65CHAPTER 1:

NATURE AND PURPOSE OF COST ACCOUNTING

I Introduction to Cost Accounting

Introduction
Terminologies
Purpose of cost accounting
Distinction between cost accounting and financial
accounting

II Classification of cost
Basis of classification
Introduction
Accounting is the method of identifying, measuring and communicating economic
information to permit informed judgment and decision making by the users of the
information.

It’s that part of information system of business enterprise which provides financial
information concerning the business activities of an enterprise to diverse groups of
people such as: shareholders, managers, creditors, tax authorities etc

On the basis of purpose for which the information is required, accounting is divided
in 2 parts:
i) Financial Accounting
ii) Management Accounting

Financial Accounting
Financial accounting is mainly concerned with recording business transactions in
the books of accounts for the purpose of presenting final reports to the
management, shareholders, and tax authorities.

The information supplied by financial accounts is summarized in the following

statement at the end of given period generally one year:
 Profit and loss account (the income statement).
 Balance sheet.
 Cash flow statement.
 Statement of change in equity.

Management Accounting
It’s that part of accounting that is concerned with identifying and presenting
information for formulating strategies, planning and controlling activities, decision
making on alternative decision, optimizing use of resources for interested parties
and safeguarding assets of the business.

Cost Accounting
It’s that part of management accounting that deals with ascertaining cost of
product, operation, process etc

It’s the combined of a\c and costing technique in the accumulating analysis and
control of cots and revenue.

Cost
Refers to the resource sacrificed so as to achieve a given objective

Difference between Financial Accounting & Cost Accounting

1. Users of the information- Financial Accounting information is used by

external parties as well as internally by managers whereas Cost Accounting
information is used internally by managers.
2. Compliance with GAAP- Financial Accounting statements are prepared in
compliance with GAAP (Generally Accepted Accounting Principles) whereas cost
accounting statements do not need to comply with any principles.
3. Format- Financial Accounting statements are prepared in the format presented
by the (IAS) International Accounting Standards whereas Cost Accounting
statements are prepared in the format internally decided by the management.
4. Periodicity of Reporting- Financial Accounting reports are issued periodically
e.g. annually, semi-annually etc. Cost Accounting reports can be prepared when
the management requires them.
5. Audit Requirements- Financial Accounts should be audited by an external or
independent party. Cost Accounts needs not be audited unless they contain
vital information for the audit.
6. Legal Requirement- Financial Accounting reports are compulsory by law .Cost
Accounting reports are prepared when management require them.
7. Sources of Information- Data used to prepare financial statement is historical
by nature i.e. based on past transactions. Cost Accounting uses historical,
current and sometimes future data to prepare its statement.
8. Precision- Financial Accounting requires accurate information otherwise
external parties will not have confidence in the content of the report. Cost
Accounting may allow for approximation of certain information required.
9. Unit of Measurement- All information under Financial Accounting is in terms
of money value. Cost Accounting applies any unit of measurement that is useful
in a given situation e.g. Labour hours, output, machine hours etc

CLASSIFICATION OF COSTS
Cost may be classified on the following bases:
 Functions
 Behaviour
 Traceability to end product
 Time
 Identification with stock
 Controllability
 Relevance for decision making

1. Classification by Function
On the basis of function, costs may be classified into production cost,
administration cost, selling and distribution cost and research and development
cost.
a) Production Cost
These are cost incurred in the factory in the production of goods e.g. Raw
materials, labour, factory rent etc.

b) Administration Cost
These are costs incurred in the general management of the business e.g. office
rent, salaries of office staff, depreciation of office machinery etc.

c) Selling and distributing cost

These are costs incurred in making the final products available in the market and
convincing/ persuading customers to adopt them e.g. advertisement, delivery and
sales commissions etc.

d) Research and development

These are costs incurred in developing new products and also improving on
existing ones.

2. Classification by traceability to end products

a) Direct cost
Are costs that can be traced to the final products i.e. they can specifically be
identified with the end products e.g. direct materials like timber in furniture, direct
labour like wages paid to carpenters and direct expense like the hire of special
equipment.

b) Indirect Cost (Overheads)

Are costs which are not traceable to the final products or may be traceable but
constitute small proportions of the overall cost. They include:
 Indirect material like the cost of lubricating oils, paper, rivets, vanish etc.
 Indirect labour e.g. the salaries paid to indirect workers like watchmen,
cleaners etc.
 Indirect expense like factory rents, factory power and other utilities,
depreciation of factory plants and equipment etc.

Classification by Cost Behaviour

Cost behaviour refers to the changes in the cost arising from the changes in
activity level. Activity level in an enterprise may be measured using the number of
unit produced, sales volume, labour hour etc.

On the basis of behaviour cost can be classified into:-

i) Variable costs: Are cost which change with a change in the level activity.
Variable costs can be described by a straight line equation of the form y = bx

Where:
y = total cost
b = variable cost per unit.
X = number of unit (activity level)

Graphically Variable costs are represented as:-

Cost

y = bx

8
ii) Fixed cost - are costs which remain constant irrespective of the changes in the
level of activity. They are represented by a straight line equation of the form y = a

Where:
y = Total cost
a = Total fixed cost

Graphically, fixed cost can be represented as follows

Cost

a Y= a
iii) Mixed cost: - Are cost with characteristic of both variables and fixed cost
they are further classified into semi-variable cost and semi-fixed cost.

a) Semi- variable cost: - Are cost where some components are fixed and
some varies with activity level. It can be described by a straight line e.g… of
the form.
Y= a+bx where y= total cost, b = variable cost per unit
x = number of units (activity level)
a= fixed cost.

Graphically semi-variable costs are represented as follows.

Cost

y = a +bx
b) Semi-fixed costs – Are cost which remain fixed within a given range of
activity beyond which the cost changes to the new level where it remains
constant within another new range of activity in a stepped /function.

Cost
Classified by time
On the basis of time cost can be classified into:-
- Sunk cost- is the cost that has already been incurred i.e. cost relating to 2 past
transaction.
-
- These are historical costs which are considered to be irrelevant for
classification making purpose because they cannot affect future decision.
- Future cost- are estimated for decision making purpose because the can affect
future decision.

Classifications based on identification with stock.

1. Product cost:- refers to costs that are used in the valuation of the stock finishes
goods. They’re also referred to as inventoriable cost, since they form part of
product cost. Such costs are not charged to the P&L a/c until the goods
produced have been sold. If the goods are not sold, the cost is carried forward
in the form of stock to be written off against future sales.
2. Period cost - there’re cost that arise by virtue of passage of time and are W/off
through the P&L a/c whether the good produced have been sold or not e.g.
insurance cost.

Classifications on the basis of controllability

1. controllable costs- are costs which can be influenced by management in the
long run without negatively affecting the business operating e.g. research cost,
marketing costs a/c cost etc
2. Uncontrollable cost- they cannot be influenced by managerial decision in the
short run e.g. insurance cost.

Classification based on the relevance for decision making

ii) Relevant cost – Are cost that result in a unique alternative in a decision
making environment such cost usually differ between alternatives e.g. future
cost, controllable costs etc.
iii) Irrelevant cost- They may not give a unique alternative in a decision making
situation either because they’re already been incurred or they do not differ
between the alternative e.g. sunk cost, uncontrollable.
 Other terminologies
a. Incremental cost- refers to the change in total cost (both variable and fixed
when comparing 2 alternatives or when among a decision.
b. Marginal cost- refers to the change in variable cost when comparing 2
alternatives or when making a decision.
c. Discreet cost – are cost which incurred at the discretion of management i.e. the
management has the freedom to decide whether the cost should be incurred or
not.
d. Imputed cost- these are hypothetical cost which are not cost in the strict sense
of the word because there are no financial obligations to pay any money e.g.
the rent of premised which are owned by the organization can sometimes be
included as a cost in their books.

CHAPTER 2: COST ELEMENTS

A. MATERIAL COSTING
Part Topic Page

I Introduction to Material costing

Introduction
Relevant cost for inventory management
Factors influencing stock levels

II The inventory models

The EOQ Model
The EBQ Model
The ABC System
Illustrations

III Valuing inventory issues

Methods of pricing material issues
Preparing operating income statements
Reconciliation of operating income
 Illustrations

IV Activities

Objectives
After studying this chapter you will
Know the objectives of material control
Understand the essential requirements of material control system
Appreciate the advantages of material control
Understand the distinction of centralized and decentralized purchasing
Know how to determine the various stock levels
Know how to price material issues

Introduction
The production department requires raw materials and consumable stores for
production. The purchasing department purchases these materials from different
suppliers. The storage department stores them and then issues them ultimately to
the production department. Hence there must be perfect co-ordination between
these departments to control material cost.

Objectives of material control:

The main objectives of operating material control system are:

 To avail material needed so as to reduce instance of interrupted production.
 To ensure purchase of materials in economic quantities.
 To ensure that purchase of materials is made at the favourable price.
 To facilitate proper accounting for materials
 To ensure that the quality and specification of materials conform to the
requirements of the product
 To reduce wastage and losses of materials

Essential requirements of material control system:

  Proper co-ordination and co-operation between different departments
dealing with materials e.g. purchasing department, stores departments,
quality control departments etc
 Centralization of all purchases under the control of a competent manager
 Classification, codification, standardization and rationalization of all stores
and computerization of operations
 All issues of materials should be made against duly authorized requisitions
 Materials requirements should be planned properly
 Stock position should be updated continuously based available information
from the relevant departments
 An efficient system of internal audit should be introduced for checking all
material transactions

Benefits of material control

 Material control eliminates wastage in the use of raw materials
 It reduces the risk of loss due to fraud and theft
 It reduces capital investments in inventories
 It reduces cost of storage
 It ensures uninterrupted supply of materials of high quality for use in
production
 It furnishes promptly and accurately the value of materials used in
production

Centralized and decentralized purchasing

In a centralized purchasing, the task of purchasing all types of materials is
entrusted to a separate purchasing department. However in a decentralized
purchasing, each department purchases its own materials.

Advantages of centralized purchasing

 It eliminates duplication of effort and tasks
 It helps to achieve uniform purchasing policies
 It helps to reduce overall cost by securing bulk purchase for all user units
within the same organization
 It leads to specialized skill development in purchasing
  Better controls over purchasing is made possible since reckless purchases by
authorized persons is avoided
 It economizes on paperwork and accounting for purchase transactions
 Higher quality staff may be gainfully employed to handle material control
issues

Disadvantages of centralized purchasing

 The creation and running of a special purchasing department leads to higher
administration cost that small organizations cannot afford
 It may cause delays if user units are located far away over many different
places
 There may be misunderstanding between the user departments and the
purchasing department
 The initial cost of centralized purchases is very high since a separate
purchase department has to be set up

Periodic inventory system

Under this system, the stocktaking of the physical quantities of materials of all
kinds is done at a given date. In most cases it causes a lot of disruptions to the
normal operations of the organization.

Perpetual inventory system

This is a system under which inventory records are continuously adjusted after
every transaction involving issue or receipt of stock items. The records therefore
show the physical balance of inventory items at any given point in time. Under this
system any stock discrepancies must be investigated immediately and appropriate
corrections made if the records are to be relied upon.

Setting stock levels

The following factors are considered when setting stock levels:-
i. Availability of the stock item i.e. if the stock item is readily available in the
market, then low stock levels are maintained and vice versa.
ii. Lead time /re-order period i.e. refers to the period required to process an
order and receive deliveries of the stock item. The longer the lead time,
the higher the stock level and vice versa.
 iii. Stock holding cost (storage cost)-The higher the storage cost incurred on
the stock items, the lower the stock level should be maintained and vice
versa.
iv. Consumption rate- if the consumption rate is high, then high stock levels
should be maintained and vice versa.
v. Durability –highly durable stock items requires high stock levels whereas
perishable items require low stock level.

Note- Investments in stock presents a major asset for most businesses and it’s
essential that stocks should be managed efficiently.

The costs relating to stock management are classified as follows:

i) Holding cost- this consists of the following:

a) Opportunity cost for the investment in stock i.e. what the amount would
fetch if was not tied in stock but instead invested.
b) Incremental insurance cost.
c) Warehousing and storage cost.
d) Material handling cost.
e) Obsolescence and deterioration costs.
f) Stores operations and running cost.

ii) Ordering cost- This comprises;

a. Clerical cost of preparing a purchase order.
b. Delivery costs.
c. Remuneration of purchase department personnel.
d. Clearing charges.
e. Inspection for quality costs.

iv) Purchase cost- is the amount paid to the suppliers for supplying the stock
item. It is relevant for inventory policy decisions only if there is a provision
for quantity discounts.

The Economic Order Quantity (EOQ)

 This is the order size or quantity which minimizes the total relevant cost i.e. the
sum of the total ordering cost and total holding cost.

For EOQ purpose, the total relevant cost is given as:

-
Total relevant cost = total holding cost +total ordering cost

Basic assumptions of the EOQ model

i. Holding cost per unit per annum remains constant.
ii. The average balance in stock is assumed to be equal to ½ of the order quantity.
iii. It is assumed that the annual demand is known and is constant.
iv. Replenishment of stock is assumed to be done in equal batches.
v. Ordering costs per order is fixed irrespective of the order quantity.
vi. Purchase cost per unit is assumed to be constant throughout the year.
vii. There’s no provision for quantity discount.
viii. It assumes that the lead time is known and is constant throughout the year.
ix. It assumes that there is no safety stock

2 xDxT
EOQ= Q= 2DCo
H
Ch
QH
Total holding cost = i.e. Average stock x Holding cost per unit
2
DT
Total ordering cost = i.e. No. of orders x ordering cost per order
Q

Total cost =total holding cost + total ordering cost

QH DT
TC = +
2 Q

Where: D- is annual demand

Co- is cost per order
 Ch- is annual holding cost (usually but not always) expressed as a
percentage of purchase price per unit.
Q –order quantity.

Illustration
A Company has an annual demand for its material amounting to 25,000 tons Pa.
The purchase price per ton for the stock item is ksh. 2,000 and the stock holding
cost is 25% of the purchase price. The ordering cost is ksh. 400 per order.

Required:
Calculated:
a) The EOQ
b) The total holding cost
c) The total ordering cost
d) The total relevant cost

Solution

2 x 25,000 x 400
a) EOQ = = 200 tons
25% x 2,000

QH 200x500
b) The total holding cost = = = ksh. 50,000
2 2
DT 25,000 x 400
c) Total ordering cost = = = ksh 50,000
Q 500

QH DT 200x500 25,000 x 400

d) Total relevant cost = + = + = ksh. 100,000
2 Q 2 500

Confirm from the above illustration that the total relevant cost would be higher at
all other order quantities e.g. (i) 100 tons (ii) 250 tons
Graphically the EOQ model can be represented as follows:-

Cost
Total relevant
cost

Total holding
cost

Total
ordering cost

EOQ
Order Quantity

Activity
The Company has an annual demand of a product amounting 60 000 units. The
1
price per unit is Ksh. 4,500 and the stock holding cost is 33 % of stock value.
3
Delivery cost per order is ksh. 320.
Required:
Calculated:
e) The EOQ
f) The total holding cost
g) The total ordering cost
h) The total relevant cost

LIMITATIONS OF THE EOQ MODEL

1. It assumes that the purchase price per unit is constant through the year which
is unrealistic.
2. Assume that annual demand remains constant which is unrealistic.
3. It doesn’t apply in cases where there are quantity discounts.
4. It can only be operated by people having sound knowledge in stock
management.

QUANTITY DISCOUNTS
Circumstance frequently occurs where firms are able to obtain quantity discounts
for large purchase orders. Buying in large quantities to take advantage of quantity
discounts leads to the following cost savings:
 Savings in the purchase cost. This consists of the amount on the discount itself.
 A reduction in the total ordering cost because fewer orders are made.

Note: These cost savings must however be balanced against the increased
holding cost arising from bulk stock. To determine whether or not the discount
offer is worthwhile, the benefits (cost savings) must be compared against the
additional holding cost arising from bulk purchase.

Illustration
A Company purchases raw materials from an outside supplier at a cost of ksh.7 per
unit. The total annual demand for this product is 9,000 units. The holding cost is
ksh. 4 per unit per annum and the ordering cost is ksh. 5 per order.

A quantity discount of 3% of the purchase price is available for orders in excess of

1,000 units.

Required
Should the Company accept the discount offer? (Show all your workings)

Solution:

D-9,000 units Discount rate = 3% = 0.03

T- Ksh. 5
H- Ksh. 4
 Q =?

Price = Ksh. 7 per unit

Note: Purchase cost forms part of the total relevant cost whenever there’s a
provision for quantity discount.

2 xDxT
EOQ= Q=
H

2 x9,000 x5
Q= = 150 units
4

The alternative order quantities are therefore at the EOQ and at 1,000 units. This
will result into the following costs:

Order Purchase Cost Total Ordering Total Holding Total Cost

(ksh) Cost (ksh) cost (ksh) (ksh)
Quantity
(D x Price)(1-d) DT QH
Q 2

150 9,000x 7=63,000 300 300 63,600

1,000 (9,000 x 7)x(100%- 45 2000 63,155
3%)=61,110
Savings(cos 1,890 255 (1,700) 445
t)

Therefore; the Company should take the discount offer because it leads to an
overall cost savings of ksh. 445.

