KENYATTA UNIVERSITY

INSTITUTE OF OPEN LEARNING

CAC 501: MANAGEMENT ACCOUNTING

S.K. MUNYWOKI
DEPARTMENT OF ACCOUNTING
 TABLE OF CONTENTS

LESSON ONE:.............................................................................................................................. 4
1.0. NATURE AND PURPOSE OF MANAGEMENT ACCOUNTING............................. 4
1.1 OBJECTIVES ...................................................................................................................... 4
1.2. INTRODUCTION............................................................................................................... 4
1.3. THE DECISION MAKING PROCESS................................................................................ 8
LESSON TWO ............................................................................................................................ 22
2.0. COST CONCEPTS & CLASSIFICATION.................................................................... 22
2.1. OBJECTIVES...................................................................................................................... 22
2.2. INTRODUCTION............................................................................................................... 22
2.3. CLASSIFICATION OF COSTS ......................................................................................... 23
FURTHER READING........................................................................................................ 36
LESSON THREE........................................................................................................................ 37
3.0. MARGINAL AND ABSORPTION COSTING (COST ACCUMULATION) ............ 37
3.1. OBJECTIVES...................................................................................................................... 37
3.2. INTRODUCTION............................................................................................................... 37
3.3. TRADITIONAL ABSORPTION COSTING...................................................................... 37
3.4. ACTIVITY BASED COSTING ( ABC)............................................................................. 45
FURTHER READING........................................................................................................ 54
LESSON FOUR .......................................................................................................................... 55
4.0 BUDGETING AND BUDGETARY CONTROL ........................................................... 55
4.1. OBJECTIVES...................................................................................................................... 55
4.2. INTRODUCTION............................................................................................................... 55
4.3. BUDGETARY CONTROL ................................................................................................ 57
4.4 MASTER BUDGET............................................................................................................ 61
FURTHER READING........................................................................................................ 65
LESSON FIVE ............................................................................................................................ 66
5.0. ANALYSIS OF VARIANCE............................................................................................ 66
5.1. OBJECTIVES...................................................................................................................... 66
5.2. INTRODUCTION............................................................................................................... 66
5.3 CONTEMPORARY APPROACHES TO VARIANCE ANALYSIS ................................ 70
FURTHER READING........................................................................................................ 79
LESSON SIX ............................................................................................................................... 80
6.0. CAPITAL BUDGETING TECHNIQUES ...................................................................... 80
6.1. OBJECTIVES...................................................................................................................... 80
6.2. INTRODUCTION............................................................................................................... 80
FURTHER READING........................................................................................................ 95
LESSON SEVEN ........................................................................................................................ 96
7.0. PRODUCT COSTING METHODS ................................................................................ 96
7.1. OBJECTIVES...................................................................................................................... 96
7.2. INTRODUCTION............................................................................................................... 96
7.2.1. PROCESS COSTING........................................................................................................ 96
7.2.1. JOB ORDER COSTING ................................................................................................. 101
7.5. QUESTIONS .................................................................................................................... 105
REFERENCES.......................................................................................................................... 114

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 CAC 501: MANAGEMENT ACCOUNTING

INTRODUCTION
Organisations exist in order to achieve one or more objectives. It is against the
background of limited resources that diverse objectives have to be determined. Decisions
are made which strategies to pursue and which ones to reject, which activities to
undertake immediately and which to delay until later period.

The processes of planning and control are important tasks undertaken by managers in an
organisation and these form the nucleus of the overall management system. Managers
require information to carry out these tasks. Management accounting is primarily
concerned with the provision of these tasks. Management accounting has been defined
by the Institute of Cost and Management Accountants as the provision of information
required by management for such purposes as:
(i) Formulation of policies.
(ii) Planning and controlling the activities of the enterprise.
(iii) Decision-taking on alternative courses of action.
(iv) Dislosure to those external to the entity (shareholders and others parties)
(v) Disclosure to employees and
(vi) Safeguarding assets.

COURSE OBJECTIVE
This course is aimed at providing a theoretical and practical in-depth analysis of the use
of management accounting as a tool for decision-making. It covers major areas in
costing, budgeting, variance analysis and capital budgeting with practical illustrations of
the kind of decisions made by management accountants.

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 LESSON ONE:

1.0. NATURE AND PURPOSE OF MANAGEMENT ACCOUNTING

1.1 OBJECTIVES

By the end of this lesson, you should be able to:

1. Distinguish management accounting from other financial accounting

and cost accounting.
2. Understand the nature of management accounting the users of
management accounting information.
3. Appreciate the importance of management accounting in decision
making

1.2. INTRODUCTION
Accounting is the process of identifying, measuring and communicating economic
information to permit informed judgement and decisions by users of information.

It is therefore concerned with finding information that will help decision-makers make
good decisions. To understand accounting therefore we must understand:
1) The attributes of good information
2) The process of measuring and communicating information
3) The decision making process
4) The users of accounting information

1. Users of Information
Users of accounting information can be divided into two
(a) Internal users: These are parties within the organization such as the management
or the employees.
(b) External users; These are parties outside the organization such as shareholders,
creditors, customers, Government, Financial Analysts etc.
From the users’ point of view accounting can be divided into two;
1. Management Accounting – Internal users
2. Financial Accounting – External users.

Management Accounting

Management Accounting is concerned with the provision of information to people within

the organization to help them make better decisions. It is therefore concerned with the
provision and the interpretation of information required by management for the following
purposes;
1. formulating the policies of the organization

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 2. planning the activities of the organization in the long, medium and short
term i.e strategic to operational plans
3. controlling the activities of the organization
4. decision making
5. performance appraisal at the strategic, departmental and operational levels

Management accounting can also be said to be concerned with data collection (both from
internal and external sources), processing, interpreting and communicating the resulting
information for use within the organization so that management can more effectively
plan, make decisions and control operations.

Financial Accounting
Deals with the provision of information to external users and can be defined as “the
process of measuring, classifying, summarizing and reporting financial information to be
used in making economic decisions”.

It is therefore concerned with the preparation of financial statements to be used by

external users.

Difference between Management Accounting & Financial Accounting

1. Legal requirement:
Public limited companies have statutory requirement to produce annual financial
accounts.
Management Accounts are optional and should be produced if it is cost effective
to the organization.
2. Financial accounting reports detail the whole business whereas Management
accounting reports focus on small units e.g departments, sections of the
organization e.g cost and profitability of a product, department e.t.c.
3. General accepted accounting principles (GAAPs)
Financial Accounting statements are prepared as per legal requirement and
generally accepted accounting principles established by regulatory bodies e.g.
International Accounting Standards Committee (IASC), Accounting Standards
Board (ASB) for uniformity.
Management Accounting focuses on producing reports to serve the management’s
needs for effective decision-making, planning and control functions.
4. Time Dimension;
Financial Accounting is concerned with historical reports i.e what has happened
in the past (Retrospective Accounting)
Management Accounting is concerned with future as well as past information
(Prospective Accounting)
5. Report Frequency
Financial Accounting reports are published annually for detailed reports and semi-
annually for lesser detailed reports.
Preparation of management accounting reports depend on the need by
management to make decisions and can be prepared daily, weekly, monthly e.t.c.

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 Functions of Management Accounting
A cost and management accounting system should generate information to meet
the following;
a) Allocate cash between cost of goods sold and inventories for internal and
external profit reporting;
b) Provide relevant information to help managers make better decisions.
c) Provide information for planning, control and performance measurement.
The control process involves the setting up of targets or standards against
which actual results are measured.

Difference Between Cost Accounting & Management Accounting

Cost Accounting is concerned with cost accumulation for inventory valuation to meet
the requirements of external reporting and internal profit measurement.

Management Accounting relates to the provision of appropriate information for decision

making, Planning, Control and performance evaluation

Cost Accounting is the process of cost ascertainment and cost control. It is therefore a
formal system of accounting for costs by means of which cost of products and/or services
are ascertained and controlled.

2. Attributes of good information:

Information is anything that is communicated. It is sometimes said to be processed data
Information therefore, is data processed in such a way as to be of some meaning to the
person receiving it. The attributes of good information are;

a) It should be relevant to the users needs. For the communicator (sender), it means;
i) Ability to identify the user of the information,
i.e information must be send to the right person requiring it .
ii) The communicator must get the purpose right. information is effective
when it helps the user to make decision.
iii) Communicator must get the volume right. Avoid information overload or
underload.
For costs to be relevant it must have predictive ability, value additivity and
incremental cash flow.

b) Information should be accurate within the users needs i.e information should be
correct and error free (GIGO concept)
c) It should inspire the user’s confidence. Information should not give the user any
reason to doubt, mistrust or disbelief or ignore it. This is important when we
consider business. We must try as much as possible to be neutral.
d) It should be timely information. Information must be readily available within the
time period, which makes it useful. It must be in the right place at the right time.

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e) It must be appropriately communicated. Information may lose its value if it is not
clearly communicated to the user in a suitable format through a suitable media.
f) It should be cost effective. Good information should not cost more than it is
worth. Gathering, storing and retrieving information may require expenses in
form of time, energy and resources. It is therefore important that before providing
information, it potential value (Benefit) is determined. If cost is higher than the
benefit, don’t provide the information e.g. hiring consultants to carry out research.

1.3 Role of the Management Accountant in the Management process:

The Management process involves planning, organising, controlling,
communicating, motivating, directing and co-ordinating.

1. Planning:
This is a basic function of management by means of which the manager decides.
a) What goals are to be accomplished.
b) How they are going to be accomplished. Planning gives the manager a
warning of possible future crises, and therefore the manager avoids
making bad decisions.

Role of the Management Accountant

The Management Accountant helps to formulate future plans by providing
information to assist in deciding what products, to sell in what markets, at what
price and in evaluating proposals for capital expenditure. The Management
Accountant also helps in preparation of the budget by providing data on past
performance, establishing budget produce and budget timetables. The
Management Accountant is referred to as a budgetman.

2. Controlling:
It involves a comparison of actual performance with the planned performance so
that deviation from the planned can be identified and corrective action taken. It
can therefore be defined as a process of comparing events to conform to plans.

Role of the Management Accountant

The Management Accountant helps in the control process by producing
performance reports that compare the actual outcome within the planned outcome
for each responsibility centre (segment within organization whose manager holds
delegating authority and is responsible for the segment’s performance). For each
segment the manager provides a performance report.

The Management Accountant also draws the manager’s attention to those specific
activities that do not conform to the plan. This is referred to as “management by
exception”.

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 3. Organizing:
This is process of establishing the framework within which the required activities
are to be performed and the designation of who should perform these activities.
Involves coming up with departments, sections, branches etc.

Role of the Management Accountant

The Management accountant provides information on the performance of each of
these segments.

4. Motivation:
Involves influencing human behaviour, so that the participants identified with the
objectives of the organizations can make decisions that are in harmony with those
objectives.

Role of the Management Accountant

Budget and management reports produced by management accountant help in
motivation.

5. Communication
To communicate is to make known, impart or transmit information.

Role of the Management Accountant

Management accountant aids in the communication process by installing and
maintaining effective communication and reporting system. The management
accountant comes up with management accounting information systems eg.
Budgetary system.

1.3. THE DECISION MAKING PROCESS

The process of choosing among alternatives can be said to have the following steps:

Step 1: Identification of the objective(s)

Step 2: Search for alternative courses of action
Step 3: Collection of data on the alternatives
Step 4: Selection of the best alternative
Step 5: Implementation of the decision
Step 6: Comparison of outcome with the planned outcome.
Step 7: Correct any deviations from the planned performance.

Decision making Environment:

There are four areas under which decisions can be made:
a) Certainty
b) Risk
c) Fundamental uncertainty
d) Competition –(e.g. when advertising and competitors advertise)
A case of such decision-making environment is the Prisoner’s Dilemma.

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(a) Certainty Environment:
Complete information is available regarding which state of nature will
occur. Certainty models are used to make decisions in such this environment.
The decision making process in this environment involves just picking the best
alternatives. Certainty environment is an ideal case, which doesn’t exist, in real
life.

(b) Risky Environment

Risk involves situations that may or may not occur but whose probability of
occurrence may be calculated statistically and the frequency of their occurrence
predicted from past records. In this environment, the expected monetary value
(EMV) can be computed and the decision that maximizes the expected monetary
value (EMV) chosen.

(c) Fundamental Uncertainty Environment:

Uncertain events have outcomes that cannot be predicted with statistical
confidence, i.e. the decision-maker may not know all the variables that are
relevant or can he estimate their probability. Decisions in this environment
depend on the decision-makers attitude towards risk.
Risk taker - assumes the best alternative will occur. (Pessimistic)
Risk averter – assumes the worst alternative will occur (Optimistic)

(d) Competitive Environment

Decisions of the company are affected by decisions of other companies who have
opposing intentions/interests.

Illustration: (Decision making under Risk and Uncertainty)

ABC Ltd. is trying to set up the selling prices of its product and the prices
under consideration are Shs. 4.00,. Shs. 4.30 and Shs. 4.40.
The demand is uncertain but this estimate has been made as follows;
NB: state of nature cannot be changed, Conditions can be changed.

Selling Price Sh 4.00 Sh 4.30 Sh 4.40

Expected sales vol. (Units)
Best possible (BP) 16,000 14,000 12,500
Most likely (ML) 14,000 12,500 12,000
Worst possible (WP) 10,000 8,000 6,000

The fixed cost is Sh. 20,000 and the variable cost per unit is Sh.2.00

Required:
Advice the management on the best price to set.

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 Methods that can be used

1. Maximax Decision criterion

This criterion looks at the best possible result and from this it chooses the
maximum sales. We need to come up with the profit table.

Compute profit

Payoff Matrix (profit)

Selling Price Sh4.00 Sh4.30 Sh4.40
Expected profit
BP 12,000 12,200 10,000
ML 8,000 8,750 8,800
WP 0 (1,600) (5,600)
Maximum profit 12,000 12,200 10,000

Profit = [(Sh 4.30-2.00) 14,000 units]– Sh 20,000= Sh 12,200

At a price of Sh4.00 the condition chosen is the Best Possible.
Decision
Set a price of Sh 4.30 since it is the maximum of the maximum payoff.

This criteria appeals to risk takers as they are ready to take huge risks if they occur. It is
optimistic.

2. Maximin Decision Criterion

Under this rule decision makers look at the worst possible outcome of each decision
alternative and then chooses the alternative that offers the best alternative. In other words
we choose the alternative that maximizes the minimum payoff.

Payoff Matrix
We choose a price of Sh 4.30 since it maximizes the minimum outcome.

Selling Price Sh 4.00 Sh 4.30 Sh 4.40

Expected profit
Best possible 12,000 12,200 10,000
Most likely 8,000 8,750 8,800
Worst possible 0 (1,600) (5,600)
Minimum 0 (1,600) (5,600)

Limitation:
A conclusion is exclusive caution appealing to risk-averse decision-makers.

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3. Minimax Regret Criterion
This criterion seeks to minimise the maximum regret that would occur from choosing a
particular strategy as alternative. A regret is the opportunity loss taking one decision
given that a certain state of nature occurs.

Opportunity loss table

Selling Price Sh 4.00 Sh 4.30 Sh 4.40
Opportunity loss (Sh)
BP 200 0 2,200
ML 800 50 0
WP 0 1,600 5,600
Max 800 1,600 5,600

Decision
Set a price of Sh. 4.00 since it minimises the opportunity loss.

4. Laplace Criterion of rationality

This criterion holds that if decision makers do not know the probability of various states
of nature and have no reason to think otherwise then the states of nature should be
considered to be equally likely. Based on this the expected monetary value is computed
and the alternative that maximises the expected monetary value (EMV) chosen. The
expected value can be given as:

n
EMV = Pt
∑ MV
t=1
t

Where MVt is the monetary value under condition t

Pt is the probability of condition t occurring.

Selling Price Sh 4.00 Sh 4.30 Sh 4.40

Expected profit Prob.
Best Possible(BP) 1/3 12,000 12,200 10,000
Most Likely ( ML) 1/3 8,000 8,750 8,800
Worst Possible (WP) 1/3 0 (1,600) (5,600)
EMV 6,667 6,450 4,400

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 EMV4.00 = 1/3(12,000) +1/3 (8,000)+1/3(0) =Sh 6,667
EMV4.30 = 1/3 (12,200) + 1/3 (8,750) + 1/3(-1,600) =Sh 6,450
EMV4.40 = 1/3(10,000) +1/3 (8,800)+1/3 (-5,600)= Sh 4,400

Decision
Set a price of Sh 4.00 since it maximises the EMV.

Decision making under Risk

In this environment it is possible to attach probabilities to the various states of nature

decision criteria will either be the expected monetary value/EMV the expected
opportunity loss.

Illustration
Assuming the ABC pricing decision that the probability of the best outcome is 0.2, most
likely 0.6 and the worst likely 0.2.

Required:
Using the EMV and the expected opportunity loss (EOL) advice the management on the
best price to set.

Selling Price Sh 4.00 Sh4.30 Sh 4.40

EMV Prob
BP 0.2 12,000 12,200 10,000
ML 0.6 8,000 8,750 8,800
WP 0.2 0 (1,600) (5,600)
EMV 7,200 7,370 6,160

MV4.00 =0.2(12,000) +0.6 (8,000) +0.2(0) = Sh 7,200

Decision
Set a price of Sh 4.30 since it maximizes the EMV.

Compute expected opportunity loss (EOL)

Selling Price Sh 4.00 sh 4.30 sh 4.40
EOL (Sh) Prob.
BP 0.2 200 0 2,200
ML 0.6 800 50 0
WP 0.2 0 1,600 5,600
EOL 520 350 1,560

EOL4.00 = 0.2(200) +0.6(800)+ 0.2(0) = Sh 520

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EOL4.30 = Sh 350, EOL 4.40 = Sh 1,560

Decision
Set a price of Sh 4.30 since it minimizes the Expected Opportunity Loss (EOL)

Note. The EMV and the expected opportunity loss (EOL) lead to similar decision since the
choice that maximises the EMV also minimises the EOL.

Measures of Risk
1. The Standard deviation is a measure of variability.

Total business risk as measure using the standard deviation is calculated as follows:

n
∂ = (∑ ( MVt − EMV ) 2 Pt )1 / 2
t =1

The higher the standard deviation the higher the risk.

SD4.00 =[(12,000 – 7,200)2 0.2 + (8,000 – 7,200)2 0.6 + (0-7,200)2 0.2)]1/2

= Sh3,919

SD4.30 =[(12,200 – 7,370)2 0.2 = (8,750 – 7,370)2 0.6 = (-1,600 – 7,370)2 0.2]½

=Sh 4,679

SD4.40 = [(10,000 – 6,160)2 0.2 + (8,800 – 6,160)2 0.6 + (-5,600 – 6,160)2 0.2)]1/2

=Sh 5,898

Decision:
Set the price at Sh4.00 since it has the lowest risk (lowest standard deviation).

2. Co-efficient of variation (CV)

This is a measure of a relative business risk and is used to choose from alternatives of
significantly different magnitude.

CV= SD
EMV

CV4.00 = 3,919 = 0.544,

7,200

CV4.40 = 5,898 = 0.957

6,160

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 CV4.30 = 4,679 = 0.635
7,370

NOTE
The higher the co-efficient of variation the higher the relative business risk

Decision
Set a price of Sh 4.00 since it minimises the coefficient of variation.

Multi-stage decision making

This involves the use of decision trees.
A decision tree is a graphical representation of a decision process indicating decision
alternatives, states of nature, associated probabilities and conditional payoffs for each
combination of a decision alternative and a state of nature.

Illustration 1:

Consider the ABC pricing decision illustrated above and using a decision tree advice the
management.

