CAF-03

Cost and
Management
Accounting

Vol. II

Practice Manual Examination

Questions & Answers

Book Contains Translations of

QURANIC AYATS & AHADITHS,
Therefore Handle Carefully.
 table of contents
Chapter Topics Page No.
No.
1 Breakeven 01

2 CVP Test 48

3 Decision Making 56

4 Ghauri Limited 107

5 Test Decision Making and CVP 110

6 Factory Overhead 121

7 Job Order Costing 151

8 Target Costing 169

9 Journal Entries 187

10 Labor and Learning Curve 209

11 Inventory Valuation 245

12 Material Part 1 260

13 Material Including Probability Part 2 275

14 Variance Part 2 289

15 Extra Questions 299

16 Spring 2020 381

17 Autumn 2020 389

18 Spring 2021 401

19 Cost Autumn 2021 408

20 Activity Based Costing 415

21 ABC Extra Questions 427

22 Spring 2022 434

 We should only discuss our sorrows and sadness with ALLAH

Marginal Costing and Absorption Costing

Absorption Costing:
In Absorption costing, fixed production overheads are included in the cost of production (and therefore to closing
stock). Therefore fixed production overheads are charged in the income statement of the period in which inventory
is sold. [Fixed production overheads are treated as product cost].

Marginal Costing:
In marginal costing, fixed production overhead are not included in cost of production (and therefore to closing stock).
Therefore fixed production overheads are charged in the income statement of the period in which they are incurred.
[Fixed production overheads are treated as a period cost].

Sometimes costs of the business are presented in income statement according to variable and fixed for the purpose
of decision making.

Important points to remember:

 Variable cost varies with production/sale; therefore controllable with production / sale decisions.
 Fixed cost remains constant irrespective of production and sales; therefore not controllable with production
/ sale decisions.

COST VOLUME PROFIT (CVP) and breakeven ANALYSIS

[this topic is on the basis of Marginal costing technique]
Basic assumptions
■ Costs are either fixed or variable (if not then we will convert them)
■ Variable cost per unit remains constant at all level of activity (output and sale)
■ Total Variable production cost varies with production.
■ Total variable selling cost varies with sales
■ Production and sale will be different if there is stock.
■ Total fixed costs remains constant.
■ Per unit fixed cost varies inversely with the activity level
■ Sale price per unit remains constant for every unit of product sold
■ Per unit contribution: sale price per unit - variable cost per unit

Conclusion: if both the sale price per unit and variable cost per unit are constant then it means contribution per
unit will remain constant at all levels of sale. From this discussion, we can calculate contribution / sale ratio (CS
ratio) or contribution margin ratio (CM ratio) as follows:
ContributionPerUnit
x100
Sale Pr icePerUnit

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Breakeven Analysis:
Breakeven Point: It is the volume of sale in a period at which there is neither profit nor loss.
(Means, Revenue = cost)
As we know,
Total cost + Profit = Sales
OR
Total variable cost + Total fixed cost + Profit = Sales
At breakeven point profit is zero therefore;
T.V.C + T.F.C + 0 =Sales
Or T.F.C = Sales - T.V.C
Or T.F.C= [Sale Price/unit × units] - [Variable cost/unit × Units]
Or T.F.C= Units × [Sale Price/unit - Variable cost/unit]
Or T.F.C= Units × Contribution/unit
Or Breakeven units = Total Fixed cost
Contribution/unit
If breakeven is to be calculated in amounts then;
(Breakeven units × Sale Price/unit)
Or breakeven point expressed in sales revenue (directly)
Breakeven point (in revenue) = Total fixed cost
CS ratio
Margin of safety:
[Budgeted sales – breakeven sales] (units or amount)
It is the maximum amount by which actual sales can be lower than budgeted sales without incurring a loss for the
period.
[if budgeted sales are not given then instead use given level of sales]

Margin of safety Ratio:

Margin of safety × 100
Budgeted sales
(Answer will be in %age of budgeted sales)
Calculation can either be on the basis of units or amount.
Target Profit:
Management might want to know what the volume of sale will be, in order to achieve a target profit.
Target Profit (units) = Total fixed cost + Target profit
Contribution/unit
Or Target profit expressed in sales revenue = Total fixed cost + Target profit
C/S ratio

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 Worries Ends When SALAH (NAMAZ) Begins
Practice Question:
Q.
SP = 20
Unit
VC = (12)
Unit
Contribution/unit 8
Fixed cost
600,000

600,000
Break even (Units) = 75,000
8
Revenue 75,000 × 20 = 1,500,000
Income statement
Sales (75,000 x 20) 1,500,000
Variable Cost (75,000 x 12) (900,000)
Contribution 600,000
Total fixed cost (600,000)
Net Profit --

CS Ratio:
Contributi on
= Unit × 100
Sales
Unit
= 8 × 100 = 40%
20
Contribution is 40% of Sales.
TFC 600,000
Breakeven Sales (directly) = = = 1,500,000
CS Ratio 40 %
Q.

Budgeted Sales Volume for the period = 25,000 Units

Sale Pr ice = 16
Unit
Variable Cost = 4
Unit
Fixed Cost = 240,000 for the period
Breakeven Units = 240,000 = 20,000 Units
12
Income statement (break even)
Sales (20,000 × 16) 320,000
Variable Cost (20,000 × 4) (80,000)
Contribution 240,000
Total fixed cost 240,000
Net Profit --

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 Budgeted Income Statement
Sales (25,000 × 16) 400,000
Variable Cost (25,000 × 4) (100,000)
Contribution 300,000
Fixed Cost (240,000)
Net Profit 60,000
or (12 × 5,000)

Margin of Safety:
5,000
× 100 = 20% of budgeted sales
25,000
Budgeted Sales 25,000 100
Breakeven Sales 20,000 80
Margin of Safety 5,000 20

Q.1
a) Delta Limited makes pipes. The budget for the year is as follows:
Sales Units Rupees
150,000 3,000,000
Costs: Variable (Rs) Fixed (Rs)
Direct Material 600,000 -
Direct labor 450,000 766,000
Overheads:
Production 300,000 -
Admin - 554,000
Total 1,350,000 1,320,000

You are required to calculate;

i. Contribution per unit
ii. Contribution margin ratio (or Contribution sales ratio)
iii. Breakeven point in units and rupees
iv. Margin of safety ratio
b) Delta Limited is considering the acquisition of a new machine. This will add Rs 262,500 to fixed production
overheads but will reduce the total labor cost by 50%.

All other factors will remain same.

You are required to answer the following:
i. What will be the new breakeven point in terms of both units and rupees?
ii. What level of sales will be required to earn at least same level of profit as before acquisition of new
machine?

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 Fear Allah because of his punishment. Love Allah because he is full of mercy

Q.2 Octa Electronics produces and markets a single product. Presently, the product is manufactured in a plant
that relies heavily on direct labor force. Last year, the company sold 5,000 units with the following results:
Rupees
Sales 22,500,000
Less: Variable expenses 13,500,000
Contribution margin 9,000,000
Less: Fixed expenses 6,300,000
Net income 2,700,000
Required:
a) Compute the break-even point in rupees and the margin of safety. (04 Marks)
b) What would be the contribution margin ratio and the break-even point in number of units if variable cost
increases by Rs. 600 per unit? Also compute the selling price per unit if the company wishes to maintain the
contribution margin ratio achieved during the previous year.
(05 Marks)
c) The company is also considering the acquisition of a new automated plant. This would result in the
reduction of variable costs by 50% of the amount computed in (b) above whereas the fixed expenses will
increase by 100%. If the new plant is acquired, how many units will have to be sold next year to earn net
income of Rs. 3,150,000. (03 Marks)

Q.3 Emerald Limited (EL) is engaged in the manufacture and sale of a single product. Following statement
summarizes the performance of EL for the first two quarters of the financial year 2022:
Quarter 1 Quarter 2
Sales volume in units 580,000 540,000
Rs in ‘000
Sales revenue 493,000 464,400
Cost of Goods sold
Material (197,200) (183,600)
Labor (98,600) (91,800)
Factory overheads (84,660) (80,580)
(380,460) (355,980)
Gross Profit 112,540 108,420
Selling and distribution expenses (26,500) (25,500)
Administrative expenses (23,500) (23,500)
(50,000) (49,000)
Net Profit 62,540 59,420

i. In the second quarter of the year EL increased the sale price, as a result of which the sales volume and net
profit declined. The management wants to recover the shortfall in profit in the third quarter. In order to
achieve this target, the product manager has suggested a reduction in per unit price by Rs. 15.
ii. The marketing director however, is of the opinion that if the price of the product is reduced further, the
field force can sell 650,000 units in the third quarter. It is estimated that to produce more than 625,000
units the fixed factory overheads will have to be increased by Rs. 2.5 million.

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Required:

(a) Compute the minimum number of units to be sold by EL at the reduced price in third quarter, to recover the
shortfall in the second quarter profits as well as to earn the same profit as was in first quarter.
(b) Determine the minimum price which could be charged to maintain the profitability calculated in (a) above, if EL
wants to sell 650,000 units. (14 marks)

Discussion of formulas with tax effect

At Breakeven:
Sales 500,000
Variable Cost (200,000)
Contribution 300,000
Fixed Cost (300,000)
Net Profit --
Sales = Variable Cost + Fixed Cost
Or Sales – Variable Cost = Fixed Cost
Or Contribution = Fixed Cost
Or
Units Sold × Contribution/Unit = Fixed Cost
Fixed Cost
Unit Sold =
Contributi on / Unit

At Target Profit Level:

Sales 500,000
Variable Cost (200,000)
Contribution 300,000
Fixed Cost (200,000)
Net Profit 100,000
Sales = Variable Cost + Fixed Cost + Profit
Sales – Variable Cost = Fixed Cost + Profit
Contribution = Fixed Cost + Profit
Or
Units Sold × Contribution/Unit = Fixed Cost + Profit
Fixed Cost + Pr ofit
Unit Sold =
Contribution / Unit
At Target Profit Level (
with involvement of tax):
Sales 500,000
Variable Cost (200,000)
Contribution 300,000
Fixed Cost (200,000)
Profit before tax 100,000
Tax@ 30% (30,000)
Profit after tax 70,000
500,000 = 200,000 + 200,000 + 30,000 + 70,000

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 Balance Your Dunya (world) around your deen (faith), its just a matter of priorities.

Or Sales = Variable Cost + Fixed Cost + Tax + PAT

Or Sales – Variable Cost = Fixed Cost + PBT
Or Contribution = Fixed Cost + PBT
Or
Units Sold × Contribution/Unit = Fixed Cost + PBT
Fixed Cost + PBT
Unit Sold =
Contributi on / Unit

Q.4 Altar Limited (AL) produces and markets a single product. Following information is available from AL’s
records for the month of February 2013:

Sales price Rs. 26 per unit

Direct material (2 kg at Rs. 5 per kg) Rs. 10 per unit
Direct labor Rs. 2 per unit
Variable overheads Rs. 4 per unit
Fixed overheads Rs. 3.50 per unit
Selling expenses Rs. 295,000
Administration expenses (fixed) Rs. 101,400
Production (Good units) 175,000 units
Closing inventory 30,000 units

Additional information:
i. Inspection is performed at the end of production and defective units are estimated at 20% of the inspected
units. The defective units are sold as scrap at Rs. 5 per unit.
ii. Fixed overheads per unit are calculated on the basis of good units produced.
iii. As compared to last month, selling expenses in February 2013 have decreased by Rs. 42,000.
iv. In January 2013, AL produced and sold 180,000 units.

Required:
Assuming there was no inventory at the beginning of February 2013; calculate break-even sales in quantity for the
month of February 2013. (12 Marks) (Spring2013)

Remember that:
• Cost is not allocated to normal loss. If it has some recovery value it is adjusted against cost of production.
• In CVP analysis, fixed production cost is treated as a period cost rather than a product cost
• Cost is allocated to abnormal loss and if it has some recovery value then it is adjusted against cost of abnormal
loss and then net amount is recognized as an expense in income statement.
• If there is no information about loss, then assume it is normal loss.

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MULTI-PRODUCT ANALYSIS (mixed break even)
In some situations, businesses may be producing and selling more than one product. However, in this discussion it
is assumed that more than one products are sold in a certain constant mix (percentage)
The following budgeted information refers to two products of a company:

X Y
Sale price per unit 100 120
Variable cost per unit (75) (111)
Contribution per unit 25 9
Budgeted sale volume 15,000 5,000
Sales Mix 3 1

Fixed cost = Rs. 315,000

Break-even point in Batches= Fixed Cost

Contribution/Batch
Contribution per batch = 25×3 + 9 × 1 = 84/batch
= 315,000 ÷ 84 = 3,750 Batches

X Y
11,250 Units 3,750 Units = 15,000 Units
(3,750 × 3) (3,750 × 1)
Break-even in rupees
X = 11,250 × 100 = 1,125,000
Y = 3,750 × 120 =450,000 Total 1,575,000
Calculation of Break even in rupees directly
= Fixed Cost ÷ CS Ratio per batch

C/S ratio per batch:

Contribution per batch = 84
Revenue per batch = 420 (3 × 100) + (120 × 1)
C/S ratio per batch = (84/420) × 100
= 20 % of sales
Breakeven revenue = 315,000 ÷ 0.2 = 1,575,000 ÷420 =3,750 batches

X (Revenue) Y (Revenue)
(3,750 ×3 × 100) (3750 × 1 ×120 )
OR (300 ÷ 420 × 1,575,000) OR (120 ÷ 420 × 1,575,000)
=1,125,000 =450,000

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 Problematic situations in life open our eyes to those things we weren’t paying much attention before.

Margin of safety: [Budgeted Level – Break-even level]

Batches Units Revenue

Budgeted Activity Level (Given) 5,000 20,000 2,100,000
(20,000÷4) (15,000+5,000) (15,000× 100) + (5,000 × 120)
Break-even point 3,750 15,000 1,575,000
Margin of safety 1,250 5,000 525,000
Margin of safety ratio 25% 25% 25%

Target Profit
Suppose in the above scenario; company wishes to make a profit of Rs 189,000.
Fixed cost + Target Profit = 315,000 + 189,000 = 6,000 batches
Contribution/batch 84
Or
Fixed cost + Target Profit = 315,000 + 189,000 = 2,520,000
C/S ratio/batch 20%

Q.5 Hydra Electronics assembles and sells three products – W, X and Y. The variable cost per unit for each
product is as follows:
W X Y
Rupees Rupees Rupees
Direct materials 4,880 1,600 1,000
Direct labor 4,000 2,000 700
Variable overheads 1,360 480 348

Total fixed production overheads are estimated to be 133,230,000

The fixed selling and administrative costs are expected to be Rs. 71,270,400.

Management estimates that the ratio of sales quantities of W, X and Y shall be 1:3:4 and selling price per unit shall
be Rs. 12,800; Rs. 6,000 and Rs. 3,600 respectively.

Required:
(a) Calculate the number of units of W, X and Y to be sold in order to achieve break even.
(b) Calculate the break even sales in terms of Rupees.
(16 Marks) (Autumn2007)

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Extra practice question 5 Macchinato

Q.6 Cost analyst assumed the following situation for a company’s three major products. The per unit
information is as follows:
Product
A B C
Sales price 10.00 8.00 11.00
Variable cost 6.00 5.00 9.00
Contribution margin 4.00 3.00 2.00

Total fixed cost is Rs. 200,000.

Required:
1. The break-even point (in total and for each product) if the three products are sold in the ratio of 4:3:7 units.
2. The new break-even point (in total and for each product) if management decides to concentrate its sales efforts
on Product A with its higher contribution margin, resulting in a new sales ratio of 6:3:5 units.

Q. 7 KPK Dairies Limited (KDL) is planning to introduce three energy flavored milk from 1 July 2015. In this respect,
following projections have been made:
C-Plus I-Plus V-Plus
Planned production (No. of packets) 540,000 275,000 185,000
Sales (No. of packets) 425,000 255,000 170,000
Production cost per packet: -- Rupees --
Direct material 100 98 97
Direct labour 15 13 12
Variable overheads 23 19 16
Fixed overheads 25 22 20
Selling and distribution cost per packet:
Variable overheads 12 8 10
Fixed overheads 5 5 5
Total cost per packet 180 165 160

In addition, KDL will sell its products through a distributor at a commission of 5% of sale price and expects to earn a
contribution margin of 40% of net sales i.e. sales minus distributor's commission.

Required:
Compute break even sales in packets and rupees, assuming that ratio of quantities sold would be as per projections.
(17)

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 Parents are blessing from Allah.
Extra practice question 6 Basket ball

Q.9 Solvent Limited has two divisions each of which makes a different product. The budgeted data for the next year
is as under:
Product A Product B
Rupees
Sales 200,000,000 150,000,000
Direct material 45,000,000 30,000,000
Direct labour 60,000,000 45,000,000
Factory overheads 35,000,000 15,000,000
Price per unit 20 25

Details of factory overheads are as follows:

• Product A is stored in a rented warehouse whose rent is Rs. 0.25 million per month. Product B is required to be
stored under special conditions. It is stored in a third party warehouse and the company has to pay rent on the
basis of space utilized. The rent has been budgeted at Rs. 0.12 million per month.
• Indirect labour has been budgeted at 20% of direct labour. 70% of the indirect labour is fixed.
• Depreciation for assets pertaining to product A and B is Rs. 6.0 million and Rs. 2.0 million respectively.
• 80% of the cost of electricity and fuel varies in accordance with the production in units and the total cost has
been budgeted at Rs. 4.0 million.All other overheads are fixed.

Required:
Compute the break-even sales assuming that the ratio of quantities sold would remain the
same, as has been budgeted above.

Break Even Charts:

Break-even point can also be found by using a graphical approach; for example.
No. of Units Sales @ Variable cost @ Fixed cost Total cost Profit/(Loss)
4/unit 2.4/unit
0 - - 1,600,000 1,600,000 (1,600,000)
250,000 1,000,000 600,000 1,600,000 2,200,000 (1,200,000)
500,000 2,000,000 1,200,000 1,600,000 2,800,000 (800,000)
750,000 3,000,000 1,800,000 1,600,000 3,400,000 (400,000)
1,000,000 4,000,000 2,400,000 1,600,000 4,000,000 -
1,250,000 5,000,000 3,000,000 1,600,000 4,600,000 400,000

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 Y-Axis Profit Sales Line

5,000 - Break-even point Total Cost Line

4,000 - . Variable Cost Line

3,000 - Variable cost area

2,000 - Fixed Cost Area

1,000 - . Fixed Cost Area

X-Axis

0 250 500 750 1,000 1,250 (No. of Units)

How to plot the graph:

• Total cost line will start from fixed cost point
• Variable cost and sale line will start from zero.
• Difference between variable cost line and the total cost line will remain constant and represents fixed cost.
• Breakeven point will be that point where sales line intersects with total cost line.

Profit/Volume Chart (P/V Chart)

It is an alternate to a breakeven chart for presenting CVP information. It is a chart that shows the profit or loss at all
levels of sales.

Profit Amount

1,600,000-

1,200,000-

800,000- Profit Line

400,000-

400,000- 250 500 750 1000 1250 (Units) sold or (amount) of sale

800,000- Break-even point

1,200,000-

1,600,000-

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 Coming soon! Our interview with ALLAH! Try to prepare for it.
How to plot a graph:
■ In this case graph will start from below zero.
■ With every additional unit, profit will increase.
■ The point on x axis where profit line intersects with it represents the break even point.

Extra Questions of Graphs

Q.
Rs.000
Sales Contribution @ 42% Fixed Cost Profit
Zero -- 297.8 (297.8)
200 84 297.8 (213.8)
400 168 297.8 (129.8)
600 252 297.8 (45.8)
800 336 297.8 38.2
1,000 420 297.8 122.2

Required: prepare a profit volume chart

Q.
Rs. 000
Sales Contribution @ 37.7% Fixed Cost Profit
Zero -- 309.8 (309.8)
200 75.4 309.8 (234.4)
400 150.8 309.8 (159)
600 226.2 309.8 (83.6)
800 301.6 309.8 (8.2)
1,000 377.7 309.8 67.9
1,200 452.4 309.8 142.6

Required: prepare a profit volume chart

Practice Question (Using Graph)

You are a management accountant for a business that develops specialist computers. You are consulted to
investigate the viability of marketing a new type of hand-held computer.

With the help of the manager of research and development, the production manager, the buyer and the sales
manager, you have made the following estimates of annual sales and profitability:
Sales Profit / loss)
Units Rs.
12,000 (30,000)
15,000 150,000
18,000 330,000

The selling price will be Rs. 150 / unit.

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Required:
(a) Prepare a traditional break-even chart using the information given above. (Breakeven Chart).
(b) Calculate the margin of safety if annual sales are expected to be 15,000 units and its percentage.
A.
(a)

Rs.

(2,700,000)

(2,370,000)

750,000

18,000
Sales

WORKINGS:
Sales Sales (at Rs. 150) Profit
Units Rs. Rs.
18,000 2,700,000 330,000
12,000 1,800,000 (30,000)
Difference 6,000 900,000 360,000

An increase in sales from 12,000 units to 18,000 units results in an increase of Rs. 900,000 in revenue and Rs. 360,000
in contribution and profit. (because fixed cost will remain same).

From this, we can calculate that the contribution is Rs. 60 per unit (Rs. 360,000/6,000) and the C/S ratio is 0.40 (Rs.
360,000/Rs. 900,000). Variable costs are therefore 0.6 or 60% of sales.

To draw a break-even chart, we need to know the fixed costs.

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 Fill your heart with Emaan and it will become the most peaceful place on earth.
Substitute in high or low equation
When sales are: 18,000 units 12,000
units
Sales (at Rs. 150 each) 2,700,000 1,800,000
Variable cost (sales × 60%) 1,620,000 1,080,000
Contribution (sales × 40%) 1,080,000 720,000
Profit (330,000) 30,000
Therefore fixed costs 750,000 750,000
When Sales are: 18,000 units 12,000
units
(b) Fixed cost 750,000 750,000
Variable cost (see above) 1,620,000 1,080,000
Total cost 2,370,000 1,830,000

Breakeven Point = Fixed Cost / CS Ratio

= 750,000 / 40% = 1,875,000 ÷ 150 = 12,500 units

Margin of Safety = 15,000 – 12,500 = 2,500 units

15,000 − 12,500 
Margin of Safety =   × 100 = 16.67% of sales.
 15,000 

Q.10 ABC Limited deals in manufacturing and marketing of perfumes. The company has three brands to cater for
different classes of customers. The selling prices and contribution margins for the year 2013 were as follows:
A B c
-Rs. per unit-
Sale price 10,000 8,000 5,000
Contribution margin 5,000 3,000 2,000

Total sale for the year 2013 was Rs. 15,600 million and sales volume ratio for A, B and C was 2:3:5 respectively.
The following estimates pertain to the year ending 31 December 2014:
■ The average sale prices and variable costs for the next year are expected to increase by 14% and 8%
respectively.
■ The normal market growth is estimated at 5% per annum. However, the company plans to launch an aggressive
marketing campaign for which additional advertising budget of Rs. 250 million has been approved. With
increased advertisement, increase in sales volume for A, B and C has been forecasted at 15%, 12% and 10%
respectively.

Required:
Compute the projected contribution margin for the year 2014 and the impact of advertising on profit of the
company.

15 Page 15 of 47
Americano
Q.11 Orient Stores Limited (OSL) operates retail outlets at various petrol pumps across the city. The average
monthly performance of these outlets is as under:
Rs. in ‘000
Sales 1,500
Rent expense 50
Other fixed costs 150

OSL earns contribution margin of 15% on items on which retail prices are printed. These items constitute 40% of the
total sales. All other items are sold at the contribution margin of 25%.

Sohaib Enterprises (SE) has offered OSL to establish an outlet at one of its petrol pumps located in a posh area of the
city. OSL’s planning department estimates that:
• At the proposed location, the sales volumes would be 20% lower than average.
• Being a posh area, OSL would be able to charge 10% higher prices on items on which retail prices are not
printed.
• Other fixed costs would be the same as the average of the existing outlets.

Required:
(a) Determine the break-even sales under the assumptions that SE would monthly charge:
Option I: rent of Rs. 75,000
Option II: rent of Rs. 50,000 plus 5% commission on total sales:
(b) Which of the above options would you recommend and why?

Note:
• increase in volume results into increase in variable cost and vice versa.
• Increase will sale price will not necessarily result into increase in variable cost.

Introduction of a new product

Suppose a company has following results for the year ended 31-12-2009
Sales 500,000
Variable Cost 200,000
Contribution 300,000
Fixed Cost 200,000
Profit 100,000

 It is planning to launch a new product. It is expected that there will be no additional fixed cost as the company
will use all existing facilities. How much units of new product should be sold to earn incremental profit of
50,000. Assume that sale price / unit of new product will be 8 and variable cost / unit will be 6. [we need to
consider incremental increase in fixed cost and profit].
50,000 ÷ 2 = 25,000 units

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 Indeed, ALLAH does not wrong the people at all, but it is the people who are wronging themselves.

Income statement
Sales (25,000 × 8) 200,000
Variable cost (25,000 × 6) 150,000
Contribution 50,000
Fixed cost –
Incremental profit 50,000
 If suppose additional fixed cost to be incurred is 25,000. Calculate the number of units of new product to be
sold to earn profit after tax of Rs. 50,000. Tax × @ 20%
50,000
Target profit = ×100 = 62,500
80
25,000 + 62,500
= 43,750
2
Income statement
Sales (43,750 × 8) 350,000
Variable Cost (43,750 × 6) 262,500
Contribution 87,500
Fixed Cost 25,000
Profit before tax 62,500
Tax @ 20% 12,500
Profit after tax 50,000

Q.12 Naseem (Private) Limited (NPL) is a manufacturer of industrial goods and is launching a new product. The
production will be carried out using existing facilities. However, the capacity of a machine would have to be increased
at a cost of Rs. 3.0 million.

The budgeted costs per unit are as under:

Imported material 1.3 kg at Rs. 750 per kg
Local material 0.5 kg at Rs. 150 per kg
Labor 2.0 hours at Rs. 300 per hour
Variable overheads Rs. 200 per labor hour
Selling & administration cost - variable Rs. 359

Other relevant details are as under:

i. Net weight of each unit of finished product will be 1.6 kg.
ii. During production, 5% of material input will evaporate. The remaining waste would be disposed off at a rate of
Rs. 80 per kg.
iii. The cost of existing plant is Rs. 10 million. The rate of depreciation is 10% per annum.
iv. Administration and other fixed overheads amount to Rs. 150,000 per month. As a result of the introduction of
the new product, these will increase to Rs. 170,000 per month. The management estimates that 20% of the
facilities would be used for the new product.
v. The company fixes its sale price at variable cost plus 25%.
vi. Applicable tax rate for the company is 35%.

17 Page 17 of 47
Required:
Compute the sales quantity and value, required to achieve a targeted increase of Rs. 4.5 million in after tax profit.

(10 marks)
Solutions:
A. 1 Delta Limited
a)
Sales 3,000,000
Variable 600,000+450,000+300,000 1,350,000
Contribution 1,650,000
Fixed Cost (766,000 + 554,000) (1,320,000)
330,000

i) Contribution / unit = 1,650,000 / 150,000 = 11

ii) C/S ratio = 11/20 X 100 = 55%
iii) Breakeven units = 1,320,000/11 = 120,000 units
or 1,320,000 / 0.55 = Rs 2,400,000 (120,000 x 20 = 2,400,000)
iv) Margin of safety ratio = Budgeted Sales – Breakeven x 100
Budgeted Sales
= 150,000 -120,000 x 100 = 20%
150,000
If our budgeted sales reduce by 20% then we will be at breakeven.

b)
Sales 3,000,000
Variable (600,000 + 225,000 + 300,000) (1,125,000)
Contribution 1,875,000
Fixed Cost (383,000* + 554,000 + 262,500) 1,199,500
Net profit 675,500

*766,000 x 50% = 383,000

i) Breakeven = 1,199,500/12.5* = 95,960 units
= 1,1995,500 / 62.5%** = Rs 1,919,200 [95,960 x 20]
*1,875,000 / 150,000 = 12.5 ; **12.5 / 20 x 100 = 62.5%
ii) Target Profit units = (1,199500 + 330,000)/12.5 = 122,360 units [122,360 x 20 = 2,447,200]
= (1,199,500+ 330,000)/62.5% = Rs 2,447,200

A.2 Octa Electronics

a) i) Breakeven in rupees:
= Fixed cost = 6,300,000 = 15,750,000 [9,000 / 22,500 x 100 = 40% of sales
C/S ratio 0.4
If units to be found out then
=15,750,000 ÷ 4,500 (22,500,000 ÷ 5,000) = 3,500 units
(ii) Margin of Safety = (22,500,000 – 15,750,000) = 6,750,000
Or = 5,000 – 3,500 = 1,500 x 4,500* = 6,750,000 *[22,500 / 5]

18 Page 18 of 47
 The Quran is for ourselves, not for our Shelves.

b) i) If variable cost increase by 600/unit, the contribution per unit will reduce from 1800 per unit to 1200/unit
a. 1800/unit = (9,000,000 ÷ 5,000)
b. 1200/unit = (9,000,000 ÷ 5,000) – 600

The selling price/unit is 4500 (22,500,000÷5,000).

Therefore contribution margin ratio is 26.67%

CM ratio = [1,200/4,500 x 100] = 26.67%

Breakeven units = 6,300,000 ÷ 1,200 = 5,250 units

ii)
Rupees %
Sales 100
Less: Variable expenses 3,300 60
Contribution margin 40
3,300 / 60 x 100 = 5,500

c) Target contribution = Total Profit + Fixed cost

= 3,150,000 + 12,600,000 (6,300,000 x 2)
= 15,750,000
Revised Contribution per unit = [4,500 – (3,300 x 50%)] = 2,850/unit
=15,750,000 = 5,526 units
2,850
A.3
Emeralds Limited
(a) Minimum No. of Units to be Sold at Reduced Price:
493,000,000
First Quarter Price = = 850/unit
580,000
464,400,000
Second Quarter Price = = 860/unit
540,000
Revised selling price in third quarter = 860 – 15 = 845
Rs. ‘000’
Shortfall in profit of second quarter (62,540 – 59,420) = 3,120
Profit for the 1st quarter 62,540
Target profit for third quarter 65,660
Add: Fixed Cost
Administrative Cost (100% fixed as given) 23,500
Fixed factory overheads (W-1) 25,500
Fixed selling and distribution expenses (W-1) 12,000
61,000

19 Page 19 of 47
 Target contribution required 126,000
Contribution per unit (845 – 637) (w-2) 208
No. of units to be sold 608,942
 Fixed Cost + T arg et Pr ofit 
T arg et Volume = ;
 Contribution / Unit 
= 61,000,000 + 65,660,000
208
= 608,942

W-1 Computation of Fixed Factory Overheads Using High Low Method:

Factory Overheads Selling & Distribution
At 580,000 Volume 84,660,000 26,500,000
At 540,000 Volume 80,580,000 25,500,000
Difference 4,080,000 1,000,000
Variable cost/unit (4,080,000/40,000) 102 (1,000,000/40,000) 25
Fixed Cost = Total Cost – Variable Cost
80,580,000 – (540,000×102) 25,500,000 – (540,000×25)
25,500,000 12,000,000
Or 84,660,000 – (580,000×102) 26,500,000 – (580,000×25)
25,500,000 12,000,000

W-2 Computation of Variable Cost / Unit:

183,600,000 
Material  
540,000
340
197,200,000 
 580,000 
 91,800,000 
 540,000 
Labour 170
 98,600,000 
 580,000 
Factory Overheads – Variable (W 1) 102
Selling and Distribution Expenses Variable (W 1) 25
637
(b)
Variable Cost (650,000 × 637) 414,050,000
Fixed Cost (61,000,000 + 2,500,000) 63,500,000
Total Cost 477,550,000
Profit 65,660,000
Total Sales 543,210,000
No. of Units to be Sold 650,000
Per Unit sale price 835.70

20 Page 20 of 47
 Prayer isn’t For Allah, It’s for us. He doesn’t need us But we need him.

A.4 Altar Limited

Break even sales in quantity for the month of February 2013:
Units produced [ 175,000 ÷ 0.80 ] 218,750
Less: Defective units [218,750 - 175,000] OR [ 218,750 x 20%] (43,750)
Good units produced 175,000
Less: closing inventory (30,000)
Number of units sold 145,000
Rupees
Variable Costs:
Direct material (218,750 x 5 x 2) 2,187,500
Direct labour (218,750 x 2) 437,500
Variable overheads (218,750 x 4) 875,000
Less: Defective units sold (43,750 x 5) (218,750)
Total variable cost of production 3,281,250
Variable cost per good unit (3,281,250 ÷ 175,000) 18.75

Calculation of variable selling expenses per unit [using high-low method]:

= _____42,000____ 1.20
(180,000 - 145,000)
Fixed costs
- Fixed overheads (175,000 x 3.5) 612,500
- Selling expenses 295,000 - (145,000 x 1.2) 121,000
- Administration expenses 101,400
Total fixed costs 834,900

Contribution margin per unit (26 - 18.75 - 1.2) 6.05

Break even quantity (834,900 ÷ 6.05) 138,000

ALT ER (not required for additional information)

Income Statement (At Breakeven Point)
Rs. Rs.
Sales (138,000 × 26) 3,588,000
Less: Variable Cost:
Variable Cost of Sales:
Opening Stock --
Variable Production Cost (175,000 × 18.75) 3,281,250
Closing Stock (175,000 – 138,000 × 18.75) (693,750) (2,587,500)
Gross Contribution 1,000,500
Variable Selling Expenses (138,000 × 1.2) (165,600)
Net Contribution 834,900
Fixed Cost (834,900)
Net Profit --

21 Page 21 of 47
 Income Statement (At Given Level of question)
(i.e. 175,000 units produced and 145,000 unit sold)
Rs. Rs.
Sales (145,000 × 26) 3,770,000
Less: Variable Cost:
Variable Cost of Sales:
Opening Stock --
Variable Production Cost (175,000 × 18.75) 3,281,250
Closing Stock (30,000 × 18.75) (562,500) (2,718,750)
Gross Contribution 1,051,250
Variable Selling & Admin (145,000 × 1.2) (174,000)
Net Contribution 877,250
Fixed Cost (834,900)
Net Profit 42,350
Or [145,000 – 138,000] * 6.05 (26-18.75-1.2)

A. 5
Breakeven In Units
Fixed Cost
=
Contribution / Batch
(a) Fixed Cost:

Production Overheads: 133,230,000

Add: Selling & Admin Expenses 71,270,400
Total Fixed Cost 204,500,400

Weighted Average Contribution / Unit:

W X Y
Weight (Sales Mix) 1 3 4 =8
Sale Price / Unit 12,800 6,000 3,600
Variable Cost / Unit
Material 4,880 1,600 1,000
Labour 4,000 2,000 700
Overheads 1,360 480 348
(10,240) (4,080) (2,048)
Contribution per Unit 2,560 1,920 1,552
Contribution/batch (2,560×1) (1,920×3) (1,552×4) = 14,528
(sales mix means if one unit of w; then 3 of X and 4 of Y)

22 Page 22 of 47
 = 204,500,400 ÷ 14,528 = 14,076 batches

X 1 = 14,076 units X 3 = 42,229 unit X 4 = 56,305 units

(W) (X) (Y)

Breakeven Sales Rupees

W 14,076 × 12,800 = 180,172,800
X 42,229 × 6,000 = 253,374,000
Y 56,305 × 3,600 = 202,698,000
636,244,800
OR
Calculation of breakeven rupees directly:
Fixed Cost
Breakeven Sales =
CS Ratio / Batch
Contribution per Batch (as above) 14,528
Revenue per Batch:
12,800 × 1 + 6,000 × 3 + 3,600 × 4 = 45,200
14,528
× 100 = 32.14%
45,200
204,500,400
=
32.14%
636,248,491

(W) (X) (Y)

12,800 18,000 14,400
× × ×
45,200 45,200 45,200
= 180,176,564 = 253,373,293 = 202,698,634

= 636,248,491

A.6
(1)
A B C
Contribution margin / unit 4.00 3.00 2.00
Contribution/batch (4×4) (3×3) (2×7)
16 9 14 =39 /
batch

Breakeven point = 200,000 / 39 = 5,128 batches

23 Page 23 of 47
Breakeven point for each product
Units Sales Price Break-even Sales

A (5128 x 4) 20,512 10 205,120

B (5128 x 3) 15,384 8 123,072

C (5128 x 7) 35,896 11 394,856

Total 723,066

or
Sales A– 4 x 10 = 40
B– 3 x 8 = 24
C– 7 x 11 = 77
141
Variable costs: A – 4 x 6 = 24
B – 3 x 5 = 15
C – 7 x 9 = 63 102
Contribution margin 39

= 200,000
(39 / 141) x100
= 723,077

(2)
A B C
Contribution margin 4.00 3.00 2.00
Contribution/batch (4×6) (3×3) (2×5)
24 9 10 =43 /
batch

= 200,000 / 43 = 4,651 batches

Breakeven point for each product
Units Sales Price Break-even Sales

A (4651 x 6) 27,900 10 279,000

B (4651 x 3) 13,950 8 111,600

C (4651 x 5) 23,250 11 255,750

Total 646,350

Or
Sales: A – 6 x 10 = 60
B – 3 x 8 = 24
C – 5 x 11 = 55 139

24 Page 24 of 47
 Never think that any request you have is too much for ALLAH

Variable costs: A – 6 x 6 = 36
B – 3 x 5 = 15
C – 5 x 9 = 63 96
Contribution Margin 43

= 200,000
(43 / 139) x100
= 646,512

A.7
A batch can be a packet of units, a box of packets or a cartoon of boxes.

In the given question, a box contains 5 : 3 : 2 packets (sales mix should be on the basis of number of units sold)

Breakeven in Packets
= Fixed Cost ÷ Contribution per batch
= 27,500,000 (A) ÷ 956 (B) = 28,765 batches
In 28,765 batches ; packets should be as follows:
C Plus = 28,765 × 5 = 143,825 Packets
I Plus = 28,765 × 3 = 86,295 Packets
V Plus = 28,765 × 2 = 57,530 Packets
Breakeven Sale Rupees will be:
C Plus = 143,825 × 263.16 = 37,848,987
I Plus = 86,295 × 243.11 = 20,979,177
V Plus = 57,530 × 236.84 = 13,625,405
72,453,569
(A) Fixed Cost:
Production Fixed Overheads: Rupees
25 × 540,000 = 13,500,000
22 × 275,000 = 6,050,000
20 × 185,000 = 3,700,000
23,250,000

Selling & Distribution Fixed Overheads: Rupees

5 × 425,000 = 2,125,000
5 × 255,000 = 1,275,000
5 × 170,000 = 850,000
4,250,000
Total Fixed Cost = 23,250,000 + 4,250,000 = 27,500,000

25 Page 25 of 47
(B) Contribution per Batch:
C Plus I Plus V Plus
* Sale price / per packet 263.16 242.11 236.84
Variable Cost per Packet
Direct Material 100 98 97
Direct Labour 15 13 12
Variable Production Overhead 23 138 19 130 16 125
Variable Selling Overheads 12 150 8 138 10 135
**Commission to distributors 13.16 12.11 11.84
(163.16) (150.11) (146.84)
Contribution per packet 100 92 90

* Sale Price: (40% CS Ratio of net sales) = V.C + C = S = 60 + 40 = 100

C Plus = 150/60 × 100 = 250 / 95 × 100 = 263.16 × 5% = 13.16**
I Plus = 138/60 × 100 = 230 / 95 × 100 = 242.11 × 5% = 12.11
V Plus = 135/60 × 100 = 225 / 95 × 100 = 236.84 × 5% = 11.84

**Commission:
C Plus = 263.16 – 250 = 13.16
I Plus = 242.84 – 230 = 12.11
V Plus = 236.84 – 225 = 11.84

Weighted contribution per batch:

100 × 5 + 92 × 3 + 90 × 2 = 956

Breakeven Sales Rupees (Directly):

Fixed Cost ÷ CS Ratio / Batch
Sale Price / Batch (263.16 × 5 + 242.11 × 3 + 236.84 × 2) 2,515.78
Variable Cost / Batch (1,559.81)
(163.16 × 5 + 150.11 × 3 + 146.84 × 2)
Contribution / Batch 955.97
CS Ratio / Batch = 955.97/2,515.78 × 100
= 37.99% or 38%
27,500,000
= = 72,368,421
38 %

26 Page 26 of 47
 ALLAH makes the impossible, Possible.
Income Statement (not required just for additional information)
(on the basis of planned level of production)
C I V Total
Sales 111,843,000 61,738,050 40,262,800 213,843,850
(425,000×236.16) (255,000×242.11) (170,000×236.84)
Variable COS:
Opening Stock -- -- -- --
+ Variable COGM 74,520,000 35,750,000 23,125,000 133,395,000
(540,000×138) (275,000×130) (185,000×125)
– Closing Stock (15,870,000) (2,600,000) (1,875,000) (20,345,000)
(115,000×138) (20,000×130) (15,000×125)
(58,650,000) (33,150,000) (21,250,000) (113,050,000)
Gross Contribution 53,193,000 28,588,050 19,012,800 100,793,850
Variable Selling Exp. (10,693,000) (5,128,050) (3,712,800) (19,533,850)
(425,000×25.16) (255,000×20.11) (170,000×21.84)
Net contribution 42,500,000 23,460,000 15,300,000 81,260,000
Fixed Cost:
Production (23,250,000)
Selling (4,250,000)
Net profit 53,760,000
Cross check

Contributions:
At Breakeven Level:
143,825 × 100 = 14,382,500
86,295 × 92 = 7,939,140
57,530 × 90 = 5,177,700
Equal to total fixed cost 27,499,340
Extra profit at Budgeted Level:
425,000 – 143,825 × 100 = 28,117,500
255,000 – 86,295 × 92 = 15,520,860
170,000 – 57,530 × 90 = 10,122,300
53,760,660

A.9
Solvent Limited
Mixed Breakeven
Product A Product B Total
Sales – Rupees 200,000,000 150,000,000 350,000,000
Price / Units 20 25
Sales – Units 10,000,000 6,000,000 16,000,000
Sales Mix [10] 62.5% [6] 37.5% [16]
Variable Costs:

27 Page 27 of 47
 Material 45,000,000 30,000,000
Direct Labour 60,000,000 45,000,000
Variable OH (W-1) 5,600,000 5,340,000
110,600,000 80,340,000
Per Unit Variable Cost 11.06 13.39
Contribution per Unit 8.94 11.61
Contribution per batch (having 16 units in total)
[8.94 × 10 + 11.61 × 6] = 159.06/ batch

Fixed Cost ( W − 1) 39,060,000

Breakeven batches = = = 245,568 batches.
Contributi on / batch 159 .06

× 10 ×6
2,455,677 units 1,473,406 units Total
× 20 = 49,113,542 × 25 = 36,835,157 = 85,948,699

OR
Breakeven directly:
39,060,000
= 85,948,699
45 .45 %
Sale Price / Batch:
20 × 10 + 25 × 6 = 350
159 .06
× 100 = 45.45%
350

W-1
Rs. Rs. Rs.
Total Overheads 35,000,000 15,000,000 50,000,000
Variable OH:
Rent based on space (120,000 × 12) -- 1,440,000 1,440,000
Indirect Labour:
60,000,000 × 20% × 30% 3,600,000 3,600,000
45,000,000 × 20% × 30% 2,700,000 2,700,000
Electricity & Fuel:
(4,000,000 × 80%) / 16,000,000 × 10,000,000 2,000,000 2,000,000
(4,000,000 × 80%) / 16,000,000 × 6,000,000 1,200,000 1,200,000
Variable overheads 5,600,000 5,340,000 10,940,000
Fixed overheads (balance) 29,400,000 9,660,000 39,060,000

28 Page 28 of 47
 We prefer the life of this world, while the hereafter is better and everlasting.
A.10 ABC Limited
Projected contribution margin(CM) for 2014 A B C Total
Projected CM on sales for 2014 (after advertising) CxK 3,120 2,827 3,058 9,005
Rs. in million

CM on normal sales growth rate of 5% CxH 2,850 2,649 2,920 8,419

Rs. in million
Additional CM due to advertising 270 178.56 137.76 586
Advertising cost (250)
Net increase in profit due to advertising 336
Rs. in million

Working:
Sale price per unit Rs. A 10,000 8,000 5,000
CM per unit Rs. 5,000 3,000 2,000
Variable cost per unit Rs. B 5,000 5,000 3,000

Revised sales price with 14% increase Rs. (Ax1.14) 11,400 9,120 5,700
Revised variable cost with 8% increase Rs. (Bx1.08) (5,400) (5,400) (3,240)
Projected CM per unit for 2014 Rs. C 6,000 3,720 2,460

Sales quantities for 2013 and 2014:

Sales volume ratio D 2 3 5 10
Sales ratio E (AxD) 20,000 24,000 25,000 69,000
Total sales Rs. in million F(E^69x 15.6) 4,522 5,426 5,652 15,600

Total sales quantities for 2013 Units in million G (FAA) 0.452 0.678 1.130

Sales quantities for 2014 at estimated normal H (Gx1.05) 0.475 0.712 1.187
growth of 5% Units in million
Sales volume increase % for 2014 with advertising J 15% 12% 10%
Sale quantities for 2014 having advertising effect K
Units in million [Gx(1+J)1 0.520 0.760 1.243

29 Page 29 of 47
A.11 Orient Stores Limited (OSL)
Rs in 000
Option I Option II
Sales-Retail price printed (1,500 x 40% x 0.8) 480 480
Sales-Retail price not printed (1,500 x 60% x 0.8 x 1.1) 792 792
Total Sales A 1,272 1,272
Variable cost – Retail price printed (1,500 x 40% x 80% x (408) (408)
85%)
Variable cost – Retail price not printed (540) (540)
(1500 x 60% x 0.8 x 75%)
55 commission to outlet owner (1,272 x 5%) - (63.6)
Contribution Margin B 324 260.4
Fixed Cost (150 + 75) C (225) (200)
Profit 99 60.4
Contribution Margin Ration D = (B ÷ A) x 100 25.47% 20.47%
Breakeven sales C ÷ D 883.39 977.04

b) I would recommend option I as under option I, profit on expected sales is much higher and the breakeven sales is
also lower than option II.

A.12
Incrementa l Fixed Cost + T arg eted Increased Pr ofit
=
Incrementa l Contributi on per Unit
540,000 + 6,923,077
Units = = 12,437
600 .025
12,437 × 3,000.25 = 37,314,108

Incremental Fixed Cost

Depreciation on cost of additional Capacity (3,000,000 × 10%) 300,000
Incremental admin & other fixed overheads (170,000 – 150,000) × 12 240,000
540,000
Targeted Profit:
Profit after tax 4,500,000
Profit before tax (4,500,000 ÷ 65%) 6,923,077
Contribution per Unit:

Variable Cost per Unit

Qty Rate Cost per Unit
Imported RM 1.3 750 975
Local Material 0.5 150 75
1.8 1,050
Sale of wastage (1.8 × 95% - 1.6) 0.11 80 (8.80)
Cost of material / unit 1,041.20
Labour (2 × 300) 600

30 Page 30 of 47
Overheads (2 × 200) 400
Selling & Admin Cost (given) 359
2,400.20
 2,400 .3 
Sale Price / Unit   125  3,000.25
 100 
Contribution / Unit 600.05

Income Statement (not required for additional information)

Rs.
Sales (12,437 × 3,000.25) 37,314,109
Variable Cost (12,437 × 2,400.2) (29,851,287)
Contribution 7,462,822
Fixed Cost (540,000)
Profit before tax 6,922,822
Tax @ 35% (2,422,988)
Profit after tax 4,499,834

31 Page 31 of 47
Extra practice questions:

Question 1
Himalayan Rivers (HR) is planning to install a new plant. Planned production from the plant for the next year is
150,000 units. Cost of production is estimated as under:
Rs. In million
Direct material 6.00
Direct labour 5.00
Production overheads 10.29
Production overheads include the following:
(i) Factory premises would be acquired on rent at a cost of Rs. 1.8 million per annum.
(ii) Indirect labour has been budgeted at 30% of direct labour cost, 50% of which would be fixed.
(iii) Depreciation of the plant would be Rs. 0.5 million.
(iv) Total power and fuel cost has been budgeted at Rs. 3 million. 80% of power and fuel cost would vary in
accordance with the production.
(v) All remaining production overheads are variable.

The sales and marketing budget includes the following:

(i) Employment of two sales representatives at a monthly salary of Rs. 25,000 each and a sales commission of
2% on sales achieved.
(ii) Hiring of a delivery van at Rs. 70,000 per month.
(iii) Launching an advertisement campaign at a cost of Rs. 1.5 million.

Required:
Calculate the breakeven sales revenue and quantity for the next year if HR expects to earn a contribution margin of
40% on sales, net of 2% sales commission. (10)

Q. 2 Auto Industries Limited (AIL) manufactures auto spare parts. Currently, it is operating at 70% capacity. At this
level, the following information is available:
Break-even sales Rs. 125 million
Margin of safety Rs. 25 million
Contribution margin to sales 20%

AIL is planning to increase capacity utilization through the following measures:

■ Selling price would be reduced by 5% which is expected to increase sales volume by 30%.
■ Increase in sales would require additional investment of Rs. 40 million in distribution vehicles and working
capital. The additional funds would be arranged through a long-term loan at a cost of 15% per annum.
Depreciation on distribution vehicles would be Rs. 5 million.

As a result of increased production, economies of scale would reduce variable cost per unit by 10%.
Required:
• Prepare profit statements under current and proposed scenarios.
• Compute break-even sales and margin of safety after taking the above measures.

32 Page 32 of 47
 No one besides ALLAH can rescue a soul from Hardship” Quran (53 : 58)
Note: if nothing is mentioned then depreciation is always a fixed cost. Interest on loan is also a fixed cost which
neither varies with production nor sales.

Question 3 [CVP & Joint By Product]

Ideal Chemicals (IC) blends and markets various cleaning chemicals. Presently, IC’s plant is working at 70% capacity.
To utilize its idle capacity. IC is planning to acquire rights to produce and market a new brand of chemical namely Z-
13 on payment of fee of Rs. 160,000 per month.

In this respect the relevant information is summarized as under:

(i) Z-13 would be produced using the existing plant whose cost is Rs. 81 million. Processing would be carried out
in batches of 2,000 litres of raw materials. Production costs per batch are estimated as under:
Raw material: Imported 1,200 litres @ Rs. 1,500 per litre
Local 800 litres @ Rs. 900 per litre
Direct labour 4,000 hours @ Rs. 165 per hour
Variable production overheads @ Rs. 120 per direct labour hour
1,700 litres of Z-13 is produced from each batch. 100 litres are lost by way of evaporation whereas 200 litres
of input is converted into solid waste. The approximate weight of the solid waste is 225 kg per batch.
(ii) Net volume of each bottle of Z-13 would be 1.25 litres.
(iii) The solid waste would be refined to produce a by-product, polishing wax. Refining would cause an estimated
loss of 2% of by-product output.
(iv) Cost of refining and sales price of wax would be Rs. 250 and Rs. 400 per kg respectively. Net sales revenue
(sales less refining cost) from sale of wax is to be deducted from the cost of the main product.
(v) Variable selling overheads are estimated at Rs. 175 per unit.
(vi) The plant is depreciated at 10% per annum. It is estimated that production of Z-13 would utilise 20% capacity
of the plant.
(vii) To introduce Z-13, IC plans to launch a sales campaign at an estimated cost of Rs. 3.5 million.
(viii) IC wishes to sell Z-13 at a contribution margin of 40% on sales.

Required:
Determine Z-13’s sale price per unit and annual units to be sold, if IC intends to earn an incremental profit before
tax of Rs. 10 million from its sale. (11)

Q. 4 Americano Limited (AL) is engaged in the assembling and marketing of three products, Alpha, Beta and
Gamma. AL is in the process of preparation of product-wise projected statement of contribution margin for the next
financial year commencing from 1 January 2020. Following information in this regard is available:

(i) Total sales of AL for the year ending 31 December 2019 are estimated to be Rs. 28 million. The current
sales price and ratio of sales for each of three products are given below:

Alpha Beta Gamma

Sale price per unit (Rs.) 8,000 12,000 10,000
Ratio of quantities sold 4 1 2

33 Page 33 of 47
 With effect from 1 January 2020, AL is intending to increase the selling prices by 10%.
The demand would decline by 2% due to increase in sale prices.

(ii) The details of components that are used in each product are as follows:

Components
Description
A B C
----------- Units -----------
Alpha 4 2 5
Beta 5 4 6
Gamma 4 3 4
------------ Rs. ------------
Purchase price per component 45 60 30

The suppliers have informed AL that prices of components would increase by 15% with effect from 1
April 2020.

(iii) All products pass through assembling and finishing departments. Details of labour costs at each
department are as follows:

Assembling Finishing
Description
Direct labour (Hours)
Alpha 10 15
Beta 12 20
Gamma 10 18
------------ Rs. ------------
Rate per hour 50 40

(i) Factory overheads are estimated at 60% of direct labour cost. 40% of factory overheads are fixed.

Required:
Prepare a product-wise statement showing projected contribution margin for the year ending
31 December 2020. (16)

34 Page 34 of 47
 Be Patient – For what was written for you was written by the greatest of writers

Q.5 Macchiato (Private) Limited (MPL) is planning to launch a new business of manufacturing carpets and rugs.
The extracts from the projected statement of profit or loss of the new business are given below:

Rs. in '000
Sales 500,000
Cost of goods sold (360,000)
Gross profit 140,000
Operating expenses (90,000)
Profit before taxation 50,000
Taxation @ 35% (17,500)
Profit after taxation 32,500

Selling prices of carpets and rugs would be Rs. 24,000 and Rs. 4,000 per unit with contribution margin of 25%
and 20% respectively. Carpets and rugs would be sold in the ratio of 1:4.

Required:
(a) Compute the sales revenue at break-even and the margin of safety in units. (07)
(b) Determine the number of carpets and rugs that must be sold if MPL wishes to
maintain profit after taxation equivalent to 10% of budgeted sales. (05)

Q. 6 Basketball (Private) Limited (BPL) is in the process of planning for the next year. BPL is currently
operating at 70% of the production capacity. The management wants to achieve an increase of Rs. 36 million
in profit after tax of the latest year.

The summarized statement of profit or loss for the latest year is as follows:

Rs. in million
Sales 567
Cost of sales (60% variable) (400)
Gross profit 167
Operating expenses (40% variable) (47)
Profit before tax 120
Tax (25%) (30)
Profit after tax 90

Following are the major assumptions/projections for the next year’s budget:

35 Page 35 of 47
 (i) Selling price of all products would be increased by 8%. However, to avoid any adverse impact of price
increase, 10% discount would be offered to the large customers who purchase about 30% of the total
sales. Additionally, distributor commission would be increased from 2% to 3% of selling price.

(ii) Average variable costs other than distributor commission are projected to increase by 4% while fixed
costs other than depreciation are projected to increase by 5%.

(iii) Depreciation for the latest year was Rs. 90 million and would remain constant.

Required:
(a) Compute the amount of sales required to achieve the target profit. (09)
(b) Determine the production capacity that would be utilized to achieve the sales as computed
in (a) above. (02)

Answer 1
Breakeven Revenue & Quantity:
Rs. In Millions
Total Fixed Cost / CS Ratio 6,590,000/39.2% 16,811,224
Breakeven Units = 16,811,224/200 84,056 Units
OR
6,590,000/78.4 84,056 Units
84,056 × 200 = 16,811,224
Workings:
(W-1) Total Fixed Cost:
Production Fixed Cost:
Rent – factory premises 1.8
Indirect labour (5 × 30% × 50%) 0.75
Depreciation 0.5
Power & Fuel (3 × 20%) 0.6
3.65
Sales and marketing Expenses:
Employees Salary (25,000 × 2 × 12) 0.60
Delivery Van (70,000 × 12) 0.84
Advertisement Campaign 1.50
Total Fixed Cost 6.59
(W-2) Variable Cost: (Excluding Commission)
Direct Material 6.00
Direct Labour 5.00
V-OH (10.29 – 3.65) 6.64
17.64
Per Unit Variable Cost (17.64 M ÷ 150,000) 117.6 / unit
V.C + C = S
60 + 40 = 100
117 .6
× 100 = 196
60

36 Page 36 of 47
 Gross Sales – Commission = Net Sales
100 – 2 = 98
196
× 100 = 200 (Selling Price)
98

Per Unit Contribution:

Sale price/unit = 200
V.C / unit = (117.6)
Commission / unit (200 × 2%) (4)
78.4
C/S Ratio = 78.4/200 × 100 = 39.2%
A. 2
(a)
(i) Profit Statement Current
Sales (125 + 25) 150
Variable cost of sales (150 × 80%) (120)
Contribution 30
*Fixed cost (25)
Net Profit 5
*At breakeven point, contribution is equal to fixed cost; so 125 × 20% = 25 should be contribution as
well as fixed cost.
(ii) Profit Statement Proposed
Sales (150 × 1.3 × 0.95) 185.25
Variable cost of sales (120 × 1.3 × 0.9) (140.4)
Contribution 44.85
Fixed cost (25 + 5 + 40 × 15%) (36.00)
Net Profit 8.85
(b) Breakeven Sales:
Fixed cost ÷ CS Ratio
36 ÷ 24.21% = 148.70
CS Ratio:
(44.85 ÷ 185.25) × 100 = 24.21%
Margin of Safety = 185.25 – 148.7 = 36.55

Answer 3
(a) Selling Price per Unit:
V.C + C = S
60 + 40 = 100
2,841 .80 ( W − 1)
= × 100 = 4,736.34 per unit
60
(b) Number of units to be sold to earn an incremental profit before tax of 10 millions:
Incrementa l Total Fixed Cost + Incrementa l Pr ofit Before Tax
=
Incrementa l Contributi on / Unit
5,420,000 ( W − 2) + 10,000,000
= = 8,139 units
1,894 .54 ( W − 3)

37 Page 37 of 47
 Workings:
(W-1) Per batch [of 2,000 × litres]

Imported 1,200 L 1700 L F.G

100 L Loss (Normal)
Sold Polishing
200 L Waste Waste Vax
Local 800 L
[225 kg] 100%
2%
2,000 L
[221 kg]

Rs. ‘000’
Material: Imported [1200 × 1500] = 1,800 221 × 400 = 88,400
Local [800 × 900] = 720 221 × 250 = 55,250
Labour: [4,000 × 165] = 660 33,150
Variable Overheads: [4,000 × 120] = 480
Total variable Production Cost 3,660
Less: net revenue from the by-product (33.15)
Net variable production cost (of 1700 litres) 3626.85

No. of bottles to be produced from

1700 litres [1,700 ÷ 1.25] = 1,360 units (bottles)
Variable Production Cost per Unit = [3,626,850 ÷ 1,360] = 2,666.8
Variable Selling Cost per Unit [given in point (v)] = 175
Total Variable Cost per Unit 2,841.80

(W-2) Incremental total Fixed Cost

Manufacturing rights [160,000 × 12] = 1,920,000
Fixed Selling Cost 3,500,000
5,420,000
(W-3) Contribution per Unit:
Sale price per unit = 4,736.34
Variable cost per unit = (2,841.80)
Contribution per unit 1,894.54

Not required for extra information:

If working in litres rather than bottles:
Net variable production cost (of 1,700 litres) = 3,626,850
Variable production cost per litre = 3,626,850/1,700 = 2,133.44
Variable selling cost per litre [175 ÷ 1.25] = 140.0
Total variable cost per litre 2,273.44

38 Page 38 of 47
Contribution per Litre:
2,273 .44
× 40 = 1,515.63/litre
60
No. of litres to be sold to earn an incremental profit before of 10 million:
5,420,000 + 10,000,000
= = 10,174 litres
1,515 .63
10,174
or = 8,139 bottles.
1.25

Ans. 4 American Limited

Product-wise Statement of Contribution Margin
For the year ended 31-12-2020
Alpha Beta Gamma
Sales (w-1) 15,092 5,659.5 9,432.5
Variable Cost of Sales:
Opening Stock - - -
+Variable Cost of Goods Manufactured
Direct Material (w-2) 858.5715 307.654 457.905
Direct Labor (w-3) 1,886.5 606.25 1,046.15
Variable Overheads (w-4) 679.14 216.09 376.614
3,424.21 1,123.994 1,880.669
Closing Stock - - -
Contribution Margin 11,667.79 4,535.506 7,551.831

(W-1) Sold Units of Alpha, Beta and Gamma in 2019

Sale price per Batch: 8000 × 4 + 12,000 × 1 + 10,000 × 2
= 64,000
28,000,000/64,000 = 437.5 batches

×4 ×1 ×2
1,750 units 437.5 units 875 units

Sale in 2020
“000”
Alpha 1,750 × 98% = 1,715 × 8,000 × 1.1 = 15,092
Beta 437.5 × 98% = 428.75 × 12,000 × 1.1 = 5,659.5
Gamma 875 × 98% = 857.5 × 10,000 × 1.1 = 9,432.5
3,001.25

39 Page 39 of 47
W-2) Direct Material Cost
Alpha:
A 1,715 × 4 = 6,860/12 × 3 × 45 = 77.175
B 1,715 × 2 = 3,430/12 × 3 × 60 = 51.45
C 1,715 × 5 = 8,575/12 × 3 × 30 = 64.3125
192.9375
6,860/12 × 9 × 45 × 1.15 = 266.254
3,430/12 × 9 × 60 × 1.15 = 177.502
8,575/12 × 9 × 30 × 1.15 = 221.878
665.634
Total = 192.9375 + 665.634 = 858.5715
Beta:
A 428.75 × 5 = 2,143.75/12 × 3 × 45 = 24.117
B 428.75 × 4 = 1715/12 × 3 × 60 = 25.725
C 428.75 × 6 = 2572.5/12 × 3 x 30 = 19.294
69.136
2,143.75/12 × 9 × 45 × 1.15 = 83.204
1,715/12 × 9 × 60 × 1.15 = 88.751
2,572.5/12 × 9 × 30 × 1.15 = 66.563
238.518
Total (69.136 +238.518) = 307.654

Gamma:
A 857.5 × 4 = 3,430/12 × 3 × 45 = 38.587
B 857.5 × 3 = 2572.5/12 × 3 × 60 = 38.587
C 857.5 ×4 = 3430/12 ×3 × 30 = 25.725
102.899
3430/12×9×45×1.15 =133.127
2572.5/12×9×60×1.15 =133.127
3430/12×9×30×1.15 =88.751
355.006
Total (102.899 +355.006) = 457.905

(W-3) Direct Labour:

Alpha: 1715×10×50+1715×15×40 = 1,886.5
Beta: 428.75×12×50+428.75×20×40 = 600.25
Gamma: 857.5×10×50+857.5×18×40 = 1046.15
(W-4) Variable Overhead:
Alpha: 1886.5×60%×60% = 679.14
Beta: 600.25×60%×60% = 216.09

Gamma: 1046.15×60%×60% =376.614

40 Page 40 of 47
 Before going to sleep every night Forgive everyone and sleep with Clean Heart
Q.5
𝑇𝑜𝑡𝑎𝑙 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡
(a) Breakeven in Rupees =
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛/𝑏𝑎𝑡𝑐ℎ
65,000,000 (𝑊−3)
=
9,200 (𝑊−4)
= 7,065 batches

1 4
Carpets: 7,065 units Rugs: 28,260 units
24,000 =169,560,000 4,000 =113,040,000

282,600,000
Workings:
W-1 Budgeted Units:
Sale price per batch =24,0001+4,0004 = 40,000 / batch
500,000,000 = 12,500 batches
40,000

1 4
Carpets: 12,500 units Rugs: 50,000 units

W-2: Contribution per batch

Carpets Rugs
Selling price/unit 24,000 4,000
Variable Cost/unit (75%) (18,000) (3,200) (80%)
Contribution/unit (25%) 6,000 800 (20%)
W-3
Fixed Cost:
Total Cost
360,000,000 + 90,000,0000 = 450,000,000
Less:12,50018,000+50,0003,200=
Variable Cost 385,000,000

Fixed Cost =450,000,000-385,000,000

=65,000,000
W-4 Contribution per batch:
6,0001 + 8004 = 9,200/batch

Margin of Safety in units:

Carpets Rugs
Budgeted units 12,500 50,000
Breakeven units (7,065) (28,260)
Margin of safety units 5,435 21,740

41 Page 41 of 47
(b)
𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡+𝑃𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑇𝑎𝑥
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛/𝑏𝑎𝑡𝑐ℎ
65,000,000+500,000,000  10%÷ 65%
9,200
=15,426 batches

X1 x4
Carpets: 15,426 units Rugs: 61,704 units
Answer: 6 a)
……………….. Rs. in million ………………..
Amount of sales to achieve the target profit = Total fixed cost + Target profit before tax
Contribution sales ratio
(Because information of units is not available)

= 193.11 (W-1) + 168 (W-2)

53.67 (W-3)
= 672.83

W-1 Total fixed cost:

Cost of sales (400 x 40%) 160
Operating expenses (47 x 60%) 28.2
Existing total fixed cost 188.2
Less: Depreciation (90)
Other fixes cost 98.2
x 1.05 103.11
÷ Depreciation (Constant) 90
Revised total fixed cost 193.11

W-2 Target profit before tax

Target profit after tax 126
(90 + 36)
Target profit before tax 168
(126/75 x 100)

W-3 Contribution sales ratio

Sales (W-3.1) 594
Total variable cost (W-3.2) (275.18)
Contribution 318.82
318.82/594 x 100 = 53.67% of sales

W-3.1 Sales
567 x 1.08 612.36
612.36 x 30% x 90% 165
612.36 x 70% 429

42 Page 42 of 47
 Total sales 594

W-3.2 Variable cost

Variable cost of sales (400 x 60%) 240
Variable operating expenses (47 x 40%) 18.8
Existing total variable cost 258.8
Less: Existing commission (567 x 2%) (11.34)
Other variable cost 247.46
X 1.04 257.36
Add: Revised commission (594*3%) 17.82
Revised total variable cost 275.18

b) Total capacity available: 567/70*100 = 810

810 is at latest year’s price,
Therefore convert it
Into next year’s price 810 x 1.08 874.8

874.8 x 30% x 90% 236.2

874.8 x 70% 612.36 848.56

Capacity utilization 672.83/848.56 x 100 79.29%

Test questions:
Q.1 The following information pertains to Hope Limited the latest financial year:
Rupees

Sales price unit 1,600

Direct labour per unit 240
Variable cost (other than direct labour) per unit 960
Fixed cost (no labour cost included) 850,000

Volume of sales and production was 6,000 units which represent 80% of normal capacity. The management of the
company is planning to increase wages of direct labour by 15% with effect from next financial year.

Required:
a) Calculate the number units be sold maintain the current profit the sales price remains Rs. 1,600 and the 15%
wage increase goes into effect. (04)
b) The management believes that an additional investment of Rs. 760,000 is required on machinery will be
depreciated by 10%. It will increase total capacity by 25%. Determine the selling price per unit in order to earn
profit Rs.2 million assuming that units produced because of increased capacity be sold and that the wage increase
goes into effect. (05)

43 Page 43 of 47
SOLUTION 1:
a) Number of units to be sold to maintain current profit:
Current profit: Rs. in “000”
Sales (6,000 × 1,600) 9,600
Variable Cost [6,000×(240+960)] (7,200)
Contribution 2,400
Fixed cost (850)
Net profit 1,550
Target Profit (units) = Total fixed cost + Current year profit
Contribution/unit

850,000+1,550,000
= 6,593 units
∗ 364
*Contribution Per unit:
Sale price per unit 1,600
Variable cost per unit (240×1.15+960) (1,236)
364
b) Selling price per unit to earn a profit of Rs. 2 million:

Sales [9,375(w-1)×1,548(w-2)] 14,513,500

Variable cost of sales [9375×(960+240×1.15)] (11,587,500)
Contribution 2,926,000
Fixed cost [850,000+(760,000×10%)] 926,000
Profit 2,000,000
(w-1) 6,000/80×100=7,500 (At 100% capacity)
7,500×1.25=9,375
(w-2) Reverse working to get selling price of 1,548:
14,513,500 ÷ 9,375 = 1,548

Example: From the books and records of the CDE Company, the cost analyst determined that sales were Rs.
1,000,000 and costs were as follows:

Description Variable cost Rs. Fixed cost Rs. Total cost Rs.

Direct material 300,000 - 300,000

Direct labour 300,000 - 300,000
Factory overhead 80,000 50,000 130,000
Marketing expenses 70,000 30,000 100,000
Administrative expenses 50,000 20,000 70,000

The company is considering two alternative proposals that would change certain cost items. Proposal 1 would
increase fixed cost by Rs. 10,000, with sales and variable costs remaining the same. Proposal 2 would modernize
present equipment at an annual increase of fixed costs of Rs.25,000, with the expectation of saving the same
amount in each of the direct materials and directlabour costs.

44 Page 44 of 47
Required: Calculation of (i) current contribution to sales ratio; (ii) current break-even point; (iii) the break- even point
and profit, if proposal 1 is adopted and (iv) contribution to sales ratio, the breakeven point and profit, if proposal
2 is adopted, are given below.
i. Current contribution to sales ratio

Rupees
Current sales 1,000,000
Less: Variable cost:
Direct material (300,000)
Direct labour (300,000)
Variable factory overhead (80,000)
Variable marketing expenses (70,000)
Variable administrative expenses (50,000)
(800,000)
Contribution margin 200,000
CS ratio (200,000/1,000,000) x 100 20%

ii. Current breakeven point, is calculated below.

Rupees
Fixed cost
Factory overhead 50,000
Marketing expenses 30,000
Administrative expenses 20,000
100,000
CS ratio 20%
Breakeven point in Rs. (100,000/0.20) 500,000
iii) Breakeven point and profit, if proposal 1 is adopted.

Rupees
CS ratio (see-i) 20%
Fixed cost as given in ii 100,000
Incremental fixed cost 10,000
Fixed cost under proposal 1 110,000
Hence breakeven point (110,000/20%) 550,000
Profit under proposal 1
Contribution (see-i) 200,000
Less: Fixed cost (110,000)
Profit 90,000

45 Page 45 of 47
 Iv) CS ratio, breakeven point and profit, if proposal 2 is adopted.

Rupees
Sales 1,000,000
Less: Variable costs:
Direct material (300,000-25,000) (275,000)
Direct labour (300,000-25,000) (275,000)
Variable factory overhead (80,000)
Variable marketing expenses (70,000)
Variable administrative expenses (50,000)
(750,000)
Contribution margin 250,000
CS ratio (250,000/1,000,000) 25%
fixed cost as given in ii 100,000

Incremental fixed cost 25,000

Fixed cost under proposal 1 125,000
Hence breakeven point (125,000/25%) 500,000
Profit under proposal 1
Contribution 250,000
Less: Fixed cost (125,000)
Profit 125,000

► Example: [CVP]
Entity E has monthly sales of Rs. 128,000, but at this level of sales, its monthly profit is only Rs.
2,000 and its margin of safety is 6.25%.
From the above information we can calculate (i) fixed costs as well as (ii) the level of monthly
sales needed to increase the monthly profit to Rs.5000 as follows:
i. The margin of safety is 6.25%. Therefore, the break-even volume of sales = 93.75%
ofbudgeted sales = 0.9375 × Rs. 128,000 = Rs. 120,000

Budget (Rs.) Break-even (Rs.)

Sales 128,000 120,000
Profit 2,000 0
Total costs 126,000 120,000

46 Page 46 of 47
This gives us the information to calculate fixed and variable costs, using high/lowanalysis.

Rs. Revenue Rs. Cost

High: Total cost at 128,000 126,000
Low: Total cost at 120,000 120,000
Difference: Variable cost of 8,000 6,000
Therefore, variable costs = Rs. 6,000/Rs. 8,000 = 0.75 or 75% of sales revenue.

Substitute in high or low equation Cost (Rs.)

Total cost at Rs.128,000 revenue 126,000

Variable cost at Rs.128,000 revenue (× 0.75) (96,000)
Therefore, fixed costs 30,000

47 Page 47 of 47
Test CVP
Question 1: Spicy food limited (SFL) offers three type of spices BX , BY and BZ. The profitability of SFL is declining
and it has incurred a loss during the year ended 31 March 2012.The product wise results are as under.
BX BY BZ
No. of units sold 400,000 600,000 300,000
--------------Rs. in Million------------------
Sales 140 180 126
Cost of sale (105) (135) (120)
Operating cost (30) (49) (13)
Net profit/(loss) 5 (4) (7)

Other relevant information is as under:

i. Cost of sales includes fixed costs of Rs.135 million. Fixed cost have been allocated to the products on the
basis of labor hours. BX, BY and BZ require 1.50, 1.75 and 2.00 labor hours per unit respectively.
ii. Variable operating cost of BX, BY and BZ are Rs. 45, Rs. 49 and Rs. 26 per unit respectively.
iii. In order to increase sales and improve operating results, SFL is considering a proposal to introduce a ‘jumbo
economy pack ‘. The details of the proposal are as under:
• The jumbo pack would consist of one packet of each of three type of spices. It would sold at the price
equivalent to 90% of total price of three packs. It has been projected that on introduction of jumbo
pack, the sale of individual packets would reduce by 20%.
• The existing packing machine would need to be replaced. The new machine would reduce the variable
cost of production by 2%. Annual fixed costs would increase by Rs. 3 million.
• To market the jumbo pack, SFL plans to launch a sale campaign at a cost of Rs. 4 million.

Required:
Calculate the number of jumbo packs that should be sold during the year to achieve a net profit of Rs. 5 million.
(14)
Question no: 2
ABC limited deals in manufacturing of tables and chairs. The profit and loss account of the company for the year
ended 30 June 2014 is as follows:
Rs. in“000”
Sales 243,000
Cost of goods sold (211,500)
Gross profit 31,500
Operating expenses (57,300)
Net loss before taxation (25,800)
Taxation -
Net loss after taxation (25,800)

Additional information
(i) Selling price per table and chair is Rs. 22,000 and Rs. 8,000 per unit having contribution margin of 35% and
30% respectively. Tables and chairs are sold in the ratio of 1: 4.
(ii) 80% of the operating expenses are fixed while the remaining expenses are directly attributable to the
number of units sold.

48 Page 1 of 8
(iii) The corporate tax is applicable is @ 30% while no tax is required to be paid in case of loss.
(iv) The share capital of the company is Rs.180 million.

Required:
(a) Determine the breakeven sales revenue. (08)
(b) Determine the number of tables and chairs that need to be sold if the company wants to pay dividend of 10%
and retain profit of Rs. 10 million. (08)

Question no: 3
Twinkle Company Limited is expected to achieve a sale of Rs. 120 million during the current year. The contribution
margin is estimated to be 20% whereas the margin of safety is estimated at 25%.

During the next year, the company intends to reduce its prices by 5% and plans to market its products vigorously to
increase the sales volume.

Salaries constitute 40% of the total fixed cost and according to the union agreement an increment of 20% is to be
given to all staff. Other fixed costs are likely to remain constant.

Required:
Compute the percentage of increase in sales volume that the company should achieve so as to maintain a safety
margin of 25%. (07)

Question 4:
ABC (Private) limited operates a fast food chain and has 15 outlets all over the Pakistan. The company’s turnover
for the year ending June 30 , 2011 is estimated at Rs. 181 million and the annual fixed cost are estimated at Rs. 30
million. The analysis of sale has revealed the following:
Products Sale price Quantity wise sale Contribution margin as %
(Rs.) ratio of sale price
Burger 150 6 40
Fries 50 7 45
Cold drinks 40 8 50
Ice cream 80 3 60

The company has witnessed very little growth in turnover and profitability during the past two years. In order to
increase the profitability, the management is considering the following options:

Option 1:
To introduce the following deals:
Deal 1 offering burger, fries and cold drinks for Rs. 210

Deal 2 offering burger, fries, cold drink and ice cream for Rs.280
As a result, the total turnover is expected to increase by 25%. The ratio between sale of Deal 1 and Deal 2 would be
60% and 40% respectively. 70% of the revenues would be generated from the sale of deals and 30% from the sale of
individual items in the existing ratio.

49 Page 2 of 8
Option 2:
Under this option the price of all the products would be reduced by 20% to make the prices competitive in the
market. In addition, home delivery would be allowed for orders of Rs. 250 and above. Home delivery would require
additional fixed costs of Rs. 850,000 per annum and variable cost of Rs. 20 per delivery.

It is estimated that the above measures would increase the total sales revenue by 35% inclusive of sales through
home delivery service which is estimated at Rs. 30 million. The average revenue per delivery is estimated at Rs. 600.
All sales would increase in the existing ratio except that ice-cream would not be sold through home deliveries.

Required: Evaluate each of the above options and give your recommendations.
(20)

Answer 1:
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡+𝑡𝑎𝑟𝑔𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡
Target sales (units) =
𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
BX BY BZ Total
Units 400,000 600,000 300,000
Labor hours/unit ×1.5 ×1.75 ×2
600,000 1050,000 600,000 2250,000

𝑡𝑜𝑡𝑎𝑙 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 135,000,000

Fixed cost /hour = = 2250,000
=Rs. 60/hour
𝑙𝑎𝑏𝑜𝑟 ℎ𝑜𝑢𝑟𝑠

BX BY BZ
Fixed overheads/Hour 60 60 60
Labor hours ×600,000 ×1050,000 ×600,000
Total fixed cost 36,000,000 63,000,000 36,000,000
Total cost of goods sold 105,000,000 135,000,000 120,000,000
Variable cost of goods sold(bal.) 69,000,000 72,000,000 84,000,000
No. of units 400,000 600,000 300,000
Variable cost of goods sold per unit 172.5 120 280
Variable operating cost 45 49 26
No. of units 400,000 600,000 300,000
Total variable operating cost 18,000,000 29,400,000 7,800,000
Total operating cost 30,000,000 49,000,000 13,000,000
Fixed operating cost (bal.) 12,000,000 19,600,000 5,200,000

50 Page 3 of 8
Computation of contribution margin/pack:
BX BY BZ Jumbo pack
Sale price (140,000,000÷400,000) 350 300 420 963
(350+300+420)×0.9
Less: variable cost of production (169.05) (117.6) (274.4) (561.05)
(172.5×98%) (169.05+117.6+274.4)
Less variable operating costs (45) (49) (26) (120)
(45+49+26)
Contribution per unit 135.95 133.4 199.6 281.95
No. of units (400,000×80%) ×320,000 ×480,000 ×240,000
Total Contribution margin 43,504,000 64,032,000 28,704,000
Total existing Contribution margin
[43,504,000+64,032,000+28,704,000
=136,240,000]

Fixed cost Production 135,000,000

Operating (12+19.6+5.2) 36,800,000
Increase in fixed cost 3,000,000
Advertising 4,000,000
Total fixed cost 178,800,000
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡+𝑇𝑎𝑟𝑔𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡−𝐸𝑥𝑖𝑠𝑡𝑖𝑛𝑔 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛
Target sales(units) =
Contribution per jumbo pack
178,800,000+5000,000−136,240,000
= = 168,683 units
281.95

Answer no:2 (a)

Total Fixed cost(w−1) 103,650,000
= = 5,991 batches
Contribution per batch(w−1) 17,300
|

×1 ×4
5,991 tables 23,964 chairs
× 22,000 × 8,000
= 131,802,000 + = 191,712,000 = 323,514,000

(w-1) Sale price per batch

22,000 × 1 + 8,000 × 4 = 54,000 per batch

No. of batches sold in 30-6-2014

243,000,000 ÷ 54,000 = 4,500 batches
|

×1= 4,500 tables x4 = 18,000 chairs

Contribution per unit:

22,000 × 35% = 7,700
8,000 × 30% = 2,400

51 Page 4 of 8
Contribution per batch:
7,700 × 1 + 2,400 × 4 = 17,300

We can now calculate total contribution and therefore, balancing figure of existing total fixed cost i.e.
Contribution (4,500×7,700+18,000×2,400) = 77,850,000
Fixed Cost (bal.) 103,650,000
Loss (Given) 25,800,000
(b)
𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡+𝑃𝐵𝑇 103,650,000+40,000,000(𝑤−1)
= =8,303 batches
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑏𝑎𝑡𝑐ℎ 17,300
|

×1 ×4
8,303 tables 33,212 chairs

(W-1) Rs. In “Millions”

Retained Earnings
PAT (bal.) 28
Dividend (180×10%) (Given) (18)
Retained Profit (Given) 10

28
Then we can calculate profit before tax × 100 = 40 millions
70

Answer: 3
𝑏𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑆𝑎𝑙𝑒𝑠−𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑆𝑎𝑙𝑒𝑠
Margin of Safety (%) = × 100
𝑏𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑆𝑎𝑙𝑒𝑠
120−𝐵𝑎𝑙𝑎𝑛𝑐𝑒 𝑆𝑎𝑙𝑒𝑠
× 100 = 25%
120

Breakeven Sales (using above equation) = 90 m

𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡
Breakeven Sales (Rs) =
𝐶𝑀 𝑅𝑎𝑡𝑖𝑜
𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡
90 m =
0.2

Fixed Cost (Existing) = Rs 18m

|

40% 60%
Salaries Other Fixed Cost
Rs 7.2 m × 1.2 (Wage Increase) Rs 10.8 m(Unchanged)
Rs 8.64

Total Revised fixed cost= 8.64+10.8=Rs 19.44 million

52 Page 5 of 8
Revised CM Ratio is Calculated as Follows:
Sales (120×95%) 114
V.C (120×80%) (96)
Contribution 18
[18/114 ×100] = 15.79%

𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 19.44

Revised breakeven sales = = =123.12m
𝑐𝑠 𝑟𝑎𝑡𝑖𝑜 15.79%

Budgeted sales in next year

123.12
×100 =164.16
75

Percentage of increase in volume

164.16
×100 =172.8
95
172.8−120
×100 =44%
120

Answer 4:
• Sales = 181 million
• Fixed Cost = 80 Million
Product Sale Price per unit Contribution Margin per Variable
unit Cost/unit
A B C= A-B
Burger 150 (×0.4) 60 90
Fries 50 (0.45) 22.5 27.5
Cold drink 40 (×0.5) 20 20
Ice-Cream 80 (×0.5) 48 32

Contribution per batch = [ 60×6+22.5×7+20×8+48×3] = 821.5

Sale price per batch = [ 150×6+50×7+40×8+80×3] = 1,810
821.5
CS Ratio per batch = × 100
1,810
= 45.39%

Option 1
Revised Turn Over = 181,000,000×1.25 = 226,250,000

Deals (70%)
158,375,000 Individual Sales (30%)

Deal 1 Deal 2 67,875,000

60% 40%
95,025,000 63,350,000
Profit = Contribution – Fixed Cost

53 Page 6 of 8
OR
Profit = [Sales × Contribution margin Ratio] – Fixed Cost

Computation of CM Ratio
Deal 1 Rs.
Sale Price per deal (Given) 210
Less: Variable Cost per deal (90+27.5+20) 137.5
Contribution per Deal 72.5
CM Ratio [72.5÷210] ×100 34.5%
Deal 2 Rs.
Sale price per Deal (Given) 280
Less: Variable Cost (90+27.5 +20+32) (169.5)
Contribution per Deal 110.5
CM Ratio [110.5÷280] ×100 39.46%

Sales CM Ratio Total Contribution

Deal 1 95,025,000 ×34.5% = 32,783,625
Deal 2 63,350,000 ×39.46% = 24,997,910
Individual Products 67,875,000 ×45.39% = 30,808,463
Total CM 88,589,998
Less: Fixed costs (30,000,000)
Net Profit 58,589,998

Option 2
Revised Sales => 181,000,000 × 1.35 = 244.35m

Sales through Home Delivery Other Products

30,000,000 214,350,000

Sales = 600 Per Delivery (Given)

No of Deliveries = [ 30,000,000 ÷ 600 = 50,000 Deliveries]

Total cost of home deliveries: 850,000 + 20×50,000 = 1,850,000

Product Sale Price per Variable Cost Per Contribution margin per Unit
unit unit
B 120 90 30
F 40 27.5 12.5
C 32 20 12
I 64 32 32

54 Page 7 of 8
Contribution per batch = [30×6+12.5×7+12×8+32×3] = 459.5
Sale Price per batch = [120×6+40×7+32×8+64×3] = 1,448
459.5
Contribution margin Ratio per batch = [ × 100] = 31.73%
1,448

Contribution margin ratio for delivery

Contribution per batch (30x6+12.5x7+12x8) = 363.5
Sale price per batch (120x 6+40x7+32x8) =1,256
Contribution margin ratio :(363.5/1,256 x100) =28.91%

SALES CM RATIO TOTAL CM

Individual sales 214,350,000 ×31.73% = 68,013,255
Deliveries 30,000,000 ×28.9% = 8,670,000
Total CM excluding delivery Cost 76,683,225
Less: Delivery Cost (1,850,000)
Less: Fixed cost (30,000,000)
Net Profit 44,833,255

Recommendation: Management should adopt Option I as it would result into more profit.

55 Page 8 of 8
 Stay close to anything that reminds you of ALLAH

Decision Making
Product Abandoning Decisions: (this discussion is on the basis of relevant costing)

Scenario (A)
A B C Total
Sales 400 200 450 1,050
Variable cost (200) (110) (230) (540)
Contribution 200 90 220 510
Fixed Cost (90) (100) (140) (330)
Profit / Loss 110 (10) 80 180

Lets product B is abandoned; then

Sales (400 + 450) 850
Variable cost (200 + 230) (430)
Contribution 420
Fixed cost (Remains fixed) (330)
Profit 90

Profit is reduced by the amount of contribution from B as less contribution is available to cover total fixed
cost. Therefore we should not abandon product B as it is contributing towards fixed cost.

Scenario (B)
A B C Total
Sales 200 250 200 650
Variable cost (80) (130) (220) (430)
Contribution 120 120 (20) 220
Fixed Cost (50) (65) (50) (165)
Profit 70 55 (70) 55

Lets product C is abandoned; then

Sales (200 + 250) 450
Variable cost (80 + 130) (210)
Contribution 240
Fixed cost (165)
Profit 75

Profit is increased by the amount of negative contribution from product C because negative contribution is
decreasing the amount of overall profit.

Conclusion:
We should abandon the product only if it shows negative contribution otherwise continue producing it.

56 Page 1 of 51
Limiting Factor Decisions (Scarce Resource Decisions)
Example:
A B C
Selling price / unit 2,300 1,550 2,000
Variable cost/unit (1,825) (1,176) (1,537)
Contribution per unit 475 374 463
Estimated demand (units) 10,000 20,000 9,000

If there is no constraint on resources then produce all products.

However, suppose there are only 100,000 machine hours available and machine hours / unit are required as
follows:
A = 4/unit
B = 2.5/unit
C = 3/unit

If we produce according to above mentioned ranking of products based on contribution then:

First produce (A) 10,000 × 4 = 40,000 hours utilized
Then produce (C) 9,000 × 3 = 27,000 hours utilized
Total hours utilized 67,000
Remaining hours 100,000 – 67,000 = 33,000 ÷ 2.5
= 13,200 units of B can be produced.
In that case, total contribution will be:
A 10,000 × 475 = 4,750,000
B 13,200 × 374 = 4,936,800
C 9,000 × 463 = 4,167,000
Total contribution 13,853,800

But if we work according to contribution per unit of limiting factor basis then contribution will be as follows:
A B C
Contribution / unit = 475 374 463
Machine hours / unit = 4 2.5 3
Contribution / machine hour 118.75 149.6 154.33
Ranking 3 2 1

Now scarce resource will be allocated as follows:

Units Hours Required Hours Used Hours Unused
C 9,000 3 27,000 73,000
B 20,000 2.5 50,000 23,000
A 5,750 4.0 23,000 --
(23,000 ÷ 4)

57 Page 2 of 51
Total Contribution will be as follows:
9,000 × 463 = 4,167,000
20,000 × 374 = 7,480,000
5,750 × 475 = 2,731,250
Total contribution 14,378,250

Conclusion: it means if there is any limiting factor, then we should make decision on the basis of contribution per
limiting factor rather than only contribution per unit.

Limiting Factor:
It is a resource (material, labour, machine time or cash etc) which is in short supply; so that total opportunities that
exist for making profitable use of resources exceed resources available.

If there is a constraint on any resource then the business should focus on products that has a highest amount of
contribution per limiting factor.

The following procedure should be adopted:

(a) Identify the limiting factor (if any)
(b) Calculate the contribution / unit for each product.
(c) Calculate the limiting factor per unit.
(d) Calculate contribution per limiting factor.
(Contribution per unit ÷ limiting factor per unit)
(e) Rank the products (first being the product with the highest contribution per limiting factor and so on).
(f) Prepare an optimal production plan* start with first ranked product until scarce resource is used up.
Spring 2012 → Bauxite → (14.9)

*Optimal production plan means a plan of production according to ranking.

Q. 1 Bauxite Limited (BL) is engaged in the manufacture and sale of three products viz. Pentagon, Hexagon
and Octagon. Following information is available from BL’s records for the month of February 2012:

Pentagon Hexagon Octagon

Sales price per unit (Rs.) 2,300 1,550 2,000
Material cost per Kg. (Rs.) 250 250 250
Labour time per unit (Minutes) 20 30 45
Machine time per unit (Hours) 4 2.5 3
Net weight per unit of finished product (Kg.) 6 4 5
Yield (%) 90 95 92
Estimated demand (Units) 10,000 20,000 9,000

Each worker is paid monthly wages of Rs. 15,000 and works a total of 200 hours per month. BL’s total
overheads are estimated at 20% of the material cost.