Illustration: 2
A Company is revising its stock policy and has the following alternatives available
for the evaluation of its stock;
i) Purchase stock twice monthly of 100 units.
ii) Purchase stock monthly of 200 units
iii) Purchase stock every 3 months of 600 units
iv) Purchase stock every 6 months of 1,200 units
v) Purchase stock every 12 months of 2,400 units

It’s ascertained that the purchase price per unit is ksh. 0.80 for the whole order
where deliveries are up to 500 units. A 5% discount is offered by the supplier on
the total order for deliveries between 500-1,000 units and 10% discount for
deliveries in excess of 1,000 units. The holding cost is ksh. 0.25 per unit of
average stock held per annum and the ordering cost per order is ksh. 5.

Required
Advise the management on the optimum order quantity

Solution:
Since the purchase price is not constant, the EOQ analysis would be inappropriate;

H- Ksh 0.25 per unit

Disc -5% for 500 -1,000 units and 10% for 1,000 units and above
D= 2,400 units

Order Total Total Purchase Total cost

quantity ordering holding cost
cost cost
100 120 12.5 1,920 2,052.5
200 60 25 1,920 2,005
600 20 75 1,824 1,919
1,200 10 150 1,728 1,888*
2,400 5 300 1,728 2,033
*The company should purchase the stock semi-annually thus implement the 10%
discount policy because it’s the cheapest alternative.

Re-order level
This is the level at which an organization places an order to replenish its stock. It
depends on the lead time and the rate of demand during the lead time.

Re-order level= Demand During Lead Time + Safety Stock i.e. ROL = DDLT +SS
Or.
ROL= Maximum Consumption rate x maximum lead time.

Minimum stock (safety /Buffer stock)

The safety stock refers to that stock level that should be maintained to take care of
eventualities regarding lead time and usage. It is a stock allowance meant to cover
errors in forecasting the lead time and demand during the lead time.

Minimum stock level = ROL – (Average Consumption x Average Lead Time)

Maximum Stock level

This refers to the maximum investment that should be made in stock if the
business is to make good use of its working capital.

Maximum Stock level = ROL +EOQ – (Minimum consumption x Minimum Lead

time)

Average stock level

Is the average of the minimum and maximum stock level

Max. stock level  Min. stock level

Average stock level=
2

Illustration
The Company has provided the following data in respect of its major raw materials.
Max. Consumption 1,200 units
Ave/Normal consumption 900 units
Minimum consumption 600 units
Lead time 4-6 wks
Re-order Quantity 6,000 units

Required
i) Reorder level
ii) Max stock level
iii) Min. stock level
iv) Average stock level

(i) ROL= Max. Consumption Rate x Max. LT

= 1,200x6
= 7,200 units

(ii) Maximum stock level = 7,200- (4x600) + 6,000

= 10,800 units

(iii) Minimum stock level = ROL– (Average Consumption x Average LT)

= 7,200- (5x900)
= 7,200- 4500
= 2,700 units

Max. stock level  Min. stock level

(iv) Average stock level =
2

=2,700 + 10,800
2
= 6,750 units
Graphically, this can be represented as follows:
 Max. stock
level

ROL

Buffer stock

ABC ANALYSIS (PARETO ANALYSIS)

Usually a firm has to maintain several types of inventory. It’s not desirable to keep
the same degree of control over all items. The firm should pay a lot of attention to
those items whose value is the highest. Therefore they should classify them to
identify which items should receive the most attention in controlling and hence the
analytical approach called ABC analysis. It tends to measure the significance of
each item in terms of its value.

High value items are termed as “A- items’ and would be under the tighest control.
“C-items” represent relatively low value items and would be under minimal control.
“B-items” fall between these two categories and require reasonable attention of
the management.
The following steps are involved in implementing an ABC inventory plan:
 Classify the items of inventories by determining their relative value.
 Rank them in accordance with their value; 1st rank- “A-items’ high value
items; 2nd rank- “B-items” and 3rd rank- “C-items”.
 Compute the percentage of the number of units in each class and the
percentage of the value in each class.

PRICING AND COSTING OF MATERIAL ISSUES

When materials are issued from stores, they are valued in order to determine the
material cost of the products. The following methods are used in valuing material
issues:.
i) First in- first out (FIFO)
ii) Last in-first out (LIFO)
iii) Simple average
iv) Weighted average
v) Standard cost method
vi) Next in-first out (NIFO) or replacement cost method.
FIFO
This values materials issued on the basis of sequence/order in which they were
bought i.e. on the premise that the first items to be received are first to be
released/issued.

LIFO
This method assumes that materials issued at any time are those that are most
recently acquired. The last units to be received are the first ones to be issued out
to production or sales department.

Simple average
Simple average of prices of all consignment of stock is calculated and the average
price is used in valuing materials issued. When the first consignment is exhausted
then the price of that consignment is eliminated from the calculation of the simple
average price. Therefore in some sense, this method follows FIFO method.

Weighted average
The total value of materials in stock is divided by number of units in stock and the
resulting figure is the weighted average price.

Standard cost method

Material issues are valued on the basis of the pre-determined standard cost which
is set by management and therefore it ignores the market price at which stock
items were acquired.

Next in first out (NIFO)

Stock issues are valued on the basis of the prevailing market prices that would be
incurred to purchase the next consignment of stock.
Specific or unit price method
Where the item issued can be identified with the relevant invoice, the actual cost
can be charged. This is usually only possible with special purpose items bought for
a particular job.

Illustration
The following transactions relate to item X15 which is regularly acquired and
stocked by general Products Kenya Limited for the month of October 2010. The
following was entered in the Company stock ledger

Oct 2010 Receipt (units) Issue (units) Unit cost (Ksh)

4 2,800 18
6 3,300
12 2,700 21
15 2,800
18 3,100 22
19 2,800 21
22 2,250
25 2,750 22
26 3,950
27 3,200 23
28 2,600
29 3,250 24

The closing balance for September 2010 was 3,000 units received at a unit cost of
Ksh 20.

Required;
Prepare stores ledger for October using:-
i) FIFO
ii) LIFO
iii) Simple average
iv) Standard cost method (assume a standard cost of ksh. 22 per unit)
 v) Weighted average
vi) NIFO

Solution
Stores ledger (FIFO-method)

Date RECEI PTS I SSUES BALANCE

OCT. 2010
Qty Price Amount Qty Price Amount Qty Amount
1 3,000 60,000
4 2,800 18 50,400 5,800 110,400
6 3,000 20 60,000 2,800 50,400
300 18 5,400 2,500 45,000
12 2,700 21 56,700 5,200 101,700
15 2,500 18 45,000 2,700 56,700
300 21 6,300 2,400 50,400
18 3,100 22 68,200 5,500 118,600
19 2,800 21 58,800 8,300 177,400
22 2,250 21 47,250 6,050 130,150
25 2,750 22 60,500 8,800 190,650
26 150 21 3,150 8,650 187,500
3,100 22 68,200 5,550 119,300
700 21 14,700 4,850 104,600
27 3,200 23 73,600 0 8,050 178,200
28 0 2,100 21 44,100 5,950 134,100
29 3,250 24 78,000 500 22 11,000 5,450 123,100

Therefore the closing stock is 5,450 units worth ksh. 123,100

Stores ledger (LIFO-method)
Date RECEI PTS I SSUES BALANCE
OCT. 2010
Qty Price Amount Qty Price Amount Qty Amount
1 3,000 60,000
4 2,800 18 50,400 5,800 110,400
6 2,800 18 50,400 3,000 60,000
500 20 10,000 2,500 50,000
12 2,700 21 56,700 5,200 106,700
15 2,700 21 56,700 2,500 50,000
100 20 2,000 2,400 48,000
18 3,100 22 68,200 5,500 116,200
19 2,800 21 58,800 8,300 175,000
22 2,250 21 47,250 6,050 127,750
25 2,750 22 60,500 8,800 188,250
26 2,750 22 60,500 6,050 127,750
550 21 11,550 5,500 116,200
650 22 14,300 4,850 101,900
27 3,200 23 73,600 8,050 175,500
28 2,600 23 59,800 5,450 115,700
29 3,250 24 78,000 5,450 115,700

Therefore the closing stock is 5,450 units worth ksh. 115,700

Stores ledger (Simple average-method)
Date RECEI PTS I SSUES BALANCE
OCT. 2010
Qty Price Amount Qty Price Amount Qty Amount
1 3,000 60,000
4 2,800 18.0 50,400 5,800 110,400
6 3,000 19.0 57,000 2,800 53,400
300 19.0 5,700 2,500 47,700
12 2,700 21.0 56,700 5,200 104,400
15 2,500 19.5 48,750 2,700 55,650
300 19.5 5,850 2,400 49,800
18 3,100 22.0 68,200 5,500 118,000
19 2,800 21.0 58,800 8,300 176,800
22 2,250 21.3 48,000 6,050 128,800
25 2,750 22.0 60,500 8,800 189,300
26 3,950 21.5 84,925 4,850 104,375
27 3,200 23.0 73,600 8,050 177,975
28 2,600 22.0 57,200 5,450 120,775
29 3,250 24.0 78,000 5,450 120,775

Therefore the closing stock is 5,450 units worth ksh. 120,775

Stores ledger (Standard cost-method)

Date RECEI PTS I SSUES BALANCE

OCT. 2010
Qty Price Amount Qty Price Amount Qty Amount
1 3,000 60,000
4 2,800 18 50,400 5,800 110,400
6 3,300 22 72,600 2,500 37,800
12 2,700 21 56,700 5,200 94,500
15 2,800 22 61,600 2,400 32,900
18 3,100 22 68,200 5,500 101,100
19 2,800 21 58,800 8,300 159,900
22 2,250 22 49,500 6,050 110,400
25 2,750 22 60,500 0 8,800 170,900
26 3,950 22 86,900 4,850 84,000
27 3,200 23 73,600 0 8,050 157,600
28 2,600 22 57,200 5,450 100,400
29 3,250 24 78,000 5,450 100,400

Therefore the closing stock is 5,450 units worth ksh. 100,400

Stores ledger (Weighted average cost-method)

Date RECEI PTS I SSUES BALANCE
OCT. 2010
Qty Price Amount Qty Price Amount Qty Amount
1 3,000 60,000
4 2,800 18 50,400 5,800 110,400
6 3,300 19.0 62,814 2,500 47,586
12 2,700 21 56,700 5,200 104,286
15 2,800 20.1 56,154 2,400 48,132
18 3,100 22 68,200 5,500 116,332
19 2,800 21 58,800 8,300 175,132
22 2,250 21.1 47,476 6,050 127,657
25 2,750 22 60,500 8,800 188,157
26 3,950 21.4 84,457 4,850 103,700
27 3,200 23 73,600 8,050 177,300
28 2,600 22.0 57,265 5,450 120,035
29 3,250 24 78,000 5,450 120,035

Therefore the closing stock is 5,450 units worth ksh. 120,035

Stores ledger (NIFO-method)

Date RECEI PTS I SSUES BALANCE

OCT. 2010
Qty Price Amount Qty Price Amount Qty Amount
1 3,000 60,000
4 2,800 18 50,400 5,800 110,400
6 3,300 21 69,300 2,500 41,100
12 2,700 21 56,700 5,200 97,800
15 2,800 22 61,600 2,400 36,200
18 3,100 22 68,200 5,500 104,400
19 2,800 21 58,800 8,300 163,200
22 2,250 22 49,500 6,050 113,700
25 2,750 22 60,500 0 8,800 174,200
26 3,950 23 90,850 4,850 83,350
27 3,200 23 73,600 0 8,050 156,950
28 2,600 24 62,400 5,450 94,550
29 3,250 24 78,000 5,450 94,550

Therefore the closing stock is 5,450 units worth ksh. 94,550

Activity
Tindo ltd buys and sells product Q-3. It values stock on the basis of last in first out
(LIFO). On 1 June 2010, stock in hand consisted of 4,500 units which were acquired
at ksh. 50 per unit. The operations for the month were as follows:
Date Purchases Sales
June 2 5,000 @ ksh.48
4 6,000 @ ksh. 60
5 5,500 @ ksh. 49
7 4,000 @ ksh. 50
11 7,000 @ ksh. 61
12 5,000 @ ksh. 50
13 6,000 @ ksh. 47
18 7,000 @ ksh. 62
19 8,000 @ ksh. 64
20 6,000 @ksh. 49.50
21 5,000 @ ksh. 65
22 7,000 @ ksh. 50
25 6,000 @ ksh. 49
26 2,000 @ ksh. 47
28 500 @ ksh. 60
29 14,000 @ ksh. 64

The company incurred operating cost of ksh. 450,000 during the month.

Required:
a) Prepare the stores ledger card.
 b) Determine the closing stock valuation.

c) Prepare the trading account for the month.

Recommended texts for further reading

Costing T. Lucey
Costing, An Introduction, Colin Drury
Wheldon’s, “Costing Simplified”
Colin Drury, “Management and Cost Accounting”

CHAPTER 3
LABOUR COSTING

I Introduction to labour costing

Methods of labour remuneration
Advantages of the various remuneration methods
Disadvantages of the various remuneration methods

II The treatment of premium bonus

Types of bonus schemes
Illustrations

IV Comprehensive illustrations
Objectives
After studying this chapter you will:
 Know the main categories of remuneration
 Understand the features of time-based system
 Know the features of output based system
 Be able to distinguish between straight and differential piecework
 Understand the treatment of bonus schemes

ACCOUNTING FOR LABOUR

Methods of labour remuneration
This can be classified into four:-
i) Time based system
ii) Performance/output based system
iii) Bonus schemes
iv) Profit sharing/co-ownership
Time based system
This is further subdivided into two
a) Basic system (flat rate)
Under this system workers are paid for the number of hours worked at the basic
rate e.g. 40 hours/week at Ksh 1,000/hrs.

The wages are calculated as follows:

Wages = number of hours x rate/hour

Any hours worked in excess of the basic time will be considered as an overtime
and paid at a higher rate e.g. 1 ½ x the basic hour rate

Advantages of basic system:

 Simple to understand and administer
 It simplifies wage negotiations since only one rate needs to be determined
 The workers need not work in hurry and this guarantees quality.
 Remuneration is assured and therefore workers have a feeling of security.
Disadvantages of basic system:
 No real incentive to increase output
 Employees in the same grade are paid the same amount regardless of
performance
 Constant supervision may be necessary
 The resultant decrease in production tends to increase the average cost per
unit because of fewer units to which overheads are to be charged.

b) Highly day-rate system

Is a time based system designed to provide a strong incentive by paying rates
above the basic time rate in exchange for above average performance.

Advantages of highly day-rate system:

 It can attract higher grade workers
 It provides a direct incentive without the complications of individual
piecework rates
 It’s simple to understand and administer
 It requires less supervision since the performance targets are agreed on in
advance
 The workers need not work in hurry and this guarantees quality.

Disadvantages of highly day-rate system

1. The highly day rate system may lead to competition i.e. raising the wage
rate so as to attract higher grade workers which may eventually make labour
cost be expensive in the entire industry.
2. Problems may occur when the original performance targets are not achieved

Areas where time based system is most appropriate

 Where the quality of work is more important than quantity e.g. in teaching,
medicine manufacturing, safety considerations etc
 Where output cannot be measured in quantitative terms e.g. in the case of
indirect work like the work of a watchman, teacher etc.
 Where output is beyond the control of a particular work e.g. in process
industries where goods move from one person to another before obtaining
the final output, in power stations etc.
 Where the worker is a learner or an apprentice.
Performance/output based system
This uses output obtained to determine the wages. There are two categiries of
output based system
a) Straight piece work system
The work is paid an agreed rate/unit for all the number of units produced

The wage is computed as follows:

Wages = number of units produced x rate per unit

b) Differential piece work system

One objection to the straight piecework system is that the incentive effect at
higher production levels declines because a flat rate per unit is paid throughout.
Differential piecework seeks to overcome this by motivating workers to increase
output. The units produced are divided into classes/bands such that units at higher
levels are paid at higher rates. The rates are increased progressively at various
production levels. For example:
Up to 100 units – ksh. 100 per unit
101 – 150 units – ksh. 150 per unit
151 – 200 units – ksh. 200 per unit
201 – above units – ksh.250 per unit

Advantages of performance/output system

 It benefits both the employee and employer i.e. the employee can earn
higher incomes while the employer gets increased output.
 Boosts the morale of workers since extra effort is rewarded.
 Higher grade workers may be attracted due to the opportunity to earn
higher wages.
 Minimal supervision is required.
Disadvantages
i) Complex and expensive to administer.
ii) Unskilled workers may earn as much as skilled workers leading to
dissatisfaction among the skilled workers.
iii) There is the possibility of low quality output.
Bonus schemes
These schemes provide the basis for sharing the gains in labour efficiency between
the employer and the employees.

