MA Study Notes 1

ACCA
Management
Accounting
(MA)
Study Notes
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Management Accounting - Syllabus Notes
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Contents Page
Section A: The nature, source and purpose of management information

A1 Accounting for Management 05
A2 Sources of Data 09
A3 Presenting Information 12
A4 Cost Classification 17
Section B: Data analysis and statistical techniques

B1 Statistical Techniques 25
Section C: Cost accounting techniques

C1 Accounting for Materials 36
C2 Accounting for Labour 45
C3 Accounting for Overheads 51
C4 Absorption and Marginal Accounting 58
C5 Job, Batch and Process Costing 61
C6 Service and Operation Costing 68
C7 Alternative Costing Principles 70
Section D: Budgeting
D1 Budgeting 75
D2 Capital Budgeting 82
Section E: Standard Costing

E1 Standard Costing 91
Section F: Performance Measurement

F1 Performance Measurement Techniques 98
F2 Performance Measurement in Specific Situations 105
F3 Spreadsheets 109
Introduction to Management Accounting (MA)

Purpose of the syllabus
The syllabus for Management Accounting (MA)/(FMA), introduces candidates to elements of management accounting
which are used to make and support decisions. The syllabus starts by introducing the nature, the source and purpose of
management information followed by the statistical techniques used to analyse data. To develop knowledge and
understanding of management accounting techniques to support management in planning, controlling and monitoring
performance in a variety of business contexts.
Then the syllabus addresses cost accounting and the costing techniques used in business which are essential for any
management accountant. The syllabus then looks at the preparation and use of budgeting and standard costing and
variance analysis as essential tools for planning and controlling business activities. The syllabus concludes with an
introduction to measuring and monitoring the performance of an organisation.
The syllabus
The broad syllabus headings are;
A The nature, source and purpose of management information
B Data analysis and statistical techniques
C Cost accounting techniques
D Budgeting
E Standard Costing
F Performance Measurement
The Exam
Knowledge level exams are all computer-based exams. The Management Accounting is assessed by a two-hour exam.
The pass mark is 50%. All questions in the exam are compulsory. The exam format will comprise of two sections.
Questions will assess all parts of the syllabus. The examination will consist of:
Number of marks
Section A - Thirty-five 2-mark questions 70
Section B - Three 10-mark questions 30
––––
Total time allowed: 2 hours
Total marks: 100 marks
A The nature, source and purpose

of management information
Key Topics;
Ø Accounting for management
Ø Sources of data
Ø Cost classification
Ø Presenting information
How to use the materials;

The content for each topic area commences with a brief explanation or definition to put
the topic into context. Recommended to follow the content along with the recorded
lecture videos. These are worked and arranged in a systematic manner which will help
you to understand better. Upon completion of learning the content its recommended to
try out EduTray practice questions relevant to the chapter.
A1. ACCOUNTING FOR MANAGEMENT

What is Management Accounting and how does it compare to Financial Accounting?
Cost and Management accounting is a system for recording data and producing information about costs for the products
produced by an organisation and/or the services it provides.
Financial accounting involves recording the financial transactions of an organization related to the lapsed financial
period and summarising them in periodic financial statements for external users who wish to analyse and interpret the
financial position of the organisation. The differences between financial accounting and management accounting;
Financial Accounting Management Accounting

ü Produced mainly for external use ü Produced mainly for internal use
ü The purpose is to record the financial ü The purpose is to aid planning, controlling and
performance in a period and the financial decision making
position at the end of that period
ü It is not a statutory requirement
ü It is a statutory requirement
ü There is no specific format and this can be
ü The format and content of financial accounts
decided upon the requirements of the
should intend to give a true and fair view and
management
should follow accounting standards and company
law ü Consists of both financial and non-financial
information
ü Consists mainly of financial information
ü Prepared based on historic events and forward-
ü Prepared based on historic events (also called
looking events (also referred to as future
historic accounting)
accounting)
The role of a Management Accountant for an organization is to prepare;

ü Financial accounts
ü Budgets and forecasts
ü Cash flow reports
ü Cost reports
ü Variance analysis reports
ü Capital investment appraisal reports
ü Product profitability reports
Data and Information
Data: Data means facts. It consists of numbers, letters, figures, symbols, raw facts, etc. In other words, these are
currently in an unusable state as they have not been processed. Eg: The names and ages of all students in a classroom.
Information: Information’ is data that has been processed to give out meaning to the user of it. Eg: A bar chart
categorizing students in a classroom according to their age.
Data (Process) Information
Attributes of Good Information

This is classified by the acronym ‘ACCURATE.’
Accurate : Good information will be true and correct
Complete : The user of the information must be given all the information they need to make decisions
Cost Beneficial : The value of information should not exceed the cost involved in obtaining it
Understandability : The information must easily be understood by the reader
Relevant : The information must be relevant for its purpose
Accessible : The information should be easy to access by its users
Timely : The information needs to be provided in time for users to make decisions based on it
Easy to Use : The users of the information should find it easy to use it
The Management Process

The management process of planning, decision making and control. In any organization, the management will be
involved in the process of planning, making decisions and control.
1. Planning: This involves establishing the objectives of the organization and formulating relevant strategies with
the aim of achieving said objectives.
2. Decision Making: This involves making business decisions based on the information received. It would
generally involve selecting between a few alternatives to satisfy specific business requirements.
3. Control: This involves comparing the actual performance of the organization, to what was initially planned.
The aim here is to identify the areas where the organization performed rather poorly and plan towards improving
the performance for future periods.
Mission Statements
A mission statement is a statement used by a company to explain, in simple and concise terms, its purpose(s) for being.
Eg: Tesla Inc.’s mission statement is “To accelerate the world’s transition to sustainable energy.” There are 4 key
elements to a mission statement as described below;
Purpose Why does the business exist & who does it exist for?
Strategy What does the business provide & how is it provided?
Policies and Culture How does the business expect its staff to act?
Values What are the core principles of the business?
Levels of Planning
In the planning process, the objectives of the organization will be the basis for planning the decisions which need to be
made. The aims and objectives of an organization should thus be ‘SMART’, as described below:
Specific : It should give a clear idea of what needs to be achieved
Measurable : It should measurable in quantitative or qualitative terms
Attainable : The objectives should be achievable with the resources and skills currently available
Relevant : The objectives should be relevant for the purpose of the organization’s existence
Time Bound : The objectives should have a target date or deadline for achievement
There are 3 levels of planning
Strategic
Planning
Long-term objectives
and plans (strategies)
for the whole organisation
are formulated.
Tactical Planning
Breaks down the strategic plan down into
manageable chunks and prepare short to
medium term plans to achieve them.
Operational Planning
Involves making day-to-day decisions about what to
donext and how to deal with problems as they arise.
Responsibility Centres
This relates to an individual part of an organization whose manager is responsible for its performance. The main
responsibility centres are;
Cost Centres : This is a production or service location, function, activity or item of equipment whose costs
are identified and recorded. Eg: For a café, a cost centre would be the baking department.
Revenue Centres : This is a part of the organisation that earns sales revenue.
Profit Centres : This is a part of the organization which incurs both costs and revenue.
Investment Centres : This is a Part of the organisation for which profits and capital employed are measured.
The limitations of management information
The main reasons why management information fails to satisfy the objectives are;
ü Failing to comply with the characteristics of good information (i.e., “ACCURATE”)

ü Cost and Revenue figures provided aren’t relevant
ü Relevant costs and figures should be future, incremental and cash flows
ü Difficulties in understanding and quantify non-financial information
ü Exclusion or inconsideration of external information
A2. SOURCES OF DATA

Primary and Secondary Sources of Data
Primary Data: This is data directly obtained from first hand sources such as interviews, surveys, observations and
experiments. It is brand new data which has previously not been published.
Secondary Data: This This is data which has already been collected or researched. This could be from newspapers,
company reports, governmental reports, the internet and many more.
However, there are certain limitations and problems related to secondary data. This includes;
ü The accuracy and validity of the data
ü The data could be out of date
ü The data may be incomplete
ü The data may not be of great value to the organization, as everyone else would have access to it
Internal and External Sources of Information

1. Internal Sources
This can come from various sources;
The accounting system : This could be sales reports, inventory reports, cost reports, etc.
Payroll system : This can provide information related to labour costs, labour turnover, labour productivity,
labour absenteeism, etc.
Benefits and limitations of internal sources can be tabled as follows;
Benefits Limitations
ü Readily available data ü Data may need to be further analysed to be of

actual use for management accounting purposes
ü Data can be easily sorted and analysed as
required
ü Reports can be extracted when required
2. External Sources
This can come from various sources;
Government sources: The primary purpose of this data is to provide information for economic planning at the national
level - macroeconomics.
The internet: This can provide information for almost any requirement and it contains a vast pool of information.
Trade associations and trade journals : This could be in the form of annual publications, for example.
Information Research Agencies: Organisations can pay to obtain information from such agencies
Business Contracts
Benefits and Limitations of external sources are as follows;
Benefits Limitations
ü Wide pool of external sources of information ü Finding relevant information can be time
consuming
ü Easily accessible especially using the internet
ü Data may not be accurate
ü Mostly available for free
ü Can source specific information needs
General economic environment
The status of the economic environment will have an impact on the costs and revenues of an organization. The inflation
rates, exchange rates, growth rates, interest rates and their stability will impact the productivity and profitability of the
business. For example, higher interest rates could increase finance costs for an organization on the loans and overdrafts
it may obtain. A change in the exchange rate could impact the cost of production, if direct materials are imported.
Sampling Techniques
Sampling is used to gain as much information as possible about the population by observing only a small proportion of
that population. This could be a sample of biscuits or invoices for example; it doesn’t have to be people alone.
Sampling is necessary due to;
- The high cost involved in testing the entire population

- The time involved in testing the entire population
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When selecting a sample, it is necessary to observe the two following rules;
- The sample size: A suitable sample size must be selected. A larger sample would increase the reliability of the
results (this is the general idea)
- The sample must be chosen in such a way that it is representative of the population.
There are several methods of obtaining a sample, such as;
Random Sampling : This is a random selection from the population. The sample is taken in such a way that every
member of the population has an equal chance of being selected.
Systematic Sampling : This is selecting a sample based on pre-established guidelines. For example, if there are 20,000
items and a sample size of 200 is required, the guideline could be to select 1 sample out of sets of every 100 items. This
could be further systemized to select the 35th out of 100 items in each set of 100 items.
Stratified Sampling : This is if the population has well defined groups, for example: men and women, age groups,
etc. Then the sample could be prepared in a way items are selected from each group. This is done in such a way that the
number in each sample is proportional to the size of that group in the population and is known as sampling with
probability proportional to size (PPS). For example, so if 60% of the population consists of milk chocolate lovers, 25%
consisting of white chocolate lovers and 15% consisting of dark chocolate lovers, the sample must be selected in the
ratio of 60: 25: 15.
Multi-Stage Sampling : This method is often applied if the population is particularly large and is done in stages. These
stages could vary according to the requirements of the sample, but generally involves breaking down the population into
smaller sub segments and then selecting the sample out of each segment.
Cluster Sampling : This is similar to multi-stage sampling; however, the population will be broken into the main
clusters and a few selected clusters will be randomly sampled.
Quota Sampling : This is where the interviewer will be given a list comprising the different types of people to
be questioned and the number or quota of each type. For example, the quota could be 20 males and 30 females
A3. PRESENTING INFORMATION

Step Approach to Report Writing
Prepare Plan Write Review
Step 1 : Prepare
This would involve the determining the type of document, such as, detailed report, discussion notes. The type of
language and choice of words to be used and the end use of the report.
Step 2 : Plan
This would involve selecting the relevant data and turning it into information and deciding on the order which the
information is to be set in.
Step 3 : Write
This is basically the report writing process. The grammar, spellings and arithmetic must be clear and logical.
Step 4: Review
This is to re-read the written report and ensure that grammar and spelling errors are corrected and to ensure it meets the
requirements
Report Structure
Title : This would show who the report is to, who it is from, the date and a heading
Introduction : This would show what information was requested, the work done and where results and conclusions
can be found.
Analysis : This is where the information required will be presented in a series of subsections.
Conclusion : This marks the end of the document and may contain recommendations, if any.
Appendices : This would contain detailed calculations, tables of underlying data, etc. and references of items used
in the report.
The use of languages; A report can be written in any language, as required by the user. However, it is important that the
reader understands the information provided in the report. This includes avoiding lengthy sentences & irregularly used
words, use of punctuation, explaining acronyms and proper grammar.
Tables
Tabulation is the process of presenting data in the form of a table – an arrangement of rows and columns. There are
certain rules to be followed when preparing tables;
Title : The table should have a clear title
Source : The source of the material used in drawing up the table should be stated
Units : The units of measurement should be mentioned (e.g.: $’000s)
Headings : The relevant columns and rows should have headings
Totals : Where necessary, the totals of a set of rows or columns should be provided
Percentages and Ratios : Where necessary, these should be included
A table would consist of rows and columns as follows;
Column 1 Column 2
Row 1
Row 2
Graphs and Charts

Graphs and charts are very important parts of presentations, reports, and website pages. This is since graphs and charts
make the information presented look pleasing and, in most cases, easy to understand. There are different types of graphs
and charts that can be used;
Bar Charts: These are the most commonly used type of graph, which displays and compares the number, frequency or
other measure, for different discrete categories of data. There are 3 types of bar charts;
- Simple Bar Chart: This illustrates only one variable
Sales Units
80,000.00
60,000.00
40,000.00
20,000.00
-
Smartphone Laptop Smartwatch Earbuds
- Component Bar Chart: This shows information about different sub-groups of the main categories.
The component bar chart could also be presented with % instead of units for the measurement. This would look like;
- Compound Bar Chart: A compound (multiple) bar chart can show the same information as a component bar
chart but instead of the data being stacked into one column a separate bar is used for each sub-group
Line Graphs: These are usually used to show time series data, how one or more variables vary over a continuous period
of time.
Line graphs can also be used to show the split between a few variables. It would be as follows;
Scatter Diagram: These are used to show the relationship between pairs of quantitative measurements made for the
same object or individual. For example, the relationship between costs and output can be shown as below;
Pie Charts: This is a circular graph that shows the relative contribution that different sub-groups contribute to an overall
category.
A4. COST CLASSIFICATION

Analysis of Costs
A cost can be defined as object or action that requires the payment of a specified sum of money before it can be acquired
or done. Analysing the costs, we can come across the following;
1. Cost Objects: This is any activity for which a separate measurement of cost is undertaken. This could be, for
example, the cost of a product or service.
2. Cost Units: This is a unit of product or service in relation to which costs are ascertained. This could be, for
example, the cost of manufacturing a chocolate bar (for chocolate manufacturers).
3. Cost Centres: This is a production or service location, function, activity or item of equipment for which costs
can be ascertained. This could be, for example, a department such as Human Resources.
4. Cost Cards: This is used to show the breakdown of the costs of producing output based on the classification
of each cost. The cost card can be produced based on the management requirement, which could be for one unit
or entire planned level of production in the business organisation during that defined time period.
The following costs are brought together and recorded on a cost card:
Other Direct
Direct Material Direct Labour
Expenses
Variable Production Fixed Production Non-Production

