Cost and Management Accounting II: University of Education, Winneba

UNIVERSITY OF EDUCATION, WINNEBA
Institute for Educational Development and Extension

CENTRE FOR DISTANCE EDUCATION
Cost and Management Accounting II

COST AND MANAGEMENT
ACCOUNTING II
Written by:
T. S. Ackorlie (DBA)
Charles Coffie
Isaac Oduro
ED
UC CE
ATI VI
ON FOR SER
Institute for Educational Development and Extension

University of Education, Winneba
© IEDE - UEW
ED E
UC IC
ATIO RV
N FOR SE
All rights reserved including translation. No part of this publication

may be reproduced or transmitted in any form or by any means,
electronic or mechanical, including photocopying, recording or
duplication in any information storage or retrieval system, without
prior permission in writing from the Director, IEDE,
University of Education, P. O. Box 25, Winneba.
Cost and Management Accounting II

Published 2015 by
The Institute for Educational Development and Extension
University of Education
P O Box 25
Winneba
Tel: (0)3323 22 046
Fax: (0)3323 22 497
Email: iede@uew.edu.gh
© Institute for Educational Development and Extension, 2015

ISBN xxxxxxx
Credits
Graphic Design and Layout:

E Owusu
Agyemang Simon Fosu
S Kwesi Nyan
Printed in Ghana:
UEW Printing Press
P O Box 25
Winneba, Ghana
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1 OVERVIEW OF COST AND MANAGEMENT ACCOUNTING
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INTRODUCTION 12
SECTION 1 INTRODUCTION TO COST AND MANAGEMANT 14

Meaning of Cost and Management Accounting 14
Estimating and Pricing 16
SECTION 2 COST CONCEPTS AND CLASSIFICATION 22

Cost centre and cost unit 23
Classification according to Purpose 26
Types of cost 27
Controllable and non-controllable costs 28
Imputed (notional) and Sunk Costs 29
Relevant and Irrelevant Costs 29
Opportunity and Incremental Costs 29
Conversion cost 30
SECTION 3 ELEMENTS OF COST 32

Total cost of a product or service 32
Direct costs and indirect costs (Overheads) 32
Components of Total Cost 33
Total expenditure may therefore be analyzed as follows 33
Computing the cost of a product 34
SECTION 4 INCOME DETERMINATION WHERE THERE EXIST OPENING

STOCK 38
What happens to profit under both techniques when there is an opening
stock 38
Illustration 38
SECTION 5 INCOME DETERMINATION WHERE THERE EXIST BOTH OPENING

AND CLOSING 40
Difference in profit under marginal costing and absorption costing
where there exist both opening and closing stocks 40
Illustration 40
Income Statement (Absorption costing) 42
SECTION 6 USES OF ABSORPTION AND MARGINAL COSTING 44

Advantages and disadvantages of Marginal Costing 44
Arguments in favour of Absorption Costing 45
Problem and Solutions 46
Difference in profit 58
Reason for Difference. 58
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ABSORPTION COSTING AND MARGINAL COSTING
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INTRODUCTION 62
SECTION 1 MEANING AND CHARACTERISTICS OF MARGINAL AND

ABSORPTION COSTING 64
Absorption Costing 64
Marginal costing 64
Product costs and Period costs. 64
Meaning of Marginal Cost 65
Distinction between absorption costing and marginal costing 67
SECTION 2 INCOME DETERMINATIONS UNDER MARGINAL COSTING AND

ABSORPTION COSTING 70
Profit Measurement 70
Income statement (Absorption costing) 70

STOCK 74
What happens to profit under both techniques when there is a closing
stock? 74
Income Statement (Marginal Costing) 75

STOCK 76
What happens to profit under both techniques when there is an opening
stock 76
Profit statement under absorption costing 77
SECTION 5 INCOME DETERMINATION WHERE THERE EXIST BOTH OPENING

AND CLOSING STOCKS 78
Difference in profit under marginal costing and absorption costing
where there exist both opening and closing stocks 78
SECTION 6 USES OF ABSORPTION AND MARGINAL COSTING 82

Advantages and disadvantages of Marginal Costing 82
Arguments in favour of Absorption Costing 83
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3 COST-VOLUME-PROFITS ANALYSIS
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INTRODUCTION 100
SECTION 1 OVERVIEW OF COST VOLUME-PROFIT (CVP) ANALYSIS 102

Meaning of CVP analysis 102
The relevant range of activity and assumptions of cost behaviour 103
Concept of Profit and the arithmetic of CVP analysis 103
Basic Principles of CVP 104
Objectives of CVP 105
Assumptions of CVP Analysis 106
SECTION 2 MEASURES OF CVP ANALYSIS 108

Contribution and Marginal Cost Equation 108
Profit-Volume Ratio (P/V Ratio) 109
Uses of P/V Ratio 110
Improvement in P/V Ratio 111
SECTION 3 MEASURES OF CVP ANALYSIS II 112

Break-Even Analysis 112
Assumptions underlying Break-even Analysis 112
Breakeven Point 112
Calculation of Profit at different Sale Volume 114
Cash Break-even point 118
SECTION 4 MARGIN OF SAFETY 120

Definition and Determination of Margin of Safety 120
The effect of a price reduction is always to reduce P/V ratio, raise the
break-even point and shorten the margin of safety. 121
SECTION 5 GRAPHIC PRESENTATION OF BREAK-EVEN ANALYSIS 126

Break-even Chart 126
Construction of Profit-Volume Chart 134
Multi-product-Volume Charts 135
Uses of Break-even Analysis 137
SECTION 6 SALE MIX 140

Definition and Explanation of the Concept: 140
Sales Mix (Multiple Products) and Break Even Analysis: 140
Uses of Break-even Analysis 143
Limitations of Cost volume profit (CVP) analysis 143
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RELEVANT COSTING AND SHORT TERM DECISION MAKING

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INTRODUCTION 152
SECTION 1 OVERVIEW OF DECISION MAKING PROCESSES, RELEVANT

COST AND REVENUE 154
Management Decision Making 154
Decision Process 154
Types of Relevant Cost and Revenue 156
SECTION 2 DECISION-MAKING AND MARGINAL COSTING 158

Selling Price Decisions 158
Selling prices under normal circumstances 158
Pricing in competition and depression 158
Selling Price below Marginal Cost 159
Exploring new markets to utilize spare plant capacity 160
Exploring Foreign Markets–Export Sales 161
SECTION 3 MAKE OR BUY DECISIONS 164

Make or Buy Decisions 164
Outsourcing and Idle Capacity. 165
Make or Buy under Limiting Factor Conditions 169
SECTION 4 SELECTION OF SUITABLE METHOD OF PRODUCTION 172

Production Method Decision 172
Plant Shut Down Decisions 172
SECTION 5 DIFFERENTIAL COST ANALYSIS 176

Meaning of differential Cost 176
Differential Cost Analysis vs. Marginal Costing 177
Practical Applications of Differential Cost Analysis 178
SECTION 6 OTHER SHORT TERM DECISIONS 180

Acceptance of a Special Order 180
Adding or dropping a product line 181
Evaluating make or buy alternatives 183
Decision regarding further processing of joint/by-products 183
Problems and Solutions 184
Calculation of Fixed overhead 186
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5 BUDGETING AND BUDGETARY CONTROL
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INTRODUCTION 198
SECTION 1 NATURE OF BUDGET 200

Concept of Budget 200
Characteristics 200
Concept of Budgetary Control 200
Forecast and Budget 201
Objectives of Budgetary Control 202
Advantages of Budgetary Control 203
Limitations of Budgetary Control 204
SECTION 2 PRELIMINARIES IN THE INSTALLATION OF BUDGET SYSTEM208

Setting up & Administration of Budgetary Control System 208
SECTION 3 CLASSIFICATION OF BUDGET 214

Functional Budgets 214
Production Budget 216
Production Cost Budget 217
Raw Materials Budget 218
Labour Budget 220
Production Overhead Budget 221
Selling and Distribution Cost Budget 222
SECTION 4 CASH BUDGET 224

Meaning and Purpose of the cash Budget 224
Receipts and Payments Method 224
Illustration 5.4 225
Master Budget 228
SECTION 5 FIXED AND FLEXIBLE BUDGETS 230

Fixed Budget 230
Distinction between fixed and flexible budgets 231
Preparation of flexible budgets 231
Revision of Budgets 236
Budget Reports 238
Form of Budget Report 238
SECTION 6 OTHER TYPES OF BUDGET 240

Zero-Based Budgeting (ZBB) 240
Main Features of Zero-Based Budgeting (ZBB) 241
Performance Budgeting 242
Steps in Performance Budgeting 243
Responsibility Accounting 243
Pre-requisites for Responsibility Accounting 244
Responsibility Centre 244
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STANDARD COSTING AND VARIANCE ANALYSIS

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INTRODUCTION 268
SECTION 1 INTRODUCTION TO STANDARD COSTING 270

Historical Costing 270
Concept of Standard Cost 271
Concept of Standard Costing 271
Steps in Standard Costing 271
Applicability of Standard Costing 272
Limitations of standard costing 273
Standard Hour 276
Variance Analysis 278
Controllable and Uncontrollable Variances 279
Variances for Each Element of Cost 280
SECTION 2 DIRECT MATERIAL COST VARIANCE 282

Reasons for Material price Variance 283
Classification of Material Usage Variance 285
SECTION 3 DIRECT LABOUR COST VARIANCE 292

Reasons for labour rate variance. 293
Labour Efficiency (or Time) Variance 294
Classification of Labour Efficiency Variance 294
SECTION 4 OVERHEADS VARIANCE 300

Standard Overhead Rate 300
When overhead rate per hour is used 301
When overhead rate per unit is used 301
Overhead Cost Variance 302
Variable Overhead (VO) Variances 302
Fixed Overhead (FO) Variances 304
SECTION 5 SALES VARIANCES 314

Methods of calculating sales variance 314
Turn over Method or Sales Value Method 315
Alternative Method of Computing Sales Mix Variance 319
Sale Margin Method 321
SECTION 6 REPORTING OF VARIANCES 326

Essentials of Effective Variance Report 326
Cost Variance Report Format 326
Problems and Solutions 330
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ACCOUNTING II COURSE INTRODUCTION
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COURSE INTRODUCTION ACCOUNTING II
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ACCOUNTING II COURSE PLANNER
You may use this page as your course planner. Write the dates that
you expect to complete each unit in this course. When you actually
complete a unit, write the date you completed it. This will help you to
keep track of your work and monitor your progress throughout this
course.
Planned completion date Actual completion date

Unit1:
Unit 2:
Unit 3:
Unit 4:
Unit 5:
Unit 6:
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ACCOUNTING II
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ON
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OVERVIEW OF COST AND MANAGEMENT

ACCOUNTING
SECTION 1 INTRODUCTION TO COST AND MANAGEMENT ACCOUNTING 14
SECTION 2 COST CONCEPTS AND CLASSIFICATIONS 22
SECTION 3 ELEMENTS OF COST 32
SECTION 4 INCOME DETERMINATION WHERE THERE EXIST OPEN STOCK 38
SECTION 5 INCOME DETERMINATION WHERE THERE EXIST BOTH OPENING AND 44

CLOSING 40
SECTION 6 USES OF ABSORPTION AND MARGINAL COST 44
the adinkra symbol used in the UEW crest

Mate masie I have heard what you have said
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ABSORPTION COSTING AND MARGINAL

COSTING
SECTION 1 MEANING AND CHARACTERISTICS OF MARGINAL AND ABSORPTION
COSTING 64
SECTION 2 INCOME DETERMINATION UNDER MARGINAL AND ABSORPTION

COSTING 70
SECTION 3 INCOME DETERMINATION WHERE THERE EXIST OPENING STOCK 74
SECTION 4 INCOME DETERMINATION WHERE THERE EXIST OPENING STOCK 76
SECTION 5 INCOME DETERMINATION WHERE THERE EXIST BOTH OPENING AND

CLOSING STOCK 78
SECTION 6 USES OF ABSORPTION AND MARGINAL COST 82

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3 ACCOUNTING II
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COST VOLUME-PROFIT ANALYSIS

SECTION 1 OVERVIEW OF COST VOLUME PROFIT ANALYSIS 102
SECTION 2 MEASURES OF CVP ANALYSIS 108
SECTION 3 MEASURES OF CVP ANALYSIS II 112
SECTION 4 MARGIN OF SAFETY 120
SECTION 5 GRAPHIC REPRESENTATION OF BREAK EVEN ANALYSIS 126
SECTION 6 SALE MIX 140

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4 ACCOUNTING II
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RELEVANT COSTING AND SHORT TERM

DECISION MAKING
SECTION 1 OVERVIEW OF DECISION MAKING PROCESSES, RELEVANT COST AND 154
REVENUE
SECTION 2 DECISION MAKING AND MARGINAL COSTING 158
SECTION 3 MAKE OR BUY DECISIONS 164
SECTION 4 SELECTION OF SUITABLE METHODS FOR PRODUCTION 172
SECTION 5 DIFFERENTIAL OF COST ANALYSIS 176
SECTION 6 OTHER SHORT TERM DECISIONS 180

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5 ACCOUNTING II
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BUDGETING AND BUDGETARY CONTROL

SECTION 1 NATURE OF BUDGET 200
SECTION 2 PRELIMINARIES IN THE INSTALLATION OF BUDGET SYSTEM 208
SECTION 3 CLASSIFICATION OF BUDGET 214
SECTION 4 CASH BUDGET 224
SECTION 5 FIXED AND FLEXIBLE BUDGET 230
SECTION 6 OTHER TYPES OF BUDGET 240

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6 ACCOUNTING
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STANDARD COSTING AND VARIANCE

ANALYSIS
SECTION 1 INTRODUCTION OF STANDARD COSTING 270
SECTION 2 DIRECT MATERIAL COST VARIANCE 282
SECTION 3 DIRECT LABOUR COST VIRIANCE 292
SECTION 4 OVERHEAD VIRANCE 300
SECTION 5 SALES VARIANCE 314
SECTION 6 REPORTING OF VARIANCE 326

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XXXXXXX 1 OVERVIEW OF COST AND MANAGEMENT
UNIT Unit X, section X: XXXXXXX
ACCOUNTING
You are welcome to this very interesting and important subject called Cost
and Management Accounting II. This subject is a continuation of Cost and
Management Accounting I which you may have gone through in semester
one. This course exposes you to accounting tools for decision making and
controls.
 Section 1: Introduction to cost and management accounting.
 Section 2: Costs concepts and classification
 Section 3: Elements of costs
 Section 4: Cost behaviour
 Section 5: Separating fixed and variable cost
 Section 6: Traditional costing versus Activity- Based- Costing
This opening unit introduces you to the subject. It tries to give you a
panoramic view of what the subject is all about. The Unit is divided into six
sessions.
Session one deals with the Introduction to cost and management accounting.
It begins with the meaning of cost and management accounting and looks at
it advantage to stakeholder. The second session examines cost concept and
classification. Session three covers the elements of cost and session four
looks at cost behaviour. Session five covers how to determine fixed cost and
variable cost. The Unit conclude with introduction to Activity-Based costing
and compares it with the Traditional Costing.
As stated in the overview this unit gives you a general understanding of the
concept of cost and management accounting and the concept of cost.
Therefore at the end of your study of this unit, you should be able to:
 explain the meaning of cost and management accounting
 distinguish between cost centre and cost unit
 explain the element of cost
 determine fixed cost and variable cost
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This page is left blank for your notes ACCOUNTING II
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XXXXXXX
Unit X, section X: XXXXXXX
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UNITAND MANAGEMENT
1 SECTION 1 INTRODUCTION TO COST AND MANAGEMANT
ACCOUNTING II Unit 1, section 1: Introduction to cost and management
Hi learner! You are most welcome to the first unit of the course on cost and
management accounting II. You are going to find this unit very interesting
especially if you took your cost accounting I studies serious. You will bear
with me that as an organisation expands beyond certain level, it becomes
necessary to decentralise the management functions, for diverse activities
will need to be carried out to meet the organisation’s objective. For
management to perform their functions effectively and efficiently they will
need adequate, reliable and relevant information to serve as a basis for
carrying out their functions and such information is designed and produced
by cost and management accounting systems. This session provides an
overview of the introduction to cost and management accounting.
By the end of the lesson the student should be able to:

 explain the meaning of cost and management accounting
 identify and explain the importance/advantages of cost and management
accounting
 limitations and criticisms of cost and management accounting
Meaning of Cost and Management Accounting

Cost accounting can be defined as “that branch of accounting dealing with
the classification, recording, allocation, summarization and reporting of
current and prospective costs.” (Kohler in his dictionary for Accountants)
Cost Accounting can also be defined as a system by means of which costs of

products or services are ascertained and controlled. It is defined as “the
application of accounting and costing principles, methods and techniques in
the ascertainment of costs and the analysis of savings and/or excesses as
compared with previous experience or with standards”. Thus, whereas
costing is simply cost finding, which can be carried out by means of
memorandum statements, arithmetic process etc., and cost accounting
denotes the formal accounting mechanism by means of which costs are
ascertained.
In simple words, costing means finding out the cost of something, and cost
accounting means costing using double entry book keeping methods as a
basis for ascertainment of costs. However, cost accounting and costing are
often used interchangeably.
Cost accounting forms part of the internal management information systems

with its principal uses as a managerial decision making, planning, control
and general estimation of costs.
Management accounting on other hand involves accounting designed for the

management, i.e., accounting which provides necessary information to the
management for discharging its functions. It is basically concerned with
presentation of accounting information in a manner which can assist the
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Unit 1, section 1: Introduction to cost and management ACCOUNTING II
management in the creation of policy and in the day-to-day operations of an

undertaking. Its aim primarily is to assist the management in performing its
functions effectively.
The Chartered Institute of Management Accountants (CIMA) London,

defines Management Accounting as follows: “The application of
professional knowledge and skill in the preparation of accounting
information in such a way as to assist management in the formation of
policies and in the planning and control of the operations of the
undertaking.”
The definition given by the Management Accounting Team of the Anglo-

American Council of Productivity seems to be more precise. It reads:
“Management accounting is the presentation of accounting information in
such a way as to assist management in the reaction of policy and in the day
to-day operations of an undertaking”.
The above definitions clearly indicate that management accounting is

concerned with accounting information which is useful to the management.
Efficiency of the various phases of management is, as a matter of fact, the
common thread which underlies all these definitions. However, it should be
clearly understood that it does not supplement financial accounting but
rather it supplements it in order to serve the diverse requirements of modern
management.
Advantages of Cost and management Accounting

A good costing and management accounting system serves the needs of
large sections of people. The advantages of cost accounting are discussed
below.
Advantages to Management
Analysis
This involves gathering data about past, present and planned activities, from
both inside and, where relevant, outside of the company. The management
accountant’s role is to design mechanisms to capture operational data in a
cost-effective manner and then to produce information in an appropriate
form for presentation to management. For example, through the production
of monthly management accounts efficiency studies on production methods
and processes, product costs, etc.
Planning
One of the key features of cost/cost accounting is its focus on future events.
In most businesses historic information will be of only limited value in
evaluating major operational changes and new strategic directions. Cost
accounting has an important role to play in providing support for planning
by ensuring that all subsidiary activities are coordinated into one master
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plan with quantified objectives. A detailed budget will then be prepared to

guide the company through the next 12 months.
Control
While the management accountant would not normally have executive
control over the day-to-day running of the businesses, they have an
important role to play in the design and maintenance of the mechanisms
required for monitoring and controlling activity. By comparing planned
activity targets with actual performance, the management accountant would
identify variances, undertake further investigation and then suggest possible
remedial action to management. In most businesses, it is not sufficient to
simply have everything measured, accounted for and controlled. This is
because if the function of cost accounting is to add value to the business,
then the level of control, and the analysis involved, must be cost-effective in
relation to the potential benefits of the investigation.
Fixation of responsibility: Whenever a cost centre is established, it implies

establishing a kind of relationship between superior and subordinates. Thus
responsibilities are fixed on every individual who is concerned with
incurrence of cost.
Measures economic performance: By applying cost control techniques such

as budgetary control and standard costing it helps in assisting the
performance of business.
Estimating and Pricing

Pricing decisions are complex and many interacting factors need to be
considered including; the type of market in which the organisation operates,
the extent of competition, demand and elasticity of demand, the cost
structure of the product, the state of the economy and many others. Indeed,
it is one of the functions of cost accountant to estimate suitable or optimum
prices for a product or service a business renders. In setting the optimum
price for the product or service the business renders, the cost account should
bear in mind the stake of the business remaining competitive and making
acceptable margin simultaneously. Quotations can be supplied to
prospective customers to secure orders.
Aids in decision-making: It helps management in making suitable decisions

such as make or buy, replace manual labour by machines, shut down or
continue operations based on cost reports.
Cost/management accountants do not actually make decisions outside of

their own function, but they do have an important role to play in providing
relevant information to allow other managers to solve problems in the most
effective way. Within the context of the overall process of analysis,
planning and control, the management accountant’s role in providing
information can be summarised as follows:
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 identify the problem and define the objectives of a solution; e.g.,

improve efficiency by reducing consumption of materials;
search for alternative courses of action; e.g. change production method,
alter product specification, change supplier or materials in specification,
etc.;
 collect data about the possible courses of action; e.g., equipment costs,
running costs, potential cost savings, customer reaction, etc.;
Select the appropriate course of action after evaluation of the
alternatives; for example, revised product costing, cost volume profit
analysis, cost/benefit analysis, discounted cash flow, etc.
Helps in the preparation of interim final accounts: By the process of

continuous stock taking it enables to know the value of closing stock of
materials at any time. This facilitates preparation of final accounts wherever
desired.
Helps in minimizing wastages and losses: Cost accounting system enables

entities to locate the losses relating to materials, idle time and under-
utilization of plant and machinery.
Facilitates comparison: It facilitates cost comparison in respect of jobs,

processes, and departments and also between two periods. This reveals the
efficiency or otherwise of each job process or department.
Assists in increasing profitability: Costing reports provide information about

profitable or unprofitable areas of operation. The management can
discontinue that product line or that department which are responsible for
incurring losses. Thereby only profitable lines of activities alone are
retained.
Reconciliation with financial accounts: A well maintained cost accounting

system facilitates reconciliation with financial accounts to check the
arithmetical accuracy of both the systems.
Advantages to Employees
Cost accounting system enables employees to earn better wages through
overtime wages and incentive systems of wage payment.
By providing better facilities it ensures job security to employees.
Employees benefit by merit rating techniques which is conducted by
scientific process.
Advantages to Creditors
It increases the confidence of creditors in the capital employed in the
business.
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The frequent preparation of reports and statements help in knowing

solvency position of the business.
Advantages to the Government

 It helps government in formulating policies regarding export, import,
taxation, price control measures, wage fixation, etc.
 It helps in assessing excise duty, sales tax, value added tax (VAT) and
income tax of the business.
 Costing information helps in preparing national plans.
Advantages to Society
Cost reduction and cost control programmes go to minimize cost of
production of goods and services. A portion of the reduced cost of
production is shared by customers by paying fewer prices for goods and
services.
It offers employment opportunities in the cost accounting department in the

capacity of cost accountants and cost clerks.
Limitations and Criticisms of Cost and management Accounting

It is expensive:
The system of cost accounting involves additional expenditure to be
incurred in installing and maintaining it. However, before installing it, care
must be taken to ensure that the benefits derived are more than the
investment made on this system of accounting.
The system is more complex:

As the cost accounting system involves number of steps in ascertaining cost
such as collection and classification of expenses, allocation and
apportionment of expenses, it is considered to be complicated system of
accounts. Moreover the system makes use of several documents and forms
in preparing the reports. This will tend to delay in the preparation of
accounts.
Inapplicability of same costing method and technique:

All business enterprises cannot make use of a single method and technique
of costing. It all depends upon the nature of business and type of product
manufactured by it. If a wrong technique and method is used, it misleads the
results of business.
Not suitable for small scale units:

A cost accounting system is applicable only to a large-sized business but not
to a small-sized one. Hence, there is limitation to its application to all types
of business.
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It lacks social accounting:

Cost accounting fails to take into account the social obligation of the
business. In other words, social accounting is outside the purview of cost
accounts.
Cost accounting is merely a system of estimates and probabilities and

therefore lacks accuracy:
Though the main purpose of cost accounting is to ascertain the cost of
production with a reasonable degree of accuracy, yet absolute accuracy is
not possible owing to the two reasons.
 Indirect expenditures are absorbed on the basis of predetermined rates
instead of actual rates, and
 The material cost and labour cost are inflated so as to cover the normal
loss and wastage of materials and normal idle time of workers.
Cost accounting is unnecessary in such business enterprises

which make large
Profits:
It is argued that industries which earn large amount of profit need not have a
system of cost accounting. This statement is absolutely wrong. Earning of
more profit by industry does not necessarily mean that its cost of production
is lowest and there is no scope for further reduction in the cost. Profit
represents the difference between the selling price and the cost of a product.
Profit earned by a business may be high because of increased price
prevailing in the market.
Two or more than two products manufactured by business may earn profit
for one line of product and loss by other. The profit earned by one product
may outweigh the loss suffered by other product thus resulting in overall
profit. So it is wrong to judge the efficiency of the business on the basis of
overall profitability of the business. If necessary steps are taken to reduce or
eliminate losses suffered by a second line product, the industry would earn
more amount of profit. It is in this context that a system of costing is felt.
It is unnecessary:
This criticism is leveled owing to lack of understanding of the objectives
and advantages of costing. In the present-day competitive world, every
manufacturer must know the cost of production for each article so that he
can fix selling price on a reliable and reasonable basis. Further he can also
compare his selling price thus fixed with the price prevailing in the market.
Cost ascertainment involves application of certain principles and techniques.
Having ascertained the cost, control techniques are used to keep the costs
under check and thereby increase the profit. Thus it can be said that cost
accounting is necessary in most of the concerns.
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Competition governs price and hence there is no need for costing

system:
Some critics contend that in these days of competition prices are determined
by the forces of demand and supply as against fixation of selling price by
adding a desired margin of profit on the cost price. This argument is
incorrect. Even in this situation cost accounts disclose the margin of profit
that is earned by comparing the market price and cost of production. It
impresses upon management the need to reduce cost by increasing the
volume of production or by elimination of losses and wastages if any. If the
cost price tend to be higher than the market price, it is desirable to abandon
such product line and pay attention to profitable line of products.
There is no need for costing where production efficiency is high:

The statement is misleading as without a yardstick to measure the efficiency
it is not possible to appraise the efficiency of a business. Cost accounting
system offers number of techniques such as standard costing, budgetary
control, inter-firm comparison and so on. The cost of production can also be
compared between two periods of time to know whether business is
currently running efficiently when compared to previous year. In case of
inefficient operation remedial measures can be taken to improve the
business.
Other objections:
Some other objections that are raised against the installation of cost
accounting system are follows:
It is a mere matter of forms and rulings:

Often it is argued that the cost accounting system degenerates into a matter
of mere forms and rulings. This is not the defect of cost accounting system
but the way in which the system is maintained. No doubt different forms are
necessary under costing system but they must be simplified and altered to
meet the changing condition.
Failure in many cases:

The system of cost accounting is often condemned as defective inasmuch as
it has failed to produce the desired result. The defect does not lie in the
costing system but for some other reasons such as indifferent attitude of the
management, lack of adequate facilities, non-cooperation or opposition from
employees. These defects can be overcome by reversing the above trend.
For want of necessity:

It is contended by some that costing is of recent origin and that its
application was not felt in the past. Though it was not used earlier, still
many industries prospered. So it is felt by some critics that the installation
of costing involves unnecessary expenditure. However it is to be
remembered that today’s business functions in a competitive conditions and
every manufacturer must know the actual cost of production in order to
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reduce the selling price. Many industrial failures in the past may be
attributed to the lack of knowledge on the part of management relating to
the actual cost of production thereby selling product below cost.
Conclusion
In this Session, we have looked at the meanings of cost and management
accounting, the importance of cost and management accounting to
management, employees, society, creditors and the government. We also
realised that despite its numerous importance, cost and management
accounting is not without limitations, and some of the limitations identified
against cost and management accounting has been outlined in this Session.
Assessment
1. Explain in detail the meaning of cost and management accounting
2. Identify and explain the importance of cost and management accounting
3. Cost and management accounting is not without shortcomings, identify
and explain four shortcomings.
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COST AND MANAGEMENT COST CONCEPTS AND CLASSIFICATION
UNIT 1 SECTION
ACCOUNTING II 2
Unit 1, section 2: Cost concepts and classification
You are warmly welcome to Session two of unit one. It is our fervent hope
that you enjoyed reading the first Session of this unit which focused on the
introduction to cost and management accounting. In this Session our
attention shall be focused on the cost concepts and its classification. Cost is
use in different disciplines to mean different things at different situations.
For management to perform its functions efficiently and effectively there is
the need to ascertain the cost of all activities and operations as compared to
the benefits that will be derived from such activities in order to ascertain the
profitability of such activity. This Session therefore will provide an
understanding of the basic cost concepts and classification.
By the end of the lesson, the student should be able to:

 understand the concept of cost and distinction among cost, expenses and
losses
 distinguish between cost centre and cost unit
 appreciate the basis on which cost can be classified
 identify and explain the various types of cost used in cost and
management accounting
Concept of cost
The scope of term ‘cost’ is extremely broad and general. It is therefore, not
easy to define or explain this term without leaving any doubt concerning its
meaning. Cost accountants, economists and others develop the concept of
cost according to their needs. This concept should, therefore, be studied in
relation to its purpose and use. Some of the definitions of ‘cost’ are
reproduced below:
 cost is “the amount of expenditure (actual or notional) incurred on or
attributable to a given thing”. (c.i.m.a. london).
 cost is a foregoing, measured in monetary terms, incurred or potentially
to be incurred to achieve a specific objective. (committee on cost
concepts and standards of the american accounting association).
 cost is “an exchange price, a foregoing, a sacrifice made to secure
benefit”. (a tentative set of broad accounting principles for business
enterprises).
It is true that a cost must be understood in its relationship to the purposes

which it is to serve. When the term ‘cost’ is used specifically it should be
qualified with reference to the object costed by such descriptions as fixed
cost, direct cost, labour cost, selling cost, marginal cost, standard cost,
conversion cost, differential cost, out-of-pocket cost, imputed cost, prime
cost, joint cost etc. All these terms have been explained in this lesson.
Cost versus expenses and losses

Cost should be distinguished from expenses and losses though in practice
the terms cost and expenses are sometimes used synonymously. An expense
22 UEW/IEDE
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Unit 1, section 2: Cost concepts and classification ACCOUNTING II
is defined as including “all expired costs which are deductable from

revenue”.
When a portion of the service potential of an asset is consumed, that portion

of its cost is re-classified as an expense. These expenses are then matched
against the revenues that they helped to generate. Examples of expenses are
depreciation, selling expenses, and office salaries etc., which are charged
against revenue in the period in which they are incurred. The unexpired
costs, i.e. the costs for which economic benefit is yet to be received are
known as deferred costs, such as prepaid insurance. Such items are shown in
the balance sheet. In other words, an unexpired cost is an asset and is
converted into an expense when the cost factor expires while helping to earn
revenues.
In contrast, “losses are reduction in firm’s equity, other than by withdrawals

of capital, for which no compensating value has been received.” A loss is an
expired cost resulting from the decline in the service potential of an asset
that generated no benefit to the firm. Obsolescence or destruction of stock
by fire is example of a loss.
Cost centre and cost unit

Cost is ascertained by cost centres or cost units or by both. The terms are
discussed below:
Cost Centre
A cost centre is “a location, person, or item of equipment or group of these
for which costs may be ascertained and used for the purpose of control”.
Thus, a cost centre refers to a section of the business to which costs can be
charged. It may be a location (a department, a sales area), an item of
equipment (a machine, a delivery van), a person (a salesman, a machine
operator) or a group of these (two automatic machines operated by one
workman).
A cost centre is primarily of two types:

 Personal cost centre-which consists of a person or a group of persons.
 Impersonal cost centre- which consists of a location or an item of
equipment or group of these.
From functional point of view, cost centres may be of the following two
types:
Production cost centres are those cost centres where actual production work
takes place. Examples are melting shop, machine shop, welding shop,
finishing shop, etc.
Service cost centre - those cost centres which are ancillary to and render
services production cost centres. Examples of service cost centres are power
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ACCOUNTING II Unit 1, section 2: Cost concepts and classification
house, tool room, stores department, repair shop, canteen, etc. Cost incurred
in service cost centres are of indirect type.
Cost accountant sets up cost centres to enable him to ascertain the costs the
needs to know. A cost centre is charged with all the costs that relate to it,
e.g. if a cost centre is a machine, it will be charged with the costs of power,
light, depreciation and its share of rent etc. The purpose of ascertaining the
cost of a cost centre is cost control. The person in charge of a cost centre is
held responsible for the control of cost of that centre.
The number of cost centres and the size of each vary from one undertaking
to another. It all depends upon the expenditure involved and requirements of
the management of the purpose of cost control. A large number of cost
centres tend to be expensive but having too few cost centres defeat the very
purpose of control.
Cost Unit
It has been seen above that cost centres help in ascertaining the costs by
location, equipment or person. Cost unit is a step further which breaks up
the cost into smaller sub divisions and helps in ascertaining the cost of
saleable products or services.
A cost unit is a “unit of product, service or time in relation to which cost

may be” ascertained or expressed”, (C.I.M.A. London). Cost units are the
‘things’ that the business is set up to provide of which cost is ascertained.
For example, in a sugar mill, the cost per tonne of sugar may be
ascertained; in a textile mill the cost per-meter of cloth may be ascertained.
Thus a tonne of sugar and ‘meter’ of cloth are cost units. In short, cost unit
is unit of measurement of cost. Broadly, cost unit may be:
 Units of production, e.g. a meter of cloth, a ream of paper, a tone of
steel, a meter of cable, etc. or
 Units of service, e.g. passenger miles, cinema seats, consulting hours
etc.
Classification of cost
The process of grouping costs according to their common characteristics is
called classification of cost. It is a systematic placement of like items
together according to their common features. The followings are the
important ways of classifying costs.
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Classification According to Functions: This is a traditional classification.

A business has to perform a number of functions like manufacturing,
administration, selling, distribution and research. Cost may have to be
ascertained for each of these functions. On this basis, costs are classified
into the following groups:
 Manufacturing cost: This is the cost of the sequence of operations
which begins with supplying materials, labour and services and ends
with completion of production.
 Administration cost: This is general administrative cost and includes
all expenditure incurred in formulating the policy, directing the
organization and controlling the operations of an undertaking, which is
not directly related to production, selling and distribution, research and
development activity or function
 Selling and distribution costs: Selling cost is the cost of seeking to
create and simulating demand and of securing orders. Distribution cost
is the cost of sequence of operations which begins with making the
packed product available for dispatch and ends with making the
reconditioned returned empty package for re-use
 Research and development cost: Research cost is the cost of searching
new or improved products or methods. It comprises wages and salaries
of research staff, payments to outside research organisations, materials
used in laboratories and research departments, etc.
Classification based on cost behaviour

Depending on the variability, behavior costs can be classified into variable
and fixed costs.
 Variable cost: The variable cost is a cost that tends to vary in
accordance with level of activity within the relevant range and within a
given period of time. The Prime product costs i.e., direct material, direct
labour and direct expenses tend to vary in direct proportion to the level
of activity. An increase in the volume means a proportionate increase in
the total variable costs and a decrease in volume will lead to a
proportionate decline in the total variable costs. There is a linear
relationship between volume and variable costs. They are constant per
unit.
 Fixed cost: The fixed cost is a cost that tends to be unaffected by
changes in the level of activity during a given period of time. The fixed
costs remain constant in the total regardless of changes in volume up to
a certain level of output. They are not affected by changes in the volume
of production. There is an inverse relationship between volume and
fixed cost per unit. Fixed costs tend to remain constant for all levels of
activity within a certain range. It follows that some fixed costs will
continue to be incurred even when the activity comes down to nil.
Some fixed costs are liable to change from one period to another. For
example salaries bill may go up because of annual increments or due to
change in the pay rates and due to pay structure
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COST AND MANAGEMENT
 Semi-variable cost or semi-fixed cost: Many costs fall between these

two extremes. They are called as semi-variable cost or semi- fixed costs.
They are neither perfectly variable nor absolutely fixed in relation to
changes in volume. They change in the same direction as volume but not
in direct proportion thereto. An example is found in telephone charges.
The rental element is a fixed cost whereas charges for call made are a
variable cost. The distinction between fixed and variable cost is
important in forecasting the effect of short run changes in volume upon
costs and profits.
Classification according to Purpose

Costs are classified into direct and indirect on the basis of their
identifiability with cost units or jobs or processes:
 Direct costs: These are those costs which are incurred for and may be
conveniently identified with a particular cost unit, process or
department.
 Indirect costs: These costs cannot be conveniently identified with a
particular cost unit, process or department. These are general costs and
are incurred for the benefit of a number of cost units or cost centres.
Cost of raw materials used, wages of machine operators are common
examples of direct costs. Examples of indirect costs are rent, repairs,
depreciation, managerial salaries, coal, lubricating oil, wages of
foreman, etc
Classification According to Controllability

The costs can also be classified into controllable and uncontrollable:
 Controllable costs: These are the costs which may be directly regulated
at a given level of management authority. Variable costs are generally
controllable by department heads. For example, cost of raw material
may be controlled by purchasing in larger quantities.
 Uncontrollable costs: These are those costs which cannot be influenced
by the action of a specified member of an enterprise. Fixed costs are
generally uncontrollable. For example, it is very difficult to control costs
like factory rent, managerial salaries, etc. Two important points should
be noted regarding this classification. First, controllable costs cannot be
distinguished from uncontrollable costs without specifying the level and
scope of management authority. In other words, a cost which is
uncontrollable at one level of management may be controllable at
another level of management. Secondly, in the long-run all costs are
controllable.
Classification by nature
This is the means of classifying cost according to what makes up the cost.
By their nature cost can be classified as Material cost, Labour cost and
Expenses.
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 Material cost is incurred to acquire the items used in producing the cost
unit or object and by which the cost unit can be identified with.
 Labour cost is incurred on the human effort employed in producing the
cost unit or cost object. They may be in the form wages and salaries.
 Expenses are all the other cost incurred apart from those incurred on
materials and labour used in producing the cost unit.
Types of cost
The clear understanding of various cost concepts is essential for the study of
cost and management accounting. Description of these concepts follows
now.
Product and period costs

The product cost is aggregate of costs that are associated with a unit of
product. Such Costs may or may not include an element of overheads
depending upon the type of costing system in force-absorption or direct.
Product costs are related to goods produced or purchased for resale and are
initially identifiable as part of inventory. These product or inventory costs
become expenses in the form of cost of goods sold only when the inventory
is sold. Product cost is associated with unit of output.
The period cost is a cost that tends to be unaffected by changes in level of

activity during a given period of time. Period cost is associated with a time
period rather than manufacturing activity and these costs are deducted as
expenses during the current period without having been previously
classified as product costs. Selling and distribution costs are period costs
and are deducted from the revenue without their being regarded as part of
the inventory cost.
Common and Joint costs

The common cost is an indirect cost that is incurred for the general benefit
of a number of departments or for the whole enterprise and which is
necessary for present and future .operations. The joint costs are the cost of
either a single process or a series of processes that simultaneously produce
two or more products of significant relative sales value.
Short-run and long-run costs

The short-run costs are costs that vary with output when fixed plant and
capital equipment remain the same and become relevant when a firm has to
decide whether or not to produce more in the immediate future. The long-
run-costs are those which vary with output when all input factors including
plant and equipment vary and become relevant when the firm has to decide
whether to set up a new plant or to expand the existing one.
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COST AND MANAGEMENT
Past and future cost

The past costs are actual costs incurred in the past and are generally
contained in the financial accounts These costs report past events and the
time lag between event and its reporting makes the information out of date
and irrelevant for decision-making. These costs will just act as a guide for
future course of action. The future costs are costs expected to be incurred at
a later date and are the only costs that matter for managerial decisions
because they are subject to management control. Future costs are relevant
for managerial decision making in cost control, profit projections, appraisal
of capital expenditure, introduction of new products, expansion programmes
and pricing etc.
Controllable and non-controllable costs

The controllable cost is a cost chargeable to a budget or cost centre, which
can be influenced by the actions of the person in whom control of the centre
is vested. It is always not possible to predetermine responsibility, because
the reason for deviation from expected performance may only become
evident later. For example excessive scrap may arise from inadequate
supervision or from latent defect in purchased material. The uncontrollable
cost is a cost that is beyond the control (i.e. uninfluenced by actions) of a
given individual during a given period of time.
Replacement and Historical Costs

The Replacement cost is a cost at which material identical to that is to be
replaced could be purchased at the date of valuation (as distinct, from actual
cost price at the date of purchase). The replacement cost is a cost of
replacing an asset at any given point of time either at present or the future
(excluding any element attributable to improvement).
The Historical cost is the actual cost, determined after the event. Historical
cost valuation states costs of plant and materials, for example, at the price
originally paid for them whereas replacement cost valuation states the costs
at prices that would have to be paid currently. Costs reported by
conventional financial accounts are based on historical valuations. But
during periods of changing price level, historical costs may not be correct
basis for projecting future costs. Naturally historical costs must be adjusted
to reflect current or future price levels.
Avoidable and unavoidable costs

The avoidable cost is a cost that will not be incurred if an activity is not
undertaken or discontinued. Avoidable cost will often correspond-with
variable costs. Avoidable cost can be identified with an activity or sector of
a business and which would be avoided if that activity or sector did not
exist.
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Unavoidable cost on the other hand is those cost that cannot be saved or
avoided irrespective of the decision or option opted.
Imputed (notional) and Sunk Costs

The imputed cost is a cost which does not involve actual cash outlay, which
are used only for the purpose of decision making and performance
evaluation. Imputed cost is a hypothetical cost from the point of view of
financial accounting. Interest on capital is common type of imputed cost. No
actual payment of interest is made but the basic concept is that, had the
funds been invested elsewhere they would have earned interest. Thus,
imputed costs are a type of opportunity costs.
The Sunk costs are those costs that have been invested in a project and
which will not be recovered if the project is terminated. The sunk cost is one
for which the expenditure has taken place in the past. This cost is not
affected by a particular decision under consideration. Sunk costs are always
results of decisions taken in the past. This, cost cannot be changed by any
decision in future. Investment in plant and machinery as soon as it is
installed its cost is sunk cost and is not relevant for decisions.
Relevant and Irrelevant Costs

The relevant cost is a cost appropriate in aiding to make specific
management decisions. Business decisions involve planning for future and
consideration of several alternative courses of action. In this process the
costs which are affected by -the decisions are future costs. Such costs are
called relevant costs because they are pertinent to the decisions in hand.
Irrelevant costs are those cost to be incurred which cannot be changed by a
particular decision made. Thus irrespective of the decision made, the cost
will be incurred.
Opportunity and Incremental Costs

The opportunity cost is the value of a benefit sacrificed in favour of an
alternative course of action. It is the maximum amount that could be
obtained at any given point of time if a resource was sold or put to the most
valuable alternative use that would be practicable. Opportunity cost can be
defined as the revenue forgone by not making the best alternative use.
The Incremental cost is the extra cost of taking one course of action rather
than another. It is also called as different cost. The incremental cost is the
additional cost due to a change in the level of nature of business activity.
The change may take several forms e.g., changing the channel of
distribution, adding a new machine, replacing a machine by a better
machine, execution of export order etc. Incremental costs will be different in
case of different alternatives. Hence, incremental costs are relevant to the
management in the analysis for decision making.
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COST AND MANAGEMENT
Conversion cost
The conversion cost is the cost incurred for converting the raw material into
finished product. It is referred to as the production cost excluding the cost of
direct materials:
Committed cost
The committed cost is a cost that is primarily associated with maintaining
the organisation’s legal and physical existence over which management has
little discretion. The committed cost is a fixed cost which results from
decision of prior period. Committed cost does not fluctuate with volume and
remains unchanged until action is taken to increase or reduce available
capacity. Committed cost does not present any problem in cost behaviour
analysis. Examples of committed cost are depreciation, insurance premium,
rent, etc.
Shutdown and Abandonment costs

The shutdown costs are the cost incurred in relation to the temporary closing
of a department/division/enterprise. Such costs include those of closing as
well as those of re-opening. The shutdown costs are defined as those costs
which would be incurred in the event of suspension of the plant operation
and which would be saved if the operations are continued.
The Abandonment cost is the cost incurred in closing down a department or

a division or in withdrawing a product or ceasing to operate in a particular
sales territory etc. The abandonment costs are the cost of retiring altogether
a plant from service; Abandonment arises when there is a complete
cessation of activities and creates a problem as to the disposal of assets.
Marginal cost
The marginal cost is the variable cost of one unit of a product or a service
i.e., a cost which would be avoided if the unit was not produced or provided.
In this context, a unit in usually either a single article or a standard measure
such as litre or kilogram, but may in certain circumstances be an operation,
process or part of an organisation. The marginal cost is the amount at any
given volume of output by which aggregate costs are changed if the volume
of output is increased or decreased by one unit.
Conclusion
In this Session we have been able to explain the term cost and how it differs
from expenses and losses in cost and management accounting. We also saw
the distinction between a cost centre and a cost unit. Various forms of cost
classification was identified and explained in details and finally the various
types of cost one is likely to face in cost and management accounting were
explained.
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Self-assessment questions
1. Explain the following terms:
a. cost
b. expenses
c. losses
2. Distinguish between cost centre and cost unit.

a. Explain the term cost classification
b. State and explain the various ways by which cost are classified.
3. Identify and explain five (5) types of cost
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UNITAND MANAGEMENT
1 SECTION 3 ELEMENTS OF COST
ACCOUNTING II Unit 1, section 3: Elements of cost
Dear student, in the previous Session attention was focused on the cost
concepts and classification. This third Session will take us to another
equally important and interesting topic, i.e ‘the elements of cost’. You will
realize that this topic is so exciting because it exposes you to the very root
of the components that forms the computation of the cost of an item.
By the end of the lesson the student should be able to:

 understand the elements of cost
 appreciate the direct and indirect component of the cost elements
 understand the components of total cost.
Total cost of a product or service

Total cost of a product or service consist of:
 The cost of materials consumed in making the product or providing the
service;
 The cost of the wages and salaries of employee of the organisation, who
are directly or indirectly involved in producing the product or providing
the services
 The cost of other expenses, apart from materials and labour costs. These
include items such as rent and rates, electricity bills, gas bills,
depreciation, interest charges, the cost of contractors’ services (e.g. sub-
contractors, office cleaners etc), telephone bills etc.
Direct costs and indirect costs (Overheads)

Materials, labour costs and other expenses can be classified as direct costs
or as indirect costs.
A direct cost is a cost that can be traced in full to the product or service (or
department etc) that is being costed
 Direct materials cost are the costs of materials that are known to have
been used in making and selling a product (or even providing a service).
 Direct labour costs are the specific costs of the workforce used to make
a product or provide a service. Direct labour costs are established by
measuring the time taken for a job, or the time taken in “direct product
work’. Traditionally, direct labour costs have been restricted to wages-
earnings factory workers, but in recent years, with the development of
systems for costing services (‘service costing’), the costs of some
salaried staff might also be treated as a direct labour cost.
 Other direct expenses are those expenses that have been incurred in
full as a direct consequence of making a product, or providing service,
or running a department ( depending on whether a product, a service or a
department is being costed
 An indirect cost is a cost that is incurred in the course of making a
product, providing a service or running a department, but which cannot
be traced directly and in full to the product, service or department.
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COST AND MANAGEMENT
Unit 1, section 3: Elements of cost ACCOUNTING II
 Indirect materials costs are therefore those ‘which are not charged
directly to a product, All material which is used for purposes ancillary to
the business and which cannot be conveniently assigned to specific
physical units is termed as “indirect Material”. Consumable stores, oil
and waste, printing stationery etc. are a few examples of indirect
material. Indirect material may be used in the factory, the office or the
selling and distribution divisions.
 Indirect labour costs are ‘labour costs which are not charged directly to
a product. Labour employed for the purpose of carrying out tasks
incidental to goods or services provided, is indirect labour.. It cannot be
practically traced to specific units of output. Wages of store-keepers,
foremen, time-keepers, directors fees, salaries of salesmen, etc. are all
examples of indirect labour costs. Indirect labour may relate to the
factory, the office or the selling and, distribution divisions.
 Indirect expenses are ‘expenses which are not charged directly to a
product, here are expenses which cannot be directly, conveniently and
wholly allocated to cost Centres of cost units. e.g. buildings insurance,
water rates’.
The quotations are of definitions provided in the CIMA’s Management

accounting official terminology.
Components of Total Cost

 Prime cost: It consists of direct material, direct labour and direct
expenses. It is also known as basic, first or flat cost.
 Factory cost: It comprises of prime cost and, in addition, works or
factory overheads which include costs of indirect material, indirect
labour, and indirect expenses of the factory. The cost is also known as
works cost, production or manufacturing cost.
 Office Cost: If office and administrative overheads are added to factory
cost, office cost is arrived at. This is also termed as administrative cost
or the total cost of production.
 Total Cost: Selling and distribution overheads are added to the total
cost of production to get the total cost or the cost of sales.
Total expenditure may therefore be analyzed as follows:

Material cost = Direct material cost + Indirect material cost
Wages = Direct wages + Indirect wages
Expenses = Direct expenses + Indirect expenses
Total Cost = Prime cost + Overhead
Thus prime cost is the aggregate of all direct costs and overhead is the
aggregate of all indirect costs. Total cost is the sum of prime cost and
overhead.
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COST AND MANAGEMENT
(Note: the CIMA Official Terminology comments that the term prime cost
is commonly restricted to direct production costs only and does not
customarily include direct costs of marketing or research and development.)
In a ‘traditional’ costing system for manufacturing organisation, costs are

classified as:
 Production or manufacturing costs;
 Administration costs;
 Marketing, or selling and distribution costs.
Many expenses fall comfortably into one or other of these three broad
classifications. Manufacturing costs are associated with the factory, selling
and distribution costs with the sales, marketing, warehousing and transport
departments and administration costs with general office departments (such
as accounting and personnel).
Other expenses that do not fall fully into one of these classifications might
be categorized as ‘general overheads’ or even listed as a classification on
their own (e.g. research and development costs).
Functional costs, in more detail: Functional costs include the following.

 Production costs: the costs which are incurred by the sequence of
operations beginning with the supply of raw materials, and ending with
the completion of the product ready for warehousing as a finished goods
item. Packaging costs are production costs where they relate to
‘primary’ packing (e.g. boxes, wrappers, etc.)
 Administration costs: the costs of managing an organisation, i.e.
planning and controlling its operations, but only insofar as such
administration costs are not related to the production sales, distribution
or research and development functions.
 Selling costs, sometimes known as marketing costs, are the costs of
creating demand for products and securing firm orders from customers.
 Distribution costs: the costs of the sequence of operations beginning
with the receipt of finished goods from the production department and
making them ready for dispatch and ending with the reconditioning for
re – use of returned empty containers.
 Research and development costs:
 research costs are the costs of searching for new or improved
products;
 development cost is the costs incurred between the decision to
produce a new or improved product and the commencement of full,
formal manufacture of the product.
Computing the cost of a product

In costing a small product made by a manufacturing organisation direct
costs are usually restricted to some of the production costs (although it is not
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COST AND MANAGEMENT
uncommon to find a salesman’s commission for selling the product as a

direct selling cost). A commonly found build-up of costs is therefore:
Production costs GH¢

Direct materials A
Direct wages B
Direct expenses (if any) C
Prime cost A+B+C
Production overheads D
Full factory cost A+B+C+D
Administration overheads E
Selling and distribution overheads F
Full cost of sales A+B+C+D+E+F
‘Full’ costing or absorption costing is described in a later chapter.
Illustration
1. The following figures have been extracted from the books of XYZ Ltd
for the year ending 31st March, 2000.
GH¢
Direct materials 70,000
Direct wages 75,000
Indirect wages 10,000
Other direct expenses 5,000
Factory rent and rates 500
Office rent and rates 500
Indirect materials 500
Depreciation of plant 1,500
Depreciation of office furniture 100
Managing Director’s remuneration 12,000
General factory expenses 5,700
General office expenses 1,000
General selling expenses 1,000
Travelling expenses 1,100
Office salaries 4,500
Carriage outward 1,000
Advertisements 2,000
Sales 250,000
2. From the above figures, calculate the following:

a. Prime cost
b. Works cost
c. Cost of production
d. Cost of sales
e. Net profit
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Solution:
XYZ LTD.
Cost Sheet for the year ending 31st March, 2000
GH¢ GH¢
Direct materials consumed 70,000
Direct wages 75, 000
Direct expenses 15,000
Prime Cost 160,000
Factory overhead:
Indirect wages 10,000
Factory rent & rates 5,000
Indirect materials 500
Depreciation of plant 1,500
General factory expenses 5,700 22,700
Works cost 182,700
Office and Administration Overhead:

Office rent and rates 500
Depreciation of office furniture 100
Managing Director’s remuneration 12,000
General office expenses 1,000 18,100
Cost of Production 200,800
Selling and distribution overhead:

Travelling expenses 1,100
General selling expenses 1,000
Advertisements 2,000
General selling expenses 1,000 5,100
Cost of Sales 205,900
Profit 44,100
Sales 250,000
Conclusion
From the above Session we have discussed mainly about the elements of
cost being material, labour and expenses. We also saw that each element has
two aspects. That is direct component and indirect component. How these
elements are put together to compute for the cost of a product has also been
demonstrated in this Session.
Assessment
1. Explain and provide examples of each of the following:
a. direct material
b. indirect material
36 UEW/IEDE
COST AND MANAGEMENT
c. direct labour
d. indirect labour e. direct expenses
e. indirect expenses.
2. Show the distinction between the following:

a. Cost centre and cost unit
b. Standard cost and budgeted cost
c. Production cost and Administrative cost
UEW/IEDE 37
COST AN MANAGEMENT INCOME DETERMINATION WHERE THERE EXIST OPENING
UNIT 1 SECTION
ACCOUNTING II 4 STOCK
Learner, you are once again warmly welcome to the fourth Session of unit
two where we will be looking at the determination of profit in a situation
where there exist opening stock. In Session 3 we saw how marginal and
absorption costing both treat closing inventory and in the end how it affects
their profit. In this Session too we will look at the how both methods will
treat the closing stock and the effect on the profit.
By the end of the lesson, the learner should be able to:

 compute the profit under marginal and absorption costing where there
exists opening stock
 outline the reasons for the differences in the profit figures under both
methods.
What happens to profit under both techniques when there is an

opening stock
Marginal costing treats production fixed overheads as period cost and that,
no fixed overheads is in the value of the closing stock. The total fixed
production overheads will be charged against profit in the previous year and
no fixed overheads will be carried forward to the current period thus the
opening stock will be valued at variable cost only. On the other hand,
absorption costing treats production fixed overheads as product cost and
that, some element of fixed overheads is in the value of the opening stock.
This implies that not only the total production fixed overheads that relates to
the period will be charge against profit but also the fixed cost element in the
stock brought forward as opening stock.. The effect is that profit under
marginal costing will be higher than that of the absorption costing by the
amount of fixed overheads absorbed in the opening stock. This is
demonstrated below:
Illustration
A company produces 17,500 units of a product during period just ended at a
full cost of GHc16.00 per unit. Three quarter of this cost is variable and the
remaining one quarter is fixed. At the start of the period, opening stocks of
finished goods was 2,500 units. During the period 20,000 units of the
products were sold at GHc25 per unit.
Prepare the profit statements of the company based on the two costing
techniques considered.
Solution
The production cost per unit under each method can be computed as
follows;
38 UEW/IEDE
COST AND MANAGEMENT
Unit 1, section 4: Income determination where there exist opening stock ACCOUNTING II
Absorption costing Marginal costing

GH¢ GH¢
Variable cost 3
× 1612 12
4
Fixed Production 1
overheads × 164 -
4
Production cost per unit 16 12
Profit statement under absorption costing

GH¢ GH¢
Sales 20,000@GH¢25 500,000
Less full production cost of sales

Opening stock 2,500@GH¢16 40,000
Production cost 17,500@GH¢16 280,000
Less closing stock 320,000
Profit 180,000
Profit statement under marginal costing

GH¢ GH¢
Sales 20,000@GH¢25 500,000

Less closing stock --- 240,000
Contribution 260,000
Less fixed production 17,500@GH¢4 70,000
overheads
Profit 190,000
Conclusion
Comparing the two profit statements, it can be observed that, the profit
under the marginal costing is higher. This is because, the fixed cost that
relates to the total activity level of 17,500 units has been charged to
contribution that relates to 20,000units under marginal costing implying the
violation of the matching concept.
UEW/IEDE 39
COST AND MANAGEMENT Unit 1, section
INCOME 5: Income determinationWHERE
DETERMINATION where there existEXIST
THERE both opening
BOTHand
UNIT 1 SECTION
ACCOUNTING II 5
closing OPENING AND CLOSING
Once again you are welcome to the fifth Session of this unit. In Sessions 3
and 4, we went through the determination of profit under marginal and
absorption costing where there is only closing stock and where there is only
closing stock. In this Session, we will be looking at how to determine the
profit where there exist both opening and closing stocks. It is our hope that
you will find it very interesting.
By the end of this Session, the learner should be able to:

 determine the profit under both marginal and absorption costing
techniques where there exist both opening and closing stocks
Difference in profit under marginal costing and absorption

costing where there exist both opening and closing stocks
Profit under the two systems may be different because of difference in the
stock valuation. Position in this regard is summarized as follows:
 Production equal to sales
 When there are no opening and closing stock, profit/loss under
absorption and marginal costing systems are equal.
 When opening stock is equal to closing stocks then also profit/loss
under the two systems will be equal provided the fixed cost element
in opening and closing stocks is the same amount.
 Production more than sales

When production during a period is more than sales, i.e., when closing
stock is more than opening stock, the profit as per absorption costing
will be more than that shown by marginal costing. This is because in
absorption costing a part of fixed overhead included in closing stock
value is carried forward to next accounting period in the form of closing
stock.
 Production less than sales

When production during a period is less than sales, i.e., when opening
stock is more than closing stock, profit shown by marginal costing will
be more than that shown by absorption costing. This is because under
absorption costing, cost of goods sold is higher because a part of fixed
cost from the preceding period is added to the current year’s cost of
goods sold in the form of opening stock.
Illustration
Top Class Company supplies you the following standard cost per unit for
one of its products.
Direct material GH¢ 1.60
Direct labour GH¢ 1.50
Variable factory overhead GH¢ 1.20
Fixed factory overhead GH¢ 3.00
40 UEW/IEDE
Unit 1, section 5: Income determination where there exist both opening and COST AND MANAGEMENT
closing ACCOUNTING II
Production at normal capacity is 200,000 units. Variable selling and

administrative overhead per unit is GH¢0.50 and fixed selling and
administrative overhead are GH¢ 75,000 per year. Production and sales data
for the year 2005 and year 2006 are as follows:
Units produced in year 2005 200,000
Units sold in the year 2005 160,000
Inventory – 31st Dec. 2005 68,000
Units sold in year 2006 180,000
Selling price in each year was GH¢ 10.50. Prepare Income Statement for the
two years under
 Absorption costing, and
 Marginal costing
Solution
Basic data
Year 2005 Year 2006
Production units 200,000 150,000
Sales units 160,000 180,000
Opening inventory 28,000 68,000
Closing inventory 68,000 38,000
Solution
Income Statement (Absorption costing)
Year 2005 Year 2006
GH¢ GH¢
Sales (@ GH¢ 10.50 per unit) 1,680,000 1,890,000
Direct materials (@ GH¢ 1.60 per unit 320,000 240,000
produced)
Direct labour (@ GH¢1.50 per unit) 300,000 225,000
Variable factory O/H (@ GH¢ 1.20 per unit) 240,000 180,000
Fixed factory overhead (@ GH¢ 3 per unit) 600,000 450,000
Production cost (@ GH¢ 7.30 per unit) 1,460,000 1,095,000
Add: Opening inventory (@ GH¢7.30 per unit) 204,400 496,400
1,664,400 1,591,400
Less: Closing inventory (@ GH¢ 7.30 per unit) 496,400 277,400
Cost of goods sold 1,168,000 1,314,000
Add: Under-absorbed fixed overhead (50,000 150,000
units @ GH¢3)
Total manufacturing cost 1,168,000 1,464,000
Selling and Adm. Overhead
Variable (@GH¢ 0.50 per unit sold) 80,000 90,000
Fixed 75,000 75,000
Total cost 1,320,000 1,629,000
UEW/IEDE 41
COST AND MANAGEMENT Unit 1, section 5: Income determination where there exist both opening and
ACCOUNTING II closing
Profit (sales – total cost) 357,000 261,000

