Managerial Accounting

Diploma
in
Business Administration

Study Manual
Managerial Accounting
The Association of Business Executives
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ABE Diploma in Business Administration
Study Manual
Contents
Study
Unit
Title Page

Syllabus i

1 Management Accounting and Information 1
Management Accounting 2
Information 4
Collection and Measurement of Information 6
Information for Strategic, Operational and Management Control 11
Information for Decision Making 14

2 Cost Categorisation and Classification 17
Accounting Concepts and Classifications 19
Categorising Cost to Aid Decision Making and Control 21
Management Responsibility Levels 29
Cost Units 30
Cost Codes 31
Patterns of Cost Behaviour 32
Influences on Activity Levels 36
Numerical Example of Cost Behaviour 36

3 Direct and Indirect Costs 39
Material Costs 40
Labour Costs 43
Decision Making and Direct Costs 48
Overhead and Overhead Cost 49

4 Absorption Costing 51
Definition and Mechanics of Absorption Costing 52
Cost Allocation 53
Cost Apportionment 54
Overhead Absorption 59
Treatment of Administration and Selling and Distribution Overhead 64
Uses of Absorption Costing 65

5 Marginal Costing 69
Definitions of Marginal Costing and Contribution 70
Marginal Versus Absorption Costing 72
Limitation of Absorption Costing 76
Application of Marginal and Absorption Costing 79

6 Activity-Based and Other Modern Costing Methods 91
Activity-Based Costing (ABC) 92
Throughput Accounting 106
Backflush Accounting 107
J ust-in-Time (J IT) Manufacturing 108

7 Product Costing 113
Costing Techniques and Costing Methods 115
J ob Costing 116
Batch Costing 121
Contract Costing 122
Process Costing 124
Treatment of Process Losses 127
Work-In-Progress Valuation 131
J oint Products and By-Products 134
Other Process Costing Considerations 139

8 Cost-Volume-Profit Analysis 141
The Concept of Break-Even Analysis 142
Break-Even Charts (Cost-Volume-Profit Charts) 146
The Profit/Volume Graph (or Profit Graph) 154
Sensitivity Analysis 158

9 Planning and Decision Making 161
The Principles of Decision Making 162
Decision-Making Criteria 167
Costing and Decision Making 169

10 Pricing Policies 177
Fixing the Price 178
Pricing Decisions 178
Practical Pricing Strategies 182
Further Aspects of Pricing Policy 188

11 Budgetary Control 191
Definitions and Principles 192
The Budgetary Process 196
Budgetary Procedure 201
Changes to the Budget 213

12 Further Budgetary Control Techniques 215
Flexible Budgets 216
Budgeting With Uncertainty 221
Budget Problems and Methods to Overcome Them 224
Alternative Budgetary Approaches 227
Behavioural Aspects of Budgeting 230

13 Standard Costing 137
Principles of Standard Costing 238
Setting Standards 241
Setting Standards The Learning Curve 247
The Standard Hour 253
Measures of Capacity 254

14 Standard Costing Basic Variance Analysis 259
Purpose of Variance Analysis 260
Types of Variance 264
Marginal versus Absorption Costing 269
Mix and Yield Variances 271

15 Advanced Variance Analysis and Investigation 277
Planning and Operational Variances 278
Investigation of Variances 287
Variance Interpretation 297
Interdependence between Variances 298

16 Management of Working Capital 301
Principles of Working Capital 302
Management of Working Capital Components 303
Dangers of Overtrading 306
Preparation of Cash Budgets 306
Cash Operating Cycle 308

17 Financial Mathematics I: Interest and Present Value 311
Simple Interest 312
Compound Interest 314
Present Value 318
To Find the Rate or the Number of Years 322
Depreciation 323

18 Financial Mathematics II: Capital Investment Appraisal 333
Payback Method 335
Return on Investment Method 336
Introduction to Discounted Cash Flow Methods 337
The Two Basic DCF Methods 341

19 Presentation of Management Information 353
General Principles of Presentation 354
Management Information 354

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Diploma in Business Administration Part 2
Syllabus
Aims
1. Understand the costing methods and techniques available.
2. Select appropriate methods and techniques which an organisation can use to calculate costs
under different situations.
3. Construct budgets for both planning and control purposes, including cash flow forecasts.
4. Understand all aspects of working capital management.
5. Appreciate how information technology can assist when preparing information for
management.
6. Understand capital investment appraisal and financial mathematics
Programme Content and Learning Objectives
After completing the programme, the student should be able to:
1. Understand the control systems required for materials, labour and overheads
! the nature of costs
! recognise the differences between fixed, variable, semi fixed and semi variable costs
! problems of allocation/apportionment of overheads
! pricing of materials
! calculation of overhead recovery rates
2. Analyse data according to various cost classifications and the effect of volume on costs
! cost volume profit analysis
! comparison between the economists and accountants cost volume chart
3. Recognise how cost systems differ by activity i.e. job and process costing
! characteristics of process costing, equivalent units, methods of pricing, normal and
abnormal waste, joint and by products
! methods of apportionment of joint costs
4. Use costs for short term decision-making
! marginal costing, key factors, opportunity costs, sunk costs, differential costs, qualitative
aspects
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5. Appreciate the difference between marginal and absorption costing
! format of a marginal profit statement, format of an absorption profit statement
6. Recognise the purpose of budgetary control
! construct budgets for both planning and control purposes
! administration of budgets, roll over budgets, objectives of budgets, the budget key factor,
functional budgets, master budgets, behavioural aspects of budgetary control
! zero based budgets
7. Explain the purpose of standard costing
! calculate and analyse variances for materials, labour
! overheads and sales, types of standards, preparation of operating statements
8. Explain the purpose of working capital management
! operating cycle, funding and control of working capital
9. Understand the uses of information technology when presenting management with
information
10. Capital investment appraisal and financial mathematics
! financial and non-financial factors to be considered when making investment decisions
! methods of investment appraisal, including payback, the time value of money and
average rate of return
! the calculation of compound interest
! discounted cash flow
! net present value
! internal rate of return
Method of Assessment
By written examination. The pass mark is 40%. Time allowed 3 hours.
The question paper will contain:
Six questions of which four must be answered.
Five questions will be computational with written parts in the majority of these questions and one will
be an essay question.
All questions carry equal marks.
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Reading List
Essential Reading
! Drury, C. (1995), Costing: An Introduction, 3rd Edition; Thomson Business Press
Additional Reading
! Drury, C. (2000), Management and Cost Accounting, 5th Edition; Thomson Business Press
Journals
! Management Accounting (CIMA)
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1
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Study Unit 1
Management Accounting and Information
Contents Page
Introduction 2
A. Management Accounting 2
Some Introductory Definitions 2
Objectives of Management Accounting 3
Setting Up a Management Accounting System 4
The Effect of Management Style and Structure 4
B. Information 4
Information and Data 4
Users of Information 5
Characteristics of Useful Information 5
C. Collection and Measurement of Information 6
Sources of Information 6
Relevancy 7
Measuring Information 7
Communicating Information 8
Value of Information 9
Quantitative and Qualitative Information 10
Accuracy of Information 10
Financial and Non-Financial Information 10
D. Information for Strategic, Operational and Management Control 11
Elements of Control 11
Feedback 12
Control Information 12
E. Information for Decision Making 14
2 Management Accounting and Information
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INTRODUCTION
We begin our study of this module with some definitions which will make clear what managerial or
management accounting is, what it involves and what its objectives are.
A number of factors must be considered when setting up a management accounting system and the
management style and structure of an organisation will affect the system which it creates.
Information is an important part of any such system and the study unit will go on to examine its
various types and sources.
A. MANAGEMENT ACCOUNTING
Some Introductory Definitions
The Chartered Institute of Management Accountants (CIMA) in its Official Terminology describes
accounts as follows:
! The classification and recording of actual transactions in monetary terms, and
! The presentation and interpretation of these transactions in order to assess performance over a
period and the financial position at a given date.
The American Accounting Association (AAA) supplies a slightly more succinct definition of
accounting:
....the process of identifying, measuring and communicating economic information to
permit informed judgements and decisions by users of information.
Another way of saying this is that accounting provides information for managers to help them make
good decisions.
Cost accounting is referred to in the CIMA Terminology as:
That part of management accounting which establishes budgets and standard costs and
actual costs of operations, processes, departments or products and the analysis of
variances, profitability or social use of funds. The use of the term costing is not
recommended.
Management accounting is defined as:
The provision of information required by management for such purposes as:
(1) formulation of policies;
(2) planning and controlling the activities of the enterprise;
(3) decision taking on alternative courses of action;
(4) disclosure to those external to the entity (shareholders and others);
(5) disclosure to employees;
(6) safeguarding assets.
The above involves participation in management to ensure that there is effective:
(a) formulation of plans to meet objectives (long-term planning);
Management Accounting and Information 3
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(b) formulation of short-term operation plans (budgeting/profit planning);
(c) recording of actual transactions (financial accounting and cost accounting);
(d) corrective action to bring future actual transactions into line (financial control);
(e) obtaining and controlling finance (treasurership);
(f) reviewing and reporting on systems and operations (internal audit, management
audit).
Financial accounting is referred to as:
That part of accounting which covers the classification and recording of actual
transactions of an entity in monetary terms in accordance with established concepts,
principles, accounting standards and legal requirements and presents as accurate a view
as possible of the effect of those transactions over a period of time and at the end of that
time.
All three branches of accounting should be integrated into the companys reporting system.
! Financial accounting maintains a record of each transaction and helps control the companys
assets and liabilities such as plant, equipment, stock, debtors and creditors. It satisfies the legal
and taxation requirements and also provides a direct input into the costing systems.
! Cost accounting analyses the financial data into more detail and provides a lot of the
information used for control. It also provides key data such as stock valuations and cost of
sales which are fed back into the financial accounting system so that accounts can be finalised.
! Management accounting draws from the financial and cost accounting systems. It uses all
available information in order to advise management on matters such as cost control, pricing,
investment decisions and planning.
Objectives of Management Accounting
(a) Planning: all organisations should plan ahead in order that they can set objectives and decide
how they should meet them. Planning can be short- or long-term and it is the role of the
management accounting system to provide the information for what to sell, where and at what
price. Management accounting is also central to the budgetary process which we shall look at
in more detail later.
(b) Control: production of the companys internal accounts, its management accounts, enables the
firm to concentrate on achieving its objectives by identifying which areas are performing and
which are not. The use of management by exception reports enables control to be exercised
where it is most useful.
(c) Organisation: there is a direct relationship between the organisational structure and the
management accounting system. It is often difficult to determine which has the greater effect
on the other, but it is necessary that the management accounting system should produce the
right information at the right cost at the right time, and the organisational structure should be
such that immediate use is made of it.
(d) Communication: the existence of a budgetary and management accounting system is an
important part of the communication process; plans are outlined to managers so that they are
fully aware of what is required of them and the management accounts tell them whether or not
the desired results are being achieved.
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(e) Motivation: more will be said about the motivational aspects of budgeting later, but suffice to
say here that the targets included in any system should be set at such a level that managers and
the people who work for them are motivated to achieve them.
Setting Up a Management Accounting System
There are several factors which should be borne in mind when a system is being set up:
! What information is required?
! Who requires it?
! How often is it required?
Further thought will need to be given to such matters as:
! What data is required to produce the information?
! What are the sources of this data?
! How should it be converted?
! How often should it be converted?
Finally, factors such as organisational structure, management style, cost and accuracy (and the trade-
off between them) should also be taken into account.
The Effect of Management Style and Structure
Theories of management style range from the autocratic at one end of the spectrum to the democratic
at the other. Which style a particular organisation uses very much affects the management accounts
system. With a democratic style for instance, it is likely that decision making is devolved further
down the management structure and information provided will need to reflect this. An autocratic
style, by contrast, means that decision making is exercised at a higher level and therefore the
necessary information to enable the function to be carried out will similarly be provided at this level
also.
In addition, the management structure will also have an impact, a flat management structure will
mean that a particular manager will need to be provided with a greater range of reports (e.g. on sales,
marketing, production matters, etc.) than in a company with a functional structure where reports are
only required by a manager for his or her own function, such as sales.
Note that management structure is much more formalised than management style; it is possible for
instance to have both democratic and autocratic managers within a particular management structure.
B. INFORMATION
Information and Data
Information can be distinguished from data in that the latter can be looked upon as facts and figures
which do not add to the ability to solve a problem or make a decision, whilst the former adds to
knowledge. If, for instance, a memo appears on a managers desk with the figure 10,000 written on
it, this is most certainly data but it is hardly information.
Information has to be more specific. If the memo had said sales increased this month by 10,000
units then this is information as it adds to the managers knowledge. The way in which data or
information is provided is also affected by the Management Information System (MIS) which is in
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use. Taking our example in a slightly different context, the figure of 10,000 may be input to the
system as an item of data which, at some stage, will be converted and detailed in a report giving the
information that sales have increased by 10,000 units.
Users of Information
The Corporate Report of 1975 set out to identify the objectives of financial statements and identified
the user groups which it considered were legitimate users of them. The following list is important in
that once we define whom a report is for, it can be tailored specifically to their needs.
Users of information and the uses to which that information can be applied are as follows:
! Managers to help in decision making.
! Shareholders and investors to analyse the past and potential performance of an enterprise and
to assess the likely return on investments.
! Employees to assess the likely wage rate and the possibility of redundancy and to look at
promotion prospects.
! Creditors to assess whether the enterprise can meet its obligations.
! Government the Office for National Statistics collects a range of accounting information to
help government in its formulation of policy.
! Inland Revenue to assess taxation.
Non-profit-making (or not-for-profit) organisations also need accounting information. For example, a
squash club has to establish its costs in order to fix its subscription level. A local authority needs
accounting information in order to make decisions about future expenditure and to fix the level of
contribution by local residents via the Council Tax. Churches need to keep records of accounting
information to satisfy the local diocese and to show parishioners how the churchs money has been
spent.
Characteristics of Useful Information
There are certain characteristics which relate to information:
(a) Purpose if information does not have a purpose then it is useless and there is no point in it
being produced. To be useful for its purpose it should enable the recipient to do his or her job
adequately. The ability of information to achieve its purpose depends on the following:
! The level of confidence that the recipient has in the information.
! The clarity of the information.
! Completeness.
! How accurate it is.
! How clear it is to the user.
(b) The recipients of the information must be clearly identified; for information to be useful it is
necessary to know who needs it.
(c) Timeliness information must be communicated when it is required. A monthly report which
details a problem must be produced as quickly as possible in order that corrective action can be
taken. If it takes a month to produce then this may be too long a time-scale for it to be useful.
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(d) Channel of communication information should be transmitted through the appropriate
channel; this could be in the form of a written report, graphs, informal decisions, etc.
(e) Cost as data and information cost money to produce, it is necessary that their value
outweighs their costs.
To summarise, having looked at the general qualities of information, the characteristics of good
information are:
! It should be relevant for its purpose.
! It should be complete for its purpose.
! It should be sufficiently accurate for its purpose.
! It should be understandable to the user.
! The user should have confidence in it.
! The volume should not be excessive.
! It should be timely.
! It should be communicated through the appropriate channels of communication.
! It should be provided at a cost which is less than its value.
C. COLLECTION AND MEASUREMENT OF
INFORMATION
Sources of Information
The information used in decision making is usually data at source and has to be processed to become
information. The main sources of information can be categorised as internal or external.
(a) Internal
The main sources and types of internal information, and the systems from which such
information derives, are summarised in the following table.
Source System Information
Sales invoices Sales ledger Total sales
Debtor levels
Aged debtors
Sales analysis by category
Purchase orders/Invoices Purchase ledger Creditor levels
Aged creditors
Total purchases by category
Wage slips Wages and salaries Total wages and salaries
Salaries by individual/department
Employee analysis (i.e. total number,
number by department)
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(b) External
There is a wealth of information available outside of the organisation and the following table
provides just a few examples:
Source Information
Market research Customer analysis, competitor analysis, product information,
market information.
Business statistics Exchange rates, interest rates, productivity statistics, social
statistics (i.e. population projections, family expenditure
surveys, etc.), price indices, wage levels and labour statistics.
Government Legislation covering all aspects of corporate governance such
as insider dealing, health and safety requirements, etc.
Specialist publications Economic data, foreign market information.
Some of the above overlap and there are certainly many more sources of information that you may be
able to think of, both internal and external. The uses that the information can be put to are greater
than the sources and will depend on whom the information is for. The sales department, for instance,
may wish to have details of a customer in order to market a new product to them, whilst the credit
control department may wish to have information which may lead them to decide that no more credit
should be given to the customer.
Again, a few moments reflection should provide you with many more examples of the uses to which
information can be put and the potential conflicts that can arise.
Relevancy
For information to be useful it has to be relevant and an accounting system is designed to be a filter
similar to the brain, providing only relevant information to management. Obviously the system must
be designed to comply with the wishes or needs of management.
Consider a manager who has to decide on a course of action in a situation where he plans to purchase
a machine, and has an operating team which can perform two distinct functions with the machine. It
would be irrelevant for him to consider the cost of the machine in his decision-making process as,
irrespective of which course of action he decides upon the cost of the machine remains the same.
Relevance is thus at the heart of any accounting or management information system. The accountant
must be familiar with the needs of the enterprise, since if information has no relevance it has no
value.
The inclusion of non-relevant data should be avoided wherever possible, since its inclusion may
increase the complexity of the decision-making process and potentially lead to the wrong decision
being taken.
Measuring Information
Accountants are used to expressing information in the form of quantified data. Accountants are not
unique in this approach; in the world of sport we record the performance of an athlete in the time he
takes to run a certain distance, or how far he throws the javelin, or how high he jumps. Even in
gymnastics the performance of the gymnast is reduced to numbers by the judges.
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Not all decisions can be reduced to numbers and although accounting information is usually
expressed in monetary terms, a management accountant must be prepared to provide accounting
information in non-monetary terms.
If management decides that it wishes to adopt a policy to improve employee morale and to foster
employee loyalty in order to achieve a lower labour turnover rate, the benefit in lower training costs
may be expressed in monetary terms, but the morale and loyalty cannot be directly measured in such
terms. Other quantitative and qualitative measures will be needed to evaluate alternative courses of
action.
In order to measure information the unit of measurement should remain stable, but this is not always
possible. Inflation and deflation affect the value of a monetary measure and we shall discuss how we
can allow for such changes when we consider ratios in a later study unit.
Finally, when considering measurement within an information system we must always be aware of
the cost of such a system. The value of measuring information must be greater than the costs
involved in setting-up the system.
Figure 1.1 illustrates the point that above a certain level of information the cost of providing it rises
out of all proportion to the value.
Figure 1.1
Communicating Information
A communication system must have the following elements:
! transmitting device
! communication channel
! receiving device.
These elements are required in order to communicate information from its source to the person who
will take action on this information. We can illustrate the process diagrammatically as follows:
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SOURCE OF
INFORMATION
TRANSMITTER
Communication
Channel
RECEIVER
ACTION
TAKEN
NOISE
Figure 1.2
So let us look at the various elements in the communication system as they apply to an accounting or
management information system. We have already considered the sources of information.
The accountant is the transmitter and he or she prepares an accounting statement to cover the
economic event. The accounting statement is the communication channel and the manager is the
receiver. The manager then interprets or decodes the accounting statement and either directly or
through a subordinate action is taken.
In a perfect system this should ensure that accountancy information has a significant influence on the
actions of management. However, noise can, by its nature, render a system imperfect.
Noise is the term used for interference which causes the message to become distorted. In accounting
terms this can be the transposition of figures or the loss of a digit in transmission. The minimisation
of noise in an accounting system can be achieved by building in self-checking devices and other
checks for errors.
Noise can also result from information overload, where the quantity of information is so great that
important items of information are overlooked or misinterpreted. Remember the importance of
relevance: too much irrelevant information will lead to information overload and the failure of the
receiver to identify essential information.
We must also consider the human factor in information. We shall mention this in a later study unit,
but for now it is important for you to note that the human factor can affect how managers use or fail
to use accounting information.
Value of Information
Any accounting system should operate in such a way that it provides the right information to the right
people in the right quantity at the right time.
We have already discussed the cost of providing information and the fact that the value of the
information should exceed the cost of providing it.
Consider the situation where a company is offered an order to the value of 500,000. The customer
would not be adversely affected if the company declined the order so there is no knock-on effect
whether the order is accepted or rejected. The cost of producing the order is estimated to be either
375,000 or 525,000.
The weighted average cost of production is thus:
375, 525,
450,
000 000
2
000
+
=
giving an expected profit of 50,000.
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If we assume that there is a 50% chance that costs will be 375,000, leading to a profit of 125,000,
and a 50% chance that costs will be 525,000 in which case the order would be rejected and no profit
and no loss would be made, the expected value of possible outcomes is:
125,
62,
000 0
2
500
+
=
In order to make a decision it would be necessary to obtain further information. Using the above two
profit figures of 50,000 and 62,500 we can establish that the gross value of information is 12,500
(62,500 50,000). The company could thus spend up to 12,500 on obtaining additional
information. If the information needed only cost 10,000 then the net value of information would be
2,500.
In this example we have assumed that the information that could be obtained was perfect information.
Information that is less than perfect (this applies to most information!) is called imperfect
information. To be perfect information in this case, the information would have to be such that the
cost of production would be known with certainty.
Quantitative and Qualitative Information
Quantitative information can be most simply described as being numerically based, whereas
qualitative information is more likely to be based on subjective judgements. Thus if the manager
concerned with a particular project is told that the potential cost of a contract will be either 375,000
or 500,000, then this is quantitative information. As we have seen, it is usually necessary to obtain
further information before a proper decision can be made and this may take the form of qualitative
data which will vary according to circumstances. Thus, the ability of a supplier to meet deadlines and
provide materials of a sufficient quality is all qualitative information.
Accuracy of Information
The level of accuracy inherent in reported information determines the level of confidence placed in
that information by the recipient of it; the more accurate it is the more it will be trusted.
Accuracy is one of the key features of useful information, for without it incorrect decisions could
easily be made. Returning to our earlier example, if the potential costs of the project under
consideration are assessed at either 275,000 or 375,000, then the average cost would be 325,000
and the expected profit (500,000 325,000) 175,000. Thus as both extremes produce a profit, it
is unlikely that additional information would be requested which would have shown that the costs
were inaccurate.
There is often, however, a trade-off between getting information 100% correct and receiving it in
time for a decision to be made. In this instance it is usual for an element of accuracy to be sacrificed
in the interests of speed.
The concept of accuracy and related areas such as volume changes and how uncertainty in relation to
accuracy is overcome will be discussed in more detail when we consider budgeting and variable
analysis.
Financial and Non-Financial Information
The most usual way for reporting to be undertaken is through the use of financial information in
terms of turnover, profit, ratio analysis, etc. Another way of defining this would be to say that
performance is cost based and the department being assessed is therefore a cost centre (which will be
more fully defined later). In certain circumstances, however, i.e. where costs cannot be allocated to a
department, then non-financial performance measures must be considered instead. Non-financial
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indicators will be described in detail in a later study unit, but for now one or two examples should
help. For a maintenance department, these indicators might include:
(a) production time, i.e.
Actual service time
Total time available
; or
(b) ratio of planned to emergency (or unplanned) services in terms of time.
D. INFORMATION FOR STRATEGIC, OPERATIONAL AND
MANAGEMENT CONTROL
Elements of Control
A large proportion of the information produced for and used by management is control information.
By having this information, managers will be aware of what is happening within the organisation and
its environment, and be able to use that information in making future plans and decisions. Control
information provides the means of identifying past mistakes and preventing their reoccurrence.
The diagrammatic representation of this is as follows:
ACTUAL RESULTS
SENSOR
Feedback
COMPARATOR
Standards
Variances
INVESTIGATOR
EFFECTOR
Figure 1.3: Single Loop Control System
The operation of the model is as follows:
(a) Results are measured via the sensor.
(b) These are compared with the original objectives or standards by the comparator.
(c) The process by which the information is collected and compared is known as feedback and this
will be looked at in more detail shortly.
(d) Corrective action is identified using variance analysis.
(e) The corrective action is implemented via the effector.
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As an example, suppose the planning department of a local authority has a target of producing a
particular planning report within three weeks from the date of the request. The fact that it takes on
average perhaps four weeks to produce such a report may be picked up by the internal audit
department or through the provision of standard control information detailing such items as the length
and content of the report. Whichever it is, this will be the sensor and the process of receiving the
information is the feedback.
The comparator compares the actual length of time taken to produce the report against the required or
expected time; in this instance four weeks as opposed to three. The operation of the comparator
could be carried out either internally or external to the department concerned. In the latter instance
the task could again fall to the internal audit department (assuming one exists of course).
The process of variance analysis would investigate the reasons why the time-scales are not being met.
At the basic level this will be either that the standards are set at such a level that they cannot be met,
or the standards are reasonable and it is the methods of achieving them that are inefficient.
Assume for the purposes of our current example that it is impossible, due to other circumstances, to
achieve a time-scale of three weeks. In this case it is likely that the standard would be altered to four
weeks.
The next time a planning report is produced, the process would be entered into and if the revised
time-scale was not being met, the reasons why would be investigated and appropriate action taken.
Feedback
Feedback may be described as being positive or negative. When a system is using a measured scale it
is travelling in any one of three directions at any time, i.e. it is travelling either:
(a) straight ahead; or
(b) in an upwards direction; or
(c) in a downwards direction.
Positive feedback is the term used when the corrective action needed is to move the system in the
direction it is already travelling in, e.g. when a favourable sales volume variance occurs it means
actual sales volume is higher than that budgeted. One course of action to exploit this favourable
variance is to increase production so that increased sales can be taken advantage of.
Negative feedback is the term used when the corrective action needed is to move the system in the
opposite direction to that in which it is travelling. For example, when the maximum level of stock for
a particular item is exceeded, the corrective action is to reduce the stock level for that item by
reducing production and/or increasing sales.
Control Information
The dividing line between control and decision making is a narrow one; in essence control is part of
the decision-making process which we shall look at in more detail shortly.
Control information systems are part of an organisations structure; the structure of most
organisations is a pyramid or hierarchy and therefore the control system operates in the same form.
The diagram of this is as follows:
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Figure 1.4: Flow of Control Information
The information flows are:
! between the levels, and
! within the same level.
Control information can be classified as follows:
(a) Strategic Control Information
This will be about the whole organisation and its environment. The main source of this
information will be from the organisations objectives, plans and budgets. It would also
include information on items such as interest and exchange rates, population trends, economic
trends and so on.
(b) Management Control Information
The information in this category will be about each division or department within the
organisation. It will specifically depend upon the way the organisation is structured and the
type of organisation it is. For instance, in an organisation structured by function, information
will be about each function such as manpower (personnel), sales (marketing), production and
finance for each division.
(c) Operating Control Information
This will be much more detailed and specialised than the previous two categories. It usually
relates to each operating department within the organisation, e.g. stock control, credit control,
etc.
To illustrate the differences a little more clearly, operating information could be the sales value for a
particular product, management control information the total sales value for the division concerned
and finally the total sales for the company an input to the strategic planning process.
Large organisations are frequently split into these smaller divisional units. In such organisations it is
essential that the top level of the organisations control system covers every division, as it is only
through the control system that top management can know what is happening in the whole
organisation.
STRATEGIC
CONTROL
MANAGEMENT
CONTROL
OPERATIONAL
CONTROL
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E. INFORMATION FOR DECISION MAKING
As we mentioned earlier, the control and decision-making processes are closely interwoven study
the following diagram:
Identify Objectives
Look for Various Courses of
Action
Gather Information on
Alternatives
Select Course of Action
Implement the Decision
PLANNING
Compare Actual Results with
Plan
CONTROL
Take Action to Correct Errors
Figure 1.5: Control and Decision Making
You will see from this that the control element we have studied forms an integral part of the process.
Note also the loop to allow us to make changes and see the effect this has on the system in order to
decide if such changes were the right ones. If, for example, we have a pair of shoes priced at 30 per
pair and we decide to reduce the price to 25 in order to shift some stock, we can then gather
information on the impact of the price change on the sales volume. If volumes remain fairly static,
we may decide to put the price back up or lower it still further and again measure the effect.
Planning is a long-term strategy and as such is determining the long-term view the strategic view.
Information must be collected on market size, market growth potential, state of the economy, etc.
The implications of long-term strategic decisions will influence operating or short-term decisions for
years to come and it is sometimes necessary to consider the operating decisions as part of the
planning process. Examples of short-term decisions are:
! level of the selling price of each individual item
! level of production
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! type of advertising
! delivery period
! level of after-sales service.
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17
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Study Unit 2
Cost Categorisation and Classification
Contents Page
Introduction 19
A. Accounting Concepts and Classifications 19
Financial Accounting 19
Management Accounting 19
B. Categorising Cost to Aid Decision Making and Control 21
Fixed and Variable 21
Relevant and Common Costs 21
Opportunity Costs 22
Controllable and Uncontrollable Costs 25
Incremental Costs 25
Other Definitions 26
A Worked Example of Relevant Costing 27
C. Management Responsibility Levels 29
Cost Centre 29
Service Cost Centres 29
Revenue Centres 29
Profit Centres 30
Investment Centres 30
D. Cost Units 30
E. Cost Codes 31
(Continued over)
18 Cost Categorisation and Classification
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F. Patterns of Cost Behaviour 32
Fixed Costs 33
Variable Costs 33
Stepped Costs 34
Semi-Variable Costs 35
Other Cost Behaviour Patterns 35
G. Influences on Activity Levels 36
H. Numerical Example of Cost Behaviour 36
Cost Categorisation and Classification 19
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INTRODUCTION
Now that we have had an introduction to management accounts and the importance of information,
we can start to look in more detail at how managerial accounting operates in practice. This study unit
will describe the different ways in which costs can be classified in order to provide meaningful
management information. You should always bear in mind that the ultimate purpose of any
management accounting system is to provide information for management to make decisions.
In addition to cost classification, we shall look further at how costs behave under differing conditions
an important thing to understand when making decisions based on the information to hand as well
as how this information is likely to be presented to you.
A. ACCOUNTING CONCEPTS AND CLASSIFICATIONS
Financial Accounting
The accounts for limited companies are prepared and presented in accordance with the Companies
Act, Statements of Standard Accounting Practice (SSAPs) and Financial Reporting Standards (FRSs).
These legal and quasi-legal requirements endeavour to ensure that uniform methods are used in
arriving at the profit or loss for the period and valuations for balance sheet purposes. The principles
should already be familiar to you through your accounting studies. No similar set of guidelines or
legal requirements applies to management accounting reports and statements, and therefore these are
normally designed to meet the needs of the individual firm.
Management Accounting
(a) Categories of Cost
The following CIMA definitions relate to general concepts and classifications used in cost and
management accounting. An understanding of these is a necessary starting point in your
studies, before you commence the more detailed analyses which follow later in the course.
! Direct Materials
The cost of materials entering into and becoming constituent elements of a product or
saleable service and which can be identified separately in product cost.
! Direct Labour
The cost of remuneration for employees efforts and skills applied directly to a product
or saleable service and which can be identified separately in product costs.
! Direct Expenses
Costs, other than materials or labour, which can be identified in a specific product or
saleable service.
! Indirect Materials
Materials costs which are not charged directly to a product, e.g. coolants, cleaning
materials.
! Indirect Labour
Labour costs which are not charged directly to a product, e.g. supervision.
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! Indirect Expenses
Expenses which are not charged directly to a product, e.g. buildings insurance, water
rates.
! Prime Cost
The total cost of direct materials, direct labour and direct expenses. The term prime
cost is commonly restricted to direct production costs only and so does not customarily
include direct costs of marketing or research and development.
! Conversion Cost
Costs of converting material input into semi-finished or finished products, i.e.
additional direct materials, direct wages, direct expenses and absorbed production
overhead.
! Value Added
The increase in realisable value resulting from an alteration in form, location or
availability of a product or service, excluding the cost of purchased materials or
services.
Note: Unlike conversion cost, value added includes profit.
! Overhead Cost
The total cost of indirect materials, indirect labour and indirect expenses. (Note that
overhead costs may be classified under the main fields of expenditure such as
production, administration, selling and distribution, research.)
(b) Specimen Calculation
Direct materials X
Direct labour X
Direct expenses X
Prime cost X
Production overhead X
Manufacturing cost X
Administration overhead X
Selling and distribution X
Total cost X
Profit X
Sales X
Conversion cost = prime cost +production overhead absorbed or charged against production.
Value added = sales direct materials and purchased services.
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B. CATEGORISING COST TO AID DECISION MAKING
AND CONTROL
Categorisation of costs is an important early step in the decision-making process; if it is carried out
correctly it should become much easier to make decisions. Even though the cost data used is
historical, correct categorisation can help in future assessment. Thus, if a cost is fixed (we shall look
at this concept in more detail below) regardless of the level of activity, then it is an easy matter to
assess its likely future impact on the business. Similarly, identifying those costs which the manager is
able to influence is essential if those costs are to be properly controlled.
We shall now go on to look in more detail at several different methods of categorisation.
Fixed and Variable
Costs may be categorised according to the way they behave. This is a very important distinction
which will be developed later and is a major factor in marginal costing and decision making.
(a) Fixed Costs
Fixed costs are costs that do not change as output either increases or decreases. Examples
would include rent and rates.
(b) Variable Costs
Variable costs are costs that will change in direct proportion with the increase or decrease in
output. For example, direct material costs will increase in direct proportion to any change in
output.
(c) Semi-Fixed Costs
Semi-fixed costs will change with the increase or decrease in output. However, in this case
there will not be a proportionate relationship. As its name implies, semi-fixed costs include
elements of both fixed and variable costs. For example, telephone costs include a fixed
element (the rental charge) and a variable call cost.
(d) Stepped Costs
Strictly speaking, these costs are fixed but change at a certain point in volume. For example,
we have already seen that rent is a fixed cost but this only applies up to a certain level of
volume; it is likely that new premises would be required when volume exceeds this optimum
point, but then this element of cost would remain fixed until those new premises were
outgrown, and so on.
Ultimately all costs are variable but the time-scales concerned vary for all costs and so some never
change. This classification applies to a number of costs found in industry and commerce. However,
in order to aid decision making it is necessary to break down these costs into their fixed and variable
components. Details on how this is achieved will be given later in the course.
Relevant and Common Costs
When managers are deciding between various courses of action, the only information which is useful
to them is detail about what would be changed as a result of their decision, i.e. they need to know the
relevant costs (or incremental or differential costs). The CIMA defines relevant costs as costs
appropriate to aiding the making of specific management decisions.
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Common costs are those which will be the same in the future regardless of which option is favoured,
and they may be ignored. A frequent example of this is fixed overheads; you may be told a fixed
overhead absorption rate, but unless there is evidence that the total fixed overhead costs would
change as a result of the decision, fixed overhead may be ignored.
Opportunity Costs
An opportunity cost is the value of a benefit sacrificed in favour of an alternative course of action.
This is an important concept, and the following example gives you practice in using opportunity
costs.
Example
Itervero Ltd, a small engineering company, operates a job order costing system. It has been invited to
tender for a comparatively large job which is outside the range of its normal activities and, since there
is surplus capacity, the management are keen to quote as low a price as possible.
It is decided that the opportunity should be treated in isolation without any regard to the possibility of
its leading to further work of a similar nature (although such a possibility does exist). A low price
will not have any repercussions on Iterveros regular work.
The estimating department has spent 100 hours on work in connection with the quotation and they
have incurred travelling expenses of 1,100 in connection with a visit to the prospective customers
factory overseas. The following cost estimate has been prepared on the basis of their study:
Inquiry 205H/81
Cost Estimate

Direct material and components
2,000 units of A at 50 per unit 100,000
200 units of B at 20 per unit 4,000
Other material and components to be bought in (specified) 25,000
129,000
Direct labour
700 hours of skilled labour at 7 per hour 4,900
1,500 hours of unskilled labour at 4 per hour 6,000
Overhead
Department P 200 hours at 50 per hour 10,000
Department Q 400 hours at 40 per hour 16,000
Estimating department
100 hours at 10 per hour 1,000
Travelling expenses 1,100
Planning department
300 hours at 10 per hour 3,000
171,000
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The following information has been brought together.
! Material A: this is a regular stock item. The stock holding is more than sufficient for this job.
The material currently held has an average cost of 50 per unit but the current replacement cost
is 40 per unit.
! Material B: a stock of 4,000 units of B is currently held in the stores. This material is slow-
moving and the stock is the residue of a batch bought seven years ago at a cost of 20 per unit.
B currently costs 48 per unit but the resale value is only 36 per unit. A foreman has pointed
out that B could be used as a substitute for another type of regularly used raw material which
costs 40 per unit.
! Direct labour: the workforce is paid on a time basis. The company has adopted a no
redundancy policy and this means that skilled workers are frequently moved to jobs which do
not make proper use of their skills. The wages included in the cost estimate are for the mix of
labour which the job ideally requires. It seems likely, if the job is obtained, that most of the
2,200 hours of direct labour will be performed by skilled staff receiving 7 per hour.
! Overhead Department P: Department P is the one department of Itervero Ltd that is working
at full capacity. The department is treated as a profit centre (see later) and it uses a transfer
price of 50 per hour for charging out its processing time to other departments. This charge is
calculated as follows:
Estimated variable cost per machine hour 20

Fixed departmental overhead 16
Departmental profit 14
50
! Department Ps facilities are frequently hired out to other firms and a charge of 60 per hour is
made. There is a steady demand from outside customers for the use of these facilities.
! Overhead Department Q: Department Q uses a transfer price of 40 for charging out
machine processing time to other departments. This charge is calculated as follows:
Estimated variable cost per machine hour 16

Fixed departmental overhead 18
Departmental profit 6
40
! Estimating department: the estimating department charges out its time to specific jobs using a
rate of 10 per hour. The average wage rate within the department is 5 per hour but the higher
rate is justified as being necessary to cover departmental overheads and the work done on
unsuccessful quotations.
! Planning department: this department also uses a charging out rate which is intended to cover
all departmental costs.
You are required to restate the cost estimated by using an opportunity cost approach. Make any
assumptions that you deem to be necessary and briefly justify each of the figures that you give.
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Solution
Cost Estimate Using Opportunity Cost Approach
Notes
Direct material and components:
Material A 2,000 units at 40 80,000 (a)
Material B 200 units at 40 8,000 (b)
Other material and components 25,000
113,000
Direct labour - (c)
Overhead:
Department P 200 hours at 60 per hour 12,000 (d)
Department Q 400 hours at 16 per hour 6,400 (e)
Estimating department - (f)
Planning department - (g)
Opportunity cost of accepting job 131,400
Notes
(a) As a result of using Material A on this job, future requirements will have to be bought at a price
of 40. The replacement cost is therefore the opportunity cost.
(b) If Material B was not used on this job, the best use to which it could be put would be as a
substitute for the other raw material. The cost of this material, 40, is therefore the opportunity
cost. The replacement cost of B, 48, is not relevant, since this stock has been held for seven
years, and it seems unlikely that the material would be replaced.
(c) The skilled labour which will be used on this job will be paid 7 per hour, whether or not this
job is taken. Assuming that no extra labour will be hired as a result of this job, the opportunity
cost is nil.
(d) Since Department P is working at full capacity, any extra work that must be done in this
department would mean that the company forgoes the opportunity to hire out the facilities to
other firms. The opportunity cost of using Department Ps facilities is therefore 60 per hour.
(e) The cost per hour of 40 for Department Q includes two items which are not relevant to this
decision. The fixed departmental overhead of 118 would be incurred anyway, even if this job
is not undertaken, and can therefore be excluded. The departmental profit of 16 can also be
excluded, since we are giving an estimate of cost, on to which, hopefully, a profit margin will
be added. The relevant cost is therefore the incremental cost incurred per hour in Department
Q, i.e. 16 per hour.
(f) None of the costs of the estimating department will now be affected by a decision to accept this
job. The wages and travelling expenses incurred are past or sunk costs (see later), and are not
relevant to the opportunity cost estimate.
(g) All of the planning department costs seem to be costs that will be incurred anyway, regardless
of whether or not this job is accepted. They are not, therefore, relevant to the decision.
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N.B. If you are given this type of question in the examination, it is important that you state clearly
any assumptions that you make. Your point of view on what constitutes a relevant cost may differ
from that of the examiner, so it is vital that you discuss your reasoning in your answer.
Usefulness of Opportunity Costs
Opportunity costs should be used with caution. They were useful in the example given above,
because the lowest possible price was required, and we were told that a low price on this job would
not have any repercussions on Iterveros regular work.
It is important that managers do not lose sight of the need to cover past costs and fixed costs in the
long run (e.g. the travelling expenses, in this example) in order to make profits.
Bearing this in mind, it is essential that you have all relevant information to hand. In any
examination questions, you should always look out for past costs.
Controllable and Uncontrollable Costs
The distinction between these two classifications depends upon managements ability to influence
cost levels.
! Controllable costs include those expenses that can be controlled by the respective manager.
! Uncontrollable costs include those expenses that cannot be controlled by the respective
manager. Such expenses may include rent, rates and depreciation.
Classification of a cost as either controllable or uncontrollable will probably be influenced by the
managers position within the business. A director will be able to influence more costs than a
departmental manager.
Control over managers financial performance will be exercised through the companys budgetary
control system. The distinction between controllable and uncontrollable costs is therefore very
important. Managers should be held accountable only for the costs over which they have control. In
practice you may find statements which, for example, apportion some administrative overheads to
each manager. In this case administrative overspends may feature on the line managers control
statement even though he or she is not in a position to control these expenses. This type of approach
can have dysfunctional effects on the company and should be avoided if possible.
Incremental Costs
The CIMA definition of incremental costing is:
A technique used in the preparation of ad hoc information where consideration is given
to a range of graduated or stepped changes in the level or nature of activity, and the
additional costs and revenues likely to result from each degree of change are presented.
Put simply, they are the additional costs incurred as a consequence of a decision and can be used
where these options are being considered.
Incremental costing is useful in deciding on a particular course of action where the effect of
additional expenditure can be measured in sales. This is commonly applied to advertising
expenditure and the incremental increase in revenue.
Suppose, for example, that a particular company with sales of 2 million and an annual advertising
budget of 75,000 earns a contribution from sales of 700,000. Additional advertising expenditure
would increase sales at the following rate:
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Increase in
Advertising
Increase in Sales
%
5,000 1
Additional 5,000 0.5
Additional 5,000 0.25
We can now calculate the effect of the incremental advertising expenditure on sales and compare this
to the additional contribution earned to ascertain if it is worth undertaking.
Increase in
Advertising
Increase in
Sales
Increase in
Contribution
Marginal
Profit/(Loss)
5,000 20,000 (1%) 7,000 (35%) 2,000

Additional 5,000 10,000 (0.5%) 3,500 (1,500)
Additional 5,000 5,000 (0.25%) 1,750 (3,250)
As you can see, the extra benefit from increasing the advertising expenditure only extends to the first
additional 5,000. Thereafter the additional contribution earned does not cover the additional
expenditure.
Other Definitions
(a) Avoidable Costs
These are defined as Those costs, which can be identified with an activity or sector of a
business and which would be avoided if that activity or sector did not exist.
The concept of avoidable cost applies primarily to shut-down and divestment decisions and
numerical examples of these will be covered in a later study unit.
(b) Committed Costs
These are costs already entered into but not yet paid, which will have to be paid at some stage
in the future. An example would be a contract already entered into by an organisation.
(c) Sunk Cost
This is a cost that has already been incurred. The money has been spent and cannot be
recovered under any circumstances.
For example, 20,000 may have been spent on a feasibility study for a particular project that a
property development firm is considering undertaking. A further 250,000 needs to be spent if
the project goes ahead which will generate income of 260,000. In this situation the sunk costs
may be ignored and the decision on whether to continue with the project can be made by
comparing future sales with future costs. Assuming that there are no non-financial reasons for
not continuing with the project then it should be undertaken, as it will generate additional sales
of 260,000 and incur additional costs of 250,000. As a result the business will be 10,000
better off.
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However, it must be stressed that in the long term a company must recover all costs, and even
though in this example it pays the company to proceed with the project, it must not lose sight
of the fact that it has actually lost 10,000 on the order.
(d) Notional Cost
A company may include a cost in its profit and loss account even though the cost has not been
incurred. For example, a holding company may control subsidiaries that own land and other
subsidiaries that have to pay rents. This accident of history may distort the operating
performances of these subsidiary companies, and to compensate for this, the holding company
may decide that companies will prepare accounts as if all the property was rented. In this case
those subsidiaries that own land will charge a notional rent cost in their accounts. In this way a
meaningful comparison can be made between each companys operating performance.
A Worked Example of Relevant Costing
New Facility PLC is currently undertaking a research project which to date has cost the company
300,000. This project is being reviewed by management. It is anticipated that should the project be
allowed to proceed, it will be completed in approximately one year, when the results are expected to
be sold to a government department for 600,000. The following is a list of additional expenses
which the Board of Directors estimate will be necessary to complete the project:
(a) Materials 120,000
This material, which has just been delivered, is toxic and if not used in the project would have
to be disposed of by a specialised contractor at a cost of 15,000.
(b) Labour 80,000
Personnel employed on the project are difficult to recruit and were transferred from a
production department. At a recent directors meeting the Production Director requested that
these members of staff should be returned to the production department because they could
earn the company an additional 300,000 sales in the next year. The Management Accountant
calculates that the prime cost of these sales would be 200,000 and the fixed overhead
absorbed would be 40,000.
(c) Research Staff 120,000
A decision has already been made that this will be the last research project undertaken by the
company, consequently when work on this project ceases the specialist research staff employed
will be made redundant. Redundancy and other severance pay is estimated to be 50,000.
(d) Share of General Business Services 75,000
The directors are not sure what specifically is included in this cost but a similar charge is made
each year to each department.
Required: assuming the estimates are accurate, advise the Board of Directors on the course of action
to take. You must explain the reasons for your treatment of each item, carefully and clearly.
Suggested Solutions
The first thing to do when answering questions like this is to define the possible courses of action.
These are:
! To terminate the project immediately; this means the production workers can be redeployed on
alternative work.
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! To continue the project for another year and sell the results to the government department.
A financial comparison must be made of the two options, using both relevant and differential costing.
You can either work out the costs and benefits of terminating the project or continuing with it.
Costs and Benefits of Continuing With the Project

Sale proceeds of the project work 600,000
Cost saving of using the material (a) 15,000
Total expected benefit 615,000
Total relevant cost of continuing with the project
Labour cost of project (b) 80,000
Contribution lost by using production labour (c) 100,000
Research staff costs (d) 120,000 (300,000)
Contribution earned by continuing with the project 315,000
Notes and Workings
(a) The disposal cost of material is a benefit because it will only be incurred if the project is
discontinued.
(b) The production labour cost is included because it is a direct cost of the project.
(c) This figure is calculated as follows:

Sales revenue earned by production labour engaged in alternative work 300,000
less Prime cost of this work (200,000)
Contribution this is an opportunity cost of continuing with the project 100,000
(d) This cost is included because it will only be incurred if the project continues.
The following costs are not relevant:
! The cost to date of 300,000; this is a sunk cost.
! Material costs of 120,000; this is a sunk cost the materials are already in stock.
! Fixed production overhead 40,000; this cost is not relevant to the project.
! Research staff redundancy costs of 50,000; this cost is not relevant as it will be incurred
whether the project is terminated or continues. The question states that this is the last research
project the company will undertake.
! General business services 75,000; this is an arbitrary apportionment of an overhead and is not
relevant to the project.
Recommendation: based upon financial information alone the project should be proceeded with as
it results in an expected contribution of 315,000.
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Other factors which should also be taken into account are:
! How certain it is that the results will be purchased by the government department.
! If the project continues the directors can review their decision to discontinue further research
work in one years time.
! How certain it is that production workers can be used on alternative work.
! To discontinue the project would lead to a reduction in labour morale in the company.
! Competitors may recruit research staff if the project is discontinued. Competitors will then
benefit from the work.
(Note carefully how the topics covered in this study unit relate to this decision-making question.)
C. MANAGEMENT RESPONSIBILITY LEVELS
Cost Centre
This is any unit within the organisation to which costs can be allocated, and is defined by CIMA as a
location, function or items of equipment in respect of which costs may be ascertained and related to
cost units for control purposes. It could be in the form of a whole department or an individual,
depending on the preferences of the organisation involved, the ease of allocation of costs and the
extent to which responsibility for costs is decentralised.
Thus an organisation which prefers to make senior management alone responsible will probably have
very few centres to which costs are allocated. On the other hand, firms which allocate responsibility
further down the hierarchical ladder are likely to have many more cost centres.
If we were to take as an example a small engineering firm, it may be the case that it is organised so
that each machine is a cost centre. It may also be the case, of course, that it is not always beneficial
to have too many cost centres. This is partly because of the administrative time involved in keeping
records, allocating costs, investigating variances and so on, but also because an operative of a single
machine, for instance, may have no control over the costs of that machine in terms of power, raw
materials, etc., along with any apportioned cost.
This brings us to another point, which is the distinction between the direct costs of the centre and
those which are apportioned from elsewhere (e.g. general overheads). Although it is important to
allocate out as much cost as possible, it must also be remembered that the cost centre has no control
over the apportioned cost. This is important when considering who is responsible for the costs
incurred.
Service Cost Centres
These generally have no output to the external market but provide support internally.
Revenue Centres
These are concerned with revenues only, and are described in the CIMA Official Terminology as a
centre devoted to raising revenue with no responsibility for production, e.g. a sales centre, often used
in a not-for-profit organisation. In a commercial organisation therefore it may be that a particular
marketing department would be judged on its level of sales. The drawback of this approach,
however, is that it gives no indication as to the profitability of those sales.
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Profit Centres
As their name suggests, profit centres are areas of the organisation for which sales and costs are
identifiable and attributable, and are defined by CIMA as a segment of the business entity by which
both revenues are received and expenditures are caused or controlled, such revenues and expenditure
being used to evaluate segmental performance. A profit centre will usually contain several cost
centres and thus will be a much larger unit than a cost centre. To be effective, the person responsible
must be able to control the level of sales as well as the levels of cost being incurred. Where a profit
centre does not sell to the external market but instead provides its output to other areas of the
organisation internally, then its performance may well be judged by the use of transfer prices. This
will be the sales value to the profit centre concerned and the cost to the centre to which the output is
transferred.
Investment Centres
In this final example the manager of the unit has discretion over the utilisation of the capital
employed. CIMA defines it as a profit centre in which inputs are measured in terms of expenses and
outputs are measured in terms of revenues, and in which assets employed and also measured, the
excess of revenue over expenditure then being related to assets employed.
An investment centre is therefore the next step up from a profit centre and is likely to incorporate
several of the latter.
D. COST UNITS
An important part of any costing system is the ability to apply costs to cost units. The CIMA Official
Terminology describes cost units as A quantitative unit of product or service in relation to which
costs are ascertained.
Thus, a cost unit in a hospital might be an operation or the cost of a patient per night. Generally, such
terms are not mutually exclusive, although it is of course better to take a consistent approach to aid
comparison. Once the cost system to be used by the particular organisation has been identified, costs
can be coded to it (we shall look at cost codes in more detail shortly) and its total cost built up. This
figure can then be compared with what was expected or what happened last year or last month and
appropriate decisions taken if action is required.
The point is that the organisation is able to identify the lowest item in the system that incurs cost,
which can then be built up into the total cost for a cost centre by adding all the costs of the cost units
together. By adding sales values to the cost units the cost centre becomes a profit centre.
It is not always possible to identify exactly how much cost has been incurred by a particular item; in
certain instances it is not possible to allocate cost except in an arbitrary way. It could be that the
costing system in use is not sophisticated enough to cope.
Different organisations will use different cost units; in each case it will be the most relevant to the
way they operate. Here are a few examples:
! Railways cost per tonne mile.
! Airlines cost per flight/cost per passenger.
! Manufacturing cost per batch/cost per contract.
! Oil extraction cost per 1,000 barrels.
! Textile manufacture cost per garment.
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! Football clubs cost per match.
! Car manufacture cost per vehicle.
E. COST CODES
Having looked at how costs are identified in order to build up the costs incurred by cost units and
cost centres, it is useful at this point to look briefly at how the physical allocation of such costs is
undertaken. Costs are allocated by means of cost codes, which is defined by CIMA as:
A system of symbols designed to be applied to a classified set of items, to give a brief
accurate reference facilitating entry, collation and analysis.
Every business will have its own coding system unique to the way it is organised and the types of cost
it incurs. Some will be more complex than others, but remember the objective of any coding system
is to allocate costs accurately and consistently, to aid interpretation and decision making.
The CIMA definition goes on to cite an example:
... in costing systems, composite symbols are commonly used. In the composite symbol
211.392 the first three digits might indicate the nature of the expenditure (subjective
classification), while the last three digits might indicate the cost centre or cost unit to be
charged (objective classification).
Alternatively, a coding system might be set up with the objective classification before the subjective
classification. For instance, an insurance company, which operates on a nationwide basis, may have a
centralised system for paying overheads which need to be allocated to its divisions. Each division is
also split into three regions, all of which operate as cost centres. The following is an example of how
it might be set up:
Southern 30
Thames Valley 01
S. West 02
Wessex 03
Midlands 40
E.Anglia 11
Central 12
E. Mids 13
Northern 50
Yorks 21
Lancs 22
Cumbria 23
Thus, each region within a division has a four digit stem code which is used to allocate costs to it. In
addition to the above, there will be a list of overhead codes which cover all the different types of cost
incurred, such as salaries, rent and rates of office buildings, telephones, entertaining expenses and so
on. Suppose that the following is an extract from the overhead code listing:
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Salaries: Administration 1100
Sales 1200
Marketing 1300
Office Expenses: Telephones 2100
Rent and Rates 2200
Cleaning 2300
The overhead codes used need not be four digit as we have shown; they could be two, three, five or
whatever, depending on how the system is set up.
The cost code for Marketing salaries in Lancashire, for example, would therefore be 50 22 1300 and
for cleaning in Wessex it would be 30 03 2300. The list of codes used would, of course, be much
more extensive than that shown, in order to make coding a simple exercise which is not open to
subjectivity, so that those using the costing information can be confident that it is accurate and
consistent.
The important elements of a good coding system are as follows:
! The coding system should be simple to operate.
! It should be capable of being easily understood by non-financial managers.
! It should be logical so that where there are a number of people responsible for coding items, it
is easy to be consistent.
! The coding system should allow for expansion so that new costs can be easily incorporated
without the need for major changes.
! All codes should be issued centrally to avoid confusion or duplication.
F. PATTERNS OF COST BEHAVIOUR
Costing systems are designed to collect information on historic costs but what they are not designed
to do is provide information on what those costs will be in the future. This is the remit of the
management accounting function, which will take this historic cost and extrapolate it forward for the
length of time under consideration.
In order to predict with confidence, it is necessary to know exactly how these costs will behave in the
future. We have already seen that costs may be categorised as fixed, semi-variable or variable and it
is therefore important to know into which category such costs will fall in the future.
Furthermore, it is also necessary to know what influences will cause such costs to change. It could
be, for instance, that supervising costs have remained static in the past, but suppose that turnover is
forecast to rise in the future to the critical point at which more supervising costs are needed (this is
known as a stepped cost which we shall look at in more detail shortly). To be accurate in our
forecasting we need to know not only that supervising costs do display this tendency but also, and
more importantly, the point at which the change is reached.
When considering cost behaviour it is important to remember that we are only considering situations
in which changes in activity cause any changes in the level of cost incurred. We shall look at other
influences on changes in cost behaviour later.
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Fixed Costs
We have already defined a fixed cost as one that does not vary with output. In graphical terms we can
show total fixed costs as follows:
Figure 2.1: Total Fixed Costs
Thus, if we have fixed costs of 100,000 and produce one unit of production, the cost per unit is
100,000, but if we produce 100,000 units the unit cost falls to 1.
Figure 2.2: Unit Fixed Costs
Variable Costs
These are costs which do vary directly with the level of output, so that if 1 worth of material is used
in the production of one unit, then 10,000 worth will be used in the production of 10,000 units. This
presupposes that no bulk-purchase discounts are available and there is no wastage (or at least it is at a
constant rate per unit).
Total
cost ()
100,000
Activity level
0
Unit
fixed
costs ()
Activity level
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Figure 2.3: Total Variable Cost
The following graph indicates that the variable cost per unit remains constant.
Figure 2.4: Unit Variable Costs
Stepped Costs
These are costs which are fixed up to a certain point but vary after this point, and are then fixed once
again.
Figure 2.5: Stepped Cost
Total
variable
cost ()
Activity level
Unit
variable
cost ()
Activity level
Total
cost ()
Activity level
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Wages and salaries are an example of this type of cost; the number of employees will be constant up
to a certain level, after which more employees will be required.
Fixed asset depreciation is another example of this type of cost; the amount will be fixed for each
asset owned but the total cost will vary with the number of machines.
Semi-Variable Costs
This type of cost incorporates both fixed and variable elements; a good example would be a gas or
electricity bill which has a fixed charge regardless of usage and a variable charge based on the
number of units consumed.
Other Cost Behaviour Patterns
Bulk-purchase discounts may have an important effect on the cost per unit of an item; the effect will
depend very much upon how the discount is applied. Three possibilities are shown in the following
figures.
Figure 2.6: Fixed minimum charge, variable with output
Figure 2.7: Variable charge, fixed above certain activity level
Total
cost ()
Activity level
Fixed charge
Variable charge
Total
cost ()
Activity level
Fixed charge
Variable charge
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Figure 2.8: Retrospectively applied discount at set activity levels
G. INFLUENCES ON ACTIVITY LEVELS
We have already seen that the distinction between a cost being fixed or variable is affected by activity
of the business concerned. It is useful, therefore, to consider the influences that can change the
current or expected level of activity.
! Capacity levels: less cost will be incurred if the company is operating below full capacity, as
there is less likelihood that new plant and machinery is required, with resultant lower set-up
costs.
! Time-scales involved: if the increase in activity is short-lived, it may be possible to cope with
existing resources.
! Labour force: greater automation and mechanisation may mean that increased activity levels
may be absorbed at lower cost. Labour-intensive industries may need to take on additional
workers.
! Economic climate: a strong general economy may mean that the company will have difficulty
in obtaining the necessary resources to cope with an increase in activity.
H. NUMERICAL EXAMPLE OF COST BEHAVIOUR
To finish off this area, it will be useful to look at a numerical example of the effects of activity on
different types of cost.
An architects practice employing 10 staff has an annual salary bill of 240,000 including on-costs
such as National Insurance and provision of vehicles where appropriate. The office has four
Computer Aided Design (CAD) machines that cost 6,000 each new and are depreciated over three
years. Office rental is 25,000 per annum, fixed office costs (cleaning, office equipment,
maintenance, etc.) is 10,000 per annum and there are variable costs that vary with the level of work
undertaken at the rate of 4,000 per contract undertaken. Each contract has an approximate value of
20,000.
At present 18 contracts are expected to be completed in the current financial year. One new contract
will require an extra employee, but a further new contract could be undertaken with the increased
Total
cost ()
Activity level
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workforce. What is the financial position now and what would it be with one and two additional
contracts?
The current position is as follows:

Sales (18 20,000) 360,000
less: Salaries 240,000
Office Rental 25,000
Variable Office Costs (18 4,000) 72,000
Fixed Office Costs 10,000
Depreciation (4 20,000) 8,000 355,000
Net Profit 5,000
Now let us see what the position is with a change in the level of activity when one new contract is
undertaken and the cost base alters.