Overheads Overheads Overheads
The following illustrates a sample cost card:

$$$ $$$
Direct Materials XXX
Direct Labour XXX
Direct Expenses XXX
PRIME COST XXX
Variable Production Overheads XXX
TOTAL VARIABLE PRODUCTION COST XXX
Fixed Production Overheads XXX
TOTAL PRODUCTION COST XXX
Non-Production Overheads:
Selling Overheads XXX
Distribution Overheads XXX
Administration Overheads XXX
TOTAL COST XXX
Classification of Cost based on element, nature, function and behaviour

Element : This is to classify costs as to whether they relate to material, labour or expenses.
Nature : This is to classify costs as to how they relate to production. There are 2 classifications for this;
Direct Costs : These are the costs which can be directly identified with a specific cost unit or cost centre. There are
three main types of direct costs;
ü Direct Material - Cost of material needed to produce a product Eg: Cost of Flour to make bread
ü Direct Labour - Wages paid to the Chef at a restaurant
ü Direct Other Expenses - Royalty paid to a designer
The total of the above direct costs is known as ‘Prime Costs’
Indirect Costs : These are the are costs which cannot be directly identified with a specific cost unit or cost centre. The
main types of indirect costs are;
ü Indirect Materials - Eg: Fluid used to clean the machinery and factory floor
ü Indirect Labour - Eg: Wages paid to floor factory supervisors
ü Indirect Other Expenses - Eg: Factory Rent
Function : This is to classify costs based on whether they are production costs or non-production costs.
Production Costs: These are the costs that relate to the manufacture of a product or provision of a service. This includes;
ü Direct Materials
ü Direct Labour
ü Direct Other Expenses
ü Variable Production Overheads
ü Fixed Production Overheads
Non-Production Costs : These are the costs that are not directly associated with the production of the businesses output.
This can include;
ü Administrative Costs
ü Distribution Costs
ü Selling Costs
ü Finance Costs
Behaviour: This is to classify costs based on how they change in relation to levels of output or activity. This can be
based on;
ü Variable Cost : These are costs that vary in direction proportion with the level of activity. What this means is
that the cost increases for every additional unit produced and vice versa. Examples for this are generally the
direct materials and direct labour costs.
ü Fixed Cost: This is a cost which is incurred for an accounting period, and which within certain activity levels
remains constant. Examples for this include the rent, and insurance.
ü Stepped Fixed Cost: This is a type of fixed cost, which changes once a certain level of production has been
passed. This includes the rent for extra factory space if production exceeds the current factory capacity, for
example.
ü Semi-Variable Cost: This contains a fixed cost element and as well as a variable cost element. The cost overall
increases when production increases. Examples include electricity and telephone, for example.
Key Takeaways
Fixed costs will remain constant in total throughout the year
Variable costs are constant per unit
Semi-variable costs are neither constant in total nor constant per unit
High-Low Method
Separation of fixed and variable costs can be done using the High-Low method. The breakdown of a semi-variable cost
is as follows;
Total Cost = Fixed Cost Element + (Variable Cost Element * Activity Level)
The High-Low Method can be done in 4 steps as follows;
Step 1 : Select the highest and lowest activity levels and their associated costs. Eg: Consider the following costs and
activity levels
Cost Units
55,000.00 100
60,000.00 200
65,000.00 300
The highest and lowest activity levels respectively are 300 and 100, while the corresponding costs are 65,000 and 55,000.
Step 2 : The next step is to calculate the variable cost per unit. This is done using the formula;
Cost at high level of activity - Cost at low level of activity

Variable Cost per unit =
High level of activity - Low level of Activity
For the example in step 1, it would be calculated as follows;

65,000-55,000 10,000
= = 50 per unit
300-100 200
Step 3 : This step is to calculate the Fixed cost, by using either the high or low activity level. The following formula is
used;
Fixed cost = Total cost at activity level – (Variable cost × Activity level)
Applying it to the above example it would be;
55,000 - (50 X 100) = 50,000
Step 4: This is an optional step. This can be used to calculate the total cost at different levels of activity.
In the scenario of a stepped fixed cost being present, the calculation is similar, however the following must be observed;
ü Select the high and low activity levels based on the levels at which the fixed cost remains unchanged, i.e. the
low activity level would be the activity level after which the stepped fixed cost applies and the high activity
level would be the highest activity level available.
ü Ensure to make the relevant adjustments for the stepped fixed cost
In the scenario where the variable cost is set to change, the high-low method can still be applied. Similar to with stepped
fixed costs, the activity levels at which the variable costs per unit remain unchanged must be used. The advantages and
disadvantages of the high low method are as follows;
Advantages Disadvantages
ü Easy to use and understand ü Relies on historical data, this may be bound to
change making it less reliable
ü The assumption that only activity levels affect

costs may not be valid
ü At higher activity levels, costs can be lower due

to discounts on bulk raw material purchases.
§ Cost Equations
ü Cost Equations can be applied to estimate future costs. These rely on past data.
ü Cost equations are assumed to have a linear function and therefore the equation of a straight line can be
applied:
y = a + bx
Where,
‘a’ is the intercept, i.e. the point at which the line y = a + bx cuts the y axis (the value of y when x = 0).
‘b’ is the gradient/slope of the line y = a + bx (the change in y when x increases by one unit).
‘x’ = independent variable.
‘y’ = dependent variable (its value depends on the value of ‘x’)
The following illustration shows the application of the equation;
If y=100 + 2.5X
Fixed Cost 100
Variable Cost per unit 2.5
=100 + (2.5 X 100 units)
Total Cost for 100 units =350
Cost Codes
A Cost Code is a system of symbols designed to be applied to a classified set of items, to give a brief accurate reference,
which helps entry into the records, collation and analysis. E.g.: An organization can decide to allocate the cost code
‘08’to their canteen. There are two main types of cost codes;
1. Generic/Functional Codes: Once a cost has been allocated its correct cost centre code then it may also be useful
to know the particular type of expense involved. Therefore, some more digits might be added to the cost centre
code to represent the precise type of cost.
E.g.: if the canteen incurs a cost to purchase paper towels, it may have the cost cost code of ’08-06’
2. Specific Codes : Finally, it may be necessary for cost allocation, decision making or accounting purposes to
allocate a code which specifically identifies the item of cost. For example, the canteen could have the following
cost code, ‘080206’, which would be ‘08’ for the canteen, ‘02’ for purchases and ‘06’for paper towels.
Coding systems
Sequential Code: This is the most basic type of code. It simply means that each code follows a numerical or alphabetical
sequence. E.g.: Telephone expenses could be 001, Internet expenses could be 002
Block Code: These are often used to categorise sequential codes together. E.g.:
Code Item
1000 Expenses
2000 Income
As the “1000” block is allocated to expenses, it can have up to 1,000 different expenses categorized
Hierarchical Code: Each digit in the code represents a classification. As the code progresses from left to right each
digit represents a smaller subset.
Significant Digit Code : This contains individual digits and letters that are used to represent features of the coded item.
E.g.:
Code Item
1000 Ink Pens
1001 Red Ink Pen
1002 Blue Ink Pen
1003 Black Ink Pen
Faceted Code: This is broken down into a number of facets or fields, each of which signifies a unit of information.
Code Region Code Department Code Expense

001 India 001 Sales 345 Salaries
002 Japan 002 Finance 346 Telephone
Mnemonic Code: This means something that aids the memory or understanding. This uses an alphabetical coding
rather than a numerical coding system. E.g.,
Code Meaning
CLEXP Controllable Expenses
NCLXP Non-Controllable Expenses
Data Analysis and Statistical

Techniques
Key Topics;
Ø Statistical Techniques

B1. STATISTICAL TECHNIQUES

Forecasting Techniques
In every organization, the process of preparing management accounts will involve the use of forecasting techniques.
This is true especially when it comes to budgeting, since budgets can be prepared for long time periods. The purpose of
preparing a budget is to make the targets more realistic and motivate the budget holder to achieve the established targets.
The budgets can be then used for control purposes. The following forecasting techniques are used;
ü Regression Analysis
ü Time Series Analysis
ü High-Low Method
ü Index Numbers
Regression Analysis
This method of forecasting is used to establish the relationship between two variables. In this chapter, the Least Squares
regression analysis will be looked at. This relies on using a formula rather than a scatter diagram to identify the
relationship between the two variables.
The regression analysis is used to find the line of best fit using formula. The equation of the straight line is;
y = a + bx
where y = dependent variable
a = intercept (on y-axis)
b = gradient
x = independent variable
n = number of pairs of data available
!"#$% "#"$
and b = !"# ! %("#)!
"$ )"#
and a= !
− !
Consider the following example to get a better understanding of how the regression analysis works.
The CEO at Company R has found an interest in the relationship between the level of sales of ice creams and the revenue
raised. For this, the sales manager has come up with the following information based on sales achieved in the past 6
months, along with the revenue raised from it.
Month Ice Creams sold Sales Revenue

1 1,000 $1,500
2 3,000 $4,000
3 4,000 $5,000
4 3,500 $4,600
5 5,000 $6,100
6 6,000 $7,200
Now, in order to carry out a regression analysis and understand the relationship between the variables, the following
steps need to be carried out.
Step 1: Identify the x (independent) and y (dependent variables)

Based on the information made available, ice creams sold is independent, thus “x”, and sales revenue is the dependent
variable as the revenue raised depends on how many ice creams are sold, thus “y”
Step 2: This step requires a few calculations to be made. This includes finding the values with the 𝜀 values for the
respective information. The following calculations have been made as such;
The sum of the independent (x) variable is 22,500
The sum of the dependent (y) variable is $28,400
The sum of multiplying the total of x and y is 639,000,000
The individual figures of x being squared (x2) and summed together is 99,250,000
The individual figures of y being squared (y2) and summed together is 101,627,200
**for the purposes of the ease of calculation, figures will be considered with three decimal places
Step 3: We can now proceed to calculate the line of best fit using the regression analysis
!"#$% "#"$
b = !"# ! %("#)!
(6 × 639,000) − (22.5 × 28.4)

(6 × 99,250) − (22.5)*
3,833,361
594,993.75
=6.45
"$ )"#
a= !
− !
28.4 (6.45 × 22.5)

−
6 6
= -19.5
Therefore, the regression equation (y = a + bx) = -19.5 + 6.45x
Interpreting the above, what the equation means is that each time x increases by 1, y increases by 6.45. So, every time
an ice cream is sold, revenue rises by $6.45.
The advantages and disadvantages of using linear regression are as follows;

ü Simple and easy to use. ü There could be multiple independent variables
which affect the dependent variable.
ü Considers the basic relationship of two sets of
data. ü There is the assumption that there will be a
similar flow of data in the foreseeable future.
ü Useful to forecast when preparing budgets.
ü There is the assumption that a linear relationship

ü Use of existing information means that there is
between variables exists.
no difficulty in gathering it.
ü Makes the budgeting process simpler for the

accountant.
Correlation Coefficient
Now once the relationship between variables has been calculated, we can take this a step further and calculate the
strength of the straight-line relationship is. This is done with the use of the following formula;
𝑛𝜀𝑥𝑦 − 𝜀𝑥𝜀𝑦
𝑟 =
8(𝑛𝜀𝑥 * − (𝜀𝑥)* )(𝑛𝜀𝑦 * − (𝜀𝑦)* )
Let’s apply this formula to the following example to understand the application of the correlation.
The following information related to RS PLC has been made available.

Cars Sold Selling Costs
100 $100
200 $150
300 $200
400 $300
500 $350
Based on the information available, the finance executive has come up with the following conclusions;
𝜀𝑥 = 15, 𝜀𝑦 = 11, 𝜀𝑥𝑦 = 3,950, 𝜀𝑥 * = 5,500, 𝜀𝑦 * = 2,850, 𝑛 = 5
Calculate the correlation coefficient for the data given.
𝑛𝜀𝑥𝑦 − 𝜀𝑥𝜀𝑦
𝑟 =
8(𝑛𝜀𝑥 * − (𝜀𝑥)* )(𝑛𝜀𝑦 * − (𝜀𝑦)* )
(5 × 3,950) − (15 × 11)

8(5 × 5,500 − (15)* )(5 × 2,850 − (11)* )
19,585
19,631
= + 0.99765
Once the calculation has been completed, the strength of the correlation can be determined. The strength of the
correlation coefficient is categorized as follows;
r must always be between -1 and +1
if r = 1, there is perfect positive correlation between the variables
if r = 0, there is no correlation between the variables
if r = -1, there is perfect negative correlation between the variables
r > o.8 = strong positive correlation
r < -0.8 = strong negative correlation
Graphs can also be drawn up to document the correlation between the two variables.
The two graphs above show the perfect correlation between the variables. What this means is that there is an exact
linear relationship between the variables.
The twp graphs above do not have an exact relatioship between the variables, however the high values of x tend to be
associated with the high values of y and vice versa.
The graph shows no correlation, meaning the two variables are not connected
Coefficient of Determination
The Coefficient of Determination is used to measure the change in the proportion of changes in “y” that can be
explained by the changes in “x.” The following formula is used for this purpose.
Coefficient of Determination = r2
Applying the CoD to the example in the previous part, the CoD would be = 0.997652 = 0.995
Time Series Analysis

Time series is yet another forecasting tool. It is based on the historical figures recorded overtime. The figures could
relate to any time period. Eg: inflation rates over the past 5 years. Time series is used to identify if there is an underlying
trend. This is since over time, the changes that occur can be similar, giving presence to the existence of a trend. There
could certain specific seasonal variations that need to be taken into account too. There are 4 components required to be
considered under a time series analysis;
1. Trend - This is based on how events have transpired in the past and is calculated based on that
2. Seasonal Variations - In specific time periods, apart from the trend, there could be short term fluctuations due
to time specific events taking place. E.g.: Sales in December could be much higher than the rest of the months.
When forecasting figures in the presence of the seasonal variation, we need to adjust the figures to reflect on
the seasonal factor. This is done using either one of the two models listed;
ü Additive Model: Trend + Seasonal Variation
ü Multiplicative Model: Trend x Seasonal Variation
3. Cyclical Variations - These are usually medium to long term influences that occur from the economy, making
it out of business control.
4. Residual/random/other possible variations - These are events that occur randomly and are usually difficult to
predict. Eg: natural disasters
Example
Over a 24-month period, Company X's sales have been found to have an underlying linear trend of Y=6.453 + 2.638X,
where Y is the number of items sold and X represents the month. If the volume of sales in month 25 is expected to be
1.15 times the trend value, what is the forecast number of items to be sold in month 25(to the nearest whole number)?
Answer = 83
Workings
[6.453 + {(2.638 x 25) x 1.15} = 83]
Now in a time series analysis, there could be moving averages. This is when there are multiple variations in the trend
within a given time period. Instead of relying on multiple variations, one common variation can be calculated and used
as a trend. Look at the example below to understand this further. The following sales figures relate to the 6-month period
at JJ Limited. The company operates in periods of 3 months each.
Month Sales
April $100
May $150
June $60
July $56
August $100
September $100
Calculate the forecast sales for the upcoming two months of October and November.
Step 1: Calculate the 3-month moving average total
Month Sales Moving Average Total

April $100
May $150 $310
June $60 $266
July $56 $216
August $100 $256
September $100
Step 2: Calculate the trend by dividing the 3-month moving average total by 3 to get the average for the 3 months
Month Sales Moving Average Total Trend

April $100
May $150 $310 $103
June $60 $266 $89
July $56 $216 $72
August $100 $256 $85
September $100
Step 3: Compare the trend to actual sales figures to calculate the seasonal variation (Actual Sales – Trend)
Month Sales Trend Seasonal Variation

April $100
May $150 $103 +$47
June $60 $89 -$29
July $56 $72 -$16
August $100 $85 +$15
September $100
Step 4: Extrapolate the trend for the upcoming months, based on how the trend has changed over the past few months
and apply the seasonal variation to calculate the forecast sales value.
Month Trend Seasonal Variation Forecast sales value

April
May $103 +$47
June $89 -$29
July $72 -$16
August $85 +$15
September $71(W1) +$47 $117
October $54(W2) -$29 $25
November $67 -$16 $51
(W1) = 85 – (103-89) = 71
(W2) = 71 – (89-72) = 54
The advantages of time series include;
ü Forecasts are made based on assumptions of a smooth functioning in future

ü Historical data is accurate and can be relied upon when applying to many industries/organisations
ü Prior experience using the data can be used to improve the accuracy of the forecasting
The disadvantages of time series include;
ü The possibility of unforeseen events can make historical data ineffective for the purpose
ü There is too much reliance on historical data
ü The assumption of a constant seasonal variation can be vague
High-Low Method
This has been covered in later chapters
Index Numbers
An index number is used to measure and compare the changes that occur in a group of items over a period of time.
This is done by the allocation of a common platform to the activity that occurs in each year. The year used as the
initial year for comparison is the base year.
The base year always gets an index of 100. The changes in the activity that happen overtime will increase/reduce the
index figure. Consider the example.
The Following information relates to questions 1-3

Year 2009 2010 2011 2012 2013 2014 2015
Profits ($ m) 1.2 1.5 1.8 1.9 1.6 1.5 1.7
If the base year was 2009, what will be the index figure for 2010?
Answer = (100/1.2) x 1.5 = 125
These can be applied to calculations related to prices changes, wage changes, and so on. The following example is
related to the Revenue.
M Co has seen an increase in annual revenue from $212 million to $225 million between 20X3 and 20X6, in nominal
terms. CPI Data is given below as a fixed index.
Year 20X2 20X3 20X4 20X5 20X6

CPI 100 106 110 117 125
Calculate how much annual revenues have changed in real terms between 20X3 and 20X4.
Answer: 10%
This can be addressed by expressing the sales in terms of base year (i.e., 20X2) prices. 20X3 sales can be adjusted by
dividing by 106/100 i.e., $212m/1.06 = $200m
There are 3 main types of index numbers.

