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ACC313 MANAGEMENT ACCOUNTING SUMMARY
UNIT 1: GENERAL PRINCIPLES OF COSTING
MEANING OF COSTING
Costing refer to a system of calculating the amount of money it takes to produce goods or
operate a business. Costing may be defined as ‗the technique and process of ascertaining
costs‘. According to Wheldon, ‗Costing refers to classifying, recording, allocation and
appropriation of expenses for the determination of cost of products or services and for the
presentation of suitably arranged data for the purpose of control and guidance of
management. It includes the ascertainment of cost forever order, job, contract, process,
service units as may be appropriate. It deals with the cost of production, selling and
distribution. For any business organization, ascertaining of costs is must and for this purpose
a scientific procedure should be followed. ‗Costing‘ is precisely this procedure which helps
them to find out the costs of products or services.
IMPORTANCE AND BASIC PRINCIPLES OF COSTING
Computation of cost on scientific basis and thereafter cost control and cost reduction is of
paramount importance. Hence it has become essential to study the basic principles and
concepts of cost accounting.
Cost:- Cost can be defined as the expenditure (actual or notional) incurred on or attributable
to a given thing. It can also be described as the resources that have been sacrificed or must be
sacrificed to attain a particular objective. In other words, cost is the amount of resources used
for something which must be measured in monetary terms.
Cost Accounting:- Cost accounting is a combination of art and science, it is a science as it has
well defined rules and regulations, it is an art as application of any science requires art and it
is a practice as it has to be applied on continuous basis and is not a onetime exercise. Cost
Accounting primarily deals with collection, analysis of relevant cost data for interpretation
and presentation for solving various problems of management. Cost accounting takes into
cognizance, the cost of products, service or an operation. It is defined as, ‗the establishment
of budgets, standard costs and actual costs of operations, processes, activities or products and
the analysis of variances, profitability or the social use of funds‘.
Cost Accountancy:- Cost Accountancy is a broader term and is defined as, ‗the application of
costing and cost accounting principles, methods and techniques to the science, art and
practice of cost control and the ascertainment of profitability as well as presentation of
information for the purpose of managerial decision making.
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DIFFERENCE BETWEEN COSTING AND COST ACCOUNTING
ESSENTIALS OF A GOOD COSTING SYSTEM
For availing of maximum benefits, a good costing system should possess the following
characteristics.
A. Costing system adopted in any organization should be suitable to its nature and size of the
business and its information needs.
B. A costing system should be such that it is economical and the benefits derived should be
more than the cost of operating the cost system.
C. Costing system should be simple to operate and understand. Unnecessary complications

should be avoided.
D. Costing system should ensure proper system of accounting for material, labour and
overheads and there should be proper classification made at the time of recording of the
transaction itself.
E. Before designing a costing system, need and objectives of the system should be identified.
F. The costing system should ensure that the final aim of ascertaining of cost as accurately
possible should be achieved.
CLASSIFICATION OF COSTING
Classification of costs can be made according to the following basis:
A. Classification according to elements:- Costs can be classified according to the elements.

There are three elements of costing, viz-a-viz: material, labour and expenses. Total cost of
production/services can be divided into the three elements to find out the contribution of each
element in the total costs.
B. Classification according to nature:- As per this classification, costs can be classified into
Direct and Indirect. Direct costs are the costs which are identifiable with the product unit or
cost centre while indirect costs are not identifiable with the product unit or cost centre and
hence they are to be allocated, apportioned and then absorbed in the production units. All
elements of costs like material, labour and expenses can be classified into direct and indirect.
They are mentioned below.
i. Direct and Indirect Material Costs:- Direct material is the material which is identifiable
with the product. For example, in a cup of tea, quantity of milk consumed can be identified,
quantity of glass in a glass bottle can be identified and so these will be direct materials for
these products.
ii. Direct and Indirect Labour Costs:- Direct labour can be identified with a given unit of
product, for example, when wages are paid according to the piece rate, wages per unit can be
identified.
iii. Direct and Indirect Expenses:- Direct expenses refers to expenses that are specifically
incurred and charged for specific or particular job, process, service, cost centre or cost unit.
These expenses are also referred to as chargeable expenses. Examples of these expenses are
cost of drawing, design and layout, royalties payable on use of patents, copyrights etc.
consultation fees paid to architects, surveyors etc.
C. Classification according to behaviour:- Costs can also be classified according to their

