e-learning content

Director Dcel: [email protected]

COURSE:BACHELOR OF COMMERCE

Unit code: HBC 2203

Unit title : COST ACCOUNTING

Author : Cpa, Jacob 0. Indika

Department of Accounting & Finance ,Faculty of commerce ,

The Cooperative University College of Kenya (Cuck)

Date:8th December, 2014

CONTENTS

LESSON ONE : INTRODUCTION TO COST ACCOUNTING

LESSON TWO : OVERHEADS

LESSON THREE: MARGINAL AND ABSORPTION COSTING

LESSON FOUR : RELEVANT COSTING

LESSON FIVE: COST ACCOUNTS

LESSON SIX : CONTRACT COSTING

LESSON SEVEN : COST-VOLUME-PROFIT (C-V-P) ANALYSIS

LESSON EIGHT: BUDGETING AND BUDGETARY CONTROL

LESSON NINE: PROCESS COSTING

LESSON TEN: STANDARD COSTING AND VARIANCE ANALYSIS

LESSON ONE: INTRODUCTION TO COST ACCOUNTING

Lesson Objectives:
After studying this lesson, the learner is expected to:

Define and explain the purposes and scope of Cost accounting.

Explain the differences between Cost accounting, Management accounting and Financial
accounting.
Identify elements of costs and classify costs.
Understand need for cost control systems, their effects and problems
Apply costing principles and prepare cost statements.
1.1 Definitions of cost accounting
Cost accounting may be defined as The establishment of budgets, standards costs and
actual costs of operations, processes , activities or products and the analysis of variances, or
the social use of funds .Terminology.
Cost accounting has been defined as The application of accounting and costing principles,
methods and techniques in the ascertainment of costs and the analysis of savings and /or
excesses as compared with previous experience or with standards. C.I.M.A.
It is clear from the above definitions that cost accounting or costing is important for provision
of accounting information that is useful for planning , decision making and cost control in
both commercial and non-profit making organisations. The first step in costing is to ascertain
or establish costs incurred or to be incurred in making a product or providing a service .For
instance, the costs incurred in manufacture of a product are direct materials, direct labour
and production overheads (eg fuel, electricity, water, lubricants).Costs incurred in training
would include hire of lecture hall, facilitators fees, computers, laptops, projectors, stationery,
meals and transport etc.
1.2 Purposes of cost accounting
The following can be described as the main purposes of costing:
Ascertainment of costs-establishment of cost incurred historically by cost centres, by
predetermined standards and variance analysis or by use of marginal methods.
Decision making-such as choice of product mix, make or buy and special order
decisions
Cost control-comparison of budgeted and actual results and variance analysis
Planning-expansion of business, acquisition of new plant and machinery ,increasing
production capacity
Measurement of efficiency-better utilisation of resources and improving performance
Setting of selling prices-cost plus profit mark-up used to get sales price
Evaluation of profitability- determination of performance via net income achieved.
Budgeting-preparation of operational and financial budgets such as material, labour,
production cost budgets and profit or loss budgets.

1.3 cost control and cost reduction

It is necessary to distinguish between cost control and cost reduction. Cost control
aims at conformity with some set standards, norms or benchmarks which are taken to be
targets for measuring efficiency. Standards are taken as the minimum costs for
production or providing a service or running a department. Therefore cost control can
only be effective when certain standards are set and communicated to managers
responsible for achieving them.
Cost reduction is an achievement of real and permanent reductions I costs and even
continuously challenges standards for improvement. It is embraces a dynamic approach
and corrective function as compared to cost control. It may be said that cost control is
only an attempt to cost reduction.
1.4 Cost Accounting and management accounting
Management accounting may be defined as An integral part of management concerned
with identifying , presenting and interpreting information used for Formulating strategy,
Planning and controlling activities ,Decision making; Optimising the use of resources
,Disclosure to shareholders and others external to the entity, Disclosure to employees,
Safeguarding assets. Thus the management accountant is part of senior management and
his task is to ensure that there is effective formulation of plans to meet company both longterm and short- term company objectives ,sourcing and utilisation of funds, recording of
transactions , communicating of financial and operating information ,analysing costs and
revenues and reporting on variances and making regular reviews on systems and operations
and recommend corrective action as necessary .It can be said that cost accounting is part of
management accounting with greater emphasis on the costs of functions ,activities,
processes and products. Essentially, there is a thin line between cost accounting and
management accounting.
1.5 Cost accounting and financial accounting
Financial accounting can be defined as The classification and recording of monetary
transactions of an entity in accordance with established concepts, principles, accounting
standards and legal requirements and presentation of a view of those transactions during
and at the end of an accounting period. Financial accounting deals mainly with the
preparation of financial statements (Final accounts) for external reporting .Final accounts
detail the performance of an organisation over a defined period and show the state of affairs
at the end of that period in form of profit or Loss and Balance Sheet statements. In Kenya, it
is mandatory for limited liability companies to prepare annual accounts in accordance with
the requirements of the Companies Act and International Accounting Standards. Financial
accounting relies heavily on historical financial information of monetary nature. On the other
hand, cost accounting emphasises on internal reporting. However, financial accounting
heavily relies on costing information for financial data. Because of the significance of these
two types of accounting, most organisations have set up costing and financial accounting
departments to address the aforementioned functions .The basic differences between cost
accounting and financial accounting can also be summarised in next paragraph.
1.6 Typical issues that may confront the Cost Accountant
The following are the typical problems that may confront the cost accountant:
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1. How a company can attempt to produce and sell more products within the existing
capacity or limited resources.
2. Effect of dropping a certain product/ department on the companys net profit.
3. Effect on net profit on acceptance of a special order.
4. The make or buy decision
5. Whether selling prices should be increased as a result of a wage increase award.
6. Decreases in net profit despite substantial increase in output.
.
1.7 Elements of cost
A cost may be defined as The amount of expenditure (actual or notional) incurred
on, or attributable to, a specific thing or activity.
The total cost of making a product or providing a service consists of cost of materials
, cost of wages and salaries(labour costs ) and cost of other expenses (egg Rent and
rates, Electricity, water , fuel and lubricants, depreciation etc.).
Costs may be classified as under:
1) Fixed and Variable costs
Total cost is the sum of fixed cost and variable costs, although some
A fixed cost is a cost which is incurred for a particular period of time and which,
within certain activity levels is unaffected by changes in the level of activity.
A variable cost is a cost which tends to vary with the level of activity. Activity is
measured by output or volume of sales (quantity).
Examples of fixed costs are rent and rates, insurance, salaries, interest charges,
cost of stationery, advertising and sales promotion expenses.
Variable costs include the cost of direct materials, direct wages, and sales
commission.
2) Direct and indirect cost
A direct cost is a cost that can be fully traced to the product, service, or
department that utilises that cost.
An indirect cost is a cost which cannot be directly traced to a particular
product, service or department that incurred the cost.
Material, labour and other expenses can be classified as either direct costs or
indirect costs.
Direct materials, direct labour and direct expenses are direct costs .They are
often referred to as prime cost.
Direct materials include raw materials, component parts, work in progress and
key packaging materials.
Direct labour includes direct wages for workers engaged in factory, product
inspectors, analysts and testers specifically required for such production,
foremen and shop clerks etc.
Direct expenses ( also called chargeable expenses) include expenses for hire of
specialised tools or equipment for a particular job, maintenance costs of tools ,
fixtures etc.

Indirect costs are costs for indirect material, indirect wages and indirect
expenses. Indirect materials are materials which cannot be traced in the finished
product eg consumable stores (nuts, bolts, nails, lubricating oil ).
Indirect wages include wages for non-productive personnel in the production
department eg factory supervisors or foremen wages, storemens wages, wages
for maintenance, cleaners and repairers.
Indirect expenses include Rent, rates and insurance of factory, depreciation, fuel
, water, power, electricity charges ,maintenance of plant, machinery and
factory buildings.
3) Functional costs
This is the tradition costing system of classifying costs .It involves classifying
costs as either production/manufacturing costs, administrative costs , selling
costs or distribution costs.
Production costs are costs related to factory or manufacture and consist of costs
of raw material, labour and production overheads (factory rent, insurance,
depreciation , electricity and water etc ).
Administration overheads are costs related to general office work and support
departments ( Accounting, personnel, stores, purchasing, office maintenance )
and include office rent ,salaries ,depreciation ,stationery, finance costs,
directors emoluments, research and development, training etc.
Selling costs or marketing costs are the costs associated with promoting
products and securing customers orders. These include advertisement expenses,
salesmen salaries and commission, depreciation on delivery vans etc.
Distribution costs are the costs of the consequence of operations and are
incurred to ensure the finished product from warehouse is finally delivered to
customers. These costs include transport costs from factory to warehouse and
customers premises, costs of maintaining delivery vans( fuel, insurance ,repair
charges), salaries of delivery van drivers, mechanics, clerks, rent, rates,
insurance, water and electricity charges for the warehouse.
Research and development costs are cost for searching for new or improved
products ,enhancement of knowledge and innovations.
4) Other cost classifications :
Other cost classifications which may be of interest to a costing student are as
follows:
Product and period costs
Avoidable and unavoidable costs
Controllable and uncontrollable costs
Committed fixed costs and discretionary fixed costs
1.8 Cost control systems
The purposes of cost accounting can only be achieved if an effective costing
system is established and installed in the organisation .A costing system is
designed based on the requirements of the business entity .The system should
be designed so to be simple, economical and practicable.
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1Essential elements of an effective cost control system

The following are prerequisites for the success of a cost control system:
a) Cooperation and support from staff at all levels.
b) Budgets or standards should be mutually agreed upon where
appropriate.
c) Involvement of staff in the design and operation of system .
d) A well developed and adequate accounting system.
e) Staff training and development for better job performance and
competence.
f) Support and involvement of top management in the budgeting process.
2General possible problems with cost control systems
Possible problems of cost control systems include:
Resistance of introduction of new system due to job insecurity.
Setting standards and budgets is sometimes difficulty and time
consuming.
Set standards may be inaccurate if done in haste.
In order to mitigate the typical problems, before installing a cost control
system , a variety of factors such as the size and nature of organisation
business, methods of manufacturing processes, availability of equipments
,staff capability and capacity and other cost factors should be considered so
to come up with a well-designed system.
It is important to note that costing systems may be automated in order to
enhance efficiency or throughput e.g adoption of boilers to fasten
manufacturing processes in a factory .Other possible cost effects of such
automation include reduction of direct labour cost per unit, variable costs
and cost per unit. However, automation has often been resented by workers
through their labour unions due to fear of massive lay-offs of employees.
1.9 Cost Statements
Cost information may be presented in the form of statements under appropriate
headings depending on whether the organisation is in service, trading or
manufacturing industry. The two common forms of cost statements are:
production cost and profit statements. These statements may be prepared to
show:
Production cost or factory cost ( cost of goods manufactured )
Total cost of sales.
Total cost of sales, profit and sales (income statement).
The following cost relationship may be helpful in preparing cost
statements:
Direct material + Direct labour + Direct expenses = prime cost
Prime cost + production overheads = Full factory cost
Full factory cost + selling +administration + distribution overheads= Full
cost of Sales.
It is important to note the following when preparing cost statements:
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(i) Work in progress (WIP) :opening WIP is added to and closing WIP is
deducted from factory cost to obtain net factory cost as
necessary.
(ii) Profit Mark-up and Margin: There is a relationship between cost,
profit and sales ie COST PRICE + PROFIT =SALES PRICE or COST
OF SALES + PROFIT = SALES.
Profit mark-up =profit/cost price
Profit margin = profit/sales price
(iii)
Contribution: It is defined as the difference of sales and
variable (marginal) costs .
Example 1
The cost accountant of Florida Ltd, which manufactures a product called
Flora, has provided the following information for a period:
Shs
Direct material cost
300,000
Direct wages
80,000
Direct expenses
20,000
Fixed factory overheads
20,000
Distribution cost (fixed)
23,300
Additional information
Variable production overheads are absorbed at 12% of the prime cost.
Administrative expenses (20% variable ) are 5% of factory cost.
Selling costs (50% variable) are 50% of the total administrative and
distribution costs.
The companys profit margin is estimated to be 25%.
7,203 units of the product were sold during the period ; there were no
opening and closing stocks.
Required
a) Compute the selling price and sales ( to the nearest hundred) for the period.
b) Compute the contribution and contribution margin per unit.
Solution
a) Flora Ltd
Shs
Direct materials
300,000
Direct labour
80,000
Direct expenses
20,000
Variable production overheads
50,000
Variable administration overheads
4,700
Variable selling overheads
11,700
Variable cost of sales
466,400
Fixed production overheads
20,000

administration overheads
18,800

selling overheads
11,700
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distribution overheads
23,300
Total cost of sales
540,200
Add: profit mark-up 1/3
180,067
SALES
720,300
Selling price She 720,3007,203 = shs 100
b) Contribution = sales-variable cost of sales.
= shs 720,300-466,400 = shs 253,900
Contribution per unit = shs 253,900 7,203 = shs 35

LESSON ONE: QUIZZES

1 Which of the following is a characteristic of cost control?
A Its main objective is to have continuous economy of costs.
B It is not contented only with performance as per predetermined standards.
C It is an achievement of predetermined costs or goals.
D It regards standards as benchmarks which can be improved upon.
Correct answer C
2 Which of the following is true of direct costs?
A They are production overheads
B They are prime costs .
C They are direct expenses
D They are not incurred in providing services
Correct answer B
3The costs involved in manufacture of a unit of product were : direct materials sh 4,000,
direct labour sh 3,000 ;production overheads were half of prime cost and direct expenses
were 25% of production overheads. The factory cost was:
A sh 12,000
B sh 8,000
C sh 7,000
D sh 11,000
Correct answer A
Factory cost=direct materials +direct labour+direct exps+producton ohd
= sh 4,000 +3,000+1,000+4,000=sh 12,000.
4 Match the following costs with the appropriate cost classification
Cost
cost classification
a Salary of finance managers secretary
(1) production costs
b Trade discounts given to customers
(2) Administration overheads
c overtime pay for machine operators
(3) selling costs
d Freight-in on materials used
(4) Research& Development
e cost of chemicals used in the laboratory (5) Distribution costs
Answer
a(2), b(3), c(1), d(5), e (4)

5 State five factors to be considered when installing a costing system.

6 Identify six typical problems of installing a costing system.
7 Give two examples each for committed fixed and discretionary fixed costs.
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8 Explain any five advantages of having a costing department in an organisation.

9 Suggest any five limitations of cost accounting ( 10 marks)
Answers to quizzes 5-9
5Factors to be considered when installing a costing system:
The size and organisation of the business.
The methods of manufacture
The type of product
The availability of staff
Amount of data processing , equipment availability etc
6 Typical problems when installing a cost control system :
Definition of responsibilities
Definition of cost centres
Compilation of comprehensive coding systems
Accurate recording systems for materials, labour, machine usage etc
Definition of direct and indirect costs, fixed and variable costs,period and
product costs etc
Development of appropriate methods for overhead apportionment and
absorption
Development of appropriate material issues and valuation methods
7)i Committed fixed costs are those costs arising from the possession of fixed and
intangible assets such as plant and machinery, Motor vehicles , computers , goodwill
.These assets give rise to depreciation and amortization expenses.
ii Discretionary fixed costs are controllable costs which result from managements
decisions and are easily altered and incurred depending on prevailing circumstances.
They include training expenses, research and development and some personal
emoluments.
8 Advantages of cost accounting
Communicating financial information for :
iplanning product design, standardisation. Pricing, budgeting
iicost control- variance analysis and investigations
iii Decision making-Make or Buy ,special order, product mix , shut down decisions etc
iv performance measurement and evaluation -responsibility accounting
v Formulating overall strategies and long term plans
9 Limitations of cost accounting
I It entails a lot of costs to instal and operate a costing system
ii Complexity of systems and bereucracy in running them
iiiCosting systems may not be easily implemented or appropriate to the entity
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ivThere may resistance from workers union against introduction of new system.

LESSON ONE:QUESTIONS
1 Copa sacco Ltd owns a printing press. The costs involved in printing and selling a batch
of 100 books are as follows:

Direct materials
Direct labour

shs
87,500
12,500

Direct expenses
3,000
Indirect factory overheads
17,000
Administration overheads
15,000
Distribution overheads
5,000
Selling overheads
4,000
Profit margin
20%
Required: Prepare cost statements to show Prime cost, Production cost, Total cost , Sales
and selling price ( 10 marks).

Answer
Copa sacco Ltd
Cost statement
shs
Direct material
87,500
Direct labour
12,500
Direct expenses
3,000
PRIME COST
103,000
Indirect factory overheads 17,000
PRODUCTION COST
120,000
Administrative overheads 15,000
Distribution overheads
5,000
Selling overheads
4,000
TOTAL COST
144,000
Add : Profit (144,000)
36,000
SALES
180,000
Selling price per book sh 1,800

(10 marks)

2 A firm manufactures a product whose sales are very volatile. It engages salesmen and a manager
who are paid on commission basis. Sales commission is 5% of sales. Managers commission is 10% of
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profits before his commission. It is the firms policy to charge sales commission before other
expenses. In year 2012, the Net profit was shs 9,000 (sh000) and factory expenses, excluding the
commissions , were shs 6,500 (sh000).
Required:
a) Formulate an equation to show the relationship between sales, factory expenses and profit ( 6
marks).
b) Determine the sales commission and managers commission ( 4marks)
c) Prepare profit statement for the period ( 6 marks)
d) Suppose the sales were shs 20,000 ( sh000) and factory expenses were shs 7,000 ( sh000),
calculate the managers commission and Net profit for the period ( 4 marks)
Answer
a)

Let S= sales
e= sales commission
C= managers sales commission
E= factory expenses excluding commissions.
P= Net Profit,
Then S-e-C-E=P and C=1/10 ( 0.95S-E), e= 0.05 S
Solving for P, P=0.855S-0.9E or S= I/0.855 ( P+ 0.95 E).
b) If P=9,000 and E= 6,500
Sales (S)= 1/0.855 ( 9000+ 0.906,500)=17,368 (sh000)
Sales commission (e)=5% 17,368= 868 (sh000)
Managers commission=1/10 ( 0.95 17,368- 6.500)= 1,000 (sh000)
c

Profit statement for year 2012

sh000
17,368
868
16,500
Less :Expenses
6,500
Profit before managers commission 10,000
Less: Managers commission
1,000
Net Profit
9,000
d
Profit, P= 0.855(20,000)-0.90 (7,000 )= 10,800 (sh000)
Managers commission, C= 1/10 ( 0.9520,000-7000 )=1,200 (sh000)
sales
Less:sales commission

3 Morris Ochoka,the financial controller of Sabatia enterprises Ltd, accidentally tossed the
companys cost records into a wastebasket which had been light .On realising that mistake, he
rushed to the roaring blaze and managed to retrieve only a few of the records.From the salvaged
records, he managed to determine the following facts about the current year 2014:
(i) Sales totalled sh 1000,000 during 2014.
(ii) The beginning inventories for the year were : work in progress sh 120,000; Finished
goods sh 60,000.
(iii) There were no closing inventories of raw materials.
(iv) Direct labour is equal to 25% of conversion cost; direct labour is also equal to 40%
of prime cost.
(v) The work in progress inventory decreased by sh 20,000 during the year.
(vi) Gross margin during the year was 55% of sales.
(vii) Manufacturing overheads amounted to sh 240,000 in the year.
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(iv)Administrative expenses for 2014 were twice as great as net income but only 25% of
selling expenses.
The companys Board of directors requires cost statements from Mr. Ochoka for an
urgent board meeting.
Required :Prepare cost statements for cost of goods manufactured, cost of goods
sold and profit for the year (clearly show workings for direct material and direct
labour cost for the year) ( 20 marks )
Answer
Let M=direct materials , L= direct labour, A=Administration expenses, S= Selling
expenses and N= net profit/income.
L= 25% ( L+ 240,000 ) , 4L= L+ 240,000, L=80,000
Also L=40% ( M+80,000) ie 80,000= .40 ( M+80,000) , M=120,000
Then A=2N and A= 25% S ie S=8N
Gross profit (GP)= 55% 1000,OOO = 550,000; then cost of sales =450,000
GP-A-S=N ie 550,000-2N-8N=N, Solving for N, N=50,000
A=250,000=100,000 and S= 4100,000=400,000.
Sabatia enterprises
a Statement of cost of goods manufactured for year 2014
Sh
Direct materials
120,000
Direct labour
80,000
Manufacturing overheads
240,000
440,000
Add: Beginning WIP
120,000
Less: Ending WIP
(100,000)
Cost of goods manufactured
460,000
b Cost of goods sold (sales)
Sh
Beginning finished goods inventory 60,000
Add:Cost of goods manufactured
460,000
520,000
Less: Ending finished goods inventory 70,000
Cost of sales
450,000
c Profit statement for year 2014
shs
Sh
Sales
1,000,000
Less: Cost of sales
450,000
Gross profit
550,000
Less: Operating expenses
Administration expenses 100,000
Selling expenses
400,000 500,000
Net profit
50,000

14

LESSON TWO: OVERHEADS

Lesson objectives
At the end of this lesson, the learner should be able to:
a) Explain the different treatment of direct and indirect expenses.
b) Allocate and apportion production overheads to cost centres using an appropriate basis.
c) Describe the steps involved in calculating overhead absorption rates
d) Calculate and explain under and over absorbed overheads.

1.1 Overheads and absorption costing

Overhead is the cost incurred in the course of making a product, providing a service or running a
department , but which cannot be traced directly and in full to the product, service or
department .Overheads comprise indirect materials , indirect labour and indirect expenses.
Overheads can be classified as production, administration, selling and distribution .
Absorption costing method is generally used in dealing with overheads.The objective of
absorption costing is to include in the total cost of a product an appropriate share of the
organisations total overhead Unlike marginal costing , absorption costing recognises both fixed
and variable production overheads as important elements of production.The theoretical
justification for using absorption costing is that all production overheads are incurred in the
production of the organisations output and so each unit of the product receives some benefit
from these costs. Each unit of output should therefore be charged with some of the overhead
costs.
The main reasons for using absorption costing are inventory valuations , pricing decisions and
establishing the profitability of different products. The three main stages in absorption costing
(sometimes referred to as allotment ) are allocation, apportionment and absorption.
1.2 Procedures for dealing with production (factory )overhead costs
The following are the guiding steps in dealing with manufacturing or factory overheads:
a. The factory is divided into cost centres: those departments concerned with actually
making the product to be sold ( production cost centres) and those departments which
to not actually make the products but contribute to the efficient working of the
production cost centres ( service cost centres).
b. Wherever possible, a direct charge or allocation is made to the cost centres.
c. Each cost incurred jointly by a number of cost centres is apportioned to them on some
equitable or fair basis.
d. The service costs are transferred to the production cost centres.
e. All products made in a particular cost centre are charged with a fair share of the
overhead costs
1.3 Overhead allocation
Allocation is the allotment of whole items of costs to cost centres and this method should be used
whenever possible .It is the process by which the whole cost items are charged to a cost unit or
as a cost centre eg salary of a service department manager. A Cost centre may be a production
department,a production area service department, an administrative department, a selling or a
distribution department, or an overhead cost centre.For instance, direct labour would be charged
to a production cost centre whereas costs such as canteens are charged direct to the various
overhead cost centres.When allocating overheads one must ensure that a cost centre
necessitated the overhead to be incurred and the exact amount of overhead is known.
1.4 Overhead apportionment
Apportionment refers to the division or sharing of costs among two or more cost centres in
proportion to the estimated benefit received or derived ,using a fair basis or proxy. This occurs where
the total value of an overhead item is shared among cost centres that used the overhead through
15

primary apportionment or distribution. Service centre costs may further be reapportioned (via
secondary distribution) to production cost centres by using various methods such as direct method ,
reciprocal method etc.
Bases of apportionment
The following bases may be used to equitably apportion overhead costs to cost centres :
Overhead to which the basis applies
Basis of apportionment
Rent, rates, heating and lighting, repairs and
Floor area occupied by each cost centre
Depreciation of buildings
Floor area
Depreciation and insurance of equipment
cost or book value of equipment
Managers salary, canteen costs, supervision
Number of employees, wages paid, output
Medical expenses
,,
,,
,,
Heating and lighting (factory boilers)
Volume of space occupied by each cost centre
Maintenance of building
Floor area
Maintenance costs of plant, fire and machine
plant values
Insurance of machinery
plant values
Stores
Store requisitions
Fire and machine insurance
plant values
Note that some overheads may be apportioned on the basis of the unit of measure of service
consumed eg electricity and water- meter reading( k/ watts and litres), maintenance ( number of
workers or hours spend in each cost centre, Horse power(H.P) Hours etc. Where it is not practicable,
apportion the overheads on the basis of a factor which approximates to the amount of service
consumed.
Example 1 The following total expenses are to be apportioned to the departments X,Y and Z in
the month :
shs
Electric power
10,500
Rates
1,500
Maintenance& repairs of machinery 21,000
Supervision
45,000
Insurance of premises
1,500
79,500
You are also given the following information:
Department
X
Y
Z
Floor Area ( sq. m)
5000
7500
2500
Total H.P of machinery
15
10
5
Value of machinery (sh)
30,000 20,000 100,000
Number of personnel
30
100
20
Answer
Overhead apportionment summary
Department
X
Y
Z
Total
Overhead
base
sh
sh
sh
sh
Electric power
HP of machinery
5,250 3,500 1,750
10,500
Rates
Floor area
500
750
250
1,500
Maintenance
Value of machinery
4,200 2,800 14,000
21,000
Supervision
No. of personnel
9,000 30,000 6,000
45,000
Insurance (premises) Floor area
500 750
250
1,500
Total
19,450 37,800 22,250
79,500
Apportionment of service cost centre costs to production departments
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Service department costs are charged to production departments by an allocation process. Only
production department produce the goods that will finally be sold to the consumer at a
predetermined price. It is therefore prudent to transfer all costs, direct and indirect to the production
department for absorption of total cost to production units. Hence, indirect costs of service
departments such as stores, maintenance, purchasing and personnel, should eventually be
transferred to production cost centres using an appropriate method .Service (support ) departments
may also provide services to each other. Services provided between service departments are known
as interdepartmental or reciprocal services. There may arise a rare situation in which a production
department also provides services to service departments. In such a case, the related production
depatments service cost should be removed and apportioned first before the normal
apportionment progresses. A technical assessment of services given to another department or to
each other is usually provided in the form of ratios. The following are the commonly used methods to
apportion service department costs to production departments :
a.
Direct method ignores the costs of services between departments and allocates all
service department costs directly to production departments using the ratios of services
provided. It is the simplest method of dealing with reciprocal services.
b.
Step-down or elimination method- provides for allocation of a departments costs to
other service as well as to production departments in a sequence manner. Preferably start
the allocation with the service department that provide more services to other service
departments .The previous services department whose costs have been apportioned is
dropped or eliminated from subsequent apportionments. The direct method and step-down
methods are much simpler but less accurate and therefore rarely examined.
c.
Repeated distribution or reciprocal method- service department costs are allocated to
both the production departments and service departments that use the services. The service
department costs are then gradually and repeatedly apportioned to the production
department until the amounts allotted to and from the service departments diminish. It is
also known as the continuous allotment method. This method is used where there are inter
departmental or reciprocal services and is the most accurate apportionment method.
However, this method is cumbersome and tedious especially when more than three service
departments or production departments are involved.
d.
Algebraic or simultaneous equations method-This is an alternative to the reciprocal
method. Two simultaneous equations for the total overhead costs for the service cost centres
are derived and solved. The resultant service costs are then apportioned to production
departments in using the technical assessment service ratios However, where there are
more than two service cost centres, this method becomes complex and as such, the
reciprocal method should be used. For example, in case of two service cost centres, A and B
with total overheads of shy 10000 and shy 7800 respectively. A provides 20% of its services to
B , while B provides 10% of its services to A, then the total overhead equations ( X and Y for A
and B respectively ) would be as here below :
X= 10000 + 10% Y and Y= 7800 + 20% X.