1. Simple Indices - Used to measure either a change in the price or quantity of a single item. The calculation is
made based on the price of the current year and the price of the base year.
2. Chain base indices - Used to measure the change in the price or quantity using the current year’s value against
the previous year’s value.
3. Weighted indices - Used to measure the changes in overall price or quantity for a number of different items
against the base year.
Example
In 20Z6 the retail price index was 198 with 20X7=100. Convert a weekly wage of $421 in 20Z6 back to 20X7 prices
(to two decimal places)
Answer: 212.63
421 x (100/198) =212.63

The chain base index for an item last year was 130. The price of the item has risen by 10% between last year and this
year. What is the chain base index for this year?
Answer:110
100 + (100 x 10%) =110
A company manufactures 3 products, A, B & C and the quantities sold in 2014 and 2015 were as follows;
Product Quantity Sold Weights
2014 2015
A 7 10 85
B 12 15 68
C 25 25 45
Find the index of the quantity sold in 2015 with 2014 as a base using the weights given by using the relatives method.
Answer: 127.0
Product Q1/Q0 W W x (Q1/Q0)

A 1.4286 85 121.4
B 1.25 68 85
C 1 45 45
198 251.4
Relative Quantity Index = 100 x (251.4/198) = 127.0
The advantages and disadvantages of index numbers are;

ü The management will find the use of index ü The index numbers are only relative numbers and
numbers easier to understand. may not paint the whole picture.
ü Easier to understand than using the full figures. ü There are multiple ways of conducting index-
related calculations, which can be confusing to
ü Comparisons of similar items overtime is easier. those carrying it out
ü Shows the changes in data/information

overtime.
C Cost Accounting Techniques
Key Topics;
Ø Accounting for Materials
Ø Accounting for Labour
Ø Accounting for Overheads
Ø Absorption and Marginal Costing
Ø Job, Batch and Process Costing
Ø Service and Operation Costing

C1. ACCOUNTING FOR MATERIALS

The Process Related to Inventory
Ordering Receiving Issuing
Inventory can relate to different types of purchases for a business organization. It could be the materials required for
production, uniforms for staff or even cleaning liquid for cleaning floors. In management accounting however, the main
focus is towards the materials necessary for production, since this is generally purchased in the largest quantities. So, in
such organisations, the process would involve 3 steps as follows;
1. Ordering: Firstly, the sales department will notify the production manager on the required output for the upcoming
period. The production manager would then decide on the required quantity of raw materials and send a materials
requisition request to the stores department. The stores department will check for existing stocks in their inventory and
if there is a shortage, they will send a purchase requisition to the purchasing department. The purchasing manager will
then negotiate with the external suppliers on the quantity, price and delivery date of the materials and proceed to place
the order by sending a purchase order.
2. Receiving: Once the external supplier receives the order, they will prepare and dispatch the order. They will issue a
purchase invoice to the stores department and this will be received by the stores department, where it will be kept in
stock until required by production.
3. Issuing: When the production department requires the material for production, the stores department will issue the
required quantity of material.
The Costs Related to Inventory

Inventory Holding and Ordering Costs
The idea in an organization is that anything which occupies space, will be a cost to the organization. As inventory is
stored before production is started, there will be costs involved with storing it such as rent. Once again, when placing
orders for inventory, there may be certain costs involved, such as a processing fee charged by the supplier. However,
this is not all bad. Inventory plays a major function in an organization. A few key reasons why an organization should
hold inventory could be as follows;
ü It acts as a buffer in times of unusually high consumption

ü Cost savings can arise from buying stock in bulk (bulk discounts)
ü Delays in production due to lack of stock can be eliminated or kept to a minimum
Looking at the costs of holding inventory, the total cost of having inventory consists of the following;
ü Purchase price
ü Holding costs;
Insurance cost
Opportunity cost of capital tied up
Damages and wastages
Obsolescence and deterioration
Stores labour and administration costs
The holding cost can also be categorized as Fixed holding costs (such as rent of storage space and insurance) and as
Variable holding costs (such as interest on cost of capital tied up). The cost of holding inventory can be calculated as
follows;
Total annual holding cost = holding cost per unit of inventory × average inventory (Ch × Q/2)
Where average inventory held is equal to half of the order quantity (Q/2).
Looking at the ordering costs, this includes the;
ü Clerical and Administrative costs

ü Transport Costs
The cost of ordering can be calculated as follows;
Total annual ordering cost = cost of placing an order × number of orders (Co × D/Q)
Where the number of orders in a year = Expected annual demand/order quantity (D/Q).
However, there can be downsides to not holding sufficient inventory as well. This can include;
ü Loss of sales if unable to cater to the demand

ü Damage to the business brand if unable to cater to the demand
ü Higher ordering costs due to emergency orders
In order to calculate the total annual cost of inventory, which combines the total of purchasing costs and ordering costs,
the following formula is used;
Total annual cost = PD + (Co × D/Q) + (Ch × Q/2)
Take a look at the following illustration to get a clear understanding of the use of the formula.
A company uses 10,000 units of component X per year, which are bought in at a cost of $1.50 each from the supplier.
The company orders 2,000 units each time it places an order and the average inventory held is 500 units. It costs $50
each time to place an order, regardless of the quantity ordered. The total holding cost is 15% per annum of the average
inventory held.
Calculate the;
1. The annual holding cost
2. The annual ordering cost
Answer;
1. Annual holding cost = average inventory held x cost per unit × 15%
500 units x $1.50 x 15% = $ 112.5
+,,-./ 01.23
2. Annual ordering cost = 45635 1783
𝑥 $50
(10,000 units/2000 units) x $50 = $250
Let’s take a look at the disadvantages of holding high inventory levels
ü High holding costs such as rent and storage

ü Cost of capital tied up in inventories, such as the cash spent to purchase those inventory
The stock may become damaged or obsolete if held for too long
Re-Order Level
The reorder level is the quantity of inventory in hand when a replenishment order should be placed. It can be calculated
with the following formula;
Reorder level = Maximum usage × Maximum lead time
Follow along the following illustration to learn how to apply the formula;
A company uses Component X at the rate of 15,000 per week. The time between placing an order and receiving the
components is four weeks. The reorder quantity is 84,000 units. Calculate the reorder level.
Answer
Reorder level = Usage x Lead time
= 15,000 units x 5 weeks = 75,000 units
Economic Order Quantity and Economic Batch Quantity

Economic Order Quantity (EOQ) is the reorder quantity at which the total costs associated with holding and ordering
inventory are at a minimum. This is calculated with the following formula;
2C4 D
:
C9
Where:
D = Demand per annum
CO = Cost of placing one order
Ch = Cost of holding one unit for one year
Q = Reorder quantity (EOQ)
The following illustration shows the application of the formula.
A company uses 1,000 units of component X per month, which are bought in at a cost of $1.50 each from the supplier.
It costs $50 each time to place an order, regardless of the quantity ordered. The total holding cost is 20% per annum
of the average inventory held.
Calculate;
1. The EOQ
2. Total Annual Cost
Answer
* : $<= : >,=== -,7@1 : >* AB,@91
1. EOQ == *=% : $>.<=
= 2000 units
>=== -,7@1 : >* AB,@91 *=== -,7@1

2. Total Annual Cost = ($1.50 x 1000 x 12) + ($50 x *=== -,7@1
) + ($1.50 x 20% x *
)
= $ 18,600
However, EOQ is simply a calculation and takes into account a few assumptions, such as;
ü Demand and lead time are constant and known

ü Purchase price is constant
ü No buffer inventory is held
There is a possibility to negotiate the purchase price offered by the supplier if bulk purchases are to be made. If such
discounts are available, the following effects will be there;
ü The annual purchase price will decrease.

ü The annual holding cost will increase.
ü The annual ordering cost will decrease.
Let’s take a look at how to apply discounts to the EOQ.
Step 1 : Calculate the EOQ the usual way (ignore the discount)
Step 2 : The supplier will have a minimum order quantity for discounts to apply. So, if the EOQ is smaller than that
minimum, calculate the total for the EOQ of the annual inventory holding costs, inventory ordering costs and inventory
purchase costs
Step 3 : Now, recalculate the annual inventory holding costs, inventory ordering costs and inventory purchase costs
for a purchase order size that is at the minimum order quantity for the discount to apply.
Step 4 : Compare the two costs that were calculated and select the minimum cost alternative, i.e., the one which costs
less.
Step 5 : This step applies only if there are further discounts at higher levels of purchases. So, repeat the same
calculations for the higher level.
Consider the following illustration
A company uses 1,000 units of component X per month, which are bought in at a cost of $1.50 each from the
supplier. It costs $50 each time to place an order, regardless of the quantity ordered. The total holding cost is 20%
per annum of the average inventory held. The supplier offers a 10% discount on the purchase price for order
quantities of 4,000 items or more. The current EOQ is 2,000 units.
Should the discount be accepted?
Answer
Order Quantity = 2,000 4,000
Order Cost = (12000/2000 x $50) = $ 300 (12000/4000 x $50) = $ 150
Holding Cost = (20% x 1.50 x 2000/2) = $ 300 ((20% x 1.50) x 90% x 4000/2) = $ 540
Purchase Cost = (12000 x 1.50) = $ 18,000 (12000 x 1.50 x 95%) = $ 17,100
Total Annual Costs = $ 18,600 $ 17,790
The discount should be accepted as the company can save $ 810 annually (18600 – 17790)
Gradual Replenishment of Inventory
With regards to production, it is essential for organisations to know the most economical batch size for production. This
can be done with the Economic Batch Quantity formula, which is an EOQ with slight adjustments.
The EBQ can help make decisions on whether to produce small batches with short intervals or produce large batches
and build up a stock.
The formula is as follows;
2C4 D
Economic Batch Quanitity = :
D
C9 (1 − R)
Where:
Q = Batch size
D = Demand per annum
Ch = Cost of holding one unit for one year
CO = Cost of setting up one batch ready to be produced
R = Annual replenishment rate
The following illustration shows how the EBQ is applied;
The following information relates to item X.

- Output per week is 250 units.
- Annual demand is 9,000 units, spread evenly over a 52-week year.
- Set up cost is $1,500 per batch
- Storage cost is $3 per unit per year
Calculate the EBQ for item X
Answer
Annual Production = 250 units x 52 weeks = 13,000 units
* # ><== # E===
EBQ = = "### = 5408 units
F # (>% )
$%###
The Valuation of Inventory

Maximum and minimum inventory levels are warning levels between which inventory must be held. The inventory held
should not be above the maximum level or below the minimum level. It is established by considering the;
ü Consumption rates
ü Lead time for obtaining inventory
ü Durability/expiry time of inventory
ü Storage space available for inventory
ü Seasonal demand factors
Control policies to minimize discrepancies and losses
Stocktaking : This involves checking the physical quantity of inventory held on a certain date and then checking this
balance against the balances on the stores ledger (record) cards or bin cards. This can be carried out either on a periodic
basis (at the end of the financial period) or on a continuous basis (on a rotating basis on each day)
Inventory Valuation
Perpetual Inventory : This is the recording as they occur of receipts, issues and the resulting balances of individual
items of inventory in either quantity or quantity and value. The organization will use various valuation techniques to
value inventory. This could be;
1. First In First Out (FIFO): This assumes that materials are issued out of inventory in the order in which they
were delivered into inventory. The following inventory has been valued with the FIFO assumption in mind.
Receipts Issues Balance

Date Unit Unit Unit Unit Unit
Unit Cost s Total Cost s Total Cost s Total
Opening
Balance 5.00 10 50.00
5.00 10 50.00
1st January 100
6.00 600.00 6.00 100 600.00
650.00
5.00 10 50.00 6.00 70 420.00

3rd January
6.00 30 180.00
230.00
The advantages and disadvantages of FIFO include;

ü It can be easily understood and it is logical (as ü In periods of rising prices, profits reported may
older stock is more likely to be sent out first) be high (as closing valuations are high)
ü Inventory is valued at up-to-date prices ü Makes cost comparisons between jobs difficult.
ü It is acceptable as per IAS 2
2. Last In First Out (LIFO): This assumes that materials are issued out of inventory in the reverse order to which
they were delivered. The following inventory has been valued with the LIFO assumption in mind.