BP 12,000
0.2
ML 8,000
0.6
7,200 WP 0
0.2
BP 12,200
0.2

7,370 price 4.30 7,370 ML 8,750

0.6

WP (1,600)
0.2

BP 10,000
0.2
6,160 ML 8,800
0.6
WP (5,600)
0.2

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Illustration:

Assume that a Software Company has just won a contract worth $80,000 if it delivers a
successful product on time, but only $40,000 if it is late. It faces this problem now of whether to
produce the software of to subcontract at a cost of $50,000. The subcontractor is so reliable that
it is certain it will produce the software on time (prob.1)

If the software is produced in-house the cost will be $20,000 but based on past experience there
is only a 90% chance that a successful product is produced. In the event of the software not
being successful, there would be insufficient time to re-write the whole package internally.
However, there would be the option of late rejection at an extra cost of $10,000 or late sub-
contracting on the same terms as before. With the late subcontracting the sub-contractor has a
50% chance of producing it on time. Assume that the subcontractor will be paid $50,000
regardless of whether he meets the deadline or not.
Required:
Using a decision tree advice the manager.

Successful 80,000

0.9 Late rejection 0

(10,000)

23,000

Inhouse late rejection 0

(10,000)
20,000 Failure
0.1 10,000

Late subcontractors

On time 80,000
50,000 0.5
₤53,000
Late
Subcontractor on time 80,000 0.5
1 40,000
50,000 80,000
0
40,000

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The decision that maximizes the EMV is to attempt initially to produce in-house and, if it fails,
subcontract. The EMV would be Sh5,300 and the Company has a 90% chance of making
Sh60,000, a 5% chance of making profit of Sh10,000 and a 5% likely profit (monetary loss) of
Sh(30,000).

0.9 x 60,000 = Sh 54,000

0.5 x 10,000 = Sh 5,000
0.5 x 30,000 = Sh (15,000)

Perfect and Imperfect Information:

Uncertainty about the future outcomes can sometimes be reduced by first obtaining more
information on what is likely to occur. Such information can be obtained from various sources
e.g. marketing research surveys, conducting pilot tests or building a prototype model.
Information can be categorised depending on how reliable it is likely to be in predicting what
will happen in the future and therefore for helping management in making better decisions.
Perfect information is information that is guaranteed to predict the outcome with 100% accuracy.
Imperfect information on the other hand, although it might be quite good and better
though having no additional information it could be wrong in its prediction of the future.
Imperfect information is also referred to as sample information. Both perfect and imperfect
information will be costly to acquire and therefore its value must be determined.

Perfect Information

Value of Perfect Information= EMV with Perfect Information–EMV without Perfect Information

Illustration:

Assume that given ABC pricing decision (above) it is possible to obtain ideal information at Sh.
500.
Required:
Determine whether the perfect information should be acquired.
Solution:
Selling Price Sh 4.00 4.20 4.40
Expected profit Prob.
BP 0.2 1,200 12,200 10,000
ML 0.6 8,000 8,750 8,800
WP 0.2 0 (1,600) (5,600)

Expected Monetary Value (EMV)

With PI = Sh 12,200 (0.2) + 0.6 (8,800) + 0.2(0) = Sh 7,720

Value of Perfect Info = Sh 7,720 – 7,370 = Sh 350

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Decision:
Don’t pay for perfect information (PI) since it has a higher cost than its worth.

NOTE: The value of perfect information is equal to the minimum Expected Opportunity Loss.

Imperfect Information

Value of Imperfect Information = EMV with Imperfect Info - EMV without Imperfect Info

Illustration:
Assume that a small oil company is wants to decide whether to drill on a particular site and the
Chief Engineer has assessed the following probabilities:
Probability
There will be Oil 0.2
There will be No Oil 0.8

It is possible for the Oil Company to hire a firm of international consultants to carry out a
complete survey of the site. The Oil Company has used the consultants many times before and
has made the following estimates;

i) If there is Oil then there is a 95% chance that the report will be favourable.
ii) If there is No Oil then there is a 10% chance that the report will be favourable.
The cost of drilling is $ 10 million
Value of benefit is $ 70million
Cost of hiring the consultant $ 3 million.
Required:
a) Advice the company.
b) Compute the value of the sample information.

Solution:
P(Oil) = P(O) = 0.2
P(No Oil)= P(N) = 0.8
P(F/O) = 0.95
P(F’/O) = 0.05
P(F/N) = 0.10
P(F’/N) = 0.90

Where:

P(F/O) = probability that the report will be favourable given that there will be oil.
P(F’/O) = probability that the report will be not favourable given that there will be oil.
P(F’/N) = probability that the report will be favourable given that there will be no oil.

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From Bayes Theorem

P(B/A) = P(B) x P(A/B) = P(BnA)

P (A) P(A)

Thus:

P(O/F) = P(O) x P (F/O)

P(F)

F
0.95
0il F1

0.2 0.05

No Oil
F

0.8 0.1
1
F O.9

P(F) = 0.2 X 0.95 + 0.8 X 0.1 = 0.27

P(F) = 0.73

P(O/F) = P(O) x P(F/O) = 0.2 X 0.95 = 0.704

P(F) 0.27

P(O/F) = 1 – 0.704 = 0.296

P(N/F1) = P(N) X P(F1/N) = 0.8 X 0.9 = 0.986

P (F1) 0.73

P(O/F1) = 1 – 0.986 = 0.014

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 ₤70m
Oil
0.2
Drill 14
4 (10m) No Oil
0
Don’t drill O 0.8

No consultants

7.61m
₤70m
Oil
0.704

Drill No Oil
49.28 0.296 0
(3m) Hire Consultants Drill
10
39.28 Don’t Drill 0
F
0.27 ₤70m
10.61 F 0.16
0.73 Drill 9814 0.014
0 ₤10 No Oil
0.980 0
Don’t Drill

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Decision:
Hire the consultant and if the report is favourable drill. If not favourable don’t drill.

Value of imperfect information

= 10.61 – 4.0 m = Ksh 6.61 m

Hire consultants and if the report is favourable you will drill, if it is not favourable do not drill.
The net benefit of hiring the consultant

= Ksh 6.61m – 3 = 3.61m

or
= Ksh 7.61 – 4m = 3.61m

QUESTION

1. Distinguish perfect from imperfect information.

2. Distinguish Management Accounting from Financial Accounting.
3. Explain the role of the Management Accountant in the management
process.
4. Explain the good qualities of management accounting information.

SUMMARY

In Lesson One we looked at management accounting and its distinction

from other fields in accounting. We also looked at how management
accounting is applied in decision making and good qualities of management
accounting information.

KEY WORDS

• Prospective Accounting
• Retrospective Accounting
• Payoff
• Expected Value
• Expected opportunity Loss
• Decision Tree

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FURTHER READING

1. Drury, Colin (1996), "Management and Cost Accounting" 4th Edition,

International Thomson Business Press, London.
2. Horngren, C.T. (1997) "Cost Accounting: A Managerial Emphasis", 9th
Edition, Prentice Hall.
3. Horngren, C.T. & Sundem, G.L. 1990, "Introduction to Management
Accounting" 8th Edition, Prentice Hall International.

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 LESSON TWO

2.0. COST CONCEPTS & CLASSIFICATION

2.1. OBJECTIVES

By the end of this lesson, you should be able to:

1. Distinguish various type of costs and classify them appropriately

2. Identify relevant and irrelevant costs
3. Show how various costs influence the decisions made.

2.2. INTRODUCTION
To ensure that the learner gets a better grasp of the lesson we will start by defining some key
terminologies to be used in the discussion.

Definition of terms
(a) Cost
Accountants define cost as resources forgone or satisfied to achieve a specific objective. It is the
monetary unit that must be given up for goods or services.

(b) Cost Objects

If the users of accounting information want to know the cost of something, this something is
called cost object.
Any activity for which a separate measurement of cost is desired e.g. products, costs, services or
a combination of products and services. Cost objects can be divided into two:

(c) Cost Unit

This is a unit of product or service in relation to which costs can be ascertained or expressed. It
is the basic control unit for costing purposes. It’s nature will depend on type of goods produced
and services being offered by the company. e.g. cost of producing OMO - basic control unit is
cost of producing a kilo of Omo.

(d) Cost Centre

This is a location, a person, item of equipment, (or group of these) for which costs may be
ascertained and used for control purposes. A cost centre acts as a collecting place for costs
before they are analysed further e.g. department, division.
Note: The total costs of a cost centre may be related to the cost units that have passed through the
centre, or the total cost reallocated over other cost centres.
Examples: Production department, production service department (e.g departures),
Administration department, Sales and distribution department, Research and Development
department. etc

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2.3. CLASSIFICATION OF COSTS
Costs are classified according to the purposes.
1. Costs are classified for stock valuation and profit measurement. Under this category, we have
periodic cost and product cost.

(a) Product costs are costs that can be identified with the goods and services produced for sale in
manufacturing firm, these costs are attached to the products and therefore can be said to be
inventoriable costs.
(b) Periodic costs are costs not included in the stock valuation and therefore treated as expenses
in the period in which they are incurred. They are incurred through the passage of time and
therefore there is no attempt to attach them to the product for stock valuation e.g.
administration costs such as salary of a Managing Director incurred over a period and not
unit, rent.

1. Classification of Costs for Decision Making, Planning and Control

(a) According to cost behaviour

According to the variability with the level of activity (volume) we have fixed, mixed and
variable costs.

(i) Variable costs

A cost that changes in total in direct proportion to changes in the related activity level or volume
e.g cost of material, sales commission, purchase cost. Diagrammatically these can be shown as
below:

Cost
Total variable
Costs

0 Volume(units)

From the above diagram variable cost per unit is constant.

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(ii) Fixed Costs:
These are costs that remain unchanged in total for a given time period despite changes in
the related level of activity e.g. rent, management salaries etc. (See diagram below)

Cost

Volume (units)

The total cost remains the same whether production goes up or down. The fixed cost per
unit is however variable as shown below (i.e. declines as the level of activity rises)

Cost

Fixed cost per unit

Volume (units)

(iii) Mixed Costs (semi-variable costs):

These have characteristics of both fixed and variable components and are partly affected by
fluctuations in the level of activity e.g. cost of electricity or telephone bills (they include a
standing/basic charge and a cost based on number of units consumed).

Cost Cost
Mixed cost (semi-variable)
e.g Telephone, Electricity - mixed costs

- Semi-fixed (stepped costs)

e.g postage

0
Volume Volume

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Cost Cost

Maximum costs

e.g sales commission with maximum pay e.g sales commission with
minimum pay and commission
thereafter

Volume Volume

2. According to the degree of traceability to the final product:

By looking at the final product, one can see the production costs e.g. management cost of a
chalk.
We have direct and indirect costs.

(i) Direct Costs ( also prime costs)

Costs that can be valued in total to the product or service that is being costed e.g. direct material
costs, direct labour costs and direct expenses.

Prime cost = direct expenses + direct labour + direct expenses

(ii) Indirect costs (Overhead costs)

Costs which in the process of making a product or providing a service or running a department
but which cannot be traced directly and in full to the product, service or department e.g. indirect
materials, indirect labour, indirect expenses such as cost of utilities, stationery, supervisory,
salaries etc.

Overheads = indirect material + indirect labour + indirect expenses

Total cost of production = prime costs + overheads
Conversion costs = Total costs – material costs
Convention cost is cost of converting input material into final product.

3. According to the relevance:

We have relevant costs and irrelevant costs.

(i) Relevant Costs:
Cost which can change the decision under consideration.

(ii) Irrelevant costs:

Costs which if changed will not affect the decision under consideration.

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To be relevant a cost must:
(i) Relate to the future - historical costs are not relevant.
(ii) Be incremental (differ between cost with decision and cost what decision)
(iii) Be Cash flow in nature - costs which do not affect cost inflows and outflows e.g.
depreciation, notional (imputed) rent/interest etc.

4. Avoidable or Unavoidable

According to what degree costs can be avoided we have:

(i) Avoidable costs:
Cost saved by not adopting a given alternative.

(ii) Unavoidable costs:

These are costs that will be incurred regardless of whether the decision is made or not.

Avoidable costs are relevant for decision-making. Unavoidable costs are irrelevant for decision-
making

Opportunity Cost
Measures the opportunity foregone or sacrifice made when the choice of the action requires an
alternative action to be given up. It relates to the use of scarce resources.

(a) Classification by function or department. Costs can be classified either as manufacturing,

sales and marketing, Research & Development costs etc.

(i) Manufacturing costs: (Production costs)

These are costs incurred by the sequence of operation beginning with the supplier of raw
materials and ending with the completion of the product ready for warehousing (inputs to
finished goods).

(ii) Administration costs

These are costs of managing an organization i.e. costs of planning and controlling company
operations e.g. management salaries.

(iii) Sales and marketing costs

These are costs of creating demand for the product and securing firm orders from the customers.

(iv) Distribution costs

These are costs of sequence of operations beginning with the receipt of finished goods from
production department and ending with the reconditioning for re-use of returned empty
containers.

(v) Research and Development costs

These are costs of searching for new or improved products and costs of producing such products.

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Other costs
(i) Discretionary and Non-discretionary costs
Discretionary costs These are costs where managers make decisions to incur or not.
These relate to support services e.g. advertising costs

Non discretionary costs: must be incurred you cannot choose not to incur material costs
for production to take place.

(ii) Committed costs

These are costs that have not been incurred but have been planned to be incurred e.g. a
contract. They are irrelevant costs.

(iii) Sunk costs

Historical costs that have no future benefits. Have already been incurred or paid for.
They are not relevant for decision making.

RELEVANT COSTS FOR NON-ROUTINE DECISIONS

Relevant costs are appropriate costs to specific management decisions and therefore affected by
the decisions. Their main features are:

(i) They are future costs – A decision is always about the future and may not change what
has been done. A cost induced in the past is totally irrelevant to any decision being made
now e.g. sunk costs, committed costs.
(ii) They are cash flows. It is assumed that decisions are taken that will maximize the
satisfaction of the company’s owners and therefore such decisions must change the net
cashflows. Costs that do not reflect additional cash outflows should be ignored in
decision making process.
(iii) They should be incremental - arise as a direct consequence of a decision i.e the
differential costs if the decision is “undertaken” and if it is “not undertaken”.

Assumptions of irrelevant costing

(1) The cost behaviour patterns are known ( e.g. fixed, variable etc)
(2) The objective of decision making in the short term is to maximise short term profits.
(3) The information on which a decision is based is complete and reliable i.e decisions are made
with perfect information.

Make or buy decisions – No limiting factors

It involves a decision by an organization about whether it should make a product or carry out an
activity with its own internal resources or whether to pay another organization to make the
product or carry out an activity.

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Illustration
Assume ABC Limited makes four components for which costs in the coming year are:
PRODUCT
W X Y Z
Production (units) 1,000 2,000 4,000 3,000
US$ US$ US$ US$
Direct materials 4 5 2 4
Direct labour 8 9 4 6
Variable costs 2 3 1 2
Total variable cost/unit 14 17 7 12

Directly attributable fixed costs Subcontractor’s price

To: PRODUCT
W - US$1,000 W = US$ 12
X- 5,000 X= 21
Y- 6,000 Y= 10
Z- 8,000 Z= 14

Committed fixed costs = US$ 30,000

Required:
(a) Advice the company whether to buy or make the component.
(b) What other factors will you consider in the decisions (a) above

Solution:
(a)
W X Y Z

Unit variable cost of making (US$) 14 17 7 12

Unit variable cost of buying (US$) 12 21 10 14
Extra unit VC of buying (US$) (2) 4 3 2
Annual requirements (US$) 1,000 2,000 4,000 3,000
Total extra VC of buying (US$) (2,000) 8,000 12,000 6,000
Less attainable fixed costs (US$) 1,000 5,000 6,000 8,000
Extra cost of buying (US$) (3,000) 3,000 6,000 (2,000)

Note:
Committed fixed costs are irrelevant and not considered.
DECISION: Buy W and Z and Make X and Y.

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(b) Other factors (outsourcing)
(i) How reliable is the supplier who will supply the buy items.
(ii) The quality of inputs used by the supplier and hence the quality of the outsourced
product.
(iii) Effect on employees - outsourcing will mean redundancies.
(iv) Consider the expected change in price given by the subcontractor – this will affect the
decisions already made.
(v) Effect of outsourcing on suppliers e.g. if there is a prior commitment or economies of
scale.

Make or Buy decisions (With Limiting factors)

One reason for buying from another organization is the scarcity of the resources. A company
may want to do more things than it has resources for and therefore it would be required to
combine internal resources with buying externally to improve profitability.

A major decision to consider is how to increase the work between internal and external efforts.
In situations where the company must sub-contract work to make up for shortfall in its inhouse
capability its costs would be minimized where the marginal cost of buying is least for every unit
of scarce resource saved by buying externally.

Illustration.
Assume that ABC Limited manufacturers 3 components; A, B and C using the same machine.
The components are assembled into units of product X. One unit of this product requires one
component of A, B and C each. The budget for next year requires production of 4,000 units of X
at the following costs.

Variable costs Machine hrs required Subcontractors Price

A Ksh 20 3 hours Ksh 29
B Ksh 36 2 hours Ksh 40
C Ksh 24 4 hours Ksh 34
Assembly costs = Sh 20 per unit

Only 24,000 machine hours will be available during the next year.

Required: Advice the company.

Solution

Required machine hours:

A = 4,000 X 3 12,000
B = 4,000 X 2 8,000
C = 4,000 X 4 16,000
Total 36,000
Available mhrs (24,000)
Shortfall 12,000

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Analysis
A B C
V.C of making (Ksh) 20 36 24
VC of buying (Ksh) 29 40 34
Expan VC of buying (Ksh) 9 4 10
Divide by no of MHrs ÷3 ÷2 ÷4
Additional VC of buying
per Machine Hour (Ksh) 3 2 2.5
Priority for buying (Ranking) 3 1 2
Priority for making 1 3 2

The production mix ( i.e flow much to make and buy)

Make Units Mhrs Buy Units Mhrs saved

A 4,000 12,000 B 4,000 8,000
C 3,000 12,000 C 1,000 4,000
24,000 12,000

Assembly cost is irrelevant

- No future cost
- Not cash flow
- Not incremental

Attributable fixed costs

A Ksh 10,000 Total no of Mhrs
B 18,000 A=12,000
C 20,000 B= 8,000
C=12,000 + 4,000 = 16,000

A B C
V.C of making (Ksh) 20 36 24
V.C of buying (Ksh) 29 40 34
Extra V.C buying (Ksh) 9 4 10
Number of units 4,000 4,000 4,000
Total extra VC of buying 36,000 16,000 40,000
Less Attributable fixed costs 10,000 18,000 20,000
Net extra cost of buying 26,000 (2,000) 20,000
Total M/hrs required ÷12,000 ÷8,000 ÷16,000
Net extra costs of buying per
Machine hour saved 2.17 (0.25) 1.25
Priority for buying 3 1 2
Priority for making 1 3 2

When there are two or more limiting factors we use linear programming and not the above
method.

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Shut down Problems
These problems involve decisions about:
(1) Whether or not to close down a factory, a department, a product line either because it is
making losses or it is too expensive to manage.
(2) If the decision is to shutdown, whether the closure should be permanent or temporary.

In practice shutdown problems involve long term considerations of capital expenditure and
revenue. It is possible however to simplify these decisions into short term decisions either by
assuming that:
1. Fixed Asset sales and redundancy costs would be negligible.
2. Income from fixed asset sales would match the redundancy costs i.e will cancel (offset)

Illustration
Assume a company makes three products P, R & B and following information is prundent.

P R B Total If you stop R

US$ US$ US$ US$ US$
Sales 50,000 40,000 60,000 150,000 110,000
Variable costs 30,000 25,000 35,000 90,000 90,000
Contribution 20,000 15,000 25,000 60,000 45,000
Fixed costs 17,000 18,000 20,000 55,000 50,000
Profit (loss) 3,000 (3000) 5,000 5,000 (5,000)

The company is concerned with the poor performance and is considering stopping production of
product R. Attributable fixed cost of US$ 5,000 is avoidable.

Required:
(a) Advice the company whether to stop production of R.
(b) Assume the resources released by stopping product R can be switched to producing product
C which has: Sales = US$ 50,000, Variable costs = US$30,000 and Extra fixed cost = US$
6,000.
Advice the company.

