Management Information Certificate Level Unlocked

The Institute of Chartered Accountants of Bangladesh
MANAGEMENT
INFORMATION
Professional Stage Knowledge Level
Paper 4
www.facebook.com/cainbd
Study Manual
www.icab.org.bd
Management Information
The Institute of Chartered Accountants of Bangladesh Professional Stage
These learning materials have been prepared by the Institute of Chartered Accountants in England and Wales
ISBN: 978-1-84152-636-2
First edition 2009
All rights reserved. No part of this publication may be reproduced or

transmitted in any form or by any means or stored in any retrieval system, or
transmitted in, any form or by any means, electronic, mechanical, photocopying,
recording or otherwise without prior permission of the publisher.
© The Institute of Chartered Accountants in England and Wales, March 2009

ICAB President Welcome
© The Institute of Chartered Accountants in England and Wales, March 2009 iii
iv © The Institute of Chartered Accountants in England and Wales, March 2009
Contents
Page
 Introduction vii
 Specification grid for Management Information viii
 The learning materials ix
 Study guide x
 Getting help xvii
 Syllabus and learning outcomes xviii
1 The fundamentals of costing 1
2 Calculating unit costs (Part 1) 25
3 Calculating unit costs (Part 2) 47
4 Marginal costing and absorption costing 79
5 Pricing calculations 103
6 Budgeting 127
7 Cash budgets and the cash cycle 161
8 Performance management 181
9 Standard costing and variance analysis 219
10 Breakeven analysis and limiting factor analysis 247
11 Investment appraisal techniques 277
 Sample paper questions 311
 Sample paper answers 327
 Appendix 345
© The Institute of Chartered Accountants in England and Wales, March 2009 v

vi © The Institute of Chartered Accountants in England and Wales, March 2009
INTRODUCTION
1 Introduction
1.1 What is Management Information and how does it fit within the
Professional Stage?
Structure
The syllabus has been designed to develop core technical, commercial, and ethical skills and knowledge in a
structured and rigorous manner.
The diagram below shows the fourteen modules at the Professional Stage, where the focus is on the
acquisition and application of technical skills and knowledge, and the Advanced Stage which comprises three
technical modules and the Case Study.
The knowledge base

The aim of the Management Information module is to enable students to prepare essential financial
information for the management of a business.
Progression to application level
The knowledge base that is put into place here will be taken further in a number of application modules, in
particular the Financial Management and Business Strategy modules. The student’s basic understanding of
forecasting and monitoring cash flows will be built upon in Financial Management, where the student will
learn to identify and manage a business’s capital requirements. The knowledge of basic investment appraisal
techniques will provide a firm foundation for progression into the more advanced aspects of investment
appraisal such as taxation, inflation and risk, within Financial Management at the application level. The
understanding acquired of the use of cost and management information to plan and control a business’s
activities will underpin the student’s studies of the Business Strategy syllabus, where the aim will be to
provide students with an understanding of how businesses develop and implement strategy.
Progression to advanced stage
The advanced stage papers then take things further again. The underpinning knowledge acquired in the
student’s study of Management Information is particularly important in planning and strategic decisions.
Students will be able to apply and build on their management accounting knowledge to, among other things,
© The Institute of Chartered Accountants in England and Wales, March 2009 vii
Management information
undertake business analysis, develop performance management approaches and assess and advise on
appropriate costing and pricing approaches for business.
The above illustrates how knowledge of the principles of effective management information gives a platform
from which a progression of analytical and decision making expertise is developed.
1.2 Services provided by professional accountants

Professional accountants should be able to:
 Establish the costs associated with the production of products and provision of services and use them
to determine prices
 Select appropriate budgeting approaches and methods and prepare budgets
 Identify key features of effective performance management systems, select appropriate performance
measures and calculate differences between actual performance and standards or budgets
 Identify and calculate relevant data for use in management decision making.
2 Specification grid for Management Information

2.1 Module aim
To enable students to prepare essential financial information for the management of a business.
2.2 Specification grid

This grid shows the relative weightings of subjects within this module and should guide the relative study
time spent on each. Over time the marks available in the assessment will equate to the weightings below,
while slight variations may occur in individual assessments to enable suitably rigorous questions to be set.
Weighting (%)
1 Costing and pricing 25
2 Budgeting and forecasting 25
3 Performance management 25
4 Management decision making 25
100
viii © The Institute of Chartered Accountants in England and Wales, March 2009
INTRODUCTION
3 The learning materials

You will find the learning materials are structured as follows:
 Title page
 Contents page
 Introduction. This includes
– A review of the subject to set the context
– A list of the top level learning outcomes for this subject area entitled 'Services provided by
professional accountants' (set with reference to what a newly qualified accountant would be
expected to do as part of their job)
 The specification grid for Management Information
 Title page a brief note about the learning materials
 Study Guide. This includes
– Hints and tips on how to approach studying for your ACA exams
– Guidance on how to approach studying with this study manual
– A detailed study guide suggesting how you should study each chapter of this study manual and
identifying the essential points in each chapter
 Information on how to obtain help with your studies
 The detailed syllabus and learning outcomes
Each chapter has the following components:
 Introduction
– Learning objectives
– Practical significance
– Stop and think
– Working context
– Syllabus links
 Examination context
– Exam requirements
– Examiner's comments on how students tackle questions
 Chapter topics
 Summary and Self-test
 Answers to Self-test
 Answers to Interactive questions
The study guide below explains how each part of the chapter is useful in preparing you for the exam.
© The Institute of Chartered Accountants in England and Wales, March 2009 ix

4 Study guide
4.1 Help yourself study for your ACA exams
Exams for professional bodies such as ICAB are very different from those you have taken at college or
university. You will be under greater time pressure before the exam – as you may be combining your
study with work. Here are some hints and tips.
The right approach

1 Develop the right attitude
Believe in yourself Yes, there is a lot to learn. But hundreds have succeeded
before and you can too.
Remember why you're doing it You are studying for a good reason: to advance your career.
2 Focus on the exam
Read through the Syllabus and These tell you what you are expected to know and are
Study Guide supplemented by Examination context sections in the
text.
3 The right method
See the whole picture Keeping in mind how all the detail you need to know fits into
the whole picture will help you understand it better.
 The Introduction of each chapter puts the material in
context.
 The Learning objectives, Section overviews and
Examination context sections show you what you
need to grasp.
Use your own words To absorb the information (and to practise your written
communication skills), you need to put it into your own
words.
 Take notes.
 Answer the questions in each chapter.
 Draw mindmaps.
 Try 'teaching' a subject to a colleague or friend.
Give yourself cues to jog your The Study Manual uses bold to highlight key points.
memory
 Try colour coding with a highlighter pen.
 Write key points on cards.
4 The right recap
Review, review, review Regularly reviewing a topic in summary form can fix it in your
memory. The Study Manual helps you review in many ways.
 The Chapter summary will help you to recall each
study session.
 The Self-test actively tests your grasp of the essentials.
 Go through the Examples in each chapter a second or
third time.
x © The Institute of Chartered Accountants in England and Wales, March 2009

INTRODUCTION
4.2 Study cycle

The best way to approach this Study Manual is to tackle the chapters in order. We will look in detail at how
to approach each chapter below but as a general guide, taking into account your individual learning style,
you could follow this sequence for each chapter.
Key study steps Activity
Step 1 This topic list is shown in the contents for each chapter and helps you navigate
Topic list each part of the book; each numbered topic is a numbered section in the chapter.
Step 2 This sets your objectives for study by giving you the big picture in terms of the
Introduction context of the chapter. The content is referenced to the Study guide, and
Examination context guidance shows what the examiners are looking for. The
Introduction tells you why the topics covered in the chapter need to be studied.
Step 3 Section overviews give you a quick summary of the content of each of the main
Section chapter sections. They can also be used at the end of each chapter to help you
overviews review each chapter quickly.
Step 4 Proceed methodically through each chapter, particularly focussing on areas
Explanations highlighted as significant in the chapter introduction or study guide.
Step 5 Take brief notes, if you wish. Don't copy out too much. Remember that being
Note taking able to record something yourself is a sign of being able to understand it. Your
notes can be in whatever format you find most helpful; lists, diagrams, mindmaps.
Step 6 Work through the examples very carefully as they illustrate key knowledge and
Examples techniques.
Step 7 Check yours against the suggested solutions, and make sure you understand any
Answers discrepancies.
Step 8 Review it carefully, to make sure you have grasped the significance of all the
Chapter summary important points in the chapter.
Step 9 Use the Self-test to check how much you have remembered of the topics
Self-test covered.
Step 10 Attempt the question(s) relating to this chapter in the Revision Question Bank.
Question practice
Moving on...
When you are ready to start revising, you should still refer back to this Study Manual.
 As a source of reference.
 As a way to review (the Section overviews, Examination context, Chapter summaries and Self-test
questions help you here).
Remember to keep careful hold of this Study Manual – you will find it invaluable in your work. The technical
reference section has been designed to help you in the workplace by directing you to where you can find
further information on the topics studied.
© The Institute of Chartered Accountants in England and Wales, March 2009 xi

4.3 Detailed study guide

Use this schedule and your exam timetable to plan the dates on which you will complete each study period
below:
Study Approach Essential Points Due

Period Date
1 Read quickly through section 1 of Chapter The difference between cost

1 to set cost accounting in context. Spend accounting and financial
more time making sure that you accounting
understand the basic concepts in section 2.
The definitions of a cost object
Learn the two definitions in section 3.
and a cost unit
Once you have read through section 4
practice drawing all of the cost behaviour Direct v indirect costs
patterns you have learned about. Skim
Fixed, variable and semi-variable
through section 5 and learn the definitions.
costs
You will meet all of these concepts again in
Chapter 8. Finally work through the self- Controllable and uncontrollable
test questions carefully to ensure that you costs
have grasped the main points in the
chapter.
2 Read quickly through section 1 of Chapter Direct v indirect costs
2 to reinforce your understanding of direct
FIFO, LIFO, Weighted average
and indirect costs. Spend a little more time
pricing:
thinking about each item in interactive
question 1 and use this to test whether you  Effect on inventory valuation
really understand the concepts.
 Effect on profit
Section 2 of this chapter is very important
 Effect on issue prices
and requires you to be actively involved.
Do not just skim over all the workings. Get  Advantages and
a calculator and check that you understand disadvantages of each
where each figure in the tabulations comes
from. Find a method of laying out the
calculations that works for you. Although
you won’t receive marks for workings in
the actual exam you will need to use a
clear layout to achieve the necessary 100
per cent accuracy.
Finally work through the self-test questions
at the end of the chapter.
xii © The Institute of Chartered Accountants in England and Wales, March 2009
INTRODUCTION

Period Date
3 Chapter 3 contains a lot of very important Cost apportionment

material. Read quickly through sections 1.1
Calculating and applying overhead
and 1.2. In section 1.3 skim through
absorption rates
interactive question 1 and then give the
worked example extra attention. Check Calculating under and over
that you understand the derivation of all of absorbed overheads
the figures in the final table. Think about
ABC: cost drivers, cost pools
the apportionment of service cost centre
costs: why it is necessary and how it is Job costing, batch costing,
done. Work carefully through the worked contract costing, process costing:
example. the difference between the
methods and when each is
Section 1.4 is of vital importance. The
appropriate
techniques and principles that you learn
here will arise a number of times Life cycle costing
throughout this syllabus so you must get a
Target costing
firm grasp of them before you continue.
Work carefully through the example and Just in time
interactive question.
Read quickly through section 1.5 and then
give section 1.6 extra attention. Students
often find the calculation of under and over
absorption difficult so spend the time
necessary to gain a good understanding of
this topic.
Read section 2 quickly and ensure that you
know the difference between activity based
costing (ABC) and traditional absorption
costing. Learn what is meant by a cost
driver and a cost pool. Skim through the
worked example to reinforce your
understanding of the difference between
the two methods and the overhead costs
that might be derived from each.
Read quickly through section 3 and make
notes about the different costing methods
and when each is most appropriate. Try
Interactive question 7 to ensure you have
understood the principles covered.
Read quickly through section 4, paying
particular attention to the diagrams which
are a good way of fixing the principles in
your mind.
Lastly, study the summary carefully to
ensure you have absorbed all the material
in this important chapter. Then try all the
self-test questions.
© The Institute of Chartered Accountants in England and Wales, March 2009 xiii

Period Date
4 Skim through section 1 of chapter 4 but Contribution

spend some time thinking about the
Different accounting treatment
conclusions in section 1.3 and ensuring you
applies to fixed production
have absorbed the points made. Learn the
overheads only
quick calculation method described in this
section. Use the worked example in Advantages and disadvantages of
section 2 to reinforce your learning from marginal and absorption costing
Chapter 3 and to compare the two costing
Reconciliation of reported profits
systems.
with the two systems
Work through all the examples, learn the
advantages of each system and lastly try all
the self-test questions.
5 Read quickly through sections 1 and 2 of Advantages and disadvantages of
Chapter 5 and learn the advantages and cost-plus pricing
disadvantages of full cost-plus and marginal
Mark-ups and margins and the
cost-plus pricing.
difference between them
Section 3 looks deceptively straightforward
The behavioural impact of transfer
but you should devote a sufficient amount
prices: goal congruence and sub-
of time to understanding the difference
optimal decisions
between mark up and margin. Many
students get the principle wrong in the
exam so ensure that you try interactive
question 2.
Learn the aims of a transfer pricing system
and work through all the material about
the behavioural impact of transfer prices.
Lastly try all the self-test questions.
6 Read sections 1 and 2 of Chapter 6 to put The link between budgeting and
budgeting into context in your mind. Study standard costing
the order of budget preparation and work
High-low method
carefully through the worked example in
section 3.3. Spend some time thinking Measures of correlation and their
about the link between budgeting and interpretation
standard costing because this is an
Mechanics, advantages and
important issue. In section 4 think about
disadvantages of different
how all the functional budgets provide the
approaches to budgeting
basic data for the master budget. The high-
low method in section 5 is a very
important technique that you must practice
several times. It could arise in the context
of various types of question, not just those
on budgeting. Ensure that you understand
all the measures of correlation and how to
interpret them. Read section 6 carefully
and commit to memory the advantages and
disadvantages of the different approaches
to budgeting.
Lastly try all the self-test questions, reading
all the narrative questions particularly
carefully.
xiv © The Institute of Chartered Accountants in England and Wales, March 2009
INTRODUCTION

Period Date
7 The content of section 1 of Chapter 7 is Calculating the cash operating

relatively straightforward but ensure that cycle
you test your knowledge as you go by
Calculating and interpreting
working carefully through the worked
liquidity ratios
examples and interactive questions in
section 2. Learn all of the formulae
required to calculate the cash operating
cycle and to assess the liquidity position of
a business.
Try all of the self-test questions to ensure
that you have absorbed all the material in
the chapter.
8 Read carefully through section 1 of The behavioural impact of
Chapter 8, paying particular attention to performance measurement
the behavioural impact of performance
Controllability principle
measurement. In section 2 learn the
advantages and disadvantages of ROI and RI: their calculation,
decentralisation and the features of the behavioural impact and advantages
four types of responsibility centre. Focus and disadvantages
particularly on the controllability principle.
Flexible budgets: preparation and
Learn all of the formulae in section 3 and
interpretation
work carefully through the interactive
questions and worked examples. Read
quickly through section 4 and then use
interactive question 3 to ensure you have
understood the main principles. Section 5
contains some very important information.
Read it carefully and practice all the
examples. You will need a thorough
understanding of flexible budgets when you
move on to Chapter 9.
Work carefully through all of the self-test
questions.
© The Institute of Chartered Accountants in England and Wales, March 2009 xv


Period Date
9 Read quickly through section 1 of Chapter Marginal cost variances and sales
9 to place standard costing in context. variances: calculation and
Section 2 is very practical and contains a interpretation
lot of important information. You need to
Working backwards from variance
be able to calculate all of the variances
information to derive actual data
quickly and accurately so do not be
tempted to skim the workings. Try
calculating each variance before working
through the solution provided. Learn the
calculation of the sales variances in section
3 and try Interactive question 1. This will
enable you to check that you can calculate
all of the variances and give you practice at
preparing an operating statement. Study
the table in section 4 to get an idea of the
range of possible causes of a variance.
Work carefully through the example in
section 4.3 because questions that work
backwards from variance information to
derive the actual results are a common way
of testing variance analysis in an exam.
Finally, try all of the self-test questions,
make a note of any questions that you get
wrong and try them again after a day or
two.
10 Chapter 10 is another practical chapter Calculating the breakeven point,
which requires active participation from the margin of safety and the level
you. In section 1 learn the formulae for of activity required for a target
calculating the breakeven point, the profit
contribution ratio and the margin of safety.
Calculating the effect of changes in
Work through all the examples carefully,
decision variables
trying to produce your own answer before
looking at the solution. Study the labels on Interpreting a breakeven chart
the breakeven charts in section 2 and make
Limitations of breakeven analysis
sure that you know how to read
information from the chart. In section 3 Decision rule for a single limiting
learn the series of steps required to factor situation
maximise contribution in a limiting factor
Decision rule for a single limiting
situation. Section 3.4 is particularly
factor situation with an
important because a make or buy decision
outsourcing option
with scarce resources often causes
difficulty for students. A definite decision
rule is stated before the worked example.
Memorise the decision rule and then apply
it to the data in the example before you
look at the solution.
Lastly try all of the self-test questions.
xvi © The Institute of Chartered Accountants in England and Wales, March 2009
INTRODUCTION

Period Date
11 Read quickly through section 1 of Chapter Discounted cash flow techniques

11 and then read section 2 about the
Comparing the IRR and NPV
payback period. Calculation of the payback
period should not cause you too many Payback method
problems but make sure that you know the
Calculating the ARR
advantages and disadvantages of this
appraisal method. In section 3 learn both
formulae for calculating the ARR, practice
their application in the worked example
and study the method’s advantages and
disadvantages. Section 4 is very important
and explains a number of techniques and
their advantages and disadvantages. It is
crucial that you work carefully through all
the examples and narrative information in
this section. Study all of the graphs in
section 5 and learn the formula for
calculating the IRR. In section 5.7 use the
Interactive question to practice sketching
NPV profiles. This is a useful technique
which might come in handy in the exam.
Although you would not be required to
produce a sketch you might need to be
able to do so for your own workings in
order to select the correct option in a
multiple choice question.
Finally work carefully through all of the
self-test questions.
Revision phase
Your revision will be centred around using the questions and revision guidance in the ICAB Revision
Question Bank.
5 Getting help
Firstly, if you are receiving structured tuition, make sure you know how and when you can contact your
tutors for extra help.
Identify a work colleague who is qualified, or has at least passed the paper you are studying for, who is
willing to help if you have questions.
Form a group with a small number of other students, you can help each other and study together, providing
informal support.
© The Institute of Chartered Accountants in England and Wales, March 2009 xvii
6 Syllabus and learning outcomes

Covered in
1 Costing and pricing chapter
Candidates will be able to establish the costs associated with the production of
products and provision of services and use them to determine prices.
In the assessment, candidates may be required to:
(a) Recognise the use of cost information for different purposes 1
(b) Classify costs as fixed, variable, direct or indirect 1
(c) Calculate unit costs from information provided, using: 2, 3, 4
 Direct costing
 Absorption costing
and reconcile the differences between the costs obtained
(d) Select the most appropriate method of costing for a given product or service 3
(e) Calculate the sales price for a given product or service using cost based pricing 5
(f) Calculate transfer prices for specified sales to internal customers which take 5
account of appropriate costs.
2 Budgeting and forecasting

Candidates will be able to select appropriate budgeting approaches and
methods and prepare budgets.
(a) Apply forecasting techniques to assist management in performance measurement 6
and planning
(b) Prepare budgets, or extracts therefrom, from information supplied 6
(c) Select the most appropriate of the following budgeting approaches and methods, 1, 6
taking into account their advantages and disadvantages for planning, control and
motivation:
 Bottom-up and top-down approaches to generating and managing budgets
 Activity-based, responsibility-based and product-based budget structures
 Zero-based and incremental budgeting
(d) Prepare a cash budget for a business which highlights the quantity and timing of cash 7
surpluses and deficits
(e) Calculate the cash cycle for a business and recognise its significance 7
(f) Recognise how a business manages surpluses and deficits predicted in cash budgets. 7
3 Performance management
Candidates will be able to identify key features of effective performance
management systems, select appropriate performance measures and calculate
differences between actual performance and standards or budgets.
In the assessment, candidates may be required to: 8
(a) Identify the reasons for and key features of effective performance management 8
systems
xviii © The Institute of Chartered Accountants in England and Wales, March 2009
INTRODUCTION
Covered in
chapter
(b) Select appropriate financial and non-financial performance measures which 8
effectively encourage the business as a whole to meet its objectives
(c) Identify the role of controls in ensuring effective performance management 8
(d) Identify how performance measures and compliance measures are integrated into 8
the general systems of control in businesses
(e) Calculate differences between actual performance and standards or budgets in 8, 9
terms of price and volume effects and identify possible reasons for those differences
(f) Calculate and reconcile profits under direct, absorption or marginal costing. 4
4 Management decision making

Candidates will be able to identify and calculate relevant data for use in
management decision making.
(a) Calculate the break even point, contribution and margin of safety for a given 10
product or service
(b) Allocate scarce resource to those products or services with the highest 10
contribution per limiting factor
(c) Calculate the net present value, internal rate of return, payback period or 11
accounting rate of return for a given project
(d) Identify the advantages and disadvantages of the investment appraisal techniques 11
specified in 4(c) above.
© The Institute of Chartered Accountants in England and Wales, March 2009 xix
xx © The Institute of Chartered Accountants in England and Wales, March 2009

chapter 1
The fundamentals of costing
Contents
Introduction
Examination context
Topic List
1 What is cost accounting?
2 Basic cost accounting concepts
3 Cost classification for inventory valuation and profit measurement
4 Cost classification for planning and decision-making
5 Cost classification for control
Summary and Self-test
Answers to Self-test
Answers to Interactive questions
© The Institute of Chartered Accountants in England and Wales, March 2009 1

Introduction
Learning objectives Tick off

 Understand the concept of cost, and how cost information can be used for different purposes
 Understand different cost classifications and the meaning and use of fixed, variable, direct and
indirect costs
 Classify costs as fixed, variable and semi-variable (or semi-fixed) and recognise where each
can be used in decision making
The specific syllabus references for this chapter are: 1a, b, 2c.
Practical significance
All businesses, including sole traders, partnerships and companies incur costs every day. Accounting systems
can be set up to record the amount of expenditure incurred on different types of cost, such as rent, power
(gas and electricity) and salaries.
Such systems can include methods for business managers to obtain the information they need to manage
the business on a day-to-day basis. For example, providing detailed answers to questions such as the
following.
 What did it cost to provide a particular service to a particular client?
 What price should be tendered for a contract?
 What is the cost of operating different departments each period?
 How much sales revenue is generated by a particular product?
 Are the actual costs incurred on a particular activity higher or lower than the planned costs?
The aim of the cost accounting system within an overall accounting system is to provide the information
that helps to answer these and similar questions. The cost accounts form the basis of the internal
management accounting information that managers will use for planning, control and decision-making.
Stop and think

Why do you think that management accounting is an internal service for a business's managers? Why are
management accounts not usually distributed to interested parties outside the business?
Working context
You will come across cost classifications in a variety of contexts in your working life. For example, when
inventories are being valued it is important to be able to identify which costs are direct costs of the
inventory items and which are indirect costs and cannot be attributed to the inventory items. Correct cost
classification is fundamental to the determination of the cost of any cost object.
Syllabus links
An understanding of how costs may be classified in different ways according to the purpose of the
information being prepared is fundamental to this syllabus and underpins many of the learning objectives. It
also has links to the Accounting syllabus in the context of understanding how costs are classified for the
purposes of inventory valuation and profit measurement.
2 © The Institute of Chartered Accountants in England and Wales, March 2009

THE FUNDAMENTALS OF COSTING 1
Examination context
Exam requirements
Many of the fundamental aspects of costing covered in this chapter do not lend themselves easily to
numerical objective test questions.
Therefore, you are more likely to see the majority of these subjects in narrative questions. For example,
you might be required to pick out correct definitions or statements from a number of statements supplied
in a question, or you might have to identify an appropriate cost unit from a number of suggestions for a
particular organisation to use as the basis of its accounting system.
In the examination, candidates may be required to:
 Understand the purpose of a cost unit
 Classify costs as fixed, variable and semi-variable (or semi-fixed)
 Understand what is meant by the elements of cost
 Understand the difference between a direct cost and an indirect cost, between a controllable cost and
an uncontrollable cost and between a product cost and a period cost
Knowing the various definitions is fundamental to answering questions in this area. For example it is
essential to determine the 'cost object' in a question (ie the thing being costed), in order to determine
whether costs are direct or indirect as regards that cost object.

1 What is cost accounting?
Section overview
 The management information system provides information to assist management with planning,
control and decision-making.
 In general terms, financial accounting is for external reporting whereas cost and management
accounting is for internal reporting.
 The financial accounting and cost accounting systems both record the same basic data but each set of
records may analyse the data in a different way. Ultimately, financial results from both systems can,
and should be, reconciled with each other.
1.1 The cost accountant

The cost accountant or a person having access to cost information should be able to provide the answers
to questions such as the following.
 What was the cost of goods produced or services provided last period?
 What was the cost of operating a department last month? All are historical
 What revenues were earned last week? cost
Knowing about costs incurred or revenues earned enables management to do the following.
 Assess the profitability of a product, a service, a department, or the whole organisation.
 Determine appropriate selling prices with due regard to the costs of sale and target profit margins.
 Put a value on inventory (whether raw materials, work in progress, or finished goods) that is still
held at the end of a period, for preparing a balance sheet of the company's assets and liabilities, and
determining the cost of materials (goods) used or sold in a period.
These are all historical questions. The cost accountant also needs to provide information to help provide
forecasts or estimates for the future, such as:
 What are the future costs of goods and services likely to be?
 What information does management need in order to make sensible decisions about future profits and
costs?
 What financial resources will be needed to fund future growth or activities?
1.2 Cost accounting and management accounting

Originally cost accounting dealt with ways of accumulating historical costs and of charging these costs to
units of output, or to departments, in order to establish inventory valuations, profits or losses and balance
sheet items. It has since been extended into planning, control and decision making, so that the cost
accountant is now able to answer both sets of questions in section 1.1 above. In today's environment the
role of cost accounting in the provision of management information is therefore almost indistinguishable
from that of management accounting, which is basically concerned with the provision of information to
assist management with planning, control and decision making.
1.3 Cost accounting systems

The managers of a business have responsibility for planning and controlling the resources used. To carry out
this task effectively they must be provided with sufficiently accurate and detailed information, and the
cost accounting system should provide this. Indeed, a costing system provides the foundations for an
organisation's internal financial information system for managers.

Cost accounting systems are not restricted to manufacturing operations.

 Cost accounting information is also used in service industries, government departments and not-for-
profit organisations, including charities.
 Within a manufacturing organisation itself, the cost accounting system should be applied not only to
manufacturing operations but also to administration, selling and distribution, research and
development and so on.
Cost accounting is concerned with providing information to assist the following.
 Establishing inventory valuations, profits or losses and balance sheet items
 Planning (for example the provision of forecast costs at different activity levels)
 Control (such as the provision of actual and standard costs (see Chapter 9) for comparison purposes)
 Decision making (for example, the provision of information about actual unit costs for the period
just ended for pricing decisions).
1.4 Financial accounting versus cost accounting

The financial accounting and cost accounting systems in a business both record the same basic data for
income and expenditure, but each set of records may analyse the data in a different way. This is because
each system has a different purpose.
 Financial accounts are usually prepared for stakeholders external to an organisation, eg
shareholders, banks, customers, suppliers, HM Revenue and Customs and employees.
 Management accounts are usually prepared for internal managers of an organisation.
The data used to prepare financial accounts and management accounts are the same. The differences
between the financial accounts and the management accounts arise because the data is usually analysed
differently.
Financial accounts Management accounts

Financial accounts detail the performance of an Management accounts are used to aid management to
Definition organisation over a defined period, including its record, plan and control the organisation's activities
cash flows and the state of affairs at the end of and to help the decision-making process.
that period.
Regulation to In Bangladesh, limited companies must, by law, There is no legal requirement to prepare management
prepare accounts prepare financial accounts. accounts.
The format of published financial accounts is The format of management accounts is entirely at
Rules to prepare determined by IFRS, relevant Acts and Rules as management discretion: no strict rules govern the way
accounts applicable. In theory the accounts of different they are prepared or presented. Each organisation can
organisations can therefore be easily compared. devise its own management accounting system and
format of reports.
Financial accounts often concentrate on the Management accounts can focus on specific areas of an
business as a whole, aggregating revenues and organisation's activities such as operating departments,
costs from different operations, and are wholly individual sites or business streams. Information may be
historical. Financial accounts are usually historical produced to aid a decision rather than to be an end
product of a decision. Management Accounts usually prepared
for aiding a decision
Most financial accounting information is of a Management accounts incorporate non-monetary
monetary nature. measures. Management may need to know, for
example, tonnes of product produced, monthly
machine hours, or miles travelled by sales
representatives. These are often called 'Key
Performance Indicators'.
Financial accounts present an essentially Management accounts are both a historical record and
historical picture of past operations. a future planning tool, linking to budgets and forecasts.

2 Basic cost accounting concepts
Section overview
 A cost object is anything for which we are trying to ascertain the cost.
 Cost units are the basic control units for costing purposes.
 The term 'cost' can be used as a noun or as a verb.
 Costs need to be arranged into logical groups or classified in order to facilitate an efficient system for
collecting and analysing costs.
2.1 Functions and departments

An organisation, whether it is a manufacturing company, a provider of services (such as a bank or a hotel)
or a public sector organisation (such as a hospital), may be divided into a number of different functions,
within which there are a number of departments. A manufacturing organisation might be structured as
follows.
Board of directors
Production Administration Marketing
Mixing Baking Stores
Suppose the organisation above produces chocolate cakes for a number of supermarket chains. The
production function is involved with the making of the cakes, the administration department with the
preparation of accounts and the employment of staff and the marketing department with the selling and
distribution of the cakes.
Within the production function there are three departments, two of which are production departments
(the mixing department and the baking department), which are actively involved in the production of the
cakes, and one of which is a service department (stores department), which provides a service or back-up
to the production departments.
2.2 Cost objects
Definition
Find Out/ Discover
A cost object is anything for which we are trying to ascertain the cost.
Examples of cost objects include:

 A unit of product (eg a car)
 A unit of service (eg a valet service of a car)
 A department or function (eg the accounts department)
 A project (eg the installation of a new computer system)
 A new product or service (eg to enable the cost of development to be identified)

In the example above, cost objects could include:

 Individual chocolate cakes
 The administration function or mixing department
2.3 Cost units

Definition
A cost unit is the basic measure of product or service for which costs are determined.
Businesses are often interested in one particular cost object – the cost unit – and the cost per cost unit.
Determining the cost per cost unit can help with pricing decisions, which you will study in more detail in
Chapter 5.
Organisation Possible cost unit
Steelworks Tonne of steel produced
Tonne of coke used
Hospital Patient/day
Operation
Out-patient visit
Freight organisation Tonne/kilometre
Passenger transport organisation Passenger/kilometre
Accounting firm Audit performed
Chargeable hour
Restaurant Meal served
2.4 Composite cost units

Notice that some of the cost units in the above table are made up of two parts, for example the
patient/day cost unit for the hospital. These two-part cost units are known as composite cost units and
they are used most often in service organisations.
Composite cost units help to improve cost control. For example, the measure of 'cost per patient' might
not be particularly useful for control purposes. The cost per patient will vary depending on the length
of the patient's stay, therefore monitoring costs using this basis would be difficult.
The cost per patient/day is not affected by the length of the individual patient's stay. Therefore it would be
more useful for monitoring and controlling costs. Similarly, in a freight organisation the cost per
tonne/kilometre (the cost of carrying one tonne for one kilometre) would be more meaningful for
control than the cost per tonne carried, which would vary with the distance travelled.
Interactive question 1: Cost units [Difficulty level: Easy]

Identify which of the following cost objects would be suitable cost units for an hotel. Tick the boxes to
indicate which would be suitable.
Suitable cost unit
Bar
Restaurant
Room/night
Meal served
Conference delegate
Fitness suite
Conference room/day
See Answer at the end of this chapter.

2.5 The concept of cost

The term 'cost' can be used as a noun when describing the amount of money incurred in producing a
product: 'The cost to produce 100 units of product X last period was CU3,400'.
Alternatively, 'cost' can be used as a verb, for example when describing the act of determining the amount
of money incurred in operating a department: 'Please gather the information necessary to cost the quality
control activity'.
You will rarely see the word 'cost' used alone. Costs need to be classified in some way so that they
can be arranged into logical groups in order to facilitate an efficient system for collecting and analysing
costs.
As you work through this Study Manual you will encounter many different types of cost, each of which has
its usefulness and limitations in various circumstances.
2.6 Direct v indirect costs and cost objects

Direct costs are costs identified with a cost object. Indirect costs cannot be identified with a particular cost
object. For example if a chair is a cost object then certain costs such as materials and the labour required to
assemble the chair would be classed as direct costs for an individual chair. Factory rent could not be
associated with an individual chair so would be classed as an indirect cost of the chair. However, if the cost
object were the factory itself then the rent is a direct cost of the factory.
3 Cost classification for inventory valuation and profit

measurement
Section overview
 The total cost of a cost unit is usually made up of three cost elements: materials, labour and other
expenses. Each of these cost elements can be classified as direct costs or indirect costs.
 A direct cost can be traced in full to the cost unit that is being costed. Prime Cost/ Total Direct Cost
=
 The total direct cost (or 'prime cost') is the sum of the direct material cost + direct labour cost + Direct Material Cost
+
direct expenses. Direct Labor Cost
+
Other Direct Expenses
 An indirect cost (or overhead) cannot be traced directly and in full to the cost unit that is being
costed.
 Types of indirect cost (or overhead) include production overhead, administration overhead, selling
overhead and distribution overhead.
 Product costs are costs identified with goods produced or purchased for resale. These costs are
allocated to the value of inventory until the goods are sold.
 Period costs are costs deducted as expenses during a particular period. These costs are not regarded
as part of the value of inventory.
In this section we are only concerned with cost units (ie an individual job or unit of product or unit of
service) as the cost object.
3.1 Cost elements

For the purposes of inventory valuation and profit measurement, the cost of one unit must be determined.
The total cost of a cost unit of product or service is made up of the following three elements of cost.
 Materials
 Labour
 Other expenses (such as rent and rates, interest charges and so on)
Cost elements can be classified as direct costs or indirect costs as far as cost units are concerned.

3.2 Direct cost and prime cost

Definition
A direct cost is a cost that can be traced in full to the cost unit.
There are three types of direct cost.

 Direct material costs are the costs of materials that are known to have been used in making and
selling a unit of product (or providing a service). Examples are components and packing materials.
 Direct labour costs are the specific costs of the workforce used to make a unit of product or
provide a service. Direct labour costs are established by quantifying the cost of the time taken for a
job, or the time taken in 'direct production work'. For example, the wages paid to an employee sewing
buttons on a coat is a direct cost of that cost unit.
 Other direct expenses are those expenses that have been incurred in full as a direct consequence
of making a unit of product, or providing a service, or running a department. For example, the cost of
hiring a special machine for a job is a direct cost of that job.
Another term used to describe the total direct cost is prime cost.
Prime cost = total direct cost = direct material cost + direct labour cost + direct expenses
3.3 Indirect cost and overhead

Definition
Indirect cost (or overhead): A cost that is incurred which cannot be traced directly and in full to the
cost unit.
Examples of indirect costs, where the cost object is a unit of output, might be the cost of supervisors'
wages on a production line or cleaning materials and buildings insurance for a factory. These costs cannot
be traced directly and in full to the cost unit in question.
Total expenditure may therefore be analysed as follows.
Materials cost = Direct materials cost + Indirect materials cost
+ + +
Labour cost = Direct labour cost + Indirect labour cost
+ + +
Expenses = Direct expenses + Indirect expenses
Total cost = Direct cost/prime cost + Indirect cost/overhead
3.3.1 Production overhead

Production (or manufacturing or factory) overhead includes all indirect material costs, indirect wages and
indirect expenses incurred in the factory from receipt of the order until its completion, including:
 Indirect materials, which cannot be traced to units of the finished product.
– Consumable stores, eg material used in negligible amounts or across several different products
 Indirect wages, meaning all wages not charged directly to a unit of product.
– Salaries of non-productive personnel in the production department, eg supervisor
 Indirect expenses (other than material and labour) not charged directly to units of production
– Rent, rates and insurance of a factory
– Depreciation, fuel, power and maintenance of plant and buildings

3.3.2 Administration overhead

Administration overhead is all indirect material costs, wages and expenses incurred in the direction,
control and administration of an undertaking, including:
 Depreciation of office equipment
 Office salaries, including the salaries of secretaries and accountants
 Rent, rates, insurance, telephone, heat and light cost of general offices
3.3.3 Selling overhead

Selling overhead is all indirect materials costs, wages and expenses incurred in promoting sales and
retaining customers, including:
 Printing and stationery, such as catalogues and price lists
 Salaries and commission of sales representatives
 Advertising and sales promotion, market research
 Rent, rates and insurance for sales offices and showrooms
3.3.4 Distribution overhead

Distribution overhead is all indirect material costs, wages and expenses incurred in making the packed
product ready for despatch and delivering it to the customer, including:
 Cost of packing cases
 Wages of packers, drivers and despatch clerks
 Depreciation and running expenses of delivery vehicles
3.4 Product costs and period costs

For the preparation of financial statements, costs are often classified as either product costs or period Cost are identified
as=
costs. Product costs are costs identified with goods produced or purchased for resale. Period costs are 1. Product Cost
costs deducted as expenses during a particular period. 2. Period Cost
Consider a retailer who acquires goods for resale without changing their basic form. The only product cost
is therefore the purchase cost of the goods. Any unsold goods are held as inventory. The inventory is
valued at the lower of purchase cost and net realisable value, which is the valuation basis stipulated in
accounting standards, and included as an asset in the balance sheet. As the goods are sold, their cost
becomes an expense in the form of 'cost of goods sold'. A retailer will also incur a variety of selling and
administration expenses. Such costs are period costs because they are deducted from revenue without
ever being regarded as part of the value of inventory.
Now consider a manufacturing firm in which direct materials are transformed into saleable goods with the
help of direct labour and factory overheads. All these costs, even the factory overheads, are product costs
because they are allocated to the value of inventory until the goods are sold (See Chapter 3). As with the
retailer, selling and administration expenses are regarded as period costs.

4 Cost classification for planning and decision-making
Section overview
 Costs can be classified according to how they vary in relation to the level of activity.
 A knowledge of how the cost incurred varies at different activity levels is essential to planning and
decision-making.
 A fixed cost is not affected by changes in the level of activity.
 A variable cost increases or decreases as the level of activity increases or decreases.
 A semi-variable cost is partly fixed and partly variable and is therefore partly affected by a change in
the level of activity.
 The relevant range is the range of activity levels within which assumed cost behaviour patterns occur.
4.1 Cost behaviour patterns

A different way of classifying costs is in terms of their behaviour patterns. This means grouping costs
according to how they vary in relation to the level of activity.
The level of activity can be measured in a variety of different ways depending on the circumstances.
Examples of possible ways of measuring the level of activity are as follows.
 The volume of production in a period
 The number of items sold
 The number of invoices issued
 The number of units of electricity consumed
Planning and decision-making are concerned with future events and so managers require information on
expected future costs and revenues. A knowledge of how the cost incurred varies at different
levels of activity is essential to planning and decision-making.
For our purposes in this chapter, the level of activity will generally be taken to be the volume of
production/output or sales.
4.2 Fixed costs

Definition
A fixed cost is a cost that, within a relevant range of activity levels, is not affected by increases or
decreases in the level of activity.
Fixed costs are a period charge, in that they relate to a span of time; as the time span increases, so too
will the fixed costs. Figure 1.1 shows a sketch graph of a fixed cost.
Graph of fixed cost
CU
Cost
Volume output (level of activity)
Figure 1.1: Fixed cost

Examples of fixed costs include the following.

 The salary of the managing director (per month or per annum)
 The rent of a single factory building (per month or per annum)
 Straight line depreciation of a single machine (per month or per annum)
4.3 Variable costs
Definition
A variable cost is a cost that increases or decreases as the level of activity increases or decreases.
A variable cost tends to vary directly with the level of activity. The variable cost per unit is the same
amount for each unit produced whereas total variable cost increases as volume of output increases. Figure
1.2 shows a sketch graph of a variable cost.
Variable Cost is fixed with per unit basis
Graph of variable cost
Fixed Cost is variable with per unit basis
CU
Cost
Volume of output
Figure 1.2: Variable cost

Examples of variable costs include the following.
 The cost of raw materials (where there is no discount for bulk purchasing, since bulk purchase
discounts reduce the unit cost of purchases).
 Direct labour costs, which are usually classed as a variable cost even though basic wages are often
fixed.
 Sales commission that is variable in relation to the volume or value of sales.
4.4 Semi-variable costs (or semi-fixed costs or mixed costs)
Definition
Semi-variable, semi-fixed or mixed costs are costs that are part-fixed and part-variable and are
therefore partly affected by changes in the level of activity.
Examples of semi-variable costs include the following.

 Electricity and gas bills. There may be a 'standing' basic charge plus a charge per unit of
consumption.
 Sales representative's salary. The sales representative may earn a basic monthly amount plus a
commission based on the value of sales made.

The behaviour of a semi-variable cost can be presented graphically as shown in Figure 1.3.
CU
Cost
Variable
part
Fixed part
Volume of output
(or, say, value of sales)
Figure 1.3: Semi-variable cost
4.5 Cost behaviour and total and unit costs

If the variable cost of producing a unit is CU5 per unit then it will remain at that cost per unit no matter
how many units are produced (within the relevant range).
However, if the business's fixed costs are CU5,000 then the fixed cost per unit will decrease the more
units are produced: for example, one unit will have fixed costs of CU5,000 per unit; if 2,500 are produced
the fixed cost per unit will be CU2; if 5,000 are produced the fixed cost per unit will be only CU1. Thus as
the level of activity increases the total costs per unit (fixed cost plus variable cost) will decrease.
In sketch graph form this may be illustrated as shown in Figure 1.4.
Variable cost Fixed cost Total cost

Cost Cost Cost
per per per
unit unit unit
CU CU CU
Number of units Number of units Number of units
Figure 1.4: Cost behaviour

Interactive question 2: Fixed, variable or semi-variable cost? [Difficulty level: Easy]
Tick the appropriate box for each cost.
Fixed Variable Semi-variable
(a) Telephone bill
(b) Annual salary of the chief accountant
(c) Cost of materials used to pack 20 units of

product X into a box

4.6 The relevant range
Definition
The relevant range is the range of activity levels within which assumed cost behaviour patterns occur.
For example, a fixed cost is only fixed for levels of activity within the relevant range, after which it could
'step up'.
The relevant range also broadly represents the activity levels at which an organisation has had
experience of operating in the past and for which cost information is available. It can therefore be
dangerous to attempt to predict costs at activity levels that are outside the relevant range (extrapolation).
For example, the rent of a factory is generally assumed to be a fixed cost. However, if the volume of activity
increases beyond the relevant range then it may be necessary to rent an additional factory. The rent cost
will then increase to a new, higher level. This is called a step increase in fixed cost and can be represented
graphically as shown in Figure 1.5.
Figure 1.5: Step increase
Interactive question 3: Activity levels [Difficulty level: Intermediate]

Select the correct words in the following sentence.
In general, as activity levels rise within a relevant range, the variable cost per unit will (a) rise/fall/stay the
same, the fixed cost per unit will (b) rise/fall/stay the same and the total cost per unit will (c)
rise/fall/stay the same.
Interactive question 4: Cost behaviour graphs [Difficulty level: Easy]

Match the sketches (1) to (4) below to the listed items of expense. In each case the vertical axis relates to
total cost, the horizontal axis to activity level. Each graph may be used more than once. Write the graph
number in the space provided.
(a) Electricity bill: a standing charge for each period plus a charge for each unit of electricity consumed.
(b) Supervisory labour, which is paid as a monthly salary.
(c) Sales commission, which amounts to 2% of sales revenue.
(d) Machine rental cost of a single item of equipment. The rental agreement is that CU10 should be paid
for every machine hour worked each month, subject to a maximum monthly charge of CU480.

(e) Photocopier rental costs. The rental agreement is that CU80 is paid each month, plus CU0.01 per
photocopy taken.
(1) (2)
(3) (4)
Expense description Graph number
(a)
(b)
(c)
(d)
(e)
5 Cost classification for control

Section overview
 For control purposes the most effective classification of costs is by responsibility, ie according to
whether the costs are controllable or uncontrollable by a particular manager.
 A system of responsibility accounting segregates costs and revenues into areas of personal
responsibility in order to monitor and assess the performance of each part of the organisation.
 A responsibility centre is a part of a business whose performance is the direct responsibility of a
specific manager.
 An uncontrollable cost is a cost that cannot be influenced by a manager within a given time span.
5.1 Responsibility accounting

Allocating costs to products is not always useful for the purposes of control, as the production of a
product, say, may consist of a number of operations, each of which is the responsibility of a different
person. A product cost does not therefore provide a link between costs incurred and areas of
responsibility. So costs (or revenues) must be traced in another way to the individuals responsible for each
cost or revenue. This 'other way' is known as responsibility accounting.

Definitions
Responsibility accounting is a system of accounting that segregates revenue and costs into areas of
personal responsibility in order to monitor and assess the performance of each part of an organisation.
A responsibility centre is a department or function whose performance is the direct responsibility of a
specific manager.
Managers of responsibility centres should only be held accountable for costs over which they have
significant influence. From a motivation or incentivisation point of view this is important because it can be
very demoralising for managers to have their performance judged on the basis of something over which
they have no influence. It is also important from a control point of view that management reports should
ensure that information on costs is reported to the manager who is able to take action to control them.
Responsibility accounting attempts to associate costs, revenues, assets and liabilities with the managers
most capable of controlling them. As a system of accounting, it therefore distinguishes between controllable
and uncontrollable costs.
5.2 Controllable and uncontrollable costs
Definitions
A controllable cost is a cost that can be influenced by management decisions and actions.
An uncontrollable cost is a cost that cannot be affected by management within a given time span.
Most variable costs within a department are thought to be controllable in the short term because
managers can influence the efficiency with which resources are used, even if they cannot do anything to
raise or lower price levels.
A cost that is not controllable by a junior manager might be controllable by a senior manager.
For example, there may be high direct labour costs in a department caused by excessive overtime working.
The junior manager may feel obliged to continue with the overtime to meet production schedules, but his
senior may be able to reduce costs by hiring extra full-time staff, thereby reducing the requirements for
overtime.
A cost that is not controllable by a manager in one department may be controllable by a
manager in another department. For example, an increase in material costs may be caused by buying at
higher prices than expected (controllable by the purchasing department) or by excessive wastage
(controllable by the production department) or by a faulty machine producing rejects (controllable by the
maintenance department).
Some costs are non-controllable, such as increases in expenditure due to inflation. Other costs are
controllable, but in the long term rather than the short term. For example, production costs might
be reduced by the introduction of new machinery and technology, but in the short term, management must
attempt to do the best they can with the resources and machinery at their disposal.

Summary
Financial information
Financial accounting Management accounting

Aggregate information for external Internal management information
reporting for planning, control and decision-
making
Cost objects Classification for planning Classification for control

and decision-making System of responsibility
Requires knowledge of cost accounting segregates
behaviour patterns controllable costs and
Cost units
uncontrollable costs
Basic control unit for
costing purposes
Fixed cost Variable cost Semi-variable

Not affected by Changes in line cost
Classification for inventory changes in with level of Partly affected by
valuation and profit activity activity changes in
measurement
activity
Cost elements = materials,
labour and other expenses
Direct cost or Indirect cost or Product cost Period cost

prime cost can be overhead cannot Allocated to value Deducted as
traced in full to be traced in full to of inventory until expenses in a
cost object being cost object being sold particular period
costed costed
Self-test
Answer the following questions
1 Which of the following statements about a direct cost are correct?
(a) A direct cost can be traced in full to the product, service or department that is being costed.
(b) A particular cost can be a direct cost or an indirect cost, depending on what is being costed.
(c) A direct cost might also be referred to as an overhead cost.
(d) Expenditure on direct costs will probably vary every period.
A (a) and (b) only
B (a) and (c) only
C (a), (b) and (d) only
D (a), (b), (c) and (d)

2 Which one of the following items might be a cost unit within the management accounting system of a
university or college of further education?
A Business studies department
B A student
C A college building
D The university itself
3 Identify whether the statements shown below are true or false.
True False
A cost unit is a unit of product that has costs attached
A cost object is always a unit of product or service
Costs can be divided into three elements: materials, labour and expenses
An overhead is another name for an indirect cost
4 Which of the following are likely to be classed as variable costs?
Yes No
Telephone bill
A royalty payment for each unit produced
Direct materials for production
Annual salary of chief accountant
Annual salary of factory supervisor
5 A company hires its vehicles under an agreement where a constant rate is charged per mile travelled,
up to a maximum monthly payment regardless of the miles travelled.
This cost is represented by which of the following graphs?
A
Total
cost
Level of activity
B
Total
cost
Level of activity

C
Total
cost
Level of activity
D
Total
cost
Level of activity
6 Cost units are:
A Units of a product or service for which costs are ascertained
B Amounts of expenditure attributable to a number of different products
C Functions or locations for which costs are ascertained
D Things for which we are trying to ascertain the cost
7 Which of the following items might be a suitable cost unit within the sales department of a
manufacturing company?
Suitable Unsuitable
Sales commission
Order obtained
Unit of product sold
8 In a factory one supervisor is required for every five employees. Which one of the following graphs
depicts the cost of supervisors?
A
Total
cost
No. of employees

B
Total
cost
No. of employees
C
Total
cost
No. of employees
D
Total
cost
No. of employees
9 Which of the following might describe a cost unit?

A A unit of production or service to which costs can be related
B A cost incurred in selling a product or service
C A cost that can be traced in full to the product, service or department that is being costed
D A cost identified with the goods produced or purchased for resale
10 Prime cost is:
A All cost incurred in manufacturing a product
B The total of direct costs
C The material cost of a product
D The cost of operating a department
Now go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these
objectives, please tick them off.

1 C The correct answer is: (a), (b) and (d) only.

Statement (a) is correct. Direct costs are specific and traceable to the relevant product, service
or department.
Statement (b) is correct. For example, a departmental manager's salary is a direct cost of the
department but it is an indirect cost of the individual cost units passing through the department.
Statement (c) is incorrect. An indirect cost (not a direct cost) might also be referred to as an
overhead cost.
Statement (d) is correct. It is likely that activity changes from period to period, in which case so
will the expenditure on direct costs, as direct costs are traced directly to cost units.
2 B A student is likely to be a cost unit (cost per student per course). The others are all cost objects
but not the most basic unit of product or service for which costs are determined.
3 The correct answers are:
True False
A cost unit is a unit of product that has costs attached


A cost object is always a unit of product or service

Costs can be divided into three elements: materials, labour and expenses

An overhead is another name for an indirect cost

A cost object is anything for which we are trying to ascertain the cost. It could be a unit of
product or service but it could also be other items such as a department, a function or an item of
equipment.
4
Yes No
Telephone bill
A royalty payment for each unit produced


Direct materials for production

Annual salary of chief accountant
Annual salary of factory supervisor
The royalty payments described and the cost of direct materials for production are likely to
increase in line with output levels and are therefore classed as variable costs.
A telephone bill is a typical example of a semi-variable cost, with a fixed line rental and a variable
cost element that relates to the number of telephone calls made.
Salaries are a typical example of a fixed cost.

5 C The correct graph is:
Total
cost
Level of activity
The cost described begins as a linear variable cost, increasing at a constant rate in line with
activity. After a certain level of activity is reached, the total cost reaches a maximum as
demonstrated by the horizontal line on the graph. The cost becomes fixed regardless of the level
of activity.
6 A Amounts of expenditure attributable to a number of products (option B) are classed as
overheads.
Functions or locations for which costs are ascertained (option C) are cost objects.
Option D is the definition of a cost object.
7 A
Suitable Unsuitable
Sales commission

Order obtained

Unit of product sold

Either calculating the cost of each order obtained or the cost of each unit of product sold would be
suitable cost units within the sales department.
Sales commission is an expense of the business, and therefore not suitable to use as a cost unit.
8 A The correct graph is:
Total
cost
No. of employees
9 A Cost units are the basic units for costing purposes. Different organisations would use different
cost units, such as patient/day in a hospital or meals served in a restaurant.
A cost incurred in selling a product or service (option B) describes a period cost.
A cost that can be traced in full to the product, service or department that is being costed
(option C) describes a direct cost.
A cost identified with the goods produced or purchased for resale (option D) describes a
product cost.
10 B Prime cost is the total of direct material, direct labour and direct expenses.
Option A describes total production cost, including a share of production overhead. Option C is
only a part of prime cost. Option D is an overhead or indirect cost.

Answer to Interactive question 1

Suitable cost unit
Room/night 
Meal served 
Conference delegate 
Conference room/day 
(a) Semi-variable 
(b) Fixed 
(c) Variable 
(a) Stay the same
(b) Fall; because the same amount of fixed cost is spread over more units
(c) Fall; because the fixed cost per unit included within the total cost will reduce

Expense description Graph number Discussion
(a) (1) A semi-variable cost that has both a fixed element and a
variable element that changes with the level of activity
(b) (4) A fixed cost that remains constant within the relevant
range
(c) (2) A variable cost that varies in direct proportion to the
level of activity
(d) (3) Graph passes through origin because at zero activity no
cost is incurred. Variable cost pattern until maximum
cost is reached. Thereafter cost is fixed
(e) (1) A semi-variable cost that has both a fixed element and a
variable element that changes with the level of activity


chapter 2
Calculating unit costs (Part 1)
Contents
Introduction
Examination context
Topic List
1 Identifying direct and indirect costs for cost units
2 Inventory valuation

Introduction

 Classify costs as direct or indirect as regards cost units
 Calculate direct material and direct labour costs from information provided
The specific syllabus reference for this chapter is: 1c.
An important task to be fulfilled by the management information system is to provide unit costs as the basis
for a variety of management planning and control activities.
But how are the individual elements of costs to be determined for each cost unit? For example there must
be mechanisms for recording the hours worked by employees and the tasks they accomplish in this time.
As regards material, if several different batches of material are purchased, all at different prices, which price
should be reported within unit costs for managers to use as the basis of their day to day operational and
planning decisions?
Information providers need mechanisms to systematically record the prices paid for material and the
quantities purchased and issued to production or sales.
Stop and think

In times of rapid inflation, why is it important to use up to date prices when reporting costs to the manager
who is responsible for determining the selling price of the company's main products or services?
Working content
You may come across inventory valuations in the context of audit engagements. Typical procedures might
involve checking that costs have been calculated and recorded correctly and that the inventory valuation
method has been applied consistently.
Syllabus links
A thorough understanding of the valuation of materials inventory will underpin your understanding of
inventory valuation for the Accounting syllabus.

CALCULATING UNIT COSTS (PART 1) 2
Examination context
Exam requirements
The context of much of this chapter provides scope for a range of numerical questions. However, you
should also be prepared to deal with narrative questions that examine your understanding of the
implications of the techniques you are using.
Narrative questions on the pricing of materials issues and on the classification of costs have been popular in
past examinations.
 Classify costs as direct or indirect
 Calculate the prime cost of a cost unit
 Calculate the price of materials and the value of inventory using ('first in, first out') FIFO, ('last in, first
out') LIFO and average pricing methods
It is important to realise that in this chapter and the next, ideas from Chapter 1 are being applied in
determining the cost of a unit of output. The cost object is, therefore, the unit of output and all terms such
as direct and indirect are used in that context. It is also essential to appreciate that direct and variable costs
and indirect and fixed costs are NOT the same thing. The narrative is as important as the calculations for
FIFO, LIFO and weighted average inventory valuations.

1 Identifying direct and indirect costs for cost units
Section overview
 Direct costs are those that can be specifically identified with the cost unit being costed.
 Direct material cost is all material becoming part of the cost unit, unless used in negligible amounts.
 Direct labour cost is all wages paid to labour that can be identified with a specific cost unit.
 Direct expenses are expenses incurred on a specific cost unit, other than direct material and direct
labour costs.
 Indirect costs are those that cannot be identified directly with the cost unit being costed.
For the purposes of this chapter and Chapter 3 the cost object is a cost unit (eg a unit of product, a job, a
batch, a unit of service).
1.1 Direct material cost

Direct material is all material becoming part of the cost unit (unless used in negligible amounts and/or
having negligible cost).
Direct material costs are charged to the cost unit as part of the prime cost. Examples of direct material
are as follows.
 Component parts or other materials purchased for a particular product, service, job, order or
process.
 Primary packing materials like cartons and boxes.
Materials used in negligible amounts and/or having negligible cost can be grouped under indirect materials as
part of overhead.
1.2 Direct wages or direct labour costs

Direct wages are all wages paid for labour (either as basic hours or as overtime) that can be identified
with the cost unit.
Direct wages costs are charged to the cost unit as part of the prime cost.
Examples of groups of labour receiving payment as direct wages are as follows.
 Workers engaged in altering the condition, conformation or composition of the product.
 Inspectors, analysts and testers specifically required for such production.
1.3 Direct expenses

Direct expenses are any expenses that are incurred on a specific cost unit other than direct material
cost and direct wages.
Direct expenses are charged to the product as part of the prime cost. Examples of direct expenses are as
follows.
 The cost of special designs, drawings or layouts for a particular job
 The hire of tools or equipment for a particular job

1.4 Indirect costs

Indirect costs or overheads are those costs that cannot be traced in full to a specific cost unit.
For example, a garage carries out a repair job on a customer's car.
 The direct material cost of the job will include the replacement parts used.
 The direct labour cost will be wages paid to the mechanics who carried out the work. The labour is
treated as a direct cost in this case, even if the mechanics are paid a fixed amount each period. This is
because it is possible to measure exactly how long each person worked on the repair, and their hourly
rate of pay.
 The indirect costs of the repair job will include a share of the overhead costs incurred in the garage,
such as the rent, the buildings insurance, the depreciation of the garage equipment and so on. These
costs cannot be traced to any single job worked on during the period.
Try this interactive question to ensure you have understood the principle of how to distinguish a direct
cost from an indirect cost.
Interactive question 1: Direct cost or indirect cost? [Difficulty level: Intermediate]

Indicate whether each of the following costs would be classified as a direct cost or an indirect cost of a
particular car repair in a garage. The repair was worked on in overtime hours due to an unusually large
number of repairs being booked into the garage that day.
Cost incurred Direct or indirect?
The salary of the garage's accountant

The cost of heating the garage
A can of engine oil used in the repair
A smear of grease used in the repair
An overtime premium paid to the mechanic
carrying out the repair
An idle time payment made to the mechanic while
waiting for a delivery of parts for a number of jobs
The wages of the supervisor overseeing the
mechanic carrying out the repair
1.5 Direct and indirect costs: some further points

There are a few possible misconceptions about direct and indirect costs that should be clarified at this
stage.
 Direct costs are not necessarily bigger in size than indirect costs. In highly-automated service
industries, direct materials and direct labour costs are likely to be very small, relative to overhead
costs. The relative size of direct and indirect costs per unit of output varies according to the type of
output, the industry, the technology, etc.
 Indirect costs are not less important than direct costs. Although they cannot be directly
attributed to individual units of output or to individual jobs, they represent expenditure on resources
that are essential for the units to be made or the jobs to be done. In the example of the garage repair
job, the rent of the garage is an indirect cost, but the rental cost represents a share of the use of the
garage space, without which the job could not have been done.

 It is easy to confuse fixed and variable costs with indirect and direct costs. A direct cost is
often also a variable cost: for example, the cost of raw materials that goes into making a unit of
product is both a direct cost and a variable cost. However, a direct cost may be a fixed cost rather
than a variable cost. For example, the direct cost of the labour employed to do a certain type of work
is a fixed cost to the business if the employees are paid a fixed amount of wages or salary regardless of
the amount of work they do. Similarly, an indirect cost may a variable cost. For example, the cost of
heating in a manufacturing plant may rise as more hours are worked. The cost of heating cannot be
directly attributed to an individual job or unit of output. Nevertheless, it is a cost that rises with the
level of activity, and is a variable cost. Variable indirect costs are more commonly referred to as
variable overheads.
2 Inventory valuation
Section overview
 The pricing of issues of inventory items and the valuation of closing inventory have a direct effect on
the calculation of profit. Several different methods can be used in practice.
 With FIFO all issues are priced at the cost of the earliest delivery remaining in inventory.
 With LIFO all issues are priced at the cost of the most recent delivery remaining in inventory.
 The cumulative weighted average pricing method calculates a weighted average price for all units in
inventory whenever a new delivery of materials is received into store.
 The periodic weighted average pricing method calculates a single weighted average price at the end of
the period. The average is based on the opening inventory plus all units received in the period.
 Each method of inventory valuation usually produces different figures for the value of closing
inventories and the cost of material issues. Therefore, profit figures using the different inventory
valuations are usually different.
2.1 Valuing inventory in financial accounts

You may be aware from your studies of Accounting that, for financial accounting purposes, inventories are
valued at the lower of cost and net realisable value. In practice, inventories will probably be valued at
cost in the stores records throughout the course of an accounting period. Only when the period ends will
the value of the inventory in hand be reconsidered so that items with a net realisable value below their
original cost will be revalued downwards, and the inventory records altered accordingly.
2.2 Charging units of inventory to cost of production or cost of sales

It is important to be able to distinguish between the way in which the physical items in inventory are
actually issued and the way in which inventory is costed. In practice a storekeeper may issue goods in the
following way.
 The oldest goods first
 The latest goods received first
 Randomly
 Those that are easiest to reach
By comparison, the cost of goods issued must be determined on a consistently applied basis, and must
ignore the likelihood that the materials issued will be costed at a price different from the amount paid for
them.
This may seem a little confusing at first, and it may be helpful to explain the point further by looking at an
example.

2.3 Example: Inventory valuation

Suppose that there are three units of a particular material in inventory.
Units Date received Purchase cost
A June 20X1 CU100
B July 20X1 CU106
C August 20X1 CU109
In September, one unit is issued to production. As it happened, the physical unit actually issued was B. The
accounting department must put a value or cost on the material issued, but the value would not be the cost
of B, CU106. The principles used to value the materials issued are not concerned with the actual unit
issued, A, B, or C. Nevertheless, the accountant may choose to make one of the following assumptions.
 The unit issued is valued as though it were the earliest unit received into inventory, ie at the purchase
cost of A, CU100. This valuation principle is called FIFO, or first in, first out.
 The unit issued is valued as though it were the most recent unit received into inventory, ie at the
purchase cost of C, CU109. This method of valuation is LIFO, or last in, first out.
 The unit issued is valued at an average price of A, B and C. The three units cost a total of CU315, an
average of CU105 each.
2.4 Pricing methods in inventory valuation

In the following sections we will consider each of the pricing methods detailed above, using the following
transactions to illustrate the principles in each case.
TRANSACTIONS DURING MAY 20X6
Quantity Unit cost Total cost Market value
per unit on date
of transaction
Units CU CU CU
Opening balance, 1 May 100 2.00 200
Receipts, 3 May 400 2.10 840 2.11
Issues, 4 May 200 2.11
Receipts, 9 May 300 2.12 636 2.15
Issues, 11 May 400 2.20
Receipts, 18 May 100 2.40 240 2.40
Issues, 20 May 100 2.42
Closing balance, 31 May 200 2.45
1,916
2.5 FIFO (first in, first out

FIFO assumes that materials are issued out of inventory in the order in which they were delivered into
inventory: issues are priced at the cost of the earliest delivery remaining in inventory.

Worked example: FIFO

Using FIFO, the cost of issues and the closing inventory value of the transactions in section 2.4 would be
as follows.
Date of issue Quantity issued Value
Units CU CU
4 May 200 100 b/f at CU2 200
100 at CU2.10 210
410
11 May 400 300 at CU2.10 630
100 at CU2.12 212
842
20 May 100 100 at CU2.12 212
Cost of issues 1,464
Closing inventory value 200 100 at CU2.12 212
100 at CU2.40 240
452
1,916
Using a tabular format, as below, is a practical way of tracking items when carrying out a FIFO calculation:
CU2.00 CU2.10 CU2.12 CU2.40 Total
b/f 100 100
Receipt 3 May 400 400
Issue 4 May (100) (100) (200)
Issue 11 May (300) (100) (400)
Issue 20 May (100) (100)
– – 100 100 200
Points to note
1 The cost of materials issued plus the value of closing inventory equals the cost of purchases plus the
value of opening inventory (CU1,916).
2 The market price of purchased materials is rising dramatically. In a period of inflation, there is a
tendency with FIFO for materials to be issued at a cost lower than the current market value, although
closing inventories tend to be valued at a cost approximating to current market value.
2.6 Advantages and disadvantages of the FIFO method

Advantages Disadvantages
It is a logical pricing method, which probably FIFO can be cumbersome to operate because of
represents what is physically happening: in practice the need to identify each batch of material
the oldest inventory is likely to be used first. separately.
It is easy to understand and explain to managers. Managers may find it difficult to compare costs and
make decisions when they are charged with varying
prices for the same materials.
The inventory valuation can be near to a valuation In a period of high inflation, inventory issue prices
based on replacement cost. will lag behind current market value.