Example 2
A company has three production departments and two service departments . The overheads for
these departments for a period are as follows:
shs
Production dept: P 25,000
Q 20,000
R 15,000
Service dept: A 10,000
17

B
7,800
Total overhead 77,800
The overheads of service centres are charged as under:
Department
P
Q
R
A
B
Service dept : A
30%
30%
20%
-----20%
B
40%
30%
20%
10%
---Required : Show the overheads chargeable to the three production departments using
direct method, step-down method, repeated distribution and Simultaneous equations or
algebraic method
Solution
a Direct method
P
Q
R
Total
Sh
sh
sh
sh
Overheads (given )
25,000
20,000
15,000
60,000
Service Dept A
3,750
3,750
2,500
10,000
Dept B
3,467
2,600
1,733
7,800
Total
32,217
26,350
19,233
77,800

b Step-down method

Overhead ( as given)
Apportion As service costs
Apportion Bs service costs
Total
c Repeated distribution method

Overheads ( as given)
Apportion As service costs
Total
Apportion Bs service costs
Total
Apportion As service costs
Total
Apportion Bs service costs
Total
Apportion As service costs
Total

P
Q
R
Sh
sh
sh
25,000 20,000
15,000
3,000 3000
2000
28,000 23,000
17,000
4356
3267
2177
32, 356 26,267 19,177
P
Sh
25,000
3,000
28,000
3,920
31,920
294
32,214
78
32292
8
32,300

A
B
sh
sh
10,000 7,800
(10000) 2000
0
9,800
0
(9,800)
0
0

Q
R
A
sh
sh
sh
20,000 15,000 10,000
3,000 2,000 (10,000)
23,000 17,000
2,940
1,960 980
25,940 18,960 980
294
196 (980)
26,234 19,156
59
39 20
26,293
19,195 20
8
4 (20)
26,301
19,199

Total
sh
77,800

77,800
77,800

B
Total
sh
sh
7,800 77,800
2,000
9,800
(9,800)
196
196
(196)

77,800

dSimultaneous equations method

Let x=Total overhead of dept A
y= Total overhead of dept B
Then x= 10,000 + 0.1y and y= 7,800 + 0.2x,two simultaneous equations derived.
Solving for x and y we get x=11,000 and y=10,000
The service costs for dept A only are 80%11,000= shs 8,800
The service costs for dept B only are 90% 10,000 =shs 9,000
18

The next step is to apportion the service department costs to the production departments
Only in the ratios of services provided to them.

Apportionment of service costs to production departments- Simultaneous

Equations method
Production departments
P
Q
R
Overheads allocated
(shs)
25,000 20,000
15,000
Apportion A service costs
3,300
3,300
2,200
Apportion B service costs
4,000
3,000
2,000
Total
32,300 26,300
19,200

Total (shs)
60,000
8,800
9,000
77,800

1.5 Overhead absorption

This refers to the sharing out of overheads to the various cost centres that used the overheads .It
is used when the overheads cannot be allocated or attributed to a specified cost centre .The aim
is to establish the overhead absorption rate eg overhead cost per unit. Having allocated and or
apportioned overhead costs, the next step should be to absorb them into the cost of production.
As mentioned on absorption costing, the reasons for absorbing overheads are:
The control of overhead expenditure.
Charging of overhead to cost units.
Valuation of work in progress.
Valuation of abnormal losses.
Profit measurement
Decision making
The two stages of absorbing overheads in cost units are namely; computation of predetermined
overhead absorption rate (OAR) and application of this rate to cost units.
1 Choosing the appropriate overhead base
The predetermined overhead absorption rate is calculated using budgeted figures.
It is therefore necessary that an appropriate absorption method be selected depending on
the prevailing circumstances of the organisation. Some organisations may be labourintensive, while others may be capital-intensive or produce all identical units . Hence the
choice of an absorption method may be based on the following factors: units of output,
direct labour hours, machine hours, direct material cost, direct labour cost and prime cost.
The choice of an absorption rate requires personal judgement and common sense, depending
on the characteristics and real circumstances of a particular cost centre/ department.
However, most factories use direct labour hours or machine hours.
2General procedure in overhead absorption
The basic steps in absorbing overheads to cost units are as follows:
a) Estimate the overhead likely to be incurred during the coming period.
b) Estimate the activity level for the period e g direct hours, machine hours.
c) Divide the estimated overhead by the budgeted activity to determine the
OAR.
d) Absorb the overhead into the cost unit by applying the calculated absorption
rate.
3Over and under absorption of overheads
Over and under absorption of overheads occurs because the predetermined overhead
Absorption rates are based on budgeted/ estimated figures. Hence, the overheads
Absorbed by the process may not agree with the actual overheads incurred for the period
19

Over absorption occurs if the overhead absorbed exceed the actual overheads
while Under absorption occurs if the overhead absorbed are less than the actual overheads.
Example 3
Department S has provided the following data for a period:
Budgeted overheads shs 200,000
Actual overheads
shs 200,500
Budgeted direct labour Hours (DLH) 40,000
Actual direct labour hours 42000
Required: a) overhead absorption rate (OAR)
b) overhead absorbed
c) over or under absorbed overheads
solution
a) OAR = Budgeted overheads
= shs 200,000 = shs 5 per DLH
Budgeted direct labour hours
40,000 hrs
b) Overheads absorbed = Actual direct labour Hrs OAR =42,000shs5 = shs 210,000
c) Over absorbed overheads =Overhead absorbed- Actual overhead incurred
=She 210,000-200,500 = shs 9,500.
1.6 Overheads and Activity-based costing (ABC)
Absorption costing has been criticised because all overheads are absorbed into production
volume (measured by labour or machine hours), even though many support overheads vary,
not with production volume, but with the range and complexity of production. Nowadays,
support overheads form a major component of total cost as direct costs continue to diminish.
Thus, support overheads relating to technical engineering and design services, planning,
tooling, data processing are becoming increasingly significant proportion of total costs in
modern factories due to advanced technological developments. ABC was developed to
address the problem inherent in conventional approaches such as absorption costing so as
to ensure that support overheads are traced to the product costs more practically. ABC is a
method of charging overheads to cost units on the basis of benefits derived from a particular
indirect activity e.g ordering, planning ,setting etc and thus attempts to show the
relationship between overhead costs and the activities that cause them (cost drivers ). We
have already with classification of costs under the traditional systems in lesson one.
1 Cost classifications using Activity Based Costing
Using the ABC , Kaplan and Cooper have proposed classification of overheads in the
following manner :
a Short-term variable costs: These are costs that vary with production volume. These costs
should ideally be traced to products using production volume influencers as appropriate.
Examples include direct labour hours, machine hours , direct material cost, direct labour cost,
prime cost and units of production .ABC recognises that there could be several cost drivers
whenever production volume influencers are used in varying proportions to cost products.
c Long-term variable costs-These are overhead costs which do not vary with production
volume but do vary with other measures of activity but not immediately. These are costs for
support activities such as stock handling, production scheduling, set-ups etc. which tend to be
fixed in the short term but vary in the longer term depending on the varieties and complexity
of products manufactured. These costs which were traditionally considered as fixed should be
traced to products using transaction based cost drivers.
c Fixed costs-These costs to not vary with production activity in the short term. These costs
include managers salary; Rent, rates etc. tend to relatively small.
2 Outline of ABC system
The main steps involved in ABC are as follows:
20

i)
ii)
iii)
iv)

Identify the main activities in the organisation .These activities include material
handling, purchasing, reception, despatch, machining, assembly etc.
Identify the factors which determine the costs of an activity or cost drivers such as
number of purchase orders, number of orders delivered, number of set-ups etc.
Collect the cost of each activity or cost pools or cost centres.
Charge support overheads to products on the basis of their usage of the activity,
expressed in terms of the chosen cost driver(s).

2 Transaction- based cost drivers

ABC focuses mainly on factors that cause or driver costs otherwise called the cost drivers. Cost
drivers can be defined as Activities or transactions which are significant determinants of cost .
Choosing ideal cost drivers is a difficult task. According to Cooper, There are no simple rules that
pertain to the selection of cost drivers .The best approach is to identify the resources that
constitute a significant proportion of the product costs and determine their cost behaviour .If
several are long term variable costs, a transaction based cost system should be considered .A
well designed ABC system enables an organisation to determine value or cost addition of its
departments and what causes the activity for which the department is responsible.
Examples of transactional based cost drivers are given below :
Support Department costs ( i.e cost pools )
Possible cost driver
Production scheduling
Number of production runs
Set-up costs
Number of production runs
Material handling
Number of production runs
Finished goods stock handling
Number of orders delivered
Despatch costs
Number of orders delivered
Purchasing costs
Number of purchase orders
Raw material stock handling
Number of orders received
Quality control
Number of inspections
Machinery (power, depreciation etc )
Number of machine hours
Example 4
Two products X and Y are made using similar equipment and methods. The data for the
last period are:
X
Y
Units produced
6000
8000
Labour hours per unit
1
2
Machine hours per unit
4
2
Set-ups in a period
15
45
Orders handled in the period
12
60
Overheads for the period
shs
Relating to production set-ups
179,000
Relating to order handling
30,000
Relating to machine activity
55,000
264,000
Required: Calculate the overheads to be absorbed per unit of each product based on
a)
Conventional absorption costing using labour hour rate.
b)
An ABC approach using suitable cost drivers.
Answer
a) Using conventional absorption costing
Labour hours
21

Product X = 6000 units @ 1 = 6000

Product Y = 8000 units @ 2 = 16000
Total labour hours
22000
Absorption overhead rate (OAR), based on labour hrs= Shs . 264000=Shs 12 per hour
22000
Overheads absorbed : Product X shs 1 12 =sh12,Total overheads=6000 sh12=shs72000
Product Y shs 212 =sh24,Total overheads =8000 shs24=shs192000
Total overheads =
shs 264000
b) Using ABC
Machine hours per period : Product X: 60004= 24000
Product Y =80002 =16000
40000
Cost driver rates
Production set-ups = shs 179000 =shs 2983 per set-up
60
Order handling = shs 30000 =shs 417 per order
72
Machine costs = shs
55000 = shs 1.375 per hour.
40000
Overheads using ABC
costs
Product X
product Y
Total
Shs
shs
shs
Set-ups
15 shs 2983 =
44745 45 shs2983 = 134235
Orders
12 shs 417
=
5000
60shs 417 =
25020
Machines
24000 shs 1.375 =
33000 16000shs 1.375=22000
82745
181255
264000

22

LESSON TWO
QUIZZES
1State the objective of overhead absorption.
2Give five examples of absorption.
3Give three methods used in the allotment of reciprocal service costs.
Answers to quizzes 1-3
1 The objective of overhead absorption (absorption costing) is to include in the total cost of a
Product an appropriate share of the organisation s total overhead .An appropriate share is
generally taken to mean an amount which reflects the amount of time and effort that has
gone into
producing a unit or completion of a job in terms of indirect costs other than materials and
labour.
2 Absorption bases include direct labour hours, machine hours, units of output.
3 Methods of apportioning service department costs to production cost centres- step-down,
Reciprocal and Simultaneous equations methods.
4Match the following overheads with the most suitable basis of apportionment.
Overhead
Basis of apportionment
a) Cost accounting
(1) Number of employees
b) Cafeteria
(2)Labour hours
c) Fire & machine insurance (3)Floor area
d) Heating& Lighting
(4)Plant value
Answer
a(2), b(1), c(4),d(3).
5 The following data relates to a cost centre in one year:
Budgeted labour hours 25,000
Actual labour hours
24,000
Budgeted overheads sh 350,000
Actual overheads shs 356,000
The over or under absorbed overhead based on labour hours for the period was
A sh 6,000
B sh 14,000
C sh 20,000
D sh 8,000
Correct answer C.
OAR=sh350,000/25,000 hrs=sh14, overhead absorbed=24,000 hrs@sh14=sh 336,000
Overhead under-absorbed=Actual ohs-absorbed ohs=sh 356,000-336,000=sh20,000.
6Which of the following are two basics of absorption costing?
A calculate the direct labour rate and rate per machine hour
B Estimate the budgeted overhead and budgeted activity for the period
C Ascertain the budgeted overhead and actual activity for the period
D Estimate the budgeted overhead and budgeted machine hours for the period
Correct answer B
23

LESSON TWO QUESTIONS

1 A company has three production departments and two service departments and for a period,
the departmental overheads distribution summary has the following totals:
Shs
Production Dept : A
80000
B
70000
C
50000
Service Dept :
1
23400
2
30000
253400
The expenses of the service departments are charged out on a percentage basis
as follows :
A
B
C
1
2
Service department : 1
20%
40%
30%
10%
2
40%
20%
20%
20%
Required: Show the apportionment of the overheads to the production departments using:
a) Simultaneous Equations method
b) Repeated distribution method
Answer
A simultaneous equations method
Let x= Total overhead for Dept 1
Y= Total overhead for Dept 2
Then x= 23,400 +0.20y and y= 30,000 + 0.10 x.
Solving for x and y , x=300,00 and y=330,000
Apportionment using simultaneous equations method
Total
A
B
C
shs
shs
shs
shs
Overheads (given) 200,000
80,000
70,000
50,000
Service Dept: 1 :
27,000
6,000
12,000
9,000
2:
26,400
13,200
6,600
6,600
253,400
99,200
88,600
656,000
a Repeated distribution method

Overheads (as given )

Apportion Dept 1 service costs
Sub-total
Apportion Dept 2 service costs
Sub-total
Apportion Dept 1 service costs
Sub-total
Apportion Dept 2 service costs
Sub-total
Apportion Dept 1 service costs
Sub-total

A
B
Sh
sh
80,000 70,000
4,680
9,360
84,680 79,360
12,936 6,468
97,616
85,828
1,294
2,587
98,910
88,415
260
129
99,170
88,544
26
52
99,196
88,596

C
sh
50,000
7,020
57,020
6,468
63,488
1,940
65,428
129
65,557
39
65,596

1
sh
23,400
(23,400)
6,468
6,468
(6,468)
129
129
(129)

2
Total
sh
sh
30,000
253,400
2,340
32,340
( 32,340)
647
647
(647)
12
12
24

Apportion Dept 2 service costs

Total

6
99,202

3
88,599

3
65,599

(12)
253,400

2 X Ltd has four departments, A,B,C and D . The actual costs for a period are as follows:
Shs
shs
Rent
10,000
supervision
15,000
Repairs to plant
6,000
fire insurance
5,000
Depreciation to plant
4,500
power
9,000
Light
1,000
Employers Liability
Insurance
1,500
The following information is also available in respect to the four departments:
Department
A
B
C
D
Area sq. m
1,500
1,100
900
500
Number of employees
20
15
10
5
Total wages (shs)
60,000 40,000
30,000
20,000
Value of plant (shs)
240,000 180,000
120,000
60,000
Value of stock (shs)
150,000 90,000
60,000
Required : Apportion the costs to the various departments on fair basis.
Answer
Apportionment to departments
A
B
C
D
Total
Overhead item
Base
shs
shs
shs
shs
shs
Rent
Area sq.m
3,750
2,750
2,250
1,250
10,000
Repairs to Plant
Value of plant
2,400
1,800
1,200
600
6,000
Depreciation to plant value of plant
1,800
1,350
900
450
4,500
Light
Area sq.m
375
275
225
125
1,000
Supervision
No. of employees
6,000
4,500
3,000
1,500
15,000
Fire insurance
Value of plant
2,000
1,500
1,000
500
5,000
Power
Area sq.m
3,375
2,475
2,025
1,125
9,000
Liability insurance
Total wages
600
400
300
200
1,500
Totals
20,300 15,050 10,900
5,750
52,000
3 Comp ware Ltd is a company based in the industrial area that manufactures computer accessories.
The company uses predetermined overhead rates in applying overhead s to production orders .It uses
cost of labour in applying overhead incurred in department A , while in department B, it uses
Machine hours. The company made the following projections at the commencement of year 2013:
Department
A
B
Shs
Shs
Direct material
1,800,000
400,000
Direct labour
1,200,000
250,000
Production overheads
960,000
220,000
3,960,000
870,000
Machine hours
96,000
22,000
Direct labour hours
80,000
25,000
During the year, Job L10 consumed the following inputs :
A
B
Material issued (shs )
11,000
2,500
Direct labour cost (shs)
9,600
2,000
25

Machine hours
768
176
Direct labour hours
640
200
Required:
a Overhead absorption rates for department A and B
b Total cost of production for Job L10
c At the end of the year 2013, the actual factory overhead cost incurred amounted to Sh 944,000
for Dept A and Sh 231,000 for Dept B. Actual direct labour cost was shs 1,100,000 in Dept A and a
total of 24,000 machine hours were used in Dept B. Calculate the over or under absorption of
overheads for the two departments and the company as a whole.
Answer
a Calculation of overhead absorption rates(OAR)
OAR= Total budgeted overhead
Budgeted activity
Dept A : OAR = sh 960,000sh1,200,000=0.80 per direct labour cost
Dept B : OAR = sh 220,000 22,000 = sh 10 per machine hour.
b Total cost of production for Job L10
A
B
Total
Sh
sh
sh
Direct material
11,000
2,500
Direct labour
9,600
2,000
Production overheads
7,680
1,760
Production cost
28,280
6,260
34,540
c Over and under absorption of overheads in 2013
A
B
Total (for company)
sh
sh
sh
Actual overheads incurred
944,000
231,000
Overheads absorbed
880,000
240,000
Over / (under) absorption
( 64,000)
11,000
53,000

4 Chakula safi Ltd makes four products namely: Bora, Sawa , Afya and Mpya.Details of the four
products and relevant information are given below for one period :
Product output Number of
Direct
Machine Material
Material
Units production
labour hours hours
cost
components
Runs in a period per unit
per unit
per unit
per unit
Bora
50
6
2
2
sh 30
4
Sawa
75
8
4
4
sh 75
5
Afya
250
10
2
2
sh 30
4
Mpya 250
10
4
4
sh 75
3
Direct labour cost is sh 7 per hour.
Overhead costs are as follows :
Cost
cost driver
Sh
Short run variable costs Machine hours
18,250
Scheduling costs
No. of production runs
17,680
Set-up costs
No. of production runs
13,600
Material handling
No. of components
16,970
Total
66,500

26

Required:
a) Calculate the total cost for each product if all overhead costs are absorbed on a machine hour
basis
b) Calculate the total costs for each product, using activity based costing.
Answer
a
Conventional or traditional product costing based on machine hours
Overhead absorption rate (OAR) (based on machine hour)= Total overhead cost/machine hours
= sh 66,500 1,900 = sh 35 per machine hour.
Product
Cost per unit No of units Total cost(sh)
Bora
2 machine hrs@ sh 35
sh70
50
3,500
Sawa
4 ,,
@ sh 35 sh 140
75
10,500
Afya
2 ,,
@ sh 35 sh 70
250
17,500
Mpya
4 ,,
@ sh 35
sh 140
250
35,000
66,500
Machine hours=2 50+ 475 +2250 + 4250=100+300+500+1,000=1,900 hours
Machine hours: Bora (100 ), Sawa (300), Afya (500) and Mpya( 1,000)
b Activity bases costing (based on cost drivers)
Activity
Short run
scheduling setup
material
Total (sh)
Variable cost costs
costs
handling costs
Cost of activity (sh)
18,250
17,680 13,600
16,970
66,500
Consumption ( cost driver)
1900
34
34
23 25
Machine hrs production production material
Runs
Runs
components
Cost per unit
Of consumption
sh 9.61
sh520
sh400
sh7.30
Allocation of cost
Total cost unit cost
To products
sh
sh
sh
sh
sh
sh
Bora
961
3,120
2,400
1460
7,941
159
Sawa
2,883
4,160
3,200
2,738
12,981
173
Afya
4,805
5,200
4,000
7,300
21,305
85
Mpya
9,610
5,200
4,,000
5,463
24,275
97
Total
18,259 17,680
13,600
16961
66,500
514
7 Western emporium Ltd has two production departments ( P and Q) and two service department
Stores (S) and Maintenance ( M). It incurred the following overhead costs :
P
Q
S
M
Shs
Shs
shs
shs
Allocated costs
60,000
40,000
10,000
20,000
Apportioned costs
20,000
10,000
10,000
5,000
Total costs
80,000
50,000
20,000
25,000
Production department P made 120 requisitions of materials while Department Q made 80
requisitions of materials in the same period. Department M provided 500 hours of work for
department P and 750 hours for Department Q.
Required : Determine the total production overhead costs of department P and Q

27

Solution
Allocation of overhead costs to production departments (using direct method)
P
Q
S
M
Sh
sh
sh
sh
Overheads allocated
80,000 50,000
20,000
25,000
Apportion Ss costs to P & Q
12,000
8,000 (20,000)
Subtotal
92,000 58,000
Apportions Ms costs to P&Q
10,000 15,000
( 25,000)
102,000 73,000

Total
sh

175,000

28

LESSON THREE: MARGINAL AND ABSORPTION COSTING

Lesson objectives
At the end of this lesson, the learner should be to:
a) Identify marginal costs and full costs
b) Distinguish between Marginal and Absorption costing and state their
advantages and limitations.
c) Prepare operating statements using Marginal and Absorption costing
Principles
d) Reconcile profits/ losses obtained using marginal and absorption costing
principles.
2.1 Marginal and Full costs
In lesson one , we attempted to distinguish between Fixed costs and variable costs.
Variable costs are sometimes referred to as marginal costs. These are the costs that
vary with levels of activity i e volume or output. As output changes ( increases or
decreases ), marginal costs change as well. Marginal cost is the cost of a unit of a
product or service which would be avoided if that unit were not produced or
provided. It is for this reason that these costs are considered by managers as
important for decision making and even stock valuation. Examples of marginal cost
of sales are prime costs, variable production overheads, salesmen commissions and
other commissions based on profits or sales or production levels. Marginal
production cost are prime costs plus variable production overheads.
Full cost ( or absorbed costs ) of sales are all costs, fixed and variable , that are
associated with production and sale of the product.In other words, full costs
comprise prime cost, production overheads , administration, selling and distribution
oveheads or expenses.Full costs of production would comprise marginal costs of
production plus variable and fixed production overheads.
2.2 Marginal costing
Marginal costing is an alternative method of costing to absorption costing.
This costing technique is invariably referred to as variable or direct costing or
contribution approach. Under this technique, only direct costs are charged to cost of
product or cost of sale and contribution is calculated. Fixed costs attributable to a
relevant period are written off in full against the contribution of the period. Thus,
fixed costs are treated as period costs and charged in full to the profit or loss
account of the accounting period in which they are incurred.They are considered as
irrelevant for managerial decisions involving alternative products.
Contribution is the difference between sales and marginal cost of sales.
Contribution = Sales- Marginal cost of sales.
Contribution- Fixed costs = Profit.
The concept of contribution is vital in marginal costing and is often used to mean
contribution towards covering fixed overheads and making a profit .
In marginal costing, the closing stocks of Raw materials, work in progress and
finished goods are valued at marginal or variable cost of production.

29

2.3 Absorption costing

Under this method, all costs are absorbed into production and thus operating
statements do not distinguish between fixed and variable costs. It is also referred
full costing or indirect costing .Consequently, the valuation of stocks and work
progress contains both fixed and variable elements. Absorption costing is the basis of
financial accounting.
2.4 Marginal costing versus absorption costing
The following are the arguments in favour of marginal costing:
a)Simple to operate especially where variable and fixed costs are
separable.
b) The method avoids apportionment of fixed costs to products which
may be difficult and arbitrary.
c) When sales are constant but production fluctuates marginal costing
shows steady net profit whereas absorption costing shows amounts of
fluctuating net profits.
d) Under or over absorption of overheads is almost entirely avoided in
case fixed overheads are excluded in the calculation of absorption rates.
e) Fixed costs are incurred on a timely basis and do not relate to activity
and it is only logical to write them off in the period they are incurred using
marginal costing.
f) Marginal costing operating statements nearly approach cash flow
statements and can be used ascertain actual cash position .
The following arguments are in support of absorption costing:
a)It is fair to share fixed production costs between units of production as
such costs are incurred in order to make output and should not be ignored.
b) Closing stocks are valued in accordance with International
Financial Reporting Standards.
c) It is easier to determine the profitability of several products by charging a
share of fixed overheads to them rather than basically using contribution.
d) Fixed costs should be included in stock valuations in order to prevent a
series of losses especially in industries have large amounts of such costs.
2.5 Operating (profit ) statements using Marginal and absorption costing principles
Differences arise in the profit or loss obtained when using marginal and absorption costing.In
marginal costing: closing stocks are valued at marginal production cost, fixed costs are
treated as period costs and cost of sales does not include a share of fixed overheads.Thus, in
marginal costing, it is necessary to identify variable costs, contribution and fixed costs.
On the other hand, when using absorption costing, closing stocks are valued at full
production cost, fixed costs are absorbed into unit costs and cost of sales does include a
share of fixed overheads. If there are any opening stocks, they should be valued at full
production cost, unless they are already valued. In absorption costing, it is not necessary to
30

distinguish variable costs from fixed costs. Under both methods, the initial step is therefore
to evaluate cost of production per unit as a basis of valuing stocks.
The differences in profits reported under the two costing systems is due to the different stock
valuation methods used and hence it is necessary to prepare a reconcilliation statement.
Example 1
The following data was provided by the cost accountant of KK Ltd for a certain period:
Selling price
sh 600 per unit
Sales
1,000 units
Production
800 units
Opening stock
400 units
Closing stock
200 units
Direct material cost shs 80,000
Direct labour cost shs 16000
Variable factory overheads shs 24,000
Fixed factory overheads shs 40,000
Required: prepare operating statements for the period using:
a)Marginal costing
b)Absorption costing
c)Reconcile the profits in (a) and (b) above.
Solution
Evaluation of cost of production per unit
a) Marginal costing
b) absorption costing
Qty
value (shs)
Qty
value (shs)
Direct materials
800
80,000
800
80,000
Direct labour
16,000
16,000
Variable factory OHDS
24,000
24,000
Fixed factory OHDS
--------40,000
Cost of production
800
120,000
800
160,000
Cost of production per unit = shs 150
cost of production per unit = shs 200
Value of closing stocks=200 units shs 150
value of closing stocks=200 unitsshs 200
= shs 30,000
=shs 40,000
Operating statements
a) Marginal costing
b) Absorption costing

Sh
600,000

Sales 1,000 units @ shs 600

Less: Cost of sales
Opening stock 400@shs 150
60,000
Cost of production 800 @ shs150 120,000
Closing stock 200 @ shs 150
(30,000)
150,000
Contribution
450,000
Less: Fixed factory overheads
40,000

sh
600,000

Sales
Less: cost of sales
Opening stock 400@shs 200 80,000
cost of production 800@shs 200 160,000
closing stock
200 @ shs 200 (40,000)
200,000
Gross profit
400,000
Fixed factory overheads
--------31

PROFIT

410,000
c)