Sales (19 20,000) 380,000
less: Salaries 264,000
Rental 25,000
Variable Office Costs (19 4,000) 76,000
Fixed Office Costs 10,000
Depreciation (5 20,000) 10,000 385,000
Net Loss 5,000
You can see from this scenario that the increase in activity has led to increases in costs that appeared
fixed at the lower level, namely salaries and depreciation. In effect these have become stepped costs.
The profit of the contract taken in isolation is:

Sales 20,000
Variable Cost (4,000)
Salary Increase (24,000)
Depreciation Increase (2,000) (30,000)
Net Loss 10,000
With the second additional contract the position alters to:
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Sales (20 20,000) 400,000
Salaries (264,000)
Office Rental (25,000)
Variable Office Costs (80,000)
Fixed Office Costs (10,000)
Depreciation (10,000) (389,000)
Net Profit 11,000
So we can see that the contract has improved the profitability by 16,000 (20,000 increased sales
value less the increase in variable costs of 4,000). Note also that salaries and depreciation have
once again become a fixed cost when viewed purely in terms of this transaction.
39
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Study Unit 3
Direct and Indirect Costs
Contents Page
Introduction 40
A. Material Costs 40
Material Control Systems 40
Stock Levels 40
Economic Order Quantity 41
Materials Control Accounting Records 42
Materials Handling Costs 43
B. Labour Costs 43
Controlling Direct Labour Cost 43
Timekeeping and Time Booking 44
Methods of Remuneration 45
Treatment of Overtime 46
Labour Turnover 47
C. Decision Making and Direct Costs 48
D. Overhead and Overhead Cost 49
What is Overhead Cost? 49
Identification of Overheads 49
Problem of Overheads for the Modern Manager 49
Classifying Overheads 49
40 Direct and Indirect Costs
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INTRODUCTION
Having studied cost units with various categorisations of cost, and the various management
responsibility levels, in this study unit we will concentrate on the costs themselves. The usual split is
between direct and indirect; the former can be identified with the associated unit of production,
whilst the latter have to be allocated, apportioned or expensed according to the particular system in
use.
A. MATERIAL COSTS
When considering the unit cost of an item, the three major elements of direct cost are materials,
labour and direct production overhead. The last two elements will be considered shortly, so we will
look at materials in more detail now.
Material Control Systems
Expenditure on materials may be a major part of total cost, so that a sound system of control through
all stages from purchasing to conversion into finished goods is essential. Material control systems
are often computerised and provide essential links with the financial, cost and management
accounting systems. In order for the control system to be effective, requests for the purchase of
materials must only be made by suitably authorised personnel and must be made to the purchase
officer, who can co-ordinate the requirements of several departments.
The purchasing officer should maintain records so that the best possible terms can be obtained for the
goods required. (This will usually mean the best possible price, but occasionally it may be necessary
to accept a higher price, for instance to obtain speedier delivery.)
Stock Levels
In order to ensure that the flow of production is not impaired by a lack of materials, and also that
excessive capital is not tied up in stocks, it is necessary to make sure that the level of stock held
always lies between certain limits.
(a) Maximum Quantity
This represents the greatest amount of an item of stock which should be carried, if the best
use of working capital is to be made.
In determining the maximum stock level, the following are among the factors to be considered:
! Capital tied up in stocks.
! Cost of storage (including rent, insurance, labour costs).
! Storage space available.
! Consumption rate.
! Economic purchasing quantities.
! Market conditions and prices and seasonal considerations.
! Nature of the material possible deterioration or obsolescence.
Direct and Indirect Costs 41
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(b) Minimum Quantity
This represents the level below which the stock should not normally be allowed to fall if the
requirements of production are to be met.
The minimum level is determined by the rate of consumption of materials and the time taken
between placing an order and receiving the material.
(c) Reorder Level
It is necessary to set a point at which an order must be placed. This point is known as the
reorder level. It will be higher than the minimum level, to cover use during the period before
the order is received (the reorder period).
(d) Reorder Quantity
The reorder quantity is the quantity which should be ordered at the time the reorder level is
reached. It will depend on the discounts available from suppliers for bulk ordering, the cost of
placing an order and the cost of storage.
Economic Order Quantity
There is a formula which indicates to a company the optimum batch size in which to purchase
goods. The formula is:
Q =
2DS
H
where: Q = the economic order quantity;
D = the annual demand for the product;
S = is the fixed cost of placing an order, i.e. delivery charges, clerical time in placing the
order, checking invoice, etc. which does not vary with the size of the order; if the
goods are produced internally it will include fixed production costs incurred
specifically in producing the batch, e.g. tool setting; and
H = the annual cost of holding one unit of stock.
Notice that the model is rather limited. The unit cost is assumed to be constant. There is no
provision for quantity discounts which might make it more attractive to purchase larger quantities.
Example
A company uses 4,000 components of type A in a year. The cost of placing an order is 20. The
stockholding cost is 4 per item per year. Stocks are replenished when the stock level falls to
50 units; orders placed are received the same day. Calculate the economic order quantity.
Solution
Using the formula: Q =
2DS
H
Then: Q=
4
20 4,000 2
= 40000 ,
= 200
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Therefore, orders should be placed for batches of 200 units at a time.
Materials Control Accounting Records
(a) Perpetual Inventory and Continuous Stocktaking
When the balances of stock are recorded after each issue or receipt of materials, a perpetual
inventory is in operation. This can be combined with a continuous stocktaking system,
whereby a few items are physically counted every day.
The advantages of this system are as follows:
! The temporary dislocation of work caused by end-of-period stocktaking is avoided.
! The daily checking of items can be so arranged that all items are checked at least twice a
year, but fast-moving or valuable lines can be checked more frequently.
! Explanations of differences between physical stock and records can be made more easily
and perhaps measures can be taken to prevent recurrence.
! There is a greater morale effect on the staff.
! The annual accounts can be prepared earlier, as the book value of the stores is acceptable
for balance sheet purposes. The stock value can also be used to prepare monthly
accounts.
! The opportunity can be taken to check that maximum stock levels are not being
exceeded, so the disadvantages of excessive stocks are more easily avoided.
(b) Accounting of Waste and Scrap
There are three main categories of waste and scrap in the context of materials handling and
accounting:
! Waste material such as trimmings and offcuts this should be controlled within
reasonable limits. Records can show waste as a percentage of material used. This type
of waste will be collected and periodically sold, destroyed or dumped.
! Offcuts and other waste from one process may be suitable for making other things.
Such material is returned to store.
! A proportion of finished output will be rejected on inspection, and will either be sold as
scrap or will be subjected to further processing to make it suitable for sale.
Scrap and waste are considered in greater depth later in the course under Process Costing.
(c) Pricing and Accounting for Materials Issues
In times of changing prices, firms have to make a decision as to how they will price the
materials issued to production when they are trying to arrive at overall production costs.
Should it be the price they actually paid for the material, or the current price of the same type
of material (which could well be higher)?
There is also the question of the valuation of closing stock which, you already know, affects
the reported profit, since a manufacturer, in drawing up his manufacturing account, will use the
formula:
Opening stock +Purchases Closing stock = Cost of materials consumed.
(We must not confuse the profit from manufacturing with the paper profit which could arise in
a time of rapidly rising prices as stocks become worth more than the firm paid for them.)
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It must be emphasised that, when we talk about pricing of material issues, it does not matter
which materials are actually, physically, issued to production. A good storekeeper will issue
the oldest materials first, especially if the materials are perishable. But that does not mean that
a firm must charge production with the cost of those particular materials, if management feels
that that would not adequately reflect current conditions.
Materials Handling Costs
(a) Nature of Costs Incurred
The costs of transportation, storage, movement and administration of materials may include
such items as:
! carriage outward, packing and despatch
! van and transport costs
! rent, rates and insurance of stores
! light, heat and power related to stores, etc.
These and any other related costs must be absorbed into production or product costs.
(b) Methods of Absorbing Costs
Various methods are found in practice of absorbing costs into a total cost figure. These
include:
! Adding a percentage loading to the cost of materials used,
! Including the costs in production overheads,
! Using a rate based upon the volume or weight of materials,
! Inclusion in selling and distribution costs.
The choice of method or methods to be adopted will depend upon the amount of cost involved and
the policy of the organisation. The inclusion of the costs in general production overheads is the
simplest method, but it is likely to be the least accurate, as the volume or value of materials may vary
from one job or product to another. This aspect is dealt with in greater detail later in the course.
B. LABOUR COSTS
Controlling Direct Labour Cost
All elements of labour cost should be subject to a control system. We are going to discuss here the
factors to be considered when dealing with that section of labour cost which can be wholly and
exclusively attributed to particular cost units (i.e. direct labour). The balance of labour costs
indirect labour will be dealt with when we consider overheads. Thus direct labour is more
applicable to manufacturing industry where labour costs will form part of the total cost of the
physical item produced. Indirect labour cost allocation is therefore more relevant in service
industries.
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Timekeeping and Time Booking
(a) Records to be Kept
Records must be kept of the following:
! Time spent in the factory, in respect of which the worker is entitled to draw wages. This
is known as timekeeping, and relates to all labour employed by the organisation
(whether direct or indirect).
! Time spent on individual cost units time booking, i.e. the recording of time spent on
each cost unit, is necessary so that the correct labour cost for each job can be
ascertained. By implication, time booking refers only to direct workers.
(b) Methods of Time Recording
! Time Spent in Factory (Attendance Time)
Register
Here, the workers simply sign a register, recording their arrival time. The timekeeper
may draw a line after the name of the last worker to sign on by the appointed starting
time, so that the names of latecomers can be seen at a glance. This method requires
considerable supervision and is only suitable with small numbers of staff.
Mechanical Time Recorders
Where there is a large number of employees, mechanised time-recording apparatus can
be used to advantage. There are many types of machine available.
Computerised Time Recorders
This type of time recording system is directly linked to a computer. Each employee is
issued with a card or badge, with personal data encoded into a magnetic strip, which is
swiped through a reader at the beginning and end of the day. Data is sent direct to the
computer system which can be used to produce an instantaneous attendance record and
calculate wages. There may also be links with the costing system in order to provide
accurate labour costing data.
! Time Spent on Cost Units (Job Time)
In order to allocate labour costs to particular cost units, it is necessary to establish the
time spent by employees on those cost units. The records to enable this to be carried out
are best maintained by means of time clocks and job cards.
J ob cards are used to ensure that time spent on a job or cost unit is properly evaluated
and charged against that particular unit of cost. The type of industry and organisation
will have a great influence on the kind of job card used and the procedure followed, but
the routine described below will serve to illustrate the method.
The production control department, through the foreman, allocates a job to an employee,
and the foreman issues to that employee his or her appropriate card. The employee
reports to the timekeeper, who clocks on the time of commencement of the job and
returns the card to the worker. When the worker completes the job, he or she reports to
the foreman, who enters the details of good and scrap work and initials the card. It is
then taken by the worker to the timekeeper, who clocks off the card.
The card is then forwarded to the wages office for calculation and extension. The job
cards associated with each employee are gathered together each week to provide the
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figure of gross earnings for the week. The job cards are subsequently collated by job
number, so that the total wages cost for each cost unit is established and charged to the
job.
It is of prime importance that the attendance and job times be reconciled at the end of
each week. The difference between the total attendance time and job time is clearly a
loss to the organisation in the form of idle time. This is usually regarded as an overhead
and is dealt with as such in the costing routine.
Methods of Remuneration
The two main methods of remuneration of labour are payment by time of attendance and payment
by results.
(a) Payment by Time of Attendance
The great drawback which exists under this method is that there is no incentive to increase the
level of production, and production can be maintained only by emphasis on supervision. There
are certain types of work in which it is satisfactory to pay by time methods and these may be
summarised as follows:
! Executive and management posts.
! Where the application of skill and care is a basic requirement for the proper completion
of the job.
! Where no satisfactory incentive scheme can be applied e.g. security men.
! Where trainees are employed.
There is also the high day-rate scheme, advocated in the USA by Henry Ford. The idea is that
high rates are paid, but strict performance targets are set. The aim is to attract the best
workers those who have confidence in their ability to meet the targets.
(b) Payment by Results
! Piece-Work Schemes
Under these schemes, the operative is paid a certain rate for each unit he or she
produces. This rate is arrived at after assessing (using work study methods) the time
which should be taken to produce one unit. The aim of a piece-work scheme is, of
course, to give the worker an incentive to increase production.
Strict supervision is needed, otherwise quality may be sacrificed for quantity. Also,
employees may tend to slacken once they realise that they have reached a certain level of
earnings, e.g. the level at which they start to pay tax.
This latter difficulty can be overcome to some extent by the use of differential piece
rates, whereby the rate per unit is increased once a certain minimum output has been
achieved. An example would be payment of 1 per unit for the first 10 units produced
each day, and 1.50 for each additional unit produced.
! Individual Premium Bonus Scheme
You should note that, when payment is by time of attendance, the employer receives all
the benefit from increased production; under piece-work schemes, the employee receives
all the benefit (though the employer has the incidental benefit associated with all
payment by results schemes, namely that fixed costs per unit are reduced, because they
are spread over a larger number of units).
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The idea of premium bonus schemes is to establish a partnership between employer and
employee, so that each benefits from the savings from increased production.
There are seven basic requirements of a premium bonus scheme:
(ii) The scheme should be simple in operation and capable of being easily
understood by each employee.
(iii) There should be a sound basis for setting production targets.
(iv) There should be good relations and liaison between the rate-fixers and the
employees representatives.
(v) The targets set should be capable of being attained by an average employee.
(vi) There should be no limit to the additional earnings the workers are allowed to
receive under the scheme.
(vii) Workers should not be penalised for circumstances beyond their control.
(viii) The calculation should be carried out quickly, to ensure prompt payment of the
bonus.
! Profit-Sharing Schemes
Schemes of this type are becoming increasingly popular. The employee is given a share
of the profits of the business, either in the form of a cash bonus or in shares in the
company.
The main disadvantage is that, as payment is remote from the actual performance of
tasks (payment will take place only once or twice a year), the incentive element is not
strong. In addition, workers may be rewarded for good results which have come about
through no effort on their part, or be penalised for bad results which are not their fault,
because the profit level may depend on good or bad management action.
Particularly where shares are given, however, such schemes give employees an interest
in the long-term prosperity of their company and may help to reduce labour turnover.
Profit sharing is particularly suitable for management grades, whose work is such that
they cannot be rewarded by any other type of incentive payment.
Treatment of Overtime
Treatment of overtime is subject to the following underlying principle: charge the cost to the cost
unit causing the expense.
(a) Job Cost
Charge to individual jobs if the customer wishes the delivery date to be brought forward and
overtime has to be worked to do so.
(b) General Overhead
This category of overhead account is charged with overtime if general pressure of business
has caused occasional overtime working. It would be unfair to make an extra charge to those
jobs which just happened to be done in the evening.
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(c) Direct Labour Cost
On the other hand, if overtime is worked regularly and consistently because of a shortage of
direct workers, it is really part of the normal direct labour cost, and should be treated
accordingly. An average hourly rate would be calculated, based on the number of hours at
standard rate and the number of hours at premium rates, and all jobs would be charged with
labour at this average rate.
(d) Departmental Overhead
If inefficiency within a particular department has caused overtime working, then that
departmental overhead account should be charged with the cost.
If overtime has been worked in Department B because of Department As inefficiency, the cost
of overtime in Department B should be charged to the departmental overhead of
Department A.
Labour Turnover
(a) Measuring Turnover
The most common measure of labour turnover is:
Number of leavers replaced
Average workforce
100%
Thus, if a reduction in the workforce was planned e.g. by offering early retirement the
people retiring early would not come into the turnover statistics. In measuring labour turnover,
management is concerned to control the cost of having to replace leavers.
(b) Cost of Turnover
The cost of labour turnover can be high. It includes the following:
! Personnel Department
Under this heading come all the costs associated with recruitment: advertising,
interviewing, interviewees expenses, etc.
! Training New Recruits and Losses Resulting
Every new recruit must have some training. Training costs money in the form of the
time of another operator who has to show the new starter the job, or the time of a
supervisor or training school. Even after training, the new starter will be unable for
some time to do a full days work equivalent to that of a skilled operator with years of
experience. The result is that the machines used by the new recruit are underemployed,
causing further loss.
The new starter is also likely to cause more scrap and possibly break tools and
equipment more readily than a skilled operator. He or she is more liable to accidents,
causing further loss.
(c) Prevention and Cure
A certain amount of labour turnover is inevitable employees die or retire and is indeed
desirable, because it gives younger staff opportunities for promotion. However, since labour
turnover is costly, it should be controlled. Every effort should be made to find out why
workers leave and to rectify any apparent defects in the company and its personnel policy.
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! Reasons for High Turnover
Where labour turnover is high and workers are being regularly lost to other firms in the
same locality, the following factors require careful consideration:
(i) Methods of wage remuneration for example, is skill being adequately
rewarded? Does average remuneration compare well with other local firms? Can
workers reach an adequate rate of earnings without a high proportion of overtime
working?
(ii) Have the employees confidence in the future long-term prospects of
employment within the organisation? If not, can their fears be modified?
(iii) Is there any antagonism on the part of the employees, as a result of inefficient
management?
(iv) Are there sufficient general incentives to encourage employees to stay within the
organisation e.g. long service awards, pensions and housing incentives, canteen
facilities, joint consultation procedures, sports and health care facilities, etc.?
! Potential Remedies
Personnel Department
If recruitment procedures are good, labour turnover will be reduced because the right
people will be given the right jobs. The personnel department can also help reduce
labour turnover by developing and maintaining good employee/employer relations. J oint
consultation may be developed. Clearly wage rates will be an important issue, as will
opportunities for training and promotion.
General Welfare
Good employee/employer relations may be developed by the personnel department, but
certain services will also go a long way towards maintaining such relationships and
improving morale. The most important of these include the provision of sports and
health facilities, e.g. sports field, tennis court, gym, private health insurance cover, etc.;
canteen facilities with, possibly, subsidised meals; adequate first aid facilities with
possibly a medical centre run by a doctor (depending on the size of the firm); a pension
scheme and housing/mortgage subsidies a very powerful factor in reducing labour
turnover among employees over 30 years of age. Part of the expense of providing these
facilities must be set against the cost of labour turnover, although some of these services
will also tend to reduce absenteeism and sickness.
C. DECISION MAKING AND DIRECT COSTS
Understanding exactly what material and labour costs are and how they can be controlled is an
integral part of the decision-making process. Once it is recognised, for instance, that overtime is
likely to be required in the near future because the volume of work is forecast to rise, management
can make the decision to employ more direct labour. Much will depend on the level of capacity at
which the firm operates; if spare capacity is available within the workforce, it is advisable to consider
whether there is sufficient flexibility to spread the workload, so avoiding the need for additional
employees or perhaps even overtime.
Similarly with material costs; as an example, more expensive materials should be of better quality
than the cheaper alternatives and therefore produce less wastage. The trade-off between higher cost
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with lower wastage and lower cost with higher wastage should be understood and the appropriate
policy decision taken.
D. OVERHEAD AND OVERHEAD COST
What is Overhead Cost?
Overhead cost is defined in the CIMA Terminology as:
The total cost of indirect materials, indirect labour and indirect expenses.
This means those items of material, labour or expenses which, because of their general nature,
cannot be charged direct to a particular job or process, but have to be spread in some way over
various jobs or processes.
Identification of Overheads
In considering what is a direct charge and what is an indirect charge i.e. overhead regard must be
paid to the type of industry, the method of production, and the particular organisation of the firm
concerned. For instance, in a general machine shop making a variety of products, the foremans
wages would be an indirect or overhead charge, as there is no obvious method of identifying the cost
of the foremans wages with a particular job; but on a building site the foremans wages would be a
direct expense, as they can relate only to the contract in hand.
Problem of Overheads for the Modern Manager
Dealing with overhead expense is perhaps one of the most important problems facing the cost
accountant today. The spread of mechanisation and automation has resulted in direct labour
becoming an increasingly small proportion of total cost, and overhead expenses have become very
much larger.
Classifying Overheads
There are three main functional classifications of overheads:
! Production overheads
! Administration overheads
! Selling and distribution overheads.
These are obviously associated with the three main functions of the business organisation and, as a
first step, we should attempt to classify overhead expenditure into the appropriate categories.
Clearly, there are certain items of cost which appertain to all three such as electricity, rent and rates
and it will be necessary to break these individual charges down to the shares appropriate to the main
functional headings.
(a) Production Overheads
Before any business can start producing goods or providing a service, it must have a building
which has to be heated, lit, ventilated and provided with power. The building must be kept
clean and will need repair and redecoration from time to time and, in addition, rent and rates
will have to be paid. The products will have to be designed, and production must be planned,
supervised and checked.
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Records have to be kept, wages calculated, and materials must be stored and conveyed from
point to point within the building.
These functions, and others, are not directly concerned with actual production, but are none the
less essential and may be looked upon as services to the actual job of production. It is the costs
of providing these services which constitute the production overheads.
(b) Administration Overheads
We have already stated that the type of industry will affect the levels of each of the different
types of overhead. Manufacturing industry will incur a greater proportion of production
overhead than administration overhead, whereas, in general, it will be the other way round for
service industries.
Examples of administration overhead are the salaries of those people in the offices not directly
concerned with production, heating and lighting of the offices, stationery, office repairs and so
on.
Taking our architects practice that we looked at in the previous study unit, the costs of the
salaries of the architects specifically engaged on contract work for customers would be classed
as a direct labour cost to the particular contract concerned. In addition, associated costs such
as specified computer software and perhaps allocation of rent, rates, electricity, etc. would all
be classed as production overhead. The costs of a secretary and any other non-direct office
costs would be classed as administration overhead.
The distinctions between each will probably be unique to each organisation in the way it is set
up and operated. Remember that these allocations are to provide costing information for
management and (as we will see in the next three study units) stock values.
(c) Selling and Distribution Overheads
The dividing line between production overheads and selling and distribution overheads comes
when the finished goods are delivered to the finished goods store. Examples of selling and
distribution overheads include salespeoples salaries, commission and expenses, advertising,
warehouse charges and so on. In addition, carriage, packing and despatch costs may sometimes
also be included.
51
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Study Unit 4
Absorption Costing
Contents Page
Introduction 52
A. Definition and Mechanics of Absorption Costing 52
Definition 52
B. Cost Allocation 53
C. Cost Apportionment 54
Methods of Apportionment 54
Specimen Overhead Allotment Calculation (Including Service Activities) 55
D. Overhead Absorption 59
Percentage Rates 59
Absorption on Basis of Time 59
Predetermined Absorption Rates 62
E. Treatment of Administration and Selling and Distribution Overhead 64
Administration Overhead 64
Selling and Distribution Overhead 64
F. Uses of Absorption Costing 65
Stock Valuations 65
Pricing 65
Profit Comparison 66
Summary 66
52 Absorption Costing
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INTRODUCTION
In this study unit and the next two, we shall be looking at the different methods used to add overheads
to the direct costs of production. The first method, absorption costing, is the most criticised and is
becoming increasingly less used, although it is still an important topic to be able to understand and
critically assess.
A. DEFINITION AND MECHANICS OF ABSORPTION
COSTING
What we are attempting, in absorption costing, as well as marginal costing and activity-based costing
which will be examined later is to obtain an accurate cost of producing an item, which will
include the overheads that have been incurred in its production, together with labour and materials.
Definition
The CIMA Terminology describes absorption costing as:
A principle whereby fixed as well as variable costs are allotted to cost units and total
overheads are absorbed according to activity level.
The same text also supplies a diagram (Figure 4.1.)which should help to bring together much of what
we have looked at so far.
The diagram illustrates how the total cost of an item is built up using direct costs (also known as
prime cost), absorbed production overhead and what might be termed other overhead comprising
the cost of marketing, administration and Research and Development functions. It is the method of
absorbing production overhead with which we shall be primarily concerned here.
Absorption costing comprises three stages:
! cost allocation;
! cost apportionment;
! cost absorption.
Absorption Costing 53
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Figure 4.1: Elements of Cost
B. COST ALLOCATION
The CIMA Terminology defines cost allocation as:
The charging of discrete identifiable items of cost to cost centres or cost units.
In other words, where the overhead can be directly identified, it can be allocated straight to the cost
unit or cost centre. Referring to Figure 4.1, such costs would be classified as direct cost expenses and
would include such items as a foremans wages for a production department, or the electricity charge
for a production department if they are on a separate meter. Note that if the foreman covered several
different production departments or the electricity bill could not be separately identified then such
costs would need to be apportioned.
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C. COST APPORTIONMENT
Cost apportionment is defined as:
The division of costs amongst two or more cost centres in proportion to the estimated
benefit received, using a proxy, e.g. square feet.
Referring once again to Figure 4.1, it is the unallocated production overhead that will need to be
apportioned. We have already seen that this would include block items such as electricity, but it
would also comprise items such as the total factory rent, depreciation of the plant and machinery and
so on.
Cost centres may consist of one of the following:
! production departments
! production area service departments
! administration, selling/distribution or R and D departments
! overhead cost centres.
Each cost centre will have the appropriate costs charged to it. Thus, direct materials and labour will
be charged to the production department together with allocatable overheads. Overhead to be
apportioned, which remember will form part of the prime cost (refer again to Figure 4.1 if you are not
sure), will be charged to the production area service departments.
Methods of Apportionment
The production overhead so coded will then need to be apportioned to the production department cost
centres. There are a number of ways of achieving this distribution as follows:
(a) Capital Value of Cost Centre
Where overhead cost is increased by reference to the capital value of the cost centre, it should
be apportioned in the same way, e.g. fire insurance premium charged by reference to capital
value.
(b) Cost Centre Labour Cost
Where the overhead cost depends on the extent of labour cost of the centre such as in the
case of employers liability insurance premiums this should also form the basis for the
apportionment of the premium paid.
(c) Cost Centre Area
Where overhead cost depends on the floor area, it should be apportioned in the same way, e.g.
rent and rates.
(d) Cost Centre Cubic Capacity
Where overhead cost is incurred in phase with cubic capacity e.g. heating it should be
apportioned on this basis.
(e) Cost Centre Employees
The overhead cost of providing a canteen service is generally proportional to the numbers
employed, so it is reasonable to apportion it by reference to the numbers employed at each
cost centre.
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(f) Technical Estimate
The chief engineer of a factory should give estimates as to the incidence of the overhead cost
of certain expenses between the various cost centres of the factory:
! Light
The wattage used in each department can be calculated, and the cost of lighting
apportioned to each cost centre accordingly.
! Power
The horsepower of machines in each cost centre can be established, and the cost of
power apportioned on this basis.
(g) Proportionate to Materials Issued
The overhead expenses of operating the stores department, and normal stores losses, may be
apportioned by this method, measuring materials by value, weight, or volume, as appropriate.
(h) Proportionate to Production Hours
There are many items of overhead expenditure which usually can be apportioned on this basis,
although the figures are usually available only where a fairly comprehensive costing system is
in operation. Either labour hours or machine hours may be used. Items which may be
apportioned on this basis are:
! overtime wages (where not allocated direct)
! machine maintenance (where not chargeable direct).
Specimen Overhead Allotment Calculation (Including Service Activities)
A company has 2 production departments, X and Y, and 3 service departments stores, maintenance
and production control.
The following data are available:
Stores Mainten-
ance
Prodn
Control
X Y Total
Areas in sq. m 300 400 100 3,000 4,200 8,000
No. of employees 4 12 30 200 300 546
Value of equipment (000) - 8 - 20 12 40
Electricity (000 units) - 20 - 320 210 550
No. of extraction points 1 2 - 14 23 40
Indirect material cost () 11 25 44 31 63 174
Indirect labour cost () 287 671 1,660 1,040 1,805 5,463
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Other overhead costs for the year are as follows:
Rent 800
Factory administration costs 2,184
Machine depreciation 440
Power 550
Heat and light 80
Machine insurance 40
Fumes extraction plant 120
You are required to prepare an overhead analysis sheet showing the basis for apportionments made.
Figure 4.2 shows the form in which the figures should be displayed.
The figures for indirect material and indirect labour have been pre-allocated obviously because it is
possible to identify exactly how much has been incurred by each respective department.
So that you can understand the calculations for each of the items, we shall go through the calculations
for one of them. The rent will be based on each departments square footage as a percentage of the
total square footage. Thus for the stores department this will be:
300
8000 ,
800 30 =
and so on for all the other departments until the total rent of 800 has been allocated.
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We have now arrived at an estimate of the overhead appropriate to each department or cost centre.
However, we really need to express all overhead costs as being appropriate to one or other of the two
production departments, so that we can include in the price of the products an element to cover
overhead for it is only in this way that costs incurred will be recovered. Although costs have been
incurred by the service departments, they have really in the end been incurred for production
departments. We need to associate all costs with a production department, so that we can relate these
costs to cost units which pass through the production departments.
So the next step is to reapportion the costs of the service departments (see Figure 4.3). The
methods employed are similar to those used in the original apportionment.
Additional data is provided: the total number of material requisitions was 1,750, of which 175 were
for the maintenance department, 1,000 for Department X and 575 for Department Y. This data will
be used to apportion the costs of the stores department to these three departments. Maintenance costs
will be directly allocated to production control and Departments X and Y. (In practice, a record may
be kept of the number of maintenance hours needed in each department, to provide data for cost
apportionment.) Production control costs will be apportioned between X and Y, according to the
number of employees in these departments (already given).
Note that when departmental costs are reapportioned, the cost is credited to that department.
Item Apportionment
Basis
Stores
Mainten-
ance
Prodn
Control
Costs b/f 350 910 1,835 2,803 3,953

Stores Dept costs
reapportioned
No. of requisitions 350 35 - 200 115
Maintenance Dept.
costs allocated
Allocation - 945 126 263 556
Production Control
costs reapportioned
No. of employees - - 1,961 784 1,177
Totals Nil Nil Nil 4,050 5,801
Figure 4.3: Reapportionment of Service Department Costs
Having completed the reapportionment, you will see that the total of overhead now attributed to
Departments X and Y is, of course, equal to the original total of overhead.
Having apportioned the indirect production overhead, the important part is to analyse and critically
appraise the figures provided. The total costs for Departments X and Y can now be apportioned over
the number of cost units to provide a cost per unit.
For the purpose of our example, let us assume that Department X has produced 1,000 small print
rollers and Department Y 4,000 canisters. The direct cost per unit has been calculated as 9.50 for
the rollers and 4.50 for the canisters, so we are now in a position to compare the total cost against
that originally estimated.
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Department X
Department Y
Direct cost per unit 9.50 4.05

Allocated overhead per unit
(4,050/1,000; 5,801/4,000) 4.50 1.45
13.55 5.95
Standard cost 12.00 6.00
Variance (1.55) 0.05
The variance can be analysed in a number of ways and standard costing and its associated variance
analysis will be covered in more detail later. In the case of Department X it may be deemed
necessary to investigate why each unit has cost 1.55 more than expected. The important thing here
is that we have ascertained the cost per unit and have then been able to compare it with the cost that
was expected.
In this example we have assumed that the allocated overhead is simply divided by the number of units
of production. This is possible in instances where identical products are manufactured but in practice
it is not that simple. We shall now go on to look at the various ways in which the overhead is
absorbed into each cost unit.
D. OVERHEAD ABSORPTION
The CIMA definition of overhead absorption is:
The charging of overhead to cost units by means of rates separately calculated for each
cost centre.
In other words, the amount of overhead absorbed by a product means the proportion of the total
overhead which, we estimate, is appropriate to that product.
Overhead costs may be absorbed into product costs in a variety of ways, but the two principal
methods are:
! by the use of percentages;
! by rates based on time.
Percentage Rates
The use of percentages is generally less satisfactory than rates based on time. An overall or blanket
percentage rate may be calculated by relating all factory overhead to total labour costs, and applying
this single percentage rate throughout the factory. This can give rise to anomalies, particularly where
the incidence of overheads varies from one cost centre to another. If percentages are to be used, a
better approach is to apply a separate percentage rate for each cost centre, based on the overheads
incurred and labour cost for each cost centre.
Absorption on Basis of Time
If you have had any experience of costing, you will have concluded that much overhead expenditure
is, above all else, subject to the time factor in its relation to output. If one article takes twice as long
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to go through the factory as another, it should attract to itself twice the charge for lighting the factory
as the other product; this is only one example which can be multiplied many times from a managers
own experience. It is generally true, therefore, that by far the most valuable method of apportioning
overheads is on a time basis, and this is usually of one or two kinds a rate per direct labour hour
or arate per machine hour, depending on the degree of mechanisation within the particular cost
centre.
Occasionally, a combination of both of these will be in operation, and a composite rate per
production hour used.
(a) Direct Labour Hour Rate
Where this system is used, the number of hours of direct labour worked in a production centre
is divided into the total figure shown in the expense summary for that production centre for the
corresponding period. The resultant figure gives the overhead cost per direct labour hour.
This is a very satisfactory method, particularly where a production centre uses little elaborate
or expensive machinery, and when it may reasonably be said that every hour of direct labour
incurs the same amount of expense. You must remember, however, that separate direct labour
hour rates should be calculated for each production centre and that holidays should be
excluded, as should overtime hours (except when this is a regularly recurring feature).
A rate per labour hour is defined as an actual or predetermined rate of cost apportionment or
overhead absorption, which is calculated by dividing the cost to be apportioned (or absorbed)
by the labour hours expended or expected to be expended.
The advantages of this system are outlined below:
! The result is not made unworkable by use of both skilled and unskilled labour.
! Proper provision is made to deal with fast and slow workers who are paid piece-rates.
! The figure of labour hours is a more useful guide to the management than the value of
wages paid, because fluctuations due to varying overtime rates and wage increases are
avoided.
The formula for calculating a rate per direct labour hour is:
hour - labour direct per Rate
period in the worked be or to worked hours - labour Direct
period for the Overheads
=
(b) Rate per Machine Hour
Where machinery rather than labour is the dominant feature of a production centre, a rate of
overhead per hour of machine time should be substituted for a rate per direct labour hour.
To find this rate per machine hour, it is necessary to estimate the number of hours of
operation of the machine or machines in the cost centre during the period under
consideration. Allowance must be made for idle time and for cleaning and setting-up time.
The total expense is then divided by the number of working machine hours.
(c) Specimen Rate per Machine Hour Calculation
Let us return to our earlier example of overhead allotment. After the service departments costs
had been reapportioned, the costs attributed to the production departments X and Y were
4,050 and 5,801 respectively.
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Now suppose that Department X had 5 identical machines working 162 hours each during the
period under consideration. Department Y is not automated, and has 20 direct workers, each
working 160 hours during the period.
The total number of machine hours worked in Department X is 5 162 =810 hours.
Therefore, the rate per machine hour is 4,050 810 =5 per machine hour.
The total number of direct labour hours worked in Department Y is 20 160 =3,200 hours.
Therefore, the rate per labour hour is 5,801 3,200 =1.81 per direct labour hour.
Suppose that the manufacture of a print roller takes 4 machine hours in Department X. It is
then passed to Department Y for hand finishing, which takes 6 hours. The amount of overhead
absorbed (incurred) by this article is then:
4 5 (Dept X) +6 1.81 (Dept Y) =30.86
(Note that earlier we assumed that Department Y actually manufactured an entirely different
product rather than carrying out a further process. In reality either situation could and does
occur.)
In determining the total cost of the article, this sum would be added to the cost of the direct
materials, direct labour and direct expenses incurred.
In this calculation above, only one hourly rate has been calculated for each department. In
practice, fixed and variable overhead, if possible, will be kept separate, and a separate
absorption rate will be calculated for each.
When the machines in a department are not identical (as they were in our specimen calculation)
it is necessary to calculate the rate for each machine separately. The following principles may
be generally applied:
! Some expenditure can be directly allocated to the particular machine e.g. power, cost
of repairs, depreciation.
! Overhead chargeable to the production centre in which the machine is located, and not to
the individual machine, e.g. rent, rates, heating, is apportioned on the basis of area
occupied.
(d) Specimen Machine-Hour Absorption Rate Calculation
Using the data below, you are required to calculate a machine-hour absorption rate for multi-
drilling machine No. 5.
Relating Specifically to Machine No. 5
Original cost: 13,300
Estimated life span: 10 years
Estimated scrap value after 10 years: 300
Floor space occupied: 250 square metres
Number of operators: 2
Estimated running hours: 1,800 per annum
Estimated cost of repairs: 240 per annum
Estimated cost of power: 1,000 per annum
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Relating to Department in which Machine No. 5 is Situated
Floor area: 5,000 square metres
No. of operators: 60
Rent: 4,400 per annum
Supervision: 3,600 per annum
In addition to the costs specifically relating to machine No. 5, the following apportioned costs
must be taken into account:
! Rent on the basis of floor area occupied.
! Supervision on the basis of number of operators for machine No. 5 compared with the
whole department.
Therefore, the total costs appropriate to machine No. 5 are as follows:
per annum
Depreciation: (13,300 300) 10 1,300
Rent (
1
20
of departments cost) (250 out of 5,000) 220
Supervision (
1
30
of departments cost) (2 out of 60) 120
Repairs 240
Power 1,000
2,880
Therefore, the rate per machine hour is
2880
1800
,
,
=1.60 per machine hour.
Predetermined Absorption Rates
In the examples considered so far, we have been dealing with a known total of overhead which was
allocated or apportioned to cost centres and, hence, to cost units. In practice, of course, costs are
being incurred while production is taking place, and total costs are not known until the end of the
period. However, management needs timely information on product costs as they are being incurred.
To overcome this problem, predetermined overhead rates are used. These are based on estimated
overheads and estimated production levels. Each job then absorbs overhead at a predetermined rate.
(a) At the end of each period, it is necessary to compare the overhead which has been absorbed
with that actually incurred. Almost certainly, there will be differences. Overhead will have
been over-absorbed if the production level was greater than anticipated, or if overhead costs
were lower than anticipated. Conversely, overhead will have been under-absorbed if the
production level was lower than anticipated or overhead costs were greater.
(b) The overhead over- or under-absorbed each month is transferred to an overhead adjustment
account, and at the end of the year the net amount over- or under-absorbed is transferred to the
profit and loss account. This method is preferable to the alternative of carrying forward a
balance on the overhead account each month, although this alternative method is acceptable if
the under- or over-absorption is caused purely by seasonal fluctuations where an average
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annual rate of overhead absorption is in use. In this case, there will be under-absorption in
some periods and over-absorption in others, because of the seasonal factors, but the net effect
over a year will be nil. Nevertheless, since a cost accountant will rarely be in a position to say
that all under- or over-absorption is due to seasonal factors, it is still considered preferable to
operate an overhead adjustment account.
Specimen Calculation Using Predetermined Absorption Rates
In a period in which 1,600 direct labour hours are expected to be worked, fixed overheads are
expected to be 20,000. In fact, only 1,550 direct labour hours are worked and the actual overhead
incurred is 19,750.
The predetermined rate for absorption of overhead is 12.50 per direct labour hour (20,000
1,600). Thus, for instance, a job which took 20 hours to complete would absorb 250 fixed overhead.
Because 1,550 direct labour hours are worked, the amount of overhead which has been absorbed by
the end of the period, using the predetermined absorption rate, is 1,550 12.50 =19,375.
Comparing this with the actual overhead incurred, we see that overhead has been under-absorbed by
375.
Extracts from the relevant accounts are given below.
Overhead Control

Incurred 19,750 Work-in-progress
absorbed overhead 19,375
Overhead adjustment
under-absorbed overhead 375
19,750 19,750
Work-in-Progress

Direct material
Direct labour
Overhead absorbed 19,375
Transferred to finished goods
stock 19,375
19,375 19,375
Overhead Adjustment

Overhead control
under-absorbed overhead 375
Profit and loss 375
375 375
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E. TREATMENT OF ADMINISTRATION AND SELLING
AND DISTRIBUTION OVERHEAD
We have already seen that items of production overhead can be directly allocated or apportioned.
Generally, administration and selling and distribution overhead can either be apportioned or written
straight off to the profit and loss account. Whichever method is used, the usual requirements of a
common sense, consistent approach are needed.
Administration Overhead
It is not generally worthwhile to attempt to be too scientific in apportioning administration costs to
products. For pricing purposes, the inclusion of an agreed percentage on production costs will
generally be adequate. For other purposes there is no need to absorb administration costs into
production costs instead they can be treated as period costs to be written off in the profit and loss
account.
Selling and Distribution Overhead
(a) Variable Elements
Some elements of selling and distribution overheads vary directly with the quantities sold for
instance, commission paid to a salesperson on a unit basis. Such items can be charged directly
to the product concerned in addition to the production cost.
(b) Fixed Elements
Other elements are incurred whether products are sold or not for instance rent of showrooms,
salaries of salespeople. Such items may be treated as period costs and written off in the profit
and loss account; or they may be absorbed in one of three ways, as shown below.
! Percentage on Sales Value
Selling overhead for year: 250,000
Estimated sales value for year: 2,500,000
Absorption rate =
Cost
Activity
100
=
250,
2, ,
000
500000
100 or 10%
In this case we add 10% of the sales value of the cost unit to the cost to cover selling
overheads.
This method is useful when prices are standardised and the proportions of each type of
article sold are constant
! Rate per Article
Selling overheads for year: 250,000
No. of articles to be produced: 1,000,000
Absorption rate =
Cost
Activity
=
250,
1, ,
000
000000
or 25p per article
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For each article produced, 25p is added to the cost.
This method is particularly applicable where a restricted range of articles is produced,
but it can be used for an extended range by evaluating different sizes, using a points
system.
! Percentage of Production Costs
Selling overhead for year: 250,000
Estimated production cost of sales for year: 2,000,000
Absorption rate =
Cost
Activity
100 =
250,
1, ,
000
000000
100
or 12%
12% of the production cost of each unit is calculated and added to that cost.
Care must be taken in applying this method. For instance, suppose a company makes
two products, A and B. A costs twice as much as B to produce. Therefore a percentage
on production-cost basis would charge A with twice as much selling and distribution
overhead as B. But suppose there is a ready market for product A, which means that the
firm has no need to advertise it, while with product B the firm is in competition with
others and spends 5,000 p.a. on advertising B. Then it is clearly incorrect to charge A
with twice as much overhead as B! (In fact, the cost of advertising B should have been
charged directly to Product B.)
This method is, however, acceptable if the costs involved are small, or if there is a
limited range of products and those costs which clearly do not vary with cost of
production (as in the above example) can be charged direct.
F. USES OF ABSORPTION COSTING
The arguments put forward for the use of absorption costing are as follows.
Stock Valuations
These are integral to the financial accounts not only for providing a value for the closing stock in the
balance sheet but also for determining the cost of sales figure in the profit and loss account.
The importance of this lies in the fact that stock sold in an accounting period will usually consist of
some items held in stock at the beginning of the period and some produced during the period. The
calculation of the cost of sales figure to use is therefore:
Value of opening stock
plus Cost of goods produced
minus Value of closing stock
Thus in those instances where financial and costing systems are integrated, the method used to value
stock is extremely important.
Pricing
This is covered in greater detail in later study units, but it is useful in the context of absorption
costing to mention that one method of arriving at a selling price is to add a percentage to the cost of
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producing the item. This is known as cost plus pricing and ensures that all the costs of production
are covered and some of the sales value is left over to be put towards the companys selling and
administration overhead and providing a profit.
As an example, if a companys cost of producing a particular item is 4 and a pricing system of cost
plus 25% operates, then the selling value will be 5. This covers the cost of production and
provides 1 towards overhead and profit.
Profit Comparison
By apportioning overhead to production it is possible to compare how profitable different items are.
This occurs particularly with those items that take a disproportionate overhead but have a relatively
low cost in terms of materials and labour. In this instance if we were to compare items merely on
prime cost we could make the wrong production decision, particularly where we have limited
resources.
As an example, consider the following:
Product Prime Cost
Apportioned
Overhead
Full Cost
Selling Price
Wooden garden seat A 65 15 80 100

Wooden garden seat B 55 30 85 100
Assume that seat B uses far less materials but is more complex to manufacture and therefore takes
more overhead because the company uses a predetermined absorption rate based on labour hours. As
you can see, if we take prime cost only, it appears that seat B is far better because it makes a profit
before overhead of 45 (100 55) as opposed to seat A which makes 35. If we then use this
information to allocate our scarce resources (which could be labour, materials, factory space, etc.)
then we could end up producing more of seat B which only makes 15 after overhead is apportioned.
One criticism against this type of approach could be that it is unrealistic to make such decisions based
on an arbitrary allocation of overhead, particularly when a blanket predetermined absorption rate is
used.
In practice the information would be better used to price seat B at 105, so making the same profit as
seat A. This presupposes, of course, that people are willing to pay the increased price.
SUMMARY
Absorption costing is increasingly seen as less relevant when compared with the newer approaches of
marginal and activity-based costing which will be covered in the next two study units. Despite this,
it is still widely used in industry and there is a good chance that you will meet it at some stage,
particularly in connection with traditional manufacturing industry.
The concept of absorption costing has many critics and, as we shall see in the next study unit on
marginal costing, incorrect decisions can occur as a result of misinterpretation of the results it
produces. In that case, you may ask, why does it continue to be used? One reason is cost; many
older, particularly smaller, firms cannot afford to implement a completely new system. Another
reason is that the benefits of introducing a new system are seen as negligible, especially when the
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absorption costing method is considered to provide sufficiently accurate information on which to base
managerial decisions.
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69
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Study Unit 5
Marginal Costing
Contents Page
Introduction 70
A. Definitions of Marginal Costing and Contribution 70
Marginal Costing Example 70
Contribution/Sales Ratio 71
B. Marginal Versus Absorption Costing 72
Manufacturing for Profit 73
Long-Term Comparisons 74
Which is Best? 75
C. Limitation of Absorption Costing 76
D. Application of Marginal and Absorption Costing 79
Where Sales and Production Differ 79
When Production is Constant but Sales Fluctuate 83
When Sales are Constant but Production Fluctuates 85
Where Resources are Limited 88
Summary 88
70 Marginal Costing
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INTRODUCTION
Marginal costing is a very important subject area. The topic often features in examination questions
and a thorough grasp of this area of costing will provide you with valuable techniques for resolving
many different types of business problem.
In this study unit we shall consider the principles of marginal costing and examine how this and the
previous technique absorption costing produce different results from the same information. We
shall also attempt to determine the conditions under which each method is considered more
appropriate.
A. DEFINITIONS OF MARGINAL COSTING AND
CONTRIBUTION
The CIMA Official Terminology defines marginal costing as:
A principle whereby variable costs are charged to cost units and the fixed cost
attributable to the relevant period is written off in full against the contribution for that
period.
In order for you to understand fully the above, it is necessary at this point to define contribution:
The difference between sales value and the variable cost of those sales, expressed either in absolute
terms or as a contribution per unit.
This is a central term in marginal costing, when the contribution per unit is expressed as the
difference between its selling price and its marginal cost. In turn this is then often related to a key or
limiting factor to give a sum required to cover fixed overhead and profit, such as contribution per
machine hour, per direct labour hour or per kilo of scarce raw material.
You should recall from your earlier studies that costs can be simply classified as fixed or variable.
Absorption costing recognises some elements of fixed cost as part of the cost of a unit of output,
whereas marginal costing only takes variable costs into consideration. Fixed costs are written off in
the period in which they are incurred, regardless of output.
Variable costs include direct costs as before (i.e. direct labour, direct materials and direct expenses)
plus variable production overhead. In addition, the variable costs of administration, sales and
distribution may also be included.
The concept of contribution should also be explained more fully at this point. As marginal costing
only takes variable costs into account on a per unit basis the contribution is sales value less the
calculated variable cost. In other words it is the remainder that is the contribution towards covering
the fixed costs and making a profit.
You may also meet the term variable costing which is merely another name for marginal costing.
Marginal Costing Example
An example of marginal costing should prove useful at this point to aid in your understanding of the
principles involved. We shall look at profit calculations using both marginal and absorption costing
later.
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Beanland Ltd make a single product, the Beany, which sells for 15 per unit. Opening stock is zero
and 10,000 units are produced in the period. Variable costs (labour, material and expenses) are 10
per unit and fixed costs are 37,500.
Calculate the profits at sales volumes of 5,000, 7,500 and 10,000 units.
5,000 Units 7,500 Units 10,000 Units

Sales 75,000 112,500 150,000
Opening Stock
Variable Production Cost 100,000 100,000 100,000
Closing Stock (50,000) (25,000)
Variable Cost of Sales 50,000 75,000 100,000
Contribution 25,000 37,500 50,000
Fixed Costs 37,500 37,500 37,500
Profit (Loss) (12,500) 12,500
There are several point to note from the above example.
! Closing stock is valued at variable production cost, i.e. 10 per unit; so at sales volumes of
5,000 units and production of 10,000 units, the closing stock value will therefore be 5,000 units
10 =50,000.
! Contribution per unit is constant so the more units that are sold the greater the contribution
towards fixed cost and profit.
! Overall profits vary because fixed costs are written off in their entirety regardless of the level
of sales achieved.
Contribution/Sales Ratio
It may be apparent from the previous example that there is a simple way of calculating expected
contribution at various levels of sales once we know the contribution per unit. Thus, with a sales
value of 15 and variable costs per unit of 10 the contribution per unit is 5. If, for example, we
wish to know the expected level of profit for sales of 8,000 units, it is simply 8,000 5 =40,000.
By deducting the fixed costs we can arrive at the expected profit of 2,500.
The usefulness of this is that it not only gives a volume-related profit figure much more quickly, but
also provides us with the level of sales needed to break even.
In the above example, for instance, the calculation would be:
Fixed costs
Contribution per unit
= Break-even sales
37,
5
500
= 7,500
which incidentally was the figure that provided neither a profit nor a loss in the original calculations.
72 Marginal Costing
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This is a useful decision-making tool and will be examined in more detail in the study unit on Cost
Volume Profit Analysis.
B. MARGINAL VERSUS ABSORPTION COSTING
By now you should be aware of the fact that the fundamental difference between marginal and
absorption costing is the treatment of fixed overheads.
Under marginal costing principles, fixed costs are written off in the period and closing stock is valued
at variable cost only. With absorption costing, a share of fixed production cost is included in the
value of closing stock.
An example showing how the two techniques produce different profits will be useful at this stage.
Referring back to our earlier work on Beanland Ltd, the results using the absorption costing method
would be as follows:

Sales 75,000 112,500 150,000
Opening Stock
Fixed Production Cost 37,500 37,500 37,500
Closing Stock (68,750) (34,375)
68,750 103,125 137,500
Profit (Loss) 6,250 9,375 12,500
Closing stocks are valued at variable plus fixed production cost, i.e.
100, 37,
,
13.
000 500
10000
75
+
= .
The comparison of profits under the two techniques is therefore as follows:
Sales Absorption
Marginal
Difference
5,000 units 6,250 (12,500) 18,750

7,500 units 9,375 9,375
10,000 units 12,500 12,500
As you can see, there is quite a difference in the reported profits. This is due to the fact that, under
absorption costing, more of the fixed cost is carried forward to a later period. In the case of sales of
5,000 units, for instance, the closing stock value has increased from 50,000 to 68,750 (an increase
of 18,750 which equals the increase in profit of 18,750).
An alternative way of viewing this is to calculate the additional cost per unit multiplied by the
number of units in stock (i.e. 13.75 10.00 5,000 =18,750)
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Where there is no change in stock levels, both techniques give the same profit figure as the cost of
sales is exactly the same no matter how it is calculated.
Manufacturing for Profit
One of the major arguments put forward against absorption costing is that, because fixed costs are
apportioned to production and therefore carried forward in closing stock, it is possible to increase
production and thereby increase profit even if sales volumes are static or falling.
This is only a short-term measure though as the costs will still be offset against profit, albeit in a later
accounting period. Using our earlier example once again, let us see what the effect is under
absorption costing of increasing production whilst keeping sales volumes at the same level.
The management at Beanland Ltd decide that although there will be no increase in sales volume this
year from the current potential levels of 5,000, 7,000 or 10,000 units, production will be increased to
15,000 units. All other figures are as before, i.e. sales value per unit is 15, variable costs are 10 per
unit and fixed costs 37,500. The revised profitabilities under absorption costing would be:

Sales 75,000 112,500 150,000
Opening Stock
Fixed Production Cost 37,500 37,500 37,500
Closing Stock (125,000) (93,750) (62,500)
62,500 93,750 125,000
Profit production 15,000
units
12,500 18,750 25,000
Profit production 10,000
units
6,250 9,375 12,500
In all cases the profit is increased because the fixed overhead is spread over more units. The
increased units are carried forward as increased stock and therefore the fixed cost element is carried
also. At production volumes of 15,000 units and sales volumes of 5,000 units for instance, fixed
costs are absorbed at 2.50 per unit, which means that 25,000 of fixed costs will be carried forward
(10,000 2.50). At production volumes of 10,000, fixed cost was absorbed at 3.75 per unit and
therefore 18,750 was carried forward in closing stock (5,000 3.75). The increased level of fixed
cost carried forward is therefore 25,000 18,750 =6,250 the increase in profit for the period at
sales volume of 5,000 units.
Under marginal costing principles, the profit for the period is unchanged because only variable cost is
being carried forward. To prove the point, at sales of 5,000 units the results are as follows:
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Marginal Costing Sales of 5,000 Units, Production of 15,000 Units

Sales 75,000
Opening Stock
Variable Cost 150,000
Closing Stock (100,000) 50,000
Contribution 25,000
Fixed Cost 37,500
Profit (12,500)
which is the same loss that we calculated under production of 10,000 units.
This shows clearly how figures could be manipulated in the short term using absorption costing.
Long-Term Comparisons
Although, as we have just seen, absorption costing can be used to enhance short-term profitability,
over the longer term both techniques will produce the same profitability. This is because the fixed
cost element is the same amount under both it is just that there is a timing differential whereby
some may be carried forward in stock to be expensed in a later period.
To illustrate this, consider the position where we have two accounting periods, sales of 7,500 units in
period 1 and 12,500 units in period 2. Sales values are 15 per unit and variable production costs 10
per unit. Production is 10,000 units per period and opening stock at the beginning of period 1 is zero.
Fixed costs are 37,500 per period; we shall compare the position over the two periods using both
absorption and marginal costing.
(a) Marginal Costing
Period 1 Period 2 Total

Sales 112,500 187,500 300,000
Opening Stock 25,000
Production cost 100,000 100,000
Closing stock (25,000)
75,000 125,000 200,000
Contribution 37,500 62,500 100,000
Fixed cost (37,500) (37,500) (75,000)
Profit/(Loss) 25,000 25,000
Marginal Costing 75
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(b) Absorption Costing
Period 1 Period 2 Total

Sales 112,500 187,500 300,000
Production cost 137,500 137,500
Closing stock (34,375)
103,125 171,875 275,000
Profit/(Loss) 9,375 15,625 25,000
Both methods give the same overall profits because there is no opening stock at the beginning of
period 1 and no closing stock at the end of period 2. The difference is therefore purely one of timing.
The difference in period 1 profit is 9,375, which is the additional fixed cost carried forward under
absorption costing. In the second period this forms part of the cost of sales and hence the absorption
costing profits are 9,375 lower.
Which is Best?
It is generally agreed that marginal costing is more useful in decision making, where a choice has to
be made between alternatives. Marginal costing shows the differential costs, which are more relevant
for decision making.
However, a choice has to be made between marginal and absorption costing in the routine internal
cost accounting system. There is no straightforward answer as to which system should be used. The
system designer must consider all the advantages and disadvantages and what is required from the
system before making a decision. It is therefore worth considering the arguments in favour of each
system in turn.
(a) Arguments in Favour of Absorption (Full) Costing
! When production is constant but sales fluctuate, absorption costing will cause fewer
profit fluctuations than marginal costing. Unnecessary concern could be caused by
marginal costing in periods when stocks are being built up to match future increased
sales demand (see previous example).
! No output can be achieved without incurring fixed production costs, and it is therefore
logical to include them in stock valuations.
! If managers continually use marginal cost pricing, there is a danger that they may lose
sight of the need to examine fixed costs. Absorption costing values all production at full
cost, so that managers are always aware of fixed costs.
(b) Arguments in Favour of Marginal Costing
Supporters of the use of marginal costing systems would argue the following:
! When sales are constant but production fluctuates, marginal costing will give a more
logical, constant profit picture.
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! Since fixed costs accrue on a time basis, it is logical to charge them against sales in the
period in which they are incurred. The internal costing system simply has to meet the
information needs of managers. The marginal costing system will also give a better
indication of the actual cash flow of the business.
! Under- or over-absorption of overheads is not a problem with marginal costing, and
managers are never working under a false impression of profit being made, which
could be totally altered by an adjustment for under- or over-absorbed overheads in
absorption costing.
C. LIMITATION OF ABSORPTION COSTING
You have learned that marginal costing is more useful for decision making. Let us consider the
following scenario. Bill Bloggs and Co., a small company, manufactures three products: the alpha,
the beta and the gamma. It follows the principle of absorption costing, allocating both its factory
fixed overheads and its selling fixed overheads on what it considers to be a correct basis. After six
months, the following profit statement was produced.
Profit Statement Total Cost Basis
Element of Cost Total Cost Product
Alpha
Product Beta Product
Gamma

Direct wages 12,000 3,000 4,000 5,000
Direct material 14,000 6,000 6,000 2,000
Factory overheads
Variable 1,500 600 600 300
Fixed 3,000 1,000 1,000 1,000
Selling overheads
Variable 3,000 2,000 700 300
Fixed 4,500 1,500 1,500 1,500
Total Cost 38,000 14,100 13,800 10,100
Sales Value 48,000 21,000 18,000 9,000
Profit/(Loss) 10,000 6,900 4,200 (1,100)
As a result of this situation, the decision is taken to stop production of Gamma, since it is a loss-
making product. It is easy for Bill Bloggs and Co. to dispense with the services of the workforce
producing Gamma as they are largely part-timers.
Production will concentrate on making Alpha and Beta only. No increase in sales of Alpha and Beta
is possible in the next six months and fixed costs are not capable of being reduced. However,
management looks forward to a better second half of the year with levels and standards of production
being maintained. They assume their second half-yearly profits will be 11,100 (10,000 +1,100).
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The second half of the year profit statement shows the following.
Alpha
Product
Beta

Direct wages 7,000 3,000 4,000
Direct material 12,000 6,000 6,000
Factory overheads
Variable 1,200 600 600
Fixed 3,000 1,500 1,500
Selling overheads
Variable 2,700 2,000 700
Fixed 4,500 2,250 2,250
Total Cost 30,400 15,350 15,050
Sales Value 39,000 21,000 18,000
Profit/(Loss) 8,600 5,650 2,950
The peril of using absorption costing is clear! Management realised eventually by studying these
figures that while they had saved the loss on Gamma of 1,100, Alpha and Beta had to bear the
2,500 fixed costs which had previously been borne by Gamma, hence the profits from Alpha and
Beta were 2,500 less in total. Therefore +1,100 2,500 =1,400. Hence the profit dropped
from 10,000 to 8,600.
78 Marginal Costing
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If the profit statement for the first six-month period had been set out in marginal costing format, it
would have shown the following.
Profit Statement Marginal Costing Basis
Alpha
Product
Beta
Product
Gamma

Sales 48,000 21,000 18,000 9,000
Direct wages 12,000 3,000 4,000 5,000
Direct material 14,000 6,000 6,000 2,000
Variable overheads
Factory 1,500 600 600 300
Selling 3,000 2,000 700 300
Total Variable Cost 30,500 11,600 11,300 7,600
Contribution 17,500 9,400 6,700 1,400
Total Fixed Costs 7,500
Profit 10,000
Notice that Gamma has a contribution of 1,400 towards covering fixed costs. It is this amount that
was lost when the wrong decision to cancel Gamma was made. Marginal costing clearly shows that
Gamma should be retained.
It will be clear to you that however correct the basis on which fixed costs are allocated, it is
nevertheless arbitrary.
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Consider the situation in the first six months if, instead of allocating the fixed factory and selling
overheads equally between Alpha, Beta and Gamma, they had been allocated in the ratio 3 : 2 : 1 (for
some good reason). The profit statement for the first six months would have been as follows.
Alpha
Product Beta Product
Gamma

Direct wages 12,000 3,000 4,000 5,000
Direct material 14,000 6,000 6,000 2,000
Factory overheads
Variable 1,500 600 600 300
Fixed 3,000 1,500 1,000 500
Selling overheads
Variable 3,000 2,000 700 300
Fixed 4,500 2,500 1,500 750
Total Cost 38,000 15,350 13,800 8,850
Sales Value 48,000 21,000 18,000 9,000
Profit/(Loss) 10,000 5,650 4,200 150
Perhaps management might not then have considered taking corrective action to improve the
situation!
It is the allocation of fixed costs which can cause wrong management decisions to be made in
situations such as this.
D. APPLICATION OF MARGINAL AND ABSORPTION
COSTING
To finish off this study unit we shall now look at some more complex comparisons between the two
techniques.
The following example is based on a situation where sales and production differ; thereafter we shall
consider the position when production is constant but sales fluctuate and finally when sales are
constant but production fluctuates. In each case we shall examine which of the two methods is
considered to give the more reasonable calculation of profit.
Where Sales and Production Differ
Using (a) marginal costing, and (b) absorption costing, prepare profit statements, given the following
information.
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Per unit:
Sales price 50
Direct material cost 18
Direct wages 4
Variable production overhead 3
Per month:
Fixed production overhead 99,000
Fixed selling overhead 14,000
Fixed administration overhead 26,000
Variable selling overhead: 10% of sales value
Normal capacity was 11,000 units per month.
March April
(Units) (Units)
Sales 10,000 12,000
Production 12,000 10,000
Answer
The valuation of units of production and stock will differ with each of the costing methods
applied:
(a) Marginal Costing
All units will be valued at the variable production cost of 25:
Direct material cost 18

Direct wages 4
Variable production overhead 3
Total variable production cost 25
Sales Price 50
Production Variable Costs 25
Selling Variable O/H 5 30
Contribution 20 per unit
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Profit Statements for the Months of March
and April Using Marginal Costing
March April
Units 000 Units 000
Sales @ 50 10,000 500 12,000 600
less Cost of sales:
Opening stock @ 25 2,000 50
Variable cost of production @ 25 12,000 300 10,000 250
12,000 300 12,000 300
less Closing stock @ 25 2,000 50
10,000 250 12,000 300
Variable selling overhead 50 60
Total variable cost of sales 300 360
Contribution 200 240
000 000
less Fixed overheads:
Production 99 99
Selling 14 14
Administration 26 26
139 139
Net profit 61 101
Total net profit for March and April = 162,000
(b) Absorption Costing
The valuation of units of production and stock will include a share of the fixed production
overhead for the month. In this example, therefore, the rate for absorption of fixed production
overheads should be based on an activity level of 11,000 units per month:
Therefore, fixed production overhead absorption rate =
99,
,
9
000
11000
= per unit
Therefore, full production cost for one unit to be used in stock valuation is:
per unit
Variable cost 25 (as before)
Fixed production overhead 9
34
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Profit Statements for the Months of March
and April Using Absorption Costing
March April
Units 000 Units 000
Sales @ 50 10,000 500 12,000 600
less Cost of sales:
Opening stock @ 34 2,000 68
Production cost absorbed @ 34 12,000 408 10,000 340
12,000 408 12,000 408
less Closing stock @ 34 2,000 68
10,000 340 12,000 408
Gross profit 160 192
Adjustment for over/(under)-absorption of overheads 9 (9)
169 183
000 000
less Variable selling overhead 50 60
Fixed selling overhead 14 14
Fixed administration overhead 26 26
90 100
Net profit 79 83
Total net profit for March and April = 162,000
Calculation of Over/(Under)-Absorption of Fixed Production Overheads
Production Overhead
Absorbed
Per Unit
Total
Overhead
Absorbed
Overhead
Incurred
Over/(Under)-
Absorption
Units
March 12,000 9 108,000 99,000 9,000
April 10,000 9 90,000 99,000 (9,000)
Note that the net profits for March and April together are the same under both methods
162,000. This is because all of the stock is sold by the end of April and, therefore, all costs
have been charged against sales. The adjustment for over-/under-absorption arises because in
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both months there was 99,000 fixed production overhead but in March 1,000 more units than
normal were produced and in April 1,000 less.
The net profit figure for March is 18,000 higher using absorption costing, owing to 18,000
of fixed production overhead being carried forward in stock, to be charged against the sales
revenue for April. Stock =2,000 units 9 =18,000.
When Production is Constant but Sales Fluctuate
Absorption costing is usually considered more suitable in these circumstances.
Example
MC Ltd manufacture and sell a single product. Cost and revenue details of the product are as
follows:
Per unit:
Sales price 20
Variable cost of production 6
Per month:
Fixed selling and administration overhead 3,000
It is MCs policy to maintain a constant production output at the normal capacity of 1,000 units per
month, despite fluctuations in monthly sales levels. Sales achieved for the months of J anuary to April
were as follows:
Units
J anuary 400
February 500
March 1,400
April 1,700
You are asked to prepare profit statements for J anuary to April, using:
(a) marginal costing;
(b) absorption costing.
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Answer
(a) Profit Statements Using Marginal Costing
January February March April
Units Units Units Units
Sales @ 20 400 8,000 500 10,000 1,400 28,000 1,700 34,000
less
Cost of sales:
Opening stock @ 6 600 3,600 1,100 6,600 700 4,200
Variable production
cost @ 6 1,000 6,000 1,000 6,000 1,000 6,000 1,000 6,000
1,000 6,000 1,600 9,600 2,100 12,600 1,700 10,200
less
Closing stock @ 6 600 3,600 1,100 6,600 700 4,200
400 2,400 500 3,000 1,400 8,400 1,700 10,200
Contribution 5,600 7,000 19,600 23,800

less
Fixed overheads:
Production 5,000 5,000 5,000 5,000
Selling and
administration 3,000 3,000 3,000 3,000
8,000 8,000 8,000 8,000
Profit/(Loss) (2,400) (1,000) 11,600 15,800
Total profit for the four months = 24,000
(b) Using Absorption Costing
Fixed production overhead absorption rate=
5,
,
000
1000
units
= 5 per unit
Therefore, full production cost = 5 +6 variable cost per unit
= 11 per unit
Note that there will be no over- or under-absorption of fixed production overheads, because the
production for every month is equal to the normal capacity of 1,000 units.
Marginal Costing 85
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Profit Statements Using Absorption Costing
Sales @ 20 400 8,000 500 10,000 1,400 28,000 1,700 34,000
less
Cost of sales:
Opening stock @ 11 600 6,600 1,100 12,100 700 7,700
Full production
cost @ 11 1,000 11,000 1,000 11,000 1,000 11,000 1,000 11,000
1,000 11,000 1,600 17,600 2,100 23,100 1,700 18,700
less
Closing stock @ 11 600 6,600 1,100 12,100 700 7,700
400 4,400 500 5,500 1,400 15,400 1,700 18,700
Gross Profit 3,600 4,500 12,600 15,300
less
Fixed overheads:
Selling and
administration 3,000 3,000 3,000 3,000
Net Profit 600 1,500 9,600 12,300
Total profit for the four months = 24,000
You can see, therefore, that when production is constant but sales fluctuate each month, absorption
costing will cause fewer profit fluctuations than marginal costing. Managers could have been caused
concern if marginal costing had been used, because of the losses which this method would show in
J anuary and February. With absorption costing, the fixed production overheads were carried forward
in stock, to be matched against the relevant revenue when it arose in March and April. In these
circumstances no corrective action is necessary, provided the increase in sales in March and April
was foreseen.
When Sales are Constant but Production Fluctuates
This is not likely to occur in practice but, in this situation marginal costing would show a constant
level of profit linked to the constant sales.
Consider again the previous example of MC Ltd, and prepare profit statements using:
(a) marginal costing,
(b) absorption costing,
for J anuary to April, based on the same cost data and the following activity levels:
86 Marginal Costing
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Sales Units Production Units
J anuary 1,000 1,900
February 1,000 1,000
March 1,000 600
April 1,000 500
Note: 1,000 units per month is still considered to be normal capacity.
(a) Profit Statements Using Marginal Costing
Sales @ 20 1,000 20,000 1,000 20,000 1,000 20,000 1,000 20,000
less
Cost of sales:
Opening stock @ 6 900 5,400 900 5,400 500 3,000
Variable production
cost @ 6 1,900 11,400 1,000 6,000 600 3,600 500 3,000
1,900 11,400 1,900 11,400 1.500 9,000 1,000 6,000
less
Closing stock @ 6 900 5,400 900 5,400 500 3,000
1,000 6,000 1,000 6,000 1,000 6,000 1,000 6,000
Contribution 14,000 14,000 14,000 14,000

less
Fixed overheads:
Production 5,000 5,000 5,000 5,000
Selling and
administration 3,000 3,000 3,000 3,000
8,000 8,000 8,000 8,000
Profit/(Loss) 6,000 6,000 6,000 6,000
Total net profit for the four months = 24,000
Marginal Costing 87
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(b) Profit Statements Using Absorption Costing
Sales @ 20 1,000 20,000 1,000 20,000 1,000 20,000 1,000 20,000
less
Cost of sales:
Opening stock @ 11 900 9,900 900 9,900 500 5,500
Full production
cost @ 11 1,900 20,900 1,000 11,000 600 6,600 500 5,500
1,900 20,900 1,900 20,900 1,500 16,500 1,000 11,000
less
Closing stock @ 11 900 9,900 900 9,900 500 5,500
1,000 11,000 1,000 11,000 1,000 11,000 1,000 11,000
Gross Profit 9,000 9,000 9,000 9,000
Adjustment for over/
(under)-absorbed overheads 4,500 (2,000) (2,500)
13,500 9,000 7,000 6,500
less
Fixed overheads:
Selling and
administration 3,000 3,000 3,000 3,000
Net Profit 10,500 6,000 4,000 3,500
Total net profit for the four months = 24,000
Calculation of Over/(Under)-Absorption of Fixed Production Overheads
Production Overhead
Absorbed
Per Unit
Total
Overhead
Absorbed
Overhead
Incurred
Over/(Under)-
Absorption
Units
J anuary 1,900 5 9,500 5,000 4,500
February 1,000 5 5,000 5,000
March 600 5 3,000 5,000 (2,000)
April 500 5 2,500 5,000 (2,500)
88 Marginal Costing
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Where Resources are Limited
From what we have learnt so far, it will be clear that in Marginal Costing, the increase in profit arises
from the increase in contribution and/or reduction in fixed costs. Normally an organisation will
concentrate on increasing contribution by selling (subject to market conditions) those products which
produce the greatest contribution per unit. Sometimes, however, there is a limit to the amount of
resources available to the organisation, e.g. man hours, machine hours or raw materials. In this event
the organisation should concentrate on selling the product(s) which produce the greatest contribution
per unit of limited resource.
For example, we have three Products; A, B and C.
A B C