Interactive question 2: FIFO [Difficulty level: Intermediate]

Complete the table below in as much detail as possible using the information from the last worked example.
Receipts Issues Inventory
Date Unit Unit Unit
price Amount price Amount price Amount
Quantity CU CU Quantity CU CU Quantity CU CU
2.7 LIFO (last in, first out)

LIFO assumes that materials are issued out of inventory in the reverse order from that in which they were
delivered: the most recent deliveries are issued before earlier ones, and issues are priced accordingly.
Worked example: LIFO

Using LIFO, the cost of issues and the closing inventory value of the transactions in section 2.4 would be as
follows.
Date of issue Quantity issued Valuation
Units CU CU
4 May 200 200 at CU2.10 420
11 May 400 300 at CU2.12 636
100 at CU2.10 210
846
20 May 100 100 at CU2.40 240
Closing inventory value 200 100 at CU2.10 210
100 at CU2.00 200
410
1,916
A tabular format similar to that in section 2.5 can also be used in section 2.7.
Points to note
2 In a period of inflation there is a tendency with LIFO for the following to occur.
– Materials are issued at a price that approximates to current market value.
– Closing inventories become undervalued when compared to market value.

2.8 Advantages and disadvantages of the LIFO method

Inventories are issued at a price which is close to The method can be cumbersome to operate
current market value. because it sometimes results in several batches
being only part-used in the inventory records
before another batch is received.
Managers are continually aware of recent costs when LIFO is often the opposite of what is physically
making decisions, because the costs being charged to happening and can therefore be difficult to
their department or products will be current costs. explain to managers.
As with FIFO, decision making can be difficult
because of the variations in prices.
2.9 Cumulative weighted average pricing

The cumulative weighted average pricing method calculates a weighted average price for all units in
inventory. Issues are priced at this average cost, and the balance of inventory remaining would have the
same unit valuation. The average price is determined by dividing the total cost by the total number of units.
A new weighted average price is calculated whenever a new delivery of materials is received into
store. This is the key feature of cumulative weighted average pricing.
Worked example: Cumulative weighted average pricing

Using cumulative weighted average pricing, issue costs and closing inventory values of the transactions in
section 2.4 would be as follows.
Total
Date Received Issued Balance inventory value Unit cost
Units Units Units CU CU CU
Opening inventory 100 200 2.00
3 May 400 840 2.10
* 500 1,040 2.08
4 May 200 (416) 2.08 416
300 624 2.08
9 May 300 636 2.12
* 600 1,260 2.10
11 May 400 (840) 2.10 840
200 420 2.10
18 May 100 240 2.40
* 300 660 2.20
20 May 100 (220) 2.20 220
Closing inventory value 200 440 2.20 440
1,916
* A new inventory value per unit is calculated whenever a new receipt of materials occurs.
Points to note
2 In a period of inflation, using the cumulative weighted average pricing system, the value of material
issues will rise gradually, but will tend to lag a little behind the current market value at the date of
issue. Closing inventory values will also be a little below current market value.

2.10 Advantages and disadvantages of cumulative weighted average

pricing
Fluctuations in prices are smoothed out, making it The resulting issue price is rarely an actual
easier to use the data for decision making. price that has been paid, and can run to several
decimal places.
It is easier to administer than FIFO and LIFO, because Prices tend to lag a little behind current market
there is no need to identify each batch separately. values when there is gradual inflation.
Interactive question 3: Inventory valuation methods [Difficulty level: Intermediate]

Shown below is an extract from records for inventory item number 988988.
Receipts Issues Balance
Date Qty Value Total Qty Value Total Qty Value Total
CU CU CU CU CU CU
5 June 30 2.50 75
8 June 20 3.00 60
10 June 10 A
14 June 20 B
18 June 40 2.40 96
20 June 6 C D
(a) The values that would be entered on the stores record for A, B, C and D in a cumulative weighted
average pricing system would be:
A CU ........................................
B CU ........................................
C CU ........................................
D CU ........................................
(b) The values that would be entered on the stores record for A, B, C and D in a LIFO system would be:
A CU ........................................
B CU ........................................
C CU ........................................
D CU ........................................
2.11 Periodic weighted average pricing

This average method differs from the cumulative weighted average method. Instead of calculating a new
inventory value per unit whenever a receipt occurs, a single average is calculated at the end of the period
based on all purchases for the period. Unless stated to the contrary, assume the cumulative
method is required in an exam question.

Worked example: Periodic weighted average pricing

Using periodic weighted average pricing, the issue costs and closing inventory of the transactions in section
2.4 would be as follows.
Cost of opening inventory + Total cost of receipts in period
Periodic weighted average price =
Units in opening inventory + Total units received in period
= (CU200  CU1,716)
(100  800)
= CU2.129 per unit
This average price is used to value all the units issued and the units in the closing inventory.
CU
Cost of issues = 700 units  CU2.129 1,490
Closing inventory value = 200 units  CU2.129 426
1,916
Notice that once again the cost of materials issued plus the value of closing inventory equals the cost of
purchases plus the value of opening inventory (CU1,916).
2.12 Inventory valuation and profitability

Each method of inventory valuation usually produces different figures for the value of closing inventories
and the cost of material issues. A summary of the valuations based on the transactions in section 2.4 is as
follows.
Valuation method Closing Cost Total
inventory of issues
value
CU CU CU
FIFO (section 2.5) 452 1,464 1,916
LIFO (section 2.7) 410 1,506 1,916
Cumulative weighted average (section 2.9) 440 1,476 1,916
Periodic weighted average (section 2.11) 426 1,490 1,916
Since material costs affect the cost of production, and the cost of production works through eventually into
the cost of sales (which is also affected by the value of closing inventories), it follows that different
methods of inventory valuation will provide different profit figures.
The following example will help to illustrate the point.
Worked example: Inventory valuation and profitability

On 1 November 20X2, DD Ltd held 3 pink satin dresses with orange sashes, designed by Freda Swoggs.
These were valued at CU120 each. During November 20X2, 12 more of the dresses were delivered as
follows.
Date Dresses received Purchase cost per dress
10 November 4 CU125
20 November 4 CU140
25 November 4 CU150
A number of the pink satin dresses with orange sashes were sold during November as follows.
Date Dresses sold Sales price per dress
14 November 5 CU200
21 November 5 CU200
28 November 1 CU200

Requirements
Calculate the gross profit from selling the pink satin dresses with orange sashes in November 20X2,
applying the following principles of inventory valuation.
(a) FIFO
(b) LIFO
(c) Cumulative weighted average pricing
Calculate gross profit using the formula: gross profit = (sales – (opening inventory + purchases – closing
inventory)).
Solution
(a) FIFO
Cost Closing
Date of sales Total inventory
CU CU
14 November 3 units  CU120
+ 2 units  CU125
610
+ 3 units  CU140
670
28 November 1 unit  CU140 140
Closing inventory 4 units  CU150 600
1,420 600
(b) LIFO
Cost of Closing
Date sales Total inventory
CU CU
+ 1 unit  CU120
620
+ 1 unit  CU120
680
28 November 1 unit  CU150 150
Closing inventory 3 units  CU150
+ 1 unit  CU120
570
1,450 570
(c) Cumulative weighted average pricing
Balance in Cost of Closing
Units Unit cost inventory sales inventory
CU CU CU CU
1 November 3 120.00 360
10 November 4 125.00 500
7 122.86 860
14 November 5 122.86 614 614
2 246
20 November 4 140.00 560
6 134.33 806
21 November 5 134.33 672 672
1 134
25 November 4 150.00 600
5 146.80 734
28 November 1 146.80 147 147
30 November 4 146.80 587 1,433 587

Profitability Weighted
FIFO LIFO average
CU CU CU
Opening inventory 360 360 360
Purchases 1,660 1,660 1,660
2,020 2,020 2,020
Closing inventory 600 570 587
Cost of sales 1,420 1,450 1,433
Sales (11  CU200) 2,200 2,200 2,200
Gross profit 780 750 767
2.13 Profit differences

In this example, different inventory valuation methods produced different costs of sale and
hence different gross profits. As opening inventory values and purchase costs are the same for
each method, the different costs of sale are due to different closing inventory valuations. The
differences in gross profits therefore equal the differences in closing inventory valuations.
The profit differences are only temporary. In the example, the opening inventory in December 20X2 will
be CU600, CU570 or CU587, depending on the inventory valuation method used. Different opening
inventory values will affect the cost of sales and profits in December, so that in the long run, inequalities in
costs of sales each month will even themselves out.

Summary
Direct costs Indirect costs

Can be traced in full to cost unit Cannot be traced in full to cost
being costed object being costed
Direct material cost Direct labour cost Direct expenses

All material becoming part of the Wages that can be identified with Non-material and labour cost that
cost unit a specific cost unit can be identified with a specific
cost unit
FIFO LIFO Weighted average

Issues priced at oldest prices in Issues priced at latest prices in Issues priced at a calculated
inventory inventory weighted average
Cumulative weighted average Periodic weighted average

New average calculated whenever Single average calculated at end of
a delivery is received each period
Self-test
Answer the following questions.
1 Which two of the following are cost objects?
A A packing machine
B The factory canteen
C Direct materials for production
D Annual salary of the chief accountant
E A telephone bill
2 Which two of the following are classified as indirect costs of individual units of output or of individual
projects?
A The cost of overtime worked specifically to complete a one-off project
B The depreciation of a machine on an assembly line
C Primary packing materials, eg cartons and boxes
D The hire of maintenance tools or equipment for a factory

3 Which one of the following would be classified as an indirect cost of individual batches of output, units
of service or of individual projects of the organisation concerned?
A The cost of sugar used for a batch of cakes in a bakery
B The lease rental cost of a leased car used by a site foreman travelling to a specific construction
project
C The accountant's salary in a factory
D The cost of drinks served on an intercity train journey
4 When costing cost units, wage payments for idle time within a production department are classified as
A Direct labour cost
B Prime cost
C Administration overhead
D Factory overhead
5 A retailer currently uses the LIFO method to value its inventory of goods for sale.
If the retailer decides instead to use the FIFO method, in a period of rising prices
A The closing inventory value will be lower and the gross profit will be lower
B The closing inventory value will be lower and the gross profit will be higher
C The closing inventory value will be higher and the gross profit will be lower
D The closing inventory value will be higher and the gross profit will be higher
6 A wholesaler had an opening inventory of 750 units of geronimos valued at CU80 each on 1 March.
The following receipts and sales were recorded during March.
4 March Received 180 units at a cost of CU85 per unit
18 March Received 90 units at a cost of CU90 per unit
24 March Sold 852 units at a price of CU110 per unit
Using the weighted average cost method of valuation, what was the cost of geronimos sold on 24
March? (to the nearest CU)
A CU35,320
B CU38,016
C CU38,448
D CU69,660
7 At the beginning of week 10 there were 400 units of component X held in the stores. 160 of these
components had been purchased for CU5.55 each in week 9 and 240 had been purchased for CU5.91
each in week 8.
On day 3 of week 10 a further 120 components were received into stores at a purchase cost of
CU5.96 each.
The only issue of component X occurred on day 4 of week 10, when 150 units were issued to
production.
Using the FIFO valuation method, what was the value of the closing inventory of component X at the
end of week 10?
A CU1,980.45
B CU2,070.15
C CU2,135.10
D CU2,200.55

8 A wholesaler had an opening inventory of 330 units of product T valued at CU168 each on 1April.
The following receipts and sales were recorded during April.
4 April Received 180 units at a cost of CU174 per unit
18 April Received 90 units at a cost of CU186 per unit
24 April Sold 432 units at a price of CU220 per unit
Using the LIFO valuation method, what was the gross profit earned from the units sold on 24 April?
A CU16,350
B CU18,120
C CU18,520
D CU19,764
9 Which of the following statements is/are correct?
True False
Using LIFO, managers are continually aware of recent costs when making
decisions, because the costs being charged to their departments or products
will be current costs
FIFO lets managers value issues at current prices in a period of high inflation
The use of the cumulative average pricing method of inventory valuation is

easier to administer than FIFO and LIFO because there is no need to identify
each batch separately
10 A business buys and sells boxes of item J. The transactions for the latest quarter are shown below.
Opening inventory 400 boxes valued at CU1,000
Purchases Sales
Boxes Value Boxes
CU
July 1,000 2,600 1,100
August 1,200 3,300 900
September 1,000 3,000 800
The business values its inventories using a periodic weighted average price calculated at the end of
each quarter.
To the nearest CU, the value of the inventory at the end of September is CU........................................ .

1 A, B It is possible to ascertain the cost of these two cost objects.

The other three items are costs that might be attributed to a particular cost object, but they are
not cost objects in themselves.
2 B, D The cost of overtime worked specifically to complete a one-off project (option A) is direct
labour.
Primary packing materials, eg cartons and boxes, (option C) are direct materials.
3 C The accountant's salary is an indirect cost because it cannot be traced to a specific cost unit. It
would be classified as an administration overhead.
All of the other costs can be traced to a specific cost unit.
The cost of sugar would be a direct ingredients cost of a specific batch of cakes.
The lease rental cost would be a direct cost of a construction project.
The cost of drinks served would be a direct cost of a particular train journey.
4 D Idle time is usually treated as an overhead; in this case it is within the production department and
is therefore a factory overhead.
5 D The FIFO method prices issues from inventory at the cost of the earliest delivery remaining in
inventory.
The closing inventory will therefore be valued at the higher prices paid.
The charge to cost of sales will be lower than with LIFO, therefore the gross profit will be
higher.
6 D
CU
Weighted average cost per unit:
750 units  CU80 60,000
180 units  CU85 15,300
90 units  CU90 8,100
1,020 83,400
Weighted average cost per unit = CU83,400/1,020
= CU81.76
Cost of units sold on 24 March = CU81.76  852 units
= CU69,660

7 C Components issued on day 4 = 150 from week 8 receipts

Closing inventory week 10:
CU
Remaining 90 Components from week 8  CU5.91 531.90
160 Components from week 9  CU5.55 888.00
120 Components from week 10  CU5.96 715.20
370 2,135.10
8 D The LIFO method uses the cost of the most recent batches first.
CU
Cost of units sold on 24 April:
90 units  CU186 16,740
180 units  CU174 31,320
162 units  CU168 27,216
432 75,276
Sales revenue = 432 units  CU220 95,040

Less cost of units sold 75,276
Gross profit 19,764
9
True False
Using LIFO, managers are continually aware of recent costs when making
decisions, because the costs being charged to their departments or
products will be current costs

FIFO lets managers value issues at current prices in a period of high
inflation 
The use of the cumulative average pricing method of inventory valuation is
easier to administer than FIFO and LIFO because there is no need to
identify each batch separately

FIFO lets managers value issues at current prices in a period of high inflation is incorrect. Under
FIFO, inventory issues are valued at the cost of the earliest delivery remaining in inventory. In
times of inflation, this will mean that issue prices will be lower than current prices.
10 To the nearest CU, the value of the inventory at the end of September is CU2,200.
Total inventory available during quarter:
Boxes Value
CU
Opening inventory 400 1,000
Purchases: July 1,000 2,600
August 1,200 3,300
September 1,000 3,000
3,600 9,900
Periodic weighted average price = CU9,900/3,600
= CU2.75 per box
Closing inventory = 3,600 – (1,100 + 900 + 800)
= 800 boxes
Value of closing inventory = 800  CU2.75
= CU2,200


Cost incurred Direct or indirect?
The salary of the garage's accountant Indirect

The cost of heating the garage Indirect
A can of engine oil used in the repair Direct. This cost can be directly attributed to this
particular repair.
A smear of grease used in the repair Indirect. This cost is negligible and would not be
recorded separately as a direct cost.
An overtime premium paid to the mechanic Indirect. The overtime is being worked due to a
carrying out the repair generally heavy work load. This particular repair
has not caused the overtime premium to be
incurred. The cost is indirect and must be shared
over all the repair jobs carried out.
An idle time payment made to the mechanic while Indirect. The cost cannot be identified with any
waiting for a delivery of parts for a number of jobs particular repair job.
The wages of the supervisor overseeing the Indirect. The supervisor is overseeing all repair
mechanic carrying out the repair jobs being undertaken.

Receipts Issues Inventory
Date Unit Unit Unit
price Amount price Amount price
Quantity CU CU Quantity CU CU Quantity CU Amount CU
1.5.X6 100 2.00 200.00
3.5.X6 400 2.10 840.00 100 2.00 200.00

400 2.10 840.00
500 1,040.00
4.5.X6 100 2.00 200.00

100 2.10 210.00 300 2.10 630.00
9.5.X6 300 2.12 636.00 300 2.10 630.00

300 2.12 636.00
600 1,266.00
11.5.X6 300 2.10 630.00

100 2.12 212.00 200 2.12 424.00
18.5.X6 100 2.40 240.00 200 2.12 424.00

100 2.40 240.00
300 664.00
20.5.X6 100 2.12 212.00 100 2.12 212.00

100 2.40 240.00
31.5.X6 200 452.00


(a) A CU27
B CU54
C CU15
D CU135
WORKINGS
CU
8 June Inventory balance = 30 units  CU2.50 75
20 units  CU3.00 60
50 135
Weighted average price = 135/50
= 2.70
10 June Issues = 10 units  CU2.70 CU27
18 June Inventory balance = remaining 20 units  CU2.70 54
receipts 40 units  CU2.40 96
60 150
Weighted average price = 150/60
= 2.50
Inventory balance = 54 units  CU2.50 135
(b) A CU30
B CU55
C CU14.40
D CU131.60
WORKINGS
CU
10 June 10 units  CU3.00 30.00
14 June Issues 10 units  CU3.00 = 30.00
10 units  CU2.50 = 25.00
55.00
20 June Issues: 6 units  CU2.40 = 14.40
Balance: 34 units  CU2.40 81.60
20 units  CU2.50 50.00
54 131.60


chapter 3
Calculating unit costs (Part 2)
Contents
Introduction
Examination context
Topic List
1 Absorption costing
2 Activity based costing
3 Costing methods
4 Other approaches to cost management

Introduction

 Calculate unit costs from information provided, using absorption costing
 Select the most appropriate method of costing for a given product or service
The specific syllabus references for this chapter are: 1c, d.
We have seen that it is possible to attribute direct costs to individual cost units. However, for certain
management decisions, for example, when determining selling prices or valuing finished goods inventory,
management might need to know the full cost of the item, including a share of the indirect costs or
overheads.
Accordingly a method has to be devised for sharing the indirect costs between all the units that benefit
from them.
The costing method used to determine an organisation's unit costs will ultimately depend on the nature of
the organisation's operations.
Stop and think

Why will the costing method used by a company that builds motorway bridges be different from the costing
method used by a company that manufactures canned soup? What aspects of their operations mean that a
different costing method will be required?
Working context
Once again you are likely to come across the subject matter of this chapter in the context of auditing
inventory valuations. Typical procedures might involve checking that the indirect cost attributed to
inventory items is determined using a realistic and systematic basis.
Syllabus links
A knowledge of the method of determining a full unit cost will underpin your understanding of inventory
valuation for the Accounting syllabus.

Examination context
Exam requirements
Numerical questions on the calculation of overhead absorption rates and of over and under absorption of
overheads have been popular in past papers. Furthermore, the sample paper for this syllabus included a
question that required the calculation and application of a fixed overhead absorption rate based on labour
hours.
You should also be prepared to tackle narrative questions on overhead absorption as well as on the
selection of the most appropriate costing method in specific circumstances. The latter subject also featured
in the sample paper for this syllabus.
You will not be required to answer numerical questions about Activity Based Costing but you should be
able to demonstrate a general understanding of the underlying principles of this costing system.
 Calculate the full cost of a cost unit using absorption costing
 Demonstrate an understanding of the basic principles of activity based costing
 Identify the most appropriate costing method in specific circumstances
 Demonstrate an understanding of the general principles of target costing, life cycle costing and just in
time
It is essential to appreciate the difference between the allocation and apportionment of overheads, which
links back to the ideas about direct and indirect cost covered earlier.
A common difficulty is failing to allow for under/over absorption when predetermined overhead rates are
used.

1 Absorption costing
Section overview
 In absorption costing the full cost of a cost unit is equal to its prime cost plus an absorbed share of
overhead cost.
 The three stages in determining the share of overhead to be attributed to a cost unit are allocation,
apportionment and absorption.
 Overheads are absorbed into product or service costs using a predetermined overhead absorption
rate, usually set annually in the budget.
 The absorption rate is calculated by dividing the budgeted overhead by the budgeted level of activity.
For production overheads, the level of activity is often measured in terms of direct labour hours or
machine hours.
 Over or under absorption of overhead arises because the absorption rate is based on estimates.
1.1 Calculating the absorption cost of a cost unit

To calculate the full cost of an item using absorption costing (sometimes referred to as full costing) it is
necessary first to establish its direct cost or prime cost and then to add a fair share of indirect costs or
overhead.
The full or absorption cost per unit is therefore made up as follows.
CU
Direct materials X
Direct labour X
Direct expenses (if any) X
Total direct cost (prime cost) X
Share of indirect cost/overhead X
Absorption (full) cost X
There are three stages in determining the share of overhead to be attributed to a cost unit.
 Overhead allocation
 Overhead apportionment
 Overhead absorption
1.2 Overhead allocation

The first step in absorption costing is allocation. Allocation is the process by which whole cost items are
charged direct to a cost centre. A cost centre acts as a collecting place for costs before they are analysed
further.
Cost centres may be one of the following types.
 A production department, to which production overheads are charged.
 A production service department, to which production overheads are charged.
 An administrative department, to which administration overheads are charged.
 A selling or a distribution department, to which sales and distribution overheads are charged.
 An overhead cost centre, to which items of expense which are shared by a number of departments,
such as rent and rates, heat and light and the canteen, are charged.

The following are examples of costs that would be charged direct to cost centres via the process of
allocation.
 The cost of a warehouse security guard will be charged to the warehouse cost centre.
 Paper on which computer output is recorded will be charged to the computer department.
Worked example: Overhead allocation

Consider the following costs of a company.
CU
Wages of the supervisor of department A 200
Wages of the supervisor of department B 150
Indirect materials consumed in department A 50
Rent of the premises shared by departments A and B 300
The cost accounting system might include three cost centres.
Cost centre: 101 Department A
102 Department B
201 Rent
Overhead costs would be allocated directly to each cost centre, ie CU200 + CU50 to cost centre 101,
CU150 to cost centre 102 and CU300 to cost centre 201. The rent of the factory will be subsequently
shared between the two production departments, but for the purpose of day to day cost recording in this
particular system, the rent will first of all be charged in full to a separate cost centre.
1.3 Overhead apportionment

The next step in absorption costing is overhead apportionment. This involves apportioning general
overheads to cost centres (the first stage) and then reapportioning the costs of service cost centres to
production departments (the second stage).
1.3.1 First stage: apportioning general overheads

Overhead apportionment follows on from overhead allocation. The first stage of overhead apportionment
is to identify all overhead costs as production department, production service department, administration
or selling and distribution overhead. This means that the costs for heat and light, rent and rates, the canteen
and so on (that is, costs which have been allocated to general overhead cost centres) must be shared out
between the other cost centres.
Overhead costs should be shared out on a fair basis. You will appreciate that because of the complexity of
items of cost it is rarely possible to use only one method of apportioning costs to the various cost centres
of an organisation. The bases of apportionment for the most usual cases are given below.
Overhead to which the basis applies Basis
Rent, rates, heating and light, repairs and Floor area occupied by each cost centre
depreciation of buildings
Depreciation, insurance of equipment Cost or book value of equipment
Personnel office, canteen, welfare, wages and cost Number of employees, or labour hours worked in
offices, first aid each cost centre
Heating, lighting (see above) Volume of space occupied by each cost centre

Interactive question 1: Bases of apportionment [Difficulty level: Easy]

The following bases of apportionment are used by a factory.
A Volume of cost centre
B Value of machinery in cost centre
C Number of employees in cost centre
D Floor area of cost centre
Complete the table below using one of A to D to show the bases on which the production overheads
listed in the table should be apportioned.
Production overheads Basis
Rent
Heating costs
Insurance of machinery
Cleaning costs
Canteen costs
Worked example: Overhead apportionment

McQueen Co has incurred the following overhead costs.
CU'000
Depreciation of factory 100
Factory repairs and maintenance 60
Factory office costs (treat as production overhead) 150
Depreciation of equipment 80
Insurance of equipment 20
Heating 39
Lighting 10
Canteen 90
549
Information relating to the production and service departments in the factory is as follows.
Department
Production Production Service Service
1 2 100 101
Floor space (square metres) 1,200 1,600 800 400
Volume (cubic metres) 3,000 6,000 2,400 1,600
Number of employees 30 30 15 15
Book value of equipment CU30,000 CU20,000 CU10,000 CU20,000
The overhead costs are apportioned using the following general formula.
Total overhead cost
 Value of apportionment base of cost centre
Total value of apportionment base
For example, heating for department 1 = CU 39,000  3,000 = CU9,000

13,000

Total To department
Item of cost Basis of apportionment cost 1 2 100 101
CU CU CU CU CU
Factory depreciation (floor area) 100 30.0 40 20.0 10.0
Factory repairs (floor area) 60 18.0 24 12.0 6.0
Factory office costs (number of employees) 150 50.0 50 25.0 25.0
Equipment depreciation (book value) 80 30.0 20 10.0 20.0
Equipment insurance (book value) 20 7.5 5 2.5 5.0
Heating (volume) 39 9.0 18 7.2 4.8
Lighting (floor area) 10 3.0 4 2.0 1.0
Canteen (number of employees) 90 30.0 30 15.0 15.0
Total 549 177.5 191 93.7 86.8
Interactive question 2: Apportioning overheads [Difficulty level: Easy]

Pippin Co has three production departments (forming, machining and assembly) and two service
departments (maintenance and general).
The following is an analysis of budgeted overhead costs for the forthcoming twelve-month period.
CU CU
Rent and rates 8,000
Power 750
Light, heat 5,000
Repairs, maintenance:
Forming 800
Machining 1,800
Assembly 300
Maintenance 200
General 100
3,200
Departmental expenses:
Forming 1,500
Machining 2,300
Assembly 1,100
Maintenance 900
General 1,500
7,300
Depreciation:
Plant 10,000
Fixtures and fittings 250
Insurance:
Plant 2,000
Buildings 500
Indirect labour:
Forming 3,000
Machining 5,000
Assembly 1,500
Maintenance 4,000
General 2,000
15,500
52,500

Other available data are as follows.

Effective
Floor Plant Fixtures horse-
area value & fittings power
m2 CU CU
Forming 2,000 25,000 1,000 40
Machining 4,000 60,000 500 90
Assembly 3,000 7,500 2,000 15
Maintenance 500 7,500 1,000 5
General 500 – 500 –
10,000 100,000 5,000 150
Using direct allocation where possible, and the most appropriate apportionment basis where direct
allocation is not possible, calculate the overhead cost of each department.
(a) Forming is CU
(b) Machining is CU
(c) Assembly is CU
(d) Maintenance is CU
(e) General is CU
1.3.2 Second stage: service cost centre cost apportionment

The second stage of overhead apportionment concerns the treatment of service cost centres. For
example, a factory is divided into several production departments and also a number of service
departments, but only the production departments are directly involved in the manufacture of the units. In
order to be able to add production overheads to unit costs, it is necessary to have all the overheads
charged to (or located in) the production departments. The next stage in absorption costing is, therefore,
to apportion the costs of service cost centres to the production cost centres. Examples of possible
apportionment bases are as follows.
Service cost centre Examples of possible bases of apportionment
Stores Number of materials requisitions

Maintenance Hours of maintenance work done for each cost centre
Production planning Direct labour hours worked in each production cost centre
Interactive question 3: Production and service cost centres [Difficulty level: Easy]
Which of the following are production cost centres and which are service cost centres?
Production cost centre Service cost centre

Cost centre
( ) ( )
Finished goods warehouse

Canteen
Machining department
Offices
Assembly department

Worked example: Service centre cost apportionment

JPE Ltd is divided into five departments that are also cost centres. These are departments A, B and C
(through which cost units physically pass), an administrative department and a canteen.
Some details of the business are as follows:
A B C Canteen Admin
Floor area (sq metres) 5,000 5,000 4,000 4,000 2,000
Personnel (persons) 10 20 10 10 5
Remuneration per month
Direct (CU) 1,920 3,600 2,240 – –
Indirect (CU) 360 480 240 320 870
Direct materials consumed (CU) 5,500 250 400 – –
Machine hours per month 600 2400 200 – –
Power costs per month (CU) 50 500 20 80 –
General overheads per month (CU) 1,000 2,000 1,200 650 1,230
The monthly rent of the company’s premises is CU6,000.
The monthly takings of the canteen are CU600. Food bills for the canteen totalled CU470. None of the
administrative staff use the canteen.
The monthly electricity charge for heat and light is CU1,000.
The administration costs are made up mainly of personnel-related costs.
Requirement
Apportion all overheads to the production cost centres.
Solution
Step 1: Primary allocation and apportionment
Where possible, costs should be allocated directly to each cost centre. Where costs are shared, a fair basis
of apportionment should be selected. Remember that the analysis is concerned only with overheads. Direct
material and direct wages costs are not included.
Basis of
Cost item apportionment A B C Canteen Admin
CU CU CU CU CU
Indirect labour Allocation 360 480 240 320 870
Power Allocation 50 500 20 80 0
General overhead Allocation 1,000 2,000 1,200 650 1,230
Canteen takings Allocation (600)
Food Allocation 470
Rent Floor area 1,500 1,500 1,200 1,200 600
Electricity Floor area 250 250 200 200 100
3,160 4,730 2,860 2,320 2,800
Point to note
The apportionment of rental costs and electricity costs have been made on the basis of floor area, because
this seems 'fair'. The choice of the fairest basis, however, in practice, is a matter for judgement.
Step 2: Re-apportion the service centre costs
The next step is to apportion the costs of the service cost centres to the production cost centres. The
method illustrated here is as follows.
 The first apportionment is for the service cost centre with the largest costs. These costs are shared
between all the other cost centres, including the other service cost centre, on a fair basis.
 The costs of the second service cost centre, which will now include some of the first service cost
centre’s costs, are apportioned between the production cost centres, on a fair basis. This is illustrated
below.

Basis of
Cost item apportionment A B C Canteen Admin
CU CU CU CU CU
Costs allocated and
apportioned 3,160 4,730 2,860 2,320 2,800
Apportion admin No. of employees
excluding admin 560 1,120 560 560 (2,800)
3,720 5,850 3,420 2,880 0
Apportion canteen No. of employees
in A, B and C 720 1,440 720 (2,880) –
4,440 7,290 4,140 0 0
Points to note
1 The costs of the administration department were taken first because these are the largest service
centre costs. The basis of apportionment selected is number of employees, since administration costs
are largely personnel-related.
2 The costs of the canteen have also been apportioned on the basis of number of employees, because
canteen work is primarily employee-related.
3 Service centre costs must ultimately be apportioned to the production cost centres; otherwise there
will be no mechanism for absorbing the costs into the cost of output units.
4 Workings: Apportionment of administration department costs
CU2,800
= CU56.00 per employee
(10  20  10  10)
The apportionment of costs is therefore (10  CU56) = CU560 to Department A, (20  CU56) =
CU1,120 to Department B, (10  CU56) = CU560 to Department C, and (10  CU56) = CU560 to
the canteen.
5 Workings: Apportionment of canteen costs
CU2,880 = CU72.00 per employee

(10  20  10)
The apportionment of costs is therefore (10  CU72) = CU720 to Department A, (20  CU72) = CU1,440
to Department B, and (10  CU72) = CU720 to Department C.
1.4 Overhead absorption

Having allocated and/or apportioned all overheads, the next stage in absorption costing is to add them to,
or absorb them into, the cost of production or sales.
 Production overheads are added to the prime cost (direct materials, labour and expenses), the
total of the two being the factory cost, or full cost of production. Production overheads are therefore
included in the value of inventories of finished goods.
 Administration, selling and distribution overheads are then included. The aggregate of the
factory cost and these non-production overheads is the total cost of sales. These non-production
overheads are therefore not included in the value of closing inventory.
1.4.1 Predetermined absorption rates

In absorption costing, it is usual to add overheads into product costs by applying a predetermined
overhead absorption rate. The predetermined rate is usually set annually in advance, as part of the
budgetary planning process.

Overheads are not absorbed on the basis of the actual overheads incurred but on the basis of estimated or
budgeted figures (calculated prior to the beginning of the period). There are several reasons why the rate at
which overheads are included in production costs (the absorption rate) is determined before the
accounting period begins.
 Goods are produced and sold throughout the year, but many actual overheads are not known until
the end of the year. It would be inconvenient to wait until the year end in order to decide what
overhead costs should be included in production costs.
 An attempt to calculate overhead costs more regularly (such as each month) is possible, although
estimated costs must be added for periodic expenditure such as rent and rates (usually incurred
quarterly). The difficulty with this approach would be that actual overheads from month to month
could fluctuate therefore overhead costs charged to production would be inconsistent. For example, a
unit made in one week might be charged with CU4 of overhead, in a subsequent week with CU5, and
in a third week with CU4.50. Only units made in winter would be charged with the heating overhead.
Such charges are considered misleading for costing purposes and administratively inconvenient.
 Similarly, production output might vary each month. For example, actual overhead costs might be
CU20,000 per month and output might vary from, say, 1,000 units to 20,000 units per month. The unit
rate for overhead would be CU20 and CU1 per unit respectively, which would again lead to
administration and control problems.
1.4.2 Calculating predetermined overhead absorption rates

The absorption rate is calculated by dividing the budgeted overhead by the budgeted level of activity.
For production overheads the level of activity is often budgeted direct labour hours or budgeted machine
hours.
Overhead absorption rates are therefore predetermined as follows.
 The overhead likely to be incurred during the coming period is estimated.
 The total hours, units, or direct costs on which the overhead absorption rates are to be based (the
activity level) are estimated.
 The estimated overhead is divided by the budgeted activity level to arrive at an absorption rate for the
forthcoming period.
1.4.3 Selecting the appropriate absorption base

Management should try to establish an absorption rate that provides a reasonably 'accurate' estimate
of overhead costs for jobs, products or services.
There are a number of different bases of absorption (or 'overhead recovery rates') that can be used.
Examples are as follows.
 A rate per machine hour
 A rate per direct labour hour
 A rate per unit
 A percentage of direct materials cost
 A percentage of direct labour cost
 A percentage of prime cost
The choice of an absorption basis is a matter of judgement and common sense. There are no strict rules or
formulae involved, although factors that should be taken into account are set out below. What is required is
an absorption basis that realistically reflects the characteristics of a given cost centre and avoids undue
anomalies, for example:
 A direct labour hour basis is most appropriate in a labour intensive environment.
 A machine hour rate would be used in departments where production is controlled or dictated by
machines. This basis is becoming more appropriate as factories become more heavily automated.
 A rate per unit is only effective if all units are identical in terms of the resources utilised in their
manufacture in each cost centre.

Worked example: overhead absorption bases

The budgeted production overheads and other budget data of Calculator Co are as follows.
Production Production
Budget dept 1 dept 2
Production overhead cost CU36,000 CU5,000
Direct materials cost CU32,000
Direct labour cost CU40,000
Machine hours 10,000
Direct labour hours 18,000
Units of production 1,000
The production overhead absorption rates using the various bases of apportionment would be as follows.
 Department 1
CU 36 ,000
– Percentage of direct materials cost =  100% = 112.5%
CU 32 ,000
CU 36 ,000
– Percentage of direct labour cost =  100% = 90%
CU 40 ,000
CU 36 ,000
– Percentage of prime cost =  100% = 50%
CU 72 ,000
CU 36 ,000
– Rate per machine hour = = CU3.60 per machine hour
10 ,000 hrs
CU 36 ,000
– Rate per direct labour hour = = CU2 per direct labour hour
18,000 hrs
 Department 2
– The department 2 absorption rate will be based on units of output.
CU 5,000
= CU5 per unit produced
1,000 units
The choice of the basis of absorption is significant in determining the cost of individual units, or jobs,
produced. In this example, suppose that an individual product has a material cost of CU80, a labour cost of
CU85, and requires 36 labour hours and 23 machine hours to complete. The production overhead cost of the
product would vary, depending on the basis of absorption used by the company for overhead recovery.
 As a percentage of direct materials cost, the overhead cost would be 112.5%  CU80 = CU90.00
 As a percentage of direct labour cost, the overhead cost would be 90%  CU85 = CU76.50
 As a percentage of prime cost, the overhead cost would be 50%  CU165 = CU82.50
 Using a machine hour basis of absorption, the overhead cost would be 23 hrs  CU3.60 = CU82.80
 Using a labour hour basis, the overhead cost would be 36 hrs  CU2 = CU72.00
In theory, each basis of absorption would be possible, but the company should choose a basis for its own costs
that seems to be 'fairest'. In our example, this choice will be significant in determining the cost of individual
products, as the following summary shows, but the total cost of production overheads is the budgeted
overhead expenditure, no matter what basis of absorption is selected. It is the relative share of overhead costs
borne by individual products and jobs that is affected by the choice of overhead absorption basis.

A summary of the product costs is shown below.

Basis of overhead recovery
Percentage of Percentage of Percentage of Machining Direct labour
materials cost labour cost prime cost hours hours
CU CU CU CU CU
Direct material 80.00 80.00 80.00 80.00 80.00
Direct labour 85.00 85.00 85.00 85.00 85.00
Production overhead 90.00 76.50 82.50 82.80 72.00
Total production cost 255.00 241.50 247.50 247.80 237.00
Interactive question 4: Overhead absorption rates [Difficulty level: Easy]

Use the following information to determine suitable overhead absorption rates for a company's three
production cost centres.
Forming Machining Assembly
Budgeted cost centre overheads CU13,705 CU28,817 CU9,978
Budgeted direct labour hours per annum 5,482 790 4,989
Budgeted machine hours per annum 1,350 5,240 147
(a) The forming department rate is CU per direct labour hour/ machine hour
(delete as appropriate)
(b) The machining department rate is CU per direct labour hour/ machine hour
(c) The assembly department rate is CU per direct labour hour/ machine hour
1.5 Blanket absorption rates and departmental absorption rates

A blanket or single factory overhead absorption rate is an absorption rate used throughout a
factory and for all jobs and units of output irrespective of the department in which they were produced.
For example, if total overheads were CU500,000 and there were 250,000 machine hours during the period,
the blanket overhead rate would be CU2 per machine hour and all units of output passing through the
factory would be charged at that rate.
Such a rate is not appropriate, however, if there are a number of departments and units of output do not
spend an equal amount of time in each department.
Worked example: Absorption rates

AB Ltd has two production departments, for which the following budgeted information is available.
Department 1 Department 2 Total
Budgeted overheads CU360,000 CU200,000 CU560,000
Budgeted direct labour hours 200,000 hrs 40,000 hrs 240,000 hrs
If a single factory overhead absorption rate is applied, the rate of overhead recovery would be:
CU 560 ,000
= CU2.33 per direct labour hour
240 ,000 hours

If separate departmental rates are applied, these would be:

Department 1 Department 2
CU 360 ,000 CU 200 ,000

= CU1.80 per direct labour hour = CU5 per direct labour hour
200 ,000 hours 40 ,000 hours
Department 2 has a higher overhead cost per hour worked than department 1.
Now let us consider two separate products.
 Product A has a prime cost of CU100, takes 30 hours in department 2 and does not involve any work
in department 1.
 Product B has a prime cost of CU100, takes 28 hours in department 1 and 2 hours in department 2.
Requirements
What would be the production cost of each product, using the following rates of overhead recovery?
(a) A single factory rate of overhead recovery
(b) Separate departmental rates of overhead recovery
Solution
Product A Product B
(a) Single factory rate CU CU
Prime cost 100.00 100.00
Production overhead (30  CU2.33) 70.00 70.00
Production cost 170.00 170.00
(b) Separate departmental rates CU CU
Prime cost 100.00 100.00
Production overhead: Department 1 (0  0.00 (28  50.40
CU1.80) CU1.80)
Department 2 (30  CU5) 150.00 (2  CU5) 10.00
Production cost 250.00 160.40
Using a single factory overhead absorption rate, both products would cost the same. However, since
product A is produced entirely within department 2 where overhead costs are relatively higher,
and product B is produced mostly within department 1, where overhead costs are relatively lower, it is
arguable that product A should cost more than product B. This can be seen to be the case if separate
departmental overhead recovery rates are used to reflect the work done on each job in each department
separately.
Interactive question 5: Calculating the overhead to be absorbed

[Difficulty level: Intermediate]
In relation to calculating total absorption cost, label the following descriptions in the correct order as
Steps 1 – 5.
Description Step
A Apportion fixed costs over cost centres

B Establish the overhead absorption rate
C Choose fair methods of apportionment
D Apply the overhead absorption rate to products
E Reapportion service cost centre costs

1.6 Over and under absorption of overheads

The overhead absorption rate is based on estimates (of both numerator and denominator) and it is quite
likely that either one or both of the estimates will not agree with what actually occurs. Actual overheads
incurred are unlikely to be equal to the overheads absorbed into the cost of production.
(a) Over absorption means that the overheads charged to the cost of production are greater than the
overheads actually incurred.
(b) Under absorption means that insufficient overheads have been included in the cost of production.
Worked example: Over and under absorption of overheads

Suppose that the budgeted production overhead in a production department is CU80,000 and the budgeted
activity is 40,000 direct labour hours. The overhead recovery rate (using a direct labour hour basis) would
be CU2 per direct labour hour.
Actual production overheads in the period are, say, CU84,000, and 45,000 direct labour hours are worked.
CU
Overhead incurred (actual) 84,000
Overhead absorbed (45,000  CU2) 90,000
Over absorption of overhead 6,000
In this example, the cost of produced units or jobs has been charged with CU6,000 more than was actually
spent. An adjustment to reconcile the overheads charged to the actual overhead is necessary and the
over-absorbed overhead will be written as a credit to the income statement at the end of the accounting
period. By making this adjustment the total overhead in the income statement would be reduced to
CU84,000, matching the overhead cost actually incurred.
1.6.1 The reasons for under/over absorbed overhead

The overhead absorption rate is predetermined from budget estimates of overhead cost and the
expected volume of activity. Under or over recovery of overhead will occur in the following circumstances.
 Actual overhead costs are different from budgeted overheads; or
 The actual activity level is different from the budgeted activity level.
It is mathematically possible, but unlikely, that if both variations occur together they could cancel each other
out so that no over or under absorption occurs.
Interactive question 6: Under and over absorption of overheads

Using your answer to Interactive question 4 and the following information, determine whether the overhead
in each of the three production departments is under or over absorbed and by how much for the year.
Forming Machining Assembly
Actual direct labour hours 5,370 950 5,400
Actual machine hours 1,300 6,370 100
Actual overhead CU13,900 CU30,300 CU8,500
(a) The overhead in the forming department is under/over* absorbed by CU
(b) The overhead in the machining department is under/over* absorbed by CU
(c) The overhead in the assembly department is under/over* absorbed by CU

* Delete as applicable

2 Activity based costing
Section overview
 Activity based costing (ABC) is an alternative approach to absorption costing.
 ABC involves the identification of the factors (cost drivers) that cause the costs of an organisation’s
major activities.
 Activity costs are assigned to products or services on the basis of the number of the activity’s cost
drivers that each product or service generates.
 The resulting product costs provide more accurate information for cost management and control.
2.1 The problem with traditional absorption costing

We have seen that the traditional absorption costing system relies on subjective judgement concerning the
basis of apportionment of overheads to cost centres. To a greater or lesser extent, all methods of
apportionment and absorption are arbitrary in nature. Where overheads form a relatively low proportion
of the total costs of a business, the arbitrary nature of overhead apportionment and absorption may not be
a serious issue. However, a significant feature of many modern businesses is the relatively high level of
overhead costs in relation to total costs. In this situation, the traditional absorption costing system can
create a problem for management seeking to accurately identify unit costs and exert control over these
costs. This problem has particular significance given the highly competitive environment faced by many
businesses.
Worked example: The problem with traditional absorption costing

A business sells 20,000 coffee mugs per year comprising large mugs (10,000), medium size mugs (8,000) and
small mugs (2,000). The time spent by direct labour is the same for each mug and the time spent on the
machines is also the same for each mug. This will mean that, using either the direct labour hour method or
the machine hour method of apportionment, the overheads absorbed by each mug will be the same. Thus,
assuming the total overheads are CU15,000, each mug will bear CU0.75 (ie CU15,000/20,000) of the total
overheads.
Overall, the large mugs will absorb 50 per cent of the total overheads (ie 10,000/20,000), the medium size
mugs will absorb 40 per cent of the total overheads (ie 8,000/20,000) and the small mugs will absorb 10 per
cent (ie 2,000/20,000). However, this may not be an equitable apportionment of overhead costs. For
example, where there are high set up costs or there are demanding requirements concerning a particular
product, the volume of output may be an unreliable guide to the time and effort expended by the service
departments on each product. It may be that each type of mug produced places equal demands on the
support departments such as administration, distribution, packaging, etc. If this situation occurs, it can be
argued that the large mugs and medium size mugs, which are the higher volume items, will bear too high a
proportion of the total overheads and the small mugs, which have a lower volume of output, will bear too
low a proportion of the total overheads if the traditional approach is followed.
2.2 The activity based costing approach

Activity based costing (ABC) provides an alternative to the traditional method of absorption
costing. The objective of this method is to establish a better means of relating overheads to output. It is
claimed that the ABC method provides managers with a better basis for both cost control and for the
analysis of profitability.

The major concepts underlying ABC can be demonstrated as follows.
Traditional absorption costing

assigns a large share of overhead
to large volume items and a small This is because overheads are usually absorbed using an hourly rate.
share to small volume items.
In high-technology production and

in service operations there are
many 'support' activities that are Activities include setting up machines and order processing.
not related to output.
Activities cause costs. Products create a demand for the activities, but not necessarily in
relation to the volume manufactured.
The costs of an activity are caused The cost of the ordering activity might be driven by the number of
or driven by factors known as orders placed, the cost of the despatching activity by the number of
cost drivers. despatches made.
The costs of an activity are If product A requires five orders to be placed, and product B 15
assigned to products on the basis orders, ¼ (ie 5/(5 + 15)) of the ordering cost will be assigned to
of the number of cost drivers. product A and ¾ (ie 15/(5+15)) to product B.
2.2.1 Cost drivers

For those costs that vary with production levels in the short term, ABC uses volume-related cost
drivers such as labour hours or machine hours. The cost of oil used as a lubricant on machines would
therefore be added to products on the basis of the number of machine hours, since oil would have to be
used for each hour the machine ran.
For costs that vary with some other activity and not volume of production, ABC uses
transaction-related cost drivers such as the number of production runs for the production scheduling
activity.

2.2.2 Calculating product costs using ABC

Step 1
Identify an organisation's major activities.
Step 2
Identify the factors (cost drivers) which
cause the costs of the activities.
Step 3
Collect the costs associated with each Cost pools are equivalent to cost centres used with
activity into cost pools. traditional absorption costing.
Step 4 Suppose the cost pool for the ordering activity totalled
Charge the costs of activities to products CU100,000 and that there were 10,000 orders (orders
on the basis of their usage of the activities. being the cost driver). Each product would therefore
A product's usage of an activity is measured be charged with CU10 for each order it required. A
by the quantity of the activity's cost driver batch requiring five orders would therefore be charged
it generates. with CU50.
Although you will not be required to perform numerical calculations using ABC in your exam, the following
example will help to clarify the differences between ABC and traditional absorption costing.
Worked example: Comparing ABC with traditional absorption costing

Suppose that AB Ltd manufactures four products, W, X, Y and Z. Output and cost data for the period just
ended are as follows.
No. of production Material cost Direct labour Machine hours Total machine
Output runs in the period per unit hours per unit per unit or labour hours
Units CU
W 10 2 20 1 1 10
X 10 2 80 3 3 30
Y 100 5 20 1 1 100
Z 100 5 80 3 3 300
14
Direct labour cost per hour is CU10. Overhead costs are as follows.
CU
Short-run variable costs 3,080
Set-up costs 10,920
Production and scheduling costs 9,100
Materials handling costs 7,700
30,800

Traditional absorption costing

Using absorption costing and an absorption rate based on either direct labour hours or machine hours, the
product costs would be as follows.
W X Y Z Total
CU CU CU CU CU
Direct material 200 800 2,000 8,000 11,000
Direct labour 101100 300 111,000 3,000 44,400
Overheads * 700 2,100 7,000 21,000 30,800
1,000 3,200 10,000 32,000 46,200
Units produced 10 10 100 100
Cost per unit CU100 CU320 CU100 CU320
* CU30,800  440 hours = CU70 per direct labour or machine hour
Activity based costing

Using activity based costing and assuming that the number of production runs is the cost driver for set-up
costs, production and scheduling costs and materials handling costs and that machine hours are the cost
driver for short-run variable costs, unit costs would be as follows.
W X Y Z Total
CU CU CU CU CU
Direct material 200 800 2,000 8,000 11,000
Direct labour 100 300 1,000 3333,000 4,400
Short-run variable overheads (W1) 70 210 700 2,100 3,080
Set-up costs (W2) 1,560 1,560 3,900 3,900 10,920
Production and scheduling costs (W3) 1,300 1,300 3,250 3,250 9,100
Materials handling costs (W4) 1,100 1,100 2,750 2,750 7,700
4,330 5,270 13,600 23,000 46,200
Units produced 10 10 100 100
Cost per unit CU433 CU527 CU136 CU230
WORKINGS
(1) CU3,080  440 machine hours = CU7 per machine hour
(2) CU10,920  14 production runs = CU780 per run
Summary
Absorption
costing ABC
Product Unit cost Unit cost Difference
CU CU CU
W 100 433 + 333
X 320 527 + 207
Y 100 136 + 36
Z 320 230 – 90
The figures suggest that the traditional volume-based absorption costing system is flawed.
 It under allocates overhead costs to low-volume products (here, W and X) and over allocates
overheads to higher-volume products (here Z in particular).
 It under allocates overhead costs to less time consuming products (here W and Y with just one hour
of work needed per unit) and over allocates overheads to more time consuming products (here X and
particularly Z).

3 Costing methods
Section overview
 An organisation's costing method will depend on the nature of its operations.
 Specific order costing methods are appropriate when each cost unit is separately identifiable.
 Types of specific order costing method are job, batch and contract costing.
 Job and batch costing are appropriate when jobs are of relatively short duration. Each batch is a
separate job consisting of a number of identical units.
 Contract costing is appropriate when cost units are of relatively long duration. Contracts are usually
undertaken away from the organisation's own premises.
 The process costing method is appropriate when output consists of a continuous flow of identical units.
 In a process costing environment unit costs are determined on an averaging basis.
Regardless of the materials pricing method that is selected by management or whatever basis is used to
absorb overheads into cost units, the overall costing method used by an organisation will ultimately depend
on the nature of the organisation’s operations.
3.1 Specific order costing

Some organisations produce ‘one off’ products or services to a customer’s specific requirements, where
each cost unit is separately identifiable from all others. The operations of these organisations can range
from providing plumbing services, repairing vehicles or manufacturing a custom-made garden bench, to
building a school or a hospital or a block of flats.
3.1.1 Job costing

Job costing is appropriate where each separately identifiable cost unit or job is of relatively short
duration, such as the plumbing services and the garden bench in the examples above. Each job would be
allocated a separate job number and costs would be accumulated against this number in order to determine
the total cost of the job.
 Issues of direct material would be charged to each job using FIFO or LIFO, etc.
 Direct labour charges would be determined from detailed time records kept for each employee.
 Overhead costs would be absorbed into the total cost of each job using the predetermined overhead
absorption rate for each cost centre through which the job passes.
Direct material issues Direct labour costs

FIFO, LIFO etc Based on time records
Job No.
XXXX
Production overhead costs
Absorbed from cost centre A,

cost centre B, etc

3.1.2 Contract costing

Contract costing is appropriate where each separately identifiable cost unit is of relatively long
duration, such as the building of the school or hospital in the examples above. Contracts are often
undertaken away from the organisation’s own premises.
Each contract would be allocated a separate number and costs would be accumulated against this number in
order to determine the total cost of the contract.
 Many direct materials would be delivered straight to the contract but issues of direct material from
stores would be charged to each contract using FIFO or LIFO, etc.
 Many direct employees would be permanently employed on the contract site but direct labour charges
for those employees travelling between sites would be determined from detailed time records kept
for each employee.
 Many overhead costs can be allocated directly to the contract but administrative overhead might be
absorbed into contract costs using some form of absorption basis.
3.1.3 Batch costing

Batch costing is similar to job costing except that each separately identifiable cost unit would be a
batch of identical items. For example, batch costing can be applied when production takes the form of
separately identifiable batches of shoes or batches of printed advertising leaflets.
Each batch would be allocated a number to identify it and costs would be accumulated for the batch in the
same way as for a job in job costing. The cost per unit manufactured in a batch is the total batch cost
divided by the number of units in the batch.
3.2 Process (continuous operation) costing

Some organisations have a continuous flow of operations and produce a large number of identical products.
Food processing is one example and oil refining is another.
Such operations often consist of a number of consecutive processes where the output of one process
becomes the input of the subsequent process and so on until the finished output is produced.
For example, the processes involved in making bottled sauces might be as follows.
Mixing Cooking Bottling Packing Output to

Process Process Process Process finished goods
Each process usually acts as a cost centre and material, labour and overhead costs are collected to derive a
total cost for each process for each period. The cost per unit of output from each process is
determined by dividing the total process cost by the number of units produced each period.
This unit cost then becomes an input cost for the subsequent process and so on until the final cost of a
completed unit is accumulated.
Additional materials
and labour
Materials
Process 1 Process 1 input Process 2 Average total unit cost
Labour
to finished goods
Overhead
Additional overhead
Process costing can also be applied in a service environment. For example, in an organisation that provides
a shirt laundering service the processes involved might be as follows.
Washing Drying Pressing Packing Finished output

Process Process Process Process

The cost per shirt laundered would be determined by the same averaging process as described earlier.
Interactive question 7: Costing methods [Difficulty level: Intermediate]

Tick one costing method that would be appropriate in each of the following industries.
Process Job Contract Batch
Fitting kitchens
Manufacturing components
Manufacturing chemicals
Building offices
4 Other approaches to cost management
Section overview
 Life cycle costing tracks and accumulates the costs and revenues attributable to each product over its
entire life cycle.
 Life cycle costs include those incurred in developing the product and bringing it to market, as well as
the costs incurred after sales of the product have ceased.
 Target costing begins with a concept for a new product for which a required selling price is
determined after consideration of the market conditions.
 The required profit margin is deducted from the selling price to determine the target cost for the
product.
 The costs to be incurred over the product’s entire life cycle are then examined to ensure that the
target cost is achieved.
 Just in time (JIT) is an approach to operations planning and control based on the idea that goods and
services should be produced only when they are needed.
4.1 Life cycle costing

A product incurs costs over the whole of its life cycle, from the design stage through development to
market launch, production and sales, and its eventual withdrawal from the market.
Component elements of a product's costs over its life cycle include the following.
 Research and development costs: design, testing and so on.
 Training costs: including initial operator training.
 Production costs: materials, labour and so on.
 Distribution costs: transportation, handling, inventory cost.
 Marketing costs: advertising, customer service.
 Retirement and disposal costs: dismantling specialised equipment.

Costs Costs incurred during production

incurred and sales stage, eg direct materials,
marketing costs
Costs incurred before

production and sales
begin, eg R&D Costs incurred once
production has ceased,
eg disposal costs
Time
Figure 3.1: Costs incurred during the life cycle of a product or service
Traditional management accounting systems are based on the accounting year and tend to dissect the
product's life cycle in a series of annual sections. This means that a product's profitability over its entire life
is not assessed, but rather its profitability is assessed on a periodic basis.
In contrast, life cycle costing tracks and accumulates actual costs and revenues attributable to
each product over its entire life cycle, hence the total profitability of any given product can be
determined.
4.2 Target costing

We have seen how the full cost of a product can be determined using some form of absorption costing.
This full cost is often used as the basis of the selling price decision: a desired profit mark-up is added to the
full cost to determine the product's selling price.
Target costing works the other way round. It begins with a concept for a new product and, after
considering the situation in the potential market for the product, a required selling price is determined.
From this price is deducted the desired profit margin, and the resulting acceptable cost becomes the target
cost. Thus the selling price determines the cost rather than the other way round.
Determine Determine
unit cost target cost
Add desired Deduct desired

profit margin profit margin
Determine Determine
selling price selling price
Traditional Target
pricing costing
The costs to be incurred over the product's entire life cycle are then examined and engineered in order to
ensure that the target cost is achieved.
Of particular importance is the initial design of the product. This is because many of the costs to be
incurred over the product's entire life cycle are built into the product at the design stage.

4.3 Just in time

Just in time (JIT) is an approach to operations planning and control based on the idea that goods and
services should be produced only when they are needed. They should not be produced too early, so
that inventories build up, nor too late, so that the customer has to wait.
JIT consists of JIT purchasing and JIT production.
 JIT production is driven by demand for a product so that no items are produced until they are needed
by a customer or by the next stage in a production process.
 JIT purchasing requires that material is delivered by the supplier just as it is needed in the production
process.
JIT systems are often referred to as 'pull' systems, whereby demand from a customer pulls products
through the production process. This is in contrast to traditional manufacturing systems, which are 'push'
systems because a delivery from a supplier pushes products through production into inventory.
'Push' systems 'Pull' systems

Supplier Production Customer Supplier Production Customer
4.3.1 Operational requirements for JIT

A number of operational requirements are vital to the success of a JIT system.
 High quality. Production must not be disrupted by quality failures.
 Speed. Throughput in the operation must be fast so that customer orders can be met by production
rather than out of inventory.
 Reliability. Supplies and production must be reliable, to avoid hold-ups.
 Flexibility. To respond immediately to customer orders, production must be flexible and in small
batch sizes.
 Efficient production planning. To ensure that goods are ready just when they are needed and that
overproduction does not occur.
 Reliable sales forecasting. More accurate sales forecasts ensure that sales and production are
better coordinated. This helps to avoid the build-up of inventories when forecasts are over-optimistic,
or delays when production is not ready in time to meet sales requirements which exceed forecasts.
4.3.2 JIT and cost management

An efficient JIT system enables managers to control and reduce costs in a number of areas, including the
following.
 Warehousing costs. Reduced storage costs result from holding lower inventories.
 Improved capacity utilisation. Efficient production planning enables capacity to be used in the
most effective way with a faster throughput, thus reducing unit costs.
 Reduction in waste. The focus on high quality reduces the incidence of costs due to rejects.
 Reduction in write-offs due to obsolescence. Since goods are produced only as customers need
them there is a reduction in obsolescence costs due to unexpected changes in customer requirements.

Summary
Self-test
1 The direct materials involved in the manufacture of a Whoopie cost CU2 per unit and the direct
labour cost is CU2.50 per unit. There are also direct expenses of CU0.50 per Whoopie.
Fixed costs allocated to one Whoopie amount to CU3.15.
Calculate the prime cost of a Whoopie.
The prime cost of a Whoopie is CU

2 A company has two production departments and two service departments with production overheads
as shown in the following table.
dept W dept X dept Y dept Z
Production overheads (CU'000) 500 600 600 800
Service department Y divides its time between the other departments in the ratio 3:2:1 (for W, X and
Z respectively).
Department Z spends 40% of its time servicing department W and 60% of its time servicing
department X. If all service department overheads are apportioned to production departments, the
total fixed overhead cost of department W is: CU
3 An overhead absorption rate is used to:
A Share out common costs to benefiting cost centres.
B Find the total overheads for a cost centre.
C Charge overheads to products.
D Control overheads.
4 A company produces two products, Bubble and Squeak, in two production cost centres. The initial
allocation and apportionment of budgeted production overheads has been completed. Extracts from
the budget are as follows:
Machining Finishing
cost cost
centre centre
Production overheads CU38,000 CU10,350
Machine hours per unit:
product Bubble 6 2
product Squeak 4 1
Production overheads are absorbed on a machine hour basis. Budgeted production is 800 units of
Bubble and 700 units of Squeak.
The budgeted production overhead cost per unit of Bubble is
A CU39.00
B CU45.00
C CU45.20
D CU54.00
5 ABC Co has been using an overhead absorption rate of CU6.25 per labour hour in its packing
department throughout the year.
During the year the overhead expenditure amounted to CU257,500, and 44,848 labour hours were
used.
Which of the following statements is correct?
A Overheads were under absorbed by CU27,600
B Overheads were under absorbed by CU22,800
C Overheads were over absorbed by CU27,600
D Overheads were over absorbed by CU22,800
6 Budgeted and actual data for the year ended 31 December 20X1 is shown in the following table.
Budget Actual
Production (units) 5,000 4,600
Fixed production overheads CU10,000 CU10,000
Sales (units) 4,500 4,000
Fixed production overheads are absorbed on a per unit basis, based on a normal capacity of 5,000
units per annum.

Why did under absorption of fixed production overheads occur during the year ended 31 December
20X1?
A The company sold fewer units than it produced
B The company sold fewer units than budgeted
C The company produced fewer units than budgeted
D The company budgeted to sell fewer units than produced
7 A management consultancy absorbs overheads on chargeable consulting hours. Budgeted overheads
were CU615,000 and actual consulting hours were 32,150. Overheads were under-absorbed by
CU35,000.
If actual overheads were CU694,075, what was the budgeted overhead absorption rate per hour?
A CU19.13
B CU20.50
C CU21.59
D CU22.68
8 Which TWO of the following statements about traditional absorption costing and ABC are correct?
A Traditional absorption costing tends to assign too small a proportion of overheads to high
volume products.
B ABC costing systems will provide accurate unit costs because cost drivers are used to trace
overhead costs to products and services.
C An ABC system does not use volume-related cost drivers.
D Cost pools in an ABC system are equivalent to cost centres used in traditional absorption
costing.
E A cost driver is the factor that influences the cost of an activity.
9 Which TWO of the following statements are correct?
A Process costing is the most appropriate costing method when a continuous flow of identical units
is produced.
B Job costing and contract costing can only be applied where work is undertaken on the
organisation's own premises.
C In process costing the cost per unit is derived using an averaging calculation.
D Process costing cannot be applied in a service environment.
E For batch costing to be applied each unit in the batch must be separately identifiable.
10 Which TWO of the following statements are correct?
A Life cycle costing is the profiling of cost over a product's production life.
B The aim of target costing is to reduce life cycle costs of new products in order to achieve a cost
that will produce the target profit.
C Once a product's target cost has been determined, the desired profit mark up is added to derive
the product's selling price.
D JIT systems are referred to as 'push' systems becasuse they push products through the
production process as quickly as possible.
E JIT purchasing requires small, frequent deliveries from suppliers as near as possible to the time
the raw materials and parts are needed.

1 CU5
Whoopie prime cost CU per
unit
Direct materials 2.00
Direct labour 2.50
Direct expenses 0.50
Prime cost 5.00
Remember that prime cost is the total of all direct costs. The fixed cost of CU3.15 per unit is
excluded from the prime cost calculation.
2 CU1,160,000
dept W dept X dept Y dept Z
CU'000 CU'000 CU'000 CU'000
Production overheads 500 600 600 800
Apportion Y (3:2:1) 300 200 (600) 100
900
Apportion Z (40:60) 360 540 – (900)
1,160
3 C A is incorrect because this is overhead apportionment.
B is incorrect because total overheads are found for cost centres by analysing cost information.
D is incorrect because overheads are controlled using budgets and other management
information.
4 A
Machining Finishing
Budgeted machine hours:
Bubble (6  800) 4,800 (2  800) 1,600
Squeak (4  700) 2,800 (1  700) 700
7,600 2,300
Production overhead absorption rate
per machine hour (CU38,000/7,600) CU5.00 (CU10,350/2,300) CU4.50
Production overhead per unit of Bubble = (6 hours  CU5.00) + (2 hours  CU4.50)

= CU39.00
5 D Actual overheads were CU257,500. Absorbed overheads = CU6.25  44,848 = CU280,300.
Actual overheads – absorbed overheads = CU257,500 – CU280,300
= CU22,800 over absorbed
Overheads were therefore over absorbed by CU22,800.
6 C Options A and B are incorrect because it is the levels of production that bring about under/over
absorption.
Option D is incorrect because the company was budgeting to produce the normal capacity on
which the absorption rate is based. This would have led to zero under or over absorption,
whatever the level of sales achieved.