Kinds of bonus schemes:

i) Halsey bonus scheime;
 1
bonus = x time saved x hourly rate
2
ii) Halsey- wier scheme;
1
Bonus = x time saved x hourly rate
3
iii) Rowan scheme
Time saved
Bonus = x basic pay
Time allowed
Or
Time taken
Bonus = xTime saved x hourly rate
Time allowed

Illustration
Consider the following examples;
Time allowed 500 hours
Time taken 400 hours
The hourly rate is ksh. 1,000 per hour

Required;
Compute the bonus payable to the employees under each of the above methods.

Halsey bonus scheme;

1
Bonus = x time saved x hourly rate
2
1
= x 100 x 1,000
2
= Kshs 50,000

Halsey –wier scheme

1
Bonus = x 100 x 1000 = Kshs 33 333.33
3

Rowan scheme
100
Bonus = x 400,000 = Kshs 80,000
500
Note: Organizations have different policies regarding bonus and do not have to
stick to any of the above methods

Profit sharing/co-ownership
This is where employees are encouraged to own shares in the company that they
work for. It allows workers to take part in the dividends at the end of the year
which gives them sufficient motivation to increase output so as to share the
company’s gross profit.

Factors influencing wages

General economic climate of a particular industry.
Government policy i.e. whether there is a minimum wage requirement or
not.
 Profitability of the firm.
 Strength of the union.
 The supply of labour in the market.
 Strategic importance of the industry to the economy e.g. electricity supply
 Availability of workers with appropriate skills.
 The extent of danger and hazards at the work place.
 The rate of labour turnover (rate at which workers join and leave the
organization).
 Wage rates prevailing locally and internationally
Labour turnover
This refers to the rate at which employees leave and new employees join a firm. It
is normally expressed as a ratio as follows:

Number of employees replaced per period

Labour turnover =
Average total number of employees in the period

Causes of labour turnover

a) Unavoidable causes
i) Sickness, insanity, accident etc
ii) Movement of families from one locality to another.
iii) Marriage, pregnancy and difficulties in child care provision.
iv) Death.

b) Avoidable causes
i) Paying lower wages than is available elsewhere.
 ii) Requiring workers to work in unsafe or highly stressful conditions.
iii) Lack of opportunities for career development.
iv) Poor relationship between management and employees.
v) Lack of job satisfaction.
vi) Lack of training
vii) Redundancy

Illustration
Rapid results limited manufactures 3 products; A, B and C. The company has 30
workers being paid under a group bonus scheme. There are 3 categories of
employees who are paid bonus of the excess of time allowed over time taken. The
bonus is computed at the rate of 75% of the employees’ base rate and is shared
among the direct workers in proportion to the time spent on the work. The relevant
production details for the period under consideration are as follows:-

Product Units produced Time allowed

per unit
(minutes)
A 80 63
B 160 120
C 300 100

Category of Number of Base rate Hours worked

employees direct workers per employees
(ksh)
1 10 20 15
2 4 18 32
3 16 16 25

Required:
a) Compute the time allowed, time taken and time saved during production
b) Compute the percentage of hours saved to hours taken
c) Compute the total bonus due to each category of employees
d) Compute the total earnings due to the group.
Solution
Time allowed

Product Units produced Time allowed (min) Total time allowed (hours)
A 80 63 84
B 160 120 320
C 300 100 500
Total time allowed 904

Total time allowed = 904 hours

Total time taken;

Category of Number of direct Hours worked per Time taken

employee workers employees (hours)
1 10 15 150
2 4 32 128
3 16 25 400
Total time taken 678

Time saved = time allowed – time taken

= 904hrs – 678 hrs
= 226 hrs
226
% of hrs saved to hrs taken = x 100 = 33.33%
678
Total bonus due to each category of employees

Categor Base rate Time taken Bonus (ksh)

y
1 20 150 75 150
x 20 x x 226 = 750
100 678
75 128
2 18 128 x 18 x x 226 = 576
100 678
75 400
3 16 400 x 16 x x 226 =1,600
100 678
678

The total earnings due the group

Employee Basic Bon Gross

Category us pay

1 20 x 150 = 3000 750 3750

2 18 x 128 = 2304 576 2880
3 16 x 400 = 6400 1600 8000
Total earnings to the group 14,630

Activity 1:
Ardhi Company Ltd is considering the type of remuneration scheme to adopt for its
employees.
The following information is availed to you for your analysis:
Employees

Mam Sai Mbo Zaina

bo di go bu
Actual hours worked 38 36 40 34
Hourly rate of pay 30 20 25 36
(ksh)
Output (units): A 42 120 - 120
B 72 76 - 270
C 92 - 50 -
Output

A B C
Standard time allowed per unit 6 9 15
(minutes)

For the calculation of piecework earnings the company values each minute at a
rate of 50 cents.

Required:
Calculate the earnings for each employee using:
a) Basic guaranteed hourly rates.
b) Piecework rates.
c) Premium bonus, given that an employee earns the premium bonus at the
rate of two thirds of the time saved.

Activity 2
Ushindi Ltd manufactures ornaments for export trade. Jobs are allocated to two
operators. Mbotela and Juma with bonus paid for hours saved.

In the month of February 2009, Mbotela made 186 units and Juma made 210 units
for which the time allowed of 30 standard minutes and 25 standard minutes per
unit respectively was credited.

The basic wage was ksh. 18 per hour for both employees. For every hour saved a
bonus was paid at 20% of the basic wage rate. Hours worked in excess were paid
at the basic wage rate plus two thirds.

Mbotela completed his job in 44 hours and Juma completed his job in 39 hours.
A basic working week has 40 hours.

Required:
For each operator, calculate:
i. The amount of bonus payable.
ii. The total gross wage payable.
iii. The wages cost per unit.
CHAPTER 4

ACCOUNTING FOR OVERHEAD COST

I Introduction to overheads
Classification of overhead cost

II Apportionment of overheads
Primary distribution of overheads
Secondary distribution of overheads
Illustrations

III Overhead recovery

Methods of overhead absorption
Treatment of over or under absorbed overhead
Cost statement for jobs
Illustrations

IV Activities

Objectives
After studying this chapter you will
 Understand the principles of overhead apportionment
 Understand the difference between primary and secondary distribution of
overheads
 Know the methods of transferring service department costs to the production
departments
 Understand the methods of overhead absorption
 Know how to calculate over or under absorption of overheads
 Know how to prepare cost statements for jobs
Introduction:
Overhead refers to the total cost of indirect materials, indirect labour and indirect
expenses. Indirect costs are those which cannot be identified with the production
of some specific goods or services. These costs are incurred for the organization as
a whole.

Allocation of overhead cost

Overhead allocation occurs when an overhead can be identified as belonging to a
specific cost centre and is charged to that centre. Therefore there is no need for
apportionment of such overheads.

Apportionment of overhead cost

Overhead apportionment occurs when overheads cannot be identified as belonging
to a specific cost Centre and are therefore shared out on an equitable basis.
Overheads though not directly related to the items being manufactured, should
finally form part of the total cost of the products being manufactured. If an
organization has two or more departments each carrying out a separate activity,
then the overheads of the organization should be divided among these
departments equitably.

The process of sharing the overhead costs between products or departments or

divisions in an organization is referred to as apportionment of overheads. The
initial distribution of overheads that is done to all departments, whether production
or service departments, is called primary distribution of overheads.

Bases of overhead apportionment

This refers to the logic for sharing a common overhead cost between various
departments or products within the organization. The most common bases of
overhead apportionment include:

Base Overhead to which the base may apply

Floor area Rent, rates, heat and lighting costs, depreciation of buildings,
maintenance of building, insurance of buildings etc.

Book value of Maintenance and repairs of plant and machinery, insurance of

assets plant and machinery etc.
Number of Expenses of personnel canteens, welfare expenses, safety
employees expenses, supervision expenses etc.

Weight of Material handling expenses, packaging expenses.

material

Sales value Advertisement costs, selling and distribution costs etc

Technical Power consumption, water usage etc.

estimates

Direct wages Staff training expenses, provident fund contributions etc.

Illustration 1
The following information relates to a factory which has four departments:
Overhead items Cost in
(Ksh)
Rent 80,000
Repairs to plant 50,000
Depreciation of 40,000
plant
Total 170,000

The following information is also available in respect of the department

A B C D
Area (m2) 1,500 1,200 800 50
0
Value of 500,00 300,00 200,00 ----
plant 0 0 0

Required:
Prepare an overhead analysis statement showing clearly the basis of
apportionments.
Solution
Overhead analysis statement

Overhead Total Base Ratio Appointment

item cost
Dept. Dept. Dept. Dept.
A B D
C
Rent 80,000 Area 15:12:8: 30,00 24,00 16,000 10,000
5 0 0

Repairs to 50,000 Value of 5:3:2:0 25,00 15,00 10,000 ----

plant plant 0 0

Depreciation 40,000 Value of 5:3:2:0 20,00 12,00 8,000 ----

to plant plant 0 0

Total 170,00 75,00 51,00 34,00 10,00

0 0 0 0 0
Illustration 2
A modern company (X ltd) has 4departments A, B, C and D. The actual cost for a
given period was extracted from their books as follows:
Costs
(ksh.‘00
0’)
Indirect materials: Department 950
A
Department 1,200
B
Department 200
C
Department 1,500
D

Indirect labour Department 900

A
Department 1,100
B
Department 300
C
Department 1,000
D

Rent 2,000
Repairs to plant 1,200
Depreciation of plant 900
Lighting expenses 200
Supervision 3,000
Insurance of stock 1,000
Employees insurance (employer’s 300
liability)
Power costs 1,800
Employees personal expenses 1,500
Total 19,050

The following data is also available in respect of the 4 departments:

Dept. Dept. Dept. Dept.
A B C D
Area (m2) 150 110 90 50
No. of workers 24 16 12 8
Total wages (Ksh. ‘000’) 8,000 6,000 4,000 2,000
Value of plant (Ksh. 64,000 18,000 12,000 6,000
‘000’)
Value of stock (Ksh. 15,000 9,000 6,000 ----
‘000’)
Kilowatt-hours 45 15 20 20

Required:
Apportion the above costs to the various departments on the basis of the most
equitable base.

Solution:
Overhead analysis statement
Overhead item Total Base Ratio Apportionment
Dept. A Dept. B Dept. C Dept. D
I ndirect materials 3,850 Actual 950 1,200 200 1,500
I ndirect labour 3,300 Actual 900 1,100 300 1,000
Rent 2,000 Floor area 15:11:9:5 750 550 450 250
Repairs to plant 1,200 Value of plant 32:9:6:3 768 216 144 72
Depreciation of plant 900 Value of plant 32:9:6:3 576 162 108 54
Lighting expenses 200 Floor area 15:11:9:5 75 55 45 25
Supervision 3,000 No. employees 6:4:3:2 1,200 800 600 400
Employees insurance 300 No. employees 6:4:3:2 120 80 60 40
I nsurance of stock 1,000 Value of stock 5:3:2:0 500 300 200 0
Power costs 1,800 KWH 9:3:4:4 810 270 360 360
Employees personal expenses
1,500 Wages 4:3:2:1 600 450 300 150
Total 19,050 7,249 5,183 2,767 3,851

Overheads of service departments

Service departments are those which are not engaged in production of any specific
items but provide support to production department e.g. stores department,
repairs and maintenance department, personnel department etc

The overheads charged to service department must further be reapportioned to

the production departments. This is called, secondary distribution of overhead or
reapportionment of service department overheads.

Methods of reappointment of service department overheads

There are main methods include
i. Repeated distribution method (continuous allocation method)
ii. Algebraic method (simultaneous equation method)
iii. Direct allocation method
iv. Sequential allocation method

Repeated distribution method

Under this method the overheads of the service department are transferred to the
production department on the basis of the benefit that the production department
enjoys from these service departments.

The process of transferring the overheads can begin by allocating the overheads of
one service department to other production departments before proceeding to the
next service department and so on.
If the service departments are engaged in reciprocal relationships i.e. service
departments provides services to one another, then in the process of reallocating
the overheads of any given service department, some overhead cost is transferred
to a previously closed service department and the process has to begin all over
again.

Algebraic/simultaneous method
This method transfers the overheads of service departments by modeling the
problem into a system of simultaneous equations and solving it using any of the
conventional methods.

Illustration
The departmental distribution summary for XY Ltd has been extracted as follows

Ksh.
Production 1 24,00
department: 0
2 18,00
0
3 12,00
0
4 6,000

Service department: A 3,600

B 1,800
Total 65,40
0

It has been estimated that the cost of running service departments can be charged
to the various departments according to the following percentages:

1 2 3 4 A B
A 40% 10% 20% 20% - 10%
B 20% 30% 10% 20% 20% -
Required:
Determine the total overheads apportioned to production department 1- 4 using;
i) Repeated distribution method/ continuous allocation method
ii) Algebraic method

Solution
Overhead analysis statement
Total Dept. 1 Dept. 2 Dept. 3 Dept. 4 Dept. A Dept. B
Overhead cost 65,400 24,000 18,000 12,000 6,000 3,600 1,800
Secondary distribution:
A 0 1,440 360 720 720 -3,600 360
B 0 432 648 216 432 432 -2,160
A 0 173 43 86 86 -432 43
B 0 9 13 4 9 9 -43
A 0 3 1 2 2 -9 1
B 0 0 0 0 0 0 -1
Total 65,400 26,057 19,065 13,029 7,249 0 0

Using algebraic method

Let the total overheads in department A be x
Let the total overheads in department B be y

x = 3600 + 0.2y x = 3600 + 0.2y

y = 1800 +0.1x x = 3600 + 44081
y= 1800 + 0.1 (3600 +0.2y) x= 4040.82
y = 1800+360+0.03y
y = 2160+0.02y
0.98 y 2160
=
0.98 0.98
Y= 2204.08

Total Dept. 1 Dept. 2 Dept. 3 Dept. 4 Dept. A Dept. B

Overhead cost 65,400 24,000 18,000 12,000 6,000 3,600 1,800
Secondary distribution:
A 0 1,616 404 808 808 -4,041 404
B 0 441 661 220 441 441 -2,204
Total 65,400 26,057 19,065 13,029 7,249 0 0

Direct allocation method

Under this method overheads of the service departments are transferred to the
production department on the basis of the benefit that the production departments
enjoy from a particular service department. In this method, no overhead is
allocated to another service department even if it enjoys the services of any given
service department. Therefore the basis of transferring the overheads is the ratio
formed in the production department only with respect to benefits enjoyed.

Sequential allocation/ step down method

Under this method, the service departments are ranked in a descending order on
the basis of the total amount of the benefits they offer to other departments. The
overhead cost of the service departments that gives the highest amounts of
services is allocated first to the other (departments including other service
department).

The service department that gives the second highest amount of service then
reallocated to the other departments but nothing is reallocated back to the first
service department even if it enjoys the benefits. The process continues until all
the overheads of the service department have been reallocated.

Illustration
MMC Limited operates two production department and two service department.
The budgeted cost and normal activity levels for each of the four departments are
given below:

Service departments Production departments

 Maintenanc Power Grinding Assembly
e
Ksh Ksh Ksh Ksh
Overhead cost 1,000,000 2,000,000 1,000,000 500,000
No. of employees 8 7 30 30
Maintenance 2,000 200 6400 1600
hours

Additional information
The cost of maintenance department is allocated on the basis of number of
employees while those of power department on the basis maintenance hours

Required
Allocate the service department overheads using:
i) Direct allocation method
ii) Sequential allocation method
Solution

Direct allocation method:

Total MaintenancePower Grinding Assembly

Overhead cost 4,500,000 1,000,000 2,000,000 1,000,000 500,000
Secondary distribution: 0
Maintenance: 0 -1,000,000 500,000 500,000
Power: 0 -2,000,000 1,600,000 400,000
Total 4,500,000 0 0 3,100,000 1,400,000

Sequential allocation method

 Total Maintenance Power Grinding Assembly
Overhead cost 4,500,000 1,000,000 2,000,000 1,000,000 500,000
Secondary distribution:
Power: 400,000 -2,000,000 1,280,000 320,000
Maintenance: -1,400,000 700,000 700,000
Total 4,500,000 0 0 2,980,000 1,520,000

OVERHEAD ABSORPTION / RECOVERY/APPLICATION/CHARGING

Once overheads have been allocated or apportioned to the various production
departments, the total overhead cost of production departments are ultimately
charged or absorbed in the cost of products passing through these departments.
Absorption of overheads is therefore the last step in the distribution plan of
overheads.

There are two steps in the absorption of overheads:

a) Computation of overhead absorption rates (OARs)
b) Application of these rates to the cost units
Computation of overhead absorption rates
There are various methods of determining overhead absorption rates
 1. Rate per unit of output

Budgeted OH cos t
OAR =
Budgeted output

Illustration
A company estimated its overhead cost in a given period to be Ksh. 3,000,000 and
for an estimated output of 150,000 units.
Required:
Determine;
i) The OAR
ii) If the actual output turned out to be 175,000 units for which the actual
overhead cost of Ksh. 3,200,000 was incurred, compute the over/under
absorbed overhead.