Selling Price per unit 10 12 16
Variable Cost per unit 4 7 14
Contribution 6 5 4
Obviously without a limiting factor it is best to sell as many items of A as possible, then B, then C.
However suppose there is a limit on the man hours available and the following man hours are used on
each unit:
A 3 hours
B 2 hours
C 1 hour
The contribution per limiting factor becomes:
A:
3
6
= 2 contribution per man hour
B:
2
5
= 2.50 contribution per man hour
C:
1
4
= 4 contribution per man hour
Then the organisation should concentrate first on selling C, then B, then A and thus maximise
contribution relative to the limited resource available.
SUMMARY
As you may gather from the preceding examples, there are arguments for and against both costing
methods.
To summarise, the arguments put forward in favour of marginal costing are:
(a) It is inappropriate to apportion fixed costs over production because they are not affected by
output and therefore should be charged in full to the period in question.
Marginal Costing 89
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(b) Contribution varies directly with the level of sales; it is therefore much easier to assess likely
profits using marginal costing rather than apportioning fixed overhead which will make the
decision-making process more complex.
(c) Marginal costing is a simpler technique to understand and operate.
(d) There is always the danger that, under absorption costing, production will be increased to
absorb fixed overheads over a larger number of units, thereby increasing short-term profits.
(e) It is more appropriate to value stocks at variable costs only.
The arguments in favour of absorption costing are:
! To comply with certain statutory stock reporting requirements, it is considered that absorption
costing gives a truer view of the costs incurred in production.
! Apportioning fixed overhead ensures that, for decision-making purposes, fixed overhead is
fully covered when setting selling prices.
! As fixed overhead is incurred in order to produce output, it is reasonable that such cost should
be charged out.
90 Marginal Costing
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91
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Study Unit 6
Activity-Based and Other Modern Costing Methods
Contents Page
Introduction 92
A. Activity-Based Costing (ABC) 92
Problems of Traditional Methods 92
Stages in Activity-Based Costing 93
Cost Drivers 93
Advantages of ABC 94
Problems Encountered 94
Example 95
Criticism of the Activity-Based Costing Technique 99
The Debate About ABC 106
B. Throughput Accounting 106
C. Backflush Accounting 107
D. Just-in-Time (JIT) Manufacturing 108
Features 108
Goals 109
Cost Savings Under J IT 110
Advantages of J IT 111
Disadvantages of J IT 112
92 Activity-Based and Other Modern Costing Methods
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INTRODUCTION
Having looked in detail at the traditional approaches of absorption and marginal costing, we will now
concentrate in this study unit on up-to-date theories that have arisen in recent years, partly as a
response to the shortcomings of the traditional methods.
Activity-based costing, on which the major part of this study unit is based, is an attempt to apply
costs to the activities which cause them. As well as covering the theory of this method, consideration
will also be given as to how results differ compared to the traditional methods.
Finally, throughput and backflush costing will be considered along with an appraisal of J ust-In-Time
(J IT) manufacturing and its impact on costing systems.
A. ACTIVITY-BASED COSTING (ABC)
Problems of Traditional Methods
Both the traditional absorption and marginal costing systems (used prior to activity-based costing)
have fundamental weaknesses and can therefore be inaccurate as a means of costing. In the case of
marginal costing, the main problem is that overheads are virtually ignored. This is because
overheads are a sunk cost, i.e. they must be paid for regardless of the level of activity. Ignoring
overheads tends to inflate profits artificially. The profit is, in effect, the contribution. The major
danger, therefore, is that overheads are not allocated to products and may not be recovered when
setting a selling price. As a result, the company may drift into loss and eventually go out of business.
Absorption costing, on the other hand, allocates or apportions all overheads to products. In order to
do this, companies must allocate and apportion service overheads to the main production
departments. Direct labour and/or machine hour rates are then calculated. Costs are therefore
allocated to various departments and the process assumes that overheads relate directly to the level of
production. The problem with this approach is that the allocation of costs is carried out on an
arbitrary basis and may not reflect accurately on those activities which are truly responsible for the
costs. Sometimes, a particular product or activity may show a loss simply because the ways in which
costs are allocated have changed.
Absorption costing is also time-consuming. It requires a lot of time and energy to decide and
implement a basis of overhead allocation and apportionment. However, this allocation process may
obscure the main causes for these costs.
ABC theory has arisen as a result of dissatisfaction with traditional costing methods. It attempts to
apportion costs in relation to activities. Specifically, the problems it intends to counteract are as
follows:
(a) Traditional costing methods split costs between fixed and variable. It is argued, however, that
the time-scales applicable to most projects make this approach redundant. Instead, costs
should be looked at in terms of short-term and long-term, since most strategy decisions cover a
three- to five-year time-scale during which period most costs can become variable.
(b) In addition, as businesses grow over a period of time, the complexity of the business increases
also. Thus, costs vary due to this complexity and not necessarily with volume. A business
which produces, for example, a hundred items will probably require more sophisticated support
functions than a business which produces only one or two. When costs are allocated on
volume, the products with the highest output will be allocated the highest level of apportioned
Activity-Based and Other Modern Costing Methods 93
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cost. In reality, however, the items with the smaller volumes may take a disproportionate
amount of time and material to set up, but will only be allocated a very small proportion of
support cost.
(c) Many costing systems are based on financial costing systems and are therefore inappropriate
for decision-making purposes. In particular, only production overheads may be absorbed into
product cost for the purposes of stock valuation, whilst ignoring selling and administration
overheads.
(d) Labour hours are often used as the basis for absorption, even though direct labour often forms
a relatively small proportion of total cost.
Stages in Activity-Based Costing
The stages in activity-based costing are as follows:
(a) Identify those activities that cause overheads to be incurred.
(b) Adjust the accounting system so that costs are collected by activity rather than by cost centre.
(c) Identify those factors which cause each activitys costs to change (the cost drivers see
below).
(d) Establish the volume of each cost driver.
(e) Calculate the cost driver rates by dividing the activitys cost by the volume of its cost driver.
(f) Establish the volume of each cost driver required by each product.
(g) Calculate overheads attributable to each product by multiplying step (e) by step (f).
Certain jobs which are high volume in nature tend to be over-costed under the traditional system.
This is because costs are often allocated based on the number of machine hours, etc. However, small,
less routine jobs which can often prove troublesome are under-costed, simply because they do not use
up too many machine hours, etc. This situation arises perhaps because there are additional costs
associated with short-run production costs which are not adequately reflected in the companys
costing system.
Cost Drivers
Emphasising the approach of ABC to identifying activities and their associated costs is the concept of
cost drivers which can be defined as activities which cause costs rather than the costs themselves.
A distinction can also be made between those processes which add value and those which do not.
The importance of this is that processes which do not add value are potential areas for cost reduction
without affecting the product itself.
Short-term variable costs may be allocated using volume-related cost drivers such as direct labour
hours, machine hours, or direct material cost. Items such as electricity would be driven by machine
hours and apportioned according to the variability of the driver. In a similar way, some items may
vary with the value of materials consumed or with direct labour hours.
In terms of support functions, it is the transactions undertaken by the personnel of the support
department which are the relevant cost drivers. A few examples will help to make this a little clearer.
! The number of goods inwards orders drives the goods inwards department.
! The number of production runs undertaken drives several items such as inspection, set-up and
production scheduling costs.
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! The number of despatch orders would drive the costs of the goods outwards department.
Once the cost drivers are identified, each one is designated as a cost centre to which are allocated all
associated costs. In the goods outwards example, the costs identified with the cost centre are divided
by the number of goods outwards to determine the charge-out rate. If, for example, costs were
identified as 5,000 and 1,000 items were despatched, the charge-out rate would be 5 per item.
Advantages of ABC
The benefits put forward for the ABC approach include the following:
(a) The identification of costs with the activities which cause them becomes much clearer, the
resultant cause and effect enhancing managerial control.
(b) Cost drivers can be used not only as a cost measure but also as a performance measure.
(c) The identification of costs from cost-driver analysis is helpful for budgeting within support
departments.
(d) The availability of cost-driver rates can be used as an input into the design of new products and
modification to existing ones.
(e) In overcoming some of the historic problems associated with cost allocation, the provision of
costing information is viewed with much more confidence by the relevant managers.
(f) In comparison with traditional methods, costs will be allocated in different proportions, so
highlighting unprofitable products that should either be improved or removed from the range.
Problems Encountered
ABC is a relatively new technique and the potential problems may appear only over a longer period
of time as more investigation and analysis is undertaken in instances where it is installed in a real
life situation. One thing that is unclear at present is the impact on motivation and managerial
behaviour, because it is a new technique. The complete change from traditional methods may result
in hostility to the new format, especially in large organisations where the change aversion culture is
deep set. It may again prove to be the smaller, innovative companies where the technique proves
most successful.
Other problems are as follows:
(a) The impact of ABC on profitability and cost reduction is as yet unclear also.
(b) The information produced is on a historic basis so care must be exercised when using it as a
basis for future strategy.
(c) Initial problems are often encountered because of the change of emphasis on the cause of costs.
(d) The identification of cost drivers is not always obvious. If the wrong ones are identified the
whole system will be incorrect.
(e) The reporting of activity-based costs often cuts across traditional boundaries of control when
attempting to define responsibility. Care must be taken to ensure that the costs allocated to a
cost centre or driver are controllable by the manager concerned.
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Example
Product X is manufactured in long production runs, while product Y, even though it has more
components, is manufactured in small batches.
Product X Product Y
Monthly production 5,000 6,000
Direct material costs
Department A 4.00 5.00
Department B 4.00 4.00
Department C 2.00 10.00 3.00 12.00
Direct labour costs 5.00 7.00
Machine hours
Department A 0.5 0.6
Department B 0.5 0.9
Department C 0.25 0.5
In addition, the following overheads are incurred:

Production department overheads
Department A 20,000
Department B 15,000
Department C 10,000
Service department overheads
Purchasing 6,000
Production control 5,000
Tool setting 12,000
Maintenance 3,000
Quality control 4,000
(a) Product Costs Calculated Using Absorption Costing
The first step is to apportion the service department overheads to the production departments.
In this example we will use the following basis of apportionment:
! Purchasing: direct material costs
! Production control: direct material costs
! Tool setting: direct material costs
! Maintenance: machine hours
! Quality control: machine hours
We can calculate the monthly material costs and machine hours from the previous data as
follows:
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Department
A
Department
B
Department
C
Total
Machine hours
Product X 2,500 2,500 1,250 6,250
Product Y 3,600 5,400 3,000 12,000
Total 6,100 7,900 4,250 18,250
Department % of total 33.42% 43.28% 23.28% 100%
Direct materials
Product X 20,000 20,000 10,000 50,000
Product Y 30,000 24,000 18,000 72,000
Total 50,000 44,000 28,000 122,000
We can now prepare the overhead analysis sheet apportioning service department overheads to
production departments.
Overheads Cost Basis Dept A Dept B Dept C

Production overheads:
Department A 20,000 20,000
Department B 15,000 15,000
Department C 10,000 10,000
Service overheads:
Purchasing 6,000 (direct materials) 2,459 2,164 1,377
Production control 5,000 (direct materials) 2,049 1,803 1,148
Tool setting 12,000 (direct materials) 4,918 4,327 2,754
Maintenance 3,000 (machine hours) 1,003 1,298 698
Quality control 4,000 (machine hours) 1,337 1,731 931
Total 75,000 31,766 26,323 16,908
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We can now calculate a machine hour rate as follows:
Dept A Dept B Dept C
Total cost 31,766 26,323 16,908
Machine hours 6,100 7,900 4,250
Rate per hour 5.21 3.33 3.98
And finally, on the basis of the hourly usage, we can now allocate overheads as follows:
Dept A Dept B Dept C Total
Rate per hour 5.21 3.33 3.98
Hours Product X 0.5 0.5 0.25
Overhead charge X 2.60 1.67 0.99 5.26
Hours Product Y 0.6 0.9 0.5
Overhead charge Y 3.13 3.00 1.99 8.12
(b) Cost Calculation Using Activity-Based Costing
With activity-based costing we try to identify the cost drivers. The cost drivers determine the
cost level and may be categorised in the above example as follows:
Activity Cost Driver
Purchasing Number of orders
Production control Number of components produced
Tool setting Number of tool changes
Maintenance Machine hours
Quality control Number of components inspected
Production Dept A Machine hours
Production Dept B Machine hours
Production Dept C Machine hours
In order to keep this example simple, we assume that the production department overheads are
directly related to machine hours worked. In practice we might find it worthwhile to divide
each department into a number of different activities, each with their own cost driver.
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In order to carry out the allocation of overheads on the basis of activity-based costing we shall
need additional information as follows:
Cost Driver Product X Product Y Total
Number of orders 300 900 1,200
Number of components produced 15,000 48,000 63,000
Number of tool changes 10 60 70
Machine hours 6,250 12,000 18,250
Number of components inspected 2,000 11,000 13,000
Total 95,520
On the basis of the above information we can now make the following calculations:
Cost Driver Cost Allocation Allocation Rate
Number of orders 6,000 1,200 5.00
Number of components produced 5,000 63,000 0.08
Number of tool changes 12,000 70 171.43
Machine hours 3,000 18,250 0.16
Number of components inspected 4,000 13,000 0.31
Machine hours Dept A 20,000 6,100 3.28
Machine hours Dept B 15,000 7,900 1.90
Machine hours Dept C 10,000 4,250 2.35
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The allocation under activity-based costing is:
Cost Driver Product X
Product Y
Total
Number of orders 1,500 4,500 6,000

Number of tool changes 1,714 10,286 12,000
Machine hours 1,027 1,973 3,000
Number of components inspected 615 3,385 4,000
Production Dept A 8,197 11,803 20,000
Production Dept B 4,747 10,253 15,000
Production Dept C 2,941 7,059 10,000
Total 21,931 53,069 75,000
Quantity produced 5,000 6,000
Overhead per product 4.39 8.84
In the case of purchasing the calculation for Product X is 1,500 (5 rate per order multiplied
by 300 number of orders for Product X). Note that correcting to 2 decimal places may make
figures difficult to reconcile.
Product Ys cost is greater than that obtained from the traditional absorption costing method
and reflects the additional costs involved in its manufacture.
Criticism of the Activity-Based Costing Technique
Although activity-based costing is a more accurate method of allocating costs, its major weakness lies
in its complexity. As you can see from the example, you need a considerable amount of information
before activity-based costing can apply. For instance, we needed to know the number of orders, the
components produced, the components inspected, etc. All this information may be difficult to obtain
and may also be inaccurate. The result is that costs may be apportioned on an incorrect basis. It is
likely that only large companies will resort to activity-based costing techniques.
Nevertheless, as a student, activity-based costing will help you to understand exactly what
management accounting is trying to achieve. The traditional methods of costing are often unreliable,
because they penalise large volume projects even though such projects may be relatively
straightforward to implement and may involve only minimum administration costs.
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Example
Assume that you are given the following information about a company that makes compact discs and
LP records:
Compact
Discs
Records
Monthly production 15,000 5,000
Direct material costs
Pressing Dept 5.00 6.00
Cutting Dept 5.00 7.00
Packing Dept 3.00 13.00 2.00 15.00
Machine hours
Packing Dept 0.5 0.3
In addition, the following overheads are incurred:
Basis of Apportionment
Production department overheads
Pressing Dept 25,000
Cutting Dept 30,000
Packing Dept 16,000
Service department overheads
Purchasing 7,000 direct material costs
Production control 5,000 direct material costs
Set-up costs 12,000 direct material costs
Maintenance 3,000 machine hours
Quality control 4,000 machine hours
Question 1
The company wishes to introduce a pricing system which is 20% mark-up on marginal costs.
Calculate the price it should charge for compact discs and records. Outline the disadvantages
associated with this approach.
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Solution
Under the marginal cost pricing method we apply the mark-up on variable costs only. Fixed costs are
ignored. Therefore the price which we charge is calculated as follows:
Compact Discs Records

Direct material costs:
Packing Dept 3.00 13.00 2.00 15.00
Total variable costs 18.00 22.00
Mark-up 20% 3.60 4.40
Price 21.60 26.40
The disadvantage with this approach is that we fail to consider fixed costs. If the volume sold is
very high then the fixed cost overhead charge may be insignificant because the costs are allocated
over a large number of products. However, if we fail to consider fixed costs, then the company could
incur losses.
Question 2
The company decides to charge 15% on full cost (absorption basis). What will the new price be for
compact discs and records? Outline the advantages of the absorption approach in this case.
Solution
If the company adopts the absorption approach, it needs to prepare the following schedule:
Pressing Dept Cutting Dept Packing Dept Total
Machine hours
Compact discs 9,000 9,000 7,500 25,500
Records 2,500 2,500 1,500 6,500
Total 11,500 11,500 9,000 32,000
Direct materials
Compact discs 75,000 75,000 45,000 195,000
Records 30,000 35,000 10,000 75,000
Total 105,000 110,000 55,000 270,000
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On the basis of this we can now allocate the overheads as follows:
Overheads Cost Basis Pressing Cutting Packing

Production overheads:
Pressing Dept 25,000 25,000
Cutting Dept 30,000 30,000
Packing Dept 16,000 16,000
Service overheads:
Purchasing 7,000 (direct materials) 2,722 2,852 1,426
Production control 5,000 (direct materials) 1,944 2,037 1,019
Set-up costs 12,000 (direct materials) 4,667 4,889 2,444
Maintenance 3,000 (machine hours) 1,078 1,078 844
Quality control 4,000 (machine hours) 1,438 1,437 1,125
Total 102,000 36,849 42,293 22,858
The department hourly rates are therefore:
Pressing Dept Cutting Dept Packing Dept
Total cost 36,849 42,293 22,858
Machine hours 11,500 11,500 9,000
Rate per hour 3.20 3.68 2.54
We can now allocate these hourly rates to the compact discs and records as follows:
Pressing
Dept
Cutting
Dept
Packing
Dept
Total
Hours Compact discs 0.6 0.6 0.5
Overhead charge Compact discs 1.92 2.21 1.27 5.40
Hours Records 0.5 0.5 0.3
Overhead charge Records 1.60 1.84 0.76 4.20
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Finally, we can calculate the full cost price as follows:

Packing Dept 3.00 13.00 2.00 15.00
Fixed cost allocation 5.40 4.20
Total cost 23.40 26.20
Mark-up 15% 3.51 3.93
Price 21.91 30.13
The advantage of this approach is that we consider fixed costs and therefore price the products with
the intention of recovering those fixed costs. The disadvantage is that costs are allocated on an
arbitrary basis, which bears no relationship to the level of activity involved. Strictly speaking,
although the process of making compact discs may be more complex, there is still the benefit that we
are dealing in large quantities compared to records and therefore the fixed cost per unit should ideally
be a lot lower than it is.
Question 3
The company decides to continue charging 15% on full cost, but this time they use activity-based
costing rather than the conventional absorption approach. Show the new pricing policy and outline
the advantages and disadvantages of the new approach.
You may find the following information helpful:
Activity Cost Driver
Purchasing Number of orders
Production control Number of components produced
Tool setting Number of tool changes
Maintenance Machine hours
Quality control Number of components inspected
Pressing Dept Machine hours
Cutting Dept Machine hours
Packing Dept Machine hours
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Cost Driver Compact Discs Records Total
Number of orders 200 2,000 2,200
Number of tool changes 100 200 300
Machine hours 6,000 15,000 21,000
Number of components inspected 4,000 13,000 17,000
Total 22,300 80,200 102,500
Solution
The first step is to calculate the cost-driver rates:
Cost Driver Cost Allocation Allocation Rate
Number of orders 7,000 2,200 3.18
Number of components produced 5,000 62,000 0.08
Number of tool changes 12,000 300 40.00
Machine hours 3,000 21,000 0.14
Number of components inspected 4,000 17,000 0.24
Pressing Dept 25,000 11,500 2.17
Cutting Dept 30,000 11,500 2.61
Packing Dept 16,000 9,000 1.78
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We now allocate the costs between the products:
Cost Driver Compact Discs
Records
Total
Number of orders 636 6,364 7,000

Number of components produced 968 4,032 5,000
Number of tool changes 4,000 8,000 12,000
Machine hours 857 2,143 3,000
Number of components inspected 941 3,059 4,000
Pressing Dept 19,565 5,435 25,000
Cutting Dept 23,478 6,522 30,000
Packing Dept 13,333 2,667 16,000
Total 63,778 38,222 102,000
Quantity produced 15,000 5,000
Overhead per product 4.25 7.64
In the case of orders the 636 represents the number of orders for compact discs multiplied by the
allocation rate of 3.18. All the other figures can be obtained using the same method. (Again allow
for rounding errors.)
We now return to our pricing chart but taking the new overhead charges into consideration.

Packing Dept 3.00 13.00 2.00 15.00
Fixed cost allocation 4.25 7.64
Total cost 22.25 29.64
Mark-up 15% 3.34 4.45
Price 25.59 34.09
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The Debate About ABC
... (Activity-based costing) certainly ranks as one of the two or three most important
management accounting innovations of the twentieth century
(H. T. J ohnson quoted in the Foreword to Innes, J . and Mitchell, F.(1991) Activity-
Based Cost Management A Case Study of Development and Implementation, London,
CIMA).
... (Activity-based costing) is on the surface appealing and logical, but it does not stand
up to close scrutiny
(Piper, J . A. and Walley, P., Testing ABC Logic in Management Accounting,
September 1990).
Absorption costing and marginal costing approaches have their critics but the accuracy of ABC
systems is also challenged by some writers, as it is probably necessary to adopt simplifying
assumptions in order to keep down the number of cost drivers. Despite improvement arising from the
ABC approach, it is still necessary to apportion some overheads, such as rent and rates, to products
on what may still be considered an arbitrary basis.
The accuracy of ABC methods can certainly be challenged but it needs to be recognised that those
companies which have introduced the approach do not consider more accurate product costs as the
main reason for change. The prime motive has been the belief that ABC will help them understand
the nature of costs and the factors that drive them. They appreciate, too, that the involvement of
the management team in the investigative processes necessary to identify activities and drivers should
also lead to improvements and cost reduction. It is not, therefore, solely a costing technique.
In conclusion, it must be appreciated that production techniques have changed dramatically in recent
years with the advent of Total Quality Management and J ust-in-Time (J IT) production. Costing
techniques must also change. Traditional methods measure machine and factory efficiency and put a
cost on machinery and equipment that is not fully utilised. These costing techniques have encouraged
production management to adopt long production runs in order to improve efficiency. This has led
sometimes to high stock levels and inflexibility, as in some cases it will not be economical to
introduce product improvements and design changes until stocks have been consumed. There are
also additional handling costs and damage associated with higher stock levels. ABC focuses on the
activities that cause costs to be incurred and the drivers that cause them to change. This should
improve the quality of managements decisions and lead to improved profitability.
B. THROUGHPUT ACCOUNTING
One of the potential drawbacks with the concept of ABC is that whilst it is useful for medium- to
long-term decisions, it largely ignores the impact of short-term decisions.
Because of the rapid changes that have occurred within manufacturing, both in terms of concept (such
as J IT, etc.) and process (i.e. robotics and automation in general), accounting systems designed to
monitor and control them have had to be adapted also. Perhaps the greatest change has occurred in
the nature of costs:
(a) Companies using J IT and similar techniques now hold much lower stock levels.
(b) The increasing level of automation means a greater proportion of costs are fixed.
(c) As a consequence of (b), the level of direct labour has also fallen.
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The concept of throughput accounting attempts to recognise this shift in fixed costs and also
overcomes one of the difficulties with ABC by concentrating on the short term. It does this by
assuming that all costs except those of materials are fixed in short time spans. In addition, it takes the
view that traditional costing systems are wrong to value stocks and work-in-progress as cost plus
added value, because this results in an incorrect value being accorded to them. Instead, it sees the
speed of response to customer demand as important and views levels of stock as inefficiency in the
ability to meet that demand (i.e. if customer demands cannot be met immediately, this will result in a
buffer of stock being held and this is inefficient).
Furthermore, bottlenecks should be concentrated on to ensure maximum utilisation of resources; it is
pointless running one machine at maximum capacity whilst there is a bottleneck elsewhere, as this is
merely producing more work-in-progress.
Throughput accounting is consistent with J IT in that it aims for minimal stock levels by concentrating
on areas of constraint, but it has been severely criticised because it concentrates too much on the
short term.
C. BACKFLUSH ACCOUNTING
The CIMA definition of backflush accounting is as follows:
A cost accounting system which focuses on the output of an organisation and then
works backwards to attribute costs to stock and cost of sales.
The aim of backflush accounting is simplification; the idea is to allocate conversion costs at certain
points in the production process, i.e. at the point where materials are requisitioned, after the first
process, and so on. There is no maximum or minimum number of these points and the easiest way is
to charge when materials are issued and the goods completed.
Conversion costs consist of the labour and overhead required to produce the finished goods and are
charged at standard cost. A variance between the actual incurred and standard charged is written off.
Example
MNO Ltd has incurred the following costs over the year:
Sales 250,000 items @ 10 each
Direct labour cost 800,000
Raw materials cost 1,250,000
Finished goods produced 260,000 items
The company operates a system of backflush accounting and the following information is also
relevant:
Standard cost of raw material per unit 4.80
Standard conversion cost per unit 3.10
Standard cost per unit 7.90
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If we assume that there are no opening stocks then the system of backflush accounting will calculate
the cost of sales as follows:
Raw materials 250,000 4.80 = 1,200,000
Conversion cost 250,000 3.10 = 775,000
Total cost 250,000 7.90 = 1,975,000
Gross profit will therefore be:
Sales (250,000 10) 2,500,000

Direct cost (as above) 1,975,000
Gross profit 525,000
Raw materials in stock will be:
Purchased 1,250,000
less Allocated to finished goods (260,000 4.80) (1,248,000)
2,000
Finished goods in stock will be:
Raw materials used (as above) 1,248,000

plus Conversion cost allocated (260,000 3.10) 806,000
less Allocated to cost of sales (1,975,000)
79,000 (10,000 units @ 7.90)
The difference between conversion cost incurred (800,000) and the amount allocated (775,000) of
25,000 is written off at the end of the financial year.
This system of cost allocation therefore does away with the need to calculate many different overhead
allocations as with a traditional system.
As with throughput accounting, backflush accounting is based on the view put forward earlier that
with increasing usage of J IT, overall stock levels will decrease, with the result that it is difficult to
justify having a complex system to calculate stock values.
D. JUST-IN-TIME (JIT) MANUFACTURING
Features
In the context of what we have covered so far in this study unit, J IT is a modern manufacturing
concept with radical implications for the associated costing systems. It is a method of providing
production with the inputs it requires as and when they are needed.
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A common misconception is that J IT is purely a form of stock control, whereas it is in effect an
overall management philosophy covering all aspects of the production process.
(a) Quality
This is not necessarily quality of the product to the final customer, but rather quality in the
following terms:
! Products should be standardised and easy to produce.
! Processes, e.g. plant layout and tool and machinery design, are of critical importance.
! Suppliers should consist of a small number, each of whom provides proven quality in
terms of product and delivery deadlines.
(b) Purchasing
This is the most well known aspect whereby small numbers of items are delivered when
required, but much more frequently.
(c) Production Control
Final customer demand forms the basis of the determinants of output and therefore materials
used. The demand pulling of materials can be centralised with traditional pushing methods
where the size of the economic batch quantity determines materials usage requirements. The
speed of production should also be dictated by the needs of the customer, i.e. how quickly the
items are required.
In addition, set-up times do not add value and should therefore be eliminated or reduced as
much as possible.
(d) Employee Involvement
Employees are expected to be much more flexible in addition to experiencing greater levels of
participation and responsibility.
Goals
(a) Elimination of Non-Value-Adding Activities
J IT is dedicated to the elimination of waste, which is defined as anything that does not add
value to a product. In manufacturing, the following activities occur before the item is sold
(this is called the lead time):
! process time
! inspection time
! move time
! queue time
! storage time.
Of these five activities only process time adds value to the product. The other activities, in J IT
terms, are non-value-adding activities. The idea of J IT is to reduce the lead time until it equals
the process time.
The first stage in implementing a J IT system involves the rearrangement of the factory layout.
In a traditional or functional plant layout similar machines are grouped together, and the item
being manufactured travels from department to department as the various manufacturing
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processes occur to the item, e.g. the item will go to the drilling department, then to the grinding
department, then to the turning department.
In a J IT system dissimilar machines are arranged, often in a U shape, around a J IT cell which
manufactures the item. Each member of the cell can operate all the machines and the aim is
that the item is manufactured without ever leaving the cell. The item does not go back to store
or sit around awaiting the next process. J IT uses what is known as cellular manufacturing.
As we said earlier, the aim of J IT is to produce the right part at the right time. This results in
the pull manufacturing system as opposed to traditional manufacturing methods, which are
called push manufacturing systems because the items push their way from department to
department, often resulting in them waiting in queues for the next process.
(b) Zero Inventory
As you will see from the description of J IT as a pull manufacturing system, the idea is that
items are only produced as they are required and thus no large stocks of manufactured goods
are accumulated.
(c) Zero Defect
J IT is based on doing it right first time. In a conventional system it is assumed that some
items will become defective and some departments will suffer breakdowns. This results in the
maintenance of stocks of work-in-progress to provide work for departments at all times. It also
results in high stock levels which J IT does not sanction.
(d) Batch Size of One
Small batches of items are usually avoided because the cost of setting-up the machines is too
high to make small batches economic. As J IT works to eliminate set-up time as it is a non-
value-adding activity, batch sizes can be reduced, thus preventing the development of
bottlenecks, which occur when long production runs are used.
(e) Zero Breakdown
Zero breakdown is aimed for by planning for preventive maintenance to be carried out within
the cell; all members are trained not only to use but also to maintain their machines.
Breakdowns can thus be reduced significantly and repair carried out more quickly should a
breakdown occur.
(f) 100% On Time Delivery
If the previous aims are achieved then it follows that delivery will always be on time.
(g) JIT Purchasing
The principles of J IT are applied equally to all outside purchases of components. Suppliers
must not only supply on time in the quantities required, but must also guarantee quality. This
saves costs by eliminating handling costs as inspection is no longer needed.
Cost Savings Under JIT
As we have seen, the main objective of J IT is to eliminate or reduce those tasks which do not add
value to the final product. As a numerical example of the savings that can occur under a J IT system,
consider the following example.
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Example
Non-J IT Ltd and J IT Ltd produce identical goods from similar raw materials. The following are the
costs applicable to Non-J IT Ltd and J IT Ltd:
Non-JIT Ltd
JIT Ltd
Materials inspection costs 75,000

Materials storage costs 30,000
Materials movement costs 25,000 10,000
Process 1 costs 45,000 45,000
Process 2 costs 35,000 35,000
J IT costs 25,000
Factory overhead apportioned 50,000 50,000
Total cost 260,000 165,000
Notes
! Materials inspection costs include costs incurred when goods are received as well as final
inspection. The objective is to ensure a close enough liaison with suppliers so that materials
received are of sufficient quality that obviates the need for them to be inspected. In a similar
way operatives are trained to monitor their own quality control to remove the need for a final
inspection.
! Because materials will be received as and when required, there should be no need to store them
before they are processed. If the layout of the factory is reorganised, it should also remove the
need to store between processes.
! Materials movement costs will be lower as a result of less moving to and from storage.
! J IT costs could include increased payments to operatives for them to inspect their work,
allocation of costs for changing the layout of the factory and so on.
From our example we can also calculate the cost saving per item and translate this into the potential
saving that could be passed on to the customer. Suppose that the number of items produced was
20,000; the cost per item for Non-J IT Ltd would be 13 (260,000/20,000) whilst the cost per item
for J IT Ltd is 8.25 (165,000/20,000).
Therefore the cost saving per unit is 4.75 at the J IT cost level, which represents 36% of original
cost. Decisions can then be made as to whether or not to pass some or all of the saving to the
customer.
Advantages of JIT
(a) Work-in-progress and stock levels are reduced, representing cost savings of working capital
requirements.
(b) Much smoother production flow should lead to increased productivity.
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(c) Improvements in quality should result in less rework.
(d) Because of shorter production times, paperwork is reduced, e.g. the amalgamation of the stores
and work-in-progress account.
Disadvantages of JIT
(a) The J IT technique is tailored to situations of regular demand, relatively unchanging processes
and a large percentage of common components. Thus, it is not necessarily suitable for all types
of production. Problems can arise if attempts are made to implement J IT in situations which
do not match its requirements. It is possible, however, to introduce parts of the philosophy on
an individual basis.
(b) Implementation is over a very long time-scale and a large degree of patience is required by
those whose responsibility it is.
(c) J IT involves a different cultural approach from that traditionally to be found in Western
manufacturing industries particularly in terms of consensus decision-making.
(d) J IT is considered weak in terms of medium- and long-term planning.
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Study Unit 7
Product Costing
Contents Page
Introduction 115
A. Costing Techniques and Costing Methods 115
B. Job Costing 116
Definitions 116
Procedure 116
Elements of Cost Involved 117
Specimen Cost Calculations for a J ob 118
J ob Costing Internal Services 120
C. Batch Costing 121
Definitions 121
Example 121
D. Contract Costing 122
Definitions 122
Problems Associated with Contract Costing 122
Contract Costs 123
SSAP 9: Stocks and Long-Term Contracts 124
E. Process Costing 124
General Principles 124
Comparison of J ob and Process Costing 126
Method of Process Costing 126
Material Usage 126
Accounting for Labour 127
Direct Expenses 127
Overhead Expenses 127
(Continued over)
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F. Treatment of Process Losses 127
Normal Wastage 127
Abnormal Loss or Gain 129
G. Work-In-Progress Valuation 131
Example Valuing WIP Using Equivalent Units 131
H. Joint Products and By-Products 134
J oint Products 134
By-Products 135
Example: J oint and By-Products 135
I. Other Process Costing Considerations 139
Limitations of J oint Cost Allocations 139
Defective Units and Reworking 139
Product Costing 115
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INTRODUCTION
Previous study units have looked at how costs for particular products are built up, how overheads are
allocated and so on. This study unit will concentrate on costing systems. Different types of business
operate with different costing systems which could be job, batch, contract or process costing.
We start by looking at job, batch and contract costing, concentrating on the methods for accumulating
and applying cost as well as reviewing the circumstances under which each system operates most
effectively.
We shall see that these systems are relevant to those situations where a separately identifiable unit (or
units) is being produced. In situations where this is not the case, process costing is used. Thus,
where continuous production is in operation, such as chemicals, paper, foods and drinks, textiles, etc.,
then this method needs to be used. We shall consider the basics of process costing and go on to look
at some of the problems which are particular to this method, such as losses in process, dealing with
common costs and the differences between joint and by-products.
A. COSTING TECHNIQUES AND COSTING METHODS
An initial distinction must be made between costing techniques and costing methods.
(a) Costing Techniques and Principles
Costing techniques and principles such as marginal costing, absorption costing, incremental
costing, differential costing, budgetary control and standard costing are of general application
to different industries and services. These techniques are used for purposes of decision making
and control over costs and performance and they are applicable to all types of manufacturing
and service industries.
(b) Costing Methods
Costing methods refers to the system (or systems) adopted to arrive at the cost of products or
services within a particular organisation.
The type of costing system to be adopted should be tailored to meet the needs of the individual
business and its manufacturing processes.
Two main types of product costing system are used:
! Job costing is used where products or batches of products are made to individual
customer specifications. Examples include general engineering, printing, foundries,
contracting, and building. Individual cost analyses are prepared for each separate order.
! Process costing applies where large quantities are made in a continuous flow or by
repetitive operations. The total costs incurred are averaged over all production (see the
next study unit).
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B. JOB COSTING
Definitions
The CIMA Official Terminology refers to job costing as applying:
....where work is undertaken to customers special requirements and each order is of
comparatively short duration (compared with those to which contract costing applies).
The work is usually carried out within a factory or workshop and moves through
processes and operations as a continuously identifiable unit. The term may also be
applied to work such as property repairs and the method may be used in the costing of
internal capital expenditure jobs.
Businesses that operate in a job-costing environment generally do not manufacture for stock but
instead to specific customer requirements. Very often an enquiry will be received from a prospective
customer asking the firm to quote for producing a particular item. The estimating department will
price up the potential work using standard charge-out rates based on its job costing system.
Pricing (which we will be looking at in more detail in a later study unit) is generally on a cost-plus
basis. This means that a standard percentage is added to the calculated cost to arrive at the price to
the customer.
Not all work is arrived at in this way; the foregoing example only applies where new business is
involved. Very often the work undertaken by a firm operating a job-costing system will be repeat
business and the cost of such work will already be known.
Procedure
(a) Setting up the System
There are two main items to which attention must be paid when setting up a method of job
costing:
! We must first establish what is to be considered as a job this being our logical unit of
cost. In factories where job costing is employed, we may look upon the job in any of the
following ways:
(i) An order for one large unit of production which has to be made to specification.
(ii) An order for a quantity of stock units of production which is required to keep up
the warehouse supply.
(iii) A number of small orders for the same unit of production which can be
conveniently accumulated into a batch and regarded as a single job.
! There must be an adequate method in operation whereby it is possible to allocate
distinctive numbers to the various jobs which have to be done, so that cost can be
coded by reference to the job number.
(b) Total Cost of Each Job
The total cost of each job is obtained by labelling cost as it occurs with the number of the job
on behalf of which the cost was expended. The collection of these labelled costs will give the
total job cost.
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Elements of Cost Involved
We shall now consider the elements of cost which are involved, and decide on the techniques which
should be used in cost collections to obtain the appropriate cost for each job number.
(a) Accounting for Materials
When dealing with the control of materials, material issued from stores has to be signed for on
a stores requisition slip. The description and quantity of material issued is shown on this slip.
If we associate the correct job number with each slip, we have the basis for associating
materials used with the jobs for which they were used. Of course, where the material is
indirect, the slip will bear the reference number of the appropriate overhead account.
Copies of the stores requisition slips will be passed to the costing department, to be priced and
entered, and at the end of each costing period, they are analysed by job number and to the
appropriate job account or to an overhead account, in the case of indirect material. The total
material cost posted to the debit of job and overhead accounts will, of course, equal the total of
the postings to the credit of the individual stores ledger accounts.
(b) Accounting for Labour
We discussed the booking of time spent within the factory in an earlier study unit.
Wages will be charged as follows:
Direct wages direct time charged to job number
idle time charged to overheads
Indirect wages charged to overheads
The data will be obtained in the following ways:
! The charges for labour applicable to overheads will be obtained from the gate cards of
the indirect workers. If indirect workers serve several cost centres in the course of the
week, they will fill up job cards showing the time spent on each, and the cost centre
reference number.
! The direct labour force will be issued with a job card on which they will record the time
spent on each job, and its number. The job cards will be analysed and the relevant
amount posted to each job account.
(c) Accounting for Overheads
Overheads are charged to the various cost units in a costing routine by means of a system of
precalculated overhead absorption rates. The method to be used will vary from system to
system, and it is almost certain that a variety of methods will be used in each organisation,
dependent on the characteristics of the various cost centres, e.g. some will use a rate per
machine-hour and others a rate per labour-hour. This will give a fairer allotment of cost than
the use of a blanket (average) rate to cover the whole organisation.
(d) The Job Account
We have now discussed the elements of cost involved in a factory job costing system, and the
techniques we would use to establish the charges for each cost element to be made to each job.
It is essential that this information be assembled in a systematic fashion, and we do this by
opening a separate job account in the cost ledger for every job that we undertake. The
number of this account will be the job number originally allotted to the unit of cost.
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The method of entering the information in the books of account is straightforward but the job
account would, normally, be analysed into direct materials, direct labour, direct charges,
production overhead by cost centre, administration and selling costs where these are
apportioned between products.
Specimen Cost Calculations for a Job
J ob number 707, the copper plating of 100 tubes, was completed in three departments of a factory.
Cost details for this job were as follows:
Department Direct Materials
Direct Wages
Direct Labour
Hours
X 650 800 1,000
Y 940 300 400
Z 230 665 700
Works overhead is recovered on the basis of direct labour hours and administrative overheads as a
percentage of works cost.
The figures for the last cost period for the three departments on which the current overhead recovery
rates are based, were:
Departments X Y Z
Direct material 6,125 11,360 25,780
Direct wages 9,375 23,400 54,400
Direct labour hours 12,500 36,000 64,000
Works overhead 5,000 7,200 9,600
Administrative overhead 2,870 14,686 8,978
You are required to draw up a cost ledger sheet, showing the cost of job 707, and to show the price
charged, assuming a profit margin of 20% on total cost.
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Answer
(a) Calculation of Works Overhead Recovery Rate
Department
X Y Z
Direct labour hours 12,500 36,000 64,000
Recovery rate per direct labour hour 0.40 0.20 0.15
Direct labour hours spent on job 707 1,000 400 700
Works overhead recovered on job 707 400 80 105
(b) Calculation of Administrative Overhead Recovery Rate
Department
X Y Z
Direct materials 6,125 11,360 25,780
Direct wages 9,375 23,400 54,400
Works cost 20,500 41,960 89,780
Administration overhead 2,870 14,686 8,978
Administration overhead as % of works
overhead 14% 35% 10%
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Cost of Job 707
Department
X Y Z
Total

Direct materials 650 940 230 1,820.00
Direct wages 800 300 665 1,765.00
Works overhead (from (a)) 400 80 105 585.00
Works cost 1,850 1,320 1,000 4,170.00
Administration overhead (applying
percentages found in (b)) 259 462 100 821.00
Total cost 2,109 1,782 1,100 4,991.00
Profit margin 20% 998.20
Price to be charged 5,989.20
Job Costing Internal Services
In those instances where an internal support department such as maintenance or marketing exists, it
can be more efficient to treat the work done by it on a job-costing basis rather than by arbitrary
allocation of the costs it incurs.
The advantages of such a system are as follows:
! More efficient use of resources user departments will be much more aware of what they are
being charged for when they take advantage of the internal service. In this way, user
departments should be more careful in how they use the service. Where a system of arbitrary
cost allocation exists, some user departments may overuse the service department on the basis
that it will not cost them any more to do so.
! Correct allocation of resources the costing of work is made easier, and more correct, by using
a job-costing system. This also helps facilitate pricing the work, as the correct gross-up can be
added in the certain knowledge that all relevant costs have been accounted for.
! Service department efficiency is enhanced job-costing internal services also means that
analysis of the efficiency of the service department is enhanced. It is much easier to compare
specific charge-outs against expected standard costs than to attempt to measure efficiency
using arbitrary allocations.
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C. BATCH COSTING
Definitions
Batch costing is defined in the CIMA Terminology as:
That form of specific order costing which applies where similar articles are
manufactured in batches either for sale or for use within the undertaking.
In most cases the costing is similar to job costing.
A batch cost is described as:
Aggregated costs relative to a cost unit which consist of a group of similar articles
which maintains its identity throughout one or more stages of production.
The main point to note, therefore, is that it is a method of job costing, the main difference being that
there are a number of similar items rather than just one. Batch costing will apply in similar situations
to those we mentioned in job costing, i.e. general engineering, printing, foundries, etc.
Costs will be worked out in a similar fashion to job costing and then apportioned over the number of
units in the batch to arrive at a unit cost.
Example
The following is an example of how batch costing operates.
The XYZ Printing Co. has received an order for printing 1,000 special prospectuses for a customer.
These were processed as a batch and incurred the following costs:
! Materials 500
! Labour design work 150 hours at 15 per hour
printing/binding 10 hours at 5 per hour.
Administration overhead is 10% of factory cost.
The design department has budgeted overheads of 20,000 and budgeted activity of 10,000 hours.
The printing/binding department has budgeted overheads of 5,000 and budgeted activity of 1,000
hours.
Calculate the cost per unit.
Solution
The overhead absorption rates are as follows:
Design (20,000/10,000) 2 per labour hour
Printing/binding (5,000/1,000) 5 per labour hour.
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The cost per unit can therefore be calculated as:

Direct material 500
Direct labour:
Design (150 15) 2,250
Printing (10 5) 50 2,300
Prime Cost 2,800
Overheads:
Design (150 2) 300
Printing (10 5) 50 350
Factory Cost 3,150
Admin. cost (10% of factory cost) 315
Total Cost 3,465
As this is the total cost of the batch, we find the cost per unit simply by dividing by the number of
units in the batch, i.e.:
3,
,
465
1000
= 3.465 per unit (3.47 rounded).
D. CONTRACT COSTING
Contract costing is similar in some ways to job costing in that it relates to identifiable units.
However, the major difference is in the scale of the relative items. Whereas job costing is applicable
in the instances where an item or items may take hours or perhaps days to complete, contract costing
is used for large-scale projects which may take more than one financial year to complete.
Definitions
Contract costing is defined in the CIMA Terminology as:
That form of specific order costing which applies where work is undertaken to
customers special requirements and each order is of long duration (compared with
those to which job costing applies). The work is usually constructional and in general
the method is similar to job costing.
A contract is defined as:
Aggregated costs relative to a single contract designated a cost unit.
Problems Associated with Contract Costing
(a) Allocating profit to different accounting periods: as already noted, longer duration contracts
may start in one accounting period and end in another. One problem that this raises is the
equitable apportionment of the contracts profit between the relevant accounting periods. We
shall consider this point in more detail shortly.
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(b) Cost control: large-scale contracts, particularly where a remote site is involved, may lead to
problems of controlling costs relating to damage, pilferage, plant and machinery usage and so
on.
(c) Direct cost allocation: most of the cost allocated to such contracts will be classed as direct cost
rather than production overhead. This would include supervisors, plant allocation costs and so
on.
Contract Costs
(a) Application and Cost Collection
Costs are collected by reference to a contract number and a separate account kept for each
contract. There is also a separate account for each contractee (i.e. the customer for whom the
contract is carried out).
(b) Subcontractors
In some cases there may be specialised routines which it is prudent to have performed by
outside experts. These specialists are known as subcontractors, and payments to them are dealt
with as direct expenses and debited to the contract account.
(c) Materials
Materials may be requisitioned from the companys own stores, in which case a materials
requisition note will be issued allocating the necessary materials. This will record the cost of
materials issued, which will form part of the build-up of total cost. Alternatively, materials
may be delivered direct from the supplier to the contract site. In this instance the whole cost of
the delivery can be allocated to the contract and the accounting department will check the
goods received note against the original order before making the allocation.
(d) Direct Labour
Labour employed on site may be either direct labour, i.e. employed by the company, or
subcontract labour, i.e. external labour employed only for that particular contract. Direct
labour on site is usually paid on an hourly basis. It is a simple matter for the hours worked to
be logged and the total labour cost for the contract to be identified.
(e) Overheads
As has already been noted, what would usually be classed as production overhead tends to be a
direct cost in the case of contract costing. General administration overheads may be added at
the end of each accounting period, but this should not happen if the job is unfinished at that
point, because only production overhead should be carried within the work-in-progress.
(f) Plant on Site
Where plant is sent out to a particular site, the contract is charged with the capital value of the
plant. When the plant returns from the site, it is revalued and credited to the contract; the
difference is the depreciation charged to the contract. This procedure is also carried out at the
date of the balance sheet. Alternatively, a calculated periodic charge for plant may be made. If
plant is in use on several contracts, this may be on a daily basis.
(g) Retentions and Architects Certificates
In contract work, the contractor would have serious cash flow problems if he received no
payment until the contract was completed. There are usually, therefore, stage payments as the
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work proceeds. The amount to be paid is decided by an architect or surveyor, who inspects the
work and issues certificates stating the value of completed work to date.
It is normal to find a clause in a contract to the effect that a percentage of the certified value
may be held back by the contractee and paid to the contractor only after a suitable time-lapse
following the completion of the contract say, six or 12 months after completion. This is to
protect the contractee by ensuring that the contractor will put right any defects found in the
work within that time. (If he did not put right the defects, the contractee could withhold
payment.) The money held back in this manner is called retention money.
SSAP 9: Stocks and Long-Term Contracts
Accounting for long-term contracts is covered by SSAP 9 Stocks and Long-Term Contracts. This
standard requires companies to account for turnover as the contract progresses and allows for
attributable profit to be reflected in the profit and loss account as long as the outcome of the contract
can be assessed with reasonable certainty.
Turnover should reflect the stage of completion of the contract and may be calculated by using the
value certified or by expressing the costs to date as a percentage of total costs and then applying this
percentage to the contract price.
Profit must be assessed on a prudent basis and will be calculated by matching the above turnover
figure with its attributable costs.
The company must also assess whether the completed contract will be profitable and if it is felt that a
loss will result then this fact must immediately be reflected in the profit and loss account.
SSAP 9 has standardised the balance sheet treatment of balances associated with long-term contracts.
The standard states that stocks should be stated in the balance sheet at total costs incurred, net of
amounts transferred to the profit and loss account in respect of work carried out to date, less
foreseeable losses and applicable payments on account. It goes on to say that if turnover exceeds
payments on account an amount recoverable on contracts is established and separately disclosed
within debtors. Payments on account in excess of reported turnover will be shown as a deduction in
stock values but it should be noted that stock cannot go negative which in turn requires any excess to
be shown as part of creditors.
E. PROCESS COSTING
General Principles
The CIMA Official Terminology defines process costing as:
The basic costing method applicable where goods or services result from a sequence of
continuous or repetitive operations or processes to which costs are charged before being
averaged over the units produced during the period.
This method of costing applies not only to the areas mentioned above, but may also be used in
situations of continuous production of large numbers of low cost items such as tin cans or light bulbs.
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Diagrammatically, process costing can be represented as follows:
Bought-in
materials
PROCESS A
Input labour/
materials/prodn
overhead
Output to Process
B
PROCESS B
Input labour
overhead
Output to finished
goods stock
Finished
goods stock
Figure 7.1: Process Costing
Production is moved from process to process and the costs are transferred with it so that it is the
cumulative cost that is carried to finished goods stock.
In accounting terms the costs are built up as follows:
PROCESS A

Labour 5,000 Transferred to Process B 10,000
Materials 4,000
Overheads 1,000
10,000 10,000
PROCESS B

Transferred from Process A
Labour
Materials
Overheads
10,000
3,000
4,000
1,000
Transferred to finished goods
stock 18,000
18,000 18,000
FINISHED GOODS STOCK

Transferred from Process B 18,000
18,000
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Comparison of Job and Process Costing
Job Process
Items are discrete and identifiable. Items are homogeneous.
Costs are allocated to individual units of
production.
No attempt is made to allocate costs on an
individual basis.
Losses are not generally expected to occur in
the course of production.
Losses are expected to occur (see later).
As costs are allocated to each unit, each item
of finished production has its own costs.
As costs are allocated to the process, finished
goods have an average value.
Stock consists of unlike units. Stock consists of like units.
Direct costs (labour, materials and product overhead) are the same under both systems.
Method of Process Costing
(a) The method is essentially one of averaging, whereby the total costs of production are
accumulated under the headings of processes in the manufacturing routine, and output figures
are collected in respect of the various processes. The total process cost is divided by the total
output of the process, so that an average unit cost of manufacturing is arrived at for each
process.
(b) Where there are several processes involved in the production routine, it is normal to cost each
process, and to build up the final total average cost step by step. The output of one process
may be the raw material of a subsequent one, thus making it necessary to establish the process
cost at each stage of the manufacturing operation.
(c) Each process carried out is regarded as a cost centre, and information is collected on the usage
of materials, costs of labour and direct expenses exclusively attributable to individual
processes. Each process, in an absorption costing system, will be charged with its share of
overhead expenses. This principle is assumed to be in operation throughout this study unit.
(d) We have stated that an average cost per unit is obtained for each process. This average cost is
arrived at by dividing the cost of each process by the number of good units of production
obtained from it. Hence, it is necessary to set up a report scheme to find the number of units
produced by each process. Since it is unlikely that all material entering a process will emerge
in the form of good production, the recording scheme should provide records of scrap from
each process, in addition to records of good production achieved. These records should, if
possible, be kept by clerks, rather than by foremen who are preoccupied by production
problems.
Material Usage
(a) The method of charging material usage will depend on the factory layout and organisation. If
there is only one injection of raw material at the stage of the initial process, the problem is
simplified, and material usage can be computed from the stores requisition slips. In this case,
the output of the first process becomes the raw material of the second, and so on.
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(b) If further raw material is required in a subsequent process, it may be convenient to establish
new material stores adjacent to the point of usage, and record the usage from the stores
requisition slips.
(c) In many cases, material may be used which is of little value unit-wise (e.g. nails) and the
volume of paperwork required to record each issue would be prohibitive. In such cases, the
method of charging would be to issue the anticipated usage for a costing period at one time, the
issue being held for use at the point of manufacture. A physical stocktaking at the end of the
period would establish actual usage of material, which could be compared with the theoretical
usage expected for the output achieved.
Accounting for Labour
Accounting for labour where process costing is in operation is, normally, straightforward. Fixed
teams of operatives are associated with individual processes, and the interchange of labour between
processes is not encouraged from the point of view of efficiency. It is often as simple as collating
names on the pay sheets to establish the wages cost for a process. Where process labour is
interchangeable, labour charges per process may be established by issuing job cards to employees, to
record the time spent on each process.
Direct Expenses
All expenses wholly and exclusively expended for one particular process will be given the proper
process number and allotted to the cost centre on this basis.
Overhead Expenses
In absorption costing, the indirect material, labour and expenses not chargeable to one particular
process must be borne, eventually, by production. Absorption rates are used as before, and we need
to establish rates in advance for each of our cost centres. This means that the total overhead
expenses of the business must be estimated and allocated or apportioned to the processes, in terms of
the rules which we have already explained. As we have seen, it is necessary to assess the output
expected at each cost centre. Then, the absorption rates for the cost centres can be calculated by
dividing the estimated costs associated with them by the estimated output per cost centre.
In this way, we establish a relationship between overhead cost and activity and, at the close of each
period, the actual activity achieved by the cost centre is multiplied by the predetermined rate, to give
the charge for overheads.
F. TREATMENT OF PROCESS LOSSES
Normal Wastage
All waste, theoretically, is avoidable, and it can be said that inefficiency exists wherever waste
occurs. However, no factory can avoid producing some waste, and every effort must be made to
reduce it to an absolute minimum, by the proper use of materials, machines or methods. Processing
operations are particularly prone to losses through evaporation, spillage or rejection of substandard
output. How should such losses be costed?
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One method is to assume that the losses have no cost and the unit is based on the actual number of
units produced. Assume we have a process which incurs process costs of 350,247 for an input of
1,000 litres. What would the unit cost be if output was (a) 850 litres or (b) 950 litres?
(a)
350,247
850
= 412.06 per litre unit cost
(b)
350,247
950
= 368.68 per litre unit cost
The problem with this approach is that the unit cost will fluctuate from period to period making it
difficult to plan forward, particularly if the level of wastage varies widely from period to period.
Alternatively, the average loss over a period of time could be used as a basis for calculating average
unit cost, say on a weekly or monthly basis.
A second method is to assume that losses do have a cost which should be accounted for. In this
instance the cost per unit is based on units of input rather than units of output. Referring back to our
previous example:
At output of 850 litres
Cost per unit =
350,
,
247
1000
= 350.25 per litre
Total cost of output = 350.25 850 = 297,710
Total cost of loss = 350.25 150 = 52,537
At output of 950 litres
Cost per unit = 350.25 (as above)
Total cost of output = 350.25 950 = 332,735
Total cost of loss = 350.25 50 = 17,512
All such losses incurred would be written off to the profit and loss account. The problem with this
method is that some cost of production may be unnecessarily written off if some process losses are
unavoidable.
The third and most widely used method attempts to allow for the fact that some loss is inevitable.
Such loss is not given any cost but any wastage over and above this is called abnormal loss and is
given a cost. Any loss under that which is expected is called abnormal gain, the value of which is
debited to the process account.
The normal waste in processes can be expressed as a percentage of the total input of material. The
cost of normal wastage is borne by the process, less any incoming credit in respect of the sale of
waste.
Specimen Process Waste Accounts
Consider the following information:
Cost of process 2,000
No. of units entering process 1,000
Percentage of input regarded as normal waste 10%
Value of waste per unit 25p
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The process account will then be as follows:
PROCESS ACCOUNT
Units Units
Input in units 1,000 Normal waste 100 25
Cost of process 2,000 Cost of normal output 900 1,975
1,000 2,000 1,000 2,000
Calculations
(a) Normal waste 10% of input = 100 units
(b) Credit value of (a) above, 100 units at 25p per unit = 25
(c) Cost of normal output per unit =
2,000 25
900
= 2.19
It will be seen that the cost of normal waste is written into the cost of good production but that credit
is given for its scrap value, if any.
Abnormal Loss or Gain
As we have seen, if wastage is greater than normal, there is said to be an abnormal loss, while if
wastage is less than normal there is an abnormal gain. Normal waste is treated in exactly the same
manner as above i.e. its scrap value is credited to the process account and the cost per unit of
normal output is found. Abnormal losses or gains are valued at the same value as good production,
and transferred to the abnormal loss or gain account, and thence to the profit and loss account, after
making any adjustments for the income from the sale of abnormal loss.
Specimen Abnormal Loss Process Accounts
Consider the following information:
Total cost of process =7,385
No. of units input =700
Normal loss =5% of input
Actual loss =40 units
Scrapped units are sold at 2 each.
Produce the process account, abnormal loss account and scrap account.
Workings
Normal loss: 5% of 700 =35 units
Scrap value of normal loss =35 2 =70
Actual loss =40 units
Therefore, abnormal loss =5 units
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Normal output expected =700 35 =665 units
Therefore, cost per unit of normal output =
( , ) 7385 70
665
(allowing credit for scrap value of normal loss)

=11 per unit
i.e. abnormal loss and good production are each valued at 11/unit.
Therefore, cost of abnormal loss =5 11 =55
Therefore, cost of good production =660 11 =7,260
PROCESS I ACCOUNT
Units Units
Input 700 7,385 Normal loss (scrap value) 35 70
Process II 660 7,260
Abnormal loss 5 55
700 7,385 700 7,385
ABNORMAL LOSS ACCOUNT

Process I (see note (a)) 55 Scrap (see note (b)) 10
Profit and loss a/c (see note (c)) 45
55 55
SCRAP ACCOUNT