Year Year
2005 2006
GH¢ GH¢
Sales (@ GH¢ 10.50 per unit) 1,680,000 1,890,000
Direct materials (@ GH¢ 1.60 per unit produced) 320,000 240,000
Direct labour (@GH¢ 1.50 per unit) 300,000 225,000
Variable factory O/H (@ GH¢ 1.20 per unit) 240,000 180,000
Production cost (@ GH¢ 4.30 per unit) 860,000 645,000
Add: Opening inventory (@ GH¢ 4.30 per unit) 120,400 292,400
980,400 937,400
Cost of goods sold 688,000 774,000
Add: Variable selling and adm. Overhead 80,000 90,000
Total cost (variable) 768,000 864,000
Contribution (sales – total variable cost) 912,000 1,026,000
Fixed overhead – Factory 600,00 600,000
Selling and adm. 75,000 75,000
Total fixed cost 675,000 675,000
Profit (Contribution – Fixed cost) 237,000 351,000
Conclusion
Year 2005 – Closing stock is more than opening stock (production is more
than sales), profit shown by absorption costing is more than that of marginal
costing.
Year 2006 – Closing stock is less than opening stock (sales are more than
production), profit shown by marginal costing is more than that of
absorption costing.
42 UEW/IEDE
Unit 1, section 5: Income determination where there exist both opening and COST AND MANAGEMENT
notes ACCOUNTING II
closing
This page is left blank for your
UEW/IEDE 43
COST AND MANAGEMENT
UNIT 1 SECTION
ACCOUNTING II 6 USES OF ABSORPTION AND MARGINAL
Unit 1, section 6: Uses of absorption and marginal costing
COSTING
Hello learner, you are most welcome to the sixth and last Session of unit 2.
In this Session we will be looking at the uses of both marginal and
absorption costing techniques and some arguments against the use of these
techniques.
By the end of the lesson, the students should be able to:

 outline the argument in favour and against the use of marginal and
absorption techniques in income determination
Advantages and disadvantages of Marginal Costing

Advantages
The following advantages are claimed for marginal costing over total
absorption costing:
 Help in managerial decisions. The most important advantages of
marginal costing is the assistance that it renders to management in
taking many valuable decisions. Information regarding marginal cost
and contributions provided by marginal costing facilitates making policy
decisions in problems like fixing selling prices below cost, make or buy,
introduction of a new product line, utilization of spare plant capacity,
selection of the most profitable product mix, etc. This has been
discussed in detail later in a separate chapter.
 Cost control. Greater control over cost is possible. This is to because
by classifying costs into fixed and variable, the management can
concentrate more on the control of variable costs which are generally
controllable and pay less attention to fixed costs which may be
controlled only by the top management and that too, to a limited extent.
 Simple technique. Marginal costing is comparatively simple to operate
because it avoids the complications involved in allocation,
apportionment and absorption of fixed overheads which is, in fact,
arbitrary division of indivisible fixed costs.
 No under and over-absorption of overheads. In marginal costing,
there is no problem of under-or over-absorption of overheads.
 Constant cost per unit. Marginal costing takes into account only
variable costs which remain the same per unit of product irrespective of
the volume of output. It therefore avoids the effect of varying cost per
unit as it ignores fixed costs which are incurred on a time basis and have
no relation with the size of production.
 Realistic valuation of stocks. In marginal costing, stocks of work-in-
progress and finished goods are valued only at variable costs. Thus no
fictitious profits can arise due to fixed cost begin absorbed and
capitalized in unsold stock. This is because marginal costing prevents
the carry forward in stock valuation of some portion of current year’s
fixed costs. Stock valuation in marginal costing is, therefore more
realistic and uniform.
 Aid to profit planning. To aid profit planning marginal costing
technique enables data to be presented to management in such a way as
44 UEW/IEDE
COST AND MANAGEMENT
Unit 1, section 6: Uses of absorption and marginal costing ACCOUNTING II
to show cost-volume-profit relationship. Graphic presentation in the

form of breakeven charts and profit-volume charts are also used to
facilitate planning future performance.
 Valuable adjunct to other techniques. Marginal costing is a valuable
adjunct to standard costing and budgetary control.
Disadvantages
The main disadvantages of marginal costing are as follows:
 Difficult analysis. Marginal costing assumes that all costs can be
analysed into fixed and variable elements. In practice however, it may
be difficult to segregate all costs into fixed and variable components.
Certain costs are caused purely by management decisions and cannot be
strictly classified as fixed or variable, e.g., amenities to staff, bonus to
workers, etc.
 Ignores time factor. By ignoring fixed cost, time factor is also ignored.
For instance, marginal cost of two jobs may be identical but if one job
takes twice as long to complete as the other, the true cost of the job
taking longer time is higher than that of the other. This is not disclosed
by marginal costing. Production cannot be achieved without incurring
fixed costs but marginal costing creates an illusion that fixed costs have
nothing to do with production.
 Difficulty in application. It is difficult to apply marginal costing
technique in industries where large stocks of work-in-progress are
locked up. Thus in ship building, or construction contracts, if fixed
overheads are not included in the valuation of work-in-progress, there
may be losses in each year, while on the completion of contracts, there
may be huge profits. Such fluctuation in profits can be avoided if total
absorption costing is employed.
 Less effective in capital intensive industries. In capital intensive
industries, the proportion of fixed costs (like depreciation, maintenance
etc.) is large. The marginal costing technique, which ignores fixed cost,
thus proves less effective in such industries. With the increased
automation in industries, marginal costing is, therefore, left with a
limited scope.
 Improper basis of pricing. Where prices are fixed by competition,
marginal costing gives the impression that so long as prices exceed
marginal cost, production is profitable. It ignores the danger of too much
sales being made at marginal cost or marginal cost plus some
contribution as it may result in overall losses. Although in certain
circumstances product may be sold at less than total cost, prices in the
long run must cover total cost as otherwise profit cannot be earned.
Arguments in favour of Absorption Costing

The arguments put forward in favour of absorption costing are:
 Since all production costs are incurred with a view to creating a product
for sale, all costs should attach to products until they are sold.
UEW/IEDE 45
COST AND MANAGEMENT
ACCOUNTING II Unit 1, section 6: Uses of absorption and marginal costing
 In the longer term, fixed overhead costs must be recovered through sales
if the business is to survive. Setting the stock value by reference to full
costs encourages a pricing policy which covers full cost.
 If fixed production costs are treated as period costs (as happens in
marginal costing) and there is a low level of sales activity in a period,
then a relatively low profit or loss will be reported. If there is a high
level of sales activity, there will be a relatively high profit. Absorption
costing smooth out these fluctuations by carrying the fixed costs forward
until the goods are sold.
 Absorption costing helps the ‘matching concept’ of matching sales with
the cost of sales of the same period
 Where overhead costs are high in relation to direct costs, and fixed
overheads are high in relation to variable costs, a marginal costing
approach would bring out only a small portion of the total cost picture.
 Absorption costing can be used in a ‘cost plus profit’ approach to
pricing a contract for a customer.
Problem and Solutions

Problem 1
From the following information prepare an income statement under:
a. Marginal costing
b. Absorption costing
Products
X Y Z
GH¢ GH¢ GH¢
Direct materials 7,500 30,000 3,000
Direct wages 9,000 9,000 1,500
Factory overhead – Fixed 3,000 1,500 1,500
– Variable 3,900 9,000 4,500
Selling overhead – Fixed 1,500 900 600
– Variable 2,100 6,000 3,000
Sales 32,000 61,000 16,000
Fixed factory overhead and fixed selling overhead were apportioned to

products X, Y, and Z on equitable bases.
Solution
Income Statement (Marginal Costing) (a)
46 UEW/IEDE
COST AND MANAGEMENT
Products
Total
X Y Z (X + Y +Z)
GH¢ GH¢ GH¢ GH¢
(A) Sales 32,000 61,000 16,000 109,000
Variable costs:
Direct materials 7,500 30,000 3,000 40,500
Direct wages 9,000 9,000 1,500 19,500
Variable overhead:
Factory 3,900 9,000 4,500 17,400
Selling 2,100 6,000 3,000 11,100
Total Variable Cost (B) 22,500 54,000 12,000 88,500
Contribution (A – B) 9,500 7,000 4,000 20,500
Less: Fixed cost (total of fixed and selling overhead) 9,000
Profit 11,500
Income Statement (Absorption Costing)

Products
Total
X Y Z (X + Y +Z)
GH¢ GH¢ GH¢ GH¢
Direct wages 9,000 9,000 1,500 19,500
Variable overhead:
Fixed 3,000 1,500 1,500 6,000
Variable 3,900 9,000 4,500 17,400
Cost of production 23,400 49,500 10,500 83,400
Selling overhead:
Fixed 1,500 900 600 3,000
Variable 2,100 6,000 3,000 11,100
Total cost 27,000 56,400 14,100 97,500
Profit 5,000 4,600 1,900 11,500
Sales 32,000 61,000 16,000 109,000
Comments
It may be noted from the above that total profit under the marginal costing
and absorption costing is the same, i.e., GH¢ 11,500. This is because there
are no opening and closing stocks of finished goods or work-in-progress.
Problem 2
XZED limited sells its products at GH¢ 3 per unit. The company uses a
first-In First-Out actual costing system. A new fixed manufacturing
overhead allocation rate is computed each year by dividing the actual fixed
UEW/IEDE 47
COST AND MANAGEMENT
manufacturing overhead cost by the actual production costs. The following

simplified data are related to its first two years of operation:
Year I Year II
Sales (units) 1,000 1,200
Production (units) 1,400 1,200
Costs GH¢ GH¢
Variable manufacturing 700 500
Fixed manufacturing 700 700
Variable marketing and administration 1,000 1,200
Fixed marketing and administration 400 400
Required:
1. Prepare income statements based on:
a. Absorption costing and
b. Variable costing for each year
2. Give reasons for the difference in the answer.
Solution
Basic data Year I Year II
Production units 1400 1000
Sales units 1000 1200
Opening stock units 400
Closing stock units 400 200

Year I Year II
GH¢ GH¢
Sales 3,000 3,600
Manufacturing cost – variable 700 500
– fixed 700 700
1,400 1,200
Add: Opening stock* - 400
Cost of Goods Available for sale 1,400 1,600
Less: Closing stock* 400 240
Cost of Goods Sold 1,000 1,360
Marketing and administration costs.
- variable 1,000 1,200
- fixed 400 400
Total cost 2,400 2,960
Net income (sales – total cost) 600 640
Working Note
Cost per unit year in I = GH¢ 1400 ÷ 1400 units = GH¢ 1
Cost per unit year in II = GH¢ 1200 ÷ 1000 units = GH¢ 1.20
Closing stock value in year I = 400 units @ GH¢ 1 = GH¢ 400
Costing stock value in year II = 200 units @ GH¢ 1.20 = GH¢ 240
48 UEW/IEDE
COST AND MANAGEMENT
Income statement (Variable costing)

Year I Year II
GH¢ GH¢
(A) Sales 3,000 3,600
Variable manufacturing cost 700 500
Add: Opening stock __ 200
Cost of Goods available for sale 700 700
Less: Closing stock 200 100
Cost of Goods Sold 500 600
Variable marketing and adm.cost 1,000 1,200
(B) Total variable cost 1,500 1,800
(C) Contribution (A – B) 1,500 1,800
Fixed cost – Manufacturing 700 700
– Administration 400 400
(D) Total Fixed Cost 1,100 1,100
Net Income (C – D) 400 700
Reason for difference in profit. Reason for difference in profit under

absorption costing and marginal costing is the difference in the valuation of
stocks.
In year 1, profit under absorption costing is higher at GH¢ 600 as compared

to GH¢ 400 in marginal costing. This is because closing stock value is more
than opening stock. In year II, profit under marginal costing is higher at
GH¢ 700 as compared to GH¢ 640 in absorption. This is because opening
stock value is more than closing stock.
Problem 3
ABC Motors assembles and sells motor vehicles. It uses an actual costing
system, in which unit costs are calculated on a monthly basis. Data relating
to March and April, are:
March April
Unit data:
Beginning inventory 0 150
Production 500 400
Sales 350 520
Variable – cost data: GH¢ GH¢
Manufacturing costs per unit produced 10,000 10,000
Distribution costs per unit sold 3,000 3,000
Fixed-cost data:
Manufacturing costs 2,000,000 2,000,000
Marketing costs 600,000 600,000
The selling price per motor vehicle is GH¢ 24,000

Required:
UEW/IEDE 49
COST AND MANAGEMENT
1. Present income statement for ABC Motors in March and April under (a)
variable costing and absorption costing.
2. Explain the differences between (a) and (b) for March and April.
Solution
Basic data:
March April
Sales units 350 520
Opening inventory units 0 150
Closing inventory units 150 30
Income Statement (Variable Costing)

March April
GH¢ GH¢
(A) Sales 8,400,000 12,480,000
Variable manufacturing cost 5,000,000 4,000,000
Add: Opening inventory @GH¢10,000 per 1,500,000
unit
Cost of Goods available for sale 5,000,000 5,500,000
Less: Closing inventory @ GH¢ 10,000 per 1,500,000 300,000
unit
Variable cost of goods sold 3,500,000 5,200,000
Variable distribution cost 1,050,000 1,560,000
(B) Total variable cost 4,550,000 6,760,000
(C) Contribution (A – B) 3,850,000 5,720,000
Fixed cost – Manufacturing 2,000,000 2,000,000
– Marketing 600,000 600,000
(D) Total Fixed Cost 2,600,000 2,600,000
Net Income (C – D) 1,250,000 3,120,000
Income statement (absorption costing)
50 UEW/IEDE
COST AND MANAGEMENT
March April
GH¢ GH¢
(A) Sales 8,400,000 12,480,000
Fixed manufacturing cost 2,000,000 2,000,000
7,000,000 6,000,000
Add: opening inventory* 2,100,000
Cost of goods available for sale 7,000,000 8,100,000
Less: Closing inventory* 2,100,000 450,000
Cost of goods sold (B) 4,900,000 7,650,000
Add: Distribution cost – Variable 1,050,000 1,560,000
Add: Marketing cost – Fixed 600,000 600,000
(B) Total Cost 6,550,000 9,810,000
Net Income (A – B) 1,850,000 2,670,000
Comments
Marginal costing rewards sales while absorption costing rewards
production. This means that when sales are more than production, marginal
costing produces higher profit and vice versa, when production is more than
sales, absorption costing shows higher profit.
In March, absorption costing shows higher profit by GH¢600,000 (i.e.,

1850,000 – 1,250,000) than marginal costing because production is more
than sales. In April, marginal costing shows higher profit than absorption
costing by GH¢450,000 (i.e., GH¢3,120,000 – 2,670,000) because sales are
more than production. Difference profit is exactly equal to difference
inventory values in the two months.
Working Notes:
In marginal costing inventory is valued at variable manufacturing cost while
in absorption costing inventory valuation is done as follows:
For April, closing inventory of 30 units:
GH¢
Variable manufacturing cost (30 units @ GH¢ 10,000) 300,000
Fixed manufacturing cost (30 units @ GH¢ 5000) 150,000
450,000
Fixed manufacturing cost per unit is calculated as under:
GH¢20,00,000
= GH¢5,000 per unit
400 units of production
For March, inventory of 150 units:

GH¢
Variable manufacturing cost (150 units @ GH¢ 10,000) 1,500,000
UEW/IEDE 51
COST AND MANAGEMENT
Fixed manufacturing cost (150 units @ GH¢ 4,000) 600,000

2,100,000
Fixed manufacturing cost per unit =

GH¢20,00,000
Problem 4
XYZ Ltd. has a production capacity of 200,000 units per year. Normal
capacity utilization is reckoned as 90%. Standard variable production costs
are GH¢ 11 per unit. The fixed costs are GH¢ 360,000 per year. Variable
selling costs are GH¢ 3 per unit and fixed selling costs are GH¢ 270,000 per
year. The unit selling price is GH¢ 20.
In the year just ended on 30th June, 2006, the production was 160,000 units
and sales were 150,000 units. The closing inventory on 30th June was 20,000
units. The actual variable production costs for the year were GH¢ 35,000
higher than the standard.
1. Calculate the profit for the year
a) By absorption costing method and b) by marginal costing method
2. Explain the difference in the profits.
Solution
For the year ending 30th June 2006
GH¢
Sales (150,000 units @ GH¢ 20) 3,000,000
Production Costs:
Variable (160,000 units @ GH¢ 11) 1,760,000
Add: Increase 35,000 1,795,000
Fixed (160,000 units @ GH¢ 2*) 320,000
Cost of goods produced 2,115,000
Add: Opening stock (10,000 units @) GH¢ 13)* 130,000
GH¢21,15,000 2,245,000
Less: Closing stock ( × 20,000units)
1,60,000
264,375
Cost of goods sold 1,980,625

Add: Under absorbed fixed production overhead (360,000 – 320,000) 40,000
2,020,625
Add: Non-production costs:
Variable selling cost (150,000 units @ GH¢ 3) 450,000
Fixed selling costs. 270,000
Total cost 2,740,625
Profit (sales – total cost) 259,375
52 UEW/IEDE
COST AND MANAGEMENT
Working Notes:
1. Fixed production overhead are absorbed at a pre-determined rate based
on normal capacity, i.e., GH¢ 360,000 ÷ 180,000 units = GH¢ 2
2. Opening stock is 10,000 units, i.e., 150,000 units + 20,000units –
160,000 units.
It is valued at GH¢ 13 per unit, i.e., GH¢ 11 + GH¢ 2 (Variable + fixed)
Income statement (Marginal Costing)

For the year ended 30th June, 2006
GH¢
Sales (150,000 units @ GH¢ 20) 3,000,000
Variable production cost (160,000 units @ 1,795,000
GH¢ 11 + GH¢ 35,000)
2,245,000
Add: Opening stock (10,000 units @ GH¢ 11) 110,000
2,355,000
Less: Closing stock 224,375
𝐺𝐻¢17,95,000
( 1,60,000 × 20,000units)
Variable cost of goods sold 2,130,625
Contribution. (sales – variable cost of goods sold) 869,375
Less: Fixed cost – Production 360,000
– Selling 270,000 630,000
Profit 239,375
Reasons for Difference in Profit: GH¢

Profits as per absorption costing 259,375
Add: Op. stock under-valued in marginal costing 20,000
(GH¢ 13,000 – 11,000)
279,375
Less: Cl. Stock under-valued in marginal costing 40,000
(GH¢ 264,375 – 224,375)
Profit as per marginal costing 239,375
Problem 5
Betty & Co. is currently working at 50% capacity and produces 10,000
units. At 60% working raw material cost increase by 2% and selling price
falls by 2%. At 80% working raw material cost increase by 5% and selling
UEW/IEDE 53
COST AND MANAGEMENT
price falls by 5%. At 50% capacity working the product costs GH¢ 180 per
unit and is sold at GH¢ 200 per unit. The unit cost of GH¢ 180 is made up
as follows:
Material GH¢ 100
Wages GH¢ 30
Factory overheads GH¢ 30 (40% fixed)
Administration overheads GH¢ 20 (50% fixed)
Prepare a marginal cost statement showing the estimated profit of the

business when it is operated at 60% and 80% capacity.
Solution
Marginal cost statement
Items 50% capacity 60% capacity 50% capacity
(10,000 units) (12,000 units) (16,000 units)
Per unit Total Per unit Total Per unit Total
GH¢ GH¢ GH¢ GH¢ GH¢ GH¢
(A) Sales 200 2,000,000 196 2,352,000 190 3,040,000
Material cost 100 1,000,000 102 1,224,000 105 1,680,000
Wages 30 300,000 30 360,000 30 480,000
Variable factory 18 180,000 18 216,000 18 288,000
overhead
Variable Adm. Overhead 10 100,000 10 120,000 10 160,000
(B) Marginal cost 158 1,580,000 160 1,920,000 163 2,608,000
(C) Contribution (A – B) 42 420,000 36 432,000 27 432,000
Fixed overheads:
Factory 12 120,000 10.00 120,000 7.50 120,000
Administration 10 100,000 8.33 100,000 6.25 100,000
(D) TFC 22 220,000 18.33 220,000 13.75 220,000
Profit (C – D) 20 200,000 17.67 212,000 13.25 212,000
Notes:
1. At 60% material cost is GH¢ 100 + 2% = GH¢ 102 per unit
At 80% material cost is GH¢ 100 + 5% = GH¢ 105 per unit
2. At 60% selling price is GH¢ 200 – 2% = GH¢ 196 per unit

At 80% selling price is GH¢ 200 – 5% = GH¢ 190 per unit
3. Factory overhead:
Fixed – GH¢ 30 x 40% = GH¢ 12 per unit.
Variable (GH¢ 30 – 12) = GH¢ 18 per unit.
Total fixed factory overheads = (10,000 units x GH¢ 12)
= GH¢ 120,000.
At 60% fixed factory overhead per unit will decrease, i.e.,
120,000 ÷ 12,000 = GH¢ 10.
54 UEW/IEDE
COST AND MANAGEMENT
At 80% fixed overhead per unit will further decrease, i.e., 120,000 ÷ 16,000
= GH¢ 7.50
Variable overhead per unit will not change but will increase in total when
production increases to 60% and 80%.
Similar calculation can be made for administration fixed overheads.
Problem 6
The monthly cost figures for production in a manufacturing company are:
GH¢
Variable costs 120,000
Fixed cost 35,000
Total 155,000
The normal monthly sales figure is GH¢ 200,000. Actual sales figures for
three separate months are:
First month GH¢ 200,000
Second month GH¢ 165,000
Third month GH¢ 235,000
Under as system of marginal costing stocks are valued as under:

First month Second month Third month
GH¢ GH¢ GH¢
Opening stock 84,000 84,000 105,000
Closing stock 84,000 105,000 84,000
If absorption costing is used, stocks would be valued as follows:

GH¢ GH¢ GH¢
Opening stock 108,500 108,500 135,625
Closing stock 108,500 135,625 108,500
Prepare Income Statements under marginal costing and absorption costing

in comparative form and comment on the results.
UEW/IEDE 55
COST AND MANAGEMENT
Solution
Comparative Income Statements
Marginal Absorption costing
Months Months
I II III Total I II III Total
GH¢ GH¢ GH¢ GH¢ GH¢ GH¢ GH¢ GH¢
(A) Sales 200,000 165,000 235,000 600,000 200,000 165,000 235,000 600,000
Opening stock 84,000 84,000 105,000 273,000 108,500 108,500 135,625 352,625
Add: variable costs 120,000 120,000 120,000 360,000 120,000 120,000 120,000 360,000
Fixed cost ___ ___ ___ ___ 35,000 35,000 35,000 105,000
Total 204,000 204,000 225,000 633,000 263,500 263,500 290,625 817,625
Less: Closing 84,000 105,000 84,000 273,000 108,500 135,625 108,500 352,625
stocks
(B) Cost of goods 120,000 99,000 141,000 360,000 155,000 127,875 182,125 465,000
sold
(C) Contribution 80,000 66,000 94,000 240,000 __ __ __ __
(A-B)
(D) Fixed cost 35,000 35,000 35,000 105,000 __ __ __ __
Profit (C – D ) 45,000 31,000 59,000 135,000 __ __ __ __

(A – B) __ __ __ __ 45,000 37,125 52,875 135,000
Comments
 First month. When opening and closing stocks are equal (or when there
are no opening or closing stocks) profit/loss under the two months with
be the same.
 Second month. When closing stock is more than opening stock (i.e,
production is more than sales), profit shown by absorption closing will
be more under marginal costing.
 Third month. When closing stock is less than opening stock (i.e. sales
are more than productions), profits shown by marginal costing will be
more under absorption costing.
 Overall position. When we consider overall position of the three months,
opening stock is equal to closing stock. Thus total profit for the three
months under the two systems is equal.
Problem 7
The following is the standard cost data per unit of product ‘X’
GH¢
Selling price 40
Direct material 8
Direct labour 5
56 UEW/IEDE
COST AND MANAGEMENT
Variable factory overhead 2
Fixed factory overhead GH¢ 5 (based on a budgeted normal output of

36,000 units per year)
Variable selling overhead GH¢ 6

Fixed selling overhead per year were GH¢ 120,000
During a month the company produced 2,000 units of the product and sold
1,500 units.
There was no opening stock.
You are required to prepare an income statement under

a. absorption costing, and
b. marginal costing.
Explain the difference in profit if any.
Solution
GH¢
Sales (1500 units x GH¢ 40) 60,000
Production costs:
Material (2,000 units x GH¢ 8) 16,000
Labour (2,000units x GH¢ 5) 10,000
Variable factory overhead (2,000 units x GH¢ 2) 4,000
Fixed factory overhead (2,000 units x GH¢ 5) 10,000
Cost of production 40,000
Less: Closing stock (500 units x GH¢ 20)* 10,000
Cost of Goods sold 30,000
Add: Under absorbed overhead* 5,000
35,000
Add: Selling expenses – variable (1,500 units x GH¢ 6) 9,000
Fixed (GH¢ 120,000 ÷ 12months) 10,000
Total cost of sales 54,000
Profit (Sales – Total cost) 6,000
Working Notes:
 Closing stock is valued at production cost per unit i.e., GH¢ 40,000 ÷
2,000 units = GH¢ 20.
 Fixed factory overhead per month (36,000 x GH¢ 5) ÷ 12months =
GH¢15,000
Less: Fixed factory overhead absorbed (2,000 units x GH¢ 5) = GH¢ 10,000
Under absorbed overhead GH¢ 5,000
UEW/IEDE 57
COST AND MANAGEMENT
Income Statement (Marginal Costing)

GH¢
Sales (1,500 units x GH¢ 40) 60,000
Variable production costs:
Direct materials (2,000 units x 8) 16,000
Direct labour (2,000 units x 5) 10,000
Factory overhead (2,000 units x 2) 4,000
Total variable production cost 30,000
Less: Closing stock (500 units x GH¢ 15) 7,500
22,500
Add: Variable selling overhead 9,000
(1,500 units x GH¢ 6)
Total cost (variable) 31,500
Contribution (Sales – Total variable cost) 28,500
Less: Fixed cost – Factory overhead 15,000
– Selling overhead 10,000 25,000
Profit 3,500
Difference in profit
Profit as per absorption costing GH¢ 6,000
Profit as per marginal costing GH¢ 3,500
Difference GH¢ 2,500
Reason for Difference. This difference in profit is due to the differences in

stock valuation under the two systems as explained below:
Stock valuation in absorption costing GH¢ 10,000
Stock valuation in marginal costing GH¢ 7,500
Theoretical Questions
1. What do you mean by marginal costing? Discuss its usefulness and
limitations.
2. Distinguish between marginal costing and absorption costing.
3. Distinguish between marginal costing and total costing
4. What are the characteristics of marginal costing?
5. Define marginal cost and marginal costing. How would you treat
variable cost and fixed costs in marginal costing?
6. “Absorption costing income exceeds variable costing income when the
number of units sold exceeds the number of units produced”. Do you
agree?
7. “Marginal costing rewards sales whereas absorption costing rewards
production”, Comment.
8. How is ‘prime cost’ different from ‘marginal cost’? State the elements
of cost included in the two types of cost indicating their significance in
cost accounting.
58 UEW/IEDE
COST AND MANAGEMENT
9. State the distinction between marginal cost and absorption cost as

regards valuation of finished goods inventories.
10. Explain the concept of marginal costing. Describe the characteristics and
limitations of marginal costing.
11. Define marginal costing. Explain its managerial uses.
Practice Questions
From the following information prepare an income statement under (a)
Absorption costing, and (b) Marginal costing. (1)
GH¢ GH¢
Sales 150,000 Adm. O/H – Fixed 5,000
Direct materials 50,000 variable 12,000
Direct labour 20,000 selling O/H – fixed 20,000
Fixed factory overhead 10,000 variable 15,000
Variable factory overhead 5,000
The following information is given for the year ending 31st Dec. 2005. (2)
Opening stock - 1000 units valued at GH¢ 70,000
(including variable cost of GH¢ 50 per unit)
Variable cost - GH¢ 60 per unit
Fixed cost (Total) - GH¢ 120,000
Production - 10,000 units
Sales - 8,000 units at GH¢ 90 per unit
Prepare income statement under (a) absorption costing, and (b) marginal
costing.
1. Your company has a production capacity of 12,500 units and normal
capacity utilization is 80%. Opening inventory of finished goods on 1-1-
2005 was 1,000 units. During the year ending 31-12-2005, it produced
11,000 units while it sold only 10,000 units. GH¢ 1.50. Total fixed
selling and administration overheads amounted to GH¢ 10,000. The
company sells its product at GH¢ 10 per unit.
Prepare income statements under absorption costing and marginal costing.

Explain the reasons for difference in profit, if any.
2. First Class Co. manufacturing ball pens is working at 40% capacity
producing 10,000 pens per year. The cost elements for each ball pen are
given as under:
Material GH¢ 20
Labour GH¢ 6
Overheads GH¢ 10 (40% variable)
Each ball pen sells for GH¢ 40. The selling price falls by 3% if production
is at 50% capacity and by 5% if worked at 90% capacity. The fall in selling
prices is accompanied by similar fall in material prices.
UEW/IEDE 59
COST AND MANAGEMENT
You are required to find out profit at 50% and 90% capacities using
marginal costing approach.
3. The following information is given for the year ending 31st Dec. 2005:
GH¢
Sales (@ GH¢ 50 per unit) 1,000,000
Direct material 290,000
Direct labour 310,000
Fixed factory overhead 240,000
Selling and administration overhead (fixed) 60,000
Selling and administration overhead (variable) 20,000
During the year 24,000 units were produced but only 20,000 units were
sold. There was no opening stock.
1. Prepare an income statement under
a. Absorption costing and
b. Marginal costing
2. Explain the difference in profit, if any.
60 UEW/IEDE
XXXXXXX 2 ABSORPTION COSTING
UNIT Unit X, section AND MARGINAL COSTING
X: XXXXXXX
Unit Outline
Session 1 Meaning and characteristics of Marginal and Absorption
costing
Session 2 Income determination under marginal and absorption costing
I
II
III
IV
Session 6 Uses of absorption and marginal costing
Unit Overview
You are welcome to unit two of the manual. This unit discusses the two
main approaches to profit measurement, Absorption and Marginal costing
techniques. In absorption costing, all manufacturing costs are ‘absorbed’ in
the cost of the products produced. In this system, fixed factory overheads
are absorbed on the basis of a predetermined overhead rate based on normal
capacity. The alternative costing system is known as variable costing,
marginal costing or direct costing. Under this alternative, only variable
manufacturing costs are assigned to products and included in the inventory.
Fixed manufacturing costs are not allocated to product cost, but are
considered as period cost and charge directly to the profit statement.
The unit is divided into six sessions. Session one deals with the meaning
and characteristics of Marginal and Absorption costing. Session two to five
cover income determination under marginal and absorption costing under
different conditions and the final session looks at the uses of absorption and
marginal costing.
After studying this unit, you should be able to:

 explain the difference between an absorption costing and marginal
costing system;
 prepare profit statements based on marginal costing and absorption
costing system;
 explain the difference in profit between variable and absorption costing
profit calculations;
 explain the argument for and against marginal and absorption costing.
62 UEW/IEDE
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UEW/IEDE 63
MEANING 1: Meaning and characteristics of marginal
AND CHARACTERISTICS and absorption
OF MARGINAL AND
UNIT 2 SECTION
ACCOUNTING II 1
costing ABSORPTION COSTING
Hello student, you are warmly welcome to the first Session of unit two.
Costing techniques are techniques use in the presentation of costing
information to management. There are different techniques for presenting
costing information, each of them having their own assumptions. Two
techniques shall be discussed under this unit. In this Session, we will be
looking at the meanings of the main two techniques of product costing and
income determination
 absorption costing, and
 marginal costing.

 explain the concept of absorption costing and marginal costing
 identify the characteristics of both techniques
 outline the distinction of absorption and marginal costing
Absorption Costing
This is a total cost technique under which total cost (i.e., fixed cost as well
as variable cost) is charged as production cost. In other words, in absorption
costing, all manufacturing costs are ‘absorbed’ in the cost of the products
produced. In this system, fixed factory overheads are absorbed on the basis
of a predetermined overhead rate based on normal capacity. Under/over
absorbed overhead are adjusted before computing profit for a particular
period. Closing stock is also valued at total cost which includes fixed
factory overhead (and sometimes administration overhead also).
Absorption costing is a traditional approach and is also known as
‘Conventional Costing’ or ‘Full Costing’.
Marginal costing
An alternative to absorption costing is marginal costing, also known as
‘variable costing’ or ‘direct costing’. Under this technique, only variable
costs are charged as product costs and included inventory valuation. Fixed
manufacturing costs are not allotted to products but are considered as period
costs and thus charged directly to profit and loss account of that year. Fixed
costs also do not enter in stock valuation.
Both absorption costing and marginal costing treat non-manufacturing costs

(i.e., administration, selling and distribution overhead) as period costs. In
other words, these are not inventoriable costs.
Product costs and Period costs.

The concepts of product costs and period costs were explained in Unit 1 of
this manual. It may be recalled that product costs are those costs which
become a part of production cost. Such costs are also included in inventory
valuation. Period costs, on the other hand, are those costs which are not
64 UEW/IEDE
Unit 2, section 1: Meaning and characteristics of marginal and absorption COST AND MANAGEMENT
costing ACCOUNTING II
associated with production. Such costs are treated as an expense of the

period in which these are incurred.
Meaning of Marginal Cost

Marginal cost is the additional cost of producing an additional unit of
product. It is the total of all variable costs. It is composed of all direct costs
and variable overheads. The CIMA London has defined marginal cost ‘as
the amount of any given volume of output by which aggregate costs are
changed, if volume of output is increased or decreased by one unit’. It is the
cost of one unit of product which would be avoided if that unit were not
produced. An important point is that marginal cost per unit remains
unchanged irrespective of the level of activity.
Example: A company manufactures 100 units of a product per month. Total

fixed cost per month is GH¢ 5,000 and marginal cost per unit is GH¢ 250.
The total cost per month will be:
GH¢
Marginal (variable) cost of 100 units 25,000
Fixed cost 5,000
Total cost 30,000
If output is increased by one unit, the cost will appear as follows:

Marginal cost (101 x 250) 25,250
Fixed cost 5,000
Total cost 30,250
Thus the additional cost of producing one additional unit GH¢ 250, which is
its marginal cost. However, where fixed costs also increase with the increase
in the volume of output, this may be the result of increase in production
capacity. Such increases in fixed costs are dealt with as a part of what is
known as ‘differential cost analysis’ discussed in Unit on Decision Making.
Meaning of Marginal Costing

Marginal costing is defined by CIMA London as “The accounting system in
which variable costs are charged to cost units and fixed costs of the period
are written off in full against the aggregate contribution. Its special value is
in decision making.”
Characteristics of Marginal Costing

The essential characteristics and mechanism of marginal costing technique
may be summed up as follows:
 Segregation of costs into fixed and variable elements. In marginal
costing all costs are classified into fixed and variable. Semi-variable
costs are also segregated into fixed and variable elements.
UEW/IEDE 65
COST AND MANAGEMENT Unit 2, section 1: Meaning and characteristics of marginal and absorption
ACCOUNTING II costing
 Marginal costs as products costs. Only marginal (variable) costs are

charged to products produced during the period.
 Fixed cost as period costs. Fixed costs are treated as period costs and
are charged to Costing Profit and Loss Account of the period in which
they are incurred.
 Valuation of inventory. The work-in-progress and finished stocks are
valued at marginal cost only.
 Contribution. Contribution is the difference between sales value and
marginal cost of sales. The relative profitability of products or
departments is based on a study of ‘contribution’ made by each of the
products or departments.
 Pricing. In marginal costing, prices are based on marginal cost plus
contribution.
 Marginal costing and profit. In marginal costing, profit is calculated
by a two stage approach. First of all, contribution is determined for each
product or department. The contributions of various products or
departments are pooled together and such a total of contributions from
all products is called ‘Fund’. Then from this fund is deducted the total
fixed cost to arrive at a profit or loss.
Sales of Sales of Sales of

product A product B product C
Less Less Less
Marginal Marginal Marginal
cost of A cost of B cost of C
= = =
Contribution Contribution Contribution
of A of B of C
Total
Contribution
pool
Less
Total
Fixed cost
=
Profit
Fig. 1.1 Profit Ascertainment in Marginal Costing in a Multi-product

Company
66 UEW/IEDE
costing ACCOUNTING II
Distinction between absorption costing and marginal costing

The points of distinction between marginal costing and absorption costing
are summarized as follows:
 Treatment of fixed and variable costs. In marginal costing, only
variable costs are charged to products. Fixed costs are treated as period
costs and charged to profit and loss account of the period.
 In absorption costing all costs (both fixed and variable) are charged to
product. The fixed factory overhead is absorption in units produced at a
rate pre-determined on the basis of normal capacity utilization (and not
on the basis of actual production).
 Valuation of stock. In marginal costing, stock of work-in-progress and
finished goods are valued at marginal cost only.
 In absorption costing, stocks are valued at total cost which includes both
fixed and variable costs. Thus stock values in marginal costs are lower
than that in absorption costing.
 Measurement of profitability. In marginal costing, relative profitability
of products or departments is based on a study of relative contribution
made by respective products or departments. The managerial decisions
are thus guided by contribution.
In absorption costing, relative profitability is judged by profit figures which

are also a guiding factor for managerial decisions.
Direct materials Charged to cost Charged as

Direct labour of goods expense when
Variable factory produced goods are sold
overhead
Fixed factory
overhead
Charged as
All selling and adm. expense when
overhead incurred
Fig. 1.2 Absorption Costing Approach

Direct materials Charged to cost Charged as
Direct labour of goods expense when
Variable factory produced goods are sold
overhead
Fixed factory Charged as

overhead and all expense when
selling and adm. incurred
overhead
Fig. 1.3 Marginal Costing Approach
UEW/IEDE 67
COST AND MANAGEMENT Unit 2, section 1: Meaning and characteristics of marginal and absorption
ACCOUNTING II costing
Conclusion
We have seen that the two major techniques used in the determination of
income is the absorption costing and the marginal costing. Absorption
costing, which is also known as full costing is a costing technique where all
stock items are valued at their full production cost. Marginal costing on
other hand is a technique where all stock items are valued at their variable
production cost.
68 UEW/IEDE
notes ACCOUNTING II
costing
This page is left blank for your
UEW/IEDE 69
INCOME 2: Income determination under
DETERMINATIONS UNDER marginal costingCOSTING
MARGINAL and
UNIT 2 SECTION
ACCOUNTING II 2
absorption costing
AND ABSORPTION COSTING
You are welcome to Session 2 of unit 2. It is our hope that you have enjoyed
the theoretical aspect of the topic Marginal and absorption costing. In this
Session, we want to look at how to determine an income using both
techniques. We will first begin with a situation where no closing or opening
stocks exist.
By the end of the Session, the learner should be able to:

 prepare the income statement to determine the profit where there is no
inventory.
 explain why profits under both methods are the same.
Profit Measurement
The net profit under the two systems may be same or may be different.
Difference in profit may be because of the different basis of inventory
valuation. In marginal costing stocks of work-in-progress and finished
goods are valued at variable cost whereas in absorption costing stocks are
valued at total cost.
Income statement under the two systems may be prepared in the formats
given on next page.
Income statement (Absorption costing)

GH¢
Sales xxxxx
Production costs:
Direct material consumed xxxxx
Direct labour cost xxxxx
Variable manufacturing overhead xxxxx
Fixed manufacturing overhead xxxxx
Cost of production xxxxx
Add: Opening stock of finished goods xxxxx
(valued at cost of previous periods production)
xxxxx
Less: Closing stock of finished goods xxxxx
(valued at production cost of current period)
Cost of Goods sold xxxxx
Add: (or loss) under (or over) absorption of fixed xxxxx
manufacturing overhead
Add: Selling and distribution costs xxxxx
Administration costs xxxxx xxxxx
Total cost xxxxx
Profit (sale – total cost) xxxxx
Illustration
Zen Ltd. Supplies you the following data:
70 UEW/IEDE
Unit 2, section 2: Income determination under marginal costing and COST AND MANAGEMENT
absorption costing ACCOUNTING
Direct material cost GH¢ 48,000

Direct wages GH¢ 22,000
Variable overhead – Factory GH¢ 13,000
– Adm. And selling GH¢2,000
Fixed overhead – Factory GH¢ 20,000
– Adm. And selling GH¢ 8,000
Sales GH¢ 125,000
Prepare an income statement under absorption costing.
Solution
Income statement (Absorption Costing)
GH¢
(A) Sales 125,000
Direct wages 22,000
Factory overhead – Variable 13,000
– Fixed 20,000 33,000
Cost of Production 103,000
Adm. And selling overhead – Variable 2,000
– Fixed 8,000 10,000
(B) Total cost 113,000
Profit (A – B) 12,000

GH¢
Sales xxxx
Variable manufacturing costs
- Direct material consumed xxxxx
- Direct labour xxxxx
- Variable manufacturing overhead xxxxx
Cost of Goods Produced xxxxx
Add: Opening stock of finished goods xxxxx
(valued at variable cost of previous period)
Less: Closing stock of finished goods (valued at current
variable cost)
Costs of Goods sold xxxxx
Add: Variable adm. Selling and dist. Overhead xxxxx
Total variable cost xxxxx
Contribution (sales – total variable cost) xxxxx
Less: Fixed costs (production, adm. Selling and dist.) xxxxx
Net profit xxxxx
UEW/IEDE 71
COST AND MANAGEMENT Unit 2, section 2: Income determination under marginal costing and
ACCOUNTING II absorption costing
Illustration
From the data given in illustration 2.1 prepare an income statement under
marginal costing.
Solution
GH¢
(A) Sales 125,000
Direct wages 22,000
Variable overhead – Factory 13,000
– Adm. And selling 2,000
85,000
(B) Variable cost 40,000
(C) Contribution (A – B) – Factory
Fixed overhead – Factory 20,000
– Adm. And selling 8,000
(A) Total fixed overhead 28,000
Profit (C – D) 12,000
Conclusion
Profit under absorption costing and marginal costing is the same. This is
because there is no opening and closing stocks and all the fixed overheads,
either treated as a product or period cost, has been charged against revenue
in arriving at the net profit. However, when there are opening and/or closing
stocks, profit/loss under the two systems may be different.
72 UEW/IEDE
Unit 2, section 2: Income determination under marginal costing and COST AND MANAGEMENT
absorption
This page is left blank notes ACCOUNTING
costing
for your
UEW/IEDE 73
GUIDANCE AND INCOME DETERMINATION WHERE THERE EXIST OPENING
UNIT 2 SECTION
COUNSELLING
CHILDHOOD
IN EARLY 3 STOCK
Dear learner, it is our believe that you were able to follow the processes
involved in determining the profit under both marginal and absorption
costing techniques in Session 2. In this Session we are going to compute the
profit where there exists closing stock of inventory to see the changes in the
two profits from the two techniques.

 ascertain the profit under both marginal and absorption costing where
there exist closing stocks of inventory.
 explain what accounts for the difference in the profit under both
methods
What happens to profit under both techniques when there is a

closing stock?
production overheads will be charged against profit and no fixed overheads
will be carried forward to the next period. On the other hand, absorption
costing treats production fixed overheads as product cost and that, some
element of fixed overheads is in the value of the closing stock. Not all the
total fixed production overheads will be charged against profit rather only
the portion of the overheads that relates to sales units will be charged
against profit, but the portion relating to the stocks left will be carried
forward to the next period. The effect is that profit under marginal costing
will be lesser than that of the absorption costing by the amount of fixed
overheads absorbed in the closing stock. This is demonstrated below:
Illustration
XYZ Ltd. supplies you the following data for the year ending 31st Dec.
2005.
Production – 1100 units, sales 1,000 units
There was no opening stock
Variable manufacturing cost per unit GH¢ 7
Fixed manufacturing overhead (total) GH¢ 2,200
Variable selling and administration overhead per unit GH¢0.50
Fixed selling and administration overhead GH¢ 400
Selling price per unit GH¢ 15
Prepare
a. Income statement under marginal costing.
b. Income statement under absorption costing.
c. Explain the difference in profit under marginal and absorption costing, if
any.
74 UEW/IEDE
COST AND MANAGEMENT
Solution
For the year ended 31st Dec. 2005
GH¢
Sales (1000 units @ GH¢ 15) 15,000
Variable manufacturing overhead (1100 units @ 7,700
GH¢7)
Fixed manufacturing overhead (1100 units @ GH¢ 2) 2,200
Cost of goods produced 9,900
Less: Closing stocks (100 units @ GH¢ 9)* 900
Cost of goods sold 9,000
Add: Selling and adm. Overhead
- Variable (1000 units x GH¢ 0.50) 500
- Fixed 400 900
Total cost 9,900
Closing stock is valued at manufacturing cost per unit i.e., GH¢ 7 + 2 =

GH¢ 9 per unit.

For the year ending 31st Dec. 2005
GH¢
Sales (1000 units @ GH¢ 15) 15,000
Variable manufacturing overhead (1100 units @ GH¢ 7) 7,700
Less: Closing stocks (100 units @ GH¢ 7) 700
Cost of goods produced 7,000
Add: Variable selling and adm. Overhead (1000 @ GH¢ 500
0.50)
Total variable cost of goods sold 7,500
Contribution (Sales – total variable cost) 7,500
Less: fixed overhead - manufacturing 2,200
- Selling and adm. 400 2,600
Profit 4,900
Conclusion
Profit under absorption costing is GH¢ 5,100 and under marginal costing
GH¢ 4,900. The difference of GH¢ 200 in profit is due to over-valuation of
closing stock in absorption costing by GH¢ 200 (i.e., GH¢ 900 – 700).
UEW/IEDE 75
COST AND MANAGEMENT INCOME DETERMINATION WHERE THERE EXIST OPENING
UNIT 2 SECTION
ACCOUNTING II 4
Unit 2, section 4: Income determination where there exist opening stock
STOCK
Learner, you are once again warmly welcome to the fourth Session of unit
two where we will be looking at the determination of profit in a situation
where there exist opening stock. In Session 3 we saw how marginal and
absorption costing both treat closing inventory and in the end how it affects
their profit. In this Session too we will look at the how both methods will
treat the closing stock and the effect on the profit.

 compute the profit under marginal and absorption costing where there
exists opening stock
 outline the reasons for the differences in the profit figures under both
methods.
What happens to profit under both techniques when there is an

opening stock
production overheads will be charged against profit in the previous year and
no fixed overheads will be carried forward to the current period thus the
opening stock will be valued at variable cost only. On the other hand,
absorption costing treats production fixed overheads as product cost and
that, some element of fixed overheads is in the value of the opening stock.
This implies that not only the total production fixed overheads that relates to
the period will be charge against profit but also the fixed cost element in the
stock brought forward as opening stock.. The effect is that profit under
marginal costing will be higher than that of the absorption costing by the
amount of fixed overheads absorbed in the opening stock. This is
demonstrated below:
Illustration
A company produces 17,500 units of a product during period just ended at a
full cost of GHc16.00 per unit. Three quarter of this cost is variable and the
remaining one quarter is fixed. At the start of the period, opening stocks of
finished goods was 2,500 units. During the period 20,000 units of the
products were sold at GHc25 per unit.
Prepare the profit statements of the company based on the two costing
techniques considered.
76 UEW/IEDE
COST AND MANAGEMENT
Solution
The production cost per unit under each method can be computed as
follows;
Absorption costing Marginal costing
GH¢ GH¢
Variable cost 3 12
× 1612
4
Fixed Production 1 -
× 164
4
overheads
Production cost per 16 12
unit
Profit statement under absorption costing

GH¢ GH¢
Sales 20,000@GH¢25 500,000


Profit 180,000
Profit statement under marginal costing

GH¢ GH¢
Sales 20,000@GH¢25 500,000
Less full production cost of
sales
Less fixed production overheads 17,500@GH¢4 70,000
Profit 190,000
Conclusion
Comparing the two profit statements, it can be observed that, the profit
under the marginal costing is higher. This is because, the fixed cost that
relates to the total activity level of 17,500 units has been charged to
contribution that relates to 20,000units under marginal costing implying the
violation of the matching concept.
UEW/IEDE 77
INCOME 5: Income determination,
DETERMINATION where there
WHERE THEREexistEXIST
both opening
BOTH and
UNIT 2 SECTION
ACCOUNTING II 5
closing stock
OPENING AND CLOSING STOCKS
Once again you are welcome to the fifth Session of this unit. In Sessions 3
and 4, we went through the determination of profit under marginal and
absorption costing where there is only closing stock and where there is only
closing stock. In this Session, we will be looking at how to determine the
profit where there exist both opening and closing stocks. It is our hope that
you will find it very interesting.

 determine the profit under both marginal and absorption costing
techniques where there exist both opening and closing stocks
Difference in profit under marginal costing and absorption

costing where there exist both opening and closing stocks
Profit under the two systems may be different because of difference in the
stock valuation. Position in this regard is summarized as follows:
Production equal to sales

 When there are no opening and closing stock, profit/loss under
absorption and marginal costing systems are equal.
 When opening stock is equal to closing stocks then also profit/loss under
the two systems will be equal provided the fixed cost element in opening
and closing stocks is the same amount.
Production more than sales

When production during a period is more than sales, i.e., when closing stock
is more than opening stock, the profit as per absorption costing will be more
than that shown by marginal costing. This is because in absorption costing a
part of fixed overhead included in closing stock value is carried forward to
next accounting period in the form of closing stock.
Production less than sales

When production during a period is less than sales, i.e., when opening stock
is more than closing stock, profit shown by marginal costing will be more
than that shown by absorption costing. This is because under absorption
costing, cost of goods sold is higher because a part of fixed cost from the
preceding period is added to the current year’s cost of goods sold in the
form of opening stock.
Illustration 5.1
Top Class Company supplies you the following standard cost per unit for
one of its products.
Direct material GH¢ 1.60
Direct labour GH¢ 1.50
Variable factory overhead GH¢ 1.20
Fixed factory overhead GH¢ 3.00
78 UEW/IEDE
Unit 2, section 5: Income determination, where there exist both opening and COST AND MANAGEMENT
closing stock ACCOUNTING II
Production at normal capacity is 200,000 units. Variable selling and

administrative overhead per unit is GH¢0.50 and fixed selling and
administrative overhead are GH¢ 75,000 per year. Production and sales data
for the year 2005 and year 2006 are as follows:

Units sold in the year 2005 160,000
Inventory – 31st Dec. 2005 68,000
Units sold in year 2006 180,000
Selling price in each year was GH¢ 10.50. Prepare Income Statement for the
two years under
a) Absorption costing, and
b) Marginal costing
Solution
Basic data
Year 2005 Year 2006
Production units 200,000 150,000
Sales units 160,000 180,000
Opening inventory 28,000 68,000
Closing inventory 68,000 38,000
Solution
Year 2005 Year
GH¢ 2006
GH¢
Sales (@ GH¢ 10.50 per unit) 1,680,000 1,890,000
produced)
Direct labour (@ GH¢1.50 per unit) 300,000 225,000
Variable factory overhead (@ GH¢ 1.20 per 240,000 180,000
unit)
Fixed factory overhead (@ GH¢ 3 per unit) 600,000 450,000
Production cost (@ GH¢ 7.30 per unit) 1,460,000 1,095,000
Add: Opening inventory (@ GH¢ 7.30 per 204,400 496,400
unit)
1,664,400 1,591,400
Cost of goods sold 1,168,000 1,314,000
Add: Under-absorbed fixed overhead (50,000 150,000
units @ GH¢3)
Total manufacturing cost 1,168,000 1,464,000
Selling and Adm. Overhead
UEW/IEDE 79
COST AND MANAGEMENT Unit 2, section 5: Income determination, where there exist both opening and
ACCOUNTING II closing stock
- Variable (@GH¢ 0.50 per unit sold) 80,000 90,000

- Fixed 75,000 75,000
Total cost 1,320,000 1,629,000
Profit (sales – total cost) 357,000 261,000

Year Year 2006
2005 GH¢
GH¢
Sales (@ GH¢ 10.50 per unit) 1,680,000 1,890,000
produced)
Direct labour (@GH¢ 1.50 per unit) 300,000 225,000
Variable factory overhead (@ GH¢ 1.20 per 240,000 180,000
unit)
Production cost (@ GH¢ 4.30 per unit) 860,000 645,000
Add: Opening inventory (@ GH¢ 4.30 per unit) 120,400 292,400
980,400 937,400
Cost of goods sold 688,000 774,000
Add: Variable selling and adm. Overhead 80,000 90,000
Total cost (variable) 768,000 864,000
Contribution (sales – total variable cost) 912,000 1,026,000
Fixed overhead – Factory 600,00 600,000
- Selling and adm. 75,000 75,000
Total fixed cost 675,000 675,000
Profit (Contribution – Fixed cost) 237,000 351,000
Conclusion
Year 2005 – Closing stock is more than opening stock (production is more
than sales), profit shown by absorption costing is more than that of marginal
costing.
Year 2006 – Closing stock is less than opening stock (sales are more than
production), profit shown by marginal costing is more than that of
absorption costing.
80 UEW/IEDE
Unit 2, section 5: Income determination, where there exist both opening and COST AND MANAGEMENT
closing
This page is left blank for stock ACCOUNTING II
your notes
UEW/IEDE 81
COST AND MANAGEMENT USES OF ABSORPTION AND MARGINAL COSTING
UNIT 2 SECTION
ACCOUNTING II 6
Unit 2, section 6: Uses of absorption and marginal costing
Hello learner, you are most welcome to the sixth and last Session of unit 2.
In this Session we will be looking at the uses of both marginal and
absorption costing techniques and some arguments against the use of these
techniques.
By the end of the lesson, the students should be able to:

 outline the argument in favour and against the use of marginal and
absorption techniques in income determination
Advantages and disadvantages of Marginal Costing

Advantages
The following advantages are claimed for marginal costing over total
absorption costing:
 Help in managerial decisions. The most important advantages of
marginal costing is the assistance that it renders to management in
taking many valuable decisions. Information regarding marginal cost
and contributions provided by marginal costing facilitates making policy
decisions in problems like fixing selling prices below cost, make or buy,
introduction of a new product line, utilization of spare plant capacity,
selection of the most profitable product mix, etc. This has been
discussed in detail later in a separate chapter.
 Cost control. Greater control over cost is possible. This is to because
by classifying costs into fixed and variable, the management can
concentrate more on the control of variable costs which are generally
controllable and pay less attention to fixed costs which may be
controlled only by the top management and that too, to a limited extent.
 Simple technique. Marginal costing is comparatively simple to operate
because it avoids the complications involved in allocation,
apportionment and absorption of fixed overheads which is, in fact,
arbitrary division of indivisible fixed costs.
 No under and over-absorption of overheads. In marginal costing,
there is no problem of under-or over-absorption of overheads.
 Constant cost per unit. Marginal costing takes into account only
variable costs which remain the same per unit of product irrespective of
the volume of output. It therefore avoids the effect of varying cost per
unit as it ignores fixed costs which are incurred on a time basis and have
no relation with the size of production.
 Realistic valuation of stocks. In marginal costing, stocks of work-in-
progress and finished goods are valued only at variable costs. Thus no
fictitious profits can arise due to fixed cost begin absorbed and
capitalized in unsold stock. This is because marginal costing prevents
the carry forward in stock valuation of some portion of current year’s
fixed costs. Stock valuation in marginal costing is, therefore more
realistic and uniform.
 Aid to profit planning. To aid profit planning marginal costing
technique enables data to be presented to management in such a way as
82 UEW/IEDE
COST AND MANAGEMENT
to show cost-volume-profit relationship. Graphic presentation in the

form of breakeven charts and profit-volume charts are also used to
facilitate planning future performance.
 Valuable adjunct to other techniques. Marginal costing is a valuable
adjunct to standard costing and budgetary control.
Disadvantages
The main disadvantages of marginal costing are as follows:
 Difficult analysis. Marginal costing assumes that all costs can be
analysed into fixed and variable elements. In practice however, it may
be difficult to segregate all costs into fixed and variable components.
Certain costs are caused purely by management decisions and cannot be
strictly classified as fixed or variable, e.g., amenities to staff, bonus to
workers, etc.
 Ignores time factor. By ignoring fixed cost, time factor is also ignored.
For instance, marginal cost of two jobs may be identical but if one job
takes twice as long to complete as the other, the true cost of the job
taking longer time is higher than that of the other. This is not disclosed
by marginal costing. Production cannot be achieved without incurring
fixed costs but marginal costing creates an illusion that fixed costs have
nothing to do with production.
 Difficulty in application. It is difficult to apply marginal costing
technique in industries where large stocks of work-in-progress are
locked up. Thus in ship building, or construction contracts, if fixed
overheads are not included in the valuation of work-in-progress, there
may be losses in each year, while on the completion of contracts, there
may be huge profits. Such fluctuation in profits can be avoided if total
absorption costing is employed.
 Less effective in capital intensive industries. In capital intensive
industries, the proportion of fixed costs (like depreciation, maintenance
etc.) is large. The marginal costing technique, which ignores fixed cost,
thus proves less effective in such industries. With the increased
automation in industries, marginal costing is, therefore, left with a
limited scope.
 Improper basis of pricing. Where prices are fixed by competition,
marginal costing gives the impression that so long as prices exceed
marginal cost, production is profitable. It ignores the danger of too much
sales being made at marginal cost or marginal cost plus some
contribution as it may result in overall losses. Although in certain
circumstances product may be sold at less than total cost, prices in the
long run must cover total cost as otherwise profit cannot be earned.
Arguments in favour of Absorption Costing

The arguments put forward in favour of absorption costing are:
 Since all production costs are incurred with a view to creating a product
for sale, all costs should attach to products until they are sold.
UEW/IEDE 83
COST AND MANAGEMENT
 In the longer term, fixed overhead costs must be recovered through sales
if the business is to survive. Setting the stock value by reference to full
costs encourages a pricing policy which covers full cost.
 If fixed production costs are treated as period costs (as happens in
marginal costing) and there is a low level of sales activity in a period,
then a relatively low profit or loss will be reported. If there is a high
level of sales activity, there will be a relatively high profit. Absorption
costing smooth out these fluctuations by carrying the fixed costs forward
until the goods are sold.
 Absorption costing helps the ‘matching concept’ of matching sales with
the cost of sales of the same period
 Where overhead costs are high in relation to direct costs, and fixed
overheads are high in relation to variable costs, a marginal costing
approach would bring out only a small portion of the total cost picture.
 Absorption costing can be used in a ‘cost plus profit’ approach to
pricing a contract for a customer.
Problem And Solutions

Problem 1
From the following information prepare an income statement under:
(a) Marginal costing (b) (b) Absorption costing
Products
X Y Z
GH¢ GH¢ GH¢
Direct wages 9,000 9,000 1,500
Factory overhead – Fixed 3,000 1,500 1,500
– Variable 3,900 9,000 4,500
Selling overhead – Fixed 1,500 900 600
– Variable 2,100 6,000 3,000
Sales 32,000 61,000 16,000
Fixed factory overhead and fixed selling overhead were apportioned to

products X, Y, and Z on equitable bases.
Solution
(a) Income Statement (Marginal Costing)
Products
Total
X Y Z (X + Y
+Z)
GH¢ GH¢ GH¢ GH¢
(A) Sales 32,000 61,000 16,000 109,000
Variable costs:
84 UEW/IEDE
COST AND MANAGEMENT
Direct wages 9,000 9,000 1,500 19,500

Variable overhead:
Factory 3,900 9,000 4,500 17,400
Selling 2,100 6,000 3,000 11,100
Total Variable Cost (B) 22,500 54,000 12,000 88,500
Contribution (A – B) 9,500 7,000 4,000 20,500
Less: Fixed cost (total of fixed and selling overhead)
9,000
Profit 11,500

Products
Total
X Y Z (X + Y
+Z)
GH¢ GH¢ GH¢ GH¢
Direct wages 9,000 9,000 1,500 19,500
Variable overhead:
Fixed 3,000 1,500 1,500 6,000
Variable 3,900 9,000 4,500 17,400
Cost of production 23,400 49,500 10,500 83,400
Selling overhead:
Fixed 1,500 900 600 3,000
Variable 2,100 6,000 3,000 11,100
Total cost 27,000 56,400 14,100 97,500
Profit 5,000 4,600 1,900 11,500
Sales 32,000 61,000 16,000 109,000
Comments. It may be noted from the above that total profit under the
marginal costing and absorption costing is the same, i.e., GH¢ 11,500. This
is because there are no opening and closing stocks of finished goods or
work-in-progress.
Problem 2
XZED limited sells its products at GH¢ 3 per unit. The company uses a
first-In First-Out actual costing system. A new fixed manufacturing
overhead allocation rate is computed each year by dividing the actual fixed
manufacturing overhead cost by the actual production costs. The following
simplified data are related to its first two years of operation:
UEW/IEDE 85
COST AND MANAGEMENT
Year I Year II
Sales (units) 1,000 1,200
Production (units) 1,400 1,200
Costs GH¢ GH¢
Variable manufacturing 700 500
Fixed manufacturing 700 700

Variable marketing and administration 1,000 1,200
Fixed marketing and administration 400 400
Required:
1. Prepare income statements based on:
a) Absorption costing and
b) Variable costing for each year
2. Give reasons for the difference in the answer.
Solution
Basic data Year I Year II
Sales units 1000 1200
Opening stock units __ 400
Closing stock units 400 200