7 B
CU
Actual overheads 694,075
Under absorbed overheads 35,000
Overheads absorbed by 32,150 hours 659,075
Overheads absorbed = consulting hours  budgeted absorption rate
CU659,075 = 32,150  budgeted absorption rate
CU659,075
Budgeted absorption rate =
32,150
= CU20.50
8 D,E Statement A is incorrect because traditional absorption costing tends to assign too large a
proportion of overheads to high volume products, because it uses volume-related cost drivers.
Statement B is incorrect. ABC costing systems tend to provide more accurate unit costs than
traditional absorption costing systems. However, some arbitrary apportionments and absorptions
will still be necessary, therefore the unit costs are not accurate.
Statement C is incorrect. An ABC system uses volume-related cost drivers such as labour hours
or machine hours for costs that vary with production levels in the short term, such as machine
power costs.
Statement D is correct. Cost pools are used as collecting places to accumulate the costs
associated with each activity.
Statement E is correct. The cost of an activity increases in line with the number of cost drivers.
9 A,C Statement A is correct. Process costing is a form of continuous operation costing.
Statement B is incorrect. Both job costing and contract costing can be applied where work is
undertaken on the customer's premises, for example, a decorating job (job costing) and building
an extension on a school (contract costing).
Statement C is correct because process costs are divided by the number of units produced to
derive an average unit cost for the period.
Statement D is incorrect because process costing can be applied in a service environment where
there is a continuous flow of identical units.
Statement E is incorrect. Each batch must be separately identifiable but the units within each
batch will be identical.
10 B,E Statement A is incorrect because life cycle costing includes development costs and other cost
incurred prior to production as well as any costs such as dismantling costs incurred after
production has ceased.
Statement B is correct. The target cost is calculated by deducting the target profit from a
predetermined selling price based on the market situation.
Statement C is incorrect. The target cost is derived by deducting the desired profit margin from a
competitive market price.
Statement D is incorrect. JIT systems are 'pull' systems because demand from a customer pulls
products through production.
Statement E is correct. JIT relies heavily on reliable, high quality suppliers.


Production overheads Basis
Rent D
Heating costs A
Insurance of machinery B
Cleaning costs D
Canteen costs C

(a) Forming is CU 11,250
(b) Machining is CU 22,175
(c) Assembly is CU 8,025
(d) Maintenance is CU 6,750
(e) General is CU 4,300
WORKINGS
Basis Forming Machining Assembly Maint'nce General Total
CU CU CU CU CU CU
Directly allocated overheads:
Repairs, maintenance 800 1,800 300 200 100 3,200
Departmental expenses 1,500 2,300 1,100 900 1,500 7,300
Indirect labour 3,000 5,000 1,500 4,000 2,000 15,500
Apportionment of other overheads:
Rent, rates 1 1,600 3,200 2,400 400 400 8,000
Power 2 200 450 75 25 0 750
Light, heat 1 1,000 2,000 1,500 250 250 5,000
Depreciation of plant 3 2,500 6,000 750 750 0 10,000
Depreciation of F&F 4 50 25 100 50 25 250
Insurance of plant 3 500 1,200 150 150 0 2,000
Insurance of buildings 1 100 200 150 25 25 500
11,250 22,175 8,025 6,750 4,300 52,500
Basis of apportionment:
1 Floor area
2 Effective horsepower
3 Plant value
4 Fixtures and fittings value


Cost centre Production cost centre Service cost centre
Finished goods warehouse  

Canteen  
Machining department  
Offices  
Assembly department  
Only the machining department and assembly department are directly involved in the manufacture of units.
The other cost centres support the production activity and are therefore service cost centres.

The relative proportions of labour hours and machine hours in each cost centre can be used to identify
whether the cost centre is labour intensive or machine intensive.
CU 13,705
(a) Forming (labour intensive) = CU 2.50 per direct labour hour
5,482
CU 28 ,817
(b) Machining (machine intensive) = CU 5.50 per machine hour
5,240
CU 9 ,978
(c) Assembly (labour intensive) = CU 2 per direct labour hour
4 ,989

Description Step
A Apportion fixed costs over cost centres 2

B Establish the overhead absorption rate 4
C Choose fair methods of apportionment 1
D Apply the overhead absorption rate to products 5
E Reapportion service cost centre costs 3

(a) Under absorbed by CU 475
(b) Over absorbed by CU 4,735
(c) Over absorbed by CU 2,300

WORKINGS
Forming CU
Overhead absorbed (CU2.50  5,370) 13,425
Overhead incurred 13,900
Under absorbed overhead 475

Machining CU
Overhead absorbed (CU5.50  6,370) 35,035
Over absorbed overhead 4,735
Assembly CU
Overhead absorbed (CU2  5,400) 10,800

Process Job Contract Batch
Fitting kitchens (1)  

Manufacturing components    (2)
Manufacturing chemicals (3)   
Building offices   (4) 
Points to note
1 Each fitted kitchen would be a separately identifiable cost unit of relatively short duration, hence job
costing is most appropriate.
2 A number of identical components would be manufactured in each separately identifiable batch.
3 Chemical manufacture involves a continuous flow of processes.
4 Each office building would be a separately identifiable cost unit of relatively long duration. Therefore
contract costing is most appropriate.

chapter 4
Marginal costing and absorption costing
Contents
Introduction
Examination context
Topic List
1 Marginal cost and marginal costing
2 Marginal costing and absorption costing compared

Introduction

 Understand the basic principles of marginal costing
 Calculate and reconcile profits under absorption costing or marginal costing

The specific syllabus references for this chapter are: 1c, 3f.
We have seen in Chapter 1 that costs may be classified as product costs or period costs. Product costs are
costs identified with goods produced or purchased for resale. Such costs are initially identified as part of the
value of inventory and only become expenses when the inventory is sold.
In contrast, period costs are costs that are deducted as expenses during a particular period without ever
being included in the value of inventory held.
In Chapter 3 we saw that with absorption costing, fixed production overheads are treated as product costs
and are absorbed into the cost of units of output that go into inventory.
In contrast, marginal costing treats all fixed costs as period costs and deducts them from sales value as
expenses during a particular period. Only variable production costs are treated as product costs and
included in inventory valuations.
Each costing system, because of the different inventory valuations used, produces a different profit figure.
This clearly has practical implications for management decision making and control. Each method of costing
has its own supporters and can be useful in different situations.
Stop and think

In which types of situation might it be more useful for managers to focus on the variable unit costs rather
than on the full cost per unit that includes absorbed fixed production overheads?
Working context
If a company's management accounting system is prepared on a marginal costing basis you may need to
check that the management accounting profit is correctly reconciled to the financial accounting profit. The
latter will always be prepared on an absorption costing basis.
Syllabus links
A knowledge of marginal costing and absorption costing will underpin your understanding of inventory
valuation for the Accounting syllabus.

MARGINAL COSTING AND ABSORPTION COSTING 4
Examination context
Exam requirements
The calculation of the different profits reported under marginal costing and absorption costing is likely to be
a popular examination topic. You are also likely to be asked to reconcile the difference between the profits
reported under the two systems.
 Calculate the profit reported under marginal costing and under absorption costing using the same
basic set of data
 Reconcile the difference between the profits reported under the two systems
 Derive the marginal costing profit from data provided that is prepared using absorption costing, and
vice versa
Examiner's comments
Most students are comfortable with marginal costing but have difficulty with absorption costing, particularly
the under or over absorption of overheads. Narrative questions as well as numerical questions are
important in this area of the syllabus.

1 Marginal cost and marginal costing
Section overview
 In a marginal costing system only variable production costs are included in the valuation of units.
 All fixed costs are treated as period costs and are charged in full against the sales revenue for the
period.
 Contribution towards fixed costs and profit is calculated as sales revenue less variable cost of sales.
 Marginal costing profit for the period = contribution less fixed costs.
1.1 Marginal costing

Marginal costing is an alternative costing system to absorption costing. With marginal costing, only variable
production costs are included in the valuation of units. All fixed costs are treated as period costs and
are charged in full against the sales revenue for the period.
The marginal production cost per unit usually consists of the following:
 Variable materials
 Variable labour
 Variable production overheads
1.2 Contribution
Contribution is an important measure in marginal costing, and it is calculated as the difference between
sales value and marginal cost.
The term 'contribution' is really short for 'contribution towards fixed overheads and profit'.
The contribution per unit can be calculated as follows.
CU per CU per
unit unit
Selling price x
Variable materials x
Variable labour x
Variable production overheads x
Marginal production cost x
Variable selling, distribution and administrative cost x
Total marginal cost (x)
Contribution x
Interactive question 1: Contribution [Difficulty level: Easy]

A particular electrical good is sold for CU1,009.99. The variable material cost per unit is CU320, the
variable labour cost per unit is CU192 and the variable production overhead cost per unit is CU132. Fixed
overheads per annum are CU100,000 and the budgeted production level is 1,000 units.
The contribution per unit of the electrical good is CU .
Worked example: Marginal costing

Water Ltd makes a product, the Splash, which has a variable production cost of CU6 per unit and a sales
price of CU10 per unit. At the beginning of September 20X0, there was no opening inventory and

production during the month was 20,000 units. Fixed costs for the month were CU45,000 (production,
administration, sales and distribution). There were no variable marketing costs.
Requirements
Calculate the contribution and profit for September 20X0, using marginal costing principles, if sales were as
follows.
(a) 10,000 Splashes
(b) 15,000 Splashes
(c) 20,000 Splashes
The first stage in the profit calculation must be to identify the variable costs, and then the contribution.
Fixed costs are deducted from the total contribution to derive the profit. All closing inventories are valued
at marginal or variable production cost (CU6 per unit).
10,000 Splashes 15,000 Splashes 20,000 Splashes
CU CU CU CU CU CU
Sales (at CU10) 100,000 150,000 200,000
Opening inventory 0 0 0
Variable production cost 120,000 120,000 120,000
120,000 120,000 120,000
Less value of closing
inventory (at marginal 60,000 30,000 –
cost)
Variable cost of sales 60,000 90,000 120,000
Contribution 40,000 60,000 80,000
Less fixed costs (45,000) (45,000) (45,000)
Profit/(loss) (5,000) 15,000 35,000
Profit/(loss) per unit CU(0.50 CU1 CU1.75
)
Contribution per unit CU4 CU4 CU4
1.3 Conclusions
The conclusions that may be drawn from this example are as follows.
(a) The profit per unit varies at differing levels of sales, because the average fixed overhead cost per
unit changes with the volume of sales.
(b) The contribution per unit is constant at all levels of output and sales. Total contribution, which is
the contribution per unit multiplied by the number of units sold, increases in direct proportion to the
volume of sales.
(c) Since the contribution per unit does not change, the most effective way of calculating the
expected profit at any level of output and sales would be as follows.
(i) First calculate the total contribution.
(ii) Then deduct fixed costs as a period charge in order to find the profit.
This calculation method is much quicker and is therefore the method you are recommended to use in
the examination. The contribution and profit figures would be calculated as follows, arriving at the
same answers as above.
10,000 15,000 20,000
Splashes Splashes Splashes
CU CU CU
Total contribution at CU4 per unit 40,000 60,000 80,000
Less fixed costs (45,000) (45,000) (45,000)
Profit/(loss) (5,000) 15,000 35,000

Interactive question 2: Marginal costing principles [Difficulty level: Intermediate]

PQR Ltd makes two products, the Loo and the Wash. Information relating to each of these products for
April 20X1 is as follows.
Loo Wash
Opening inventory nil nil
Production (units) 15,000 6,000
Sales (units) 10,000 5,000
CU CU
Sales price per unit 20 30
Unit costs
Variable materials 8 14
Variable labour 4 2
Variable production overhead 2 1
Variable sales overhead 2 3
Fixed costs for the month CU
Production costs 40,000
Administration costs 15,000
Sales and distribution costs 25,000
Requirement
Using marginal costing principles and the approach in section 1.3, calculate the profit in April 20X1.
2 Marginal costing and absorption costing compared
Section overview
 In a marginal costing system inventories are valued at marginal or variable production cost; all fixed
overhead is charged against sales for the period in which it is incurred.
 In an absorption costing system an amount of absorbed fixed production overhead is included in the
inventory valuation.
 Reported profit figures using marginal and absorption costing will differ if there is any change in the
level of inventories during the period.
 If the fixed production overhead absorption rate per unit is the same each period, the difference in
reported profit is calculated as the change in inventory units x fixed production overhead absorption
rate per unit.
 If the fixed production overhead absorption rate is not the same each period, the difference in
reported profit is equal to the change in the fixed production overhead in the inventory.
 In the long run the total reported profit will be the same whether marginal costing or absorption
costing is used.
 Each of the costing systems has a number of advantages.
2.1 Summarising the differences between the two costing methods

The differences between the two costing systems can be summarised as follows:
 In marginal costing
– Closing inventories are valued at marginal or variable production cost.
– Fixed costs are charged in full against the profit of the period in which they are incurred.
– No fixed costs are included in the inventory valuation.

 In absorption costing (sometimes referred to as full costing)

– Inventories are valued at full production cost, and include a share of fixed production costs.
– This means that the cost of sales in a period will include some fixed overhead incurred in a
previous period (in opening inventory values) and will exclude some fixed overhead incurred in
the current period which is carried forward in the closing inventory value. This will be a charge
to a subsequent accounting period.
With these differences in mind, work through the following example.
Worked example: Marginal and absorption costing compared

TLF Ltd manufactures a single product, the Claud. The following figures relate to the Claud for a one-year
period.
Sales and production (units) 800
CU
Sales 16,000
Production costs
Variable 6,400
Fixed 1,600
Sales and distribution costs
Variable 3,200
Fixed 2,400
The normal level of activity for the year is 800 units. Fixed costs are incurred evenly throughout the year,
and actual fixed costs are the same as budgeted. A predetermined overhead absorption rate is used for the
year.
There were no inventories of Claud at the beginning of the year.
In the first quarter, 220 units were produced and 160 units sold.
Requirements
For the first quarter:
(a) Calculate the fixed production costs absorbed by Clauds if absorption costing is used.
(b) Calculate inventory values per unit using both absorption costing and marginal costing.
(c) Calculate the under/over absorption of overheads.
(d) Calculate the profit using absorption costing.
(e) Calculate the profit using marginal costing.
(f) Explain why there is a difference between the answers to (d) and (e).
The requirements provide useful steps for analysing the example.
(a) Budgeted fixed production costs CU1,600
Budgeted output (normal level of activity) =
800 units
Absorption rate = CU2 per unit produced.

During the quarter, the fixed production overhead absorbed would be 220 units × CU2 = CU440.
(b) Inventory values per unit
Absorption Marginal
costing costing
CU per CU per
unit unit
Variable production cost (CU6,400/800) 8 8
Fixed production cost (CU1,600/800) 2 –
Inventory value per unit 10 8

(c) CU
Actual fixed production overhead 400 (1/4 of
CU1,600)
Absorbed fixed production overhead 440
Over absorption of fixed production overhead 40
(d) Profit for the quarter, absorption costing
CU CU
Sales (160 × CU20) 3,200
Production costs
Variable (220 × CU8) 1,760
Fixed (absorbed overhead (220 × CU2)) 440
Total (220 × CU10) 2,200
Less closing inventories (60 × CU10) 600
Production cost of sales 1,600
Adjustment for over-absorbed overhead 40
Total production costs 1,560
Gross profit 1,640
Less: sales and distribution costs
Variable (160 × CU4) 640
Fixed (1/4 of CU2,400) 600
1,240
Net profit 400
Using the 'short-cut' calculation method this answer can be derived as follows.
CU per CU
unit
Sales price 20
Less
Full absorption cost (10)
Variable sales and distribution cost (4)
6
 sales volume 160 units 960
Less fixed sales and distribution costs (600)
360
Adjust for over absorbed overhead 40
Net profit 400
(e) Profit for the quarter, marginal costing
CU CU
Sales 3,200
Variable production costs 1,760
Less closing inventories (60 × CU8) 480
Variable production cost of sales 1,280
Variable sales and distribution costs 640
Total variable costs of sales 1,920
Total contribution 1,280
Less: Fixed production costs 400
Fixed sales and distribution costs 600
1,000
Net profit 280

Using the 'short-cut' calculation method this answer can be derived as follows.
CU per CU
unit
Sales price 20
Less
Variable production cost (8)
Variable sales and distribution cost (4)
Contribution per unit 8
 sales volume 160 units = contribution 1,280
Less
Fixed production costs (400)
Fixed sales and distribution costs (600)
Net profit 280
(f) The difference in profit is due to the different valuations of closing inventory. In absorption costing, the
60 units of closing inventory include absorbed fixed overheads of CU120 (60 × CU2), which are
therefore costs carried over to the next quarter and not charged against the profit of the first quarter.
In marginal costing, all fixed costs incurred in the period are charged against profit.
CU
Absorption costing profit 400
Fixed production costs carried forward in inventory values (60 units × CU2)* 120
Marginal costing profit 280
* Change in inventory units  fixed production cost per unit
2.2 Conclusions
We can draw a number of conclusions from this example.
(a) Marginal costing and absorption costing are different techniques for assessing profit in a period.
(b) If there are changes in inventories during a period, marginal costing and absorption costing
give different results for profit obtained.
Assuming that the variable cost per unit and the fixed cost per unit are constant:
(i) If inventory levels increase, absorption costing will report a higher profit because some
of the fixed production overhead incurred during the period will be carried forward in closing
inventory. This reduces cost of sales and carries forward cost to be set against sales revenue in
the following period.
(ii) If inventory levels decrease, absorption costing will report a lower profit because as
well as the fixed overhead incurred, fixed production overhead which had been brought forward
in opening inventory is released and is included in cost of sales.
(c) If the opening and closing inventory levels are the same, marginal costing and absorption costing will
give the same profit figure if unit costs remain constant.
(d) In the long run, total profit for a company will be the same whether marginal costing or absorption
costing is used as all inventory is sold. Different accounting conventions merely affect the profit of
individual accounting periods.

Interactive question 3: Reconciling the difference in reported profits

The overhead absorption rate for product X is CU10 per machine hour. Each unit of product X requires
five machine hours.
Production of product X last period was 4,800 units and the sales volume achieved was 4,750 units.
(a) The absorption costing profit would be (tick one box):
Greater than
The same as
Less than
the marginal costing profit.
(b) The differences between the reported profits would be CU .

Worked example: Comparison of total profits

To illustrate the point in conclusion 2.2(d) above, let us suppose that a company makes and sells a single
product. At the beginning of period 1, there are no opening inventories of the product, for which the
variable production cost is CU4 per unit and the sales price CU6 per unit. Fixed costs are CU2,000 per
period, of which CU1,500 are fixed production costs.
Period 1 Period 2
Sales 1,200 units 1,800 units
Production 1,500 units 1,500 units
Requirements
What profit would be reported in each period and in total using the following costing systems?
(a) Absorption costing. Assume normal output is 1,500 units per period.
(b) Marginal costing.
(a) Absorption costing: the absorption rate for fixed production overhead is
CU1,500
= CU1 per unit
1,500 units
Period 1 Period 2 Total

CU CU CU CU CU CU
Sales 7,200 10,800 18,000
Production costs
Variable 6,000 6,000 12,000
Fixed absorbed 1,500 1,500 3,000
7,500 7,500 15,000
Add opening inventory b/f – 1,500
7,500 9,000 15,000
Less closing inventory c/f 1,500 – –
Production cost of sales 6,000 9,000 15,000
(Under)/over absorbed
overhead – – –
Total production costs 6,000 9,000 15,000
Gross profit 1,200 1,800 3,000
Other costs 500 500 1,000
Net profit 700 1,300 2,000

Using the 'short-cut' method of calculation the profit figures can be calculated as follows.
Period 1 Period 2
CU per CU CU
unit
Sales price 6
Full absorption cost:
Variable production cost (4)
Absorbed fixed production cost (1)
1
 sales volume 1,200 1,800
Other costs 500 500
Net profit 700 1,300
(b) Marginal costing
Period 1 Period 2 Total
CU CU CU CU CU CU
Sales 7,200 10,800 18,000
Variable production cost 6,000 6,000 12,000
Add opening inventory b/f – 1,200 –
6,000 7,200 12,000
Less closing inventory c/f 1,200 – –
Variable production cost
of sales 4,800 7,200 12,000
Contribution 2,400 3,600 6,000
Fixed costs 2,000 2,000 4,000
Profit 400 1,600 2,000
Using the 'short-cut' method of calculation the profit figures can be calculated as follows.
Period 1 Period 2
CU per CU CU
unit
Sales price 6
Less variable production costs (4)
Contribution per unit 2
 sales volume = total contribution 2,400 3,600
Less fixed costs 2,000 2,000
Profit 400 1,600
Points to note
The total profit over the two periods is the same for both costing systems, but the profit in each period is
different.
It is important to notice that although production and sales volumes in each period are different (and
therefore the profit for each period using absorption costing is different from the profit reported by
marginal costing), over the full period, total production equals sales volume, the total cost of sales is the
same, and therefore the total profit is the same using either system of accounting.
Interactive question 4: Marginal and absorption costing

[Difficulty level: Exam standard]
X Ltd commenced business on 1 March making one product only. Unit cost information for the product is
as follows.
CU
Variable labour 5
Variable material 8
Variable production overhead 2

Fixed production overhead 5

Standard production cost 20
The fixed production overhead figure has been calculated on the basis of a budgeted normal output of
36,000 units per annum.
You are to assume that all the budgeted fixed expenses are incurred evenly over the year. March and April
are to be taken as equal period months.
Selling, distribution and administration expenses are as follows.
Fixed CU120,000 per annum
Variable 15% of the sales value
The selling price per unit is CU35 and the number of units produced and sold was as follows.
March April
Units Units
Production 2,000 3,200
Sales 1,500 3,000
(a) If a marginal costing system is in operation:
(i) The value of the closing inventory for each month will be:
March CU
April CU
(ii) The loss reported for March will be CU
(iii) The profit reported for April will be CU

(b) If an absorption costing system is in operation:
(i) The value of the closing inventory for each month will be:
March CU
April CU
(ii) The production overhead for March will be under/over* absorbed by CU
(iii) The production overhead for April will be under/over* absorbed by CU
(iv) The loss reported for March will be CU
(v) The profit reported for April will be CU
* Delete as applicable

2.3 Marginal costing and absorption costing compared

(a) Advantages of absorption costing
(i) Fixed production costs are incurred in order to make output; it is therefore 'fair' to charge
all output with a share of these costs.
(ii) Closing inventory values, by including a share of fixed production overhead, will be valued on the
principle required by accounting standards for the financial accounting valuation of
inventories for external reporting purposes.
(iii) A problem with calculating the contribution of various products made by a company is that it may
not be clear whether the contribution earned by each product is enough to cover fixed costs,
whereas by charging fixed overhead to a product it is possible to ascertain whether or not
it is profitable.
(b) Advantages of marginal costing
(i) It is simple to operate.
(ii) There are no apportionments of fixed costs, which are frequently done on an arbitrary basis.
Many costs, such as the managing director's salary, are indivisible by nature.
(iii) Fixed costs will be the same regardless of the volume of output, because they relate to a
period of time and are period costs. It makes sense, therefore, to charge them in full as a cost to
the period.
(iv) The cost to produce an extra unit is the variable production cost. It is realistic to value closing
inventory items at this directly attributable cost.
(v) Under or over absorption of overheads is avoided.
(vi) Marginal costing information can be more useful for decision making since it focuses on the
variable costs that are most likely to be altered as the result of a decision.

Summary
Alternative costing
systems
Marginal costing (mc) Absorption costing (ac)
Highlights contribution
= sales value less
variable costs
Fixed production
overhead absorbed
Fixed costs charged in into unit production
full against revenue for costs
period
Inventories valued at
full production cost, ie
Inventories valued at
including a share of
variable production cost fixed production costs
Different inventory valuation may

result in different profit results in
short term
Assuming that variable costs per

unit and fixed costs per unit are
constant
If inventories increase: If inventories do not alter: If inventories

mc profit < ac profit mc profit = ac profit decrease:
mc profit > ac profit
Difference in profit = change in

inventory units × fixed
production overhead per unit

Self-test
1 The following cost card relates to one unit of Product EZ.
CU
Variable materials 20
Variable labour 40
Production overheads
Variable 10
Fixed 5
Sales and distribution overheads
Variable 5
Fixed 10
Total cost 90
The marginal production cost of one unit of Product EZ is CU

2 A new product has a variable material cost of CU5.50 per unit, a variable labour cost of CU2 per unit
and a fixed overhead absorption rate of CU3.50 per unit.
Production during the first month was 23,000 units and sales were 21,000 units.
Calculate to the nearest CU the inventory valuation under both marginal costing and absorption
costing.
Marginal costing: CU (to the nearest CU)
Absorption costing: CU (to the nearest CU)

3 A company manufactures Luxury and Standard items. The following information relates to period 1.
Luxury Standard
Variable materials CU16 per unit CU12 per
unit
Variable labour CU21 per unit CU9 per unit
Variable production overhead CU10 per unit CU8 per unit
Budgeted production 3,500 units 3,300 units

Actual production 3,500 units 3,300 units
Closing inventory 290 units 570 units
Variable labour is paid CU6 per hour.
Fixed costs totalled CU120,400 and are recovered on the basis of variable labour hours.
Calculate to the nearest CU the inventory valuation under both marginal costing and absorption
costing.
Luxury Standard
Marginal costing: CU CU
Absorption costing: CU CU

4 A company has just completed its first year of trading. The budgeted production volume of 26,000
units was achieved and the sales volume was 24,500 units at CU40 each.
The following actual cost information is available.
CU
Variable cost per unit
Manufacturing 18.50
Selling and administration 9.20
Fixed costs (as budget)
Manufacturing 91,000
Selling and administration 49,000
Calculate the net profit figures using both absorption and marginal costing.
Absorption net profit CU
Marginal net profit CU

5 When opening inventories were 8,500 litres and closing inventories 6,750 litres, a firm had a profit of
CU62,100 using marginal costing.
Assuming that the fixed overhead absorption rate was CU3 per litre, what would be the profit using
absorption costing?
A 41,850
B 56,850
C 67,350
D 82,350
6 Which of the following are arguments in favour of marginal costing?
Closing inventory is valued in accordance with financial reporting standards.

It is simple to operate.
There is no under or over absorption of overheads.
Fixed costs are the same regardless of activity levels.
The information from this costing system may be more useful for decision making.
7 Which two of the following statements are correct assuming that unit costs are constant?
A product showing a positive contribution under marginal costing will always show a profit under
absorption costing.
If inventory levels increase, marginal costing will report a lower profit than absorption costing.
If inventory levels decrease, marginal costing will report a lower profit than absorption costing.
If inventory levels increase, marginal costing will report a higher profit than absorption costing.
If opening and closing inventory levels are the same, marginal costing and absorption costing will
report the same profit figure.
8 Last period a company reported absorption costing profits of CU36,000. Actual fixed production
overheads were CU42,000 and the actual production volume of 6,000 units resulted in over absorbed
fixed production overhead of CU6,000.
A sales volume of 7,100 units was achieved during the period.
The marginal costing profit for the period would have been CU .

9 Last period 17,500 units were produced at a total cost of CU16 each. Three quarters of the costs were
variable and one quarter fixed. 15,000 units were sold at CU25 each. There were no opening inventories.
By how much will the profit calculated using absorption costing principles differ from the profit if
marginal costing principles had been used?
A The absorption costing profit would be CU10,000 less
B The absorption costing profit would be CU10,000 greater
C The absorption costing profit would be CU30,000 greater
D The absorption costing profit would be CU40,000 greater
10 In a period, a company had opening inventory of 31,000 units and closing inventory of 34,000 units.
Profits based on marginal costing were CU850,500 and on absorption costing were CU955,500.
If the budgeted total fixed costs for the company were CU1,837,500 what was the budgeted level of
activity in units?
A 32,500
B 52,500
C 65,000
D 105,000

1 The correct answer is: CU70.

Marginal production cost is the total of all variable production costs.
Marginal production cost of product EZ
CU per unit
Variable labour 40
Variable production overheads 10
70
2 The correct answers are: marginal costing: CU15,000 and absorption costing: CU22,000.
Marginal cost of product = Variable material cost + variable labour cost
= CU5.50 + CU2
= CU7.50 per unit
In marginal costing, closing inventories are valued at marginal production cost, which includes the
variable material cost of CU5.50 and the variable labour cost of CU2 for 2,000 units.
Therefore inventory valuation = CU7.50  2,000
= CU15,000
Absorption cost of product = Marginal cost + fixed production overheads
= CU7.50 + CU3.50
= CU11 per unit
In absorption costing, closing inventories are valued at CU11 each (this includes a share of fixed
production overheads).
Therefore inventory valuation = CU11  2,000
= CU22,000
3
Luxury Standard
Marginal costing CU13,630 CU16,530
Absorption costing CU20,735 CU22,515
Marginal costing
In marginal costing, closing inventories are valued at marginal production cost (variable materials,
variable labour and variable production overhead).
Luxury = CU16 + CU21 + CU10 = CU47 per unit.
There are 290 of them, so closing inventory value = 290  CU47 = CU13,630.
Standard = CU12 + CU9 + CU8 = CU29 per unit.
There are 570 of them, so closing inventory value = 570  CU29 = CU16,530.
Absorption costing basis
Absorption costing includes fixed production overheads in inventory values rather than charging them
against profit.
Based on the labour costs, the number of hours to produce each item is Luxury 3.5 (CU21  CU6),
Standard 1.5 (CU9  CU6).
Luxury = The overhead absorption rate is CU120,400 / ((3,500  3.5) + (3,300  1.5 )) = CU7 per
direct labour hour.

Absorption costing inventory values of luxury items are therefore CU7  3.5 hours  290 units
greater than marginal costing inventory values, ie CU13,630 + CU7,105 = CU20,735.
Standard = The overhead absorption rate is CU7 per direct labour hour. Absorption costing inventory
values are therefore CU7  1.5 hours  570 units greater than marginal costing inventory values, ie
CU16,530 + CU5,985 = CU22,515.
4 Absorption net profit CU 166,600
Marginal net profit CU 161,350

WORKING
Absorption net profit
CU91,000
Fixed manufacturing cost per unit = = CU3.50
26,000
Budgeted production = actual production, therefore no under or over absorption of overhead
occurred.
CU CU
Sales revenue 24,500  CU40 980,000
Manufacturing cost of sales 24,500  CU(18.50 + 3.50) (539,000)
Gross profit 441,000
Less: Selling and administration costs
Variable 24,500  CU9.20 225,400
Fixed 49,000
(274,400)
Absorption costing net profit 166,600
Using the 'short-cut' method:
CU per unit
Sales price 40.00
Less: Variable manufacturing cost per unit (18.50)
Variable selling and administration cost per unit (9.20)
Fixed manufacturing cost per unit (3.50)
8.80
CU
 sales volume 24,500 units 215,600
Less: Fixed selling and administration costs 49,000
Inventories increased during the period, therefore the marginal costing net profit will be lower.
CU
Difference in profits (change in inventory 1,500 units  CU3.50) (5,250)
Marginal costing net profit 161,350
Check using the 'short-cut' method: CU

Marginal costing contribution = 24,500  CU(40 – 18.50 – 9.20) 301,350
Less: Fixed costs (CU91,000 + CU49,000) (140,000)
Marginal costing profit 161,350

5 B
Difference in profit = (8,500 – 6,750)  CU3 = CU5,250

Absorption costing profit = CU62,100 – CU5,250 = CU56,850
Since inventory levels reduced, the absorption costing profit will be lower than the marginal costing
profit. You can therefore eliminate options C and D.
6 The following statements are arguments in favour of marginal costing
 It is simple to operate.
 There is no under or over absorption of overheads.
 Fixed costs are the same regardless of activity levels.
 The information from this costing system may be more useful for decision making.
The first statement is incorrect. A marginal costing system does not value inventory in accordance
with financial reporting standards because it does not include absorbed fixed production overheads.
The information from an absorption costing system is therefore more useful for external reporting
purposes.
7 The correct statements are:
 If inventory levels increase, marginal costing will report a lower profit than absorption costing.
 If opening and closing inventory levels are the same, marginal costing and absorption costing
will report the same profit figure.
The first statement is incorrect because a positive contribution will not always show a profit under
either costing system. The level of reported profit will depend on the magnitude of fixed overheads.
The remaining statements can be assessed using the following rules:
 If inventory levels increase, absorption costing profit is higher than marginal costing profit
(because of the fixed overhead carried forward in inventory).
 If inventory levels decrease, absorption costing profit is lower than marginal costing profit
(because of the fixed overhead 'released' from inventory).
 If inventory levels remain the same then both costing systems will report the same profit figure.
8 The marginal costing profit for the period would have been CU44,800.
WORKING
CU
Actual fixed production overhead 42,000
Absorbed fixed production overhead 48,000
CU48,000
Therefore absorption rate per unit = = CU8 per unit
6,000
Inventory decrease = 7,100 units – 6,000 units = 1,100 units
CU
Absorption costing profit 36,000
Profit difference (1,100 units × CU8) 8,800
Marginal costing profit 44,800

9 B
Fixed costs per unit = CU16/4 = CU4
Units in closing inventory = 17,500 – 15,000 = 2,500 units
Profit difference = inventory increase in units x fixed overhead per unit
= 2,500 × CU4 = CU10,000
Inventories increased, therefore fixed overhead would have been carried forward in inventory using
absorption costing and the profit would be higher than with marginal costing.
10 B
Inventory levels increased by 3,000 units and absorption costing profit is CU105,000 higher
(CU955,500 – CU850,500).
Therefore fixed production cost included in inventory increase = CU105,000/3,000 = CU35 per unit
of inventory.
Budgeted fixed costs
= CU1,837,500
Fixed cost per unit 35
= 52,500 units


The contribution per unit is CU 365.99 .
WORKING
CU CU
Selling price per unit 1009.99
Marginal cost per unit
Variable material 320
Variable labour 192
Variable production overhead 132
644.00
Contribution per unit 365.99
Absorbed fixed overheads are not included in the calculation of marginal cost per unit or contribution per
unit.

CU
Contribution from Loos (unit contribution = CU20 – CU16 = CU4  10,000 units) 40,000
Contribution from Washes (unit contribution = CU30 – CU20 = CU10  5,000 units) 50,000
Total contribution 90,000
Fixed costs for the period 80,000
Profit 10,000

(a) The absorption costing profit would be greater than the marginal costing profit.
This is because production exceeded sales, therefore the inventory level increased. Some of the fixed
production overhead incurred during the period would be carried forward in the inventory value with
absorption costing, thus reducing the charge to cost of sales.
(b) The difference between the reported profits would be CU2,500.
This is calculated as follows.
Difference in profit = change in inventory levels × fixed overhead absorption rate per unit
= 50 units  (CU10 × 5 hours)
= CU2,500

(a) (i) March CU7,500 (500 units  CU15)
April CU10,500 (700 units  CU15)
(ii) The loss reported for March will be CU2,875
WORKING
Contribution per unit:
CU per unit
Selling price 35.00
Variable production cost (15.00)
Variable selling expenses (CU35  15%) (5.25)
Contribution per unit 14.75
Loss for March:
CU
Contribution (1,500  CU14.75) 22,125
Fixed production overhead (CU5  36,000  1/12) (15,000)
Fixed selling expenses (10,000)
Loss (2,875)
(iii) The profit reported for April will be CU19,250
WORKING
CU
Contribution (3,000  CU14.75) 44,250
Fixed production overhead (15,000)
Fixed selling expenses (10,000)
Profit 19,250
(b) (i) March CU10,000 (500 units  CU20)

April CU14,000 (700 units  CU20)
(ii) The production overhead for March will be under absorbed by CU5,000
(iii) The production overhead for April will be over absorbed by CU1,000
WORKING
March April
CU CU
Overhead absorbed (2,000  CU5) 10,000 (3,200  16,000
CU5)
Overhead incurred (CU5  36,000  15,000 15,000
1/12)
Under/(over) absorbed 5,000 (1,000)
(iv) The loss reported for March will be CU375.
(v) The profit reported for April will be CU20,250.
WORKING
March April
CU CU
Marginal costing (loss)/profit (2,875) 19,250
Plus increase in inventory @ CU5 fixed overhead per unit:
500 units  CU5 2,500
200 units  CU5 1,000
Absorption costing (loss)/profit (375) 20,250
chapter 5
Pricing calculations
Contents
Introduction
Examination context
Topic List
1 Full cost-plus pricing
2 Marginal cost-plus pricing
3 Mark-ups and margins
4 Transfer pricing
Introduction

 Calculate the sales price for a given product or service using cost based pricing
 Calculate transfer prices for specified sales to internal customers which take account of
appropriate costs
The specific syllabus references for this chapter are: 1e, f.
The price charged by an organisation for the sale of its product or services to external customers will be
one of the major influences on the organisation's profits. If the price is too low it might fail to cover all of
the organisation's costs. If it is too high then it might deter customers so that potentially profitable sales are
forgone.
Clearly the determination of a selling price is a very important management decision.
The other aspect of pricing we will consider in this chapter is the pricing of products or services provided
within the organisation, for example the pricing of the transfer of goods from one department to another
or from one subsidiary to another. This is called transfer pricing and involves a consideration of the
behavioural aspects as well as the numerical aspects of pricing.
Stop and think

In what ways would the price charged for transfers of goods or services between divisions affect the
willingness of the supplying division to make the transfer and of the buying division to accept the transfer?
Working context
You might come across the need to audit the determination of sales prices where the agreement between
the buyer and the supplier allows prices to be based on the actual costs incurred. In this case the buyer is
likely to require assurance that costs are adequately recorded and controlled.
Syllabus links
An understanding of the use of cost information as a basis for pricing decisions will underpin your studies of
strategic choice within the Business Strategy syllabus.
PRICING CALCULATIONS 5
Examination context
Exam requirements
Pricing decisions could feature as a narrative question or as a calculation question. The sample paper for
this syllabus featured one calculation question and one narrative question about pricing as well as a
calculation question about transfer pricing.
The need for an understanding of profit margins also underpinned a number of other questions on the
sample paper.
The content of this chapter is deceptively straight forward. A thorough knowledge of this, and earlier topics
such as fixed and variable costs, is required to answer questions in this area.
 Calculate a selling price using full cost-plus pricing
 Calculate a selling price using marginal cost-plus pricing
 Demonstrate an understanding of the difference between mark-up and margin and of the relationship
between them
 Derive the mark up percentage that will achieve a desired return on the investment in a product
 Calculate a transfer price that will achieve profit maximisation and encourage an alignment of the goals
of groups or individuals with the goals of the organisation as a whole.
1 Full cost-plus pricing
Section overview
 In full cost-plus pricing the sales price is determined by calculating the full cost of the product or
service and then adding a percentage mark-up for profit.
 The full cost may be a fully absorbed production cost only, or it may include some absorbed selling,
distribution and administration overheads. In the former case the mark-up on costs must be greater
in order to recover the other costs.
 The most important criticism of full cost-plus pricing is that it fails to recognise that since sales
demand may be determined by the sales price, there will be a profit-maximising combination of price
and demand.
1.1 Cost-plus pricing

In practice cost is one of the most important influences on price. While in economic theory it is possible to
set a sales price that will maximise profit, in reality there is a lack of precise information about cost
behaviour patterns and the effect of price on sales demand.
This will lead some organisations to base their selling price decision on simple cost-plus rules, whereby
costs are estimated and then a percentage mark-up is added in order to set the price.
1.2 Setting full cost-plus prices

The full cost may be a fully absorbed production cost only, or it may include some absorbed selling,
distribution and administration overhead.
Therefore there are two options for calculating a full cost-plus price.
Option 1
Unit sales price = Total production cost per unit + Percentage mark-up
Option 2
Unit sales price = Total production cost per unit + Other costs* per unit + Percentage mark-up
*Other costs include selling, distribution and administration costs
Clearly, to achieve the same sales price, the mark-up on cost must be greater under Option 1 than under
Option 2 in order to recover the other costs.
Worked example: Calculating a cost-plus selling price

XY Ltd has begun to produce product S, for which the following cost estimates have been prepared.
CU per
unit
Variable materials 14.00
Variable labour at CU12 per hour 54.00
Variable production overheads at CU3 per hour 13.50
Variable production cost per unit 81.50
Fixed production overheads are budgeted to be CU69,000 each period. The overhead absorption rate will
be based on 17,250 budgeted direct labour hours each period.
The company wishes to add 20 per cent to the full production cost in order to determine the selling price
per unit for product S.
Step 1
Calculate the fixed production overhead absorption rate.
CU69,000
Overhead absorption rate =
17,250
= CU4 per direct labour hour
Step 2
Calculate the full production cost per unit.
Direct labour hours per unit = CU54/CU12 = 4.5 hours
CU per unit
Variable production cost per unit 81.50
Fixed production overhead absorbed (4.5 hours  CU4) 18.00
Full production cost per unit 99.50
Step 3
Add the required mark-up to determine the selling price.
CU per unit
Full production cost per unit 99.50
Mark-up 20% 19.90
Full cost-plus selling price 119.40
Interactive question 1: Adjusting the mark-up percentage

The full cost of providing a service is CU40 per hour and its selling price is currently determined as full cost
plus 60%. In each of the following separate situations, calculate the required profit mark-up percentage.
Situation Write your answer here

%
1 A competitor launches a similar service for CU60 per

hour. In order to sell the service at the same price as the
competitor the percentage mark-up must be reduced to:
2 The full cost of providing the service increases to CU50
per hour. The required mark-up percentage to achieve
the same absolute value of mark-up per hour of service
provided is:
1.3 Determining the mark-up percentage

A business may have an idea of the percentage profit mark-up it would like to earn, and so may decide on
an average profit mark-up as a general guide for pricing decisions. This would be particularly useful for
businesses that carry out a large amount of contract or jobbing work, for which individual job or contract
prices must be quoted regularly to prospective customers.
However, the percentage profit mark-up does not have to be rigid and fixed. It can be varied to
suit the circumstances. In particular, the percentage mark-up can be varied to suit anticipated supply and
demand conditions in the market.
1.4 Determining the mark-up to achieve a required return on

investment
A business might calculate the mark-up percentage for a product in order to achieve a required return on
the investment in the product.
Worked example: Pricing to generate a return on investment

ZZ Ltd requires an annual return of 30% on the investment in all of its products. In the forthcoming year
CU800,000 will be invested in non-current assets and working capital to produce and sell 50,000 units of
product Z. The full cost per unit of product Z is CU100.
The annual return required on the investment in product Z = CU800,000  30%
= CU240,000
Total cost to be incurred on product Z = 50,000 units  CU100 = CU5,000,000
Mark-up as a percentage of full cost = (CU240,000/CU5,000,000)  100% = 4.8%
The selling price can now be calculated as follows.
CU per unit
Full cost 100.00
Mark-up 4.8% 4.80
Selling price of product Z 104.80
1.5 Allowing for inflation when setting selling prices

We have seen that the mark-up added to total cost must be sufficient to earn the required profit, or in the
case of adding a mark-up to total production cost, the mark-up must be sufficient to recover all non-
production costs in addition to earning the required profit.
Therefore managers must estimate costs as accurately as possible and must decide whether to
include allowances for anticipated inflation. Even if some sort of allowance is added for inflation the seller
bears the risk of inflation when a selling price is determined prior to delivery of the goods or
services.
However, if the buyer agrees to prices based on actual cost incurred plus a profit mark-up then all of the
cost increases caused by inflation can be passed to the buyer. Thus all of the inflation risk is borne by the
buyer. The following points about this pricing policy should be noted.
 The buyer is likely to require some form of assurance that costs are adequately controlled.
Otherwise the supplier's cost inefficiencies will be passed directly to the buyer and there is no
incentive for the supplier to control costs. The principle of 'Open Book Accounting' can be
introduced, where the buyer is given open access to the cost information contained in the accounts of
the seller.
 Moreover the supplier actually has an incentive to overspend, since all costs will be passed to the
buyer and a profit mark-up will also be earned on all expenditure by the supplier.
 If a credit period is offered to the buyer then the supplier will bear the inflation risk from the
date that the final price is agreed until payment is received from the customer. However
in low inflation economies this additional inflation risk is likely to be acceptable to a supplier.
1.6 Advantages and disadvantages of full cost-plus pricing

The advantages of full cost-plus pricing are as follows.
 The price is quick and easy to calculate.
 Pricing decisions can be delegated to more junior employees. This is particularly important with
jobbing work where many prices must be established and quoted each day.
 A price in excess of full cost should ensure that an organisation working at normal capacity will
cover all its costs.
 Price increases can be justified as costs rise.
However full cost-plus pricing does have a number of disadvantages.
 It fails to recognise that since demand may be determining price, there will be a profit-
maximising combination of price and demand.
 It reduces incentives to control costs.
 It requires arbitrary absorption of overheads into product costs.
 If full cost-plus pricing is applied strictly the organisation may be caught in a vicious circle like the one
shown in Figure 5.1.
Price is set using total

cost per unit based on
budgeted sales volume
Resulting price may be

too high to achieve the
budgeted demand
Reduced output volume

increases the fixed cost
per unit
Higher selling price

results from full cost-plus
formula
Figure 5.1: Application of cost-plus pricing
2 Marginal cost-plus pricing
Section overview
 Marginal cost-plus pricing involves adding a profit mark-up to the marginal or variable cost of
production or sales.
 The chief advantage of marginal cost-plus pricing is that it avoids the arbitrary apportionment and
absorption of fixed costs.
2.1 Setting marginal cost-plus prices

Marginal cost-plus pricing is a method of determining sales prices whereby a profit mark-up is added to
either the marginal cost of production or the marginal cost of sales.
In practice, marginal cost-plus pricing is used in businesses where there is a readily identifiable basic variable
cost. The most obvious example is retail organisations, where the price of goods in shops is often
determined by adding a mark-up to the purchase price of the item.
Worked example: Calculating a marginal cost-plus price

Product Y incurs direct variable production costs of CU7 per unit. Fixed production costs amount to
CU17,900 each period.
Variable selling and distribution costs are CU3.80 per unit and fixed selling, distribution and administration
costs amount to CU24,800 each period.
Selling prices are determined on a marginal cost-plus basis, using a mark-up of 30% of the marginal cost of
sales.
Calculate the selling price per unit of product Y and the profit that will result from sales of 26,800 units
each period.
Step 1
Calculate the total marginal or variable cost of sales per unit.
CU per unit
Variable production cost 7.00
Variable selling and distribution cost 3.80
Total marginal cost 10.80
Step 2
Add the required mark-up to determine the selling price.
CU per unit
Total marginal cost 10.80
Mark-up 30% 3.24
Marginal cost-plus selling price 14.04
Step 3
Determine the total contribution and deduct the fixed costs to derive the period profit.
The mark-up per unit is the same as the contribution earned per unit. It contributes towards the fixed costs
and profit for the period.
CU CU
Total mark-up/contribution (26,800 x CU3.24) 86,832
Less fixed costs:
Production 17,900
Selling, distribution and administration 24,800
42,700
Profit 44,132
2.2 Advantages and disadvantages of marginal cost-plus pricing

The advantages of marginal cost-plus pricing are as follows.
 It is a simple method to use.
 It avoids the arbitrary apportionment and absorption of fixed costs that is necessary with
absorption costing.
 It is more useful than total cost-plus pricing for short-term management decision making.
This is because it draws management's attention to contribution and the effect on profit of higher or
lower sales volumes. The level of contribution will vary in direct proportion to the sales volume.
The disadvantages of marginal cost-plus pricing are as follows.
 The full costs might not be recovered in the long term.
 Although the size of the mark-up can be varied in accordance with demand conditions, the pricing
method does not ensure that sufficient attention is paid to demand conditions,
competitors’ prices or profit maximisation.
3 Mark-ups and margins
Section overview
 The mark-up is the profit expressed as a percentage of the marginal cost, total production cost or
total cost
 The margin is the profit expressed as a percentage of the sales price.
3.1 The difference between mark-up and margin

When sales prices are being determined on a cost-plus basis it is extremely important to be clear about
whether the profit to be added to unit costs is calculated as a percentage of costs or as a percentage of
selling price.
Cost-plus
pricing
Mark-up percentage Margin percentage

Profit expressed as a Profit expressed as a
percentage of cost percentage of sales price
Figure 5.2: Mark-up percentage v margin percentage
Worked example: The difference between mark-up and margin

Product Q incurs a total cost of CU80 per unit and its selling price is set at CU100 per unit.
The mark-up applied to product Q = (CU20/CU80)  100%
= 25% of total cost
The margin earned by product Q = (CU20/CU100)  100%
= 20% of sales price
Interactive question 2: Mark-ups and margins [Difficulty level: Intermediate]
Question Write your answer here
1. If the full cost is CU14 per unit, calculate the

price to achieve a margin of 20% of the selling
price.
2. The selling price is CU27 per unit, determined
on the basis of full cost-plus. If the full cost is
CU18 per unit, calculate the mark-up
percentage.
3. A selling price of CU165 per unit earns a mark-
up of 106.25% of the full cost. What is the full
cost per unit?
4. A product's selling price is determined by adding
33.33% to its full cost. What percentage margin
on sales price does this represent?
4 Transfer pricing
Section overview
 A transfer price is the amount charged by one part of an organisation for the provision of goods or
services to another part of the same organisation.
 A transfer pricing system has a number of aims, which may conflict with each other.
 Inappropriate transfer prices may lead to sub-optimal decisions and a lack of alignment of corporate
goals (called goal congruence).
 In a perfectly competitive market the optimum transfer price is the market price. This should be
reduced for savings in costs that are not incurred on internal transfers, such as distribution costs,
advertising and marketing costs, and bad debts.
 A problem with cost-plus pricing is that the receiving division will perceive the transfer price to be a
wholly variable cost, whereas it includes some costs which are fixed from the point of view of the
company as a whole. This could lead to sub-optimal decision making.
 With two part transfer prices, all transfers are charged at a predetermined standard variable cost. A
periodic charge for fixed costs would also be made by the supplying division to the receiving division.
 In a dual pricing system the receiving division is charged with the standard variable cost of all
transfers. The supplying division is credited with the market value or a cost-plus price in order to
provide a profit incentive to make the transfer.
4.1 What is a transfer price?

Transfer pricing is used when divisions of an organisation need to charge other divisions of the same
organisation for goods or services that they provide to them. For example, subsidiary A might manufacture
a component that is used as part of a product made by subsidiary B of the same company. The component
can also be bought on or sold to the external market. Therefore there will be two sources of revenue for
subsidiary A.
 External sales revenue from sales made to other organisations.
 Internal sales revenue from the transfer prices charged for components supplied to subsidiary B.
4.2 Aims of a transfer pricing system

 To enable the realistic measurement of divisional profit.
 To provide the supplier with a realistic profit and the receiver with a realistic cost.
 To give autonomy to managers.
 To encourage goal congruence, whereby individual managers' own goals are the same as the goals
of the company as a whole.
 To ensure profit maximisation for the company as a whole.
It may be difficult to reconcile all of these aims.
4.3 Practical methods of transfer pricing

PRACTICAL METHODS
OF TRANSFER PRICING
MARKET COST- TWO PART DUAL

PRICE PLUS TRANSFER PRICING
PRICE PRICE
Figure 5.3: Practical methods of transfer pricing
4.3.1 Market price

If a perfectly competitive market exists for a product, then the external market price is the optimum
transfer price if the supplying division is operating at full capacity.
The market price should be adjusted for savings in certain costs that may not be incurred on internal
transfers, such as:
 Packaging costs
 Advertising costs
 Distribution costs
 Bad debts.
Care must be taken to ensure that the division's product is the same as that offered by the external market
(for example in terms of quality, delivery terms etc).
Using market price can, however, lead to problems. Interactive question 3 illustrates this.
Interactive question 3: Using market value as the transfer price

Division A Division B
CU per CU per
unit unit
Variable cost 10 15
Transfer price at market value – 20
Fixed costs 5 10
Profit 5 25
Transfer price/selling price 20 70
Division A can sell externally at CU20 per unit or transfer internally to Division B at CU20 per unit.
Division B receives an offer from a customer of CU30 per unit for its final product.
Requirements
(a) Would Division B accept the offer of CU30 per unit given the existing transfer price?
Yes No
(b) Is this the correct decision from the company's point of view if:
(i) Division A has surplus capacity? Yes No

(ii) Division A is operating at full capacity? Yes No
4.3.2 A cost-plus approach to transfer pricing

This transfer pricing method works in the same way as cost-plus pricing, discussed earlier in this chapter.
The supplying division determines the transfer price by adding a profit mark-up to the cost of the product
or service. Some form of cost-based transfer pricing method will usually be necessary where there is no
external market for the product or service. A number of issues arise with this transfer pricing method.
 A pre-determined standard cost should be used rather than actual cost. A standard cost is a
predetermined unit cost which is calculated by taking account of the expected price and usage of
resources to produce one unit of product or service. If standard costs are not used then all efficiencies
and inefficiencies are transferred from one division to another and divisional profit measurement is
distorted.
 To ensure that overheads are recovered the supplying division will wish to base the
transfer price on total cost. However, the supplying division's fixed costs will then be perceived as
variable costs from the point of view of the receiving division. This could lead to sub-optimal decisions.
Worked example: Sub-optimal decision making

A company has two divisions, S and R. Both divisions manufacture multiple products. Division S transfers its
output of component C to division R at full cost plus 10%. Division R then incurs further costs to convert
component C into finished product P for sale on the external market at CU40 per unit.
Costs incurred are as follows.
Division S Division R
CU per CU per
unit unit
Variable cost 20 15
Fixed cost absorbed 10
Full cost 30
Requirements
Would the transfers be recommended from the point of view of:
(a) The company as a whole?
(b) The manager of division R?
Solution
(a) The transfers would be recommended from the point of view of the company as a whole.
The variable cost incurred by the company as a whole for each unit of product P is CU35.
CU per
unit
Variable cost – Division S 20
– Division R 15
35
The fixed costs are irrelevant to this analysis because they would be incurred even if the transfers are
not made.
Therefore from the point of view of the company as a whole the transfers are worthwhile because
product P earns a contribution of CU5 per unit (CU40 – CU35).
(b) The transfers would not be recommended from the point of view of the manager of division R.
Transfer price per unit of component C = CU30 + 10% = CU33
The manager of division R would view the transfer price of component C as a variable cost, since it is
an additional cost incurred by division R for every unit of product P manufactured.
Therefore, from the point of view of the manager of division R the variable cost of each unit of
product P is CU48.
CU per unit
Variable cost – component C (perceived variable cost) 33
– additional cost incurred 15
48
Division R would not recommend the transfer of component C and the manufacture of product P
since the division would record a negative contribution of CU8 for each unit manufactured.
CU per unit of
P
External market price 40
Division R perceived variable cost (48)
Contribution (8)
In this example the use of a full cost-plus transfer price has led to sub-optimal decision making. There is a
lack of goal congruence because the manager of division R, in pursuing the division's own goals, was not at
the same time automatically pursuing the goals of the company as a whole.
In the situation depicted in Interactive question 3 (b)(i) there was also a lack of goal congruence. The
divisional manager's own goals were not congruent with those of the company as a whole. The transfer
pricing system was leading the manager of division B to make a sub-optimal decision from the point of view
of the company as a whole when division A had spare capacity.
4.3.3 Two part transfer price

To avoid the sub-optimal decisions that may occur when the fixed costs of one division are perceived as
variable costs by another division, a two part transfer price might be used.
Transfers are charged at a predetermined standard variable cost. A periodic charge for fixed costs would
also be made by the supplying division to the receiving division.
This helps to ensure goal congruence, since the receiving division would be fully aware of the cost
behaviour patterns of the company as a whole.
4.3.4 Dual pricing

In dual pricing the supplying division is credited with a different price from that which is charged to the
receiving division.
This transfer pricing method charges the receiving division for all transfers at variable or marginal cost. This
may lead to improved decision making.
The supplying division is credited with the market value or with a cost-plus transfer price in order to
provide a profit incentive to make the transfer.
The dual pricing method can be effective in avoiding sub-optimal decisions but it can be administratively
cumbersome.
Summary
Self-test
1 The following variable costs are incurred producing each unit of product F.
CU per unit
Variable material 8.00
Variable labour at CU14 per hour 42.00
Variable production overheads are incurred at the rate of CU4 per hour. Fixed production overheads
of CU60,000 are absorbed on the basis of 25,000 budgeted direct labour hours. Other overheads are
recovered at five percent of total production cost.
If selling prices are set to recover the full cost plus 50% the selling price per unit of product F is:
A CU72.66
B CU99.62
C CU103.80
D CU108.99
2 The marginal cost per unit of a product is 70% of its full cost. Selling prices are set on a full cost-plus
basis using a mark-up of 40 percent of full cost.
Which percentage mark-up on marginal cost would produce the same selling price as the full cost-plus
basis described?
A 70%
B 90%
C 100%
D 200%
3 Jay operates a car valeting service and charges CU16 per car. He incurs a total cost of CU10 per car
valeted.
Calculate the mark-up and margin earned per car valeted.
Mark-up %
Margin %
4 Which of the following statements is correct?
A A full cost-plus sales price will always be higher than a marginal cost-plus sales price
B If the selling price is agreed at the point of sale then the seller bears the inflation risk during any
credit period offered to the buyer
C A selling price in excess of the full cost per unit will always result in an overall profit for the
organisation
D A cost-plus selling price takes account of the effect of price on the quantity demanded
5 A company requires a 20% annual return on the investment in product F.
The budgeted investment in non-current assets and working capital for product F for the next year is
CU90,000. The full cost per unit of product F is CU5.00 and budgeted production and sales for next
year is 36,000 units.
The profit margin as a percentage of the sales price of product F is:
A 9.1%
B 10.0%
C 20.0%
D 50.0%
6 When goods are transferred from division A to division B a charge is made to division B at standard
variable cost. Each quarter division B is also charged with a lump-sum as a share of A's fixed costs. This
type of transfer pricing system is a:
A Marginal cost-plus system
B Dual pricing system
C Two part transfer pricing system
D Standard cost transfer pricing system
7 Which of the following are advantages of marginal cost-plus pricing?
A It is simple to use
B The percentage mark-up can be varied
C It pays attention to profit maximisation
D It ignores fixed overheads in the pricing decision
8 Division U makes components which it sells to external customers at a price of CU24 per unit,
earning a mark-up of 20% of total cost. Variable costs account for 40% of Division U’s total cost.
Division U also transfers components at market value to Division V within the same company. Division
V incurs additional total costs of CU8 per unit to convert and pack the component for international
sales. Variable costs account for 70% of Division V’s total cost.
Both divisions currently have surplus capacity.
Division V has an opportunity to sell a batch of components to a customer for CU15 per unit.
Which of the following statements is correct with regard to this potential order?
A The order is not acceptable from the company’s point of view and the manager of division V
will make a sub-optimal decision
B The order is not acceptable from the company’s point of view and the manager of division V
will not make a sub-optimal decision
C The order is acceptable from the company’s point of view and the manager of division V will
make a sub-optimal decision
D The order is acceptable from the company’s point of view and the manager of division V will
not make a sub-optimal decision
9 Division M manufactures product R incurring a total cost of CU30 per unit. Fixed costs represent 40%
of the total unit cost.
Product R is sold to external customers in a perfectly competitive market at a price of CU50 per unit.
Division M also transfers product R to division N. If transfers are made internally then division M does not
incur variable distribution costs, which amount to 10% of the variable costs incurred on external sales.
The total demand for product R exceeds the capacity of division M.
From the point of view of the company as a whole, enter the optimum price per unit at which division
M should transfer product R to division N.
Transfer price per unit = CU

10 The following data relate to the Columba group, a company with several divisions. Division D
produces a single product, which it sells to Division R and also to organisations outside the Columba
group.
Division D sales to Division R Division D external sales
CU CU
Sales revenue at CU70 per unit 700,000
Sales revenue at CU60 per unit 300,000
Variable costs at CU36 per unit (180,000) (360,000)
Contribution 120,000 340,000
Fixed costs (100,000) (240,000)
Profit 20,000 100,000
The Columba group profit is CU550,000.
A supplier offers to supply 3,000 units at CU50 each to Division R.

Divisional managers of Columba are given freedom of choice for selling and buying decisions, and their
performance is judged solely according to divisional profitability.
Calculate the profit for Division D and for Columba if Division D does not match the lower price
offered by the external supplier and cannot increase its external sales, and Division R chooses to
purchase from the external supplier.
1 D
WORKINGS
Labour hours per unit = CU42/CU14 = 3 hours
Fixed production overhead absorption rate = CU60,000/25,000
= CU2.40 per hour
CU per
unit
Variable material 8.00
Variable labour 42.00
Variable production overhead (3 hrs at CU4) 12.00
Fixed production overhead (3 hrs at CU2.40) 7.20
Total production cost 69.20
Other overhead at 5% 3.46
Full cost 72.66
Mark-up at 50% 36.33
Selling price 108.99
2 C
WORKINGS
%
Marginal cost 70
Absorbed fixed cost 30
Full cost 100
Mark-up 40
Selling price 140
(30  40)
Required mark up on marginal cost =  100%
70
= 100%
3 Mark-up = 60.0%
Margin = 37.5%
WORKINGS
Mark-up % = CU(16 10)  100%
CU10
= 60.0%
Margin % = CU(16 10)  100%
CU16
= 37.5%
4 B
A incorrect because both prices will depend on the mark-up percentage that is added to cost. If a very
large mark-up percentage is added to marginal cost then a higher selling price may result than with a
full-cost plus sales price.
C is incorrect because the full cost includes fixed costs per unit which have been derived based on
estimated or budgeted sales volumes. If the budgeted volumes are not achieved then the actual fixed
cost per unit will be higher than estimated and the selling price might be lower than the actual cost per
unit.
D is incorrect because one of the major criticisms of cost-plus pricing is that it fails to recognise that
sales demand may be determined by the sales price.
5 A
WORKINGS
Required annual return from product F = CU90,000  20%
= CU18,000
Total cost incurred = 36,000  CU5 = CU180,000
 Required percentage mark-up on cost = (CU18,000/CU180,000)  100%
= 10%
Product F selling price = CU5 + 10%
= CU5.50
Profit margin as a percentage of sales price = (CU0.50/CU5.50)  100%
= 9.1%
6 C
A marginal cost-plus system would involve adding a percentage to marginal cost in order to provide
the selling division with a contribution towards its fixed costs and profit.
A dual pricing system operates by charging the buying division for transfers at marginal cost and
crediting the selling division with either the market value or with a cost-plus transfer price.
The description of a standard cost transfer pricing system is imprecise because it does not specify
whether marginal or full cost is used.
7 A, B
The method is simple to use and the mark-up can be adjusted to reflect demand conditions.
Option C is not an advantage. Although the size of the mark-up can be varied in accordance with
demand conditions, it is not a method of pricing which ensures that sufficient attention is paid to
demand conditions, competitors' prices and profit maximisation.
Option D is not an advantage. Although there is no arbitrary apportionment and absorption of fixed
overheads, these costs are not ignored. They are taken into account in ensuring that the mark-up is
large enough to make a profit after covering fixed costs.
8 D
Since both divisions have surplus capacity no full-price sales will be forgone as a result of accepting this
order. The fixed costs will not alter, therefore provided the order covers the variable costs and earns
a contribution it will be acceptable.
Division U total cost = 100/120  CU24 = CU20 per unit
Division U variable cost = 40%  CU20 = CU8
From the point of view of the company as a whole:
CU per unit CU per
unit
Sales price per component 15.00
Variable cost incurred:
Division U 8.00
Division V (CU8  70%) 5.60
13.60
Contribution 1.40
The order earns a contribution therefore it is acceptable from the company's point of view.
From the point of view of Division V:

CU per CU per unit
unit
Sales price per component 15.00
Variable cost incurred:
Transfer price 24.00
Own variable cost 5.60
(29.60)
Negative contribution (14.60)
The manager of Division V will perceive the transfer price to be a variable cost which is incurred for
each component sold. Therefore, this order will not be accepted. The decision will be sub-optimal
because the profit of the company as a whole will not be maximised.
9 Transfer price per unit = CU48.20
The total demand for product R exceeds the capacity of division M therefore internal transfers will
displace external sales. The optimum transfer price can be calculated as follows.
Optimum transfer price = external market price – cost savings with internal transfer
Cost savings with internal transfer = 10%  variable costs
Fixed costs represent 40% of the total unit cost therefore variable costs are equal to 60% of the total
unit cost.
Cost savings with internal transfer = 10%  (CU30  60%)
= CU1.80
 Optimum transfer price = CU50 – CU1.80
= CU48.20
10 The correct answer is profit for Division D = CU48,000; profit for Columba Group = CU508,000
Division R will buy the 3,000 units externally at a price of CU50 per unit, leaving it with only 2,000
units to buy from Division D at CU60 per unit.
Profits of Division D
CU'000
Contribution from external sales 340
Contribution from sales to Division R 48
388
Fixed costs 340
Profit 48
The group as a whole will be paying CU(50 – 36) = CU14 per unit extra for each unit that Division R
purchases externally, thus reducing Columba's profits by 3,000  CU14 = CU42,000.
Columba's profit will therefore reduce to CU550,000 – CU42,000 = CU508,000.