Fixed overheads are estimated at Rs. 5 million per month and are allocated to each product on the basis of
machine hours. 100,000 machine hours are estimated to be available in February 2012

58 Page 3 of 51
Required:
Based on optimum product mix, compute BL’s net profit for the month of February 2012

Note: if the availability of any resource is not given then assume that it is available.

Limiting Factor (with make or buy option)

Scenario 1:
A B C
Sales / unit 500 600 400
Variable cost / unit (300) (500) (350)
Contribution / unit 200 100 50

If no limitation of resources then produce all products.

Lets assume if labour hours are limiting resource then we calculate contribution / unit of limiting factor e.g.
hours / unit 10 4 1
Contribution per unit per limiting factor 20 25 50

Therefore first produce C, then B, then A as in this ranking C is generating maximum benefit per hour of limiting
factor.

Scenario 2:
If there is an option to purchase from outside supplier and there is a limiting factor then compare variable cost per
unit with cost per unit of supplier.

For Example:
A B C
Variable cost/unit 550 1,900 3,050
Outsourcing cost /unit 750 2,000 3,500
Saving by producing / unit (or extra cost of purchasing / unit) 200 100 450
e.g assume hours/unit (limiting factor) 0.5 1.00 1.5
Cost saving / hour 400* 100 300

*400 means extra cost of purchasing / hour of limiting factor.

Ranking 1 3 2

(According to which product is to be produced rather than purchase)

Conclusion: We have to produce that which is more costly to purchase

Make or buy decisions with scarce resources:

Sometimes the problem of a limiting factor can be overcomed by outsourcing some work to external supplier who
makes similar products.

59 Page 4 of 51
In this situation, following steps should be performed:
1. (Purchase cost – variable manufacturing cost) ÷ limiting factor.
2. Do ranking for each product, the product with highest value will be ranked first and will be considered to
make first.
3. Produce an optimal production plan, the highest ranked product is made first, followed by other products
until limiting factor is fully utilized.
4. The rest of the products which cannot be manufactured will be bought from external supplier.

Q. 2 Qamber Limited (QL) is engaged in the manufacture and sale of textile products. In February 2013 QL
received an order from JCP, a chain of stores, for the supply of 11,000 packed boxes of its products per month at
an agreed price of Rs. 8,000 per box. The boxes would be supplied every month for a period of one year. It was
further agreed that:
▪ Each box would contain a pillow cover, a bed sheet and a quilt cover.
▪ QL would be solely responsible for the quality of supplied products whether they are being manufactured at
its own facility or outsourced to third party, either wholly or partially.

JCP would provide its logo and printed materials for the packing of these boxes. Following information is available
for the manufacture of each unit of these products:
Products
Pillow Bed Quilt
Cover Sheet Cover
Cloth required (Meters) 1 4 5
Cost of cloth per meter (Rs.) 200 300 400
Direct labour per meter (Minutes) 30 15 18
Machine time (Minutes) 30 75 120
Variable overheads per machine minute (Rs.) 5 4 3.75
Outsourcing cost (Rs.) 750 2,000 3,500

For in-house completion of the above order, a total of 45,000 machine hours and 25,500 labour hours are
estimated to be available each month. The labourers are paid at a uniform rate of Rs. 400 per hour. The cost
incurred on quality check, before supply of the boxes to JCP, is estimated at Rs. 300 per box. Fixed overheads are
estimated at Rs. 10,000,000 per month.

Required:
Calculate net profit for the month, assuming QL wants to produce as many products as possible within the
available resources, and outsource the rest to a third party. (15)

Q.3 A company produces three products using the same raw material. The raw material is in short supply and only
3,000 kilograms shall be available in April 2009, at a cost of Rs. 1,500 per kilogram.

60 Page 5 of 51
The budgeted costs and other data related to April 2009 are as follows:
Products X Y Z
Maximum demand (units) 1,000 800 1,200
Selling price per unit (Rs.) 3,750 3,500 4,500
Material used per unit (kg) 1.6 1.2 1.8
Labour hours per unit (Rs. 75 per hour) 12 16 15

Required:
• Determine the number of units that should be produced by the company to earn maximum profit
• Determine the number of units to be produced if finished products are also available from an external supplier
at the following prices per unit:
Rupees
X 3,450
Y 3,100
Z 3,985

Q. 4 The following projections are contained in the budget of Scientific Chemicals Limited for the year ending 31
December 2014:

(i) Annual local and export sales

Product C031 Product D032

Rs. per unit Units Rs. per unit Units
Local sales 1,965 40,000 1,410 50,000
Export sales 2,100 25,000 1,500 24,000

(ii) Raw material and labour per unit

Product Product
C031 D032
Raw material-A at Rs. 25 per kg. (Kg.) 4.0 3.0
Raw material-B at Rs. 60 per kg. (Kg.) 3.5 2.6
Skilled labour hours at Rs. 250 per hour (Hours) 2.4 2.0
Semi-skilled hours at Rs. 120 per hour (Hours) 5.0 2.5

iii) Variable overheads for each unit of product C031 and D032 are estimated at Rs. 125 and Rs. 60 respectively.

Fixed overheads including admin & selling overheads would amount to Rs. 3 million per month.
The company is faced with the under-mentioned constraints:

▪ The supplier of material-B can supply 27,700 kg. per month only.
▪ Only 35 skilled workers will be available for each shift of 8 hours while factory will be operated for 25 days in a
month on 3 shift basis.

61 Page 6 of 51
 No matter how hurt you are, You will always find comfort with ALLAH.

Required:
Determine optimal production plan for the next year assuming that the company cannot afford to terminate the
export sales contract because of the heavy damages payable in case of default.
(16)

Another concept:
If there is a limiting factor and some products can be outsourced while others are not, then calculate the
contribution per unit for those products which cannot be outsourced and calculate saving by producing per unit for
those products which can be outsourced. All other discussion remain same.

Q.5 Artery Limited (AL) produces and markets three products viz. Alpha, Beta and Gamma. Following information is
available from AL’s records for the manufacture of each unit of these products:

Alpha Beta Gamma

Selling price (Rs.) 66 88 106
Material-A (Rs.4 per kg) (Rs.) 8 0 12
Material-B (Rs. 6 per kg) (Rs.) 12 18 24
Labour (Rs. 10 per hour) (Rs.) 25 30 25
variable overhead based on:
- Labour hours (Rs.) 1.5 1.8 1.5
- Machine hours (Rs.) 1.6 1.4 1.2
Total (Rs.) 3.1 3.2 2.7
Other data:
Machine hours 8 7 6
Maximum demand per month (units) 900 3,000 5,000

Additional information:
▪ AL is also engaged in the trading of a fourth product Zeta, which is very popular in the market and generates a
positive contribution. AL currently purchases 600 units per month of Zeta from a supplier at a cost of Rs. 40
per unit. In-house manufacture of Zeta would require: 2.5 kg of material-B, 1 hour of direct labour and 2
machine hours.
▪ Materials A and B are purchased from a single supplier who has restricted the supply of these materials to
22,000 kg and 34,000 kg per month respectively. This restriction is likely to continue for the next 8 months.
▪ AL has recently accepted a Government order for the supply of 200 units of Alpha, 300 units of Beta and 400
units of Gamma each month for the next 8 months. These quantities are in addition to the maximum demand
stated above.
▪ There is no beginning or ending inventory.

Required:
Determine whether AL should manufacture Zeta internally or continue to buy it from the supplier during the next 8
months. (10 marks)

62 Page 7 of 51
 Make or buy decisions non financial factors
Non-financial considerations relevant to make or buy decision (from book as well)
Risks of outsourcing work:
• Supplier may produce items of a lower standard of quality.
• The supplier may fail to meet delivery dates and the buyer may be dependent on the supplier to commit
onward delivery to its buyer. In case of buying of a component, production process of the end-product may be
held up by a lack of component.

Benefits of outsourcing work:

• Outsourcing work will enable the management to focus all of its efforts on those aspects of operation the
entity does best (e.g. we have no experyise of manufacturing tyres as a car manufacturer).
• The external supplier may have specialist expertise which enables it to provide outsourced products more
efficiently and at a cheaper price. 14.1 (At the end)
14.2

Q. 6 Toy Limited is engaged in the production of a single product. On the basis of past history, the management
has estimated the cost of production per unit, as follows:
Rupees
Raw material - 5 kg @ Rs. 40 per kg 200
Labour - 10 hours @ Rs. 25 per hour 250
Variable overheads - 60% of direct labour 150
Total 600

The annual production requirement is 100,000 units.

The management has been deeply concerned with the performance of its labour as it has been witnessing various
inefficiencies. The industrial relations department has recently carried out a study under the guidance of a
consultant. It has put forward a plan whereby the company’s wage policy is to be revised as under:
■ Rate of wages would be increased by 12%.
■ Workers who perform their tasks in less than the estimated time of 10 hours per unit would be given a
premium of Rs. 18 per hour saved.

The consultant is of the view that the following efficiencies can be brought about by introducing the above change:
i. Raw material input per unit includes wastage of 7%. It would reduce to 3% .
ii. 70% of the workers would work more efficiently and improve their efficiency by 20%.
iii. Overheads will be reduced to 55% of the revised cost of direct labour (including premium).
iv. The quality of production will improve and the rate of rejection will be reduced from 4% to 3%. Rejected units
are sold for Rs. 150 each.

Required:
Determine whether it would be beneficial for the company to adopt the wage plan recommended by the industrial
relations department.

Note: in such a question, first calculate the profit in the current scenario and then in revised scenario. After that
make a comparison between the profits.

63 Page 8 of 51
 Why wish upon a star? when we can pray to the one who created that star

SHORT TERM DECISION MAKING

If there is some spare production capacity available.

Suppose a factory has available capacity of 100,000 units. Available orders are of suppose 80,000 units. Lets
assume we are at a profit.

However, there is a spare capacity of 20,000 units.

Suppose there is a call from a customer to purchase 8,000 units and we have to quote a selling price to the
customer.

To calculate our selling price we should first calculate the relevant cost of 8,000 units which should be sum of
relevant cost of material, labor and overheads.

Minimum price for a one off contract is its total relevant cost.

Relevant Cost of Material:

Is material No Current
in stock Purchase Price
Yes

Is material of Yes Replacement

regular use Cost

No Contribution
form alternate
use, if any
Higher of

NRV from
Sale

Important points:
• If suppose material is in stock but not used regularly and in addition it can neither be sold nor there is any
alternate use; then the relevant cost is zero.
• If suppose in the above situation, the material was required to be disposed off by incurring any cost; then the
cost will be saved if material is used instead of being disposed off. It will therefore be deducted while
calculating the total relevant cost of the contract.

64 Page 9 of 51
Relevant Cost of Labour: (Permanent)
Is labour Idle or Spare Time Available for the Contract

Yes No

Relevant Cost is Zero Can they be hired

Yes No

Rate/hour + Cost of hiring Lower of:

(e.g advertisement in  Overtime payment to
newspaper and training existing workers; and
cost)  Opportunity Cost of
abanding the other job
(contribution lost from
abandoning the
contract which is
being fulfilled in
normal time)
 Variable overheads are a relevant cost
 Incremental fixed costs are relevant costs
 General fixed costs or fixed costs based on absorption rate are not relevant costs.

Q. 7 Tychy Limited (TL) is engaged in the manufacture of Specialized motors. The company has been asked to
provide a quotation for building a motor for a large textile industrial unit in Punjab. Following information has
been obtained by TL’s technical manager in a one-hour meeting with the potential customer. The manager is paid
an annual salary equivalent to Rs. 2,500 per eight-hour day.
▪ The motor would require 120 ft of wire-C which is regularly used by TL in production. TL has 300 ft of wire-C in
inventory at the cost of Rs. 65 per ft. The resale value of wire-C is Rs. 63 and its current replacement cost is Rs.
68 per ft.
▪ 50 kg of another material viz. Wire-D and 30 other small components would also be required by TL for the
motor. Wire-D would be purchased from a supplier at Rs. 10 per kg. The supplier sells a minimum quantity of
60 kg per order. However, the remaining quantity of wire-D will be of no use to TL after the completion of the
contract. The other small components will be purchased from the market at Rs. 80 per component.
▪ The manufacturing process would require 250 hours of skilled labour and 30 machine hours. The skilled
workers are paid a guaranteed wage of Rs. 20 per hour and the current spare capacity available with TL for
such class of workers is 100 direct labour hours. However, additional labour hours may be obtained by either:
✓ Paying overtime at Rs. 23 per hour; or
✓ Hiring temporary workers at Rs. 21 per hour. These workers would require 5 hours of supervision by AL’s
existing supervisor who would be paid overtime of Rs. 20 per hour. The machine on which the motor
would be manufactured was leased by TL last year at a monthly rent of Rs. 5,000 and it has a spare
capacity of 110 hours per month. The variable running cost of the machine is Rs. 15 per hour.
▪ Fixed overheads are absorbed at the rate of Rs. 25 per direct labour hour.

65 Page 10 of 51
Required:
Compute the relevant cost of producing textile motor. Give brief reasons for the inclusion or exclusion of any cost
from your computation. (10 marks)

12.1,12.2,12.3
Global (Pvt) Ltd.
Discussion of the chapter from the book (decision making)
Discussion of the chapter from the book (relevant costing)

Depreciation:
Relevant cost means a future cash flow incurred as a direct consequence of making a decision.

Is depreciation is a relevant cost?

Depreciation is not a relevant cost if the asset is already purchased / used by the business; irrespective of the
method of depreciation. However, if a decision making scenario requires to purchase an asset then depreciation is
a relevant cost.

Q. 8 Decimal World Limited manufactures and sells modems. It manufactures its own circuit boards (CB), an
important part of the modem. The present cost to manufacture a CB is as follows:

Rupees
Direct material 440
Direct labour 210
Variable overheads 55
Fixed overheads
Depreciation 60
General overheads 30
Total cost per unit 795

The company manufactures 400,000 units annually. The equipment being used for manufacturing CB has worn out
completely and requires replacement. The company is presently considering the following options:
▪ Purchase new equipment which would cost Rs. 240 million and have a useful life of six years with no salvage
value. The company uses straight-line method of depreciation. The new equipment has the capacity to
produce 600,000 units per year. It is expected that the use of new equipment would reduce the direct labour
and variable overhead cost by 20%.
▪ Purchase from an external supplier at Rs.730 per unit under a two year contract.

The total general overheads would remain the same in either case. The company has no other use for the space
being used to manufacture the CBs.

Required:
• Which course of action would you recommend to the company assuming that 400,000 units are needed each
year? (Show all relevant calculations)
• What would be your recommendation if the company’s annual requirements were 600,000 units?
• What other factors would the company consider, before making a decision?

66 Page 11 of 51
Q.9 Areesh Limited deals in various products. Relevant details of the products are as under:

AW AX AY AZ
Estimated annual demand (units) 5,000 10,000 7,000 8,000
Sales price per unit (Rs.) 150 180 140 175
Material consumption:
Q(kg) 2 2.5 1.5 1.75
S (kg) 0.5 0.6 0.4 0.65
Labour hours 2 2.25 1.75 2.5
Variable overheads (based on labour cost) 75% 80% 100% 90%
Fixed overheads per unit (Rs.)
(based on 80% capacity utilization) 10 20 14 16
Machine hours required:
Processing machine hours 5 6 8 10
Packing machine hours 2 3 2 4

Company has a long term contract for purchase of material Q and S at a price of Rs. 15 and Rs. 20 per kg
respectively. Wage rate for 8 hours shift is Rs. 200.

The estimated overheads given in the above table are exclusive of depreciation expenses. The company provides
depreciation on number of hours used basis. The depreciation on each machine based on full capacity utilization is
as under:
Hours Rs.
Processing machine 150,000 150,000
Packing machine 100,000 50,000

The company has launched an advertising campaign to promote the sale of its products. Rs. 2 millions have been
spent on such campaign. This cost is allocated to the products on the basis of sale.

Required:
Compute the number of units of each product that the company should produce in order to maximize the profit
and also compute the product wise and total contribution at optimal product mix. (15)

67 Page 12 of 51
 When Love is for the sake of ALLAH, It never dies.

Solutions:

A. 1 Computation of net profit on the basis of optimum product mix:

Pentagon Hexagon Octagon
Selling price 2,300 1,550 2,000
Less: Variable Costs
Direct Material
(250 x 6 /0.9) 1,666.67
(250 x 4 /0.95) 1,052.63
(250 x 5 /0.92) 1,358.70
Direct Labour
[15,000 /200 x (20/60)1 25
[15,000 /200 x (30/60)1 37.5
[15,000 /200 x (45/60)1 56.25
Variable Overheads
[1666.66 x 20% - (Rs. 50 x 4 hrs) 133.33
[1052.63 x 20% - (Rs. 50 x 2.5 hrs)l 85.53
[1358.70 x 20% - (Rs. 50 x 3 hrs)l 121.74
Total Variable Cost 1,825.00 1,175.66 1,536.69
Contribution per unit 475.00 374.34 463.31
Machine Hours required per unit 4.0 2.5 3.0
Contribution per Machine Hour 118.75 149.74 154.44
Ranking 3 2 1

Now, the scarce Hours will be allocated as per ranking.

Product Volume Hours required Hours used Balance unused
100,000
Octagon 9,000 3.0 27,000 73,000
Hexagon 20,000 2.5 50,000 23,000
Pentagon (Bal.) 5,750 4.0 23,000 -

Profit arising from above production plan

Product Units Contribution per unit Contribution margin
Octagon 9,000 463.31 4,169,790
Hexagon 20,000 374.34 7,486,800
Pentagon 5,750 475.00 2,731,250
Total Contribution 14,387,840
Less: Fixed costs (5,000,000)
Net Profit 9,387,840

68 Page 13 of 51
A. 2 Calculation of net profit for the month:
Computation of limiting factor:

25,500
Estimated labour hours available each month

Divided by labour hours required per box [(30 x 1)+(15 x 4)+(18x5)] / 60 3

No. of boxes that can be produced within available labour hours 8,500
45,000
Estimated machine hours available each month
Divided by : machine hours required per box [(30 + 75 + 120)] / 60 3.75`
No. of boxes that can be produced within available machine hours 12,000
Therefore, limiting factor is labour hours.

Products
Pillow Bed Quilt
Cover Sheet Cover
Direct material [1x200],[4x300],[5x400] 200 1,200 2,000
Direct labor
[400x30-60x1],[400x15-60x4],[400x18-60x5] 200 400 600
Variable overhead [5x30],[4x75],[3.75x120] 150 300 450
Variable cost per product 550 1,900 3,050
Less: Outsourcing cost per product (750) (2,000) (3,500)
Cost saving from in-house production 200 100 450
Direct labour hours per unit 0.50 1.00 1.50
Cost saving per labour hour 400 100 300
Ranking 1 3 2

Scarce hours allocated as per ranking (optimum production plan):

Labour aurs Available

Quantity used Hours
25,500
First Produce - Pillow cover 11,000 5,500 20,000
Then Produce - Quilt cover 11,000 16,500 3,500
Finally produce - Bed sheet 3,500 3,500 -
No. of Bed sheets to be outsourced 7,500

Statement showing net profit for the month:

Products
Pillow Bed Quilt Rs. in ‘000
Cover Sheet Cover
Rupees
Sales [11,000 x Rs. 8,000] 88,000
Less: Expenses:

69 Page 14 of 51
Units produced 11,000 3,500 11,000
Variable manufacturing cost per product 550 1,900 3,050

6,050,000 6,650,000 33,550,000 (46,250)

Units outsourced 7,500

Outsourcing cost per bed sheet 2,000
Cost on quality check [11,000xRs. 300] 15,000,000 (15,000)
(3,300)

Total variable costs (64,550)

Total contribution 23,450
Less: Fixed cost (10,000)
Net profit for the month 13,450

A.3

a) Production Mix to earn Maximum Profit:

X Y Z
Selling Price 3,750 3,500 4,500
Less: Variable Cost (2400) (1800) (2700)
Labor (12x75) (900) (1200) (1125)
Contribution Margin 450 500 675
Material Required for Unit 1.6 1.2 1.8
Contribution/Kg of material 281 417 375
Ranking III I II

Maximum Availability of Material = 3000 Kg

Material to be utilized for Y (800x1.2) = (960) Kg
Material Available for others 2,040 Kg

Units of Z = 2,040/1.8
= 1,133 Units
Therefor as still there is a remaining demand of Z, X cannot be produced.

b) Production Mix
X Y Z
Purchase Price per unit 3,450 3,100 3,985
Less: Variable Cost per unit (3,300) (3,000) (3,825)
Extra Cost of purchasing per unit 150 100 160
Material required for a unit 1.6 1.2 1.8
Extra cost of purchase per unit of limiting factor 94 83 89
Ranking 1 3 2

70 Page 15 of 51
 Maximum Availability of Material = 3000 Kg
Material to be utilized for X (1000x1.6) = (1600) Kg
Material Available for others 1,400 Kg

Units of Z = 1,400/1.8
= 778 Units
So Y Cannot be produced

Therefor company should plan as follows:

Produce Purchase
X 1000 units Nil
Z 778 units 422 (1,200-778)
Y Nil 800

A. 4
Identification of limiting factor limiting factors: Material B (kg) Skilled labour
(hrs.)
Available resources per annum (27,700x12),(35x3x25x12x8) 332,400 252,000
Total required resources:
C031 (40,000+25,000)x3.5, 2.4 (227,500) (156,000)
D032 (50,000+24,000)x2.6, 2.0 (192,400) (148,000)
Shortage of material B and skilled labour (87,500) (52,000)

Product C031 Product D032

Rs. Per unit

Sales price 1,965.00 1,410.00
Variable costs
Material A 4x25 3x25 (100) (75)
Material B 3.5x60 2.6x60 (210) (156)
Labour skilled 2.4x250 2x250 (600) (500)
Labour semi skilled 5x120 2.5x120 (600) (300)
Overheads (125) (60)
(1,635) (1,091.00)
Contribution margin per unit A 330 319
Contribution margin per limiting
factor:
■ Material B (A+3.5), (A+2.6) 94.29 122.69
■ Skilled labour (A+2.4), (A+2.0) 137.50 159.50
Priority 2 1

71 Page 16 of 51
 Every new breath that ALLAH allows you to take is not just a blessing but also a responsibility.

Optimum production using the limiting factors:

Material B:
Available 332,500
Required for:
Export 031 (25,000 x 3.5) 87,500
Export 032 (24,000 x 2.6) 62,400
Local 032 (50,000 x 2.6) 130,000
Remaining 52,500

Remaining material can be used for local 031, however only 15,000 units can be produced (52,500/3.5)

Skilled labor:
Available 252,000
Required for:
Export 031 (25,000 x 2.4) 60,000
Export 032 (24,000 x 2) 48,000
Local 032 (50,000 x 2) 100,000
Remaining 44,000

Remaining hours can be used for local 031, however only 18,333 units can be produced (44,000/2.4)

Conclusion: on the basis of the available resources; we can only produce 15,000 units of local 031.

Another scenario:
In same previous question; scientific chemicals limited, suppose there is no restriction of export contract.
Product 031 Product 032
Export Local Export Local
Sale Price / Unit 2,100 1,965 1,500 1,410
Variable Cost / Unit (1,635) (1,635) (1,091) (1,091)
465 330 409 319
Material B 3.5 3.5 2.6 2.6
Skilled Labor 2.4 2.4 2.00 2.00
Material B (465 / 3.5) 132.9 94.29 157.3 122.69
Skilled Labor (465 / 2.4) 193.75 137.5 204.5 159.50
Ranking for Material B 2 4 1 3
Ranking for Skilled Labor 2 4 1 3

72 Page 17 of 51
A.5
Ranking of Products:
A B G Z
External
Selling Price per unit 66 88 106 40
purchase price
Variable Cost per unit (8+12+25+3.1) (48.1) (51.2) (63.7) (26)*
(Saving by
Contribution per unit 17.9 36.8 42.3 14
Manufacturing)
Kgs required per unit 2 3 4 2.5
Contribution/kg of B (working) 8.95 12.27 10.58 5.6
(17.9 ÷ 2) (36.8 ÷ 3) (42.3 ÷ 4) (14 ÷ 2.5)
Ranking (3) (1) (2) (4)

* Variable Cost of Z:
Material 2.5 kg × 6 = 15
Labour 1 hr. × 10 = 10
Variable OHs:
Labour hours (1 × 0.6) = 0.6
Machine hours (2 × 0.2 ) = 0.4
26

Calculation of Variable OH Rate per Hour:

Using Alpha (or other product can also be used)
Rs. 1.5 / unit = Labour rated V-OH
Labour hours / unit = 25/10 = 2.5 hours
So 1.5 / 2.5 = 0.6/hour
Machine Related VOH
1.6/8 = 0.2 per hour

or Beta
1.8/3* = 0.6
*(30/10)
1.4/7 = 0.2
or Gamma
1.5/2.5* 0.6
*(25 ÷ 10)
1.2 / 6 = 0.2

73 Page 18 of 51
 Dua Heals All Negativity, Hurt, Anger, Worries and Depression. Pray to ALLAH Daily.

Production Plan:
Required Kg Remaining
Available 34,000 kg. First Produce Beta = 9,900 24,100
Then produce Gamma = 21,600 2,500
Then produce Alpaha = 2,200 300
Then produced (300 ÷ 2.5) = 120 units
of zeta and purchase from market 480 (600 - 120)

Workings:
Both Material A and Material B are limited in supply during next 8 months, but calculation are required to
determine whether this scarcity affects the production plans of AL. the resources required for the maximum
demand must be compared with the resources available to determine whether either of the materials is a binding
constraint. Total quantity of each product to be manufactured:

Government Order Market Demand Total

Alpha 200 900 1,100
Beta 300 3,000 3,300
Gamma 400 5,000 5,400
Zeta -- 600 600

Resource Available Alpha Beta Gamma Zeta Total

Material – A 22,000 2,200 -- 16,200 -- 18,400 Sufficient
(1,100 x2) (not req) (5,400x3) (not req)
Material – B 34,000 2,200 9,900 21,600 1,500 35,200 Scarce
(1,100×2) (3,300×3) (5,400×4) (600×2.5)

It can be seen from the above working that the scarcity of material B is a binding constraint and therefore the
contributions of each product and the contribution per kg of material B must be compared.

A.6
TOY LIMITED
100,000 
Existing Scenario:   100 = 104,167 Units
 96 
Material 104,167 × 200 = 20,833,400
Labour 104,167 × 250 = 26,041,750
VOH 104,167 × 150 = 15,625,050
62,500,200
Recovery (4,167 × 150) = (625,050)
61,875,150

74 Page 19 of 51
 100,000 
Revised Scenario:   100 = 103,093 Units
 97 
Material (103,093 × 4.794 × 40) = 19,769,114
Direct Labour:
103,093 × 10 × 30% = 309,279 hr
103,093 × 10 × 70% × 80% = 577,321 hr
Hrs. Required in revised scenario 886,600

886,600 × 25 × 1.12 = 24,824,800

Add: Premium:
103,093 × 10 1,030,930
Utilized hrs (as above) 886,600
Saved Hours 144,330

× 18 = 2,597,940

Over Heads (70% of 27,422,740*) 15,082,507

*[24,824,794 + 2,597,940]

Recovery (3,093 × 150) (463,950)

61,810,411
Saving by implementing the plan: 64,739 (61,875,150 – 61,810,411)

A. 7
Tychy Limited (TL)
Note Rs.
Technical manager - meeting 1 NIL
Wire – C (120 x 68) 2 8,160
Wire – D 3 600
Components 4 2,400
Direct labour 5 3,250
Machine running cost 6 450
Fixed overhead 7 NIL
Total relevant cost 14,860

Notes:
▪ In case of technical manager’s meeting with the potential client, the relevant cost is NIL because it is not only a
past cost but also the manager is paid an annual salary and therefore TL has incurred no incremental cost on
it.
▪ Since wire-C is regularly used by TL, its relevant value is its replacement cost. The historical cost is not relevant
because it is a past cost and the resale value is not relevant since TL is not going to sell it.
▪ Since wire-D is to be purchased for the contract therefore its purchase cost is relevant. TL only requires 50 kg
of wire-D but due to the requirement of minimum order quantity TL will be purchasing 60 kg of the material
and since TL has no other use for this material, the full cost of purchasing the 60 kg is the relevant cost.

75 Page 20 of 51
 Men and Women have equal rewards for their deeds”. Quran 3:195

▪ Since the components are to be purchased from the market at a cost of Rs. 80 each. Therefore, the entire
purchase price is a relevant cost.
▪ The 100 hours of direct labour are presently idle and hence have zero relevant cost. The remaining 150 hours
are relevant. TL has two choices: either use its existing employees and pay them overtime at Rs. 23 per hour
which is a total cost of Rs. 3,450: or engage the temporary workers which would cost TL Rs. 3,250 including
supervision cost of Rs. 100. The relevant cost is the cheaper of the two alternatives i.e. Rs. 3250.
▪ The lease cost of machine will be incurred regardless of whether it is used for the manufacture of motors or
remains idle. Hence, only the incremental running cost of Rs. 15 per hour is relevant.

Fixed overhead costs are incurred whether the work goes ahead or not so it is not a relevant cost.

A.8
Decimal World Limited:
(a) Per Unit Cost of In-house Manufacturing: (if 400,000 units are needed)
Material 440
Labour (210 × 80%) 168
Variable Overheads (55 × 80%) 44
 240M 
Depreciation   ÷ 400,000 100*
 6 
752
*incremental fixed cost
Per unit cost offered by supplier = 730
Therefore company should purchase from external supplier.
(b) If the company decides to produce 600,000 units, depreciation per unit would reduce to 67
(240 M ÷ 6 / 600,000) and the cost of production to 719 (440 + 168 + 44 + 67). In that case, company should
produce in-house.
(c) Other Factors to be Considered before Making Decision:
(i) Quality of CB manufactured by external supplier.
(ii) External supplier’s capacity to cope future increase in demand of CB by decimal world limited.
(iii) What would be the price of CB after 2 years?
(iv) Alternate use of surplus capacity of 200,000 units.

76 Page 21 of 51
A.9
Contribution per Unit:
AW AX AY AZ
Sales 150 180 140 175
Total Variable Costs:
Material Q (2×15) 30 (2.5×15) 37.5 (1.5×15) 22.5 (1.75×15) 26.5
Material S (0.5×20) 10 (0.6×20) 12 (0.4×20) 8 (0.65×20) 13
Labour  200   200   200   200 
  2  50   2.25  56.25   1.75  43.75   2.5  62.5
 8   8   8   8 
Variable Overheads (50×75%) 37.5 (56.25×80%) 45 (43.75×100%) 43.75 (62.5×90%) 56.25
(127.5) (150.75) (118) (158)
Contribution/Units 22.50 29.25 22.00 17.00

Total Packing Machine Hours Required:

(5,000 × 2) + (10,000 × 3) + (7,000 × 2) + (8,000 × 4) = 86,000 hrs.
Total packing machine hours available are 100,000 whereas 86,000 hours are required. Therefore, packaging
machine hours, although limited, are not limiting factor.

Total Processing Machine Hours Required:

(5,000 × 5) + (10,000 × 6) + (7,000 × 8) + (8,000 × 10) = 221,000 hrs.
However, only 150,000 hours are available

Hence limiting factor is processing machine hours.

Product AW AX AY AZ
Contribution per unit 22.5 29.25 22.00 17.00
Hours needed (of limiting factor) 5 6 8 10
Contribution / hr of limiting factor 4.5 4.88 2.75 1.7
Ranking 2 1 3 4

Units
AX 10,000 Hours remaining = 150,000 – 60,000 = 90,000
AW 5,000 Hours remaining = 90,000 – (5,000 × 5) = 65,000
AY 7,000 Hours remaining = 65,000 – (7,000 × 8) = 9,000
AZ 900 9,000/10 = 900 units

77 Page 22 of 51
 Many skin colors. One Ummah. No Racism is ISLAM.

Contribution at Optimal Production:

Product AW AX AY AZ Total
Contribution /unit 22.5 29.25 22.00 17.00
No. of units produced 5,000 10,000 7,000 900
Contribution 112,500 292,500 154,000 15,300 574,300

Extra questions
Question 1
NK Enterprises produces various components for telecom companies. The demand of those components is
increasing. However, NK’s production facility is restricted to 50,000 machine hours only. Therefore, NK is
considering to buy certain components externally. In this respect, the following information has been gathered:
Components
Description
X-1 X-2 X-3 X-4
Estimated demand in units 6,500 2,000 7,100 4,500
Machine hours required per unit 8 4 5 2
In-house cost per unit: ----------- rupees -------------
Direct material 20.0 28.0 23.0 22.0
Direct labour 9.0 5.0 9.0 8.0
Factory overheads 16.0 8.0 8.5 5.0
Allocated administrative overheads 5.0 4.0 3.0 2.0
50.0 45.0 43.5 37.0
External price of the component per unit 35.0 40 34.0 33.0

Factory overheads include fixed overheads estimated at Rs. 1.50 per machine hour.

Required:
Determine the number of units to be produced in-house and bought externally. (13)

Answer 1
NK Enterprises
Number of units to be produced in-house and bought externally:
Identification of limiting factor:
X – 1 (6,500 × 8) = 52,000
X – 2 (2,000 × 4) = 8,000
X – 3 (7,100 × 5) = 35,500
X – 4 (4,500 × 2) = 9,000
Required hrs 104,500
Available hrs 50,000
Shortfall hrs 54,500

78 Page 23 of 51
Variable Cost of In-house Manufacturing:
X–1 X–2 X–3 X–4
Material / Unit 20 28 23 22
Labour / Unit 9 5 9 8
V-OH / Unit 4 2 1 2
(16 – 8 × 1.5) (8 – 4 × 1.5) (8.5 – 5 × 1.5) (5 – 2 × 1.5)
Manufacture Variable Cost /Unit 33 35 33 32
Buying Cost / Unit 35 40 34 33
Saving by Production / Unit 2 5 1 1
Machine hrs / Unit 8 4 5 2
Saving by Production / M hr 0.25 1.25 0.2 0.5
Ranking for in-house product 3 1 4 2
In-house production 4,125 2,000 4,500
(50,000-8,000- (2,000×4)
9,000/8)
Hrs Consumed 33,000 8,000 9,000
(4,125×8) (4,500×2)
Units to be ought externally 2,375 - 7,100 -
(6,500 – 4,,125)

Question 2
Sword Leather Limited (SLL) produces and sells shoes. The following information pertains to its latest financial
year:
Rs. In million
Sales (62,500 pairs) 187.5
Fixed production overheads 35.0
Fixed selling and distribution overheads 10.0

Variable production cost (in proportion of 40:35:25 for material, labour and overheads 60% of sale
respectively)
Variable selling and distribution cost 15% of sale

To increase profitability, SLL has decided to introduce new design shoes and discontinue the existing deigns. In this
regard it has carried out a study whose recommendations are as follows:
(i) Replace the existing fully depreciated plant with a new plant at an estimated cost of Rs. 50 million. The new
plant would:
▪ Reduce material wastage from 10% to 5%;
▪ Decrease direct wages by 5%; and
▪ Increase variable overheads by 6% and fixed overheads by Rs. 15 million (including depreciation
on the new plant).
(ii) Improve efficiency of the staff by paying 1% commission to marketing staff and annual bonus amounting to
Rs. 1.5 million to other staff.
(iii) Introduction of new designs would require an increase in variable selling and distribution cost by 2%.
(iv) Sell the newly designed shoes at 10% higher price.
(v) Maintain finished goods inventory equal to one month’s sale.

79 Page 24 of 51
 “He Knows what is in every Heart” – Surah Mulk {67:13}

Required:
Compute the budgeted production for the first year if the budgeted sale has been determined with the objective
of maintaining 25% margin of safety on sale.

Answer 2
Company is planning to maintain 25% margin of safety; it means if:
Budgeted sales = 100
Breakeven sales = (75)
Margin of safety 25

We can calculate breakeven sales from the above data and then work back wards for budgeted sales and budgeted
production.
Total Fixed Cost
Breakeven sales Units =
Contributi on per Unit
61,500,000 (W − 1)
=
1050.4 (W − 2)
= 58,549 pairs
Budgeted sale = 58,549/75 × 100 = 78,065 Pairs
Pairs to be held in stock [78,065/12] = 6,505 Pairs
Budgeted Production 84,570 Pairs

Workings:
(W-1) Total Fixed Cost:
Rs.
Fixed production OH-given 35,000,000
Increase in fixed OH 15,000,000
Fixed selling and distribution 10,000,000
Annual bonus to employees 1,500,000
61,500,000
(W-2) Contribution/Unit:
Rs.
Sale Price / Unit [187.5 ÷ 62,500] = [3,000 × 1.1] 3,300
Less: variable cost / Unit:
Material [187.5 × 60% × 40% ÷ 100 x 90 / 95 x 100]/62,500 (682.10)
Labour [187.5 × 60% × 35% × 95%]/62,500 (598.5)
V-OH [187.5 × 60% × 25% × 1.06]/62,500 (477)
Variable selling –existing [187.5 × 15% × 1.02]/62,500 (459)
Variable Commission [3,300 × 1%] (33)
Contribution / Unit 1,050.40

80 Page 25 of 51
Question 3
Galaxy Engineers (GE) manufactures and sells a wide range of products. One of the raw materials XPI is in short
supply and only 80,000 kg are available in GE’s stores. Following information pertains to the products in which XPI
is used:
Product A Product B Product C
Budgeted local sales/requirement Units 4,500 1,000 2,500
Committed export sales as per agreement Units - 800 -
------------------------- Per Unit -----------------------
Sales price Rs. 20,000 14,100 For internal use
Material XPI (Rs. 500 per kg) kg 14 12 2
Other material (Rs. 300 per kg) kg 5 3 1
Direct labour hours (Rs. 100 per hour) hours 20 15 5
Variable overheads based on labour cost % 80% 80% 80%
Fixed overheads per direct labour hour Rs. 95 75 60

Product C is used in other products made by GE. If it could not be produced internally, it has to be purchased from
market at Rs. 3,000 per unit.

Required:
Determine the number of units of each product that should be manufactured, to earn maximum profit. (12)

Answer 3
Galaxy engineers
Units to be manufactured to earn maximum profit
Material
Product A Product B Product C
XPI kg
------------ Units -------------
Budgeted sales/requirements 4,500 1,800 2,500
----------- Rupees ----------
For
Sale price per unit 20,000 14,100 internal
use
Purchase price - - 3,000
Cost of production per unit:
Material XPI usage at Rs. 500 per kg (7,000) (6,000) (1,000)
Other material usage at Rs. 300 per kg (1,500) (900) (300)
Direct labour at Rs. 100 per hour (2,000) (1,500) (500)
Variable overheads at 80% of labour cost (1,600) (1,200) (400)
(12,100) (9,600) (2,200)
CM/savings from own manufacturing (A) 7,900 4,500 800

Per unit usage of material XPI (B) kg 14 12 2

CM per one kg of material XPI (A) ÷ (B) Rs. 564 375 400
Ranking based on CM per XPI kg 1st 3rd 2nd

81 Page 26 of 51
Production from available material XPI:
Production of committed export sales - 800 - 9,600
Production in ranking order 4,500 200 2,500 70,400
Optimal production Units 4,500 1,000 2,500 80,000

Question 4
Global (Pvt.) Limited (GPL) is in the process of preparing bid documents for a special order of 5,000 units of a new
product Zeta. In this respect, GPL’s technical department has worked-out the following projections/information:
(i) The order would be completed in 15 days.
(ii) GPL has sufficient stock of the required materials to produce Zeta. Some of the relevant information is as
follows:
Material A Material B Material C
Quantity required 5,000 kg 3,000 kg 2,000 kg
Original purchase price Rs. 180 per kg Rs. 150 per kg Rs. 50 per kg
Current purchase price Rs. 200 per kg Rs. 175 per kg Rs. 60 per kg
Current disposal price Rs. 100 per kg Rs. 135 per kg Nil

• Material A is used by GPL in many products and therefore sufficient stock is maintained.
• Material B has no use other than in the production of Zeta.
• The stock of material C was purchased several years ago for another project. It can only be used in
the production of Zeta. Otherwise, it will have to be disposed of at a cost of Rs. 10 per kg to meet
environmental legislation.
(iii) The production of Zeta would require:
• 800 skilled labour hours at Rs. 200 per hour. Presently, 1,440 labour hours remain idle during each
month.
• 250 unskilled labour hours which can be hired at Rs. 120 per hour.
• 150 machine hours. If the machine is not used for Zeta, it may be leased out at Rs. 4,000 per day.
(iv) GPL absorbs overheads at Rs. 400 per skilled and unskilled labour hours. Based on normal capacity of
50,000 hours, fixed overheads are estimated at Rs. 6,000,000. If GPL decides to produce Zeta, fixed
overheads would increase by Rs. 150,000.
(v) As result of production of Zeta, general administration cost would increase by Rs. 100,000.
(vi) The planning department of GPL has incurred a cost of Rs. 20,000 on preparing feasibility for production of
Zeta.

Required:
Compute the bid price that GPL should quote, if it wants to earn profit (based on relevant costs only) of 20% of
selling price.

82 Page 27 of 51
Answer 4
Global (Pvt.) Limited
Computation of bid price for Zeta
Rupees
Material A – at current purchase price 5,000×200 1,000,000
Material B – at current selling price 3,000×135 405,000
Material c – disposal cost saving 2,000×10 (20,000)
Skilled labour hours –after using idle hours [800-(1440÷2)]×200 16,000
Unskilled labour hours 250×120 30,000
Machine opportunity cost 15 days × 4,000 60,000
Variable overheads
[6,000,000 / 50,000 = 120 hrs; 400 – 120 = 280; 280 x (800 + 250)] 294,000
Incremental fixed overheads 150,000
Increase in general administrating costs 100,000
Feasibility cost incurred by planning department – sunk cost -
Total relevant cost 2,035,000

Bid price to earn 20% profit on selling price [2,035,000 ÷ 80 x 100] 2,543,750

Q.5 Topaz Limited (TL) is the manufacturer of consumer durables. Pearl Limited, one of the major
customers, has invited TL to bid for a special order of 150,000 units of product Beta.

Following information is available for the preparation of the bid.

(i) Each unit of Beta requires 0.5 kilograms (kg) of material “C”. This material is produced internally in
batches of 25,000 kg each, at a variable cost of Rs. 200 per kg. The setup cost per batch is Rs. 80,000.
Material “C” could be sold in the market at a price of Rs. 225 per kg. TL has the capacity to produce
100,000 kg of material “C”; however, the current demand for material “C” in the market is 75,000 kg.
(ii) Every 100 units of product Beta requires 150 labour hours. Workers are paid at the rate of Rs.9,000
per month. Idle labour hours are paid at 60% of normal rate and TL currently has 20,000 idle labour
hours. The standard working hours per month are fixed at 200 hours.
(iii) The variable overhead application rate is Rs. 25 per labour hour. Fixed overheads are estimated at
Rs. 22 million. It is estimated that the special order would occupy 30% of the
total capacity. The production capacity of Beta can be increased up to 50% by incurring additional
fixed overheads. The fixed overhead rate applicable to enhanced capacity would be
1.5 times the current rate. The utilized capacity at current level of production is 80%.
(iv) The normal loss is estimated to be 4% of the input quantity and is determined at the time of inspection
which is carried out when the unit is 60% complete. Material is added to the
process at the beginning while labour and overheads are evenly distributed over the process.
(v) TL has the policy to earn profit at the rate of 20% of the selling price.

Required:
Calculate the unit price that TL could bid for the special order to Pearl Limited.

83 Page 28 of 51
A.6
TOPAZ LIMITED
Rs.
Material Cost (W-1) 17,033,125
Labour Cost (W-2) 9,838,125
Variable Cost (W-3) 5,765,625
Fixed Overheads (W-4) 3,300,000
Total Cost 35,936,875
Profit Margin (35,936,875 ÷ 80 × 20) 8,984,219
Sales 44,921,094
Total Units 150,000
Per Unit Sale Price 299.47

WORKINGS:
(W-1) Material Cost:
Units of beta to be produced = 150,000
Each unit requires 0.5 kg of material
So material required = 75,000 kg to convert into 150,000 units.
As there is a 4% normal loss therefore
Input raw material – Lost raw material = Raw material in Output
100% – 4% = 96%
75,000 ÷ 96% = 78,125 kg will be needed to be produced to get 150,000 units of Beta.
25,000 kg can be manufactured as capacity is available:
25,000 × 200 5,000,000
Set up cost (incremental for 25,000 kgs) 80,000
5,080,000

Remaining kgs will need to be manufactured by reducing market sale so that the relevant cost will be market value
lost (Opportunity Cost).
(78,125 – 2,5000) × 225 / kg = 11,953,125
(200 variable cost + 25 contribution lost) 17,033,125
(W-2) Labour Cost:
Hours per unit:150/100 = 1.5
Per hour rate = 9,000 ÷ 200
= 45/hour
But labour cost is required to be incurred on 156,250 units (78,125 x 2).
Therefore total hours required will be:
Hours
Completed units = 150,000 x 1.5 = 225,000
Lost unit = (156,250-150,000) = 6,250 x 1.5 × 60% = 5,625
Total hours required 230,625
So labour cost = (20,000 × 45 × 40%) + (210,625 × 45) = 9,838,125
(W-3) Variable Overheads:
230,625× 25 = 5,765,625

84 Page 29 of 51
(W-4) Fixed Overheads:
Current Fixed Overheads at 100% capacity = 22M
Fixed Overheads for 1% capacity = 0.22M
Fixed overheads for 1% of increase in capacity (1.5 times of normal) = 0.33M
Special order would take 30% capacity and 20% capacity is unused and free so only 10% capacity needs to
be increased and therefore cost of increased capacity is relevant for special order. So total relevant cost is
0.33 × 10 = 3.3M.

Q.6 Alpha Limited (AL) manufactures and sells products A, B and C. In view of limited production capacity, AL is
meeting the demand for its products partly through imports.

The following information has been extracted from the budget for the next year:

A B C
Machine hours used in production 240,000 225,000 270,000
- No. of units
Sale 42,000 35,000 26,500
Production 30,000 25,000 22,500
Imports 12,000 10,000 4,000
Rs. in million
Sales 252.00 175.00 185.50
Cost of production:
- Direct material 48.00 31.25 40.50
- Direct labour 45.00 40.00 56.25
- Variable overheads 33.00 25.00 29.25
- Fixed overheads 28.80 27.00 32.40
Cost of import of finished products 68.40 47.00 26.88

Additional information:
▪ AL is working at 100% capacity.
▪ AL believes that it can obtain substantial quantity discounts from foreign suppliers if it increases the import
volumes. Each product is supplied by a different supplier. After intense negotiations, the suppliers have
offered discounts of 15%, 10% and 12% for products A, B and C respectively.

Required:
Prepare a product-wise plan of production/imports to maximize the company’s profitability.

85 Page 30 of 51
A.7
identification of limiting factor:
Total available hours(240,000+225,000+270,000) 735,000
Total required hours:
A (42,000 x 8) 336,000
B(35,000 x 9) 315,000
C(26,500 x 12) 318,000
Total 969,000

Machine hours are a limiting factor.

Production / import plan:

Product A Product B Product C
Capacity utilization (Machine hours)
(A) 240,000 225,000 270,000

Sales of units to be produced (B) 30,000 25,000 22,500

Sales of units to be imported (C) 12,000 10,000 4,000
Total sale units 42,000 35,000 26,500

Rupees in million
Variable Cost of production:
Direct material 48.00 31.25 40.50
Direct labour 45.00 40.00 56.25
Overheads 33.00 25.00 29.25
Total cost (D) 126.00 96.25 126.00

Rupees
Cost per produced unit F (D/B) 4,200.00 3,850.00 5,600.00

Rupees in million
Cost of imports:
Existing cost of imported finished goods: 68.40 47.00 26.88
Bulk discount offered 15% 10% 12%
Discounted price of imported goods (F) 58.14 42.30 23.65

Rupees
Cost per imported unit G (F/C) 4,845.00 4,230.00 5,912.50

Variable cost of production / unit 4,200 3,850 5,600

Outsourcing cost per unit 4,845 4,230 5,912.5
Saving by producing per unit 645 380 312.5
Machine hours per unit (240,000/30,000) 8 9 12
Saving per hour 80.625 42.22 26.04

86 Page 31 of 51
Ranking 1 2 3
Product-A Units demand 42,000
Hrs. utilized (42,000x8) 336,000
Product-B Units demand 35,000
Hrs. utilized (35,000x9) 315,000
Product-C Units from remaining hrs. 7,000
Remaining hrs, [735-336-315] 84,000

Import plan:
Product-C:
Demand exceeding production (26,500-7,000) .- -. 19,500
Total units 42,000 35,000 26,500

87 Page 32 of 51
 Prayer isn’t For Allah, It’s for us. He doesn’t need us But we need him.

Terms used in relevant costing

Several terms are used in relevant costing, to indicate how certain costs might be relevant or not relevant to a
decision.

Incremental cost
An incremental cost is an additional cost that will occur if a particular decision is taken. Provided that this
additional cost is a cash flow, an incremental cost is a relevant cost.

Differential cost
A differential cost is the amount by which future costs will be different, depending on which course of action is
taken. A differential cost is therefore an amount by which future costs will be higher or lower, if a particular
course of action is chosen. Provided that this additional cost is a cash flow, a differential cost is a relevant cost.

Example:
A company needs to hire a photocopier for the next six months. It has to decide whether to continue using a
particular type of photocopier, which it currently rents for Rs.2, 000 each month, or whether to switch to using a
larger photocopier that will cost Rs.3, 600 each month. If it hires the larger photocopier, it will be able to
terminate the rental agreement for the current copier immediately.

The decision is whether to continue with using the current photocopier, or to switch to the larger copier. One
way of analysing the comparative costs is to say that the larger copier will be more expensive to rent, by Rs.1,
600 each month for six months. The differential cost of hiring the larger copier for six months would therefore
be Rs.9, 600

Avoidable and unavoidable costs

An avoidable cost is a cost that could be saved (avoided), depending whether or not a particular decision is
taken. An unavoidable cost is a cost that will be incurred anyway.
❑ Avoidable costs are relevant costs.
❑ Unavoidable costs are not relevant to a decision.

Example:
A company has one year remaining on a short-term lease agreement on a warehouse. The rental cost is
Rs.100,000 per year. The warehouse facilities are no longer required, because operations have been moved to
another warehouse that has spare capacity.

If a decision is taken to close down the warehouse, the company would be committed to paying the rental cost
up to the end of the term of the lease. However, it would save local taxes of Rs.16,000 for the year, and it would
no longer need to hire the services of a security company to look after the empty building, which currently costs
Rs.40,000 each year.

The decision about whether to close down the unwanted warehouse should be based on relevant costs only.

88 Page 33 of 51
Local taxes and the costs of the security services (Rs.56,000 in total for the next year) could be avoided and so
these are relevant costs.

The rental cost of the warehouse cannot be avoided, and so should be ignored in the economic assessment of the
decision whether to close the warehouse or keep it open for another year.

Committed cost
Committed costs are a category of unavoidable costs. A committed cost is a cost that a company has already
committed to or an obligation already made, that it cannot avoid by any means.

Committed costs are not relevant costs for decision making.

Leases normally represent a committed cost for the full term of the lease, since it is extremely difficult to
terminate a lease agreement.

Sunk costs
Sunk costs are costs that have already been incurred (historical costs) or costs that have already been committed
by an earlier decision. Sunk costs must be ignored for the purpose of evaluating a decision, and cannot be relevant
costs.

DESCRIBE THE TERMS

(a) Opportunity cost:

An opportunity cost is a cost that measures the opportunity that is lost or sacrificed when the choice of
one course of action requires that an alternative course of action be given up.

Example
A company has an opportunity to obtain a contract for the production of Z which will require processing
on machine X which is already working at full capacity. The contract can only be fulfilled by reducing the
present output of machine X which will result in reduction of profit contribution by Rs. 200,000.

If the company accepts the contract, it will sacrifice a profit contribution of Rs. 200,000 from the lost
output of product Z. This loss of Rs. 200,000 represents an opportunity cost of accepting the contract.

(b) Sunk cost

A sunk cost is a historical or past cost that the company has already incurred. These costs cannot be
changed/recovered in any case and are ignored while making a decision.

Example
A company mistakenly purchased a machine that does not completely suit its requirements. The price of
the machine already paid is a sunk cost and will not be considered while deciding whether to sell the
machine or use it.

89 Page 34 of 51
(c) Relevant cost:
The predicted future costs that would differ depending upon the alternative courses of action, are called
relevant costs.
Example
A company purchased a raw material few years ago for Rs. 100,000. A customer is prepared to purchase
it for Rs. 60,000. The material is not otherwise saleable but can be sold after further processing at a cost
of Rs. 30,000.

In this case, the additional conversion cost of Rs. 30,000 is relevant cost whereas the raw material cost of
Rs. 100,000 is irrelevant.

Decision Making Techniques

Make-or-buy decisions: non-financial considerations
When relevant costs are used to make a decision, it is assumed that the decision should be based on financial
considerations and whether the decision will add to profit (cash flows).

In reality, however, managers are likely to think about non-financial issues as well as financial issues when
making their decisions. The non-financial considerations in any decision will depend on the circumstances, and
will vary from one decision to another. Non-financial considerations can influence a decision. In your
examination, be prepared to identify relevant non-financial issues in a particular situation, and discuss their
potential implications.

Non-financial considerations that will often be relevant to a make-or-buy decision include the following.

1. When work is outsourced, the entity loses some control over the work. It will rely on the external
supplier to produce and supply the outsourced items. There may be some risk that the external supplier
will:
• produce the outsourced items to a lower standard of quality, or
• fail to meet delivery dates on schedule, so that production of the end- product may be held up by a
lack of components.

2. The entity will also lose some flexibility. If it needs to increase or reduce supply of the outsourced item at
short notice, it may be unable to do so because of the terms of the agreement with the external supplier.
For example, the terms of the agreement may provide for the supply of a fixed quantity of the outsourced
item each month.

3. A decision to outsource work may have implications for employment within the entity, and it may be
necessary to make some employees redundant. This will have cost implications, and could also adversely
affect relations between management and other employees.
4. It might be appropriate to think about the longer-term consequences of a decision to outsource work.
What might happen if the entity changes its mind at some time in the future and decides either (a) to bring
the work back in-house or (b) to give the work to a different external supplier? The problem might be that
taking the work from the initial external provider and placing it somewhere else might not be easy in
practice, since the external supplier might not be co-operative in helping with the removal of its work.

90 Page 35 of 51
The non-financial factors listed above are all reasons against outsourcing work. There might also be non-
financial benefits from outsourcing work to an external supplier.

• If the work that is outsourced is not specialised, or is outside the entity’s main area of expertise,
outsourcing work will enable management to focus their efforts on those aspects of operations that the
entity does best. For example, it could be argued that activities such as the management of an entity’s fleet
of delivery vehicles, or the monthly payroll work, should be outsourced because the entity itself has no
special expertise on these areas.
• The external supplier, on the other hand, may have specialist expertise which enables it to provide the
outsourced products or services more efficiently and effectively. For example a company might outsource
all its IT support operations, because it cannot recruit and retain IT specialists. An external service provider,
on the other hand, will employ IT specialists

Example: One-off contract decision

Faisal Ltd. is deciding whether or not to proceed with a one-off special contract for which it would receive a
once-off payment of Rs. 200,000.
Details of relevant costs are:
1. The special contract requires 200 hours of labour at Rs.600 per hour. Employees possessing the necessary
skills are already employed by Faisal Ltd. but are currently idle due to a recent downturn in business.
2. Materials X and Y will be used. 100 tonnes of material X will be needed and sufficient material is in
inventory as the material is in common use by the company. Original cost of material in inventory was
Rs.150 per tonne but it would cost Rs.180 per tonne to replace if used in this contract. Material Y is in
inventory as a result of previous over-purchasing. The original cost of material Y was Rs.50,000 but it has no
other use. Unfortunately material Y is toxic and if not used in this contract Faisal Ltd. must pay Rs.24,000 to
have it disposed.
3. The contract will require the use of a storage unit for three months. Faisal is committed to rent the unit for
one year at a rental of Rs.8,000 per month. The unit is not in use at present. However, a neighbouring
business has recently approached Faisal Ltd. offering to rent the unit from them for Rs.11,000 per month.
4. Overheads are absorbed at Rs.750 per labour hour which consists of Rs.500 for fixed overhead and Rs.250
for variable overhead. Total fixed overheads are not expected to increase as a result of the contract.

A trainee accountant has calculated that it will cost Rs. 359,000 to deliver the contract (calculation below) and
concluded that the contract should therefore not be accepted for Rs.200,000.

Description Relevant cost

Rs.
Labour: 200 hours x Rs. 600 120,000
Material X: 100 tonnes x Rs. 150 15,000
Material Y: Original cost 50,000
Storage: 3 months x Rs. 8,000 24,000
Overheads: Rs. 750 x 200 150,000

Total 359,000

91 Page 36 of 51
 No one besides ALLAH can rescue a soul from Hardship” Quran (53 : 58)
Required:
Advise whether the contract should be accepted or not on financial grounds.

Answer: One-off contract decision

1. The relevant cost of labour is zero as no extra cost will be incurred as a result of this contract.
2. The relevant cost of a material that is used regularly is its replacement cost. Additional inventory of the
material must be purchased for use in this contract. The relevant cost of material X is therefore Rs.180 per
tonne i.e. Rs.180 x 1 0 0 = Rs.18, 000.
3. There is a relevant saving from using material Y from not having to pay the disposal cost of Rs.24, 000.
4. As Faisal is already committed to rent the storage unit for one year the monthly rental cost is not relevant to
the contract. However, the opportunity cost is the foregone rental income that Faisal would have made from
the neighbouring business for the three months needed for this contract. i.e. 3 x Rs.11, 000 = Rs.33, 000.
5. The fixed overhead is not relevant because there is no increment to fixed overheads expected as a result of
this contract. Therefore the relevant overhead cost is just the variable part of Rs.250 per hour x 200 hours =
Rs.50,000

So in total the relevant cost is Rs. 77,000 as follows:

Description Relevant cost

Rs.
Labour 0

Material X 18,000

Material Y (24,000)

Storage 33,000

Overheads 50,000

Total 77,000

Conclusion: The contract should be accepted as it would make an incremental profit to Faisal of Rs. 123,000
(revenue of Rs. 200,000 less relevant costs of Rs. 77,000).

Shutdown decisions
A shutdown decision is a decision about whether or not to shut down a part of the operations of a company. From
a financial viewpoint, an operation should be shut down if the benefits of shutdown exceed the relevant costs.

A shutdown decision may be a long-term decision when there are large initial expenditures involved (for example,
costs of making the work force redundant). For the purpose of the examination, however, any shutdown decision
will be a short-term decision.

92 Page 37 of 51
 Example:

Company V makes four products, P, Q, R and S. The budget for next year is as follows:

P Q R S Total

Rs.000 Rs.00 Rs.00 Rs.00 Rs.000

0 0 0
Direct materials 300 500 400 700 1,900

Direct labour 400 800 600 400 2,200

Variable
overheads 100 200 100 100 500
800 1,500 1,100 1,200 4,600

Sales 1,800 1,650 2,200 1,550 7,200

Contribution 1,000 150 1,100 350 2,600

Directly
attributable
fixed costs (400) (250) (300) (300) (1,250)
Share of
general fixed
costs (200) (200) (300) (400) (1,100)
Profit/(loss) 400 (300) 500 (350) 250

‘Directly attributable fixed costs’ are cash expenditures that are directly attributable to each
individual product. These costs would be saved if operations to make and sell the product
were shut down.

Required

State with reasons whether any of the products should be withdrawn from the market.

Joint product further processing decisions

Example:
A company produces two joint products from a common process. For every 100 kilograms of input to the
common process, output consists of 40 kilograms of joint product 1 (JP1) and 60 kilograms of joint product 2
(JP2). The costs of the common process are Rs.400 per 100 kilograms of input.

JP1 can be sold for Rs.10 per kilogram and JP2 can be sold for Rs.16 per kilogram.

93 Page 38 of 51
 When Love is for the sake of ALLAH, It never dies.

Alternatively, JP1 can be processed to make a finished product, FP1. Costs of further processing consist of
variable costs of Rs.6 per kilogram and fixed costs of Rs.120, 000 per year. Of these fixed costs, Rs.96, 000 would
be directly attributable to the further processing operations, and the remaining Rs.24, 000 would be an
apportionment of general fixed overhead costs. The further processed product (FP1) would have a selling price of
Rs.28 per kilogram.

It is estimated that 15,000 kilograms of JP1 will be produced each year. There are no losses in any process.

Required
Should JP1 be sold as soon as it is produced from the common process, or should it be further processed into
Product FP1?

Answer
The common processing costs are irrelevant to the further processing decision. The annual relevant costs and
benefits of further processing JP1 are as follows:

Revenue from selling FP1 (per kilogram) 28

Variable further processing cost (6)

Additional variable revenue from further processing 22

Opportunity cost: sales of JP1 forgone (10)

Benefit per kilogram from further processing 12

Number of kilograms produced each year 15,000

Rs.

Total annual benefits before directly attributable fixed costs 180,000

Directly attributable fixed costs of further processing (96,000)

Net annual benefits of further processing 84,000

Recommendation: The joint product should be processed to make FP1, because this will increase annual profit by
Rs.84,000.

94 Page 39 of 51
ICAP QUESTION BANK
1. MATERIALS AND RELEVANT COSTS
A company is considering whether to agree to do a job for a customer. It has sufficient spare
capacity to take on this job.

To do the job, three different direct materials will be required, Material X, Material Y and Material Z. Data
relating to these materials is as follows:

Quantity Quantity Original cost Current Current

needed currently of units purchase disposal
Material for the held as currently price value
Job inventory held as
inventory
Units units Rs. per unit Rs. per unit Rs. per unit
X 800 200 20 23 22
Y 600 400 15 19 12
Z 500 300 30 40 20

Material X is regularly used by the company for other work. Material Y is no longer in regular use, and the units
currently held as inventory have no alternative use.

Material Z is also no longer in regular use, but if the existing inventory of the material is not used for this job,
they can be used as a substitute material on a different job, where the contribution would be Rs.25 per unit of
Material Z used.

Required
Calculate the total relevant costs of the materials for this job for the customer.

2. JD
JD is a small specialist manufacturer of electronic components and much of its output is used by the makers of
aircraft. One of the small number of aircraft manufacturers has offered a contract to Company JD for the supply
of 400 identical components over the next twelve months.

The data relating to the production of each component is as follows:

(a) Material requirements:

3 kilograms material M1: see note 1 below
2 kilograms material P2: see note 2 below
1 Part No. 678: see note 3 below

Note 1
Material M1 is in continuous use by the company. 1,000 kilograms are currently held in stock at a carrying
amount of Rs.4.70 per kilogram but it is known that future purchases will cost Rs.5.50 per kilogram.

95 Page 40 of 51
Note 2
1,200 kilograms of material P2 are held in inventory. The original cost of the material was Rs.4.30 per kilogram
but as the material has not been required for the last two years it has been written down to Rs.1.50 per kilogram
(scrap value). The only foreseeable alternative use is as a substitute for material P4 (in current use) but this
would involve further processing costs of Rs.1.60 per kilogram. The current cost of material P4 is Rs.3.60 per
kilogram.

Note 3
It is estimated that the Part No. 678 could be bought for Rs.50 each.
(a) Labour requirements
Each component would require five hours of skilled labour and five hours of semi-skilled. An employee
possessing the necessary skills is available and is currently paid Rs.5 per hour. A replacement would,
however, have to be obtained at a rate of Rs.4 per hour for the work that would otherwise be done by
the skilled employee. The current rate for semi-skilled work is Rs.3 per hour and an additional employee
could be appointed for this work.
(b) Overhead
JD absorbs overhead by a machine hour rate, currently Rs.20 per hour of which Rs.7 is for variable
overhead and Rs.13 for fixed overhead. If this contract is undertaken it is estimated that fixed costs will
increase for the duration of the contract by Rs.3,200. Spare machine capacity is available and each
component would require four machine hours.
A price of Rs.145 per component has been suggested by the small aircraft manufacturer.

Required
State whether or not the contract should be accepted and support your conclusion with appropriate
figures for presentation to management.

3. PRODUCT B22
BB Company has received an enquiry from a customer for the supply of 500 units of a new product, product
B22. Negotiations on the final price to charge the customer are in progress and the sales manager has asked
you to supply relevant cost information.

The following information is available:

(1) Each unit of product B22 requires the following raw materials:
Raw material type
X 4 kg
Y 6 kg
(2) The company has 5,000 kg of material X currently in stock. This was purchased last year at a cost of Rs.7
per kg. If not used to make product B22, this stock of X could either be sold for Rs.7.50 per kg or
converted at a cost of
Rs.1.50 per kg, so that it could be used as a substitute for another raw material, material Z, which the
company requires for other production. The current purchase price per kilogram for materials is Rs.9.50
for material Z and Rs.8.25 per kg for material X.
(3) There are 10,000 kilograms of raw material Y in inventory, valued on a FIFO basis at a total cost of
Rs.142,750. Of this current inventory, 3,000 kilograms were purchased six months ago at a cost of
Rs.13.75 per kg. The rest of the inventory was purchased last month. Material Y is used regularly in
normal production work. Since the last purchase of material Y a month ago, the company has been

96 Page 41 of 51
 advised by the supplier that the price per kilogram has been increased by 4%.
(4) Each unit of product B22 requires 3 hours at a rate of Rs. 6 per hour.

(5) The company has a surplus of workers who are paid a fixed wage for a 37-hour week. It is estimated that
there are 900 hours of unused labour time available during the period of the contract. The balance of the
labour requirements could be met by working overtime, which is paid at time and a half.
(6) The company absorbs production overheads by a machine hour rate. This absorption rate is Rs.22.50 per
hour, of which Rs.8.75 is for variable overheads and the balance is for fixed overheads. If production of
product B22 is undertaken, it is estimated that an extra Rs.4,000 will be spent on fixed costs. Spare
machining capacity is available and each unit of B22 will require two hours of machining time in its
manufacture using the existing equipment. In addition, special finishing machines will be required for two
weeks to complete the B22. These machines will be hired at a cost of Rs.2,650 per week, and there will be
no overhead costs associated with their use.
(7) Cash spending of Rs.3,250 has been incurred already on development work for the production of B22. It is
estimated that before production of the B22 begins, another Rs.1,750 will have to be spent on
development, making a total development cost of Rs.5,000.

Required
Calculate the minimum price that the company should be prepared to accept for the 500 units of product B22.
Explain briefly but clearly how each figure in the minimum price calculation has been obtained.

(Note: The minimum price is the price that equals the total relevant costs of producing the items. Any price in
excess of the minimum price will add to total profit).

Solution:
1. MATERIALS AND RELEVANT COSTS
Material X: This material is in regular use. Its relevant cost is therefore its current replacement cost, because
any existing inventory will be replaced if it is used on the job.

Materials Y and Z: The relevant cost of the additional quantities that will have to be purchased is their
current replacement cost.

Material Y: units already held in inventory. The relevant cost of these units is their opportunity cost, which
is the cash that could be obtained by disposing of them.

Material Z: units already held in inventory. The relevant cost of these units is the higher value of their
disposal value (Rs.20 per unit) and the contribution that they would earn if they are used as a substitute
material on a different job (Rs.25 per unit)

97 Page 42 of 51
Relevant costs
Rs. Rs.
Material X: 800 units x Rs.23 18,400
Material Y:
Opportunity cost of units in inventory = disposal value (400 units x
Rs.12) 4,800
Purchase cost of additional units (200 units x Rs.19) 3,800
8,600
Material Z:
Opportunity cost of units in inventory = (300 units x Rs.25) 7,500
Purchase cost of additional units (200 units x Rs.40) 8,000
15,500
Total relevant cost of materials 42,500

2. JD
The contract should be accepted if the revenue from the contract will exceed the relevant costs of the contract.

Workings
Material M1. This material is in continuous/regular use. The relevant cost of the 1,000 kilograms is their
replacement cost.

Relevant cost = 400 components × 3 kilos × Rs.5.50 per kilo = Rs.6,600.

Material P2. The material held in inventory has a relevant cost that is the higher of its scrap value (Rs.1.50) and
the costs saved by putting it to an alternative use, which is Rs.2 (Rs.3.60 – Rs.1.60).

There are more units held in stock than are needed for the contract. The excess quantity should be ignored.
Relevant cost of material in stock = 400 components × 2 kilos × Rs.2 per kilo = Rs.1,600.

Part 678. Relevant cost = 400 components × Rs.50 = Rs.20,000.

Skilled labour. The relevant cost of skilled labour is the extra cash that would have to be spent to hire
additional labour.

Relevant cost = 400 components × 5 hours per component × Rs.4 per hour = Rs.8,000.

Semi-skilled labour. Relevant cost = 400 components × 5 hours per component × Rs.3 per hour = Rs.6,000.

Variable overheads. It is assumed that the overhead absorption rate for variable overheads is the rate at which
cash expenditure is incurred on variable overheads.

Relevant cost = 400 components × 4 machine hours per component × Rs.7 per machine hour = Rs.11,200.

98 Page 43 of 51
Relevant cost statement Rs.
Material M1 6,600
Material P2 1,600
Part 678 20,000
Skilled labour 8,000
Semi-skilled labour 6,000
Variable overheads 11,200
Incremental fixed costs 3,200
Total relevant costs 56,600
Contract sales value (400 x Rs.145) 58,000
Incremental profit 1,400

Undertaking the contract will add Rs.1,400 to total profit. On a purely financial basis, this means that the
contract is worth undertaking. However, management might take the view that a higher profit margin is
desirable, and the suggested price of Rs.145 per component might be negotiable.

3. PRODUCT B22
Workings for relevant costs Material X
The company has enough kilograms of material X in inventory for the contract. When it is used, the inventory
of material X will not be replaced. The relevant cost of the material is therefore its opportunity cost, not its
replacement cost. The opportunity cost is the higher of its current sale value (Rs.7.50 per kg) or the net saving
obtained if it is used as a substitute for material Z (Rs.9.50 – Rs.1.50 = Rs.8 per kg). The relevant cost of
material X is therefore Rs.8 per kg.

Material Y
Material Y is in regular use, so its relevant cost is its current replacement cost.

kg Rs.
Total inventory 10,000 142,750
Purchased six months ago 3,000 (x Rs.13.75) 41,250
Purchased last month 7,000 101,500
Purchase price last month = Rs.101,500/7,000 kg = Rs.14.50 per kg. Current
purchase price = 4% higher = Rs.14.50 × 1.04 = Rs.15.08.

labour
900 unskilled labour will be available at no incremental cost to the company (as it is already being paid and is
not fully employed). There is no relevant cost for these hours. The additional 600 hours required will involve
extra wage payments, including overtime payments. The relevant cost of these 600 hours is Rs.6 per hour ×
150% = Rs.9 per hour, including the overtime premium.

99 Page 44 of 51
Overheads
Variable overheads are included as relevant costs because they will be additional costs if the units of B22 are
made. The only incremental fixed costs, however, are the extra cash costs of Rs.4,000. The fixed overhead
absorption rate is ignored. The additional costs of hiring special finishing machinery are also included as a
relevant cost.

Development costs
Those costs already incurred are past costs (sunk costs) and are not relevant. The future development costs
involve additional expenditure and are included as relevant costs.

Minimum price for making 500 units of B22

Materials: Rs.
X (500 units x 4kg) x Rs.8 16,000
Y (500 units x 6kg) x Rs.15.08 45,240
Labour:
[(500 x 3) – 900] x 6 x 1.5 5,400
Overheads:
Variable (500 units x 2 hours) x Rs.8.75 8,750
Fixed Incremental spending 4,000
Machine hire (2 weeks x Rs.2,650) 5,300
Development costs 1,750
Minimum price 86,440

LIMITING FACTORS
(a) Company X manufactures four liquids: A, B, C and D. The selling price and unit cost details for these
products are as follows:

Liquid A Liquid B Liquid C Liquid D

Rs. per Rs. per Rs. per Rs. per
litre litre litre litre
Selling price 100 110 120 120
Costs:
Direct materials 24 30 16 21
Direct labour
(Rs.6/hour) 18 15 24 27
Direct expenses 0 0 3 0
Variable overhead 12 10 16 18
Fixed overhead
(note 1) 24 20 32 36
Total cost per litre 78 75 91 102
Profit per litre 22 35 29 18

100 Page 45 of 51
 Note 1
Fixed overhead is absorbed on the basis of labour hours, based on a budget of 1,600 hours
per quarter (three months).

During the next three months the number of direct labour hours is expected to be limited to
1,345 hours. The same labour is used for all products.

The marketing director has identified the maximum demand for each of the four products
during the next three months as follows:
Liquid A 200 litres
Liquid B 150 litres
Liquid C 100 litres
Liquid D 120 litres

No inventories are held at the beginning of the period that could be used to satisfy demand
in the period.

Required
(i) Determine the number of litres of liquids A, B, C and D to be produced and sold in the
next three months in order to maximise profits.
(ii) Calculate the profit that this would yield.
(b) Suppose that a contract has been made before the beginning of the period by Company X and
one of its customers, Company Y. Company X has agreed to supply Company Y with supply 20
litres of each A, B, C and D during the three month period.
This sales demand from Company Y is included in the demand levels shown above in part (a) of
the question.

Required
(i) Given the contract with Company Y, determine the number of litres of liquids A, B, C and D to be
produced and sold in the next three months in order to maximise profits, if the maximum number of
labour hours remain 1,345 hours for the period.
(ii) Calculate the profit that this would yield.

101 Page 46 of 51
SHORTAGES
An engineering company has been experiencing problems with restricted availability of resources. The
company manufactures a variety of casings. It makes four types of casing. Each casing requires the same
bought-in component and some high- grade steel. The standard costs for the four types of casing are as
follows:

Casing A B C D
Rs. Rs. Rs. Rs.
Steel 250 500 190 390

Bought-in component 50 50 50 50

Direct labour 60 60 50 100

Variable production costs 40 50 40 50

Fixed production costs 180 240 150 270

Selling and administration costs 145 225 120 215

Profit 35 55 30 55

Selling price 760 1,180 630 1,130

All the selling and administration costs are fixed and the same single component is used for each of the four
products. Direct labour is paid Rs.8 per standard hour and each member of the workforce is capable of
producing any of the casings.

The company’s main customer has ordered 30 units of Casing A, 20 units of B, 30 units of C and 20 units of D
for production and delivery in the next month. Senior management have agreed that this order should be
treated as a priority order and that these casings must be manufactured and delivered to the customer next
month. This is necessary to maintain the goodwill of the customer. It is estimated that this order represents
10% of the total demand next month for each type of casing.

The company operates a just in time system, and has no inventories of steel, components or finished
goods.

Required
If the aim is to maximise profit for the month, establish the production and selling plan for the company next
month in each of the following situations:
(a) Situation 1. Supplies of steel are limited to Rs.250,000.
(b) Situation 2. Only 400 bought-in components are available from suppliers.
(c) Situation 3. A labour dispute restricts available productive labour hours in the month to 2,125.
(d) Situation 4. A labour dispute restricts available productive labour hours in the month to 2,125; but the
manufacture of any quantities of the four casings could be sub-contracted to an outside supplier. The cost
of buying the casings externally would Rs.475, Rs.705, Rs.380 and Rs.640 for Casing A, Casing B, Casing C
and Casing D respectively. In addition, it should be assumed that the major customer insists that its order
is completed by the company itself and the manufacture should not be sub-contracted.

102 Page 47 of 51
Each of the restrictions on production should be treated independently, as four different situations.

Solutions:
14.1 LIMITING FACTORS
(a)

A B C D
Rs. Rs. Rs. Rs.
Sales price 100 110 120 120
Variable cost per litre 54 55 59 66
Contribution per litre 46 55 61 54
Direct labour hours/unit 3 2.5 4 4.5
Contribution /direct labour hour (Rs.) 15.33 22 15.25 12
Priority for manufacture/sale 2nd 1st 3rd 4th

The fixed overhead absorption rate is Rs.8 per hour. This can be calculated from the
overhead cost and direct labour hours for any of the four products.
The budgeted labour hours for calculating this absorption rate was 1,600 hours,
therefore budgeted fixed costs are 1,600 hours × Rs.8 = Rs.12,800.

The output and sales that will maximise contribution and profit is as follows:

Contribution Contribution
Product Litres Hours /litre /profit
Rs. Rs.
B 150.0 375 55 8,250.0
A 200.0 600 46 9,200.0
C (balance) 92.5 370 61 5,642.5
1,345 23,092.5
Fixed costs (see above) 12,800.0
Profit 10,292.5
(b) In this situation, there is a minimum sales demand from Company Y that must be met:

Contribution
Product Litres Hours /litre Contribution
Rs. Rs.
A: (3 hours/litre) 20 60 46 920
B: (2.5 hours/litre) 20 50 55 1,100
C: (4 hours/litre) 20 80 61 1,220
D: (4.5 hours/litre) 20 90 54 1,080
280 4,320
Total hours available 1,345
Hours remaining 1,065

103 Page 48 of 51
 No one can help you get through your problems But ALLAH.

The remaining 1,065 hours should be used to maximise contribution, using the same
priorities as before. However, maximum sales demand should be reduced by 20 litres for
each product, to allow for the sales to Company Y.

The output and sales that will maximise contribution and profit, allowing for the sales to
Company Y, are as follows:

SHORTAGES

Working: contribution per unit

A B C D
Rs./unit Rs./unit Rs./unit Rs./unit
Profit 35 55 30 55
Fixed costs:
Production 180 240 150 270
Selling 145 225 120 215
Contribution 360 520 300 540
Resources required for the priority order for the major customer

Units
Casing required Steel Direct labour
per unit Total per unit Total
Rs. Rs. hours hours
A 30 250 7,500 7.5 225.0
B 20 500 10,000 7.5 150.0
C 30 190 5,700 6.25 187.5
D 20 390 7,800 12.5 250.0
Total 31,000 812.5

(a) Steel in short supply and restricted to Rs.250,000

Casing A B C D
Rs. Rs. Rs. Rs.
Contribution/unit 360 520 300 540
Steel costs/unit 250 500 190 390
Contribution/Rs.1 steel cost 1.44 1.04 1.58 1.38
Ranking for manufacture 2nd 4th 1st 3rd

104 Page 49 of 51
 It is assumed that the sales forecasts for the month are correct.

Profit-maximising production schedule

Steel A B C D
used
Rs. units units units units
Priority order 31,000 30 20 30 20
Sales of C 51,300 270
Sales of A 67,500 270
Sales of D 70,200 180
220,000
Balance: Sales of B 30,000 60
Total steel available 250,000
Total production/sales 300 80 300 200

(b) Components are in short supply and restricted to 400 units

A B C D
Contribution/unit Rs.360 Rs.520 Rs.300 Rs.540
Components/unit 1 1 1 1
Contribution/component Rs.360 Rs.520 Rs.300 Rs.540
Ranking for manufacture 3rd 2nd 4th 1st
Profit-maximising production schedule

Components used A B C D
units units units units units
Priority order 100 30 20 30 20
Sales of D 180 180
280
Balance: Sales of B 120 120
Total available 400
Total production/sales 30 140 30 200

105 Page 50 of 51
(c) Labour is in short supply and restricted to 2,125 hours

Casing A B C D
Contribution/unit Rs.360 Rs.520 Rs.300 Rs.540
Labour hours/unit 7.5 7.5 6.25 12.5
Contribution per hour Rs.48.00 Rs.69.33 Rs.48.00 Rs.43.20

Ranking for manufacture 2nd 1st 2nd 4th

Profit-maximising production schedule

Labour hours A B C D
units units units units
Special order 812.5 30 20 30 20
Remaining hours 1,312.5 175
Total hours 2,125.0
Total production/sales 30 195 30 20
(d) Make or buy decision

A B C D
Rs. Rs. Rs. Rs.
Contribution if made 360 520 300 540
Contribution if bought in 285 475 250 490
Extra contribution if made 75 45 50 50
Labour hours 7.5 7.5 6.25 12.5
Extra contribution per hour Rs.10 Rs.6 Rs.8 Rs.4
Ranking/priority for making 1st 3rd 2nd 4th

Profit-maximising production schedule

Casing Hours A B C D
Special order 812.5 30 20 30 20
Remaining hours 1,312.5 175
Total hours 2,125.0
Made internally 205 20 30 20
Purchased externally 95 180 270 180
Total sales 300 200 300 200

106 Page 51 of 51
Q.1 Ghauri Limited (GL) is engaged in the manufacturing of product Zee. Presently, GL is considering to bid for a
tender which requires supply of modified version of product Zee (Modified Zee) for three years. The marketing
director believes that it is unlikely to win the tender if the bid price of Modified Zee exceeds Rs.5000 per unit.

Following Information is Available:

(1) GL would require to supply 40,000,80,000 and 50,000 units in year 1, 2 and 3 respectively. The price quoted in
the tender would be the same in all three years.
(2) The planning department of GL has incurred a cost of Rs.0.5 million on preparing the feasibility for production
of modified Zee.
(3) GL would purchase a machine having useful life of 3 years and costing Rs.50 million to meet the additional
production requirements. At the end of year 3, the machine would have no use for GL and would be disposed
of at 50% of original cost. It is the policy of GL to depreciate its plant and machinery on straight line basis.
(4) Production of each unit of modified Zee would require three raw materials i.e.,3 units of AB5, 2 units of CD7 and
1 unit of EF2. Current stock position of all three raw materials are as follows:
Raw Material Units in stock Original Current Current Remarks
purchase price purchase price Disposal value
per unit per unit per unit
AB5 100,000 450 500 250 See Note 1
CD7 90,000 375 330 220 See Note 2
EF2 40,000 125 150 75 See Note 3

Note 1: The material is in continuous use of GL.

Note 2: This material has not been required for last one year. The only alternative utilization of this material is to
use as a substitute for material PK1 (in current use) but this would involve further processing cost of Rs 240 per unit.
The current cost of material is PK1 is Rs 540 per unit.

Note 3: It was purchased two years ago for another project. It can be used in the production of Modified Zee.
Otherwise, it would be disposed of. The disposal cost would be Rs 25 per unit.

(5) Every 100 units of Modified Zee would require 600 skilled labour hours and 400 unskilled labour hours. Skilled
labors are paid at the rate of Rs.30,000 per month whereas replacement would be obtained at the rate of
Rs.35,000 per month. Idle labour hours are paid at 70% of normal rate. The standard working hour per month
are fixed at 200 hours. Unskilled labour can be hired at Rs.50 per hour
If GL is not able to win this project, there would be 14,000,18,000 and 16,000 idle skilled labour hours in years
1,2 and 3 respectively.
(6) Presently, GL absorbs overheads at Rs.150 per skilled labour hour, 40% of which are consisted fixed overheads.

Requirement:
a) Compute the total cost of modified Zee for next three years by using relevant costing technique.
b) Recommend whether it is likely to win the bid.

107 Page 1 of 3
A. Year 1 Year 2 Year 3
Units to supply A 40,000 80,000 50,000
Material: Rs.”000”
AB5 (current purchase price Ax3x500) 60,000 120,000 75,000
CD7 (W-1) 24,000 52,500 33,000
EF2 2,000 12,000 7,500
[40,000×50(75– (80,000x150)
25)] (50,000x150)
86,000 184,500 115,500
Labour
Skilled (W - 2) 40,180 81,660 50,420
Unskilled [A×4(400/100)×50] 8,000 16,000 10,000
48,180 97,660 60,420
Factory overhead
FOH – Variable 21,600 27,000
(240,000x150x60%) 43200 (300,000x150x60%)
(480,000x150x60%)
FOH – Fixed(40% irrelevant) - - -
Future Deprecation of machine(W-3) 8,330 8,330 8,330

Cost of planning department - - -

(Sunk Cost)
164,110 333,690 211,250

W-1: Year Year 2 Year 3

1
Units required (A×2) 80,000 160,000 100,000
Units in stock (given) 90,000 10,000 -
Units to buy - 150,000 100,000

---------------------- Rs. in '000 ----------------------

Cost of existing stock to include 24,000 3,000 -
Year 1: [80,000×300 [540-240]
Year 2: [10,000× 300]
Cost of units to buy - 49,500 33,000
Year 2: [150,000× 330]
Year 3: [100,000× 330]
24,000 52,500 33,000

W-1.1) Higher of :
Current disposal proceeds = 220

108 Page 2 of 3
Benefits of alternate use (540-240) =300

W-2: Cost of skilled labour hours Year1 Year 2 Year 3

Skilled labour hours required [A×6 (600/100)]B 240,000 480,000 300,000
(40,000x6) (80,000x6) (50,000x6)
Less: Idle hour available (given) C 14,000 18,000 16,000
Normal hour D=B–C 226,000 462,000 284,000

---------------------- Rs. in '000 ----------------------

Cost of normal hours [D×175(35000/200)] 39,550 80,850 49,700
Cost of idle hours [C×45(30000/200×30%)] 630 810 720
40,180 81,660 50,420

(W-3) Future Depriciation of machine

50−25
Year 1 = =8.33
3
Year 2 = 8.33
Year 3 = 8.33
*(on straight line basis depreciation remain same for all years)

b)

Year 1 Year 2 Year 3

Cost per Unit 4,103 4,171 4,225
(164,110/40) (333,690/80) (211,250/50)
Bid price per unit 5,000 5,000 5,000

As the cost per unit is less than bid price per unit, therefore it is likely that tender can be won.

109 Page 3 of 3
Test Decision Making and CVP
Q.1 Sarwar Limited (SL) manufactures two industrial products i.e. K2 and K9. It also manufactures other products
in accordance with the specification of customers. SL’s products require specialised skilled labour. Maximum
labour hours available with the company are 300,000 per month.

Following information has been extracted from SL’s budget:

K2 K9
---- Rs. per unit ----
Selling price 16,500 26,000
Direct material 6,000 8,000
Direct labour (Rs. 300 per hour) 4,500 7,500
Variable production overheads (based on labour hours) 1,875 3,125
Applied fixed production overheads (based on labour hours) 1,500 2,500

Monthly demand (Units) 5,000 8,000

An overseas customer has offered to purchase 3,000 units of a customized industrial product ‘A-1’ at a price
of Rs. 35,000 each. The duration of contract would be one month. The cost department has ascertained the
following facts in respect of the contract:
1. Each unit of A-1 would require 3 units of raw material B-1 and 2 units of raw material C-3. B-1 is available
in the local market at Rs. 2,500 per unit. However, the required quantity of C-3 is not available in the local
market and would be imported from Srilanka at a landed cost of Rs. 2.4 million.
2. Each unit of A-1 would require 35 labour hours.
3. A specialised machinery would be hired for five days. However, due to certain production scheduling issues,
it is difficult for SL to exactly predict when the machine would be required. As a result of negotiations, SL
has received the following offers:

Falah Modarba has quoted a rent of Rs. 0.9 million for the entire month. If accepted, SL would be able to sublet the
machine at Rs. 20,000 per day.

Tech Rentals has quoted a rent of Rs. 57,000 per day and guaranteed availability of machinery when required.

The management want to take the contract of A-1 because of its highest contribution and believes that it can
decrease the production of K2 and K9, if required. [means we should only rank K2 and K9]

Required:
(a) Determine the maximum profit that can be earned by SL, in the above situation. (10)
(b) Solve the same question by ignoring last paragraph.

110 Page 1 of 11
Q.2 Lily (Private) Limited (LPL) has two factories. LPL manufactures a product Delta in its Quetta factory. One unit of
Delta is assembled from three components P, Q and R which are produced in the Hub factory. Monthly demand of
Delta is estimated at 5,000 units.

Following information is available in respect of each component:

P Q R
Quantity required for one unit of Delta 2 2 3
Machine hours required for producing each component 4 3 5
Cost of production: --------- Rupees ------

▪ Direct material 900 800 300

▪ Direct labour 270 250 240
▪ Factory overheads 500 700 280
▪ Allocated administrative overheads 40 30 50

Fixed factory overheads are charged at Rs. 20 per machine hour.

Production capacity at Hub factory is restricted to 100,000 machine hours per month. In order to meet the demand,
LPL is considering to purchase P, Q and R from a vendor at Rs. 1,700, Rs. 1,800 and Rs. 870 per unit respectively.

Required:
Determine how LPL can optimise its profit in the above situation. (11)

Q.3 Snooker (Private) Limited (SNPL) manufactures a component ‘Beta’ which is used as input for many products.
The current requirement of Beta is 18,000 units per annum. Current production cost of Beta is as follows:

Rs. per unit

Direct material 3,670
Direct labour 1,040
Variable manufacturing overheads 770
Fixed manufacturing overheads 870
Total cost 6,350

A supplier has recently offered SNPL to supply Beta at Rs. 7,000 per unit. The management has nominated a team
to evaluate the offer which has gathered the following information:

1. There is a shortage of labour. However, some of the labour would become available due to outsourcing of Beta,
which would be utilized for production of a product ‘Zee’. The estimated selling price of Zee is Rs. 5,800 per unit
whereas production cost would be as follows:
i. Direct material would cost Rs. 2,600 per unit.
ii. Each unit of Zee would require 20% more labour as compared to each unit of Beta. Estimated variable
manufacturing overheads would be Rs. 480 per unit.