Year I Year II
GH¢ GH¢
Sales 3,000 3,600
Manufacturing cost – variable 700 500
– fixed 700 700
1,400 1,200
Add: Opening stock* __ 400
Cost of Goods Available for sale 1,400 1,600
Less: Closing stock* 400 240
Cost of Goods Sold 1,000 1,360
Marketing and administration costs.
- variable 1,000 1,200
- fixed 400 400
Total cost 2,400 2,960
Net income (sales – total cost) 600 640
Working Note
Cost per unit year in I = GH¢ 1400 ÷ 1400 units = GH¢ 1
Cost per unit year in II = GH¢ 1200 ÷ 1000 units = GH¢ 1.20
Closing stock value in year I = 400 units @ GH¢ 1 = GH¢ 400
Costing stock value in year II = 200 units @ GH¢ 1.20 = GH¢ 240
86 UEW/IEDE
COST AND MANAGEMENT
Income statement (Variable costing)

Year I Year II
GH¢ GH¢
(A) Sales 3,000 3,600
Variable manufacturing cost 700 500
Add: Opening stock __ 200
Cost of Goods available for sale 700 700
Less: Closing stock 200 100
Cost of Goods Sold 500 600
Variable marketing and adm.cost 1,000 1,200
(B) Total variable cost 1,500 1,800
(C) Contribution (A – B) 1,500 1,800
Fixed cost – Manufacturing 700 700
– Administration 400 400
(D) Total Fixed Cost 1,100 1,100
Net Income (C – D) 400 700
Reason for difference in profit. Reason for difference in profit under

absorption costing and marginal costing is the difference in the valuation of
stocks.
In year 1, profit under absorption costing is higher at GH¢ 600 as compared

to GH¢ 400 in marginal costing. This is because closing stock value is more
than opening stock. In year II, profit under marginal costing is higher at
GH¢ 700 as compared to GH¢ 640 in absorption. This is because opening
stock value is more than closing stock.
Problem 3
ABC Motors assembles and sells motor vehicles. It uses an actual costing
system, in which unit costs are calculated on a monthly basis. Data relating
to March and April, are:
March April
Unit data:
Beginning inventory 0 150
Production 500 400
Sales 350 520
Variable – cost data: GH¢ GH¢
Manufacturing costs per unit produced 10,000 10,000
Distribution costs per unit sold 3,000 3,000
Fixed-cost data:
Manufacturing costs 2,000,000 2,000,000
Marketing costs 600,000 600,000
UEW/IEDE 87
COST AND MANAGEMENT
The selling price per motor vehicle is GH¢ 24,000

Required:
(i) Present income statement for ABC Motors in March and April
under (a) variable costing and (b) absorption costing.
(ii) Explain the differences between (a) and (b) for March and April.
Solution
Basic data:
March April
Sales units 350 520
Opening inventory units 0 150
Closing inventory units 150 30
Income Statement (Variable Costing)

March April
GH¢ GH¢
(A) Sales 8,400,000 12,480,000
Add: Opening inventory @ GH¢ 10,000 __ 1,500,000
per unit
Cost of Goods available for sale 5,000,000 5,500,000
Less: Closing inventory @ GH¢ 10,000 1,500,000 300,000
per unit
Variable cost of goods sold 3,500,000 5,200,000
Variable distribution cost 1,050,000 1,560,000
(B) Total variable cost 4,550,000 6,760,000
(C) Contribution (A – B) 3,850,000 5,720,000
Fixed cost – Manufacturing 2,000,000 2,000,000
– Marketing 600,000 600,000
(D) Total Fixed Cost 2,600,000 2,600,000
Net Income (C – D) 1,250,000 3,120,000

March April
GH¢ GH¢
(A) Sales 8,400,000 12,480,000
Fixed manufacturing cost 2,000,000 2,000,000
7,000,000 6,000,000
Add: opening inventory* __ 2,100,000
Cost of goods available for sale 7,000,000 8,100,000
Less: Closing inventory* 2,100,000 450,000
Cost of goods sold (B) 4,900,000 7,650,000
Add: Distribution cost – Variable 1,050,000 1,560,000
88 UEW/IEDE
COST AND MANAGEMENT
Add: Marketing cost – Fixed 600,000 600,000

(B) Total Cost 6,550,000 9,810,000
Net Income (A – B) 1,850,000 2,670,000
Comments
Marginal costing rewards sales while absorption costing rewards
production. This means that when sales are more than production, marginal
costing produces higher profit and vice versa, when production is more than
sales, absorption costing shows higher profit.
In March, absorption costing shows higher profit by GH¢600,000 (i.e.,

1850,000 – 1,250,000) than marginal costing because production is more
than sales. In April, marginal costing shows higher profit than absorption
costing by GH¢450,000 (i.e., GH¢3,120,000 – 2,670,000) because sales are
more than production. Difference profit is exactly equal to difference
inventory values in the two months.
Working Notes:
In marginal costing inventory is valued at variable manufacturing cost while
in absorption costing inventory valuation is done as follows:
For April, closing inventory of 30 units:
GH¢
Variable manufacturing cost (30 units @ GH¢ 10,000) 300,000
Fixed manufacturing cost (30 units @ GH¢ 5000) 150,000
450,000
Fixed manufacturing cost per unit is calculated as under:

GH¢20,00,000
For March, inventory of 150 units:

GH¢
Variable manufacturing cost (150 units @ GH¢ 10,000) 1,500,000
Fixed manufacturing cost (150 units @ GH¢ 4,000) 600,000
2,100,000
Fixed manufacturing cost per unit =
GH¢20,00,000
Problem 4
XYZ Ltd. has a production capacity of 200,000 units per year. Normal
capacity utilization is reckoned as 90%. Standard variable production costs
are GH¢ 11 per unit. The fixed costs are GH¢ 360,000 per year. Variable
selling costs are GH¢ 3 per unit and fixed selling costs are GH¢ 270,000 per
year. The unit selling price is GH¢ 20.
In the year just ended on 30th June, 2006, the production was 160,000 units
and sales were 150,000 units. The closing inventory on 30th June was 20,000
UEW/IEDE 89
COST AND MANAGEMENT
units. The actual variable production costs for the year were GH¢ 35,000
higher than the standard.
1. Calculate the profit for the year
a. By absorption costing method and b) by marginal costing method
2. Explain the difference in the profits.
Solution
For the year ending 30th June 2006
GH¢
Sales (150,000 units @ GH¢ 20) 3,000,000
Production Costs:
Variable (160,000 units @ GH¢ 11) 1,760,000
Add: Increase 35,000 1,795,000
Fixed (160,000 units @ GH¢ 2*) 320,000
Cost of goods produced 2,115,000
Add: Opening stock (10,000 units @) GH¢13)* 130,000
Less: Closing stock 2,245,000
GH¢21,15,000
( 1,60,000
× 20,000units)
264,375
Add: Under absorbed fixed production overhead (360,000 – 320,000) 40,000
2,020,625
Add: Non-production costs:
Fixed selling costs. 270,000
Total cost 2,740,625
Working Notes:
1. Fixed production overhead are absorbed at a pre-determined rate based
on normal capacity, i.e., GH¢ 360,000 ÷ 180,000 units = GH¢ 2
2. Opening stock is 10,000 units, i.e., 150,000 units + 20,000units –
160,000 units.
It is valued at GH¢ 13 per unit, i.e., GH¢ 11 + GH¢ 2 (Variable + fixed)
Income statement (Marginal Costing)

For the year ended 30th June, 2006
90 UEW/IEDE
COST AND MANAGEMENT
GH¢
Sales (150,000 units @ GH¢ 20) 3,000,000
Variable production cost (160,000 units @ GH¢ 11 + GH¢ 1,795,000
35,000)
2,245,000
Add: Opening stock (10,000 units @ GH¢ 11) 110,000
2,355,000
Less: Closing stock 224,375
𝐺𝐻¢17,95,000
( 1,60,000 × 20,000units)
Variable cost of goods sold 2,130,625
Contribution. (sales – variable cost of goods 869,375
sold)
Less: Fixed cost – Production 360,000
– Selling 270,000 630,000
Profit 239,375
Reasons for Difference in Profit: GH¢

Profits as per absorption costing 259,375
Add: Op. stock under-valued in marginal costing (GH¢ 13,000 20,000
– 11,000)
279,375
Less: Cl. Stock under-valued in marginal costing (GH¢ 40,000
264,375 – 224,375)
Profit as per marginal costing 239,375
Problem 5
Betty & Co. is currently working at 50% capacity and produces 10,000
units. At 60% working raw material cost increase by 2% and selling price
falls by 2%. At 80% working raw material cost increase by 5% and selling
price falls by 5%. At 50% capacity working the product costs GH¢ 180 per
unit and is sold at GH¢ 200 per unit. The unit cost of GH¢ 180 is made up
as follows:
Material GH¢ 100

Wages GH¢ 30
Factory overheads GH¢ 30 (40% fixed)
Administration overheads GH¢ 20 (50% fixed)
Prepare a marginal cost statement showing the estimated profit of the
business when it is operated at 60% and 80% capacity.
UEW/IEDE 91
COST AND MANAGEMENT
Solution
Items 50% 60% capacity 50% capacity
capacity (12,000 units) (16,000 units)
(10,000
units)
Per Total Per Total Per unit Total
unit GH¢ unit GH¢ GH¢ GH¢
GH¢ GH¢
(A) Sales 200 2,000 196 2,352,00 190 3,040,
,000 0 000
Material cost 100 1,000 102 1,224,00 105 1,680,
,000 0 000
Wages 30 300,0 30 360,000 30 480,00
00 0
Variable factory 18 180,0 18 216,000 18 288,00
overhead 00 0
Variable Adm. 10 100,0 10 120,000 10 160,00
Overhead 00 0
(B) Marginal cost 158 1,580 160 1,920,00 163 2,608,
,000 0 000
(C) Contribution 42 420,0 36 432,000 27 432,00
(A – B) 00 0
Fixed overheads:
- Factory 12 120,0 10.00 120,000 7.50 120,00
00 0
- Administra 10 100,0 8.33 100,000 6.25 100,00
tion 00 0
(D) Total fixed 22 220,0 18.33 220,000 13.75 220,00
cost 00 0
Profit (C – D) 20 200,0 17.67 212,000 13.25 212,00
00 0
Notes:
1. At 60% material cost is GH¢ 100 + 2% = GH¢ 102 per unit
At 80% material cost is GH¢ 100 + 5% = GH¢ 105 per unit
2. At 60% selling price is GH¢ 200 – 2% = GH¢ 196 per unit
At 80% selling price is GH¢ 200 – 5% = GH¢ 190 per unit
3. Factory overhead:
Fixed – GH¢ 30 x 40% = GH¢ 12 per unit.
Variable (GH¢ 30 – 12) = GH¢ 18 per unit.
Total fixed factory overheads = (10,000 units x GH¢ 12) = GH¢ 120,000.
At 60% fixed factory overhead per unit will decrease, i.e., 120,000 ÷ 12,000
= GH¢ 10.
At 80% fixed overhead per unit will further decrease, i.e., 120,000 ÷ 16,000
= GH¢ 7.50
92 UEW/IEDE
COST AND MANAGEMENT
Variable overhead per unit will not change but will increase in total when
production increases to 60% and 80%.
Similar calculation can be made for administration fixed overheads.
Problem 6
The monthly cost figures for production in a manufacturing company are:
GH¢
Variable costs 120,000
Fixed cost 35,000
Total 155,000
The normal monthly sales figure is GH¢ 200,000. Actual sales figures for
three separate months are:
First month GH¢ 200,000
Second month GH¢ 165,000
Third month GH¢ 235,000
Under as system of marginal costing stocks are valued as under:

GH¢ GH¢ GH¢
Opening stock 84,000 84,000 105,000
Closing stock 84,000 105,000 84,000
If absorption costing is used, stocks would be valued as follows:

GH¢ GH¢ GH¢
Opening stock 108,500 108,500 135,625
Closing stock 108,500 135,625 108,500
Prepare Income Statements under marginal costing and absorption costing

in comparative form and comment on the results.
Solution
Comparative Income Statements
Marginal Absorption costing
Months Months
I II III Total I II III Tot
G GH¢ GH¢ GH¢ GH¢ GH¢ GH al
H ¢ G
¢ H¢
(A) 2 165,0 235,00 600,00 200,00 165,00 235, 60
Sale 0 00 0 0 0 0 000 0,0
s 0, 00
0
0
0
Ope 8 84,00 105,00 273,00 108,50 108,50 135, 35
UEW/IEDE 93
COST AND MANAGEMENT
ning 4, 0 0 0 0 0 625 2,6

stoc 0 25
k 0
0
Add: 1 120,0 120,00 360,00 120,00 120,00 120, 36
varia 2 00 0 0 0 0 000 0,0
ble 0, 00
costs 0
0
0
Fixe _ ___ ___ ___ 35,000 35,000 35,0 10
d _ 00 5,0
cost _ 00
Tota 2 204,0 225,00 633,00 263,50 263,50 290, 81
l 0 00 0 0 0 0 625 7,6
4, 25
0
0
0
Less 8 105,0 84,000 273,00 108,50 135,62 108, 35
: 4, 00 0 0 5 500 2,6
Clos 0 25
ing 0
stoc 0
ks
(B) 1 99,00 141,00 360,00 155,00 127,87 182, 46
Cost 2 0 0 0 0 5 125 5,0
of 0, 00
good 0
s 0
sold 0
(C) 8 66,00 94,000 240,00 __ __ __ __
Cont 0, 0 0
ribut 0
ion 0
0
(A-
B)
(D) 3 35,00 35,000 105,00 __ __ __ __
Fixe 5, 0 0
d 0
cost 0
0
Profi 4 31,00 59,000 135,00 __ __ __ __
t (C 5, 0 0
–D) 0
0
94 UEW/IEDE
COST AND MANAGEMENT
0
_ __ __ __ 45,000 37,125 52,8 13
(A – _ 75 5,0
B) 00
Comments
 First month. When opening and closing stocks are equal (or when there
are no opening or closing stocks) profit/loss under the two months with
be the same.
 Second month. When closing stock is more than opening stock (i.e,
production is more than sales), profit shown by absorption closing will
be more under marginal costing.
 Third month. When closing stock is less than opening stock (i.e. sales
are more than productions), profits shown by marginal costing will be
more under absorption costing.
 Overall position. When we consider overall position of the three
months, opening stock is equal to closing stock. Thus total profit for the
three months under the two systems is equal.
Problem 7
The following is the standard cost data per unit of product ‘X’
GH¢
Selling price 40
Direct material 8
Direct labour 5
Variable factory overhead 2
Fixed factory overhead GH¢ 5 (based on a budgeted normal output of

36,000 units per year)
Variable selling overhead GH¢ 6
Fixed selling overhead per year were GH¢ 120,000
During a month the company produced 2,000 units of the product and sold
1,500 units.
There was no opening stock.
You are required to prepare an income statement under (i) absorption
costing, and (ii) marginal costing. Explain the difference in profit if any.
Solution
GH¢
Sales (1500 units x GH¢ 40) 60,000
Production costs:
Material (2,000 units x GH¢ 8) 16,000
Labour (2,000units x GH¢ 5) 10,000
Variable factory overhead (2,000 units x GH¢ 2) 4,000
Fixed factory overhead (2,000 units x GH¢ 5) 10,000
UEW/IEDE 95
COST AND MANAGEMENT
Cost of production 40,000

Less: Closing stock (500 units x GH¢ 20)* 10,000
Cost of Goods sold 30,000
Add: Under absorbed overhead* 5,000
35,000
Add: Selling expenses – variable (1,500 units x GH¢ 6) 9,000
Fixed (GH¢ 120,000 ÷ 12months) 10,000
Total cost of sales 54,000
Profit (Sales – Total cost) 6,000
Working Notes:
1. Closing stock is valued at production cost per unit i.e., GH¢ 40,000 ÷
2,000 units = GH¢ 20.
2. Fixed factory overhead per month (36,000 x GH¢ 5) ÷ 12months =
GH¢15,000
Less: Fixed factory overhead absorbed (2,000 units x GH¢ 5) =GH¢
10,000
Under absorbed overhead GH¢ 5,000

GH¢
Sales (1,500 units x GH¢ 40) 60,000
Variable production costs:
Direct materials (2,000 units x 8) 16,000
Direct labour (2,000 units x 5) 10,000
Factory overhead (2,000 units x 2) 4,000
Total variable production cost 30,000
Less: Closing stock (500 units x GH¢ 15) 7,500
22,500
Add: Variable selling overhead (1,500 units x GH¢ 9,000
6)
Total cost (variable) 31,500
Contribution (Sales – Total variable cost) 28,500
Less: Fixed cost – Factory overhead 15,000
– Selling overhead 10,000 25,000
Profit 3,500
Difference in profit
Profit as per absorption costing GH¢ 6,000
Profit as per marginal costing GH¢ 3,500
Reason for Difference. This difference in profit is due to the differences in

stock valuation under the two systems as explained below:
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Stock valuation in absorption costing GH¢ 10,000

Stock valuation in marginal costing GH¢ 7,500
Theoretical Questions
1. What do you mean by marginal costing? Discuss its usefulness and
limitations.
2. Distinguish between marginal costing and absorption costing.
3. Distinguish between marginal costing and total costing
4. What are the characteristics of marginal costing?
5. Define marginal cost and marginal costing. How would you treat
variable cost and fixed costs in marginal costing?
6. “Absorption costing income exceeds variable costing income when the
number of units sold exceeds the number of units produced”. Do you
agree?
7. “Marginal costing rewards sales whereas absorption costing rewards
production”, Comment.
8. How is ‘prime cost’ different from ‘marginal cost’? State the elements
of cost included in the two types of cost indicating their significance in
cost accounting.
9. State the distinction between marginal cost and absorption cost as
regards valuation of finished goods inventories.
10. Explain the concept of marginal costing. Describe the characteristics and
limitations of marginal costing.
11. Define marginal costing. Explain its managerial uses.
Practice Questions
1. From the following information prepare an income statement under (a)
Absorption costing, and (b) Marginal costing.
GH¢ GH¢
Sales 150,000 Adm. Overhead – Fixed 5,000
Direct materials 50,000 – variable 12,000
Direct labour 20,000 selling overhead – fixed 20,000
Fixed factory overhead 10,000 -variable 15,000
2. The following information is given for the year ending 31st Dec. 2005.
Opening stock - 1000 units valued at GH¢ 70,000
(including variable cost of GH¢ 50 per
unit)
Variable cost - GH¢ 60 per unit
Fixed cost (Total) - GH¢ 120,000
Production - 10,000 units
Sales - 8,000 units at GH¢ 90 per unit
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COST AND MANAGEMENT
Prepare income statement under (a) absorption costing, and (b) marginal
costing.
3. Your company has a production capacity of 12,500 units and normal

capacity utilization is 80%. Opening inventory of finished goods on 1-1-
2005 was 1,000 units. During the year ending 31-12-2005, it produced
11,000 units while it sold only 10,000 units. GH¢ 1.50. Total fixed
selling and administration overheads amounted to GH¢ 10,000. The
company sells its product at GH¢ 10 per unit.
Prepare income statements under absorption costing and marginal costing.

Explain the reasons for difference in profit, if any.
4. First Class Co. manufacturing ball pens is working at 40% capacity

producing 10,000 pens per year. The cost elements for each ball pen are
given as under:
Material GH¢ 20
Labour GH¢ 6
Overheads GH¢ 10 (40% variable)
Each ball pen sells for GH¢ 40. The selling price falls by 3% if production
is at 50% capacity and by 5% if worked at 90% capacity. The fall in selling
prices is accompanied by similar fall in material prices.
You are required to find out profit at 50% and 90% capacities using
marginal costing approach.
5. The following information is given for the year ending 31st Dec. 2005:
GH¢
Sales (@ GH¢ 50 per unit) 1,000,000
Fixed factory overhead 240,000
Selling and administration overhead (fixed) 60,000
Selling and administration overhead (variable) 20,000
During the year 24,000 units were produced but only 20,000 units were
sold. There was no opening stock.
6. Prepare an income statement under

(a) Absorption costing and
(b) Marginal costing
7. Explain the difference in profit, if any.
98 UEW/IEDE
XXXXXXX 3 COST-VOLUME-PROFITS ANALYSIS
UNIT Unit X, section X: XXXXXXX
Unit Outline
Session 1 Overview of CVP analysis
Session 2 Measures of CVP analysis I
Session 3 Measures of CVP analysis II
Session 4 Margin of Safety
Session 5 Graphic Presentation of Break-even analysis
Session 6 Sale mix
Unit Overview
Dear students, I want to welcome your to the third unit of this course-Cost
and Management Accounting II. This unit provides you in-depth knowledge
in accounting information for short term decision making using cost-
volume-profit analysis. The Cost -Volume-Profit analysis is a systematic
method of examining the relationship between changes in activity (ie
output) and changes in total sales revenue, expenses and net profit.
This Unit is divided into six sessions. Session one looks at the overview of
Cost-Volume-Profit (CVP) analysis. Session two and three cover
measurement of CVP analysis. In session four the concept of margin of
safety and it measurement will be considered. Sessions five and six deal
with graphical presentation of break-even analysis and sales mix
respectively.

 explain the concept of cost-volume-profit analysis
 identify and explain the assumption on which cost-volume-profit
analysis is based
 apply mathematical approach to determine break-even point and
contribution sales ratios
 construct break-even, contribution and contribution and profit-volume
graphs
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UEW/IEDE 101
COST AND MANAGEMENT OVERVIEW OF COST VOLUME-PROFIT (CVP) ANALYSIS
UNIT 3 SECTION
ACCOUNTING II 1
Unit 3, section 1: Overview of cost volume-profit (CVP) analysis
Hello learner you are welcome to Session one of unit three. This unit will
take us through another interesting technique in cost and management
accounting known as cost volume profit analysis (CVP analysis). In this
Session we want to look at the overview of CVP Analysis. In simple terms
CVP analysis is a cost management technique, tool or method for
understanding the relationship between revenue, cost and sales volume
(level of activity) for short term decision making.

 explain the concept of cvp analysis
 appreciate the relevant range of activity and assumptions of cost
behaviour
 understand the concept of profit and the arithmetic of cvp analysis
 outline the objectives of cvp analysis
Meaning of CVP analysis

Cost-volume-profit analysis (CVP analysis) is an extension of the principles
of marginal costing. It studies the inter-relationship of three basic factors of
business operations:
 Cost of production,
 Volume of production/sales, and
 Profit
These three factors are inter-connected in such a way that they act and react
on one another because of cause and effect relationship amongst them. The
cost of a product determines its selling price and the selling price determines
the level of profit. The selling price also affects the volume of sales which
directly affects the volume of production and volume of production in turn
influences cost. In brief, variations in volume of production results in
changes in cost and profit. CIMA London has defined CVP analysis as, “the
study of the effects on future profits of changes in fixed cost, variable cost,
sales price, quantity and mix”.
An understanding of CVP analysis is extremely useful to management in

budgeting and profit planning. It explains the impact of the following on the
net profit:
 Changes in selling price
 Changes in volume of sales
 Changes in variable cost
 Changes in fixed cost
 CVP analysis helps in determining the probable effect of change in any
one of these factors on the remaining factors.
CVP analysis is generally applied to the long-term product(s) of a business

and uses cost behaviour theory to answer questions like:
 What level of sales is needed to break even?
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Unit 3, section 1: Overview of cost volume-profit (CVP) analysis ACCOUNTING II
 What is the margin of safety offered by the expected or budgeted level

of activity?
 What level of activity is needed to achieve a particular level of profit?
 What will be the effect on profit of changes in the costs or selling prices
or volume of activity?
 If we incur additional costs, what changes should we make to our selling
price or to the volume that we need to sell?
Knowledge of cost behaviour patterns is essential to help management in

their decision-making. This involves considering the combined effect on
both cost and revenue functions of changes in the level of output by
examining the interrelation of costs, volume and profits. Accountants tend
to call this break even analysis.
The relevant range of activity and assumptions of cost

behaviour
CVP is used by accountants in a relatively simplistic manner. While most
businesses will sell a wide range of product/services at many different prices
(e.g. quantity discounts), accountants assume a constant product/service mix
and average selling prices per unit. The assumption is that these
relationships are linear, rather than the curvilinear models preferred by
economists that reflect economies and diseconomies of scale.
The accountant limits this problem by recognizing the relevant range. The
relevant range is the volume of activity within which the business expects
to be operating over the short-term planning horizon, typically the current or
next accounting period, and the business will usually have experience of
operating at this level of output. Within the relevant range, the accountant's
model and the economist's model are similar.
Concept of Profit and the arithmetic of CVP analysis

Profit can be shown as the difference between revenue and costs (both fixed
and variable). This relationship can be shown in the following formula:
Net profit = revenue - (fixed costs + variable costs)
Net profit= (units sold x selling price) - [fixed costs + (units sold x unit
variable cost)]
In mathematical terms, this is:P = Su - (F + Vu)

Where:
P = net profit
u = number of units sold
S = selling price per unit
F = total fixed costs
V = variable cost per unit
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ACCOUNTING II Unit 3, section 1: Overview of cost volume-profit (CVP) analysis
Illustration 1.1
XYZ Limited has the capacity between 10,000 and 30,000 units of a product
each period. Its fixed costs are GH¢ 200,000. Variable costs are GH¢ 10 per
unit.
Using an example of XYZ Limited, a selling price of GH¢25 for 20,000

units would yield a net profit of:
P = (GH¢ 25 x 20,000) - [GH¢ 200,000 + (GH¢ 10 x 20,000)
P = GH¢ 500,000 - GH¢ 400,000
P = GH¢ 100,000
Basic Principles of CVP

In its simplest form, it is based on the assumption of a linear total cost
function, i.e. of a constant unit variable cost and constant total fixed costs-
and so it is an application of marginal costing principles.
Marginal costing is a technique of ascertaining cost used in any method of

costing. According to this technique, variable costs are charged to cost units
and the fixed cost attributable to the relevant period is written off in full
against the contribution for that period. Contribution is the difference
between sales value and variable cost.
Marginal Cost is the cost of a product or service which would be avoided if

that unit were not produced or provided. The marginal production cost per
unit of an item usually consists of the following: direct materials, direct
labour and variable production overheads.
Thus, all expenses are classified under two groups, variable and fixed.
Two significant relationships between Sales, Cost and Profit can be
established; they are:
a. Sales – Variable cost = Contribution
b. Contribution – Fixed cost = Profit or
Contribution = Fixed cost + Profit.
Hence, Sales—Variable cost = Fixed cost + Profit.

From the above equation, it is clear that if any three of the above are known,
the fourth one can be worked out.
The principles of marginal costing

The principles of marginal costing are as follows:
Period fixed costs are the same, for any volume of sales and production
(provided that the level of activity is within the ‘relevant range’). Therefore,
by selling an extra item of product or service the following will happen: -
 revenue will increase by the sales value of the item sold,
 costs will increase by the variable cost per unit,
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Unit 3, section 1: Overview of cost volume-profit (CVP) analysis ACCOUNTING II
 profit will increase by the amount of contribution earned from the extra
item
Similarly, if the volume of sales falls by one item, the profit will fall by the
amount of contribution earned from the item.
Profit measurement should therefore be based on an analysis of total

contribution. Since fixed costs relate to a period of time, and do not change
with increases or decreases in sales volume, it is misleading to charge units
of sale with a shared of fixed costs. Absorption costing is therefore
misleading, and it is more appropriate to deduct fixed costs from the total
contribution for the period to derive a profit figure.
When a unit of product is made, the extra costs incurred in its manufacture
are the variable production costs. Fixed costs are unaffected, and no extra
fixed costs are incurred when output is increased.
Objectives of CVP
CVP permits sensitivity analysis. Sensitivity analysis is an approach to
understanding how changes in one variable [e.g. price) affect other variables
(e.g. volume). This is important, because revenues and costs cannot be
predicted with certainty and there is always a range of possible outcomes,
i.e. different mixes of price, volume and cost.
Using sensitivity analysis, a business may ask questions such as:

 what selling prices are required for given levels of profit and sales
 how much volume of output is required to break even?
 how much sales volume is necessary to earn a target profit?
 how much profit will be made from a given level of activity?
 what effect will changes in price, variable cost, fixed cost or sales mix
on profit level?
 what price to set for a product?
 how would a change in the mix of products sold affect the break-even
and target volume and profit potential?
Elements of CVP Analysis

The elements or components of CVP analysis as a tool of understanding the
interaction between cost, level of output and profit of an organisation are:
 unit price of products
 volume or level of activity
 unit variable cost
 total fixed cost
 product mix being sold
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ACCOUNTING II Unit 3, section 1: Overview of cost volume-profit (CVP) analysis
These variable or elements are very important in CVP analysis. The whole
analysis is focused on how changes in these variables influence the
contribution margin and the profit.
Assumptions of CVP Analysis

Like any other concept, CVP analysis operates under certain basic
assumptions. Under CVP analysis it is assumed that:
 selling price per unit is constant over the entire relevant range of output.
 variable cost per unit is constant and total variable cost changes in direct
proportion to production.
 total fixed costs remain unchanged with changes in production volume.
 all output is sold - stock levels do not vary significantly, so that
production output and sales levels, in units, may be treated as the same
volumes.
 cost structure is affected by only changes in volume or level of activity.
 the sales mix is constant at all levels of activity, where more than one
product is included in the analysis.
 all cost of production can be identified as either variable or fixed
 the activity (usually sales volume and production output) has been
chosen correctly as the factor which most influences cost behaviour.
Conclusion
As stated in the introduction, CVP analysis in simple terms is a cost
management technique, tool or method for understanding the relationship
between revenue, cost and sales volume (level of activity) for short term
decision making. Again the profit equation stated above forms the basis of
CVP and break even analysis. Technically, managers use CVP analysis as a
tool to determine and understand the impact of changes in the cost structure
and changes in level of activity (volume) on profit or net income levels.
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Unit 3, section 1: OverviewThis
of cost
page
volume-profit
is left blank (CVP)
for your notes ACCOUNTING II
analysis
UEW/IEDE 107
COST AND MANAGEMENT MEASURES OF CVP ANALYSIS
UNIT 3 SECTION
ACCOUNTING II 2
Unit 3, section 2: Measures of CVP analysis
You are again welcome learner, to Session two of unit three as we look at
the various measures of CVP analysis. Because CVP analysis is used in
making variety of decisions in production situations, it involves a variety of
measures or tools. The most common tools or measures of CVP analysis
are: Contribution Margin, Contribution/sales margin ratio, Breakeven Point,
Target Profit and Margin of safety. In this Session will be looking at
contribution margin and contribution/sales margin ratio.

 understand the concept behind contribution margin approach in cvp
analysis
 appreciate the use of profit/volume ratio
Contribution and Marginal Cost Equation

As stated earlier, contribution is the difference between sales and the
marginal (variable) cost of sales. It is also known as contribution margin
(CM) or gross margin. Thus contribution is calculated by the following
formula:
Contribution = Sales - Variable cost ( C = S - V)
Also, Contribution = Fixed cost + Profit ( C = F + P )
or Contribution = Fixed cost + Loss ( C = F - L )
From this, the following marginal cost equation is developed:

S – V = F + P
If any three of the above four factors in the equation are known, the fourth
one can be easily found out. Thus:
or P = S – V – F
P = C – F
F = C – P
V = S – F - P
Example:
Sales = GH¢ 12,000
Variable cost = GH¢ 7,000
Fixed cost = GH¢ 4,000
Thus:
C = S – V
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Unit 3, section 2: Measures of CVP analysis ACCOUNTING II
C = 12,000 – 7,000 = GH¢ 5,000
P = C – F
P = 5,000 – 4,000 = GH¢ 1,000
Thus profit GH¢ 1,000
If sales figure is not given but contribution is given then sales can be found
out as follows;
S = C + V
S = 5,000 + 7,000 = GH¢ 12,000
When fixed cost (F) is not given but profit is given, then:
F = C – P
F = 5,000 – 1,000 = GH¢ 4,000
When variable cost (V) is not given, then:

V = S – C
V = 12,000 – 5,000 = GH¢ 7,000
The concept of contribution is extremely helpful in the study of break-even

analysis and management decision-making.
Profit-Volume Ratio (P/V Ratio)

The profit/volume ratio, better known as contribution/sales ratio (C/S ratio),
express the relation of contribution to sales.
Contribution c s-v
Symbolically P/V ratio = = =
Sales s s
By transposition, we have
(i)
C = S x P/ V ratio
(ii)
C
S =
P/V ratio
Illustration 2.1:
Sales = GH¢ 10000
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ACCOUNTING II Unit 3, section 2: Measures of CVP analysis
Variable cost = GH¢ 8000
c s-v 10,000-8,000 2,000 2

Then P/V ratio = = = = =
s s 10,000 10,000 10
When expressed in percentage,
2
P/V ratio = x 100 = 20%
10
When P/V ratio is given, the contribution can be quickly calculated from
any given level of sales. In the above example, if only sales and P/V ratio
were given, contribution can be calculated as under:
C = S x P/V ration
C = 10,000 x 20% = GH¢ 2,000
P/V ratio may be computed by comparing the change in contribution to

change in sales (or change in profit to change in sales). Any increase in
profit will mean increase in contribution because fixed costs are assumed to
remain constant at all levels of production. Thus:
Change in contribution Changes in profit

P/V ratio = =
Change in sales Changes in sales
Illustration 2.2:
Year Sales Net Profit
GH¢ GH¢
2005 20,000 1,000
2006 22,000 1,600
Change in profit 16,00-1,000

P/V ratio = = x 100
Change in sales 22,000-20,000
600
= x 100 = 30%
2,000
Uses of P/V Ratio

P/V ratio is one of the most important ratios to watch in business. It is an
indicator of the rate at which profit is being earned. A high P/V/ ratio
indicate high profitability and a low ratio indicates low profitability in the
business. The profitability of different Session of the business such as sales
areas, classes of customers, product lines, methods of production, etc., may
also be compared with the help of profit-volume ratio. The P/V ratio is also
used in making the following type of calculations.
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 calculation of break-even point

 calculation of profit at a given level of sales
 calculation of the ovule of sales required to earn a given profit
 calculation of profit when margin of safety is given
 calculation of the volume of sales required to maintain the present level
of profit, if selling price is reduced.
Improvement in P/V Ratio

As P/V ratio indicates the rate of profitability, any improvement in this ratio
without increase in fixed cost would result in higher profits. As a note of
caution, erroneous conclusions may be drawn by mere reference to P/V
ratio. Therefore, this ratio should not be used in isolation.
P/V ratio is the function of sales and variable cost. Thus, it can be improved
by widening the gap between sales and variable cost. This can be achieved
by :
 increasing the selling price
 reducing the variable cost
 changing the sales mix, i.e., selling more of those products which have
larger p/v ratio, thereby improving the overall p/v ratio.
Conclusion
Contribution margin is the amount of profit or income the company makes
before deducting fixed cost. In other words, contribution margin is the
excess of sales revenue over variable cost. Contribution / Sales Ratio is the
ratio of contribution to sales. It measures the percentage of sales that
represents contribution. It is also known as Profit/Volume ratio
UEW/IEDE 111
COST AND MANAGEMENT MEASURES OF CVP ANALYSIS II
UNIT 3 SECTION
ACCOUNTING II 3
Unit 3, section 3: Measures of CVP analysis
You are warmly welcome to Session three of this unit. It is our hope that
you have enjoyed and understood the previous topics treated in the above
Sessions. This Session is a continuation of Session 2 and we will be looking
at how to calculate break-even point in sales unit and in value (Break even
analysis). We will also discuss units to be produced in order to achieve a
target or estimated profit.
By the end of the lesson, the learner should be able:

 appreciate the concept behind break- even point.
 calculate break- even point in sales units and in value.
 calculate units to produce to achieve a target profit
Break-Even Analysis
Break-even analysis is a widely used technique to study the CVP
relationship. It is interpreted in narrow as well as broad sense. In its narrow
sense, break even analysis is concerned with determining breakeven point,
i.e., that level of production and sales where there is no profit and no loss.
At this point total cost is equal to total sales revenue.
When used in broad sense, break-even analysis is used to determine

probable profit/loss at any given level of production/sales.
Assumptions underlying Break-even Analysis

The break-even analysis based on the following assumptions:
 All costs can be separated into fixed and variable components.
 Variable cost per unit remains constant and total variable cost varies in
direct proportion to the volume of production.
 Total fixed cost remains constant.
 Selling price per unit does not change as volume changes.
 There is only product or in the case of multiple products, the sales mix
does not change. In other words, when several products are being sold,
the sale of various products will always be in some predetermined
proportion.
 There is synchronization between production and sales. In other words,
volume of production equals volume of sales.
 Productivity per worker does not change.
 There will be no change in the general price level.
Breakeven Point
Break –even analysis may be performed by the following two methods:
 Algebraic calculations
 Graphic presentation
Algebraic Method (Calculations in Break-even Analysis)
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Break-even point. The break-even point is the volume of output or sales at

which total cost is exactly equal to sales. It is a point of no profit and no
loss. This is the minimum point of production at which total cost is
recovered and after this point profit begins.
The fundamental formula to calculate break-even point is:

Total fixed cost F
Break-even point (in units) = =
Contribution per unit S-V
Break-even point (in Total fixed cost f x S

= x Sales =
Cedis) Contribution S - V
Total fixed cost

or Break-even point (in Cedis) =
P/V ratio
Illustration
Following data is given:
Total fixed cost = GH¢ 12,000
Selling price = GH¢ 12 per unit
Variable cost = GH¢ 9 per unit
Thus:
Contribution = S–V
= 12 – 9 = GH¢ 3 per unit
𝐶 3
P/V ratio = × 100 = × 100 = 25%
𝑆 2
Fixed cost 12000

B.E Point (in units) = = = 4,000 units
Contribution per unit 3
Total fixed cost

Break – even point (in GH¢) = x Sales
Contribution
12,000
= x = GH¢ 48,000
3 GH¢ 12
Also,
Break-even point (in GH¢)
Total fixed cost GH¢ 12,00 48,000
= = =
P/V ratio 25%
Verification
Break-even point may be verified as follows:
Total cost = Fixed cost + Variable cost
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COST AND MANAGEMENT
Total cost = GH¢ 12,000 + (4,000 units x GH¢ 9) = GH¢

48,000
The sales value and total cost at break-even point are exactly equal.
Additional Calculations
In addition to the calculation of break-even point, the above formula can
also be used in making certain additional calculations. These are:
 calculation of profit at different sales volumes
 calculation of sales for desired profit(target profit)
 finding missing figures.
Example: The following data is given:
Calculation of Profit at different Sale Volume

What will be the profit when sales are (a) GH¢60,000 (b) GH¢ 100,000?
From the above calculation,
C 3
P/V ratio = = = 25% therefore:
S 12
a.
When sales = GH¢ 60,000
Contribution = Sales × P/V ratio

= GH¢ 60,000 × 25% = GH¢ 15,000
Profit = Contribution– Fixed

= GH¢ 15,000– GH¢ 12,000 = GH¢ 3,000
b.
When sales = GH¢ 100,000
Contribution = GH¢100,000 ×25% = GH¢25,000
Profit = GH¢25,000–GH¢12,000 GH¢13,000
Calculations of Sales for Desired Profits (Target Profit)

Target profit is the net income or profit management desires to achieve at
the end of a business period. Management will therefore need to know the
level of activity required to meet the target.
To calculate the required sales level, the targeted income is added to the
total fixed cost and the results is divided by contribution margin ratio
Continuing with the same figures, what will be the amount of sales if it is
desired to earn a profit of (a) GH¢ 6,000; (b) GH¢ 15,000?
Fixed cost+Target profit
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P/V ratio
Fixed cost+Target profit

Sales for desired profit =
P/V ratio
GH¢ 12,000+ GH¢ 6,000

= = GH¢ 72,000
25%
a.
GH¢ 12,000+ GH¢ 15,00
= GH¢ 108,000
25%
Calculation of Missing figures

Example:
Given: Break-even point = GH¢ 30,000
Profit = GH¢ 1,500
Fixed cost = GH¢ 6,000
What is the amount of variable cost?
Solution
Contribution = Fixed cost + profit
= GH¢ 6,000 + GH¢1,500 = GH¢ 7,500
Fixed cost
Break-even point = x Sales
Contribution
6,000
GH¢ 30,000 = x Sales
7,500
7,500
Sales = x 3000 = GH¢ 37,500
6,000
Contribution 7,500
P/V ratio = x x 100 = 20%
Sales 37,500
Variable cost = 100 – P/V ratio

Variable cost = 100 – 20% = 80% (of sales)
Variable cost at break- 80

= GH¢ 37,500 = x = GH¢ 30,000
even sales %
Variable cost at break-

= GH¢30,000 x 80% = GH¢ 24,000
even sales
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Also, variable cost at Fixed cost

= 30,000 –
Break-even sales
= 30,000 – 6,000 = GH¢24,000
Example:
Sales = 4000 units @ GH¢ 10 per unit
Break-even point = 1500 units
Fixed cost = GH¢ 3000
What is the amount of (a) variable cost: and (b) profit?
Solution
Fixed cost
Break-even point (in units) =
Contribution
GH¢3,000
1,500 =
Contribution per unit
GH¢ 3,000
Contribution per unit = = GH¢ 2
1,500 units
a.
Variable cost = Selling price – Contribution
GH¢ 10 – GH¢ 2 = GH¢ 8 per unit
Contribution at sales of 4,000

= 4,000 units x GH¢ 2 = GH¢ 8,000
units
b.
Profit = Contribution – Fixed cost
= GH¢8,000 – GH¢ 3,000 = GH¢5,000
Example:
Given:
Fixed cost GH¢8,000
Profit earned GH¢2,000
Break-even sales GH¢40,000
What is the actual sale?
Solution
Contribution at break-even point is equal to fixed cost.
c = 8,000
Thus,P/V ratio = = 20%
s 40,000
Fixed cost + Profit

Actual Sales =
P/V ration
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8000+1,20,000 60,000 1
= = =
180,000 180,000 3
F 30,000
New P/V ratio = = = GH¢90,000
P/V ratio 1/3
c. When variable cost increases by 10% new variable cost

= 120,000 + 10 = GH¢ 132,000
2,00,000+1,32,00 680,000
New P/V ratio = = x 100 = 34%
2,00,000 2,00,000
New Break-even point = 34% = GH¢88,235
d. If fixed cost increases by 10%,new fixed cost = 30,000 + 10% =

GH¢33,000
P/V ratio remains unaffected at 40%
30,000
New Break-even point = = GH¢ 82,500
34%
Illustration 3.2
From the following particulars, find out the selling price per unit if B.E.
Point is to be brought down to 9,000 units.
Variable cost per unit = GH¢ 75
Fixed expenses = GH¢ 270,000
Selling price per unit = GH¢ 100
Solution
Fixed cost
Break-even point =
270,000
9,000 units =
270,000
Contribution per unit = = GH¢ 30
9,000
At present the contribution is GH¢ 25 (i.e., 100 - 75). In order to bring B.E.
Point at 9,000 units, contribution should be brought to GH¢ 30. This means
that selling price should be increased by GH¢ 5. Thus, the new selling price
should be GH¢ 105.
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Illustration
You are given the following data:
Fixed expenses GH¢ 4,000
Break-even point GH¢ 10,000
Calculate:
(i) P/V ratio
(ii) Profit when sales are GH¢ 20,000
(iii) New break-even point if selling price is reduced by 20 %
Solution
At break-even point, contribution is equal to fixed cost thus when sales are
GH¢ 10,000, contribution = GH¢ 4,000.
(i)
c 4,000
P/V ratio = x 100 = x 100 = 40%
s 10,000
(ii) When sales are GH¢ 20,000, contribution will be:

20,000 x 40% = 8,000
Profit = Contribution-Fixed cost

= 80,000-4000 = GH¢ 4,000
(iii) New break-even point when selling price is reduced by 20%

New sales figure = 20,000 - 20% = GH¢16,000
Variable cost = GH¢12,000

Contribution 16,000 - 12,000 = GH¢ 4,000
c 4,000
New P/V ratio = = = 25%
s 16,000
F 4,000
New Break-even point = = = GH¢16,000.
P/V ratio 25%
Cash Break-even point

When break-even point is calculated only with those fixed costs which are
payable in cash, such a break-even point is known as cash break-even point.
This means that depreciation and other non-cash fixed costs are excluded
from the fixed costs in computing cash break-even point. Its formula is:
Cash fixed costs
Cash break-even point
Conclusion
The breakeven point is the point at which total costs equal total revenue;
that is where there is neither a profit nor a loss. This can be re-stated in
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many ways: It is the level of sales value or sales unit at which profit is zero.
Or It is the point where, contribution margin is equal to fixed cost. It is
important to note that the moment the break-even point in units is known,
the break-even point in sales value can be calculated by multiplying the
break-even units by the unit price and when the break-even sales value is
known, the break-even units can be calculated by dividing the break-even
sale value by the unit price.
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COST AND MANAGEMENT MARGIN OF SAFETY
UNIT 3 SECTION
ACCOUNTING II 4
Unit 3, section 4: Margin of safety
Hello learner, you are again welcome to Session four of this unit as we look
at another interesting topic. In this Session we will be looking at margin of
safety in cost volume profit analysis. The margin of safety is a measure of
the difference between the anticipated and breakeven levels of activity. It
states the amount by which sales can drop before losses begin to be
incurred.
By the end of this lesson, the student should be able to:

 calculate the margin of safety
 calculate contribution per key factor
Definition and Determination of Margin of Safety

Margin of safety may be defined as the difference between actual sales and
sales at break-even point: In other words, it is the amount by which actual
volume of sales exceeds the breakeven point. The lower the margin of
safety, the higher the risk, as sales do not have to fall much before reaching
the breakeven point. Conversely, there is less risk where businesses operate
with higher margins of safety.
Margin of safety may be expressed in absolute money terms or as a

percentage of sales. Thus,
M/S=Actual sales-Break-even point Example:
Example:
Company X Company Y
Actual sales GH¢ 120,000 GH¢ 60,000
Less: Break-even point GH¢ 40,000 GH¢ 40,000
Margin of safety GH¢ 80,000 GH¢ 20,000
80,000 20,000
Margin of safety as a % of sales = × 100 = × 100
120,000 60,00
2 = 1
= 66
3% 33 3%
The size of the margin of safety indicates soundness of a business. When

margin of safety is large, it means the business can still make profits after a
serious fall in sales. In such a situation, the business stands better chance of
survival in times of depression. A large margin of safety usually indicates
low fixed costs. When margin of safety is low, any loss of sales may be a
matter of serious concern.
Margin of safety is directly related to profit. This is shown below:
Profit (P) = Margin of safety × Profit / volume ratio
P = M/S × P/V ratio
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Unit 3, section 4: Margin of safety ACCOUNTING II
Thus:
p
M/S =
p/v ratio
If profit is 10% and P/V ratio is 40%, then

10
M/S = = 25%
40%
When actual sales are given:

Profit = M/S ratio x P/V ratio x Actual sales
When profit is not known but M/X is known, then

P = M/S × P/V ratio
P = 25% × 40% = 10%
Improvement is M/S. When margin of safety is not satisfactory, the

following steps may be taken to improve it:
(a) Increase the volume of sales, (b) Increase the selling price, (c) Reduce
fixed cost, ()d) Reduce variable cost, (e) Improve sales mix by
increasing the sales of products with large P/V ratio.
The effect of a price reduction is always to reduce P/V ratio,

raise the break-even point and shorten the margin of safety.
This is illustrated below:
Example: Suppose price is reduced from GH¢. 75 to GH¢ 60.

Before price After price reduction
reduction
GH¢ GH¢
Selling price per units (S) 75 60
Variable cost per unit (V) 50 50
Total fixed cost (F) 10,000 10,000
Contribution (S-V) 25 10
P/V ratio 25 = 1 10 = 1
75 3 60 6
F 10,000 10,000
Break even point ( ) = =
P/V ratio 1/6 1/6
= 30,000 = 60,000
Actual sales 75,000 75,000
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ACCOUNTING II Unit 3, section 4: Margin of safety
M/X ( Actual sales- B.E Point) 75,000-30,000 75,000
= 45,000 = 15,000
Illustration 4.1
The profit/volume ratio of Escorts Ltd. is 50% and the margin of safety is
40%. You are required to work out the net profit and the break-even point if
sales volume is GH¢1,000,000.
GH¢
Sales 1,000,000
Less: Margin of safety (40% of sales) 400,000
Break-even point 600,000
Contribution = Sales x P/V ratio

Contribution at B.E. Point = 600,000 x 50% = GH¢ 300,000
Thus,
fixed cost = GH¢300000.
At break-even point, the entire amount of contribution is fixed cost since
there is no profit at this point.
Profit = Contribution - Fixed cost
Contribution on sales of GH¢ 1,000,000 = 1,000,000 × 50%

= GH¢ 500,000
Profit = 500,000 - 300,000 = GH¢ 200,000
These calculations can be verified as follows:

Profit% = M/S × P/N
= 40% × 50% = 20% of sales
Profit = 1,000,000 × 20% = GH¢ 200,000
Limiting or Key Factor

The objective of a business is to earn maximum profit. However, it is not
always easy to achieve this objective because profit earning is affected by a
variety of factors. For example, an undertaking may have sufficient orders
on hand, ample skilled labour and production capacity, but may be unable to
obtain all the quantity of material it needs for the manufacture of maximum
quantities which could be sold. Thus, martial is the factor which limits the
size of output and prevents an undertaking from maximizing its profit.
Similarly, sometimes a business is not able to sell all that it can produce. In
such a case, sales is the limiting factor.
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Unit 3, section 4: Margin of safety ACCOUNTING II
A limiting or key factor may thus be defined as the factor in the activities of
an undertaking, which at a particular point in time or over a period will limit
the volume of output. Examples of limiting factors are:
 Sales
 Materials
 Labour of particular skill
 Production capacity or machine hours
 Financial resources.
The purpose of the limiting factor technique is to indicate the most

profitable course of action in all such cases where alternatives are possible.
Contribution per unit of key factor - When a key factor is operating, the
most profitable position is reached when contribution per unit of key factor
is maximum. For instance, if a choice lies between producing product A
which yields a contribution of GH¢15 per unit and product B would be more
profitable.
If however, product A takes 3 kg., of material (which is a limiting factor)

and product B takes 5kg. the respective contributions per kg. of material
would be:
Product A = GH¢15 ÷ 3kg = GH¢5

Product B = GH¢20 ÷ 5kg = GH¢4
Product A, which gives the greater contribution in terms of per unit of

limiting factor will be more profitable.
Illustration 4.2
The following data is given:
Product A Product B
Direct materials GH¢24 14
Direct labour @ GH¢ 3 per hour GH¢6 9
Variable overhead @ GH¢ 4 per hour GH¢8 12
Selling price GH¢100 110
Standard time 2 hrs. 3 hrs.
State which product you would recommend to manufacture when:

(a) Labour time is the key factor
(b) Sales value is the key factor
Solution
Product A Product B
GH¢ GH¢
Selling price (S) 100 110
Direct material 24 14
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ACCOUNTING II Unit 3, section 4: Margin of safety
Direct labour 6 9
Variable overhead 8 12
Variable cost (V) 38 35
Contribution (S-V) 62 75
a. Contribution per labour hour GH¢62÷2hrs GH¢75÷3hrs
= GH¢31 = GH¢ 25
b. Contribution per cedis of sales = GH¢62÷100 = GH¢75÷110
value
= GH¢0.62 = GH¢0.68
Conclusion
 Product A is recommended when labour time is the key factor because
contribution per labour hour product A is more than that of product B.
 When sales value is the key factor, product B is recommended because
contribution per cedis of sales value of product B is more than that of
product A.
 When sale quantity is the key factor, product B is more profitable
because its contribution per unit is higher than that of product A.
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COST AND MANAGEMENT GRAPHIC PRESENTATION OF BREAK-EVEN ANALYSIS
UNIT 3 SECTION
ACCOUNTING 5
Unit 3, section 5: Graphic presentation of breaking even-analysis
You are welcome to the last but one Session of unit three. In this Session,
we will be looking at the graphical presentation of break-even analysis. This
will assist learners to explain break-even points using pictorial
presentations.

 construct the break even chart
 construct the profit/volume chart
 interpret the break-even chart
Break-even Chart
Break-even chart is a graphic presentation of break-even analysis. This chart
takes its name from the fact that the point at which the total cost line and the
sales line intersect is the break-even point. A break-even chart not only
shows the break-even point but also shows profit and loss at various levels
of activity. Thus a break-even chart portrays the following information:
Volume of sales (Units ‘000)

Fig. 5.1 Break-even chart
 Break-even point - the point at which neither profit nor loss is made
 The profit/loss at different levels of output.
 The relationship between variable cost, fixed cost and total cost.
 The margin of safety.
 The angle of incidence, indicting the rate at which profit is being made.
 The amount of contribution at various levels of sales (This can be shown
only on a specially designed ‘contribution break-even chart.’)
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Unit 3, section 5: Graphic presentation of breaking even-analysis ACCOUNTING II
Construction of Break-even Chart

The principal steps in the construction of a break-even chat are as follows:
 Select a scale on X-axis. The X-axis is horizontal base line which is
drawn and spaced into equal distances to represent any one or more of
the following factors:
 Volume of output (units)
 Volume of output (in Cedis value)
 Volume of sales (units)
 Volume of sales (in Cedis volume)
 Production capacity (in percentage)
 Select scale on Y-axis. The Y-axis is a vertical line at the extreme left
of the chart which is spaced into equal distances. On this Y-axis, it is
usual to show cost and sales in cedis value.
Fig. 5.2 Break-even Chat Steps 1, 2 and 3

 Draw the fixed cost line. This is drawn parallel to X-axis, starting from
an appropriate point on Y-axis. For example, when fixed cost is
GH¢30,000, it will be plotted as is shown in Fig. 5.2.
 Draw the total cost line. The variable cost is depicted in the chart by
superimposing it on the fixed cost line. Thus a total cost line is drawn
starting from the point on the Y-axis which represents fixed cost. For
example, when total variable cost is GH¢50,000 (fixed cost being
GH¢30,000), a total cost line is drawn from GH¢30,000, the fixed cost
point of Y-axis, to the GH¢80,000 cost point on the right side of the Y-
axis. This is shown below in Fig. 5.3.
 Drawn the sales line. This line starts from the 0 point at the left (the
intersection of X-axis and Y-axis, where there is no production at nil
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ACCOUNTING Unit 3, section 5: Graphic presentation of breaking even-analysis
cost) and extends to the point of maximum or any other sales value.
Further assuming sales GH¢100,000 (Fixed cost GH¢30,000, variable
cost GH¢50,000), the sale line will be drawn from 0 point at the left to
the GH¢100,000 point on the right Y-axis. This is illustrated in Fig. 5.4.
Output (’000)
Fig. 5.3 Break-even Chart Step 4
Fig. 5.4 Break-even Chart Step 5
The sales line intersects the total cost line at break-even point representing
GH¢ 60,000 sales and output.
Contribution Break-even Chart

This is an alternate form of break-even chart and shows the amount of
contribution at different levels of output. In such charts variable cost is
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drawn first and fixed cost is super-imposed on the variable cost line. The
space between total variable cost and sales line represents contribution.
Example is shown figure 5.5
Fig. 5.5 Contribution Break-even Chart with Assumed Data
Analytical Break-even Chart

This type of break-even chart can be constructed to show greater details by
breaking down fixed and variable costs into sub-classifications. Fixed costs,
for example, may be divided into factor overhead and fixed administration,
selling and distribution overhead. Similarly, variable costs may be classified
into direct materials, direct labour, variable factor overheads, variable
administrative, selling and distribution overheads. Even profit area may be
subdivided indicating appropriation of profit to income tax, interest and
dividend payments, reserves, etc. This type of break-even chart will appear
as shown in Fig. 5.6
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Fig. 5.6 Analytical Break-even Chart with Assumed Data
Effect of Change in the Profit Factors

The break-even chart can also show the effect of change in any of the
following factors, which affect profit:
 Change in fixed cost
 Change in variable cost
 Change in selling price
 Change in sales volume
The profit of a business can be increased when there is (a) decrease in fixed
cost, and/or (b) decrease in variable cost, and/or (c) increase in selling price,
and (d) increase in sales volume. The first three, i.e., (a), (b) and (c) factors
will have the effect of lowering the break-even point and thus increasing
profit. The separate effect of each of these is shown in the following charts
and calculations:
Illustration 5.1
Fixed cost GH¢ 5,000 Variable cost GH¢ 10 per unit
Selling price GH¢ 20 per unit Sales volume GH¢ 1,000 units
Draw a break-even chart and show the effect of the following:

 10% decrease in fixed cost
 10% decrease in variable cost
 10% decrease in selling price
 10% increase in sale volume.
Solution
a) Effect of 10% decrease in fixed cost
A 10% decrease in fixed cost would amount to GH¢ 500 and would result in
105 increase in profits. This is known in Fig. 5.7
Calculations
Break- Fixed cost Selling GH¢5,000
= x = x GH¢ 20
even point Contribution price GH¢ 10
= GH¢ 10,000 or 500 units
New Fixed cost = GH¢ 5,000-10% = GH¢ 4,500
GH¢ 4,500 GH¢9,000 or 450

New Break-even point = x 20 =
GH¢ 10 units
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Profit = Sales-Variable cost-Fixed cost = Fixed cost

= 10,00-5,000 = GH¢ 5,000
New profit = GH¢ 20,000-10,000-4,500 = GH¢ 5,500
b) Effect of 10% decrease in variable cost

A 10% decrease in variable cost would amount to GH¢ 1,000 at the present
level of output and, therefore increase profit by 20%. This is depicted on
Fig. 5.8.
Calculations
Fixed cost
Break-even point = × Selling price
Contribution
New variable cost = GH¢ 9 per unit
New contribution GH¢ 20 - GH¢9 = GH¢11
Volume of output (units)
Fig. 5.7 Break-even chart showing the effect of 10% decrease in fixed cost
GH¢5,000
New Break-even point = x 20 = GH¢ 9,091 (Approx.)
GH¢11
New profit = GH¢ 20,000 - GH¢5,000 = GH¢ 6,000.
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Fig. 5.8 Break-even chart showing of 10% decrease in variable cost.
c) Effect of 10% increase in selling price

A 10% increase in selling price would add GH¢2,000 to sales revenue and
would increase the current profit by 40%. This is shown on the following
Fig. 5.9
Calculations
New sales figure = 20,000+105 = GH¢ 22,000
New contribution per unit = 22-10 = GH¢ 12
New break-even point = 5,000

× 22 = GH¢9,167(Approx.)
12
= 417 units (Approx.).
New profit = GH¢ 22,000-10,000-5,000 = GH¢7,000
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Fig 5.9 Break-even chart showing the effect of 10% increase in selling
price.
d) Effect of 10% increase in sales volume

A 10% increase in sales volume would increase profit by GH¢1,000 (i.e., at
the rate of contribution of GH¢10 per unit for 100 unit). Increase in sales
volume will have no effect on the break-even point (See Fig. 5.10)
Calculations
New sales figure = 1100 units x GH¢20 = GH¢22,000
New variable cost = 1100 units x GH¢10 = GH¢11,000
New profit = GH¢11,000 - 11000-5000 = GH¢6,000
Profit-Volume Chart
The profit-volume chart or profit graph portrays the profit and loss at
different levels of sales and is an alternative presentation of the facts
illustrated in the break-even chart. Such a chart can be constructed from the
same basic data from which a break-even chart can be drawn.
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Fig. 5.10 Break-even chart showing the effect of 10% increase in sales
volume
Construction of Profit-Volume Chart

The following steps should be taken to construct a profit-volume chart.
 Select a scale on horizontal axis. The horizontal axis in the profit-
volume graph represents sales. This horizontal line, known as sales line
divides the graph into two parts.
 Select a scale on vertical axis. This vertical axis shows fixed cost and
profit. The fixed costs are market below the sales line on the left hand
vertical line and profit is shown above the sales line on the right hand
vertical line.
 Plot fixed cost and profit. Points are plotted for the given fixed cost
and profit. These points are connected by a diagonal line which crosses
the sales line at break-even point.
Example:
Sales GH¢20,000 (100 units @ GH¢20)
Variable cost Variable cost
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This data has been plotted on P.E. Chart in Fig. 5.11
Calculation
s-v 20,000-10,000
Profit-volume ratio = = x 100 = 50%
s 20,00
Fixed cost GH¢ 5,000

Break-even point = = = GH¢10,000
P/V ratio 20,00
Profits = S - F-V = 20,000-5,000-10,000 = GH¢5,000
Fig. 5.11 Profit-Volume Chart
Multi-product-Volume Charts
When a business produces two or more products, a separate profit-volume
chart may be prepared for each of the products. Alternatively a single profit
volume char may also be prepared to portray the position of each individual
product. In such a situation, the profit-volume chart will appear as shown in
Fig. 5.12
A single profit volume chart may also be prepared to s how the overall
position of all the products taken together. The procedure is to calculate P/V
ratio for each product and arrange the products in the descending order on
the basis of P/V ratios. Cumulative figure of profit/loss and sales should be
calculated/.
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Fig. 5.12 Profit-volume Chart in a multi-product company showing the

separate position of each product.
First of all, the product with the highest P/V ratio is plotted, then the
product, with the second highest P/V ratio is plotted with cumulative
figures, the process will end with the product having the lowest P/V ratio.
The fixed cost point and the profit point of the last product are connected by
a straight line which intersects the sales line at break-even point.
Illustration 5.3
The following figures apply to a manufacturing company producing a wide
range of products which may be classified into three main groups:
Product group Annual sales Variable cost
GH¢ GH¢
A 3,000,000 1,000,000
B 3,000,000 2,000,000
C 3,500,000 3,000,000
Fixed cost is GH¢250,000.