Write your answer here
Situation
%
1 A competitor launches a similar service for CU60 per 50%

hour. In order to sell the service at the same price as
the competitor the percentage mark-up must be
reduced to:
2 The full cost of providing the service increases to CU50 48%
per hour. The required mark-up percentage to achieve
the same absolute value of mark-up per hour of service
provided is:
WORKINGS
Situation 1
Absolute mark-up per hour of service sold = CU(60 – 40) = CU20
Mark-up percentage = (20/40)  100% = 50%
Situation 2
Current absolute value of mark-up per hour of service sold = 60%  CU40 = CU24
Mark-up percentage required = (CU24/CU50)  100% = 48%

Question Write your answer here
1 If the full cost is CU14 per unit, calculate the price to CU17.50
achieve a margin of 20% of the selling price.
2 The selling price is CU27 per unit, determined on the 50%
basis of full cost-plus. If the full cost is CU18 per unit,
calculate the mark-up percentage.
3 A selling price of CU165 per unit earns a mark-up of CU80
106.25% of the full cost. What is the full cost per unit?
4 A product's selling price is determined by adding 25%
33.33% to its full cost. What percentage margin on
sales price does this represent?
WORKINGS
(1) Cost and selling price structure:
%
Cost 80
Profit 20
Price 100
 Price = 100/80  CU14 = CU17.50 per unit
(2) Profit per unit = CU27 – CU18 = CU9

Mark-up percentage = CU9/CU18 = 50% of full cost
%
Cost 100.00
Profit 106.25
Price 206.25
 Full cost = (100.00/206.25)  CU165 = CU80 per unit

%
Cost 100.00
Profit 33.33
Price 133.33
Percentage margin on sales price = (33.33/133.33)  100% = 25%

(a) No
Division B would reject the offer as there is a negative contribution of –CU5 (CU30 – CU20 transfer
price – CU15 variable cost)
(b) (i) No
If division A has surplus capacity then no full-price external sales would be forgone as a result of
transferring an additional unit to division B. Since the fixed costs are an arbitrary apportionment
of costs that would be incurred anyway, the only marginal cost to be incurred within division A
to provide another unit to B is CU10 per unit.
From the point of view of the company as a whole, all the apportioned fixed costs can be ignored
because they will be incurred anyway. The sale of a unit from B to a customer for CU30 would
earn a contribution of CU5 as follows.
CU30 – CU10 variable cost in A – CU15 variable cost in B = CU5
Therefore division B's decision to reject the offer of CU30 per unit would not be the correct
decision from the company's point of view if division A has surplus capacity.
(ii) Yes
If division A is operating at full capacity then the transfer of an additional unit to division B would
mean that a full price external sale at CU20 per unit is displaced, thus forgoing contribution of
CU10 (CU20 – CU10 variable cost)
Therefore from the point of view of the company as a whole, the sale of a unit from B to a
customer for CU30 would generate a negative contribution of – CU5 as follows.
CU per
unit
Selling price 30
Variable cost in division A (10)
Forgone contribution in division A (10)
Variable cost in division B (15)
Contribution (5)
Therefore division B's decision to reject the offer of CU30 per unit would be the correct
decision from the company's point of view if division A is operating at full capacity. In this
situation there would be goal congruence and the manager of division B would not make a sub-
optimal decision.
chapter 6
Budgeting
Contents
Introduction
Examination context
Topic List
1 Why do organisations prepare budgets?
2 A framework for budgeting
3 Steps in the preparation of a budget
4 The master budget
5 Preparing forecasts
6 Alternative approaches to budgeting
Introduction

 Apply forecasting techniques to assist management in performance measurement and
planning
 Prepare budgets, or extracts therefrom, from information supplied
 Select the most appropriate of the following budgeting approaches and methods, taking into
account their advantages and disadvantages for planning, control and motivation:
– Bottom-up and top-down approaches to generating and managing budgets
– Activity-based, responsibility-based and product-based structures
– Zero-based and incremental budgeting

The specific syllabus references for this chapter are: 2a, b, c.
Individual managers within a company have responsibility for providing a service or product within the
company or to the company’s customers. For example, the manager of the accounts receivable (AR)
department must ensure that the staff and other necessary resources are in place to administer the
expected number of customer accounts and to provide the required credit control services and so on.
The AR manager will need to be able to incur costs within the department without seeking separate
authorisation for each item of expenditure. For example, it may be necessary to send a member of the
credit control staff on a training course. If the manager has to contact the accounts department first to
check that the money is available then time will be wasted by the manager and by the accounts department.
To avoid this situation the AR manager may be provided with a budget, which is a plan for the forthcoming
period and details the authorised level of expenditure that may be incurred on each type of cost during the
period.
Thus a budget acts as a plan and as an authorisation to allow a manager, such as the AR manager, to incur
expenditure.
Another main role of a budget is as a control tool. The actual expenditure can be compared with the
budgeted expenditure for each period and variances highlighted. Monitoring these variances means that
control action can be taken if necessary to correct such deviations from the budget.
Budgets have other roles in addition to authorisation and control, which we will also investigate in this
chapter.
Stop and think

Is the budgetary planning and control process concerned only with numbers? Why are effective budget
systems designed with full consideration of their behavioural impact? For example, suppose you were
planning the budgeted expenditure for the next period for the department in which you work. Would you
prepare a completely objective plan without any bias, or would you be influenced by the desire to ensure
you do not overspend your budget or by a feeling of self-importance if your authorised budget is larger than
those of your colleagues? A budgetary planning and control system is about managing people as well as
managing numbers.
BUDGETING 6
Working context
You will come across budgets throughout your working life. Even if you are not a budget holder,
responsible for planning and controlling costs and revenues, you are likely to work for somebody who is a
budget holder. You might be asked your opinion about the estimated expenditure for the forthcoming
period, or perhaps you will be asked to help to investigate the reason for an overspend against the budget
for your department.
Syllabus links
You will need an understanding of how the annual budgeting exercise acts as a step towards the
achievement of an organisation's longer-term plans when you study the Business Strategy syllabus.
Examination context
Exam requirements
Numerical questions will be limited in scope (eg individual budgets). Narrative questions need to be read
very carefully, particularly those that ask whether statements are true or false.
 Demonstrate an understanding of the
– Objectives of a budgetary planning and control system
– Difference between a budget and a forecast
– Administrative process of budget preparation
 Prepare functional budgets and the income statement and balance sheet elements of a master budget
from data supplied
 Calculate the effect on budget outcomes of changes in specified variables
 Demonstrate an understanding of a range of budgeting approaches and methods
BUDGETING 6
1 Why do organisations prepare budgets?
Section overview
 An organisation's budgets fulfil many roles.
 A forecast is a prediction of what is likely to happen, whereas a budget is a plan of what the
organisation intends should happen.
 To be useful for planning and control purposes a budget must be quantified, but not necessarily only
in financial terms.
1.1 Reasons for preparing budgets

An organisation's budget fulfils many roles. Here are some of the reasons why budgets are used.
Function Detail
Compel planning Budgeting forces management to look ahead, to set out detailed plans
for achieving the targets for each department, each operation and
(ideally) each manager and to anticipate problems.
Communicate ideas and A formal system is necessary to ensure that each person affected by
plans the plans is aware of what he or she is supposed to be doing.
Communication might be one-way, with managers giving orders to
subordinates, or there might be two-way communication.
Coordinate activities The activities of different departments need to be coordinated to
ensure everyone in an organisation is working towards the same goals.
This means, for example, that the purchasing department should base
its budget on production requirements and that the production
budget should in turn be based on sales expectations.
Means of allocating It can be used to decide how many resources are needed (cash,
resources labour and so on) and how many should be given to each area of the
organisation's activities. Resource allocation is particularly important
when some resources are in short supply. Budgets often set ceilings
or limits on how much administrative departments and other service
departments are allowed to spend in the period. Public expenditure
budgets, for example, set spending limits for each government
department or other public body.
Authorisation A formal budget delegates authority to budget holders to take action
and, within specified control limits, to incur expenditure on the
organisation's behalf.
Provide a framework for Budgets require that managers are made responsible for the
responsibility accounting achievement of budget targets for the operations under their personal
control.
Establish a system of Control over actual performance is provided by the comparison of
control actual results against the budget plan. Departures from budget can
then be investigated and the reasons can be divided into controllable
and uncontrollable factors.
Provide a means of Budgets provide targets that can be compared with actual outcomes
performance evaluation in order to assess employee performance. They also provide a means
to establish a personal incentive and bonus scheme.
Function Detail
Motivate employees to The interest and commitment of employees can be retained if there is
improve their performance a system that lets them know how well or badly they are performing.
The budget can act as a target for achievement, and the identification
of controllable reasons for departures from budget with managers
responsible provides an incentive for improving future performance.
1.2 Budgets compared with forecasts

A forecast is a prediction of what is likely to happen in the future, given a certain set of circumstances. This
is different from a budget, which is a quantified plan of what the organisation intends should happen in the
future.
The budget is based on the forecast, therefore the two are connected, but they are not the same thing.
Measures might be taken to ensure that budgeted targets are achieved, thus a budget forces management
into decision-making and taking action. For example, a gap between forecast sales revenue and the sales
budget could force sales promotions or an increase in advertising.
1.3 Quantified budgets

To fulfil the range of purposes for which it is prepared, a budget must be quantified. For example, the
following two statements would not be particularly useful for planning and control purposes.
'We plan to utilise fully all the available hours of semi-skilled labour next period.'
'We plan to minimise expenditure on advertising next period.'
Without quantification these are merely general statements of purpose. The following quantified budgets
are more useful for planning and control.
'We plan to utilise 24,800 hours of semi-skilled labour next period.'

'We plan to spend CU107,000 on advertising next period.'
These budgets provide definite plans, as well as yardsticks for control purposes. Notice that the
labour hours budget is not expressed in financial terms. It still fulfils the role of a budget because it is
quantified. Therefore a budget does not necessarily need to be expressed in financial terms. Of course the
semi-skilled labour hours budgeted can be converted into a budget expressed in financial terms by applying
a rate of pay per hour to the budgeted number of labour hours.
An important feature of any quantified budget is the fact that it is time bound. Just to say, 'We plan to
spend CU107,000 on advertising' without specifying a period over which this amount is to be spent would
render the 'budget' useless.
2 A framework for budgeting
Section overview
 The budget committee is the coordinating body in the preparation and administration of budgets.
 The budget period is the period covered by the budget, which is usually one year. The budget is
divided into a number of control periods, typically calendar months.
 The budget manual is a collection of instructions relating to the preparation and use of budgetary
data.
BUDGETING 6
2.1 Budget committee

The budget committee is the coordinating body in the preparation and administration of budgets. The
budget committee is usually headed up by the managing director (as chairman) who is assisted by a budget
officer, who is usually the finance director or another accountant. Every part of the organisation should be
represented on the committee, so there should be a representative from sales, production, marketing and
so on.
Functions of the budget committee include the following.
 Coordination and allocation of responsibility for the preparation of budgets
 Issuing of the budget manual
 Timetabling
 Provision of information to assist in the preparation of budgets
 Communication of final budgets to the appropriate managers
 Monitoring the budgeting process by comparing actual and budgeted results
Often the budget committee is the senior management team of an organisation or the board of directors
itself.
2.2 The budget period

The budget period is the period covered by the budget, which is usually one year. However, budgets can be
prepared and used for longer periods, for example capital expenditure budgets. Budgets can also be
prepared for shorter periods, for example in an environment where technology or other factors are rapidly
changing with the result that annual budgets quickly become out of date.
In the common situation where a budget is prepared for a year it will usually be divided into monthly
control periods so that regular comparisons can be made of the actual and budgeted results.
Some organisations divide the annual budget into 13 periods of four weeks. Others have 12 budget periods
but they are not calendar months, but periods of 4, 4 and 5 weeks for each quarter of the year.
2.3 The budget manual

The budget manual is a collection of instructions governing the responsibilities of persons and the
procedures, forms and records relating to the preparation and use of budgetary data.
A budget manual may contain the following.
(a) An explanation of the objectives of the budgetary process
 The purpose of budgetary planning and control
 The objectives of the various stages of the budgetary process
 The importance of budgets in the long-term planning of the business
(b) Organisational structures
 An organisation chart
 A list of individuals holding budget responsibilities
(c) An outline of the principal budgets and the relationship between them
(d) Administrative details of budget preparation
 Membership and terms of reference of the budget committee
 The sequence in which budgets are to be prepared
 A timetable
(e) Procedural matters
 Specimen forms and instructions for their completion
 Specimen reports
 Account codes (or a chart of accounts)
 The name of the budget officer to whom enquiries must be sent
3 Steps in the preparation of a budget
Section overview
 The principal budget factor is that factor which limits an organisation's activities. The budget for the
principal budget factor must be prepared first.
 If sales volume is the limiting factor then the sales budget should be prepared first.
 The production budget will then be prepared by adjusting the sales budget for planned changes in
finished goods inventory.
 The next stage will be the preparation of budgets for production resources such as direct materials
usage and direct labour.
 The direct materials purchases budget is prepared by adjusting the direct materials usage budget for
planned changes in raw materials inventory.
 Overhead cost budgets will be prepared, taking account of the level of activity to be achieved and the
support needed to be given to the 'direct' operations. A budgeted income statement can then be
produced.
 A number of budgets such as the capital expenditure budget, the working capital budget and the cash
budget must be prepared in order to provide the necessary information for the budgeted balance
sheet.
 Standard costs provide the basic unit rates to be used in the preparation of a number of functional
budgets.
The procedures for preparing a budget will differ from organisation to organisation but the steps described
below will be indicative of those followed by many organisations. The preparation of a budget may take
weeks or months and the budget committee may meet several times before the master budget
(budgeted income statement, budgeted balance sheet and budgeted cash flow) is finally agreed. Functional
budgets (sales budgets, production budgets, direct labour budgets and so on), which are amalgamated into
the master budget, may need to be amended many times as a consequence of discussions between
departments, changes in market conditions and so on during the course of budget preparation.
Ideally, a master budget should be finished prior to the start of the period to which it relates.
3.1 Identifying the principal budget factor

The budget for the principal budget factor must be prepared first. The principal budget factor is that factor
which limits an organisation's activities. This factor is usually sales demand. A company is usually
restricted from making and selling more of its products because there would be no sales demand for the
increased output at a price that would be acceptable/profitable to the company. The principal budget factor
may alternatively be machine capacity, distribution and selling resources, the availability of key raw materials
or the availability of cash. Once this factor is defined then the remainder of the budgets can be prepared.
For example, if sales are the principal budget factor then the production manager can only prepare the
production budget after the sales budget is complete.
3.2 The order of budget preparation

Assuming that sales has been identified as the principal budget factor, the stages involved in the preparation
of a budget for a manufacturing business can be summarised as follows.
(a) The sales budget is prepared in terms of units of product, unit selling price and total sales value. The
finished goods inventory budget can be prepared at the same time. This budget decides the
planned increase or decrease in finished goods inventory levels.
BUDGETING 6
(b) With the information from the sales and inventory budgets, the production budget can be prepared.
This is, in effect, the sales budget in units plus (or minus) the increase (or decrease) in finished goods
inventory. The production budget will be stated in terms of units.
(c) This leads on logically to budgeting the resources for production. This involves preparing a
materials usage budget, machine usage budget and a labour budget.
(d) In addition to the materials usage budget, a materials inventory budget will be prepared, to decide
the planned increase or decrease in the level of inventory held. Once the raw materials usage
requirements and the raw materials inventory budget are known, the purchasing department can
prepare a raw materials purchases budget in quantities and value for each type of material
purchased. Similarly warehousing and distribution budgets can be prepared.
(e) During the preparation of the sales and production budgets, the managers of the cost centres of the
organisation will prepare draft budgets for their department overhead costs. Such overheads will
include maintenance, stores, administration, selling and research and development.
(f) From the above information a budgeted income statement can be produced.
(g) In addition, several other budgets must be prepared in order to arrive at the budgeted balance
sheet. These are the capital expenditure budget (for non-current assets), the working capital
budgets (for budgeted increases or decreases in the level of receivables and accounts payable as well
as inventories), and a cash budget.
The following diagram shows the major budgets and their inter-relationships.
Sales budget
Inventory budget Other cost budgets: Receivables

(finished goods) Sales and distribution costs budget
Administration costs
R&D
Production budget
Raw materials Direct labour Machine usage

usage budget budget Budget
Inventory budget
(raw materials)
Recruitment or Production
redundancy budgets overhead budget
Raw materials
purchase budget
Payables budget Cash budget

Capital
expenditure
budget
Budget income
statement and
balance sheet
A similar flow chart could be prepared for a service based business.
Interactive question 1: The order of budget preparation [Difficulty level: Easy]

For the following pairs of budgets use the table to identify, under normal circumstances, whether the first
budget should be produced before or after the second or whether it does not matter. Tick one box for
each row. Assume that sales demand is the principal budget factor.
Before After Doesn't matter
Sales revenue; sales quantities
Finished goods inventories; production volume
Materials usage; labour hours
Materials usage; materials purchases
3.3 Preparing functional budgets

Functional/departmental budgets include budgets for sales, production, purchases, labour and
administration. Having seen the theory of budget preparation, let us look at functional (or
departmental) budget preparation, which is best explained by means of an example.
Worked example: Preparing a materials purchases budget

ECO Co manufactures two products, S and T, which use the same raw materials, D and E. One unit of S
uses 3 litres of D and 4 kilograms of E. One unit of T uses 5 litres of D and 2 kilograms of E. A litre of D is
expected to cost CU3 and a kilogram of E CU7.
Budgeted sales for 20X2 are 8,000 units of S and 6,000 units of T; finished goods in inventory at 1 January
20X2 are 1,500 units of S and 300 units of T, and the company plans to hold inventories of 600 units of
each product at 31 December 20X2.
Inventories of raw material are 6,000 litres of D and 2,800 kilograms of E at 1 January and the company
plans to hold 5,000 litres and 3,500 kilograms respectively at 31 December 20X2.
The warehouse and stores managers have suggested that a provision should be made for damages and
deterioration of items held in store, as follows.
Product S : loss of 50 units
Product T : loss of 100 units
Material D : loss of 500 litres
Material E : loss of 200 kilograms
Requirement
Prepare a material purchases budget for the year 20X2.
Solution
To calculate material purchases requirements it is first necessary to calculate the material usage
requirements. That in turn depends on calculating the budgeted production volumes.
Product S Product T
Units Units
Production required
To meet sales demand 8,000 6,000
To provide for inventory loss 50 100
For closing inventory 600 600
8,650 6,700
Less inventory already in hand (1,500) (300)
Budgeted production volume 7,150 6,400
BUDGETING 6
Material purchases budget Material D Material E

Litres Kgs
Usage requirements
To produce 7,150 units of S 21,450 28,600
To produce 6,400 units of T 32,000 12,800
To provide for inventory loss 500 200
For closing inventory 5,000 3,500
58,950 45,100
Less inventory already in hand (6,000) (2,800)
Budgeted material purchases 52,950 42,300
Unit cost CU3 CU7
Cost of material purchases CU158,85 CU296,10
0 0
Total cost of material purchases CU454,950
The basic principles for the preparation of each functional budget are similar to those above. Work carefully
through the following question, which covers the preparation of a number of different types of functional
budget.
Interactive question 2: Preparing functional budgets [Difficulty level: Intermediate]

XYZ company produces three products, X, Y and Z. For the coming accounting period budgets are to be
prepared based on the following information.
Budgeted sales
Product X 2,000 at CU100 each
Product Y 4,000 at CU130 each
Product Z 3,000 at CU150 each
Budgeted usage of raw material
RM11 RM22 RM33
Product X 5 2 -
Product Y 3 2 2
Product Z 2 1 3
Cost per unit of material CU5 CU3 CU4
Finished inventory budget
Product X Product Y Product Z
Opening 500 800 700
Closing 600 1,000 800
Raw materials inventory budget
RM11 RM22 RM33
Opening 21,000 10,000 16,000
Closing 18,000 9,000 12,000
Expected hours per unit 4 6 8
Expected hourly rate (labour) CU9 CU9 CU9
Fill in the blanks.

(a) Sales budget
Product X Product Y Product Z Total
Sales quantity
Sales value CU CU CU CU
(b) Production budget

Units Units Units
Budgeted production
(c) Material usage budget

RM11 RM22 RM33
Units Units Units
Budgeted material usage
(d) Material purchases budget

RM11 RM22 RM33
Budgeted material purchases CU CU CU
(e) Labour budget
Budgeted total wages CU
3.4 The link between budgeting and standard costing

In the practical exercises in section 3.3 involving the preparation of budgets you used data about the
expected price and usage of the resources required to manufacture one unit of product in the budget. For
example, to prepare the labour cost budget you were provided with information about the expected labour
hours for each unit of product to be manufactured, as well as the expected rate to be paid for each hour of
labour.
This information about the expected price and usage of resources is provided by a standard costing
system. A standard cost is a predetermined unit cost that details the price and quantity of resources
(material, labour and so on) required for each unit of product or service. This unit cost is multiplied by the
budgeted activity level to determine the budgeted total cost for each of the relevant cost elements.
Thus standard costs provide the basic unit rates to be used in the preparation of a number of functional
budgets. The detailed standard cost also enables control to be exercised over actual performance.
The departures from budgets, or variances, can be analysed in detail using the standard cost information
about the price and quantity of resources that should have been used for each unit of production or
service.
In Chapter 8 you will study the use of budgets for control purposes, and in Chapter 9 the analysis of
standard costing variances will be explored in detail.
BUDGETING 6
4 The master budget
Section overview
 The master budget consists of the budgeted income statement, the budgeted balance sheet and the
cash budget.
 The master budget provides a consolidation of all the subsidiary budgets and is likely to be of most
interest to senior managers and directors.
 A sensitivity analysis might be carried out on the master budget to show the effect on the budgeted
outcome of changes in the budgeted assumptions.
4.1 The content of the master budget

The master budget provides a consolidation of all the subsidiary budgets and normally comprises a
budgeted income statement, a budgeted balance sheet and a cash budget.
Cash budgeting will be discussed in detail in Chapter 7. In this chapter we will focus on the budgeted
income statement and budgeted balance sheet.
Worked example: Preparing a budgeted income statement and balance sheet

Use the following information to prepare a budgeted income statement for the six months ended 30 June
and a budgeted balance sheet at that date.
A new business is to be started and details of budgeted transactions are as follows.
 Non-current assets will be purchased for CU12,000. Depreciation will be charged on a straight line
basis, assuming that the assets will have a useful life of five years after which they will have no residual
value.
 Month-end inventories will be maintained at a level sufficient to meet the forecast sales for the
following month.
 Forecast monthly sales are CU4,000 for January to March, CU5,000 for April to June and CU6,000 per
month for July onwards.
 The gross profit margin is budgeted to be 20% of sales value.
 Two months' credit will be allowed to customers and one month’s credit will be received from
suppliers of inventory.
 Operating expenses (excluding depreciation) are budgeted to be CU350 each month.
 The budgeted closing cash balance as at 30 June is CU16,700.
Solution
Budgeted income statement for six months ended 30 June
CU CU
Revenue ((CU4,000  3) + (CU5,000  3)) 27,000
Cost of sales (CU27,000  80/100) 21,600
Gross profit 5,400
Operating expenses (CU350  6) 2,100
Depreciation ((CU12,000/5)  6/12) 1,200
3,300
Budgeted profit 2,100
Budgeted balance sheet as at 30 June

CU CU
Non-current assets (CU12,000 - CU1,200 depreciation) 10,800
Current assets
Inventories (July cost of sales = CU6,000 x 80/100) 4,800
Receivables (May and June sales) 10,000
Cash 16,700
31,500
Current liabilities
Trade payables (June purchases = July cost of sales) 4,800
Net current assets 26,700
37,500
Owner’s capital 37,500
4.2 Performing a sensitivity analysis

Since the master budget provides a summary of all the subsidiary budgets it is likely to be of most interest
to senior managers and directors who may not need to be concerned with the detail of budgets outside
their own areas of responsibility.
Of particular interest to senior managers will be the sensitivity of the budget outcomes to changes in
the budget assumptions. For example, they might like to know the answers to questions such as the
following.
 What will be the budgeted profit if sales revenue is five per cent higher or lower than the budget?
 What will be the total budgeted costs if direct material costs are ten per cent higher or lower than the
budget?
A sensitivity analysis (sometimes called a ‘what if?’ analysis) might be performed to show the effect of
changes such as these, and to assess the impact on critical areas such as cash resources.
Worked example: 'What if?' analysis

R Ltd manufactures and sells a single product. The budgeted income statement contained in the master
budget for the forthcoming year is as follows.
CU CU
Sales revenue (20,000 units) 640,000
Variable materials cost 190,000
Variable labour cost 172,000
Variable overhead 13,000
Fixed overhead 155,000
530,000
Budgeted net profit 110,000
The directors wish to know what the budgeted profit will be if a higher quality material is used. This will
increase material costs per unit by ten per cent but sales volume will be increased by five per cent. There
will be no change in the unit selling price.
Assumptions
The budgeted sales volume will increase to 21,000 units and, in the absence of information to the contrary,
we will assume there will be no changes in the total fixed overhead cost incurred and no changes in the
variable labour and overhead costs per unit.
BUDGETING 6
The revised budgeted income statement will look like this.

CU CU
Sales revenue (CU640,000/20,000) x 21,000 672,000
Variable materials cost (CU190,000/20,000) x 1.1 x 21,000 219,450
Variable labour cost (CU172,000/20,000) x 21,000 180,600
Variable overhead (CU13,000/20,000) x 21,000 13,650
568,700
The proposed changes are not worthwhile since the contribution from the increase in sales volume is not
sufficient to compensate for the increase in material costs.
5 Preparing forecasts
Section overview
 Techniques that use past data to forecast future events assume that the past will provide a good
indication of what will happen in the future.
 The high-low method is a technique for analysing the fixed and variable elements of a semi-variable
cost and thus predicting the cost to be incurred at any activity level within the relevant range.
 A major disadvantage of the high-low method is that it takes account of only two sets of data.
 Linear regression analysis establishes a straight line equation to represent cost or revenue and activity
data. It takes account of all sets of data that are available.
 Correlation is the degree to which one variable is related to another.
 The coefficient of correlation, r, can take any value between -1 (perfect negative correlation) and +1
(perfect positive correlation). If r = 0 then the variables are uncorrelated.
 The coefficient of determination, r2, is a measure of the proportion of the change in one variable that
can be explained by variations in the value of the other variable.
5.1 Forecasting using historical data

Numerous techniques have been developed for using past costs as the basis for forecasting future values.
These techniques range from simple arithmetic to advanced computer-based statistical systems. With all
these techniques the important presumption is made that the past will provide guidance to the future.
The forecasting methods that we will review in this section of the chapter are based on the assumption that
a linear relationship links levels of cost and levels of activity.
5.2 Linear relationships

A linear relationship can be expressed in the form of an equation that has the general form y = a + bx,
where
y is the dependent variable, depending for its value on the value of x
x is the independent variable, whose value helps to determine the corresponding value of y
a is a constant, a fixed amount
b is a constant, being the coefficient of x (that is, the number by which the value of x should be
multiplied to derive the value of y)
For example if there is a linear relationship between total costs and the level of activity, y = total costs, x =
level of activity, a = fixed cost and b = variable cost per unit.
5.3 The high-low method

The high-low method is a technique for analysing the fixed and variable cost elements of a semi-variable
cost and thus predicting the cost to be incurred at any activity level within the relevant range.
The steps taken to prepare a forecast using the high-low method are as follows.
Step 1
Records of costs in previous periods are reviewed and the costs of the following two periods are selected.
 The period with the highest volume of activity
ie the high/low values of the independent variable
 The period with the lowest volume of activity
The difference between the total cost of these two periods will be the total variable cost of the
difference in activity levels (since the same fixed cost is included in each total cost).
Step 2
The variable cost per unit may be calculated from this as (difference in total costs  difference in activity
levels).
Step 3
The fixed cost may then be determined by substitution.
Step 4
The linear equation y = a + bx can be used to predict the cost for a given activity level.
Worked example: The high/low method

The costs of operating the maintenance department of a computer manufacturer, Bread and Butter Ltd, for
the last four months have been as follows.
Month Cost Production volume
CU Units
1 110,000 7,000
2 115,000 8,000
3 111,000 7,700
4 97,000 6,000
Requirement
Calculate the costs that should be expected in month 5 when output is expected to be 7,500 units. Ignore
inflation.
Solution
Step 1
Units CU
High output 8,000 total cost 115,000
Low output 6,000 total cost 97,000
Total variable cost 2,000 18,000
Step 2
Variable cost per unit CU18,000/2,000 =
CU9
Step 3
Substituting in either the high or low volume cost:
High Low
CU CU
Total cost 115,000 97,000
Variable costs (8,000  CU9) 72,000 (6,000  54,000
CU9)
Fixed costs 43,000 43,000
BUDGETING 6
Step 4
Estimated maintenance costs when output is 7,500 units:
CU
Fixed costs 43,000
Variable costs (7,500  CU9) 67,500
Total costs 110,500
Interactive question 3: High/low method [Difficulty level: Easy]

The Valuation Department of a large firm of surveyors wishes to develop a method of predicting its total
costs in a period. The following past costs have been recorded at two activity levels.
Number of valuations Total cost
(V) (TC)
Period 1 420 CU82,200
Period 2 515 CU90,275
Write the appropriate figures in the boxes below to derive an equation that can be used to represent the
total cost model for a period.
TC = CU + CU V
A major disadvantage of the high-low method is that it takes account of only two sets of data, which
may not be representative of all the data available. In particular, one of them could be a rogue set of data.
For example, the pattern of data might be as follows.
The straight-line equation derived using the high-low method, as shown in the diagram above using points H
and L, would be inaccurate. It does not take into account all of the recorded combinations and fails to allow
for the fact that the majority of points lie below the line joining the highest and lowest activity.
5.4 Linear regression analysis

Linear regression analysis is a statistical technique for establishing a straight line equation to represent a set
of data. Linear regression analysis is superior to the high-low method because it takes account of all
sets of recorded data, rather than only the highest and lowest activity.
However, even though the linear regression technique is more accurate than the high-low method, it is
important to remember that its use in forecasting is still based on the presumption that past events are a
good guide to what will happen in the future.
A further issue with the use of both the high-low method and linear regression analysis is that the quality
or reliability of the linear equation derived will depend upon the correlation between the
variables.
5.5 Correlation
Correlation is the degree to which one variable is related to another, ie the degree of interdependence
between the variables.
(a) (b)
In the scatter diagrams above, you should agree that the straight line equation is more likely to reflect the
'real' relationship between X and Y in (b) than in (a). In (b), the pairs of data are all close to the line of best
fit, whereas in (a), there is much more scatter around the line.
In the situation represented in diagram (b), forecasting the value of Y from a given value for X would be
more likely to be accurate than in the situation represented in (a). This is because there would be greater
correlation between X and Y in (b) than in (a).
5.5.1 Degrees of correlation

Two variables might be perfectly correlated, partly correlated, uncorrelated or subject to non-
linear correlation.
Perfect correlation
All the pairs of values lie on a straight line. An exact linear relationship exists between the two variables.
BUDGETING 6
Partial correlation
In the left hand diagram, although there is no exact relationship, low values of X tend to be associated
with low values of Y, and high values of X with high values of Y.
In the right hand diagram, there is no exact relationship, but low values of X tend to be associated
with high values of Y and vice versa.
No correlation
The values of these two variables are not correlated with each other.
Non-linear or curvilinear correlation
There is a relationship between X and Y since the points are on an obvious curve but it is not a linear
relationship.
5.5.2 Positive and negative correlation

Correlation, whether perfect or partial, can be positive or negative.
 Positive correlation is the type of correlation where low values of one variable are associated with
low values of the other, and high values of one variable are associated with high values of the other.
 Negative correlation is the type of correlation where low values of one variable are associated with
high values of the other, and high values of one variable with low values of the other.
5.6 Measures of correlation

5.6.1 The coefficient of correlation, r
The degree of correlation between two variables can be measured using the coefficient of correlation, r.
r has a value between –1 (perfect negative correlation) and +1 (perfect positive correlation). If r=0
then the variables are uncorrelated.
5.6.2 The coefficient of determination, r2

The coefficient of determination, r2, is a measure of the proportion of the change in one variable that can be
explained by variations in the value of the other variable.
Worked example: The coefficient of determination

The coefficient of correlation, r, between vehicle maintenance costs and vehicle running hours has been
calculated to be 0.96.
This indicates that there is a fairly high degree of positive correlation between x (vehicle running hours) and
y (vehicle maintenance cost) because r is quite close to +1. The coefficient of determination, r2, is equal to
(0.96)2 = 0.9216. This means that 92% of variations in the value of y (cost) can be explained by a linear
relationship with x (running hours). This leaves only 8% of variations in y to be predicted from other
factors.
Therefore it is likely that vehicle running hours could be used with a high degree of confidence to predict
vehicle running costs during a period.
Interactive question 4: The coefficient of determination [Difficulty level: Easy]

Tick the boxes to indicate whether the following statements about the coefficient of determination are true
or false.
True False
(a) It is the square of the coefficient of correlation
(b) It can never quite equal 1
(c) If it is high, this proves that variations in one variable cause variations in the other
BUDGETING 6
6 Alternative approaches to budgeting
Section overview
 An organisation’s budgeting style can be participative (bottom-up) or imposed (top-down).
 Participative budgeting tends to have the most favourable motivational impact but it does have its
disadvantages.
 Budget slack is the intentional overstating of costs or understating of revenues in a budget, in order
to set an ‘easy’ budget target.
 Incremental budgeting involves basing the next year’s budget on the current year’s results, with
adjustments for known changes and inflation.
 Zero based budgeting requires all budgets to be prepared from the very beginning or zero.
 Rolling budgets, also known as continuous budgets, are continuously updated by adding a further
month or quarter to the end of the budget as each month or quarter comes to a close.
 The structure of budgets may be designed around one of a number of frameworks, including product
based budgets, responsibility based budgets and activity based budgets.
6.1 Participation in the budgeting process

It has been argued that participation in the budgeting process will improve motivation and so will improve
the quality of budget decisions and the efforts of individuals to achieve their budget targets.
There are basically two ways in which a budget can be set: from the top down (imposed budget) or from
the bottom up (participatory budget).
6.1.1 Imposed or top-down style of budgeting

In this approach to budgeting, top management prepare a budget with little or no input from
operating personnel, which is then imposed upon the employees who have to work to the budgeted
figures.
The times when imposed budgets are effective
 In newly-formed organisations
 In very small businesses
 During periods of economic hardship
 When operational managers lack budgeting skills
 When the organisation's different units require precise coordination
There are, of course, advantages and disadvantages to this style of setting budgets.
(a) Advantages
 Strategic plans are likely to be incorporated into planned activities.
 They enhance the coordination between the plans and objectives of divisions.
 They use senior management's awareness of total resource availability.
 They decrease the input from inexperienced or uninformed lower-level employees.
 They decrease the period of time taken to draw up the budgets.
(b) Disadvantages
 Dissatisfaction, defensiveness and low morale amongst employees. It is hard for people to be
motivated to achieve targets set by somebody else, particularly if managers consider the budget
targets to be unrealistic.
 The feeling of team spirit may disappear.
 The acceptance of organisational goals and objectives could be limited.
 The budget may be viewed as a punitive device.

 Managers who are performing operations on a day to day basis are likely to have a better
understanding of what is achievable.
 Unachievable budgets could result if consideration is not given to local operating and political
environments. This applies particularly to overseas divisions.
 Lower-level management initiative may be stifled.
6.1.2 Participative or bottom-up style of budgeting

In this approach to budgeting, budgets are developed by lower-level managers who then submit
the budgets to their superiors. The budgets are based on the lower-level managers' perceptions of
what is achievable and the associated necessary resources.
Advantages of participative budgets
 They are based on information from the employees most familiar with the department.
 Knowledge spread among several levels of management is pulled together (ie information asymmetry is
reduced).
 Morale and motivation is improved.
 They increase operational managers' commitment to organisational objectives.
 In general they are more realistic.
 Co-ordination between units is improved.
 Specific resource requirements are included.
 Senior managers' overview is mixed with operational level details.
 Individual managers' aspiration levels are more likely to be taken into account.
Disadvantages of participative budgets
 They consume more time.
 Changes implemented by senior management may cause dissatisfaction.
 Budgets may be unachievable or much too soft if managers are not qualified to participate.
 They may cause managers to introduce budget slack (overstating costs or understating revenues) and
budget bias.
 They can support 'empire building' by subordinates.
 An earlier start to the budgeting process could be required.
6.2 Incremental budgeting

The traditional approach to budgeting is to base the forthcoming year's budget on the current year's results
modified for changes in activity levels, for example by adding an extra amount for estimated growth or
inflation next year. This approach is known as incremental budgeting since it is concerned mainly with
the increments in costs and revenues which will occur in the coming period.
Incremental budgeting is a reasonable approach if the current operations are as effective, efficient and
economic as they can be.
In general, however, it is an inefficient form of budgeting. It encourages slack, which is unnecessary
expenditure built into the budgets. Past inefficiencies are perpetuated because cost levels are rarely
subjected to close scrutiny.
BUDGETING 6
6.3 Zero based budgeting

Zero based budgeting (ZBB) is an approach to budgeting that attempts to ensure that inefficiencies are not
concealed.
The principle behind ZBB is that, instead of using the current year's results as a starting point, each
budget should be prepared from the very beginning or zero. Every item of expenditure must be
justified separately to be included in the budget for the forthcoming period.
Increments of expenditure are compared with the expected benefits received, to ensure that
resources are allocated as efficiently as possible.
ZBB can be particularly useful when applied to discretionary costs such as marketing and training costs. This
type of cost is not vital to the continued existence of an organisation in the way that, say, raw materials are
to a manufacturing business.
A major disadvantage of ZBB is that it is a time-consuming task that involves a great deal of work.
6.4 Rolling budgets

Rolling budgets are sometimes called continuous budgets. They are particularly useful when an
organisation is facing a period of uncertainty so that it is difficult to prepare accurate plans and budgets.
For example, it may be difficult to estimate the level of inflation for the forthcoming period.
Rolling budgets are an attempt to prepare targets and plans that are more realistic and certain,
particularly with a regard to price levels, by shortening the period between preparing budgets.
Instead of preparing a periodic budget annually for the full budget period, budgets would be prepared,
say, every one, two or three months (four, six, or even twelve budgets each year). Each of these budgets
would plan for the next twelve months so that the current budget is extended by an extra period as the
current period ends: hence the name rolling budgets. Cash budgets, which are the subject of the next
chapter, are usually prepared on a rolling basis.
Suppose, for example, that a rolling budget is prepared every three months. The first three months of the
budget period would be planned in great detail, and the remaining nine months in lesser detail, because of
the greater uncertainty about the longer-term future.
(a) The first continuous budget would show January to March Year 1 in detail, and April to December
Year 1 in less detail.
(b) At the end of March, the first three months of the budget would be removed and a further three
months would be added at the end for January to March Year 2.
(c) The remaining nine months for April to December Year 1 would be updated in the light of current
conditions, adding more detail to the earliest three months, April to June Year 1.
The detail in the first three months would be principally important for the following.
 Planning working capital and short-term resources (cash, materials, labour and so on)
 Control: the budget for each control period should provide a more reliable yardstick for comparison
with actual results.
The advantages of rolling budgets are as follows.
(a) They reduce the element of uncertainty in budgeting. If a high rate of inflation or major changes
in market conditions or any other change that cannot be quantified with accuracy is likely, rolling
budgets concentrate detailed planning and control on short-term prospects where the degree of
uncertainty is much smaller.
(b) They force managers to reassess the budget regularly, and to produce budgets that are up to
date in the light of current events and expectations.
(c) Planning and control will be based on a recent plan instead of an annual budget that might have
been prepared many months ago and is no longer realistic.
(d) There is always a budget that extends for several months ahead. For example, if rolling
budgets are prepared quarterly there will always be a budget extending for the next 9 to 12 months. If
rolling budgets are prepared monthly there will always be a budget for the next 11 to 12 months. This
is not the case when annual budgets are used.
The disadvantages of rolling budgets can be a deterrent to using them.
(a) A system of rolling budgets calls for the routine preparation of a new budget at regular intervals during
the course of the one financial year. This involves more time, effort and money in budget
preparation.
(b) Frequent budgeting might have an off-putting effect on managers who doubt the value of
preparing one budget after another at regular intervals, even when there are major differences
between the figures in one budget and the next.
6.5 Alternative budget structures

The structure of budgets may be designed around one of a number of frameworks, including the following.
6.5.1 Product based budgets

Product based budgets are drawn up by preparing separate budgets for each product. For example a
separate production budget would be established for product A, for product B and for product C as well as
a separate marketing cost budget, a separate distribution cost budget, a separate sales revenue budget and
so on.
This structure is appropriate when the cost and revenue responsibilities differ for each product,
or when a single manager is responsible for all aspects of one product.
The individual product budgets might also be aggregated across products, for example where a distribution
manager has overall responsibility for all product distribution costs.
The separate product budgets and the possibility for aggregation across products enables senior managers
to look both down and across the whole organisation in terms of budgets.
6.5.2 Responsibility based budgets

Responsibility based budget systems segregate budgeted revenues and costs into areas of personal
responsibility in order to monitor and assess the performance of each part of an organisation.
Budgetary control is based around a system of budget centres. Each budget centre will have its own budget,
and an individual manager (a budget holder) will be responsible for managing the budget centre and ensuring
that the budget is met.
Responsibility based budgets can have a positive motivational impact, as long as the budget holder is not
held responsible for costs and revenues over which they have no control.
6.5.3 Activity based budgets

Activity based budgets are based on a framework of activities, and cost drivers are used as a basis for
preparing budgets.
The budget for each activity is derived from the quantity of the activity's cost driver  the appropriate cost
driver rate.
BUDGETING 6
Worked example: activity based budget

An organisation expects to place 500 orders with suppliers during the forthcoming budget period. The rate
per cost driver has been established as CU100. The budgeted cost of the ordering activity is therefore 500
 CU100 = CU50,000.
Activity based budgeting (ABB) involves defining the activities that underlie the financial figures in each
function. The level of activity in terms of cost drivers is used to decide how much resource should be
allocated and how well the activity is being managed, and to explain differences between the budget and
actual results.
Implementing ABB leads to the realisation that the business as a whole needs to be managed with more
reference to the behaviour of activities and cost drivers identified.
(a) Traditional budgeting may make managers 'responsible' for activities that are driven by
factors beyond their control: the cost of setting up new personnel records and of induction
training would traditionally be the responsibility of the personnel manager even though such costs are
driven by the number of new employees required by managers other than the personnel manager.
(b) The budgets for costs not directly related to production are often traditionally set using an
incremental approach because of the difficulty of linking the activity driving the cost to production
level. However, this assumes that all of the cost is unaffected by any form of activity level, which is
often not the case in reality. Some of the costs of the purchasing department, for example, will be
fixed (such as premises costs) but some will relate to the number of orders placed or the volume of
production, say. In an ABB framework the budget for the purchasing department can take account of
the expected number of orders.
Summary
Budgets
Fulfil many
objectives/roles
Must be quantified but

not necessarily in
financial terms
Organisational Budgets are Alternative

Alternative
procedures based on approaches
structures
forecast
Forecasts based Bottom up

Budget period Product or
on historical
based Top down
data
Establishing
Responsibility Incremental
Budget committee linear
based budget
relationships
Linear
High-low Activity Zero based
Budget manual regression
method based budget
analysis
Functional
Correlation Rolling budgets
budgets
Master Coefficient of
budget determination
Sensitivity
analysis may
be performed
BUDGETING 6
Self-test
1 Which of the following is the budget committee not responsible for?
A Preparing functional budgets
B Timetabling the budgeting operation
C Allocating responsibility for the budget preparation
D Monitoring the budgeting process
The following data relate to questions 2 and 3.
Budgeted sales revenues for R Ltd, a wholesaler, are as follows.
July August September October
CU CU CU CU
180,000 150,000 165,000 210,000
One month's credit is allowed to credit customers, who account for 50 percent of all sales. Other
customers pay cash in the same month the sale occurs.
One month's credit is received from suppliers.
Month-end inventories are maintained at a level sufficient to meet 50 percent of the forecast sales for
the next month.
R Ltd adds a profit mark-up of 20 percent to the cost of purchases in order to derive the selling price.
2 The budgeted balance sheet as at the end of September will show a receivables balance of:
A CU75,000
B CU82,500
C CU150,000
D CU165,000
3 The budgeted balance sheet as at the end of September will show a payables balance of:
A CU118,750
B CU137,500
C CU150,000
D CU156,250
4 Which of the following is unlikely to be contained in a budget manual?
A Organisational structures
B Objectives of the budgetary process
C Selling overhead budget
D Administrative details of budget preparation
5 BC Ltd manufactures two products, P and Q, from the same material, S.
A finished unit of product P contains three litres of material S and a finished unit of product Q
contains five litres. However, there is a high wastage rate of materials and 25 percent of the input
materials are lost in production.
The budgeted production volumes for next year are 6,000 units of P and 8,100 units of Q. At the
beginning of the year the company expects to have 20,000 litres of material S in inventory but intends
to reduce inventory levels to 5,000 litres by the end of the year.
The purchase cost of material S is CU1.60 per litre.
The purchases budget for material S is:
A CU63,000
B CU93,000
C CU100,800
D CU148,800
6 Which TWO of the following are included in the master budget?

A Cash budget
B Sales budget
C Capital expenditure budget
D Budgeted balance sheet
7 A retailing company is preparing its annual budget. It plans to make a profit of 25% on the cost of
sales. Inventories will be maintained at the end of each month at 30% of the following month's sales
requirements.
Details of budgeted sales are as follows
Credit sales – gross Cash sales
CU CU
December 1,900,000 400,000
January 1,500,000 250,000
February 1,700,000 350,000
March 1,600,000 300,000
(a) Budgeted inventory levels at the end of December are CU
(b) Budgeted inventory purchases for January are CU

8 The coefficient of correlation between advertising expenditure and the number of theatre tickets sold
is 0.97. Which TWO of the following statements are correct?
A 97 percent of the variation in ticket sales can be explained by variations in advertising
expenditure
B 94 percent of the variation in ticket sales can be explained by variations in advertising
expenditure
C A 97 percent increase in advertising expenditure will result in a 97 percent increase in ticket sales
D There is a fairly high degree of positive correlation between advertising expenditure and ticket
sales
9 A transport company has recorded the following maintenance costs for the last two periods.
Period 7 Period 8
Miles travelled 30,000 50,000
Maintenance cost per mile CU1.90 CU1.30
The forecast maintenance cost for period 9, when 38,000 miles will be travelled, is CU
10 In what circumstances might participative or bottom-up budgets not be effective?
A In centralised organisations
B In well-established organisations
C In very large businesses
D During periods of economic affluence
BUDGETING 6
1 A The budget committee is not responsible for preparing functional budgets. The manager
responsible for implementing the budget must prepare it, not the budget committee.
Since the committee is a co-ordinating body it is definitely responsible for timetabling and
allocating responsibility for budget preparation. It is also responsible for monitoring the whole
budgetary planning and control process.
2 B The budgeted receivables balance at the end of September is CU82,500.
Since one month's credit is given to credit customers, the outstanding receivables balance at the
end of each month is equal to the credit sales for that month.
Credit sales for September = 50%  CU165,000 = CU82,500
If you answered CU165,000 you did not allow for the fact that only 50 percent of sales are made
on credit.
If you answered CU75,000 or CU150,000 you based your answer on the sales revenue for
August, all of which will have been received from customers by the end of September.
3 D The budgeted payables balance at the end of September is CU156,250.
Since one month's credit is received from suppliers the payables balance at the end of each
month is equal to the credit purchases for that month.
The budgeted cost of goods sold in each month is derived by multiplying each sales figure by
(100/120) to remove the profit mark-up.
September
CU
Budgeted cost of goods sold (CU165,000  100/120) 137,500
Budgeted closing inventory (CU210,000  100/120  50%) 87,500
225,000
Less budgeted opening inventory (CU165,000  100/120  50%) (68,750)
Budgeted purchases = budgeted payables 156,250
If you answered CU118,750 you reversed the budgeted opening and closing inventory.
The option of CU137,500 is incorrect because the purchases are not equal to the cost of goods
sold since there are budgeted changes in inventory.
If you answered CU150,000 you treated the 20 percent profit as a margin on the sales price
rather than as a mark-up on the cost of purchases.
4 C The selling overhead budget is unlikely to be contained in a budget manual. All of the other items
are concerned with the organisation and co-ordination of the budgetary process, therefore they
would be included in the budget manual.
5 C
Material S
litres
Material S required for production:
Product P: 6,000 units  3  100/75 24,000
Product Q: 8,100 units  5  100/75 54,000
Total material S required for production 78,000
Plus budgeted closing inventory 5,000
83,000
Less budgeted opening inventory (20,000)
Budgeted material purchases in litres 63,000
 purchase cost per litre  CU1.60
Budgeted material purchases in CU CU100,800
If you answered CU63,000 you selected the figure for purchases in litres rather than the value of
the budgeted purchases.
If you answered CU93,000 you did not deal correctly with the losses. The 25 percent loss is
based on the input materials. You calculated a 25 percent loss based on the output.
If you answered CU148,800 you reversed the opening and closing inventory.
6 A, D
The cash budget and the budgeted balance sheet form a part of the master budget, together with the
budgeted income statement.
The sales budget and the capital expenditure budget are subsidiary budgets that provide the basic data
for consolidation into the master budget.
7 (a) Budgeted inventory levels at the end of December are CU420,000.
(b) Budgeted inventory purchases for January are CU1,472,000.
WORKINGS
(a) Sales in January = CU1,500,000 + CU250,000
= CU1,750,000
Cost of sales (100/125) = CU1,400,000
End of December inventory = 30%  CU1,400,000
= CU420,000
(b) Sales in February = CU1,700,000 + CU350,000
= CU2,050,000
Cost of sales (100/125) = CU1,640,000
End of January inventory = 30%  CU1,640,000
= CU492,000
January
CU
Cost of goods sold 1,400,000
Budgeted closing inventory 492,000
1,892,000
Less budgeted opening inventory (420,000)
Budgeted purchases 1,472,000
8 B, D
A is incorrect and B is correct. The coefficient of determination (r2) = (0.97)2 = 0.9409, therefore 94%
of the variation in the value of y (ticket sales) can be explained by a linear relationship with x
(advertising expenditure).
C is incorrect because it misinterprets the meaning of the coefficient of correlation.
D is correct. There is a fairly high degree of positive correlation because r, the coefficient of
correlation, is close to 1.
BUDGETING 6
9 The forecast maintenance cost for period 9 is CU60,200.

To use the high-low method we need to know the total cost incurred at each activity level.
Miles Total cost
travelled incurred
CU
Period 8 50,000 ( 65,000
CU1.30)
Period 7 30,000 ( 57,000
CU1.90)
Variable cost 20,000 8,000
Variable cost per mile = CU8,000/20,000 = CU0.40
Fixed cost = CU65,000 – (50,000 miles  CU0.40) = CU45,000
Forecast maintenance cost for 38,000 miles: CU
Variable cost (38,000  CU0.40) 15,200
Fixed cost 45,000
60,200
10 A Participative (bottom-up) budgets might not be effective in centralised organisations. An imposed
or top-down budgeting system is likely to be most effective in this situation.

Before After Doesn't matter
Sales revenue; sales quantities


Finished goods inventories; production volume

Materials usage; labour hours

Materials usage; materials purchases

The sales revenue budget is derived by multiplying the budgeted sales quantities by the standard selling
price. Therefore the sales revenue budget must be prepared after the budget for sales quantities.
The production volume budget is derived by adjusting the budgeted sales quantities for budgeted changes in
finished goods inventories. Therefore the budget for finished goods inventories must be prepared before
the production volume budget.
The materials usage budget and the labour hours budget are derived from the production volume budget,
independently of each other.
The materials purchases budget is derived by adjusting the materials usage budget for budgeted changes in
materials inventories. Therefore the material usage budget must be prepared before the materials purchases
budget.

(a) Sales budget
Product X Product Y Product Z Total
Sales quantity 2,000 4,000 3,000

Sales price CU100 CU130 CU150
Sales value CU200,000 CU520,000 CU450,000 CU1,170,000
(b) Production budget
Sales quantity 2,000 4,000 3,000

Closing inventories 600 1,000 800
2,600 5,000 3,800
Less opening inventories (500) (800) (700)
Budgeted production 2,100 4,200 3,100
(c) Material usage budget
Production RM11 RM22 RM33
Units Units Units Units
Product X 2,100 10,500 4,200 –
Product Y 4,200 12,600 8,400 8,400
Product Z 3,100 6,200 3,100 9,300
Budgeted material usage 29,300 15,700 17,700
BUDGETING 6
(d) Material purchases budget
RM11 RM22 RM33

Units Units Units
Budgeted material usage 29,300 15,700 17,700
Closing inventories 18,000 9,000 12,000
47,300 24,700 29,700
Less opening inventories (21,000) (10,000) (16,000)
Budgeted material purchases 26,300 14,700 13,700
Cost per unit of material CU5 CU3 CU4
Budgeted material purchases CU131,500 CU44,100 CU54,800
(e) Labour budget
Product Production Hours required Labour budget Rate per Cost
per unit Total hours hour
Units CU CU
X 2,100 4 8,400 9 75,600
Y 4,200 6 25,200 9 226,800
Z 3,100 8 24,800 9 223,200
Budgeted total wages 525,600

TC = CU 46,500 + CU 85 V
Although we only have two activity levels in this question we can still apply the high/low method.
Valuations Total cost
CU
Period 2 515 90,275
Period 1 420 82,200
Change due to variable cost 95 8,075
 Variable cost per valuation = CU8,075/95 = CU85.
Period 2: fixed cost = CU90,275 – (515  CU85)

= CU46,500

Statement (a) is true. The coefficient of determination is r2.
Statement (b) is false. r can reach 1 or –1, therefore r2 can reach 1.
Statement (c) is false. A high coefficient of determination means it is very likely that variations in one
variable cause variations in the other. The high degree of correlation may, however, be due to chance (ie
spurious correlation).
chapter 7
Cash budgets
and the cash cycle
Contents
Introduction
Examination context
Topic List
1 Cash budgets
2 The cash operating cycle
Introduction

 Prepare a cash budget for a business, which highlights the quantity and timing of cash
surpluses and deficits
 Calculate the cash cycle for a business and recognise its significance
 Recognise how a business manages surpluses and deficits predicted in cash budgets
The specific syllabus references for this chapter are: 2d, e, f.
The cash budget is one of the most important planning tools available to an organisation. It shows the cash
effect of all decisions taken in the budgetary planning process. For example, a manager might have budgeted
to increase inventories or to grant additional credit to customers.
Both of these planning decisions will have a negative impact on the company’s cash flow, which must be
planned for. Hence the preparation of the cash budget can lead budget managers to modify their budgets if
it shows that there are insufficient cash resources to finance the planned operations.
Liquidity is vital to the survival of any business. Even a highly profitable business might face liquidity
problems from time to time. An effective manager must be equipped with the tools to monitor the liquidity
position. Important measures that can be used in this context will be covered in this chapter.
Stop and think

For what reasons might an organisation’s budgeted income statement reveal a substantial increase in profit
compared to the latest year while at the same time the cash budget forewarns of a significant budgeted cash
outflow during the year?
Working context
In this chapter you will learn how to monitor the cash operating cycle. You will also see how high levels of
receivables and inventory, for example, can create a long cash operating cycle and cause liquidity problems.
In a working context this should help you to appreciate the cash flow effect of a delay in collecting payment
from a client because of slow invoicing procedures or poor credit control operations, or the cash flow
effect of excessive inventories of stationery and other items.
Syllabus links
As with Chapter 6, this budgeting chapter will underpin your study of planning within the Business Strategy
syllabus. You will study the management of working capital in more depth for the Business and Finance
syllabus and an understanding of the cash operating cycle will also be useful when you are analysing the
capital requirements of a business for the Financial Management syllabus.
CASH BUDGETS AND THE CASH CYCLE 7
Examination context
Exam requirements
You will not be asked to prepare a full cash budget in the exam. However, you could be asked to prepare
an extract from information provided. For example, you may be asked to calculate the budgeted receipts
from customers or the budgeted payments made to suppliers, taking account of the budgeted activity and
planned credit periods.
 Use data supplied to prepare extracts from cash budgets
 Select appropriate actions to be taken in the light of information provided by a cash budget
 Calculate and interpret the cash cycle for a business
 Assess the liquidity of a business using current and quick ratios
1 Cash budgets
Section overview
 A cash budget shows the cash effect of all the decisions taken in the budgetary planning exercise.
 It is a statement tabulating future cash receipts and payments to show the forecast cash balance of a
business at defined intervals.
 The appropriate management action to be taken in response to forecast cash deficits or surpluses will
depend on whether the situation is expected to be short term or longer term.
 Certain non-cash items such as depreciation are not included in a cash budget.
A cash budget is a statement in which estimated future cash receipts and payments are tabulated in such a
way as to show the forecast cash balance of a business at defined intervals.
1.1 Preparing cash budgets

For example, in December 20X2 an accounts department might wish to estimate the cash position of the
business during the three following months, January to March 20X3. A cash budget might be drawn up in
the following format.
Jan Feb Mar
CU CU CU
Estimated cash receipts
From accounts payable 14,000 16,500 17,000
From cash sales 3,000 4,000 4,500
Proceeds on disposal of non-current assets 2,200
Total cash receipts 17,000 22,700 21,500
Estimated cash payments
To suppliers of goods 8,000 7,800 10,500
To employees (wages) 3,000 3,500 3,500
Purchase of non-current assets 16,000
Rent and rates 1,000
Other overheads 1,200 1,200 1,200
Repayment of loan 2,500
14,700 28,500 16,200
Net surplus/(deficit) for month 2,300 (5,800) 5,300
Opening cash balance 1,200 3,500 (2,300)
Closing cash balance 3,500 (2,300) 3,000
In this example the accounts department has calculated that the cash balance at the beginning of the budget
period, 1 January, will be CU1,200. Estimates have been made of the cash that is likely to be received by the
business (from cash and credit sales, and from a planned disposal of non-current assets in February). Similar
estimates have been made of cash due to be paid out by the business (payments to suppliers and employees,
payments for rent, rates and other overheads, payment for a planned purchase of non-current assets in
February and a loan repayment due in January).
From these estimates it is a simple step to calculate the net cash movement in each month. In some months
the budgeted cash payments may exceed cash receipts and there will be a deficit for the month; this
occurs during February in the above example because of the large investment in non-current assets in that
month.
The last part of this cash budget shows how the business's estimated cash balance can then be rolled along
from month to month. Starting with the opening balance of CU1,200 at 1 January a cash surplus of CU2,300 is
generated in January. This leads to a closing January balance of CU3,500, which becomes the opening balance
for February. The deficit of CU5,800 in February throws the business's cash position into overdraft and the
overdrawn balance of CU2,300 becomes the opening balance for March. Finally, the cash surplus of CU5,300
in March leaves the business with a favourable cash position of CU3,000 at the end of the budget period.
1.2 The usefulness of cash budgets

Cash budgets enable management to make any forward planning decisions that may be needed, such
as advising their bank of estimated overdraft requirements or strengthening their credit control procedures
to ensure that customers pay more quickly.
The cash budget can also give management an indication of potential problems that could arise and
allows them the opportunity to take action to avoid such problems. A cash budget can show four
positions as in section 1.3 below. Management will need to take appropriate action depending on the
potential position.
1.3 Potential cash positions

Cash position Appropriate management action
Short-term surplus  Pay suppliers early to obtain discount

 Attempt to increase sales by increasing receivables and inventories
 Make short-term investments
Short-term shortfall  Increase accounts payable, ie delay payments to suppliers
 Reduce receivables, for example by tightening credit control
 Arrange an overdraft
Long-term surplus  Make long-term investments
 Expand or diversify, for example by acquisition
 Increase dividends
 Replace/update non-current assets
 Buy back shares
Long-term shortfall  Raise long-term finance (such as via issue of share capital)
 Consider selling non-current assets
 Consider shutdown/disinvestment opportunities
 Plan a controlled shut down
Notice that the appropriate management action takes account of whether there is a budgeted cash surplus
or shortfall and of how long the surplus or shortfall is expected to last.
Interactive question 1: Cash budget [Difficulty level: Easy]

Tick to show which of the following should be included in a cash budget.
Include Do not include

Funds from the receipt of a bank loan
Revaluation of a non-current asset
Receipt of dividends from outside the business
Depreciation of distribution vehicles
Bad debts written off
Share dividend paid
See Answer at the end of this chapter
Worked example: Preparing a cash budget

Penny operates a retail business. Purchases are sold at cost plus 331/3%.
(a) Budgeted sales Labour cost Expenses incurred
in month in month in month
CU CU CU
January 40,000 3,000 4,000
February 60,000 3,000 6,000
March 160,000 5,000 7,000
April 120,000 4,000 7,000
(b) It is management policy to have sufficient inventory in hand at the end of each month to meet half of
next month's sales demand.
(c) Suppliers for materials and expenses are paid in the month after the purchases are made/expenses
incurred. Labour is paid in full by the end of each month.
(d) Expenses include a monthly depreciation charge of CU2,000.
(e) (i) 75% of sales are for cash.
(ii) 25% of sales are on one month's credit.
(f) The company will buy equipment costing CU18,000 for cash in February and will pay a dividend of
CU20,000 in March. The opening cash balance at 1 February is CU1,000.
Requirement
Prepare a cash budget for February and March and comment on the result.
Solution
Cash budget
February March
Receipts CU CU
Receipts from sales 55,000 (W1) 135,000 (W2)
Payments
Trade payables 37,500 (W3) 82,500 (W3)
Expense payables 2,000 (W4) 4,000 (W4)
Labour 3,000 5,000
Equipment purchase 18,000 –
Dividend – 20,000
Total payments 60,500 111,500
Receipts less payments (5,500) 23,500
Opening cash balance b/f 1,000 (4,500)
Closing cash balance c/f (4,500) 19,000
WORKINGS
(1) CU
Receipts in February 75% of Feb sales (75%  CU60,000) 45,000
25% of Jan sales (25%  CU40,000) 10,000
55,000
(2) CU
Receipts in March 75% of Mar sales (75%  CU160,000) 120,000
25% of Feb sales (25%  CU60,000) 15,000
135,000
(3) Purchases
January February
CU CU
For Jan sales (50% of CU30,000) 15,000
For Feb sales (50% of CU45,000) 22,500 (50% of CU45,000) 22,500
For Mar sales – (50% of 60,000
CU120,000)
37,500 82,500
These purchases are paid for in February and March.
(4) Expenses
Cash expenses in January (CU4,000 – CU2,000) and February (CU6,000 – CU2,000) are paid in
February and March respectively. Depreciation is not a cash item.
Notes: Steps should be taken either to ensure that an overdraft facility is available for the cash shortage
at the end of February, or to defer certain payments so that the overdraft is avoided. Some payments
must be made on due dates (payroll, taxation and so on) but it is possible that other payments can be
delayed, depending on the requirements of the business and/or the goodwill of suppliers.
Interactive question 2: Cash budget [Difficulty level: Intermediate]

You are presented with the budgeted data shown in Annex A for the period November 20X1 to June 20X2
by your firm. It has been extracted from the other functional budgets that have been prepared.
You are also told the following.
(a) Sales are 40% cash, 60% credit. Credit sales are paid two months after the month of sale.
(b) Purchases are paid in the month following purchase.
(c) 75% of wages are paid in the current month and 25% the following month.
(d) Overheads are paid the month after they are incurred. The overhead figures include monthly
depreciation of CU2,000.
(e) Dividends are paid three months after they are declared.
(f) Capital expenditure is paid two months after it is incurred.
(g) The opening cash balance is CU15,000.
Annex A
Nov X1 Dec X1 Jan X2 Feb X2 Mar X2 Apr X2 May X2 June X2
CU CU CU CU CU CU CU CU
Sales 80,000 100,000 110,000 130,000 140,000 150,000 160,000 180,000
Purchases 40,000 60,000 80,000 90,000 110,000 130,000 140,000 150,000
Wages 10,000 12,000 16,000 20,000 24,000 28,000 32,000 36,000
Overheads 12,000 12,000 17,000 17,000 17,000 22,000 22,000 22,000
Dividends declared 20,000 40,000
Capital
expenditure 30,000 40,000
Use the following framework to prepare the cash budget.

January February March April May June
CU'000 CU'000 CU'000 CU'000 CU'000 CU'000
Receipts
Sales revenue:
Cash
Credit
Payments
Purchases
Wages
75%
25%
Overheads
Dividends
Capital
expenditure
Net cash flow

Opening balance
Closing balance
2 The cash operating cycle
Section overview
 The cash operating cycle is the length of time between paying out cash for raw materials and other
input costs and receiving the cash for goods or services supplied.
 The length of each element of working capital (receivables, payables and so on) can be calculated in
days and then summed to determine the length of the cash operating cycle.
 Liquidity problems can be caused if the cash cycle becomes too long. The forecasting and control of
working capital requirements is critical to the management of the cash operating cycle.
 Liquidity can be assessed using the current and quick ratios.
2.1 What is the cash operating cycle?