Solution

Budgeted Actual
Output (units) 150,000 175,000
OVERHEAD (Kshs) 3,000,000 3,200,000

3,000,000
OAR =
150,000

OAR = ksh. 20 per unit

Ksh.
Total overhead absorbed (175,000 x 3,500,
20) 000
Actual overhead Cost 3,200,000
Over-absorbed overheads 300,000
Illustration II
A company budgeted to incur an overhead cost amounting to Ksh 6 million for a
budgeted activity level of 50,000 units. During the year, the company produced
47,500 units for which they actually incurred a total overhead cost of Ksh 5 million.

Required:
i) Compute the OAR
ii) Determine the over/under absorbed overhead
Solution

Budgeted Actual
Output (unts) 50,000 47,500
overhead (Kshs) 6,000,000 5,000,000

6,000,000
OAR = = Ksh 120 per unit
50,000

Ksh.
Total overhead absorbed (47,500 x 5,700,
120) 000
Actual overhead Cost 5,000,000
Over-absorbed overheads 700,000

2. Direct material cost percentage method

Under this method, the amount of overhead cost to be absorbed by a cost unit is
determined by the cost of direct materials consumed in producing it.

Budgeted overhead cos t

OAR = x100
Budgeted direct material cos t

Illustration
X Ltd estimated that its overhead cost in a given period to be ksh. 1.2 million
during which period the direct material cost was also estimated at ksh. 1.8 million.
At the end of the period, the actual overhead cost incurred was ksh. 1 million and
the expenditure on direct material amounted to ksh. 1.4million.
Required;
i) Calculate the OAR
ii) Compute the overhead over/under absorbed overheads

Budgeted Actual
Overhead 1,200,000 1,000,000
Direct material cost 1,800,000 1,400,000

1200
OAR = x 100 = 66.7%
1800

OAR = 66.7% of direct material cost

Ksh.
Total overhead absorbed (1,400,000 x 933,333
66.7%)
Actual overhead Cost 1,000,00
0
Under-absorbed overheads 66,667

3. Direct labour cost percentage method

Under this method, the amount of overhead cost to be absorbed by a cost unit is
determined by the cost of direct labour consumed in producing it.

Budgeted overhead cos t

OAR = x100
Budgeted direct labour cos t

Illustration
The following information was obtained from the books of ABC Ltd
 Budget Actual
ed
Direct 600,000 650,000
material
Direct labour 1,000,00 1,150,00
0 0
Overhead 800,000 900,000

The company is engaged in a process that will produce a product whose cost
details are as follows:-
Job No. Y200

Ksh
.
Direct 120
materials
Direct labour 150
Total 270

Required:
i) Calculate the OAR
ii) Calculate the over/under absorbed overhead
iii) Determine the selling price of job number Y200 given that the company
has a policy of 20% mark-up. (the company absorbs overheads on the
basis of direct labour cost)
Solution
800,000
i) OAR = x 100 = 80% of direct labour
1,000,000

ii) Over-absorbed overheads

Ksh.
Total overhead absorbed (1,150,000 x 920,00
80%) 0
Actual overhead Cost 900,00
0
Over-absorbed overheads 20,000

iii) Selling price for job Y200:

Cost statement for job Y200

Ksh
.
Direct materials 120
Direct labour 150
Overheads absorbed (80% of 120
150)
Total cost 390
Add: mark-up (20% of 390) 78
Selling price 468

4. Prime cost percentage method

Prime cost refers to the total direct cost i.e. direct material cost plus direct labour
cost plus direct expenses.

Budgeted overhead cos t

OAR = x100
Budgeted Pr ime cos t

Illustration
The following information was obtained from the books of KCA Ltd

Budget Actual
ed
D/Material 400,000 430,00
0
D/Labour 500,000 600,00
0
D/Expenses 300,000 250,00
0
Overhead 600,000 560,00
cost 0 During the year, the company incurred cost of
job no. 120 as follows
 Ksh.
Direct 3,000
materials
Direct labour 1,800
Direct 200
expenses
Total 5,00
0

Required;
i) Compute the OAR
ii) Compute the SP for job 120 given that the company adds a margin of 20%
(use prime cost percentage method)
Solution
600,000
i) OAR = x 100 = 50% of prime cost
1,200,000

ii)
Ksh.
Total overhead absorbed (1,280,000 x 640,00
50%) 0
Actual overhead Cost 560,00
0
Over-absorbed overheads 80,000

iii)
Cost statement for job no. 120

Ksh.
Direct materials 3,000
Direct labour 1,800
Direct expenses 200
Overheads absorbed (50% of 5,000) 2,500
Total cost 7,500
  20%  1,875
Add: mark-up (   25% of
 100%  20% 
7,500)
Selling price 9,37
5

5. Labour Hour Method

Under this method, the amount of overhead cost to be absorbed by a cost unit is
determined by the direct labour hours consumed in producing it.

Budgeted overhead cos t

OAR =
Budgeted labour hours

Illustration
KCA Ltd budgeted to incur an overhead cost amounting to ksh. 3.5 million and to
work ksh. 175,000 direct labour hours. During the period the actual results was
recorded as follows:

Actual overhead ksh. 4.3 million

Actual direct labour hours 210,000

The cost accountant has extracted the following details with respect to job K002.
 Direct material 450
 Direct labour 300
 Direct expense 150
 Machine hours 15
 Labour hours 12

It’s the policy of the company to charge a profit margin of 25%. The company
absorbes overheads on the basis of direct labour hours

Required;
 i) Calculate the over/under absorbed overhead
ii) Determine the selling price of job number K002

Solution
3,500,000
OAR =
175,000

OAR = ksh.20 per direct labour hour

i)

Ksh.
Total overhead absorbed (210,000 x 4,200,00
20) 0
Actual overhead Cost 4,300,00
0
Under-absorbed overheads 100,000

ii) Cost statement for job k002

Ksh.
Direct materials 450
Direct labour 300
Direct expenses 150
Overheads absorbed (12 x20) 240
 Total cost 1,140

 25%  1 380
Add: mark-up (   33 % of
 100%  25%  3
1,140)
Selling price 1,52
0

6. Machine hour method

Under this method, the amount of overhead cost to be absorbed by a cost unit is
determined by the machine hours consumed in producing it.

Budgeted overhead cos t

OAR =
Budgeted machine hours

Illustration
JK Ltd presented the following information regarding their cost for the year 2010

Budgeted Actual
Overhead 4,500,000 4,350000
Direct material cost 6,000,000 7,500,000
Direct labour cost 5,250,000 5,000,000
Labour hours 160,000 185,000
Machine hours 150,000 145,000

During the same period, the company’s cost accountant extracted the full
information with respect to job No. JK010 as follows:
 Labour hours 25
 Machine hours 18
 Direct labour cost 420
  Direct expenses 180
 Direct material 600

Required;
i) Compute the over/under absorbed overhead
ii) The selling price of Job No JK010, given that the company has a policy of
15% mark up
Solution

OAR = 4,500,000
150,000

OAR = Ksh 30 per machine hour

Ksh.
Total overhead absorbed (145,000 x 4,350,00
30) 0
Actual overhead Cost 4,350,00
0
Under/over-absorbed overheads 0

i) Cost statement for job Jk010

Ksh.
Direct materials 600
Direct labour 420
Direct expenses 180
Overheads absorbed (18 x 540
30)
Total cost 1,740
Add: mark-up (15% of 261
1,740)
Selling price 2,00
1
Activity 1
BCD ltd manufactures office and household furniture to customers’ specifications.
Because of the specialized nature of the manufacturing process, each job is
treated separately for costing purposes. There are two stages in the manufacture
of each item namely, Assembly and Finishing. In the assembly department,
overheads are absorbed on the basis of prime cost incurred in that department. In
the finishing department, overheads are applied on the basis of total accumulated
cost on the job in both the two stages inclusive of overhead absorbed in assembly.
The selling price of the item is then determined by applying the usual 40% profit
margin.

The following information is provided about budgeted data for the next financial
period:
Assembly Finishing
Materials ksh. 480,000 300,000
Overheads ksh. 594,000 418,500
Labour cost ksh 180,000 120,000
Labour hours 3,000 1,500
Required:
a) Calculate the overhead absorption rates for each production process.

b) Job no. 148 shows the following data concerning its production:
Assembly Finishing
Materials shs. 5,000 3,500
Labour cost shs. 2,700 1,600
Labour hours 12 4

Required:
Prepare the cost statement for this job and indicate the proposed final selling
price.

c) The following data relates to the actual manufacturing operations as

accumulated for the whole financial period:
Assembly Finishing
Overhead incurred shs. 660,000 450,000
 Materials shs. 530,000 288,000
Labour cost shs. 200,000 135,000
Labour hours 3,450 1,650
Required:
Calculate the amount of overhead over applied or under applied for the company
as a whole.

d) Comment on the overhead absorption rates used by the company in light of the
results obtained in (c) above.

Activity 2
Mwangaza Metals Ltd. Fabricates steel products for export to the COMESA region.
The products go through three processing departments: forming, machining and
finishing.

The following information relates to operations for the year ended 31 October
2010.

1. Budget manufacturing costs for the year ended 31 October 2010 were as
follows

Departme
nts
Formi Machining Finishi Total
ng ng
Sh. Sh. Sh. Sh.
‘000’ ‘000’ ‘000’ ‘000’
Direct materials 340,00
0
Direct labour 80,000 40,000 120,00 240,00
0 0
Manufacturing 20,000 80,000 60,000 160,00
overheads 0

2. The actual manufacturing costs incurred for the year ended 31 October
 Departme
nts
Formi Finishi Total
ng Machining ng
‘000’ ‘000’ ‘000’ ‘000’
Direct materials 360,00
0
Direct labour 88,000 38,000 144,00 270,00
0 0
Manufacturing 24,000 72,000 78,000 174,00
overheads 0

3. While there were no finished goods or work-in-progress inventories at the beginning of the year, stocks
on 31 October 2010 were made up as follows:

ksh.
Work-in- 39,000,000
progress
Finished goods 121,000,00
0

The above balances include actual direct materials, direct labour and
absorbed overhead costs.

4. Manufacturing overhead costs are absorbed into products on the basis of

direct labour costs, at rates pre-determined at beginning of the year, using the
annual budgeted data.

Two alternatives of absorbing overheads could be employed:

 Use a single factory wide manufacturing overhead rate.
 Use separate departmental manufacturing overhead rates.

5. The policy of the company is to dispose of over (under) absorbed overheads

at the year-end by allocating the amount between ending inventories and cost of
goods sold in proportion to their unadjusted cost balances.
 Required:
(a) Using the separate departmental manufacturing overhead rates:
(i) Determine the total under/over absorbed overheads for the year.
(ii) Allocate the over/under absorbed overheads to the relevant
accounts.

(iii) Prepare a journal entry to record the disposal of the over/under absorbed
overheads.
(b) A particular order code named E20, from a customer was worked on and completed during the year.
The following costs were incurred in relation to the order.

Ksh. Ksh.
Direct 3,000,00
materials 0
Direct labour: Forming 400,00
0
Machinin 380,00
g 0
Finishing 480,00 1,260,00
0 0

Required:
Using the factory wide absorption rate, determine total overhead applied to the
order (E20).

CHAPTER 6

COST BOOK-KEEPING

Part Topic Page

I Introduction to cost book-keeping
Introduction
Distinction between integrated accounts and
interlocking accounts
II Integrated system
Accounting entries
Final accounts and balance sheet
Illustrations

III Non-integrated system

Accounting entries
Reconciliation of cost accounts with financial accounts
Illustrations

IV Activity

Objectives
After studying this chapter you will;
 Understand the distinction between integrated and interlocking cost
accounts
 Know the double entries required in integrated and interlocking systems
 Be able to reconcile the profits of cost and financial accounts

Introduction:
Cost book-keeping refers to a system of recording various cost information in the
books of accounts. There are two systems of cost book-keeping:
i. Integrated system
ii. Non-integrate system/interlocking system.

Integrated system
This is one in which cost accounts and financial accounts are combined in one set
of books of accounts.

Non-integrate system/interlocking system

This is an alternative system where the cost and financial accounts are maintained
independently. At the end of each period, two profits are calculated i.e. costing
profits and the financial profit.

Cost book keeping is based on control accounts. A control account is a summary

account where entries are made from totals of transactions for a period. For
example total raw materials purchased are recorded in “Material Control Account”
also known as “Stores Ledger Control Account”.

Cost book-keeping is based on the principle of double entry. The main control
accounts for purposes of accumulating costs are:

i) Raw materials control account.

ii) Wages control account.
iii) Production overhead control account.
iv) Work in progress control account.
v) Administration overhead control account
vi) Finished goods control account.
vii) Selling and distribution overhead control account etc.

Double entry for integrated system

1. To record the purchase raw materials.
Dr. Raw material control account.
Cr. Creditors/Bank account.

2. To record materials returned to suppliers.

Dr. Creditors control account.
Cr. Raw materials control account.

3. To record the issue of direct materials to production.

Dr. Work in progress control account.
Cr. Raw materials control account.

4. To record the issue of indirect materials to production

Dr. Production overhead control account.
Cr. Raw materials control account.

5. Recording of labour is done in two stages.

a) To record total wages incurred.
Dr. Wages control account.
 Cr. Bank/wages payable account

b) To allocate the wages between direct and indirect wages

Dr. Work in progress control account (with direct wages).
Dr. Production overhead control account (with indirect wages).
Cr. Wages control account.

6. To record other indirect expenses (other than indirect materials and indirect
labour)
Dr. Production overhead control account.
Cr. Bank/expenses payable account.

7. To transfer the absorbed overhead to production.

Dr. Work in progress account (with absorbed production overhead)
Cr. Production overhead control account.

Note:
The balancing figure in the production overhead control account represents over or
under absorbed overheads. This is transferred to the P & L account.

8. To record the cost of goods produced (fully complete goods)

Dr. Finished goods control account.
Cr. Work in progress control account.

9. To record selling and distribution overheads incurred.

Dr. selling and distribution expenses control account.
Cr. Bank/expenses payable account.

NB: this is closed as an expense to the P&L account i.e.

Dr. Profit & Loss account.
 Cr. Selling and distribution control account.

10. To record the cost of goods sold:

Dr. Cost of sales account.
Cr. Finished goods control account
11. To record sales of goods:
Dr. Debtors or cash account
Cr. Sales account.

Given the sales, cost of sales and selling and distribution expenses, the net profit
can be determined by preparing the profit and loss account.
 Materials Wages

Direct Indirect Indirect Direct

wages
Materials Materials Wages

Production OHs

Work-in-progress

Finished goods

Cost of sales. Sales

Profit & loss account

Illustration
Journalize the following transactions in the integrated books of account.
1. Credit purchases ksh. 1.2 m.
2. Wages incurred ksh. 700,000 (direct wages ksh. 550,000 and indirect wages
ksh. 150,000
3. Direct materials issued to production ksh. 800,000.
4. Indirect materials issued ksh. 200,000
5. Work expenses charged to production ksh. 850,000.
6. Finished goods transferred from production ksh. 2,100,000.
7. Administration expenses incurred and charged to production ksh 150,000.
8. Work expenses outstanding ksh. 120,000
9. Work expenses paid ksh. 460,000
10. Cost of goods issued for sale ksh. 1,950,000
11. Sales (all on credit) ksh. 3,250,000
12. Selling and distribution expenses incurred ksh. 230,000

Solution
To record the purchase raw materials:
Dr. Raw material control account ksh. 1,200,000
Cr. Creditors control account. Ksh. 1,200,000
Materials issued to production:
Dr. Work in progress control account ksh. 800,000
Dr. Production overhead control account ksh. 200,000
Cr. Raw materials control account ksh. 1,000,000

To record wages incurred:

Dr. Wages control account ksh. 700,000
Cr. bank account ksh. 700,000
The wages incurred is allocated between direct wages and indirect wages as
follows:
Dr. Work in progress control account ksh. 550,000
Dr. Production overheads control account ksh. 150,000
Cr. Wages control account ksh. 700,000

Total work expenses incurred is the sum of work expenses outstanding and work
expenses paid. This is recorded in the journals as follows:
Dr. Production overheads control account ksh. 580,000
Cr. Bank account ksh. 580,000
The absorbed production overhead is recorded as follows:
Dr. Work in progress control account ksh. 850,000
Cr. Production overhead control account ksh. 850,000

To record the administration overhead incurred

Dr. Administration overhead control account ksh. 150,000
Cr. Bank or Administration expenses payable ksh. 150,000
This is charged to production as follows:
Dr. Work in progress control account ksh. 150,000
Cr. Administration overhead control account ksh. 150,000

To record the cost of goods produced (fully complete goods)

Dr. Finished goods control account ksh. 2,100,000
Cr. Work in progress control account ksh. 2,100,000

To record the cost of goods sold

Dr. Cost of sales account ksh. 1,950,000
Cr. Finished goods control account ksh. 1,950,000

To record sales
Dr. Debtors control account ksh. 3,250,000
Cr. Sales account ksh. 3,250,000
The sales account is then closed into profit and loss account as follows:
Dr. Sales account ksh. 3,250,000
Cr. Profit and loss account ksh. 1,950,000