Abnormal loss (see note (b)) 10 Cash (see note (e)) 80
Process I normal loss
(see note (d)) 70
80 80
Notes on Abnormal Loss Account and Scrap Account
(a) This is the double entry of the abnormal loss appearing in the process account.
(b) These are the two halves of a double entry, and they represent the scrap value of abnormal loss
(5 units @ 2).
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(c) This is the loss to be transferred to profit and loss account, arising from the abnormal loss. It is
found as the balancing figure on the account.
(d) This is the double entry of the normal loss entry in the process account.
(e) This is the cash which would be received from sale of both normal and abnormal loss
(40 units @ 2).
G. WORK-IN-PROGRESS VALUATION
One of the difficulties that arises with process costing is the valuation of work-in-progress. This is
because costs need to be apportioned fairly over the units of production which, as you are now aware,
are not generally separately identifiable. Materials may be added in full at the start, or at varying
rates through the differing processes; the cost of labour may not necessarily be incurred in proportion
to the level of output achieved.
In order to apportion costs fairly, the concept of equivalent units is used. The CIMA Official
Terminology defines them as:
A notional quantity of completed units substituted for an actual quantity of incomplete
physical units in progress, when the aggregate work content of the incomplete units is
deemed to be equivalent to that of the substituted quantity of completed units, e.g. 150
units 50% complete = 75 units.
The principle applies when operation costs are being apportioned between work-in-
progress and completed output.
Example Valuing WIP Using Equivalent Units
Paint by Numbers Ltd is a paint manufacturing company which produces a range of different paint
products. The production of vinyl silk paint requires two different processes.
In process I the costs incurred during J anuary were:
000
Materials 2,000
Labour 2,700
Overhead 1,600
6,300
There was no opening work-in-progress. 1,100,000 litres were introduced into the process. 700,000
were completed during J anuary and transferred to process II. The remaining 400,000 were:
%
75 complete as to materials
50 complete as to labour
25 complete as to overhead
Calculate: cost per unit; total value of finished production; value of closing work-in-progress.
Draw up the process account.
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Answer
The idea of equivalent units is that 200 units half complete are equivalent to 100 units fully complete,
in terms of cost. In the above example, we have different degrees of completion for the different
elements of cost units comprising the closing WIP have had 75% of the required material
incorporated in them. This has taken 50% of the labour processing time necessary to complete a full
unit; and the overhead content is put at 25% of that for a full unit (e.g. the units concerned have had
25% of the necessary machine time).
Since there is no mention of overhead absorption rates in this question, we assume that overhead is
charged to production as it is actually incurred, rather than by the use of predetermined absorption
rates.
Valuations:
Total cost per equivalent unit = 7 (see Table 7.1)
Value of finished production = 7 700,000 = 4,900,000
Value of closing WIP (ascertained by reference to no. of equivalent units for each category of cost):
000
Material (75% 400,000) 300,000 2 = 600
Labour (50% 400,000) 200,000 3 = 600
Overhead (25% 400,000) 100,000 2 = 200
1,400
PROCESS I ACCOUNT
Units Units
Material 1,100,000 2,000 Process II 700,000 4,900
Labour 2,700 WIP c/d 400,000 1,400
Overhead 1,600
1,100,000 6,300 1,100,000 6,300
WIP b/d 400,000 1,400
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Table 7.1: Calculation of Equivalent Units and Cost per Unit
Material Labour Overhead
%
Completion
Equivalent
Units
%
Completion
Equivalent
Units
%
Completion
Equivalent
Units
Completed units
transferred to next
process 100 700,000 100 700,000 100 700,000
WIP c/d (400,000) 75 300,000 50 200,000 25 100,000
Total equivalent
units (a) 1,000,000 900,000 800,000
Costs incurred,
000 (b) 2,000 2,700 1,600
Cost per equivalent
unit
((b) (a)) 2 3 2
It should be noted that the Equivalent Units technique relates to partially completed items at a
satisfactory state of partial completion. It sometimes happens that during the processes, some items
regarded as partially complete become, for whatever reason, faulty and useless as potentials for sale.
In this event it is usual to calculate two figures for total units. For example:
Using the weighted average method:
Units started during current period 164,000
Total units 196,000
and also:
Units completed & transferred out 160,000
Units in closing WIP stock 24,000
Total units accounted for 184,000
Therefore, 12,000 spoilt during processing.
By dividing the total material and conversion costs by the different figures (196,000 and 184,000),
different unit costs can be determined.
The cost of the faulty units will be the number of faulty units (12,000) multiplied by the unit cost
figure from the calculation using the 184,000 divisor. The additional process cost becomes the
number of faulty units (12,000) multiplied by the difference between the two different unit cost
figures. This method is often referred to as the method of neglect.
This method of neglect does not encourage managers to decrease the number of faulty units, because
exclusion of faulty units does not make them accountable, as they are excluded from the EUP
calculation.
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H. JOINT PRODUCTS AND BY-PRODUCTS
Joint Products
Where two or more products emerge from a process in such proportions that neither can be termed
the main product, they are known as joint products. The problem which arises here is to apportion
the expenses of the joint process to the individual products. These joint products may be either
different commodities unavoidably produced (such as fuel oil and petrol, mutton and wool), or
different grades of the same product (such as coal raised from a mine).
Split-off Point
The point at which individual products can be identified and costed separately is known as the split-
off point. Up to this stage, the costs incurred are common to all units produced and their allocation
to products must, necessarily, be arbitrary.
Apportioning Costs Incurred
The following methods are used for apportioning costs incurred up to the separation stage:
(a) Physical Measurement
If a load of coal is raised, comprising two grades 80 tons of grade A and 20 tons of grade B
the costs of raising the full load may be apportioned 80% to A and 20% to B. This method is
unsuitable if the market value varies considerably, or if there is no common basis of
measurement e.g. if one product is a solid and the other a gas.
(b) Market Value at Separation Point
Under this method the joint products are valued at market value, and the relationship emerging
is the basis on which the process cost is allocated to the joint products.
For example, the process cost of producing A and B is 140 and the market values at point of
separation are A: 100, B: 75.
Thus, the relationship to be used to split the process cost is A: 4 and B: 3. The total process
cost is thus split A: 80 and B: 60.
This method cannot be used if there is no market value at separation point (i.e. the products
cannot be sold without further processing), or if the costs of further processing are
disproportionate.
(c) Reversion From Sales Price
In this method we work back from the selling prices of the joint products to obtain the
relationship to split the process costs.
For example, two joint products, X and Y, have selling prices of 300 and 400, respectively.
We have estimated that the costs incurred after separation amount to 40 for X and 50 for Y.
The process costs of the joint products were 200. The profit margins, expressed as
percentages of selling price, are X, 10% and Y, 20%.
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Product X Product Y

Sales value 300 400
less Profit 30 80
270 320
less Costs after separation 40 50
230 270
The joint process cost of 200 is allocatedas follows:
230
500
200 to X and
270
500
200 to Y.
The actual figures are 92 and 108, respectively.
Note: If the profit percentage is not known, it is an acceptable approximation to use simply
sales values less the post-separation costs.
By-Products
These are items which are, in themselves, of little value (relative to the main product) which are
unavoidably produced in the course of producing the main product. Often, by-products can be
regarded as waste, and sold as such, with the amount realised being credited to the main process
account. If further processing will give a reasonable return, however, a sub-process will be carried
out. It is usual, in this case, to credit the main process account with the sales value of the by-product,
less the cost of further processing. Alternatively, the amount realised from sales of the by-product,
less the cost of further processing, may be credited directly to the profit and loss account.
Example: Joint and By-Products
From a single raw material, a chemical company makes three products A, B and C. Product A is
considered to be a by-product. Products B and C are treated as major joint products.
In process I, by-product A is obtained, and the remaining output passes to process II, where products
B and C are obtained.
During the month, materials cost 7,200.
Operating expenses were: process I 12,000
process II 15,000
Work-in-progress was negligible at both the beginning and end of the month.
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Production and sales were as follows:
Product Production Sales
A 12,000 gallons 6,000 gallons @ 5p per gallon
B 18,000 tons 15,000 tons @ 2 per ton
C 5,000 tons 3,000 tons @ 4.80 per ton
Initial stocks were:
A 1,200 gallons at 5p per gallon
B 1,500 tons at 1.50 per ton
C 100 tons at 3.75 per ton
Required information:
(a) Stock valuation (using weighted price for B and C, market price for A).
(b) Statement of gross profit.
Answer
In this question there are two matters about which we must make a decision before we start any
calculations:
! Treatment of By-product A
In this case we shall credit the main process account with the sales value of the product, and
maintain a product A stock account at market value. There will be no profit shown on product
A, the income from which reduces the cost of the two main joint products.
! Allocation of Joint Cost
Costs up to separation point are allocated between B and C, in relationship to the sales value of
the products:
(i) Statement of Net Joint Cost
Process I Raw materials 7,200

Operating expenses 12,000
19,200
less Market value of by-product
12,000 gallons @ 5p per gallon 600
18,600
Process II Operating expenses 15,000
Net joint product costs 33,600
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(ii) Basis of Joint Cost Allocation
Production of product B valued at SP

18,000 tons @ 2 per ton 36,000
Production of product C valued at SP
5,000 tons @ 4.80 per ton 24,000
Basis of allocation of joint cost:
Product B: 3/5 33,600 20,160
Product C: 2/5 33,600 13,440
33,600
(iii) Calculation of Stock Values and Cost of Sales
Product B Product C
Units Value Units Value

Opening stock 1,500 2,250 100 375
add Production 18,000 20,160 5,000 13,440
19,500 22,410 5,100 13,815
Sales 15,000 3,000
Closing stock 4,500 2,100
Product B Product C
Stock valued at
weighted price
22410
19500
,
,
4,500
5,172
13815
5100
,
,
2,100
5,689
Cost of sales valued
at weighted price
22410
19500
,
,
15,000
17,238
13815
5100
,
,
3,000
8,126
22,410 13,815
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Product A
Units Value
Opening stocks 1,200 60

add Production 12,000 600
13,200 660
less Sales 6,000 300
Closing stocks 7,200 360
Hence, the solution of part (a) of the problem is:
Stock valuations
Product
A 360
B 5,172
C 5,689
(iv) Calculation of Gross Profit

Sales
Product A (6,000 gallons at 5p per gallon) 300
Product B (15,000 tons at 2 per ton) 30,000
Product C (3,000 tons at 4.80 per ton) 14,400
44,700
Cost of Sales
Product A as per (iii) above 300
Product B as per (iii) above 17,238
Product C as per (iii) above 8,126 25,664
Gross profit 19,036
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I. OTHER PROCESS COSTING CONSIDERATIONS
Limitations of Joint Cost Allocations
The allocation of common costs to joint products is necessary for stock valuation purposes and profit
measurement. For decision-making, these allocations have little or no relevance. Costs and income
beyond split-off point are the key factors in decisions. The application of incremental costs to further
processing decisions will be considered further in a later study unit.
Defective Units and Reworking
Where units do not meet the standards of quality laid down, they may either be sold at reduced prices
as seconds or reworked, to bring them to the required standard.
The advisability of reworking defective units must depend on the cost of rectification compared with
the increase in unit value. If an item can be sold for 50 without reworking or can be sold for 100
by incurring a reworking cost of 40, then, clearly, the reworking is justified. The cost of reworking
is usually charged to factory overheads, and it is, thus, spread over all units. Reports to the
management on reworking and rectification costs should be made on a routine basis.
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Study Unit 8
Cost-Volume-Profit Analysis
Contents Page
Introduction 142
A. The Concept of Break-Even Analysis 142
Cost Equations 142
Contribution to Sales (C/S) Ratio 143
Margin of Safety 143
Target Profits 144
Effect of Changes in Selling Price or Costs 145
B. Break-Even Charts (Cost-Volume-Profit Charts) 146
Information Required 147
Plotting the Graph 148
Break-Even Chart for More than One Product 149
Assumptions and Limitations of Break-Even Charts 149
Interpretation of Break-Even Charts 150
Changes in Cost Structure 151
Extending Beyond the Known Range of Activity 151
Contribution Break-Even Chart 152
C. The Profit/Volume Graph (or Profit Graph) 154
Profit and Activity Level 154
Drawing the Graph 154
Specimen Profit/Volume Calculations and Graph 154
Further P/V Calculations 156
D. Sensitivity Analysis 158
Sensitivity Analysis and Break-Even Charts 160
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INTRODUCTION
This study unit marks the start of the work we shall be doing on the area of decision making.
We considered the use of variable costing methods in an earlier study unit and we noted that some
costs are of a variable nature (according to the volume of output), while others are fixed and remain
unaltered within limits of output. In this study unit we shall consider the significance of cost
behaviour and its relation to break-even analysis and information for decision making.
A. THE CONCEPT OF BREAK-EVEN ANALYSIS
The terms cost-volume-profit (CVP) and break-even (B/E) analysis are interchangeable for the
purposes of our work here. The B/E point is that at which the firm makes neither a profit nor a loss
and can be expressed as either the sales value required or the number of units to be sold. There are a
number of important elements within the framework of B/E analysis as follows.
Cost Equations
The difference between sales and variable cost is known as the contribution. This shows the amount
available to meet fixed costs and to contribute towards profit. The equation to express these
relationships is:
S V = F +P
where: S = Sales
V = Variable cost
F = Fixed cost
P = Profit
Example
To illustrate the arithmetic, consider the following simple example:
Sales value: 5 per unit
Variable costs: 2 per unit
Fixed costs: 30,000
Compute the B/E point.
Using the above formula, we need to calculate how many units we require to sell so that
S = V +F
and therefore no profit or loss is made. Firstly we need to calculate the contribution per unit which in
this instance is 3 (sales value 5 less variable costs per unit of 2). Next we must determine how
many contributions of 3 are needed to cover our fixed costs of 30,000, i.e.
F
S V
=
30,
3
000
= 10,000 units.
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The profit and loss account will show the following:

Sales (10,000 5) 50,000
Variable cost (10,000 2) (20,000)
Fixed cost (30,000)
Profit
If we were to sell one extra unit, the figures would change to:

Sales (10,001 5) 50,005
Variable cost (10,001 2) (20,002)
Fixed cost (30,000)
Profit 3
Contribution to Sales (C/S) Ratio
This is an important ratio and is also known as the profit/volume (P/V) ratio. It is an alternative way
of expressing the break-even point in terms of sales revenue. The formula for the C/S ratio is:
S V
S
In the above example, this would be:

5 2
5

= 60%
Put another way, 60% of the sales value of each item is the contribution towards fixed cost and profit.
The calculation of the break-even point using this calculation is:
Sales revenue at break-even point =
F
C/S
In our example, this is:
30,000
60%
= 50,000
This is the same figure that we calculated earlier.
Margin of Safety
The margin of safety is the amount by which the expected level of sales exceeds the break-even level
of sales. It may be expressed as a percentage of the budget sales volume. In our previous example, if
budgeted sales had been 11,000 units then the margin of safety would be 11,000 10,000 =1,000
units.
Knowledge of the size of the margin of safety is important information for management to be aware
of; once it is known, decisions can be taken on, in particular, pricing and production levels which
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may otherwise be subject to uncertainty. Taking our example further, if the company had the
potential of gaining an order in addition to the expected level of sales, it could afford to lower the
price in the knowledge that fixed costs should already be covered by existing volumes.
We shall expand on this theme of using information for decision-making purposes in the next unit.
Target Profits
In addition to calculating the break-even level of sales, a company can set itself a target to achieve a
certain level of profits. This is again based on the concept of contribution and can be expressed as:
Contribution required = F +P
where: P is the required profit.
Example
Petal Plastics make and sell a particular item, the details of which are as follows:
Direct material per unit 11

Direct labour per unit 7
Variable production overhead per unit 2
Selling price per unit 35
Fixed costs are 45,000 in total. If the company wishes to make a profit of 30,000 per annum, what
sales level will be required?
The contribution required is F +P, which in this instance will be 45,000 +30,000 =75,000.
Required sales therefore is:
Required contribution
Contribution per unit is 35 11 7 2 =15, so that
Sales level required =
75,
15
000
= 5,000 units
Proof:
Sales (5,000 35) 175,000

less Variable cost (5,000 20) 100,000
Contribution 75,000
less Fixed costs 45,000
Profit 30,000
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The alternative way to calculate the required level of sales is using the C/S ratio, which is:
C/S ratio =
35 20
35
= 42.86%
Sales revenue required =
Required contribution
C/S ratio
=
75,
.
000
4286%
= 175,000
Effect of Changes in Selling Price or Costs
(a) Selling Price Changes
The analysis can also be used to ascertain the effect of changes in the parameters on the level
of sales value or volume required. For instance, take the example of Petal Plastics again;
suppose that the management consider that a reduction in sales price will lead to an increase in
the level of sales. What they need to know is whether the increased volumes at this lower price
will provide more profit.
The management considers that reducing the selling price to 30 will produce more sales; what
is the level of sales required to maintain current profit levels?
In this scenario, all parameters are unchanged apart from the sales value. The new contribution
level per unit is therefore 10, so to maintain profit of 30,000:
Sales volume required =
75,
10
000
= 7,500 units
Proof:
Sales (7,500 30) 225,000

less Variable cost (7,500 20) 150,000
Contribution 75,000
less Fixed cost 45,000
Profit 30,000
What management must now decide is whether a reduction in sales price of approximately
14% (5/35) will produce increased sales volume of 50%, i.e.:
( , , )
,
7500 5000
5000
.
(b) Cost Changes
Changes in the variable costs of production can also give rise to management decisions similar
to those arising from changes in sales values. These decisions usually arise as a result of the
change in the relationship between fixed and variable costs.
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Example
Petal Plastics is considering automating part of its production process, which it is envisaged
will result in variable costs falling to 15 per unit, but fixed costs will increase to 67,500 per
annum due to increased hire charges and machine servicing costs. How many units must be
sold to maintain the profit level? What will the profit be at the original production target of
5,000 units per annum and what is the new B/E point?
With variable costs at 15 per unit and assuming sales values remain at 35, the new level of
contribution per unit is 20. Our target contribution is now 97,500 (fixed costs of 67,500
plus intended profit of 30,000). Sales volume to maintain the level of profit is therefore:
97,
20
500
= 4,875 units
This shows that the decision to automate is the correct one, because profit will be maintained
even though 125 units less are sold. If sales volume is kept at 5,000 units, the profit will be:
Contribution (5,000 20) 100,000

Profit 32,500
which is an increase of 2,500. Another way of calculating this is to take the full contribution
on the additional units, i.e. 125 20 =2,500. This is because our target contribution is
already covered by selling 4,875 units; any sales over this and the full contribution is an
addition to profit.
The revised B/E point is as follows:
B/E =
Fixed costs
=
67,
20
500
= 3,375 units
B. BREAK-EVEN CHARTS (COST-VOLUME-PROFIT
CHARTS)
An alternative to calculating the B/E point is to show the results graphically using what is known as a
B/E chart.
The CIMA definition of such a chart is:
A chart which indicates approximate profit or loss at different levels of sales volume
within a limited range.
The vertical axis of the chart is for sales revenue and costs; the horizontal axis is for volume of
activity (i.e. output). Three lines are then drawn on the chart as follows:
! Sales, which begins at zero and represents the linear relationships between value and volume
(i.e. 1 unit =10, 10 units =100 and so on).
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! Fixed cost this is a line drawn parallel to the horizontal axis which cuts the vertical axis at
the point which represents the total value of the fixed costs.
! Total cost again this shows a linear relationship and begins at the point where the fixed cost
line meets the vertical axis.
Where the sales and total cost lines intersect, this is the B/E point. We shall now examine these
charts and the information they provide in more detail. Please note that you are not required to be
able to produce them in the examination, but the ability to draw a rough sketch to emphasise a point
may be useful.
Information Required
(a) Sales Revenue
When we are drawing a break-even chart for a single product, it is a simple matter to calculate
the total sales revenue which would be received at various outputs. Let us take the following
figures:
Output
units
Sales Revenue
0 0
2,500 10,000
5,000 20,000
7,500 30,000
10,000 40,000
We then need data on fixed and variable costs, before we can draw a break-even graph or chart.
(b) Fixed Costs
Overhead costs may sometimes have a fixed and a variable element semi-fixed or semi-
variable overheads. Let us assume that the fixed expenses total 8,000.
(c) Variable Costs
The variable elements of cost must also be assessed at varying levels of output:
Output
units
Sales Revenue
0 0
2,500 5,000
5,000 10,000
7,500 15,000
10,000 20,000
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Plotting the Graph
When tackling this type of question I suggest you always convert the data into the following standard
format which provides all the figures needed to prepare break-even charts.
Sales 40,000
less Variable cost 20,000
Contribution 20,000
Profit 12,000
The graph can now be drawn to cover the sales range of 0 units up to 10,000 units. (See Figure 8.1.)
! Sales
The sales line will start at 0 units, 0 and increase to 10,000 units, 40,000.
! Fixed Costs
This is constant at 8,000 and is drawn parallel to the horizontal axis.
! Total Cost
Even if no units are sold the company will still incur fixed overheads of 8,000. When 10,000
units are sold, the company will incur costs of 28,000 being the addition of its fixed and
variable costs. The total cost line therefore starts at 0 units, 8,000 and increases to 10,000
units, 28,000.
Note that, although we have information available for four levels of output besides zero, one level is
sufficient to draw the chart, provided we can assume that sales and costs will lie on straight lines.
We can plot the single revenue point and join it to the origin (the point where there is no output and,
therefore, no revenue). We can plot the single cost point and join it to the point where output is zero
and total cost =fixed cost.
In this case, the break-even point is at 4,000 units, or a revenue of 16,000.
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Figure 8.1: Break-Even Chart (Cost-Volume-Profit Chart)
Break-Even Chart for More than One Product
You will have noticed that a break-even chart can be drawn only for a single product, because of the
assumptions of constant unit costs and revenues. It is possible to draw a break-even chart for more
than one product, if we can assume a constant product mix. Even so, the break-even chart is not a
very satisfactory form of presentation when we are concerned with more than one product; a better
graph the profit/volume graph is discussed later.
Assumptions and Limitations of Break-Even Charts
Apart from the above point about the difficulty of catering for more than one product, the following
limitations should be borne in mind.
! Break-even charts are accurate only within fairly narrow levels of output. It is unwise to
extrapolate beyond the known range of data. This is because if there were a substantial change
in the level of output, the proportion of fixed costs could change.
! Even with only one product, the income line may not be straight. A straight line implies that
the manufacturer can sell any volume he likes at the same price. This may well be untrue: if
he wishes to sell more units, he might have to reduce the price. Whether this increases or
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decreases his total income depends on the elasticity of demand for the product. Therefore, the
sales line may curve upwards or downwards but, in practice, is unlikely to be straight.
! Similarly, we have assumed that variable costs have a straight-line relationship with level of
output, i.e. variable costs vary directly with output. This might not be true. For instance, the
effect of diminishing returns might cause variable costs to increase beyond a certain level of
output.
! Break-even charts hold good only for a limited time-span.
! Break-even charts assume that sales and production are matched. This may not be so, and
there may be a change in stocks which would affect profits if absorption costing is used.
Nevertheless, within these limitations a break-even chart can be a very useful tool. Managers who
are not well versed in accountancy will probably find it easier to understand a break-even chart than a
calculation showing the break-even point.
Interpretation of Break-Even Charts
The skeleton break-even chart in Figure 8.2 illustrates the margin of safety and angle of incidence.
Figure 8.2: Skeleton Break-Even Chart
(a) Margin of Safety
! Safety of Profit Level
The margin of safety is a measure of how far sales can fall before a loss is incurred.
This can be easily read from a break-even chart, and it gives managers an idea of how
safe the profit level is the larger the margin of safety, the less risk of incurring a loss
if the sales volume is allowed to fall.
From Figure 8.2, you will see that the margin of safety is the difference between the
actual output being achieved and the break-even point.
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! Expressing Margin of Safety
In Figure 8.1, the company had an actual output of 10,000 units and a break-even point
of 4,000 units. Margin of safety may be expressed in any of the following ways:
Margin of safety = 4,000 to 10,000 units, or
= 16,000 sales to 40,000 sales, or
= 40% to 100% of actual output, or
= sales may fall by 60% before reaching break-even.
(b) Angle of Incidence
The angle of incidence shows the rate at which profits increase once the break-even point is
passed. A large angle of incidence means a high rate of earning (also, it means that, if sales
fell below break-even point, the loss would increase rapidly). This is also illustrated by the
size of the profit and loss wedges.
Changes in Cost Structure
If costs increase, the break-even point will be reached at a higher level of sales. The break-even chart
in Figure 8.3 illustrates the effect of such changes.
Figure 8.3: Break-Even Chart and Cost Structure
Extending Beyond the Known Range of Activity
We have already mentioned that it is unwise to extrapolate beyond the known range of data with
break-even charts. A common error is to assume that, once break-even point has been passed, then
any increase in output must lead to an increase in profit. This may not be so a second break-even
point may be reached, beyond which losses will be incurred. Figure 8.4 will help to demonstrate this:
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Figure 8.4: Second Break-Even Point
! The first break-even point occurs at BEP1 but it would be wrong to assume that a profit will be
made at any output above this level, because of the cost-behaviour patterns.
! At a level of output x, there is a step in the fixed costs (perhaps owing to an extra supervisors
salary), causing a corresponding step in the total cost line.
! At a level of output y, the angle of the sales line reduces sharply, possibly indicating that a
discount is necessary to achieve the higher sales volume.
! A second point, BEP2, is reached, beyond which total costs exceed sales and, therefore, the
assumption that any output above break-even point will produce profit is invalidated.
For this reason, break-even charts should be used only within the known range of data, and cost and
revenue relationships should not be assumed to be valid outside this range. This range of data for
which the known costs and revenue behaviour patterns are valid is known as the relevant range.
Contribution Break-Even Chart
A contribution break-even chart is an important improvement on the traditional break-even chart,
since it is possible to read contribution direct from the chart. Instead of commencing by measuring
the fixed costs from the base line, the variable costs are taken. The fixed costs are then shown above
the variable costs, drawn parallel to the variable cost line.
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Specimen Break-Even Chart Calculations and Construction
Variable costs 2 per unit
Fixed costs 80,000
Maximum sales 200,000
Selling price per unit 20
Prepare a contribution break-even chart (see Figure 8.5).
Figure 8.5: Contribution Break-Even Chart
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C. THE PROFIT/VOLUME GRAPH (OR PROFIT GRAPH)
Profit and Activity Level
With the traditional break-even chart, it is not easy to read from the chart the profit at any one level
of activity. The profit/volume graph (or profit graph) overcomes this problem, and it may be more
easily understood by managers who are not trained in accountancy or statistics.
In this graph, the level of activity is plotted along the horizontal axis, against profit/loss on the
vertical axis. You need, therefore, to work out the profit before starting to plot the graph:
Sales revenue Variable cost = Fixed cost +Profit, or
Profit = Sales revenue Variable cost Fixed cost, or
Profit =
Selling price
per unit

Number of
units sold

Variable cost
per unit

Number of
units sold
Fixed cost, or
Profit = Contribution per unit Number of units Fixed cost
(The form of the equation which is most convenient will depend on the presentation of the
information in the particular question.)
Drawing the Graph
The general form of the graph is illustrated in Figure 8.6.
Figure 8.6: Profit Graph (or Profit/Volume Graph)
The distance A0 on the graph represents the amount of fixed cost, since, when no sales are made,
there will be a loss equal to the fixed cost.
Specimen Profit/Volume Calculations and Graph
Try this practical problem for yourself, using some graph paper if possible. MC Ltd manufactures
one product only, and, for the last accounting period, the firm has produced the simplified profit and
loss statement shown below:
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Profit and Loss Statement

Sales 300,000
Costs:
Direct materials 60,000
Direct wages 40,000
Direct cost 100,000
Variable production overhead 10,000
Fixed administration overhead 60,000
Variable selling overhead 40,000
Fixed selling overhead 20,000 270,000
Net profit 30,000
You need to construct a profit/volume graph, from which you can state the break-even point and the
margin of safety.
You are again advised to adopt the suggested layout of
Sales
less Variable cost
Contribution
less Fixed costs
Profit
Answer
Sales 300,000
less Variable cost 150,000
Contribution 150,000
Profit 30,000
When sales are nil the company will still have to pay its fixed costs. It will therefore incur a loss of
120,000. This provides the first point (A) on the graph.
When sales are 300,000 there is a profit of 30,000 which provides the second point (B) on the
graph.
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Figure 8.7: Profit/Volume Graph for MC Ltd
Further P/V Calculations
Attempt this second practical problem for yourself, before studying the solution.
The following information has been extracted from the books of XYZ Ltd.
XYZ Ltd

Variable costs:
Direct material 100,000
Direct labour 50,000
50% of production overhead 50,000 200,000
Fixed costs:
Administration 100% 100,000
50% of production overhead 50,000 150,000*
Profit 50,000*
Sales revenue (80,000 units) 400,000
Note: Fixed costs (150,000) + Profit (50,000) = Contribution (200,000)
B
A
BEP
240,000
Margin of safety
60,000
60
Profit
(000)
Sales (000) 300 200 100
40
20
0
20
40
60
80
100
120
Loss
(000)
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Prepare the following:
(a) A break-even chart showing the break-even (B/E) point (in and units), and the margin of
safety.
(b) Arithmetical calculations supporting the information required in (a) above.
Answer
(a) Figure 8.8 shows the required break-even graph.
F
i
g
u
r
e

8
.
8
:

X
Y
Z

L
t
d
.

B
r
e
a
k
-
E
v
e
n

G
r
a
p
h
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(b) Calculation of break-even point and margin of safety using formulae.
Break-even:
B/E () =

S
V S
F
where F =Fixed costs; S =Sales; V =Variable costs.
=

000 , 400
000 , 200 000 , 400
000 , 150
= 150,000 2 = 300,000
B/E (units) =
F
C per unit
=
150,000
200,000

80,000
= 60,000 units
Margin of safety:
M/S = P
S
C
= 50,000
400,
,
000
200000
= 100,000
400,000 300,000 = 100,000
No. of units =
100,
,
000
400000
80,000 = 20,000 units
(80,000 60,000 = 20,000).
D. SENSITIVITY ANALYSIS
Sensitivity analysis involves adjusting one parameter at a time and measuring the effect that this has
on the outcome. Thus, in terms of break-even analysis, this could involve adjusting the sales price or
volume, variable or fixed costs and seeing which has the greater effect on profit. The objective is to
find those parameters which are the most sensitive, i.e. with the greatest relative influence, so that
management can be made aware of them.
Example
To illustrate the concept of sensitivity analysis, consider a firm which produces and sells one item
which has a selling price of 6, variable cost of 4 and fixed costs of 700,000 per annum. Expected
sales volume is 400,000 units per annum. Examine the sensitivity of each of these items.
If we assume a 5% movement on each item individually, we can compare how sensitive each
parameter is. The current profitability is:
Sales (400,000 6) 2,400,000

less Variable cost (400,000 4) 1,600,000
Profit 100,000
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A 5% decrease in sales value would have the following effect:
Sales (400,000 5.70) 2,280,000

less Variable cost 1,600,000
Profit (20,000)
This shows that it has the effect of reducing profit by 120%.
Now consider a 5% increase in variable cost per unit:
Sales 2,400,000
less Variable cost (400,000 4.20) 1,680,000
Profit 20,000
This results in an 80% decrease in profit.
Next let us review a 5% reduction in sales volume:
Sales (380,000 6) 2,280,000

less Variable cost (380,000 4) 1,520,000
Profit 60,000
This is a 40% reduction in profit.
Finally, consider a 5% increase in fixed cost:
Contribution (as per original) 800,000

less Fixed costs (including 5% increase) 735,000
Profit 65,000
This is a 35% reduction in profit.
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What these figures show, therefore, is that sales value is the most sensitive item in that a
proportionate percentage change causes a disproportionate decrease in profit. There is, however, a
danger that too much could be read into the figures unless further investigation were to be carried out.
The decrease in sales value, for instance, may result in increased sales volumes which would partially
offset any drop in profits. The important thing to remember is that sensitivity is an indication to
management of where potential problem areas may be, or, conversely, where improvements should be
made which will yield greater results in terms of the effort put in.
Sensitivity Analysis and Break-Even Charts
The effects of sensitivity analysis can also be shown using a B/E chart. If we take the original
example we considered and also show the effect of a decrease in sales revenue, we have a graphical
picture of the change.
Figure 8.9
The original B/E point is
700,
6 4
000
= 350,000 units.
The revised B/E point is
700,
5. 4
000
70
= 411,765 units.
In other words, an additional 61,765 units would need to be sold to achieve the break-even position,
which represents an increase of 17.6%. Recalculate the break-even point using the other changes
outlined earlier to confirm that sales value is the most sensitive item.
Note that changes in relative costs and sales value will alter the slope of the line. P/V charts can also
be sensitised but in this instance the slope does not alter. Instead, the intersection of the lines will
change and hence the B/E point will change also.
161
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Study Unit 9
Planning and Decision Making
Contents Page
Introduction 162
A. The Principles of Decision Making 162
Effective Decision-Making 162
Levels of Decision Making 163
Stages of the Decision-Making Process 165
B. Decision-Making Criteria 167
Quantitative Factors 167
Qualitative Factors 168
Thinking for Decisions 169
C. Costing and Decision Making 169
Relevant Costing 169
Differential Cost Analysis 170
Sell or Process Further 172
162 Planning and Decision Making
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INTRODUCTION
Earlier in the course we examined the types and sources of information which management require in
order to make decisions. Following on from that, we considered how information can be categorised
in terms of cost analysis to provide management with what they require in the appropriate format to
aid the decision-making process.
Before looking at specific scenarios, this study unit will develop the concept of decision making by
examining when and why it is required and the steps involved in it.
Management decision-making is complex and requires knowledge of:
! management accounting principles and techniques
! organisational objectives and functions
! management techniques
! the relationship between an organisation, its members and its environment.
A. THE PRINCIPLES OF DECISION MAKING
We can state this quite simply as making the right decision at the right time in the right place. While
this objective is simple to state, it is far more difficult to achieve.
! The right decision can only be made by analysing the circumstances which relate to the
decision and the purpose of making it.
! The right time acknowledges the fact that decisions are followed by action. Decisions must be
made at the appropriate time so that effective action can be taken.
! The right place ensures that decisions are made in the most effective location. This is
particularly important in large organisations with extended communication channels.
Frequently the right place for making decisions is where the action they relate to will be carried
out.
The whole point of management decision-making is that it should result in effective action.
Effective Decision-Making
The effectiveness of any manager in todays business environment will depend upon his ability to
make effective decisions. A business can only achieve its objectives if its managers make effective
decisions that are compatible with the organisations objectives.
Example
If the objective of a retail store is profit maximisation, decisions must be made on:
! What range of products to stock
! What quantity of each product to stock
! What price to charge for each product
! Where the retail outlet should be located
! What staffing levels are required
! When the store should open for business
Planning and Decision Making 163
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! Whether premises should be rented, leased or purchased
This list of decisions is only the beginning. You must appreciate that managing a business or any
other type of organisation in todays environment is complex and can only be achieved by managers
continuously making a series of complex decisions, all of which are interrelated. Decision making is
further complicated by the fact that the environment is changing at a very fast rate; this means that
decisions made at one time may quickly become obsolete. Decisions should therefore be related to
the environment, and expected changes which are likely to occur in the environment should be taken
into account when decisions are made.
The following factors should be taken into account when making management decisions.
(a) Decisions must be compatible with the organisations objectives.
(b) Decisions must be based upon the facts surrounding the situation. To make effective decisions
a decision maker must obtain relevant information.
(c) Decisions must be made before action can follow.
(d) Sufficient time must be allowed so that a decision maker can assimilate the relevant
information.
(e) Decisions must be expressed in clearly defined plans, standards and instructions so that the
appropriate action can be executed.
(f) Decisions made by a decision maker should be compatible with his responsibilities and
authority.
(g) Decision makers should have the expertise and ability to make the decisions for which they are
responsible.
(h) Information presented to decision makers should be in a form they can understand.
(i) There must be fast and effective communication channels between people involved in the
decision-making process.
(j) Each decision must be related to its effect on the whole organisation. This is important so that
sub-optimisation is avoided.
(k) Each decision must be carefully considered with regard to its effect on the environment, e.g.
the reaction of competitors must be considered when making marketing decisions.
(l) The faster decisions can be made, the sooner action can be taken.
Levels of Decision Making
Decision making can be related to the hierarchy of an organisation. You can see this illustrated in
Figure 9.1.
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Figure 9.1
(a) Strategic Decisions
These are decisions made by top management. They normally relate to the long-term future
and will provide the basis upon which an organisations long-term plans will be formulated.
Strategic decisions usually affect the whole organisation and involve the expenditure of large
amounts of capital.
It is essential that at this level wrong decisions are not made. Bad strategic decisions are
difficult to change and may result in substantial losses.
An example of strategic decision-making is when the directors of a company decide that a
company should go into full-scale production of a new product.
If the new product is successful the companys profitability should increase, but if the new
product is a failure, substantial losses will result and the money invested in producing and
marketing the new product will be lost.
(b) Tactical Decisions
This type of decision is made by middle management and relates to the specialist divisions
within the organisation. The divisions within an organisation will depend upon:
! The nature of its activities
! Its size
! The way it is structured
You must note these three factors when thinking about tactical decision-making.
If an organisation is structured by function, tactical decisions will relate to each specialist
function, e.g. marketing, production, personnel and finance.
If an organisation is structured by region, tactical decisions will relate to each area, e.g. in the
National Health Service tactical decisions will relate to each Regional Health Authority.
If an organisation is structured by product type, tactical decisions will relate to each product
classification.
STRATEGIC
CONTROL
MANAGEMENT
CONTROL
OPERATIONAL
CONTROL
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Tactical decisions have a shorter time horizon than strategic decisions and have a less far-
reaching effect on the organisation.
(c) Operating Decisions
These are decisions made by operating (low-level) managers. They are made on a day-to-day
basis, usually on an ad hoc basis. These decisions are dictated by events at the operating level
of the organisation and are most effective when made:
! Quickly so that fast action can be taken.
! By a trained decision maker.
! Close to where the action is to be executed so that action can be instantly controlled by
the decision maker.
Frequently, operating decision-making is not effective because of a failure to apply one or more
of these three criteria.
Effective operating decision-making is an essential requirement for running a service
undertaking successfully. In these undertakings situations quickly deteriorate when operating
problems arise and rapid decisions are needed by properly trained personnel to solve them.
Operating decisions involve less capital investment than strategic and tactical decisions, but
their long-term effect on an organisation is often underestimated by senior management.
Operating decisions affect staff morale and/or customer goodwill.
Examples of important operating decisions are:
! Deciding what action to take to deal with customer complaints.
! Dealing with individual staff problems.
! Deciding how to allocate scarce resources on a day-to-day basis.
Operating decisions are often needed for unpredicted events and are made as a result of
feedback.
Stages of the Decision-Making Process
Organisations normally initiate formal decision-making procedures which are followed by
management. These procedures will vary between organisations but are likely to follow a number of
stages arranged in a structured sequence.
It is important that any person making an organisational decision is able to adopt a logical, structured
approach. Managers cannot be trained to make specific decisions; they can only be trained to take a
specific approach to decision making.
We can list the approaches to decision making as follows:
Stage 1: Identifying the Objectives of the Organisation
As we said earlier, decisions made by management must be compatible with the organisations
objectives.
Stage 2: Defining the Purpose of the Decision
Every organisational decision made should have a purpose. In any decision-making situation it is
important to define the purpose of making the decision; this is normally the logical reason for taking
or not taking a particular course of action. A lot of the work involved in decision making is based
upon logic.
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Stage 3: Identifying the Potential Courses of Action
At this stage it is important to consider the potential courses of action that are dependent upon the
decision. In decision-making situations it is important to establish exactly how many possible
courses of action there are. Situations that arise include:
! Where only one course of action is considered, and the decision is whether to follow the
particular course of action or not, such as in branch or departmental closure decisions.
! Where a number of alternative courses of action are possible but only one can be taken, such as
in investment decision situations where, perhaps, four different projects are being considered,
but there are only sufficient funds available for one to be selected.
! Where many alternative courses of action are possible and all of them can be achieved
simultaneously, such as when deciding upon the range of products to be produced and sold
when resources exist to produce the whole range.
! When the possible courses of action are mutually exclusive. In this situation the following of
one course of action automatically means that the others are not possible, e.g. setting a
production level for a product.
Stage 4: Obtaining the Relevant Information
Once the potential courses of action have been identified, the information that is relevant to them
should be collected, processed and produced in a report for analysis. Management accounting
techniques are widely used at this stage particularly:
! Relevant costing
! Differential costing
! Contribution analysis
! Opportunity costing
! Capital investment appraisal
Stage 5: Evaluation of the Options
At this stage each possible option must be carefully evaluated and the relevant information analysed.
This evaluation must take into account the organisations objectives and the purpose of making the
decision. Care should be taken to consider all the relevant criteria including quantitative and
qualitative factors.
Stage 6: Making the Appropriate Decision
This is the point at which the course of action to be taken is decided upon. This should always be
after the options have been evaluated.
Stage 7: Action
Once made, the decision should be communicated to those people responsible for carrying it out.
Effective decisions should always result in effective action being taken.
Stage 8: Review
The final stage of the decision-making process is to carry out a review of events after the decision has
been implemented. This is done by implementing control procedures. The review will enable
management to see if the original decision was effective.
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B. DECISION-MAKING CRITERIA
An important element of decision making is the relationship between a decision and the organisation
and its environment. Decisions must be coordinated so that the whole organisation benefits from the
action that follows. A decision maker has to make a number of criteria into account when making a
decision. These decision-making criteria fall into two basic groups: quantitative factors and
qualitative factors.
Quantitative Factors
These criteria cover all those factors which can be expressed in measured units. The following is a
detailed list of the quantitative factors which a management decision-maker should take into
consideration.
(a) Profitability
Commercial undertakings operate with profit maximisation as a primary objective; business
decisions should be made with this objective in mind. In business, the effect of a decision on
profitability is an important consideration.
(b) Effect on Cash Flow
Many decisions, especially those involving the investment of funds, affect the organisations
cash flow. You must appreciate that cash is a limited resource which places a severe restriction
on management action.
(c) Sales Volume
Another factor that must be considered is the effect of a decision on the sales volume of a
product or service. This is very important in pricing decisions, decisions affecting the quality
of a product and decisions that affect a product or service availability.
(d) Market Share
In a highly competitive environment businesses consider market share to be an important
factor. In such a situation the effect of a decision on a firms market share for a particular
product or service should be taken into account.
(e) The Time Value of Money
Another important factor to consider in long-term decision making is the fact that money in the
future is worth less than it is at present. Techniques which take this into account are widely
used in long-term decision making, e.g. Net Present Value (NPV) and the Internal Rate of
Return (IRR).
(f) Efficiency
Organisations also operate with maximisation of efficiency as an important objective.
Efficiency is measured by using the ratio:
Output
Input
If this ratio is less than 100% it means some resources used have been wasted. The effect of
decisions on the organisations efficiency should be taken into account. Many decisions should
be made specifically to improve efficiency, e.g.:
! To reduce idle time
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! To improve the productivity of the workforce
! To eliminate the loss of materials
(g) Time Taken to Make a Decision
One quantitative factor often overlooked in decision making is how long it takes to make a
decision. To be effective it should always take less time to make a decision than it takes to
effect action from the present time. For example, if action must be taken within the next three
months, the decision whether to take action or not must take less than three months.
Qualitative Factors
These decision-making criteria cover all those factors which must be considered that cannot be
expressed in measured units of any kind. These factors are just as important as the quantitative ones,
and include:
(a) Competitors
In a business situation some decisions, such as those affecting prices, conditions of trade,
availability of products and services, marketing, takeovers and mergers and the quality of
goods and services, will result in competitors reacting to them in a certain way. The likely
reaction of competitors must be carefully evaluated before such decisions are made.
(b) Customers
Many decisions made within organisations affect customers. The effect of business decisions
on customers must always be considered if a firm is to survive and be profitable. Such
decisions will be those which affect marketing and prices, product/service availability,
product/service quality and the organisations image.
(c) Government
Some decisions, particularly strategic ones, must take into account the attitude of both central
and local government. Such decisions will be those affecting employment, location of
premises, takeovers and mergers, importing and exporting. The government can support,
oppose or prevent decisions being made, e.g. the Monopolies Commission can prevent one
company merging with, or taking over, another business.
(d) Legal Factors
The effect of laws on decisions must also be considered, e.g. the effect of the relevant
employment legislation must be taken into account when making decisions relating to
personnel matters. The relevant tax laws are also important legal factors which must be
considered. Taxation can also be viewed as a quantitative factor.
(e) Risk
Decisions are made about the future based upon information available at the present time. In
such a situation there is always a risk that actual events, when they occur, will not be as
expected. This means that there is always a risk that decisions may not work out as expected.
The longer the time horizon affected by the decision, the greater the risk.
(f) Staff Morale
The effect of decisions on the morale of the workforce must always be considered. Decisions
to close down part of an operation, discontinue a product line, make staff redundant or
purchase products or components from outside suppliers instead of manufacturing them in-
house, tend to lower the morale of the workforce.
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(g) Suppliers
Suppliers must also be taken into account. An organisation which becomes dependent upon
just one or two suppliers becomes vulnerable if a supplier decides to change its product range
or specification. The supplier can then dictate terms and increase its prices knowing that the
customer is dependent upon it. Another factor to consider in this situation is what might
happen if a competitor was to take over a major supplier.
(h) Flexibility
The environment is constantly changing. It is important that flexibility is considered when
making decisions. Decisions should always be kept under review and new decisions made
when necessary. Management should always remember that decisions can be changed right up
to the time action is taken. An adaptive approach to decision making should always be taken.
(i) Environment
One factor that has become increasingly important in recent years is for a decision maker to
evaluate the effect of a decision on the environment. Organisations are open systems which
interact with their environment. Decisions that affect pollution, noise, social services and the
physical environment such as buildings, must take the environment into consideration.
(j) Availability of Information
A decision maker must consider whether sufficient information is available to make a decision.
Frequently decisions have to be made with incomplete information; this is where a managers
ability to judge a situation is important. A decision maker must also be able to assess the
reliability and accuracy of information used. Many bad decisions are made because of
inaccurate information.
Thinking for Decisions
An effective decision-maker must carefully relate the decision being made and its effects on:
(a) The part of the organisation directly involved
(b) Other parts of the organisation not directly involved
(c) The whole organisation
(d) The environment
(a) and (b) mean thinking laterally, (c) means thinking vertically, and (d) means thinking
outwardly.
C. COSTING AND DECISION MAKING
Relevant Costing
This topic was discussed earlier in the course, but it may be useful at this stage to refresh your
memory.
Relevant costing is an important part of the decision-making process. When managers are deciding
between various courses of action, the only information which is useful to them is detail about what
could be changed as a result of their decision making i.e. they need to know the relevant costs (or
incremental or differential cost see the next section).
Remember the CIMA definition of relevant costs:
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Costs appropriate to aiding the making of specific management decisions.
Differential Cost Analysis
Most business decisions involve an estimation of future costs. Costs which change as a result of a
decision are differential or incremental costs involving both fixed and variable elements.
Incremental or differential cost analysis is particularly used where changes in volume are being
considered or further processing decisions are to be made. The following example illustrates the
application of this type of analysis to a decision on the possible closure of a factory.
Example
X Ltd has two factories, East and West, both of which produce product EW 90. West occupies a
company-owned freehold factory; the East factory is leased.
The lease for the East factory is now due for renewal and, if the proposed terms are accepted, the
rental will increase by 15,000 per annum. The companys head office costs are allocated to factories
on the basis of sales value. The following sales and costs apply to the budgeted results for the year
before the rental increase.
West East Head
Office
Total
Sales (units) 30,000 20,000 50,000

Sales 600,000 400,000 1,000,000
Variable costs
Materials 120,000 80,000 200,000
Direct wages 180,000 110,000 290,000
Variable manufacturing overheads 60,000 30,000 90,000
360,000 220,000 580,000
Fixed costs
Rent 40,000 5,000 45,000
Depreciation 60,000 20,000 10,000 90,000
Other fixed overheads 70,000 60,000 65,000 195,000
Total costs 490,000 340,000 80,000 910,000
If the lease of the East factory is not renewed, the production facilities at the West factory can be
expanded to cover the loss of production from East. To produce the additional output, new plant and
equipment will be required which will cost 200,000. The additional plant would be depreciated over
a five-year period on the straight-line basis with no residual value anticipated. The purchase would
be financed by a loan, bearing interest at 10% per annum.
Additional selling and distribution costs of 0.20 per unit sold will be incurred on sales made to
customers at present in the territory covered by East.
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The expansion of the West factory would cause its fixed costs to rise by 40%. Head office costs
would not be affected. Variable manufacturing costs would be based on the present unit costs
incurred by West.
Receipts from the sale of plant and equipment would cover closure costs of the East factory.
Required:
(a) Give calculations to show which alternative would be more profitable.
(b) Show the return on the additional investment if all manufacturing is carried out at the West
factory.
Answer
(a) The present profit is 90,000. If the lease is renewed, this will fall to:
90,000 15,000 = 75,000.
The position if East is closed and West expanded will be as follows:
West
(as now)
Incremental
revenue and costs
New
total

Sales 600,000 400,000 1,000,000
Variable costs
Direct wages 180,000 120,000 300,000
Variable overheads 60,000 40,000 100,000
Additional selling and distribution
expenses 4,000 4,000
360,000 244,000 604,000
Contribution 240,000 156,000 396,000
Fixed overheads
Depreciation 60,000 40,000 100,000
Interest on loan 20,000 20,000
Fixed overheads 70,000 28,000 98,000
130,000 88,000 218,000
Surplus 110,000 68,000 178,000
HO costs 80,000
Net profit 98,000
The net profit of 98,000 compares with a net profit of 75,000 if the lease on the East factory
is renewed.
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Note that variable costs have been based on Wests present unit costs.
(b) The return on the additional capital employed will be:
68000
20000
,
,
= 34%
This represents the additional surplus earned by West in relation to the additional capital
invested.
Sell or Process Further
Decisions relating to the further processing of products are often associated with joint products,
where separation point is reached and the products can either be sold or subjected to further
processing with an increase in their saleable value. These decisions involve the principle of
incremental costing and the basic requirement is to compare the incremental sales value with the
incremental costs. For the purposes of such decisions, the joint costs of production are irrelevant.
Example 1
Xcel Ltd produces three joint products, X, Y and Z, from a common process. Annual costs for the
joint process are as follows:

Direct wages 60,000
Variable overheads (150% of direct wages) 90,000
Fixed overheads 90,000
The budgeted outputs and selling prices at separation point are:
Production
Tons
Price
per ton
X 2,000 100
Y 1,000 150
Z 500 200
Production capacity is available to process further any one or all of the products. Additional labour
and materials would be required in each case, and the following estimates have been prepared of
costs and sales values if further processing is carried out:
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X Y Z
Quantities (tons) 2,000 1,000 500
Additional materials 12,000 15,000 10,500
Additional direct wages 12,000 10,000 10,000
Total sales value (after further processing) 240,000 210,000 150,000
The management wishes to know which products should be sold or processed further, and the
difference in the anticipated trading results between processing and selling at separation point.
Answer
It should be noted that, in addition to the added materials and labour, allowance must be made for
variable overheads, and these should be included in the calculations at the rate of 150 per cent of
direct wages.
The first step is to calculate the incremental sales and costs figures. Sales values before further
processing are:
Product X 2,000 100 = 200,000
Product Y 1,000 150 = 150,000
Product Z 500 200 = 100,000
The incremental sales values are, therefore, as follows.
X
Before further processing 200,000 150,000 100,000

After processing 240,000 210,000 150,000
Incremental value 40,000 60,000 50,000
Incremental costs are:
X

Direct wages 12,000 10,000 10,000
Variable overheads 18,000 15,000 15,000
42,000 40,000 35,500
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The incremental profits and losses are:
Product
X (loss) (2,000)
Y profit 20,000
Z profit 14,500
Net gain 32,500
The recommendation is that only products Y and Z should be further processed. This will result in
additional profit of 34,500.
The results with and without additional processing are as follows:
Without additional processing

Sales 450,000
Direct wages 60,000
Variable overheads 90,000
Fixed overheads 90,000 395,000
Net profit 55,000
With additional processing

Sales 600,000
Direct wages 92,000
Fixed overheads 90,000 512,500
Net profit 87,500
Incremental profit =87,500 55,000 =32,500
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Example 2
A company manufactures four products from an input of raw material to Process 1. Following this
process, Product A is processed in Process 2, Product B in Process 3, Product C in Process 4 and
Product D in Process 5.
The normal loss in Process 1 is 10% of input and there are no expected losses in the other processes.
Scrap value in Process 1 is 0.50 per litre. The costs incurred in Process 1 are apportioned to each
product according to the volume of output of each product. Production overhead is absorbed as a
percentage of direct wages.
Data in respect of one months production
Process
1 2 3 4 5
Total
000 000 000 000 000 000
Direct materials at 1.25 per ltr 100 100
Direct wages 48 12 8 4 16 88
Production overhead 66
Product
A
litres
B
litres
C
litres
D
litres
Output 22,000 20,000 10,000 18,000

Selling price 4.00 3.00 2.00 5.00
Estimated sales value at end of Process 1 2.50 2.80 1.20 3.00
You are required to suggest and evaluate an alternative production strategy which would optimise
profit for the month. It should not be assumed that the output of Process 1 can be changed.
Answer
The object of the exercise is to determine whether the best option available is to process the output
further or sell it at a particular point. Much will depend on the assumptions made in respect of the
various costs involved. For instance, can the direct wages and/or production overhead be avoided if
further processing does not take place after Process 1? We shall assume that the production overhead
is fixed and therefore cannot be avoided in the short term, and that the direct wages are variable with
output and therefore can be avoided.
The first exercise to carry out is to ascertain the additional sales value arising from further processing
and then to compare this with the additional costs incurred.
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A
Selling price at end of Process 1 2.50 2.80 1.20 3.00

Selling price after further processing 4.00 3.00 2.00 5.00
Increase in sales value per unit 1.50 0.20 0.80 2.00
litres litres litres litres
Output (litres) 22,000 20,000 10,000 18,000
000 000 000 000
Increase in revenue from further processing 33 4 8 36
Avoidable costs after split-off point 12 8 4 16
Benefit/(cost) of further processing 21 (4) 4 20
It would appear that Products A, C and D should be further processed in order to increase the overall
return, but that Product B should be sold at the end of Process 1, thus avoiding a loss of 4,000 per
annum.
Consideration should also be given to ascertaining whether some or all of the production overhead
would be saved. These overheads constitute 75% of direct wages (66,000 to 88,000) so that the
saving by not further processing Product B rises by 6,000 (75% of 8,000), whilst the decision on
Product C becomes marginal as 3,000 (75% of 4,000) could be saved by leaving an incremental
value of just 1,000.
177
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Study Unit 10
Pricing Policies
Contents Page
Introduction 178
A. Fixing the Price 178
B. Pricing Decisions 178
Determinants of Upper and Lower Limits to Price 178
Demand Analysis 179
Cost Considerations 180
Pricing Policy and Procedures 180
Pricing Decisions and the Product Life-Cycle 181
C. Practical Pricing Strategies 182
Full Cost Plus Pricing 182
Marginal Cost Plus Pricing 183
Competitive Pricing 183
Market Forces Pricing 184
Loss Leaders 184
Discriminating Pricing 184
Target Pricing 185
Market Penetration and Market Skimming 185
Minimum Pricing 186
Limiting Factor Pricing 186
Return on Capital Pricing 187
D. Further Aspects of Pricing Policy 188
Short- and Long-Term Policy 188
Quantity Incentives 188
Discount Policy 189
Single and Multiple Price Arrangements: Differential Pricing 189
Pricing Short-Life Products 190
Pricing Special Orders 190
178 Pricing Policies
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INTRODUCTION
This study unit will be considering the importance to the firm of setting the correct price for its
products and the different methods by which price can be calculated.
Through pricing, a company provides for the recovery of the costs of its operations marketing,
production and administration. In addition, the company must recover sufficient surplus over and
above these costs to meet profit objectives. It is important, therefore, to consider price as a
fundamental part of a companys overall effort and to ensure that it plays an important role in the
development and control of a companys strategy.
A. FIXING THE PRICE
External selling prices will be influenced by many different factors, but as a basis for further
calculations, many firms begin by calculating the costs of production, including fixed and variable
costs, and adding a desired profit margin, to arrive at a provisional selling price. Before fixing a
final selling price, other factors may require consideration, including:
! The firms sales and profit strategies and target figures.
! The extent of competition, and whether prices are determined mainly by dominant firms in the
industry.
! The current level of demand for the companys products.
! Whether demand is seasonal, constant, or products are made to individual customer
requirements.
! Whether demand is elastic or inelastic (see your notes on economics if you wish to revise the
meaning of these terms).
! The present stage of the life-cycle of the product, and whether an existing line is being phased
out and stocks run down (see later).
! Any element of dislocation which may be caused by the urgency of a particular order or
delivery requirements.
Prices may also be influenced by legal and general economic factors, such as government policies
and regulations, and exchange-rate fluctuations.
We shall now consider some of the above in greater detail.
B. PRICING DECISIONS
Determinants of Upper and Lower Limits to Price
We may think in terms of upper and lower limits to the price charged for a product or service.
The upper limit is determined by the maximum price which a potential purchaser will pay. The price
of a product or service should not exceed the value of its benefit to the buyer. The lower limit is
determined by the fact that in the long term the price should not fall below the cost of making and
distributing the product.
Pricing Policies 179
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The two factors which simultaneously determine the upper and lower limits to price, therefore, are
demand and cost. Because of their importance in pricing decisions, we will examine each of these
factors in greater detail.
Demand Analysis
(a) Information Required
Of all the factors affecting pricing decisions, information on demand is perhaps the most
important.
We have stressed that demand forms the upper limit to pricing decisions. We cannot charge
prices higher than those which the market will bear. Ideally, we should have information
bearing on the following two interrelated questions:
! What will be the quantity demanded at any given price?
! What is the likely effect on sales volume of changes in price?
What we are discussing may be referred to as the price sensitivity of demand and, clearly,
knowledge of this places us in a position to make informed decisions on price. However,
useful as such information is in assessing and interpreting price sensitivity of demand, we must
remember that:
(i) In markets where suppliers are able to differentiate their products from those of
competitors, sales volume for the individual company is a function of:
! the total marketing effort of that company
! the marketing efforts of competitors.
It is therefore difficult to appraise the impact of a price policy upon sales without
analysing the marketing activity of competitors.
(ii) Price sensitivity may be expected to differ between individual customers and/or groups
of customers.
(b) Perceived Value and Pricing
Taken together, differentiated products and differences in price sensitivity mean that the price
sensitivity of demand confronting a company is influenced by the choice of market segment
and the extent to which prices are congruent with the total marketing effort applied to these
segments.
In analysing demand it is necessary to examine the buyers perception of value as the key to
pricing decisions. Essentially, that involves appraising the benefits sought by customers, these
benefits being reflected in their buying criteria.
This examination enables a company to select the most appropriate market targets and then to
develop a marketing mix for those targets with respect to price, quality, service, etc.
(c) External Influences on Demand
Finally, we need to remember that overall demand and possible changes in demand for
products can be influenced by factors which may be outside a companys control. Examples of
these factors are income levels, legislation and fuel prices.
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Cost Considerations
(a) The Role of Cost Inputs
Even though costs generally do not determine prices, obviously cost is a primary factor in
evaluating pricing decisions. Among the key roles which information on costs plays are:
! measuring the profit contribution of individual selling transactions
! determining the most profitable products, customers, or market segments
! evaluating the effect on profits of changes in volume
! indicating whether a product can be made and sold profitably at any price.
(b) Requirements of a Costing System
Accurate, relevant and timely data on costs is essential for a costing system. In addition, the
costing system should be flexible. These key aspects of information on cost are expanded
below.
(i) Accuracy
It is important that a companys cost analysis allows it to identify costs accurately for
each product, activity, customer etc. In this way management is able to make informed
decisions about volume mix and pricing to target market segments.
(ii) Relevance
It is important that cost analysis is performed and presented on a basis relevant to
decision-making. In particular, the cost analysis should distinguish between fixed and
variable costs, and specify the relationship between these and volume. Also required is
information on costs relative to those of competitors.
(iii) Timeliness
In order to be useful for decision-making, information on costs should be made available
at the appropriate time. This means that cost information should relate not only to
historic costs but also to future expected costs.
Within this framework, information on costs should include:
! Costs of production and marketing historical and future.
! Volume anticipated extent of plant utilisation.
! Relation of capacity to cost.
! Contribution to overheads of products, activities, customers, etc.
! Break-even points.
! Interrelationships between costs of items in the product mix.
Pricing Policy and Procedures
Clearly, pricing decisions require that a number of factors be taken into consideration. A policy
framework for pricing decisions is required which covers the following areas:
! determination of product price levels for existing products
! pricing new products
! implementation of price changes: strategic and tactical
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! deviations from price levels, such as discount levels, rebate policy, etc.
In addition, a company must establish suitable organisational procedures for the implementation and
administration of pricing, to cover, for example:
! responsibility for pricing decisions
! procedures for quoting prices
! procedures for price changes
Pricing Decisions and the Product Life-Cycle
The product life-cycle shows how firms adopt different pricing policies at different stages of a
products life. According to the product life-cycle theory a product goes through four stages:
! Introduction
! Growth
! Maturity
! Decline
(a) Introduction
At the introductory stage a firm is likely to charge high prices. This is because the product is
new and will therefore have a novelty appeal. There will also be very few substitutes available
and there is therefore no need to price competitively. The firm may have spent vast sums of
money in developing and promoting the product, and so will be anxious to recover as much
money as possible quickly and will consequently charge a high price.
(b) Growth
At the growth stage a firm will be keen to establish a high market share and may therefore
slightly lower its price in order to generate more sales. This is usually a very profitable stage
for the company because prices are still relatively high but the firm may have found techniques
to lower costs, so contribution will be quite high. Sales volume increases considerably during
this period and as a result a firm can make substantial profits. Naturally such firms will try to
erect barriers to entry in order to discourage competition. Brand advertising together with
patents and copyright are often an effective means of achieving this.
(c) Maturity
At the maturity stage a company may face severe competition. The high profits which it
enjoyed in the growth stage may have attracted competition, and a number of new firms will
have entered the market. This results in very competitive pricing. Generally, it is at this stage
that firms achieve economies of scale. Factories will operate to full capacity and the
manufacturing process (if one exists) is likely to become automated. All these factors will
reduce costs and firms anxious to maintain or increase their market share will choose a price
which is only slightly above average costs.
(d) Decline
Finally, at the decline stage a number of firms may be forced to leave the market. The
reduction in the overall market may reduce the advantage of economies of scale. As a result
prices may increase slightly, but profitability will drop.
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C. PRACTICAL PRICING STRATEGIES
We will now examine some of the main pricing strategies which can be implemented by a business.
You should be able to recognise and calculate prices for each method.
Full Cost Plus Pricing
This pricing strategy involves first calculating the full cost of producing a product or providing a
service including a charge for fixed overheads. A percentage is then added to this cost as a profit
margin.
Example
A company producing hand-crafted cut glass calculates its costs as follows for each glass produced.
Direct material 2.50