111 Page 2 of 11
 2. Outsourcing of Beta and production of Zee would result in net reduction in fixed manufacturing overheads
by Rs. 1,900,000 per annum.

Required:
Advise SNPL whether it should outsource component Beta or not. (09)

Q.4 Following information has been extracted from the projected results of Saffron Limited (SL) for the year
ending 31 March 2019:

Sales Rs. 160 million

Contribution margin 30%
Margin of safety 25%
Information for the next year ending 31 March 2020:
i. SL is planning to increase its sales by reducing sales prices by 5% and launching a sales campaign at a cost of Rs.
5 million.
ii. Cost efficiency measures planned for the next year are expected to reduce variable cost per unit by 10%.
iii. Inflation impact on all costs would be 8%, except depreciation. At present, depreciation is 40% of the total fixed
cost.
iv. Margin of safety would be maintained at 25%.

Required:
1. A budgeted statement of profit or loss for the year ending 31 March 2020 based on the above projections.
(8)
2. Calculate the percentage increase in sales volume
(2)

112 Page 3 of 11
Ans.1 Sarwar Limited
Identification of limiting factor:
Available Hrs. 300,000 300,000
Required Hrs.:
A-1 (3,000 x 35) 105,000
Remaining available: 195,000
K2 (5,000 x 15) 75,000 = 75,000
K9 (8,000 x 25) 200,000 = 200,000
= 105,000
Shortfall Hrs. 80,000 80,000

Contribution from A-1

Selling price 35,000.00

Variable cost 23,270.00
(W-1)
Contribution per unit 11,730.00

K2 K9
Selling price per unit 16,500.00 26,000.00
Variable cost per unit 12,375.00 18,625.00
(6,000+4,500+1,875) (8,000+7,500+3,125)
Contribution per unit 4,125.00 7,375.00
Labour hours required per unit 15 25
(4,500/300) (7,500/300)
CM per labour hour (Rs.) 275.00 295.00
Ranking 2 1
Allocation of 195,000 hours - 195,000
(300,000–105,000)
7,800.00
Units to be produced - (195,000/25)

113 Page 4 of 11
Contribution margin for the month after accepting special contract
Rs. millions
A-1 (3,000×11,730) 35.19
K-9 (7,800×7,375) 57.53
Contribution margin 92.72
Fixed cost (1,500/15)×300,000 30.00
Maximum profit 62.72
W-1: Relevant cost for A-1 Rs. per unit
Material cost - B1 (3×2,500) 7,500.00
Material cost - C3 (2,400,000/3,000) 800.00
Labour cost (35×300) 10,500.00
Variable overheads [{1875÷(4,500÷300)}×35] 4,375.00
[Lower of (57,000×5) and
Machine hire cost {900,000– (20,000×25)}]/3,000 95.00
23,270.00

Answer: 2
Number of components required:
P 5,000 x 2 10,000
Q 5,000 x 2 10,000
R 5,000 x 3 15,000

Identification of limiting factor:

Available hours = 100,000
Required hours:
For compound P = 40,000
(10,000x 4)
For compound Q = 30,000
(10,000 x 3)
For compound R = 75,000
(15,000 x 5)
145,000
Shortfall of hours = 45,000

114 Page 5 of 11
Relevant production cost:
P Q R
Direct Material 900 800 300
Direct Labour 270 250 240
FOH 420 640 180
(500 – 20 x 4)
Total variable cost per component 1,590 1,690 720
Outstanding cost 1,700 1,800 870
Cost saving per component 110 110 150
Limiting factor (machine hours) 4 3 5
Cost saving per limiting factor 27.5 36.67 30
Priority in production 3 1 2

Optimum production plan:

Available Hours 100,000
Q [10,000 x 3] 30,000
Remaining hours 70,000
R (14,000x 5) 70,000

External purchases:
R = Total Required component – Produced component
= 15,000 – 14,000 = 1,000 components
P = 10,000 (All to be purchased)

Answer: 3
Total saving by production of Beta:
Variable manufacturing cost/unit 5,480
(3,670 + 1,040 + 770)
Outsourcing cost/Unit 7,000
Saving production/Unit 1,520
Units required 18,000
Total saving by production 27,360,000
(18,000 x 1,520)

Total saving if ZEE is produced instead:

Variable manufacturing cost/unit 4,328
(2,600 + 1,040 x 1.2 + 480)
Selling price/unit 5,800
Contribution/unit 1,472
Units that can be produced 15,000
(18,000/1.2)
Total contribution that can be generated (15,000 x 1,472) 22,080,000
Saving in fixed cost 1,900,000
Total saving 23,980,000
Net saving if Beta is produced rather than being outsourced 3,380,000
(27,360,000 – 23,980,000)

115 Page 6 of 11
Conclusion:
SNPL Should not outsourced the production of Zeta.

Answer: 4 (a)
Budgeted statement of profit or loss for the year ending 31 March 2020
Rs. in million
Sales (Workings) 200.75
Variable cost (200.75/100x71.62*) (143.78)
*(if contribution sales ratio is 28.38% the variable cost is eequal to 100 – 28.38 = 71.62)

Contribution margin (or 200.75 x 0.2838) 56.97

Fixed cost (W 2) (42.73)

Net profit 14.24
Workings:
1.revised contribution margin in 2020:
Sales (160 x 95%) 152
Variable cost (160 x 70%) x 1.08 x 90% (108.86)
Contribution margin 43.14

However question requires that margin of safety would be maintained at 25%. In addition, fixed cost
of 2020 (W 2) is also expected to change therefore breakeven sales would change and from there we
can find out final budgeted sales of 2020 by maintaining the margin of safety at 25% as required in
question.

2.Fixed Cost in 2020

- For 2019
From margin of safety of 25%, we can find out breakeven sales of 2019. As we know that at
breakeven sales contribution is equal to fixed cost we can calculate it.
160/100 x 75 = 120 x 30% = 36

- For 2020:
Depreciation (36×40%) 14.40
Other fixed cost (36-14.40)×1.08 23.33
Sales compaign 5.0
42.73
W 3) From this revised fixed cost and revised contribution margin ratio, we can calculate revised
breakeven sales and therefore budgeted sales in 2020.
Fixed cost = 42.73
Contribution margin ratio = 28.38% (43.14/152 x 100)
Breakeven sales = 42.73/28.38% = 150.56
If margin of safety of 25% is to be maintained then:

116 Page 7 of 11
Margin of safety = budgeted sales – breakeven sales
25 = 100 -75

Budgeted sales: 150.56/75 x 100 =200.75

(b) Increase in sales volume %

Increase in sales volume %:

Budgeted sales of 2020 at 2019 prices (200.75÷95x100) 211.32
Increase in sales volume (%) (211.32–160)÷160 32.07%

Or 160 x 0.95 = 152

200.75 -152 / 152 32.07%.

Extra question CVP

Q.1 Digital Industries Limited (DIL) incurred a loss for the year ended 30 June 2017 as it could achieve sales
amounting to Rs. 89.6 million which was 80% of the break-even sales. Contribution margin on the sales was 25%.
Variable costs comprised of 45% direct material, 35% direct labour and 20% overheads.

During a discussion on the situation, the Marketing Director was of the view that no increase in sales price was
possible due to severe competition. However, sales volume can be increased by reducing prices. The Production
Director was of the view that since the plant is quiet old, the production capacity cannot be increased beyond the
current level of 70%.

Accordingly, the management has developed the following plan:

• A new plant would be installed whose capacity would be 20% more than installed capacity of the existing plant.
The cost and useful life of the plant is estimated at Rs. 30 million and 10 years respectively. The funds for the
new plant would be arranged through a long-term bank loan at a cost of 10% per annum. Capacity utilization of
85% is planned for the first year of the operation.
• The new plant would eliminate existing material wastage which is 5% of the input and reduce direct labour
hours by 8%.
• The existing plant was installed fifteen years ago at a cost of Rs. 27 million. It has a remaining useful life of three
years and would be traded in for Rs. 2 million.
• DIL depreciates its fixed assets on straight line basis over their estimated useful lives.
• To sell the entire production, selling price would be reduced by 2%.
• Material would be purchased in bulk quantity which would reduce direct material cost by 10%.
• Direct wages would be increased by 8% which would increase production efficiency by 10%.
• Impact of inflation on overheads would be 4%.

Required:
Compute the projected sales for the next year and the margin of safety percentage after incorporating the
effect of the above measures. (12)

117 Page 8 of 11
Ans 1: Digital Industries Limited
Projected sales and margin of safety % for the next year:
M
Projected sales for the next year [89.6 ÷ 0.7] x 1.2 x 0.85 x 0.98] 127.95
[Production = Sales because on stock]
Margin of safety % to projected sales [127.95 – 108.72] / 127.95 x 100 = 15%
Breakeven sales: [33.36 / 30.68%] [Fixed cost/CS ratio] 108.72

Workings:
Variable cost for next year: [After incorporating impact of changes]
Direct Material [89.6 x 75% x 45% ÷ 0.7 x 1.2 x 0.85] = 44.064
[44.064 ÷ 100 x 95 x 90%] or [89.6 x 75% x 45% x /100 x 95 /0.7 x 37.67
1.2 x 0.85 x 0.9]
Direct labor [89.6 x 75% x 35% ÷ 0.7 x 1.2 x 0.85] = 34.272
[34.272 x 92% x 1.08 x 0.9] 30.65
Overheads [89.6 x 75% x 20% ÷ 0.7 x 1.2 x 0.85] = 19.584
[19.584 x 1.04] 20.37
88.69

Note: [Decrease in selling price will not result into decrease in variable cost and vice versa].
Contribution sales ratio:

Sales 127.95
V.C (88.69)
Contribution 39.26

39.26/127.95 x 100 = 30.68%

Fixed cost for next year:

Fixed cost of 2017: 89.6/80 x 100 = 112 x 25% = 28[At breakeven point contribution is equal to fixed cost.
Fixed cost of 2017 28
Depreciation of old plant in 2017[27 ÷ 18] (1.5)
26.5
Impact of inflation (4%) 26.5 x 4% 1.06
Depreciation of new plant (30 ÷ 10) 3.00
Interest @ 10% [30 – 2] x 10% 2.80
33.36

Cost of new plant 30

Trade in value (2)
Cash required 28

118 Page 9 of 11
Q. 2 Washington Limited (WL) is a listed company having paid-up capital of Rs. 140 million. WL deals in the
manufacturing of washing machines. Following are the extracts from the budgeted statement of profit or loss for
the year ending 31 December 2018:
Rs. in ‘000
Sales revenue (Rs. 10,000 per unit) 168,000
Cost of goods sold (including fixed cost of Rs. 21.2 million) (127,000)
Gross profit 41,000
Operating expenses (including fixed cost of Rs. 4.5 million) (16,000)
Profit before taxation 25,000
Taxation @ 30% (7,500)
Profit after taxation 17,500

Additional information:
(i) An analysis of actual results for the first two months of the year 2018 shows that:
▪ Due to change in import duty structure, imported products have become available in the market at
much cheaper prices. Consequently, it was decided to reduce the selling price to Rs. 9,500 per unit with
effect from 1 January 2018.
▪ 1,500 washing machines were sold during the period.
▪ Due to increase in raw material prices with effect from 1 January 2018, variable cost of sales has
increased by 5%.

(ii) To boost the sales, WL has decided to launch a promotion campaign at an estimated cost of Rs. 5 million.

(iii)The directors of WL wish to pay 5% dividend to its ordinary shareholders. However, according to the agreement
with the bank, WL cannot pay dividend exceeding 80% of its profit after taxation.

Required:
Calculate the minimum number of units to be sold in remaining 10 months to enable WL
to pay the desired dividend. (10)

Ans: 2
Minimum number of unit to be sold in remaining 10 months to pay the desired dividend:
= Total fixed cost + Profit before tax
Contribution per unit
= 30,700,000 (W-1) + 12,500,000 (W-2)
2,203 (W-3)
= 19,609 units
Units already sold during the first two months of the current year = 1,500
Remaining units to be sold (19,609 – 1,500) = 18,109 units

119 Page 10 of 11
Or
By using CS Ratio:
Contribution/Unit x 100
Sale price/Unit
2,203/9,500 x 100 = 23.19%
30,700,000 + 12,500,000 = 186,287,193
23.19%
186,283,193 ÷ 9,500 = 19,606 units
Remaining units = 19,609 – 1,500 = 18,109 units

(W-1) Total fixed cost:

Production fixed cost = 21,200,000
Operating fixed cost = 4,500,000
Additional promotion campaign = 5,000,000
Total 30,700,000

(W-2) Required profit before tax:

Dividend to be paid (140,000,000 x 5%) = 7,000,000
Required profit after tax (7,000,000 ÷ 80%) = 8,750,000
Required profit before tax (8,750,000/70%) = 12,500,000

(W-3) Contribution per unit

Per Unit
Sales (1,500 x 9,500) 9,500
Variable cost of sales (127,000,000 – 21,200,000)/16,800*x1.05 (6,612.5)
Variable operating cost (16,000,000 – 4,500,000)/16,800 (684.524)
Contribution 2,203**

*168,000,000 = 16,800 units

10,000

120 Page 11 of 11
 O Muslims, Obey Allah and Fear Allah and don’t backbite.

Factory Overhead (FOH)

Cost center:
A cost center is a department to whom direct and indirect costs are allocated.

Types of cost center:

1) Producing Department engages in the actual manufacturing of a product.
2) Service Department renders a service that contributes in an indirect manner to the manufacturing of a
product.

Example of:
Production Department Service Department
a) Cutting Quality Control (Inspection)
b) Assembly Store department
c) Machining Purchasing Department
d) Knitting Medical Dispensary
e) Mixing Maintenance
f) Finishing Cafeteria

Example: apportionment of shared costs

A manufacturing company has two production departments, Machining and Assembly, and two service
departments, Repairs and Quality Control. The following information is available about production overhead costs.

Total Machining Assembly Repairs Quality control

Rs. Rs. Rs. Rs. Rs.
indirect labour cost 15,500 5,000 5,000 3,500 2,000
Indirect materials 5,300 1,500 2,400 1,000 400
Factory rental 14,400
Power costs 4,800
Depreciation (note 1) 14,000
Building insurance 1,800
Equipment Insurance 4,200
60,000

Note: Depreciation is a charge for the use of items of plant and equipment, such as machinery.

Indirect labor and indirect material costs have been allocated directly to these four cost centers. The other
overhead costs are shared between the costs centers so cannot be allocated directly.

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Other information:
Total Machining Assembly Repairs Quality control
Cost of plant/ equipment (Rs.) 70,000 40,000 15,000 5,000 10,000
Floor area (square meters) 1,800 500 900 100 300
Kilowatt hours 800 600 100 50 50

Required:
How should overheads be allocated and apportioned between the four cost centers?

Answer:
The indirect labour costs and indirect materials costs are allocated directly to the cost centres. The basis of
apportionment chosen for each of the other shared costs will be as follows:
Item of Cost Basis of Apportionment Rate of Apportionment
Factory rental Floor area Rs. 14,400/1,800 = Rs. 8 per square metre
Power costs Kilowatt hours Rs. 4,800/800 = Rs. 6 per kilowatt hour
Depreciation Cost of plant & equipment Rs. 14,000/Rs.70,000 = 20% of cost
Building insurance Floor area Rs. 1,800/1,800 = Rs. 1 per square metre
Equipment insurance Cost of plant and equipment Rs. 4,200/70,000 = 6% of cost

These apportionment rates are used to establish the amount of overheads to be apportioned to each of the four
departments.
Total Machining Assembly Repairs Quality Control
Rs. Rs. Rs. Rs. Rs.
Indirect labour cost 15,500 5,000 5,000 3,500 2,000
Indirect materials 5,300 1,500 2,400 1,000 400
Factory rental 14,400 4,000 7,200 800 2,400
Power costs 4,800 3,600 600 300 300
Depreciation (note 1) 14,000 8,000 3,000 1,000 2,000
Building insurance 1,800 500 900 100 300
Equipment insurance 4,200 2,400 900 300 600
60,000 25,000 20,000 7,000 8,000

APPORTIONMENT OF SERVICE DEPARTMENT COSTS

After the production overheads have been allocated and apportioned to production and service departments, the
costs of service departments must then be apportioned to the production departments.

The purpose of doing this is to calculate an absorption rate for each production department. Absorption rates are
then used to add overhead costs to cost of production (means cost units).

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 Put your trust in Allah. He is one who can improve your condition to make it better

SECONDARY APPROTIONMENT
Apportionment of service department cost to the production departments.

Scenarios:
(a) Service Departments do not serve Each Other:

Example: 1
A manufacturing company has two production departments, Department 1 and Department 2. It also has two
service departments, quality control and the repairs department.

Allocated overhead costs and apportioned general overhead costs for each cost centre are as follows:
Department 1: Rs. 100,000
Department 2: Rs. 200,000
Quality Control: Rs. 150,000
Repairs: Rs. 220,000

The repairs department does not work for quality control: 75% of its time is spent on repair work for Department 1
and 25% of its time is spent on repair work for Department 2.

The quality control department does not work for repairs: 40% of its time is spent on Department 1 and 60% of its
time is spent on Department 2.

Answer Example 1:
Service Departments do not serve each other:
I II Quality Repair
Control
Allocated and Apportioned overheads (Given) 100,000 200,000 150,000 220,000
Quality Control (40 : 60) 60,000 90,000 (150,000) --
Repairs (75 : 25) 165,000 55,000 -- (220,000)
325,000 345,000 -- --

(b) Only one Service Department serve the Other Service Department:
In this case, first apportion the cost of that service department which serve the other service department
and then the new total cost for the second service department is apportioned.

Example: 2
A manufacturing company has two production departments, Department 1 and Department 2. It also has two
service departments, the factory canteen and the repairs department.

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Allocated overhead costs and apportioned general overhead costs for each cost centre are as follows:
Department 1: Rs. 100,000
Department 2: Rs. 200,000
Canteen: Rs. 150,000
Repairs: Rs. 220,000

The repairs department does no work for the canteen: 75% of its time is spent on repair work for Department 1
and 25% of its time is spent on repair work for Department 2.

There are 10 employees in Department 1, 20 employees in Department 2 and 20 employees in the repairs
department.

Canteen costs are to be apportioned based on the number of employees in each department.

Answer Example 2:
Only one Service Departments serve other one service department:
I II Canteen Repair
Allocated and Apportioned overheads (Given) 100,000 200,000 150,000 220,000
Canteen (10 : 20 : 20) 30,000 60,000 (150,000) 60,000
Repairs (75 : 25) 210,000 70,000 -- (280,000)
340,000 330,000 -- --

Practice Question
A manufacturing company has two production departments, P1 and P2 and two service departments, S1 and S2.
The following information is available.
P1 P2 S1 S2
Rs. Rs. Rs. Rs.
Allocated and apportioned production overheads 200,000 250,000 195,000 180,000
Work done by service department for other departments
S1 40% 60%
S2 50% 25% 25%

Required:
Apportion the overheads to the two production departments.

(c) Both Service Department serve each other as well as other Production Departments:
A situation may arise where both service departments do work for the other services department, as well as the
production departments.

In this type of situation, the secondary apportionment is more complex. The process is now called reciprocal
apportionment and can be done in either of two ways each of which gives the same result:
(1) Repeated Distribution Method
(2) Simultaneous Equations Method.

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 If you have Islam then you have everything.”

Repeated Distribution Method

Taking each service department in turn the overheads of that department are apportioned to all departments that
use its service i.e. to the other service department as well as to the production departments.

This leaves the first service department with no overheads. The overheads of the second service department are
then apportioned to all departments that use its service i.e. to the first service department as well as to the
production departments and so on until fully apportioned.

Example 3
A manufacturing company has two production departments, Machining and Assembly, and two service
departments, Repairs and Quality Control. The following information is available.
Total Machining Assembly Repairs Quality Control
Rs. Rs. Rs. Rs. Rs.
Allocated/apportioned overhead cost 60,000 25,000 20,000 7,000 8,000
Work done by the service departments:
Repairs 100% 60% 10% - 30%
Quality Control 100% 30% 50% 20% -

Required: allocate the overheads by using:

• Repeated distribution method
• Simultaneous equation method

Answer Example 3:
Both service Departments serve each other:
Repeated Distribution Method
Total M A Repair Quality
control
Allocated and Apportioned overheads 60,000 25,000 20,000 7,000 8,000
(Given)
Repair (60 : 10 : 30) 4,200 700 (7,000) 2,100
Quality control (30 : 50 : 20) 3,030 5,050 2,020 (10,100)
Repair (60 : 10 : 30) 1,212 202 (2,020) 606
Quality control (30 : 50 : 20) 182 303 121 (606)
Repair (60 : 10 : 30) 73 12 (121) 36
Quality control (30 : 50 : 20) 11 18 7 (36)
Repair(60 : 10 : 30) 4 1 (7) 2
60,000 33,713 26,287 -- --

Simultaneous Equation Method:

Lets assume, total overheads apportioned from repairs department be X
Let assume, total overheads apportioned from Q.C department be Y
X = 7,000 + 0.2 Y
Y = 8,000 + 0.3 X

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Put ‘Y’ into ‘X’:
X = 7,000 + 0.2 (8,000 + 0.3 x)
X = 7,000 + 1,600 + 0.06 x
0.94 x = 8,600
X = 9,149

Put ‘X’ into ‘Y’:

Y = 8,000 + 0.3 (9,149)
Y = 10,745
Total M A Repair Quality
control
Allocated and Apportioned overheads 60,000 25,000 20,000 7,000 8,000
(Given)
Repair (60 : 10 : 30) 5,489 915 (9,149) 2,745
Quality (30 : 50 : 20) 3,224 5,373 2,149 (10,745)
60,000 33,713 26,288 -- --

Note: It is irrelevant whether we distribute repair first or quality control, answer will be same.

When the overheads have been allocated and apportioned, they are charged to the cost of products by calculating
an absorption rate.

Summary of the above discussion

Steps in calculation of departmental overhead rate:

A. Direct departmental expenses in producing and servicing department (Allocation)
Majority of direct departmental overheads can be categorized as follows:
i. Indirect Labor
ii. Labor’s benefits (Like Holiday pay, Group Insurance , Medical, Pension cost etc to direct labor as well
as indirect labor for practical purpose.)
iii. Indirect material and factory supplies
iv. Repair and maintenance of departmental assets.
v. Equipment’s and other asset’s depreciation, existed in the department.

B. Indirect expenses. (Apportionment)

Expenses such as power, light, rent and depreciation of building etc, when shared by all departments, should
be apportioned to all departments after selecting some appropriate base e.g
Rent and rates Floor Area
Insurance Building Floor Area
Depreciation building Floor Area
Property tax Floor Area
Medical Insurance No. of employees
Canteen Expenses No. of employees
Power KWH/Hrs power
Maintenance cost Maintenance Hrs

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 “Forgive and forget people and keep having sabr.”

C. Distribution of service department cost to other departments.

The amounts allocated to other service departments should be distributed to both producing and service
department or just to producing department.
Service Department
a. Service department serve only to b. Service department serve to production as well as
production department other service department

D. Calculate the departmental FOH rates (after selecting an appropriate base)

Examples: Allocation and apportionment

• The salary of the manager of the production planning department can be allocated directly as a cost of the
production planning cost center (a service department cost center within production).
• The rental cost of equipment used by engineers in the maintenance department can be allocated directly as a
cost of the maintenance department (a service department cost center within production).
• If the machining department has its own, electricity power supply, electricity charges for the machining
department can be allocated directly to the department, (a production department cost center).
• The salary of a supervisor in the finishing department can be allocated directly to the finishing department (a
production department cost center).
• The cost of security guards for the manufacturing site cannot' be allocated to any specific department or cost
center; therefore security guard services are likely to be recorded as a general production overhead expense,
and the cost is allocated to ‘security services’.

Questions:

1. APPORTIONMENT
A production centre has three production departments, A, B and C. Budgeted production overhead
costs for the next period are as follows:
Rs.
Factory rent 60,000
Equipment depreciation 80,000
Insurance 20,000
Heating and lighting 18,000
Indirect materials:
Department A 7,000
Department B 6,600
Department C 9,400
Indirect labour:
Department A 40,000
Department B 27,000
Department C 20,000

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 Insurance costs relate mainly to health and safety insurance, and will be apportioned on the basis of
the number of employees in each department. Heating and lighting costs will be apportioned on the
basis of volume.

Other relevant information is as follows:

Total Department A Department B Department C

Direct labour hours 18,000 8,000 6,000 4,000

Number of employees 50 20 16 14
Floor area (square metres) 1,200 300 400 500
Cost of equipment (Rs.000) 1,000 200 600 200

(Rs.000s)
Volume (units) 18,000 8,000 6,000 4,000

Required
(a) Calculate the overhead costs for each production department.
(b) Calculate an overhead absorption rate for the period for each department, assuming that a separate direct
labour hour absorption rate is used for each department.
(c) Calculate an overhead absorption rate for the period, assuming that a single factory-wide direct labour hour
absorption rate is used.

2. SERVICE DEPARTMENTS
In a factory with three production departments and two service departments, the operating costs for the month of
October were as shown below.
Rs.
Production Department 1 700,000
Production Department 2 300,000
Production Department 3 400,000
Service departments
Canteen 78,000
Boiler house 100,000
1,578,000

The costs of running the canteen are apportioned to each department on the basis of the estimated use of the
canteen by employees in each department.

The costs of the boiler house are apportioned on the basis of the estimated consumption of power by each
department.

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The service departments’ costs are therefore apportioned as follows:

Canteen Boiler
house
% %
Production Department 1 40 30
Production Department 2 20 30
Production Department 3 30 20
Service departments
Canteen - 20
Boiler house 10 -

Required
Prepare a statement showing the allocation of costs to the production departments using:
(d) the repeated distribution method
(e) the simultaneous equations method.

3. TERNARY ENGINEERING LIMITED

Ternary Engineering Limited produces front and rear fenders for a motorcycle manufacturer.

It has three production departments and two service departments. Overheads are allocated on the basis of direct
labour hours. The management is considering changing the basis of overhead allocation from a single overhead
absorption rate to departmental overhead rate. The estimated annual overheads for the five departments are as
under:

Production Departments Service

Fabrication Phosphate Painting Inspection Maintenance
Rs.000 Rs.000 Rs.000 Rs.000 Rs.000
Direct materials 6,750 300 750
Direct labour 1,200 385 480
Indirect material 30 75
Other variable overheads 200 70 100 30 15
Fixed overheads 480 65 115 150 210
Total departmental expenses 8,630 820 1,445 210 300

Maximum production capacity 20,000 25,000 30,000

Direct labour hours 24,000 9,600 12,000
Machine hours 9,000 1,000 1,200
Use of service departments:
Maintenance - Labour hours 630 273 147

Inspection - Inspection hours

1,000 500 1,500

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129
Required
i. Compute the single overhead absorption rate for the next year. (06)

ii. Compute the departmental overhead absorption rates in accordance with the following:
1. The Maintenance Department costs are allocated to the production department on the basis of labour
hours.
2. The Inspection Department costs are allocated on the basis of inspection hours.
3. The Fabrication Department overhead absorption rate is based on machine hours whereas the
overhead rates for Phosphate and Painting Departments is based on direct labour hours.

4. PRODUCTION AND SERVICE

The expenses of the production and service departments of a company for a year are as follows:

Department Expenses before Service provided (%age)

distribution of service Dept. X Dept. Y
department costs
Rs. ‘000
Production department - A 500 50 40
-B 400 30 50

Service department – X 100 - 10

-Y 60 20 -
Required
Allocate the service departments expenses to production departments by:
❑ Repeated distribution method
❑ Simultaneous equation method (13)

Solution:
1. APPORTIONMENT
Tutorial note: The answers to all three parts of the question are shown here, but are not labelled.

Basis of Total A B C
apportionment
Rs. Rs. Rs. Rs.
Indirect Allocation 23,000 7,000 6,600 9,400
materials
Indirect Allocation 87,000 40,000 27,000 20,000
labour
Rent Floor area 60,000 15,000 20,000 25,000
Depreciation Equipment cost 80,000 16,000 48,000 16,000
Insurance Employee 20,000 8,000 6,400 5,600
numbers
Heating, Volume 18,000 8,000 6,000 4,000
lighting
Total 288,000 94,000 114,000 80,000

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 Direct labour hours 8,000 6,000 4,000
Absorption (per direct labour hour) Rs. Rs.19 Rs.20
rate 11.75

If a single factory-wide absorption rate is used instead of separate absorption rates for each
department, the absorption rate would be Rs.16 per direct labour hour
(= Rs.288,000/18,000 hours).

2. SERVICE DEPARTMENTS
ii. Repeated distribution method
C = Canteen
BH = Boiler house

Dept 1 Dept 2 Dept 3 C BH

Rs. Rs. Rs. Rs. Rs.
Initial overheads 700,000 300,000 400,000 78,000 100,000
Apportion:
BH (30:30:20:20) 30,000 30,000 20,000 20,000 (100,000)
98,000
C (40:20:30:10) 39,200 19,600 29,400 (98,000) 9,800
BH (30:30:20:20) 2,940 2,940 1,960 1,960 (9,800)
C (40:20:30:10) 784 392 588 (1,960) 196
BH (30:30:20:20) 59 59 39 39 (196)
C (40:20:30:10) 15 8 12 (39) 4
BH (30:30:20:20) 1 1 1 1 (4)
C (40:20:30:10) 1 0 0 (1) 0
Total overhead 773,000 353,000 452,000

iii. Simultaneous equations method

Let X = the total overheads apportioned from the Canteen
Let Y = the total overheads apportioned from the Boiler House This gives us the simultaneous equations:
X = 78,000 + 0.2 Y … (1)
Y = 100,000 + 0.1 X … (2)

Re-arrange:

78,000 = X – 0.2 Y … (1)

100,000 = – 0.1 X + Y … (2)
Multiply (2) by 10

1,000,000 = – X + 10Y … (3)

Add (1) and (3)
1,078,000 = 9.8Y
Y = 110,000

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 Therefore, from (1) and substituting Y = 110,000: X =
78,000 + 0.2 (110,000) = 100,000.

Dept 1 Dept 2 Dept 3

Rs. Rs. Rs.
Initial overheads 700,000 300,000 400,000
Apportion:
BH (30%, 30% and 20% of 110,000) 33,000 33,000 22,000
C (40%, 20% and 30% of 100,000) 40,000 20,000 30,000
Total overhead apportionment 773,000 353,000 452,000

3. TERNARY ENGINEERING LIMITED

(a) Rs. (000)

Production departments
Variable overhead 370
Fixed overhead 660
Service department
Inspection 210
Maintenance 300
1,540
Estimated direct labour hours (DLH)
Fabrication 24,000
Phosphate 9,600
Painting 12,000
Total estimated direct labour hours 45,600

Estimated Total Overheads

Single overhead absorption rate =
Estimated Direct Labour Hours
=Rs.1,540,000 = Rs. 33.77 per direct
labour hour
45,600 hours

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 “Verify news/message before you spread.”

(b)
Production Service

Fabrication

Maintenance
Phosphate

Inspection
Painting
Rupees in thousand
Variable Overhead 200 70 100 60 90
Fixed Overhead 480 65 115 150 210

Allocation of Maintenance
Department Costs on the basis of
labour hours
630 ÷ 1,050 x 300 180 (180)
273 ÷ 1,050 x 300 78 (78)
147 ÷ 1,050 x 300 42 (42)
Allocation of Inspection Department
Costs on the basis of Inspection
hours
1,000 ÷ 3,000 x 210 70 (70)
500 ÷ 3,000 x 210 35 (35)
1,500 ÷ 3,000 x 210 105 (105)
930 248 362 - -

Base Machine hours Direct labour hours

number of hours 9,000 9,600 12,000
Departmental Overhead Rate (Rs.) 103.33 25.83 30.17

4. PRODUCTION AND SERVICE

(a) Service department expenses allocation by repeated distribution method:

Production Service
Department Department
A B X Y
Total expenses as given 500 400 100 60
Allocation of X department cost 50 30 (100) 20
Allocation of Y department cost 32 40 8 (80)
Allocation of X department cost 4 2 (8) 2
Allocation of Y department cost 1 1 - (2)
587 473 - -

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 (b) Service department expenses allocation by simultaneous equation method:

Let total expenses of department X inclusive of expenses allocated from department Y

=x
Let total expenses of department Y inclusive of expenses allocated from department X
=y
Then according to question x = 100 + 0.1 y ------------ eq (1)
y = 60 + 0.2 x -------------- eq (2)
Putting the value of y from eq(1) in eq(2)

x = 100 + 0.1 (60 + 0.2x)

= 100 + 6 + 0.02 x
x – 0.02 x = 106
x = 108
y = 60 + 0.2x
= 60 + 22 = 82
ALLOCATIONS
Production
Description Department
A B
Product department costs 500 400
Distribution of X department cost (108
50%) & (108 30% ) 54 32
Distribution of Y department cost (82
40%) & (82 50% ) 33 41
587 473

Extra practice questions

Q.1 Salman Limited (SL) has two production departments, PD-A and PD-B, and two service departments, SD-1 and
SD-2. A summary of budgeted costs for the year ending June 2015 is as follows:
PD-A PD-B SD-1 SD-2 Total
Rs. in ‘000
Direct labour 5,400 3,048 - - 9,048
Direct material 13,500 9,120 - - 22,620
Indirect labour 1,900 600 50 20 2,570
Indirect materials 900 1,100 150 55 2,205
Factory rent - - - - 1,340
Power cost - - - - 1,515
Depreciation - - - - 3,500

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 “Islam is the biggest wealth for the believers. Without Islam we will get lost.”

Other related data is as follows:

PD-A PD-B SD-1 SD-2
Production (units) 2,250 800 - -
Direct labour hours (per unit) 20 38 - -
Machine hours 19,250 12,250 2,800 700
Kilowatt hours (000) 800 600 50 150
Floor area (square feet) 5,000 4,000 500 500
Machine Direct labour - -
Basis of overhead application Hours hours

SL allocates the costs of service departments applying repeated distribution method. Details of services provided
by SD-1 and SD-2 to the other departments are as follows:
Service Departments PD-A PD-B SD-1 SD-2
SD-1 30% 65% - 5%
SD-2 55% 35% 10% -

Required:
Compute the departmental overhead absorption rate.

Q.2 Zaiqa Limited (ZL) is engaged in the business of manufacturing fruit jam. It has three production and two
service departments. Following information is available from ZL’s records for the month of August 2013:
Rupees
Rent and rates 85,000
Indirect wages 60,000
General lighting 75,000
Power 150,000
Depreciation machinery 50,000

Following further information relating to the departments is also available:

Production departments Service departments

Selection Jam making Bottling Storage Distribution

Direct wages (Rs.) 60,000 80,000 32,000 8,000 20,000

Power consumed (KWH) 1,000 6,000 2,000 1,000 -

Floor area (Sq. ft) 1,500 2,000 1,250 1,000 500

Light points (Nos.) 10 20 15 5 10
Production hours 1,533 3,577 1,815 - -
Labour hours per bottle 0.10 0.25 0.15 - -
-
Cost of machinery (Rs.) 600,000 1,200,000 900,000 300,000

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After production, the jam bottles are finally packed in a carton consisting of 12 bottles. The service departments
costs are apportioned as follows:

Production departments Service departments

Selection Jam making Bottling Storage Distribution

Storage 10% 30% 40% - 20%

Distribution 20% 50% 30% - -

Raw and packing material costs of Rs. 36 and labour cost of Rs. 25 is incurred on each bottle.

Required:
Calculate the cost of each carton. (16)

Question 3
Omega Industries Limited (OIL) produces two products Alpha and Beta. These products are processed through
Fabrication and Finishing departments. Quality control and Logistics departments provide all the necessary support
for the production.

OIL allocates production overheads to Alpha and Beta at a pre-determined rate of Rs. 1,300 and Rs. 500 per unit
respectively. Any under/over absorbed overheads are adjusted to cost of sales.

Following actual data has been extracted from the cost records of OIL for the month of Decemebr 2015:
Quality
Fabrication Finishing Logistics Total
Control
Indirect labour Rs. In ‘000’ 1,500 1,200 500 400 3,600
Factory rent Rs. In ‘000’ 2,000
Power Rs. In ‘000’ 1,200
Depreciation – Plant Rs. In ‘000’ 9,000
15,800
Other information:
Cost of plant Rs. In ‘000’ 32,000 20,000 2,000 6,000 60,000
Floor area Square feet 10,000 5,000 3,000 2,000 20,000
Power KWH 50,000 40,000 4,000 6,000 100,000
Hours worked for Alpha 70% 60% - - -
Hours worked for Beta 30% 40% - - -
Services provided by:
- Quality control 40% 60% - - 100%
- Logistics 60% 35% 5% - 100%

8,000 units of Alpha and 10,000 units of Beta were produced during the month of December 2015.

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Required:
(a) Compute product wise actual overheads for Alpha and Beta. (10)
(b) Prepare journal entries to record:
(i) Applied production overheads; and
(ii) Under/over absorbed production overheads (02)

Q. 4 Opal Industries Limited (OIL) produces various products which pass through Processing and Finishing
departments. Logistics and Maintenance departments provide necessary support for the production. Following
information is available from OIL’s records for the month of June 2017:

(i) Overhead costs Direct labour hours

Departments *Budgeted Actual Budgeted Actual
-------- Rupees -------- -------- Hours --------
Processing 560,000 536,000 14,000 14,350
Finishing 320,000 258,000 10,000 9,800
Logistics - 56,700 - -
Maintenance - 45,000 - -

*including apportionment of overhead costs of support departments

(ii) Costs of support departments are apportioned as under:

Processing Finishing Logistics Maintenance

Logistics 50% 40% - 10%
Maintenance 35% 45% 20% -

Required:

(a) Allocate actual overhead costs of support departments to production departments

using repeated distribution method. (05)
(b) Compute under/over applied overheads for the month of June 2017. (03)

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 5. RT LIMITED
Following information has been extracted from the records of RT Limited for August 2013:

Departments
Production Service
P-1 P-2 P-3 S-1 S-2
Budgeted machine hours 60,000 100,000 120,000
Actual machine hours 60,500 110,000 100,000
Budgeted labour hours 50,000 200,000 75,000
Actual labour hours 55,000 190,000 75,000
Budgeted material cost (Rs. 50,000 40,000 3,000
Actual material cost (Rs. ‘000) 50,000 42,000 3,200
Budgeted overheads (Rs. ‘000) 1,200 2,000 2,250 600 700
Actual overheads (Rs. ‘000) 1,250 2,000 1,800 500 750
Services provided by S-1 20% 30% 40% - 10%
Services provided by S-2 30% 40% 20% 10% -
Basis of overhead application Machine Labour 75% of
hours hours Material cost

Required
i. Allocate budgeted costs of service departments using repeated distribution method.
ii. Compute department wise over / under applied overheads. (12)

6. AMBER LIMITED
Amber Limited (AL) manufactures a single product. Following information pertaining to the year 2014 has been
extracted from the records of the company’s three production departments.

Department Material Labour Machine

Rs. in million Hours
A 80 200,000 400,000
Budgeted B 150 500,000 125,000
C 120 250,000 350,000
A 80 220,000 340,000
Actual B 150 530,000 120,000
C 120 240,000 320,000

AL produced 3.57 million units during the period. The budgeted labour rate per hour is Rs. 120. The overheads for
department-A is budgeted at Rs. 5.0 million, for department-B at 15% of labour cost and for department-C at 5% of
prime cost of the respective departments. Actual overheads for department A, B and C are Rs. 5.35 million, Rs.
8.90 million and Rs. 7.45 million respectively. Overheads are allocated on the following basis:

Department-A Machine hours Department-B

Labour hours Department-C
Percentage of Prime cost

There was no beginning or ending inventory in any of the production departments.

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Required
i. Budgeted overhead application rate for each department. (05)
ii. The total and departmental actual cost for each unit of product. (08)
iii. The over or under applied overhead for each department. (03)

A1
Salman Limited
Allocation of overheads and overheads absorption rate
Allocation Total PD-A PD-B SD-1 SD-2
basis Rs. in 000
Direct labour - - - - -
Direct material - - - - -
Indirect labour - 1,900 600 50 20
Indirect materials - 900 1,100 150 55
Factory rent Floor area 1,340 670 536 67 67
Power Kilowatt hrs. 1,515 758 568 47 142
Depreciation Machine hrs. 3,500 1,925 1,225 280 70
6,153 4,029 594 354
Allocation of service departments cost:
SD-1 30:65:5 178 386 (594) 30
SD-2 55:35:10 211 134 39 (384)
SD-1 30:65:5 12 25 (39) 2
SD-2 55:35:10 1 1 0 (2)
6,555 4,576 - -

Machine D. labour
Allocation basis hrs. hrs.
Machine/D. labour hours 19,250 30,400 800x38
Overhead absorption rate per hour Rs. 340.52 150.53

Note: depreciation should be allocated on the basis of cost of related assets. However, as it is not available,
therefore assuming if it relates to machines then allocate on the basis of machine hours. If it relates to building
then allocate on the basis of floor area. In the above ICAP solution depreciation has been allocated on the basis of
machine hours.

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A.2
Zaiqa Limited
Primary Distribution of Overheads
Production Departments Service Departments
Basis of Total
Items Jam
Apportionment overheads Selection Bottling Storage Distribution
Making
Direct wages Given 28,000 - - - 8,000 20,000
Rent and rates Floor area 85,000 20,400 27,200 17,000 13,600 6,800
General lighting Light points 75,000 12,500 25,000 18,750 6,250 12,500
Indirect wages Direct wages 60,000 18,000 24,000 9,600 2,400 6,000
(assumed)
Power KWH consumed 150,000 15,000 90,000 30,000 15,000 -
Depreciation Cost of machinery 50,000 10,000 20,000 15,000 5,000 -
Total Departmental Overheads 448,000 75,900 186,200 90,350 50,250 45,300

60,000 20,000
× 60,000 × 60,000
200,000 700,000

Secondary Distribution of Overheads

Production Departments Service Departments
Items
Section Jam Making Bottling Storage Distribution
Total overheads as above 75,900 186,200 90,350 50,250 45,300
(1 : 3 : 4 : 2) Storage 5,025 15,075 20,100 (50,250) 10,050
(2 : 5 : 3 : 0) Distribution 11,070 27,675 16,605 - (55,350)
Total 91,995 228,950 127,055
Production hours 1,533 3,577 1,815
Rate per hour (Rs.) 60.0 64.0 70.0

First distribution the cost of that service department which is serving the other service department.
Cost of One Carton
Rs. Rs.
Raw and packing material (36 × 12) 432
Direct labour (25 × 12) 300
Overheads:
Selection (0.1 × 12 × 60) 72
Jam making (0.25 × 12 × 64) 192
Bottling (0.15 × 12 × 70) 126 390
Total 1,122

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Answer 3 (a)
Omega Industries
Actual overheads for production of Alpha and Beta

Cost allocation to production department:

Production Department Service Department
Total Quality
Items Allocation basis Fabrication Finishing Logistics
Control
---------------------------------- Rs. In ‘000’ ----------------------------------
Indirect labour Given 3,600 1,500 1,200 500 400
Factory rent Floor area 2,000 1,000 500 300 200
Power KwH consumed 1,200 600 480 48 72
Depreciation Plant cost 9,000 4,800 3,000 300 900
1,148 1,572
Service
departments:
Logistics* 60:35:5 1,572 943 550 79 (1,572)
1,227
Quality control 40:60 1,227 491 736 (1,227)
9,334 6,466

Note: first allocate that service department which is servicing the other service department.

Cost allocation to Alpha and Beta:

Alpha Beta Total
Actual no. of units produced 8,000 10,000
\--------------- Rs. In ‘000’ --------------
Overheads allocation on the basis of hours worked:
- Fabrication department in the ratio of 70:30 6,534* 2,800 9,334
- Finishing department in the ratio of 60:40 3,880 2,586** 6,466
10,414 5,386 15,800
*9,334 x 70% = 6,534
**6,466 x 40% = 2,586

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 “Forgive the people and avoid revenge.”

Answer (b)
Accounting entries for absorption of overheads:
Debit Credit
--------- Rs. In ‘000’ ---------
1 Work in process (8,000 × 1,300) + (10,000 × 500) 15,400
Factory overheads account 15,400
(Overheads charged to production at pre-determined rate)

2 Cost of sales 400

Factory overheads account 400
(Overheads under applied charged to cost of sales)

F-OH
Cash 15,800 WIP 15,400
PL 400

Ans. 4 Opal Industries Limited

(a) Allocation of support departments' actual overheads:

Production departments Support departments

Processing Finishing Logistics Maintenance
------------------------- Rupees -------------------------
Cost incurred 536,000 258,000 56,700 45,000
Allocation of support departments'
costs:
Logistics 50%:40%:0%:10% 28,350 22,680 (56,700) 5,670
Maintenance 35%:45%:20%:0% 17,734 22,802 10,134 (50,670)
Logistics 5,067 4,054 (10,134) 1,013
Maintenance 354 456 203 (1,013)
Logistics (Being immaterial
amount,
allocated to production dept.
only) 50:40 113 90 (203) -
Total - Actual overhead costs A 587,618 308,082 - -

(b) Under/over applied overheads:

Predetermined overhead rate:
Budgeted direct labour hours B 14,000 10,000
Budgeted overhead
costs C 560,000 320,000
Budgeted overhead
rate (C÷B) D 40.00 32.00

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 Overheads applied:
Actual direct labour hours E 14,350 9,800
Overheads applied (D×E) F 574,000 313,600

Overheads under/(over) applied (A-F) 13,618 (5,518)

A F
5. R.T. Limited
(a) Allocation of Service Department Using Repeated Distribution Method.
R.T Limited
FOH distribution Sheet
For the month of August, 2009
(Based on Budgeted Cost for Computation of Budgeted OAR)

Production Departments Service Departments

Particulars Basis
P1 P2 P3 S1 S2
Budgeted 1,200,000 2,000,000 2,250,000 600,000 700,000
Overheads
Redistribution

S–1 20:30:40:10 120,000 180,000 240,000 (600,000) 60,000

S–2 30:40:20:10 228,000 304,000 152,000 76,000 (760,000)

S–1 20:30:40:10 15,200 22,800 30,400 (76,000) 7,600

S–2 30:40:20:10 2,280 3,040 1,520 760 (7,600)

S–1 20:30:40:10 152 228 304 (760) 76

S–2 30:40:20:10 23 30 15 8 (76)

S–1 20:30:40:10 2 3 3 (8) -

365,657 510,101 424,242 0 0

Total 1,565,657 2,510,101 2,674,242

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 R.T Limited
FOH Distribution Sheet
For the month of August, 2009
(Based on Actual Cost to be used for Computation of Departmental Under / Applied OH)

Production Departments Service Departments

Particulars Basis
P1 P2 P3 S1 S2
Actual Cost - 1,250,000 2,000,000 1,800,000 500,000 750,000

Re-distribution of S – 1 20:30:40:10 100,000 150,000 200,000 (500,000 50,000

)
S–2 30:40:20:10 240,000 320,000 160,000 80,000 (800,000)

S–1 20:30:40:10 16,000 24,000 32,000 (80,000) 8,000

S–2 30:40:20:10 2,400 3,200 1,600 800 (8,000)

S–1 20:30:40:10 160 240 320 (800) 80

S–2 30:40:20:10 24 32 16 8 (80)

S–1 20:30:40:10 2 3 3 (8) -

358,586 497,475 393,939

Total 1,608,585 2,497,475 2,193,939

(b) Department Wise Over / Under Applied Overheads:

P-1 P-2 P-3
Total budgeted OH’s (I) (as above) 1,565,657 2,510,101 2,674,242
Budgeted Base Machine Hours Labour Hours Material Cost
60,000 200,000 -
Budget OAR (II) Rs. 26.0943 Rs. 12.5505 75% of DMC
Per m.h Per m.h Given
Actual data of Base (III) 60,500 hrs 190,000 hrs Rs. 3,200,000
Applied FOH (III × II) Rs. 1,578,705 2,384,595 2,400,000
Actual FOH (W-1) (as above) 1,608,586 2,497,475 2,193,939
(Under)/Over FOH Applied (29,881) (112,880) 206,061

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 “May Allah give us sabr and let us to die as Muslim.”

6. AMBER LIMITED
Rate is calculated on the basis of budgeted figures and then applied to actual activity level to calculate Applied
factory overheads and then compared with actual factory overheads to calculate under/over applied factory
overheads.

(a) (i) Budgeted Overhead Rate for Department A:

Per Machine Hour:
Budgeted F − OH 5,000,000
= = = 12.5/hr.
Budget Machine hrs 400,000
(ii) Budgeted Overhead Rate for Department B:
Budgeted F − OH 500,000  120  15%
= = = 18/hr.
Budget Labour hrs 500,000
(iii) Department C:
5% of Prime Cost (means D.M + D.L)
Budgeted material = 120,000,000
Budgeted Labour = 30,000,000 (250,000 × 120)
=150,000,000 x 5% = 7,500,000 / 150,000,000 x 100 = 5% of prime cost

(b) Computation of Actual Cost of Producing one Unit:

Department (Rs. In Millions)
A B C Total
Material Cost 80 150 120 350
Labour Cost
A (220,000 × 120) 26.40 26.40
B (530,000 × 120) 63.60 63.60
C (240,000 × 120) 28.80 28.80
Actual factory overheads 5.35 8.90 7.45 21.70
111.75 222.50 156.25 490.5
Units Produced 3.57 3.57 3.57 3.57
Per Unit Cost 31.30 62.32 43.77 137.39
(c) under / over Applied factory overheads:
Actual factory overheads 5.35 8.90 7.45
Applied F-OH: (Actual Activity × Predetermined Rate)
(340,000 × 12.5) 4.25
(530,000 × 18) 9.54
(120 + 28.8) × 5% ____ _____ 7.44
Under / (over) applied factory overheads 1.1 (0.64) 0.01

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ICAP Study Text
Factory overheads:

MANUFACTURING EXPENSES
Manufacturing expenses are of two types:
1. Direct expenses – expenses that are fully traceable to the product, service or department that is being costed.

Examples:
• Raw Materials that are specifically used for the product in consideration,
• Labor which is directly involved in converting the raw material
• Other expenses that are specifically incurred for the product.
2. Indirect expenses (Production overheads) –are those expenses that incur in the course of making a product,
providing of service or running department but which cannot be traced directly and fully to the product,
service or department.
Examples:
• Labor which is not directly involved in the conversion of raw material but indirectly involved in making of the
product. Such as supervisor who is responsible to supervise the production process is not directly involved and
therefore treated as indirect cost,
• Tools, spares and materials that are used in the machinery or equipment used in the production,
• Factory rent if the factory premises are hired,
• Depreciation of machinery and equipment.
• Electricity and other utility expenses incurred for the production facilities

The manufacturing expenses generally comprise:

a) Direct materials,
b) Direct labors and
c) Production / manufacturing / factory overheads.

Note:
Material cost + direct Labor cost are called ‘Prime Costs’
Direct Labor cost + factory Overhead cost are called ‘Conversion Costs’

Cost Behaviors:
Cost behaviors refer to how a cost reacts to changes in the level of activity. As the activity level rises or falls, a
particular cost may rise or fall as well or it may remain constant. To help make such distinctions, the costs are often
categorized as ‘variable cost’ or ‘fixed cost’

Variable costs are those that vary with the level of output. For example, 100 units of raw materials are used to
produce 100 units of the final product. It means for one unit of final product one unit of raw material will be
required. Where the cost of one unit of material is Rs.10, the cost of 100 units will be (10x100) Rs. 1,000. Similarly,
labors take two hours to produce 1 unit of final product and so 400 hours will be used to produce 200 units. The
labors charge Rs. 5 per hour and so there cost at 200 units using 400 hours will be Rs. 2,000.

Since these costs vary with the variations in the output therefore, these are called variable costs.

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 “Islam teaches us truth and helps us in promoting peace and humanity.”

The variable expenses are fixed per unit of output while they vary in total.

Note: there are few expenses that are called ‘Semi-variable’ because they carry some fixed part of cost and some
variable. For example, electricity bill comprises of fixed charges as line rent / fixed connection charges as well as
variable charges based on units of power consumed.

Fixed costs are those that occur irrespective of the level of output. For example, the rent of the factory shall be
charged on monthly basis whether or not the production is carried. The rent is charged for the occupation of the
premises and therefore, do not vary with the production.

Fixed expenses vary per unit of output while they are fixed in total.

For example, factory rent is Rs. 10,000 per month. During month 1, the company produced 100 units and during
month 2 it produced 150 units. The rent per unit for month 1 and 2 would be Rs. 100 (10,000/100) and Rs. 66.67
(10,000/150) however, the actual cost paid is Rs. 10,000 each month.

Note: Few fixed costs are called ‘Step fixed costs’ which remains same at certain activity level and changes when
the activity level changes. For example, a company uses one supervisor to supervise up to 25 labors who produce
100,000 units a month. The cost of supervisor is Rs. 15,000. Next month, the company intends to produce 125,000
units using 6 more labors. Now a new supervisor would be required to supervise additional 6 labors and 25,000
units. The cost is now increased to 30,000 (15,000 x 2) when the activity level increased.

Production overheads and non-production overheads: Production Overheads:

Overheads that incur in relation to the production processes are called production overheads (also called
manufacturing overheads / factory overheads). For example, salary of factory supervisor, depreciation of
production machine, electricity cost of factory, rent of factory premises etc.

Non-Production Overheads:
Overheads that incur to support the overall objectives of the business are called non-production overheads. For
example, salaries of sales team, salaries of finance, HR and IT teams, rent of the building occupied by finance, IT,
sales and HR departments (other than production department), Depreciation of computers being used in these
departments etc. These are classified as ‘Administrative Expenses, Marketing, Selling and Distribution Expenses’ in
the Statement of Comprehensive Income.

Administrative Expenses:
The term administration generally relates to the functions necessary for the overall running of the business.
Administrative costs include all costs associated with the general management of the organization rather than with
manufacturing or selling. Examples of administrative activities include implementing and ensuring the effectiveness
of fire extinguishing system for the safety of employees and overall business, ensuring the overall security of the
business premises, the accounting and finance, human resource and information technology functions of the
business are classified under administration and the cost incurred to run these functions are called administrative
expenses.

These are mostly fixed expenses and charged to profit and loss account in the period in which they occur.

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Marketing, Selling and Distribution Expenses:
These expenses are related to the process of selling inventory to customers. These costs include all costs that are
incurred to secure customer orders and get the finished product to the customer. Examples of marketing, selling and
distribution activities are advertising the company’s products / services on electronic and print media, devising and
implementing marketing strategies to enter new markets, obtaining information about customers and
competitors, distributing products to the markets for the customers, obtaining feedbacks from customers after
sales and providing after sales services. The costs so incurred in performing such activities are classified as
marketing, selling and distribution expenses.

These are both fixed and variable. Salaries of marketing staff, cost of advertisement, depreciation of equipment
used in the marketing and distribution department etc. are fixed expenses. Commission of sales staff which
depends on the number of units sold, delivery charges per weight of the unit or area of the carrier occupied by the
unit are considered as variable expenses.

The administrative and marketing, selling and distribution expenses are never made part of the cost of the
product. However, for internal reporting purposes (marginal costing) the variable marketing and selling costs are
charged to cost of goods sold in determining the contribution margin. (This concept is discussed in Chapter 5)

In addition to classifying costs as manufacturing and non-manufacturing, they can also be classified as period cost
and product cost. To understand the difference between product costs and period costs, we must first recall the
matching principle from financial accounting.

The matching principle is based on the accrual concept that costs incurred to generate a particular revenue should
be recognized as expenses in the same period that the revenue is recognized. This means that if a cost is incurred
to acquire or make something that will eventually be sold, then the cost should be recognized as an expense only
when the sale takes place—that is, when the benefit occurs. Such costs are called product costs.

Period costs are all costs that are not product costs. Period costs are not included as part of the cost of either
purchased or manufactured goods instead, period costs are expensed in the period in which they are incurred.

Identifying manufacturing overheads:

Overhead Classification
Depreciation of factory machinery Manufacturing overhead
Factory insurance Manufacturing overhead
Salary of the Finance Director Administration overhead
Depreciation of the accounts clerk’s computer Administration overhead
Petrol used in delivery vehicles Selling overhead
Cost of an advertising campaign Selling overhead

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COSTING OF PRODUCTION OVERHEADS
When more than one products are being produced using the same facilities, then they are allocated cost on
individual basis. The costs that are directly attributable to the product can be easily allocated to that product.
However, costs that are incurred in accumulation for all the products, need to be allocated on systematic basis.

The simplest way to allocate such cost is to divide the total cost on total units produce. If all the products utilize
same amount of the resources, then such a method is acceptable. However, practically, the products use the
resources in different proportion.

Also, businesses tend to keep their costs at predetermined / estimated rates (standard rates) so that planning and
budgeting can be made with some certainty.

Furthermore, as the fixed cost per unit change when the volume changes, it will not be good to charge the cost of
inefficiency (that is low production volumes) to the customers as the cost per unit will increase if volume
decreases. Similarly, the savings on high volume production is also not offered to the customers.

Another reason is that sales price is kept constant during a certain period (say for one year) because if on the basis
of fixed costs, the cost per unit changes every month and the company changes the sale price accordingly, the
customers would have to compare the prices with competitors each time the price changes, which may result in loss
of customers as well as fluctuating results every month. Therefore, the sales price is kept constant. When the sale
price is constant, the management should want the cost per unit be constant so as to identify inefficiencies and to
avoid month to month fluctuations.

Therefore, an overhead rate is determined using estimates of cost and activity level rather than actual results.

Predetermined Factory Overhead Rate:

𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝐹𝑎𝑐𝑡𝑜𝑟𝑦 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝐵𝑎𝑠𝑒 𝑡𝑜 𝑏𝑒 𝑈𝑠𝑒𝑑
Estimated factory overhead:
The estimated factory overhead is the amount of overheads that management expects to incur in the coming
periods. This shows that factory overhead rate is calculated in advance and for certain length of period (say for one
year).

Base to be used:
The following bases can be used for this purpose:
1. Physical output
2. Direct material cost
3. Direct labor cost
4. Direct labor hours
5. Machine hours

The selection of the base depends upon the nature or the function of the factory overhead. For example, if the
factory overhead cost comprises indirect labor predominantly, the direct labor cost or hour can be used as base. If it
relates to machine expenditures such as maintenance, depreciation and normal wear tear, then the base could be
machine hours.

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149
The base selection also depends on the nature of business and it may vary from company to company, department
to department and one cost center (department) to the other.

Inclusion and Exclusion of Fixed Overheads:

In cost accounting there are two methods of assigning costs to the product:
a) Absorption costing / conventional costing or full costing
b) Marginal Costing or Direct Costing

In Absorption costing, both fixed and variable manufacturing expenses are included in product cost. However, in
Marginal costing, fixed expenses are considered as period cost and not the product cost and therefore, are not
included in the cost of the product.

Similarly, when predetermined overhead rate is determined, both fixed and variable overhead expenses are taken
into account when using absorption costing, whereas, only variable overhead costs are taken into account in
marginal cost system. This way, the fixed expenses shall be charged off in the profit and loss account in full unlike
absorption where the portion of fixed cost is absorbed in the actual production.

Single Overhead Rate or Several Rates:

Overhead rates can be classified as:
a) Blanket rate or Plant (Factory)-wide rate,
b) Departmental rates or Cost centers or cost pool rates.

A plant-wide or blanket overhead rate is used to describe a single overhead rate that is established for the
organization as a whole.

If a business produces single product using one or more producing departments, a single overhead rate can be
used. However, if more than one products are produced using more than one departments, and each of them
consuming different amount of overheads in each department, then using a blanket rate would not allocate the
justified cost to products. Therefore, a separate rate is determined for each independent department and are
called departmental rates. Departments are also called cost centers. However, cost centers may be a small
segment within a department.

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 “Forgive the people and avoid revenge.”

Discussion of Factory Ledger Accounts

JOB ORDER COSTING (JOC):
Determination of product cost is the basic objective of cost accounting.

Job order costing procedures:

The JOC keeps the costs of various jobs or contracts separate during their manufacture. JOC method is applicable
to job order work in factories, workshops as well as builders, construction engineers, ship builders and printers.
The cost unit (the unit for which cost is calculated) is the job or contract and records will show the cost of each.

Job order cost sheet:

In job order costing, each job is a cost unit to which materials, labor and factory overhead costs are assigned by
means of a job order number. The cost of each order produced for a given customer is recorded on a sheet called
as job order cost sheet.

Cost Accounting Procedures for factory overhead

The quantity and cost of materials and labour used on a given order can generally be measured in a straight
forward and reasonably exact manner. The cost element, factory overhead, presents a more detailed problem.

If a company contracts to make 50 units, the material cost and labour cost can be taken from material requisitions
and labour time sheets. But how much depreciation of factory building and other factory assets, how much power,
light, insurance, repairs, security guard salary, plant manager salary etc were necessary to produce 50 units of this
contract. An extra difficulty is that some of these expenses remain fixed regardless of units produced, while some
overheads like lubricating oil, power vary with the quantity of goods manufactured. How, then is it possible to
charge a finished job (means a completed contract) at the time of completion with reasonable share of factory
overhead when actual amount of these expenses is often not known until the end of accounting period.

Estimated factory overhead

Factory overhead are entered on the job order cost sheets on the basis of a predetermined factory overhead rate
based on an appropriate base like direct labour hours, direct labour cost, machine hours etc. The procedure is as
follows:

Suppose accountant determines a relationship between two factors such as direct labour hours and factory
overhead and uses this relationship as the means of charging factory overhead to jobs. For example, company’s
direct labour hours for the month were estimated to be 7,000 hours and factory overhead were estimated to
15,400 / month. These estimates lead to the assumption that for each hour of direct labour there is Rs. 2.2
(15,400/7,000 hours) of factory overhead. The job order cost sheet for any job done during the period would
disclose the factory overheads applicable to the job (direct labour hours worked on the job multiplied by the
factory overhead rate) (e.g. 1,000 hrs × 2.2) = 2,200.

The cost accounting entry of applied factory overheads is:

WIP A/c 2,200
F OH A/c 2,200

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The actual amounts of factory overheads are recorded during the period by using the following entry,
e.g.:
F OH A /c xx
Cash / payable xx

At the end of the period, the difference if any in the factory overheads account is adjusted as over / under applied
overheads either as an adjustment in cost of sales or in gross profit. (Preferably in cost of sales)

Q. 1 Ahmer and Company is engaged in production of engineering parts. It receives bulk orders from bicycle
manufacturers and follows job order costing. On July 1, 2008 two jobs were in progress whereas two jobs were
opened during the year. The details are as follows:

JOBS
A B C D
Work in process - opening (Rs.) 1,400,000 2,500,000 - -
Raw material issued from stores (Rs.) 800,000 1,200,000 1,500,000 600,000
Direct labour hours worked (Hours) 20,000 30,000 15,000 18,000
Rate of direct labour per hour (Rs.) 20 18 16 15

Other related information is as follows:

• Factory overhead is applied to the jobs at Rs. 10 per labour hour.
• Actual factory overheads for the year amounted to Rs. 900,000.
• Under/over applied factory overheads are charged to profit and loss account.
• Job A was completed during the year. All the goods were shipped to the customers.
• Job B was also completed during the year. However, about 10% of the goods were rejected during inspection.
These were transferred to Job C where they will be used after necessary adjustments.

Required:
Prepare journal entries to record all the above transactions. (14)

Q. 2 Modern Engineering Workshop (MEW) is engaged in production of customized spare parts of textile
machinery. The following information pertains to the jobs worked by MEW during the month of June 2014:

Job 101 Job 202

Size of job order 4,000 units 5,000 units
Rs. in ‘000
Opening work in process 15,000
Nil
Raw material consumed 10,000 31,000
Direct labour used (Rs. 100 per hour) 5,000 8,000

• Overheads are applied to jobs at Rs.25 per direct labour hour. Under/over applied overheads are transferred
to cost of sales.

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 “Spread message of Quran and Sunnah and earn reward from Allah.”

• Job 101 was completed during the month and the goods were sent to the warehouse for delivery to the
customer. During the transfer to the warehouse, 160 units were damaged. Net realizable value of the
damaged units was Rs.500, 000. Remaining units were transferred to the customer.
• Job 202 is in process; however, 2,000 units are fully complete and were transferred to the warehouse during
the month while 3,000 units are 70% complete as at 30 June 2014.

Actual overheads for the month of June 2014 amounted to Rs. 4,000,000.

Required:
Prepare journal entries to record the above transactions.

Q.3 RI Limited (RIL) is engaged in the manufacturing of spare parts for industrial machines. RIL receives
bulk orders from its customers and follows job order costing. Following data pertains to two of the
jobs which were started in the month of February 2018:

(i) Job F01 Job F02

Size of job order (Units) 5,400 3,600
Labour hours used 27,500 21,600
Labour rate per hour Rs. 360 Rs. 400

(a) Each unit of both jobs require 24 kg of raw material S40. Purchase price of S40 was Rs. 30 per kg.
(b) The inventory of S40 at beginning and end of the month was Rs. 2,940,000 and Rs. 1,740,000 respectively.
(c) Wages were paid on 28 February 2018. Income tax withheld from the wages amounted to Rs. 500,000 which
would be deposited in government treasury in the following month.
(d) Job F01 was in process at month-end. However, Job F02 was completed during the month of February and
finished goods were sent to warehouse. During the delivery to the customer, 500 units were damaged badly
and their realizable value is 50% of the cost.

Total labour hours utilized during the month were 100,000. Factory overheads are applied at Rs. 120 per direct
labour hour. Under/over applied factory overheads are charged to cost of sales at month-end. Total actual factory
overheads amounted to Rs. 11,000,000, out of which 40% were fixed.

Required:
Prepare journal entries to record the transactions for the month of February 2018. (13)

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Solutions:
A. 1 JOURNAL
Particular Rs. Rs.
WIP (Job A) A/c 800,000
WIP (Job B) A/c 1,200,000
WIP (Job C) A/c 1,500,000
WIP (Job D) A/c 600,000
Material Control A/c 4,100,000

WIP (Job A) A/c (20,000 × 20) 400,000

WIP (Job B) A/c (30,000 × 18) 540,000
WIP (Job C) A/c (15,000 × 16) 240,000
WIP (Job D) A/c (18,000 × 15) 270,000
Factory payroll 1,450,000

WIP (Job A) A/c (20,000 × 10) 200,000

WIP (Job B) A/c (30,000 × 10) 300,000
WIP (Job C) A/c (15,000 × 10) 150,000
WIP (Job D) A/c (18,000 × 10) 180,000
F-OH A/c 830,000

FOH Control A/c 900,000

Cash / Accounts Payable 900,000

P&L A/c or CGS 70,000

FOH A/c 70,000

Finished Goods A/c (1,400 + 800 + 400 + 200) 2,800,000

WIP (Job A) A/c (W-1) 2,800,000

Cost of Goods Sold A/c (W-1) 2,800,000

Finished Goods A/c 2,800,000
(Job A Sold)
Finished Goods A/c – B (2,500 + 1,200 + 540 + 300) × 90% 4,086,000
WIP Job C A/c (W-1) (2,500 + 1,200 + 540 + 300) × 10% 454,000
WIP Job B A/c 4,540,000

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 The cure of soul is in obedience of Allah.
WORKINGS:
(W-1) F OH A/c
Rs. Rs.
Cash / payable 900,000 WIP 830,000
P/L 70,000

Work-in-process (Job B) A/c

Rs. Rs.
Balance b/d 2,500,000
Material 1,200,000
Wages control 540,000 Job C a/c (4,550,000 × 10%) 454,000
FOH 300,000 Finished goods A/c 4,086,000
4,540,000 4,540,000

A.2
Modern Engineering Works
Journal Entries Rs 000
Date Particulars Debit Credit
1 Work in process Job # 101 10,000
Work in process Job # 202 31,000
Raw material 41,000
(Raw material consumed for jobs)
2 Work in process Job # 101 5,000
Work in process Job # 202 8,000
Factory Payroll 13,000
(Direct labour cost allocated for jobs)
3 Work in process Job # 101 5,000 / 100*25 1,250
Work in process Job # 202 8,000 / 100*25 2,000
Factory overheads A/c 3,250
(Overheads applied to the jobs @ Rs. 25 per direct labour hour)
4 Factory overheads 4,000
Cash / payable 4,000
5 Cost of sales – overhead under applied (4,000 – 3,250) 750
Factory overheads A/c 750
(under applied overheads charged to cost of sales)
6 Finished goods (Job # 101) (15,000+10,000+5,000+1,250)*3,840/4,000 30,000
Damaged goods (at NRV) 500
Loss {Profit and loss] (damaged goods cost exceeding NRV)
(31,250×160/4,000)-500 750
Work in process Job # 101 (15,000+10,000+5,000+1,250) 31,250
(WIP of Job order # 101 transferred to finished goods)
7 Cost of Sales 30,000

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 Finished goods 30,000
(Finished goods of Jobs # 101 transferred to cost of sales)
8 Finished goods (31,000+8,000+2,000)/(2,000+3,000*0.7)*2,000 20,000
Work in process Job # 202 20,000
(Units fully completed for job # 202 transferred to finished goods)

(4,100 equivalent units)

WIP – I
Rs. Rs.
Balance b/d 15,000 Damaged goods 1,250
Material 10,000 Finished goods 30,000
Payroll 5,000
F-OH 1,250 Balance c/d --

WIP – II
Rs. Rs.
Balance b/d -- F.G 20,000
Material 31,000
Payroll 8,000
31 + 8 + 2
F-OH 2,000 Balance c/d × 2,100 21,000
4,100
F.G A/c
Rs. Rs.
WIP 30,000 COS 30,000
Damaged (at NRV) 500
WIP 20,000
F.OH
Rs. Rs.
Cash 4,000WIP I 1,250
WIP II 2,000
COS (bal) 750
Damaged Goods
Rs. Rs.
WIP 1,250 Loss (P/L) 750
F.G 500

156 Page 6 of 18
Ans.3 RI Limited
Journal entries
Debit Credit
Date Particulars
----------- Rs. in '000 -----------
Purchases - Raw material (W-1) 5,280
1 Supplier/cash 5,280
(Purchased raw material)
Work in process (F01) (W-1) 3,888
Work in process (F02) (W-1) 2,592
2
Raw material 6,480
(Allocated raw material consumed to the jobs)
Work in process (F01) (27,500×360) 9,900
Work in process (F02) (21,600×400) 8,640
3
Payroll 18,540
(Allocated direct labour to the jobs)
Payroll 18,540
Accrued payroll tax 500
4
Bank/Cash 18,040
(Paid of payroll)
Work in process (F01) (27,500×120) 3,300
Work in process (F02) (21,600×120) 2,592
5 Factory overheads 5,892
(Applied factory overheads to the jobs @ Rs. 120 per
direct labour hour)

Finished goods (W-2 ) (2,592+8,640+2,592) 13,824

6 Work in process (F02) 13,824
(Transferred WIP of job F02 to finished goods)
Damaged goods (at NRV) (13,824/3,600×500×50%) 960
Abnormal loss - P&L (13,824/3,600×500×50%) 960
Cost of sales (13,824/3,600 x 3,100) 11,904
7
Finished goods 13,824
(Transferred total finished goods to cost of sales and
Recorded 500 damaged units )
Work in process 6,108
8 Factory overheads (10,000 x 120 – 5,892) 6,108
(recording of other applied factory overheads)

11,000

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 Factory overheads
9 Cash/suppliers 11,000
(Recorded actual factory overheads incurred)
10 Factory overheads (W 2) 1,000
Cost of sales 1,000

W-1: Rs. in '000

Material consumption - F01 (5,400×24×30) 3,888.00
Material consumption - F02 (3,600×24×30) 2,592.00
Add: Closing stock of raw material Given 1,740.00
Less: Opening stock of raw material Given (2,940.00)
Purchases - Raw material 5,280.00

W-2:

FOH
Cash 11,000 WIP (5,892 + 6,108) 12,000

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Job Costing
The nature of job costing
Job costing is used when a business entity carries out tasks or jobs to meet specific customer orders.

Examples of ‘jobs’ include work done for customers by builders or electricians, audit work done for clients by a firm
of auditors, and repair work on motor vehicles by a repair firm.

Job costing is similar to contract costing, in the sense that each job is usually different and carried out to the
customer’s specification or particular requirements. However, jobs are short-term and the work is usually carried
out in a fairly short period of time. Contracts are usually long-term and might take several months or even years to
complete.(like Dams, Airports or Motorways)

The cost of a job

A cost is calculated for each individual job, and this cost can be used to establish the profit or loss from doing the
job.

The features of Job costing are as follows:

• Work is undertaken to customer’s special attention (customer specific)
• Each order is of short duration
• Jobs move through processes and operations as a continuously identifiable unit.
• Each job usually differs in one or more respects from every other job and therefore a separate record must be
maintained to show the details of a particular job.
• Job costs are allocated on a job cost sheet or job cost card.

A job costing system is usually based on absorption costing principles, and in addition a cost is included for non-
production overheads, as follows.

Illustration: Job cost Rs.

Direct materials 500
Direct labor 300
Direct expenses 200
Prime cost 1,000
Production overhead absorbed 750
Production cost of the job 1,750
Non-production overheads (Allocated selling and administrative expenses) 400
Total job cost 2,150

In many cases, job costs include not just direct materials costs and direct labor costs, but also direct expenses,
such as:
• the rental cost of equipment hired for the job
• the cost of work done for the job by sub-contractors
• the depreciation cost of equipment used exclusively on the job.

Production overheads might be absorbed on a direct labor hour basis, or on any other suitable basis.

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Non-production overheads might be added to the cost of the job:
• as a percentage of the prime cost of the job, or
• as a percentage of the production cost of the job.

Example:
The following cost information has been gathered about Job number 453.

The direct materials cost is Rs.100, the direct labor cost is Rs.60 and direct expenses are Rs.40. Direct labor costs
Rs.20 per hour. Production overheads are charged at the rate of Rs.30 per direct labor hour and non-production
overheads are charged at the rate of 40% of prime cost.

The job cost for Job 453 is calculated as follows:

Job cost: Job 453 Rs.

Direct materials 100
Direct labor (3 hours at Rs.20) 60
Direct expenses 40
Prime cost 200
Production overhead (3 hours at Rs.30) 90
Production cost of the job 290
Non-production overheads (40% of prime cost) 80
Total job cost 270

Cost records and accounts for job costing

In order to establish the cost of each individual job in a costing system, it is necessary to have procedures for
recording direct costs in such a way that they can be allocated to specific jobs. Production overheads and non-
production overheads can be charged using overhead absorption rates within a system of absorption costing.

Each job is given a unique identity number, or job number. The costs for individual jobs are recorded as follows.
• The direct materials for a job are issued directly from stores to the job. The materials requisition note should
specify the job number and the costs of the materials are charged to the job.
• The labor time spent on a job is recorded on time sheets or job sheets. The time sheets for each individual
employee identify the jobs he has worked on and the time that he spent on each job. These can be converted
into a cost for the job at the employee’s hourly rate.
• A system is needed for recording direct expenses to specific jobs. Costs might be obtained from purchase
invoices from suppliers, and recorded in the job cost record (the ‘job sheet’) for the job.
• Production overheads are charged to the job (absorbed, in an absorption costing system) at the appropriate
absorption rate, when the job has been completed.
• Similarly, non-production overheads can be charged when the job has been finished by charging them at the
appropriate absorption rate.

Direct costs and overheads are recorded on a job sheet or job card for the job. At one time, a job card used to be
an actual card or sheet of paper, although job costing systems are now likely to be computerized.

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 Remember Allah. Allah will remember you.”

In a costing system, a job account is similar to a work in progress account, except that it is for one job only. In a
company that specializes in jobs, the work in progress account is the total of all the individual job accounts.

Service Costing
The nature of services and operations
It is usual to explain costing in terms of how to calculate and record the costs of manufactured products. However,
many business entities do not make and sell products; they provide services.

Service organization do not make or sell tangible goods. Services are any activity carried out by a party to the
benefit of another that is essentially intangible and does not result in the ownership of anything.

Examples include hotel services, consultancy services, legal and accounting services, providers of telephone
services (telecommunications companies), providers of television and radio channels, postal services, medical
services, and so on.

Characteristics of services
These are major characteristics of services:
• Intangibility: They do not have a physical substance unlike goods. They cannot be held or seen.
• Inseparability: Consumption and creation of a service cannot be separated. Services are consumed as they are
created. A service does not exist until it is consumed by the person being served.
• Variability: Services face the problem of maintaining consistency in the standard of output. Goods can usually
be supplied to a standard specification. This is more difficult to achieve for services.
• Perishability: Services cannot be stored. They do not have a shelf life.
• Lack of ownership: Services do not result in the transfer of property in anything. The purchase of a service only
confers on the customer a temporary benefit.
• Heterogeneous: a haircut is heterogeneous and so the exact service received will vary each time, not only will
two hairdressers cut hair differently, but a hairdresser will not consistently deliver the same standard of
haircut.

Operations
Operations are activities. Like services, they do not result in a finished product to sell to customers. Examples of
operations include a customer service center taking telephone calls and e-mails from customers, and the staff
canteen providing meals to employees.

Service costing, product costing and job costing compared

Costs can be established for services, such as hotel accommodation, telephone calls, auditing work, holidays and
travel, and so on. The costs of a service are the sum of direct materials, direct labor, direct expenses (if any) and a
share of operational overheads.

Costs can also be established for operations, in a similar way.

Service costing differs from costing in manufacturing industries in several ways.
• There is no production system; therefore, there are no production overheads.
• Direct materials costs are often a fairly small proportion of total costs (for example, the direct materials costs to

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 a telecommunications company of providing telephone services are very small).
• In some service industries, direct labor costs are high (for example, in the film-making industry, accountancy and
investment banking).
• General overhead costs can be a very high proportion of total costs.

Inventory is usually very small; therefore, absorption costing is usually of little or no value for management
information purposes.

Not all entities that provide services will use service costing. The purpose of service costing is to provide
information to management about the costs of different services that the entity provides, and the profitability of
each of the different services. Each service should be fairly standard. If they are not standard services, it is more
sensible to use job costing to calculate the cost of each ‘job’ of service. For example:
• Service costing might be used by a hospital to record or calculate the cost of each of the different services
provided by the hospital, such as the cost of treating a patient for a particular condition such as cardiac arrests
etc.
• Job costing might be used by a professional firm such as a firm of accountants or solicitors, where the cost of
each job depends largely on the amount of time spent on each job by the professional staff.

Cost units in service costing: composite cost units

One of the main problems with service costing is that it can be difficult to identify a suitable cost unit for the
service. It is often appropriate to use a composite cost unit in service costing. This is a cost that is made up from
two variables, such as a cost per man per day (a cost per ‘man/day’). Here, the two variables are ‘men’ (the
number of employees) and ‘days’.

Examples of composite cost units used in service costing are as follows:

• The cost per room per day. This is a useful unit cost in the hotel services industry.
• The cost per passenger per mile or the cost per passenger kilometer (= the average cost of transporting a
passenger for one mile or one kilometer). This unit measure of cost is used by transport companies that
provide bus or train services.
• The cost per ton mile per delivered (= the average cost of transporting one ton of goods for one mile). This
unit cost is commonly used for costing freight services and delivery operations.
• The cost per patient/day (= the average cost of treating one patient for one day) or the cost per hospital
bed/day (= the cost of maintaining one hospital bed in a hospital for one day). These costs are used by health
service providers.
• The cost per man per day. This unit cost is widely used in professional services, such as auditing, legal services
and consultancy services.

Composite cost units can be used in addition to a ‘job costing’ type of service costing system. For example, a firm of
accountants might calculate the cost of each job performed for a client. In addition, it might calculate the average
cost per man day for the professional services such as taxation, auditing, consultancy etc. that it provides.
• The cost of each service ‘job’ enables management to monitor costs and profits on individual jobs for a
customer.
• The composite cost, which is an average cost for all ‘jobs’ allows management to monitor the general level of
costs.

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 “Obey and Remember Allah wherever you are.”

Calculating the cost per unit of service (or operation)

The cost of a service unit (or composite cost unit) is calculated as follows.
Formula

Total costs of the service

Cost per unit of service =
Number of units of service

Total costs are the costs of direct materials, direct labor, direct expenses and variable overheads plus a charge for
fixed overheads (unless marginal costing is used to cost the services).
The total number of service units might be a bit more difficult to calculate. Here are a few examples.

Example:
A hotel has 80 standard twin-bedded rooms. The hotel is fully-occupied for each of the 350 days in each year that
it is open. The total costs of running the hotel each year are Rs. 3,360,000.

What would be a useful measure of the cost of providing the hotel services?
A useful unit cost is the cost per room/day. This is the average cost of maintaining one room in the hotel for one
day.

Room available in a year = 80 rooms × 350 days = 28,000 Cost per room/day = Rs. 3,360,000/28,000 = Rs 120. or
3,360,000/80 = 42,000 /350 = 120

Example:
A train company operates a service between two cities, Southtown and Northtown. The distance between the cities
is 400 miles. During the previous year, the company transported 200,000 passengers from Southtown to
Northtown and 175,000 passengers from Northtown to Southtown. The total costs of operating the service were
Rs.60 million.

What would be a useful measure of the cost of providing the train service between the two cities?

A useful unit cost is the cost per passenger/mile. This is the average cost of transporting one passenger for one
mile.

Passenger/miles per year = (200,000 × 400) + (175,000 × 400) = 150 million. Mile = Rs. 60,000,000/150,000,000 =
Rs.0.40.

Or 60,000,000/375,000 = 160 / 400 = 0.40

163 Page 13 of 18
Example:
The Composite Manufacturing Company uses job order costing. At the beginning of May, two jobs were in process:
Job 469 Job 475
-------------Rs. In ‘000---------------
Materials 9,000 7,500
Direct labour 4,200 3,300
Applied production overhead 6,300 4,950

There was no inventory of finished goods on May 1. During the month Job 476 to 481 were started. Materials
requisitions for May totaled Rs. 55,300; direct labour cost Rs. 48,600 and actual production overheads Rs. 75,000.
Production overhead is absorbed at the rate of 150% of direct labour cost.

The only job still in process at the end of May is Job 481, with costs of Rs. 5,900 for materials and Rs. 4,200 for
direct labour the only finished job on hand at the end of May, has a total cost of Rs. 9,500.

Required
Prepare:
(a) Combined T accounts for work in process, finished goods, cost of goods sold and factory overhead control.
(b) General entries to record the cost of goods manufactured, cost of goods sold and closing of over or under
absorbed production overheads to cost of goods sold,

Solution
(a)

Work in process control

Rs. In ‘000 Rs. In ‘000
Balance b/d W-1 35,250 Finished goods (Bal. Fig.) 195,650
Materials control 55,300
Salaries & wages control 48,600
Production overhead control
(48,600 x 150%) 72,900 Balance c/d W-2 16,400
212,050 212,050
Finished goods
Rs. In ‘000 Rs. In ‘000
Work in process control 195,650 Cost of sales (Bal. Fig.) 186,150
Balance c/d 9,500
195,650 195,650
Cost of goods sold
Rs. In ‘000 Rs. In ‘000
Finished goods 186,150
Production overheads control 2,100 Profit & Loss account 188,250
188,250 188,250
Production overheads control

164 Page 14 of 18
 Rs. In ‘000 Rs. In ‘000
Cash or payables (Actual) 75,000 Work in process control 72,900
Cost of sales (bal) 2,100
75,000 75,000

W-1 Opening Inventory of WIP Job 469 Job 472 Total

---------Rs. In ‘000------------
Materials 9,000 7,500 16.500
Direct labour 4,200 3,300 7,500
Applied production overhead 6,300 4,950 10,250
Total 19,500 15,750 35,250

W-2 Closing Inventory of WIP-Job 481 Rs. In ‘000

Materials 5,900
Direct labour 4,200
Applied production overhead (4,200 x 150%) 6,300
Total 16,400

(b) Journal entries

Debit Credit
Date Particulars
Rs. in '000
Finished goods 195,650
Work in process control 195,650
(Recording of cost of goods manufactured)
Cost of goods sold 186,150
Finished goods 186,150
(Recording of cost of goods sold)
Cost of goods sold 2,100
F OH 2,100

165 Page 15 of 18
Example: best products provided the following data for Jan 2021.

Rs. In 000

Materials:
Inventory, January 1, 2021 12,000
Purchases on account 36,000
Labour:
Accrued, January 1, 2021 3,600
Paid during January 30,000
Factory overhead costs:
Supplies (issued from materials) 1,800
Indirect labour 4,200
Depreciation 1,200
Other production overheads (all are on account) 17,400

Products

Job A Job B Job C

Work in process:
Rs. In ‘000
Work in process January 1, 2021 1,200 - -
Jobs costs during January, 2021:
Direct materials 4,800 7,200 6,000
Direct labour 6,000 9,600 8,400
Absorbed production overheads 6,000 9,600 8,400

Job A: Started in December, 2020, finished during January and sold to customer for Rs. 25,200,000.
Job B: Started in January, 2021, not yet finished.
Job C: Started in January 2021, finished during January 2021 and now in the finished goods warehouse awaiting
customer’s disposition. There was no finished goods inventory at start of January, 2021.

Required
Prepare relevant ledger accounts for the month of January, 2021. Prepare separate WIP A/C for each job.

166 Page 16 of 18
 Solution
Materials control
Rs. In ‘000 Rs. In ‘000
Balance b/d 12,000 Production overheads control 1,800
Accounts payable 36,000 Work in process –Job A 4,800
Work in process –Job B 7,200
Work in process –Job C 6,000
Balance c/d 28,200
48,000 48,000

Work in process –Job A

Rs. In ‘000 Rs. In ‘000
Balance b/d 1,200
Materials control 4,800
Payroll 6,000
Production overhead control 6,000 Finished goods 18,000
18,000 18,000
Work in process –Job B
Rs. In ‘000 Rs. In ‘000
Materials control 7,200
Payroll 9,600
Production overhead control 9,600 Balance c/d (bal) 26,400
26,400 26,400
Work in process –Job C
Rs. In ‘000 Rs. In ‘000
Materials control 6,000
Payroll 8,400
Production overhead control 8,400 Finished goods 22,800
22,800 22,800
Finished Goods
Rs. In ‘000 Rs. In ‘000
Work in process- Job A 18,000 Cost of sales 18,000
Work in process- Job C 22,800 Balance c/d 22,800
40,800 40,800
Production overheads control
Rs. In ‘000 Rs. In ‘000
Materials control 1,800 Work in process –Job A 6,000
Payroll 4,200 Work in process –Job B 9,600
Accumulated depreciation 1,200 Work in process –Job C 8,400
Accounts payable 17,400 Cost of sales 600
24,600 24,600
Payroll
Rs. In ‘000 Rs. In ‘000
Accrued payroll (bal) 28,200 Work in process –Job A 6,000

167 Page 17 of 18
 Work in process –Job B 9,600
Work in process –Job C 8,400
Production overheads 4,200
28,200 28,200

Accrued Payroll
Rs. In ‘000 Rs. In ‘000
Cash 30,000 Balance b/d 3,600
Balance c/d (bal) 1,800 Payroll 28,200
31,800 31,800
Cost of sales
Rs. In ‘000 Rs. In ‘000
Finished goods 18,000
Production overheads control 600 Profit and Loss 18,600
18,600 18,600
Sales
Rs. In ‘000 Rs. In ‘000
Profit and Loss 25,200 Accounts receivables 25,200
25,200 25,200

168 Page 18 of 18
 “Speak truth and avoid bad company.”

Target Costing
Suppose:
Estimated manufacturing cost per unit 100,000.
Desired Profit per unit 20,000
Estimated selling Price per unit 120,000
20,000
× 100 = 20% of cost; or
100,000
20,000
× 100 = 16.67 of sale.
100,000

If target costing technique is used, then:

First decide target Sale Price = 100,000.
Then decide target Profit = 20,000
Difference is target Cost = 80,000

After that calculate the COST GAP = expected cost – target cost
= 100,000 – 80,000
= 20,000

169 Page 1 of 18
Target Costing
Steps used in deriving a target cost (Manufacturing Industries):
Step 1
A product is developed that is perceived to be needed by the customers and therefore will attract
adequate sales volumes.
(New design of a car with certain specification)

Step 2
A target selling price is then set, based on the customer’s perceived value of the product. This will
therefore be a market based price.
(E.g. Target Price= Rs 1,000,000)

Step 3
The required target operating profit per unit is then calculated. This may be based on their return
on sales, or return on investment. (E.g. Target profit is 20% or Rs 200,000)

Step 4
The target cost is derived by subtracting the target profit from the target price.
(1,000,000-200,000=800,000)

(E.g. Target Price= Rs 1,000,000)

Step 5
Identify cost gap and try to eliminate.
If there is a cost gap, attempts will be made to close the gap.

Step 6
Negotiation with customers may take place before deciding whether to go ahead with the project.
(If possible, negotiate with the customers for price increase if required.)