To record the selling and distribution overheads:

Dr. Selling and distribution account ksh. 230,000
Cr. Bank account ksh. 230,000
This account is closed to the profit and loss account as follows:
Dr. Profit and loss account ksh. 230,000
Cr. Selling and distribution control ksh. 230,000

The above journals can be posted into ledger accounts as follows:

Raw materials control account

Creditor 1,200,00 Work in progress 800,000
s 0
Production 200,000
overhead
Balance c/f 200,000
1,200,00 1,200,00
Wages 0 0 control
account
Cas 700,00 Work in progress 550,00
h 0 0
Production 150,00
overhead 0
700,00 700,00
0 0

Production overhead control account

Raw materials 200,00 Work in 850,00
0 progress 0
Wages control 150,00
0
Bank account 460,00
0
Work expenses 120,00 Profit & loss a/c 80,000
payable 0

930,00 930,00
0 0
 Administration overhead control account
Ban 150,00 Work in 150,00
k 0 progress 0

150,00 150,00
0 0
Work in
progress control account
Raw materials 800,000 Finished goods 2,100,00
control 0
Wages control 550,000
Production overhead 850,000
Administration 150,000 Balance c/d 250,000
overhead

2,350,00 2,350,00
0 0

Finished goods control account

Work in 2,100,00 Cost of sales 1,950,00
progress 0 account 0
Balance c/f 150,000
2,100,00 2,100,00
0 0
Cost of sales
account
Finished goods 1,950,00 Profit and loss 1,950,00
control 0 account 0

1,950,00 1,950,00
0 0
Sales
account
Profit and loss 3,250,00 Debtors control 3,250,00
account 0 account 0

3,250,00 3,250,00
0 0
 Selling and distribution control account
Ban 230,00 Profit and 230,00
k 0 loss 0

230,00 230,00
0 0
Debtors control account
Sale 3,250,00 Balance 3,250,00
s 0 c/f 0

3,250,00 3,250,00
0 0
Creditors control account
Balance 1,200,00 Raw materials 1,200,00
c/f 0 control 0

1,200,00 1,200,00
0 0
Bank account
Balance c/f 1,160,000 Wages account 700,000
Production 460,000
overhead
1,160,000 1,160,000

Profit and loss account

Cost of sales 1,950,00 Sale 3,250,00
0 s 0
Selling and 230,000
distribution
Production overhead 80,000

Net profit 990,000

3,250,00 3,250,00
0 0
Double entry for
Non-integrated system
An interlocking system is a system where the cost and financial accounts are
maintained separately and independently of each other. In the accounts, no
attempt is made to keep a separate record of the financial transactions. Examples
of financial accounting transactions are those relating to;
 Capital account
 Bank accounts
 Debtors account
 Creditors account.

To maintain double entry records, an account must be opened in the cost books to
record the corresponding double entry which in the integrated system would
normally be made in one of the financial accounts listed above. This account is
known as Cost Ledger Control Account (CLC a/c) or General Ledger Adjustment
account or Financial Ledger Adjustment account.

Journals
1. To record the purchases of materials either in cash or credit.
Dr. Raw materials control
Cr. Cost ledger Control

2. To record materials returned to suppliers.

Dr. CLC
Cr. Raw materials control.

3. To record the issue of materials to production.

Dr. Work – in- progress (direct materials)
Dr. Production overhead (indirect materials)
Cr. Raw materials control account

4. To record wages incurred.

Dr. Wages control account
Cr. CLC.
5. To allocate wages between direct and indirect:
DR. Work –in-progress (direct wages)
 Dr. Production overhead (indirect wages)
Cr. Wages control account

6. To record other production overhead incurred

Dr Productions overhead control.
Cr. Cost ledger control
7. To record the production overhead charged to production.
Dr. Work in progress control (with absorbed overhead)
Cr. Production overhead

NB the balancing figure in production overhead control account represents the

under or over absorbed overhead which is transferred to the costing Profit and
Loss account.

8. To record selling and distribution expenses.

Dr. Selling and distribution expenses control account
Cr. Cost ledger control

NB: the selling and distribution expenses are then transferred to the P & L account
or absorbed into the cost sales.
Dr. costing profit & Loss a/c
Cr. Selling and distribution

13. To transfer the finished good from production

Dr. finished goods control account
Cr. Work in progress control account

14. To record the sales of goods.

Dr. Cost ledger control
Cr. Sales

A trial balance under the non-integrated system is then extracted and will normally
contain the following items;
Trial balance

Dr. Cr.
CLC - XX
Raw materials control a/c XX
Work in progress control a/c XX
Finished goods control a/c XX

XX XX

The costing profit is normally determined as the balancing figure in the CLC
account or it can be calculated by preparing the costing Profit & Loss account.

Illustration
The following are the cost ledger balances of the company as at 31 st December
2008.

Dr. Cr.
CLC 22,100
Raw materials 8,500
W.I.P 6,600
F. Goods 7,000
22,10 22,10
0 0

Operations during the year 2009 were as follows:

Purchases ksh. 40,000
Stock issued to production ksh. 38,000
Stock issued to work repairs ksh. 750
Stock issued not chargeable ksh. 250
Wages: - Productive ksh. 45,000
 : - Repairs ksh. 800
: - Unproductive ksh. 4,500

Work overhead expenses (excluding wages and materials) - ksh. 15,000

Work overhead recovered (absorbed) ksh. 21,000
Administration expenses ksh. 4,500
Administration expenses absorbed ksh. 5,000
Sales ksh. 130,000
Finished goods as at 31 December. 2009 ksh. 5,000
Work in progress as at 31 December. 2009 ksh. 3,100

Required:
a) Write up the cost books.
b) Prepare the costing profit & loss account.
c) Extract a trial balance as at 31st December. 2009

Solution

Raw materials control account

Balance 8,500 Work in progress 38,00
b/f 0
CLC 40,00 Production 1,000
0 overhead
Balance c/f 9,500
48,50 48,50
Wages 0 0 control
account
CL 50,30 Work in progress 45,00
C 0 0
Production 5,300
overhead
50,30 50,30
0 0
 Production overhead control account
Raw 1,000 Work in 21,00
materials progress 0
Wages 5,300
control
CLC 15,00 Costing P &L 300
0 a/c

21,30 21,30
0 0

Administration overhead control account

CLC 4,50 Work in 5,00
0 progress 0
Costing 500
P&L
Work in progress
5,00 5,00
control account
0 0
Balance b/f 6,600
Raw materials 38,000 Finished goods 112,50
control 0
Wages control 45,000
Production overhead 21,000
Administration 5,000 Balance c/d 3,100
overhead

115,60 115,60
0 0

Finished goods control account

Balance b/f 7,000 Cost of sales 114,500
account
Work in 112,50 Balance c/f 5,000
progress 0
119,50 2,100,00
Profit and loss0 130,00 CLC 0
130,00
account 0 a/c 0
Sales account

130,00 130,00
0 0
 Profit and loss account
Cost of sales 114,50 Sales 130,00
0 0
Production 300 Administration 500
overhead overhead

CLC-Net profit 15,700

130,50 130,50
0 0
CLC
account
Sales 130,00 Balance b/f 22,100
0
Raw materials control 40,000
Wages 50,300
Production overhead 15,000
Administration 4,500
overhead
Balance 17,600 Costing P&L a/c 15,700
c/f

147,60 147,60
0 0
Trial balance
Raw materials 9,500
Work in 3,100
progress
Finished goods 5,000
CLC 17,60
0

17,60 17,60
0 0
RECONCILIATION OF COST ACCOUNTS AND FINANCIAL ACCOUNTS
When cost and financial accounts are separately maintained in the two sets of
books, two profit and loss accounts will be prepared, one for the costing book and
the other for the financial books.

The profit or loss shown by the costing books may not agree with that shown by
the financial books. It therefore becomes necessary to reconcile the two profits or
loss figures.

Reasons for the disagreement

Differences in profits or losses between cost and financial accounts may arise due
to the following reasons.
1. Items appearing only in the financial accounts.
 Financial charges e.g. loss on sale of assets.
 Discount on bonds or debentures.
 Interest charged on bank loans.
 Fines and penalties.
 Profit on sale of assets.
 Rent receivable.
 Donations etc.

2. Item appearing only in the cost accounts.

Charge for the use of premises which are owned by the business where no rent is
payable i.e. notional rent. This will be included in the cost books for purposes of
product costing. Since no obligation to pay any third party is created, no entries
will be made in the financial books in respect of notional rent.

Under or over absorption of overheads

In cost accounts, overheads are absorbed at a predetermined rate whereas in
financial accounts, they are recorded based on the actual cost incurred. This may
lead to a difference between overheads absorbed in the cost accounts and
overheads actually incurred and charged in financial accounts. Such differences
should be written off in the costing profit and loss account. However, where over or
under absorbed overheads are not transferred to the costing profit and loss
account, it results into a difference in the profits shown by the two sets of books
calling for reconciliation.
Different bases of stock valuation
In cost accounts stocks are valued according to the methods adopted like FIFO,
LIFO, NIFO etc. On the other hand, valuation of stock in financial accounting is
based on the principle of cost or realizable value whichever is lower.

Different charges for depreciation

Sometimes the depreciation charge in the costing books differs from the charge in
the financial books.

Proforma reconciliation statement

Profit as per cost accounts xxx

Add: expenses appearing only in the cost xxx
books
Add: purely financial incomes xxx
Less: incomes appearing only in the cost xxx
books
Less: purely financial charges xxx
Profit as per financial accounts xxx

Illustration
Dominion Ltd. operates separate cost accounting and financial accounting
systems. Given below is the manufacturing and trading statements of the
company for the year ended 30th June 2010:

(i) Manufacturing statement ksh. ksh.

Raw materials consumed:
Opening stock 96,000
Purchases 217,600
313,600
Less closing stock 104,000
209,600
Direct labour 80,400
 Prime cost 290,000
Production overheads 121,800
411,800
Add opening work-in-progress 128,800
Less closing work-in-progress (116,000)
Production cost 424,600

(ii) Trading statement: ksh. ksh.

Sales 880,000
Opening stock 240,000
Production cost 424,600
664,600
Less closing stock 243,800
Cost of sales 420,8000
Gross profit 459,200

The following information was extracted from the cost accounts:

ksh.
Control account balances:
Raw materials stores 99,000
Work-in-progress 120,200
Finished goods 230,800

Transactions for the year:

Raw materials issued 209,600
Cost of goods produced 445,000
Cost of goods sold 424,200
Loss of materials 4,800

Additional information:
(i) A notional rent of ksh. 8,000 per month has been charged in the cost
accounts.
(ii) Production overhead was absorbed at the rate of 185% of direct wages.

Required:
Prepare:
(a) Control accounts in the cost ledger
(b) A statement showing the profit as per the cost accounts
(c) A reconciliation statement for the gross profit as per the accounts and as per
the cost accounts and as per the financial accounts.

Solution
Ledger accounts in the cost books:
Raw materials control account
 Work in progress control account
Balance b/f 120,20 Finished goods 445,00
0 control 0
Raw materials 209,60
0
Wages control 80,400
Production 148,74 Balance c/d 113,94
overhead 0 0

558,94 558,94
0 0

Finished goods control account

Balance b/f 230,80 Cost of sales 424,20
0 account 0
Work in 445,00 Balance c/f 251,60
progress 0 0
675,80 675,80
Cost of 0 0 sales
account
Finished 424,20 Costing P&L 424,20
goods 0 account 0
424,20 424,20
0 0
Sales account
Profit and loss 130,00 CLC 130,00
account 0 a/c 0

130,00 130,00
0 0
Sales account
Profit and loss 880,00 CLC 880,00
account 0 a/c 0

880,00 880,00
0 0
Material lost account
 Raw materials 4,80 Costing P&L 4,80
control 0 account 0
4,80 4,80
0 0

Profit and loss account

Cost of sales 424,20 Sale 880,00
0 s 0
Production 69,060
overhead
Material lost a/c 4,800
CLC-Net profit 381,94
0
880,00 880,00
0 0
CLC account
Sales 880,000 Balance b/f 450,000
Raw materials 217,600
control
Wages 80,400
Production 217,800
overhead

Balance 467,740 Costing P&L a/c 381,940

c/f

Trial 1,347,74 1,347,74 balance

0 0
Raw materials 102,20
0
Work in 113,94
progress 0
Finished goods 251,60
0
CLC 467,74
0

467,74 467,74
0 0
Reconciliation statement

Profit as per cost accounts 381,94

0
Add:
Opening stock of raw materials overvalued in cost books (99,000- 3,000
96,000)
Closing stock of raw materials undervalued in cost books (104,000- 1,800
102,200)
Notional rent 96,000
Closing stock of W.I.P undervalued 2,060
Less:
Opening stock of W.I.P undervalued (128,800 -120,200) (8,600)
Opening stock of finished goods undervalued (240,000- 230,800) (9,200)
Closing stock of finished goods overvalued (251,600- 243,800) (7,800)
Profit as per financial accounts 459,20
0

Activity 1
Millennium Fabricators Ltd is a company engaged in the manufacture of specialist
marine engines. It operates a job costing accounting system which is not
integrated with financial accounts.

At the beginning of the month of May 2010, the operating balances in the cost
ledger were as follows:

ksh.’00
0’
Stores ledger control account 85,000
Work in progress control 167,000
account
Finished goods control 49,000
account
Cost ledger control account 301,000

During the month, the following transactions took place.

Materials: Purchases 42,700
Issues to: Production 63,400
General maintenance 1,400
Assembling of manufacturing
equipment
7,600

Factory wages: Total wages paid 124,000

Of the total wages paid ksh 12,500,000 was incurred in the assembly of
manufacturing equipment ksh. 35,700,000 was indirect wages and the balance
was direct wages.

Other production overhead costs incurred amounted ksh. 152,000,000. ksh.

30,000,000 or which was absorbed by the manufacturing equipment under
assembly while ksh7,500,000 was under absorbed overhead costs written off.

One of the engines manufactured by the company is produced under license.

During the month of May 2010 ksh 2,100,000 was paid as royalty for that
particular engine.

Selling overheads and distribution overhead costs were ksh. 22,000,000

Sales were ksh. 410,000,000

The company’s gross profit margin is 25% on factory cost.

At the end of May 2010, the stock of work in progress had increased by ksh.
12,000,000. The manufacturing equipment under assembly was completed within
the month and transferred out of the cost ledger at the end of the month.

Required:
Prepare:
a) Control accounts in the cost ledger
b) A statement showing the profit as per the cost accounts
 c) Extract a trial balance at the of the period

Activity 2
The following are the transactions of XYZ Ltd. for the month of February 2010

1. Raw materials of ksh.455,000 were purchased on credit

2. Raw materials of ksh.5,000 were returned to the supplier
3. The total of stores requisitions for direct materials issued for the
period was ksh. 412,500
4. The total issues for indirect materials during the period was ksh.
25,000
5. Gross wages of ksh. 462,500 were incurred during the period
consisting of:
Wages paid to employees ksh. 262,500
PAYE due to Inland Revenue ksh. 150,000
NSSF contributions due ksh. 50,000
6. All the amounts in 5 were settled by cash during the period.
7. The allocation of the gross wages for the period was as follows:
Direct wages ksh.362,500
Indirect wages ksh.100,000
8. The employers contribution to NSSF deductions was ksh.62,500
9. Indirect factory expenses of ksh.102,500 was incurred during the
period.
10. Depreciation of factory machinery was ksh.75,000
11. Overhead expenses charged to jobs by means of factory overhead
absorption rates was ksh.350,000 for the period.
12. Non-manufacturing overhead incurred during the period was
ksh.100,000
13. The cost of jobs completed and transferred to finished goods stock
was ksh.750,000
14. The sales value of goods withdrawn from stock and delivered to the
customers was ksh.1,000,000 for the period
15. The cost of goods withdrawn from stock and delivered to customers
was ksh.625,000 for the period
Required:
Post the cost ledger accounts and prepare the costing profit and loss account.

CHAPTER 8 : COST VOLUME PROFIT ANALYSIS

Part Topic Page

Introduction to C-V-P Analysis
Introduction
Economists perspective verses accountants perspective
General assumptions of the C-V-P Analysis
The C-V-P Chart and the PV Chart
Limitations of C-V-P Analysis

Activity

COST-VOLUME- PROFIT ANALYSIS (CVP)

This is a systematic way of examining the relationship between changes in activity
level and changes in the total sales revenues, expenses and net profit.

The objective of CVP analysis is to establish what would happen to the financial
results if a specified activity level or volume fluctuates.

This information is important to the management because volumes or output is the

major variable influencing the sales revenue, total cost and profit.