behaviour. This classification is explained below.
i. Fixed Costs:- Out of the total costs, some costs remain fixed irrespective of changes in the
production level. These costs are referred to as fixed costs. The feature of these costs is that
the total costs remain unchanged while per unit fixed cost varies with teh level of production.
Examples of these costs are salaries, insurance, rent, etc.
ii. Variable Costs:- These costs are variable in nature, i.e. they change according to the level
of production. Their variability is in the same proportion to the production. For example, if
the production units are 2,000 and the variable cost is #5 per unit, the total variable cost will
be #10,000 (i.e. 2,000 x #5), if the production units are increased to 5,000 units, the total
variable costs will be #25,000, i.e. the increase is exactly in the same proportion of the
production.
iii. Semi-variable Costs:- Certain costs are partly fixed and partly variable. In other words,
they contain the features of both types of costs. These costs are neither totally fixed nor
totally variable. Maintenance costs, supervisory costs etc. are examples of semi-variable
costs. These costs are also referred to as ‗stepped costs‘.
D. Classification according to functions:- Costs can also be classified according to the
functions/activities. This classification can be done as mentioned below.
i. Production Costs:- All costs incurred for production of goods are known as production
costs.
ii. Administrative Costs:- Costs incurred for administration are known as administrative
costs. Examples of these costs are office salaries, printing and stationery, office telephone,
office rent, office insurance etc.
iii. Selling and Distribution Costs:- All costs incurred for procuring an order are referred to as
selling costs while all costs incurred for execution of order are distribution costs. Market
research expenses, advertising, sales staff salary, sales promotion expenses are examples of
selling costs. Transportation expenses incurred on sales, warehouse rent etc. are examples of
distribution costs.
iv. Research and Development Costs:- In recent times, research and development has become
one of the important functions of a business organization. Expenditure incurred for this
function can be classified as Research and Development Costs.
E. Classification according to time:- Costs can also be classified according to time. This
classification is explained below
i. Historical Costs:- These are the costs which are incurred in the past, i.e. in the past year,
past month or even in the last week or yesterday. The historical costs are ascertained after the
period is over. In other words it becomes a postmortem analysis of what has happened in the
past.
ii. Predetermined Cost:- These costs relating to the product are computed in advance of
production, on the basis of a specification of all the factors affecting cost and cost data. Pre-
determined costs may be either standard or estimated.
F. Classification of costs for Management decision making:- One of the important functions
of cost accounting is to present information to management for the purpose of decision-
making. For decision making certain types of costs are relevant. Classification of costs based
on the criteria of decision making can be done in the following manner:
i. Marginal Cost:- Marginal cost is the change in the aggregate costs due to change in the
volume of output by one unit. For example, suppose a manufacturing company produces
10,000 units and the aggregate costs are #25,000, if 10,001 units are produced the aggregate
costs may be #25,020 which means that the marginal cost is #20. Marginal cost is also termed
as variable cost and hence per unit marginal cost is always same, i.e. per unit marginal cost is
always fixed. Marginal cost can be effectively used for decision making in various areas.
ii. Differential Costs:- Differential costs are also known as incremental cost. This cost is the
difference in total cost that will arise from the selection of one alternative to the other. In
other words, it is an added cost of a change in the level of activity.
iii. Opportunity Costs:- It is the value of benefit sacrificed in favour of an alternative course
of action. It is the maximum amount that could be obtained at any given point in time if a
resource was sold or put to the most valuable alternative use that would be practicable.
iv. Relevant Cost:- The relevant cost is a cost which is relevant in various decisions of
management. Decision making involves consideration of several alternative courses of action.
VI. Abnormal Costs:- It is an unusual or a typical cost whose occurrence is usually not
regular and is unexpected. This cost arises due to some abnormal situation of production.
Abnormal cost arises due to idle time or may be due to some unexpected heavy breakdown of
machinery
VII. Controllable and Uncontrollable Costs:- In cost accounting, cost control and cost
reduction are extremely important. In fact, in the competitive environment, cost control and
reduction are the key words. Hence it is essential to identify the controllable and
