CTRLSOFT

MANAGERIAL
ACCOUNTING
For ISQ Examination – Institute of Bankers Pakistan

Compiled by Muhammed Ilyas, Ex-Vice President, National Bank of Pakistan

e-mail ilyas_jk@hotmail.com Contact No. 0306-2604829
CHAPTER I
Cost Terms, Concepts and Classifications

Managers working with any commercial, social or government entity have an important common
task. This common task demands that they must make good decisions to obtain and use the
organization’s resources comprising of people, money, inventory, fixed assets, investments,
technology and equipment in the most effective way so as to contribute in enhancement of the
owner’s wealth.

Some of the management decisions provide answers to questions namely:

1. What products or services should produce and sold?

2. Where should they be sold?
3. What are the responsibilities of each management position?
4. Who should be hired to fill these positions?
5. How much does it cost to produce a product or offer a service?
6. What is the most profitable combination of products or service?
7. What will happen to profits if selling prices increased or decreased?
8. How much operating capacity I needed in the form of people, funds, inventory, and
fixed assets?
9. How should the organization finance its various activities?

The general purpose financial statements are available to the managers of a business, but they
have limited utility from the management angle. Managerial accounting is an important branch
of accounting that provides the information needed by managers to determine how resources
should be obtained, organized and controlled in any type of business, large or small.

Comparison of Financial Accounting with Managerial Accounting

Although the emphasis is different, both managerial and financial accounting involve three types
of functions:
(1) Record keeping of financial transactions.
(2) Performance evaluation on the basis of reports that are compiled on classification and
summarization of the financial results.
(3) Decision making that is performed by a wide variety of interested parties (both
external and internal to the firm) who must choose between alternative courses of action
regarding the business’s future.

Despite important similarities listed above, there are several important differences between the
two types of accounting. These differences are narrated below to learn the scope and utility of
managerial accounting.

Financial Account Managerial Accounting

User Orientation Both external/internal users Exclusively for internal Users

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Freedom of choice Mandatory to follow the Complete freedom of choice
Current IFAS

Main time focus Historical – quarterly, half Futuristic – according to

yearly, yearly etc. specific needs of the entity.

Accounting entity Mainly whole firm Mainly firm’s one or more

segments under investigation.

Reporting frequency Well defined schedule Whenever needed.

Degree of precision Objective principle More subjective

Other discipline used Little use Used often

Characteristics of Managerial Accounting.

The two important terms “data” and “information” are often used synonomously by accountants,
a useful distinction can be drawn between them. Data are recorded facts; information is data that
have been processed in some prescribed manner so they are more useful to a potential user. In
order to make managerial accounting information to serve the desired utility to the managers, it
should possess the following important characteristics:

1. Relevance
2. Accuracy
3. Timeliness
4. Understandability
5. Cost effectiveness

Role of the Controller

When a firm commits itself to managerial accounting, the position of controller is created and a
person with an appropriate credentials and experience is assigned the responsibilities for the
organization’s entire accounting functions. The specific responsibilities of a controller vary
significantly from firm to firm. Some of the important responsibilities that a controller normally
undertakes to discharge are:

1. Planning, evaluating, and controlling operations for all levels of management;

2. Safeguarding the organization’s assets and;
3. Communicating with interested parties outside the organizations such as shareholders,
and regulatory bodies.

Code of conduct for Management Accountants

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A management accountant is not obliged to observe the IASB, but he has ethical responsibilities
which can grouped in four broad areas:

i) To maintain a high level of professional competence and how it can be achieved:

a) By maintaining an appropriate level of professional expertise by continually
developing knowledge and skill.
b) Perform professional duties in accordance with relevant laws, regulations and
technical standards.
c) Provide decision support information and recommendations that are accurate,
clear, concise and timely.
d) Recognize and communicate professional limitations or other common
constraints.

ii) To treat sensitive matters with confidentiality:

a) Keep information confidential except when disclosure is authorized or legally
required.
b) Inform all relevant parties regarding appropriate use of confidential information.
c) Refrain from using confidential information for unethical or illegal advantage.

iii) To maintain personal integrity.

a) Mitigate actual conflicts of interest. Advise all parties of any potential conflicts.
b) Refrain from engaging in any conduct that would prejudice in carrying out duties
ethically.
c) Abstain from engaging in or supporting any activity that might discredit the
profession.

iv) To disclose information in credible fashion.

a) Communicate information fairly and objectively.
b) Disclose all relevant information that could reasonably be expected to influence
an intended user’s understanding of the reports, analyses or recommendations.
c) Disclose delays or deficiencies in information, timeliness, process or internal
controls in conformance with organization policy and/or applicable law.

Cost Classification by Business Functions

Costs are incurred in all types of organizations – service, merchandizing and manufacturing to
secure revenues. The specific cost items incurred by a given organization and the way they are
classified will depend on the business functions performed by the firm.

A manufacturing firm is generally has the most complex types of accounting data because it
involves a manufacturing function, a selling function and an administrative function.
Accordingly the costs incurred by them can be classified on the basis of manufacturing, selling
and administrative.

Manufacturing costs include all costs needed to acquire basic raw material from a supplier and
converting them into finished products that are salable in different forms. Selling costs are all

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costs incurred to market and deliver the finished products including advertising, sales salaries,
free samples, salesmen commission, transportation charges etc. Administrative costs are all costs
needed for the general management of the organization and includes executive salaries,
accounting services cost, office supplies etc.

Product Costs include all costs that are incurred to make a product. In the case of manufacturing
goods, these costs consist of raw materials, direct labour, and manufacturing overhead. An
important characteristic of product cost is that they are inventoried as assets until the products
are sold. When the goods are sold, the costs are released from inventory as expense, also termed
as “cost of goods sold” which is matched against sales revenue.

Period Cost are costs that are not product cost. It includes both selling and administrative costs
of an entity of the given period. Period costs are not added to product cost or manufacturing cost
of goods, instead period cost are assigned to the income statement in the period in which they are
incurred on accrual basis of accounting.

Prime Cost & Conversion Cost

Manufacturing cost can further be classified into two distinct heads – prime cost and conversion
cost. Prime cost is the sum of direct material and direct labour. Conversion costs are those costs
which are involved to convert the direct material into the finished goods and hence comprises of
direct labour cost and manufacturing overhead.

Prime Cost Conversion Cost

Direct Material + Direct Labour Direct Labour + Factory Overhead

Variable Cost : A variable cost is a cost that varies, in total, in direct proportion to changes in
the level of activity. The level of activity can be expressed in many ways such as units produced,
units sold, miles driven, beds occupied etc. The most common example of variable cost is raw
material. The cost of direct material used during a period will vary in total, in direct proportion to
the number of units that are produced. Other examples of variable costs include items such as
shipping cost, sales commission and some elements of manufacturing overhead such as
lubricants etc. The direct labour is also considered to be a variable cost but in many instances, it
acts as a fixed cost as well.

Fixed Cost: A fixed cost is a cost that remains constant, in total, regardless changes in the level
of activity. Unlike variable costs, fixed costs are not affected by changes in activity.
Consequently, as the level of activity rises or falls, total fixed costs remains constant unless
influenced by some outside forces such as price changes. Rent is a good example of fixed cost.

