:
Level of activity (units) 69000

$
Direct material 207000
Direct labour 358800
Production overheads 397000
Fixed overheads 100000
1062800
Explanation:
We need to check the type of costs for each cost. Direct materials and direct labour are variable
costs. This can be found out by checking if the cost per unit is the same at all activity levels.
Direct materials per unit:

210000/70000 =$3
222000/74000 =$3
216000/72000 =$3
The same goes for direct labour. Hence, 69000 units can be multiplied with $3 for direct materials
and $5.2 (364000/70000) for direct labour.
However, production overheads are semi variable. If you divide the cost by the units, the variable
cost is different.
400000/70000 =$5.71
412000/74000 =$5.57
406000/72000 =$5.64
This means that the cost has a fixed element to it. We calculate it using high low method:
Variable cost = (412000-400000)/ (74000-70000) =$3
Fixed cost =412000 – (74000 x 3) =$190000
Semi variable cost at 69000 units = $190000 + ($3 x 69000) =$397000
The last overhead is fixed and does not change at any activity levels. Hence, it will not change even
at an activity level of 69000 units.
Introduction to variances
Budgeting 190
The difference between the flexed budget and the actual costs, or if a fixed budget is used, then the
difference there, is known as a variance. Say our costs incurred were $12000, but according to our
flexed budget, the costs should have been $11500, the difference is known as a variance.
A variance can be adverse or favorable. An adverse variance is any variance that will decrease the
profit, meaning it’s bad for the company and is denoted by (A). A favorable variance is any variance
that will increase the profit, meaning it’s good for the company and is denoted by (F).
In our case, the variance is an adverse one, of $500. It is adverse because it cost us more than our
budget and that will decrease our profit. We will learn about variances in our next syllabus section.
For now, we need to learn how to calculate simple variances and prepare a budgetary control
statement.
It is quite simple, and let’s directly move ahead with the same Illustration as before.
A ltd has a production capacity of 75000 units. In the last three months, the following activity levels
were seen, and the flexible budgets are as follows:
Level of activity (units) 70000 74000 72000

$ $ $
Direct material 210000 222000 216000
Direct labour 364000 384800 374400
Production overheads 400000 412000 406000
Fixed overheads 100000 100000 100000
1074000 1111800 1096400
The actual costs incurred for the month when 69000 units were produced are:
$
Direct material 209000
Direct labour 354300
Production overheads 407000
Fixed overheads 100000
Prepare a budgetary control statement.
Solution:
Budgetary control statement

Flexed budget Actual Variance
69000 units 69000 units
$ $
Direct material 207000 209000 2000 A
Direct labour 358800 354300 4500 F
Production overheads 397000 407000 10000 A
Fixed overheads 100000 100000 0
1062800 1070300 7500 A
Budgeting 191
Remember, the total variance needs to tally for the answer to be correct. The difference between
the actual and the flexed budget is $7500, and the same can be arrived at when individual variances
are totaled. If not, something in your calculation must have gone wrong. That’s it.
The question now arises, what do we do after we calculate the variance. The answer is simple, we
ignore it. NO! Variances like these can heavily affect the profit. Hence, they simply can’t be ignored.
These variances must be investigated, and whatever the reason they must be eliminated.
If the budget was incorrect, future budgets must be updated, if there was an exceptional case, care
must be taken that the case does not happen again. But to do so, we need to know who was
responsible for the variance in the first place. To find this out, companies do something which is
known as responsibility accounting.
Sustainability in Budgeting
Sustainability in budgeting refers to the practice of incorporating environmental, social, and

economic considerations into the budgeting process. It involves aligning financial plans with long-
term sustainability goals to ensure that financial decisions not only meet short-term objectives but
also contribute to the well-being of future generations and the planet.
Here are some key aspects of sustainability in budgeting:
1. Environmental Considerations: Sustainable budgeting takes into account the environmental

impact of financial decisions. It promotes the allocation of resources towards eco-friendly practices,
energy-efficient technologies, waste reduction, and sustainable sourcing of materials.
2. Social Impact: Budgeting for sustainability considers the social impact of financial choices on
employees, customers, communities, and other stakeholders. It may include investments in
employee well-being, diversity and inclusion initiatives, community development projects, and
ethical sourcing practices.
3. Long-Term Perspective: Sustainable budgeting looks beyond short-term profits and expenses,
focusing on the long-term implications of financial decisions on the organization's resilience and
success.
4. Integration with Corporate Strategy: Sustainable budgeting aligns with the organization's overall
sustainability strategy and values, ensuring that financial decisions support broader sustainability
objectives.
5. Risk Management: It addresses financial risks associated with sustainability issues, such as
regulatory changes, environmental risks, and social disruptions, and plans for contingencies
accordingly.
6. Stakeholder Engagement: Involving stakeholders in the budgeting process allows for a better
understanding of their sustainability concerns and ensures that budgeting decisions consider the
interests of all relevant parties.
7. Metrics and Reporting: Sustainable budgeting incorporates sustainability metrics and reporting to
track progress and assess the impact of financial decisions on environmental and social goals.
Budgeting 192
8. Innovation and Research: It encourages budgeting for research and development of sustainable
technologies and practices that can create long-term cost savings and benefits.
9. Training and Education: Budgeting for sustainability includes investments in training and
education for employees to foster a sustainability-oriented culture and mindset.
10. Transparent Communication: Organizations adopting sustainable budgeting practices

communicate their sustainability efforts and progress transparently to stakeholders, building trust
and credibility.
By integrating sustainability considerations into budgeting processes, organizations can drive

positive change, minimize risks, and contribute to a more sustainable and responsible future.
Sustainability in budgeting reinforces the idea that financial decisions have broader implications
beyond the organization's immediate financial performance, and they can play a pivotal role in
shaping a better world.
Responsibility accounting
In any organization, it is important that managers are given clear authority and responsibility. They
must be made aware of what directly comes under their watch. This process may be difficult, but it
is necessary to ensure that all areas are allocated to a manager. No ‘grey’ areas must be left behind
which do not come in direct control of a manager.
Once all responsibility is allocated, an organizational chart can be created to ensure all
responsibilities are well defined and in case new managers are appointed, they know their scope of
work.
As we have discussed in the past, a responsibility center can be a profit center, a cost center, a
revenue center or an investment center. Each manager responsible will receive their budget, the
control over any resources that lead to costs or revenue. All costs that incur or sales that are earned
then are directly traced to that manager.
One problem here is the allocation of non-production overheads. These cannot be directly traced
back to a manager, and since they don’t have control over those costs, those costs are not justified if
traced back to the manager. Careful consideration is taken to allocate them.
Some costs may be allocated between two departments. For example, the material purchase can be
allocated to both purchasing and production department. It becomes difficult to trace the costs to
either department. This is known as dual responsibility. The problem that arises is due to both
departments contributing to the same cost.
Some guidelines can be followed here:

I. If the manager is in control of quantity and price – that manager is responsible for all
expenditure variances.
II. If the manager is only in control of price – that manager is responsible for price movements.
III. If the manager is only in control of quantity – that manager is responsible for usage
movements.
IV. If the manager controls neither – that manager is not responsible for any movements,
whoever is responsible for the two in the organizational chart will be responsible.
Budgeting 193
Controllable and uncontrollable costs
Controllable costs are the costs that are under the control of a manager. Meaning they arise due to
the decisions of the manager and can be fully avoided if the manager chooses to.
Uncontrollable costs are the costs that the company will have to incur regardless of the individual
manager who will be allocated the costs. The manager, in no manner, can reduce these costs and
handle the budget.
A manager hence, should only be judged upon the controllable costs. If his performance is judged
including uncontrollable costs, it may decrease the motivation of the manager. However, it is
difficult to identify some costs as controllable or non-controllable as they are complex. Some costs
may also be joint costs between two managers. These costs fall between the two concepts.
Importance of motivation
To motivate means to make a person want to do something on their own. It is important for
employees to be motivated in order to achieve the goals and objectives, or more primarily, the
budgets.
For a businessman, motivation comes from money, they are motivated to work because they can
earn money. For a student, motivation comes from holding a graduation certificate. It is important
to have the motivation to do a task, or else we won’t give our 100%, and that’s not beneficial to
anyone. Like if employees are not motivated, they will do the task because they have to, and that
will lead to poor quality, wasted resources etc.
Various factors in budgeting influence motivation. Let’s discuss them in detail.
4. Setting of budgets and targets
The main process of setting a budget and target for the employees to achieve can be motivating or
demotivating.
If the budget is set to be way too difficult and unachievable, the employees can be demotivated as
they will feel they are not capable of achieving the goals.
If the budget is set to be way too easy, they will not find it to be challenging, and will give less efforts
to achieve it. This will be demotivating in the long run as they will not be interested in doing their
job. Humans tend to look for things that challenge them rather than what they can easily do.
The budget should therefore fall somewhere between the two, a level which is achievable with some
efforts and not too easy to meet.
5. Incentive schemes
We’ve discussed incentive schemes and how they motivate workers in the previous chapters. Giving
employees bonuses if they work better is a simple monetary way to motivate an employee.
However, only financial aspects don’t motivate an employee. Non-financial factors such as a
promotion, greater responsibility, leadership opportunities etc., can motivate an employee too.
A good employee reward scheme must be:

• Fair to all employees
• Motivational enough for them to try and achieve the target
• Easily understood by the employees so they can work accordingly
• Based on the objective of the company, so the bonus benefits the company in the long term
Budgeting 194
• Applicable to all employees and all the time.
There are three main types of incentive schemes:
2. Performance related pay (PRP) –

• Piecework – reward related to the pace of work or effort. The faster the employee works,
the higher the output and the greater the reward.
• Management by objectives (MBO) – key results are identified for which rewards will be paid
on top of salary.
• Points system – this is an extension to MBO reward systems where a range of rewards is
available based on a point system derived from the scale of improvement made, such as the
amount of cost reduction achieved.
• Commission – paid on the performance of an individual typically paid to salaried staff in
sales functions, where the commission earned is a proportion of total sales.
• Bonus schemes – usually a one off as oppose to PRP schemes which are usually a continual
management policy.
• Profit sharing – Usually available to a wide group of employees (often companywide) where
payments are made in the light of the overall profitability of the company. – Share issues
may be part of the scheme.
Incentives need to encourage effort or action towards the delivery of 194rganization194l objectives.
There can be potential conflict when contrasting long and short term objectives.
Long-term incentive schemes will be those that are designed to continually motivate and deliver
organizational objectives.
Short-term incentive schemes will be those that motivate in the short-term but do not deliver
ongoing motivation and are often achieved at the detriment of longer term objectives
Budget participation
Every company is different when it comes to the participation of employees. We can see how it
affects motivation.
1. Top down approach
In the top down approach, the senior management is involved in setting the budgets and
then communicated to the lower levels of management. The lower level is expected to
implement the budget and achieve.
This tends to be demotivating as managers are not consulted, and budgets are forced upon
them. They may have more information and would positively contribute to the process.
However, there are some benefits too, as involving the lower level can be more time
consuming.
2. Bottom up approach
The lower level of management is involved in the budget making process. This is known as
participative budgeting. It is usually more motivating as employees and lower level
managers have a say in a budget they’ll be working to achieve.
The advantages and disadvantages are the opposite of top down approach. However, there
is a major issue in this approach. Managers may intentionally set easy targets to achieve by
setting low revenue targets or high cost targets and then outperform it. This is known as
budgetary slack.
Budgeting 195
Budgetary bias is where a manager deliberately sets a lower revenue target or a higher cost
target.
The effects of this sort of bias can be 195rganizat by careful control at the budget setting
stage and by monitoring the budget from one year to the next. An extension of the bottom
up approach is the concept of budget challenging – employees are given the chance to
question a budget presented to them (in a positive way) before it is 195rganizat.
Feedback and feedforward controls:

Feedback is the comparison of budget and actual performance with a view to revising plans,
budgets or operations. The control action takes place after the event.
Planning is a form of feedforward control. An example of a feedforward control is cash

budgeting which will warn management if a major cash surplus or deficit is expected to arise
at some date in the future so that management can take action now.
Budgeting 196
• A budget is a plan of what the 196rganization is aiming to achieve and what it has set as a
target.
• The main functional budgets are:
– Sales budget
– Production budget
– Raw material usage budget
– Raw material purchases budget
– Labour budget
– Overheads budget
• Cash budgets are vital to the management of cash. They show the expected inflows and
outflows of cash through the company.
• Budgetary control involves controlling costs by comparing the budget with the actual results
and investigating any significant differences between the two.
• A flexible budget is a budget that adjusts or flexes for changes in the volume of activity.
1) Which of the following statements about motivation are correct?
1) There are both financial and non-financial ways to motivate an employee

2) All employees should be motivated by the employer to work towards the mission of the
organization
a) Statement 1 only
b) Statement 2 only
c) Both statements
d) Neither statement
2) Which TWO of the following are true of participative budgeting?
a) It increases operational managers’ commitment to organizational objectives

b) Top management prepare a budget with little or no input from operating staff
c) It encourages deliberate overestimation of costs and underestimation of revenues in a
budget
d) It is least effective in large organizations
Budgeting 197
3) The single product manufactured by S Co. requires 3kg of a single raw material per unit of
product. The material costs $11/kg.
Budgets are being prepared, and the following additional information is available:
- Budgeted sales for the next three periods are:
Period 1 – 40,000 units

- Opening inventory of finished goods in each period is budgeted to be 20% of the budgeted sales
demand in that period,
- Opening inventory of raw material in each period is budgeted to be ¼ of the budgeted material
usage in that period.
Task 1
Calculate the budgeted inventory of finished goods at the beginning of Period 1.
Task 2
Calculate the budgeted production volume of the product in Period 2.
Task 3:
If the budgeted production in P3 is 32,000 units and in P4 is 30,000 units:
What are the budgeted purchases of the raw material in P3? (In kgs) – 94,500
What is the budgeted cost of the raw material usage requirement in P4? (In $)
990,000
Task 4:
It is possible that raw material availability will be restricted to 77,000 kg per period. If this situation
arises, 77,000 kg of the material will be purchased and used in each period. Any sales demand not
satisfied in a period would be lost.
Assume that the restriction on raw material supply occurs throughout the budget period and that
there would be no inventory of raw material or finished goods at the beginning of P1. In this
circumstance –
What would be the finished goods inventory at the end of P2?
Task 5:
Which of the following will influence output quantity?
a) Introduce a perpetual inventory system

b) Introduce continuous stocktaking
c) Use raw materials more efficiently
d) Take advantage of a settlement discount
Budgeting 198
4) Jay Company manufactures and sells a single product. It is preparing budgets for the three-month
period ending 31 December 20X7. The budget is virtually complete, and the remaining task is to
prepare the budgeted statement of financial position as at 31st and December 20X7. Sales of the
product and purchases of materials are all made on credit items. There were no purchases or
dispose of non-current assets in the period 31 December 2017. And trees marked ’n/a’ are yet to be
calculated. The following data is available.
Statement of financial position at
30 September 20X7 $ $
Assets
Non-current assets (net) 13,000

Current assets
Raw material inventory 16,000
Trade receivables 12,000
Cash 4,000 32,000
45,000
Equity and liabilities
Ordinary shareholders fund 38,000

Current liabilities
Trade payables 7,000
45,000
Budgeted Statement of financial position at
30 September 20X7 $ $
Assets
Non-current assets (net) n/a

Current assets
Raw material inventory 20,000
Trade receivables n/a
Cash n/a
Equity and liabilities
Ordinary shareholders fund 41,500

Current liabilities
Trade payables n/a
Budgeted statement of profit or loss for the quarter ending 31 Dec 20X7
$
Budgeting 199
Sales 78,000
Direct materials 42,000
Direct wages 21,500
Depreciation 5,000
Net profit/ (loss) 10,000
Cash budget for the quarter ending 31 Dec 20X7
Receipts from customer 69,000

Payment
Materials 38,000
Wages 21,500
Net cash Flow 9,500
Task 1
What Figure should be included in the budgeted statement of financial position as at 31 December
2018 for each of the following items?
Noncurrent assets $_______________
Receivables $__________________
Task 2
Jay company is about to start work on budgets for 2018. 1 KG of direct materials is required to make
3 units of its product. Each unit of the product also requires 6 KG of material B and 5 hours of direct
labor. Demand for the product and the supply of material is unlimited, but only 80,000 KG of
material B and 60,000 labor are available in the coming period.
What is the principal budget factor of 2017?
a) Sales demand
b) Direct material A
c) Direct marketing B
d) Direct labour
Task 3
What should be the order of budget preparation for a manufacturing company whose principal
budget factor was sales demand?
a) Sales budget, production budget, purchases budget

Budgeting 200
b) Sales budget, purchase budget, production budget

c) Purchase budget, production budget, sales budget
5) Which of the following statements are true?
a) Budgets should be set easy so it can be achievable

b) Management accounting planning and control systems can have a significant effect on
managers and employee motivation.
6) The following statements refer to aspects of budget administration:
A. Budget committee is responsible for communicating policy guidelines to the people who
prepare the budgets and for setting and approving a budget.
B. Budget manual is a strategic planning
Which of the statements are correct?
a) 1 only
b) 2 only
c) Both
d) Neither
7) Is each of the following statements about aspects of budget true or false?
The limiting factor is known as the limiting budgeting factor
A budget manual consists of an organization chart
8) Is this the correct order of budget preparation?
1. Sales budget
2. Production budget
3. Principal budget factor
Yes/No?
9) A company manufactures and sells a single product. At the end of the manufacturing process, all
units are inspected, and 30% are rejected and scrapped. Next year the budgeted sales are 200,000
units, and the inventory of finished units will increase by 3,000 units.
What is next year’s budgeted production (in units), which will be subject to inspection?
$____________
10) A company rents its factory for $68,400 per annum. This year 45,600 units have been
manufactured in the factory utilizing 57% of its total capacity. Next year the plan is to manufacture
76,000 units by using the existing factory at full capacity and by renting just sufficient additional
capacity. The additional capacity is available at the same rental cost per square metre as the existing
factory.
What is the budgeted total rental cost for next year?