uncontrollable costs.
VIII. Shutdown Cost:- These costs are the costs which are incurred if the operations were to
close down and they will disappear if the operations are continued. Examples of these costs
are costs of sheltering the plant and machinery and construction of sheds for storing exposed
property.
IX. Capacity Cost:- These costs are normally fixed costs which are incurred by a company for
providing production, administration and selling and distribution capabilities in order to
perform various functions. Capacity costs include the costs of plant, machinery and building
for production, warehouses and vehicles for distribution and key personnel for
administration.
X. Urgent Costs:- These costs are those which must be incurred in order to continue
operations of the firm. For example, cost of material.
COSTING METHODS AND TECHNIQUES
Methods of Costing:- The following are the methods of costing.
I. Job Costing:- This costing method is used by firms which work on the basis of job work.
There are some manufacturing units which undertake job work and are called job order units.
The main feature of these organizations is that they produce according to the requirements
and specifications of the consumers. Each job may be different from the other one.
Production is only on specific order and there is no pre-demand production. B
II. Batch Costing:- This method of costing is used in those firms where production is made on
continuous basis. Each unit coming out is uniform in all respects and production is made
prior to the demand, i.e. in anticipation of demand. One batch of production consists of the
units produced from the time machinery is set to the time when it will be shut down for
maintenance.
III. Process Costing:- Some of the products like sugar, chemicals etc. involve continuous
production process and hence process costing method is used to work out the cost of
production. In process costing, cost per process is worked out and per unit cost is worked out
by dividing the total cost by the number of units. Manufacturing companies that engage in the
production of products such as sugar, edible oil, chemicals are examples of continuous
production process and they use process costing.
IV. Operating Costing:- This type of costing method is used in service sector to work out the
cost of services offered to the consumers. For example, operating costing method is used in
hospitals, power generating units, transportation sector etc. A cost sheet is prepared to
compute the total cost and it is divided by cost units for working out the per unit cost.
V. Contract Costing:- This method of costing is used in construction industry to work out the
cost of contract undertaken. For example, cost of constructing a bridge, commercial complex,
residential complex, highways etc. is worked out by use of this method of costing.
TECHNIQUE OF COSTING
The following are the techniques of costing.
I. Marginal Costing:- This technique is based on the assumption that the total cost of
production can be divided into fixed and variable. Fixed costs remain same irrespective of the
changes in the volume of production while the variable costs vary with the level of
production, i.e. they will increase if the production increases and decrease if the production
decreases. Variable cost per unit always remains the same.
II. Standard Costing:- Standard costs are predetermined costs relating to material, labour and
overheads. Though they are predetermined, they are worked out on scientific basis by
conducting technical analysis. They are computed for all elements of costs such as material,
labour and overheads. The main objective of standard costing is to have a benchmark against
the actual performance. This means that the actual costs are compared with the standards. The
difference is called ‗variance‘.
III. Budgets and Budgetary Control:- Budget is defined as, ‗a quantitative and/or a monetary
statement prepared prior to a defined period of time for the policies during that period for the
purpose of achieving a given objective.‘ If we analyse this definition, it will be clear that a
budget is a statement, which may be expressed either in monetary form or quantitative form
or both.
UNIT 2 COST ACCOUNTING SYSTEMS
WHAT IS COST ACCOUNTING SYSTEM?
A cost accounting system (also called product costing system or costing system) is a
framework used by firms to estimate the cost of their products for profitability analysis,
inventory valuation and cost control. Estimating the accurate cost of products is critical for
profitable operations. Note that cost accounting is a process of collecting, recording,
classifying, analysing, summarising, allocating and evaluating various alternative courses of
action and control of costs. Its goal is to advise management on the most appropriate course
of action based on cost efficiency and capability. Cost accounting provides the detailed cost
information that management needs in order to control current operations and plan for the
future.
Types of Cost Accounting include the following:
1. Standard cost accounting