Opening stocks
Closing stocks
Profit

Reconcilliation statement
Marginal costing (shs)
600,000
30,000
30,000
410,000

400,000

Absorption costing(shs)
80,000
40,000
40,000
400,000

Difference (shs)
(20,000)
(10,000)
(10,000)
10,000

32

LESSON THREE
QUIZZES
1 Which of the following statements is TRUE about marginal costing?
A Period costs are ignored when preparing operating statements
B Only variable costs are considered when preparing operating statements
C It may lead to the firm setting prices which are lower than total costs
D It is recommended for valuation of stocks and work in progress in financial accounts.
Correct answer C
2 A firm makes and sells a product whose variable production cost is sh 6 per unit and
selling price sh 10. In a period, production was 20,000 units but only 18,000 units sold. Total
fixed costs were sh 45,000. A sales commission of 5% is offered. There were no opening
inventories in the period. The profit for the period using marginal costing was
A Sh 18,000
B sh 60,000
C sh 14,000
D sh 15,000
Correct answer A
Profit=sales variable production cost-sales commission-fixed costs
=sh 180,000-108,000-9,000-45,000= sh18,000, closing stock=2,000@sh6=sh12,000
Variable cost of production=20,000@sh6-12,000=sh 108,000.
3Match the following descriptions with the correct costing term
Description
costing term
a) Sales minus product and period costs 1 marginal cost
b) Sales minus variable costs
2 Absorption cost
c) Fixed plus variable costs
3 contribution
d) Total costs minus fixed costs
4 net profit
Answer
a(4), b(3), c(2), d(1)
LESSON THREE:
QUESTIONS
1 The following information has been extracted from the books of Langata Ltd for 2013:
Cost element
Amount (sh)
Direct material
7,200,000
Direct labour
1,800,000
Variable production overheads
1,500,000
Fixed production overheads
2,700,000
Sales Salaries
450,000
Sales commission
300,000
Advertisement expenses
480,000
Sundry fixed expenses
720,000
Addition information:
Production was 30,000 and sales 24,000 units.
Selling price per unit sh 550
33

Required: a)Prepare operating statements using:

iMarginal costing method
iiAbsorption costing method
b )Reconcile the profit figures (if any ) arising from the above statements.
Solution
Langata Ltd
Operating statements
Marginal costing
Absorption costing
sh
sh
sh
sh
Sales (24,000 @550)
13,200,000
13,200,000
Less: cost of production
Variable cost of production 10,500,000
10,500,000
Fixed cost of production
2,700,000
Cost of production
10,500,000
13,200,000
Less :Closing finished goods 2,100,000 8,400,000
2,640,000
10,560,000
4,800,000
2,640,000
Less: Sales commission
300,000
Contribution
4,500,000
Less: Fixed costs:
Less:Operating expoenses
Fixed production cost
2,700,000
sales commission 300,000
Sales salaries
450,000
sales salaries 450,000
Advertising expenses
480,000
Advertising
480,000
Sundry fixed expenses
720,000
4,350,000 sundry fixed exps720,000 1,950,000
Profit
150,000
690,000

2 Jo Enterprises Ltd has an annual production capacity of 300,000 units and normal capacity
is reclaimed at 90%. Standard variable production cost were shs 18 per unit and fixed
production cost amounted to shs 540,000 per annum. Variable selling cost were shs 4.50 per
unit while fixed selling cost were shs 405,000. The unit selling price was shs 30. For the year
ended 30th June 2014, the units sold were 225,000.
Required :
a Income statement under absorption costing.
b Income statement under marginal costing.
c Reconcile the two profits (loss) above and explain the reasons for the difference.
Answer
Jo enterprises Ltd
Income statements for year ended 30th June , 2014
Marginal costing
Sh
Sales(300,00090%@ sh 30)
Less:Cost of production
Variable cost (270,000@18) 4,860,000

Absorption costing

sh
6,750,000

sh

sh
6,750,000

4,860,000
34

Fixed cost

Less:closing stock (45,000@18)( 810,000 ) 4,050,000

Gross contribution
2,700,000
Less: Variable selling costs
1,012,000
Contribution
1,687,500
Less: Fixed costs
Production costs 540,000
Selling costs
405,000
945,000
Net profit
742,500

540,000
5400,0000
(900,000)

4,500,000
2,250,000

1,012,000

405,000

1,417,500
832,500

3 The following budgeted information relates to Mamba Ltd which sells a single product ,for the
month of June 2014:
Sh per unit
Selling price
16
Prime cost
8
Fixed production cost
3
Additional information:
Variable production cost are 25% of prime cost
Units sold were 18,000 but there were 7,000 units of closing stock.
There were no opening stock.
Required: Prepare operating statements for the month on the basis of Marginal and
absorption costing.
SOLUTION
Mamba Ltd
Marginal costing
Absorption costing
Shs
sh
Sales (18,000@ sh16)
288,000
sales
288,000
Less: Marginal cost of production
250,000
Full cost of production
325,000
Less: Closing stock(7,000 @10)
( 70,000)
( 91,000)
Net cost of production
180,000
234,000
Contribution
108,000
Gross profit
54,000
Less :Fixed production cost
75,000
Net profit
33,000
54,000

35

LESSON FOUR: RELEVANT COSTING AND DECISION MAKING

Lesson objectives
After studying the lesson, the learner should be able to:
a) Explain the concept of relevant costing
b) Identify the relevant costs of materials , labour and overheads
c) Calculate contribution and contribution per unit of the limiting factor.
d) Determine the optimal production plan where a single binding constraint exists
e) Ascertain whether a company should make or buy a product or consider a special order.
3.1 Decision making
Decision making is one of the major responsibilities of a manager .The manager is constantly faced
with problems of deciding what products to sell, what production methods to use , whether to make
or buy component parts , what prices to charge , what channels of distribution to use , whether to
accept special orders at special prices , and so forth. At best, decision making is a difficult and
complex task .Decision making is concerned with the future and involves a choice between
alternatives. Financial information is critical when making choices. For instance, one may to consider
whether to join university next year or forego employment as a clerical officer in the County at a
salary of She 20,000 per month. Other than quantitative factors, qualitative factors need to be
considered as well. In the above case, the person should consider the possibility of getting
employment after university and salary expected. It is therefore important to obtain relevant
information on cost and revenues before making an appropriate decision. A relevant cost is a future
cash flow arising as a direct consequence of a decision. Stated in another way, the relevant costs of a
decision are those costs (and revenues) that can are differential as between the alternative being
considered. Decision making should therefore be based on relevant costs.
. Information may be said to be relevant when it is about: (i) future costs and revenues (ii) future
cash flows and (iii) incremental costs and revenues. Other terms that are sometimes used to describe
relevant costs are avoidable costs, differential costs, opportunity cost and attributable costs. Any cost
that is avoidable is relevant for decision making purposes. An avoidable cost can be defined as accost
that can be eliminated as a result of choosing one alternative over another in ma decision making
situation. All costs are considered to be avoidable , except sunk costs and future costs that do not
differ between the alternatives at hand.
Marginal costs can be considered as relevant in decision making. Fixed costs remain constant over
the activity range and are therefore irrelevant in decision making unless they are directly attributable
to the activity
3.2 Short run tactical decisions and marginal costing
36

The concept of marginal costing and contribution comes in the fore again when discussing relevant
costing. In making tactical or short run decisions, which seek to make the best use of existing
facilities, marginal cost, revenue and contribution of each alternative is relevant. The alternative
which maximises the contribution per unit of the key factor should be chosen in order of ranking. The
key factor or limiting factor or principal budget factor is a factor which is a binding constraint to the
organisation in terms of availability of resources and capacity. However, the maximisation of the
contribution per unit of the limiting factor(cpu) decision rule can only be useful in case of a single
binding constraint and where the constraint is continuously divisible. Examples of limiting factors are
sales demand, labour, materials ,capacity and financial constraints.
Typical short run decisions where marginal costing principles may be applied are acceptance of a new
order, make or buy decisions, shut down decisions and choice of product where a limiting factor
exists. The following steps are important in analysing the problems and making appropriate
decisions : ( a) Separate fixed and variable costs b) Identify directly attributable fixed and general
fixed costs (c) calculate the contribution ( revenue less marginal cost) of each alternative.(d)
identify the limiting factor and calculate the contribution per unit of the limiting factor (cpu) .e)
Finally, choose the alternative which maximises the contribution per unit of the limiting factor and
rank them based on the highest cpu.
3.3 Choice of product ( product mix) decisions
Sometimes there may be limited resources to meet a potential demand. A choice has therefore to be
made about which products to make and in what unit quantities using the available resources in the
most efficient and effective way. This is possible where there is a single binding constraint or limiting
factor. The objective of management is to maximise profits and the profits will be maximised when
contribution is maximised. The product that yields the highest contribution per unit of the limiting
factor should be chosen in that order. The possible quantities of production within the binding
constraints are then used to calculate sales, variable costs and contribution .Fixed costs are deducted
from the contribution and prepare to derive overall profit and hence companys profit statement.
Example 1
The following details are available regarding two products, A and B produced by a company :
A
B
Per unit
shs
shs
Direct materials
5
4
Direct labour
3
3
Variable production overheads 2
1
10
8
Selling price
15
8
Direct labour hours per unit
4
2
Sales demand (units)
500
500
Fixed costs for the period amounted to shs 2,000. Direct labour hours available for the period are
limited to 1,500 hours.
Required :
Determine the optimum production plan and profit for the period.
Solution
Product
A (shs)
B(shs)
Contribution per unit
5 (15-10)
4 (12-8)
Contribution per unit of
Limiting factor (labour hours )
1.5 (54)
2 (42)
Ranking of products : B.A, production of Product B should be given priority using the
available labour hours.
37

Direct labour hours required: Product B, 500 units@ 2hrs =1,000 hrs
Product A , 500 units @ 4 hrs=2,000 hrs
Total
3,000 hrs
Production plan
Direct labour hrs
units
product
Sales demand(units)
Required
Available
produced
B
500
1,000
1,000
500
A
500
2,000
500
125
1000
3,000
,1500
625
Thus, optimum production would be : product B, 500 units and product A, 125 units.
Profit statement
shs
Contribution : product B 500 units @shs4 = shs 2,000
Product A 125 units @ shs 5 = shs 625
2,625
Less : Fixed cost
2,000
PROFIT
625
3.4 Make or Buy decisions
The manufacture of a product involves many steps .These steps involves acquisition of raw
materials, processing these raw materials to remove impurities to obtain desirable usable ones ,
fabrication, actual manufacture of finished product and finally, distribution of the final product to the
ultimate consumer. When a company is involved in more than one of these steps, it is said to be
vertically integrated. Some firms may choose to become fully vertically integrated but others may
integrate partially and choose to produce only certain fabricated parts or components that go into
their final products. Any decision relating to vertical integration may be considered is a make or buy
decision. A make or buy decision involves a companys decision as to whether it should make a
product / carry out an activity with its own internal resources or pay another company to make the
product / carry out an activity .It is a question of internal or external sourcing .Examples of make or
buy decisions are :
a A decision to produce a fabricated part or component internally, rather than to the part
externally from a supplier
b A decision by a construction company to undertake work entirely with its own labour force or
subcontract some jobs to other companies
The relevant costs will be the differential costs between making and buying .In general, the marginal
(variable) cost of manufacture of the product /component should be compared with the buying
price. Where the marginal cost of manufacture is less than the buying price, the firm should make the
product rather than buy and vice versa. However, when manufacturing the component displaces
existing production, the lost contribution must be added to the marginal cost of the component
before comparison with the buying price. Additionally ,in a situation where a company must
subcontract work to make up a shortfall in its own production capability, its total costs are
minimised if those components or products subcontracted are those with the lowest extra variable
cost of buying per unit of limiting factor saved by buying.
Apart from the relevant costs, other qualitative factors that may be considered in make or buy
decisions include
i) Profitable use of spare capacity left in contracting company and resistance of its
labour force for fear of losing work to an outside subcontractor
ii)Reliability of subcontractor with delivery times and quality of outside components
iii)Flexibility and need to maintain better control over operations by company making
everything itself.
iv)Reliability of estimates of fixed costs .

38

Example 2
Kazuri Ltd makes three components, X,Y and Z. The following costs have been recorded:
X
Y
Z
Unit cost shs
shs shs
Variable cost
30
70
60
Fixed cost
20
80 40
Total cost
50
150 100
A subcontractor has offered to supply the components to the company at the following prices :
components Xshs 45, Y shs 60 and Z shs 65 per unit.
Required: Determine which components should the company buy.
Solution
Component
X
Y
Z
Shs
shs
shs
Variable cost of making
30
70
60
Variable cost of buying
45
60
65
Savings from buying
(15)
10
(5)
The variable cost of making component Y is greater than the variable cost of buying it.BB Ltd
should consider buying in component Y only and manufacture X and Z internally.
3.5 Special order decisions
This decision can also be thought of as one-off contract decision .It is a decision which will concern
a contract which would utilise a companys spare capacity but which would have to be accepted at a
price lower than that normally required by the organisation. In general, a contract would be accepted
if it increases contribution and profits. Otherwise the contract would be rejected if it lowers profits.
Fixed costs are irrelevant in such a decision in case they change as result of the order, then they
should be considered.
However, it would be prudent to consider a number of factors before a final decision is made such as:
I whether acceptance of one order at a lower price will lead to other customers in demanding lower
prices or favourable price discounts as well.
Ii Whether the special order is the most profitable way of using the spare capacity.
Iii Whether the special order could tie up capacity which could be used for future full price business
Iv whether fixed costs will change or not as a result of the order.
V Likely future sales demand for the product.
Vi future state of the economy
Example 3
X Ltd makes a single product which sells for shs 20.I t has a full cost of shs15, which is made up as
follows:
Shs
Direct materials
4
Direct labour (2 hours)
6
Variable overhead
2
General fixed overhead
3
15
The labour force is currently working at 90% of capacity and so there is a spare capacity of 2,000
units. A customer has approached the company with a request for the manufacture of a special order
of 2,000 units for which he is willing to pay shs25,000.Fixed costs are expected to increase by shs 200.
Required: Assess whether the special order should be accepted.
Solution
Shs
Value of special order (price)
25,000
39

Less: cost of sales

Direct materials ( 2,000 units@ sh2)
Direct labour ( 2,000 units @ sh 6 )
Variable Overheads (2,000 units @ sh2)
Attributable fixed costs
Relevant cost of order
Profit from order acceptance

4,000
12,000
4,000
200
24,200
800

The special order should be accepted since it increases profits by shs 800.
3.6 Shut down or discontinuing decisions
These decisions involve the following:
a) Dropping a product which is unprofitable
b) Closure of a factory, department or branch due to persistent losses or excessive running expenses
c) If the decision is to shut down, whether the closure should be permanent or temporary.
In such cases, the total contribution of the profitable product(s) should be determined and total
general fixed costs (including for unprofitable ones) deducted therefrom to arrive at the new profit.
However, any fixed costs that are attributable to the dropped product and which would be saved if its
production ceased should be deducted from total general fixed costs. The previous total profit should
then be compared with the new profit to determine whether to shut down or not. If the result is an
increase in profit, then the product should be dropped.
Other factors that need to be considered are whether more profitable products would replace the
dropped ones, new markets are available and if general fixed costs will remain same alter.
Example 4
Rongai Ltd produces three X, Y and Z. The current net profits from the three products is as follows:
X
Y
Z
Total
shs
shs
shs
shs
Sales
500,000 400,000 600,000
1,500,000
Variable costs
300,000 250,000 350,000
900,000
Contribution
200,000
150,000 250,000
600,000
Fixed costs
170,000 180,000 200,000
550,000
Profit (Loss)
30,000
(30,000) 50,000
50,000
The Managing director of the company is disturbed with the persistent losses incurred in making
product Y and and has asked you as a cost accountant for advice as to whether the product should be
dropped or not. Sh 50,000 of the fixed costs of Y would be saved if its production ceased. All other
fixed costs would remain the unchanged. There are no anticipated changes in selling prices.
a) Assess whether product Y should be dropped or not.
b) The company is also considering to utilise the resources realised from dropping production of
Y to production of a new product ,N. Product would sell for shs 500,000 and incur variable
costs of shs300,000 and extra direct fixed costs of shs60,000. Advise whether product Y
would be dropped.
Solution
a)Contribution : product X shs 200,000
Product Z shs
250,000
Total contribution
shs 450,000
Less: Fixed costs remaining shs 500,000
Loss
( 50,000)
The dropping of product Y results in decrease of company profits from shs 50,000 to
a loss of shs 50,000. It is recommended that product Y be dropped.
b) Comparison of profits expected from old(Y) and new product(N):
40

Y
N
Increment
Shs
shs
sh
Sales
400,000
500,000 100,000
Less : variable costs
250,000
300,000
50,000
Contribution
150,000
200,000
50,000
Less : Direct Fixed costs
50,000
60,000
10,000
Profit
100,000
140,000
40,000
It would be more profitable to drop production of Y and utilise resources to making N as
profits will increase by sh40,000.

41

LESSON FOUR:
QUIZZES
1) Which of the following statements is NOT TRUE about relevant costs?
A They are future costs, cash flows and incremental costs
B They are avoidable, differential and opportunity costs
C They are attributable fixed and and controllable costs
D They are committed fixed costs and uncontrollable costs
Correct answer D
2A firm produces three products X,Y and Z whose unit sales prices are sh 50,sh 60 and sh 80
respectively. Their unit variable costs are sh 20,sh36 and sh40;and the labour hours (limited
) required to produce each unit are 3 hours,2hours and 5 hours respectively .The ranking of
the products in priority of production would be:
A X,Y,Z
B Z,Y,X
C Y,X,Z
D Z,X,Y
Correct answer C
Contribution per unit: X sh30,Y sh24 ,Zsh40, Labour hrs per unit: X 3hrs,Y 2 hrs and Z 5hrs.
Contribution per unit of labour hr=Xsh10,Y sh 12 ,Z sh 8
Ranking based on contribution per labour hour(from highest): Y ,X,Y

3Which of the following statements best describes a key factor ?

A It is limited direct material, direct labour and machine hour.
B It is limited demand for sales, materials and lack of space.
C It is a constraint which prevents indefinite expansion or unlimited profits.
D It is factor which limits expansion and profits.
Correct answer C
LESSON FOUR QUESTIONS
1JJ co Ltd makes two products , the K and the L. K sells for shs 50 per unit and L sells for shs 70 per
unit. Their variable costs per unit are shs 35 and shs 40 respectively. Each unit of K uses 2kg of raw
material and L uses 3kg of material. In the forthcoming period, the availability of raw material would
be limited to 2,250 kgs. The company is contracted to supply 500 units of K to a supermarket.
Maximum demand for L is 250 units while the demand for K is unlimited. Fixed costs are shs 5,750
per annum.
Required : Determine the profit-maximising product mix and profit results.
solution
Product
K
L
Selling price per unit (sh)
50
70
Variable cost per unit (sh)
35
40
Contribution per unit (sh)
15
30
Material usage per unit (kg)
2
3
Contribution per unit of limiting factor sh/kg) 7.5
10
As material is limiting factor, produce L followed by K. However, since the demand for K is unlimited,
any remaining materials would be utilised to produce K.
Material
Product
Requirements
Available
production
Kg
kg
units
L
750
750
250
42

K
Total

1,000
1,750

1,500
2,250

Profit statement :
Contribution : product K (750@sh 15)
Product L ( 250@ sh 30)
Less : Fixed costs
Net profit

750
1,000
sh
11,250
7,500
18,750
5,750
13,000

2 Masai Lane Ltd manufactures two components, the A and the B, using the same machines for
each. The budget for the next year calls for the production of 4,000 units of each component. The
variable production cost per unit of the final product, G , is as follows:
Machine hours
variable cost (shs}
1 unit of A
3
20
1 unit of B
2
36
56
Machine hours are limited to 18,000 hours. A subcontractor has quoted the following unit
prices for supplying the components: A shs 29 and B shs 40.
Advise Green Lane Ltd.
Solution
Production mix
Product
Machine hours
production
Units Required
Available
units
A
4,000
12,000
12,000
4,000
B
4,000
8,000
6,000
3,000
8,000
20,000
18,000
7,000
Comparison of variable costs of making and buying
A
B
Sh
sh
Variable cost of making
20
36
Variable cost of buying
29
40
Extra variable cost of buying
9
4
Machine hours saved by buying 3hrs
2hrs
Extra variable cost of buying
sh 3
sh 2
( per hour saved)
Recommendation: Priority would be to make 4,000 units of A (12,000 machine hrs) and 3,000 units
B(6,000 machine hrs), using 18,000 machine hours. Then subcontract 1,000 units of B ( 2,000
machine hrs).
Total variable production costs of the component:
sh
For making: A 4,000 units@ sh 20
80,000
B 3,,000 units @ sh 36
108,000
188,000
For buying B 1,000 units@ sh 40
40,000
228,000

43

3 KK Ltd makes four components, K, L ,M and N. for which costs in the forthcoming year are
expected to be as follows :
K
L
M
N
Production ( units )
1,000
2,000 4,000
3,000
Unit marginal costs :
Shs
shs
shs
shs
Direct materials
40
50
30
40
Direct labour
80
90
40
60
Variable production overheads
30
40
10
30
150
180
80
130
Specific fixed costs of manufacture
10,000 70,000 80,000 80,000
Other committed fixed costs per annum are sh 300,000.
An outsider has offered to supply units of K, L, M and N for sh 130, shs220, shs 110 and shs150 per
unit respectively.
Required: Assess whether the company should make or buy the components.
Solution
Analysis of variable costs between making and buying would give some cost savings ie differencial
costs which are relevant costs. Specific or directly attributable fixed costs would also be saved when
buying.
Product
K
L
M
N
Sh
sh
sh
sh
Unit variable cost of making
150
180
80
130
Unit variable cost of buying
130
220
110
150
Extra cost of buying (per unit)
(20)
40
30
20
Production ( in units)
1,000
2,000
4,000
3,000
Extra variable cost of buying (per annum) (20000)
80,000
120,000
60,000
Attributable fixed costs saved by buying
10,000
70,000
80,000
80,000
Extra total cost of buying
(10,000)
10,000
40,000
(20,000)
Conclusion: The company should buy components K and N and make savings of sh 10,000 and sh
20,000 .Purchase cost of K are less than the variable production cost of making it .On the other hand,
there is a saving in fixed cost of sh 80,000 when product N is bought rather than internally
manufactured .Products Land M should be made internally.
Note that the relevant costs are variable cost of making and buying as well as the savings in directly
attributable fixed costs of making. Other fixed committed costs are irrelevant costs because they will
not change whether the components are bought or not.

4 During a month when 1,000 units were made, costs and sales per unit were as follows :
Shs
Sales
480
Less: Prime cost
220
Fixed cost
140
360
Profit
120
A proposal has been made to reduce the selling price to shs 450 per unit at which price ,sales
would be 1,300 units. This volume would necessitate paying overtime to the labour which
44

would result in an increase of shs 10 in the labour costs and engaging a wages clerk at a
salary of sh 10,000 per month.
Determine whether the new proposal is worthwhile or not
Solution
Profit statement:
Current
proposed
Sales (units)
1,000
1,300
Sh
sh
Contribution per unit
260 (480-220)
220 (450-230)
Contribution
260,000
286,000
Fixed cost
140,000
150,000
Net profit
120,000
136,000

5 Usafi Ltd produces a detergent called ZE . The following budget has been prepared for next year.
Raw material 25,000 Litres
shs 100,000
Direct wages 30,,000 Hours
75,000
Variable overhead
30,000
Fixed costs
125,000
Total cost
330,000
Profit
70,000
Sales
shs 400,000
The company has special bulk order of the detergent but is hesitant to accept it. The order
would use 5,000 litres and 4,000 hours of labour.
Calculate the minimum price at which the company could accept the order, assuming
a) Raw material supplies are the limiting factor.
b) Direct labour is the limiting factor.
Solution
sh
Direct material 5,000 litres@sh 4
20,000
Direct labour 4,000 hours@ sh 2.5
10,000
Variable overheads 4,000 hours@sh1 4,000
Variable cost
34,000
a) If material supply is limited
Contribution per unit of material (litres)= contribution/litres ordered=Sh 195,00025,000
= sh 7.80 per litre
Variable cost
sh
34,000
Contribution: 5,000litres @ sh 7.8 39,000
Contract price
sh
73,000
b) If labour is limited
Contribution per unit of labour hour= sh 195,00030,000 hrs= sh 6.50 per hr
Variable cost
sh
34,000
Contribution : 4,000hrs @ sh 6.5
26,000
Contract price
sh 60,000

45

CHAPTER FIVE: Cost Accounts

Lesson objectives
After studying this lesson , the learner should be able to:
a) Explain how an interlocking system operates
b) Distinguish between interlocking and integral costing systems
c) Prepare cost ledgers and Trial balance from given financial information.
d) Identify the causes of differences of profit in financial and cost accounts
e) Reconcile the profits in financial and cost accounts
1.0 Interlocking Accounts
Interlocking accounting system is also called non-integral cost accounting.
It is a system of cost accounting where cost and financial transactions are kept separately .The cost
accounts have no double entry connection with the financial accounts but use the same basic data.
The cost ledger and financial ledger are maintained separately. The responsibilities of recording the
ledgers can shared as follows: cost accountant (cost ledgers) and the financial accountant (financial
ledgers).
The principal financial ledgers are General ledger, Debtors ledger and Creditors ledger .On the other
hand, the principal cost ledgers are:
i Cost ledger- contains nominal accounts and some real accounts (principal ledger).
ii Stores ledger- Contains stores such as Raw materials, WIP, Receipts and Issues
(Subsidiary ledger).
iii Work-in-progress (Subsidiary ledger).
iv Finished Goods Ledger (Subsidiary ledger).
There are three types of accounts maintained in the financial ledger, namely: i) Personal accounts eg
debtors and creditors, ii)Real accounts eg cash, fixed assets, stocks etc and iii)Nominal accounts eg
wages, heat and lighting, rent and rates, discounts, carriage etc. On the other hand, cost
Ledger contains only impersonal accounts. Transactions affecting the nominal accounts are recorded
separately in both ledgers.
Cost profit and financial profit do not agree due to items may appear in financial ledgers only while
some in cost ledgers only. These items need to be reconciled at the end of the year.
1.1 Advantages of maintaining cost ledger
The cost ledger is the principal ledger in the cost accounting book-keeping system and
several advantages can be derived from it, including the following:
a) It facilitates prompt preparation of costing profit and loss account, Balance sheet .
b) It is the basis for analysis and control of costs , preparation of accounts for each cost
centre, for cost ascertainment and control purposes
c) It assists management in formulating policies as the ledger summarises the detailed
information regarding cost available in subsidiary records.
d) It helps to check all transactions, records in the financial accounts and therefore
Provides internal check through the use of various control accounts
e) It helps to determine value of closing stock and Work-in-progress (WIP) promptly.
f) It provides detailed information for planning, control and decision making through
the generation of internal reports.
1.2 Control accounts
These are the total accounts in the cost ledger which summarises totals of individual accounts-entries
are made once at the end of each accounting period based on the periodical totals of transactions in
related subsidiary ledgers and books eg purchases of individual items of stores appearing in
individual accounts in the stores ledger are totalled and posted in Stores Ledger control account in
the Cost ledger in total purchases. Thus the Stores ledger control account is stores ledger in summary
46

form. Similarly, a control account is also maintained for each of the subsidiary ledgers. The objective
of opening a control account for cost ledger is to complete the double entry .
1.3 Main advantages of control accounts
1 Provides management detailed information for policy formulation.
2 Enables preparation of final accounts- profit and loss account and Balance sheet
3 Provides internal check leading to greater accuracy of the accounts and proper
bookkeeping.
1.4Principal accounts in the Cost ledger
The main control accounts maintained in the cost ledger are : General ledger adjustment account,
Stores ledger control account, Wages control account, purchases overhead account, Administration
overhead account ,Selling and Distribution account, Work in Progress , Finished Goods, Cost of Sales,
Costing Profit and Loss accounts. These accounts and their respective accounting entries are
discussed as herebelow :
1) General ledger adjustment control Account (GLA)
This account is also known as the Cost ledger control account, or Cost ledger contra
account or Financial ledger account. The account takes care of personal accounts and
real accounts since in the cost ledger only impersonal accounts are maintained. This
account is needed to maintain the double entry principle within the cost ledger and
contains postings which affect accounts outside the costing system eg Debtors,
Creditors, Cash. The main entries which are made in this account are as follows :
a. When materials are purchased: DR Stores ledger adjustment account CR
General ledger adjustment account
b. When wages are paid : DR Wages control account CR General ledger
adjustment account
c. When overheads are paid : DR Overhead account (eg selling, distribution
expense) CR General ledger adjustment account
d. When sales are made : DR General ledger adjustment account CR Costing Profit
and loss account
e. Sales returns: DR Costing profit & loss account CR General ledger adjustment
account
f. When recording costing profit : DR Costing profit and loss account CR General
ledger adjustment account.
Example 1
X Ltd made purchases of raw materials worth shs 40,000 and paid wages
amounting shs 10,000.Prepare entries in the cost books.
1 purchase of raw materials:
Dr Stores ledger control account
40,000
Cr General ledger adjustment account
40,000
2 wages paid :
Dr Wages control account
10,000
Cr General ledger adjustment account
10,000
Notes
All items of income and expenditure taken from financial accounts and
all transfers from cost books to financial books for transactions (eg
Returns for materials from stores, transfers to capital expenditure
performed by factory, transfer of costing profit and loss etc are recorded
in the account .