170 Page 2 of 18
 “Do good deeds and fear Allah. Allah will help you.”

Example:1
A company has designed a new product NP8. It currently estimates that in the current market, the product could
be sold for Rs.70 per unit. A gross profit margin of at least 30% on the selling price would be required, to cover
administration and marketing overheads and to make an acceptable level of profit.

A cost estimation study has produced the following estimate of production cost for NP8.

Cost item
Direct material M1 Rs.9 per unit
Direct material M2 Each unit of product NP8 will require three metres of material M2, but there will be loss
in production of 10% of the material used. Material M2 costs Rs.1.80 per metre.
Direct labour Each unit of product NP8 will require 0.50 hours of direct labour time. However it is
expected that there will be unavoidable idle time equal to 5% of the total labour time
paid for. Labour is paid Rs.19 per hour.
Production It is expected that production overheads will be absorbed into product costs at
overheads the rate of Rs.60 per direct labour hour, for each active hour worked.
(Overheads are not absorbed in idle time.)*
Required
i) The expected cost of Product NP8.
ii) The target cost for NP8.
iii) The size of the cost gap.

*Note: This assumption is always relevant. Overheads are always in actual hours worked.

Closing the cost gap:

Target cost gap = Estimated cost – target cost
Steps to eliminate the Cost Gap:
Questions that a manufacturer may ask in order to close the gap include:
• Can any materials be eliminated, e.g cut down on packing materials?
• Can a cheaper material be substituted without affecting quality?
• Can labour savings be made without compromising quality for example by using lower skilled workers?
• Can productivity be improved for example by improving motivation or by training?
• Can production volume be increased to achieve economies of scale? (per unit fixed cost will decrease by
increasing volume)
• Could cost saving be made by negotiating with suppliers. e.g discount from suppliers?
• Can part-assembled components be bought in to save on assembly time?

Q.2 A selling price of Rs 44 has been set in order to compete with a similar radio on the market that has
comparable features to Co's intended product. The board has agreed that the acceptable margin (after allowing for
all production costs) should be 20%.

Cost information for the new radio is as follows:

171 Page 3 of 18
Component 1 (Circuit board) - these are bought in at a cost of Rs 4.10 each. They are bought in batches of 4,000
components and additional delivery costs are Rs 2,400 per batch.

Component 2 (Wiring) in an ideal situation 25 cm of wiring is needed for each completed radio. However, there is
some waste involved in the process as wire is occasionally cut to the wrong length or is damaged in the assembly
process. Company estimates that 2% of the purchased wire is lost in the assembly process. Wire costs Rs 0.50 per
meter to buy.

Other material - other materials cost Rs 8.10 per radio.

Assembly labour - It takes 30 minutes to assemble a radio and the assembly workers are paid Rs 12.60 per hour. It
is estimated that 10% of hours paid to the assembly workers is for idle time.

Production Overheads recent historic cost analysis has revealed the following production overhead data:
Total production overhead Total assembly labour hours
Month 1 620,000 19,000
Month 2 700,000 23,000

Fixed production overheads are absorbed on an assembly hour basis. In a typical year an estimated 240,000
assembly hours will be worked by Company.

Required:
Calculate the expected cost per unit for the radio and identify any cost gap that might exist. (13 marks)

Note: 1 meter = 100 cm

Question bank Pollar company question

Q.3 Hi-tech Limited (HL) assembles and sells various components of heavy construction equipment. HL is
working on a proposal of assembling a new component EXV-99. Based on study of the product and market survey,
the following information has been worked out:
Projected lifetime sale of the component EXV-99 Units 500,000
Selling price per unit Rs. 11,000
Target gross profit percentage 40%

Information about cost of production of the new component is as follows:

i) One unit of EXV-99 would require:
Parts no. Net quantity Cost per unit/kg (Rs.)
XX 1 unit 2,350
YY 1.5 kg 1,400
ZZ 1 unit 1,200

The above parts would be imported in a lot, for production of 1,000 units of EXV-99. Custom duty and other import
charges would be 15% of cost price. HL is negotiating with the vendor who has agreed to offer further discount.

172 Page 4 of 18
 “Control your tongue and speak good.”

ii) On average, assembling of one unit of EXV-99 would require 1.8 skilled labour hours at Rs. 200 per hour. The
production would be carried out in a single shift of 8 hours. At the start of each shift, set-up of machines
would require 30 minutes. 6% of the input quantity of YY and ZZ would be lost during assembly process.
iii) HL works at a normal annual capacity of 4,000,000 skilled hours. Actual production overheads and skilled
labour hours for the last two quarters are as under:

Quarter Total skilled labor Production

Ended hours overheads (Rs.)
30-Sep-2014 950,000 65,600,000
31-Dec-2014 1,050,000 68,000,000
iv) A special machine that would be used exclusively for the production of EXV-99 would be purchased at a cost of
Rs. 1,500,000.

Required:
From the above information, determine the discount that HL should obtain in order to achieve the target gross
profit. (16) [Spring 2015]

Q.4 Rugby Limited (RL) is engaged in manufacturing of a product ‘B1’. Presently, RL is considering to launch a
new product B1–Extra which has a demand of 10,000 units per month. The estimated selling price of B1–
Extra is Rs. 2,000 per unit. Other relevant information is as follows:
(i) Each unit of B1-Extra would require 2 kg of material X and 1.5 labour hours. Material X is available in
the market at Rs. 520 per kg. Alternatively, instead of material X, RL can use 2.5 kg of a substitute
material Y which can be produced internally. Production of each kg of Y would require raw material
costing Rs. 300 and 0.5 labour hour.
(ii) Presently, about 14,000 labour hours remain idle each month and are paid at the rate of 50% of the
normal wage rate of Rs. 250 per hour and such payments are charged to administration expenses.
(iii) Any shortfall in required labour hours can be met through overtime at the rate of 40% above the
normal wage rate.
(iv) Records of last 4 months show the following factory overheads (variable and fixed) at different
levels of direct labour hours:

Month 1 Month 2 Month 3 Month 4

Direct labour (Hours) 174,000 172,000 170,000 168,000
Factory overheads (Rs. in ‘000) 58,280 57,840 57,400 56,960

Required:
Calculate the expected relevant cost per unit of B1-Extra and determine the cost gap (if any) if RL requires
a margin of 30%. (11)

173 Page 5 of 18
Solutions:
A1

Input Loss 0ut put

100 5 95

0.526 AHP 0.5 AHW

Estimated cost/unit
M1 = 9/unit =9
3
M2 = 100 1.8 =6
90
0.5
Direct Labor = ( 10019) = 10
95
Production overheads (0.5 x 60) =30
Estimated cost/unit 55

(b)
Targeted Cost:
70
 70 49
100
Cost Gap 6
A.2
Cost per unit and cost gap calculation

Component 1
2,400 4.70
(4.10 + )
4,000 units
Component 2
25 100 0.128
(  0.5  )
100 98
Material – other 8.10
Assembly labor
30 100 7.00
( 12.60 / hr  )
60 90
Variable production overhead
30 10.00
(  20 / hr )
60
Fixed production overhead
30 6.00
(  12 / hr )
60

174 Page 6 of 18
Total Cost 35.928
Desired cost (44 x x0.8) 35.20
Cost gap 0.728

Working
1. Production overhead cost
Using a high low method
Extra overhead cost between month 1 & 2 80,000
Extra assembly hours 4,000
Variable cost per hour 20/hr
Monthly fixed production
700,000 – (23,000 x 20/hr) 240,000
Annual fixed production overhead (240,000 x 12)
2,880,000 12/hr
Absorption rate = =
240,000 hrs

A. 3
Discount required from vendors to achieve target gross profit from sale of EXV-99

Cost/Unit:
After Discount
Material
XX 2,350 (5,861 – 562.8) = 5298
YY (1.5/94 x 100 x 1400) = 2,234
ZZ (1/94 x 100 x 1200) = 1,277 5,861 X 15% = 795
Custom duty (15% x 5,861) 879
6,093
Total 6,740/Unit

Difference 647

Labor: 1 unit requires = 1.8 hours

In a shift effectively 7.5 hour will be worked. Therefore in 7.5 hours we will produce 7.5/1.8 = 4.167 units.
However, we have to pay for 200 x 8 = 1,600 for these units. Therefore per unit labor cost will be 1600/4.167 =
384/units. (or 1600/7.5 = 213.33 x 1.8 = 384).

It means 8 / 4.167 = 1.92 hrs x 200 = 384 / unit.

Variable OH = 1.8 x 24(W) = 43.2

Fixed OH = 1.8 x 42.8 (W) = 77.04

[Overheads are assumed to be incurred in hours actually worked]

1,500,000 3.00
New Machine cost/unit ( )
500,000

175 Page 7 of 18
 Total Cost 7,247.24
11,000 6,600.00
Target cost (  60)
100
Cost Gap 647.24

647.24
100 = 562.8 / unit (Discount required from vendor)
115
562.8
% of discount required = 100 = 9.6% of purchase price
5861
Working:
High –Low Method:
1,050,000 68,600,000
950,000 65,600,000
Difference 100,000 2,400,000 24/unit
Fixed cost per quarter:
65,600,000 Or 68,600,000
22,800,000 (950,000 x 24) 25,200,000
42,800,000/Quarter 42,800,000/Quarter
42,800,000
= 42.8 / hr
1,000,000 *
4,000,000
* = 1,000,000
4
Answer 4:
Material (10,000 x 520 x 2) 10,400,000
Labour (W 3) 2,100,000
Variable OH (15,000 X 220) 3,300,000
15,800,000
Estimated selling price = 2,000
Target cost 2000 x 70 = 1,400
100
1,400 x 10,000 = 14,000,000
Cost gap = Expected cost – Target cost
= 15,800,000 – 14,000,000
= 1,800,000 ÷ 10,000 = 180 per unit

(W-1):
Per unit material X
2 x 520 = 1,040
(1,181.25 – 1,040) = 141.25 Difference
Material Y
Total Hrs. required for Y if it is to be internally produced
0.5 x 2.5 x 10,000 = 12,500

176 Page 8 of 18
 “Read the Quran, There is healing and mercy for the believers.”

Material 300
Labour (0.5 x 125) 62.5
V.OH (0.5 x 220) 110
472.5
1 unit requires 2.5 kg (2.5 x 472.5
1,181.25

As cost on producing Y internally is higher than purchasing Material X so we should pyrchase Material X.

(W-2): Labour hours required

Existing hours 14,000
Required hours (10,000 x 1.5) 15,000
Overtime hours 1,000

(W-3): Labour cost

Existing (14,000 x 50% x 250) 1,750,000
Overtime (1,000 x 1.4 x 250) 350,000
2,100,000 - 10,000 = 210/unit

Factory OH (by using high low method)

174,000 58,280,000
168,000 56,960,000
6,000 1,320,000

Variable OH:
1320,000/6,000 = 220 Per hour

fixed FOH:
174,000 58,280,000
174,000 X 220 38,280,000
Fixed FOH 20,000,000/Month

177 Page 9 of 18
Target Costing
Target Costing – Defined
Target costing involves setting a target cost by subtracting a desired profit margin from a competitive Selling/
market Price.

Target Costing – Explained

Target costing is used mainly for new product development. This is because whenever a new product is designed and
developed for a competitive market, a company needs to know what the maximum cost of the new product must
be so that it will sell at a profit.

A company might decide the price that it would like to charge for a new product under development, in order to
win a target share of the market. The company then decides on the level of profitability that it wants to achieve for
the product, in order to make the required return on investment. Having identified a target price and a target profit,
the company then establishes a target cost for the product. This is the cost at which the product must be
manufactured and sold in order to achieve the target profits and return at the strategic market price.

Target cost - Defined

Target cost is an estimate of a product cost which is determined by subtracting a desired profit margin from a
competitive selling / market price. This target cost may be less than the planned initial product cost but it is
expected to be achieved by the time the product reaches the maturity stage of the product life cycle.

Cost gap - Defined

Cost gap is the difference between the expected cost and the target cost. it can be calculated as:

Cost gap = Expected cost – Target cost

Origins of target costing

Target costing originated in Japan in the 1970s. It began with the recognition that customers were demanding
more diversity in products that they bought, and the life cycles of products were getting shorter. This meant that
new products had to be designed more frequently to meet customer demands.

Companies then became aware that a large proportion of the costs of making a product are committed at the
design stage, before the product goes into manufacture. The design stage was therefore critical for ensuring that
new products could be manufactured at a cost that would enable the product to make a profit for the company. It
is not just a cost cutting exercise but rather holistically redesigning the entire production process to eliminate
unnecessary costs, without reducing the value created by the product.
Closing the target cost gap
Target costs are rarely achievable when the product is first manufactured, target cost may be much lower than the
current cost determined by current technology and processes.
Target costing should involve a multi-disciplinary approach to close the cost gap. The management accountant
should be involved in measuring estimated costs. Ways of reducing costs might be in product design and
engineering, manufacturing processes used, selling methods and raw materials purchasing. Ideas for reducing
costs can therefore come from the sales, manufacturing, engineering or purchasing departments.

178 Page 10 of 18
 “Don’t be sad nor grieve. Allah is with us.”
Common methods of closing the target cost gap are:
• To re-design products to make use of common processes and components that are already used in the
manufacture of other products by the company.
• To discuss with key supplier’s methods of reducing materials costs. Target costing involves the entire ‘value
chain’ from original suppliers of raw materials to the customer for the end-product, and negotiations and
collaborations with suppliers might be an appropriate method of finding important reductions in cost.
• To eliminate non-value added activities or non-value added features of the product design. Something is
‘non-value added’ if it fails to add anything of value for the customer. The cost of non-value added product
features or activities can therefore be saved without any loss of value for the customer.
• To train staff in more efficient techniques and working methods. Improvements in efficiency will reduce
costs.
• To achieve economies of scale. Producing in larger quantities will reduce unit costs because fixed overhead
costs will be spread over a larger quantity of products. However, production in larger quantities is of no
benefit unless sales demand can be increased by the same amount.
• To achieve cost reductions as a result of the learning curve. The learning curve effect is often observed in labor
tasks of a complex nature. It results in cost savings as workers become more familiar with performing a new
and complex task and this can be modelled mathematically.

Example:
Scriba Company (SC) is trying to launch a new product into a competitive market in North America. Test marketing
has revealed the following demand curve for the product:
P = 600 – 0.005Q
P means target price
Q means demand

The estimated market for the product is 500,000 units per year. The company would like to capture 10% of this
market.

The company has established a cost card per unit based on 50,000 units of sales each year:

Rs.
Direct materials 100
Direct labor 30
Fixed overhead 70
Total cost 200

The company wishes to achieve a target profit of Rs. 10,000,000 for sales of this product per year.
a) What price will the company have to charge to capture its required market share and what is the target unit
cost to achieve its target profit?

Tutorial note: The company will need to sell 50,000 units to gain 10% of the market.

179 Page 11 of 18
The first step is to calculate the price that the item has to be sold at to achieve this market share. This can be
calculated by using the demand curve:
P = 600 – 0.005Q
P = 600 – (0.005 50,000)
P = 600 – 250
P = Rs.350

Since the company wishes to generate Rs.10,000,000 profit in total, this equates to a unit profit of:
Rs.10,000,000 / 50,000 = Rs.200 per unit.

Once target price and target profit are available it is possible to calculate target cost: Target price – target profit =
target cost
Rs.350 – Rs.200 = Rs.150 per unit

b) What is the size of the target cost gap and how might Scriba Company seek to close this gap?
The target cost gap is calculated as:

Rs.
Target unit cost 150
Current unit cost 200
Target cost gap 50

Currently actual cost is one third higher than it should be to reach the target profit.
Steps to reduce the cost gap:
The company can undertake various strategies to bring costs down to target:

Product redesign
This is the most effective way of reducing costs. Once the design of a product has been finalized it is difficult to
reduce significantly the majority of a product's cost. If SC has not yet finalized the design and production of the
product, it would be very worthwhile them revisiting the design and production planning stages of the product
lifecycle.

Outsourcing
SC could seek a deal with a third party manufacturer to make the product. Complete outsourcing would not only
remove the variable cost element of production but could also lead to huge fixed cost savings. This is a course of
action worth exploring by the company. Suitable controls over any patents and quality would need to be in place,
together with guarantees of delivery times and the ability to be flexible with production volumes.

Cost reduction
SC has to be careful with cost cutting. If applied badly the company could damage the value of the product, leading
to a fall in market price. Cost reduction, however, seeks ways of lowering cost without reducing the value of the
product. SC would seek to preserve those features of the product key to its customer value whilst seeking to reduce
the cost of other areas. This, for instance, could involve cutting down on the quality of packaging.

180 Page 12 of 18
IMPLICATIONS AND ADVANTAGES
Advantages of target costing

There are several possible advantages from the use of target costing.
• It helps to improve the understanding within a company of product costs.
• It recognizes that the most effective way of reducing costs is to plan and control costs from the product design
stage onwards.
• It helps to create a focus on the final customer for the product or service, because the concept of ‘value’ is
important: target costs should be achieved without loss of value for the customer.
• It is a multi-disciplinary approach, and considers the entire supply chain. It could therefore help to promote co-
operation, both between departments within a company and also between a company and its suppliers and
customers.
• Target costing recognizes that process improvement and cost cutting is not a top down process but rather one
where workers who actually work on the product could come up with valuable suggestions

The implications of using target costing

The use of a target costing system has implications for pricing, cost control and performance measurement.

Target costing can be used with pricing policy for a company’s products or services. A company might decide on a
target selling price for either a new or an existing product, which it considers necessary in order to win market share
or achieve a target volume of sales. Having identified the selling price that it wants for the product, the company
can then work out a target cost.

Cost control and performance measurement has a different emphasis when target costing is used.
• Cost savings are actively sought and made continuously over the life of the product
• There is joint responsibility for achieving benchmark savings. If one department fails to deliver the cost savings
expected, other departments may find ways to achieve the savings
• Staff are trained and empowered to find new ways to reduce costs while maintaining the required quality.
Target costing is more likely to succeed in a company where a culture of ‘continuous improvement’ exists.

Target costing and services

Target costing can be used for services as well as products. Services vary widely in nature, and it is impossible to
make general statements that apply to all types of services. However, features of some service industries that
make them different from manufacturing are as follows.
• Some service industries are labor-intensive, and direct materials costs are only a small part of total cost.
Opportunities for achieving reductions in materials costs may therefore be small.
• Overhead costs in many services are very high. Effective target costing will therefore require a focus on how to
reduce overhead costs.

A service company might deliver a number of different services through the same delivery system, using the same
employees and the same assets. Introducing new services or amendments to existing services therefore means
adding to the work burden of employees and the diversity or complexity of the work they do.

181 Page 13 of 18
A system of target costing therefore needs to focus on quality of service and value for the customer. Introducing a
new service might involve a loss of value in the delivery of existing services to customers. For example, adding a
new service to a telephone call center could result in longer waiting times for callers.
• New services might be introduced without proper consideration being given to whether the service is actually
profitable. For example, a restaurant might add additional items to its menu, in the belief that the only
additional cost is the cost of the food. In practice there would be implications for the purchasing and
preparation of the food and possibly also for the delivery of food from the kitchen to the restaurant dining
area. New items added to the menu might therefore make losses unless all aspects of cost are properly
considered.
• When a single delivery system is used for services, the cost of services will consist largely of allocated and
apportioned overheads. For target costing to be successful, there must be a consistent and ‘fair’ method of
attributing overhead costs to services (both existing services and new services).
• Services might be provided by not-for-profit entities. For example, health services might be provided free of
charge by the government. When services are provided free of charge, target costing can be used for new
services. However, it is doubtful whether concepts of ‘target price’ and ‘target profit’ can be used by a not-
for-profit entity. This raises questions about how to decide what the target cost should be and will probably be
some arbitrary figure.

Example:
A company wishes to introduce a new product to the market.

The company estimates the market for the product to be 50,000 units. The company uses target costing.
Current projected costs are as follows:
Rs. ‘000
Manufacturing cost
Bought in parts (100 components) 50,000
Direct labor (assembly of components) 10 hours x Rs. 500 per hour 5,000

Machine costs (750,000,000 ÷ 50,000) 15,000

Ordering and receiving 500
(500 orders x 100 components x Rs. 500 per order) ÷ 50,000 units
Quality assurance (10 hours x Rs. 800 per hour) 8,000
Rework costs 1,000
10% (probability of failure) x Rs. 10,000 (cost of rework)
Non-manufacturing costs
Distribution 10,000
Warranty costs 1,500
10% (probability of recall) x Rs. 15,000 (cost to correct)
Total cost 91,000
Target selling price (Rs.) 100,000
Target margin 20%
Target profit (Rs.) 20,000
Target cost (Rs.) 80,000

182 Page 14 of 18
 “May Allah forgive us and guide us all to right path.”

The company has undertaken market research which found that several proposed features of the new product were
not valued by customers. Redesign to remove the features leads to a reduction in the number of components down
to 80 components and therefore a direct material cost reduction of 12%.

The reduction in complexity has other impacts: Assembly time will be reduced by 20%.

Quality assurance will only require 6 hours.

The probability of a failure at the inspection stage will fall to 5%. The probability of an after-sales failure will also
fall to 5%.

Cost of warranty corrections will fall by Rs. 2,000.

Reduced weight of the product will reduce shipping costs (means distribution cost) by Rs. 1,000 per unit.

The revised projected costs are as follows:

Rs. ‘000
Manufacturing cost
Bought in parts (80 components) [50,000 x 88%] 44,000
Direct labor (assembly of components)
10 x 80 = 8 hours (20% reduction) x Rs. 500 per hour 4,000
Machine costs (750,000,000 ÷ 50,000) 15,000
Ordering and receiving
500 orders x 80 components x Rs. 500 per order/50,000 units 400
Quality assurance
6 hours x Rs. 800 per hour 4,800
Rework costs
5% x Rs. 10,000 500
Non-manufacturing costs
Distribution [10,000 – 1,000] 9,000
Warranty costs
5% x Rs. 13,000 650
78,350
The target cost is achieved.

183 Page 15 of 18
Example:
Atlas Gaming Company, a manufacturer of computer games, is in the process of introducing a new game to the
market and has undertaken market research to find out about customer’s view on the value of the product. The
results of this research have been used to establish a target selling price of Rs. 6,000. This is the price that the
company thinks it will have to sell the product at to achieve the required sales volume.

Cost estimates have been prepared based on the proposed product specification.
Manufacturing cost per unit Rupees
Direct material 321
Direct labour 2,403
Direct machinery cost 112
Ordering and receiving 23
Quality assurance 460
Non-manufacturing cost per unit

Marketing 815
Distribution 325
After sales service 130

The target profit margin for the game is 30% of target selling price.

Required:
Identify the cost gap.

Ans:
Target cost gap Rupees
Target selling price 6,000
Target profit (6,000 x 30%) (1,800)
Target cost 4,200

Estimated cost (Given)[sum of all above] 4,589

Target cost gap 389

The estimated cost exceeds the target cost by Rs. 389 and it is the target cost gap.

184 Page 16 of 18
Example:
Fintech company assembles and sells many types of radios. It is considering to apply target costing for one of its
new product which includes technology advancement. Following data is provided for calculation of estimated cost
of production.
i. Selling price of Rs. 2,500 has been set in order to compete with the similar radio on the market that has
comparable features to Fintech Company’s intended product. The board have agreed that the acceptable
margin (after allowing for all production costs) should be 20%.
ii. Component 1- Circuit board: These are bought in and cost Rs. 410 each. They are bought in batches of
4,000 and additional delivery costs are Rs. 240,000.
iii. Component 2- Wiring: In an ideal situation 25cm of wiring is needed for each completed radio. However,
there is some waste involved in the process as wire is occasionally cut to the wrong length or is damaged
in the assembly process. Fintech company estimates that 2% of the purchased wire is lost in the assembly
process. Wire costs Rs. 50 per meter to buy.
iv. Other material: Other material cost Rs. 810 per radio.
v. Assembly Labour: these are skilled people who are difficult to recruit and retain. Fintech company has
more staff of this type than needed but is prepared to carry this extra cost in return for the security it
gives the business. It takes 30 minutes to assemble a radio and the assembly workers are paid Rs. 1,260
per hour. It is estimated that 10% of hours paid to assembly workers is for idle time.
vi. Production overheads: Recent historic cost analysis has revealed the following production overhead data:
Total Production Total assembly
Month overheads Rs. labour hours
Month 1 62,000,000 190,000
Month 2 70,000,000 230,000

Fixed production overheads are absorbed on an assembly hour basis based on normally annual activity levels. In a
typical year 2,400,000 assembly hours will be worked by Fintech Company.

Required: Calculate the expected cost per Radio and any cost gap that exists.

Note: 1 meter is equal to 100 centimetres

Solution:
Workings: production overhead costs

Production overhead costs can be estimated using the high-low method.

Production overheads Hours Rs.
Month 2: Total cost 230,000 70,000,000
Month 1: Total cost 190,000 62,000,000
Therefore variable cost 40,000 8,000,000

Variable production overhead cost per hour = Rs. 8,000,000/40,000 = Rs. 200

185 Page 17 of 18
Production overheads Rs.
Month 1: Total cost of 190,000 hours 62,000,000
Variable cost (190,000  Rs.200) (38,000,000)
Therefore fixed costs per month 24,000,000

Annual fixed production overhead costs = Rs.24,000,000  12 = Rs.288,000,000.

Fixed production overhead absorption rate = Rs. 288,000,000 / 2,400,000 = Rs.120

Cost estimate and cost gap estimate
Cost per unit of Rs.
Circuit board: Rs. 410 + (Rs.240,000/4,000) 470.00
Wiring: 25 / 100 x 98 / 100  Rs. 50 12.76
Other parts 810.00
Assembly labour cost: 30/60 x 100 / 90  Rs. 1,260 700.00
Variable overheads: 30/60  Rs. 200 100.00
Fixed overheads: 30/60  Rs.120 60.00
Total estimated production cost 2,152.76
Target cost (Rs. 2,500 / 100 x 80) 2,000.00
Cost gap (152.76)

186 Page 18 of 18
 “Repent and seek forgiveness from Allah. Allah forgives all sins.”

Journal Entries
Gross Salary 100,000
Provident fund Deduction (10,000)
Income Tax Deduction (10,000)
Net salary 80,000

Accounting entry:
Salary Expense 100,000
Provident fund Payable 10,000
Income Tax Pay 10,000
Salary Expense Payable 80,000

Integrated Accounts:
Set of accounting records that provides information for both financial accounting and cost accounting.

Inter Locking Accounts:

Cost accounting records (kept in factory) are separate from financial accounting records (kept in head office).
Following accounts are generally maintained in factory:

(1) Material account

(2) Factory payroll (direct ; indirect)
(3) Factory overheads account
(4) WIP account
(5) Finished Goods account

In practice most companies and ERP solutions available in the market use integrated accounting system.
Journal Entries
Integrated Accounts Interlocking Accounts
Basic Factory Books Head Office Book
Material Purchased From Supplier:
Material A/C
Accounts Payable Material A/C Factory Ledger control A/c
General Ledger control A/c Account Payable
Material Returned To Supplier:
Accounts Payable General Ledger control A/c Account Payable
Material Account Material Account Factory Ledger control A/c

Material Issued : WIP (Direct) No entry

WIP (Direct) FOH Account (Indirect)

187 Page 1 of 22
FOH Account(Indirect) Material
Material
Material Issued Returned To Store:
Material
WIP (Direct) Material No entry
FOH Account (Indirect) WIP (Direct)
FOH Account (Indirect)
Payroll:
Recording Of Payroll:
HO Payroll (Selling + Admin) Factory payroll (D+I) Factory Ledger control A/c
Factory payroll (Direct +Indirect) General ledger control A/c HO Payroll (Selling+ Admin)
Provident Fund payable Provident Fund payable
Income Tax payable Income Tax payable
Accrued payroll Accrued payroll

Employer’s Contribution To
Provident Fund:
WIP (Direct) WIP (Direct) Factory Ledger control A/c
FOH account (Indirect) FOH Account (Indirect) Selling
Selling General ledger control A/c Admin
Admin Provident Fund Payable
Provident fund payable
Payment Of Payroll: Accrued payroll
Accrued payroll No entry Bank
Bank
Payment Of Deductions:
Income tax payable Income tax payable
Provident fund payable No entry Provident fund payable
Cash Cash

Distribution Of Payroll:
WIP (Direct) WIP (Direct) Selling expenses
FOH Account (Indirect) FOH Account (Indirect) Admin Expenses (office)
Selling Expense Factory Payroll Payroll
Admin Expense (office)
Payroll
Factory Payroll

FOH Applied Charged To

Production:
WIP WIP No entry
FOH Account FOH Account

188 Page 2 of 22
 Goods Completed And Transferred
To Finished Goods Store Room:
Finished Goods No entry
WIP Finished Goods
WIP
Recording Of Cost Of Sales:
Cost of Goods Sold General Ledger control A/c Cost of Goods Sold
Finished Goods Finished Goods Factory Ledger control A/c
Recording Of Sales: Account Receivable
Account Receivable No entry Sales
Sales
Collection From Debtors:
Cash No entry Cash
Account Receivable Account Receivable
Payment for Accounts Payable:
Accounts payable -- Account Payable
Cash Cash
Recording of Depreciation of Fixed Assets:
F-OH (Depreciation) F-OH Factory Ledger control A/c
Acc Depreciation General Ledger control A/c Acc Depreciation
Payment of other F-OH:
F-OH F-OH Factory Ledger control A/c
Cash / payable General Ledger control A/c Cash/ payable
Under-applied F-OH closed Against CGS:
COS General Ledger control A/c COS
F-OH F-OH Factory Ledger control A/c
Over-applied F-OH Closed Against CGS:
F-OH F-OH Factory Ledger control A/c
COS General Ledger control A/c COS

There are separate records but these are kept in agreement or are readily reconcilable
Q.1 Sapphire limited (SL) fabricates parts for auto manufacturers and follows job order costing. The company’s head
office is situated in Lahore but the factory is in Karachi. A separate set of records is kept at the head office and at the
factory. Following details were extracted from SL’s records for the month of February 2011.
Jobs
A B C
Materials issued to production (units)
■ Material X 40,000 - 10,000
■ Material Y - 75,000 25,000
Direct labour hours worked (hours) 6,000 9,000 15,000
Labour rate per hour (Rs.) 75 60 65

189 Page 3 of 22
The other related information is as follows:
• Materials purchased on account:
o 100,000 units of material X at Rs. 25 per unit
o 150,000 units of material Y at Rs. 35 per unit
• The head office prepared the payroll and deducted 8% for payroll taxes. The payroll amounted to Rs. 3.0 million
out of which Rs. 1.0 million pertained to selling and administrative staff salaries. After charging direct labour
cost to each job the balance amount of payroll cost was attributed to general factory overhead.
• Factory overhead was applied to the jobs at Rs. 25 per direct labour hour.
• Actual factory overheads amounted to Rs. 700,000 including depreciation on machinery amounting to Rs.
400,000. All payments were made by head office.
• Over or under-applied factory overheads are closed to cost of goods sold account.
• Jobs A and B were completed during the month. Job A was sold for Rs. 2.0 million to one of the auto
manufacturer on credit. The customer however, agreed to settle the transaction at 2% cash discount.
• Selling and administrative expenses, other than salaries paid during the month were Rs. 500,000.

Required:
Prepare journal entries to record all the above transactions in SL’s factory ledger and general ledger for the month
of February 2011.
(16 marks)

Q. 2 S Corporation has its general office in lahore and its factory in nearby town. A separate set of records is kept at
the general office and at the factory.

On January 1, the factory trial balance showed the following:

Finished Goods 19,000
Work in Process 28,500
Materials 49,000
General Ledger 96,500

The following transactions were completed at the factory during the month:
(a) Materials purchases Rs.55,000
(b) Materials requisitions:
➢ Direct 67,000
➢ Indirect 10,000
(c) Return of materials to suppliers 950
(d) Payments to vendors (before 2% discount) 50,000
(e) Payrolls for the month:
➢ Direct labor (Rs.6 per hour) 26,400
➢ Indirect labor 6,400
➢ Sales salaries 2,800
➢ Office salaries 2,300
(Deduct 6.5% for FICA tax and 10% for federal income tax. Liability for payrolls and payroll taxes is kept on the
home office books.)
(f) Workers are paid and employer payroll taxes are recorded.
(g) Sundry factory overhead expenses, Rs.32,000.
(h) Factory overhead is applied to production at Rs.5 per direct labor hour.

190 Page 4 of 22
 “If you want that Allah love you then obey Allah.”

(i) Goods completed amounted to 80% of the total cost in the work in process account.
(i) Finished goods costing to Rs.114,000 were shipped to customers. (A gross profit of 25% is made on these
shipments.)

Required:
Entries in journal form to record the January transactions, using one work in process account and two parallel vertical
columns factory books and head office books.

Solution:
A.1
Journal Entries
(Factory Books) (Head Office Books)
Date Particular Debit Credit Particular Debit Credit
❖ Material X (100,000×25) 2,500,000 Factory Ledger 7,750,000
Material X (150,000×35) 5,250,000 Trade Creditors 7,750,000
General Ledger 7,750,000
(Purchase of material)
❖ Factory Payroll (3M – 1M) 2,000,000 Factory Ledger 2,000,000
General Ledger 2,000,000 H.O payroll A/c 1,000,000
Accrued payroll (bal) 2,760,000
Payroll taxes
(Payroll accrual) (3,000,000× 80%) 240,000
❖ No Entry Accrued payroll 2,760,000
Payroll Taxes 240,000
Bank 3,000,000
(payment of payroll & taxes)
❖ Work in process A (40,000×25) 1,000,000 No Entry
Work in process B (75,000×35) 2,625,000
Work in process C
(10,000×25 + 25,000×35) 1,125,000
Material X
(40,000×25+10,000×25) 1,250,000
Material Y
(75,000×35+25,000×35) 3,500,000
(Issuance of raw mat. to WIP)
❖ Work in process A (6,000x75) 450,000 Selling & admin 1,000,000
Work in process B (9,000x60) 540,000 H.O payroll 1,000,000
Work in process C(15,000x65) 975,000
Factory overheads (balance) 35,000
Factory Payroll 2,000,000
(Direct lab. Cost allocated to
WIP & F OH)
❖ Work in process A (6,000×25) 150,000 No Entry

191 Page 5 of 22
 Work in process B (9,000×25) 225,000
Work in process C (15,000×25) 375,000
Factory overheads 750,000
(Factory overheads applied to
WIP)
❖ Factory overheads 700,000 Factory Ledger 700,000
General Ledger 700,000 Bank 300,000
Accumulated Dep. 400,000
(Actual factory OH
Transferred)
Factory overheads 15,000 Factory Ledger 15,000
❖
General Ledger 15,000 Cost of goods sold 15,000
(over applied OH transferred
to cost of goods sold) (700 +35
-750)
❖ Finished goods A No Entry
(1,000+450+150) 1,600,000
Finished goods B
(2,625+540+225) 3,390,000
Work in process A 1,600,000
Work in process B 3,390,000

(Jobs A and B completed &

Transferred to finished goods)
❖ General Ledger 1,600,000 Cost of goods sold 1,600,000
Finished goods A 1,600,000 Factory Ledger 1,600,000
(Job A delivered & transferred
to cost of goods sold)
❖ No Entry Trade Debtors 2,000,000
Sales 2,000,000
(Job A sold to customer)
❖ No Entry Bank 1,960,000
Discount Allowed 40,000
Trade Debtors 2,000,000
(Amount realized from
customer)
❖ No Entry Selling & Admin. Expenses 500,000
Bank 500,000
(Payment of selling and
admin. Expenses)

192 Page 6 of 22
A.2SPACE CRAFT CORPORATION
Factory books Head Office books

Material 55,000 F.L 55,000

G.L 55,000 Payable 55,000
Purchase
G.L 950 Payable 950
Material 950 To F.L 950
Return to Supplier
WIP 67,000
FOH 10,000 X
Material 77,000
(material issued)
Payable 50,000
X
Discount Received 1,000
Cash 49,000
(payment to vendors)
Payroll:
Factory Payroll 32,800 H.O Payroll 5,100
G.L 32,800 F.L 32,800
FICA Tax payable 2,464
I.T Payable 3,790
Accrued payroll 31,646

FICA Tax payable 2,464

I.T Payable 3,790
Accrued payroll 31,646
Cash / bank 37,900

Distribution:
WIP 26,400 Selling 2,800
FOH 6,400 Admin 2,300
Facility payroll 32,800 H.O Payroll 5,100

193 Page 7 of 22
 FOH A/c 32,000 F.L 32,000
G.L 32,000 To Cash 32,000

WIP 22,000
FOH (applied) FOH 22,000 X
(*4,400 × 5) – (W-1)

Finished goods 115,120

Cost of WIP
WIP 115,120 X
transferred to
(80%) – (W-2)
finished

G.L 114,000 COS 114,000

Cost of Sales Finished goods 114,000 F.L
114,000

Sales Debtor 152,000

X To Sales
152,000
(114,000 / 75 *100)
Underapplied G.L 26,400 COS 26,400
FOH FOH 26,400 F.L 26,400

WORKINGS:
26,400
(W-1) = 4,400 × 5 = 22,000
6
(W-2) WIP
Rs. Rs.
b/d 28,500 Output (80%) 115,120
Material 67,000
Labour 26,400
FOH 22,000 c/d 28,780
143,900 143,900
Finished Goods
Rs. Rs.
b/d 19,000
WIP 115,120 COS 114,000
c/d 20,120
134,120 134,120
F-OH
Rs. Rs.
Material 10,000 WIP 22,000
Payroll 6,400 COS 26,400
Cash 32,000
48,400 48,400

194 Page 8 of 22
Inter locking accounts: these accounts involve using separate ledger for costing and financial reporting purposes.
1. Head office maintains a general ledger which is used to generate financial statements for external users.
[general ledger means ledgers maintained in Head office].
2. Factory maintains a cost ledger or factory ledger which is used to record manufacturing entries for
management [cost ledger means ledgers maintained in factory].

General ledger contains a Factory ledger control account to record the transactions between the factory and head
office.

factory ledger contains a General ledger control account to record the transactions between the factory and head
office.

Advantages of integrated accounts

• This system avoids duplication of effort between cost and financial accounting systems, by eliminating
unnecessary duplicate record.
• There is no need to reconcile the profits of cost and financial accounting, as single set of accounts calculates
profits for both.
• This system helps to reduce the cost of keeping two separate set of accounts.

Disadvantages of integrated accounts

• Using a single system for external reporting and the provision of management information reduces flexibility.
For example, inventory must be valued at full absorption cost for external reporting purposes (in accordance
with IAS 2: Inventories) but management might require marginal cost information for decision making.
• The system causes delay in providing information to management. Since this system is developed to provide
information to both financial and cost accounting, it might get complicated.
• This system creates difficulty for large entities which require detailed cost and financial information on on-
going basis.

Advantages of interlocking accounts

1. Allows greater flexibility

Disadvantages of interlocking accounts

1. Duplication of effort as entries need processing in both sets of ledgers
2. Different profit figures may emerge (because of different inventory valuations in financial and cost accounting)
3. Inventory valuations will be different between the two systems
4. Reconciliation may be necessary (which takes time and effort)

ACCOUNTING FOR INVENTORY

There are two main methods of recording inventory.
• Periodic inventory method (period end system)
• Perpetual inventory system

Each method uses a ledger account for inventory but these have different roles.

195 Page 9 of 22
Periodic inventory method
In periodic inventory method, inventory is measured at period-end on the basis of physical count and no record is
maintained in the form of stock ledger card. At year-end, closing inventory is valued and recorded in books. In this
system, opening inventory in the trial balance (a debit balance) and purchases (a debit balance) are both transferred
to cost of sales thus clearing both accounts.

Closing inventory is recognized in the inventory account as an asset (a debit balance) and the other side of the entry
is a credit to cost of sales. Cost of sales comprises purchase in the period adjusted for movements in inventory level
from the start to the end of the period.

Cost of sales = Opening inventory + Purchases (net) – Closing inventory.

Perpetual inventory method

In perpetual inventory method, stock ledger is maintained showing movements of inventory at the time of
occurrence. Inventory account is maintained and all movements in inventory is recorded in it.. The inventory account
is used to show the current cost of inventory in hand. In this type of accounting, a separate account for purchases is
not maintained as part of double entry records. The account is also used to record all issues out of inventory. These
issues constitute the cost of sales.

When the perpetual inventory method is used, when inventory is bought, it is debited to inventory account but when
it is sold, inventory is credited and cost of sales is debited.

Each issue of inventory is assigned a cost, and the cost of the items issued is either the actual cost of the inventory
(if it is practicable to establish the actual cost i.e. the inventory is individually identifiable) or a cost obtained using a
valuation method.

Each receipt and issue of inventory is recorded in the inventory account. This means that a purchases account
becomes unnecessary, because all purchases are recorded in the inventory account. Though a separate detail of
purchases may be maintained for vendor documentation purposes.

All transactions involving the receipt or issue of inventory must be recorded, and at any time, the balance on the
inventory account should be the value of inventory currently held. Though there is no need for inventory count but
one at the end of each period is conducted to maintain control over the integrity of records.

Accounting for the production of inventory

Cost Flow
Cost flow represents movement of cost and inventories through various ledgers until cost are sold and closed to cost
of sales. In this chapter, we will discuss how three elements of cost (Material, Labour and Production overheads)
combine to compute cost of sales.

As a simple starting point:

• For a retail company, the cost of goods sold is simply the purchase price of the goods.
• For a manufacturing company, the cost of goods sold is the total production cost including direct materials,
direct labour and production overheads. The accounting systems must identify these costs and then transfer
them into finished goods (usually via work-in-progress) and thus into cost of sales.

196 Page 10 of 22
Explanation of Inventory ledgers
Raw materials
Raw materials ledger is inventory account and it shows the inventory movement. When raw material is purchased it
is debited and when material is issued, it is credited and transferred to work in progress account. The balance at
year end represents raw material inventory on hand and is shown in statement of financial position.

Work in progress
Work in progress is another inventory account in manufacturing concern and it shows that goods are in progress. It
includes direct labour cost and absorbed production overheads, in addition to direct materials transferred from raw
material ledger. The work completed during the year is credited to work in progress and transferred to Finished
goods. The year-end balance of work in progress is production cost which is not yet completed and shown as
inventory in statement of financial position.

Finished goods
Finished goods is third inventory account which is maintained by manufacturing concern. This account is debited by
amount transferred from work in progress and represents completed goods. When the goods are sold, finished
goods account is credited and ultimately transferred to cost of sales, to complete the cost flow. The year-end balance
represents unsold goods and treated as inventory which is shown in statement of financial position.

Cost ledger control account (CLC) [Factory books in which General ledger Account for head office is maintained]
This account is used for ‘the other side’ of cost accounting double entries within interlocking accounts to replace
accounts that are not included (as being of no interest for costing purposes). This account is sometimes called ‘the
dustbin account’.

Examples of such accounts include:

• Cash
• Bank
• Trade receivables
• Trade payables

 Illustration:
The following diagram provides an overview of the various ledger accounts and the flow of information represented
by the accounting entries used within fully interlocking accounts.

197 Page 11 of 22
COMPREHENSIVE EXAMPLES
 Example:
At 1 July a manufacturing company had the following balances in the general ledger adjustment account in its cost
ledger (other name of factory ledger(which mean books of factory)):
Rs.
Balance IN general ledger control account brought forward (credit) 5,625
Material ledger control account 2,125
Finished goods stock control account 1,500
Work in progress control account 2,000

Required: Open ledger accounts for the above items in the cost ledger and post the following items which occurred
in the four-month period up to 31 October and prepare profit or loss statement.
Stock material purchased 12,000
Stock materials issued to production 12,500
Stock materials issued to maintenance department 1,000
Wages – direct 10,830
Included in direct wages is indirect work 600
Factory overheads incurred 4,200
Factory overheads absorbed into production 5,800
Work transferred to finished stock, at cost 24,000
Factory cost of sales 22,500
Sales at selling price 28,750
Administrative and selling costs 4,250

General ledger a/c

Rs. Rs.
Balance b/d 5,625
Cost of sales 22,500 material 12,000
Wages 10,830
Production overhead 4,200
Balance c/d 10,155

198 Page 12 of 22
 32,655 32,655

Material ledger a/c

Rs. Rs.
Balance b/d 2,125 Work in progress 12,500
General ledger 12,000 Production overhead 1,000
Balance c/d 625
14,125 14,125
Wages control a/c
Rs. Rs.
General ledger 10,830 Production overhead 600
Work in progress 10,230
10,830 10,830

Production overhead a/c

Rs. Rs.
Material ledger 1,000 Work in progress 5,800
Wages 600
General ledger 4,200
5,800 5,800

Administration and selling expenses a/c

Rs. Rs.
General ledger 4,250 Profit and loss a/c 4,250
4,250 4,250

Sales a/c
Rs. Rs.
Profit and loss a/c 28,750 Debtor 28,750
28,750 28,750

Work in progress a/c

Rs. Rs.
Balance b/d 2,000 Finished goods 24,000
Material 12,500
Wages[10,830-600] 10,230
Production overhead 5,800 Balance c/d 6,530
Finished good a/c
Rs. Rs.
Balance b/d 1,500 General Ledger 22,500
Work in progress 24,000
Balance c/d 3,000
25,500 25,500

199 Page 13 of 22
 Statement of profit or loss
Sales 28,750
Cost of goods sold 22,500
Administration and selling expenses 4,250
Profit 2,000

 Example:
Kaat Ltd operates separate cost accounting and financial accounting systems. The following manufacturing and
trading statement has been prepared from the financial accounts for the quarter ended 31 March.
Rs. Rs.
Raw materials
Opening stock 48,000
Purchases 108,800
156,800
Closing stock (52,000)
Raw materials consumed 104,800
Direct wages 40,200
Production overhead 60,900
Production cost incurred 205,900
Work in progress
Opening stock 64,000
Closing stock (58,000) 6,000
Cost of goods produced carried down 211,900
Sales 440,000
Cost of goods sold
Opening finished goods 120,000
Cost of goods produced 211,900
Finished goods closing stock (121,900) (210,000)
Gross profit 230,000

The following information has been extracted from the cost accounts:

Control account balances at 1 January

Rs.
Raw material stores 49,500
Work in progress 60,100
Finished goods 115,400

Transactions for the quarter

Rs.
Raw materials issued 104,800
Cost of goods produced 222,500
Cost of goods sold 212,100

200 Page 14 of 22
 Loss of materials damaged by flood (insurance claim pending) 2,400

An additional rent of Rs. 4,000 per month has been charged in the cost accounts. Production overhead was absorbed
at the rate of 185% of direct wages. Gross Profit at the end of the period is shown as Rs. 238,970.

Required
(a) Prepare the following control accounts in the cost ledger(means books of factory):
(i) Raw materials stores
(ii) Work in progress
(iii) Finished goods
(iv) Production overhead.

(b) Prepare a statement reconciling the gross profit as per the cost accounts and the financial accounts.(difference
will be because of stocks)

Note: stocks of raw material may be different because of FIFO or weighted average in financial and cost accounting
and WIP and Finished goods stocks may be because of marginal and absorption costing.

Solution
a) Preparation of the relevant control accounts in the cost ledger, would be as follows:
Raw materials stores a/c
Rs. Rs.
Balance b/f 49,500 Work in progress 104,800
General Ledger 108,800 Loss due to flood (in P.L) 2,400
Balance c/f 51,100
158,300 158,300
Work in progress control a/c
Rs. Rs.
Balance b/f 60,100 Finished goods 222,500
Raw materials 104,800 Balance c/f 56,970
Direct wages 40,200
Production overhead 74,370
(40,200 x 185%)
279,470 279,470

Finished goods control a/c

Rs. Rs.
Balance b/f 115,400 General ledger 212,100
Work in progress 222,500 Balance c/f 125,800
337,900 337,900

201 Page 15 of 22
 Production overhead
Rs. Rs.
General ledger control 60,900 Work in progress 74,370
Additional rent (4,000 x 3) 12,000
General ledger Bal. 1,470
74,370 74,370

b) Reconciliation statement
Rs. Rs.
Profit as per financial accounts 230,000
Difference in stock values
Opening raw material 48,000
Closing raw material (52,000)
Opening work in progress 64,000
Closing work in progress (58,000)
Opening Finished Goods 120,000
Closing Finished Goods (121,900)
Raw Material opening (49,500)
Raw Material closing 51,100
Opening work in progress (60,100)
Closing work in progress 56,970
Opening Finished Goods (115,400)
Closing Finished Goods 125,800
8,970
Profit as per cost accounts 238,970

 Example:
Mirza Limited is engaged in the manufacturing of spare parts for automobile industry. The company records the
purchase and issue of materials in a store ledger (in respect of quantity) which is not integrated with the financial
ledger. It is the policy of the company to value inventories on weighted average basis. The valuation is carried out
by the Finance Department using stores memorandum record. A physical stock count is carried out after every six
months. Any shortage/excess is then adjusted in the financial as well as stores ledger.

On December 31, 2013, physical stock count was conducted by the Internal Auditor of the company. He submitted
the following statement to the Finance Department:
Balance (in units) Cost per unit (Rs.)
Item Code Financial
Store Ledger Physical Average Current
Records
010-09 20,500 20,500 20,000 2.00 2.25
013-25 10,000 10,000 10,000 4.00 1.50
017-10 5,500 5,500 5,000 1.00 1.10
022-05 4,000 4,500 5,500 2.00 2.00
028-35 1,200 1,200 1,000 2.75 2.50
035-15 640 600 600 3.00 3.50

202 Page 16 of 22
On scrutinizing the details, Finance Department was able to ascertain the following reasons:
Item Code Reasons
010-09 500 units were defective and therefore the Internal Auditor excluded
them while taking the physical count.
013-25 This item is not in use and is considered obsolete. The net realizable value is Rs.
0.60 per unit.
017-10 Shortage is due to theft.
022-05 A receipt of 1,000 units was not recorded.
028-35 200 units returned to a supplier were not recorded. The invoiced cost was Rs. 3
per unit.
035-15 Discrepancy is due to incorrect recording of a Goods Receipt Note.

Required
a) Prepare necessary Journal entries to record the adjustments in the financial ledger. [accounting records]
b) State how would you make the necessary adjustments in the stores ledger. [store records where only quantities
are recorded]

Solution
a) Journal Entries in Financial Ledger[means where there is double entry system]
Dr. Cr.
Rupees Rupees
(i) Abnormal loss 1,000
Material A/c (500 x 2) 1,000
(Record the loss of item # 010-09)
(ii) Cost of sales 34,000
Material [10,000 x 3.4 (4 – 0.6)] 34,000
(Record the provision for obsolescence against item # 013-25)
(iii) Abnormal loss 500
Material (500 x 1) 500
(Record the theft of item # 017-10) (500 x 1)
(iv) (a) Material A/c 2,000
Creditors / Cash (1,000 x 2) 2,000
(Record the purchase of items # 022-05 )
(b) No adjustment as no further difference in physical and financial records
(v) Creditors/ Cash (200 x 3) 600
material A/c 600
(Record the return of item # 028-35)
(vi) No adjustment in financial ledger because financial and physical records are same
b) Recording in Stores Ledger
i. The quantity should be shown as negative figure.
ii. No adjustment.
iii. 500 units should be shown as a negative figure.
iv. 1,500 units should be recorded on the receipt side of individual stores ledger account.
v. 200 units should be reduced from the receipt.
vi. The postings of incorrectly recorded Goods Receipt Note should be corrected by reducing 40 units.

203 Page 17 of 22
 Example:
The following information is available for the month of December 2000 of Khalid Enterprises:
Rs.
Accounts payable December 01 6,000
Work in process December 01 30,000
Finished goods December 01 50,000

Materials December 31 15,000

Accounts payable December 31 10,000

Finished goods December 31 60,000

Actual factory overheads 150,000

Cost of sales 300,000

Payment of accounts payable used only for material purchases 35,000

Factory overhead is applied at 200% of direct labour cost. Jobs still in process on December 31, have been charged
Rs. 6,000 for material and Rs. 12,000 for direct labour hours (1,200 hours). Actual direct labour hours 10,000 @ Rs.
8.00 per hour.

Required
Calculate material purchases, cost of goods manufactured, applied factory overheads, Work in process December
31, Material used, Materials as on December 01 and under or over applied factory overhead,
Solution
Calculation of material purchases, cost of goods manufactured, applied factory overheads, Work in process
December 31, Material used, Materials as on December 01 and under or over applied factory overhead, along with
relevant ledgers, are given below:

Materials Inventory
Rs. Rs.
Balance b/f (Bal. Fig.) 58,000 Work in progress (from WIP) 82,000
Purchases (from payable) 39,000 Balance c/f 15,000
97,000 97,000
Accounts payable
Rs. Rs.
Cash 35,000 Balance b/f 6,000
Balance c/f 10,000 Purchases (Balancing figure) 39,000
45,000 45,000
Work in process
Rs. Rs.
Balance b/f 30,000
Materials (Bal. Fig.) 82,000 Finished goods (from FG) 310,000
Payroll (10,000 x8) 80,000
Production overheads W-1 160,000 Balance c/f W-2 42,000
352,000 352,000

204 Page 18 of 22
 Finished goods
Rs. Rs.
Balance b/f 50,000 Cost of sales 300,000
Work in process (Bal. Fig.) 310,000 Balance c/f 60,000
Production overheads
360,000 360,000
Rs. Rs.
Cash 150,000 Work in process 160,000
Cost of sales Bal. 10,000
Cost of sales
160,000 160,000
Rs. Rs.
Finished goods 300,000 Production overheads 10,000
Profit & Loss 290,000
W-1 Factory overhead applied and290,000
over absorbed overheads Rs.
290,000
Factory overhead applied (80,000 x 200%) 160,000
Actual factory overheads 150,000
Over absorbed overheads 10,000
W-2 Closing inventory of work in process Rs.
Materials 6,000
Labour 12,000
Factory overhead applied (12,000 x 200%) 24,000
42,000

 Example:
The incomplete cost accounts for a period of Company A are given below:
Store ledger control account(material account)
Rs. 000 Rs. 000
Opening balance 2,640
Financial ledger 3,363

Production wages control account

Rs. 000 Rs. 000
Financial ledger 2,940
Production overhead control account
Rs. 000 Rs. 000
Financial ledger 1,790
Work in process control account
Rs. 000 Rs. 000
Opening balance 1,724

The balances at the end of the period in Rs. 000 were:

Store ledger Rs. 2,543
WIP ledger Rs. 2,295

During the period 65,000 kilos of direct material were issued from stores at a weighted average price of Rs. 48 per
kilo. The balance of materials issued from stores represented indirect materials.

205 Page 19 of 22
Two thirds of the production wages are classified as ‘direct’. Average gross wage of direct workers was Rs. 20 per
hour. Production overheads are absorbed at a predetermined rate of Rs. 30 per direct labour hour.

Goods were delivered immediately after completion, as no finished goods store is maintained.

Required
Complete cost accounts for the period.

Note: financial ledger is an other name of General ledger control account.

Solution Completion of cost accounts for the period, are given below:

Store ledger control account

Rs. 000 Rs. 000
Opening balance (Given) 2,640 Work in process control
(65,000x48) 3,120
Financial ledger(Given) 3,363 Production overheads (Bal) 340
Closing balance 2,543

Production wages control account

6,003 6,003
Rs. 000 Rs. 000
Financial ledger(Given) 2,940 Work in process control
(2,940,000 x 2/3) 1,960

Production overheads (Bal) 980

Production overhead control account
2,940 2,940
Rs. 000 Rs. 000
Financial ledger 1,790 Work in process control (1,960,000
(Given) /20 x 30) 2,940
Store ledger 340
Production wages 980 Cost of sales (Under absorbed) 170
Work in process control account
(Bal.)
Rs. 000
3,110 Rs. 000
3,110
Opening balance (Given) 1,724 Financial ledger (Bal.) 7,449
Store ledger control 3,120
Production wages 1,960 Closing balance 2,295
Production overhead
2,940
9,744 9,744

206 Page 20 of 22
Example:
Mr. Azad had provided you the following information from his factory ledger for the quarter ended 31 December
2005.
Rs.
Control account balances as on October 1, 2005
Materials 49,500
Work in process 60,100
Finished goods 115,400
Transaction for quarter ended 31 December 2005
Material purchased 108,000
Direct wages 50,200
Payments for factory overheads 30,900
Depreciation of factory building and machine 42,000

Other related information is as under:

− Closing stock of raw materials and finished goods at December 31, 2005 amounted to Rs. 50,300 and Rs. 125,800
respectively.
− Cost of goods produced is Rs. 222,500.
− Factory overheads are absorbed in production @ 160% of direct wages.
− Diesel costing Rs. 2,000 included in the factory overheads was transferred to head office for use in generator.
− A bill for repairs amounting to Rs. 12,000 undertaken at the factory remained unpaid at the end of the quarter.
− Material costing Rs. 2,400 was destroyed by rain.

Required: Prepare Materials, Work in process, Finished goods, Factory overheads and Cost of sales ledgers.

Solution
Preparation of Materials, Work in process, finished goods, Factory overheads and Cost of sales ledgers are given
below.

Materials
Rupees Rupees
Balance b/f 49,500 Profit & Loss(loss) 2,400
payable 108,000 Work in process (Bal) 104,800
Balance c/f 50,300
157,500 157,500

Work in process
Rupees Rupees
Balance b/f 60,100 Finished goods 222,500
Wages 50,200
Factory overhead 80,320
(50,200 x 160%)
Materials 104,800 Balance c/f (Bal.) 72,920
295,420 295,420

207 Page 21 of 22
 Finished Goods
Rupees Rupees
Balance b/f 115,400 Cost of sales 212,100
Work in process 222,500 Balance c/f 125,800
337,900 337,900

Factory overheads
Rupees Rupees
Cash 30,900 Work in process 80,320
Accumulated depreciation 42,000 Admin expense 2,000
Payables 12,000 Cost of sales (Bal.) 2,580
84,900 84,900

Cost of sales
Rupees Rupees
Finished goods 212,100 Profit and loss 214,680
Factory overheads 2,580
214,680 214,680

208 Page 22 of 22
 Don’t take prayer (Salat) as burden. Prayer gives us relief from burden.

LEARNING CURVE THEORY

It has been observed in some industries that there is a tendency for labor time per unit to reduce in time as more
of the units are produced; workers become more familiar with the task and get quicker.

From the experience of aircraft production during World War II, aircraft manufactures found that the rate of
improvement was so regular that it could be expressed in terms of a formula; and labor hours can be predicted
with high degree of accuracy from a learning curve.

The first time a new operation is performed, both the workers and operating procedures are untried. As the
operation is repeated, the workers become more familiar with the work, labor efficiency increases and labor cost
per unit declines.

Basic Principle
The basic principle is that as cumulative output doubles, cumulative average time per unit falls to a fixed
percentage (the learning rate) of the previous average time.

The learning process starts from the point when the first unit comes off the production line. From then on, each
time cumulative production is doubled, the cumulative average time per unit is a fixed percentage of its previous
level.

For example a 90% learning curve means that each time cumulative output doubles the cumulative average time
per unit falls to 90% of its previous value.

The tabular approach :( of learning curve)

Example:
No. of Units Time to make the concerned units
1 10 hours
2 8 hours
3 7.386 hours
4 7.014 hours

What is clear from the above data that we are getting quicker, it is not obvious how the times to make successive
units are related. However, a pattern becomes apparent if we look at the cumulative average time per unit as
follows:
Units Time to make the Total cumulative time to Cumulative average time
concerned unit make all units so far per unit
(hours)
1 10.0 10.00 10.0
2 8.00 18.00 (10 + 8) 9.0 (18/2)
3 7.386 25.386 (18 +7.386) 8.462 (25.386/3)
4 7.014 32.40(25.386 + 7.014) 8.1 (32.40/4)

209 Page 1 of 36
In this example, it is verified that the cumulative average decreases to 90% of the previous cumulative average
time per unit every time we double the cumulative output, such as from 1 to 2 units and from 2 to 4 units. We can
therefore say that the process demonstrates a 90% learning rate.

All learning curve calculations use this idea of cumulative average, so imagine all units having serial numbers so
you can see that they fit into the cumulative picture.

For example how long would it take to make further 4 units (means extra 4 i.e. from 5 to 8), doubling the
cumulative total to 8 units? The order of calculation is very important:

Step 1: Calculate the cumulative average time for the target total production. The cumulative average time per
unit for the first 8 units = 8.1 x 90%= 7.290.

Step 2: Calculate the total cumulative time. The total cumulative time for the first 8 units =7.290 x 8 = 58.32 hours

Step 3: time to make the next 4 units i.e. from 5 units to 8 units
Time to make 8 units in total 58.32 hours
Time to make first 4 units 32.40 hours
Time to make extra 4 units(from 5 to 8) 25.92 hours

Or the table can be extended as follows:

Units Total cumulative time to make all Cumulative average time per unit
units so far

1 10.00 10.0(10/1)
2 18.00 9.0(18/2)
4 32.40 8.10(32.4/4)
8 58.32(7.29 x 8) 7.290
16 104.976(6.561 x 16) 6.561

Similarly we can find out how long would it take to make extra 8units (from 9 to 16) doubling the cumulative total
to 16?

i.e,
Time to make 16 units in total 104.976 hours
Time to make first 8 units 58.32 hours
Time to make extra 8 units (from 9 to 16) 46.656 hours

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 Prayer purifies our hearts and brings mercy of Allah to us.”

Limitation of tabular form of learning curve approach:

The problem with total doubling is that we cannot calculate averages for all levels of production.
For example, how would we go about calculating how long the fifth unit should take to make?

The Algebric Approach (of learning curve)

The learning curve in the table approach is useful if output keeps doubling, but for intermediate output levels we
can obtain the information by using the following formula:

Formula:
Y = a x Xb
Y = cumulative average time per unit to produce “X” units
X = cumulative number of units
a = time required to produce first unit of output
b = Index of learning:
Log r/log 2;

Where r = learning rate expressed as a decimal figure.

Example: Assume that it takes 400 direct labor hours to produce the first unit of a new product and an 85%
learning curve applies.

Required: Calculate the total time to produce the third unit?

Solution: This example cannot be solved by using tabular form therefore algebraic form
b = log 0.85/log 2 = -0.234

The cumulative average time per unit to produce the first 2 units is
Y = 400x 2(-0.234) =340.1

The total time to produce the first 2 units

340.1 x 2 = 680.2 hours

The cumulative average time per unit to produce the first 3 units is:
Y = 400x 3-0.234= 309.3

The total time to produce first three units =

309.3 x 3 = 927.9 hours

The total time to produce the third unit is =

927.9-680.2=247.7

211 Page 3 of 36
Question: the first unit of a new product is expected to take 100 hours. An 80% learning curve is known to apply.
Use algebraic method.

Calculate:
(a) Cumulative average time per unit to produce first 16 units?
Log 0.8/ Log 2 = -0.3219
100 X 16(-0.3219) = 40.96 hours/unit
Or by table; 100 x .8 x .8 x .8 x .8 = 40.96 hrs per unit

(b) Cumulative average time per unit for the first 25 units?
100 X 25(-0.3219) = 35.48 hrs/unit

(c) The time it takes to make the 20th unit?

(i) 100X20 (-0.3219) = 38.12 X 20 = 762.42 hours
(ii) 100X19(-0.3219) = 38.76 X 19 = 736.35 hours

Time to make 20th unit = 762.42-736.35 = 26.07 hours

Question: the first batch* of a new product took 20 hours to produce. The learning rate is 90 %.
*consider batch as a unit in the formula

Required: If the learning effect ceases after 72 batches (i.e all subsequent batches take same time as 72 nd) , how
long will it take to make a total of 100 batches.

Solution:
Step 1: Calculate the cumulative average time for the number of units/batches at which the learning effect ceases.
b = Log 0.9/Log 2 = -0.152003
Y = a x Xb

Cumulative average time per batch for 72 batches

Y = 20 x 72-0.152003= 10.44 hours/batch

Step 2 Calculate the cumulative average time per unit or batch for the number of units or batches at which the
learning effect ceases, minus 1:
X = 71 batches
Y = 20 x 71(-0.152003) = 10.46 hrs/batch

Step 3 calculates the time taken to make the unit or batch at which the learning effect ceases.
Batches 1 to 71 will take 71 x 10.46 = 742.66 hrs.
Batches 1 to 72 will take 72 x 10.44 = 751.68 hrs.
Batch 72 will take 9.02 hrs.

Step 4 calculate the total hours required for numbers of units or batch (which in this case are 100 batches?)
Batches 1 to 72 will take = 751.68 hrs.
Batches 73 to 100 will take (28 x 9.02) = 252.56 hrs.

212 Page 4 of 36
 “May Allah accept our prayers and forgive our sins’”

Batches 1 to 100 will take 1004.24 hrs.

OR
Batches 1 to 71 will take = 742.66 hrs.
Batches 72 to 100 will take (29 x 9.02) = 261.58 hrs.
Batches 1 to 100 will take 1004.24hrs

Question:
Cumulative average time per unit for product X has been tabulated as follows:
Units Cumulative average time per unit

1 20 minutes
2 17.2 minutes
4 14.792 minutes
8 12.72 minutes

Required: What is the learning curve rate?

Solution:
1) Each time the cumulative output doubles , the cumulative average time per unit will go down by the learning
rate.

To get from 1 to 8 the total has doubled 3 times we need to apply a factor of x r3 to the average time:
20 minutes x r3 = 12.72 minutes
r3 = 12.72/20
r3 = 0.636
or r = 0.6361/3
or r = 0.6360.333
So r = 0.86 or 86%
Icon is  on calculator.
or
2) It could easily be calculated from the data given in the question as well:

17.2/20 = 0.86
14.792/17.2 = 0.86
12.72/14.792 = 0.86
If however, only data of unit 1 and 8 is given as follows:

Units Cumulative avg time per

unit
1 20 minutes

8 12.72 minutes

In that case method 1 above could only be used.

213 Page 5 of 36
Labour Costing

1 INTRODUCTION TO LABOUR COSTING AND LABOUR COST CONTROL

Introduction

Labour cost is the second important element of the cost of production after material cost. Labour cots constitute a
major portion of the total cost of a product or service that may take the form of wages, salaries and/or other
incentives of employee remunerations. The profitability and growth of the entity depends greatly upon the proper
utilization of the human resources that in turn needs to be properly recoded and controlled.

Types of labour cost:

The labour cost has two types:

Direct Labour Cost: Direct labour cost is any cost that is specifically incurred for or can be readily charged to or
recognized with any specific contract, job or work order. In cost accounting it is classified as direct labour cost
which becomes part of prime cost.

Example: In a watch manufacturing factory, a worker operating molding machine to produce a part of wrist watch.

Indirect Labour Cost: Where the direct labour can be recognized with and charged to the job, the indirect labour
cannot be so charged and hence is treated as part of the factory overheads.

Example: Wages paid to supervisor of a factory or salary paid to driver of delivery van used for distribution of the
product.

Wage payments are generally based on the productivity, time and skill or the combination of these three. Proper
control and accounting for this cost factor and motivation of worker is important in bringing efficiency to an
enterprise.

Example:

Wage payment based on productivity: Wages paid on the basis of number of units produced, like stitching 2000
pieces of shirts at Rs. 75 per piece.

Wage payment based on time: Wages paid on the basis of number of hours a worker worked in a production line,
like 160 hours paid at Rs. 175 per hour.

Wage payment based on skill: A wage differentiation due to varied skills, like skilled workers are paid higher than
apprentice for the same job.
Measuring labour activity

It is important to differentiate between “production” and “productivity” while measuring labour activity.

214 Page 6 of 36
 “If you want success then obey Allah, remember Allah and Pray to Him.”

•
Production: Production refers to the quantity or volume of the output produced i.e. the total number of units
produced. Production therefore is a measure of quantity of work.
•
Productivity: Productivity unlike production is a measure of efficiency with which the units have been
produced.

Example:
Mr. X is supposed to produce six units in every hour at work. The standard productivity rate is six units per hour for
every employee. During the week he made 252 units in 38 hours of work. The productivity ratio is worked out as:

The total production in the week is 252 units.

Productivity is a relative measure of the hours actually taken and the hours that should have been taken to make
the output.

It might be determined in either of the following two methods

Method 1:
252 units should take 42 hours
But took 38 hours
Productivity ratio = 42/38 x 100 110.5%
Method 2:
In 38 hours Mr.X should make 228 units
But made 252 units
Productivity ratio = 252/228 x 100 110.5%

Comment: A productivity ratio greater than 100% indicates that the actual efficiency is better than the standard or
expected level of efficiency.

Labour payment methods

The choice of appropriate labour payment method is very important for any organisation as it:
o may affect the cost of the finished products specially when it is a labour intensive organisation,
o casts a major impact on the morale and efficiency of the employees and serious consideration should
therefore be given to the possible motivational impact of the remuneration method being adopted.

The two widely known basic labour payment methods are:

• Time rate
• Piecework

215 Page 7 of 36
Time rate
Time rate/ time work or basic pay is where the employee gets paid on the basis of his time spent at work. The
most common form of this type is a day-rate system.

The formula used for calculating wages under this method is:

Wages = Hours worked x Per hour pay rate

Overtime: If an employee works for more hours than the basic daily requirement or on days which do not
constitute a part of the working week (e.g. Saturdays and Sundays), then he may be entitled to an overtime
payment. The overtime hours are usually paid at a premium rate such as “time and a quarter”, “time and a half” or
“double-time”.

Time and a quarter for example, means that 1.25 times the basic hourly rate is paid for hours worked in excess of
the basic requirement. The overtime premium is the extra rate paid over and above the basic rate.

If employees work unsocial hours, e.g. overnight, then they are entitled to a shift premium which is quite similar to
an overtime premium and means that the employees are paid at an increased hourly rate.

Example:
If the basic rate of pay per hour is Rs. 6 and overtime rate is time and a half, then calculate the overtime premium
for 8 hours worked in excess of the basic requirement.

Solution:
Rs.
Basic Pay (8 x Rs. 6) 48
Overtime premium (8 x Rs. 3) 24
Total (8 x Rs. 9) 72

Piecework
Under this method the employee is paid an agreed amount for each unit of output completed or for each task
carried out. Output units per hour may also be an agreed upon number that is referred to as “standard hour
produced”. It is also normal under piecework scheme that the employees get a guaranteed minimum wage
regardless of the number of units produced. This safeguards them from loss of earnings when the production is
low and is not on account of their own fault.

The wages under the piecework system can be calculated as:

Wages = Units produced x Per unit pay rate

Example: Straight piecework with guaranteed minimum wage

Sameer is paid Rs. 20 for each unit produced with a guaranteed wage of Rs. 2000 for a 40 hour week. For a series
of 4 weeks of the month he produced 140, 160, 180 and 200 units. Calculate total amount for the month.

216 Page 8 of 36
 “Prayer cures a sick soul, heals broken hearts and stops us from doing wrong.”

Solution:
Rs.
Week 1 [(140 units x Rs. 20) + Rs. 2000] 4,800
Week 2 [(160 units x Rs. 20) + Rs. 2000] 5,200
Week 3 [(180 units x Rs. 20) + Rs. 2000] 5,600
Week 4 [(200 units x Rs. 20) + Rs. 2000] 6,000
Total for the month 21,600

Basis of labour cost control

Labour cost control requires analysis of labour cost with different angles and perspectives, such as, cost per hour,
cost by departments, by product lines, by direct and indirect angle, by rates, by jobs or processes.

Labour cost controls aim to achieve maximum efficiency without compromising the quality and effectiveness of
the operations. Cost analysis and wage system help in achieving this objective.

Example:
ABC Publishers Limited pays wages to workers working on book binding machine at the rate of Rs. 17 per book.
Workers are not paid for the misaligned binding and such book is scraped for Rs. 15 per kg. The policy motivates
the workers to work hard and maximize productivity. However, the rate of wastage in ABC is 3% as against industry
average of 1%.

ABC re-visited the wage policy and felt that it is likely that workers tend to compromise the quality because of
insignificant loss they suffer due to bad quality. It intends to bring a policy whereby a deduction of Rs. 70 will be
made from the wages for each misaligned binding beyond 1% industry average. However, it is estimated that such
policy will reduce the efficiency of workers because they would reduce the speed to achieve desired quality
benchmark and avoid deduction.

The cost controller of ABC is supposed to work out the differential cost and revenue to evaluate the policy before
implementation. For this purpose, cost controller needs precise data with reasonable accuracy about the machine
capacity, labour related wastage, impact of slow speed and contribution margin per unit.

Tools for effective control on labor cost:

Effective labour cost control is achieved through different tools including;
• analyzing the targeted production,
• preparing labour budget and standardizing labour cost per unit,
• monitoring output, quality, wastage ratios, rework cost due to bad workmanship wage incentive systems.

Management of productivity and efficiency:

Labour Productivity:
Labour productivity can be described as a ratio between labour hours and units produced. Productivity may be
defined as the measurement of production performance using the expenditure of human effort as a yardstick.
Greater productivity can be achieved by better processes, improved or modern equipment and other factor that
improves the utilization of manpower. Productivity can be measured by following formula.

217 Page 9 of 36
 𝐴𝑐𝑡𝑢𝑎𝑙 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛
𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑣𝑖𝑡𝑦 = 𝑥 100
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛
Labour Efficiency:
Labour efficiency measures how efficiently workers produce a given quantity of units. It can be calculated by
creating the ratio between standard hours and actual hours. Efficiency can be calculated with the help of following
formula.

Productivity can be stated in one figure, such as; in Engine Installation Department of Motor company, 3 units per
8 labour hours is the productivity of the department. In assessing efficiency, a single figure would not suffice. There
should be any comparable figure, like own historical data, industry average or budgeted productivity.

If Motor company achieved 3 units per 8 labour hours’ productivity in 2018 in Engine Installation Department as
against 2.8 units per 8 labour hours in 2017. The department efficiently utilized its human resources in the year
2018 as compared to 2017.

Efficiency is achieved through high motivation and skills of workers and by better processes and quality of
machines and tools. Improved productivity positively impacts the business profits and the earnings of workers.

It may be noted that productivity and efficiency measures generally indicate number of outputs as against the
labour input and do not usually refer to the quality and level of bad workmanship. The quality aspect is also
important to achieve the objectives of cost controls.

The importance of measuring productivity and efficiency

In a competitive business environment where the price of a product is difficult to be controlled by the producers,
the efficient utilization of resources is the key. Labour cost in many industries is so significant that its efficiency can
make the difference. A producer should be able to set standards of performance in terms of hours and cost per
hour or cost per unit of production.

The performance standards measure the performance in unit and rupee term and variances help the managers to
focus around the problem areas.

Example:
In a production department the performance standards for a production of 3,000 units are set as 2,000 hours at
Rs. 90 per hour. If 2,200 hours are used at standard rate of Rs. 90 per hour to produce 3,000 units then there is an
unfavourable labour efficiency ratio of 90.9% (2,000 /2,200). In rupee term the unfavourable variance is Rs. 18000
(2,200 – 2,000) x 90 = 18,000.

There can be a variance as against the performance standards, which arises due to difference in wage rates.
Therefore, a total variance between the performance standards and actual results is analyzed in a way that we
arrive at the break up of both variances, namely, labour efficiency variance and labour rate variance.

218 Page 10 of 36
 “Focus on prayers and leave worries because prayers can change the situation.”

Example:
In a production department the performance standards for production of 3,000 units are set as 2,000
hours at Rs. 90 per hour. If 2,200 hours are used at Rs. 85 per hour to produce 3,000 units, the analysis
of variance is as follows:

Actual 2,200 labour hours at Rs.85 per hour Rs.187,000

Standard 2,000 labour hours at Rs.90 per hour Rs.180,000
Total variance (unfavourable) Rs. 7,000
Labour rate variance
Actual 2,200 labour hours at Rs.85 per hour Rs.187,000
At standard rate 2,200 labour hours at Rs.90 per hour Rs.198,000
Variance (favourable) Rs. 11,000
Labour efficiency variance
At standard rate 2,200 labour hours at Rs.90 per hour Rs.198,000
Standard 2,000 labour hours at Rs.90 per hour Rs.180,000
Variance (unfavourable) Rs. 18,000
Net (unfavourable) Rs. 7,000

The above analysis shows the importance of proper analysis before reaching to any conclusion about
the efficiency of labour force.

Wage Incentive Plans

Introduction
In general, bonus/incentive schemes initially had been introduced for workers who had been working
under a time-based system, in order to compensate them for their inability to increase their earnings.
Wage incentive plans refer to performance linked compensation paid to improve motivation and
productivity. Incentive schemes may either be short-term or long-term schemes.

Bonus systems base workers’ earnings on a combination of extra time served and work done. The
indirect labour is usually paid on a weekly or monthly basis, such wages and salaries may also be
increased by bonus payments.

219 Page 11 of 36
 Amount of work
Time taken
done

Bonus
system

Time Piecework

Time allowed for

rate rate
actual output

Characteristics of bonus systems

▪
A target is set and the performance is matched against that target.
▪
Employees feel trusted and motivated, the productivity increase and they are paid more for their
increased efficiency.
▪
Despite of the organization’s labour cost being increased in terms of bonus payments, the total unit
cost of the output stands reduced and the profit per unit of sale is increased.

The widely known bonus/ incentive schemes are discussed in the following paragraphs.

High day-rate system

Under a high day-rate system employees get paid at a higher than average hourly rate provided they
agree to produce a given amount of product at a given quality.

Example: High day-rate system

Shahid makes 200 units in a 40 hour week if he were to be paid Rs. 4 per hour, but 240 units if he were
paid Rs. 5 per hour.

Calculate
i. the amount to be paid to Shahid in both the cases,
ii. labour cost per unit
iii. cost per unit of output if the production overhead is recorded at the rate of Rs. 4 per direct
labour hour.

220 Page 12 of 36
Solution:

Rs.

i. Amount to be paid to Shahid

a. Under low day-rate scheme
40 hours x Rs. 4 160

b. Under high day-rate scheme

40 hours x Rs. 5 200

ii. Labour cost per unit

a. Under low day-rate scheme
160
200
0.8/unit

b. Under high day-rate scheme

200
240 0.833/unit

iii. Cost per unit

c. Under low day-rate scheme
160 + (40 x 4)
200
1.60/unit

d. Under high day-rate scheme

200 +(40 x 4)
240
1.5/unit

Comment:

Though in the given example the labour cost per unit is lower under the low day-rate scheme but the
total unit cost is lower under the high day-rate scheme. Therefore we see that the high day-rate scheme
in the given scenario would reward both i.e. the employer (a lower unit cost by 10p) and employee (an
extra Rs.1 earned per hour).

Advantages
o It is easier to calculate and understand.
o It assures the employee a consistently high wage.

221 Page 13 of 36
Disadvantages
o Employees cannot go beyond the fixed hourly rate for the extra effort they put in. In the example
given above if the employee makes 280 units instead of 240 units in a 40 hours week, the cost per
unit would decrease even further but all the savings would go to the benefit of the employer and
none would go to the employee.
o The high wages might become the accepted wage level for normal working. Management might
need to keep checks on the productivity and efficiency levels of the employees.

Individual bonus schemes

An individual bonus scheme sets out performance objectives/targets and usually forms part of the
performance appraisal systems of organizations. Every individual’s bonus is calculated separately and is
unique to every employee. So basically it is an incentive whereby an employee has to qualify to be
entitled for a bonus on top of his/ her basic wage.

For Example, Rs.100 per unit bonus is paid to an employee if he produced at least 500 units per month.
If an employee achieves that performance standard then he will be entitled to get a bonus on all units
produced.

Question number 2
Group bonus schemes
In cases where individual efforts cannot be exactly measured and employees work as a team, individual
incentive schemes become impracticable. In such scenarios group incentive schemes are found to be
more relevant and feasible. Even in cases where an individual alone cannot complete his job without
the cooperation of his fellow workers, there too, group incentive schemes are given preference over the
individual bonus schemes.

Group bonus plans reward all team members equally based on overall performance of the team
members. It usually comes into play when individual output cannot be measured with accuracy.
Therefore, team performance is evaluated on the basis of time taken to complete the job rather than
output produced. Usually, the bonus earned by the group is divided among the group members in
accordance with their respective base rates.

For Example, a bonus may be paid to department which has a reject rate in unit of output below a
specified ratio in proportion to their respective basic wages.

Advantages
•
Group schemes reduce the clerical efforts to be put in for the calculations of individual incentive
schemes.
•
They are easy to be administered.
•
Group schemes improve the team cohesion.

Disadvantages
•
Employees might demand for minimum targets for accepting the scheme.
• Employees doing the best and the worst might fall victim to team’s politics.

222 Page 14 of 36
 “Sins take you away from Allah while prayers take you back to Allah.”

Question number 3
Profit sharing schemes
A profit sharing scheme offers the employees a certain proportion of the organization’s profits. The size
of this offer is related to the designation of the employee and also the length of the employment period
to date.

Advantages
The biggest advantage is that the organization will pay only what it can afford to pay out of the
actual profits earned.
Such schemes can be offered to indirect labour as well.

Disadvantages
Employees may be putting in best of their efforts yet the organization might still incur losses on
account of issues beyond the control of the employees.
It is a long term commitment that the organization is asking for. The employees have to wait for
the bonus until the year ends. The reward is not an immediate one.

Share incentive schemes

A share incentive scheme is where the employees of the company are given an option to acquire the
shares as an incentive. In this way the employees’ morale rises so does their loyalty due to the feeling
that they now have a stake in the company they work for.

Question number 1

1 Question # 1

IB Company, a manufacturer and supplier of specialized equipment, is currently engaged in

producing the new equipment.

The company has been producing 150 units per week of new product; factory overhead (all fixed) was
Rs.12,000 per week. The following is a schedule of the pay rates of three workers.

Employee Hourly Rate

Sami Rs.60

Ali Rs.80

Pervaiz Rs.70

Customers have been calling in for additional units but management does not want to work more than
40 hours per week. To motivate its workers, the company decided to introduce an incentive wage plan.
Under the plan, each worker would be paid a base rate per hour, as shown in the following schedule,

223 Page 15 of 36
 and a premium of Rs. 10 per unit when the total number of units exceeds 150. (on all units produced by
employees)

Employee Base Rate

Sami Rs.35

Ali Rs. 55

Pervaiz Rs. 45

As a result, production increased to 165 units. The supervisor studied the results and considered the plan
too costly; production has increased 10%, but the labour cost has increased by approximately 23.2% (as
compared with original labor cost). The supervisor requested permission to redesign the plan in order to
make the labour cost increase proportionate to the productivity increase.

Required:
1. The Rupees amount of the 23.2% labour cost increase (means make a comparison between the
new scheme and old scheme)
2. An opinion, supported by figure, as to whether the supervisor was correct in assuming that the
incentive wage plan was too costly, and a discussion of other factors to be considered.

2 Question # 2

Standard production for an employee, Tayyab, in the Assembly department of

Moazzam Ltd. is 20 units per hour in an 8-hours day. The hourly wage rate is Rs.75.
Required:
Tayyab’s earning under each of the following condition
1. If an incentive plan is used, with the worker receiving 80% of the time saved each
day and record indicate:

Day Unit Hours Day Unit Hours Day Unit Hours

Monday 160 8 Tuesday 170 8 Wednesday 175 8

2. If the 100 percent bonus plan is used and 880 units are produced in a 40-hour
week.

224 Page 16 of 36
 3. If an incentive plan is used, providing an hourly rate increase of 5%
for all hours worked each day that quota production is achieved and records
indicate:

Day Unit Hours Day Unit Hours Day Unit Hours

Monday 160 8 Tuesday 170 8 Wednesday 175 8

3 Question # 3
Group bonus plan

Employees of Abdullah Enterprises work in groups of five plus a group leader. Standard production
for a group is 400 units for a 40-hour week. The workers are paid Rs.60 an hour until production reaches
400 units then a bonus of Rs.120 per unit is paid with Rs.100 being divided equally among the five workers
and the remainder passing to the group leader (who is also paid a weekly salary of Rs.3,000). Factory
overhead is Rs.60 per direct labour hour and includes the group leader's earnings. The production record
of a group for one week shows:

Hours worked Units produced

Monday 40 72

Tuesday 40 81

Wednesday 40 95

Thursday 40 102

Friday 40 102

Total 200 452

Required
1. The week’s earnings of the group (excluding the leader), the labour cost per unit, the overhead cost
per unit and the conversion cost per unit, based upon the above data.
2. A schedule showing daily earnings of the group (excluding the leader), unit labour cost, unit
overhead cost, and the conversion cost per unit, assuming that the company uses the group bonus
plan (with 100% bonus per hour saved)

225 Page 17 of 36
 “Prayer is the key of success. Prayer will work for us If we obey Allah.”

ANSWERS

1 Answer # 1

1. Regular Work Week

Employee Hourly Work Total Incentive Pay Total
Rate Week Labour Base Pay (Units Produced Labour
(Rs.) Cost (Base Rate x Incentive Cost
x Premium) (Rs.)
(Rs.) Work Hours) (Rs.)
(Rs.)
Sami 60 40 hrs. 2,400 165 x 10 = 1,650 3,050
35x40 hrs. =
Ali 80 40 hrs. 3,200 1,400 165 x 10 = 1,650 3,850
55x40 hrs. =
Pervaiz 70 40 hrs. 2,800 2,200 165 x 10 = 1,650 3,450
45x40 hrs. =
1,800

226 Page 18 of 36
 “Sincere prayer and faith in Allah brings light in the heart.”

2. To assess properly the effectiveness of the new plan, it is necessary to analyze its effect on
conversion costs and not just on direct labour cost. Although direct labour cost unit may rise, this
increase may be more than offset by distributing the overhead over a large volume.

A comparison of the two pay plans and their effects on conversion cost per unit shows:

Total Labour Total Overhea Total Unit

Labour Cost per factory d per Convers Convers
Cost unit overhea unit ion Cost ion Cost
(Rs.) (Rs.) ds (Rs.) (Rs.) (Rs.) (Rs.)

Incentive wage 10,350 62.8 12,000 72.7 22,350 135.5 *

plan

Straight Hourly 8,400 56.0 12,000 80 20,400 136 **

Rate

Difference 6.8 (7.3) (0.50)

* Rs. 22,350 / 165 units = 135.5 / unit

** Rs. 20,400 / 150 units = 136.0 / unit

The decrease in conversion cost is minimal: however, the fact that customers can be served sooner
might be worth the additional labour cost. Based on learning curve theory, the productivity of the
worker might increase sufficiently to reach a satisfactory output and cost level.

227 Page 19 of 36
2 Answer # 2

1.

Monday Tuesday Wednesday

Hours x Hourly Rate [Rs.75/hour*8 hours) - Rs.600 Rs.600 Rs.600

A

Units above standard - 10 15

Hours saved (10/20 and 15/20) - 0.50 0.75

Value of time saved (wage rate / hour x - Rs.37.5 Rs.56.25

hours saved)

80% of value of time saved – B - Rs.30 Rs.45

Earning (A+B) Rs.600 Rs.630 Rs.645

2. Earnings= *110% x Rs.75 hourly rate x 40 Hours = Rs.3,300 (*Efficiency ratio = 880 unit
(actual)/800(normal) =110%)
3. Earnings => Rs.75 hourly rate * 5% rate increase x 24 Hours = Rs.1,890

3 Answer # 3

1.

Hours Worked (5 Workers x 40 Hours) 200

Regular Wage (200 Hours x Rs.60) - A Rs.12,000

Units Produced – B 452

*Bonus – C Rs.5,200

Weekly earnings (A+C=D) Rs.17,200

Unit Labour Cost (D/B=E) Rs.38.05

Unit factory overhead (A/B=F) Rs.26.55

228 Page 20 of 36
 Unit conversion cost (E+F) Rs.64.6

*Bonus
452 units produced
400 units standard

52 units above standard x Rs.100 workers share = Rs.5,200

2. ABDULLAH ENTERPRISES

Monday Tuesday Wednesday Thursday Friday Total

Unit 72 81 95 102 102 452

produced
Standard 36 40.5 47.5 51 51 226
Hours for
unit
produced
(W1)
Actual 40 40 40 40 40 200
Hours
Bonus, -- Rs.30 Rs.450 Rs.660 Rs.660 Rs.1,800
Rs.60 x
hours saved
Total Rs.2,400 Rs.2,430 Rs.2,850 Rs.3,060 Rs.3,060 Rs.13,800
earnings
Unit Labour Rs. Rs.30 Rs.30 Rs.30 Rs.30 Rs.30.53
Cost (W2) 33.33
Unit Factory Rs. Rs.29.6 Rs.25.3 Rs.23.5 Rs.23.5 Rs. 26.55
overhead 33.33
(W2)
Unit Rs. Rs.59.6 Rs.55.3 Rs. 53.5 Rs.53.5 Rs.57.1
conversion 66.67
cost

W1

400 units per 40 hours= 10 units per hour

10 units per hour / 5 workers = 2 units per hour per worker 72 units produced / 2 units per hour= 36
hours standard time

229 Page 21 of 36
W2
If the group bonus is computed for the week rather than daily, the bonus would be Rs.60 x 30 hours
saved = Rs.1,800. Then per unit labour cost is Rs.30.53 (Rs.13,800/452 units) and per unit overhead
cost would be Rs.26.55 (Rs.12,000/452 units)

230 Page 22 of 36
Learning Curve Theory

When learning curve can apply:

• The activity is labor intensive
• Production units are identical
• Low labor turnover
• No prolonged breaks in production.