Look back in this chapter to the table of appropriate management actions in response to predicted cash
surpluses or deficits. You will notice that most of the recommended actions in response to short term
surpluses and deficits relate to the management of working capital items, for example paying suppliers early
or late and reducing receivables.
Thus, movements in working capital will have an impact on an organisation’s cash balance. The efficient
control of working capital is therefore of vital importance in the management of an organisation’s cash.
The measurement of the cash operating cycle focuses on the length of time between an organisation paying
out cash for its raw materials and other input costs and receiving the cash for goods or services supplied.
The cash operating cycle is normally measured in days and it may be referred to as the working capital
cycle. It can be depicted in Figure 7.1 below.
Cash payment
PAYABLES
CASH
Cash
collection Purchases
RAW MATERIALS
RECEIVABLES INVENTORY
Production
Sales
FINISHED GOODS WORK-IN-PROGRESS

INVENTORY INVENTORY
Production
Figure 7.1: The cash operating cycle
2.2 Calculating the length of the cash operating style

The length of the cash cycle and its component parts can be calculated as follows
Days
average inventory of raw materials
Raw materials holding period  365 = X
annual usage
average trade payables

Average payables payment period  365 = (X)
annual purchases
average inventory of work in progress
Average production period  365 = X
annual cost of sales
average inventory of finished goods
Average inventory-holding period  365 = X
annual cost of sales
average receivables X
Average receivables collection period  365 =
annual sales revenue
Length of cycle X
Where averages cannot be calculated or are not available then period end balances should be used.
Interactive question 3: Calculating the cash operating cycle

YZ Ltd has the following estimated figures for the coming year:
Sales CU3,600,000
Average receivables CU306,000
Gross profit margin 25% on sales
Average inventories
Finished goods CU200,000
Work in progress CU350,000
Raw materials CU150,000
Average payables CU130,000
Inventory levels are constant.
Raw materials represent 60% of total production cost.
Requirement
Complete the table to calculate the company's cash operating cycle. Use the space provided in the table for
your workings.
Cost of sales =
Days
Raw materials in inventory =
Credit taken from suppliers = ( )
WIP in inventory =
Finished goods in inventory =
Credit given to customers =
Number of days between payment and receipt

See Answer at the end of the chapter.
2.3 The significance of the cash operating cycle

The amount of cash required to fund the cash operating cycle will increase as:
 The cycle gets longer
 Sales (and hence purchases of inventory required) increase
This can often happen at the start of a new business, since:
 There is no trading record, so suppliers are likely to insist on a very short credit period
 There is no reputation to draw in customers, so a long credit period is likely to be extended to
customers in order to break into the market
 If the business has found a 'niche market', rapid sales expansion may occur
This is likely to lead to the cycle being 'out of balance', and short-term financing may well be necessary to
get over this initial period. If this finance is unavailable it may be necessary to sell non-current assets to pay
debts. As a result, the forecasting and control of working capital requirements is of particular
importance for new businesses.
2.4 Assessing the liquidity position

In addition to forecasting and controlling working capital it is important that the business should monitor its
liquidity position on a regular basis. Two important measures that can be used to assess the liquidity
position are the current ratio and the quick (liquidity) ratio.
2.4.1 Current ratio

This ratio measures the ability to meet short-term liabilities from easily or quickly realisable current assets.
It is calculated as follows.
Current assets
Current ratio =
Current liabilities
A higher value for the ratio indicates that the business is more liquid and is able more easily to meet its
current liabilities from its available current assets.
In general a higher ratio is preferable to a lower one. However, if a business has a very high ratio this
may indicate that funds are tied up in current assets, such as inventory and cash that may be used more
productively elsewhere in the business.
The most appropriate level for the current ratio will depend on the type of business. For
example a supermarket will have a relatively low current ratio because it does not hold inventories of raw
materials and work in progress and a large proportion of its sales to customers are made for cash, with
consequently a low investment in receivables.
On the other hand a manufacturer will have a relatively high current ratio because of the need to invest in
inventories of raw materials and work-in-progress and to provide credit to customers.
2.4.2 Quick (liquidity) ratio

The nature of the inventory in some types of business means that it cannot be easily or quickly converted
into cash. This inventory cannot be relied upon as a liquid asset when it is necessary to meet short-
term liabilities.
The quick ratio therefore excludes inventory from the current assets as follows.
Current assets less inventories
Quick (liquidity) ratio =
Current liabilities
Interactive question 4: Calculating ratios to assess the liquidity position

[Difficulty level: Easy]
The following balances were recorded for a business at the end of last week.
CU'000
Inventories 982
Receivables 648
Cash 78
Payables 653
Requirement
Complete the table below to compare the current ratio and quick (liquidity) ratio with the average for
businesses in the industry. Comment on the results.
Ratio for this business Industry average
Current ratio 2.5:1

Quick (liquidity) ratio 1.4:1
Comments on the results:
Summary
Cash planning
Cash budget Cash operating cycle
Length of time between

paying for inputs and
receipt of cash from
Forecast surpluses Forecast deficits customers
Can be calculated for

Short term Short term deficit each element
surplus (receivables, payables,
– Increase payables etc) in days
– Pay suppliers by delaying
early in return for payments to
settlement suppliers
discounts – Reduce
Liquidity problems
– Increase receivables and
caused if cycle too long
receivables and inventories
inventories – Arrange overdraft
– Invest short term
Important to assess
liquidity
– Current ratio
– Quick (liquidity) ratio
Long term Long term deficit

surplus – Raise long term
– Invest long term finance
– Expand – Consider
– Diversify divestment
– Replace non- – Consider selling
current assets non-current
– Increase assets
dividends – Plan a controlled
– Buy back shares shutdown
Self-test
1 X will begin trading on 1 January 20X3. The following sales revenue is budgeted for January to March
20X3.
January February March
CU13,000 CU17,000 CU10,000
Five per cent of sales will be for cash. The remainder will be credit sales. A discount of 5% will be
offered on all cash sales. The payment pattern for credit sales is expected to be as follows.
Invoices paid in the month after sale 75%
Invoices paid in the second month after sale 23%
Bad debts 2%
Invoices are issued on the last day of each month.
The amount budgeted to be received from customers in March 20X3 is:
A CU15,428
B CU15,453
C CU15,618
D CU16,215
2 ST Ltd budgeted the following for a month:
CU'000
Accounting net profit 100
Increase in receivables 35
Increase in inventories 20
Increase in payables 20
Depreciation 70
Increase in provisions
Doubtful debts 10
Taxation 30
The budgeted increase in cash balances for the month is CU
3 A retailing company earns a gross profit margin of 37.5% on its monthly sales of CU20,000. In order to
generate additional cash, the following changes are proposed:
Present Proposed
Inventory holding period 1.5 months 1.0 month
Trade payable payment period 1.0 month 1.3 months
How much additional cash will be generated at the end of the month in which these changes take
place?
A CU2,500
B CU3,750
C CU6,250
D CU10,000
The following information relates to questions 4 and 5
The production overhead costs to be incurred during January to March are as follows.
January February March
CU CU CU
Production overhead cost incurred 85,000 64,000 72,000
Within these figures is CU40,000 per month for fixed production overhead cost, which includes CU3,000
for depreciation of production machinery. The remaining cost is variable overhead, which is paid for 60% in
the month incurred and 40% in the following month. The fixed overhead is paid in the month following that
in which it is incurred.
4 The amount to be included in the cash budget for February in respect of payments for variable
production overhead is:
A CU24,000
B CU27,200
C CU32,400
D CU36,600
5 The amount to be included in the cash budget for February in respect of payments for fixed
production overhead is:
A CU37,000
B CU40,000
C CU43,000
D CU69,400
6 Selected figures from a firm's budget for next month are as follows:
Sales CU450,000
Gross profit on sales 30%
Decrease in trade payables over the month CU10,000
Increase in cost of inventory held over the month CU18,000
What is the budgeted payment to trade payables?
A CU343,000
B CU323,000
C CU307,000
D CU287,000
7 A company's cash budget for next year shows a cash deficit for the months of April and May. For the
remaining months there will be a cash surplus.
Which two of the following management actions would be most appropriate in response to the
expected cash position in April and May?
A Increase inventories of raw materials
B Arrange a bank overdraft
C Delay the payment of suppliers as much as possible
D Issue additional share capital
E Offer additional credit to customers
8 The following are items from APC Ltd's opening and closing balance sheet and income statements for
the year 20X8.
1 January 31 December
CU'000 CU'000
Receivables 800 900
Inventory 600 700
Payables 200 250
Credit sales CU10,000,000
Cost of goods sold CU6,000,000
What is the approximate length of the cash operating cycle?
A 54 days
B 57 days
C 61 days
D 84 days
9 QR Ltd is a retail company that has average sales of CU14.6m per annum and earns a mark-up of 25%.
Inventory averages CU2.0m, receivables average CU0.9m and trade payables CU0.6m.
If all sales and purchases are on credit, how long is the company's cash operating cycle (to the nearest
day)?
A 58 days
B 66 days
C 69 days
D 104 days
10 A company sells inventory at a profit to a customer on credit. How will this transaction affect each of
the following ratios immediately after the transaction?
Current ratio Increase Decrease Stay the same

Quick (liquidity) ratio Increase Decrease Stay the same
1 A
Received in March
CU
Cash sales (5%  CU10,000)  95% 475.00
February sales (CU17,000  95%)  75% 12,112.50
January sales (CU13,000  95%)  23% 2,840.50
15,428.00
If you answered B you forgot to allow for five per cent discount on cash sales.
If you selected C as the correct answer you have included the bad debts for March as a cash receipt.
If you answered D you forgot that credit sales amounted to only 95 per cent of each month's
budgeted sales revenue.
2 The budgeted increase in cash balances for the month is CU175,000.
CU'000 CU'000
Profit 100
Plus Increase in payables 20
Depreciation 70
Doubtful debts (non-cash items added back) 10
Taxation 30
130
230
Less Increase in receivables 35
Increase in inventories 20
55
Increase in cash balances 175
3 D
Monthly cost of sales = CU20,000  62.5%
= CU12,500
CU CU
Existing inventory level 1.5  CU12,500 18,750
New inventory level 1  CU12,500 (12,500)
Change in inventory level 6,250
Existing payables 1  CU12,500 12,500
New payables 1.3  CU12,500 16,250
Change in payables 3,750
Total change in working capital 10,000
If you answered A you treated the change in payables as a cause of a reduction in cash. However, if
payables increase this will increase their cash inflow. The other two incorrect options considered each
of the changes separately, but their effects must be combined to derive the correct answer.
4 C
CU
February variable overhead (CU64,000 – CU40,000)  60% 14,400
January variable overhead (CU85,000 – CU40,000)  40 % 18,000
Cash payment in February 32,400
The answer option CU24,000 is the variable overhead cost for February, which makes no allowance
for the timing of cash payments.
If you selected CU27,200 you included a 40 per cent payment in advance for March, instead of in
arrears for January. The answer option CU36,600 has the percentages the wrong way round, ie 40% of
February cost and 60% of January cost.
5 A
The depreciation is not a cash flow; the monthly cash payment is CU40,000 – CU3,000 = CU37,000.
If you selected B you forgot to deduct the non-cash depreciation cost, and if you selected C you added
the depreciation instead of deducting it. D is the total cash cost of overheads for February, but this
includes the variable overhead.
6 A
CU'000
Cost of sales for month = CU450,000  70% 315
Decrease in trade payables 10
Increase in inventory 18
Budgeted payment to trade payables 343
If you selected an incorrect option you did not treat the change in trade payables and inventory
balances correctly.
An increase in inventory indicates that budgeted purchases are greater than the budgeted cost of
goods to be sold in the month, which would increase the amount payable to suppliers. Since the
balance owed to suppliers is budgeted to decrease, this further increases the amount budgeted to be
paid to suppliers.
7 B, C
The budget forewarns of a short term deficit and these are the two most appropriate responses to
this situation.
Action taken to increase inventories or to offer additional credit to customers will result in cash
outflows. These are not appropriate actions in the light of a short term deficit.
Although the issue of additional share capital would help to reduce or eliminate a cash deficit, this
would be a more appropriate action to take if the predicted deficit were expected to continue in the
longer term.
8 B
Average inventory = CU650,000
650  365 39.54 days
Inventory period = =
6,000
Average receivables = CU850,000
850  365 31.03 days
Receivables period = =
10,000
Average payables = CU225,000
Purchases = cost of goods sold
plus increase in inventory
= CU6,000,000 + CU100,000
= CU6,100,000
225  365 (13.46) days
Payables period = =
6,100
Cash operating cycle 57 days
If you selected 54 days or 61 days you based your calculations on the opening and closing balance
sheet figures respectively, instead of on the average balances.
If you selected 84 days you added together the days for each element of working capital. However, the
payable period, during which the company takes credit from suppliers, reduces the length of the cycle
and hence should be deducted.
9 B
Days
Receivable days (0.9/14.6)  365 22.5
Payable days (0.6/(14.6 ÷ 1.25))  365 (18.7)
Inventory days (2.0/(14.6 ÷ 1.25))  365 62.5
66.3
If you selected 58 days you based your calculations of payables days and inventory days on the sales
revenue rather than on the cost of sales.
If you arrived at an answer of 69 days you performed your calculations using a margin of 25 per cent
of sales, rather than a mark up of 25 per cent of cost.
If you selected 104 days you added together the days for each element of working capital. The
payables days should be subtracted, since credit from suppliers reduces the cash operating cycle.
10 Both ratios will increase. The current liability figure used as the denominator will stay the same in both
cases. The total of the current assets will increase because of the profit element in receivables,
therefore the current ratio will increase. The total of the liquid assets will also increase therefore the
quick (liquidity) ratio will increase.

Any item that is a cash flow will be included. Non-cash items are excluded from a cash budget.
Include Do not include

Funds from the receipt of a bank loan 
Revaluation of a non-current asset 
Receipt of dividends from outside the business 
Depreciation of distribution vehicles 
Bad debts written off 
Share dividend paid 

January February March April May June
CU'000 CU'000 CU'000 CU'000 CU'000 CU'000
Receipts
Sales revenue:
Cash 44 52 56 60 64 72
Credit 48 60 66 78 84 90
92 112 122 138 148 162
Payments
Purchases 60 80 90 110 130 140
Wages:
75% 12 15 18 21 24 27
25% 3 4 5 6 7 8
Overheads 10 15 15 15 20 20
Dividends 20
Capital expenditure 30 40
85 114 178 152 181 235
Net cash flow 7 (2) (56) (14) (33) (73)
Opening balance 15 22 20 (36) (50) (83)
Closing balance 22 20 (36) (50) (83) (156)

Cost of sales = 75% × CU3,600,000 = CU2,700,000
Days
150,000
Raw materials in inventory =  365 34
2,700,000  60%
130,000
Credit taken from suppliers =  365 (29)
* 2,700,000  60%
350,000
WIP in inventory =  365 47
2,700,000
200,000
Finished goods in inventory =  365 27
2,700,000
306,000
Credit given to customers =  365 31
3,600,000
Number of days between payment and receipt 110
* Since inventory levels are constant, annual purchases = annual usage.

Ratio for this business Industry average
(982  648  78) 1,708

Current ratio = = 2.6:1 2.5:1
653 653
Quick (liquidity) ratio (1,708 - 982) = 1.1:1 1.4:1
653
Comments on the results:

The current ratio is close to the industry average, which appears to suggest an adequate level of liquidity.
However when inventory is deducted from the current assets the quick ratio is below the industry average.
This business is more reliant than average on liquidating its inventory in order to meet its current liabilities.
The importance of this will depend upon how quickly the inventory can be turned into cash, ie the length of
the cash operating cycle. Moreover, the business has relatively little cash and its liquidity as measured by the
quick ratio relies on the quality of its receivables, ie how likely customers are to pay their debts and how
quickly they will pay.
chapter 8
Performance management
Contents
Introduction
Examination context
Topic List
1 Performance evaluation
2 Responsibility centres
3 Performance measures
4 The balanced scorecard
5 Budgetary control
Introduction

 Identify the reasons for and key features of effective performance management systems
 Select appropriate financial and non-financial performance measures which effectively
encourage the business as a whole to meet its objectives
 Identify the role of controls in ensuring effective performance management
 Identify how performance measures and compliance measures are integrated into the general
systems of control in businesses
The specific syllabus references for this chapter are: 3a, b, c, d, e.
The basis of a performance management system is the setting of appropriate targets for managers to
achieve and then the monitoring of the actual results for comparison with the targets. This monitoring and
comparison of the actual results establishes a control mechanism which enables managers to confirm that all
parts of the organisation are continuing to work towards the achievement of the overall objectives.
The targets must be set in such a way that managers are motivated to take actions that will contribute to
the achievement of the organisation’s objectives. In this chapter we will see that a number of criteria must
be met in order to establish an appropriate set of performance measures.
Effective management accounting reporting and control mechanisms will enable convergence between the
management accounting system and the system for producing financial accounting reports.
Stop and think

Can you think of situations where a performance measure might motivate a manager to act in a
dysfunctional way, which is not in the best interests of the organisation?
Working context
Throughout your career your performance will be assessed by your superiors and you will at times be
responsible for assessing the performance of your staff and of businesses as a whole. A sound understanding
of the features of effective performance management systems will be an invaluable tool in this respect.
Particularly if you work in audit, you may also be called upon to assess the adequacy of an organisation’s
internal control system and to understand how the performance measures selected by the organisation’s
management support and supplement the general systems of control in the business.
Syllabus links
Decentralisation and an understanding of responsibility centres also feature in the Business and Finance
syllabus, in the context of appreciating how these structures help to achieve business objectives. You will
also study internal controls in more depth in the context of your Assurance syllabus and some of the
performance measures covered in this chapter will be met again when you are studying the interpretation
of financial information for the Financial Reporting syllabus.
PERFORMANCE MANAGEMENT 8
Examination context
Exam requirements
It is important to appreciate that both numerical and written questions will be set on performance
measures and a thorough understanding of flexed budgets is required as a basis for variance analysis in the
next chapter.
 Identify the most appropriate performance measure in a given situation
 Demonstrate an understanding of the effect of management actions on specific performance measures
 Demonstrate an understanding of the purpose and operation of a responsibility accounting system
 Interpret the information provided by specific performance measures
 Calculate the flexed cost budget for a given level of activity
 Interpret the information provided by a flexed budget comparison
1 Performance evaluation
Section overview
 The term ‘feedback' is used to describe both the process of reporting back control information to
management and the control information itself.
 Effective feedback information should have the following features.
– Clear and comprehensive
– Use an exception reporting format
– Identify separately the controllable costs and revenues
– Prepared on a regular basis
– Timely
– Sufficiently accurate for the purpose intended (not containing irrelevant detail).
– Communicated to the manager who has authority and responsibility to act on the information
 Inappropriate performance measures can lead to a lack of goal congruence and may introduce budget
bias.
 Hopwood identified three styles of evaluation: budget constrained; profit conscious; non-accounting.
1.1 Feedback control

The term 'feedback' is used to describe both the process of reporting back control information to
management and the control information itself. In a business organisation, it is information produced from
within the organisation (management control reports) with the purpose of helping management and other
employees with control decisions.
The feedback loop can be depicted as follows.
INPUT
RESOURCES
Plan, target
or budget Compare OPERATIONS
actual results Control
with plan action
OUTPUTS
Feedback of Measure
(eg actual output
information outputs
revenues, costs)
Figure 8.1: Feedback loop in the control cycle

The elements in the control cycle, illustrated in Figure 8.1, are as follows.
Step 1
Plans and targets are set for the future. These could be long-, medium- or short-term plans. Examples
include budgets, profit targets and standard costs (which we will learn more about in the next chapter).
Step 2
Plans are put into operation. As a consequence, resources are consumed and costs are incurred.
Step 3
Actual results are recorded and analysed.
Step 4
Information about actual results is fed back to the management concerned, often in the form of
accounting reports. This reported information is feedback.
Step 5
The feedback is used by management to compare actual results with the plan or targets (what
should be or should have been achieved).
Step 6
By comparing actual and planned results, management can then do one of three things, depending on how
they see the situation.
(1) They can take control action. By identifying what has gone wrong, and then finding out why,
corrective measures can be taken.
(2) They can decide to do nothing. This could be the decision when actual results are going better
than planned, or when poor results were caused by something which is unlikely to happen again in the
future.
(3) They can alter the plan or target if actual results are different from the plan or target, and there
is nothing that management can do (or nothing, perhaps, that they want to do) to correct the
situation.
It may be helpful at this stage to relate the control system to a practical example, such as monthly sales.
Step 1
A sales budget or plan is prepared for the year.
Step 2
Management organises the business's resources to achieve the budget targets.
Step 3 and 4
At the end of each month, actual results are reported back to management.
Step 5
Managers compare actual results against the plan.
Step 6
Where necessary, they take corrective action to adjust the workings of the system, probably by amending
the inputs to the system.
 Sales people might be asked to work longer hours
 More money might be spent on advertising
 Some new price discounts might be decided
 Delivery periods to customers might be reduced by increasing output
Where appropriate the sales plan may be revised, up or down.
1.2 Features of effective feedback

(a) Reports should be clear and comprehensive.
(b) The 'exception principle' should be applied so that significant differences between the target and the
actual results are highlighted for investigation. Areas that are conforming to plan should be given less
prominence in the management control reports.
(c) The controllable costs and revenues should be separately identified. These are the items that
can be directly influenced by the manager who receives the report. It can be demotivating if managers
feel that they are being held responsible for items which are outside their control and which they are
unable to influence. Uncontrollable items might be included for information (rather than action).
(d) Reports should be produced on a regular basis to ensure that continual control is exercised.
(e) Reports should be made available to managers in a timely fashion. This means they must be
produced in good time to allow the manager to take control action before any adverse results get
much worse.
(f) Information should be sufficiently accurate for the purpose intended.
(g) Irrelevant detail should be excluded from the report.
(h) Reports should be communicated to the manager who has responsibility and authority to
act on the information.
1.3 The behavioural impact of performance measurement

Research evidence suggests that all too often performance measures lead to a lack of goal congruence.
Managers seek to improve their performance on the basis of the indicator used, even if this is not in the
best interests of the organisation as a whole.
For example, a production manager may be encouraged to achieve and maintain high production levels and
to reduce costs, particularly if his or her bonus is linked to these factors. Such a manager is likely to be
highly motivated. However, the need to maintain high production levels could lead to high levels of slow-
moving inventory, resulting in an adverse effect on the company's cash flow. Thus the manager’s
behaviour has been distorted by the control system.
The impact of an accounting system on managerial performance depends ultimately on how the information
is used. Research by Hopwood has shown that there are three distinct ways of using budgetary information
to evaluate managerial performance.
Style of evaluation Comment
Budget 'The manager's performance is primarily evaluated upon the basis of his
constrained ability to continually meet the budget on a short-term basis. This criterion of
performance is stressed at the expense of other valued and important
criteria and the manager will receive unfavourable feedback from his
superior if, for instance, his actual costs exceed the budgeted costs,
regardless of other considerations.'
Profit conscious 'The manager's performance is evaluated on the basis of his ability to
increase the general effectiveness of his unit's operations in relation to the
long-term purposes of the organisation. For instance, at the cost centre level
one important aspect of this ability concerns the attention which he devotes
to reducing long-run costs. For this purpose, however, the budgetary
information has to be used with great care in a rather flexible manner.'
Non-accounting 'The budgetary information plays a relatively unimportant part in the
superior's evaluation of the manager's performance.'
A summary of the effects of the three styles of evaluation is as follows.

Style of evaluation
Budget Profit Non-
constrained conscious accounting
Involvement with costs High High Low
Job-related tension High Medium Medium
Manipulation of the accounting reports (bias) Extensive Little Little
Relations with the supervisor Poor Good Good
Relations with colleagues Poor Good Good
Research has shown no clear preference for one style over another.
1.4 Budget bias

In the table above we have indicated that bias or manipulation of accounting reports is more likely
to occur if the manager is under pressure to achieve short-term budget targets.
In the process of preparing budgets, managers might introduce budget slack into their estimates. This is
when a manager deliberately overestimates costs and/or underestimates revenues, so that they will not be
blamed in the future for overspending and/or poor results.
In controlling actual operations, managers might ensure that their spending rises to meet their inflated
budget, otherwise they will be 'blamed' for careless budgeting.
A typical situation is for a manager to pad the budget and waste money on non-essential expenses so that
all budget allowances are used. The reason behind the manager’s action is the fear that unless the allowance
is fully spent it will be reduced in future periods, thus making the manager’s job more difficult as the future
reduced budgets will not be so easy to attain. Because inefficiency and slack are allowed for in budgets,
achieving a budget target means only that costs have remained within the accepted levels of inefficient
spending.
Budget bias can work in the other direction too. It has been noted that, after a run of mediocre
results, some managers deliberately overstate revenues and understate cost estimates, no doubt feeling the
need to make an immediate favourable impact by promising better performance in the future. They may
merely delay problems, however, as the managers may well be censured when they fail to hit these
optimistic targets.
This is another example of management's reaction to control systems distorting the processes that the
control systems are meant to serve.
2 Responsibility centres
Section overview
 Divisionalisation involves splitting the organisation into separate divisions, for example according to
location or the product or service provided.
 In a decentralised organisation the authority for certain decisions is delegated to less senior managers.
The most appropriate degree of decentralisation depends on a range of factors.
 There are a number of advantages and disadvantages of decentralisation.
 Responsibility accounting is the term used to describe decentralisation of authority, with the
performance of the decentralised units measured in terms of accounting results.
 With a system of responsibility accounting there are four types of responsibility centre: cost centre,
revenue centre, profit centre, investment centre.
 An investment centre manager has responsibility for capital investment in the centre.
 The performance of the responsibility centre manager should be monitored and based only on those
items over which the manager can exercise control:
– Controllable costs and revenues should be separated from non-controllable costs and revenues
– Controllable elements of divisional investment should be separated from non-controllable
elements
2.1 Divisionalisation
As companies grow, and possibly also spread geographically, it is likely that they will consider some form of
divisionalisation. This involves splitting the company into divisions, for example according to location or
according to the product or service provided. Divisional managers are then given the authority to make
decisions concerning the activities of their divisions.
2.2 Decentralisation
In general, a divisional structure will lead to decentralisation of the decision making process.
Divisional managers may have the freedom to set selling prices, choose suppliers, make output decisions
and so on. Later in this section we will see that the degree of decentralisation depends on how much
freedom managers are given to make decisions.
2.2.1 Factors affecting the degree of decentralisation

 Management style. An authoritarian style is likely to mean that decision making is centralised.
 The size of the organisation. Decentralisation tends to increase as an organisation grows.
 The extent of activity diversification. A greater diversification of activities will lead to more
decentralisation.
 Effectiveness of communications. Decentralisation can only operate if information is
communicated effectively both up and down the organisation.
 The ability of management. The more able the management team, the more decentralisation is
likely to result.
 The speed of technological advancement. Managers lower down the organisation are more likely
to be familiar with changing technology, therefore decentralisation would be more appropriate.
 The geography of locations and the extent of local knowledge needed. If an organisation is
spread over a wide range of locations then decentralisation is likely to be most effective. Local
managers would make more effective decisions based on their knowledge of local markets.
2.2.2 The advantages of decentralisation

 Senior managers are freed from detailed involvement in day to day operations and can
devote more time to strategic issues.
 The quality of decisions is likely to improve because local managers may be able to make more
informed judgements based on local knowledge.
 The increased responsibility should motivate managers in decentralised organisations.
 Decisions should be taken more quickly in response to changing conditions.
 Decentralised operations provide valuable training grounds for future senior managers by
giving them experience of managerial skills in what may be a less complex environment than that faced
by more senior managers.
2.2.3 The disadvantages of decentralisation

 It can be difficult to coordinate the activities of the organisation since several people are
making decisions rather than just a few.
 The organisation might effectively divide into a number of self-interested segments,
leading to a lack of goal congruence in decision making.
 Senior managers lose control over day to day activities.
 Evaluating the performance of managers and their area of responsibility becomes
difficult.
 There may be a duplication of some roles, for example administration, with consequent increased
costs.
2.3 Responsibility accounting

We have already discussed responsibility accounting in outline in the context of cost classification in the
first chapter of this Study Manual.
Responsibility accounting is the term used to describe decentralisation of authority, with the performance
of the decentralised units or responsibility centres measured in terms of accounting results.
Within a system of responsibility accounting there are four main types of responsibility centre: cost
centre, revenue centre, profit centre and investment centre.
Decentralisation is a matter of degree, depending on how much freedom and authority is given to
managers. In the weakest form of decentralisation a system of cost centres or revenue centres might be
used. As decentralisation becomes stronger the responsibility accounting framework will be based around
profit centres. Decentralisation in its strongest form means that investment centres are used.
Type of Principal performance

responsibility centre Manager has control over measures
Cost centre Controllable costs Variance analysis

Efficiency measures
Revenue centre Revenues only Revenues
Profit centre Controllable costs Profit
Sales prices (including transfer prices) Profit margins
Investment centre Controllable costs Return on investment
Sales prices (including transfer prices) Residual income
Output volumes Other financial ratios
Investment in non-current assets and
working capital
2.4 Cost centres

A cost centre manager is responsible for, and has control over, the costs incurred in the cost centre. The
manager has no responsibility for earning revenues or for controlling the assets and liabilities of
the centre.
Functional departments such as production and personnel might be treated as cost centres and made
responsible for their costs.
It is important that control reports for a cost centre show a clear distinction between controllable costs,
over which the cost centre manager can exercise some control, and uncontrollable costs, which cannot
be controlled by the cost centre manager.
2.5 Revenue centres

The manager of a revenue centre is responsible only for raising revenue but has no responsibility for
forecasting or controlling costs. An example of a revenue centre is a sales centre where a sales manager
might be responsible for achieving a budgeted level of sales revenue.
2.6 Profit centres

A profit centre is a part of a business accountable for both costs and revenues.
For a profit centre organisation structure to be established it is necessary to identify units of the
organisation to which both revenues and costs can be separately attributed. Revenues might come from
sales of goods and services to external customers, or from goods and services provided to other
responsibility centres within the organisation. These internal 'sales' are charged at a transfer price, which
you learned about in Chapter 5.
A profit centre's performance report, in the same way as that for a cost centre, would identify separately
the controllable and non-controllable costs as well as the controllable and non-controllable
revenues. A profit centre performance report might look like this.
PROFIT CENTRE Y
INCOME STATEMENT FOR THE PERIOD
Budget Actual Variance
CU'000 CU'000 CU'000
Sales revenue X X
Variable cost of sales (X) (X)
Contribution X X
Directly attributable/controllable fixed costs
Salaries (X) (X)
Stationery costs (X) (X)
etc etc
Gross profit (directly attributable/controllable) X X
Share of uncontrollable costs (eg head office costs) (X) (X)
Net profit X X
The budget for the sales revenue and variable cost of sales will be flexed according to the activity level
achieved. You will learn how to do this later in this chapter.
The variances (differences between budgeted and actual results) could be analysed in further detail for the
profit centre manager.
Notice that three different 'profit levels' are highlighted in the report.
(a) Contribution, which is within the control of the profit centre manager
(b) Directly attributable gross profit, which is also within the manager's control
(c) Net profit, which is after charging certain uncontrollable costs and which is therefore not controllable
by the profit centre manager.
2.7 Investment centres

Where a manager of a division is allowed some discretion about the amount of investment undertaken by
the division, assessment of results by profit alone (as for a profit centre) is clearly inadequate. The profit
earned must be related to the amount of capital invested. Such divisions are sometimes called
investment centres for this reason.
Performance can be measured by return on capital employed (ROCE), often referred to as return on
investment (ROI) and other subsidiary ratios, or by residual income (RI).
The amount of capital employed attributed to an investment centre should consist only of
directly attributable non-current assets and working capital (net current assets).
(a) Subsidiary companies that are treated as investment centres are often required to remit spare cash to
the central treasury department at group head office. In this situation the directly attributable working
capital would normally consist of inventories and receivables less payables, but minimal amounts of
cash.
(b) If an investment centre is apportioned a share of head office non-current assets, the amount of capital
employed in these assets should be recorded separately because it is not directly attributable to the
investment centre or controllable by the manager of the investment centre.
Interactive question 1: Controllable investment in division [Difficulty level: Easy]

The manager of division D has complete autonomy regarding the purchase and use of non-current assets
and inventory but the payment of all suppliers is undertaken by head office which maintains a central bank
account. The manager also has authority to establish the division’s own credit policy with regard to its
customers. The division operates a credit control department but all cash received from customers is
remitted immediately to head office.
Classify the following assets and liabilities to indicate whether or not they are a part of the divisional
investment that is within the control of the manager of division D.
Item Part of controllable Not part of controllable

divisional investment divisional investment
Non-current assets
Trade receivables
Trade payables
Inventory
3 Performance measures
Section overview
 Effective performance measures should promote goal congruence, incorporate only controllable
factors and encourage the pursuit of longer term as well as short-term objectives.
 Inappropriate performance measures may lead to sub-optimal behaviour.
 Two performance measures for investment centres that relate the profit earned to the capital
invested are Return on Investment (ROI) and Residual Income (RI).
 In certain circumstances the use of ROI as a performance measure might not lead to goal congruent
decisions.
 ROI tends to focus attention on short-term performance.
 RI is a measure of an investment centre’s profits after deducting a notional or imputed interest cost
of the capital invested in the centre.
 RI is less useful as a comparative measure because it is absolute.
 RI will encourage marginally profitable investments because it will increase if a proposed project earns
a return which is higher than the cost of capital.
3.1 General requirements for effective performance measures

One or more performance measures, or key performance indicators (KPIs), might be used to monitor the
performance of each responsibility centre. Before going on to consider some of the individual measures in
detail it will be useful to summarise the features of effective performance measures.
 They should promote goal congruence by providing an incentive to promote the responsibility
centre’s performance in line with overall company objectives
 The measures should incorporate only those factors over which the responsibility centre
manager has control
 They should encourage the pursuit of longer term objectives as well as short-term, budget-
constrained objectives
3.2 Potential problems with inappropriate performance measures

Problems that may arise through the use of inappropriate measures include the following.
 Managers may manipulate information in order to ensure achievement of the KPIs
 The measures might cause demotivation and stress-related conflict between a manager and the
manager's subordinates, superiors or fellow managers.
 The measures might promote excessive concern for the control of short-term costs, possibly
at the expense of longer term profitability
 They may lead to the assessment of a responsibility centre as an isolated unit, rather than as
an integral part of the whole organisation
3.3 Performance measures for a cost centre

Since the manager of a cost centre has responsibility for the costs incurred within the centre, appropriate
performance measures could be as follows.
 Cost variances, which are the differences between the budgeted or standard costs and the actual costs
 Cost per unit
 Cost per employee
 Other non-financial measures such as the rate of labour turnover or staff absenteeism
3.4 Performance measures for a revenue centre

Appropriate performance measures would be related to the revenue earned.
 Revenue variances, which are the differences between the budgeted or standard revenue and the
actual revenue achieved
 Revenue earned per employee
 Percentage market share achieved
 Growth in revenue
3.5 Performance measures for a profit centre

Since the manager of a profit centre has responsibility for the revenue earned and the costs incurred within
the centre all of the above performance measures would be suitable. Additional measures might include the
following.
 Gross profit margin, which is the difference between the selling price and the direct costs incurred,
often expressed as a percentage of the selling price
 Operating profit margin, which is the gross profit less indirect costs incurred such as administrative
salaries, often expressed as a percentage of the selling price
3.6 Performance measures for an investment centre

All of the measures appropriate for a cost, revenue and profit centre would be suitable for monitoring the
performance of an investment centre. In addition, certain measures related to the management of the
investment in the division would also be useful. Such measures might include a number of working capital
ratios.
 Liquidity measures such as the current ratio and the quick (liquidity) ratio
 Rate of inventory turnover
 Receivables and payables periods
Two other measures monitor the return achieved in the division in relation to the level of investment.
 Return on investment (ROI)
 Residual income (RI)
We studied the liquidity ratios in detail in Chapter 7. Now we will go on to look further at the other
measures.
3.6.1 Rate of inventory turnover

We calculated the average inventory-holding period in Chapter 7. The rate of inventory turnover is based
on the same data but the measure is expressed in a different way.
The rate of inventory turnover monitors how many times inventory turns over during the trading period.
Cost of sales
Rate of inventory turnover =
Average inventory
In general the rate of turnover should be as high as possible since this means that the inventory is
lower, thus reducing costs such as space costs, insurance, obsolescence write-offs and the cost of capital
being tied up. However, potential sales might be forgone if inventory is so low that customer's needs cannot
be met.
3.6.2 Receivables collection period

This KPI monitors how long on average it takes to collect debts.
Average receivables
Receivables collection period (in days) = × 365
Annual sales revenue
The collection period can also be measured in months, in which case the ratio calculation would be
multiplied by 12 instead of by 365.
The lower this period, the lower the capital cost of the money invested in receivables balances and the
lower the risk of bad debts. However, customers may go elsewhere if the credit period offered is too low.
3.6.3 Payables payment period

This KPI monitors how long on average the company waits before paying its suppliers.
Average payables
Payables payment period = × 365
Annual purchases
In general this period should be as high as possible. However supplier goodwill may be lost if the
period of credit taken is too long. Continuity of supply could also be disrupted if suppliers place overdue
accounts on stop.
The payment period can also be measured in months, in which case the ratio calculation would be
multiplied by 12 instead of by 365.
Worked example: Working capital ratios

Division S is a retail operation. Its year-end working capital comprises inventory valued at cost, trade
receivables of CU90,000, cash and trade payables. Its financial performance ratios include the following
Gross profit margin 25%
Current ratio 2.3:1
Receivables collection period 30 days
Payables payment period 40 days
Rate of inventory turnover 18 times
The opening inventory, receivables and payables balances are the same as the closing balances.
Requirement
Calculate the division's year-end cash balance.
Solution
Step 1
Calculate the annual sales revenue
Average receivables
Receivables collection period (in days) = × 365
Sales revenue
Sales revenue = CU90 ,000 x 365

30
= CU1,095,000
Step 2
Calculate the cost of sales/purchases
Since the opening and closing inventories are equal, the cost of sales is equal to the purchases.
Cost of sales = CU1,095,000  0.75
= CU821,250
Step 3
Calculate the inventory balance
Cost of sales
Average inventory
Inventory = CU821,250
18
= CU45,625
Step 4
Calculate the trade payables balance
Average payables
Payables payment period = × 365
Purchases
Trade payables = 40 xCU82,250

365
= CU90,000
Step 5
Calculate the current assets balance
Current assets
Current ratio =
Current liabilities
Current assets = 2.3  CU90,000
= CU207,000
Step 6
Calculate the cash balance
CU CU
Total current assets 207,000
Less: inventory 45,625
receivables 90,000
135,625
Cash balance 71,375
3.7 Return on investment (ROI)

ROI is often used as a measure to monitor the performance of an investment centre. It shows how much
profit has been earned in relation to the amount of capital invested in the centre.
Controllable divisional profit

ROI =  100%
Divisional capital employed
The main reason for the widespread use of ROI is that it ties in directly with the accounting system
and is identifiable from the income statement and balance sheet.
Use of the ROI facilitates comparisons but ranking is difficult as the measure is a relative percentage. For
example, is a five per cent return on CU1 (20p) really better than a one per cent return on CU1 million
(CU10,000)?
Worked example: Ranking using ROI

Suppose that a company has two investment centres, A and B, which show results for the year as follows.
A B
CU CU
Profit 60,000 30,000
Capital employed 400,000 120,000
ROI 15% 25%
Investment centre A has generated double the profits of investment centre B, and in terms of profits alone
has therefore been more 'successful'. However, B has achieved its profits with a much lower capital
investment, and so has earned a much higher ROI. This suggests that B has been a more successful
investment than A.
3.7.1 Capital employed

A decision needs to be taken on which assets to include in capital employed. Leased assets, shared assets,
idle assets and goodwill need to be given careful consideration. Centrally-controlled assets are excluded
because the investment centre manager cannot exercise control over their use.
Usually, opening capital employed or an average of opening and closing capital is used, on the grounds that
this has been generating the year’s profits.
The use of historical cost/carrying amount may lead to problems as shown below.
Worked example: The effect of changing the capital employed base

An asset costs CU100,000, has a life of four years, and its scrap value is nil. The asset generates annual cash
flows of CU34,000 and straight line depreciation is used.
Requirements
(a) Calculate annual ROI using opening carrying amount (ie depreciation is deducted from the asset value).
(b) Calculate annual ROI using historical cost (ie no depreciation is deducted from the asset value).
(c) Comment on any problems identified by these calculations.
Solution
ROI using opening carrying amount
Year 1: (34 – 25) ÷ 100 = 9%
Year 2: (34 – 25) ÷ 75 = 12%
Year 3: (34 – 25) ÷ 50 = 18%
Year 4: (34 – 25) ÷ 25 = 36%
ROI improves despite constant annual profits. Consequently divisional managers may hold assets for too
long.
ROI using historical cost
Years 1 – 4: (34 – 25) ÷ 100 = 9%
ROI using historical cost overcomes the increasing return problem of using the carrying amount. However,
it is not perfect.
Using the historical cost/carrying amounts may be misleading, particularly when comparing divisions, if:
 Assets have been bought at different points in time and prices have changed due to inflation
 Assets of one division are older than those of another and have been written down to a lower value
 Different depreciation policies are applied by different divisions.
To resolve this, one solution would be to use a replacement cost valuation.
3.7.2 Profit
Usually the profit figure taken as the numerator in the ROI calculation is after depreciation, but this may
lead to distortion, as discussed above.
It is common for divisions and managers to be assessed on pre-tax profit, since the company’s ultimate tax
charge is likely to be significantly affected by central decisions and is therefore not controllable by divisional
managers.
However, it is important that managers are made aware of the tax implications of their operational
decisions.
3.7.3 ROI and goal congruence

In certain circumstances the use of ROI as a performance measure might not lead to goal
congruent decisions.
Worked example: ROI and goal congruence

Data for an investment centre are as follows.
Target ROI (= cost of capital) 20%
Divisional profit CU300,000
Capital employed CUlm
Requirement
Would the division manager accept a project requiring capital of CU100,000 and generating profits of
CU25,000, if the manager were paid a bonus based on ROI?
Solution
CU300 ,000
Divisional ROI without the project = x100%
CU1m
= 30.0%
Divisional ROI with the project = CU325,000

x100%
CU1.1m
= 29.5%
Although the project ROI is acceptable to the company (25%), the manager would not be motivated to
accept a project which lowers divisional ROI.
A limitation of ROI is that it tends to focus attention on short-term performance, whereas

investment decisions should be evaluated over their full life.
3.8 Residual income (RI)

An alternative way of measuring the performance of an investment centre is residual income (RI). RI is a
measure of the centre's profits after deducting a notional or imputed interest cost of the capital
invested in the centre.
RI can avoid some of the behavioural problems of dysfunctionality that arise with the use of ROI.
Worked example: Residual income and goal congruence

Returning to the data in the previous example, would the division manager accept the proposed project if
the manager's bonus was based on RI?
Solution
CU'000
Divisional RI without the project:
Divisional profit 300
Imputed interest charge (20%  CU1m) 200
100
Divisional RI with the project:

Divisional profit 325
Imputed interest charge (20%  CU1,100,000) 220
105
The RI would increase therefore the manager would accept the project. In this particular circumstance, RI
would lead to the correct decision since the project ROI of 25% is acceptable to the company.
Note that the ROI and the RI are both based on the same figures for profits and capital employed. The
difference is that ROI is a relative measure whereas RI is an absolute measure.
3.8.1 RI and comparisons

RI is less useful as a comparative measure because it is absolute.
Worked example: Using ROI and RI to measure comparative performance

A company has a target ROI of 20% for each of its investment centres. Which of the two divisions is
performing better, using the following performance measures?
(a) Residual income
(b) Return on investment
Division 1 Division 2
Capital employed CU1,000,000 CU100,000
Controllable profits:
Year 1 CU200,000 CU20,000
Year 2 CU220,000 CU40,000
Solution
(a) Residual income
CU'000 CU'000
Year 1
Divisional profit 200 20
Imputed interest charge
(CU1,000,000  20%) 200
(CU100,000  20%) 20
RI – –
Year 2
Divisional profit 220 40
Imputed interest charge 200 20
20 20
Using RI the relative performance of the two divisions appears to be the same. Both divisions have
increased the annual RI by CU20,000.
(b) Return on investment
Year 1 CU200,000/CU1,000,000 20%
CU20,000/CU100,000 20%
Year 2 CU220,000/CU1,000,000 22%

CU40,000/CU100,000 40%
Return on investment shows that division 2 is out performing division 1. Despite earning the same
absolute increase in RI it is much easier for the larger division to generate a further CU20,000 of RI.
Hence using RI to compare divisions of different sizes is misleading.
Interactive question 2: ROI and RI [Difficulty level: Intermediate]

An investment centre with capital employed of CU570,000 is budgeted to earn a profit of CU119,700 next
year. A proposed non-current asset investment of CU50,000, not included in the budget at present, will
earn a profit next year of CU8,500 after depreciation. The company's cost of capital is 15%.
Complete the boxes to show the budgeted ROI and RI for next year, both with and without the
investment.
ROI RI
Without investment % CU
With investment % CU
3.8.2 The advantages and disadvantages of RI compared with ROI

The advantages of using RI
(a) Residual income will increase when investments earning above the cost of capital are undertaken and
investments earning below the cost of capital are eliminated.
(b) Residual income is more flexible since a different cost of capital can be applied to investments with
different risk characteristics.
The disadvantages of RI are that it does not facilitate comparisons between investment centres nor
does it relate the size of a centre's income to the size of the investment.
3.8.3 RI versus ROI: marginally profitable investments

Residual income will increase if a new investment is undertaken which earns a profit in excess of the
imputed interest charge on the value of the asset acquired. Residual income will go up even if the profit
from the investment only just exceeds the imputed interest charge, and this means that 'marginally
profitable' investments are likely to be undertaken by the investment centre manager.
In contrast, when a manager is judged by ROI, a marginally profitable investment would be less likely to be
undertaken because it would reduce the average ROI earned by the centre as a whole.
4 The balanced scorecard
Section overview
 The balanced scorecard approach to the provision of information focuses on four different
perspectives: customer, innovation and learning, financial and internal business.
 The information provided in the balanced scorecard includes both financial and non-financial
elements.
 As with all techniques, problems can arise when the balanced scorecard approach is applied.
4.1 Introduction
The balanced scorecard was developed to help companies manage the multiple objectives they have to
satisfy to compete in today’s markets. Traditional accounting measures have a number of weaknesses that
make them less relevant today.
 They tend to concentrate on a single factor, eg profit, revenue, ROI or RI

 They are primarily historical, eg how have we done compared with last year
 They are capable of distortion
 There is often confusion between measures and objectives
 Traditional accounting performance measures are of little use as a guide to action
4.2 The balanced scorecard approach

The balanced scorecard involves the following steps:
 Identify the critical success factors for the business from four perspectives:
– Financial perspective – how do we create value for our shareholders?
– Customer perspective – what do new and existing customers value from us?
– Innovation and learning perspective – can we continue to improve and create value?
– Internal business perspective – at what must we excel?
 Identify the core competences and resources required to achieve them
 Develop the key performance indicators (financial and non-financial – see below) to best measure
progress towards achieving the necessary competences and resources
 Set targets
 Monitor performance
4.3 Non-financial performance measures

It is important to realise that financial measures will only tell part of the story. To minimise the risk of
suboptimal decisions, a company should use as broad a range of measures as possible, both
quantitative and qualitative.
Other measures to consider could include:
 The number of new products developed
 The rate of employee turnover
 Customer praise/complaints
 The number of outstanding orders
 The number of warranty claims
 Health and safety incident statistics
4.4 Potential measures

A selection of potential measures is detailed below. These would obviously need adapting for the
circumstances of the individual company concerned.
Financial perspective
Possible financial measures include:
 Survival, eg cash flows
 Growth, eg sales revenue
 Cost reduction, eg unit costs
 Asset utilisation, eg working capital ratios
 Risk, eg order books
Customer perspective
Possible customer perspective measures include:
 Time, eg product delivery lead times
 Quality, eg defect rates
 Price, eg compared with the prices of competitors
 Satisfaction, eg repeat purchases
Innovation and learning perspective

Possible measures include:
 Employees, eg the rate of staff turnover
 Learning, eg the number of days spent on staff training
 Products and services, eg the percentage of revenue generated by new products and services
Internal business perspective
Possible measures include:
 The number or percentage of quality control rejects
 The average set-up time
 The speed of producing management information
The scorecard is 'balanced' in the sense that managers are required to think in terms of all four
perspectives, to prevent improvements being made in one area at the expense of another.
Interactive question 3: Balanced scorecard evaluation

Radlan & Dunne are a firm of High Street solicitors. They have traditionally measured their success in terms
of ROI. They have decided to modernise their approach and plan to use the Balanced Scorecard to measure
performance. Suggest three measures they could use under each of the four balanced scorecard
perspectives.
Perspective Measures
Financial 1
2
3
Customer 1
2
3
Innovation and learning 1
2
3
Internal business 1
2
3
4.5 Problems
As with all techniques, problems can arise when the balanced scorecard is applied.
Problem Explanation
Conflicting Some measures in the scorecard such as research funding and cost reduction
measures may naturally conflict. It is often difficult to determine the balance which will
achieve the best results.
Selecting measures Not only do appropriate measures have to be devised but the number of
measures used must be agreed. Care must be taken that the impact of the
results is not lost in a sea of information.
Expertise Measurement is only useful if it initiates appropriate action. Non-financial
managers may have difficulty with the usual profit measures. With more
measures to consider this problem will be compounded.
Interpretation Even a financially-trained manager may have difficulty in putting the figures into
an overall perspective.
Too many measures The ultimate objective for commercial organisations is to maximise profits or
shareholder wealth. Other targets should offer a guide to achieving this
objective and not become an end in themselves.
5 Budgetary control
Section overview
 A fixed budget is a budget which is set for a single activity level.
 A flexible budget recognises different cost behaviour patterns and is designed to change as the
volume of activity changes.
 Effective budgetary control involves comparing a flexible budget (based on the actual activity level)
with the actual results. The differences between the flexible budget figures and the actual results are
called budget variances.
5.1 Effective budgetary control

We have seen that the performance of all types of responsibility centres may be monitored by the
comparison of actual costs and revenues with the budget for the period.
However if activity levels fluctuate then the comparison of the actual results with a budget
prepared for a different activity level might not be valid for control purposes.
To be more meaningful, the actual results should be compared with a realistic budget for the actual activity
level achieved.
5.2 Fixed budgets

The master budget prepared before the beginning of the budget period is known as the fixed budget. By
the term 'fixed', we do not mean that the budget is kept unchanged. Revisions to a fixed master budget will
be made if the situation so demands. The term 'fixed' means the following.
(a) The budget is prepared on the basis of an estimated volume of production or output and an estimated
volume of sales, but no plans are made for the event that actual volumes of production and sales may
differ from budgeted volumes.
(b) When actual volumes of production and sales during a control period (month or four weeks or
quarter) are achieved, a fixed budget is not adjusted (in retrospect) to represent a new target for the
new levels of activity.
The major purpose of a fixed budget lies in its use at the planning stage, when it seeks to define the broad
objectives of the organisation.
Fixed budgets (in terms of a pre-set expenditure limit) are also useful for controlling any fixed cost,
and particularly non-production fixed costs such as advertising, because such costs should be
unaffected by changes in activity level (within a certain range).
5.3 Flexible budgets

A flexible budget recognises different cost behaviour patterns and is designed to change as the volume of
activity changes.
A flexible budget has two advantages.
(a) At the planning stage, it may be helpful to know what the effects would be if the actual outcome
differs from the prediction. For example, a company may budget to sell 10,000 units of its product, but
may prepare flexible budgets based on sales of, say, 8,000 and 12,000 units. This would enable
contingency plans to be drawn up if necessary, and is an example of sensitivity analysis which we
discussed in Chapter 6.
(b) At the end of each month or year, actual results may be compared with the relevant activity level in
the flexible budget as a control procedure.
5.4 Preparation of flexible budgets

Step 1
The first step in the preparation of a flexible budget is the determination of cost behaviour patterns, which
means deciding whether costs are fixed, variable or semi-variable.
 Fixed costs are easy to spot. They remain constant as activity levels change.
 For non-fixed costs, divide each cost figure by the related activity level. If the cost is a variable cost,
the cost per unit will remain constant. If the cost is a semi-variable cost, the unit rate will reduce as
activity levels increase.
Step 2
The second step in the preparation of a flexible budget is to calculate the budget cost allowance for each
cost item.
Budget cost allowance = Budgeted fixed cost + (Number of units  Variable cost per unit)
Semi-variable costs therefore need splitting into their fixed and variable components so that the budget cost
allowance can be calculated.
Interactive question 4: Analysing semi-variable costs [Difficulty level: Intermediate]

One method for splitting semi-variable costs is the high/low method, which we covered in Chapter 6.
Attempt the following question to make sure you remember how to do this.
The cost of factory power has behaved as follows in past years.
Units of Cost of
output factory
produced power
CU
20X1 7,900 38,700
20X2 7,700 38,100
20X3 9,800 44,400
20X4 9,100 42,300
Budgeted production for 20X5 is 10,200 units.
Ignoring inflation, the cost of factory power which will be incurred is estimated to be CU .
Worked example: Preparing a flexible budget

(a) Prepare a budget for 20X6 for the variable direct labour costs and overhead expenses of a production
department flexed at the activity levels of 80%, 90% and 100%, using the information listed below.
(i) The variable direct labour hourly rate is expected to be CU7.50
(ii) 100% activity represents 60,000 direct labour hours
(iii) Variable costs
Indirect labour CU0.75 per direct labour hour
Consumable supplies CU0.375 per direct labour hour
Canteen and other welfare services 6% of direct and indirect labour costs
(iv) Semi-variable costs are expected to relate to the direct labour hours in the same manner as for
the last five years.
Direct labour Semi-variable
Year hours costs
CU
20X1 64,000 20,800
20X2 59,000 19,800
20X3 53,000 18,600
20X4 49,000 17,800
20X5 40,000 (estimate) 16,000 (estimate)
(v) Fixed costs
CU
Depreciation 18,000
Maintenance 10,000
Insurance 4,000
Rates 15,000
Management salaries 25,000
(vi) Inflation is to be ignored.
(b) Calculate the budget cost allowance (ie expected expenditure) for 20X6 assuming that 57,000 direct
labour hours are worked.
Solution
(a) 80% level 90% level 100% level
48,000 hrs 54,000 hrs 60,000 hrs
CU'000 CU'000 CU'000
Variable direct labour 360.00 405.00 450.00
Other variable costs
Indirect labour 36.00 40.50 45.0
Consumable supplies 18.00 20.25 22.5
Canteen etc 23.76 26.73 29.7
Total variable costs (CU9.12 per hour) 437.76 4492.48 547547.2
Semi-variable costs (W) 17.60 18.80 20.0
Fixed costs
Depreciation 18.00 18.00 18.0
Maintenance 10.00 10.00 10.0
Insurance 4.00 4.00 4.0
Rates 15.00 15.00 15.0
Management salaries 25.00 25.00 25.0
Budgeted costs 527.36 583 583.28 639.2
WORKING
Using the high/low method:
CU
Total cost of 64,000 hours 20,800
Variable cost of 24,000 hours 4,800
Variable cost per hour (CU4,800/24,000) 0.20
CU
Variable cost of 64,000 hours ( CU0.20) 12,800
Fixed costs 8,000
Semi-variable costs are calculated as follows.
CU
60,000 hours (60,000  CU0.20) + CU8,000 = 20,000
54,000 hours (54,000  CU0.20) + CU8,000 = 18,800
48,000 hours (48,000  CU0.20) + CU8,000 = 17,600
(b) The budget cost allowance for 57,000 direct labour hours of work would be as follows.
CU
Variable costs (57,000  CU9.12) 519,840
Semi-variable costs (CU8,000 + (57,000  CU0.20)) 19,400
Fixed costs 72,000
611,240
5.5 Flexible budgets and control

Suppose W Co manufactures a single product, the CL. Budgeted results and actual results for June 20X2
are shown below.
Actual
Budget results Variance*
Production and sales of the CL (units) 2,000 3,000
CU CU CU
Sales revenue (a) 20,000 30,000 10,000 (F)
Direct materials 6,000 8,500 2,500 (A)
Direct labour 4,000 4,500 500 (A)
Maintenance 1,000 1,400 400 (A)
Depreciation 2,000 2,200 200 (A)
Rent and rates 1,500 1,600 100 (A)
Other costs 3,600 5,000 1,400 (A)
Total costs (b) 18,100 23,200 5,100 (A)
Profit (a) – (b) 1,900 6,800 4,900 (F)
* The variance is the difference between the budget and the actual results. A favourable variance (F)
indicates that the difference would result in a higher profit (higher sales revenue or lower cost). An adverse
variance (A) indicates that the difference would result in a lower profit (lower sales revenue or higher cost).
(a) In this example, the variances are meaningless for purposes of control. Costs were higher than budget
because the volume of output was also higher; variable costs would be expected to increase
above the budgeted costs in the fixed budget. There is no information to show whether control action
is needed for any aspect of costs or revenue.
(b) For control purposes, it is necessary to know the answers to questions such as the following.
 Were actual costs higher than they should have been to produce and sell 3,000 CLs?
 Was actual revenue satisfactory from the sale of 3,000 CLs?
5.5.1 The correct approach to control

The correct approach to control is as follows.
 Identify fixed and variable costs.
 Produce a flexible budget based on the actual activity level.
In the previous example of W Co, let us suppose that we have the following estimates of cost behaviour.
(a) Direct materials, direct labour and maintenance costs are variable.
(b) Rent and rates and depreciation are fixed costs.
(c) Other costs consist of fixed costs of CU1,600 plus a variable cost of CU1 per unit made and sold.
The control analysis should therefore be based on a flexible budget as follows.
Fixed Flexible Actual Budget
budget budget results variance
(a) (b) (c) (c)-(b)
Production & sales (units) 2,000 3,000 3,000
CU CU CU CU
Sales revenue 20,000 30,000 30,000 0
Variable costs
Direct materials 6,000 9,000 8,500 500 (F)
Direct labour 4,000 6,000 4,500 1,500 (F)
Maintenance 1,000 1,500 1,400 100 (F)
Semi-variable costs
Other costs 3,600 4,600 5,000 400 (A)
Fixed costs
Depreciation 2,000 2,000 2,200 200 (A)
Rent and rates 1,500 1,500 1,600 100 (A)
Total costs 18,100 24,600 23,200 1,400 (F)
Profit 1,900 5,400 6,800 1,400 (F)
CU3,500 (F) CU1,400 (F)

Volume variance Expenditure variance
CU4,900 (F)
Total variance
Notice that the total variance has not altered. It is still CU4,900 (F) as before. The flexible budget
comparison merely analyses the total variance into two separate components.
5.5.2 Interpretation of the control statement

We can analyse the above as follows.
(a) In selling 3,000 units the expected profit is shown by the flexible budget. This is not the fixed budget
profit of CU1,900, but the flexible budget profit of CU5,400. Instead, actual profit was CU6,800, ie
CU1,400 more than we should have expected. This is the CU1,400 favourable expenditure variance.
The reason for this CU1,400 improvement is that, given output and sales of 3,000 units, overall costs
were lower than expected (and sales revenue was exactly as expected). For example, the direct
material cost was CU500 lower than expected.
(b) Another reason for the improvement in profit above the fixed budget profit is the sales volume. W
Co sold 3,000 units of CL instead of 2,000, with the following result.
CU CU
Budgeted sales revenue increased by 10,000
Budgeted variable costs increased by:
Direct materials 3,000
Direct labour 2,000
Maintenance 500
Variable element of other costs 1,000
6,500
Budgeted fixed costs are unchanged –
Budgeted profit increased by 3,500
Budgeted profit was therefore increased by CU3,500 because sales volume increased. This is the
CU3,500 favourable volume variance.
(c) A full variance analysis statement would be as follows.
CU CU CU
Fixed budget profit 1,900
Variances
Sales volume 3,500 (F)
Direct materials cost 500 (F)
Direct labour cost 1,500 (F)
Maintenance cost 100 (F)
Other costs 400 (A)
Depreciation 200 (A)
Rent and rates 100 (A)
Total expenditure variance 700 (A) 2,100 (F) 1,400 (F)
Actual profit 6,800
If management believes that any of these variances are large enough to justify it, they will investigate
the reasons for them to see whether any corrective action is necessary.
Interactive question 5: Budget cost allowances [Difficulty level: Intermediate]

WL Co manufactures and sells a single product, R. Since the R is highly perishable, no inventories are held
at any time. WL Co's management uses a flexible budgeting system to control costs. Extracts from the
flexible budget are as follows.
Output and sales (units) 4,000 5,500
Budget cost allowances CU CU
Direct material 16,000 22,000
Direct labour 20,000 24,500
Variable production overhead 8,000 11,000
Fixed production overhead 11,000 11,000
Selling and distribution overhead 8,000 9,500
Administration overhead 7,000 7,000
Total expenditure 70,000 85,000
Production and sales of product R amounted to 5,100 units during period 5.
The total budget cost allowances in the flexible budget for period 5 will be:
(a) Direct material

CU
(b) Direct labour
CU
(c) Variable production overhead
CU
(d) Fixed production overhead
CU
(e) Selling and distribution overhead
CU
(f) Administration overhead
CU
(g) Production and sales of product R in period 6 amounted to 5,500 units. Budgeted output for the
period was 4,000 units. Actual total expenditure was CU82,400.
(i) The total expenditure variance for period 6 was CU favourable/adverse (delete as
necessary)
(ii) The volume variance for period 6 was CU favourable/adverse (delete as necessary)
Summary
Performance management systems
Effective feedback information
Clear and comprehensive

Exception principle
Highlight controllable items Hopwood’s three
Regular and timely
Sufficiently accurate styles of evaluation
Exclude irrelevant detail
Budget constrained
Communicated to correct manager
Profit conscious
Non-accounting
Decentralisation
The authority for

certain decisions is
delegated to less
senior managers
Responsibility centres
Cost centre Revenue centre Profit centre Investment centre

Responsible for
Responsible for Responsible for Responsible for
Costs incurred
Costs incurred Revenues earned Costs incurred
Revenues earned
Revenues earned
Capital invested
Performance
Balanced scorecard measures related to
capital employed
A
Perspectives:
Financial
Customer
Internal business Return on Residual
Innovation and learning investment (ROI) income (RI)
Budgetary control
Dysfunctional focus Reduces
on short-term dysfunctional
performance behaviour
Fixed budget Flexible budget Most useful as a Encourages
comparative marginal
Realistic budget measure investments
For a single
cost allowance for
activity level
actual activity level
Self-test
1 Which of the following items would be excluded in the calculation of controllable divisional profit?
A Sales to external customers
B Head office costs
C Variable divisional expenses
D Controllable divisional fixed costs
2 A subsidiary which sells goods wholesale has a year-end trade payables balance of CU192,000. The
remainder of the working capital items consist of trade receivables, inventories and cash.
The inventory, receivables and payables balances were the same at the year end as at the beginning of
the year.
Relevant financial ratios for the year are as follows:
Quick (liquidity) ratio 1.7:1
Rate of inventory turnover 6 times p.a.
Payables payment period 1.5 months
The current ratio at the year end is

3 Division Y is considering a project which will increase annual profit by CU45,000 but will require
average inventory levels to increase by CU180,000. The current return on investment for the division
is 28% and the imputed interest cost of capital is 20%.
Would the performance measures of ROI and RI motivate the manager of division Y to act in the
interest of the company as a whole?
ROI RI
A No No
B No Yes
C Yes No
D Yes Yes
4 Which of the following is not a perspective which is monitored using the balanced scorecard approach
to performance measurement?
A Financial
B Innovation and learning
C Internal business
D Sales
5 A retailing company's working capital consists of inventory, trade receivables, cash and trade payables.
All working capital balances were the same at the beginning and the end of the year. The sales revenue
for the year was CU900,000.
The financial ratios for the year include the following.
Current ratio 3.4:1

Receivables collection period 73.0 days
Payables payment period 36.5 days
Gross profit margin 20.0%
The closing cash balance was CU
6 A division currently has an investment base of CU2,400,000 and annual profits of CU480,000. The
following additional investments are being considered.
Annual
Outlay profit
CU000 CU000
Investment Q 1,400 350
Investment R 600 200
Investment S 400 88
Which combination of investments will maximise the division's return on investment?
A Investment Q only
B Investment R only
C Investments Q and R
D Investments Q, R and S
7 On the last day of the financial year an investment centre has net assets with a total carrying amount
of CU1.2 million, with a return on investment (ROI) of 15%.
The manager of this division is considering selling one of its non-current assets immediately prior to
the year end. The non-current asset has a carrying amount of CU105,000 and a net realisable value of
CU80,000.
What would be the division's ROI immediately after the sale of the asset at the end of the year?
A 13.2%
B 14.2%
C 15.3%
D 16.4%
8 A divisionalised company uses return on investment (ROI) and residual income (RI) to assess the
performance of its divisions. Straight-line depreciation is used and assets are valued at net book value.
If the cash flows from a new investment in a depreciable non-current asset are likely to be constant
over the life of the investment, what will be the effect of the investment on the ROI and RI over the
life of the asset?
ROI RI
A Increase Increase
B Increase No change
C No change No change
D Decrease Decrease
9 What is a budget cost allowance?
A A budget of expenditure applicable to a particular function
B A budget allowance which is set without permitting the ultimate budget manager the opportunity
to participate in setting the budget
C The budgeted cost expected for the actual level of activity achieved during the period
D A fixed budget allowance for expenditure which is expected every period, regardless of the level
of activity
10 BF Limited manufactures and sells a single product. An extract from the flexed budget for production
costs is as follows.
Activity level
80% 90%
CU CU
Direct material 3,200 3,600
Direct labour 2,800 2,900
Production overhead 5,400 5,800
Total production cost 11,400 12,300
The total production cost in a budget that is flexed at the 88% level of activity will be CU
Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these
1 B Head office costs are not controllable by the divisional manager and should be excluded from the
calculation of controllable divisional profit
2 The current ratio at the year end is 3:1
WORKING
Average payables
Payables payment period (in months) = ×12
Purchases
1.5 = CU192 ,000 x12

Purchases
Purchases = CU1,536,000
Inventory = unchanged  cost of sales = Purchases
Cost of sales
Average inventory
6 = CU1,536,000
Inventory
From the quick ratio, receivables and cash = 1.7  CU192,000
= CU326,400
Current ratio = CU256,000  CU326,400

CU192,000
= 3:1
3 B ROI on marginal investment = CU45,000/CU180,000
= 25%
This is higher than the cost of capital therefore it would be acceptable to the company as a
whole. However, the manager would reject the project based on ROI because it is lower than
the current divisional ROI.
Incremental RI = CU45,000 – (CU180,000  20%)
= CU9,000
Therefore the manager would accept the project if performance was assessed on the basis of
residual income. This would be acting in the interest of the company as a whole.
4 D The sales perspective is not one of the four perspectives of the balanced scorecard approach.
The four perspectives are financial, innovation and learning, internal business and customer.
5 The closing cash balance was CU 16,800
WORKING
Since gross profit margin = 20%
Cost of sales = 80%  CU900,000
= CU720,000
Inventory = unchanged cost of sales = purchases
Average trade payables

Payables payment period (in days) = 365
Purchases
36.5 = Trade payables  365

CU720,000
Trade payables = CU72,000
Current assets
Since current ratio = = 3.4:1
Current liabilities
Current assets = 3.4  CU72,000
= CU244,800
Cost of sales
Average inventory
15 = CU720,000
Inventory
Average trade receivables
Receivables collection period (in days) =  365
Sales revenue
73 = Trade receivables  365

CU900,000
Trade receivables = CU180,000
Current assets = Inventory + Receivables + Cash
CU244,800 = CU48,000 + CU180,000 + Cash
Cash = CU16,800
6 C
Investment Q only = CU480,000  CU350,000 = 21.8%

CU2,400,000  CU1,400,000
Investment R only = CU480,000  CU200,000 = 22.7%

CU2,400,000  CU600,000
Investments Q and R = CU480,000  CU350,000  CU200,000 = 23.4%

CU2,400,000  CU1,400,000  CU600,000
Investments Q, R and S = CU480,000  CU350,000  CU200,000  CU88,000 = 23.3%

CU2,400,000  CU1,400,000  CU600,000  CU400,000
7 A
CU
Original profits = 15%  CU1.2 million 180,000
Loss on sale of asset = CU105,000 – CU80,000 25,000
Revised profits 155,000
Revised investment base = CU(1,200,000 – 105,000 + 80,000)
= CU1,175,000
Revised ROI = CU155,000

CU1,175,000
= 13.2%
8 A If returns are constant and the value of the asset base is falling, both ROI and RI will increase.
9 C A budget cost allowance is the expected expenditure in a budget which has been flexed to the
actual level of activity. It includes a basic, unchanged allowance for fixed costs and an amount for
variable costs according to the level of activity.
Option A describes a functional budget and option B is an imposed or top-down budget. A
budget cost allowance includes an amount for variable overhead therefore option D is not
correct.
10 The total production cost in a budget that is flexed at the 88% level of activity will be CU 12,120 .
WORKING
Direct material cost per 1% activity = CU40
Direct labour cost per 1% activity is not a constant amount at both activity levels, so this must be a
semi-variable cost. Since production overhead is also a semi-variable cost the two costs can be
analysed together, to save time (since the question asks only for a total cost in the answer).
CU
Direct labour and production overhead
At 80% activity 8,200
At 90% activity 8,700
Change 10% 500
Variable cost per 1% change in activity = CU500 = CU50

10%
Substituting in 80% activity:
CU
Variable cost = 80  CU50 4,000
Total cost 8,200
Fixed cost 4,200
Flexed budget cost at 88% level of activity is as follows.