Plot on a graph the marginal income slopes for the product group in
alphabetical order to enable you to plot the average marginal income slope
or the total output.
Solution
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The graph is to be drawn in the order of descending P/V ratio, i.e., product
having the highest P/V ratio should be drawn first and so on. The relevant
data required for plotting the graph is shown in Fig. 5.14.
Product Sales V.C. Cont P/V ratio F.C New profit Cumula
ribut loss (-) tive
ion (Cumulative) sales
A 30 10 20 66.67% 25 (-) 5 (loss) 30
B 30 20 10 33.33% 25 5 60
C 35 30 -5 14.28% 25 10 95
Fig. 5.14 Profit-Volume Chart is a multi-product company showing the

combined effect of all products.
Overall P/V ratio = 35/95 = 7/19
F 25,000,000
BE Point = = = GH¢6,785,715
P/V ration 7/19
Uses of Break-even Analysis

Some of the important uses of break-even analysis are summarized below:
 It helps in determining the break-even point.
 .It helps in determining the selling price which will give the desired
profit.
 It helps in determining the sales volume to earn a desired profit or return
on capital employed.
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 It helps in determining the costs and revenue at different levels of

output.
 It helps in determining the most profitable sales mix.
 It helps in determining comparative profitability of each product line.
 It studies the effect of change in selling price or price differentiation in
different markets e.g., home market and foreign market.
 It studies the impact of increase or decrease in fixed and variable costs
on profits.
 It studies the effect on profits and breaks-even points of high proportion
of variable costs with low fixed cost and vice-versa.
 It compares the profitability of various firms.
 It helps in management decision-making, e.g., in maker or buy
decisions, discontinuance of a product line, acceptance of special job,
etc.
 It help in determining cash requirements at difference levels of operation
with the help of cash break-even charts.
Conclusion
The various chart discussed above helps one to explain the relationship
among sales, price, revenue and cost pictorially. Every student should try
and understand how the chart works.
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Unit 3, section 5: Graphic presentation
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even-analysis
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COST AND MANAGING SALE MIX
UNIT 3 SECTION
ACCOUNTING II 6
Unit 3, section 6: Sale mix
Dear learner, it is our hope that you have enjoyed the topic so far. We are in
the last Session of unit three as we look at another interesting topic, which is
sales mix. When a company sells multiple products break-even analysis is a
bit complex and that is the focus of this last Session.
By the end of the lesson, the student should be able to:

 define and explain the concept of sales mix
 compute the break-even point when there is a sales mix
Definition and Explanation of the Concept:

The term sale mix refers to the relative proportion in which a company's
products are sold. The concept is to achieve the combination that will yield
the greatest amount of profits. Most companies have many products, and
often these products are not equally profitable. Hence, profits will depend to
some extent on the company's sales mix. Profits will be greater if high
margin rather than low margin items make up a relatively large proportion
of total sales.
Changes in sales mix can cause interesting variation in profits. A shift in

sales mix from high margin items to low margin items can cause profits to
decrease even though total sales may increase. Conversely, a shift in sales
mix from low margin items to high margin items can cause reverse effect; -
total profit may increase even though total sales decrease. It is one thing to
achieve a particular sales volume; it is quite a different thing to sell most
profitable mix of products.
Sales Mix (Multiple Products) and Break Even Analysis:

If a company sells multiple products, break even analysis is somewhat more
complex than discussed above for a single product. The reason is that the
different products will have different selling prices, different costs, and
different contribution margin. Consequently, the breakeven analysis will
depend on the mix in which the various products are sold.
CVP analysis can easily work with this complication by obtaining some data
about the product mix. First, we need to know the proportion in which each
of the products is sold. Then we can calculate the contribution margin for
each product. After that we can define the weighted average contribution
margin, which is used in the determination of the break-even point or the
amount of sales required to gain a desired profit.
Example: 1
ABC Company
Product A Product B Total
GH¢ % GH¢ % GH¢ %
Sales 20,000 100 80,000 100 45,000 45
15,000 75 40,000 50 27,000 27
Less: Variable 5,000 25 40,000 50 18,000 18
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Unit 3, section 6: Sale mix ACCOUNTING II
Expenses
Contribtion
Less Fixed
Expenses
Net Operating
Income
Computation / Calculation of Break-even Point = Fixed Expenses /
Overall Contribution
= GH¢ 27,000 / 45%
= GH¢ 60,000
GH¢60,000 sales represent the break-even point for the company as long as
the sales mix does not change.
If the sales mix changes, then the break-even point will also change. This is
illustrated below.
Example: 2
ABC Company
Product A Product B Total
GH¢ % GH¢ % GH¢ %
Sales 80,000 100 20,000 100 100,000 100
60,000 75 10,000 50 70,000 70
Less: Variable 20,000 25 10,000 50 30,000 30
Expenses 27,000 27
3,000 3
Contribution
Less Fixed Expenses
Net Operating Income
Computation / Calculation of Break-even Point = Fixed Expenses /

Overall Contribution
= GH¢ 27,000 / 30%
= GH¢ 90,000
Although sales have remained unchanged at GH¢100,000, the sales mix is

exactly the reverse of what it was in example1, with the bulk of sales now
coming from the less profitable product A. Notice that this change in the
sales mix has caused both the overall contribution margin and total profits to
drop sharply. The overall contribution margin (CM ratio) has dropped from
45% to 30% and net operation income has dropped from GH¢18,000 to
GH¢3,000. The company's break- even point is no longer GH¢60,000 in
sales. Since the company is now realizing less contribution margin per cedi
of sales, it takes more sales to cover the same amount of fixed costs. Thus
the break-even point has increased from GH¢60,000 to GH¢90,000 in sales
per year.
Example 3
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ACCOUNTING II Unit 3, section 6: Sale mix
Assume that the David and Paul Company Ltd produces three (3) types of
valves: truck valves, car valves, and motor-bike valves. The following data
is available:
Truck Valve Car Valve Motor Bike
Share in Physical Volume Sold% 30 45 25
Selling Price per Unit GH¢ 10 8 7
Variable Cost per unit GH¢ 7 6 5
Contribution per unit GH¢ 3 2 2
Contribution Margin Ratio% 30 25 29
Fixed Cost GH¢ 10,000
To calculate the weighted average contribution margin we need to weight

the contribution margin per unit of these three products and present it as
"three-in-one". The Weighted Average Contribution Margin per Unit = 30%
x GH¢3 + 45% x GH¢2 + 25% x GH¢2 = GH¢2.3. Now the break-even
point may be calculated.
The calculation of the break-even point in a multiple-product company

follows the same logic as in a single-product company. While the numerator
will be the same fixed costs, the denominator will now be the weighted
average contribution margin. The modified formula is as follows:
Break-even Point (in units)
Fixed Cost
=
Weighted Average Contribution Margin per Unit
For our example, the break-even point (in units) approximates 4,348 units
(i.e., GH¢10,000 ÷ GH¢2.3).
These 4,348 units are then allocated to different valve types according to the
proportion defined in row 1 in the table above:
Truck values : 4,348 units × 30% = 1,304 units
Car valves : 4,348 units × 45% = 1,957 units
Motor-bike valves : 4,348 units × 25% = 1,087 units
So, David and Paul Co Ltd will break-even (i.e., will get neither profit nor
loss) if it sells these volumes of valves at the given proportion of
30%:45%:25%. It is important to note that changes in the product mix will
result in different break-even points. For example, if the market situation
changes and Friends Company switches to the products mix with
proportions of 45%:30%:25%, the break-even point will change. In this
case, the weighted average contribution margin per unit will be GH¢2.45
and zero profits will be earned when the unit sales equal around 4,082
valves.
The change occurred because the contribution ratio per unit of truck valves
is the highest (GH¢3 per truck valve versus GH¢2 per car or motor-bike
valve). Thus, more income can be generated by producing and selling truck
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valves and the break-even point is reached faster (with fewer total items
produced and sold).
The break-even point for a multiple-product scenario can be calculated in

values as well. Here also, the numerator is the same fixed costs. The
denominator will now be weighted the average contribution margin ratio.
Try your hands on it.
Uses of Break-even Analysis

Some of the important uses of break-even analysis are summarized below:
 It helps in determining the break-even point.
 .It helps in determining the selling price which will give the desired
profit.
 It helps in determining the sales volume to earn a desired profit or return
on capital employed.
 It helps in determining the costs and revenue at different levels of
output.
 It helps in determining the most profitable sales mix.
 It helps in determining comparative profitability of each product line.
 It studies the effect of change in selling price or price differentiation in
different markets e.g., home market and foreign market.
 It studies the impact of increase or decrease in fixed and variable costs
on profits.
 It studies the effect on profits and breaks-even points of high proportion
of variable costs with low fixed cost and vice-versa.
 It compares the profitability of various firms.
 It helps in management decision-making, e.g., in maker or buy
decisions, discontinuance of a product line, acceptance of special job,
etc.
 It helps in determining cash requirements at difference levels of
operation with the help of cash break-even charts.
Limitations of Cost volume profit (CVP) analysis

Despite the advantages presented by CVP analysis, there are some
significant limitations arising from the assumptions made:
 Volume is the only factor that causes prices and variable costs to alter
(in practice, production efficiencies, product/service mix, price levels
etc. all influence costs and revenues).
 There is a single product/service or a product/service mix that remains
constant (in practice, product/service mix can vary significantly and
different product/services may have different cost structures, prices and
contributions).
 Costs can be accurately divided into fixed and variable elements
(although in practice many costs are semi-variable and semi-fixed).
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 Fixed costs do not change (although in practice they vary with the range
of items produced and with product complexity).
 Total costs and revenues are linear (while this is likely within the
relevant range, increases in volume may still lead to lower unit prices or
economies of scale and curvilinear costs and revenues may be more
accurate).
 The CVP analysis applies only to the relevant range (although decisions
may be made in the current period to move outside this range).
 The analysis applies only to the short term and cannot reliably be used in
the longer term. For longer-term analysis that considers the entire life-
cycle of a product, one therefore often prefers activity-based costing or
throughput accounting.
Conclusion
Despite its limitations, CVP analysis is a useful tool in making decisions
about pricing and volume, based on an understanding of the cost structure of
the business.
Problems and Solutions

Problem 1
a) The fixed costs for the year are GH¢40,000. Variable cost per unit for a
single product being made is GH¢2. Each unit sells at GH¢ 10. You are
required to calculate the break-even point.
b) It has been found that GH¢80,000 will be the likely sales turnover for
the next budget period. The cost and the selling price remain the same.
Calculate the estimated contribution and profit.
c) A profit target of GH¢30,000 has been budgeted. Calculate the turnover
required.
Solution
(a)
Contribution = S-V = GH¢10- GH¢2 = GH¢8
c 8
P/V ratio = x 100 = x 10 = 80%
s 10
Fixed cost 40,000

Break-even point = = = GH¢50,000
P/V ratio 80
(b)
Contribution = Sales×P/V ratio = GH¢80,000×80% = GH¢64,000
Profit = Contribution-Fixed cost = GH¢64,000- GH¢40,000
= GH¢24,000
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(c)
Fixed cost+Targeted profit
Turnover for desired profit =
P/V ratio
GH¢ 40,000+ GH¢30,000 70,000

= = = GH¢87,500
P/V ratio 80%
Problem 2
a) A company has fixed expenses of GH¢90,000 with sales at GH¢300,000
and a profit of GH¢60,000. Calculate the Profit/Volume ratio. If in the
next period the company suffered a loss of GH¢30,000, calculate the
sales volume.
b) What is the margin of safety for a profit of GH¢60,000 in (a) above?
Solution
(a)
Contribution Cost+Profit = GH¢90,000+GH¢60,000
= GH¢150,000
c× 1,50,000
P/V ratio = 100 = 150,000 = ×10 = 50%
s 300,000
In the next period

Contribution = Fixed cost-Loss = GH¢90,000- GH¢30,000
= GH¢60,000
60,000
P/V ratio = = 50%
Sales
60,000
Sales = = GH¢120,000
50%
Thus at sales of GH¢120,000, there will be a loss of GH¢30,000.
(b)
Profit 60,000
Margin of safety = = = GH¢120,000
P/V ratio 50%
or M/S = Sales-even point
Fixed cost 90,000

= 300,000- = 300,000- ( )
P/V ratio 50%
= GH¢120,000.
Problem 3
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From the following data calculate the break-even point.

Direct material per unit GH¢3
Direct labour per unit GH¢2
Fixed overhead (Total) GH¢10,000
Variable overhead 100% on direct labour
Selling price per unit GH¢10
Trade discount 5%
Also determine the net profits, if sales are 10% above the break-even point.
Solution
Marginal Cost Statement
GH¢.
Net selling price (GH¢10 - 5% discount) 9.50
Direct material 3.00
Direct labour 2.00
Variable overhead 2.00
Variable cost 7.00
Contribution (GH¢9.50 - 7.00) 2.50
F 10,000
Break-even point = = = 4,000 units
C 2.50
B.E. Point (in GH¢.) = 4,000 units@GH¢10 = GH¢40,000
Less : 5% discount 2,000

Net sales value at B.E. Point GH¢38,000
When sales are 10% above B.E. Point
Sales = 4,000+10% = 4,400 units
Contribution (4,400 units ×GH¢2.50) GH¢11,000
Less: Fixed cost GH¢10,000
Profit GH¢1,000
Problem 4
Western Radio Company sold 10,000 radios last year at a price of GH¢500
each. The cost structure per radio is as follows:
GH¢
Materials 100
Labour 50
Variable overheads 25
Marginal cost 175
Fixed overheads 200
Total cost 375
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Due to competition, the price has to be reduced to GH¢425 for the coming
year. Assuming that there will be no change in costs, find out how many
radios shall be sold to ensure the same amount of total profit as last year.
Solution
Statement of Marginal Cost and Contribution
Per radio GH¢ Total (10,000 Radios) GH¢

(A) Sales 500 5,000,000
Materials 100 1,000,000
Labour 50 500,000
Variable overheads 25 250,000
(B) Variable cost 175 1,750,000
Contribution (A - B) 325 3,250,000
Less: Fixe overheads 200 2,000,000
Profit 125 1,250,000
Contribution at new selling price = New SP-VC

= GH¢425 - GH¢175 = GH¢250
Fixed cost+Desired profit

Sales to earn a desired profit =
Sales to earn a profit of GH¢125,000 at reduced selling price

20,00,000+ 12,50,000
= = 13,0000 Radios
Thus if selling price is reduced to GH¢425 per radio, then 13,000 radios will
have to be sold to earn the same profit.
Verification GH¢
New sales (13,000 ×425) = 5,525,000

Less: Variable cot (13,000×175) = 2,275,000
Contribution = 3,250,000
Less: Fixed cost = 2,000,000
Profit = 1,250,000
Problem 5
A Company has a P/V of 40%. By what percentage must sales be increased
to off-set:
(a) 10% reduction in selling price
(b) 20% reduction in selling price
Solution
GH¢
Suppose -Sales = (100 units @ GH¢ 1 each) 100
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Less: Contribution ( 4o% of sales) 40

Variable cost 60
When selling price is reduced by 10%, then –

New sales 90
Less: Variable cost 60
New contribution 30
Volume of sales to maintain the same contribution will be
Contribution 40
= × New sales = × 90 = GH¢120
New Contribution 30
Thus if the selling price is reduced by 10%, the volume of sales will have to
be increased by 20%, i.e. from GH¢ 100 to GH¢ 120.
(b) If selling price is reduced by 20%

New sales GH¢ 80
Less: Variable cost GH¢60
New contribution GH¢20
In order to maintain the same contribution, the volume of sales should be:
40
× 80 = GH¢160
20
Thus if selling price is reduced by 20%, the sales will have to be increased
by 60%.
Problem 6
GH¢
Selling price 20 per unit
Variable manufacturing costs 11 per unit
Variable selling costs 3 per unit
Fixed overhead overheads 540,000 per year
Fixed selling costs 252,000 per year
You are required to compute:

 Break-even point expressed in amount of sales in cedis;
 Number of units that must be sold to earn a profit of GH¢ 60,000 per
year.
 How many units must be sold to earn a net income of 10% of sales
Solution
S-V 20-14 6
P/V ratio = = = = 30%
S 20 20
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i)
Fixed cost 5,40,000+2,52,000
Break-even point = =
P/V ratio 30%
GH¢ 7,92,000
= = GH¢ 2,640,000
30%
ii) Units to be sold to earn a profit of GH¢ 60,000

Fixed cost+ desired profit = 7,92,000+ 60,000
= = 142,000 units
Contribution = S -V = 20-14 = GH¢ 6
iii) Suppose units to be sole to earn 10% profit=‘x’

Total sales = Selling price × units = 20 x
Total sales = Variable cost + Fixed cost+ Profit

20x = 14x + 792,000 + 2x
4x = 792,000
x = 792,000 ÷4
x = 198,000
Thus sales to earn a net income of 10% on sales=198,000 units.
Assessment Questions
Problem 1. Sultan Plastic Company makes plastic buckets. An analysis of
their accounting reveals:
Variable cost per bucket GH¢20
Fixed cost GH¢ 50,000 for the year
Capacity 2,000 buckets per year
Selling price per bucket GH¢70
Required:
(i) Find the break-even point
(ii) Find the number of buckets to be sold to get a profit of GH¢ 30,000
If the company can manufacture 600 buckets more per year with an
additional fixed cost of GH¢ 2,000, what should be the selling price to
maintain the profit per bucket as at (ii) above.
Problem 2.
A company manufactures a single product having a marginal cost of GH¢
0.75 a unit. Fixed costs are GH¢ 12,000. The market is such that up to
40,000 units can be sold at GH¢ 1.50 a unit, but any additional sale must be
made at GH¢ 1.00 a unit. There is a planned profit of GH¢ 20,000. How
many units must be made and sold?
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Problem 3. Company A and Company B, both under the same management,

make and sell the same type of product. Their budgeted profit and loss
account for June are as under:
Company A Company B
GH¢ GH¢ GH¢ GH¢
Sales 300,000 300,000
Less: Variable 240,000 200,000
cost 30,000 270,000 70,000 270,000
Fixed cost 30,000 30,000
Profit
You are required to:

 Calculate the break-even point for each.
 Calculate the sales volume at which each of the two companies will
make a profit of GH¢10,000.
 Assess how their profitability will change with increase or decrease in
sales volume.
Problem 4.
You are given the following data:
Sales Profit
Year 2004 GH¢ 120,000 8,000
Year 2005 GH¢ 140,000 13,000
Find out:
i. P/V ratio,
ii. B.E. Point,
iii. Profit when sales are GH¢ 180,000.
iv. Sales required to earn a profit of GH¢ 12,000.
v. Margin of safety in year 2005.
Problem 5 PQR Ltd. has finished the following data for the two years:
2004 2005
Sales GH¢ 800,000 ?
Profit / Volume Ratio (P/V ratio) 50% 37.5%
Margin of safety sales as a % of total sales 40% 27.875%
There has been substantial in the fixed cost in the year 2005 due to the
restricting process. The company could maintain its sales quantity level of
2004 in 2005 by reducing selling price.
You are required to calculate the following:

 Sales for 2005 in GH¢.
 Fixed cost for 2005
 Break-even sales for 2005 in cedis.
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XXXXXXX 4 RELEVANT COSTING
UNIT Unit X, section AND SHORT TERM DECISION
X: XXXXXXX
MAKING
Session 1: Overview of Decision Making Process, Relevant Cost and

Revenue
Session 2: Decision-making and Marginal Costing
Session 3: Make or Buy Decisions (In sourcing vs. Outsourcing)
Session 4: Selection of Suitable Method of Production
Session 5: Differential cost Analysis
Session 6: Other Short Term Decision
You are welcome to unit four of the manual. In this unit we are going to
focus on measuring costs and benefits for non-routine decisions. Non
routine decisions require only those costs and revenues that are relevant to
the specific alternative courses of action to be reported. The term decision
relevant approach is used to describe the specific costs and benefits that
should be reported for non-routine decisions. This unit provides you with an
understanding of the principles that should be used to identify relevant cost
and revenues.
This unit is divided into six sessions. The first session deals with the
overview of decision making process, relevant cost and revenue. The second
session discusses decision-making and marginal costing. Session three
covers make or buy decisions (In sourcing vs. Outsourcing) with session
four covering selection of suitable method of production. Session five looks
at differential cost Analysis and the last session discusses other short term
decision.
By the end of this unit, you should be able to:

 explain the decision making process
 distinguish between relevant and irrelevant costs and revenue
 describe opportunity cost
 apply relevant cost and revenue in decision making
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OVERVIEW1: Overview of decision
OF DECISION making processes,
MAKING PROCESSES,relevant cost and
RELEVANT
UNIT 4 SECTION
ACCOUNTING II 1
revenue COST AND REVENUE
Dear learner, you are welcome to the first lesson of this unit. This lesson
tries to introduce you to decision making techniques one can use as a
manager. One of the important functions of management is decision
making. Management Accounting helps in this crucial area by providing
relevant information to the management. Techniques like marginal costing
helps to generate information, which will be useful for taking decisions.
Decisions include make or buy decisions, adding or dropping a product line,
working of additional shift, shut down or continue operations, capital
expenditure decisions and so on. Decisions based on information are
expected to be more rational and objective rather than subjective.
By the end of this Session, the student should be able to:

 explain the decision making process
 understand the concept of relevant cost and revenues
Management Decision Making

Decision-making is one of the basic functions of management. It involves
selecting the best course of action from two or more available alternative.
Thus management is continuously engaged in evaluating various alternative
courses of action and in selecting best out of these. For each managerial
problem, generally there are at least two alternatives available. For example,
in a company, which is manufacturing televisions, the management may
have to decide whether to make the picture tube within the company or to
buy it from an outside supplier. Similarly, a company may have to decide
whether to sell in the domestic market at a profit or to accept an export order
at less than prevailing domestic price. The decision to be taken will be
affected by cost and other factors and the cost accountant must use all the
information at his disposal to help management make the right decision.
Decision Process
Various stages in decision-making process are summarized as follows:
 Defining the problem
This process must, as a minimum, identify root causes, limiting
assumptions, system and Organisational boundaries and any stakeholder
issues. The goal is to express the issue in a clear, one-sentence problem
statement that describes both the initial conditions and the desired
conditions. Of course, the one-sentence limit is often exceeded in the
practice in case of complex decision problems. The problem statement must
however be a concise and unambiguous written material agreed by all
decision makers and stakeholders. Even if it can be sometimes a long
iterative process to come to such an agreement, it is a crucial and necessary
point before proceeding to the next step.
 Identifying various alternatives

Alternatives offer different approaches for changing the initial condition
into the desired condition. Be it an existing one or only constructed in mind,
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any alternative must meet the requirements. If the number of the possible
alternatives is finite, we can check one by one if it meets the requirements.
The infeasible ones must be deleted (screened out) from the further
consideration, and we obtain the explicit list of the alternatives. If the
number of the possible alternatives is infinite, the set of alternatives is
considered as the set of the solutions fulfilling the constraints in the
mathematical form of the requirements.
 Determining relevant cost and revenue data and evaluating the

data.
When management makes decisions, it has to concentrate on relevant costs
and relevant revenues. Not all costs and revenues are relevant. The relevant
costs and relevant revenues are those expected future costs and expected
future revenues that differ under different alternative courses of action being
considered. Thus relevant costs and relevant revenues should have two
characteristics:
(a) The costs and revenues must relate to future, and
(b) They must differ among different courses of action
The focus in the future because decision to be made affect only future.
Nothing can be done to change the past. Management cannot change the
cost of plant and machinery purchases in 2001. It can change future costs by
its current decisions. Hence, relevant costs are future costs that will differ
depending on the actions of the management. For each decision, the
management must decide which costs are relevant.
 Weigh evidence. In this step, you draw on your information and

emotions to imagine what it would be like if you carried out each of the
alternatives to the end. You must evaluate whether the need identified in
Step 1 would be helped or solved through the use of each alternative. In
going through this difficult internal process, you begin to favor certain
alternatives which appear to have higher potential for reaching your
goal. Eventually you are able to place the alternatives in priority order,
based upon your own value system.
 Choose among alternatives. Once you have weighed all the evidence,
you are ready to select the alternative which seems to be best suited to
you. You may even choose a combination of alternatives. Your choice in
Step 5 may very likely be the same or similar to the alternative you
placed at the top of your list at the end of Step 4.
 Take action. You now take some positive action which begins to
implement the alternative you chose in Step 5.
Step 7: Review decision and consequences. In the last step you experience
the results of your decision and evaluate whether or not it has “solved” the
need you identified in Step 1. If it has, you may stay with this decision for
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ACCOUNTING II revenue
some period of time. If the decision has not resolved the identified need, you
may repeat certain steps of the process in order to make a new decision. You
may, for example, gather more detailed or somewhat different information
or discover additional alternatives on which to base your decision.
Types of Relevant Cost and Revenue

Relevant costs are future costs that will be changed by a decision, i.e. they
are future cash flows which are differentials between alternatives. A
relevant cost is a future cash flow arising from a direct consequence of a
decision. Irrelevant costs are costs that will not be affected by a decision.
Decision-making should be based on relevant costs
 Relevant costs are future costs:A decision is about the future; it cannot
alter what has been done already. Costs that have been incurred in the
past are totally irrelevant to any decision that is being made ‘now’. Such
costs are past costs or sunk costs. Costs that have been incurred include
not only costs that have already been paid, but also committed costs (a
future cash flow that will be incurred anyway, regardless of the decision
taken now.
 Relevant costs are cash flows. Only cash flow information is required.
This means that costs or charges which do not reflect additional cash
spending (such as depreciation and notional costs) should be ignored for
the purpose of decision-making
 Relevant costs are incremental costs. For example, if an employee is
expected to have no other work to do during next week, but will be paid
his basic wage (of say, GH¢ 100 per week) for attending work and doing
nothing, his manager might decide to give him a job which earns the
entity GH¢ 40. The net gain is GH¢ 40 and the GH¢ 100 is irrelevant to
the decision because although it is a future cash flow, it will be incurred
anyway whether the employee is given work or not.
 Other terms are sometimes used to describe relevant costs such as
Differential Costs. Differential Cost is the difference in total cost
between alternatives. For example, if decision option A costs GH¢ 300
and decision option B costs GH¢ 360, the differential cost is GH¢ 60
Opportunity Cost
 The CIMA Official Terminology defines an opportunity cost as, ‘the
value of the benefit sacrificed when one course of action is chosen, in
preference to an alternative.’
 Suppose for example that there are three options, A, B and C, only one
of which can be chosen. The net profit from each would be GH¢ 80,
GH¢ 100 and GH¢ 70, respectively. Since only one option can be
selected, option B would be chosen because it offers the biggest benefit,
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GH¢
Profit from option B100
Less opportunity cost (i.e. the benefit from the most profitable alternative)
80
Differential benefit of option 20
The decision to choose option B would not be taken simply because it offers
a profit of GH¢ 100, but because it offers profit of GH¢ 20 in excess of the
next best alternative.
Irrelevant Cost
 Past / Sunk cost: This is the cost which has already being incurred and
cannot be changed by any future action undertaken.
 Sunk costs are irrelevant for decision-making because they do not
change irrespective of the alternative course of action that is taken. The
principle underlying decision accounting is that management’s decisions
can only affect the future. Examples of sunk costs are: depreciation of
fixed assets (PPE), research and development costs which have already
been incurred.
Committed Cost
The committed cost is a cost that is primarily associated with maintaining
the organisation’s legal and physical existence over which management has
little discretion. The committed cost is a fixed cost which results from
decision of prior period. Committed cost does not fluctuate with volume and
remains unchanged until action is taken to increase or reduce available
capacity. Committed cost does not present any problem in cost behaviour
analysis. Examples of committed cost are depreciation, insurance premium,
rent, etc.
Notional Cost
Imputed (notional): The imputed cost is a cost which does not involve actual
cash outlay, which are used only for the purpose of decision making and
performance evaluation. Imputed cost is a hypothetical cost from the point
of view of financial accounting. Interest on capital is common type of
imputed cost. No actual payment of interest is made but the basic concept is
that, had the funds been invested elsewhere they would have earned interest.
Thus, imputed costs are a type of opportunity costs.
Conclusion
Session one has introduced us to the decision making process that a
manager faces in deciding what the organization should do or not do. In
doing this, we have realized that the manager shouldn’t lose sight of the
concept of relevant cost and irrelevant cost in the decision making process.
Since a decision is for the future, future cost/cash flows are relevant in the
decision making process. Past cost as we have seen is irrelevant.
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COST AND MANAGEMENT DECISION-MAKING AND MARGINAL COSTING
UNIT 4 SECTION
ACCOUNTING II 2
Unit 4, section 2: Decision making-marginal costing
Dear learner, once again you are welcome to Session 2 of unit 4. In this
Session we are looking at the role of marginal costing in the decision
making of managers. The most useful contribution of marginal costing is the
assistance that it renders to the management in vital decision-making. This
is to say that marginal costing is an invaluable aid to management decision-
making.

 explain areas where marginal costing assists in the decision making of
management.
Specific areas where marginal costing proves it worth in decision-making

are explained below:
Selling Price Decisions

Although prices are regulated more by market conditions of demand and
supply and other economic factors than by the decisions of management, the
management while fixing prices has to keep in view the level of profit
desired. In the long-run, the selling prices of products or services must be
higher than the total cost as otherwise the profit cannot be earned. But
frequently circumstances arise for management to consider special
conditions and sell its regular product at a special price which may be lower
than the total cost. Such conditions may be like the following:
 Under normal circumstances
 In times of competition and/or trade depression.
 Accepting additional bulk orders to utilize spare plan capacity
 Exploring foreign markets.
Selling prices under normal circumstances

In the long run, under normal circumstances, the selling price must cover
total cost (i.e., variable cost plus fixed cost) and also give a reasonable
amount of profit. This is essential for the survival of a business. In the short
run, the selling price may have to fix below total cost but it should be above
variable cost. In other words, the selling price may be temporarily fixed at
marginal cost plus contribution basis and the amount of contribution
depends upon demand and supply, acuteness of competition, non-cost
factors etc. But it should be noted that fixation of selling price below total
cost may be made only on a short term basis.
Pricing in competition and depression

When there is acute competition or in periods of depression, products may
have to be priced below total cost, if such a step is necessary to meet the
special situation. When marginal cost technique is used for pricing, the price
should be higher than the marginal cost so that it makes a contribution
towards fixed cost and help reduce the loss. When price is just equal to
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Unit 4, section 2: Decision making-marginal costing ACCOUNTING II
marginal cost, the amount of loss will also be equal to the amount of fixed
cost because in such situations the selling prices make no contribution
towards fixed costs.
Thus, under special circumstances, like the trade depression or competition,

if selling price is higher than marginal cost, even though it is below total
cost, the production should be not be stopped. This is because fixed costs
will have to be incurred irrespective of whether production is continued or
not, and continuing the production will help in reducing the amount of loss.
As a note of caution, fixation of selling price below total cost should be

made only on a short-term basis. Pricing based on marginal cost plus
contribution helps companies to take advantage of short-term opportunities.
But at the same time, no firm can afford to incur loss on a long-term basis
and thus in the long-run, the selling price must cover total cost and give a
reasonable amount of profit.
Example:
Fixed cost GH¢ 1,000,000 (total)
Marginal cost GH¢ 7 per unit
Current market price GH¢ 8 per unit
Output 50,000 units.
Should company Y sell or not?
Solution
Marginal cost (50,000 units @ GH¢ 7) GH¢ 350,000
Fixed cost 100,000
Total cost 450,000
Cost per unit = GH¢ 450, 000 ÷ 50,000 units = GH¢ 9
Although the selling price does not cover the total cost, yet it is wise to
continue to produce and sell because such a step will reduce the loss (on
account of fixed cost) that will be incurred if production is stopped. If
production is stopped, the loss would be GH¢ 100, 000 (the amount of fixed
cost), but if production is continued the loss will be as follows:
Sales (50,000 units @ GH¢ 8) GH¢ 400,000
Less: Total cost (Marginal cost + Fixed cost) GH¢ 450,000
Loss GH¢ 50,000
Thus, by continuing to produce and sell at below total cost, the loss is
reduced by GH¢ 50,000, i.e., from GH¢ 100,000 to GH¢ 50,000.
Selling Price below Marginal Cost

When selling price falls below marginal cost, the loss will be more than the
amount of fixed cost. In such an eventuality, it will be better to stop
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ACCOUNTING II Unit 4, section 2: Decision making-marginal costing
production so as to reduce the amount of loss because stoppage in

production means loss will be just equal to fixed cost.
However, in certain special circumstance like the following, production may
be continued even if the selling price is below the marginal cost.
 To popularizes a new product. A new product introduced in the market
may be sold at a very low price so as to make it popular.
 To eliminate competitors from the market.
 To dispose of perishable products so as to avoid total loss.
 To export so as to earn foreign exchange. Government may allow import
quota against foreign exchange earnings and profit from import quota
may be more than the loss on exporting the product at low prices.
 To keep plant and machinery in operation as idle machines may be liable
to deterioration.
 To prevent loss of future orders as temporary closure may break
business connections with customers that can be re-established at a
heavy expenditure.
 To help in the sale of a conjoined product which is making large profits.
 To maintain production and to keep employees occupied.
Exploring new markets to utilize spare plant capacity

Sometimes, a company is not able to fully utilize plant capacity when
selling at total cost plus profit basis. In such a case, it may explore new
markets and find opportunities to receive additional bulk order or export
order at a price which may be below total cost but above marginal cost so
that the price makes a ‘contribution’. The entire amount of contribution
from such sales is profit because fixed cost is already recovered from
current sales at total cost plus profit basis. Such additional sales at below
total cost is possible only because in accepting bulk orders and export sales,
price discrimination is possible. In this way spare plant capacity can be
utilized to earn additional profit.
Illustration 4.1
A manufacturer of plastic buckets makes an average profit of GH¢ 2.50 per
piece on a selling price of GH¢14.50 by producing and selling 60,000 pieces
at 60% of potential capacity. His cost of sales is:
GH¢ Per piece
Direct materials 4.00
Direct wages 1.00
Factory overhead (variable) 3.00
Selling overhead (variable) 0.25
Total fixed cost is GH¢ 225,000
During the current year, he intends to produce the same number of units, but
anticipates that (a) fixed cost will go up by 10% and (b) material and labour
costs will go up by 5% each.
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Under these circumstances, he obtains an offer for a further 20% of his

capacity. What minimum price you would recommend for acceptance to
ensure an overall profit of GH¢ 160,000.
Solution
Budgeted statement for the current year prior to acceptance of 20%
capacity order
Per piece Total
GH¢ GH¢
Sales (60,000 pieces) 14.50 870,000
Direct material (GH¢ 4 + 5%) 4.20 252,000
Direct labour (GH¢ 1 + 5%) 1.05 63,000
Variable factory overhead 3.00 180,000
Variable selling overhead 0.25 15,000
Variable cost 8.50 510,000
Contribution (Sales – Variable cost) 6.00 360,000
Fixed cost GH¢ 225,000 + 10% = GH¢ 247,500
Profit = Contribution– Fixed cost =360,000 – 247,500 = GH¢ 112,500

Planned profit = GH¢ 160,000
Increase in profit (or contribution) required = 160,000 – 112,500

= GH¢ 47,500
Variable cost of additional 20,000 pieces (order for 20% capacity, i.e.,
20,000 x GH¢ 8.50) = GH¢ 170,000
Add: Additional contribution desired GH¢47,500

Total sales value GH¢ 217,500
Selling price per unit = GH¢ 217,500 ÷ 20,000 units = GH¢ 10.875
Thus, minimum price for sale of additional 20,000 units is GH¢ 10.875 so
as to ensure an overall profit of GH¢ 160,000.
Exploring Foreign Markets–Export Sales

Additional orders may be accepted from a foreign market at below normal
price or below total cost but above marginal cost. Export sales yield
additional contribution when such sales are at a price which is above
marginal cost.
While determining profitability of accepting export orders, the following

additional factors should be considered.
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ACCOUNTING II Unit 4, section 2: Decision making-marginal costing
 Export sales may result in additional costs like special packing cost,
additional quality checks, freight and insurance charges, etc., if not
borne by importer. These costs should be deducted from contribution to
determine profit from export order.
 Export sales may result in certain cost benefits like export subsidy from
government, exemption or concessions in excise duty or duty
drawbacks, etc. In determining profit from export order, these items
should be deducted from cost or added in contribution.
Illustration 4.2
Ghana-British Company has a capacity to produce 5,000 articles but
actually produces only 2,000 articles for home market at the following costs.
GH¢
Materials 40,000
Wages 36,000
Factory overheads – Fixed 12,000
– variable 20,000
Administration overhead – Fixed 18,000
Selling and distribution overheads – Fixed 10,000
– variable 16,000
Total cost 152,000
The home market can consume only 2,000 articles at a selling price of GH¢
80 per article. An additional order for the supply of 3,000 articles is received
from a foreign country at GH¢ 65 article. Should this order be accepted or
not, if execution of this order entails an additional packing cost of GH¢
8,000.
Solution
Statement of Marginal Cost and Contribution
(of 3,000 articles for export)
GH¢
Materials @ GH¢ 20 per article 60,000
Wages @ GH¢ 18 per article 54,000
Variable overhead – Factory @ GH¢ 10 per article 30,000
– Selling and dist. @ GH¢ 8 per article 24,000
Material cost of sales 168,000
Sales (3,000 articles @ GH¢ 65) 195,000
Contribution 27,000
Less: Additional packing cost 3,000
Additional profit 24,000
Acceptance of this export order results in additional profit of GH¢ 24,000
and thus the order should be accepted.
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Note: Fixed overhead have not been taken into account in deciding the
acceptability of this order because fixed overhead have already been
recovered from sale in the home market.
Non-Cost Factors or Qualitative Factor. Apart from cost and profit

considerations, certain non-cost factors should also be kept in mind while
making an exporting decision. These include:
 Foreign exchange earnings.
 Export house status.
 Enhancement in company prestige and goodwill, etc.
 Employment opportunities.
Conclusion
 In normal times, prices should be based on total cost plus profit.
 In market conditions like trade depression and competition, price may be
fixed on marginal cost plus basis so as to make a contribution. This is
valid only for a short period.
 In order to utilize spare plant capacity, bulk orders from home market or
from foreign market may be accepted at less than total cost but above
marginal cost. This adds to the total profit of the company. This is
possible only when price discrimination is such sales in different
markets is possible.
UEW/IEDE 163
COST AND MANAGEMENT MAKE OR BUY DECISIONS
UNIT 4 SECTION
ACCOUNTING II 3
Unit 4, section 3: Make or buy decisions
Hello learner, welcome to Session 3 of unit one. I hope you are making
progress in your studies. Well done. In this Session, we will be looking at
another important topic being Make or Buy decisions. Businesses may be
faced with the decision whether to make components for their own product
themselves or to concentrate their resources on assembling the products, the
components from outside suppliers instead of making them ‘in house’.

 understand make or buy decisions that confronts management
 appreciate the sales mix appropriate for an organisation
Make or Buy Decisions

Marginal cost analysis renders useful assistance when a decision has to be
taken by the management on whether a component part should be
manufactured internally or purchased from an outside firm. In sourcing is
producing the goods by the firm itself whereas outsourcing is the process of
purchasing the goods or services from outside supplier. For example, a car
manufacture may rely on outside vendors to supply some component parts
but chooses to manufacture other parts internally.
This is particularly so when a component part is available in the market at a

price below firm’s own total cost. This type of decision based on total cost
analysis may be misleading. Such a decision can be arrived at by comparing
the outside supplier’s price with firms’ own marginal cost. On the face of it,
since the only cost to manufacture the component is its marginal cost, then
the amount by which marginal cost falls below supplier’s price is the saving
that arises in making. Therefore, it will be profitable to buy from outside
only when supplier’s price is below firm’s own marginal cost.
For example, total cost of making a component is GH¢ 100 per unit,
consisting of GH¢ 80 as variable cost and GH¢ 20 as fixed cost. Suppose,
an outside firm is prepared to supply this component at GH¢ 90, it may
appear that it is cheaper to buy the component. But a study of cost analysis
will show that each unit if manufactured makes a contribution of GH¢ 20
towards recovery of fixed cost. This fixed cost has to be incurred whether
we make or buy. The real cost of making the component part is only GH¢
80 which is its variable cost. This offer of GH¢ 90 per unit should not be
accepted because if accepted, the component will really cost GH¢ 110, i.e.,
GH¢ 90 of purchase price plus GH¢ 20 of fixed cost which cannot be saved
if component is not produced.
However, before arriving at final decision, due consideration should be

given to other factor GH¢ For example, it should also be considered as to
whether plant capacity released by the non-manufacture of the component
part is put to some alternative use or not.
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Unit 4, section 3: Make or buy decisions ACCOUNTING II
Outsourcing and Idle Capacity.

When a firm has no spare capacity and manufacturing a component involves
setting aside other work, the loss of contribution of displaced work should
also be given due consideration. In other work, it will be profitable to buy
only when the purchase price is below marginal cost plus loss of
contribution of displaced work. The loss of contribution is usually best
found by the use of contribution per unit of key factor.
Illustration 4.3
Manufacture of product A takes 20 hours on machine No. 101. It has a
selling price of GH¢150 and marginal cost of GH¢ 110. Component part Y
could be made on machine No. 101 in 4 hour at GH¢2 per hour. The
marginal cost of component part is GH¢ 9 of which outside supplier’s price
is GH¢ 15.
Should one make or buy component Y. Discuss in both situation when
a) Machine No. 101 is working at full capacity.
b) There is idle capacity.
Solution
a)
Contribution per unit of A = GH¢ 150 – 110 = GH¢ 40
Contribution per machine hour = GH¢ 40 ÷ 20hrs = GH¢ 2 per hour
If component Y is manufactured then as it takes 4 hours, the loss of

contribution is GH¢ 8 (i.e., 4hrs @ GH¢ 2). The total cost to make
component Y will be GH¢ 9 ÷ GH¢ 8 = GH¢ 17.
This is more than supplier’s price of GH¢ 15 and so it is better to buy than
to make component Y.
b) If, however, there is some unutilized machine capacity, then there would
be no loss of contribution and so the cost of making component Y would
only be its marginal cost, i.e. GH¢ 9. In such a case, it would be
economical to make the product than buy it.
Non-cost or qualitative factor. While making a decision on make or buy a

component, the following non-cost factors should also be considered.
a) Assurance of continued supply, if bought from outside.
b) Assurance of quality of the product by the supplier.
c) Assurance of no price increase during the period of agreement.
 Sales Mix Decisions

Sales mix or product mix denotes the proportion in which various products
are sold or produced. The problem of selecting a profitable mix of sales
thus, arises only when a business enterprise has a variety of product lines
and each making a contribution of its own. Any change in sales mix also
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ACCOUNTING II Unit 4, section 3: Make or buy decisions
results in the change in profit position. The technique of marginal costing

helps the management in determining the most profitable sale mix.
The discussion on selection of the most profitable product mix may be

discussed in two parts:
a) When there is no key factor, and (b) when there is a key factor
 When there is no key (or limiting) factor

The concept of key factor was explained in the chapter on Cost Volume
Profit Analysis. When there is no key factor, the product mix that provides
the highest amount of contribution is considered as the most profitable sales
mix. This holds good when fixed cost does not change due to changes in
sales mix.
However, when changes in sales mix are associated with changes in fixed
cost, then that sales mix which provides the highest profit is considered as
the most profitable sales mix. In other words, relative profitability of mixes
will be evaluated on the basis of their profit and not on the basis of their
contribution when a change in product mix is associated with change in
fixed cost.
Illustration 4.4
Allied Manufacturing Company had given you the following information.
Product A GH¢ Product B GH¢
Fixed overhead – GH¢ 10,000 p.a.
Direct materials per unit 20 25
Direct labour per unit 10 15
Variable overhead (100% of direct
labour)
Selling price per unit 60 100
You are required to present a statement showing the marginal cost of each
product and recommend which of the following sales mixes should be
adopted:
a. 900 units of A and 600 unit of B.
b. 1,800 units of A only.
c. 1,200 units of B only.
d. 1,200 units of A and 400 units of B.
Solution
Per unit
Product A Product B
GH¢ GH¢
Direct materials 20 25
Direct labour 10 15
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Variable overhead 10 15
Marginal cost 40 55
Contribution 20 45
Selling price 60 100
Statement of Contributions and Profits of different Sales Mixes

Sale mix Contribution Contribution Total Fixed Profi
per unit GH¢ Contribution Cost t
GH¢ GH¢ GH¢ GH¢
a) A – 20 18000
900 45 27000 45,000 10,000 35,00
unit 0
s
B – 600
units
b) A – 20 36,000
1,80 45 Nil 36,000 10,000 26,00
0 0
unit
s
B – Nil
c) A – 20 Nil
Nil 45 54,000 54,000 10,000 44,00
B – 1,200 0
units
d) A – 20 24,000
1,20 45 18,000 42,000 10,000 32,00
0 0
unit
s
B – 400
units
Thus, sales mix (c) is recommended as it yields the highest profit of GH¢
44,000. This is because contribution per unit of B is more than that of A,
and therefore, any sales mix that takes into account the maximum number of
units of B would be more profitable.
 When there is a key factor

When a key factor is operating, selection of the most profitable sales
mix is based on contribution per unit of key factor. The product which
makes the highest amount of contribution per unit of key factor is the
most profitable one and its production is pushed up. The second
preference is to be given to product which yields the second highest
contribution per unit of key factor and so on and in the end that product
should be produced which yields least contribution per unit of key factor
and to the extent of availability of the key factor.
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In case a number of key factors are operating simultaneously, the basic

principle remains the same but problem becomes more mathematical in
nature and one has to resort to Linear Programming to determine the
optimal product mix.
Illustration 5.5
A company manufactures three products. The budgeted quantity, selling
prices and unit costs are as under:
A B C
GH¢ GH¢ GH¢
Raw materials (@ GH¢ 20 per kg) 80 40 20
Direct wages (@ GH¢ 5 per hour) 5 15 10
Variable overheads 10 30 20
Fixed overheads 9 22 18
Budgeted production (in units) 6,400 3,200 2,400
Selling price per unit (in GH¢) 140 120 90
Required:
i) Present a statement of budgeted profit.
ii) Set optimal product-mix and determine the profit, if the supply of
raw materials is restricted to 18,400kg.
Solution
(i) Statement of Budgeted Profit
A B C Total
GH¢
Budgeted production (units) 6,400 3,200 2,400
Selling price GH¢ 140 120 90
Sale (S) 896,000 384,000 216,000 1,496,00
0
Raw materials 512,000 128,000 48,000
Direct wages 32,000 48,000 24,000
Variable overhead 64,000 96,000 48,000
Total variable cost (V) 608,000 272,000 120,000 1,000,00
0
Contribution (S-V) 288,000 112,000 96,000 496,000
Less: Fixed cost* 171,200
Profit 324,800
Calculation of Fixed Cost

A = 6,400 unit x GH¢ 9 GH¢ 57,600
B = 3,200 units x GH¢ 22 70,400
C = 2,400 units x GH¢ 18 43,200
Total fixed cost = GH¢ 171,200
iii) When raw material is the key factor
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A B C
Raw material per 4kg 2kg 1kg
unit of output
Total raw material 6400 × 4 3200 × 2 2400 × 1

consumed (kg)
= 25,600 = 6,400 = 2,400
Contribution per kg GH¢ 288,000 GH¢ 112,000 GH¢ 96,000

= = =
of raw material 25,600kg 6,400 kg 2,4000kg
Ranks III II I
Contribution per kg of raw material is calculated as:

Total contribution ÷ Total raw materials consumed.
Suggested sales mix (raw material is the key factor)

Rank I – Product C – 2,400 units x 1 kg = 2,400kg
Rank II – Product B – 3,200 units x 2kg = 6,400kg
Rank III – Product A – 2,400units x 4kg (balance) = 9,600kg
Total materials = 18,400kg
Thus product mix is: A – 2,400 units, B – 3,200units and C – 2,400 units
Calculation of profit Contribution
Product A 2,400 units @ GH¢ 45 per unit. GH¢ 108,000
B 3,200 units @ GH¢ 35 per unit GH¢ 112,000
C 2,400 units @ GH¢ 40 per unit. GH¢ 96,000
Total contribution 316,000
Less: Total fixed cost 171,200
Profit 144,800
Make or Buy under Limiting Factor Conditions

Where there are limiting factors on production other than sales (eg
materials, labour etc) one way of overcoming the limitation on production is
to sub-contract the work. Where this problem arises, profit is maximized by
producing or buying all the components or products at the cheapest costs.
The costs of bought in components supplied by sub-contractors normally
exceeds the marginal cost of making products internally, because the
supplier’s cost includes a contribution/profit margin on his costs. A
company would then prefer to make all its own products, but the limiting
factor makes it impossible.
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Illustration 5.6
Paurene ltd. manufactures three components, the shotter, the alba and the
tross using the same machine for each. The budget for the next year calls for
the production and assembly of 4,000 of each component.
The variable production cost per unit of the final product, is
Machine hours variable cost (GH¢)
1 unit of shotter 2 20
1 unit of alba 2 36
1 unit of tross 4 24
Assembly 20
100
Only 24,000 hours of machine time will be available during the year, and a
sub-contractor has quoted the following unit prices for supplying
components.
Shotter GH¢29 alba GH¢40 Tross GH¢34 Advice Paurene Ltd.
Solution
a. There is a short fall in machine hours available, and some products must
be sub-contracted:
Product Unit Machine hours
Shotter 4,000 12,000
Alba 4,000 8,000
Tross 4,000 16,000
Required 36,000
Available 24,000
Shortfall 12,000
b. the assembly costs are irrelevant costs because they are unaffected by the
make or buy decisions. The units sub contracted should be those which will
add least to the costs of Paurene Ltd. Since 12,000 hours of work must be
sub contracted, the cheapest policy is to sub-contract work which adds the
least extra costs.
c.
Shotter Alba Tross
(GH¢) (GH¢) (GH¢)
Variable cost making 20 36 24
Variable cost of buying 29 40 34
Extra variable cost of buying 9 4 10
Machine hours saved by buying 3hrs 2hrs 4hrs

Extra V.C of buying /hr. saved GH¢3 GH¢2 GH¢2.5
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It is cheaper to buy alba than to buy Tross and it is most expensive to buy
Shotters. The priority for making the components in house will be in the
reverse order to the preference for buying them from a sub-contractor.
Make 1st Shotter
2nd Tross
3rd Alba
d.
component Hrs. per unit hrs. Required cumulative
to make in house in total hrs
Shotter 3hrs 12,000 12,000
Tross 4hrs 16,000 28,000
Alba 2hrs 8,000 36,000
Hours available 24,000
12,000
There are enough machine hours to make all 4,000 units of shotter and
3,000units of Tross. 8000 hours production of Alba and 4000 hours of Tross
must be sub contracted.
E.
Component Machine hrs number of units Unit V.C Total V.C
GH¢ GH¢
Shotter 12,000 12,000 20 80,000
Tross(bal) 12,000 3,000 24 72,000
24,000 152,000
Buy Hrs saved
Tross (bal) 4,000 1,000 34 34,000
Alba 8,000 4,000 40 160,000
Total variable costs of components = 80,000

Assembly costs (4,000* GH¢20) = 426,000
This is the highest cheapest production policy available.
Conclusion
Management of any organization must be careful in deciding which
products to produce themselves or to buy from outside. It is a very hectic
decision which must be taking by looking at the various relevant cost
involve in either making the product or buying the product from outside. By
so doing the profitability of the company will not be compromised.
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COST AND MANAGEMENT SELECTION OF SUITABLE METHOD OF PRODUCTION
UNIT 4 SECTION
ACCOUNTING II 4
Unit 4, section 4: Selection of suitable method of production
Hello learners lets continue our studies in unit 4. In this Session we are
looking at how to select a suitable method of production in producing a
particular product. The management should select the method which gives
the largest contribution (i.e. the lowest marginal cost), keeping in view the
limiting factor.

 identify and proof with figures a suitable production method for a
particular product
 appreciate why an organization may decide to shutdown
 explain role of committed and discretionary fixed costs in shutdown
decisions.
Production Method Decision

Sometimes the management is confronted with the problem of choosing
from amongst alternative methods of production. For example, a new
product may have been developed and the management is faced with the
problem of determined the best method of production, i.e., whether to
employ a machine or to produce entirely by hand labour. Similarly,
management may have to decide whether to employ an ordinary machine or
an automatic machine.
Example, X Ltd. has developed a new product which can be manufactured

on Machine I or Machine II.
Machine I Machine II
(a) Total machine hours per annum 3,000 3,000
(b) Production per hour 5 units 8 units
GH¢ GH¢
(c) Selling price per unit 200 200
Material per unit 70 70
Labour per unit 30 20
Variable overheads per unit 50 70
(d) Marginal cost per unit 150 160
(e) Contribution per unit (c – d) 50 40
(f) Contribution per hour (e x b) 250 320
(g) Contribution per annum (f x a) 750,000 960,000
Apparently, machine II is more profitable as it makes a large contribution

provided there is no other factor to be considered.
Plant Shut Down Decisions

The management under certain circumstances might feel that plant shut
down, i.e., closing down the business is better than operating at a loss.
However, marginal costing analysis may prove that this is not always so.
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Unit 4, section 4: Selection of suitable method of production ACCOUNTING II
This type of situation usually arises when sufficient sales cannot be

achieved.
This type of decision may be either (a) temporary suspension of production
activities, or (b) permanent closing down of production.
 Temporary closed down. Temporary suspension of activities is a short-

term measure. The object is usually to stop operations until trade
depression has passed. The question before management is: when should
operations be suspended? Or in other words, how long should operations
be continued? The answer to this question is that if products are making
a contribution towards fixed cost, then generally speaking, production
should not be suspended. This is so because continuing production will
help minimizing loss which would be incurred if plant is shut down.
Thus, the information needed to solve this type of problem involves a
comparison between probable loss at a given level of output and the loss
that would be suffered if production is suspended temporarily.
Example: A manufacturing company supplies you the following
information:
Normal capacity of plant 10,000 units
Fixed cost GH¢ 100,000
Marginal cost per unit GH¢ 75
Estimated selling price GH¢ 80
Estimated sales volume at this selling price 5,000 units

Total sales (5,000 units x GH¢ 80) 400,000
Less: Marginal cost (5,000 units x GH¢ 75) 375,000
Contribution 25,000
Fixed cost 100,000
Loss (-)75,000
If plant is shut down, the loss due to fixed cost would be GH¢ 100,000.
However, if plant is operated, the loss would only be GH¢ 75,000. This is
because selling price is above the marginal cost and is making a
contribution towards fixed cost.
 Role of Committed and Discretionary Fixed Costs. Sometimes,

certain fixed costs can be avoided by management when plant is not
operative. These are termed as discretionary fixed costs. Committed
fixed costs, on the other hand, are those that cannot be avoided even if
production is discontinued.
In decisions to close down temporarily, contribution should be

compared with fixed cost which is to be incurred when plant is shut
down, i.e, committed fixed cost.
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ACCOUNTING II Unit 4, section 4: Selection of suitable method of production
Examples of fixed costs which may be avoided by closing down are:

advertisement cost, research and development, part of salaries, etc.
Longer the period of shut down, the larger the amount of avoidable fixed
cost is likely to be.
Example
Normal capacity of plant 10,000 units
Fixed cost when plant is operating GH¢ 100,000
Fixed cost when plant is shut down GH¢ 80,000
Variable cost per unit GH¢ 75
Selling price per unit GH¢ 80
Estimated sales volume at this price – 5,000 units

Total sales (5,000 units @ GH¢ 80) 400,000
Less: Marginal cost (5,000 units @ GH¢ 75) 375,000
Contribution 25,000
Fixed cost 100,000
Loss (-) 75,000
Now if the plant is shut down, the loss due to fixed cost would be GH¢
80,000 whereas, if plant is operated, the loss would be GH¢ 75,000 (i.e.,
80,000 – 75,000). Thus keeping in view this small amount, operating a plant
offers certain non-cost advantages like keeping the plant in gear, retaining
the customers, retaining all the skilled labour and managerial personnel.
Thus, it would be advisable to continue the production even if there is a
small amount of loss because the non-cost factors outweigh the loss.
In case the selling price is below the marginal cost and makes no
contribution towards fixed cost, then on cost considerations, the plant
should be temporarily shut down. But a final decision in the regard should
be taken after considering non-cost factors like effect of shut down on plant,
fear of losing the market, effect on relationship with workers and suppliers,
etc.
 Permanent Shut Down. So far as permanent closing down of business

is concerned, such a decision is a drastic step and should be taken only
when in the long run, the business does not expect to earn a sufficient
return to cover the risk involved. In other words, in the long-run, selling
price must not only cover the total cost but should also give a reasonable
return on the capital employed.
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Unit 4, section 4: Selection is leftmethod
suitable blank for your notes ACCOUNTING II
of production
UEW/IEDE 175
COST AND MANAGEMENT DIFFERENTIAL COST ANALYSIS
UNIT 4 SECTION
ACCOUNTING II 5
Unit 4, section 5: Differential cost analysis
You are most welcome to the last but one Session of unit 4. In this Session
attention will be focused on differential cost analysis. It has been stated
earlier that in decision-making, the management has to compare two or
more alternatives. Differential cost analysis is a special technique to help
management in decision-making which shows how costs and revenues
would be different under different alternative courses of action.

 explain differential cost
 outline the link similarities and differences between differential cost and
marginal costing
Meaning of differential Cost

Differential cost is the difference in cost between one alternative and
another. It is obtained by subtracting the cost of one alternative from the
cost of the other alternative. For example, when management is considering
a change in the level of production, differential cost will be calculated by
subtracting the cost at lower level of production from that of a higher level.
Example:
Alternative I Alternative Differential
II cost/revenue
Output (units) 5,000 7,500 2,500
GH¢ GH¢ GH¢
Materials 20,000 30,000 10,000
Labour 6,000 9,000 3,000
Variable overhead 4,000 6,000 2,000
Fixed overhead 5,000 6,000 1,000
Total cost 35,000 51,000 16,000
Sales 50,000 70,000 20,000
Thus, in order to produce additional 2,500 units, additional cost is GH¢

16,000 (i.e., 51,000 – 35,000). In other words, differential cost for 2,500
units is GH¢ 16,000. It should be noted in this example, that if additional
output does not involve any additional fixed cost to be incurred, the
differential cost will be equal to marginal or variable cost. Thus, when fixed
costs remain constant, the differential cost is synonymous with the variable
costs of producing the n-units. It is for this reason that differential cost is
sometimes referred to as marginal cost.
Sometimes the term incremental cost is also interchangeably used with

differential cost. The readers should note that incremental cost actually
means only an increase in cost from one alternative to another. In the above
example, it costs GH¢ 51,000 to produce 7,500 units and GH¢ 35,000 to
produce 5,000 units, the incremental (and differential) cost of producing
additional 2,500 units is GH¢ 16,000. In the same way, differential cost may
176 UEW/IEDE
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Unit 4, section 5: Differential cost analysis ACCOUNTING II
be referred to a decremental cost, were decrease in output is being

considered.
Incremental Revenue. Difference in revenue of two alternatives is termed

as incremental revenues. In differential cost analysis, decisions are taken on
the basis of comparison of differential cost with incremental (or
decremental) revenue. An alternative is considered profitable when
incremental revenue is more than differential cost. In the above example,
differential cost is GH¢ 16,000 whereas incremental revenue is GH¢ 20,000.
This means alternative II produces additional profit of GH¢ 4,000 (i.e.,
20,000 – 16,000) and is thus, acceptable.
Differential Cost Analysis vs. Marginal Costing

As stated earlier, differential cost may be synonymous with marginal cost.
In fact, the theory of marginal costing is only a part of the more
comprehensive technique of differential costing. There two techniques are
similar in some respects but also differ in certain other fields. The points of
similarity and difference are summarized below:
Similarities
 Both the techniques are based on the classification of costs into fixed
and variable. When fixed costs do not change, the differential cost and
marginal cost are the same.
 Both differential costing and marginal costing are techniques of cost
analysis and presentation.
 Both the techniques are used by the management in decision-making
and formulating policies.
Difference
 The technique of marginal costing excludes all fixed costs from its
analysis, whereas, differential cost analysis includes identifiable or
traceable fixed costs. (Identifiable fixed cost are those which change
between alternatives since these are identifiable with specific
alternative).
 Marginal costs may be incorporated into the formal accounting system
while differential costs are worked out separately for reporting to
management for making specific decisions.
 In marginal costing, contribution, P/V ratio, key factors, etc., are the
main yardsticks for evaluation of performance and making-decisions. In
differential cost analysis, on the other hand, comparison is made
between differential cost and incremental revenue for decision-making
purposes.
 Differential cost analysis can be made in the case of both absorption
costing as well as marginal costing.
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ACCOUNTING II Unit 4, section 5: Differential cost analysis
Practical Applications of Differential Cost Analysis