Date Unit Unit Unit
Unit Cost s Total Unit Cost s Total Unit Cost s Total
Opening
Balance 5.00 10 50.00
5.00 10 50.00
1st January 6.00 10 60.00 6.00 10 60.00
110.00
6.00 10 60.00 5.00 5 25.00
3rd January 5.00 5 25.00
85.00
The advantages and disadvantages of LIFO include;

ü Prices are up-to-date ü Usually not accepted by accounting
standards
ü In times of rising prices, profits reported
maybe lower (due to lower inventory ü Inventory values might become out of date,
valuation) as older stock is held onto for longer
ü Makes cost comparisons between jobs

difficult.
3. Weighted Average Cost: This is where all issues and inventory are valued at average price. The formula for
the weighted average cost is Running Total of costs/Running total of units. The following inventory has valued
using the Weighted Average cost;

Date Unit Unit Unit
Unit Cost s Total Unit Cost s Total Unit Cost s Total
Opening
Balance 5.00 10 50.00
1st January 6.00 10 60.00 5.50 20 110.00
3rd January 5.50 10 55.00 5.50 10 55.00
Workings;
Weighted Average Cost After 1st January Delivery = (50.00+60.00)/(10+10) = $5.50 per unit
The advantages of Weighted Average Cost include;
ü Acceptable to Accounting Standards ü The issue price and purchase price aren’t the
actual price
ü Logical since all units are valued equally
ü Inventory values may be higher or lower than the
current prices
Material Inventory Account

Since materials are current assets, they are recorded under inventory in the Statement of Financial Position. Transactions
related to material movements are recorded in the Material Inventory account. The standard format for the account is as
follows;
Material Inventory Account
Purchases XX Issues to production XX

Returns to Stores XX Returns to Supplier XX
Production
Overhead
Payables XX Ac XX
Any Debit entries relate to inventory increasing, whilst credit entries reduce inventory levels.
Only direct materials used in production are recorded here. Indirect materials are not a direct cost of manufacture and
are treated as overheads. They are therefore transferred to the production overhead account by way of a credit to the
material inventory account.
C2. ACCOUNTING FOR LABOUR

Direct and Indirect Labour
The most important distinctions of labour is between direct and indirect costs. Direct Labour in this case would be part
of the prime cost of a product, as the employees are involved in production and is the basic wage paid to staff. Indirect
Labour on the other hand is treated as an overhead, as they aren’t involved in production and includes the basic wage
paid to them. Indirect labour costs may also include the following;
ü Bonuses paid
ü Benefit contribution
ü Sick pay
ü Idle time
ü Time spend by direct workers on indirect jobs
In a situation where employees are expected to work overtime (in hours excess of their contracted hours), they are bound
to be paid for it. This payment will include a basic pay element and an Overtime Premium. Check out the illustration
below to see how it is calculated.
An employee has a contract to work a 40 hour week, with a basic pay of $15 per hour worked. The company has a
policy to pay overtime at 50% in excess of the basic pay. How much will this employee earn for working 50 hours in
a specific week?
Answer:
Direct Labour = Basic Pay for 50 hours = $15 x 50 hours = $750
Indirect Labour = Overtime premium @ 50% of basic wage = ($15 x 50%) x10 hours = $75
It must be noted that the Direct Labour will include the basic pay for all hours worked, whilst the Indirect Labour will
consist of the overtime premium. However, in special cases, the overtime premium can be classified as direct labour
too. This could be due to the extra hours are being worked due to a customer request, for example.
Calculation of Labour Costs involved in products and services;
With regards to the time spend by an employee, organisations need to ensure that there are systematic procedures in
place to record the time worked. This can be done by implementing various techniques such as;
ü Time Sheets
ü Time Cards
ü Job Sheets
Once these records are made available, it can be sent to the payroll department. Functions related to payments to labour
will be conducted here. This includes;
ü Calculating gross wages from time and activity records

ü Calculation of net wages after deductions from payroll
ü Conducting analysis of direct wages, indirect wages, and cash required for payment
Accounting for Labour Costs

Labour costs are recorded in an organisation’s statement of profit and loss. The labour account is debited with the labour
costs incurred by an organisation. The total labour costs are then analysed into direct and indirect labour costs. Consider
the following illustration for a clearer understanding;
The following payroll records relate to company X.

Direct ($) Indirect ($) Total ($)
Basic Pay 20,000 10,000 30,000
Overtime – Basic Pay 6,000 4,000 10,000
Overtime – Premium 3,000 2,000 5,000
Sick Pay 650 350 1,000
Idle time 1,000 - 1,000
Prepare the Labour Account.
Labour Account
Bank 47,000.00 Works In Progress (20,000 + 6,000) 26,000.00
Indirect Labour(10,000 + 4,000) 14,000.00

Overtime Premium 5,000.00
Sick Pay 1,000.00
Idle Time 1,000.00
47,000.00 47,000.00
It must be noted that the direct labour has been classified as Works-In-Progress. This is due to direct labour being
incurred for production.
Methods of Remuneration
There are two commonly used remuneration methods.
1. The first one is Time-Related Systems.
ü This is where wages are calculated based on the number of hours worked by an employee.
ü There is no incentive or motivation for employees to improve in terms of productivity.
ü Employees are paid at a basic rate, with overtime payments if worked.
The following formula can be used;

Total wages = (total hours worked × basic rate of pay per hour) + (overtime hours worked × overtime
premium per hour)
2. The other method is Output-Related systems.
ü This is where wages are calculated based on the number of units produced. It is also called the piecework system.
ü It can act as a incentive to improve productivity as the more units produced, the higher wage employees can
earn.
The following formula is used;

Total wages = (units produced × rate of pay per unit)
Consider the following illustration related to piecework remuneration.
A company operates a piecework system of remuneration. Each unit should take 3 minutes to produce (standard
time). Employees are paid based on the number of hours their output should have taken them (standard hours).
Piecework is paid at the rate of $10 per standard hour. If an employee produces 100 units in ten hours on a particular
day, what
is the employee gross pay for that day?
Answer:
Standard time = 100 units x 3 minutes = 300 minutes or 6 hours
Employee Gross Pay = $10 x 6 hours = $60
Incentive Schemes
As organisations wish to improve in terms of productivity and cost savings, incentive schemes can be aimed at
individuals and/or groups. One of the most common incentive schemes is bonus payment. This is based on the effort of
employees and should be beneficial to the employees. Moreover, it needs to be easy and simple to operate and
understand. Most bonus schemes pay a basic time rate, plus a portion of the time saved as compared to some agreed
allowed time. These bonus schemes are known as premium bonus plans. Examples of such schemes are Halsey and
Rowan.
Halsey - This is where the employee receives 50% of the time saved. It can be calculated as follows;
Time Allowed - Time Taken Time

Bonus = x
2 Rate
Rowan - This is where the proportion paid to the employee is based on the ratio of time taken to time allowed.
Time Taken Time Time

Bonus = x x
Time Allowed Rate Saved
Measured Day Work - This is approach is to pay a high time rate, but this rate is based on an analysis of past
performance. Initially, work measurement is used to calculate the allowed time per unit. This allowed time is compared
to the time actually taken in the past by the employee, and if this is better than the allowed time an incentive is agreed.
Share of Production - This is where the share of production plans are based on acceptance by both management and
labour representatives of a constant share of value added for payroll. Thus, any improved production performance or
cost savings are shared by employees in this pre-agreed ratio.
Measures Related to Labour
This is a measure of the proportion of people leaving relative to the average number of people employed. It is calculated
as follows;
Number of employees that left in the period

Labour Turnover = x 100 = %
Average Number of Employees in the period
The following can be seen as a few causes for labour turnover to occur;
ü Poor Remuneration
ü Poor Working Conditions
ü Lack of Growth Prospects
ü Discrimination and Bullying in the workplace
ü Retirement
ü Death
ü Illness
ü Relocation
Organisations will face several costs with replacing vacancies of ex-employees. Such costs could include;
ü Advertising for open vacancies

ü Cost of Recruitment and Selection
ü Training newly employed staff
2. Labour Efficiency
The labour efficiency ratio is used to calculate the performance of the workforce by comparing the actual time taken to
do a job with the expected or standard time (i.e. the time it should have taken). The following formula is used;
Standard Hours for Actual Output

x 100
Actual hours worked to produce output
3. Idle Time
During certain times, the staff maybe idle. This can be for various reasons such as;
ü If machines break down

ü Delay in delivery of raw materials
Thus, we use the idle time ratio to measure how much of the working time was spent by labour being idle. The following
formula is used;
Idle Hours
x 100
Total Hours
4. Labour Capacity Ratio
This is used to measures the number of hours spent actively working as a percentage of the total hours available for
work (full capacity or budgeted hours). The following formula is used;
Actual hours worked to produce output

x 100
Budgeted Hours
5. Labour Production Volume Ratio
This is also called the activity ratio. It is used to compare the number of hours expected to be worked to produce actual
output with the total hours available for work (full capacity or budgeted hours). It can be calculated with the following
formula;
Standard Hours for Actual Output

x 100
Total Budgeted Hours
C3. ACCOUNTING FOR OVERHEADS
Overheads are built up of indirect materials, indirect labour and other indirect expenses. These can be grouped based on
where in the business they are incurred, such as;
o Production
o Administration
o Sales and Distribution
The production overheads of a factory can consist of the heating and lighting cost, rent, etc. The production cost centres
could include;
o Assembly
o Machining
o Painting
o Finishing
In order to support these cost centres, there could also be service cost centres such as;
o Canteen
o Maintenance
o Stores
Overheads can be absorbed using Absorption Costing.
Absorption Costing
This is where production overheads are recovered by absorbing them into the cost of a product. It allows business to
make decisions about pricing policies and value inventory in accordance to IAS 2. The following are the stages to carry
out the absorption costing process;
ü Allocation and apportionment of overheads to the different cost centres

ü Reapportionment of service (non-production) cost centre overheads to the production cost centres
ü Absorption of overheads into the products
Allocation and Apportionment of Overheads

The first stage of the absorption costing process involves the allocation and apportionment of overheads.
Allocation is where overheads are directly charged to specific departments. For example, cost of paints can be directly
charged to painting or cost of cleaning liquid to maintenance.
For overheads that belong to more than one department, the cost must be shared between the departments using
apportionment. This can be done based on the following examples of bases of apportionment;
ü Floor Area - For rent and rates

ü Carrying amount of non-current assets - for depreciation and insurance of machinery
ü Number of employees - for canteen costs
ü Units of electricity consumed - for heating and lighting costs
Consider the following illustration for apportionment.
Company J has two cost centres (assembly and finishing) and a service department (maintenance) with the following
costs. Indirect Materials - $20,000, Rent - $10,000, Electricity - $5,000, Depreciation - $12,000
The following information is available
Assembly Finishing Maintenance Total
Area (Sq. Ft.) 2200 1500 300 4000
kWh consumed 600 300 100 1000
Machine Value $ 55000 40000 5000 100000
Indirect Material 5000 1000 14000 20000
Budget $
Answer;
Overhead Basis of Assembly $ Finishing $ Maintenance Total $
Apportionment $
Indirect Allocated 5000 1000 14000 20000
Material
Rent Area 5500 3750 750 10000
Electricity kWh 3000 1500 500 5000
Depreciation Machine 6600 4800 600 12000
Value
Total 20100 11050 15850
Workings;
Indirect Material - Cost is already allocated as per details provided
Rent - Total rent is $10000 and total area is 4000 Sq. Ft. Therefore, rent per Sq. Ft. = 10000/4000 = $2.5
Rent for Assembly = 2200 x 2.5 = $5500
Electricity - Total Electricity is $5000 and kWh consumed is 1000. Therefore, electricity per kWh = 5000/1000 = $5
Electricity for Assembly = 600 x 5 = $3000
Depreciation - Total Depreciation is $12000 and total machine value is $100000. Therefore, depreciation per $ of
machine value = 12000/100000 = $0.12
Depreciation for Assembly = 0.12 x 55000 = $6600
Re-Apportionment of Overheads
Service cost centres (departments) are not directly involved in making products. Thus, the production overheads of
service cost centres must be shared out between the production cost centres (departments) using a suitable basis.
There are 3 suitable methods;
1. Direct Method : This is where the cost of each service cost centre is re-apportioned to the production cost
centres only
2. Step Down Method: This is used when one service department works or provides a service for other service
departments as well as the production departments.
3. Reciprocal Reapportionment : This is also called the repeated distribution method. This is where used where
service cost centres do work for each other as well as provide a service for the production cost centres. It involves
carrying out many reapportionments until all of the service departments’ overheads have been reapportioned to
the production departments.
Consider the following illustration;
The total overheads allocated and apportioned to the production and service departments of Company Y are as follows;
Assembly - $ 20000
Finishing - $ 12000
Maintenance - $ 10000
Canteen - $ 15000
The canteen caters to the employees of assembly and finishing departments.
Assembly Finishing Maintenance Canteen Total
No. of Employees 20 10 5 5 40
Conduct the reapportionment based on the following methods;

1. Direct Method (based on time spent of 60% to Assembly and 40% to Finishing for maintenance)
2. Step Down Method (based on time spent of 60% to Assembly and 40% to Finishing for maintenance and by
number of employees for canteen)
3. Reciprocal Method (based on time spent of 50% to Assembly, 40% to Finishing and 10% for Canteen for
maintenance and by number of employees for canteen)
Answer;
1.
Basis of Assembly Finishing Maintenance Canteen Total
Apportionment
Total from 20000 12000 10000 15000 57000
above
Reapportion Employees 10000 5000 (15000) -
Canteen
Reapportion % time spent 6000 4000 (10000) -
Maintenance
Total 36000 21000 0 0 57000
2.
Apportionment
Total from 20000 12000 10000 15000 57000
above
Reapportion Employees 8571 4286 2143 (15000) -
Canteen
Total 28571 16286 12143 0 57000
Reapportion % time spent 7286 4857 (12143) 0 -
Maintenance
Total 35857 21143 0 0 57000
3.
Apportionment
Total from 20000 12000 10000 15000 57000
above
Canteen
Total 28571 16286 12143 0 57000
Reapportion % time spent 6072 4857 (12143) 1214 -
Maintenance
Total 34643 21143 0 1214 57000
Canteen
Total 35337 21490 173 0 57000

Reapportion % Time spent 87 69 (173) 17 -
Maintenance
Total 35424 21559 0 17 57000
Canteen
Total 35433 21566 1 0 57000
Absorption of Overheads
Once overheads have been allocated, apportioned and re-apportioned to the relevant departments, it is essential that the
overheads are then absorbed to the units of product. They can be absorbed into cost units based on the following
absorption bases:
ü Units produced
ü Machine hour rate
ü Labour hour rate
ü Percentage of prime cost
ü Percentage of direct wages
The overhead absorption rate is calculated with the following formula;
Budgeted Production Overhead

OAR =
Budgeted Total of Absorption Basis
Since a product can pass through different departments in the production process (such as assembly, machining,
finishing, etc.) it can have multiple OARs, one for each department. Consider the following illustration;
Company X has two departments with the following overheads;

Assembly $ 10,000
Finishing $ 20,000
Assembly is a labor-intensive department, whilst Finishing is machine intensive. The following number of working
hours was incurred;
Labour 2500 hours
Machining 4000 hours
Calculate the OAR for both departments
Answer;
Assembly = 10000/2500 = $4 per hour
Finishing = 20000/4000 = $5 per hour
Under and Over Absorption of Overheads

If the estimates for the budgeted overheads and/or the budgeted level of activity are different from the actual results for
the year then this will lead to one of the following:
ü Under-absorption of overheads
ü Over-absorption of overheads
To calculate an under or over absorption, the following 3 steps are involved.
Step 1 : Calculate the budgeted OAR (Budgeted Overhead/Budgeted Activity Level)
Step 2 : Calculate the overhead absorbed by the actual activity
Overheads absorbed = Budgeted OAR x actual level of activity
Step 3 : Compare actual O/H vs absorbed O/H
If the overheads absorbed are greater than the actual overheads, then there has been an over-absorption of overheads.
If, on the other hand, the overheads absorbed are less than the actual overheads, then there has been an under-
absorption of overheads.
Production Overheads Account