Very few costs are completely fixed. Most costs will change if the activity changes beyond a
certain range. For example the capacity of an X ray machine at Services hospital is 100 X rays a
day. If the number of patients are increasing and it would be necessary to rent an additional

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machine, there will be an increase in the fixed costs. When we say that the cost is fixed, we mean
it is fixed within some specified range of activity.

Direct Cost : A direct cost is one that can easily and conveniently be traced to a specified cost
object. The most frequent direct cost is direct material and direct labour, but there are other
examples of direct cost like salary of sales manager etc.

Indirect cost: Indirect cost is a cost that cannot be easily and conveniently traced to a specified
cost object. For example in an assembly plant, the salary of the factory manager is an indirect
cost. Why the manager’s salary is termed as indirect cost because it cannot be related directly to
any specific product of the factory. In fact the salary cost of the factory manager is shared by the
entire products produced by a factory. Such costs are also termed as common cost. In other
words a common cost is a cost that is incurred to support a number of cost objectives but cannot
be traced to them individually. Indirect cost are peculiar examples of common cost.

Differential Cost and Revenue : The element of differential cost or revenue is involved when
choosing between available alternatives. In business decisions each alternative will have cost and
benefit that must be compared to the cost of benefit with other available alternatives.

A differential cost is also known as an incremental cost, although technically an incremental cost
should refer only to an increase in cost from one alternative to another, a decrease in cost can be
referred as decremental costs. Differential cost is broader term, encompassing both cost increases
and cost decreases between alternatives.

Relevant costs are future expected costs that will differ in a decision depending on the
alternative selected. For example, if two new sewing machines are being evaluated and the cost
of thread for each machine is significantly different, than the cost of thread is relevant cost.

Irrelevant costs are those costs that remain unaffected regardless of the alternative chosen in a
given decision. If the two new sewing machines use the same thread in production of a garment,
the cost of thread will be irrelevant.

Opportunity cost : Opportunity cost is the potential benefit that is given up when one
alternative is selected over another. Opportunity cost are not usually found in the accounting
record of an organization, but they are costs that must be explicitly considered in every decision
made by managers.

Sunk cost: A sunk cost is a cost that has already been incurred and that cannot be changed by
any decision made now or in the future. Because sunk costs cannot be changed by any decision,
they are not differential costs. And because only differential costs are relevant in a decision, sunk
cost can and should be ignored.

Controllable costs : It is a cost that can be regulated or influenced by a given level of

management decision during a specified time frame. The manager of Sewing Department would
be responsible for the direct materials and direct labour used in her department because both
items are controllable.

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Uncontrollable costs : It is a cost that cannot be regulated or influenced at a given level of
management decision during a specific time period. The depreciation on a particular sewing
machine is uncontrollable by the Sewing Department manger once the machine has been
purchased.

Multiple Choice Questions

1. A cost which is incurred for a period and which, within certain output and turnover
limits, tends to be unaffected by fluctuation in the levels of activity (output/turnover) is
termed as:
a) Historical costs
b) Conversion cot
c) Fixed cost
d) Prime cost

The answer is (c) because fixed cost remains fixed within certain output and turnover limits.

2. The term “discretionary cost” refers to those:

a) Costs which management decides to incur in the current period to enable the
company to achieve objectives other than filling of customer’s orders.
b) Costs which are likely to respond to the amount of attention devoted to them by a
specified manager.
c) Costs which are governed by past decisions that established the present levels of
operating and organizational capacity and which only change slowly in response to
small changes in capacity.
d) Costs which can be unaffected by current managerial decisions.

The answer is (a). A discretionary cost refers to such types of costs which can be changed with
the management’s decision during the current period, but it does not relate with the cost of the
product. For example entertainment expenses. The management may decide to reduce or fixed
entertainment expenses at a certain level.

3. The term “cost” refers to:

a) An asset that has given benefit and is now expired.
b) The price of products sold or services rendered.
c) The value of the sacrifice made to acquire goods or services.
d) An asset that has not given benefit and is now expired.
e) The present value of future benefits.

The answer is (c). Here sacrifices mean the price made or cost incurred to acquired an asset.

4. A cost that may carry components of both variable and fixed cost is termed as:
a) Variable cost c) Fixed cost
b) Prime Cost d) Conversion cost

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 e) Mixed Cost

The answer (e) because mixed cost comprises of both fixed cost and variable cost.

5. The term “sunk costs” refers to :

a) Past costs that are now irrevocable.
b) Costs that are directly influenced by unit managers.
c) Costs that should be incurred in a particular production process.
d) Costs that many be eliminated if some economic activity is changed or deleted.

The answer is (a). A sunk cost is one which has already been incurred on the basis of past
decisions and cannot be eliminated or avoided by current decisions.

6. The management of X’s budgeted production of 800,000 units at a cost of Rs.1,600,000.

If actual production was 800,000 units at a cost of Rs.2,000,000, then Xs production
performance shall be regarded as :
a) Effective c) Efficient
b) Both effective and efficient d) Neither effective nor efficient

The answer is (a). We cannot regard it as efficient because they have incurred extra cost than
what was budgeted.

7. Which of the following is “cost appropriate to a specific management decision”?

a) Production cost c) Joint cost
b) Product cost d) Relevant cost

The answer is (d). In decision making the cost which must have important bearing is termed as
relevant cost.

8. Which of the following is the difference in total cost between alternatives calculated to
assist decision making.
a) Indirect cost c) Product cost
b) Conversion cost d) Differential cost
The answer is (d). In case of choice between two cost alternatives, it is the differential cost which
is significant and important.

9. Which of the following is the cost of one unit of product or service which would be
avoided if that unit were not produced or provided?
a) Marginal cost c) Prime cost
b) Estimated cost d) Conversion cost

The answer is (a). The marginal cost is the cost of producing an additional product which can be
avoided if that unit were produced or provided.

10. Which of the following is the value of benefit sacrificed in favour of alternative course of
action?

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 a) Opportunity cost c) Indirect cost
b) Direct cost d) Standard cost

The answer is (a). In case of alternative course of actions, it is the opportunity cost that has to
sacrificed while selecting a certain course of action.

11. Which of the following statement is true?

a) Companies that may produce different products and service are more likely to use job
order costing than process costing.
b) Job order costing is used by service firms and process costing are used by
manufacturing firms.
c) Cost are traced to departments and then allocated to units when used job order costing
d) All of the above.

The answer is (a). The job order costing suits to companies that may produce different products
and services.