Assumptions:
o The amount of time required to complete a unit of a product or a given task will decrease every
time the task is undertaken.
o The unit time will decrease at a decreasing rate, and
o The time reductions will have a predictable pattern.

Example: Learning curve

Quality Plastics Limited (QPL) produces plastic bodies of various appliances according to the customers’
specifications. It has received an order for supply of 10,000 plastic bodies of a washing machine. The
supply is to be made within 30 days.

The following information is available:

(i) QPL carries out production process in batches of 100 units each. Cost of the
first batch is estimated as under:

Rupees

Direct material (inclusive of 10% input losses) - 1,100 kg 66,000

Direct labour cost at normal rate - 200 hours x 220 44,000

Overheads at normal rate 200 hours x 150 30,000

(ii) It is estimated that due to learning curve effect, completion of the first,
second, third and fourth batch would require 200, 160, 148 and 140 hours
respectively.

This learning effect would continue till completion of 64 batches only.

231 Page 23 of 36
 Learning effect at various learning levels is as under:

80% 85% 90%

–0.322 –0.235 –0.152

(iii) It is estimated that after completion of the first 16 batches, material input losses would be
reduced from 10% to 6%.
(iv) QPL works a single shift of 8 hours per day. For the above order, QPL can spare 8,000 direct
labour hours. Overtime hours can be worked at 1.5 times the normal rate. During the
overtime hours, overheads would be 1.25 times the normal rate.

Required:
Compute the price that QPL should quote in order to earn a margin of 25% of the selling price.

Solution:

Material Rs.

First 16 batches (16*66,000) 1,056,000

Next 84 batches [84 x 66,000]/100 x 90 /94

x100 5,308,085

Direct labour cost

Normal hours at Rs. 220 x 8,000 (W 1) 1,760,000

Overtime hours at Rs. 330 x 2,079 (W1) 686,070

Overheads

Normal hours at Rs. 150 x 8,000 (W 1) 1,200,000

Overtime hours at Rs. 187.5 x 2,079 (W1) 389,813

Total costs 10,399,968

Order price (1,0434,283 / 75 x 100) 13,866,624

232 Page 24 of 36
W.1: Learning curve %: Cumulative

Batch No. Cumulative hours Average hours per Learning

Batch curve %

1 200.00 200.00 (200 / 1)

2 (200+160) 360.00 180.00 (360 / 2) (180/200)

90%

4 (360+148+140) 648.00 162.00 (648 / 4) (162/180)

90%

Hours for first 64 batches 64x200x64-0.152 6,803

Hours for first 63 batches 63x200x63 -0.152 ( 6,712)

Hours per batch after 64th batch 91

Hours required:

First 64 batches 6,803

Last 36 batches (91×36) 3,276

Total hours 10,079

Overtime hours (10,079 – 8,000) 2,079

233 Page 25 of 36
Recording and Accounting for Labour Cost

Recording labour costs

There are various departments within an organisation that are involved in collecting, recording and
costing of labour. The procedures involve production planning, time and motion study, timekeeping,
labour budgeting, etc. A brief detail of the departments involved and procedures performed by them in
the due process is produced below.

1. Human Resource department

The HR department is primarily responsible for the hiring of employees, engaging them, their transfer,
departure and termination etc. This department maintains employees’ records and issues the reports
for the management to facilitate the decision making process of HR related issues.

2. Production Planning department

The Production Planning department schedules work, issues the job orders to production departments
and chases up jobs in the factory when they run late.

3. Time keeping department

The timekeeping department keeps track of the time spent in the factory by each worker and the time
spent by each worker on each job.

The time keeping activity might be carried out using any of the following tools with reference to the
relevance and importance to the nature of activity.

Daily time sheets: The daily time sheet is filled in by the employee on everyday basis. It will record how
his/ her time in the factory has been spent. The total time on the sheet should however correspond to
the record on the attendance form.

Weekly time sheets: They are similar to the daily time sheets but are sent to the cost office towards the
end of every week.

Job cards: Job cards are job specific and are prepared for every job or batch separately. In a time sheet
the worker if engaged with many jobs will have several entries related to the respective jobs wherein in
case of job cards, each job card will contain the detail of activities carried out by the employee in
respect to that specific job only.

Piecework or operation card: a Piecework ticket contains the record of total number of items produces
by the employee and the total number of the units rejected. Payment would be made for only the items
that are as per the required standards.

4. Cost accounting department

The cost accounting department accumulates and classifies all the data related to the labour costs. The
information is then shared with the management to help determine the control measures if required.

234 Page 26 of 36
Journal entries for recording labour costs
The primary journal entry for payroll is the summary-level entry that is compiled from the payroll
register and which is recorded in either the payroll journal or the general ledger. This entry usually
includes debits for the direct labour expense, salaries and the company's portion of payroll taxes. There
will also be credits to the liability for payroll taxes that have not been paid, as well as for the amount of
cash already paid to employees for their net pay. The basic entry (assuming no further breakdown of
debits by individual department) is:

(i) To record the total wages earned (recording)

Debit Credit

Payroll xxx

Accrued Payroll tax xxx

Payroll advances xxx

Payroll deductions (e.g. provident fund) xxx

Accrued Payroll xxx

(ii) To record payment of the payroll (payment)

Debit Credit

Accrued Payroll xxx

Cash/Bank Xxx

(iii) To record the closure of the Payroll account (distribution)

Debit Credit

W-I-P – Direct Labour Xxx

FOH – Indirect Labour xxx

Selling Expenses Control a/c – Sales Salaries xxx

Administrative Exp – Office Salaries xxx

Payroll Xxx

235 Page 27 of 36
Extra practice questions:
Q.1 Smart Processing Limited (SPL) is considering to sign a contract for manufacturing 10,000 auto parts for a
large automobile assembler. The parts would be produced in batch of 500 units each. The estimated cost of
the first batch is as under.
Rupees
Direct material (500 kg) 135,000
Direct Labour (1,500 hours) 225,000
Variable overheads (Rs. 120 per direct labour hour) 180,000
Set-up cost per batch 40,000
Fixed costs:
• Depreciation of equipment purchased for the project 45,000
• Allocation of existing overheads @ Rs. 16 per hour 24,000
Cost of first batch 649,000

Additional information:
i. The set-up cost per batch would be reduced by 5% for each subsequent batch. However, there would
be no further reduction in the set-up cost from the 5th batch onward.
ii. Learning curve effect is estimated at 90% but would remain effective for the first eight batches only.
iii. The index of 90% learning curve is -0.152.

Required:
Compute the contract price that would enable SPL to earn an incremental profit of 30% of the contract price.
Ans.1 Smart processing Limited
Computation of contract price
Rupees
Cost of material 135,000 x 20 2,700,000
Direct Labour cost:
• For the first 8 batches (W-1) 8,748
• For the last 12 batches (W-1)
031 x 12 11,244
19,992 x 150(225,000 ÷ 1500) 2,998,800
Variable overhead 19,992 x 120 2,399,040
Batch set-up cost:
• For the first 4 148,395
batches(40,000+40,000x95%+40,000x95%)x95%+40,000x95%x95%x95%)
• For the last 16 batches (40,000x95%x95%x95%x16) 548,720

Fixed costs:
• Depreciation on equipment purchased for the project 45,000 x 20 900,000
• Allocation of existing fixed overheads Irrelevant cost -
Total incremental cost of the contract 9,694,955
Contract price (9,694,955 ÷ 70 x 100) 13,849,936

236 Page 28 of 36
1) Y = 1,500 X 8-0.152
= 1,093.51 x 8 = 8,748 hrs.
-0.152
2) Y = 1,500 x 7
= 1,115.93 x 7 = 7,811 hrs.

Time for 8th batch = 8,748 – 7,811

= 937 hrs.

2 Chair co has developed a new type of luxury car seat. The estimated labor time for the first unit is 12 hours
but a learning curve of 75 % is expected for the first eight units produced. The cost of labor is 15 per hour. The
cost of materials and other variable overheads is expected to total 230 per unit.

Chair co plans on pricing the seat by adding a 50% mark-up to the total variable cost per seat, with the labor
cost being based on the incremental time taken to produce the 8 th unit.

Required:
a) Calculate the price which chair Co expects to charge for the new seat.
Note: the learning index for a 75% learning curve is -0.415
( 5 marks)

b) The first phase of production has now been completed for the new car seat. The first unit actually took
12.5 hour to make and the total time for the first eight units was 34.3 hour, at which point the learning
effect came to an end. Chair Co are planning on adjusting the price to reflect the actual time it took to
complete the 8th unit.

Required:
i. Calculate the actual rate of learning and state whether this means that the labor force actually learnt more
quickly or less quickly than expected.
(3 Marks)
ii. Briefly explain the whether the adjusted price charged by Chair Co will be higher or lower than the price
you calculate in part (a) above. You are not required to calculate the adjusted price.
(2 marks)

Answer: 2
1 Chair Co
a) Learning curve formula = y = axb
Cumulative average time per unit for 8 units:
Y = 12 X 8-0.415
= 5.0628948 hours.
Therefore cumulative total time for 8 units = 40.503158 hours.

Cumulative average time per unit for 7 units:

Y = 12 x 7-0.415
= 5.3513771 hours.
Therefore cumulative total time for 7 units = 37.45964 hours.

237 Page 29 of 36
 “Worrying gives you tension and frustration while prayer gives you peace and stability.”

Therefore incremental time for 8th unit = 40.503158 hours – 37.45964 hours = 3.043518 hours.
Total labour cost for 8th unit = 3.043518 x 15 = 45.65277
Material and overheads cost per unit = 230
Therefore total cost per unit = 275.65277
Therefore price per unit = 413.47915 (275.6522/100 x 150)
b) (i) Actual learning rate

Cumulative number of Cumulative total Cumulative average

seats produced hours hours per unit
1 12.5 12.5
2 ? 12.5 x r
4 ? 12.5 x r2
8 34.3 12.5 x r3

Using algebra: 34.3 = 8 x (12.5 x r3) OR

12.5 x r3 = 4.2875(34.3/3)
3
4.2875 = (12.5 x r )
0.343 = r3 r3 = 0.343
r = 0.70 r = 0.7
The learning effect was 70% as compared to the forecast rate of 75% meaning that the labour force learnt
more quickly than anticipated.
(ii) Adjusted price

The adjusted price charged will be lower than the original price calculated in part (a). This is because the
incremental cost of the 8th unit will be lower given the 70% learning rate, even though the first unit took 12.5
hours. We know this because we are told that the cumulative time for 8 units was actually 34.3 hours. This is
lower than the estimated cumulative time in part (a) for 8 units of 40.503158 hours and therefore, logically,
the actual incremental time for the 8th unit must be lower than the estimated 3.043518 hours calculated in
part (a). Consequently, total cost will be lower and price will be lower, given that this is based on cost.

Working:

Y = a x xb * (log 0.7/ log2)

= 12.5 x 8-0.5145*
Y = 4.2875 x 8 = 34.3
Y = a x xb
= 12.5 x 7-0.5145
= 4.593 x 7
= 32.15
Actual time taken for 8th unit:
= 34.3 – 32.15
= 2.15 hrs.

238 Page 30 of 36
Q.3
DEL Limited manufactures radiators for car manufacturers. In normal operations, about 200,000 units are sold
per annum at an average selling price of Rs. 15,000 per unit. Manufacturing process is carried out by 500 highly
skilled labours who work an average of 180 hours per month at Rs. 250 per hour. Raw material cost is Rs. 3,000
per unit. Annual factory overheads are estimated at Rs. 540 million. Variable overheads are 150% of labour
cost.

DEL had received an offer from TRU Limited to manufacture 4,000 units of radiators of trucks, at Rs. 50,000 per
unit. DEL had expected to earn significantly high margin on this order and had planned to stop normal
production for this purpose. It had already procured the raw material for Rs. 60 million but before the start of
manufacturing it came to know that TRU has gone into liquidation.

To deal with the situation, DEL’s marketing department has negotiated with another truck manufacturer, NTR
Limited. NTR’s specifications are slightly different and the price offered by NTR is Rs. 40,000 per unit.

The costs to be incurred on the new order and other relevant details are as follows:
• Additional raw material of Rs. 12 million would have to be purchased for NTR’s order.
• DEL expects that first unit would take 10 hours. The labour time would be subject to a 95% learning
rate upto 1,000 units. Thereafter, the learning rate would stop. The index of 95% learning curve is -
0.074.
• Variable overheads would be 240% of the cost of labour.
• Fixed overheads are to be applied at Rs. 400 per labour hour.
• Total cost of preparing the plant for NTR’s order and resetting it to the normal production would be Rs.
4 million.

If the order from NTR is not accepted, raw materials of Rs. 60 million already procured would have to be sold
at 70% of their cost. However, raw material worth Rs. 10 million can be utilized in the car’s radiators after
slight alteration at a cost of Rs. 1 million. The altered raw material can produce 30% components of 10,000 car
radiators.

Required:

Determine whether DEL may accept the order from NTR.

Ans.3 DEL Limited

Acceptance of order from NTR Limited for truck radiators

Rs. In Million
Revenue from NTR Limited 40,000 x 4,000 160.00
Additional raw material (12.00)
Raw material already procured – sales value (60-10)×70% (35.00)
– use value for truck radiators (W 1) (10,000×3,000×30%)-1 (8.00)
Labour cost [22,647.91 (W-2)×250] (5.66)
Variable overheads (5.66×240%) (13.58)

239 Page 31 of 36
Preparation and resetting cost of the plant (4.00)
Fixed overheads applied To be ignored -
81.76
Loss of CM for not producing car radiators 4,194 (W-3) ×8,625 (W-4) (36.17)
Profit on acceptance of the order from NTR 45.59

Conclusion:

DEL should accept the order from NTR Limited

Workings:
W-1: For remaining raw material of Rs. 10M which can be utilized:
Higher of Market value = 7(10 x 70%)
Alternate use = Cost saving = 9M (10,000 X 30,000 X 3%)
Less = Additional cost (1m)
8m

W-2: Direct labour hours for production of truck radiators

Hours
Direct labour hours for 1,000 units 5,997.91*
Direct labour hours for 999 units (5,992.36)**
Hours per unit for 1,000th unit and onward 5.55
Direct labour hours for first 1,000 units 5,997.91
Direct labour hours for next 3,000 units (5.55×3,000) 16,650.00
22,647.91

* Y = a x Xb
= 10 x 1,000-0.074
= 5,997.91/unit x 1,000
Total hrs for 1000 units = 5,997.91

** Y = a x Xb
= 10 x 999-0.074
= 5.983/unit x 999
= 5,992.36
Time for 1000th unit = 5.55
(5997.91 – 5,992.36)

W-3: No. of Car radiators to be produced if NTR's order is not accepted

Labour hours per unit of car radiator (500×180×12)÷200,000 Hrs. 5.40
No. of car radiators to be produced 22,647.91 (W-1) ÷ 5.40 Hrs. 4,194

240 Page 32 of 36
W-4: Contribution margin per unit/hour for car radiators
Rupees
Selling price 15,000
Raw material cost (Given) (3,000)
Labour cost (5.4 x 250) (1,350)
Variable overheads 150%×1,350 (2,025)
Contribution margin per unit 8,625

Q.4 Jasmine Limited (JL) manufactures various products according to customers' specifications. In March
2019, JL is required to submit a tender for supply of 5,000 plastic bodies of a washing machine. In this respect,
following information has been gathered:

(i) The production would be carried out on JL’s plant at its Sialkot factory. Cost of the plant is Rs.
3,600,000. Its estimated useful life is 96,000 hours. Each plastic body (unit) would require 2
machine hours.

(ii) Production would be carried out in ten batches of 500 units each. Cost per unit for the first
batch has been estimated as under:

Rupees
Direct material 2 kg 150
Direct labour 3 labour hours 300
*Overheads (based on direct labour hours):
Variable overheads 240
Fixed overheads 360

*Overheads do not include depreciation of the plant

(iii) Direct material consumption would reduce by 5% in each subsequent batch up to the third
batch and would become constant thereafter.

(iv) Applicable learning curve effect is 95% but it will remain effective for the first six batches only.
The index of 95% learning curve is –0.074.

Required:
Compute the bid amount that JL should quote to earn 30% contribution margin. (10)

241 Page 33 of 36
Ans.4 Jasmine Limited
Computation of bid amount to earn 30% contribution margin

Rs. In ‘000’
Direct material cost:
For first 3 batches 75,000 (150 x 500) + (75,000×0.95) + [75,000×(0.95)2] 214
For last 7 batches 75,000×(0.95)2×7 474
688
Direct labour cost:
For first 6 batches (W-1) 7,882×100 788
For last 4 batches (W-1) 1,224×4×100 490
1,278
Overheads
Variable overheads based on direct labour hours 240÷3×12,778 1,022
Variable overheads based on machine hours (molding plant depreciation) 375
3,600÷96,000×(5,000×2)
1,397
Fixed overheads -
1,397

Bid amount to earn 30% contribution margin (688+1,278+1,397)÷70x100 4,084

W-1: Direct labour hours at 95% learning curve

Hours
-0.074
For the first 6 batches 1500 x 6 x6 7,882

For the first 5 batches 1500 x 5-0.004 x 5 (6,658)

For the 7th. batch and onwards 1,224

Total labour hrs. (7,882 + 1,224 x 4) = 12,778 hrs.

Question: 5
BFG Limited is investigating the financial viability of a new product the S-pro. The S-pro is a short-life product
for which a market has been identified at an agreed design specification. The product will only have a life of 12
months.

The following estimated information is available in respect of S-pro:

1. Sales should be 120,000 in the year in batches of 100 units. An average selling price of 1,050 per batch of
100 units is expected. All sales are for cash.

242 Page 34 of 36
2. An 80% learning curve will apply for the first 700 batches after which a steady state production time will
apply, with the labour time per batch after the first 700 batches being equal to the time for the 700th
batch. The cost of the first batch was measured at 2,500. This was for 500 hours at 5 per hour.
3. Variable overhead is estimated at 2 per labour hour.
4. Direct material will be 500 per batch of S-pro for the first 200 batches produced. The second 200 batches
will cost 90% of the cost per batch of the first 200 batches. All batches from then on will cost 90% of the
batch cost for each of the second 200 batches. All purchases are made for cash.
5. S-pro will require additional space to be rented. These directly attributable fixed cost will be 15,000 per
month. A target net cash flow of 130,000 is required in order for this project to be acceptable.

Note: The learning curve formula is given on the formulae sheet. At the learning rate of 0.8(80%), the learning
factor (b) is equal to -0.3219.

Required:
a) Prepare detailed calculation to show whether product S-pro will provide the target net cash flow.
b) Calculate what length of time then second batch will take if the actual rate of learning is:
i. 80%
ii. 90%

Explain which rate shows the faster learning.

Answer: 5
(a) Sales 120,000 units
Or 1200 batches
Sales revenue 1,260,000
(1,200 x 1,050)
Costs:
Direct material (W-1) 514,000
Direct labour (W-2) 315,423
Variable overhead (W-3) 126,169
Rent (15,000 x 12) 180,000
Net cash flow 124,408
Target cash flow 130,000

The target cash flow will not be achieved

Workings:

1) Direct material Batches

First 200 @ 500 100,000
Second 200 @ 450 90,000
Remaining 800 @ 405 324,000
Total 514,000

243 Page 35 of 36
2) Direct labour
For first seven hundred batches Y = axb
Y = 2,500 x 700-0.3219
y 303.461045

All batches after the first 700 will have the same cost as the 700th batch. To calculate the cost of the 700th
batch we need to take the cost of 699 batches from the cost of 700 batches.
For 699 batches Y =axb
Y = 2,500 x 6990.3219
y = 303.600726 x 700 = 212,217
Cost of 700th batch is 212,423 - 212,217 = 206
Total cost for the 12 months of production
212,423 + (206 x 500) = 315,423

3) Variable overhead is 2 per hour or 40% of direct labour

Total labour Hrs. = 315,423 ÷ 5 = 63,085 Hrs. x 2 = 126,169

(b) To calculate the learning factor BFG will have had to measure the time taken to make the first batch (500
hours) and then the time taken to make the second batch. The learning rate measures the relationship
between the average time taken between two points as production doubles. The easiest way to measure the
learning rate is when the production doubles between the first and second batches.

At 80%
Time for first batch 500
Average time for two batches @80% 500 x 0.8 = 400
Total time for two batches 2 x 400 = 800
Time for second batch 800 - 500 =300

1 500 500 500

2 300 800 400

At 90%
Time for first batch 500
Average time for two batches @90% 500 x 0.9 = 450
Total time for two batches 2 x 450 = 900
Time for second batch 900 - 500 = 400

1 500 500 500

2 400 900 450

The 80% learning rate reduces the time taken for the two successive batches above by a greater amount (or
faster). Hence the 80% learning rate is the faster learning.

244 Page 36 of 36
 “Prayer becomes powerful when it is done with patience and sincere faith in Allah.”

Inventory Valuation
MATERIALS: PROCEDURES AND DOCUMENTATIONS
Materials are the basic components of manufacturing and production process in a goods manufacturing entity.
Materials are also called raw materials which are used in the production of a finished products (such as Crude Oil is
a raw material for Petrol, Milk is a raw material for Yogurt, Yarn is a raw material for Garment whereas Petrol,
Yogurt and Garment are the finished products).

An entity that purchases materials to be used in its production or further sale, must ensure that proper procedures
are in place to enable the controls over their costs, purchase quantity, quality as well as usage quantity.

In order to make the controls effective, their documentation is necessary so that verifiable records can be
maintained.

The following example shall illustrate the procedure of purchasing, storing and issuing the raw materials to the
production department.

Example:
A Limited is engaged in the manufacturing of Cotton Garment. It uses yarn as its raw material. It requires 10 tons
of yarn for the next production.

The Production Department raises the Material Requisition (M.R) to the Store / Warehouse of the company
depicting the quantity and time at which the stock is needed. The Store / Warehouse of the company raises a
Purchase Requisition (P.R) to the Purchase / Procurement Department. The Purchase / Procurement Department
raises a request for quotation to the yarn suppliers and on the basis of accepted quotation, raises a Purchase Order
(P.O) which is delivered to the supplier. The supplier on the basis of P.O (which includes quantity, rate and time of
delivery) delivers the yarn at the store / warehouse of A Limited and issues a Goods Dispatch / Delivery Note (GDN)
to the Store and Purchase/ Procurement Departments of A Limited. The storekeeper/ warehouse in-charge of A
Limited issues a Goods Received Note (GRN) the copy of which is given to the supplier and Purchase / Procurement
Department after inspecting the goods along with the invoice.

The Storekeeper / Warehouse in-charge arranges the goods on the First in First Out (FIFO) basis or Weighted
Average (AVCO) basis depending upon the company’s policy (usually perishable products are carried at FIFO
basis).The Store then issues the raw materials to the Production Department and prepares a Goods Issue Note
(GIN).The following table summarizes the above procedures and documents.

245 Page 1 of 15
 Process Documents

Production Department raise material requisition to Store / Warehouse Material Requisition

Store / Warehouse issues purchase requisition to Procurement / Purchase Requisition

Purchase Department
Procurement Department raises Purchase Order to the approved supplier Purchase Order

Supplier delivers goods at company’s warehouse Goods Dispatch / Delivery Note

and Invoice / Bill

The warehouse in-charge receives the goods and inspect Goods Received Note
The warehouse issues raw materials to the production department Goods Issue Note

Documentation of purchase process is therefore needed:

• to ensure that the procedures for ordering, receiving and paying for materials has been conducted properly,
and there is no error or fraud
• to provide a record of materials purchases for the financial accounts
• to provide a record of materials costs for the cost and management accounts.
• to ensure physical controls over the materials and to ensure they are used not used improperly

The detailed procedures for purchasing materials and the documents used might differ according to the size,
complexity and nature of the business. However, the basic requirements are same for all types of business where
material purchases are made.

INVENTORIES AND THEIR VALUATION

Types of Inventories:
Inventory comprises raw materials, work-in-process, stores, spares and tools and finished goods.

Raw materials are consumed in the production during a period. They are treated as expense whereas those raw
materials that are remaining at the end of the reporting period are treated as current assets and are termed as
inventories.

Work-in-process is the inventory on which partial costs have been incurred. For instance, for manufacturing a liter
of mango juice, 100% of mango pulp (raw material) has been put into process whereas the labor has worked only
50% up to the end of the reporting period. Due to this, the product is not considered completed nor it is a raw
material any more. This kind of inventory is called work-in-process and is treated as current asset.

Finished goods are the final products that are sold to the consumers / customers. The goods that have been sold to
the customers are treated as expense in the financial statements whereas, the goods that have not been sold till
the end of the reporting period are considered as inventories.

246 Page 2 of 15
Stores, spares and loose tools are used in the equipment and machinery and are kept in inventory so that in case
of any damage to the machinery or equipment, the production should not stop and necessary tools are available in
stock to resume the production at earliest.

The companies usually maintain the stock of such tools and spare parts for all the machinery and equipment,
whether or not such machinery or equipment are used in production. However, the cost of production shall only
include the cost of those stores, spares and tools that are used in the production machinery and equipment.
Accordingly, the units so used in the machineries or equipment are treated as expense and the ones which are
unused are classified as current assets.

Cost of Inventory: The following table explains the cost of each type of inventory:

Inventory Cost

Raw Material Purchase price including import duties & taxes (other than those subsequently
recoverable by the entity), transport, handling and other cost directly attributable to
the purchase of goods. Trade discounts, rebates and other similar items are deducted
in determining the cost. (IAS 2)

Work-in-process Cost of raw material as determined above, plus direct labor cost and production
overhead costs to the extent of work done.

Stores, spares and tools Same as Raw Material

Finished Goods Cost of raw material as determined above, plus direct labor cost and production
overheads.

Sometimes, the inventories are damaged or become wholly or partly obsolete. In such a case, the company
• Either have to incur more cost to bring them into saleable condition due to which the cost may exceed the
selling price
• Or sell them in the damaged / obsoleted form for which the selling price would probably be lower than actual
cost as demand of such obsoleted product may have come down

In such cases, the company needs to bring the inventories at their net realizable value.

Net Realizable Value:

Net realizable value is the estimated selling price in the ordinary course of business less the estimated cost of
completion and estimated cost necessary to make the sale (IAS 2).
It refers to the net amount that an entity expects to realize from the sale of the inventory in the ordinary course of
business (IAS 2).

Valuation of Inventory:
An entity is required to evaluate, at the end of each reporting period, the net realizable value of its inventories and
value the inventories at lower of:
• Cost or
• Net realizable value

247 Page 3 of 15
The cost of the inventories are normally lower than the net realizable value. Therefore, the inventories are carried
at their costs. However, the cost may exceed the net realizable value in the following cases:
• The inventories are damaged,
• The inventories have become wholly or partially obsolete,
• The selling price of the inventories have declined, or
• The estimated cost of completion or estimated cost to be incurred to make the sale have increased (IAS 2).

Example:
A business has three items of inventory currently carried at their cost. The market prices of the inventories have
fallen down due to sudden decrease in demand. Their estimated selling prices, cost of completion and selling costs
are as under:

Cost Sales price Cost of completion Selling costs

Rs. Rs. Rs. Rs.

Finished Product A1 8,000 7,800 - 500
Finished Product A2 14,000 12,000 - 200
Work-in-process B1 16,000 14,000 1,500 200

Calculate the NRV of the inventories.

Est. Selling price – Est. Cost of completion - Est. Selling Cost: Rs.

Finished Product A1 7,800 – 500 7,300

Finished Product A2 12,000 – 200 11,800
Work-in-process B1 14,000 – 1,500-200 12,300

It is to be noted that for finished goods no further processing cost is needed and therefore, the formula for NRV
does not include cost to complete.

Example:
A business has following items of inventories with their costs and NRV. You are required to calculate the value at
which the inventories should be carried.

Inventories Cost Cost of Cost to Selling Price

Completion Sell
---------------Rs.----------------
Raw Materials 150,000 500,000 50,000 850,000
Work-in-process 450,000 250,000 50,000 850,000
Finished Goods – in good condition 700,000 - 50,000 850,000
Finished Goods – damaged during 700,000 300,000 50,000 850,000
transport

248 Page 4 of 15
 “Prayer is the best medicine for sick soul and Allah is one who cures the sick soul.”

Calculating the value of inventories:

NRV (Est. Selling Price- Value at
Inventories Cost Est. Cost to complete- lower of
Est. Cost to Sell) cost or NRV

---------------Rs.----------------
Raw Materials 150,000 300,000 150,000
Work-in-process 450,000 500,000 450,000
Finished Goods – in good condition 700,000 800,000 700,000
Finished Goods – damaged during transport 700,000 500,000 500,000

It is to be noted here that the finished goods that were damaged during transport need to be worked on further
before sale, therefore, the formula of NRV shall now include cost to complete the goods.

Cost Formula
With some inventory items, particularly large and expensive items, it might be possible to recognize the actual cost
of each item.

In practice, however, this is unusual because the task of identifying the actual cost for all inventory items is
impossible because of the large numbers of such items and when the prices of those items differ in different
periods. The following example explains the situation well.

Example:
On 1 January a company had an opening inventory of 100 units which cost Rs.50 each. During the year it made the
following purchases:
• 5 April: 300 units at Rs. 60 each
• 14 July: 500 units at Rs. 70 each
• 22 October: 200 units at Rs. 80 each.

During the period it sold 800 units as follows:

• 9 May: 200 units
• 25 July: 200 units
• 23 November: 200 units
• 12 December: 200 units
This means that it has 300 units left at the end of the year (100 + 300 + 500 + 200 – (200 + 200+ 200 + 200 + 200))

But since the units were purchased at different prices so what price should the remaining units be allocated?
Should the units be allocated cost of units that were purchased last (that is Rs. 80)? But in that case the inventory
shall be overstated as only 200 out of 300 units were purchased at Rs. 80.

Should the cost of oldest purchased units be used? But in this case inventory will be understated. Should the units
be given the weighted average cost?

249 Page 5 of 15
A system is therefore needed for measuring the cost of inventory.
The cost of inventory is usually measured by one of the following methods:
• First in, first out (FIFO)
• Weighted average cost (AVCO)

The FIFO and weighted average cost (AVCO) methods of inventory valuation are used within perpetual inventory
systems. They can also be used to establish a cost for closing inventory with the period-end inventory
system.(means can be used whether we are using periodic inventory system or perpetual inventory system)

First-in, first-out method of valuation (FIFO)

With the first-in, first-out method of inventory valuation, it is assumed that inventory is consumed in the strict
order in which it was purchased or manufactured. The first items that are received into inventory are the first
items that go out.

To establish the cost of inventory using FIFO, it is necessary to keep a record of:
• the date that units of inventory are received into inventory, the number of units received and their purchase
price (or manufacturing cost)
• the date that units are issued from inventory and the number of units issued.

With this information, it is possible to put a cost to the inventory that is issued (sold or used) and to identify the
cost of the items still remaining in inventory.

Since it is assumed that the first items received into inventory are the first units that are used, it follows that the
value of inventory at any time should be the cost of the most recently-acquired units of inventory.(latest prices)

Weighted average cost (AVCO) method

With the weighted average cost (AVCO) method of inventory valuation it is assumed that all units are issued at the
current weighted average cost per unit.

The normal method of measuring average cost is the perpetual basis method. With the perpetual basis AVCO
method, a new average cost is calculated whenever more items are purchased and received into store. The
weighted average cost is calculated as follows:

Formula:

Cost of inventory currently in store + Cost of new items received

Average cost:
Number of units currently in store + Number of new units received

250 Page 6 of 15
Example:
XYZ Limited manufactures four products. The related data for the year ended December 31, 2013 is given below:
A B C D
Opening inventory
- Units 10,000 15,000 20,000 25,000
- Cost (Rs.) 70,000 120,000 180,000 310,000
- NRV (Rs.) 75,000 110,000 180,000 300,000
Production in units 50,000 60,000 75,000 100,000

A B C D
Costs of goods produced (Rs.) 400,000 600,000 825,000 1,200,000
Variable selling costs (Rs.) 60,000 80,000 90,000 100,000
Closing inventory (units) 5,000 10,000 15,000 24,000
Damaged units included in
closing inventory 300 600 800 1,500

Inventory valuation method in use Weighted Weighted FIFO FIFO

Average Average
Unit cost of purchase from market (Rs.) 10.50 11.00 11.50 13.00
Selling price per unit (Rs.) 10.00 12.00 12.00 12.50
Unit cost to repair damaged units (Rs.) 3.00 2.00 2.50 3.50

The company estimates that selling expenses will increase by 10% in January 2014.

Required: compute the amount of closing inventory that should be reported in the statement of financial position
as on December 31, 2013.

Answer: To calculate the cost of closing stock, we have to first calculate the cost of goods available for sale to
determine the weighted average cost per unit for the purpose of AVCO method.

Formula A B C D

Step 1: Calculating Units Sold during the period Units

Opening stock Given 10,000 15,000 20,000 25,000

Production during the Given 50,000 60,000 75,000 100,000
period
Goods available for Op. stock + production 60,000 75,000 95,000 125,000
sale during the period
Closing Stock Given (5,000) (10,000) (15,000) (24,000)
Units Sold Goods available for sale – 55,000 65,000 80,000 101,000
Closing Stock

251 Page 7 of 15
 *Units sold are calculated only to determine the mix of units for the purpose of costing of closing stock as per
FIFO.
Step 2: Calculating Cost of goods available for sale
-----------------Rs.--------------
Opening stock From the given data 70,000 110,000 180,000 300,000
valuation (at lower of
cost and NRV)

Cost of production for Given 400,000 600,000 825,000 1,200,000

the period

Cost of goods available Op. stock + production 470,000 710,000 1,005,000 1,500,000
for sale during the period

Formula A B C D
Step 3: Calculating cost of closing stock
A & B (W/Avg.): (Cost of goods available for sale 39,167 94,667
/Goods available for sale) x Closing
Stock
C & D (FIFO): (Cost of goods produced during the 165,000 288,000
period/Goods produced during the
period) x Closing Stock

4. Calculation of figures to be shown in statement of financial position:

Products A B C D
Closing Units 5,000 10,000 15,000 24,000
Damaged Units 300 600 800 1,500
Good Units(Bal) 4,700 9,400 14,200 22,500
Cost of closing 7.8334 9.4467 11 12
stock/Unit (39,167/5,000) (94,667/10,000) (165,000/15,000) (288,000/24,000)
Sale price/Unit 10 12 12 12.5

selling exp/Unit (1.2) (1.35) (1.2375) (1.089)

(60,000 ÷ 55,000
x 1.1)
NRV of good units/ unit 8.8 10.65 10.7625 11.411
Repair cost of damaged (3) (2) (2.5) (3.5)
units
NRV of damaged units 5.8 8.65 8.2625 7.911
Value of goods units 36,817 88,987 152,827.5 256,747.5
(lower) (4,700 x 7.8334) (9,400 x 9.4467) (14,200 x 10.7625) (22,500 x 11.411)
Value of damaged units 1,740 5,190 6,610 11,866.5
(300 x 5.8) (600 x 8.65) (800 x 8.2625) (1,500 x 7.911)
Total 38,557 94,177 159,437.5 268,614

252 Page 8 of 15
 “You are never too late nor old to move forward and make your life best.”
Comparison of Methods
The different methods of inventory valuation will give significantly different valuations for the cost of sales and the
value of closing inventory during a period of high inflation (when prices are increasing)
• With FIFO during a period of high inflation, the cost of sales will be lower than the current replacement cost of
materials used. The closing inventory value should be close to current value since they will be the units bought
most recently.
• With AVCO during a period of high inflation, the cost of sales will be higher and the value of closing inventory
lower than with FIFO valuation.

The valuation of closing inventory is higher and the cost of goods issued is lower using FIFO. This is typical during a
period when prices are rising steadily.

The opposite is true when prices are falling. The valuation of closing inventory is lower and the cost of goods
issued is higher using FIFO.

Advantages & Disadvantages of FIFO

Advantages
• Logical (probably represents physical reality)
• Easy to understand and explain to managers
• Gives a value near to replacement cost (means purchase cost)

Disadvantages
• Can be cumbersome to operate
• Managers may find it difficult to compare costs and make decisions when they are charged with varying prices
for the same materials
• In a period of high inflation, inventory issue prices will lag behind current market value

Advantages & Disadvantages of AVCO

Advantages
• Smoothens out price fluctuations
• Easier to administer than FIFO

Disadvantages
• Issue price is rarely what has been paid (because of taking the average)
• Prices tend to lag a little behind current market values when there is gradual inflation

Example : Quality Limited (QL) is a manufacturer of washing machines. The company uses perpetual method for
recording and weighted average method for valuation of inventory.
The following information pertains to a raw material (SRM), for the month of June 2010.
(i) Opening inventory of SRM was 100,000 units having a value of Rs. 80 per unit.
(ii) 150,000 units were purchased on June 5, at Rs. 85 per unit
(iii) 150,000 units were issued from stores on June 6.
(iv) 5,000 defective units were returned from the production to the store on June 12.

253 Page 9 of 15
(v) 150,000 units were purchased on June 15 at Rs. 88.10 per unit.
(vi) On June 17, 50% of the defective units were disposed off as scrap, for Rs. 20 per unit, because these had
been damaged on account of improper handling at QL.
(vii) On June 18, the remaining defective units were returned to the supplier (from purchase of june 5, 2010)
for replacement under warranty.
(viii) On June 19, 5,000 units were issued to production in replacement of the defective units which were
returned to store.
(ix) On June 20, the supplier delivered 2,500 units in replacement of the defective units which had been
returned by QL.
(x) 150,000 units were issued from stores on June 21.
(xi) During physical stock count carried out on June 30, 2010 it was noted that closing inventory of SRM
included 500 obsolete units having net realizable value of Rs. 30 per unit. 4,000 units were found short.

Required:
Prepare necessary journal entries to record the above transactions.
A.

Date Particular Rs. Dr. Rs. Cr.

05-06-2010 Material Control Account 12,750,000
Account Payable 12,750,000
06-06-2010 WIP 12,450,000
Material Control Account 12,450,000
12-06-2010 Material Account 415,000
WIP 415,000
15-06-2010 Material Account 13,215,000
Accounts Payable 13,215,000
17-06-2010 Cash (20 × 2,500) 50,000
Profit & Loss (abnormal loss) 165,000
Material Account 215,000
18-06-2010 Accounts Payable 212,500
Material Account 212,500
19-06-2010 WIP 430,000
Material 430,000
20-06-2010 Material Account 212,500
Accounts Payable 212,500
21-06-2010 WIP 12,900,000
Material Account 12,900,000
30-06-2010 Cost of sales 28,000
Profit & Loss Account 344,000
Material Account 372,000

254 Page 10 of 15
Workings:

Receipts Issues Balance

Date
Qty Rate Amount Qty Rate Amount Qty Rate Amount

1/6/2010 100,000 80 8,000,000

5/6/2010 150,000 85 12,750,000 250,000 83 20,750,000

6/6/2010 150,000 83 12,450,000 100,000 83 8,300,000

12/6/2010 5,000 83 415,000 105,000 83 8,715,000

15/6/2010 150,000 88.1 13,215,000 255,000 86 21,930,000

17/6/2010 (2,500) 86 (215,000) 252,500 86 21,715,000

18/6/2010 (2,500) 85* (212,500) 250,000 86.01 21,502,500

19/6/2010 5,000 86.01 430,000 245,000 86.01 21,072,450

20/6/2010 2,500 85* 212,500 247,500 86 21,284,950

21/6/2010 150,000 86 12,900,000 97,500 86 8,384,950

Weighted average rate is calculated after every purchase or purchase.

500 × 30 = 1,500 Difference

*Supplier will take return at purchase price
500 × 86.0 = 43,005 28,000 Loss
*Supplier will deliver at same price 4,000 × 86 = 334,000 Loss

Functions of storekeeper:
Storekeeper has to perform four basic functions including receiving of goods, storing of goods, issuing of goods
and recording the inventory movements.

Whenever purchase department issues purchase order, the supplier/s deliver goods to store department of entity.
It is the basic responsibility of storekeeper to check that goods are intact, means that these goods are not
damaged and are in accordance with the specification provided in the purchase order.

Storing looks more simple, but it’s one of the most important functions as negligence in proper storing may cause
damage or expiry of goods/ raw material. These goods must be stored in proper storage in such a way that existing
stock of goods/ raw material should be issued first. Similarly, few raw materials in industries require specific
storage like some chemicals should be stored in cold storage, otherwise, these could be damaged.

255 Page 11 of 15
Another important function of storekeeper is to issue the goods/ raw materials to relevant department against
purchase requisition. Storekeeper must ensure that the document is properly authorized by line manager
(production/sale manager) of that department.

All the transactions of receiving and issuing must be recorded by storekeeper; normally bin card is maintained for
each raw material item. Bin card includes quantities received and issued; running balance is maintained in it. It
helps the storekeeper to ensure that items of raw materials are not falling to re-order level, otherwise, new
purchase is required.

Example:
Jawa Enterprises received consignment on January 15, 2019, consisting of 4 different types of material items, A, B,
C and D. The relevant data is given as under:
Description A B C D Total
Invoice price Rs. 500,000 400,000 300,000 200,000 1,400,000
Relative weight Kg 1,500 2,500 2,000 1,000 7,000

Total freight paid on consignment Rs. 350,000; of which 20% shall be refundable.

Required: Calculation of cost per kg of each material, if the freight is apportioned on the basis of invoice price.

Ans . Freight cost of Rs. 280,000 (350,000 x 80%) shall be added in cost of inventories of each material while Rs.
70,000 (20% of freight) shall not be included as it is refundable.
Description A B C D
Invoice price Rs. 500,000 400,000 300,000 200,000
Freight Rs. 100,000 80,000 60,000 40,000
[500/140
0x280]
Cost of inventory Rs. 600,000 480,000 360,000 240,000
Cost per kg 400.00 192.00 180.00 240.00
[600,000
/1,500]

Required: Calculation of cost per kg of each material, if the freight is apportioned on the basis of relative weight.

Ans.
Description A B C D
Invoice price Rs. 500,000 400,000 300,000 200,000
Freight Rs. 60,000 100,000 80,000 40,000
1500/7,000
x 280,000
Cost of inventory 560,000 500,000 380,000 240,000
Rs.
Cost per kg 373.33 200.00 190.00 240.00
560,000/1,
500

256 Page 12 of 15
FORMULA OF NRV FOR MANUFACTURING BUSINESS:
FINISHED GOODS IN GOOD CONDITION
Estimated selling price xx
Less: Estimated selling expense (xx)
NRV xx
FINISHED GOODS IN DAMAGED CONDITION
Estimated selling price xx
Estimated cost of completion (cost of repair) xx
Less: Estimated selling expense (xx)
NRV xx
RAW MATERIAL AND WIP
Estimated selling price xx
Estimated cost of completion xx
Less: Estimated selling expense (xx)
NRV xx

Example:
Mehanti Limited(ML) produces and markets a single product Wee. Two chemicals Bee and Gee are used in the ratio
of 60:40 for producing 1 liter of Wee. ML follows perpetual inventory system and uses weighted average method
for inventory valuation. The purchase and issue of Bee and Gee for May 2013, are as follows:
Bee Gee
Date Receipt Issue Receipt Issue
Liter Rate Liter Liter Rate Liter
02-05-2013 - - 450 110 -
05-05-2013 - - 560 - - 650
09-05-2013 - - 300 - - 300
12-05-2013 420 52 - 700 115 -
18-05-2013 - - 250 - - 150
24-05-2013 500 55 - 250 124 -
31-05-2013 - - 500 - - 450

Following further information is also available:

i. Opening inventory of Bee and Gee was 1,000 liters at the rate of Rs.50 per liter and 500 liters at the rate of Rs.
115 per liter respectively.
ii. The physical inventories of Bee and Gee were 535 liters and 140 liters respectively. The stock check was
conducted on 01 June and 31 May 2013 for Bee and Gee respectively.
iii. Due to contamination, 95 liters of Bee and 105 liters of Gee were excluded from the stock check. Their net
realizable values were Rs20 and Rs.50 per liter respectively.
iv. 250 liters of Bee which was received on 01 June 2013 and 95 liters of Gee which was issued on 31 May 2013
after the physical count were included in the physical inventory.
v. 150 liters of chemical Bee was held by ML on behalf of a customer, whereas 100 liters of chemical Gee was
held by one of the suppliers on ML’s behalf.
vi. 100 liters of Bee and 200 liters of Gee were returned from the production process on 31 May and 01 June 2013
respectively.

257 Page 13 of 15
vii. 240 liters of chemical Bee purchased on 12th May and 150 liters of chemical Gee purchased on 24th May 2013
were in advertently recorded as 420 liters and 250 liters respectively.

Required: Reconcile the physical inventory balances with the balances as per book.

Ans.
Reconciliation (Bee) Liters
Bal. as per physical count (1st June) 535
Add: Contaminated Stock 95
Less: Receipt of June, 1 (250)
Third party stock (held on behalf of supplier) (150)
Balance as per books (W-1) 230
Reconciliation (Gee) Liters
Balance as per physical count (31st May) 140
Less: Issued after Count (95)
Actual Physical as on 31.5.20X3 45
Add: Contaminated stock 105
Stock with 3rd party 100
Stock as per books (W-2) 250

(W-1) (Bee)
Receipts Issues Balance
Date
Units PUC TC Units PUC TC Units PUC TC
1-5-13 1,000 50 50,000
5-5- 13 560 50 28,000 440 50 22,000
9-5- 13 300 50 15,000 140 50 7,000
12-5- 13 240 52 12,480 380 51.26 19480
18-5- 13 250 51.26 12,815 130 51.26 6,664
24-5- 13 500 55 27,500 630 54.23 34,165
31-5- 13 500 54.23 27,115 130 54.23 7,050
31-5- 13 100 54.23 5,423 230 54.23 12,473

*Purchases of 240 liters erroneously recorded as 420 liters now corrected. It is assumed that the error was
highlighted on 31st May or later.

(W-2) (Gee)
Receipts Issues Balance
Date
Units PUC TC Units PUC TC Units PUC TC
1-5- 13 500 115 57,500
2-5- 13 450 110 49,500 950 112.63 107,000
5-5- 13 650 112.63 73,210 300 112.63 33,790
9-5- 13 300 112.63 33,789 - - -
12-5-13 700 115 80,500 700 115 80,500
18-5- 13 150 115 17,250 550 115 63,250

258 Page 14 of 15
24-5- 13 150 124 18,600 700 116.93 81,850
31-5- 13 450 116.93 52,618 250 116.93 29,233

Required:
Determine the value of closing inventory of chemical Bee and Gee by using lower of cost and NRV principle.

Ans:
Valuation of Bee
As on 31 May 20X3

Good Quantity (230-95) 135 x 54.23 7,321

Contaminated 95 x 20 1,900
9,221

Valuation of Gee
As on 31 May 20X3

Good Quantity (250-105) 145 x 116.93 16,955

Contaminated 105 x 50 5,250
22,205

259 Page 15 of 15
 “The journey of millions of kilometers begins with one step.”

Material
Costs Associated with Inventory
Many companies particularly manufacturing and retailing companies, might hold large quantities of inventories so
that they can meet customer demand as soon as it arises. If there is no inventory when the customer asks for it (if
there is a stock out or inventory out) the customer might buy the product from a competitor instead. However
holding inventory creates costs.

The costs associated with inventory are:

(a) Purchase price of inventory
(b) Reorder costs are costs of making orders to purchase a quantity of material item from a supplier.
(c) Holding cost (storage cost or carrying cost)
(d) Shortage cost

Examples of
Holding Cost or Carrying Cost Reorder Cost or (Order Cost)
Cost of capital tied up (interest cost/opportunity cost of Cost of placing order e.g.
holding stock) Cost of telephone calls, documentation charges etc
Insurance cost Quantity inspection after purchase
Cost of warehousing including recording and handling Cost of delivery of purchased items
of stock
Losses/obsolescence

Investment in inventory has a cost and when an organization holds a quantity of inventory it must therefore obtain
finance to pay for it, or lose an opportunity to earn extra profits.

Shortage Cost:
➢ Lost profit on sale
➢ Loss of customer goodwill
➢ Cost due to production stoppage due to shortage of raw material (iidle time of labour)

Let consider an example:

Suppose Annual requirement of Raw Material = 12,000 kgs.

(1) One Order: [12,000 kgs / order].

Lets assume we have decided to purchase all material in one order at the beginning of the period; so order size will
be 12,000 kgs.

260 Page 1 of 15
12,000
kgs.
[On average we have hold 6,000 kgs of stock
Units. through out the year].

0 Time 12 M
.

(2) Two Orders: [6,000 kg/ Order]

6,000
kgs. [On average we have hold 3,000 kgs of stock
through out the year].

6M 12 M
Time

(3) Three Orders: [4,000 kg / Order]

4,000
kgs. [On average we have hold 2,000 kgs of stock
through out the year].

4M 8M 12 M

Conclusion: Lesser orders means lower ordering cost; while more holding cost and vice versa.
There is an inverse relationship between ordering cost and holding cost (carrying cost)
Less order → More purchase in bulk → More stock
More orders → Less purchase in bulk → Less stock

The average inventory falls as the order size (no. of units ordered in an order) falls thus reducing holding cost.
However smaller order size means we have to make more orders thus increase in re-ordering cost.

261 Page 2 of 15
 “If you learn from failure then it becomes like success rather than failure.”

Economic Order Quantity (EOQ):

It is a mathematical model which aims to identify the order quantity for any item of inventory that minimizes total
annual inventory cost. EOQ is based on following assumptions.
Assumption Implications
1) There are no bulk purchase discounts Order size does not affect the total annual purchase
cost of items therefore purchase price can be
ignored in the decision; as it does not affect the
outcome.
2) The order lead time (time between placing the order Delivery of new order is always timed to concide
and receiving delivery from supplier) is constant and with running out of inventory so the maximum
known. inventory kept will be equal to order size (no extra
stock is required). Therefore no risk of being out of
stock, shortage cost can be ignored.

3) Annual demand for inventory item is constant As a result, inventory in stock is equal to order size/2
throughout the year throughout the year.

As a result of these above assumptions the relevant costs are annual holding cost per item per annum and annual
ordering cost.

At EOQ Level:
(i) Annual ordering cost = Annual carrying cost; and
(ii) Sum of annual ordering cost and annual carrying cost is minimum.

2C oD
Formula of EOQ = ;
CH
Co = Cost per order
D = Annual demand
CH = Cost of holding one item of inventory per annum.

Example:
Annual requirement = 80,000 units
Cost per Unit = 6
Cost per Order = 1,200
Carrying cost per unit per annum = 50% of cost price.
Answer
2  1,200  80,000
= = 8,000 units.
3
Total Cost at EOQ level:
Purchase Price (80,000 × 6) 480,000
A.O.C (1,200 × 10*) 12,000
*[80,000 ÷ 8,000]

262 Page 3 of 15
  8,000 
A.C.C   3 12,000
 2 
Total Cost 504,000

If suppose we order 10,000 units: (Instead of 8,000 units)

Purchase Price (80,000 × 6) = 480,000
A.O.C (1,200 × 8*) 9,600
*[80,000 ÷ 10,000]
 10,000 
A.C.C   3 = 15,000
 2 
Total Cost 504,600

If suppose we order 4,000 units: (Instead of 8,000 units)

Purchase Price (80,000 × 6) = 480,000
A.O.C (1,200 × 20*) 24,000
*[80,000 ÷ 4,000]
 4,000 
A.C.C   3 = 6,000
 2 
Total Cost 510,000

If Bulk Order Discount Exist:

When EOQ formula was used it was assumed that purchase price/unit is constant regardless of order quantity. If
however bulk order discount exists then purchase price also becomes a relevant cost. In such a situation following
steps should be undertaken:
1. Calculate EOQ ignoring discount.
2. Calculate total cost at EOQ level (including purchase cost)
3. Calculate total cost at discounted levels (including purchase cost)
4. Compare results of step 2 and step 3.

Question 2.2
Reorder Level: when to order.
Reorder Quantity: How much to order.

Reorder Level and Buffer Stock:

If management policy is to avoid stock-outs entirely, the reorder level should be high enough to ensure that no
stock-out occurs during the supply lead time. A new quantity of materials should be ordered when current
inventory reaches the reorders level for that material.

If supply lead time is certain and demand during the lead time is constant, then reorder level should be calculated
as follows:
Reorder Level = Demand per day/week × Lead time in day/week
For example: 1,000 × 6 = 6,000

This is also called as Minimum Inventory Level.

263 Page 4 of 15
If supply lead time is uncertain and demand during the lead time is also uncertain the reorder level is set at the
maximum expected consumption of material item during the supply lead time. This is more than the average usage
during supply lead time. As a result more inventory is hold then that is needed on average.
Reorder Level = Max-Demand per day/week × Max-Lead time in day/week
For example: 1,500 × 10 = 15,000 units

The inventory held in excess of average requirement in order to remove the risk of stock out is called safety
inventory (Buffer stock or safety stock).

Safety Stock/Buffer Stock:

Maximum demand per day × Maximum lead time (1,500 × 10) 15,000
Less: Average demand per day × average lead time (1,000 × 6) (6,000)
9,000

Average Inventory:
Re order Quantity *
If no safety stock then;
2
*order size
If reorder quantity is equal to EOQ then:
EOQ/2.
If there is safety stock then:
Re order Quantity
+ Safety Stock
2
If reorder quantity is equal to EOQ then:
EOQ/2 + Safety Stock

Q.B 2.3
Question
Choco-king Limtied (CL) produces and markets various brands of chocolates having annual demand of 80,000 kg.
the following information is available in respect of coco powder which is the main component of the chocolate and
represents 90% of the total ingredients.
(i) Cost per kg is Rs. 600.
(ii) Process losses are 4% of the input.
(iii) Purchase and storage costs are as follows:
▪ Annual variable cost of the procurement office is Rs. 6 million. The total number of orders (of all
products) is estimated at 120.
▪ Storage and handling cost is Rs. 20 per kg per month.
▪ Other carrying cost is estimated at Rs. 5 per kg per month.
(iv) CL maintains a buffer stock of 2,000 kg.

Required:
(a) Calculate economic order quantity. (07)
(b) A vendor has offered to CL a quantity discount of 2% on all orders of minimum of 7,500 kg. Advise CL,
whether the offer of the vendor may be accepted. (06)

264 Page 5 of 15
Answer
Choco-king Limited
(a) Economic Order Quantity (EOQ)
Annual requirement of the coco powder (80,000 ÷ 0.96 × 90%) 75,000 kg
Ordering cost per order (6,000,000 ÷ 120) 50,000
Storage and handling (20 × 12) 240
Other carrying cost (5 × 12) 60
Carrying cost per kg 300
Economic Order Quantity (EOQ)
[(2 × annual demand × Ordering cost per order) ÷ Carrying cost per kg]
[(2 × 75,000 × 50,000) ÷ 300] = 25,000,000 = 5,000 kgs
(b) Analysis of purchases using EOQ / minimum quantity as offered by the vendor:
EOQ Vendor’s Offer
No. of orders (75,000 ÷5,000), (75,000÷7,500) A 15.00 10.00
Average inventory including buffer stock (Order quantity ÷2)+2,000 B 4,500 5,750
Rs. Rs.
Annual cost of placing order (A × 50,000) 750,000 500,000
Carrying cost (B × 300) 1,350,000 1,725,000
Discount on placing order of 7,500 kg each (75,000 × 600 × 2%) (900,000)
Net Cost 2,100,000 1,325,000
Annual saving on acceptance of vendor’s offer 775,000

265 Page 6 of 15
STOCK ITEMS 6786 AND 6787
(a) A company uses 15,000 units of stock item 6786 each year. The item has a purchase cost of Rs.4 per unit.
The cost of placing an order for re-supply is Rs.220. The annual holding cost of one unit of the item is
10% of its purchase cost.

Required
(i) What is the economic order quantity for item 6786, to the nearest unit?
(ii) What would be the effect of an increase in the annual holding cost per unit on (1) the EOQ and
(2) total annual ordering costs?
(b) Data relating to stores item 6787 are as follows. Daily use: 300
units
Lead time for re-supply: 5 – 20 days
Reorder quantity: 10,000 units
Required
What should be the reorder level for this stock item, to avoid the possibility of inventory-outs?

INVENTORY CONTROL
Entity G uses 105 units of an item of inventory every week. These cost Rs.150 per unit. They are stored in
special storage units and the variable costs of holding the item is Rs.4 per unit each year plus 2% of the
inventory’s cost.

Required
(c) If placing an order for this item of material costs Rs.390 for each order, what is the optimum order quantity
to minimise annual costs? Assume that there are 52 weeks in each year.
(d) Suppose that the supplier offers a discount of 1% on the purchase price for order sizes of 2,000 units or
more. What will be the order size to minimise total annual costs?

ROBIN LIMITED
Robin Limited (RL) imports a high value component for its manufacturing process. Following data, relating to the
component, has been extracted from RL’s records for the last twelve months:

Maximum usage in a month 300 units

Minimum usage in a month 200 units
Average usage in a month 225 units
Maximum lead time 6 months
Minimum lead time 2 months
Re-order quantity 750 units

Required
Calculate the average stock level for the component.

266 Page 7 of 15
Extra questions:
Question No. 1
(a) What is ‘opportunity cost’? give two practical examples of opportunity cost. (04)
(b) A company annually produces 600 units of a product. Each unit requires 6 kg of material Y. the costs related
to material Y are as follows:
Cost per kg. Rs. 16,000
Inspection charges per order Rs. 20,000
Transportation cost per trip (upto 400 units per trip) Rs. 25,000
Annual warehousing cost per unit Rs. 100
Financing cost 15%
Required:
(i) Economic Order Quantity for material Y. (05)
(ii) Total ordering and holding costs, if each order is based on EOQ and the company maintains a safety stock of
30 units. (04)

Question No. 2
Alpha Limited is preparing its departmental budgets and product cost estimates for the next year. The costs and
related data for the year ending 31 December 2014 have been estimated as follows:
Machining Assembly Finishing Maintenance Total
Costs: --------------------------------------Rs. In 000-----------------------------------
Direct wages 274 146 328 - 748
Indirect wages 46 27 36 137 246
Direct materials 365 46 18 - 429
Indirect materials 68 18 36 91 213
Power - - - - 465
Light and heat - - - - 46
Depreciation - - - - 108
Rent and rates - - - - 114
Warehousing cost - - - - 98

Other data:
Direct labour hours 12,000 8,000 16,000 6,000 42,000
Machine hours 40,000 2,000 3,000 - 45,000
No. of employees 6 4 8 3 21
Floor area (m2) 1,000 400 300 300 2,000
Net book value of fixed
assets (Rs. 000) 20,000 8,000 3,000 4,000 35,000

80% of the maintenance department’s time is used in the maintenance of machines whereas the remaining time is
consumed in cleaning and maintenance of factory buildings.

Required:
Calculate appropriate overhead absorption rates for the machining, assembly and finishing department.

267 Page 8 of 15
 Patience plays major role in our life, never let run out your patience.”

Answer No. 1(a)

An opportunity cost is a cost that measures the opportunity lost or sacrificed when the choice of one course of
action requires that an alternative course of a action be given up.

The following are examples of opportunity costs:

(i) If scarce resources such as machine hours are required for a special contract then the opportunity cost
represents the lost profit that would have been earned from the alternative use of the machine hours.
(ii) An employee is paid Rs. 100 per hour and is charged cost as Rs. 250 per hour for committed work. If that
employee is redirected to other assignment, the lost contribution of Rs. 150 per hour represents the
opportunity cost of the employee’s time.
(iii) A company owns the building in which it operates, and thus pays no rent for office space. If the building was
rented out, the company would receive rent of Rs. 4 million per annum. The foregone money from this
alternative use of the property (i.e. rent of Rs. 4 million) is an opportunity cost of using it as office space.

Answer No. 1(b)

(i) Economic Order Quantity
Requirement of material Y per annum (6 × 600) 3,600 kg.
Ordering costs per order:
Inspection 20,000
Transportation cost 25,000
Rs. 45,000
Holding cost per kg per annum:
Financing cost (15% of 16,000) 2,400
Warehousing cost 100
Rs. 2,500
2  Annual required units  cos ts per ordeer
EOQ =
Holding cos ts per kg per annum
2  3,600  45,000
=
2,500
= 129,600 = 360kg
(ii) Ordering and holding costs
Number of purchase orders (3,600 ÷ 360) 10
Average inventory excluding safety stock (360 ÷ 2) 180 kg
Safety stock 30 kg
Average inventory including safety stock kg. 210 kg
Total holding cost (2,500 × 210) 525,000
Total ordering costs (45,000 × 10) 450,000

268 Page 9 of 15
Answer No. 2
Overhead analysis sheet for Alpha Limited for the year ending 31 December 2014:
Expense Machining Assembly Finishing Maintenance Total Basis of apportionment
Direct wages
Indirect wages 46 27 36 137 246 Actual
Direct material
Indirect material 68 18 36 91 213 Actual
Power 413 21 31 465 Machine hours
Light and heat 23 9 7 7 46 Floor area (assumed)
Depreciation 62 25 9 12 108 Book value
Rent and rates 57 23 17 17 114 Floor area
Warehousing costs 83 11 4 - 98 Direct materials
(assumed)
752 134 140 264 1,290
80% based on the
Reallocation of 188 9 14 (211) - machine hours.
maintenance costs 31 13 9 (53) 20% based on the floor
area.
971 156 163 - 1,290

8,000
16,000
40,000 Direct.
Direct
Machines Labour
labour
Hours hours
hours
(assumed)
Overheads
absorption rate Rs. 24.28 19.50 10.19

269 Page 10 of 15
 “Spend your life by serving the people and doing good deeds.”

Extra practice questions:

Q.1 Aroma Herbs (AH) deals in a herbal tea. The tea is imported on a six monthly basis. The management is
considering to adopt a stock management system based on Economic Order Quantity (EOQ) model. In this
respect, the following information has been gathered:

(i) Annual sale of the tea is estimated at 60,000 kg at Rs. 1,260 per kg. Sales are evenly distributed
throughout the year.

(ii) C&F value of the tea after 10% discount is Rs. 900 per kg. Custom duty and sales tax are paid at the
rates of 20% and 15% respectively. Sales tax paid at import stage is refundable in the same month.

(iii) Use of EOQ model would reduce the quantity per order. As a result, bulk purchase discount would
be reduced from 10% to 8%.
(iv) Cost of financing the stock is 1% per month.
(v) Annual storage cost is estimated at Rs. 320 per kg.

(vi) Administrative cost of processing an order is Rs. 90,000. Increase in number of purchase orders
would reduce this cost by 10%.

(vii) AH maintains a buffer stock equal to fifteen days' sales.

Required:
Compute EOQ.
Determine the amount of savings (if any) which can be achieved by AH by adopting

the stock management system based on EOQ model. (06)

Ans: 1 Aroma Herbs

a) Economic order quantity (EOQ):

Annual demand of herbal tea (A) kg 60,000

Rupees
Purchase cost per Kg (C&F + Import duty) [(900 ÷ 0.9)*0.92 x 1.2
(B) 1,104.00
Ordering cost per purchase order 90,000 x 90%
(C) 81,000.00
Annual holding cost per kg
• Finance cost (1,104 x 1% x 12) B x 1% x 12 132.48
• Storage cost 320.00
(D) 452.48
EOQ =

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SQRT [(2 x annual demand x ordering cost) + Holding cost per kg]
SQRT [2 x 60,000 x 81,000) ÷ 452,48] (E) kg 4,635.00

EOQ = 2 x 60,000 x 81,000 = 4,635 Kgs

452.48
b) Saving on adopting EOQ:
EOQ Existing
No. of purchase orders 13 Approx. 2

(60,000 ÷ 4,635) (60,000/30,000)

Six monthly basis
Holding of inventory:
Avg stock 2,318(4,635/2) 15,000(30,000/2)
Buffer stock (60,000/365 x 15) 2,466 2,466
Total 4,784 17,466
Ordering cost (60,000 ÷ 4,635 x 81,000) 1,048,544 180,000(90,000 x 2)
*Holding cost (4,784 x 452.48) 2,164,664 7,852,714(17,466 x
449.6*)
Purchase cost of tea (60,000 x 1,104) 69,240,000 64,800,000(60,000 x
900 x 1.2)
Total 69,453,208 72,832,714

Saving by adopting EOQ (72,832,714 – 69,453,208) = 3,379,506

*Holding cost will be equal to ordering cost at EOQ level, if there is no buffer stock (e.g. 4,635/2 x 452.48) =
1,048,622.
Existing holding cost/unit (900 x 1.2 x 1% x 12) + 320 = 449.6

Q.2 Hockey Pakistan Limited (HPL) is engaged in the manufacturing of a single product ‘H-2’ which
requires a chemical ‘AT’. Presently, HPL follows a policy of placing bulk order of 60,000 kg of AT.
However, HPL’s management is presently considering to adopt economic order quantity model
(EOQ) for determining the size of purchase order of AT.

Following information is available in this regard:

1. Average annual production of H-2 is 45,600 units. Production is evenly distributed throughout the
year.
2. Each unit of H-2 requires 10 kg of AT. Cost of AT is Rs. 200 per kg. 5% of the quantity purchased is
lost during storage.
3. Annual cost of procurement department is Rs. 2,688,000. 65% of the cost is variable.
4. AT is stored in a third party warehouse at a cost of Rs. 6.25 per kg per month.
5. HPL’s cost of financing is 8% per annum.

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 “Sometimes we meet such people in our life, who don’t promise a lot but they do a lot.”

Required:

(a) Calculate economic order quantity. (06)

(iii) Supplier of AT has offered a discount of 5% if quantity per order is increased to

120,000 kg. Advise whether HPL should accept the offer. (06)
(c) Discuss any three practical limitations of using the EOQ model. (03)

Ans. 2 Hockey Limited - Economic Order Quantity

(a) Economic Order Quantity (Units to order)

2 x 480,000 x 218,400 = 48,000 units

91

W-1: Ordering cost per order (Rs.) (1,747,200( W-2)÷8 (W-3) 218,400

W-2: Purchase department cost -Variable cost (Rs.) 2,688,000×65% 1,747,200

W-3: Number of orders 480,000 (W-4)÷60,000 8

W-4: Annual Requirement of AT (kg) 45,600×10/95% 480,000

W-5: Holding cost (Rs. per unit)

Per unit
Storage cost (6.25 per kg per month×12) 75
Finance cost 200×8% 16
Total holding cost (Rs. per unit) 91

(b) Evaluation of discount offer from supplier of AT

Comparison of cost EOQ As per offer

Annual Requirement of AT (kg) A (W-4) 480,000 480,000
Order quantity (kg) B (EOQ, Given) 48,000 120,000
Number of orders C=A/B 10 4
Average inventory (kg) D=B/2 24,000 60,000

272 Page 13 of 15
 .................... Rupees ………………..
Ordering cost (480,000/48,000 x 218,400) 2,184,000 873,600
(480,000/120,000 x
218,400)
Holding cost 480,000/2 x 91 2,184,000 5,412,000
(120,000/2 x 90.2*)
Purchase cost (200X480,000); (200X480,000X95%) 96,000,000 91,200,000
Total cost 100,368,000 97,485,600

*(75+200x95%x8%)

Opinion:
Offer from AT's supplier should be accepted as it would reduce the purchase cost.

(c) The practical limitations/assumptions of EOQ are:

• The formula assumes that demand/usage is constant throughout the period. In practice, actual
demand/usage may be uncertain and subject to seasonal variations.
• Holding cost per unit are assumed to be constant. Further, many holding costs are fixed throughout the
period and not relevant to the model whereas some costs (e.g. store keepers' salaries) are fixed but
change in steps.
• Purchasing cost per unit is assumed to be constant for all purchase quantities and is ignored while
calculating order size in EOQ. In practice, quantity discounts can be available in case of bulk purchasing.
• The ordering costs are assumed to be constant per order placed. In practice, most of the ordering costs
are fixed or subject to stepwise variation. It is therefore, difficult to estimate the incremental cost per
order.

Question: 3
Orchid Limited (OL) is trading concerns. It is planning to implement Economic Order Quantity model (EOQ) from 1
April 2019. OL deals in four products each of which is purchased from a different supplier. To compute EOQ for one
of its products Beta, the following data has been gathered:
i. Actual data for the last year relating to Beta:
• Annual sales Units 72,000
• Safety stock Units 2,000
• Transit losses as % of purchases 10%
• Average holding cost per month Rs. 500,000
• Average holding cost per month per unit Rs. 80
• Number of purchase orders issued for Beta 40

ii. Total cost of purchase department for the last year amounted to Rs. 4,500,000 which included fixed cost
of Rs. 1,350,000 A total of 100 purchase orders were issued during the last year.

273 Page 14 of 15
 “Don’t break heart of anyone but do your best to mend the broken hearts.”

iii. Projections for the next year:

• Increase in sales volume 25%
• Safety stock Units 2,500
• Transit losses as % of purchases 6%
• Impact of inflation on all costs 10%

iv. Closing inventory (excluding safety stock) varies in line with the sales volume.

Required:
Calculate EOQ for Beta.

Answer: 3 Orchid Limited

Economic order Quantity (EOQ) for Beta:

EOQ = 2 X Annual demand x Cost per order

Holding cost per kg per annum

EOQ = 2 x 97,407 x 34,650

1,056

= 2,528 Units

Annual demand (Purchases): Units

Projected sales 72,000 x 1.25 90,000
Opening stock – Including safety stock (500,000 ÷ 80) (6,250)
Closing stock – Including safety stock [(6,250 – 2,000)x1.25+2,500 7,813
Purchases – Net of transit losses 91,563
Purchases including transit losses of 6% 91,563 ÷ 0.94 97,407
Ordering cost per order: Rupees
Variable cost (4,500,000 – 1,350,000)x(1.1÷ 100) 34,650
Holding cost per unit per annum 80 x 1.1 x 12 1,056

274 Page 15 of 15
 “Don’t stress nor consider your life as burden, no matter what.”

Inventory Management
WHAT IS INVENTORY MANAGEMENT?
Inventory management refers to the process of ordering, storing and using a company’s inventories. This includes
management of raw materials, components and finished products as well as warehousing and processing such
items.

Since the inventory is the most important component of any inventory-intensive sectors, special efforts are put to
ensure that:
• There is sufficient inventory of raw materials available to produce the quantity of finished goods to meet the
sale forecast,
• There is sufficient inventory of finished goods available to meet the immediate sales requirement (both
expected and unexpected) to avoid stock out situations,
• The quantity so available is not in excess of the market needs to avoid any obsolescence, damage or blockage of
finance and
• The costs associated with inventory are minimized.

Why do companies hold stocks?

There are three general reasons:
1. Transactions motive
2. Precautionary motive and
3. Speculative motive.

The transactions motive occurs when there is a need to hold stocks to meet production and sales requirements
instantaneously.

The firm might also decide to hold additional amounts of stocks to cover the possibility that it may have
underestimated its future production and sales requirements or the supply of raw materials may be unreliable
because of uncertain events affecting the supply of materials. This represents precautionary motive which applies
only when future demand is uncertain.

When it is expected that future input prices may change, a firm might maintain higher or lower stock levels to
speculate on the expected increase or decrease in future prices. This is called speculative motive.

Costs Associated with Inventories:

Inventory management is quite critical for the companies as it includes substantial costs. Following are the costs
that are associated with inventories:
1. Cost of purchasing the inventory – the price that is quoted by supplier
2. Cost of ordering the inventory – such as clerical costs of preparing the material requisition, purchase order,
receiving deliveries and paying invoices, labor cost for the inspection of goods and placing the goods in
warehouse and cost incurred in making payments.
3. Cost of holding the inventory – such as interest cost on borrowings for purchase of inventory, insurance cost,
warehouse and storage cost, handling cost and cost of obsolescence, deterioration of inventory and
opportunity cost of holding the stocks.

275 Page 1 of 14
All these costs are financed either through company’s own funding or borrowings from banks.
a) If inventories are financed using company’s own funds, the company would have to bear the opportunity cost in
a way had these funds were not invested in the inventories could be used in investing in any other avenues to
earn a fixed return. The gain so forgone shall be treated as the opportunity cost.
b) Similarly, if the inventories are funded by obtaining bank loan, the interest on such loan shall make the part of
cost of inventories.

The mathematicians have derived quantitative models to determine the level of stock to be maintained at which
the price is minimal (known as optimum stock level).

Such quantitative models undertake only relevant costs in calculation.

Relevant and Irrelevant Cost:

Relevant costs are the costs that occur on the occurrence of an activity.

Irrelevant costs are those that occur whether or not any activity is carried.

Relevant Holding Cost to be used in quantitative models should include only those items that will vary with the
levels of stock. For example, in the case of storage and warehouse only those costs should be included that will
vary with changes in number of units ordered. Such costs are called variable costs.

Example:
Fixed and variable holding costs
Salaries of storekeepers, depreciation of equipment and fixed rental of equipment and buildings are often
irrelevant because they are unaffected by changes in stock levels.

On the other hand, if storage space is owned and can be used for other productive purposes, such as to obtain rental
income, then the opportunity cost must be included in the analysis.

Similarly, the insurance cost of stock must be considered when the premium are paid at the fluctuating value of
stocks and not the fixed insurance cost per annum.

To the extent that funds are invested in stocks, the analysis must include opportunity cost (as explained
previously). The opportunity cost is reflected by the required return that is lost from investing in stocks.

The relevant holding costs for other items such as material handling, obsolescence and deterioration are difficult
to estimate and these costs are not very critical to the investment decision.

Normally, the holding costs are expressed as a percentage rate per rupee of average investment.

Same as holding costs, the ordering costs that are common to all inventory decisions are irrelevant and only the
incremental costs of placing an order are useful for this purpose.

276 Page 2 of 14
 “Never lose hope, face the situation with wisdom and patience.”

The optimum level must be determined at a level where the total relevant cost is minimized. This optimum level is
called Economic Order Quantity (EOQ).

The EOQ can be determined using the following methods:

• Tabular Method
• Graphical Method
• EOQ Formula

We shall look into these methods using the following example.

Example:
A company uses 40,000 units of stock item 6786 each year. The item has a purchase cost of Rs.10 per unit. The cost
of placing an order for re-supply is Rs.2. The annual holding cost of one unit of the item is 10% of its purchase cost.
if it would be required to calculate the economic order quantity for item 6786, to the nearest unit using:
a) Tabular method
b) Graphical method
c) EOQ formula

Tabular Method: [in the following table, the order quantity where the annual ordering cost is equal to the
annual holding cost and their sum is lowest is EOQ]

Order Quantity (Q) 100 200 300 400 500 600 800 10,000
Average Inventory (Q/2) 50 100 150 200 250 300 400 5000
Number of Purchase Orders 400 200 133 100 80 67 50 4
(Annual Demand (40,000 (40,000/
(A) / Q) /100) 10,000)
Annual Holding Cost 50 100 150 200 250 300 400 5000
(10% x 10 x Average
Inventory)
Annual Ordering Cost (2 x 800 400 266 200 160 134 100 8
No. of Orders)
Total Relevant Cost 850 500 416 400 410 434 500 5,008

So the relevant cost is minimum at 400 units per order where OC and HC are equal. This is the
optimum point or EOQ
Graphical Presentation Method:
We have taken total relevant cost (ordering cost + holding cost) on the vertical axis (y- axis) and order quantity and
average inventory on the horizontal axis. (x -axis)

We can see that as the average inventory and order size increases, the holding cost also increases whereas the order
cost decreases.

277 Page 3 of 14
It also to be noted here that the total relevant cost line is lowest at a point where ordering cost line and holding
cost line are intersecting. This intersecting point determines our EOQ.

EOQ

900

800

700

600

500
Total Relevant Cost

400

300

200

100 50 100 150 200 250 300 400

100 200 300 400 500 600 800
Order Quantity

1.Relevant Annual Cost 2 .Holding Cost 3. Ordering Cost

278 Page 4 of 14
 “Keep your thoughts and attitude positive, your life will be awesome .”

EOQ Formula:
EOQ can be identified using a formula. As of now we have understood the relationship of holding cost, ordering
cost and order quantities. We have also understood that total relevant cost is the sum of holding cost and
ordering cost:
Total Relevant Cost (TRC) = Annual Holding Cost (AHc) + Annual Ordering Cost (AOc)
We are now denoting the variables as:
Annual Demand = A
Quantity per Order / Order size = Q
Cost per Order = Oc
Holding cost per unit per year = Hc
Average Inventory = Q / 2
Annual Ordering Cost (AOc) shall be calculated as (A / Q) x Oc
Annual Holding (AHc) shall be calculated as (Q / 2) x Hc
TRC = A/Q x Oc + Q/2 x Hc

When differentiating the above equation with respect to Q and setting the derivative equal to zero, we get the
economic order quantity ‘Q’:

Assumptions of EOQ:
EOQ model is valid only as per the following assumptions:
1. The holding cost per unit will be constant
2. The average inventory is equal to one half of the order quantity as the stock is consumed at a constant rate
throughout the period.
3. The cost per order is constant
4. There are no quantity discounts available.
5. The demand for its inputs and outputs can be predicted with perfect certainty

INVENTORY LEVELS AND BUFFER STOCK

A business entity shall always maintain certain levels of inventories. These levels are:
a) Re-order Level
b) Safety Stock / Buffer Stock
c) Maximum Inventory Level
d) Minimum Inventory Level

279 Page 5 of 14
So far, it has been assumed that when an item of materials is purchased from a supplier, the delivery from the
supplier will happen immediately. In practice, however, there is likely to be some uncertainty about when to make
a new order for inventory in order to avoid the risk of running out of inventory before the new order arrives from the
supplier. The period of time between placing a new order with a supplier and receiving the delivery of the same is
called “Lead Time”. This lead time could be in days, weeks or months.

On the basis of this lead time, the companies determine the level of stock at which the order should be placed to
avoid stock-out situation. The level at which a new order is placed is called “Re-order Level”.

Such re-order level is determined using the average consumption during lead time. However, sometimes the
demand during lead time exceeds the expectations, in such case, if the demand is not fulfilled, the customers may
move to competitors and result in loss of profit and good will. Also, the delivery may delay the expected time due to
which the company may fail to produce the expected demand which again result in loss of profits. To avoid such
risk, the company also maintains a level of stock which is called “Safety Stock or Buffer Stock”

If the cost of holding safety stocks is greater than the cost of stock-out, the business would be incurring more loss.
Therefore, a level should be set where the cost of stock-out plus the cost of holding the safety stock is minimized.
Stock-out Cost are the opportunity cost of running out of stock. As the stock-out occurs when there is demand but
no stock available, therefore, the loss of profit, which could be earned had the stock available. It also leads to loss of
customers’ goodwill as the customers may move to the products of competitors. If the customer is permanently
lost, the stock-out cost is determined using the loss of future profits as well.

Once the stock-out cost has been estimated, the cost of holding safety stocks should be compared for various
demand levels. This can be done using probability theory by attaching probabilities to different potential demand
levels.

Probability Theory to determine the Safety Stocks:

A probability table can be prepared. For each possible reorder level under consideration, we can calculate:
• the probable demand in the lead time between order and delivery;
• the risk of having excess inventory (buffer stock) and its cost;
• the risk of stock-outs, and their cost.

The reorder level selected might be the reorder level at which the expected value (EV) of cost is minimized

Example:
Entity X uses item Z in its production process. It purchases item Z from an external supplier, in batches.
For item Z, the following information is relevant:

Holding cost Rs.15 per unit per year

Stock out cost (means contribution lost per unit) Rs.5 for each stock-out unit

Lead-time 1 week
EOQ (order size) 270 units

280 Page 6 of 14
 “Never do cheating with anyone in your life.”

Entity X operates for 48 weeks each year. Weekly demand for unit Z for production is variable, as follows:

Units demand during the lead time Probability

70 10%
80 20%
90 30%
100 40%

Required: Whether a reorder level of 90 units or 100 units would be more appropriate.

Solution:
Step 1: Calculate the average expected demand in the lead time
The average demand in the lead-time which is one week is:
(70 × 10%) + (80 × 20%) + (90 × 30%) + (100 × 40%) = 90 units
Average annual demand is 48 weeks × 90 units = 4,320 units.

Since the EOQ is 270 units, entity X will expect to place 4,320 /270 = 16 orders each year.
Therefore, there will be 16 lead times of one week each year.
Step 2: Set up a probability table
(Starting with a reorder level set to the average demand in the lead time and then looking at higher reorder levels).
i. Reorder level of 90 units (the company will be out of stock if demand is greater than 90)
If Demand = 100
Stock outs if demand is 100 [100-90]=10 units
Probability of demand of 100 is 40%
Cost per stock out is 5 per unit

Number of orders per year are 16

Annual stock out cost will be 10 x 40% x 16 x 5 = 320 or 10 x 16 x 5 x 40% = 320
Holding cost of extra units:
If demand is 70 units: [90-70]= 20 x 15 x 10% = 30
If demand is 80 units: [80-70]= 10 x 15 x 20% = 30
Total cost will be 60.
Therefore total cost will be 380 (320+60) at a reorder level of 90 units

ii. Reorder level of 100 units (the company will never be out of stock)
Stock out cost will therefore be nil
If demand is 70 units: [1000-70]= 30 x 15 x 10% = 45
If demand is 80 units: [100-80]= 20 x 15 x 20% = 60
If demand is 90 units: [100-90]= 10 x 15 x 20% = 45

Total cost will be 150.

Therefore total cost will be 150 at a reorder level of 100 units

281 Page 7 of 14
Conclusion:
The reorder level should be set at 100 units. The extra cost of the buffer stock (Rs. 150) achieves savings by reducing
the stock out cost (Rs. 320).

Maximum inventory level:

A company will set a maximum level for inventory. Inventory held above this would incur extra holding cost
without adding any benefit to the company.
The inventory level should never exceed a maximum level. If it does, something unusual has happened to either
the supply lead time or demand during the supply lead time. The company would investigate this and take action
perhaps adjusting purchasing behavior.
When demand during the supply lead time is uncertain and the supply lead time is also uncertain, the maximum
inventory level is found as follows.

Maximum inventory level:

Re-order level X
Add: Re-order quantity or EOQ X
XX
Less: Minimum Demand x Minimum Lead Time (X)
X
Minimum inventory level: [this is exactly safety stock]
The inventory level could be dangerously low if it falls below a minimum warning level. When inventory falls
below this amount, management should check that a new supply will be delivered before all the inventory is used
up, so that there will be no stock-out.
When demand during the supply lead time is uncertain and the supply lead time is also uncertain, the
minimum (warning) level for inventory is set as follows.

Minimum inventory level:

Re-order level (Max. demand x Max lead time) X
Less: Average Demand x Average Lead Time (X)
X

Comprehensive questions:
Example:
ABC has recently established a new unit in Multan. Its planning for the first year of operation depicts the
following:
i. Cash sales 600,000 units
ii. Credit sales 1,200,000 units
iii. Ending inventory Equivalent to 15 days sales
iv. Number of working days in the year 300
v. Expected purchase price Rs. 450 per unit

282 Page 8 of 14
 “Do good to others and wish good for others, It will bring peace in your life.”

Manufacturer offers 2% discount on purchase of 500 units or more as bulk quantity discount. The company
intends to avail this discount.
vi. Carrying costs include:
- Financial cost of investment in inventory @ 16% per annum.
- Godown rent of Rs. 10,000 per month.
vii. Ordering costs are Rs. 300 per order.

Required:Computation of the Economic Order Quantity (EOQ) and the estimated carrying costs and ordering
costs for the first year of operation:

Computation of annual requirement

Units sold on cash basis 600,000
Units sold on credit basis 1,200,000
Ending Inventory (1.8 million x 15/300) 90,000
Annual purchases (Annual demand) 1,890,000
Computation of Carrying Cost per unit
Carrying cost per unit (Rs. 450 × 98% × 16%) (intention of availing bulk quantity Rs. 70.56
discount)

Computation of EOQ
EOQ = 2 x1,890,000 x300 / 70.56
= 4,009 units
Estimated carrying cost = (EOQ/2) × carrying cost per unit
= 4,009/2 × 70.56
= Rs. 141,438
Add: Godown rent p.a. = 10,000
x 12 = Rs.120,000
Total carrying cost =
Rs.261,438
Estimated ordering cost = (annual requirement / EOQ) × cost per order
= (1,890,000 / 4,009) × 300
= Rs.141,432

Example:
Karachi Limited is a large retailer of sports goods. The company buys footballs from a supplier in Sialkot. Karachi
Limited uses its own truck to pick the footballs from Sialkot. The truck capacity is 2,000 footballs per trip and
the company has been getting a full load of footballs at each trip, making 12 trips each year.

283 Page 9 of 14
Recently the supplier revised its prices and offered quantity discount as under:

Quantity Unit price (Rs.)

2,000 400
3,000 390
4,000 380
6,000 370
8,000 360

Other related data is given below:

• All the purchases are required to be made in lots of 1,000 footballs.
• The cost of making one trip is Rs. 15,000.
• The company has the option to hire a third party for transportation which would charge Rs. 9 per
football. The cost of placing an order is Rs. 2,000.
• The carrying cost of one football for one year is Rs. 80.

Required:
i. Work out the most economical option.
ii. Also compute annual savings in case the company revises its policy in accordance with the
computation in (i) above.
Solution:
(i) Karachi Limited
Price per football A 400 390 380 370 360
Annual purchases (nos.) B 24,000 24,000 24,000 24,000 24,000
Purchase cost A×B 9,600,000 9,360,000 9,120,000 8,880,000 8,640,000
Minimum order size C 2,000 3,000 4,000 6,000 8,000
(given)
No. of orders (B / C) D 12.00 8.00 6.00 4.00 3.00
Ordering cost D × 2,000 24,000 16,000 12,000 8,000 6,000
Trips per order (C/2,000) E 1.00 1.00+(hired 2.00 3.00 4.00
transport)
Total no. of trips (D × E) F 12.00 8.00 12.00 12.00 12.00
Transportation cost F × 15,000 180,000 120,000 180,000 180,000 180,000
Hired transportation cost 8,000units×9 -- 72,000 -- -- --
Average inventory (C / 2) G 1,000 1,500 2,000 3,000 4,000
Inventory carrying cost G × 80 80,000 120,000 160,000 240,000 320,000
Total cost Rs. 9,884,000 9,688,000 9,472,000 9,308,000 9,146,000

(ii) The most economical option is to purchase 3 lots of 8,000 footballs each against the existing purchases of
12 lots of 2,000 footballs, the saving will be as under:

Cost for 12 lots of 2,000 footballs each (as above) 9,884,000

Cost for 03 lots of 8,000 footballs each. (as above) 9,146,000
Cost saving 738,000
Example:

284 Page 10 of 14
 “Do good to others and wish good for others, It will bring peace in your life.”

Modern Distributors Limited (MDL) is a distributor of CALTIN which is used in various industries and its demand is
evenly distributed throughout the year.

The related information is as follows:

• Annual demand in the country is 240,000 tons whereas MDL’s share is 32.5% thereof.
• The average sale price is Rs. 22,125 per ton whereas the profit margin is 25% of cost.
• The annual variable costs associated with purchasing department are expected to be Rs. 4,224,000
during the current year. It has been estimated that 10% of the variable costs relate to purchasing of CALTIN.
• Presently, MDL follows the policy of purchasing 6,500 tons at a time.
• Carrying cost is estimated at 1% of cost of material.
• MDL maintains a buffer stock of 2,000 tons.

Required: Compute amount of savings that can be achieved if MDL adopts the policy of placing orders based on
Economic Order Quantity.

Solution:
Purchase department’s variable cost: Rs. 4,224,000
Costs applicable to product CALTIN - 10% of above Rs. 422,400
Ordering costs per purchase order
Annual purchases of CALTIN (tons) [240,000 x 32.5%) Tons 78,000
Existing size of purchase order (tons) Tons 6,500
No. of orders (78,000 / 6,500) Orders 12
Ordering cost per order (422,400/12) Rs. 35,200
Carrying costs per ton (22,125 / 125 x 100 x 1%) Rs. Per Ton 177

Computation of EOQ 2 x 78,000 x35,200 / 177

= 5,570 tons

EOQ Existing
Demand of CALTIN Tons 78,000 78,000
Order quantity Tons 5,570 6,500
No. of orders 14 12
Average inventory excluding buffer stock (Q / 2) Tons 2,785 3,250
Cost of placing orders (Rs 35,200 per order) Rupees 492,800 422,400
Carrying cost ([Avg. Inventory+ 2,000] x Rs. 177) Rupees 846,945 929,250
Total costs Rupees 1,339,745 1,351,650
Savings on adoption of EOQ Rupees 11,905

285 Page 11 of 14
 Example:
Alpha Motors (Pvt.) Ltd. uses a special gasket for its automobiles which is purchased from a local manufacturer. The
following information has been made available by the procurement department:

Annual requirement (no. of gaskets) 162,000

Cost per gasket (Rs.) 1,000
Ordering cost per order (Rs.) 27,000
Carrying cost per gasket (Rs.) 300

The gaskets are used evenly throughout the year. The lead time for an order is normally (on average) 11 days but it
can take as much as 15 days. The delivery time and the probability of their occurrence are given below:

Delivery time (in days) Probability of occurrence

11 68%
12 12%
13 10%
14 6%
15 4%

a) Computation of EOQ and Ordering Costs, Assuming a 360 day year.