Indirect production costs are debited to Production overheads account.
Absorbed production overheads are credited out of the production overheads account and debited into the WIP account.
Any difference between the actual and absorbed overheads is known as the under- or over-absorbed overhead and is
transferred to the statement of profit or loss at the end of an accounting period
The non-production overheads will be debited to one of the following based on where it was incurred;
ü Administration Overheads Account

ü Selling Overheads Account
ü Distribution Overheads Account
ü Finance Overheads Account
Shown below is the production overheads account and as well as over/under absorption account.
Production Overheads
Indirect Labour XX WIP XX

Indirect Materials XX Under Absorption XX
Indirect Expenses XX
XXX XXX
Over/Under Absorption of Overheads
Production O/H XX Statement of Profit or Loss XX
XX XX
C4. ABSORPTION AND MARGINAL COSTING

Marginal and absorption costing are two different ways of valuing the cost of goods sold and finished goods in inventory.
Marginal Costing
This is where the cost of a unit of inventory is the total of the variable costs required to produce the unit (the marginal
cost). The fixed costs are entirely excluded when calculating the cost of production. They are treated as period costs and
deducted as an expense in the statement of profit or loss.
The marginal cost will be calculated by taking into consideration the direct materials, direct labour, direct expenses and
variable production overheads. The main benefit of using a marginal costing system is to identify the incremental or
additional cost that will be incurred from producing one extra unit and vice versa.
The contribution concept is used to identify the incremental profit that can be earned from one unit or multiple units of
a product sold. It can be calculated as follows;
Contribution = Sales Price – Total of all Variable costs
Calculating the total contribution can be done with the following formula;
Total Contribution = Contribution per unit x Sales volume
Finally we can calculate the profit using;
Profit = Total Contribution - Fixed Overheads
Absorption Costing
This is calculated by valuing each unit of inventory at the cost incurred to produce the unit. The product cost will also
include the production overheads. Consider the following illustration for clarity on marginal and absorption costing;
X PLC has the following budgeted costs for the upcoming period.
Direct Materials $5 per unit
Direct Labour $3 per unit
Variable Overheads $1 per unit
Fixed Overheads $50,000
Variable Selling Cost $2 per unit
A total of 10,000 units are expected to be produced and 8,000 units will be sold. The selling price is $25 per unit. The
actual fixed overhead at the year-end was $55,000. Assuming the opening inventory is nil, prepare the statement of
profit and loss for;
1. Marginal Costing
2. Absorption Costing
Answer;
1.
$ $
Revenue (8000 x 25) 200,000
Cost of Production
Direct Material (5 x 10000) 50,000
Direct Labour (3 x 10000) 30,000
Variable O/H (1 x 10000) 10,000
Total cost of Production 90,000
Closing inventory (90000/10000 x 2000) (18,000) (72,000)
128,000
Variable Selling O/H (2 x 8000) (16,000)
Contribution 112,000
Expenses
Fixed Cost (55,000)
Net Profit 57,000
2.
$ $
Revenue (8000 x 25) 200,000
Cost of Production
Variable O/H (1 x 10000) 10,000
Fixed Overhead 50,000
Total cost of Production 140,000
Closing inventory (140000/10000 x (28,000) (112,000)
2000)
88,000
Fixed O/H Over/(Under) Absorbed (5,000)
Gross Profit 83,000
Expenses
Variable Selling O/H(2 x 8000) (16,000)
Profit 67,000
Impact on Inventory Valuation and Profit

Following the above illustration, we see that the reported profit is higher using the absorption costing method. Moreover,
the value of closing inventory is also different between marginal costing and absorption costing.
Key Takeaways
ü If closing inventory is higher than opening inventory, absorption costing gives the higher profit.
ü If opening inventory is higher than closing inventory, marginal costing gives the higher profit.
ü If inventory levels are constant, then both methods will give the same profit.
Advantages and Disadvantages of absorption and marginal costing

Advantages of Marginal costing Advantages of Absorption costing
ü Contribution per unit is constant unlike profit per ü Absorption costing considers fixed costs and is in
unit which varies with changes in sales volumes. accordance with IAS 2.
ü There is no under or over absorption of ü Analyzing under/over absorption of overheads is

overheads, requiring no adjustments. a useful exercise in controlling costs of an
organisation.
ü Fixed costs are a period cost and are charged
entirely to the period. ü Absorbing overheads into product costs is the
best way to estimate job costs and profits for
ü Useful in the decision-making process. small organisations.
ü It is easy to operate.
Disadvantages of Marginal costing Disadvantages of Absorption costing

ü Closing inventory is not valued in accordance ü More complex to operate than marginal costing.
with IAS 2 principles.
ü It does not provide as much useful information
ü Fixed production overheads are not for decision making.
allocated/apportioned between units of
production, but written off in full instead.
C5. JOB, BATCH AND PROCESS COSTING

Job Costing
Two forms of costing systems;
1. Specific Order Costing : This is when the organization carries out work that is done in batches or as separately
identifiable jobs.
2. Continuous Operation Costing: This is when good/services are produced as a direct result of a sequence of
continuous operations or processes.
This is a form of specific order costing and it is used when a customer orders a specific job to be done. Each job is priced
separately and each job is unique. Basically, the focus is to identify the costs associated with completing the individual
job and cost it accordingly. The selling price for each job is decided by adding a % on top of the costs. The types of jobs
here are specific to the customer and will differ between different customers. For example, for a construction company,
one client’s job may be to build a pool, whilst another client’s job would be to build a garden shed.
The estimated cost for Job XYZ are as follows;
Direct Materials 5KG @ $ 35 per KG

Direct Labour 10 Hours @ $20 per hour
Variable overheads are charged at $3 per direct labour hour. Fixed production overheads are absorbed at $15 per
labour hour. Other non-production overheads are charged at $150 per job. A mark up of 20% is added on cost to
arrive at the selling price. What is the selling price of the job?
Answer;
Direct Materials (35 x 5) 175

Direct Labour (20 x 10) 200
Variable O/H (3 x 10) 30
Fixed O/H (15 x 10) 150
Non-Production O/H 150
Total Cost 705
Mark-up (705 x 20%) 141
Selling Price 846
Batch Costing
Batch costing is also a form of specific order costing and is very similar to job costing. However, costing is done for a
batch of units produced.
When the batch is completed the unit cost of individual items in the batch can be found using;
Total production cost of batch
Cost per unit in a batch =
Number of units in the batch
Job X-156 is a production batch consisting of 15,000 units and the estimated costs are as follows;
Direct Materials 2500 Kg @ $5 per KG
Labour 100 hours @ $15 per hour
Variable O/H $5 per direct labour hour
Fixed production overheads are absorbed at $14 per labour hour. Other non-production overheads are charged at
$300 per batch. What is the cost per unit produced?
Answer;

Variable O/H (100 x 5) 500
Fixed OH (100 x 14) 1,400
Non-Production O/H 300
Total 16,200
Cost per unit (16200/15000) $ 1.08
Process Costing
This costing method is applicable when goods or services result from a sequence of continuous or repetitive operations
or processes. An example could be for an organization which produces goods in mass production, such as oil. As the
products are indistinguishable to each other, the average unit cost is calculated as follows;
Net costs of inputs

Average cost per unit =
Expected output
The following details relate to process 2;

Material transferred from process 1 2,000 units at cost of $ 50 per unit
Labour cost $ 15,000
Overhead cost $ 5,000
Material transferred to process 3 2,000 units
Calculate the average cost per unit in process 2.

Answer;
Process 1 cost (2000 x 50) 100,000

Labour cost 15,000
Overhead cost 5,000
Net Costs of Input 120,000
Average cost per unit (120000/2000) $60
Losses and Gains in Process Costing

As a product passes through multiple processes, there could be losses that and gains that may occur. This could be as a
result of;
ü Damages
ü Wastages
ü Evaporation
ü Mistakes
Production units which have been affected will then be required to be either brought to a state where they can be sold,
which can cost them further or can be sold for a lower value in some cases. The following types of losses and gains will
be covered in the upcoming areas;
ü Normal Loss/Gain
ü Abnormal Loss/Gain
A Normal Loss is the expected loss in a particular process. It is expressed as a percentage of the total materials input to
the process.
Example
The following information relates to process 1.
- Materials Input is 100 units costing $5 each.
- Labour cost is $4500, Overheads $1000
- Normal Loss is 5% of output. Actual output = 95 units
- Calculate the cost per unit in Process 1 and complete the process account.
This normal loss can sometimes be sold as scrap. If it is to be sold as scrap, the following formula will be used to derive
the average cost per unit;
Total cost of inputs-scrap value of normal loss

Average cost per unit after scrap =
Input unit-normal loss units
Abnormal Losses and Gains occur when there is a difference in contrast to the expected loss. In other words, if the actual
loss was higher than the expected loss, it would be an abnormal loss and vice versa. The following example shows how
it can be calculated; The following relates to process 1.
ü Materials Input is 100 units costing $5 each.
ü Labour cost is $4500, Overheads $1000
ü Normal Loss is 5% of output and cannot be sold.
ü Actual output =92 units
ü Calculate the cost per unit in Process 1 and complete the process account.
Abnormal losses are charged to the Statement of Profit or Loss as an expense. Abnormal losses can be scrapped too.
Cash received for it is offset against the cost and transferred to SOPL.
Works-in-Progress and Equivalent Units

At the end of an accounting period, there could be some units which were still in production as at the final date of the
period. These may not be fully completed for sale, thus will be called closing work in progress. The output at a period
end consists of;
1. Fully processed/completed units – These are transferred in full value to the next process in the next period
2. Partly processed/completed units – These are the opening works-in-progress for the upcoming accounting
period. In order to allocate a value to such units, the concept of Equivalent units is used.
Concept of Equivalent Units – The idea is that that part processed unit can be expressed as a proportion of a fully
completed unit. i.e., if a product has gone through 40% of the process, then 40% of the cost can be allocated to it.
Example
The following information is available for Process 2 at RJ Limited as at the year end.
Period costs $5000
Input 500 units
Output 400 units fully completed, 100 units 50% completed
Calculate the equivalent cost per unit as at the year end.
Answer: $5000 / (400 units + (100 units x 50%)) = $11.11 per unit
Joint and By-Product Costing

In the production process, depending on the organization, there is a possibility of producing more than one product from
one process. For example, during petroleum extraction and refining, more than one product is separated. Such products
are called “Joint Products” and generally have a significant value. “By-products” are those with some value, created as
a result of the separation of joint products.
Joint Products
Examples of Joint products include petrol and diesel from crude oil. These have a high saleable value, since these are
some of the main products created from the production process.
By Products
Examples of by products include Saw dust from timber. These have low resale value compared to Timber itself.
Costing of Joint Products

The point of separation of the joint products marks a boundary. Any cost incurred before this boundary is a common
cost and needs to be apportioned to the Joint Products on an appropriate basis. The following methods are used to
apportion the joint costs;
1. Market Value/Sales Value
2. Production units
3. Net Realisable Value
Consider the following example.
MCF Limited produced two joint products, S and R. For the current period, the joint cost were $100,000. A total 10,000
units of S and 15,000 units of R were produced. Additional processing costs of $5,000 for S and $10,000 for R were
incurred. The selling price for S is $8, while R sells for $4.
Apportion the costs to both products using;

1. Market Value/Sales Value
Total market value;
S = 10,000 x 8 = $80,000
R = 15,000 x 4 = $60,000
Total market value = $140,000
Cost Apportionment;
S = (80/140) x 100 = $57,142
R = (60/140) x 100 =$42,857
2. Production Units
S = (10,000/25,000) x 100,000 = $40,000
R = (15,000/25,000) x 100,000 = $60,000
3. Net Realisable Value

Total Net Realisable Value;
S = (10000 x 8) – 5,000 = $75,000
R = (15,000 x 4) – 10,000 = $50,000
Total NRV = $125,000
Cost Apportionment;
S = (75/125) x 100,000 = $60,000
R = (50/125) x 100,000 = $40,000
Costing of By-Products
Since these don’t have a major value, these are generally of less significance and may not require a precise cost
allocation. The following methods can be used for accounting of By-product;
Non-Cost methods: They can be considered as another income in the statement of Profit or Loss
The revenue from by products can be offset against the cost of the main product.
Cost methods: They can be valued at the Opportunity Cost or replacement cost of purchasing the same by product.
A particular proportion of the joint cost can be apportioned to the by product.
C6. SERVICE AND OPERATION COSTING

Nature of Service and Operation Costing
Not every organization manufactures physical products. There are organizations that operate in the service sector too.
Costing systems have been designed keeping in mind the strenuous requirements and operations at these service sector
organisations. The following shows the differences between the output of a manufacturing firm and a service provider.
Manufacturing Organisation Service Providing Organisation

ü Products are tangible. ü Products are intangible
ü Products are homogenous ü Products may be heterogenous based on

customer need and input from staff
ü Can be produced and stored for a particular time
period ü Usually produced and consumed simultaneously
as it cannot be stored
Examples of service organisations along with the services they offer are as follows;
ü Accounting firms - statutory audit services, book keeping services, tax computations
ü Hair Salons - haircuts, hair coloring
ü University - bachelor’s programs, masters programs
When applying costing techniques to such organisations, there is no universal approach. Two companies in the same
industry may have two different approaches to costing. However, the cost unit decided needs to be realistic and reflect
on the costs actually incurred by the company. In the case where the cost is based on two variables, a composite cost
unit can be used.
This is where the cost is a variable that is dependent on another variable. For example, a delivery company may have
costs rising due to the number of kilometers driven in a particular period. Thus, the composite cost unit can be based on
the two variables as kilograms-kilometers. The costs that need to be included when making calculations related to
services are;
ü Direct Material (if any is being used)
ü Direct Labour
ü Direct Expenses
ü Overheads
Example
Junior runs a laundry in the centre of town. He on average has 300 customer jobs per month. He has a policy of ensuring
that each customer job is washed separately so that clothes of multiple customers does not mix. For the past month, the
following costs were incurred at the laundry.
Cost
Water $500
Electricity $300
Washing liquid $100
Wages $300
Calculate the cost per wash.
Answer: $4
[500 + 300 + 100 + 300]/300 washes = 1200/300 = $4
Analysis of Costs
In a situation where two organisations in the same industry are following similar costing strategies, comparisons between
the performance of the two are made much easier. This can even apply to branches of an organization which offer the
same service.
Example
JFC is a laundry operating in two locations in the same town. They offer the same service to customers. The details for
the two laundries for the past month are given below.
Cost Downtown Laundry Uptown Laundry
Water and Electricity $800 $900
Wages $2000 $1800
Washing powder $200 $300
Depreciation $500 $1000
Number of Washes 500 800
At each location, the customer is charged $10 per wash.