2. Activity-based accounting
3. Resource consumption accounting
4. Throughput accounting
5. Life cycle costing
6. Environment accounting
7. Target costing
COMPARISON BETWEEN COST ACCOUNTING AND FINANCIAL

ACCOUNTING
1. Financial accounting aims at finding out results of accounting year in the form of Profit or
Loss Account and Statement of Financial Position. Cost accounting aims at computing cost of
production/service in a scientific manner and facilitates cost control and cost reduction.
2. Financial accounting reports the results and position of business to government, creditors,
investors, and external parties.
3. Cost accounting is an integral reporting system for an organisation‘s own management for
decision-making.
4. In financial accounting, cost classification is based on type of transactions, for example,

salaries, repairs, insurance, stores and others. In cost accounting, classification is basically on
the basis of functions, activities, products, processes and on internal planning and control and
information needs of the organisation.
5. Financial accounting aims at presenting ―true and fair‖ view of transactions, Profit or Loss
for a period and Statement of financial position (Balance Sheet) on a given date. It aims at
computing ―true and fair‖ view of the cost of production/services offered by the firm.
DISTINCTION BETWEEN COST ACCOUNTING AND

MANAGEMENT ACCOUNTING
The distinction between cost accounting and management accounting may be made on the
following bases:
1. Scope: Scope of cost accounting is limited to providing cost information for managerial
uses. Scope of management accounting is broader than that of cost accounting as it provides
all types of information. Thus, management accounting is an extension of cost accounting.
2. Emphasis: The main emphasis of cost accounting is on cost ascertainment and cost control
to ensure maximum profit. On the other hand, the main emphasis of management accounting
is on planning, controlling and decision-making so as to provide a basis for ascertaining
profit of the entity.
3. Techniques Employed: Various techniques used by cost accounting include standard

costing and variance analysis, marginal costing and cost-volume-profit analysis, budgetary
control, uniform costing and inter-firm comparison.
4. Evolution: Evolution of cost accounting is mainly due to the limitations of financial

accounting. On the other hand, evolution of management accounting is due to the limitations
of cost accounting. In fact, management accounting is an extension of the managerial aspects
of cost accounting.
5. Data Base: Cost accounting is based on data derived from financial accounting, but
management accounting is based on data derived from cost accounting, financial accounting
and other sources.
PARTS OF A COST ACCOUNTING SYSTEM
A cost accounting system requires five parts that include:
1. An input measurement basis

2. An inventory valuation method
3. A cost accumulation method
4. A cost flow assumption
5. A capability of recording inventory cost flows at certain intervals.
We shall look at them one after the other.
Input Measurement Bases
The bases of a cost accounting system begin with the type of costs that flow into and through
the inventory accounts. There are three alternatives: pure historical costing, normal historical
costing and standard costing.
 Pure Historical Costing: In pure historical cost system, only historical costs flow
through the inventory accounts. Historical costs refer to the costs that have been
recorded. These are costs for direct material, direct labour and factory overhead.
 Normal Historical Costing: Normal historical costing uses historical costs for direct
material and direct labour, but overhead is charged, or applied to the inventory using a
predetermined overhead rate per activity measure. Typical activity measures include
direct labour hours, or direct labour costs.
 Standard Costing: In a standard cost system, all manufacturing costs or applied, or
charged to the inventory using standard or predetermined prices, and quantities. The
differences between the applied costs and the actual costs are charged to variance
accounts.
Inventory Valuation Methods
The inventory valuation methods encompass the following:
 Throughput method
 Direct or variable method
 Full absorption method
 Activity-based method
i) Throughput Method: The throughput method was developed to complement a concept