Many marginal decisions involving problems of alternative choices are
made with the help of differential cost analysis. Such decisions include the
following:
 Determination of the Optimum Level of Production

The optimum level is that level of production where profit is the maximum.
In order to arrive at a decision of this type, the differential costs are
compared with incremental revenue at various levels of output. So long as
the incremental revenue exceeds differential costs, it is profitable to increase
the output. But as soon as the differential cost equals or exceeds incremental
revenue, it is no more profitable to increase the volume of output.
Illustration 5.1
A company has a capacity of production 100,000 units of a certain product
in a month. The sales department reports that the following schedule of sale
prices is possible:
Volume of production Selling price per unit

GH¢
At 60% capacity 60,000 units 0.90
Variable cost of manufacture is 15 piece per unit and total fixed cost GH¢
40,000.
Prepare a statement showing incremental revenue and differential cost of

each stage. At which volume of production will the profit be maximum?
Solution
Statement of Differential Cost and Incremental Revenue
Capa Units Variable Fixed Total Different Sales Increm
city of cost @ cost cost ial cost GH¢ ental
output GH¢ GH¢ GH¢ GH¢ revenu
0.15 e
GH¢ GH¢
60% 60,00 9,000 40,000 49,000 __ 54,0 __
0 00
70% 70,00 10,500 40,000 50,500 1,500 56,0 2,000
0 00
80% 80,00 12,000 40,000 52,000 1,500 60,0 4,000
0 00
90% 90,00 13,500 40,000 53,500 1,500 60,3 300
0 00
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Unit 4, section 5: Differential cost analysis ACCOUNTING II
100% 100,0 15,000 40,000 55,000 1,500 61,0 700

00 00
At 80% volume of production, profit is maximum. This is because at this

level, incremental revenue is GH¢ 4,000 whereas, differential cost is GH¢
1,500, resulting in additional profit of GH¢ 2,500 (i.e., GH¢ 4,000 – 1,500).
After 80% level, differential cost exceeds incremented revenue thereby
resulting in a loss.
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COST AND MANAGEMENT OTHER SHORT TERM DECISIONS
UNIT 4 SECTION
ACCOUNTING II 6
Unit 4, section 6: Other short term decisions
Hello learner, you are most welcome to the last Session of unit four. I hope
you have enjoyed the previous lessons in this unit. Session six will be
looking at some other important short term decisions that management is
likely to be confronted with so that resources will be used judiciously.

 explain whether a special order should be accepted or rejected
 explain why an organization should add or drop a product line
 understand decisions regarding further processing of joint/by-products
Acceptance of a Special Order

Sometimes management has to take a decision to accept or refuse an
additional order for one of its products at a price which is below the
customary sale price. Such an order can prove attractive when a business is
working below full production capacity and the price offered results in
incremental revenue which is more than differential costs.
Illustration 5.1
Reproduce
A company has a capacity of production 100,000 units of a certain product
in a month. The sales department reports that the following schedule of sale
prices is possible:
Volume of production Selling price per unit

GH¢
Variable cost of manufacture is 15 piece per unit and total fixed cost GH¢
40,000.
Prepare a statement showing incremental revenue and differential cost of

each stage. At which volume of production will the profit be maximum?
Example: Continuing Illustration 5.1 if there is a bulk offer for export at

GH¢.50 per unit for the balance capacity over the maximum profit volume
and the price quoted will not affect the internal sales, will you advise
accepting this bid and why?
Solution
Internal Special order Total
market for export (1,00,000
(80,000 units) (20,000 units)
units)
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Unit 4, section 6: Other short term decisions ACCOUNTING II
GH¢ GH¢ GH¢

Variable cost @ GH¢.15 12,000 3,000 15,000
per unit
Fixed cost 40,000 __ 40,000
Total cost 52,000 3,000 55,000
Sales 60,000 10,000 70,000
Profit 8,000 7,000 15,000
It is advisable to accept the bulk offer @ GH¢ 0.50 per unit for the balance
capacity of 20,000 units (i.e., 100,000 – 80,000) for export as it will result in
an increase of profit by GH¢ 7,000.
Adding or dropping a product line

In a multi-product company, the management may have to decide on adding
or dropping a product line. When a new product line is added, its sales and
certain costs will also be increased and reverse will happen when a product
line is dropped. In order to arrive at such a decision, the management should
compare the differential cost and incremental revenue and study its effect on
the overall profit position of the company.
Illustration 6.1
The management of a company is thinking whether it should drop one item
from the product line and replace it with another. Given below are present
cost and output data:
Product Price GH¢ Variable costs Percentage of

per unit GH¢ sales
Book shelf 60 40 30%
Table 100 60 20%
Bed 200 120 50%
Total fixed costs per year GH¢ 750,000

Sales GH¢ 2,500,000
The change under consideration consists in dropping the line of Tables and
adding the line of Cabinets. If this change is made, the manufacture
forecasts the following cost and output data:
Product Price GH¢ Variable costs/ Percentage of

unit GH¢ sales
Book shelf 60 40 50%
Cabinet 160 60 10%
Bed 200 120 40%
Total fixed costs per year GH¢ 750,000

Sales GH¢ 2,500,000
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ACCOUNTING II Unit 4, section 6: Other short term decisions
Should this proposal be accepted? Comment.
Solution
Comparative Profit Statement
Existing situation Proposed situation
Book Table Bed Total Book Cabin Bed Total
shelf et
Sales 750,0 500,00 1,25 2,500,0 1,300 260,00 1040 2600,000
00 0 0,00 00 ,000 0 ,000
0
Less: variable
cost 500,0 300,00 750, 1,550,0 866,6 97,500 6,24, 1588,167
00 0 000 00 67 00
Contribution 250,0 200,00 500, 950,00 433,3 162,50 4,16, 1011,833
00 0 000 0 33 0 000
Less: Fixed cost 750,00 750,000
0
Profit 200,00 261,833
0
Incremental revenue = GH¢ 26, 00,000 – GH¢ 25, 00,000

= GH¢ 1, 00,000
Differential cost = GH¢ 1,588,167 – 1,550,000

= GH¢ 38,167
Additional profit Incremental revenue – Differential cost

= GH¢ 100,000 – 38,167
= GH¢ 61,833
Total profit has increased by GH¢ 61,833 from GH¢ 200,000 to GH¢
261,833 by accepting the proposal. Thus, the proposal to drop the line of
Tables and add the line of Cabinets should be accepted.
Working Notes:
Variable cost is calculated as under:
Book shelf (Present situation)
Sales = 2,500,000 × 30% = GH¢ 750,000
When selling price of book shelf is GH¢ 60, its variable cost is GH¢ 40
Thus:
750,000× GH¢ 40
Variable cost = = GH¢ 5,00,000
GH¢ 60
Book shelf (Proposed situation)
Sales = 2,600,000×50% = GH¢ 1,300,000
Variable cost = 750,000 × GH¢ 40 = GH¢ 866,667
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GH¢ 60
Similar calculations are made for other lines of products.
Evaluating make or buy alternatives

Make or buy decisions based on marginal costing have already been
discussed in this chapter. However, when making of a component requires
addition investment in plant, it results in additional fixed cost to be incurred.
In such a situation make or buy decision is based on comparison of
differential cost and incremental revenue and its effect on profit.
Decision regarding further processing of joint/by-products

Sometimes management has to take a decision regarding further processing
of joint or by-products after split off point. For example, a milk dairy may
sell cream as such or further process it into butter or ghee. In such a case
apportionment of joint cost up to split off point is not relevant for the
purpose of decision-making regarding further processing of joint products or
by-products. Such decisions are taken and the basis of process a product if
incremental revenue is more than differential cost on further processing.
Illustration 6.2
A food-processing company produces four products from a single raw
material. These four products are obtained simultaneously at the point of
separation. The product R does not require further processing before being
taken to the market. The other three products P, Q and S require further
processing before being sold.
The output, sales and further process costs for the last year were as follows:
Product Output (units) Further Sales (GH¢)
processing costs
(GH¢)
P 4,000 5,000 36,000
Q 3,500 1,750 14,000
R 2,500 __ 20,000
S 1,200 3,250 12,000

Assess the change in the profit/loss, if a proposal (stated below) made by the
top management is accepted.
PROPOSAL: To sell all the products directly to other processors just after
separation without any further processing. The expected price per unit for
the products are: P – GH¢ 7, Q – GH¢ 3.50, R – GH¢ 8 and S – GH¢ 9.
Solution
Statement of differential cost and incremental revenue
Pro Sales Numbe Sellin Sales Incremen Differe
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COST AND MANAGEMENT
duct after r of g before tal ntial

further units price further revenue cost
processi before processing (furthe
ng GH¢ furthe GH¢ r
r process
proces ing
sing cost)
GH¢ GH¢
(1) (2) (3) (4) = 2 x 3 (5) = 1 – 4
P 36,000 4,000 7.00 28,000 8,000 5,000
Q 14,000 3,500 3.50 12,250 1,750 1,750
R 20,000 2,500 8.00 20,000 __ __
S 12,000 1,200 9.00 10,800 1,200 3,250
Tota 10,950 10,000
l
Comment: Incremental revenue from further processing of all products is

higher at GH¢ 10,950 than differential cost at GH¢ 10,000 resulting in
additional profit of GH¢ 950. Thus, as a package products should be further
processed. But if considered individually only product P should be
processed further.
Conclusion
When an additional shift is introduced, certain costs are bound to rise. Such
additional costs should be compared with additional revenue so that their net
effect on profit can be known for managerial decision. Thus, differential
cost analysis helps management to decide whether additional shift should be
introduced or not.
Problems And Solutions

Problem 1 (Export Order) A company producing 24,000 units provides you
the following information:
GH¢
Direct wages 84,000
Variable overheads 48,000
Semi-variable overheads 28,000
Fixed overheads 80,000
Total cost 360,000
The product is sold at GH¢20 per unit.
The management proposes to increase the production by 3,000 units for

sales in the foreign market. It is estimated that the semi-variable overheads
will increase by GH¢ 1,000. But the product will be sold at GH¢ 14 per unit
in the foreign market. However, no additional capital expenditure will be
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incurred. The management seeks your advice as a cost accountant. What

will you advise them?
Solution
Total Per unit
(24,000 units)
GH¢ GH¢
(A) Sales 480, 000 20.00
 Direct materials 120,000 5.00
 Direct wages 84,000 3.50
 Variable overheads 48,000 2.00
(B) Marginal cost 252,000 10.50
(C) Contribution (A – B) 228,000 9.50
If production of additional 3,000 units is undertaken for sale in the foreign

market, the position of cost and profit will be as follows:
Total (3,000units)
Additional sales (3,000× GH¢ 14) 42,000
Less: Marginal cost (3,000× GH¢ 10.50) 31,500
Additional contribution 10,500
Less: Increase in semi-variable overheads 1,000
Net addition to profit 9,500
Acceptance of this offer for sale in the foreign market at GH¢ 14 per unit
will yield an additional profit of GH¢ 9,500. Therefore, the offer should be
accepted.
Problem 2
R.B. & Company is presently operating at 505 of practical capacity
producing about 50,000 units annually of a patented electronic component.
R.B. recently received an offer from overseas market to sell 30,000
components at GH¢ 6.00 per unit, FOB R.B.’s plant. R.B. has no previously
sold components in this market. Budgeted production sot for 50,000 and
80,000 units of output is as follows:
Units 50,000 80,000
Costs GH¢ GH¢
Direct material 75,000 120,000
Direct labour 75,000 120,000
Factory overhead 200,000 260,000
350,000 500,000
Cost per unit 7.00 6.25
The sales manager thinks the order should be accepted, even if it results in a
loss of GH¢ 1.00 per unit, because he feels the sales may build up future
market. The production manager does not wish to have the order accepted
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COST AND MANAGEMENT
primarily because the order would show a loss of GH¢ 0.25 per unit when
computed on the new average unit cost. The cost accountant has made a
quick computation indicating that accepting the order will actually increase
profit.

 Explain what apparently caused the drop in cost from GH¢ 7.00 per unit
to GH¢ 6.25 per unit when budgeted production increased from 50,000
to 80,000 units. Show supporting computations.
 Should the order be accepted?
Solution
Statement of Cost
50,000 units 80,000 units
Direct material Total Per unit Total Per unit
Direct labour GH¢ GH¢ GH¢ GH¢
Factory overhead 75,000 1.50 1,20,000 1.50
Variable 75,000 1.50 1,20,000 1.50
Fixed 1,00,000 2.00 1,60,000 2.00
Total 3,50,000 7.00 5,00,000 6.25
Calculation of Fixed overhead

Difference in factory overhead between two level = 260,000 – 200,000
= GH¢ 60,000
Thus, variable overhead for 30,000 (additional) units = GH¢ 60,000
Variable overhead per unit = 60,000 ÷ 30,000
= GH¢ 2
Variable overhead for 50,000 units = 50,000 ÷GH¢ 2
= GH¢ 100,000
Fixed cost = 200,000 – 100,000
= GH¢ 100,000
Comments
a. The drop in cost per unit from GH¢ 7 to GH¢ 6.25 is because of
decrease in fixed cost per unit. This is so because at 50,000 units fixed
cost is GH¢ 2 per unit while at 80,000 units this comes down to GH¢
1.25. This decrease in fixed cost by GH¢0.75 has resulted in drop in
total cost by 0.75 i.e., from GH¢ 7 to GH¢ 6.25. It is important to note
that fixed cost per unit comes down when output is increased.
b. The order from overseas, market should be accepted as it makes a
contribution to profit. This is shown below:
GH¢
Incremental revenue (GH¢ 30,000 ×GH¢ 6) 180,000
Less: Incremental cost: GH¢
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Variable overhead @ GH¢ 2 per unit 60,000 150,000
Contribution (or profit) 30,000
Thus, acceptance of this offer will result in additional profit GH¢ 30,000.
Problem 3 (Selling Price for Bulk Order)

An umbrella manufacturer makes an average profit of GH¢ 2.50 per unit on
a selling price of GH¢ 14.30 by producing and selling 60,000 units at 60
percent of potential capacity.
His cost of sales per unit is as follows:
Direct Materials GH¢ 3.50
Direct Wages GH¢ 1.25
Direct Overhead GH¢ 6.25 (50% fixed)
Sales Overhead GH¢ 0.80 (25% variable)
During the current year, he intends to produce the same number but
estimates that his fixed cost would go up by 10percent while the rates of
direct wages and direct materials will increase by 8% and 6% respectively.
However, the selling price cannot be changed. Under this situation, he
obtains an offer for a further 20% of his potential capacity.
What minimum price would you recommend for acceptance of the offer to
ensure the manufacture and overall profit of GH¢ 167,300?
Solution
Statement of Marginal Cost and Profit (For current year)
Per unit 60,units GH¢
Sales GH¢14.300 858,000
Direct materials (3.50 + 6%) 3.710 222,600
Variable overhead – Factory 3.125 187,500
Sales 0.200 12,000
Variable cost 8.385 503,100
Contribution (Sales – Variable cost) 354,900
Fixed cost 245,850
Profit 109,050
Calculation of fixed overhead

Factory–60,000 units @ GH¢ 3.125 = GH¢ 187,500
Sales –60,000 units @ Re 0. = GH¢ 36,000
= 223,500
Add: 10% increase 22,350
Statement of Price Recommendation (For 20,000 units)

GH¢
Marginal cost (GH¢ 8.385 × 20,000 units) 167,700
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Additional profit required (167,300 – 109,050) 58,250

Total sales value 225,950
Selling price per unit (225,950 ÷ 20,000) GH¢ 11.30
Problem 4 (Acceptance of a Special Order)

PQR Ltd. manufactures medals for winners of athletic events and other
contests. Its manufacturing plant has the capacity to produce 10,000 medals
each month. The company has current production and sales level of 7,500
medals per month. The current domestic market price of the medal is GH¢
150. The cost data for the month of October is as under:
Variable costs (that vary with units produced) GH¢
Direct manufacturing labour 300,000
Variable costs (that vary with number of batches

Set-ups, materials handling, quality control
150 batches × GH¢ 500 per batch 75,000
Fixed manufacturing costs 275,000
Fixed marketing costs 175,000 1,087,500
PQR Ltd. received a special one-time-order for 2,500 medals at GH¢ 100
per medal.
PQR Ltd. makes medals for its existing customers in batch size of 50
medals.
(150 batches × 50 medals per batch = 7,500 medals)
The special order for 2,500 medals requires PQR Ltd. a manufacture the
medals in 25 batches of 100 each. –
Required
(i) Should PQR Ltd. accept the special order? Why? Explain briefly.
(ii) Suppose the plant capacity was 9,000 medals instead of 10,000 medals
each month. The special order must be taken either in full or rejected
totally. Should PQR Ltd accept the special order?
Solution
(i) Profitability Statement
GH¢
Sales (2,500 medals @ GH¢ 100) 250,000
Less: Variable Costs:
Materials (2,500 medals @ GH¢ 35) 87,500
Labour (2,500 medals @ 40) 100,000
Set ups (25 batches @ GH¢ 500) 12,500 200,000
Contribution 50,000
Conclusion The special order should be accepted because it gives a

contribution of GH¢ 50,000
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(ii) When plant capacity is 9000 medals

Present contribution on 7500 medals: GH¢
Sales (7500 ×1500)
Less: Variable Costs: 262,500 1,125,000
Materials (7,500 × 35) 300,000
Labour(7,500 ×40) 75,000
Set ups(150 × 500) 637,500
Contribution on 6,8500 medals

GH¢
Sales (6,500 ×150) 975,000
Less: Variable Costs:
Materials (6,500 × 35) 227,500
Labour (6,500× 40) 260,000 552,500
Set ups (130 ×500) 65,000 422,500
Acceptance of special ode when capacity is 9,000 medals

GH¢
Gain in contribution on acceptance of special order 50,000
Loss in contribution (487,500 – 422,500) 65,000
Net Loss in contribution 15,000
Conclusion: When plant capacity is 9,000 medals, the special order should
not be accepted because it results in loss of contribution. GH¢15,000.
Problem 5 (Make or Bur Decision)

Auto Parts Ltd. has an annual production of 90,000 units for a motor
component. The component cost structure is as below:
Materials GH¢ 270 per unit
Labour (25% fixed) 180 per unit
Expenses:
Variable 90 per unit
Fixed 135 per unit
Total 675 per unit
a) The purchase manager has an offer from a supplier who is willing to

supply the component at GH¢ 540. Should the component be purchased
and production stopped?
b) Assume the resources now used for this component’s manufacture are to
be used to produce another new product for which the selling price is
GH¢ 485.
In the latter case, the material price will be GH¢ 200 per unit. 90,000 units
of this product can be produced at the same cost basis as above for labour
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COST AND MANAGEMENT
and expense. Discuss whether it would be advisable to divert the resources

to manufacture that new product, on the footing that the component
presently being produced would, instead of being produced, be purchased
from the market.
Solution
GH¢ per unit
Material 240
Labour 135
Variable expenses 90
Total variable cost when component is produced 495
Fixed cost 180
Suppliers price 540
Excess of purchase over variable cost = 540 – 495 = GH¢ 45
(a) The company should make the components because if purchase from an
outside supplier, the fixed cost of GH¢ 180 per unit will continue to be
incurred. In such a case, the component will actually cost GH¢ 540 +
180 = GH¢ 720, which is GH¢ 45 (i.e. GH¢ 72- 675) per unit more than
the own cost of production. On a total output of 90,000 units, it results in
a loss of GH¢ 4,050,000 (i.e. GH¢ 45 90,000).
(b) Cost implication of proposal to divert available production facilities for
a new product:
GH¢
Selling price of per unit of new product 485
Less: Variable costs – Material 200
Labour 135
Expenses 90 425
Loss if present component is purchase = 540 – 495= GH¢ 45
If company diverts the resources for the production of a new product, it will
benefit by GH¢ 15 (i.e. GH¢ 60 – 45) per unit.
On 90,000 units will save @ GH¢ 15, i.e., GH¢ 1,350,000. Thus it is
advisable to divert the production facilities in the manufacture of the new
product and the component presently being manufacture should be bought
from outside. This will result in additional profit of GH¢ 1,350,000.
Problem 6 (Make of Buy Decision)

XY Ltd manufactures auto parts. The following costs are incurred for
processing 100,000 units of components:
Direct material cost GH¢ 5 per unit
Direct labour cost GH¢ 8 per unit
Variable factory overhead GH¢ 6 per unit
Fixed factory overhead GH¢ 5 per unit
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The purchase of the component is GH¢ 22 per unit. The fixed overhead
would continue to be incurred even when the component is bought from
outside although there would be reduction to the extent o GH¢ 200,000.
Required:
1. Should the part be made or bought, considering that the present facility
when released following a buying decision would remain idle?
2. In case the released capacity can be rented out to another company for
GH¢ 150,000, what would be the decision?
Solution
(a) When released capacity will remain idle, variable costs to make the
component
Direct material GH¢ 5
Direct labour GH¢ 8
Variable overhead GH¢ 6
Relevant cost-to-make GH¢ 19
Purchase price of the component @ GH¢ 22 per cent GH¢ 22
Less: Reduction in fixed cost GH¢ 2
Relevant cost to buy GH¢ 20
The cost to make the component is less than cost to buy. Therefore it is
advisable to make the component.
(b) When released capacity is rented out

In such a situation, the cost to make will remain at GH¢ 19. But cost to buy
will further reduce by the income of rent. This cost to buy will be:
Purchase price GH¢ 22
Less: Saving in fixed cost 2.00
Rental income 1.50 3.50
Relevant cost to buy 18.50
As the cost to buy is less than cost of making, it is advisable to buy it.
Problem 7 (Sales Mix decision)

Three products X, Y and Z are made and sold by a company. The relevant
information is given below:
Products
X Y Z
GH¢ GH¢ GH¢
Standard costs:
Direct materials 50 120 90
Variable overheads 12 7 16
Direct labour Rate per hour Hours Hours Hours
Department A GH¢ 5 14 8 15
Department B GH¢ 6 4 3 5
Department C GH¢ 4 8 4 15
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Total fixed overheads for the year are GH¢ 300,000. The budget for the
current financial year which is prepared for a necessary period is based on
the following sales:
Product Sales Selling price per unit GH¢
X 7,500 210
Y 6,000 220
Z 6,000 300
You are required to show in the form of a statement for management, the
unit variable cost of the three products and the total profit expected for the
current year. Which of these products is the most profitable? Rank the
products.
Solution
Profitability Statement
Particulars Products Total
X Y Z GH¢
GH¢ GH¢ GH¢
Direct materials 50 120 90
Variable 12 7 16
overhead
Direct labour: 70 40 75
Department A 24 18 30
Department B 32 126 16 74 60 165
Department C 188 201 271
Total variable 210 220 300
cost 22 19 29
Sales price
per unit. 300,000
Units sold
Total 7,500 6,000 6,000
contribution 165,000 114,000 174,000
Less: Fixed
Cost
Profit 153,000
Ranking II III I
Conclusion. Product Z is the most profitable as it gives the highest amount

of contribution per unit.
Problem 8 (Selecting a Method of Production)
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In a factory, Type A and Type B machines have been designed to produce

the same object, but Type A is less automatic than Type B and requires
somewhat more labour to operate. Patient costs are as follows:
Type A Type B
GH¢ GH¢
Set up costs 400 600
Variable cost per unit 9.90 9.40
Which type of machine should be used for processing various sized orders?
Solution
Suppose size of the order = x
Type A machine should be used when:
Total cost on Type A < Total cost on Type B.
i.e.
400 + 9.9x < 600 + 9.4x
= (9.9 - 9.4) × < 600 – 400
= 0.5x < 200
200
= ×<
0.5
= ×< 400
Conclusion.
Type A machine should be used when the size of the order is less than 400
units. When the order size is more than 400 units, type B machine should be
used. But when the size of the order is exactly 400 units, either A or B may
be used because at this size of the order, total cost of both will be exactly
equal, as shown below:
Type A – GH¢ 400 + (GH¢ 9.90 × 400 units) = GH¢ 4,360
Type B – GH¢ 6000 + (GH¢ 9.40 × 400 units) = GH¢ 4,360
Problem 9 (Differential Cost Analysis)

Pioneer Manufacturing Company, makers of a specialized line of toys,
received an order for 2,000 units of toy battle tank from a large mail-order
house at a price of GH¢ 3 per unit.
The company sells this type of toy to its other customers at GH¢ 5 each but
it has surplus capacity and can take the special order without adversely
affecting its regular operations for the coming month.
The income statement of the company for the preceding month us an under:
GH¢
Net Sales – 10,000 units @ GH¢ 5 each 50,000
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Costs:
Direct materials- 15,000
Direct labour- 10,000
Factory overhead 10,000
Selling and administrative overheads 10,000
Total costs 45,000
Net profit 5,000
Direct material and direct labour costs to be incurred on the special order are
estimated to be of the same amount per unit as for the regular business.
Special tools costing GH¢ 500 would be required to meet the specifications
of the mail-order house.
You are required to prepare a Differential Costs Statement for deciding

about the acceptance of the order.
Solution
Differential Cost Statement
For 10,000 unit For 12,000 units Differential Cost

GH¢ GH¢ GH¢
Direct labour 10,000 12,000 2,000
Factory 10,000 10,000 ––
Overhead 10,000 10.000 ––
Selling & Adm. –– 500 500
Ohd. 45,000 50,500 5,500
Special tools 50,000 56,000 6,000
Total cost
Sales
Conclusion.
Increase in sales is GH¢ 6,000 while increase in cost is only GH¢ 5,500.
The special order should be accepted as it will result in increase in profit of
GH¢ 500.
Problem 10 (Differential cost Analysis)

A company at present working at 90% capacity and producing 13,500 units
per year. It operates a flexible budgetary control system. The following
figures are obtained from its budget.
90% 100%
Sales 1500,000 1600,000
Fixed expenses 300,500 300,600
Variable expenses 145,000 149,500
Semi-fixed expenses 97,500 100,000
Units manufactured 13,500 15,000
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Labour and material cost per unit is constant under present conditions. Profit
margin is 105 of sales at 90% capacity.
(a) You are required to determine the differential cost of producing 1,500
units by increasing capacity to 100%.
(b) What price would you recommend for export of these 1,500 units, taking
into account that overseas prices are much lower than indigenous prices?
Solution
The problem does not give the material and labour cost which is needed for
computing differential cost. It is computed by working backward from sales
as follows:
At 90% capacity
GH¢
Sales (13,500 units) 1,500,000
Less: Profit (10% of sales) 150,000
Less: Variable expenses 145,000
Semi-finished expense 975,000
Fixed expenses 300,500 543,000
Cost of labour and material (Prime cost) 807,000
Labour and material costs are variable in nature and thus at 100% capacity
these will be calculated as under:
100
807000 × = GH¢ 896667
90
Statement of Differential Cost Analysis

90% 100% Differential
Production (units) 13,500 15,000 1,500
Labour and material cost GH¢ 807,000 896,667 89,667
Variable expenses GH¢ 145,000 149,500 4,500
Semi-fixed expenses GH¢ 97,500 100,400 2,900
Fixed-expenses GH¢ 300,500 300,600 100
Total 1,350,000 1,447,617 97,167
Differential cost GH¢ 97,167

Differential cost per unit = =
Differential units 1,500 units
= GH¢ 6,478
At a price of GH¢ 64.78, there will be no additional profit. Therefore, any

price above GH¢ 64.78 which gives at least reasonable profit should be
acceptable for export, assuming that export will not affect the internal sales.
Problem 11(Discontinuance of a Product)
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An industrial concern which had no costing system appointed a Cost

Accountant. After installing a system of collection of cost data, the Cost
Accountant observed that out of the three products which are produced
independent of each other, loss is being incurred in product B. He
immediately decides to advise management to discontinue manufacture of
this product supported by the following tabulation.
Product Product B Product C
A
GH¢ GH¢ GH¢
Sales 100,000 65,000 490,000
Variable manufacturing cost 52,000 26,000 140,000
Fixed manufacturing overhead
(apportioned) 6,500 19,000 105,000
Variable selling and 18,000 17,000 18,000
distribution cost 4,600 4,600 4,000
Fixed selling and
distribution cost
Total cost 81,000 6,000 267,000
Net profit 18,900 –– 223,000
Net loss –– 1,600 ––
Do you agree with the Cost Accountant’s conclusion? Argue with your
views on the basis of data.
Solution
Profitability Statement
Products
A B C
GH¢ GH¢ GH¢
Sales 100,000 65,000 490,000
Variable cost:
Manufacturing 52,000 26,000 140,000
Selling and distribution 18,000 17,000 18,000
Marginal cost 70,000 43,000 158,000
Contribution 30,000 22,000 332,000
Fixed cost
Manufacturing 6,500 19,000 105,000
Selling and distribution 4,600 4,600 4,000
Total fixed cost 11,100 23,600 109,000
Profit/(Loss) 18,900 (1,600) 223,000
30% 34% 67.8%
(i) P/V ratio
(ii) Ratio of fixed cost to variable cost: 12.5% 73.1% 75%
(a) Manufacturing 25.5% 27.1% 22%
(b) Selling and distribution
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iii) Total selling and distribution cost( 22.6% 33.2% 45%

as a ratio of sales
Conclusion.
Product B should not be discontinued because:
 Product B appears unprofitable because of arbitrary apportionment of
fixed overhead. It is burdened with 73.1% fixed manufacturing overhead
of its variable cost which is almost six times that of Product A.
 Product B is no less profitable than Product A as P/V ratio of B is 34%
which is more than of A.
 Although sales of B are much less than A and C, it is burdened with the
same amount of selling and distribution costs.
 By discontinuing product B, the contribution of GH¢ 22,000 made by it
will not be available, hence the loss would be equal to the amount of
fixed cost of GH¢ 23,600 apportioned to it.
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XXXXXXX 5 BUDGETING AND BUDGETARY
UNIT Unit X, section CONTROL
X: XXXXXXX
Unit Outline:
Session 1 Nature of Budget
Session 2 Installation of a budget System
Session 3 Classification of Budget
Session 4 Cash Budget
Session 5 Fixed and Flexible Budgets
Session 6 Other types of Budget
Zero Based Budgeting( ZBB)
Performance Budget
Unit Overview
You are welcome fifth unit of this course-Cost and Management
Accounting II. In the previous units we have considered how management
accounting can assist managers in making decisions. The actions that
follows managerial decisions normally involve several aspect of business
such as the marketing, production, purchasing and finance functions, and it
is important that management should coordinate these various interrelated
aspects of decision-making. The various activities within a company should
be coordinated by the preparation of plans of actions for future periods.
These detailed plans are usually referred to as budgets. This Unit focuses on
budgeting and budgetary controls in an organisation.
This Unit is divided into six sessions. Session one looks at the Nature of
Budget
Session two covers budgeting systems and its installations. Session three
looks at the classification of budget. Session covers cash budget. Sessions
five and six covers fixed and flexible budget and other types of budget such
as zero based budgeting and performance

 explain how budgeting fits into the overall planning process and control
framework
 identify and describe the different purposes of budgeting
 identify and describe the various stages in the budgeting
 prepare functional budget, master budget and cash budget
 describe zero based budgeting process the concept of cost-volume-profit
analysis
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COST AND MANAGEMENT NATURE OF BUDGET
UNIT 5 SECTION
ACCOUNTING II 1
Unit 5, section 1: Nature of budget
Dear learner, you are most welcome to the first Session of unit five. We are
going to look at budgetary control which is an important tool for planning
and control. Planning involves looking systematically at the future so that
decisions can be made today which will bring the company its desired
results. This session will explain the nature of budget and budgeting
By the end of this session, you will be able to:

 define the concept of budget and budgeting
 describe the characteristics of budget
 define the concept of budgetary control
 describe the characteristics of budget control
 distinguish between forecasting and budgeting
Concept of Budget
Budget refers to a plan relating to a definite future period of time expressed
in monetary and/or quantitative terms. In relation to business, a budget is a
formal expression of the expected incomes and expenditures for a definite
future period. The Chartered Institute of Management Accountants
(C.I.M.A) London, has defined a budget as “a financial and/or quantitative
statement, prepared prior to a defined period of time, of the policy to be
pursued during that period for the purpose of attaining a given objective.” It
may include income, expenditure and employment of capital.
According to Brown and Howard, “A budget is a pre-determined statement

of management policy during a given period which provides a standard for
comparison with the results actually achieved.”
Characteristics
Budgets have the following characteristics:
 a budget is primarily a planning device but is also serves as a basis for
performance evaluating and control.
 a budget is prepared either in money terms or in quantitative terms or in
both.
 a budget is prepared for a definite future period.
 purpose of a budget is to implement the policies formulated by
management for attaining the given objectives.
Budgeting: The act of preparing budgets is called budgeting. In the words

of J. Batty, “the entire process of preparing the budgets is known as
budgeting.”
Concept of Budgetary Control

Budgetary control is a system of controlling costs through preparation of
budgets. Budgeting is thus only a part of the budgetary control. According
to C.I.M.A., London, “Budgetary control is the establishment of budgets
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Unit 5, section 1: Nature of budget ACCOUNTING II
relating to the responsibilities of executives of a policy and the continuous

comparison of the actual with the budgeted results, either to secure by
individual action the objective of the policy or to provide a basis for its
revision.”
In the words of Brown and Howard, “Budgetary control system is a system

of controlling costs which includes the preparation of budgets, coordinating
the departments and establishing responsibilities, comparing actual
performance with the budgeted and acting upon results to achieve maximum
profitability.”
Characteristics – The main characteristics of budgetary control are:

 establishment of budgets for each function/department of the
organization.
 comparison of actual performance with the budgets on a continuous
basis.
 analysis of variations of actual performance from that the budgeted
performance to know the reasons thereof.
 taking suitable remedial action, where necessary.
 revision of budgets in view of changes in conditions.
The principals involved in budgeting have been likened to those followed by

the captain of a ship. Before the voyage, he will plan his route, taking into
account such factors as shipping hazards, tides and possible adverse weather
forecasts. During the journey, he will record details of progress and
frequently check actual progress with that planned. Though trying to keep to
the plan, he may have to deviate from the plan if prevailing circumstances
require it. On completion of the journey, he will compare the conditions he
encountered with those he expected. The experience so gained will be used
by him in planning similar voyages in the future. This simple analogy serves
to illustrate the basic practice used in budgeting and budgetary control.
The technique of budgetary control is now widely used in the business

world. Many businesses fail because of lack of efficient planning which
could have revealed that the business should not have been started or that
one should have been prepared to face serious dangers ahead.
Forecast and Budget

It is important to note carefully the distinction between forecast and a
budget. A forecast is a prediction of what may happen as a result of a given
set of circumstances. It is an assessment of probable future events.
A budget, on the other hand, is a planned exercise to achieve a target. It is

based on the pros and cons of a forecast. Forecasting thus precedes the
preparation of budget.
Thus the main points of distinction between the two are thus:
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ACCOUNTING II Unit 5, section 1: Nature of budget
 Budgets relate to ‘planned events’, i.e., policies and programmes to be

pursued.
 Forecast is concerned with ‘probable events’, i.e., events expected to
happen under anticipated conditions.
 Budget, being a formal business plan, can be prepared only by the
anthorised management but forecast can be made by anybody.
 Budget is a tool of control while the forecast is simply an anticipation of
events.
 Forecasting is a pre-requisite for budgeting while budgeting is not a pre-
requisite for forecasting.
 Budgets relate to economic activities of business, enterprises,
government or others Forecast may relate to economic as well as non-
economic activities, e.g. weather forecast, stock market forecast, etc.
Objectives of Budgetary Control

The following are the main objectives of a budgetary control system.
 Planning: A budget provides a detailed plan of action for a business
over a definite period of time. Detailed plans are drawn up relating to
production, sales, raw material requirements, labour needs, advertising
and sales promotion performance, research and development activities,
capital additions, etc. Planning helps in anticipating many problems long
before they may arise and solutions can be sought through careful study.
Thus most business emergencies can be avoided by planning. In brief,
budgeting forces managements to think ahead, to anticipate and prepare
for the situation.
 Coordination: Budgeting aids managers in coordinating their efforts so

that objectives of the organization as a whole harmonies with the
objectives of its divisions. Effective planning and organizing contribute
a lot in achieving coordination. There should be coordination in the
budgets of various departments. For example, the budget of sales should
be in co-ordination with the budget of production. Similarly, the
production budget should be prepared in co-ordination with the purchase
budget, and so on.
 Communication: A budget is a communication device. The approved

budget copies are distributed to all management personnel who provide
not only adequate understanding and knowledge of the programmes and
policies to be followed but also alerts about the restrictions to be
adhered to.
It is not the budget itself that facilitates communication, but the vital
information is communicated in the act of preparing budgets and
participation of all responsible individuals in this act.
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 Motivation: A budget is a useful device for motivating managers to

perform in line with the company objectives. If individuals have actively
participated in the preparation of budgets, it acts as a strong motivating
force to achieve the targets.
 Control: Control is necessary to ensure that plans and objectives as laid

down in the budgets are being achieved. Control, as applied to
budgeting, is a systematized effort to keep the management informed of
whether the planned performance is being achieved or not. For this
purpose, a comparison is made between plans and actual performance.
The difference between the two is reported to the management for taking
corrective action.
 Performance Evaluation: A budget provides a useful means of

informing managers how well they are performing in meeting targets
they have previously helped to set. In many companies there is a
practice of rewarding employees on the basis of their achieving the
budget targets or promotion of a manager may be linked to his budget
achievement record.
Advantages of Budgetary Control

Budgetary control provides the following advantages:
 budgeting compels managers to think ahead – to anticipate and prepare
for changing conditions.
 budgeting co-ordinates the activities of various departments and
functions of the business.
 it increases production efficiency, eliminates waste and controls the
costs.
 it pinpoints efficiency or lack of it.
 budgetary control aims at maximization of profits through careful
planning and control.
 it provides a yardstick against which actual results can be compared.
 it shows management where action is needed to remedy a situation.
 it ensures that working capital is available for the efficient operation of
the business.
 it directs capital expenditure in the most profitable direction.
 it instills into all levels of management a timely, careful and adequate
consideration of all factors before reaching important decisions.
 a budget motivates executives to attain the given goals.
 budgetary control system creates necessary conditions for the
introduction of standard costing technique.
 budgeting also aids in obtaining bank credit.
 a budgetary control system assists in delegation of authority and
assignment of responsibility.
 budgeting creates cost consciousness and introduces an attitude of mind
in which waste and efficiency cannot thrive.
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Limitations of Budgetary Control

The list of advantages given above is impressive, but a budget is not a cure
all for organization ills. Budgetary control system suffers from certain
limitations and those using the system should be fully aware of them.
The main limitations are:
 The budget plan is based on estimates: Budgets are based on forecasts
and forecasting cannot be an exact science. Absolute accuracy,
therefore, is not possible in forecasting and budgeting. The strength or
weakness of the budgetary control system depends to a large extent, on
the accuracy with which estimates are made. Thus, while using the
system, the fact that budget is based on estimates must be kept in view.
 Danger of rigidity: A budget programme must be dynamic and
continuously deal with the changing business conditions. Budgets will
lose much of their usefulness if they acquire rigidity and are not revised
with the changing circumstances.
 Budgeting is only a tool of management: Budgeting cannot take the
place of management but is only a tool of management. “The budget
should be regarded not as a master, but as a servant.” Sometimes it is
believe that introduction of a budget programme is alone sufficient to
ensure its success. Execution of a budget will not occur automatically. It
is necessary that the entire organization must participate enthusiastically
in the programme for the realization of the budgetary goals.
 Opposition from staff: Employees may not like to be evaluated and
thus oppose introduction of budgetary control system. As such,
inefficient managers may try to create difficulties in the way of
introducing and operating this system.
 Expensive technique: The installation and operation of a budgetary
control system is a costly affair as it requires the employment of
specialized staff and involves other expenditure which small concerns
may find difficult to incur. However, it is essential that the cost of
introducing and operating a budgetary control system should not exceed
the benefits derived there from.
Essentials Effective Budgeting

A budgetary control system can prove successful only when certain
conditions and attitudes exist, absence of which will negate to a large extent
the value of a budget system is any business. Such conditions and attitudes
which are essential for effective budgeting are as follows:
 Support of top management: If the budget system is to be successful,
it must be fully supported by every member of management and the
impetus and direction must come from the very top management. No
control system can be effective unless the organization is convinced that
the top management considers the system to be important. Thus the top
management must be committed to the budget idea as well as to the
principles, policies and philosophy underlying the system.
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 Participation by responsible executives: Those entrusted with the

performance of the budgets should participate in the process of setting
the budget figures. This will ensure proper implementation of budget
programmes.
 Reasonable goals: The budget figures should be realistic and represent
reasonably attainable goals. The responsible executives should agree
that the budget goals are reasonable and attainable.
 Clearly defined organization: In order to derive maximum benefits
from the budget system, well defined responsibility centres should be
built up within the organization. The controllable costs for each
responsibility centres should be separately shown.
 Continuous budget education: The best way to ensure the active
interest of the responsible supervisors is continuous budget education in
respect of objectives, potentials and techniques of budgeting. This may
be accomplished through written manuals, meetings, etc. whereby
preparation of budgets, actual results achieved etc., may be discussed.
 Adequate accounting system: There is close relationship between
budgeting and accounting. For the preparation of budgets, one has to
depend on accounting department for reliable historical data which
primarily forms the basis for many estimates. The accounting system
should be so designed so as to set up accounts in terms of areas of
managerial responsibility. In other words, responsibility accounting is
essential for successful budgetary control.
 Constant vigilance: Reports comparing budget and actual results
should be promptly prepared and special attention focused on significant
exceptions – figures that are significantly different from those expected.
 Maximum profits: The ultimate object of realizing the maximum profit
should always be kept uppermost.
 Cost of the system: The budget system should not cost more than it is
worth. Since, it is not practicable to calculate exactly what a budget
system is worth, it only implies a caution against adding expensive
refinements unless their value clearly justifies hem.
 Integration with standard costing system: Where standard costing
system is also used, it should be completely integrated with the budget
programme, in respect of both budget preparation and variance analysis.
Conclusion
We have gone through the introductory aspect of budgeting. We have seen
the definitions of a budget, budgeting, budgetary control and the objectives
of budgetary control. Since it plays important role in the efficient use of
resources we saw that budget should be prepared with due care.
Assessment
1. Explain the following terms
a. budget
b. budgeting
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c. budgetary control
2. Explain the importance of budgeting and budgetary control.
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COST AND MANAGEMENT PRELIMINARIES IN THE INSTALLATION OF BUDGET
UNIT 5 SECTION
ACCOUNTING II 2
Unit 5, section 2: Preliminaries in the installation of budget system
SYSTEM
You are again welcome to the Session two of the fifth unit of cost and
management accounting II. I hope you have enjoyed the introductory part of
budgeting and budgetary control treated in section one. We are going to
continue by looking at Preliminaries in the Installation of Budget System.
By the end of this Session the learner should be able to:

 understand the necessary requirement for the preparation of a budgetary
control system
 outline the importance of each stage in the budgetary control system
Setting up & Administration of Budgetary Control System

Pre-requisites for the successful implementation of a budgetary control
system are as follows:
 Creation of budget centres: A budget centre is a section of the
organization of an undertaking for which a separate budget is prepared.
A budget centre may be a department or a part thereof. Budget centre
must be clearly defined because a separate budget has to be set for each
such centre with the help of the head of the department concerned. For
example, in the preparation of purchase budget, the purchase manager
has to be consulted. Similarly, while preparing labour cost budget, the
personnel manager will be of great help.
 Introduction of adequate accounting records: The accounting system
should be so designed as to be able to record and analyse the
information required. The budget procedures must also employ the same
classification of revenues and expenses as the accounting department.
Comparisons cannot be made if the classifications do not coincide. A
chart of accounts corresponding with the budget centres should be
maintained.
 Preparation of an organization chart: Proper organization is essential
for a successful budget system. An organization chart should be
prepared which clearly shows the plan of the organization. Each member
of management should know the exact scope of his authority and
responsibility and his relationship to other members For this purpose,
copies of the organization chart and written supplements should be
distributed to all concerned.
The organization chart will depend upon the nature and size of the company.
A specimen of the organization chart is given in Fig. 15.1.
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Unit 5, section 2: Preliminaries in the installation of budget system ACCOUNTING II
Managing
Director
Budget
Committee
Budget
Director
Sales Purch Product Person Chief R&D

Mana ase ion nel Accoun Manage
ger Mana Manag Manag tant r
ger er er
1. Sales Purch 1. Produ Labou 1. Cash R&D
Budget ase ction r Cost budg Budge
2. Selling Budge Budge Budge et t
Cost t t t 2. Capit
Budget 2. Plant al
3. Distrib utilizat Exp.
ution ion Budg
Cost Budge et
Budget t 3.
4. Advert Mast
ising er
Budget
Fig. 15.1 Organization Chart for budgetary Control Budg
et
 Establishment of Budget Committee: In large concerns, the direction
and execution of the budget is delegated to a budget committee which
reports directly to the top management. The financial controller is
usually appointed to serve as the budget director. He is in charge of
preparing budget manual of instructions and accumulates the budget and
actual figures for reporting. Other members of the budget committee
usually comprise various heads of functional departments, like sales
manager, purchase manager, production manager, chief accountant, etc.
as shown in the above organization chart. Each member prepares his
own departmental budget(s) which are then considered by the committee
for coordination.
Functions:
The main functions of a budget committee are as follows:
 To provide historical data to all departmental heads to help them in
estimating.
 To issue instructions to departments regarding requirements, dates of
submission of estimates, etc.
 To define the general policies of the management in relation to the
budget system.
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 To receive budget estimates from various departments for consideration

and review.
 To discuss difficulties with departmental heads and suggest possible
revisions.
 To evaluate and revise the estimates before preparing the final budget.
 To make recommendations on budget matters where there is conflict
between departments.
 To prepare budget summaries.
 To prepare a master budget after functional budgets have been approved.
 To inform departmental heads of any revisions made in their budgets by
the committee.
 To coordinate all budget work.
 To analyse variances and recommend corrective action, where
necessary.
 Preparation of budget manual: A budget manual has been defined by

C.I.M.A., London as “a document which sets out the responsibilities for
the persons engaged in the routine of and the forms and records required
for budgetary control”. A budget manual is thus a statement of budget
policies. It lays down the details of the organizational set up with duties
and responsibilities of executives including the budget committee and
budget director and the procedures and programmes to be followed for
developing budgets for various activities.
Contents: The contents of a budget manual are summarized as follows:

 Description of the budget system and its objectives.
 Procedure and forms to be used in budget preparation.
 Responsibilities of operational executives, budget committee and budget
director.
 Budget calendar, specifying definite dates for the completion of each
part of the budget and submission of the reports.
 Method of accounting and account codes in use.
 Procedure to be adopted in operating the system.
 Follow-up procedures.
 Budget period: Budget period is a length of time for which a budget is

prepared and operated. Budget periods vary between short term and long
term and no specific period can be laid down for all budgets. It varies
among concerns and industries for several factors.
A budget is usually prepared for one year which corresponds to the

accounting year. It is then sub-divided into quarters and in turn each
quarter is broken down into three separate months. When a business
experiences seasonal fluctuations, the budget period may be fixed to
cover one seasonal cycle. If the seasonal cycle covers say two or three
years, a long term budget should be prepared to cover that period. The
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Unit 5, section 2: Preliminaries in the installation of budget system ACCOUNTING II
long period may then be broken down into smaller periods by preparing
short term budgets.
Budgets for capital expenditure are usually prepared on a long term

basis. For example, in electricity companies which incur very heavy
capital expenditure, the need for new power stations is forecast possibly
five to ten years in advance. Such long term budgets are supplemented
by short term ones.
 Determination of the key factor: Also known as limiting factor,

governing factor and principal budget factor, the key factor means the
factor which limits the size of output. It is defined as “the factor the
extent of whose influence must first be assessed in order to ensure that
functional budgets are capable of fulfillment”. Such a factor is of vital
importance and affects all budgets to a large extent.
The key factor serves as the starting point for the preparation of budgets.
For instance, when sales potential is limited, sales is the key factor.
Therefore, sales budget is thus a key factor determines priorities in
functional budgets. Among the various key factors which affect
budgeting are the following:
a. Sales
i) Low market demand
ii) Shortage of experienced salesman
b. Materials
i) General shortage and seasonal shortage
ii) Restrictions imposed by licenses, quota, etc.
c. Labour
i) General shortage
ii) Shortage of specialized labour in a particular process.
d. Plant
i) Limited plant capacity
ii) Bottlenecks in certain key processes
e. Management
i) Shortage of experienced executives
ii) Paucity of know-how
In this age of competition, most often, sales is the key factor in industry. It
is possible that more than one key factor is operating at the same time.
Under such conditions, the relative impact of such factors is considered in
budget preparation. Moreover, key factor is not necessarily a permanent
factor. The management may be provided with opportunities to overcome
the limitations imposed by key factor. For example, plant capacity can be
increased by the installation of new and improved plant and machinery
which may be financed by the issue of new shares.
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Conclusion
Preparing a budget is not a onetime activity. It has to go through series of
processes for it to be an accept document that the oraganisation can work
with. Therefore the processes explained above are very critical in the
preparation of a budget for any oraganisation which should be well
understood.
Assessment
1. What is a key budget factor?
2. State and explain some key budget factors you are likely to face in the
preparation of a budget
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UNIT 5 SECTION
ACCOUNTING II 3
Unit 5, section 3: Classification of budget
Hello learner, we are gradually delving deep into the topic budgeting and
budgetary control. Your understanding of the previous topics in sessions one
and two will help you appreciate this Session. Now, in this Session we are
going to look at the various classifications of budget.
By the end of this Session the learner should be able to:

 understand the various classification of budget.
 prepare the various functional budget
Budgets may be classified into the following categories:

1. On the basis of function and scope:
 Functional budgets, and
 Master budget
 On the basis of flexibility:
 Fixed budget, and
 Flexible budget
Functional Budgets
A functional budget is one which relates to a particular function of the
business, e.g., Sales Budget, Production Budget, Purchase Budget, etc.
There are many types of functional budgets, of which the following are
important:
Sales Budget
In most companies, the sales budget is not only the most important but also
the most difficult budget to prepare. The importance of this budget arises
from the fact that if sales figure is incorrect, then practically all other
budgets will be affected. The difficulties in the preparation of this budget
arise because it is not easy to estimate consumer demand, particularly when
a new product is introduced.
The sales budget is a statement of planned sales in terms of quantity and

value. It forecasts what the company can reasonably expect to sell to its
customers during the budget period. The sales budget can be prepared to
show sales classified according to products, salesmen, customers, territories
and periods, etc.
Factors: The factors to be considered in forecasting sales are the following:

 Past sales: Analysis of the past sales shows the trends to date and any
seasonal or cyclical fluctuations. It is, therefore, not difficult to suggest
future trends from the analysis of the past sales.
 Reports by salesmen: The salesman are in close touch with the market
and thus, they may be required to prepare detailed estimates of sales that
they are likely to make in their respective areas during the budget
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Unit 5, section 3: Classification of budget ACCOUNTING
period. The report of each salesman should be studied in the light of his
past assessment and actual sales.
 Company conditions: Any change in policies and methods of the

company and their effects on sales should be considered. For example,
additional spending on advertising, introduction of new channels of
distributions, introduction of new products, etc. should all have some
effect of a sales budget.
 Business conditions: Any changes in economic conditions and that in

related business activities and their effect on company sales should be
considered. Information should be obtained about competing industries
to assess the strength of competition and about the customer requirement
to determine their demand.
 Special conditions: In the preparation of sales forecast, any new

external developments taking place should also be considered. For
example, when an industry manufactures products for another industry,
it will be necessary to analyse the trend of sales in that industry. A tyre
manufacturer would estimate the sales of cars or scooters on which tyres
are used.
 Market analysis: Some companies depend upon market analysis and

research to measure the potential demand for their products. Such an
analysis reports on the state of the market, fashion trends, the type of
products design required, activities of the competitors and other factors
which may have a bearing on the sales of the company.
Illustration 5.1
JK Ltd. sells two products Jay and Kay in four areas North, South, East and
West. The following sales are budgeted for the month of Jan. 2005:
North - Jay 5,000 units @ GH¢ 30 each and Kay 3,000 units @ GH¢
15 each
South - Kay 6,000 units @ GH¢ 15 each
East - Jay 7,500 units @ GH¢ 30 each
West - Jay 4,000 units @ GH¢ 30 each and Kay 2,500 units @ GH¢
15 each
Actual sales for the same period were as follows:

North - Jay 5,750 units @ GH¢ 30 each and Kay 3,500 units @ GH¢
15 each
South - Kay 6,250 units @ GH¢ 15 each
East - Jay 8,250 units @ GH¢ 30 each
West - Jay 4,750 units @ GH¢ 30 each and Kay 2,625 units @ GH¢
15 each
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ACCOUNTING II Unit 5, section 3: Classification of budget
On the basis of all the relevant factors, the following sales are budgeted for
the month of Feb. 2005.
North - Jay 6,000 units and Kay 3,250 units.
South - Kay 6,500 units
East - Jay 8,500 units
West - Jay 4,500 units and Kay 2,750 units
It was decided that additional advertising campaign will be undertaken in

South and East which will result in additional sales of 1,500 units of Jay in
South and 2,500 units of Kay in East.
You are required to prepare a sales budget for the month of Feb. 2005 for
presentation to management also showing the budgeted and actual sales for
the month of Jan. 2005 which are to be provided as a guide in preparing the
sales budget.
Budget Feb. 2005 Budget Jan. 2005 Actual Jan. 2005

Area Product Quantit Price Amount Quantit Price Amount Quantit Pric Amount
y units GH¢ GH¢ y units GH¢ GH¢ y units e GH¢
GH
¢
North Jay 6,000 30 180,000 5,000 30 150,000 5,750 30 172,500
Kay 3,250 15 48,750 3,000 15 45,000 3,500 15 52,500
Total 9,250 228,750 8,000 195,000 9,250 225,000
South Jay 1,500 30 45,000 - - - - - -
Kay 6,500 15 97,500 6,000 15 90,000 6,250 15 93,750
Total 8,000 142,500 6,000 90,000 6,250 93,750
East Jay 8,500 30 255,000 7,500 30 225,000 8,250 30 247,500
Kay 2,500 15 37,500 - - - - - -
Total 11,000 292,500 7,500 225,000 8,250 247,500
West Jay 4,500 30 135,000 4,000 30 120,000 4,750 30 142,500
Kay 2,750 15 41,250 2,500 15 37,500 2,625 15 39,375
Total 7,250 176,250 6,500 157,500 7,375 181,875
Total Jay 20,500 30 615,000 16,500 30 495,000 18,750 30 562,500
Kay 15,000 15 225,000 11,500 15 172,500 12,375 15 185,625
Total 35,500 840,000 28,000 667,500 31,125 748,125
Sales budge for the month of Feb. 2005
Production Budget
The production budget is a plan of production for the budget period. It is
first drawn up in quantities of each product and when the remaining budgets
have been compiled and costs of production calculated, then the quantities
of production cost are translated into money terms, what in effect becomes a
production cost budget.
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The production budget is the initial step in budgeting manufacturing

operations. In addition to production budget, there are three other budgets
relating to manufacturing activities of a company. These are raw materials
budget, labour budget and production overhead budget.
The principal considerations involved in budgeting production are:

 Sales budge: When sales is the principal budget factor, the production
budget will be based on the volume of sales forecast by the sales budget.
 Inventory policy: The management decision regarding quantities
needed in stock at all time to meet customer requirements is an
important factor. In deciding on the inventory policy, factors like storage
facilities, length of the production period, perishability of product, risk
of price changes, etc. have to be given due consideration.
 Production capacity: The production capacity of each department
should be worked out and budget figures should be within these limits.
However, when production capacity falls short of sales requirements, the
following alternatives may be considered:
 Purchase of additional plant and machinery
 Introduction of additional shift
 Introduction of overtime working
 Hiring machinery.
 Sub-contracting production of components.
 Management policy: Production policy of the management plays an
important role in budgeting production. For example, management may
decide to buy a particular component part from outside instead of
manufacturing it. This will influence production budget.
Production Cost Budget

This budget shows the estimated cost of production. The production budget
(explained above) shows the quantities of production. These quantities of
production are expressed in terms of cost in production cost budget. The
cost of production is shown in detail in respect of material cost, labour cost
and factory overhead. Thus Production Cost Budget is based upon
Production Budget, Material Cost Budget, Labour Cost Budget and Factory
Overhead Budget.
Illustration 5.2
The following information has been made available from the records of
Precision Tools Ltd for the six months of 2005 (and the sales of January
2006) in respect of product X;
i) The units to be sold in different months are:
July 2005 1,100 November 2005 2,500
August 2005 1,100 December 2005 2,300
September 2005 1,700 January 2006 2,000
ii) There will be no work-in-progress at the end of any month.
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iii) Finished units equal to half the sales of the next month will be in
stock at the end of every month (including June 2005).
iv) Budget production and production cost for the year ending 31st Dec.,
2005 are thus:
Production (units) 22,000
Direct materials per unit GH¢ 10
Direct wages per unit GH¢ 4
Total factory overhead apportioned to production GH¢ 88,000
You are required to prepare:
a) Production Budget for the six month of 2005 and
b) Summarized Production Cost Budget for the same period.
Solution
Production Budget
For the six months ending Dec. 2005
July Aug. Sep. Oct. Nov. Dec. Total
units units units units units units
Estimated 1,100 1,100 1,700 1,900 2,500 2,300
sales
Add: 550 850 950 1,250 1,150 1,000
Closing
stock
1,650 1,950 2,650 3,150 3,650 3,300
Less: 550 550 850 950 1,250 1,150
Opening
stock
1,100 1,400 1,800 2,200 2,400 2,150 11,050
Production
Production Cost Budget

For the six months ending Dec. 2005
(Production: 11,050 units)
GH¢
Direct materials @ GH¢ 10 for 11,050 110,500
units
Direct wages @ GH¢ 4 for 11,050 44,200
units
*Factory overhead @ GH¢ 4 for 11,050 44,200
units
Total Production Cost 198,9000
* Factory overhead per unit = GH¢ 88,000 ÷ 22,000 units = GH¢ 4.
Raw Materials Budget

This budget shows the estimated quantities of all the raw materials and
components needed for production demanded by the production budget.
Raw material budget serves the following purposes:
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 It assists purchasing department in planning the purchases.