Exercise 1

The following cost and inventory data are taken from the accounting records of Mason Company
for the year just completed:

Cost Incurred
Direct labour cost $ 70,000
Purchase of raw materials 118,000
Indirect labour 30,000
Maintenance, factory equipment 6,000
Advertising expense 90,000
Insurance factory equipment 800
Sales salaries 50,000
Rent, factory facilities 20,000
Supplies 4,200
Depreciation, office equipment 3,000
Depreciation, factory equipment 19,000

Beginning of End of
The year year
Inventories
Raw materials $ 7,000 $15,000
Work in Process 10,000 5,000
Finished goods 20,000 35,000

Required :

1. Prepare a schedule of cost of goods manufactured in good form

2. Prepare the cost of goods sold section of Mason Co.’s income statement for the year.

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Answer 1

Schedule of Cost of Goods Manufactured

Direct material
Raw material inventory (opening) $ 7,000
Purchases 118,000
Raw material available for use 125,000
Less material inventory (closing) 15,000
Raw material consumed 110,000
Direct labour 70,000
Manufacturing overhead
Indirect labour 30,000
Maintenance, factory equipment 6,000
Insurance, factory equipment 800
Rent, factory facilities 20,000
Depreciation – factory equipment 19,000 75,800
Total Manufacturing cost 255,800
Add Work in Process Inventory (beginning) 10,000
265,800
Less Work in Process Inventory (closing) 5,000
Cost of goods manufactured 260,800

Schedule of Cost of Goods Sold

Finished goods Inventory (Beginning) 20,000
Add Cost of goods manufactured 260,800
Cost of goods available for sale 280,800
Less Cost of goods Inventory (Closing) 35,000
Cost of goods sold 245,800

Exercise 2

Income Statement for Broad Corporation for four years are presented below:

Income Statement

Sales ? ? 240,000 225,000

Finished goods, beginning inventory 32,500 ? ? ?
Work in Process, beginning inventory 10,000 ? ? 7,500
Raw material used 44,500 47,500 30,000 42,500
Direct labour cost ? 52,500 50,000 27,500
Manufacturing overhead 50,500 ? 37,500 30,000
Work in Process, ending inventory 15.000 ? ? ?
Cost of goods manufactured ? ? 122,500 95,000

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Finished goods, ending inventory 42,500 ? ? 11,500
Cost of goods sold 145,500 144,500 131,000 ?
Gross Profit 137,500 ? ? 105,000
Operating Expenses 42,500 37,500 ? 35,000
Net Income ? 90,000 60,000 ?

Required : Fill in the missing information (Hint 1990 data provide information required to find
1989 unknown).

Answer 2

Income Statement
1987 1988 1989 1990
Raw material used 44,500 47,500 30,000 42,500
Direct labour cost 65,500 52,500 50,000 27,500
Manufactured overhead 50,500 44,500 37,500 30,000
Total Manufacturing Cost 160,500 144,500 117,500 100,000
Add Work in Process
Beginning 10,000 15,000 12,500 7,500
170,500 159,500 130,000 107,500
Less Work in Process Closing 15,000 12,500 7,500 12,500
Cost of goods manfuactured 155,500 147,000 122,500 95,000
Add Finished goods
Beginning 32,500 42,500 45,000 36,500
Cost of goods available for
Sale 188,000 189,500 167,500 131,500
Less Finished Goods closing 42,500 45,000 36,500 11,500
Cost of Goods Sold 145,500 144,500 131,000 120,000

Sales 283,000 272,000 240,000 225,000

Cost of Goods Sold 145,500 144,500 131,000 120,000
Gross Margin 137,500 127,500 109,000 105,000
Operating Expenses 42,500 37,500 59,000 35,000
Net Income 95,000 90,000 50,000 70,000

1990
Net Income = 105,000 – 35,000 = 70,000
Cost of goods sold = Sales - Gross Profit
225,000 – 105,000 = 120,000
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Cost of goods manufactured =
Total Mfg. Cost + WIP (Beg) - WIP (End)
95,000 = (42,500 + 27,500 + 30,000) + 7,500 - ? = 12,500
Finished goods beginning
Cost of goods sold = Cost of goods Mfg. + Finished goods (Beg.) - Finished goods (End)
120,000 = 95,000 + ? - 11,500 = 36,500

1989
Sales - Cost of goods sold = Gross Profit
240,000 - 121,000 = 119,000
Cost of goods Manufactured
Total Mfg. Cost + WIP (Beg) - WIP (End)
112,500 = 30,000 + 50,000 + 37,500 + ? - 7,500 = 2,500
Cost of goods sold = Beg. Finished goods Inventory + Cost of Goods Manufactured – Ending
Finished Goods Inventory
121,000 = ? + 112,500 - 36,500 = 45,000

Exercise 3

Visic Corporation, a manufacturing company, produces a single product. The following

information has been taken from the company’s production, sales and cost records for just
completed year.

Production in units 29,000

Sales in units ?
Ending finished goods inventory in units ?
Sales in dollars $1,300,000
Costs
Advertising $105,000
Entertainment and travel 40,000
Direct labour 90,000
Indirect labour 85,000
Raw materials purchased 480,000
Building rent (production uses 80% of the
space; adm. & sales uses the rest) 40,000
Utilities factory 108,000
Royalty paid for use of production
Patent, $1.50 per unit produced ?
Maintenance, factory 9,000
Rent for special production equipment,
$ 7,000 per year plus $ 0.30 per unit produced)
Selling and Adm. Salaries 210,000
Other selling and Adm. Expenses 17,000

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 Beginning End of
of the year year
Inventories
Raw materials $ 20,000 $ 30,000
Work in Process 50,000 40,000
Finished goods 0 ?

The finished goods inventory is being carried at the average unit product cost for the year. The
selling price of the product is $ 50 per unit.

Required :
1. Prepare a schedule of cost of goods manufactured for the year.
2. Compute the following :
a. The number of units in the finished goods inventory at the end of the year.
b. The cost of units in the finished goods inventory at the end of the year.
3. Prepare an income statement for the year.

Answer 3
1.
Schedule of Goods Manufactured
Direct Material
Raw Material opening 20,000
Raw material purchased 480,000
Raw material available for use 500,000
Less Raw material closing 30,000
Raw Material used 470,000
Direct labour 90,000
Manufacturing overhead
Indirect labour 85,000
Building rent 32,000
Utilities – factory 108,000
Rent for patent on units produced 43,500
Maintenance factory 9,000
Rent for special product (7,000 + 8,700) 15,700
Other factory overhead 6,800 300,000
Total manufacturing cost 860,000
Add Work in Process (beginning) 50,000
910,000
Less Work in Process (ending) 40,000
Cost of goods manufactured 870,000

2(a) Units in Finished Goods Inventory

Total units produced 29,000
Less units sold

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(Sales/unit price) 1,300,000/50 26,000
Units in finished goods inventory 3,000

2(b) Cost of Finished Goods Inventory

Cost of goods manufactured 870,000
Number of units produced 29,000
Cost per unit (870,000/29,000) 30
Cost of finished goods inventory (3,000 x 30) 90,000

c)
Income Statement

Sales (26,000 x 50) 1,300,000

Less Cost of goods sold (26,000 x 30) 780,000
Gross Margin 520,000

Operating Expenses
Advertising 105,000
Entertainment 40,000
Building 8,000
Selling & Adm. Expenses 210,000
Total Operating Expenses 17,000 380,000
Net Income 140,000

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CHAPTER II
Predetermined Overhead Rate
As against direct material and direct labour, the overhead cost of a job is difficult to determine
especially when a job is completed and needed to be invoiced. In order to manage this situation
many organizations typically base their predetermined rates on the estimated, or budgeted
amount of the allocation based for the upcoming period. An example will help to understand why
it is used and helpful in practice. Suppose a company acquired a CD duplicating machine which
is capable of producing a new CD every 10 seconds from a master CD. The lease cost is
$180,000 per year, and this is the company’s only manufacturing overhead cost. With allowances
for set ups and maintenance, the machine is theoretically capable of producing upto 900,000 CDs
per year. However, due to weak retail sales of CDs, the company’s commercial customers are
unlikely to order more than 600,000 CDs next year. The company uses machine as the allocation
base to apply manufacturing overhead to CDs. These data are summarized below:

Total manufacturing overhead cost $ 180,000

Allocation base – machine time per CD 10 seconds per CD
Capacity 900,000 CDs per year
Budgeted output for next year 600,000 CDs

Here using the capacity of the machine for estimating manufacturing overhead rate will provide
incorrect data. Instead the estimated budgeted output of the machine shall reflect a more accurate
information to the management.