referred to as the Theory of Constraints (TOC). In this method, only direct material costs are
charged to the inventory. All other costs are expensed during the period.
ii) Direct or Variable Method: In the direct (or variable method), only the variable
manufacturing costs are capitalised, or charged to the inventory. Fixed manufacturing costs
flow into expense in the period incurred. This method provides some advantages and some
disadvantages for internal reporting.
iii) Full Absorption Method: Full absorption costing is a traditional method where all
manufacturing costs are capitalised in the inventory, that is, charged to the inventory and
become assets. This means that these costs do not become expenses until the inventory is
sold.
iv) Activity-Based Method: Activity-based costing is a relatively new type of procedure that
can be used as an inventory valuation method. The technique was developed to provide more
accurate product costs. This improved accuracy is accomplished by tracing costs to products
through activities.
Cost Accumulation Method
Cost accumulation refers to the manner in which costs are collected and identified with
specific customers, jobs, batches, orders, departments and processes. The four accumulation
methods are job order, process, back flush, and hybrid (or mixed) method.
 Job Order: In job order costing, costs are accumulated by jobs, orders, contracts, or
lots. The idea is that the work is done to the customers‘ specifications.
 Process: Costs are accumulated by departments, operations, or processes in process
costing. The work performed on each unit is standardised or uniform where a
continuous mass production or assembly operation is involved
 Back Flush: Back flush is a simplified cost accumulation method that is sometimes
used by companies that adapt just-in-time (JIT) production systems.
 Hybrid (or Mixed) Methods: Hybrid or mixed systems are used in situations where
more than one cost accumulation method is required. For example, in some cases,
process costing is used for direct materials and job order costing is used for
conversion costs (that is, direct labour and factory overhead).
Cost Flow Assumptions
A cost flow assumption refers to how costs flow through the inventory accounts, not the flow
of work or products on a production line. This distinction is important because the flow of
costs is not always the same as the flow of work. The various types of cost flow assumptions
include:
 Scientific identification (e.g., by job)

 First in, first out (FIFO)
 Last in, first out (LIFO)
 Weighted average
Recording Interval Capability
Inventory records can be maintained on a perpetual or periodic basis. Consequently, the

perpetual inventory method provides a company with the capability of maintaining
continuous records of the quantities of inventory and the costs flowing through the inventory
accounts. The periodic method, on the other hand, requires counting the quantity of inventory
before inventory records can be updated.
NECESSITY FOR COST ACCOUNTING SYSTEM
A company having a proper cost accounting system will help management in the following
areas as highlighted:
1. The analysis of profitability of individual products, services or jobs.
2. The analysis of the different departments or operations.
3. The analysis of cost behaviour of various items of expenditure in the organisation. This
will help in future cost estimation with reasonable accuracies.
4. It locates differences between actual results and expected results. Such differences can also
be traced to the individual cost centres with the efficient cost system.
5. It will assist in setting the process so as to cover costs and generate an acceptable level of
profit.
6. The effects on profits of increase or decrease in output or shutdown of a product line or

department can be analysed with the adoption of efficient cost accounting system.
7. Cost records serve as the base for Management Information System (MIS).
8. The cost system generates regular performance statements which management needs for
control purposes.
UNIT 3: DETERMINATION OF COST BEHAVIOUR
COST BEHAVIOUR CONCEPT
Cost behaviour is the study of the ways in which cost react or do not react to changes in the
level of activity of an organisation. Knowledge of cost behaviour is the basis of all cost-
volume-profit (C. V.P) analyses. When we know the behaviour of costs, then financial
planning is made simpler.
LEVEL OF ACTIVITY
The level of activity is the amount of work done or the number of events that has occurred.
The type of activity which influences cost varies according to the nature o work done in the
organisation or department, and the nature of the items of cost whose behaviour is being
analysed depending on the circumstance, the level of activity may refer to the volume of
production in a period, the number of items sold, the value of items sold, the number of
invoices issued, the number of invoices received the number and units of electricity
consumed, etc.
REASONS FOR STUDYING COST BEHAVIOUR
There are three principal reasons for studying how costs respond to changes in the level of
activities:
1. For the prediction of cost to facilitate budgetary and corporate planning