CU
Direct material (88  CU40) 3,520
Direct labour and production overhead: Variable (88  CU50) 4,400
Fixed 4,200
12,120

Item Part of controllable Not part of controllable
divisional investment divisional investment
Non-current assets

Trade receivables

Trade payables

Inventory

ROI RI
Without investment 21.0% CU34,20

0
With investment 20.7% CU35,20
0
WORKINGS
Without With
investment investment
ROI
CU119,700/CU570,000 21.0%
CU128,200/CU620,000 20.7%
RI
CU CU
Profit 119,700 128,200
Imputed interest charge:
CU570,000  15% 85,500
CU620,000  15% 93,000
34,200 35,200

Many answers are possible. They could include:
Financial perspective
All the standard measures plus:
 Proportion of income from legal aid
 Regularity of income paid in prolonged cases
 Net fee income from ‘No Win, No Fee’ litigation
Customer perspective
 Number of cases won
 Number of new clients won through recommendations
 Cost of key services (eg conveyancing) compared to other local firms
Innovation and learning

 Continuing Professional Development (CPD) courses attended
 New services offered
 New methods of service delivery introduced (eg online Wills)
Internal business perspective
 Time taken to process key services (eg to draft and type Wills)
 Administration cost (eg courier services, website maintenance)
 Speed of accessing archives
 Ease of access to legislative and case law databases

The cost of factory power is estimated to be CU 45,600 .
WORKINGS
Units CU
20X3 (highest output) 9,800 44,400
20X2 (lowest output) 7,700 38,100
2,100 6,300
The variable cost per unit is therefore CU6,300/2,100 = CU3.
The level of fixed cost can be calculated by looking at any output level.
CU
Total of factory power in 20X3 44,400
Less variable cost of factory power (9,800  CU3) 29,400
Fixed cost of factory power 15,000
An estimate of costs in 20X5 is as follows.
CU
Fixed cost 15,000
Variable cost of budgeted production (10,200  CU3) 30,600
Total budgeted cost of factory power 45,600

(a) Direct material CU 20,400
(b) Direct labour CU 23,300
(c) Variable production overhead CU 10,200
(d) Fixed production overhead CU 11,000
(e) Selling and distribution overhead CU 9,100
(f) Administration overhead CU 7,000
2,600
(g) (i) The total expenditure variance for period 6 was CU favourable
15,000
(ii) The volume variance for period 6 was CU adverse
WORKINGS
(a) Direct material is a variable cost of CU16,000/4,000 = CU4 per unit
Budget cost allowance for 5,100 units = 5,100  CU4 = CU20,400
(b) Direct labour is a semi-variable cost which can be analysed using the high-low method.
Output
Units CU
High 5,500 24,500
Low 4,000 20,000
Change 1,500 4,500
Variable cost per unit = CU4,500/1,500 = CU3
Substituting in high output, fixed cost = CU24,500 – (5,500  CU3)
= CU8,000
Budget cost allowance for 5,100 units:
CU
Variable cost = 5,100  CU3 15,300
Fixed cost 8,000
23,300
(c) Variable production overhead per unit = CU8,000/4,000 = CU2 per unit
Budget cost allowance for 5,100 units = 5,100  CU2 = CU10,200
(d) Fixed production overhead cost allowance is fixed at CU11,000.
(e) Selling and distribution is a semi-variable cost which can be analysed using the high-low method.
Output
Units CU
High 5,500 9,500
Low 4,000 8,000
Change 1,500 1,500
Variable cost per unit = CU1,500/1,500 = CU1
Substituting in high output, fixed cost = CU9,500 – (5,500  CU1)
= CU4,000
Budget cost allowance for 5,100 units:
CU
Variable cost = 5,100  CU1 5,100
Fixed cost 4,000
9,100
(f) Administration overhead cost allowance is fixed at CU7,000.
(g) The budgeted and actual output volumes correspond to the two activity levels provided in the
question data. The total budget cost allowance for each activity level can be used as the basis for the
variance calculations.
(i) Expenditure variance = Budget cost allowance for 5,500 units – actual expenditure for
5,500 units
= CU85,000 – CU82,400
= CU2,600 favourable
(ii) Volume variance = budget cost allowance for original budget of 4,000 units – budget cost
allowance for actual volume of 5,500 units
= CU70,000 – CU85,000 = CU15,000 adverse
chapter 9
Standard costing and

variance analysis
Contents
Introduction
Examination context
Topic List
1 Standard costing and standard costs
2 Cost variances
3 Sales variances and operating statements
4 Interpreting variances and deriving actual data
from variance detail
Answers to Interactive question
Introduction

 Calculate differences between actual performance and standards in terms of price and
volume effects and identify possible reasons for those differences
 Calculate and reconcile budgeted and actual profits using standard marginal costing.
The specific syllabus reference for this chapter is: 3e.
We have seen how the use of a system of flexible budgets enables managers to exercise control over
revenues and expenditures through the comparison of the actual results with a realistic budget cost
allowance for the actual level of activity achieved.
However the absolute variances derived from this comparison do not help the manager to identify the
reasons for each variance. For example, if the actual cost of direct materials is greater than the budget cost
allowance, is this difference caused by the quantity of material used being too high or by the price paid for
materials being too high?
In a standard costing system, standard costs are determined for each cost unit in terms of the price and
quantity of each resource to be consumed. For example, the standard material cost per unit is established in
terms of the price of material and the quantity of material to be used to produce each unit. This enables the
total variance for material cost, obtained from the flexible budget comparison, to be further analysed for
improved cost control.
Clearly a standard costing system will be useful for cost control in a manufacturing environment. However,
standard costs and variance analysis can also be used in a service organisation. For example the expected
number of hours to carry out an audit for a client, together with the expected labour rate per hour, can be
determined in advance. This will represent a standard cost which can then be compared with the actual
cost of the audit. The detail in the predetermined standard cost means that any difference or variance
between the standard cost and the actual cost of the audit can be analysed. This would enable managers to
establish how much of the variance is caused by a difference in the labour rate per hour and how much is
caused by a difference in the number of hours worked.
Stop and think

The example described, of the analysis of labour cost variances arising on a client’s audit, is carried out after
the event. Since it is not possible to go back now and take action to correct the variances, what is the point
of carrying out the analysis at all?
Working context
You will come across standard costs in service organisations as well as in manufacturing organisations. We
have seen above the example of standard costs being used to plan and control the cost of an audit. Standard
revenues might also be used, for example in terms of a standard charge-out rate per hour of a consultant’s
time.
Syllabus links
An understanding of variance analysis as a part of the work of the finance function will be necessary for
your Business and Finance syllabus and as a part of performance measurement within that syllabus.
STANDARD COSTING AND VARIANCE ANALYSIS 9
Examination context
Exam requirements
The calculation and analysis of variances lends itself well to numerical exam questions. However you are
also likely to be presented with narrative questions, perhaps testing your understanding of the meaning of
calculated variances.
The examiner is also likely to ask you to ‘work backwards’ from variance information to derive extracts
from the actual results or the original standards. This requires a thorough understanding of the methods of
variance calculation and of the meaning of the results of the calculations.
 Calculate and interpret variances for variable costs
 Calculate and interpret contribution-based variances for sales
 Derive actual cost and standard cost data from calculated variances
 Demonstrate an understanding of the meaning and use of standard cost operating statements
Traditionally students find variances a difficult area. They can be approached in a tabular manner or using
formulae – find the one that suits you best. Understanding the meaning can help with understanding and
remembering the calculations.
1 Standard costing and standard costs
Section overview
 Standard costing is the preparation of standard costs to use in variance analysis, a key management
control tool.
 Standards for each cost element are made up of a monetary component and a resources requirement
component.
 Standard costing enables the principle of management by exception to be practised.
 If they are to continue to be useful for control purposes, standard costs must be revised whenever
there are changes in required resource inputs or in the price of resources.
1.1 Standard costing
Definition
Standard costing is defined by CIMA as a 'control technique that reports variances by comparing actual
costs to pre-set standards so facilitating action through management by exception'.
Standard costing (for control) therefore involves the following.

 The establishment of predetermined estimates of the costs of products or services
 The collection of actual costs
 The comparison of the actual costs with the predetermined estimates.
1.2 Standard costs

A standard cost per unit is the expected, or normal, cost per unit, based on expectations (standards) for:
 The usage of resources; and
 The price per unit of resource.
A simple standard cost card, taking account of only variable costs, is shown below.
Standard cost: Widget Price per
Units of unit of
resource resource CU
Material 6 kg CU5 30
Labour 2.5 hours CU8 20
Variable production overhead 2.5 hours CU2 5
Standard variable production cost 55
Standards provide an expected cost for one unit of output. A budget is a financial plan for a period of
time. However, standard costs can be used in the preparation of budgets.
When standard costs are used, budgetary control variance analysis is based on a comparison between actual
results and a flexed budget that uses standard costs. The particular advantage of standard costs is that the
cost information consists of a quantity of resources (units of raw material, hours of direct labour and
variable overheads) and a price per unit of resource (cost per kilogram of material or cost per hour for
labour, etc).
As a result of this additional information, the analysis of the cost variances can be more detailed, and so can
provide more control information to management.
1.3 Standard costing and management by exception

Standard costs, when established, are average expected unit costs. Because they are only averages and
not a rigid specification, actual results will vary to some extent above or below the average. Standard costs
can therefore be viewed as benchmarks for comparison purposes, and variances should only be
reported and investigated if there is a significant difference between actual and standard. The problem is in
deciding whether a variation from standard should be considered significant and worthy of investigation.
Tolerance limits can be set and only variances that exceed such limits would require investigation.
Standard costing therefore enables the principle of management by exception to be practised.
Definition
Management by exception is defined by CIMA as the ‘practice of concentrating on activities that require
attention and ignoring those which appear to be conforming to expectations. Typically standard cost
variances or variances from budget are used to identify those activities that require attention.’
1.4 Setting standard costs

Standards for units of production or service should be based on careful investigation and research, and
standards should be continually monitored to ensure that they are reasonable and reliable. If
there is an inaccuracy in the standard cost, a comparison of actual results against the standard will provide
meaningless and unhelpful variance information.
A possible reason for a variance may be that the standard is unreliable or inaccurate, rather than that actual
results were worse or better than they should have been. Companies that use standard costs therefore try
to make their standard costs as reliable as possible, and will revise the standard whenever there are changes
in resource inputs required or in the price per unit of resource.
1.5 The advantages of standard costing

 Carefully planned standards are an aid to more accurate budgeting.
 Standard costs provide a yardstick against which actual costs can be measured.
 The setting of standards involves determining the most appropriate materials and methods
which may lead to economies.
 A target of efficiency is set for employees to reach and cost consciousness is stimulated.
 Variances can be calculated which enable the principle of 'management by exception' to be
operated. Only the variances which exceed acceptable tolerance limits need to be investigated by
management with a view to control action.
 Standard costs simplify the process of bookkeeping in cost accounting, because they are easier
to use than LIFO, FIFO and weighted average costs.
 Standard times simplify the process of production scheduling.
 Standard performance levels might provide an incentive for individuals to achieve targets for
themselves at work.
2 Cost variances
Section overview
 Variances measure the difference between actual results and expected results. The process by which
the total difference between standard and actual results is analysed is known as variance analysis.
 The material total variance can be divided into the material price variance and the material usage
variance.
 Since material inventories are usually valued at standard cost in a standard costing system, material
price variances are usually extracted at the time of purchase of the materials, rather than at the time
of usage.
 The labour total variance can be divided into the labour rate variance and the labour efficiency
variance.
 The variable overhead total variance can be divided into the variable overhead expenditure variance
and the variable overhead efficiency variance.
 If the variable overhead rate is stated in terms of a rate per labour hour, then the variable overhead
efficiency variance, in hours, is exactly the same as the labour efficiency variance in hours, and it
occurs for the same reasons.
 The fixed overhead expenditure variance is the difference between the budgeted and actual fixed
overhead expenditure in the period.
2.1 Variances
Definition
A cost variance is defined by CIMA as 'the difference between a planned, budgeted, or standard cost and
the actual cost incurred. The same comparisons may be made for revenues.'
Variance analysis is defined as the 'evaluation of performance by means of variances, whose timely
reporting should maximise the opportunity for managerial action'.
As we saw in Chapter 8, when actual results are better than expected results, we have a favourable
variance (F). If, on the other hand, actual results are worse than expected results, we have an adverse
variance (A).
2.2 Material variances
Definition
The material total variance 'measures the difference between the standard material cost of the output
produced and the actual material cost incurred' (CIMA).
The material total variance can be divided into the material price variance and the material usage
variance.
(a) The material price variance

This is the difference between the standard cost and the actual cost for the actual quantity of material
used or purchased. In other words, it is the difference between what the material did cost and what it
should have cost.
(b) The material usage variance
This 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
price per unit of material. In other words, it is the difference between how much material should have
been used and how much material was used, valued at standard price.
Worked example: Material variances

Product X has a standard material cost as follows.
10 kilograms of material Y at CU10 per kilogram = CU100 per unit of X.
During period 4, 1,000 units of X were manufactured, using 11,700 kilograms of material Y which cost
CU98,631.
Requirement
Calculate the following variances.
(a) The material total variance
(b) The material price variance
(c) The material usage variance
Solution
(a) The material total variance
This is the difference between what 1,000 units should have cost and what they did cost.
CU
1,000 units should have cost ( CU100) 100,000
but did cost 98,631
Material total variance 1,369 (F)
The variance is favourable because the units cost less than they should have cost.
Now we can break down the material total variance into its two constituent parts: the material price
variance and the material usage variance.
(b) The material price variance
This is the difference between what 11,700 kgs should have cost and what 11,700 kgs did cost.
CU
11,700 kgs of Y should have cost ( CU10) 117,000
but did cost 98,631
Material Y price variance 18,369 (F)
The variance is favourable because the material cost less than it should have.
(c) The material usage variance

This is the difference between how many kilograms of Y should have been used to produce 1,000 units
of X and how many kilograms were used, valued at the standard cost per kilogram.
1,000 units should have used ( 10 kgs) 10,000 kgs
but did use 11,700 kgs
Usage variance in kgs 1,700 kgs (A)
 Standard price per kilogram  CU10
Usage variance in CU CU17,000 (A)
The variance is adverse because more material was used than should have been used.
(d) Summary
CU
Price variance 18,369(F)
Usage variance 17,000 (A)
Total variance 1,369 (F)
2.2.1 Using formulae to calculate materials variances

You may prefer to use formulae to calculate standard cost variances. The formulae for the material cost
variances are as follows.
Material price variance = (Standard price per unit of materials – Actual price per unit of materials) 
Actual quantity of materials
(SP – AP)  AQ
Material usage variance = (Standard quantity of materials for actual output – Actual quantity used) 
Standard price per unit of material
(SQ – AQ)  SP
The total material cost variance in formula terms is:
(Standard price per unit of materials  standard quantity of materials)
less
(Actual price per unit of materials  actual quantity of materials)
ie (SP  SQ) – (AP  AQ)
Algebraically, material price variance + material usage variance
= (SP – AP)  AQ + (SQ – AQ)  SP
= (SP  AQ) – (AP  AQ) + (SQ  SP) – (AQ  SP)
= (SP  SQ) – (AP  AQ)
(as above)
Worked example: Using formulae to calculate material variances

Using the data in the last example the formulae would be applied as follows.
Materials price variance = (SP – AP)  AQ
= [CU10 – (CU98,631/11,700)]  11,700
=CU18,369 (F)
Materials usage variance = (SQ – AQ)  SP
= [(1,000  10kg) – 11,700kg]  CU10
=CU17,000 (A)
2.2.2 Materials variances and opening and closing inventory

Suppose that a company uses raw material P in production, and that this raw material has a standard price
of CU3 per metre. During one month 6,000 metres are bought for CU18,600, and 5,000 metres are used in
production. At the end of the month, inventory will have been increased by 1,000 metres. In variance
analysis, the problem is to decide the material price variance. Should it be calculated on the basis of
materials purchased (6,000 metres) or on the basis of materials used (5,000 metres)? The answer to
this problem depends on how closing inventories of the raw materials will be valued.
(a) If closing inventories of raw materials are valued at standard cost, (1,000 units at CU3 per unit) then
the price variance is calculated on material purchases in the period.
(b) If closing inventories of raw materials are valued at actual cost (FIFO) (1,000 units at CU3.10 per
unit) then the price variance is calculated on materials used in production in the period.
2.2.3 When to calculate the material price variance

A full standard costing system is usually in operation and therefore the price variance is usually
calculated on purchases in the period. The variance on the full 6,000 metres will be written off to the
costing income statement, even though only 5,000 metres are included in the cost of production.
There are two main advantages in extracting the material price variance at the time of purchase.
(a) If variances are extracted at the time of purchase they will be brought to the attention of
managers earlier than if they are extracted as the material is used. If it is necessary to correct any
variances then management action can be more timely, such as negotiating the price down with the
supplier.
(b) Since variances are extracted at the time of purchase, all inventories will be valued at standard
price. This is administratively easier and it means that all issues from inventories can be made at
standard price. If inventories are held at actual cost it is necessary to calculate a separate price
variance on each batch as it is issued. Since issues are usually made in a number of small batches this
can be a time-consuming task, especially with a manual system.
The price variance would be calculated as follows.
CU
6,000 metres of material P purchased should cost (  CU3) 18,000
but did cost 18,600
Price variance 600
2.3 Labour variances

The calculation of labour variances is very similar to the calculation of material variances.
Definition
The labour total variance measures the difference between the standard labour cost of the output
produced and the actual labour cost incurred.
The labour total variance can be divided into the labour rate variance and the labour efficiency
variance.
(a) The labour rate variance
This is similar to the material price variance. It is the difference between the standard cost and the
actual cost for the actual number of hours paid for.
In other words, it is the difference between what the actual labour used did cost and what it should
have cost.
(b) The labour efficiency variance
This is similar to the material usage variance. It is the difference between the hours that should have
been worked for the number of units actually produced, and the actual number of hours worked,
valued at the standard rate per hour.
Worked example: Labour variances

The standard labour cost of product X is as follows.
2 hours of grade Z labour at CU10 per hour = CU20 per unit of product X.
During period 4, 1,000 units of product X were made, and the labour cost of grade Z labour was CU17,825
for 2,300 hours of work.
Requirement
(a) The labour total variance
(b) The labour rate variance
(c) The labour efficiency variance
Solution
(a) The labour total variance
This is the difference between what 1,000 units should have cost and what they did cost.
CU
1,000 units should have cost ( CU20) 20,000
but did cost 17,825
Labour total variance 2,175 (F)
The variance is favourable because the units cost less than they should have done.
Again we can analyse this total variance into its two constituent parts.
(b) The labour rate variance
This is the difference between what 2,300 hours should have cost and what 2,300 hours did cost.
CU
2,300 hours of work should have cost ( CU10) 23,000
but did cost 17,825
Labour rate variance 5,175 (F)
The variance is favourable because the labour cost less than it should have cost.
(c) The labour efficiency variance

1,000 units of X should have taken ( 2 hours) 2,000 hrs
but did take 2,300 hrs
Efficiency variance in hours 300 hrs (A)
 Standard rate per hour × CU10
Efficiency variance in CU CU3,000 (A)
The variance is adverse because more hours were worked than should have been worked.
(d) Summary
CU
Rate variance 5,175 (F)
Efficiency variance 3,000 (A)
Total variance 2,175 (F)
2.3.1 Using formulae to calculate labour variances

The formulae that you may wish to use to calculate the labour cost variances are as follows.
Labour rate variance = (Standard rate of pay per hour – Actual rate of pay per hour)  Actual
labour hours
= (SR – AR)  AH
Labour efficiency variance = (Standard labour hours for actual output – Actual labour hours )  Standard
rate of pay per hour
= (SH – AH)  SR
As with the materials variances, the total labour cost variance can be shown algebraically to be (SR  SH) –
(AR  AH).
Worked example: Using formulae to calculate labour variances

Labour rate variance = (SR – AR)  AH
= [CU10 – CU17,825/2,300)]  2,300
= CU5,175 (F)
Labour efficiency variance = (SH – AH)  SR
= [(1,000  2 hours) – 2,300]  CU10
= CU3,000 (A)
2.4 Variable production overhead variances
Definition
Variable production overhead total variance measures the difference between the variable
production overhead that should be used for actual output and the variable production overhead actually
used.
Variable production overhead expenditure variance measures the actual cost of any change from
the standard variable overhead rate per hour.
Variable production overhead efficiency variance is the standard variable production overhead cost
of any change from the standard level of efficiency.
The variable overhead total variance can be subdivided into the variable overhead expenditure variance and
the variable overhead efficiency variance.
Worked example: Variable overhead variances

Suppose that the variable overhead cost of product X is as follows.
2 hours at CU1.50 = CU3 per unit
During the latest period, 400 units of product X were made. The labour force worked 760 hours. The
variable overhead cost was CU1,672.
(a) The variable overhead total variance
(b) The variable overhead expenditure variance
(c) The variable overhead efficiency variance
Solution
(a) The variable overhead total variance
This is similar to the labour total variance. It is the difference between the standard variable overhead
cost of 400 units and the actual variable overhead cost incurred.
CU
400 units of product X should cost ( CU3) 1,200
but did cost 1,672
Variable overhead total variance 472 (A)
(b) The variable overhead expenditure variance
This is the difference between the amount of variable overhead that should have been incurred in the
actual hours worked, and the actual amount of variable overhead incurred.
CU
760 hours of variable overhead should cost ( CU1.50) 1,140
but did cost 1,672
Variable overhead expenditure variance 532 (A)
(c) The variable overhead efficiency variance
400 units of product X should take ( 2 hrs) 800 hrs
but did take 760 hrs
Variable overhead efficiency variance in hours 40 hrs (F)
 Standard rate per hour  CU1.50
Variable overhead efficiency variance in CU CU60 (F)
If the variable overhead rate is stated in terms of a rate per labour hour, the variable overhead
efficiency variance is exactly the same, in hours, as the labour efficiency variance, and occurs for the
same reasons.
However, the variable overhead rate is sometimes stated in terms of a rate per machine hour, in
which case the difference must be calculated between the actual machine hours and the standard
machine hours for the output achieved.
The difference in hours, whether expressed in terms of labour hours or in terms of machine hours, is
evaluated at the standard variable overhead rate per hour.
(d) Summary
CU
Variable overhead expenditure variance 532 (A)
Variable overhead efficiency variance 60 (F)
Variable overhead total variance 472 (A)
2.4.1 Using formulae to calculate variable overhead variances

The formulae that you may wish to use to calculate the variable overhead cost variances are as follows.
Variable overhead expenditure variance = (Standard variable overhead rate per hour – Actual variable
overhead rate per hour)  Actual hours
= (SR – AR)  AH
Variable overhead efficiency variance = (Standard hours for actual output – Actual hours)  Standard
variable overhead rate per hour
= (SH – AH)  SR
The standard rate per hour, and the actual and standard hours, can be expressed in terms of labour or in
terms of machine hours.
The same algebraic breakdown of variable overhead variances can be derived as for materials and labour
variances.
Worked example: Using formulae to calculate variable overhead variances

Using the data from the last example the formulae would be applied as follows.
Variable overhead expenditure variance = (SR – AR)  AH
= [CU1.50 – (CU1,672/760)]  760
= CU532 (A)
Variable overhead efficiency variance = (SH – AH)  SR
= [(400  2) – 760]  CU1.50
= CU60 (F)
2.5 Fixed overhead expenditure variance

The fixed overhead expenditure variance is simply the difference between the budgeted and actual
fixed overhead expenditure in the period. By definition, fixed overheads should remain the same, regardless
of the volume of production and sales. Any difference between budget and actual spending must be due to
higher-than-expected or lower-than-expected spending, and can have nothing to do with differences in
volume of activity.
The fixed overhead expenditure variance is (Budgeted fixed overhead cost – Actual fixed overhead cost).
3 Sales variances and operating statements
Section overview
 The sales price variance is a measure of the effect on expected contribution of charging a different
selling price from the standard selling price.
 The sales volume variance measures the increase or decrease in standard contribution as a result of
the actual sales volume being higher or lower than budgeted.
 Operating statements used in a standard marginal costing system show how the combination of
variances reconcile the budgeted contribution and the actual contribution for a period.
3.1 Sales variances

Just as it is possible to set predetermined standards for cost, so it is also possible to set predetermined
standards for sales: the unit sales price and the sales volume. This enables variances to be calculated to
monitor and control the actual sales price and the actual sales volume achieved.
3.1.1 Sales price variance

The sales price variance is a measure of the effect on expected contribution of charging a different selling
price from the standard selling price. It is calculated as the difference between what the sales revenue
should have been for the actual quantity sold, and what it actually was.
3.1.2 Sales volume variance

The sales volume variance is the difference between the actual units sold and the budgeted quantity,
valued at the standard contribution per unit. In other words, it measures the increase or decrease in
standard contribution as a result of the sales volume being higher or lower than budgeted.
Worked example: Calculating sales variances

A company budgets to sell 8,000 units of product J for CU12 per unit. The standard variable cost per unit is
CU7. Actual sales were 7,700 units, at a price of CU12.50 per unit.
The sales price variance is calculated as follows.
CU
Sales revenue from 7,700 units should have been ( CU12) 92,400
but was (7,700  CU12.50) 96,250
Sales price variance 3,850 (F)
The variance is favourable because the actual price was higher than standard.
The sales volume variance is calculated as follows.
Budgeted sales volume 8,000 units
Actual sales volume 7,700 units
Sales volume variance in units 300 units (A)
 Standard contribution CU(12 – 7)  CU5
Sales volume variance 1,500 (A)
The variance is adverse because actual sales volume was less than budgeted.
3.1.3 Using formulae to calculate sales variances

The formulae that you may wish to use to calculate the sales variances are as follows.
Sales price variance = (Actual selling price per unit – Standard selling price per unit) 
Actual sales quantity
= (AP – SP)  AQ
Sales volume variance = (Actual sales quantity – Budgeted sales quantity)  Standard
contribution per unit
= (AQ – BQ)  SC
Worked example: Using formulae to calculate sales variances

Sales price variance = (AP – SP)  AQ
= (CU12.50 – CU12.00)  7,700
= CU3,850 (F)
Sales volume variance = (AQ – BQ)  SC
= (7,700 – 8,000)  CU(12 – 7)
= CU1,500 (A)
3.2 Operating statements

So far, we have considered how variances are calculated in a standard marginal costing system without
considering how they combine to reconcile the difference between budgeted contribution and actual
contribution during a period. This reconciliation is usually presented as a report to senior management at
the end of each control period. The report is called an operating statement or statement of variances.
An operating statement might look like this.
OPERATING STATEMENT FOR PERIOD 8 CU
Budgeted contribution 928,000
Sales volume variance 17,320 (A)
Actual sales less standard variable cost of sales 922,510
VARIABLE COST VARIANCES Favourable Adverse
CU CU
Material price 7,120
Material usage 6,190
Labour rate 5,340
Labour efficiency 4,140
Variable overhead expenditure 4,920
Variable overhead efficiency 2,870
Total variable cost variances 12,040 18,540 6,500 (A)
ACTUAL CONTRIBUTION 916,010
CU
Budgeted fixed overhead 400,470
Fixed overhead expenditure variance 15,010 (A)
Actual fixed overhead 415,480
Actual profit 500,530
Note that favourable variances are added to the budgeted contribution and adverse variances are
subtracted, in reaching the actual profit figure.
However, in the case of the adverse fixed overhead expenditure variance, this is added to the budgeted
expenditure because the actual expenditure was higher than budgeted.
Interactive question 1: Operating statement [Difficulty level: Intermediate]

NN Co manufactures a single product, the SK. The standard variable cost for this item is as follows.
CU CU
Materials:
P (8 kg at CU0.40 per kg) 3.20
Q (4 kg at CU0.70 per kg) 2.80
6.00
Labour (3 hours at CU7.50) 22.50
Variable overhead (3 labour hours at CU0.50) 1.50
30.00
Budgeted fixed overhead expenditure is CU8,600.
The standard sales price per unit is CU40. The budgeted production and sales for period 7 were 3,000
units.
Actual results for period 7 were as follows.
Sales and production 2,800 units
Sales revenue CU113,120
Materials purchased and used:
P 19,000 kg Cost CU7,410
Q 14,000 kg Cost CU10,220
Labour 8,300 hours Cost CU64,740
Variable overhead CU4,067
Fixed overhead CU8,250
Complete the operating statement for period 7 shown below. You should insert each cost variance into the
correct box according to whether it is adverse or favourable. For the sales variances, indicate in the box
whether they are adverse (A) or favourable (F).
OPERATING STATEMENT FOR PERIOD 7
CU
(a) Sales volume variance
(b) Sales price variance
Actual sales less standard variable cost of sales
Favourable Adverse
Variable cost variances CU CU
(c) Material price
(d) Material usage
(e) Labour rate
(f) Labour efficiency
(g) Variable overhead expenditure
(h) Variable overhead efficiency
Total variable cost variances
Actual contribution 26,683

CU
(i) Fixed overhead expenditure variance
Actual fixed overhead

4 Interpreting variances and deriving actual data from

variance detail
Section overview
 There is a wide range of possible reasons for the occurrence of sales and cost variances.
 Individual variances should not be looked at in isolation. It is possible that one variance is inter-related
with one or more other variances.
 Variances can be manipulated to derive actual data from standard cost details.
4.1 The reasons for variances

There is a wide range of reasons for the occurrence of adverse or favourable sales and cost variances.
The following list is not exhaustive but it should give you an idea of the type of circumstance that could give
rise to each of the variances.
Variance Favourable Adverse
Material price  Unforeseen discounts received  Price increase in the market

 More care taken in purchasing  Careless purchasing
 Material standard price set too high  Material standard price set too low
Material usage  Material used of higher quality than  Defective material
standard
 Excessive waste
 More effective use made of material
 Theft
 Errors in allocating material to jobs
 Stricter quality control
 Errors in allocating material to jobs
Labour rate  Use of apprentices or other workers  Wage rate increase
at a rate of pay lower than standard
 Use of higher grade labour
Labour efficiency  Output produced more quickly than  Lost time in excess of standard
expected because of work allowed
motivation, better quality of
 Output lower than standard set
equipment or materials, or better
because of deliberate restriction,
methods
lack of training, or sub-standard
 Errors in allocating time to jobs material used
 Errors in allocating time to jobs
Variable  Change in types of overhead or their  Change in types of overhead or
overhead cost their cost
expenditure
Variable  As for labour efficiency (if based on  As for labour efficiency (if based on
overhead labour hours) labour hours)
efficiency
Fixed overhead  Fixed overheads include a wide range of different items of expense. Any of
expenditure these might be higher or lower than budgeted. For example rent, rates or
insurance for the period might be higher or lower than budgeted
Variance Favourable Adverse
Sales price  Supply shortages meant customers  Supply surplus meant customers
prepared to pay higher prices wished to pay lower price
 Quantity discounts given to  Quantity discounts given to
customers were lower than customers were higher than
expected expected
 Original standard selling price set  Original standard selling price set
too low too high
Sales volume  Efficient sales force  Demotivated sales force
 Successful advertising campaign  Competitor increased advertising
effort
 Potential market was larger than
expected  Original budgeted sales were too
optimistic
 Original budgeted sales were very
conservative
4.2 Inter-relationships between variances

Quite possibly, individual variances should not be looked at in isolation. One variance might be
inter-related with another, and much of it might have occurred only because the other, inter-related,
variance occurred too.
Here are some examples of inter-related variances.
(a) Materials price and usage
It may be decided to purchase cheaper, lower quality materials for a job in order to obtain a
favourable price variance, possibly with the consequence that materials wastage is higher and an
adverse usage variance occurs. If the cheaper materials are more difficult to handle, there might also
be an adverse labour efficiency variance and an adverse variable overhead efficiency variance.
If a decision is made to purchase more expensive materials, which perhaps have a longer service life,
the price variance will be adverse but the usage variance might be favourable.
(b) Labour rate and efficiency
If employees are paid higher rates for experience and skill, using a highly skilled team to do some work
would incur an adverse rate variance, but should also obtain a favourable efficiency variance. In
contrast, a favourable rate variance might indicate a larger-than-expected proportion of inexperienced
workers in the workforce, which could result in an adverse labour efficiency variance, and perhaps
poor materials handling and high rates of wastage or product rejections (adverse material usage
variance).
(c) Sales price and sales volume
The inter-relationship between sales price and sales volume variances should (hopefully) be obvious to
you. A reduction in the sales price might stimulate bigger sales demand, so that an adverse sales price
variance might be offset by a favourable sales volume variance. Similarly, a price rise would give a
favourable price variance, but possibly at the cost of a fall in demand and an adverse sales volume
variance.
(d) Cost and sales variances
(i) If there are favourable cost variances (perhaps cheaper labour or material have been used, say, so
that there are favourable labour rate or material price variances), the possible drop in quality of
the product could lead to an adverse sales volume variance because customers don’t wish to buy
the lower quality product.
(ii) If product quality is improved this might result in an adverse cost variance.
 If more expensive material is used (adverse material price variance)
 If labour are more careful in production of the product and hence take longer than standard
(adverse labour efficiency variance)
 If more skilled labour is used (adverse labour rate variance)
But the change in quality might result in a favourable sales volume variance because customers
want to buy more of the higher-quality product or a favourable sales price variance as a higher
price could be charged for the better quality product.
(iii) If costs have risen (resulting in adverse labour rate, material price and variable overhead
expenditure variances), the sales price might have to be increased to cover the extra costs. This
would result in a favourable sales price variance, but could lead to an adverse sales volume
variance.
4.3 Deriving actual data from standard cost details and variances
Variances can be manipulated to derive actual data from standard cost details.
Worked example: Deriving actual data

The standard marginal cost card for the TR, one of the products made by P Co, is as follows.
CU
Material 16 kgs  CU6 per kg 96
Labour 6 hours  CU12 per hour 72
168
P Co reported the following variances in control period 13 in relation to the TR.
Material price: CU18,840 favourable
Material usage: CU480 adverse
Labour rate: CU10,598 adverse
Labour efficiency: CU8,478 favourable
Actual wages cost CU171,320. P Co paid CU5.50 for each kg of material. There were no opening or closing
inventories of the material.
Requirement
Calculate the following.
(a) Actual output
(b) Actual hours worked
(c) Average actual wage rate per hour
(d) Actual number of kilograms purchased and used
Solution
(a)
CU
Total wages cost 171,320
Adjust for variances:
Labour rate (10,598)
Standard wages cost 169,200
 Actual output = Total standard cost  unit standard cost

= CU169,200  CU72
= 2,350 units
(b)
CU
Total wages cost 171,320.0
Less rate variance (10,598.0)
Standard rate for actual hours 160,722.0
 Standard rate per hour ÷ CU12.0
Actual hours worked 13,393.5 hrs
(c) Average actual wage rate per hour = Actual wages/actual hours = CU171,320/13,393.5 = CU12.79 per
hour.
(d) Number of kgs purchased and used = x
CU
x kgs should have cost ( CU6) 6.0x
but did cost ( CU5.50) 5.5x
Material price variance 0.5x
 CU0.5x = CU18,840
 x = 37,680 kgs
Alternatively the formula for the material price variance could be used as follows.
Price variance = (SP – AP)  AQ
CU18,840 = CU(6 – 5.50) AQ
AQ = CU18,840 /CU0.50
= 37,680 kgs
Summary
Standard costs
Predetermined unit costs
Price element Quantity element
Material Material
price variance usage variance
Labour Labour
rate variance efficiency variance
Variable overhead Variable overhead

expenditure variance efficiency variance
Fixed overhead Predetermined standard sales

expenditure variance price and sales volume
Total cost Sales price Sales volume

variance variance variance
Reconciliation of budgeted and

actual contribution/profit
Operating
statement
Self-test
1 CD Ltd manufactures a product with a standard material cost of CU11. This is made up as follows.
CU
Material X 2 kgs at CU1.00 2
Material Y 6 kgs at CU1.50 9
11
Actual production of 1,010 units required the following material purchases.
Material X 2,200 kgs CU2,530
Material Y 6,080 kgs CU8,512
There were no opening and closing inventories, and materials X and Y are not substitutable.
Using the table identify the total material price variance and whether it is adverse or favourable.
Adverse Favourable
A CU150
B CU162
C CU210
D CU278
2 Based on the same data as for question 1, using the table identify the total materials usage variance and
whether it is adverse or favourable.
Adverse Favourable
A CU150
B CU162
C CU210
D CU278
3 S Limited has extracted the following details from the standard cost card of one of its products.
Labour standard 4.5 hours @ CU6.40 per hour
During March, S Limited produced 2,300 units of the product and incurred wages costs of CU64,150.
The actual hours worked were 11,700.
The labour rate and efficiency variances were:
Rate (CU) Efficiency (CU)
A 10,730 (F) 8,640 (F)

B 10,730 (F) 8,640 (A)
C 10,730 (A) 8,640 (A)
D 10,730 (F) 7,402 (A)
4 The following diagram represents the standard and actual material costs incurred in manufacturing a
product.
R
Actual Z V
Standard Y U
T
Material
prices
0 Material W X
quantities Standard Actual
Using the table identify the areas corresponding to the conventional price and usage variances. Tick
one box for each variance.
Area
WXRV WXTU YZVU YZRT
A Price variance
B Usage variance
5 A firm incurred a total adverse labour variance of CU750. The standard pay rate was CU7.50 per
hour, while the actual pay rate was CU8 per hour. The labour rate variance was CU2,250. What are
the flexed budgeted hours for labour?
A 4,300 hours
B 4,500 hours
C 4,600 hours
D 4,700 hours
6 Using the table identify the most likely labour variance to arise under each of the circumstances
described. Tick one box for each circumstance.
Adverse Adverse Favourable Favourable

rate efficiency rate efficiency
A Labour more skilled than expected
B More machine breakdowns than

expected
C Pay increase less than expected
7 Using the table identify the most likely impact of the following on the fixed overhead expenditure
variance. Tick one box for each item.
Adverse Favourable No impact
A Volume of activity up marginally
B Supervisors’ salaries increase less than expected
C Higher energy consumption
8 The budgeted sales revenue of GH Ltd for August was CU210,000 with an estimated selling price of
CU84 and estimated variable cost per unit of CU70. Actual sales in August were 2,650 units,
amounting to CU219,950 revenue with a total resultant profit of CU35,775.
Using the table below indicate the monetary value of the sales volume variance and whether it is
adverse or favourable.
Adverse Favourable
A CU2,025
B CU2,100
C CU12,450
D CU12,600
9 A company had budgeted contribution of CU26,700 for the latest period. The variances reported to
managers at the end of the period were as follows.
CU
Material price 3,020 (A)
Labour efficiency 310 (A)
Variable overhead efficiency 217 (A)
Variable overhead total 149 (F)
Sales volume 2,700 (F)
The actual contribution for the period was CU........................................
10 The following sales data are available for product P for the last period.
Budget Actual
Sales revenue CU69,000 CU79,530

Sales volume (units) 4,600 4,820
The sales price variance for the period was:

A CU3,300 (F)
B CU6,900 (F)
C CU7,230 (F)
D CU10,530 (F)
1 D Favourable
CU CU
Material X
2,200 kgs should cost ( CU1.00) 2,200
but did cost 2,530
Materials price variance 330 (A)
Material Y
6,080 kgs should cost ( CU1.50) 9,120
but did cost 8,512
Materials price variance 608 (F)
Total materials price variance 278 (F)
2 C Adverse
kgs CU
Material X
1,010 units produced should use ( 2 kg) 2,020
but did use 2,200
Variance in kgs 180 (A)
 Standard price per kg ( CU1.00) 180 (A)
Material Y
1,010 units produced should use ( 6 kg) 6,060
but did use 6,080
Variance in kgs 20 (A)
 Standard price per kg ( CU1.50) 30 (A)
Total materials usage variance 210 (A)
3 B
CU
11,700 hours should cost ( CU6.40) 74,880
but did cost 64,150
Labour rate variance 10,730 (F)
2,300 units should take ( 4.5 hrs) 10,350 hrs

Variance in hours 1,350 hrs (A)
Labour efficiency variance CU8,640 (A)
If you selected options A or C you calculated the correct monetary values of the variances but
misinterpreted their direction.
If you selected option D you valued the efficiency variance in hours at the actual rate per hour instead
of the standard rate per hour.
4 A = YZVU
The material price variance is based on the actual quantity purchased
B = WXTU
The usage variance is evaluated at the standard price
5 D
The flexed budgeted hours for labour are the standard hours allowed for the actual production.
Labour rate variance = Actual hours worked  difference in labour rate
2,250 = Actual hours worked  (CU8.00 – CU7.50)
Actual hours worked = 4,500
Since total labour variance = Efficiency variance + rate variance
 CU750 (A) = Efficiency variance + CU2,250 (A)
Efficiency variance = CU1,500 (F)
1,500 (F) = Saving in labour hours compared with standard  standard
rate per hour
Saving in labour hours = CU1,500/CU7.50
= 200 hours
Standard hours for actual production = 4,500 hours worked + 200 hours saved
= 4,700 hours
6 A Favourable efficiency. More skilled workers would work at a faster rate
B Adverse efficiency. Labour hours would still be recorded but there would be no output
C Favourable rate. The hourly rate of pay would be lower than that used in the standard cost
calculation
7 A No impact. Fixed overhead expenditure would not be affected by a marginal increase in the
volume of activity
B Favourable
C No impact. Energy costs related to consumption are variable overheads
8 B Favourable
Budgeted sales volume (CU210,000/CU84) 2,500 units
Sales volume variance in units 150 units (F)
 Standard contribution per unit (CU84 – CU70)  CU14
Sales volume variance CU2,100 (F)
9 The actual contribution for the period was CU26,219
CU
Variances
Material price (3,020)
Labour efficiency (310)
Variable overhead total 149
(excluding variable overhead efficiency because included within the total variance) –
Sales volume variance 2,700
10 C
Standard sales price per unit = CU69,000/4,600
= CU15
CU
4,820 units should sell for ( CU15) 72,300
but did sell for 79,530
Answers to Interactive question

OPERATING STATEMENT FOR PERIOD 7
CU
(a) Sales volume variance 2,000 (A)
(b) Sales price variance 1,120 (F)
Actual sales less standard variable cost of sales 29,120

CU CU
Variable cost variances Favourable Adverse
(c) Material price 230
(d) Material usage 600
(e) Labour rate 2,490
(f) Labour efficiency 750
(g) Variable overhead expenditure 83
(h) Variable overhead efficiency 50
Total variable cost variances 2,437 (A)

CU
(i) Fixed overhead expenditure variance 350 (F)
Actual fixed overhead 8,250

WORKING
(a) Sales volume
CU
Budgeted sales volume 3,000 units
Sales volume variance in units 200 units (A)
 Standard contribution per unit (CU(40 – 30))  CU10
Sales volume variance in CU CU2,000 (A)
(b) Sales price
CU
Revenue from 2,800 units should have been ( CU40) 112,000
but was 113,120
(c) Material price

CU CU
19,000 kg of P should cost ( CU0.40) 7,600
but did cost 7,410
Material P price variance 190 (F)
14,000 kg of Q should cost ( CU0.70) 9,800
but did cost 10,220
Material Q price variance 420 (A)
Total material price variance 230 (A)
(d) Material usage
Material P
2,800 units of SK should use ( 8 kgs) 22,400 kgs
Material P usage variance in kgs 3,400 kgs (F)
 Standard price per kg  CU0.40
Material P usage variance in CU CU1,360 (F)
Material Q
2,800 units of SK should use ( 4 kgs) 11,200 kgs
Material Q usage variance in kgs 2,800 kgs (A)
 Standard price per kg  CU0.70
Material Q usage variance in CU CU1,960 (A)
Total material usage variance (CU1,960 – CU1,360) CU600 (A)
(e) Labour rate
CU
8,300 hours of labour should cost ( CU7.50) 62,250
but did cost 64,740
Labour rate variance 2,490 (A)
(f) Labour efficiency
To make 2,800 units of SK should take ( 3 hrs) 8,400 hrs
Labour variance in hrs 100 hrs (F)
Labour efficiency variance in CU CU750 (F)
(g) Variable overhead expenditure
CU
8,300 worked hours should cost ( CU0.50) 4,150
but did cost 4,067
Variable overhead expenditure variance 83 (F)
(h) Variable overhead efficiency (same as labour hours)
CU
100 hrs (F)  Standard rate (CU0.50) CU50 (F)
(i) Fixed overhead expenditure

CU
Budgeted expenditure 8,600
Actual expenditure 8,250
Fixed overhead expenditure variance 350 (F)
chapter 10
Breakeven analysis and

limiting factor analysis
Contents
Introduction
Examination context
Topic List
1 Breakeven analysis and contribution
2 Breakeven charts
3 Limiting factor analysis
Introduction

 Calculate the breakeven point, contribution and margin of safety for a given product or
service
 Allocate scarce resources to those products and services with the highest contribution per
unit of limiting factor
The specific syllabus references for this chapter are: 4a, b.
We have seen how an understanding of cost behaviour patterns enables

managers to control costs more effectively through the use of a flexible
budgeting system.
This valuable understanding of cost behaviour patterns also assists managers in their decision making
activities. Equipped with an understanding of which costs will change as a result of their decisions (usually
the variable costs) managers can manipulate data to calculate important measures such as the level of
activity required to achieve a target profit or to break even, earning neither a profit nor a loss. This is called
the 'break even point'.
An understanding of the contribution earned by different products and services will also help managers to
determine how best to allocate a restricted resource in order to maximise contribution.
Stop and think

Within the relevant range of activity, why will the maximisation of contribution automatically lead to the
maximisation of profits?
Working context
If you are managing a team of auditors you might at times have more work available than your staff can deal
with. In this situation you will need to know how to allocate the restricted staff time in order to earn the
maximum profit. Furthermore you will need to know how to decide whether or not to outsource work,
which tasks should be outsourced and which should be kept in-house.
Syllabus links
You will study the identification and management of limiting factors in more depth in the context of the
Business Strategy syllabus.
BREAKEVEN ANALYSIS AND LIMITING FACTOR ANALYSIS 10
Examination context
Exam requirements
Examination questions about breakeven analysis and limiting factor analysis can be quite complicated but
there are strict decision rules which can be applied in every question of this type. For example, unless
otherwise stated, the absolute amount of expenditure on fixed costs and the variable cost per unit
remain the same for every level of activity.
Questions on this area of the syllabus will usually involve some calculations.
 Calculate the breakeven point, margin of safety and contribution ratio for a product or service
 Calculate the volume of sales or level of activity required to achieve a target profit for the period
 Calculate the effect on profit, breakeven point, etc, of changes in the major decision variables
 Identify the optimum production plan or similar when a resource is in limited supply, and when
– There is a maximum and/or minimum limit on the demand for individual products or services;
and/or
– It is possible to alleviate the resource restriction by subcontracting work to parties outside the
business
This area involves candidates following a logical series of steps (or rules) which must be learned. The most
difficult type of question in this area normally involves consideration of the possibility of sub contracting or
outsourcing work.
1 Breakeven analysis and contribution
Section overview
 Breakeven analysis or cost-volume-profit (CVP) analysis is the study of the interrelationships between
costs, volume and profit at various levels of activity.
 Contribution = selling price less variable costs; profit = contribution less fixed costs.
 The breakeven point occurs when there is neither a profit nor a loss and so fixed costs equal
contribution.
 Breakeven point in units = total fixed costs ÷ contribution per unit.
 The contribution ratio is a measure of how much contribution is earned per CU1 of sales revenue. It
is usually expressed as a percentage.
 Breakeven point (in CU) = total fixed costs ÷ contribution ratio.
 The margin of safety is the difference between the budgeted sales volume and the breakeven sales
volume. It is sometimes expressed as a percentage of the budgeted sales volume.
 The contribution required for a target profit is equal to the fixed costs plus the target profit.
1.1 Contribution
Breakeven analysis or cost-volume-profit (CVP) analysis is the study of the interrelationships
between costs, volume and profit at various levels of activity.
Contribution, a concept we encountered in Chapter 4, is fundamental to CVP analysis. As you know,
contribution per unit is the difference between the selling price per unit and the variable costs per unit. The
total contribution from the sales volume for a period can be compared with the fixed costs for the
period. Any excess of contribution is profit, any deficit of contribution is a loss.
1.2 Breakeven point

The management of an organisation usually wishes to know the profit likely to be made if the aimed-for
production or activity and sales for the year are achieved. Management may also be interested to know the
activity level at which there is neither profit nor loss. This is known as the breakeven point.
The breakeven point (BEP) can be calculated as
Breakeven point = Number of units of sale required to breakeven
Total fixed costs
=
Contribution per unit
Contribution required to breakeven

=
Worked example: Breakeven point

Expected sales 10,000 units at CU8 = CU80,000
Variable cost CU5 per unit
Fixed costs CU21,000
Requirement
Compute the breakeven point.
Solution
The contribution per unit is CU(8  5) = CU3
Contribution required to break even = fixed costs = CU21,000
Breakeven point (BEP) = CU21,000 ÷ CU3
= 7,000 units
In revenue, BEP = (7,000  CU8) = CU56,000
Sales above CU56,000 will result in profit of CU3 per unit of additional sales and sales below CU56,000 will
mean a loss of CU3 per unit for each unit by which sales fall short of 7,000 units. In other words, profit will
improve or worsen per unit of sales by the level of contribution per unit.
7,000 units 7,001 units
CU CU
Revenue 56,000 56,008
Less variable costs 35,000 35,005
Less fixed costs 21,000 21,000
Profit 0 (= breakeven) 3
1.3 The contribution ratio

The contribution ratio is a measure of how much contribution is earned from each CU1 of sales
revenue.
An alternative way of calculating the breakeven point to give an answer in terms of sales revenue and using
the contribution ratio is as follows.
Breakeven point = Sales revenue required to break even
Contribution required to break even

=
Contribution ratio
Fixed costs
=
Contribution ratio
Worked example: Contribution ratio

Using the data in the last worked example the contribution ratio is CU3 = 37.5%
CU8
Breakeven is where sales revenue equals CU21,000 = CU56,000. At a price of CU8 per unit, this represents
0.375
7,000 units of sales, as calculated earlier.
Interactive question 1: Contribution ratio [Difficulty level: Easy]

The contribution ratio of product W is 20%. IB, the manufacturer of product W, wishes to make a
contribution of CU50,000 towards fixed costs.
If the selling price is CU10 per unit, the number of units of W that must be sold is .
1.4 The margin of safety

As well as being interested in the breakeven point, management may also be interested in the amount by
which actual sales can fall below anticipated sales without a loss being incurred. This is the margin of
safety.
The margin of safety is the difference in units between the budgeted or expected sales volume and the
breakeven sales volume. It is sometimes expressed as a percentage of the budgeted sales volume.
Alternatively the margin of safety can be expressed as the difference between the budgeted sales revenue
and breakeven sales revenue, expressed as a percentage of the budgeted sales revenue.
Worked example: Margin of safety

Mal de Mer Co makes and sells a product which has a variable cost of CU30 and which sells for CU40.
Budgeted fixed costs are CU70,000 and budgeted sales are 8,000 units.
Requirement
Calculate the breakeven point and the margin of safety.
Solution
Total fixed costs
(a) Breakeven point = = CU70,000
Contribution per unit CU( 40  30)
= 7,000 units
(b) Margin of safety = 8,000  7,000 units = 1,000 units
1,000 units
which may be expressed as × 100% = 12½% of budget
8,000 units
(c) The margin of safety indicates to management that actual sales can fall short of budget by 1,000 units
or 12½% before the breakeven point is reached and no profit is made.
1.5 Cost-volume-profit analysis and profit targets

Once the selling price and cost structure have been established for a product or service it is possible to
manipulate the data to provide a variety of information for management decisions.
Worked example: CVP analysis

Butterfingers Company makes a product which has a variable cost of CU7 per unit.
Requirement
If fixed costs are CU63,000 per annum, calculate the selling price per unit if the company wishes to break
even with a sales volume of 12,000 units.
Solution
Contribution required to breakeven (= fixed costs) = CU63,000
Volume of sales = 12,000 units
CU
Required contribution per unit = CU63,000 ÷ 12,000 = 5.25
Variable cost per unit = 7.00
Required sales price per unit = 12.25
Worked example: Target profits

RB Co makes and sells a single product, for which variable costs are as follows.
CU per
unit
Materials 10
Labour 8
Production overhead 6
24
The sales price is CU30 per unit, and fixed costs per annum are CU68,000. The company wishes to make a
profit of CU16,000 per annum.
Requirement
Determine the sales required to achieve this profit.
Solution
Since the contribution earned in a period is literally the contribution towards fixed costs and profit, in
order to achieve a certain target profit the contribution required is equal to the fixed costs plus the target
profit.
Required contribution = fixed costs + profit = CU68,000 + CU16,000 = CU84,000
Required sales can be calculated in one of two ways.
Required contribution CU84,000 = 14,000 units, or CU420,000 in revenue

(a) =
Contribution per unit CU(30  24)
Required contribution CU84 ,000

(b) = = CU420,000 of revenue, or 14,000 units.
Contribution ratio 20% *
* Contribution ratio = CU30  CU24 = CU6 = 0.2 = 20%.

CU30 CU30
Interactive question 2: Target profits [Difficulty level: Easy]

SLB Limited wishes to sell 14,000 units of its product, which has a variable cost of CU15 to make and sell.
Fixed costs are CU47,000 and the required profit is CU23,000.
The required sales price per unit is CU .