47

All transactions in the cost ledger must be recorded through control

account.
The balance in this account will always be equal to the sum of all the
balances of the impersonal accounts.
If a transaction is of an internal nature affecting cost accounts only (
transfers from stores ledger to Work in progress(WIP) , WIP to Finished
Goods (FIGS), then no entry is required in GLA ,as a double entry is
possible without recourse to this balancing account.
2) Stores ledger control account (SLA)
This account shows a record of material receipts and issues to production. In case of any
material returns, their value will be credited to this account. The balance in this account
represents material in hand at the end of the period. The necessary entries to this
account are as here below:
a) Material purchased or received: DR Stores ledger control account CR General ledger
adjustment account
b) Material Rejected and Returned to Suppliers: DR General ledger adjustment
account CR Stores ledger control account
c) Material issued to production : DR Work in progress CR Stores ledger control
account
d) Material Rejected/Returned from production: DR Stores ledger control account CR
Work in progress

3) Work in progress control account

This account records direct materials, direct labour, direct expenses, production
overheads incurred and cost of sales or finished goods. The balance on this account
represents the value of WIP at the end of the year .The necessary entries to this account
are as follows :
a Prime costs incurred : DR Work in progress account CR Individual prime/direct costs
b Production overheads incurred :DR Work in progress account CR Production
overheads
c Special material purchases : DR WIP account CR Special purchases
d Value of Finished goods : DR WIP account CR Finished Goods account

4)Finished Goods Ledger control account

This account shows the cost of completed jobs and the cost of finished goods sold.The
balance on this account shows the value of finished goods on hand at year end.The
necessary double entry is as below :
a Cost of finished goods transferred from WIP : DR FIGS account CR Cost of finished
goods transferred from WIP
b Cost of goods sold : DR Cost of goods sold CR FIGS account
5)Wages control account
This account shows the total wages paid to the employees. It is not really a control
account as it does not control a subsidiary ledger. However, the account does not have
any closing balance. The necessary double entries are as below :
a Gross Wages incurred : DR Wages control account CR General ledger adjustment
account
b Direct wages : DR WIP account CR Wages control account
48

c Indirect wages : DR Production, adm,selling or distribution Overhead individual

accounts CR Wages control account.
6)Production overhead account
DR Indirect materials , indirect labour, indirect expenses incurred CR Overheads
absorbed/recovered.
The balance is transferred to Overhead Adjustment account (OAA) or Costing Profit&
Loss Account (CP&L )

7)Administration overhead account

DR Administration Expenses CR Overheads absorbed by Finished goods.
The balance of under or over absorbed overheads is transferred to OAA or CP&L.
8) Selling and Administration Overhead account
DR Selling & Administration expenses CR Overheads recovered from cost of goods sold.
The balance of under or over absorbed overheads is transferred to OAA.
9) Cost of sales account
DR Cost of Sales CR Selling& Administration expenses. This is eventually transferred to
Costing Profit/ Loss account by the entry below :
DR Costing Profit/ Loss account CR Cost of sales
10)Overhead adjustment account (OAA )
This account may be maintained. All under or over absorbed overheads are transferred
to the account and the balance shows the overall figure of under or over recovered
overheads. The overall figure is eventually transferred to the Costing Profit& Loss
account or Suspense account.
DR Under absorbed overheads for production, administration, selling & distribution
overheads CR OAA
DR OAA CR Over absorbed from respective Overhead control accounts.
11)Costing Profit and Loss account (CP&L )
DR Cost of sales, abnormal losses, under recovery of overheads CR CP&L.
DR CP&L
CR Sales, Abnormal gains, over absorbed overheads , Value of goods
sold etc.
The balance on this account represents Costing Profit or Loss which is to be transferred
to General Ledger adjustment account . This profit is reconciled with the Financial Profit
or Loss .To facilitate correct recording or posting of the above transactions, it may be
helpful to open T-accounts.
12)Other accounts requiring special treatment:
a) Carriage inwards : DR Production overhead account CR General ledger adjustment
account
b)Capital orders completed : DR Capital orders account CR WIP.
The asset , when capitalised , is transferred to the financial ledger by : DR General
ledger Adjustment account CR Capital order account.
c)special repair orders completed : DR Special repair orders account CR WIP
The cost of repair is then charged to user department by: DR Production,
administration, selling, distribution overhead account CR Special repairs order
account.

49

Example 1
The following transactions took place during the month of March 2000 in West end manufacturers
Ltd:
1)
Shs
Materials purchased:
a) Cash purchases
20,000
b) Credit purchases
60,000
c) Credit purchases (special job)
16,000
2) Returns to suppliers
10,000
3) Direct materials issued to production 40,000
4) Indirect materials issued to production 18,,000
5) Materials returned from production
To store
6,000
6) Materials transferred from Job no.11
To Job no.15
2,000
Required: Enter the transactions in the cost books.
Solution
1 a)
Stores ledger control account
General ledger adjustment account
b)

2
3
4
5
6

Stores ledger control account

General ledger adjustment account
C ) WIP ledger control account
General ledger adjustment account
General ledger adjustment account
Stores ledger control account
WIP ledger control account
Stores ledger control account
Production Overhead account
Stores ledger control account
Stores ledger control account
WIP ledger control account
Job No. 15 account
Job No.11 account

DR(shs)
20,000

CR (shs)
20,000

60,000
60,000
16,000
16,000
10,000
10,000
40,000
40,000
18,000
18,000
6,000
6,000
2,000
2.000

1.5 Reconcilliation of Cost and Financial accounts

When interlocking accounting system is used, differences arise between the profit shown
by the cost accounts and the financial accounts and hence a reconciliation becomes
necessary. The reconciliation between the cost accounts and financial accounts may be
done through preparation of either a Reconciliation statement or Memorandum
Reconcilliation account. However, if intergral accounts are prepared, there is no need
for such reconciliation.

50

Reasons for Reconcilliation

a) To find out the causes for the differences and to ensure that no item of
expenditure or income has been omitted and that there is no over or under
recovery of overheads.
b) Cost ascertainment and cost control depend on accuracy of cost analysis,
distribution and allocation. Hence reconciliation ensures accuracy.
c) Helps to check the arithmetic accuracy of both sets of accounts and hence
facilitates internal control by testing the reliability of cost accounts through
highlighting differences that cause increase or decrease in profits.
d) Helps in the standardization of accounting policies such as inventory valuation,
overhead absorption and depreciation provisions.
e)Promotes coordination and cooperation among the costing and financial
accounting departments in generating correct and reliable accounting
information that satisfy both Statutory requirements and managerial decision
making.
Causes for the differences of profits in cost accounts and financial accounts
These differences can arise due to the following items :
1 Items included only in financial accounts (they do not relate to manufacturing
activities.
a) Purely financial charges , reducing profit:
These items include fines and penalties; interest on bank loans/ mortgages;
discount on shares, debentures and bonds; loss on investment or on its sale; loss
on sale of fixed assets, scrapping of machinery, uninsured destruction of assets;
stamp duty ,discount and other expenses, transfer of stock, shares, bonds,
debentures; remuneration paid to the proprietor in excess of a fair reward for
services rendered.
b) Purely financial income , increasing profit:
Items here include rental income; fees received on issue, transfer of shares; profit
on sale of fixed assets, investments; interest received on bank deposits and other
investments; dividends received on investment in shares; share premium.
c) Appropriation of profit :
Donations and charities, income tax, goodwill, preliminary expenses, debenture
discount, dividends paid, transfer to General reserve, appropriation to sinking
funds, additional provisions for depreciation etc
2) Items included only in the cost accounts :
Notional rent on premises owned ; notional interest on capital employed in
Production, salary for the proprietor where he works but does not charge
salary.
3) Under or over absorption of overheads
In financial accounts the actual overheads incurred is taken into account. In cost
Accounts, overheads are applied to costs units at predetermined rates and
Amount recovered may vary from actual overheads .If over and under recovery
are not charged to Costing profit and loss account, the profits on the two sets of
books will not tally.
4)Use of different methods of stock valuation
51

In financial accounts stock is valued at cost or market value ,whichever is lower.

In costs accounts, stock valuation methods used include LIFO, LIFO, Weighted
Average cost .
5)Use of different rates of depreciation
In financial accounts the rates are given by Companies Act and Income Tax Act.
.In cost accounts, Machinery Hour Rate (MHR), production unit method.
The formats of reconciliation statement and memorandum reconciliation
statements are shown as below:

AProforma Reconcilliation Statement

Shs
Profit as per cost accounts

xxx

Add: 1) Financial incomes not recorded in cost accounts

2) Overvaluation of OPENING stocks ,
3) Under valuation of CLOSING stocks,
4) Over absorption of overheads
5) Items charged in cost accounts only
Less: 1) Financial charges not considered in cost accounts
2) Undervaluation of OPENING stocks ,
3) Overvaluation of CLOSING stocks ,
4) Under absorption of overheads
Profit as per Financial accounts

shs

xx
xx
xx
xx
xx
xx
xx
xx
xx
xxx

Proforma Memorandum Reconciliation Account

Sh
Under absorption of overheads
xxx
In cost accounts
Overvaluation of Closing Stocks xxx

Profit as per cost accounts

over-absorption of OHDs in cost
accounts

sh
xxx
xxx

Undervaluation of opening stocks xxx

undervaluation of closing stocks, xxx
Purely financial charges
xxx overvaluation of opening stocks, xxx
Net profit as per Financial accounts
Items charged only in cost accounts xxx
(Balancing figure)
xxx financial incomes not recovered
In cost accounts
xxx
XXXX

XXXX

52

1.6 Integral Accounts

The reconciliation of profits in financial and cost accounts can be avoided by designing an
integrated or integral system of accounting .Basically, the integral accounts system is similar
to the separate accounting and costing systems, except that of course it eliminates the
duplication of entries , and the maintenance of unnecessary accounts .The integral system is a
single set of accounts which provides both financial and cost accounting information. Unlike the
interlocking system, both personal and impersonal accounts are maintained in the ledger. In
effect, there are accounts for stock, production, administration, selling and distribution
overheads followed by such final accounts as cost of sales, profit and loss .The basic principles in
the design of an integral accounting system are as below:
a) Under the double entry method, cost ledger includes the creditors control account, cash
account; debtors control account and provision for depreciation account, replacing the
General ledger cost control account.
b) Under the Third entry method which is similar to the double entry method, except that a
third entry is made in respect of elements of cost. All items of cost eg purchases, are debited
in total in a Cost ledger control account, and credited to a Creditors account. The cost is then
analysed into Third-entry accounts (which are not part of a double-entry system) in respect of
materials, factory overheads, administration, selling and distribution overheads. The totals of
these accounts are then transferred to Finished Goods account, Profit and Loss account etc.
However, it is felt that the ordinary double- entry principles are sufficient, because the
analysis work described in the third-entry method would be obtainable from the job cards,
standing order cards, etc.
Benefits of integrated accounts
a) Avoids the need for reconciliation.
b) Enables more reliance to be placed on cost information as subject to formal control
procedures.
c) The development of integrated system becomes easier eg Stock control, payroll, which
incorporates accounting records.

Example 2
The costing profit of Gataka Ltd for the year ending 31st December 2006 was shs 92,000, whereas the
financial profit for shs 120,000. The following information is given:
1)The cost accounting records show :
53

iThe opening stock as January 1, was shs 230,000 and closing stock on 31st
December was valued at shs 308,000 .
iiProduction overhead recovered was shs 136,,000
iiiAdministration overhead was absorbed at 5% of sales
ivSelling and distribution overhead was recovered at 7% of sales
vNotional rent and interest on capital were shs 16,000 and shs 12,000.
2)The companys financial Trading and Profit and Loss account the year ending 31st
December, 2006 was as under:
shs
opening
stock
280,,000
material purchase 1,120,000

shs

1,400,000
Less: closing stock
320,000
Direct materials consumed 1,080,000
Direct wages
480,000
Prime cost
1,560,000
Production overheads
140, 000
Factory cost
1,700,000
Gross profit
300,000
2, 000,000
Discount allowed
Administration expenses
Debenture interest
Selling& distribution expenses
Net profit

16,000
110,000
10,000
134, 000
120, 000

2,000,000
Gross profit
300,000
Discounts received 30,000
Dividends received 36,000
Interest received 24,000

390,000

390,000

Required: Prepare a memorandum or proforma reconciliation statement.

Answer
Memorandum Reconcilliation Statement

54

Sh
Profit as per cost accounts
Add: Items not credited in cost accounts:
Discount received
30,000
Dividends received
36,000
Interest received
24,000
Add: Difference in closing stocks
Add: Selling &distribution ohds over-recovered
Less: Items not debited in cost accounts:
Discounts allowed
16,000
Debenture interest
10,000
Add: Difference in opening stock
Add: Overheads under-recovered in cost accounts:
Production ohds
4,000
Administration ohds
10,000
Financial profit

sh

90,000
12,000
16,000

sh
92,000

118,000
210,000

26,000
50,000

14,000

90,000
120,000

LESSON FIVE
QUIZZES
1 Which of the following are the control accounts of the cost ledger?
A General ledger, stores ledger, work- in- progress ledger and finished goods ledger.
B Cost ledger contra, stores ledger, work in- progress ledger, finished goods Ledger.
C General ledger , stores ledger, finished goods ledger and wages control.
D General ledger, cost ledger contra, stores ledger, work in progress ledger
Correct answer B
2Match the following transactions with their credit cost journal entries:
Transaction
journal
a) purchases
1 Work in progress
b) materials allocated
2 Finished goods
c) Jobs delivered
3 Stores control
d ) completed jobs
4 Cost ledger contra
Correct answer
a(4), b(3),c(2), d(1)
3The financial profit and loss account of kkm Ltd showed a gross profit of sh 500,000 before
charging the following expenses: office salaries sh 96,680, office expenses sh64,280, sales
managers salary sh 20,000,Sales mens salaries 85,120, sales expenses sh 68,380, packing costs
sh 17,500, distribution expenses sh 24,920. Only the office salaries and office expenses had
been charged in the cost accounts. The costing profit would be:
A Sh 123,120
B sh 215,920
C Sh 339,040
D sh 284,080
Correct answer C
Financial profit=gross profit-expenses= sh 500,000-376,880=123,120
Cost profit=financial profit +expenses(excluding office salaries and office expenses)
=sh123,120+20,000+85,120+68,380+17,500+24,920=sh339,040.
55

LESSON FIVE QUESTIONS

1 The cost accounts of Neema Ltd revealed profit for the year as shs 48,390. The
companys financial accounts disclosed the following position :

Manufacturing Account
Shs shs
Shs
Raw material:
_opening stock 1,900
Purchases less returns
54,900
56,800
Less: Closing Stock
1,800
55,000
Direct labour
35,500
Factory overhead
21,400
111,900
WIP- opening
8,400
-closing
(8,900)
Factory cost of production

111,400

Finished Goods account

Opening stock
11,600
Transfer from
manufacturing account
111,400

123,000

Transfers to finished stock

111,400

111,400

Cost of sales transferred to

trading a/c
110,700
Closing stock 12,300

123,000

56

Trading account
Factory cost of sales
transferred from
stock a/c 110, 700

Sales184,500

Gross profit c/d

73,800
184,500

184.500

Profit and Loss Account

Sh

Shs

Administrative expenses 15,600

Gross profit b/d

Distribution expenses

10,182

Discount received

Discount allowed

1,511

Interest received

Debenture interest

850

Dividends received

Fines

73,800
1,806
37
300

500

Leases(non -trading)
Net profit

350
46,950
75,943

75,943

Stock valuations in the cost accounts were as follows :

Opening balance

closing balance

Shs
shs
Raw materials
1,969
1,850
Work in progress
8,280
8,730
Finished stock
11,396
12,810
Depreciation amounting to sh 6,146 was charged in the cost accounts whereas Factory
overhead in the Financial accounts included Sh 5,873 for this expense.
The profit shown in the cost accounts has been arrived at before charging Notional rent shs
1,500.
Required: Prepare a reconciliation of the two profit figures.
57

Sh
Profit as per cost accounts
Add: Items not credited in cost accounts
Stock valuations:
Raw materials
19
Work in progress
50
Depreciation
273
Less: Items not debited to cost accounts
Finished goods

sh

sh

48,390

342
714

(372)
48,018

Per Financial accounts

Less: Administration
Distribution

shs 73,800?
15,600
10,182

25,782
48,018

Note : All other items in the Profit and Loss Account would not appear in the cost accounts.
2The balances shown in the cost accounts of Mcosti Ltd as at September 30th are as follows :
:
Cost ledger control account
Stores ledger control a/c
WIP Control a/c
Wages control a/c (accrued wages )
Factory overhead control a/c
( under absorbed overhead)
Finished Goods Stock a/c
Cost of sales a/c
Administration overhead control a/c
Marketing overhead control a/c
Sales

shs
69,600
3,696
6,390

shs

622
336
24,000
364,000
55,600
37,000

560,622
The following transactions occurred in the month of October :
Total invoices for material stocks
Gross wages payable (including employers contributions
Shs 900) :
Factory direct wages
Factory indirect wages
Accrued wages October 31st
P.A.Y.E (Income tax deductions)
Other deductions
Net wages cheque drawn
Materials issued to production
Wages allocated:
Factory direct wages shs 12,000
Factory indirect wages shs 6,024

560,000
560,622
Shs
30,244

12,000
5,800

17,800
846
3,200
1,000
12,700
28,370

58

Indirect materials issued to factory

Invoices for factory overhead expenses
Stores stock October 31st
Work in progress October 31st
Finished Goods stock October 31st
Administration overheads incurred
Marketing overhead incurred
Sales
Interim dividend paid
Required: a) Prepare entries to record the transactions in cost books.
a) Extract the Trial Balance from the cost accounts as at 31 st October.
Solutions
a)

1,740
4,248
3,830
8,760
28,000
6,200
4,100
64,000
16,000

Journal entries
DR (shs)
CR (shs)
1)

Stores ledger control

Cost ledger control a/c
Invoices for materials
2) Wages control
Cost ledger control
Gross wages
3) Work in progress
Stores ledger control
Materials issued
4) Work in progress
Factory overhead control
Wages control
Allocated wages
5) Factory overhead control
Stores ledger control
Indirect materials issued
6) Factory overhead control
Cost ledger control
Overhead invoices
7) Finished stock
Work in progress
Prime cost of goods completed
8) Finished stock
Factory overhead
9) Cost of sales
Finished stock
10) Administration overhead
Marketing overhead
Cost ledger control
Overhead incurred
11) Cost ledger control
Sales

30,244
30,244
17,800
17,800
28,370
28,370
12,000
6,024
18,024
1,740
1,740
4,248
4,248
38,000
38,000
12,000
12,000
46,000
46,000
6,200
4,100
10,300
64,000
64000

59

b)Mcosti Ltd
Trial Balance as at 31st October

Dr
Shs
71,008
3,830
8,760

Cost ledger control a/c

Stores ledger control
Work in progress
Wages control
Factory overhead control
Finished goods stock
Cost of sales
Administration overhead control
Marketing overhead control
Sales

Cr
shs

846
348
28,000
410,000
61,800
41,100
624,846

624,000
624,846

3 The profit shown in the financial accounts of Copa Ltd is shs 92,960 and for the same period the
cost accounts showed a profit of shs 102, 480 .Analysis of the two sets of accounts disclosed the
following information:
Stock valuation
cost accounts
Financial accounts
Raw materials:
shs
shs
Opening stock
34,105
36,295
Closing stock
27,415
25,640
Finished Goods : Opening stock
66,455
64,525
Closing stock
57,150
55,655
Dividends and interest received of shs2,760 and a loss of shs8,750 on the sale of an old computer
equipment were not entered in the cost accounts.
Required : Reconcile the profit figures.

Answer
Memorandum reconciliation statement
Sh

sh

Profit as per cost accounts

102,480

Add: Items not credited in cost accounts:

Dividends& interest received
Add : Difference in opening stock (FIGS)
Less: Difference in closing stock(FIGS))
Difference in opening stock (RMI)
Difference in closing stock(RMI))
Loss on sale of computer
Profit as per financial accounts

sh

2,760
1,930
1,495
2,190
1,775
8,750

4,690
107,170

14,210
92,960
60

4The following information is provided by the cost accountant of Kk Ltd:

shs
( 1)a) Cost of services obtained
240,000
b) Petty cash spend for various expenses
10,000
Analysis of services reveals :
Production overheads
100,000
Administration overheads
60,000
Selling& distribution overheads
80,000
Analysis of petty cash reveals :
Production overheads
6,000
Administration overheads
800
Selling& distribution overheads
3,200
(2 )Overhead absorbed is as under :
a) Production overhead
96,000
b) Administration overhead
64,000
c) Selling & distribution overhead
80,000
Required : Record the above transactions in the cost books.
Cost books:
(1 )a)

b)

(2) a)

Production overhead a/c

Sundry creditors a/c

Dr (sh)
240,000

240,000

Production overhead a/c

Administration overhead a/c

Selling& distribution
a/c
General ledger adjustment a/c
Work in progress a/c

Cr (sh)

6,000
800

3,200
10,000
96,000
61

Production overhead a/c

96,000
b) Finished goods ledger a/c
64,000
Administration overhead a/c
64,000
c)
Cost of sales
80,000
Selling& distribution
80,000
The under and over-absorbed overhead are transferred to Costing Profit and Loss a/c via overhead
adjustment a/c as follows:
(3) a)
Administration overhead a/c (0ver -absorbed)
3,200
Overhead adjustment a/c
10,000
Production overheads (under-absorbed)
10,000
Selling& distribution overhead ( ,,
)
3,200
b)
Costing Profit& Loss a/c
10,000
Overhead adjustment a/c
10,000

LESSON SIX : CONTRACT ACCOUNTS

Lesson objectives
After studying this lesson, the learner should be able to:
a) Identify key characteristics of contract costing.
b) Distinguish the various types of contracts and methods of contract accounting.
c) Identify cost elements of a contract and calculate notional profit and interim profits for
incomplete contracts.
d) Calculate work in progress and extract contract Balance Sheet items
e) Prepare Contract and contractee accounts.
1.0 Definitions of a contract and contract types
Contract costing is a form of specific order costing which also includes job and batch
costing.Contract costing is a term derived from a contract ,which is a cost unit or cost centre which
accumulates direct costs of production and apportioned head office overhead expenses. Thus,
contract costing is a form of specific order costing that is applied to relatively large cost units which
take a long duration to complete due to enormous work involved. Most contracts are of
constructional nature where work undertaken includes construction of buildings, bridges, roads,
dams, ship-building , specialised equipment and oil exploration .Although the contract itself can be
regarded as a cost unit, subunits will often be used for cost analysis. For example, in a building
contract, the subunits may include foundations, steelwork, walls, roof, electrical installations,
plumbing, floors, painting and decorating etc. Contract or terminal costing is similar to job costing
except for the distinct characteristics highlighted below. Builders, civil-engineering contractors,
constructional and mechanical-engineering and similar firms make use of this type of costing
method.
Construction contracts may be of three types, namely:
1) Fixed price contracts : Where the contractor (builder/ supplier) agrees with the Contractee (client
/customer)to a fixed contract price or charge for service rendered.
62

2)Fixed price contracts subject to escalation clause: The contract and contractee agree on a fixed
price subject to escalation clause which provides for variation in contract price due to price changes
in prime costs and other overheads , if any. The contractor can only be reimbursed the excess
expenditure provided he has sufficient proof such as genuine purchase invoices and receipts.
3) Cost plus contracts :The contractor is reimbursed the actual cost incurred on contract plus a
percentage markup to cover for profit on contract.
Furthermore, IAS 11 Accounting for construction contracts recommends two methods of
accounting for contracts: Percentage of completion method and Completed contract method. This
particular standard is largely dealt with in financial accounting and reporting and therefore we will
not duel on it here.
1.1 Characteristics of construction contracts
a) A formal contract/Agreement is usually made between the contractor and client for
reference in case of disputes.
b) Work is undertaken to suit clients special requirements or specifications.
c) Work usually takes a long duration, more than one year.
d) Work is done on site, with own cashier and timekeeper, away from the contractors own
premises or office .Perhaps some initial assemblies such as pre-cast concrete frames
,window and door frames, may be prepared at contractors premises.
e) Work is mostly constructional or civil works.
f) Except for general administrative overheads, most of the items of cost are directly
chargeable to the contract. General administration overhead is apportioned over a
number of contracts.
g) Substantial part of a contract is generally subcontracted or sublet to specialists.
h) A separate account is opened for each contract to ascertain its profit or loss.
i) Payments by the customer are made at different stages of the contract based on
surveyors or architects certificate on value of work completed. A retention money ( a
specified percentage of work certified) is withheld by the client until a specific period
of time, agreed in the original contract, has elapsed.
j) Penalties may be imposed on the contractor for failing to complete the work within the
agreed time.
k) Contracts may either be fixed price contracts or fixed price with escalation clause or
cost plus contracts.
However, there are some problems associated with contract costing. These include identifying
direct costs, low indirect costs, difficulties of cost control and dividing the profit between two or
more accounting periods.
2.0

Contract costs
The main costs of construction contracts are:
a) Direct materials-These may be obtained from contractors stores or purchased
locally and delivered to site. Material delivery notes should be used to correctly
record materials delivered and received by the site supervisor or engineer. Excess
or defective materials should be returned to store with material return note. Any
unused materials at the end of the accounting period are carried forward to the
next period. Material costs form a large component of direct costs of a contract.
b) Direct labour-Cost of direct labour ( including supervision) incurred on a particular
contract should be recorded using work or time sheets and charged to the
contract as a direct cost.
c) Direct expenses In addition to direct materials and direct labour, there are high
direct expenses incurred on contracts. These direct expenses include costs of
hiring/leasing plant and machinery, site office expenses, establishment charges,
63

costs of power, water, stationery, telephones, repairs etc .However, all other
overheads( general head office expenses) incurred for the company as a whole
should be assessed , apportioned on a fair basis and charged to specific contract.
d) Cost of plant- If Plant is owned by the company and used on contract , three
accounting methods may be used. These methods include charging depreciation
on straight-line or declining balance basis to the contract, charging the contract
with current book value of plant or opening a separate plant account for recording
depreciation costs and running costs ( ie repairs, fuels etc) of related to the used
equipment. In the later case, a notional charge is then made to user contracts at a
predetermined rate. Most contractors use the second method of charging the
contract with the current book value of plant. Plants used on contracts include
cranes, trucks, mixers, lorries, bulldozers etc and their costs are charged as direct
costs of contract using any of the methods mentioned above. However, cost plant
of plant transferred to another contract should be removed and charged to user
contract.
e) Subcontractors fees-Much work on large contracts is often given to subcontractors
,who are specialists, so as to accomplish the contract in time. Such subcontractors
may include ventilation engineers, lift manufacturers, flooring specialists,
electricians, plumbers etc. The invoiced amounts of the subcontractors works will
be charged as direct costs to the contract. Small amounts of subcontractors fees
may be conveniently charged as direct materials or direct expenses or overheads
to the contract account. Note that the subunits are the ones mostly
subcontracted.
f) Architects or Survey fees- Usually an architect or surveyor would be called upon by
the Client to inspect the contract work done periodically and certify the amount of
work completed. The architects certificate is used by the contractor to make
claims for payments by client. Architects fees is charged as direct cost of the
contract.
3.0 Contract account
A contract or job account ( or work in progress account) is usually opened for each
Contract and debited with the cost of direct materials, direct labour, direct expenses and
overhead charges on the contract. The cost of plant or depreciation charge is debited
contract account depending on the method used. Value of Work certified and cost of work
done is credited to the account. Any unused and returned materials and material transfers
are credited to the contract. Material and plant on site at the end of the accounting period
are similarly credited to the contract account and forward to the next period. Any proceeds
on sale of materials and plant are credited to this account. On an uncompleted contract,
where no profits are taken mid-way through the contract, the cost of work in progress
(WIP) is carried forward as a closing stock balance. The purpose of the contract account is to
ascertain the profit or loss on a contract.
The contractor may also prepare a debtors or contractee account to show the amount owed by
the client. The contractee account will be debited with the value of work Certified and credited
with the cash received and retention monies, if any.