Predetermined = Estimated total manufacturing overhead cost

overhead rate Estimated total amount of the allocation base

$ 180,000
600,000 x 10 seconds per CD
0.03 per second

Since each CD requires 10 seconds of machine time, each CD will be charged for $0.30 of
overhead cost.

In general the actual factory overhead may not agree with applied factory overhead, whatever the
basis being used by an entity. When the applied factory overhead turns out to be more or less
than the actual factory overhead for the respective period, the excess or shortfall in the applied
amount is called over applied or under applied factory overhead.

Exercise 4
Fancy Pottery works makes a variety of pottery products that it sells to retailers. The
manufacturing process has two departments, molding and painting. The company uses
predetermined overhead rate based on machine hours in the molding department, and the rate in
painting department is based on direct labour cost. At the beginning of the year, the company’s
management made the following estimates:

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 Department
Molding Painting
Direct labour hours 12,000 60,000
Machine hours 70,000 8,000
Direct material cost $510,000 $650,000
Direct labour cost $130,000 $420,000
Manufacturing overhead cost $602,000 $735,000

Job 120 was started on June 1 and completed on June 10. The company’s cost records show the
following information concerning the job.

Department
Molding Painting
Direct labour hours 30 85
Machine hours 110 20
Materials placed into production $470 $332
Direct labour cost $290 $680

Required :
1. Compute the predetermined overhead rate used during the year in the Molding
Department. Compute the rate used in Painting Department.
2. Compute the total overhead cost applied to Job 120.
3. What would be the total cost recorded for Job120? If the job contained 50 units, what
would be the unit product cost?
4. At the end of the year, the records of Fancy Pottery works revealed the following actual
costs and operating data for all jobs worked on during the year.

Department
Molding Painting
Direct labour hours 10,000 62,000
Machine hours 65,000 9,000
Materials placed into production $430,000 $680,000
Manufacturing overhead $570,000 $750,000

What was the amount of under or overapplied overhead in each department at the end of the
year.

Answer 4

i) Predetermined overhead rate

Molding Department $ 602,000/70,000 = $8.60 per machine hours
Painting Department $ 735,000/420,000 = $ 1.75 per direct labour cost

ii) Applied overhead

Molding = 110 x $ 8.60 =$ 946

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 Painting = $680 x 1.75 = $ 1,190
Total applied overhead cost $ 946 + 1,190 = $ 2,136

iii)
Department
Molding Painting
Direct material cost 470 332
Direct labour cost 290 680
Manufacturing overhead cost 946 1,190
Total Cost 1,706 2,202

Total product cost 50 units 1,706 + 2,202 = ,3,908

Cost per unit 3,908/50 = $78.16

iv) Applied overhead for the year

Molding Actual $ 570,000
Applied 559,000 (65,000 x 8.60)
Underapplied 11,000
Painting Actual $ 750,000
Applied 763,000 (436,000 x 1.75)
Overapplied 13,000

Exercise 5

M/s ‘B’ makes furniture using the latest automated technology. The company uses a job order
costing system and applies manufacturing overhead cost to products on the basis of machine
hours. The following estimates were used in preparing the predetermined overhead rate at the
beginning of the year.

Machine hours 75,000

Manufacturing overhead cost $900,000

During the year due to excessive imports from China, the sale was badly affected resulting in
cutting back product and build up of furniture in the company’s warehouse. The company’s cost
records revealed the following actual cost and operating data for the year:

Machine hours 60,000

Manufacturing overhead cost $ 850,000
Inventories at year end:
Raw materials $30,000
Work in Process (includes overhead $100,000
Applied $36,000)
Finished goods (includes overhead $500,000
Applied $180,000)
Cost of goods sold (includes overhead $1,400,000
Applied 504,000)

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Required :
1. Compute the company’s predetermined overhead rate.
2. Compute the under or overapplied overhead.
3. Assume that the company closes any under or overapplied directly to Cost of Goods
Sold. Compute the revised cost of goods sold.
4. Assume that the company allocates any under or overapplied overhead to Work in
Process, Finished goods, and Cost of Goods Sold on the basis of the amount of ovherhead
applied that remains in each account at the end of the year. Compute the amount to be
adjusted to all the three inventories.
5. How much higher or lower will net operating income be if the under or overapplied
overhead is allocated rather than closed to Cost of Goods Sold?

Answer 5

i) Predetermined overhead rate : $900,000/75,000 = $ 12 per machine hr.

ii) Applied overhead
Machine hours : 60,000
Rate $ 12 per machine hr.
Overhead applied 60,000 x $12 = $720,000
Actual Overhead cost $ 850,0000
Overhead under applied $ 850,000 – 720,000 = $ 130,000

iii) Cost of goods Sold $1,400,000

Add overhead under applied $130,000
Revised cost of goods sold $1,530,000

iv) Overhead cost allocated to all inventories including cost of goods sold
Work in Process 36/720 x 130,000 $ 6,500
Finished Goods 180/720 x 130,000 32,500
Cost of goods sold 504/720 x 130,000 91,000
Total 130,000

WIP Overhead 36,000 36/720

Finished Goods overhead 180,000 180/720
Cost of goods sold overhead 504,000 504/720
Total 720,000

v) Overhead underapplied transferred to

Cost of goods sold under part (iii) $ 130,000
Overhead underapplied transferred to
Cost of goods sold under part (iv) 91,000
Difference 39,000

The net operating income will be higher by $ 39,000 by using the method (iv).

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Service Department Allocations

Most of the organizations have both operating department and service departments. The main
function like manufacturing is carried out by the operating department. Whereas service
departments do not directly engage in operating activities, instead, provide services or assistance
to the operating departments to accomplish their tasks.

The overhead costs of operating departments commonly include allocations of costs from the
service departments. To the extent that service department costs are classified as production
costs, they should be included in unit production costs and thus must be allocated to operating
departments in process costing systems.

Three approaches are used to allocate the costs of service departments to other departments: the
direct method, the step down method and reciprocal method.

Direct Method: It is the simplest of the three allocation methods. It ignores the services
provided by a service department to other service department and allocates all service
department costs directly to operating departments. Even if a service department (such as
personnel) provides a large amount of service to another service department (such as the
cafeteria), no allocations are made between the two departments. Rather all costs are allocated
directly to the operating departments, by passing the other service departments.

Step Down Method: Unlike the direct method, the step down method allocates service
department’s costs to other service departments, as well as to operating departments. The step
down method is sequential. The sequence typically begins with the department that provides the
greatest amount of service to other service departments. After its costs have been allocated the
process continues, step by step, ending with the department that provides the least amount of
services to other service departments. This method of allocating cost is termed as step down
method.

Reciprocal Method : The reciprocal method gives full recognition to interdepartmental services.
Under the step down method discussed above partial recognition of interdepartmental services is
possible. The step down method always allocates costs forward never backward. The reciprocal
method by contrast, allocates services department costs in both directions. Since this method is
more complicated, its use is restricted to highly organized and cost sensitive institutions.
Exercise 6

Karachi University has provided the following data to be used in its service department cost
allocation.
Service Departments Operating Departments
Facility Undergraduate Graduate
Administration Service Programme Programme
Departmental cost
Before allocations $2,400,000 $1,600,000 $26,800,000 $5,700,000
Student credit hours 20,000 5,000
Space occupied – 25,000 10,000 70,000 30,000

19
Square feet

Required :
Using the direct method, allocates the cost of the service departments to the two operating
departments. Allocate administrative costs on the basis of student credit hours and facility
services costs on the basis of space occupied.