 It helps in the preparation of purchase budget.
 It provides data for raw material control.
It should be noted that raw material budget generally deals with only the
direct materials. Indirect materials and supplies are included in the overhead
cost budget.
Purchase Budget
Careful planning of purchases offers one of the most significant areas of
cost saving in many companies. The purchase manager should be assigned
the direct responsibility for preparing a detailed plan of purchases for the
budget period and for submitting the plan in the form of a purchase budget.
The purchase budge provides details of the purchases which are planned to
be made during the period to meet the needs of the business. It indicates:
 The quantities of each type of raw material and other items to be
purchased;
 The timing of purchases;
 The estimated cost of material purchases.
Factors: In preparing a purchase budget, a number of factors must be

considered, including the following:
 Opening and closing stock to be maintained as it will affect material
requirements.
 Maximum and minimum stock quantities.
 Economic order quantities.
 Financial resources available.
 Purchase orders placed before the budget period against which supplies
will be received during the period under consideration.
 Policy of the management regarding materials or components to be
manufactured within the business as distinct from those purchased from
outside.
Purposes: The main purposes of a purchase budget are as follows:

 To enable the purchasing department to plan its purchases and enter into
long term contracts, where advantages.
 To record the material prices on which the plan represented by the
budget is based.
 To facilitate the management of finance of the business by defining the
cash requirements in respect of the budget period and for shorter runs.
The purchase budget differs from the raw material budget in that purchase
budget specifies both quantities and cedis cost, whereas raw material budget
is usually limited to quantities only. Secondly, purchase budget includes
direct and indirect materials, finished goods for resale, services like
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electricity and gas, etc., while raw material budget includes only direct
material requirements.
Illustration 5.3
The sales manager of Mahindra & Co. Ltd reports that next year he expects
to sell 50,000 units of a certain product.
The production manager consults the storekeeper and cast his figures as
follows:
Two kinds of raw materials A and B are required for manufacturing the
product. Each unit of the product requires 2kg of A and 3kg of B. The
estimated opening balances at the commencement of the next year are –
Finished product, 10,000 units; A, 12,000kg; B 15,000kg. The desirable
closing balances at the end of the next year are: Finished product, 14,000
units; A, 13,000kg; B, 16,000kg.
Draw up a Materials Purchases Budget for the next year.
Solution
As production quantity during the year is not given, it is calculated as under
Sales during the year 50,000 units
Add: Desired stock at the end of next year 14,000 units
Total 64,000 units
Less: Expected stock at the beginning of the next year 10,000 units
Estimated production 54,000 units
Purchases Budget for the period

Item Material A kg Material B kg
Consumption during the
year:
A – 54,000 units @ 2 kg 1,08,000 ____
per unit
B – 54,000 units @ 3 kg ____ 1,62,000
per unit
Add: Desired stock at the 13,000 16,000
end of next year
1,21,000 1,78,000
Less: Expected stock at 12,000 15,000
the commencement of
next year
Quantities of materials 1,09,000 1,63,000
to be purchased
Labour Budget
Labour cost is classified into direct and indirect. Some companies prepare a
labour budget that includes both direct and indirect labour, while others
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include only direct labour cost and include indirect labour in the overhead
cost budget.
The labour budget represents the forecast of labour requirements to meet the
demands of the company during the budget period. This budget must be
linked with production budget and production cost budget. The method of
preparing labour budget is like this. The standard direct labour hours of each
grade of labour required for each unit of output and standard wage rate for
each grade of labour are ascertained. Multiplication of units of finished
goods to be produced by the labour cost per unit gives the direct labour cost.
The indirect labour is normally a fixed amount, so should be easy to
calculate in total for the period.
Purposes: The labour budget serves the following purposes:

 To estimate the labour cost of production.
 To determine the direct labour required in terms of labour hours and
hence the number and grade of workers required to meet the production
requirements.
 To provide the personnel department with personnel requirements so
that it may plan recruitment activities.
 To provide data for determination of each requirements for payment of
wages.
 To provide data for managerial control of labour cost.
Production Overhead Budget

After budgeting of material and labour cost, next logical step is to prepare a
budget for production overheads. The production overhead budget
represents the forecast of all the production overhead (fixed, variable and
semi-variable) to be incurred during the budget period. The fact that
overheads include many dissimilar types of expenses creates considerable
problems in:
 The allocation of production overheads to products manufactured, and
 Control of production overheads.
The production overhead budget involves the preparation of overhead

budgets for each department of the factory as it is desirable to have
estimates of manufacturing overheads prepared by those individuals who
have the responsibility for incurring them. The budget expenses for each
sub-period during the budget period should be indicated and the
classification of expenses should be the same as used by the accounting
department. The budgeted overhead costs of service departments are totaled
and apportioned to production departments according to the services
received by each such production department. The budgeted overhead costs
of service departments are totaled and apportioned to production
departments according to the services received by each such production
department.
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Factors: The factors to be considered in preparing this budget are as

follows:
 The classification of all overhead costs into fixed and variable elements.
In the case of semi-variable items, the degree of variability should be
ascertained. The level of output at which fixed costs change also be
determined.
 The level of activity likely to be achieved during the budget period like
units of output, labour hours, etc.
 Policy of management regarding matters like overtime work, number of
shifts to be worked, depreciation, replacement of hand labour by
machines, etc.
 Individual items of cost incurred in the past.
Selling and Distribution Cost Budget

This is closely related to sales budget and represents the plan of all costs
incurred in selling and distributing the company’s products during the
budget period. As a general rule, the sales budget and the selling and
distribution cost budgets are prepared simultaneously, since each has a
definite impact on the other.
The sales manager is responsible for selling and distribution cost budget. He
prepares this budget with help of heads of sub-divisions of the sales
department. Some companies prepare a separate advertising budget,
particularly when spending on advertising are quite heavy.
Administration Cost Budget

This budget represents forecast of all administration expenses like directors’
fees, managing director’s salary, office lighting, heating and air
conditioning, etc. Most of these expenses are fixed, so should not be too
difficult to forecast.
Capital Expenditure Budget

This budget represents the expenditure on all fixed assets during the budget
period. It includes such items as new buildings, machinery, land and
intangible items like patents, etc.
Special Features: The capital expenditure budget has certain characteristic
features which distinguish it from other functional budgets. These are:
 Capital expenditure budget deals with items not directly related to profit
and loss account. Expenses related to capital expenditure such as
depreciation, repairs and maintenance, etc are however, correlated to this
budget and they are included in overhead budgets.
 Capital expenditure is frequently planned a number of year in advance,
perhaps five to ten years, in which case it is broken down into
convenient periods like years or months. As compared to this, other
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functional budgets are normally prepared for a shorter period, say, one
year.
 This budget involves large amount of expenditure which needs top
management approval. The capital expenditure budget is, therefore,
subject to a strict management control.
Purposes: The objectives of capital expenditure budget are stated below:

 To enable the company to establish a system of priorities in expenditure.
 To correct capacity imbalances.
 To provide a tool for controlling capital expenditure.
 To make proper financial provision to meet planned expenditure.
 To provide budgets for depreciation and maintenance costs for inclusion
in the departmental expense budgets.
Conclusion
The preparation of the functional budget explained above is a very
important activity in the preparation of a final budget usually known as the
master budget. The functional budget are the pieces put together to arrive at
the final and complete budget for an entity and therefore must be well
understood by learners.
Assessment
1. Explain the various functional budgets and demonstrate how they are
prepared.
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UNIT 5 SECTION
ACCOUNTING II 4
Unit 5, section 4: Cash budget
You are welcome to Session four of unit five. In this Session we will be
looking at the cash budget and how it is prepared. This is a budget prepared
to show the expected cash receipt and payment during the budget period
incorporating both revenue and capital items. Every learner should try as
much as possible to understand its preparation.

 explain what cash budget is.
 outline the purpose of the cash budget
 identify and explain the components of the cash budget
 prepare a cash budget for a particular period.
Meaning and Purpose of the cash Budget

The cash budget is one of the most important and one of the last to be
prepared. It is a detailed estimate of cash receipts from all sources and cash
payments for all purposes and the resultant cash balances during the budget
period. It makes certain that the business has sufficient cash available to
meet its needs as and when these arise. It is a device for coordinating and
controlling the financial side of the business to ensure solvency and provide
a basis for planning and financing required to cover up any deficiency in
cash. Cash budget thus plays an important role in the financial management
of a business undertaking.
Purpose: The main purposes of cash budget are outlined below:

 It ensures that sufficient cash is available when required.
 It indicates cash excesses and shortages so that action may be taken in
time to invest any excess cash or to borrow funds to meet any shortages.
 It establishes a sound basis for credit.
 It shows whether capital expenditure may be financed internally.
 It establishes a sound basis for control of cash position.
Preparation of cash budget; There are three months of preparing cash

budget:
 Receipts and payments method
 Adjusted profit and loss method
 Balance sheet method.
Receipts and Payments Method

This method is usually used for short term cash forecast and is much more
detailed than the other two methods.
The cash budget begins with the opening balance of cash in hand and at
bank. To this will be added the cash receipts from various sources and from
this will be deducted all payments of cash, whether on capital or revenue
account. The resultant figure is closing cash balance.
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Unit 5, section 4: Cash budget ACCOUNTING II
Cash receipts in most situations arise from cash sales, collections from
debtors, interest on investments and loans, sale of capital assets and
miscellaneous sources. In the case of credit sales, adjustment should be
made for the time lag between the point of sale and realization of cash.
Cash payments are made for raw material purchases, direct labour, out of
pocket expenses, capital expenditure projects, dividends. Etc. The period of
credit appropriate to the payment concerned should be taken into account.
Illustration 5.4
Prepare a cash budget for the three months ending 30th June, 2005 from the
information given below:
a)
Month Sales GH¢ Materials GH¢ Wages GH¢ Overheads GH¢
February 14,000 9,600 3,000 1,700
March 15,000 9,600 3,000 1,900
April 16,000 9,200 3,200 2,000
May 17,000 10,000 3,600 2,200
June 18,000 10,400 4,000 2,300
b. Credit terms are:

Sales and debtors – 10% of sales are on cash, 50% of the credit sales are
collected next month and the balance in the following month:
Creditors Materials 2 months
Wages ¼ month
Overheads ½ month
Cash and bank balance on 1st April, 2005 is expected to be GH¢ 6,000
c. Other relevant information are:
 plant and machinery will be installed in february 2005 at a cost of gh¢
96,000. the monthly installment of gh¢ 2,000 is payable from april
onwards.
 dividend @ 5% on preference share capital of gh¢ 2,000,000 will be
paid on 1st june.
 advance to be received for sale of vehicles gh¢ 9,000 in june.
 dividends from investments amounting to gh¢ 1,000 are expected to be
received in june.
 income tax (advance) to be paid in june is gh¢ 2,000.
Solution
Cash budget
For three months ending 30th June, 2005
April May June Total
GH¢ GH¢ GH¢ GH¢
Balance b/f 6,000 3,950 3,000 6,000
Receipts:
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ACCOUNTING II Unit 5, section 4: Cash budget
Sales* 14,650 15,650 16,650 46,950

Dividend __ __ 1,000 1,000
Advance against vehicle __ __ 9,000 9,000
Total 20,650 19,600 29,650 62,950
Payments:
Creditors (materials) 9,600 9,000 9,200 27,800
Wages 3,150 3,500 3,900 10,550
Overheads 1,950 2,100 2,250 6,300
Installment for plant 2,000 2,000 2,000 6,000
Pref. dividend __ __ 10,000 10,000
Income-tax advance __ __ 2,000 2,000
Total 16,700 16,600 29,350 62,650
Closing balance 3,950 3,000 300 300
Working Notes:
 Calculation of collection from debtors
Feb. March April May June
GH¢ GH¢ GH¢ GH¢ GH¢
Sales 14,000 15,000 16,000 17,000 18,000
Cash sales (10%) 1,400 1,500 1,600 1,700 1,800
Credit sales 12,600 13,500 14,400 15,300 16,200
50% collection in next 6,750 7,200 7,650
month
50% collection in the 6,300 6,750 7,200
following month
Total collection 13,050 13,950 14,850
Cash sales 1,600 1,700 1,800
Cash receipts from sales 14,650 15,650 16,650
 Payment to creditors for materials wages and overhead has been

computed on a similar pattern.
i) For example, payment for creditors for materials will be: February
purchases will be paid in April, March purchases will be paid in
May, and April purchases will be paid in June.
ii) Payment for wages in April = (3,000 x 1/4) + (3,200 x 3/4) = GH¢
3,150
May = (3,200 x 1/4) + (3,600 x 3/4) = GH¢ 3,500
June = (3,600 x 1/4) + (4,000 x 3/4) = GH¢ 3,900
iii) Payment for overhead in April = (1,900 x 1/2) + (2,000 x 1/2) =
GH¢ 1,950.
Similar calculations for May and June.
 Adjusted Profit And Loss Method

This method is suitable for long term cash forecast. It is based on the
view that it is the profit that is the source of cash in the business. The
profit as per profit and loss accounts is converted into cash figure by
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preparing an Adjusted Profit and loss Account. All those items of

income and expenditure (like depreciation, provisions etc.) which do not
involve an inflow or outflow of cash are adjusted in the forecasted profit
figure to arrive at the figure of cash made available by profit.
Given in Fig. 5.2 is a cash budget pro-forma under this method showing
the various items that require adjustments in the profit figure for finding
out the cash position at the end of a particular period.
The adjusted profit and loss method is often termed as cash flow
statement because it converts the profit and loss account into cash
forecast. The main difference between this method and the receipts and
payment method is that whereas the former considers non-cash items for
adjustment in the profit figure, the latter takes into account only cash
transactions.
It will be appreciated that under the adjusted profit and loss method, the
equation that PROFIT = CASH will hold good if there were no credit
transactions, accruals, capital transactions, depreciation, stock
fluctuations or appropriations of profit. But such a situation cannot exist
in practice.
 Balance Sheet Method

This method is also used for forecasting cash requirements for long
periods and is rather similar to adjusted profit and loss account method
discussed above. Under this method, a budgeted balance sheet is
prepared with all items of assets and liabilities excepting cash or bank
balance. The two sides of the balance sheet are then totaled and the
balancing figure is taken as cash. If the liabilities are more than assets,
this reveals a balance of cash and or bank, and if assets exceed
liabilities, this reveals a bank overdraft.
Cash Budget
For the period…..
Jan. Feb. March Total
GH¢ GH¢ GH¢ GH¢
Opening Balance of Cash
Additions:
Budgeted net profit
Depreciation
Provisions
Sale of plant
Issue of capital and debentures
Reduction in debtors
Reduction in stocks
Accrued expenses
Increase in liabilities
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Total additions
Total Cash Available
Deductions:
Dividends
Prepayments
Capital profit
Increase in stocks
Increase in debtors
Decrease in liabilities
Total deductions
Closing Balance of Cash
Fig. 5.2 Adjusted Profit and Loss Method of Cash Budget.
Thus, under the adjusted profit and loss method, cash figure is computed by
preparing a cash flow statement and the same figure is computed as a
balancing figure under the balance sheet method.
Master Budget
When all the functional budgets have been prepared, these are summarized
into what is known as a master budget. Thus a master budget is a
consolidated summary of all the functional budgets. According the
C.I.M.A., London, “master budget is a summary budget incorporating its
component functional budgets and which is finally approved, adopted and
employed.”
A master budget has two parts (i) operating budget, i.e., budgeted profit and
loss account, and (ii) financial budget, i.e., budgeted balance sheet. Thus, a
projected profit and loss account and a balance sheet together constitute a
master budget.
The master budget is prepared by the budget director (or budget officer) and
is presented to the budget committee for approval. It approved, it is
submitted to the Board of Director for final approval. The Board may make
certain amendments/ alternation before it is finally approved.
Illustration
Glass Manufacturing Company requires you to present the budget for the
next year from the following information:
Sales: GH¢ 6,00,000

Toughened Glass GH¢ 2,00,000
Bent Glass 60% of sales
Direct material cost 20 workers @ GH¢ 150 per
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month
Direct wages
Factory overheads:
Indirect labour -
Works manager GH¢ 500 per month
Foreman GH¢ 400 per month
Stores and spares 2.5% on sales
Depreciation on machinery GH¢ 12,600
Light and power GH¢ 3,000
Repairs and maintenance GH¢ 8,000
Other sundries 10% on direct wages
Administration, selling and distribution GH¢ 36,000 per year
expenses
Solution
Master budget for the year ending…….
Sales: GH¢
Toughened Glass 6,00,000
Bent Glass 2,00,000
Total Sales 8,00,000
Less: Direct materials (60% of GH¢ 4,80,000
8,00,000)
Direct wages (20 x 150 x 36,000
12months)
Prime Cost 5,16,000
Fixed Factory Overhead:
Works manager’s salary (500 x 12) 6,000
Foreman’s salary (400 x 12) 4,800
Depreciation 12,600
Light and power 3,000 26,400
Variable Factory Overhead:
Stores and spares 20,000
Repairs and maintenance 8,000
Sundry expenses 3,600 31,600
Works Cost 574,000
Gross Profit 226,000
Less: Adm., selling and dist. 36,000
expense
Net Profit 190,000
Conclusion
We have seen that the cash budget is an integral part of the whole budget
preparation. It gives the company the sources of cash and how it will be
spent. This will always guide the organization in its financing decisions.
Every student of cost and management accounting II should be able to
prepare a cash budget.
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UNIT 5 SECTION
ACCOUNTING II 5
Unit 5, section 5: Fixed and flexible budgets
Dear learner, I hope you have enjoyed and understood the previous lesson
on cash budget since it is essential in the budget preparation of every
organization. In this Session we are going to study another important budget
prepared by organisations as alternative budget. These budgets are fixed and
flexible budget. It is important to know that based on level of activity or
capacity utilization, budgets are classified into fixed budget and flexible
budget.

 explain the terms fixed budget and flexible budget
 outline the distinction between fixed and flexible budget
 prepare a flexible budget.
Fixed Budget
A fixed budget is one which is prepared keeping in mind one level of
output. It is defined as a budget “which is designed to remain unchanged
irrespective of the level of activity attained.” *If actual output differs from
budgeted level of output, variances will arise. Fixed budget is prepared on
the assumption that output and sales can be estimated with a fair degree of
accuracy. This means that in those situations where sales and output cannot
be accurately estimated, fixed budget does not suit.
Flexible Budget
In contrast to a fixed budget, a flexible budget is one “which is designed to
change in relation to the level of activity attained.” *The underlying
principle of flexible budget is that a budget is of little use unless cost and
revenue are related to the actual volume of production. Flexible budgeting
has been developed with the objective of changing the budget figures to
correspond with the actual output achieved. Thus a budget might be
prepared for various levels of output actually reached; it can be compared
with an appropriate level.
Flexible budgets are prepared in those companies where it is extremely

difficult to forecast output and sales with accuracy. Such a situation may
arise in the following cases.
 Where nature of business is such that sales are difficult to predict, e.g.,
demand for luxury goods is quite unpredictable.
 Where sales are affected by weather conditions, e.g., soft drink industry,
woolen garments, etc.
 Where sales are affected by changes in fashion, e.g., readymade
garments.
 Where company frequently introduces new products.
 Where large part of output is intended for export.
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Unit 5, section 5: Fixed and flexible budgets ACCOUNTING II
Uses of Flexible Budgets: The figures in flexible budgets are adaptable to

any given set of operating conditions. It is, therefore, more realistic than a
fixed budget which is true only in one set of operating conditions.
Flexible budgets are also useful from control point of view. Actual
performance of an executive should be compared with what he should have
achieved in the actual circumstances and not with what he should have
achieved under quite different circumstances.
In brief, flexible budgets are more realistic, practical and useful. Fixed
budgets, on the other hand, have a limited application and are suited only for
items like fixed costs.
Distinction between fixed and flexible budgets

The main points of distinction between the two are as follows:
 Fixed budget assumes static business conditions whereas flexible budget
is based on the assumption of changing business conditions.
 Fixed budget is prepared for only one level of activity but flexible
budgets may be prepared for different capacity levels or for any level of
activity changes.
 Fixed budget figures are not changed when actual level of activity
changes. But in flexible budgets, the figures are adjusted according to
the actual level of activity attained.
 When actual level of activity differs from budgeted level of activity,
then in fixed budgets meaningful comparison between actual and budget
figures is not possible. But in flexible budgets, such comparison are
quite realistic.
 Under changing business environments, fixed budgets have very limited
use for control. But flexible budgets are very useful for cost control and
performance evaluation under changing business environments.
Preparation of flexible budgets

The preparation of flexible budgets necessitates the analysis of all costs into
fixed and variable components. This analysis, of course, not peculiar to
flexible budgeting, is more important in flexible budgeting than in fixed
budgeting. This is so because inflexible budgeting, varying levels of output
are considered and each class of overhead will be different from each level.
In flexible budgeting, a series of budgets are prepared for every major level
of activity so that whatever that actual level of output, it can be compared
with appropriate budget or can be interpolated between budgets of the
activity levels on either side. For example, budgets may be prepared for,
say, 60%, 70%, 80%, 90% and 100% levels of activity. If the actual level of
activity is 85%, then the budget allowance for 85% activity should be
computed.
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ACCOUNTING II Unit 5, section 5: Fixed and flexible budgets
While computing fixed cost at various levels, it is to be noted that fixed cost
in total amount remains unchanged at various levels of activity. However,
fixed cost per unit decreases when level of output increases and vice versa,
i.e., fixed cost per unit increases when level of activity decreases.
Regarding the behaviour of variable costs, it is important to note that total

variable cost increases in production to increase in the level of activity and
vice versa. However, variable cost per unit does not change with the change
in level of activity.
Semi-variable cost should be separated into fixed and variable components.

Fixed component of the semi-variable cost will not change between levels
but viarable part of the semi-variable cost will change in the proportion of
level of activity. This is explained in the following illustration s.
Illustration 5.6
Draws up a flexible budget for overhead expenses on the basis of the
following data and determines the overhead rates at 70%, 80% and 90%
plant capacity.
At 80% capacity
GH¢
Variable overheads:
Indirect labour 12,000
Stores including spares 4,000
Semi-variable overheads:
Power (30% fixed, 70% variable) 20,000
Repairs and maintenance (60% fixed, 40% 2,000
variable)
Fixed overheads:
Depreciation 11,000
Insurance 3,000
Salaries 10,000
Total overheads 62,000
Estimated direct labour hours 1,24,000 hrs.
Solution
Flexible budget for the period
At 70% At 80% At 90%
Particulars capacity capacity capacity
Variable overheads: GH¢ GH¢ GH¢
Indirect labour 10,500 12,000 13,500
Stores including spares 3,500 4,000 4,500
Semi-Variable overheads:
Power: Fixed 6,000 6,000 6,000
Variable 12,250 14,000 15,750
Repairs and Maintenance:
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Fixed 1,200 1,200 1,200

Variable 700 800 900
Fixed overheads:
Depreciation 11,000 11,000 11,000
Insurance 3,000 3,000 3,000
Salaries 10,000 10,000 10,000
(A) Total overhead 58,150 62,000 65,850
(B) Estimated direct labour hours 108,500 124,000 139,500
Direct labour hour rate (A ÷ B) GH¢ 0.500 0.472
0.536
Working Notes:
70
1. Indirect labour cost at 70% = 12,000 × = GH¢ 10,500
80
90 =
at 90% = 12,000 × GH¢ 13,500
80
2. Power – Fixed = GH¢ 6,000, Variable = GH¢ 14,000
70
Variable power at 70 % = 14,000 × = GH¢ 12,250
80
= 14,000 × 90
at 90% = GH¢ 15,750
80
70
3. Direct labour hours at 70% = 1,24,000 × = 1,08,500
80
× 90
at 90% = 1,24,000 = 1,39,500
80
Illustration 5.7
The expenses budgeted for production of 10,000 units in a factory are
furnished below:
GH¢ Per unit
Materials 70
Labour 25
Variable overheads 20
Fixed overheads (GH¢ 1,00,000) 10
Variable expenses (direct) 5
Selling expenses (10% fixed) 13
Distribution expenses (20% fixe) 7
Administration expenses (GH¢ 50,000) 5
Total 155
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6,000 units 8,000 units 10,000 units

Per Total Per Total Per Total
unit GH¢ unit GH¢ unit GH¢
GH¢ GH¢ GH¢
Materials 70 420,000 70 560,000 70 700,000
Labour 25 150,000 25 200,000 25 250,000
Direct exp. 5 30,000 5 40,000 5 50,000
(variable)
Variable 20 120,000 20 160,000 20 200,000
overhead
Fixed 16.67 100,000 12.50 100,000 10 100,000
overhead
Selling exp: 2.17 13,000 1.63 13,000 1.30 13,000
Fixed
Variable 11.70 70,200 11.70 93,600 11.70 117,000
Distribution
expenses:
Fixed 2.33 14,000 1.75 14,000 1.40 14,000
Variable 5.60 33,600 5.60 44,800 5.60 56,000
Adm. Exp: 8.33 50,000 6.25 50,000 5.00 50,000
Fixed
Total cost 166.80 1,000,800 159.42 1,275,400 155.00 1,550,000
Prepare a budget for the production of (a) 8,000 units, and (b) 6,000 units.
Assume that administration expenses are rigid for all levels of production.
Solution
Flexible Budget for the period
Working Notes:
 Material, labour, direct expenses and variable overhead are variable
costs and do not change per unit. Total amount changes in proportion to
number of units produced.
 Fixed overhead total amount remains at GH¢ 100,000 at all levels of
output. Per unit fixed overhead is GH¢ 100,000 divided by the number
of units produced.
 Adm. Expenses are also fixed. It is calculated in the same manner as
fixed overhead.
 Selling expenses are 10% fixed when output is 10,000 units, i.e., GH¢
13,000 (GH¢ 1.30 x 10,000 units). Variable selling expenses per unit are
90% of GH¢ 13, i.e, GH¢ 11.70. Total fixed cost of GH¢ 13,000
remains the same at each level and per unit is calculated by dividing
GH¢ 13,000 by the number of units at each level. Variable selling
expense per unit is GH¢ 11.70 which remains the same at each level.
Total variable selling expenses are calculated by multiplying GH¢ 11.70
by the number of units at each activity level.
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 Distribution expenses are calculated in the same way as selling

expenses.
In the above flexible budgets, the following important points should be

noted:
 A total fixed cost for each level remains unchanged.
 Per unit fixed cost decreases when level of output increases.
 Total variable cost increases in proportion to increase in the level of
output.
 Per unit variable cost remains unchanged at each level.
Illustration 5.8
For the production department of XXL Ltd you are required to:
 Prepare a fixed budget of overheads;
 Prepare a flexible budget of overheads at 70% and 110% of budgeted
volume;
 Calculate a departmental hourly rates of overhead absorption as per (a)
and (b) above.
The budgeted level of activity of the department is 5,000 hours per period
and a study of the various items of expenditure reveals the following:
GH¢ Cost
per hr.
Indirect __ 0.40
wages
Repairs Up to 2,000 hours 100
For each additional 500 hours
up to a total 4,000 hours 35
Additional from 4,001 to 5,000 hours 60
Addition above 5,000 hours 70
Rent and 350
rates
Power Up to 3,600 hours 0.25
From hours above 3,600 0.20
Consumable 0.24
supplies
Supervision Up to 2,500 hours 400
Additional for each extra 600 hours
above 2,500 and up to 4,900 hour 100
Additional above 4,900 hours 150
Depreciation Up to 5,000 hours 650
Above 5,000 hours and up to 6,500 820
hours
Cleaning Up to 4,000 hours 60
Above 4, 000 hours 80
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Heat and From 2, 100 hours to 3,500 hours 120

lighting
From above 3,500 hrs. to 5,000 hours 150
Above 5,000 hours 175
Solution
Fixed and Flexible Budget for the Period….
Items of Nature of Fixed Flexible budget
overhead overhead budget
100% 5,000 70% 3,500 110%
hrs. hrs. 5,500 hrs.
GH¢ GH¢ GH¢
Indirect wages Variable 2,000 1,400 2,200
Repairs Semi- 300 205 370
variable
Rent and taxes Fixed 350 350 350
Power Semi- 1,180 875 1,280
variable
Consumable Variable 1,200 840 1,320
supplies
Supervision Semi- 950 600 950
variable
Depreciation - do - 650 650 820
Cleaning - do - 80 60 80
Heat and lighting - do - 150 120 175
Total 6,860 5,100 7,545
GH¢ 6,860 GH¢ 5,100 GH¢
Hourly rate of overhead 7,545
(Total overhead ÷ Hours) 5,000 hrs. 3,500 hrs. 5,500 hrs.
= GH¢ 1.37 = GH¢ 1.46 GH¢ 1.37
Revision of Budgets
Sometimes the original budget prepared may have to be revised due to one
or more of the following factors
 Changes in management policies and other internal factors like change
in the capacity utilization or addition to the production capacity, etc.
 Unforeseen changes in uncontrollable or external factors like change in
market prices of materials and other inputs, changes in fashions and
consumer tastes, etc.
 Errors committed in the preparation of original budget.
While preparing a revised budget, changes in all the factors requiring

consideration should be taken into account. The method of preparing a
revised budget may be similar to preparing a flexible budget so long as it
pertains to changes in level of output or capacity utilization.
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Illustration 5.9
A company produces two products and budgets at 60% level of activity for
the year 2006. It gives the following information:
Product A Product B
Raw material cost per unit GH¢ 7.50 3.50
Direct wages per unit GH¢ 4.00 3.00
Variable overhead per unit GH¢ 2.00 1.50
Fixed overhead per unit GH¢ 6.00 4.50
Selling price per unit GH¢ 20.00 15.00
Production and sales (units) 4,000 6,000
The managing director is not satisfied with the budgeted results as stated
above and wants to improve the performance. The managing director
proposed that the sales quantities of products A and B could be increased by
50% provided the selling price was reduced by 5% in the case of product A
and 10% in the case of product B. the price reduction should be made
applicable to the entire quantity of sales of each of the two products.
You are required to present the overall profitability under the original
budget and revised budget after taking the increased sales into
consideration.
Solution
Original and revised budget for the year 2006
Original budget Revised budget
A B Total A B Total
Sales (units) 4,000 6,000 6,000 9,000
GH¢ GH¢ GH¢ GH¢ GH¢ GH¢
(A) Sales 80,000 90,000 1,70,000 1,14,000 1,21,500 2,35,500
(value)
Cost:
Raw 30,000 21,000 51,000 45,000 31,000 76,500
material
Labour 16,000 18,000 34,000 24,000 27,000 51,000
Variable 8,000 9,000 17,000 12,000 13,500 25,500
overhead
Fixed 24,000 27,000 51,000 24,000 27,000 51,000
overhead
(A) Total 78,000 75,000 1,53,000 1,05,000 99,000 2,04,000
cost
Profit (A – 2,000 15,000 17,000 9,000 22,500 31,500
B)
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Working Note: Revised sales figures are computed as follows:

A B
Selling price per unit GH¢ 20 15
Less: 5% and 10% GH¢ 1 1.50
GH¢ 19 13.50
Sales value = 6,000 units x GH¢ 19 = GH¢ 114,000

= 9,000 units x GH¢ 13.50 = GH¢ 121,500
Budget Reports
Establishing budgets in itself is of no use unless there is a continuous flow
of budget reports showing comparison of actual and budget figures. Budget
reports should be prepared at regular intervals (say, every month) showing
the reasons for the differences between actual and budget figures. The
reports should be prepared in such a way that they establish the
responsibility for the variances. Reports should also reveal whether a
variance is favourable or unfavourable and also whether a variance is
controllable or uncontrollable.
The contents of the budget report differ according to the need of managerial
level. For example, lower level of management is generally provided with
detailed reports of such activities with which the manager is directly
concerned. Thus a foreman will be concerned with reports concerning his
own Session. As the level of management grows higher, the amount of
detail becomes less although the coverage of the report will widen.
Essential of a Budget Report: The following essentials should be kept in

mind while preparing budget reports:
 The budget reports should be simple and suitable for the level of
understanding for the user.
 Reports should be presented promptly.
 Reports should be accurate but the extreme accuracy should not be at the
cost of promptness.
 The principle of exception should be utilized, where possible.
 The reports should contain only essential information according to the
needs of the user.
Form of Budget Report

The budget reports may be presented in the form of financial statements or
diagram as illustrated below:
Budget Report
Budget Centre Period
Code Item of Budget Actual Variance Reason
No. expenses GH¢ GH¢ Adverse Favourable
GH¢ GH¢
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Conclusion
In summary, we have seen that fixed budget is prepared based on an
estimated single activity level with respect to variables such as sales
quantity, production volume, production mix etc. and no attempt is made
restate the budget to reflect the actual activity level in the event where the
actual activity level differ from the estimated level of activity. However, the
flexed budget is prepared to reflect the actual level of activity.
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UNIT 5 SECTION
ACCOUNTING II 6
Unit 5, section 6: Other types of budget
Hello learner, you are most welcome to the last Session of this unit which is
Session six. In this Session, we will be looking at some other types of
budget preparation methods and other important issues under budgeting. It
is our hope that this last Session will complete your understanding of the
topic budgeting and budgetary control.
 by the end of this session, the learner should be able to:

 explain zero based budgeting (zbb) and performance budget
 outline the importance of zbb over the traditional budgeting methods
 explain responsibility accounting and its functions
Zero-Based Budgeting (ZBB)

ZBB is a recent development in the area of management control system and
is steadily gaining importance in the business world. Before preparing a
budget, a base is determined from which the budget process begins. Quite
often current year’s budget is taken as the base or the starting point for
preparing the next year’s budget. The figures in the base are changed as per
the plan for the next year. This approach of preparing a budget is called
incremental budgeting since the budget process is concerned mainly with
the increase or changes in operations that are likely to occur during the
budget period. For example, sales of the current year’s budget may be taken
as the base and the next year’s sales budget will be current year’s sales plus
an allowance for price increase and expected changes in sales volumes. The
main drawback of this approach is that it perpetuates the past inefficiencies.
Zero-based budgeting (ZBB) is an alternative to incremental budgeting.

ZBB was introduced at Texas Instruments in USA in 1969 by Peter Phyrr,
who is known as the father of ZBB. It is not based on incremental approach
and previous year’s figures are not taken as the base for preparing next
year’s budget. Instead, the budget figures are developed with zero as the
base, which means that a budget will be prepared as if it is being prepared
for a new company for the first time.
Peter Phyrr has defined ZBB as “a planning and budgeting process which
requires each manager to justify his entire budget request in detail from
scratch (hence zero base). Each manager status why he should spend any
money at all. This approach requires that all activities be identified as
decision packages which will be evaluated by systematic analysis ranked in
order of importance.”
According to C.I.M.A., London, ZBB is defined as “a method of budgeting

whereby all activities are revalued each time a budget is set. Discrete levels
of each activity are valued and a combination chosen to match funds
available.”
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Unit 5, section 6: Other types of budget ACCOUNTING II
In simple words, ZBB is a system whereby each budget item, regardless of

whether it is new or existing, must be justified in its entirety each time a
new budget is prepared. It is a formalized system of budgeting for the
activities of an enterprise as if each activity were being performed for the
first time, i.e., from zero base.
The novel part of the ZBB is the requirement that the budgeting process
starts at zero with all expenditures to be completely justified. This contrasts
with the usual approach in which a certain level of expenditure is allowed as
a starting point and the budgeting process focuses on requests for
incremental expenditures.
In ZBB, budget requests for appropriation are accepted on the basis of

cost/benefit approach which ensures value for money. It questions long
standing assumptions and systematically examines and perhaps abandons
any unproductive projects. This means that those of activities which are of
no value find no place in the forthcoming budget even though these might
have been an integral part of the past budget prepared under the traditional
approach. ZBB in a way tries to locate those activities which are not
essential.
Main Features of Zero-Based Budgeting (ZBB)

The main features of ZBB are as under:
 All budge items, both old and newly proposed, are considered totally
afresh.
 Amount to be spent on each budget item is to be totally justified.
 A detailed cost benefit analysis of each budget programme is undertaken
and each programme has to compete for scarce resources.
 Departmental objectives are linked to corporate goals.
 The main stress in not on “how much’ a department will spend but on
‘why’ it needs to spend.
 Managers at all levels participate in ZBB process and they have
corresponding accountabilities.
These days ZBB is widely used. In fact, when Jimmy Carter became the
President of USA, he directed that all federal government agencies adopt
ZBB. On a review of literature on the use of ZBB, it is found that in many
organizations, ZBB has led to a considerable improvement in the budget
process. But at the same time, in many organizations it has not proved
successful.
Advantages: The main advantages of ZBB are:

 In ZBB, all activities included in the budget are justified on cost benefit
considerations which promote more effective allocation of resources.
 ZBB discards the attitude of accepting the current position in favour of
an attitude of questioning and challenging each item of budget.
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ACCOUNTING II Unit 5, section 6: Other types of budget
 In the course of ZBB process, inefficient and loss making operations are
identified and may be removed.
 It adds psychological push to employees to avoid wasteful expenditure.
 It is an educational process and can promote a management team of
talented and skillful people who tend to promptly respond to changes in
the business environments.
 Cost behaviour patterns are more closely examined.
 Deliberately inflated budget requests get automatically weeded out in
the ZBB process.
Disadvantages: Despite being a useful technique, ZBB suffers from the

following disadvantages:
 ZBB leads to an enormous increase in paper work and results in high
cost of preparing budgets every year.
 Managers may resist new ideas and changes. They may feel threatened
by ZBB because all expenditures are questioned and need to be justified.
 In ZBB, there is danger of emphasing short-term gains at the expense of
long-term benefits.
 It has a tendency to regard any activity not foreseen and sanctioned in
the most recent ZBB as illegitimate.
 For introducing ZBB, managers need to be given proper training and
education regarding this new concept, its pros and cons and
implementation.
 It may not always be easy to properly rank decision packages and this
may give rise to conflicts.
Performance Budgeting
Performance budget is also a recent development which tries to overcome
the limitations of traditional budgeting. In traditional system of budgeting as
used in business enterprises and government departments, the main defect is
that the control of performance in terms of physical units and the related
costs is not achieved. This is because in such budgeting, money concept is
given more importance. Performance budgeting is a relatively new concept
which focuses on functions, programmes and activities.
In other words, in case of traditional budgeting, both input and output are
mostly measured in monetary unit while performance budgeting lays
emphasis on achievement of physical targets. Performance budgets are
established in such a manner that each item of expenditure related to a
specific responsibility centre is closely linked with the performance of that
centre. Thus performance budgeting lays stress on activities and
programmes. It tries to answer questions like – What is to be achieved. How
is it to be achieved, When is it to be achieved, etc.
The Government of Ghana has now decided to introduce performance

(programmed-based) budgeting in all its departments in a phased manner.
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An example of performance budgeting in government system of accounting

may be that generally expenditure is classified under the heads like pay and
allowances, transport, repairs and maintenance, etc. in performance
budgeting, the classification of expenditure may be setting up of a steel mill,
construction of a railway station, computerization of railway booking
system, purchases of an aircraft carrier, etc. and other physical targets.
When work on these activities is started, funds are obtained against these
physical targets. Reports are then prepared for any under-spending or over-
spending which are then analysed for corrective action to be taken.
Performance budgeting is sometimes called Programme Budgeting or

Planning, Programme and Budget System (PPBS).
Steps in Performance Budgeting

 Establishment of responsibility centre: First of all, responsibility
centres are established. A responsibility centre is a segment of an
organization where an individual manager is held responsible for the
performance of the segment.
 Establishment of Performance targets: For each responsibility
centres, targets are set in terms of physical performance to be achieved.
For example, for sales department, which is a responsibility centre,
targets may be set in terms of number of units to be sold during the
budget period. For production department, the target would then be the
number of units to be produced.
 Estimating financial requirements: In this step, the financial support
needed to achieve the physical targets is estimated. In other words, the
amount of expenditure involved under various heads to meet the
physical performance is forecasted.
 Comparison of actual with budgeted performance: This is a usual
step in budgetary control to evaluate the actual performance.
 Reporting and Action: Variances from budgeted performance are
analysed and reported for corrective action to be taken.
Responsibility Accounting
Responsibility accounting is one of the basic components of a good control
system. The main characteristic feature of this control system is that it is
relevant to measurement of performance of departments or divisions of an
organization while other control systems are applicable to the organization
as a whole. Budgeting and variance analysis (standard costing) are thus part
of the responsibility accounting process.
Responsibility accounting is a method of accumulating and reporting both

budgeted and actual costs and revenues by divisional managers responsible
for them. It means in responsibility accounting, business activities are
identified with persons rather than products or functions and responsibility
is assigned to the manager best placed to effect control. The idea of
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responsibility accounting is that managers will be held responsible only for

those items over which they can exercise a significant amount of control.
Horngren has defined responsibility accounting as “a system of accounting

that recognizes various responsibility centres throughout the organization
and reflects the plans and actions of each of these centres by assigning
particular revenues and costs to the one having the pertinent
responsibility.”
Responsibility accounting has no scope in a small organization because all

decision making is centralized at one place and one individual. However, in
big business houses, there are various functional departments such as
purchasing, production, marketing, research and development, etc. All these
departments are under the charge of their respective departmental heads who
are accountable for their performance. These departmental heads have the
decision-making authority and with authority come the responsibility. This
means that managers of decentralized departments who have decision
making powers should also be responsible for result of their divisions.
Pre-requisites for Responsibility Accounting

Responsibility accounting is based on certain assumption. These pre-
requisites/assumptions are as follows:
 The areas of responsibility are well defined at different levels of the
organization.
 There are clearly set goals and targets for each responsibility centre.
 Managers actively participate in establishing the budgets against which
their performance is measured.
 Accounting system generates correct and dependable information for
each responsibility centre.
 The managers are held responsible only for those activities over which
they exercise significant degree of control.
 Managers must try to attain the goals and objectives.
 Goals for each area of responsibility should be attainable with efficient
performance.
 Performance reporting should be timely and should contain significant
information relating to the responsibility centre.
Responsibility Centre
Responsibility accounting is based on the recognition of individual areas of
responsibility as specified in the organization structure of the firm. These
areas of responsibility are known as responsibility centres. A responsibility
centre may be defined as a section of an organization for which an
individual manager is held responsible for the performance of that section.
A responsibility centre may be a department (like personnel department), a
product line (like steel wires, steel casting), a territory (like west zone or
south zone) or any other type of clearly identifiable area of responsibility.
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An important criterion for creating responsibility centre is that the unit of

the organization should be separable and identifiable for the purpose of its
performance evaluation. Responsibility centres are of the following three
types.
 Cost Centre: It is defined by C.I.M.A., London as “a production or
service location, function, activity or item equipment whose costs may
be attributed to cost units”. A responsibility centre is a cost centre
where the manager is accountable for the costs that are under his control
but not for its revenues. Only those costs are charged to cost centre
which are controllable by the manager of the cost centre.
 Profit centre: According to C.I.M.A., London, a profit centre is “a part
of a business accountable for costs and revenues. It may be called a
business centre, business unit, or strategic business unit.” Thus a
responsibility centre is a profit centre where the manager is accountable
for sales revenue as well as costs. The difference between revenues and
costs is profit. For example, a department of a company is a profit centre
if it is responsible for sales as well as production in that department.
 Investment centre: It is defined by C.I.M.A, London, as “a profit
centre whose performance is measured by its return on capital
employed.” Thus a responsibility centre is an investment centre where is
manager is responsible for sales revenues and costs and in addition is
responsible for some capital investment decision relating to working
capital management, capital structure and capitalization etc. His
performance is measured in terms of profit as related to capital base.
The objectives of responsibility accounting are to accumulate costs and

revenues for each responsibility centre so that variances from budgets
are attributed to the manager concerned. Responsibility accounting is
implemented by issuing performance reports at frequent intervals that
inform the manager of the responsibility centre regarding the variance
between actual and budgeted results.
Features: The basic method of control in responsibility accounting is the

same as used in budgetary control and standard costing and may be stated in
the following points:
 Responsibility centres are created.
 A plan is prepared in the form of budgets or standards for each
responsibility centre.
 The performance of the responsibility centre is evaluated by comparing
actual results with those budgeted in the regular monthly reports.
 Variances between actual and budgeted performance are analysed so as
to fix responsibility.
 Corrective and preventive action is taken, wherever possible.
Advantages: The following advantages accrue from a system of

responsibility accounting:
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 Responsibility for any adverse performance is clearly identified. As a

result, the individual managers may find it difficult to shift the
responsibility to any other manager.
 The moral of the managers is high because of their active participation
in decision making.
 Responsibility accounting provides increased job satisfaction and greater
motivation to put in their best efforts.
 It helps in quick reporting of performance oriented results of
management of various levels.
 Managers of responsibility centres get an opportunity to gain valuable
managerial skill.
 Responsibility accounting facilitates sticker control on costs and
revenues.
Responsibility accounting is often focused on the lowest level managers

who have the most day-to-day influence on costs, where a person can
significantly influence the amount of cost through his own action. A major
problem in responsibility accounting is establishing controllability. In the
strict sense, a particular item of cost is controllable when it can be definitely
influence by a given manager within a given time span. But the problem is
that hardly any costs are clearly under the sole influence of only one person.
Take the case of material costs. Material prices are influenced by the
purchase manager while material quantities consumed are influenced by the
production manager.
Responsibility accounting can never be a substitute of good management. It

is simply a tool of management. Some systems that all otherwise sound
never get off the ground because the managers do not really understand
them nor put them to good use. Nor responsibility accounting is an
accounting technique that stands or falls on the accountant’s use of it. It is
an integral part of the management process and the accountant’s role is a
technical and supporting one. Unless the operating managers
enthusiastically support responsibility accounting and make it to work, even
the best conceived system will fail.
Conclusion
In this Session we have seen the importance of using the ZBB approach in
the preparation of budget in these modern times. The Session also
introduced us to performance budget and responsibility accounting. Our
understanding of these issues will help us as management accountant to use
resources efficiently and effectively.
Assessment Problems and Solutions

Problem 1
A department of XYZ Company attains sales of GH¢ 600,000 at 80% of its
normal capacity. Its expenses are given below:
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GH¢
General expenses 2% of sales
Depreciation 7,500
Rent and rates 8,750
Selling Cost:
Salaries 8% of sales
Travelling expenses 2% of sales
Sales office 1% of sales
General expenses 1% of sales
Distribution Cost:
Wages 15,000
Rent 1% of sales
Other expenses 4% of sales
Draw up Flexible Administration, Selling and Distribution Costs Budget,

operating at 90 percent, 100 percent and 110 percent of normal capacity.
Solution
Flexible Budget
for the period…………..
80% 90% 100% 110%
GH¢ GH¢ GH¢ GH¢
Sales 600,000 675,000 750,000 825,000
Administration Costs:
Office salaries (fixed) 90,000 90,000 90,000 90,000
General expenses (2% of sales) 12,000 13,500 15,000 16,500
Depreciation (fixed) 7,500 7,500 7,500 7,500
Rent and rates (fixed) 8,750 8,750 8,750 8,750
(A) Total Adm. Costs 118,250 119,750 121,250 122,750
Selling Costs:
Salaries (8% of sales) 48,000 54,000 60,000 66,000
Travelling expenses (2% of 12,000 13,500 15,000 16,500
sales )
Sales office (1% of sales) 6,000 6,750 7,500 8,250
General expenses (1% of sales) 6,000 6,750 7,500 8,250
(B) Total selling costs 72,000 81,000 90,000 99,000
Distribution Costs:
Wages (fixed) 15,000 15,000 15,000 15,000
Rent (1% of sales) 6,000 6,750 7,500 8,250
Other expenses (4% of sales) 24,000 27,000 30,000 33,000
(C) Total Dist. Costs 45,000 48,750 52,500 56,250
Total Cost (A + B + C) 235,250 249,500 263,750 278,000
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Note: All fixed costs have been assumed to remain unchanged even at 110%
capacity. However, in practice, fixed costs may change when capacity
utilization exceeds 100%.
Problem 2
The budget manager of Jupiter Electricals Limited is preparing flexible
budget for the accounting year starting from 1 July, 2006.
The company produces one product – DETX II. Direct material costs GH¢ 7
per unit. Direct labour averages GH¢ 2.50 per hour and requires 1.6 hours to
produce one unit of DETX II. Salesmen are paid a commission of GH¢ 1
per unit sold. Fixed selling and administrative expenses amount to GH¢
85,000 per year.
Manufacturing overhead is estimated in the following amounts under

specified volumes:
Volume of production (in units) 120,000 150,000
Expenses: GH¢ GH¢
Indirect material 264,000 330,000
Indirect labour 150,000 187,500
Inspection 90,000 112,500
Maintenance 84,000 102,000
Supervision 198,000 234,000
Depreciation of plant and equipment 90,000 90,000
Engineering services 94,000 94,000
Total manufacturing overhead 970,000 1,150,000
Prepare a Total cost Budge for 140,000 units of production.
Solution
Budget for the year ending 30th June, 2007
Output 140,000 units
Variable costs: GH¢
1. Direct material @ GH¢ 7 per unit 980,000
2. Direct labour @ GH¢ 4 per unit 560,000
3. Salesmen’s commission @ GH¢ 1 per unit 140,000
4. Indirect materials @ GH¢2.20 per unit 308,000
5. Indirect labour @ 1.25 per unit 175,000
6. Inspection @ GH¢ 0.75 per unit 105,000
Semi-variable costs:
1. Supervision – Fixed 54,000
– Variable @ GH¢ 1.20 per unit 168,000
2. Maintenance – Fixed 12,000
– Variable @ GH¢ 0.60 per unit 84,000
Fixed Costs:
1. Depreciation 90,000
2. Engineering services 94,000
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3. Selling and distribution expenses 85,000

Total 2,855,000
Working Notes:
Fixed and variable components of each item of cost are determined as
follows:
1. Indirect material
Change in cost GH¢ 3,30,00-2,64,000
Variable cost per unit = =
Change in output 1,50,000-1,20,000 units
66,000
= = GH¢ 2.20
30,000
Variable indirect material = 1, 20,000 x GH¢ 2.20 = GH¢ 264,000 for

120,000 units. Hence there is no fixed cost element and this item is purely
variable. Similar calculation for indirect labour and inspection.
2. Supervision
Change in cost GH¢ 2,34,000-1,98,000
Variable cost per unit = =
Change in output 1,50,000-1,20,000 units
36,000
= = GH¢ 1.20 per unit
30,000
Fixed supervision cost = 198,000 – (120,000 x 1.20) = GH¢ 54,000
Similar calculation for maintenance cost.
3. Depreciation and engineering services costs are the same at two levels of
production. Thus these are fixed costs.
Problem 3
The manager of Repairs and Maintenance Department in response to a
request, submitted the following budget estimates for his department that are
to be used to construct a flexible budget to be used during the coming
budget year:
Details of cost Planned at 6,000 Planned at 9,000
direct repair hours direct repair hours
Employee salaries 30,000 30,000
Indirect repair materials 40,200 60,300
Miscellaneous cost, etc. 13,200 16,800
(a) Prepare a flexible budget for the department up to activity level of

10,000 repair hours (use increments of 1,000 hours).
(b) What would be budget allowance at 8,500 direct repair hours?
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Solution
a. Flexible Budget for the period
Direct repair hours 6,000 7,000 8,000 9,000 10,000
Employee salaries 30,000 30,000 30,000 30,000 30,000
Indirect materials 40,200 46,900 53,600 60,300 67,000
Misc. costs: Fixed 6,000 6,000 6,000 6,000 6,000
Variable 7,200 8,400 9,600 10,800 12,000
Total 83,400 91,300 99,200 107,100 115,000
b. Budget allowance for 8,500 repair hours

= Fixed cost + variable cost for 8,500 repair hours
= 36,000 + (8,500 hrs. x GH¢ 7.90)
= GH¢ 103,150
Working Notes:
1) Employee salaries are a fixed cost and thus is the same at all levels.
2) Indirect repair material is a variable cost @ GH¢ 6.70 (i.e., 40, 200 ÷
6,000) per repair hour.
3) Misc. cost is a semi-variable item. It is separated into fixed and variable
components follows:
Difference in cost 16,800-13,200 3,600
Variable = = =
Difference in hours 9,000-6,000 3,000
= GH¢ 1.20 per repair hour.
Fixed = [GH¢ 13,200 – (6,000 x GH¢ 1.20)] = GH¢6,000
Total fixed cost = Employee salary + Misc. cost (fixed)

= 30,000 + 6,000 = GH¢ 36,000
Total variable cost per hour = Indirect material + Misc. cost

= GH¢ 6.70 + 1.20 = GH¢ 7.90 per hour
Problem 4
Excellent Manufactures can produce 4,000 units of a certain product at
100% capacity. The following information is obtained from the books of
account:
Aug. 2006 Sept. 2006
Unit produced 2,800 3,600
GH¢ GH¢
Repairs and maintenance 500 560
Power 1,800 2,000
Shop labour 700 900
Consumable stores 1,400 1,800
Salaries 1,000 1,000
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Inspection 200 240

Depreciation 1,400 1,400
Rate of production per hour is 10 units. Direct material cost per unit is GH¢
1 and direct wages per hour is GH¢ 4.
a. Compute the cost of production at 100%, 80% and 60% capacity
showing the variable, fixed and semi-variable items under the flexible
budget.
b. Find out the overhead absorption rate per unit at 80% capacity.
Solution
Flexible Budget
100% 80% 60%

4,000 units 3,200 units 2,400
GH¢ GH¢ units
GH¢
Variable costs:
Direct materials [@ GH¢ 1 per 4,000 3,200 2,400
unit]
Direct wages [@ GH¢ 4 per unit 1,600 1,280 960
for 10 units]
Shop labour 1,000 800 600
Consumable stores 2,000 1,600 1,200
Total ‘A’ 8,600 6,880 5,160
Semi-variable costs:
Power 2,100 1,900 1,700
Inspection 260 220 180
Repairs and maintenance 590 530 470
Total ‘B’ 2,950 2,650 2,350
Fixed costs:
Salaries 1,000 1,000 1,000
Depreciation 1,400 1,400 1,40
Total ‘C’ 2,400 2,400 2,400
Total cost (A + B + C) 13,950 11,930 9,910
Cost per unit (Total cost ÷ Units) 3.49 3.73 4.13
c. Calculation of overhead absorption rate per unit at 80% capacity
Total cost at 80% GH¢ 11,930
Less: Direct material and direct wages (i.e., GH¢ 3,200 + 1,280) 4,480
Overhead cost 7,450
Overhead rate per unit = GH¢ 7,450 ÷ 3,200 = GH¢ 2.33
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Working Notes:
Calculation of semi-variable costs
Difference in cost
Variable =
Difference in units
2,000-1,800 200
Power = = = GH¢ 0.25
3,600-2,800 units 800 units
At 70%, fixed element in power cost = 1,800 – 700 (i.e., 2,800 units @)
0.25 per unit
= GH¢ 1,100
Semi-variable power cost at 100% = 1,100 + 1,000 (i.e, 4,000 units
@ 0.25)
= GH¢ 2,100
Semi-variable power cost at 80% = 1,100 + 800 (i.e., 3,200 units
= @ 0.25)
= GH¢ 1,900
Semi-variable power cost at 60% = 1,100 + 600 (i.e. 2,400 units @
0.25)
GH¢ 1,700
Similar calculations for inspection and repairs and maintenance.
Problem 5
The following are the estimated sales of a company for eight months ending
30.10.2006:
Months Estimated sales (units)

April 2006 12,000
May 2006 13,000
June 2006 9,000
July 2006 8,000
August 2006 10,000
September 2006 12,000
October 2006 14,000
November 2006 12,000
As a matter of policy, the company maintains the closing balance of finished

goods and raw materials as follows:
Stock item Closing balance of a month
Finished goods 50% of the estimated sales for the next
month.
Raw materials Estimated consumption for the next
month.
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Every unit of production requires 2kg of raw material costing GH¢5 per kg.
Prepare Production Budget (in units) and Raw Material Purchase Budget (in
units and cost) of the company for the half year ending 30 September 2006.
Solution
Production Budget for the half year ending 30-9-2006
April May June July Aug. Sept.
Units Units Units Units Units units
Estimated Sales 12,000 13,000 9,000 8,000 10,000 12,000
Add: Closing 6,500 4,500 4,000 5,000 6,000 7,000
stock
18,500 17,500 13,000 13,000 16,000 19,000
Less: Opening 6,000 6,500 4,500 4,000 5,000 6,000
stock
Estimated 12,500 11,000 8,500 9,000 11,000 13,000
Production
Raw Material Purchase Budget for the half year ending 30-9-2006
April May June July Aug. Sept.
kg kg kg kg kg kg
Material @ 2
kg per unit of 25,000 22,000 17,000 18,000 22,000 26,000
production
Add: Closing 22,000 17,000 18,000 22,000 26,000 26,000
stock
47,000 39,000 35,000 40,000 48,000 52,000
Less: Opening 25,000 22,000 17,000 18,000 22,000 26,000
stock
Purchases 22,000 17,000 18,000 22,000 26,000 26,000

Cost of
purchases @ 110,000 85,000 90,000 110,000 130,000 130,00
GH¢ 5 per kg 0
GH¢
Problem 6
Shangrila Food Products Limited has prepared the following Sales Budget
for the first five months of 2006:
Sales Budget (in unit)

January 10,800
February 15,600
March 12,200
April 10,400
May 9,800
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The inventory of finished products at the end of every month is to be equal

to 25 percent of the sales estimate for the next month. On 1 January 2006,
there were 2,700 units of product on hand. There is no work-in-process at
the end of any month.
Every unit of product requires two types of materials in the following

quantities:
Material A 4kg
Material B 5kg
Materials equal to one-half of the next month’s production are to be in hand

at the end of every month. This requirement was met on 1 January, 2006.
Budgeted prices for the purchase of materials are: Prepare a Material Budget
for the first quarter of 2006 in a logical form showing the quantities of each
type of material to be purchased every month. Also prepare a Purchase
Budget.
Solution
Before preparing material budget, production has to be estimated by
preparing a production budget.
Production Budget
For the Quarter 1st Jan. to 31st. March, 2006
Budget period
Jan. units Feb. units March April
units
Estimated sales 10,800 15,600 12,200 10,400
Add: Closing stock 3,900 3,050 2,600 2,450
14,700 18,650 14,800 12,850
Less: Opening stock 2,700 3,900 3,050 2,600
Production 12,000 14,750 11,750 10,250
Working Notes:
Calculation of closing stock and opening stock
Closing Stock Opening stock
Jan. 25% of 15,600 units = 25% of 10,800 units for Jan = 2,700
3,900
Feb. 25% of 12,200 units = Closing stock of Jan is opening stock
3,050 of Feb and closing stock of Feb. is
March 25% of 10,400 units = opening stock of March.
2,600
Material Budget
For the quarter Jan. 1 to March 31, 2006
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Jan. Feb. March

A B A B A B
kg kg kg kg kg Kg
Materials for
production
@ 4 kg. per unit 48,000 60,000 59,000 73,750 47,000 58,750
for A
@ 5 kg. per unit
for B
Add: Closing 29,500 36,875 23,500 29,375 20,500 25,625
stock
77,500 96,875 82,500 1,03,125 67,500 84,375
Less: Opening 24,000 30,000 29,500 36,875 23,500 29,375
stock
Quantity to be 53,500 66,875 53,000 66,250 44,000 55,000
purchased
Working Notes:
Closing stock for each month is calculated as under:
For A
Jan. – 50% of 59,000 kg. = 29,500kg.
Feb. – 50% of 47,000kg. = 23,500kg
Mar. – 50% of (10,250 x 4kg) = 20,500kg
For B
Jan. – 50% of 73,750 kg = 36,875kg.
Feb. – 50% of 58,750kg. = 29,375kg
Mar. – 50% of (10,250 x 5kg) = 25,625kg
Purchases Budget
Material Jan. Feb. Mar. Total

Qyt. Pri Amt. Qyt. Kg Price Amt. Qyt. Price Amt. Amt.
Kg ce GH¢ GH¢ GH¢ Kg GH¢ GH¢ GH¢
G
H¢
A 53,500 3 160,500 53,000 3 159,000 44,000 3 132,000 451,500
B 66,875 2 133,750 66,250 2 132,500 55,000 2,110,000 376,250 376,250
Total 294,250 291,500 242,000 827,750
For the Quarter Jan 1 of March 31, 2006
Problem 7
The following data relate to Bookshop Ltd:
The financial manager has made the following sales forecasts for the first
five months of the coming year, commencing from 1st April, 2006:
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Month Sales (GH¢)

April 40,000
May 45,000
June 55,000
July 60,000
August 50,000
Other data
i. Debtors’ and creditors’ balance at the beginning of the year are GH¢
30,000 and GH¢ 14,000 respectively. The balance of other relevant
assets and liabilities are:
ii. Cash Balance GH¢ 7,500
iii. Stock GH¢ 51,000
iv. Accrued Sales Commission GH¢ 3,500
v. 40% sales are on cash basis. Credit sales are collected in the month
following the sale.
vi. Cost of sales in 60 per cent on sales.
vii. The only other variable cost is a 5% commission to sales agents. The
sales commission is paid in a month after it is earned.
viii. Inventory (stock) is kept equal to sales requirements for the next two
month budgeted ales.
ix. Trade creditors are paid in the following month after purchases.
x. Fixed costs are GH¢ 5,000 per month including GH¢ 2,000
depreciation.
You are required to prepare a Cash Budget for the month of April, May and
June, 2006 respectively.
Solution
Cash Budget
For the month of April, May and June, 2006
April GH¢ May GH¢ June GH¢
Opening Balance 7,500 33,000 37,000
Receipts:
Cash sales (40% of sales) 16,000 18,000 22,000
Receipt for debtors 30,000 24,000* 27,000*
Total cash available (A) 53,500 75,000 86,000
Payment:
Creditors 14,000 33,000* 36,000*
Fixed cost (5000 – 2000) 3,000 3,000 3,000
Total payment (B) 20,500 38,000 41,250
Closing balance (A – B) 33,000 37,000 44,750
Working Note:
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Calculation of receipts from debtors, purchases and payment to creditors

(assuming that all purchases are on credit basis)
April May June July Aug.
Credit sales 60% of total 24,000 27,000 33,000 36,000 30,000
sales
Cost of sales 60% of 24,000 27,000 33,000 36,000 30,000
total sales
Desired closing 60,000 69,000 66,000
inventory at cost
84,000 96,000 99,000
Less: Opening Inventory 51,000 60,000 69,000
Purchases 33,000 36,000 30,000
Payment to creditors 14,000 33,000 36,000
Problem 8
From the following prepare Cash budget of a company:
1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr.
GH¢ GH¢ GH¢ GH¢
Opening cash balance 10,000 __ __ __
Collection from customers 125,000 150,000 160,000 221,000
Payment:
Purchases of materials 20,000 35,000 35,000 54,200
Other expenses 25,000 20,000 20,000 17,000
Salary and wages 90,000 95,000 95,000 109,200
Income tax 5,000 __ __ __
Purchases of machinery __ __ __ 20,000
The company desired to maintain a cash balance of GH¢ 15,000 at the end
of each quarter. Cash can be borrowed or repaid in multiples of GH¢ 500 at
an interest of 10% per annum. Management does not want to borrow cash
more than what is necessary and wants to repay as early as possible. In any
event, loans cannot be extended beyond four quarter. Interest is computed
and paid when the principal is repaid. Assume that borrowing take place at
the beginning and repayments are made at the end of the quarter.
Solution
Cash Budget for the period………….
1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr.
GH¢ GH¢ GH¢ GH¢
Opening cash balance 10,000 15,000 15,000 15,325
Add: Collections from
125,000 150,000 160,000 221,000
customers
Total Cash Available (A) 135,000 165,000 175,000 236,325
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Payments:
Purchases of materials 20,000 35,000 35,000 54,200
Other expenses 25,000 20,000 20,000 17,000
Salary and wages 90,000 95,000 95,000 109,200
Income tax 5,000 __ __ __
Purchase of machinery __ __ __ 20,000
Total cash payment (B) 140,000 150,000 150,000 200,400
Minimum cash balance
15,000 15,000 15,000 15,000
required
Total cash required (C) 155,000 165,000 165,000 215,400
Excess (Deficit) (A) – (C) (20,000) __ 10,000 20,925
Financing:
Borrowing 20,000 __ __ __
(Repayment) __ __ (9,000) (11,000)
Interest payment __ __ (675) (1,100)
Total effect of financing (D) 20,000 __ (9,675) (12,100)
Closing Cash Balance (A + D
15,000 15,000 15,325 23,825
– B)
Problem 9
Prepare a cash budget in respect of 6 months from July to December 2006
from the information given in table as under:
Overheads
Month Sales Mate- Wages Produc- Admini- Selli Distri Resea
rials tion stration ng - rch &
butio deve-
n lopme
nt
GH¢ GH¢ GH¢ GH¢ GH¢ GH¢ GH¢ GH¢
000 000 000 000
April 100 40 10.0 4.4 3,000 1,60 800 1,000
0
May 120 60 11.2 4.8 2,900 1,70 900 1,200
0
June 80 40 8.0 5.6 3,000 1,50 700 1,200
0
July 100 60 8.0 4.3 2,900 1,70 900 1,200
0
Augus 120 70 10.0 5.6 3,000 1,90 1,100 1,400
t 0
Septe 140 80 10.0 5.4 3,000 2,00 1,200 1,400
mber 0
Octob 160 90 10.0 5.8 3,000 2,35 1,250 1,600
er 0
Nove 180 100 11.0 6.0 3,100 2,15 1,350 1,400
mber 0
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Decem 200 110 11.6 6.4 3,200 2,30 1,500 1,600

ber 0
Cash balance on 1 July was expected to be GH¢ 150,000
Expected capital expenditure:

Plant and machinery to be installed in August at a cost of GH¢ 40,000 will
be payable on 1 September. Extension to Research and Development
Department amounting to GH¢ 10,000 will be completed on 1 August
payable GH¢ 2,000 per month from completion date. Under a hire-purchase
agreement GH¢ 4,000 is to be paid month.
Cash sales of GH¢2,000 per month are expected. No commission is payable.