4.0 Profit on incomplete contracts

There are no accounting difficulties if a contract is constructed and completed within the
same accounting period. In that case, the entire profit or loss can be transferred to the Profit
64

and Loss account (P&L A/C).However, there arises a problem whenever a contract takes longer
than one year to complete, as is common in most construction contracts. The issue here is how
to determine how much of the profit is to be transferred to P& Loss A/C and how much to carry
forward in the next period. Obviously, this will depend on the completion stage of the contract.
4.1 Procedure for determining the profit to be taken to the Profit and Loss account
i.

When the contract is completed less than 25% only, no profit should be
credited to the P&L A/C.
ii.
When the contract is completed or work certified is 25% or more but less
than 50% of total value of contract,
Profit taken=1/3 Notional Profit Cash received/ work certified.
iii.
When the contract is completed or work certified 50% or more but less than
75% of the total value of contract,
Profit taken=2/3 Notional profit Cash received/work certified.
iv.
Where the contract is more than 75% complete, total profit of the contract
should be estimated after considering the cost already incurred plus the
additional or estimated expenditure or cost to be incurred in order to
complete the contract. In such a case, profit should be credited to P&L A/C,
being computed as:
Profit taken=Estimated Profit Work certified/Contract price.
v.
For loss on contract, however, the entire amount of loss should be
transferred to the P& Loss account by debiting P&LA/C and crediting the
Contract A/C.
Notes
Notional profit =Value of work completed-Cost incurred to
date.
Estimated profit=Contract price-Cost incurred to dateestimated costs of completion.
Work in progress=Cost incurred to date + Profit taken-Cash
received.
4.2 Necessary Journal Entries to record contract transactions
a) When materials are issued to a contract: DR Contract A/c CR Materials a/c.
b) When wages are paid or outstanding: DR Contract a/c Cr Wages or Outstanding
wages a/c.
c) When direct expenses are paid or outstanding :DR Contract a/c CR Direct expenses
or Outstanding direct expenses a/c.
d) When plant and Machinery are installed : DR Contract a/c CR Plant& Machinery
a/c.
e) When materials are transferred from one contract to another (say, from contract
A to Contract B): DR Contract B a/c CR Contract A a/c.
f) When materials remain at the site at year end : DR Materials in hand a/c CR
Contract a/c.
65

g) When materials are returned to store at the year end: DR Material Returns a/c CR
Contract a/c.
h) When Plant and Machinery remained at site at year end at Written Down Value :
DR Plant& Machinery a/c CR Contract a/c.
i) When works are certified : DR Work certified a/c CR Contract a/c.
j) When works are uncertified : DR Works uncertified a/c CR Contract a/c.
k) When materials or Plants are sold: DR Bank a/c CR Contract a/c (at cost) CR P& L
a/c (with profit on sale).(In case of loss on sale, P&L a/c should be debited ).
l) When materials are lost or stolen and covered by the insurance company in part:
DR Bank a/c (with amount received from the Insurance company) CR P&L
a/c(actual loss) CR Contract a/c
m) When scrap is sold: DR Bank a/c CR Contract a/c.
n) When cheque or cash is received from Contractee (Client): DR Bank/Cash CR
Contractee a/c.
o) When profit is made on contract: DR Contract a/c CR P& L a/c CR Reserve/
Provision a/c
p) When a loss is made : DR P&L a/c CR Contract a/c.
Example 1
The following sums have been spent on a contract, still incomplete on the day the books of
accounts of KK Contractors Ltd are being closed for the year ending 30th June, 2009:
Shs
Materials
1,600,000
Wages
1,400,000
Direct charges
1,000,000
The contractor has received from the client shs 4,000,000, being 80% of the work
certified. The value of work not certified at that date was She 200,000.
Required: Determine amount of profit to be credited to the Profit and Loss Account.
Solution
KK Contractors Ltd
Contract Account for the year ending 30th June,2009
Dr
shs
shs Cr
sh
sh
To: Materials
1,600,000
WIP
: certified
5,000,000
Wages
1,400,000
uncertified
200,000
Direct charges
1,000,000
Profit & Loss a/c(note 1)
640,000
Balance c/d
560,000
5,200,000
5,200,000
Next yr:
:
WIP: Certified
5,000,000
66

uncertified

200,000
5,200,000
560,000
4,640,000

Less: Balance b/d

4,640,000

Note 1 : Profit to P& L a/c: 2/3 shs 1,200,000 80% = shs 640,000
Notional profit= Work certified +work uncertified- costs incurred to date= Sh
= shs 5,200,000- 1,600,000-1,400,000-1,000,000= shs 1,200,000.

Example 2
The following is the summary of the entries in a contract ledger account on 31st December
2005 in respect of Contract No. 12 undertaken by Mijengo contractors Ltd :
Shs
Materials
3,500,000
Wages
1,800,000
Establishment charges 800,000
Materials from stores
700,000
Plant
3,420, 000
Scrap sold
182,000
Direct expenses
700, 000
Additional information :
Accruals as at 31st December, 2005 : Wages shs 90,000, direct
expenses shs 120,000.
The cost of work not certified included in materials shs
260,000; Wages shs 100.000 and direct expenses shs 150,000.
Sh 200,000 worth of plant and shs 300,000 worth of materials
were destroyed by fire.
Sh 400,000 worth of plant was sold for shs 300,000 and
materials costing shs 500,000 were sold for shs 600,000.
Depreciation till 31st December 2005 on plant was shs
1000000.
Materials at site shs 500000.
Cash received from contractee shs 6,000,000, being 80% of
works certified.
Contract price shs 10,000,000.
Required : a) Prepare Contract account and Contractee account.
b) Compute the value of Work in progress.
c) Show Balance Sheet ( Extract).
Solution
Mijengo contractors Ltd
a)i
Contract account No. 12 to 31st December, 2005
Dr
To:

She
Materials
Materials

Sh
3,500,000

Shs
P &Loss a/c :
Plant a/c

Cr
Shs

200,000
67

from stores
700,000
Wages paid
1,800,000
,,
Accrued
90,000 1,890,000
Direct expenses
700,000
,,
Accrued
120,000
820,000
Establishment
charges
800,000
Plant a/c
3,420,000
P & Loss a/c:
Profit on material
sold( 600000100,000
500000)
Notional profit
782,,000
c/d

Material
a/c(destroyed)
Bank:Sale of scrap
Sale of materials
Sale of plant
P& Loss a/c :
Loss on sale of
Plant (400,000300,000)
Work in progress
a/c:
Material on site
Work certified
Work uncertified:
Materials
Wages
Expenses
Plant

12,012,000
To: P&Loss a/c
Profit provision c/d

417,100
364,,900

300,000

500,000
182,000
600,000
300,000

100,000

500,000
7,500,000
260,000
100,000
150,000
1,820,000 10,330,000

12,012,000
Notional profit b/d

782,000

782,000

782,000

(a)ii

Dr
Work certified

Contractee account
shs
7,500,,000
Bank
Balance c/d
7,500,000

Cr
Shs
6,000,000
1,500,000
7,500,000

b)Work in progress (WIP)=cost incurred to date +profit taken-cash received

= shs 722,8000+417,100- 600000= shs 164,5100.
Or WIP= Contractees a/c balance+ Cost of work not certified-Profit provision
= shs 1,500,000+510,000-364,900= shs 1,645,100.
c)
Balance Sheet (Extract) as at 31st Dec 2005
Liabilities :
shs
Assets :
shs
Accrued wages
90,000 Materials 500,000
68

,, direct expenses 120,000

Plant
WIP

1,820,000
1,645,100

LESSON SIX QUIZZES

1 A construction contractor has recorded the following details in a year: contract price sh
4,000,000, work certified sh 3,000,000, work not certified sh76,000 ,costs incurred to date sh
2,100,000 and cash received from client sh 2,520,,000.The profit to be taken in the years
final accounts would be:
A sh 546,560
B sh 976,000
C sh 924,000
D sh 429,440
Correct answer A
2 Which of the following are NOT characteristics of contract costing?
I Customer driven production.
11 complete production extends to multiple periods.
111 Method of costing not similar to job costing.
A 1 and 11 only
B 1 and 111 only
C 11 and 111 only
D 111 only
Correct answer D
3 Match the following contract cost with their classification in contract accounts.
Cost
classification
a Depreciation of plant
1 indirect cost
b Normal rectification costs
2 direct cost
c Head office expenses apportioned 3 direct expense
d Sub-contractors fee
4 production overhead
answer
a(2),b(4),c(1),d(3)
LESSON SIX: QUESTIONS
1 Mr.Kibisu, a contractor, started work on 1st January 2010 , for the construction of an office
block for Mumias Farmers Society Ltd .The agreed contract price was Sh 5,000,000.On 31st
March 2010 when he prepared his final accounts, the following information relating to the
contract was extracted from his books of accounts :
Shs
Materials issued from stores to site
1,600,000
Wages paid
1,012,000
Wages outstanding on 31st march 2010
375,200
st
New machines sent to site on 1 January
1,480,000
69

Direct charges paid

75,000
Direct charges outstanding on 31st march
6,000
Establishment charges apportioned to contract
64,000
On 31st march 2010: unused materials on site were shs 216,200. Machines were depreciated
at 20% p.a. Value of certified work shs 3,500,000; Cost of work done but not yet certified to
date shs 180,000.
On the basis of the architects certificate, Mr.Kibisu had received a total sum of shs 2,800,000
from the client till 31st march 2010.
Required: a) Prepare Contract account and Contractees account in Mr Kibisus ledger.
b) Calculate the work in progress (WIP).
c)Show the relevant portion of the contractors Balance Sheet as at 31st march 2010.
solution
a) Mr Kibisu
Contract account for year ended 31st March, 2010
Dr
Cr
Sh
Sh
Material from store
1,600,000
Materials on hand
216,200
Wages paid
1,012,000
Machines on site
1,406,000
Wages accrued
375,200
Work certified
3,500,000
New machines
Work uncertified
180,000
installed
1,480,000
Direct charges paid
75,000
Direct charges accrued
6,000
Establishment costs
64,000
4,612,200
Notional profit c/d
690,000
5,302,200
5,302,200
i)

Profit taken(w1)
Profit provision c/d

368,000
322,000
690,000

Notional profit/d

690,000
690,000

W1 Calculation of profit taken( work less than 75% complete)

Profit taken=2/3notional profit cash received
Work certified
= 2/3 690,0002,800,000
3,500,000
= sh 368,000
Profit provision=sh 690,000-368,000=sh 322,000.
ii)

Dr

Contractees account
Sh
Work certified
3,500,000 cash
Bal c/d
3,500,000

Cr
sh
2,800,000
700,000
3,500,000
70

b) W2 work in progress(wip)
WIP=Cost to date+profit provision-cash received= sh2,990,000+368,000-2,800,000
= sh 558,000
Or WIP=work certified +work uncertified less profit provision-cash received
= sh 3,500,000+180,000-322,000-2,800,000=sh 558,000.
Or WIP= Contractees a/c balance+cost of work uncertified-profit provision
= Sh700,000+180,000-322,000=sh 558,000.

c)

Mr.Kibisu
Balance sheet (extracts) as at 31st march, 2010

ASSETS
Material onsite
Machines on site
WIP(w2)

Sh

Sh

LIABILITIES
216,200 Wages accrued
1,406,000 Direct charges accrued
558,000
Capital account(profit)

375,200
6,000
368,000

2Rongai Builders Ltd was awarded a contract to build a library complex at Copa Training Institute
and work commenced at the site on 1st May, 2009.During the period to 28thFebruary,2010,the
expenditure on the contract was as follows:
Shs
Materials issues from store
941,100
Materials purchased
2,807,000
Wages
1,849,300
Direct expenses
614,900
Administrative expenses allocated
214,600
Plant purchased for use at site
1,218,000
The contractor had received on account the sum of shs 6, 417,000 , representing the amount of
certificate no.1 issued by the architect in respect of work completed to 28th February 2010, after
deducting 10% retention money.
The following relevant information is also available:
(i) The plant and machinery had an effective life of 5 years with no residual value and
(ii) The company only takes credit for 2/3 of the profit on work certified.
Required:(a) Prepare Contract account for the period to 28th February 2010.
(b)Show your calculation of profit to be credited to Profit & Loss account.
c) calculate value of work in progress.
solution
a)Rongai Builders Ltd
Contract account for the year ended 28th February,2010
Dr
Cr
Sh
Sh
71

Material issued from

store
Material purchased
Wages
Direct expenses
Adm expenses
Plant sent to site
Notional profit c/d

941,100
2,807,000
1,849,300
614,900
214,600
1,218,000
7,644,900
500,100
8,145,000

Plant on site
Work certified

8,145,000
Notional profit b/d

Profit taken(w1)
Profit provision

1,015,000
7,130,000

300,060
200,040
500,100

500,100

500,100

b) W1calculation of profit on contract

Profit taken=2/3notional profit cash received
Work certified
=2/3500,1006417,006,417,000
7,130,000
=sh 300,060
Profit provision= sh 500,100-300,060=sh 200,040.
W2 plant on site
= cost less depreciation= sh 1,218,000-203,000=sh1,015,000
Depreciation on plant=20%1,218,00010/12 ( for 10 months)
= sh 203,000.
c) work in progress(WIP)
WIP=work certified-profit provision-cash received= sh 7130,000-200,040-6,417,000=sh 512,960
3 Isinya construction Ltd comment work on a contract for shs 10,000,000 on 1st July 2005 . The
following details about the contract obtained at the end of the year:
Shs
shs
Materials purchased
2,000,000
wages paid
900,000
General expenses
200,000
Plant purchased
1,000,000
Materials on hand (30.6.2006)
500,000
wages accrued
100,000
Works certified
4,000,000
cash received
3,000,000
Works uncertified
300,000
Depreciation on plant 100,000
An escalation clause in the contract read as follows : in the event of process materials and
rates of wages increase by more than 5% , the contract price would be increased accordingly by
25% of the rise in the cost of materials and wages beyond 5% in each case. Since the date of
72

signing the agreement, prices of materials and wage rates increased by 25%. The above clause is
not considered for purposes of work certification.
Required : Prepare the Contract account.
Solution
Isinya construction Ltd
Contract account
Dr
Cr
Sh
Sh
Materials
2,000,000 Materials on hand
500,000
Wages
900,000 Plant on site
900,000
Wages accrued
100,000 Escalation costs(w3)
100,000
General expenses
200,000 Work certified
4,000,000
Plant
1,000,000 Work uncertified
Profit taken(w1)
400,000
300,,000
Profit provision(w2)

1,200,000
5,800,000

5,800,000

W1 Calculation of profit on contract( less than 50% complete)

Notional profit= value of work done-costs incurred to date
=sh 4,000,000+300,000-2,700,000=sh 1,600,000
Profit to be taken=1/3notional profit cash received
Work certified
= 1/31,600,0003,000,000
4,000,000
=sh 400,000
W2Profit provision
Profit provision= Notional profit-profit taken
=sh 1,600,000-400,000=sh 1,200,000
Plant on site=cost less depreciation= sh 1,000,000-100,000 =sh 900,000
W3Calculation of escalation costs
Based on increase of 25%
Estimated cost of material at the date of contract= sh 1,500,0001.25=sh 1,200,000
Cost of wages at the date of contract= sh 1,000,0001.25= sh 800,000.
Total cost of materials and wages =sh 2,000,000
Escalation cost =5%sh 2,000,000=sh 100,000
4 Ujenzi Bora Ltd commenced a contract on 1.7.2004. The total contract price was shs 5,000,000
but the company accepted the same for shs 4,500,000. It was decided to estimate the total profit
and to take to the credit of Profit &Loss a/c that portion of estimated profit on cash basis which
the work completed bore to the total contract. Actual expenditure till 31.12.2004 and estimated
expenditure in 2005 are given as below:
Actuals till 31.12.2004
Estimate for 2005
Shs
shs
Materials
750,000
1,300,000
Labour
550,000
600,000
Plant purchased (original cost) 400,000
-----73

Miscellaneous expenses
200,000
355,000
Plant returned to store (31.12.2004)
(original cost )
100,000
250,000( as at 30.9.2005)
Materials at site
50,000
------Work certified
2,000,000
Full
Works uncertified
75,000
-----Cash received
1,800,000
Full
Plant is subject to annual depreciation at 20% of original cost. It is the companys policy to
charge depreciation on time basis. The contract is likely to be completed on 30.9.2005.
Required : Contract account for the year ended 31.12.2004.
solution
Ujenzi Bora Ltd
Contract account for the year ended 31st December, 2004
Dr
Cr
Sh
Sh
Materials
700,000
WIP:
Labour
550,000
Materials
50,000
Plant
400,000
Plant(w2)
270,000
Misc. expenses
200,000
Plant returned to store
90,000
P&Loss a/c(w1)
264,000
Work certified
2,000,000
Provision
321,000
Work not certified
75,000
2,485,000
2,485,000
W1 Estimated total profit
Sh
sh
Estimated incomes:
Plant returned to stores
90,000
(100,000-10,000)
Plant ,2005
187,500
277,500
Plant on site (50,000-12,500)
37,500
Contract price
4,500,000
4,815,000
Less:Estimated expenditure
Materials (75000+130,000)
2,050,000
Labour ( 55,000+60,000)
1,150,000
Plant
400,000
Misc. expenses
555,000
4,155,000
Estimated profit
660,000
Profit to be credited to P&L a/c=Estimated profit cash received
Total contract price
= sh 660,0001,800,000 =sh 264,000.
4,500,000
Profit provision= sh 660,000-264,000=
W2 Plant on site as at 31.12.2004
= cost-plant returned-depreciation
=Sh 400,000-100,000-30,000=sh 270,000.
5 Ongata Construction Ltd obtained a contract for the construction of a bridge. The value of the
contract is shs 2,400,000 and the work commenced on 1st October 2008.The following details are
shown in the books for the year ended 30th September, 2009:
74

Shs
shs
Plant purchased
120,000
wages paid
680,000
Materials issued to site
672,000
direct expenses
16,000
General overheads apportioned
64,000
wages accrued
5,600
Materials on site
8,000
direct expenses accrued 2,400
Work not yet certified at cost
28,000
Cash received from the contractor was shs 1,200,000, being 80% of the value of work certified.
Life of plant purchased is 5 years and scrap value is nil.
Required :
a) Prepare the Contract Account for the year ended 30th September, 2009.
b) Show the amount of profit which you consider might be fairly taken on the
contract and how you have calculated it.

a Ongata construction
Contract account for year ended 30th September,2009
Dr
Sh
Plant purchased
120,000
Material on site
Material
672,000
Plant on site**
General ohds
64,000
Work certified
Wages paid
680,000
Work uncertified
Wages accrued
5,600
Direct expenses
16,000
,, accrued
2,400
Profit taken(w1)
38,400
Profit provision
33,600
1,632,000

Cr
Sh
8,000
96,000
1,500,000
28,000

1,632,000

b) calculation of profit to be taken

Notional profit =value of work-costs incurred to date
=sh 1,500,000 +28,000-1,456,000=sh 72,000.
Profit taken=2/3 notional profitcash received
Work certified
=2/372,000 1,200,000
1,500,000
= 48,00080%= sh 38,400
**Profit provision =sh 72,000-38,400=sh33,600.
plant on site= sh120,000 less annual depreciation (20%
=120,000-24,000=sh 96,000

75

LESSON SEVEN: COST-VOLUME-PROFIT (C-V-P) ANALYSIS

Learning objectives
After studying this lesson, the learner should be able to:
a) State the uses and assumptions of C-V-P Analysis.
b) Calculate and interpret breakeven point (BEP) and margin of safety.
c) Understand and use the concepts of a target profit and contribution to sales
ratio.
d) Apply CVP Analysis to single product firms
e) Explain the effects of changes in the Sales mix on contribution margin and
on the BEP.
f) Identify the limitations of CVP Analysis.
1.0 CVP or Break even Analysis: Definition and Uses
Cost-Volume -Profit (CVP) Analysis or model involves the study of the interrelationships
between costs, volume and profit at various levels of activity. In its simplest form , it
means sales minus costs equals profit. It is sometimes referred to as break even
analysis, although the later term is narrower and may be misleading. CVP Analysis comes
into play when the management of an organisation wishes to know the profit likely to be
made in a period for expected production and sales levels. The management may also be
interested to known the firms breakeven point and margin of safety. Needless to say,
Cvp analysis is one of the most important tools the manager can use to unearth an
organisations untapped resources and profit potential.
The break even point (BEP) is the activity level (volume) at which there is neither profit
nor loss ( ie profit equals zero).The margin of safety (MOS) is the excess of actual or
budgeted sales over break even sales. Henceforth,we shall use BEU and BES to represent
break even point in Units and sales value respectively.
CVP Analysis uses the principles of marginal costing and is an important tool for short
term planning and decision making. The key concept of marginal costing is that costs
should be separated into variable and fixed costs. Since fixed costs remain constant over
the activity range, they are considered as irrelevant in decision making. In marginal
costing, only variable costs are deemed relevant for decision making. Thus, CVP Analysis
seeks the most profitable combination of variable costs, fixed costs, selling price and
sales volume. Typical short-run or tactical decisions where CVP Analysis or marginal
costing can be applied include : Choice of product mix, special order decisions, Make or
buy decisions , shut-down or discontinuing decisions. Pricing of products, marketing
strategy and utilisation of productive facilities.
1.2 Limiting assumptions behind CVP or Break Even Analysis
Several limiting assumptions must be made in CVP Analysis. The key assumptions are:
a) All costs are classified as either fixed or variable.
b) Variable costs are proportional to sales volume
c) Fixed costs are constant within the relevant range.
d) The selling price per unit will remain constant.
e) All functions- that is sales, variable costs and fixed costs- are linear.
f) The analysis is for either one product or a single mix that remain constant.
g) The beginning and ending inventory levels are not significantly different.
76

h) The only factor affecting costs is sales volume.

2.0 CVP Analysis using equations
The Breakeven point can be determined using a a formula (equation ) or graph.We shall
derive important CVP Analysis formulae using equation method, since this is the method
commonly preferred by examiners.
Let S= Sales value, C= Total cost, V= variable costs ,F= Fixed cost and P= Profit or Net
income. The Cvp relationship can be given as: Sales= Total costs + profit
or Sales- Total cost= Profit before tax, which can be expressed further as :
Sales- variable costs- Fixed costs= PROFIT or S-V-F=P. At Break even point, profit is zero
(P=0) and therefore S-V-F=0 or S= V+F. Suppose we know the selling price (s), variable
cost per unit(v) and quantity(q),then :
sq-vq-F=P.
It follows that: sq-vq-F= P, then q(s-v)=F+P ie q= F+P /(s-v).
For a targeted level of profit, the quantity to be produced and sold would be:
Quantity sold= (Fixed cost + Target Profit)(selling price-variable cost per unit)
At breakeven point : BEU= F/(s-v) ie
Quantity= Fixed cost (selling price-variable cost per unit)
Note: i) Contribution (cm) =sales variable cost or contribution per unit (cu) = selling
price-variable cost per unit.
ii) Contribution to sales, contribution margin ratio or profit/ volume ratio (C/S or
PV Ratio) = s-v/s or S-V/S, which can also be expressed as a percentage.
iii) Variable cost ratio (VCR) = v/s or V/S
iv)BES=F/cms or BES= FPV ratio
v) BEU ( for target profit after Tax =( F + P/ (1- t))/ (s-v),where t= corporation tax rate.
vi) BES (for multi-product firm ) = F/cm S.
2.0 Sales mix
The concept of sales mix applies to multi-product firms.Sales mix is the relative combination
of products represented in total sales.For firms that produce many products,they must consider
sales mix in their breakeven analysis or Cvp Analysis.In such a case , the contribution margins for
each product cannot be used in isolation. Instead, they must be weighted by the number of each
unit expected to be sold (or sales ratio) and a weighted contribution margin per mix(wcmpm)
ratio derived. This ratio is then used in the same manner as the contribution margin per unit or
Pv ratio in single product situations. The Cwmpm is calculated as follows: Firstly, multiply each
products contribution margin by its unit sales to arrive at it contribution margin per mix.
Secondly, sum the individual contribution per mix.
Example 1
A company sells its single product for shs250 per unit.The variable costs per unit is
shs150 and fixed cost total shs35,000 per annum.
Required :
a) Breakeven point in units and value.
b) Contribution margin ratio and Variable cost ratio.
c) Quantity to be sold to earn a net profit of shs10,000 and margin of safety.
d) Profit earned when 400 units are sold .
e) Re compute (c) and (d) if the company is in the 25% tax bracket.
Solution
a) BEU = F/s-v = Shs 35000/ (350-250)= 350 units or BES =shs 87500 ( 350
shs 250 ).
b) PV ratio= s-v/(s) 100% =( 350-250)/ 350 100%= 100/350 100%=28.6%,
Variable cost ratio =VCR = v/s 100%= 250/350 100%= 71.4%
77

c) Quantity (q) = F+P/s-v= (35000+10000)/350-250 =45000100=450 units

.Margin of safety=Actual sales-BEU=450-350 = 100 units or shs 35,000
d) Profit when q=400, sq-vq-F=P =shs 350400-250400-35000=140000100000-35000=shs 5000.
e) I) Q=F +(P/(1-t)/(s-v)= {35000 +10000(1-0.25)}/350-250=35000 +
(10000/.75 ) /100=(35000+13333)/100= 48333/100=483 units.
Ii) Q=400, then 400={35000+( P/.75)}100, solving for P, Profit =shs3750.
Example 2
Singer Ltd sells product P for shs 50 per unit. Fixed costs are shs 210,000 p.a and the current
variable cost ratio is 60% . Its profit margin has remained consistently at 10%.Required:
aBreakeven point (in units and value) and contribution margin ratio.
bSales (in units and shs ) and margin of safety.
cIn an effort to improve its profitability, the company is considering a new strategy
:introducing a 10% sales commission and reducing advertisement costs by shs 60,000 .Calculate
the new breakeven point and sales volume and assess whether this new strategy is worthwhile.
solution
a) BEP (Units)= 210,000(50-30) =210,000/20 =10500 units or shs 525,000.Contribution margin
or C/s ratio =50-30/50 =0.4 or 40% , note variable cost per unit=60% selling price
=0.6shs50=shs30.
b) sq- vq-210000= 10%(sq)=50q-30q-210,000=0.150q=20q-210,000=5q, solving for q,
q=14,000 units or shs 700,000. Margin of safety= 14,000-10,500=3,500 units or shs 175,000.
c) Reducing advertisement cost , reduces fixed costs to shs 150000 (shs210000-60000) , variable
cost increases by 10% of Shs50 ie by shs 5 to shs 35. New BEP= 150000 (5035)=150,00015=10,000 units or shs500,000. New sales volume:50q-35q-150,000=10% 50q
,solving for q, q=15,000 units or shs750,000. Current profit=10% sh5014000 =shs 70,000,
profit with new strategy= 10% shs50 15,000= shs 75,000. The new strategy increases profit
by shs 7,500 and is worthwhile on purely financial perspective.