Answer 6
Service Departments Operating Departments
Facility Undergraduate Graduate
Administration Service Programme
Programme
Departmental cost
Before allocations $2,400,000 $1,600,000 $26,800,000 $5,700,000
Administration cost -2,400,000 $ 1,920,000 $ 480,000
Facility Service -1,600,000 $ 1,120,000 $ 480,000
Total Cost Allocation 0 0 $28,112,000 $6,660,000

Cost allocation Administration : 20,000/25,000 x 2,400,000, 5,000/25,000 x 2,400,000

Cost allocation Facility Serv. : 70,000/100,000 x 1,600,000, 30,000/100,000 x 1,600,000

Exercise 7

The Oxford Publishing House has three service departments and two operating departments.
Selected data from a recent period on the five department follow:

Service Departments Operating Departments

Administrat. Janitorial Maintenance Binding Printing Total

Overhead costs $140,000 $105,000 $ 48,000 $275,000 $430,000 $998,000

No. Employees 60 35 140 315 210 760
Square feet of space 15,000 10,000 20,000 40,000 100,000 185,000
occupied
Hours of press time 30,000 60,000 90,000

The company allocates service department costs by direct method in the following order:
Administration (number of employees), Janitorial (space occupied) and maintenance (hours of
press time).

Repeat the same using the step down method, allocates the service department cost on the same
line mentioned above.

20
Answer 7

Direct Method

Service Departments Operating Departments

Administrat. Janitorial Maintenance Binding Printing Total
Overhead costs $140,000 $105,000 $ 48,000 $275,000 $430,000 $998,000

Administration -140,000 84,000 56,000 140,000

Janitorial -105,000 30,000 75,000 105,000
Maintenance -48,000 16,000 32,000 48,000
Total cost after
Allocation -0- -0- -0- 405,000 593,000 998,000

Administration : Binding 315/525x140,000 Printing 210/525x140,000

Janitorial : Binding 40,000/140,000x105,000 Printing 100,000/140,000x105,000
Maintenance : Binding 30,000/90,000x48,000 Printing 60,000/90,000x48,000

Step Down Method

Service Departments Operating Departments

Administrat. Janitorial Maintenance Binding Printing Total

Overhead costs $140,000 $105,000 $ 48,000 $275,000 $430,000 $998,000

Administration -140,000 7,000 28,000 63,000 42,000 140,000
Janitorial -112,000 14,000 28,000 70,000 112,000

Maintenance -90,000 30,000 60,000 90,000

Total cost after
Allocation -0- -0- -0- 396,000 602,000 998,000

Administration : 35/700x140,000, 140/700x140,000, 315/700x140,000, 210/700x140,000

Janitorial : 20,000/160,000x112,000, 40,000/160,000x112,000, 100,000/160,000x112,000
Maintenance : Binding 30,000/90,000x90,000 Printing 60,000/90,000x48,000

21
Multiple Choice Questions

1. Linkage company uses predetermined overhead rate to apply overhead cost to jobs. The
pre-overhead rate is based on labour cost in Department A and machine hour in
Department B. At the beginning of the year the company made the following estimates.
Department A Department B
Direct labour cost $ 15,000 $ 20,000
Manufacturing overhead 30,000 25,000
Direct labour hour 12,000 16,000
Machine hours 1,000 5,000
What predetermined overhead rate would be used in Department A, and Department B
respectively.
a) $15, 110%
b) 50%, $5
c) 50%, $8
d) 200%, $5

Answer (d) Manufacturing overhead cost / Direct labour cost 30,000/15,000 x 100 =
200%. Manufacturing overhead cost/ Machine hours = $25,000/5,000 = $ 5

2. Hayat Company has the following estimated cost for the next year.
Direct material $ 30,000
Direct labour 110,000
Sales commission 150,000
Salary of production supervisor 70,000
Indirect material 10,000
Advertising expenses 22,000
Rent on factory equipment 32,000

Hayat estimates that 30,000 direct labour and 32,000 machine hours will be worked
during the year. If overhead is applied on machine hours, the overhead rate per hour will
be?
a) $ 3.50 b) $ 6.94 c) $ 7.63 d) $ 8.56

Answer (a) $ 3.50

Overhead cost Salary of production supervisor $ 70,000
Indirect material 10,000
Rent on factory equipment 32,000
Total 112,000

Overhead rate $ 112,000/32,000 machine hours = $3.50

3. In job order costing, indirect labour cost would be recorded as a debit to:
a) Raw material
b) Work in Process

22
 c) Manufacturing overhead
d) Finished goods
Answer (c) Manufacturing overhead

4. In job order cost system direct material would be recorded as debit to:
a) Work in process inventory
b) Finished Goods inventory
c) Manufacturing overhead
d) Raw material inventory

Answer (a) Work in Process

5. Glenn Company’s overhead rate is based on direct labour cost. The company’s work in
process inventory has a balance of $ 1,200 which relate to one job which was not
completed at the end of accounting period. The related cost sheet include total charges
$200 for direct material $ 500 for direct labour. The predetermined overhead rate as
percentage of direct labour cost must be:
a) 17%
b) 40%
c) 50%
d) 100%

Answer (d) Work in Process Inventory $ 1,200 – ($200 + 500)/500 x 100 = 100%

6. Penn Company uses predetermined overhead rate based on direct labour hours to apply to
manufacturing overhead to jobs. At the beginning of the year company estimated
manufacturing overhead $100,000 and direct labour hours 10,000. The actual figure were
$ 110,000 for manufacturing overhead and 10,500 direct labour hours. The cost record
would show:
a) Overapplied overhead $ 10,000
b) Underapplied overhead $ 10,000
c) Underapplied overhead $ 5,000
d) Overapplied overhead $ 5,000

Answer (a) Overapplied overhead $ 10,000 ($110,000 – 100,000) = 10,000

7. Serit Company predetermined overhead rate is based on direct labour hours. At the
beginning of the current year the company estimated its manufacturing overhead would
total $220,000 during the year. During the year company incurred $200,000 in actual
manufacturing overhead cost. The manufacturing overhead cost showed that
manufacturing overhead was over applied by $8,000 during the year. If the predetermined
overhead rate was $ 20 per direct labour hours, how many hours worked during the year.
a) 9,600 hours
b) 10,000 hours
c) 10,400 hours
d) 11,000 hours

23
 Answer 9,600 hours. Actual cost $200,000 – 8,000 (over applied)/20 = 9,600 hours.

8. Artsy Sportswear manufactures a specialty line silk screen shirts. The company uses a job
order costing system. During May the following costs were incurred on Job PS4, direct
material $27,400, direct labour $9,600. In addition selling and shipping costs of $ 14,000
were incurred. Manufacturing overhead was applied at the rate of $25 per machine hour
and Job PS4 require 160 per machine hours. If Job PS4 consisted of 5,000 shirts, the cost
of goods sold per shirt was?
a. $ 7.40
b. $ 8.20
c. $11.00
d. $25.00

Answer : $27,400 + $9,600 + 14,000 + (160 x $25)/5,000 = $ 11 per shirt.