Solution:
US$
(a) Contribution of R 15,000
Less attributable fixed cost 5,000
Contribution to shield fixed costs 10,000

Decision
Continue producing R since it has a positive contribution to shield fixed costs.

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(b)Compare R and C

R C
Sales (US$) 40,000 50,000
Variable cost (US$) 25,000 30,000
Contribution (US$) 15,000 20,000
Avoidable fixed cost 5,000 6,000
Contribution to
Shield fixed cost 10,000 14,000

DECISION: Switch from R and produce C. This could result in the reduction of demand for P
and B because of switch by customers.

Extra Shift Decisions

These decisions are concerned with whether or not a company should work for 8 hrs, 16 hrs or
24 hrs a day, weekdays only or weekends also. The factors to be considered are:

1. Whether the employees will be willing to work extra shifts and if so whether the shift
premium/overtime pay will be accepted.
2. Whether extra hours have to be worked to remain competitive. ( i.e if competitors increases
working hrs you have to increase also)
3. Whether extra hours will result in more sales revenue or whether there will be merely a
change of demand patterns from customers.

Illustration
XYZ Limited currently operates a single production shift which incurs costs earns revenues as
shown below:

Ksh Ksh
Sales (10,000 units) 360,000

Direct materials 120,000

Direct labour 100,000
Variable overheads 20,000 240,000
Contribution 120,000
Fixed costs 90,000
Profit 30,000

Sales demand exists for extra 6,000 units at the existing selling price, which could be made in a
second shift. Labour cost in the 2nd shift will be 11/4 times and additional fixed costs will Ksh
10,000 but because of increased purchases of materials a quantity discount of 5% will be
obtained on all materials purchased.

Required:
Advice the company on whether to operate the 2nd shift.

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Solution
Second shift
Ksh
Sales (6,000 units @x 36 units) 216,000
Less direct materials
Total material cost (95%x12x16,000) =182,400
Less material cost of shift 1 120,000
Incremental material costs
(Relevant material cost) 62,400
Labour cost (1.25 x 100,000) 125,000
Variable overheads (6,000 x Ksh2) 12,000 199,400
Contribution 16,600
Incremental fixed costs 10,000
Incremental profit 6,600

DECISION: Operate 2nd shift because we have extra profit Ksh 6,600. This is when demand is
extra and cannot be served by the first shift.

Other factors should also be considered e.g

- Effects on employees of working an extra shift.
- Whether machines will be overworked (available physical production capacity)

Joint Product Decisions

When a manufacturing company carries out an operation in which two or more joint products are
produced from a common process, then a number of problems can arise. These are:

1. If the joint products can be sold at the existing conditions at the split-off point or after further
separate processing then a decision should be made on whether to process further.
2. If there is extra demand for one joint product and not the other, then it will be necessary to
know whether it is worth to make more output of the joint product in order to make a profit
on one and dispose off the other.
3. It may be possible to change the production in order to change the product mix. The product
mix decision will then have to be made, taking into account the cost of changing the mix and
the incremental sales revenue from selling the new mix.

1. Joint product further processing decision

The relevant costs are the additional costs of further processing which should be compared with
the incremental revenue of further processing. Joint costs (cost before the split-off point) are
irrelevant.

Illustration:
ABC Ltd produces product A and B from the same process and incurs a joint processing costs of
Ksh 150,000 upto the split off point where 100,000 units of A and 50,000 units of B are
produced. The selling prices at split off points are as follows:

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 Unit selling prices
Product A Ksh 1.25
Product B Ksh 2.00

Product A can be processed further to produce 60,000 units of A+ but extra variable costs of Ksh
0.30 per unit and extra fixed costs of Ksh 20,000 will be incurred.
The selling price of A+ is Ksh 3.25 per unit.
Required:
Advice the company on whether to process A further to A+.

Solution
Incremental sales revenue = [60,000 x 3.25]-[100,000 x 1.25] Ksh 70,000
Incremental costs of further processing ([0.3x100,000] +20,000) Ksh 50,000
Incremental Benefits of further processing Ksh 20,000

Product A should be processed further to A* since there will be an incremental benefit of Ksh
20,000.

ACTIVITY

1. Extra demand for one joint product and not the other
2. Product mix decision
3. Explain in details FIVE ways in which costs can be classified.
4. Discuss any five limitations/problems/pitfalls encountered in cost predictions
5. Explain briefly the following cost concepts:
(i) Direct costs
(ii) Indirect costs
(iii)Variable costs
(iv) Fixed costs
(v) Semi-variable costs
(vi) Marginal cost
(vii) Sunk cost

QUESTIONS
1. Explain what is meant by period costs and product costs.
2. You have been given the following information from Molecular Limited relating to its
product and cost data for the year ended 2000.
Ksh
Materials used 20,000
Wages paid 15,000
Variable manufacturing expense 10,000
Fixed manufacturing expense 30,000
Administration expenses 25,000

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Selling and distribution 38,500

Required
Prepare a statement showing product costs and period costs using the direct costing method.

Qtn. 3. Given the following information calculate the marginal cost of production.

Units of output 63,000 880,000

Kshs Kshs
Variable costs @Sh 46 per unit 2,898,000 4,048,000
Fixed costs 1,100,000 1,500,000
Total Cost 3,998,000 5,548,000

Qtn. 4. A Manufacturing Company produces three products in two departments. It has 60

employees, 20 work in the Machining department, 30 in the Assembly department and 10 are
management and staff.

The Managing Director owns the business that he founded three years ago with only five
employees. He is an engineer by training and has relied on the auditors to prepare half-yearly
trading and profit statements and balance sheets. These he has received ten weeks after the end
of each half-year.

The Managing Director is considering installing a cost accounting system. He has asked you to
prepare a report to:
(a) Describe briefly the main aims of the cost accounting system.
(b) List six specific types of information which could be obtained from the system, that cannot
be obtained from half yearly accounts presently prepared by the auditors, which would be of
significant help to him in running the business. You are required to write the report.

Qtn. 5. The transport department of the Norwest Council operates a large fleet of assorted
vehicles. These vehicles are used as the need arises by the various departments of the council.
Each month a statement is prepared for the transport department comparing actual results with
budget.

One of the items in the transport departments' monthly statement is the cost of vehicle
maintenance. Maintenance is carried out by the employees in the department.

To facilitate his control the transport manager has asked that future statements should show
vehicle maintenance cost analysed into fixed and variable costs. Data for the six months from
January to June inclusive are given below:
Vehicle Maintenance Vehicle Running
Cost ($) hours
January 13,600 2100
February 15,800 2800
March 14,500 2,200

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April 16,200 3,000
May 14,900 2,600
June 15,000 2,500

Required:
(a) (i) Analyse the vehicle maintenance costs into fixed and variable costs, by means of a graph,
based on the data given;
(ii) Prove your results by utilizing the least squares method (18 marks)
(b) Discuss briefly how you would propose to calculate rates for charging out the total costs
incurred to the user departments.

SUMMARY

In Lesson Two we have seen how cost can be classified and their relevance or irrelevance
in decision making. The learner should now be in a position to identify relevant costs and
make good management accounting decisions involving costs.

KEY WORDS

• Cost centres
• Cost objects
• Step costs
• Limiting factor
• Joint products

FURTHER READING

1. Deakin, E.B. & Mather, M.W. (1991) "Cost Accounting" 3rd Edition,
Richard D. Irwin Inc.
2. Drury, Colin (1996), "Management and Cost Accounting" 4th Edition,
International Thomson Business Press, London.
3. Hirsch, Maurice L. Jr. (1998) "Advanced Management Accounting" 2nd
Edition PWS-Kent Publishing Company, Boston.
4. Horngren, C.T. (1997) "Cost Accounting: A Managerial Emphasis", 9th Edition, Prentice
Hall

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 LESSON THREE

3.0. MARGINAL AND ABSORPTION COSTING (COST ACCUMULATION)

3.1. OBJECTIVES

By the end of this lesson, you should be able to:

1. Understand the application of the two costing techniques

2. Understand the merits and demerits of the two costing methods
3. Appreciate the use of Activity Based Costing (ABC)

3.2. INTRODUCTION
In Lesson Two we looked at how costs are classified and the importance of this classification in
decision-making. In Lesson Three we will be looking at how costs are accumulated.
Cost accumulation means building up cost of something usually the cost of a net product such as
a unit of production, a job or a service. The main purpose of a cost accounting system is to
provide a way in which costs can be recorded and accumulated. Two main methods of cost
accumulation are:
1. Traditional absorption costing
2. Marginal costing

3.3.Traditional Absorption Costing

Absorption costing means establishing costs for work done by adding indirect costs (overheads)
to the direct costs of materials and labour used in producing the work. The principle justification
of absorption costing is the matching or accrual concept of accounting whereby revenues are
matched with the associated costs both direct and indirect.

Any item that is costed must have both direct costs (and in a system of absorption costing, a
share of indirect cost). Direct costs can easily be traced to the final product, job or service.
Overheads however cannot be directly traced to the final product and therefore a system must be
established to determine the overhead attributable to the unit, service or job. This can be
achieved through:
(a) Overhead cost allocation
(b) Overhead cost apportionment
(c) Overhead cost absorption (or recovery)

(a) Overhead Cost Allocation

It is that part of cost attribution which charges a specific cost to a cost unit or a cost centre.
Every item of overhaul must be changeable directly to a specific cost centre and the cost
accounting system must be designed in such a way that there are sufficient cost centres to ensure
that this can be done.
Examples of cost centres are:

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 - Production departments
- Production service cost centres which services production centre e.g canteen
- Administration dept
- Sales and distribution department and shared cost centres

(b) Overhead Apportionment

This is that part of cost attribution which shares costs ensuring two or more cost centers or cost
units in proportion to the extracted benefit received. The purposes of cost apportionment are:

(i) To group overhead costs into three broad categories. These are:
1. Production overheads
2. Administration overheads
3. Selling, marketing and distribution overheads.

(ii) To group total production overheads into departmental overhead costs for each direct
production departmental overheads.

(c) Overhead Cost Absorption:

This is the process whereby the costs of production cost centres are added to the cost units ( unit
of production, job or service)

Overhead cost apportionment:

When overheads have been allocated they can apportioned. The 1st step in overhead
apportionment is to identify overhead cost as production, production service, administration or
selling and distribution overheads. This then means that the shared overheads must be divided
between other cost centres. The overheads must be shared on a fair basis and therefore a suitable
basis of apportionment of such cost then should be identified.
Examples of appropriate basis include:

Overheads Basis of Apportionment

1 Rent/Rates/Repairs & depreciation on buildings Floor area occupied
2 Depreciation and insurance of equipment Cost or book value of equipment in each
dept
3 Personnel office, canteen, welfare, wages, dept No. of employees – personal office
costs , cost office, administration costs labour costs- e.g insurance labour hours
worked in each department
4 Heating and lighting Volume of space or floor area occupied
by each department

Overhaul apportionment is concerned with the treatment of production overheads. In order to be

able to add production overheads unit cost, it is necessary to have all the overheads charged to
production department. This requires that service department costs be apportioned to production
department. This can be done through various methods. The method we are going to use
include:

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1. Direct method
This method ignores service usage. It apportions the cost of such service cost centre in turn to
the production department only.

Illustration
ABC Ltd has two production departments and two service departments as shown below.

Production Dept Service Department

A B Stores Maintenance Total

O/H Costs (Sh) 10,030 8,970 10,000 8,000 37,000

Cost of material
Requisition(Sh) 30,000 50,000 - 20,000 100,000
Manufacture(Hrs) 8,000 1,000 1,000 - 10,000

Required:
Apportion the total overhead costs between the production departments A and B.

Solution:
Determine the percentage usage:
A B Stores Maintenance
Materials & equip 30% 50% - 20%
Maintenance 80% 10% 10% -

Using direct method, then we have.

A B Stores Maintenance Total

Shs
Overheads allocated 10,030 8,970 10,000 8,000
Apportion to Stores 3,750 6,250 (10,000) -
Apportion to Maint. 7,111 889 - (8,000)
20,891 16109 0 0 37,000

Stores: 30% x 10,000 =3,750 Mantenance : 80% x 8,000= 7,111

80% 90%

Stores: 50% x 10,000 =6 250 Maint: 10% x 8,000 = 889

80% 90%

Disadvantage of the method

Ignores inter-service usage, thus it might allocate more overheads to the service.

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1) Step (elimination) method
This method lists service cost centres in order of priority on the basis of the percentage of their
work which is done for other service cost centres. The cost of the work done by the cost centre
at the top of the list is apportioned between/among the production cost centres and other service
cost centres.

The cost of the second service centre on the list is then apportioned and so on. Once the service
cost center cost have been apportioned, then the cost centre is eliminated from further
apportionment.

Illustration: ( Using example in method 1 above)

A B Stores Maintenace Total

Ovhds allocation 10,030 8,970 10,000 8,000
Apportioned stores Ovhds 3,000 5,000 (10,000) 2,000
Apparatus main Ovhds 8,889 1,111 - (10,000)
21,919 15,081 0 0 37,000

S to A: 30,000 x 10,000=3,000 Stores Dept is eliminated

10,000 continously

M to A: 80%x 10,000 = 8,889 Stores is eliminated first because

90% it gives more services to others

M to B: 10% x 10,000 = 1,111

90%

3. Repeated ( continous) Distribution

This method apportions the costs of each same cost centre to production department and also to
other service centre that make use of its services. This therefore requires the repetitive
apportionment of the overheads until the service cost centre costs are approximately equal to
zero.

A B S M Total
Ovhds allocated 10,030 8,970 10,000 8,000 37,000
Apportioned Stores Ovhds 3,000 5,000 (10,000) 2,000
Apportioned main office 8,000 1,000 10,000 (10,000)
1,000
Apportioned Stores Costs 300 500 (1,000) (200)
0 200
Apportion Maint. Cost 160 20 20 (200)
20 0
Apportion Stores Cost 6 10 (20) 4

40
Apportion Maint. Cost 32 0.4 0.4 (4)
21,499.2 1,550.4 0.4 0 37,000

4. Algebraic Method
This method uses simultaneous equations to determine the total cost of each service centre which
is then apportioned to the production cost centre.

Let S be the total overheads of stores department, and

M be the total overheads of maintenance department

Then
S= 10,000 + 0.1M
M= 8,000 + 0.2S

Solving the Simultaneous Equations:

M= 8,000 + 0.2 (10,000 + 0.1M)

M= 8,000 + 2,000 + 0.2 M

0.8M = 10,000
M= 10,000 = 100,000 = 10,204.08
0.8 8
S= 10,000 + 0.1 (10204.08)= 11,020.08 = 11,020.4

Thus these costs are apportioned directly.

A B S M Total
Overheads 10,030 8,970 10,000 8,000
Apportiened of Stores Ovhds 3,306. 1 55,10.2 (11,020.4) 2,204.1
Apportioned of Maint. Ovhds 8,163.1 1020.4 1,020.4 (10204.1)
Total OHS 21,499.4 15,500.6 0 0 37,000

Below is an illustration when the department has three service departments.

Using Elimination Method

A B S M C Total
OHS allocated 10,030 8,970 10,000 8,000 12,000 49,000
Apportioned of
Stores corts 3,000 4,000 (10,000) 2,000 1,000
0 10,000
Apparatus marts 6,667 1,111 - (10,000) 2,222
O[joihj 0 15,222
Apparatus of C costs 5,708.2 9,573.8 0 (15,222)
25,405 23,594.8 0 49,000
(See working in next page).

41
Workings
M’s cost apportioned to: C’s cost apportioned to
To A: 6/9x10,000 To A: 3/8 x 15,222
B: 1/9 x 10,000 B: 5/8 x 15,222
C: 2/9 x 10,000

Using the Algebraic Method

S= 10,000 + 0.1 m+ 0.1 C
M= 8,000 + 0.25 + 0.1 C
C= 12,000 + 0.15 + 0.2 m

ACTIVITY
Use substitution method or Cramer’s rule to solve the above simultaneous equations.

Overhead Absorption

Having allocated and apportioned the overhead, the next step is to add them to the cost of
production or cost of sales. The production overheads are added to the cost of production though
the work in progress accounts and therefore would be concluded in the stocks finished goods and
any unfinished working progress at the end of the accounting period.

The absorption of production overheads into factory costs should be done on a fair basis.
Examples of the bases that could be used are:
1. Percentage of direct material costs
2. Percentage of direct labour costs
3. Percentage of prime costs
4. As a rate for machine hour
5. As a rate per direct labour hour
6. As a rate per unit

From the previous example.

Illustration
Assume in previous illustration, that the following additional information is provided for dept A
and B.

A B
No of units produced 1,000 1,000
Direct material costs(sh) 20,000 25,000
Direct labour costs (sh) 10,000 20,000
Direct labour hours 2.5 1
Machine hrs 1.5 3

Required:
Compute the overhead absorption rate and the total cost of each unit produced. Assume that the
units are first worked on in department A before being moved to department B for finishing.

42
Solution:

A B
Total overhead cost 21,500 15,500

Overhead Absorption Rate = Total overheads

(OAR) Total rate base

OAR A B

21,500 15,500 = sh 15.5 per unit

1,000 =.21.5 1,000

Total Cost per unit produced:

Department
A B Total
Ksh Ksh Ksh
Direct Materials 20 25 45
Direct Labour 10 20 30
Fixd Overheads 21.5 15.5 37
TC/unit 51.5 60.5 112

Direct Material costs

A B
OAR = 21,500 = shs 8.6 per dlh 15,500 x15.5. per dlh
2500 1,000

8.6 x 2.5 15.5 x 1

Problem of the method

It can only be applied at the end of the period, thus you wait until overheads have been valued.
Then it will be too late for decision making.

What is done is to predict overheads in advance i.e overhead predetermination.

Overhead Predetermination
This is given by

Pre-determined OAR = Budgeted overheads

Budgeted rate base

Assume:
A B
Budgeted overheads= 4,000 000 3,000,000

43
Budgeted labour hrs= 200,000 100,000
Predetermined OAR= 4m=sh 20 3m= sh 30 per d/lh
0.2m per dlh 0.1m

Assume in January
A B
No of units 10,000 10,000
Direct materials 20,000 25,000
Direct labour costs 10,000 20,000
Direct labour costs 1200 800

Cost of production
A B
Direct materials 20,000 25,000
Direct labour 10,000 20,000
Absorbed OHS 24,000 24,000
Total cost 54,000 69,000
No. of units ÷1,000 ÷ 1,000
Cost per unit Sh 54 Sh 69

A B
Actual OH 25,000 20,000
Absorbed OH 24,000 24,000
Other (under) (1,000) 4,000

This is done at the end of the period.

To reconcile, the under-absorption is disposed at the end of the period. If it is immaterial it is

write off. Determination of materiality varies from one company to another.

Although actual costs must be recorded in costs accounts, it is inconvenient to use these actual
costs in absorbing overheads into cost units. This is because overheads are incurred through the
passage of time and therefore actual overheads will be determined at the end of the period. At
this time, it may be too late to make decisions and for this reason, overheads changed into cost
units are based on budget overhead costs and do not relate to actual overheads.

The procedure followed in overhead pre-determination:

1. Compute the pre-determined overhead absorption rate. This requires the estimation of the
total overheads to be incurred during the period and the total rate base (measures of activity
level).
2. Determine the actual volume during the period.
3. Apply the overheads by multiplying the actual volume of the rate base by the overhead
absorption rate (OAR) computed in Step 1.
4. At the end of the period account for any differences between the actual overheads incurred
and the total overheads absorbed into production.

44
Illustration

Assume that the budgeted overhead per month is Sh 100,000 and budgeted direct return hrs is
5,000 hrs.