A sales commission of 5 percent on (credit) sales is to be paid within the
month following the sales.
Period of credit allowed by suppliers 3 months
Period of credit of overheads 2 months
Delay in payment of overheads 1 month
Delay in payment of wages 1 month
Income tax of GH¢ 100,000 is due to be paid on 1 October. Preference share
dividend of 10 percent on GH¢ 200,000 is to be paid on 1 November.
Ten percent calls on ordinary share capital of GH¢ 400,000 is due on 1 July
and 1 September. Dividend from investments amounting to GH¢ 30,000 is
expected on 1 November.
Solution
Cash Budget
For the six months ending December 2006
Figure rounded off to GH¢ Thousand

July Aug. Sept. Oct. Nov. Dec Tot
. al
(A) Opening 150 244 236 263 189 233 150
balance
Receipts:
Cash sales 2 2 2 2 2 2 12
Debtors 120 80 100 120 140 160 720
Dividend income __ __ __ __ 30 __ 30
Call money on ord. 40 __ 40 __ __ __ 80
shares
(B) Total receipts 162 82 142 122 172 162 842
(A) Total cash 312 326 378 385 361 395 992
available (A
+ B)
Payments:
Creditors 40 60 40 60 70 80 350
Wages 8 8 10 10 10 11 57
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COST AND MANAGEMENT
Commission on 4 5 6 7 8 9 30
sales
Total overheads 12 11 13 13 14 14 77
Plant and __ __ 40 __ __ __ 40
machinery
Research and __ 2 2 2 2 2 10
development
Hire-purchase 4 4 4 4 4 4 24
Income-tax __ __ __ 100 __ __ 100
Preference dividend __ __ __ __ 20 __ 20
(D) Total payment 68 90 115 196 128 120 717
Closing balance (C 244 236 263 189 233 275 275
– D)
Note: Closing balance should be worked out on monthly basis. Closing

balance of July is the opening balance of August and so on.
Problem 10
The cost accountant of a manufacturing company provides you the
following details for the year 2006:
GH¢ GH¢
Direct materials 175,000 Other variable 80,000
costs
Direct wages 100,000 Profit 115,000
Fixed factory overheads 100,000 Other fixed 80,000
costs
Variable factory 100,000 Sales 750,000
overheads
During the year, the company manufactured two products A and B and the
output and costs were:
A B
Output (units) 200,000 100,000
Selling price per unit GH¢ 2.00 GH¢ 3.50
Direct materials per unit GH¢. 0.50 GH¢ 0.75
Direct wages per unit GH¢. 0.25 GH¢0.50
Variable factory overhead are absorbed as a percentage of direct wages and
other variable costs have been computed as:
Product A GH¢ 0.25 per unit, and B GH¢ 0.30 per unit.
During 2007, it is expected that the demand for product A will fall by 25%
and for B by 50%. It is decided to manufacture a additional product C, the
costs etc. for which are estimated as follows:
Product C
Output (units) 200,000
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Selling price per unit GH¢ 1.75

Direct materials per unit GH¢ 0.40
Direct wages per unit GH¢0.25
It is anticipated that the other variable costs per unit will be the same as for
Product A. prepare a budget to present to the management, showing the
current position and for 2007. Comment on the comparative results.
Solution
Budget showing current position and position for 2007
Current Position Position for 2007
A B Total A B C Total
(A + B) (A+B
+C)
Sales (units) 200,000 100,000 __ 150,000 50,0 2,0 __
00 0,0
00
GH¢ GH¢ GH¢ GH¢ GH¢ GH GH¢
¢
(A) Sales 400,000 350,000 750,000 300,000 175, 350 825,00
(GH¢) 000 ,00 0
0
Direct 100,000 75,000 175,000 75,000 37,5 80, 192,50
materials 00 000 0
Direct wages 50,000 50,000 100,000 37,500 25,0 50, 112,50
00 000 0
Factory 50,000 50,000 1,00,000 37,500 25,0 50, 1,12,5
overhead 00 000 00
(variable)
(B) Marginal 250,000 205,000 455,000 187,500 102, 230 520,00
cost 500 ,00 0
0
(C) 150,000 145,000 295,000 112,500 72,5 120 305,00
Contribution 00 ,00 0
(A-B) 0
Fixed cost: 100,000 100,00
Factory 0
Others 80,000 80,000
(D) Total fixed 180,000 180,00
cost 0
Profit (C – D) 115,000 125,00
0
Comments: Introduction of production of product C is likely to increase

profit by GH¢10,000 (i.e., from GH¢115,000 to GH¢125,000) in 2007 as
compared to 2006. Therefore, introduction of product C is recommended.
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ACCOUNTING II
COST AND MANAGEMENT Unit 5, section 6: Other types of budget
ACCOUNTING II This page is left blank for your notes
262 UEW/IEDE
XXXXXXX 6 STANDARD COSTING
UNIT Unit X, section AND VARIANCE ANALYSIS
X: XXXXXXX
Unit Outline
Session 1 Introduction to Standard Costing
Session 2 Material Variance
Session 3 Labour Variance
Session 4 Overheads Variance
Session 5 Sales Variance
Session 6 Reporting of Variance
Unit Overview
Dear students, I want to welcome your to the sixth unit of this Cost and
Management Accounting II manual. In this Unit we shall consider a
financial control system that enables the deviation from budget to be
analysed in detail, thus enabling cost to be controlled more effectively. This
system of control is called standard costing. In particular we shall examine
how a standard costing system operates and how the variances are
calculated.
This Unit is divided into six sessions. Session one looks at the overview of
standard costing. Session two covers direct material variance with session
three covering direct labour variance. Session four considers overheads
variance and session five looks at sales variance. The Unit ends with session
six which covers reporting of variance

 explain how a standard costing system operates
 explain how standard cost are set
 define basic, ideal and attainable standards
 calculate material, labour, overheads and sales variance and reconcile
actual profit with budgeted.
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This page is left blank for your notes ACCOUNTING
UEW/IEDE 269
COST AND MANAGEMENT INTRODUCTION TO STANDARD COSTING
UNIT 6 SECTION
ACCOUNTING II 1
Unit 6, section 1: Introduction to standard costing
Hello learner, you are welcome to session one of unit six of cost and
management accounting II as we look at standard costing and variance
analysis. Standard costing is one of the most important tools to control
costs. In this system, all costs are pre-determined, i.e., costs are determined
in advance of production. Such pre-determined costs are then compared
with the actual costs. The difference between the actual costs and pre-
determined costs, known as variances, are then analyzed and investigated to
know their reasons. Variances are reported to management for taking
remedial steps so that actual costs adhere to pre-determined or standard
costs.
This Session introduces you to the concepts of standard costing.

 understand the concept of historical costing and standard costing
 explain the steps in standard costing system
 explain the advantages and disadvantages of standard costing
 explain the preliminaries in establishing a system of standard costing
 explain the types of standards
 understand the concept of variance
Historical Costing
As against standard costing, in historical costing only actual costs are
ascertained. Historical costs are the actual costs which have been incurred in
the past. Such costs are ascertained only after these have been incurred. In
the initial stages of development of cost accounting, historical costing was
the only system available for ascertaining costs.
Limitations of Historical Costing: A system of historical costing suffers

from the following limitations:
 No basis for cost control: Historical costs cannot be used for the
purpose of cost control as the cost has already been incurred before the
cost figures can become available to management.
 No yardstick for measuring efficiency: Historical costs do not provide
any yardstick against which efficiency can be measured. It only
indicates the actual cost which is of little value in measuring
performance efficiency.
 Delay in availability of information: Cost data under historical costing
is obtained too late and is not of much use in price quotations and
production planning.
 Expensive system: Historical costing is comparatively an expensive
system of costing as it involves the maintenance of a larger volume of
records.
These limitations encouraged the development of a more satisfactory

standard costing approach based on pre-determined costs. Standard costing
is not an alternative system to job order on process costing. It is a special
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Unit 6, section 1: Introduction to standard costing ACCOUNTING II
technique to control costs and can be used in conjunction with any other
system like job costing, process costing or marginal costing etc.
Concept of Standard Cost

The word standard means ‘a norm’ or a criterion. Standard cost is thus a
criterion cost which may be used as a yardstick to measure the efficiency
with which actual cost has been incurred. In other words, standard costs are
pre-determined costs or target costs that should be incurred under efficient
operating conditions.
According to Chartered Institute of Management Accountants (C.I.M.A.),

London, “Standard cost is the pre-determined cost based on technical
estimates for materials, labour and overhead for a selected period of time for
a prescribed set of working conditions”.
The main object of standard cost is to look forward and assess what the cost
‘should be’ as distinct from what the cost has been in the past.
Concept of Standard Costing

Standard costing is simply the name given to a technique whereby standard
costs are computed and subsequently compared with the actual costs to find
out the differences between the two. These differences (known as variances)
are then analyzed to know the causes thereof so as to provide a basis of
control.
The C.I.M.A. London has defined standard costing as “the preparation of

standard costs and applying them to measure the variations from actual costs
and analyzing the courses of variations with a view to maintain maximum
efficiency in production”. Brown and Howard have defined it, “as a
technique of cost accounting which compares the standard cost of each
product or service with the actual costs, to determine the efficiency of the
operations so that any remedial action may be taken immediately”.
Steps in Standard Costing

Standard costing system involves the following steps:
 The setting of standard costs for different elements of cost, i.e., material,
labour and overheads.
 Ascertaining actual costs.
 Comparing standard costs with actual costs to determine the differences
between the two, known as ‘variances’.
 Analyzing variances for ascertaining reasons thereof.
 Reporting of these variances and analysis thereof to management for
appropriated action, where necessary.
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ACCOUNTING II Unit 6, section 1: Introduction to standard costing
Applicability of Standard Costing

The application of standard costing requires certain conditions to be
fulfilled. These are:
 A sufficient volume of standard products or components should be
produced.
 Methods, operations and processes should be capable of being
standardized.
 A sufficient number of costs should be capable of being controlled.
Industries producing standardized products which are repetitive in nature,

i.e., industries using process costing method, fulfill all the above conditions
and thus the system can be used to the best advantage in such industries.
Examples are fertilizers, cement, steel, sugar, etc.
In jobbing industries, it is not worthwhile to develop and employ a full

system of standard costing. This is because in such industries each job
undertaken may be different from another and setting standards for each job
may prove difficult and expensive. In such industries, therefore, a partial
system may be adopted in appropriate circumstances. For example, certain
processes and operations performed may be of a repetitive nature and thus
the principles of standard costing may be applied by setting standard for
each such process or operation.
Advantages of Standard Costing

The advantages to be derived from a system of standard costing will vary
from one business to another. Much depends upon the degree of
sophistication achieved and the acceptance by the management of utility of
the system. Possible advantages are as follows:
 Effective cost control: The most important advantages of standard
costing is that it facilitates the control of costs. Control is exercised by
comparing actual performance with standards and taking action on the
basis of variance so revealed.
 Helps in planning: Establishing standards is a very useful exercise in
business planning which instills in management a habit of thinking in
advance.
 Provides incentives: Standards provide incentives and motivation to
work with greater effort. Schemes may be formulated to reward those
who achieve or surpass the standard. This increases efficiency and
productivity.
 Fixing prices and formulating policies: Standard costs are a valuable
aid to management in determining prices and formulating production
policies. For example, prices may be fixed by adding a standard margin
of profit to standard cost. Similarly, standard costing furnishes cost
estimates while planning production of new products.
 Facilitates delegation of authority: In other that responsibility for off-
standard performance may be identified directly with the persons
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concerned, an organization chart is prepared which shows delegated

authority and established responsibility of each executive.
 Facilitates coordination: While establishing standards, the performance
of different departments such as production, sales, purchases etc. is
taken into account. Thus through the working of standard cost system,
coordination of various functions is achieved.
 Eliminates wastes: By fixing standards, certain waste such as material
wastage, idle time, lost machine hours, etc. are reduced.
 Valuation of stocks: Standard costing simplifies the valuation of stock
because the stock is valued at standard cost. This difference between
standard and actual cost is transferred to a variance account. This
ensures uniform pricing of stocks in the form of raw materials, work-in-
progress and finished goods.
 Management by exception: Reporting of variances is based on the
principles of management by exception. Only variances beyond a
predetermined limit may be considered by the management for
corrective action. This also reduces the cost of preparing reports.
 Economical and simple: Standard costing is an economical and simple
means of cost accounting and generally results in savings in the cost of
costing system. It results in reduction in paper work in accounting and
needs fewer number of forms and records. This leads to considerable
saving in clerical labour.
Limitations of standard costing

Standard costing system may suffer from certain disadvantages. This may
be because of lack of education and communication and resultant
misunderstanding on the part of managerial staff. Possible disadvantages
are:
 The system may not be appropriate to the business.
 The staff may not be capable of operating the system.
 A business may not be able to keep standards up-to-date. In other words,
a business may not revise standards to keep pace with the frequent
changes in manufacturing conditions. Firms may avoid revising
standards as it is a costly affair.
 Inaccurate and unreliable standards cause misleading results and thus
may not enjoy the confidence of the users of the system.
 Operation of the standards costing system is a costly affair and small
firms cannot afford it.
 Standard costing is expensive and unsuitable in job order industries
which are manufacturing non-standardize products.
Preliminaries in Establishing a System of Standard Costing

In establishing a system of standard costing, there is a number of
preliminaries to be considered. These are as follows:
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 Establishment of Cost Centre

The first step in the establishment of a system of standard costing is the
establishment of cost centres with clearly defined areas of responsibility.
The meaning of cost centre is explained in Chapter one. In this context it
may be noted that in establishing cost centres, there should be no doubt
about the responsibility of each cost centre so that in case of off standard
performance, responsibility may be identified.
 Classification of Accounts
Accounts are classified according to the purpose in hand. Classification
may be by function, revenue item, etc. For speedy collection and
analysis of accounts, codes and symbols may be used.
 Types of Standards
Standards may be divided into the following two main classes – basic
and current.
 Basic Standards. These are the standards which are established for an
indefinite period of time. It is similar to an index number against which
all later results are measured. Variances from basic standards show
trends of deviation of the actual cost. However, basic standards are of no
practical utility from the point of view of cost control.
 Current Standards. Such standards remain in operation for a limited
period and are related to current conditions. These standards are revised
at regular intervals. Current standards are of three types: (i) Ideal
standards, (ii) Expected standards; and (iii) normal standards.
 Ideal standards. This is a theoretical standard which is rather not
practicable to attain. It pre-supposes that the performance of men,
materials and machines is perfect and thus makes no allowance for loss
of time, accidents, machine breakdowns, wastage of materials and any
other type of waste or loss. This ideal is obviously unrealistic and
unattainable. Such standards have the advantage of establishing a goal
which though not attainable in practice, is always aimed at.
 Expected or practical standards. This is a standard which may be
anticipated to be attained during a future period. Such standards are
based on expected performance after making a reasonable allowance for
unavoidable losses and other inevitable lapses from perfect efficiency.
By far this is the most commonly used type of standard and is best
suited from cost control point of view.
 Normal standards. This is known as Past Performance Standards
because it is based on the average performance in the past. The aim of
such as standard may be to eliminate the variations in the cost which
arise out of trade cycles.
 Setting Standard Costs

The success of a standard costing system depends on the reliability,
accuracy and acceptance of the standards. Extreme care, therefore, must
be taken to ensure that all factors have been considered in the
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establishment of standards. Standard costs are set for each element of

cost i.e. direct materials, direct labour and overheads. These are
described below
Setting standards for direct materials. Two standards are developed for
materials costs:
 Material price standard
 Material usage (or quantity) standard.
Material price standard. This is a forecast of the average prices of

materials during the future period. This standard is quite difficult to
establish because prices are regulated more by the external factors than by
the company management. The purchasing department notifies the standard
prices after considering factors like:
 Purchases prices of recent orders,
 Prices specified in the long term contracts,
 Forecasts of the commodity price trends.
Provision should be made for discounts, packing and delivery charges, etc.
Material quantity (or usage) standard. While setting quantity standard,

the quality and size of material items to be consumed should be
standardized. The standard is usually developed from material specifications
prepared by the department of engineering of product design.
Setting standards for direct labour. The following two standards are
usually established for direct labour costs:
 Labour rate standard
 Labour time standard
Labour rate standard. This standard is determined having regard to the
current rates of pay and any anticipated variations. Sometimes an agreement
between trade unions and employer covers a number of future months or
year. In such cases, the agreed rate should be adopted as the standard rate
for the period.
Where workers are paid on time basis, it is necessary to establish:
 The labour time standard for each operation
 The wage rate of each grade of labour
 The grades of labour to be employed.
Type of operation will determine the grade of labour to be employed – male
or female, skilled, unskilled or semi-skilled, etc.
Where workers are paid on piece basis, the standard cost will be a fixed rate
per piece.
Labour time (or efficiency) standard. Standard time for labour should be
scientifically determined by time and motion studies carried out in
conjunction with a study to determine the most efficient method of working.
Due allowance should be made for normal loss of labour time like fatigue,
idle time, tool setting, etc.
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Setting standards for direct expenses

Direct expenses are not very common, but if there are any direct expenses
relating to the cost unit, standards for these too much be set. Setting these
standards is usually quite simple as these may be based on past records
adjusted according to anticipated changes therein.
Setting standards for overheads

Setting standards for overheads is more complex than the development of
material and labour standards. Developing this standard involves the
following two distinct calculations:
 Determination of the standard overhead costs; and
 Determination of the estimates of production, i.e., standard level of
activity reduced to a common base, such as direct labour hours, units of
production, machine hours, etc.
A standard overhead absorption rate is computed with the use of these two
figures by the following formula:
Standard overhead cost for the period
Standard overhead rate (per hour) =
Standard hours for the period
OR
Standard overhead rate Standard overhead cost for the period
=
(per hour) Standard production (in unite) for the period
Thus this rate may be per unit of production when base is in units of
production and it will be per hour, if base is the number of hours.
An overall blanket rate of overhead absorption is rarely accurate in any
costing system. Thus a separate rate should be computed for each cost
centre (or department) created for this purpose.
Overhead standards will be more useful to management if they are divided
to show fixed and variable components. Separate overhead absorption rates
should be computed for these two types of overheads, i.e., fixed overhead
and variable overheads.
Standard Hour
Production may be expressed in diverse type of units such as kilograms,
tones, litres, gallons, numbers, etc. When a company is manufacturing
different types of products, it is almost impossible to aggregate the
production, which cannot be expressed in the same unit. Therefore, it is
essential to have a common unit in which the production which is measured
in different type of units can be expressed. As time factor is common to all
operations, a common practice is to express the various units in terms of
time-known as standard hour. The standard hour is the quantity of output or
amount of work which should be performed in one hour.
In the words of C.I.M.A., London, a standard hour is “a hypothetical hour
which represents the amount of work which should be performed in one
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hour under stated conditions”. Time and motion studies may indicate what
the output of each process in one hour should be. For example, if 10 units of
product should be produced in one hour, then an output of 200 units would
represent 20 standard hours.
Example
XYZ Co. Ltd. Produces three types of biscuits – Nice, Hot and Pearl.
Production per hour should be 50 packets, 75 packets and 100 packets
respectively. Actual production during a month is 500 packets, 1,500
packets and 5,000 packets of Nice, Hot and Pearl respectively. Production
measured in standard hours will be as follows:
Product Actual output Standard Standard

(packets) (a) output per hour hours
(packets) (b) (a ÷ b)
Nice 500 50 10
Hot 1,500 75 20
Pearl 5,000 100 50
Total standard 80
hours
Standard cost card (Standard Cost Sheet)

Once the standard costs have been established, these are recorded on a
standard cost card. A standard cost card is thus a record of the standard
material, labour and overhead costs
Standard Cost Card

Product: component PLY – 102 Date of fixing standard: 1 May, 2005
Unit: Dozen Date of revision………..
Rate Dept. I Dept. II Total
GH¢. GH¢. GH¢ GH¢
Direct material:
4 units of material X 40 160 __ 160
10 units of material Y 60 __ 600 600
Total 760
Direct labour:
Machine operator grade I
10 hours 30 300 __ 300
5 hours 30 __ 150 150
Total 450
Factory overhead:
Machine hour rate I 10 20 200 __ 200
hrs.
II 5 hrs. 40 __ 200 200
Total 400
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Cost Summary
Direct materials GH¢ 760
Direct labour GH¢ 450
Factory overhead GH¢ 400
Standard cost per unit GH¢ 1,610
Fig. 6.1 Standard cost card
Such a card is maintained for each product or service. The card will
normally show the quantity and price of each material item to be consumed,
the time and rate of labour required, the overheads to be absorbed and the
total cost. Costs shown in the card should be approved by the person who
will be responsible for the operations concerned, otherwise he may not co-
operate with much enthusiasm in attaining the standards. A standard cost
and with assumed Figures is given in Fig.6.1
Variance Analysis
Cost Variance – Cost variance is the “difference between a standard cost
and the comparable actual cost incurred during a period”. C.I.M.A., London.
Variance analysis is the process of analyzing variances by sub-dividing the

total variance in such a way that management can assign responsibility for
any off standard performance. According to C.I.M.A., London,
Terminology, variance analysis is “the process of computing the amount of
variance and isolating the causes of variance between actual and standard”.
An important aspect of variance analysis is the need to separate controllable
from uncontrollable variances. A detailed analysis of controllable variances
will help the management to identify the persons responsible for its
occurrence so that corrective action can be taken.
Favourable and Unfavourable Variances

Where the actual cost is less than standard cost, it is known as ‘favourable’
or ‘credit’ variance. On the other hand, where the actual cost is more than
standard cost, the difference is referred to as ‘unfavourable’, ‘adverse’ or
‘debit’ variance.
In other words, any variance that has a favourable effect on profit is

favourable variance and any variance which has an adverse or unfavourable
effect on profit is unfavourable variance.
Many students experience difficulty in ascertaining whether a variance is

favourable or adverse. In the formulae given in this book, positive (+)
variance will indicate favourable variance and negative (-) variance will
indicate adverse variance. Favourable variances will be designated by (F)
and Adverse by (A).
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Controllable and Uncontrollable Variances

If a variance can be regarded as the responsibility of a particular person,
with the result that his degree of efficiency can be reflected in its size, then
it is said to be a controllable variance. For example, excess usage of material
is usually the responsibility of the foreman concerned. However, if the
excessive usage is due to material being defective, the responsibility may
rest with the Inspection Department for non-detection of the defects.
If a variance arises due to certain factors beyond the control of management,

it is known as uncontrollable variance. For example, change in the market
prices of materials, general increase in the labour rates, increase in the rates
of power or insurance premium, etc. are not within the control of the
management of the company. Responsibility for uncontrollable variances
cannot be assigned to any person or department.
The division of variances into controllable and uncontrollable is extremely

important. The management should place more emphasis on controllable
variance as it is these variances which require investigation and possibly
corrective action. The uncontrollable variances, on the other hand, may be
ignored. This follows that well known “principle of exception” whereby
those matters which are going right are ignored and any deviations from
efficient performance are investigated.
Methods Variance
While setting standards, specific methods of production are kept in view. If,
for some reason or the other, a different method of production is adopted, it
will give rise to a different amount of cost, thereby resulting in a variance.
Such a variance is known as methods variance. Thus a method variance
arises due to the use of methods other than those specified. According to
C.I.M.A., London Terminology, methods variance is ‘the difference
between the standard cost of a product or operation produced or performed
by the normal method and the standard cost of a product or operation
produced or performed by the alternative method actually employed.”
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Variances for Each Element of Cost

The total cost variance is divided into variances as shown in Fig. 16.2
Total Cost
Variance
Materia Labour Overhe

l cost cost ad cost
varianc varianc varianc
e e e
Material Material Labour Labour

price usage rate efficiency
variance variance varianc variance
e
Material Material Labour Idle time Labour

mix yield mix variance yield
variance variance variance variance
Variable Fixed
overhead cost overhead
variance cost
variance
Expenditur Efficiency Expenditur Volume

e or variance e or variance
Budget Budget
variance variance
Fig. 6.2 Cost Variance Analysis Effici Capac Calen

ency ity dar
varian varian varian
Conclusion ce ce ce
In this Session, we have looked at the concept of historical costing and its
limitations; and the concept of standard cost and standard costing. We
discussed the steps in standard costing and its applicability. The advantages
and limitations of standard costing were also dealt with. We have also
looked at the preliminaries in establishing a system of standard costing
where the types of standards were explained. The concept of variance was
also discussed.
Assessment
1. What is historical costing and what are its limitations?
2. Explain standard costing and identify the steps involve
3. Explain in detail the various types of standards
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4. What is cost variance and how different is variance from standard cost
5. Differentiate between the following
a. Favourable and Unfavorable Variance
b. Controllable and Uncontrollable Variance
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UNIT 6 SECTION
ACCOUNTING II 2
Unit 6, section 2: Direct material cost variance
Hello learner, you are welcome to Session two of unit six of cost and
management accounting II. In this Session, we look at direct material
variance analysis. This is the difference between the budgeted material cost
for a product and the actual material costs after production. The direct
material variance is broken into two categories: direct material price
variance and direct material usage variance.

 calculate material price variance
 calculate material usage variance
 determine material mix and yield variance
Material Price Variance

This is “that portion of the material cost variance which is due to the
difference between the standard price specified and the actual price paid”. It
is calculated by the following formula:
Material Price Variance = (Standard price – Actual price) ×Actual quantity
MPV = (SP – AP) ×AQ
Thus, this is the difference between standard price and actual price
multiplied by actual quantity.
Example
A furniture company uses Formica for tables. It provides the following data:
Standard quantity of Formica per table 4 sq. ft.
Standard price per sq. ft. of Formica GH¢ 5
Actual production of tables 1,000
Formica actually used 4,300 sq. ft.
Actual purchase price of Formica per sq. ft. GH¢ 5.50
Material cost variance will be calculated as follows:

MCV = SQ × SP) – (AQ ×AP)
MCV = (1,000 × 4 ×GH¢ 5) – (4,300 ×GH¢ 5.50)
= 20,000 – 23,650
= 3,650 (A)
The material cost variance may be further divided into price variance and
usage variance.
Example.
With the figures in Example given above the material price variance will be
calculated as follows:
MPV = (SP – AP) ×AQ
MPV = (5 – 5.50) ×4,300
= GH¢ 2,150 (A)
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Unit 6, section 2: Direct material cost variance ACCOUNTING II
Reasons for Material price Variance

This variance usually arises due to the following reasons:
 Change in the market price of materials
 Failure to purchase the specified quality, thereby resulting in a different
price being paid.
 Change in the quantity of materials, thereby leading to lower/higher
quantity discount.
 Not availing cash discounts, when standards set took into account such
discounts.
 Inefficient purchasing.
 Change in the delivery costs.
 Rush purchases.
 Purchase of a substitute material on account of non-availability of the
material specified.
 Change in the rates of excise duty, purchase tax, etc.
 Off-season purchasing for certain seasonal products like jute, cotton etc.
Material Usage (or Quantity) Variance

This is “that portion of the material cost variance which is due to the
difference between the standard quantity specified and the actual quantity
used”. Its formula is:
Standard quantity- actual standard
Material Usage Variance = ( ) ×
For actual output- quantity price
MUV = ( SQ – AQ) ×SP
Thus, this is the difference between standard quantity and actual quantity
multiplied by the standard price.
Example
Continuing example given above, material usage variance will be calculated
as under:
MUV = (SQ – AQ) ×SP
= (4,000 – 4,300) ×5
= GH¢ 1,500 (A)
Reasons for Material Usage Variance

The material usage variance may be caused by some or all of the following
reasons:
 Use of defective or substandard materials.
 Carelessness in the use of materials.
 Pilferage
 Poor workmanship.
 Defect in plant and machinery.
 Change in the design or specification of the product.
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ACCOUNTING II Unit 6, section 2: Direct material cost variance
 Change in the quality of materials.

 Use of substitute materials.
 Use of substitute materials.
 Use of non-standard material mixture.
 Yield from materials in excess of or less than standard yield.
Check
The algebraic sum of material price variance and material usage variance
should be equal to material cost variance. Thus:
MCV = MPV + MUV
3,650 (A) = GH¢ 2,150 (A) + GH¢1,500 (A)
Illustration 2.1
From the following particulars, compute:
(a) Material cost variance,
(b) Material price variance
(c) Material usage variance
Quantity of materials purchased 3,000 units
Value of materials purchased GH¢ 9,000
Standard quantity of materials per ton of output. 30 units
Standard rate of material GH¢ 2.50 per unit
Opening stock of materials Nil
Closing stock of materials 500 units
Output during the period 80 tons
Solution
Basic calculations
Actual quantity of material purchased = 3,000 units
Value of materials purchased = GH¢ 9,000
= GH¢ 9,000
Actual price per unit
3,000 units
= GH¢ 3 per unit
Standard price = 2.50 per unit
Standard quantity = 80 tons ×30 units
= 2,4000
Actual quantity = Opening stock + Purchase –
Closing stock
= Nil + 3,000 – 500 = 2,500
units
Calculation of variances
(a) Material Cost Variance
= SC – AC
= (SQ × SP) – (AQ × AP)
= (2,400 × 2.50) – (2,500 × 3.00)
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MCV = GH¢1,500 (A)
(b)
Material Price Variance = (SP – AP) ×AQ
= (2.50 – 3.00) ×2,500
MPV = (2.50 – 3.00) ×2,500
(c)
Material Usage Variance = (SQ – AQ) ×SP
= (2,400 – 2,500) ×2.50
MUV = GH¢250 (A)
Check
MCV = MPV + MUV
GH¢1,500 (A) = GH¢1,250 (A) + GH¢250 (A)
GH¢1,500 (A) = GH¢1,500 (A)
Classification of Material Usage Variance

Materiel usage variance is further sub-divided into:
 Material Mix variance
 Material yield variance (Or Material sub-usage variance)
Material Mix Variance

This is sub-variance of material usage variance. It arises only where more
than one type of material is used for producing the finished product. A
company may be using a mixture of materials which does not comply with
the standard mixture. This gives rise to material mix variance.
The material mix variance is defined as that portion of the material usage
variance which is due to the difference between standard and actual
composition of materials. It may arise in industries like chemicals, rubber
etc. where a number of raw materials are mixed to produce a final product.
Change from the standard mix may be due to non-availability of one more
components of the mix or due to non-purchase of materials at proper time.
Increase in the proportion of cheaper materials results in favourable mix
variance and vice versa, the use of more expensive materials in larger
proportion results in adverse variance.
This variance is calculated with the help of the following formula:

Revised standard Actual Standard
Material Mix Variance = ( - ×
quantity quantity price
MMV = (RSQ – AQ) ×SP
The revised standard quantity is nothing but the standard proportion of total
of actual quantities of all the materials. This is calculated as under:
Standard quantity of one material Total of actual quan-
RSG = ×
Total standard quantities of all material tities of all material
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Illustration 2.2
From the following data, calculate material mix variance. Also calculate
price usage variance.
Raw material Standard Actual
X 40 units @ GH¢ 50 per unit 50 units @ GH¢ 50 per unit
Y 60 units @ GH¢ 40 per unit 60 units @ GH¢ 45 per unit
100 units 110 units
Solution
Calculation of Revised Standard Quantity (RSQ).
= 40
RSQ of X × 110 = 44 units
100
60
RSQ of Y = × 110 = 66 units
100
Material Mix Variance = (RSG – AG) × SP

Material X = (44 – 50) ×50 = GH¢ 300 (A)
Material Y (66 – 60) ×40 = GH¢ 240 (F)
MMV = GH¢ 60 (A)
Material Price Variance = (SP – AG) × AQ

Material Y = (50 – 50) × 50 = Nil
Material Y = (40 – 45) × 60 = GH¢ 300 (F)
MPV = GH¢ 300 (A)
Material Usage Variance = (SG – AQ) × SP

Material X = (40 – 50) × 50 = GH¢ 500 (A)
Material Y = (60 – 60) × 40 = Nil
MUV = GH¢ 500 (A)
Material Sub-usage (or Material Revived Usage) Variance

This is a sub-variance of the material usage variance and represents that
portion of the material usage variance which is attributed to reasons other
than those which give rise to material mix variance. Thus the algebraic sum
of this revised usage variance and material mix variance is equal to material
usage variance. Its formula is:
Material revised standard Revised standard Standard
= ( - ) ×
Usage variance quantity quantity price
MRUV = (SQ – RSQ) × SP
In illustration 2.3 material revised usage variance is calculated as follows:
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MRUV = (SQ – RSQ) × SP

X = (40 – 44) × 50 = GH¢ 200 (A)
Y = (60 – 66) × 40 = GH¢ 240 (A)
MRUV = GH¢ 440 (A)
Check
MUV = MMV + MRUV
500 (A) = 600 (A) + 440 (A)
Material Yield Variance

This is also a sub-variance of material usage variance. It arises in process
industries, like chemicals, where loss of materials in production in
inevitable. While setting standards, the normal or standard loss is taken into
account. But actual loss may differ from normal or standard loss. This result
is actual yield or output being different from standard yield.
This material yield variance is that portion of the material usage variance
which is due to the difference between standard yield specified and actual
yield obtained. The standard yield is the output expected to be obtained
from actual usage of raw materials. It should be noted that yield variance as
used in standard costing is the same thing as abnormal loss or abnormal gain
in the other costing systems.
One important feature of yield variance which differentiates it from other

material variances (price, usage and mix variances) is that yield variance is
on output variance while others are input variances. In other words, yield
variance represent a gain or loss on output in terms of finished production,
while other variances represent a gain or loss on the cost of material input. It
is formula is as follows:
Material Yield Actual Standard Standard
= ( - ) ×
Variance yield yield Output Price
Standard output price (SOP) is the standard material cost per unit of output.
Illustration 2.3
During the month of May, the following data applies:
Raw Standard mix Actual mix
material
Units Price Amount Units Price Amount
Kg. GH¢ Kg. GH¢ GH¢.
X 60 25 1,500 56 25 1,400
Y 40 50 2,000 44 50 2,200
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Total 100 3,500 100 3,600

Less: Loss 30 26
Yield
70 74
Calculate
a. Material yield variance
b. Material mix variance
Solution
a.
Material Yield Variance = (AY – SY) × SOP
MYV = (74 – 70) × 50 = GH¢ 200 (F)
Standard material cost per unit of output is calculated as follows:

Standard materials cost GH¢ 3,500
SOP = = = GH¢ 50
Standard output 70
b.
Material Mix Variance = (RSQ – AQ) × SP
Material X = (60 – 56) × 25 = GH¢ 100 (F)
Material Y = (40 – 44) × 50 = GH¢ 200 (A)
MMV GH¢100 (A)
Note. In this case, standard quantity and revised standard quantity (RSQ) is
the same because total actual quantity of all the materials and total standard
quantity is the same, i.e. 100 units.
Illustration 2.4
The standard mix to produce one unit of product is as follows:
Material A 60 units @ GH¢ 15 per unit = 900
Material B 80 units @ GH¢ 20 per unit = 1,600
Material C 100 units @ GH¢ 15 per unit = 2,500
Total = 240 units 5,000
During the month of April, 10 units were actually produced and

consumption was as follows:
Material A 640 units @ GH¢17.50 per unit = 11,200
Material B 950 units @ GH¢ 20 per unit = 17,100
Material C 870 units @ GH¢ 15 per unit = 23,925
= 2460 units 52,225
Calculate all materials variances
Solution
Raw Standard for 10 units Actual for 10 units
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material
Qty. Rate Amt Qty Rate Amount
units GH¢ GH¢ Units GH¢ GH¢
A 600 15 9,000 640 17.50 11,200
B 800 20 16,000 950 18.00 17,100
C 1,000 25 25,000 870 27.50 23,925
2,400 50,000 2,460 52,225
1.
Material Cost Variance = Standard cost – Actual cost
= GH¢ 50,000 – GH¢ 52,225 (A)
MCV = GH¢ 2,225 (A)
2.
Material Price Variance = (St. Price – Actual Price) × Actual Qty.
Material A = (15 – 17.50) × 640 = GH¢ 1,600 (A)
Material B = (20 – 18) × 950 = GH¢ 1,900 (F)
Material C = (25 – 27.50) × 870 = GH¢ 2,175 (A)
MPV = GH¢ 1,875 (A)
3.
Material Usage Variance = (St. Qty. – Actual Qty.) × St. Price
Material A = (600 – 640) × 15 = GH¢ 600 (A)
Material B (800 – 950) × 20 = GH¢ 3,000 (A)
Material C = (1,000 – 870) × 25
MUV = GH¢ 350 (A)
Check
MCV = MPV + MUV
GH¢ 2,225 (A) = GH¢ 1,875 (A) + GH¢ 350 (A)
4.
Material Mix Variance = (Revised St. Qty. – Actual Qty.) × St. Price
Material A = (615 – 640) × 15 = GH¢ 375 (A)
Material B = (820– 950) × 20 = GH¢ 2,600 (A)
Material C = (1,025 – 870) × 25 = GH¢ 3,875 (F)
MMV = GH¢ 900 (A)
Revised Standard Quantity ( RSQ) is calculated as follows:

2460
Material A = × 600 = 615 units
2400
2460
Material B = × 600 = 615 units
2400
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2460
Material C = × 600 = 615 units
2400
5. Material Yield Variance

For yield variance, certain basic calculations have to be made as follows:
Actual usage of materials 2460
Standard yield = = = 10.25
Standard usage per unit of output 240
SOP (St. Material cost per unit of output)

= GH¢ 50,000 ÷ 10 units
= GH¢ 5,000
Material Yield Variance = (AY – SY) × SOP
MYV = (10 – 10.25) × 5,000
= GH¢ 1,250 (A)
Material Revised Usage or (Sub-usage) Variance (MRUV)

= (Standard Quantity – Revised Standard Quantity) × Standard price
Material A (600 – 615) × 15 = GH¢ 225(A)

Material B (800 – 820) × 20 = GH¢ 400(A)
Material C (1,000 – 1,025) × 25 = GH¢ 625 (F)
MRUV = GH¢ 1,250 (A)
Note. Either MMV or MRUV is calculated. These two are always equal.
Check
MUV = MMV + MYV (Or MRUV)
GH¢ 350 (A) = GH¢ 900 (F) + GH¢ 1,250 (A)
Or
MCV = MPV + MMV (Or MRUV)
GH¢ 2,225 (A) = GH¢ 1,875 (F) + GH¢ 1,250 (A)
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Unit 6, section
This page
2: Direct
is left
material
blank for
cost
your notes ACCOUNTING II
variance
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COST AND MANAGEMENT DIRECT LABOUR COST VARIANCE
UNIT 6 SECTION
ACCOUNTING II 3
Unit 6, section 3: Direct labour cost variance
Hello learner, you are welcome to Session three of unit six of cost and
management accounting II manual. In this Session, we look at direct labour
cost variance analysis. A labor variance arises when the actual expense
associated with a labor activity varies (either better or worse) from the
expected amount. The expected amount is typically a budgeted or standard
amount. The labor variance concept is most commonly used in the
production area, where it is called a direct labor variance. This variance can
be subdivided into two additional variances, which are:
 Labor efficiency variance. Measures the difference between actual and
expected hours worked, multiplied by the standard hourly rate.
 Labor rate variance. Measures the difference between the actual and
expected cost per hour, multiplied by the actual hours incurred.
The labor variance can be used in any part of a business, as long as there is
some compensation expense to be compared to a standard amount. It can
also include a range of expenses, beginning with just the base compensation
paid, and potentially also including payroll taxes, bonuses, the cost of stock
grants, and even benefits paid.

 calculate labour cost variance
 calculate labour rate variance
 determine efficiency and idle time variance
 calculate labour mix and labour yield variance
Labour Variances
The analysis and computation of labour variances is quite similar to material
variances.
Labour Cost Variance

This the difference between the standard direct labour costs specified for the
activity achieved and the actual direct labour cost incurred. It is calculated
as under:
St. Labour cost Actual labour
Labour Cost Variance = ( × )
of actual output cost
LCV = SC - AC
Or
St hours St. rate
Labour Cost Variance = ( )
Of actual output Per hour
Actual Actual Rate

( )
hours per hour
LCV = (SH × SR) - (AH × AR)
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Unit 6, section 3: Direct labour cost variance ACCOUNTING II
Example: The following information is given:

Standard hours per unit 15
Standard rate GH¢ 4 per hour
Actual data:
Actual production 1,000 units
Actual hours 15,300 hours
Actual rate GH¢ 3.90 per hour
Calculate labour cost variance
Solution
Labour Cost Variance = (SH for actual output × SR) – (AH × AR)
= (1,000 × 15 × 4) – (15,300 × 3.90)
LCV = GH¢ 330 (F)
Labour cost variance is further divided into rate variance and efficiency
variance.
Labour Rate Variance

This is that portion of the labour cost variance which is due to the difference
between the standard rate specified and the actual rate paid. Its formula is:
Labour Rate Variance = (Standard – Actual rate) ×Actual hours
LRV = (SR – AR) × AH
Thus this is the difference between standard and actual rates of wages,
multiplied by actual hours
Example.
Using the data given in above example:
LRV = (SR – AR) ×AH
= (4 – 3.90) × 15,300 = GH¢ 1,530 (F)
Reasons for labour rate variance.

Usual reasons are:
 change in the basic wage rates
 use of a different method of wage payment
 employing workers of grades different from the standard grades
specified
 unscheduled overtime
 new workers not being paid at full rates.
Often, labour rate variance will be an uncontrollable variance as labour rates

are usually determined by demand and supply conditions in the labour
market, backed by negotiable strength of the trade union. Where this
variance is due to the use of a grade of labour other than that specified, there
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ACCOUNTING II Unit 6, section 3: Direct labour cost variance
may well be such acceptable explanations as non-availability of the labour

grade specified. But when a foreman carelessly employs a wrong grade of
labour on a job, he may be held responsible.
Labour Efficiency (or Time) Variance

This is that portion of the labour cost variance which is due to the difference
between labour hours specified for actual output and the actual labour hours
expended. This variance is calculated as follows:
Labour Efficiency St. Hours for Actual
= ( - ) × Standard rate
Variance Actual output hour
LEV = (SH – AH) × SR
Thus this variance is the difference between standard and actual time valued
at standard rate.
Example
Using the data given in above example.
LEV = (SH for actual output – AH) × SR
= (15,000 – 15,300) × GH¢4 =1200(A)
The algebraic total of labour rate variance and labour efficiency variance is
equal to labour cost variance. Thus:
LCV = LRV + LEV
GH¢ 330 (F) = GH¢ 1,530 (F) + GH¢ 1,200 (A)
Reasons for labour efficiency variance.

The variance is usually caused by one or more of the following reasons:
 Poor working conditions e.g., inadequate lighting and ventilation,
excessive heating, etc.
 Defective tools and plant machinery
 Inefficient workers
 Incompetent supervision
 Use of defective or non-standard materials
 Time wasted by factors like waiting for materials, tools or machine
break-down etc.
 Insufficient training of workers
 Change in the method of operation
 Non-standard grade of workers
Classification of Labour Efficiency Variance

Labour efficiency variance is further divided into the following sub-
variances
 Idle time variance
 Labour mix variance
 Labour Yield Variance (or Labour revised-efficiency variance)
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Idle Time Variance

This variance represents that portion of the labour efficiency variance which
is due to abnormal idle time; such as time lost due to machine break-down,
power failure, strike, etc. It is calculated by valuing idle hours at standard
rate. Thus:
Idle Time Variance = Idle hours × Standard rate
ITV = IH × SR
As idle hours represent a loss, idle time variance is always unfavourable.

Some accountants do not treat Idle Time Variance as a part of labour
efficiency variance but treat it as a part of labour cost variance.
Example
Using the data give in the above example and further assuming that idle
time is 200 hours, then the idle time variance would be:
ITV = 200 × 4 = GH¢ 800(A)
When idle time variance is treated as a sub-variance of labour cost variance

and not of labour efficiency variance, then for labour efficiency variance,
the actual time would be 15,300 – 200 = 15,100 hours. Labour efficiency
variance will be calculated on the basis of 15,100 hour. Thus
Labour Efficiency Variance = (SH – AH) × SR
= (15,000 – 15,100) × 4 GH¢ 400 (A)
Labour Mix Variance (Gang Composition Variance)

This variance is similar to material mix variance. It arises only when more
than one grade of workers are employed and the composition of actual grade
of workers differ from those specified. It is calculated with the help of the
following formula:
Labour Mix Revised standard Actual
= ( - ) × Standard rate
Variance hours hours
LMV = (RSH – AH) ×SR
Illustration 3.1
Coates Ghana Ltd. Manufactures a particular product, the standard direct
labour cot of which is GH¢ 120 per unit whose manufacture involves the
following:
Grade of workers Hours Rate Amount
GH¢
A 30 2 60
B 20 3 60
50 120
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During a period, 100 units of the product were produced, the actual labour
cost of which was as follows:
Hours Rate Amount
Grade of workers
GH¢
A 3,200 1.50 4,800
B 1,900 4.00 7,600
5,100 12,400
Calculate
a. Labour Cost Variance
b. Labour Efficiency Variance
c. Labour Rate Variance
d. Labour Mix Variance
Solution
Grade of worker Standard for 10 units Actual for 10 units
hours Rate Amt Hours Rate Amount
GH GH¢ GH¢ GH¢
A 3,000 2 6,000 3,200 1.50 4,800
B 2,000 3 6,000 1,900 4.00 7,600
Total 5,000 12,000 5,100 12,400
(a)
Labour Cost Variance = SC – AC
= 12,000 – 12,400 = GH¢ 400 (A)
(b)
Labour Rate Variance = (SR – AR) × AH
A = (2 – 1.50) × 3,200 = GH¢ 1,600 (F)
B = (3 – 4.00) × 2,900 = GH¢ 1,900 (A)
LRV = GH¢ 300 (A)
(c)
Labour Efficiency = (SH – AH) × SR
Variance
A = (3,000 – 3,200) × 3,200 = GH¢ 400 (A)
B = (3 – 4.00) × 2,900 = GH¢ 300 (F)
LEV = GH¢ 100 (A)
Check LCV = LRV + LEV

400 (A) = 300 (A) + 100 (A)
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(d)
Labour Mix Variance = (SRH* – AH) × SR
A = (3,060 – 3,200) × 2 = GH¢ 280 (A)
B = (2,040 – 1,900) × 3 = GH¢ 420 (F)
LMV = GH¢ 140 (F)
Calculation of Revised Standard Hours (RSH)

St. Hours of the grade
RSH = × Total actual hours
Total of st. hours
3,000
Grade A = × 5,100 = 3,600 hrs
5,000
2,000
Grade B = × 5,100 = 2,040 hrs
5,000
Labour Revised Efficiency Variance

(Or Labour Sub-efficiency Variance) This is similar to Material Revised
Usage Variance and is a sub-variance of labour efficiency variance. It arises
due to factors other than those which give rise to idle time variance and
labour mix variance. Thus, this is a residue of labour efficiency variance left
after idle time and mix variance have been separated. Its formula is:
Labour Revised St. Hours for Revised

= ( - ) × St. Rate
Efficiency Variance Actual output St. hours
LREV = (SH – RSH) × St. Rate
Example
Using the data given in illustration 3.1
Labour Revised Efficiency Variance = (SH – SRH) × SR
Grade A = (3,000 – 3,060) × 2 = GH¢ 120 (A)
Grade B = (2,000 – 2,040) × 3 = GH¢ 120 (A)
LREV = GH¢ 240 (A)
Check LCV = LRV + LEV

GH¢ 100(A) = GH¢ 140 (F) + GH¢ 240 (A)
Labour Yield Variance

This is quite similar to Material Yield Variance. This variance reveals the
effect on labour cost of actual output or yield being more or less than the
standard yield. Its formula is:
Labour yield Actual St. yield St. Labour cost
= ( - ) ×
variance yeild From actual input Per unit of output
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Illustration 3.2
Standard output 500 units
Actual output 450 units
Standard time 1000 hrs.
Standard rate GH¢ 20 per hour
Calculate Labour Yield Variance
Solution
St. Time per unit = 100 hrs. ÷ 500 units = 2hrs
St. Cost per unit = 2 hrs. @ 20 = GH¢ 40
Actual - St. cost

Labour Yield Variance = ( St. yield )
yield of output
= (450 – 500) × GH¢ 40 = GH¢ 2000 (A)
Illustration 3.3
The standard labour employment and labour engaged in a week for a job are
as under:
Skilled Semi-skilled Unskilled
workers workers workers
Standard no. of workers in the 12 6
gang 32 18 4
Actual no of workers employed 28 2 1
Standard wage rate per hour 3 3 2
Actual wage rate per hour 4
During the 40 hours working week, the gang produced 1,800 standard
labour hours of work. Calculate:
a. Labour Cost Variance
b. Labour Rate Variance
c. Labour Efficiency Variance
d. Labour Mix Variance
e. Labour Yield Variance
Solution
Standard Actual
Category of HGH¢* Rate Amount GH¢ Rate Amount
workers GH¢ GH¢
Skilled 1,280 3 3,840 1,120 4 4,480
Semi- skilled 480 2 960 72, 3 2,160
Unskilled 240 1 240 160 2 320
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2,000 5,040 2,000 6,960
Hrs = No of workers × 40 hours
GH¢ 5,040
St. Cost of actual output = × 1,800 hrs = GH¢ 4,536
2,000 hrs
LCV = GH¢ 4,536 - 6,960 = GH¢ 2,424 (A)

Skilled = (3 – 4) × 1,120 = GH¢ 1,120 (A)
Semi-skilled = (2 – 3) × 720 = GH¢ 720 (A)
Unskilled (1 – 2) × 160 = GH¢ 160 (A)
LRV GH¢ 2,000 (A)
Labour Rate Variance = (SH for actual output – ARH) × SR

Skilled = (1,152 – 1,120) × 3 = GH¢ 96 (F)
Semi-skilled = (432 – 720) × 2 = GH¢ 576 (A)
Unskilled = (216 – 260) × 1 = GH¢ 56 (F)
LRV = GH¢ 424 (A)
St. hrs. for actual output are calculated as follows:

1,800
Skilled = × 1,280 = 1,152 hrs.
2,000
1,800
Semi-skilled = × 480 = 432 hrs.
2,000
1,800
Unskilled = × 240 = 216 hrs.
2,000
Labour Rate Variance = (Revised St. Hrs. – AH) × SR

Skilled = (1,280 – 1,120) × 3 = GH¢ 480 (A)
Semi-skilled = (480 – 720) × 2 = GH¢ 480 (A)
Unskilled (240 – 160) × 1 = GH¢ 80 (A)
LRV GH¢ 80 (F)
Labour Actual St. output St. Rate per

Yield = ( output - for actual hours ) × hour of work
Variance
5,040 =
LYV = (1,800 – 2,000) × GH¢ 424 (A)
2,000
UEW/IEDE 299
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Check
i.
LCV = LRV + LEV
GH¢ 2,424 (A) = GH¢ 2,000 (A)
ii.
LEV = LMV + LYV
GH¢ 424 (A) = GH¢ 80 (F) + GH¢ 504 (A)
300 UEW/IEDE
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Unit 6, section
This page
3: Direct
is left labour
blank for
cost
your notes ACCOUNTING II
variance
UEW/IEDE 301
COST AND MANAGEMENT OVERHEADS VARIANCE
UNIT 6 SECTION
ACCOUNTING II 4
Unit 6, section 4: Overheads variance
Hello learner, you are welcome to Session four of unit six of cost and
management accounting II. In this Session, we look at overheads variance
analysis. Overhead is the aggregate of indirect materials, indirect labour and
indirect expenses. Analysis of overhead variances is different from that of
direct material and direct labour variances and is considered to be a difficult
part of variance analysis. There are mainly two reasons for this difficulty.
Firstly, standard overhead rate for fixed overhead is difficult to establish

because changes in the volume of output will distort this rate even though
there is no change in the amount of fixed overhead cost. Generally fixed
overhead absorption rate is determined on the basis of normal volume of
output.
Secondly, there is conflicting terminology and different ways of computing

overhead variances. Overhead variances may be separately computed for
fixed overheads. Then there are two variance, three variances and four
variance methods of analyzing overhead variances. Moreover, overhead rate
may be per hour or per unit of output. All these lead to confusion in
overhead variance analysis.
In this Session, overhead variances have been classified into fixed and
variable overhead variances and then further analyzed according to causes.
It is important to understand at the outset that overhead variance is nothing
but under or over-absorption of overhead. Certain basic terms used in
connection with overhead variances are explained first of all.

 calculate overheads variance
 calculate variable overheads variance labour rate variance
 determine fixed overheads variance
Standard Overhead Rate

This overhead absorption rate may be computed per hour or per unit,
depending upon the method of absorption. This is calculated as follows:
Budgeted overhead
Standard overheads rate ( per hour) =
Budgeted hours
Or
Budgeted overhead
Standard overheads rate ( per hour) =
Budgeted output (in units)
Where overhead variances are separately computed for fixed and variance
overheads, separate overheads rates are to be computes for fixed overhead
and variable overhead.
300 UEW/IEDE
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Unit 6, section 4: Overheads variance ACCOUNTING II
When overhead rate per hour is used

The following basic calculations should be made before computing
variances.
(a) Standard hours for actual output (SHAO). It is required to be calculated
when overhead are absorbed on the basis of overhead rate per hour. It is
calculated as under:
Budgeted hours
SHAO = × Actual output
Budgeted output
(b)
St. hrs. St. overhead
Absorbed (or Recovered) overhead = ×
for actual output rate per hour
(c)
Actual St. overhead
Standard overhead = ×
hours rate per hour
(d)
Budgeted St. overhead
hours rate per hour
When overhead rate per unit is used

The following basic calculations should be made:
(a) Standard output for actual hours (SOAH). It is required to be calculated
when overhead are absorbed on the basis of overhead rate per unit. It is
Budgeted hours ( in units)
SHAO = × Actual output
Budgeted output
(b)
Actual St. overhead
Absorbed overhead = ×
output rate per hour
(c)
St. output St. overhead
for actual time rate per hour
(d)
Budgeted St. overhead
Budgeted overhead = ×
output rate per hour
(e)
Actual Actual overhead
Actual overhead = ×
output rate per unit
UEW/IEDE 301
COST AND MANAGEMENT
ACCOUNTING II Unit 6, section 4: Overheads variance
Overhead Cost Variance

This is the total overhead variance and can be described as the difference
between total standard overhead absorbed and total actual overhead
incurred. C.I.M.A., London has defined it as “the difference between the
standard cost of overhead absorbed in the output achieve and the actual
overhead cost.” Thus, this variance arises due to the actual overhead
incurred differing from the standard overhead arises due to the actual
overhead incurred differing from the standard overhead absorbed and is
simply under or over-absorption of overheads. Its formula is:
Overhead Cost Variance = Absorbed overhead – Actual overhead
St. hours for St. overhead
OCV = × ) - St. Rate per hour of work
actual output absorption rate
Example Budgeted output 10,000 units

Budgeted hours 10,000
Budgeted overhead GH¢ 20,000
Actual overhead GH¢ 22,000
Actual output 12,000
Calculate Overhead Cost Variance (OCV)

Solution
Budgeted overhead
St. Overhead absorption rate =
Budgeted hours
GH¢ 20,000
=
10,000
= GH¢ 2 per hour
10,000 hrs
St. Hours for actual output = × 12,000 units
10,000 units
= 12,000 hours
OCV = (12,000 × 2) – GH¢ 22,000
= GH¢ 2,000 (F)
Overhead Cost Variance is divided into variable overhead and fixed

overhead variances.
Variable Overhead (VO) Variances

Variable overhead Cost Variance: It may be defined as the difference
between absorbed variable overhead and actual variable overhead. Its
formula is:
Variable overhead St. hours for St. variable Actual over
= ( × ) -
Cost variance actual output ohd.rate head cost
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VOCV = (Absorbed V.O. – Actual V.O.)
This variance is sub-divided into the following two variances:

(a) Variable Overhead Expenditure Variance. This is also known as
Spending Variable or Budget Variance. This variance arises due to the
difference between standard variable overhead allowed and actual
variable overhead incurred. Its formula is:
V.O. Expenditure St. variable Actual Actual over
= ( × ) -
Variance. overhead rate hours head cost
= (Standard V.O. – Actual V.O.)
(b) Variable Overhead Efficiency Variance. This variance arises due to

the difference between standard hours allowed for actual output and
actual hours. The reasons for this variance are the same which give rise
to labour efficiency variance, Its formula is as follows:
V.O. Expenditure St. hours for Actual St. Variable
= ( × ) ×
Variance. actual output hours overhead rate
= (Absorbed V.O. – Standard V.O.)
Check
V.O.Expenditure V.O Efficiency
V.O. Cost Variance = +
Variance Variance
Illustration 4.1
Calculate variable overhead variances from the following:
Budgeted Actual
Output (units) 20,000 19,000
Hours 5000 4,500
Overhead - Fixed GH¢ 10,000 10,500
Variable GH¢ 5,000 4,800
Solution
Basic calculations:
(a)
St. variable Budgeted overhead GH¢ 5,000
= = = GH¢ 1 per hour
overhead rate Budgeted hours 5,000 hours
(b)
St. hours for actual Budgeted overhead
= × Actual output
output Budgeted output
5,000
= × 19,000
20,000
= 4,750 hours
UEW/IEDE 303
COST AND MANAGEMENT
Calculation of Variances
(a)
Variable Overhead St. hours for Actual variable
= ( - St. Rate ) -
Cost Variance Actual output overhead
= (4,750 × 1) – 4,800 = GH¢ 50 (A)
(b)
Actual Actual variable
Expenditure Variance = ( × St. rate ) -
hours overhead
= ( 4,500 × 1 ) = GH¢ 300 (A)
(c)
St. hours for Actual
Efficiency Variance = ( - ) × St. Rate
actual output hours
= ( 4,750 – 4,500 ) × 1 = GH¢ 250 (F)
Check
V.O. Cost Variance = Expenditure Variance + Efficiency Variance
50 (A) = 300 (A) + 250 (F)
Fixed Overhead (FO) Variances

 Fixed Overhead Cost Variance. It is the difference between standard
fixed overhead cost for actual output (or absorbed overhead) and actual
fixed overhead. Its formula is:
F.O. Cost St. hours for St. F.O
= ( - ) - Actual fixed overhead
Variance actual rate
= Absorbed overhead - Actual overhead
Fixed overhead cost variance is sub-divided in to the following two

variances:
 Fixed Overhead Expenditure Variance. This is also known as
Spending Variance or Budget Variance. It arises due to the difference
between budgeted fixed overhead and actual fixed overhead. Its formula
is:
Budgeted Actual
F.O. Expenditure Variance = ( - )
Fixed overhead Fixed overhead
 Fixed Overhead Volume Variance. This variance arises due to the

difference between standard output and actual output. It is defined as
that portion of overhead variance which arises due to the difference
between standard cost of overhead absorbed by actual production and
the standard allowance for the output.
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St. hours for Budgeted