9. Under Eastern Job Order Costing system manufacturing overhead is applied to Work in
Process Inventory using a predetermined overhead rate. During May Eastern’s
transactions included the following :
Direct labour cost incurred $ 214,000
Direct material issued to production 180,000
Indirect material issued to production 16,000
Manufacturing overhead cost applied 226,000
Manufacturing overhead cost incurred 250,000
Eastern Company has no beginning or ending inventories in May. What was the cost of
goods manufactured for May?
a) $ 604,000
b) 620,000
c) 644,000
d) 660,000

Answer : $180,000 + 214,000 + 16,000 + 250,000 = $ 660,000

24
CHAPTER III
COST BEHAVIOUR ANALYSIS AND USE

We have so far discussed the various types of costs. Under cost behavior analysis we shall study
how a cost would change as the level of activity changes. The understanding of this behavior is
relevant because it provides an insight to the managers that an increase or decrease in production
not necessary results in increasing cost or decreasing income. Let us first recapitulate the three
cost elements which are involved in production process.

Variable Cost : A variable cost is a cost whose total dollar amount varies in direct proportion to
changes in the activity level. If the activity level doubles, the total variable cost also doubles. If
the activity decreases to one half, the variable cost will also decrease by 50%.

A cost to be variable, it must be variable with respect to something. That “something” is its
activity base. An activity base is a measure of whatever causes the changes in variable cost. An
activity base is some time called the cost driver. Some of the most activity base are direct labour
hours, machine hours, unit produce and unit sold. Other examples of activity bases include the
number of miles driven by salespersons, the number of pounds of laundry cleaned by a hotel
number of calls handled by technical support staff at a software company, and the number of
beds occupied in a hospital. The undernoted chart shall help to understand the variable cost
drivers in different types of organizations.

Types of Organization Costs that are normally variable

with respect to output - Drivers

1. Merchandizing company Cost of goods (merchandise)

2. Manufacturing company Direct material
Direct labour
Variable elements of manufacturing overhead
Indirect materials
Lubricants
Supplies
Power
3. Both merchandizing & Variable elements of selling and
Manufacturing administrative costs like commission, shipping
Sales in Dollars
No. of units sold
4. Service Organization Variable elements of variable cost e.g. Banks
No. of accounts
Cheques handled per day

25
True Variable versus Step Variable Costs

Not all variable costs have exactly the same behavior pattern. Some variable costs behave in a
true variable or proportionately variable pattern. Other variable costs behave in a step variable
patterns.

True Variable Costs : Direct materials is a true or proportionately variable cost because the
amount used during a period will vary in direct proportion to the level of production activity.

Step Variable Costs : The cost of a resource that is obtainable only in large chunks and that
increases or decreases only in response to fairly wide change in activity is known as a step-
variable cost. For example, the wages of skilled repair technicians are often considered to be a
step variable.

Fixed Costs : A fixed costs is one that remains constant within a relevant range of activity. Since
fixed costs remain constant in total, the average fixed cost per unit decreases with the level of
activity. For example a group of 20 student have occupied a room in a hotel at a monthly rent of
Rs.5,000. The average rent per student would be Rs.250 per month. If the number of students
were increased to 50, the average rent per student would drop to Rs.100.

Types of Fixed Cost : Fixed costs are sometimes referred to as a capacity costs, since they
results from outlays made for buildings, equipment, skilled professional employees, and other
items needed to provide the basic capacity for operations. For planning purposes, fixed costs can
be viewed to either committed or discretionary.

Committed Fixed Costs : Investment in facilities, equipments and the basic organization that
cannot be significantly reduced even for short periods of time without making fundamental
changes are referred to as committed fixed costs.

Discretionary Fixed Costs : Discretionary fixed costs (often referred to as managed fixed costs)
usually arise from annual decisions by management to spend on certain fixed cost items.
Examples of discretionary fixed costs include advertising, research public relations, operating
system, special software etc.

To make the fixed cost more identifiable, a discretionary fixed cost is short term in nature,
usually a single year. By contrast committed fixed costs have planning horizon that is spread
over several years. Secondly, discretionary fixed costs can be cut for short periods of time with
minimal damage to the long run goals of organization, but committed fixed costs cannot be
altered without making major changes in the organization set up and operation.

Mixed Costs

A mixed cost contains both variable and fixed cost elements. Mixed costs are also known as semi
variable costs. For example in banks the teller’s salary is a fixed cost but the cost of cheque
books issued is a variable cost depending upon the number of transactions in a particular

26
account. Since mixed cost has a relationship with the level of activity, it can be expressed with
the undernoted equation:

Y = a + bX

In this equation,
Y = The total mixed cost
a = The total fixed cost (the vertical intercept of the line)
b = The variable cost per unit of activity (the slope of the line)
X = The level of activity.

Since the variable cost per unit equals the slope of the straight line, the steeper the slope, the
higher the variable cost per unit.

Y
Maintenance Cost Variable Cost
│
│
│
│
│
│_______________________________ Fixed Cost
│
│
│
│
│______________________________ X
No. of patients

Methods to Separate Mixed Cost into Fixed & Variable

Cost behavior with the help of Scattergraph Plotting

The first step in analyzing the cost and activity data is to plot the data on a scattergraph. This plot
immediately reveals any non-linearities or other problems with the data. The scattergraph of
maintenance costs versus patient day at Services Hospital is shown below:

Month Activity level Maintenance

Patient Type Cost incurred
January 5,600 $ 7,900
February 7,100 8,500
March 5,000 7,400
April 6,500 8,200
May 7,300 9,100

27
 June 8,000 9,800
July 6,200 7,800

1. The total maintenance cost, Y, is plotted on the vertical axis. Cost is known as the
dependable variable. Since the amount of cost incurred during a period depends on the
level of activity for the period.
2. The activity, X (patient days in this case) is plotted on the horizontal axis. Activity is
known as independent variable, since it causes variations in the cost.
Y
Maintenance Cost
16000 │
14000 │
12000 │
10000 │
8000 │
6000 │
4000 │
2000 │
│_____________________________ X
2000 4000 6000 8000 10000
No. of Patients

From the scattergraph, it is evident that maintenance costs do increase with number of patient
days. In addition, the scattergraph reveals the relation between maintenance costs and patient
days is approximately linear. In other words, the points lie more or less along a straight line.
Such a straight line has been drawn using a ruler. Cost behavior is considered linear whenever a
straight line is a reasonable approximation for the relation between cost and activity. Note that
the data points do not fall exactly on the straight line. This will almost always happen in practice.
The relation is seldom perfectly linear.

Note that the straight line has been drawn through the point representing 7,300 patient days and a
total maintenance cost of $ 9,100. Drawing the straight line through one of the data points helps
make a quick and dirty estimate of variable and fixed costs. The vertical intercept when the
straight line crosses the Y axis in this case, about $ 3,300 – is the rough estimate of the fixed
cost. The variable cost can be quickly estimate by subtracting the estimated fixed cost from the
total cost at the point lying on the straight line.