During the period 5,500 hrs of direct labour hrs worked Actual hrs = Sh 105,000

Required:
(a) Compute the pre-determined Overhead Absorption Rate (OHAR)
(b) Compute the under or over-absorbed overheads

Solution:
(a) Predetermined = budget OvHdS = 100,000 = Sh. 20 per hrs
OAR Budgeted rate base 5000

(b) Absorbed OHS= 20 x 5,500 = 110,000

Actual OHS= 105,000
Over-absorbed OvHds 5,000

Absorption costing has a very restricted purpose. Its aims are:

1. To value closing stocks according to a well established principle of accounting (matching

purpose) i.e match total expenses a total revenue
2. To evaluate the cost of sales and therefore the profits in a period in a manner consistent with
the principles used to value closing stock.
3. To set prices which allow for pre-determined profit margin on total costs.
4. To ensure that products are earning enough revenue to cover not only the variable cost of
sales but also a fair share of fixed costs so that the company at least breaks even.

Drawbacks of Absorption Costing

It is not an effective and accurate method for:

(a) Identifying the manager’s responsible for the control of costs.
(b) Establishing whether resources have been used in the most effective and efficient way
(c) Providing information to help management make decisions about changes in output, making
the most profitable use of scarce resources, opening or shutting down a product line or a
department etc.

3.4. Activity Based Costing ( ABC)

Originated from the work of Kaplan and Cooper on early 1990’s ( 1990-92) at same time dealing
with balanced score card.
ABC is a method of charging overheads to cost units on the basis of the benefits received from
the specific indirect activity such as ordering, planning, setting up machines etc.

45
ABC seeks to attribute overheads to product costs on a more realistic basis than simply
production volume and also attempts to show the relationship between the overhead costs and the
activities that cause them.
The main steps in ABC are:

1. Identify the main activities in the organization - break the whole process to activities which
can be evaluated e.g material ordering , purchasing etc.
2. Identify the factors which determine the cost of an activity (ie.cost drivers)
3. Collect data on the cost of each activity i.e collect the related costs together into cost pools (
cost centres).
4. Charge support overheads to products on the basis of the usage of the activity expressed as a
proportion of the chosen cost driver.

Classification of Overheads
In ABC overheads can be classified into:

Short-term variable overheads

Long-term variable overheads and
Fixed overheads

Short-term variable overheads:

Cost that vary with production volume and therefore would be classified as variable costs in
traditional absorption costing e.g indirect material costs which may vary with material inputs,
direct labour, cost of power -varies with machine hours etc.

Long term variable costs

These are long term OH costs which do not vary with volume but do vary with other measures of
activity (usually in the long term) e.g cost of support activities e.g such as stock handling costs,
production scheduling, machine set up costs etc. These costs are fixed in the short term but vary
in the long term according to the range and complexity of the products manufactured. ABC
requires that these overheads be traced to products by transaction based cost drivers rather than
volume based drivers.

Fixed Overheads
Costs which do not vary, for any given time period with any activity indicators e.g salary of MD-
overhead with no clear variation method.

Cost Pools Cost Drivers

1.Production scheduling 1. No of production runs
2.Set up costs 2. No of production runs
3.Material handling 3. No of production runs
4. Stock handling and despatch costs 4. No of orders received
5. Purchasing costs 5. No of orders received

46
Illustration:
Assume a firm makes four products A,B C and D and the following information is provided:

A B C D
Output 25 25 250 250
No of prodn lines 3 4 7 10
Labour hrs per unit 2 4 2 4
Machine hrs per unit 2 4 2 4
Material costs per unit 30 75 30 75
Material components/unit 8 5 8 6
Direct labour costs is shs. 7 per direct labour hr

Overheads: Shs
Short term Variable Ovheads 8,250
Scheduling Ohs 7,680
Set up costs 3,600
Material handling 7,650
27,180

Required:
Compute the cost per unit using
(a) The conventional absorption costing (use machine hours as the base for overhead
absorption).
(b) Using ABC and the appropriate cost drivers
(c) Comment on the results of the two methods

Solution:
(a) Absorption Costing:
OAR = 27,180 1,650 = (25X20 + (25X4)+ (250X2)+(250X4)
1,650
= sh 16.47 per mhrs

Cost summary:

A B C D
Direct material(shs) 30 75 30 75
Direct labour(sh) 14(7x2) 28(7x4) 14(7x2) 28(7x4)
Prime costs 44 103 44 103
Ovhds (52.94) 33 66 33 66
Cost per Unit 77 169 77 169

47
(b) Using Activity Based Costing
1. Short term variable Overheads = 8,250 = Shs per man
1,650

2. Scheduling cost = 7650 = Shs. 320 per per line (run)

24

3. Set up Ovhds = 3,600 = Sh 150 per each time

24

4. Material handing = 7,650 = Sh 2 per component

3,825

(Total component) 3,825 =(8x25)+(5x25)+(250x8)+(6x250)

Cost Summary:

A B C D
Direct Material 30 75 30 75
Direct Labour 14 28 14 28
Prime Cost 44 103 44 103
Short term Ovhds (sh5) 10 20 10 20
Scheduling Costs (Sh320
per production Line 38 51 9 13
Set up costs (150) 18 24 4 6
Material handling cost at
Shs. 2 per component 16 10 16 12
Cost per unit 126 208 83 154

Conclusion
Cost of A having low volume (two machine lines) and long number of production lines was
underestimated i.e the cost is low for both A and B.
Absorption V/s Marginal Costing
In absorption costing fixed manufacturing overheads are absorbed into cost units and for this
reason stocks are valued at full costs (direct material, direct labour, valuable overheads and
fixed overheads). Overheads are therefore charged in the P& L A/C of the period in which
the stocks are sold.

In marginal costing however overheads are not absorbed into cost units and therefore stocks
are valued at marginal or variable costs (direct material, direct labour and variable overheads
only). For this reason fixed manufacturing overheads are treated as periodic costs and are
changed to the P & L A/c of the period in which they are incurred.

48
Illustration 1
Assume that company A produces a single product and has the following budget:

Sh
Selling price 10
Direct materials 3
Direct wages 2
Variable oveheads 1
Fixed product OH/s Sh 10,000 per month
Production Volume 5,000 units per month

Required:
Calculate the cost per unit to be used in stock valuation under
(a) Absorption costing
(b) Marginal costing

Solution:
(a) Absorption Costing
- Compute overhead absorption rate (OAR)

OAR= Total Ovheads = 10,000 = Sh 2 per unit

Total rate base 5,000

Cost per unit

Sh
Direct materials 3
Direct labour 2
Valuable overheads 1
Fixed pln OHS 2
Total Cost/Unit Sh8

(b) Marginal costing

Cost per unit
Sh
Direct materials 3
Direct labour 2
Valuable Ohs 1
Cost per unit Sh6

49
 Illustration 2
Assume in the previous illustration that production is 6,000 units
Sales is 4,800 units
1,200 - unsold –closing stock

Assume all costs were as budgeted

Required:
(a) Prepare a profit statement for the months under
(i) Absorption costing
(ii) Marginal costing

(b) Prepare a reconciliation statement to reconcile the profit reported in (a) above.

Solution:
(a) Absorption costing P & L

Sh Sh
Sales (4,800 x sh10) 48,000
Cost of sales
Opening stock 0
Prodn cost 6,000x Sh8 48,000
48,000
Less closing stock 9,600 38,400
91200xSh8) 9,600

Absorbed overheads Sh2x6,000 12,000

Actual Ovhds 10,000
Over-absorption 2,000
Add: over-absorbed Ovhds 2,000
Adjusted given profit 11,600

(b) Marginal Costing P & L

Sales 4800 x Sh10 48,000

Less valuable costs
Opening stock 0
Product cost 6,000 x 6 36,000
36,000
Less closing stock (1200x6) 7,200 28,800
Contribution 19,200
Less fixed cost 10,000
Profit 9,200

This is no better method. All are equal but measure differently.

50
(c) Reconciliation
Reconciliation items are
Sh
Profits as per absorption costing 11,600
Differences in opening stock 0
Differences in closing stock (9600-7200) (2,400)
Profit as per management costing 9,200

Which method is appropriate?

- Inventory increases marginal costing thus higher profits
- Inventory decrease absorption costing shows high profits . For decision making and
control marginal costing is preferable

ACTIVITY

1. What are the merits and demerits of absorption and marginal

costing?
2 Marginal costing and absorption costing compared: which is better?

QUESTIONS
1. Discuss the effect of absorption costing and marginal costing on short-term results where sales
and production are not equal.
2. Outline the procedures and information required in order to establish a set of predetermined
production overhead absorption rates for a company manufacturing a range of different products
in a factory containing a number of production departments and several service departments.
3. X Ltd commenced business on 1 March making one product only, the standard cost of which
is as follows.
$
Direct labour. 5
Direct material 8
Variable production overhead 2
Standard production 5
20
The fixed production overhead figure has been calculated on the basis of the budgeted normal
output of 36,000 units per annum.

51
Assume that all the budgeted fixed expenses are incurred evenly over the year. March and April
are to be taken as equal period months.

Selling, distribution and administration expenses are as follows.

Fixed $120,000 per annum
Variable 15% of the sales value.
The selling price per unit is $ 35 and the number of units produced and sold was as follows.

March April
Units Units.
Production 2,000 3,200
Sales 1,500 3,000

Required
(a) Prepare profit statements for each month using the following methods:
i. Marginal costing
ii. Absorption costing
(b) Present a reconciliation of the profit or loss figure given in your answers to (a) (i) and (a) (ii)
accompanied by a brief explanation.

SUMMARY
(a) Arguments in favour of adsorption costing are as follows.
i. Fixed production costs are incurred in order to make output; it is therefore fair to
charge all output with a share of these costs.
ii. Closing stock values, by including a share of fixed production overhead, will be
valued on the principle required for the financial accounting valuation of stocks
by statement of standards accounting practice on stocks and long term contracts
(SSAP 9)
iii. A problem with calculating the contribution of various products made by a
company is that it may not be clear whether the contribution earned by each

52
 product is enough to cover fixed cost, whereas by charging fixed overhead to a
product it is possible to ascertain whether it is profitable or not.
(b) Arguments in favour of marginal costing are as follows.
i. It is simple to operate.
ii. There are no apportionments, which are frequently done on an arbitrary basis, of
fixed costs. Many costs such as the managing director’s salary; are indivisible by
nature.
iii. Fixed costs will be the same regardless of the volume of output, because they are
period costs. It makes sense, therefore, to charge them in full as a cost to the period.
iv. The cost to produce and extra unit is the variable production cost. It is realistic to
value closing stock items at this directly attributable cost.
v. Under or over absorption of overheads is avoided.
vi. Marginal costing information is useful in decision-making but absorption costing
information is not suitable for decision making.
vii. Fixed costing (such as depreciation, rent and salaries) relates to a period of time and
should be charged against the revenues of the period in which they incurred.

KEY WORDS

• ABC Costing
• Marginal Costing
• Absorption Costing
• Cost Centre
• • Cost Drivers
• Overhead absorption rate (OAR)

53
FURTHER READING

1. Deakin, E.B. & Mather, M.W. (1991) "Cost Accounting" 3rd Edition, Richard D.
Irwin Inc.
2. Dominiak, G.F. & Lounderback J.G. (1998) "Managerial Accounting" 5th Edition,
PWS-Kent Publishing Company, Boston.
3. Drury, Colin (1996), "Management and Cost Accounting" 4th Edition,
International Thomson Business Press, London.
4. Hirsch, Maurice L. Jr. (1998) "Advanced Management Accounting" 2nd Edition
PWS-Kent Publishing Company, Boston.
5. Horngren, C.T. (1997) "Cost Accounting: A Managerial Emphasis", 9th Edition,
Prentice Hall

54
 LESSON FOUR

4.0 BUDGETING AND BUDGETARY CONTROL

4.1. OBJECTIVES

By the end of this lesson, you should be able to:

1. Understand the budget preparation techniques
2. Appreciate the role of the human behaviour in budget preparation.
3. Understand the problems encountered in budgeting
4.2. INTRODUCTION

CONTROL THEORY
A system must be controlled to keep it steady or enable it change safely, therefore each system
must have its control system. This is required because of unpredictable disturbances that may
arise and enter the system so that actual results (output from the system) deviate from the
expected results or goals. Examples of disturbances in a business system include:

1. The entry of a powerful new competitor into the market.

2. Unexpected increase in labour costs
3. Failure of a supplier to deliver promised raw materials etc.

A control system therefore must ensure that the business system is capable of saving these
disturbances by dealing with it in an appropriate manner. To have a control system, there has to
be a plan, a standard, a budget, or other types of targets/guidelines the system as a whole should
be aiming .Two main types of control systems in accounting are:
(a) The budgetary control system and
(b) Standard costing

Note:
Control in business is therefore a process of guiding apparatus into viable patterns of activity in a
changing environment. i.e control system gets input type done:

These are two types of control system

(a) Feedback control system
(b) Feed forward control system

1. Feedback control system

Feedback is information about actual achievement produced from within the organization e.g
Management accounting could reports with the purpose of helping with the control decisions.
Feedback is information gathered by measuring the output of a system itself. Feedback can
either be negative or positive.

55
(a) Negative feedback:
Information that indicates that the system is deviating from its plan or prescribed cause of action
and that some re-adjustments are necessary to bring it back on course. This feedback is referred
to as negative because the control action will seek to reverse the direction or movement of the
system back towards its planned course.

Negative feedback: gives rise to attempts to changes direction of actual movement of the system
to bring it back in line with the plan.

Remedy -administrative
-nine employees
-nine capacity

Plan negative feedback

(Negative deviation)

Actual control action

Negative plan attempts to reverse the actual.

(b) Positive feedback

Results in control action which causes actual results to maintain (or increase) the a path of
deviation from planned results and action.

Actual
Control positive feedback
(positive deviation)

plan

Feedback is important, but there are four necessarily conditions that must be satisfied before any
process can be said to be controlled.

These are:

1. Objectives for the process being controlled must exist.

56
2. The output of the process must be measurable in terms of dimensions defined by the
objective.(ie. Quantifiable)

3. A predictive model of process being controlled is required so that cannot non-attainment of

objectives can be determined and proposed corrective actions taken/evaluated.
4. These must be a capability of taking action so that deviations from the plan can be reduced.

2. Feed forward control system

Feed forward describes a control system in which deviations in the system are anticipated in a
focused or future results so that corrective actions can be taken advance of any deviations
actually happening e.g. critical path method, cash budget.

Feedback – actual errors are identified before a decision is made

Feedforward- likely errors are identified and steps are taken to avoid them.

4.3. Budgetary Control

A budget is a plan expressed in monetary terms. It is prepared and approved prior to the budget
period and may show the income, expenditure and the capital to be employed. A budget is what
the company wants to happen as opposed to forecast, which is what is likely to happen.
Budgetary control is establishment of budget relating the responsibilities of the executives to the
requirement of a policy, and the continuous comparison of actual with budgeted results either to
secure ( by individual action) the objectives of that policy or to provide a basis for its revision.

Uses of budgetary control

1. To define the objectives of the organization as a whole.

2. To rebuilt the extent by which actual results have exceeded or fallen short of the budget.
3. To indicate why actual results differ from the budgets.
4. As a basis for the revision of the current budget or the preparation of future budgets.
5. To ensure that resources are used as efficiently as possible.
6. To see how well the activities of the organization have been coordinated.

There should be conclusion of production budget and sales budget. This is done through “master
budget”.

7. Provide some central control where activities are decentralized.

Human Behavior and Budgetary Controls

How does human behaviour affect budgetary control?
Human problems in budgeting were identified in 1953 by Chris Argyris who identified following
four prospects:

57
(a) Pressure device:
The budget is seen as a pressure devices used by management to fence lazy employees to work
harder. The intention of such pressure is to improve performance that the unfavourable reactions
of subordinates against it seems to be at the core of the budget problem.

(b) Budgetman want to see failure (Accountants). The accountants would succeed by
reporting deviation from the real. The accounting dept is usually responsible for recording
actual achievement and comparing this against the budget. Accountants are therefore budget
men. Their success is to find significant adverse variances and identify managers
responsible. The success of the budgetman therefore is the failure of another manager and
this failure causes loss of interest and declining performance. He also pointed out that the
accountant on the other hand was fearful on having the budget criticised by the management
may deliberately make it more difficult to understand.
(c) Targets and goal congruence
The budget usually sets targets for each department. Achieving the departmental targets
becomes of paramount importance regardless of the effect this may have on other
departments and overall company’s performance. This is the problem of goal congruence -
“results in inter-departmental targets rather than organizational goals’-

(d) Management Style

Budgets are used by managers to express their character and patterns of leadership on
subordinates. Subordinates resentful of their leadership styles may blame the budget rather
than the leader (budget man). Would these perspectives hold in current organizational
management?

Budgetary Styles

There are two styles that can be undertaken in a firm:

(1) Imposed budget

(2) Participatory budget

1. Imposed budget (Top-down)

It is an approach where management prepares budget with little or no input from operating
personnel, which is then imposed upon the employees who have to work to the budget figures.
This is effective in the following conditions:
(a) Newly formed organizations
(b) In small business/organization – manager know what is going on
(c) During periods of economic hardships.
(d) When operational managers lack budgeting skills
(e) When the organization’s different units require precise coordination.

Advantages of Imposed budgets:

(a) Such budgets increase the probability that the organizational strategic plans are incorporated
into the planned activities.

58
(b) They enhance the coordination between the plans and objectives of divisions.
(c) They use senior managers awareness of the total resource availability.
(d) They decrease the possibility of inputs from inexperienced or uniformed lower level
employees
(e) They reduce the period of time taken to draw up the budget.

Disadvantages of Imposed Budget

(a) It may result in dissatisfaction, defensiveness and low morale among employees who must
implement the budget.
(b) The feeling of team spirit disappears.
(c) The acceptance of the organizational goals and objectives could be limited.
(d) The feeling of buyer as a punitive device could arise i.e as a way of forcing workers to work
hard.
(e) Unachievable budget from overseas divisions may be imposed in local divisions if
consideration is not given to the local operating and political environment.

2. Participative Budgeting (Bottom-up)

In this level budget are developed by lower level managers was then submit them to their
superiors. It is thus referred to bottom-up approach. The transfers are based on lower level
manages perception of what is achievable and the associated resources required. The degree to
which lower level management are allowed to participate depends on

(a) The senior managers awareness of the advantages of participatory budgeting.

(b) Their agreement with its advantage

Participative budgeting is effective in the following areas:

(a) Well established organizations

(b) In a very large business
(c) During periods of economic boom i.e when no hardship is there
(d) When operational managers have strong budgetary skills
(e) When the organizational different units are autonomous/independent

Advantages of Imposed Budget

(a) Information from employees most familiar with each unit needs and constraints is included.
(b) Knowledge spread over several level of management is pooled together.
(c) Morale and motivation is improved
(d) Acceptance and commitment to organizational goals and objectives by operational managers
is increased.
(e) Coordination within divisions is improved.
(f) Operating managers are able to develop budget plans, which are realistic- since they know
the implementation and quality required.
(g) Specific resource requirements are included. We have more detailed budget.
(h) An expression of the expectations of both senior managers and subordinates is provided.

59
Disadvantages of Imposed Budgets
(a) Consumes more time and therefore expensive.
(b) The advantage of lower level management participation may be repeated by changes
implemented by senior management leading to dissatisfaction similar to that
experienced with imposed budgets.
(c) Such budgets may cause manages to produce budgetary slacks (margin set in budget
facing difference between what managers state is to achieve and what is achievable)
e.g if production is 100 , a manager states 90 making a slack of 10. This will make
the budget easily achievable and not motivating
(d) Managers may be unqualified to participate and the budget produced may be
unachievable.
(e) An earlier start to the budgeting process may be required when there is uncertainty
about the future.

Contingency theory
Some researchers have argued that the context in which budgetary control is used is as
important as the style in which it is implemented and used. This is known as contingency
theory. The contingency approach to management accounting is based on the assumption
that there is no universally appropriate accounting system applicable to all organizations
on all circumstances rather the contingency theory attempts to intensify specific items of
system that are associated with certain defined circumstances and to demonstrate an
appropriate matching.