CVP analysis is also called Break Even analysis and can graphically be represented
as follows:-

Accountants’ model:
The accountants assume that total revenue and total cost are linear functions of
output
 TR
Revenue
Cost profit area
TC

FC
Loss area
Loss

Q (BEP) output/ volume

The economists’ model:

Economists assume that total revenue is a curvilinear function of output. They
believe that the business can only sell increasing quantities of the product if they
lower the prices. This gives rise to two break even points making the

TC
Revenue
Cost TR

FC

Q1(BEP) Q2(BEP) output/ volume

General assumption of CVP analysis

 i. Variable cost per unit is assumed to remain constant.
ii. Selling price per unit is assumed to remain constant.
iii. The fixed cost is assumed to be constant within the relevant range.
iv. The total cost and total revenue are assumed to be linear functions
output.
v. Costs can accurately be divided into their variable and fixed component.
vi. The analysis applies in the short term time horizon only.
vii. Production quantity equals to sales quantity i.e. there are no stocks.
viii. It assumes a single product or a constant sale mix in the case of multiple
products.

THE CVP MODEL

Net profit = Total revenue – Total cost

Therefore net profit = Total revenue – total variable cost – total fixed cost

Assume the following notations:

NP = net profit Q = the volume (output/sales quantity)
p = selling price per unit a = Total fixed cost
b = Variable cost per unit

Therefore NP= Q(p-b)-a

Therefore net profit = total revenue – total variable cost – total fixed cost
NP = Qp – Qb-a

At BEP, the NP = Zero;

0 = Qp –Qb-a =
a
From the above Q =
p b

FC
Thus BEP in units =
SP  VC

Generally, the difference between selling price and variable cost per unit is
referred to as contribution margin (CM)
Therefore:
FC
1. BEP (units) =
CM

FC FC
2. BEP in terms of sales value = xSP or
CM C / S ratio

CM
Where C/S ratio =
SP

FC  T arg et profit
3. Quantity to be sold to earn a target profit = Q T =
CM
4. Additional units to be sold so as to cover additional fixed cost is given by:
Additional FC
Q(additional) =
CM

5. Net profit = (selling price – variable cost) Q –FC

Illustration
XY Ltd provided the following information with respect to their products
Estimated FC = Ksh 1,200,000
Variable cost = Ksh 200 per unit
Selling price = Ksh 400 per unit

Required;

a)Calculate the number of units to be sold as to break-even

b)How many units must be sold to earn Ksh 300,000 target profit
c)What profit would result if 8,000 units are sold?
d)What selling price will have to be charged to have a NP of Shs 300,000 on
sales of 8000 units
e) How many additional units must be sold to cover the extra FC of Shs 800,000
incurred in advertising?
Solution
 FC
BEP (units) =
SP  VC
1,200,000
a) BEP (units) = = 6,000 units
(400  200)

b) Units to be sold to earn a target profit of ksh 300,000

FC  T arg et profit
QT =
SP  VC

1,200,000  300,000
QT= = 7500 units
400  200

c) Profit realized when 800 units are sold

NP = (SP – VC) Q – FC
NP = (400 – 200) 8000 – 1200,000
NP = (200X8000) – 1,200,000
NP = 1,600,000 – 1,200,000
NP = Ksh 400,000

d) SP that will be charged to give a NP of ksh 300,000

NP = (SP –VC) Q –FC
NP = 300,000 (SP – 200) 800 – 1,200,000
SP = 187.5 + 200
SP = ksh 387.5

Additional FC
e) QAdditional =
SP  VC

800,000
QAdditional = = 4,000 Units
200
Activity
Baobab fabricators Ltd. have been facing a lean financial spell for the past two
years. Profits have been declining steadily and results of the preceding year
showed total losses amounting to Sh.2, 000,000, the first time the company had
not reported profits in its 10 year history.

The Chairman and the board of directors have been agonizing on the remedial
steps to implement to arrest the situation. Four competing proposals have been
suggested by a task force, set up some months back, aimed at boosting sales and
improving efficiency of operations in the current year. You, as a member of the
task force, have been invited to attend the next board meeting which will
deliberate on the proposals. You know the following facts:

1. The target profit for the current year is Sh. 4, 000,000 regardless of the
proposal that will be adopted.

2. The company’s fixed costs currently amount to Sh. 20,000,000 per year.

3. The company can sell up to a maximum of 12,000 units of its product in the
local market and unlimited quantities in a neighbouring country. For the
sales in the local market, unit variable costs amount to Sh.5, 000, while for
the sales in the neighbouring country, an extra Sh.500 per unit is incurred in
transportation expenses.

4. The same selling price normally prevails both in the local market and
neighbouring country.

5. Sales for the past year amounted to 9,000 units, all in the local market.

The main requirements of the four competing proposals are as follows:

Proposal A: The Company should improve the quality of packaging of its products
at a cost of Sh.500 a unit.

Proposal B: The Company should spend Sh. 2,000,000 on an advertising campaign.

Proposal C: The Company should cut the selling price by Sh.500 per unit

Proposal D: The Company should buy efficient machinery. This would cut the
variable cost per unit by Sh.1, 000 at all levels of sales.
Required:
a) For proposals A, B and C, determine the number of units to be sold in the
neighbouring country in order t achieve the target profit.

b) If proposal D is adopted and sales remain constant at 9,000 units, determine

the maximum increase in fixed machine cost if the target profit is to be
achieved.

c) Briefly explain four benefits of using break-even analysis.

CHAPTER 8: MARGINAL AND ABSORPTION COSTING

Part Topic Page

I Introduction
Distinctive features of Both costing methods

II The income statement

Preparing the income statement under marginal costing
Preparing the income statement under absorption
costing
Illustrations

III Activities

Objectives
 After studying this chapter you will
 Know what is meant by marginal costing and absorption costing
 Understand the difference between marginal costing and absorption costing
 Be able to calculate stock valuations using marginal costing and absorption
costing
 Know how to prepare multi-period marginal and absorption costing
statements
Introduction

MARGINAL COSTING/DIRECT COSTING/VARIABLE COSTING

This is a costing technique in which only variable manufacturing costs are
considered and used in valuing inventories and also in determining the cost of
goods sold i.e. only variable production cost are considered as products cost and
are allocated to the products manufactured. These costs include; direct material,
direct labour, direct expenses and variable manufacturing overheads.

Fixed manufacturing overheads are not considered as product cost. Instead they
are treated as period costs to be written off to the profit and loss account.

ABSORPTION COSTING/FULL COSTING/INDIRECT COSTING

All manufacturing costs (variable and fixed) are considered as cost of production
and are used in determining the cost of goods manufactured and the value of
inventories. Fixed manufacturing overheads are absorbed into the cost of finished
goods.

Differences between marginal costing and absorption costing

Cost elements included in production

They differ in the absorption of fixed production overheads. Selling and
administration expenses, whether variable or fixed are treated as period costs and
do not form part of product cost. Instead they are charged as expenses in the
profit and loss account.
Inventory values
The value of inventories of finished goods under marginal costing is relatively low
since inventory values are determined only on the basis of variable production
cost. In absorption costing the value of inventories is comparatively high because
it includes even fixed manufacturing overheads, as part of the product cost.

Net income
The treatment of fixed manufacturing Overheads brings about a difference in net
profit figures in the two costing techniques only where there are inventories of
finished goods.

Income statement format (marginal costing)

 ksh ksh
Sales xxx
Less: variable production cost
Direct materials xxx
Direct labour xxx
Direct expenses xxx
Variable production overheads xxx
Total production cost xxx
Add: opening stock of finished goods xxx
Less: closing stock of finished goods (xxx
)
Cost of goods sold (xxx
)
Gross profit xxx
Less: expenses
Actual fixed manufacturing overheads (xxx
)
Variable selling and distribution (xxx
expenses )
Fixed selling and distribution (xxx
expenses )
Net profit xxx
Income statement format (absorption costing)

ksh ksh
Sales xxx
Less: production cost
Direct materials xxx
Direct labour xxx
Direct expenses xxx
Variable production overheads xxx
Fixed production overheads absorbed xxx
Total production cost xxx
Add: opening stock of finished goods xxx
Less: closing stock of finished goods (xxx
)
Cost of goods sold (xxx
)
Gross profit xxx
Add: over absorbed fixed production xxx
overheads
Less: under absorbed fixed production (xxx
overheads )
Less: expenses
Variable selling and distribution expenses (xxx
)
Fixed selling and distribution expenses (xxx
)
Net profit xxx

Reconciliation statement

ksh
Net profit as per marginal costing xxx
Less: opening stock undervalued in marginal (xxx
costing )
Add: closing stock undervalued in marginal xxx
costing
Net profit as per absorption costing xxx

OR
Reconciliation statement

ksh
Net profit as per absorption costing xxx
Add: opening stock overvalued in absorption xxx
costing
Less: closing stock overvalued in absorption (xxx
costing )
Net profit as per marginal costing xxx

Illustration:
The following data have been extracted from the budgets and standard costs of
ABC Limited, a company which manufactures and sells single product.

ksh. per
unit
Selling price 45.00
Direct materials cost 10.00
Direct wages cost 4.00
Variable overhead 2.50
costs

Fixed production overhead costs are budgeted at Sh.400,000 per annum. Normal
production levels are thought to be 320,000 units per annum.
Budgeted selling and distribution costs are as follows:

Variable ksh. 1.50 per unit sold

Fixed ksh. 80,000 per annum

Budgeted administration costs are ksh. 120,000 per annum (fixed).

The following patterns of sales and production are expected during the first six
months of 2010.

January – March April – June

Sales (units) 60,000 90,000
Production (units) 70,000 100,000

There is no stock on 1 January 2010.

Required:
Prepare profit statements for each of the two quarters, in a columnar format, using
the following method:

a) Marginal costing
b) Absorption costing
c) Reconcile the profits in (a) and (b) above

Income statement (marginal costing)

 January-March April-June
Ksh.’000 Ksh.’00 Ksh.’00 Ksh.’00
’ 0’ 0’ 0’
Sales 2,700 4,050
Less: variable production cost
Direct materials 700 1,000
Direct wages 280 400
Variable production overheads 175 250
Total production cost 1,155 1,650
Add: opening stock of finished goods ---- 165
Less: closing stock of finished goods (165) (330)
Cost of goods sold (990) (1,485)
Gross profit 1,710 2,565
Less: expenses
Actual fixed manufacturing overheads  400  (100) (100)
 
 4 

Variable selling and distribution (1.50 x (90) (1.50x9 (135)

expenses 60) 0)
Fixed selling and distribution  80  (20) (20)
expenses  
 4
Fixed administration cost  120  (30) (30)
 
 4 

Net profit 1,470 2,280

Income statement (absorption costing)

January-March April-June
Ksh.’000 Ksh.’00 Ksh.’00 Ksh.’00
’ 0’ 0’ 0’
Sales 2,700 4,050
Less: production cost
Direct materials 700 1,000
Direct wages 280 400
Variable production overheads 175 250
fixed production overheads (1.25x70) 87.5 (1.25x10 125
0)
Total production cost 1,242.5 1,775
Add: opening stock of finished goods ---- 177.5
Less: closing stock of finished goods (177.5) (355)
Cost of goods sold (1,065) (1,597.
5)
Gross profit 1,635 2,452.5
Less: under-absorbed fixed prod. OH (12.5) -----
Add: over-absorbed fixed prod. OH ----- 25
Less: expenses
Variable selling and distribution (1.50 x (90) (1.50x9 (135)
expenses 60) 0)
Fixed selling and distribution  80  (20) (20)
expenses  
 4
Fixed administration cost  120  (30) (30)
 
 4 

Net profit 1,482.5 2,292.5

 400,000 
Fixed production overheads absorption rate =   =ksh. 1.25 per unit
 320,000 
produced

 400,000 
Fixed production overhead per quarter =   = ksh. 100,000
 4 
Therefore, there is an under-absorption in Q1 amounting to 100-87.5 = ksh. 12.50
There is an over-absorption in Q2 amounting to 100-125 = ksh. 25

Note: Fixed costs are all assumed to evenly accrue throughout the year

Reconciliation statement

January- April-June
March
(Ksh.
(Ksh. ‘000’) ‘000’)
Net profit as per marginal costing 1,470 2,280
Less: opening stock undervalued in marginal ------ (12.50)
costing
Add: closing stock undervalued in marginal 12.50 25
costing
Net profit as per absorption costing 1,482.50 2,292.50

Arguments for the use of marginal costing

 It is simple to operate
 No arbitrary apportionment of fixed cost to products or departments
 Where sales are constant, but production fluctuates, marginal costing shows
a constant profit whereas absorption costing shows varying profits
 Under or over absorption of overheads is almost entirely avoided
 Fixed costs are incurred on a time basis e.g. salaries, rent, rates etc, and do
not relate to activity. Therefore it’s logical to write them off in the period
they are incurred and this is done using marginal costing
 Accounts prepared using marginal costing more nearly approach the actual
cash flow position

Arguments for the use of absorption costing

 Where production is constant but sales fluctuate, net profit fluctuations are
less with absorption costing than with marginal costing
 Where the nature of the business is such that stock of finished goods is likely
to build, the inclusion of fixed costs in stock valuation is desirable as it is
done in absorption costing. Otherwise a series of fictitious loses will be
reported in the earlier periods to be offset eventually by excessive profits in
the subsequent periods when the goods are sold.
 Fixed costs constitute a substantial proportion of costs in many
manufacturing concerns in modern industries. Production cannot be
achieved without incurring the fixed production costs. It then becomes an
inescapable part of the production cost, so should be included in stock
valuation as is done in the absorption costing.
 The calculation of marginal costs and the concentration upon contribution
may lead to the firm setting selling prices which are below total cost
although producing some positive contribution. Absorption costing makes
this less likely because it includes fixed production overheads in product
cost.
Activity 1
Horizon Ltd is a manufacturing company which products a single product. The
following standard unit costs relate to the product:

Cost ksh.
Variable manufacturing 90
Fixed manufacturing 70
Variable selling and administration 16
Fixed selling and administration 60
236

Fixed manufacturing costs per unit are based on a predetermined absorption rate
established at a normal activity level of 45,000 production units per period. Fixed
selling and administration costs are absorbed into the cost of sales at 20% of
selling price. Under/over absorbed overheads are transferred to the profit and loss
account at the end of the period.

The following information is available for two consecutive periods:

Sales – units 42,500

Sales – value 12,750,00
0
Production units
40,000
Variable manufacturing costs (ksh)
3,600,000
Fixed manufacturing costs (ksh.)
3,200,000
Variable selling and administration costs
(ksh.) 680,000
Fixed selling and administration costs 2,700,000
(ksh.)
Required:
a) Prepare income statements using marginal and absorption costing

b) Prepare a reconciliation statement of profits in (a) above

 c) Outline strengths and weaknesses of marginal costing.

Activity 2
Duplex Limited makes and sells two products, Alpha and Beta. The following
information is available.

Period 1 Period 2
Production (units)
Alpha 2,500 1,900
Beta 1,750 1,250
Sales (units)
Alpha 2,300 1,700
Beta 1,600 1,250

Financial data: Alpha Beta

ksh. ksh.
Unit selling price 90 75
Unit variable costs:
Direct materials 15 12
Direct labour (ksh.6/hr) 18 12
Variable production 12 8
overheads
Fixed costs for the company in total were ksh.110,000 in period 1 and ksh.82,000
in period 2. Fixed costs are recovered on direct labour hours.

Required:
a) Prepare profit and loss account for period 1 and for period 2 based on
marginal costing principles.

b) Prepare profit and loss accounts for period 1 and for period 2 based on
absorption costing principles.
c) Reconcile the profits in (a) and (b) above

CHAPTER 9: STANDARD COSTING AND VARIANCE ANALYSIS

This chapter consists of eight parts as follows;

Part Topic Page

I Introduction
Types of standards
Advantages of standard costing system
Disadvantages of standard costing system
Variance analysis

II Direct material variances

Direct material price variance
Direct material usage variance

III Labour variances

Labour rate variance
Labour efficiency variance

IV Variable overhead variances

Variable overhead expenditure variance
 Variable overhead efficiency variance

V Fixed overhead variances

Fixed overhead expenditure variance
Fixed overhead volume variance
Fixed overhead capacity variance
Fixed overhead efficiency variance

VI Activities

Part I
BACKGROUND STUDY

After studying this topic, the student should be able to:

1. Define standard costing
2. Understand the advantages of a standard costing system
3. Understand the disadvantages of a standard costing system
4. Calculate the various variances

Introduction
Standard costing- is a technique which establishes predetermined estimates of
the cost of products and then compares these predetermined costs with actual
costs as they are incurred.
The predetermined costs are known as standard costs and the difference between
standard cost and the actual cost is known as a variance. The process by which the
total difference between the standard cost and actual cost is broken down into its
constituent parts is known as variance analysis.

Types of standards
Basic standards- these are long term standards which would remain unchanged
over the years. Their sole use is to show trends over time for items such as
material prices, labour rates, and efficiency and to show the effect of changing
methods. They cannot be used to highlight current efficiency or inefficiency and
would not normally form part of the reporting system.
Ideal standards- these are based on the best possible operating conditions. Such
standards therefore assume no machine breakdowns, no material wastage, no
stoppage or idle time. It assumes perfect efficiency. Ideal standards are
unattainable in practice and therefore not very popular.