EOQ = 2 x1,620,000 x 27,000 / 300

EOQ = 5,400 gaskets
Number of orders = 162,000 / 5,400 = 30
Orders
Ordering costs = 30 x Rs. 27,000 = Rs. 810,000
b) Computation of the safety stock and re-order level if the company is willing to take:
• 20% risk of being out of stock?
• 10% risk of being out of stock?
(Assuming a 360 day year)

Solution:
i. Safety stock required to be maintained at 20% and 10% risk level
450x x 11 = 4,950 units
Risk level
20% 10%
Safety Stock
450 x 12 – 4,950 450
450 x 13 – 4,950 450

286 Page 12 of 14
 “Be polite and behave people with good manners.”

W-1
Average Stock requirements per day = Annual Demand ÷ 360 days
= 162,000 ÷ 360 = 450

ii. Re-Order Level at 20% and 10% risk level

Re-order level at 20% = (450 x 12) = 5,400 gaskets (we have to maintain a stock of 12 days if we are
willing to take 20% risk)

Re-order level at 10% = (450 x 13) + 900 = 5,850 gaskets (we have to maintain a stock of 13 days if we
are willing to take 10% risk)

Example:
Khan Limited (KL) imports and sells a product ‘AA’. KL is faced with a situation where lead time is mostly
predictable i.e. 1 month but lead time usage varies quite significantly. Data collected for past three years shows
that probability for lead time usage is as follows:

No. of units demanded during lead time Probability of demand during lead time (%)
1,000 30
660 50
450 20

Other relevant information is as follows:

i. Annual demand is 8,640 units.
ii. Contribution margin is Rs. 40 per unit.
iii. Purchase orders are raised on the basis of economic order quantity model.
iv. Annual holding cost is Rs. 100 per unit whereas average cost of placing an order is Rs. 6,750.

Required: Evaluate which of the following re-order levels will maximize KL’s profit:
• 1,000 units
• 450 units

Solution
Step 1: Calculate the average demand in the lead time
The average demand in the lead-time which is one month is:
(1,000 × 30%) + (660 × 50%) + (450 × 20%) = 720 units
Annual demand (Given) = 8,640*
*If however it is not given then it can be calculated as follows:
Annual demand is 12* months × 720 units = 8,640 units.
**lead time is one month

287 Page 13 of 14
Since the EOQ is 1,080 (W 1) units, KL will expect to place 8,640 /1,080 = 8 orders each year.
W 1:
EOQ = 2 x8,640 x 6,750 / 100
Therefore, there will be 8 lead times each year.

i.Reorder level of 1,000 units:

Stock out cost: the company will not be out of stock because we are holding upto maximum demand therefore no
stock out cost at this level.)

If demand is 450 units: [1000-450]= 550 x 100 x 20% = 11,000

If demand is 660 units: [1000-660]= 340 x 100 x 50% = 17,000
Therefore total annual holding cost will be = 28,000
Therefore total Annual cost will be 28,000 at a reorder level of 1,000 units

ii. Reorder level of 450 units

Stock out cost: there could be stock out for 8 times during the lead time because we are holding less stock then
probable demand during the lead time; so

Annual stock out cost will be:

(1,000-450)= 550 x 30% x 8 x 40 = 52,800 [or 550 x 8 x 40 x 30%]
(660-450)= 210 x 50% x 8 x 40 = 33,600 [or 210 x 8 x 40 x 50%]
Total = 86,400
There will be no extra holding cost at a reorder level of 450 units.
Therefore total Annual cost will be 86,400 at a reorder level of 450 units

Conclusion:
The reorder level should be set at 1,000 units as it will reduce cost and therefore profit will be maximized.

288 Page 14 of 14
 “Trust in the plans of Allah. Be patient, Keep smiling and never overthink.”

Variance Analysis Part 2

DIRECT LABOR: Idle time variance
Idle time occurs when the direct labor employees are being paid but have no work to do. The causes of idle time
may be:
• A breakdown in production, for example a machine breakdown that halts the production process
• Time spent waiting for work due to a bottleneck or hold-up (e.g. generator is without fuel ) in the production
process
• Running out of a vital raw material, and having to wait for a new delivery of the materials from a supplier.
• A lack of work to do due to a lack of customer orders.

A feature of idle time is that it is recorded, and the hours ‘lost’ due to idle time are measured. Idle time variance
is part of the labor efficiency variance.

There are two possible situations:

• Idle time is not a regular feature of production process and therefore idle time is not built into the standard
cost, the idle time variance is always adverse

FORMULA: [AHP - AHW] x standard rate

• Idle time is a regular feature of production process and therefore idle time is built into the standard cost, idle
time variance might be favorable or adverse depending on whether the actual idle time is more or less than the
standard idle time.

FORMULA: [Expected idle time - Actual idle time] x standard rate

Methods of including idle time in standard costs

There are two methods to build idle time in a standard cost.
• Method 1. Include idle time as a separate element of the standard cost, so that the standard cost of idle time
is a part of the total standard cost per unit.
• Method 2. Include a standard amount of idle time in the standard hours per unit for each product. The
standard hours per unit therefore include an allowance for expected idle time.

Example:
Standard labor rate = Rs. 500 per hour
A unit of production should take 3.6 hours to produce.

Expected idle time is 10% of total time paid for.

Therefore 3.6 hours is 90% of the time that must be paid for to make 1 unit.
4 (3.6/90%) hours must be paid for to make 1 unit.

Expected idle time is 0.4 hours (10% of 4 hours) or 3.6/0.9 x 0.1 = 0.4

289 Page 1 of 10
Idle time can be built into the standard as follows:

Method 1(Standard cost per unit) Rs.

Labor 3.6 hours Rs. 500 per hour 1,800
Idle time 0.4 hours Rs. 500 per hour 200
2,000
Method 2(Standard cost per unit)
Labor 4 hours Rs. 500 per hour 2,000

The two methods will result in the identification of the same overall variance for idle time plus labor efficiency but
the breakup of variance may be different.

Venue limited

Example:
A company manufactures two products, X and Y. In 2011 it budgets to make 2,000 units of Product X and 1,000
units of Product Y. Budgeted resources per unit and costs are as follows:
Product X Product Y
Direct materials per unit:
Material A 2 units of material 1.5 units of material
Material B 1 unit of material 3 units of material
Direct labour hours per unit 0.75 hours 1 hour
Costs
Direct material A Rs.4 per unit
Direct material B Rs.3 per unit
Direct labour Rs.20 per hour
Variable production overhead Rs.4 per direct labour hour

Fixed production overheads per unit are calculated by applying a direct labour hour absorption rate to the
standard labour hours per unit, using the budgeted fixed production overhead costs of Rs.120,000 for the year.

Required: Prepare standard full production cost per unit of product X and Y.
A. First calculate the budgeted overhead absorption rate.
Budgeted direct labour hours hours
Product X: (2,000 units  0.75 hours) 1,500
Product Y (1,000 units  1 hour) 1,000
Total 2,500
Budgeted fixed production overheads Rs.120,000
Fixed overhead absorption rate/hour Rs.48
(120,000 / 2,500)

290 Page 2 of 10
 Product X Product Y
Rs. Rs.
Direct materials
Material A (2 units  Rs.4) 8 (1.5 units  Rs.4) 6
Material B (1 unit  Rs.3) 3 (3 units  Rs.3) 9
Direct labour (0.75 hours  Rs.20) 15 (1 hour  Rs.20) 20
Variable production overhead (0.75 hours  Rs.4) 3 (1 hour  Rs.4) 4
Standard variable prod’n cost 29 39
Fixed production overhead (0.75 hours  Rs.48) 36 (1 hour  Rs.48) 48
Standard full production cost 65 87

Example: Omega Limited plans to sell its new skin care lotion, Lanosof, in 100ml bottle. Cost and production studies
show these standard costs of materials , ingredients and labour required are
Container: Description Cost Allowance for
waste and
breakage
Item 153 100ml bottle Rs. 3,600 per pack of 144 bottles 3%
Item 253 Label Rs. 1,100 per pack of 500 labels 5%

Materials Description Cost Quantity used for

batch of 1 liter
Item C3A Compound 3A Rs. 200 per 250 lbs. 550 lbs.
Item AG Alcohol Rs. 500 per 800 lbs. 750 lbs.
Item PO Perfume oil Rs. 5,000 per 100 lbs. 10 lbs.

Labour Time for batch of Rate Idle time

1 liter
Skilled 12 hours Rs. 60 per hour 2%
Unskilled 30 hours Rs. 25 per hour 5%

Required:
Prepare standard prime cost card for one bottle of 100ml of new skin care lotion, Lanosof.

Note: I liter has 1,000ml

Ans:
Standard cost card of 100ml bottle of Lanosof Rs.
Container:
Item 153 (3,600/144 = 25 / 97 x 100) 25.77
Item 253 (1,100/500 = 2.20/ 95 x 100) 2.32
28.09
Materials:
Item C3A (550 /1,000 x 100= 55 lbs) x (200/250 = 0.80 per lb.) 44.00
Item AG (750 /1,000 x 100= 75 lbs) x (500/800 = 0.625 per lb.) 16.88
Item PO (10 /1,000 x 100= 1 lb) x (5,000/100 = 50 per lb.) 50.00

291 Page 3 of 10
Standard cost card of 100ml bottle of Lanosof Rs.
110.88
Direct labour:
Skilled (12 /1,000 x 100= 1.20/ 0.98= 1.22 hours) at rate of Rs. 60 per hour 73.20
Skilled (30 /1,000 x 100= 3.00/ 0.95= 3.16 hours) at rate of Rs. 25 per hour 79.00
152.20
Standard prime cost of 100ml bottle 291.17

Revise the lettuce and moongazer

Example:
Mansoori Limited makes and sells a single product. Each unit of the product requires 9kg of material at Rs. 14 per
kg.

The actual details for last period were that 1,200 units of finished goods were produced; 11,000 kg of material was
purchased for Rs. 148,500 and 10,700 kg was used.

Mansoori limited maintains its raw materials inventory at standard cost

Required:
Calculate Material price and usage variances

Note: if there is a stock of raw material and it is measured at standard cost then material price variance should be
calculated on AQP rather than AQU.

Ans:

MATERAIL VARIANCES

PRICE USAGE
(SR-AR) X AQP (SQU-AQU) X S.R
(14 – 148,500 / 11,000) X 11,000 (1,200 x 9 – 10,700) X 14
5,500 F 1,400 F

292 Page 4 of 10
Journal entries-direct materials in standard costing
Debit Credit
Description
-------- Rupees --------
1.Material price variance is recognized at the time of usage
Materials Inventory (AQP x AR) X
Accounts payable (AQP x AR) X
(As in this case AQP is not considered in material variances)
(Record purchase of raw materials)
Material is issued to production[based on total variance and its
breakup]
Work in progress control (SQU x SR) X
Material usage variance (If adverse) Expense X
Material price variance (If adverse) Expense X
Material usage variance (If favorable) Income X
Material price variance (If favorable) Income X
Material Inventory (AQU x AR) X

It can be explained with the help of following example.

Example:
The Shawn Furniture House uses 12 meters of pipe at cost of Rs. 8 per meter as standard for the production of one
of its chairs Model No. CHRA12. During one month’s operations, 50,000 meters of pipe were purchased at Rs. 7.80
a meter and 3,600 chairs were produced using 43,800 meters of pipe.

Required: Assuming that material price variance is recognized at the time of issue of materials. Calculation of
material price and usage variance along with journal entries are given below.

MATERIAL VARIANCES
[SQU for AP x S.R] – [AQU for AP x A.R]
[3,600 x 12 x 8] – [43,800 x 7.8]
345,600 – 341,640 = 3,960 F

PRICE USAGE
(SR-AR) X AQU (SQU-AQU) X S.R
(8 – 7.8) X 43,800 (3,600 x 12 – 43,800) X 8
8,760 F 4,800 A

293 Page 5 of 10
 Debit Credit
Description
-------- Rupees --------
Materials Inventory (50,000 x 7.80) 390,000
Accounts payable (50,000 x 7.80) 390,000
(Record purchase of raw materials)
Work in progress control (3,600 x 12 x 8) 345,600
Material usage variance 4,800
Material price variance 8,760
Material Inventory (43,800 x 7.80) 361,640
(Record issue of material to production)

Journal Entries related to direct labour in standard costing [Based on total Variance and its breakup]
Debit Credit
Description
-------- Rupees --------
Work in progress control (SWH x SR) X
Adverse variances (expense) X
Favorable variances (Income) X
Payroll (Actual) [AHW x AR]* X
(Record charging direct labor cost to production)
*if idle time then AHP x AR

Example:
The standard cost card of Rashid Food Manufacturing Limited shows that the processing of a product FDL560
requires 1 hour at a standard wage rate of Rs. 60 per hour.

The 2,000 units actually taken 1,975 hours at a cost of Rs. 122,450, including 25 idle hours.

Required: Calculation of direct labour rate, efficiency and idle time variances and journal entry to charge direct
labour to production.
LABOURE VARIANCE
[SHW for AP x S.R] – [AHP for AP x A.R]
[2,000 x 1 x 60] – 122,450
120,000 – 122,450 = 2,450 A

Rate Idle time Efficiency

(SR – AR) × AHP (AHP – AHW) × S.R (SHW – AHW) × S.R
 122,450 
 60 −  × 1,975 (1,975 – 1,950 ) × 60 (2,000 × 1 – 1,950] × 60
 1,975 
3,950 A 1,500 A 3,000 F

294 Page 6 of 10
Journal entry to charge direct labour cost to production in standard costing is given below.
Debit Credit
Description
-------- Rupees --------
Work in progress control (2,000 x 1 x 60) 120,000
Labour rate variance 3,950
Labour idle time variance 1,500
Labour efficiency variance 3,000
Payroll [AHP for AP x A.R][Given] 122,450
(Record charging direct labour cost to production)

Journal Entries of variable production overhead cost charged to production in standard costing [Based on total
Variance and its breakup]
Debit Credit
Description
-------- Rupees --------
Work in progress control (SHW x AR) X
Adverse variances X
Favourable variances X
Variable Production overhead (AHW x AR) X
(Record charging variable production overheads to production)

Example:
The normal capacity of Rizwan manufacturing limited is 20,000 direct labour hours per month. The standard cost
card shows that 2 hours are required to produce one unit of product ABT. At normal capacity the budgeted
variable production overhead rate is Rs. 1.50 per direct labour hour.

During July, the plant operated 18,000 direct labour hours, with variable production overhead of Rs. 26,800. Actual
production for the month of July is 9,200 units.

Variable OH
[SHW for AP x S.R] – [AHW for AP x A.R]
[9,200 x 2 x 1.5] – 26,800
800 F

Expenditure Efficiency
(SR – AR) × AHW (SHW – AHW) × S. R
26,800
[1.5 - ] x 18,000 [(9,200× 2) –18,000] × 1.5
18,000

200 F 600 F

295 Page 7 of 10
Journal entry to charge variable production overheads to product cost in standard costing is given as under:
Debit Credit
Description
-------- Rupees --------
Work in progress control (9,200 x 2 x 1.50) 27,600
Variable production overhead expenditure variance 200
Variable production overhead efficiency variance 600
Variable Production overhead variable[AHW for AP x A.R][Given] 26,800
(Record charging variable production overheads to production)

Journal Entries to absorb fixed production overhead to product cost in standard costing[Based on total Variance
and its breakup]
Debit Credit
Description
-------- Rupees --------
Work in progress control [Applied] X
Adverse variances X
Favourable variances X
Fixed Production overhead [Actual] X
(Record charging fixed production overheads to production)

Example:
ST Company operates a standard costing system for its only product. The standard cost card relating to fixed
production overhead showed as 2 hours at Rs. 10 per hour.

Fixed production overhead are absorbed on the basis of labour hours. Fixed overhead costs are budgeted at Rs.
12,000 per annum, arising at a constant rate during the year.

Actual production during the month was 60 units, with actual fixed production overhead costs being Rs. 980.

Calculation of fixed production overhead expenditure and volume variance, along with entry to absorb fixed
production overhead in standard costing, is given below.

296 Page 8 of 10
 Fixed Production Overheads
Actual Fixed overheads 980
Applied Fixed overheads[60 x 20] 1,200
220 F

Expenditure Volume
Budgeted Fix OH 1,000 Budgeted fixed FOH 1,000
12,000 / 12 50 x 20

980 Applied Fix OH 1,200

Actual Fixed
60 x 20
20 F 200 F

Debit Credit
Description
-------- Rupees --------
Work in progress control (60 x 2 x10) 1,200
Fixed production overhead expenditure variance 20
Fixed production overhead volume variance 200
Fixed Production overhead [Actual][Given] 980
(Record charging fixed production overheads to production)

Journal entries-direct materials in standard costing

.Material price variance is recognized at the time of purchase
(based on breakup only)
Materials Inventory (AQP x SR) X
Material price variance (If adverse) Expense X
Material price variance (If favorable) Income X
Accounts payable (AQP x AR) X
(Balancing figure is either adverse or favorable variance)
(Record purchase of raw materials)
Material is issued to production
Work in progress control (SQU x SR) X
Material usage variance (If adverse) Expense X
Material usage variance (If favorable) Income X
Material Inventory (AQU x SR) X
(Balancing figure is either adverse or favorable variance)

Example:
The Shawn Furniture House uses 12 meters of pipe at cost of Rs. 8 per meter as standard for the production of one
of its chairs Model No. CHRA12. During one month’s operations, 50,000 meters of pipe were purchased at Rs. 7.80
a meter and 3,600 chairs were produced using 43,800 meters of pipe.

297 Page 9 of 10
Required: Assuming that material price variance is recognized at the time of purchases. Calculation of material
price and usage variance along with journal entries are given below.

Answer:
MATERAIL VARIANCES

PRICE USAGE
(SR-AR) X AQP (SQU-AQU) X S.R
(8 – 7.8) X 50,000 (3,600 x 12 – 43,800) X 8
10,000 F 4,800 A

Debit Credit
Description
-------- Rupees --------
Materials Inventory (50,000 x 8) 400,000
Material price variance 10,000
Accounts payable (50,000 x 7.80) 390,000
(Record purchase of raw materials)
Work in progress control (3,600 x 12 x 8) 345,600
Material usage variance 4,800
Material Inventory (43,800 x 8) 350,400
(Record issue of material to production)

298 Page 10 of 10
 Being Muslim is for all day, Not just 5 times a day.

Extra Questions
Job order costing
Q. Power Limited (PL) is engaged in the business of overhaul and repair of turbo-generators. The company uses job
order costing system. Following data has been extracted from the cost cards relating to jobs completed in the
month of August 2013:
Rs. `000`
Materials issued 55,000
Direct labour 41,000
Overheads on material 25%
Overheads on direct labour 80%

The clients are billed at each month-end on the basis of cost of goods manufactured.

Actual expenses for the month of August 2013 were as under:

Rs. `000`
Factory wages (inclusive of indirect labour) 65,000
Factory expenses 15.000
Store expenses 7,500
Other office expenses 4,500

Following information is also available:

i. Material requisitions not recorded in the cost cards amounted to Rs. 5,600,000.
ii. Direct labour shown as indirect in the cost cards amounted to Rs. 2,900,000.
iii. Details of stock and work in process for the month of August 2013 are as under:
Opening Closing
............ Rs. `000’ …………
Stock of materials 5,000 5,500
WIP – material 10,000 10,500
WIP – Conversion 2,500 4,500

Required:
Calculate the following for the month of August 2013:
a) Purchases
b) Direct labour
c) Under/Over absorbed overheads
d) Actual profitability of completed jobs
(12)

299 Page 1 of 82
Solution:
a) Purchases
Material A/c
b/d 5,000 WIP (55,000 + 5,600) 60,600
Purchase 61,100
c/d 5,500
66,100 66,100

b) Direct labour
Given as per cards 41,000
Add: Direct labour booked as indirect labour 2,900
43,900

c) Under/Over absorbed overheads

Factory oh A/c
Cash/ Payable (W-1) 43,600 WIP (W-2) 50,270
Cost of sales 6,670
Over absorbed overheads are 6,670

W-1 Actual Factory overheads

Indirect labour (65,000-43900(a)) 21,100
Factory expenses 15,000
Store expenses 7,500
43,600

W-2 Absorbed Factory overheads

Overheads on material (60,600(a) x 25%) 15,150
Overheads on labour (43,900 (b) x 80%) 35,120
50,270

d) Actual Profitability of completed jobs

Sales (W-1) 190,338
Cost of sales:
Opening stock of Finished goods -
Add: Cost of goods Manufactured (W-2) 152,270
Less: Closing stock of Finished goods - 152,270
Over absorbed Factory overhead (c) (6,670)
Cost of Sales(Actual) (145,600)
Gross Profit 44,738
Other Office expenses 4,500
Net Profit 40,238

300 Page 2 of 82
 No one can help you get through your problems But ALLAH
W-1
Cost of goods manufactured as per cards (because clients are billed on the basis of cards) 152,270
(W 2)
Sales (152,270/80 x 100) 190,338

W-2 Cost of Goods Manufactured

Direct Material consumed 60,600
Direct Labour 43,900
Factory overheads-Applied[as in c above] 50,270
Manufacturing cost 154,770
Opening WIP (10,000 + 2,500) 12,500
Closing WIP (10,500 + 4,500) (15,000)
152,270
Break even:
Q. A soft drink company is planning to produce mineral water. It is contemplating to purchase a plant with a
capacity of 100,000 bottles a month. For the first year of operation the company expects to sell between 60,000
to 80,000 bottles. The budgeted costs at each of the two levels are as under:

Rupees
Particulars 60,000 bottles 80,000 bottles
Material 360,000 480,000
Labor 200,000 260,000
Factory overheads 120,000 150,000
Administration expenses 100,000 110,000

The production would be sold through retailers who will receive a commission of 8% of sale price.

Required:
a) Compute the break-even point in rupees and units, if the company decides to fix the sale price at Rs. 16 per
bottle.
b) Compute the break-even point in units if the company offers a discount of 10% on purchase of 20 bottles or
more, assuming that 20% of the sales will be to buyers who will avail the discount.
A
(a) break even point:
= fixed cost / contribution per unit
= 120,000 / 3.72*
*16 – 12.28 (W)
= 32,258 units
= 32,258 x 16 = 516,128
Fixed Cost
(b)
Contributi on
Batch

301 Page 3 of 82
 Working:
Contributi on
Bottle
Bottles
Sale Price 16 14.4
Variable Cost (12.28) (12.152)
(11 + 16 × 8%) (11 + 14.4 × 8%)
Contributing/Bottle 3.72 2.248
Sales Mix 4 1

Contribution / Batch of 5 Bottles:

= 3.72 × 4 + 2.248 × 1
= 17.128/Batch
120,000
= = 7,006 Batches
17.128

×4 ×1
28,024 bottles 7,006 bottles
× 16 × 14.4
= 448,384 = 100,886
CHECK
28,024 × 16 = 448,384 7,006 × 14.4 = 100,886
28,024 × 12.28 = (344,134) 7,006 × 12.152 = 85,136
104,249 15,749

Total Contribution 119,998

Fixed Cost (120,000)
Net profit --
WORKINGS:

W-2
360,000 480,000
Material Cost = =6 Or =6
60,000 80,000
W-3 Labour Cost (Semi – Variable) (High low Method)
260,000 − 200,000
Per unit variable cost = =3
80,000 − 60,000
Fixed cost:
Total labour cost of 80,000 units 260,000
Variable Cost (80,000 × 3) (240,000)
Fixed cost 20,000

W-4 Factory Overheads (Semi – Variable) (High low Method)

150,000 − 120,000
Per unit variable cost = = 1.5
80,000 − 60,000

302 Page 4 of 82
 “Those who cheat are not of us.” [Muslim]
Fixed cost:
Total F-OH of 80,000 units 150,000
Variable Cost (1.5 × 80,000) (120,000)
Fixed cost 30,000

W-5 Admin Expenses (Semi – Variable) (High low Method)

110,000 − 100,000
Per unit variable cost = = 0.5
80,000 − 60,000
Fixed cost:
Total Admin Cost of 80,000 units 110,000
Variable Cost (80,000 × 0.5) (40,000)
Fixed cost 70,000

Process costing:
Q. Ababeel Foods produces and sells chicken nuggets. Boneless chicken is minced, spiced up, cut to standard size
and semi-cooked in the cooking department. Semi-cooked pieces are then frozen and packed for shipping in the
finishing department.

Materials are added at the beginning of the process.Inspection is carried out when the process in the cooking
department is 80% complete. Normal loss is 5% and comprises of:
• 2% weight loss due to cooking; and
• 3% rejection of nuggets. The rejected nuggets are sold at Rs. 60 per kg.

Overheads are applied at the rate of 120% of direct labour cost. Inventory is valued using weighted average cost.
Following information pertains to cooking department for the month of June 2014:
Material Labour
Kg.
Rs. in ‘000

Opening work in progress (100% complete to

material and 50% complete to conversion) 30,000 6,260 1,288
Costs for the month 420,000 50,000 20,000
Weight after cooking 440,000 - -
Transferred to finishing department 362,000 - -
Closing work in progress
(100% complete to material and 65%
complete to conversion) 65,000

Required:
Prepare process account for cooking department for the month of June 2014. (15)

303 Page 5 of 82
A Ababeel Foods
(6260+1288+1288x1.2)
Cooking department production and cost for June 2014

Process account - Cooking department

Kg. Rs. in '000' Kg. Rs. in '000'

Opening WIP 30,000 (W-2)9,094 Normal loss: 19,250 693

Material 420,000 50,000 (11,550 x 60)
Labour 20,000
Overheads (20,000x1.2) 24,000 Abnormal loss(bal) 3,750 829

Transferred out (W.2) 362,000 88328

13244
Closing WIP (W.2) 65,000
450,000 103,094 450,000 103,094

W-1: Normal and abnormal losses: Abnormal

Total loss Normal loss (Cooking loss at 2% loss
& rejection loss at 3%) (Balancing) This
Kg separation
Weight loss: is required
Opening WIP 30,000 because
Input for the month 420,000 only
450,000 rejected
nuggets
Transferred to finishing department (362,000)
have
Closing WIP (65,000)
recovery
Total loss 23,000
value)
Weight loss (450,000-440,000) 10,000 (450,000-65,000)x2% 7,700 2,300
Rejection loss (balancing) 13,000 (450,000-65,000)x3% 11,550 1,450
23,000 19,250 3,750
W-2) Working for normal loss:
Opening WIP 30,000 (100%M, 50%C)
Input 420,000
Closing WIP 65,000 (100%M,65%C)
Stage of inspection 100%M ; 80%C
(30,000+420,000-65,000) *2%=7,700
(30,000+420,000-65,000) *3%=11,550
Total 19,250

304 Page 6 of 82
 “Give workers their wages before their sweat (on their foreheads) have dried.”
EQUIVALENT PRODUCTION UNITS:

Material Conversion
Finished goods 362,000 362,000 362,000

Abnormal loss 3,750 3,750 3,000(80%)

c/d WIP 65,000 65,000 42,250(65%)

430,750 407,250

Cost per unit:

Material= (6,200+50,000-693)/430,750 =129
Conversion cost = (2,834+44,000)/407,250 =115
Total = 244
b) COST ALLOCATION:
finished goods =262,000*244 = 88,328
abnormal loss = 3,750 x 129+3,000 x 115 = 829
c/d WIP = (65,000*129+42,250*115) =13,244

Same question if FIFO:

Ababeel Foods
Process Account – Cooking Department
Units Amount Units Amount
Opening WIP 30,000 9,094 Normal loss 19,250 693
Material 420,000 50,000
Labor 20,000
F OH (20,000 × 1.2) 24,000 Abnormal loss 3,750 798

Transferred out 362,000 88,867

Closing WIP 65,000 12,737
450,000 103,095 450,000 103,095

WORKINGS:
Equivalent Units (FIFO)
Material Conversion
30,000 -- 15,000
Finished goods 362,000
332,000 332,000 332,000
Closing WIP (100% Material ; 65% Conversion) 65,000 65,000 42,250 (65%)
Abnormal loss (100 3,750 3,750 3,000 (80%)
% Material ; 80% Conversion)
400,750 392,250

305 Page 7 of 82
Cost / Kg:
Rs.
Material = [50,000 – 693] ÷ 400,750 = 123.037
Conversion = [44,000] ÷ 392,250 = 112.173
235.21

Cost Accounted For: Rs. ’000’

Finished goods:
From opening WIP (6,260 + 1,288 + 1,288 × 1.2) = 9,094
+ (15,000 × 112.173) = 1,683
+ (332,000 × 235.21) = 78,090
88,867
Closing WIP (65,000 × 123.037) + (42,250 × 112.173) = 12,737
Abnormal loss (3,750 × 123.037) + (3,000 × 112.173) = 798

Q. Smart Processing Limited produces lubricants for industrial machines. Material COX is introduced at the start of
the process in department A and subsequently transferred to department B. Normal loss in department A is 5% of
the units transferred.

In department B, material COY is added just after inspection which takes place when the production is 60%
complete. 10% of the units processed are evaporated before the inspection stage. However, no evaporation takes
place after adding material COY. During the year, actual evaporation in department B was 10% higher than the
estimated normal losses because of high level of Sulpher contents in natural gas used for processing.

Other details for the year ended December 31, 2009 are as under:
Department A Department B
Rupees
Opening work in process 2,184,000 2,080,000
Material input - 600,000 Litres 17,085,000
- 500,000 Litres [material COY] 9,693,000
Labour 8,821,000 6,389,000
Overheads 2,940,000 3,727,000

Department A Department B
Completion % Completion %
Litres Conversion Litres Conversion
Material Material
costs costs
Opening WIP 64,500 100 60 40,000 100 60
Closing WIP 24,000 100 70 50,000 100 80

Conversion costs are incurred evenly throughout the process in both departments. The company uses FIFO method
for inventory valuation.

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 Nobody has eaten better food than that won by his own labor

Required:
• Equivalent production units
• Cost of abnormal loss and closing WIP
• Cost of finished goods produced

A.
SMART LIMITED
Process Account - A
Units Amount Units Amount
Opening 64,500 2,184,000 Units transferred 610,000 29,975,000
Material 600,000 17,085,000 N. Loss (610,000 × 5%) 30,500 --
Labour 8,821,000 Closing WIP 24,000 1,056,000
F-OH 2,940,000
664,500 31,030,000 664,500 31,030,000

Calculation of Normal Loss: (5% of Units Transferred)

64,500 + 600,000 – 24,000 = 640,500

These are sum of units transferred and normal loss.

Normal loss is 5% of units transferred (with normal loss)

640,500 = 105
Units transferred (640,500 × 100/105) = 610,000
Normal loss (640,500 × 5/105) = 30,500
Equivalent unit (FIFO) Material Labour F-OH
64,500 -- 25,800 25,800
Transferred 610,000 (40%) (40%)
545,500 545,500 545,500 545,500
Closing WIP 24,000 24,000 16,800 (70%) 16,800 (70%)
569,500 588,100 588,100
Cost 17,085,000 8,821,000 2,940,000
Per Unit 30 15 5
Transferred units:
Rs.
From Opening = 2,184,000
During the year (64,500 × 40% × 15) + (64,500 × 40% × 5) 516,000
2,700,000
Add: Started & Completed during the period
545,500 × (30 + 15 + 5) 27,275,000
Total 29,975,000
From Closing WIP:
(24,000 × 30) + (16,800 × 15) + (16,800 × 5) 1,056,000

307 Page 9 of 82
Process Account - B
units Amount units Amount
b/d WIP 40,000 2,080,000 Transferred (balance) 1,032,900 49,366,723
Received from A 610,000 29,975,000 Abnormal Loss 6,100 209,450
Material COY 500,000 9,693,000 (61,000 × 10%)
Labour 6,389,000 Normal Loss (610,000 × 10%) 61,000 --
F-OH 3,727,000 c/d WIP 50,000 2,277,400

1,150,000 51,863,000 1,150,000 51,853,573

(Normal loss is before adding material COY so 10% of 610,000)

Equivalent Units (FIFO):

Proceeding
Material COY Labour F-OH
Department
40,000 -- -- 16,000 16,000
Transferred 1,032,900 (40%) (40%)
992,900 992,900 992,900 992,900 992,900
* Abnormal loss 6,100 (At 60%) 6,100 -- 3,660 3,660
(COY added (60%) (60%)
after
Inspection)

Closing work in process 50,000 50,000 50,000 40,000 40,000

(80%) (80%)
1,049,000 1,042,900 1,052,560 1,052,560
Cost 29,975,000 9,693,000 6,389,000 3,727,000
Per Unit 28.57 9.29 6.07 3.54
Total cost per unit 47.47

Cost of Units Transferred: 1,032,900 units

From Opening 2,080,000
Add: 16,000 x 6.07 + 16,000 x 3.54 = 153,760

Add: 992,900 x 47.47 = 47,132,963

49,366,723

Abnormal loss [6,100 x 28.57 + 3,660 x 6.07 + 3,660 x 3.54] 209,450

ClosingWIP = 2,277,400
(50,000×28.57)+(50,000×9.29)+(40,000×6.07)+(40,000×3.54)

308 Page 10 of 82
Variances:
Q. (a) Hexa Limited uses a standard costing system. The following profit statement summarizes the performance of
the company for August 2008:
Rupees
Budgeted profit 3,500
Favorable variance:
Material price 16,000
Labour efficiency 1 1.040 27.040
Adverse variance:
Fixed overheads expenditure (16.000)
Material usage (6,000)
Labour rate (7,520) (29,520)
Actual profit 1,020

The following information is also available:

Standard material price per unit (Rs.) 4.0
Actual material price per unit (Rs.) 3.9
Standard wage rate per hour (Rs.) 6.0
Standard w age hours per unit 10
Actual wages (Rs.) 308.480
Actual fixed overheads (Rs.) 316.000
Fixed overheads absorption rate 100% of direct wages

Required:
Calculate the following from the given data:
• Budgeted output in units
• Actual number of units purchased
• Actual units produced
• Actual hours worked
• Actual wage rate per hour

b) State possible causes of favourable material price variance, unfavourable material quantity variance, favourable
labor efficiency variance and unfavourable labor rate variance

Answer:
HEXA LIMITED
(a) Budgeted Output in Units:
Actual fixed overheads (given) 316,000
Fixed OH Adverse Variance (16,000)
Budget Fixed overheads 300,000

309 Page 11 of 82
 Since fixed OHs absorption rate is 100% of direct wages therefore:
Budgeted direct wages 300,000
Budgeted direct wage/unit (10 × 6) 60
Budgeted output (300,000 ÷ 60) 5,000 units
(b) Actual Number of Units Purchased:
Material price Variance = (SR – AR) × AQP
16,000 = (4 – 3.9) AQP
AQP = 16,000/0.1
= 160,000 units
(c) Actual Units Produced:
Labour Cost Variance = Labour rate variance + Lab. Efficiency Variance
= (7,520) + 11,040
= 3,520 F
Labour Cost Variance = Std. Wages for Actual Production – Actual Wages
(SHW for A.P × SR) – (AHW × AR)
3,520 = 6 × 10 × x – 308,480
60x = 312,000
x = 5,200 (Units Produced)
(d) Actual Hours Worked:
Labour Efficiency Variance = (SHW for Actual Production – AHW) × S.R
11,040 = (52,000 × 10 – x) × 6
11,040 = (5,200 – x) × 6
11,040 = 312,000 – 6 x
6x = 312,000 – 11,040
x = 50,160 hours.
(e) Actual Wage Rate per Hour:
Actual Wages = Actual Hours × Actual Rate
308,480 = 50,160 × x
x = 6.15 / hour.
Note: In the absence of information it is assumed that hours worked = hours paid.

b)
Possible causes of favorable material price variance
Fortunate buy

Inferior quality materials

Unusual discount due to bulk quantity purchase
Drop in market price
Less costly method of transportation

Possible causes of unfavorable material quantity variance

Carelessness
Poorly adjusted machines
Unskilled workers
New equipment
Inferior quality materials

310 Page 12 of 82
 Islam brings peace in the life of the people who truly practice it.

Possible causes of favorable labor efficiency variance

Use of better skilled workers
High quality material
New equipment

Possible causes of unfavorable labor rate variance

Use of workers with better skills
Change in pay scales
Overtime

Variance:
Q. Following information pertains to Espresso Limited (EL), engaged in manufacturing of a product ‘Rita’:

Extracted from last year’s records:

• EL budgeted to produce 16,000 units of Rita by utilizing 32,000 budgeted machine hours.
• The absorption rate for fixed overheads was determined at Rs. 1,250 per machine hour.
• Actual fixed overheads incurred were Rs. 41.20 million that included depreciation of Rs. 12.50 million.

The actual production was 17,000 units by utilizing 32,400 machine hours.

EL absorbs fixed overheads by using pre-determined machine hour rate.

For the next year, the management of EL has made the following projections:
• Production and demand for Rita is expected to increase by 15%. EL is intending to buy a new automated
machinery costing Rs. 7.3 million to increase the actual efficiency by 25%. The new machinery would have a
useful life of 8 years with residual value of Rs. 1 million.
• Existing fixed overheads other than depreciation are expected to increase by 10%. Additional supervision
cost would need to be incurred at Rs. 70,000 per month.

Required:
(a) Compute under/over absorption of fixed overheads for the last year and analyse it into fixed overhead
expenditure, efficiency and capacity variances.
(b) Determine fixed overheads absorption rate for the next year.

A. Rs.’000’
Actual Fixed OH 41,200
Applied Fixed OH 42,500
(17,000X2,500*) 1,300 F (over applied)
*(1,250x2=2,500)

Expenditure Volume
Actual Fixed OH 41,200 Budgeted Fixed OH 40,000
Budgeted Fixed OH 40,000 (16,000X2,500)
(16,000X2,500) 1,200A Applied Fixed OH 42,500

311 Page 13 of 82
 (17,000X2,500) 2,500F

Capacity Efficiency
Budgeted Capacity hrs x S.R = 40,000 Actual Consumed hrs x S.R= 40,500 (
32,000X1,250 ) (32,400X1,250)
Actual Consumed hrs x S.R = 40,500 Standard hrs. for A.P x S.R = 42,500
(32,400X1,250) 500F (17,000 x 2 x1,250) 2000F

Budgeted hrs. in the next year:

32,400 x 1.15 x 75% = 27,945

Budgeted Fixed OH
(41,200 – 12,500) * 1.1 = 31,570
Depreciation (12,500)+ New Machine(7,300 – 1,000/8) = 13,288
+ Supervision (70,000 x 12) = 840
45,698

Fixed overheads rate per machine hr[for next year] = 1635.28

(45,698,000 ÷ 27,945)

Decision making:
RELEVANT COSTING
Example:
The manager of a small printing business has received enquires about printing three different types of advertising
leaflet, type A, type B and type C. Selling price and cost information for these leaflets is shown below:

The manager of a small printing business has received enquires about printing three different types of advertising
leaflet, type A, type B and type C. Selling price and cost information for these leaflets is shown below:
Leaflet type: Type A Type B Type C
Rs. Rs. Rs.
Selling price, per 1,000 leaflets 300 660 1,350
Estimate printing costs:
Variable costs, per 1,000 leaflets 120 210 390
Specific fixed costs per month 7,200 12,000 28,500

In addition to the specific fixed costs, Rs.12,000 per month will be incurred in general fixed costs.

The printing business receives an enquiry from a customer about printing 30,000 of a different type of leaflet. The
customer is willing to pay Rs.25,000. The variable labor and overhead costs of producing these leaflets would be
Rs.80 per 1,000 leaflets.

312 Page 14 of 82
 One who remembers ALLAH is never Lonely.
The leaflets would be printed on a special type of paper. This costs Rs.500 per 1,000 leaflets. However, there are
already sufficient quantities of the paper in inventory for 20,000 of the leaflets. This special paper was purchased
three months ago for a customer who then cancelled his order. The material has a disposal value of Rs.1,500, but it
could also be used to produce 20,000 units of leaflet C. The cost of normal paper for leaflet C is Rs.300 per 1,000
leaflets.

Required: Calculate the relevant costs of making the leaflets for this special order and profit increase as a result of
undertaking the order.
A.

Relevant costs Rs.

Materials
To be purchased: 10,000 Rs.500/1,000 5,000
Currently held in inventory 6,000
(Relevant cost = higher of [Rs.1,500 and (20,000 x Rs.300/1,000)]
Variable costs of labor/overheads 2,400
(30,000 x Rs.80/1,000)
Total relevant costs (13,400)
Contract price 25,000
Incremental profit 11,600

CVP ANALYSIS
Q. The manager of a small printing business has received enquires about printing three different types of
advertising leaflet, type A, type B and type C. Selling price and cost information for these leaflets is shown below:

Leaflet type: Type A Type B Type C

Rs. Rs. Rs.
Selling price, per 1,000 leaflets 300 660 1,350
Estimate printing costs:
Variable costs, per 1,000 leaflets 120 210 390
Specific fixed costs per month 7,200 12,000 28,500

In addition to the specific fixed costs, Rs.12,000 per month will be incurred in general fixed costs.

Required: Assuming that fixed orders have been received to print 50,000 of Leaflet A and 50,000 of Leaflet B each
month, the quantity of Leaflet C that must be sold to produce an overall profit, for all three leaflets combined, of
Rs.5,400 per month.

313 Page 15 of 82
A.
Rs. Rs.
Target profit 5,400
General fixed costs 12,000
Specific fixed costs:
Leaflet Type A 7,200
Leaflet Type B 12,000
Leaflet Type C 28,500
Total contribution required 65,100
Contribution from:
50,000 Leaflets Type A: (50 (300 – 120)) 9,000
50,000 Leaflets Type B: (50 (660 – 210)) 22,500
31,500
Contribution required from Leaflets Type C 33,600

The contribution from Leaflets Type C is Rs.(1,350 – 390) = Rs.960 per 1,000 leaflets or 0.96 per leaflet The sales
quantity of Leaflets Type C required to achieve a target profit of Rs.5,400 each month is therefore Rs.33,600/0.96 =
35,000 leaflets.

DECISION MAKING
Q. Super clean Company is a contract cleaning company. It provides three services; daily office cleaning, intensive
cleaning of office space and minor repairs. However it has insufficient resources to do all the work available, and
wishes to use a sub-contractor to take on some of the work.

Information relating to the different type of work is as follows:

Average labor Variable cost Budgeted Sub-contractor

hours per job (Rs.) number of quote per job
per jobs (Rs.)
job

Daily office cleaning 4 60 1,500 80

Intensive cleaning 6 108 400 150
Minor repairs 3 56 640 100

There are 8,000 labor hours available. The serviced that should be sub-contracted would be analyzed using
following workings

The company can do all three types of job more cheaply with its own staff than by hiring the sub- contractor.
However, provided that it earns more than Rs.80 for a daily office cleaning job, Rs.150 for an intensive cleaning job
and Rs.100 for a minor repairs job, it is profitable to use the sub- contractor to make up the shortfall in in-house
resources.

314 Page 16 of 82
 Take everyday as a chance to become a better Muslim.
Required: Calculate the cost minimizing plan:

A. The problem is to decide which work to outsource/sub-contract. The ranking should be established as follows:

Daily office Intensive Minor

cleaning cleaning repairs

Rs. Rs. Rs.

Cost of doing the work in-house 60 108 56
Cost of sub-contractor 80 150 100
Extra cost of outsourcing, per job 20 42 44

Daily office Intensive Minor

cleaning cleaning repairs

Hours saved by sub-contracting 4 6 3

Extra cost per hour saved Rs.5 Rs.7 Rs.14.
st
Priority for outsourcing 1 2nd 3rd
rd
Priority for doing work with own resources 3 2nd 1st

It is cheaper to sub-contract office cleaning than intensive cleaning. It is most expensive to sub- contract minor
repairs and this is the first choice of job to be carried out in-house. The cost- minimizing plan should be to carry
out the following work:

Budgeted Total labor Total

jobs hours variable cost

Rs.
Minor repairs 640 1,920 35,840
Intensive cleaning 400 2,400 43,200
Office cleaning (balance) 920 3,680 55,200
Maximum labor hours available 8,000
Sub-contract: Office cleaning 580 46,400
180,640

Decisions for Discontinuing operations

Some operations are more profitable than the others. In this respect, organizations may often consider less
profitable ventures to be discontinued for allocation of resources to those making more profits.

315 Page 17 of 82
Q. Stamba makes two components, A and B, for which costs in the next year are expected to be as follows:

A B
Production (units) 30,000 20,000
Variable costs per unit: Rs. Rs.
Direct materials 6 5
Direct labor 3 9
Variable production overheads 1 3
Variable production cost 10 17

Direct labor is paid Rs.12 per hour. There will be only 19,500 hours of direct labor time available next year, and
any additional components must be purchased from an external supplier.

Total fixed costs per annum are expected to be as follows:

Rs.
Incurred as a direct consequence of making A 40,000
Incurred as a direct consequence of making B 50,000
Other fixed costs 30,000
120,000

An external supplier has offered to supply units of A for Rs.12.50 and units of B for Rs.23.

Required: Recommend regarding whether Stamba should shut down internal production of Component A or
Component B and switch to external purchasing.

A.
Component A Component B
Rs. Rs.
Cost of making internally 10.0 17.0
Cost of buying 12.5 23.0
Extra variable cost of buying 2.5 6.0
Quantities required next year 30,000 20,000
Total extra variable cost of buying 75,000 120,000
Fixed costs saved by closure 40,000 50,000
Net extra costs of buying 35,000 70,000

It appears that it would cost the company more each year to shut down internal production of either component
and switch to external purchasing.

Required: Recommend regarding the quantities that Stamba should make of the components, and the quantities
that it should buy externally, in order to obtain the required quantities of both components at the minimum cost.

316 Page 18 of 82
A.
Production hours required Hours
Component A (30,000 x 0.25 hours) 7,500
Component B (20,000 x 0.75 hours) 15,000
Total hours required 22,500
Total hours available 19,500
Shortfall 3,000

There are insufficient hours available to manufacture everything internally. Some components must be purchased
externally.

Component A Component B
Rs. per unit Rs. per unit
Cost of making internally 10.0 17.0
Cost of buying 12.5 23.0
Cost saved by making 2.5 6.0
Hours required to make internally 0.25 hours 0.75 hours
(Rs.3/Rs.12 per hour: Rs.9/Rs.12 per hour)
Costs saved per hour by making Rs.10 Rs.8
(Rs.2.50/0.25 hours: Rs.6/0.75 hours)

It is better to make Component A internally than Component B.

Component Units Hours Cost/unit Cost

Rs. Rs.
A 30,000 7,500 10 300,000
B (balance) 16,000 12,000 17 272,000
Variable cost of internal manufacture 19,500 572,000
Cost of external purchase – balance of units
required 4,000 23 92,000
Fixed costs 120,000
Total costs 784,000

Required: Non-financial considerations relevant to make-or-buy decision are discussed below:

Risks of outsourcing work:

• Supplier may produce items to a lower standard of quality.
• The supplier may fail to meet delivery dates and the buyer may dependent on the supplier to commit onward
delivery to its buyer. In case of buying of a component, production process of the end-product may be held
up by a lack of component.

317 Page 19 of 82
 Benefits of outsourcing work:
• Outsourcing work will enable the management to focus all of its efforts on those aspects of operation the
entity does best.
• The external supplier may have specialist expertise which enables it to provide outsourced products more
efficiently and at a cheaper price.

Comprehensive question of shutdown decision:

Q. Nasib Ltd. has prepared the following budgeted income statement for the year 2006:
Product Caps Crowns Rings Pallets Tubes Total
(Rupees in thousands)
Sales 30,800 34,300 45,500 35,700 63,700 210,000

Manufacturing costs
Materials 1,540 4,620 9,240 7,700 11,550 34,650
Labour 3,500 5,600 10,500 9,800 12,600 42,000
Production overheads:
Variable 1,750 2,450 2,800 3,500 5,040 15,540
Fixed 2,450 4,200 7,700 7,000 6,650 28,000
9,240 16,870 30,240 28,000 35,840 120,190

Transportation 840 2,520 5,040 4,200 4,550 17,150

Packaging 1,400 700 1,400 700 2,100 6,300
2,240 3,220 6,440 4.900 6,650 23,450

Administrative costs 4,620 5,145 6,825 5,355 9,555 31,500

Selling and advertising

Expenses 5,040 3,815 3,675 3,885 5,285 21,700
Total cost 21,140 29,050 47,180 42,140 57,330 196,840
Profit 9,660 5,250 (1,680) (6,440) 6,370 13,160

The Management Accountant of the company has provided the following additional information which describes
the basis on which budgeted income statement has been prepared:
1. Material costs include purchase cost plus 10% additional charge, which is added in order to recover the fixed
costs of storage and stores administration.
2. Labour cost is totally variable.
3. Fixed production overhead includes both directly attributable fixed costs and general fixed production
overheads. The general fixed production overheads amount to Rs. 21 million and have been allocated in
proportion to labour costs. The attributable fixed cost is avoidable if the related product is not produced.
4. Transport charges include fixed costs of Rs. 3,150,000 which have been allocated to products in proportion to
their material costs. Remaining costs are variable.
5. Selling and advertising expenses include commission of 5% of sales revenue. The remaining amount is the
advertising cost which is directly attributable to each product.
6. Administrative cost is fixed and is apportioned in the ratio of sales revenue.
7. Packaging is a variable cost.

318 Page 20 of 82
 “Allah is enough for us”
8. The Managing Director has shown his concern that Rings and Pallets are showing loss and affecting the
financial results of the company. A study which has been carried out recently has analyzed as under:

Sales are influenced by advertising and can be increased upto 40% by extensive advertising. However each 10%
increase in sale would require a 75% increase in advertising expenditure.

The management is considering the following two options:

• To discontinue the product Ring and Pallets.
• To launch an advertising campaign which will increase the sale of each product by 40%.

Required: Calculate the effect of each of the above options on the profitability of the company.

A
(i) Discontinuance of Product:
(Check whether there is a +ve contribution or not)
Rings Pallets
Sales 45,500 35,700
Less: Variable Cost:
Material (9,240 ÷ 110 × 100) 8,400 7,000 (7,700 ÷ 110 × 100)
Labour (Given) 10,500 9,800
V-OH (Given) 2,800 3,500
Transportation (W-1) 4,200 3,500
Packing (Given) 1,400 700
Selling & Advertisement (Given) 3,675 3,885
Contribution 14,525 7,315
Directly attributable fixed cost (W-2) (2,450) (2,100)
Net contribution 12,075 5,215

As there is +ve contribution so company should not discontinue operations otherwise company will loss
contribution towards fixed cost.
(W-1) Transportation Cost:
R P
Total 5,040 4,200
Less: Fixed Cost [9,240/34,650 x 3,150] (840) (700) 7,700/34,650 x 3,150
4,200 3,500
(W-2) Directly Attributable Fixed Cost:
R P
Total Fixed Cost 7,700 7,000
General Fixed OH [10,500/42,000 x 21,000] (5,250) (4,900) 9,800/42,000 x 21,000
2,450 2,100

319 Page 21 of 82
(ii) Launch an Advertisement Campaign:
Rs.
Sales 210,000 × 140% 294,000
Less: Cost: (Production is equal to sales)
 100 
Material: Variable  34,650   140 %  44,100
 110 
Fixed 34,650/110 x 10 remains fixed 3,150
Labour: (42,000 × 140%) 58,800

Production Overheads:
Variable (15,540 × 1.4) 21,756
Fixed (remains same) 28,000
Transportation:
Variable (17,150 – 3,150) × 140% 19,600
Fixed 3,150
Packing (6,300 × 140%) 8,820
Admin (Fixed) 31,500
Selling commission (294,000 × 5%) 14,700
Advertisement (W-1) 44,800
Total cost 278,376
Profit 15,624

(W-1) Advertisement cost:

Existing Advertisement Expenditure 21,700
Less: Commission (10,500) (210,000 × 5%)
11,200
11,200 + 11,200 × 75% × 4* 44,800
*(40% increase)
As new profit will increase by 2,464 (15,624 – 13,160) so scheme should be followed.

Q. In May 2015, the board of directors of Sahil Limited (SL) had decided to close one of SL’s operating segments
at the end of the next year. The sales and production for the next year were budgeted at 50,000 units and on the
basis thereof, the budget of the segment for the next year was approved as follows:

Rs. 000
Sales 5,000
Direct material (50,000 kg) (950)
Direct labor (1,000)
Variable production overheads (500)
Fixed production overheads (1,750)
Administrative and selling overheads (500)
Budgeted net profit 300

320 Page 22 of 82
 “Have fear of Allah wherever you are”

However, rumors of the closure prompted majority of the segment’s skilled labor to leave the company.
Consequently, the management is considering the following alternatives to cope with the issue:
• Close the segment immediately and rent the factory space for one year at a rent of Rs. 40,000 per month; or
• Employ contract labor which would be able to produce a maximum of 40,000 units in the year. The quality of
the product is however expected to suffer due to this change.

The following further information is available:

1. The sales manager estimates that a sales volume of 30,000 units could be achieved at the current selling price
whereas sales volume of 40,000 units would only be achieved if the price was reduced to Rs. 90 per unit.
2. 25,000 kg of raw material is in stock. Any quantity of the material may be sold in the market at a price of Rs.
19 per kg after incurring a cost of Rs. 2 per kg. Up to 15,000 kg can be used in another segment of the
company in place of a material which currently costs Rs. 18 per kg.
3. Wages of contract labor would be Rs. 24 per unit. SL would also be required to spend Rs. 40,000 on the
training of the contract labor.
4. Due to utilization of contract labor, variable production overheads per unit are expected to increase by 20%.
5. Fixed production overheads include:
• Depreciation of three machines used in the segment amounting to Rs. 170,000. These machines
originally costed Rs. 1.7 million and could currently be sold for Rs. 830,000. If the machines are used for
production in the next year, their sales value would reduce by Rs. 5 per unit of production.
• All other costs included in ‘fixed production overheads’ represent apportionments of general overheads.
6. 40% of administrative and selling overheads are variable whereas the remaining amounts represent
apportionment of general overheads.

Required: Advice the best course of action for Sahil limited.

A.
Sahil Limited
Analysis of Option:

i. Immediate closure and renting of factory building:

Rental income (40,000x12) 480,000
Proceeds from sale of machine 830,000
Direct Material (Can be used in other segment) [15,000 x 18] 270,000
Direct Material (Sale externally) [10,000 x (19 - 2)] 170,000
Total Saving 1,750,000

ii. Operations using contract labor to produce 30,000 units

Sales [30,000 x 100 (5,000,000 + 50,000)] 3,000,000

Proceeds from sale of machine [830,000 - (30,000 x 5)] 680,000

321 Page 23 of 82
Relevant costs:
Material:
One unit requires 50,000kgs/50,000 units = 1kg/unit
Opportunity cost of 15,000 kgs [15,000 x 18] (270,000)
Opportunity cost of 10,000 kgs [10,000 x 17(19 - 2)] (170,000)
Purchase of direct material [5,000kg (30,000 - 25,000) x 19(950,000/50,000)] (95,00)

Labor:
Training of contract labor (40,000)
Contract labor cost (30,000 x 24) (720,000)
Variable production overheads[500,000/50,000 x 1.2 x 30,000] (360,000)
Variable selling and Admin [(500,000 x 40%) ÷ 50,000 x 30,000] (120,000)
Net Profit 1,905,000

Following costs are not relevant in this decision:

• Fixed production overheads; whether existing deprecation or general overheads.
• Fixed Selling and administrative overheads which are also apportionment of general overheads.

iii. Operating using contract labour to produce 40,000 units:

Sales (40,000 x 90) 3,600,000
Proceeds from sale of machine [830,000 – (40,000 x 5)] 630,000
Relevant costs:
Material:
One unit requires 50,000 kgs/50,000 units = 1kg/Unit
Opportunity cost of 15,000 kgs (15,000 x 18) (270,000)
Opportunity cost of 10,000 kgs [10,000 x 17 (19 – 2)] (170,000)
Purchase of direct material (15,000 (40,000 – 25,000) x 19 (285,000)
Labour:
Training cost (40,000)
Contract labour cost (40,000 x 24) (960,000)
Variable production overheads (500,000/50,000 x 1.2 x 40,000) (480,000)
Variable selling and admin [(500,000 x 40%) ÷ 50,000 x 40,000] (160,000)
Net profit 1,865,000

Following costs are not relevant in this decision:

• Fixed production overheads; whether existing deprecation or general overheads.
• Fixed Selling and administrative overheads which are also apportionment of general overheads.

Recommendation:
Since the highest saving occur with a production level of 30,000 units, SL should operate the segment at this level
of activity.

322 Page 24 of 82
 “When things are too hard to handle, retreat & count your blessings instead.”

Question of Further processing decision:

Q. Zee Chemicals Limited (ZCL) produces two joint products, Alpha and Beta from a single production process.
Both products are processed upto split-off point and sold without any further processing.
Presently, ZCL is considering the following proposals:
• Expansion of the existing facility by installing a new plant
• Installation of a refining plant to sell either Alpha or Beta after refining

To assess the above proposals, following data has been gathered:

Actual cost incurred in the month of December 2014:

Rs. 000
Direct material 15,000
Variable conversion costs (Rs. 230 per hour) 4,890
Fixed overheads 2,600
Actual production and selling price for the month of December 2014:

Liters Selling price per liter (Rs.)

Alpha 11,300 1,000
Beta 14,700 1,125

There is no process loss and joint costs are apportioned between Alpha and Beta according to the weight of their
output.

Details of the proposed plans are as follows:

Expansion of Installation
existing facility of refining
plant

Capacity in machine hours per month 5,000 5,000

------------ Rs. in '000 ------------
Cost of plant and its installation 20,000 25,000
Estimated residual value at the end of life 1,400 2,800
Estimated additional fixed overheads per month 250 500
Estimated useful life of the plant 20 Years 20 Years

323 Page 25 of 82
Estimated variable cost of refining and sales price of refined products:

Alpha Beta
Rupees Per litre
Direct material 90per liter 125
Conversion cost (Rs. 150 per hour) 68 80
Selling price 1,380 1,525

There would be no loss during the refining process. There is adequate demand for Alpha and Beta at split-off point
and after refining.

Required: Evaluate each of the above proposals and give recommendations.

A.
Zee Chemical Limited
Evaluation of proposals:

i. Expansion of existing facility: (Sale at split off point)

Alpha Beta
Existing contribution margin per liter:
Sale price per liter 1,000 1,125
Variable cost per liter (W-1) (765) (765)
Contribution per unit 235 360
Contribution margin from additional 5,000 hours:
Production from 5,000 hrs. (W-2) 2,651 Litres 3,449 Litres
Contribution (2,651 x 235) (3,449 x 360) 622,985 1,241,640

Total contribution (622,986 + 1,241,640) = 1,864,625

Additional fixed cost:
Depreciation (20,000 – 1,400) ÷ 20/12 = (77,500)
Additional fixed overheads (250,000)
Net profit per month 1,537,125

Workings:

W-1
Existing fixed cost is not relevant; Variable joint cost to be allocated on the basis of weight of output (point iii)
Variable joint cost:
Direct material 15,000,000
Direct labour 4,890,000
19,890,000

324 Page 26 of 82
Allocation Per unit
Alpha 11,300 8,644,500 (11,300/26,000 x 19,890,000) 765(8,644,500/11,300)
Beta 14,700 11,245,500 (14,700/26,000 x 19,890,000) 765(11,245,500/14,700)
26,000 19,890,000

W-2
If 26,000 liters (11,300 + 14,700) are produced from 21,261 hrs. (4,890,000 ÷ 230) in December 2014, then;
26,000/21,261 = 1.22 Liters/hour.
Therefore, during 5,000 hours;
5,000 x 1.22 = 6,100 liters can be produced.

The mix would be

Alpha (11,300/26,000 x 6,100) = 2,651 Liters
Beta (14,700/26,000 x 6,100) = 3,449 Liters

ii. Installation of refining plant to sell Alpha after refining:

Incremental sale value per liter (1,380 – 1,000) 380
Incremental variable cost of refining per liter (90 + 68) (158)
Incremental contribution margin per liter 222
Hours per liter to refine Alpha (68 ÷ 150) 0.453
Production from 5,000 hrs. (5,000 ÷ 0.453) 11,038 liters
Contribution margin (11,038 x 222) 2,450,436
Additional fixed cost:
Depreciation (25,000 – 2,800) ÷ 20/12 (92,500)
Fixed cost per unit (500,000)
Net profit per month 1,857,936

iii. Installation of refining plant to sell Beta after refining:

Incremental sale value per liter (1,525 – 1,125) 400
Incremental variable cost of refining per liter (125 + 80) (205)
Incremental contribution margin per liter 195
Hours per liter to refine Beta (80 ÷ 150) 0.533
Production from 5,000 hrs. (5,000 ÷ 0.533) 9,381 Liters
Contribution margin (9,381 x 195) 1,829,295
Additional fixed cost:
Depreciation (25,000 – 2,800) ÷ 20/12 (92,500)
Fixed cost per month (500,000)
Net profit for the month 1,236,795

Recommendation:
As refining of Alpha produces the highest profit, ZCL should install refining plant to refine and sell 11,038 liters of
Alpha.

325 Page 27 of 82
Marginal costing and Absorption costing
Q. Mazahir (Pakistan) Limited manufactures and sells a consumer product Zee. Relevant information relating to the
year ended June 30, 2010 is as under:
Raw material per unit 5 kg at Rs. 60 per kg
Actual labour time per unit (same as budgeted) 4 hours at Rs. 75 per hour
Actual machine hours per unit (same as budgeted) 3 hours
Variable production overheads Rs. 15 per machine hour
Fixed production overheads Rs. 6 million
Annual sales 19,000 units
Annual production 18,000 units
Selling and administration overheads (70% fixed) Rs. 10 million

Salient features of the business plan for the year ending June 30, 2011 are as under:
• Sale is budgeted at 21,000 units at the rate of Rs. 1,100 per unit.
• Cost of raw material is budgeted to increase by 4%.
• A quality control consultant will be hired to check the quality of raw material. It will help improve the quality
of material procured and reduce raw material usage by 5%. Payment will be made to the consultant at Rs. 2
per kg.
• The management has negotiated a new agreement with labour union whereby wages would be increased by
10%. The following measures have been planned to improve the efficiency:
1. 30% of the savings in labour cost, would be paid as bonus.
2. A training consultant will be hired at a cost of Rs. 300,000 per annum to improve the working capabilities
of the workers.
On account of the above measures, it is estimated that labour time will be reduced by 15%.
• Variable production overheads will increase by 5%.
• Fixed production overheads are expected to increase at the rate of 8% on account of inflation. Fixed
overheads are allocated on the basis of machine hours.
• The company has a policy of maintaining closing stock at 5% of sales. In order to avoid stock-outs, closing stock
would now be maintained at 10% of sales. The closing stocks are valued on FIFO basis.

Required:
• Prepare a budgeted profit and loss statement for the year ending June 30, 2011 under marginal and
absorption costing.
• Reconcile the profit worked out under the two methods. (20 marks)
Mazahir (Pakistan) Limited
(a) Budgeted Profit & Loss A/C (Marginal Costing)
For the year ended June 30, 2011
Sales (21,000 × 1,100) 23,100,000
Variable Cost of Sales:
Opening Stock (950 × 645 (W-2)) 612,750
Production Cost (22,150 × 648.5 (W-3)) 14,364,275

Closing Stock (2,100 × 648.5) (1,361,850)

(13,615,175)
Gross Contribution 9,484,825

326 Page 28 of 82
Variable Selling and Admin (10,000,000 x 30% / 19,000 × 21,000) (3,315,789)
Net Contribution 6,169,036
Fixed Overheads:
Fixed Production Overheads (6,000,000 × 1.08) (6,480,000)
Training Consultant (Fixed) (300,000)
Selling & Admin (10,000,000 × 70%) (7,000,000)
Net Loss (7,610,964)

WORKINGS:
W-1 Production for 2011
Opening (19,000 × 5%) 950 Sold 21,000
Production (bal) 22,150 c/d(21,000 x 10%) 2,100

W-2 Variable Cost in 2010

RM (5 × 60) 300
DL (4 × 75) 300
V-OH (3 × 15) 45
Per Unit 645

W-3 Variable Cost in 2011

RM (5 × 95% × 60 × 104%) 296.4
DL (4 × 85% × 75 × 110%) 280.5
*Bonus 14.85
Payment to Consultant (5 × 95% × 2) 9.5
Variable overheads (3 × 15 × 105%) 47.25
Per Unit 648.5

*Cost would have been: 4 × 75 × 1.1 = 330

Reduced cost have been: 4 × 85% × 75 × 1.1 = 280.5
Difference (saving) 49.5
× 30% 14.85

Budgeted Profit & Loss A/C (Absorption Costing)

For the year ended June 30, 2011
Sales (21,000 × 1,100) 23,100,000
Cost of Sales:
Opening Stock (950 × (645 + 333.33 (W-5)) 929,413
Production Cost (22,150 × (648.5 + 306.09 (W-4)) 21,144,275

Closing Stock (2,100 × (648.5 + 306.09) (2,004,639)

(20,069,049)
Gross Profit 3,030,951

327 Page 29 of 82
Selling and Admin Expenses:
Variable (10,000,000 x 30% / 19,000 × 21,000) (3,315,789)
Fixed (10,000,000 × 70%) (7,000,000)
Loss for the year (7,284,838)

Note: Absorption rate is applied on budgeted units therefore no under – over applied Fixed overheads.
W-4 Fixed Overhead Rate for 2011
Fixed overheads (6,000,000 × 1.08) 6,480,000
Training Consultant 300,000
6,780,000
To calculate absorption rate estimated production is used because normal capacity is not given.
6,780,000 ÷ 22,150 = 306.09
W-5 Fixed Overhead Rate for 2010
6,000,000 ÷ 18,000 = 333.33
(b) Reconciliation of Profits:
(Loss)/Profit as per marginal costing (7,610,964)
Closing Stock as per M. Costing (1,361,850)
Opening Stock as per M. Costing 612,750
Closing Stock as per Ab. Costing 2,004,639
Opening Stock as per Ab. Costing (929,413)
(Loss/Profit as per Absorption Costing (7,284,838)
Q,
Zulfiqar Limited makes and sells a single product and has the total production capacity of 30,000 units per month.
The company budgeted the following information for the month of January 20X4:

Normal capacity (units) 27,000

Variable costs per unit:
Production (Rs.) 110
Selling and administration (Rs.) 25
Fixed overheads:
Production (Rs.) 756,000
Selling and administration (Rs.) 504,000
The actual operating data for January 20X4 is as follows:

Production 24,000 units

Sales @ Rs. 250 per unit 22,000 units
Opening stock of finished goods 2,000 units
During the month of January 20X4, the variable factory overheads exceeded the budget by Rs. 120,000.
a) Required: Prepare profit statement for the month of January using marginal and absorption
costing.
b) Required: Reconcile the difference in profits under the two methods.

328 Page 30 of 82
A.
a)
Sales (22,000 x 250) 5,500,000
Variable cost of sales:
Opening Stock (2,000 x 110) 220,000
+ Variable COGM
Variable Production cost (24,000 x 110) 2,640,000
+ Additional variable cost 120,000
2,760,000
- Closing cost (2,760,000/24,000 x 4,000) (460,000) (2,520,000)
Gross contribution 2,980,000
Variable selling and admin (22,000 x 25) (550,000)
Net contribution 2,430,000
Fixed cost:
Production (756,000)
Selling and admin (504,000)
Net profit 1,170,000
Profit statement under Absorption costing:
Sales (22,000 x 250) 5,500,000
Cost of sales:
Opening stock [2,000 x 138 (W-1)] 276,000
+ COGM: 2,640,000
Variable production cost (24,000 x 110) 120,000
Additional variable cost 2,760,000
Fixed production cost (24,000 x 28) 672,000
3,432,000
- Closing stock (3,432,000/24,000 X 4,000) (572,000) (3,136,000)
Adjustment of under applied overhead (W-2) (84,000)
Adjusted cost of sales (3,220,000)
Gross profit 2,280,000
Selling and admin expenses (504,000 + 22,000 x 25) (1,054,000)
Net Profit 1,226,000

b)
Reconciliation between Profits:
Profit as per A.C 1,226,000
Opening stock as per A.C 276,000
Closing stock as per A.C (572,000)
Opening stock as per M.C (220,000)
Closing stock as per M.C 460,000
Profit as per M.C 1,170,000

329 Page 31 of 82
Workings:
W-1
Variable production overhead per unit 110
Fixed production overhead per unit (756,000/27,000) 28
138

W-2
Fixed Production Overheads
Cash/Payable 756,000 WIP 672,000
COS 840,000

Factory overheads
Q. On December 1, 2013 Zia Textile Mills Limited purchased a new cutting machine for Rs. 1,300,000 to augment
the capacity of five existing machines in the Cutting Department. The new machine has an estimated life of 10
years after which its scrap value is estimated at Rs. 100,000. It is the policy of the company to charge depreciation
on straight line basis.

The new machine will be available to Cutting Department with effect from February 1, 2014. It is budgeted that the
machine will work for 2,600 hours in 2014. The budgeted hours include:
- 80 hours for setting up the machine; and
- 120 hours for maintenance.

The related expenses, for the year 20X4 have been estimated as under:
i. Electricity used by the machine during the production will be 10 units per hour @ Rs.
8.50 per unit.
ii. Cost of maintenance will be Rs. 25,000 per month.
iii. The machine requires replacement of a part at the end of every month which will cost Rs. 10,000 on each
replacement.
iv. A machine operator will be employed at Rs. 9,000 per month.
v. It is estimated that on installation of the machine, other departmental overheads will increase by Rs. 5,000
per month.

Cutting Department uses a single rate for the recovery of running costs of the machines. It has been budgeted
that other five machines will work for 12,500 hours during the year 2014, including 900 hours for maintenance.
Presently, the Cutting Department is charging Rs. 390 per productive hour for recovery of running cost of the
existing machines.

Required: Compute the revised machine hour rate which the Cutting Department should use during the year
2014.

330 Page 32 of 82
 “Our Interview with ALLAH is Coming”
A. Calculation of revised machine hour rate
Rupees
Total budgeted costs of existing five machines (Rs. 390 x (12,500 - 900)) 4,524,000

Add: Costs of new machines

i. Depreciation (1,300,000 – 100,000)/10 x 11/12 110,000
ii. Electricity (2,600-80-120 = 2,400 x 10 x Rs. 8.5) 204,000
iii. Cost of maintenance (Rs. 25,000 x 11) 275,000
iv. Part replacement (Rs. 10,000 x 11) 110,000
v. Operator Wages (Rs. 9,000 x 11) 99,000
vi. Departmental expenses (Rs. 5,000 x 11) 55,000
Total Cost 5,377,000
Productive Budgeted hours (12,500 + 2,600 - 900 - 120 - 80) 14,000
Adjusted machine hours rate 384.07

Q. Sparrow (Pvt) Limited (SPL) is engaged in the manufacture of two products A and B. These products are
manufactured on two machines M1 and M2 and are passed through two service departments, Inspection and
Packing, before being delivered to the warehouse for final distribution. SPL’s overhead expenses for the month of
August 2011 were as follows:

Rupees

Electricity 2,238,000
Rent 1,492,000
Operational expenses of machine M1 5,500,000
Operational expenses of machine M2 3,200,000
Following information relates to production of the two products during the month:

A B

Units produced 5,600 7,500

Labor time per unit – Inspection department 15 minutes 12 minutes
Labor time per unit – Packing department 12 minutes 10 minutes

331 Page 33 of 82
The area occupied by the two machines M1 and M2 and the two service departments is as follows:

Square feet
Machine M1 5,500
Machine M2 4,800
Inspection department 12,000
Packing department 15,000

Machine M1 has produced 50% units of product A and 65% units of product B whereas machine M2 has produced
50% units of product A and 35% units of product B.

Required: Allocate overhead expenses to both the products A and B.

A.

Allocation of costs to Basis Machine M1 Machine M2 Inspection Packing Total

cost centers

Area Occupied 5,500 4,800 12,000 15,000 37,300

Allocation of Area(Ass 330,000 288,000 720,000 900,000 2,238,000
Electricity umed)
or number
of units
produced

Allocation of rent Area 220,000 192,000 480,000 600,000 1,492,000

Operational cost 5,500,000 3,200,000 - - 8,700,000

(given)

6,050,000 3,680,000 1,200,000 1,500,000 12,430,000

ALLOCATION OF COST TO PRODUCTS
Basis of Cost Allocation A B TOTAL
Units produced 5,600 7,500
Inspection time (minutes) 84,000 90,000 174,000
(5,600 x 15 min) & (7,500 x 12 min)
Packing time (hrs.) 67,200 75,000 142,200
(5,600 x 12 min) & (7,500 x 10 min)
Units produced on Machine M1 2,800 4,875 7,675
(50% A and 65% B)

332 Page 34 of 82
 Units produced on Machine M2 2,800 2,625 5,425
(50% A and 35% B)
Cost Allocated
Machine M1 cost (2,800/7,675x6,050,000) 2,207,166 3,842,834 6,050,000
Machine M2 cost (2,800/5,425x3,680,000) 1,899,355 1,780,645 3,680,000
Inspection department cost 579,310 620,690 1,200,000
(84,000/174,000x1,200,000)
Packing department cost 708,861 791,139 1,500,000
(67,200/142,200x1,500,000)
5,394,692 7,035,308 12,430,000

Example: (Allocation and apportionment)

The AJFA & Co is preparing its production overhead budgets and therefore need to determine the apportionment
of these overheads to products. Cost center expenses and related information have been budgeted as below:
Production department Service departments
Total Machine Machine Assembly Canteen Maintenance
Shop A Shop B
Direct wages (Rs.) 518,920 128,480 99,640 290,800
Indirect wages (Rs.) 313,820 34,344 36,760 62,696 118,600 61,420
Consumable 67,600 25,600 34,800 4,800 2,400
materials (incl.
maintenance)
Rent & rates (Rs.) 66,800
Building insurance 9,600
(Rs.)
Heat & light (Rs.) 13,600
Power (Rs.) 34,400
Depreciation of 160,800
machine (Rs.)
Area (Sq ft) 90,000 20,000 24,000 30,000 12,000 4,000
Value of machines 1,608,000 760,000 716,000 88,000 12,000 32,000
(Rs.)
Power usage (%) 100 54 40 3 1 2
Direct labour hours 72,020 16,020 21,410 43,590
Machine usage 54,422 14,730 37,632 2,060
hours

Required: Allocation and apportionment sheet of AJFA & Co budgeted production overheads

333 Page 35 of 82
Answer:
Base Production department Service departments
Total Machine Machine Assembly Canteen Maintenance
Shop A Shop B
Indirect wages Allocated
313,820 34,344 36,760 62,696 118,600 61,420
Consumable
materials (incl. Allocated
maintenance) 67,600 25,600 34,800 4,800 2,400
Rent & Rates Area sqft 66,800 14,844 17,813 22,267 8,907 2,969
Building
insurance Area sqft 9,600 2,133 2,560 3,200 1,280 427
Heat & Light Area sqft 13,600 3,022 3,627 4,534 1,813 604
Power Power
usage % 34,400 18,576 13,760 1,032 344 688
Depreciation Value of
of machine machine 160,800 76,000 71,600 8,800 1,200 3,200
Allocated &
Apportion cost 666,620 174,519 180,920 107,329 134,544 69,308

Single Overhead Rate or Several Rates:

Overhead rates can be classified as:
a) Blanket rate or Plant-wide rate or composite rate,
b) Departmental rates or Cost centers or cost pool rates.

A plant-wide or blanket overhead rate or composite rate is used to describe a single overhead rate that is
established for the organization as a whole.

If a business produces single product using one or more production departments, a single overhead rate can be
used. However, if more than one products are produced using more than one departments, and each of them
consuming different amount of overheads in each department, then using a blanket rate would not allocate the
justified cost to products. Therefore, a separate rate is determined for each independent department and are
called departmental rates. Departments are also called cost centers. However, cost centers may be a small
segment within a department.

Example: (Blanket rate and departmental rates)

A company makes two products, Product X and Product Y. Each product is processed through two cost centers,
CC1 and CC2. The following budgeted data is available.
CC1 CC2
Allocated and apportioned overheads Rs. 126,000 Rs. 180,000
(All overheads are fixed costs.)
Direct labour hours per unit
Product X 1.5 2.0
Product Y 1.2 2.6

334 Page 36 of 82
The budgeted production is 12,000 units of Product X and 10,000 units of Product Y. Fixed overheads are absorbed
into costs on a direct labour hour basis.
a) Calculate the Blanket rate of factory overheads:
In blanket rate, the overhead costs and labour hours of both departments / cost centers shall be summed and
evenly distributed between both the products irrespective of their usage of the labour hours.
FOH rate = 306,000[126,000 + 180,000]/((1.5 + 2.0) × 12,000 + (1.2 + 2.6) × 10,000)
FOH rate = 306,000 / 80,000
Blanket rate of overhead = Rs. 3.825 per direct labour hour
b) Calculate Cost center (or departmental rates) rates:
In cost center rates, the total hours of each center shall be calculated first. The overhead cost of each department
shall be divided by the total hours of that department to arrive at the absorption rate for each department / cost
center. Thereafter, the overhead cost shall be charged to products on the basis of hours used by each unit of
products.
CC1 CC2
Total hours Total hours
Product X 12,000 × 1.5 18,000 12,000 × 2.0 24,000
Product Y 10,000 × 1.2 12,000 10,000 × 2.6 26,000
30,000 50,000

Total overheads Rs.126,000 Rs.180,000

Absorption rate per hour Rs.4.20 Rs.3.60

c) Calculate fixed overheads rate per unit:

If blanket rate of overheads is used.

Product X Product Y
Fixed overhead cost/unit
Rs. Rs.
Product X (1.5+2.0) x 3.825 13.39
Product Y (1.2+2.6) x 3.825 14.54

If separate rates are used for each department, then absorption of fixed overheads are:
Product X Product Y
Fixed overhead cost/unit
Rs. Rs.
CC1 1.5 × Rs.4.20 6.30 1.2 × Rs.4.20 5.04
CC2 2.0 × Rs.3.60 7.20 2.6 × Rs.3.60 9.36
Total 13.50 14.40

In some situations, it is possible to go a stage further and establish separate overhead rates for small segments
within a department (such as group of similar machines in a department). These small segments are called cost
centers. A department can be reciprocated as cost center. However, a cost center describes a location to which
overhead costs are initially assigned. The total cost accumulated in each cost center are then assigned to cost
objects using a separate allocation base for each cost center. Therefore, it can be a department but it can also be a
smaller segment.

335 Page 37 of 82
When a departmental overhead rate is determined for the entire department, it may result in inaccurate allocation
of overheads when a department consists of a number of different production centers with products passing
through the departments consume overheads of each production center in different proportions. Therefore,
determining overhead rates for each production centers / cost pools would help achieving the more accurate
results.

Example:
The Torrence manufacturing company has four production departments and three service departments:
Maintenance, Toolroom and Storeroom. The estimated annual production overheads for these seven departments
is given below:
Departments
Producing Service
01 02 03 04 Maintenance Tool-room Store-room
Estimated overheads Amount in Rupe es
Fixed production
overheads 360,000 480,000 450,000 300,000 150,000 105,000 120,000
Variable production
overheads 240,000 220,000 200,000 200,000 108,000 105,000 30,000
Total 600,000 700,000 650,000 500,000 258,000 210,000 150,000

The management distributed the fixed overheads of service departments as follows:

Allocation of fixed production overheads of
Total 01 02 03 04
service departments
Amount in Rupees
Maintenance 150,000 50,000 40,000 30,000 30,000
Toolroom 105,000 35,000 25,000 25,000 20,000
Storeroom 120,000 60,000 30,000 20,000 10,000

The variable production overheads of the service departments are distributed on the basis of charging rate based
on the following plant survey and other pertinent data:
Storeroom
Maintenance Toolroom
Departments (Number of Material
(Area in sqft) (Number of employees)
requisitions)
01 12,000 40 30,000
02 10,000 30 30,000
03 9,000 20 28,000
04 5,000 10 12,000
Maintenance 5,000
Tool-room 3,000
Storeroom 1,000

Maintenance department cost is apportioned to other service departments along with production departments
but costs of tool-room and storeroom is transferred to production departments only.

336 Page 38 of 82
Required:
Prepare a production overhead apportionment sheet
Answer: Production overhead apportionment sheet on the basis of above data and analysis, is given below.
Departments
Producing Service
01 02 03 04 Maintenance Tool-room Store-room
Estimated overheads Amount in Rupees
Fixed production
overheads 360,000 480,000 450,000 300,000 150,000 105,000 120,000
Maintenance 50,000 40,000 30,000 30,000 (150,000)
Tool-room 35,000 25,000 25,000 20,000 (105,000)
Storeroom 60,000 30,000 20,000 10,000 (120,000)
Apportioned fixed
production overheads
(A) 505,000 575,000 525,000 360,000
Variable production
overheads 240,000 220,000 200,000 200,000 108,000 105,000 30,000
Maintenance (sqft) *32,400 27,000 24,300 13,500 (108,000) 8,100 2,700
Tool-room (no. of 22,620
emp) **45,240 33,930 11,310 (113,100)
Storeroom (material
requisition) ***9,810 9,810 9,156 3,924 (32,700)
Apportioned variable
production overheads
(B) 327,450 290,740 256,076 228,734
Apportioned total
production overheads
(A+B) 832,450 865,740 781,076 588,734

Maintenance department variable overheads are allocated on the basis of area in sq. feet (excluding its own area)
e.g. 12,000 / 40 x 108,000 = 32,400
*[12/40(12+10+9+5+3+1) x 108][without considering the maintenance department area]
**40/100 x 113,100
***30,000/100,000[30+30+28+12] x 32,700

Example:
Hi-way Engineering Limited uses budgeted overhead rate for applying overhead to production orders on a direct
labour cost basis for department A and on a machine hour basis in department B.
The company made the following forecasts for August 2006:
Dept A Dept B
Budgeted factory overhead (Rs.) 216,000 225,000
Budgeted direct labour cost (Rs.) 192,000 52,500
Budgeted machine hours 500 10,000

337 Page 39 of 82
During the month, 50 units were produced in Job no. CNG-011. The job cost sheet for the month depicts the
following information:
Dept A Dept B
Material issued (Rs.) 1,500 2,250
Direct labour cost (Rs.) 1,800 1,250
Machine hours 60 150

Actual data for the month were as follows:

Dept A Dept B
Factory overhead (Rs.) 240,000 207,000
Direct labour cost (Rs.) 222,000 50,000
Machine hours 400 9,000

Required
a) Compute predetermined overhead rates for each department.
b) Compute total costs and unit cost of Job no. CNG-011.
c) Calculate the under / over applied overheads of each department

 Solution
a) Predetermined overhead rates for each department would be computed as follows:
Dep A Dep B
Budgeted factory overhead (Rs.) 216,000 225,000
Pre determined Overhead rate 216,000/192,000*100= 225,000/10,000=
1.125 per direct labour 22.5 per machine hours
Rupee

b) The total costs and unit cost of Job no. CNG-011, would be as follows
Dep A Dep B Total
cost
Material issued (Rs.) 1500 2250 3750
Direct labour cost (Rs.) 1800 1250 3050
Factory overheads (actual activity*predetermined 2025 3375 5625
overhead rate) (1,800 x (150 x
1.125) 22.5)
Total cost 5550 6875 12425
Number of units 50 50 50
Per unit cost (total cost/number of units) 111 137.5 248.5

338 Page 40 of 82
c) The over / under applied overhead for each department would be as follows:
Dep A Dep B
Actual factory overheads 240,000 207,000
Applied factory overheads (actual activity*predetermined overhead 249,750 202,500
rate) (222,000x (9,000x22.5)
1.125)
Over/ under applied factory overheads 9,750 4500

Material
Example:

Ore Limited (OL) is a manufacturer of sports bicycles. The company buys tyres from a local vendor.
Following data, relating to a pair of tyres, has been extracted from OL’s records:
Cost (per unit) Rs.
Storage cost based on average inventory 80
Insurance cost based on average inventory 60
Other relevant details are as follows:
i. The purchase price is Rs. 900 per pair.
ii. The annual demand for tyres is 200,000 pairs.
iii. The ordering cost per order is Rs. 8,000.
iv. The delivery cost per order is Rs. 3,000.
v. OL’s rate of return on investment in inventory is 15%.
vi. Recently the vendor has offered a quantity discount of 3% on orders of a minimum of 5,000 pairs.

Required:
Calculate the total cost of Inventory if quantity discount is to be obtained

Answer: Annual Ordering Cost, can be calculated as follows:

Annual Ordering Cost = Number of orders per annum x cost per order
Number of orders = Annual demand / order size = 200,000/5000 = 40 orders per annum
Cost per Order = Ordering Cost + Delivery Cost = Rs. 8,000 + Rs. 3,000 = 11,000
Therefore, the annual ordering cost = 40 x 11,000 = Rs. 440,000
Average Inventory = 5000 / 2 = 2,500 pairs
Annual Holding Cost = Holding Cost per unit per annum x Average Inventory
Holding cost per unit:
Storage cost based on average inventory = 80
Insurance cost based on average inventory = 60
Opportunity Cost = Rs. 900 x 97% x 15% = 130.95
Total (relevant) holding cost per unit = 270.95
Annual Holding Cost = 270.95 x 2,500 = 677,375
Lastly, Total Cost of Inventory would be
Total Cost of Inventory:
Purchase cost (net of discount) = 900 x 200,000 x 97% = 174,600,000
Annual Ordering Cost = (a) = 440,000
Annual Holding Cost = (c) = 677,375

339 Page 41 of 82
Total Cost of Inventory per annum = 175,717,375

Example:
W Co. is retailer of barrels. The company has an annual demand of 30,000 barrels. The barrel cost Rs. 12 each.
Fresh supplies can be obtained immediately, with ordering and transport costs amounting to Rs. 200 per order.
The annual cost of holding one barrel in stock is estimated to be Rs. 1.20 per year.
A 2% discount is available on orders of at least 5,000 barrels and 2.5% discount is available if the order quantity is
7,500 barrel or above.

Required:
a) Calculate EOQ.
b) Calculate the optimum order size considering the quantity discount
Ans. a)
Calculation of EOQs (Ignoring discounts)
Holding cost per barrel per year = Rs. 1.20
Cost per order = Rs. 200
Annual demand = 30,000 barrels
2  200  30,000 = 3,162 barrels
EOQ =
1.20

Calculation of annual inventory cost at Q= 3,162

Order size
Annual costs
3,162 barrels
Rs.
Purchases (30,000 x 12) 360,000
Ordering cost (30,000/3,162 x 200) 1,898
Holding cost (3,162/2 x 1.20) 1,897
Total Inventory Cost 363,795

Calculation of annual inventory cost at each discount level

Order size Order size
Annual costs 5,000 7,500
barrels barrels
Rs. Rs.
Purchases (30,000 x 12 x 98%) / (30,000 x 12 x 97.5%) 352,800 351,000
Ordering cost (30,000/5,000 x 200) / (30,000/7,500 x 200) 1,200 800
Holding costs (5,000/2 x 1.20) / (7,500/2 x 1.20) 3,000 4,500
Total Inventory cost 357,000 356,300

Conclusion:
The optimal order size should be 7,500 barrels as at this level, annual inventory cost is minimum.

Example:
Raveen Shah Enterprises produces Product Y and its monthly demand is 2,000 units. 2.5 kg of material K is required
to produce one unit of Product Y. Cost of placing an order is Rs. 150 and purchase price of Material K is Rs. 80 per

340 Page 42 of 82
Kg. Average holding cost is 8% of purchase price. Recently, vendor offers discount of 2% at minimum purchase
quantity of 5,000 kg and 3% at minimum purchase quantity of 10,000 kg.
Required:
a) Calculate EOQ.
b) Calculate the optimum order size considering the quantity discount

Ans. a)
In order to calculate EOQ following steps are used:
Calculation of EOQs (Ignoring discounts)
Holding cost per unit per year = Rs. 6.40 (80 x 8%)
Cost per order = Rs. 150
Annual demand = 60,000 kg (2,000 x 12 x 2.5)
2  150  60,000 = 1,677 kg
EOQ =
6.40
b) Calculation of annual inventory cost at Q= 1,677
Order size
Annual costs
1,677 Kg
Rs.
Purchases (60,000 x 80) 4,800,000
Ordering cost (60,000/1,677 x 150) 5,367
Holding cost (1,677/2 x 6.40) 5,366
Total Inventory Cost 4,810,733
Calculation of annual inventory cost at each discount level
Order size Order size
Annual costs
5,000 Kg 10,000 Kg
Rs. Rs.
Purchases (60,000 x 80 x 98%) / (60,000 x 80 x 97%) 4,704,000 4,656,000
Ordering cost (60,000/5,000 x 150) / (60,000/10,000 x 150) 1,800 900
Holding costs (5,000/2 x 80 x 98% x 8% ) / (10,000/2 x 80 x 97% 15,680 31,040
x 8%)
Total Inventory cost 4,721,480 4,687,940

Conclusion: The optimal order size should be 10,000 kg as at this level, annual inventory cost is minimum.
Example:
XY Enterprises produces product that requires two components X and Y and relevant data for each type of
components are given as below:
Description
Normal (Average) usage in kg for each component per week 500
Minimum usage in kg for each component per week 250
Maximum usage in kg for each component per week 750
Re order quantity X: 4,000 kg
Y: 6,000 kg
Re order period X: 4-6 weeks
Y: 2-3 weeks

341 Page 43 of 82
Required. Compute re order level, safety stock level and average stock level for each component of material.