Budgeting 201
$_____________
11) Flexed budgets for the cost of electricity in the hotel depend on the number of beds occupied.
The following information is available for different levels of occupancy:
Proportion 78 85
of beds
occupied
(%)
Electricity 50,687 50,400
costs ($)
In March, 82% of seats were occupied.
What should the costs be for March?
$__________________
12) Budgeted production in a factory for the next period is 5,300 units. Each unit requires 9 labour
hours to make. Labour is paid $15 per hour. Idle time represents 25% of the total labour time.
What is the budgeted total labour cost for the next period?
a) $954,000
b) $715,500
c) $894,375
d) $926,000
13) What is the purpose of a flexible budget?
a) To cap discretionary expenditure

b) To produce revised forecast by changing the original budget when the actual cost is known
c) To control resources efficiency
d) To communicate target activity levels within an organization by setting a budget in advance
of the period to which it relates.
14) Which of the following statements about fixed and flexible budgets true or false?
1. A flexible budget is a budget that is produced during the budget period to recognise the
effects of any changes in prices and methods of operations that have occurred.
2. The main purpose of a fixed budget is at the planning stage of the budget period
3. A fixed budget is a budget that considers all of an organisation costs and revenues for a
single level of activity
a) 1 and 2 only
b) 1 and 3 only
c) 2 and 3 only
d) All of these
Budgeting 202
15) The budgeted costs for X Co for June are as follows:
Sales 30,000 units
$
Materials 130,000
Labour 210,000
Fixed overheads 360,000
Total cost 680,000
If the budget is flexed for 35,000 units, what will be the budgeted total cost?
$_________
Solutions:
1) c
Not all employees are motivated by money. Many are motivated by spending time with their
families or a desire to do a good job.
It is important that goals for all employees are aligned with the organization’s overall mission.
Employers must motivate employees to achieve these goals. This is vital for the future success of the
business.
2) A) & C)
- Participative budgets are prepared with significant input from operational levels. Therefore, the
operational managers tend to introduce cost buffers and reduce revenue targets in the budget –
to ensure that they can meet their cost/revenue targets.
- It increases operational managers’ commitment to organizational objectives – because they have
prepared the budgets themselves and feel a sense of responsibility to meeting targets that they
have created for themselves (contributing to org. objectives)
3)
Task 1
The inventory of finished goods at the beginning of P1 will be 20% of the sales in that period:
40,000 units * 0.2 = 8,000 units
Task 2
37,000 units
The production volume in Period 2 will be the sales in that period, adjusted for any change in the
finished goods inventory:
Sales in Period 2 38,000 units
+ Finished goods inventory at the end of Period 2 6,600 units (33,000 units × 0.20)
Budgeting 203
- Finished goods inventory at the start of Period 2 7,600 units (38,000 units × 0.2)
= Production in Period 2 37,000 units
Task 3
The purchases of raw material in Period 3 will be the usage in production in that period, adjusted for
any change in raw material inventory:
Raw material usage in Period 3 96,000 kg (32,000 units × 3 kg/unit)
+ Raw material inventory at the end of Period 3 22,500 kg (30,000 units × 3 kg/unit÷ 4)
- Raw material inventory at the start of Period 3 24,000 kg (32,000 units × 3 kg/unit ÷ 4)
= Raw material purchases in Period 3 94,500 kg
The cost of the raw material used in Period 4 will be:
Production in Period 4, 30,000 units × 3 kg/unit × $11.00/kg = $990,000
Task 4
Because of the restriction on raw material supply, the maximum production quantity per period is
now: 75,000 kg / 3 kg/unit = 25,000 units.
The finished goods inventory at the end of Period 2 will be any excess of production over sales in
that period plus the inventory at the start of the period (if any):
There will not be any finished goods inventory at the start of Period 2 because sales demand in
Period 1 exceeds the maximum production.
Sales demand in Period 2 is 30,000 units which is 5,000 units less than production.
Finished goods inventory at the end of Period 2 is therefore 5,000 units
Task 5
d) Use raw materials more efficiently High
4)
Task 1
Budgeted statement of financial position at 31 December 20X5:
$ $ Note
Assets:
Non-current 8,000 (1)
assets
Budgeting 204
Current
assets:
Raw 4,500
material
inventory
Trade 16,000 (2)
receivables
Cash 6,000 (3)
15,500
24,000
Equity and
liabilities:
Ordinary 19,500
shareholders
funds
Current
liabilities:
Trade 4,500 (4)
payables
24,000
As there are no purchases or disposals of non-current assets in the period, the non-current assets at
31 December will be:
Non-current assets at 30 September $13,000

Less depreciation in the 3 months to 31 December $5,000
Non-current assets at 31 December $8,000
Trade receivables at 30 September $7,000
Plus, credit sales in the 3 months to 31 December $78,000
Less receipts from customers in the 3 months to $69,000
31December
Trade receivables at 31 December $16,000
Cash balance at 30 September $4,000
Plus net cash inflow in the 3 months to 31 December $9,500
Cash balance at 31 December $13,500
Task 2
Direct Labour
Neither sales demand nor supply of material A will limit what can be produced and sold in 20X8.
Maximum production in Period 6:
From availability of material B = 80,000 kg / 6 kg/unit = 13,333 units
From availability of direct labour = 60,000 hours / 5 hours/unit = 12,000 units
Therefore, material B is the principal budget factor for 20X6.
Task 3
Sales budget, production budget, purchases budget

Budgeting 205
The principal budget factor should be the first budget to be prepared as this determines the level of
activity that can be achieved and thus all other budgets. As sales demand is the principal budget
factor, the sales budget should be prepared first, followed by the production budget, which will
influence what is purchased.
5) a-False b-True
If a budget is set easy, then actual performance will appear to be better than budgeted but may
have not challenged the employee
Management accounting planning and control systems can have a significant effect on managers and
employee motivation. Eg employee reward system
6) a) 1 only
Budget manuals are instructions relating to objectives, procedures and preparation of the budgets.
These are coordinated by a budget committee which consists of representatives from major
functions of the business. The managers from these functions are responsible for preparing the
budget, e.g. purchasing manager should set the material purchases budget. It is a tactical planning as
it is made for 1 accounting period.
7)
The limiting factor is known as limiting budgeting factor. True
A budget manual consists of an organization chart. True
Budget manual gives details of the responsibilities of those involved in the budgeting process,
including organization charts and a list of budget holders.
Generally, there will be one factor in business that will limit the activity of an organization in a given
period. Generally, its sales
8)
No, the principal budget factor is the factor that limits the activities of the company; therefore, it
must be constructed first – because it controls everything else.
Then the sales budget is prepared, and after that, the production budget is prepared. (You must first
know how much needs to be sold, and then produce that amount.
9) 290,000
Total units required for sales and inventory = 203,000 (200,000 + 3,000)
203,000 represents 70% of the total output required (as 30% of output is rejected).
Total output required = 290,000 (203,000 / 0.7)
10) $64,980
The company produces 45,600 units at 57% capacity. Therefore, it would produce 80,000 units at
100% capacity (45,600 / 0.57).
Budgeting 206
Rent per unit of output at 100% capacity = $0.855 (68,400 / 80,000)

Total rent cost at 100,000 units of output = $64,980 (0.855 x 76,000)
11) $50,564
Using the high low method:
$ %
50,687 85
50,400 78
287 7%
The variable cost = $287 / 7% = $41 per 1%
Fixed element = $50,687 – (85 x $41) = $47,202
Costs at 82% occupancy = $47,202 + ($41 x 82) = $50,564
Note: In this case, it was not necessary to indicate that electricity costs have both fixed and variable
elements. If it was only variable, the cost values would have been different from the ones specified
in the question at the given different levels of activity.
12) $954,000
Total labour time = 9 hours plus 25% idle time
Total labour time = 12 hours (9 / 0.75)
Total budgeted labour cost = $954,000 (5,300 x 12 x 15)
13) C
A flexible budget helps to control resources efficiency by providing a realistic budget cost allowance
for the actual level of activity achieved. Control action can therefore be more effective because the
effects of any volume change have been removed from the comparison
14) C) A flexible budget is prepared during the budget period, but it recognises only the effects of
changes in the volume of activity
The fixed budget is prepared at the planning stage when it seeks to define the objectives of the
organization. There is little benefit in comparing a fixed budget with actual sales for a different level
of activity.
A fixed budget is prepared for a single level of activity
15) $755,500
Materials and labour are variable costs.
Materials cost per unit = $130,000 / 30,000 units = $4.3 per unit
Labour cost per unit = $210,000 / 30,000 units = $7 per unit
Fixed overheads are fixed costs so do not vary with volume of activity.
Cost for 35,000 units: $

Materials (35,000 x $4.3) 150,500
Labour (35,000 x $7) 245,000
Budgeting 207
Fixed overheads 360,000

Total 755,500
Capital budgeting 208
Capital budgeting
Introduction
When a business invests money to acquire any assets with a view to generate a return, it is known as
capital investment. It is usually for long term benefits to the company.
Since these decisions are long term, proper consideration must be taken before any decision is
made, as these decisions affect the company.
Expenditure is classified into two:
1. Capital expenditure
Capital expenditure refers to the spending on non-current assets for business use or enhancing
their revenue-generating potential. This expenditure is initially reflected in the statement of
financial position as non-current assets and is subsequently allocated to the statement of profit
or loss over multiple periods through depreciation charges.
When we purchase a non-current asset or significantly improve an existing asset, it is known as
capital expenditure. We capitalize such expenditure, which means we show it as an asset in our
financial statements and depreciate it over time.
2. Revenue expenditure
Revenue expenditure refers to the spending incurred in various areas of the business, including
the purchase of assets for resale, the manufacturing and distribution of goods, and the daily
administration of the business. It also encompasses the costs associated with maintaining the
revenue-generating capacity of non-current assets, such as repairs. Revenue expenditure is
typically recognized in the statement of profit or loss for the period in which the expenditure
occurred.
All other expenditures done to buy assets that we sell (inventory), to manufacture assets to sell
or maintain assets we hold are classified as revenue expenditure. Such expenditure is expensed
out in our profit and loss statements.
Capital budget
Capital budgeting means to budget the capital expenditure that the company will incur over time.
Since these are major costs, the budgeting process is very important.
An important step in the budgeting process is Investment appraisal. To appraise means to assess
whether an investment is profitable or beneficial to the company. Whether the initial investment
will be recovered in time and make a profit or not. Appraisals help in filtering projects, so the
investment is made in the best opportunity.
Time value of money
Money today will not hold the same value forever. We mean, $10 today and $10 5 years ago don’t
have the same value. Money’s value decreases over time. If we can buy 1kg tomatoes for $1 today,
the same $1 two years later may only buy us 750gms of tomatoes. This is the time value of money.
In our investment appraisal, it is necessary to incorporate the time value of money, as the
investment will usually be longer than one year. Time value of money is due to the cost of finance
(the interest we charge or pay), inflation, risk etc.
Interest
1. Simple interest
Simple interest is the interest that we get on the money we invest. Any past interest does
not fetch us more interest. If we invest $100 at 10% return, we get $10 each year, this is
known as simple interest. This is calculated as:
Simple interest sum = P + (PxNxR/100)
Where,
P is Present investment
N is number of time periods
R is rate of interest
2. Compound interest
Compound interest is interest on the total sum that includes initial investment and interest
that we’ve already earned. Basically, it includes interest on interest. This is calculated as:
Compound interest sum = P (1 + r)n

Where,
P is Present investment
N is number of time periods
R is rate of interest
$1000 is invested in an account for 3 years. The interest rate is 6% per annum. Calculate the value
after three years using simple interest and compound interest.
Solution:
1) Simple interest sum = $1000 + ($1000 x 3 x 6/100) =$1180

2) Compound interest sum = $1000 (1 + 0.06)3 =$1191
$1000 is required in 5 years. Interest rate earned today is 6% p.a. How much $ needs to be invested
today?
Solution:
1000= P (1 + 0.06)5
P = 1000/1.065
P = $747.25
Hence, if we invest $747.25 today, which is compounded at 6% per annum, after 5 years, we will
have $1000.
Interest rate
1. Nominal interest rate

The interest rate that we see is simply the nominal interest rate. It is stated for a time
period, such as per month, per annum etc., 10% p.a. is an example of nominal interest rate.
2. Effective interest rate
The effective interest rate gives us the interest rate that includes the effects of the
compounding of the nominal interest rate. We mean, if a nominal interest rate is in per
month, we will receive interest in the second month on the interest of the first month. After
this keeps happening, what will we effectively earn after the year? That’s known as an
effective interest rate. We calculate it using the following formula:
R = (1 + i/n)n – 1
Where,
R = effective interest rate
I = nominal interest rate
n = number of time periods
A company has a nominal interest rate of 10% compounded per month. If a company is going to
invest for 9 months, calculate the effective interest rate.
Solution:
R = (1 + i/n)n – 1
R = (1 + 0.1/9)9 – 1
R = 1.01119 – 1
R = 1.104 – 1 = 0.104 = 10.4%
Discounting
To put it simply, discounting is the opposite of compounding. If compounding finds the future value
of money we invest today, discounting takes a future sum and finds the value of it today. The value
of money in today’s terms is known as Present value (PV). It is very important to be able to calculate
the present value of future cash flows in investment appraisals.
Formula for discounting:
Present value = Future value x discount factor
Discount factor = 1/(1 + r)n

Where:
r is the interest rate in decimal
n is the number of time periods
The discount factor is also given in the exam, in the present value table. The table has discount rates
® as columns and time periods (n) as rows. The factor that we need can simply be found and used.
Let’s see that in an Illustration.
Assumptions used in discounting are:

Unless told otherwise
1. All cash flows occur at the start or end of the year.
2. Initial investments occur at once, other cashflow starts in one years time
Calculate the present value of $12000 receivable in 10 years’ time if the interest rate is 5% per
annum.
Solution:
Calculating the discount factor:

DF = 1/ (1 + 0.05)10 = 0.614
Finding the discount factor in the present value table:

Simply go to the 5% column, and take the value for the 10th year, i.e. 0.614
Present value:
PV = FV x DF
PV = $12000 x 0.614
PV =$7368
Annuity
An annuity is a constant continuous cash flow over a few years. For example, if we invest $100 in a
10% simple interest account for 5 years, the $10 we receive each year for 5 years forms an annuity.
Rather than discounting the $10 individually for 5 years to arrive at a total present value, we can do
it directly using an annuity factor.
An annuity factor is simply the total of present values. If the present value for year 1 at 10% is 0.909
and year 2 is 0.826, the annuity factor at the end of year 2 would be 1.735. The annuity factors too,
like present value factors are given in the exam in an annuity factor table. It can also be calculated
using the following formula:
AF = 1 – (1 + r)-n
r
For example, a 10-year annuity at 15% would be:

Given in the table under 15% at the 10th year as 5.019
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528
3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326
7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605
8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837
9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031
10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192
It can be calculated as:

AF = 1 – (1 + r)-n
r
AF = 1 – (1 + 0.15)-10
0.15
AF = 0.753/0.15 =5.019
Cash inflows for 5 years are fixed at $125000 each year. Calculate the present value of the total cash
flows at 8%.
Solution:
AF = 1 – (1 + r)-n
r
AF = 1 – (1 + 0.08)-5
0.08
AF = 0.319/0.08 =3.993
Present value = Future value x annuity factor
PV = $125000 x 3.993 = $499125
Perpetuity
A perpetuity is an annual cash flow that occurs forever. For example, if we invest $100 in a 10%
simple interest account, the $10 we receive each year forms a perpetuity since ideally, we’ll be
receiving the $10 forever. (Or until we withdraw the initial investment).
Discounting a perpetuity is not possible with our previous formulae as they require a time period.
Hence, the formula to be used to discount a perpetuity is simply dividing the cash flow by the
interest rate.
PV of perpetuity = Cashflow/r
Advanced cash flows

Until now, we have been assuming that our cash flows incur at the end of year 1. Hence, they need
to be discounted to be brought at their value today. But at times, cash flows may start immediately,
and the value doesn’t need to be discounted.
Simply put, the value of $10 today is $10. This doesn’t need to be discounted.
Hence, if all cash flows are at the start of the year, they don’t need to be discounted for that year.
Let’s understand this with the help of an Illustration.
An 8-year $750 annuity is starting today. Interest rates are 5%. Find the PV of the annuity.
Solution:
The first cash flow will be received today, hence it doesn’t need to be discounted. The second cash
flow will be at the start of Year 2, basically at the end of year 1, hence it needs to be discounted for 1
year. Similarly, the other cash flows will be one year behind.
We take the annuity factor for 7 years at 5% and not 8 years. The first cash flow will be directly
added as it holds full value.0
Calculation of PV: $750 + $750 x 5.786

PV = $5089.5
Delayed cash flows

Like advanced cash flows, some cash flows may also start after a few years. They need to be
discounted accordingly.
For example, a 3-year annuity that will start at the end of year 3.
This means, we will receive money in the 3rd, 4th and the 5th year. We simply calculate the annuity as
usual, as a 3-year annuity.
The value we have is the value of the total money at the end of year 3. This value will be discounted
normally using the present value to arrive at the value today. Let’s look at an Illustration to clarify it
further.
Calculate the present value of $250 incurred each year for 7 years, starting in 4 years’ time. The
discount rate applicable is 12%.
Solution:
First, we calculate the annuity of 7 cash flows at 12%

Annuity = $250 x 4.564 (Remember, there will be seven years where we receive $250, hence n is 7)
Annuity = $1141
Now, this $1141 represents the value of money at the end of year 3. We take the present value at
12% for year 3 and calculate the present value.
PV = $1141 x 0.7117
PV =$812.049
Cash flows for investment appraisal
Now we’ll learn a few investment appraisal methods. In investment appraisals, we usually take cash
flows and not accounting profits. Profits usually include incomes and expenses that are not
monetary, such as depreciation. If these expenses are included in appraisals, they may make various
profitable decisions unprofitable and hence making them unacceptable.
Similarly, the outflow of cash when we purchase the asset or invest the money, there is a major cash
outflow which needs to considered right away. Depreciation is a correct accounting measure, but for
investment appraisals, relevant cash flows give us more information.
Relevant cash flows include:

• Future costs – costs already incurred will not affect our cash position in our future, hence
they don’t need to be considered for a future decision. These costs are known as sunk costs.
• Cash flows – like we discussed, any non-cash expenses such as depreciation are not
considered. The costs are known as notional costs.
• Incremental costs – If we invest, the additional costs that will arise are known as incremental
costs. Obviously, these costs need to be fully included in our investment appraisal.
Other cost terms that we need to know:

• Opportunity costs: This is a cost that we incur as we let go the second-best alternative. For
example, if we are currently earning $5 per hour from our existing business, and to do
another business, we need to stop this, the $5 represents an opportunity cost. Think about
it, if we will be earning $4 per hour, we actually start losing $1 per hour from our existing
position. Hence including $5 that we’ll not earn anymore as a cost is necessary.
• Avoidable costs: These are the costs that we avoid by doing something or not doing
something. For example, if we invest in A, we will avoid existing administration expenses.
That is known as an avoidable cost.
• Differential cost: the difference in total cost or revenue between two alternatives.
Assumptions for investment appraisal

• We assume that all cash flows occur at the start or end of the year, for simple discounting.
• The start of year 1 is known as T0, this is where our initial investment is made, hence it
doesn’t need discounting. All other cash flows are at year end, and the end of year 1 is
known as T1. T2, T3 etc., follow.
Appraisal methods
We’ll be learning 4 methods of investment appraisal. i.e.:
Discounted
Payback Period NPV Method IRR Method
Payback Period
These methods (except payback period) use discounting, hence show time value of money. They are
known as Discounted cash flow (DCF) techniques.
1. Payback period
As the name suggests, the payback period is used to calculate the time required by the project to
recollect the initial investment. The sooner this period is, the better. A company may compare
various projects by their payback period and select the one with the lowest one. The company may
also have a maximum payback period policy, all projects above which are automatically rejected.
Decision criteria:
• Compare the payback period to the company’s maximum return time allowed, and if the payback
is quicker, the project should be accepted.
• Faced with mutually exclusive projects, choose the project with the shortest payback.
A project requires an initial investment of $25m, and it is expected to generate net cash inflows of
$3.41m each year for 9 years. What is the payback period of the project?
Solution:
This question is dealing with even cash flows, or constant cash flows. We need to check when will we
recover our initial $25m. This can be done by simply dividing the initial investment by the annual
cash flows.
Payback period = $25m/$3.41m

Payback period = 7.33 years
Remember, the 0.33 years cannot be stated into months directly. To state the answer in months, we
multiply 0.33 into 12, the answer to which is 4.
The payback period therefore is 7 years and 4 months or simply 7.33 years.
A project requires an initial investment of $12m, the scrap value at the end of its life is $1m.
Annual cash flows are:
Year 1 $1.5m
Year 2 $3m
Year 3 $4m
Year 4 $2.5m
Year 5 $2m
Year 6 $1m
Calculate the payback period.
Solution:
Here, the cash flows are uneven, meaning they are not of the same sum. We prepare a cumulative
cash flow table and our payback period is when the table crosses 0.
Project Cashflow ($’m) Cumulative cash flow ($’m)

Year 0 -12 -12
Year 1 1.5 -10.5
Year 2 3 -7.5
Year 3 4 -3.5
Year 4 2.5 -1
Year 5 2 1
Year 6 2 3
In year 6, the cash flow is $2m as we will also have scrap income of $1m. As we can see, the
cumulative cash flows become positive somewhere between year 4 and year 5. To find out exactly
where, we divide the year 5 cash flow by our requirement. The same have been highlighted above.
Which is 4 years and ½ =0.5
Our payback period is, therefore 4.5 years or 4 years and 6 months.
2. Discounted payback period

Discounted payback is simply using discounted cash flows and calculating the payback period. It
gives more valuable information as it tells us when exactly will we recover our initial investment in
absolute terms. Since we’ve already learned discounting, we can directly go forward with an
Illustration.

A project requires an initial investment of $12m, the scrap value at the end of its life is $1m.
Annual cash flows are:
Year 1 $1.5m
Year 2 $3m
Year 3 $4m
Year 4 $2.5m
Year 5 $3m
Year 6 $2m
Calculate the payback period using a discount rate of 10%.
Solution:
Project Cashflow ($’m) Present value ($’m) Cumulative cash flow ($’m)
Year 0 -12 -12 -12
Year 1 1.5 1.3635 -10.6365
Year 2 3 2.478 -8.1585
Year 3 4 3.004 -5.1545
Year 4 2.5 1.7075 -3.447
Year 5 3 1.863 -1.584
Year 6 3 1.692 0.108
As we can see, our payback period lies between year 5 and year 6. It will be calculated the same
way:
5 years and -1.584/1.692 =0.94
Payback period =5.94 years
Advantages of payback period

• Simple to understand
• Comparable with other projects
Disadvantages of payback period
• Doesn’t measure absolute profitability (Gives an answer in years and not $)
• Does not take into account cash flows beyond the payback period (If project is super
profitable but takes time to reach there, it will not be selected under this method.)
3. Net present value (NPV)

NPV analysis simply calculates the net benefit or loss the company will make on present value terms.
A positive NPV would suggest that the project will earn the business more money than the initial
investment.
We take the cost of capital, which is the % return we pay on the capital we use, or any other
discount factor acceptable and calculate NPV. If positive, it means that we’ll earn more from the
project after paying those who provided us with the capital.
The decision criteria are simple, positive NPV projects are acceptable, negative NPV projects are
rejected, the projects with the highest NPV can be selected amongst other projects.
We simply discount the cash flows, and deduct the initial investment and we are left with the NPV.

A project is being considered where the following cash flows are estimated to be:
Year Cash flow ($)

0 (375,000)
1 95000
2 125000
3 145000
4 90000
5 55000
Calculate the NPV if the cost of capital for the company is 12%
Solution:
Year Cash flow Discount factor Discounted cash flow

1 95000 0.893 84835
2 125000 0.797 99625
3 145000 0.712 103240
4 90000 0.636 57240
5 55000 0.567 31185
376125
0 375000 1 (375000)
NPV 1125
Advantages of NPV
• Considers time value of money
• Measures of absolute profitability
• Considers cash flows not profits
• Considers the whole life of the project
Disadvantages of NPV
• Complicated in nature
• Difficult to explain to managers who are the end decision makers
• May be difficult to determine the cost of capital
IMP: Must know the advantages and disadvantages of NPV.
4. Internal rate of return (IRR)
IRR is closely linked to NPV. IRR simply calculates the discount rate at which the NPV for the project
is $0. Knowing the IRR can then be compared with the company’s cost of capital to make investment
decisions.
If the IRR is greater than the company’s cost of capital, it means the NPV at the cost of capital will be
positive. Hence, when IRR is greater than COC, the project must be accepted.
To calculate IRR, we follow the following steps:

Step 1: Calculate NPV at cost of capital or any discount rate.

Step 2: Based on the first NPV, calculate another NPV at another discount rate. This discount rate
must be selected accordingly:
• If the NPV at first discount rate is positive, pick a discount rate higher than the first discount
rate.
• If the NPV at first discount rate is negative, pick a discount rate lower than the first discount
rate.
Step 3: Use the following formula to calculate IRR
𝑁𝑃𝑉(𝑙)
IRR = 𝐿 + 𝑁𝑃𝑉 (𝑙)−𝑁𝑃𝑉 (ℎ)
(𝐻 − 𝐿)
Where,
H is higher rate of interest
L is lower rate of interest
NPV (h) is NPV at higher rate of interest
NPV (l) is NPV at lower rate of interest
You may be asked to calculate NPV’s, which we have learnt previously or be given two NPV’s and be
asked to calculate the IRR.

A potential project’s predicted cash flows gives an NPV of $25000 at a discount rate of 8% and at the
discount rate of 12% an NPV of ($2500)
Calculate the IRR
Solution:
𝑁𝑃𝑉(𝑙)
IRR = 𝐿 +
𝑁𝑃𝑉 (𝑙)−𝑁𝑃𝑉 (ℎ)
(𝐻 − 𝐿)
25000
IRR =8% + (12 − 8)
25000–2500
IRR = 8% + (0.909 x 4)
IRR = 8% + 3.64% =11.64%
This means that at a discount rate of 11.64%, the project will give an NPV of $0. So hypothetically, if
the company’s cost of capital is 10%, the NPV will be positive at that rate.
Advantages of IRR
• Considers time value of money
• Expressed as a percentage so managers can understand
• Considers cash flows not profits
• Calculated without reference to cost of capital
Disadvantages of IRR
• Not a measure of absolute profitability
• Complicated to calculate
• Uneven cash flows can give two IRRs
• May conflict with NPV (NPV usually given higher preference)
• Capital investment involves expenditure on non-current assets for use in a project which is
intended to provide a return by way of interest, dividends or capital appreciation.
• Compounding FV = PV (1+r) ^ n
Discounting is compounding in reverse.

PV = FV
(1 + r) ^ n
r – rate of interest
n – number of time periods
• Relevant costs are those whose inclusion affects the investment decision.
• Discounted cash flow, or DCF, is an investment appraisal technique that takes into account
both the timing of cash flows and also the total cash flows over a project’s life.
• The NPV is the value obtained by discounting all the cash outflows and inflows for the
project capital at the cost of capital and adding them up. If NPV negative- decline the
project, if NPV positive – Accept the project, if NPV is zero, then it means that the cash
inflows from a capital investment will yield a return exactly equal to the cost of capital
• An annuity is a fixed (constant) periodic payment or receipt which continues either for a
specified time or until the occurrence of a specified event,
• Perpetuity is a periodic payment or receipt continuing for a limitless period.
• The payback period is the time that it takes for an investment to pay for itself.
• The discounted payback period is, therefore, the time it will take before the project’s
cumulative NPV becomes positive.
1) A manufacturing company is considering the production of a new type of widget. Each

widget will take two hours to make. Fixed overheads are apportioned on the basis of $1 per
labour hour. If the new widgets are produced, the company will have to employ an
additional supervisor at a salary of $15,000 per annum. The company will produce 10,000
widgets per annum.
Required:
What are the relevant cash flows?
2) An investment has the following net present values (NPV), depending on the cost of capital.
Cost of capital of 10%: NPV = $8,000
Cost of capital of 18%: NPV = ($2,000)
What is the internal rate of return (IRR)?
a) 27.5%
b) 16.4%
c) 17.5%
d) 18.1%
3) Which of the following statements about payback/discounted payback is true?
a) Discounted payback considers the time value of money, but payback does not
b) Payback allows you to know how long the initial investment will take to be returned from the
project
c) Payback allows us to know the breakeven point of a project
4) The following information is available for two projects. Only one project can be undertaken.
Project A Project B
Internal rate of return (IRR) 8% 12 %
Discounted payback period 3.9 years 4.5 years
Net present value (NPV) $22,875 $20,700
Which TWO of the following statements are true?
a) Project A should be accepted because it has the higher NPV

b) Project B should be accepted because it has the higher IRR
c) At a cost of capital of 17%, project B would have a zero NPV
d) Project B should be accepted based on the discounted payback period
5) D. Co is evaluating a project which will generate cash flows of $6,750 each year in years 7 to
10 (The first amount will be received in 7 years from now.
What is the present value of the project cash flows using a discount rate of 9%?
a) $ 21,870
b) $ 43,321.5
c) $ 30,280.5
d) $ 13,041
Solutions:
1)
Of the costs mentioned, only the $15,000 salary is relevant as it is incurred as a direct result of
making the decision to manufacture the new widgets. The fixed overheads are not incremental to
the decision and should be ignored. Other costs that would be relevant include any direct material,
direct labour and direct expenses incurred as a result of the production of the new widgets. Also,
any variable production overheads
2) b) 16.4%
IRR = A + (a / (a – b) x (B – A))
= 10+ (8,000 / (8,000 + 2,000) x 8)
= 16.4%
3) A and B
Payback does not tell us the breakeven point of a project.
4) Project A should be accepted because it has the higher NPV
At a cost of capital of 12%, project B would have a zero NPV
The NPV method is superior to all other criteria for investment appraisal. Therefore, statement
about accepting project A for its higher NPV is true, and the statement about accepting project B for
its higher IRR is false.
Moreover, IRR is the cost of capital which gives a zero NPV, and so the statement about the cost of
capital is 12% is also true.
A discounted payback period of 3.9 years is more favorable than 4.5 years because a shorter
payback is considered to be less risky.
5) d)
We need the cumulative discount factor for years 6 to 10.
Cumulative discount factor for years 1 – 10 at 9% 6.418

Less: cumulative discount factor for years 1 – 6 at 9% 4.486
Cumulative discount factor for years 7 – 10 at 9% 1.932
The present value = 6,750 x 1.932 = $13,041
Note: This is another valid method of calculating a delayed annuity. The method taught above yields
the same answer.
Standard costing
Variance analysis 223
Variance analysis
Introduction
Until now, we’ve learnt absorption and marginal costing, now we’ll be learning standard costing.
While standard costing is not another method, it is more like a complement to the other two
methods, as it uses the two methods as well.
A standard cost is basically a planned ‘target’ cost of a product or a service, or how much should the
cost have been. These are set beforehand during the planning process and represents how much the
cost should be. But in reality, the cost will slightly differ.
Such a difference is called a variance, in standard costing we’ll be studying why variances occur, how
to calculate and justify the difference in cost or variance. We have seen basic variances in budgeting,
when we compare flexed budgets, but still, we need to know:
A profitable or a positive variance is known as a favorable variance. If we ended up spending less

than we budgeted, it will be known as a favorable movement and hence a favorable variance.
A costly or a negative variance is known as an adverse variance. If we ended up spending more than
we budgeted, it will be known as an adverse movement and hence an adverse variance.
For such budgeting, we use marginal and absorption costing.
Types of cost standards
The standard cost we discussed, can be based on one of the following four standards:
• Basic standards
A basic standard is a long-term unchanged standard. Their use is fairly limited and are the
least useful type of standard. They are mainly used to show a change in cost prices over
time.
• Ideal standards
These standards are based on perfect operating conditions. Where there is no wastage,
labor is fully trained and efficient, machine breakdowns are impossible etc. These aren’t
possible to achieve in reality but can be set to compare how far currently we are.
• Attainable standards
These are the standards at a level which the production can reach with over time. Conditions
which will be efficient, however not perfect. These are the most frequently used standards.
They are set above current standards and are constantly updated once achieved.
• Current standards
These standards are based on current levels of production efficiency. Where we stand
currently. These are obviously required and necessary. Comparing these with attainable
standards is where we find out areas to optimize. Current standards include allowances for
breakdowns, idle time etc. and are easily achievable, hence they should not be used to set
targets, but to close the gap with targets.
Next, we’ll learn how to make a standard cost statement. Remember, a standard cost statement is
simply a cost statement at standard costs for each cost. Let’s do this using an Illustration.
Terrible Co manufacturers Product T. The following information is provided:

Budgeted output for the year: 1500 units
Standard costs:
Materials: 3000kgs at $12 per kg
Labour: 1500 hours at $8.5 per hour
Variable overhead: $6 per hour
Fixed production overheads: $25000
Other fixed overheads: $17250
Prepare a standard cost card and calculate standard cost per unit under marginal and absorption
costing.
Solution:
Standard cost card -T $

Direct materials (3000 x $12) 36000
Direct labour (1500 x $8.5) 12750
Variable overhead (1500 x $6) 9000
Marginal cost 57750
Fixed production overhead 25000
Absorption cost 82750
Other fixed overhead 17250
Total standard cost 100000
Standard cost per unit (Marginal costing):

Total marginal cost $57750
Budgeted units 1500
Standard cost per unit $38.5
Standard cost per unit (Absorption costing):

Total absorption cost $82750
Budgeted units 1500
Standard cost per unit $55.2
Calculating how to prepare a cost statement and cost per unit is fairly simple, and we’ve learnt it
earlier. Remember, a standard cost statement or cost per unit will simply be calculated at all
standard costs. We take total marginal cost and total absorption cost, divide it by budgeted
production to arrive at standard cost per unit under whichever method.
1. Sales variances
There are two reasons why sales variances may arise:

• The selling prices were different from than budgeted
• The sales volume (no. of units sold) was different than budgeted
We’ll look at each of these in detail next.
Total Sales Value Variance

This deals with the overall value of sales and creates a comparison between the budgeted sales and
actual sales.
Total Sales Value Variance = Standard Sales – Actual Sales
Sales Price Variance

This deals with the impact that a different selling price than that budgeted will have on the business.
So, if our actual selling price was more than our budgeted selling price, we’ll have a favorable price
variance as we sold at a higher price. Similarly, if we charged a lower price, the variance will be
adverse.
Sales Price Variance = (Standard SP – Actual SP) x Actual Quantity sold
Sales Volume Variance

Above, we took the actual quantity sold. Here we find out the variance due to the difference
between budgeted sales volume quantity and actual quantity sold. If we sell more, our variance will
be favorable. If we sell less, our variance will be adverse. Remember, we need to show the variances
in monetary ($) terms and not quantity terms.
The formula for this variance will therefore be different in absorption and marginal costing.
Absorption costing
Sales Volume Variance = (Standard quantity – Actual quantity) x Profit per unit
Marginal costing
Sales Volume Variance = (Standard quantity – Actual quantity) x Contribution per unit
The costs deducted from contribution are fixed and hence will not differ even if quantity or volume
of sales change thus is excluded when finding the sales volume variance using marginal costing.
Sales Value Variance
Sales Price Variance Sales Volume Variance
The following information is of Product B:
Budgeted sales: 50000 units
Budgeted selling price: $22 per unit
Budgeted contribution per unit: $16 per unit
Budgeted profit per unit: $12 per unit
Actual sales: 52500 units @$20 units
Calculate total sales variance for Product B
Solution:
Absorption costing:
Sales price variance = ($22-$20) x 52500 =105000 A

Sales volume variance = (50000-52500) x $12 =30000 F
Total sales variance =75000 A
Marginal costing:
Sales price variance = ($22-$20) x 52500 =105000 A

Sales volume variance = (50000-52500) x $16 =40000 F
Total sales variance =65000 A
From the following information about sales, calculate necessary sales variances.
Product Standard Actual
Quantity SP Total Quantity SP Total
A 5,000 5 25,000 6,000 6 36,000
B 4,000 6 24,000 5,000 5 25,000
C 3,000 7 21,000 4,000 8 32,000
12,000 70,000 93,000
Solution:
i) Total sales value variance
= Std Sales – Actual Sales

= 70,000 – 93,000
= 23000 (F)
(as we did more sales, so favourable)
ii) Selling Price Variance
= ( Std SP – Actual SP) = Actual Qty

A = (5-6) 6000 = 6000 (F)
B = (6-5) 5000 = 5000 (A)
C = (7-8) 4000 = 4000 (F)
iii) Sales Volume Variance
= (Std Qty – Actual Qty) Std SP

A = (5000 – 6000) 5 = 5000 (F)
B = (4000 – 5000) 6 = 6000 (F)
C = (3000 – 4000) 7 = 7000 (F)
18000
Check: 23000 (F) = 5000 (F) + 18000 (F)
2. Material cost variances
The two main reasons of variances in material costs are:

• We used more material per unit than required
• We paid more for the material than we budgeted
Let’s understand how these lead to variances:
Material Cost Variance

This is the difference between the budgeted cost of material the company decided to buy for a
particular level of production and the actual cost of the same. This signifies the direct relationship
between the cost of materials so as to be able to understand how the purchase manager and
production manager handled their responsibilities.
Material Cost Variance = Actual Cost – Standard Cost
Material Price Variances

If we budgeted that, we’ll have to pay $10 per kg for the material used, and we ended up paying $12
per kg, hence it means that we paid more for the materials than we budgeted. This will give rise to
an adverse variance. Thus, it can be concluded that material price variances are calculated as the
difference between the actual price paid and the budgeted price. Hence, if the actual price exceeds
the budgeted price then there will be an adverse variance and vice versa. Thus, material price
variance can be calculated as follows-
Material Price Variance = (Standard Rate - Actual Rate ) x Actual quantity purchased
Material Usage Variance

No matter the reason, if we use more or less material than we budgeted, it will give us a variance.
For example, to make 100 units, we budgeted 5kgs per unit, but ended up using 6kgs per unit due to
wastage, we’ll end up using 100kgs more to produce 100 units. Thus, material usage variance can be
calculated as follows-
Material Usage Variance = (Standard Quantity – Actual Quantity) x Standard Rate
In conclusion, material price variances tell us if each unit of material cost more or less than
expected, and material usage variance tells us if actual production use more or less units of materials
than expected.
Material Cost Variance
Material Price Variance Material Usage Variance

Budgeted:
Direct materials cost (25kgs at $6 per kg) $150
In the month, 92000 kgs were used to produce 4000 units purchased at a price of $6.5
Calculate the total materials cost variance
Solution:
Materials price variance = ($6 - $6.5) x 92000 =46000 A

Materials usage variance = (100000 – 92000*) x $6 =48000 F
Total material cost variance = 2000 F
*4000 units as per standard cost should’ve taken 25 kgs each, hence total material requirement
would’ve been 100000 kgs.
Alternate calculation for materials usage variance:
Actual usage per unit =92000/4000 =23 kgs
Budgeted usage per unit =25 kgs
Variance = (25 – 23) x $6 x 4000 units = 48000 F
Remember, the usage variance will differ if we didn’t use all the materials we purchase. However,
we still pay for all materials; hence the price variance quantity will be at purchase quantity. Let’s
look at this with an Illustration.
👩‍🏫 Illustration 5: (Closing inventory)

Budgeted:
Direct materials cost (25kgs at $6 per kg) $150
In the month, 95000 kgs were purchased at a price of $6.5. 92000kgs were used to produce 4000
units.
Calculate the total materials cost variance
Solution:
Materials price variance = ($6 - $6.5) x 95000 =47500 A

Materials usage variance = (100000 – 92000*) x $6 =48000 F
Total material cost variance = 500 F
The 3000 kgs closing inventory will bare an adverse price variance of $1500.
Avocado Ltd. Is a manufacturing company producing a single product. It gives the following
standards regarding raw material:
RM X - $5 per kg
RM Y - $10 per kg
Standard quantities of raw materials to be used for every 10 kg of the product are:
RM X - 4 kgs
RM Y - 8 kgs
Actual output for the year is 1000 kg. and the actual material cost is as follows:
RM X - 500 kgs at $3 per kg
RM Y - 1100 kgs at $11 per kg
Calculate: Material variances.
Solution:
Type of Given Standard Revised Standard Actual

RM
10 kgs of FG 1000 kgs of FG 1000 kgs of FG
Qty Rate Amount Qty Rate Amount Qty Rate Amount
X 4 5 20 400 5 2,000 500 3 1,500
Y 8 10 80 800 10 8,000 1,100 11 12,100
Input 12 100 1,200 10,000 1,600 13,600

Loss (2) (200) (600)
Output 10 100 1,000 10,000 10,000 13,600
Calculation of Variances:
1. Total Material Cost Variance
= Standard cost – Actual cost
= 10,000 – 13,600
= 3,600 A
2. Material Price Variance

= (Standard Rate – Actual Rate) x Actual Quantity Purchased
X = (5 – 3) x 500 = 1,000 F
Y = (10 – 11) x 1,100 = 1,100 A
100 A
3. Material Usage Variance

= (Standard Quantity – Actual Quantity) x Standard Rate
X = (400 – 500) x 5 = 500 A
Y = (800 – 1,100) x 10 = 3,000 A
3,500 A
Check: 1 = 2 + 3
3,600 A = 100 A + 3,500 A
3. Labour variances
Labour variances are very similar to material variances; are of two types:
• When the labour rate was different than what we budgeted
• When more or less time was required per unit
A labor variance arises when the actual cost associated with a labor activity varies (either better or
worse) from the expected amount. The expected amount is typically a budgeted or standard
amount. The labor variance concept is most commonly used in the production area, where it is
called a direct labor variance. This variance can be subdivided into two additional variances, which
are noted below.
The labor variance can be used in any part of a business, as long as there is some compensation
expense to be compared to a standard amount. It can also include a range of expenses, beginning
with just the base compensation paid, and potentially also including payroll taxes, bonuses, the cost
of stock grants, and even benefits paid.
Labour Cost Variance

It is the difference between the standard cost of labour allowed (as per standard laid down) for the
actual output achieved and the actual cost of labour employed. It is also known as wages variance.
Labour Cost Variance = Standard Cost – Actual Cost
Labour Rate (of Pay) Variance

It is that portion of the labour cost variance which arises due to the difference between the standard
rate specified and the actual rate paid.
Labour Rate Variance = (Standard Rate – Actual Rate) x Actual hours
Labour Time or Efficiency Variance

It is that part of labour cost variance which arises due to the difference between standard labour
cost of standard time for actual output and standard cost of actual time paid for.
Labour Time Variance = (Standard Hours – Actual Hours) x Standard Rate
Labour Cost Variance
Labour Rate Variance Labour Time Variance
Budgeted:
Direct labour costs (6 hours at $9 per hour) $54
In the month,25000 hours were used at a price of $8.5 to produce 4000 units.
Calculate the total labour cost variance
Solution:
Labour rate variance = ($9 – $8.5) x 25000 =12500 F

Labour efficiency variance = (24000 – 25000) x $9 =9000 A
Total labour variance =$3500 F
Banana Ltd. manufactures product X which requires 2 hours of skilled men, 3 hours of semi-skilled
men and 5 hours of unskilled men, per unit at $ 5, 3 & 2 per hour respectively. During April, the
production department reported output of 2500 units of product X. The labour cost incurred was as
detailed below:
Type of labour Hours paid for Rate per hour
Skilled 4,500 $7.00
Semi skilled 8,500 $2.75
Unskilled 15,000 $1.50
The total hours paid for included 500 idle hours due to machine break down etc., out of which 250
hours pertained to skilled men, 200 hours pertained to semi-skilled men and the balance to unskilled
men.
Required: Calculate the labour cost variances.
Solution:
Type of Revised Standard Actual

labour
2500 units / 25000 standard 2500 units / 25000 standard
hours hours
Skilled 5,000 5 25,000 4,500 7.00 31,500

Semi 7,500 3 22,500 8,500 2.75 23,375
skilled
Unskilled 12,500 2 25,000 15,000 1.50 22,500
Paid for 25,000 72,500 28,000 77,375
Idle hrs 0 (500)
Worked 25,000 72,500 27,500 77,375
for
Calculation of Variances:
1. Total Labour Cost Variance

= Standard cost – Actual Cost
= 72,500 – 77,375
= 4,875 A
2. Labour Rate Variance

= (Standard Rate – Actual Rate) x Actual Hours
Skilled = (5 – 7) x 4,500 = 9,000 A
Semi-skilled = (3 – 2.75) x 8,500 = 2,125 F
Unskilled = (2 – 1.5) x 15,000 = 7,500 F
625 F
3. Labour Time Variance

= (Standard Hours – Actual Hours) x Standard Rate
Skilled = (5,000 – 4,500) x 5 = 2,500 F
Semi skilled = (7,500 – 8,500) x 3 = 3,000 A

Unskilled = (12,500 – 15,000) x 2 = 5,000 A
5,500 A
Check: 1 = 2 + 3
9,000 A = 625 F + 5,500 A
3. Variable overhead variances
These are exactly like labour rate variances, since they are based on labour hours in the first place.
They can be due to two reasons:
• More or less hours were worked incurring more or less variable overheads
• The rate of variable overheads was different than expected
Variable Overhead Cost Variance
Variable Overhead Cost Variance is the overall variance that is calculated for a given set of
production. It is merely the difference between the standard cost and actual costs.
Variable Overhead Cost Variance = Standard Variable Overheads – Actual Variable Overheads
Variable Overhead Expenditure Variance

The variable overhead rate variance, also known as the spending variance, is the difference between
the actual variable manufacturing overhead and the variable overhead that was expected given the
number of hours worked.
Variable Overhead Expenditure Variance = (Standard VOH rate – Actual VOH rate) x Actual Hours
worked
Variable Overhead Efficiency Variance

The variable overhead efficiency variance, also known as the controllable variance, is driven by the
difference between the actual hours worked and the standard hours expected for the units
produced. This variance measures whether the allocation base was efficiently used.
Variable Overhead Efficiency Variance = (Standard hours – Actual hours) x Standard VOH Rate per
hour
Variable Overheads
Cost Variance
VOH Expenditure VOH Efficiency

Variance Variance
Budgeted:
Direct labour costs (6 hours at $9 per hour) $54
Variable overhead expenditure $5 per hour
In the month,25000 hours were used at a price of $8.5 to produce 4000 units.
Actual variable overhead expenditure: $6 per hour
Calculate the total labour cost variance
Solution:
Revised Standard Actual

4000 units 4000 units
Hours Rate Amount Hours Rate Amount
24000 5 120,000 25000 6 150,000
1. Total VOH Cost Variance

= Standard cost – Actual cost
= 120,000 – 150,000
= 30,000 A
2. VOH Expenditure Variance

= (Standard Rate – Actual Rate) x Actual Hours
= (5 – 6) x 25,000
= 25,000 A
3. VOH Efficiency Variance

= (Standard Hours – Actual Hours) x Standard Rate
= (24,000 – 25,000) x 5
= 5,000 A
Check: 1 = 2 + 3
30,000 A = 25,000 A + 5,000 A
b. Fixed cost variances
Fixed cost is treated differently in absorption and marginal costing systems. Hence variances are
examined differently.
Total Fixed Overhead Cost Variance

This represents under or over absorption. It shows how much the company had to incur for the
actual output vis-à-vis how much they actually incurred.
Total Fixed Overhead Cost Variance = Absorbed Overheads – Actual Overheads
Marginal costing
Since we directly take fixed costs at the end, the only variance arises if the actual expenditure was
different than our budgeted expenditure. That variance is:
Fixed overhead expenditure variance = Standard Fixed overheads – Actual Fixed Overheads
A higher actual expenditure will give rise to an adverse variance.
Absorption costing
In absorption costing, since we absorb fixed costs, investigating variances are a bit more
complicated. One option is to calculate the expenditure variance directly, but that wouldn’t help
answer why the variances arise or give the full answer. The following flowchart will help you
understand volume variances.
Fixed overhead expenditure variance = Standard Fixed overheads – Actual Fixed Overheads
A higher actual expenditure will give rise to an adverse variance.
Fixed overhead volume variance: This variance helps us find out the difference between budgeted
overhead expenditure and the amount of overhead absorbed by the actual production. Calculating
both expenditure variance and volume variance answers the whole variance. Between actual
expenditure and actual overhead absorbed.
Fixed Overheads Volume Variance

This is the difference in the output with respect to the cost of Fixed overheads.
Fixed Overheads Volume Variance = (Standard output – Actual output) x Absorption rate per unit
Fixed Overheads Capacity Variance

This represents how many hours were paid for to the workers in comparison to how many actual
hours they spent working.
Fixed Overheads Capacity Variance = (Standard hours paid for – Actual hours paid for) x
Absorption rate per hour
Fixed Overheads Idle Time Variance

This simply represents how many hours were spent in wastage of fixed overheads spent in actual.
Fixed Overheads Idle Time Variance = Idle hours x Absorption rate per hour
Fixed Overheads Efficiency Variance

This represents how many units should have been produced in the actual hours worked in
comparison to how much was actually produced.
Fixed Overheads Efficiency Variance = (Standard output in actual hours – Actual output) x
Absorption rate per unit
Another way to represent this is also by comparing how many hours should have been taken for the
actual output and how many hours were actually taken.
Fixed Overheads Efficiency Variance = (Standard hours for actual output – Actual hours worked) x
Absorption rater
per hour
Fixed Overheads Cost

Variance
FOH Expenditure Variance FOH Volume Variance
FOH Capacity Variance FOH Idle Time Variance FOH Efficiency Variance
The following information is available for product A:
Budgeted:
Fixed production overheads $4500
Units 300
Standard hours per unit 5
Actual
Units 325
Labour hours 1675
Calculate detailed volume variances
Solution:
First, we will calculate FOAR, i.e. 4500/(300x5) =$3 per hour
Fixed overhead capacity variance = (4500 - 1675 x 3) =$525 F

Fixed overhead efficiency variance = (5*325 – 1675) x 3 =$150 A
Fixed overhead volume variance =$375 F
Under/over absorption
Remember how we learnt under and over absorption of overheads in the previous area? The same
answer is found by calculating the total fixed overhead variance.
If the total fixed overhead variance is favorable, it would mean we had over absorbed by the same
amount.
If the total fixed overhead variance is adverse, it would mean we had under absorbed by the same
amount.