Attainable standards- this is a standard based on efficient but not perfect operating
conditions. Such a standard would include allowances for normal material losses,
realistic allowances for fatigue, machine breakdowns etc. attainable standards
provide a tough but realistic target and thus can provide motivation to the
management.

Advantages of standard costing

 Standard costing is an example of “management by exception”. By studying
the variances, management’s attention is directed towards those items
which are not proceeding according to plan.
 The process of setting, revising and monitoring standards encourages re-
evaluation of methods and techniques leading to cost reduction
 Standard cost provides a better guide to pricing than historical cost.
 A properly developed standard costing system with full participation and
involvement creates a positive cost effective attitude through all levels of
management right down to the shop floor.

Disadvantages of standard costing

 It may be expensive and time consuming to install and maintain
 In volatile conditions with rapidly changing methods, rates and prices,
standards quickly become out of date and thus lose their control and
motivational effects.
 Standards only focus on financial data while other significant non-financial
data can also affect efficiency of operations e.g. lead times, customer
satisfaction, service quality etc.
Variance analysis
Cost variances are classified as follows:
 Total
production
cost variance

Total direct Total direct Total variable Fixed overhead

material wages overhead expenditure
variance variance variance variance

Material Material Labour Labour Variable Variable OH

price usage rate efficiency OH efficiency
variance variance varianc variance expenditur variance
e e variance

Fixed OH Fixed OH
Expenditure Volume
variance variance

Fixed OH Fixed OH
Capacity Efficiency
Variance variance
Direct material cost variance:
1) Material cost variance = (actual price x actual quantity) - (standard price x
standard quantity)
2) Material price variance = (actual price – standard price) actual quantity
3) Material usage variance = (actual quantity – standard quantity) x standard
price

Direct labour cost variance:

1) Labour cost variance =(actual hours x actual rate) – (standard hours x
standard rate)
2) Labour rate variance = (actual rate – standard rate) x actual hours
3) Labour efficiency variance = (actual hours – standard hours) x standard rate

Variable overhead cost variance:

1) Variable overhead variance = (standard variable overhead – actual variable
overhead)
2) Variable overhead expenditure variance = (actual production x standard
variable OH rate) – actual variable OH
3) Variable OH efficiency variance = ( standard production x standard rate) -
actual variable OH

Fixed overhead cost variance:

1) Fixed OH expenditure variance = (actual fixed OH – budgeted fixed OH)
2) Fixed OH volume variance = (budgeted fixed OH – Standard fixed OH)
3) Fixed OH capacity variance = (budgeted fixed OH – Absorbed fixed OH)
4) Fixed OH efficiency variance = (Absorbed fixed OH - Standard fixed OH)

Illustration
Brian Ltd. produces and sells one product only, the Blob, the standard cost for one
unit being as follows:
 ksh
.
Direct materials A– 10 kilograms at ksh.20 20
per kg 0
Direct materials B – 5 litres at ksh.6 per litre 3
0
Direct wages – 5 hours at ksh.6 per hour
3
Direct expenses
0
Fixed production overhead
Total standard cost 5
5
0
31
5

The fixed overhead included in the standard cost is based on an expected monthly
output of 900 units. Fixed production overheads are absorbed on the basis of
direct labour hours.

During April 2010 the actual results were as follows:

Production 800 units

Materials A 7,800 kg used, costing
ksh.159,900
Materials B
4,300 units used, costing
Direct wages
ksh.23,650
Direct expenses
4,200 hours worked for
Fixed production ksh.24,150
overhead
ksh.3,750
ksh.47,000

Required:
(a) Calculate price and usage variances for each material
(b) Calculate labour rate and efficiency variances
(c) Calculate the expense variance
(d) Calculate fixed production overhead expenditure and volume variances and
then subdivide the volume variance.

Solution
a) Material price variance= (AP-SP)AQ

 159,900 
Material A= (   -20) x 7,800= ksh. 3,900 (A)
 7,800 

 23,650 
Material B= (   -6) x 4,300 = ksh. 2,150 (F)
 4,300 

Material usage variance = (AQ-SQ) SP

Material A = 7,800  800 x10   x 20 = ksh. 4,000 (F)

Material B = 4,300  800 x5  x 6 = ksh. 1,800 (A)

b) Direct labour rate variance = (AR-SR)AH

 24,150 
= (  - 6) x 4200 = ksh. 1,050 (F)
 4,200 

Direct labour efficiency variance = (AH-SH) SR

= 4,200  800 x5x6 = ksh 1,200 (A)

c) Direct expenses variance = actual expense – standard expense

= 3,750 – (800x 5)
= ksh. 250 (F)

d) Fixed OH expenditure variance = (actual fixed OH – budgeted fixed OH)

= 47,000  900 x50  

= ksh. 2,000 (A)

Fixed OH volume variance = (budgeted fixed OH – Standard fixed OH)

= 900 x50  800 x50 

 = ksh. 5,000 (A)

For purposes of absorption it is important to compute the budget labour

hours and the standard hours

 50 
OAR =   = ksh. 10 per labour hour
 5 
Fixed OH capacity variance = (budgeted fixed OH – Absorbed fixed OH)

= 900 x5 x10   4,300 x10  

= ksh. 2,000(A)

Fixed OH efficiency variance = (Absorbed fixed OH - Standard fixed OH)

= 4,300 x10  4,000 x10  

= ksh. 3,000 (A)

Activity 1
Nacomi ltd manufactures one product. The following information was extracted for
the month of October 2010.

Production in units 5,000

Ksh.
Actual cost of direct materials purchased 5,712,000
Actual direct wages paid 4,080,000
Variable overhead incurred 630,000
Fixed overheads incurred 4,800,000

The variances from standard costs were:

Ksh.
 Direct material usage variance 144,000 F
 Direct material price variance 272,000 A
  Direct wages efficiency variance 112,000 A
 Direct wages rate variance 120,000 F
 Variable overhead expenditure variance 46,000 A
 Fixed overhead volume variance 232,000 F
 Fixed overhead expenditure variance 360,000 A

F indicates a favourable variance while A indicates an adverse variance.

Other information:
1. The company uses only one grade of direct material. Direct materials are
purchased in kilograms. Throughout the month, the actual price paid was sh
8.00 above the standard price per kilogram. The standard material cost of
the product is sh 720 per unit.
2. The company employs one grade of direct labour. During the month, the
actual wage rate paid was sh 68 per hour. Three standard hours are required
to produce one unit.
3. Fixed and variable overhead absorption rates are based upon standard hours
produced.
4. There were no stocks of materials, work in progress or finished goods held at
either the beginning or end of the month. There were no process losses.

Required:
Calculate for the month of October 2010:
a. The actual quantity of direct material consumed, in kilogram.
b. The actual price, per kilogram paid for the material.
c. The actual direct labour hours worked.
d. The direct labour hours worked in excess of the standard.

Activity 2
Nyundo Limited manufactures a product whose standard variable cost is given
below:

Ksh.
Direct materials (2Kg @ ksh.3) 6
 Direct labour 0.75 hours @ ksh.4 3
Variable overheads 1

The company treats fixed costs as period costs and therefore they are not charged
on products.

The following information relates to the month of March 2010:

1/3/201 31/3/201
0 0
Ksh. Ksh.
Stocks (all at standard
cost)
Raw materials 12,000 6,000
Finished goods 36,000 42,500

The following information is available for the month of March 2001:

ksh.
Sales @ ksh.20 per unit 200,00
0
Material purchases @ ksh.3.50 per 42,000
Kg
Direct labour cost (8,000 hours) 30,000
Variable overheads 12,000
The management is wondering whether they could have performed better.

Required:
Calculate the following variances in each case stating two possible causes:
(a) Materials usage variance.
(b) Labour rate variance.
(c) Labour efficiency variance.
(d) Variable overhead expenditure variance
(e) Variable overhead efficiency variance.
CHAPTER 10: BUDGETARY CONTROL

This chapter consists of three parts as follows;

Part Topic Page

I Introduction to budgets
Introduction
Advantages of budgets

II Types of budgets
Functional budgets
Cash budgets
Master budgets
Flexible budgets

III Motivational aspects of budgeting

Budget setting styles
Traditional incremental budgets
Zero-based budgeting

IV Activities

After studying this topic, the student should be able to:

1. Understand the interrelationship between the functional budgets
2. Relate the functional budgets with the master budget
3. Understand the comparative advantages and disadvantages zero-based
budgeting and incremental budgets

BUDGETING AND BUDGETARY CONTROL

A budget- is a formal expression of income and expenditure for a given future

period.
Budgeting- refers to the mechanism of preparing budgets.
Budgetary control- refers to the process of comparing actual results with
budgeted results and analyzing the causes of any variances so as to provide the
basis for managerial planning and control.

Advantages of budgetary control

 It ensures the achievement of organizations objectives.
 It compels planning i.e. the management is forced to look ahead and set out a
detailed plan for achieving the targets.
 It communicates the ideas and plans in a formal system that ensures that each
person affected by the plan is aware of his responsibility in the budget process.
 A formal budget may act as a formal authorization to budget managers to incur
expenditure.
 It helps to establish a system of control.
 It provides a means of performance evaluation.
 It motivates employees to improve their performance.

 Leads to economy in operations

 Gives motivation to workers
 Serves as a medium of communication i.e. translates goals and targets of
the organization in quantitative and monetary terms.
 Encourages management by exception (MBE) i.e. The management can
concentrate only on the areas where performance is below the targets.
Disadvantages of budgetary control
i) Are prepared using estimated figures which may not be accurate
ii) Installation and operation of a budgetary control system is expensive since it
requires technical and qualified staff
iii) Opposition by staff i.e. budgets provide a ‘yard stick’ against which the
workers performance may be measured. Inefficient workers may create
difficulties in the operation of the budgetary control systems.
iv) It’s simply a tool of management and cannot replace the management.
Classification of budgets
Budgets can be classified as follows

Functional budgets
i) Sales budget
ii) Functional budget
iii) Material usage budget
iv) Material purchase budget
v) Labour cost budget
 vi) Cash budget
Sales budget
This is a forecast of sales in a given period both in quantity and in value.

Illustration
XY Ltd sells 2 products which are manufactured in one plant during the year 2009,
it planned to sell following quantities of each products

Q1 Q2 Q3 Q4
PRODUCT X(Units 90,00 230,00 300,000 80,00
S ) 0 0 0
Y(Units) 65,00 75,000 55,000 85,00
0 0

Product X sells at Ksh 10 per unit while Y at Ksh 20 per unit.

A study of past experience reveals that XY limited loses 3% of its billed revenue
each year due to bad debts.

Required:
prepare sales budget incorporating the given information

Solution
Sales budget

Q1 Q2 Q3 Q4 Total
PRODUCTS X(Ksh 900,000 2,300,000 3,000,000 800,000 7,000,000
)
Y(Ksh 1,300,000 1,500,000 1,100,000 1,700,000 5,600,000
)
2,200,000 3,800,000 4,100,000 2,500,000 12,600,000
Less: bad 66,000 114,000 123,000 75,000 378,000
debts 3%
Net sales 2,134,00 3,686,00 3,977,00 2,425,00 12,222,00
 0 0 0 0 0

Production Budgets
This is an estimate of the quantity of goods that must be produced during the
budget period so as to satisfy the budgeted sales and the desired stock levels of
finished goods.
i. Estimated sales quantity.
ii. Estimates opening stock of finished goods in units.
iii. Desired closing stock of finished goods in units.
iv. Available physical resources e.g. raw materials.
v. Management policy.

Illustrations
The following information was obtained from the books of PQ ltd for the year ended
31st Dec. 2009.

Product A B C D
Estimate opening stock of goods 30,000 25,000 10,000 5,000
Sales Quantity 80,000 60,000 50,000 20,000
Desire c-stock FGDs 35,000 20,000 15,000 10,000

Required:
prepare a production budget.

Solution:

A B C D
Product
Sales Quantity 80,000 60,000 50,000 20,00
0

Less: estimated opening stock of finished (30,000 (25,000 (10,000) (5,000

goods ) ) )
Add: desired closing stock of finished 35,000 20,000 15,000 10,00
goods 0
Production budget 85,000 55,000 55,000 25,00
0

Materials usage budgets

This represents the quantity of material required to produce the units in the
production budget.

Material purchases budgets.

This is the quantity of materials to be purchased so as to satisfy the material usage
budget after adjusting for the opening and closing stocks of raw materials.

Illustration
The sales director of a manufacturing company reported that in year 2011 he
expects to sell 54,000 units of a product. The production manager consulted the
purchasing Manager and cast his figures as follows:-
2 types of raw materials A and B are required for the manufacture. Each unit of the
final product requires 2 kgs of material A and 3 kgs of B.

The estimated balances at the beginning of the period are as follow:

 Finished products 10,000 units
 Material A 12,000 kgs
 Material B 15,000 Kgs.

The balances at the end of the period are expected to be:

 Finished products 14,000 units
 Material A 13,000 kgs
  Material B 16,000 kgs.

Required:
Draw up budgets for the following:
i) Production budget (in units)
ii) Material usage budget (in units)
iii) Material purchase budget (in units)

Solution

Production budget Units

Sales quantity 54,000
Add: desired closing stock of finished goods 14,000
Less: estimated opening stock of finished (10,000
goods )
Production budget 58,000

Note – the company must produce large enough to cover what it wants to sell plus
what should remain as closing stock of finished goods

Material usage budget

Material A Material B
Usage per unit in kgs 2kgs 3kgs
Budget output of finished goods 2x58,000= 3x58,000=
(58,000 units) 116,000 kgs
174,000 kgs

Material purchase budget

Material Material
A B
Material usage (kg) 116,000 174,000
Less: opening stock of (12,000) (15,000)
materials
Add: closing stock of 13,000 16,000
materials
Materials purchases budget 117,000 175,000
(kg)

Labour cost budgets.

This is the budgeted cost of direct labour required to satisfy budget production
quantity. It is determined by multiplying the total direct labour hours by the labour
rate per hour.

Illustration
The management accountant of KCA ltd has presented the following information
for the next budget period.

Expected sales quantity 45,000 units

Estimated opening stock of finished goods 5,000 units
Desired closing stock of finished goods 10,000 units

It is established that the production of the product uses 2 grades of labour: L 1 & L2
such that 4 hours of L1 & 2 hours of L2 are required per unit of the final product.
The company pays labour at ksh 500 per hour & ksh 750 per hour for L 1 & L2
respectively.

Required:
Prepare labour cost budget for KCA ltd.

Solution

Production budget
Sales quantity 45,000 units
Less: estimated opening stock (5,000 units)
Add: desired closing stock 10,000 units
Production quantity 50, 000 units

Labour cost budget

L1 L2 Total
Labour requirement per 4 2
unit(hours)
Production quantity 50,000 units 200,000 100,000
Labour rate per hour (ksh) 500 750
Labour cost (ksh) 100,000,00 75,000,00 175,000,00
0 0 00

IV Cash budgets.
This is a forecast of the cash position of a business for a given period and
represents cash receipts and payments and also the estimated cash balance at the
end of each month of the budget period.

Importance of cash budget

i. It ensures that sufficient cash is available to meet the requirements of the
business.
ii. It reveals any expected shortage of cash so as to enable the management to
arrange for any overdraft.
iii. It reveals any expected surplus of cash available for investment outside the
business.

Illustration
The following information was extracted from the books of PQ ltd regarding its
budget for the 2nd Quarter of the year 2010.
Sales: February ksh. 50,000
March ksh. 40,000
April- June ksh. 60,000 per month.

Half the sales are for cash. 90% of the credit sales are collected in the month
following the month of sale and the balance one month later. Purchases budget for
the 2nd quarter (April-June) was 15,000 units, 18,000 units and 25,000 units
respectively at ksh 2 per unit. Purchases are made in cash so as to take advantage
of a cash discount of 5%. Wages and salaries for the 2 nd quarter are budgeted at
ksh. 13,000 per month.

Manufacturing and other expenses for the quarter are:

Cash expenses Ksh. 9,000
Depreciation Ksh. 15,000
Selling expenses Ksh. 6,000
Administration Expenses Ksh. 4,000 (equally in April and May only)

Required:
Prepare a cash budget for the 2nd quarter.

Solution
Sales analysis

February March April May June

Total sales 50,000 40,000 60,000 60,000 60,000
Cash sales 50% 25,000 20,000 30,000 30,000 30,000
Credit sales 50% 25,000 20,000 30,000 30,000 30,000
Collections:
90%-After 1 month 22,500 18,000 27,000 27,000
10%-One month later 2,500 2,000 3,000
Total Colle ctions 20,500 29,000 30,000

Purchases analysis
 April May June
Purchase quantity 15,000 18,000 25,000
Purchase price 2 2 2
Purchase amount 30,000 36,000 50,000
Less: 5% discount 1,500 1,800 2,500
Ne t cost/payme nt 28,500 34,200 47,500

Cash budget (April-June)

April May June

Cash balance b/f 0 2,000 6,800
Add: receipt of cash
Cash sales 30,000 30,000 30,000
Collections from debtors 20,500 29,000 30,000
Bank overdraft
Total Receipts 50,500 61,000 66,800

Less: payments
Purchases 28,500 34,200 47,500
Salaries & wages 13,000 13,000 13,000
Cash expenses 3,000 3,000 3,000
Selling expenses 2,000 2,000 2,000
Administration expenses 2,000 2,000
Total payments 48,500 54,200 65,500
Cash balance c/f 2,000 6,800 1,300

Master budget
This is the total budget package for an organization. It is the end product of the
budget preparation process. It is therefore a summary budget which incorporates
its component functional budgets and which is finally approved, adopted and
employed. When all the functional budgets are prepared, they can be summarized
to produce budgeted profit and loss account and budgeted balance sheet. The
budgeted cash flow statement may also be included.