78

LESSON SEVEN:QUIZZES
1 Which of the following is one of the assumptions that underly CVP analysis:
A The actual selling price per unit must change in proportion to units sold in the period
B For variable costs, the actual cost per unit of output must remain constant.
C For fixed costs, the actual costs per unit of output must remain constant
D The sales mix must change with production level.
Correct answer C
In a given period the companys sales were sh 600,000 , variable cost sh 480,000 and fixed
cost sh 60,000.Determine BEP and sales volume required to earn a profit of sh 20,000.
Answer
PV ratio= contribution/ sales
= 120,000/600,000= 0.20
BEP(shs)= Fixed cost/PVratio=60,000/0.20=sh 300,000.
Sales (sh)= (Fixed cost + target profit)/Pv ratio
= (60,000+20,000)/0.20=sh 400,000.
Kware Ltd manufactures and sells two products, Alpha an Beta in the ratio of 5:3 respectively.
The fixed costs are sh 70,250 and the contribution margin per composite unit is sh 85.
Determine the number of Betas that will be sold to break even.
Answer
BEP=Fixed cost/ contribution margin per composite unit
= sh 70,250/sh 85= 850 mixers
Number of Betas required at breakeven point
=850@ 3= 2,550 units.
Match the following terms with their equivalent meanings.
Term
meaning
a) Contribution
b) Margin of safety
c) PV ratio
d) Break even point
Answer
a(2),b(3),c(1),d(4)

1 contribution to sales
2 Fixed cost plus target profit
3 Actual sales-Total cost
4 Total cost

5Galleria Ltd makes a product which sells for shs40 and has a variable cost of shs 30 per unit
.Budgeted fixed costs are shs70,000 and budgeted sales are 8,000 units. calculate
i)
BEP in units and value
ii)
Margin of safety and budgeted profit.
iii)
Budgeted sales at a targeted profit of shs 20,000.
LESSON SEVEN:QUESTIONS
1 Mamba Ltd produces a single product. The Selling price per unit is shs 200,Variable cost per unit
shs 150 and Fixed costs shs 180,000.A sales commission of 10% is offered to its salesmen.
Required:
i) Contribution margin ratio and BEP.
79

ii)

Sales volume required to earn a profit margin of 10%.

Solution
I
Pv ratio= unit contribution /selling price =30/200=0.15 or 15%
,unit variable cost= sh150 +10% of sh 200=sh 170, unit
contribution=sh 200-170=sh30.
BEP (units)= 180,000 /(200-170)=180,000/30=6,000 units.
2Sales required to earn a profit of 10% on sales
Let q=sales volume or units
200q-170q-180,000=10%(200q)
30q=180,000+20q
10q=180,000
Solve for q to get q=18,000 units or sh3,600,000.

2Wellma Ltd sells a product at a price of shs20 per unit. Its variable cost per unit is shs12 and
fixed costs are shs 360,000 p.a. In the next financial year, the company wishes to earn before
tax target income of shs 480,000.To achieve this target, the company intends to offer its
sales manager an incentive of shs2 per unit in excess of breakeven sales. Determine
a) BEP units before the incentive offer.
b) How many units must be sold to earn the targeted income.
c) New BEP after the incentive offer is introduced.
1
2

BEP units=Fixed cost/unit contribution margin=360,000/8=45,000 units.

Let q= units to be sold to achieve targeted profit;
Sales-variable cost-fixed cost=profit (selling price remains same)
Then, 20q-{(12q +2 (q-45,000)} -360,000=480,000
20q-12q-2q+90,000-360,000=480,000
6q=360,000+480,000-90,000=750,000, q=125,000
Units to be sold 125,000 units.
3 New Variable costs =12 (125,000)+2 (125,000-45,000)=1,500,000 +160,000
=sh 1,660,000
New variable cost per unit=sh1,660,000/125,000=sh13.28 per unit.
BEP=360,000/(20-13.28)=360,000/6.72=53,571 units.
i)
3 The super eagle Ltd is the sole distributor for a new product in West Kenya.The product sells for
shs 60 per unit and has a contribution margin ratio of 40%.The companys fixed expenses are shs
360,000 per year.
Required:
a) Variable cost per unit.
b) i) BEP in units and shs.
ii)Sales ( in units and shs) required to earn an annual profit of shs 50,000.
iii)Assume that through negotiation with the manufacturer, the company is able to
reduce its variable cost by shs 3 per unit.Calculate the companys new BEP in units
and shs.
Solution
1Pv ratio = unit contribution/selling price, let v=variable cost per unit
( 60-v )/60=40%=0.40; solving for v=36
Unit contribution=selling price-variable cost per unit=60-36=sh24.
2BEP (units)=fixed cost/unit contribution=360,000/24=15,000 units or sh 900,000
New BEP= 360,000/(60-33)=360,000/27=13,333 units.
3Sales for a targeted profit of sh 50,000
80

S=( F+P)/PV ratio= (360,000+50,000)/0.40= sh 1,025,000 or 17,083 units.

4Bela bela Ltd provides the following information for a year:

Fixed cost per annum sh 432,000
Break even sales sh 1,440,000
Units sold 20,000 units
Annual profit sh 240,000
Required:
a) Annual sales,selling price and variable cost per unit.
b) If the new variable cost ratio is 60%,determine the new BEP.
c) If sales volume are increased by 5%, without change in other factors, what would
be the new annual profit?
Solution
1BEP sh= fixed cost /pv ratio
Then, 1,440,000=432,000/pvratio
Pv ratio=432,000/1,440,000=0.30 or 30%
Variable cost ratio=0.70 or 70%
Sales for a profit of sh 240,000, q=20,000
Sales (S)=( Fixed cost+profit)/pv ratio=(432,000 +240,000)/0.30=sh 2,240,000
Selling price per unit =S/q=sh 2.240,000/20,000= sh 112.
Variable cost per unit=70%sh 112=sh78.40.
2 New pv ratio=40%=0.40
New BEP= 432,000/0.40=sh 1,080,000 or 9,643 units.
3
New sales ,q=21,000 units
Then profit (P) =q(s-v)-F, P=21,000(112-78.40)-432,000=
=sh 705,600-432,000
=sh 273,600
5 Close Bridge Ltd makes a product which has a variable production cost of shs 80 per unit
and a variable sales cost of shs 20 per unit. Fixed costs are shs 600,000 per annum , the
Selling price is shs 150 and the current volume of sales is 20,000 units.
The company is considering whether to have an improved machine for production .Annual
Hire costs for the machine would be sh 106,000 and it is expected that the variable
Production cost would fall to shs60 per unit.
Required: a) Determine the sales volume needed to achieve the same profit as is currently
earned if the machine is hired. b) Assess if it is worthwhile to hire the
machine if sales volume remains the same.
Solution
1 Current profit,
P=q(s-v)-F=20,000(150-80-20)-600,000=1,000,000-600,000=sh 400,000.
Unit Variable cost=sh 80+20=sh100.
With hire of new machine,
New unit variable cost=sh 60+20=sh 80
New fixed costs=600,000+106,000 =sh 706,000 ( raised due to machine hire cost)
Sales units required to achieve profit of sh400,000 :
q(s-v)-F=P, profit=q(150-80)-706,000=400,000,
solving for q we get q=15,800 units.
81

Sales volume 15,800 units 2Profit with mew machine when sales are 20,000 units P=q(s-v)F=20,000(150-80)-706,000= sh 694,000The new machine increases profits by sh 294,000 (sh
694,000-400,000) and is therefore worthwhile.

LESSON EIGHT: BUDGETING

Lesson objectives
After studying this lesson, the learner should be able to:
a) Define a budget and explain the objectives of budgeting.
b) Demonstrate an understanding of budgetary planning and budgetary control
c) Distinguish between Fixed and Flexible Budgets and prepare Flexible Budgets.
d) Prepare Income Statement Budgets and Balance sheet Budgets
e) Known the salient features of Zero-based Budgeting and Activity-based budgeting.
f) Identify the problems associated with budgeting
1.0 Definitions of a budget and objectives of budgeting
A budget is quantitative statement for a defined period of time , which may include planned
revenues, expenses, assets, liabilities and cash flows .A budget facilitates planning. (CIMA official
Terminology).From the above statement, we can deduce that a budget is a quantified plan of
action for a future accounting period which can aid an organisation to achieve its set targets.
Once you assign a monetary value on a plan, it becomes a budget .Most organisations including
Governments prepare budgets well in advance before the beginning of every financial year or
other defined periods of time. Budgets enables them translate their overall objectives into
comprehensive plans of actions .The importance of planning need not be overemphasised. Thus,
even in our daily lives, we plan for household purchases, childrens fees, travelling expenses,
Christmas parties , Weddings and Construction of houses and other projects etc. The aim is to
know how much you are likely to spend against your revenue and avoid unnecessary or
unachievable expenditure. The process of preparing a budget is known as budgeting. This will
form the basis of our discussion in the rest of this lesson.
1.2 The objectives of budgeting
Budgets help us to achieve the following objectives
e) Coordination of activities of different departments or divisions towards a single plan.
f) Communication of targets to the line managers responsible for achieving them.
g) Controlling the operating results by comparing the budgeted and actual results and
reporting variances for investigation and recommending remedial action.
h) Planning the activities or requirements of the organisation by managers.
i) Evaluating the performance of manager based on set targets.
j) Motivating managers who achieve departmental set targets and assessing how well
individual objectives compare favourably with overall organisation goals (goal
congruence)
k) Clarification of authority and responsibility.
1.2 Conditions necessary for successful budgeting
As a perquisite, budgeting is likely to succeed if the following conditions are met:
a) Top management is involved and supports the process.
b) The organisation sets out clear and realistic or achievable goals and objectives
c) Managers are properly assigned and are aware of their responsibilities or duties and
enjoy delegated authority.
d) The organisation has a well -developed structure in terms of responsibility, profit or
investment centres under the control of its managers.
e) An adequate accounting system exists
f) There is full participation and involvement of line managers in the budgeting process
82

g)

Effective communication at all staff levels to create awareness of organisational

objectives, targets which form the basis of budgeting.
h)
Budget education to enhance knowledge and budgeting skills among staff
i)
There is Flexibility as budgets are subject to changes due to the dynamic business
environment
1.3 Budgetary planning and Control
Planning and control do not mean the same thing. Planning involves the development of future
objectives and the preparation of various budgets to achieve those objectives, while control involves
the steps taken by management to ensure that the set objectives are realised and that the various
units or departments functions are consistent with overall organisational policies and practices. An
effective organisation must built objectives against which control can be directed .In essence, it must
have both plans and controls. The important aspects of budgetary planning and control comprises
the budgeting process and organisation of budget control.
1.3.1 The budgeting process
The budgeting process essentially involves the following steps:
a) Communicating organisational and unit set objectives and targets
to the budgeters with the use of a budget manual.
b) Determining the key or limiting factor which could be machine
hours, labour hours, material, finance, operating capacity etc
c) Preparation of the Sales budget, which is the starting point for
preparing the Master budget.
d) Initial preparation of other budgets like production budget, direct
materials budget, direct labour budget, manufacturing overhead
budget etc.
e) Lobbying for support of budgets from senior managers.
f) Coordination, review of the various budgets and draft Master
budget by budget committee.
g) Submission and approval of final budget by Board of directors,
University Council, Trustees.
h) Budget implementation.
i) Monitoring of budgets.
1.3.2 Organisation of budget control
Budget control means the establishment of budgets relating the
responsibilities of executives to the requirements of a policy and analysing
variances between budgeted and actual results for corrective action. Policies
may not be static due to changing environment factors and are therefore
subject to revision. The following are the key elements to achieving budget
control:
a) The creation of budgets centres
b) The introduction of adequate accounting system.
c) The preparation of organisational charts
d) The establishment of a budget committee.
Below is a brief look at each of the above four elements.
Budget centre:A section of an organisation defined for the purposes of budgetary
Control. It is sometimes referred to as a responsibility centre. It is a department
or Organisational function whose performance is the direct responsibility of a specific
manager.Ideally, costs should be charged to budget centres before they are apportioned to other
centres for purposes of responsibility.

83

Accounting system: Asystem of recording transactions related to material

purchases and issues, labour costs and factory overheads incurred.This is the basis of cost
accumulation.
Organisation charts: This is the layout of assigned responsibilities,authorities and
reporting levels for every manager in the organisation.
Budget committee:It is the coordinating authority in the preparation and
administration of budgets It helps to resolve difficulties and disputes which may arise between
functional managers and take decision.It is usually chaired by the Managing director and assisted by
a budget officer (an accountant). However, critical policy decisions must be referred to the Board of
directors. The budget committee, which comprises functional managers, is often guided by a budget
manual in carrying out its functions.
1.4
Budgeting systems
Different organisations have developed different budgeting systems and methods to suit their
legislative or regulatory or policy requirements .Budgets may be majorly classified as continuous
(rolling), static or flexible. One common method used in developing budget estimates for static and
flexible budgets is zero-based budgeting. We will discuss flexible budgets and Master budgets( major
component of static budgets ) in subsequent sections.
1.5 Flexible Budgets
Unlike fixed budgets which are set for a single level of activity, flexible budgets may be
altered to accommodate different levels of activities. A flexible budget may be defined
as that budget which by different cost behaviour patterns is designed to change as
volume of activity changes. Flexible (or flexed) budgets are used at the planning stage to
ascertain the effects of differing actual results and budgeted production. These budgets
are also used for controlling. Thus, at the end of each month or year, actual results may
be compared with the relevant activity level in the flexible budget, and the resulting
differences analysed for investigation and remedial action as deemed necessary. It is
important to note that flexible budgeting uses the principles of marginal or direct
costing; past cost behaviour patterns are analysed by separating costs into fixed and
variable elements. Costs which are semi-variable (mixed ) may pose some problem. In
such a case, the High-Low method is recommended in estimating the level of future
costs. This is a method of separating a mixed cost into fixed and variable elements in
analysing the change in the activity and cost between the high and low points in a group
of observed data.
Steps in preparing flexible budgets
a) Identify the relevant activity level (eg units, machine hours, labour hours)
b) Identify the fixed and variable cost elements in costs being considered for
budgeting
c) Calculate the variable cost per unit in each cost element (if any )
d) Prepare the flexible budget (or estimate cost ) for each activity level by
multiplying the variable cost per unit by the activity level and then add the
respective fixed cost.
Example 1
The production overheads for KK Manufacturers have been recorded in the
past four years and are given as below:
Year
Output (units)
production overhead (shs)
2010
15,800
774,000
2011
15,400
762,000
2012
19,600
888,000
2013
18,200
850,000
Budgeted production for year 2014 is 20,000 units.
84

Required: Estimate the production overhead for the year using the High-Low
method.
Solution
Units
shs
2012(Highest point)
19,600
888,000
2011(Lowest point)
15,400
762,000
Difference
4,200(q)
126,000(c)
Variable cost per unit (v)= change in cost/change in units=cq
= shs 126,0004200 = shs 30 per unit.
Total cost (Tc) = Variable cost (V) + Fixed cost (F).
= v x + F
If we take 2012: shs 888,000= shs3019,600 +F =588,000 +F.
Solving for F, F=30,000.Therefore Fixed costs are shs 30,000.
For 2014, quantity (q) =20,000,
Total cost (Tc) = shs30 20,000 +30,000 =shs 600,000 +30,000 = shs 630,000.
Example 2
New innovations Ltd uses flexible budgets that are based on the following
data:
Sales commission: 10% of sales.
Advertising expense: 18% of sales.
Miscellaneous selling expenses: shs 28,000 p.m. plus 4% of sales.
Office salaries expense: shs 180,000 p.m.
Office supplies expense: 3% of sales.
Miscellaneous administration expenses: shs 220,000 plus 2% of sales.
Required: Prepare a FLEXIBLE Selling and administration expenses budget
for January for sales volume of shs 1000,000, shs 1,250,000 and shs
1,500,000.
Solution
New Innovations: Flexible Selling and administration expenses Budget
shs
shs
shs
Sales volume
1,000,000
1,250,000
1,500,000
Variable costs:
Sales commission (10%)
100,000
125,000
150,000
Advertising expenses(18%)
180,000
225,000
270,000
Miscellaneous selling exps (4%) 40,000
50,000
60,000
Office supplies expenses (3%)
30,000
37,5000
45,000
Miscellaneous admin expenses(2%) 20,000
25,000
30,000
Total variable costs
370,000
462,500
555,000
Fixed costs:
Miscellaneous selling expenses
28,000
28,000
28,000
Miscellaneous salary expenses
180,000
180,000
180,000
Miscellaneous admin expenses
22,000
22,000
22,000
Total fixed costs
230,000
230,000
230,000
Total costs
600,000
692,500
785,000
1.6
Master Budgets
In a manufacturing business, it is common to find the following functional budgets:
Operating Budgets: Budget type
preparer
Sales budget
sales manager
Production budget
production manager
Direct materials purchases budget
Chief Buyer
85

Financing budget:
Investing budget:

1.6.1

Direct Labour cost budget

Human Resources manager
Factory production overheads budget
Production manager
Cost of Goods sold budget
Finance manager
Selling& Administration expenses budget Finance manager
Marketing manager
Cash Budget
Finance manager
Capital Expenditure budget
Research & Development budget **

Managing Director
Research Director

The following points should be noted :

I)
The budgeted Income Statement integrates the sales
budget, cost of goods sold budget and selling and
administration budget..
II)
The budgeted balance sheet budget integrates the cash
budget and capital expenditure budget .
III)
The Master Budget integrates the operating, financing and
investing budget(capital expenditure budget)
IV)
**The research & development budget is a discretionary
expenditure budget.
Preparation of the Operating budgets
1.
Sales budget: It is the most important budget and should be
prepared prior to other operating budgets ( production, labour cost
budgets etc) .It is usually difficult to prepare due to uncertainties in
demand, selling prices, competition, new lines and trade conditions
and Government policy etc. The sales budget helps production
managers to plan their requirements in a realistic manner as it acts a
target to be achieved .Sales equal to selling prices per unit
multiplied by the respective quantities.
2.
Production budget: Initially, a production forecast in quantity only
will be developed from the sales budget after allowing for policy
decisions in respect of finished inventories and thereafter translated
into budget requirements for the major productive resources. In
manufacturing business, the production budget will be derived as
below:
Expected units to be sold
xx
Add: Desired units in Ending Finished Inventory
xx
Less: Estimated units in Beginning Finished Inventory (xx)
Total units to be produced
xx

3 Direct material purchases budget:

In a manufacturing concern, the material units to be purchased will be
determined as follows:
Materials (usage) required for production
xx
Add: Desired Ending material Inventory
xx
Less: Estimated Beginning material Inventory
(xx)
Direct materials to be purchased (units)
xx
The estimated quantities of direct materials to be purchased are aimed at
Supporting budgeted production and desired inventory level.
86

Sometimes a separate material usage budget is prepared before the

material purchases budget.
However, in a merchandise firm which buys finished goods for resale,
stock (in units)to be purchased to meet customer demand will be arrived at
as here below:
Budgeted sales
xx
Add: Desired Ending inventory
xx
Less : Beginning inventory
(xx)
Finished inventory to be purchased
xx
4 Direct labour cost budget : This estimates the direct Labour hours and relate
Cost needed to support budgeted production. Direct labour cost equals
Labour hours required times hourly wage rate.
5 Factory production overhead budget: This is made up of expenses related to
sh
Factory:
Indirect factory overhead
xx
Supervisors salaries
xx
Power and lighting
xx
Depreciation on plant& equipment
xx
Indirect materials
xx
Maintenance of plant& equipment
xx
Insurance, Rent, Rates ,Taxes
xx
Total factory overhead costs
shs
xx
3
Cost of goods sold Budget :This budget integrates the direct materials purchases
Budget, direct labour cost budget, factory overhead cost budget and estimated and
desired inventories for direct materials, work in progress and finished goods.
Cost of goods sold will then be determined as under:
sh
Beginning Finished Goods Inventory
xx
Add: Cost of goods manufactured
xx
Less : Ending finished goods inventory
(xx)
Cost of goods sold
xx
4 Selling and administration expenses budget
This consists of selling or marketing costs, administration costs including distribution
expenses. They are additional expenses incurred to ensure that goods manufactured
eventually reach the customer or consumer. The expense emanates from service
departments such as accounting, purchasing, marketing, finance, stores/warehousing and
transport etc. The related costs may be summarised as under:
sh
Selling expenses:
Sales salaries& expenses
xx
Advertising
xx
Salesmen commissions
xx
Travel allowances
xx
Xx
Administration expenses:
Office salaries expenses
xx
Office rent, rates & insurance
xx
Office supplies
xx
Office power, water, telephones
xx
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Miscellaneous admin expenses

Total selling& Admin expenses

xx
Xx
xx

1.7Balance sheet budget

1.6.2 Cash Budget
A cash budget is the most common balance sheet budget prepared by many
business entities. Most cash budgets are prepared on monthly, quarterly or
semi- annually , to guide management on the liquidity position of the firm. It
is an analysis of expected cash receipts and cash payments in a period.
Difference between cash receipts and cash payments would be surplus or
deficit. The analysis begins with opening cash or overdraft, then all cash
receipts are added and cash payments deducted for the relevant period.
Any surplus (excess cash) or deficit ( cash shortages) for the period are
carried forward to the next period and so on. The main sources of cash
receipts and cash payments are as follows:
1 Cash Receipts
a. Cash receipts from cash sales.
b. Cash collections from debtors based on credit terms ( a
schedule of cash collections to be prepared).
c. Cash receipts from interest, dividends, rent, rates .fines and
penalties.
d. Loans, grants and donations compensations.
e. Miscellaneous receipts from sale of fixed assets, issue of shares
and debentures, calls, sale of scrap.
2 Cash payments
a) Cash payments for cash purchases
b) Cash payments to creditors (suppliers) based on credit terms ( a
schedule of cash payments should be prepared).
c) Cash payments for administration, selling and distribution overheads
such as office salaries, rent, insurance, electricity, water, telephones,
taxes, rates,
d) Cash payments towards loans and interests, dividends, financial
charges commissions and fees), law suits, fines and penalties.
e) Purchase of fixed assets, shares and debentures, calls.
Note that overdraft balance may be offset by borrowing while
surplus cash may be used to invest in short term securities. The
terms of loans, repayments of interest and payments on the
securities should be studied and complied with.
1.7 Zero-based budgeting( ZBB)
ZBB is A method of budgeting whereby all activities are re-evaluated each time a
budget is formulated. Each functional budget starts with the assumption that the
function does not exist and is at zero cost. Increments of cost are compared with
increments of benefit, culminating in the planning maximum benefit for a given
budgeted cost ( CIMA ,Terminology).
ZBB was first developed in North America as an alternative method to incremental
budgeting. The ZBB is based on Cost/Benefit analysis in an attempt to ensure value for
88

money. It questions the long-standing assumptions and serves as a tool for

systematically examining unproductive projects. For instance, it interrogates questions
such as: should the function be performed at all and in what way? What should be
quantity level and are we doing too much or too little? What should be the cost of the
project?
In this way, a questioning attitude is developed whereby each cost item and its level has
to be justified in relation to the way it helps to meet objectives and how the expenditure
benefits the organisation. ZBB can be applied in both profit-making and Non-profit
making and Non governmental organisations (NGOs).
According to Stonish (1976), ZBB involves the following three stages:
a) A description of each organisational activity in a decision package. Decision
packages of a county government might include care of the elderly, childcare,
care for the deaf and blind, bursary schemes, rural road projects, medical
facilities etc.
b) The decision packages are then evaluated and ranked.
c) The resources are then allocated accordingly.
The benefits that may be derived from ZBB include:
Leads to efficient allocation of resources by need and
benefit.
Develops a questioning attitude on long-standing
assumptions and systematically examines and identifies
inefficient and valueless operations.
Focuses on outputs in relation to value for money.
Enhances staff participation in decision making and leads to
improved motivation and performance.

1.8 Activity-based budgeting(ABB)

ABB is a planning and control system which seeks to support the objective of continuous
improvement and is based on activity analysis techniques. It uses the principles of
Activity-based costing (ABC) by identifying the major organisational activities, factors
that influence the cost of a particular activity (cost drivers) and creates a cost
centre(cost pool) for each activity.
According to Brimson and Fraser, the outline of ABB will be as follows:
A linkage between strategy , planning guidelines and operational plans
The use of activity analysis techniques to relate costs to activities
Identification of improved options, budget proposals and priority lists
Implement activity-based budgets or plans through participatory approach and
control for sustainable continuous improvement.
Example 3
A firm has the following plans for the next few months:
Month
sales material purchases
wages &salaries
Shs
shs
shs
September 600,000
200,000
120,000
October
600,000
400,000
150,000
November 700,000
400,000
170,000
December 900,000
300,000
130,000
Additional information:
89

I.