Direct labour 3 hours at 7.50 per hour 22.50
25.00
Variable overhead 3 hours at 2 per hour 6.00
Total variable cost 31.00
Fixed overheads 3 hours at 3 per hour 9.00
Total cost per unit 40.00
The companys pricing strategy is to charge a price based upon a products full cost plus 25%.
The selling price of one glass will be:
Total cost 40.00

add 25% 40.00 10.00
Selling price 50.00
Full cost plus pricing has three serious disadvantages:
! It ignores what price customers are prepared to pay for a product or service.
! It assumes that a firm operates at budgeted capacity. It does not take into account inefficiency
such as idle time.
! It ignores the prices charged for competing products and services.
Full cost plus pricing does not take into account market forces. It is still in frequent use particularly
by small firms and in certain industries such as the building trade.
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Marginal Cost Plus Pricing
This pricing strategy involves calculating the marginal cost of producing a product or providing a
service. This excludes a charge for fixed costs. A percentage is then added to the marginal cost for
contribution.
Example
A company operating a hotel calculates the cost of providing accommodation as follows:
Variable cost per guest per night: 18.00
This is the marginal cost.
The companys pricing strategy is to charge a price based upon marginal cost plus 100%.
Therefore, the charge per guest per night will be:
Marginal cost 18.00

add 100% margin for contribution (100% 18) 18.00
Selling price 36.00
Marginal cost plus pricing has the following disadvantages:
! It ignores what price customers are prepared to pay for a product or service.
! If a business is operating at below its break-even point no profit will be made.
! It ignores the prices charged for competing products and services.
Marginal cost plus pricing is used as an alternative to full cost plus pricing and is frequently used by
undertakings providing repair services, e.g. in motor vehicle servicing.
Competitive Pricing
This pricing strategy involves charging prices for products and services which are based upon the
prices charged by competitors. It is an aggressive strategy which should ensure that an organisation
maintains its competitive position. This strategy is compatible with objectives which are aimed at
maximising sales volume or market share.
Example
An electrical retailer purchases a particular model of electric kettle at 84 for ten.
The prices charged by three competitors for the same product are as follows:
Retailer A 10.85 each
Retailer B 11.99 each
Retailer C 11.85 each
In such a situation it is likely that potential customers will compare selling prices and therefore a
competitive pricing strategy should be operated. This will ignore the cost of the product. In the
situation above, any price could be charged between 10.85 and 11.99.
If the retailer wants to maximise sales volume, a price of 10.85 or lower should be charged for each
electric kettle.
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A price below 10.85 could be charged but the effect this will have on Retailer A, who may then
reduce the products price and start a price war, will have to be carefully considered.
Competitive pricing is widely used in retailing.
Market Forces Pricing
This pricing strategy takes account of market forces such as total market supply and demand and
what value customers place on a product or service. Market forces are difficult to predict and are
constantly changing. Firms operating this pricing strategy are constantly changing the prices of their
product/service range with frequent price rises when demand exceeds supply and discounts when
supply exceeds demand. Such firms spend considerable amounts of money on advertising to
influence demand and on market research. This pricing method is used for marketing products that
are unique, such as new and second-hand motor vehicles.
Example
A market research survey shows that many companies allow executives to purchase company cars at
the following values.
12,000
15,000
18,000
24,000
Each price depends upon the
grade of employee
A car manufacturer then produces and sells a range of new cars at these prices. When the value of
company cars is increased by employers by, say 10%, the manufacturer simply increases the selling
price of its product range by the same amount.
Loss Leaders
Some organisations are prepared to sell certain products at a loss. Their reasons for this may be to:
! attract customers who will then purchase other profitable products at the same time
! clear obsolete stock
! make room for more profitable stock when space is a limiting factor
! stimulate stagnant market conditions
Discriminating Pricing
Discriminating pricing is a strategy which results in different prices being charged for a product or
service at different times. It is widely used in service industries where demand fluctuates over a short
period of time. Its purposes are to:
! increase profitability when demand for the product or service is high
! reduce demand when it is higher than supply
! use of spare capacity when demand is low by increasing demand.
Discriminatory pricing is particularly used in the holiday trade, transport and by the electricity
industry.
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Example
A company selling holiday package tours finds that demand for holidays is high over the Christmas
period and from late J uly to mid-September each year. From May to mid-J uly and during late
September demand is moderate, while for the remainder of the year demand is low.
The pricing strategy operated by this company is as follows:
Period Price
1 October 15 December and
7 J anuary 30 April
Holidays are priced at a basic rate
1 May 20 J uly and
15 September 30 September
Holidays are priced at the basic rate plus
a 30% premium.
21 J uly 14 September and
16 December 6 J anuary
Holidays are priced at the basic rate plus
a 75% premium.
Over a 12 month period this company charges three different prices for the same holiday.
Target Pricing
This involves targeting profit mark-up to a desired rate of return on total costs at an estimated
standard volume.
The target pricing approach can be more flexible than the full-cost pricing approach in that the profit
margin added to costs can be varied by individual product, product line, individual customer, market
segments or a combination of these. In this way, the mark-up may be adjusted to reflect demand and
competitive conditions between products and markets, to give an overall target rate of return to the
company.
The main disadvantage of target pricing is that it has a major conceptual flaw. The method uses an
estimate of sales volume to derive price, whereas in fact price influences sales volume. A target
selling price pegged to a derived rate of return does not guarantee that it is acceptable in the market
place.
Market Penetration and Market Skimming
These approaches to pricing are not so much methods of pricing as two contrasting approaches to
determining the overall level of prices for a companys products compared with the competition.
Market penetration and market skimming approaches to pricing are particularly relevant to new
product pricing.
(a) Market Penetration
With a penetration pricing approach, the price is set low to stimulate growth of the market and
to achieve a large market share. Market penetration is a valid approach to pricing a new
product in the following circumstances:
! If the market is price-sensitive, i.e. if reductions in price bring about substantial increase
in demand.
! If, by increasing its market share, and therefore its output, a company is able
substantially to reduce average costs, i.e. it is able to make economies of scale.
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! If a low price would discourage actual or potential competition.
! Where a company has sufficient financial assets to support a low price policy and
possible initial losses.
(b) Market Skimming
In this approach to pricing, initial prices are set high and reduced in the later stages of the
product life-cycle.
This approach assumes that some market segments are willing to pay more than others; for
example, higher income groups and customers willing to pay for being among the first to
purchase a new product.
The price is set high to obtain a premium from them and gradually it is reduced to attract the
more price-sensitive segments of the market. This is a useful method of pricing if:
! there is a sufficient number of buyers whose demand is not price-sensitive
! unit production and distribution costs of producing a small volume do not cancel out the
advantage of the price premium
! high prices do not stimulate potential new entrants to the market. This is the case if
there is a patent, or high costs of entry into the market.
Minimum Pricing
This method is based on ensuring that certain costs to the business will be recovered. It is not
necessarily the price that will be charged but it is an indication of the point below which sales prices
must not drop. The costs to be considered are:
! The opportunity costs of the resources used in manufacturing and selling the product.
! The incremental costs of producing and selling the product.
Thus, relevant costing is an important part of calculating the minimum price; if there are scarce
resources then the price would be based on the opportunity cost of production, whereas if there are no
limits on production the price will be based on the incremental cost.
Limiting Factor Pricing
This is again based on relevant costing and could be used when a company is operating at full
capacity and has a shortage of resources. Prices can be set based upon a mark-up per unit of limiting
factor.
Example
Scoffit Bakeries Ltd produces 10,000 loaves a day from its two ovens which operate 24 hours a day,
seven days a week (except for cleaning and maintenance). The limiting factor on the company is
therefore the time available as the installation of a third oven would be uneconomic.
Per 100 loaves, the costs are 10 for direct material, 10 for direct labour and 30 direct production
overhead. The latter includes the cost of power for the ovens. Fixed costs are 1,000 per day.
If the company wishes to make a contribution of 25 per 100 loaves, what should the selling price per
loaf be and what will the daily profit be at this selling price?
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Sales Price
Per 100 Loaves
Direct material 10
Direct labour 10
Product overhead 30
50
Contribution required 25
Total sales 75
Sales price per loaf is therefore 75p.
Profit per Day

Sales (10,000 75p) 7,500
Direct material (1,000)
Direct labour (1,000)
Production overhead (3,000)
Contribution 2,500
Fixed costs (1,000)
Daily profit 1,500
Return on Capital Pricing
This method of pricing attempts to achieve a required return on capital employed (ROCE). It is first
necessary to establish the required rate of return on capital and to prepare an estimate of total annual
costs.
Example
Assuming that A Ltds capital employed is 1m, estimated total costs for the coming year are 1.5m,
and the required rate of return on capital is 15 per cent. The mark-up on costs becomes:
1
1.5m
m
15% = 10% on cost
As with other forms of pricing, this method must be operated with some degree of flexibility to allow
for selling prices to be varied according to circumstances from time to time.
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D. FURTHER ASPECTS OF PRICING POLICY
Short- and Long-Term Policy
In the short term, prices which result in a loss may be justified, provided that the price level is
consciously fixed in order to establish a new product, or gain a foothold in a new market. Short-term
policies are in many ways much easier to plan and execute than long-term policies, since an error of
judgement or calculation will not have such disastrous effects. In addition a short-term plan is open
to amendment by its very nature; the policy-makers will always bear in mind that it may be
discharged after a limited period of time.
It is, on the other hand, very difficult to formulate a long-term plan in view of the likelihood of
steadily rising costs. This likelihood necessitates periodic checks on the progress of the plan, and
these might obstruct a true long-term pricing policy. Much will depend, however, upon the nature of
the business, and, to some extent, on the nature of the product. In a manufacturing business there is
always the prospect that a new process will be invented that will reduce production costs, and also
that astute bulk buying of raw materials will prevent the average raw material costs from rising too
sharply. These advantages are frequently offset, however, by rising costs of labour and also by
increases in production and other overheads.
In a merchanting business it is possible to frame a marketing or purchasing policy in the long term,
but where the products are subject to wide variations in supply and demand during the course of a
season, a long-term pricing policy would usually be impracticable. For example, in the commodity
trades the merchant has to consider not only whether the crop is likely to be adequate to meet world
demand, but also whether it is likely to be late, or the quality fully up to the required standard. In
addition, there may be certain occurrences which nobody can foresee, such as natural disasters,
severe labour unrest or political upheaval.
If a merchant charges prices that are too low he or she will incur regular losses, but if prices are too
high most business will go to the competitors. The most satisfactory form of pricing policy is one
where the seller aims to earn a certain fixed percentage above actual cost, but even here it may be
necessary to make occasional adjustments where the prices asked are unattractive to buyers.
Quantity Incentives
Most sellers, whether manufacturers or merchants, would normally prefer to sell a large rather than a
small quantity of the products in which they deal. It is sometimes necessary for a seller to give some
form of incentive in order to attract large business. Some buyers prefer to spread their purchases over
a number of suppliers in order not to be wholly dependent upon one source. If the seller, however,
can give sufficient incentive to the buyer, it may be possible to book the whole quantity.
The form which the incentive takes will depend upon the negotiating powers of both parties, and also,
to some extent, on the strength of the competition. The most obvious incentive is a reduction in
price, although the seller must be particularly careful that the concession granted does not make the
business uneconomic. Alternatively, the incentive may take the form of credit facilities at favourable
rates of interest. Here it is not merely the cost of the credit given that must be considered, but also
the feasibility of the credit plan. The credit concession may involve the company in a medium-term
financial commitment which exceeds its facilities, and this may prove embarrassing to all concerned.
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Discount Policy
There are two forms of discount trade discount and cash discount.
(a) Trade Discount
A trade discount is one which is offered in the normal course of business, and may vary
according to the quantity of goods sold. It is usual to give no discount for small quantities, and
a discount on an ascending scale thereafter. An example of this would be no discount for 50
items; between 50 and 100, 1% discount; between 100 and 200, 2% discount; over 200, 2%
discount.
However, trades differ in this matter. If a builder went into a builders merchants to buy a bath
he would normally get credit. If your small local garage owner had to fit a new part to your
car, say a Ford, he would go to the nearest Ford main dealer with whom he may even have an
account and purchase the part. He would get trade discount unless the item or items were
particularly small, such as the purchase of two washers. Do bear in mind that such discounts
are offered to traders in the normal course of business.
Whether or not a company decides to operate a system of discounts depends entirely upon the
nature and terms of its general trade.
(b) Cash Discount
Cash discounts are offered to buyers who pay promptly for the goods they have bought. The
normal terms of sale in a trade may be on a monthly account basis, where goods are invoiced
during the course of a particular month and a statement sent at the end of that month for
settlement by the buyer. The seller normally offers a discount for settlement before the due
date, and here again discounts may be graduated according to the speed with which the account
is settled. For example, under a monthly account system the seller may be prepared to offer a
cash discount of 2% for payments received within 7 days of the date of the invoice, and 1% for
payments received within 14 days of the date of invoice. This type of policy may be linked
with that of early cash recovery.
Cash discounts of this nature are sometimes called settlement discounts.
Single and Multiple Price Arrangements: Differential Pricing
A single-product price structure is devised on the basis of a policy which will be drawn up in
accordance with factors already mentioned. If the product is a mass mover, the success of the pricing
policy depends entirely upon the ability of the company to distribute many units.
If sales of the product are negotiated on the basis of individual units, or a small number of units per
order, the approach may be varied according to the characteristics of the individual buyer. The
pricing of a single type of product may be conducted on the basis of its own particular merits.
Multiple pricing involves two aspects: first, offering the same goods to different buyers at different
price levels; second, price arrangements relating to a number of different items, the sales of which are
normally achieved in similar quantities and in similar demand centres. A manufacturer might produce
a particular product which is found to be successful in, for example, south-east England, and wish to
sell it in north-east England. Since the market has already been secured in the south-east on the basis
of a particular price, this need not be changed; but it might be necessary, in order to attract the initial
demand, to offer the product to the north-east at a lower price. Because various demand areas will
often be at different stages of development, it is possible that several different prices are being paid
for the same product.
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When a manufacturer is marketing a range of products, possibly under a single brand name, it is
important to ensure that price concessions in one particular product are reflected in the other products
in that range. The reason for this is that the manufacturer is competing with others not only in respect
of each individual product, but also in respect of the brand range as a whole.
Pricing Short-Life Products
The difficulty with the pricing of short-life products is that, as their name suggests, they have a very
short life-cycle during which a profit can be made. Examples of this type of item include
commemorative items produced for a special occasion, such as the Queens Silver J ubilee, or items
which quickly become out-of-date, such as diaries or calendars. An example from the financial world
would be National Savings Certificates, which have to have their price fixed in terms of the interest
rate return offered. As long as the prevailing level of market interest rates does not change, then the
current issue of NSCs should not be over- or under-competitive. However, a change in rates often
leads to a completely new issue at a different rate of interest.
Consideration needs to be given to the price charged in view of the products short life; it is often
necessary to be able to charge a premium to reflect this. In the case of products which are produced
as part of a limited edition, such as collectors plates or prints, it is usually the case that a sufficiently
low number produced will give the item sufficient rarity value to enable the premium to be charged.
This gives rise to a further problem in deciding how many should be produced to maintain this rarity
value.
Pricing Special Orders
Special orders usually arise in one of two situations:
! where a firm has no regular work and relies on its ability to win jobs at tender or in the general
market place. Examples would include architects and other professional firms as well as many
sub-contract firms, particularly those in the building and engineering sectors.
! where a firm has spare capacity over and above its normal level of operations. One example of
this would be a bakery producing 2,000 loaves of bread a day with a capacity of 2,500 loaves.
In the first category, firms will tend to take a much longer view of the decision on whether or not to
take special orders because this is their standard type of work. In the latter category, firms will be
able to take a much shorter-term view and use the concept of minimum pricing to decide on whether
or not to take the work on.
Minimum pricing basically involves calculating the break-even position of the work if it is
undertaken and then pricing accordingly to cover the incremental cost of the work plus an allowance
for profit. How much this allowance is will depend on how much spare capacity is available and the
level of fixed costs that must be covered by the firm overall.
191
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Study Unit 11
Budgetary Control
Contents Page
Introduction 192
A. Definitions and Principles 192
Budgets 192
Budgetary Control 192
Advantages to be Derived from Budgetary Control Systems 194
Types of Budget 195
B. The Budgetary Process 196
Timetable 196
Organisation 196
Preparing a Budgeted Profit and Loss Account 197
Preparing a Budgeted Balance Sheet 198
Budget Review 201
Control by Correction of Adverse Variances 201
C. Budgetary Procedure 201
Budgetary Control Data 201
Sales Budget 206
Production Budget 206
Materials Purchase Budget 207
Direct Materials Cost Budget 208
Direct Labour Cost Budget 208
Production Overhead Budget 209
Selling and Distribution Overheads Budget 209
Administration Overheads Budget 210
Budgeted Trading and Profit and Loss Account 211
Budgeted Balance Sheet 212
D. Changes to the Budget 213
Problem of Long-Term Planning 213
Need to Update Budgets 213
192 Budgetary Control
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INTRODUCTION
This study unit, and the four that follow, will concentrate on the use of budgetary control and
standard costing as an aid to managing the business.
It is necessary to be able to set targets and then be able to compare performance accurately against
them. Without this process it is impossible to determine whether the business is functioning properly.
In addition, where differences do occur, it is possible to investigate them and take remedial action.
Budgetary control involves everyone in the organisation and it is therefore an excellent way of
communicating and ensuring they are aware of what is expected. This first study unit considers how
useful budgets are in more detail and the usual procedures that are followed in terms of budget
implementation. We shall also look at a numerical example of how a budget is put together. Do not
be concerned that this example is manufacturing-based; the description of the people and products
involved will vary from industry sector to industry sector, but the basic principles laid down will
usually apply.
There are several different budgetary methods which can be employed and these will be looked at in
more detail in the next study unit. Thereafter the applications of standard costing and resultant
variance analysis will be considered.
A. DEFINITIONS AND PRINCIPLES
Budgets
The CIMA definition of a budget is:
A plan quantified in monetary terms, prepared and approved prior to a defined period
of time, usually showing planned income to be generated and/or expenditure to be
incurred during that period and the capital to be employed to attain a given objective.
A budget is therefore an agreed plan which evaluates in financial terms the various targets set by a
companys management. It includes a forecast profit and loss account, balance sheet, accounting
ratios and cash flow statements which are often analysed by individual months to facilitate control.
Budgets are normally constructed within the broader framework of a companys long-term strategic
plan covering the next five and ten years. This strategic plan sets out the companys long-term
objectives, whilst the budget details the actions that must be taken during the following year to ensure
that its short- and long-term goals are achieved.
Budgetary Control
The CIMA definition of budgetary control is:
The establishment of budgets relating the responsibilities of executives to the
requirements of a policy, and the continuous comparison of actual with budgeted results,
either to secure by individual action the objective of that policy or to provide a basis for
its revision.
Companies aim to achieve objectives by constantly comparing actual performance against budget.
Differences between actual performance and budget are called variances. An adverse variance tends
to reduce profit and a favourable variance tends to improve profitability.
Budgetary control therefore allows management to review variances in order to identify aspects of the
business that are performing better or worse than expected. In this way a company will be able to
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monitor its sales performance, expenditure levels, capital expenditure projects, cash flow, and asset
and liability levels. Corrective action will be taken to reduce the impact of adverse trends.
The financial aspects of budgets are prepared in the same format as the companys profit and loss,
balance sheet and cash flow statements. In this way it is easy to compare actual and budgeted results
and calculate variances.
Here is a typical statement comparing actual and budgeted results:
PROFIT AND LOSS ACCOUNT MAY 200X
Description Month Year to Date
Budget Actual Variance Budget Actual Variance
% % % %
Sales
Tickets
Catering
Souvenirs
Other
Total
Gross Profit
Tickets
Catering
Souvenirs
Other
Total
Overheads
Staff
Rent
Local authority tax
Electricity
Gas
Cleaning
Repairs
Renewals
Advertising
Entertainment
Commissions
Laundry
Motor expenses
Total
Net Profit
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You can see that this statement details the months performance together with that for the year to date.
It covers the whole company and in order to obtain even greater control it is necessary to prepare
operating statements evaluating the contribution from each area of the business. These additional
statements usually cover the activities of individual managers, to identify which of them are failing to
achieve their targets. A typical style of operating statement is presented below:
OPERATING STATEMENT
Maintenance Department
Month of May 200X
Description Month Cumulative
Budget Actual Variance Budget Actual Variance

Salaries 16,000 15,500 500 70,000 67,000 3,000
Wages 51,000 53,000 (2,000) 250,000 255,000 (5,000)
Indirect materials 2,000 1,900 100 10,000 12,000 (2,000)
Maintenance 6,000 6,000 24,000 23,900 100
Electricity 8,000 10,000 (2,000) 40,000 39,000 1,000
Gas 6,500 7,000 (500) 26,500 28,000 (1,500)
Total 89,500 93,400 (3,900) 420,500 424,900 (4,400)
This statement includes all expenditure under the control of the maintenance manager. It details
expenditure for the month of May and the cumulative position for the year to date. The statement
identifies the months main areas of overspend as wages, electricity and gas. For the year to date the
main problem areas are wages, indirect materials and gas.
Under a system of budgetary control the maintenance manager will be asked to prepare a report
explaining all variances and the action being taken to bring the department back onto budget. These
actions will be monitored in the following months to ensure that corrective measures have been taken.
Advantages to be Derived from Budgetary Control Systems
(a) Agreed Targets
Budgets establish targets for each aspect of a companys operations. These targets are set in
conjunction with each manager. In this way managers are committed to achieving their
budgets. This commitment also acts as a motivator.
(b) Problems Identified
Budgets systematically examine all aspects of the business and identify factors that may
prevent a company achieving its objectives.
Problems are identified well in advance, which in turn allows a company to take the necessary
corrective action to alleviate the difficulty. For example, a budget may indicate that the
company will run short of cash during the winter period because of the seasonal nature of the
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service being provided. By anticipating this position the company should be able to take
corrective action or arrange additional financing.
(c) Scope for Improvement Identified
Budgets will identify all those areas that can be improved, thereby increasing efficiency and
profitability.
Positive plans for improving efficiency can be formulated and built into the agreed budget. In
this way, a company can ensure that its plans for improvement are actually implemented.
(d) Improved Co-ordination
All managers will be given an outline of the companys objectives for the following year. Each
manager will then be asked to formulate plans so as to ensure that the companys overall
objectives are achieved.
All the managers plans will be combined and evaluated so that a total budget for the company
can be prepared. During this process the company will ensure that each individual plan fits in
with the company's overall objectives.
(e) Control
It is essential for a company to achieve its budget. Achievement of budget will be aided by the
use of a budgetary control system which constantly monitors actual performance against the
budget. All variances will be monitored and positive action taken in order to correct those
areas of the business that are failing to perform.
(f) Raising Finance
Any provider of finance will want to satisfy itself that the company is being managed correctly
and that a loan will be repaid and interest commitments honoured. The fact that a company has
established a system of budgetary control will help to demonstrate that it is being managed
correctly. The budget will also show that the company is able to meet all its commitments.
Types of Budget
There are a number of different types of budget covering all aspects of a companys operations.
These can be summarised into the following categories:
(a) Operating Budgets
Master budgets cover the overall plan of action for the whole organisation and normally
include a budgeted profit and loss account and balance sheet. The master budget is analysed
into subsidiary budgets which detail responsibility for generating sales and controlling costs.
Detailed schedules are also prepared showing the build-up of the figures included in the
various budget documents.
(b) Capital Budgets
These budgets detail all the projects on which capital expenditure will be incurred during the
following year, and when the expenditure is likely to be incurred. Capital expenditure is
money spent on the acquisition of fixed assets such as buildings, vehicles and equipment.
The capital budget enables the fixed asset section of the balance sheet to be completed and
provides information for the cash flow budget.
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(c) Cash Flow Budgets
This budget analyses the cash flow implications of each of the above budgets. It is prepared on
a monthly basis and includes details of all cash receipts and payments. The cash flow budget
will also include the receipt of finance from loans and other sources, together with forecast
repayments.
B. THE BUDGETARY PROCESS
Timetable
Each company prepares its budgets at a specific time of the year. The process is very time-consuming
and allowance must be made for:
! Each manager to prepare estimates
! The accumulation of the managers estimates so that a provisional budget can be built up for
the whole company
! The provisional budget to be reviewed and any changes to be agreed
A large company with a J anuary to December financial year will therefore probably commence its
budget preparation in August of the preceding year. This will allow 4-5 months for the work to be
completed. If it is to be completed successfully, it is essential that a timetable is prepared detailing
what information is required and the dates by which it must be submitted. The preparation of budgets
is a major project and it must be managed correctly.
Organisation
As we have just said, the preparation of budgets is a very important task which is given a high level
of visibility within the company. The overall co-ordination of the budgeting process is therefore
handled at a high level.
Budgeting may be the responsibility of the Finance Director, who will have responsibility for
bringing together the directors and managers initial estimates. The Finance Director will specify the
information that is required and the dates by which it is required. He/she will also circulate a set of
economic assumptions so that all directors and managers are preparing their forecasts against the
same economic background.
The Finance Director will eliminate most of the obvious inconsistencies from the initial estimates and
submit a preliminary budget to the Chairman of the company and its Board of Directors. The Board
will then consider the overall framework of this preliminary budget, to ensure that the budget is
acceptable and that it gives the desired results.
The Board must also ensure that the budget is realistic and achievable. If the Board does not accept
any part of the budget then it will be referred back to the relevant managers for further consideration.
Some companies set up a budget committee to co-ordinate the budgeting process. This committee
carries out similar functions to those we described above, but will involve more of the companys
senior directors and managers. The committee will probably be chaired by the Chairman of the
company.
The final budget must be accepted by the Board of Directors. It will then form the agreed plan for the
following year against which the company will be monitored and controlled.
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Preparing a Budgeted Profit and Loss Account
The following data will need to be converted into a budgeted profit and loss account which should be
analysed to individual months and prepared in the same format as the companys management
accounts.
There will also be detailed operating statements which allocate costs to individual managers. These
statements are also prepared on a monthly basis so that actual expenditure can be compared with
budget.
In preparing the budgeted profit and loss account, note that a companys financial performance will
be constrained by what are known as limiting factors. These include:
! Demand for products
! Supply of skilled labour
! Supply of key components
! Capacity or space
Each of these constraints limits the companys ability to generate sales and profits. Sales cannot
exceed the demand for its products, and production cannot exceed the limits imposed by labour and
material availability and capacity.
It is essential that a company recognises the fact that it may have a limiting factor, as this will govern
the overall shape of its budget.
(a) Sales
Sales budgets are normally prepared by the companys marketing department. The sales
budget of a small company may be set by its managing director working in conjunction with
the sales team. The sales budget will take into account the following factors:
! What is the sales trend for each product/service? Are sales increasing or decreasing and
why?
! Will any new product/service be launched and when?
! Will any of the existing products/services be phased out?
! What price increases can be obtained during the year?
! What is the advertising and promotional budget likely to be?
! What will be the pattern of sales throughout the period covered by the budget?
! What will the companys competitors be doing?
Are they introducing new products?
What is their pricing policy?
Are they being aggressive in order to gain market share?
What is their advertising expenditure likely to be?
Are there any new competitors entering the market?
(b) Cost of Sales
Having established a preliminary sales budget, it is now necessary to calculate the cost of sales.
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From the standard costs within a standard costing system, most companies know how much
each of their products costs to produce. These costs must be updated to allow for the forecast
level of price increases and proposed changes to specifications or methods. Hence budget
formation and control and standard costing often operate side by side.
(c) Labour Costs
Labour costs will be calculated by multiplying the number of people required to complete the
budget by their rates of pay. Full allowance will have to be made for any planned wage
increases.
(d) Overheads
The sales budget will be circulated to all managers with responsibility for controlling costs.
This document will enable each manager to understand the proposed scale of the companys
operations. Each manager will consider the items of expenditure that must be incurred in order
to ensure that the company can achieve its sales targets.
Each manager should understand the cost of running his or her area and from this information
should be able to estimate the cost levels required for the budget year. By accumulating all the
managers individual estimates it is possible for the company to build up a total cost budget.
(e) Profit before Tax
Sales Cost of sales Overheads = Profit before tax
(f) Taxation
From the budgeted level of profit the company will be able to calculate the level of corporation
tax payable.
(g) Dividends
Dividends will be budgeted based on the forecast level of profits and the companys overall
financial policy.
(h) Retained Earnings
Profit before tax Tax Dividends = Retained earnings.
Retained earnings will be added to the balance sheet reserves.
Preparing a Budgeted Balance Sheet
Having completed a budgeted profit and loss account it is now necessary to complete a budgeted
balance sheet.
(a) Fixed Assets
Capital Budgets
Each manager will be asked to submit details of capital expenditure requirements, together
with a brief summary of the reasons why the expenditure is necessary. A more detailed
appraisal will be required before the expenditure is actually committed, using for example,
Discounted Cash Flow techniques.
The capital budget will include items such as:
! New buildings
! Machinery and equipment
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! Office equipment
! Computers
! Commercial vehicles
! Motor cars
The sum total of all the managers capital expenditure requirements will form a provisional
capital budget.
Disposals
Fixed assets may be sold or dismantled during the year. These will be listed and an estimate
made of any sales proceeds that may arise.
If a company sells a fixed asset for more than its net book value then a profit will be made. A
loss will result if an asset is sold for less than its net book value.
Depreciation
The first step in completing budgeted depreciation is to calculate the charge for the year on the
assets already owned by the company. This will require the company to examine each of its
assets and calculate the depreciation charge.
All companies are required to keep a fixed asset register, which includes details of all their
fixed assets. Many companies have computerised their fixed asset registers, which improves
considerably the speed with which this part of the budgeting process can be completed.
A company must also calculate the depreciation charge on the projects included in its capital
budget.
A total depreciation charge can then be derived.
Net Book Value
We can now see how a company can complete the fixed asset section of its budgeted balance
sheet. Here is an example:
Cost Depreciation Net Book
Value

Balances as at 1 J an 125,000 (35,000) 90,000
Asset disposals (7,000) 6,000 (1,000)
Depreciation (12,000) (12,000)
Additions 55,000 (2,000) 53,000
Balance as at 31 Dec 173,000 (43,000) 130,000
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(b) Working Capital
Stocks
Companies calculate stock turnover ratios in order to monitor their stock control function. The
formula for calculating stock turnover is:
Stock Turnover =
Cost of Sales
Average Stock
Companies strive for a high stock turnover, which means they are carrying low stocks and
managing the function effectively. It is therefore possible to target improved performance by
setting a higher stock turnover target for the following year which can be converted into a stock
valuation by adopting the following formula:
Budgeted Average Stock =
Budgeted Cost of Sales
Stock Turnover
Debtors
A company will also calculate debtors ratios in order to monitor the effectiveness of its credit
control function. From these ratios a company will establish target ratios which can be used to
calculate budgeted debtors in a similar way to the above stock calculation.
Debtors Ratio =
Debtors
Credit Sales
365 days
Budgeted Debtors =
Debtors Ratio Credit Sales
365
Cash in Hand and Cash in Bank

In practice the budgeting process will use cash as the balancing figure in the balance sheet.
This approach may seem strange but if you think about it, you will see that a companys cash
position will be the result of everything else that the company does.
Creditors
Creditors will be calculated in a very similar way to the above debtors calculation. A target
creditors ratio will be determined, which will then be applied to the purchases figure derived
from other parts of the budgeting process.
Creditors Ratio =
Creditors
Credit Purchases
365 days
Budgeted Creditors =
Creditors Ratio Credit Purchases
365
Bank Overdraft
The cash budgeting process may indicate that a bank overdraft will be required.
(c) Share Capital
The value of a companys share capital will only change if new shares are issued. This
decision will be taken at the highest level within a company.
(d) Reserves
The opening balance on reserves will be known. The final figure will be the opening balance
plus or minus the value of retained earnings taken from the budgeted profit and loss account.
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(e) Loans
The opening position will be known. The final figure will be the opening position plus the
value of any new loans less the value of loans repaid.
(f) Budgeted Balance Sheet
All the preceding data will be presented in the same format as the company adopts for its
monthly accounts. This statement will also be prepared on a monthly basis to facilitate
comparison with actual results.
Budget Review
The company has now completed provisional profit and loss, capital, cash flow and balance sheet
budgets.
The provisional budget will be considered by the Board of Directors. The Board must satisfy itself
that the budget is achievable and that it is consistent with the companys overall strategy. If the
Board accepts the budget it will become the standard by which the company will be monitored
throughout the following year. If the Board does not accept part of the budget then it will be referred
back to management for further work.
In large groups of companies, the budget will also have to be approved by the Board of the companys
holding company.
Control by Correction of Adverse Variances
The budget will detail all aspects of the companys operations. The company will prepare monthly
profit and loss accounts, operating statements, cash flow statements and balance sheets. Each of the
figures in these documents will be compared with the budget.
Variances will be calculated (which are the differences between actual and budgeted results).
Excessive costs and inadequate sales will be highlighted and positive action will be required in order
to ensure that the company corrects any adverse variances.
C. BUDGETARY PROCEDURE
To show the general principles of budget preparation, we shall now work through an extended
example which illustrates the typical budget procedure complete with problems. We shall start with
the basic information from which the budget will be built.
Budgetary Control Data
Venture Ltd produces two products X and Y. The products pass through two departments
department 1 and department 2.
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The following standards have been prepared for direct materials and direct wages:
Product
X Y
Material A 5 kg 8 kg
Material B 4 kg 9 kg
Direct labour:
Department 1 3 hours 2 hours
Department 2 2 hours 4 hours
The standard costs for direct material and direct labour are as follows:
Material A: 2.00 per kg
Material B: 1.20 per kg
Direct labour: Department 1 3.00 per hr
Department 2 3.50 per hr
Standard selling prices are:
Product X: 50.00 per unit
Product Y: 80.00 per unit
The budgeted sales for each product for the coming year are:
Product X: 8,000 units
Product Y: 10,000 units
The company plans to increase the stocks of finished goods, so that the closing stock of product X
will be 2,000 units and the closing stock of product Y will be 3,000 units.
Opening stocks of finished goods are:
Product X: 1,000 units
Product Y: 2,000 units
Finished goods are valued at variable production cost.
Opening stocks of direct material are:
Material A: 12,000 kg
Material B: 15,000 kg
The required closing stocks of materials are:
Material A: 19,000 kg
Material B: 15,000 kg.
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Variable overhead rates are as follows.
Rate per direct labour hour
Dept 1 Dept 2

Light, heat, power 0.20 0.20
Consumable stores, indirect materials 0.40 0.30
Indirect wages 0.30 0.50
Repairs and maintenance 0.20 0.30
Standard variable selling and distribution expenses are as follows.
Rate per of sales value
Product X Product Y
(%) (%)
Commission 5 5
Carriage, packing, despatch 4 2.5
Telephone, postage, stationery 2 2
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Fixed production, selling and distribution and administration overheads are budgeted to be as
follows:
Production Selling and
Distribution
Administration

Salaries:
Dept 1 10,000
Dept 2 12,000
Selling and distribution:
Product X 20,000
Product Y 30,000
Administration 22,000
Depreciation:
Dept 1 20,000
Dept 2 22,000
Product X 5,000
Product Y 6,000
Stationery, postage, telephone:
Dept 1 1,100
Dept 2 1,200
Product X 800
Product Y 1,000
Sundry expenses:
Dept 1 1,400
Dept 2 1,300
Selling and distribution: 1,200
Product X
Product Y 1,500
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The companys balance sheet at the beginning of the year was as follows:

Fixed assets at cost 1,000,000
less Accumulated depreciation 200,000
800,000
Current Assets
Stock: material 42,000
finished goods 145,000
Debtors 150,000
Cash 40,000
377,000
Current Liabilities
Creditors 110,000
Net current assets 267,000
1,067,000
Represented by:
Share capital 800,000
Reserves 267,000
1,067,000
The budgeted cash flows per quarter are:
Quarter
1 2 3 4

Debtors 250,000 200,000 300,000 300,000
Creditors 110,000 100,000 102,000 120,000
Wages 90,000 90,000 92,000 92,000
Expenses 83,000 84,000 87,000 88,000
From this information, we shall now work through the preparation of the following budgets:
! Sales
! Production
! Materials purchases
! Direct materials cost
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! Direct labour cost
! Production overheads
! Selling and distribution overheads
! Administration overheads
! Trading and profit and loss account
! Balance sheet at year-end
Sales Budget
The sales budget will frequently be the starting point of the budgeting process, and it is in this case.
The sales figures will usually determine the production requirements subject, as in this case, to
any required adjustment to the stocks of finished goods. The sales budget will be derived from
salespeoples reports, market research, or other intelligence or information bearing on future sales
levels and demand for the companys products. The sales budget would be analysed according to the
regions or territories involved, with monthly budget figures for territories, salespeople and products,
so that sales representatives would have specific targets against which actual performances could be
measured.
The total sales budget in terms of units and values for the two products will be as follows:
Product Units Unit Price Sales Value

X 8,000 50.00 400,000
Y 10,000 80.00 800,000
1,200,000
Production Budget
The purpose of this budget is to show the required production for the coming year, so that
production scheduling can be completed in advance, and individual machine loading schedules can be
prepared. This will enable the production department to assess the budgeted usage of plant, the
labour requirements and the extent of any under- or over-capacity. As with the sales budget, the total
annual requirements must be analysed into monthly figures.
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The total production budget for the year is:
Product
X Y
units units
Sales 8,000 10,000
plus Closing stock required 2,000 3,000
10,000 13,000
less Opening stock 1,000 2,000
Production requirement 9,000 11,000
Materials Purchase Budget
This budget sets out the purchasing requirements for each type of material used by the organisation,
so that the purchasing department can place orders for deliveries, to take place in accordance with
production requirements the essential need being that production shall not be held up for lack of
materials. Purchase orders should be placed, and deliveries phased, according to the production
schedules, care being taken that no excessive stocks are carried. The standard for the products will
also specify the quality of material required, so that the purchasing department will be responsible for
obtaining the materials required, of the standard quality.
As with other budgets, the purchasing budget should show the monthly quantities to be purchased,
allowing for any lead time in suppliers deliveries.
Materials
A B
kg kg
Production: Product X 45,000 36,000
Product Y 88,000 99,000
133,000 135,000
plus Required closing stock 19,000 15,000
152,000 150,000
less Opening stock 12,000 15,000
Purchases required 140,000 135,000
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Direct Materials Cost Budget
The figures for this budget flow from the materials purchases budget, and they show the financial
implications of the planned purchases, for purposes of financial control and cash flow
requirements.
Material A Material B
Purchases required 140,000 kg 135,000 kg
Price per kg 2.00 1.20
Cost of purchases 280,000 162,000
Note that the quantities for production represent the number of production units in the production
budget multiplied by the kg per unit.
Direct Labour Cost Budget
This budget shows the number of direct labour hours required to fulfil the production requirements,
and the monetary value of those hours. Departmental figures are given, so that departmental
supervisors are made aware of the labour hours and costs over which they are expected to exercise
control. Periodic reports would be made to supervisors, showing the output achieved and the relevant
standard hours and costs for that output (and, where necessary, the reports required on any significant
variances from the standards).
Direct Labour Hours
Product X Product Y
Department Units Hours per
unit
Total
hours
Units Hours per
unit
Total
hours
Combined
totals
1 9,000 3 27,000 11,000 2 22,000 49,000
2 9,000 2 18,000 11,000 4 44,000 62,000
Direct Labour Cost
Department Hours Rate Total

1 49,000 3.00 147,000
2 62,000 3.50 217,000
111,000 364,000
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Production Overhead Budget
The variable and fixed overheads are shown by department. The departmental supervisors will be
expected to exercise control over those items for which they are responsible, and monthly reports,
highlighting the variances from budget, will be provided to assist them. The variable overheads are
expressed as amounts per direct labour hour but these could also be shown in relation to some other
factor, such as machine time, units of production, materials to be consumed, or other relevant factors.
In practice, a combination of these factors might be used.
Variable Overheads
Department 1 Department 2
(Direct lab. hours 49,000) (Direct lab. hours 62,000)
per hour per hour
Light, heat, power 0.20 9,800 0.20 12,400
Consumable stores,
indirect materials 0.40 19,600 0.30 18,600
Indirect wages 0.30 14,700 0.50 31,000
Repairs, maintenance 0.20 9,800 0.30 18,600
53,900 80,600
Fixed Overheads
Department 1 Department 2
Salaries 10,000 12,000
Depreciation 20,000 22,000
Stationery, postage, telephone 1,100 1,200
Sundry expenses 1,400 1,300
32,500 36,500
Selling and Distribution Overheads Budget
As with other overhead budgets, the object of this budget is to identify the overheads to be
controlled by the management in this case, the sales management. Further analyses of the
overheads would be required to show the budgeted costs on a monthly basis, and by regions and
representatives where appropriate.
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Variable Overheads
Product X Product Y
Sales 400,000 800,000
% of sales % of sales
Commission 5 20,000 5 40,000
Carriage, packing, despatch 4 16,000 2.5 20,000
Telephone, postage, stationery 2 8,000 2 16,000
44,000 76,000
Fixed Overheads
Product X
Product Y
Salaries 20,000 30,000

Stationery, postage, telephone 800 1,000
Sundry expenses 1,200 1,500
27,000 38,500
Administration Overheads Budget
The administration overheads are likely to be mainly of a fixed character, and not affected by
production or sales levels, except where there are wide fluctuations. These overheads will cover the
general administration and accounting services of the organisation, and they will be the responsibility
of the chief executive concerned. Separate budgets for the accounting company secretariat and other
departments will be required in larger organisations. The budgets will be prepared after detailed
studies have been made of the level of service required to provide the necessary accounting,
secretarial and other administrative services needed. Where a complete review is required, an
organisation and methods study may be undertaken. Monthly reports will show actual and
budgeted results, as with other functions, and variances highlighted for further investigation. (The
costs in this problem have been assumed to be entirely fixed.)
Salaries 22,000
Depreciation 6,000
Stationery, postage, telephone 2,500
Sundry expenses 1,500
32,000
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Budgeted Trading and Profit and Loss Account
This account is part of the master budget, and it shows the expected trading profit or loss based on the
sales and cost budgets previously prepared. In the light of these results, the management may decide
to recommend changes to the sales and cost figures, to bring the expected results into line with a
required return of capital or gross and net profit percentages related to sales. Once the final figures
have been approved, the budgeted trading and profit figures become the target for the company as a
whole. Using the figures arising from the previous budgets, the budgeted trading and profit and loss
account would be as follows:
Budgeted Trading and Profit and Loss Account
for the year ended 200X

Sales 1,200,000
Opening stock of materials 42,000
Purchases 442,000
484,000
less Closing stock of materials 56,000
428,000
Direct wages 364,000
Variable production overheads 134,500
926,500
Opening stock of finished goods 145,000
1,071,500
less Closing stock of finished goods * 236,000 835,500
Gross profit 364,500
Overhead expenses
Variable selling and distribution overhead 120,000
Fixed overheads:
Production 27,000
Selling and distribution 54,500
Depreciation:
Production 42,000
Selling and distribution 11,000
Administration 6,000 286,500
Net profit 78,000
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Note on value of closing stock of finished goods in Budgeted Trading Profit and Loss Account
This is made up as follows:
2,000 units of X:- Mat A 10.00; Mat B 4.80; Lab 1 9.00; Lab 2 7.00;
Variable overheads: Dept. 1 3.30; Dept. 2 2.60;
Total: 36.70 each unit 2,000 =73,400
3,000 units of Y: - Mat A 16.00; Mat B 10.80; Lab 1 6.00; Lab 2 14.00;
Variable overheads: Dept. 1 2.20; Dept. 2 5.20;
Total 54.20 each unit 3.000 =162.600
Grand Total = 236,000
Budgeted Balance Sheet
This also forms part of the master budget, and it shows the expected overall financial position
resulting from the budgets. It enables assessments to be made of the return on capital and ratios of
profitability and liquidity for example, the current asset/current liability position, credit collection
periods, and other financial ratios. This may also be part of a review process in which some revisions
may be required before final approval is given.
Budgeted Balance Sheet as at . . . . .

Fixed assets at cost 1,000,000
less Accumulated depreciation 259,000
741,000
Current Assets
Stock: material 56,000
finished goods 236,000
Debtors 300,000
592,000
Current Liabilities
Creditors 120,000
Bank overdraft (+40 88) 48,000
168,000
Net current assets 424,000
1,165,000
Represented by:
Share capital 800,000
Reserves 365,000
1,165,000
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D. CHANGES TO THE BUDGET
Problem of Long-Term Planning
One fact about any forecast is that no person can be sure that the forecast will come true! This means
that no manager can be certain that future events will occur as planned or predicted. The further
ahead the planning horizon, the less certain the prediction. A classic example of this is trying to
forecast the weather, yet the weather affects the fortunes of most businesses e.g. those involved in
the construction industry, retailing, extraction of raw materials, the clothing trade. The future
weather pattern is something that must be considered when preparing budgets and other business
plans.
Need to Update Budgets
It often happens that, since the time when a budget was prepared, more information about the budget
period becomes available. The problem then arises whether to change the budget in the light of
additional information or whether to ignore the additional information and leave the original budget
alone. To obtain maximum benefit, the management should change the original budget, and produce
a revised budget which takes account of the changes. The differences between the first and second
budgets are caused by the plan being changed, and they are part of the organisation's planning
variances.
Example
XYZ Plc produces monthly budgets six months in advance. The original budget for Month 6 is
summarised as follows:
000
Sales 850
Costs 725
Budgeted profit 125
At the end of Month 3, additional information showed that the results for Month 6 would be expected
to be different from those budgeted for. XYZ Plcs management decided to update the first budget
and produce a new budget, reflecting the expected changes, as follows:
000
Sales 825
Costs 750
Budgeted profit 75
Normally, the updated budget is compared with actual results, and the original budget is compared
with the updated one. The planning profit variance in this example is 125,000 75,000 =50,000
(being the original budgeted profit less the updated profit). If more than one update of the budget is
needed, each updated budget can be compared with the previous update. The latest updated budget is
the one that should be compared with actual results.
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The main advantages of updating budgets are that:
! The budget reflects all known relevant information about the budget period.
! The management can assess the reliability of information used to prepare budgets.
! The ability of the planners to plan properly can be assessed i.e. the planners performance
can be evaluated.
! Operating managers are not held responsible for variances that are caused by the plan being
inaccurate.
215
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Study Unit 12
Further Budgetary Control Techniques
Contents Page
Introduction 216
A. Flexible Budgets 216
Cost Behaviour 216
Preparation of Flexible Budgets 217
B. Budgeting With Uncertainty 221
Effects of Technological Changes on Budgets 221
Effects of Obsolescence on Budgets 223
C. Budget Problems and Methods to Overcome Them 224
Inflation and Rolling Budgets 224
Production Volume Uncertainty and Probabilistic Budgeting 225
Sub-Optimality and the Use of Management by Objectives (MBO) 226
D. Alternative Budgetary Approaches 227
Zero-Based Budgeting (ZBB) 227
Activity-Based Budgeting 229
Incremental Budgeting 229
Budgeting and TQM 230
E. Behavioural Aspects of Budgeting 230
Reaction of Managers to Budget Levels 230
Motivation of Staff 231
Need for Employees to be Committed 232
Problem of Separate Budget Centres in Relation to Staff Motivation 232
Need for Staff Participation 233
Identifying Where Motivation is Lacking 233
Reasons for Absence of Motivation 233
Participation and Aspiration Levels 234
216 Further Budgetary Control Techniques
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INTRODUCTION
This study unit will be looking at budgetary techniques which can be used in a particular set of
circumstances. Flexible budgets, for instance, change with changes in the level of activity and
attempt to overcome the problems inherent in static budgetary systems. Probabilities can be used
to good effect where different future scenarios need to be included and three-tier budgets can be
produced showing the best, worst and most likely outcomes.
Budgetary control in not-for-profit organisations is an important subject and zero-based budgeting is
one technique which has specific applications to those types of organisation.
The motivational effect of budgetary control will also be considered during this study unit.
A. FLEXIBLE BUDGETS
The budgets which we have described so far are those which are used to plan the activity of the
organisation. Cost control begins by comparing actual expenditure with the budget. Remember,
though, that if the level of activity differs from that expected, some costs will change, and the
individual manager cannot be expected to control the whole of that change. If activity is greater than
budgeted, some costs will rise; if activity is less than budgeted, some costs will fall. The question is
whether the manager has kept costs within the level to be expected, given the activity level.
A flexible budget is one which by recognising the difference in behaviour between fixed and
variable costs in relation to fluctuations in output, turnover, or other variable factors, such as number
of employees is designed to change appropriately with such fluctuations. It is the flexible budget
which is used for control purposes, not the fixed budget.
Cost Behaviour
To understand how to prepare flexible budgets, we must recall our earlier definitions of fixed and
variable costs:
! Fixed Cost
This is a cost which accrues in relation to the passage of time and which, within certain output
and turnover limits, tends to be unaffected by fluctuations in the level of activity. Examples are
rent, local authority property taxes, insurance and executive salaries.
! Variable Cost
This is a cost which, in the short term, tends to follow the level of activity. Examples are all
direct costs, sales commission and packaging costs.
! Semi-Variable Cost
This is a cost containing both fixed and variable elements, which is, therefore, partly affected
by fluctuations in the volume of output or turnover.
! Discretionary Cost
This is a fourth category of cost, which may be incurred or not, at the managers discretion. It
is not directly necessary to achieving production or sales, even though the expenditure may be
desirable. An example is research and development expenditure.
Further Budgetary Control Techniques 217
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Discretionary costs such as this are a prime target for cost reduction when funds are scarce,
precisely because they are not related to current production or sales levels. This might be a
very short-sighted policy nevertheless, it is useful to have these costs separately identified in
the budget.
! Controllable Costs or Managed Costs
As we know, the emphasis in budgeting is on responsibility for costs (budgetary control is one
form of responsibility accounting). The aim must be to give each manager information about
those costs he or she can control, and not to overburden him or her with information about
other costs. A controllable cost is one chargeable to a budget or cost centre which can be
influenced by the actions of the person in whom control of the centre is vested.
Given a long enough time-period, all costs are ultimately controllable by someone in the
organisation (e.g. a decision could be taken to move to a new location, if factory rental became
too high). Controllable costs may, however, be controllable only to a limited extent. Fixed
costs are generally controllable only given a reasonably long time-span. Variable costs may be
controlled by ensuring that there is no wastage but they will still, of course, rise more or less in
proportion to output.
Preparation of Flexible Budgets
Example 1
The fixed budget for Budget Centre A is shown below. This is the budget based on the expected
level of output, and it will therefore be the budget used to plan the resources needed in that
department. You will note that the activity level is given in standard hours. The standard hour is a
measure of output, not of time: it is the quantity of output or amount of work which should be
performed in 1 hour. This concept is used because it enables us to compare different types of work.
Instead of saying 400 units of X which takes 2 hours per unit plus 200 units of Y which takes 1 hour
per unit we can simply say 1,000 standard hours.
Budget Centre A
Budget Period 3 Activity 1,000 std hrs
Fixed Variable Total

Process labour 2,000 2,000
Indirect labour 50 85 135
Fuel and power 450 800 1,250
Consumable stores 5 15 20
3,405
From the above figures we can evaluate a level of expense which is appropriate to any level of
output, within fairly broad limits. The figures have been set as the total allowance of expense which
is expected to be incurred at an output level of 1,000 standard hours. Should, however, the output not
be as envisaged, the allowance of cost can be varied to compensate for the change in level of activity.
This adjustment is known as flexing a budget for activity.
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We would expect that if 1,000 standard hours were produced, the cost incurred would be 3,405. If
the level of output changes for some reason, the level of cost usually changes. Lets assume that the
levels of output attained were 750 standard hours in period 4 and 1,200 standard hours in period 5.
The budgets would be flexed to compensate for the changes which have taken place in the actual
output compared with those anticipated:
Budget Centre A
Actual output: 750 std hrs
Budgeted output: 1000 std hrs
Budget Period 4 Production volume ratio 75%
Basic Budget Flexed Budget
Fixed Variable Total Fixed Variable Total
Actual

Process labour 2,000 2,000 1,500 1,500 1,509
Indirect labour 50 85 135 50 64 114 126
Fuel and power 450 800 1,250 450 600 1,050 986
Consumable stores 5 15 20 5 11 16 19
In this instance, the fixed expenses are deemed to have remained the same but the basic budget
variable figures have been allowed at only 75% of the full budget. We thus attempt to show that
activity has had its effect on cost. For example, we expected that only 1,500 would be expended on
process labour for the output achieved but, in fact, we spent 1,509, and we exceeded the allowed
cost by 9.
Lets now take the effect on the budget in period 5 of having gained a greater output than that
envisaged originally:
Budget Centre A
Actual output: 1200 std hrs
Budgeted output: 1000 std hrs
Budget Period 5 Production volume ratio 120%
Basic Budget Flexed Budget
Fixed Variable Total Fixed Variable Total
Actual

Process labour 2,000 2,000 2,400 2,400 2,348
Indirect labour 50 85 135 50 102 152 193
Fuel and power 450 800 1,250 450 960 1,410 1,504
Consumable stores 5 15 20 5 18 23 19
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Here, we have used a factor of 120% as applied to the variable elements of the basic budget. For fuel
and power we observe that the fixed element has remained constant, but we have assumed that the
variable element of 800, having risen in sympathy with the level of output, will have gone up by
20%, to 960. The flexed budget figure for fuel and power thus becomes 1,410, compared with the
basic budget figure of 1,250.
It is clearly more reasonable to compare the actual cost of fuel and power for the period i.e. 1,504
with the flexed budget rather than with the basic budget. This explains the entire purpose of
flexible budgeting, insofar as it attempts to provide a value comparison between the actual figure of
cost and the budget figure.
Comment
Budget Centre A involved a production budget. The flexing for activity was therefore carried out
according to different levels of output. The definition of flexible budgets given earlier referred to
fluctuations in output, turnover, or other factors. Obviously, the selling costs budget will be flexed
according to turnover (i.e. number of units sold) rather than output levels, while the canteen will be
flexed according to number of employees.
Example 2
The flexible budget for the transport department of a manufacturing company contains the following
extract:
Flexible Budget for Four-Weekly Period
Ton-miles to be run 80,000 100,000 120,000

Costs: Depreciation 240 240 240
Insurance and road tax 80 80 80
Maintenance materials 160 190 190
Maintenance wages 120 120 160
Replacement of tyres 40 50 60
Rent and rates 110 110 110
Supervision 130 130 130
Drivers expenses 200 400 600
1,080 1,320 1,570
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In the four-weekly period No. 7, the budgeted activity was 100,000 ton-miles but the actual activity
was 90,000 ton-miles. The actual expenditure during that period was:
Costs: Depreciation 240

Insurance and road tax 80
Maintenance materials 165
Maintenance wages 115
Replacement of tyres 35
Rent and rates 110
Supervision 130
Drivers expenses 315
1,190
Prepare a tabulation of the variances from budget in relation to period No. 7.
Budgeted
Activity
Flexed
Budget
Actual
Expense
Expense Variance
Ton-miles 100,000 90,000 90,000

Expense:
Depreciation (F) 240 240 240
Insurance and road tax (F) 80 80 80
Maintenance materials (S-V) 190 190 165 25 saving
Maintenance wages (S-V) 120 120 115 5 saving
Replacement of tyres (V) 50 45 35 10 saving
Rent and rates (F) 110 110 110
Supervision (F) 130 130 130
Drivers expenses (V) 400 300 315 15 over-spending
1,320 1,215 1,190 25 saving
Notes on the Answer
Maintenance materials may cause a little difficulty. There is no indication in the problem at what
level of activity the rise from 160 to 190 takes place. From the information given, it could be taken
as 80,000 ton-miles or 99,999 ton-miles. You will have to make a decision on which to take but
remember that the level of activity taken in the solution is 80,001 ton-miles and above this level the
budgeted expense will be 190.
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B. BUDGETING WITH UNCERTAINTY
It is unfortunate but it is almost always the case that the future does not occur as it was envisaged
when the budgeting procedure was carried out. Very often the causes of the differences in volume or
selling price or any one of a large number of variables that go to make up the budget are the result of
factors which are beyond the control of the individual firm.
Thus, the future actions of a foreign government of a country to which a firm exports cannot be
assessed with any degree of accuracy. The government in power could fall without warning, it could
decide to increase interest rates and thereby affect the exchange rate, it could subsidise home
produced competitive goods and so on.
Similarly, social change can also have an effect; in recent years the green revolution has forced
many firms to produce their goods in recycled packaging or use materials from a replaceable source.
This can cause high initial (and perhaps ongoing) investment in new plant and machinery, more
expensive raw materials and so on.
Economic change is perhaps the most common cause of budget changes as it will tend to have a much
more direct effect on volume. An increase in interest rates, for example, may cause fewer people to
consider buying a new house or car by obtaining a loan to finance the purchase. In the same way
changes in taxation relief on home loans could cause similar uncertainty.
We shall now look at a particular impact on budget accuracy, that of technological change.
Effects of Technological Changes on Budgets
(a) Expected Benefits and Costs
In order to appreciate fully the impact of such changes on the budgets, let us detail the benefits
that are expected from an increase in levels of automation.
! Savings from having continuous production runs with higher levels of efficiency from
the use of tools and equipment. This will often be accompanied by the introduction of
shift working.
! Quicker setting up of work.
! A reduction in wastage because standards of quality will be on a consistent basis.
! A reduced level of inspection.
! A reduction in manpower.
The financial burden of such changes is likely to be felt in the heavy capital cost of the
equipment; the training of personnel; and possibly in labour problems. There may be
resistance to the changes, particularly where certain employees are required to alter the nature
of their work.
(b) Relating Benefits and Costs to the Budget Revision
! Continuous Production
Although it may be possible to calculate the estimated increases in the levels of output
with some degree of accuracy, will there be a ready market for these additional units? In
other words, can we increase our sales budget absolutely in line with our revised
production forecasts? It is possible that, although sales will increase in the short term,
the increase will be smaller than the increase in production, and therefore the level of
stocks of finished products will rise. This means, of course, that the new levels of
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finished stocks will necessitate a revision of the budget for the finished stores or
warehouses. Also, there could be an effect on our existing staff of salespeople, again
calling for changes in the sales budget. There may even be an effect on the volume of
work in the accounts department credit control, etc. This illustrates the need to
consider carefully the possible effects of changes in the budget of one department, on the
budgets of other departments.
! Quicker Setting-Up of Work
This should be reflected in a reduction of the budget for the production planning
departments, since there will be less frequent demands for the work of forward planning.
However, these reductions may not be as significant as supposed, since many of these
costs are fixed, certainly in the short term. Also, staff numbers may not actually fall as
existing employees may well be replaced by employees of different types or grades.
! Reduction of Wastage
As this will result in a substantial fall in the use of raw materials, this element of the
budget could be reduced with some confidence. We should also consider the possibility
of a change in the type or quality of the materials currently in use. It is possible that the
new techniques may require the use of materials that are more suitable for this type of
processing. This will make the computation of new standard prices necessary.
! Reduction in Level of Inspection and Manpower Level
Both of these will call for a revision of our manpower budget and of the wages element
in the main financial budget. Indeed, the shift working mentioned above will also
require a budget revision. Although it may be comparatively easy to quantify such
revisions, the implementation of such changes is by no means so easy. If any changes in
working conditions or in the activities of employees are contemplated then lengthy
negotiations are often required. It is an even greater problem when redundancy is
contemplated. We know that employees are offered a great deal of legislative protection
against the danger of unfair dismissal and it is essential that the procedures laid down by
the law are followed. Inevitably, there will be a considerable passage of time before the
full effects of staff reductions are felt and this time-lag must be fully reflected in the
budget revision. There is also a strong possibility that redundancy payments will have to
be made. Again, these costs, less the proportion that will be refunded by the
government, must appear in the revised budget.
! Acquisition of New Equipment
This involves the capital budget. If the purchases were planned at the start of the trading
year, then no revision of the capital budget will be needed. However, the decision to
make the change may have been forced on the management at short notice and the call
on the capital resources may mean that approved projects will have to be delayed and
revisions made. The method of financing is also relevant here. It could be in the form of
outright purchase, leasing, hire purchase or perhaps on a straight hire basis. In this last
case, the capital budget would not be involved but the revenue budget should include the
estimated expenditure. Although one method of financing may have been planned, when
the time comes to act, an alternative method may appear to be more attractive. With a
change in the method, a revision of the budget becomes necessary.
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! Costs of Training
A degree of planning is demanded before training costs can be shown in the revised
budget. These costs will usually form part of the budget of the personnel department
and the training officer needs to conduct research into the most suitable form of training
to meet the demands of the new technology. The training department may be entering
into a field of training that is quite new and initially the training officer must identify the
members of the staff who will derive the greatest benefit from such training. It will then
be necessary to determine what local facilities are available; from this basic information
the training department will be able to assess the budget provisions needed.
(c) Use of Technological Change Variances
When technological changes take place, it is possible to continue the use of the original
budgets and to produce technological change variances. To illustrate possible budget revisions
that may be required as a result of such technological advances, let us compare the production
budget, before and after:
Original Revised

Raw materials 300,000 300,000
Wages 200,000 180,000
Direct expenses: Power 8,000 18,000
Heat and light 10,000 10,000
Cleaning 4,000 4,000
Telephones 2,000 2,000
Stationery 1,000 30,000 1,000 60,000
Allocation of indirect expenses 40,000 60,000
570,000 600,000
Output (units) 100,000 120,000
Cost per unit 5.7 5.0
A number of employees have been replaced by advanced types of machinery that require
additional power and depreciation charges. Indirect expenses are likely to rise as a result of the
use of computer equipment, together with the employment of specialist operations staff.
Effects of Obsolescence on Budgets
If changes have been forced upon the business because of the sudden obsolescence of the existing
plant and equipment, special problems will arise. There will be no financial provision in the existing
budget to meet this situation and it may not be possible or even desirable to make a sudden change in
selling prices. The activities of competitors must be carefully assessed, particularly in respect of the
methods of production that they employ. We should revise the whole of our existing budget, looking
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for ways in which we can effect economies in order to absorb the expense of this sudden
commitment. The postponement of certain expenditure until a future date may be possible. After this
general study, the budget revision can be made.
C. BUDGET PROBLEMS AND METHODS TO OVERCOME
THEM
Inflation and Rolling Budgets
The problem of estimating expected inflation levels has long been one of the fundamental problems
in budget setting. The longer the time-scale the more difficult the problem becomes. Thus, a budget
for the next 12 months can at least take current levels as a starting-point in the knowledge that, even
in volatile times, it is likely to move only a few per cent either way. The further forward one predicts,
the more likely the estimates are to be incorrect.
One method sometimes used to try to counteract this uncertainty is rolling or continuous budgets.
These operate in such a way that when the end of a particular budgeted period is reached (i.e. month,
quarter, year, etc.) a similar period is added to the remainder of the budget so that there is always a
budget in existence for, say, twelve months ahead which has been altered to reflect changing
conditions. This may be illustrated as follows:
Budget
Year 1 Year 2 Year 3 Year 4 Year 5