The following information is available for product A:
Budgeted:
Units 300
Actual
Units 325
Calculate total fixed overhead variances
Solution:
FOAR= 4500/300 =$15 per hour

Fixed overhead expenditure variance = 4500 – 4200 = $300 F
Fixed overhead volume variance = (4500 - 325 x 15) = $375 F
Fixed overhead total variance =$675 F
Overheads absorbed =325 x 15 =$4875

Overheads incurred =$4200
Over absorption =$675
Causes of variances
A variance may arise due to various reasons.

• Poor planning in the first place while setting a standard would give rise to an unavoidable
variance. Proper planning is a must, and even if planning is going wrong due to reasons out
of control, future plans must take into consideration all those reasons.
• Operational inefficiency will be the next important cause. If the target is beyond the
capability of the staff, or simply they are not efficient enough, they will require more
resources which will lead to a variance.
• Measurement errors are also a major cause. It means that to set the standard, the required
time or required material was measured incorrectly in the first place. Obviously, the actual
requirement would differ, leading to a variance.
• Random factors include other factors that are uncontrollable. Care can be taken to allow for
them in advance.
Interrelationship between variances
An interrelationship means that one variance will move with another variance. An interrelationship
can be positive or negative.
A positive relationship means that if one variance increases, another increases due to it. Moving the
same way. An example would be, if labour price variance is adverse, the variable overhead variance
may be adverse too.
A negative relationship means that if one variance increases, the other will decrease. If good quality
materials are purchased, material price variance may be adverse, but material usage variance may
be favorable.
A common relationship is found between the sales price and sales volume variance. If the price
increases, volume of sales decreases and vice versa. As this is an external factor, it is more due to the
economic concept of demand.
Solution to overcome variances

A solution heavily depends on the cause of the variance. The variance must be investigated, the
impact of a solution on other variances must be considered. Some possible solutions include:
• Better suppliers must be found to get better prices and better-quality materials.
• Quantity discounts for materials can be negotiated.
• Labour training can reduce wastage and require less hours.
• Monitoring budgets properly will lead to proper budgeting etc.
Each variance has various reasons and solutions, it goes down to which factors really matter and
need correcting. Writing down every solution is impossible, obviously.
Missing information
When variances are given with either actual results or standard/budgeted results, we can simply
work backwards to calculate the missing information.
We apply the same formula, since the variance is given, some other information will be missing that
we will find. Let’s look at an Illustration for understanding how to do it.

The following information is available for a material:
Standard allowance for actual production 1100 units

Standard price $2 per unit
Actual purchase quantity 1250 units
Material price variance (Favorable) $155
Calculate the actual price per unit of the material.
Solution:
We know the formula for material price variance
Variance = (Actual price – budgeted price) x Actual quantity
Since, the variance was favorable, remember the budgeted price was less than the actual price.
$155 = ($2 – $x) x 1250
Now, we simply solve the equation and find x
$155/1250 = $2 - $x
$0.124 = $2 - $x
$x = $2 - $0.124 =$1.876
Actual purchase price per unit was therefore, $1.876
Practicing more questions and remembering the formulae is the only way to get these correctly, as
they are simply reverse calculations, and there is no new concept involved. Let’s look at a few more
tricky calculations as these are frequently tested.

Actual usage 5500 kgs

Standard cost for actual usage $18750
Adverse material usage variance $3150
Calculate standard usage for the material
Solution:
We know the formula for material volume variance
Variance = (Actual quantity – standard quantity) x Standard price
We know the variance was adverse meaning we used more material than we were supposed to,
therefore, the actual quantity will be more than the standard quantity.
We are given standard cost for actual usage, using which we can find out standard cost.
Standard cost =$18750/5500 =$3.41
We fill in the information in our formula:
$3150 = (5500 – X) x $3.41
5500 – X = $3150/$3.41
X = 5500 – 923.75
X = 4576.25 kgs

Units made 39000

Labour efficiency variance $12000 A
Labour rate variance NIL
Actual wages $90000
Wage per hour $10
Calculate standard labour hours per unit
Solution:
We know the formula for labour efficiency variance:

Variance = (Actual hours – standard hours) x Standard/Budgeted rate
We know that the actual hours worked were more since the variance is adverse.
Actual hours worked can be found out by dividing total wages by wage per hour.
Actual hours worked = $90000/$10 =9000
We also know that since there is no rate variance, the standard rate and actual rate are the same.
Therefore,
$12000 = (9000 – X) x $10
1200 = 9000 – X
X = 9000 – 1200 = 7800
Hence, 7900 hours were budgeted to be required to produce 39000 units. Therefore, standard cost
per unit:
Standard cost per unit = 7800/39000 =0.2 hours per unit
Absorption costing: Profit reconciliation statement
Standard
cost
operating
statement
$
Budgeted XX
profit
Sales Favorable Adverse

variances:
$ $
Sales price
variance
Sales profit
volume
variance
X
XX
Cost Favorable Adverse
variances
$ $
Direct
labour rate
Direct
labour
efficiency
Direct
materials
price
Direct
material
usage
Variable
overhead
expenditure
Variable
overhead
efficiency
Fixed
overhead
expenditure
Fixed
overhead
efficiency
Fixed
overhead
capacity
X X X A/F
Actual XX
profit
We start at a budgeted profit, add all favorable variances and deduct all adverse variances to arrive
at an actual profit. Preparing this statement helps us identify internal and external factors. Since this
is absorption costing, there will be additional fixed cost variances which need to be included. You
may be given actual profit and may be asked to calculate budgeted profit, in that case, simply
reverse calculate each variance that is given. Remember, all variances do not necessarily exist.
Marginal costing: Profit reconciliation statement
Standard
cost
operating
statement
$
Budgeted XX
profit
Add: X
Budgeted
fixed costs
Budgeted XX
contribution
Sales Favorable Adverse

variances:
$ $
Sales price
variance
Sales
contribution
volume
variance
X
XX
Cost Favorable Adverse
variances
$ $
Direct
labour rate
Direct
labour
efficiency
Direct
materials
price
Direct
material
usage
Variable
overhead
expenditure
Variable
overhead
efficiency
Actual X
contribution
Budgeted X
fixed
overhead
Fixed X
overhead
expenditure
variance
F/A
Actual fixed X
costs
Actual XX
profit
Marginal cost statement is a little different. Remember, in marginal costing, we do not include fixed
costs. Hence, we add back budgeted costs to arrive at the budgeted contribution. Contribution –
Fixed costs = Profit hence, Profit + Fixed costs will be a contribution.
Then again, we add and remove all sales and cost variances except fixed costs. Finally, we will deduct
the actual fixed cost to arrive at an actual profit. Budgeted fixed cost can also be adjusted with fixed
cost variance to arrive at an actual fixed cost. This is necessary to present.
In the exam, a section B question may be tested where you have to calculate individual variances
and then reconcile them with the given profit reconciliation statement.
• A standard cost is a predetermined estimated unit cost, used for inventory valuation and
budgeting using a standard cost card.
• Differences between actual and standard costs are called variances.
• A variance is the difference between a planned, budgeted or standard cost and the actual
cost incurred. The same comparisons can be made for revenues. The process by which the
total difference between standard and actual results is analysed is known as variance
analysis.
• Performance standards are used to set efficiency targets. There are four types: ideal,
attainable, current and basic.
• The direct material total variance can be subdivided into the direct material price variance
and the direct material usage variance.
• The variable production overhead total variance can be subdivided into the variable
production overhead expenditure variance and the variable production overhead efficiency
variance (based on actual hours).
• The fixed production overhead total variance can be subdivided into an expenditure
variance and a volume variance. The fixed production overhead volume variance can be
further subdivided into an efficiency and capacity variance.
• The sales volume profit variance is the difference between the actual units sold and the
budgeted (planned) quantity, valued at the standard profit per unit. In other words, it
measures the increase or decrease in standard profit as a result of the sales volume being
higher or lower than budgeted (planned).
• There are two main differences between the variances calculated in an absorption costing
system and the variances calculated in a marginal costing system. – In a marginal costing
system, the only fixed overhead variance is an expenditure variance.
1) Product G is one of the products that are manufactured by a company. The following direct cost
standards were set, for each batch of 75 units of product G for the period just ended
Materials: 25 kg of material X at $13.5 per Kg

5 L of material Y at $8.80 per litre
Labour: 25 hours at $14.40 per hour
Variable production overheads were absorbed at a standard rate of $4.30 per direct labor hour.
Fix production overheads were observed at a standard rate per machine hour using the following
budgeted data for the factory
Budgeted fixed production overhead $58,500
Budgeted machine hours 1,800
Each Batch of product A requires 9 machine hours
30 batches of product A were manufactured in the period just ended, and the following direct
resources were used
Material X 817 Kg
Material Y 125 L
Labor 780 hours
Task 1
1) What was the standard total variable production cost?
per unit of Production A (to two decimal places)? $_______________

2) What was the standard fixed production overheads cost?
per unit of Production A (to two decimal places)? $________________

3) What was the labour efficiency variance? $________________ __________________
Task 2
A company uses standard marginal costing. Last month, when all sales were at the standard selling
price, the standard contribution from actual sales was $ 50,000, and the following variances arose:
Total variable cost variances $3,500 adverse
Total fixed cost variances $1,000 favourable
Sales volume contribution variance $2,000 favourable
Task 3
Which of the following could be the cause of an adverse sales volume variance for garden furniture?
a) The company offers a discount on sales prices in order to maintain business.
b) Poor weather leads to a reduction in sales
c) A strike in the factory causes a shortage of finished goods
2) Kent Co. uses a standard marginal costing system for cost control of its single product. The
standard cost card for the product is:
$ Per unit
Direct material 3.5 Kg at $9.00 per kg 31.50
Direct labour 3 hours at $9.20 per hours 27.60
Variable production overhead 6.60
65.7
Fixed production overheads are budgeted at $125,600 per month.
Actual results for the month just ended included:
Production 4,800 units
Direct materials 11,780 kg purchased and used a total cost of $152,620
Direct labour 9,760 hours worked
Total variable Production overhead $40,940
Fixed production overheads $122,840
Task 1
Calculate the following variances:
Direct material price $ ___________ ___________
Direct material usage $ ___________ ___________
Direct labour efficiency $ ____________ ___________
Total variable production overhead $ ____________ ___________
Fixed production overhead expenditure $ ___________ ___________
Task 2
The direct labour rate variance in the month just ended was $4,673 favourable.
What was the total direct cost in the month?

a) 128,153
b) 85,119
c) 118,807
d) 89792
3) Rooney company uses a standard marginal costing system to control the cost and revenues of its
only product. The following spreadsheet follows a standard cost-based operation operating
statement for the month of July. Entries for some cells have been deliberately omitted.
A B C D E
1 Standard cost operating statement
2 $
3 Budgeted contribution 230,000
4 Omitted (1) 8,000 Adverse
5 Standard contribution on actual sales 222,000
6 Omitted (2) 14000 Favourable
7 236,000
8 Variable cost variances Favourable Adverse
9 $ $
10 Direct labor rate 4000
11 Direct labor efficiency 16,950
12 Direct materials price 3,200
13 Direct material usage 3,150
14 10,350 16,950 6,000 Adverse
15 Omitted (3) 230,000
16 Budgeted fixed overhead 25,000
17 Fixed overhead expenditure variance 14,000 Favourable
18 Actual profit Omitted
19
Task 1:
Complete the following cells with the correct text label
Cell A4
Cell A15
Task 2
Which of the following will calculate correctly the value in cell D18?
=D7-D14+D17
=D7-D14-D16+D17
=D7+D16+D17
= sum (D3:D17)
Task 3 Which of the following could be the cause of an adverse sales volume variance for garden
furniture?
1) The company of ours discount on sales prices in order to maintain business.

2) Poor weather leads to a reduction in sales.
3) A strike in the factory causes a shortage of finished goods.
Task 4
Rooney company is now considering changing the costing system from a standard marginal cost into
standard absorption costing system you are given further details that were used to prepare the July
operating statement as follows:
1) Budgeted sales and production were 7,000 units