All sales are made on credit. Half of the debtors are expected to pay
within the month of sale and to claim a 2% cash discount. The
remainder are expected to pay in the following month.
II.
The firm plans to pay its creditors in full in the month following that
of the purchase.
III.
All employees are paid in full in the month in which the wage or
salary is earned.
IV.
Rent of shs 100,000 each quarter is payable on the normal quarter
days.
V.
Other cash overheads of shs20,000 per month are payable.
VI.
Some new plant due for delivery in September will be paid in
November at a cost of shs 250,000.
VII.
On 1st October, the firm plans to have shs 100,000 in the bank.
Required: A cash budget for the months of October to December ( inclusive ).
Solution
Cash budget (October -December)
October
November
December
shs
shs
shs
Cash receipts (Inflows):
Debtors: current month 294,000
343,000
441,000
Previous month 300,000
300,000
350,000
Total cash inflows (A) 594,000
643,000
791,000
Cash payments (outflows):
Creditors
200,000
400,000
400,000
Wages &salaries
150,000
170,000
130,000
Rent
100,000
Overheads
20,000
20,000
20,000
Plant acquired
250,000
Total cash outflows (B) 370,000
840,000
650,000
Cash surplus (deficit) (A-B) 224,000
(197,000)
141,000
Opening Bank balance
100,000
324,000
127,000
Cumulative cash balance 324,000
127,000
268,000

Example 4
Mavuno Ltd manufactures two products, namely Q and P. Two types of material X and Y are used
in manufacture of these products. The following information is provided by the company for the
year 2009:
i) Budgeted sales :
Product
Quantity(Units)
Price (shs)
Q
18,000
65
P
20,000
80
ii) Materials used:
Material
X
Y
Unit cost per kg
shs 6
shs 3
Quantity used ( kgs per unit)
Q
3
6
P
5
4
The following were the stock levels of the finished product:
Product
opening
closing
90

Q
3,000
1,500
P
2,000
2,500
Material (kgs)
X
5,000
6,000
Y
4,000
3,000
Required: Prepare the following budgets:
a) Sales budget.
b) Production budget.
c) Material usage quantities budget.
d) Material purchases budget (in quantities and shs).
Solution
a) Sales budget
Product
Quantity unit price
Total (shs)
Q
18,000 shs65
1,170,000
P
20,000
shs 80
1,600,000
2,770,000
b) Production budget(in units)
Q
P
Sales (units)
18,000
20,000
Add: Closing stock units
1,500
2,500
Total requirements
19,500
22,500
Less: stocks at Beginning
3,000
2,000
Production in units
16,500
20,500
c) Material usage budget (in quantities)
Product
X
Y
Total
Q
49,500
99,000
P
102,500
82,000
Total (kgs)
152,000
181,000
333,000
d) Material purchases budget (in kgs and shs)
X
Y
Material usage
152,000
181.000
Closing stock
6,000
3,000
Total requirements
158,000
184,000
Less: Opening stock
5,000
4,000
Material purchases
153,000
180,000
Cost per unit
shs6
shs 3
Material purchases cost (shs) 918,000
540,000

91

LESSON EIGHT:
QUIZZES
1 Which of the following make up the master budget?
A Sales budget, operating budgets, financial budget
B Sales budget, capital expenditure budget, financial budget
C Operating budgets, financial budget and capital expenditure budget.
D Operating budgets, sales budget,budgeted income statement.
Correct answer C
2 Which of the following comprise a Cost of Goods Sold budget?
A Production budget, material purchases budget, labour cost budget
B Material purchases budget, labour cost budget, factory overhead cost budget
C Sales budget, production budget, material cost budget
D Material purchases budget, labour cost budget, selling expenses budget
Correct answer B
3 Tea cups Ltd manufactures cups. Budgeted sales are 64,000 cups for next year. The
estimated beginning inventory is 2,500 cups and the expected ending inventory is
3,500 cups. Determine the production budget (in units) for next year.
Answer
Production=budgeted sales plus desired closing inventory minus estimated beginning
inventory
=64,000+3,000-2,500= 65,000 units
4 Usenge Ltd has budgeted to produce 59,000 units and sale 50,000 units in
July,2016.Each unit of the product requires 8kg of material .Beginning inventory of
material is 27,000 kg and the desired ending material inventory is 25,000 kg. Material
costs sh 0.50 per kg. Determine the material purchases budget for July, 2016.
Answer
Units of material purchases=production plus desired ending material inventory minus
estimated beginning inventory.
=59,000+25,000-27,000=470,000 units
Material purchase cost=470,000@ sh 0.50=sh 235,000.
LESSON EIGHT:QUESTIONS
1 Victoria furnishers Ltd manufactures office cabinets from steel. The following
information has been provided by its production department:
Steel per cabinet
50 kg
Direct labour per cabinet
18 Minutes
Variable factory overheads
20% of direct labour cost
Supervisors salaries
shs 320,000 per month
Depreciation
shs 50,000 per month
Direct labour rate
shs 46 per hour
Steel cost
shs 3.70 per kg
Required: Prepare a Flexible budget for 15,000 bulbs for the month of January 2015,
assuming that inventories are not significant.
92

Solution
Victoria furnishers Ltd
Flexible budget for Jan ,2015 (15,000 units)
sh
Variable costs:
Direct material
2,775,000
Direct labour
207,000
Factory overheads
41,400
Fixed costs:
QSupervisor salaries
320,000
Depreciation
50,000
Total cost
3,393,400

ABC Ltd makes two products, X and Y, using two types of raw materials ( A and B).The following
information is given for a budget period:
i Budget sales
Product
Quantity (units)
selling price (sh)
X
10,000
40
Y
8,000
30
ii Material usage
A
B
Unit cost (per kg) shs 5
shs8
Quantities used (kg per unit)
A
B
Product X
5
3
Y
4
2
iii Finished Goods Budget (units)
X
Y
Beginning inventory
500
1500
Ending inventory
1,000
500
iv Raw material Budget (units)
A
B
Beginning inventory
1,500
2,500
Ending inventory
1,000
3,000
Required:
a) Sales Budget ( in shs)
b) Production Budget (in units)
c) Material usage Budget (in kg)
d) Material purchases Budget (in kg and shs)
Solution
a) Sales Budget
Product
units to be sold
X
10,000
Y
8,000

price per unit

40
30

shs
400,000
240,000
640,000

b) Production Budget ( in units)

Units to be sold
Add: Desired Ending Finished inventory

X
10,000
1,000

Y
8,000
500
93

Total needs
11,000
8,500
Less: Desired Beginning Finished inventory 500
1,500
Units to be produced
10,500
7,000
c) Material usage Budget (in kg)(Based on units to be produced)
Product units
A
B
X
10,500
52,500
31,500
Y
7,000
28,000
14,000
Material usage
80,500
45,500
d) Material purchases Budget (in kg ) ( Based on material usage)
A
B
Material usage
80,500
45,500
Add: Desired Ending material inventory
1,000
3,000
Total material requirements
81,500
48,500
Less: Desired Beginning material inventory 1,500
2,500
Required material purchases
80,000
46,000
Cost per kg
shs 5
shs 8
Budgeted material purchases
400,000
368,000

Total

768,000

Fryz inn Ltd makes pizzas for sale .It has determined from its production budget the following
production estimated volumes for small and large frozen pizzas for June 2015:
Budgeted production volume: small pizza 5,200 units
Large pizza 9,400 units
There are three direct material units used in producing the two types of pizza. The quantities
of direct materials expected to be used for each pizza are as follows :
Direct materials
small pizza
large pizza
Dough
0.90 kg per unit
1.50 kg per unit
Tomato
0.60 kg per unit
1.0 kg per unit
Cheese
0.75 kg per unit
1.25 kg per unit
In addition, Fryz has determined the following information about each material:
Dough
Tomato
Cheese
Estimated inventory Jan, 1
580 kg
210 kg
325 kg
Desired inventory June, 30
640 kg
200 kg
355 kg
Price per kg
shs 11 shs 26
shs 28
Required: Prepare the companys Direct materials purchases budget for the month of June.
Solution
Fyz inn Ltd
Material purchases budget
Dough
Tomato
Cheese
Kg
kg
kg
Total(shs)
Material for production (kgs)
18,780
12,520
15,650
Add:desired ending inventory
640
200
355
19,420
12,720
16,005
Less:Estimated beginning inventory
580
210
325
Units of material purchases(kgs)
18,840
12,510
15,680
Unit purchase cost
sh 11
sh 26
sh 28
Material purchases budget
207,240
325,260
439,040
971,540

94

CHAPTER NINE: PROCESS COSTING

Lesson objectives
After studying this lesson, the learner should be able to:
a) Define process costing and explain the basis of all process costing systems.
b) Distinguish between normal and abnormal losses and prepare process, normal
loss, abnormal loss/gain , scrap accounts.
c) Explain the concept of equivalent units and the valuation of finished goods and
work in progress.
d) Distinguish between joint products and by-products.
e) Demonstrate an understanding of the methods of accounting for joint products
and joint products in process accounts.
f) Explain the methods of accounting for by-products.
1.0 Definition and basis of process costing
Process costing is a form of operation costing where it is not easy to identify separate
units of production or jobs due to the nature of the production processes involved.
Unlike in job or batch costing, a product passes through distinct processes or stages of
manufacture before the final product or output is realised. Process costing is common
in industries in which the material handled is liquid or semi-solid. Industries with
continuous process production include oil refining, paper, foods, chocolates and
drinks, chemicals, paint, cement, textile and detergents etc.
Characteristics of Process costing
iControl accounts are established for each process or departments which act as
process cost centres used to record and accumulate all process costs (direct material,
labour and overheads).
ii As production moves from one process stage to another, costs are transferred to it
and the chargeable cost of the output of one process becomes the raw material input
of the next process and so on.
iii There is usually closing work in progress (WIP) which must be valued .Process costs
for a period is apportioned between completed output and work in progress using
FIFO or Average cost methods.
iv There is often a loss in the process due to spoilage, waste, evaporation ,defects or
other cause, which should be accounted for using average cost per unit of good output
or scrapped value.
vApart from final process output, there may be a by-product(s) and or joint product (s)
,which need to be accounted for separately.
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Elements of process costs

As stated earlier, the final output of a process comes after undergoing several
processes .Control accounts are established for each process and direct costs and
production overheads are allocated to each process. Direct costs are charged and
allocated in the same manner as in job costing. However, the detailed work of
allocating costs as in job costing is not necessary in this case. A process account is
opened for each process and debited with all direct costs and production oveheads
and credited with costs of output, abnormal loss and scrap value of normal loss.The
main elements of process costs are :
1 Direct materials: Raw material is introduced as input into a production process and
transferred into subsequent processes as necessary. Some more materials may be
added to the original material at each stage

2 Direct labour
Cost of direct labour or wages is debited to the each process account. However, due
to automation in many process industries, the cost of direct labour is insignificant.
3 Direct expenses: These include cost of packaging, hire of specialised tools and
equipment. These are also debited to each process account, albeit being insignificant.
4 Production or factory (manufacturing) overheads
The proportion of production overheads is relatively high due to automated plant
and machinery. Each process is charged with a reasonable share of the production
overheads on fair basis. The total cost of direct labour, direct expenses and production
overhead is often referred to as conversion cost.
1.1 Basic Procedures used in process costing
There are four key steps in process costing depending on whether there are normal
losses, scrap, opening and closing work in progress. These are :
a) Determining Output and Losses: calculate the expected output ,normal and
abnormal loss or gain. In case there is opening or closing WIP, equivalent units
are calculated.
b) Calculate the cost per unit of output or equivalent unit.Cost per unit is based
on good output.
c) Calculate the total cost of output, losses and WIP. In case there is WIP, a
statement of equivalent production and statement of evaluation will be
prepared. Cost per unit is used to calculate cost of output (completed
production ( and abnormal loss or gain. Normal loss is not given a cost.
d) Prepare process, Normal loss and abnormal losses accounts as necessary.
1.2 Losses in process costing
In the course of manufacture, there may arise process losses: Normal and abnormal
loss and abnormal gain ( on rare occasions).
A normal loss is the loss which is expected under normal circumstances like
evaporation; it is unavoidable and therefore absorbed into good production. It is not
given a cost. However, proceeds realised from sale of normal loss units are credited to
the process account.
An abnormal loss is the loss which is not expected and occurs under abnormal
circumstances which may include machinery breakdown, defective materials
industrial accidents or labour inefficiency. The opposite of abnormal loss is abnormal
gain. Abnormal loss and gain units are costed at the same cost per unit as the good
production as they do not affect good output. Their costs are analysed separately

96

and posted to their respective accounts. The abnormal loss is credited to process
account while the abnormal gain is debited .
The following guidelines may be useful in calculating normal and abnormal loss units:
a) Actual loss = Input-Actual production (output).
b) Expected production= Input-Normal loss.
c) Abnormal loss= Expected production-Actual production
= Actual loss- Normal loss.
d) Normal loss= Actual loss-Abnormal loss.
e) Actual loss = Normal loss + Abnormal loss.
1.3 Accounting for scrap
Losses which arise from the process may be sold at scrap value ( minimal price).The
sales proceeds (revenue) realised from scrap are used to reduce the process costs.The
following procedures may be used to account for scrap in process accounts :
a) Scrap value of normal loss units: DR Scrap value account CR Process account (with
the value of sale proceeds)
b) Scrap value of abnormal loss : DR Scrap value account CR Abnormal loss account
(with the sale proceeds from abnormal loss units)
c) Scrap value of abnormal gain : DR Abnormal gain account CR Scrap value account (
with the sale proceeds from abnormal gain )
d) Cash received from scrap sales : DR Cash or Bank CR Scrap value account .
e) Scrap sold on credit : DR Debtors account CR Scrap value account.
There may arise disposal costs on normal and abnormal losses. In such a case,
the disposal costs of normal loss units should be debited to the process costs or
reduced from scrap value of normal loss units. On the other hand, include the
disposal costs of abnormal loss units in the abnormal loss account and then
transfer the cost of abnormal loss to the Profit and Loss account.
Sometimes a process may also have waste, which is material arising from the
production process that has no value.
1.4 Process costing with and without process losses
a) Without process losses: All materials and conversion costs are debited to the
Process account and the accumulated costs are transferred to the next process.
Columns will be opened on both sides of the process account to shown input units
(for memorandum only). This is uncommon.
b) With process losses : In case there are normal and abnormal losses, all material
and conversion costs are debited to process account and credited with normal
losses ( Scrap value ), abnormal losses , Output.
1.5 Valuation of Work in progress(WIP)
The concept of equivalent units is used when there are opening and closing work in
progress. Equivalent units (EU)are defined as a notional quantity of completed units
substituted for an actual quantity of in completed physical units in process , where
the aggregate work content of the incomplete units is deemed to be equivalent to
that of the substituted quantity of completed units .
When opening WIP is involved, the value of completed units transferred to
substituted is computed by either F.I.F.O (First-in First-out) or Average or Weighted
Average Method. These methods are considered here below:
a) F.I.F.O Method : It is a method of accounting for cost flows in a process costing
system in which effective or equivalent units of production and unit costs relate
to only work done and completed during the current period. WIP moves on a
First-in First-out basis. Incomplete units in opening WIP is first completed
before taking up work on any new units. Opening WIP units are separated with
97

the closing WIP. This is shown separately in a Statement of equivalent units

production costs. Inventory brought forward from the previous year is not
added to the current costs. The objective of the FIFO method is to value closing
WIP at current costs. This is the commonest method of stock valuation. It is
appropriate when the degree of completion of each element in opening stock is
given but not the value of each cost element.
This method is considered to be more superior than the average cost for
purposes of cost control; current performance should be measured in relation
to costs of the current period only rather than on current plus previous costs.
b) AVERAGE cost Method: It is a method of accounting for cost flows in a process
costing system in which units in the opening work in progress inventory are
presumed to have been started and completed during the current period. The
method is used when the degree of completion of each element in opening WIP
is not given but the value of each cost element is provided. Opening WIP Units
are not shown separately in the equivalent production statement, but are
included in the total units completed and transferred to the subsequent process
and finished stock. The method is simple to simpler to apply than the FIFO
method but has less usefulness in cost control.
The value of opening WIP is added to the costs incurred during the current
accounting period and total cost divided by the total equivalents to get the
average cost of equivalent units. It is necessary to breakdown the elements of
cost into materials, labour and overheads.
c) WEIGHTED Average Method: This method is used when dissimilar products are
produced in the same process .A close study of production and costs of each
variety of products is essential. The relative importance of one product as
compared to other should also be indicated in terms of points. These points are
used as a common denominator. To find cost of production in weighted
average, statements of weighted average production in terms of points and cost
for each variety of products should be prepared .When weights or points are
considered, the calculation of weighted average process cost becomes easier.
1.1 Joint and by-product costing
During a production process, there may arise joint products and or by-products.
Joint products are two or more products which simultaneously emerge from a
production process but each of which has a significant relative sales value .These
products are indistinguishable from each other up to the point of sale. Examples of
joint products can be found in oil refining where diesel fuel, petrol, paraffin and
lubricants emerge from the same production process. Since a joint product is regarded
as having a significant value, it should be costed separately and its profitability
determined.
By-products are products which arise from the simultaneous production process
incidentally and have a minor or low sales value when compared to joint products.
They are supplementary or secondary products. By-products may arise in timber
industry eg saw dust, small offcuts and park .In sugar processing, molasses may arise
as a by-product. Unlike joint products, by-products are not separately costs due to
their insignificant value.
1.2 Accounting for joint products
The main problem for joint products is the apportionment of joint costs prior to the
point of separation (split-off point) on a fair basis. Joint costs are not separately
identifiable until the split-off point is reached in production process. A decision needs to
98

be made regarding the basis of apportionment and also whether the joint product can
be sold profitably at one stage of processing or subsequently after further processing. Of
course post-separation costs (materials, labour, and overheads) will be incurred on
further processing. However, subsequent costs after the split off point may not pose
accounting problems since they can easily be traced directly to the product.
The methods of accounting for joint products are :
a) Physical unit or measurement basis
b) Average unit cost method
c) Weighted average (or survey) method
d)
i) Market value method (at the point of separation)
ii) Market value method ( after further processing)
iii) Net value method
iv)Standard cost method
v)Contribution method
1 Physical units or measurement method
In this method, the joint costs are apportioned on the basis of weight, volume or
unit of output of the joint products. However, this method is not appropriate where
the products separate during the processes into different states and where one
product generates more income than the other relative to its physical measurement.
2 Average unit cost method
The pre-separation joint cost is divided by the total units of production of the joint
products to arrive at the average unit cost .This unit cost is then multiplied by the
weight of each product to get its apportioned joint cost.
3 Weighted average or survey method
Weights or points are assigned to each individual joint product. The individual
product units are then multiplied with the respective weights to get equivalent or
weighted units. Then total units of the products are divided by the sum of the
Equivalent units to arrive at the weighted average cost. The weighted average cost is
multiplied by the products equivalent units to get its apportioned cost.
4 Market value or Sales value basis
Under this method, the joint costs are apportioned in proportion to the relative sales
value of the product. Sales value is taken as market value at the point of separation.
This method is suitable where joint products have different economic values. Where
the post separation costs are too high, the alternative method is to apportion joint
costs using sales value less far processing or post separation costs. This method is also
called notional sales value method.
It may be important to say that the choice of a method of apportioning joint products
depends on the circumstances and personal judgement of the cost accountant
provided the apportionment is made on a fair basis.

Example1
Product Z is produced after two processes. The following information is available:
99

Process
1
2
Item
Total cost (sh)
shs
shs
Direct material
360,000
280,000
80,000
Direct labour
70,000
30,000
40,000
Direct expenses
100,000
100,000
Production overhead incurred is Sh 120,000 and is on 200% of direct labour.
Production during the period was 2,000 kgs and there were no opening or closing
stocks or process losses.
Required:
Prepare process 1 and 2 accounts.

Dr
Units
Material 2000
Labour
Expenses
Overheads
2,000

DR
From process1
Materials
Labour
Expenses
Overhead

Units
2,000

2,000

Process 1 account
shs
280,000
30,000
100,000
60,000
470,000

Cr
Units

To process2 2,000

shs
470,000

---------------------------2,000
470,000

Process 2 account
shs
Units
470,000 Finished stock 2,000
80,000
40,000
80,000
670,000
2,000

Cr
shs
670,000

670,000

Example 2
A production process produces three joint products A,B and C. The pre-separation
costs amounted to shs 400,000. The output from the three products was : A 10,000
kg, B 2,000 kg and C 8,000 kg.
Required : a) Apportion the joint products using i) physical unit basis ii) Average cost
method.
b)Assume the joint products have been assigned weight factors of 6, 8 and 4 for A,B
and C respectively, apportion the joint costs using the Weighted average or survey
method.
Solution
a i)
Physical unit basis
Apportionment of joint costs : Product A : 1020 shs400,000 = shs 200,000
100

Product B : 220 shs 400,000 = shs 40,000

Product C :820 shs 400,000 = shs 160,000

ii)
Average cost method
Average cost per kg = sh 400,000 20,000kgs = shs 20 per kg.
Apportionment of joint costs : Product A 10,000 kgs shs 20 = shs 200,000
Product B 2,000 Kgs shs 20 = shs 40,000
Product C 8,000kgs shs 20 = shs 160,000
c)
Weighted average cost method
Product
units weight weighted
weighted
Apportioned
(kgs)
Units (kgs)
average
cost
A
10,000
6 60,000
3.7037
222,220
B
2,000
8 16,000
3.7037
59,250
C
8,000
4 32,000
3.7037
118,530

Example 3
Process 2 receives units from process 1, processes them and transfers the units to the next
process 3.The following information is given for a period:
Opening WIP : 400 units ( 25% complete) valued at sh 50,000
1,600 units were received from process1 valued at sh 86,000
1,640 units were transferred to process 3
Closing WIP : 320 units (50% complete)
The process costs for the period were sh 331,600.
No units were scrapped.
Required: a) calculate the effective units of production.
b)Prepare process 2 accounts using:
i FIFO method of valuation
ii AVERAGE COST method of valuation
Solution
a)FIFO method
Effective units=Completed units+ Equivalent units in closing WIP-Equivalent
units in Opening WIP= 1,680 + 50% 320 -25% 400=1,680+ 160-100= 1,740
Total cost for the period=previous costs+transfers in =sh 331,600+ 86,000
=sh 417,600
Cost per unit=Total costs / effective units=(417,600/870=sh 240
Value of closing WIP= 320 units 50%@sh 24= sh 38,400

Units

Process 2 account(using FIFO method)

Sh
Units
Sh

101

Opening WIP

400

50,000

From process1

1,600

86,000

Process costs

331,600

2,000

Transferers to
Process3

1,680

429,200

Closing WIP

320

38,400

2,000

467,600

467,600

b) Average cost method

Effective units=1,680 + 32050%=1,680+160=1,840 units.
Total costs=Costs of opening WIP+valuation of units transferred in +process 2 costs
=sh 50,000+ 86,000+ 331,600=sh 467,600
Cost per unit =sh 467,600/ 1,840=sh 254.13.
Value of transfers to process 3= 1,680 units@ sh 254.13= sh 426,939
Valuation of closing WIP= 320 units @ 50%@sh254.13= sh40,661.

Process 2 account (using average cost method)

Units
Sh
Units
Sh
Opening WIP
From process
1
Process costs

400
1,600
2,000

Transfers to
process 3

1,680

426,939

86,000
331,600 Closing WIP
467,600

320
2,000

40,661
467,600

50,000

102

LESSON NINE: QUIZZES

1 Which of the following statements is NOT TRUE about process costing?
A It is a form of operating costing.
B Wok in progress is a distinguishable homogeneous mass.
C Normal loss is usually valued at the cost per unit of good output.
D Poses a problem on how to value closing work in progress and completed units.
Correct answer C
2 Mafuta Ltd input to a process 2,000 units. Process costs were sh 90,000 and normal loss
was 10% .Actual output was 1,750 units and normal loss units were sold for at sh 9.00 each.
There were no opening or closing work in progress. Determine normal and abnormal losses,
cost per unit and cost of output.
Solution
Normal loss= 10% 2,000 =200 units
Abnormal loss= Actual loss- normal loss=(2,000-1,750)-200= 250-200=50 units. Expected
output=input-normal loss=2,000-200=1,800 units.
Scrap value of normal loss= 200 units@ sh 9 =sh 1,800
Cost per unit= Process costs- scrap value of normal loss =sh 90,000-1,800= sh 49.
Expected or good output
1,800
Cost of output= 1,750 units@ sh 49=sh 85,750.
3Match the following cost terms with their appropriate basic process costing
Cost term
meaning
A normal loss
1.It is given a cost
B Abnormal loss
2.It is not given a cost
C Expected output
3 It is deducted from material cost
D Scrap
4 It is used to calculate unit cost
Correct answer
a(2),b(1),c(4),d(3)

LESSON NINE: QUESTIONS

1The Production department of Chuma Ltd has given the following data:
Opening work in progress-2,300 kg( 70% complete).
Completed production:46,500 kg .
Closing work in progress-1,800 kg (25% complete)
Materials are added at the beginning of the process.
Determine the total equivalent units for direct materials and conversion costs

103

Answer
Calculation of Effective or Equivalent units of production(EU)
Equivalent units=completed units + Equivalent closing WIP units- Equivalent
WIP units
a Materials: Equivalent units
=46,500+1,800-2,300=46,000 units.
bConversion costs: Equivalent units= 46,500 +1,80025% -2,30070%
=46,500+450-1,610=45,340 units

Opening

2 The process manager of Koitobos Ltd has given the following information for July,2013:
Opening work in progress-4,000 (30% complete).
Completed units: 58,000 litres .
Closing work in progress :3,000 litres (60% complete).
cost of materials transferred in the process :sh 22,800 ; conversion cost for the period sh 8,790.
Assume that materials are added at the beginning of the process.
Required:
a)Total equivalent units for direct materials and conversion costs.
b) Direct material cost per equivalent unit and conversion cost per equivalent unit.

Solution
a)Effective units of production=completed units+Equivalent units in Closing WIP-Equivalent units in
Opening WIP
For Materials: effective units=58,000+3000-4,000=57,000 units ( 100% completed)
For conversion costs : effective units=58,000 + 3,000@60%-4,000@30%
=58,000 +1,800-1,200=58,600 units.
b)
Direct material cost per equivalent unit=material cost/material effective units=sh22,800/57,00=sh
0.40 per litre.
Conversion cost per equivalent unit= conversion cost/conversion cost effective units
=sh 8,790/58,600=sh0.15 per litre.
Cost
element

Completed + Equivalent- Equivalent = Total effective

Units
units in
units in
units
Closing WIP Opening WIP

Material
58,000
Conversion 58,000
cost

+ 3000
+ 1,800

- 4,000 =
-1,200 =

57,000
58,600

Costs
Shs

Cost per
(sh)
unit

22,800 0.40
8,790 0.15
0.55

3 Simiti Ltd manufactures a product which undergoes through two processes. During the year
ending 31st December, 2013, the following data was recorded in the first process:
Opening work in progress: 10,000 units (materials 100% complete, conversion 70% complete)
Units started into production :150,000 units
Units completed and transferred to next process:140,000 units
Closing work in progress:20,000 units (materials 60% complete, conversion 25% complete)
104

Required: Determine the equivalent units of production using

a) FIFO method
b) Average cost method

a FIFO
Effective or equivalent units of production
Materials: Equivalent units=complete units+ equiv units in Closing WIP+ equiv units in Opening WIP
=140,000+20,000@60%-10,000@100%=140,000+12,000-10,000=142,000
units
Conversion: Equivalent units=140,000 +20,000@25%-10,000@70%=140,000+5,000-7,000=138,000
b Average cost method
Materials : Equivalent units=completed units+ equivalent units in closing WIP.
= 140,000 +20,000@60%=140,000+12,000=152,000 units.
Conversion :Equivalent units=140,000+20,000@25%=140,000+5,000=145,000 units.

Pamoja products Ltd produces three joint products but each of which can be processed further
before sale. The following information is given for one month:

Product
A
B
C
Selling price per unit(at split-off point)
sh12
sh 16
sh18
Selling price per unit(post processing)
sh 20
sh 40
sh 60
Post-separation point costs
sh 40,000
sh 20,000
sh50,000
Units of output
3,500
2,500
2,000
The joint costs before split-off were sh 80,000.The management is also considering to stop
further processing of loss- making products in future.
Required: Prepare a profit statement for each product using the physical measurement method and
determine the maximum amount to be spend on post-separation cost of product A
Solution
Product
A
B
C
Sh
sh
sh
Sales
70,000
100,000
120,000
Costs:
Joint product costs(@sh 10 per unit)
35,000
25,000
20,000
Post separation costs
40,000
20,000
50,000
Total costs
75,000
45,000
70,000
Profit (loss)
( 5,000)
55,000
50,000
Joint costs are apportion on the basis of output: ie sh 80,000/8,000 units=sh 10 per unit
Product A has a loss of sh 5,000.The maximum post separation cost should be at break even point.
Therefore maximum post separation costs are sh 35,000 ( sh 40,000-5,000)
5 The following information is given for a milling process for June:
Material input:3,000 litres
Output :2,000 litres
Material costs sh 234,000
Conversion cost sh 126,000
Normal loss is 10%.Loss units are sold at sh 20 each.
Required:
105

aDetermine output and losses

b calculate the cost per unit,total cost of output and losses
c prepare the milling process account and abnormal loss or gain account.
Solution
Output and losses
Normal loss= 3,000@10%=300 units; scrap value of normal loss=300@sh 20=sh 6,000.
Actual loss= input-output=3,000-2,000=1,000 units.
Abnormal loss= Actual loss-normal loss= 1,000-300=700 units.
Expected output=input-normal loss=3,000-300=2700.
bCost perunit, total cost of output and losses
Cost per unit=process costs-scrap value of normal loss
Expected output
= (sh 234,000+126,000-6,000)/2,700 = sh131.10
Output: 2,000 units@sh 131= sh 262,200
Abnormal loss: 700 units@sh 131=sh 91,800
Normal loss : 300 units@ sh 20= sh 6,000*
Total cost
360,000
*scrap value of normal loss is credited to Process account.