Detail
Total
Figure 12.1: Rolling Budget
At the end of Year 1, the actual figures for that year are known and so the budget for that year falls
out and is replaced by the budget for Year 6. At any time therefore, we always have a budget
covering a period of the next 5 years.
The main advantages of rolling budgets are as follows:
! The company is forced to look at its future plans in detail, at least once a year.
! There is an opportunity given to revise the budget estimates for each of the ensuing years.
When we are attempting to make forecasts that relate to 5 years ahead, they are bound to
require adjustments as we get nearer to that time.
! There is always a budget extending forward for a fixed period, i.e. twelve months.
! Uncertainty is reduced; fixed budgets may become obsolete due to changing economic
conditions. Because rolling budgets are adjusted due to such changes they are likely to be
more realistic.
! Planning and control are easier to implement because of reduced uncertainty.
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Rolling budgets, however, also have their disadvantages:
! More frequent budgeting involves additional time and expense.
! The frequency with which the budgets are updated may lead to a lack of confidence in the
budgeting process. If the exercise is carried out once a year it tends to assume prime
importance and has the effect of focusing everyones attention on the information being
produced.
! There is no real reason why the existing fixed period budget could not be updated during its
life to reflect changing market conditions. Thus, interest rates may have moved to such an
extent that by month six a complete revision of those used in the budget is required for months
seven to twelve.
Production Volume Uncertainty and Probabilistic Budgeting
The problems of sales forecasting have an effect on budgets. The difficulty faced when setting the
budget is determining exactly what levels of output and sales are likely to occur. If, for example,
after the budget is set, a new large customer is found (or an old one lost), then the new levels of
output required could make the old budget obsolete. One way of overcoming this is to have a budget
which assigns probabilities to likely levels of sales, output and cost.
As an example, a sales budget may be assigned probabilities as follows:
Sales () Probability
100,000 0.3
150,000 0.3
200,000 0.2
250,000 0.2
Costs can be estimated for each level of sales and thus the overall contribution found, e.g.
Sales

Variable Costs
Contribution (C)
Probability P C
100,000 70,000 30,000 0.3 9,000

150,000 97,500 52,500 0.3 15,750
200,000 120,000 80,000 0.2 16,000
250,000 137,500 112,500 0.2 22,500
63,250
The expected contribution level is therefore 63,250. It can also be read from the figures that there is
a 20% chance of making a contribution of 112,500, but a 30% chance of making a contribution of
only 30,000. This method can also be used to consider different scenarios such as testing the likely
levels of contribution at different price levels and choosing that which maximises the best possible
outcome.
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There are two other techniques which can be employed to analyse the uncertainty in a budget. The
first is three-tier budgeting whereby three budgets are produced, best possible, worst possible and
most likely. The advantage of this, although simple, is that it gives an indication of the potential
variations in profitability.
Secondly, there is sensitivity analysis which we also looked at earlier and which basically involves
testing the effect on the budget of altering one variable, e.g. what happens if interest rates are actually
2% lower than predicted or material costs increase by 5% more than expected and so on.
The advantage of all three techniques is that they give indications as to the possible range of results
which may occur depending on circumstances. It must also be remembered though that the
assessments must be based on some premise of reality, otherwise any results produced will be
meaningless.
Sub-Optimality and the Use of Management by Objectives (MBO)
We saw earlier that one of the purposes of the budget is to act as a co-ordinating function within the
organisation. If different divisions and departments have budgets that are not related to any of the
others then sub-optimality may result. One method of overcoming this problem is Management by
Objectives (MBO), the stages of which are as follows:
! Individual objectives are set for each manager and each department. This initially takes the
form of the managers defining their own objectives and then, after discussions with their
supervisor, a final set of objectives is agreed.
! Key tasks are analysed and performance standards agreed.
! The individual and departmental objectives are brought together as divisional plans are
reviewed to ensure consistency of approach and intended targets.
! Periodic performance appraisal is undertaken at which the achievements to date of each
manager and department are analysed. If performance is found to be below standard, the
opportunity may be taken to suggest management training in the area of deficiency.
MBO is also useful for an organisation in that it can be used as a means to identify those individuals
with the potential for advancement. It can also form the basis of bonus schemes linked to levels of
performance.
The main point to remember about this technique is that it is essentially a two-way process; it is not
designed to identify those people who are not performing and then beat them with a stick until they
are.
It enables individuals to be involved in setting their own objectives and to receive helpful advice and
counselling if they fall short of the required standards. MBO is also very much concerned with
motivational aspects of budgeting control which we will come to shortly.
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D. ALTERNATIVE BUDGETARY APPROACHES
Zero-Based Budgeting (ZBB)
ZBB starts from the assumption that previous budgets are meaningless in the context of those
currently being set and so all budgeting starts at a nil basis from which all expenditure is identified.
The CIMA definition of ZBB is as follows:
A method of budgeting whereby all activities are re-evaluated each time a budget is
formulated. Each functional budget starts with the assumption that the function does not
exist and is at zero cost. Increments of cost are compared with increments of budget,
culminating in the planned maximum benefit for a given budgeted cost.
An American fostered concept, this definition shows that the benefit to be derived exceeding its cost
is a central factor. No activity can automatically assume that funds will continue to be received; it is
necessary to prove that any funds that are allocated will achieve a positive benefit for the
organisation.
Stages of implementation of ZBB
! Definition of Objectives
Each area of the organisation is analysed according to its function and is given an objective. In
relation to the provision of health care for instance this might include breaking it down into the
distinct units of maternity care, psychiatric treatment and so on. Each of these areas then has
its own objective.
! Decision Units
Once the organisation has been broken down into logical units the next step is to analyse it into
decision units which are basically any activity for which a decision needs to be made about the
resources to be allocated to it. Thus there may, for instance, be several decision units within
maternity care which itself is a function of overall health care for which an objective has been
set.
! Decision Packages
Each decision unit has a budget prepared for it by the function concerned which details the
resources it requires and the benefits which should accrue. In order for this stage to be
effective it is necessary for senior management to provide guidance and assistance in terms of,
for instance, expected activity levels and so on.
Each package will be made up of a base package, which details the minimum requirements
for the decision unit concerned, and incremental packages which are the provision of greater
levels of service that the manager concerned considers desirable. In relation to road
maintenance, for example, the base package may consist of a request for resources to monitor a
certain mileage of roads, and incremental packages may include replacement of kerbstones,
resurfacing of a certain number of roads, road bridge strengthening and so on. Each package
will have its own budget and analysis of expected benefits.
! Evaluation and Ranking of Packages
Each package is then ranked in accordance with how important it is considered to be. This
may be done by senior management, who are responsible for the overall allocation of resources
within the organisation, or by the managers themselves, because, as you can imagine, there is
the potential for there to be a vast number of packages under consideration.
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One way of deciding on who evaluates what is to have a cut-off limit in terms of spending,
such as 10,000; below this the ranking is carried out by the managers concerned and above
this figure it is the responsibility of senior management.
Each base package should be ranked as the highest priority for that particular decision unit
with each of the incremental packages ranked in descending order of importance.
Evaluation will be carried out using Cost-Benefit Analysis (CBA) based on the overall level of
resources available. It is possible therefore, that one decision unit may have all its decision
packages ranked high enough to be accepted; another unit may receive only a portion because
its expected benefits in terms of cost are ranked lower overall.
! Allocation of Resources
Once the evaluation has taken place, the resources available can then be allocated accordingly.
Advantages
! The allocation of scarce resources should be carried out much more efficiently because of the
practice of ranking each decision package.
! The traditional problem of slack being built into incremental budgeting exercises should be
eradicated because each request for funds starts from a zero-base and has to justify itself.
! Inefficient operations, i.e. those whose costs exceed their benefits, can be much more easily
identified, and, if necessary, excluded.
! Past inefficiencies that have been built into the budget are excluded.
! Because there is much more involvement in this type of process, those involved should
experience a higher level of motivation towards budget achievement.
! It is possible to apply the process selectively to those areas where scarceness of resources
poses the greatest problem.
Difficulties encountered
! There is a large volume of extra work associated with starting the budgeting process from
scratch in each new period.
! It is a radical idea, which, because of its emphasis on efficiency, can cause conflict within some
organisations, especially those which have practised traditional budgeting techniques for many
years.
! There is the difficulty of deciding on benefits derived under Cost-Benefit Analysis.
! If major changes to the organisation occur during the budgeting year, the original CBA can be
radically altered and may well become out of date. Thus, packages which were originally
accepted might be rejected if the analysis were to be undertaken again and vice versa.
! There could also be a lack of continuity if a package which is accepted in one period is rejected
in the following. This can be overcome by making sure that a package is used as a base and
therefore obtains a higher priority. An example would be the construction or widening of a
major road which obviously started should be completed or the earlier work undertaken will
lose its usefulness.
ZBB, despite its many advantages, is much less widespread in the UK than it is in the United States,
possibly because of the large amount of extra work involved and the much more traditional outlook
of British companies.
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Note that ZBB as a technique is generally applicable to profit-seeking as well as not-for-profit (NFP)
organisations.
Activity-Based Budgeting
This is based on an amalgam of various planning and budgeting techniques such as priority-based
budgeting (itself a derivative of zero-based budgeting) and activity-based costing. It also forms a link
between planning and budgeting.
The process begins with the breaking down of the strategic plan into plans or objectives for
individual business units and, by the use of activity analysis, into plans for the individual activities
themselves. Minimum levels of activity are analysed as are incremental levels and key constraints
are identified which in turn leads to the quantification of resource requirements. Critical success
factors are also an important element in the process and once these are known, performance
indicators can be set for them to determine how the company is performing in comparison to its
activity-based budget. The technique also provides a method of feedback to the updating of strategic
plans.
The advantages claimed for the process are similar to those for activity-based costing:
! Identification of inefficient processes and unprofitable products is made easier.
! Elimination of non-value-added activities.
! Enhanced performance measurement and control.
! There is better control over the causes of cost by identifying them with the activities they result
from.
! It provides the ability to view the organisation from a different perspective that cuts across
traditional departmentalisation.
Incremental Budgeting
This is the traditional method of budgetary control which uses the previous years budget as the basis
for the current years budget, usually with an allowance for change due to inflationary activity or
efficiency. The approach therefore assumes that the basis of the current budget is correct. The
disadvantages of such an approach, particularly when compared to the previous two budgeting
methods are as follows:
! There is no focus on the efficient use of resources by identifying the activities they emanate
from.
! Because the change in the budget can be somewhat arbitrary, it is often the case that cuts are
made with regard to overall constraints rather than by identification of inefficient products or
processes.
! The link with the strategic plan is often non-existent.
! A further result of its arbitrary nature is that commitment on the part of those responsible for
budget achievement may be low.
! New activities can tend to be constrained, again because of the overall rigidity of the
technique.
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Budgeting and TQM
Modern approaches to methods of work such as Total Quality Management have resulted in radical
changes in budgetary processes. TQM is an overall concept that attempts to ensure that the highest
quality output is produced with minimum defects. It involves everyone in the organisation. The
budgeting system can be very effective in providing the data to assess how effectively TQM is
operating; budgets can be set for departments, particularly in terms of quality related costs such as
internal failure, re-working or prevention costs, variances against which will indicate if TQM is
operating properly or not.
In addition, as TQM involves everyone, individual targets can be set within the overall departmental
budgets so that each person can assess his or her own contribution.
E. BEHAVIOURAL ASPECTS OF BUDGETING
Reaction of Managers to Budget Levels
The budgeting exercise is, very often, seen more importantly as a planning mechanism whereby the
desired levels of cost, expenditure and so on are decided upon for the forthcoming period. Once the
budgets are set, however, they are transformed into a mechanism for controlling the activities of the
organisation by comparing actual results with those to which the organisation originally aspired.
How effective that control is depends very much on what those aspirations were in terms of difficulty
of achievement and the viewpoints of the individual managers concerned. Research was undertaken
by Atkinson which suggested that managers would aspire to one of two levels:
(a) If the desire is to achieve success rather than avoid failure, then budgets set which are too
difficult or too easy act as demotivators, whereas those of middling difficulty provide the
highest levels of motivation.
(b) If the desire is to avoid failure rather than achieve success, then budgets of even middling
difficulty will not motivate the manager concerned. Only those with an easy level of difficulty
will be attempted, and anything else will not even be considered.
Under (b) above, the levels of performance are lower than under (a). Further analysis by Hopwood
of the original research suggested that two different budgeting levels could be implemented; one for
expected levels of performance which would be the planning budget, and one for aspired levels of
performance, which would act as the control budget.
There are several variations that can be employed on this basis:
! Using the expected budgets at operational planning levels, and the target budgets for
management control further up the hierarchy.
! Budgeting on a target basis for control, but using planning variances to convert the target to an
expected actual level.
Care must be taken, however, where two different budgets are produced; the duplication of the
original work and the information being produced having a tendency to alienate those involved. In
addition, managers may, effectively, disregard their target levels, believing that the achievement of
expected levels only is satisfactory.
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Motivation of Staff
Motivation can be defined as the reason why a person acts in a certain way; ideally the actions he or
she undertakes to achieve personal ambitions will be commensurate with the attainment of the overall
goals of the organisation. In order to be able to assess the best ways of motivating an individual, and
understanding why motivation may be absent, we will begin by briefly examining some motivational
theory.
(a) Maslow
In his work Motivation and Personality, Maslow put forward the idea of the hierarchy of
needs:
Figure 12.2: Maslows Hierarchy of Needs
Thus physiological needs are food, warmth, shelter and so on; safety and security would
include a job free from the threat of redundancies or change; social needs are the desire to
belong to a group of people; egotistic and esteem needs include the attainment of status and
respect, whilst the final category, self-fulfilment, is the ultimate state that an individual aspires
to.
Once a need is satisfied it no longer motivates an individual as strongly. The achievement of
each of the needs is not necessarily chronological; a person may attempt to achieve his or her
self-fulfilment without having achieved any social needs. However, the research suggests that
people will attempt to achieve those needs at the lower levels of the hierarchy first. High
levels of motivation in the workplace will be achieved in instances where job security exists
with the potential for self-fulfilment and the satisfaction of egotistic and esteem needs through
the attainment of respect and recognition.
(b) McGregor
McGregors Theory X and Theory Y is another of the better known motivational theories.
Put forward in his book The Human Side of Enterprise (1961), Theory X states that a certain
type of worker does not like work, avoids it whenever possible and needs to be coerced or
threatened in order to perform. Theory Y, on the other hand, is based on the belief that workers
will attempt to achieve objectives to which they feel dedicated and will learn to look for
responsibility themselves given that the correct environmental conditions apply.
Self-
fulfilment
Egotistic and
esteem needs
Social needs
Safety and security needs
Physiological needs
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Under Theory X, therefore, the use of threats or rewards to get things done is very common,
whereas those managers who believe Theory Y allow subordinates to achieve their personal
objectives with much more of a laissez-faire approach from management.
In the latter case, people do not necessarily like to work, but they develop their approach to it
in accordance with their own personal experience of it.
(c) Herzberg
In Work and the Nature of Man (1966), Herzberg put forward the idea that job satisfaction
and dissatisfaction are not direct opposites to each other. J ob satisfaction arises out of actual
attainment of the task being done, and dissatisfaction from the environment in some way.
Therefore, removal of the causes of dissatisfaction would not automatically lead to job
satisfaction; the work itself has to present opportunities to the worker so that satisfaction can
be obtained.
Herzberg considered that extrinsic motivators attracted people to work, and if retained,
would persuade people to remain. They would include remuneration, working hours and so on.
Intrinsic motivators, on the other hand, relate to work content and include challenging and
interesting tasks and the opportunities for development and achievement.
Budgetary control would therefore play an important part in the achievement of the intrinsic
motivators by providing the mechanism by which they could be attained.
Need for Employees to be Committed
However comprehensive our system of budgetary control may be, and however much thought has
been given to the preparation of such a system, we must never forget that it has to be operated by
human beings, and to ensure success it is essential for each employee to be highly committed to the
project. The budget in itself will not change a poor sales person into a good one it is only one piece
of equipment available to management.
Let us consider some of the ways in which the level of motivation may be raised.
! It should be demonstrated to each employee the benefits that he or she can derive as a person
from the process. It is unfortunate that many people believe that budgetary control is used by
management as yet another stick to beat the employee and that it will be quoted as evidence of
his or her failings. We must remove this belief at the earliest possible moment.
! Great encouragement can be given to employees if it is made clear to them that when they
show their understanding and use of the system, they are proving their potential for future
promotion. They are showing that they appreciate the importance of one of the techniques of
management and this is part of the training ground for future top management.
! Many managements are quick to find fault and to conduct most thorough investigations where
adverse variances are revealed, but they are most reluctant to pass on words of praise although
they may be well deserved. Let us remember that people do respond when they are made to
realise that their efforts have been recognised and appreciated.
Problem of Separate Budget Centres in Relation to Staff Motivation
A problem within a large organisation is that there are many separate budget centres. It is very
difficult for the budgets of one centre to be related to the budgets of the remaining centres, and
although each centre will know its own results, it may be unable to appreciate how these results have
contributed to the total business performance. By good communications and a wide distribution of
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information, we must ensure that there is no attitude of my individual contribution cannot possibly
have any effect on the end results.
Need for Staff Participation
There is a very close link between participation and motivation. When related to budgetary control,
staff who have been involved in the preparation of budgets will want to see the project succeed.
Where mere imposition of budgets has taken place, there is little chance of great enthusiasm being
generated.
We must remind ourselves that the general factors affecting human effort at work can also be related
to motivation in the operation of budgets and standards. Each of the following has an influence:
! General attitude of individuals to their work
! Interrelationships of people
! Effects of environmental conditions
! Attitude of management to other employees
! Changing social attitudes.
Identifying Where Motivation is Lacking
Having identified motivation and looked at ways of enhancing it, it is useful to look at evidence
which indicates that demotivation exists:
! Budgets may have been set by a department with neither thought nor care that they should be
co-ordinated with those of other departments.
! Budgetary slack may be built into budgets, especially where the manager concerned has a fear
of failure and/or the budget is used by senior management as a pressure device.
! Managers may do just enough to achieve their budgeting targets without making much attempt
to exceed them.
! There may be a failure to control by management, shown by a willingness to accept work of a
substandard nature from subordinates.
! As well as the lack of co-ordination mentioned earlier, there is also the possibility of a lack of
co-operation between managers. This would become especially important in those cases where
each managers department relies on the other, for instance where the output of one forms the
input of the other.
! A sudden rush to spend up to the budget limit near the end of the budgeting period because it is
felt that expenditure targets will be reduced in the following period.
Reasons for Absence of Motivation
! Absence of consultation between those responsible for implementing and those responsible for
setting the budgets. (The question of participation in the budgeting process will be examined
again shortly.)
! There may be a lack of flexibility on the part of senior management in the setting of budgeting
targets, the argument from those on whom the budgets are imposed being that less rigidity is
needed when taking operational decisions.
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! Budgets may be seen as pressure devices; their only reason for existence being to find fault
rather than identify where individuals and departments are performing correctly. This again
refers to the attitude which is often adopted by those managers who wish merely to avoid
failure by attempting to get targets set at a relatively easy level.
! There could be a lack of understanding on the part of those concerned, especially in how their
individual contribution relates to the organisations objectives.
! The control information being produced may be suspect. This could be because the managers
concerned have not been properly trained to understand it, but it might also be because the
reports have been proven to contain errors in the past. Once this happens it is very difficult to
make people believe reports are correct. In addition, if there is too much information too often
it will lose its effectiveness and the individual managers will, therefore, be unable to recognise
if they are outside their budget or performing well. Allied to this latter point are the problems
that may occur if control information is produced a long time after the period to which it
relates; again it may be largely ignored, and with good reason.
Participation and Aspiration Levels
When we refer to budgetary participation, we must be careful not to produce this glibly as a stock
answer to a question on how to improve the objectiveness of the budget as a tool for control and
performance measurement. The level of participation should be carefully controlled; if negotiation
between a manager and his or her superiors is part of the process it will inevitably expand the amount
of time required for its completion. Care must be taken, therefore, to allow sufficient time rather than
overrun into the period in question and be forced to impose budgetary targets from the top.
This also applies to the number of people who are involved; the more people, the longer it will take
and so from this point of view you can have too much of a good thing. Most of the time allocated for
deciding upon the budgets will be spent at a low level in the organisation with everyone arguing for
their own slice of the action.
Remember, too, that directors/senior management have the final say as to what the budgets will be.
If, even after participation, they are arbitrarily imposed it will be seen as positively demotivating
rather than the opposite.
(a) Aspiration Levels
Much research work has been conducted by behavioural theorists into the target levels set
within a budget, both by the individuals responsible for attaining them and those responsible
for setting them: these are known as aspiration levels. This research has generally shown
that targets that are set too high do not act as motivators at all. They are considered
unattainable and thus no effort is expended on attempting to achieve them and a worse than
usual performance results. In a similar way, targets which are too easy can also act as
demotivators; the ease with which targets are reached being no spur to improving performance.
The optimum target is the most difficult that will be accepted and here the element of
participation is most important. It is, of course, extremely difficult to ascertain this optimum
position, because every situation differs. It is a matter of close collaboration and negotiation
for the parties concerned.
Some individuals, for instance, will have aspiration levels far in excess of their colleagues; the
mere fact that extremely difficult targets are being set is, for them, a spur to greater
achievement. In this scenario, however, failure by too great a margin is likely to be counter-
productive in the same way as excessive targets normally are.
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(b) Does Participation Help?
It can be recognised from the research that has been undertaken by the likes of Stedry and
Hofstede that participation does have an effect on helping to improve performance. Straight
imposition of a budget without regard to the views of those responsible for achieving it is
likely to result in little or no effort to do so.
There are also problems which arise, such as how much participation should be allowed and at
what stage participation should end and imposition begin. If too much participation is allowed
the budgets may not be set properly, and at some stage senior management must impose a
budget which will be for the benefit of the organisation as a whole; if it can be set so as to
motivate the individual manager and his or her department, however, so much the better.
If aspiration levels can be ascertained, then the target element of the budget becomes much
easier to determine. The difficulty is in ascertaining it because, as Stedry has showed,
aspiration levels alter with the target itself.
Unfortunately, there is also empirical evidence which suggests that participation does not
automatically lead to improved performance. Argyris for example, found that some companies
practise what he termed pseudo-participation, i.e., that they profess to allow it when in actual
fact such participation is subject to managerial pressure.
Some of the factors which determine if participation is effective are:
! Culture of the Organisation
Hopwood found that participation was less effective in instances where greater
regimentation or automation was in place because there was less chance of actually
having an impact on results. The opposite was also true, however, situations of greater
innovation being more suitable for participation to take place.
! Attitudes of the Individual
Some people prefer to have targets imposed on them; they like to please their superiors
by having targets which the authorities have set. Others, by contrast, are more
independent, and will object to the imposition of budgets.
! Experience
This refers to the fact that managers may be used to the idea of having targets imposed,
and thus, knowing no different, they fail to realise the benefits of having an influence on
the budget.
! Social
The effectiveness of participation will vary from country to country. The culture of
Eastern European countries, even in the 1990s, is towards acceptance of authority.
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237
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Study Unit 13
Standard Costing
Contents Page
Introduction 238
A. Principles of Standard Costing 238
Definitions 238
Types of Standard Cost and System 239
Application of Standard Costing 239
The Advantages and Disadvantages of Standard Costing 240
Types of Variance 240
B. Setting Standards 241
Setting Standard Costs for Direct Materials 241
Setting Standard Costs for Direct Labour 242
Setting Standard Costs for Overheads 243
Standard Product Costs 244
Machine Time or Operator Time 245
Computerised Systems 246
Problems with Standard Setting 246
C. Setting Standards The Learning Curve 247
Where Not to Use the Learning Curve 250
Further Example 250
Learning Curve Further Considerations 252
D. The Standard Hour 253
Measure of Output Achieved 253
E. Measures of Capacity 254
Level of Activity Ratios 254
238 Standard Costing
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INTRODUCTION
One of the principal objects of any management accounting system should be to assist in the planning
and control of operations. The techniques of budgetary control and standard costing can help
management carry out this vital function.
In this and the next two study units, we will be looking at the objectives and methods of standard
costing; these will help us understand its purpose, the methods by which standards are set, the
procedures for calculating variances, and the interpretation of variances (and their relationship with
budgeting).
A. PRINCIPLES OF STANDARD COSTING
Whereas budgetary control is concerned with the overall plans of the organisation and assignment of
responsibilities for control over revenues and expenditure, standard costing is concerned with the
establishment of detailed performance levels, together with the related costs and revenues per unit
and in total for the planned activities of the organisation.
Budgetary control and standard costing have certain features in common:
! The setting of targets or standards
! The recording of actual results
! The comparison of actual results with standards
! The computation of variances and their analysis, and arranging the appropriate corrective
action.
However, you should note that standard costs are used in the construction of budgets. The
companys standard cost for each product will be updated and recalculated at the appropriate rates
relating to the following year. Budgeted sales quantities multiplied by these updated standards
provide the cost of sales figures for the budgeted profit and loss account. This approach also allows
budgeted standards to be compared with actual performance once this has been calculated. Any
corrective action can be taken in respect of standards and/or budgets and in the actual production
methodology.
Definitions
The Chartered Institute of Management Accountants (CIMA) uses the following definitions:
! Standard Costing
A technique which uses standards for costs and revenues for the purpose of control through
variance analysis.
! Standard Cost
A predetermined calculation of how much costs should be, under specified working
conditions.
It is built up from an assessment of the value of cost elements and correlates technical
specifications and the quantification of materials, labour and other costs to the prices and/or
wage rates expected to apply during the period in which the standard cost is intended to be
Standard Costing 239
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used. Its main purposes are to provide bases for control through variance accounting, for the
valuation of stock and work in progress and, in some cases, for fixing selling prices.
We can see from these definitions that standards are compiled prior to production taking place, and
that they relate to specific assessments of physical quantities and cost. They are, in effect, yardsticks
against which actual quantities and costs or revenues can be measured. If circumstances or
conditions change, then a revision of standards will be required so the standards in use reflect the
current specifications. The standards may also be subject to annual or periodic updating.
Types of Standard Cost and System
! Ideal Standard Costs
These are based on ideal conditions i.e. 100% efficiency is expected from workers,
machinery and management: it is only in an automatic and very efficiently run factory that
ideal standard costs are likely to be achieved.
! Attainable Standards
These are based on attainable conditions, and they are more realistic than ideal standard costs.
Provided that all the factors of production are made as efficient as possible before the
standards are set, the standard costs are likely to be of great practical value. They represent, to
workers and management, realistic figures, capable of achievement, since they include
allowances for normal shrinkage, waste, breakdowns etc. The variances really do mean
increased or reduced efficiency.
! Basic Standard Costs
These are a special type of standard cost. The idea is to select a base year, and then set the
standards (ideal or attainable at that time). The standard costs then remain in force for a
number of years without being revised.
Their principal advantage is that trends in costs over a number of years can be seen quite
readily. Another advantage is that the actual value of stocks is known and so there is no
problem of converting standard costs to actual costs for use in final accounts. This assumes, of
course, that it is desirable to use the actual cost of the stocks. There is a tendency to advocate
the use of the standard costs for stock valuation and, if this view is taken, there is no
disadvantage in using ordinary standard costs.
! Current Standard Costs
These are standard costs which represent current conditions i.e. they are kept up to date.
Ideal standards and attainable standards are both current standard costs, which are changed
when conditions change.
Application of Standard Costing
Standard costing is applied most successfully to continuous or repetitive operations, where large
volumes of a standard product are produced. The application of standard costing principles to job
costing systems is more difficult, as products will vary each one may be unique. As the products
themselves are not standardised, the emphasis will be on the machines and operations concerned.
Standard feeds and speeds for machines may be developed, as well as output for handwork
operations. These standards will then be applied to the specifications for individual products.
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The Advantages and Disadvantages of Standard Costing
The advantages of using a standard costing system are as follows:
! Standard costing is a useful basis for budgetary control.
! It can be used as the basis for setting targets to motivate staff.
! Efficiency in the use of resources should be enhanced, providing standards are set with the
objective of utilising the most appropriate resources for the job in hand.
! By using various investigative models (which we shall examine later), it is possible to identify
the point at which investigation should take place without the need for management constantly
to monitor the situation (i.e. management by exception).
! The impetus will exist to ensure that the most efficient use is made of resources.
! Standard costing can be used in control systems to enhance positive variances and tackle
negative ones.
The disadvantages are as follows:
! A standard costing system can be time-consuming and expensive to install and operate.
! Responsibility for the cause of variances is not always easy to identify.
! Standards may be viewed as pressure devices by staff.
! Standards are difficult to determine with accuracy.
Types of Variance
The difference between a standard cost (or budgeted cost) and an actual cost is known as a variance.
! Favourable and Adverse Variances
Variances may be favourable or adverse. If actual cost exceeds standard or budgeted cost, then
the variance is adverse. On the other hand, if actual cost is less than standard or budgeted
cost, then the variance is favourable. (Note here that overhead volume variance is an
exception to this general statement.) An adverse variance is often shown in brackets, although
the convention is also used of showing F after figures for favourable variances and A for
adverse variances.
! Classification According to Cost Element
To make the variances as informative as possible, they are analysed according to each element
of cost i.e. material, labour and overhead. A further analysis is then made, under each
heading (material, etc.), according to price and quantity etc. We will be discussing further
subdivisions of some of these variances later.
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B. SETTING STANDARDS
Before manufacturing costs can be predetermined, the following factors must be stated:
! The volume of output.
! The relevant, clearly-defined, conditions of working (grade of materials, etc.).
! The predetermined level of efficiency.
Each element of cost material, labour and overhead must be taken in turn, and the standard cost
for each product determined. The object must be to ascertain what the costs should be, and not what
they will be.
Before any attempt is made to set the standards, all functions entering into production should be
examined and made efficient. It will then be possible to have standard costs which represent true
measures of efficiency.
The following have therefore to be predetermined:
! Standard Quantities
Due allowance should be made for normal losses or wastage. Abnormal losses should be
excluded from the standards, as these are not true standard costs.
! Standard Prices or Rates
The aim should be to estimate the trend of prices or rates, and then predetermine these, having
full regard to expected increases or reductions.
! Standard Quality or Grade of Materials, Workers or Services
Unless the appropriate grade of material or worker is clearly defined when the standards are
set, there will be great difficulty in measuring accurately any variance which may arise.
Setting Standard Costs for Direct Materials
The product is analysed into its detailed material requirements, and all the materials are listed on a
form called a standard material specification.
(a) Material Quantities
Determination of material quantities may be accomplished by one of the following methods:
! Referring to past records e.g. stores records kept when historical costing was adopted.
! Making a model of the product, noting all significant facts when the test runs are carried
out.
! Establishing the relationship between the size or weight of the product and the material
content, thereby calculating the standard quantity in the case of screws, for example,
the weight of the screws will indicate the metal content, and a standard quantity can then
be fixed.
Great care must be exercised in calculating a reasonable allowance to cover unavoidable
material wastage owing to cutting, for example.
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(b) Material Prices
Standard prices for materials will be set by the purchasing officer and the accountant.
The actual practice adopted can vary from company to company. Some companies set
standards based on what is expected to be the average price ruling during the budget year.
This has the effect of over-costing products during the first half of the year, and under-costing
them during the second half. These differences are called variances (we will cover their
calculation in the next study unit).
An alternative approach is to set standard prices based on actual prices ruling on the first day
of the new financial year. This can be completed before the year begins, as suppliers
generally notify price increases in advance. As standards are based on actual prices at the
beginning of the year, it is necessary to calculate a budget for material price variances which is
the company's estimate of the impact inflation will have on material prices.
This approach has the advantage that costs are based on actual prices and not on forward
estimates which may or may not be accurate. The standard cost represents the actual cost on
the first day of the year and can be used with confidence by the marketing team. As the year
progresses the actual material prices will be compared with these standard prices and the
financial impact on the company calculated. By comparing actual prices with the prices ruling
on the first day of the year it is possible to get an accurate assessment of the rate of inflation
applicable to material purchases. This information will be compared with the forecast rate of
inflation built into the companys budget, and can be used to assess the need for selling price
adjustments or other corrective actions.
(c) Standard Cost
The standard cost is obtained as follows:
Standard quantity Standard price
This will be done for each type of material, and the totals added together to arrive at the
material standard cost for the product.
Setting Standard Costs for Direct Labour
An analysis of the operations required to manufacture each product will be essential before the
standards are set. The correct grade of worker for each operation must also be established:
(a) Standard Time for Each Operation
The standard time for each operation will be set by one of the following methods:
! Referring to past records, and then adjusting to allow for any changes in conditions.
! Use of time-studies based on work study. Each element of an operation is timed, and
then a total standard is determined by adding together all the element times and adding
on allowances for relaxation, interruption, etc.
! Employment of synthetic time studies. This is really a combination of the above
methods. Detailed records are built up by the use of the time-studies, and then, from
these records, the appropriate elemental times are selected to arrive at the total standard
time for any operation which has not been timed.
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(b) Standard Wage Rates
As with material prices, the actual practice adopted will vary from company to company.
Some companies base their standards on what they expect to be the average rate during the
budget year. This means that they have to anticipate wage increases and changes in methods.
An alternative approach is to base standard labour costs on the rates and methods applicable on
the first day of the financial year, and then forecast variances based on projected wage
increases and changes in methods. In this way the standard labour cost for each product
represents the actual cost on the first day of the financial year, and provides similar advantages
to those which we outlined in the previous section on material prices.
When an incentive method of payment is in operation, setting the standard rate may be
relatively simple. For example, for a piece-rate system, the standard rate will be the fixed rate
per piece. To avoid having too many wage rates, average wage rates may be used.
To summarise, the standard cost for direct labour is:
Standard direct labour hour Standard direct labour rate
Setting Standard Costs for Overheads
Overhead costs are often the most difficult costs to predetermine.
(a) Preliminary Classification
One of the first steps will be to divide such costs into the following three classes:
! Fixed Overhead Costs
In this class, the total remains the same irrespective of output. Senior management
determines the extent of the fixed costs when formulating policy.
! Variable Overhead Costs
In this class, the total increases with increased output, and reduces with decreased
output, since variable overhead costs are fixed at so much per unit of output or standard
hour. For example, the rate may be 0.35 per unit so, for each additional unit of output
to be produced, a further 0.35 must be included in the budget.
! Semi-Variable Overhead Costs
These are partly fixed and partly variable, and they have to be divided into two parts
thus showing quite clearly the fixed element and the variable element. Once the division
has been made, the predetermination of the costs is greatly facilitated. The methods
used for separating fixed and variable costs are:
(i) Regression chart
(ii) Method of least squares
(iii) High/low output calculations (thus isolating the overhead total charge which
must be variable).
(b) Determination of Standard Amounts
This may be done by using past records or by using a form of time-study, when work can be
divided into work units. For example, it may be possible to estimate the requirements so far as
factory cleaners are concerned by fixing a time per square yard of floor for sweeping, washing,
or other appropriate task.
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The volume of output must be predetermined, so that total variable costs for each type of
expense may be predetermined. Particular attention must be paid to the allowances to be made
for normal time losses (labour absenteeism, waiting for material, tools, etc.) and also the
abnormal time losses owing to a falling-off in the volume of sales. It has been suggested that
up to 20%, or even more, may have to be deducted to arrive at a normal operating figure for the
short period (known as the normal capacity to manufacture), and a further 20% or
thereabouts deducted to arrive at a figure to cover losses of sales (known as the normal
capacity to produce and sell). In the latter case, the long-term (say, six or seven years) figures
are taken, and then a net yearly average is calculated.
(c) Preparation of Budgets for Factory Overheads
Once the appropriate capacity has been selected and the overhead costs have been classified
into fixed or variable, the factory budgets can be prepared. Usually they are prepared
departmentally i.e. a separate budget for each cost centre or department. The hourly
absorption rate (machine hour or direct labour hour) is then calculated for each cost centre, and
applied on the appropriate standard cost card.
For each volume of output it is possible to have a cost equation, which may take the following
form:
Total for each class of expenses = Fixed costs +
Variable cost
per unit

Units to
be made
The units to be made may be expressed in terms of physical units or in standard hours. The
variable cost per unit will have been ascertained from the direct material and labour content,
together with variable overheads. Once the variable cost per unit has been calculated, the
budget may be built up stage by stage, by entering each expense, and then its amount.
Note at this stage that in practice two types of budget are in use:
! Fixed Budget
This shows the output and costs for one volume of output only; it thus represents a rigid
plan.
! Flexible Budget
A number of outputs will be shown together with the cost for each type of expense. The
fixed costs will be the same for all volumes of output, whereas the variable costs will
increase with increases in activity.
Standard Product Costs
Standard product costs are compiled for each product made. This is done by bringing together the
standard product materials specifications, the standard operations, the performance standards, and the
standard rates. A standard product cost card is given in Figure 13.1.
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STANDARD PRODUCT COST
Product Group: Supershields Part No.: S12
Unit: per part
Standard materials specification Standard
Quantity
Standard Price Cost
lb
E.N. 2.A.1.25" steel 30.0 0.04 1.200
Scrap and swarf (12.0) 0.004 (0.048)
Total standard materials 18.0 1.1520
Standard operations Standard time Standard m/c
hr rate
Cost
Std hrs
Press out on 70 ton press 0.01 1.32 0.0132
Turn on capstan 0.04 1.26 0.0504
Braze 0.02 1.22 0.0244
Pack 0.05 1.20 0.0600
Total standard operations 0.1480
Works standard cost 1.3000
Administration overhead: 10% of works standard cost 0.1300
Selling overhead: 3% of works standard cost 0.0390
Total standard cost 1.4690
Standard selling price 1.60
Standard gross margin (on works standard cost): 18.75% 0.30
Figure 3.1: Standard Product Cost Card
Machine Time or Operator Time
So far, the standard rates for labour and overheads have been expressed in terms of operator-time.
However, in some circumstances the direct process time is relevant to the machine hour, rather than
the labour hour. In these cases, labour and overheads are expressed in terms of a machine hour rate.
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You can see from the standard cost card in Figure 13.1 that the standard gross margin is 0.30 per
part, and that the analysis of the standard gross margin is:
Standard gross margin 0.3000

Administration and selling overhead 0.1690
Standard net profit 0.1310
Computerised Systems
The standard-setting process is enhanced if the company operates a computerised Material
Requirements Planning (MRP) system which requires a detailed breakdown of every component and
sub-component used in the finished product. These systems are used in the production planning and
purchasing functions, and allow companies to explode the forecast production programme into a
detailed list of all the metal and components required to manufacture it. This requirement can then be
compared with the companys stock positions so that order quantities can be calculated. It is
therefore relatively easy to add the standard cost of each component to the computer system, which
then enables the computer to calculate the standard material cost of each product. The purchasing
system is often linked into MRP systems and as a result it is also possible to update standard costs to
actual costs.
Problems with Standard Setting
One of the major shortcomings of a standard costing system is the difficulty in setting standards
against which meaningful comparisons can be made of actual results. Here are some of the problems
that need to be considered.
(a) Labour Cost Standards
! The departments that have to supply the basic information may not be competent to do
so without guidance.
! The operations involved in the carrying out of a job have to be clearly established and
this may involve a number of departments.
! The different operations involved may not coincide with the separate cost centres.
! The grades of employees that will be employed at each stage must be known, but these
may vary. For example, if trainees or learners are used at any one time, the speed of
production will fall and the incidence of spoilage will rise.
! Will the pattern of normal time and overtime used in the production of the standard be
followed in practice?
! Work measurement may be required and this can be a lengthy and costly operation.
(b) Direct Material Standards
! It is often difficult to establish a realistic allowance that should be made for defective
materials and for spoilage arising during production.
! If standards are set on the basis of test runs, then such runs should be as realistic as
possible.
! Different suppliers of the same material can produce significant variances in quality.
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! The prices of many raw materials change so frequently that even with the use of price
variances, much of the value of the standard can be lost.
(c) Overhead Standards
! It is very difficult to establish what the overhead costs ought to be. There is a tendency
to use past results and this can lead to very imperfect standards.
! These costs should be related to a normal level of activity. This activity is difficult to
define.
! The standards of output must be determined and it is then necessary to determine what
overhead costs should be incurred at these levels. These overhead costs will include
indirect materials and indirect wages as well as expenses and the exercise can be most
complex.
C. SETTING STANDARDS THE LEARNING CURVE
The CIMA defines the cost experience curve as:
The relationship plotted between cost per unit expressed in constant money terms, and
cumulative units produced per unit usually plotted on a double logarithmic scale.
This is commonly referred to as the learning curve.
As workers become more familiar with repetitive manual tasks, they tend to become more efficient,
with a consequent lowering of production time and costs. It has been found that improvement
through the learning process conforms to a regular pattern and that labour hours can be predicted with
a high degree of accuracy.
The learning curve is represented by the percentage reduction in cumulative average hours per unit
each time production quantities are doubled. Recorded results show that this percentage
improvement is commonly of the order of 1 to 40 per cent. The learning curve is usually denoted by
the complement of its number that is to say a 10 per cent reduction in time would be referred to as a
90 per cent curve.
The features of an 80% learning curve are shown in Table 13.1, from which you can see that the first
unit is produced in 100 hours and the second in 60 hours. The total hours for the first two units are
160, giving an average of 80 hours, which is 80% of the time taken for the first unit an 80%
learning curve.
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Table 13.1: Learning Curve Data
Units
Produced
Cumulative
Units
Average
Hours Per
Unit
Total Hours Incremental
Hours
Incremental
Hours Per Unit
(a) (b) (c) (d) = (b) (c) (e) (f) = (e) (a)
1 1 100.0 100.0 100.0 100.0
1 2 80.0 160.0 60.0 60.0
2 4 64.0 256.0 96.0 48.0
4 8 51.2 409.6 153.6 38.4
8 16 41.0 656.0 246.4 30.8
16 32 32.8 1,049.6 393.6 24.6
You can see from column (c) that there is a progressive reduction of 80% on each preceding figure. If
production quantities were to be increased sufficiently, it would be found that the cumulative average
time per unit would tend to level off and become stabilised.
Cost reduction associated with the learning curve can also be predetermined. Using the production
times given in Table 3.1, and assuming that direct wages and related overhead costs are 10 per hour,
cumulative costs in total and per unit can be calculated as in Table 13.2.
Table 13.2: Cumulative Costs
Units
Produced
Cumulative
Units
Total Hours Total Cost Incremental
Cost
Incremental Cost
Per Unit
(a) (b) (c) (d) = (c) 10 (e) (f) = (e) (a)
1 1 100.0 1,000 1,000 1,000
1 2 160.0 1,600 600 600
2 4 256.0 2,560 960 480
4 8 409.6 4,096 1,536 384
8 16 656.0 6,560 2,464 308
16 32 1,049.6 10,496 3,936 246
Learning curve statistics can be particularly useful where quotations for long-term contracts are being
prepared, or there is a start-up period in the production of a new product. The estimation of costs
may also be important for budget purposes.
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Example
XY Limited is planning to introduce a new product which will be subject to a learning curve of 80%.
The planned production is as follows:
Period Units
1 1
2 1
3 2
4 4
5 8
6 16
The first unit will require 1,220 hours of production. The direct wage rate will be 3 per hour.
Construct tables to show:
(a) (i) Average hours per unit;
(ii) Total hours; and
(iii) Incremental hours per period.
(b) The direct wages per period and for the whole quantity.
Solution
(a) Production Period
Period Units in
Period
Cumulative
Units
Average Hours
per Unit
Total Hours Incremental
Hours
1 1 1 1,220 1,220 1,220
2 1 2 976 1,952 732
3 2 4 781 3,124 1,172
4 4 8 625 5,000 1,876
5 8 16 500 8,000 3,000
6 16 32 400 12,800 4,800
12,800
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(b) Direct Wages
Period Hours Worked Direct Wages
@ 3 per Hour
1 1,220 3,660
2 732 2,196
3 1,172 3,516
4 1,876 5,628
5 3,000 9,000
6 4,800 14,400
12,800 38,400
Where Not to Use the Learning Curve
It must be appreciated that there are certain situations in which the learning curve should not be
applied or where it may be ignored when setting labour standards. These situations include the
following:
! Where labour turnover is high and the full benefits of the learning process are not realised.
! Where the learning period is very short and workers have previously shown an ability to adapt
to new work very rapidly.
! Where morale and motivational factors are involved either enthusiasm to learn new work and
processes, thus reducing the learning period, or where past experience has shown that there are
restraints by the workforce on the reduction of labour time.
! Where industries or production processes are subject to rapid technological change and new
standards are introduced at frequent intervals.
Further Example
A company is asked to quote for a contract to which an 80% learning curve will apply. The contract
calls for an initial order of 200 units followed by a possible second order for 100 units. Relevant
standards for the initial order are:
Direct materials: 15 metres at 8.00 per metre
Direct labour: Dept AR 8 hours at 3.00 per hour
Dept AS 100 hours at 3.60 per hour
Dept AT 30 hours at 2.40 per hour
Variable overhead: 25% of direct labour
Fixed overhead: Dept AR 5.00 per direct labour hour
Dept AS 3.00 per direct labour hour
Dept AT 2.00 per direct labour hour
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The three departments differ in their work composition. Department AR is highly automated and its
output, predominantly machine-controlled, is little influenced by operator efficiency. Output in
Departments AS and AT is almost exclusively influenced by operator skills.
Required
Calculate prices per unit for the initial order and the second order, allowing a profit margin of 3% on
direct materials cost and 10% on conversion cost.
Note: An 80% learning curve shows the following relationship between volume (x axis) and
cumulative average price of elements subject to the learning curve (y axis):
x y %
1.0 100.00
1.1 96.90
1.2 93.30
1.3 91.70
1.4 89.50
1.5 87.60
Solution
The cost per unit of the first order is:

Direct materials 120.00
Direct labour: Dept AR (8 hours @ 3.00) 24.00
Dept AS (100 hours @ 3.60) 360.00
Dept AT (30 hours @ 2.40) 72.00
456.00
Variable overhead (@ 25%) 114.00 570.00
Variable cost 690.00
Fixed overheads: Dept AR (8 hours @ 5.00) 40.00
Dept AS (100 hours @ 3.00) 300.00
Dept AT (30 hours @ 2.00) 60.00 400.00
Total cost 1,090.00
Profit:
3% on direct materials cost 3.60
10% on conversion cost of 970.00 97.00
Selling price per unit 1,190.60
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Cost of second order:
(Note that the cumulative production is 300 units and that for Departments AS and AT the learning
ratio is 87.60%, this being the ratio for a quantity 1.5 times the initial order.)

Direct materials 120.00
Direct labour: Dept AR (8 hours @ 3.00) 24.00
Dept AS (100 hours @ 3.60 87.60%) 315.36
Dept AT (30 hours @ 2.40 87.60%) 63.07
402.43
Variable overhead (@ 25%) 100.61 503.04
Variable cost 623.04
Fixed overheads: Dept AR (8 hours @ 5.00) 40.00
Dept AS (100 hours @ 3.00 87.60%) 262.80
Dept AT (30 hours @ 2.00 87.60%) 52.56 355.36
Total cost 978.40
Profit:
3% on direct materials cost 3.60
10% on conversion cost of 858.40 85.84
Selling price per unit 1,067.84
Note the change in fixed overhead absorption because of the reduction in direct labour hours.
Learning Curve Further Considerations
! Obtaining data to assess the impact of the learning curve can be very difficult.
! There is a limit to the number of times the learning curve will apply; eventually it will become
impossible to carry out the tasks any more efficiently.
! Not all industries and processes lend themselves to learning curve phenomena.
! The workforce must be sufficiently motivated in order to achieve constant reductions in the
amount of time the work takes to complete. This could involve the payment of productivity
bonuses, which could in turn lead to problems if the workforce feels that these bonuses are
under threat due to the reduction in the time taken. It is therefore better for such bonuses to be
unit, rather than time, related.
! The learning curve presumes that working conditions remain relatively stable in terms of
technology and labour turnover. If, for instance, the workforce is expanded significantly then
the learning curve may be adversely affected as the new employees settle in.
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! If it is considered that the learning curve is present, care must be taken to ensure that
production scheduling is set up accordingly and that functions such as marketing and
distribution are informed also.
! Care must be exercised when setting-up standard costs if the learning curve effect is known to
be present. Interim standards can be used until the learning curve is no longer causing
variations in the time the work takes.
D. THE STANDARD HOUR
Perhaps the most satisfactory way of explaining this expression is to consider the definition put
forward in the CIMA Terminology. This defines the standard hour/minute as:
The quantity of work achievable at standard performance, expressed in terms of a
standard unit of work in a standard period of time.
Measure of Output Achieved
From this definition, you can see that a standard hour refers to a measurement of output, and not
to the physical passage of time. If an operative works harder than envisaged by the standards, he or
she may produce 1.25 standard hours within the physical time of 60 minutes; and, conversely, if an
operative works more slowly than standard he or she may only produce 0.75 standard hours in 60
minutes.
In assessing output, the time passage will be 60 minutes and the number of units produced in that
time will be recorded to establish the output of a standard hour. Suppose a factory produces rulers,
and in 60 minutes it is observed that an operative can produce 400 rulers, then 1 standard hours
output will be assessed at 400 rulers. Further, suppose that, in the course of an 8-hour day, the output
of an operative was 3,600 rulers, on the basis of the agreement the output would be assessed at 9
standard hours.
Note: 9 standard hours have been produced in 8 clock hours. This distinction between standard hours
and clock hours is vital to the statistics of standard costing.
Example
AB & Co. Ltd produces cars of differing engine capacity, the output being assessed in standard hours
as shown below:
Engine
Capacity
Standard Hours
Per Unit
1,000 cc 20
1,500 cc 32
2,000 cc 40
2,600 cc 50
The output statement for a week could then be shown in the following way:
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AB & Co. Ltd
Output Week no. 14
Product Standard Hours
per Unit
No. of Cars
Produced
Output in
Standard Hours
1,000 cc 20 120 2,400
1,500 cc 32 140 4,480
2,000 cc 40 30 1,200
2,600 cc 50 25 1,250
Total: 9,330
Obviously, when there are changes in methods of production, output comparisons week by week will
not be valid. The figures produced above are not affected by changes in rates of pay or any change in
the value of money.
The standard overhead cost is expressed as:
Standard hours Standard overhead rate
E. MEASURES OF CAPACITY
The CIMA Terminology includes three measures of capacity, which are defined below:
! Full Capacity
Production volume expressed in standard hours that could be achieved if sales orders,
supplies and workforce were available for all installed workplaces.
! Practical Capacity
Full capacity less an allowance for known unavoidable volume losses.
! Budgeted Capacity
Standard hours planned for the period, taking into account budgeted sales, supplies and
workforce availability.
Level of Activity Ratios
Using the above measures as a starting point, various ratios can be developed to show the level of
activity attained, and the efficiency of production. The CIMA Terminology refers to three ratios:
idle capacity, production volume and efficiency.
You can see that full capacity refers to an ideal situation, where there are no losses of any kind.
Practical capacity reflects an attainable level of performance, while budgeted capacity takes into
account anticipated conditions in relation to sales, production and labour facilities which will be
available.
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Lets assume the following data for an accounting period (where full capacity is 11,000 standard
hours):
Practical capacity expressed in standard hours 10,000 (A)
Budgeted capacity in standard hours assuming 80% efficiency 8,000 (B)
Standard hours produced 7,000 (C)
Actual hours worked 8,500 (D)
The following ratios can be produced:
(a) Idle Capacity Ratio
(A) (B)
(A)
=
10,000 8,000
10,000

=20 per cent
Note that practical capacity is used, NOT full capacity.
(b) Production Volume Ratio
(C)
(B)
=
7,000
8,000
=87.5 per cent
(c) Efficiency Ratio
(C)
(D)
=
7,000
8,500
=82 per cent approx.
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257
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Study Unit 14
Standard Costing Basic Variance Analysis
Contents Page
Introduction 258
A. Purpose of Variance Analysis 258
Variances Produced 258
Variance Analysis, Absorption and Marginal 260
B. Types of Variance 262
Material Variances 263
Labour Variances 264
Variable Overheads 264
Fixed Overhead Variance 265
Sales Revenue Variances 265
Reconciliation Between Budgeted Profit and Actual Profit 266
C. Marginal versus Absorption Costing 267
Fixed Overhead Variances 267
Fixed and Variable Overheads (Alternative Approach) 267
Sales Revenue Variances 268
Idle Labour and Idle Machine Time 268
D. Mix and Yield Variances 269
Materials Price, Mix and Yield Variances 269
Sales Variances 272
258 Standard Costing Basic Variance Analysis
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INTRODUCTION
Having established quantity standards for sales, materials and direct labour with the relevant standard
sales and cost values, actual operational results are compared with these standards. The differences
between the money values for the actual and standard results are known as variances. These
variances are intended as a guide to management, to identify the causes of discrepancies between
actual and standard performance, and to provide a basis for investigation, possible corrective action
and decision-making.
This study unit consists of basic and more advanced variances: note that you will not be expected to
be able to compute them in the examination but you must know how they arise, not least because this
is an important element of understanding their cause. This latter element will be considered in more
detail in the next study unit.
The variances will be calculated from the point of view of a marginal costing system with reference
later to the differences that occur when an absorption costing system is used.
A. PURPOSE OF VARIANCE ANALYSIS
In studying the analysis of variances, you should not only understand the techniques of the
calculations but also the meaning and possible causes of variances.
Variances are calculated for:
! Sales
! Direct wages
! Direct materials
! Variable overheads
! Fixed overheads.
In each case the variances are classified according to their nature whether price, efficiency or
volume each type of variance having its own title. The analysis of variable and fixed overheads
will depend upon whether absorption or variable costing methods are used.
Variances Produced
Figures 14.1 and 14.2 show the differences that exist between the two different costing methods when
carrying out variance analysis.
Standard Costing Basic Variance Analysis 259
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OPERATING PROFIT VARIANCE
FIXED OVERHEADS VARIABLE COST SALES
Fixed production-
centred expenditure
variance
Fixed administrative
cost variance
Sales margin price
variance
Sales volume
contribution variance
Total direct
wages variance
Total direct
materials variance
Variable production
overhead variance
Wage rate
variance
Labour
efficiency
variance
Materials
price variance
Materials
usage variance
Variable
overhead
expenditure
variance
Variable
overhead
efficiency
variance
Figure 14.1: Marginal Costing Variances Produced
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OPERATING PROFIT VARIANCE
TOTAL COST SALES
Sales margin price
variance
Sales margin volume
variance
Total direct
wages variance
Total overhead
variance
Total direct
materials variance
Wage rate
variance
Labour
efficiency
variance
Variable
overhead
variance
Fixed
overhead
variance
Materials price
variance
Materials usage
variance
Variable overhead
expenditure variance
Variable overhead
efficiency variance
Fixed overhead volume
variance
Fixed overhead
expenditure variance
Efficiency variance Capacity variance
Figure 14.2: Absorption Costing Variances Produced
As you can see, many of the variances are the same. The differences occur in fixed overheads, which
become just an expenditure variance under marginal costing; and sales which is based on contribution
with marginal costing as opposed to the standard profit margin under absorption costing.
Variance Analysis, Absorption and Marginal
The method for the calculation of profits under the marginal cost system differs from that of the
absorption system. When preparing profits under the marginal cost system, the contribution is
calculated by taking the difference between the sales revenue and the variable costs. Fixed costs are
then deducted to arrive at profit. Since fixed costs are not considered part of the overall costs for the
purposes of calculating closing stock, it follows that the closing stock under the marginal cost system
will be lower than that calculated under the absorption system.
When calculating the variances for the sales volume, the marginal system uses the contribution
margin whereas the absorption system uses the standard profit margin.
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Profit and Loss (Absorption Statement)

Sales revenue 45,000
Materials 20,000
Labour 5,000
Total costs 42,500
Profit 2,500
Although the marginal statement will give the same profit (because there is no opening or closing
stock), the layout is a little different:
Profit and Loss (Marginal Statement)

Materials 20,000
Labour 5,000
27,500
Contribution 17,500
less Fixed overheads 15,000
Profit 2,500
You will see these differences as we examine variances under each of these different areas. We shall
start with the marginal system, and then modify it to explain how variances apply under the
absorption system.
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B. TYPES OF VARIANCE
We shall now work through the calculation of the basic variances using a hypothetical example. The
more advanced subvariances for sales, direct materials and direct labour will be considered later.
Calc-u-like manufactures electronic adding machines and calculators. One specific model, the C12,
has a forecast production of 600 units in the forthcoming period and the company has produced a
standard costing card as follows:
Unit Costs Quantity Used Price per Unit
Kg/Hours
Materials 10 4 40
Labour 5 2 10
Variable overheads 5 1 5
Total production cost 55
Selling price 90
Contribution 35
Fixed overheads (based on 500 units) 30
Profit 5
The company uses this information to prepare a projected profit and loss account under the
absorption system.
Budgeted Profit and Loss

Materials 24,000
Labour 6,000
Total direct cost 33,000
Contribution 21,000
Profit 6,000
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The actual results during the year were as follows:
Sales price 95 per unit
Produced and sold 600 units
Direct material (6,140 kg) 24,420
Labour (3,250 hours) 6,760
Use the above information to prepare a profit and loss account using the marginal costing statement.
Solution
Actual Profit and Loss

Materials 24,420
Labour 6,760
Total direct cost 34,360
Contribution 22,640
Profit 7,530
Now, we must analyse why there is a difference between the budgeted profit 6,000 and the actual
profit 7,530.
Material Variances
On the basis of the above information, we should have used 6,000 kg (10 kg 600) of material and
we should have paid 4 per kg. The actual results show that we used 6,140 kg and we paid 24,420.
We can break the difference down between a material usage variance and a material price
variance.
Direct material price: AQ (SP AP) or AQ SP AQ AP 141
Direct material usage: SP (SQ AQ) or SQ SP AQ SP 560
Direct material total: 419
where: AQ =actual quantity used (6,140)
SQ =quantity that we should have used (6,000)
SP =standard price per unit (4)
AP =actual price (24,420/6,140 =3.977)
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AQ SP =6,140 4 =24,560 AQ AP =24,419
A positive figure indicates a favourable variance, i.e. we spent less than expected.
A negative sign indicates an unfavourable or adverse variance, i.e. we spent more than
expected.
In this case the price variance is favourable while the usage variance is unfavourable. A possible
reason for this is that we bought cheaper material and as a result there was higher wastage.
Labour Variances
The formulae for labour variances are as follows:
Direct labour rate: AH (SR AR) or AH SR AH AR 260
Direct labour efficiency: SR (SH AH) or SH SR AH SR 500
Direct labour total: 760
where: AH =actual hours worked (3,250)
SH =standard hours that we should have used (600 5 =3,000)
SR =standard rate per hour (2)
AR =actual rate (6,760/3,250 =2.08)
AH SR =3,250 2 =6,500 AR AH =6,760
In this case both the rate variance and the efficiency variance are unfavourable (the company spent
more than expected). Possibly the company had union difficulties whereby workers demanded more
pay. The efficiency variance could be caused by demarcation disputes or lack of worker cooperation,
etc.
Variable Overheads
The formulae are:
Variable overhead expenditure: AH (SVOR AVOR) or AH SVOR AH AVOR 72
Variable overhead efficiency: SVOR (SH AH) or SVOR SH SVOR AH 250
Variable overhead total: 178
where: AH =actual hours worked (3,250)
SVOR =standard variable overhead rate per hour (1)
AVOR =actual variable overhead rate (3,180/3,250 =0.978)
AH SVOR =3,250 1 =3,250 AVOR AH =3,178
The variable overhead expenditure variance is favourable, possibly because there was tight control on
expenses. The efficiency variance is unfavourable because more hours were worked than expected.
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Fixed Overhead Variance
As explained earlier, with marginal costing systems, fixed overheads consist of an expenditure
variance only:
Fixed overhead expenditure variance: (BFO AFO) 110
where: BFO =budgeted fixed overheads (15,000)
AFO =actual fixed overheads (15,110)
Sales Revenue Variances
The sales revenue variances can be broken down as follows:
Selling volume contribution variance: SC (AQ BQ) 0
Selling price variance: AQ (AP SP) 3,000
Total sales variance: 3,000
where: BQ =budgeted quantity(600)
AQ =actual quantity (600)
SC =standard contribution (40)
SP =standard price(90)
AP =actual price (95)
In this case the budgeted quantity 600 is the quantity which was sold. Therefore, contribution
variance is nil. The price variance is positive simply because we sold the products for a higher price
than we expected.
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Reconciliation Between Budgeted Profit and Actual Profit
Having calculated all the ratios, we can now summarise them as follows:

Budgeted profit 6,000
Budgeted fixed production overheads 15,000
Budgeted contribution 21,000
Selling price variance 3,000(F)
Sales volume variance
3,000
Actual sales minus the standard variable cost of sales 24,000
Variable cost variances
Material price 141(F)
Material usage 560(A)
Labour rate 260(A)
Labour efficiency 500(A)
Variable overhead expenditure 72(F)
Variable overhead efficiency 250(A)
1,357(A)
Actual contribution 22,643
Budgeted fixed production overheads 15,000
Expenditure variance 110(A)
Actual fixed production overheads 15,110
Actual profit 7,533
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C. MARGINAL VERSUS ABSORPTION COSTING
As we have already noted, the differences in variance analysis under the two costing systems concern
the treatment of fixed overheads and sales.
Fixed Overhead Variances
The formulae for fixed overhead variances are as follows:
Fixed overhead exp. variance: (BFO AFO) 110
Fixed overhead volume variance: SFOR (AQ BQ) 0
Total fixed overhead variance: 110
where: BFO =actual fixed overheads (15,000)
AFO =actual fixed overheads (15,110)
SFOR =standard fixed overhead rate per unit (15,000/600 =25)
BQ =budgeted quantity (600)
For the moment, this is relatively straightforward because the actual quantity sold (600) agrees with
that budgeted (600). The adverse expenditure variance simply means that more was spent than was
budgeted for.
Fixed and Variable Overheads (Alternative Approach)
The fixed and variable overheads can be combined as one under the absorption costing system.
Three ratios replace all the fixed and variable overheads. These are:
! Efficiency variance
! Volume variance
! Overhead expenditure.
In order to calculate these ratios we need the following information.
Per hour/kg
Standard fixed overhead cost 5
Standard variable cost 1
Standard total cost 6
Budgeted overhead expenditure 18,000
Actual overhead expenditure 18,290
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We can now calculate the three ratios as follows:
Efficiency variance 1,500 STC (AH SH)
Volume variance 1,250 SFO (AH SH)
Overhead expenditure 40 (SO AO)
Overhead total variance 290
where :AO =actual overheads (18,290)
STC =standard total cost per hour (6)
AH =actual hours worked (3,250)
SFO =standard fixed overhead per hour (5)
SO =standard overheads
i.e. Standard fixed cost +(Standard variable cost Actual hours)
= 15,000 +(1 3,250) =18,250
The efficiency variance is unfavourable because the company took more hours to produce 600 goods
than was previously budgeted. Nevertheless, the volume variance is favourable; this simply means
that there was a greater number of hours worked, so the fixed cost per hour was below standard. The
overhead expenditure variance (which is unfavourable) simply means that more was spent than was
budgeted for.
Sales Revenue Variances
The sales revenue variances can be broken down as follows:
Sales volume profit variance: SPR (AQ BQ) 0
Selling price variance: AQ (AP SP) 3,000
Total sales variance: 3,000
where: BQ =budgeted quantity (600)
SPR =standard profit (5)
SP =standard price (90)
AP =actual price (95)
In this case, the budgeted quantity 600 is the quantity which was sold. Therefore, volume variance is
nil. The price variance is positive simply because we sold the products for a higher price than we
expected.
Idle Labour and Idle Machine Time
If a supplier makes a late delivery then both employees and machines will incur idle time. Separate
variances are often calculated so that the management accountant can see how much an unsatisfactory
supplier is costing the company. Idle variances can also arise because a machine breaks down, in
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which case the variances can reveal how much an idle machine is really costing the company. The
formula for idle labour variances is:
Standard labour rate per hour Number of idle hours
and for machines:
Standard machine rate per hour Number of idle hours
Example
A company produces 600 products each of which requires 5 hours of labour. The standard rate per
hour is 2. Actual results were:
Total hours paid 3,300 = 6,930
Total hours worked 3,200
The appropriate variances are:
Direct labour rate: 320 AH (SR AR)
Direct labour efficiency 400 SR (SH AH)
Idle capacity variance: 200 SR Idle Hours
Direct labour total: 920
where: AH =actual hours worked (as opposed to paid) (3,200)
SR =standard rate (2)
AR =actual rate (6,930/3,300 =2.10)
SH =standard hours (600 5 =3,000)
Idle Hours =100
D. MIX AND YIELD VARIANCES
For the purpose of providing more informative analyses for the management, it may be necessary to
subdivide some variances into subvariances, to show more clearly the causes and to provide better
guidelines for management action. These subvariances can take many forms, and they can be
developed according to the circumstances and the particular requirements of managers. Two typical
situations are:
! Subdivision of the materials usage into mix and yield variances.
! Division of the sales volume variance into mix and volume subvariances.
Materials Price, Mix and Yield Variances
In process industries it is common for two or more materials to be mixed together to produce a new
material. There will be a standard specification for the proportion of each material to be used a
standard mix or mixture which will also specify the allowance for normal wastage from a given
input of material. This specification will usually be a standard batch of mixture, according to the
normal quantity of input, to produce a given volume of output. This type of operation can lead to
variances arising from variations in the mix of materials or the amount of wastage incurred, and the
yield obtained from a given input. The material usage variances can therefore be analysed to show
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the causes arising from these two factors. The example that follows indicates the detailed
calculations required to arrive at mix and yield variances. As mentioned earlier, you will not need to
undertake the calculations in the examination but you should be aware of them.
Example
A company mixes three chemicals together to produce a new material for further processing. The
standard specification is:
Input per batch (1,000 kg)
Material Quantity Price per kg
kg
A 500 1.00
B 300 3.00
C 200 5.00
The standard output per batch is 900 kg.
During an accounting period in which five batches of the mix were processed, the following results
were recorded:
Input Quantity Price per kg
kg
A 2,400 1.20
B 1,700 2.80
C 900 5.20
5,000
Output for the period: 4,320 kg
There are three variances: price, mix and yield. The price variance is already familiar.
The mix variance represents the gain or loss arising from departures from the standard percentages or
proportions in which materials are mixed.
The yield variance represents the gain or loss arising from greater or smaller wastage than that
specified in the standard.
The steps in the analysis are:
(a) Calculate the actual cost of input.
(b) Calculate the standard cost of the actual input.
(c) Restate the total input quantity in the standard proportions specified.
(d) Calculate the standard input required for the actual output, and multiply by the standard cost to
give the standard cost of the actual output.
The calculations are as follows:
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The variances are:
(A) (B) materials price variance:
12,320 12,000 = (320) (adverse) A 480 (Adv)
B 340 (Fav)
C 180 (Adv)
(B) (C) materials mix variance:
12,000 12,000 = NIL A 100 (Fav)
B 600 (Adv)
C 500 (Fav)
(C) (D) materials yield variance:
12,000 11,520 = (480) (adverse) A 100 (Adv)
B 180 (Adv)
C 200 (Adv)
Summary

Actual cost 12,320
Materials price variance (320) A
Materials mix variance 0
Materials yield variance (480) A
Net variance (800) A
Standard cost of actual output 11,520
Sales Variances
In the same way as the materials usage mix can be subdivided, so the sales volume variance can be
further analysed into mix and volume variances, where more than one product is sold. These
additional variances show the gains or losses arising from a change in the composition of sales.
Different products are likely to have different profit margins therefore, although gross sales figures
may be above budget levels, the profitability of sales may not be as high as budgeted if more units are
sold of a less profitable product.
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Example
Out of Style Ltd has the following budgeted and actual sales for an accounting period:
Budget
Product Units Selling Price
per Unit
Standard Cost
per Unit
Standard Profit
per Unit

A 5,000 10.00 8.00 2.00
B 2,000 30.00 20.00 10.00
C 3,000 15.00 6.00 9.00
10,000
Actual
Product Units Selling Price
per Unit
Standard Cost
per Unit
Standard Profit
per Unit

A 5,000 11.00 8.00 3.00
B 3,000 28.00 20.00 8.00
C 2,000 13.00 6.00 7.00
11,000
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Analysis of variances
! Sales Price Margin Variance
(a) (b) = 56,000 60,000 = (4,000) (adverse)
! Sales Mix Margin Variance
(b) (c) = 60,000 62,700 = (2,700) (adverse)
! Sales Volume Margin Variance
(c) (d) = 62,700 57,000 = 5,700 (favourable)
Summary

Actual profit 56,000
Sales price margin variance (4,000) A
Sales mix margin variance (2,700) A
Sales volume margin variance 5,700 F
Net adverse variance (1,000) A
Budgeted profit 57,000
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277
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Study Unit 15
Advanced Variance Analysis and Investigation
Contents Page
Introduction 278
A. Planning and Operational Variances 278
Ex Ante and Ex Post 278
Planning and Operational Variances in Relation to Contribution 280
Avoidable and Unavoidable Planning Variances 281
Subvariances 284
Operating Statements 286
Summary of Planning and Operational Variances 287
B. Investigation of Variances 287
Preliminary Points to Consider 287
Deciding to Investigate 287
Procedures for Investigation 288
Trend Analysis 288
Variance Trend 289
Management Signals 291
Uncertainty in Variance Analysis 292
Significant Variances 292
Control Charts 293
Statistical Significance Method of Control 295
Statistical Decision Theory 296
Rule of Thumb (or Heuristic) Method 296
C. Variance Interpretation 297
D. Interdependence between Variances 298
278 Advanced Variance Analysis and Investigation
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INTRODUCTION
In the last study unit we introduced the concept of basic variance analysis and outlined its importance
to management. The most crucial element of variance analysis, however, is not its calculation but the
determination of the reasons for its occurrence.
This study unit will consider various methods of investigation, both statistically and graphically, and
examine the main causes of variances. We begin, however, by looking at a different method of
analysis known as planning and operational variances.
A. PLANNING AND OPERATIONAL VARIANCES
Having studied variances in the previous study unit, you may conclude that because of their
complexity they are not used very much in practice. To some extent this is true. However, a new
system of planning and operational variances was devised with the intention of making variances
easier to understand and, more importantly, easier to calculate. The major benefit of planning and
operational variances is that they allow for the fact that the original standard or plan was unrealistic
to begin with. In this section you will learn how planning and operational variances are calculated
and used as part of the decision-making process.
Ex Ante and Ex Post
Often it is necessary to revise budgets simply because the original standards or targets were, for
whatever reason, unrealistic to begin with. The original budget is often referred to as the ex ante
budget, whereas the revised budget is ex post.
Example 1
A companys cost structure is as follows:
Sales price 150 per unit
Variable costs 80 per unit
Contribution 70 per unit
Fixed costs 16,000
The company planned to produce 500 units in a particular five-day period. However, as a result of a
strike, production for one day was lost, so the company only worked for four out of the five days.
Show the planning and operational variances.
(Note: The planning variance is the difference between the ex post budget and the ex ante budget.
The operational variance is the difference between the ex post budget and the actual result.)
Advanced Variance Analysis and Investigation 279
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Solution
Original
Budget
Revised
Budget
Actual
Budget
Units produced 500 400 410

Sales revenue 75,000 60,000 61,500
Variable costs 40,000 32,000 32,800
Contribution 35,000 28,000 28,700
less Fixed costs 16,000 16,000 16,000
Profit 19,000 12,000 12,700
The planning variance is the difference between the original budget contribution (35,000) and the
revised budget contribution (28,000) which is 7,000 (unfavourable).
The operational variance is the difference between the revised contribution (28,000) and the actual
contribution (28,700) which is 700 (favourable). We can now prepare a reconciliation statement as
follows:
Original profit 19,000
Planning variance 7,000
Operational variance 700
Actual profit 12,700
Example 2
A company operates four machines, each of which produces Dictaphones. In a particular period,
there are 5,200 machine hours available. Each Dictaphone requires 4 hours production time. The
selling price of each Dictaphone is 30 and the variable costs are 14. Fixed costs are 9,000.
Calculate the operating and planning variances if actual production details were as follows:
Actual Result
Units produced 700
Variable costs 9,800
Fixed costs 9,000
Note: During the period one of the machines broke down. The company therefore operated using
only three machines.
Solution
If the managers had been aware of the machine breakdown in advance they would have prepared a
realistic budget. They anticipated producing 1,300 Dictaphones (5,200/4). However, as a result of
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the machine breakdown the maximum they could produce was (5,200 1,300)/4 =975. Therefore
the planning variance represents 325 contribution (16) =5,200.
You can see this from the following table:
Original
Budget
Revised
Budget
Actual
Budget
Units produced 1,300 975 700

Sales revenue 39,000 29,250 21,000
Variable costs 18,200 13,650 9,800
Contribution 20,800 15,600 11,200
less Fixed costs 9,000 9,000 9,000
Profit 11,800 6,600 2,200
The operational variance is simply the difference between the revised contribution (15,600) and
the actual contribution (11,200) =4,400.
Planning and Operational Variances in Relation to Contribution
Up to now we have looked at planning and operational variances in relation to sales quantity.
However, they could also apply to sales contribution.
Example
A company expects to make 8,000 products which yield a contribution of 20 per unit. However,
during the year the company realises that the contribution of 20 was based on costs which have now
changed. Accordingly, the correct contribution should have been 16. During the year 8,000 units
were sold giving an overall contribution of 136,000. Calculate the planning and operational
variances.
Solution
(a) Planning Variance
Original contribution budget: 20 8,000 = 160,000
Revised contribution budget: 16 8,000 = 128,000
Difference: = 32,000 (adverse variance)
(b) Operational Variance
Revised contribution budget: 16 8,000 = 128,000
Actual contribution: = 136,000
Difference: = 8,000 (favourable)
The original contribution was based on unrealistic costs which were too low, so the planning variance
was unfavourable or adverse. However, perhaps owing to very efficient production arrangements, the
actual contribution was higher than it should have been, i.e. 136,000 instead of 128,000.
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The benefit of breaking down variances in this way is that we can distinguish those expenses which
are controllable and those which are not. Planning variances are uncontrollable. There is nothing
you can do if unrealistic budgets are set to begin with; however, operational budgets are controllable
and can reveal areas of inefficiency which can be corrected.
If a firm experiences a lot of adverse planning variances, then its budget-setting process is unrealistic.
Planning variances can therefore highlight areas where unrealistic assumptions were made. The
management accountant may find this information useful when preparing future budgets.
The variances in the previous study unit did not distinguish between planning and operational and it
was therefore difficult to determine whether adverse variances occurred due to poor planning or
inefficiencies. Consequently, the variances produced were of only limited value.
Avoidable and Unavoidable Planning Variances
We can also break down planning variances between those which were avoidable and those which
were unavoidable. Unavoidable variances do not require investigation, but avoidable errors could
indicate a weakness in the budget-setting process and therefore merit closer analysis.
If budgets are drafted on an unrealistic basis then overall profitability of the firm could be affected.
Example 1
Peppard Bros employs an accountant to prepare budgets. At the start of the year the following budget
was agreed for Product X:
Units/Hours Cost (Units/Hours) Total
Raw materials 2 1 2
Labour 3 3 9
11
The product required 2 units of raw material and 3 hours of labour. The selling price was 12 per
unit and the company expected to make and sell 400 products. During the year, the company realised
that the raw material cost was understated; the real cost of raw materials was 1.97 per unit instead of
1 per unit.
Actual production costs were 5,160 (labour costs were 3,600). Assume no fixed costs. Calculate
the operational and planning variance. Can we conclude that the accountant was responsible for the
loss?
Solution
Generally, if a budget is not realistic this should not affect profits because profits are based on actual
results, not budgets. However, sometimes bad budgeting can encourage decisions which
subsequently contribute to losses. In this case the original budget was as follows:
Sales revenue 4,800
Contribution 400
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If the accountant had been aware that the cost of raw materials was 1.97 instead of 1 per unit, the
budget would have been as follows:
Sales revenue 4,800
Contribution 376
A negative contribution arises. The accountant would therefore prevent the project from proceeding
and thus save the company 376. The overall planning variance is 776 adverse. This planning
variance can be broken down between:
! Unavoidable planning variance: 400 (adverse)
! Avoidable planning variance: 376 (adverse)
The avoidable planning variance arises because the management accountant could have avoided the
negative contribution if he had used a more realistic price.
The operational variance in this case is positive. The actual result is:
Sales revenue 4,800
Contribution 360
The difference in contribution is 16 favourable.
Example 2
The firm for which you are management accountant produces a wide range of products, one of which
contains a material for which there is a substitute and which is budgeted to cost 10 per kg.
5 kg of the material is required to make the product. Subsequent to the completion of the budget, the
price of the raw material increases to 10.50 but if the substitute had been used, this would have cost
10.25 per kg.
During the period in question (month 1) 1,980 units were produced with a material cost of 120,000.
Calculate all the necessary operational and planning variances including, for the latter, the extent to
which the variance was potentially avoidable.
Solution
(a) Operational Variance
Actual cost for 1,980 units 120,000

Revised standard cost (1,980 10.50 5) 103,950
16,050 (A)
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(b) Planning Variance
(i) Total planning variance using original materials:

Original standard cost (1,980 10 5) 99,000
4,950 (A)
(ii) Possible avoidable planning variance (using alternative method):

Alternative standard cost (1,980 10.25 5) 101,475
Avoidable 2,475 (A)
(iii) Unavoidable:
Original standard cost (1,980 10 5) 99,000

Alt. minimum standard (1,980 10.25 5) 101,475
2,475 (A)
(c) Summary

Standard material cost (1,980 10 5) 99,000
Operational variances 16,050 (A)
Planning variances
Avoidable 2,475 (A)
Unavoidable 2,475 (A)
4,950 (A)
Total planning & operational variances 21,000 (A)
Actual cost of 1,980 units 120,000
Example 3
A company plans to sell 100,000 units at 5 each. Variable cost of each item is 3. Actual results for
the first month of its budgeting year show that although it sold as many units as expected (100,000)
and variable costs were 3 per unit, the sales price was budgeted far too high and could more
reasonably have been set at 3.50. Total sales value for the period was eventually 400,000.
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Calculate the appropriate variances.
Solution
Note that we have three different selling prices here: that which we originally expected to achieve,
that which was later considered reasonable and, finally, that which was achieved.
Total variances are:
Budgeted contribution (100,000 (5 3) 200,000

Actual contribution (400,000 (100,000 3)) 100,000
Total variance 100,000 (A)
(a) Operational Variance
This is purely related to sales price and is the difference between the revised and actual sales
price.
Actual sales (100,000 4) 400,000

Revised budget (100,000 3.50) 350,000
50,000 (F)
(b) Planning Variance
This is the difference between that which we originally felt could be achieved and that which
the estimates were later revised to.
Original budget (100,000 5) 500,000

Revised budget (100,000 3.50) 350,000
150,000 (A)
(c) Summary
Operational variance 50,000 (F)

Planning variance 150,000 (A)
Total variance 100,000 (A)
Subvariances
Before we leave the subject of planning and operational variances, it is worth examining the
subvariances that occur within operational variances, i.e. between price and usage.
In Example 2 on avoidable and unavoidable planning variances, the operational variance was shown
to be 16,050 (A).
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The pertinent details are now as follows:
Budget production 2,000 units
Budgeted usage 5 kg per unit
Budgeted price per kg 10
Price revision 10.50
Actual units 1,980
Actual cost 120,000
Actual usage 10,400 kg
(Note that on this occasion we shall not be assuming that an alternative material can be used.)
Total operational variance:
Actual cost 120,000

Revised standard (1,980 5 10.50) 103,950
16,050 (A)
This total operational variance can be split as follows:
Operational price:
Actual price of actual units 120,000

Revised standard of actual (10,400 kg 10.50) 109,200
10,800 (A)
Operational usage:
kg
Actual quantity used 10,400
Should have been (1,980 5 kg) 9,900
500 (A)
At revised standard price (10.50) 5,250 (A)
Summary
Operational price variance 10,800 (A)

Operational usage variance 5,250 (A)
Total operational variance 16,050 (A)
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Operating Statements
An operating statement is designed to reconcile the original budgeted contribution with that actually
achieved by identifying all the constituent planning and operational variances which have caused the
difference.
The following is one particular way in which the information could be provided but the actual format
will very much depend on the circumstances of the particular case. It is likely that only a small
number of the headings will apply at any one time.
OPERATING STATEMENT FOR ABC LTD
PERIOD 1
Original budgeted contribution X
Planning variances:
Sales price X
Sales volume X
Labour rate X
Labour efficiency X
Material price X
Material usage X
Machine expenditure X
Machine efficiency X
Machine idle time X
Total planning variances X
Contribution before operating variances X
Operating variances:
Sales price X
Sales volume X
Labour rate X
Labour efficiency X
Material price X
Material usage X
Machine expenditure X
Machine efficiency X
Machine idle time X
Total operating variances X
Actual contribution X
By differentiating between the two different categories of variances it is possible to identify
responsibility much more clearly; planning variances for instance are the responsibility of those who
set the budgets, whereas operating variances are the responsibility of functional management.
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Summary of Planning and Operational Variances
If budgets are based on unrealistic standards then the variances calculated between the budgeted and
actual results will have only a limited meaning. By breaking down variances between variances
caused by poor standards and variances caused by operational inefficiencies, the information can be
more useful for corrective action.
Despite the fact that this form of variance analysis is easy to understand it does have certain pitfalls.
First, it is difficult to determine (even with hindsight) what a realistic standard is. There are too many
yardsticks to measure against and any opinions in this area are very subjective.
In addition, disputes may arise as to the extent to which variances are avoidable or unavoidable. For
instance, if an accountant estimated too low a price for raw materials, was it entirely his or her fault,
or was the decision based on the information which was available after exhaustive enquiries?
B. INVESTIGATION OF VARIANCES
We shall now go on to look at the investigation of the variances themselves, particularly in relation to
their potential significance.
Preliminary Points to Consider
You must remember that there are negative aspects to variance investigation. Staff subject to the
investigation may resent the implication that variances arise because they are operating inefficiently
or their workmanship is poor. If a variance investigation is to reap rewards then it must operate
within guidelines so that investigation time is spent only on those areas that merit investigation.
In addition, variances should as far as possible be broken down between those which are controllable
and those which are not. The use of planning and operational variance analysis helps to achieve this
objective. It is also helpful to break down variances between those which are avoidable and those
which are not.
If a variance is avoidable then a procedure should be implemented which would correct the system so
that avoidable variances do not recur. Poor budgeting can often lead to a loss of profits because it
encourages firms to apply resources to areas where the profit is not as high as it should be.
Deciding to Investigate
Even when the above points are taken into consideration, management must recognise that not all
variances can be investigated. When deciding whether or not to investigate, the above points may
assist. However, there are other factors which should also be considered:
! Variances are interdependent. An accountancy firm may incur an adverse wage (or salary)
variance by hiring top-class accountants. However, in the long run the fee revenue variance
may be favourable because the firm has built up a high reputation.
! Sometimes standards are prepared on an ideal basis. This means that the standard is set on the
basis that nothing can go wrong. For obvious reasons, such standards are difficult to attain, so
a large adverse or negative variance is bound to arise. Investigation of these variances may not
prove beneficial.
! Even where a variance is significant, i.e. well above the tolerance level, investigation is only
worthwhile provided that the expected benefits (success in money terms multiplied by the
probability of success) exceed the cost of investigation.
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Procedures for Investigation
A proposed procedure for investigating variances is as follows:
! Standards should be broken down between those which are ideal and those which are
attainable. Variances, for the purposes of investigation, should concentrate on the difference
between attainable standards and actual results.
! To prevent management from setting unrealistic standards, staff participation is vital. Those
responsible for keeping within budget should have a say in the preparation of the budget. In
addition, management should try to learn from past mistakes. If in previous budget periods
planning variances were unusually large, then this may indicate that the budget was unrealistic,
perhaps because not enough trouble was taken to collect essential information on prices, etc.
! To overcome staff reluctance in budgeting, management and staff should arrange for training
on the budget-setting process. If staff are fully aware of the firm's objectives and goals, they
can then view budgeting in that context. When setting targets they may therefore try to obtain
a figure which best achieves the firm's stated objectives rather than pick on some arbitrary
figure.
! It would be helpful if staff were aware of the tolerance limit procedure that would apply when
selecting variances for investigation. The statistical model may seem like an accurate measure
but because it is hard to understand and implement a more practical solution would be the rule
of thumb method (see later).
! If staff are to maintain confidence in the budget procedure then accuracy is very important.
Costs should be coded correctly so that only those who authorise certain expenses are held
accountable for them. This is a basic requirement for responsibility accounting.
! Where corrective action is necessary, it should be taken as soon as possible otherwise the
variance may accumulate, causing profits to fall or even losses to emerge. It is helpful if a
variance for the current month is calculated and shown alongside a cumulative (year to date)
figure. By doing this a trend may be visible.
Trend Analysis
! Trend
It may appear obvious but it is very often overlooked that a variance that occurs in one period
may be a one-off or matched by an equal and opposite variance in the period immediately
before or after. What is important is that the trend must be examined to determine if it may be
a problem, either within the standards or in the operations. For instance, an adverse material
usage variance of 50,000 which is matched by a favourable variance of the same amount in
the preceding period, is of less significance than an adverse variance of 5,000 per month for
the last ten months.
! Materiality
The variance to be investigated must be of a suitable size to be worthwhile. In our previous
example, for instance, the variance of 5,000 per month would not be worth investigating if
total material usage was 500,000, but probably would be if it was only 50,000.
! Controllability
The ability to control the variance should also be taken into consideration when deciding if any
further action should be taken. A rise in the level of VAT, for instance, which adversely affects
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sales volume, cannot be controlled but higher wage levels due to excessive overtime can be
dealt with.
Variance Trend
Following on from our brief outline of the importance of trends within variance analysis it is worth
examining numerically the effects of trend over time.
Suppose, for example, that a firm has budgeted for a certain labour rate on a specific job. Figures are
compiled for a six month period, at which point they are analysed. The original budget assumes an
output of 10,000 units per month, and each unit required two hours of labour at a rate of 7.50 per
hour. The total labour cost per month was therefore expected to be 150,000 (10,000 2 7.50).
The following are the actual figures for the six month period:
Period Units Hours Total Cost Variance
%
1 9,900 19,900 155,000 3.33
2 9,500 19,950 160,000 6.66
3 9,850 20,200 158,000 5.33
4 10,600 21,500 175,000 16.66
5 10,900 21,200 172,000 14.66
6 10,000 20,500 165,000 10.00
The variance % is the difference in absolute terms from the original budget and makes no allowance
for variations in volume. As you can see, the volume in the first three months is down and costs are
up, but because the variance is quite low in percentage terms, it probably would not be investigated
until period 4, by which time volume has picked up but costs have risen still further. We can now go
on to calculate labour rate and labour efficiency variances and see how the trend has moved by
comparison.
Period Labour Rate
Variance
Labour Efficiency
Variance
Total Variance
%
1 5,750 (A) 750 (A) 6,500 (A) 4.33
2 10,375 (A) 7,125 (A) 17,500 (A) 11.66
3 6,500 (A) 3,750 (A) 10,250 (A) 6.83
4 13,750 (A) 2,250 (A) 16,000 (A) 10.66
5 13,000 (A) 4,500 (F) 8,500 (A) 5.66
6 11,250 (A) 3,750 (A) 15,000 (A) 10.00
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J ust to remind you of the calculation for the labour rate and efficiency variances; those for period 1
are as follows:
19,900 hours should cost ( 7.50 per hour) 149,250

Actual cost 155,000
Variance 5,750 (A)
Labour efficiency hours
9,900 units should take ( 2 hours per unit) 19,800
Actual hours taken 19,900
100 (A)
At the standard rate per hour of (7.50) 750 (A)
Total Variance 6,500 (A)
By looking at the variances it is possible to infer some potential causes which could be investigated
further; the labour efficiency variance, for example, rises quite strongly in period 2 which could
imply that new labour was taken on which may not have been as familiar with the processes involved
as the existing workforce. Thereafter, the efficiency variance falls, which could indicate the
existence of a learning curve effect on the part of the new workers.
Similarly, the labour rate variance is strongly adverse in periods 4, 5 and 6, which could indicate, if
taken with the increases in volume at the same time, that overtime rates were being paid.
Armed with this information managers can now decide on an appropriate course of action; should
they, for instance, employ more workers if the increased output is likely to continue, should more
training be provided to the new workers to overcome the adverse efficiency variance when they start?
Consideration should also be given to the standards; are they still realistic? There are relatively
adverse variances in labour rates, for instance, which do not drop below 5,750 in any month.
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The cumulative trend can also be calculated and this would provide an earlier indicator of things
going wrong (we shall look at the mechanics of this in more detail under control charts).
Numerically, the cumulative variances are as follows:
Before budget flexing After budget flexing
Period Adverse
Variance
Cumulative Adverse
Variance
Cumulative
% %
1 5,000 5,000 3.33 6,500 6,500 4.33
2 10,000 15,000 5.00 17,500 24,000 8.00
3 8,000 23,000 5.11 10,250 34,250 7.61
4 25,000 48,000 8.00 16,000 50,250 8.38
5 22,000 70,000 9.33 8,500 58,750 7.83
6 15,000 85,000 9.44 15,000 73,750 8.19
This shows that, after flexing the budget, the level of variance remains fairly constant at around 8%
and the large adverse movement occurs in periods 1 and 2. Without flexing the budget, the period
that seems to cause the trouble is number 4. If a cumulative variance of 8% was taken as the point at
which an investigation should be made then under the unflexed budget this would not be carried out
until period 4 by which time it may be too late to take corrective action. Under the flexed budget, the
problem would be identified in period 2, allowing corrective action to be taken that much earlier.
Management Signals
One of the most important purposes of trend analysis is to identify potential problems where an
interrelationship exists between different variances.
Examples of these signals include the following:
(a) Sales Price and Sales Volume
If demand for a product is inelastic (i.e. not affected unduly by sales price), then there should
be no problem as changes in price will correspond with changes in volume. In those instances
where demand is elastic, a small change in price will lead to a large change in volume. If a
company is attempting to increase its share of the market through higher volume, for instance,
it may be possible to identify this from trend analysis. It is likely that the trend for the sales
volume variance will be improving while sales price variance may be worsening or have
worsened but is now stable.
(b) Labour Rate and Labour Efficiency
We have already examined the link that can exist between these in our previous example. To
recap, employment of new members of staff may lead to a lower labour rate and hence a
favourable variance, whereas it is likely that, for a short time at least, labour efficiency will
suffer an adverse variance. The effects of the learning curve should not be discounted
subsequently.
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(c) Material Price and Material Usage
Another commonplace relationship exists between the quality of materials used and its effect
on price and usage variances. If a company decides to use a lower grade substitute material,
for instance, there could be a positive price variance which may be offset by a negative
efficiency variance. This is because the lower quality causes more wastage and a higher
volume of material is required to produce the same output as previously.
(d) Material Price
There can be many reasons for adverse material price variances which include seasonal
variations, general price inflation and scarcity of raw materials.
Uncertainty in Variance Analysis
It may appear from the foregoing that the investigation of variances is quite straightforward and they
can usually be attributed to a particular reason. Unfortunately, this is not the case and the following
are a few of the areas which can cause uncertainty over the true causes of variances:
(a) Planning
One reason for a variance, of course, may be that the original standards against which the
actuals are judged are incorrect. A major price rise imposed by a supplier may have been
missed when the original standards were set or a wage rise which occurred early in the budget
period may not have been forecast. In addition, if the standards are not regularly updated or
there is a long time-scale between updates it is likely that they will quickly become out of date.
(b) Measurement
Difficulties can arise in ascertaining figures with absolute certainty. Sales value and volume
are usually no problem if an adequate invoicing system is maintained, but material allocation is
much more difficult to identify with complete accuracy. Particular difficulties arise when
allocating power for instance.
(c) Model
Any variance analysis is only as good as the model that reports it. Any deficiencies in the
working of that model will cause shortcomings in the whole analysis, if, for example, a
relationship between variables (such as that discussed earlier) is not built into the model.
(d) Implementation
The people responsible for implementing the system of variance analysis may not be
implementing it correctly. This could be caused by a lack of training or a lack of willingness;
in the latter case this could be to hide potentially damaging results.
(e) Random Deviations
Figures reported are only ever averages and therefore some level of deviation must be
expected. Whether that level of deviation is acceptable or not is another matter and we shall
now consider the implications further.
Significant Variances
In directing the attention of managers to significant variances, we can ensure that the time they spend
on investigation and corrective action is directed to the areas that should yield the most productive
results. Sometimes, to decide the interpretation of significant on a percentage basis, e.g. any item
that shows a variance of +or 3% from budget, may not be satisfactory. The expenditure involved in
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a variance of that size may be insignificant when considering some budget items but it may be very
large indeed when other items are involved. It may be a better solution to lay down actual amounts of
variance that can be regarded as acceptable, but even this idea may have its drawbacks. An
apparently small variance in one department can lead to quite serious effects in other departments.
This is where the judgement and experience of managers are important.
Control Charts
When managers are presented with variance reports indicating that there is a need for investigation
and explanations, there must be a follow-up to ensure that the necessary action has been taken. This
control may be exercised by the financial manager so that at the time the reports are issued, control
charts are prepared, indicating the areas of deviation, the managers responsible and the time allowed
for reporting back. The explanations, when received, can be charted and they will form the basis for
subsequent reports to the Board. There should also be provision for the control of the results of
departments in later periods so that a judgement can be made on the effectiveness of the corrective
action that has been taken.
There are three types of control chart:
(a) Basic Variance Control Chart
This is shown as Figure 15.1. The weekly or monthly variances will be plotted and the chart
will show the favourable and adverse variance for each period. This is shown in absolute
terms, each period being independent of the others.
Figure 15.1: Variance Control Chart
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(b) Average or Mean Variance Chart
This type of chart (Figure 15.2) is based on statistical significance and uses the mean and
standard deviation (see later). The mean would be calculated in the usual way and, for
instance, one standard deviation set as the inner warning limit and two as the outer control
limit. The use of the inner warning limit serves as an early indication that a process may
shortly be out of control. The outer limit represents that situation occurring.
Figure 15.2: Average or Mean Variance Chart
(c) Cumulative Sum (Cusum) Chart
The important element of this chart (Figure 15.3)is that it uses the original data, as the name
suggests, in such a way that non-significant variances cancel each other out. Only when
variances are significant over a period of time do they become apparent. This is the main
difference from the previous examples which took absolute values in each period.
A cusum chart is also helpful for the purpose of investigating variances. The cusum chart
recognises that although individual variances may not be significant, when they are
accumulated they can be substantial. For instance, if a machine costs more to maintain and
repair than was budgeted for, this could indicate that the machine is coming to the end of its
useful life. Therefore, as the machine gets older, the maintenance expense will continue to
increase and over a period of time the variance may become significant. Obviously, if this
variance is picked for investigation, then the accountant can decide if the cost of replacing the
machine is less than the cost of repairing or maintaining the old machine.
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Figure 15.3: Cumulative Sum (Cusum) Chart
Statistical Significance Method of Control
This model is based on the concept of standard deviations and their dispersal around the mean. You
should recall from your earlier studies that a normal distribution is evenly distributed either side of
the mean and it is therefore possible, using probabilities, to determine the likelihood of a cost falling
outside a certain number of standard deviations from the mean.
Once the historical figures are known and the standard deviation has been calculated it is possible to
apply significance levels to future data to determine if further investigation is merited. At the 95%
significance level, assuming a normal distribution, there is a 95% chance that the data will lie within
1.96 standard deviations of the mean while at the 99% significance level there is a 99% chance that
the data will lie within 2.58 standard deviations from the mean.
Thus, if a 95% significance level is set, any errors more than 1.96 standard deviations from the mean
should be investigated, while at the 99% significance level, any data more than 2.58 standard
deviations from the mean will require further analysis.
As an example, suppose that a firm has determined its average expenditure on maintenance of its
machinery is 25,000 per month with a standard deviation of 1,000. If, in a particular month, a
variance of 2,250 was identified, should it be investigated further?
The answer depends on the significance level which the firm uses; 2,250 represents 2.25 standard
deviations; at 99% significance no further investigation will be called for because this is less than
2.58 standard deviations but at 95% significance it will be investigated because it is more than
1.96 standard deviations from the mean.
A business will have various different types of expenses, some of which will deviate considerably
from the mean and some of which will not. Those with a higher standard deviation will be given a
higher tolerance limit for investigation purposes.
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The advantage of using the statistical model is that predictable expenses (those with a low standard
deviation) will merit an investigation, if, for whatever reason, the variance is higher than it should be.
Alternatively, those small petty expenses which have a higher standard deviation will escape
investigation.
A problem with this model is that standard deviation must be calculated from past data. Past
performance may not continue and thus the standard deviation may not be appropriate for future data.
Statistical Decision Theory
Cost/benefit analysis can also be used to determine if a variance should be investigated. The theory
basically states that if the cost of investigating the variance exceeds the benefit to be derived
therefrom then the investigation should not take place.
The formula for this is as follows:
pB I +pC
where: p = the probability that the process is out of control
B = the benefit to be derived from corrective action
I = the cost of investigation
C = the cost of corrective action if it is required
Taking a simple example, assume that we have a variance of 10,000, the cost of investigating the
variance is 1,000, the cost of corrective action is 3,000, and there is a 50% chance that the variance
is controllable and the benefits from corrective action would be 6,000.
Using our formula, the calculation is as follows:
( ) ( ) 05 6000 1000 05 3000 . , , . , +
= 3,000 2,500
= 500
As the value is positive it is worth investigating the cause of the variance and taking the necessary
corrective action.
The difficulties with this approach are:
! To carry out this type of analysis for every variance on a regular basis would be very time-
consuming.
! The estimate of the probability that corrective action will work is highly subjective and
therefore prone to error.
! The estimates of the benefits to be derived from corrective action can also be difficult to
assess.
! The approach presupposes that the variance will not be repeated and it therefore fails to take
account of any future benefits to be derived from corrective action.
Rule of Thumb (or Heuristic) Method
Also known as the materiality significance model, this is not as sophisticated or accurate as the
above models but it is considered more practical. Here, a firm decides on a percentage (say 10%)
and investigates variances which are greater than the given percentage based on standard costs. The
great advantage of this model is its simplicity. Unfortunately there are several disadvantages:
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! Expenses with a high standard deviation will be continuously investigated regardless of
whether they are material or not.
! The setting of a particular limit is rather arbitrary, particularly if applied as a limit across all
expenditure. This can be overcome however by varying the percentage for different categories
of expenditure.
! If the limit is set too high there is the possibility that a variance that is regularly adverse but
does not quite exceed the limit will not be investigated when perhaps it should be.
! The benefits and costs of any investigation are ignored.
! There is no distinction between favourable and unfavourable variances.
! If variances which in the past have been low, say 3% adverse, then rise suddenly, up to 6%
adverse (i.e. a doubling of the variance), if the limit is set at 10% no investigation will take
place although clearly it should.
C. VARIANCE INTERPRETATION
Having looked at how variances arise, we shall now consider why. Once this is known, corrective
action can be taken if the variances are negative, or alternatively favourable variances can be
encouraged.
! Direct Material Price
This variance would probably be the responsibility of the Purchasing Department. Where the
actual purchase prices are below standard prices, the difference may arise from special
purchase terms, discounts, a general reduction in prices or the purchase of lower quality
materials.
Where the purchase prices are above standard, the cause may be a general rise in prices, a
change in materials specifications, or the purchase of smaller quantities from more than one
supplier, with a loss of discounts or less favourable terms.
! Direct Materials Usage
The material usage variance is primarily the responsibility of the factory foreman or supervisor.
It may be caused by faulty machinery, loss or pilferage, excess wastage, lower quality of
materials, faulty handling, or changes in inspection or quality standards.
! Direct Labour Rate
The wage rate variance can be caused by changes in wage rates not provided for in the
standards, or the use of a different class or grade of labour from that specified in the standards.
Unscheduled overtime premiums or shiftwork rates may also account for variations in labour
rates. Where wage rates have changed since the standards were prepared, the variance will not
be within the control of managers. Where a different grade of labour is used from that
specified, the manager may be held responsible and the matter would require further
investigation.
! Direct Labour Efficiency
The responsibility for the labour efficiency variance will generally rest with the supervisor or
factory foreman. It may arise through the use of a different machine or machines from those
specified, machine breakdown, lack of maintenance of plant, the use of defective or
substandard materials, the use of different grades of labour from those specified, changes in
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operating arrangements or inspection standards, or faulty rate-setting. Delays in production
can arise from lack of instructions or bad organisation.
! Variable Overhead Expenditure
The variance indicates that the total of the individual items making up the variable cost is
below standard cost of those items for the number of hours worked. It will be necessary to
examine each item in detail in order to show the causes of the difference. The costs covered
under this heading will be the variable elements of indirect wages, indirect materials and
indirect expenses. It will also be necessary to establish which managers or executives are
responsible for the control of these costs.
! Variable Overhead Efficiency
This follows the same pattern as that for the calculation of direct labour efficiency and,
therefore, the same causes will apply.
! Fixed Overhead Expenditure
As with variable overhead expenditure variances, the individual items must be examined to
identify where savings have been made or, in the case of adverse variances, where
overspending has occurred. In the case of fixed overheads, it is likely that a number of the
items will be outside the control of production managers or supervisory staff.
! Sales Margin Price
This variance, together with the sales volume margin/contribution variance is the responsibility
of the Sales Department. The change in selling prices may have resulted from sales at specially
discounted prices or from allowances for quantity purchases. The company might operate in an
industry in which prices are determined by market leaders, and it may be forced to follow the
market trends. The Sales Department must also check that price concessions given by its sales
staff are justified, and take care that any major price reductions are authorised by senior staff.
! Sales Margin Volume/Contribution
This variance may be caused by internal factors (through failure to achieve sales targets set in
the budget) or sales targets for representatives may have been set too optimistically, and not be
attainable in practice. External factors might include a general depression in the industry
concerned or the entry of new competitors.
D. INTERDEPENDENCE BETWEEN VARIANCES
We have touched on this subject already. The following are some of the more common areas where
variances can be interrelated.
! Labour Rate and Efficiency
An obvious interrelationship between two variances is that of labour rate and labour efficiency.
If, for example, less skilled workers are employed, it is likely that they will be paid at a lower
rate than the existing skilled employees. The result will be a favourable variance to the
standard (assuming that the standards are not adjusted in advance to allow for the dilution in
wage rates). However, the new employees, being less skilled, will take time to settle in and
benefit from training and the effect of the learning curve. It is likely, therefore, that an adverse
variance will occur in labour efficiency terms. (This can occur the opposite way round as well
if a more highly skilled team, costing more to employ, improves the rate of labour efficiency
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but leads to an adverse labour rate variance.) There is also the possibility that materials usage
may suffer because a lower efficiency level leads to more wastage.
! Material Price and Usage
Where more expensive materials are purchased, there will usually be an adverse materials price
variance as a result. A consequence of this, however, should be that the materials will be of a
better quality, which should result in less wastage and therefore a favourable usage variance.
There should also be less re-work and so a favourable labour efficiency variance should follow.
If cheaper materials are purchased, there may be a favourable price variance, but there may
also be greater wastage and therefore an adverse usage variance.
! Sales Price and Volume
Assuming that the usual rates of elasticity of supply and demand apply, an increase in sales
price should lead to a reduction in volume. This will mean that there will be a favourable price
variance but an adverse volume variance. The reverse will also apply and a reduction in price
should lead to increased sales, and therefore there will be an adverse price but a favourable
volume variance.
! Mix and Yield
Variations in the mix of materials used can have several outcomes. Using a more expensive
mix may lead to a favourable yield variance, but conversely an adverse mix variance will also
occur. If a cheaper mix is used, resulting in a favourable mix variance, the yield may be lower
giving an adverse variance. Sales volume might also suffer if the output is substandard and
difficult to sell. It may be necessary to sell at a discount, which in turn means an adverse sales
price variance.
The above are just some of the instances where a variance in one item may be related to a variance
elsewhere. Whenever you look at the causes of variances, it is always useful to bear this in mind and
consider whether there is any interdependence between them.
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301
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Study Unit 16
Management of Working Capital
Contents Page
A. Principles of Working Capital 302
Working Capital Cycle 302
Importance to the Organisation 302
Striking the Right Balance 303
B. Management of Working Capital Components 303
Management of Stocks 303
Management of Debtors 304
Management of Cash 305
Management of Creditors 306
C. Dangers of Overtrading 306
D. Preparation of Cash Budgets 306
Income 306
Expenditure 307
Advantages of Cash Budgets 307
E. Cash Operating Cycle 308
Control of Cash Operating Cycle 308
302 Management of Working Capital
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A. PRINCIPLES OF WORKING CAPITAL
Working capital is defined as the excess of current assets over current liabilities, i.e:
Working Capital =Current Assets Current Liabilities
Every business requires cash to meet its liabilities and all the constituents of working capital will, in
the short term, turn into cash or require cash.
Working Capital Cycle
When a business begins to operate, cash will initially be provided by the proprietor or shareholders.
This cash is then used to purchase fixed assets, with part being held to buy stocks of materials and to
pay employees wages. This finances the setting-up of the business to produce goods/services to sell
to customers for cash or on credit. Where goods are sold on credit, debtors will be created. When the
cash is received from debtors, it is used to purchase further materials, pay wages, etc; and so the
process is repeated. The following diagram summarises this cycle:
Figure 16.1
The working capital cycle is taking place continually. Cash is continually expended on purchase of
stocks and payment of expenses, and is continually received from debtors. Cash should increase
overall in a profitable business and the increase will either be retained in the business or withdrawn
by the owner(s).
Problems arise when, at any given time in the business cycle, there is insufficient cash to pay
creditors, who could have the business placed in liquidation if payment of debts is not received. An
alternative would be for the business to borrow to overcome the cash shortage, but this can be costly
in terms of interest payments, even if a bank is prepared to grant a loan.
Importance to the Organisation
Working capital requirements can fluctuate because of seasonal business variations, interruption to
normal trading conditions, or government influences, e.g. changes in interest or tax rates. Unless the
business has sufficient working capital available to cope with these fluctuations, expensive loans
become necessary; otherwise insolvency may result. On the other hand, the situation may arise where
Expenses incurred with
suppliers/ employees
Cash from debtors
DEBTORS
STOCK
Goods/services produced
CREDITORS
CASH
Management of Working Capital 303
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a business has too much working capital tied up in idle stocks or with large debtors, which could lose
interest and therefore reduce profits.
It is therefore extremely important to ensure that there is sufficient working capital at all times, but
that it is not excessive. Without adequate working capital a company will fail, no matter how
profitable or valuable its assets. This is because, if a company cannot meet its short-term liabilities,
suppliers will only supply on a cash-on-delivery basis, legal actions will start and will cause a
snowball effect, with other suppliers following suit.
Conversely, if working capital is too high, too much money is being locked up in stocks and other
current assets. Possibly excessive working capital will have been built up at the expense of fixed
assets. If this is the case, efficiency will tend to be reduced, with the inevitable running-down of
profits.
The balance sheet layout is ordered so as to show the calculation of working capital (i.e. current
assets less current liabilities). Provision of information about working capital is very important to
users of balance sheets, e.g. investors and providers of finance such as banks or debenture holders.
A prudent level of current assets to current liabilities is considered to be 2:1 but this depends very
much upon the type of business.
Striking the Right Balance
Excess working capital is a wasted resource and therefore the aim of good working capital
management should be to reduce working capital to the practical minimum without damaging the
business. The areas of concern will be stock, debtors, cash and creditors. The management of these
areas is an extremely important function in a business. It is mainly a balancing process between the
cost of holding current assets and the risks associated with holding very small or zero amounts of
them.
B. MANAGEMENT OF WORKING CAPITAL
COMPONENTS
The main objective in stock management is to ensure that the level of stock held is just sufficient to
meet customers requirements efficiently.
Management of Stocks
Control of stock levels begins with calculating the length of time taken to process an item from order
through to despatch. A flowchart can aid establishment of the minimum time path. Some safety
levels will need to be built in but these should be realistic and not excessive, as too much stock can
often end in increased obsolescent stock and decreased efficiency.
A J ust-in-Time (J IT) approach can be used, which entails converting raw materials for delivery to the
customer in the shortest possible time rather than producing stocks. However, this method needs very
careful planning and total supplier reliability. Such reliability is, of course, sometimes unattainable.
Stocks may, in a manufacturing business, include:
! Raw materials
! Work in progress
! Finished goods
The costs involved may be considered under two extremes:
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(a) Costs of Holding Stocks
! Financing costs the cost of producing funds to acquire the stock held
! Storage costs
! Insurance costs
! Cost of losses as a result of theft, damage, etc.
! Obsolescence cost and deterioration costs
These costs can be considerable estimates suggest they can be between 20% and 100% per
annum of the value of the stock held.
(b) Costs of Holding Very Low (or Zero) Stocks
! Cost of loss of customer goodwill if stocks are not available
! Ordering costs low stock levels are usually associated with higher ordering costs than
are bulk purchases
! Cost of production hold-ups owing to insufficient stocks
The organisation will seek the balance which achieves the minimum total cost, and arrive at optimal
stock levels.
Management of Debtors
The main objective in the management of debtors (or credit control) is to ensure that all credit sales
are paid within the agreed credit period with the minimum administration cost to the company. It is
important to maintain a balance so that customers are not alienated in the companys quest for
receiving payment on time. Credit terms, credit ratings, settlement discounts and collection
procedures need to be drawn up and communicated to the staff involved, from sales representatives to
credit controllers.
The terms may differ for different customers, perhaps depending upon the size of the order. In many
cases a small number of customers account for a high proportion of sales and therefore a large
proportion of debt. In these cases, collecting the cash from the sale should be treated as importantly
as the sale itself.
The following procedures may be adopted:
! Assignment of a high-calibre credit manager to deal with these customers.
! The credit manager to discover who is responsible for the payment decisions on behalf of the
customer and to deal with him/her personally.
! To liaise with the customer in advance of the due date to ensure that any disputes are resolved
and a promise of payment is obtained.
The management of debtors therefore requires identification and balancing of the following costs:
(a) Costs of Allowing Credit
! Financing costs
! Cost of maintaining debtors accounting records
! Cost of collecting the debts
! Cost of bad debts written off
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! Cost of obtaining a credit reference
! Inflation cost outstanding debts in periods of high inflation will lose value in terms of
purchasing power
(b) Costs of Refusing Credit
! Loss of customer goodwill
! Security costs owing to increased cash collection
Again, the organisation will attempt to balance the two categories of costs although this is not an
easy task, as costs are often difficult to quantify. It is normal practice to establish credit limits for
individual debtors.
Ratio of Debtors to Sales (or Debtors Turnover Ratio)
It is useful to be able to calculate the number of days credit allowed to customers and compare this
with the general conditions in the same industry. This figure is obtained as follows:
365
sales Credit
debtors Average
= credit days' of Number
By taking trade debtors as a fraction of total credit sales, we have an indication of the proportion of
sales unpaid at the end of the year. For example, if the figure is one-twelfth then we can more or less
assume that no sales made within the last month have been paid for. As this ratio is normally
expressed in days, the fraction is multiplied by 365.
Similarly, the ratio of creditors to purchases indicates the use of credit that we are making. A rising
ratio is not sound.
If the average debtors figure is unavailable, debtors at the year-end can be used.
Management of Cash
Cash at bank and cash in hand should also be carefully monitored, to ensure that sufficient cash is
available to meet all needs, but not to have idle cash which could be put to a profitable use.
The preparation of cash budgets (see later) aids the control of cash flow by planning ahead for the
cash requirements of the business.
Again, two categories of cost need to be balanced:
(a) Costs of Holding Cash
! Loss of interest if cash were invested
! Loss of purchasing power during times of high inflation
! Security and insurance costs
(b) Costs of Not Holding Cash
! Cost of inability to meet bills as they fall due
! Cost of lost opportunities for special-offer purchases
! Cost of borrowing to obtain cash to meet unexpected demands
Once again, the organisation must balance these costs to arrive at an optimal level of cash to hold.
The technique of cash budgeting is of great help in cash management.
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Management of Creditors
Whereas a business needs to make sure that excessive cash is not tied up in debtors and stock, it also
has to attempt to maximise the credit period from suppliers, without incurring the risk of supplies
being cut off. Payment dates should therefore be adhered to as far as is practically possible.
Suppliers may be more willing to give extended credit terms if the company shows itself to be
reliable about repayment dates.
By ensuring that the organisation is always in a position to meet its liabilities, the reputation of the
business will grow from the viewpoint of obtaining credit from its suppliers.
C. DANGERS OF OVERTRADING
Overtrading is expansion with insufficient working capital. Even a profitable firm can have cash-
flow problems when it is trying to expand, despite the fact that no additional capital equipment is
required.
Consider a hypothetical firm which is trying to expand:
! In J anuary it takes on extra salesmen extra cost straight away. They take time to get
established, and do not bring in extra orders until March.
! During February the firm has been building up its raw material stocks in anticipation of the
extra orders, and its suppliers must be paid in March or April.
! During April additional overtime has to be worked to process the extra orders more
additional cost.
! The goods are completed during May and delivered to the customers, to whom, in accordance
with normal practice, the company grants one months credit.
! Cash is not received until J une the firm has had to finance extra costs for almost six months
before it starts to get any benefit.
This clearly shows the difficulties which can arise. It is all very well to launch a business on a plan
where sales yield a certain profit figure as per the budgeted profit and loss account, but these plans
must be backed up by the available cash. By preparing a cash budget, a business can anticipate such
problems and therefore plan for them for instance by arranging a loan for the crucial period. If it
does not make such plans a firm could be forced into liquidation by creditors whom it cannot pay.
D. PREPARATION OF CASH BUDGETS
When drafting cash budgets, essentially all we are doing is writing up bank and cash accounts in
advance. All expected income and expenditure will be included.
Income
(a) Sales
Sales revenue will generally form the bulk of the revenue. The sales budget can be broken
down by reference not only to when the goods will be sold, but to when the payments are likely
to be received.
There will be some cash sales, i.e. sales which are paid for immediately, and some credit sales.
The cash from credit sales will be included in the cash budget after the normal term of credit
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has elapsed, or after the period of time which has been shown by experience to be normal
between the sale and the receipt of cash.
(b) Sundry Revenue Items
These are all sundry items of revenue income which are not covered by sales:
! Rent of property leased: the date of receipt and amount will be readily available from
leases.
! Interest on loans etc: again, reference may be made to agreements and past experience
to establish the amounts receivable and the dates on which receipts can be anticipated.
! Income from investments: Stock Exchange records will assist in establishing the time
of receipt and the expected amount.
(c) Sundry Capital Items
This will include all proceeds of sale of assets and repayments of loans. Information of this
type may be obtained from the capital expenditure budget by referring to the new items and
assessing the probable income from the sale of the old, and also agreements relating to loans
outstanding.
Expenditure
Items of expenditure may include the following, but note that the list is not exhaustive:
! Purchases of goods and services required to be paid in any period. Payment dates will be
calculated according to the normal period of credit allowed by suppliers.
! Capital expenditure due to be paid, e.g. for new fixed assets.
! Wages and salaries
! Light, heat, telephone etc.
! Loan repayments
! Miscellaneous expenses, e.g. subscriptions
Note: Depreciation should NOT be included because this is not a CASH expense.
Advantages of Cash Budgets
(a) Credit Rating
By ensuring that the organisation is always in a position to meet its liabilities, the reputation of
the business will grow from the viewpoint of obtaining credit from its suppliers.
(b) Finance Planning
Having consciously examined the position with regard to the availability of cash, it may be
found that at given points of time there will be either a shortage or surplus of cash.
! Cash Shortage
An adjustment to expenditure may be made, e.g. purchase of a fixed asset may be
delayed, or an approach can be made to the bank to provide short-term credit facilities.
Where a bank is shown the full position, supported by a system of budgets, it is more
likely that sympathetic treatment will be given to the request.
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! Cash Surplus
Arrangements can be made to invest in the best possible short- or long-term
propositions, as appropriate. Full advantage can be taken of any discounts offered by
suppliers for prompt payment.
E. CASH OPERATING CYCLE
The length of time it takes between paying for stock through to receipt of cash from debtors is called
the cash operating cycle.
Example
A company purchases materials on 1 J uly. The materials are issued to production on 1 August and
payment to the supplier is made on 15 August. The finished goods are sold to customers on
1 September and cash is received from debtors on 1 November.
The stock is taking 2 months to be turned into finished goods (i.e. from 1 J uly to 1 September).
Debtors are taking 2 months to pay (from 1 September to 1 November) and the credit period taken
from suppliers is 1 months (from 1 J uly to 15 August). The cash operating cycle is therefore:
Stock turnover period 2 months
Debtors turnover period 2 months
Creditors turnover period (1 months)
Cash operating cycle 2 months
The company therefore needs cash available to cover the cash operating cycle of 2
1
2
months.
Control of Cash Operating Cycle
To detect a possible shortage of working capital, a careful watch should be kept on the ratio of
current assets to current liabilities. If, year by year, trade creditors are growing faster than trade
debtors, stock and bank balances, we may well suspect that, before long, the business will be short of
working capital. The speed with which a company collects its debts and turns over its stock are also
indications of the working capitals adequacy.
(a) Control of Stocks
Stock turnover rates should be calculated and monitored regularly. Comparison of these rates
from one period to another will reveal whether the stock management of the company is
deteriorating or improving; and this will be an indicator of the general management standards
of the company.
Comparison of stock turnover rates will also reveal any tendency to manufacture for stock.
Manufacturing goods to be held in stock is a dangerous practice as it involves the company in
expenditure on materials, wages, expenses, etc. but no receipts will be obtained for these items.
(b) Control of Debtors
Debtors turnover rates should also be calculated and monitored regularly. Any increase in the
length of time debtors take to pay could indicate one of the following:
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! A decline in the number of satisfied customers (implying a drop in standards of
management, manufacturing or delivery).
! A drop in the standard of debt control.
! A falling-off in favour of the companys product, forcing the company to maintain
turnover by selling on credit to customers to whom it could not usually offer credit.
Many companies compute a debtors turnover ratio which indicates how long, on average,
customers are taking to pay their accounts. Whilst this is a useful indicator, it can hide the fact
that some of these debtor accounts may be many months overdue. The debtor age analysis
highlights this area and is a useful measurement of credit performance.
Example 1
A company calculates its debtors turnover ratio to be 60 days, which it considers reasonable.
However, an examination of the debtor balances reveals the following situation:
Aged Debt Analysis
%
Current 38
1st overdue month 27
2nd overdue month 18
3rd overdue month 6
4th overdue month 4
5th overdue month 4
6th overdue month 3
100
You can see that debts are remaining unpaid beyond 3 months. This unsatisfactory situation
would not be apparent from the debtors turnover ratio.
The above information summarises the situation, but a company will require detailed
information about each customers account. The following example is an illustration of the
breakdown of customers accounts.
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Example 2
Debt Age Analysis as at 31 May
January and
earlier
February March April May

A.P. Acorn & Son 120 50 310
S. Appleyard & Co. 75 120
Archworth Ltd 120 35
Babblebrook & Co. 820 55
Beeston Booth Ltd 360 480 250
Brook Simpson Ltd 240 510 390
Bush & Son 160 110 430
Captown & Co. 75 160
If company policy is to give 30 days credit then any amounts outstanding before April will be
overdue and should be chased up. It may be that there is a query such as a credit note
outstanding for faulty goods, but the sooner the query is settled, the sooner the balance will be
cleared. This information is very useful and should be acted upon speedily to ensure payment
as quickly as possible, but without harassing customers to the extent that valuable future
business may be lost.
(c) Control of Creditors
Monitoring the creditors turnover period (i.e. how long the business is taking to pay its
suppliers) from one period to the next will reveal:
! Whether the firm is receiving a reasonable period of credit.
! Whether it is taking full advantage of credit periods.
! Whether it is extending credit periods to dangerous levels which could lead to supplies
being cut off.
311
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Study Unit 17
Financial Mathematics I: Interest and Present Value
Contents Page
A. Simple Interest 312
B. Compound Interest 314
Compound Interest Formula 314
Additional Investment 316
C. Present Value 318
Application to Business Decision-Making 319
D. To Find the Rate or the Number of Years 322
E. Depreciation 323
Sinking Funds 325
Answers to Questions for Practice 327
312 Financial Mathematics I: Interest and Present Value
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A. SIMPLE INTEREST
Interest (I) is a charge for the use of money for a specific time. This charge is usually expressed as a
percentage called the rate per cent per annum (i.e. the amount to be paid for each 100 borrowed
for one year). Three factors determine the amount of interest:
! The sum of money on which the interest is payable; this is known as the principal (P).
! The rate (R).
! The length of time for which the money is borrowed.
When the interest due is added to the principal, the sum is called the amount (A), which is the
amount to be repaid.
Simple interest is interest reckoned on a fixed principal. Simple interest is therefore the same for
each year, and the total is found by multiplying the interest for one year by the number of years.
Example 1
(a) Find the simple interest on 200 for 3 years at 4% per annum.
Simple interest =200 24
4
100
3
(b) Find the simple interest on 200 for 3 months at 4% per annum.
Simple interest =200 2
4
100
3
12
To calculate the simple interest on a sum of money lent for a given time at a given rate per cent per
annum, the following formula is used:
I =
P R Y
100

(Y =time in years)
Note that when using symbols, the multiplication sign is omitted.)
We can use this formula to solve any problem on simple interest in which we are required to find the
principal, rate, time or interest. There are four quantities involved, so given any three, we can find
the other one.
So, starting with the basic formula:
I =
100
PRY
Multiplying both sides by 100 (or cross-multiplying), we get:
I 100 = PYR
Therefore:
P =
I 100
YR
Y =
I 100
PR
R =
I 100
PY
We can summarise this position as:

Unknown factor =
Interest 100
Two known factors
Financial Mathematics I: Interest and Present Value 313

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When you are working examples always:
! State the formula.
! Give the values to be substituted.
! See that the numbers you use are in the correct units.
! Remember to write the correct unit against the answer, not just a number only.
Example 2
(a) At what rate of simple interest will 500 earn 75 in 4 years?
R =
I 100
PY
I =75, P =500, Y =4
Therefore, R =
75 100
500 4
375%
.
(b) What sum of money will earn 2.50 at 5% per annum simple interest in 1 month?
P =
I 100
YR
I =2.50, Y =
1
12
, R =5%
Therefore, P =
250 100 12
5 1
.
=600
(c) What sum of money will amount to 500 in 4 years at 4% per annum simple interest?
Amount is principal plus interest:
A =P +
,
_
100
YR + 100
P
100
PYR
P =
YR + 100
A 100
A =500, Y =4, R =4
Therefore, P =
) 4 4 ( 100
500 100
+
=431
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B. COMPOUND INTEREST
In compound interest, the interest due is added to the principal at stated intervals, and interest is
reckoned on this increased principal for the next period, and so on, the principal being increased at
each period by the amount of interest then due.
Example
Find the compound interest and the simple interest on 1,000 invested at 2 % per annum for 4
years.
(a) Principal 1,000

add 1st years interest at 2% 25
Amount at end of 1st year 1,025
add 2nd years interest at 2% 25.625
Amount at end of year 2 1,050.625
add 3rd years interest at 2% 26.265625
add 4th years interest at 2% 26.922266
Final amount at end of 4 years = 1,103.812891
= 1,103.81
Therefore, compound interest =Final amount Principal =1,103.81 1,000 =103.81
(b) The simple interest on 1,000 at 2 % per annum over 4 years is 25 per annum (always
constant) or 100.
i.e. 1,000
25
100
4
.
100.
Now work through the above example by yourself to ensure that you fully understand the principles
involved, and then answer the following question.
QUESTION FOR PRACTICE (Answers at end of study unit)
1. Find the amount at compound interest on 3,000 at 6 per cent per annum for 2 years. Interest
is paid each six months. (Note that amount is defined as principal +interest; and that you must
add the interest due to the principal each six months.)
Compound Interest Formula
If P is the principal, and if r is the rate of interest on 1 for 1 year, then the interest on P for 1 year is:
P r, written as Pr.
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At the end of the 1st year the interest is added to the principal. Therefore:
The new principal at the end of year 1 = P +Pr or P(1 +r).
At the end of the 2nd year, the interest on the new principal, i.e. P(1 +r) is:
P(1 +r) r or Pr(1 +r).
The principal at the end of the 2nd year is now P(1 +r) +Pr(1 +r). This can be written as:
(P +Pr) (1 +r), which equals P(1 +r)
2
.
You will see that the new principal at the end of n years is equal to P(1 +r)
n
, and we therefore have
the formula for the evaluation of compound interest, which is:
A =P(1 +r)
n
where: A = final amount
P = original sum invested
r = rate of interest per annum on 1
n = number of years
Remember that r is the rate of interest on 1 for 1 year. Therefore, if the question refers to a rate of
interest of 5 per cent per annum,
(1 +r) becomes 1 +
5
100
105 .
You must become accustomed to thinking in these terms, so that visualising the formula becomes
automatic. Learn the formula by heart. Say it to yourself over and over again until it is firmly
imprinted on your mind.
Having now learned and understood the formula A =P(1 +r)
n
you will find that the real problem lies
in the evaluation of (1 +r)
n
. This is most conveniently done by the use of a calculator or by
logarithms, especially when n is large. It is usual to use seven-figure logarithms, as four-figure tables
are not sufficiently accurate for compound interest calculations.
Example 1
Find the compound interest on 1,000 for 3 years at 2 % per annum. Give the answer to the nearest
penny.
Method (a): Using 4-figure logarithms
A = P(1 +r)
n
= 1,000 (1.025)
3
log A = log 1,000 +(3 log 1.025)
= 3.0000 +(3 0.0107)
= 3.0000+0.0321 =3.0321
Therefore, A = antilog 3.0321 = 1,076.00
Therefore, compound interest = A P = 1,076 1,000 = 76
Method (b): Using ordinary multiplication (i.e. a calculator)
A = P(1 +r)
n
= 1,000 (1.025)
3
= 1,000 (1.025 1.025 1.025) = 1,000 1.076890625
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= 1,076.890625 = 1,076.89
Therefore, compound interest = A P = 1,076.89 1,000 = 76.89
You will see that method (b) differs from method (a) by 89p. This example serves to illustrate the
danger of using 4-figure logarithms in solving a problem requiring a high degree of accuracy.
Method (c): Using 7-figure logarithms
Now let us see what answer we obtain by using 7-figure logarithms.
log A = log 1,000 +(3 log 1.025) (found from method (a))
= 3.0000 +3 0.0107239 = 3.0321717
A = antilog 3.0321717 = 1,076.89
Therefore, compound interest = A P = 76.89
Thus 7-figure logarithms give acceptable accuracy.
Example 2
Calculate the compound interest to the nearest penny on 1,000 for 2 years at 6 % per annum, interest
being calculated each six months.
A = P(1 +r)
n
= 1,000 (1.03)
4
= 1,000 (1.03 1.03 1.03 1.03)
= 1,000 1.12550881 = 1,125.50881 = 1,125.51
Therefore, compound interest = A P = 1,125.51 1,000
= 125.51 to the nearest penny
Having worked carefully through the preceding examples, try to answer the following questions.
QUESTIONS FOR PRACTICE
2. What is the compound interest on 80 in 3 years, interest being at the rate of 5 % per annum?
3. Find by how much the amount at compound interest exceeds the amount at simple interest on a
sum of 1,288 for 3 years at 2 % per annum.
Additional Investment
Suppose you decide to invest 2,000 at the beginning of a particular year and that you add 100 to
this investment at the end of each year. If interest is compounded at 9 % per annum, then we can
deduce:
The amount invested at the end of the first year is:
2,000(1 +0.09) +100
The amount invested at the end of the second year is:
2,000(1 +0.09)
2
+100(1 +0.09) +100
The amount invested at the end of the nth year is:
2,000(1 +0.09)
n
+100(1 +0.09)
n1
+100(1 +0.09)
n2
+... +100(1 +0.09) +100
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Ignoring the first term on the right-hand side, the other terms can be written:
100 +100(1 +0.09) +. . . +100(1 +0.09)
n2
+100(1 +0.09)
n1
i.e. they form a GP with first term 100 and common ratio (1 +0.09). Thus, using the formula for the
sum of n terms of a GP, these terms can be written more concisely as:
100
( ) ( )
109 1
109 1
109 1
009
.
.
100
.
.
n n

Supposing we wish to know the amount invested after 3 years, then we put n =3.
Amount = 2,000(1.09)
3
+100
( )
109 1
009
3
.
.