Illustration:
A small manufacturing firm produces one product. The budgeted sales for the
month of January 2010 are for 10,000 units at a selling price of Sh. 2,000 per unit.
Other details are as follows:

1. Two components of input are used in the production of one unit of output.
 Component Number Unit cost of each
(Input component
X 5 20
W 3 10

2. Stocks at the beginning of the month are budgeted as follows:

- 4,000 units of finished goods at a unit cost of ksh.1,050 per unit
- Component X: 16,000 units at a unit cost of ksh 20
- Component W: 9,600 units at a unit cost of ksh10

3. Production of each unit requires the following labour hours.

Department Hours per unit Labour rate per

hour(ksh)
Production 4 100
Finishing 2 140

4. Factory overhead is absorbed into units cost on the basis of direct labour
hours. The budgeted factory overhead for the month is Sh.1,920,000.
5. The administration, selling and distribution overhead for the month is
budgeted at Sh.5,500,000.
6. The company plans a reduction of 50% in quantity of finished stock at the
end of the month and an increase of 30% in the quantity of each input component.

Required:
(a) For the month of October 2010
(i) Production quantity budget;
(ii) Materials usage budget
(iii) Materials purchase budget
(iv) Direct labour cost budget

(b) The budgeted profits and loss account.

Solution:

Production budget Units

Sales quantity 10,00
0
Add: desired closing stock of finished goods 2,000
Less: estimated opening stock of finished (4,000
goods )
Production budget 8,000

Material usage budget

Component component W
X
Usage per unit in 5 3
Budget output of finished goods 2x8,000= 3x8,000=
(8,000 units)
40,000 24,000 units
units

Material purchase budget

Componen Component Total

tX W
Material usage (units) 40,000 24,000
Less: opening stock of materials (16,000) (9,600)
Add: closing stock of materials 20,800 12,480
Materials purchases budget 44,800 26,880
(units)
Purchase price per units (ksh) 20 10
Purchase cost (ksh) 896,000 268,800 1,164,80
0
 Producti Finishin Total
on g
Labour requirement per 4 2
unit(hours)
Production quantity 8,000 units 32,000 16,000
Labour rate per hour (ksh) 100 140
Labour cost (ksh) 3,200,00 2,240,00 5,440,00
0 0 0

Budgeted Profit & Loss Account

 Quantity Cost/Price
Opening stock of materials 16,000 20 320,000
9,600 10 96,000 416,000

Add: Purchases 1,164,800

Less: Closing stock 20,800 20 416,000
12,480 10 124,800 540,800
Cost of materials consumed 1,040,000
Add: Direct labour cost 5,440,000
Prime cost 6,480,000
Add: Factory overheads 1,920,000
Total factory cost 8,400,000

Sales 10,000 2,000 20,000,000

Less: Cost of sales;
Opening stock of finished goods 4,000 1,050 4,200,000
Add: Production cost 8,400,000
Less: Closing stock 2,000 1,050 2,100,000 10,500,000
Gross profit 9,500,000
Less: Expenses
Administration overheads 5,500,000
Net profit 4,000,000

Fixed/static & flexible budget

A fixed budget is a budget which is drawn to remain unchanged irrespective of the
production and sales volume actually realized. It is a static budget which doesn’t
adjust itself to the actual activity level.

A flexible budget on the other hand is draw to adjust to the actual sales and
production quantities. In some sense it can be considered to be a revised budget
for actual activity realized.

Illustration
Passion Fruit processors Ltd manufactures and retails one-liter cans of passion
juice at ksh 800 per can. For the month of April 2000, the company canned and
retailed 1350 cans for a net profit of ksh 317,450 based on the cost structure:
Sh.
Direct material - Flamoxyline: 10,800 litres @ ksh 10.75 116,100
- Glamoxyline: 12,750 litres @ ksh 9.80 124,950
Direct labour - 6,500 hours@ ksh 24 156,000
Overheads 137,500
Factory cost 534,550
Variable operating expenses 96,000
Fixed operating expenses 132,000
Production cost 762,550

The company had budgeted for a production level of 1,800 cans to be retailed at
ksh 820 per can, whose level was expected to yield a profit of ksh 758,000 based
on the following budget:
ksh.
Direct material - Flamoxyline: 10,000 litres @ ksh 10 100,000
- Glamoxyline 12,000 litres @ ksh 10 120,000
Direct labour hours 6000 hours @ ksh 20 120,000
Overheads at 125% of direct labour 150,000
Factory cost 490,000
Variable operating expenses 108,000
Fixed operating expenses 120,000
Budgeted production cost 718,000

Required:
In columnar form and using production achieved:
a. Actual profit and loss statement.
b. Flexible budget profit and loss statement.
c. Without breaking down the resultant variances into their price and efficiency
components, a reconciliation of actual and flexed profit or loss.

Solution
Income statement
 Actual Flexed Difference Comment
Quantity 1,350 1,350
Sales 1,080,000 1350 x 820 1,107,000 -27,000 Adverse
Less: Costs
Direct materials;
Flamoxyline 10,800 x 10.75 116,100 10,000/1,800 x1,350 x10 75,000 41,100 Adverse
Glamoxyline 12750 x 9.80 124,950 12,000/1,800x1,350x10 90,000 34,950 Adverse
Directlabour 156,000 6000/1800 x 1,350 x 20 90,000 66,000 Adverse
Overheads 137,500 125% of direct labour 112,500 25,000 Adverse
Variable operating cost 96,000 108,000/1,800 x 1,350 81,000 15,000 Adverse
Fixed operating cost 132,000 The budget remains unflexed120,000 12,000 Adverse
Total production cost 762,550 568,500
Net profit 317,450 538,500 -221,050 Adverse

Activity
Progressive Products Ltd. plans to commence operations in July 2010. As part of
its budgetary control system the company's operations will be based on quarterly
budgets. The following information has been assembled by the company as the
basis for the preparation of the company's cash flow projection for the third
quarter of 2010.

1. Gross sales are expected to amount to Sh.500,000 for July 2010, increasing
at the rate of 20% per month for two months to the end of the quarter and
thereafter at the rate of 10% per month to the end of the year.
2. Of the gross sales, 40% is cash sales while the balance is due in the month
following the month of sale.
3. It is the company's policy to mark up sales by 25%. Purchase are paid for in
the month following the month of purchase.
4. The following expenses are expected to be incurred:
July August September
Sh Sh. Sh.
Wages, salaries and allowance 150,000 180,000 200,000
Traveling and accommodation 30,000 50,000 50,000
Utilities 20,000 20,000 30,000
Depreciation 10,000 10,000 10,000
Drawings 20,000 20,000 20,000

5. Office rent at the rate of Sh.80,000 per quarter is due and payable in arrears
at the end of each quarter.
6. The company expects to have a cash balance of Sh.100,000 on July and
maintain the same as its minimum. Overdraft facilities have been negotiated and
granted by the company's bankers.
Required:
In columnar form, a cash budget for the third quarter of 2010 reflecting any
monthly overdraft facility required by the company.

BEHAVIORAL ASPECTS OF BUDGETS

Human behavior and budgetary planning and control

An important feature in control in business is that control is exercised by the
managers over people. Their attitude and response to budgetary planning and
control will affect the way in which the business operates.

A budgetary system does not consist only of accounting, forecasting and other
management techniques. The success of a budgetary planning and control system
depends on the cooperation of those who are to be involved in its operations.
Individuals may not always behave in the best interest of the organization or they
may be unwilling to strive to achieve the budget as set for the period. This is
known as dysfunctional behavior.

A budgetary system should be designed to minimize the occurrence of

dysfunctional behavior. This can be achieved if the systems designers and
operators bear in mind the behavioral aspects of such systems. The human
aspects to be considered are numerous and many of them are unrelated but the
following are the most important:

1. Motivational aspects - The process of budget preparation and subsequent

performance evaluation by budgetary control need to be carried out so as to
motivate managers rather than create resentment and adverse reactions. The
process should be participative, encourage initiative and responsibility.

A budgetary system will not be successful if individuals do not want to achieve the
targets which have been set for their area of responsibility. A lack of the necessary
motivation can exist for many reasons including;
 The targets have not taken into account the individual aspiration
level-the level of performance that an individual has set as a personal
target. If the performance target is set too far above the aspiration level, the
individual will reject the budget as unrealistic and will be demotivated. If the
 target is set too far below the aspiration level the individual may also be
demotivated by the lack of challenge and may then work at a level of
performance below that which could otherwise have been achieved. A
department or section of an organization can also have an aspiration level
which will be the collective results of all the individuals’ aspiration levels.
 There is inadequate provision for the recognition of achievement-
When performance levels have been achieved or exceeded, it is important
that mangers acknowledge this and reward the relevant people. The reward
need not necessarily be a financial one. A good manager will be able to
motivate staff with appropriate psychological reward-simply acknowledging
the achievement may be sufficient.

i) Participation as a motivator
Participation promotes common understanding regarding objectives and makes
the acceptance of organizational goals by the employees much more likely.

If people are genuinely involved, they feel part of the team and become highly
motivated to achieve the budgets.

ii) Use of budget targets as a motivator

Once budgets have been prepared, they become targets and can be used to
motivate employees to achieve a high level of performance. The targets set
should be realistic, challenging and achievable. Ideal or unrealistic targets are
demotivating since they will always lead to adverse variances. Low targets are
also demotivating since they are easy to achieve.

iii) Performance evaluation as a motivator

Employees who are evaluated are motivated to do their best.

2. Communication- targets must be communicated to those who are expected to

achieve them. People cannot be expected to perform against the target they do
not know about. It also important that target are understood- otherwise they will
be rejected. Communication of actual results is also important; this is known as
feedback.

3. Participation- participative budgetary system is always the most successful. If

the system is dictatorial, with imposed budgets, there is more likely to be
dysfunctional behavior. Individual managers should not simply be issued with their
budgets without consultations. They should be consulted about their budget during
the planning process. Managers are then more likely to accept the target
contained in the budget when it is published.

A participative budgetary system will also encourage goal congruence. This exists
when the budgetary system motivates individuals or groups to take actions that
achieve their own personal goals while at the same time achieving those of the
organization. The system is designed so that there is a relationship between the
company’s goals and the individuals’ goals. Goals are more likely to be congruent
if individuals or groups have been involved in setting their own budgets.

Budget Setting Styles

1 Imposed style of budgeting
In this style, senior managers prepare budgets with little or no input from
operating personnel or operational managers. The budget is then imposed on the
employees who have to work with the budgeted figures.

Imposed budgets are effective in the following circumstances.

i) In newly formed organizations
ii) In very small businesses
iii) During periods of economic hardship
iv) When operational managers lack budgeting skills
v) When organization’s different units require very precise co-ordination

Advantages of imposed budgets

i) They increase the probability of incorporating organization’s strategic plans.
ii) They utilize senior management’s awareness of total resource availability
iii) They decrease the period of time taken to prepare budgets
iv) They decrease the possibility of undesirable input from inexperienced lower
level employees.

Disadvantages of imposed budgets

i) Morale of other employees is reduced since they are not involved in the
preparation of budgets.
ii) Hamper creativity of lower level management
iii) May not be fully accepted by the employees
iv) May kill team spirit

2 Participatory style of budgeting

Budgets are prepared by lower level managers and then submitted to senior
managers for approval, usually without significant adjustments
These budgets are based on the lower level manager’s perceptions of what is
achievable and the associated resource requirements.
Participatory budgets are effective in the following circumstances:

i) In well established organizations

ii) In very large businesses
iii) During periods of economic affluence
iv) When operational managers have strong budgeting skills
v) When organization’s departments are allowed to operate
independently.

Advantages of participative budgets

i) Information from employees most familiar with their departmental
needs and constraints is included.
ii) Morale and motivation of employees is improved.
iii) Leads to acceptance and commitment to organizational goals
iv) They are more realistic than imposed budgets
v) Specific resource requirements are included.

Disadvantages
i) They are time consuming
ii) Managers may introduce budgetary slacks i.e none challenging or easy
to achieve targets.
iii) They can support empire building by department heads.

3 Negotiated style of Budgeting

 - Different levels of management often agree on budgets through
negotiations.
- Operational managers may negotiate with senior managers on what
they consider to be unreasonable or unrealistic in the imposed
budgets.
- Likewise, senior managers usually review and revise budgets
presented to them under the participative approach through a process
of negotiation with lower level managers.
- The result is a negotiated budget.

Problems Associated with Budgeting

a) Budgets are developed round existing organizational structures and
departments which may be inappropriate for current conditions and may not
reflect the underlying economic realities.
b) They may introduce rigidity and hamper creativity in the organization
c) The budgetary system, perhaps because of undue pressure or poor human
relations, may cause antagonism and decrease motivation.
d) There may be too much reliance on the technique as a substitute for good
management.
e) Problems of setting the levels of attainment to be included in budgets.
f) There are inherent lags and delays in the system. Budgets and resulting
variances may be of little value in guiding current operations if there are
delays in getting feedback.
g) Managers may base future plans on past results instead of looking at
alternatives options of achieving the objectives.
h) Managers may put in only just enough effort to achieve budget targets
without trying to beat the targets.

Incremental budgeting
Before an annual budget is prepared, a base should be chosen from which the
process will begin. The traditional approach is to base the current budget on the
current year’s results plus an extra amount for estimated growth or inflation for
the next period. This method is known as incremental budgeting.

Incremental budgeting is appropriate if current operations are as effective,

efficient and economical as possible. It is however considered to be a weak
approach to budgeting because it encourages slack and wasteful spending on non
essential activities. Through incremental budgeting, past inefficiencies are
perpetuated.

Limitations of the traditional incremental budgeting:

 It assumes that the basic structure of the budget will remain unchanged
 It focuses on only the existing uses of the resources

 To ensure that inefficiencies are not concealed in the budgets, an alternative

approach to budgeting called zero based budgeting is employed.

Zero-Based Budgeting (ZBB):

Zero based budgeting is a cost benefit approach whereby it’s assumed that the
cost allowance for an item is zero and will remain so until the manager responsible
justifies the existence of the cost item and the benefit the expenditure brings.

Traditionally budgets are prepared by taking previous years estimates as the base
and then adjusting for the impact of inflation, proposed increase in the level of
activity, expected increase in the resources. This means that budgets for each year
are always a percentage of previous year’s budget.

Zero based budgeting on the other hand requires each manager to justify his
entire budget request in detail from scratch hence (zero based). Zero based refers
to a nil budget as the starting point. It starts with the promise that the budget for
the next period is zero so long as the demand for an activity is not justified. The
assumption is that without such a justification no spending will be allowed. Each
manager is responsible to justify why the money should be spent at all and to
explain in detail as to what would happen if the proposed activity is not carried out
and no money is spent thus each manager is required to make a cost benefit
analysis of each of the activities under his control.

Zero based budgeting is best applied to service and support expenditure including
administration, marketing, personnel, research and development, finance and
accounting etc.

Implementing zero based budgeting

The overall process of implementing zero based budgeting can be subdivided into
3 stages:
 a) Definition of decision packages- a decision package refers to an activity or a
group of activities for which a single manager has the responsibility for successful
performance. The decision package is specified by the managers concerned and
must show details of anticipated cost and benefits expected. There are two types
of decision packages:

i. Mutually exclusive decision package- are alternative activities required to

carry out the same job
ii. Incremental decision packages- are complementary activities.

b) Packages are evaluated and ranked-when the decision packages have been
prepared, the management will rank all the packages on the basis of their benefit
to the organization. This ranking provides a basis for allocation of resources
between activities.

c) Resources are allocated- the packages are accepted in the ranked priority
sequence and then resources are allocated.

Advantages of zero based budgeting

i. It results into a more efficient allocation of resources to activities.
ii. It focuses on the relationship between the input of recourses and output of
benefits – activities are based on cost benefit.
iii. It develops a questioning attitude and makes it easier to identify inefficient
obsolete or less cost effective operations
iv. The zero based budgeting process leads to greater staff and management
knowledge of operations of the organization and can increase motivation.
v. It provides a budgeting and planning tool for management which responds to
changes in the business environment; obsolete items of expenditure and
activities are identified and ceased.
vi. It adds a psychological impetus to employees to avoid wasteful expenditure.

Disadvantages of zero-based budgeting

i. There is considerable management skill required in both drawing up the
decision packages and for the ranking process. Such skills may be lacking in the
organization.
ii. It may encourage the wrong impression that all the decision has to be made in
the budget. Circumstances may change and new opportunities and threats can