2) Actual sales and production were 6,250
If Rooney company had used standard absorption costing in the month of July what would have
been the value of the following
Fixed overhead volume variance ________________ adverse
Sales volume variance is _________________ adverse
4) Which of the following statements are NOT true about standard costing?
a) A standard cost is a predetermined estimated cost unit
b) A standard cost can be used as a control device to help improve performance
c) A standard cost card shows the unit cost details only of each product
5) Product Z uses 6 kg of material X and 5 kg of material Y at a standard price of $ 8 per kg and $11
per kg, respectively. Product Z needs 3.5 hours of skilled labour and 1 hour of semi-skilled labour at
$8 per hour and $5 per hour, respectively.
Production overhead is absorbed at $4 per labour hour. Selling and distribution costs are $4 per unit
of product Z.
What is the standard cost of production for product Z?
a) $158.5
b) $141
c) $136
d) $148
6) A business uses marginal costing to calculate variances. If they were to use absorption costing, the
current method of calculating the sales variance would be?
a) Higher or the same
b) Lower or the same
c) The same
d) Different but not able to say higher or lower
7) The following information is available for direct material O for the month of June
$
Fixed budget 310,000
Actual cost 261,275
Flexed budget 198,500
What is the total direct materials variance for the month of March?
a) $62,775 adverse
b) $111,500 favorable
c) $111,500 adverse
d) $62,775 favorable
8) The following information relates to the January production of product D.K
Direct materials 47 square meters at 5.60 per square meter
Actual results for direct material in period: 1,000 units were produces, and 51,000 square meters of
material costing $275,400 in total were purchased and used.
Which of the following is correct?
Price variances Usage variance
a) 22,400 Adverse $10,200 favorable
b) $10,200 favorable $22,400 Adverse
c) $22,400 favorable $10,200 adverse
d) $10,200 adverse $22,400 favorable
9) The standard variable production overhead cost per unit of output is $26 (4 direct labour hours at
$6.5 per hour). Last month actual expenditure on variable production overheads was $52,150, and
8,700 direct labour hours were worked. 1,500 units of output were produced last month.
What were the variable production overhead expenditure and efficiency variances last month?
Expenditure Efficiency
a) $4,400 Fav $17,500 Adv

b) $17,500 Fav $4,400 Adv

c) $17,500 Adv $4,400 Fav
d) $4,400 Adv $17,500 Fav
10) A company uses standard costing. This year the standard labour cost of a product is $109.50 per
unit. The standard labour rate is $73.00 per hour. Last month 3,200 hours were worked, and there
was an adverse labour efficiency variance of 14,600. This variance was caused entirely by new
working practices introduced by the company. The full effect of the new working practices is to be
incorporated into the new standard cost of the product for next year. In addition, a labour rate
increase of 10% is to be built into the new standard cost.
Calculate the standard cost for the next year.
$____________
11) One material was used in the manufacture of product A. The total cost of the material
(purchased and used) in a period was $5,000. in the period the direct material price and usage
variances were $300 adverse and $400 favorable, respectively, and 1,200 units were manufactured.
What is the standard direct material cost per unit for product A?
12) Z company uses standard marginal costing. Last month when all sales were at the standard price,
the standard contribution from actual sales was $69,000, and the following variances arose:
$
Total variable costs variance 8,900 Adv
Total fixed costs variance 3,500 Fav
Sales volume contribution variance 2,400 Fav
What was the actual contribution for last month?
$____________
13) A company uses a standard absorption costing system. Last month the actual profit was
$438,000. The only variances recorded for the month were as follows.
$000
Sales volume profit variance 08 adverse
Fixed production overhead capacity variance 26 adverse
Fixed production overhead efficiency variance 39 favorable
Fixed production overhead volume variance 13 favorable
Fixed production overhead expenditure 50 adverse
Direct labour efficiency variance 35 favorable
What was the budget profit for last month?
a) $435,000
b) $448,000
c) $428,000
d) $441,000
14) A company uses standard marginal costing. Last month the standard contribution on actual sales
was $15,000, and the following variances arose:
$
Total variable costs variance 3,000 Adv
Sales price variance 700 Fav
Sales volume contribution variance 1,500 Adv
What was the actual contribution for last month?
Solutions:
1)
Task 1
Notes
What was the standard total $ 11.32 (1)
variable production cost per
unit of Product A (to two
decimal places)?
What was the standard fixed $ $3.90 (2)
production overhead cost
per unit of Product A (to two
decimal places)?
What was the labour $ 432 Adverse (3)
efficiency variance?
Notes:
(1) Standard variable production costs per unit of Product A:
$ per batch
Materials:
X: 25 kg × $13.50 per kg 337.5
Y: 5 litres × $8.80 per litre 44
Labour:
25 hours × $14.40 per hour 360
Overhead:
25 hours × $4.30 per hour 107.5
Total 849
Cost per unit of Product A = $11.32 ($849 per batch / 75 units per batch)
(2) Standard fixed production overhead cost per unit of Product A:
Standard fixed production overhead absorption rate = $58,500 / 1,800 machine hours = $32.5 per
machine hour
× 8 machine hours per batch = $292.5 per batch
/ 75 units = $3.90 per unit
(3) Labour efficiency variance = (actual labour hours – standard labour hours for the actual output) ×
standard labour rate per hour.
[780 hours – (30 batches × 25 hours per batch)] × $14.40 per hour = $432
Or:
Labour efficiency variance = [actual batches – (standard batches from actual labour hours)] ×
standard labour cost per batch.
[30 batches – (780 hours / 25 hours per batch)] × $360 per batch = $432
The labour efficiency variance is ADVERSE because actual hours worked were greater than standard
(or batches produced were less than standard).
Task 2
A sales contribution on actual sales $50,000

Less adverse total variable costs variance $3,500
Actual contribution $46,500
No adjustments are required for the favourable sales volume contribution variance it would have
already been added to the budget contribution to arrive at the standard contribution from Actual
sales given in the question. the total fixed cost variance along with budgeted fixed costs appears in a
reconciliation statement below the actual contribution
Task 3
C (1) will affect the sales price variance
2)
Task 1
Direct material price $ 44,244 Adverse

Direct material usage $ 45,180 favourable
Direct labour efficiency $ 42,688 favourable
Total variable production overhead $ 9260 favourable
Fixed production overhead expenditure $ 2760 favourable
Notes:
(1) Direct material price variance:
Actual expenditure on direct materials – (actual quantity × standard price)
$152,620 – (11,780 kg × $9.20/kg = $108,376) = $44,244
The direct material price variance is ADVERSE because the actual price exceeds the standard
(2) Direct material usage variance:
(Actual usage of raw material – standard usage for the actual output) × standard material price
[11,780 kg – (4,800 units × 3.5 kg/unit = 16,800 kg)] × $9.00/kg = $45,180
The direct material usage variance is FAVOURABLE because the actual usage is less than the
standard.
(3) Direct labour efficiency variance:
(Actual direct labour hours worked – standard hours for the actual output) × standard labour rate
[9,760 hours – (4,800 units × 3 hours/unit = 14,400 hours)] × $9.20/hour = $42,688
The direct labour efficiency variance is FAVOURABLE because the standard hours worked exceed the
actual.
(4) Total variable production overhead variance:
Actual variable production overhead expenditure – (actual output × standard variable production
overhead rate per unit)
$40,940– (4,800 units × $6.60/unit = $31,680) = $9,260
The total variable production overhead variance is FAVOURABLE because the actual expenditure is
less than the standard.
(5) The fixed production overhead expenditure variance is the difference between the actual
expenditure and the budgeted expenditure.
$122,840- $125,600 = $2,760
The fixed production overhead expenditure variance is FAVOURABLE because actual expenditure is
less than budget.
Task 2
B) $85,119
The total direct labour cost is the standard cost of the actual hours worked less the rate variance
(deducted because it is favourable and thus actual expenditure is below standard).
(9,760 hours × $9.20/hour) - $4,673 = $85,119
3)
Task 1
A B C D E
1 Standard cost operating statement
2 $
3 Budgeted contribution 230,000
4 SALES VOLUME CONTRIBUTION VARIANCE 8,000 Adverse
5 Standard contribution on actual sales 222,000
6 SALES PRICE VARIANCE 14000 Favourable
7 236,000
8 Variable cost variances Favourable Adverse
9 $ $
10 Direct labor rate 4000
11 Direct labor efficiency 16,950
12 Direct materials price 3,200
13 Direct material usage 3,150
14 10,350 16,950 6,000 Adverse
15 ACTUAL CONTRIBUTION 230,000
16 Budgeted fixed overhead 25,000
17 Fixed overhead expenditure variance 14,000 Favourable
18 Actual profit 219,000
19
The difference between the ‘budgeted contribution’ and the ‘standard contribution on actual
sales’ is the variance in the amount sold multiplied by the standard contribution per unit. The
term for this (cell A4) is the ‘sales volume contribution variance’.
Cell D7 is the sum of the standard contribution on actual sales and the favourable selling price
variance. The adverse total variable cost variance of $6,000 (net) is then deducted to determine
the ‘actual contribution’ (cell A15).
Task 2
=D7-D14-D16+D17
The actual profit (cell D18) is calculated by deducting, from cell D7, the variable cost variance (cell
D14), because it is adverse, and the budgeted fixed overheads (cell D16) and then adding the fixed
overhead expenditure variance (cell D17), because it is favourable.
Task 3
C (1) will affect the sales price variance
Task 4
The fixed overhead volume variance is the difference between the budgeted and actual volume
multiplied by the budgeted fixed overhead cost per unit.
(7,500 – 6,250 = 750 units) × ($14,000 / 7,000 units = $2/unit) = $1,500
The sales volume profit variance is the difference between the budgeted and actual sales units
multiplied by the budgeted profit per unit.
(7,000 units – 6,250 units = 750 units) × [(budgeted contribution $230,000 – budgeted fixed
overhead $25,000 = budgeted profit $205,000) / budgeted sales 7,000 units = $29.28 per unit] =
$21,964
4) C)
A standard cost card shows the standard quantities of materials and labour time as well as the unit
cost details.
5) a) $158.5
Standard cost of production for product Z:
$ per unit
Material X 6 kg @ $8 48
Y 5 kg @ $11 55
Skilled labour 3.5 hours @ $8 28
Semi-skilled labour 1 hr @ $5 5
Production overhead 4.5 hrs @ $5 22.5
158.5
Selling and distribution costs are not included in production costs.
6) A)
The sales volume variances under marginal costing is based on contribution per unit, and under
absorption, costing is based on standard cost per unit. Standard contribution is either greater or the
same as standard profit, depending on the value of fixed costs. Therefore the variance will either be
higher or the same.
7) A)
The flexed budget is prepared at the actual activity level in June. It shows what the costs of material
A should have been at that activity level. Comparing this to the actual cost gives us the total
variance.
$198,500 - $261,275 = $62,775 adverse
The variance is adverse because the actual cost was higher than it should have been for that activity
level.
8) B) Price variance: $10,200 F Usage variance: $22,400 A
The direct material price variance is the difference between what the materials should have cost and
what they actually cost
Price variances= (actual quantity X Standard price) – (actual quantity X actual price)
= (51,000 X 5.60) – 275,400
285,600-275,400 = $10,200 favorable
The direct materials usage variance is the difference between how much material should have been
used and how much was actually used.
Usage variances= (Standard quantity X Standard price) – (actual quantity X Standard price)
= (1,000 X 47 X 5.60) – (51,000 X 5.60)
=263,200 – 285,600= 22,400 Adverse
9) A)
Variable production overhead expenditure variance:

Budgeted expenditure on overheads for actual labour hours at budgeted labour rate = $56,550 (6.5 x
8,700)
Actual expenditure on overheads = $52,150

Therefore variance = $4,400 favorable (56,500 – 52,150)
Variable production overhead efficiency variance:
Budgeted hours for the actual number of units produced at budgeted hours per unit = 6,000 (4 x
1,500)
Actual number of hours worked = 8,700
Therefore 2,700 more hours were used than expected
Therefore, variance = $17,550 adverse (2,700 x 6.5)
10)
This year:
Standard labour hours = 3,000 (3,200 - (14,600 / 73))
Standard labour hours per unit = 1.5 (109.50 / 73)
Standard number of units produced = 2000 (3,000/ 1.5)
Next year:
Standard labour hours = 3,200
Standard number of units produced = 2,000
Standard labour hours per unit = 1.6 (3,200 / 2,000)
Standard cost per unit = $128.48 ((73 + 10%) x 1.6)
11) $4.25
Total cost: $5,000
Less Adverse direct material price variance ($300)
Plus, Favorable direct material usage variance of $400
= $5,100 (total standard material cost)
Total standard cost per unit: $5,100/1,200 units = $4.25
12) $63,600
Actual contribution = Actual sales revenue - Actual variable cost
The $69,000 already reflects actual sales revenue, so there is no need to adjust for the sales volume
contribution variance. The total fixed cost variance is not relevant to a calculation of contribution.
We do need to adjust the standard contribution to reflect the variable cost variance. Therefore:
Actual contribution = $63,600 (69,000 – 8900 + 3500)
13) B)
$000
Actual profit 438
Sales volume profit variance 08
Fixed production overhead volume variance (13)
Fixed production overhead expenditure 50
Direct labour efficiency variance (35)
Budgeted profit 448
The efficiency and capacity variances for fixed overheads are not included in the reconciliation as
they are the sub-variances of the fixed overhead volume variance which has been accounted for.
14) $12,700
Contribution is calculated as sales price per unit less variable cost per unit multiplied by a number of
units.
The sales volume contribution variance is irrelevant in this scenario as actual sales have
already been reflected in the $15,000.
It is the standard contribution element that should be adjusted using the other two variances to
calculate the actual contribution.
Actual contribution = $12,700 (15,000 - 3,000 + 700)
Performance measurement
Performance measurement techniques 257
Performance measurement techniques
Performance measurement, as the title suggests meaning measuring the actual performance of a
business. Analyzing actual records and finding out how well the business is doing.
Mission Statement
The mission statement simply describes the overall goal of the organization. What they want to
achieve in the long run. Business objectives at every level are decided in a way that they contribute
to the achievement of the mission statement.
For example, McDonald’s mission statement is:

McDonald's brand mission is to be our customers' favorite place and way to eat and drink. Our
worldwide operations are aligned around a global strategy called the Plan to Win, which center on
an exceptional customer experience – People, Products, Place, Price and Promotion. We are
committed to continuously improving our operations and enhancing our customers' experience.
The elements of a mission statement are:

• Purpose: What is the purpose of the business? To serve the country, to benefit the
shareholders etc., Performance measures need to be decided accordingly. For McDonald’s
it’s to be the customer’s choice for fast food.
• Strategy: How does the business plan to achieve this purpose? What strategy do they have?
To sell goods, to provide services etc. The strategy of McDonald’s is called Plan to Win.
• Policies and culture: How is their approach towards other stakeholders? Their policies
regarding customers, their culture, which benefits the workforce etc. McDonald’s policies
revolve around enhancing customer experience.
• Values: The core values of the business, the foundations on which the business is laid upon.
Are these being maintained while the business tries to achieve its objectives? McDonald’s
objective is to provide an exceptional customer experience.
Use of business objectives in performance measurement
The three business objective levels are:

• Strategic: Measuring stuff like overall profitability, company’s wealth generation, return on
investment etc. The big picture.
• Tactical: Comparing budgets to actual performance, finding out reasons for variations etc.
Keeping the business on track to achieve the big picture.
• Operational: Measuring everyday targets like production, quality etc. The everyday progress
towards achieving the big picture.
Factors affecting performance measurement
1. Economic and market conditions

The economy will never be static, meaning the same. Performance measures need to take
into effect changes in the economy and market conditions to have proper performance
measures.
2. Government regulation
The government can affect every business directly by introducing acts that restrict a
business. Employee laws, emission limits etc., need to be considered when calculating
performance. Taxes, quotas, fines etc., affect a business and their performance.
Financial performance measures
Financial measures are calculated to measure the overall performance of a company and compare
them with its competitors or past years to see if the company has grown. They are calculated by
analyzing the statement of financial position and statement of profit and loss. It is important to
know how a few formulae are calculated as they have a major practical use. In your 9 skill level
papers, 6 papers teach and expand on these same formulae. Hence, it is more important to
understand them and not simply learn how to calculate them.
Measures are divided into the following brief heads:
Profit-
ability
ratios
Financial
Liquidity
Risk ratios performance
ratios
measures
Activity
ratios
Let’s look at them one by one.
Profitability ratios
1. ROCE (Return on capital employed)
𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒑𝒓𝒐𝒇𝒊𝒕
ROCE = 𝑵𝒆𝒕 𝒂𝒔𝒔𝒆𝒕𝒔
𝒙 𝟏𝟎𝟎
Where Operating profit is profit from operations only, meaning no interest or tax. It is
commonly known as PBIT. Profit before interest and tax.
Net Assets can be calculated in two ways:

I. Total assets – current liabilities
II. Non-current liabilities + total equity
This ratio calculates the return generated by the business for every $1 of capital invested in
the business.
A high ROCE is desirable. To achieve a high ROCE, logically, the numerator must increase, i.e.
operating profit, or the denominator must decrease, i.e. capital employed.
2. Operating margin
This ratio is commonly known as the return on sales ratio or ROS
𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒑𝒓𝒐𝒇𝒊𝒕
ROS= 𝑹𝒆𝒗𝒆𝒏𝒖𝒆
𝒙 𝟏𝟎𝟎
Any margin is calculated by dividing that profit from the total revenue. It shows how much of
the revenue was converted into profit.
A high return means the sales are high or the costs are well controlled.
3. Gross/Net profit margin

Again, the margin means it is how much of the revenue.
𝑮𝒓𝒐𝒔𝒔 𝒐𝒓 𝑵𝒆𝒕 𝒑𝒓𝒐𝒇𝒊𝒕

Gross/Net profit margin= 𝒙 𝟏𝟎𝟎
𝑺𝒂𝒍𝒆𝒔 𝒓𝒆𝒗𝒆𝒏𝒖𝒆
Gross profit is revenue minus the cost of sales, and net profit is the profit after all expenses
made by the company.
A high profit margin is always good for the company. It means the company is profitable,
and that increases the likelihood of investor returns.
A Company has provided you with the following information:
$
Revenue 850000
Gross profit 450000
Operating profit 300000
Capital employed 1200000
Calculate: ROCE, ROS, GPM
Solution:
1) ROCE = 300000/1200000x100 =25%

2) ROS = 300000/850000x100 =35.3%
3) GPM = 450000/850000x100 =52.9%
Liquidity ratios
1. Current ratio
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔
Current ratio = 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
As we know, current assets and liabilities are liquid in nature. Hence, we need to know if the
company will be able to pay off its current liabilities from its current assets. This ratio is
calculated as given as X:1. A ratio above 1:1 is desirable, and a ratio of 2:1 or 1.5:1 is
considered as healthy.
If the ratio is 2:1, it means that the company has twice the current assets to pay of current
liabilities.
2. Quick ratio (Acid test ratio)

𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒂𝒔𝒔𝒆𝒕𝒔−𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚
Quick ratio= 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
This is calculated similarly. The only difference is inventory. Current assets like cash and
receivables are actually liquid, meaning they can be used to pay off current liabilities.
However, inventory cannot be sold at will. There need to be buyers to sell inventory.
Hence, the quick ratio is calculated to see if the company is able to pay of the current
liabilities from its truly liquid current assets. An ideal quick ratio is 0.8:1 or 1.2:1.
$
Receivables 28000
Cash 15500
Inventory 41000
Payables 17250
Short term borrowings 23600
Calculate current ratio and quick ratio.
Solution:
28000+15500+41000
3) Current ratio = 17250+23600
= 84500/40850 =2.07:1
28000+15500
4) Quick ratio = 17250+23600
= 43500/40850 =1.06:1
Activity ratios
1. Asset turnover
𝑹𝒆𝒗𝒆𝒏𝒖𝒆
Asset turnover= 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅
Asset turnover ratio is also shown as X:1, and it shows how well the assets have been used
to generate sales. In simple terms, how much revenue is generated from $1 of capital
employed or invested into the business.
Example: The revenue of a company is $250000, and capital employed in the business is
$175000. The asset turnover, therefore, is 1.43:1, which means for every $ of capital
employed, the company generates $1.43 in revenue.
If we have ROS and Asset turnover, we can simply multiply them and calculate ROCE. This
can be proven below:
ROCE = ROS x Asset Turnover
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡 𝑅𝑒𝑣𝑒𝑛𝑢𝑒

ROCE = 𝑥
𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
Revenue gets cut, and we’re left with the formula to calculate ROCE.
2. Inventory days
𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚
Inventory days = 𝒙 𝟑𝟔𝟓
𝑪𝒐𝒔𝒕 𝒐𝒇 𝒔𝒂𝒍𝒆𝒔
This ratio is said in days. How many days on average did we hold our inventory before we
sold it? A decrease in inventory days is desired as that reduces the risk of inventory
becoming obsolete or useless. An increase would suggest the company is having problems in
selling the inventory.
3. Receivable days
𝑻𝒓𝒂𝒅𝒆 𝒓𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆𝒔
Receivable days= 𝑪𝒓𝒆𝒅𝒊𝒕 𝒔𝒂𝒍𝒆𝒔 𝒙 𝟑𝟔𝟓
Total sales can be taken if credit sales are not given. This ratio too calculates how many days
on average does the company take to pay what it owes.
A large receivables period means long outstanding dues from customers, and this is a bad
sign for the company as it increases the risk of bad debt. A moderate period close to the
industry average is recommended.
4. Payable days
𝑻𝒓𝒂𝒅𝒆 𝒑𝒂𝒚𝒂𝒃𝒍𝒆𝒔
Payable days= 𝑪𝒓𝒆𝒅𝒊𝒕 𝒑𝒖𝒓𝒄𝒉𝒂𝒔𝒆𝒔 𝒙 𝟑𝟔𝟓
If credit purchases are not provided, the cost of sales can be taken. This ratio tells us how
many days do our customers take to pay us on average. It depends on our credit policies and
industry norms.
A large payables period is good as the company holds its cash for longer. However,
withholding payments to suppliers will not be good in the long run. It’s recommended that
these ratios are close to the industry average.

$
Receivables 28000
Inventory 41000
Payables 17250
Revenue 150000
Cost of sales 99000
Calculate receivables, payables and inventory days.
Solution:
1) Receivable days =28000/15000x365 =68 days

2) Payable days =17250/99000x365 =64 days
3) Inventory days =41000/99000x365 =151 days
Remember, we can’t have decimal answers as we have to answer in days. We can’t have 0.15 days in
reality, and hence we always round it off fully.
Risk ratios
1. Capital gearing
Gearing calculates the relationship between long term debt and equity. It is impossible to
analyze this as too much debt, or too much equity can harm the company.
Gearing can be calculated in two ways:
I. Debt/Equity
This way, we find out the balance of debt and equity in the company.
II. Debt/Debt + Equity or total capital
This way, we understand out of the total capital in the company, how much is debt.
In the exam, you will be informed about which formula to use.
2. Interest cover
Interest cover =Operating profit/Finance cost
This ratio is simple, it tells us whether we have the capacity to keep paying interests from
our profits in the future. If this formula gives us an answer of say 6, it means we could’ve
paid the interest six more times from current profits. That would be a good sign to loan
providers or lenders. (Finance cost is the cost of obtaining finance, which means any interest
we pay on loans etc.)

$
Current liabilities 17500
Long term debt 100500
Equity 75000
Finance costs 12500
Net profit 30000
Calculate gearing using debt/equity, debt/debt+equity and interest cover
Solution:
1) Gearing (Debt/Equity) =100500/75000 = 134%

2) Gearing (D/D+E) =100500/100500+75000 =57%
3) Interest cover =55000/12500 =4.4
Balanced scorecard
Investors often want more than just the financial information of companies to make investing
decisions. Balanced scorecard is an approach of performance appraisal (evaluation or assessment)
that includes both financial and non-financial factors.
It considers 4 perspectives (way of thinking). They are:
Internal Learning and

Financial Customer
Efficiency Growth
Perspective Perspective
Perspective Perspective
1. Financial Perspective
This is simple and obvious. If only the balanced scorecard is going to be provided, it must
include financial information. Decisions need financial information as a base to further
understand the company. Performance measures include:
• Earnings per share
• Dividend cover
2. Customer Perspective
Customer perspective is key to a business’s survival. Hence, it is important to measure
customer satisfaction and provide it in the balanced scorecard. Performance measures
include:
• Repeat customer rate
• Customer complaints percentage
3. Internal efficiency Perspective
Internal factors or process factors inside a company that affect the output need to be
efficient. Inefficient processes will lead to poor quality and wastage. Performance measures
include:
• Unit rejection rate
• Quality checks success rate
4. Learning and growth Perspective
This perspective focuses on the improvement of the company and their products. The needs
of customers will never remain the same, and hence learning and growth efforts by any
company are necessary. Performance measures include:
• Investment in R&D as a percentage of total investments
• Sales of new products as a percentage of total sales
Advantages of Balanced Scorecard:

1. It is hard to hide actual performance as it uses four different perspectives.
2. Harder to lie about performance
3. More long term in nature
Disadvantages of Balanced Scorecard:

1. It’s not easily comparable as different businesses choose different measures

2. More subjective in nature
3. Large no. of calculations are required and can be used to show a false picture using an
incorrect calculation.
Critical success factors (CSF’s)
CSF’s as the same suggests, are factors that are critical to the success of an organization. These are
essential areas that need to be performed well in order to achieve the goals and objectives of a
business.
Missions are the goals; objectives quantify the goals, and CSF’s focus on achieving such objectives.
Key performance indicators or KPI’s are used to measure CSF’s. KPI’s are indicators decided by the
organization as suitable ratios that identify the key performance. They can be financial as well as
non-financial.
Example:
If the mission statement of a McDonald’s is to become the customers favorite place to eat and drink,
their objective would be to provide an exceptional experience, so McDonald’s becomes their
favorite. Their CSF here would be quality of food items, and KPI can be anything like no. of customer
complaints, wastage from production.
Value for money analysis (VFM)
Organizations having goals and objectives other than seeking profit also need to measure their
performance. However, as we notice, most financial performance measures are linked to profit.
They are good for investors in a profit motive company but less useful to non-profit organizations.
VFM revolves around 3E’s:
Efficiency
Economy
Effectiven
ess
3 E's of VFM
1. Economy
Measures the inputs. Has the money to purchase inputs well spent? Did we get good
quality materials? Etc.
Economy =Standard input/Actual input x 100

A business can see how economical they are in their material purchases by comparing the
standard cost of buying the materials and the actual cost they incurred.
Economy for a not for profit organization will be determined based on how well they can
raise funds from the cheapest means, i.e. costs that they incur to raise funds.
2. Efficiency
Measures the input conversion into output. Are we producing the maximum we can from
our inputs? Are we using our resources in an optimum manner? Etc.
Efficiency =Actual output/Actual input x 100
A manufacturer can see if the workforce was efficient by comparing output in standard
hours (hours required) and actual hours worked (Actual input). A ratio above 100% would
mean the workforce was more efficient than expected.
A not-for-profit organization that relies on donations, such as a charity incurs costs that are
also deducted from the donations. Efficiency will therefore be, how much do they take as
inputs and how much can they use as output. If a charity can donate $89 dollars from $100
dollars received due to their own operational costs, it will be 89% efficient.
3. Effectiveness
Measures the outputs. Have we achieved our main objectives from the outputs? Have we
succeeded in our plans? Etc.
Effectiveness =Actual output/Standard output x 100
A service provider can check how well their services were and compare it with their desired
service quality to see how effective they were.
A not for profit organization such as a charity can check how effective they were by
comparing how helpful was their charity and how helpful did they want it to be.
Manufacturing industries
1. Contract costing
In contract costing, the price of the contract is quoted, and hence it is necessary to get the job done
with proper costs in order to make a profit. Hence, cost control is important. Performance measures
focus on resource utilization such as:
• Level of idle time (Labour utilization)
• Plant utilization
• % of materials wasted
2. Process costing
Process costing too needs to control costs and aim to maintain production around predicted losses.
Performance measures include:
• Levels of abnormal loss

• Rejected product rate
Service industries
As the world slowly moves towards the provision of services, it is important to measure how services
are provided and take action to improve it. Two main factors are financial performance and quality
of service.
3. Financial performance
Many previously learnt ratios can be used. Some include:
• Revenue per service
• Staff cost as a % of revenue
• Market share
• Training costs as a % of total costs
4. Quality of service
Good quality service ensures customer satisfaction and repeat sales. Performance measures are
mostly non-financial and include customer related factors. They include:
• Staff attitude
• Staff responsiveness
• Ease of customer access
• % Change in staff performance after training
Manager ratios
Companies are often so big that one person can’t handle everything. Hence every department has
managers to do so. These managers need to be assessed regularly for various reasons, such as
promotion, bonus, change etc. Performance measures such as ROI and RI help in doing so.
Return on investment
𝑪𝒐𝒏𝒕𝒓𝒐𝒍𝒍𝒂𝒃𝒍𝒆 𝒑𝒓𝒐𝒇𝒊𝒕
ROI = 𝒙 𝟏𝟎𝟎
𝑪𝒐𝒏𝒕𝒓𝒐𝒍𝒍𝒂𝒃𝒍𝒆 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅
Return on investment is similar to ROCE but is an internal measure. How much did a manager invest
and manage a return of?
Controllable profit, as the name suggests, is the profit that the manager can control. Hence it is after
depreciation but before tax.
ROI is simple to calculate; everyone is familiar with it and is a widely used measure. It gives an
answer in percentage terms, whereas RI gives an answer in absolute terms.
However, ROI is based on accounts which can be manipulated, distorted. Managers may take
decisions which are not beneficial for the company but boosting ROI.
Residual income
RI = Controllable profit – Notional interest on capital

Cost of capital is the rate at which the company gets capital. This will be given to you in the exam.
Capital invested will be given to you in the exam as well. Notional interest on capital is the cost of
capital x capital invested.
RI is the net operating income generated by a manager. It means he has managed to earn more from
the capital he was given, which costed the company money to get.
RI encourages more investment as all positive projects add to the company’s wealth, but it lacks
comparability as other projects cannot be compared using RI. Appropriate cost of capital is a must.

$m
Controllable profit 11
Controllable assets 56
Cost of capital 15%
Calculate ROI and RI
Solution:
1) ROI = $11m/$56mx100 =19.6%

2) R1 =$11m – $8.4m (15% of $56m) =$2.6m
Cost control
Cost control is the process of identifying and reducing business expenditure to increase profits.
Variance analysis and standard costing are useful methods of cost control. Comparison of actual
costs and actual performance against targets and plans is known as cost control.
Cost reduction
Simply put, cost reduction is the process of reducing unit costs without reducing the quality of goods
or services. Costs that compromise quality should not be targeted. Instead, costs that are actually
avoidable by optimizing processes should be targeted. Various cost reduction techniques include:
• Value engineering
Value engineering is a technique commonly used in target costing. A products costing is
carefully engineered in a way such that the best possible value is achieved at the lowest
possible cost.
• Work study
Work study, as the name suggests, is the study of the work that is done in order to produce
goods or services. It aims to increase efficiency and improve the effective use of resources
such that unnecessary costs are avoided. Example: If A answers to B and B forwards that to
their superior C, if A can directly talk to C, B’s job can be repositioned or eliminated,
increasing efficiency and saving the company money.
Two areas of work study include:

o Method study – Analyzing the current work and new work techniques to enable
better ways to do the work and reduce costs.
o Work measurement – Calculating time needed to do a job or task by experienced
members and aiming so that tasks are achieved in such time by the complete
workforce.
• Value analysis
Value analysis is the process of cutting costs on items for which the customers don’t find
value. If a customer doesn’t need a particular feature, he shouldn’t be paying for it, is the
aim of value analysis. This can be achieved if customer feedback and requirements are
seriously considered. It can also benefit the company as the customers are more satisfied.
Value can be of two types:

o Utility value – Value of an item due to its use. (Value of a car due to its ability to
transport passengers across distances.)
o Esteem value – Value of an item because of its features or beauty. (Value of a car
due to its company, engine features, engineering etc.)
Problems of using only Financial Indicators
Using only financial indicators has various problems. Some are highlighted below:
Short-termism vs long term performance

When bonuses for managers are linked to financial indicators, they have an incentive to show a
picture today that will earn them that bonus. Hence, they think and make decisions accordingly.
They may take some decisions which are not beneficial in the long run and would’ve been avoided
otherwise.
Example: A manager may not spend more in capital expenditure today to keep their capital
employed low and ratios such as ROCE and ROI high, this will reduce efficiency and innovation,
which will create issues in the long run.
Manipulation of results
Another way of showing a good picture is by manipulating the picture itself. It means showing a false
good picture of the business. This can be done in various ways and is misguiding the investors about
the company’s performance.
Example: It may be possible to include certain income items of non-recurring nature in profit and
boost ROCE, however this would not give a fair ROCE as ROCE should only have operating profit that
is profit from continuous activities of the business.
Actual performance doesn’t get covered

The actual performance by an organization simply can’t be covered by using financial indicators only.
Customer satisfaction, quality etc., are important to both the company and the investors and are
non-financial indicators.
Example: A manager who focuses on innovation, who spends more and gets more out in terms of
quality etc., would get less bonuses than another manager if bonuses are paid on the basis of
financial ratios only where quality and innovation don’t matter.
Benchmarking
Next, we’ll learn about benchmarking. Benchmarking is a process of measuring the performance of a
company's products, services, or processes against those of another business considered to be the
best in the industry. The point of benchmarking is to identify internal opportunities for
improvement.
Types of benchmarking:
1. Internal benchmarking
Here, best performing departments of one company are used as benchmarks for the rest.
This is beneficial if the company has various geographic departments or multiple businesses
having the same departments. For example, the marketing department of Amazon USA can
be used as a benchmark for marketing departments of Amazon around the world.
2. Competitive benchmarking
Here, the most successful competitors are used as a benchmark. However, it is unlikely that
a competitor’s information is easily available. A competitor’s product may be purchased as
dismantled to collect information and set benchmarks. Example: Amazon can order goods
from Flipkart and keep track of their processes, and set benchmarks accordingly.
3. Functional benchmarking
Here, functions of one department are compared with the same department but of another
business. For example, Walmart, a supermarket store can compare it’s purchasing function
with Flipkart, an e-commerce website which it owns.
4. Strategic benchmarking
Here, various competitors in the same industry come together to set benchmarks. This may
be done by a third party which will collect each company’s data and calculate averages.
Such averages may be then used by each company as benchmarks. Example: Flipkart,
Amazon, Alibaba, E-bay etc., may agree to a strategic benchmarking process for their door
to door delivery option and benefit from one another.
Internal
Types of Competiti
Strategic
Benchmarking ve
Functional
• The higher level of an organization requires a clear vision of what the organization should be
doing in the longer term and how it should be doing it. This is covered in a mission
statement.
• From the mission statement, objectives provide the targets for the periodic budget process.
• Performance measure can be divided into two groups. – Financial performance measures –
Non-financial performance measures, Financial performance measures include profit,
revenue, costs, share price and cash flow.
• Performance measures can be quantitative or qualitative.
• Comparing non-profit seeking entities with the private sector raises several problems. The
difficulties led to the creation of the 3E approach (economy, efficiency and effectiveness).
• Profitability can be measured by return on investment (ROI) / return on capital employed

(ROCE), profit margin, gross profit margin or cost/sales ratios.
• Asset turnover is a measure of how well the assets of a business are being used to generate
sales. It is calculated as (sales capital employed).
• The current ratio is the 'standard' test of liquidity and is the ratio of current assets to current
liabilities. The quick ratio, or acid test ratio, is the ratio of current assets less inventories to
current liabilities.
• The inventory turnover period indicates the average number of days that items of inventory
are held for. Inventory turnover is a measure of how fast a business is trading.
• The balanced scorecard measures performance in four different perspectives: customer

satisfaction, financial success, process efficiency and growth.
• Benchmarking is an attempt to identify best practices and, by comparison of operations, to

achieve improved performance.
• Cost reduction measures are planned programmes to reduce costs rather than crash
programmes to cut spending levels.
• Value analysis is a planned, scientific approach to cost reduction, which reviews the material
composition of a product and the product's design so that modifications and improvements
can be made which do not reduce the value of the product to the customer or user.
1) Which of the following statement about cost control or cost reduction is correct?
a) Cost control can be measured using standard costing and variance analysis
b) Cost control involves the reduction in unit cost without impairing suitability for the use
intended
c) Cost reduction is setting of targets for cost center managers
d) Work study is a method of cost control
2) Which two of the following could be used to control costs?