Major factors identified by the theory are:

1. Environmental factors
e.g
(a) Its degree of predictability
(b) Degree of competition faced in the market
(c) Number of different products in the market
(d) Degree of hostility exhibited by competitors

2. Organisational structure factors. Examples are

(a) The size of the organization
(b) Interdependence of the parts or sub-units
(c) Degree of decentralization
(d) Availability of resources

3. Technological factors
(a) Nature of production process – converting inputs to outputs
(b) Complexity of production process
(c) How well is relationship between inputs and outputs is understood
(d) Amount of variety in each task that has to be performed

60
 Contingency Theory
This approach assumes that the applicability of a management accounting control
system is contingent on the circumstance faced by the organization.
The contingency approach to management accounting is based on the premise that
there is no universally appropriate accounting system applicable to all organizations
in all circumstances. Rather a contingency theory attempts to identify specific
aspects of an accounting system that are associated with certain defined
circumstances and to demonstrate an appropriate matching.
Deals with social and political roles of management accounting
There is no one best design for a management accounting information system, but it
all depends upon situational factors.

Major Factors/Cohesion
- The external environment
- Competitive strategy and strategic mission
- Technology
- Business unit, firm and industry variables
- Knowledge and observability factors

4.4 MASTER BUDGET

Organisation required for the preparation of a master budget
(a) There should be a budget manual. This is a written manila of instructions setting out the
responsibilities of individuals, and the procedures and forms and records relating to the
preparation of the master budget. The budget manual will also indicate the following.
i. The timescale for preparing each part of the budget.
ii. The individual departments operational or functional budgets to be prepared.

(a) Where the business uses a system of standard costing, there should be an
organisation/responsibilities for reviewing the standards annually.
(b) There should be a budget committee, possibly chaired by the chief executive, with
members (senior managers) representing every department or operation in the
organisation. This committee should have the authority to make decisions about the
budget and give instructions accordingly to departmental management.
(c) There should be a budget officer, possibly management accountant, to act as secretary
the budget committee, issue committee meeting minutes, chase up late departmental
budget bring together the master budget into a P & L statement and budgeted balance
sheet and so on.

61
(d) The departmental/operational budgets required to produce the master budget must be
clearly defined and stated in sequence of preparation – for example sales budget
finished goods stock budget, production budget, machine utilisation budget, direct
labour budget, materials usage budget, overhead cost centre budgets, cash budget and
so on budgeted costs and revenues are built up o the basis of cost centres. There must
be a structure of such centres, and mangers responsible for the budget of each
individual centre.
(e) In large organisations with subsidiary companies, the budget organisation for the
group must provide for budgeting at subsidiary level, followed by budgeting at group
level.
(f) For control purposes, the budget period should be divided up into control periods, and
the budgeted revenues, costs and cash flows also divided accordingly. Budget cost
allowances can thus be produced. A budget cost allowance is the cost, which a budget
centre is expected to incur in a control period.
(g) A system should exist for reviewing the fixed assets expenditure budget within the
framework of the preparation the annual master budget.

Alternative approach to Budgeting

We have two:
(a) Incremental budgeting
(b) Zero based budgeting

(a) Incremental budgeting

Incremental budgeting is used to describe an incremental cost approach to budgeting
where the budget of next period is based on the current period results plus an extra
amount (an increment) for estimated growth or inflation next year. Incremental
budgeting is effective only if current operations are effective, efficient and economical
within any alternative course of action available to the organisation.

Although incremental budget is easy to prepare it encourages tax and wasteful spending
to into the budget and because a normal feature of actual feature spending. It does not
encourage performance to be improved or alternative approaches of carrying out
production to be looked at.

62
Incremental budgeting is mainly used in budgeting for non-discretionary expenditure
such as labour, materials and production overheads.

(b) Zero-based Budgeting (ZBB)

Budgetary from zero base
For discretionary expenditure e.g R &D
The principle behind ZBB is that each budget for each centre should be made from
scratch or from a zero-base. It starts with a basic assumption that budget for next year is
zero and therefore every process and expenditure must be justified fastly before being
included in the budget for next period. ZBB is mainly used in budget for discretionary
costs such as advertising and R & D.

In ZBB there is a positive attempt to eliminate inefficiencies and slacks from the current
expenditure. The basic approach to ZBB has five steps. These are

Step 1: Managers within the organisation are asked to specify their decision units.

A decision unit is a program of work or capital expenditure or an area of activity

which can be individually evaluated.

Step II. Each of the separate activities or decision units is then described in a decision
package.

A decision package is a document which identifies and describes the specific

activities in such a way that management can evaluate it and rank it in order of
priority against other activities.

Step III. Each activity or decision package is evaluated and ranked by cost-benefit
analysis

Step IV. Activities which cost more than their worth both in qualitative and quantitative
tems should be droptial ( Cost-benefit analysis)

Step V: Resources are then allocated according to availability of funds and evaluation
and ranking of competing decision packages

Zero-based budgeting is also known as priority-based budgeting

Focuses on programme of activities rather than functional departments based on line-
items which is a feature of traditional budgeting.
Decision packages are identified for each decision unit. Decision units represent separate
programmes or groups of activities that an organisation undertakes

63
Benefits of ZBB over traditional methods
1. It avoids the deficiencies of incremental budgeting, and represents a more towards the
allocation of resources by need or benefit. Thus the level of funding is not taken for
granted.
2. ZBB creates a questioning attitude rather than one that assumes that current practice
represents value for money.
3. ZBB focuses attention on outputs in relation to value for money.
4. Effect allocation of resources.

Disadvantages

1. Too costly and time consuming

2. Lack of insufficient information could result in very poor estimation
3. Difficult to determine performance measures
4. The process is different to follow and managers do not support it

ACTIVITY

1. Explain the behavioural factors that influence the budgeting process?

2. How do employees affect budgeting?
3. What are the advantages of Zero-Based Budgeting?
4. What are the disadvantages of ZBB to a company?

QUESTIONS

1. Outline the organization required for the preparation of master budget..

2. Describe briefly the benefits to cash budgeting from the use of a
particular type of software package.
3. Give three reasons why the reported profit figure for a period does not
normally represent the amount of cash generated in that period.

KEY WORDS

• Master Budget
• Zero Based Budgeting
• Participative Budgeting
• Bottom-up Budgeting
• • Negative Feedback

64
 FURTHER READING

1. Dominiak, G.F. & Lounderback J.G. (1998) "Managerial Accounting" 5th Edition, PWS-
Kent Publishing Company, Boston.
2. Hirsch, Maurice L. Jr. (1998) "Advanced Management Accounting" 2nd Edition PWS-
Kent Publishing Company, Boston.

65
 LESSON FIVE

5.0. ANALYSIS OF VARIANCE

5.1.OBJECTIVES

By the end of this lesson, you should be able to:

1. Calculate the various types of variances both traditional and

contemporary.
2. Explain the causes of those variances
3. Dispose the variances appropriately

5.2. INTRODUCTION

In this lesson we will be comparing the performance of an entity with budgets to account
for any deviations and their possible cause.
In a typical organisation the planning process starts with a budget followed by actual
performance. How do the two relate?
Performance leads to preparation of a performance report.
From these comparisons (budget and actual performance) we compute the deviations or
variances. This gives an indication of exceptions.
Variances signal those areas that require managerial attention/problem areas.
These variances lead to investigation in those problem areas and their corrective action.

Computation of Variances

1. Traditional approaches
2. Contemporary approaches

1. Traditional Approaches

Management focuses mainly on change in prices and inputs. Seeks to explain the change
in profits i.e change in revenues and change in costs. We seek to explain changes in
output prices and change in output quantities.

66
Change in Pi and Change in Qi

Pi – price of product i

Changes in OP- Change in sales- Change in output prices

Quantities

Usage efficiency Change in profits Prices Variances

Variances

Change in input Change in costs Change in input

Quantities prices

We hold corresponding efficiency (usage) constant to be able to compute the price

variances ( to isolate the effect of changes in price).

AQ.AO AQ.SP SQxSP

Price Variance Efficiency Variance

Total Variance

Types of Output Variances

Labour - Labour rate variance
- Labour efficiency variance

Materials- Material price variance

- Material usage variance

Overheads - Variable overhead rate variance

- Variable overhead efficiency variance
- Fixed overhead variance – volume variance
- capacity variance

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ILLUSTRATION
The standard cost for a production system in a given model is as follows:

Inputs Std. Qty Std price Std cost limit

Materials 3 kg sh 4.00 sh 2.00
Direct labour 21/2 hrs sh 14.00 sh 35.00
Variableov’hds 21/2 hrs sh 3.00 sh 7.50

During the month 6,500 kg of raw materials were purchased at sh. 3.80 per kg and all the
material was used to produce 2,000 units of finished products. 4,500 hrs of direct labour
time were used at a total cost of ksh 64,350. The actual variable overhead cost was sh
13,950.

Required:
Compute the production variances

SOLUTION
(a) Materials
(i) Materials price variance = (AQ x AP)-(AQxSP)
= (6,500 X 3.80)- (6,500 X 4.00)
= 24,700 – 26,000
Favourable MPV= Ksh 1,300

(ii) Materials efficiency (usage) variance = (AQ X SP) –(SQxSP)

= ( AQ-SQ) .SP
=(6500 – 6000) 4.00
500 x 4.00
= 2000 (unfavourable)

(iii) Total materials variance

= ( AQ X AP) – ( SQX SP)
( 6500 x 3.80)- (6000 x 4.00)
=24,700 – 24,000
TMV = 700 (unfavourable)

Note: TMV = MPV + MEV

Cause- Waste of materials in the production process

- Nature of material used – poor quality
2. Poorly trained-uskilled employees
3. Inefficient machinery/equipment

(b) Labour
(i) Labour rate variance = (AH X AR)- (AH X SR)
= AH ( AR – SR)

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 AH X AR= 64350

= 64,350 – (4,500 X 14) = 64,350 – 63,000

LRV = sh 1,350 unfavourable
We spent more than budgeted.

(ii) Labour efficiency variance

= (AH & SR) – (SH x SR)
= (AH –SH) SR

= (4500- 5000) 14
(500 X 14)
LEV = sh 7,000 ( F)

(iii) Total Labour Variance = LRV + LEV

= (1350) + 7,000
= sh 5,650 F

Cause of Unfavourable Labour Efficiency Variance

- Idle time- Machine breakdowns (down time)
- Poor quality of materials
- Untrained personnel

(c) Variable overhead variances

Note: There is a close link between the actual direct labour hours used and the overheads
incurred in the production process.

(i) Variable Overhead rate variance

Rate variance = (AH –AR)- (AH-SR)
=Sh 13,950-(4500 X 3,000)
= 13,950 – 13,500
= SH 450 ( UF)

(ii) Variable Overhead Efficiency Variance

= (AH XSR)- (SH X SR)
= (4,500 X 3.00)- (5,000 X 3000)
= 13,500 - 15,000
V’OH E.V = sh 1,500 ( F)

(iii) Total Overhead Variance

= (AH X AR) – (SH X SR)
= 13,950 – 5,000 X 3.00
= 13,950 X 15,000 = sh 1,050

69
5.3 CONTEMPORARY APPROACHES TO VARIANCE ANALYSIS

Seeks to explain the change in profit. Focus is different i.e on price recovery attributable
to the link between input prices and output prices.

Changes in output Change in output prices

Quantities

Change in sales & changes in change in price

Productivity profits recovery

Change in input change in output prices

Quantities

Thus we can isolate variances related to:-

(a) Sales activity
(b) Price recovery
(c) Productivity

(a) Sales Activity Variances

Seek to explain the changes in inputs consumed which are attributable to changes in
volumes and mix of the sales.

Sales activity = (Actual – budgeted) x Standard contribution margin

Variance output output

Sales volume variance = (changes in unit sales) x (Avg. Contrib. Margin)

Where Avg CM = Total budgeted CM

Total units Sales

AQ-BQ (ACM)
Sales Mix Variance = Change in X (Budgeted CM – Avg CM)
Unit sales
(AQ-BQ) (BCM-ACM)

(b) Productivity Variances

Seeks to explain changes in inputs resulting from efficient or inefficient usage.

Thus productivity variances are like efficiency variances for all inputs.

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 Productivity = (Actual – Std inputs) x Standard cost
Variance units allowed
Sold

(AQ- SQ) SC

i.e Productivity variance = sum of all efficiency variances

LEV + VOE +.MUV

(c) Price recovery Variances

Seek to explain the change in profits ( NI) attributable to the difference between the
average price received for outputs and the average price period for inputs. I.e seeks to
explain whether the increase in prices for output compensates for the rise in input costs.

(a) Sales price variance= ( Actual –Budgeted) – Actual sales volume

Price Price
(AP-BP) AQ

(b) Input Cost Variance = Actual - Std input x Actual inputs used
Input cost used
Cost

(AIP Cost –SIC) AI

LEVELS OF VARIANCE ANALYSIS

Level 1: Total Net Income Variance

Level 2: Contribution Margin Variance
Level 3: Individual item variances
Level 4: Analysis of variances in level 3
Level 5: Comparison of variances across all levels

On what basis does management decide to investigate the variance? Consideration?

Revenue projections are low

Targets too low
Favourable variances may be experienced now (temporarily) at the expense of future production
sales or output
Both Favourable and Unfavourable variances must be investigated.

Considerations
1. Materiality – Mgt should define a materiality level- as a % of the value in total or a point
relative to the total.

2. Sensitivity:-

71
e.g where variances translate to a cashflow implication
- very highly sensitive – set a low materiality level to trigger investigation
- If very low sensitivity –set a high materiality level

3. Consistency/frequency of occurrence
A variance occurring consistently triggers a problem with the underlying budget.

4. Control
Does the manager of where the variance occurred have influence on the invariance?
Note: It may be caused by external factors like - Government intervention; Unfavourable price
changes (inflation), Exchange rate changes etc.
Where the variance is outside the managements influence it cannot be controlled.

4. Cost consideration –– (Cost Benefit Analysis)

Variances can only be investigated at cost.
If the cost of investigation exceeds the benefits of such investigation then this should not be
carried out.

5. The management style currently in use.

Military (Autocratic style) – all variances will be investigated because actions are not expected to
deviate from the stipulated.
Country club (participate) style
Democratic

Illustration
A Company produces 2 products whose budget for a given year was as follows;

Product Product
I II Total
Budgeted sales ($) 500,000 375,000 875,000
Variable costs ($)
Direct materials 250,000 150,00
Direct Labout 100,000 75,00
Energy 50,000 40,000
Total VC 400,000 265,000 665,000

Contribution 100,000 110,000 210,000

Less fixed costs 100,000

Next income 110,000
The actual results were as follows;
Product II. Product II Total
Sales 630,000 300,000 930,000
Variable costs
Direct materials 426,400

72
 Direct labour 170,000
Energy 104,496
700,896
Contribution 229,104
Fixed cost 110,000
Net Income 119,104

The unit quantities were as follows;

Budget Price Actual Price

Sales
Product 1 50,000 Units 10.00 60,000 Units 10.50
Product II 25,000 Units 15.00 20,000 Units 15.00

Standard Inputs
Std.
Product Product Cost /unit
I II
Direct labour (HRS) 0.2 0.3 Sh.10.00/HR
Direct Materials (KGS) 1.0 1.2 5.00/Kg.
Energy (KWH) 0.5 0.8 2.00/KWH

Actual Inputs

Qty Actual cost

Direct Labour 17,000 Hrs. Sh. 10.00
Direct Material 82,000 Kg. 5.20
Energy 46,760 KWHs 2.10

Management requires a detailed report to explain the net income variance

SOLUTION

Level 1 of Variance Analysis

Net income variance Budget NI – Actual NI
= $ 110,000 – 119,104 = $9,104 F

@ SALES ACTIVITY VARIANCES

{Actual output – Budgeted output}x Std. Contribution margin

73
Standard Contribution. Margin

Product 1 : 1000,000/50,000=$2.00
Product II 1000,000
25,000 =$4.40
(i) Product 1:
(60,000-50,000) 2.00
SAVP = $20,000 f

(ii) Product II: (20,000 – 25,000) 4.4

SAV
P2 = $(22,000) (UF)
(iii) Total sales activity variance = SAVP1 + SAVPII
= 20,000 + (22,000)
= 2,000 UNF

Decomposition

i) Sales Volume Variance;

= (Change in unit sales) Avg CM.

Avg. CM = Total Budgeted CM/ Total budgeted CM/B units

= = (100,000 + 110,000) / (50,000 + 25,000) =210,000 / 75,000

Product 1
ACM = $2.80

(60,000-50,000) $2.80
= $ 28,000 (F)
Product II

(20,000 – 28,000) $2.80

= (14,000) (UNF)

Total Sales volume variance

28,000 + (14,000)
= 14,000 (F)

ii) Sales Mix variance

Change in unit sales x (Budgeted CM– Average CM)

Product I

(60,000 – 50,000) (2.0 – 2.8)

=$ 8,000 (UF)

74
 Product II

= (20,000 – 25,000) (4.4 – 2.8)

($8,000 UNF
Total sales mix variances
(8,000 + (8,000) = $(16,000) (UNF)
Sales Activity Variance = sales volume variance + sales mix variance
= 14,000 + (16,000)
= $ 2000 (UNF)

b. PRICE RECOVERY VARIANCE

This indicates whether there is sufficient increase in the output prices to compensate for
the increases in input – costs?

i) Sales Price variance

= (AP – SP) AQ
Product 1: (10.50 – 10.00) 60,000 = 30,000 (F)

Product II: (15.00 – 15.00) 20,000 = 0

Total S price variance 30,000 (F)

ii) Input Cost Variances.(ICV)

ICV = {Actual unit cost – budgeted unit cost} Actual inputs used
= Actual total cost - Budgeted cost at actual output

Actual Std Input Actual

Input InputCost Cost Diff Input used Variance
Direct labour & 10.00 10.00 0 17,000 0
Direct materials 5.20 5.00 0.20 82,000 16,400 UF
Energy 2.00 2.00 0.10 49,760 4,976 UF
Fixed Overheads 110,000 100,000 10,000 UF
Total Input cost variance 31,376 UF

The sales price did not rise sufficiently to cater for increases in input costs.

Total Price Recovery = Sales Price Input Cost

-
Variance Variance Variance
= Sh. 30,000 – 31,376 = 1,376 (UF)

(c) PRODUCTIVITY VARIANCES

These are similar to efficiency variances.

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 Productivity Variance = {Actual inputs – Std. Inputs allowed} x Std Cost

Std.(w1) Total Actual

Consumpt. Std.Input Inputs Std
Inputs Allowed Used Diff. Cost Variance
Input P1 PII
Direct labour 12,000 6,000 18,000 17,000 (1,000) 10.00 (10,000) F
Dir. Materials 60,000 24,000 84,000 82,000 (2,000) 5.00 (10,000) F
Energy 30,000 16,000 46,000 49,760 3,760 2.00 7,520 UF
Total productivity variance (12,480) F

Cost savings = $12,480

Workings
Direct Labour
Product I: (60,000 = 0.2) = 12,000 hrs.
Product. II: 20,000 x 0.3 = 6,000 hrs.

Materials
Product I: 60,000 x 1.00 = 60,000 Kgs.
Product II: 20,000 x 1.2 = 24,000 Kgs.

Energy

Product I: 60,000 X 0.5 = 30,000 Kwhrs.

Product II: 20,000 x 0.8 = 16,000 Kwhrs.

Report to Management:

The following were analysed as the causes of income variance.

There was:
Variance in sales activity of = $ 2,000 UF
Variance in Price recovery = 1,376 UF
Variance in Productivity = (12,480) F
9,104) F

Sensitivity – materiality levels are established so that investigation of the variances can be based
on those levels.
These are expressed as a percentage of budgeted sales or absolute value related to total budgeted
sales

e.g
Variance Materiality Variance Investigate?
Level %

$ 2,000 1,000 100% YES

76
QUESTIONS

1. Doodle Ltd manufactures and sells a range of products, one of which is the Squiggle.
The following data relates to the expected costs of production and sale of the Squiggle.