= 2,590.06 +327.81 = 2,917.87
In general, if an amount P is invested at the beginning of a year and a further amount a is invested at
the end of each year, then the sum, S, invested after n years is:
S = P(1 +r)
n
+a(1 +r)
n1
+a(1 +r)
n2
+. . . +a(1 +r) +a
= P(1 +r)
n
+a
( ) 1 1
1 1
+
+
r
r
n
( )
=P(1 +r)
n
+a
( ) 1 1 + r
r
n
=(P + ( )
a
r
r
a
r
n
) 1+
It is probably not worthwhile trying to remember this formula but you should know how to obtain it
and apply it to specific examples. Similar reasoning can of course be applied when the investment is
reduced by a constant amount.
4. You win 1,500 on the football pools which you invest on the stock market. Your accountant
advises you that the value of your investment can be expected to grow by 8% per annum.
Estimate the value of the investment after 8 years. You now decide to make an additional
annual investment of 100. If the first purchase is made one year after your pools win,
estimate the value of the investment after 8 years.
5. The managing director is due to retire at the end of the year and the board vote that an income
of 12,000 p.a. be paid to him or his family for 10 years. You, as the company accountant,
have been instructed to set aside now, a sum of money from which the income will be paid. If
the fund can be invested at 8% per annum, how much should you set aside? (Hint: the sum
invested at the end of the period will be zero.)
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C. PRESENT VALUE
The present value of a future sum of money is best defined as the principal which will amount to a
given sum of money in a given number of years invested at compound interest.
Consider the equation A =P(1 +r)
n
By simply dividing by (1 +r

)
n
, we have
( )
A
r
P
n
1+

This gives us the equation for calculating present value:
( )
A
r
n
1+
Example 1
What is the present value of 1,000 due in 3 years? (Interest is compound at 2 % per annum.)
Present value =
( )
A
r
n
1+
=
1000
1025
3
,
( . )
=
1000
1076890625
,
.
= 928.60 to nearest p
Example 2
What is the present value of a claim for 1,500 due in 3 years at 5 % per annum? Answer to nearest
penny.
Present value =
( )
A
r
n
1+
=
1500
105
3
,
( . )
=
1500
1157625
,
.
= 1,295.756 =1,295.76 to nearest p
A table showing the present value of 1 received or paid over n years is given in the Appendix to Unit
18. Using these tables for Example 2, where r =5 per cent and n =3 years, we have:
PV of 1 = 0.8638
Therefore, PV of 1,500 = 0.8638 1,500 = 1,295.70
This agrees with our previous answer. In the next study unit we shall make more use of PV tables.
6. What sum invested now would yield 1,000 after 5 years at compound interest rate 5% per
annum?
7. A manufacturer proposes to purchase some machinery. Under the terms of the contract he has
to pay 2,500 now and 7,500 in two years time. What is the present cash value using a 6%
interest rate compounded annually?
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Application to Business Decision-Making
(a) Annuities
An application of the concept of present value is to annuities. An annuity is an investment
which earns interest for a number of years but from which we draw a given sum of money each
year until the capital and interest are exhausted. We have in fact tackled this type of question
(in Practice Question 5) but we shall now look at annuities using the concept of present value.
Consider an annuity yielding a per year when the rate of interest is r per 1 per annum over a
period of n years.
PV of a receivable one year hence =
a
1+r
PV of a receivable two years hence =
( )
a
1+r
2
PV of a receivable n years hence =
( )
a
1+r
n
Therefore, the total present value of the annuity is (in ):
( )
( ) ( )
a
1+r
a
1+r
a
1+r
n
+ + +
2
...
This is a GP with first term
a
1+r
, ratio
1
1+r
.
Its sum =
( )
a
1+r
r
r)
n
1
1
1
1
1
1
1
]
1
+
( )
(
=
[ ] a
(1+r)
r)
r
(1+r)
n
1 1 +

(
= a
[ ]
1 1 +

( r)
r
n
Using our earlier example (Practice Question 5) we have
a =12,000, r =0.08, n =10
Thus the present value of the annuity is:
12,000
[ ]
1 108
008
12000
008
1 046319
10

1
]
1

( . )
.
,
.
.
= 80,521
which agrees with the earlier result.
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8. On retiring at 65, a male employee can choose between a terminal gift of 2,000 or a pension
amounting to 450 per year for life. Assume a rate of interest of 5% and that a man aged 65
has a life expectancy of 7 years, to work out which option the employee should choose. (You
may assume that the lump sum would not be invested.)
9. In order to purchase a property for 20,000 a loan of 15,000 is negotiated with a finance
company. The balance of 5,000 is to be paid out of personal resources. The terms of the loan
are as follows:
! Duration of the loan is for 15 years.
! Rate of interest is fixed at 10% per annum throughout the 15 years. The annual interest
charge is to be calculated on the balance outstanding at the beginning of each year.
! Repayment is to be in 15 equal annual instalments.
! Each instalment will include both interest and capital.
You are required to calculate the amount to be paid each year on the loan of 15,000.
(b) Amortisation of a Debt
It is often necessary to work out the amount that must be paid at regular intervals to clear a
loan or mortgage. For example, if a mortgage of 12,500 repayable over 25 years is taken out
at a rate of 14% per annum, what annual repayments are required to clear the loan, assuming
the interest rate does not change?
Method (i)
Let X be the annual repayment.
At the end of the first year, X is repaid so the amount (in ) outstanding is:
12,500 (1 +r) X
At the end of the second year, X is repaid and the amount (in ) outstanding is:
12,500 (1 +r)
2
X(1 +r) X
Similarly after 25 years, the amount () outstanding is:
12,500 (1 +r)
25
X(1 +r)
24
X(1 +r)
23
. . . X(1 +r) X
However, this amount must be zero to clear the loan.
Therefore,
12,500 (1 +r)
25
X(1 +r)
24
X(1 +r)
23
. . . X(1 +r) X = 0
X[1 +(1 +r) +(1 +r)
2
+. . . +(1 +r)
23
+(1 +r)
24
] = 12,500 (1 +r)
25
X
(
( )
, ( )
1 1
1 1
125001
25
+
+
1
]
1
+
r)
r
r
25
Where we have used
S
n
=a
(r
r
n
1
1
)
, for the sum of a GP.
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Therefore:
X
(
, ( )
1 1
125001
25
+
+
r)
r
r
25
X =
125001
1
, ( +
r) r
(1+r)
25
25
= 1,818.73, putting r =0.14
Thus 25 annual repayments of 1,818.73 are needed to clear the loan.
Method (ii)
Let X be the annual repayment.
The present value () of X payable 25 years hence is
X
(1+r)
25
The present value () of X payable 24 years hence is
X
(1+r)
24
Similarly, the present value () of X payable one year hence is
X
(1+r)
.
The sum of all these present values must equal 12,500, the amount of the loan.
Therefore:
X
(1+r)
25
+
X
(1+r)
24
+... +
X
(1+r)
=12,500
X
1
1
1
1
1
1
12500
( (
... ,
+
+
+
+ +
+
1
]
1

r) r) r
25 24
X
1
1
1
1
1
1
1
1
12500
+
_
,
1
]
1
1
1
1
r
r)
r
25
(
,
where we have used
S
n
=a
(1- r
r
n
)
1
for the sum of a GP
Therefore:
X
r r)
25
1
1
1
12500
+
1
]
1

(
,
X =
125001
1
, ( +
r) r
(1+r)
25
25
This is identical to the formula obtained using Method (i).
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10. 20,000 is borrowed from a building society, repayable over 20 years at 14% per annum
compound interest. How much must be repaid each year?
11. On 31 December Year 1 a man borrowed 100. The terms of the loan were:
(i) Interest to be compounded at 6% p.a.
(ii) He would repay 20 each 31 December.
By 31 December Year 6 he had, in fact, saved enough money to pay off the loan with interest in
full. What sum did he repay?
D. TO FIND THE RATE OR THE NUMBER OF YEARS
Having learned the formula A =P(1 +r)
n
and having worked through the examples shown, you can
use the formula for finding the rate per cent or the number of years, provided A and P are given or a
relationship between them is established.
Example 1
In how many years will 100 amount to 112.36 at 6% compound interest, interest being computed
yearly?
Formula is: A = P(1 +r)
n
In this case: P =100, and A =112.36
Therefore, 112.36 = 100(1 +0.06)
n
1.1236 = 1.06
n
This expression can be solved by taking logarithms of both sides of the equation:
log 1.06
n
= log 1.1236
nlog 1.06 = log 1.1236
n =
log 1.1236
log 1.06
=
00506
00253
.
.
= 2 years
Example 2
At what rate per cent will a principal of 100 amount to 115.76 in 3 years?
Formula is: A = P(1 +r)
n
In this case: P =100, and A =115.76
Therefore, 115.76 = 100(1 +r)
3
1.1576 = (1 +r)
3
(1 +r) = 11576
3
. =
3
1
) 1576 . 1 (
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To evaluate
3
1
) 1576 . 1 ( , we must use either a calculator with an
Y
1
X facility or logarithms.
! Using a calculator,
3
1
) 1576 . 1 ( =1.05
! Using logarithms,
log
3
1
) 1576 . 1 ( =
3
1
log 1.1576 =
00636
3
00212
.
.

3
1
) 1576 . 1 ( = antilog 0.0212 = 1.05
1 +r = 1.05
r = 0.05
i.e. rate of interest is 5% per annum.
QUESTION FOR PRACTICE
12. If the sum of 1,000 becomes 1,210 after 2 years, find the accumulated amount (to the
nearest ) after 4 years, assuming a constant rate of compound interest.
E. DEPRECIATION
Depreciation is a loss in value. Such things as land, buildings, machinery, furniture and fixtures are
the fixed assets of a business. These may drop in value, but their true market value must be recorded
periodically as a book value. The depreciation can be calculated either on a straight line method, i.e.
a fixed sum over the life of the asset, or on a reducing (or diminishing) balance method where the
book value is reduced by a fixed percentage each year.
Example 1
Company A bought a fleet of 20 cars for its salesmen each costing 5,250. It decided to write off
equal instalments of the capital cost over 5 years. Company B bought an exactly similar fleet but it
decided to write off 20% of their value each year. Calculate the value of the cars to Company A and
to Company B at the end of the third year.
Capital outlay = 5,250 20 = 105,000
! Company A (straight-line method):
Depreciation for 3 years =
105000
5
3
,
= 63,000
Company A value at the end of 3 years = 42,000
! Company B (reducing balance method):
Depreciation during first year =
20
100
105000 , =21,000
Book value after Year 1 = 84,000
Depreciation during second year =
20
100
84000 , =16,800
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Depreciation during third year =
20
100
67200 , =13,440
Example 2
The furniture and fixtures of a building cost 12,000. The firm writes off 6% at the end of each year
as depreciation. What will be their book value after 3 years?
Depreciation during 1st year =
6
100
12000 , = 720
Book value after one year = 12,000 720 = 11,280
Depreciation during 2nd year =
6
100
11280 , = 676.80
Book value after two years = 11,280 676.80 = 10,603.20
Depreciation during 3rd year =
6
100
1060320 , . = 636.19
Book value after 3 years = 10,603.20 636.19 = 9,967.01
We can rewrite the above example in general terms. Let P be the original value and let r be the rate
of depreciation on 1 per year. The problem is to find the book value after n years.
Depreciation during 1st year = Pr
Book value after one year = P Pr = P(1 r)
Depreciation during 2nd year = P(1 r)r
Book value after two years = P(1 r) P(1 r)r
= P(1 r) (1 r) = P(1 r)
2
After n years, book value = P(1 r)
n
You can check that this gives the same answer as before by substituting r =0.06, n =3 and
P =12,000.
Sometimes we need either to calculate the annual rate of depreciation or the number of years before
the book value drops below a certain figure. Calculations of this type involve the use of logs to solve
the equation for r or n and you should study the following examples carefully to make sure that you
understand every step.
Example 3
It is estimated that a machine costing 5,000 will have a saleable value of 2,048 after four years.
Find the depreciation rate per cent to be applied during the four years life assuming the reducing
balance method of depreciation is used.
P =5,000, n =4, r =rate of depreciation on 1 per year
Book value after 4 years =2,048
but this book value also equals 5,000(1 r)
4
i.e. 2,048 =5,000(1 r)
4
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To solve equations of this type, always isolate the term containing the power:
(1 r)
4
=
2048
5000
,
,
= 0.4096
(1 r) =
4
1
4096 . 0
Using a calculator,
4
1
4096 . 0 = 0.8
Using logarithms:
log
4
1
4096 . 0 =
4
1
log 0.4096 =
1.6124
4
=
+ 1 06124
4
.
=
03876
4
.
= 0.0969
Thus (1 r) =antilog (0.0969)
We cannot look up the log of a negative number so we must rewrite it in bar number form first, i.e.
(1 r) = antilog ( 1.9031)
1 r = 0.8000 using tables of antilogs
1 0.8000 = r
r = 0.2
Thus the depreciation rate per cent is 0.2 100 =20%
Sinking Funds
Usually a company puts aside a regular sum of money into a sinking fund so that, when a piece of
machinery has to be replaced, the cost of its replacement can be met from the fund.
Example
A machine has an expected life of seven years and its replacement price is expected to be 5,000.
How much money should be set aside each year to cover this replacement cost if the money can be
invested at 7% per annum?
Let a be the sum invested at the end of each year.
Value of investment (in ) at end of Year 1 =a
Value of investment (in ) at end of Year 2 =a +a(1 +0.07)
Value of investment (in ) at end of Year 3 =a +a(1 +0.07) +a(1 +0.07)
2
Value of investment (in ) at end of Year 7 =a +a(1 +0.07) +a(1 +0.07)
2
+.

.

. +a(1 +0.07)
6
This can be simplified as it is a GP with common ratio 1.07. Therefore:
Value at end of year 7 = a
( )
107 1
107 1
7
.
.

= a
( ) 160578 1
007
.
.

= a
060578
007
.
.
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However, we are told that this value has to be 5,000. Therefore:
5,000= a
060578
007
.
.
a =
350
060578 .
=578 to nearest whole number
Therefore the amount to be set aside each year in the sinking fund is 578.
Once again this formula can be generalised. If at the end of each year a sum a is invested at rate r
per 1 per annum and the process is repeated for n years, then the value, T, of the investment after n
years is given by the sinking fund formula:
T = a
( ) 1 1 + r
r
n
You should try to obtain this result yourself.
13. A machine costing 5,000 will have an estimated useful life of 5 years after which its scrap
value will be 389. If the reducing balance method of depreciation is to be used, find the
annual percentage rate of depreciation.
14. An asset costing 40,000 is expected to have a useful life of 20 years after which its scrap
value will be 4,000. If the reducing balance method of depreciation is to be used, find the
annual percentage rate of depreciation.
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ANSWERS TO QUESTIONS FOR PRACTICE
1. 2 years at 6 per cent per annum =4 payments at 3 per cent
Principal 3,000
Add interest for 6 months at 3% 90
3,090
Add interest for 6 months at 3% 92.70
3,278.181
Amount at end of second year 3,376.52643
= 3,376.53
2. A =P(1 +r)
n
= 80(1.05)
3
= 92.61
Interest =12.61
3. A =P(1 +r)
n
= 1,288(1.025)
3
= 1,288 1.076890625 = 1,387.035125
Compound interest = 1,387.035125 1,288 =99.035125
= 99.04
Simple interest I =
100
3 2 288 , 1
100
Prn
1288 5 3
200
60
,
96.
Answer = 99.04 96.60 = 2.44
4. a =1,500, r =0.08, and n =8
S = P(1 +r)
n
= 1,500(1.08)
8
= 1,500 1.85093
= 2,776 to nearest whole number
Value of investment after 8 years is 2,776 to the nearest .
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For the new investment:
After 1 year, value of investment = 1,500 (1.08) +100
After 2 years, value of investment = 1,500 (1.08)
2
+100 (1.08) +100
After 8 years, value of investment = 1,500
( )
( . )
.
.
108 100
108 1
008
8
8
+

=2,776 +1,064 = 3,840 to nearest 1
5. Let the amount invested originally be P
After 1 year:
Value of investment =P(1.08) 12,000
After 2 years:
Value of investment =P(1.08)
2
12,000(1.08) 12,000
After 10 years:
Value of investment =P(1.08)
10

( )
12000
108 1
008
10
,
.
.

As the fund is exhausted after 10 years, this value must be zero, so:
P(1.08)
10
=
( )
08 . 0
1 08 . 1
000 , 12
10

i.e. P =
12000108 1
108 008
10
10
, ( . )
. .

=
1390710
01727
8052096
, .
.
, .
The accountant should set aside 80,521.
6. PV =
1000
1 005
53
5
,
( . )
783.
+
to the nearest p
7. PV of 7,500 payable in 2 years time =
7500
1 006
7500
11236
2
,
( . )
,
. +
= 6,674.97 to nearest p
Therefore total cash value = 2,500 +6,674.97
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8. PV of 450 per year for 7 years at 5% pa compound interest
=
( ) ( )
450
1 105
005
1 071068
005
7
1
]
1
1

.
.
450
.
.
=2,603.88 to nearest p
This is greater than 2,000 so the employee should choose the pension.
9. Let X be the amount payable each year.
Amount outstanding at end of Year 1 =15,000(1 +r) X
Amount outstanding at end of Year 2 =15,000(1 +r)
2
X(1 +r) X
Amount outstanding at end of Year 15 = ( ) ( ) ( ) 150001
15 14
, ... + r X 1+r X 1+r X =0
Therefore:
( )
( )
1
1
]
1
+
1 r 1
1 r + 1
X r) 1 ( 000 , 15
15
15
X =
1 1 . 1
1 . 1 1 . 0 000 , 15
1 r) 1 (
r) + 15,000r(1
15
15
15
15
+
since r =0.1
10. Let X be the annual repayment
( ) ( ) ( ) ( )
[ ]
200001 1 1 0
20 2 19
, ... + + + + + + r X 1+1+r r r
Therefore, ( )
( )
1
1
]
1

+
r
1 r + 1
X r 1 000 , 20
20
20
X =
( )
200001
1
20
, ( +
r) r
1+r
20
=
( )
20000 114 014
114 1
20
20
, ( . ) .
.

=
20000 1374349 014
1274349
301972
, . .
.
, .

Hence 3,020 (correct to the nearest ) must be repaid each year.

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11. Sum owing at end of Year 2 is (in ) = 100(1 +0.06) 20
At the end of Year 6 the balance outstanding, before the normal 20 repayment, is:
( ) ( ) ( ) ( ) ( ) 1001 006 201 006 201 006 201 006 201 006
5 4 3 2
+ + + + + . . . . .
= ( ) ( )( )
1001 006 201 006 1 106 106 106
5
2 3
+ + + + + . . . . .
=133.82 92.74 =41.08
Settlement figure at the end of Year 6 is 41.08.
12. A =P(1 +r)
n
1,210 = 1,000(1 +r)
2
(1 +r)
2
= 1.210
(1 +r) = 121 . = 1.1
Therefore, r =0.1 and the rate of interest is 10 per cent.
We must find, therefore, the value of either 1,000 at 10% pa for 4 years, or alternatively the
value of 1,210 at 10% pa for 2 years.
A +P(1 +r)
n
Therefore, A =
4
) 1 . 1 ( 000 , 1
= 1,000 1.4641 =1,464.10
The alternative is as follows:
A = P(1 +r)
n
= 1,210(1.1)
2
= 1,210 1.21 = 1,464.10
13. After 5 years, value =5,000 (1 r)
5
but this must equal 389
i.e. 5,000(1 r)
5
= 389
(1 r)
5
= 0.0778
5 log (1 r) = log 0.0778
5 log (1 r) = 28910 .
5 log (1 r) = 1.1090
log (1 r) = 0.2218 =17782 .
(1 r) = 0.60
r = 0.40
Therefore, annual percentage rate of depreciation is 40%
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14. 40,000(1 r)
20
= 4,000
(1 r)
20
= 0.1
20 log (1 r) = log 0.1 = 1
log (1 r) = 0.05 = 19500 .
1 r = 0.8913
r = 0.1087
i.e. Annual percentage rate of depreciation is 10.9%
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333
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Study Unit 18
Financial Mathematics II: Capital Investment Appraisal
Contents Page
Introduction 334
A. Payback Method 335
B. Return on Investment Method 336
Return per 1 Invested 336
Percentage Rate of Return 336
Average Annual Return per 1 Invested 337
C. Introduction to Discounted Cash Flow Methods 337
Basis of the Method 337
Information Required 338
Importance of Present Value 338
Procedure 339
D. The Two Basic DCF Methods 341
Yield (Internal Rate of Return) Method 341
Net Present Value (NPV) Method 346
Appendix: Present Values Tables 349
334 Financial Mathematics II: Capital Investment Appraisal
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INTRODUCTION
If a business is to continue earning profit, its management should always be alive to the need to
replace or augment fixed assets. This usually involves investing money (capital expenditure) for long
periods of time. The longer the period, the greater is the uncertainty and, therefore, the risk involved.
With the advent of automation, machinery, equipment and other fixed assets have tended to become
more complex and costly. Careful selection of projects has never been so important. The principal
methods of selecting the most profitable investments are discussed below.
These methods do not replace judgement and the other qualities required for making decisions.
However, it is true to say that the more information available, the better a manager is able to
understand a problem and reach a rational decision.
Classification of Investment Problems
Capital investment problems may be classified into the following types, and each may require a
different method of calculation:
(a) The replacement of, or improvement in, existing assets by more efficient plant and equipment
(often measured by the estimated cost savings).
(b) The expansion of business facilities to produce and market new products (measured by the
forecast of additional profitability against the proposed capital investment).
(c) Decisions regarding the choice between alternatives where there is more than one way of
achieving the desired result.
(d) Decisions whether to purchase or lease assets.
Methods of Decision-Making
The main methods used for deciding the most profitable project from a number of investments are:
(a) Payback method (also known as payback period method).
(b) Return on investment or average rate of return method.
(c) Discounted cash flow method, which may be subdivided into:
! Yield method or internal rate of return method.
! Net present value method.
We shall now discuss each of these methods in greater detail.
Financial Mathematics II: Capital Investment Appraisal 335
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A. PAYBACK METHOD
The payback method ranks investments in order of preference by referring to the period in which
each investment is expected to pay for itself.
If an investment is expected to produce a uniform cash return that is constant from year to year, the
following formula may be used:
Payback period in years =
cost in saving or income in increase Annual
outlay Cash
If the cash return is not constant from year to year then the payback period must be determined by
adding up the proceeds expected in successive years, until the total equals the cash outlay.
If two machines will fulfil the same purpose, and are being compared, the one which is expected to
earn sufficient to cover its cost in the shorter time will be the one selected. A simple example will
illustrate the principle.
Yearly earnings of machines A and B:
Machine A
Machine B
Net earnings: Year 1 5,000 4,000

Year 2 5,000 4,000
Year 3 4,000
Total earnings 10,000 12,000
Capital cost 10,000 10,000
Payback period 2 years 2 years
Under the payback method, Machine A would be the better investment.
The payback method has many weaknesses. As you can see from the example given, no account is
taken of the fact that earnings may accrue after the payback period has expired. Machine A earns
nothing in the third year and in fact produces no profit, simply covering the original cost. In other
words, the true profitability is not considered. A further disadvantage may arise from the fact that
some companies have a policy of limiting possible investments to those with a reasonably short life,
up to, say, five years. Many profitable investments may have a longer life than five years and yet,
because of the rule, are excluded from consideration.
Another serious criticism of this method is the inaccuracy which must inevitably arise from ignoring
the timing of receipts. Money expected in the future should not be taken at its face value. If there are
two possible investments, costing the same to purchase, with earnings occurring as shown below, can
it be said that they are equally attractive?
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Machine X
Machine Y
Net earnings: Year 1 1,000 6,000

Year 2 1,000 3,000
Year 3 8,000 1,000
Total earnings 10,000 10,000
Although they both show equal earnings, Machine Y will be preferred because the bulk of the
earnings are expected in the first two years. The 8,000 due from Machine X in the third year is so
remote in time that a large discount would have to be deducted to arrive at the present value. This
matter is discussed further under third method of deciding investments discounted cash flow.
The limitations of the payback method should not be allowed to give the impression that it should
never be used. When assets being considered have equal lives, the payback method may give quite a
good ranking of investments. The fact that only short periods are usually considered means that
forecasting is more certain and, furthermore, there is less danger of obsolescence.
B. RETURN ON INVESTMENT METHOD
The investment which shows the higher rate of return is taken to be the most profitable investment.
Unfortunately, there is no standardised method of calculating the average rate of return, and the
methods that are used may show different rankings for investments. Three possible methods are:
return per 1 invested; percentage rate of return; average annual return per 1 invested. These are
explained by reference to the example relating to machines A and B given earlier.
Return per 1 Invested
Machine A
Machine B
Earnings 10,000 12,000

Investment 10,000 10,000
Return per 1 invested 1 1.2
Percentage Rate of Return
The return per 1 invested can be expressed in percentage form as follows:
Total earnings
Total investment
100
Not all accountants advocate the use of this formula, and there are many alternatives. Some use the
average annual earnings, others the annual net profit; many accountants prefer the use of an average
investment obtained by dividing the total investment by two. This principle is based on the
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assumption that straight-line depreciation is charged, which gives an average investment which is
approximately half of the total being invested.
Using the formula shown, the results are:
Machine A
10,
10,
000
000
100 100% =
Machine B
12,
10,
000
000
100 120% =
Average Annual Return per 1 Invested
Machine A
Machine B
Earnings 10,000 12,000

Average annual earnings 5,000 4,000
Investment 10,000 10,000
Return per 1 invested 0.5 0.4
The return per 1 invested should be self-explanatory. In the first example the investment cost is
divided into the earnings. The result in the above table is obtained by dividing investment cost into
average annual earnings. This latter method purports to show that Machine A is the better investment
even though the total return is less than from Machine B. This is a weakness of the method. Only
when the serviceable life of each machine is of equal length can comparable results be obtained.
C. INTRODUCTION TO DISCOUNTED CASH FLOW
METHODS
The discounted cash flow (DCF) method can be used to overcome most of the disadvantages of the
previous methods since it takes into account the time span and distribution of earnings and
expenditure. It uses the concepts and formulae of compound interest.
Basis of the Method
The method is based on the criterion that the total present value of all increments of income from a
project should, when calculated at a suitable rate of return on capital, be at least sufficient to cover
the total capital cost. It takes account of the fact that the earlier the return the more valuable it is, for
it can be invested to earn further income.
By deciding on a satisfactory rate of return for a business, this can then be applied to several projects
over their total life to see which gives the best present cash value.
For any capital investment to be worth while it must give a return sufficient to cover the initial cost
and also a fair income on the investment. The rate which will be regarded as fair income will vary
with different types of business, but as a general rule it should certainly be higher than could be
obtained by an equivalent investment in shares.
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Information Required
To make use of DCF we must have accurate information on a number of points. The method can
only be as accurate as the information which is supplied. This information will have to be collected
by other means before we can attempt a DCF assessment, and in an examination you will always be
given the appropriate details (or some means of discovering them).
The following information is necessary as a basis for calculation:
! Estimated cash expenditure on the capital project.
! Estimated cash expenditure over each year.
! Estimated receipts each year, including scrap or sale value, if any, at the end of the assets life.
! The life of the asset.
! The rate of return expected (in some cases you will be given a figure for cost of capital and you
can easily use this rate in the same way to see whether the investment is justified).
The cash flow each year is the actual amount of cash which the business receives or pays each year
in respect of the particular project or asset (a net figure is used). This represents the difference
between (c) and (b).
Clearly the receipts and expenditures may occur at irregular intervals throughout the year, but
calculations on this basis would be excessively complicated for problems such as may arise in your
examination. So unless you are told otherwise you can assume that the net receipt or expenditure for
the year occurs at the end of the relevant year.
Importance of Present Value
Before we proceed to a detailed examination of the method used by DCF there is one important
concept which you must understand the idea of present value.
Anyone offered the choice of 100 now or 100 in a years time would choose the 100 now. This
would apply even if the person concerned intended to save the money until next year anyway,
because by obtaining the same sum a year earlier, it could be put to use and interest could be
obtained. Thus if an investment could be found which gave a rate of return of 10%, the 100 now
would be worth 110 in a years time. Conversely the present value of 110 in a years time is 100
because at the stated interest rate this is the present-day sum which represents 110 in a years time.
Now take a businessman who is buying a machine. It will give him, say, an output worth 100 at the
end of the first year, and the same at the end of each successive year. He must bear this in mind when
buying the machine which costs, say, 1,000. But he must pay out the 1,000 now. His income, on
the other hand, is not worth its full value now, because it will be a year before he will receive the first
100, two years before he will receive the second 100, and so on. So if we think of the present
value of the income which he is to receive, the first 100 is really worth less than 100 now, and the
second is worth less still. In fact, the present value of each increment of 100 is the sum now which,
at compound interest, will represent 100 when the sum falls due.
This can easily be calculated, or it may be ascertained from present value tables, which take account
of time and of varying interest rates. An example of such tables are set out in the Appendix to this
unit and are easily used.
We can see, for example, that if we assume a cost of capital of 7%, 1 in two years time is worth
0.8734 now. This is the sum which would grow to 1 in two years at compound interest of 7%.
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Thus we have established the present value of 1.00 in 2 years time, discounted at compound interest
of 7%.
We can now look again at the businessman and his machine. The present value of the first years
income (received at the end of the year, for the purposes of this example) is 100 0.9346, if we
assume that his cost of capital is also 7%; the present value of the second years income is 100
0.8734. The same method can be used for succeeding years in the same way.
Present value tables can usually be used when you are required to undertake calculations. However,
for a fuller understanding of the discounting theory, we shall now consider the formula used to arrive
at these factors.
From the previous study unit, we have:
PV =
C
(1+r)
n
where: PV =Present value
C =Cash flow
r =Rate of interest on 1 for 1 year
n =Number of years
When cash flows are spread over a number of years the formula is expanded to:
C
(1+r)
1
+
C
(1+r)
2
2
+
C
(1+r)
3
3
...
C
(1+r)
n
n
where: C
1
=Cash flow in year 1
C
2
=Cash flow in year 2, etc.
Example
1 to be invested for 3 years, discounted at 10% per annum.
Factor
Present value of 1 receivable in one years time =
1
1 01
1
11 ( . ) . +
= = 0.9091
Present value of 1 receivable in two years time =
1
11
1
121
2
( . ) .
= = 0.8264
Present value of 1 receivable in three years time =
1
11
1
1331
3
( . ) .
= = 0.7513
Now refer to the 10% column of the extract from present value tables where you will see these
factors in the tabulation.
If you are required to undertake such calculations without the assistance of discount tables, the
formula set out above must be used.
Procedure
Since our DCF appraisal will be carried out before the beginning of a project, we shall have to reduce
each of the net receipts/expenditures for future years to a present value. This is discounting the cash
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flow, which gives DCF its name, and it is usually done by means of tables, an extract of which you
have already seen.
At the very start of a project the capital expenditure itself may be made, so that at that point there
may be a substantial negative present value, since money has been paid out and nothing received. If
all the present values of the years of the life of the investment (including the original cost) are added
together, the result will be the net present value. This is known as the NPV and is a vital factor,
because if it is positive it shows that the discounted receipts are greater than expenditures on the
project, so that at that rate of interest the project is proving more remunerative than the stated interest
rate.
The greater the NPV the greater the advantages of investing in the project rather than leaving the
money at the stated rate of interest. But if the NPV is a minus quantity, it shows that the project is
giving less return than would be obtained by investing the money at that rate of interest.
Example
A businessman is considering the purchase of a machine costing 1,000 which has a life of 3 years.
He calculates that during each year it will provide a net receipt of 300; it will also have a final scrap
value of 200. Instead, he could invest his 1,000 at 6%. Which course would be more
advantageous?
First we must work out the cash flow.
Receipts Payments Net Receipt
Year 0 Nil 1,000 1,000
Year 1 300 Nil +300
Year 2 300 Nil +300
Year 3 500 Nil +500
(Remember that the scrap value will count as a receipt at the end of the third year.)
But the businessman could be earning 6% interest instead; so this is the cost of his capital, and we
must now discount these figures to find the present value:
Net Receipt Discount Factor Present Factor
Year 0 1,000 1.0000 1,000.00
Year 1 +300 0.9434 +283.02
Year 2 +300 0.8900 +267.00
Year 3 +500 0.8396 +419.80
Net present value: 30.18
As we have seen above, a negative NPV means that the investment is not profitable at that rate of
interest. So the businessman would lose by putting his money into the machine. The best advice is
for him to invest at 6%.
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D. THE TWO BASIC DCF METHODS
You have now seen a simple example of how DCF is used, and you already have a basic knowledge
of the principles which the technique employs. There are two different ways of using DCF the
yield (or rate of return) method, and the net present value method, which was used in the
example above. The important point to remember is that both these methods give identical results.
The difference between them is simply the way they are used in practice, as each provides an easier
way of solving its own particular type of problem.
As we will see, the yield method involves a certain amount of trial-and-error calculation. Questions
on either type are possible, and you must be able to distinguish between the methods and to decide
which is called for in a particular set of circumstances.
In both types of calculation there is the same need for accurate information as to cash flow, which
includes the initial cost of a project, its net income or outgoing for each year of its life, and the final
scrap value of any machinery.
Yield (Internal Rate of Return) Method
This method is used to find the yield, or rate of return, on a particular investment. By yield we mean
the percentage of profit per year of its life in relation to the capital employed. In other words, we
must allow for repayment of capital before we consider income as being profit for this purpose.
Obviously the profit may vary over the years of the life of a project, and so may the capital employed,
so an average figure needs to be produced. DCF, by its very nature, takes all these factors into
account.
The primary use of the method is to evaluate a particular investment possibility against a guideline
for yield which has been laid down by the company concerned. For example, a company may rule
that investment may be undertaken only if a 10% yield is obtainable. We then have to see whether
the yield on the desired investment measures up to this criterion. In another case, a company may
simply wish to know what rate of return is obtainable from a particular investment; thus, if a rate of
9% is obtainable, and the companys cost of capital is estimated at 7%, it is worth its while to
undertake the investment.
What we are trying to find in assessing the figures for a project is the yield which its profits give in
relation to its cost. We want to find the exact rate at which it would be breaking even, i.e. the rate at
which discounted future cash flow will exactly equal the present cost, giving an NPV of 0. Thus if
the rate of return is found to be 8%, this is the rate at which it is equally profitable to undertake the
investment or not to undertake it; the NPV is 0. Having found this rate we know that if the cost of
capital is above 8% the investment will be unprofitable, whereas if it is less than 8% the investment
will show a profit. We thus reach the important conclusion that once we have assembled all the
information about a project, the yield, or rate of return, will be the rate which, when used to discount
future increments of income, will give an NPV of 0. We shall then know that we have found the
correct yield.
Make sure you have followed why this will be the correct rate, and that you know exactly how and
when to use the method, as practical questions are very much more likely than theoretical ones in the
examination.
(a) When to Use the Yield Method
This is not a difficult problem, because you will use the method whenever you require to know
the rate of return, or yield, which certain increments of income represent on capital employed.
You must judge carefully from any DCF question whether this is what you need to know.
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The yield method can be used to compare the internal rate of return with the cost of borrowing
money from a bank.
(b) How to Use the Yield Method
The calculation is largely dependent on trial and error. When you use this method, you know
already that you are trying to find the rate which, when used to discount the various increments
of income, will give an NPV of 0. You can do this only by trying out a number of different
rates until you hit on the correct result. A positive NPV means that the rate being tried is lower
than the real rate; conversely, a negative NPV means that too high a rate is being used. So you
need to work the problem out as many times as is necessary to hit on the appropriate rate for
obtaining the NPV of 0. If this process is done sensibly, for simple problems such as those
which we are going to encounter, it should not take many steps to hit upon the right result.
Watch out for any instructions concerning rounding of yields for example, to the nearest %.
(c) Examples of the Yield Method
Example 1
A company is considering investing in a three-year project that would cost 12,000 to
commence. The annual returns would be 6,000, 4,000 and 2,000. At the end of the three
years the machinery could be sold for 5,000. The company wishes to evaluate the internal
yield in order to see what sorts of interest rate would be viable from the various sources known
to the company.
The discount factor has to be assumed, so we shall start with 15%:
Year Net Income/
Outgoing
Discount Factor Discounted Present
Value
0 12,000 1.0000 12,000
1 +6,000 0.8696 +5,218
2 +4,000 0.7561 +3,024
3 +7,000 0.6575 +4,603
Net present value: +845
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A positive result, which means that the discount factor is too low, so try 20%:
Year Net Income/
Outgoing
Value
0 12,000 1.0000 12,000
1 +6,000 0.8333 +5,000
2 +4,000 0.6944 +2,778
3 +7,000 0.5787 +4,051
Net present value: 171
So the yield must come between the two values of 15% and 20%. Try 17%:
Year Net Income/
Outgoing
Value
0 12,000 1.0000 12,000
1 +6,000 0.8547 +5,128
2 +4,000 0.7305 +2,922
3 +7,000 0.6244 +4,371
Try 19%:
Year Net Income/
Outgoing
Value
0 12,000 1.0000 12,000
1 +6,000 0.8403 +5,042
2 +4,000 0.7062 +2,825
3 +7,000 0.5934 +4,154
So 19% is the yield. This means that it would be unwise to take out a loan that has an interest
rate in excess of 19%. Similarly, a loan which is less than 19% interest will prove to be
profitable under this project.
Example 2
A businessman is considering investment in a project with a life of 3 years, which will bring a
net income in the first, second and third years of 800, 1,000 and 1,200 respectively. The
initial cost is 2,500, and there will be no rebate from scrap values at the end of the period. He
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wishes to know, to the nearest 1%, the yield which this would represent. Using the present
value tables, make the necessary calculation.
We must begin by choosing a possible rate and testing to see how near this is. Lets try 7%.
Referring to the tables, we reach the following results.
Year Net Income/
Outgoing
Value
0 2,500 1.0000 2,500.00
1 +800 0.9346 +747.68
2 +1,000 0.8734 +873.40
3 +1,200 0.8163 +979.56
Net present value: +100.64
A positive NPV, as we have seen, means that we have taken too low a rate for our attempt.
Lets try 10% instead:
Year Net Income/
Outgoing
Value
0 2,500 1.0000 2,500.00
1 +800 0.9091 +727.28
2 +1,000 0.8264 +826.40
3 +1,200 0.7513 +901.56
Net present value: 44.76
This time we have obtained a negative NPV so our rate of 10% must be too high. We now
know that the rate must be between 7% and 10%. Only a proper calculation can give us the
true answer, but having obtained a positive NPV for 7% and a negative NPV for 10% we can
ascertain the approximate rate by interpolation using the formula:
Rate = X +
a
a+b
Y X ( )
where: X =Lower rate of interest used
Y =Higher rate of interest used
a =Difference between present values of the outflow and the inflow at X%
b =Difference between present values of the outflow and the inflow at Y%
Inserting the rates of 7% and 10% into this formula, we get:
Rate = 7 +
101
101 45
10 7
+
( )
= 7 +2 = 9% (approx.)
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So we shall try 9%.
Year Net Income/
Outgoing
Value
0 2,500 1.0000 2,500.00
1 +800 0.9174 +733.92
2 +1,000 0.8417 +841.70
3 +1,200 0.7722 +926.64
Clearly since we are working to the nearest 1% we are not going to get any closer than this.
However, if you have time available there is no reason why you should not work out the next
nearest rate (in this case, 8%) just to check that you already have the nearest one.
So the yield from this investment would be 9%.
Note
The interpolation may be performed graphically rather than by calculation, as shown in the
following graph. The discount rate is on the horizontal axis and the net present value on the
vertical axis. For each of the two discount rates, 7% and 10%, we plot the corresponding net
present value. We join the two points with a ruled line. The net present value is zero where
this line crosses the horizontal axis. The discount rate at this point is the required internal rate
of return. We see that the rate is 9%, correct to the nearest 1%, and this confirms the result of
the calculation.
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Net Present Value (NPV) Method
The NPV method is probably more widely used than the yield method, and its particular value is in
comparing two or more possible investments between which a choice must be made. If a company
insists on a minimum yield from investments of, say, 10%, we could check each potential project by
the yield method to find out whether it measures up to this. But if there are several projects each of
which yields above this figure, we still have to find some way of choosing between them if we cannot
afford to undertake all of them.
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At first sight the obvious choice would be that which offered the highest yield. Unfortunately this
would not necessarily be the best choice, because a project with a lower yield might have a much
longer life, and so might yield greater profit.
However, we can solve the problem in practice by comparing the net present values of projects
instead of their yields. The higher the NPV of a project or group of projects, the greater is its value
and the profits it will bring.
We must remember that in some instances the cost of capital will be higher for one project than for
another. For example, a company which manufactures goods may well be able to borrow more
cheaply for its normal trade than it could if it decided to take part in some more speculative process.
So each project may need to be assessed at a different rate in accordance with its cost of capital. This
does not present any particular problems for DCF.
(a) NPV Method and Yield Method Contrasted
You should now be able to see the important difference between the NPV method and the yield
method. In the yield method we were trying to find the yield of a project by discovering the
rate at which future income must be discounted to obtain a fixed NPV of 0. In the NPV
method we already know the discounting rate for each project (it will be the same as the cost of
capital) and the factor which we are now trying to find for each project is its NPV. The project
with the highest NPV will be the most profitable in the long run, even though its yield may be
lower than other projects.
So you can see that comparison of projects by NPV may give a different result from
comparison by yields. You must decide for each particular problem which method is
appropriate for it.
(b) How to Use the NPV Method
You must first assemble the cash flow figures for each project. Then carry out the discounting
process on each annual net figure at the appropriate rate for that project, and calculate and
compare the NPVs of the projects. As we have seen, that with the highest NPV will be the
most profitable.
(c) Example of the NPV Method
An earlier example was based on the NPV method, but the following one shows use of the
method to compare two projects.
Example
The ABC Engineering Co. are trying to decide which of the two available types of machine
tool to buy. Type A costs 10,000 and the net annual income from the first 3 years of its life
will be 3,000, 4,000 and 5,000 respectively. At the end of this period it will be worthless
except for scrap value of 1,000. To buy a Type A tool, the company would need to borrow
from a finance group at 9%. Type B will last for three years too, but will give a constant net
annual cash inflow of 3,000. It
costs 6,000 but credit can be obtained from its manufacturer at 6% interest. It has no ultimate
scrap value. Which investment would be the more profitable?
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Type A
Year Net Cash
Income
Discount Factor
9%
Discounted Present
Value
0 10,000 1.0000 10,000.00
1 +3,000 0.9174 +2,752.20
2 +4,000 0.8417 +3,366.80
3 +5,000
+1,000
0.7722 +4,633.20
Type B
Year Net Cash
Income
Discount Factor
6%
Discounted Present
Value
0 6,000 1.0000 6,000.00
1 +3,000 0.9434 +2,830.20
2 +3,000 0.8900 +2,670.00
3 +3,000 0.8396 +2,518.80
Net present value: +2,019.00
Thus we can see that Type B has a far higher NPV and this will be the better investment. (Note
carefully how the different costs of capital affect the result. You must always watch out for
similar complications if they should arise in problems.)
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APPENDIX: PRESENT VALUES TABLES
These tables give the present values of 1 at different rates of interest (to four significant figures).
Table 1
Rate
Year
2% 3% 4% 5% 6% 7%
1 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346
2 0.9612 0.9426 0.9246 0.9070 0.8900 0.8734
3 0.9423 0.9151 0.8890 0.8638 0.8396 0.8163
4 0.9238 0.8885 0.8548 0.8227 0.7921 0.7629
5 0.9057 0.8626 0.8219 0.7835 0.7473 0.7130
6 0.8880 0.8375 0.7903 0.7462 0.7050 0.6663
7 0.8706 0.8131 0.7599 0.7107 0.6651 0.6227
8 0.8535 0.7894 0.7307 0.6768 0.6274 0.5820
9 0.8368 0.7664 0.7026 0.6446 0.5919 0.5439
10 0.8203 0.7441 0.6756 0.6139 0.5584 0.5083
11 0.8043 0.7224 0.6496 0.5847 0.5268 0.4751
12 0.7885 0.7014 0.6246 0.5568 0.4970 0.4440
13 0.7730 0.6810 0.6006 0.5303 0.4688 0.4150
14 0.7579 0.6611 0.5775 0.5051 0.4473 0.3878
15 0.7430 0.6419 0.5553 0.4810 0.4173 0.3624
16 0.7284 0.6232 0.5339 0.4581 0.3936 0.3387
17 0.7142 0.6050 0.5134 0.4363 0.3714 0.3166
18 0.7002 0.5874 0.4936 0.4155 0.3503 0.2959
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Table 2
Rate
Year
8% 9% 10% 11% 12% 13%
1 0.9259 0.9174 0.9091 0.9009 0.8929 0.8850
2 0.8573 0.8417 0.8264 0.8116 0.7972 0.7831
3 0.7938 0.7722 0.7513 0.7312 0.7118 0.6931
4 0.7350 0.7084 0.6830 0.6587 0.6355 0.6133
5 0.6806 0.6499 0.6209 0.5935 0.5674 0.5428
6 0.6302 0.5963 0.5645 0.5346 0.5066 0.4803
7 0.5835 0.5470 0.5132 0.4817 0.4523 0.4251
8 0.5403 0.5019 0.4665 0.4339 0.4039 0.3762
9 0.5002 0.4604 0.4241 0.3909 0.3606 0.3329
10 0.4632 0.4224 0.3855 0.3522 0.3220 0.2946
11 0.4289 0.3875 0.3505 0.3173 0.2875 0.2607
12 0.3971 0.3555 0.3186 0.2858 0.2567 0.2307
13 0.3677 0.3262 0.2897 0.2575 0.2292 0.2042
14 0.3405 0.2992 0.2633 0.2320 0.2046 0.1807
15 0.3152 0.2745 0.2394 0.2090 0.1827 0.1599
16 0.2919 0.2519 0.2176 0.1883 0.1631 0.1415
17 0.2703 0.2311 0.1978 0.1696 0.1456 0.1252
18 0.2502 0.2120 0.1799 0.1528 0.1300 0.1108
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Table 3
Rate
Year
14% 15% 16% 17% 18% 19%
1 0.8772 0.8696 0.8621 0.8547 0.8475 0.8403
2 0.7695 0.7561 0.7432 0.7305 0.7182 0.7062
3 0.6750 0.6575 0.6407 0.6244 0.6086 0.5934
4 0.5921 0.5718 0.5523 0.5337 0.5158 0.4987
5 0.5194 0.4972 0.4761 0.4561 0.4371 0.4190
6 0.4556 0.4323 0.4104 0.3898 0.3704 0.3521
7 0.3996 0.3759 0.3538 0.3332 0.3139 0.2959
8 0.3506 0.3269 0.3050 0.2848 0.2660 0.2487
9 0.3075 0.2843 0.2630 0.2434 0.2255 0.2090
10 0.2697 0.2472 0.2267 0.2080 0.1911 0.1756
11 0.2366 0.2149 0.1954 0.1778 0.1619 0.1476
12 0.2076 0.1869 0.1685 0.1520 0.1372 0.1240
13 0.1821 0.1625 0.1452 0.1299 0.1163 0.1042
14 0.1597 0.1413 0.1252 0.1110 0.09855 0.08757
15 0.1401 0.1229 0.1079 0.09489 0.08352 0.07359
16 0.1229 0.1069 0.09304 0.08110 0.07078 0.06184
17 0.1078 0.09293 0.08021 0.06932 0.05998 0.05196
18 0.09456 0.08081 0.06914 0.05925 0.05083 0.04367
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Table 4
Rate
Year
20% 21% 22% 23% 24% 25%
1 0.8333 0.8264 0.8197 0.8130 0.8065 0.8000
2 0.6944 0.6830 0.6719 0.6610 0.6504 0.6400
3 0.5787 0.5645 0.5507 0.5374 0.5245 0.5120
4 0.4823 0.4665 0.4514 0.4369 0.4230 0.4096
5 0.4019 0.3855 0.3700 0.3552 0.3411 0.3277
6 0.3349 0.3186 0.3033 0.2888 0.2751 0.2621
7 0.2791 0.2633 0.2486 0.2348 0.2218 0.2097
8 0.2326 0.2176 0.2038 0.1909 0.1789 0.1678
9 0.1938 0.1799 0.1670 0.1552 0.1443 0.1342
10 0.1615 0.1486 0.1369 0.1262 0.1164 0.1074
11 0.1346 0.1228 0.1122 0.1026 0.09383 0.08590
12 0.1122 0.1015 0.09198 0.08339 0.07567 0.06872
13 0.09346 0.08391 0.07539 0.06780 0.06103 0.05498
14 0.07789 0.06934 0.06180 0.05512 0.04921 0.04398
15 0.06491 0.05731 0.05065 0.04481 0.03969 0.03518
16 0.05409 0.04736 0.04152 0.03643 0.03201 0.02815
17 0.04507 0.03914 0.03403 0.02962 0.02581 0.02252
18 0.03756 0.03235 0.02789 0.02408 0.02082 0.01801
353
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Study Unit 19
Presentation of Management Information
Contents Page
Introduction 354
A. General Principles of Presentation 354
Information for Decision Making 354
Timing and Accuracy 354
B. Management Information 354
Reports and Analyses 354
User Requirements 354
Information to be Supplied 355
Effectiveness of Management Information Systems 356
Report Writing 357
Diagrams and Charts 357
354 Presentation of Management Information
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INTRODUCTION
The purpose of this last study unit is to provide you with guidance on how to present the information
you will have gathered in the course to date. No matter how much knowledge you possess on a topic,
if you cannot impart the information concisely and succinctly then much of its impact can be lost.
We shall, therefore, examine different aspects of presentation such as report writing, the use of
diagrams and charts and tailoring the information to the needs of the user.
A. GENERAL PRINCIPLES OF PRESENTATION
Information for Decision Making
Management accounting data is produced for the purpose of planning, control and decision making
and these factors must be borne in mind in the preparation and presentation of information. Different
levels of management will require different types of information, according to their status and
responsibilities. The general principles which should be followed in the presentation of information
are as follows:
! Data and reports should be produced as soon as possible after the event.
! Reports should be as accurate as possible.
! The requirements of the individual manager must be provided for.
Timing and Accuracy
Speed of presentation is crucial in the process of control and decision making. Information which is
entirely accurate and produced a long time after the event may be of little or no use to the manager,
whereas information which is approximately correct and produced quickly can be used effectively.
B. MANAGEMENT INFORMATION
Reports and Analyses
Reports and analyses can take a number of different forms but, in most organisations, regular,
periodic reports will be produced on standard forms. Routine and special reports may be illustrated
or supplemented by charts, graphs and statistics, provided that the receiver is not confused by too
much detail.
User Requirements
The amount of detail provided will depend upon the level of management for which the information
is supplied.
At the highest level, such as the managing director or the general manager, the reports will be broadly
based and designed to give an overall picture of the organisation. These reports will be designed to
enable the executive to monitor the progress of all activities, and they will be as free from detail as
possible.
At lower levels, more details will be required, but restricted to the function or activity being
covered. At the lowest level, just one cost centre or activity may be involved, such as for a
superintendent of a machine group.
Presentation of Management Information 355
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Information to be Supplied
(a) Managing Director
! Budget Reports
Monthly reports, showing the actual and budgeted results, with variances showing where
corrective action is required.
! Financial Accounts
Monthly profit and loss accounts and balance sheets.
! Sales Reports
Weekly/monthly reports, showing budgeted and actual sales by product, territory,
customer or other required analysis. This may also include details of orders received
under similar headings.
! Factory Reports
Output: daily/weekly figures.
Stocks: details of stockholdings under major headings of raw materials, work-in-
progress and finished goods.
! Cash Flow
Weekly/monthly cash flow statements on a rolling budget basis.
! Capital Expenditure
Budgeted and actual capital expenditure, with details of under- or over-spending and
projections of future capital expenditure.
! Special Analyses
Reports on new projects or special situations, as necessary.
(b) Sales Director
! Budget Reports
Sales in money value and units, analysed by product, territory, salesperson, as required,
with actual and budget comparisons.
Cost figures for the sales function, with budget and actual comparisons.
! Bad Debts
Source of bad and doubtful debts, and salespeople involved.
! Orders Received
Weekly/monthly analyses.
! Stocks
Stock levels of finished goods.
! Special Reports
Analysis for pricing decisions, advertising campaigns, launch of new products.
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(c) Production Director
! Budget Reports
Actual and budget cost comparisons by cost centres.
! Efficiency Reports
Standard and actual comparisons for materials, labour and overheads, with additional
analyses for variances which require further investigation.
! Stock Reports
Raw materials, work-in-progress, finished goods.
! Capital Expenditure
Planned and actual expenditure.
Schedules for delivery and installation of new equipment.
! Machine Use
Percentages of capacity employed and analysis of causes of lost or idle time.
! Maintenance
Cost of maintenance, with actual and budget comparisons.
! Service Costs
Factory, services and supplies.
Costs for stores, internal transport and other factory services.
! Other Reports
These will usually be related to proposals concerning new equipment, working
arrangements, bonus schemes or changes in methods, and particularly the costing aspects
of such changes.
(d) Other Executives
Depending on the nature of the company concerned, other managers should receive reports on
similar lines to those supplied to the managers mentioned above. The general aim will be to
show budgeted and actual expenditure and controllable variances.
Effectiveness of Management Information Systems
Periodic reviews of management information systems should be carried out to test the suitability and
effectiveness of the system. The objects of such a review should be:
! To assess the suitability of the information supplied and the degree of accuracy required by
the manager.
! To find the use to which information is put, and whether it is the right type of information for
the purposes for which it is required.
! To see the speed with which the information is produced, and if it is presented in time and in
the most effective manner.
! To consider the cost of providing information and the benefits obtained.
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Report Writing
The communication of information in the form of reports is an important aspect in the study of
management accounting. Reports are required in practical business situations for many different
purposes, and examination questions often simulate a practical problem, requiring an answer in report
format. The general principles of report writing are relatively simple but they require careful
observance:
! Title
This should be as short as possible but it must convey clearly the subject of the report.
! Date
This should not be overlooked, as it may be very relevant when subsequent developments are
being considered.
! Addressee(s)
The name(s) of the receiver(s) of the report should be shown, together with the name of the
writer of the report. (For examination question answers you should not use your own name.)
! Introduction
A short introduction may be required, indicating the reason or brief for preparing the report.
! Body of the Report
This will contain the main substance of the report, with reference to facts, conclusions and
recommendations.
! Appendices
To avoid overloading the main content and conclusions, it may be necessary to append charts,
graphs and statistical tables as numbered appendices, making the main section of the report
easier to read.
! Style
Try to adopt a logical sequence in the report, with section and subsection headings as
necessary.
Diagrams and Charts
Trends and major features of statistical data can often be more easily appreciated by the use of
diagrams and charts. Comparisons can be made on a single chart but trends, rather than actual
figures, will be shown.
Care must be taken not to make charts too complicated, as over-elaboration will confuse, rather than
highlight the significant points in the data.
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(a) Line Graphs
The characteristic of line graphs, or histograms, is that the vertical axis is the unit of the
subject being observed. The horizontal axis represents the time factor hours, day, months,
years (see Figure 19.1).
Monthly Sales: January to June
Month
J an 9,000
Feb 9,500
Mar 8,700
Apr 9,200
May 9,400
J un 9,700
Figure 19.1: Histogram of Monthly Sales Data
As an alternative to plotting actual number values, the logarithms of these numbers may be
used. These will be helpful in judging the relative rate of increase or decrease in the numbers
observed.
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(b) Z Charts
These charts, called Z charts because of the outline shape of the graph, combine three curves:
! The curve of the original data
! The cumulative total of the original data
! The moving average total of the data.
The chart is particularly suited to showing sales curves, as in Figure 19.2.
Monthly Sales: January to June
Month Monthly Sales
Cumulative Sales
Six-Months Moving
Average Total
J an 1,200 1,200 6,800

Feb 900 2,100 7,000
Mar 1,100 3,200 7,100
Apr 1,300 4,500 7,300
May 1,000 5,500 7,000
J un 1,100 6,600 6,600
Figure 19.2: Z Chart of Monthly Sales Data
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(c) Bar Charts
This type of chart uses varying lengths of bar to show values of units, and it is widely used for
making comparisons. Simple bar charts use a single bar to represent each item. In
component or compound bar charts, the bars are divided into segments to show sub-totals or a
breakdown into categories.
Figure 19.3 is a bar chart of the following wages data:
Wages
Factory
000
Admin.
000
Total
000
Yr. 0: Quarter 1 40 10 50
2 38 11 49
3 42 12 54
4 45 12 57
165 45 210
Yr. 1: Quarter 1 46 13 59
2 45 13 58
3 47 14 61
4 49 15 64
187 55 242
Figure 19.3: Bar Chart of Wages Data
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(d) Pie (or Circle) Charts
The pie chart is so called because it is based on a circle divided into segments, or slices, in
order to show the relationship of the various portions to the whole. It is commonly used to
show division of a companys costs and profits, as in Figure 19.4.
Pie charts suffer from the fact that it is difficult to show actual relationships from one period to
another, and the sizes of different circles can sometimes lead to incorrect interpretation. While
pie charts make an immediate impression, their usefulness is limited.
Figure 19.4: Pie Charts of Company Costs and Profits
They are based on calculations related to the degrees in a circle totalling 360. Hence for Yr. 1, say,
the total of profit and costs had been as follows:

Production cost 100,000 360
100
200
=180
Profit 25,000 360
25
200
=45
Selling and Distribution cost (S & D) 55,000 360
55
200
=99
Admin. cost 20,000 360
20
200
=36
Total 200,000
The appropriate segments are shown in the pie chart.
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Diploma

Estimated variable cost per machine hour 20

Estimated variable cost per machine hour 16

5,000 20,000 (1%) 7,000 (35%) 2,000

Costs b/f 350 910 1,835 2,803 3,953

Direct cost per unit 9.50 4.05

Wooden garden seat A 65 15 80 100

5,000 units 6,250 (12,500) 18,750

Direct material cost 18

Number of orders 1,500 4,500 6,000

Number of orders 636 6,364 7,000

Sales (250,000 10) 2,500,000

Raw materials used (as above) 1,248,000

Materials inspection costs 75,000

(allowing credit for scrap value of normal loss)

Process I Raw materials 7,200

Production of product B valued at SP

Opening stocks 1,200 60

In the above example, this would be:

Direct material per unit 11

Sales (5,000 35) 175,000

Sales (7,500 30) 225,000

Contribution (5,000 20) 100,000

Sales (400,000 6) 2,400,000

Sales (400,000 5.70) 2,280,000

Sales (380,000 6) 2,280,000

Contribution (as per original) 800,000

Direct materials 155,000

Before further processing 200,000 150,000 100,000

Direct materials 12,000 15,000 10,500

Selling price at end of Process 1 2.50 2.80 1.20 3.00

Direct material 2.50

Total cost 40.00

Marginal cost 18.00

Cash in Hand and Cash in Bank

Salaries 20,000 30,000

Costs: Depreciation 240

100,000 70,000 30,000 0.3 9,000

Standard gross margin 0.3000

Actual cost for 1,980 units 120,000

Revised standard cost (1,980 10.50 5) 103,950

Revised standard cost (1,980 10.50 5) 103,950

Original standard cost (1,980 10 5) 99,000

Budgeted contribution (100,000 (5 3) 200,000

Actual sales (100,000 4) 400,000

Original budget (100,000 5) 500,000

Operational variance 50,000 (F)

Actual cost 120,000

Actual price of actual units 120,000

Operational price variance 10,800 (A)

19,900 hours should cost ( 7.50 per hour) 149,250

We can summarise this position as:

Financial Mathematics I: Interest and Present Value 313

(a) Principal 1,000

Hence 3,020 (correct to the nearest ) must be repaid each year.

Net earnings: Year 1 5,000 4,000

Net earnings: Year 1 1,000 6,000

Earnings 10,000 12,000

Earnings 10,000 12,000

J an 1,200 1,200 6,800