Total maintenance cost for 7,300 patient days

(a point line on straight line) $ 9,100
Less estimated fixed cost (the vertical intercept 3,300
Estimated total variable cost for 7,300 patient days 5,800

The average variable cost per unit at 7,300 patient days is computed as follows:

Variable cost per unit = 5,800 ÷ 7,300 patient days

= $0.79 per patient day (rounded)

28
High and Low Method

The other method which is more commonly used for estimating the fixed and variable cost is
called the high and low method. Assuming that the scattergraph plot indicates a linear
relationship between the cost and activity, a fixed and variable cost element of a mixed cost can
be estimated using the high low method or the least square regression method. The high and low
method is based on the rise over run formula for the slope of a straight line.

Variable cost = Slope of the line = Rise = Y2 - Y1

Run X2 - X1

To analyse mixed cost with the high-low method, begin by identifying the period with the lowest
level of activity and the period with the highest level of activity. The period of lowest activity is
selected as the first point in the above formula and the period with the highest activity is selected
as the second point.

Variable cost = Cost at the high activity level - Cost at the low level of activity
High activity level - Low level of activity

Variable cost = Changes in cost

Changes in activity

9,800 - 7,400 = 2,400 = $ 0.80 per day

8,000 - 5,000 3,000

Fixed cost element = Total Cost – Variable cost element

$ 9,800 - $0.80 per patient x 8,000 patient days
$ 3,400

Both the variable and fixed cost elements have been isolated. The cost of maintenance can be
expressed as $ 3,400 per month plus 80 cents per patient a day or as:

Y = $3,400 + $0.80 X

Least Square Regression Method: It is a more accurate cost estimation technique because it
mathematically determines the straight line (called the regression line) that minimizes the sum of
the squared differences between that line and the various data point. When only two variables are
considered (as is the case the number of patients and maintenance cost), the analysis is referred
to as simple linear regression analysis. When more than two variables are considered, multiple
linear regression analysis is needed.

The mathematics involved in linear regression analysis can be reduced to the solution of the
following two equations that are derived from the basic equation for a straight line (y = a +bx).

Variable cost = b = ∑(x - x mean)(y – y mean)

∑(x – x mean)2

29
Where b represents variable cost
X The level of activity
X mean Average level of activity
Y Total mixed cost
Y mean Average level of mixed cost

After determining the value the fixed cost can be computed with the help of original equation i.e.
Y = a + b.

Note : For the purpose of calculating fixed cost the mean value of Y will be used in the equation
and not actual value.

Multiple Choice Questions

1. Over applied factory overhead will always result when a predetermined factory overhead
rate is employed and:
a. Production is greater than budgeted capacity.
b. Actual overhead costs are more than expected.
c. Defined capacity is less than normal capacity.
d. Actual overhead incurred is less than applied overhead.

2. If a predetermined factory over head rate not employed and the volume of production is
reduced from the level planned, the cost per unit would be expected to:
a. Remain unchanged for fixed cost and increase for variable cost.
b. Increase for fixed cost and remain unchanged for variable cost.
c. Increase for fixed cost and decrease for variable cost.
d. Decrease for fixed cost and decrease for variable cost.

3. Factory overhead should be allocated on the basis of:

a. An activity basis which relates to cost incurrence.
b. Direct labour hours
c. Direct labour cost
d. Machine hours.

4. When a manufacturing company has highly automated manufacturing plant producing

many different products, the most appropriate basis for applying factory overhead to
work in process is:
a. Direct labour hours
b. Direct labour costs
c. Machine hours
d. Cost of material used
5. Which of the following should not be on a monthly cost control report of a department
manager?
a. Departmental labour cost
b. Departmental supplies cost

30
 c. Depreciation on departmental equipment
d. Cost of materials used in the department

6. Periodic internal performance reports based upon a responsibility accounting system

should not:
a. Distinguish between controllable and uncontrollable costs
b. Be related to the organization chart
c. Include allocated fixed overhead in determining performance evaluation
d. Include variances between actual and controllable costs

7. The concept of management by exception refers to management’s:

a. Lack of a predetermine plan;
b. Consideration of only rare events;
c. Consideration of items selected at random;
d. Consideration of only those items which vary materially from plans.

Management by exception means when the costs incurred by on a specified head depart
significantly from the standards fixed by the management, managers investigate the discrepancy
to find the causes of problem and eliminate it. This process is called management by exception.

8. Of most relevance in deciding how much cost should be assigned to a responsibility

centre is :
a. Avoidabiliy
b. Causality
c. Controllability
d. Variability

9. An example of discretionary fixed costs would be:

a. Executive salaries
b. Rent
c. Insurance
d. None of the above

10. What effect does an increase in volume have on fixed cost:

a. Unit fixed cost would increase
b. Total fixed cost would decrease
c. Unit fixed cost would decrease
d. Total fixed cost would increase

Answers 1(a), 2(b), 3(a), 4(c), 5(b), 6(c), 7(d), 8(c), 9(d), 10(c)

31
Additional Multiple Choice Questions

1. Expense # 1 is a fixed cost: expense # 2 is a variable cost. During the current year the
activity level has increased, but is still within the relevant range. In terms of cost per unit
of activity, we would expect that :
a) Expense # 1 will be unchanged.
b) Expense # 2 will decrease.
c) Expense # 1 will decrease.
d) Expense # 2 will increase.
Correct answer is (c). With the increase in the level of activity while fixed cost is constant,
per unit fixed cost will decline. (fixed cost / number of units produced)

2. Which costs will change with an increase in activity within the relevant range?
a) Total fixed costs and total variable cost.
b) Per unit fixed costs and total variable cost.
c) Per unit variable cost and per unit fixed cost.
d) Per unit fixed cost and total fixed cost.

3. An analysis of past janitorial costs indicates that janitorial cost is an average of $ 0.40 per
machine hour at an activity level of 20,000 machine hours and $ 0.50 per machine hour at
an activity level of 16,000 machine hours. Assuming that this activity is within the
relevant range, what is the total expected janitorial cost if the activity level is 18,500
machine hours?
a) $ 1,600 b) 6,960 c) $ 8,000 d) $ 9,000

4. Shipping expense is $ 34,000 for 16,000 pounds shipped and $ 40,000 for 19,000 pounds
shipped. Assuming that this activity is within the relevant range, if the company ships
18,000 pounds, its expected shipping expense is closest to:
a) $37,000 b) $37,895 c) $ 38,000 d) $ 38,250

5. Given the cost formula Y = $ 30,000 + 5x, total cost an activity level of 16,000 units
would be:
a) $30,000 b) $ 46,000 $ 80,000 d) 110,000

6. Coolant Company would like to classify the following costs according to cost behavior.
The following data is available:
July August
Sales in units 3,000 3,200
Cost # 1 $ 70,000 $ 72,000
Cost # 2 $ 32,000 $ 32,000
Cost # 3 $135,000 $144,000

Which of the following classification best describes the behavior of cost # 2?

a) Mixed b) Variable c) Fixed d) None of the above.

32
7. Coolant Company would like to classify the following costs according to cost behavior.
The following data is available:
July August
Sales in units 3,000 3,200
Cost # 1 $ 70,000 $ 72,000
Cost # 2 $ 32,000 $ 32,000
Cost # 3 $135,000 $144,000

Which of the following classification best describes the behavior of cost # 3?

a) Mixed b) Variable c) Fixed d) None of the above.