Solution
In times of uncertainties, for each component of material, re order level, safety stock level and average stock level
is calculated as under:

Re-order level = Maximum usage per week x Maximum lead time per week
Component Kg
Component X (750 x 6) 4,500
Component Y (750 x 3) 2,250

Safety stock level = (Maximum usage x Maximum lead time) - (Average usage x Average lead time)
Component Kg
Component X [(750 x 6) - (500 x 5)] 2,000
Component Y [(750 x 3) - (500 x 2.5)] 1,000

Average stock level = EOQ/2 + Safety stock level

Component Kg
Component X (4,000/2) + 2,000 4,000
Component Y (6,000/2) + 1,000 4,000

Example:
QZ Ltd., deals in domestic appliances and supplies special toasters to various outlets in south zone of the country.
Special toaster is a popular product of QZ Ltd., which is distributed in large quantities throughout the year. The
company’s Chief Executive Officer, Mr. Kamal came to know the fact that company is holding excessive stocks
which causes increase in monthly cost.

Mr. Kamal is of the opinion that application of Economic Order Quantity (EOQ) model will help in reducing cost.
Being a Management Accountant, you are asked to guide Mr. Kamal regarding EOQ application.
Information regarding stocks for the month of January 2015 is given below:
Toasters demand from outlets (Units) 40,000
Carrying cost per lot (Rs. 0.20 per toaster) (Rs.) 200
Ordering cost (Rs.) 60

Special toasters are ordered from outlets in lot sizes of 1,000 units.

Required:
Calculation of optimal order quantity in lots and number of orders that should be placed by the company:

Ans Annual demand (40,000 x 12) = 480,000 units

Carrying cost per unit (0.20 x 12) = Rs. 2.40 per toaster
Order cost = Rs. 60 per order
Hence, EOQ shall be:
2 x 480,000 x 60
EOQ =
2.40

342 Page 44 of 82
EOQ = 4,899 units or 5 lots approx
Number of orders = 480* lots / 5 lots = 96 orders [*annual demand in lots 480,000/1,000 = 480]

Required:
Impact on EOQ and number of orders if carrying cost per month is reduced to Rs. 0.10:

Ans: Carrying cost per unit (0.10 x 12) = Rs. 1.20

Hence, EOQ shall be:

EOQ =
2 x 480,000 x 60
1.20
EOQ = 6,928 units or 7 lots (approx.)
Number of orders = 480 lots / 7 lots = 69 orders

The EOQ will increase to 7 lots per order and orders will reduce to 69 which means approx. 6 orders per month.

Required:
Impact on EOQ and number of orders if order cost is reduced to Rs. 20:

Ans: Order cost = Rs. 20 per order

Hence, EOQ shall be:

EOQ =
2 x 480,000 x 20
2.40
EOQ = 2,828 units or 3 lots
Number of orders = 480 lots / 3 lots = 160 orders

The EQO will decrease to 3 lots per order but orders will increase to 160 orders which means approx. 13 orders
per month, in case per order cost will reduce to Rs. 20.

Required:
Impact on EOQ and number of orders if order cost is reduced to Rs. 20 and carrying cost is declined to Rs. 0.10 per
month:

Ans: Carrying cost per unit (0.10 x 12) = Rs. 1.20

Order cost = Rs. 20 per order
Hence, EOQ shall be:

EOQ =
2 x 480,000 x 20
1.20
EOQ = 4,000 units or 4 lots
Number of orders = 480 lots / 4 lots = 120 orders

The EQO will decrease to 4 lots per order but orders will increase to 120 orders which means 10 orders per
month, in case per order cost will reduce to Rs. 20 and carrying cost per month will decline to Rs. 0.10.

343 Page 45 of 82
Example:
Two-way Engineering Limited has been experiencing stock-outs on one of its important product RD-11. Using the
EOQ formula, the company places orders of 1,250 units whenever the stock level reduces to 1,500 units. The
records of the company show the following data relating to the usage of Product RD-11 during lead times:
Usage (Units) 1,800 1,600 1,400 1,200 1,000
Usage Probability (%) 4% 6% 10% 20% 60%

The company sells RD-11 at a price of Rs. 500 per unit. The annual carrying cost of one unit is Rs. 30. The company
estimates that the cost of being out of stock is Rs. 125 for each unit.

Required:
The optimal safety stock above 1,500 units:
a) if 0 units
b) 100 units
c) 200 units
d) 300 units

Total of Stock out

Stock out Stock out Holding Cost
Safety Stock (Units) Probability and Holding cost
(Units) cost (Rs.) (Rs.)
(Rs.)
A B C D=B x 125 x C E=A x 30 D+E
0 300 4% 1,500 0
(1,800-1,500) 2,250
100 6% 750 0
(1,600-1,500)
100 200 4% 1,000 3,000 4,000
[1,800 - (100 x 30)
(1,500+100)]
200 100 4% 500 6,000 6,500
[1,800- (200 x 30)
(1,500+200)]
300 0 - 0 9,000 9,000
(1,800- (300 x 30)
1,500+300)
The optimal level of safety stock is zero units, as at this level, annual stock out and holding cost is minimum i.e. Rs.
2,250.

Labor:
Example:
Standard production of an employee in the Assembly department is 20 units per hour in an 8-hour day. The hourly
rate is Rs. 30.

The first day of week, employee produced 150 units and on second day of week, he produced 180 units. On both
days he worked for 8-hours.

344 Page 46 of 82
Required
Calculate the earnings of employee, effective rate per hour and labour cost per unit:
(a) if bonus of 50% of time saved is applied.
(b) If bonus of 100% of time saved is paid to employee.

Solution
(a) If bonus of 50% of time saved is applied, the earnings of employee, effective rate per hour and labour cost per
unit is computed as under:
Day Actual Standard Extra Bonus Basic Bonus Total
units units units hours pay
A A/ 20x --------------Rupees-----------
50%
1 150 160 - - 240 - 240
20x8 (8 x 30)
2 180 160 20 0.50 240 15 255
20x8 (8 x 30) (1x30x50%)

Calculation of effective rate and cost per unit on each day Rs.
Day-1
Effective earnings by employee per hour (240/ 8) 30.00
Cost per unit(240 / 150) 1.60
Day-2
Effective earnings by employee per hour (255/ 8) 31.88
Cost per unit (255 / 180) 1.42

(b) If bonus of 100% of time saved is paid to employee; the earnings of employee, effective rate per hour and
labour cost per unit is computed as under.
Day Actual Standard Extra Bonus Basic Bonus Total
units units units hours pay
A A/ 20 --------------Rupees-----------
1 150 160 - - 240 - 240
(8 x 30)
2 180 160 20 1 240 30 270
(8 x 30) (1x30x100)

Calculation of effective rate and cost per unit on each day Rs.
Day-1
Effective earnings by employee per hour (240/ 8) 30.00
Cost per unit (240 / 150) 1.60
Day-2
Effective earnings by employee per hour (270/ 8) 33.75
Cost per unit (270 / 180) 1.50

345 Page 47 of 82
Importance of Learning curve effect:
Learning curve theory helps users to predict how much time is required to complete the future tasks. It is helpful in
determination of realistic cost of labour and is also useful in planning, control and decision-making. In pricing
decisions, it is extremely important to know the average time incorporating the learning effect, otherwise, cost will
be higher if it is based on first unit which requires maximum time. In planning and control, learning curve is also
important because in standard costing, cost of one unit is calculated. If the learning effect is ignored, then standard
cost will be overstated, resulting unrealistic variances at period end.
Example:
a) The following information relates to a week’s work for three employees:
Employee A Employee B Employee C
Output (units) 160 276 68
Time allowed (hours per unit) 0.5 0.25 0.75
Basic hourly wage rate (Rupees) 80 100 70
Hours worked as direct labour 48 54 30
Hours worked as indirect labour - - 12
(outside production department)

The normal working week is 42 hours. For the first six hours, overtime is paid at 50% above the normal rate. Any
further overtime is paid at equal the normal rate.In addition bonus is also paid at three-fifth of the normal rate for
the hours saved.

Required: Calculate total wages of each employee.

Solution
Total wages of each employee is calculated below:
Particulars Employee A Employee B Employee C
Hours worked 48 54 42(30+12)
Normal hours per week 42 42 42
Overtime hours 6 12 -

Normal wages (48×80), (54×100), 3,840 5,400 2,940

[42(30+12)×70]
First six overtime hours 240 300 -
(6×80×50%), (6×100×50%)
Overtime hours > (Greater than) 6 - 600 -
hours (6×100)
Total wages in Rs. (A) 4,080 6,300 2,940
Bonus amount
Hours allowed (160×0.5), 80 69 51
(276×0.25), (68×0.75)
Direct hours worked 48 54 30
Bonus hours earned/Time saved 32 15 21
Bonus in Rs. (B) 1,536 900 882
32 x 80 x 3/5 15 x 100 x 3/5 21 x 70 x 3/5

Total wages in Rs. (A + B) 5,616 7,200 3,822

346 Page 48 of 82
ICAP Past Papers (Labor)
Question
Magnesium Ltd (ML) produces and markets a single product. The management is concerned about the increasing
rate of labour turnover in their factory and wants to assess the losses suffered by ML due to high labour turnover.
Following information is available from ML’s records for the year ended 31.12.2011:
Sales price per unit Rs. 200
Direct material per unit 0.5 kg at Rs. 96 per kg
Direct labour hours paid 480,000 hours
Labour rate per hour Rs. 55
Actual hours per unit of product 1.5 hours
Variable overhead rate per labour hour Rs. 20
Fixed overheads Rs. 6,000,000

The direct labour hours include 9,000 hours spent on training and replacement, only 50% of which were
productive. Moreover, 12,000 hours of potential work could not be availed because of delayed replacement. The
cost incurred on appointments amounted to Rs. 200,000. ML has no beginning or ending inventory.

Required:
Prepare a comparative statement showing net profit for the year and profit foregone as a result of labour
turnover; assuming the potential production loss could have been sold in the market at prevailing prices.
(Marks 15)
Answer
Comparative statement showing (i) actual profit; and (ii) potential profit without labour turnover.
Actual Potential
Productive hours: [480,000 – (9,000 × 50%)] & [480,000 + 12,000] 475,500 492,000
Unproductive hours [9,000 × 50%] 4,500 -
Hours paid for 480,000 492,000
Production of units[475,500/1.5]&[492,000/1.5] 317,000 328,000
Direct material [317,000x0.5x96]&[328,000x0.5x96] 15,216,000 15,744,000
Direct labour [480,000x55]&[492,000x55] 26,400,000 27,060,000
Variable overheads [480,000x20]&[492,000x20] 9,600,000 9,840,000
Fixed overheads 6,000,000 6,000,000
Cost incurred on appointments 200,000 -
Total cost 57,416,000 58,644,000
Sale value [317,000x200]&[328,000x200] 63,400,000 65,600,000
Net profit 5,984,000 6,956,000
Loss of profit due to labour turnover is Rs. 972,000 [6,956,000 – 5,984,000]

Question
Mr. Lark works as a machinist on a machine running 54 hours a week. Following information pertains to his last
week’s work on the machine:
Total hours worked 51 hours
Overtime (included in total hours worked) 4 hours
Idle time due to machine break down (to be classified in indirect labour) 3 hours
Basic hourly wage rate Rs. 25

347 Page 49 of 82
The overtime is paid at basic rate plus 45%.

Required:
Calculate the total wages paid to Mr. Lark allocating it between direct and indirect labour. Also give reasons for
such allocation. (5 Marks)

Answer
Allocation of wages between direct and indirect labour:
Direct Indirect Total
Basic wages 51 hours × Rs. 25 1,275 - 1,275
Overtime premium 4 × Rs. 25 × 45% 45 - 45
Idle time wages 3 × Rs. 25 - 75 75
1,320 75 1,395

Reasons for allocation:

(a) Basic wage and overtime paid is charged to production and therefore it is a direct labour
cost
(b) Idle time wage is unproductive and therefore it should be charged to indirect labour.

Question[link with Toy limited]

Zircon Ltd (ZL) manufactures and supplies footballs for both domestic and international markets.
Following information is available from the company’s records:
Number of skilled workers 250
Standard working hours per month 200
Actual hours per unit of product 1.5
Standard labour rate per hour (Rs.) 42
Variable overhead rate per labour hour (Rs.) 75

The company manufactures 40,000 footballs per month. Overtime is paid to the workers @ 75% over and above
the standard wage rate.

In order to increase the production efficiency and reduce the cost of conversion, the management is currently
evaluating various wage incentive plans. The production manager has suggested the following options to the
management.

Option 1: Introduce a piece wage system at the rate of Rs. 72 per unit. It is expected to improve the current
production efficiency from 65% to 78%.

Option 2: Introduce a bonus plan with a guaranteed wage of Rs. 48 per hour based on a standard 1.4 hours per
unit of product. This plan is expected to reduce the overtime by 60%.

Required:
Evaluate the above options in contrast with the existing scheme and advise the management about the most
economical option. (Marks 15)

348 Page 50 of 82
Answer
Existing Situation
Rs.
Basic rate per hour 42
Overtime rate per hour (42 × 1.75) 73.5
Production (units) 40,000
Actual hours required (40,000 × 1.5) 60,000
Standard hours available (200 × 250) 50,000
Overtime hours 10,000
Rs. ‘000’
Basic wages (50,000 × 42) 2,100
Overtime (10,000 × 73.5) 735
Variable overheads (60,000 × 75) 4,500
Total Cost 7,335
Option 1:
Rs. ‘000’
Basic wages (40,000 Given × 72) 2,880
Variable Overheads (50,000 W-1 × 75) 3,750
Total Cost 6,630
Option 2:
Production (units) 40,000
Actual hours under existing option (40,000 × 1.5) 60,000
Less: Estimated reduction in overtime (10,000 from existing situaton x 60%) 6,000
Estimated actual hours under option 2 54,000

Rs. ‘000’
Basic wages (40,000 x 1.4 = 56,000 × 48) 2,688
Overtime premium (4,000 × 48 × 75%) 144
Variable Overheads (54,000 × 75) 4,050
Total Cost 6,882

Result: Option 1 is the most economical option for ZL with the total cost of Rs. 6.63 million.

Existing situation:
Actual hrs 60,000 Required hrs 39,000
100 65

Revised situation:
Actual hrs 50,000 Required hrs 39,000
100 78

349 Page 51 of 82
Question
Pakair Ltd manufactures special tools. Information pertaining to payroll costs for the month of April 2010 is as
under:
Gross salaries excluding
Overtime Income tax deductions
overtime
Department Rs. In Thousands
Machining 1,000 75 25
Assembly 400 40 15
Tool room 25 5 -
Warehouse 75 15 -
Details of other benefits are as under:
(i) 35 paid leaves are allowed per year including annual, casual and sick leaves. (Assume 360 days)
(ii) Annual bonus equal to one month salary is paid in June.
(iii) The company maintains a contributory Provident Fund in which 8.33% of the monthly salary is
contributed by the employer as well as the employees.
(iv) During April 2010, the employees availed leaves that cost Rs. 85,000.
(v) Advances against salary paid and recovered during the month amounted to Rs. 17,000 and Rs. 28,000
respectively.
(vi) Accrued payroll, provident fund payable and income tax payable are paid at the end of April 2010

The company follows a policy of accruing bonus and paid leaves on a monthly basis

Required:
Prepare journal entries to record payroll and its disbursements for the month of April 2010.

Note: Machinery and Assembly are production departments; while tool room and warehouse are service
departments.

Answer

Pakair Ltd.
Journal entries
Particulars Debit Credit
Payroll expense 1,635,000
Income tax payable (W-2) 40,000
Advance against salary 28,000
Provident fund payable (employee contribution) (W-2) 125,000
Accrued payroll 1,442,000
Payroll expense 125,000
Provident fund payable 125,000
(Employer Contribution)
Payroll expense 125,000
Bonus Payable 125,000
Payroll expense 145,833
Vacation pay 145,833

350 Page 52 of 82
Vacation payable 85,000
Bank 85,000
(To record leaves availed by employees)
Advance against salary 17,000
Bank 17,000
(To record advances paid to employees)
Accrued payroll (1,470 – 28) 1,442,000
Contribution to P.F. payable[125x2] 250,000
Employees income tax payable 40,000
Bank 1,732,000
(Payment of the accrued payroll, contribution to P.F. and employees’ income tax)

Distribution of Payroll:
WIP (1,338,888 + 545,555) 1,884,443
F-OH (36,596 + 109,792) 146,388
Payroll 2,030,831

Workings:
(W-1)
Machining Assembly Tool room Stores
Total
WIP Overheads
Gross salaries 1,000,000 400,000 25,000 75,000 1,500,000
Overtime 75,000 40,000 5,000 15,000 135,000
Total salary 1,075,000 440,000 30,000 90,000 1,635,000
Employer’s contribution to PF 83,333 33,333 2,083 6,250 125,000
(1,000.000 x 8.33%)
Bonus (1,000/12) 83,333 33,333 2,083 6,250 125,000
Vacation pay 97,222 38,889 2,430 7,292 145,833
[1,000/30 × 35 ÷ 12]
263,888 105,555 6,596 19,792 395,833
1,338,888 545,555 36,596 109,792 2,030,833

(W-2)
Deductions from employees:
Employee’s income tax 25,000 15,000 - - 40,000
Employee’s contribution to PF 83,333 33,333 2,083 6,250 125,000
108,333 48,333 2,083 6,250 165,000
1,230,,555 497,222 34,513 103,542 1,865,833

351 Page 53 of 82
Question
Unity Electronics Limited manufactures and supplies condenser fans used in the production of Refrigerators to
Sigma Corporation. Following information is available from the company’s records.
Number of employees 180
Standard working hours (9 hours / day) 54
Standard hours per unit (at 100% efficiency) 3
Standard labour rate per hour (rupees) 30

Due to the rise in demand for Refrigerators, Sigma Corporation has increased the size of its order. However, the
management is concerned about the productivity of its labour force. An analysis of the employees performance
report has revealed that the company is suffering on account of the following:
• A tendency to waste time as a result of which approximately 9 working hours are lost per week per
employee.
• A tendency to work inefficiently, as a result of which the production efficiency is only 74%.

In order to meet the increased demand, the management is considering an increase in wages by Rs. 5 per hour.
The increase is likely to motivate the employees and reduce the wastage of time by 5 hours and will also improve
the production efficiency to 88%.

Required:
Advise on the weekly basis working whether Unity Electronic Limited should revise the wages. Show all necessary
supporting calculations. (09 Marks)

Answer No. 5
Existing:
54 × 30 = 1,620 ÷ 11.1* = 146/unit
*54 – 9 = 45 / 100 × 74 = 33.3 ÷ 3 = 11.1 units

Revised:
54 × 35 = 1,890 ÷ 14.67* = 129/unit
* 54 – 4 = 50 / 100 × 88 = 44 ÷ 3 = 14.67 units

Workings:
If 100% efficiency:
Actual hrs 3 Required hrs 3
100 100

If 74% efficiency:
Actual hrs 4.054 Required hrs 3
100 74
45/4.054 = 11.11 units

352 Page 54 of 82
If 88% efficiency:
Actual hrs 3.409 Required hrs 3
100 88
50/3.409 = 14.67 units

Conclusion:
The wage plan should be revised as it results into decrease in per unit cost.

Question
Ishaq Limited manufactures plastic bottles for pharmaceutical companies. It has recently introduced a 100%
weekly group bonus plan with a guaranteed wage of Rs. 150 per hour. Standard production per hour is 50 bottles.
Each worker is supposed to work 8 hours a day from Monday to Friday and 5 hours on Saturday. Presently, there
are 20 workers who are entitled for this plan. Production for the first week under the 100% bonus plan was:
Days Monday Tuesday Wednesday Thursday Friday Saturday
No. of bottles 8,700 7,350 9,750 7,500 8,950 4,550

Most of the workers have raised objection on the company’s bonus plan. They are of the view that bonus
calculation should be based on daily production instead of weekly production. The management of the company
has asked you to determine the impact of such a change.

Required:
Prepare statements showing labour cost per unit under each of the two options. Give reasons for the differences,
if any. 10 Marks)

Answer
(c) I WEEKLY BONUS PLAN
Option 1:
Guaranteed Wages Rs. 150 per hour
Bonus 100%
No. of hours 8 / day (Monday – Friday)
5 hrs = (Saturday)

Total Hrs / week For each employee (8 × 5 + 5) 45 hrs

Std.bottles to produce by each employee (45 × 50) 2,250
Bottles
For 20 Employees (2,250 × 20) 45,000
For the week in hand bottles produced (8,700 + 7,350 + 9,750 + 7,500 + 8,950 + 4,550) 46,800
Excess produced 1,800
No. of hrs required that are saved (1,800 / 50) 36 hrs
Thus Bonus will be (36 × 150) 5,400
Total Labour Cost for the week
Normal Wages (45 × 20 × 150) 135,000
Bonus for the week 5,400
+ 140,400
Per unit Cost (140,400/46,800) 3.00

353 Page 55 of 82
(d) II BONUS BASED ON DAILY PRODUCTION
Option 2
Hours
No of Bottles No. of Bottles to be Excess / Required
Days Bonus
produced Produced (Shortage) that will be
saved
A B C D E
(A-B) (C/50) (Dx150)
Mon 8,700 (8×50×20) = 8,000 700 14 2,100
Tue 7,350 (8×50×20) = 8,000 (650) (13) -
Wed 9,750 (8×50×20) = 8,000 1,750 35 5,250
Thus 7,500 (8×50×20) = 8,000 (500) (10) -
Fri 8,950 (8×50×20) = 8,000 950 19 2,850
Sat 4,550 (8×50×20) = 5,000 (450) (9) -
46,800 45,000 1,800 36 10,200
Total Labour Cost
Normal Wages (45 × 20 × 150) 135,000
Bonus for the week 10,200
145,200
Per unit Cost (145,200/46,800) 3.10

REASONS FOR DIFFERENCE IN THE BONUS

The reason for difference in the two bonuses is the fact that when we measure efficiency on a daily basis, worker is
not penalized for his inefficiency because of minimum wage. However, when computed on aggregate basis
inefficiency of a day is offset against efficiency of another day.

Question
A factory manufactures three components A, B and C.

During a week, the following was recorded:

Labour Grade Number of Employees Rate per hour (Rs.) Individual hours worked
I 6 40 40
II 18 32 42
III 4 28 40
IV 1 16 44

Actual output and standard times are given below:

Component Output of components Standard minutes per component
A 444 30
B 900 54
C 480 66

354 Page 56 of 82
The normal working week is of 38 hours. Overtime is paid at a premium of 50% of the normal hourly rate. A group
incentive scheme is in operation and a bonus is paid based on the time saved. The rate of bonus payment is 75% of
normal hourly rate. The time saved is allocated to each labour grade in proportion to the number of hours worked
by each group.

Required:
Calculate the total payroll showing the basic pay, overtime premium and bonus pay for each grade of labour. (12 Marks)

Answer
Tota
Norm
Labo Rat l Allocati
No. of al Hours
ur e/ Tim on of Basic Over Time
Employ worki Work Incentive Total
Grad Hou e Time Pay Premium
ees ng ed
e r Take Saved
Hours
n
(a) (b) (c) (d) (e) (f) (g) (h) (i)
(axd (exb) (d-c) (bxfx75%) (g+h+l)
) xaxbx50%
I 6 40 38 40 240 72* 9,600 240 2,160 12,000
240x (40- 72x40x75 9600+240+21
40 38)x6x40x5 % 60
0%
II 18 32 38 42 756 227 24,19 1,152 5,448 30,792
2 (42- 227x32x7 24192+1152+
38)x18x32x 5% 5448
50%
III 4 28 38 40 160 48 4,480 112 1,008 5,600
IV 1 16 38 44 44 13 704 48 156 908
120 360 W- 38,97 1,552 8,772 49,366
0 1 6
*240 / 1,200 x 360 =72

Workings:
W-1 Incentive
Total time allowed
Stnd. Minutes Total minute
Group Output in Units
per Unit Allowed
A 444 30 13,320
B 900 54 48,600
C 480 66 31,680
93,600
Minutes per hour 60
Not of Hours Allowed (93,600 / 60) 1,560
Total time taken (“e” above) 1,200
Time saved 360

355 Page 57 of 82
Joint and By product with Process costing:
Example:
The Star Company manufactures three joint products from a single raw material. A summary of production costs
shows:
Products
S K A Total
Output in kilograms 80,000 200,000 160,000 440,000
Selling price per kilogram Rs. 0.75 1.00 1.50

Products
S K A Joint cost Total
Production costs:
Materials - - - 90,000 90,000
Direct labour Rs. 3,000 20,000 30,000 27,000 80,000
Variable production overheads Rs. 2,000 10,000 16,000 17,000 45,000
Fixed productin overheads Rs. 15,000 34,000 30,000 36,000 115,000

All separable costs have been assigned to products but the joint cost has not been allocated. All of the year’s
output was sold.

Required: Gross profit for each product, after allocating the joint cost by sales value method, is calculated as
under.

Answer:
Products
S K A Total
-------------------Rupees------------------
Sales 60,000 200,000 240,000 500,000
(80,000x0.75/200,000x1/160,000x1.50)
Less: Cost of sales:
Direct labour (3,000) (20,000) (30,000) (53,000)
Variable production overheads (2,000) (10,000) (16,000) (28,000)
Fixed production overheads (15,000) (34,000) (30,000) (79,000)
Joint cost allocated W-1 (20,400) (68,000) (81,600) (170,000)
(40,400) (132,000) (157,600) (330,000)
Gross profit 19,600 68,000 82,400 170 000

356 Page 58 of 82
 W-1 Allocation of Joint cost
Products Units Unit sales Total Sales Joint cost
Produced price Rs. value Rs. allocated
Rs. W-2
S 80,000 0.75 60,000 20,400
K 200,000 1.00 200,000 68,000
A 160,000 1.50 240,000 81,600
500,000 170,000

W-2 Calculation of Joint Cost

Description Rupees
Materials 90,000
Direct labour (80,000 – 3,000- 20,000 – 30,000) 27,000
Variable production overheads (45,000- 2,000- 10,000- 16,000) 17,000
Fixed production overheads (115,000- 15,000- 34,000- 30,000) 36,000
Total joint cost to be allocated 170,000

Example:
PQR Limited produces two joint products – P and Q- together with a by-product R, from a single main process
(process 1). Product P is sold at the point of separation for Rs. 5 per kg, whereas product Q is sold for Rs. 7 per kg
after further processing into product Q2 in process 2. By-product R is sold without further processing for Rs. 1.75
per kg.

Process 1 is closely monitored by a team of chemists, who planned the output per 1,000kg of input materials to be
as follows:
Products Kg
P (50%) 500
Q (35%) 350
R (10%) 100
Toxic waste (5%) 50

The toxic waste is disposed of at a cost of Rs. 1.50 per kg, and arises at the end of processing.

Process 2, which is used for further processing of product Q into Q2, has the coversion cost of rs. 10,350

357 Page 59 of 82
The following actual data relate to the first week of accounting period
Process 1 Rs.
Opening work in process Nil
Materials 10,000 kg input 15,000
Direct labour 10,000
Variable production overhead 4,000
Fixed production overhead 6,000
Output: Kg
Product P 4,800
Product Q 3,600
Product R 1,000
Toxic waste 600
Closing work in process Nil
Process 2 Kg
Opening work in process Nil
Input of product Q 3,600
Output of product Q2 3,300
Closing work in process (50% coverted) 300

Conversion costs were incurred evenly throughout the process.

Required: Prepare process 1 account

Ans:
Process 1 Account
Kg Rs. Kg Rs.
Materials 10,000 15,000 Normal loss 500 (750)
Abnormal loss
Direct labour 10,000 W-1 100 400
Product R
Variable overheads 4,000 (1,000 x 1.75) 1,000 1,750
Fixed overheads 6,000 Product P W-4 4,800 21,000
Product Q W-4 3,600 12,600
10,000 35,000 10,000 35,000

W-1 Abnormal loss in units and Rs.

Kg
Input 10,000
Product P (4,800)
Product Q (3,600)
Product R (1,000)
Normal loss (50/1,000 x 10,000) (500)
Abnormal loss in units 100
x Unit cost W-2 4.00
Cost assigned to abnormal loss 400

358 Page 60 of 82
 W-2 Unit cost [35,000+750-1,750]/[4,800+3,600+100]=4
100 x 4 = 400

W-3 Joint cost to be allocated

Rs.
Total input cost plus disposal cost W-1 34,000
Cost assigned to abnormal loss W-2 (400)
33,600

W-4 Allocation of Joint cost

Product Prod. Final Ultimate Further NRV Joint cost
Units Sales sale cost allocated
price price Rs. W-2
Rs.
P 4,800 5.00 24,000 - 24,000 21,000
Q 3,600 7.00 25,200 10,800 14,400 12,600
(3,600 x 3)
49,200 38,400 33,600

W-5 Further processing cost of Product Q per unit

Total further processing cost (A) 10,350
Equivalent units: Units
Units completed and transferred 3,300
Units in process (300 x 50%) 150
Equivalent Unit (B) 3,450
Unit cost of further processing (A/B) 3.00

Example:
Production at Platinum Chemicals (PC) involves two processes I and II. Following information pertains to the month
of August 2017:
i. Actual cost:
Process I Process II
--------- Rupees ---------
Direct material (12,000 liters) 5,748,000 -
Conversion 2,610,000 1,542,000

ii. Production and sales

Process I Process II
Description Remarks
------ Liters ------
Products:
Joint product – J101 5,000 - Sold for Rs. 1,200 per liter after
incurring packing cost of Rs. 120 per
liter
Joint product – J202 4,500 - Transferred to process II for
conversion into a new product J-plus

359 Page 61 of 82
 By-product – BP01 1,000 - Sold at the split-off point for Rs. 500
per liter
J-plus - 3,400 Sold for Rs. 1,400 per liter
Work-in-process:
Opening - -
Closing - 650 70% complete as to conversion

iii. Materials are introduced at the beginning of process I and PC uses 'weighted average method' for inventory
valuation.
iv. Proceeds from sale of by-product are treated as reduction in joint costs. Joint costs are allocated on the basis
of net realizable values of the joint products at split-off point.
v. Normal production losses in both processes are estimated at 10% of the input and are incurred at beginning of
the process. Loss of each liter in process I results in a solid waste of 0.8 kg which is sold for Rs. 100 per kg. Loss
of process II has no sale value.

Required:
1. Calculate the cost of sales of J101 and J-plus for the month of August 2017
2. Pass accounting entries to record production gains/losses and their ultimate disposal

Ans. (a)
Cost of sales for the month of August 2017

J 101 [5,000 units] J Plus [3,400 units]

Total manufacturing cost 4,345 (W-3) 4,094 (W-4)
Packing cost (5,000 x 120) 600 -
Cost of Sales 4,945 4,094

Workings:

W-1

J1 5,000 l Packing 5,000 x 120 = 600

P-I
J202 4,500 l P II 3,400 l
12,000 l
By product 1000 l
Normal loss 1,200 l (10%) 450 l (10%)

650 l (70%
5,748 + 2,610 Abnormal loss 300 l
complete)

360 Page 62 of 82
 W-2
Process-I Rs. ‘000’
Units Amount Units Amount
b/d - - Finished goods [J101] 5,000 4,345
Direct material 12,000 5,748 P-II [J202] 4,500 3,258
Conversion 2,610 By product 1,000 500
(1,00 x500)
N. loss 1,200 96
(1,200x0.8x100)
Abnormal loss Bal. 300 159
12,000 8,358 12,000 8,358

Equivalent units:
Material Conversion
Finished goods [J101] 5,000 5,000 5,000
P –II [J202] 4,500 4,500 4,500
Abnormal loss 300 300 -
9,800 9,500

Cost/unit:
Material: 5,748 – 500 – 96 / 9,800 = 0.53
Conversion: 2,610/ 9,500 = 0.27
0.80
Cost Allocation:
Abnormal Loss = 300 x 0.53 = 159
Remaining cost is to be allocated between J101 and J202 based on NRV i.e
=5,748 + 2,610 – 96 – 500 – 159
= 7,603

W-3) Allocation of Joint cost NRV basis :

Rs. ‘000’
Ultimate Sales Allocation
Ultimate
Units produced Sale price / Further processing cost value at
Sales Value
unit split off
J 101 5,000 1,200 6,000 600 5,400 4,345
(120 x 5,000)
J plus 4,050 1,400 5,670 1,620 4,050 3,258
(3,400 (4,050 x 400 W-4)
+650)
9,450 7,603

361 Page 63 of 82
W-4
Process-II Rs. ‘000’
Units Amount Units Amount
b/d - - Finished goods [J plus] 3,400 4,094
Process I (W-3) 4,500 3,258 Normal loss (10%) 450 -
Conversion - 1,542 c/d 650 705
4,500 4,800 4,500 4,800

Cost/unit:
Process I : 3,258 (W-3) / (3,400 + 650) = 804
Conversion: 1,542 / (3,400 +650 x 70% ) = 400
1,204
Cost Allocation:
J Plus = 3,400 x 1,204 = 4,094
Closing WIP = 650 x 804 +650 x70% x 400 = 705

b) Accounting Entries:
i. Normal loss 96
Process I 96

ii. Cash 96
Normal loss 96

iii. Abnormal loss 159

Process I 159
iv. Cash 24
Abnormal loss 24 [300x0.8x100]
v. P&L 133
Abnormal loss 133

Marginal abd absorption costing

Example:
JSS Enterprises produces and sells a single product. Following budgeted information is related to this product for
first 3-months of business:
May June July
Units produced 6,000 5,000 7,000
Budgeted production 6,000 6,000 6,000
Units sold 5,500 5,300 7,000

362 Page 64 of 82
Data relating to cost and sales is given below.
Rs.
Direct material per unit 18
Direct labor per unit 11
Variable production overhead per unit 6
Fixed production overhead total per month 30,000
Variable selling & administration cost 20% of sales
Fixed production & administration cost 25,000
Selling price per unit 60

Required:
Prepare income statement under marginal costing principle from May to July

Ans:
Marginal costing income statement for 3-Months May June July
Rupees Rupees Rupees
Sales (5,500 x 60)/(5,300 x 60)/(7,000 x 60) 330,000 318,000 420,000
Variable cost of sales:
Opening inventory - 17,500 7,000
Variable production costs:
Direct materials (6,000 x 18)/(5,000x18)/(7,000x18) 108,000 90,000 126,000
Direct labour (6,000 x 11)/(5,000x11)/(7,000x11) 66,000 55,000 77,000
Variable POH (6,000 x 6)/(5,000x6)/(7,000x6) 36,000 30,000 42,000
210,000 175,000 245,000
Less: Closing inventory W-1 (17,500) (7,000) (7,000)
(192,500) (185,500) (245,000)
Gross contribution 137,500 132,500 175,000
Variable selling and distribution costs (20% of sales) (66,000) (63,600) (84,000)
Net Contribution margin 71,500 68,900 91,000
Fixed costs:
Production fixed costs (30,000) (30,000) (30,000)
Selling and administration costs (25,000) (25,000) (25,000)
(55,000) (55,000) (55,000)
Profit 16,500 13,900 36,000

Example:
Entity RH makes and sells one product. Currently, it uses absorption costing to measure profits and inventory
values. The budgeted production cost per unit is as follows:
Rs.
Direct labour 3 hours at Rs.6 per hour 18
Direct materials 4 kilograms at Rs.7 per kilo 28
Production overhead (Fixed cost) 20
66

363 Page 65 of 82
Normal output volume is 16,000 units per year and this volume is used to establish the fixed overhead absorption
rate for each year.
Costs relating to sales, distribution and administration are:
Variable 20% of sales value
Fixed Rs.180,000 per year.

There were no units of finished goods inventory at 1 October Year 5.

The fixed overhead expenditure is spread evenly throughout the year.

The selling price per unit is Rs.140.

For the two six-monthly periods detailed below, the number of units to be produced and sold are as follows:
Six months ending Six months ending
31 March 2016 30 September 2016
Production 8,500 units 7,000 units
Sales 7,000 units 8,000 units

The entity is considering whether to abandon absorption costing and use marginal costing instead for profit
reporting and inventory valuation.

Required: Calculate the budgeted fixed production overhead costs.

Ans:
Budgeted production overhead expenditure =
Normal production volume × Absorption rate per unit
= 16,000 units × Rs.20 = Rs.320,000.

Since expenditure occurs evenly throughout the year, the budgeted production overhead expenditure is
Rs.160,000 in each six-month period.

Required:
Prepare statements for management showing sales, costs and profits for each of the six-monthly periods using
marginal and absorption costing.
i. marginal costing
ii. absorption costing

A(i) Marginal Costing:

Six Months to Six Months to
31st March 30th September
Sales (7,000 × 140)/(8,000 × 140) 980,000 1,120,000
Less: Variable Cost of Sales:
Opening Stock - 69,000
Variable Production Cost (8,500×46)/(7,000×46) 391,000 322,000
Closing Stock (1,500 × 46)/(5,000 × 46) (69,000) (23,000)

364 Page 66 of 82
 322,000 368,000
Gross Contribution 658,000 752,000
Variable Selling Cost(980,000×20%)/(1,120,000×20%) (196,000) (224,000)
Net Contribution 462,000 528,000
Fixed Cost:
Production (160,000) (160,000)
Other Selling & Admin (90,000) (90,000)
Profit 212,000 278,000

(ii) Absorption Costing:

Six Months to Six Months to
31st March 30th
September.
Sales 980,000 1,120,000
Less: Cost of Sales
Opening Stock - 99,000
Production Cost (8,500×66)/(7,000×66) 561,000 462,000
Closing Stock (1,500 × 66)/(500 × 66) (99,000) (33,000)
(462,000) (528,000)
Gross Profit 518,000 592,000
Under/Over applied (500×20)/(1,000×20) 10,000 (20,000)
Adjusted Gross Profit 528,000 572,000
Variable – Selling & Admin (196,000) (224,000)
Fixed – Selling & Admin (90,000) (90,000)
Profit 242,000 258,000
Reconciliation
31st March 30th
September.
Profit as per M.C 212,000 278,000
Closing Stock M.C (69,000) (23,000)
Opening Stock M.C -- 69,000
Closing Stock A.C 99,000 33,000
Opening Stock A.C -- (99,000)
242,000 258,000

365 Page 67 of 82
 Example:
Ali Limited makes and sells one product, the standard production cost of which is as follows for one unit:
Rupees
Direct labour (3 hours @ Rs. 6 each) 18
Direct material (4 Kilogram @ Rs. 7 per kg) 28
Variable production overheads 3
Fixed production overheads 20
Standard product cost per unit 69

Normal output is 16,000 units per annum and this figure is used for the fixed production overhead calculation.

Costs relating to selling, distribution and administration are:

Rupees
Variable 20% of sales price
Fixed per annum 180,000

The only variance is a fixed production overhead volume variance. There are no units in finished goods stock at 1
October 2020. The fixed overhead expenditure is spread evenly throughout the year. The selling price per unit is
Rs. 140.

For each of the six monthly periods, the number of units to be produced and sold are budgeted as:
Six months ending Six months ending 30
31 March 2021 September 2021
Production (units) 8,500 7,000
Sales (Units) 7,000 8,000

Required: a) Statement for management showing sales, costs and profits for each of the six-monthly period under
marginal costing.
b) Prepare statement for management showing sales, costs and profits for each of the six-monthly period under
absorption costing
C) Prepare explanatory statement reconciling for each six-monthly profit using marginal costing and absorption
costing.

366 Page 68 of 82
Answer: a)
Six months Six months
ending 31 ending 30
March 2021 September 2021
Rupees Rupees
Sales (7,000 x 140)/ (8,000 x 140) 980,000 1,120,000
Variable cost of sales:
Opening stock - 73,500
Direct labour (8,500 x 18)/(7,000 x 18) 153,000 126,000
Direct material (8,500 x 28)/(7,000 x 28) 238,000 196,000
Variable production OH (8,500 x 3)/(7,000 x 3) 25,500 14,000
416,500 409,500
Closing stock (1,500 x 49)/ (500 x 49) (73,500) 24,500
(343,000) (385,000)
Gross contribution 637,000 735,000
Variable selling, distribution and administration cost
(20% of sales) (196,000) (224,000)
Contribution margin 441,000 511,000
Fixed cost:
Production (16,000 x 20 /2) (160,000) (160,000)
Selling, distribution & administration (180,000/2) (90,000) (90,000)
(250,000) (250,000)
Net profit 191,000 261,000

b)

Six months Six months

ending 31 ending 30
March 2021 September 2021
Rupees Rupees
Sales (7,000 x 140)/ (8,000 x 140) 980,000 1,120,000
Cost of sales:
Opening stock - 103,500
Direct labour (8,500 x 18)/(7,000 x 18) 153,000 126,000
Direct material (8,500 x 28)/(7,000 x 28) 238,000 196,000
Variable production OH (8,500 x 3)/(7,000 x 3) 25,500 14,000
Fixed production OH (8,500 x 20)/(7,000 x 20) 170,000 140,000
Closing stock (1,500 x 69)/ (500 x 69) (103,500) (34,500)
(483,000) (545,000)
(Under) over absorbed OH (170,000-
160,000)/(140,000-160,000) 10,000 (20,000)
(473,000) (565,000)
Gross profit 507,000 555,000
Selling, distribution and administration cost:

367 Page 69 of 82
 Variable (196,000) (224,000)
Fixed (90,000) (90,000)
(286,000) (314,000)
Net profit 221,000 241,000

C)
31st March 30th
September.
Profit as per M.C 191,000 261,000
Closing Stock M.C (73,500) (24,500)
Opening Stock M.C -- 73,500
Closing Stock A.C 103,500 34,500
Opening Stock A.C -- (103,500)
221,000 241,000

Example:
Khan Company is a small business which has the following marginal costing profit and loss account for the month
ended June 30, 2020:
Rupees
Sales 96,000
Variable cost of sales:
Opening stock 6,000
Production cost 72,000
Closing stock (14,000)
(64,000)
Gross contribution 32,000
Variable selling cost (6,400)
Contribution margin 25,600
Fixed costs:
Production (8,000)
Administration (7,200)
Selling (2,400)
(17,600)
Net profit 8,000

368 Page 70 of 82
The standard cost per unit is:
Rupees
Direct material (1 kg) 16
Direct labour (3 hours) 18
Variable production overheads 6

Selling price per unit is Rs. 60.

The company’s normal level of activity is 4,000 units per month. It has budgeted fixed production costs at Rs. 8,000
per month and absorbed them on the normal level of the activity of units produced.

Required: convert the marginal costing statement into absorption costing statement

A. Statement of profit and loss under absorption costing for the month ended June 30, 2020..
Rupees
Sales 96,000
Cost of sales:
Opening stock {6,000 +(6,000/40 x 2 W-1)} 6,300
Production cost {72,000 +(72,000/40 x 2 W-1)} 75,600
81,900
Closing stock {14,000 +(14,000/40 x 2 W-1)} (14,700)
(67,200)
(Under) absorbed OH (72,000/40-4,000) x 2 (4,400)
(71,600)
Gross profit 24,400
Selling and administration cost:
Variable (6,400)
Fixed (7,200 + 2,400) (9,600)
(16,000)
Net profit 8,400

b) Statement reconciling for each six-monthly profit using marginal costing and absorption costing.

Profit as per A.C 8,400

Closing Stock A.C 6,300
Opening Stock A.C (14,700)
Closing Stock M.C (6,000)
Opening Stock M.C 14,000
Profit as per A.C 8,000
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝐹𝑂𝐻
W-1 Fixed overheads =
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝐵𝑎𝑠𝑒

8,000
= =2
4,000

369 Page 71 of 82
 FOH A/C
Rent, Insurance etc 8,000 WIP (72,000 / 40 x 2) 3,600
Cost of sales (bal) 4,400

Relevant costing
Example:
R Ltd has been approached by a customer who would like a special job to be done for them. The job would require
the following materials.
Book value of
Total Already in Replacement
units in Realisable value
Material required inventory cost
inventory
units units Rs. Per unit Rs. per unit Rs. per unit
A 1,000 0 - - 6
B 1,000 600 2 2.50 5
C 1,000 700 3 2.50 4
D 200 200 4 6.00 9

a) Material B is used regularly by R Ltd and if units of B are required for this job, they would need to be replaced
to meet other production demand.
b) Material C and D are in inventory as the result of previous overbuying, and they have a restricted use. No
other use could be found for material C, but the units of material D could be used in another job as substitute
for 300 units of material E, which currently costs Rs. 5 per unit (of which the company has no units in
inventory at the moment).

Required: calculate the relevant cost of material:

Ans:The relevant costs of material, in deciding whether or not to accept the order, is calculated as under, along
with reasons.
Relevant costs Note Rs.
Material A (1,000 x 6) [Note 1] 6,000
Material B (1,000 x 5) [Note 2] 5,000
Material C (300 x 4) + (700 x 2.50) [Note 3] 2,950
Material D [Note 4] 1,500
15,450
Note-1:
Material A is not owned and would have to be bought in full at the replacement cost of Rs. 6 per unit.

Note-2:
Material B is used regularly by the company. There is existing inventory (600 units) but if these are used on the
contract under review, a further 600 units would be bought to replace them. Relevant costs are therefore 1,000
units at the replacement cost of Rs. 5 per unit.

370 Page 72 of 82
Note-3:
1,000 units of Material C are needed and 700 are already in inventory. If used for the contract, a further 300 units
must be bought at Rs. 4 each. The existing inventory of 700 units will not be replaced, if they are used for the
contract, they could not be sold at Rs. 2.50 each. The realizable value of these 700 units is an opportunity cost of
sales revenue forgone.

Note-4:
Material D are already in inventory and will not be replaced. There is an opportunity cost of using D in the contract
because there are alternative opportunities either to sell the existing inventory for Rs. 6 per unit (Rs. 1,200 in total)
or avoid other purchases of material E, which would cost 300 x Rs. 5= Rs. 1,500. Since substitution for E is more
beneficial, Rs. 1,500 is the opportunity cost and thus relevant cost.

Example:
The Telephone Co (T Co) is a company specialising in the provision of telephone systems for commercial clients.
There are two parts to the business:
– Installing telephone systems in businesses, either first time installations or replacement installations;
– Supporting the telephone systems with annually renewable maintenance contracts.

T Co has been approached by a potential customer, Push Co, who wants to install a telephone system in new
offices it is opening. Whilst the job is not a particularly large one, T Co is hopeful of future business in the form of
replacement systems and support contracts for Push Co. T Co is therefore keen to quote a competitive price for
the job. The following information should be considered:
1. One of the company's salesmen has already been to visit Push Co, to give them a demonstration of the new
system, together with a complimentary lunch, the costs of which amounting to Rs. 4,000.
2. The installation is expected to take one week to complete and would require three engineers, each of whom is
paid a monthly salary of Rs. 140, 000. The engineers have just had their annually renewable contract renewed
with T Co. One of the three engineers has spare capacity to complete the work, but the other two would have
to be moved from contract X in order to complete this one. Contract X generates a contribution of Rs. 50 per
engineer hour. There are no other engineers available to continue with Contract X if these two engineers are
taken off the job. It would mean that T Co would miss its contractual completion deadline on Contract X by
one week. As a result, T Co would have to pay a one-off penalty of Rs. 5,000. Since there is no other work
scheduled for their engineers in one week's time, it will not be a problem for them to complete Contract X at
this point.
3. T Co's technical adviser would also need to dedicate eight hours of his time to the job. He is working at full
capacity, so he would have to work overtime in order to do this. He is paid an hourly rate of Rs. 400 and is paid
for all overtime at a premium of 50% above his usual hourly rate.
4. Two visits would need to be made by the site inspector to approve the completed work. He is an independent
contractor who is not employed by T Co, and charges Push Co directly for the work. His cost is Rs. 20,000 for
each visit made.
5. T Co's system trainer would need to spend one day at Push Co delivering training. He is paid a monthly salary
of Rs. 150,000 but also receives commission of Rs. 1,250 for each day spent delivering training at a client's site.
6. 120 telephone handsets would need to be supplied to Push Co. The current cost of these is Rs. 182 each,
although T Co already has 80 handsets in inventory. These were bought at a price of Rs. 168 each. The
handsets are the most popular model on the market and frequently requested by T Co's customers.
7. Push Co would also need a computerised control system called 'Swipe 2'. The current market price of Swipe 2
is Rs. 10,800, although T Co has an older version of the system, 'Swipe 1', in inventory, which could be

371 Page 73 of 82
 modified at a cost of Rs. 4,600. T Co paid Rs. 5,400 for Swipe 1 when it ordered it in error two months ago and
has no other use for it. The current market price of Swipe 1 is Rs. 5,450, although if T Co tried to sell the one
they have, it would be deemed to be 'used' and therefore only worth Rs. 3,000.
8. 1,000 metres of cable would be required to wire up the system. The cable is used frequently by T Co and it has
200 metres in inventory, which cost Rs. 12 per metre. The current market price for the cable is Rs.13 per
metre.
9. You should assume that there are four weeks in each month and that the standard working week is 40 hours
long.

Required:
Prepare cost statement, using relevant cost principles, showing the minimum cost that T Co. should charge for the
contract, along with explanation of each cost item.

Ans:
Computation of Minimum Cost Note Rupees
Demonstration and complimentary lunch 1 -
Engineers 2 5,000
Technical advisor 3 4,800
Site inspector visit 4 -
Training cost 5 1,250
Telephone handsets 6 21,840
Computerised control system 7 7,600
Cable cost 8 13,000
Minimum price 53,490

Notes:
1. Demonstration and complimentary lunch
The salesman has already been to visit Push Co to demonstrate the new system. The associated costs are sunk
costs (they have already been incurred) and are therefore excluded from the cost statement.
Relevant cost = Rs.0
2. Engineers
One of the three engineers has spare capacity to complete the installation and his salary will be paid
regardless of whether they work on the contract for Push Co. The relevant cost is therefore Rs. Nil.
The other two engineers are currently fully utilised and earn a contribution of Rs.50 per hour each on Contract
X. The engineers could be temporarily taken off of Contract X to work on the contract for Push Co. Work on
Contract X would recommence in one week's time when there is no other scheduled work for the engineers.
Delaying the work on Contract X would result in T Co missing the contractual completion deadline and having
to pay a one-off penalty of Rs. 5,000.
Relevant cost = Rs. 5,000
Delay in work will not result into loss of contribution of 50 per hour because it will be subsequently
completed.
3. Technical adviser
The technical adviser is working at full capacity so would need to work 8 hours overtime on the contract for
Push Co. All overtime is paid at a premium of 50% above his usual hourly rate of Rs. 400 (Rs.400 × 1.5 = Rs.
600).

372 Page 74 of 82
 Relevant cost = Rs. 600 × 8 hours = Rs. 4,800
4. Site inspector visits
The site inspector is an independent contractor who is not employed by T Co and charges Push Co directly for
the work. Since the site engineer charges Push, the relevant cost for T Co is nil.
Relevant cost = Rs. Nil
5. Training costs
The system trainer is paid a monthly salary of Rs. 150,000. This is not a relevant cost, as it is not incremental.
The trainer is also paid Rs. 1,250 commission for each day spent delivering training at a client's site. This cost
will arise as a direct result of the decision and is therefore included.
Relevant cost = Rs. 1,250 per day × 1 day = Rs. 1,250
6. Handsets
120 handsets would need to be supplied to Push Co. Though 80 handsets are already in inventory, the
handsets are frequently requested by T Co's customers and so would need to be replaced if supplied to Push
Co. The current cost of a handset is Rs.182.
Relevant cost = Rs.182 × 120 handsets = Rs. 21,840
7. Computerised control system
The current market price of Swipe 2 is Rs. 10,800.
The original cost of Swipe 1 (Rs. 5,400) is a sunk cost and not relevant to the decision.
The current market price of Swipe 1 (Rs. 5,450) is also not relevant to the decision as T Co has no intention of
replacing (means purchasing) Swipe 1.
The company could sell Swipe 1 for Rs. 3,000 if it does not use it for this contract. This represents an
opportunity cost.
In addition to the Rs. 3,000, Swipe 1 could be modified at a cost of Rs. 4,600, bringing the total cost of
converting Swipe 1 to Rs. 7,600.
The total cost of converting Swipe 1 (Rs. 7,600) is significantly less than purchasing Swipe 2 (Rs. 10,800). It is
assumed that the company would choose the cheaper option.
Relevant cost = Rs. 7,600
8. Cable costs
1,000 metres of cable is required. Although T Co has 200 metres of cable in inventory, it is used frequently and
so would need to be replaced. All 1,000 metres should be valued at the current market rate (Rs. 13 per metre).
The original purchase cost of Rs. 12 per metre is a sunk cost and is not relevant to the decision.
Relevant cost = 1,000 metres × Rs.13 per metre = Rs. 13,000

Decision making
Example:
Wombat Company makes four products, W, X, Y and Z. All four products are made on the same machines, and the
machine capacity for the year at Wombat’s factory is 3,500 hours. However, it is able to obtain any of these
products in unlimited quantities from a sub-contractor.

373 Page 75 of 82
Budgeted data is as follows.
Product W X Y Z
Annual sales demand (units) 4,000 6,000 3,000 5,000
Rs. Rs. Rs. Rs.
Sales price per unit 15 20 18 17
Variable cost per unit, in-house manufacture 5 7 6 7
Cost of external purchase (outsourcing) 8.0 11.8 10.5 11.0
Machine hours per unit, in-house production 0.25 0.50 0.30 0.40

Required:
a) Which items should be produced in-house and which should be outsourced?

Ans:
The selling price for each product is higher than the variable cost of purchasing each product externally; therefore,
profit will be maximized by making the products in-house. However, because of limiting factor proceed will be as
follows:
Product W X Y Z
Rs. Rs. Rs. Rs.
Variable cost per unit, in-house manufacture 5.00 7.00 6.00 7.00
Cost of external purchase (outsourcing) 8.00 11.80 10.50 11.00
Saving by production, per unit 3.00 4.80 4.50 4.00
Machine hours per unit, in-house production 0.25 0.50 0.30 0.40
Saving per machine hour Rs.12 Rs.9.60 Rs.15 Rs.10
rd st
Priority for outsourcing 3 1 4th 2nd
nd th
Priority for in-house production 2 4 1st 3rd

b) Optimum production plan

Product
Units Machine hours
In-house production:
Y 3,000 900
W 4,000 1,000
Z (balance) (1,600 / 0.4) 4,000 1,600
3,500
Outsource:
Z (5,000 - 1,000 ) 1,000
X (as it is) 6,000
Total variable cost

Example:
Cappuccino Limited (CL), incorporated in January 2018, is engaged in manufacturing and marketing of two types of
products, S1 and S2. Due to strict quality standards at CL, the ratio of damaged goods is high. Damaged units of S1
can only be identified at 100% completion whereas damaged units of S2 can be identified at 60% completion.
Damaged units of S1 and S2 can be sold at 80% and 50% of market prices respectively.

374 Page 76 of 82
CL’s production department believes that damaged units can be sold at full market price after incurring per unit
rectification costs of Rs. 150 and Rs. 450 on S1 and S2 respectively.

Additional information:
• Following information has been extracted from CL’s latest records:
S1 S2
Units
No. of units sold 347,000 218,000
Closing inventory 47,000 34,000
Rupees in ‘000
Sales 492,800 463,760
Cost of goods manufactured 431,430 349,370
Closing inventory (51,465) (48,287)
Cost of goods sold 379,965 301,083
Gross profit 112,835 162,677

• Closing inventory includes units of S1 and S2 damaged during the year i.e. 15,000 and 22,500 units
respectively.
• Fixed costs are incurred at the beginning of period and variable costs are incurred throughout the
manufacturing process.
• Cost of goods manufactured includes fixed cost of Rs. 80 million which is allocated on the basis of total units
produced.
• Selling expenses during the period was 1% of sales.

Required:
a) Whether CL should sell damaged units of each product with or without further processing
b) Determine the value of damaged units of S 1 and S 2 included in the closing inventories under each of the
following situations:
1. If CL opts for further processing
2. If CL does not opts for further processing

Solution
i) Without further processing
S1 S2
Sale price 1,136 1,064
(1,420 (W 1) x 80%) (2,127(W 1) x 50%)
Less: Cost
Variable cost (W-2) (971) (786)
[1.309(W 2)x60%]
Selling expense (1% of sale ) (11) (11)
Contribution per unit 154 267

375 Page 77 of 82
 With further processing:
S1 S2
Sale price (W-1) 1,420 2,127
Less: Cost
Variable cost (W-2) (971) (786)
Further processing (given) (150) (450)
Selling expense (1% of sale ) (14) (21)
Contribution per unit 285 870

CL should sell both products after further processing.

ii. value of closing stock (Lower of cost or NRV)

without further processing
S1 S2
Sale price 1,136 1,064

Selling expense (1% of sale ) (11) (11)

NRV 1,125 1,053
Cost:
Variable cost (W-2) 971 786
Fixed cost (W-3)[as per IAS 2] 124 124
1,095 910
Cost is lower.

Value of damaged units S1 S2

15,000 x 1,095 16,425,000 -
22,500 x 910 - 20,475,000

With further processing S1 S2

Sale price 1,420 2,127
Further processing (given) (150) (450)
Selling expense (1% of sale ) (14) (21)
NRV 1,256 1,656
Cost:
Variable cost (W-2) 971 786
Fixed cost (W-3) 124 124
1,095 910
Cost is lower.

Value of damaged units S1 S2

15,000 x 1,095 16,425,000 -
22,500 x 910 - 20,475,000

376 Page 78 of 82
Workings:
W-1
Sale price per unit S1 S2
492,800,000 / 347,000 1,420
463,760,000 / 218,000 2,127

W-2
Variable cost per unit S1 S2
Rs.000
Total cost 431,430 349,370
Fixed cost (W-3) (48,793) (31,207)
382,637 318,163
Per unit 971 1,309
382,637,000 / 394,000 318,163,000 /
243,000[W5]

W-3
Fixed cost per unit S1 S2
Total fixed cost = 80,000,000 Rs.000
Fixed cost 48,793 31,207
80,000 x 394 (W 4) / 646 ; 80,000 x 252(W 4)
/ 646
Per unit 124 124
48,793,000 / 394,000 ; 31,207,000 / 252,000
Fixed cost is incurred at the beginning of the process

W-4
Manufactured units S1 S2 Total
Sold units 347,000 218,000
Closing stock 47,000 34,000
Manufactured units 394,000 252,000 646,000

W-5
As in case of S2, damaged units are identified at 60% stage, so the variable cost of 60% would have been
incurred.however, S 1 is identified at 100% completion.
Total manufactured units 252,000
Less: damaged units 22,500

229,500
Add: 22,500x 60% 13,500
Total Equivalent units 243,000

377 Page 79 of 82
Q. Design Limited (DL) produces and markets two products viz. Olive and Mint. Following information is available
from DL’s records for the year ended 30 June 2013:
Olive Mint
Selling price per unit Rs 760 550
Variable cost of production unit Rs. 520 430
Selling and distribution expenses per unit Rs. 40 20
Fixed cost Rs. 4,400,000 5,200,000
Number of units produced and sold 120,000 150,000

The above sales volumes are based on the market demand for these products. DL is currently operating at 75% of
the installed capacity. Time required for producing each unit of Olive and Mint is the same. In order to utilize the
spare capacity of the plant, the marketing department has suggested the following options to the management:
Option 1: Introduce a single pack of both the products Olive and Mint. The price of the single pack would be 90%
of the combined price of separate products. It would increase overall market demand for these products resulting
in utilisation of full capacity. However, it is estimated that the sale of separate units of each products would reduce
by 18%.

Option 2: To launch a new product Salsa at a price of Rs. 380 per unit. Salsa is estimated to have a demand of
80,000 units per annum and a unit variable cost equal to 40% of the variable cost of Olive. It would result in
additional fixed costs of Rs. 3,200,000 per annum.

Required:
Evaluate the above options and advise the management about the most feasible option. (11)

A.

Products
Olive Mint
Sale price 760 550
Less: Variable cost (560) (450)
Contribution margin / unit 200 100
No. of units produced and sold 120,000 150,000
Existing contribution margin 24,000,000 15,000,000

Option 1:
Additional profit from the introduction of packaged products:

Quantity of packaged products: Units

Reduction in sale of Mint [150,000 18%] 27,000
Reduction in sale of Olive [120,000 18%] 21,600
Underutilization of existing capacity [(120,000 + 150,000)/75%] -270,000 90,000
138,600
Units of packaged products [1138,600 / 2] 69,300
Rupees

378 Page 80 of 82
Selling price per package (760 + 550) x 90% 1,179
Variable cost [560 + 450] 1,010

Contribution margin of packaged products 169

Contribution margin from sale of packaged products [69,300 x 169] 11,711,700
Less: Reduction in contribution margin [200 x 21,600] + [100 x 27,000] (7,020,000)
4,691,700
Option 2:
Additional profit from Salsa

Contribution margin from Salsa [380 x 80,000] - [560 x 40% x 80,000]

12,480,000
less: Additional fixed cost 3,200,000
9,280,000
Additional profit from Salsa [9,280,000 - 4,691,700] 4,588,300

Q. Zodiac Limited (ZL) produces a single product and has a maximum production capacity of 300,000 units per
annum. Following information pertains to ZL’s estimated cost of production:
(a) Direct material Rs. 12 per unit.
(b) Direct labour Rs. 8 per unit. However, based on guaranteed wages, the minimum total cost of labour is Rs.
150,000 per month.
(c) Variable overheads Rs. 6 per unit.
(d) Semi-variable overheads Rs. 450,000 per annum up to 55% capacity. An additional amount of Rs. 180,000 per
annum is estimated for every 20% increase in capacity or a part thereof.
(e) Fixed overheads Rs. 750,000 per annum.

During the first five-months of the year 2012, ZL utilized 70% of its production capacity. However, it is expected to
utilize 92% capacity during the remaining seven-months. The actual selling price during the first five-months was
Rs. 34 per unit.

Required:
Compute selling price per unit which should be charged by ZL for the remaining seven-months to earn a total profit
of Rs. 936,000 for the year 2012. (10 marks)

A.
Procedure to solve the question
Calculate the profit of first five months and deduct from the total profit to calculate the profit for the remaining
seven months.

Then add the total cost of seven months in the calculated profit to find out sales of seven months. Sales divided by
sold units of seven months is equal to sale price per units for remaining seven months.

379 Page 81 of 82
Maximum production capacity = 300,000 units per annum.
5 Months 7 Months
Capacity utilised 70% 92%
Production 87,500 units 161,000 units
[300,000 ÷ 12 × 5 × 70%] [300,000 ÷ 12 × 7 × 92%]

Units 87,500 Units 161,000

Sales (87,500 × 34) 2,975,000 --
Direct material (87,500 × 12) / (161,000 × 12) (1,050,000) (1,932,000)
Direct Labor [ 87,500 × 8 = 700,000 or 750,000] / (750,000) (1,288,000)
[161,000 × 8 = 1,288,000 or 1,050,000] (525,000) (966,000)
Variable overheads:
(87,500 × 6) / (161,000 × 6)
Semi Variable overheads (W-1) (262,500) (472,500)
Fixed [750,000 x 5/12] / 750,000 x 7/ 12] (312,500) (437,500)
Total Cost (2,900,000) (5,096,000)

Profit during first 5 months 75,000

Desired profit during next 7 months (936,000 – 75,000) = 861,000
Required sales for next 7 months = 5,957,000 (5,096,000 + 861,000)
5,957,000
Per unit sale price = = 37/unit
161,000
(W-1)
First 5 months @ 70% capacity = (450,000 + 180,000) × 5/12 = 262,500
Remaining 7 months @ 92% capacity = (450,000 + 360,000*) × 7/12 = 472,500
*180,000 x 2 = 360,000

380 Page 82 of 82
 Imagine sleeping without praying isha and waking up in your grave.

Spring 2020
Q.1
Venus Limited (VL) is engaged in the business of processing and selling cashew nuts. It purchases raw
cashew nuts which are then processed and packaged before selling to consumers.

VL uses standard costing system. The standard cost card for the month of February 2020 is given below:

Standard cost card per tonne of processed cashew nuts

Direct material 1.75 tonnes of raw cashew nuts at Rs. 50,000 per tonne.
Direct labour 8 hours at Rs. 300 per hour (idle time is estimated at 5% of total time).
Fixed production
Overheads Rs. 275 per direct labour hour for budgeted production of
17,500 tonnes of processed and packaged cashew nuts.

Actual results for the month of February 2020:

(i) 17,050 tonnes were produced.
(ii) 31,500 tonnes of direct material at Rs. 46,500 per tonne were purchased and consumed during the
month.
(iii) Each tonne of processed cashew nuts took 7 hours to produce and direct labour was paid at Rs. 375
per hour.
(iv) Scheduled maintenance of machine was not carried out which reduced the idle time to 4%.

(v) Fixed production overhead amounting to Rs. 32 million was incurred during the month.

VL’s actual profit for the month of February 2020 was higher than the budgeted profit. Views of three
department heads on high profitability are as follows:

1. Head of purchase department

Despite stable prices of raw cashew nuts in the market for last three years, his department has saved
significant cost by purchasing material from a new supplier at a relatively cheaper rate by good
negotiations. This contributes significantly to the increase in VL’s profitability.

2. Head of production department

His team’s decision to increase labour rate has resulted in an increased motivation and overall
efficiency of workers which led to the increase in VL’s profitability.
3. Head of maintenance department
Delaying the scheduled maintenance of machines has contributed to VL’s profitability. The machines are
running well, therefore, scheduled maintenance can be delayed for
another month.

381 Page 1 of 8
Required:
a) Calculate the following variances for the month of February 2020:
• All material variances
• All labour variances
• Fixed production overhead expenditure variance (08)

b) Critically evaluate the views of departmental heads. Your evaluation should include the discussion of claims
made and likely impact of their decisions on the long-term profitability of VL. (07)

Q.4 Ring Limited (RL) is engaged in the manufacture and sale of customized products. In January 2020, RL
entered into an agreement with Gamma Limited (GL) for manufacture and supply of 3,500 units of a
customized product ‘Zing’ at Rs. 4,000 per unit.
RL placed the order for raw material AA-2 and the supplier agreed to supply the material in second
week of March 2020. RL had also hired skilled labour for the production of Zing. However, in February
2020, GL went bankrupt.

RL has recently been approached by Sigma Limited (SL) for supply of 3,500 units of D-Zing which is a
modified version of Zing. RL can use the ordered raw material and the hired skilled labour for this
product. The production of D-Zing will take three months. Following information has been provided in
this regard:

Machinery
Specialized machinery will be needed to produce D-Zing. Following proposals are under consideration:

(i) Lease machinery for three months at monthly lease rentals of Rs. 250,000 and an upfront
payment of refundable security deposit of Rs. 5,000,000. The upfront
payment will be financed through running finance @ 20% per annum. As per the lease terms,
monthly maintenance cost of Rs. 15,000 will be borne by the lessor.
(ii) Lease machinery at monthly lease rentals of Rs. 160,000 for a minimum period of six months. In
this case, monthly maintenance of Rs. 20,000 will be borne by RL which will be incurred only in
the months in which machinery is operative.
Direct material
Following raw materials will be required for manufacturing of each unit of D-Zing:
(i) 15 units of AA-2: RL had already ordered 50,000 units of AA-2 at Rs. 75 per unit under the
original contract of Zing. The current market price for AA-2 is Rs. 80 per unit. If the
contract is not fulfilled, a penalty at 20% of the contract value
will be payable by RL.
(ii) 10 units of A-78: A-78 is available in market at Rs. 110 per unit. However, it can also be produced
internally at a variable cost of Rs. 80 per unit. Fixed cost would be absorbed at Rs. 25 per unit.
Internally produced A-78 would be subject to 20% normal
loss.

382 Page 2 of 8
 “Don’t betray the one who betrays you but forgive, help and guide him/her.”

5 units of C-11: Market price of C-11 is Rs. 20 per unit. However, a substitute material D-50 can also
(iii) be used after processing it at a cost of Rs. 15 per unit. Presently 5,000 units of D-50 is available
in stock as a result of over purchasing for a previous order. D-50 was purchased at Rs. 5 per unit
and can be sold back to the supplier at Rs. 3 per unit.
Direct labour

(i) RL had hired skilled labour from a third party at Rs. 1,000 per hour under the original
contract of Zing. If order from SL is not accepted, 200 labour hours would become idle and RL will
have to pay 50% of the contract rate.
(ii) If SL’s offer is accepted, then D-Zing would be produced in batches of 350 units and the first
batch would require 400 skilled labour hours. Learning curve effect is estimated at 80% but
would remain effective for the first four batches only. The index of learning curve is – 0.322.

(iii) 1.5 hours of semi-skilled labour is required for every unit of D-Zing. Since there is a shortage of
semi-skilled labour in the market, only 4,000 labour hours are available at Rs. 600 per hour.
However, labour is willing to do overtime at a 50% higher rate up to maximum of 1,500 hours.
Alternatively, unskilled labour can be hired at Rs. 200 per hour, however, unskilled labour
would require 300% of the time taken by semi-skilled labour. This can be reduced to 250% if
training is given to them at a cost of Rs. 300,000.

Variable overheads
Variable overheads would be charged at Rs. 125 per skilled labour hour.
Required:
By using the relevant costs approach, compute the minimum price per unit that RL may quote.
(20)

Q.7 (a) List any four situations in which EOQ model for determining optimum level of stocks becomes invalid.
(04)
(b) Jamal Limited (JL) purchases raw material T3 for its product DBO on a quarterly basis as per the
requirement of the production department. The management is considering to revise the existing
policy of placing orders for T3. Following information is available in this regard:

(i) Annual production of DBO is 19,000 units.

(ii) Each unit of DBO requires 1 kg of T3 which is the resultant quantity after normal loss of 5%.

(iii) Minimum order quantity set by the supplier for purchase of T3 is 3,500 kg. However, the
supplier offers following prices at different order quantities:
Order quantity (kg) Price per kg (Rs.)
3,500 305
4,000 299
5,000 296

383 Page 3 of 8
 (iv) JL maintains T3’s safety stock of 320 kg.
(v) The cost of placing each order is Rs. 4,200 out of which Rs. 1,780 pertains to fixed salaries of
staff of purchase department.
(vi) Holding cost per kg of average stock is Rs. 260 which includes rent of Rs. 180 for the floor
space occupied by each kg. Variation in the stock held has no effect on the remaining holding
cost.
Required:
Determine the purchase order quantity of T3 offered by the supplier at which JL’s cost would be
minimized. (08)

A.1
(a)
Material:
[SQU for A.P x S.R] – [AQU for A.P x
A.R]
(17,050 x 1.75 x 50,000) – (31,500 x
46,500)
1,491,875,000 – 1,464,750,000 = 27,125,000 F

Rate Usage
(SR – AR) × AQU for A.P (SQU for A.P – AQU for A.P) x S.R
(50,000 – 46,500) x 31,500 [(17,050 x 1.75) – 31,500] x 50,000
110,250,000 F 83,125,000 A

Labour:
[SHW for A.P × S.R] – (AHP for A.P × A.R)
(17,050 x 8 x 300) – [(17,050 x 7) x 375)]
40,920,000 – 44,756,250 = 3,836,250 A

Rate Efficiency
(SR – AR) x AHP for A.P (SHW for A.P – AHW) x S.R
(300 – 375) x (17,050 x 7) [17,050 x 8 – (17,050 x 7)] x 300
8,951,250 A 5,115,000 F

Breakup of Efficiency variance instead of above:

[(17,050 x 8 x 95%) – (17,050 x 7 x 96%)] x 300
4,501,200 F

384 Page 4 of 8
 Idle time variance:
Estimated idle time (17,050 x 8 x 5%) 6,820
Actual idle time (17,050 x 7 x 4%) 4,774
2,046
x 300 613,800 F

Or
Standard cost per unit Rs.
Labor 7.6 hours x Rs. 300 per hour 2,280
Idle time 0.4 hours x Rs. 300 per hour 120
2,400
Direct labor idle time variance
FORMULA: [Expected idle time - Actual idle time] x standard rate
[(17,050 x 0.4) – (17,050 x 7 x 4%)] x 300
613,800 F

Efficiency variance
(SHW – AHW) × S.R
[(17,050 x 7.6) – (17,050 x 7 x 96%)] x 300
4,501,200 F

Fixed expenditure:
Budgeted fixed OH (17,500 x 8 x 95% x275) = 36,575,000
Actual fixed OH = 32,000,000
4,575,000 F
(b) Commentary
Material variances
Purchase department’s claim is correct to the extent that savings have been made by
purchasing from a new supplier at a cheaper rate as indicated by favourable direct material price variance of Rs.
110.25 million. However, his claim of getting good price by using good negotiation skills does not seem correct as
market for cashew nuts remained stable for the past three years. It seems that quality of direct material is
compromised as indicated by adverse direct material usage variance of Rs. 83.13 million. Although total direct
material variance is still favourable i.e. Rs. 27.13 million, using low quality material may adversely affect the quality
of final product which might create a risk of losing customers and profitability in the long-term.

Labour variances
Favourable labour efficiency variance of Rs. 4.5 million indicates that increase in labour rate has boosted workers'
morale and increased their motivation level which has made them work more efficiently. However, this decision
has also resulted in an adverse labour rate variance of Rs. 8.95 million which ultimately results in overall adverse
labour variance amounting Rs. 3.8 million. It is implied that labour rate should have been increased by a lower
amount as the impact of increased rate is currently outweighing the benefit obtained from it i.e. efficiency. If this
trend continues, it would adversely impact the overall profitability of the company in the long-term.

Further, delaying the scheduled maintenance of machines is the reason for lower idle labour hours which means
that the entire increase in efficiency cannot be fully attributed to the wage increase.

385 Page 5 of 8
Fixed production overhead expenditure variance
The maintenance department’s decision to delay the annual maintenance has resulted in a favourable fixed
production overhead expenditure variance of Rs. 4.575 million. In fact, the scheduled maintenance should be
carried out regularly to avoid any future shutdowns and disturbances in production which may adversely impact
the long-term profitability of the company.

A.4
Machinery ----------- Rupees ----------
-
Lower of:
Proposal 1
- Lease rentals [250,000×3] 750,000
- Finance cost [(5,000,000×20%) x 3/12] 250,000
1,000,000
Security deposit is refundable therefore not a cost it is an
asset.
AND
Proposal 2
- Lease rentals (160,000×6) 960,000
- Maintenance [20,000×3] 60,000
1,020,000 1,000,00
0

Direct Material
AA-2
Contract price [50,000×75] 3,750,000
Less: Savings from penalty [50,000×75×20%] (750,000)
amount
Purchasing cost [{(3,500×15)=52,500- 200,000 3,200,00
50,000]x80 0

A-78
Lower of:
Purchasing cost [3,500×10×110] 3,850,000
AND
Internal cost 3,500,000 3,500,00
(3,500×10)÷80x100x80 0
Absorbed fixed overheads are not relevant.
C-11
Opportunity cost of selling back [5,000×3] 15,000
Further processing cost [5,000×15] 75,000
Or [5,000x(3+15)]=90,000 90,000
Purchasing cost [(3,500×5)– 250,000 340,000
5,000]×20

386 Page 6 of 8
 “We don’t pray to exist! We exist to pray!.”

Direct Labor ----------- Rupees -----------

Skilled [(2,116 (W.1) – 200)]x 1,000 + (200 x 1,000 x50%) 2,016,000

Semi-skilled
Lower of:
Normal rate [4,000×600] 2,400,000
Overtime [(3,500×1.5)–4,000]×600×1.5 1,125,000
3,525,000
AND
Unskilled
Without training
Labour cost [3,500×1.5×300%×200] 3,150,000

AND
With training
Labour cost [3,500×1.5×250%×200] 2,625,000
Training cost 300,000
2,925,000 2,925,000

Variable OH
Cost 2,116(W – 1) x125 264,500
Total relevant costs 13,245,500

Minimum price to be quoted/Unit (13,245,500÷3,500) 3,784

Irrelevant costs/income
- Fixed overhead absorbed for internal production of A-78 (Irrelevant cost)
- Maintenance cost of machine under proposal A i.e. that is lease offer (to be borne by lessor)
- Original purchase cost of D-50 of Rs. 5 per unit (sunk cost)

W-1: Learning curve effects [3,500÷350]=10 batches No. of hours

For the first 4 batches [4×400×(4)–0.322] 1,024
For the first 3 batches [3×400×(3)–0.322] 842
For the 5th batch and onwards (1,024‒842) 182
Total hours from 5th to 10th batch (182×6) 1,092
Total hrs (1,024+1,092) 2,116

387 Page 7 of 8
A.7
(a) The EOQ model becomes invalid in the following situations:
• The holding cost per unit is not constant.
• The stock is not consumed at a constant rate throughout the period due to which average inventory is not
equal to one half of the order quantity.
• The cost per order is not constant.
• There are quantity discounts available.
1,9000 x 1
(b) Annual usage x 100 = 20,000
95

Annual costs
Order quantity Cost per kg Purchase of Holding cost at
cost of Order cost Rs. 180 per unit
20,000 kg (Note 1) (F) Total cost (C +
E= E +F)
A B C=20,000×B
3,500 305 6,100,000 13,829 372,600 6,486,429
(20,000/3,500 x
2,420 (4,200-1,780))
4,000 299 5,980,000 12,100 417,600 6,409,700
5,000 296 5,920,000 9,680 507,600 6,437,280

Note 1:
Holding cost = (*average stock + safety stock) × holding cost per unit
(3,500/2 + 320) x 180 = 372,600

*Average stock = Order quantity ÷ 2

Conclusion:
The order quantity to achieve minimization of costs is 4,000 kg, or JL will have to place
5 orders every year.

388 Page 8 of 8
Autumn 2020
Q.2 Pizza Inc. has pizza outlets in all major shopping malls in the city. It prepares and sells approximately 4,850
standard pizzas per week. A premium quality imported cheese (cheese), the key ingredient for pizza
preparation is purchased from a supplier at Rs. 1,200 per kg. Other costs related to cheese are as
follows:

Rupees
Administration cost per order 150,000
Transportation cost per order 22,500
Quality inspection cost per order 20,000
Refrigeration cost per kg 250
Warehouse cost per annum 4,420,000

Cost of financing the stock per month 1.5%

Other information:
(i) The company places orders on the basis of Economic Order Quantity (EOQ).
(ii) Each standard size pizza requires 0.25 kg of cheese. However, 3% of cheese is lost in
refrigeration.
(iii) 80% of administration cost and 50% of warehouse cost are variable. All other costs are fixed.
(iv) The company operates throughout the year which is 52 weeks.
The supplier has offered to reduce 5% price if the company agrees to double the size of order for the
coming year. However, it would have following implications:
(i) 4% of cheese would be lost in refrigeration.
(ii) Variable cost of warehouse, transportation cost and inspection cost would increase by 50%.
(iii) Refrigeration cost would increase by 75%.
Required:
Advise whether Pizza Inc. should accept offer of the supplier. (13)

Q#3 Francisco Limited (FL) is a manufacturer of product Z and has annual operational capacity of 82,500
machine hours. FL uses absorption costing.

Below is a summary of FL’s profit or loss statement for the years ended 31 August 2019 and 2020:
31 August 2020 31 August 2019
Units Rs. in '000 Units Rs. in '000
Sales 9,950 149,250 10,500 155,500
Opening inventory – finished goods 3,500 31,000 2,500 20,000
Cost of production 10,450 94,050 11,500 97,750
Closing inventory – finished goods 4,000 (36,000) 3,500 (31,000)
Cost of goods sold (89,050) (86,750)
Gross profit 60,200 68,750
(Under)/over absorbed fixed production (400) 650
overheads
Selling and administration cost (21,375) (22,475)
Net profit 38,425 46,925

389 Page 1 of 12
In both years, the actual and standard machine usage per unit are 6 hours. However, the standard machine usage
was 80% and 82% of the operational capacity in 2019 and 2020 respectively.
Fixed overhead absorption rate of Rs. 700 per machine hour was applied in 2019. FL revises its fixed overhead
absorption rate for each year on the basis of prior year’s actual fixed overhead expenditure.

Required:
(a) Calculate budgeted and actual fixed overheads for 2019 and 2020. (04)
(b) Prepare profit or loss statement for the year ended 31 August 2020, using marginal costing. (05)
(c) Reconcile the actual profits under marginal and absorption costing for the year ended 31 August
2020. (02)

Q#4 Siyab Limited (SL) is involved in manufacturing and exporting of products BA, CA and DA. Keeping in view the
continuous operating losses in product BA, the management is considering to discontinue the production of BA.

Summarised operating results of BA for the year 2019 are as follows:

Units sold (2018: 156,250 units) 150,000

Rs. in '000
Sales revenue 30,000
Raw material consumption (12,000)
Labour (6,000)
Variable manufacturing overheads (3,000)
Fixed manufacturing overheads:
Directly attributable (2,800)
Allocated (30% of total) (750)
Selling expenses (2018: Rs. 8,050,000) (7,800)
Operating loss (2,350)

Chief Financial Officer (CFO) is of the view that discontinuance of BA would save all manufacturing and selling
expenses except allocated fixed manufacturing overheads. It is estimated that total allocated fixed manufacturing
overheads will be reduced by 10%.

In a recent management meeting, SL’s sales director does not agree with the suggestion to discontinue this
product. She is of the view that BA is in high demand in the local market and the management should consider to
launch this product in the local market through an online marketplace, Jamal Express (JE). She argues that this will
not only minimize the selling expenses but also allow SL to reach maximum customers.

Following information have been available in respect of launching an online store of BA at JE:
(i) Existing production capacity of BA is 172,000 units.
(ii) Existing demand of BA in the online market is sufficient to boost sales by 10% from the previous year.
However, for achieving this target level of sales, a digital marketing service provider would be hired at an
annual cost of Rs. 800,000.
(iii) BA would be sold at Rs. 180 per unit.
(iv) SL would have to pay an annual subscription fee of Rs. 110,000 to JE to operate as a seller. In addition, JE

390 Page 2 of 12
 would charge 2% sales commission.
(v) JE also provides an additional facility of handling delivery and sales return to its clients. This service can be
availed by paying either an annual lump sum fee of Rs. 1,500,000 or an additional commission of 5% of the
selling price. If this service is availed, entire fixed selling expenses will be saved.
(vi) Fixed and variable selling expenses pertaining to BA would be reduced by 10% and 80% respectively.
(vii) Additional support staff would be hired at a cost of Rs 200,000 per month. This additional hiring cost can be
reduced to 80% if existing staff is given additional responsibilities with overtime payment which would
increase variable selling expense by 10%.

Required:
Evaluate the suggestions of CFO and sales director and recommend the best course of action to the management.
(17)

Q.5 Siyara Pakistan Limited (SPL) manufactures and sells a single product Zeta. The product passes through
two processes before transferring to warehouse for sale. Following data pertains to Process I for the
month of August 2020:

Standard cost information:

(i) Direct material per unit – 1 kg at Rs. 75.

(ii) Direct labour per unit – 1.2 hours at Rs. 40 per hour.

(iii) Factory overheads per unit – 150% of direct labour. Factory overheads are budgeted on the basis
of 250,000 direct labour hours. 40% of factory overheads are variable.

Actual data for the month of August 2020:

Rs. in '000
Direct material issued: Rs. 75 per kg 6,750
Rs. 85 per kg 11,475
Direct labour paid for 235,000 hours 9,870
Variable factory overheads 6,345
Fixed factory overheads 11,250
45,690

(i) Direct material is added at the beginning of the process. Conversion costs are incurred evenly
throughout the process. Losses up to 7% of the input are considered as normal. However, losses
are determined at the time of inspection which takes place when product is 75% complete.

(ii) During the month, 225,000 kg of direct material was issued to Process I and 200,000 units were
transferred to Process II.
(iii) Opening and closing work in processes were 25,000 units (80% completed) and 35,000 units (60%
completed) respectively.
(iv) 10% of direct labour hours were idle due to machine break-down but fully paid.

(v) SL uses FIFO method for inventory valuation.

391 Page 3 of 12
 Required:
(a) Calculate the following variances for the month of August 2020:
1. Material price and usage
2. Labour rate, efficiency and idle
3. Variable factory overhead expenditure and efficiency
4. Fixed factory overhead expenditure and volume (17)

(b) Reconcile the budgeted expenditure of actual production with actual expenditure for the
month of August 2020 by using relevant variances calculated in part (a).
(03)

A.2
Existing Situation:
Purchase Cost [65,000 (W.1) x 1,200] 78,000,000
Annual Ordering Cost [65,000 /3,493 (W.7) x 162,500 (W.2)] 3,023,905
Annual Carrying Cost [3,493/2 x 1,731 (W.3)] 3,023,192
Total Cost 84,047,097
Purposed Scenario:
Purchased Cost [65,677 (W.4) x 1,200 x 95%] 74,871,780
Annual Ordering Cost [65,677/6,986(W.4) x 183,750 (W.5)] 1,727,476
Annual Carrying Cost [6,986/2 x 2,540.5 (W.6)] 8,868,886
Total Cost 85,468,142

Conclusion:
The Company should not accept the offer of suppliers as it would result into extra cost of 1,421,045.

Workings:
W.1) Annual Demand Existing [4,850 x 0.25 = 1,212.5/97 x100 = 1,250 x 52] 65,000

W.1.1)
1,250 1,212.5
100 97

W.2) Ordering Cost per order (Existing)

Administration Cost (150,000 x 0.8) 120,000
Transportation Cost 22,500
Quality inspection Cost 20,000
Total 162,500

W.3 Carrying Cost per Kg (Existing)

Refrigeration Cost 250
Financing Cost (1,200 x 1.5 % x 12) 216
Warehouse Cost [4,420,000 x 50% / 3,493 (W.7)/2] 1,265
Total 1,731

392 Page 4 of 12
W.4 Revised Annual demand and order size

1,212.5/96 x 100 x 1,263 x 52 65,677

W.4.1
1,263 1,212.5
100 96

Order size will be double ; i.e 3,493 x 2 = 6,986

W.5 Ordering Cost per order : [Revised]
Administration Cost 120,000
Transportation Cost (22,500 x 1.5) 33,750
Quality inspection Cost (20,000 x 1.5) 30,000
Total 183,750

W.6 Carrying Cost per Kg (Revised)

Refrigeration Cost (250 x 1.75) 438
Financing Cost (1,200 x 95% x 1.5 % x 12) 205
Warehouse Cost [ 1,265 x 1.5 1,897.5
Total 2,540.5

393 Page 5 of 12
W-7) For determining EOQ and warehouse cost.

Ordering cost = Carrying cost

Let’s EOQ is x.
65,000/x × 162,500 = x/2 × [250 + 216 + [(4,420,000 × 50%)/x/2]]
10,562,500,000/x = x/2 × [466 + (2,210,000/(x/2)]
10,562,500,000/x = x/2 × (466 + (2,210,000 × 2/x))
10,562,500,000/x = x/2 × (466 + 4,420,000/x)
10,562,500,000 = x2/2 × (466 + 4,420,000/x)
= 466x2/2 + (4,420,000/x × x2/2)
10,562,500,000 = 233x2 + 2,210,000x
233x2 + 2,210,000x - 10,562,500,000 = 0
After that press mode then button 5 and 3 buttons on calculator and put the figures as follows :
233 then press equal to sign
+ 2,210,000 then press equal to sign
- 10,562,500,000 then press two times equal to sign
x = 3,493 units

The answer cab also be calculated by putting the figures on the calculator.
A.3
a) (i) Budgeted Fixed Production overheads:
For 2019:
Budgeted Machine hrs x Overhead Absorption rate per machine hour
82,500 x 80% = 66,000 x 700 (Given) or 82,500 x 80% = 66,000 / 6 x 700 x 6
= 46,200,000
For 2020:
Budgeted Machine hrs x Overhead Absorption rate per machine hour
82,500 x 82% = 67,650 x 704 (w-1) or 82,500 x 82% = 67,650 / 6 x 704 x 6
= 47,625,600

(ii) Actual Fixed Production overheads:

For 2019:
Applied Fixed Production overheads [11,500 x 4,200 (w-2)] = 48,300,000
Overapplied Fixed Production overheads (Given) = (650,000)
Actual Fixed Production overheads 47,650,000
For 2020:
Applied Fixed Production overheads [10,450 x 4224 (w-2)] = 44,140,800
Underapplied Fixed Production overheads (Given) = 400,000
Actual Fixed Production overheads 44,540,800

394 Page 6 of 12
(b)
Francisco Limited
Profit and Loss Statement (By using Marginal Costing )
For the year ended 31.8.2020

Rs.”000”
Sales 149,250 149,250
Less :Variable cost of Sales:
Opening Stock [31,000 – (3,500 x 4.2 (W.2))] 16,300
Cost of Production [94,050 – (10,450 x 4.224 (W.2))] 49,909
Closing Stock [36,000 – (4,000 x 4.224 (W.2))] (19,104)
(47,105)
Gross contribution 102,145
Variable selling and admin expenses [9,950 x 2,000] (19,900)
Net contribution 82,245
Fixed cost:
Fixed production overheads (a) (44,541)
Selling and Admin expenses (W.3) (1,475)
Net Profit 36,229

C)
Reconciliation between Actual profits under marginal and absorption costing for the year ended 31.8.2020.