Budgeted production for the year 11,400 units

Standard details for one unit:
Direct material 30 metres at Sh 6.10 per metre
Direct wages
Department P 40 hours at Sh 2.20 per hour
Department Q 36 hours at Sh 2.50 per hour

Budgeted costs and hours per annum

Variable production overhead (factory total)
Department P Sh 525,000: 700,000 hours
Department Q Sh 300,000: 600,000 hours

Fixed overheads to be absorbed by the squiggle

Production Sh 1,083,000 (absorbed on a direct labor hour basis)
Administration Sh 125,400 (absorbed on a unit basis)
Marketing Sh 285,000 (absorbed on a unit basis)

REQUIREMENTS:
(a) Prepare a standard cost sheet for the squiggle, to include the following
(i) Standard total cost
(ii) Standard variable production cost
(iii) Standard production cost
(iv) Standard full cost of sale
(b) Calculate the standard sale price per unit which follows for a standard profit of
10% on the sales price

2. A four-week summary production budget for LB Ltd, an organization which produces a single
product is as follows
Production quantity 240,000 units
Production costs
Material 336,000kg at Sh4.10 per kg
Direct labor 216,000hours at Sh4.50 per hour
Overheads Sh1,920,000
Overheads are absorbed at a predetermined direct labour hour rate
During the four-week period the actual production was 220,000 units which incurred the
following costs
Material 313,060 kg costing Sh1,245,980
Direct labour 194,920 hours costingSh 886,886
Overheads Sh1,934,940

77
Required
(a) Calculate the cost variances for the period
(b) Give reasons why the direct labour efficiency variance may have arisen

3. A company produces and sells 2 products whose budget for the year was as follows:
Product 1 Product II Total
Sh.000 Sh.000 Sh.000
Budget sales 1.000 750 1,750
Variable costs
Direct materials 500 300 800
Direct labour 200 150 350
Energy 100 80 180
Total VC 800 530 1,330
Contribution 200 220 420
Less Fixed Costs 200
Net Income 220

The Actual results were as follows:

Product I Product II Total
Sh.000 Sh.000 Sh.000
Sales 1,260 600 1,860.0
Variable Costs
Direct Materials 852.8
Direct Labour 340.0
Energy 208.912
Contribution 1,401.712
Less fixed costs 458.208
Net income 220.000
238.208
The Unit quantities were as follows: -
Budgeted ` Actual
Quantity Price Quantity Price
Sales: Product I 100,000 10.00 120,000 10.50
Product II 50,000 15.00 40,000 15.00

STANDARD INPUTS
Product. I Product II Standard Cost/unit
Direct Labour (hrs) 0.2 0.3 Sh. 10.00/hr
Direct Materials (kgs) 1.0 1.2 5.00/kg
Energy (KWHS) 0.5 0.8 2.00/km

78
Actual inputs

Quantity Actual Cost.

Direct labour 34,000 10.00
Direct material 164,00 5.20
Energy 99,520 2.10

Prepare a detailed report to management explaining the best income variance.

KEY WORDS

• Variance
• Price Recovery
• Efficiency variance
• Productivity variance

FURTHER READING

1 .Dominiak, G.F. & Lounderback J.G. (1998) "Managerial Accounting" 5th

Edition, PWS-Kent Publishing Company, Boston.
2. Drury, Colin (1996), "Management and Cost Accounting" 4th Edition,
International Thomson Business Press, London.
3. Hirsch, Maurice L. Jr. (1998) "Advanced Management Accounting" 2nd
Edition PWS-Kent Publishing Company, Boston.
4. Horngren, C.T. (1997) "Cost Accounting: A Managerial Emphasis", 9th
Edition, Prentice Hall

79
 LESSON SIX

6.0. CAPITAL BUDGETING TECHNIQUES

6.1. OBJECTIVES

By the end of this lesson, you should be able to:

(i) Explain the various capital budgeting techniques, their merits and
shortcomings.
(ii) Evaluate capital projects using the various techniques.
(iii) Estimate cash flows given accounting data
(iv) Evaluate capital investment projects using the appropriate
technique

6.2. INTRODUCTION
In this Lesson we shall be looking at how viable projects can be identified using various
techniques.
Business firms make investments and incur cash outlays now for future benefits. These
proposed investments are evaluated using their expected return in terms of how close they are to
the investor’s required rate of return. In our discussion we will assume that the required rate of
return on investment projects is given and is the same for all projects.
Successful administration of capital investments by a company involves:

1. Generation of investment proposals

2. Estimation of cash flows for the proposals
3. Evaluation of cash flows
4. Selection of projects based on an acceptance criterion
5. Continual re-evaluation of investment projects after their acceptance

It is important to stress that in the next chapters we shall relax these assumptions. By doing so
we shall understand the concept of capital budgeting.

For purposes of our analysis, projects may be classified into one of the categories below:

1. New products or expansion of existing products

2. Replacement of equipment or buildings
3. Research and development
4. Exploration
5. Others

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 ESTIMATION OF CASH FLOWS

One of the most important tasks in capital budgeting is estimating future cash flows for a project.
The final results we obtain are really only as good as the accuracy of our estimates. Since cash,
not income, is central to all decisions of the firm, we express whatever benefits we expect from a
project in terms of cash flows rather than income. The firm invests cash now in the hope of
receiving cash returns in a greater amount in the future. Only cash receipts can be reinvested in
the firm or paid to stockholders in the form of dividends. In capital budgeting, good guys may
get credit, but effective managers get cash. In setting up the cash flows for analysis, a computer
spreadsheet program is invaluable. It allows one to change assumptions and quickly produce a
new cash-flow stream. For each investment proposal, we need to provide information on
expected future cash flows on an after-tax basis. In addition, the information must be provided
on an incremental basis, so that we analyze only the difference between the cash flows of the
firm with and without the project. For example, if a firm contemplates a new product that is
likely to compete with existing products, it is not appropriate to express cash flows in terms of
the estimated sales of the new product. We must take our cash-flow estimates on the basis of
incremental sales. The key is to analyze the situation with and without the new investment.
Only incremental cash flows are relevant.
In this case, sunk costs must be ignored. One should be concerned with incremental costs and
benefits; the recovery of past costs is irrelevant. They are past costs and should not enter into the
decision process. Some costs do not necessarily involve a cash outlay. If we have allocated plant
space to a project and this space can be used for something else, its opportunity cost must be
included in the project’s evaluation. If a presently unused building can be sold for $300,000, that
amount should be treated as a cash outlay at the outset of the project. Thus, in deriving cash
flows we must consider appropriate opportunity costs.

Illustration
Sport Company is considering the introduction of a new Shoe design. To launch the product
line, the company will need to spend $150,000 for special equipment and the initial advertising
campaign. The marketing department envisions the product life to be 6 years and expects
incremental sales revenue to be:
YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 5 YEAR 6
$60,000 $120,000 $160,000 $180,000 $110,000 $50,000

Cash outflows include labour and maintenance costs, material costs, and various other expenses
associated with the product. As with sales, these costs must be estimated on an incremental
basis. In addition to these outflows, the company will need to pay higher taxes if the new
product generates higher profits, and this incremental outlay must be included. Cash outflows
should not include interest costs on debt employed to finance the project. Such costs are
embodied in the required rate of return. To deduct interest charges from net cash flows would
result in double counting.
Suppose that on the basis of these considerations, Sport Company estimates total incremental
cash outflows to be:
YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 5 YEAR 6
$40,000 $70,000 $100,000 $100,000 $70,000 $40,000

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Because depreciation is a non-cash expense, it is not included in these outflows. The expected
net cash flows from the project are:
INITIAL $’000’
COST YR1 YR2 YR3 YR4 YR5 YR6
Cash Inflows ($) 60 120 160 180 110 50
Cash outflows (150) 40 70 100 100 70 40
Net cash flows (150) 20 50 60 80 40 10

With an initial cash outflow of $150,000 the company expects to generate net cash flows of
$20,000, $50,000, $60,000, $80,000, $40,000, and $10,000 over the next 6 years. These cash
flows represent the relevant information we need in order to judge the attractiveness of the
project.

Note that the initial cash outlay, or investment, is followed by positive and increasing net cash
flows through year 4, after which they drop off as the project matures. Many other patterns are
possible, both with respect to the life of the project and to the annual cash flows.

REPLACEMENT DECISIONS AND DEPRECIATION

Suppose we are considering the purchase of a new machine to replace an old one, and we need to
obtain cash-flow information in order to evaluate the attractiveness of this project. The purchase
price of the new machine is $18,500, and it will require an additional $1,500 to install, bringing
the total cost to $20,000. The old machine can be sold at its depreciated book value of $2,000.
The initial net cash outflow for the investment project, therefore, is $18,000.
The new machine should cut labor and maintenance costs and result in other cash savings
totaling $7,100 a year before taxes for each of the next 5 years, after which it will probably not
provide any savings, nor will it have a salvage value. These savings represent the net savings to
the firm if it replaces the old machine with the new. In other words, we are concerned with the
difference between the cash flows resulting from the two alternatives; continuing with the old
machine or replacing it with a new one.
Because a machine of this type has a useful life in excess of 1 year, we cannot charge its cost
against income for tax purposes but must depreciate it. We then deduct depreciation from
income in order to compute taxable income. Under the Tax laws capital assets fall into defined
cost recovery classes (capital allowance) depending on their nature.
Suppose the machine we are considering falls under the 5-year class for cost recovery
(depreciation) purposes. Assuming straight-line depreciation at 20% the total depreciable cost of
$20,000, or $4,000 a year and a corporate income tax rate is 40 percent. The old machine has a
remaining depreciable life of 5 years with no expected salvage value at the end of this time, and
is subject to straight-line depreciation. Thus, the annual depreciation charge on the old machine
is 20 percent of its depreciated book value of $2,000, or $400 a year. Because we are interested
in the incremental impact of the project, we must subtract depreciation charges on the old
machine from depreciation charges on the new one to obtain the incremental depreciation
charges associated with the project. Given the information cited, we now are able to calculate
the expected net cash flow (after taxes) resulting from the acceptance of the project.

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 BOOK CASH-FLOW
ACCOUNT ACCOUNT
Annual cash savings $7,100 $7,100
Depreciation on new machine 4,000
Less: Depreciation on old machine 400
Additional depreciation charge $3,600
Additional income before taxes 3,500
Income tax (40%) (1,400) (1,400)
Additional income after taxes $2,100
Annual net cash flow $5,700

In determining the net cash flow, we simply deduct the additional cash outlay for income taxes
from the annual cash savings. The expected annual net cash inflow for this replacement proposal
is $5,700 for each of the next 5 years; this figure compares with additional income after taxes of
$2,100 a year. The cash flow and net profit figures differ by the amount of additional
depreciation. For an initial cash outlay of $18,000, then, we are able to replace an old machine
with a new one that is expected to result in net cash savings of $5,700 a year over the next 5
years. The relevant cash-flow information for capital budgeting purposes is expressed on an
incremental, after-tax basis.

TECHNIQUES OF INVESTMENT EVALUATION

Assume that the risk or quality of all investment proposals under consideration does not differ
from the risk of existing investment projects of the firm and that the acceptance of any proposal
or group of investment proposals does not change the relative business risk of the firm. The
investment decision will be either to accept or to reject the proposal. In this section, we evaluate
four methods of capital budgeting:

1. Non Discounted Methods

a. Average rate of return (ARR)
b. Payback

2. Discounted Cashflow Methods

a. Internal rate of return (IRR)
b. Net present value (NPV)
c. Profitability index (PI)

The non-discounted methods are approximate methods for assessing the economic worth of a
project. For simplicity, we assume that the expected cash flows are realized at the end of each
year.

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1. NON DISCOUNTED METHODS

a. Average Rate of Return (ARR)

This accounting measure represents the ratio of the average annual profits after taxes to the
investment in the project. In the previous example of the new machine, the average annual book
earnings for the 5-year period are $2,100, and the initial investment in the project is $18,000.
Therefore:

Average rate of return (ARR) =$2,100x100/$18,000 = 11.67%

If income were variable over the 5 years, an average would he calculated and used in the
numerator. Once the average rate of return for a proposal has been calculated, it may be
compared with a required rate of return to determine if a particular proposal should be accepted
or rejected.

The advantage of the average rate of return is its simplicity; it makes use of readily available
accounting information. Once the average rate of return for a proposal has been calculated, it
may be compared with a required, or cutoff, rate of return to determine if a particular proposal
should be accepted or rejected. The principal shortcomings of the method are that it is based on
accounting income rather than on cash flows and that it fails to take account of the timing of cash
inflows and outflows. The time value of money is ignored: benefits in the last year are valued
the same as benefits in the first year.

Illustration
Consider three investment proposals, each costing $9,000 and each having an economic and
depreciable life of 3 years. Assume that these proposals are expected to provide the following
book profits and cash flows over the next 3 years.

PROJECT A PROJECT B PROJECT C

Book Net Cash Book Net Cash Book Net Cash
PERIOD Profit Flow Profit Flow Profit Flow
1 $3,000 $6,000 $2,000 $5,000 $1,000 $4,000
2 2,000 5,000 2,000 5,000 2,000 5,000
3 1,000 4,000 2,000 5,000 3,000 6,000

Each proposal will have the same average rate of return: $2,000/$9,000, or 22.22 percent;
however, few, if any, firms would regard the three projects as equally favorable. Most would
prefer project A, which provides a larger portion of total cash benefits in the first year. For this
reason, the average rate of return leaves much to be desired as a method for project selection.

84
b. Payback Method

The payback period of an investment project tells us the number of years required to recover our
initial cash investment. It is the ratio of the initial fixed investment over the annual cash inflows
for the recovery period. From the previous example:

Payback period = CO/CF = $18,000/$5,700 — 3.16 years

Illustration:

If the annual cash inflows are not equal, the calculation is more difficult. Suppose annual cash
inflows are $4,000 in the first year, $6,000 in the second and third years, and $4,000 in the fourth
and fifth years. In the first 3 years, $16,000 of the original investment will be recovered,
followed by $4,000 in the fourth year. With an initial cash investment of $18,000, the payback
period is 3 years + ($2,000/$4,000), or 3~ years.
If the payback period calculated is less than some maximum acceptable payback period, the
proposal is accepted; if not, it is rejected. If the required payback period were 4 years, the
project in our example would be accepted. The major shortcoming of the payback method is that
it fails to consider cash flows after the payback period; consequently, it cannot be regarded as a
measure of profitability. Two proposals costing $10,000 each would have the same payback
period if they both had annual net cash inflows of $5,000 in the first 2 years; but one project
might be expected to provide no cash flows after 2 years, whereas the other might be expected to
provide cash flows of $5,000 in each of the next 3 years. Thus, the payback method can be
deceptive as a yardstick of profitability. In addition to this shortcoming, the method does not
take account of the magnitude or timing of cash flows during the payback period. It considers
only the recovery period as a whole.
The payback method continues as a supplement to other more sophisticated methods. The
shorter the payback period the less risky the project and the greater its liquidity in terms of
recouping the initial investment. The company that is cash poor may find the method to be very
useful in gauging the early recovery of funds invested. There is some merit to its use in this
regard, but the method does not take into account the dispersion of possible outcomes—only the
magnitude and timing of the expected value of these outcomes relative to the original
investment. Therefore, it cannot be considered an adequate indicator of risk. When the payback
method is used, it is more appropriately treated as a constraint to be satisfied than as a
profitability measure to be maximized.

85
1. Discounted Cash Flow Methods
a. Internal Rate of Return (IRR)

Due to the various limitations of the average rate of return and payback methods, it is generally
agreed that discounted cash-flow methods provide a more objective basis for evaluating and
selecting investment projects. These methods take account of both the magnitude and the timing
of expected cash flows in each period of a project’s life. The two discounted cash-flow methods
are the internal-rate-of-return and the net-present-value methods. The internal rate of return for
an investment proposal is the discount rate that equates the present value of the expected cash
outflows with the present value of the expected future inflows. It is represented by that rate, r,
such that;

∑At[(1 +r)t = 0
t=1 to n

Where At~ is the cash flow for period t, whether it be a net cash outflow or inflow, and n is the
last period in which a cash flow is expected.
Thus, r is the rate that discounts the stream of future cash flows—A1 through An—to equal the
initial outlay at time 0, A0. For our example, the problem (solved above using ARR) can be
expressed as

$18,000 + $5,700+ $5,700 $5,700 $5,700 + $5,700 =0

(1+r) (1+r)2 (1+r)3 (1+r)4 (1+r)5

Solving for r we find the internal rate of return for the project to be 17.57%.

Acceptance Criterion. The acceptance criterion generally employed with the internal-rate-of-
return method is to compare the internal rate of return with a required rate of return, known also
as the cutoff, or hurdle, rate. If the internal rate of return exceeds the required rate, the project is
accepted; if not, it is rejected. If the required rate of return is 12 percent and this criterion is
used, the investment proposal being considered will be accepted. Accepting a project with an
internal rate of return in excess of the required rate of return should result in an increase in the
market price of the stock, because the firm accepts a project with a return greater than that
required to maintain the present market price per share. We assume for now that the required
rate of return is given.
Capacity expanding investment projects may differ from cost-reduction projects and, hence,
require a different return. Edward M. Miller reasons that capital expanding projects are highly
related to the level of economic activity, producing sizable cash flows when the economy is
prosperous. Replacement projects, on the other hand, are cost reducing and would likely
produce benefits across more states of the economy. As a result, they would possess lower
systematic risk and require a lower return to satisfy investors.

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b. Net Present Value

Like the internal-rate-of-return method, the present-value method is a discounted cash-flow

approach to capital budgeting. With the present-value method, all cash flows are discounted to
present value, using the required rate of return. The net present value of an investment proposal
is
NPV=> ∑CFt (1 + k)t

Where: k is the required rate of return.

CFt the cash inflows and outflows from time 0 to time n.
If the sum of these discounted cash flows is zero or more, the proposed project is accepted; if
not, it is rejected. Another way to express the acceptance criterion is to say that the project will
be accepted if the present value of cash inflows exceeds the present value of cash outflows. The
rationale behind the acceptance criterion is the same as that behind the internal-rate-of-return
method. If the required rate of return is the return investors expect the firm to earn on the
investment proposal, and the firm accepts a proposal with a net present value greater than zero,
the market price of the stock should rise. The firm is investing in a project with a return greater
than that necessary to leave the market price of the stock unchanged.

Illustration
Given a required rate of return of 12% after taxes, the net present value of the above problem
would be:

NPV= $18,000 + $5,700+ $5,700 $5,700 $5,700 + $5,700

(1+r) (1+r)2 (1+r)3 (1+r)4 (1+r)5

= ($18,000) + $20,547 = $2,547

The problem can be solved using a computer, financial calculator, or by reference to the
appropriate present-value table. Since the NPV is greater than zero the proposal should be
accepted under the net-present-value method.
With the internal-rate-of-return method, we are given the cash flows, and we solve for the rate of
discount that equates the present value of the cash inflows with the present value of the outflows.
We then compare the internal rate of return with the required rate of return to determine whether
the proposal should be accepted. With the present-value method, we are given the cash flows and
the required rate of return, and we solve for the net present value. The acceptability of the
proposal depends on whether the net present value is zero or more.

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MUTUAL EXCLUSION AND DEPENDENCY

In evaluating a group of investment proposals, we must determine whether the proposals are
independent of each other. A proposal is mutually exclusive if the acceptance of it precludes the
acceptance of one or more other proposals. For example, if the firm is considering investment in
one of two temperature-control systems, acceptance of one system will rule out acceptance of the
other. Two mutually exclusive proposals cannot both be accepted.

A contingent or dependent proposal depends on the acceptance of one or more other proposals.
The addition of a large machine may necessitate construction of a new wing to house it.
Contingent proposals must be part of our thinking when we consider the original, dependent
proposal. Recognizing the dependency, we can make investment decisions accordingly.