Calculate the cost per service unit and identify which laundry has performed better.
Answer:
Downtown Laundry = (800 + 2000 + 200 + 500)/500 washes = $7 per wash
Profit = (500 x 10) – (500 x 7) = $1500
Uptown Laundry = (900 + 1800 + 300 + 1000)/800 washes = $5 per wash

Profit = (800 x 10) – (800 x 5) = $4000
Conclusion: Uptown laundry is more efficient since washes are $2 cheaper and more profit was earned.
C7. ALTERNATIVE COSTING TECHNIQUES

Allocation of Overheads
Traditionally, overheads are absorbed into product costs using the following two methods;
ü Absorption: Overhead is divided by the labour/machine hours used or units produced or other suitable base and
then allocated accordingly.
ü Marginal: Variable overheads are directly charged to the product, whilst fixed overheads are considered a period
cost
Activity Based Costing

In most modern organisations, more than one type of product will be offered for sale. Thus, using a common overhead
absorption rate to allocate overheads to all products may not be a viable option since the different product types may be
using the overhead differently. The introduction of Activity Based Costing has simplified the process and made the
costing of multiple products more accurate and reliable. This is done in 4 steps as follows;
Step 1: Identify the Cost pool. This is the individual overhead cost. Eg: Cost of Ordering
Step 2: Identify Cost Driver for cost pool. Each cost pool will have a cost driver, in other words the independent variable
element which will cause the cost to vary. The higher the cost driver, the higher the value of the cost pool. Eg: The cost
driver for the cost of ordering could be the number of orders placed
Step 3: Calculate the Cost-Driver rate. Ideally, this is to identify the cost per driver. Eg: The cost incurred per order
placed (Cost pool/Number of cost drivers)
Step 4: Allocate the cost driver rate to products based on how much of the cost pool activity is consumed by the product
Example
Company R makes two products: 500 units of K and 1000 units of L. An overhead incurred include Raw Material
Delivery cost of $3000. Number of deliveries was 10. Both products use the same raw materials, consuming at 2kg per
unit of K and 3kg per unit of L. Each delivery carries 400kg of Raw material. Allocate the overhead per unit of K and
L.
Answer: Step 1: Cost pool = Delivery Cost

Step 2: Cost Driver = Number of Deliveries
Step 3: Cost-Driver Rate = 3000/(400KG X 10 Deliveries) = $0.75 per KG
Step 4: K = 0.75 x 2 = $1.50 | L = 0.75 x 3 = $2.25
The advantages and disadvantages of using Activity Based Costing are;
ü More accurate way of costing products and can ü Complexity related to identifying the cost drivers
help to price products better and then carrying out calculations
ü Provides better insights into how costs are ü Time consuming and difficult nature can take
structured and what influences and drives these away accountants time from other activities
costs
ü Benefits of ABC might not justify the cost
ü In complex business environments, ABC can be incurred for it
applied to get a more realistic cost
ü Not all overheads can be allocated
ü Can be applied for both production and service
environments
Target Costing
Certain organisations look at a particular percentage of desired profit, and then communicate it to the operational
managers. Ideally, the manager will then have to identify the current selling/market price of the product and deduct the
profit requirement in order to arrive at the cost. This cost is considered the target cost, and the actual cost to be incurred
for production needs to be below or equal to the target cost.
A simpler definition would be “A product cost estimate derived by subtracting a desired profit margin from a competitive
market price.”
Example
If the market price of a ton of sugar is $100 and company policy is to have a profit margin of 30%, then what is the
maximum cost that can be incurred to manufacture the product?
Answer = 100 – (100 x 30%) = $70
Life Cycle Costing

The usual understanding in organisations is that all products will go through a series of stages in its life. The stages a
product goes through are as follows;
1. Research and Development
2. Introduction
3. Growth
4. Maturity
5. Decline
With regards to certain costs, it is much more efficient to allocate the cost and recover it over the life of the product.
This could be since initial costs incurred are too high to be charged to the initial set of customers and would require a
longer time to be recovered. Thus, the following steps are involved when using life cycle costing;
Step 1: Identify Product Life. This is where the products estimated time (from introduction to eventual decline) is
estimated.
Step 2: Identify all costs related to the product from introduction to abandonment.
Step 3: Allocate the costs to each part of the timeline.
The advantages and disadvantages of using life cycle costing are as follows;
ü It gives organisations the ability to forecast ü Difficulty in deciding a life cycle since product
profitability over the entire period of the product future maybe uncertain at the point of deciding
life
ü There could be future costs that can arise related
ü Costs once allocated over the life cycle can make to the product which cannot be predicted
the initial pricing lower, encouraging more sales
from customers. Ideally, this can lead to costs
being covered before the intended time period.
ü The actual costs incurred can be compared

against what was budgeted for the planning and
control purpose
Total Quality Management

Total Quality Management or TQM is a philosophy of quality management which focuses on 3 principles;
1. “Get it right, the first time” - This aims at reducing and achieving zero rejects and 100% quality for the product
being manufactured.
2. “Continuous Improvement” - This is a goal that can change from time to time and may not be 100% achievable.
It is based on the current way of doing things and could be different across time periods. Ideally, the aim is to
continuously improve on the current state of processes within the organization.
3. “Customer Focus” - Based on the customer’s requirement for both the product and its quality, the organization
should aim of meeting that requirement.
Quality Related Costs

A quality related cost is simply the cost of ensuring and assuring quality. There are 4 categories of Quality Related costs;
ü Prevention cost: This is the cost to prevent or reduce any defects or failures and is implemented before
production. This includes the costs of research, field trials, customer surveys, supplier material reviews, staff
training and so on.
ü Appraisal cost: This is the cost at the level of production and is incurred in ensuring conformance of the product
quality to the requirements perceived. This includes the costs related to inspection and testing, operational
audits, test equipment operating expenses, etc.
ü Internal Failure cost: This cost occurs after production, but before the product is dispatched to the final customer.
This can include costs related to rework, repairs, disposals and so on.
ü External Failure cost: This cost occurs after the customer has received the product. It includes the cost of
warranty, product recalls, complaint investigation costs, legal costs, etc.
D Budgeting
Key Topics;
Ø Budgeting
Ø Capital Budgeting

D1. BUDGETING
Purposes of Budgeting
A budget is a plan prepared for a future time period. It will contain a quantitative expression of a plan for the period it
is prepared for. The budget will contain the costs, revenues expected for the period. The purposes of preparing budgets
include;
ü Motivation of staff to work efficiently and productively towards achieving the targets
ü Planning for the future based on the objectives of the organization
ü Controlling costs and ensuring that there won’t be significant differences if the worst case happens
ü Communication of the requirements set by the senior management to individual managers
ü Evaluation of performance at the end of the period of a budget
Stages of Preparing a Budgeting

The following stages will be involved in the process of preparing a budget.
1. Firstly, the organization will need to have a mission and a set of objectives.
2. Afterwards, a budget committee is formed. This could consist of the board of directors, along with relevant
persons from the finance department. In some cases, the budget holder may also be present.
3. The budget manual is then decided upon. This will contain the details on the instructions related to preparing
the budget and using it.
4. Identification of limiting factors is then undertaken since for every organization, there would be a particular
limiting factor. For example, it could be the lack of skilled labour.
5. Afterwards, it is simply where the budgets are formulated. This is where a draft budget is prepared and sent to
the respective budget holder for feedback. Upon receiving the feedback, there may be changes made to the
budgets. After the changes are made, the budgets will be approved and reviewed regularly.
Types of Budgets
1. Participative Budgeting (Bottom Up) - This is where the budget holder, i.e., the manager responsible for the
budget, will also be taking part in the budget setting process. This way it will;
ü Increase the motivation
ü Make the budgets more realistic since frontline information is available
At the same time however, it can cause budgetary slack, as the managers may set limits/budgets which are easy for
them to achieve, and be praised for performance without much of an effort.
2. Imposed Budgeting (Top Down) - This is where the budgets are decided by the top management and passed
down to the budget holder to achieve. This will;
ü Eliminate any sort of budgetary slack and inefficiencies
ü Be in line to achieve the organizational objectives
However, this budget will have a few drawbacks too. This includes;
ü Lack of motivation since the budget holder’s views weren’t accounted
ü The budgets set may be unrealistic in some cases
ü The management may not have access to information, which lower-level managers/staff may have
access to
3. Continuous/Rolling Budgets - In certain organisations, budgets are prepared for short periods within an
accounting year. This could be for example in four quarters per year. In this case, a rolling budget is where the
budget extends into a new period when the current period has lapsed. So essentially, when Q3 of the current
year has ended, the budget has been extended up to Q3 of the following year, as an additional period has been
added.
4. Incremental Budgets - This is where the budget for the previous year has been adjusted for inflation and is being
used as the budget for the current year.
Functional Budgets
Functional Budgets are prepared for a particular part of the business and contains the income/expenditure for that part.
The main functional budgets are;
1. Sales budget
Company FS makes two products, J and L. The budgeted sales units for the upcoming year are planned to be 10,000
units of each product. The budgeted selling price is $8 for J and $15 for L. Prepare the sales budget.
Answer:
J = 10000 x 8 = $80,000
L = 10000 x 15 = $150,000
Total Budgeted sales = $230,000
2. Production budget
units of each product. The company has a policy to maintain 10% of inventory required for the upcoming sales period.
Assuming that the closing inventory is 1,500 units of each, prepare the production budget.
Answer:
J L
Opening Inventory (1,000) units (1,000) units
Sales 10,000 units 10,000 units
Closing Inventory 1,500 units 1,500 units
Budgeted Production units 10,500 10,500
3. Raw Material usage budget and Raw material purchases budget

units of each product. Each unit of J uses 5kg of raw material S and each unit of L uses 3kg of raw material of S. Raw
material S costs $1.5 per kg. The company has the a policy to maintain 10% of inventory required for the upcoming
production period. Assuming that the closing inventory is 10,000 kg of S, prepare the Raw Material Usage and Purchases
budget.
Material Usage Budget

Opening Inventory (8,000) kg [(10% x 10000 units x 5kg) + (10% x 10000 units x 3kg)]
Required 80,000 kg [(10000 units x 5kg) + (10000 units x 3kg)]
Closing Inventory 10,000 kg
Material purchases 82,000 kg
Material Purchase Budget

82,000 kg x $1.5 = $123,000
4. Labour budget
units of each product. Each unit of J requires 3 hours of skilled labour and 1 hour of unskilled labour, whilst each unit
of L requires only 2 hours of skilled labour. Skilled labour is paid at $10 per hour, while unskilled is paid at $6 per hour.
Prepare the labour budget.
Labour budget:
Product J Skilled Labour = 30,000 hours
Product L Skilled Labour = 20,000 hours
Total skilled labour = 20,000 x $10 = $200,000
Product J unskilled labour = 10,000 hours

Total unskilled labour = 10,000 x $6 = $60,000
Total Labour Budget = 200,000 + 60,000 = $260,000
5. Overheads budget
units of each product. Each unit of J requires 1 hour machining, whilst each unit of L requires 2 hours of machining.
The overheads per machine hour is estimated at $5. Prepare the Overhead budget.
Overhead budget:
Product J = 10000 x 1 x $5 = $50,000
Product L = 10000 x 2 x $5 = $100,000
Total overhead budget = $150,000
Cash Budgets and Cash Flow Forecasting

A cash budget is prepared to identify the cash receipts and payments expected to occur within a period. This would
generally contain the “confirmed” or committed receipts and payments. A cash forecast is simply an estimate of the
cash receipts and payments for a future period. Cash budgets are useful in order to;
ü Plan cash requirements
ü Compare with actual spending
ü Assist in the process of receiving/making payments
Example
The following information relates to HMS PLC.
January February March
Sales $100,000 $200,000 $150,000
Purchases $40,000 $80,000 $60,000
The following pattern has been observed in relation to payments and receivables.
In the month of sale/purchase, 40% of transactions happen on cash.
In the month after the sale/purchase, 80% of remainder is disbursed.
In the second month after the sale, 10% of the remainder of sales is written off and the rest is recovered. All
purchases are settled here.
Prepare the cash flow forecast for the month of March.
Cash Sales – March $60,000
Credit Sales – February $96,000

Credit Sales – January $10,800
Total Inflow $166,800
Cash Purchases – March $24,000

Credit Purchases – Feb $38,400
Credit Purchases – Jan $4,800
Total Outflow $67,200
The following information relates to TSJ Limited for the upcoming month.
Sales 1000 units @ $8 each

Production costs 1200 units @ $3 each
Advertising cost 5% of revenue
Wages $500
Electricity $50
Prepare the cash budget.

$
Receipts
Sales 8,000
Inflow 8,000
Payments
Production Cost 3,600
Advertising 400
Wages 500
Electricity 50
Outflow 4,550
Net cash flow for the month 3,450
Budgetary Control
Control is the process of making decisions to ensure organizational goals and objectives are met. There is particular
process to be followed in the control process. Initially, once the mission and objectives are set, the budget is prepared
and put into action. Afterwards, at the end of the budget period, the actual occurrence needs to be compared against the
budget to identify the areas where performance was poor. Afterwards, the reasons for the poor performance could be
studied and relevant changes can be made to improve the performance for the future period. This can be done using the
following methods;
ü Feedback controls: This is done once the event has taken place, in other words after the budget period. For
example, the expenditure incurred for a particular item can be compared with the budgeted amount after the
budget period.
ü Feedforward controls: These are implemented before an event takes place. For example, cash budgets are used
to identify if there will be a cash surplus/deficit in future and prepare on strategies to manage it.
Fixed and Flexible Budgets

Fixed Budget is set for a particular level of activity. For example, if the firm aims to produce 100,000 units, they will
set the budgeted amount, which will be fixed for that 100,000 units. A flexible budget is used to adjust the fixed budget
based on changes in the volume of activity. So, for example if the output was different to budgeted, then a fixed budget
can be used to adjust it accordingly.
Example
The following information relates to RSM.
Fixed Budget Actual
Sales unit 100 120
Sales Revenue $800 $900
Labour Cost $500 $700
Overheads $100 $110
Prepare the figures for the flexed budget and calculate the variances
Fixed Budget Actual Flexed Variance
Sales unit 100 120 120
Sales Revenue $800 $900 $960 $60 Adv
Labour Cost $500 $700 $600 $100 Adv
Overheads $100 $110 $120 $10 Fav
The advantages and disadvantages of flexible budgeting;
ü Figures are more realistic and updated to current ü Time consuming process can take away time
activity levels from employees
ü Makes performance evaluations easier and much ü Does not consider any factors out of control of
fairer to the budget holder budget holders
ü Gives an understanding into how costs change

based on activity levels
ü Further insights into cost drivers
Responsibility Accounting
In budgeting, we understood that a particular person holds responsibility for the budget. Thus, their area of responsibility
may vary on the task carried out by the relevant department. This includes;
ü A cost centre - Manager is responsible for controlling costs
ü A Revenue centre - Manager is responsible for generation of revenue
ü A profit centre - Manager is responsible for both cost and revenue
ü Investment centre - Manager is responsible for decisions made regarding capital investment
Controllable and Uncontrollable Costs

Controllable Costs and Revenues are those which are under the authority and responsibility of a certain manager. In the
long term, all costs are controllable. For example, if the cost of cleaning liquid is high as of the current period, the
manager can move to a different low-cost supplier for the same liquid. This shows the controllable nature of the costs.
Non controllable costs relate to any costs which cannot be prevented on sudden decision. For example, rent up to a
certain extent is an uncontrollable cost.
D2. CAPITAL BUDGETING

Capital Investments
The spending incurred by an organization to acquire new non-current assets is called a “Capital Investment.” This is
since the amount of money spent could be a large amount and the asset may be expected of multiple years of use.
Capital and Revenue Expenditure

Capital Expenditure is the expenditure related to;
ü The acquisition of non -current assets for business use
ü Alterations or improvements made to existing non-current assets in order to increase their capacity
Capital expenditure will be shown in the statement of financial position and charged to the statement of profit or loss in
the form of depreciation for every year of the asset’s effective use.
Revenue expenditure is the expenditure related to;

ü Purchase of inventory for production/sales
ü Daily expenses incurred by the business
ü Maintenance costs of non-current assets
Revenue expenditure is charged to the statement of profit or loss in the period it was incurred.
Capital Budgeting and Investment Appraisal