Techniques TICK
a) Setting targets for cost centre managers
b) Reducing the cost budget
c) Cost variance analysis
d) Increasing sales volume
3) Henna is an insurance company. Recently there has been concerned that too many quotations
have been sent to clients either late or containing errors. The department concerned has
responded that it is under staff and a high portion of the current staff has recently joined the
firm. The performance of this department is to be carefully monitored
Which of the following non-financial performance indicators would not be an appropriate measure to
monitor and improve the department’s performance?
a) Percentage of quotations found to contain errors when checked

b) Percentage of quotation not issued within company policy of three working days
c) Percentage of department’s error count after new staff training
d) Percentage of budgeted numbers of quotations actually issued
4) Which of the following statements about non-financial measures are true?
1) Non-financial measures can be useful to look at the fuller picture of the business.
2) Non-financial measures may encourage short termism.
5) D company operates for 365 days per year and makes all of its sales on credit. A summary of its
current financial information is given below
Summarized statements of profit or loss $’000
Revenue 250,000
Cost of sales 100,000
Operating expenses 80,000
Operating profit 70,000
Finances charges 15,000
Profit before tax 55,000
Summarized statement of financial position $’000
Non-current assets 90,000

Current assets all receivables 50,000
140,000
Ordinary shares capital 25,000
Reserves 40,000
Long-term liability 5% bank loan 35,000
Current liabilities 40,000
140,000
TASK 1
Calculate the following based upon Dancer Co.’s summarised financial information.
Return on capital employed (ROCE) _____________%
Asset turnover ratio (based upon capital employed) _____________ times
Receivable days _____________days
Capital gearing (debt to equity) _____________%
Interest cover ratio _____________times
Task 2
The performance of Dancer Co.’s closest rival, Competitor B, together with the industry average in
their sector, is given below.
Competitor B Industry average
ROCE% 20.0 40.0
Asset turnover ratio (based upon capital employed) 2 6
Receivable (days) 90 75
Capital gearing (debt to equity 75.0 60.0
Interest cover ratio 3.0 4.0
Current Ratio 1.8 2.0
Based on the figures above, are the statements about Competitor B true or false?
Its capital gearing is riskier than the industry average

Its liquidity position is worse than the industry average
It has a smaller operating profit than the industry average
If its operating profit were 30% lower, it would make a net loss
6) The following information, for the year to 31 December 20X9, is available for G Co which
operates in the toys and games industry
$’000
Sales 8,740
Gross profit 1,900
Capital employed 4,180
Current assets 450
The cost of capital of G Co is 14% per annum
G Co sold 300,000 units in the year ended 31 December 20X9. Total sales for the toys and games
industry for the year were 54,650,000
Task 1
Calculate the following performance measures for G Co for the year ended 31 December 20X9.
Operating profit margin (to one decimal place) _______________%
Asset turnover (to one decimal place) _______________times

Return on investment (to one decimal place) _______________%
Residual income (to one decimal place) $_______________’000
Market share (to one decimal place) _______________%
Task 2
Return on investment (ROI) and Residual income (RI) are both measures of investment performance.
Which of the following statements describe a feature of?
1) ROI
a) Ensure(s) that managers will select investment projects with positive NPV
b) Based on profit rather than cash flow.
c) Facilitates the comparison of business units of different size.
d) Provide(s) a relative measure of investment performance
2) RI
a) Ensure(s) that managers will select investment projects with positive NPV
b) Based on profit rather than cash flow.
c) Facilitates the comparison of business units of different size.
d) Provide(s) a relative measure of investment performance
An analyst has calculated the following ratios for G Co. for comparison with the toys and games
industry average
Toys and games
G Co Industry average
Current Ratio 1.3:1 1.2:1
Gearing 63% 46%
Interest Cover 7 5
Acid Test 0.7:1 0.7:1
Complete the flowing commentary on G Co.’s performance relative to the industry average.
G Co.’s liquidity is ________ than the industry average.
Its capital gearing ________ than industry average.
Its ability to service its loan is ____________ than the industry average, which could mean that G Co
is having a _______ level of profitability than the industry average.
7) Gazala Co. is an internet-based retailer of books and music. It believes that the factors critical to
the success of its business are the:
(1) Number of people visiting its website

(2) Conversion of website visits into orders
(3) Amount of time it takes to deliver an order to a customer
(4) Level of customer satisfaction with the way in which it deals with customer returns
Results for the most recent year are given below:

Website visits 4,000,000

Value of customer orders placed
$15,000,000
Average value per order placed $30
Average value of undelivered orders at the end of each day $328,750
Numbers of orders returned 90,000
Numbers of complaints about returns process 2,500
Customers place a maximum of one order per visit to the website. The company operates for 365
days per year.
Task 1 Calculate the following for Gazala Co. for the most recent year.
The average number of website visits per day (to the nearest whole number) ___________ visits
The conversion rate of website visits into orders (to the nearest whole number) __________ %
The average delivery time per order (to the nearest day) ________ days
The percentage of customer returns made without complaint (to the nearest whole number)
________ %
Task 2
Which two of the following performance indicators could be used to measure the quality of service?
a) Number of customer complaints

b) Customer retention
c) Overtime vote
d) Number of sick days
Task 3
Complete the following statement about the balanced scorecard approach, choosing from the
options available
Before a balanced scorecard approach can be considered, and organization needs to first have
_________________. The balanced scorecard approach focuses on _________________
Gap 1
a) Keep performance indicators agreed with management

b) A mission statements
c) Operational plans
Gap two
a) Short term improvements for the business

b) The long-term success of the business.
8) In the context of quality costs, what would customer compensation costs and test equipment
running cot be classified as?
Customer compensation costs Test equipment running cost
a) Internal failure cost Prevention cost

b) Internal failure cost Appraisal cost
c) External failure cost Appraisal cost
d) External failure cost Prevention cost
The management process, which involves comparison of competences with best practice within and
outside the organization, is known as?
a) Balanced scorecard
b) Benchmarking
c) Productivity
d) Resource analysis
9) The performance of a publicly funded school is monitored using measures based upon the three
‘Es’. The most important performance measure is the achievement of school targets for the is
the number of students successfully completing their diploma.
Which of the three Es best describes the above measure?
10) Which of the following statements relating to performance measurement are true?
a) The two ways of measuring profitability of a division are ROI and RI

b) One of the main areas of financial performance indicators is customer satisfaction
c) External data is always needed to assess the performance of an organization
12) The following details have been extracted from the accounts of Big Co for the quarter ended 30
June.
1 April – 30 June
$’000
Net profit 73
Non-current assets 195
Inventory 15
Receivables 23
Payables 10
Cash at bank 17
What is the quick ratio for the quarter ended 30 June?
a) 3.0
b) 3.8
c) 3.2
d) 2.4
13) Z Co has long-term loan liabilities of $16,000 and shareholders’ funds of $40,600.
What is Z Co’s capital gearing ratio?

a) 19.4%
b) 28.2%
c) 253.7%
d) 71.7%
gSolutions:
1)
Cost control can be measured using standard costing and variance analysis
Cost control is setting of targets for cost center managers and then monitoring performance against
these targets with the help of standard costing and variance analysis
Cost reduction involves the reduction in unit cost without impairing suitability for the use intended
2) a) & c)
Reducing the cost budget is cost reduction and not cost control
And increasing sales volume would result in an increase in cost as well
3) - c)
4) 1) True, 2) False
Statement 1 is true. For example, the non-financial measure of poor customer satisfaction indicates
that the financial measure of future sales may change.
Statement 2 is false. Financial performance measures used alone may provide managers with
shorter term incentives which could be detrimental to the business in the long term. For example,
price increases applied in the short term may meet financial targets but damage customer relations
in the longer term.
5)
Task 1
Notes
Return on capital employed (ROCE) 70 % (1)
Asset turnover ratio (based upon 2.5 times (2)
capital employed)
Receivables days 73 days (3)
Capital gearing (debt to equity) 53.8 % (4)
Interest cover ratio 1.3 times (5)
Notes:
(1) Return on capital employed = (operating profit / capital employed) × 100%

($70,000 / $100,000) × 100% = 70%
(2) Asset turnover = revenue / capital employed
$250,000 / $100,000 = 2.5 times
(3) Receivables days = (receivables / revenue) × 365

($50,000 / $250,000) × 365 = 73 days
(4) Capital gearing (debt to equity) = [long term liabilities / (ordinary share capital + reserves)] ×
100%
($35,000 / $65,000) × 100% = 53.8%
(5) Interest cover = operating profit / interest
$40,000 / $12,000 = 1.3 times
Task 2
True False
Its capital gearing is riskier than the x
industry average
It has a smaller operating profit margin x
than the industry average
Its liquidity position is worse than the x
industry average
If its operating profit were 30% lower, it x
would make a net loss
The capital gearing of Competitor A is higher than the industry average, so this would be regarded as
riskier, so this statement is TRUE; because fixed interest commitments from the profit are higher.
The current ratio of Competitor A is lower than the industry average, so its liquidity position would
be judged to be worse, so this statement is TRUE.
The operating profit margin (%) can be calculated as ROCE / asset turnover. Thus:
Competitor A 20.0% / 2.5 times = 8.0% operating profit margin
Industry average 40.0% / 6.0 times = 6.6% operating profit margin
Competitor A thus has a larger (not smaller) operating profit margin than the industry average, so
this statement is FALSE.
Competitor A would not make a net loss after interest if its operating profit was 30% lower. With an
interest cover of 2.0 times the operating profit would have to reduce by over 50% for it to make a
net loss after interest, and so this statement is FALSE.
6)
Task 1
Operating profit margin (to one decimal place) 8.2 %
Asset turnover (to one decimal place) 2.1 times
Return on investment (to one decimal place) 17.2 %
Residual income (to one decimal place) $ 134.8 ’000
Market share (to one decimal place) 15.9 %
Notes:
(1) Operating profit margin = (operating profit / sales) × 100%

(720 / 8,740) × 100% = 8.2%
(2) Asset turnover = sales / capital employed
8,740 / 4,180 = 2.1 times
(3) Return on investment = (operating profit / capital employed) × 100%
(720 / 4,180) × 100% = 17.2%
(4) Residual income = operating profit – interest on capital employed
720 – (4,180 × 0.14) = $134.8
(5) Market share = (G Co sales / industry sales) × 100%
(8,740 / 54,650) × 100% = 15.9%
Task 2
1) b, c, and d
2) Only d
Only ROI provides a relative (%) measure of investment performance and thus facilitates comparison
of performance of business units of different size.
Both ROI and RI are based on profit rather than cash flow.
Neither ROI nor RI will ensure that managers will select investment projects with a positive NPV. This
is because NPV is a discounted cash flow (not profit) evaluation method which takes account of the
timing of the cash flows over the life of an investment project.
Task 3
Fun Co's liquidity is better than the industry average.

Its capital gearing is riskier than the industry average.
Its ability to service its loans is better than the industry average, which could mean that Fun Co is
having a higher level of profitability than the Industry average.
Fun Co’s liquidity is better than the industry average because, although its acid test ratio is the same,
its current ratio is higher.
Fun Co’s capital gearing is riskier than the industry average because its gearing ratio indicates a
higher proportion of debt, and thus fixed interest commitments, in the capital mix.
Fun Co’s ability to service its loans is better because its interest cover is higher.
Fun Co’s higher interest cover could mean that it has a higher level of profitability than the industry
average. Despite having more debt, the level of profit can cover the interest on that debt better.
7)
Task 1
Notes
The average number of website 13,699 visits (1)
visits per day (to the nearest
whole number)
The conversion rate of website 30 % (2)
visits into orders (to the nearest
whole number)
The average delivery time per 5 days (3)

order (to the nearest day)
The percentage of customer 99 % (4)
returns made without complaint
(to the nearest whole number)
Notes:
(1) The average number of website visits per day is:
4m visits / 365 days = 10,959 visits per day
(2) The conversion rate of website visits into orders is the number of orders (calculated below) as a
proportion of the number of visits to the website:
[($15m value of orders / $30 value per order = 0.5m orders) / 5m visits] × 100% = 12.5%
(3) The average delivery time per order is the value of the undelivered orders ($328,750) / the
average value of the orders per day ($15m / 365 = $41,096) = 8 days
(4) The number of orders returned without complaint is 87,500 (90,000 orders returned – 2,500 with
complaint) which as a proportion of the orders returned is 97.2% [(149,000 / 150,000) × 100%].
Task 2
A and B -Number of customer complaints and customer retention
Task 3
Gap1- A mission statement
Gap 2- The long-term success of the business
8) c)
External failure costs are those incurred due to poor quality of goods delivered to the customer
therefore, this includes compensation cost
Appraisal costs are those incurred in the measuring of quality of output; therefore, this includes test
equipment running costs.
9) b) Benchmarking
10) Effectiveness – students successfully completing their diploma would be classified as being
effective.
11) a)
Customer satisfaction is not used when measuring financial performance
External data is not always needed to assess the performance of an organization (e.g.) the company
can compare performance between its departments
12) a) 3.0
Quick ratio = Current assets less inventories / Current liabilities
= (Receivables + Cash at bank) / Payables
= (23 + 17) / 10
=3
13) b) 28.2%
Gearing = Prior change capital (long term debt) / Prior change capital + Shareholders equity
= 16,000 / (16,000 + 40,600) = 28.26%
Note that Capital gearing is also given by the formula = Prior change capital / Shareholders equity
= 39.4% - but that is not one of the options given

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Sources and analysis of data 1

Best way to study

Planning how to study

How to approach the exam

Syllabus wise study material

Nimbus™ Preparation tools

Interactive notes with gamification

Question Bank & Test Series

Flashcards and Interactive mind maps for revision

Examining team guidance/Exam technique & reports

Introduction to the syllabus

The syllabus for Management Accounting (MA)/(FMA), introduces candidates to elements of

ACCA Performance Objectives

Economic order quantity

Economic batch quantity

Present Value Table

Present value of 1 i.e. (1 + r)-n

Discount rate (r)

Where r = discount rate

Standard normal distribution table

The nature, source and purpose of management information

Cost accounting mainly deals with:

Whereas management accounting deals with all this and more!

Management accounting is mainly concerned with providing information to managers.

5 Purposes of Management Accounting

Decision Control & Performance

Aveer Co manufactures desks and then sells them in retail stores.

Aveer is the management accountant of Aveer Co, he is responsible for:

Planning: setting of goals

Decision: Implement the decisions taken in the planning process

Control: Collect information on the actual results

Management accounting vs Financial accounting

Management Accounting Financial Accounting

Differences between levels of planning

There are 3 levels of planning:

Level Purpose Management Time Examples

Short term decision

Which of the following activities is an example of tactical planning?

Data can be either quantitative or qualitative, as can information.

• If data can be measured, it is quantitative

Attributes of good information

The attributes of good information can be explained with the acronym:

Remember ACCURATE in the exam

Full form Explanation Example

a way that they will

R Relevant Information provided

There are 4 key elements to the mission statement:

1. Purpose: As to why and for whom the business exists

Mission statement of Amazon:

Centre Explanation Examples Manager evaluation

Profit Center This is a part of a Branch of a company Manager is responsible

What is this manager?

Limitations of management information

Management information may fail to assist management accountants in making decisions.

Relevant information consists of future / cash / incremental costs

However, many times other costs and revenues are also

An example of non-financial information is customer satisfaction -

For example, an ice cream store is preparing its purchase order

1) Which of the following is not a purpose of management accounting?

2) Which of the following statements are true/false?