C. Profitability Index (PI)

The profitability index, or benefit-cost ratio, of a project is the present value of future net cash
flows over the initial cash outlay. It can be expressed as

P1 = CF/(1 + k)t
CO

For our example

=$20,547
$18,000 = 1.14

As long as the profitability index is 1.00 or greater, the investment proposal is acceptable. In
calculating the profitability index, we compute the net rather than the aggregate index. The
aggregate index is simply the present value of cash inflows over the present value of cash
outflows. We use the net index to differentiate the initial cash outlay from subsequent cash
outlays. The initial outlay is discretionary because the firm can either commit funds to the
project or employ them elsewhere. Subsequent cash outflows are not discretionary in this sense;
they are embodied in the system. The aggregate index does not differentiate between the cash
outlay the firm has to put up initially and subsequent cash outlays. For this reason, the net
profitability index is a more rational measure of profitability than is the aggregate index.
For any given project, the net-present-value method and the profitability index give the same
accept-reject signals. If we must choose between mutually exclusive projects, the net-present-
value measure is preferred because it expresses in absolute terms the expected economic
contribution of the project. In contrast, the profitability index expresses only the relative
profitability.

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NPV VERSUS ERR

In general, the net-present-value and internal-rate-of-return methods lead to the same acceptance
or rejection decision. There is a curvilinear relationship between the net present value of a
project and the discount rate employed. When the discount rate is 0, net present value is simply
the total cash inflows less the total cash outflows of the project.

Relation between discount rate and net present value

As the discount rate increases, the present value of future cash inflows decreases relative to the
present value of outflows. As a result, NPV declines. The crossing of the NPV line with the 0
line establishes the internal rate of return for the project. If the required rate of return were less
than the internal rate of return, we would accept the project, using either method. Suppose that
the required rate were 10%.

Similarly, we would accept the project using the internal rate of return method because the
internal rate of return exceeds the required rate. For required rates greater than the internal rate
of return, we would reject the project under either method. Thus, we see that the internal rate of
return and net-present-value methods give us identical answers with respect to the acceptance or
rejection of an investment project.

COMPOUNDING RATE DIFFERENCES

It is important to identify major differences between the methods. When two investment
proposals are mutually exclusive we can select only one but two methods may give contradictory
results. To illustrate the nature of the problem, suppose a firm had two mutually exclusive
investment proposals that were expected to generate the following cash flows.

CASH FLOWS
YEAR 0 1 2 3 4
Proposal A —$23,616 $10,000 $10,000 $10,000 $10,000
Proposal B —23,616 0 5,000 10,000 32,675

Internal rates of return for proposals A and B are 25 percent and 22 percent, respectively. If the
required rate of return is 10 percent, however, and we use this figure as our discount rate, the net
present values of proposals A and B are $8,083 and $10,347, respectively. Thus, proposal A is
preferred if we use the internal-rate-of-return method, whereas proposal B is preferred if we use
the present-value method. If we can choose but one of these proposals, we obviously have a
conflict.
The conflict between these two methods is due to differences in the implicit compounding of
interest. The IRR method implies that funds are compounded at the internal rate of return. For
proposal A, the assumption is that $23,616 invested at 25 percent will compound in a way that
will release $10,000 at the end of each of the next 4 years. The present-value method implies

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compounding at the required rate of return used as the discount rate. For proposal A, the
assumption is that the $8,083 present value plus the $23,616 initial outflow, or $31,699, invested
at 10 percent will compound in such a way that it will release $10,000 at the end of each of the
next 4 years. Only if the required rate of return were 16.65 percent would the net present value
of the two proposals be the same, $4,006. Below 16.65 percent, proposal B has a higher NPV;
above, proposal A has the higher NPV.

MULTIPLE RATES OF RETURN

A final problem with the internal-rate-of-return method is that multiple IRRs are possible. A
necessary, but not sufficient, condition for this occurrence is that the cash-flow stream changes
sign more than once. All of our examples depicted situations where a cash outflow was followed
by one or more cash inflows. In other words, there was but one change in sign, which ensured a
unique internal rate of return. However, some projects involve multiple changes in sign. At the
end of the project, there may be a requirement to restore the environment. This often happens in
the extractive industry where the land must be reclaimed at the end of the project. With a
chemical plant, there are sizable dismantling costs. These costs result in a cash outflow at the
end of the project and, hence, in more than one change in sign in the cash-flow series.
Whether these changes in sign cause more than one IRR depends also on the magnitudes of the
cash flows. The relationship is complicated and requires illustration. While most projects have
but one change in sign in the cash-flow stream, some have more. When this occurs, the financial
manager must be alert to the possibility of multiple internal rates of return. With multiple IRR
situations, financial calculators and computer programs often are fooled and produce only one
IRR. Perhaps the best way to determine if a problem exists is to calculate the net present value
of a project at various discount rates. If the discount rate were increased several times and the
NPV line graphed, the connecting the dots crosses the zero NPV line more than once, you have a
multiple IRR problem.

SUMMARY
NPV method always provides correct rankings of mutually exclusive investment projects,
whereas the internal-rate-of -return method sometimes does not. With the IRR method, the
implied reinvestment rate will differ, depending on the cash-flow stream for each investment
proposal under consideration. For proposals with a high internal rate of return, a high
reinvestment rate is assumed; for proposals with a low internal rate of return, a low reinvestment
rate is assumed. Only rarely will the internal rate of return calculated represent the relevant rate
for reinvestment of intermediate cash flows. With the present-value method, however, the
implied reinvestment rate—namely, the required rate of return is the same for each proposal. In
essence, this reinvestment rate represents the minimum return on opportunities available to the
firm.

NPV method takes account differences in the scale of investment. If our objective is value
maximization, the only theoretically correct opportunity cost of funds is the required rate of
return. It is consistently applied with the net-present-value method, thereby avoiding the
reinvestment rate and scale of investment problems. Finally, the possibility of multiple rates of
return disadvantages the IRR method.

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Many managers find the IRR easier to visualize and interpret than they do the NPV measure.
One does not have to specify a required rate of return in the calculations. To the extent that the
required rate of return is but a rough estimate, the internal-rate-of-return method may permit a
more satisfying comparison of projects for the typical manager. Put another way, they feel
comfortable with a return measure as opposed to an absolute NPV figure. As long as the
company is not confronted with many mutually exclusive projects or with unusual projects
having multiple sign changes in the cash-flow stream, the IRR method may be used with
reasonable confidence. When such is not the case, the shortcomings noted must be borne in
mind. Either modifications in the IRR method or a switch to the NPV method needs to occur.

SALVAGE VALUE AND TAXES

The cash-flow pattern will change toward the better if the asset is expected to have salvage, or
scrap, value at the end of the project. As the asset will be fully depreciated at that time, the
salvage value realized is subject to taxation at the ordinary income tax rate. Suppose the asset
were sold for $10,000 at the end of year 7. With a 40 percent tax rate, the company will realize
cash proceeds of $6,000 at the end of the last year. This amount then would be added to the net
cash inflow previously determined to give the total cash flow in the last year.
If the asset is sold before it is fully depreciated, the tax treatment is different. In general, if an
asset is sold for more than its depreciated book value but for less than its cost, the firm pays taxes
at the full corporate rate. If the asset is sold for more than its cost, this excess is subject to the
capital gains tax treatment, which sometimes is more favorable. As such calculations are
complicated, the reader is referred to the tax code and/or to a tax attorney when faced with the
tax treatment of a sale of an asset.

WORKING CAPITAL REQUIREMENT

In addition to the investment in a fixed asset, it is sometimes necessary to carry additional cash,
receivables, or inventories. This investment in working capital is treated as a cash outflow at the
time it occurs. For example, if $15,000 in working capital is required in connection with our
example, there would be an additional cash outflow of $15,000 at time 0, bringing the total
outflow to $115,000. At the end of the project’s life, the working capital in vestment presumably
is returned. Therefore, there would be a $15,000 cash inflow at the end of year 7. As a result,
the cash inflow in that year would be $27,000 instead of $12,000.
This switching of cash flows obviously is adverse from a present-value standpoint: $15,000 is
given up at time 0 and is not gotten back until 7 years later.

CAPITAL BUDGETING UNDER CAPITAL RATIONING

Capital rationing occurs when there is a budget ceiling, or constraint, on the amount of funds that
can be invested during a specific period of time, such as a year. Such constraints are prevalent in
a number of firms, particularly in those that have a policy of financing all capital expenditures
internally. Another example of capital rationing occurs when a division of a large company is
allowed to make capital expenditures only up to a specified budget ceiling, over which the

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division usually has no control. With a capital rationing constraint, the firm attempts to select
the combination of investment proposals that will provide the greatest profitability.
Your firm may have the following investment opportunities, ranked in descending order of
profitability indexes (the ratio of the present value of future net cash flows over the initial cash
outlay):

PROPOSAL 4 7 2 3 6 5 1
Profitability index 1.25 1.19 1.16 1.14 1.09 1.05 0.97
Initial outlay ($'000) $400 $100 $175 $125 $200 $100 $150

If the budget ceiling for initial outlays during the present period is $1 million, and the proposals
are independent of each other, you would select proposals in descending order of profitability
until the budget was exhausted. With capital rationing, one would accept the first five proposals,
with a total initial outlay of $1 million. You will not invest in proposal 5, even though the
profitability index in excess of 1.00 would suggest its acceptance. The critical aspect of the
capital rationing constraint illustrated is that capital expenditures during a period are strictly
limited by the budget ceiling, regardless of the number of attractive investment opportunities.
Under capital rationing, the objective is to select the combination of investment proposals
that provide the highest net present value, subject to the budget constraint for the period. If
this constraint is strictly enforced, it may be better to accept several smaller, less profitable
proposals that allow full utilization of the budget than to accept one large proposal that results in
part of the budget’s being unused. Admittedly, a fixed one-period constraint is highly artificial.
Companies engaging in capital rationing seldom will set a budget so rigidly that it does not
provide for some flexibility. In addition, the cost of certain investment projects may be spread
over several years. Finally, a one-period analysis does not take account of intermediate cash
flows generated by a project. Some projects provide relatively high net cash flows in the early
years; these cash flows serve to reduce the budget constraints in the early years because they may
be used to finance other investment projects. For the reasons discussed, when capital is rationed,
management should consider more than one period in the allocation of limited capital to
investment projects.
Capital rationing usually results in an investment policy that is less than optimal. In some
periods, the firm accepts projects down to its required rate of return; in others, it rejects projects
that would provide returns substantially in excess of the required rate. If the required rate of
return corresponds to the project’s cost of capital, and the firm actually can raise capital at that
approximate cost, should it not invest in all projects yielding more than the required rate of
return? If it rations capital and does not invest in all projects yielding more than the required
rate, is it not forgoing opportunities that would enhance the market price of its stock?

In general, an inflationary economy distorts capital budgeting decisions. It is notable that

depreciation charges are based on original rather than replacement costs. As income grows with
inflation, an increasing portion is taxed, with the result that real cash flows do not keep up with
inflation.

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ILLUSTRATION
Consider an investment proposal costing $24,000 under the assumption that no inflation is
expected, that depreciation is straight line over 4 years, and that the tax rate is 40 percent. The
following cash flows are expected to occur:

CASH CASH FLOW

YEAR SAVINGS DEPRECIATION TAXES AFTER TAXES
1 $10,000 $6,000 $1,600 $8,400
2 10,000 6,000 1,600 8,400
3 10,000 6,000 1,600 8,400
4 10,000 6,000 1,600 8,400

Depreciation is deducted from cash savings to obtain taxable income, on which taxes of 40
percent are based. Without inflation, depreciation charges represent the “cost” of replacing the
investment as it wears out. Because nominal income on which taxes are paid represents real
income, the last column represents real cash flows after taxes. The internal rate of return that
equates the present value of the cash inflows with the cost of the project is 14.96%.
Consider now a situation in which inflation is at a rate of 7% per annum and cash savings are
expected to grow at this overall rate of inflation. The after-tax cash flows become

CASH CASH FLOW

YEAR SAVINGS DEPRECIATION TAXES AFTER TAXES
1 $10,700 $6,000 $1,880 $ 8,820
2 11,449 6,000 2,180 9,269
3 12,250 6,000 2,500 9,750
4 13,108 6,000 2,843 10,265

Although these cash flows are larger than before, they must be deflated by the inflation rate if
one is concerned with the real as opposed to the nominal rate of return. Therefore, the last
column becomes

QUESTIONS

Qtn.1. Stove Company is considering a new product line to supplement its range line. It is
anticipated that the new product line will involve cash investments of $700,000 at time 0 and
$1.0 million in year 1. After-tax cash inflows of $250,000 are expected in year 2, $300,000 in
year 3, $350,000 in year 4, and $400,000 each year thereafter through year 10. While the
product line might be viable after year 10, the company prefers to be conservative and end all
calculations at that time.
a. If the required rate of return is 15 percent, what is the net present value of the project? Is
it acceptable?
b. What is its internal rate of return?
c. What would be the case if the required rate of return were 10 percent?

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d. What is the project’s payback period?

Qtn.2. Chemical Company is considering the replacement of two old machines with a new, more
efficient machine. The old machines could be sold for $70,000 in the secondary market. Their
depreciated book value is $120,000 with a remaining useful and depreciable life of 8 years.
Straight-line depreciation is used on these machines. The new machine can be purchased and
installed for $480,000. It has a useful life of 8 years, at the end of which a salvage value of
$40,000 is expected. The machine falls into the 5-year property class for accelerated cost
recovery (depreciation) purposes. Due to its greater efficiency, the new machine is expected to
result in incremental annual savings of $120,000. The company’s corporate tax rate is 34
percent, and if a loss occurs in any year on the project it is assumed that the company will
receive a tax credit of 34 percent of such loss.
a. What are the incremental cash inflows over the 8 years and what is the incremental cash
outflow at time 0?
b. What is the project’s net present value if the required rate of return is 14%?
Qtn.3. Prudential Company is evaluating three investment situations: (1) produce a new line of
aluminum skillets, (2) expand its existing cooker line to include several new sizes, and (3)
develop a new higher-quality line of cookers. If only the project in question is undertaken, the
expected present values and the amounts of investment required are:

NPV OF REQUIRED
INVESTMENT PROJECT FUTURE CASH FLOWS
1 $200,000 $290,000
2 115,000 185,000
3 270,000 400,000

If projects 1 and 2 are jointly undertaken, there will be no economies; the investments required
and present values will simply be the sum of the parts. With projects 1 and 3, economies are
possible in investment because one of the machines acquired can be used in both production
processes. The total investment required for projects 1 and 3 combined is $440,000. If projects
2 and 3 are undertaken, there are economies to be achieved in marketing and producing the
products but not in investment. The expected present value of future cash flows for projects 2
and 3 is $620,000. If all three projects are undertaken simultaneously, the economies noted will
still hold. However, a $125,000 extension on the plant will be necessary, as space is not
available for all three projects. Which project or projects should be chosen?

4. Excel Limited is considering the acquisition of Folder Limited which is in a related line
of business. Folder presently has a cash flow of $2 million per year. With a merger, synergism
would be expected to result in a growth rate of this cash flow of 15 percent per year for 10 years,
at the end of which level cash flows would be expected. To sustain the cash-flow stream, Excel
will need to invest $1 million annually. For purposes of analysis and to be conservative, Excel
limits its calculations of cash flows to 25 years.
a. What expected annual cash flows would Excel realize from this acquisition?
b. If its required rate of return is 18 percent, what is the maximum price Excel should pay?

94
SUMMARY

Capital budgeting involves the outlay of current funds in anticipation of future cash-flow
benefits. Collection of cash-flow information is essential for the evaluation of investment
proposals. The key is to measure incremental cash flows with and without the investment
proposal being analyzed. Depreciation under the accelerated cost recovery system has a
significant effect on the pattern of cash flows and, hence, on present value. Also affecting the
pattern of cash flows is the presence of salvage value and a working capital requirement.
Capital budgeting methods, including the average rate of return and payback methods, were
examined under the assumption that the acceptance of any investment proposal does not change
the business-risk complexion of the firm as perceived by suppliers of capital. The two
discounted cash-flow methods; internal rate of return and net present value are the only
appropriate means by which to judge the economic contribution of an investment proposal. s The
important distinctions between the internal-rate-of-return method and the present-value method
involve the implied compounding rate, the scale of investment, and the possibility of multiple
internal rates of return. Depending on the situation, contrary answers can be given with respect to
the acceptance of mutually exclusive investment proposals. On theoretical grounds, a case can be
made for the superiority of the present-value method, though in practice the IRR is popular.
Capital rationing is likely to result in investment decisions that are less than optimal. Inflation
creates a disincentive for capital investment because depreciation charges do not reflect
replacement costs, and a firm’s taxes grow at a faster rate than inflation. In estimating cash
flows, one should take account of anticipated inflation. Otherwise a bias arises in using an
inflation-adjusted required return and non-inflation-adjusted cash flows, and there is a tendency
to reject some projects that should be accepted.
In general, we can evaluate an acquisition in much the same manner and with much the same
kind of information that we use for evaluating an investment proposal generated internally. Free
cash flows, after capital expenditures, are estimated taking account of likely synergies. The
present value of these cash flows sets an upper limit on the market value of all securities, in-
cluding cash, to be paid together with the market value of any liabilities assumed.

KEY WORDS
• Capital rationing
• Cash outlay
• Mutually Exclusive projects
• Independent projects

FURTHER READING

1. Weston & Copeland "Financial Management"

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 LESSON SEVEN

7.0. PRODUCT COSTING METHODS

7.1. OBJECTIVES

This lesson aims at discussing the main methods applied in costing.

After completion of the lesson a the candidate should be able to:
(i) Identify the appropriate method for costing a product or service.
(ii) Determine the cost of items using the methods to be discussed

7.2. INTRODUCTION

There are mainly two methods of costing

(1) Process costing
(2) Job order costing

7.2.1. Process Costing

Process costing systems are used for inventory costing where there is continuous mass
production of homogeneous goods. Process costing systems use several work in progress (WIP)
accounts, one for each process. This WIP accounts are referred to as process accounts and as
goods move from one process to another their costs are transferred accordingly.
Process costing is less concerned with distinguishing among individual units of products but
instead accumulates costs per period for each process (e.g. month)

Illustration 1:
ABC Ltd operates a manufacturing plant for soft drinks, which go through the following three
processes:
A- Mixing
B- Bottling
C- Packaging

The following data was collected for the month of January:

A B C
Material (Sh) 10,000 5,000 2,000
Labour (Sh) 5,000 2,000 1,000
Factory Overheads:
Variable 500 1,000 500
Fixed 400 200 100

During the month 10,000 litres of the soft drink were produced.
Required: Prepare process accounts for the three processes.

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Solution

PROCESS A ACCOUNT
Units Sh Units Sh
Material 10,000 10,000 Process B A/c 10,000 15,900
Labour 5,000
Overheads:
Variable 500
Fixed 400
10,000 15,900 10,000 15,900

PROCESS B ACCOUNT
Units Sh Units Sh
Mat. Input-Process A 10,000 15,900 Process C A/c 10,000 24,100
Material 5,000
Labour 2,000
Factory Overheads:
Variable 200
Fixed 1,000
10,000 24,100 10,000 24,100

PROCESS C ACCOUNT
Units Sh Units Sh
Mat. Input-Process A 10,000 24,100 Finished Goods A/c 10,000 27,700
Material 2,000
Labour 1,000
Factory Overheads:
Variable 500
Fixed 100
10,000 27,700 10,000 24,100

Cost per litre = Sh 27,700/10,000 units = Sh 2.77

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 Definition of terms

(1) Spoilage:
These are unacceptable units of production that are discarded or sold at the disposal value.
Spoilage may be partially completed or fully completed depending on the inspection point.

2) Net Spoilage Cost:

Total cost applied to the point of rejection and either plus disposal costs or less the net
disposal value.

3) Waste:
These are inputs that do not become part of the output e.g materials that evaporate, shrink
or is residual with no economic value.

4) Scrap:
Units which do not become part of the output but which have relatively low economic
value sold or re-used at the firm.