A Capital budget is one which is prepared to identify and plan the capital expenditure for the upcoming several years
for the organization. This capital budget would undergo the investment appraisal process, where it will be assessed
whether the capital investment project in the long term is beneficial to the organization or not. Further Insight into
investment appraisal will be taken a look at in a later part of the chapter.
Relevant and Non-Relevant Cash Flows

In the capital investment appraisal process, the use of cash flows over profits is considered more appropriate for the
purpose of evaluating the investment. Thus, certain cash flows will be considered as Relevant and Non-Relevant for the
consideration when making investment appraisals.
Relevant Cash Flows Non-Relevant Cash Flows

Relevant Cash Flows are those cash flows which; Non-Relevant Cash Flows are those cash flows which;
ü Are Future costs and revenues ü Are sunk costs
ü Are cash flows ü Are committed costs
ü Are incremental costs and revenues ü Are non-cash flow items (e.g.: depreciation)
ü Are opportunity costs ü Are general fixed overheads
ü Are avoidable costs
The time value of money

In time to come, the costs of products in the market are on the rise. A product which costs for example $50 today, will
cost more in 2 to 3 years. This change in the prices occurs due to the time value of money. Thus, that $50 is worth more
if it spent today, than in the coming future. The time value of money is important due to the following reasons;
ü Preserving of value overtime - Rather than having cash in hand, it is much preferred to save it in an interest-
bearing account or investment with an appropriate return so that the issue of time value of money is tackled.
ü Risk of late receipts - Receiving funds later results in a lesser value, i.e., $10 received 1 year from now is less
worth compared to receiving it now.
Interest
Interest can be defined as the financial reward for saving money or the outright cost of borrowing it. We use two methods
of calculating interest;
This is where interest is calculated based on the original amount invested.
Example
Jason saves $500 in a bank offering 5% of interest. Calculate the interest received after 5 years.
Answer = (500 x 5%) x 5 years = $125
Compound Interest
This is where interest is calculated based on the previous bank closing balance. It could be the previous year’s closing
balance if interest is credited yearly, or even the previous month’s closing balance if interest is credited monthly. The
following formula is used for the ease of the calculation;
V = X (1 + r) n
Where V = future value

X = present value (value of investment)
r = Rate of interest
n = number of periods
Example
$100 is invested for 3 years at the rate of 5% on a compound interest basis. Interest is credited annually. Calculate the
balance after the 3 years.
V = X (1 + r) n
= 100(1 + 0.05) 3
= $115.8
Nominal and Effective Interest Rate

Nominal rates of interest is the stated rate of interest for the time period.
Effective interest rates on the other hand takes into consideration the effects arising from compounding interest rates.
The following formula is used;
r = (1 + i/n) n – 1
Where r = effective interest rate

i = nominal interest rate
n = number of periods
Example
If a nominal interest rate of 10% is offered per year and compounded on a 2-month basis, what is the effective interest
rate at the end of 1 year?
r = (1 + i/n) n – 1
= (1 + 01. /6)6 – 1
= 0.10426 = 10.43%
Discounting
Discounting is the total opposite of compounding. Whilst compounding finds the future value of a sum invested now,
discounting considers how much will be received in the future by establishing it in today’s value. In other words, it
considers the time value of money and adjusts it accordingly. Unless explicitly mentioned, the assumptions for
discounting are that all cash flows happen at the start or end of the year, with the initial investment happening at year
0(instantly) and the first cash inflow happening at year 1. The following formula is used for discounting
Present Value = Future Value x Discounting factor
Example
Calculate the present value of $100,000 if it is receivable in 2 years, assuming the interest rate is 10%.
Answer: 100,000 x 0.961 = $96,100
How are the discounting factors derived?

The discounting factors are available in the present value table. This will be provided at the exam. A sample of what it
looks like is below.
Cost of Capital
The rate of interest can be expressed using other terms as well. This includes;
ü Cost of Capital
ü Discount Rate
ü Required Return
Methods of Investment Appraisal

The following methods of Investment appraisal are used;
1. Payback Period
This is the expected time a project will take to pay back the money invested. Usually, many organisations will have a
payback period policy. Ideally, the payback period the investment needs to be shorter than the company policy in order
for the investment to be selected. The following formula is used;
Initial Investment
Payback Period =
Annual Cash Flow
Example
LKS Limited has a policy for a payback period of 5 years. The following investment is currently being considered. An
investment of $5 million is required. The investment will generate net cash inflows of $800,000 for 8 years. What is the
payback period and can the investment be accepted?
Answer = 5,000,000/800,000 = 6 years 4 months - The investment cannot be accepted.
There is a possibility of uneven cash flows and discounted cash flows being considered in the question. So based on the
requirement of the question, certain adjustments need to go in. The following are the advantages and disadvantages of
using the payback period;
ü It is easy to calculate and simple to understand ü Absolute profitability may not be considered
ü It uses cash flows over profits ü There is a chance of selecting investments that
pay back quicker than those that payback higher
ü A shorter payback period could be much more amounts in the long term
suitable to most organisations
ü Any cash flows beyond the payback period aren’t
considered
2. Net Present Value (NPV)

This is used to express the loss or benefit of an investment in present value. The decision criteria for NPV are as follows;
ü A positive NPV suggests the investment is viable

ü A negative NPV suggests the investment is unviable.
ü For mutually exclusive projects, the project with the highest NPV must be selected.
Example
MSR Ltd is planning on investing in the following project.
Initial investment $100,000

Scrap Value in year 4 $10,000
Year 1 2 3 4
Annual cash flows $25,000 $45,000 $70,000 $50,000
The cost of capital is 10% assuming that the initial investment is made at the start of the year and the cash flows start
from year 1, calculate the NPV of the project.
Answer
Discount Factor Net Cash Flow PV
Initial Investment (100,000)
Year 1 0.909 25,000 22,725
Year 2 0.826 45,000 37,170
Year 3 0.751 70,000 52,570
Year 4 0.683 60,000(W1) 40,980
NPV 52,895
W1: 50,000 + 10,000 = 60,000
The following advantages and disadvantages relate to NPV;
ü The time value of money is given consideration ü The calculation is quite complex and time
ü Absolute profitability is measured consuming
ü Considers cash flows over profit ü Those without a financial background may find
ü Considers the whole life of the project difficulties in understanding it
ü Projects with a longer payback period may be
selected on the grounds of a high NPV
3. Internal Rate of Return (IRR)

This is the rate of return at which the NPV is 0. Ideally, the decision criteria here is;
ü If the IRR is greater than the company’s cost of capital, the investment must be accepted.
ü For mutually exclusive investments, select the investment with highest IRR.
The following formula is used to calculate the IRR of a project.
Lower Rate of NPV at lower rate (Higher rate – Lower

IRR = + x
Interest NPV at lower rate – NPV at higher rate Rate)
Example
The following information was provided to the finance manager by the intern at RHRK Limited.
NPV @ 8% = $500
NPV @ 10% = $(200)
Calculate the IRR

500
IRR = 0.08 + x (0.10 – 0.08)
500 – (200)
IRR = 0.0943 =9.4%
The following advantages relate to IRR;
ü The time value of money is considered ü Not a measure of absolute profitability
ü Since it is a percentage, it should be easy to ü The complicated calculation can be time
understand consuming
ü Considers cash flows over profit
ü Considers whole life of project
Key Takeaways
For projects which have equal cash flows in every year, annuity factor tables can be used instead of the present value
tables. The annuity factor table shows the accumulated present value for the number of years as required. The following
is an example of an annuity factor table;
There could be certain cash flows which happen in perpetuity. Perpetuity here means forever. The present value (NPV)
of a cash flow occurring in perpetuity is calculated as follows;
1
PV = Cash Flow x
r
In the case of an IRR with a perpetuity, the following formula is used;
Annual Inflow
IRR of a perpetuity = x 100
Initial Investment
E Standard Costing
Key Topics;
Ø Standard Costing

E1. STANDARD COSTING

Definition of Standard Costing
A standard cost relates to the cost that is pre planned for a unit of a product or service. In other words, it is the budgeted
cost.
Types of Standards
There are four main types of standards. This includes;
1. Basic Standards - These are the standards that remain unchanged over a long period of time. These are the least
used and least useful type of standard.
2. Ideal Standards - These standards are based on ideal operating conditions. This includes no waste, no scrap, no
breakdowns, no idle time and so on. These however will adversely affect the motivation since its not possible
to have a perfect operating environment, making it unachievable.
3. Attainable Standards - These are the standards most frequently seen. These are based on efficient working
condition. There are allowances for waste, breakdowns, idle time and so on. This makes it achievable.
4. Current Standards - These are based on current levels of efficiency in the industry. There are allowances for
waste, breakdowns, etc. based on the level in the industry. However, there is no motivation to perform better
even if it is possible to do so.
Sales Variances
The following variances will be looked at;
1. Sales Volume Variance: The following formula is used to identify by how much the budgeted quantity sold and
actual quantity sold varied
(Actual Quantity Sold – Budgeted sales units) x Standard Contribution or Standard Profit per unit
**Either standard contribution or profit will be used depending on whether marginal or standard costing is being used.
2. Sales Price Variance: Used to show by how much the change in the sales price and quantity affected the overall
profit. The following formula is used;
(Actual Price – Budget Price) x Actual Quantity Sold
Example
The following data relates to company R.
Actual Sales 100 units @$10 each
Budgeted Sales 80 units
Standard Price $12
Profit per unit $4
Calculate Sales Volume Variance and Sales Price Variance.
Sales Volume Variance = (100-80) x 4 = $80 Favourable
Sales Price Variance = (10-12) x 100 = $200 Adverse
Materials Cost Variances

1. Materials Price Variance: This looks at the difference in the price that should have been paid for materials vs
the price that was actually paid. The formula used is;
(Actual quantity bought × standard price) – (actual quantity bought × actual price)
2. Material Usage Variance: This looks at the cost of how much raw material should have been used against how
much was actually used. The formula used is;
(Standard quantity used for actual production × standard price) – (actual quantity used × standard
price)
3. Total Material Variance: This is the total of the two variances above.
Example
The following relates to RSS Limited for product C.
Standard Requirement: Direct Materials 40KG per unit @ $5 per KG

Actual results: 100 units were produced using 4,500 KG of material bought at $4.5 each
Calculate the materials total, price and usage variances for Product C in the period
Answer:
Price Variance = (4500 x 5) – (4500 x 4.5) = $2,250 Favourable
Usage Variance = (4,000 x 5) – (4,500 x 5) = $2,500 Adverse
Total Variance = 2,250 Adv + 2,500 Fav = $250 Adverse
Labour Cost Variances

1. Labour Rate Variance: This shows the difference between the labour rate that should have been paid and what
was actually paid. The following formula is used;
(Actual Hours x Standard Rate) – (Actual Hours x Actual Rate)
2. Labour Efficiency Variance: This is used to identify if more or less labour hours were used than required. The
following formula is used;
(Standard Hours – Actual Hours) x Standard Rate

3. Total Labour Variance = This is the total of the two variances above.
Example
Standard Requirement: Direct Labour 5 hours per unit @ $15 per hour
Actual results: 100 units were produced using 600 hours at $14.5 each
Calculate the labour total, rate and efficiency variances for Product C in the period
Answer:
Rate Variance: (600 x 15) – (600 x 14.5) = $300 Favourable
Efficiency Variance: (500 – 600) x 15 = $1,500 Adverse
Total Variance = 300 fav + 1500 adv = $1,200 Adv
Variable Overhead Variances

1. Variable Overhead Expenditure Variance: The following formula is used:

Actual Hours x (Standard Rate – Actual Rate)
2. Variable Overhead Efficiency Variance: The following formula is used:

(Standard hours – Actual Hours) x Standard Rate
3. Total Variable Overhead Variance = This is the total of the two variances above.
Example
Standard Requirement: Variable Overhead 5 hours per unit @ $10 per hour
Actual results: 100 units were produced using 600 hours at $8 each
Calculate the Variable Overhead total variance, expenditure and efficiency variances for Product C in the period.
Answer:
Expenditure Variance: 600 x (10 – 8) = $1,200 Favourable
Efficiency Variance: (500 hours – 600 hours) x 8 = $800 Adverse
Total Variance = 1200 fav + 800 adv = $400 Favourable
Fixed Overhead Variances

1. Fixed Overhead Expenditure Variance: This looks at the difference between the budgeted Fixed Overhead and
the actual. The following formula is used;
Budgeted Fixed Overhead Expenditure – Actual Fixed Overhead
2. Fixed Overhead Volume Variance: This looks at the difference of the budgeted overhead and how much was
absorbed by production. The following formula is used;
Budgeted Fixed Overhead - (Actual Output x OAR)
Example
The following relates to Indu PLC for the last period.
Budgeted fixed overhead was $100,000 to be absorbed over 10,000 units.

The actual fixed overhead for the year was $120,000 whilst 11,000 units were produced.
Calculate the Expenditure and Volume Variance.
Answer:
Expenditure Variance = 100,000 – 120,000 = $20,000 adverse
Volume Variance = 100,000 – (11,000 x 10) = $10,000 adverse
3. Fixed Overhead Capacity Variance: This looks at whether the workforce worked more or less hours than
budgeted. The following formula is used;
(Actual Hours x OAR) – Budgeted Expenditure
4. Fixed Overhead Efficiency Variance: This looks at whether the workforce worked more or less hours than the
standard. The following formula is used;
(Standard Hours for actual production x OAR) – (Actual Hours x OAR)
5. Fixed Overhead Volume Variance: This is the total of the two variances above
Example
The following relates to Indu PLC for the last period.
Budgeted fixed overhead was $100,000 to be absorbed over labour hours for 10,000 units, with each unit taking 2
hours(standard)
The actual fixed overhead for the year was $120,000 whilst 11,000 units were produced using 23,000 hours.
Calculate the Capacity, Efficiency and Volume Variance.
Answer:
Capacity variance = (23,000 x 5) – 100,000 = $15,000 favourable
Efficiency variance = (22,000 x 5) – (23,000 x 5) = $5,000 adverse
Reasons for Variances

The main reasons for variances to occur are as follows;
ü Errors in Planning: This could be as a result of inexperienced persons being involved in the planning process,
not taking into account certain potential impacts, unavailability of a contingency plan, etc.
ü Measurement Errors: This could be as a result of inaccurate work hours reported through timesheets or incorrect
measurements of quantities of raw materials issued
ü Random factors: These are uncontrollable events that can take place such as price hikes and raw material
shortages.
ü Operational factors: This could be machinery breakdowns, idle time, staff being less efficient and so on.
Solutions to Manage Variances

This can really vary between organisations. However, a few examples are given below.
ü Reducing the selling price can help increase demand for the product and lead to more sales.
ü Negotiating with suppliers to get discounts or simply switching to new suppliers
ü Increased supervision of staff to increase productivity and efficiency
ü Offering incentives to staff to increase their productivity and efficiency
ü Using higher quality materials to eliminate any wastages
ü Using skilled labour or training labour to perform much more efficiently
F Performance Measurement
Key Topics;
Ø Performance Measurement Techniques
Ø Performance Measurement Techniques in Specific Situations

F1. PERFORMANCE MEASUREMENT

Definition of Performance Management
Performance Management refers to the process of monitoring the budgets and targets against the actual results to identify
how well the business and its employees have carried out their respective duties. This can be related to both short term
and long-term objectives.
External Factors affecting Performance Management