1.5.1 Variations on breakeven and profit target calculations

You may come across variations on breakeven and profit target calculations in which you will be expected
to consider the effect of altering the selling price, variable cost per unit or fixed cost.
Worked example: Change in selling price

MN Ltd bakes and sells a single type of cake. The variable cost of production is CU0.15 per cake and the
current sales price is CU0.25 per cake. Fixed costs are CU2,600 per month, and the annual profit for the
company at the current sales volume is CU36,000. The volume of sales demand is constant throughout the
year.
The sales manager wishes to raise the sales price to CU0.29 per cake, but considers that a price rise will
result in some loss of sales.
Requirement
Ascertain the volume of sales required each month to maintain current profitability, if the selling price is
raised to CU0.29.
Solution
The volume of sales required is one which would leave total profit the same as before, ie CU3,000 per
month. Required profit should be converted into required contribution, as follows.
CU
Monthly fixed costs 2,600
Monthly profit required 3,000
Current monthly contribution 5,600
The volume of sales required after the price rise will be an amount which earns a contribution of CU5,600
per month, the same as before. The contribution per cake at a sales price of CU0.29 would be (CU0.29 –
CU0.15) = CU0.14.
Required contribution CU5,600

Required sales = = = 40,000 cakes per month
Contribution per unit CU0.14
Worked example: Change in production costs

PQ Ltd makes a product which has a variable production cost of CU8 and a variable selling cost of CU2 per
unit. Fixed costs are CU40,000 per annum, the sales price per unit is CU18, and the current volume of
output and sales is 6,000 units.
The company is considering whether to hire an improved machine for production. Annual hire costs would
be CU10,000 and it is expected that the variable cost of production would fall to CU6 per unit.
Requirement
(a) Determine the number of units that must be produced and sold to achieve the same profit as is
currently earned, if the machine is hired.
(b) Calculate the annual profit with the machine if output and sales remain at 6,000 units per annum.
Solution
(a) The current unit contribution is CU(18  (8+2)) = CU8
CU
Current contribution (6,000 × CU8) 48,000
Less current fixed costs 40,000
Current profit 8,000
With the new machine fixed costs will increase by CU10,000 to CU50,000 per annum. The variable
cost per unit will reduce to CU(6 + 2) = CU8, and the contribution per unit will increase to CU10.
CU
Required profit (as currently earned) 8,000
Fixed costs 50,000
Required contribution 58,000
Contribution per unit CU10

Sales required to earn CU8,000 profit = CU58,000/CU10 = 5,800 units
(b) If sales are 6,000 units
CU
Profit at 5,800 units of sale (see (a)) 8,000
Contribution from sale of extra 200 units (× CU10) 2,000
Profit at 6,000 units of sale 10,000
2 Breakeven charts
Section overview
 A breakeven chart is a chart that indicates the profit or loss at different levels of sales volume within
a limited range.
 A traditional breakeven chart has a line for sales revenue, for fixed costs and for total costs.
 The breakeven point is at the intersection of the sales line and the total costs line.
 A contribution breakeven chart depicts variable costs, so that contribution can be read directly from
the chart.
 Despite the usefulness of breakeven analysis, the technique has some serious limitations.
2.1 Breakeven charts

The breakeven point can be determined graphically using a breakeven chart. A breakeven chart is a
chart that indicates the profit or loss at different levels of sales volume within a limited range.
A breakeven chart has the following axes.
 A horizontal axis showing the sales/output (in value or units)
 A vertical axis showing CU for sales revenues and costs
2.2 Lines on a breakeven chart

The following lines are drawn on the breakeven chart.
(a) The sales line
 Starts at the origin
 Ends at the point signifying expected sales volume and sales value
(b) The fixed costs line
 Runs parallel to the horizontal axis
 Meets the vertical axis at a point which represents the value of total fixed costs
(c) The total costs line

 Starts where the fixed costs line meets the vertical axis
 Ends at the point which represents anticipated sales volume on the horizontal axis and the total
costs of anticipated sales on the vertical axis
The breakeven point is the intersection of the sales line and the total costs line.
The distance between the breakeven point and the expected (or budgeted) sales, in units, indicates the
margin of safety at that level of sales.
Worked example: A breakeven chart

The budgeted annual output of a factory is 120,000 units. The fixed overheads amount to CU40,000 and the
variable costs are 50p per unit. The sales price is CU1 per unit.
Requirement
Construct a breakeven chart showing the current breakeven point and profit earned up to the present
maximum capacity of 120,000 units.
Solution
We begin the construction of the breakeven chart by calculating the profit at the budgeted annual output.
CU
Sales (120,000 units) 120,000
Variable costs 60,000
Contribution 60,000
Fixed costs 40,000
Profit 20,000
The breakeven chart is shown on the following page.
The chart is drawn as follows.
(a) The vertical axis represents money (costs and revenue) and the horizontal axis represents the
level of activity (production and sales).
(b) The fixed costs are represented by a straight line parallel to the horizontal axis (in our example,
at CU40,000).
(c) The variable costs are added 'on top of' fixed costs, to give total costs. It is assumed that fixed
costs are the same in total and variable costs are the same per unit at all levels of output.
The line of costs is therefore a straight line and only two points need to be plotted and joined up.
Perhaps the two most convenient points to plot are total costs at zero output, and total costs at the
budgeted output and sales.
 At zero output, costs are equal to the amount of fixed costs only, CU40,000, since there are no
variable costs.
 At the budgeted output of 120,000 units, total costs are CU100,000.
CU
Fixed costs 40,000
Variable costs 120,000 × 50p 60,000
Total costs 100,000
(d) The sales line is also drawn by plotting two points and joining them up.
 At zero sales, revenue is nil.
 At the budgeted output and sales of 120,000 units, revenue is CU120,000.
Figure 10.1: Breakeven chart
2.3 Interpreting the breakeven chart

The breakeven point is where total costs are matched exactly by total revenue. From the chart, this can be
seen to occur at output and sales of 80,000 units, when revenue and costs are both CU80,000. This
breakeven point can be calculated as:
Required contribution (  fixed costs) CU40,000

= = 80,000 units
Contribution per unit CU0.50 per unit
The margin of safety can be seen on the chart as the difference between the budgeted level of activity and
the breakeven level.
2.4 The contribution breakeven chart

The main problem with the traditional breakeven chart is that it is not possible to read contribution directly
from the chart.
The contribution breakeven chart remedies this by drawing the variable cost line instead of the fixed
cost line. This line will always run parallel to the total cost line. A contribution breakeven chart for the last
worked example would include the variable cost line passing through the origin and the total variable cost
of CU60,000 for 120,000 units. The contribution breakeven chart is shown on the next page.
Figure 10.2: Contribution breakeven chart

If you look back at the traditional breakeven chart shown in Figure 10.1 you will see that the breakeven
point is the same, but that the budgeted contribution can now be read more easily from the chart.
Interactive question 3: Breakeven chart [Difficulty level: Easy]

Match the following labels to (a), (b), (c) and (d) marked on the breakeven chart below.
Budgeted fixed costs Margin of safety Budgeted profit Budgeted variable costs
2.5 Limitations of breakeven or CVP analysis and breakeven charts

CVP analysis is a useful technique for managers. It can provide simple and quick estimates, and
breakeven charts provide a graphical representation of breakeven arithmetic. It does, however, have
a number of limitations.
 It can only apply to a single product or a constant mix of a group of products
 A breakeven chart may be time-consuming to prepare
 It assumes fixed costs are constant at all levels of output
 It assumes that variable costs are the same per unit at all levels of output
 It assumes that sales prices are constant at all levels of output
 It assumes production and sales are the same (inventory levels are ignored – effectively marginal
costing is used)
 It ignores the uncertainty in the estimates of sales prices, fixed costs and variable cost per unit.
3 Limiting factor analysis
Section overview
 A limiting factor is anything which limits the activity of an entity.
 If a specific resource is a limiting factor, contribution will be maximised by earning the highest possible
contribution per unit of limiting factor.
 To establish the contribution-maximising product or service mix the products or services must be
ranked in order of their contribution-earning ability per unit of limiting factor.
 When there is a maximum potential sales demand for an organisation's products or services the
contribution-maximising decision is to produce the top-ranked products (or to provide the top-
ranked services) up to the sales demand limit.
 If there is a minimum demand for particular products or services, the optimum plan must first take
into account the minimum requirements. The remaining resource must then be allocated according to
the ranking of contribution per unit of limiting factor.
 In a situation where a company must sub-contract work to make up a shortfall in its own in-house
capabilities, total costs will be minimised if those units bought in have the lowest extra variable cost
of buying per unit of limiting factor saved by buying.
3.1 Limiting factors

One of the more common problems faced by management is a situation where there are insufficient
resources to meet the potential sales demand. In this situation a decision has to be made about what mix of
products to manufacture or services to provide, using the available resources as effectively as possible. The
resource that limits the organisation's ability to meet sales demand is called a limiting factor or key
factor.
A limiting factor or key factor is 'anything which limits the activity of an entity'. An entity seeks to
optimise the benefit it obtains from the limiting factor. Examples are a shortage of supply of a resource or a
restriction on sales demand at a particular price.
A limiting factor could be sales if there is a limit to sales demand but any one of the organisation's
resources (labour, materials and so on) may be insufficient to meet the level of production demanded.
It is assumed in limiting factor analysis that management wishes to maximise profit and that since there is no
change in the fixed cost incurred profit will be maximised when contribution is maximised.
3.2 Limiting factor situations

For example if grade A labour is the limiting factor, contribution will be maximised by earning the highest
contribution from each hour of grade A labour worked.
The limiting factor decision therefore involves the determination of the contribution earned by each
different product or service from each unit of the limiting factor.
Worked example: Limiting factor

AB Ltd makes two products, the Ay and the Be. Unit variable costs are as follows.
Ay Be
CU CU
Materials 1 3
Labour (CU9 per hour) 18 9
Overhead 1 1
20 13
The sales price per unit is CU26 per Ay and CU17 per Be. During July 20X2 the available labour is limited
to 8,000 hours. Sales demand in July is expected to be 3,000 units for Ays and 5,000 units for Bes.
Requirement
Determine the profit-maximising production mix, assuming that monthly fixed costs are CU20,000, and that
no inventories are held.
Solution
Step 1
Confirm that the limiting factor is something other than sales demand.
Ays Bes Total
Labour hours per unit 2 hrs 1 hrs
Sales demand 3,000 units 5,000 units
Labour hours needed 6,000 hrs 5,000 hrs 11,000 hrs
Labour hours available 8,000 hrs
Shortfall 3,000 hrs
Labour is the limiting factor on production
Step 2
Identify the contribution earned by each product per unit of limiting factor, that is per labour hour worked.
Ays Bes
CU CU
Sales price 26 17
Variable cost 20 13
Unit contribution 6 4
Labour hours per unit 2 hrs 1 hrs

Contribution per labour hour (= unit of limiting factor) CU3 CU4
Although Ays have a higher unit contribution than Bes, two Bes can be made in the time it takes to make
one Ay. Because labour is in short supply it is more profitable to make Bes than Ays.
Step 3
Determine the optimum production plan. Sufficient Bes will be made to meet the full sales demand, and
the remaining labour hours available will then be used to make Ays.
Hours Hours Priority of
Product Demand required available manufacture
Bes 5,000 5,000 5,000 1st
Ays 3,000 6,000 3,000 (bal) 2nd
11,000 8,000
Hours Contribution
Product Units needed per hour Total
CU CU
Bes 5,000 5,000 4 20,000
Ays 1,500 3,000 3 9,000
8,000 29,000
Less fixed costs 20,000
Profit 9,000
Interactive question 4: Limiting factors [Difficulty level: Easy]

LF Ltd makes a single product for which the standard cost details are as follows.
CU
Variable material (CU3 per kg) 12
Variable labour (CU8 per hour) 72
Production overhead 48
Total production cost 132
Demand for next period will be 20,000 units. No inventories are held and only 75,000 kg of material and
190,000 hours of labour will be available.
Indicate, by placing ticks where relevant in the table below, which resource or resources represent a
limiting factor for LF Ltd.
Limiting factor Not a limiting factor
Materials
Labour
Interactive question 5: Limiting factor analysis [Difficulty level: Intermediate]

POV Ltd manufactures three products – X, Y and Z – that use the same machines. The budgeted income
statements for the three products are as follows.
X Y Z
CU'000 CU'000 CU'000
Sales 1,000 1,125 625
Variable material and labour costs (500) (563) (438)
Variable overheads (250) (187) (62)
Fixed overheads (200) (315) (130)
Profit/(loss) 50 60 (5)
Annual sales demand (units) 5,000 7,500 2,500
Machine hours per unit 20 21 26
However, after the budget had been formulated, an unforeseen condition has meant that during the next
period the available machine capacity has been limited to 296,500 hours.
(a) The shortfall in available machine hours for next period is …………… hours
(b) The contribution earned per machine hour used on product X is CU ……………
The contribution earned per machine hour used on product Y is CU ……………
The contribution earned per machine hour used on product Z is CU ……………

(c) The number of units of each product that should be manufactured next period is:
(i) Product X …………… units
(ii) Product Y …………… units
(iii) Product Z …………… units
3.3 Limiting factor analysis and restricted freedom of action

In certain circumstances an organisation faced with a limiting factor on production and sales might not be
able to produce the profit-maximising product mix because the mix and/or volume of products that
can be produced and sold is also restricted by a factor other than a scarce resource.
(a) A contract to supply a certain number of products to a customer which cannot be cancelled
(b) Production/sales of a minimum quantity of one or more products to provide a complete product
range and/or to maintain customer goodwill
(c) Maintenance of a certain market share of one or more products
In each of these cases, the organisation might have to produce more of a particular product or
products than the level established by ranking according to contribution per unit of limiting factor.
If an organisation has to produce more of a particular product or products than the level
established by ranking according to contribution per unit of limiting factor, the products should be
ranked in the normal way but the optimum production plan must first take into account the minimum
production requirements. The remaining resource must then be allocated according to the ranking.
Worked example: Restricted freedom of action

Harvey is currently preparing its budget for the year ending 30 September 20X2. The company
manufactures and sells three products, Beta, Delta and Gamma.
The unit selling price and cost structure of each product is budgeted as follows.
Beta Delta Gamma
CU CU CU
Selling price 100 124 32
Variable costs:
Labour 24 48 6
Materials 26 7 8
Overhead 10 5 6
60 60 20
The labour rate is budgeted at CU6 per hour, and fixed costs at CU1,300,000 per annum. The company has
a maximum production capacity of 228,000 labour hours.
A meeting of the board of directors has been convened to discuss the budget and to resolve the problem as to
the quantity of each product which should be made and sold. The sales director presented the results of a recent
market survey which reveals that market demand for the company's products will be as follows.
Product Units
Beta 24,000
Delta 12,000
Gamma 60,000
The production director proposes that since Gamma only contributes CU12 per unit, the product should
no longer be produced, and the surplus capacity transferred to produce additional quantities of Beta and
Delta. The sales director does not agree with the proposal. Gamma is considered necessary to complement
the product range and to maintain customer goodwill. If Gamma is not offered, the sales director believes
that sales of Beta and Delta will be seriously affected. After further discussion the board decided that a
minimum of 10,000 units of each product should be produced. The remaining production capacity would
then be allocated so as to achieve the maximum profit possible.
Requirement
Prepare a budget statement which clearly shows the maximum profit which could be achieved in the year
ending 30 September 20X2.
Solution
Step 1
Ascertain whether labour hours are a scarce resource
Units demanded Labour hours per unit Total labour hours
Beta 24,000 4 (CU24/CU6) 96,000
Delta 12,000 8 (CU48/CU6) 96,000
Gamma 60,000 1 (CU6/CU6) 60,000
252,000
Labour hours are a limiting factor
Step 2
Rank the products
Since only 228,000 hours are available we need to establish which product earns the greatest contribution
per labour hour.
Beta Delta Gamma
Labour hours 4 8 1
Contribution per labour hour CU10 CU8 CU12
Ranking 2nd 3rd 1st
Step 3
Determine a production plan
The optimum production plan must take into account the requirement that 10,000 units of each product are
produced, and then allocate the remaining hours according to the above ranking.
Hours
Beta 10,000 units  4 hours 40,000
Delta 10,000 units  8 hours 80,000
Gamma 10,000 units  1 hour 10,000
130,000
Gamma 50,000 units  1 hour (full demand) 50,000
Beta 12,000 units  4 hours (balance) 48,000
228,000
Step 4
Draw up a budget.
BUDGET STATEMENT
CU
Contribution
Beta (22,000 units  CU40) 880,000
Delta (10,000 units  CU64) 640,000
Gamma (60,000 units  CU12) 720,000
Total contribution 2,240,000
Fixed costs 1,300,000
Profit 940,000
3.4 Make or buy decisions and scarce resources

An organisation might want to do more things than it has the resources for, and so its alternatives
would be as follows.
(a) Make the best use of the available resources and ignore the opportunities to buy help from outside
(b) Combine internal resources with subcontracting externally so as to do more and increase profitability
Buying help from outside is justifiable if it adds to profits. A further decision is then required on how to split
the work between internal and external effort. What parts of the work should be given to suppliers or
subcontractors so as to maximise profitability?
In a situation where a company must subcontract work to make up a shortfall in its own in-house
capabilities, its total costs will be minimised if those units bought have the lowest extra variable cost of
buying per unit of scarce resource saved by buying.
Worked example: Make or buy decisions with scarce resources

MM manufactures three components, S, A and T using the same machines for each and assembles them into
a single product. The budget for the next year calls for the production and assembly of 4,000 of each
component. The variable production cost per unit of the final product is as follows.
Machine hours Variable cost
CU
1 unit of S 3 20
1 unit of A 2 36
1 unit of T 4 24
Assembly 100
Only 24,000 hours of machine time will be available during the year, and a subcontractor has quoted the
following unit prices for supplying components: S CU29; A CU40; T CU34.
Requirement
Advise MM on its most profitable plan.
Solution
The organisation's budget calls for 36,000 hours of machine time, if all the components are to be produced
in-house. Only 24,000 hours are available, and so there is a shortfall of 12,000 hours of machine time, which
is therefore a limiting factor. The shortage can be overcome by subcontracting the equivalent of 12,000
machine hours' output to the subcontractor.
The assembly costs are not relevant costs because they are not affected by the decision.
The decision rule is to minimise the extra variable costs of subcontracting per unit of scarce
resource saved (that is, per machine hour saved).
S A T
CU CU CU
Variable cost of making 20 36 24
Variable cost of buying 29 40 34
Extra variable cost of buying 9 4 10
Machine hours saved by buying 3 hrs 2 hrs 4 hrs
Extra variable cost of buying per hour saved CU3 CU2 CU2.50
This analysis shows that it is cheaper to buy A than to buy T and it is most expensive to buy S. The
priority for making the components in-house will be in the reverse order: S, then T, then A. There are
enough machine hours to make all 4,000 units of S (12,000 hours) and to produce 3,000 units of T (another
12,000 hours). 12,000 hours' production of T and A must be subcontracted.
The cost-minimising and so profit-maximising make and buy schedule is as follows.
Machine hours Unit Total
Component used/saved Number of units variable cost variable cost
CU CU
Make: S 12,000 4,000 20 80,000
T 12,000 3,000 24 72,000
24,000 152,000
Buy: T 4,000 1,000 34 34,000

A 8,000 4,000 40 160,000
12,000
Total variable cost of components, excluding assembly costs 346,000
Interactive question 6: Make or buy and limiting factors

[Difficulty level: Exam standard]
TW manufactures two products, the D and the E, using the same material for each. Annual demand for the
D is 9,000 units, while demand for the E is 12,000 units. The variable production cost per unit of the D is
CU10, and that of the E CU15. The D requires 3.5 kgs of raw material per unit, the E requires 8 kgs of raw
material per unit. Supply of raw material will be limited to 87,500 kgs during the year.
A sub contractor has quoted prices of CU17 per unit for the D and CU25 per unit for the E to supply the
product. How many of each product should TW manufacture in order to maximise profits?
Requirement
Fill in the boxes in the sentence below.
TW should manufacture units of D and units of E to maximise profits.

Summary
Breakeven analysis or
Cost-Volume-Profit (CVP)
analysis
Contribution =
Sales price – Variable cost
Breakeven point (BEP) Contribution ratio Limiting factor

= No profit and no loss = Contribution analysis
Sales
Fixed cost Fixed costs Maximise the

BEP in units = Contribution per unit BEP in £ = contribution per
Contribution ratio
unit of limiting
factor
Margin of safety Make or buy

Budgeted sales –- BEP decision
= x 100%
Budgeted sales
Breakeven chart
Depicts the profit or
loss over a range of activities
Contribution breakeven chart

Includes the variable cost line so
that contribution is highlighted
Self-test
The following information relates to questions 1 to 3.
Information concerning K Limited's single product is as follows.
CU per unit
Selling price 6.00
Variable production cost 1.20
Variable selling cost 0.40
Fixed production cost 4.00
Fixed selling cost 0.80
Budgeted production and sales for the year are 10,000 units.
1 What is the company's breakeven point, to the nearest whole unit?

A 8,000 units
B 8,333 units
C 10,000 units
D 10,909 units
2 How many units must be sold if K Limited wants to achieve a profit of CU11,000 for the year?
A 2,500 units
B 9,833 units
C 10,625 units
D 13,409 units
3 It is now expected that the variable production cost per unit and the selling price per unit will each
increase by 10%, and fixed production costs will rise by 25%. Other costs are expected to remain the
same.
What will be the new breakeven point, to the nearest whole unit?
A 8,788 units
B 11,600 units
C 11,885 units
D 12,397 units
The following information relates to questions 4 to 6.
W Limited sells one product for which data is given below:
CU per unit
Selling price 10
Variable cost 6
Fixed cost 2
The fixed costs are based on a budgeted level of activity of 5,000 units for the period.
4 How many units must be sold if W Limited wishes to earn a profit of CU6,000 for one period?
A 1,500
B 1,600
C 4,000
D 8,000
5 What is W Limited's margin of safety for the budget period if fixed costs prove to be 20% higher than
budgeted?
A 29%
B 40%
C 50%
D 66%
6 If the selling price and variable cost increase by 20% and 12% respectively by how much must sales
volume change compared with the original budgeted level in order to achieve the original budgeted
profit for the period?
A 24.2% decrease
B 24.2% increase
C 39.4% decrease
D 39.4% increase
CU
s
le
Sa A
D sts
tal co C
To
B
ts
le cos
ab
Vari
x Units
In the above breakeven chart, the contribution at level of activity x can be read as:
A Distance A
B Distance B
C Distance C
D Distance D
8 R Limited manufactures three products, the selling price and cost details of which are given below.
Product P Product Q Product R
CU CU CU
Selling price per unit 150 190 190
Costs per unit
Variable materials (CU5/kg) 20 10 30
Variable labour (CU8/hour) 32 48 40
Variable overhead 16 24 20
Fixed overhead 48 72 60
In a period when materials are restricted in supply, the most and least profitable uses of materials are:
Most profitable Least profitable
A R P
B Q R
C Q P
D R Q
9 JJ makes two products, the K and the L. The K sells for CU50 per unit, the L for CU70 per unit. The
variable cost per unit of the K is CU35, that of the L CU40. Each unit of K uses 2 kgs of raw material.
Each unit of L uses 3 kgs of material.
In the forthcoming period the availability of raw material is limited to 2,000 kgs. JJ is contracted to
supply 500 units of K. Maximum demand for the L is 250 units. Demand for the K is unlimited.
What is the profit-maximising product mix?
K L
A 250 units 625 units
B 1,250 units 750 units
C 625 units 250 units
D 750 units 1,250 units
10 B has insufficient workshop capacity to carry out all the repair work currently required on its fleet of
delivery vehicles. In such circumstances certain repair jobs will be sub-contracted to local garages.
Set out below are the routine repair jobs scheduled for the coming week.
Job A B C D E F
Cost of parts CU1,200 CU1,375 CU1,450 CU500 CU375 CU690
Labour hours 150 100 200 50 150 100
Equipment hours 170 30 70 30 70 70
Sub-contract cost (including CU3,950 CU2,700 CU4,900 CU1,800 CU2,700 CU2,400
parts)
Labour is paid CU6 per hour. Overtime is not worked on routine jobs. Labour-related variable
overheads are CU2 per labour hour. Equipment-related variable overheads are CU1 per equipment-
hour. Depreciation on workshop equipment is CU960 per week. Other workshop fixed overheads are
CU1,540 per week.
Requirement
Tick the boxes to indicate which jobs should be subcontracted if the amount of workshop labour
available in the week is fixed at 400 hours and there is no restriction on equipment availability.
Job A
Job B
Job C
Job D
Job E
Job F
Fixed costs
1 D Breakeven point =
10,000  (CU4.00  CU0.80) CU48,000

= = = 10,909 units
(CU6.00  (CU1.20  CU0.40)) CU4.40
If you selected option A you divided the fixed cost by the selling price, but the selling price also
has to cover the variable cost. Option B ignores the selling costs, but these are costs that
must be covered before the breakeven point is reached. Option C is the budgeted sales
volume, which happens to be below the breakeven point.
2 D Contribution required for target profit = fixed costs + profit
= CU48,000 + CU11,000
= CU59,000
 Contribution per unit (from question 1) = CU4.40
CU59,000
 Sales units required = = 13,409 units
CU4.40
If you selected option A you divided the required profit by the contribution per unit, but the
fixed costs must be covered before any profit can be earned. If you selected option B you
identified correctly the contribution required for the target profit, but you then divided by the
selling price per unit instead of the contribution per unit. Option C ignores the selling costs,
which must be covered before a profit can be earned.
3 C
CU per
unit
New selling price (CU6 × 1.1) 6.60
New variable cost (CU1.20 × 1.1) + CU0.40 1.72
Revised contribution per unit 4.88
New fixed costs (CU40,000 × 1.25) + CU8,000 CU58,000
Revised breakeven point = CU58,000 = 11,885 units

CU4,88
If you selected option A you divided the fixed cost by the selling price, but the selling price also
has to cover the variable cost. Option B fails to allow for the increase in variable production
cost and option D increases all of the costs by the percentages given, rather than the production
costs only.
4 C
CU
Target profit 6,000
Fixed costs (5,000 × CU2) 10,000
Target contribution 16,000
Contribution per unit (CU10 – CU6) CU4

CU16,000 4,000
Units required to achieve target profit = =
CU4
If you selected option A you divided CU6,000 target profit by the CU4 contribution per unit, but
the fixed costs must be covered before any profit can be earned. If you selected option
B you divided by the selling price, but the variable costs must also be taken into account. If you
selected option D you divided by the profit per unit instead of the contribution per unit, but the
fixed costs are taken into account in the calculation of the target contribution.
5 B
Fixed costs (CU10,000 × 120%) CU12,000
Units required now to break even = CU12,000 = 3,000

CU4 (contribution)
Budgeted units of sales 5,000
Margin of safety (units) 2,000
2,000
In percentage terms, margin of safety = × 100% = 40%
5,000
Option A increases the variable cost by 20% and option C increases the activity by 20%. If you
selected option D you calculated the margin of safety as a percentage of the breakeven volume,
but it should be expressed as a percentage of budgeted sales.
6 A
CU
Original budgeted profit:
Contribution (5,000 × CU4) 20,000
Fixed costs 10,000
Profit 10,000
CU per
unit
New sales price (CU10 × 1.20) 12.00
New variable cost (CU6 × 1.12) 6.72
New contribution 5.28
Contribution required (as above) CU20,000

CU20,000
Sales volume now needed = = 3,788 units
CU5.28
This is 1,212 units or 24.24% less than the original budgeted level of 5,000 units of sales.
If you selected option B you identified the correct percentage change but you misinterpreted it as
a required increase. If you selected options C or D you took CU6,000 as your figure for the
original budgeted profit. However, the budgeted profit would be based on the budgeted level of
activity of 5,000 units for the period.
7 C Contribution at level of activity x = Sales value less variable costs, which is indicated by distance
C. Distance A indicates the profit at activity x, B indicates the fixed costs and D indicates the
margin of safety in terms of sales value.
8 B
Product P Product Q Product R
Kgs required per unit 4 2 6
Contribution per kg of material CU20.50 CU54 CU16.67
Ranking 2 1 3
Therefore Q is the most profitable and R is the least profitable.
If you selected option A you ranked the products according to their profit per unit, but this takes
no account of the limiting factor and is distorted by the fixed costs.
9 C
K L
Contribution per unit CU15 CU30
Contribution per unit of limiting factor CU15/2 = CU30/3 =
CU7.50 CU10
Ranking 2 1
Raw materials
used
kg
Contracted supply of K (500 x 2 kg) 1,000
Meet demand for L (250 x 3 kg) 750
Remainder of resource for K (125 x 2 kg) 250
2,000
10 Jobs B, E and F should be subcontracted
WORKING 1
A B C D E F
Additional cost of subcontracting CU1,380 CU495 CU1,780 CU870 CU1,055 CU840
(W2)
Labour hours required 150 100 200 50 150 100
Cost per labour hour saved by
subcontracting CU9.20 CU4.95 CU8.90 CU17.40 CU7.03 CU8.40
Ranking of jobs to subcontract 5 1* 4 6 2* 3*
* Subcontracted jobs
As labour capacity is restricted to 400 hours per week there is only enough capacity for jobs C, A and
D. Jobs B, E and F should therefore be subcontracted as they have the lowest incremental cost per
labour hour saved.
WORKING 2
A B C D E F
CU CU CU CU CU CU
Cost of doing work in-house
Parts 1,200 1,375 1,450 500 375 690
Labour (labour hours  CU6 per hour) 900 600 1,200 300 900 600
Labour-related overhead
(labour hours  CU2 per hour) 300 200 400 100 300 200
Equipment-related overhead
(equipment hours  CU1 per hour) 170 30 70 30 70 70
Total cost of doing work in-house 2,570 2,205 3,120 930 1,645 1,560
Cost of subcontracting (including parts) 3,950 2,700 4,900 1,800 2,700 2,400
Additional cost of subcontracting 1,380 495 1,780 870 1,055 840

The number of units that must be sold is 25,000.
WORKINGS
Required contribution CU50,000
= = CU250,000
Contribution ratio 20%
 Number of units = CU250,000  CU10 = 25,000.

The required sales price per unit is CU 20 .
WORKINGS
Required contribution = fixed costs plus profit
= CU47,000 + CU23,000
= CU70,000
Required sales 14,000 units
Required contribution per unit = CU70,000/14,000 = CU5 per unit
CU
Required contribution per unit sold 5
Variable cost per unit 15
Required sales price per unit 20

(a) = Margin of safety
(b) = Budgeted profit
(c) = Budgeted variable costs
(d) = Budgeted fixed costs

Limiting factor Not a limiting factor
Materials

Labour

Material required = 20,000 units  (CU12/CU3) = 80,000 kg
Material is therefore a limiting factor, since 75,000 kg are available.
Labour required = 20,000 units  (CU72/CU8) = 180,000 hours
Labour is not a limiting factor, since 190,000 labour hours are available.

(a) The shortfall in available machine hours for next period is 26,000 hours.
WORKINGS
Machine hours required to satisfy annual sales demand:
Hours
Product X 5,000 units  20 hrs 100,000
Product Y 7,500 units  21 hrs 157,500
Product Z 2,500 units  26 hrs 65,000
Total machine hours required 322,500
Machine hours available 296,500
Shortfall in available machine hours 26,000
(b) The contribution earned per machine hour used on product X is CU 2.50 .
The contribution earned per machine hour used on product Y is CU 2.38 .
The contribution earned per machine hour used on product Z is CU 1.92 .
WORKINGS
X Y Z
CU'000 CU'000 CU'000
Sales revenue 1,000 1,125 625
Variable material and labour costs (500) (563) (438)
Variable overheads (250) (187) (62)
Contribution 250 375 125

Contribution per machine hour CU2.50 CU2.38 CU1.92
(c) (i) Product X 5,000 units
(ii) Product Y 7,500 units
(iii) Product Z 1,500 units
WORKINGS
Demand Hours Hours Production
Ranking Product units required available units
1st X 5,000 ( 20) 100,000 100,000 5,000
2nd Y 7,500 ( 21) 157,500 157,500 7,500
3rd Z 2,500 ( 26) 65,000 39,000* 1,500
296,500
* Balance (296,500 – 100,000 – 157,500)

TW should manufacture 9,000 units of D and 7,000 units of E.
WORKINGS
D E
CU per CU per
unit unit
Variable cost of making 10 15
Variable cost of buying 17 25
Extra variable cost of buying 7 10
Raw material saved by buying 3.5 kgs 8 kgs
Extra variable cost of buying per kg saved CU2 CU1.25
Priority for internal manufacture 1 2
Production plan Material used
kgs
 Make D (9,000  3.5 kgs) 31,500
E (7,000  8 kgs) 56,000
87,500
The remaining 5,000 units of E should be purchased from the sub contractor.
chapter 11
Investment appraisal
techniques
Contents
Introduction
Examination context
Topic List
1 Making investment appraisal decisions
2 The payback method
3 The accounting rate of return method
4 The net present value method
5 The internal rate of return method
Introduction

 Calculate the net present value, internal rate of return, payback period or accounting rate of
return for a given project
 Identify the advantages and disadvantages of the investment appraisal techniques specified
above
The specific syllabus references for this chapter are: 4c, d.
Capital expenditure differs from day-to-day revenue expenditure for two reasons.
 Capital expenditure often involves a larger outlay of cash
 The benefits from capital expenditure are likely to accrue over a long period of time, usually well over
a year and often over very long time periods. In such circumstances the benefits cannot all be set
against costs in the current year's income statement
For these reasons any proposed capital expenditure should be properly appraised, and found to be
worthwhile, before the decision is taken to go ahead with the expenditure. Formal procedures should
therefore be in place for the appraisal and monitoring of investment projects before they are undertaken,
while they are in progress, and after they have been completed.
In this syllabus you will focus on the appraisal process that takes place before investment projects are
undertaken. You will be learning about the key measures that are used in practice to assess the acceptability
of a proposed capital project.
Stop and think

The most important investment appraisal techniques are concerned not only with what cash flows will arise
in the future as a result of the project, but also with the timing of those cash flows. For what reasons might
earlier, perhaps smaller, forecast cash inflows be preferred than later, perhaps larger, cash inflows?
Working context
You might become involved in the investment appraisal process, for example in the context of the purchase
of new office equipment or the development of software for internal use. An understanding of the
significance of the timing of forecast cash flows will be important if you are asked to contribute information
for the investment appraisal process.
Syllabus links
You will be using the techniques you learn in this chapter when you study the Financial Management
syllabus. In that syllabus you will explore further the investment decision-making process and associated
issues.
INVESTMENT APPRAISAL TECHNIQUES 11
Examination context
Exam requirements
Since most of this part of your syllabus is concerned with calculation techniques you can expect to
encounter predominately numerical questions about these topics.
 Calculate the net present value, internal rate of return, payback period or accounting rate of return
from data supplied
 Interpret information about the net present value, internal rate of return, payback or accounting rate
of return for a project or projects
 Demonstrate an understanding of the advantages and disadvantages of the investment appraisal
techniques specified above
 Manipulate simple data involving annuities, perpetuities and non-conventional cash flows
 Demonstrate an understanding of the derivation and meaning of the net terminal value of a project
While most of the questions in this area of the syllabus will be numerical (where such issues as the timing of
cash flows will be critical) it is vital to understand what each of the techniques involves (and their
weaknesses) in order to be able to tackle narrative questions.
1 Making investment appraisal decisions
Section overview
 A typical model for investment decision making has a number of distinct stages.
 These stages are typically: the origination of proposals, project screening, analysis and acceptance, and
monitoring and review.
1.1 The investment decision-making process

You will study the investment decision-making process in more detail in your Financial Management syllabus
so we will review the process in outline only here, to set the financial investment appraisal techniques in
context.
A typical model for investment decision making has a number of distinct stages.
 Origination of proposals. It has been suggested that good ideas for investment are likely to occur in
environments in which staff feel free to present and develop ideas. Some alternatives will be rejected
early on. Others will be more thoroughly evaluated.
 Project screening. Before a detailed financial analysis is undertaken a qualitative evaluation of the
project will be made. For example, questions will be asked such as whether the project 'fits' with the
organisation's long-term objectives and whether all possible alternatives have been considered. Only if
the project passes this initial screening will more detailed financial analysis begin.
 Analysis and acceptance. This will include a financial analysis, using the organisation's preferred
investment appraisal techniques. You will be studying the most common techniques in the remainder
of this chapter. Qualitative issues will also be considered before a decision is made whether to
proceed and the project is implemented.
 Monitoring and review. During the project's progress it will be necessary to ensure that capital
spending does not exceed the amount authorised, that the implementation of the project is not
delayed and that the anticipated benefits are eventually obtained.
2 The payback method
Section overview
 The payback period is the time it takes for a project's net cash inflows to equal the initial cash
investment.
 The payback period is often used as an initial screening process.
 If a project's payback period is shorter than a defined maximum period then the project should be
evaluated further using a more sophisticated project appraisal technique.
 A major disadvantage is that the timing of cash flows within the payback period are ignored and
therefore no account is taken of the time value of money.
2.1 The payback period
Definition
Payback is defined by CIMA as 'The time required for the cash inflows from a capital investment project to
equal the initial cash outflow(s)'.
Payback is often used as a 'first screening method'. By this, we mean that when a capital investment
project is being subjected to financial appraisal, the first question to ask is: 'How long will it take to pay back
its cost?' The organisation might have a target payback, and so it would reject a capital project unless its
payback period were less than that target payback period.
However, a project should not be evaluated on the basis of payback alone. Payback should be a first
screening process, and if a project gets through the payback test, it ought then to be evaluated with a
more sophisticated project appraisal technique, such as those presented later in this chapter.
You should note that when payback is calculated, we use profits before depreciation in the calculation,
because we are trying to estimate the cash returns from a project and profit before depreciation is likely to
be a rough approximation of cash flows.
2.2 Why is payback alone an inadequate project appraisal technique?

Look at the figures below for two mutually exclusive projects (this means that only one of them can be
undertaken).
Project P Project Q
CU CU
Capital cost of asset 60,000 60,000
Profits before depreciation
Year 1 20,000 50,000
Year 2 30,000 20,000
Year 3 40,000 5,000
Year 4 50,000 5,000
Year 5 60,000 5,000
Project P pays back in year 3 (one quarter of the way through year 3). Project Q pays back half way through
year 2. Using payback alone to judge projects, project Q would be preferred. But the returns
from project P total CU200,000 over its life and are much higher than the returns from
project Q which totals just CU85,000.
Worked example: Payback period

An asset costing CU120,000 is to be depreciated over ten years to a nil residual value. Profits after
depreciation for the first five years are as follows.
Year CU
1 12,000
2 17,000
3 28,000
4 37,000
5 8,000
Requirement
Calculate the payback period to the nearest month.
Solution
Cash flows, ie profits before depreciation should be used.
Profit after Cash Cumulative
Year depreciation Depreciation flow cash flow
CU'000 CU'000 CU'000 CU'000
1 12 12 24 24
2 17 12 29 53
3 28 12 40 93
4 37 12 49 142
5 8 12 20 162
 (120  93) 
Payback period = 3 years +  12 months 
 49 
= 3 years 7 months
2.3 Disadvantages of the payback method

There are a number of serious drawbacks to the payback method.
 It ignores the timing of cash flows within the payback period.
 It also ignores the cash flows after the end of the payback period and therefore the total project
return.
 It ignores the time value of money (a concept incorporated into more sophisticated appraisal
methods). This means that it does not take account of the fact that CU1 today is worth more than CU1
in one year's time. This is because an investor who has CU1 today can either consume it immediately or
alternatively can invest it at the prevailing interest rate, say 10%, to get a return of CU1.10 in a year's
time.
There are also other disadvantages.
 The method is unable to distinguish between projects with the same payback period.
 The choice of any cut-off payback period by an organisation is arbitrary.
 It may lead to excessive investment in short-term projects.
 It takes account of the risk of the timing of cash flows but does not take account of the
variability of those cash flows.
2.4 Advantages of the payback method

The use of the payback method does have advantages, especially as an initial screening device.
 A long payback means capital is tied up
 Focus on early payback can enhance liquidity
 Investment risk is increased if payback is longer
 Shorter-term forecasts are likely to be more reliable
 The calculation is quick and simple
 Payback is an easily understood concept
3 The accounting rate of return method
Section overview
 The Accounting Rate of Return (ARR) expresses the average accounting profit as a percentage of the
capital outlay.
 The capital outlay (the denominator in the ARR calculation) may be expressed as the initial
investment or as the average investment in the project.
 The decision rule is that projects with an ARR above a defined minimum are acceptable; the greater
the ARR, the more desirable the project.
 The main advantage of the ARR is that it is simple to calculate and understand. However it does have
a number of major disadvantages.
 The main disadvantage of the ARR is that it does not take account of the timing of the profits from a
project.
3.1 Calculating the accounting rate of return

The accounting rate of return (ARR) method of appraising a project involves estimating the accounting rate
of return that a project should yield. If it exceeds a target rate of return then the project is acceptable.
There are two different ways of calculating the ARR.
Average annual accounting profit

ARR =  100%
Initial investment
ARR =  100%
Average investment
The average investment is calculated as 1 (initial investment + final or scrap value).

2
An examination question will always make it clear whether you are to calculate the ARR based on the
average investment or based on the initial investment.
Note that this is the only appraisal method that we will be studying that uses accounting profits instead of
cash flow.
Worked example: The accounting rate of return

A project involves the immediate purchase of plant at a cost of CU110,000. It would generate annual profits
before depreciation of CU24,000 for five years. Scrap value will be CU10,000 at the end of the fifth year.
Requirement
Calculate the ARR using the initial and average investment.
Solution
(a) Using initial investment
Profits before depreciation – depreciation (CU24 ,000 x 5)  (CU110 ,000  CU10,000 )

Average profit = =
5 5
= CU4,000 p.a.
ARR = CU4 ,000 x100% = 3.6%

CU110,000
(b) Using average investment
CU4 ,000 x100% = 6.7%
CU(110,000 10,000) / 2
3.2 The ARR and the comparison of mutually exclusive projects

The ARR method of capital investment appraisal can also be used to compare two or more projects which
are mutually exclusive. The project with the highest ARR would be selected (provided that the expected
ARR is higher than the company's target ARR).
Interactive question 1: The ARR and mutually exclusive projects

Arrow wants to buy a new item of equipment. Two models of equipment are available, one with a slightly
higher capacity and greater reliability than the other. The expected costs and profits of each item are as
follows.
Equipment Equipment
item item
X Y
Capital cost CU100,000 CU175,000
Life 5 years 5 years
Profits before depreciation CU CU
Year 1 50,000 50,000
Year 2 50,000 50,000
Year 3 30,000 60,000
Year 4 20,000 60,000
Year 5 10,000 60,000
Disposal value for equipment 20,000 25,000
ARR is measured as the average annual profits divided by the average investment.
Fill in the boxes below to determine which equipment item should be purchased, if the company's target
ARR is 25%.
Item X Item Y
CU CU
Total profit over life of equipment:
before depreciation
after depreciation
Average investment
ARR, based on average investment % %
The equipment that should be purchased is item .

3.3 The advantages and disadvantages of the ARR method of project

appraisal
The ARR method has the serious disadvantage that it does not take account of the timing of the
profits from a project. Whenever capital is invested in a project, money is tied up until the project begins
to earn profits which pay back the investment. Money tied up in one project cannot be invested anywhere
else until the profits come in. Management should be aware of the benefits of early repayments from an
investment, which will provide the money for other investments.
There are a number of other disadvantages.
 It is based on accounting profits rather than cash flows, which are subject to a number of
different accounting policies
 It is a relative measure rather than an absolute measure and hence takes no account of the size
of the investment
 It takes no account of the length of the project
 Like the payback method, it ignores the time value of money
There are, however, advantages to the ARR method.
 It is quick and simple to calculate
 It involves a familiar concept of a percentage return
 Accounting profits can be easily calculated from financial statements
 It looks at the entire project life
 Managers and investors are accustomed to thinking in terms of profit, and so an appraisal method
which employs profit may be more easily understood
 It allows more than one project to be compared
4 The net present value method
Section overview
 The terminal value of an investment is its value at some point in the future, including an allowance for
interest.
 Discounting converts a sum of money receivable or payable in the future to its present value, which is
the cash equivalent now of the future value.
 Discounted cash flow (DCF) techniques discount all the forecast cash flows of an investment proposal
to determine their present value.
 The net present value (NPV) of a project is the difference between its projected discounted cash
inflows and discounted cash outflows.
 The decision rule is to accept a project with a positive NPV.
 An annuity is a constant cash flow for a number of years.
 The net terminal value (NTV) is the cash surplus remaining at the end of a project after taking
account of interest and capital payments.
 One of the principal advantages of the DCF appraisal method is that it takes account of the time value
of money.
 The payback method can be combined with DCF to calculate a discounted payback period.
 A perpetuity is a constant cash flow forever. The present value of a perpetuity is CUa , where a is the
r
constant annual amount and r is the discount rate.
4.1 Compounding: calculating the terminal value

Suppose that a company has CU10,000 to invest, and wants to earn a return of 10% (compound interest*)
on its investments. This means that if the CU10,000 could be invested at 10%, the value of the investment
with interest would build up as follows.
(a) After 1 year CU10,000  (1.10) = CU11,000
2
(b) After 2 years CU10,000  (1.10) = CU12,100
3
(c) After 3 years CU10,000  (1.10) = CU13,310
and so on.
* This means that interest is earned each year on the previous years' interest.
This is compounding. The formula for the future value or terminal value of an investment plus
n
accumulated interest after n time periods is V = X(1 + r)
where V is the future value or terminal value of the investment with interest
X is the initial or 'present' value of the investment
r is the compound rate of return per time period, expressed as a decimal (so 10% = 0.10, 5% =
0.05 and so on)
n is the number of time periods.
Usually r is an annual rate of return and n is the number of years.
Worked example: Terminal value

What is the terminal value of CU200 invested today at an interest rate of 7% per annum in ten years' time?
Solution
Terminal value = CU200  (1.07)10 = CU393
Terminal values can cause difficulties when trying to compare or choose between projects because:
 the projects may not end on the same future date (or may not end at all)
 decision makers are more likely to be interested in the effect of the project on shareholder wealth
now, rather than in the future.
It is therefore more common to look at present values. The present value of a future sum shows what that
future sum is worth today. This is in effect the reverse of compounding.
4.2 Discounting
Discounting starts with the future value (a sum of money receivable or payable at a future date), and
converts the future value to a present value, which is the cash equivalent now of the future value.
For example, if a company expects to earn a (compound) rate of return of 10% on its investments, how
much would it need to invest now to have the following investments?
(a) CU11,000 after 1 year
(b) CU12,100 after 2 years
(c) CU13,310 after 3 years
The answer is CU10,000 in each case, and we can calculate it by discounting.
The discounting formula to calculate the present value (X) of a future sum of money (V) at the end of n
time periods is X = V/(1+r)n
(a) After 1 year, CU11,000/1.10 = CU10,000
(b) After 2 years, CU12,100/1.102 = CU10,000
(c) After 3 years, CU13,310/1.103 = CU10,000
The timing of cash flows is taken into account by discounting them. The effect of discounting is to
give a bigger value per CU1 for cash flows that occur earlier: CU1 earned after one year will be
worth more than CU1 earned after two years, which in turn will be worth more than CU1 earned after five
years, and so on.
The discount rate (r) used when calculating the present value is the relevant interest rate (or cost of
capital) to the entity in question. In the exam this will always be made clear.
4.2.1 Discount factors

In the calculations above we were converting each cash flow into its present value by effectively multiplying
by a discount factor. This discount factor is calculated as 1/(1 + r)n.
The calculations could be presented as follows.
Multiply by 10% discount factor Present value CU
After 1 year CU11,000  1/1.10 10,000

After 2 years CU12,100  1/(1.10)2 10,000
After 3 years CU13,310  1/(1.10)3 10,000
Interactive question 2: Present value calculation [Difficulty level: Intermediate]

Spender expects the cash inflow from an investment to be CU40,000 after two years and another
CU30,000 after three years. Its target rate of return is 12%.
Use the table below to calculate the present value of these future returns.
Multiplied by 12%
Year Cash flow CU Present value CU
discount factor
Total present value
4.3 Net present value (NPV)

Discounted cash flow (DCF) techniques are used in calculating the net present value of a series of cash
flows. This measures the change in shareholder wealth now as a result of accepting a project.
NPV = present value of cash inflows less present value of cash outflows
 If the NPV is positive, it means that the cash inflows from a project will yield a return in excess of
the cost of capital, and so the project should be undertaken if the cost of capital is the
organisation's target rate of return.
 If the NPV is negative, it means that the cash inflows from a project will yield a return below the
cost of capital, and so the project should not be undertaken if the cost of capital is the
organisation's target rate of return.
 If the NPV is exactly zero, the cash inflows from a project will yield a return which is exactly the
same as the cost of capital, and so if the cost of capital is the organisation's target rate of return, the
project will have a neutral impact on shareholder wealth and therefore would not be
worth undertaking because of the inherent risks in any project.
Worked example: NPV

Slogger has a cost of capital of 15% and is considering a capital investment project, where the estimated
cash flows are as follows.
Year Cash flow
CU
0 (ie now) (100,000)
1 60,000
2 80,000
3 40,000
4 30,000
Requirement
Calculate the NPV of the project, and assess whether it should be undertaken.
Solution
Year Cash flow Discount factor Present value
CU 15% CU
0 (100,000) 1.000 (100,000)
1 60,000 1/1.15 = 0.870 52,200
2 80,000 1/1.152 = 0.756 60,480
3 40,000 1/1.153 = 0.658 26,320
4 30,000 1/1.154 = 0.572 17,160
NPV = 56,160
Point to note
The discount factor for any cash flow 'now' (time 0) is always 1, whatever the cost of capital.
The present value (PV) of cash inflows exceeds the PV of cash outflows by CU56,160, which
means that the project will earn a discounted cash flow (DCF) yield in excess of 15%. It should therefore be
undertaken.
4.4 Timing of cash flows: conventions used in DCF

Discounting reduces the value of future cash flows to a present value equivalent and so is clearly concerned
with the timing of the cash flows. As a general rule, the following guidelines may be applied.
 A cash outlay to be incurred at the beginning of an investment project ('now') occurs in
time 0. The present value of CU1 now, in time 0, is CU1 regardless of the value of the discount
rate r.
 A cash flow which occurs during the course of a time period is assumed to occur all at once
at the end of the time period (at the end of the year). Receipts of CU10,000 during time period 1
are therefore taken to occur at the end of time period 1.
 A cash flow which occurs at the beginning of a time period is taken to occur at the end of
the previous time period. Therefore a cash outlay of CU5,000 at the beginning of time period 2 is
taken to occur at the end of time period 1.
4.5 Cash flows, not accounting profits

It is important to remember that DCF techniques are based on the cash flows of a project, not the
accounting profits. Like the payback technique of investment appraisal, DCF is concerned with liquidity,
not profitability. Cash flows are considered because they show the costs and benefits of a project when
they actually occur. For example, the capital cost of a project will be the original cash outlay, and not the
notional cost of depreciation which is used to spread the capital cost over the asset's life in the financial
accounts.
4.6 Discount tables for the PV of CU1

Instead of having to calculate the discount factor every time we can use tables. Discount tables for the
present value of CU1, for a range of integer values of r and n, are shown in the third column of the
discount table in the Appendix at the back of this Study Manual. These tables will be provided
in the exam.
4.7 Annuities
An annuity is a series of constant cash flows for a number of years. For example, a college might enter into
a contract to provide training courses for a firm for a fixed annual fee of CU30,000 payable at the end of
each of the next three years. This would be a three year annuity.
Worked example: Calculating the present value of an annuity

In the example of the college training course, the present value of the fees, assuming a 20% cost of capital,
could be calculated as follows.
Present value
Year Cash flow Present value factor of cash values
CU 20% CU
1 30,000 0.833 24,990
2 30,000 0.694 20,820
3 30,000 0.579 17,370
2.106 63,180
Where there is a constant cash flow from year to year (in this case CU30,000 per annum for years 1–
3) it is quicker to calculate the present value by adding together the discount factors for the individual
years. These total factors could be described as 'same cash flow per annum' factors, 'cumulative present
value' factors or 'annuity' factors. They are shown in the final column of the discount tables in
the Appendix at the back of this Study Manual (2.106, for example, is in the final column for 20% per
annum and the row for year 3).
The calculation could then be performed in one step:
CU30,000  2.106 = CU63,180
4.8 Net terminal value

Net terminal value (NTV) is the cash surplus remaining at the end of a project after taking account of
interest and capital repayments.
The NTV discounted at the cost of capital will give the NPV of the project.
Worked example: The net terminal value

A project has the following cash flows.
Year CU
0 (5,000)
1 3,000
2 2,600
3 6,200
The project has an NPV of CU4,531 at the company's cost of capital of 10% (workings not shown).
Requirement
Calculate the net terminal value of the project.
Solution
The net terminal value can be determined directly from the NPV, or by calculating the cash surplus at the
end of the project.
Assume that the CU5,000 for the project is borrowed at an annual interest rate of 10% and that cash flows
from the project are used to repay the loan.
CU
Loan balance outstanding at beginning of project 5,000
Interest in year 1 at 10% 500
Repaid at end of year 1 (3,000)
Balance outstanding at end of year 1 2,500
Interest year 2 250
Repaid year 2 (2,600)
Balance outstanding year 2 150
Interest year 3 15
Repaid year 3 (6,200)
Cash surplus at end of project 6,035
The net terminal value is CU6,035.

Check
NPV = CU6,035  0.751 (10% discount factor for year 3) = CU4,532
Allowing for the rounding errors caused by three-figure discount tables, this is the correct figure for the
NPV.
4.9 Advantages of NPV

The advantages of NPV are as follows.
 It is directly linked to the assumed objective of maximising shareholder wealth as it measures, in
absolute (CU) terms, the effect of taking on the project now, ie year 0
 It considers the time value of money, ie the further away the cash flow the less it is worth in present
terms
 It considers all relevant cash flows, so that it is unaffected by the accounting policies which cloud
profit-based investment appraisal techniques such as ARR
 Risk can be incorporated into decision making by adjusting the company’s discount rate
 It provides clear, unambiguous decisions, ie if the NPV is positive, accept; if it is negative, reject.
Interactive question 3: Non-standard discount factors

A project has the following forecast cash flows.
Year CU
0 (280,000)
1 149,000
2 128,000
3 84,000
4 70,000
Using two decimal places in all discount factors, complete the following table to calculate the net present
value of the project at a cost of capital of 16.5%.
Present value
Year Cash flow CU 16.5% discount factor
CU
0
1
2
3
4
Net present value
4.10 The time value of money

DCF is a project appraisal technique that is based on the concept of the time value of money, that CU1
earned or spent sooner is worth more than CU1 earned or spent later. Various reasons could be suggested
as to why a present CU1 is worth more than a future CU1.
 Uncertainty. The business world is full of risk and uncertainty, and although there might be the
promise of money to come in the future, it can never be certain that the money will be received until
it has actually been paid. This is an important argument, and risk and uncertainty must always be
considered in investment appraisal. But this argument does not explain why the discounted cash flow
technique should be used to reflect the time value of money.
 Inflation. Because of inflation it is common sense that CU1 now is worth more than CU1 in the
future. It is important, however, that the problem of inflation should not confuse the meaning of DCF,
and the following points should be noted.
– If there were no inflation at all, discounted cash flow techniques would still be used for
investment appraisal.
– Inflation, for the moment, has been completely ignored.
– It is obviously necessary to allow for inflation.
 An individual attaches more weight to current pleasures than to future ones, and would
rather have CU1 to spend now than CU1 in a year's time. Individuals have the choice of
consuming or investing their wealth and so the return from projects must be sufficient to persuade
individuals to prefer to invest now. Discounting is a measure of this time preference.
 Money is invested now to make profits (more money or wealth) in the future. Discounted cash flow
techniques can therefore be used to measure either of two things.
– What alternative uses of the money would earn (NPV method) (assuming that money
can be invested elsewhere at the cost of capital)
– What the money is expected to earn (IRR method – to be covered in the next section of
this chapter)
4.11 Advantages of DCF methods of appraisal

Taking account of the time value of money (by discounting) is one of the principal advantages of the DCF
appraisal method. Other advantages include the following.
 The method uses all cash flows relating to the project
 It allows for the timing of the cash flows
 There are universally accepted methods of calculating the NPV and IRR
4.12 A comparison of the ROI and NPV methods

In Chapter 8 we saw that managers are often judged on the return on investment (ROI) of their division or
responsibility centre which is very similar in principle to the ARR. Managers will only want to invest in
projects that increase divisional ROI but on occasion such a strategy may not correspond with the
decision that would be arrived at if NPV were used to appraise the investment.
For example, suppose that Division M is considering an investment of CU200,000 which will provide a net
cash inflow (before depreciation) of CU78,000 each year for the four years of its life. It is group policy that
investments must show a minimum return of 15%.
As the working below shows, using net book value (NBV) at the start of each year and depreciating on a
straight line basis to a nil residual value, in year 1 the ROI would be below the target rate of return of 15%.
If management were to take a short-term view of the situation, the investment would be rejected if
the ROI measure were to be used, despite the fact that the investment's NPV is positive and that in
years 2 to 4 the ROI is greater than the target rate of return.
Years
1 2 3 4
CU CU CU CU
NBV of investment at start of year 200,000 150,000 100,000 50,000
Cash flow (before depreciation) 78,000 78,000 78,000 78,000

Less depreciation (50,000) (50,000) (50,000) (50,000)
Net profit 28,000 28,000 28,000 28,000
ROI 14.00% 18.67% 28.00% 56.00%
Net present value = – CU200,000 + (CU78,000  2.855) = CU22,690.
4.13 Discounted payback

The payback method can be combined with DCF to calculate a discounted payback period.
The discounted payback period (DPP) is the time it will take before a project's cumulative NPV turns
from being negative to being positive.
Worked example: Discounted payback

If we have a cost of capital of 10% and a project with the cash flows shown below, we can calculate a
discounted payback period.
Discount Present Cumulative
Year Cash flow factor value NPV
CU 10% CU CU
0 (100,000) 1.000 (100,000) (100,000)
1 30,000 0.909 27,270 (72,730)
2 50,000 0.826 41,300 (31,430)
3 40,000 0.751 30,040 (1,390)
4 30,000 0.683 20,490 19,100
5 20,000 0.621 12,420 31,520
NPV = 31,520
The DPP is early in year 4.
A company can set a target DPP, and choose not to undertake any projects with a DPP in excess of a
certain number of years, say five years.
4.13.1 Advantages and disadvantages of discounted payback period

The approach has all the perceived advantages of the payback period method of investment
appraisal: it is easy to understand and calculate, and it provides a focus on liquidity where this is relevant. In
addition, however, it also takes into account the time value of money. It therefore bridges the gap
between the theoretically superior NPV method and the regular payback period method.
Because the DPP approach takes the time value of money into consideration, it produces a longer
payback period than the non-discounted payback approach, and takes into account more of the
project's cash flows.
Another advantage it has over traditional payback is that it has a clear accept-or-reject criterion. Using
payback, acceptance of a project depends on an arbitrarily determined cut-off time. Using DPP, a project is
acceptable if it pays back within its lifetime (because it has a positive NPV).
DPP still shares one disadvantage with the payback period method: cash flows which occur after the
payback period are ignored (although as the DPP is longer than the payback period, fewer of these are
ignored).
4.14 The discount rate

Throughout our study of DCF techniques we have been using the same discount rate across all years of the
project under consideration, on the assumption that the cost of capital will remain the same over the life of
the project. There are a range of factors that influence the cost of capital, however, including inflation and
interest rates, and these can fluctuate widely over fairly short periods of time. An organisation may
therefore wish to use different discount rates at different points over the life of a project to
reflect this. This is possible if NPV and discounted payback methods of appraisal are being used,
but IRR (see section 5) and ARR methods are based on a single rate.
Another problem is deciding on the correct rate in the first place. This is difficult enough in year one
of a project’s life, but even more problematic five years later, say, because of economic changes and so on.
4.15 Other aspects of discounting

Now that we have learned about the basics of the discounted cash flow technique we can move on to
consider some of the complications that might arise.
4.15.1 Delayed annuities

A company may take out a loan, agreeing to repay it in equal annual instalments (ie an annuity) but starting
at the end of year 2, so that the first cash flow does not occur until after year 1. As annuity factor tables
work on the assumption that the first cash flow occurs at the end of year 1, care will be needed when using
the tables. Remember that if an annuity factor from the table is used, the present value of the annuity
stream is being found one period before the first annuity flow, so further discounting will be needed to find
the present value at year 0.
4.15.2 Annuities in advance

When, for example, a firm leases vans for its business, the lease payments are usually paid in advance, i.e.
the first cash flow occurs in year 0. This is a combination of a normal annuity starting at year 1 plus an extra
sum now which does not need to be discounted.
Worked example: Annuities in advance and delayed annuities

What is the present value of CU1,000 received annually for five years if the first receipt is:
(a) In one year’s time?
(b) Now?
(c) In three years’ time?
Use a discount rate of 15%.
Solution
(a) Present value = CU1,000  annuity factor for five years at 15%
= CU1,000  3.352 = CU3,352
(b) Only the cash flows at the end of years 1 to 4 need discounting.
Present value = CU1,000 received now + (CU1,000  annuity factor for four years at 15%)
= CU1,000 + (CU1,000  2.855)
= CU3,855
(c) This can be solved in two possible ways.
(i) Present value = CU1,000  (annuity factor for seven years – annuity factor for two years)
This leaves the cash flows for years 3, 4, 5, 6 and 7 being discounted.
= CU1,000  (4.160 – 1.626)
= CU2,534
(ii) Present value of annuity at end of year two = CU1,000  3.352

= CU3,352
Now this must be discounted again to bring it back to the present value at year 0 (now).
Present value = CU3,352  PV factor for year 2 at 15%
= CU3,352  0.756
= CU2,534
4.15.3 Annual cash flows in perpetuity

A perpetuity is an equal annual cash flow forever, ie an annuity that lasts forever.
The present value of a perpetuity of CUa per annum forever is calculated as CUa , where r is the annual
r
discount rate. This formula finds the present value of the perpetuity stream one year before the first cash flow.
Worked example: Perpetuities

(a) What is the present value of CU3,000 received in one year's time and forever if the annual interest
rate is 10%?
(b) What would be the present value if the first receipt is in four years’ time?
Solution
(a) Present value = CU3,000/0.10
= CU30,000
(b) Present value one year before the first cash flow = at end of year 3
= CU3,000/0.10
= CU30,000
Present value at year 0 = CU3,000  year 3 10% discount factor
= CU30,000  0.751
= CU22,530
4.15.4 Changing discount rates

If the discount rate changes over time the net present value is calculated as follows
Year 0 Year 1 Year 2
NPV = outflow + inflow/(1+r1) + inflow/(1+r1)(1+r2) etc
Where r1 = interest rate for year 1

r2 = interest rate for year 2
Worked example: Changing discount rates

A project's estimated cash flows are as follows.
Year 0 Year 1 Year 2
CUm CUm CUm
Cash flow (10) 6 8
Calculate the NPV if the cost of capital is 10% for the first year and 20% for the second year.
Solution
NPV = (CU10m) + CU6m  CU8m = CU1.52m
1.10 1.10 x1.20
5 The internal rate of return method
Section overview
 The internal rate of return (IRR) is the DCF rate of return that a project is expected to achieve. It is
the discount rate at which the NPV is zero.
 If the IRR exceeds a target rate of return, the project would be worth undertaking.
 The IRR can be estimated from a graph of the project's NPV profile. The IRR can be read from the
graph at the point on the horizontal axis where the NPV is zero.
 P 
 The IRR interpolation formula is IRR  A    (B  A) % .
 P  N 
 The IRR method has a number of disadvantages compared with the NPV method.
– It ignores the relative size of the investments
– There are problems with its use when a project has non-conventional cash flows or when
deciding between mutually exclusive projects
– Discount rates which differ over the life of a project cannot be incorporated into IRR
calculations.
5.1 The internal rate of return

Another discounted cash flow (DCF) technique for appraising capital projects involves calculating the
internal rate of return (IRR). The IRR is a relative measure (%) in contrast to the absolute (CU)
measure resulting from NPV calculations.
The IRR is the DCF rate of return (DCF yield) that a project is expected to achieve, in other words the
discount rate at which the NPV is zero.
If the IRR exceeds a target rate of return, the project would be worth undertaking.
5.2 Graphical approach

The easiest way to estimate the IRR of a project is to find the project's NPV at a number of costs of
capital and sketch a graph of NPV against discount rate. The graph can be used to estimate the
discount rate at which the NPV is equal to zero (the point where the curve cuts the axis).
Worked example: Graphical approach

A project might have the following NPVs at the following discount rates.
Discount rate NPV
% CU
5 5,300
10 700
15 (1,500)
20 (3,200)
This could be sketched on a graph as follows.
The IRR can be estimated as 13%. The NPV should then be recalculated using this interest rate. The
resulting NPV should be equal to, or very near, zero. If it is not, additional NPVs at different discount rates
should be calculated, the graph resketched and a more accurate IRR determined.
5.3 Interpolation method

If we are appraising a 'typical' capital project, with a negative cash flow at the start of the project, and
positive net cash flows afterwards up to the end of the project, we could draw a graph of the project's NPV
at different costs of capital. It would look like this.
If we determine a cost of capital where the NPV is (slightly) positive, and another cost of capital
where it is (slightly) negative, we can estimate the IRR – where the NPV is zero – by drawing a
straight line between the two points on the graph that we have calculated.
 If we establish the NPVs at the two points P, we would estimate the IRR to be at point A.
 If we establish the NPVs at the two points Q, we would estimate the IRR to be at point B.
The closer our NPVs are to zero, the closer our estimate will be to the true IRR.
The interpolation method assumes that the NPV rises in linear fashion between the two NPVs
close to zero. The real rate of return is therefore assumed to be on a straight line between the two
points at which the NPV is calculated.
The IRR interpolation formula to apply is:
 P 
IRR  A    (B  A) %
P  N 
where A is the (lower) rate of return with a positive NPV
B is the (higher) rate of return with a negative NPV
P is the value of the positive NPV
N is the absolute value of the negative NPV
Worked example: The IRR method and interpolation

A company is trying to decide whether to buy a machine for CU80,000 which will save costs of CU20,000
per annum for five years and which will have a resale value of CU10,000 at the end of year 5.
Requirement
If it is the company's policy to undertake projects only if they are expected to yield a DCF return of 10% or
more, ascertain using the IRR method whether this project should be undertaken.
Solution
The first step is to calculate two net present values, both as close as possible to zero, using rates for the
cost of capital which are whole numbers. One NPV should be positive and the other negative.
Choosing rates for the cost of capital which will give an NPV close to zero (that is, rates which
are close to the actual rate of return) is a hit-and-miss exercise, and several attempts may be needed to find
satisfactory rates. As a rough guide, try starting at a return figure which is about two thirds or
three quarters of the ARR.
Annual depreciation would be CU(80,000 – 10,000)/5 = CU14,000.
The ARR would be (CU20,000  depreciation of CU14,000)/(½ of CU(80,000 + 10,000)) =
CU6,000/CU45,000 = 13.3%.
Two thirds of this is 8.9% and so we can start by trying 9%. The discounted tables do not provide discount
factors for an interest rate of 9% therefore we need to calculate our own factors.
Using the formula provided at the top of the final column in the tables
1 1 
PV of an annuity = 1 
r  (1 r) n 
1  1 
PV factor for 5 years at 9% = 1  
0.09  (1.09)5 
= 3.89
1
PV factor at 9% for year 5 =
(1.09)5
= 0.65
We can use these factors to discount the cash flows.
Try 9% Year Cash flow PV factor PV of cash flow
CU 9% CU
0 (80,000) 1.00 (80,000)
1–5 20,000 3.89 77,800
5 10,000 0.65 6,500
NPV 4,300
This is fairly close to zero. It is also positive, which means that the internal rate of return is more
than 9%. We can use 9% as one of our two NPVs close to zero, although for greater accuracy, we should
try 10% or even 11% to find an NPV even closer to zero if we can. As a guess, it might be worth trying 12%
next, to see what the NPV is. Again we will need to calculate our own discount factors.
1  1 
PV factor for 5 years at 12% = 1 
0.12  (1.12)5 
= 3.605
1
PV factor at 12% for year 5 =
(1.12)5
= 0.567
Try 12% Year Cash flow PV factor PV of cash flow
CU 12% CU
0 (80,000) 1.000 (80,000)
1–5 20,000 3.605 72,100
5 10,000 0.567 5,670
NPV (2,230)
This is fairly close to zero and negative. The internal rate of return is therefore greater than 9%
(positive NPV of CU4,300) but less than 12% (negative NPV of CU2,230).
Note. If the first NPV is positive, choose a higher rate for the next calculation to get a negative
NPV. If the first NPV is negative, choose a lower rate for the next calculation.
 4,300 
So IRR = 9 +   (12  9)% = 10.98%, say 11%
 4,300  2,230 
If it is company policy to undertake investments which are expected to yield 10% or more, this project
would be undertaken. An alternative approach would be to calculate the NPV at 10%. As it would be
positive it would tell us that the IRR is greater than 10% and therefore the project should be accepted.
Interactive question 4: IRR [Difficulty level: Intermediate]

Calculate the IRR of the project below and complete the box at the end of the question.
Time CU
0 Investment (4,000)
1 Receipts 1,200
2 Receipts 1,410
3 Receipts 1,875
4 Receipts 1,150
The project IRR is %

5.4 NPV and IRR compared

The IRR method has a number of advantages and disadvantages when compared with the NPV method.
5.4.1 Advantages of IRR method

 The main advantage is that the information it provides is more easily understood by managers,
especially non-financial managers. 'The project will be expected to have an initial capital outlay of
CU100,000, and to earn a yield of 25%. This is in excess of the target yield of 15% for investments' is
easier to understand than 'The project will cost CU100,000 and have an NPV of CU30,000 when
discounted at the minimum required rate of 15%'.
 A discount rate does not have to be specified before the IRR can be calculated. A hurdle
discount rate is simply required which is then compared with the IRR.
5.4.2 Disadvantages of IRR method

 If managers were given information about both ARR and IRR, it might be easy to get their relative
meaning and significance mixed up.
 It ignores the relative size of investments. Both projects below have an IRR of 18%.
Project A Project B
CU CU
Cost, year 0 350,000 35,000
Annual savings, years 1–6 100,000 10,000
Clearly, project A is bigger (ten times as big) and so more 'profitable' but if the only information on
which the projects were judged were to be their IRR of 18%, project B would be made to seem just as
beneficial as project A, which is not the case.
 When discount rates are expected to differ over the life of the project, such variations
can be incorporated easily into NPV calculations, but not into IRR calculations.
 There are problems with using the IRR when the project has non-conventional cash flows (see
Section 5.5) or when deciding between mutually exclusive projects (see section 5.6).
5.5 Non-conventional cash flows

The projects we have considered so far have had conventional or normal cash flows (an initial cash
outflow followed by a series of inflows) and in such circumstances the NPV and IRR methods give the
same accept or reject decision. When flows vary from this they are termed non-conventional. The following
project has non-conventional cash flows.
Year Project X
CU'000
0 (1,900)
1 4,590
2 (2,735)
Project X has two IRRs as shown by the diagram which follows.
NPV
£’000 40
30
20
Positive
10
0
Cost of
5 10 20 30 40 capital %
-10
Negative
-20
-30
-40
Suppose that the required rate of return on project X is 10% but that the IRR of 7% is used to decide
whether to accept or reject the project. The project would be rejected since it appears that it can only
yield 7%. The diagram shows, however, that between rates of 7% and 35% the project should be
accepted. Using the IRR of 35% would produce the correct decision to accept the project. Lack of
knowledge of multiple IRRs could therefore lead to serious errors in the decision of whether to
accept or reject a project.
In general, if the sign of the net cash flow changes in successive periods (inflow to outflow or vice versa), it is
possible for the calculations to produce up to as many IRRs as there are sign changes.
The use of the IRR is therefore not recommended in circumstances in which there are non-
conventional cash flow patterns (unless the decision maker is aware of the existence of multiple IRRs).
The NPV method, on the other hand, gives clear, unambiguous results whatever the cash flow pattern.
Before moving on to the worked example you might like to check that the IRRs of project X are indeed 7%
and 35%. Apply the relevant discount factors to the project cash flows and on both occasions you should
arrive at an NPV of approximately zero.
Worked example: Sketching an NPV graph with non-conventional cash flows

Two projects have estimated cash flows as follows.
Year 0 Year 1 Year 2 IRR
CU CU CU
Project C (4,000) 25,000 (25,000) 25% & 400%
Project D 1,000 (1,600) 1,200 –
To clear up the confusion about whether the projects are acceptable when using IRR draw a graph. To find
the starting point on the vertical axis find the NPV at 0% (ie add up the cash flows).
NPV +
600 D
Discount rate
0%
25% 400%
NPV –
4,000
Project C is acceptable for discount rates between 25% and 400%.