2. For performance evaluation when a system of flexible budgetary control is in
operation
3. For the estimation of costs for various decision making processes e.g. pricing
decisions make or buy decision, optimal product mix, shut-down decisions etc.
CONCEPT OF RELEVANT RANGE
This is the range in which all assumptions about the level of activities and cost will remain
valid. Within this range, most items of cost will settle into a basic pattern or behaviour and
cost can be classified into either fixed or variable cost.
BASIC PRINCIPLES OF COST BEHAVIOUR
The basic principle of cost behaviour is that, as the level of activity rises, costs will usually
rise. It will cost more to produce 2,000 units of an output than it will cost to produce 1,000
units of the same product. This principle is common sense.
The problem for the accountant, however, is to determine for each item of cost, as the level of
activity increases:
The ways in which the costs behave to changes in activity level; (i.e. are costs)
Fixed, varied, stepped or mixed
By how much (i.e. what is the amount of fixed cost per period and what is the variable cost
per unit of activity?)
THE TYPES OF COST BEHAVIOUR
Fixed Costs
Fixed costs are those costs, which do not vary with output or production level. They vary
with the passage of time hence they are time or period cost. They remain constant in given
short term period and within relevant range of output. Fixed costs are costs of holding assets
and other factors of production in readiness for production. A company when defining fixed
cost should take the following factors into consideration:
 Controllability —All fixed costs are controllable in the long run. Some fixed costs are
subject to management control in the short-run.
 Relevant range —Fixed cost must be related to a range of activity. A fixed cost would
only remain constant only when level of operation is within relevant range.
 Period cost —Because they accrue with the passage of time, the amount of the fixed
costs must be related at specified period of time. Fixed costs should be related to a
financial year and expressed as a constant amount per month.
 Fixed in total but variable per units —A fixed cost is constant in total amount per
period, but variable in terms of unit cost
Examples of fixed costs are:
1. The salary per month of a supervisor

2. The rent of a single factory building per month or per annum
Step Cost
This is a variant of the fixed cost. Many items of cost are fixed in nature but within certain
levels of activity i.e. a relevant range. For example, the annual depreciation cost of a machine
may be fixed if production remains below 1,000 units for machine that has a maximum
capacity of 1,000 units, but if production is to exceed 1,000 unit, even by 1 unit, then a
second machine would be required, and the annual depreciation cost on two machines would
go up in a stepped manner.
Other examples of step cost area:
1. Rent — where accommodation requirements increase, as output levels get higher.

2. Basic wages — basic pay of employees is nowadays usually fixed, but as output rises,
more employees are required.
Variable Costs
A variable cost is one, which tends to vary with the volume of output. The variable cost per
unit is the same amount for each unit produced, which means that the amount of resources
used and the price of these resources are constant for each additional unit produced. The total
cost of a variable cost item would be shown graphically as follows:
Mixed Costs
Mixed costs are also referred to as semi-variable or semi-fixed cost. They are cost items
which are partly fixed and partly variable i.e. costs which contain a standing basic charge
plus a variable charge per unit of consumption e.g. telephone bills, electricity bill, etc.
UNIT 4: ELEMENT OF COST AND COST ESTIMATION TECHNIQUES
Definition of Cost
A cost is the value of economic resources used as a result of producing a product or service"
(WM. Harper)· Cost is "the amount of expenditure (actual or notional) incurred on or
attributable to a given thing" (ICMA)· Cost is "an exchange price, a foregoing, a sacrifice
made to secure benefit" (A tentative set of Broad Accounting Principles for Business
Enterprises).
The Nature and Types of Cost Classification
Costs can be classified in a number of different ways:
 By their behavior. Do they increase as an organisation gets busier or do they tend to