An organisations performance isn’t entirely dependent on the skills and resources it possesses. There will be external
factors that will influence the entire process too. This includes the following;
ü State of the economy - If the economy is performing poorly, there is a high chance for it to impact the business
performance. For example, if the country is in a recession, it would affect the business performance.
ü Government Regulations - Certain rules imposed by governments can severely impact businesses. This includes
import bans, bans on environmental pollution, polythene bans, etc. Apart from this, the use of competition
limiting acts is another potential issue for businesses looking to grow.
ü Community - If the community sees the company or its products unfit, they may protest against it and launch
campaigns. This builds a poor image for the business and can severely affect the sales and profit.
Critical Success Factors and Key Performance Indicators

Critical Success Factors (CSF) are the essential areas in an organization where things need to go right in order for the
mission, vision, goals and objectives to be achieved successfully. Key Performance Indicators (KPI) measures used to
evaluate the performance of the CSFs. Given below are a few examples of CSFs and KPIs.
Critical Success Factor Key Performance Indicators
Competitiveness ü Relative Market Share
ü Position in the market
ü % of customers served
Quality of Service ü Number of Complaints received
ü Number of customers gained/lost
Employee Satisfaction ü Labour Turnover
ü Overtime worked
ü Days of absence
ü Time taken to fill a job vacancy
Quality of Output ü Number of returns from customer
ü Cost of rework/repair
Measures for Financial Performance

With regards to any organization, measuring and monitoring of financial performance is given key importance. As such,
certain measures are used.
Profitability
Profitability relates to by how much the organization is exploiting its profit-making objective. The following formulas
are commonly used.
1. Gross Profit margin: This is used to measure the proportion of Gross Profit in relation to Revenue. The following
formula used;
(Gross Profit/Revenue) x 100
2. Net Profit margin = This is used to measure the proportion of Profit in relation to Revenue. The following
formula used;
(Net Profit/Revenue) x 100
3. Return on Capital Employed: This is used to measure how much of profit is generated per $1 of capital invested
in the business. The following formula is used;
(Profit before tax and Interest/Capital Employed) x 100
Example
The following information is available for KMS Limited.
Revenue $500,000
Gross Profit $300,000
Profit before tax $100,000
During the year, interest of $50,000 was paid. The capital consisted of 500,000 shares of $2 each and there was a bank
loan of $500,000. Calculate the Gross Profit Margin, Profit Margin and ROCE.
Answer;
Gross Profit Margin = (300000/500000) x 100 = 60%
Profit Margin = (100000/500000) x 100 = 20%
ROCE = (100000 + 50000)/(1000000 + 500000) x 100 = 10%
Liquidity
Liquidity relates to the businesses ability to turn assets into cash. The following formulas are used commonly to evaluate
the liquidity.
1. Current Ratio: Measures the company’s ability to meet its short-term liabilities due within the period. The
formula used is;
Current Assets/Current Liabilities
2. Acid Test/Quick Ratio: This is similar to current ratio; however, the closing inventory is not considered due to
its poor liquidity. The formula used is;
(Current Assets – Closing Inventory)/Current Liabilities
Example
The following information relates to a firm.
Current Assets $100,000
Closing Inventory $40,000
Current Liability $50,000
Calculate the Current and Quick Ratio.
Answer:
Current Ratio = 100000/50000 = 2: 1
Quick Ratio = (100000-40000)/50000 = 1.2: 1
Activity
Activity ratios look at how well items from the statement of financial position are converted into cash and to identify
the efficiency of current assets management. The following formulas are used;
1. Asset Turnover: This measures how much revenue is generated from each $1 of capital invested. The formula
used is;
Revenue/Capital Employed
2. Inventory days: Measures the average number of days inventory is held before being sold. The formula used is;
(Average Inventory/Cost of sales) x 365
3. Receivables days: Measures the average number of days for debtors to pay up. The formula is;
(Receivables/Credit sales) x 365
4. Payable days: Measures the average number of days to pay up creditors. The formula is;
(Payables/Credit Purchases) x 365
Example
The following information relates to RJ Limited.
Revenue $200,000 (50% was on credit)
Profit $40,000
Capital $300,000
Bank Loans $100,000
Avg Inventory $20,000
Cost of Sales $60,000
Purchases $50,000 (50% was on credit)
Receivables $10,000
Payables $5,000
Calculate the Asset turnover, inventory days, receivables days, payables days.
Answer:
Asset turnover: 200000 / (300000+100000) = 0.5 times
Inventory days: (20000/60000) x 365 = 121 days
Receivables days: (10000/100000) x 365 = 37 days
Payables days: (5000/25000) x 365 = 73 days
Risk
Risk is measured using the following formulas;
1. Gearing ratio: Here, the financial risk to the business is considered. The gearing ratio measures the relationship
between debt and capital. The following formula is used;
(Non-current Liabilities/Equity) x 100
2. Interest Cover: Measures how many times the interest payments could be paid out the operating profit. The
following formula is used:
Operating profit/Finance cost
Example
The following information relates to RMS Limited.
5% Bank loan $500,000
Shareholders equity consists of 500,000 shares of $3 each
Operating profit for the year was $300,000
Calculate the gearing ratio and interest cover.
Answer:
Gearing = (500000/1500000 + 500000) x 100 = 25%
Interest cover = 300000/ (500000 x 5%) = 12 times
Limitations of Financial performance measures
ü Over and understatement of figures – in order to manipulate the results, expenses and liabilities may be
understated whilst assets and revenues may be overstated.
ü Revenue from upcoming periods could be accelerated as received in the current period.
ü These do not convey the full picture, especially in the case of external factors and pressures
Measures for Non-Financial Performance

Non-Financial Performance relates to all other areas of the business. This could be for example in the areas of customer
satisfaction, product quality and so on. This can vary between organisations and the industry. Thus, depending on the
organization, appropriate measures need to be used when evaluating the performance. However, a few key common
areas include;
ü Quality - This will have a huge impact, since it will affect the organization entirely. This includes the customer’s
satisfaction with the product, the number of rejects, wastages, customers lost or gained, repeat customers and
so on.
The Balanced Scorecard

The balanced scorecard is a technique used for performance appraisal in an organization. It considers the following four
perspectives;
Customer - Focuses on
Financial - Focuses on
measuring customer
increasing shareholder
satisfaction. This can be
value. An appropriate
done by measuring
measure would be ROCE.
customer loyalty.
Learning and
Internal Process - Aims to
Growth/Development -
measure the organisations
Focuses on the skills and
efficiency. This can be done
resources needed in the
by measuring quality or the
long term to satisfy
costs incurred.
customer evolving needs.
The following are few advantages and disadvantages of using the balanced scorecard;
ü Uses multiple perspectives for evaluation. ü Requires large number of calculations which can
sometimes be complex.
ü Able to identify weak areas and take necessary
actions. ü Comparison with other businesses is not easy.
ü Focus on KPI.
Benchmarking
Benchmarking is a technique used to evaluate the current performance of the business and compare it to similar
businesses to identify where improvements can be made. The following types of benchmarking are followed;
Competitive Benchmarking
Internal Benchmarking -
- This involves
This involves benchmarking
benchmarking with
internally with units from
successful competitors from
the same organization.
the same industry.
Strategic Benchmarking -
Functional Benchmarking -
collaboratively with other
organisations in the same
with a similar function in
industry. A third party,
organisations that aren’t
generally an expert, could
competitors.
also be a part of this
process.
F2. PERFORMANCE MEASUREMENT IN SPECIFIC SITUATIONS

Business Organisations
Business Organisations are classified in multiple groups such as;
ü Manufacturer
ü Service Provider
ü Non-Profit
ü Public Sector
ü Private Sector
The many classifications of business organisations is endless.
Return on Investment (ROI)

This is similar to ROCE but is used to evaluate the investment decisions made. The following formula is used;
Controllable Profit
ROI = x 100
Controllable Capital Employed
Controllable profit is usually after depreciation but before tax. Capital employed is total assets fewer current liabilities.
Example
The following data is available for Investment centre S.
Controllable profit $100,000
Controllable assets $500,000
Calculate the ROI for investment centre S.
Answer;
(100000/500000) x 100 = 20%
Residual Income
Residual income is the net operating income that an investment centre earns above the minimum return that is required
on its operating assets. The following formula is used;
RI = Controllable profit – Notional interest on capital
Example
Investment centre F’s statement of financial position shows assets under its control amounting to $500,000. The profit
in its statement of profit or loss amounts to $150,000. The notional cost of capital of 10%.
Calculate the RI for this centre.
Answer;
Controllable Profit 150,000
Notional Cost of Capital (50,000) [500000 x 10%]
Residual Income 100,000
The following are advantages and disadvantages of using ROI for measuring performance;
ü Calculation is easy and simple ü Uses only accounting information
ü Uses readily available information ü Can be manipulated
ü Widely used and accepted ü Lower ROI may discourage investments
Manufacturing Sector
Contract Costing
With regards to certain types of organizations, they may involve in long term projects. This is true especially in the case
of construction companies. Thus, we use contract costing. This is used to calculate the attributable profit for long term
contracts. The following 4 steps will apply when carrying out a contract costing process;
Step 1: Determine the total sales value for the contract
Step 2: Compute the total expected costs to complete the contract
Step 3: Calculate the total expected profit on the contract.
Step 4: Calculate the cumulative attributable profit using;

Costs incurred so far
x Total Expected Profit
Contract Price
Example
Is currently taking up a contract with a popular client. The contract is valued at $500 million. The following information
is available;
Value of work certified $300 million
Cost incurred to complete $240 million
Future cost to complete $240 million
Calculate the profit to be recognized using:
Work Certified
Overall expected profit = 500 – (240 + 240) = $20 million (300/500) x 20 = $12 million
Costs incurred to date = (240/480) x 20 = $10 million
Apart from the above method, manufacturing industries can use the following methods of costing covered in previous
chapters;
1. Job Costing
2. Batch Costing
3. Process Costing
Service Sector
Measuring the financial performance in the service sector is done similar to the manufacturing sector. This could be
done using;
ü ROCE
ü Gross Profit Margin
ü Profit Margin
The list continues. However, measuring the non-financial aspects, in terms of the service quality for example, needs to
be done with specific approaches. These approaches need to define the service and be specific to it. For example, a car
wash might evaluate its operations based on the time taken per wash, whilst a hospital might consider the time taken per
patient. The varying objectives of the organisations means there will be varying measures.
Non-Profit and Public Sector Organisations

Non-Profit organisations are usually charities, while public sector relates to government organisations. In such
organisations, the aim isn’t profit. It is rather about value for money and serving the society to the highest extent possible.
Thus, the value for money concept lies.
Value for Money Concept

This is based on the 3Es;
ü Economy (an input measure): Measures how cheap the inputs were
ü Efficiency (process measure): Measures if the maximum output is being produced from the input
ü Effectiveness (links outputs to objectives): Measures the extent to which organizational goals are achieved by
the output.
The following formula can be applied to calculate the 3E’s.

ü Economy: (Standard input/Actual input) x 100
ü Efficiency: (Actual output/Actual input) x 100
ü Effectiveness: (Actual output/Standard output) x 100
Cost Control and Cost Reduction
Cost Reduction
This relates to the reduction in the costs incurred to produce goods and services. It could be done by;
ü Using cheaper raw materials
ü Using more efficient machinery
ü Outsourcing production to cheaper locations
ü Purchasing from low-cost suppliers
However, there are certain cost reduction techniques. This includes;
ü Value Analysis: This is a systematic examination of factors affecting the cost of a product or service. Once
carried out, any unnecessary cost can be identified and reduced or eliminated.
ü Value Engineering: This is similar to target costing which was discussed earlier.
ü Work Study: This is a systematic examination of the methods of carrying out activities. Activities can be then
adjusted to be more economical as required.
F3. SPREADSHEETS
Introduction
A spreadsheet is a software package used to enter, sort and make value of data. Examples include Microsoft Excel, WPS
Sheets, Kingsoft Spreadsheets.
Steps to open a spreadsheet

1. Open the start menu
2. Find the respective software and open it.
3. Select “Blank Workbook”
Format of spreadsheets
This is a spreadsheet consisting of rows and columns.
Formula and Functions

Following are a few functions of excel.
ü =sum: to get a total of a set of data
ü =average: to get an average of a set of data
ü =max: to identify highest value in data set
ü =min: to identify lowest value in data set
Follow the steps below to enter a formula
1. Ensure there is a data set. In the desired place where you want the value, enter “=” and enter the function.
2. Select from the dropdown list the relevant function and select the data set you wish to apply it to.
3. Press enter to get the result.
The above can be done using a formula too. Such would be done as;
1. Enter “=” and select the relevant cells, adding a “+” or “- “as necessary.
2. Press enter to get the result
Using Spreadsheets in Organisations

Please refer to the video recordings for clarification on this area
Advantages and Disadvantages

ü Easy to use ü Unable to identify input errors
ü Data can be stored for long time ü Restricted to a finite number of records
ü Can work faster using shortcuts, formulas and ü Files can get corrupted, stolen, affected by
many more viruses
ü Easier to read and understand if presented
properly
ü Able to reduce calculation errors

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ACCA

Section A: The nature, source and purpose of management information

Section B: Data analysis and statistical techniques

Section C: Cost accounting techniques

C2 Accounting for Labour 45

C3 Accounting for Overheads 51

C4 Absorption and Marginal Accounting 58

C5 Job, Batch and Process Costing 61

C6 Service and Operation Costing 68

C7 Alternative Costing Principles 70

Section E: Standard Costing

Section F: Performance Measurement

F2 Performance Measurement in Specific Situations 105

Introduction to Management Accounting (MA)

B Data analysis and statistical techniques

C Cost accounting techniques

A The nature, source and purpose

How to use the materials;

A1. ACCOUNTING FOR MANAGEMENT

Financial Accounting Management Accounting

The role of a Management Accountant for an organization is to prepare;

Data and Information

Data (Process) Information

Attributes of Good Information

Understandability : The information must easily be understood by the reader

Relevant : The information must be relevant for its purpose

Accessible : The information should be easy to access by its users

The Management Process

Strategy What does the business provide & how is it provided?

Values What are the core principles of the business?

Specific : It should give a clear idea of what needs to be achieved

Measurable : It should measurable in quantitative or qualitative terms

There are 3 levels of planning

The limitations of management information

ü Failing to comply with the characteristics of good information (i.e., “ACCURATE”)

A2. SOURCES OF DATA

Internal and External Sources of Information

Benefits and limitations of internal sources can be tabled as follows;

ü Readily available data ü Data may need to be further analysed to be of

ü Reports can be extracted when required

Benefits and Limitations of external sources are as follows;

ü Can source specific information needs

General economic environment

Sampling is necessary due to;

- The high cost involved in testing the entire population

When selecting a sample, it is necessary to observe the two following rules;

There are several methods of obtaining a sample, such as;

A3. PRESENTING INFORMATION

Prepare Plan Write Review

Title : The table should have a clear title

Units : The units of measurement should be mentioned (e.g.: $’000s)

Headings : The relevant columns and rows should have headings

Percentages and Ratios : Where necessary, these should be included

A table would consist of rows and columns as follows;

Graphs and Charts

- Simple Bar Chart: This illustrates only one variable

A4. COST CLASSIFICATION

Variable Production Fixed Production Non-Production

The following illustrates a sample cost card:

Classification of Cost based on element, nature, function and behaviour