F.O. Volume Variance = ( - ) × St. Rate
Actual output hours
Example
Calculate fixed overhead variances in Illustration 3.1
Solution
Basic calculations:
(a)
St. fixed Budgeted fixed overhead GH¢ 10,000
= = = GH¢ 2
overhead rate Budgeted hours 5,000 hours
(b)
St. hour for Budgeted hours
= × Actual output
actual output Budgeted output
5,000
= × 19,000 = 4.750 hrs
20,000
(a) Fixed Overhead Cost Variance
St. hours for
= ( - St. rate ) - Actual fixed overhead
Actual output
= ( 4,750 × 2 ) - 10,500 = GH¢ 1,000 (A)
(b) Fixed Overhead Expenditure Variance

Budgeted Actual
= ( - )
overhead overhead
= 10,000 – 10,500 = GH¢ 500 (A)
(c) Fixed Overhead Volume Variance

St. hours Budgeted
= ( - ) × St. Rate
actual output hours
= (4,750 5,000) × GH¢ 2 = GH¢ 500 (A)
Check
F.O. Cost Variance = Expenditure Variance + Volume Variance
1,000 (A) = 500 (A) + GH¢ 500 (A)
UEW/IEDE 305
COST AND MANAGEMENT
Illustration 4.2
Budget Actual
Production in units 12,5000 11,000
Man hours 6,250 5,750
Overhead costs:
Fixed 12,500 13,000
Variable 50,000 45,000
Calculate overhead variances when:

(A) Standard overhead rate per hour is used.
(B) Standard overhead rate per unit is used.
Solution
(A) When Overhead Rate Per Hour is Used
Basic calculations
GH¢ 12,500
Standard fixed overhead rate (per hour) = = GH¢ 2
6,250 hrs
= GH¢ 50,000
Standard variable overhead rate (per hour) = GH¢ 8
6,250 hrs
6,250 hrs
Standard hours for actual output = × 11,000 units
12,500 hrs
= 5.500 hrs.
(a) Variable Overhead Variances
(i) Variable Overhead Cost Variance
VOCV = ( × ) - Actual overhead cost
actual output rate
= (5,500 × GH¢ 8) – 45,000 = GH¢ 1,000 (A)
(ii) Overhead Expenditure or Budget Variance (OBV)

= Standard overhead – Actual overhead
= (Actual hrs. × St. Rate) – Actual overhead cost
= (5,750 × GH¢ 8) – 45,000
= 46,000 – 45,000 = GH¢ 1,000 (F)
(iii)Overhead Efficiency Variance (OEV)

= ( - ) × St. Overhead rate
actual output hours
306 UEW/IEDE
COST AND MANAGEMENT
= ( 5,500 – 5,750 × GH¢ 8 = GH¢ 2,000 (A)
Check
VOCV = OBV + OEV
GH¢ 1,000 (A) = GH¢ 1,000 (F) + GH¢ 2,000 (A)
(b) Fixed Overhead Variances

(i) Fixed Overhead Cost Variance
FOCV = ( × ) - Actual overhead cost
actual output rate
= 5,500 × GH¢ 2 = -13,000 = GH¢ 2,000 (A)
(ii) Overhead Expenditure or Budget Variance (OBV)

= Budgeted overhead – Actual overhead
= 12,500 – 13,000
= GH¢ 500 (A)
(iii)Overhead Volume Variance (OVV)

St. hours for Budgeted
= ( - ) × St. Rate
Actual output hours
= ( 5,500 – 6,250 ) × GH¢ 2 = GH¢ 1,500 (A)
Check
FOCV = OBV + OVV
GH¢ 2,000 (A) = GH¢ 500 (A) + GH¢ 1,500 (A)
(B) When Overhead Rate per Unit is Used

Whether standard overhead rate used is per hour or per unit, the results will
be the same. Thus the variances calculated by both the methods would be
identical. In fact, these are two different ways of looking at the same thing.
Basic calculations
(i)
GH¢ 12,500
St. fixed overhead rate = = GH¢ 1 per unit
12,500
(ii)
GH¢ 50,000
St. variable overhead rate = = GH¢ 4 per unit
12,500 units
(iii)
Budgeted output
St. output for actual hours = × Actual hours
Budgeted hours
= 12,500 units × 5,750 hrs. = 11,500 units
UEW/IEDE 307
COST AND MANAGEMENT
6,250 hrs
Calculations of Variances
Variable overhead Variances
(a) Variable overhead Cost Variance
= (Actual output × St. Rate) – Actual overhead
= (11,000 × 4) – 45,000
= GH¢ 1,000 (A)
(b) Variable Overhead Expenditure Variance

= (Standard overhead) – (Actual overhead)
= Actual output – St. output for actual hours × Standard rate
= (11,500 × 4) – 45,000
= GH¢ 1,000 (F)
(c) Variable Overhead Efficiency Variance

= (Actual output – St. Output for actual hrs.) × St. Rate
= (11,000 – 11,500) × GH¢ 4
= GH¢ 2,000 (A)
Fixed overhead Variances:

(a) Fixed Overhead Cost Variance
= (Actual output – St. Rate) – Actual overhead
= (11,000 × 1) – 13,000
= GH¢ 2,000 (A)
(b) Fixed Overhead Expenditure Variance

= Budgeted overhead – Actual overhead
= 12,500 – 13,000
= GH¢ 500 (A)
(c) Fixed Overhead Volume Variance

= (Actual output – Budgeted output) × St. Rate
= (11,000 – 12, 5000 × GH¢ 1
= GH¢ 1,500 (A)
Sub-division of Overhead Volume Variance

Volume variance is further sub-divided into the following variances:
 Efficiency Variance
 Capacity Variance
 Calendar Variance
 Fixed Overhead Efficiency Variance. This is defined as “that portion

of volume variance which reflects the increased or reduced output
arising from efficiency above o below the standard which is expected”.
This variance thus shows that the actual quantity produced is different
308 UEW/IEDE
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from standard quantity because of higher or lower efficiency of workers

engaged in production. Its formula is:
Efficiency Variance = Absorbed – Standard fixed overhead
= (St. Hrs. for actual output – Actual hours) × St. Rate
 Fixed Overhead Capacity Volume. This is “that portion of the volume

variance which is due to the working or higher or lower capacity usage
than the standard”. Thus this variance arises when plant capacity
actually utilized is more or less than the capacity planned to be utilized
due to factors like idle time, under or over customer demand, strikes
power failure, etc. Its formula is:
Capacity Variance = (Standard fixed overhead - Budgeted overhead)
= (Actual Hrs. worked – Budgeted hours) × St. Rate
Example
Calculate fixed overhead efficiency variance and capacity variance from
information given in illustration 4.2
Solution
Efficiency Variance = ( - ) × St. Rate
actual output hours
= ( 5,500-5,750 ) × GH¢ 2
= GH¢ 500 (A)
Actual Budgeted
Capacity Variance = ( - ) × St. Rate
hours hours
= ( 5,750 – 6,250 ) × GH¢ 2
= GH¢ 1,000 (A)
Check
Volume Variance = Efficiency Variance + Capacity Variance
GH¢ 1,500 (A) = GH¢ 500 (A) + GH¢ 1,000 A
Calendar Variance. It may be defined as “that portion of the volume

variance which is due to the difference between the number of working days
in the budget period and the number of actual working days in the period to
which the budget is applied”. Calendar variance is actually volume variance
arising due to a particular cause i.e., actual number of working days being
different from those budgeted due to extra holiday being declared on the
death of a national leader or any other reason. Calendar variance arises only
UEW/IEDE 309
COST AND MANAGEMENT
in exceptional circumstances because normal holidays are taken into

account while laying down the standard.
When calendar variance is calculated, the calculation of capacity variance

has to be modified so as to induct this additional variance into the analysis.
Calendar variance is calculated by the following formula:
Actual No. of St. No of St. Rate

Calendar Variance = ( - ) ×
working days working days per day
Revised budget Budgeted St. Rate

= ( - ) ×
hours hours per hour
Generally, this variance is adverse because of extra holidays, but if there are
extra working days (because of less holidays0, then this variance will be
favourable.
Example
The following information is given:
St. fixed overhead rate (per hour) GH¢ 5
St. No of working days 25
Actual hours 11,500
Actual No. of working days 22
Calculate Calendar Variance
Solution
St. No of hrs. Per day = 12,500 ÷ 25 days = 500
Revised budgeted hours = St. Hours per day × Actual No. of days
= 500 × 22 = 11,000
Calendar Variance = (11,000 – 12,500) × GH¢ 5
= GH¢ 7,500 (A)
Alternative Method
St. Overhead rate per day = St. Hrs. per day × St. Rate per hour
= 500 hrs. × GH¢ 5 = GH¢ 2,500
Calendar Actual No. of St. No of

= ( - ) × St. Rate per day
Variance Working days working days
= (22 – 25) × 2,500

= GH¢ 7,500 (A)
Revised Capacity Variance

When calendar variance is to be calculated, the method of calculating
capacity variance has to be modified. The new formula in that case is as
follows.
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Revised Capacity Actual Revised St. Rate per

= ( - ) ×
Variance hours budgeted hours day
In the example given above, capacity variance will be calculated as follows:

Revised Capacity Variance = (11,500 – 11,000) × GH¢ 5
= GH¢ 2,500 (F)
Illustration 4.3
XYZ Ltd. has furnished you with the following information for the month of
August:
Budget Actual
Output (units) 30,000 32,500
Hours 30,000 33,000
Fixed overhead GH¢ 45,000 50,000
Variable overhead GH¢ 60,000 68,000
Working days 25 26
Calculate overhead variances
Solution
Basic calculations:
Standard hours per unit = = = 1 hour
Budgeted units 30,000
St. Hrs. for actual output = 32,500 units × 1 hr. = 32,500
Budgeted overhead
St. Hrs. overhead rate per hour =
Budgeted hours
45,000
For fixed overheads = = GH¢ 1.50 per hour
30,000
60,000
For variable overhead = = GH¢ 2.00 per hour
30,000
St. F.O. rate per day = GH¢ 45,000 ÷ 25 days = GH¢ 1,800
Recovered overhead = St. Hrs. for actual output × St. Rate
For fixed overhead = 32,500 hrs.× GH¢ 1.50 = GH¢ 48,750
For variable overhead = 32,500 hrs. × GH¢ 2 = GH¢ 65,000
Standard overhead = Actual hours × St. Rate
For fixed overhead = 33,000 × 1.50 = GH¢ 49,500

For variable overhead = 33,000 × 2 = GH¢ 66,000
UEW/IEDE 311
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Budgeted hours
Revised budgeted hours = × Actual days
Budgeted days
30,000
= × 26 = 31,200 hours
25
Revised budgeted overhead (For fixed overhead)

= 31,200 × 1.50 = GH¢ 46,800
Calculation of variances
Fixed overhead variances:
(i)
F.O. Cost Variance = Recovered Overhead – Actual Overhead
= 48,750 – 50,000
= GH¢ 1,250 (A)
(ii)
F.O. Expenditure Variance = Budgeted Overhead – Actual Overhead
= 45,000 – 50,000
= GH¢ 5,000 (A)
(iii)
F.O. Volume Variance = Recovered Overhead – Budgeted Overhead
= 48,750 – 45,000
= GH¢ 3,750 (F)
(iv)
F.O. Efficiency Variance = Recovered Overhead – Standard Overhead
= 48,750 – 49,500
= GH¢ 750 (A)
(v)
F.O. Capacity
= Standard Overhead – Revised Budgeted Overhead
Variance
= 49,500 – 46,800
= GH¢ 2,700 (F)
(vi)
Actual Budgeted
Calendar Variance = ( - ) × St. Rate per day
days days
= (26 – 25) ×1,800 = GH¢ 1,800 (F)
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Variable Overhead Variances

(i)
V.O. Cost Variance = Recovered Overhead – Actual Overhead
= 65,000 – 68,000
= GH¢ 3,000 (A)
(ii)
V.O. Expenditure Variance = St. Overhead – Actual Overhead
= 66,000 – 68,000
= GH¢ 2,000 (A)
(iii)
F.O. Volume Variance = Recovered Overhead – St. overhead
= 65,000 – 66,000
= GH¢ 1,000 (A)
Check
(i)
F.O. Cost Expenditure Efficiency Coacity Calendar
= + + +
Variance Variance Variance Variance Variance
1,250 (A) = 5,000 (A) + 750 (A) + 2,700 (F) + 1,800 (F)
(ii)
Efficiency Coacity Calendar
F.O. Volume Variance = + +
Variance Variance Variance
3,750 (F) = 750 (A) + 2,700 (F) + 2,700 (F) + 1,800 (F)
(iii)
Expenditure Efficiency
V.O. Cost Variance = +
Variance Variance
3,000 (A) = 2,000 (A) + 1,000 (F)
UEW/IEDE 313
COST AND MANAGEMENT SALES VARIANCES
UNIT 6 SECTION
ACCOUNTING II 5
Unit 6, section 5: Sales variances
Hello learner, you are welcome to session five of unit six of cost and
management accounting II. In this Session, we look at sales variance which
is another component of variance analysis. Sales Volume Variance is the
measure of change in profit or contribution as a result of the difference
between actual and budgeted sales quantity. Companies regularly analyze
sales variances to explain revenue performance over a monthly, quarterly or
yearly accounting cycle. The resulting sales variance explanations help
firms isolate problems and gear their future sales and marketing efforts
towards increased sales growth. The sales variance analysis relies on a
comparison benchmark -- usually a firm's sales budget. Fluctuations in
actual versus budgeted sales may have several explanations, requiring
diligent analytical work to reveal the underlying causes.
In this Session, sales variance determination has be classified two distinct

methods: Turnover (or value) method and Margin (or profit) method

 understand the two distinct methods of calculating sales variance
 calculate sales value variance, sales volume variance and sales price
variance under the two methods
 calculate sales mix variance and quantity variance
Methods of calculating sales variance

There are two distinct methods of calculating sales variances:
 Turnover (or value) method
 Margin (or profit) method
The following chart shows the various main and sub-variances of sales.
Sales
Variance
Turnover Margin
Method Method
Price Volume Price Volume

Variance Variance Variance Variance
Mix Quantity Mix Quantity

Variance Variance Variance Variance
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Unit 6, section 5: Sales variances ACCOUNTING II
Turn over Method or Sales Value Method

Under this method, the following variances are calculated:
Sales Value Variance. This is the difference between the budgeted value
and the actual value of sales realized during a period. This variance is
 Sales Value Variance = (Actual sales) – (Budgeted sales)
Sales value variance results due to one or more of the following reasons:
 Actual sales volume being more or less than the standard sales volume.
This is expressed in sales volume variance.
 Actual sales price received higher or lower than the standard sales price.
 This is expressed in sales price variance.
 A mix of products has been sold which is different from the standard
mix. This is expressed in sales mix variance.
 Sales Volume Variance. Volume refers to the number of physical units.
Sales volume variance, therefore, represents that portion of the sales
value variance which is due to the difference between the actual volume
and standard volume of sales.
The formula is:

Actual Budgeted
Sales Volume Variance = ( - ) × St. Price
quantity quantity
= Standard sales - Budgeted sales
Reasons. The usual reasons for this variance are: 1. Ineffective advertising
and sales promotion. 2. Unexpected competition. 3. Lack of proper
supervision and control of salesmen.
Sales Price Variance. Sales price variance is that portion of the sales value
variance which is due to the difference between standard price specified and
the actual price changed. The formula for its calculation is:
Actual Standard
Sales Volume Variance = ( - ) × Actual quantity
price price
= Actual Sales - Standard Sales
If actual price is less than the standard price, possible reason may be
unforeseen competition. The price may also have to be reduced if a larger
number of units have to be sold.
Illustration 5.1
A company marketing a product supplies the following information:
Standard sales Actual sales
Qty. Price Amt. Qty. Price Amt.
Units GH¢ GH¢ Units GH¢ GH¢
UEW/IEDE 315
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ACCOUNTING II Unit 6, section 5: Sales variances
10,000 3 30,000 5,000 3 15,000

8,000 2.50 20,000
Calculate sales value variances. (C.A. Inter)
Solution
Sales Value Variance = Actual sales – Standard sales
= [(5,000 × 3) + (8,000 × 2.50)] – (10,000 × 3)
= 35,000 – 30,000
= GH¢ 5,000 (F)
Sales Volume Variance = (AQ – SQ) × SP

= (13,000 – 10,000) × 3
= GH¢ 9,000 (F)
Sales Price Variance = (AP – SP) × AQ

= (3 – 3) × 5,000
= Nil
= (2.50 – 3) × 8,000
= GH¢ 4,000 (A)
Total = GH¢ 4,000 (A)
Verification
Sales Value Variance = Volume variance + Price variance
5,000 (F) = 9,000 (F) + 4,000 (A)
Sales Mix Variance. When a company is selling more than one type of
product, a budget will be prepared to show the budgeted sales of each
product. If actual sales of different products are not in the same proportion
as budgeted, a sales mix variance will arise. Sale mix variance is “that
portion of the sales volume variance which is due to the difference between
the standard and the actual inter-relationship of the quantities of each
product or product group of which sales are composed”.
It is calculated by the following formula:

Sales Mix Actual Revised standard Standard
= ( - ) ×
Variance quantity quantity price
Or
= Standard sales - Revised standard sales
Revised standard quantity is calculated as under:

Total of actual quantities of all products Standard quantity
= ×
Total of standard quantities of all products Of one product
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Sales Quantity Variance. The variance is the difference between the

budgeted sales and revised standard sales. Its formula is:
Sales Quantity Revised standard Budgeted Standard

= ( - ) ×
= Revised standard sales - Budgeted sales
Revised standard quantity means actual sales quantity in budgeted ratio of

products. Where the budgeted quantity is more than the revised standard
quantity, this variance is adverse and when the revised standard quantity is
more than budgeted quantity, it is favourable.
Check
Sales Value Variance = Price Variance + Volume Variance
Sales Volume Variance = Mix Variance + Quantity Variance
Therefore: Sales Value Variance = Price Variance + Mix Variance +
Quantity Variance
Illustration 5.2
The following products relate to products X and Y.
Product Budget Actual
Qty. Price Value Qty. Price Value
GH¢ GH¢ GH¢ GH¢
X 1,000 5 5,000 1,200 6 7,200
Y 1,500 10 15,000 1,400 9 12,600
Total 2,500 20,000 2,600 19,800
Calculate sales variances by Turnover Method
Solution
Product Actual quantity Budgeted price Standard sales
(A) (B) (A × B )
X 1,200 5 6,000
Y 1,400 10 14,000
Total 2,600 20,000
Calculation of Revised Standard Quantity

Total AQ
Revised SQ = × SQ of each product
Total SQ
2,600
X = × 1,000 = 1,040 units
2,500
2,600
Y = × 1,500 = 1,560 units
2,500
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1.
Sales Value Variance = Actual sales – Budgeted sales
= 19,800 – 20,000
= GH¢ 200 (A)
2.
Sales Value Variance = (AP – SP) × AQ
X = (6 – 5) × 1,200
= GH¢ 1,200 (F)
Y (9 – 10) × 1,400
= GH¢ 1,400 (F)
Total = GH¢ 200 (A)
3.
Sales Value Variance = (AQ – BQ) × SP
X = (1,200 – 1,000) × 5
= GH¢ 1,000 (F)
Y (1,400 – 1,500) × 10
= GH¢ 1,000 (A)
Total = Nil
4.
Sales Mix Variance = (AQ – RSQ) × SP
X = (1,200 – 1,040) × 5
= GH¢ 800 (F)
Y (1,400 – 1,560) × 10
= GH¢ 1,600 (A)
5.
Sales Quantity Variance = (RSQ – BQ) × SP
X = (1,040 – 1,000) × 5
= GH¢ 200 (F)
Y (1,560 – 1,500) × 10
= GH¢ 600 (A)
Check
i)
Sale Value Variance = Price Variance + Volume Variance
200 (A) = 200 (A) + Nil
ii)
Volume variance = Mix Variance + Quantity Variance
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Nil = 800 (A) + 800 (F)
Alternative Method of Computing Sales Mix Variance

There are two methods of computing sales mix variance –
Quantity Technique and Value Technique.
 Quantity Technique. This technique of computing sales mix variance
and sales quantity variance has been used in the above illustration 16.12.
Under this technique, revised standard quantities are calculated of the
total actual quantity sold. This method is used when products are
homogeneous, e.g., a company selling electronic computers of different
types. This method of calculating sales mix variance is quite similar to
material mix variance. It is calculated by the following formula:
Sales Mix Actual Revised standard Standard
= ( – ) ×
Or = Standard sales – Revised standard sales
Revised standard quantity is calculated as under:

Total of actual quantities of all products Standard quantity
= ×
Total of standard quantities of all products of one product
 Value technique. In this method revised standard sales value (instead of

sales quantity) is calculated. This method is used when products sold are
not homogeneous, e.g., a company is selling television, washing
machines, air conditioners etc. Its formula is as follows:
Sales Mix Variance = Standard sales - Revised standard sales
 Sales Quantity Variance. This variance is the difference between the

budgeted sales and revised standard sales. Its formula is:
Sales Quantity Revised standard Budgeted Standard
= ( - ) ×
= Revised standard sales – Budgeted sales
Revised standard quantity means actual sale quantity is budgeted ratio of

products. Where the budgeted quantity is more than the revised standard
quantity, this variance is adverse and when the revised standard quantity is
more than budgeted quantity, it is favourable.
Verification
Sales Value Variance = Price Variance + Volume Variance
Therefore,
Sales Value
= Price Variance + Mix Variance + Quantity Variance.
Variance
UEW/IEDE 319
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Illustration 5.3
From the information in Illustration 5.2, compute sales variances by
turnover method by using Value Technique.
Solution
Under value techniques, Sales Variance, Sales Price Variance and Sales
Volume Variance will be the same as calculated under quantity Technique.
However, Mix Variance and Quantity Variance may be different and these
are computed as follows:
Basic Calculations
(a) Standard sales = Actual quantities sold valued at standard prices.
(b) Revised standard sales = Standard sales rearranged in the budgeted ratio.
Product Standard Sales (SS) Revised Standard
Sales (RSS)
Actual Standard Value Ratio GH¢
Qty. Price GH¢
GH¢
X 1,200 5 6,000 25% 5,000
Y 1,400 10 14,000 75% 15,000
Total 20,000 20,000
Revised Budgeted sales of individual product Total

= ×
standard sales Total budgeted sales standard sales
5,000
X = × 20,000 = GH¢ 5,000
20,000
= 15,000
Y × 20,000 GH¢ 15,000
20,000
Sales Mix Variance = SS – RSS
X = 6,000 – 5,000
= 1,000 (F)
Y = 14,000 – 15,000
= 1,000 (A)
Total = Nil
Sales Quantity Variance = RSS – SS

X = 5,000 – 5,000
= Nil
Y = 15,000 – 15,000
= Nil
Total = Nil
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Check
Nil = Nil + Nil
Note: It should be noted that under Turnover Method, while using value
technique, sales mix variance will always be zero because it is based on a
re-arrangement of standard sales in terms of budgeted ratio, i.e., total
standard sales and total revised standard sales represent the same figure.
Sale Margin Method

The sales margin method measures the effect on profit of deviations of
actual from planned sales. Management is primarily interested in knowing
these sales margin variances. Sales margin variance analysis assumes all
costs are at standard. Under this method, the following variances are
calculated.
Total Sales Margin (Profit) Variance. This variance is the difference

between actual profit and budgeted profit. Its formula is:
Total sales Actual Actual profit
= ( × )
Margin variance quantity Per unit
Budgeted Standard profit

- ( × )
quantity per unit
= Actual profit – Budgeted profit
Budgeted profit is calculated by multiplying budgeted quantity of sales with

budgeted (or standard) profit per unit.
Total sales margin is divided into price variance and volume variance.
Sales Margin Price Variance. It is the difference between actual profit and
standard profit. Thus:
Price Variance = Actual profit – Standard profit
Standard profit is calculated by multiplying the actual quantity of sales with

the budgeted (or standard) profit per unit. This variance is equal to the price
variance calculated under sales value method. Thus it can also be calculated
by the following formula:
Price Actual profit St. profit Actual quantity
= - ) ×
Variance per unit per unit per unit
Sales Margin Volume Variance. This is the difference between standard

profit and budgeted profit. Thus,
Volume Variance = Standard profit – Budgeted profit
UEW/IEDE 321
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It may also be calculated by the following method:

Volume Actual Budgeted Standard profit
= ( - ) ×
Variance quantity quantity Per unit
This Volume Variance is further sub-divided into mix variance and quantity
variance.
Sales Margin Mix Variance. This variance arises only when a company is
selling more than one type of product. Its formula is as follows:
Sales Margin Actual Revised standard Standard profit
= ( - ) ×
Mix Variance quantity quantity per unit
= Standard profit – Revised standard profit
Sales Margin Quantity Variance. It is the difference between revised

standard profit and budgeted profit. Its formula is:
Standard Margin Revised standard Budgeted Standard
= ( - ) ×
Quantity Variance quantity quantity profit per unit
= Revised standard profit – Budgeted profit
Check
i)
Total Sales Margin Variance = Profit Variance + Volume Variance
ii)
Sales Margin Volumes Variance = Mix variance + Quantity Variance
Therefore:
iii)
Price Mix Quantity
Total sales margin variance = + +
variance Variance Variance
Illustration 5.4
The following data is supplied to you for the month of September.
Product Budgeted sales Actual sales
Qty. Price Value Qty. Price Value
GH¢ GH¢ GH¢ GH¢
X 1,200 5 6,000 1,000 5.00 5,000
300 4.75 1,425
Y 2,000 2 1,500 2.00 3,000
4,000 350 1.90 665
Total 10,000 10,090
Budgeted costs are: X – GH¢ 4.00 per unit, Y – GH¢ 1.50 per unit
Calculate sales margin variances, by using:

 Quantity technique and
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 Value technique
Solution
(a) Quantity technique
Calculation of actual, standard and budgeted profits

Prod Actual Actual Actual St. Standa Standa Budget
uct profit quantit profit profi rd rd ed
per y t per Profit quantit profit
unit unit y
1 2 3 4 5 6 7 8
(2 ×3) (3 ×5) (5 ×7)
GH¢ GH¢ GH¢
X 1.00 1,000 1,000 1.00 1,000 1,200
1,200
0.75 300 225 1.00 300
Y 0.50 1,500 750 0.50 750 1,000
2,000
0.40 350 140 0.50 175
Tota 2,200
3,150 2,115 2,225 3,200
l
Calculation of revised standard profit

Product Revised St. Qty. St. profit per unit Revised St. profit
(units) GH¢ GH¢
1,200
X × 3,150 = 1,181 1.00 1,18.00
3,200
2,000
Y × 3,150 = 1,969
3,200
Total 2,165.50
1.
Total Sales Margin Variance = Actual profit – Budgeted Profit
2.
Sales Margin Price Variance = Actual profit – Standard Profit
= 2,115 – 2,225
= GH¢ 110 (A)
3.
Sales Margin Volume Variance = St. profit – Budgeted Profit
= 2,225 – 2,200
= GH¢ 25 (F)
4.
Sales Margin Mix Variance = St. profit – Revised St. Profit
= 2,225 – 2,165.50
= GH¢ 59.50 (F)
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5.
Sales Margin Quantity Variance = Revised St. profit – Budgeted Profit
= 2,165.50 – 2,200
= GH¢ 34.50 (A)
Check
(i)
Total Sales Margin Variance = Price Variance + Volume Variance
GH¢ 85 (A) GH¢ 110 (A) + GH¢ 25 (F)
(ii)
Volume Variance = Mix Variance + Quantity Variance
GH¢ 85 (A) = GH¢ 59.50 (F) + GH¢ 34.50 (F)
(b) Value Technique

Under this technique, price variance and volume variance will be the same
as in quantity technique shown above. However, mix variance and quantity
variance will be different as calculated below.
Calculation of standard sales and revised standard sales

Product Standard sales Revised Standard Sales
Actual Price Amount Standard Ratio Amount
Qty. GH¢ GH¢ Qty. %
X 1,300 5 6,500 1,200 60 6,120
Y 1,850 2 3,700 2,000 40 4,080
Total 10,200 10,200
Calculation of revised standard profit

Product St. rate Revised Revised St.
of profit St. sales profit
1 2 3 2×3
X 1/5 = 20% 6,120 1,224
Y 0.50/2 = 25 % 4,080 1,020
Total 2,244
Sales Margin Mix Variance = St. Profit – Revised profit

= 2,225 – 2,244
= GH¢ 19 (A)
Sales Margin Quantity Variance = Revised St. Profit – Budgeted

= 2,244 – 2,200
= GH¢ 44 (F)
Check
Volume Variance = Mix Variance + Quantity Variance
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GH¢ 25 (F) GH¢ 19 (A) + 44 (F)
UEW/IEDE 325
COST AND MANAGEMENT REPORTING OF VARIANCES
UNIT 6 SECTION
ACCOUNTING II 6
Unit 6, section 6: Reporting of variances
Hello learner, you are welcome to final Session of unit six of cost and
management accounting II. In this Session, we look at reporting of variance.
In order that a standard costing system may be of maximum value to
management, it is essential that reports exhibiting variances from standards
for each element of cost of each department and operation should be quickly
and effectively presented to management. Furthermore, it is essential that
management should act speedily to investigate variances and; where
possible, make decisions to prevent recurrence of adverse variances.

 understand the essential of effective variance report
 calculate sales value variance, sales volume variance and sales price
variance under the two methods
 calculate sales mix variance and quantity variance
Essentials of Effective Variance Report

For effective reporting under standard costing, the following points should
be kept in view:
 the reports should be simple, clear and quick. if reports do not inform
management in a clear and unmistakable manner of what has taken lace
and what action may be taken, they may not fully serve their purpose.
 the reports should show the results of the period in view and assess the
level of efficiency achieved.
 the
 the amount reports should show a comparison of results achieved with
this planned of details included in a report should vary according to the
person for whom it is intended. for example, reports for top management
should be in the nature of summarizes of period’s activities while reports
for department heads should be detailed and show individuals
responsible for sub-standard and above standard operations.
 variances arising out of each factor should be correctly segregated.
moreover controllable variances should be separated from
uncontrollable variances and analysis of uncontrollable variances should
be made with the same care as for controllable variances.
 special attention should be focused on significant variances thereby
following the “principle of exception” rule.
 wherever possible, the use of charts and graphs should be made in
variance reports.
Cost Variance Report Format

A cost variance report may be presented in the form given below:
Cost Variance Report
Variances
Items Favourable Adverse Net
GH¢ GH¢ Amount
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Unit 6, section 6: Reporting of variances ACCOUNTING II
GH¢
Total Standard Cost
Material Variances:
(i) Price
(ii) Quantity
(iii)Mix
(iv) Yield
Labour Variances:
(i) Rate
(ii) Efficiency
(iii)Idle time
(iv) Mix
(v) Yield
Overhead Variances:
(a) Variable Overhead
(i) Expenditure
(ii) Efficiency
(b) Fixed Overhead
(i) Expenditure
(ii) Volume
(iii)Efficiency
(iv) Capacity
(v) Calendar
Total Actual Cost
Illustration 6.1
The standard cost card for product X reveals:
Standard materials GH¢
2 kg of A @ GH¢ 2 per kg 4.00
1 kg of B @ GH¢ 6 per kg 6.00
Direct labour (3 hours @ GH¢ 6 per hour) 18.00
Variable overhead (3 hours @ GH¢ 4 per direct labour hour) 12.00
Total standard cost per unit 40.00
It is proposed to produce 10,000 units of X in the month of March and
budgeted costs on the information contained in the standard costs card are as
follows:
Direct materials GH¢
A 20,000 kg @ GH¢ 2 per kg 40,000
B 10,000 kg @ GH¢ 6 per kg 60,000
Direct labour (30,000 hours @ GH¢ 6 per hour) 180,000
Variable overhead (30,000 hours @ GH¢ 4 per direct labour hour) 120,000
400,000
The actual results are:

Direct materials GH¢
A 19,000 kg @ GH¢ 2.20 per kg 41,800
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ACCOUNTING II Unit 6, section 6: Reporting of variances
B 10,100 kg @ GH¢ 5.60 per kg 56,500

Direct labour (28,500 hours @ GH¢ 6.40 per hour) 182,400
Variable overhead 104,400
387,760
Actual production was 9,000 units.

From the above information, calculate the following variances and prepare a
Variance Report showing reconciliation of standard cost and actual cost.
a. Material price and usage
b. Labour wages rate and labour efficiency
c. Variable overhead
i. Total variable overhead variance
ii. Overhead expenditure variance
iii. Overhead efficiency variance
Solution
(a) Material Variances
(i)
Material Price Variance = (SP – AP) × AQ
A = (2 – 2.20) × 19,000 = GH¢ 3,800 (A)
B = (6 – 5.60) × 10,100 = GH¢ 4,040 (F)
MPV = GH¢ 240 (F)
(ii)
Material Price Variance = (SQ – AQ) × SP
A = (18,000 – 19,000) × 2 = GH¢ 2,000 (A)
B = (9,000 – 10,100) ×6 = GH¢ 6,600 (A)
MPV = GH¢ 8,600 (A)
(iii)
Material Cost Variance = MPV + PUV
= GH¢ 240 (F) + GH¢ 8,600 (A)
GH¢ 8,360 (A)
(b) Labour Variances

(i)
= (6 – 6.40) × 28,500
= GH¢ 11,400 (A)
(ii)
Labour Efficiency Variance = (SH – AH) × SR
= (27,000 – 28,500) × 6
= GH¢ 9,000 (A)
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(iii)
Labour Rate Variance = LRV + LEV
= 11,400 (A) + 9,000 (A)
= GH¢ 20,400 (A)
(c) Variable Overhead Variances

Total Variable St. hrs. St. Actual
Overhead = ( for actual × overhead ) - variable
Variance. production rate overhead
= (27,000 × 4) – 104,000
= GH¢ 4,000 (F)
9,000 units @ 3 hours per 27,000 standard hours for actual production
=
unit
(i) Overhead Expenditure Variance

= (Budgeted overhead – Actual variable overhead)
= (28,500 × 4) – 104,000
= GH¢ 10,000 (F)
(ii) Overhead Efficiency Variance

Standard hours for Actual
= ( - ) × Standard overhead rate
actual production hours
= (27,000 – 28,500) × 4
= GH¢ 6,000 (A)
Total Cost Variance = Total St. Cost – Total Actual Cost

= (9,000 units × GH¢ 40) – GH¢ 384,760
= GH¢ 24,760 (A)
(iii)Variance Report
(Reconciliation of Standard Cost and Actual Cost)
Variances Amount
Favourable Adverse (A)
(F)
GH¢ GH¢ GH¢
Total Standard Cost 3,60,000
(9,000 units @ GH¢ 40) – –
Material Price Variance 240
Material Usage Variance 8,600
Labour Rate Variance 11,400
Labour Efficiency Variance – 9,000
Overhead Expenditure Variance 10,000 –
Overhead Efficiency Variance – 6,000
UEW/IEDE 329
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Total 10,240 35,000 24,760 (A)

Total Actual Cost 3,84,760
Problems and Solutions

Problem 1
A manufacturing concern which has adopted standard costing furnishes the
following information:
Standard:
Material for 70kg finished products 100 kg
Price of material GH¢1 per kg
Actual:
Output 210,000 kg
Material used 280,000 kg
Cost of materials GH¢ 252,000
Calculate:
(a) Material usage variance, (b) Material price variance, (c) Material cost
variance
Solution
Standard Quantity (SQ) for actual output
100kg
= 210,000 kg × = 300,000 kg
70kg
Actual Quantity (AQ) = 280,000 kg

Actual Price (AP) (GH¢ 252,000 ÷ 280,000 kg) = GH¢ 0.90 per kg.
(a)
Material Usage Variance = (SQ – AQ) × SP
= (300,000 – 2.80.000) kg × 1
= GH¢ 20,000 (F)
(b)
= (1 – 0.90) × 280,000
= GH¢ 28,000 (F)
(c)
Material Cost Variance = (SQ × SP) – (AQ × AP)
= (300,000 × 1) – (280,000 × 0.90)
= GH¢ 48,000 (F)
Check
MCV = MPV + MUV
GH¢ 48,000 (F) = GH¢ 28,000 (F) + GH¢ 20,000 (F)
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Problem 2
From the following information compute:
(a) Mix, (b) Price, and (c) Usage Variances:

Standard Actual
Quantity Unit Total Quantity Unit Total
(Kg.) Price (Kg.) price
GH¢ GH¢ GH¢ GH¢
Material A 4 1.00 4.00 2 3.50 7.00
Material B 2 2.00 4.00 1 2.00 2.00
Material C 2 4.00 8.00 3 3.00 9.00
Total 8 2.00 16.00 6 3.00 18.00
Solution
Material A = (1 – 3.50) × 2 = GH¢ 5 (A)
Material B = (2 – 2) × 1 = Nil
Material C = (4 – 3) × 3 = GH¢ 5 (A)
MPV = GH¢ 2 (A)

Material A = (4 – 2) × 1 = GH¢ 2 (F)
Material B = (2 – 1) × 2 = GH¢ 2 (F)
Material C = (2 – 3) × 4 = GH¢ 3 (A)
MPV = GH¢ Nil
Material Mix Variance = (Revised SQ – AQ) × SP

Material A = (3* – 2) × 1 = GH¢ 1 (F)
Material B = (1.5* – 1) × 2 = GH¢ 1 (F)
Material C = (1.5* – 3) × 4 = GH¢ 6 (A)
MPV = GH¢ 4 (A)
Revised standard quantity is calculated as follows:

Standard quantity of material items
= × Total actual quantity
Total standard quantity
4
Material A = × 6 = 3 kg
8
2
Material B = × 6 = 1.5 kg.
8
2
Material C = × 6 = 1.5 kg.
8
UEW/IEDE 331
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Problem 3
The standard cost of a chemical mixture is as follows:
40% material A at GH¢ 20 per kg
60% material B at GH¢ 30 per kg.
A standard loss of 10% of input is expected in production. The cost records
for a period showed the following usage:
90 kg material A at a cost of GH¢ 18 per kg.
110 kg of material B at a cost of GH¢ 34 per kg.
The quantity produced was 182 kg of good product.
Calculate all material variances
Solution
Basic calculations:
Material St. cost of 100 kg. of output Actual cost of 102 kg of output
Qty Rate Amount Qty Rate Amount
Kg. GH¢ GH¢ Kg. GH¢ GH¢
A 80 20 1,600 90 18 1,620
B 120 30 3,600 110 34 3,740
Total 200 5,200 200 5,360
Less: Loss 20 –– –– 18 ––
180 5,200 182 5,360
182
St. Cost of actual output = GH¢ 5,200 × = GH¢ 5, 5257.78
180
1.
Material Cost Variance = (SC of actual output – AC)
= (5,227.78 – 5,360)
= GH¢ 102.22 (A)
2.
Material A (20 – 18) × 90 = GH¢ 180 (F)
Material B (30 – 34) × 110 = GH¢ 440 (A)
MPV = GH¢ 260 (A)
3.
Material Usage Variance = (SQ for actual – AQ) × SP
182 2
Material A = ( 80 × - 90 ) × = GH¢ 182.22 (A)
180 0
182
Material B = ( 120 × - 110 ) × 30 = GH¢ 340.00 (F)
180
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MUV = GH¢ 157.78 (F)
4.
Material A = (80 – 90) × 20 = GH¢ 200 (A)
Material B = (120 – 110) × 30 = GH¢ 300 (F)
MMV = GH¢ 100 (F)
5.
Material Yield Variance = (AY – SY) × St. material cost per unit of output
5,200
MYV = (182 – 180) × = GH¢ 57.78 (F)
180
Problem 4
The standard material cost to produce one tone of chemical X is:
 300 kg. of material A @ GH¢ 10 per kg.
 400 kg. of material B @ GH¢5 per kg.
 400 kg. of material C @ GH¢6 per kg.
During a period, 100 tonnes of chemical X were produced from the usage
of:
 35 tonnes of material A at a cost of GH¢ 9,000 per tonne
 42 tonnes of material B at a cost of GH¢ 6,000 per tonne
 53 tonnes of material C at a cost of GH¢ 7,000 per tonne
 Calculate material variances
Solution
Basic calculations
Qty. Rate Amount Qty. Rate Amount
A 30,000 10 3,00,000 35,000 9 3,15,000
B 40,000 5 2,00,000 42,000 6 2,52,000
B 50,000 6 3,00,000 53,000 6 3,71,000
Total 1,20,00 8,00,00 1,30,000 9,38,000
Less: loss 20,000 –– –– 30,000 –– ––
Output 180 –– 8,00,000 1,00,00 –– 9,38,000
1.
Material Cost Variance = SC of actual output – AC
MCV = 800,000 – 938,000
= GH¢ 138,000 (A)
UEW/IEDE 333
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2.
A = (GH¢ 10 – GH¢ 9) × 35,000
= GH¢ 35,000 (F)
B = (GH¢ 5 – GH¢ 6) × 42,000
= GH¢42,000 (A)
C = (GH¢ 6 – GH¢ 7) × 35,000
= GH¢53,000 (A)
MPV GH¢ 60,000 (A)
3.
Material Usage (or = (SQ – AQ) × SP
Quantity) Variance
A = (30,000 – 35,000) × GH¢ 10
= GH¢ 50,000 (A)
B = (40,000 – 42,000) × GH¢ 5
= GH¢ 10,000 (A)
C = (50,000 – 53,000) × GH¢ 6
= GH¢ 18,000 (A)
MUV GH¢ 78,000 (A)
4.
A = (32,500 – 35,000) × 10
= GH¢ 25,000 (A)
1,30,000
B = ( - 42,000 ) × 5
3
= GH¢ 6,667 (F)
1,62,500
C = ( - 53,000 ) × 6
3
= GH¢ 7,000 (F)
MUV 11,333 (A)
Material Mix Variance = (Revised SQ* – AQ) × SP
A = (32,500 – 35,000) × 10 = GH¢ 25,000 (A)
1,30,00
B =( - 42,000 ) × 5 = GH¢ 6,667 (F)
3
1,62,500
C =( - 53,000 ) × 6 = GH¢ 7,000 (F)
3
MMV = GH¢ 11,333 (A)
Revised Standard Quantity is calculated as follows:
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Total AQ
= × SQ
Total SQ
1,30,000
A = × 30,000 = 32,500 kg.
1,20,000
1,30,000 1,30,000
B = × 40,000 = Kg.
1,20,000 3
1,30,000 1,62,500
C = × 50,000 = kg.
1,20,000 3
5. Material Yield Variance (MYV)

= (Actual yield – St. Yield) × St. Cost per unit of output
1,62,500
= ( 100 - × 8,000 = GH¢ 66,667 (A)
3
Working Notes:
1.
Total standard cost GH¢ 8,00,000
St. cost per unit of output = =
Total standard output 100 Tonnes
= GH¢ 8,000 per tonne

2.
Actual output
Std. yield = × Total AQ
Total SQ
100 Tonnes
= × 1,30,000
1,20,000
1,300
= tonnes
12
Problem 6
The standard material cost for production of 100 kg. of Chemical D is made
up of:
Chemical A 30 kg. @ GH¢ 4.00 per kg.
Chemical B 40 kg. @ GH¢ 5.00 per kg.
Chemical C 80 kg. @ GH¢ 6.00 per kg.
In a batch, 500 kg. of Chemical D was produced from a mix of :

Chemical A 140 kg. at a cost of GH¢588
Chemical B 220 kg. at a cost of GH¢1,056
Chemical C 140 kg. at a cost of GH¢2,860
UEW/IEDE 335
COST AND MANAGEMENT
How do the yield, mix and the price factors contribute to the Variance in the
actual cost per 100 per kg. of Chemical D over the standard cost?
Solution
Basic Calculations: Variances are calculated for 100 kg. of Chemical D as
required.
kg. GH¢ GH¢ Kg. GH¢ GH¢
A 30 4 120 28 4.20 117.60
B 40 5 200 44 4.80 211.20
C 80 6 480 88 6.50 572.00
Total 150 800 160 900.80
Actual price per kg

588
A = = GH¢ 4.20
140
1,056
B = = GH¢ 4.80
220
2,860
C = = GH¢ 6.50;
440
Actual quantity per 100 kg Chemical D

140
A = = 28 kg
5
220 =
B = 44 kg
5
440
C = = 88 kg.
5
Material Cost Variance = SC – AC = 800 – 900.80 = GH¢ 100.80 (A)

A = (4 – 4.20) × 28 = GH¢ 5.60 (A)
B = (5 – 4.80) × 44 = GH¢ 8.80 (F)
C = (6 – 6.50) × 88 = GH¢ 44.00 (A)
MPV = GH¢ 40.80 (A)
Material Price Variance = (SQ – AQ) × SP

A = (30 – 28) × 4 = GH¢ 8 (F)
336 UEW/IEDE
COST AND MANAGEMENT
B = (40 – 44) × 5 = GH¢ 20 (A)

C = (80 – 88) × 6 = GH¢ 48 (A)
MPV = GH¢ 60 (A)

A = (32 – 28) × 4 = GH¢ 16.00 (F)
2
B = ( 42 - 44 ) × 5 = GH¢ 6.65 (A)
3
1
C = ( 85 - 88 ) × 6 = GH¢ 16.02 (A)
3
MMV = GH¢ 6.67 (A)
RSQ (Revised St. Quantity) is computed as below:

160
A = × 30 = 32 kg
150
160 1
C = × 80 = 85 kg
150 3
160 2
B = × 40 = 42 kg
150 3
Material Yield Variance (AY – SY) × St. Output price
2
MYV = ( 100 - 106 ) = GH¢ 53.33 (A)
3
160 2
St. Yield = × 100 = 106
150 3
St. Output price = GH¢ 800 ÷ 100 kg. = GH¢ 8
Problem 7
The standard material input required for 1,000 kg. of a product are given
below:
Material Quantity St. rate per kg.
Kg. GH¢
P 450 20
Q 400 40
R 250 60
1,100
Standard loss 100
Standard output 1,000
UEW/IEDE 337
COST AND MANAGEMENT
Actual production in a period was 20,000 kg. of finished product for which
the actual quantities of material used and the prices paid thereof were as
under:
Material Quantities Purchase price per kg.
Kg. GH¢
P 10,000 19
Q 8,500 42
R 4,500 65
Calculate
i. Material Cost Variance
ii. Material Price Variance
iii. Material Usage Variance
iv. Material Mix Variance
v. Material Yield Variance.
Present reconciliation among the variances

Solution
Basic calculations:
Material St. for 20,000 kg of output Actual for 20,000 kg. output
P 9,000 20 1,80,000 10,000 19 1,90,000
Q 8,000 40 3,20,000 8,500 42 3,57,000
R 5,000 60 3,00,000 4,500 65 2,92,500
22,000 8,00,00 23,000 8,389,500
Less: Loss 2,000 30,000
20,000 20,000
(i)
Material Cost Variance = SC – AC
= 800,000 – 839,500 = GH¢ 39,500 (A)
(ii)
P = (20 – 19) × 10,000 = GH¢ 10,000 (F)
Q = (40 – 42) × 8,500 = GH¢ 17,000 (A)
R = (60 – 65) × 4,500 = GH¢ 22,500 (A)
MPV = GH¢ 29,500 (A)
(iii)
P = (9,000 – 10,000) × 20 = GH¢ 20,000 (A)
Q = (8,000 – 8,500) × 40 = GH¢ 20,000 (A)
R = (5,000 – 4,500) × 60 = GH¢ 30,000 (F)
338 UEW/IEDE
COST AND MANAGEMENT
MUV = GH¢10,000 (A)
(iv)
9,000
P = ( 23,000 × - 10,000) × 20 = GH¢11,818 (A)
22,00
8,000
Q = ( 23,000 × - 8,500) × 40 = GH¢5,455 (A)
22,00
5,000
R = ( 23,000 × - 4,500) × 60 = GH¢ 43,636 (F)
22,00
MMV = GH¢26,363 (F)

(v)
Material Yield Variance = (AY – SY) × St. output price
20,000 8,00,000
= ( 20,000 - 23,000 × ) ×
22,000 20,000
4,60,000
MYV = ( 20,000 - × ) × 40 = GH¢36,363 (A)
22,000
Reconciliation
(i)
MCV = MPV + MUV
39,500 (A) = 29,500 (A) + 10,000 (A)
(ii)
MCV = MPV + MMV + MYV
39,500 (A) = 29,500 (A) + 26,363 (F) + 36,363
Problem 8
BK Chemicals Ltd. Manufactures BXE by mixing three raw materials. For
each batch of 100 kg. of BXE, 125 kg. of raw materials are used. In June 60
batches are prepared to produce an output of 5,600 kg of BXE. The standard
and actual particulars for June are as follows:
Raw Standard Actual Quantity of

materials Mix % Price per Mix % Price per raw materials
GH¢ kg. GH¢ kg. purchased kg.
A 50 20 60 21 5000
B 30 10 20 8 2000
C 20 5 20 6 1200
UEW/IEDE 339
COST AND MANAGEMENT
Calculate all Variances

Solution
Material Standard for 600 kg output Actual for 5,600 kg output
Kg. Rate Amount Kg. Rate Amount
GH¢ GH¢ GH¢ GH¢
A 3,750 20 75,000 4,500 21 94,500
B 2,250 10 22,500 1,500 8 12,000
C 1,500 5 7,500 1,500 6 9,000
Total 7,500 1,05,000 7,500 1,15,500
GH¢ 105,000
Standard cost of actual output = × 5,600 kg.
6,000 kg
= GH¢ 98000
Material Cost Variance = SC of actual output – AC

MCV = 98,000 – 115,000 = GH¢17,500 (A)

A = (20 – 21) × 4,500 = GH¢4,500 (A)
B = (10 – 8) × 1,500 = GH¢ 3,000 (F)
C = (5 – 6) × 1,500 = GH¢1,500 (A)
MPV GH¢3,000 (A)
Material Usage Variance = (SQ for actual output – AQ) × SP
3750
A = ( × 5,600 – 4,500 ) × 20
6,000
= (3,500 – 4,500) × 20
= GH20, 000 (A)
2,250
B = ( × 5,600 – 1,500 ) × 10
6,000
= (21,000 – 15,000) × 10
= GH¢ 6,000 (F)
1,500
C = ( × 5,600 – 1,500 ) × 5
6,000
= (1,400 – 1,500) × 5
340 UEW/IEDE
COST AND MANAGEMENT
= GH¢ 500 (F)

MUV = GH¢ 14,500 (A)
A = (3,750 – 4,500) × 20 = GH¢15,000 (A)

B = (2,250 – 1,500) × 10 = GH¢7,500 (F)
C = (1,500 – 1,500) × 50 = GH¢ Nil
MMV = GH¢ 7,500 (A)
(Actual yield – St. Yield) × St. Output cost

Material Yield Variance =
per unit
105,000
= (5,600 – 6,000) × = GH¢ 7,000 (A)
6,000
Note: In the question, quantity, quantity of material purchased is given. It

does not give quantity of material consumed. It is thus assumed that quantity
actually used is 7,500 units. In case of material C, it has been assumed that
300 units @ 6 were opening stock because purchased quantity is only 1,200
kg. while consumed quantity is 1,500 kg.
Problem 9
XYZ Ltd has established the following standard mix for producing 9 gallons
of product ‘A’:
GH¢
5 gallons – Material X at GH¢ 7 per gallon 35
3 gallons – Material Y at GH¢ 5 per gallon 14
2 gallons – Material Z at GH¢ 2 per gallon 4
GH¢ 54
A standard loss of 10% of input is expected to occur. Actual input was:

Material X – 53,000 gallons at GH¢ 7 per gallon
Material Y – 28,000 gallons at GH¢ 5.30 per gallon
Material Z – 19,000 gallons at GH¢ 2.20 per gallon
Actual output for the period was 92,700 gallons
Calculate:
i. Material Mix Variance
ii. Material Yield Variance
Solution
Standard cost Actual Cost
Gallons GH¢ GH¢ Gallons GH¢ GH¢
X 3,71,00
50,000 7 3,50,000 53,000 19
0
UEW/IEDE 341
COST AND MANAGEMENT
Y 1,48,00
30,000 5 1,50,000 28,000 42
0
Z 20,000 2 40,000 19,000 65 41,800
5,61,20
1,00,000 5,40,00 1,00,000
0
Less: Loss 10,000 7,300
Output 90,000 92,700

X = (50,000 – 53,000) × 7 = GH¢ 21,000 (A)
Y = (30,000 – 28,000) × 5 = GH¢ 10,000 (F)
X = (20,000 – 19,000) × 2 = GH¢ 2,000 (A)
MMV = GH¢ 9,000 (A)
Material Yield Variance = (AY – SY) × St. Output price
GH¢ 540,000
= (92,700 – 90,000) ×
90,000 gallons
MYV = 2,700 × 6
= GH¢ 16,200 (F)
Problem 10
From the particulars given below, compute; Material Price Variance,
Material Usage Variance, Labour Rate Variance, Idle Time Variance and
Labour Efficiency Variance with full working details.
One tonne of materials input yield a standard output of 100,000 units. The
standard price of material is GH¢ 20 per kg. Number of employees engaged
is 200. The standard wage rater per employee per day is GH¢ 6. The
standard daily output per employee is 100 units. The actual quantity of
material used is 10 tonnes and the actual price paid is GH¢ 21 per kg.
Actual output obtained is 900,000 units. Actual number of days worked is
50 and actual rate of wages paid is GH¢ 6.50 per day. Idle time paid for and
included in above time is 1/2 day.
Solution
1 tonne = 1,000 kg.

= (20 – 21) × 1,000 kg = GH¢ 10,000(A)

= (9,000 kg – 10,000 kg) × GH¢ 20
= GH¢ 20,000 (A)
342 UEW/IEDE
COST AND MANAGEMENT
Labour Rate Variance = (St. Rate – Actual rate) ×Actual days

= (6 – 6.50) × 10,000
= GH¢ 5,000 (A)
Note: Actual days = 200 employees × 50 days = 10,000
Labour Efficiency Variance = (St. Days – Actual days) × St. Rate

= (9,000 – 9,900) × 6
= GH¢5,400 (A)
Idle Time Variance = Idle days × St. Rate

= (200 employees × 1/2) × GH¢ 6
= GH¢600 (A)
Problem 11
One kilogram of product ‘K’ requires two chemicals A and B. The following
were the details of product ‘K’ for the month of June.
a. Standard mix Chemical ‘A’ 50% and Chemical ‘B’ 50%
b. Standard price per kilogram of Chemical ‘A’ GH¢ 1 and Chemical ‘B’
GH¢ 15
c. Actual input of Chemical ‘B’ 70 kilograms
d. Actual price per kilogram of Chemical ‘A’ GH¢ 15
e. Standard normal loss 10% of total input
f. Materials cost variance total GH¢ 650 adverse
g. Materials yield variance total GH¢ 135 adverse
You are required to calculate:
1. Material Mix Variance (total)

2. Material Usage Variance (total)
3. Material price Variance (total)
4. Actual loss of actual input

5. Actual input of Chemical ‘A’
6. Actual price per kilogram of Chemical ‘B’
Solution
Actual output is not given in the problem. The following solution is based
on the assumption that actual output is 90 kg. Working is shown as below:
(a) St. cost is calculated below:
Qty. Price Amount
Kg. GH¢ GH¢
Chemical A 50 GH¢ 600
Chemical B 50 12 750
100 15 1,350
Standard loss 10 ––
UEW/IEDE 343
COST AND MANAGEMENT
Output 90 1,350
(b) St. Rate per unit of output = GH¢ 1,350 × 90 kg. = GH¢ 15 per kg.
(c) St. yield for actual input is calculated as follows:
Material yield Variance = (Actual yield – St. Yield) × St. Output price
GH¢ 135 (A) = (90 kg. – St Yield) × 15
St. Yield = 99 kg.
(d)
100 kg
Actual input for 99 kg. of output = × 99 kg. = 110 kg.
90 kg
(e)
Actual input of Chemical A = 110 kg. – Actual input of Chemical B
= 110 kg. – 70 kg.
= 40 kg.
(f) Material Cost Variance is given as GH¢ 650 (A). Hence the actual cost
of actual mix of Chemicals A and B will be GH¢ 1,350 + GH¢ 650 =
GH¢ 2,000
(g) The actual cost of 40 kg. of Chemical A @ GH¢ 15 per kg. is GH¢ 600.
Thus the cost of one kg. of Chemical B used is calculated as follows:
GH¢ 2,000- Rs. 600
= GH¢ 20 per kg.
70 kg
(h) Revised St. Qty. is calculated as under:

Chemical A = 110 × 50% = 55kg.
Chemical B = 110 × 50% = 55 kg.
(1) Material Mix Variance

= (Revised St. Qty. – Actual Qty.) × St. Price
Chemical A = (55 – 40) × GH¢ 12 = GH¢ 180 (F)

Chemical B = (55 – 70) × GH¢ 15 = GH¢ 225 (A)
MMV = GH¢ 45 (A)
344 UEW/IEDE

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UNIVERSITY OF EDUCATION, WINNEBA

Institute for Educational Development and Extension

Cost and Management Accounting II

Institute for Educational Development and Extension

All rights reserved including translation. No part of this publication

Cost and Management Accounting II

© Institute for Educational Development and Extension, 2015

Graphic Design and Layout:

SECTION 1 INTRODUCTION TO COST AND MANAGEMANT 14

SECTION 2 COST CONCEPTS AND CLASSIFICATION 22

SECTION 3 ELEMENTS OF COST 32

SECTION 4 INCOME DETERMINATION WHERE THERE EXIST OPENING

SECTION 5 INCOME DETERMINATION WHERE THERE EXIST BOTH OPENING

SECTION 6 USES OF ABSORPTION AND MARGINAL COSTING 44

SECTION 1 MEANING AND CHARACTERISTICS OF MARGINAL AND

SECTION 2 INCOME DETERMINATIONS UNDER MARGINAL COSTING AND

SECTION 3 INCOME DETERMINATION WHERE THERE EXIST OPENING

SECTION 4 INCOME DETERMINATION WHERE THERE EXIST OPENING

SECTION 5 INCOME DETERMINATION WHERE THERE EXIST BOTH OPENING

SECTION 6 USES OF ABSORPTION AND MARGINAL COSTING 82

SECTION 1 OVERVIEW OF COST VOLUME-PROFIT (CVP) ANALYSIS 102

SECTION 2 MEASURES OF CVP ANALYSIS 108

SECTION 3 MEASURES OF CVP ANALYSIS II 112

SECTION 4 MARGIN OF SAFETY 120

SECTION 5 GRAPHIC PRESENTATION OF BREAK-EVEN ANALYSIS 126

SECTION 6 SALE MIX 140

RELEVANT COSTING AND SHORT TERM DECISION MAKING

SECTION 1 OVERVIEW OF DECISION MAKING PROCESSES, RELEVANT

SECTION 2 DECISION-MAKING AND MARGINAL COSTING 158

SECTION 3 MAKE OR BUY DECISIONS 164

SECTION 4 SELECTION OF SUITABLE METHOD OF PRODUCTION 172

SECTION 5 DIFFERENTIAL COST ANALYSIS 176

SECTION 6 OTHER SHORT TERM DECISIONS 180

SECTION 1 NATURE OF BUDGET 200

SECTION 2 PRELIMINARIES IN THE INSTALLATION OF BUDGET SYSTEM208

SECTION 3 CLASSIFICATION OF BUDGET 214

SECTION 4 CASH BUDGET 224

SECTION 5 FIXED AND FLEXIBLE BUDGETS 230

SECTION 6 OTHER TYPES OF BUDGET 240

STANDARD COSTING AND VARIANCE ANALYSIS

SECTION 1 INTRODUCTION TO STANDARD COSTING 270

SECTION 2 DIRECT MATERIAL COST VARIANCE 282

SECTION 3 DIRECT LABOUR COST VARIANCE 292

SECTION 4 OVERHEADS VARIANCE 300

SECTION 5 SALES VARIANCES 314

SECTION 6 REPORTING OF VARIANCES 326

Planned completion date Actual completion date

OVERVIEW OF COST AND MANAGEMENT

SECTION 2 COST CONCEPTS AND CLASSIFICATIONS 22

SECTION 3 ELEMENTS OF COST 32

SECTION 4 INCOME DETERMINATION WHERE THERE EXIST OPEN STOCK 38

SECTION 5 INCOME DETERMINATION WHERE THERE EXIST BOTH OPENING AND 44

SECTION 6 USES OF ABSORPTION AND MARGINAL COST 44

the adinkra symbol used in the UEW crest

ABSORPTION COSTING AND MARGINAL

SECTION 2 INCOME DETERMINATION UNDER MARGINAL AND ABSORPTION

SECTION 3 INCOME DETERMINATION WHERE THERE EXIST OPENING STOCK 74

SECTION 4 INCOME DETERMINATION WHERE THERE EXIST OPENING STOCK 76

SECTION 5 INCOME DETERMINATION WHERE THERE EXIST BOTH OPENING AND