The graph for project D starts at +600 on the vertical axis (the NPV at 0% = the sum of the cash flows).
The graph does not cut the horizontal axis at all because there is no IRR. Therefore, the IRR decision rule
cannot be used for project D.
5.6 Mutually exclusive projects

The IRR and NPV methods can give conflicting rankings when assessing which project should be given
priority. Let us suppose that a company with a cost of capital of 16% is considering two mutually exclusive
options, option A and option B. The cash flows for each are as follows.
Year Option A Option B
CU CU
0 Capital outlay (10,200) (35,250)
1 Net cash inflow 6,000 18,000
1
The NPV of each project is calculated below. Use the formula to calculate the discount factors.
(1 r) n
Option A Option B
Year Discount factor Cash flow Present value Cash flow Present value
16% CU CU CU CU
0 1.000 (10,200) (10,200) (35,250) (35,250)
1 0.862 6,000 5,172 18,000 15,516
2 0.743 5,000 3,715 15,000 11,145
3 0.641 3,000 1,923 15,000 9,615
NPV = + 610 NPV = + 1,026
The IRR of option A is 20%, while the IRR of option B is only 18% (workings not shown).
On a comparison of NPVs, option B would be preferred, but on a comparison of IRRs, option
A would be preferred.
The preference should go to option B because with the higher NPV it creates more wealth than
option A.
Interactive question 5: Sketching NPV profiles [Difficulty level: Intermediate]

Use the working table below to deduce the data required to sketch the NPV profiles of projects A and B
on the scales provided. At what discount rate do the two projects earn the same NPV?
Cash flows NPV at NPV at NPV at

Project Year 0 Year 1 IRR 0% 10% 30%
CU CU CU CU CU
A (1,000) 1,250 25%
B (100) 140 40%
Sketch of the NPV profiles
NPV
250
200
100
0
10 20 30 40 50 Discount
rate %
-50
See Answer at the ends of this chapter.
5.7 Reinvestment assumption

An assumption underlying the NPV method is that any net cash inflows generated during the life of the
project will be reinvested elsewhere at the cost of capital (that is, the discount rate). The IRR
method, on the other hand, assumes these cash flows can be reinvested elsewhere to earn a return
equal to the IRR of the original project. In the example in section 5.6, the NPV method assumes that
the cash inflows of CU6,000, CU5,000 and CU3,000 for option A will be reinvested at the cost of capital of
16% whereas the IRR method assumes they will be reinvested at 20%. If the IRR is considerably higher than
the cost of capital this is an unlikely assumption. In theory, a firm will have accepted all projects which
provide a return in excess of the cost of capital and any other funds which become available can only be
reinvested at the cost of capital. (This is the assumption implied in the NPV rule.) If the assumption is not
valid the IRR method overestimates the real return.
Summary
Investment appraisal
Discounted cash Non-discounting

flow techniques techniques
Discounted
Allowing for the
payback Accounting
time value of money Payback
period rate of
method return (ARR)
Net present Internal rate Uses

value (NPV) of return (IRR) Uses cash accounting
flows profits
Inconsistency between
NPV and IRR as
decision tools
Superiority of NPV
Self-test
1 The payback period takes some account of the time value of money by
A Placing greatest value on CU1 receivable in the first year and progressively less on CU1 received
in each subsequent year
B Placing least value on CU1 receivable in the first year and progressively more on CU1 received in
each subsequent year
C Placing the same value on CU1 receivable up to the payback period and no value on subsequent
receipts
D Placing the same value on each CU1 receivable over the life of a project
2 A project has the following cash flows.

Year CU
0 (40,000)
1 15,000
2 15,000
3 15,000
4 15,000
If the company were to discover that the cash inflow in year 4 had been overestimated, what would be
the effect on the project’s internal rate of return (IRR) and payback period if the error were
corrected?
IRR Payback period
A Decrease No change
B Decrease Increase
C Increase No change
D Increase Increase
3 A project requires an initial investment in equipment of CU100,000 and will produce eight equal
annual cash flows of CU40,000. The investment has no scrap value and straight line depreciation is
used.
What are the payback period and accounting rate of return (ARR), based on the initial investment?
Payback ARR
A 2 years 6 months 27.5%

B 2 years 6 months 40%
C 3 years 6 months 27.5%
D 3 years 6 months 40%
4 CU50,000 is to be spent on a machine having a life of five years and a residual value of CU5,000.
Operating cash inflows will be the same each year, except for year 1 when the figure will be CU6,000.
The accounting rate of return on the initial investment has been calculated at 30% pa.
What is the payback period?
A 2.75 years
B 2.55 years
C 2.54 years
D 2.33 years
5 A firm has two projects available. Project 1 has two internal rates of return of 15% and 30%, and
project 2 has two internal rates of return of 10% and 20%. At a zero discount rate project 1 has a
positive NPV and project 2 has a negative NPV. The appropriate discount rate for both projects is
25%.
Which of the following decisions about projects 1 and 2 should be taken?
Project 1 Project 2
A Accept Accept
B Accept Reject
C Reject Accept
D Reject Reject
6 A project has a normal pattern of cash flows (ie an initial outflow followed by several years of inflows).
What would be the effects of an increase in the company’s cost of capital on the internal rate of
return (IRR) of the project and its payback period?
IRR Payback period
A Increase Increase
B Increase No change
C No change Increase
D No change No change
7 Which two of the following statements in relation to the use of IRR as an investment appraisal method
are incorrect?
A It always establishes if a single project is worthwhile
B It always establishes which of several projects to accept
C It ignores the relative size of the investment
8 Consider the following graph.
Which of the following statements is true?

A Project Y has a higher internal rate of return than project X
B At a discount rate of less than 15%, project Y is preferred to project X
C Project X is preferred to project Y irrespective of the discount rate
D Project Y is preferred to project X irrespective of the discount rate
9 A firm is evaluating the following four mutually-exclusive projects. All four projects involve the same
initial outlay and have positive net present values. The projects generate the following cash inflows
during their lives:
Year 1 Year 2 Year 3 Year 4
CU CU CU CU
Project A 500 400 600 300
Project B 300 600 500 400
Project C 500 300 600 400
Project D 300 500 600 400
Which project should be chosen?
A Project A
B Project B
C Project C
D Project D
10 An investment of CU100,000 now is expected to generate equal annual cash flows to perpetuity of
CU15,000 pa, commencing in five years’ time.
If the discount rate is 10% pa, what is the net present value of the investment (to the nearest CU10)?
A – CU15,330
B – CU6,860
C + CU2,450
D + CU50,000
1 C Statement A describes how DCF methods account for the time of money. Statement B is the
reverse of statement A and is incorrect because it is not taking account of the time value of
money at all.
Statement D is incorrect because the payback method ignores cash flows after the payback
period.
2 A The payback period is not affected because the year 4 cash flow occurs after the payback period,
however the IRR would be reduced because of the lower cash inflow in year 4.
CU100,000
3 A Payback period =
CU40,000
= 2.5 years
CU100,000
Annual depreciation =
8
= CU12,500
Annual profit = CU40,000 – CU12,500
= CU27,500
CU27,500
ARR =  100%
CU100,000
= 27.5%
Average profit
4 C ARR =  100
Initial investment
0.3 = Average profit

CU50,000
Average profit = 0.3  CU50,000
= CU15,000
Total profit for five years = 5  CU15,000
= CU75,000
Total cash inflows equals total
profit plus total depreciation = CU(75,000 + 45,000)
= CU120,000
Cash inflow for year 1 = CU6,000
Cash flow, years 2 to 5 = CU114,000
Annual inflow, years 2 to 5 = CU28,500
CU(50,000 - 6,000)
Payback period = 1+
CU28,500
= 2.54 years
5 D The NPV profiles can be sketched as follows.
At a discount rate of 25%, both projects have a negative NPV therefore they should be rejected.
6 D Both the internal rate of return and the payback period are independent of the cost of capital.
7 A, B
A is not true because IRR cannot be used to assess projects that do not have an IRR
B is not true because NPV is used for mutually exclusive projects
8 A Statement A is correct because the NPV profile of project Y crosses the horizontal axis at a
higher discount rate than that for project X.
Statement B is incorrect because at discount rates less than 15% project X has a higher NPV and
is therefore preferred.
Statements C and D are incorrect because at discount rates less than 15% project X is preferred,
whereas at rates greater than 15% project Y is preferred.
9 A By a comparison of the cash flows A is better than C (it gives the same inflows in year 1 and year
3, but returns CU100 higher in year 2 and CU100 lower in year 4).
B is also better than D (same flows in years 1 and 4, but returns CU100 more in year 2, and
CU100 less in year 3).
By a similar argument A is better than B; therefore A is the preferred project.
 CU15,000   0.683 (year 4 factor at 10%) = CU2,450

10 C – CU100,000 +  
 0.1 

The equipment that should be purchased is item X .
Item X Item Y
CU CU
Total profit over life of equipment:
before depreciation 160,000 280,000
after depreciation 80,000 130,000
Average annual accounting profit 16,000 26,000
Average investment = (capital cost + disposal value)/2 60,000 100,000
ARR, based on average investment 26.7% 26%

Both projects would earn a return in excess of 25%, but since item X would earn a bigger ARR, it
would be preferred to item Y, even though the profits from Y would be higher by an average of
CU10,000 a year.

Multiplied by 12%
Year Cash flow CU Present value CU
discount factor
1 = 0.797
2 40,000 31,880
(1.12)2
1 = 0.712
3 30,000 21,360
(1.12)3
Total present value 53,240

Present value
Year Cash flow CU 16.5% discount factor
CU
0 (280,000) 1.00 (280,000)
1 = 0.86
1 149,000 128,140
(1.165)
1 = 0.74
2 128,000 94,720
(1.165)2
1 = 0.63
3 84,000 52,920
(1.165)3
1 = 0.54
4 70,000 37,800
(1.165) 4
Net present value 33,580
The project IRR is 15% .

The total receipts are CU5,635 giving a total profit of CU1,635 and average profits of CU409. The
average investment is CU2,000. The ARR is CU409  CU2,000 = 20%. Two thirds of the ARR is
approximately 14%. The initial estimate of the IRR that we shall try is therefore 14%.
Try 14% Try 16%
Discount Discount
Time Cash flow factor PV factor PV
CU 14% CU 16% CU
0 (4,000) 1.000 (4,000) 1.000 (4,000)
1 1,200 0.877 1,052 0.862 1,034
2 1,410 0.769 1,084 0.743 1,048
3 1,875 0.675 1,266 0.641 1,202
4 1,150 0.592 681 0.552 635
NPV 83 NPV (81)
The IRR must be less than 16%, but higher than 14%. The NPVs at these two costs of capital will be
used to estimate the IRR.
Using the interpolation formula
 83 × (16% – 14%)  = 15.01%

IRR = 14% +  83 + 81 
 
The IRR is, in fact, exactly 15%.
Cash flows NPV at NPV at NPV at

Project Year 0 Year 1 IRR 0% 10% 30%
CU CU CU CU CU
A (1,000) 1,250 25% 250 136 (38)

B (100) 140 40% 40 27 8
NPV
250
200
100
40
0
10 20 30 40 B 50 Discount
A rate %
-50
The two projects earn the same NPV at the point where the lines intersect, which is at a discount rate of
approximately 23%.
TEST PAPER
1 This test paper contains objective questions rather than short-form questions, but the level of
knowledge required corresponds with future examinations of this subject.
2 Marks are indicated at the end of each question.
3 Unless the question states otherwise, enter numerical values as whole numbers with no decimal
point.
SAMPLE PAPER: QUESTIONS
1 For each of the following industries select the appropriate method to establish the cost of products.
Process Job/contract Batch
Oil refining   
Clothing   
Car repairs   
(2.5 marks)
2 In a contract to sell a commodity the selling price is agreed between the supplier and the buyer to be
the actual costs incurred by the supplier plus a profit mark-up using a fixed percentage on actual costs.
No credit period is offered by the supplier. Which of the following best describes how the risk caused
by inflation will be allocated between the supplier and the buyer?
A The supplier and the buyer will each bear some of the inflation risk but not necessarily equally
B Only the supplier will bear the inflation risk
C Only the buyer will bear the inflation risk
D The supplier and the buyer will each bear equal amounts of the inflation risk
(2.5 marks)
3 Select the cost classification that best describes each of the following:
Fixed Variable Semi-variable
Labour paid per hour worked   

Rent of a factory   
Salary plus profit-related pay   
(2.5 marks)
4 Which two of the following statements are correct?

A Absorption unit cost information is the most reliable as a basis for pricing decisions
B A product showing a loss under absorption costing will also make a negative contribution under
marginal costing
C When closing inventory levels are higher than opening inventory levels and overheads are
constant, absorption costing gives a higher profit than marginal costing
D In a multi-product company, smaller volume products may cause a disproportionate amount of
set up overhead cost
E Marginal unit cost information is normally the most useful for external reporting purposes
(2.5 marks)
5 BB Ltd makes two products, Pye and Tan, in a factory divided into two production departments,
Machining and Assembly. Both Pye and Tan need to pass through the Machining and Assembly
departments. In order to find a fixed overhead cost per unit, the following budgeted data are relevant:
Machining Assembly
Fixed overhead costs CU120,000 CU72,000
Labour hours per unit: Pye 0.5 hours 0.20 hours
Tan 1.0 hours 0.25 hours
Budgeted production is 4,000 units of Pye and 4,000 units of Tan (8,000 units in all) and fixed
overheads are to be absorbed by reference to labour hours.
Select the value below that is the budgeted fixed overhead cost of a unit of Pye.
A CU18
B CU20
C CU24
D CU28
(2.5 marks)
6 F and G are two divisions of a company. Division F manufactures one product, Rex. Unit production
cost and the market price are as follows:
CU
Labour 16
Variable fixed overhead 8
48
Prevailing market price CU64
Product Rex is sold outside the company in a perfectly competitive market and also to division G. If
sold outside the company, Rex incurs variable selling costs of CU8 per unit.
Assuming that the total demand for Rex is more than sufficient for division F to manufacture to
capacity, select the price per unit (in round CUs) at which the company would prefer division F to
transfer Rex to division G.
A CU64
B CU56
C CU40
D CU48
(2.5 marks)
7 A company estimates indirect costs to be 40% of direct costs and it sets its selling prices to recover
the full cost plus 50%.
Select the percentage that represents the mark-up on direct costs that would give rise to the same
selling price as using the method described above.
A 90%
B 110%
C 190%
D 210% (2.5 marks)
8 The master budget for AA Ltd, a single-product firm, for the current year is as follows:
CU CU
Sales 480,000
Variable materials (20,000 tonnes at CU10 per tonne) 200,000

Variable labour 96,000
Variable overhead 48,000
Total cost (416,000)
AA Ltd has substantial excess production capacity. Late in the year a sales enquiry has been received
which will increase sales and production for the year by 25% over budget.
The extra requirement for 5,000 tonnes of material will enable the firm to purchase 7,000 tonnes at a
discount of 5% on its normal buying price. The additional 2,000 tonnes will be used to complete the
year’s budgeted production.
Select the value from the list below which represents the price that AA Ltd should charge for the
special order in order to earn the same budgeted net profit for the year of CU64,000.
A CU83,500
B CU100,500
C CU82,500
D CU101,500
(2.5 marks)
9 YZ Ltd has just completed its first year of trading. The following information has been collected from
the accounting records:
CU
Variable cost per unit
Manufacturing 6.00
Selling and administration 0.20
Fixed costs
Manufacturing 90,000
Selling and administration 22,500
Production was 75,000 units and sales were 70,000 units. The selling price was CU8 per unit
throughout the year.
Calculate the net profit for the year using absorption costing.
A CU13,500
B CU19,500
C CU21,000
D CU22,500
(2.5 marks)
10 Gabba sets up in business to clean carpets. She will charge CU30 per carpet cleaned and estimates the
direct variable and fixed costs per carpet cleaned to be CU9 and CU6 respectively. She also estimates
her variable and fixed advertising costs per carpet cleaned to be CU2 and CU3 respectively.
What is the contribution per carpet cleaned and the mark up on total costs?
Contribution Mark-up
CU %
A 21 50
B 19 100
C 10 100
D 19 50
(2.5 marks)
11 Which two of the following statements about budgeting are correct?

A A forecast is an attempt to predict what will happen
B A budget is a plan of what is intended to happen
C All budgets are prepared in financial terms
D The master budget consists of a budgeted Income Statement and a budgeted balance sheet
E A flexible budget adjusts both fixed and variable costs for the level of activity
(2.5 marks)
12 A firm that uses zero-based budgeting for its overheads has

A Zero as the starting point for budgeting the coming year's overheads
B A zero variance between budgeted and actual overhead
C An assumed sales level of zero as the starting point for budgeting the coming year's overheads
D An overhead budget of zero
(2.5 marks)
13 If an increase in inventory levels is funded by an increase in the bank overdraft, what will be the effect
on the quick (liquidity) ratio?
A Increase
B Decrease
C Remain the same
D Increase, decrease or remain the same depending on the initial size of the quick ratio
(2.5 marks)
14 The high-low method of cost estimation is useful for

A Calculating the budgeted cost for the actual activity
B Calculating the highest and lowest costs in the budget period
C Measuring the actual cost for the budgeted activity
D Predicting the range of costs expected in the budget period
(2.5 marks)
15 A company has a current ratio greater than 1:1 and a quick (liquidity) ratio less than 1:1. If the
company uses cash to reduce trade payables, how will these payments affect each of the ratios?
Ratio Increase Decrease No change
Current ratio   
Quick (liquidity) ratio   
(2.5 marks)
16 A retailing company's current assets and current liabilities comprise inventory at cost CU2,100,
receivables, cash and trade payables. Its financial ratios include the following:
Quick (liquidity) ratio 2:1
Receivables collection period 1 month
Payables payment period 1.6 months
The opening inventory, receivables and payables balances are the same as the closing balances.
Select the value that represents the closing cash in hand balance.
A CU3,100
B CU2,170
C CU1,000
D CU100
(2.5 marks)
17 ABC Ltd's projected revenue for 20X1 is CU350,000. It is forecast that 12% of sales will occur in
January and remaining sales will be equally spread among the other eleven months. All sales are on
credit. Receivables accounts are settled 50% in the month of sale, 45% in the following month, and 5%
are written off as bad debts after two months.
Select the value that represents the budgeted cash collections for March.
A CU24,500
B CU26,600
C CU28,000
D CU32,900
(2.5 marks)
18 A retail company extracts the following information from its accounts at 30 June 20X6:
CU
Average inventory 490,000
Average receivables 610,000
Average payables 340,000
Cost of sales 4,500,000
Purchases 4,660,000
Select the value that represents the number of days in the company's cash operating cycle.
A 34 days
B 44 days
C 47 days
D 51 days
(2.5 marks)
19 You are given the following budgeted cost information for LM Ltd for January.
Sales CU120,000
Unit selling price CU2
Gross profit 30% margin on sales
Opening inventory 6,000 units
Sales volumes are increasing at 20% per month and company policy is to maintain 10% of next month’s
sales volume as closing inventory.
Select the value from the list below that represents the budgeted cost of production for January.
A CU84,000
B CU85,680
C CU120,000
D CU122,400
(2.5 marks)
20 An extract from next year’s budget for a manufacturing company is shown below.
Month 3 Month 4
CU CU
Closing inventory of raw materials 22,000 12,000
The manufacturing cost of production is CU116,000 in both month 3 and month 4. Materials costs
represent 40% of manufacturing cost.
Select the budgeted material purchases for month 4 from the list below.
A CU36,400
B CU42,400
C CU46,400
D CU56,400
(2.5 marks)
21 Within decentralised organisations there may be cost centres, investment centres and profit centres.
Which of the following statements is true?
A Cost centres have a higher degree of autonomy than profit centres
B Investment centres have the highest degree of autonomy and cost centres the lowest
C Investment centres have the lowest degree of autonomy
D Profit centres have the highest degree of autonomy and cost centres the lowest
(2.5 marks)
22 A manager of a trading division of a large company has complete discretion over the purchase and use
of non-current assets and inventories. Head Office keeps a central bank account, collecting all cash
from receivables and paying all suppliers. The division is charged a management fee for these services.
The performance of the manager of the division is assessed on the basis of her controllable residual
income. The company requires a rate of return of 'R'. Using the following symbols:
Divisional non-current assets F
Divisional working capital
Receivables D
Inventory S
Payables (L)
W
Divisional net assets Z
Divisional profit P
Head office management charges (M)
Divisional net profit N
Which of the following is the correct formula for calculating the controllable residual income of the
division.
A P – [(F + S)  R]
B N – [(F+S)  R]
C N – (Z  R)
D P – (Z  R)
(2.5 marks)
23 Would each of the following actual events during the year lead to a sales volume variance being
adverse or favourable or have no impact on it?
Adverse Favourable No impact
Sales prices increased   

Successful advertising campaign   
Increased labour pay rates   
(2.5 marks)
24 When absorbing variable overheads on the basis of machine hours, the total variable overhead
variance can be ascertained by comparing actual variable overheads in a period with the product of the
absorption rate and which of the following?
A (Planned output)  (Standard machine hours per unit)
B (Actual output)  (Actual machine hours per unit)
C (Planned output)  (Actual machine hours per unit)
D (Actual output)  (Standard machine hours per unit)
(2.5 marks)
25 Which of the following sentences best describes what is necessary for a responsibility accounting
system to be successful.
A Each manager should know the criteria used for evaluating his or her own performance
B The details on the performance reports for individual managers should add up to the totals on
the report of their superior
C Each employee should receive a separate performance report
D Service department costs should be apportioned to the operating departments that use the
service
(2.5 marks)
26 A product requires raw material with a standard cost of 50p per kg. In February, 2,500 kg of raw
material were purchased at a cost of CU1,500 of which 2,300 kg of raw material were used in that
month’s production.
If raw material inventory is valued at standard cost and there was no opening inventory of raw
material, which of the following represents the material price variance for February?
A CU250 adverse
B CU230 adverse
C CU230 favourable
D CU250 favourable
(2.5 marks)
27 The following is extracted from XYZ Ltd's monthly management reporting:

Performance report for October
CU
Budgeted contribution (10,000 units) 172,000
Variances Adverse Favourable
CU CU
Labour rate 3,600
Material price 10,800
Material usage 4,800
14,400 12,800 (1,600)
Actual contribution (10,000 units) 170,400
The purchasing manager decided to buy a superior quality material that was more expensive than the
standard material for use in October. This superior material gives rise to less waste. Labour was able
to convert this superior material into the final product in less than the standard time. Also impacting
on the results, however, was a wage rise, agreed in July, which was implemented at the beginning of
October.
The decision to purchase the superior quality materials caused the profit in October to change. Select
which of the following best describes that change.
A Fall by CU1,600
B Rise by CU4,800
C Fall by CU6,000
D Rise by CU2,000
(2.5 marks)
28 The following data are available with regard to a product for a given period:
Actual Budget
Sales (units) 10,100 10,000
CU CU
Sales value 105,040 102,000
Variable costs at standard 86,860 86,000
Select the favourable sales volume variance.
A CU1,020
B CU1,040
C CU180
D CU160
(2.5 marks)
29 The following information relates to a firm's labour costs for the year:
Standard rate per hour CU2.00
Actual rate per hour CU4.00
Actual hours worked 130,000
Labour efficiency variance CU10,000 favourable
Select the value that represents the standard number of labour hours for actual output.
A 125,000 hours
B 127,500 hours
C 132,500 hours
D 135,000 hours
(2.5 marks)
30 Information concerning three divisions of JK Ltd is shown below.

Division Capital invested Return on investment
P CU1,100,000 12%
Q CU1,200,000 13%
R CU1,500,000 14%
Select the percentage that is the highest rate for the imputed cost of capital that would produce the
same ranking for these three divisions using residual income instead of return on investment.
A 11.9%
B 13.9%
C 17.9%
D 23.9%
(2.5 marks)
31 A project analyst has just completed the following evaluation of a project which has an initial cash
outflow followed by several years of cash inflows:
Internal rate of return (IRR) 15% pa
Discounted payback period (DPP) 7 years
She then realises that the company's annual cost of capital is 12% not 10% and revises her calculations.
Select the option for what will happen to each of the IRR and DPP figures when the calculations are
revised.
No change Increase Decrease
IRR   
DPP   
(2.5 marks)
32 For a project with a normal pattern of cash flows (i.e. an initial outflow followed by several years of
inflows) the internal rate of return is the interest rate that equates the present value of expected
future cash inflows to
A The project's cost of capital
B Zero
C The terminal (compounded) value of future cash receipts
D The initial cost of the investment outlay
(2.5 marks)
33 For a project with an initial cash outflow followed by a series of positive future cash inflows where the
internal rate of return is unique and the net present value is positive at the opportunity cost of capital,
indicate which of the following statements is true.
A The internal rate of return is always greater than the opportunity cost of capital
B The internal rate of return is sometimes lower than the opportunity cost of capital
C The internal rate of return is always lower than the opportunity cost of capital
D The internal rate of return is sometimes greater than the opportunity cost of capital
(2.5 marks)
34 A company has only 6,000kg of an irreplaceable raw material called Grunch. Grunch can be used to
make three possible products X, Y and Z, details of which are given below:
X Y Z
Maximum demand (units) 4,000 3,000 5,000
Constant unit selling price (CU/unit) CU3.00 CU4.00 CU5.00
Constant unit variable cost (CU/unit) CU1.50 CU2.40 CU2.60
Fixed costs (CU/unit) CU1.80 CU2.20 CU2.40
Quantity of raw material Grunch to make one unit
of product (kg) 0.30 0.40 0.80
If the company's objective is to maximise profit, which of the following production schedules should be
chosen?
X Y Z
Units Units Units
A 2,666 3,000 5,000
B 4,000 3,000 5,000
C 4,000 2,000 5,000
D 4,000 3,000 4,500
(2.5 marks)
35 A company has identified three independent projects, X, Y and Z. It has estimated the cash flows and
positive internal rates of return (IRRs) as follows:
Year Project X Project Y Project Z
CU CU CU
0 (25,000) 82,000 (50,000)
1 – (20,000) 127,500
2 – (20,000) (78,750)
3 20,000 (20,000) –
4 40,000 (20,000) –
5 (27,938) (20,000) –
IRRs 10% 7% 5% and 50%
If the three projects are of equivalent risk and the company aims to maximise shareholder wealth, at
which of the following costs of capital would all three projects be deemed to be acceptable by the
company?
A 12%
B 8%
C 6%
D 4%
(2.5 marks)
36 A company makes large plastic containers for storing chemicals. An extract from the 20X7 budget
(based on a sales volume of 10,000 units) is given below.
CU per CU per
unit unit
Selling price 200
Variable cost 80
Fixed overhead cost 20
Total cost (100)
Profit 100
Actual results for 20X7 were in line with this budget except that 12,000 units were produced and
sold.
For 20X8 all costs are expected to increase by 10%, although selling price increases are expected to
be restricted to 5%.
Select the number from the list below which represents the level of sales that must be achieved in
20X8 in order to maintain the actual profit at the 20X7 level.
A 12,400 units
B 11,639 units
C 12,000 units
D 11,967 units
(2.5 marks)
37 A company is to spend CU60,000 on a machine that will have an economic life of ten years and no
residual value. Depreciation is to be charged using the straight-line method. Estimated operating cash
flows are
Year CU
1 - 2,000
2 + 13,000
3 + 20,000
4-6 + 25,000 each year
7-10 + 30,000 each year
What is the average accounting rate of return (ARR), calculated as average annual profits divided by
the average investment?
A 75%
B 55%
C 38%
D 28%
(2.5 marks)
38 A project has an initial investment cost of CU200,000. It is expected to generate a net cash inflow of
CU20,000 at the end of its first year. This will rise to CU25,000 at the end of the second year and
remain at CU25,000 per annum in perpetuity. The relevant cost of capital is expected to be 8% in the
first year and 10% in the second and subsequent years.
Select the number that is the net present value of the project (to the nearest CU100).
A CU29,000
B CU45,800
C CU50,000
D CU68,500
(2.5 marks)
39 Next month's budget for a single product company is shown below.

CU CU
Sales of 1,200 units 600,000
Manufacturing costs:
Variable 216,000
Fixed 60,000
Selling costs:
Variable 132,000
Fixed 78,000
Administration costs (fixed) 36,000
(522,000)
Net profit 78,000
The company's variable manufacturing cost per unit is now expected to increase by 10%, but all other
costs remain unchanged.
Assuming an unchanged volume of sales, select the number below that represents the selling price per
unit that would maintain the contribution ratio.
A CU531
B CU733
C CU550
D CU518
(2.5 marks)
40 A project can be expected to generate ten annual cash inflows of CU30,000 starting immediately. The
project requires an initial cash outlay of CU150,000 and a final cash outlay at the end of ten years of
CU50,000.
If the annual cost of capital is 10%, select the number which is the net present value of the project (to
the nearest CU100).
A CU15,100
B CU23,500
C CU31,600
D CU33,500
(2.5 marks)
TEST PAPER ANSWERS
SAMPLE PAPER: ANSWERS
1 Oil refining: Process

Clothing: Batch
Car repairs: Job/contract
Explanation
Oil refining involves a continuous manufacturing process of homogeneous output and therefore is
ideally suited to process costing.
Clothing would be manufactured using batches of material, for example of a certain texture or colour.
Production would be halted before the next batch of items of a particular style is produced. The most
appropriate costing method would therefore be batch costing.
Car repair work would be very varied and each repair would be bespoke. Therefore neither process
or batch costing would be appropriate but job/contract costing would be a suitable costing method.
2 C
Explanation
Because the selling price is agreed to be the actual costs incurred by the supplier plus a profit mark-up
using a fixed percentage then any inflation adjustment to costs would also affect the selling price. The
supplier can pass on all inflation increases to the buyer and will also earn a mark-up on the cost
increase.
In this case:
The statement 'The supplier and the buyer will each bear some of the inflation risk', is incorrect as the
supplier bears no risk.
The statement 'Only the supplier will bear the inflation risk' is incorrect, as the supplier bears no risk.
The statement 'The supplier and the buyer will each bear equal amounts of the inflation risk' is also
incorrect for the same reason.
3 Labour paid per hour worked: Variable
Rent of a factory: Fixed
Salary plus profit-related pay: Semi-variable
Explanation
Labour costs will vary directly in proportion to the number of hours worked and therefore are a true
variable cost.
The factory rent will not vary even if output levels change and is therefore a fixed cost.
Salary plus profit related pay will contain a fixed element, the basic salary, plus an element that will
vary depending upon the profits of the enterprise. Therefore this will be a semi-variable cost.
4 C and D
Explanation
The statement 'Absorption unit cost information is the most reliable as a basis for pricing decisions' is not
true because short term changes in activity levels can result in unit costs being artificially high or low,
because overheads will be absorbed over the unrepresentative number of units. This could make
prices set using this cost basis artificially high or low.
The statement 'A product showing a loss under absorption costing will also make a negative contribution
under marginal costing' is not true because a product could earn a contribution under marginal costing
which then becomes a gross loss under absorption costing only because of the increase in cost from
absorbing overheads.
The statement 'Marginal unit cost information is normally the most useful for external reporting purposes' is
not true because external reporting will need to take account of unit costs right across an operation
not just unit costs when incremental (marginal) changes in activity levels are made.
The statement 'When closing inventory levels are higher than opening inventory levels and overheads are
constant, absorption costing gives a higher profit than marginal costing' is true because an increase in
inventory levels will mean that with absorption costing more overhead is being carried forward at the
end of the period than at the start of the period. This means that overheads charged against profit in
the period would be lower than under marginal costing thereby increasing the reported profit.
The statement 'In a multi-product company, smaller volume products may cause a disproportionate amount
of set up overhead cost' is true because overheads would normally be apportioned based on the time a
product spends on the production line. For smaller volume products the time taken to set up the
product run becomes a larger proportion of the total time spent in production than for higher volume
products.
5 A
Explanation
Number of hours in Machining are:
Hours
Pye 4,000  0.5 = 2,000
Tan 4,000  1.0 = 4,000
6,000
Total machining overhead is CU120,000 or CU120,000/6,000 per hour = CU20 per hour
Machining overhead cost of a unit of Pye is CU20  0.5 = CU10
Number of hours in Assembly are:
Hours
Pye 4,000 x 0.20 = 800
Tan 4,000 x 0.25 = 1,000
1,800
Total Assembly overhead is CU72,000 or CU72,000/1,800 per hour = CU40 per hour
Assembly overhead cost of a unit of Pye is CU40  0.2 = CU8
Total overhead cost of a unit of Pye is therefore CU10 (Machining) + CU8 (Assembly) = CU18
If you calculated CU20 you incorrectly either just used the total Machining overhead per hour or
added together the Machining overhead cost of a Pye and the Assembly overhead cost of a Tan.
If you calculated CU28 you incorrectly added together the Machining overhead cost of a Tan and the
Assembly overhead cost of a Pye.
CU24 was just an incorrect answer.
6 B
Explanation
Because the demand for Rex is more than sufficient for division F to manufacture to capacity, the price
that the product should be transferred to G division should represent the same profit margin as if the
product were sold externally. The external selling price is CU64 but if an external sale is made then
additional selling overhead of CU8 would be incurred. The net transfer price is therefore CU56.
The CU64 price doesn’t reflect the saving in selling costs. CU40 and CU48 give lower profit margins
for the producing division F, hence they would want to sell outside.
7 B
Explanation
If it is assumed that the direct cost of the product is CU100, then the indirect costs would be CU40
and the total cost CU140. The selling price is set to recover the full cost (CU140) plus 50%, ie plus
CU70. This makes the selling price CU210 (CU140 + CU70).
The mark-up on direct costs is therefore CU210 (selling price) less CU100 (direct cost) = CU110.
The percentage mark-up is therefore CU110/CU100 = 110%
If you calculated the mark up as 210% you probably calculated the selling price (CU210) as a
percentage of the direct cost in error.
If you calculated the mark up as 190% or 110% you probably made calculating errors.
8 C
Explanation
The total sales will use 25,000 tonnes of material, at a cost of:
(18,000  CU10) + (7,000  CU10  95%) =
(CU180,000) + (CU70,000  95%) =
CU246,500
The variable labour and overhead cost for this level of production would increase to:
(CU96,000 + CU48,000)  125% =
CU144,000  125% =
CU180,000
The fixed costs remain at CU72,000
Total costs are therefore (CU246,500 + CU180,000 + CU72,000) = CU498,500
The requirement is to earn the same budget profit of CU64,000. This means the total required sales
income will be (CU498,500 + CU64,000) = CU562,500.
The sales revenue without the extra order is CU480,000 and therefore the revenue to be generated
from the extra order is (CU562,500 – CU480,000) = CU82,500.
If you calculated the answer as CU100,500 then you probably incorrectly increased the fixed costs by
25% as well, from CU72,000 to CU90,000, meaning an extra CU18,000 would need to be recovered
through the selling price.
If you calculated the answer as either CU83,500 or CU101,500 then you either followed the correct
logic or the incorrect logic set out above, and also made an arithmetical error.
9 B
Explanation
The manufacturing cost per unit, on an absorption costing basis, is:
CU6.00 + (CU90,000/75,000) =
CU6.00 + CU1.20 =
CU7.20
The cost of sales is therefore 70,000 x CU7.20 = CU504,000
The sales revenue is 70,000  CU8 = CU560,000
The profit before selling and administration costs is therefore: CU560,000 – CU504,000 = CU56,000
The selling and administration costs are: (70,000  CU0.20) + CU22,500 = CU36,500
The net profit is therefore CU56,000 – CU36,500 = CU19,500

If you calculated the profit as CU13,500 then you calculated the net profit using marginal costing.
Total variable costs on this basis would be 70,000  CU6.20 = CU434,000 and total overheads
CU90,000 + CU22,500 = CU112,500. The net profit would therefore (incorrectly) be calculated as
CU560,000 – CU434,000 – CU112,500 = CU13,500
If you calculated the net profit as CU21,000 or CU22,500 then you probably followed the right
method but made an arithmetical error.
10 D
Explanation
The contribution is selling price less variable costs only. The variable costs are CU9 + CU2 = CU11
The contribution is therefore CU30 (selling price) – CU11 = CU19
The percentage mark-up on total cost is the profit as a percentage of total costs. The total costs per
unit are CU9 + CU6 + CU2 + CU3 = CU20. The profit is therefore CU30 – CU20 = CU10 and
the mark up % is CU10/CU20 = 50%.
If you incorrectly calculated the contribution as CU21 then you ignored the variable advertising costs
in error.
If you incorrectly calculated the contribution as CU10 then you deducted all costs from the selling
price rather than just the variable costs.
If you correctly calculated the contribution as CU19 but incorrectly calculated the mark up % as 100%
then you incorrectly used the cost value of CU20 as the numerator, rather than the profit of CU10.
11 A and B
Explanation
A forecast is a prediction by management of the expected outcome whereas a budget represents a set
of targets of what management intend to happen. A budget is usually set just once a year whereas
forecasts and re-forecasts can be carried out much more frequently.
The statement 'All budgets are prepared in financial terms' is incorrect as often a budget could include,
for example, tonnage of raw material needed or quantity (in units) of finished product.
The statement 'The master budget consists of a budgeted Income Statement and a budgeted balance sheet'
is incorrect as a master budget would also contain a cash flow budget.
The statement 'A flexible budget adjusts both fixed and variable costs for the level of activity' is incorrect as
a flexible budget adjusts just variable costs for the level of activity and not fixed costs.
12 A
Explanation
Zero-based budgeting, by its very definition, starts from zero and is built upwards.
The statement 'a zero variance between budgeted and actual overhead' is incorrect as this merely refers
to the comparison of actual performance with budgeted performance.
The statement 'an assumed sales level of zero as the starting point for budgeting the coming year's
overheads' is a meaningless statement as an overhead budget would be based on budgeted sales not
zero sales.
The statement 'an overhead budget of zero' is incorrect.
13 B
Explanation
The quick (liquidity) ratio is current assets (excluding inventory) divided by current liabilities. As
inventory is excluded from the ratio any change in inventory levels would have no effect on the ratio
unless either other current assets (such as cash at bank) or current liabilities are also affected. If
inventory levels are increased by an increase in the bank overdraft then the denominator of the ratio
would increase, reducing the ratio itself. This will always be the case regardless of the relative values
of current assets and current liabilities.
It is worth noting that if inventory levels are increased by reducing the cash at bank balance then the
quick ratio would again decrease.
14 A
Explanation
The high-low method of cost estimation is a method of linear extrapolation or interpolation between
two actual data points. It is a method for flexing a budget by calculating the budgeted cost for the
actual activity.
The high-low method uses the highest and lowest costs in the budget period for the extrapolation
process itself.
The measurement of actual cost for the budgeted activity is irrelevant.
The high-low method estimates a single cost at a certain level of activity and not a range of costs.
15 Current ratio increases, quick ratio decreases
Explanation
The current ratio is current assets divided by current liabilities. If cash is used to reduce trade
payables then both the numerator and denominator will reduce. As the current ratio is greater than
1:1 the numerator is larger than the denominator. This means that the same absolute change to the
numerator would represent a larger proportionate change to the denominator than the numerator,
thereby reducing the ratio.
The quick ratio is current assets (excluding inventory) divided by current liabilities. If cash is used to
reduce trade payables then both the numerator and denominator will reduce. As the quick ratio is
less than 1:1 the denominator is larger than the numerator. This means that the same absolute change
to the numerator would represent a smaller proportionate change to the denominator than the
numerator, thereby increasing the ratio.
16 A
Explanation
The inventory value is CU2,100. The rate of inventory turnover is 10 times p.a., therefore the annual
cost of sales is CU21,000 (we are told opening inventory equals closing inventory). The gross profit
margin is 30% which means annual sales are CU21,000/0.7 = CU30,000.
The receivables collection period is 1 month, which means closing receivables are CU30,000/12 =
CU2,500.
The payables payment period is 1.6 months, which means closing payables are CU21,000/12  1.6 =
CU2,800.
The quick ratio is 2:1 which means current assets (excluding inventory) are CU2,800  2 = CU5,600.
As receivables are CU2,500 the cash balance must be (CU5,600 – CU2,500) = CU3,100.
If you calculated incorrectly the cash balance as CU1,000 then you probably incorrectly calculated
closing payables as CU21,000/12 = CU1,750 which would mean current assets (excluding inventory)
of CU3,500 and cash of (CU3,500 – CU2,500) = CU1,000.
If you calculated incorrectly the cash balance as CU100 then you probably incorrectly calculated
closing receivables as CU2,100/12/0.7 = CU250 and closing payables as CU2,100/12 = CU175 and
therefore current assets (excluding inventory) of CU350.
17 B
Explanation
January sales are CU350,000  12% = CU42,000. Sales in each of the other months are (CU350,000
– CU42,000)/11 = CU28,000.
March cash collections will be:
50% of March sales = CU28,000  50% = CU14,000
45% of February sales = CU28,000  45% = CU12,600
Total = (CU14,000 + CU12,600) = CU26,600
If you incorrectly calculated the cash collections in March as CU28,000 then you probably calculated
collections using 50% on both March and February sales.
If you incorrectly calculated the cash collections in March as CU32,900 then you probably used
January sales of CU42,000  45% and February sales of CU28,000  50% in error.
18 C
Explanation
The company’s cash operating cycle is calculated as:
(Inventory days + receivables days – payables days)
Inventory days = CU490,000/CU4,500,000  365 = 39.7 days
Receivables days = CU610,000/(CU4,500,000/0.68)  365 = 33.6 days
Payables days = CU340,000/CU4,660,000  365 = 26.6 days
Note: The cost of sales value is used for the inventory days and also to calculate sales (using the gross
margin of 32%). However, the purchases figure is used to calculate the payables days.
The answer is therefore (39.7 + 33.6 – 26.6) days = 46.7 days (rounded to 47).
If you incorrectly calculated the answer as 34 days then you probably rounded up the inventory days
to 40 days, added the payables days in error (also rounded up at 27 days) and then deducted the
receivables days (rounded down to 33 days).
If you incorrectly calculated the answer as 44 days then you probably used the purchases figure of
CU4,660,000 in the calculations for inventory days and receivables days rather than the cost of sales
figure.
If you incorrectly calculated the answer as 51 days you probably calculated the inventory days and
payables days correctly but used the wrong gross margin to calculate the sales figure in the receivables
days formula (using 22% margin rather than 32%).
19 B
Explanation
As sales are increasing at 20% per month the expected sales for February are CU120,000  120% =
CU144,000. As the gross margin is 30% on sales the cost of sales for February is expected to be
CU144,000  70% = CU100,800.
The company policy is to maintain closing inventory at 10% of the expected next month’s sales. The
closing inventory for January is therefore CU10,080. The cost of a unit is CU2  70% = CU1.40,
meaning the closing inventory for January is CU10,080/CU1.40 = 7,200 units.
The budgeted cost of production for January would therefore need to cover January sales
(CU120,000/CU2 units = 60,000 units) plus an increase in inventory from 6,000 to 7,200 units, ie a
total of 61,200 units. This is a cost of 61,200  CU1.40 = CU85,680.
If you incorrectly calculated the cost of production as CU84,000 then you calculated the production
volume as 60,000 units (the number sold in January) and did not allow for an increase in inventory
levels.
If you incorrectly calculated the cost of production as CU120,000 then you again calculated the
production volume as 60,000 units in error and made a further error in valuing this volume at the
selling price of CU2 per unit rather than the cost price.
If you incorrectly calculated the cost of production as CU122,400 then you correctly calculated the
production volume as 61,200 units but in error valued this volume at the selling price of CU2 per unit
rather than the cost price.
20 A
Explanation
Month 4 materials cost included within cost of sales is CU116,000  40% = CU46,400. Inventory of
materials are budgeted to reduce from CU22,000 to CU12,000 and therefore budgeted materials
purchased in the month would be (CU46,400 + CU12,000 – CU22,000) = CU36,400.
CU46,400 (or above) represent the materials cost of sales rather than purchases CU46,400 -
CU12,000 + CU22,000 = CU56,400 incorrectly deducts closing stock and adds the opening. 40%
(CU116,000 + CU12,000 - (-22,000) = CU42,400 incorrectly applies the 40% adjustment to the
materials inventory figures.
21 B
Explanation
Cost centres have the lowest degree of autonomy with managers only able to control costs. Profit
centres have a higher degree of autonomy as managers can not only control costs but can also control
sales prices and revenue. Investment centres have the highest degree of autonomy as managers can
not only control costs and revenues but can also make investment decisions not open to managers in
either of the other two centres.
22 A
Explanation
Controllable residual income is defined as controllable profit less the 'cost of capital' utilised in the
business, to the extent that capital is controllable.
Controllable profit is not N (as management cannot control the head office management charges) but
is P.
The cost of capital will be R multiplied by the controllable capital. As head office collects cash from
receivables and pays suppliers then D and L do not form part of controllable capital. The division has
complete control over non-current assets (F) and inventory (S) and therefore controllable capital is
(F + S). The 'cost of capital' is therefore (F + S)  R.
The controllable residual income is therefore P – [(F + S)  R]
If you selected the formula N – [(F + S)  R] then you correctly excluded the non-controllable
receivables and payables balances but you included the non-controllable head office management
charges.
If you selected the formula P – (Z  R) then you incorrectly included the non-controllable receivables
and payables balances.
If you selected the formula N – (Z  R) then as well as incorrectly including the non-controllable
receivables and payables balances you included the non-controllable head office management charges.
23 Sales prices increased: Adverse

Successful advertising campaign: Favourable
Increased labour pay rates: No impact
Explanation
If sales prices were increased then market theory would predict a reduction in sales volumes as
potential purchasers switch to less expensive alternative products.
If an advertising campaign were successful then it would encourage potential purchasers to try the
product and therefore an increase in sales volumes would be expected.
If labour pay rates increased then this would have no impact on sales volumes unless the increase in
costs were passed on by an increase in the sales price, which is not the case here.
24 D
Explanation
Absorption costing always uses the budgeted (or standard) production time, as flexed by the actual
output in a period. This means that the actual output is multiplied by the standard machine hours
per unit in order to establish a flexed budget of machine hours for the actual production. The value of
overheads absorbed would therefore be the absorption rate multiplied by this flexed budget.
If you selected (planned output)  (standard machine hours per unit) then the result would be the
budgeted level of absorbed overhead rather than the actual absorbed overhead.
If you selected (actual output)  (actual machine hours per unit) then the result would include any
production efficiencies or inefficiencies in the actual machine hours and this would result in an
incorrect calculation of absorbed overhead.
If you selected (planned output)  (actual machine hours per unit) then you have reversed the
selections you should have made.
25 A
Explanation
Under a responsibility accounting system it is imperative that each manager knows what is expected of
him/her. The criteria used for evaluation of his/her performance must therefore be known.
The statement 'The details on the performance reports for individual managers should add up to the
totals on the report of their superior' is not necessarily true and is certainly not required for a
responsibility accounting system.
The statement 'Each employee should receive a separate performance report' represents best practice
but this is not a feature of a responsibility accounting system.
The statement 'Service department costs should be apportioned to the operating departments that
use the service' is true but relates to a method of cost apportionment and is irrelevant when
considering a responsibility accounting system.
26 A
Explanation
The cost of material purchased was CU1,500 / 2,500 per kg, or 60p per kg. The standard cost is 50p
per kg, an adverse variance of 10p per kg. In February a total of 2,500 kg were purchased of which
2,300 kg were used and as there was no opening inventory 200 kg was left in closing inventory. If
inventory were valued at actual cost then some of the adverse price variance would be carried
forward in inventory. However, we are told that inventory is valued at standard cost and therefore
the closing stock is valued at 50p per kg. This means that the whole of the price variance (2,500 kg x
10p = CU250) would be included in the February results. This variance is adverse as the price paid
for the material was higher than the standard.
If you selected CU230 adverse then you had ignored the fact that the inventory is valued at standard
cost.
If you selected CU230 favourable then you had ignored the fact that the inventory is valued at
standard cost and also misinterpreted the additional cost of the material to be a favourable variance.
If you selected CU250 favourable then you correctly calculated the variance but made the mistake of
thinking that the additional cost of the material was a favourable variance. An additional cost will
always be adverse whereas additional revenue will be favourable.
27 D
Explanation
The first important consideration is to ignore the effect of the wage rise, because this did not arise
because of the decision to procure the superior quality material. The adverse labour rate variance
should therefore be discounted.
The favourable material usage variance arose because the superior material generated less waste.
However, the superior material was more expensive leading to the adverse material price variance,
and also could be converted by the workforce more efficiently, leading to the favourable labour
efficiency variance.
The answer is therefore 8,000F + 4,800F – 10,800A = 2,000F. A favourable cost variance means that
profits will rise.
If you selected a rise of CU4,800 then you incorrectly ignored the labour efficiency and material price
variances.
If you selected a fall of CU1,600 then you incorrectly also included the adverse labour rate variance of
CU3,600.
If you selected a fall of CU6,000 then you included the material price and usage variances but
incorrectly ignored the favourable labour efficiency variance.
28 D
Explanation
The sales volume variance is defined as variance in sales volume x the budgeted unit contribution.
The volume variance is 100 units favourable.
The budgeted contribution was:
CU16,000/10,000 = CU1.60 per unit
The favourable sales volume variance is therefore CU1.60  100 = CU160
If you incorrectly calculated the sales volume variance as CU180 then you used the actual
contribution per unit rather than the budgeted contribution per unit.
100 x CU10.20 = CU1,020 uses the standard selling price rather than contribution and 100 x
CU10.40 uses the actual selling price.
29 D
Explanation
The labour efficiency variance (L) is defined as the variance in labour hours (V) x the standard rate per
hour (R), or
L=VR
Or V = L/R
L = CU10,000 (positive, as it is a favourable variance)
R = CU2.00
Therefore V = CU10,000/CU2 = 5,000
The variance in labour hours is therefore 5,000 favourable meaning the actual hours taken were 5,000
lower than the standard. The actual hours were 130,000 therefore the standard hours were 130,000
+ 5,000 = 135,000
130,000 – 5,000 = 125,000 incorrectly deducts the favourable hours variance from the actual hours.
CU10,000 / CU4 = 2,500 incorrectly uses the actual rather than the standard rate of pay. 130,000 +
2,500 = 127,500 and 132,500 hours.
30 C
Explanation
Residual income is calculated by comparing the actual return with the target return using the cost of
capital. The ranking of the three divisions based on return on investment is:
P 3rd
Q 2nd
R 1st
To establish the ranking using residual income the following table is produced:
Actual return Cost of capital
using ROI At 11.9% At 13.9% At 17.9% At 23.9%
P CU132k CU130.9k CU152.9k CU196.9k CU262.9k
Q CU156k CU142.8k CU166.8k CU214.8k CU286.8k
R CU210k CU178.5k CU208.5k CU268.5k CU358.5k
The residual income at each cost of capital is calculated by subtracting the cost of capital from the
actual return:
Residual income
At 11.9% At 13.9% At 17.9% At 23.9%
P CU1.1k -CU20.9k -CU64.9k -CU130.9k
Q CU13.2k -CU10.8k -CU58.8k -CU130.8k
R CU31.5k CU1.5k -CU58.5k -CU148.5k
The ranking of the divisional projects is therefore:
Residual income
At 11.9% At 13.9% At 17.9% At 23.9%
P 3rd 3rd 3rd 2nd
Q 2nd 2nd 2nd 1st
R 1st 1st 1st 3rd
The highest cost of capital where the rankings agree to the RoI rankings is therefore 17.9%.
31 IRR: No change
DPP: Increase
Explanation
A project’s IRR is the return at which the net present value (NPV) of the cash flows is zero. The IRR
is therefore independent of a company’s cost of capital. The revision to the cost of capital by the
project analyst will therefore not impact on the IRR, hence there is no change.
A project’s DPP is the period of time taken for the project’s cumulative discounted cash flows to turn
from the initial negative outflow to a cumulative positive position. The revision to the cost of capital
from 10% to 12% will reduce each future discounted cash inflow, and therefore increase the time
taken for the cumulative discounted cash flows to become positive.
32 D
Explanation
A project’s IRR is defined as the return at which the net present value (NPV) of the cash flows is zero.
This means that for a project with a normal pattern of cash flows the internal rate of return is the
interest rate that equates the present value of expected future cash inflows to the initial cost of
the investment outlay.
A project’s cost of capital is the benchmark return that is used to evaluate the residual income of a
project.
Zero is the present value of expected future cash inflows and the initial cash outflow discounted at a
project’s IRR.
The terminal (compounded) value of future cash receipts for a project will bear no resemblance to the
present value of expected future cash inflows.
33 A
Explanation
As the net present value of the project’s cash flows is positive at the opportunity cost of capital, this
means that the project is viable and its IRR must be higher than the cost of capital.
If the internal rate of return of a project were sometimes lower than the opportunity cost of capital
then the net present value in those instances would be negative.
If the internal rate of return were always lower than the opportunity cost of capital then the net
present value would always be negative.
If the internal rate of return of a project were sometimes higher than the opportunity cost of capital
then this would imply that sometimes it would be lower.
34 D
Explanation
This question relates to limiting factor analysis. The key to these questions is ranking the contribution
per unit of the limiting factor, in this case Grunch. In this question the contribution per unit of
Grunch will be calculated pre-fixed costs, as these will be constant whatever production schedule is
chosen.
Product X: Contribution = CU1.50 and CU1.50/0.3 = CU5 contribution per unit of Grunch
Product Y: Contribution = CU1.60 and CU1.60/0.40 = CU4 contribution per unit of Grunch
Product Z: Contribution = CU2.40 and CU2.40/0.80 = CU3 contribution per unit of Grunch
The ranking of the products is therefore X, Y, Z.
The production schedule that will maximise profit will therefore be:
4,000 units of X (maximum demand), utilising 4,000 x 0.3kg of Grunch, ie 1,200kg
3,000 units of Y (maximum demand), utilising 3,000 x 0.4kg of Grunch, ie 1,200kg
This is a total of 2,400kg and therefore 3,600kg of the 6,000kg will be available to manufacture Product
Z. This will produce 3,600/0.8 units = 4,500 units.
Any other production schedule will not maximise profit.
35 B
Explanation
The best way to attempt this question is to draw graphs of the net present value of each project at
various discount rates. The IRR of each project tells us at what point the x-axis is crossed and the
number of changes in sign of the cash flows (from positive to negative or vice versa) tells us how many
changes in direction each graph will have. The starting sign for the graph can be easily established at a
discount factor of 0% by adding the cash flows up.
The graphs of net present values for Projects X, Y and Z must look like this:
y Project X
10% x
y Project Y
7% x
y Project Z
5% 50% x
The answer is 8% because at a discount factor of 8% the NPV of project X is positive (accepted),
project Y is also positive (accepted) and project Z is also positive (accepted).
Examining the other discount factors shows that:
At a discount factor of 12% the NPV of project X is negative (rejected), project Y is positive
(accepted) as is project Z.
At a discount factor of 6% the NPV of project X is positive (accepted), project Y is negative (rejected)
and project Z is positive (accepted).
At a discount factor of 4% the NPV of project X is positive (accepted), project Y is negative (rejected)
and project Z is also negative (rejected).
36 D
Explanation
The first step is to calculate the profit achieved in 20X7. Contribution is CU120 per unit and 12,000
units were produced and sold generating CU120  12,000 = CU1,440,000. Fixed costs were CU20 
10,000 (per the budget) = CU200,000 meaning the net profit was CU1,240,000.
In 20X8 the unit selling price will be CU200  1.05 = CU210. Unit variable costs will be CU80  1.1
= CU88. The unit contribution is therefore (CU210 – CU88) = CU122. In 20X8 fixed costs will be
CU200,000  1.1 = CU220,000.
Profits in 20X8 are the same as 20X7, ie CU1,240,000, meaning the contribution must be
CU1,240,000 + CU220,000 = CU1,460,000. The number of units sold to generate this contribution
will be CU1,460,000/CU122 = 11,967.
If you calculated the number of units as 12,000 then you probably incorrectly calculated the fixed costs
in 20X7 as CU20 x 12,000 = CU240,000 and the 20X7 profits as CU1,200,000. This would mean
that you calculated the 20X8 fixed costs as CU240,000  1.1 = CU264,000 and therefore the
required contribution in 20X8 as CU1,464,000. At a unit contribution of CU122 this would mean
12,000 units.
If you calculated the number of units as 11,639 then you probably also incorrectly calculated the fixed
costs in 20X7 as CU20  12,000 = CU240,000 and the 20X7 profits as CU1,200,000. However, in
20X8 you correctly calculated the fixed costs as 10,000  CU20  1.1 = CU220,000 and therefore
the required contribution in 20X8 as CU1,420,000. At a unit contribution of CU122 this would mean
11,639 units.
37 B
Explanation
The ARR in this question is defined as average annual profits divided by the average investment.
In Year 1 profits are –CU2,000 less depreciation of (CU60,000/10), ie –CU8,000
In Year 2 profits are CU13,000 less depreciation of CU6,000, ie CU7,000
In Year 3 profits are CU20,000 less depreciation of CU6,000, ie CU14,000
In Year 4 to 6 profits are CU25,000 less depreciation of CU6,000, ie CU19,000
In Year 7 to 10 profits are CU30,000 less depreciation of CU6,000, ie CU24,000
The average profits are therefore:
(-8,000 + 7,000 + 14,000 + (19,000  3) + (24,000 x 4))/10 = CU166,000/10 = CU16,600
The investment in Year 1 is CU60,000 and the investment in Year 10 is CUnil. The average
investment is therefore (CU60,000)/2 = CU30,000
The ARR is therefore CU16,600/CU30,000 = 55%
The average cash flow (rather than profit) = (16,600 + 60,000 ) = CU22,600
10
CU531 CU31,000 = 75%
CU16,600  CU60,000 = 218% i.e. incorrect using the initial investment
CU23,600  CU60,000 = 38%, i.e. incorrect using the initial investment and average cast flow
38 C
Explanation
The cash flows for the project are:
T0 -CU200,000
T1 +CU20,000
T2 +CU25,000 and each year thereafter
The T0 outflow is not discounted.
The T1 inflow is discounted for one year at 8%, giving a NPV of CU20,000/(1.08) = CU18,519
Thereafter we have an perpetuity at a discount rate of 10% starting after one year. The perpetuity
factor is 1/0.1 = 10, and therefore the NPV is CU25,000  10/1.08 = CU231,481.
The NPV of the project is therefore (–CU200,000 + CU18,519 + CU231,481) = CU50,000
B
Incorrect discount the perpetuity back from T 1 at 10% gives (rather than 8%)
CU20,000 x 10 1.1 = CU227,273 + CU18,519 - CU200,000 =
CU45,7952 i.e. CU45,800
Not discounting the perpetuity at 8% gives (or 10%)
Discounting the perpetuity as CU25,000 10 = CU210,438

1.11.08
+ CU18,519 - CU200,000 = CU28,957 i.e. CU29,000

Incorrectly treat the previous value of CU25,000 x 10 as occurring at T 1
39 A
Explanation
Contribution is defined as sales revenue less variable cost. The current contribution ratio is therefore
(600,000 – 216,000 – 132,000)/600,000 = 42%.
The variable manufacturing cost is expected to increase by 10% to CU237,600 and therefore total
variable costs will be (CU237,600 + CU132,000) = CU369,600. If the contribution ratio is maintained
at 42% then these costs would represent 58% of sales revenue. Sales revenue is therefore
CU369,600/0.58 = CU637,241.
As the sales volume remains at 1,200 units the unit selling price must be CU637,241/1,200 = CU531.
If you incorrectly calculated the selling price as CU550 then you either calculated the contribution as
sales revenue less manufacturing variable costs only (64%) and incorrectly ignored variable selling costs
or alternatively increased both manufacturing and selling variable costs by 10%.
If you incorrectly calculated the selling price as CU518 then you probably calculated the current
contribution correctly but then inflated the selling variable costs by 10% rather than the manufacturing
variable overheads.
40 D
Explanation
As the ten annual inflows start immediately then in Year 0 the net outflow is actually -CU150,000 +
CU30,000 = –CU120,000.
The NPV of this initial outflow is –CU120,000.
The NPV of the nine remaining annual cash inflows (years 1 to 9) of CU30,000 each can be found
from the discount tables by taking the annuity factor for years 1 to 9 at 10%. This is 5.759. Therefore
the NPV of these cash inflows is CU30,000  5.759 = CU172,770.
The NPV of the outlay at the end of ten years is –CU50,000  0.386 = –CU19,300.
The project NPV is therefore (–CU120,000 + CU172,770 – CU19,300) = CU33,470 or CU33,500
to the nearest CU100.
If you incorrectly calculated the NPV as CU15,100 (to the nearest CU100) then you treated the ten
annual inflows as being received in Years 1 to 10 rather than Years 0 to 9. This meant you calculated
the NPV as –CU150,000 + CU30,000  6.145 – CU19,300 = CU15,050.
If you incorrectly calculated the NPV as CU31,600 (to the nearest CU100) then you probably
completed every calculation correctly except the discounting of the final CU50,000. You probably
used a discount factor of 0.424 rather than 0.386 meaning the NPV became CU31,570 (CU31,600 to
the nearest CU100).
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© The Institute of Chartered Accountants in England and Wales, March 2009

© The Institute of Chartered Accountants in England and Wales, March 2009 v

The knowledge base

1.2 Services provided by professional accountants

2 Specification grid for Management Information

2.2 Specification grid

3 The learning materials

© The Institute of Chartered Accountants in England and Wales, March 2009 ix

The right approach

2 Focus on the exam

3 The right method

4 The right recap

x © The Institute of Chartered Accountants in England and Wales, March 2009

4.2 Study cycle

Key study steps Activity

© The Institute of Chartered Accountants in England and Wales, March 2009 xi

4.3 Detailed study guide

Study Approach Essential Points Due

1 Read quickly through section 1 of Chapter The difference between cost

Study Approach Essential Points Due

3 Chapter 3 contains a lot of very important Cost apportionment

Study Approach Essential Points Due

4 Skim through section 1 of chapter 4 but Contribution

Study Approach Essential Points Due

7 The content of section 1 of Chapter 7 is Calculating the cash operating

© The Institute of Chartered Accountants in England and Wales, March 2009 xv

Study Approach Essential Points Due

Study Approach Essential Points Due

11 Read quickly through section 1 of Chapter Discounted cash flow techniques

6 Syllabus and learning outcomes

2 Budgeting and forecasting

4 Management decision making

xx © The Institute of Chartered Accountants in England and Wales, March 2009

The fundamentals of costing

© The Institute of Chartered Accountants in England and Wales, March 2009 1

Learning objectives Tick off

Stop and think

2 © The Institute of Chartered Accountants in England and Wales, March 2009

© The Institute of Chartered Accountants in England and Wales, March 2009 3

1 What is cost accounting?

1.1 The cost accountant

1.2 Cost accounting and management accounting

1.3 Cost accounting systems

4 © The Institute of Chartered Accountants in England and Wales, March 2009

Cost accounting systems are not restricted to manufacturing operations.

1.4 Financial accounting versus cost accounting

Financial accounts Management accounts

© The Institute of Chartered Accountants in England and Wales, March 2009 5

2 Basic cost accounting concepts

2.1 Functions and departments

Production Administration Marketing

Mixing Baking Stores

2.2 Cost objects

Examples of cost objects include:

6 © The Institute of Chartered Accountants in England and Wales, March 2009

In the example above, cost objects could include:

2.3 Cost units

2.4 Composite cost units