Rs”000”

Profit As per Absorption costing. 38,425

Opening As per A.C 31,000
Closing As per A.C (36,000)
Opening As per M.C (16,300)
Closing As per M.C 19,104
Profit as per Marginal costing 36,229

Workings:
w-1) Fixed production overheads Absorption rate of 2020:
It is to be calculated on the basis of prior year’s actual fixed production overheads.
Actual Fixed Production overheads [2019] 47,650,000
Budgeted Machine hours [2020] (82,500 x 82%) 67,650
47,650,000 ÷ 67,650 = 704 per machine hour

w-2) Fixed overhead absorption rate per unit:

2019: 700 x 6 = 4,200
2020: 704 x 6 = 4,224

395 Page 7 of 12
W-3 Computation of Fixed and variable selling and administrative expenses Using High Low Method:
Selling & Distribution
At 10,500 Volume 22,475,000
At 9,950 Volume 21,375,000
Difference 1,100,000
Variable cost/unit [1,100,000/550] = 2,000
Fixed Cost = Total Cost – Variable Cost
22,475,000 – (10,500×2,000) =1,475,000

A4.
If we discontinue BA immediately
Rs. “000”
Sales 30,000
Raw Material Consumption (12,000)
Labour (6,000)
Variable OH (3,000)
Fixed Manufacturing Expense:
Directly Attributable (2,800)
Selling Expenses (7,800)
Contribution before allocated manufacturing expenses (1,600)
10% of total Allocated manufacturing expenses [i.e 750/30 x 100 x 10%] (250)
Operating Loss (1,850)
If we discontinue this loss will be saved.

If management opt for sale through online market place:

Online Market Place
Sales [150,000 x 1.1 x 180] 29,700
RM [12,000,000/150,000x165,000 (13,200)
DL [6,000,000/150,000x165,000 (6,600)
V.OH [3,000,000/150,000x165,000 (3,300)
Fixed OH- Directly Attributable[same] (2,800)
10% of total Allocated manufacturing expenses that (250)
would not be saved if we continue producing [i.e 750/30 x
100 x 10%]
Variable Selling Expense (w-1) (1,320)
150,000x1.1x40x20%[point vi] [6,000,000 x 1.1 x 20% point (vi)]
Fixed Selling Expense (w-1) -
(100% will be saved) , 10% by launching product
(vi) and remaining by availing services of JE (v)
Digital marketing supervisor (800)
Sales Commission to JE (594)
[29,700 x 2%]
Annual subscription to JE (110)

396 Page 8 of 12
Commission (w-2) (point-v) (1,485)
Additional Support Staff (w-3) (point-vii) (2,052)
Net Loss (2,811)

Conclusion: The benefit of discontinuing BA is more therefore production of BA should be discontinued.

Workings:
W-1) Segregation of Variable and fixed selling expenses: (High Low method)
Units Sold Selling Expenses
2018 156,250 8,050,000
2019 150,000 7,800,000
Difference 6,250 250,000
250,000 ÷ 6,250 = 40 per unit

156,250 units 8,050,000

156,250 x 40 6,250,000
Fixed Selling Expenses 1,800,000 Per annum

W-2) Commission or Lump Sum Fee [point-v]:

Lumpsum fee 1,500,000
Commission ( 29,700,000 x 5% ) 1,485,000
Commission is lower i,e 1,485,000

W-3) Additional support staff [Point vii] :

Option 1: Additional support staff salary [200x12] 2,400,000
Option 2:
Additional support staff [2,400x80%] 1,920,000
+ Increase in variable selling expense
[ 6,000,000 x 1.1 x 20% (point vi) ] = 1,320,000 x 10% 132,000
2,052,000
Lower is option 2 i.e 2,052,000

397 Page 9 of 12
A.5
(a) Variances:
Material

Price
Usage
(SR – AR) x AQU for A.P (SQU – AQU) X SR
i) (75 – 75) x 90,000 (6,750,000 / 75 ) (211,700 x 1 – 225,000) X 75
= Nill 997,500 Adv.
ii) (75 – 85) x 135,000 (11,475 / 85 )
= 1,350,000 Adv.

Labour

Rate
9,870,000
(40 – ) × 235,000
235,000
= 470,000 Adv.

Idle Time Efficiency

(AHP - AHW) X S.R (SHW - AHW) x S.R
[235,000 – 211,500**] x 40 (242,730* – 211,500**) x 40
=940,000 Adv. =1,249,200 F
Or 235,000 x 10% = 23,500 x 40
=940,000 Adv.
** 235,000 x 90% = 211,500 *(202,275 x 1.2)

Variable -OH

Expenditure Efficiency
(S.R – A.R) x AHW (SHW – AHW) X S.R
6,345,000
(24* – ) × 211,500** = 1,269,000 A [(202,275 × 1.2) – 211,500] × 24 = 749,520 F
211,500
* 1.2 × 40 = 48 × 150% = 72
V.OH 72 × 40% = 28.8/unit ÷ 1.2 = 24/hr.

398 Page 10 of 12
 Fixed -OH

Expenditure Volume
Actual fixed O.H 11,250,000 Budgeted fixed O.H (w-a) 9,000,000
Budgeted fixed O.H 9,000,000* Applied fixed O.H (w-b) 8,738,280
2,250,000 F 261,720 Adv.

*Budgeted prod. X S.R/unit W-a) (250,000 ÷ 1.2 = 208,333 units x 43.2)

250,000 ÷ 1.2 = 208,333 x 43.2** = 9,000,000 W-b) (202,275 x 43.2)
** Std. Fixed OH/unit
40 x 1.2 x 150 % x 60% = 43.2

B)
Reconcialation:
Budgeted Expenditures for actual production (W-1) 40,150,500
Variances: (Workings above)
Material price 1,350,000 A
Material usage 997,500 A
Labor rate 470,000 A
Labor Idle time 940,000 A
Labor efficiency (1,249,200 F)
Variable overhead expenditure 1,269,000 A
Variable overhead efficiency ( 749,570 F)
Fixed OH Expenditure Variance 2,250,000 A
Fixed OH Volume Variance 261,720 A
Actual Expenditure 45,690,000

W-1 :
Budgeted Expenditure for Actual Production:
Direct Material 211,700 x 75 15,877,500
Direct Labor 202,275 x 1.2 x 40 9,709,200
Variable overhead 202,275 x 1.2 x 24 5,825,520
Fixed OH Expenditure 202,275 x 1.2 x 36[43.2/1.2] 8,738,280
Budgeted Expenditure 40,150,500

399 Page 11 of 12
Workings:
WIP A/C
Units Amount Units Amount
b/d WIP 25,000 Output 200,000
Input 225,000 Ab.loss(bal.) 1,700
Normal loss 13,300*
c/d WIP 35,000
250,000 250,000

* Calculation of Normal Loss:

Opening WIP 25,000 100% M ; 80% Conversion (Already tested)

Input 225,000
Closing WIP (35,000) 100% M : 60% Conversion (will be tested)

Inspections stage 100% M ; 80% Conversion.

(225,000 –35,000) x 7% = 13,300

Equivalent Production Unit table :

Material Conversion
25,000 - 5,000(20%)
Opening Units 200,000
175,000 175,000 175,000

Abnormal loss (75% Conversion) 1,700 1,275 (75%)

Closing WIP (60% Conversion) 35,000 21,000 (60%)
211,700 202,275

400 Page 12 of 12
Q.1 Mehnat Limited (ML) manufactures a product KLM which goes through two processes,Process
A and Process B. Following information pertains to process A for the month of February 2021:
kg Rs. in '000
Opening work in process (80% complete) 2,000 5,000
Materials added during the month 18,000 36,000
Conversion costs 12,000
Transferred to Process B 16,000 -
Closing work in process (60% complete) 3,000 -

Additional information relating to Process A:

(i) Costs of opening work in process consisted of Rs. 3,600,000 as to material and
Rs.1,400,000 as to conversion costs.
(ii) Materials are added at the start of the process and conversion costs are incurredevenly
throughout the process.
(iii) Process loss is determined on inspection which is carried out at 75% of completion.
(iv) Process loss is estimated at 12% of the input which is sold as scrap at Rs. 400 per kg.
(v) Inventory is valued using weighted average method.

Required:
(a) Prepare a statement of equivalent production units. (04)
(b) Compute the costs of finished goods, closing work in process and production gain/loss. (07)
(c) Prepare journal entries to record production gain/loss of process A for the month. (02)

Q.4 Standard Limited (SL) is in the business of buying and selling electric ovens. It follows perpetual
inventory system and uses weighted average method for valuation of inventory. Following
information is extracted from SL’s records for the month of February 2021:
(i) Opening inventory consisted of 220,000 units having average cost of
Rs. 7,000 per unit.
(ii) 280,000 units were purchased on 5 February 2021, at Rs. 7,200 per unit.
(iii) 180,000 units were sold to Khurram Limited (KL) on 10 February 2021.
(iv) 5,000 defective units were returned by KL on 12 February 2021.
(v) 30% of the defective units returned to SL, had a manufacturing fault and were returned
to the supplier on 15 February 2021. Remaining defective units were damaged due to
mishandling at the warehouse. These units were disposed of as scrap on 20 February
2021 for Rs. 2,000 per unit.
(vi) 5,000 units were sent to KL on 22 February 2021 in replacement of the defective units
returned.
(vii) 150,000 units were sold on 25 February 2021.

On 28 February 2021, a physical stock count was carried out and the following wasdiscovered:
▪ 4,500 units were identified as obsolete having net realizable value of
Rs.6,000 per unit.
▪ 500 units were found missing.

401 Page 1 of 7
Required:
Prepare necessary journal entries to record the above transactions relating to inventory. (09)
Q.5) Bright Limited (BL) is engaged in the manufacturing of two products, Shine and Glow. Both these
products are processed through two production departments, A and B, while department X and Y provide
services to both the production departments. Below is a summary of the indirect costs incurred by BL for
manufacture of 100,000 units of Shine and 60,000 units of Glow during the year ended 31 December 2020:
Rs. in '000
Salaries and wages 115,000
Depreciation of machinery 80,000
Building insurance 25,000
Electricity 60,000
280,000
Other information related to the four departments is given below:
Department Department Department Department Total
A B X Y
Cost of machinery
(Rs. in '000) 250,000 150,000 400,000
Floor Area (square feet) 15,000 6,000 6,000 3,000 30,000
No. of employees 150 50 25 25 250
Services provided by
− Department X 80% 20%
− Department Y 75% 15% 10%

The overhead absorption rates used by BL for allocation to Shine and Glow are Rs. 1,800 and Rs. 1,700 per
unit respectively. Any under/over absorbed overheads are adjusted to cost of sales.

Required:
(a) Compute product-wise actual overheads for Shine and Glow. (08)
(b) Compute the product-wise under/over absorbed production overheads. (02)

Q.7 Fine Limited (FL) is involved in manufacturing and distribution of various consumer products. Following
information pertains to one of its products, FGH for the year ended31 December 2020:

Rs. in'000’
Sales (500,000 units) 56,000
Material (Rs. 30 per kg) (22,500)
Skilled labour ( Rs. 125 per hour) (10,000)
Semi-skilled labour (Rs. 100 per hour) (5,000)
Production overheads (50% variable) (4,500)
Gross profit 14,000

The management of FL has decided to take following measures with respect to production of FGH for the
next year:

402 Page 2 of 7
 (i) Increase production volume by 10% to take advantage of increase in demand.Currently the plant for
FGH is operating at 80% of its capacity.
(ii) Purchase 60% of the material from FL’s associated company that has offered a bulk discount of 5%.
Additional wastage from this material is expected to be 1%.
(iii) Replace 40% of the skilled labour with semi-skilled labour. It is estimated that semi-skilled
labour will take 30% more time to do the work of skilled labour.
Impact of inflation on all costs would be 10%.

FL’s management also wants to maintain the same gross profit margin in 2021 as the previous year.

Required:
Compute the selling price per unit of FGH for the next year. (12)

A.1 a)
EQUIVALENT PRODUCTION UNITS:

Material Conversion
Process B 16,000 16,000 16,000

c/d WIP 3,000 3,000 1,800 (60%)

Ab. Gain 800 (800) (600) (75%)

18,200 17,200

Cost per unit:

Material= (3,600+36,000-720)/18,200 =2.14
Conversion cost = (1,400+12,000)/17,200 =0.78
Total =2.92
b) COST ALLOCATION:
Process B =16,000*2.92 =46,720
c/d WIP = (3,000*2.14+1,800*0.78) =7,824
Gain = 800 x 2.14 + 600 x 0.78 =2,180

c) JOURNAL ENTRIES:
Normal loss 720
Process B 720
Cash (1000*400) 400
Normal loss 400
Process B 2,180
Abnormal loss 2,180

403 Page 3 of 7
Abnormal gain 320
Normal loss 320
(720-400)
Abnormal gain 1,860
P/L 1,860

Workings for Entries:

NORMAL LOSS A/C
Units Amount Units Amount

Process B 1,800 720 Cash 1,000 400

(1,000*400)

Ab.gain 800 320

ABNORMAL GAIN A/C

Units Amount Units Amount

Normal loss 800 320 Process B 800 2,180

p/L 1,860

W-1)
PROCESS A/C –B
Units Amount Units Amount
b/d 2,000 5,000 Process B 16,000 46,720
Material 18,000 36,000 Normal loss 1,800 720
Conversion 12,000

Ab. Gain (bal.) 800 2,180 c/d 3,000 7,824

20,800 55,180 20,800 55,264

W-2) Working for normal loss:

Opening WIP 2,000 (100%M, 80%C)
Input 18,000
Closing WIP 3,000 (100%M,60%C)
Stage of inspection
100%M ;75%C
(18,000-3,000) *12%=1800

404 Page 4 of 7
A.4 Standard Limited
General Journal
Date Description Debit Credit
----------------- Rs. in '000 -----------------
05-Feb-2021 Inventory 2,016,000
Account payable 2,016,000
(Inventory purchased)
10-Feb-2021 Cost of goods sold 1,280,160
Inventory 1,280,160
(Sales made to KL)
12-Feb-2021 Inventory 35,560
Cost of goods sold 35,560
(Defective units returned by KL)
15-Feb-2021 Account Payable 10,800
Inventory 10,800
(Defective units returned to supplier)
20-Feb-2021 Cash (3,500×2,000) 7,000
Profit & loss account (Bal.) 17,891
Inventory 24,891
(Defective units sold as scrap)
22-Feb-2021 Cost of goods sold 35,558
Inventory 35,558
(Replacement of defective units to KL)
25-Feb-2021 Cost of goods sold 1,066,739
Inventory 1,066,739
(Sales made)
28-Feb-2021 Profit & Loss 3556
Inventory 3556

Cost of Sales
5,002
Inventory 5,002
(4500x(7,111,59-6,000))

Date Particulars Receipts/(Issues)

Quantity Rate Rs. in '000
01-Feb-21 Balance 220,000 7,000.00 1,540,000
05-Feb-21 Purchases 280,000 7,200.00 2,016,000
Balance 500,000 7,112.00 3,556,000
10-Feb-21 Sales to KL (180,000) 7,112.00 (1,280,160)
12-Feb-21 Returned by KL 5,000 7,112.00 35,560
15-Feb-21 Returned to supplier – defective (5000X (1,500) 7,200.00 (10,800)
30%)
Balance 323,500 7,111.59 2,300,600

405 Page 5 of 7
 20-Feb-21 Defective goods scrapped (3,500) 7,111.59 (24,891)
22-Feb-21 Replacement of defective to KL (5,000) 7,111.59 (35,558)
25-Feb-21 Sales (150,000) 7,111.59 (1,066,739)
28-Feb-21 Short inventory found in physical count (500) 7,111.59 (3,556)
Balance 164,500 7,111.59 1,169,856

A5) Bright Limited

Actual overheads for production of Shine and Glow
(a) Cost allocation to production department: Rs. in ‘’000’’

Production Service
Items Allocation basis Total departments departments
A B X Y
Salaries & wages No. of employees 115,000 69,000 23,000 11,500 11,500
(50/250)X
(150/250)X 115,00
115,000
Depreciation Cost of machine 80,000 50,000 30,000 - -
Building insurance Floor Area 25,000 12,500 5,000 5,000 2,500
Electricity Floor Area (assumed) 60,000 30,000 12,000 12,000 6,000
28,500 20,000
Service departments:
Department Y 75:15:10 20,000 15,000 3000 2000 (20,000)
30,500
Department X 80:20 30,500 24,400 6,100 (30,500)
200,900 79,100 - -

Cost allocation to Shine and Glow: Shine Glow Total

Actual units produced 100,000 60,000 160,000

Overheads allocation on the basis of units:

− Department A 125,563 75,337 200,900
100,000/160,00
0 X200,900
− Department B 49,437 29,663 79,100
100,000/160,0
00 X79,100
175,000 105,000 280,000

406 Page 6 of 7
(b) Under/over absorbed production overheads Rs.in ‘’000’’

Absorbed Actual Under/(Over)

overheads overheads absorbed
Shine @ Rs. 1,800 x 100,000 180,000 175,000 (5,000)
Glow @ Rs. 1,700 x 60,000 102,000 105,000 3,000
282,000 280,000 (2,000)

A.7
Fine Limited
Revised Sales Volume (500,000 x 1.1) 550,000 units
Rs. “000’’
Material – From Existing Suppliers 10,890
[550,000 x 1.5 (22,500,000 / 30 =750,000 kgs/ 500,000 units) x 40% x 30 x 1.1]
Material -from New supplier 15,675
(550,000 x 1.5 x 60% ÷ 99 x 100 x 30 x 1.1 x 95%)
Skilled Labor 7,260
[550,000 x 0.16 (10,000,000/125 = 80,000 hrs /500,000 units) x 60% x 125 x 1.1]
Semi-Skilled Labor 11,084
[550,000 x 0.16 x 40% x 1.3 x 100 x 1.1 + 550,000 x 0.1 ( 5,000,000/100 = 50,000 hrs
/500,000 units) x 100 x 1.1]
Variable OH 2,723
[550,000 x 4.5 (4,500,000 x 50% = 2,250,000/500,000 units) x 1.1]
Fixed OH [4,500,000 x 50% =2,250,000 x 1.1] 2,475
Total Cost 50,107
Total Sales [50,107 / 75 x 100] 66,809
Per Unit Sale Price [66,809,000 ÷ 550,000] 121.47

407 Page 7 of 7
Question 02
Yellow Limited (YL) is engaged in manufacturing and selling of three products that are Alpha, Beta and Gamma. YL
has recently received an order from an overseas customer for 3,000, 4,000 and 1000 kg of Alpha, Beta and Gamma
respectively. This order represents 25% of total demand for each of the three products. The management has
decided to consider this order as ‘high priority’ as it is expected that repeated orders would be received if the
customer is fully satisfied; therefore, this order would be fulfilled before any other order.

The per unit details of sales price, costs and direct labour hours required for each product are given below:
Alpha Beta Gamma
----------- Rupees ----------
Selling price 10,000 9,000 12,500

Specialized chemical 2,500 1,800 3,500

Direct labour 1,250 2,000 1,500
Variable production cost 250 200 500
*Fixed production cost 750 400 600
*Selling and administration costs (30% variable)
250 200 300
----------- Hours ----------
Direct labour hours required 6 5 8

*Fixed costs are allocated on the basis of expected demand

Each product requires specialized imported chemical. YL has been allowed to import that chemical maximum to Rs.
70 million per annum.

The management of YL is concerned over restrictions on import of specialised chemical in the existing country of
operation as any shortfall to meet demand cannot be fulfilled. One of the proposals is to shut-down the existing
plant and start manufacturing in Country X.

Following information is relevant if YL considers to start manufacturing in Country X:

(i) There is no import restriction on required chemical.
(ii) Direct labour hours required for manufacturing YL’s products are in short supply and available up to 100,000
hours only.
(iii) Any shortfall in the units can be met by sub-contracting to an outside supplier. The cost of buying each finished
product of Alpha, Beta and Gamma would be equivalent to Rs. 5,000, Rs. 4,500 and Rs. 7,500 respectively.
However, the order considered as ‘high priority’ would be manufactured by YL itself.
(iv) All other information unless otherwise specified would remain the same for Country X.
YL operates a just-in-time system and has no inventories of chemical or finished goods.

Required
a) Recommend whether YL should continue manufacturing in the existing country or start manufacturing from
Country X. Your recommendation should be based on profit maximizing production schedules. (15)
b) Discuss the non-financial factors that management would need to consider before deciding to sub-contract the
manufacturing of its products. (4)

408 Page 1 of 7
Ans.2
a) Continue manufacturing in existing country:
Demand
Alpha (3,000 ÷ 25%) =12,000
Beta (4,000 ÷ 25%) =16,000
Gamma (1,000 ÷ 25%) =4,000

Identification of limiting factor:

Specialized chemical
Availability 70,000,000

Required:
Alpha [12,000 × 2,500] 30,000,000
Beta [16,000 × 1,800] 28,800,000
Gamma [4,000 × 3,500] 14,000,000
72,800,000
It is a limiting factor.
Calculation of contribution per Rs. of limiting factor
Alpha Beta Gamma
Sale price 10,000 9,000 12,500
Variable Cost:
Specialized chemical 2,500 1,800 3,500
Direct labor 1,250 2,000 1,500
Variable production-OH 250 200 500
Variable selling-OH (30%) 75 60 90
(4,075) (4,060) (5,590)
Contribution per unit 5,925 4,940 6,910
Chemical cost per unit 2,500 1,800 3,500
Contribution per Rs. of chemical 2.37 2.74 1.97
Ranking 2nd 1st 3rd

Optimum production plan:

Chemical available for production 70,000,000
Special Order:
[3,000 × 2,500 + 4,000 × 1,800 + 1,000 × 3,500] (18,200,000)
Remaining chemical availability to be used in ranking 51,800,000
Beta [16,000 - 4,000] × 1,800 (21,600,000)
Remaining 30,200,000
Alpha [12,000-3,000] × 2,500 (22,500,000)
Remaining 7,700,000
Gamma [2,200(bal.)] × 3,500 (7,700,000)
` [7,700,000 ÷ 3,500] -

409 Page 2 of 7
Contribution that can be earned:
Alpha [12,000 × 5,925] = 71,100,000
Beta [16,000 × 4,940] = 79,040,000
Gamma [(1,000 + 2,200) × 6,910] = 22,112,000
Total 172,252,000

Manufacturing from country X:

Available direct labor hours = 100,000 hrs

Required direct labor hours:

Alpha (12,000 × 6) = 72,000 hrs
Beta (16,000 × 5) = 80,000 hrs
Gamma (4,000 × 8) = 32,000 hrs
Total hours 184,000
It is a limiting factor.
Alpha Beta Gamma
Variable cost of manufacturing per unit 4,000 4,000 5,500
[2,500 +1,250 +250] [1,800+2,000+200] [3,500+1,500+500]
Outsourcing cost per unit 5,000 4,500 7,500
Saving by manufacturing per unit 1,000 500 2,000
Direct labor hours per unit 6 5 8
Saving per labor hours 167 100 250
Ranking 2 3 1

Optimum production plan:

Available hours = 100,000
Special Order:
[3,000 × 6 + 4,000 × 5 + 1,000 × 8] = 46,000
Remaining hours 54,000

Utilization:
Gamma [3,000 × 8] = 24,000
Alpha [5,000(bal.) × 6] = 30,000

(30,000÷6)
To be purchased:
Alpha [12,000 - 3,000 - 5,000] = 4,000
Beta [16,000 - 4,000] = 12,000

Contribution that can be earned:

Contribution from manufacturing and sale:
Alpha [(3,000 + 5,000) × 5,925(from a)] = 47,400,000
Beta [4,000 × 4,940(from a)] = 19,760,000
Gamma [4,000 × 6,910(from a)] = 27,640,000

410 Page 3 of 7
Contribution from purchase and sale:
Alpha [4,000 × (10,000 - 5,000 - 75) = 19,700,000
Beta [12,000 × (9,000 - 4,500 - 60) = 53,280,000
Total 167,780,000
Decision:

YL should continue to produce in existing country.

(b) The management would need to consider following non-financial factors before deciding on sub- contracting
the manufacture of its products:
▪ The management may lose control over the quality and timely production/availability of product as it
would be highly relying on the supplier.
▪ The management may lose flexibility as it would be difficult to increase or reduce the supply of outsourced
products on short notice because of the fixed terms of the agreement with the supplier.
▪ A decision to outsource work may have implications for employment within the entity, and it may be
necessary to make some employees redundant. This will have cost implications, and could also adversely
affect relations between management and other employees.
▪ It might be appropriate to think about the longer-term consequences of a decision to outsource work.
What might happen if the entity changes its mind at some time in the future and decides either to bring
the work back in-house or to give the work to a different external supplier?
▪ It might be difficult to maintain competitive advantage from the work of the external supplier, since the
competitors can hire the same supplier as well.

Q.3
Following information pertains to one of the products ‘Violet’ of Blue Limited (BL), for the
month of August 2021:

(i) Production for the month was budgeted at 12,000 units. The standard cost per unit of Violet is
as follows:

Rupees
Direct materials:
Alpha – 4 kg 800
Beta – 6 kg 900
Direct labour – 2 hours 300
*Production overheads – 2 direct labour hours 260
*Fixed production overheads were estimated at Rs. 1.2 million based
on budgeted direct labour hours

411 Page 4 of 7
 (ii) Direct materials are added at the beginning of the production process. BL accounts for
material price variance at the time of issuance of material to production and uses FIFO method
for inventory valuation. Following information has been extracted from the stock cards of
Alpha and Beta:

Alpha Beta
Date Description kg Cost per kg kg Cost per kg
(Rs.) (Rs.)
1-Aug Opening balance 2,000 220 4,000 140
4,000 190 4,000 150
2-Aug Purchase returns (1,000) 190 - -
3-Aug Purchases 75,000 195 86,000 155
5-Aug Purchase returns - - (500) 140
7-Aug Issues to production (60,000) - (70,000) -

(iii) Conversion costs are incurred evenly throughout the process. Conversion costs incurred
for August 2021 are as under:

Rupees
Direct labour paid for 24,300 hours 4,000,000

Variable production overheads 2,000,000

Fixed production overheads 1,400,000

(iv) Actual sales for the month of August 2021 were 12,500 units. Details of opening and closing
inventories are hereunder:

Opening Closing
Finished goods 1,200 units 1,500 units
Work in process 1,000 units (60% complete) 500 units (80% complete)

(v) BL uses standard absorption costing system.

Required:
a) Prepare a statement of equivalent production units.(02)
b) Compute the following variances:
(i) Material price, Mix and Yield variances. (09)
(ii) Variable production overhead rate and efficiency variances. (04)
(iii) Fixed production overhead expenditure, efficiency and capacity variance.(05)

412 Page 5 of 7
A.1 violet Limited
Statement of Equivalent Units:
Material Conversion
F.G 12,800 1000 → -- 400 (1,000 × 40%)

11,800 → 11,800 11,800

Closing WIP 500 500 400 (1,000 × 80%)
12,300 12,600

W-1)
Finished goods
b/d 1,200 Sales 12,500
c/d 1,500
Production
(bal.)12,800

W-2)
Work in process A/C (Units)
b/d 1,000 F.G(from F.G) 12,800
c/d 500
Input (bal.)
12,300

b) (i) Material price variance:

ALPHA:
(SR-AR) X AQU for A.P
(200*-220) x2,000 =40,000 A
(200-190) x3,000 =30,000 F
(200-195) x55,000 =275,000 F
*800/4 60,000 265,000 F
BETA:
(SR-AR) X AQU for A.P
(150*-140) x3,500 =35,000 F
(150-150) x4,000 - -
(150-155) x62,500 =312,500 A
*900/6 70,000 277,500 A

(ii) Material Mix Variance:

Alpha (52,000-60,000)X200 = 1,600,000 A
Beta (78,000-70,000)x150 = 1,200,000 F
400,000 A

413 Page 6 of 7
Material Yeild Vaiance:
Alpha (49,200-52,000)X200 = 560,000 A
Beta (73,800-78,000)x150 = 630,000 A
1,190,000 A
Working:
SQ in SM for AP AQ in SM for AP AQ in AM for AP
Alpha 49,200 52,000 60,000
(12,300 x 4) (130,00 x 4/10)
Beta 73,800 78,000 70,000
(12,300 x 6) (130,000 x 6/10)
123,000 130,000 130,000

(ii)
Variable Overhead

Expenditure Efficiency
(SR – AR) × AHW (SHW – AHW) × S.R
(80 – 2,000,000/24,300)x24,300 [(12,600 × 2) – 24,300]× 80
56,000 A 72,000 F
Working:
Std.Production OH rate/hr (260/2) = 130
Std.Fixed OH rate/hr (1,200,000/(12,000x2)) = (50)
Std.Variable OH rate/hr 80

(iii) Fixed Production Overhead:

Expenditure Variance :
Actual fixed overheads 1,400,000
Budgeted fixed overheads 1,200,000
200,000 A

Efficiency Capacity

Std.hrs for A.P x S.R Budgeted capacity hrs x S.R

((12,600x2)x50) = 1,260,000 (12,000x2=24,000x50) =1,200,000
Acual consumed hrs x S.R Actual consumed hrs x S.R
(24,300x50) = 1,215,000 (24,300 x 50) = 1,215,000

45,000 F 15,000 F

414 Page 7 of 7
Activity Based Costing
Activity based costing (ABC) is alternative technique to traditional absorption costing technique, which is used to
absorb indirect cost to products. It is a costing method that assigns indirect cost to products based on each product’s
use of activities. In simple words, in ABC, “Products consume activities and activities consume resources”.

ABC involves the process of identification of the factors which results the costs of an organisation’s major activities
(Cost Pools). Overheads are allocated and apportioned to activity cost centres or cost pool. The overhead costs are
ultimately absorbed into product on the basis of usage of activities. Products using more activities should be
charged with high cost of respective ‘cost pool’ cost.

Activity based costing can be defined as: “method of costing which involves identifying the costs of the main
support activities and the factors that drive the costs of each activity. Support overheads are charged to products
by absorbing cost on the basis of the product’s usage of the factor driving the overheads.”

REASONS FOR THE DEVELOPMENT OF ACTIVITY BASED COSTING

Absorption costing is based on the fact that production overheads are driven by units of products as higher units will
be produced, higher production overheads are absorbed into products. These are normally absorbed into products
on the basis of volume i.e. labour hours, machine hours etc. However, activity-based costing is based onvarious cost
driver rates because of the following.

Traditional absorption costing was developed in a time when most manufacturers produced small range of
products which underwent similar operations. It was justified to include similar proportion of overheads into
product cost. In addition, overhead costs comprised of small fraction of total production cost. With the introduction
of advanced manufacturing technologies or computer-aided manufacturing, the proportion of indirect costs were
increased significantly. The drastic shift from direct to indirect cost requires more complex system of absorption and
therefore, ABC was developed in order to calculate realistic cost of product.

In the past, most of the manufacturing was considered as labour-intensive and machine depreciation cost was
not significant, but with introduction of modern manufacturing environment, the dependence on machines was
enhanced, resulting higher depreciation cost. It increased the indirect cost to higher extent than direct cost
because of manufacturing environment was shifted from labour-intensive to machine-intensive.

COST POOL AND COST DRIVER

Cost Pool
A cost pool is an activity which consumes resources and for which overheads costs are identified and allocated.
The term activity and cost pool are often used interchangeably.

For example, set up or batch cost is cost pool. More cost will be incurred in case more batches are produced.

Cost Driver
A cost driver is a factor that influences or drives the level of cost of an activity(means cost pool). For example, number
of batches is the cost driver as increase in number of batches will influence or drive the set-up cost.

415 Page 1 of 12
Following table explains the relation of cost pool and cost driver:

Cost Pool (Activity) Cost driver

Machine set up cost Number of set ups or batches
Materials handing cost Number of production runs
Dispatching cost Number of orders dispatched
Ordering cost Number of customer’s orders
Machine operational cost Number of machine hours
Production scheduling cost Number of production runs

COSTING UNDER ACTIVITY BASED COSTING

Cost of product can be calculated under activity-based costing with help of five basic steps:
Step-I Identify major activities that support manufacturing
Step-II Accumulate overhead costs of each activity. This accumulated cost of each activity is called as cost of cost
pool]
Step-III identify cost drivers of each cost pool
Identify the factors which determine the size of the costs of an activity.
Step-IV calculate absorption rate of each activity as = Amount of Cost pool / cost drivers.
Step-V Absorb the activity costs into products after charging overhead costs on the basis of their usage of the
activity.

ABC COSTING COMPREHENSIVE EXAMPLES

Example 01:
JAM Enterprises, is engaged in the manufacturing of fishing equipment for fishing industry sincea decade. Recently,
some of other manufacturers newly entered in to the same business of JAM Enterprises. As a result, a price
competitive situation has occurred in the market, to handle this situation JAM Enterprises wants to offer best prices
for the products as compare to competitors;JAM Enterprises changed its costing approach to ABC, from traditional
Absorption costing approach. [In absorprtion costing, a single overhead absorption rate is calculated based on total
overheads]

The following budgeted information is related to JAM Enterprises for the forth coming period:

Product J Product A Product M

Sales and production (units) 30,000 20,000 10,000
Selling price per unit 4,600 9,600 7,400
Prime cost per unit 3,100 8,300 6,400
Machine hours per unit 2.5 5.5 4.5
Labor hours per unit 7.5 3.5 3.5

416 Page 2 of 12
The overheads of each activity (means cost pools) for the purpose of Activity based costing,are as follows:

Activity [Cost pool] Cost pool Cost driver* Cost driver volume
Rs. 000 (Quantity) for the period
Machine services 18,400 Machine hours 230,000 machine hours
Assembly services 18,150 Direct labour hours 330,000 direct labor hours
Set-up costs 1,200 Set-ups 250 set ups
Order processing 7,200 Customer orders 16,000 customer orders
Purchasing 4,004 Supplier orders 5,600 supplier orders
Following estimates have also been provided for the period:

Cost drivers Product J Product A Product M Total

Number of set-ups 70 100 80 250
Number of customer orders 4,800 4,500 6,700 16,000
Number of supplier orders 1,800 2,200 1,600 5,600
Required: Calculate the product-wise profit statement, using activity-based costing.
*Cost driver means a factor that influence the cost of an activity.

Example 02:
Rizwan Industries has six standard products from stainless steel and brass. The company’s mostpopular product is RI-
11 and following budgeted data is given for product RI-11.

Activity(cost pool) Cost driver Cost driver Cost pool Rs.

volume/year
Purchasing costs Purchase orders 15,000 750,000
Setting costs Batches produced 28,000 1,120,000
Material handling costs Material requisition 80,000 960,000
Inspection costs Inspections 28,000 700,000
Machining costs Machine hours 500,000 1,500,000

Rizwan manufacturing industries data relating to RI-11 for the month of July, 2021 is given below.
Description
Purchase orders 25
Output in units 15,000
Production batch size in units 100
Material requisition per batch 6
Inspections per batch 1
Machine hours per unit 0.1

Required: Calculate the unit overhead cost of product RI-11 using activity-based costing.

417 Page 3 of 12
Example 03:
Giga Incorporations is at the leading edge of paint-spraying technology. It has three Products G-101, G-102 and G-103
respectively. Product G-101 requires 6 coats of paint per unit, product G-102 requires 4 coats of paint per unit and
product G-103 requires 3 coats of paint per unit. All products are of different shapes and sizes therefore, different
quantities of paint are needed. Paint is delivered in batches of various sizes, depending upon the finishing required.

Products Litres per unit

G-101 7
G-102 5
G-103 4

Production details for each product are budgeted as follows for the coming month:
Description G-101 G-102 G-103
Units sprayed 500 400 300
Total batches of paint required 10 8 6
Machine attendant time in minutes per 45 60 50
unit
Cost of paint per unit Rs. 550 500 450

Machine attendants are paid Rs. 86 per hour.

Estimated overheads in the coming month are given below:

Rupees
Paint stirring and quality control 50,000
Electricity 150,000
Filling of spraying machines 90,000

Cost drivers used for each activity are as follows:

Activity [cost pool] Cost driver*

Paint stirring and quality control Batches of paint
Electricity Coats of paint
Filling of spraying machines Litres of paint
Required: Calculate the unit cost of each product using activity-based costing.

*Cost driver means a factor that influence the cost of an activity.

418 Page 4 of 12
Example 04:
Mustajab Limited manufacturers four products, A, B, C and D. Output and cost data for the period just ended are as
follows:

Number of Material cost Direct labour Machine hours

Products Output production runs per unit Rs. hours per unit per unit
units

A 10 2 200 10 10
B 10 2 800 30 30
C 100 5 200 10 10
D 100 5 800 30 30
Overhead costs are given as under:

Cost pools (Activity) Rs. Cost

drivers
Short run variable costs 30,800 Machine hrs
Set up costs 109,200 Production runs
Expediting and scheduling costs 91,000 Production runs
Material handling costs 77,000 Production runs
Total 308,000
Labour cost per hour is Rs. 5.

Required: Calculate unit cost for each product using Activity based costing.

Example 05:
Star Limited produces three products, Sky, Moon and Sun and relevant data for the month of March 2021 is
given in the following table.

Sky Moon Sun

Actual units produced and sold 500,000 150,000 250,000
Machine hours per unit 0.01 0.05 0.04
Number of production set-ups 3 1 26
Number of components 8 12 20
Number of customer orders 21 4 25

419 Page 5 of 12
The overhead cost incurred by Star Limited during the month of March 2021 is given below.

Activity Rupees Cost drivers

Machining cost 36,000 Machine hours
Component cost 100,000 Number of components
Set-up cost 180,000 Number of set ups
Packing cost 150,000 Number of orders
Total 466,000
Required: Using ABC, calculation of product-wise overhead cost in total and per unit.

Example 06:
Rajput Enterprises manufactures two products, J and K, using the same equipment and similar processes. An extract
of the production data for these products for the month of June is shown below:

Product J Product K
Quantity produced in units 5,000 7,000
Direct labour hours per unit 1 2
Machine hours per unit 3 1
Set-ups in the period 10 40
Orders handled in the period 15 60

Overhead costs for the month of June are given below:

Activity Rupees Cost drivers

Machine related costs 220,000 Machine hours
Production run set-ups costs 20,000 Number of set ups
Order handling costs 45,000 Number of orders
Total 285,000

Required:
Production overheads absorbed by one unit of each product using Activity based costing.

420 Page 6 of 12
MERITS AND DEMERITS OF ACTIVITY BASED COSTING
Merits
1. The complexity of manufacturing has increased due to use of advance technologies and multiple products range,
along with shorter product life cycles. Activity based costing recognizes this complexity with multiple cost
drivers.
2. Activity based costing technique helped entities to absorb indirect costs into products on the basis of activities
in order to calculate realistic product cost.
3. Activity based costing can be applied to all overhead costs, and not restricted to production overheads [e.g.
dispatching cost].
4. Activity based costing can be used easily in service costing as in product costing.
Demerits
1. Activity based costing will be of limited benefit if overhead costs are not significant proportion of total costs.
2. The cost of implementing and maintaining an activity-based costing system might exceed the benefits of
improved accuracy in product or service costs.
3. This model is difficult to understand.
4. The choice of both activities and cost drivers might be inappropriate.

Comprehensive examples answers:

Answer 01:
Product-wise profit Statement
Product J Product A Product M
Rupees in thousands
Sales W-1 138,000 192,000 74,000
Less: Prime costs W-2 (93,000) (166,000) (64,000)
Less: Overheads W-3 (22,158) (16,728) (10,068)
Profit 22,842 9,272 (68)
W-1 Sales
Products Units Sales price Rs. Sales in Rs. 000
Product J 30,000 4,600 138,000
Product A 20,000 9,600 192,000
Product M 10,000 7,400 74,000

W-2 Prime cost

Products Units Prime cost per unitRs. Prime cost in Rs.
000
Product J 30,000 3,100 93,000
Product A 20,000 8,300 166,000
Product M 10,000 6,400 64,000

421 Page 7 of 12
W-3 Overhead cost
Cost drivers Product J Product A Product M Total

Machine hours W-4 75,000 110,000 45,000 230,000

Labour hours W-5 225,000 70,000 35,000 330,000

Number of set-ups (Given) 70 100 80 250

Number of customer orders (Given) 4,800 4,500 6,700 16,000

Number of supplier orders (Given) 1,800 2,200 1,600 5,600

Cost absorbed: Rupees in thousands

Machine services (75,000/230,000 x 18,400) 6,000 8,800 3,600 18,400

Assembly services 12,375 3,850 1,925 18,150

(225,000/330,000 x 18,150)
Set-up costs (70/250 x 1,200) 336 480 384 1,200

Order processing 4,800/16,000 x 7,200) 2,160 2,025 3,015 7,200

Purchasing (1,800/5,600 x 4,004) 1,287 1,573 1,144 4,004

Total overhead costs 22,158 16,728 10,068 48,954

W-4 Machine hours

Products Units Machine hours per unit Machine hours total

Product J 30,000 2.5 75,000
Product A 20,000 5.5 110,000
Product M 10,000 4.5 45,000
Total: 230,000

W-5 Labour hours

Products Units Labour hours per unit Labour hours total

Product J 30,000 7.5 225,000
Product A 20,000 3.5 70,000
Product M 10,000 3.5 35,000
Total: 330,000

422 Page 8 of 12
 Answer 02:
Overhead Cost per unit of Product RI-11

Rupees
Purchasing costs (750,000/15,000 x 25) 1,250
Setting costs (1,120,000/28,000 x 150 (W.1) 6,000
Material handling costs (960,000/80,000 x 900 10,800
(W-2)
Inspection costs (700,000/28,000 x 150 (W.3) 3,750
Machining costs (1,500,000/500,000 x 1,500 (W.4) 4,500
Total overhead cost (A) 26,300
Units produced (B) 15,000
Unit cost [26,300 ÷ 15,000] 1.75
Workings:
W-1) No of batches = 15,000 /100 = 150
W-2) No of material requisitions =150 x 6 =900
W-3) No of Inspections = 1 x 150 =150
W-4) Machine hrs. 15,000 x 0.1 = 1,500

Answer 03:
Calculation of Cost per unit of each product

G-101 G-102 G-103

Paint (Given) 550.00 500.00 450.00
Labour at Rs. 86 per hour (45/60 x 86) 64.50 86.00 71.67
Paint stirring and quality control W-1 41.67 41.67 41.67
Electricity W-2 163.64 109.09 81.82
Filling of spraying machines W-3 94.03 67.16 53.73
913.84 803.92 698.89
Unit cost
W-1 Paint stirring and quality control

Description G-101 G-102 G-103 Total

Units (A) 500 400 300
Batches (Given) 10 8 6 24
Share of overheads (10/24 x 50,000) 20,833 16,667 12,500 50,000
Unit cost (B)/(A) [20,833 ÷ 500] 41.67 41.67 41.67

423 Page 9 of 12
 W-2 Electricity

Description G-101 G-102 G-103 Total

Units (A) 500 400 300
Coats per unit (B) 6 4 3
Total coats (A) x (B) 3,000 1,600 900 5,500
Share of overheads (3,000/5,500 x 150,000) 81,818 43,636 24,546 150,000
Unit cost [81,818 ÷500] 163.64 109.09 81.82
W-2 Filling of spraying machine

Description G-101 G-102 G-103 Total

Units (A) 500 400 300
Liters per unit (B) 7 5 4
Total litres (A) x (B) 3,500 2,000 1,200 6,700
Share of overheads [3,500/6,700 x 90,000] 47,015 26,866 16,119 90,000
Unit cost [47,015 / 500] 94.03 67.16 53.73

Answer 04:
A B C D Total

Amount in Rupees

Direct materials [10 x 200] 2,000 8,000 20,000 80,000

Direct labour [10 x 10 x5] 500 1,500 5,000 15,000

Production overheads:

Short run variable cost W-1 (10 x 10=100/4,400 x 700 2,100 7,000 21,000 30,800
30,800)
Set up costs W-1 (2/14 x 109,200) 15,600 15,600 39,000 39,000 109,200

Expediting and scheduling costs W-1 (2/14 x 13,000 13,000 32,500 32,500 91,000
91,000)
Materials handling costs W-1 (2/14 x 77,000) 11,000 11,000 27,500 27,500 77,000

Total cost (A) 42,800 51,200 131,000 215,000

Units produced (B) 10 10 100 100

Unit cost (A) / (B) 4,280 5,120 1,310 2,150

424 Page 10 of 12
 W-1

Activity Cost pool Cost Driver Rate of cost pool

Rs. per cost driver
Short run variable costs 30,800 4,400 machine hours Rs. 7
[(10 x 10=100) + (10 x 30=300) + (100 per machine hour
x 10 = 1,000) + (100 x 30 = 3,000)]
Set up costs 109,200 14 production runs Rs. 7,800
(2+2+5+5) per production run
Expediting and 91,000 14 production runs Rs. 6,500
scheduling costs per production run
Material handling costs 77,000 14 production runs Rs. 5,500
per production run

Answer 05

Sky Moon Sun Total

Machining cost (5,000(W.2)/22,500 (W.2) x 8,000 12,000 16,000 36,000
36,000)
Component cost (8/40(W.2) x 100,000) 20,000 30,000 50,000 100,000
Set-up cost (3/30 (W.2) x 180,000) 18,000 6,000 156,000 180,000
(1 x 6,000) (26 x 3,000)
Packing cost (21/50(W.2) x 150,000) 63,000 12,000 75,000 150,000
Total overhead cost (A) 109,000 60,000 297,000
Units produced (B) 500,000 150,000 250,000
Unit cost (A) / (B) 0.22 0.4 1.19

W-1
Activity Cost pool Rs. Cost Driver Rate per cost driver
Machining cost 36,000 22,500 machine hours Rs. 1.60 per machine hour
W-2
Component cost 100,000 40 components Rs. 2,500 per component
(8+12+20)
Set-up cost 180,000 30 set-ups Rs. 6,000 per set up
(3+1+26)
Packing cost 150,000 50 orders Rs. 3,000 per order
(21+4+25)

425 Page 11 of 12
W-2 Machine hours

Products Units produced Machine hours per unit Machine hours

Sky 500,000 0.01 5,000
Moon 150,000 0.05 7,500
Sun 250,000 0.04 10,000
Total 22,500

Answer 06:

Product J Product K
Machine related costs (5,000x3/22,000 x 220,000) 150,000 70,000
Production run set-ups costs (10/50 x 20,000) 4,000 16,000
Order handling costs (15/75 x 45,000) 9,000 36,000
Total overhead cost (A) 163,000 122,000
Units produced (B) 5,000 7,000
Unit cost (A) / (B) 32.60 17.43
W-1

Activity Cost pool Cost Driver Rate per cost driver

Rs.
Machine related costs 220,000 22,000 machine hours Rs. 10
(5,000x3+7,000x1) per machine hour

Production run set-ups costs 20,000 50 set ups Rs. 400

(10+40) per set up
Order handling costs 45,000 75 orders handled Rs. 600
(15+60) per order

426 Page 12 of 12
Activity Based Costing
Question no. 1: Linacre Cooperates an activity-based costing system and has forecast the following information for
next year.
Cost Pool Cost Cost Driver Number of Drivers
Production set-ups 105,000 Set-ups 300
Product testing 300,000 Tests 1,500
Component supply and storage 25,000 Component orders 500
Customer orders and delivery 112,500 Customer orders 1,000

General Fixed overheads such as lighting and heating, which cannot be linked to any specific activity, are expected
to be 900,000 and these overheads are absorbed on a direct labor hour basis. Total direct labor hours for next year
are expected to be 300,000 hours.

Linacre Co expects orders for Product ZT3 next year to be 100 orders of 60 units per order and 60 orders of 50
units per order (total units = 100 x 60 + 60 x 50 = 9000). The company holds no inventories of Product ZT3 and will
need to produce the order requirement in production runs of 900 units (which means total 9000 units/900 units in
a run = 10 setups). One order for components is paced prior to each production run. Four tests are made during
each production run to ensure that quality standards are maintained. The following additional cost and profit
information relates to Product ZT3:
Component cost 1 per unit
Direct labour 10 minutes per unit at 7.80 per hour
Profit mark up: 40% of total unit cost

Required:
(a) Calculate the activity-based recovery rates for each cost pool.
(b) Calculate the total unit cost and selling price of Product ZT3.

Question no.2: Triple Limited makes three types of gold watch – the Diva (D), the Classic (C) and the Poser (P). A
traditional product costing system is used at present; although an activity-based costing (ABC) system is being
considered. Details of the three products for a typical period are:
Hours per unit Materials cost per Production units
unit
Product D ½ 1½ 20 750
Product C 1½ 1 12 1,250
Product P 1 3 25 7,000

Direct labor cost Rs. 6 per hour and production overheads are absorbed on a machine hour basis. The overhead
absorption rate for the period is 28 per machine hour.

Required
(a) Calculate the cost per unit for each product using traditional methods, absorbing overheads on the basis of
machine hours.

427 Page 1 of 7
Total production overheads are 654,500 and further analysis shows that the total production overheads can be
divided as follows:
%
Costs relating to set-ups 35
Costs relating to machinery 20
Costs relating to materials handling 15
Costs relating to inspection 30
Total production overhead 100

The following total activity volumes are associated with each product line for the period as a whole:
Number of set-ups Number of movements of materials Number of inspections
Product D 75 12 150
Product C 115 21 180
Product P 480 87 670
670 120 1,000

Required
(b) Calculate the cost per unit for each product using ABC principles (work to two decimal places).
(c) Explain why costs per unit calculated under ABC are often very different to costs per unit calculated under
more traditional methods. Use the information from the above to illustrate.

Question no. 3: Brick by Brick (BBB) is a building business that provides a range of building services to the public.
Recently they have been asked to quote for garbage conversions (GC) and extensions to properties (EX) and have
found that they are winning fewer GC contracts than expected.

BBB has a policy to price all jobs at budgeted total cost plus 50%. Overheads are currently absorbed on a labour
hour basis. BBB thinks that switch to activity-based costing (ABC) to absorb overheads would reduce the cost
associated to GC and hence make them more competitive.

You are provided with the following data:

Overhead category Annual overheads Activity driver Total number of activities
per year
Supervisors 90,000 Site visits 500
Planners 70,000 Planning documents 250
Property related 240,000 Labour hours 40,000
Total 400,000

A typical GC costs 3,500 in materials and take 300 labour hours to complete. A GC requires only one site visit by a
supervisor and needs only one planning document to be raised. The typical EX costs 8,000 in materials and takes
500 hours to complete. An EX requires six site visits and five planning documents. In all cases labour is paid 15 per
hour.

Required
(a) Calculate the cost and quoted price of a GC and of an EX using labour hours to absorb the overheads.
(b) Calculate the cost and the quoted price of a GC and of an EX using ABC to absorb the overheads.

428 Page 2 of 7
Question no. 4 Jola Publishing Co publishes two forms of book.

The company publishes a children’s book (CB), which is sold in large quantities to government-controlled schools.
The book is produced in only four large production runs bud goes through frequent government inspections and
quality assurance checks.

The paper used is strong, designed to resist the damage that can be caused by the young children it is produced
for. The book has only few words and relies on pictures to convey meaning.

The second book is a comprehensive technical journal (TJ). It is produced in monthly production runs, 12 times a
year. The paper used is of relatively poor quality and is not subject to any governmental controls and consequently
only a small number of inspections are carried out. The TJ uses far more machine hours than the CB in its
production.

The directors are concerned about the performance of the two books and are wondering what the impact would
be of a switch to an activity-based costing (ABC) approach to accounting for overheads. They currently use
absorption costing, based on machine hours for all overhead’s calculations. They have produced an analysis for the
coming year as follows:
CB TJ
per unit per unit
Paper (400g @ 2 per kg) 0.80 (100g @ 1 per kg) 0.10
Printing ink (50ml @ 30 per liter) 1.50 (150ml @ 30 per liter) 4.50
Machine costs (6 mins @ 12 per hour) 1.20 (10 mins @ 12 per hour) 2.00
Overheads (6 mins @ 24 per hour) 2.40 (10 mins @ 24 per hour) 4.00
Total cost 5.90 10.60
Selling price 9.30 14.00
Margin 3.40 3.40

The main overheads are:

Overhead Activity driver
Property costs Machine hours
Quality control Number of inspections
Production set up costs Number of set ups

As mentioned above there are three main overheads, the data for these are:
Overhead Annual cost for the coming year
Property costs 2,160,000
Quality control 668,000
Production set up costs 52,000
Total 2,880,000

The CB will be inspected on 180 occasions next year, whereas the TJ will be inspected just 20 times. Jola Publishing
will produce its annual output of 1,000,000 CBs in four production runs and approximately 10,000 TJs per month in
each of production runs.

429 Page 3 of 7
Required:
Calculate the cost per unit and the margin for the CB and the TJ using activity-based costing principles to absorb
overheads.

Ans 1.
(A) ABC Recovery rates for each cost pool:
Cost Pool Cost Cost Driver Number of Driver ABC Recovery Date
Production set ups 105,000 Set-ups 300 350 per set-up
Product testing 300,000 Tests 1,500 200 per test
Component supply and 25,000 Component 500 50 per order
storage orders
Customer orders and 112,500 Customer 1,000 112.50 per order
delivery orders

(B) Total unit cost and selling price for a product ZT3:
Cost Workings Rs/unit
Component cost 1.00 Unit cost as stated
Direct labour 2 1.30 (10/60 x 7.8)
General O/H 3 0.50
Overheads 4 3.33
Total unit cost 6.13
Mark-up 2.45 At 40% of total unit cost
Selling price 8.58

Workings:
1- Orders. 100 orders x 60 units + 60 orders x 50 units = 9,000 units
2- 10 minutes per unit at 7.80 per hour = 10/60 x 7.80 = 1.30 per unit
3- 900,000 / 300,000 = 3/ direct labour hour
9000 x 10/60 = 1,500 direct labour hours spent on manufacture (10 minutes per unit)
[1,500 x 3 /9,000] = 0.50/unit.
4- Set ups. 9,000 units / 900 units = 10 set ups. So, 350 x 10 = 3,500. Divide by 9,000 units gives 0.39/ unit.
Product test. 4 test per run x 10 runs = 40 test x at 200/test = 8,000 annual cost. Divide by 9,000 units gives
0.89/ unit
Component supply. 1 order per run x 10 runs = 10 orders. At 50 per order = 500 annual cost. Divide by 9,000
units gives 0.056/units.
Customer supply. 160 orders x 112.50 /order = 18,000 annual cost. Divide by 9,000 units gives 2/unit.
Total overhead cost from cost pools.
This is (0.39 + 0.89 + 0.056 + 2) = 3.34/unit.

430 Page 4 of 7
 Ans 2-
(A) Traditional cost per unit:
Product D Product C Product P
Material 20 12 25
Labour @ 6 per hour (0.5 x 6) 3 9 6
Direct costs 23 21 31
Production Overhead @ 28 per machine hour (1.5 x 28) 42 28 84
Total production cost per unit 65 49 115

(B) Total machine hours (needed as the driver for machining overhead)
Product Hours/unit Production units Total hours
D 1 .5 750 1,125
C 1 1,250 1,250
P 3 7,000 21,000
Total Machine hours 23,375

Analysis of total overheads and cost per unit of activity:

Type of Driver % Total Overhead Level of Driver Cost/driver
overhead Activity
Set-ups Number of set-ups 35 229,075 670 341.90
Machining Machine hours 20 130,900 23,375 5.60
Materials Material movements 15 98,175 120 818.13
handling
inspection Number of inspections 30 196,350 1,000 196.35
100 654,500

Total Overheads by product and per unit:

Product D Product C Product P Total
Activity Cost Activity Cost Activity Cost Activity Cost
Overhead
Set-ups 75 25,643 115 39,319 480 164,113 670 229,075
Machining 1,125 6,300 1,250 7,000 21,000 117,600 23,375 130,900
Materials 12 9,817 21 17,181 87 71,177 120 98,175
handling
Inspection 150 29,453 180 35,343 670 131,554 1,000 196,350
Total overhead 71,213 98,843 484,444 654,500
cost
Units produced 750 1,250 7,000
Costs per unit 94.95 79.07 69.21

431 Page 5 of 7
Cost per unit Product D Product C Product P

Direct cost (from A) 23.00 21.00 31.00

overheads 94.95 79.07 69.21
Total 117.95 100.07 100.21

(C) Summary
Product D Product C Product P
Production units 750 1,250 7,000
Conventional overhead 42 28 84
cost
ABC overhead cost 95 79 69

This table shows that overheads for products D and C are higher using activity-based costing and those of
product P are lower. This reflects the different volume of activities involved in making each product. Using
conventional costing, product P absorbs a high proportion of overheads as it takes more machine hours to
produce and it is a high-volume product. However, machinery costs are only 20% of total overheads so this
does not fairly reflect the costs involved in making this product.

Ans 3-
(A) Cost and Quoted prices for the GC and the EX using labour hours to absorb overheads
GC EX
Material 3,500 8,000
Labour 300 hrs.x15/hr. 4,500
500hrs x 15/hr. 7,500
Overheads 300hrsx10/hr.(W1) 3,000
500hrs x 10/hr. 5,000
Total cost 11,000 20,500
Quoted price (x 150%) 16,500 30,750

Workings:
Overheads Absorption rate is calculated as 400,000/ 40,000 hrs. = 10/hr.

(B) Cost and Quoted prices for the GC and the EX using ABC to absorb overheads
GC EX
Material 3,500 8,000
Labour 300 hrs.x15/hr. 4,500
500hrs x 15/hr. 7,500
Overheads
-Supervisors (W2)/(W3) 180 1,080
-Planner (W2)/(W3) 280 1,400
-Property (W2)/(W3) 1,800 3,000
Total cost 10,260 20,980
Quoted price (10,260/100 x 150%) 15,390 31,470

432 Page 6 of 7
Workings:
2- Cost drivers
Costs Number of drivers Cost per driver
Supervisors 90,000 500 180
Planner 70,000 250 280
Property 240,000 40,000 6

3- Cost per product:

Supervisor Planner Property
Cost per drivers (W2) 180 280 6
GC 180 x 1 = 180 280 x 1 = 280 6 x 300 = 1,800
EX 180 x 6 = 1,080 280 x 5 = 1400 6 x 500 = 3,000

Ans 4.
Number of machine hours
CB
1,000,000 units x 6 mins/60 = 100,000 hours
TJ
(10,000 x 12) units x 10 mins /60 = 20,000 hours
Total = 120,000
Cost per Driver:
Cost pool Cost Quantity of cost Rate per cost Driver
Drivers
Property cost 2,160,000 120,000 18 Per machine hour
Quality control 668,000 200 3,340 Per number of
inspections
Production set-up 52,000 16 3,250 Per setup

ABC overheads
Cost pool Cost Quantity of cost Drivers
Property cost (100,000 x 18) 1,800,000 360,000
Quality control (180 x 3340) 601,200 66,800
Production set-up (4 x 3250) 13,000 39,000
Total 2,414,200 465,800
Production level 1,000,000 120,000
(10,000 x 12)
Cost per Unit 2.41 3.88

Cost per Unit and margin using ABC:

CB TJ
Direct cost (0.8 + 1.5 + 1.2) 3.50 6.60
(0.1 + 4.5 + 2)
Overheads 2.41 3.88
Total cost 5.91 10.48
Sale price (given) 9.30 14.00
Margin 3.39 3.52

433 Page 7 of 7
Spring - 2022 [CMA]
Q.1 Nigeria Limited (NL) is involved in trading of various consumer goods. It purchases one of its products
'Silver' from a local supplier in batches of 3,000 kg using the EOQ model. NL receives the delivery in two
weeks of placing the order. Below are the details related to Silver'sdemand:

Demand duringlead Probability

time (kg)
1,000 35%
1,500 45%
2,000 20%

Annual holding cost of Silver is Rs. 25 per kg and contribution margin is Rs. 10 per kg.NL operates for 48
weeks each year.

Required:
Suggest which of the following reorder levels would be financially beneficial for NL:
(i) Average demand during lead time
(ii) 1,600 kg (08)

Q.2 Denmark Ice Cream (DIC) runs various ice cream parlors across the city. Below is the average weekly
information extracted from DIC's records:

Rs. in '000
Sales 500
Variable cost (350)
Fixed cost (100)
Profit 50

DIC is now planning to introduce frozen yogurt in addition to its existing ice cream range to attract more
customers. In this regard, following information has been gathered:
(i) Sale of 800 frozen yogurt cups every week is expected to be achieved at selling price of Rs. 190 per
cup. It is expected that introduction of frozen yogurt would also increase the sales volume of ice
cream by 10%.
(ii) Variable cost of frozen yogurt will be Rs. 150 per cup.
(iii) Fixed cost will increase by 12% due to launching of marketing campaign for frozen yogurt.
(iv) DIC's target is to achieve a profit margin of 14% after introducing frozen yogurt.

Required:
(a) Compute the cost gap. (03)
(b) Discuss the methods that DIC can use to close the cost gap identified in (a) above. (04)

434 Page 1 of 22
Q.3 Argentina Limited (AL) is involved in the production of a single product 'Zinc' which requires highly
skilled labour. AL’s budgeted production for the year is 120,000 units. The break-up of existing
variable cost per unit of Zinc is as follows:

Rupees
Raw material (4 kg @ Rs. 100 per kg) 400
Skilled labour (1.5 hours @ Rs. 200 per hour) 300
Variable overheads 125
825

Presently, there is a shortage of skilled labour in the market and consequently the management of AL foresees
a high labour turnover. In case of high labour turnover, AL would be required to hire substitute labour at
the existing wage rate which would cause the following inefficiencies:

(i) Increase of raw material wastage from 4% to 5%.

(ii) Increase of finished goods rejection rate from 3% to 4%. Rejected units are sold as scrapfor Rs.
300 per unit.
In order to avoid the situation, the management is considering to revise the wage plan as follows:

(i) Increase wages by 7%.

(ii) Pay a premium of Rs. 70 per hour saved to skilled labour who manufactures the productin less
than 1.5 hours.
The management believes that introduction of above wage plan would increase the efficiencyof its existing
skilled labour by 6%.

Required:
Determine whether AL should implement the proposed wage plan or hire substitute labour. (08)

Q.4 Rio Limited (RL) operates donut shops in different parts of Karachi and has average monthly sales of
Rs. 4.5 million per shop. RL earns contribution margin of 20%.
RL is now planning to open a shop in Lahore. In this respect, following two rental optionsare
under consideration:

(i) Annual rent of Rs. 2.52 million payable in advance.

(ii) Monthly rent of Rs. 0.1 million plus 2% commission on total sales, payable at the endof
each month.
Additional information:

(i) RL would introduce customized donuts, in addition to the regular range. The price of
customized donuts will be 15% higher than the regular ones.
(ii) Average monthly sales volume of this shop is expected to be 30% higher than existingsales.
20% of the sales volume will consist of customized donuts.

435 Page 2 of 22
(iii) Variable costs consist of 75% cost of making regular donuts which would increase by
5% in case of customized donuts. The remaining variable costs represent packaging costof all
donuts which is expected to increase by 4%.
(iv) Fixed costs (other than rent) is estimated at Rs. 0.8 million per month.
(v) RL will borrow 2.52 million to pay advance rent under option 1. At the rate of 14%.

Required:
Compute net profit per month and margin of safety percentage under both options and
recommend the most suitable option to RL. (10)

436 Page 3 of 22
Q.5 California Limited (CL) runs a factory which has two production departments AB and AC, and two service
departments SA and SB. CL allocates the cost of service departments using simultaneous equation
method. A summary of budgeted overheads for the year ending 31 December 2022 is as follows:

Rs. in '000
Factory rent 2,500
Fuel cost 1,800
Depreciation 2,000
Electricity and other utilities 1,100
Other related information is given below:

Production department Service department Total

AB AC SA SB
Machine hours 22,000 12,000 - - 34,000
Labour hours 8,000 10,000 - - 18,000
Floor area (square feet) 6,000 4,500 900 600 12,000
SA - % of services 40% 40% - 20%
SB - % of services 45% 40% 15% -
Basis of overhead absorption Machine Labour
hours hours
The per hour fuel consumption of machines in department AC is 50% more than that ofmachines in
department AB.
Required:
Compute the departmental overhead absorption rate. (08)

Q.6 Spain Limited uses standard costing system. Below is a summary of variances occurred during the month of
February 2022:
Rupees
Favourable variances:
Material price 15,000
Labour efficiency 12,000
Adverse variances:
Fixed overheads expenditure 9,500
Material usage 14,000
Following information is also available:
(i) Standard cost card per unit:
Rupees
Direct material (Rs. 120 per kg) 360
Direct labour (Rs. 100 per hour) 200
Variable factory overheads 175
Fixed factory overheads 150
(ii) 2,520 units were produced during the month.
(iii) Direct material was purchased from a new supplier at a discount of 2% of standardmaterial cost.
(iv) Actual wages and actual fixed overheads were Rs. 510,000 and Rs. 380,000respectively.

437 Page 4 of 22
Required:
Calculate the following:
(a) Actual material purchased (stock are measured at standard cost) (02)
(b) Budgeted units (02)
(c) Actual material used (02)
(d) Actual labour hours (02)

438 Page 5 of 22
Q.7 Assume that date today is 1 April 2022.
Zimbabwe Limited (ZL) has planned to shut down its factory in Karachi on 31 December 2022.
On receiving the news of shut down, all skilled labour employed in the Karachi factory resigned in protest
effective from 31 March 2022. This has raised concerns about the factory’s ability to continue operations for
the rest of the year.
Using the original budget document for the year 2022, following information has beenextracted relating
to the period from April 2022 to December 2022:

Production and sales (units) 50,000

Rs. in '000
Sales 83,750
Direct material (36,000)
Direct labour (14,000)
Variable production overheads (11,000)Fixed production overheads
(12,000)
Selling expenses (8,200)
Profit 2,550
Other related information:

(i) Contractual sales represent 75% of the total budgeted sales volume, which have to be fulfilled on priority
to avoid penalties. Selling price for contractual sales is 20% lower than the normal price. However, 5%
trade discount to other customers has also been budgeted.

(ii) Closing stock comprises of the following as on 31 March 2022:

- Raw material stock of 10,000 kg costing Rs. 3.4 million
- Defective 2,500 units costing Rs. 3.05 million which can be sold as scrap atRs. 100 per unit.

(iii) Budgeted fixed production overheads include depreciation of Rs. 2.5 million, technical fee of Rs. 1.2
million (paid in advance) and salary of factory supervisor of Rs. 3.6 million. The remaining amount
pertains to allocated general overheads.
(iv) Selling expenses represent salaries of five sales officers hired from a third party oncontract which
will expire on 31 December 2022.
(v) Plant and machinery costed Rs. 15 million and has an estimated resale value ofRs. 2.8 million as
on 31 March 2022.
Keeping in view the resignation of skilled labour, the board of directors of ZL is consideringthe following two
options for implementation with effect from 1 April 2022.

Option I: Close the factory now and rent out the factory space

(i) Rental income of Rs. 20 million would be received for nine months.
(ii) Penalties estimated at Rs. 3.8 million would have to be paid by ZL for its failure tofulfill contractual
commitments.

439 Page 6 of 22
(iii) Closing raw material can be used by another factory of ZL by converting it into 9,000 kg of Rita at a
processing cost of Rs. 140 per kg of input. Rita is available in the market at Rs. 350 per kg. Alternatively,
the raw material can be sold in the market atRs. 160 per kg.

(iv) An amount equal to twelve months’ salary would have to be paid to the factory
supervisor.
(v) On early termination of contract with third party for sales officers, a penalty of 30% of the amount
would have to be paid by ZL. Alternatively, this staff can be utilized at ZL's factory in Lahore. For
this purpose, ZL would have to pay the staff
relocation allowance of Rs. 2 million.

440 Page 7 of 22
 Option II: Continue operating the factory for the remaining nine months by employing
skilled labour on contract
(i) The contract for provision of skilled labour would not fulfill the entire requirement of ZL.
Considering this constraint, it is estimated that ZL would be able to produce 45,000 units
only in remaining nine months.
(ii) Skilled labour would be hired at Rs. 500 per hour, however, due to lack of training,
variable production overheads would be increased by 5%. In order to avoid this
increase, ZL can provide training to the skilled labour at a cost of Rs. 0.45 million.
(iii) Goods are produced in batches of 3,000 units each. The first batch would require 2,750
skilled labour hours. Learning curve effect is estimated at 90% that would remain effective for
the first five batches only. At 90%, the index of learning curve is –0.152.
(iv) If the factory continues to operate, the resale value of plant and machinery at31
December 2022 would be 80% of the current resale value.
Required:
Advise which of the two options would be financially beneficial for ZL. (20)

Q.8 (a) Discuss the assumptions used in marginal costing. (04)

(b) Kenya Limited (KL) is involved in the manufacture of a single product and has a total
production capacity of 60,000 units per month. It is currently operating at its normal
capacity of 80% and uses absorption costing. Below is the extract from KL's budgetfor
the month of February 2022:
Rupees
Selling price per unit 210

Variable costs per unit:

Prime cost 75
Factory overheads 45
Selling and admin expenses 15

Fixed costs:
Factory overheads 2,016,000
Selling and admin expenses 800,000

Actual operating data for the month of February 2022:

- Due to an unexpected fault in KL's manufacturing plant, it was able to operateat
75% of its production capacity only.
- Sales of 47,000 units were made at the selling price budgeted by KL.
- Opening stock of 10,000 units costing Rs. 1,600,000 was held by KL. Fixedfactory
overheads were absorbed in prior month at the rate of Rs. 40 per unit.
- Fixed factory overheads exceeded the budget by Rs. 500,000 due to increase in
electricity cost.

441 Page 8 of 22
Required:
(i) Prepare profit or loss statement for the month of February 2022 using marginal
costing and absorption costing. (11)
(ii) Reconcile the difference in profits under the two methods. (02)

442 Page 9 of 22
Q.9 Beijing Limited (BL) is engaged in manufacturing of a single product which passes through two processes.
Following information relating to process II is extracted from BL’s records for the month of February 2022:

Rs. in '000
Opening work in process 3,000
Transferred from process I - 295,000 litres 21,000
Material - 200,000 litres 8,000
Labour 8,500
Overheads 3,200

Material is added at 60% completion of process II after inspection is carried out. Normal loss is estimated at
10% of the input. Conversion costs are incurred evenly throughout the process. Information related to
opening and closing work in process and goods completed and transferred to finished goods are as
follows:

Opening work in process Closing work in process Finished goods

Litres Completion % Litres Completion % Litres
40,000 40% 50,000 70% 450,500

The company uses FIFO method for inventory valuation.

Required:
Calculate the following for process II:
(a) Quantity schedule and statement of equivalent production units. (06)
(b) Cost of finished goods, closing work in process and abnormal gain/loss. (08)

(THE END)

443 Page 10 of 22
ANSWER # 1:
Nigeria Limited

Average demand during lead time which is 2 weeks = (1,000 x 35%) + (1,500 x 45%) + (2,000 x 20%)
= (350 + 675 + 400) 1,425
Avg Annual demand (1,425 x 48/2) (lead time is 2 weeks) 34,200

𝐴𝑣𝑔 𝑎𝑛𝑛𝑢𝑎𝑙 𝑑𝑒𝑚𝑎𝑛𝑑

So number of orders will be: = = 34,200/3,000 12 Orders
𝑜𝑟𝑑𝑒𝑟 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦
(So there will be 12 lead times during the year)

OPTION # 1
If reorder level is 1,425 kgs.
Annual stock out cost
o (1,500 – 1,425) x 12 x 10 x 45% = 4050
o (2,000 – 1,425) x 12 x 10 x 20% =13800 17,850
Holding cost of extra units:
If demand is 1,000 So, Buffer stock will be (1,425 – 1,000) = 425 units
So holding cost is (425 x 25 x 35% ) 3,719
Total cost in this option (17,850 + 3,719) 21,569

Option # 2
If reorder level is 1,600 kg.
So only 2,000 demand risk left.
Annual stock out cost
(2,000 – 1,600) = 400 units
Then 400 x 10 x 12 x 20% 9,600
Holding cost of extra units
Demand might be 1,000 or 1,500
o (1,600 – 1,000) = 600 x 35% x 25 =5250
o (1,600 – 1,500) = 100 x 45% x 25 =1125 6,375
Total cost in this option (9,600 + 6,375) 15,975

So option 2 is more suitable because it result in saving of (21,569 – 15,975) = 5,594

444 Page 11 of 22
ANSWER # 2:
(a)
DENMARK ICE CREAM
Target profit is 14%
Sales
o Ice cream (500 x 1.10) 550
o Yougurt (800 x 190) 152
702
Variable cost
o Ice cream (350 x 1.1) (385)
o Yougurt (150 x 800) (120)
Total (505)
Fixed cost (100 x 1.12) (112)

So expected cost [385 + 120 + 112] = 617

Target cost will be (702/100 x 86) or (702 – 98) = 604
Cost gap is (617 – 604) = 13

(b)
i. Re-design products to make use of common processes and components that are already used in the
manufacture of other products by the company
ii. Discuss with key supplier’s methods of reducing materials costs. Target costing involves the entire ‘value chain’
from original suppliers of raw materials to the customer for the end-product, and negotiations and
collaborations with suppliersmight be an appropriate method of finding important reductions in cost.
iii. Achieve cost efficiency by reducing the wastages.
iv. Eliminate non-value added activities or non-value added features of the product design. Something is ‘non-
value added’ if it fails to add anything in value for the customer. The cost of non-value added product features
or activities can therefore be saved without any loss of value for the customer. Value analysis may be used to
systematically examine all aspects of a product cost to provide the product at the required quality at the
lowest possible cost.
v. Use standardized components that will reduce the cost. However, it might impact the innovation element for
the product.
vi. Cost efficiency may also be achieved by reducing idle time.
vii. Train staff in more efficient techniques and working methods. Improvements in efficiency will reduce costs.

445 Page 12 of 22
ANSWER # 3:
Argentina limited
Option #1: (By hiring substitute labour)
No of units to be produced (120,000/96 x 100) 125,000

Material cost (125,000 x 4.04 (W-1) x 100) 50,500,000

Labour cost (125,000 x 1.5 x 200) 37,500,000

Variable cost (125,000 x 125) 15,625,000
Recovery from rejected units (125,000 – 120,000) = 5000 x 300 (1,500,000)
Net Cost 102,125,000

Option #2: (Revised wage plan)

No of units to be produced (120,000/97 x 100) 123,711

Material cost (123,711 x 4 x 100) 49,484,400

Labour cost (123,711 x 1.5 x 94% x 200 x 1.07) 37,328,557

Premium (11,134 (W-2) x 70) 779,380
Variable cost (123,711 x 125) 15,463,875
Recovery from rejected units (123,711 – 120,000) = 3,711 x 300 (1,113,300)
Net Cost 101,942,912

Option 1 is better because it results in saving of (102,125,000 – 101,942,912) = 182,088

Working #1:
Existing material input = 4kg /unit
Required material (4/100 x 96) = 3.84 kg /unit
So new material input per unit is (3.84/96 x 101) or (3.8/0.95) = 4.04 kg /unit
100 96
4 kg 4% 3.84 kg

100 95
4.04 kg 5% 3.84 kg

Working #2:
Actual hrs. required (123,711 x 1.5) = 185,567 hrs.
Actual hrs. after revised wage (123,711 x 1.5 x 0.94) = 174,433 hrs.
Hours saved (185,567 – 174,433) = 11,134 hrs.
or
(123,711 x 1.5 x 0.06) = 11,134 hrs.

446 Page 13 of 22
ANSWER #4:
RIO LIMITED
Option #1:
Sales
o Donuts (4.5 x 1.3 x 80%) = 4.68
o Customized donuts (4.5 x 1.3 x 20% 1.15) = 1.35 6.03
Variable cost
o Regular donuts (4.68 x 80% x 75%) = 2.81
Packing (4.68 x 80% x 25% x 1.04) = 0.97 (3.78)
o Customized donuts (4.5 x 1.3 x 20% x 80% x 75% x 1.05) = 0.74
Packing (4.5 x 1.3 x 20% x 80% x 25% x 1.04) = 0.24 (0.98)

Contribution margin 1.27

Fixed cost including rent (0.8 + 2.52/12) (1.01)
Interest cost (rent amount was taken from funds) (2.52 x 14% x 1/12) (0.03)
Profit 0.23

𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
Contribution margin = 𝑥 100
𝑠𝑎𝑙𝑒𝑠
1.27
= 𝑥 100 = 21.06%
6.03
𝑡𝑜𝑡𝑎𝑙 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡
Breakeven sales (Rs) =
𝑐𝑠 𝑟𝑎𝑡𝑖𝑜
1.01+0.03
= = 4.94 million
21.06%
𝑡𝑜𝑡𝑎𝑙 𝑠𝑎𝑙𝑒𝑠−𝑏𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑠𝑎𝑙𝑒𝑠
Margin of safety = 𝑥 100
𝑡𝑜𝑡𝑎𝑙 𝑠𝑎𝑙𝑒𝑠
6.03 − 4.94
= 𝑥 100 = 18.08%
6.03
Option #2:
Sales
o Donuts (4.5 x 1.3 x 80%) = 4.68
o Customized donuts (4.5 x 1.3 x 20% 1.15) = 1.35 6.03
Variable cost
o Regular donuts (4.68 x 80% x 75%) = 2.81
Packing (4.68 x 80% x 25% x 1.04) = 0.97 (3.78)
o Customized donuts (4.5 x 1.3 x 20% x 80% x 75% x 1.05) = 0.74
Packing (4.5 x 1.3 x 20% x 80% x 25% x 1.04) = 0.24 (0.98)

Commission at 2% on total sales (6.03 x 2%) (0.12)

Contribution margin 1.15

Fixed cost including rent (0.8 + 0.1) (0.9)
Profit 0.25

𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
Contribution margin = 𝑥 100
𝑠𝑎𝑙𝑒𝑠
1.15
= 𝑥 100 = 19.07 %
6.03

447 Page 14 of 22
 𝑡𝑜𝑡𝑎𝑙 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡
Breakeven sales (Rs) =
𝑐𝑠 𝑟𝑎𝑡𝑖𝑜
0.9
= = 4.72 million
19.07%
𝑡𝑜𝑡𝑎𝑙 𝑠𝑎𝑙𝑒𝑠−𝑏𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑠𝑎𝑙𝑒𝑠
Margin of safety = 𝑥 100
𝑡𝑜𝑡𝑎𝑙 𝑠𝑎𝑙𝑒𝑠
6.03 − 4.72
= 𝑥 100 = 21.72 %
6.03
Conclusion: Option 2 is more appropriate as profit and margin of safety both are higher than option 1.

ANSWER #5:
CALIFORNIA LIMITED
AB AC SA SB TOTAL

Factory rent (floor area) 1250 937.5 187.5 125 2,500

(2,500 x 6,000/12,000)

Fuel cost 990 810 - - 1,800

(Mach hrs. (W-1)) (1,800 x 22,000/40,000)

Depreciation 1294 706 - - 2,000

(Assumed mach hrs.) (2,000 x 22,000/34,000)

Electricity & utility 550 413 83 55 1100

(Assumed floor area) (1,100 x 4,500/12,000)

4,084 2,866 270 180 7,400

Secondary
apportionment:
SA (40:40:20) 122 122 (306) 61 -
SB (45:40:15) 108 96 36 (241) -
4,314 3,084 0 0 7,400

Absorption rate will be:

AB AC

(4,314,000/22000) (3,084,000/10,000)
=196.1 =308.4
Working #1:
Fuel consumption in machine hours
if 1 litre in 1 hr in AB then 1.5 litres in 1 hour in AC.
AB = (1 x 22,000) = 22,000
AC = (1.5 x 12,000) =18,000
40,000 (so allocation base of fuel cost will be 40,000)
Working #2:
SA (x) = 270 + 0.15y
Put y in x
X = 270 + 0.15 (180 + 0.2x)

448 Page 15 of 22
X = 270 + 27 + 0.03x
X – 0.03x = 297
X = 297/0.97 = 306

SB (y) = 180 + 0.2x

Put x in y
Y = 180 + 0.2 (306)
Y = 241

ANSWER #6:
Spain Limited

(a)
(SR - AR) x AQP = 15,000
(120 – 120 x 98%) x AQP = 15,000
AQP (2.4) = 15,000
AQP = 15,000/2.4 = 6,250 kg

(b)
FOH Exp variance = Budgeted FOH – Actual FOH
(9,500) = (Budgeted production x SR/unit) – Actual FOH
(9,500) = (Budgeted production x 150) – 380,000
380,000 – 9,500 = Budgeted production x 150
Budgeted production = 370,500/150
Budgeted production = 2,470 units
(c)
(SQU -AQU) x SR = (14,000)
((3 x 2,520) - AQU) x 120 = (14,000)
(7,560 - AQU) x 120 = (14,000)
907,200 – 120 AQU = (14,000)
-120 AQU = -921,200
AQU = 921,200/120
AQU = 7,677 kg
(d)
(SHW -AHW) x SR = 12,000
((2 x 2,520) - AHW) x 100 = 12,000
(5040 - AHW) x 100 = 12,000
504,000 – 100AHW = 12,000
-100AHW = 12,000 – 504,000
AHW = 492,000/100
AHW = 4,920 hrs.

449 Page 16 of 22
Answer: Zimbabwe Limited
Option #1:
Close factory and rent out factory space
Relevant incomes: Rs. in millions
Sales [no future sale] -
Rent income 20
Saving due to conversion into Rita (W-1) 0.15
Disposal of Plant & machinery 2.8
Sale of defective units [2,500 x 100] 0.25
23.2

Relevant costs
Penalty for not fulfilling the contract (3.8)
Incremental salary to factory supervisor (3.6/9 x 3) (1.2)
[payment of 9 months would have to be paid whether we close or not]
Payment to sales officer
Lower of: (2)
• 8.2 x 30% = 2.46
• 2 million
Net saving by closure 16.2

Option #2
Continue operating with labour contract
Relevant incomes Rs. in millions
Sales:
• Contract sales (50,000 x 75%) = 37,500 x 1,600 (W-2) 60
• Other sales (45,000 – 37,500) = 7,500 x 1,900 (W-2) 14.25
Disposal of plant & machinery on 31.12.2022 2.24
(2.8 x 0.8)
Disposal of defective units (2,500 x 100) 0.25
76.74
Relevant costs
Extra material to be purchased
[36,000,000/50,000 x 45,000] = 32,400,000 (Required) (29)
(32,400,000 – 3,400,000 Already available)
Skilled labor cost (14.66)
(29,326 hrs (W-3) x 500)
V.OH (11,000/50,000 x 45,000) (W-4) (9.9)
Training cost (0.45)
22.73

450 Page 17 of 22
Conclusion:
So option 2 is more suitable because it results in extra saving of (22.73 – 16.2) = 6.53million rupees.

Note:
Technical fee paid in advance, cost of raw material , cost of defective units and cost of plant and machinery are
sunk costs. In addition, depreciation and other allocated fixed production overheads are not relevant.

Workings:
W-1: Opportunity cost of using the raw material: [Rita]
Market value forgone [10,000 x 160] 1,600,000

Processing cost to convert into Rita 1.400,000

(10,000 x 140)
Note: [10,000 kgs of raw material can be coverted into 9,000 kgs of Rita]
3,000,000

Purchase cost of Rita [9,000 x 350] 3,150,000

Saving by conversion into Rita 150,000

W-2):
Let 𝑥 is normal sale price
[50,000 x 75% x 𝑥 x 0.8 +50,000 x 25% x 𝑥 x 0.95] = 83,750,000
30,000 𝑥 + 11,875 𝑥 = 83,750,000
41,875 𝑥 = 83,750,000
𝒙 = 2,000
Contract sale price per unit (2000 x 0.8) = 1,600
Sale price per unit of other customers (2,000 x 0.95) = 1,900

W-3):
No of batches (45,000/3,000) = 15 batches
Learning curve:
Hours of first 5 batches
a x 𝑥 b x no. of batches
(2,750 x 5-0.152 x 5) = 10,766 hrs

Hours of first 4 batches

(2,750 x 4-0.152 x 4) = 8,910 hrs

So time of 5th batch is (10,766 – 8,910) = 1,876

Total hours (10,766 + 1,856 x 10) = 29,326 hours

W-4):
Increase in variable production overheads (11,000/50,000 x 45,000 x 5%) = 0.495
Training cost 0.45
[Training is better ; and therefore there would be no increase in variable production cost]

451 Page 18 of 22
ANSWER #8:
(a)
For the purpose of marginal costing, the following assumptions are normally made:
i. All elements of cost-production, administration and selling and distribution can be segregated into fixed
and variable components.
ii. Variable cost remains constant per unit of output irrespective of the level of output and thus fluctuates
directly in proportion to changes in the volume of output.
iii. The selling price per unit remains unchanged or constant at all levels of activity.
iv. Fixed cost remains unchanged or constant for the entire volume of production.
v. The volume of production or output is the only factor which influences the costs.

(b)
(i)
Kenya Limited

Profit Statement under Absorption Costing

Rupees
Sales (47,000×210) 9,870,000
Cost of sales
Opening stock (10000 units) 1,600,000
Cost of Goods manufactured:
Prime cost (45,000 x 75) 3,375,000
V.OH (45,000 x 45) 2,025,000
F. OH (45,000 x 2,016,000/48,000) 1,890,000 7,290,000

Less: Closing stock (7,290,000/45,000 x 8,000) (1,296,000)

Unadjusted cost of sales (7,594,000)

Under applied FOH (W) (626,000)
Adjusted cost of sales (8,220,000)
Gross profit 1,650,000
Less: selling and admin [(47,000×15) +800,000] (1,505,000)
Profit 145,000
Profit Statement under Marginal Costing
Rupees
Sales (47,000×210) 9,870,000
Variable Cost of sales
Opening stock (1,600,000 – 10,000 x 40) 1,200,000
Variable Cost of Goods manufactured:
Prime cost (45,000 x 75) 3,375,000
V.OH (45,000 x 45) 2,025,000
5,400,000

452 Page 19 of 22
 Less: Closing stock (5,400,000/45,000 x 8,000) (960,000)

(5,640,000)
Gross contribution 4,230,000
Less: Variable selling Expense (47,000 x 15) (705,000)
Net contribution 3,525,000
Less: Fix costs
Fix selling expense (800,000)
Fix FOH (Actual) (2,016 + 500) (2,516,000)
Profit 209,000

(ii) Reconciliation of profit worked out under marginal and absorption costing
Rupees
Profit under absorption costing 145,000
Opening stock as per absorption costing 1,600,000
Closing stock as per absorption costing (1,296,000)
Opening stock as per marginal costing (1,200,000)
Closing stock as per marginal costing 960,000
Profit under marginal costing 209,000

Workings:
Finished Goods (Units)

b/d 10,000 Sale 47,000

Production 45,000

Closing (bal.) 8,000

FOH

Actual FOH 2,516,000 Applied FOH 1,890,000

(2016000 + 500000)

COS (bal.) 626,000

453 Page 20 of 22
ANSWER #9:
Beijing Limited
(a) Quantity Schedule

WIP opening 40,000

Received from preceding department 295,000
Started in process / material added 200,000
535,000

Transferred to finished goods 450,500

WIP closing 50,000
Normal loss (40,000+295000) ×10% 33,500
Abnormal loss – Balancing figure 1,000
535,000

Equivalent Production units

Process I Material Conversion

40,000 - 40,000 24,000 (60%)

Finished goods 450,500
410,500 410,500 410,500 410,500
Ab.loss 1,000 1,000 -* 600 (60%)
Closing WIP 50,000 50,000 50,000 35,000 (70%)
461,500 500,500 470,100

* Material is added at 60% completion after inspection therefore no material will be included on Ab. loss units.

(b) Cost per unit:

21,000,000
Process I = = 45.50/unit
461,500

8,000,000
Material = = 15.98/unit
500,500

8,500,000+3,200,000
Conversion = = 24.89/unit
470,100

Total 86.37

454 Page 21 of 22
Cost of Finished goods:
Opening cost 3,000,000
(40,000 x 15.98) + (24,000 x 24.89) 1,236,560
(410,500 x 86.37) 35,454,885
39,691,445
Cost of WIP:
(50,000 x (45.50 + 15.98)) 3,074,000
(35,000 x 24.89) 871,150
3,945,150

Cost of Ab.loss:
(1000 x 45.50) 45,500
(600 x 24.89) 14,934
60,434

Process A/C Rs.’000’

Units Amount Units Amount
b/d 40,000 3000 Finished goods 450,500
Process I 295,000 21,000 N. loss 33,500 -
Material 200,000 8,000 Ab. loss 1,000
labour 8,500
overheads 3,200 Closing WIP 5,000
535,000 43,700 535,000

Normal loss:
(40,000 + 295,000) x 10% = 33,500

455 Page 22 of 22