Milling Process Account

c

Dr
Material
Conversion costs

Units
3,000

Sh
234,000
126,000

3,000

360,000

Normal loss
Output
Abnormal loss

Cr
Units
300
2,000
700
3,000

Sh
6,000*
262,200
91,800
360,000

Abnormal loss account

Dr

Cr
Sh
Sh
Process account
91,800 Scrap account
14,000**
Profit& Loss a/c
77,800
91,800
91,800
** Scrap value of abnormal loss=700 units@sh 20=sh14,000 (credited to abnormal loss
a/c)

106

LESSON TEN: STANDARD COSTING AND BASIC VARIANCE ANALYSIS

Lesson objectives
After studying this lesson, the learner should be able to:
a) Explain the objectives of standard costing and define a standard cost.
b) Distinguish between standard costing and budgetary control.
c) Explain the various types of performance standards and prepare a standard cost.
d) Define variance analysis and explain its components.
e) Calculate material, labour, fixed overhead and variable cost variances.
f) Identify the causes of material, labour and overhead variances.
1.0 Objectives of standard costing
The term standard costing is derived from standard cost. A standard cost is a planned or
predetermined unit cost of production. The total standard cost of a product is the total
planned cost per unit of materials, labour, variable and fixed overheads.It is determined
from estimates of expected prices or rates for materials ,labour and overheads.
Standard costing is a control technique which establishes predetermined estimates of the
costs of products or services, collects actual costs and output data and compares the actual
results with the predetermined estimates. It measures control by way of variance analysis,
whereby standard costs are compared with actual costs and differences arising therein are
investigated.
The main purposes or objectives of standard costing may be summarised as follows:
a. To assist in setting budgets and evaluating managerial performance.
b. To act assist in cost control by highlighting variances in cost of material,
labour and overheads.. Managers are then able to know those adverse
situations that require remedial action.
c. To provide a prediction of future costs that can be used for decision making
d. To provide a basis for inventory valuation, thus avoiding tedious methods
like FIFO, LIFO and Weighted average cost.
e. To provide targets that managers are expected to achieve .Those who
achieve the set targets become motivated.
1.1Standard cost and budgetary control
It may be important to note that most students confuse standard costing and budgetary
control. The following include some of the differences between standard costing and
budgetary control:
1) Standard costing is applied mainly in manufacturing activities whereas budgetary
control is universal.
2) Standard costing emphasises set cost standards maintained while budgetary control
emphasises profit planning

107

3) Standard costing uses standard cost per unit of product or service as benchmark
whereas budgetary control is a total concept for departmental organisation in an
entire period.
4) Standard cost is established after considering a variety of factors like production
volume, methods employed and efficiency determinants whereas budgetary control
is based on previous performance and makes adjustments for any expected changes
5) Standard costing is the basis of variance analysis which is normally revealed through
accounting; in budgetary control variances are revealed through statistical measure
6) standard costing lays the basis for investigation of variances ; budgetary control gives
more emphasis on budget over expenditures
7) Standard costing is useful in decision making pertaining to cost management;
budgetary control puts more emphasis on general administrative and policy decisions.
8) Standard costing is more useful for cost accounts whereas budgetary control mirrors
financial accounts.
1.2 Performance standards and standard standard costs
The quantity of materials and labour time required will depend on the level of performance
required by management. You may note remember that material and labour costs are prime
costs and therefore are a major determinant of a standard cost. Standards imply an
acceptable level of production efficiency and one of the major objectives of setting standard
is to motivate employees to achieve efficiency in operations
Types of performance standards
a. Basic or constant cost standards: These are constant standards that remain
unchanged over long periods of time. They provide a basis for comparison with
actual costs. However, they are seldom used because they disregard changes in
production, material prices and labour rates.
b. Ideal or theoretical standards: These are standards which can only be achieved
under perfect operating conditions. They represent perfect performance .Such
standards assume no idle time, no machine breakdowns and no material shortages
and labour strikes. They tend to be unrealistic and unattainable; they are unlikely to
be attained and used in practice due to their adverse impact on employee
motivation.
c. Attainable or expected standards: These represent costs that should be incurred
under normal or efficient operating conditions .They are standards that are difficult
but not impossible to achieve .They cater for normal material spoilage, machine
breakdowns and lost time etc.
d. Current standards: These are set for a relatively short period to reflect current
conditions .They are normally used in during inflationary times but are same as
attainable standards when the conditions stabilise .They are set for short periods
but quickly adjusted when circumstances change.
1.4Problems of standard costs
Using standard costs for performance evaluation has been criticised on the
following grounds:
1) Standards discourage operating improvements beyond the standards set.
2) Standards may not be preserved for long especially in a rapidly changing,
dynamic production environment.
3) Standard narrow employees focus to efficiency improvements and makes
them ignore overall organisational objectives.

108

4) Standards may cause employees to unduly focus attention on their own

divisional, departmental or branch operations to the detriment of other
operations that require them.
1.5Components of a standard cost
Setting a standard cost is the essence of standard costing .A standard cost is
accumulated for each product, comprising the standard cost of materials and labour (wages)
used together with a predetermined share of budgeted variable and fixed production
overheads. For standard cost of materials, material prices, quantity issued and consumed
and actual output units have to be ascertained.In case of labour costs, labour efficiency (
time worked and time paid) and estimated wage rates and actual rates are required.
variable overheads are absorbed into production on the basis of labour hours. It is therefore
necessary to estimate the variable overhead for the year and budgeted activity (output)
units or hours.These are used to calculate the variable overhead absorption rate (VOAR) per
unit.
Fixed overheads can be budgeted in total before production starts but the amount to be
included in a standard product cost depends on budgeted output. A fixed overhead
absorption overhead rate (FOAR) is the determined. The total standard production costs per
unit are summarised into a standard cost card or sheet specification.

Example 1
The standard cost for production of one unit of product Z is given as below:
Material: 1 kg at shs 4 per kg
Labour : 1 hour at shs 2 per hour
Variable overheads shs 2 per unit
Fixed overheads shs 5 per unit
Required: a) Prepare a standard cost card and determine the standard cost for production of 2,000
units.
b) calculate the unit selling price if the profit margin is estimated to be 20%.
Solution
a) Standard cost card
Cost
shs per unit
Materials : 1kg @ shs 4
4
Labour : 1 Hr @ shs 2
2
Variable overhead rate (VOAR) 2
Fixed overhead rate (FOAR)
5
Standard cost per unit
13
Standard cost for production of 2,000 units = 2,000 shs 13 =shs 26,000 .
b) Selling price per unit = shs 13 + 25% shs 13 = shs 13 +3.25=shs16.25
If profit margin is 20%(5) , the profit mark up is 25% ( ) ( Note the relationship :cost
price + profit= selling price)
Example 2
The following information is given for manufacture of a product:
Budgeted output for the year
9,800 units
Standard details for one unit:
Direct labour : 40 sq. metres at shs 53 per sq.metre
Direct wages: Bonding dept : 48 hours at shs 25 per hour
Finishing dept : 30 hours at shs 19 per hour
109

Budgeted costs and hours per annum

Variable overheads :
Shs
Hours
Bonding dept
3,750,000
500,000
Finishing dept
1,500,000
300,000
Fixed overheads :
Shs
Production
3,920,000
Selling & Distribution
1,960,000
Administration
980,000
Required:a) Prepare a standard cost card for one unit to show Prime cost, Variable
production cost, Total production cost and Total cost.
b) Calculate the selling price if profit margin is 15%.
Solution
a) Standard cost per unit ( Budget)
Shs
shs
Material : 40 sq.m @ shs53
2,120
Labour : Bonding :48 Hrs @ shs 25
1,200
Finishing:30 Hrs @ shs 19
570
1,770
PRIME COST
3,890
Variable overhead
Bonding
( shs 7.5048 hours) *
360
Finishing ( shs 5.00 30 hours)*
150
510
Variable cost of production
4,400
Fixed overheads
400**
Total production (factory) cost
4,800
Selling & distribution overheads (shs 960,0009,800 units) 200
Administration overheads (shs 980,0009,800 units)
100
300
Total cost
5,100
Add : Profit mark up (3/17 shs 5,100 )
900
Selling price per unit
6,000
*Variable overhead absorption rates (VOAR):
Bonding dept : shs 3,750,000 /500,000 Hrs= sh 7.50 per Hour.
Finishing dept : shs 1,500,000/300,000 Hrs = shs 5.00 per Hour.
**Fixed overhead absorption rate(FOAR): (shs 3,920,0009,800 units)= shs 400.
2.0 VARIANCE ANALYSIS
A variance simply means a deviation or difference from the expected. Actual costs are compared
with the budgeted or standard costs to obtain a variance. Variance analysis refers to critical
analysis of each element of production cost (material, labour, variable and fixed overheads) in an
attempt to reveal adverse or favourable variances which need to be investigated if they are out
of control.
Price or rate variance measures the difference between actual prices (AP) or rate (AR) paid and
the standard price (SP) or rate (SR) that should have been paid for materials or labour.
Quantity or efficiency variance measure the difference between the actual quantity (AQ) or hours
(AH) for direct material or labour used and the standard quantity(SQ) or hours (SH) that should
have been used.
Standard quantities or hours are based on actual units produced (output achieved).
The standard hour is the quantity of output or amount of work which should be performed in one
year.

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Variance analysis relies to a great extent on standard costing. For instance, Standard prices and
quantities and actual prices and quantities must be known in order to calculate variances.
Variance analysis is used as a control and evaluation tool. The following is the breakdown of
basic variances:
1) Material cost variance =Price variance + Usage variance.
2) Labour cost variance= Rate variance + Efficiency variance
3) Variable overhead cost variance= Expenditure variance +Efficiency variance
4) Fixed overhead cost variance= Expenditure variance+ Volume variance;
Fixed overhead volume variance=Volume efficiency variance+ Volume capacity variance.
2.1 Material cost variances
The direct material cost variance can be subdivided into material PRICE variance and
USAGE variance.
The direct material cost variance is the difference between what the output actually cost
and what it ought to have cost, in terms of material.
The material price variance is the difference between the standard cost and the actual
cost for the actual quantity of material used or purchased.
The material usage or quantity variance is the difference between the standard quantity
of materials that should have been used for the number of units actually produced and
the actual quantity of materials used, valued at the standard cost per unit of material.
PRICE variance= Actual quantity (Actual price-standard price)=AQ(AP-SP)
USAGE variance =Standard price (Actual quantity-standard quantity)=SP (AQ-SQ)
Note that the price variance may be segregated at the time of purchase ( when the
material is taken into stock) or at the time of issue from the stock(when the material is
put into production ).Both methods have their advantages and disadvantages .However,
where a full standard costing system is operation, as is usually the case, price
variance should be calculated on purchases for the period .If actual price or actual
quantity exceed the standard price or standard quantity respectively, the material cost
variances would be adverse or vice versa.
Reasons for material cost variances
Material price variance
a. Price changes as a result of wage awards,
increases in customs duties etc
b. Differences in standard and actual order
quantities due to gains or losses in quantity
discounts
c. Obtaining materials from a different supplier
other than the listed one
d. Differences between standard and actual
carriage costs ( freight, insurance, storage etc)
e. Differences between the standard and actual
quality of materials
2.2 Labour cost variances
Direct labour cost variance can be subdivided into labour rate variance and efficiency
(quantity) variance.
Labour cost variance is the difference between what the output should have cost and
what it actually cost in terms of labour.
The labour rate variance is the difference between the standard cost and the actual cost
for the actual number of hours paid for.
The labour efficiency variance is the difference between the hours that should have been
worked for the number of units actually produced and the actual number of hours
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worked valued at the standard rate per hour .The variances may either be adverse or
favourable. If actual rate or actual hours exceed the standard rate or standard hours
respectively, the labour cost variance would be adverse or vice versa.
The calculation of labour cost variances are similar to those of material cost variances.
The actual price and standard price are replaced with actual rate and standard rate
respectively in labour cost variances. Similarly, the actual quantity and standard quantity
are replaced with actual hours and standard hours respectively in labour cost variances.
RATE variance= Actual Hours paid ( Actual rate- standard rate)=AHP(AR-SR)
EFFICIENCY variance= Standard rate (Actual hours-standard hours)=SR (AH-SH)
However, note that when there is idle time, actual hours worked are used to calculate
the efficiency variance. In this case, idle time is the difference between actual time
worked (AH) and actual time or hours paid (AHP).
Idle time variance= Standard rate (Actual hours paid-Actual hours)=SR (AHP-AH).Idle
time variance is always adverse.
Reasons for labour cost variances
Labour rate variance
a)
Use of different grades of labour other than planned
b)
Payment of unplanned overtime or bonuses
c)
Material prices variance causes
Labour efficiency variance
a)
Idle time due to machine breakdowns and material
shortages
b)
Errors in allocating time to jobs
c)
Poor supervision and disorganisation in the factory
workshop
2.3 OVERHEAD COST VARIANCES
The overhead cost variance is the difference between the standard overhead cost
specified for the production achieved, i.e. the flexible budget and the actual overhead
cost incurred. The standard overhead cost usually comprises the variable and fixed
overheads. It is necessary therefore to break the overhead cost variance into variable
overhead and fixed overhead cost variances.
1VARIABLE OVERHEAD COST VARIANCES
The variable overhead cost variance can be subdivided into variable overhead expenditure
variance and variable overhead efficiency variance.
Variable overhead cost variance is the difference between the actual variable overheads
incurred and the variable overheads absorbed, which may be over or under absorbed
overheads.
Variable overhead expenditure variance is the difference between the actual variable
overheads incurred and the allowable variable overheads based on the actual hours worked.
Variable overhead efficiency variance is the difference between the allowed variable
overheads and the absorbed variable overhead.
Variable overhead efficiency variance is uses the same hours as in labour efficiency variance
but priced at the variance overhead rate per hour.
Variable overhead expenditure variance=Actual variable overhead-(VOAR Actual labour
Hours )
VOAR= Variable overhead absorption rate.
Variable overhead efficiency variance= VOAR (Actual Hours- Standard Hours).
2 FIXED OVERHEAD COST VARIANCE
Fixed overhead cost variance is the difference between the standard cost of fixed
overhead absorbed in the production achieved ,whether completed or not, and the fixed
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overhead attributed and charged to that period. The fixed overhead cost variance can be
subdivided into fixed overhead expenditure and fixed overhead volume variances.
Fixed overhead expenditure variance is the difference between the budget cost allowance for
production for a specified control period and the actual fixed expenditure attributed and
charged to that period.
Fixed overhead volume variance is the difference between the standard cost absorbed in the
production achieved, whether completed or not, and the budget cost allowance for a
specified control period.
The fixed overhead volume variance can further be subdivided into fixed overhead efficiency
variance and fixed overhead capacity variance.
The fixed overhead efficiency variance is the difference between the standard cost absorbed
in the production achieved, whether completed or not, and the actual direct labour hours
worked, valued at the standard hourly absorption rate.
Fixed overhead capacity variance is the difference between budgeted (planned) hours of
work and the actual hours worked, multiplied by the standard absorption rate per hour.
Fixed overhead expenditure=Actual Fixed overhead expenditure-Budgeted Fixed overhead
expenditure.
Fixed overhead volume variance=Standard cost unit rate
(Actual production-Budgeted production)
Fixed overhead efficiency variance=FOAR (Actual Hours in input-Standard Hours in output)
Where FOAR= Fixed overhead absorption rate.
Fixed overhead capacity variance=FOAR (Actual Hours in input-Budgeted Hours)
Or =Standard cost per unit (Budgeted production-Standard
Production)
Example 2
The standard direct material specification for product Z is to use 5 kg of raw material X at sh 60 per
kg. Last month, 30 units of product Z were produced from 160 kg of the raw material, which cost shs
9,400 in total.
Required: Calculate the material PRICE and USAGE variance.
Solution
Material price variance = AQ (AP-SP) =160kg (shs 58.75-60.00) =shs 200 F
,
usage variance =SP (AQ-SQ) = shs 60 (160-150) =shs 600 A
Material cost total variance= shs 200 F + shs 600 A=shs 400A.
Standard quantity (SQ) = Standard usage rate per unit Actual units produced=5kg30 units= 150kg.
Example 3
The standard direct cost of a unit of a product is given below:
Materials : 2kg at shs 12.50 per kg
Wages: 10 Minutes at sh 24 per hour.
In a certain period, 420 units were produced, 860 kg of material were used at a cost of shs 10,300
and 72 hours of labour were worked .Actual labour hours paid were 80 hours at a cost of shs2,000.
Required: Calculate the Material and labour cost variances.
Solution
a)material cost variances
Price variance= AQ(AP-SP)=860 kg(11.979-12.50)=shs 10,300-10750=shs450 F
Usage variance= SP(AQ-SQ)=shs12.5(860-840)= shs 250A
Material cost variance= shs 450F +250A=shs 200F.
Standard quantity (SQ)= 2kg 420 units=840 kg.
Check:material cost variance=(APAQ)-(SPSQ)=shs 10,300-(12.50840)-shs 10,30010,500=shs200F
b)Labour cost variances
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Rate variance=AHP(AR-SR)=80 hrs (sh25-24)= shs 80A

Efficiency variance =SR( AH-SH)=shs24 (72-70)=shs 48A
Idle time variance=SR (AHP-AH)=shs24 (80-72)=shs 192 A
Labour cost variance=shs 80A+48A +192A= shs 320A.
Standard hours =10/60 420 =70 hours.
Check: Labour cost variance=(ARAHP)- (SRSH)=Sh(8025)-(2470)= sh 2000-1680=sh320A.
Example 4
The variable production overhead cost of one unit of a product were:2 hours for sh 15 per Hour.
During a certain period, 400 units of the product were made. The actual labour hours were 760 hours
at a total cost of shs 12,300.
Required: Calculate the variable overhead cost variances.
Solution
Variable overhead expenditure variance=Actual variable overheads- (VOAR Actual labour hrs)
=shs 12,300-(sh15760)=shs 12,300-11,400=shs900A.
Variable overhead efficiency variance=VOAR (Actual Hours-Standard Hours)=shs 15 ( 760800)=sh600F.
Variable overhead cost variance=shs 900A+600F= shs 300A.
Variable overhead absorption rate (VOAR) = sh 15 per hour.
Standard hours= 2hours 400 units= 800 hours.
Example 4
The following information is given for product :
The standard fixed overhead cost per unit: 5 hours at sh shs 80 per hour.
Budgeted fixed overheads shs 400,000.Budgeted production 1,000 units.
Actual fixed overhead expenditure shs 409,000.Actual labour hours were 5,400 hours for output of
1,100 units.
Required: Calculate the fixed overhead cost variances.
Fixed overhead expenditure variance=Actual fixed overheads- Budgeted fixed overhead expenditure.
= shs 409,000-400,000 =shs 9,000 A
Fixed overhead volume variance=Standard cost unit rate ( Actual production-Standard production)
= shs 400 (1,100-1,000)= shs 40,000 F.
Fixed overhead volume efficiency variance=FOAR ( Actual hours-Standard hours)=shs 80( 5,4005,500)= shs 8,000 F.
Or =standard cost unit rate (Actual quantity-Standard production).
Fixed overhead volume capacity variance=FOAR (Actual hours-budgeted hours)
=shs80 (5,400-5,000)= sh 32,000 F
Or Capacity variance= Standard cost unit rate ( Budgeted production-Standard
production).Note that standard production quantity is not given .

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LESSON TEN:
QUIZZES
1
Which of the following is NOT TRUE about standard costing?
A It makes possible the use of management by exception.
B It facilitates cash planning and inventory planning.
CIt provides comparison of actual and budgeted performance at given activity levels
DIt represents realistic yardsticks, more useful for cost reduction.
Correct answer C
2 Machine tools Ltd has set the following labour standard for one unit of its product :
Direct labour time per unit: 15 minutes
Direct labour rate per hour : sh 5.50
Actual results for a period were: Actual hours worked ,7,700 hours for a total cost of sh 40,810.
Output: 30,000 units. Calculate the labour rate and efficiency variance.
Solution
Labour rate variance=AH(AR-SR)=7,700 ( 5.30-5.50)=sh1,540 F
Labour efficiency variance=SR (AH-SH)= 5.50( 7,700-7,500)= sh 1,100A.
Total labour cost variance= sh 1,540F+ sh 1,100A=sh 440F.
Standard hours(SH)=15/60 30,000 units=7,500 hours.
3 Which of the following reasons might cause adverse material quantity variances
1 Change in material standard
II Defective material
III Stricter quality control
IV Lower rate of scrap then expected
AI
B 1 and II
C 1,II and III
D I,II,III and IV
Correct answerD
.
LESSON TEN: QUESTIONS
1) New Bomas Ltd uses variance analysis as a method of cost control. The following information is
available for the year ended 30th September, 2011
Budget: Production for the year 12,000 units
Standard cost per unit:
Shs
Direct material (3kg at sh 10 per kg
30
Direct labour (4 hours at sh 6 per hour) 24
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Overheads ( 4 hours at sh 2 per hour)

8
Standard cost
62
Actual results :
Actual production for year: 11,500 units
Materials:37,250 kg at a total cost of shs 345,000
Labour: 45.350 Hours at a total cost of shs 300,000
Required : Material and labour cost variances.
Solution
Material cost variances:
Price variance =AQ (AP-SP)=37,250 kg(9.26-10)=345,00-372,500= sh 27,500F
Usage variance =SR(AQ-SQ)=sh 10 ( 37,250-34,500)=sh27,500A.
Labour cost variances:
Rate variance= AH( AR-SR)=45,350 Hrs ( 6.61-6)=shs 300,000-272,100=sh27,900 A
Efficiency variance= SR ( AH-SH)= sh 6( 45,350-46,000) =sh 3,900 F.
2 Jumba manufacturers Ltd produces single product for sale in the local market. The company
uses standard costing to control its operations. The standard cost per unit of the product is as
follows:
shs
Direct materials ( 4 litres @ sh12 )
48
Direct labour ( 3hours @ sh10)
30
Variable factory overheads (3hours @sh 6) 18
96
During the month of June, 2010, 12,000 units were produced and the following costs incurred:
Material purchases : 55,000 Litres @ sh 11 per litre
Direct labour (36,800 hours ) : total cost shs 360,000
Variable factory overheads: shs 202,000
Raw material stocks were : Beginning 6,000 litres and ending 12,200 litres.
Required :
a) material price and usage variance.
b) Labour rate and usage variance
c) Total variable factory overhead variance
d) Explain the possible causes of each of the above variances.
Solution
amaterial cost variances:
Price variance= AQ (AP-SP)= 55,000 ( sh 11-12 ) =sh 5,500 F
Usage variance = SP (AQ-SQ)= sh 12 ( 48,800-48,000)=sh 9,600A
b Labour cost variances
Rate variance= AH (AR-SR)= 36,800 ( sh 9.78-10)= sh 360,000-368,000)=sh 8,000F
Efficiency variance= SR( AH-SH )= sh 10( 36,800-36,000)=sh 8,000A.
C Total variable overhead variance= Actual variable overheads charged-( VOAR Actual output)
= sh 202,000-1812,000= sh 202,000-216,000= sh 14,000 F
d)
Causes of material and labour cost variances (refer text)
Causes of variable overhead variances:

Savings in costs incurred

More economical use of services

Efficiency in labour force work

Overtime

Machine breakdowns, strikes, labour shortages

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3The production manager of Viwandani Ltd has given a weekly budget the machining section as
follows:
Day work ( 40 hours)
Four skilled operatives
160
Ten semi-skilled operatives
400
560
Production: Product X 330 units at 1 hour each
Product Y 460 units at hour each
Wage rates are sh 50 and sh 36 for skilled and semi-skilled workers respectively.
The actual results for a week were as follows:
Five skilled and nine semi-skilled workers were paid shs 23,600 for a 40-hour week.
.Production was 300 of product X and 440 of product Y. There was a power blackout for 2 hours
which disrupted production.
Required : Calculate the direct labour variances for the week.
Solution
Labour rate variance=Actual cost-Actual hrs standard rate= sh23,600-56040=23600-22400= sh
1,200A.
Labour efficiency variance= Standard rate( Actual hrs worked-standard hours)=Sh 40( 560-520)=sh
1,600 A.
Budgeted wages= 160shs 50 + 400sh 36= sh 22,400.
Budgeted standard hours= 330 1hr + 460 hr= 560 hours.
Standard rate= sh 22,400560 hrs= sh 40 per hr.
Standard hours=3001 hr + 440 hr= 520 hours.
Idle time variance= idle time standard rate= 14 2hrs sh 40= sh 1,120.
4 A manufacturing company engages 200 artisans at the rate of sh 60 per hour in its production
department. A 42-hour working week is in operation an there are 4 weeks in January .The standard
performance is set at 60 units per hour.
During February, 182 artisans were paid at a standard rate of sh 60 per hour, but 10 artisans were
paid sh 62.50 per hour, while 8 artisans were paid at sh 57.50 per hour. The factory production was
disrupted for2 hours due to a power failure. Actual output was 10,100 units in the month.
Required: Labour cost variances.
Solution
Direct wages rate variance= AH (AR-SR)= 1,680( 62.5-60) + 1344(57.5-60)= sh 4,200 A + 3,360F=sh
840A
Direct wages efficiency variance =SR (AH-SH)= sh 60 ( 33,200-33,667 )= sh 28,000 F.
Idle time variance= idle time standard rate=2002 hours sh 60 sh 24,000A.
Actual hours worked= 200 artisans 166(168-2) hours = 33,200 hours.
Rate variance occurs when actual rate differs from standard ie 10 artisans 42 hrs4 weeks=1680
hours and 8 employees 42 hours 4 weeks=1,344 hours. Actual quantity=10,100 units.
Standard hours= Number of men Quantity produced=
Standard quantity per hour
= (20010,100)/60= 33,667 hours.
Actual hours worked per artisan= 42 hours 4 weeks= 168 hours less 2hours stoppage=166 hours
5 The standard cost for a unit of product of an item is given as follows:
Material: 1 kg @ sh 4 per kg
Labour: 1 hour @ sh 8 per hour
Variable overheads: sh 48,000 for budget period.
Fixed overheads: sh 24,000 for budget period.
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Output: 24,000 units.

Actual results:
Actual production: 2,000 units
Materials:3,000 kg @ sh 3.50 per kg
Labour : 2,400 hours @ sh 8.50 per hour
Variable overheads: sh 5,000
Fixed overheads: sh 4,000.
Time worked : 2,300 hours.
Required:
aPrepare a standard cost card for 2,000 units.
bCalculate I material cost variances
ii Labour cost variances
iii Total variable cost variance
iv Total fixed cost variance
solution
a Standard cost card (based on 2,000 units):
sh
Material : 1kg @ shs 4
sh 4@2000 units
8,000
Labour :1hr @ sh8
sh 8@2,000 units
16,000
Variable overheads (sh 48,000/24,000 ) sh 2 @2,000 units 4,000
Fixed overheads ( sh 24,000/24,000) sh 1 @2,000 units
2,000
Standard cost
sh 15 @ 2,000 units 30,000
b Material cost variances:
Price variance= AQ (AP-SP) =3000 (sh3.5-4.0) =sh 3,000 F
Usage variance = SP (AQ-SQ) = sh 4 (3,000-2,000)= sh 4,000 A
Material cost variance= sh 3,000 F+4,000 A = sh 1,000 A
c Labour cost variances:
Rate variance= AH ( AR- SR)= 2,400 ( sh 8.5-8.0)= sh 1,200A
Efficiency variance = SR (AHW-SH)=sh 8.50 ( 2,300-2,000)=sh 2,550 A
Idle time variance= SR (AH-AHW)= sh 8.50 ( 2,400-2,300)= sh 850 A
Total Labour cost variance= sh 1,200A + 2,550 A +850 A= sh 4,600 A.
AHW= Actual hours worked.
AH=Actual hours paid.
d Total variable overhead variance= Actual variable ohds- VOAR@ Actual output
= sh 5,000- sh2 @ 2000=sh5,000-4,000 =sh 1,000 A
e Total fixed overhead variance= Actual fixed ohds- FOAR @Actual output
= sh 4,000- sh 1 @ 2000 = sh 4,000-2,000= sh 2,000 A

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3 J.Wald (1984), Biggs cost Accounts, 11e, Pitman Publishing Ltd
4L.W.J Owler and J.L Brown, Wheldons cost accounting and costing methods
5Harrold Bierman Jr, Thomas R. Dyckman, Managerial cost Accounting
6Edward J blocher,Kung H.Chen, Gary Cokins, Thomas w.Lin (2005) Cost management: A strategic
emphasis 3rd Edition, Mc Graw-Hill
7Ray H. Garrison, Eric W. Noreen, G Richard Chesley, Raymond F Carrol , Managerial accounting:
Concepts for Planning, control and Decision making,Times Tower Professional Publishing , Irwin.
8Collin Drury (1990) management and cost accounting, 2rd
Edition, Chapman and Hall
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