stay the same? This is important when it comes to budgeting as it is essential to be
able to predict how costs are likely to change.
 By their location. Where in the organisation are they incurred? For example, costs
incurred in the factory are relevant to working out the cost of production. However,
costs incurred in storing and delivering finished goods are not relevant to production.
 By their function. For example costs related to research and development, marketing,
training, manufacturing.
 By the person responsible for their control. All costs need to be controlled and there
should be a clearly identified person who is responsible for the control of each cost.
For example, the managers of a branch might be held responsible for the costs
incurred there.
 By their type. For example, material, labour, other production expenses, such as the
cost of running machinery.
 By their traceability. Are they direct or indirect? Direct costs are closely related and
traceable to each item produced. Indirect costs are not so easy to relate and trace to
each unit of production.
Variable Cost
A variable cost is a cost that changes in relation to variations in an activity. In a business, the
"activity" is frequently production volume, with sales volume being another likely triggering
event. Here are a number of examples of variable costs, all in a production setting:
Direct materials. The most purely variable cost of all, these are the raw materials that go into
a product.
Piece rate labour. This is the amount paid to workers for every unit completed (note: direct
labour is frequently not a variable cost, since a minimum number of people are needed to
staff the production area; this makes it a fixed cost).
Production supplies. Things like machinery oil are consumed based on the amount of
machinery usage, so these costs vary with production volume
Billable staff wages. If a company bills out the time of its employees, and those employees
are only paid if they work billable hours, then this is a variable cost.
Commissions. Salespersons are paid a commission only if they sell products or services, so
this is clearly a variable cost.
Credit card fees. Fees are only charged to a business if it accepts credit card purchases from
customers. Only the credit card fees that are a percentage of sales (i.e., not the monthly fixed
fee) should be considered variable.
Freight out. A business incurs a shipping cost only when it sells and ships out a product.
Thus, freight out can be considered a variable cost.
Total Cost
Total cost is an economic measure that sums all expenses paid to produce a product, purchase
an investment, or acquire a piece of equipment including not only the initial cash outlay but
also the opportunity cost of their choices.
UNIT 5 BUDGETS AND BUDGETARY CONTROL
DEFINITION OF BUDGET
A budget is defined as "a quantitative statement for a defined time which may include
planned revenues, expenses, assets, liabilities and cash flow. This involves comprehensive
and coordinated plans, expressed in the financial terms, for the operation and resources of an
enterprise for some specific period in the future. A budget provides a focus for the
organisation, aids the coordination of activities and facilitates control. Budget is a financial
and/or quantitative plan of operations for a forthcoming accounting period.
The purpose of a budget is to:
(i) Communicate ideas and plans to everyone affected by them.
(ii) Coordinate the activities of different departments or sub-units of the organization.
(iii) Establish a system of control by having a plan against which actual results can be
progressively compared and variance analysed for prompt attention and action.
(iv) Motivate employees to improve their performances.
THE TYPES OF BUDGET
(a) Functional budgets
Functional budgets are prepared by the departmental heads. The order of importance in
preparation of the budget depends on the budget limiting factor of the organisation. Where
sales are considered critical to the success of the objectives, the sales budget is prepared first.
Similarly, where source of raw material is restricted and in limited supply the raw material
budget is prepared first.
(b) Master budget
The master budget consolidates the position of all the functional budgets in the form of a
budgeted trading and profit and loss account and a budgeted statement of financial position.
BUDGET PREPARATION AND APPROVAL PROCEDURES
1 Budgets Preparation Procedures
The business of any organisation must be conducted in an organised and orderly manner to
achieve the desired results. Budget preparation is a serious activity of management and some
time should be expended on it. In practice, top management may constitute a budget
committee which could comprise:
(a) The Managing Director/ Chief Executive Officer as the Chairman
(b) Chief Accountant (or Director of finance) as the budget officer.
(c) The head of department or the line and service managers who prepares the functional
budgets of the department.
2 Approval of the master budget
The budget committee will submit the master budget to the top management (usually the
board of directors) for approval. If it is approved, the master budget will then become the
blueprint for the activities of the budgeted period. If approval is not received, sections of the
budget will have to be amended to incorporate any change or review in emphasis so as to
meet the requirements of top management. However, these requirements should be realistic.
PREPARATION OF BUDGETS
1 Cash Budget
A cash budget is a summary of the company's expected cash inflows and outflows over a
given period of time. Cash is required in order to facilitate the achievement of a company's
plans and intentions. Inadequate flow of liquidity will hamper efficiency and level of
profitability of the firm. A company may be profitable but, still faces liquidity problems.
Cash is a resource which should be effectively utilised in order to generate benefits for the
company Cash budget shows the timing of expected cash flows. The benefits to be derived
from the preparation of detailed cash budget are as follows:
(i) It provides early signals of potential deficit or surplus in order to take appropriate action
(ii) It enables financial feasibility of plans to be ascertained.
(iii) It indicates the financial effects of policies within a firm.
(iv) It provides a base for monitoring actual activity.
TECHNIQUES USED IN BUDGETING
1 Flexible budget
The C1MA defines a flexible budget as "a budget which is designed to change in accordance
with the level of activity attained". A flexible budget recognises the existence of fixed,
variable and semi-variable costs, and it is designed to change in relation to the actual volume
of output or level of activity in a period.
The principles underlying the flexible budget are:
(i) to prepare 'contingency plans' in advance.
(ii) budgetary control.
The concept of flexible budget was to focus on how control could be achieved over the
operations. In a flexible budget, overheads are analysed into three, namely:
(a) fixed
(b) variable
(c) semi variable
2 Zero-based budget (ZBB) or "priority based budgeting"
ZBB was introduced in the early 1970s in the United States by O. Phyrr. ZBB is a budgeting
technique which seeks to eliminate the draw backs of traditional incremental budgeting by
taking the budgets for service or overhead centres back to a minimal operating level and then
requiring increments above this level to be quantified and justified. 'A method of budgeting
which requires each cost element to be specifically justified, as though, the budget related
were being undertaken for the first time, without approval, the budget allowance is zero"
CIMA‘‘.
ZBB is concerned with the evaluation of the costs and benefits of alternatives and, implicit in
the technique, is the concept of opportunity cost. ZBB is applied in three stages
(i) The decision unit: This means subdividing the organisation to discrete sub-units where
operations can be meaningfully and individually identified and evaluated.
(ii) The decision packages: Each decision unit manager submits no less than three budget
packages namely
(a) the lowest level of expenditure
(b) the expenditure required to maintain levels of activity
(c) the expenditure required to provide an additional level of service or activity.
(iii) Agreed packages will form the budget.
The Advantages of ZBB
(i) Results in a more efficient allocation of resources to activities and departments.
(ii) It focuses attention on value for money
(iii) ZBB develops a questioning attitude which enables management to determine