Accounting for Spoilage:

Spoilage can be classified into two; normal spoilage and abnormal spoilage

Normal Spoilage:
This is inherent in a specific process and therefore it is uncontrollable in the short term.
The cost of normal spoilage is normally considered to be part of cost of good units
because production of good units simultaneously necessitates the appearance of spoilage.
Abnormal Spoilage:
Not expected to occur under efficient operating conditions and therefore not an inherent
part of the production process i.e it is mainly controllable.
The existence of spoilt units does not involve any additional cost beyond the amount
incurred before the detection of spoilage.
The main objectives of accounting for spoilage are

(a) To accumulate the data to highlight the cost of spoilage so that

management can be made aware of its magnitude
(b) To identify the nature of spoilage and distinguish between normal
abnormal spoilage (loss).

Illustration 1

Assume that in a process 1100 units were worked on at Sh10.00 per unit (excluding spoilage
allowance). The output was as follows:
Good units completed 1,000
Normal Spoilage 30
Abnormal spoilage 70
Total production 1,100

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The spoilt units could be sold at a scrap value of Sh3.00 per unit.

Required:
(i) Prepare the process account
(ii) The abnormal Loss/spoilage account
(iii) The scrap account

Solution

PROCESS ACCOUNT
Units Sh Units Sh
Input-Costs @Sh10 1,100 11,000 Finished Goods A/c 10,000 10,196
Abnormal Loss 70 714
Normal Loss @sh3 30 90

1,100 11,000 10,000 11,000

Cost per unit = Cost to account for – scrap value of normal loss
Good output expected

= (11,000-90)/1,100 = Sh10.196

ABNORMAL LOSS ACCOUNT

Units Sh Units Sh
Process A/c@Sh10.196 70 714 Finished Goods A/c 70 210
P & L A/c 504

70 714 70 714

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SCRAP ACCOUNT
Units Sh Units Sh
Process A/c 30 90 Bank A/c 100 300
Abnormal Loss 70 210

100 300 100 300

Activity

XYZ Limited uses two processes Cutting in Department A and finishing in Department B.
Direct material introduced at the beginning of the process in Department B. Conversion costs
are added evenly throughout the two processes. Data for the month of January for Department A
is as below:

Beginning work in progress (40% complete) 10,000 units

Direct Material Costs Sh 4,000
Conversion Costs Sh 1,100
Total costs Sh 5,110

Completed & transferred to Warehouse 48,000 units

Started during January 40,000 units
Ending Work in progress (50%) 1,000 units

Input costs are:

Materials Sh 22,000
Direct Labour Sh 6,000
Overheads Sh 12,000
Total Sh 40,000

Scrap value is Sh 0.50 per unit. Normal loss is 1% of input.

Required:
Prepare Process A accounts using: (i) Weighted Average Cost Method and (ii) First in First Out
(FIFO) method.
(Hint: Prepare a production report)

100
Steps in preparing a Production Cost Report
(i) Summarise the flow of physical units
(ii) Compute the output in terms of equivalent units
(iii) Summarise the total cost per equivalent unit
(iv) Compute the cost per equivalent
(v) Apply the total cost to the units completed and the units in the ending working in process

7.2.1. Job Order Costing

Job order costing is a method applied where a work is undertaken to customers’ special
requirements and each order is of comparatively short duration. A job therefore is a cost unit
that consists of a single order or a contract.

Procedures for Performance of Jobs

The normal procedures adopted in jobbing concerns involve the following:
(a) The prospective customer approaches the supplier and indicates the requirements of the job.

(b) A responsible official sees the customer and agrees with him the precise details
(specifications) of the items to be supplied e.g. the quantity, quality, size, colour, date of delivery
and any other special requirement.

(c) The organisation's department in charge of cost estimation prepares estimates for the job.
This will include the cost of materials to be used, wages expected to be paid, the appropriate
amount of factory, selling and administration overheads, the cost of additional equipment
required if any and the organisation's profit margin.

(d) Loading the job on the factory floor to at the appropriate time. This occurs as soon as all
materials, labour and equipment are available and subject to scheduling of other jobs.

Collection of Job Costs (Procedure)

1. Material requirements are send to stores

2. The material requisitions note (a source document) is used to cost the materials will be used
to cost materials issued to the job.
3. The job ticket is passed to the staff members who are to perform the first operation;
indicating the start time and completion time, and passed to the next staff until the last
operation of the job.
4. Whether the job is completed or not the job ticket is send to the cost accounting office where
the time spend will be recorded on the job cost card
5. The relevant cost of material used, direct labour costs and direct expenses are charged to the
job account in the work in process ledger.
6. The job account is debited with the job share of the factory overhead based on the
appropriate absorption rate.

101
7. On completion of the job the job account is charged with appropriate selling, administration
and distribution overheads to ascertain the total cost of that job. The difference between the
agreed selling price and the total cost incurred will be the producer's profit or loss.

Illustration
At the beginning of July 2003, XYZ Limited had one incomplete job which had accumulated the
following costs:
JOB CARD NO. 632

Costs to date Sh
Direct Materials 630
Direct Labour (120 hrs) 350
Factory Overheads (Sh2 per direct labour hr) 240
Total Factory cost to date 1220

During the month of July, three new jobs were commenced in the factory, and costs of
production were as follows:

Direct Materials Sh
Issued to: Job No. 632 2,390
Job No. 633 1,680
Job No. 634 3,950
Job No. 635 4,420
Damaged stock written of from stores 2,300

Material Transfers
Job 634 to Job 633 250
Job 632 to Job 634 620

Material returned to stores

From Job 632 870
From Job 635 170

Direct Labour hours recorded

Job 632 430 hrs
Job 633 650 hrs
Job 634 280 hrs
Job 635 410 hrs

The cost of labour hours during the month of July was Sh 3 per hour and production overhead is
absorbed at the rate of Sh 2 per direct labour hour. Production overheads incurred during the
month amounted to Sh 3,800. Completed jobs were delivered to customers as soon as they were
completed and invoiced amounts were as follows:

102
 Sh
Job 632 5,500
Job 634 8,000
Job 635 7,500

Administration and marketing overheads are added to the cost of sales at the rate of 20% of
factory cost. Actual costs incurred during the month of July 2003 amounted to Sh 3,200.

Required

1. Prepare the job accounts for each job during July 2003 (the accounts should
only show the cost of production, and not the full cost of sale)
2. Prepare the summarized job cost cards for each job and calculate the profit on
each completed job.
3. Show how the costs would be shown in the company’s cost control accounts.

SOLUTION:
(a)
JOB NO. 632 (Sh)
Balance B/f 1,220 Job 634 A/c 620
Stores a/c 2,390 Stores A/c 870
Wages a/c 1,290 Finished Goods A/c 4,270
Production Overheads 860

5,760 5,760

JOB NO. 633 (Sh)

Stores a/c 1,680

Job No.634 A/c 250 Bal. C/f 5,180
Wages a/c (650x3) 1,950
Production Overheads
(650x2) 1,300
5,180 5,180

JOB NO. 634 (Sh)

Stores A/c 3,950 Job 633 A/c 250
Job 632 A/c 620 Finished Goods A/c 5,720
Wages a/c 840
Production Overheads 560

5,970 5,970

103
JOB NO. 635 (Sh)

Stores a/c 4,420 Stores A/c 170

Wages a/c 1.230 Finished Goods A/c 6,300
Production Overheads 820

6,470 6,470

(b)

JOB NO. 634 (Sh)

JOB NO. 632 633 634 635
Direct Material 1,530 1,930 4320 4,250
Direct Wages 1,640 1,950 840 1,230
Production Overheads 1,100 1,300 560 820
Production Costs 4,270 5,180 5,720 6,300
Admin & Mktg Ov./heads 20% 854 1,144 1,260
Cost of Sales 5,124 6,864 7,560
Sales/ Invoice Value 5,500 8,000 7,500
Profit/(Loss) 376 1,136 (60)

ACTIVITY

1. Solve part (c) in the question above.

2.What are production overheads?
3. Explain circumstances under which job order costing and process costing would be applied.

104
7.5. QUESTIONS

1. The following balances were extracted from the cost accounts of Baked Potato Limited in
November 19X1.
1st 30th
November November
$ $
Raw materials stock 62,659 77,312
Work in process: materials 9,288 7,677
Work in process: labour 5,003 4,684
Work in progress: production overhead 1,251 1,561
Finished goods stock 12,729 14,133

During the month, purchases of raw materials amounted to 96,237 and the total payroll cost to
$73,455.

The payroll cost could be analyzed as follows

Direct labour 48,680

Indirect production labour 12,806
Administration labour 4,060
Selling and distribution labour 7,909
_________

73,455
__________
Included in the issues of raw materials were the following items.

Items valued at $1,355 for factory maintenance

Items valued at $3,978 for office supplies
Items valued at $2,167 for distribution operations.
Factory overhead was budgeted at $15,000 and budgeted direct labour cost was $45,000. The
absorption rate is based on direct labour cost.

Required
From the information given, prepare the following accounts for November 19X1.
(a) Raw materials
(b) Wages and salaries cost
(c) Work in progress
(d) Finished goods stock

2. A specialist manufacturer of purpose built plant engaged in three separate jobs in May 19X3.
The following costs were incurred.

Job A Job B Job C

Sh Sh Sh

105
Direct materials purchased 524 671 382
Direct labour
Skilled (hours) 158 170 16
Semi-skilled (hours) 316 190 30
Site expenses 118 170 25
Selling price of job 3,318 2,750 1,950
Completed at 31 May 19X3 100% 80% 25%

The following information is available:

Direct materials for the completion of the job have been recorded.
Direct labour rates: skilled Sh 5 per hour; semi-skilled Sh4 per hour.
Site expenses tend to vary with output.
Administration expenses total Sh440 per month and are to be allocated to the jobs on a labour
hour basis.
On completion of the work the practice of the manufacturer is to divide the calculated profit on
each job 20% to site staff as a bonus, 80% to the company. Calculated losses are absorbed by
the company in total.

Required:
(a) Calculate the profit or loss made by the company on job A.

(b) Project the profit or loss made by the company on jobs B and C.

© Comment on any matters you think relevant to management as a result of your calculations.

4. Bonto Ltd produces a simple product in two processes, process R and process X. The
following information relates to process X for period 4.

Work in progress at start of period- nil.

Material transferred from process R during the period – 2,500 Kgs valued at Sh7,145.
Wages paid – 2341/2 hours at Sh 4 per hour.
Other direct costs allocated – 463
Normal waste during processing – 5% of process R input. This has a scrap value of 16p per kg
and is credited to the process account.
At the end of period 4 there were 2.100 Kgs transferred to finished stock, and 150 Kgs remained
in work in progress.
The work in progress is 100% complete so far as materials are concerned, but only 80% of
labour costs and 60% of other direct costs have been incurred.

Required
Construct Process X account, showing your workings clearly.
4. The following information relates to two hospitals for the year ended 31 December 1999.

St. Matthew’s St. Marks

106
 Number of in-patients 15,400 710
Average stay per in-patient 10 days 156 days
Total number of out-patient attendances 130,000 3,500
Number of available beds 510 320
Average number of beds occupied 402 307

Cost analysis Out- In- Out- In

Patients Patients Patients Patients
$ $ $ $
Patient care services
Direct treatment services and
Supplies (eg nursing staff). 6,213,900 1,076,400 1,793,204 70,490
Medical supporting services:
Diagnostic (eg pathology) 480,480 312,000 22,152 20,650
Other services (eg occupational
therapy). 237,160 288,600 77,532 27,790

General services
Patient related (eg catering) 634,480 15,600 399,843 7,700
General (eg administration) 2,196, 760 947,700 1,412,900 56,700

Note. In-patients are those who receive treatment whilst remaining in hospital.
Out-patients visit hospital during the day to receive treatment.

Required:
a) Prepare a statement showing the following for each hospital for each cost heading.
(i) Cost per in-patient day, in $ to two decimal places.
(ii) Cost per out-patient attendance, in $ to two decimal places

(b) Calculate for each hospital the bed-occupancy (percentage)

© Comment briefly on your findings.

107
5. The following spreadsheet is designed to process monthly payroll deductions for four
employees, John, Paul, George and Pokoyoyo. They pay income tax at 25% and national
insurance at 10%. The necessary formulae have not yet been input.

A B C D E
1 John Paul George Pokoyoyo
2 Gross pay 1,500 1,200 1,400 1,300
3
4 Income tax
5 National insurance
6 Total deduction
7
8 Net pay

Required
(a) Summarize the total Finishing Department costs for April 19 – 7, and assign these
costs to units completed (and transferred out) and to units in ending work in
process using the weighted-average method.
(b) Prepare journal entries for April transfers from the Forming Department to the
Finishing Department and from the Finishing Department to Finished Goods.

KEY WORDS

• Normal Loss
• Abnormal Loss
• Scrap
• Job Order Costing
• Process Costing
• Production overheads

FURTHER READING

1. Deakin, E.B. & Mather, M.W. (1991) "Cost Accounting" 3rd Edition,
Richard D. Irwin Inc.
2. Drury, Colin (1996), "Management and Cost Accounting" 4th Edition,
International Thomson Business Press, London.
3. Hirsch, Maurice L. Jr. (1998) "Advanced Management Accounting" 2nd
Edition PWS-Kent Publishing Company, Boston.
4. Horngren, C.T. (1997) "Cost Accounting: A Managerial Emphasis", 9th
Edition, Prentice Hall.

108
PAST EXAMINATION QUESTIONS FOR THE DEGREE OF MASTER OF BUSINESS AND
ADMINISTRATION
CAC 501: MANAGEMENT ACCOUNTING
-------------------------------------------------------------------------------------------------------

Question One.
a) In the context of activity based costing (ABC), it was stated in Management Accounting
Evolution not Revolution (By Bromwith and Bhimani), that ‘Cost drivers attempt to link
costs to the scope of output rather than the scale of output thereby generating less
arbitrary product costs for decision making.’
You are required to explain the terms ‘activity based costing’ and ‘cost drivers’ (8 marks)

Question TWO.
The following information relates to a production period:

Material Direct machine labour cost.

Cost per per unit time per per unit(sh)
Product Volume Unit (Sh)

A 500 5 0.5 hour 0.25 hour 3

B 5,000 5 0.5 hour 0.25 hour 3

C 600 16 2 hours 1 Hour 12
D 7,000 17 1.5 hours 1.5 hors 9

Total production overhead recorded by the cost accounting system is analysed under the
following headings:
Factory overhead applicable to machine-oriented activity is sh.37.424
Set-up costs are Sh. 4, 355. * 920 = 256
The cost of ordering materials is Sh. 1, 920 *(10 = 192
Handling materials is Sh. 7, 580 * 27
Administration for spare parts is Sh. 8, 600 *12 + 17

These overhead costs are currently absorbed by products on a machine hour rate. However,
investigation into the production overhead activities for the period reveals the following totals.:

109
 Number of number of number of number of
Product materials materials spare parts
Set-up orders was
Handled.
A 1 1 2 2
B 6 4 10 5
C 2 1 3 1
D 8 4 12 4
Required;
i. Compute overhead cost per product using both traditional absorption costing and activity
based costing, tracing overheads to production units by means of cost driver; (14 marks)
ii. Comment briefly on the differences disclosed between overheads traced by absorption
costing and those traced by activity based costing. (3 marks.)
An extensive literature on the behavioural aspects of budgeting discusses the
propensity of managers to create budgetary slack.
You are required to explain three ways in which managers many attempt to distort the
budgetary system. (9 marks)
Managerial behaviour can be quite different from that discussed in a)
You are required to explain circumstances in which managers may be motivated
to set themselves very high, possibly unachievable budgets. (6 marks)
Sections a) and b) above are examples of differing managerial behaviour in
disparate situations. There are theories which attempt to explain the con sequence
for the design of management accounting systems of disparate situations, one
which is contingency theory.
You are required to explain:
1. the contingency theory of management accounting
2. the effects of environmental uncertainty on the choice of managerial
control systems and information systems for managerial control. (10
marks) TOTAL (25 MARKS)

Question Four
a) Discuss briefly major differences between Management Accounting and
Financial Accounting (6 marks)

110
 b) Citing appropriate example explain the purposes for which management
accounting information is required. ( 5 Marks)

Question Five
A company is considering whether to lease a large factory, with a capacity of 100,000 units p.a;
or a smaller factory, with a capacity of 70,000 units p.a. for the manufacture of a new product,
which is expected to have a life of 8 years. The company believes that here is a 40% chance that
the demand will be 100,000 units p.a during the first two years, and a 60% chance that it will be
70,000 units p.a. during this time. Demand for the subsequent six years is estimated as follows:
Annual demand for the first 2 years 100,000 70,000
Annual demand for the next 6 years 100,000 70,000 50,000 100,000 70,000 50,000
Probability 3 5 2 2 6 2

The fixed costs for operation are estimated as £ 50,000 p.a. for the large factory and £40,000 p.a.
for the smaller factory. Contribution per unit is expected to be £1 with the large factory and £0.9
with the smaller. The company proposes to review the situation after two years, and would
consider the following possible changes:
a. The enlargement of the smaller factory to a capacity of 1200,000 units p.a. if demand
during the first two years is 100,000 units p.a. this would add £ 2,000 p.a to fixed costs,
but would not affect contributions per unit.
b. The reduction of the large factory to a capacity of 70,000 units p.a. if demand during the
first two year is 70,000 units p.a. this would save £8,000 p.a. to fixed costs, but would not
affect contribution per unit.
By constructing and analysing a decision tree representing this situation advise the company
what course of action to pursue.
Note: the use of discounted cash flows is not required. A company has the opportunity of
marketing a new package of computer games. It has two possible courses of action: t test market
on a limited scale or to give up the project completely. A test market would cost £ 160,000 and
current evidence suggest that consumer reaction is equally likely to be ‘positive’ or ‘negative. If
the reaction to the test marketing were to be ‘positive’ the company could either market the

111
computer games nationally or still give up the project completely. Research suggests that a
national launch might result in the following sales:

Contribution
Sales £ Million Probability
High 1.2 0.25
Average 0.3 0.5
Low -0.24 0.25
If the test marketing were to yield ‘negative’ results the company would give up the project.
Giving up the project at any point would result in a contribution of £ 60,000 from the sale of
copyright etc to another manufacturer. All contributions have been discounted to present values.
You required to:
a. Draw a decision tree to represent this situation, including all relevant probabilities and
financial values;
b. Recommend a course of action or the company of basis of expected values;
c. Explain any limitation of this method of analysis.

Question Six.
The Brownhill Manufacturing Company is considering the reproduction of a new consumer item
with a five-year product lifetime. In order to manufacture this item it would be necessary to build
a new plant. After having considered several alternative strategies, management are left with the
following three possibilities.
Strategy A
Build a large plant at an estimated cost of £600,000.
This strategy faces two types of market conditions – high demand with a probability of 0.7 or a
low demand with a probability of 0.3. if the demand is high, the company can expect to receive
and annual cash flow of £250,000 for each of the next five years. If the demand is low the cash
flow would consist of a loss of £50,000 each year because of large fixed costs and inefficiencies.

112
Strategy B.
Do not build a plant initially.
This strategy consists of leaving the decision for one year whilst more information is collected.
The resulting information can e positive or negative with estimated probabilities 0.8 and 0.2
respectively. At the end of this time management may decide to build either a large plant or a
small plant at the same costs as at present providing the information is positive. If the resulting
information is negative management would decide to build no plant at all. Given positive
information the probabilities of high and low demand change to 0.9 and 0.1 respectively,
regardless of which plant is built. The annual cash flows for the remaining four-year period for
each type of plant are the same as those given in strategies A and B.
All costs are given in present value terms and should not be discounted.

Required:
1. Draw a decision tree to represent the alternative courses of action open to the company.
2. Determine the expected return for each possible course of action and hence decide the best
course of action for the management of Brownhill if they agree to have a large plant build
immediately. What percentage discount is necessary to change the best course of action?

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REFERENCES

1. Deakin, E.B. & Mather, M.W. (1991) "Cost Accounting" 3rd Edition,
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5th Edition, PWS-Kent Publishing Company, Boston.
3. Drury, Colin (1996), "Management and Cost Accounting" 4th
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5.
2nd Edition PWS-Kent Publishing Company, Boston.
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