8. The following information has been provided by the Fast Grocery Store for the first
quarter of the year:
Sales $ 700,000
Variable selling expenses 70,000
Fixed selling expenses 50,000
Cost of goods sold 320,000
Fixed administrative expenses 110,000
Variable administrative expenses 30,000
The gross margin of Fast Grocery Store for the first quarter is:

a) $280,000 b) $ 380,000 c) $420,000 d) $ 440,000

9. The following information has been provided by the Fast Grocery Store for the first
quarter of the year:
Sales $ 700,000
Variable selling expenses 70,000
Fixed selling expenses 50,000
Cost of goods sold 320,000
Fixed administrative expenses 110,000
Variable administrative expenses 30,000
The contribution margin of Fast Grocery Store for the first quarter is:

a) $280,000 b) $ 380,000 c) $420,000 d) $ 660,,000

10. Larel Co. has provided the following data for the second quarter of the most recent years:
Sales $ 600,000
Fixed manufacturing overhead 110,000
Direct labour 145,000
Fixed selling expenses 92,500
Variable manufacturing overhead 82,000
Variable administrative expense 96,000
Direct materials 103,000
Fixed administrative expense 89,000
Variable selling expense 99,500

33
 Assuming that direct labour is variable cost and that there were no beginning or ending
inventories. The total contribution margin of Larel Co. for the second quarter was:

a) $ 74,500 b) $ 174,000 c) 352,000 d) 422,000

Exercise 8

Hot Coffee Points operates a number of coffee stands in busy suburban malls. The fixed weekly
expenses of a coffee stand is $ 1,200 and the variable cost per cup of coffee served is $0.22.

Required: Fill in the following table with your estimates of total costs and cost per cup of coffee
at the indicated levels of activity for a coffee stand. Round off the cost of a cup of coffee to the
nearest tenth of a cent.

Cups of Coffee Served in a Week

2,000 2,100 2,200
Fixed Cost ? ? ?
Variable cost ? ? ?
Total cost ? ? ?
Cost per cup of coffee served ? ? ?

Does the cost per cup of coffee served increased, decrease ore remain the same as the number of
cups of coffee served in a week increase? Explain.

Answer 8

Cups of Coffee Served in a Week

2,000 2,100 2,200
Fixed Cost 1,200 1,200 1,200
Variable cost 440 462 484
Total cost 1,640 1,662 1,684
Cost per cup of coffee served 0.82 0.79 0.77

The cost per cup of coffee is decreasing because with the increase in coffee sales, the fixed cost
per cup is declining. As regards variable cost that remains constant at all level of production and
has no role in the price of the cup.

Exercise 9

The Seerna Hotel’s guest days of occupancy and custodial supplies expenses over the last seven
months were:

Guest Days of Custodial Supplies

Occupancy Expenses
March $4,000 7,500

34
 April 6,500 8,250
May 8,000 10,500
June 10,500 12,000
July 12,000 13,500
August 9,000 10,750
September 7,500 9,750
Guest days is a measure of the overall activity at the hotel. For example, a guest who stays at a
hotel for three days is counted as three guest days.

Required:
Using the high low method estimate a cost formula for custodial supplies expenses.
Using the cost formula you derived above what amount of custodial supplies expense would you
expect to be incurred at an occupancy level of 11,000 guest days.

Answer 9

Mixed cost = Changes in cost y2 – y1

Changes in activity x2 – x1

13,500 - 7,500 = 6,000

12,000 – 4,000 8,000

0.75

Y = a + b(x)
13,500 a + 12,000(0.75)
a 13,500 – 9,000 = 4,500

Y = a + b(x)
7,500 a + 4,000(0.75)
a = 7,500 – 3,000 = 4,500

c) Y = a + b(x)
4,500 + 11,000 (0.75)
12,750

Exercise 10

A controller is interested in an anlaysis of the fixed and variable cost of electricity as related to
direct labour hours. The following data has been accumulated.

Months Electricity Cost Direct labour hours

January Rs. 15,480 297
February 16,670 350
March 14,050 241
April 15,340 280

35
 May 16,000 274
June 16,000 266
July 16,130 285
August 16,350 301
Required :
The amount of fixed overhead and the variable cost using:
a) The high and low points method
b) The method of least square

Answer 10

a) High and Low Method

Changes in Cost = 16,670 - 14,050
Changes in activity 350 - 241

= 2,620 ÷ 109 = Rs.24.037 per labour hr.

Y = a + bX
16,670 = a + 350 (24.037)
16,670 = a + 8,413
a = 8,257

b) Method of least square method

Months Labour Electricity (x – x mean) (y – y mean) (x – x mean)2 (x-x mean)

(y–y mean)

___________________________________________________________________________
January 297 15,480 10.25 -272.50 105.06 -2,793.13
February 350 16,670 63.25 917.50 4,000.56 58,031.88
March 241 14,050 -45.75 -1,702.50 2.093.06 77,889.38
April 280 15,340 - 6.75 -412.50 45.56 2,784.38
May 274 16,000 -12.75 247.50 162.56 -3,155.63
June 266 16,000 -20.75 247.50 430.56 -5,135.63
July 285 16,130 1.75 377.50 3.06 - 660.63
August 301 16,350 14.25 597.50 203.06 8,514.38
∑ 2,294 126,020 0 0 7,043.48 135,475.00

X mean = 2,294 = 286.75 hours

8
Y mean = 126,020 = Rs.15,725.5
8
Variable cos per hour = b ∑(x-x mean) (y-y mean)
∑ (x-x mean)2
=
135,475/7,043.48 = Rs.19.23 per hour

Y = a + b(x)

36
 a = 15,752.5 – (19.23 x 286.75)
= Rs. 10,238.5
15,725.50 = 10,238.50 + 5,514.20

Exercise 11

AAB Company is planning its capacity for the year 2004 at 90% of the rated capacity. For the
purpose of estimating ‘other FOH expenses’ company uses 5 years history and ‘simple
regression analysis’ method. Data in hand is as under:

Five years history of ‘other FOH expenses’ is as under:

Other FOH Direct labour

Year Expenses (Rs.) Hours
1999 90,775 23,750
2000 83,125 18,750
2001 84,800 20,000
2002 99,084 21,000
2003 84,860 19,750

In the year 2002 other FOH expenses include a penalty of Rs. 12,734 on non compliance of
certain labour laws.

Required :

You are required to calculate fixed and variable portion of estimated other FOH expenses at
planned capacity.

Answer 11

Labour Other FOH (x-x mean) (y-y mean) (x-x mean)2 (x-x mean)
Years hrs Rs. (y-y mean)
1999 23,750 90,775 3,100 4,793 9,610,000 14,858,300
2000 18,750 83,125 -1,980 -2,857 3,610,000 5,428,300
2001 20,000 84,800 - 650 - 1,182 422,500 768,300
2002 21,000 86,350 350 368 122,500 128,800
2003 19,750 84,860 - 900 -1,122 810,000 1,009,800
∑ 103,250 429,910 0 0 14,575,000 22,193,500

X mean = 103,250 = 20,650 hours

5
Y mean = 429,910 = 85,892
5

37
Variable cost per hour = b ∑(x-x mean) (y-y mean)
∑ (x-x mean)2
22,193,500 = Rs.1.5227 hrs
14,575,000

Y = a + b(x)
85,892 = a + 1.5227 (23,750)
a = 85,892 – 36,164
= Rs.49,728

High & Low Method

Variable cost = Changes in cost

Changes in activity

= 90,775 - 83,125
23,750 – 18,750

= 7,650 / 5,000 = Rs.1.53

Y = a + b(x)

90,775 = a + 23,750(1.53)

a = 90,775 – 36,338 = 54,437

38