inefficiency.
(iv) It may lead to cost reduction.
(v) Managers performance can be monitored.
The Disadvantages of ZBB
(i) ZBB is a time consuming process and generates volume of paperwork especially for the
decision packages.
(ii) It requires management skill in both drawing decision packages and for the ranking
process.
(iii) It encourages the wrong impression that all decisions have to be made in the budget.
(iv) Trade Union always go against ZBB, who prefer status quo to remain.
(v) Co-ordination of all activities may be difficult.
3 Activity based budgeting (ABB)
Activity based budgeting (ABB) which is also known as Activity Cost Management is
defined as ` method of budgeting based on an activity framework and utilizing cost driver
data in the budget-setting and variance feedback processes" (ICMA). It is a part of planning
and control system which tends to support the objectives of continuous improvement. ABB is
a form of development of conventional budgeting system. It is also based on activity analysis
techniques.
ABB FEATURES
(a) It enables costs to be managed and understood in the long run.
(b) ABB differentiates and examines activities for their value adding potentials.
(c) The department activities are driven by demands and decisions which are beyond the
control of the budget holder.
(d) It encourages immediate and relevant performance measures required than are found in
conventional budgeting systems.
The Advantages of ABB
(i) It provides stronger links between an organization‘s strategic objectives.
(ii) It has ability to tackle cross organisational issues through a participating approach.
(iii) It also uses activity analysis techniques which promotes continuous improvement.
4 Planning, Programming, Budgeting System (PPBS)
PPBS analyses the output of a given programme and also seeks for the alternatives to find the
most effective means of reaching basic programme activities. PPBS involves the preparation
of a long-term corporate plan that clearly establishes the objectives that the organization have
to achieve. PPBS is the counter part of the long-term process for profit-oriented
organisations.
Aims and Objectives of PPBS
(i) The aim of PPBS is to enable the management of a non-profit making organisation to
make more informed decision about the allocation of resources to meet the overall objectives
of the organisation.
(ii) It enables the management to identify the activities, functions or programmes to be

provided thereby establishing a basis for evaluation of their worthiness
(iii) PPBS provides information that will enable management to assess the effectiveness of its
plans.
Stages In PPBS
(i) Calls for a careful specification and overall objectives are determined.
(ii) Identify programmes that will achieve these objectives and those programmes which are
normally related to the major activities undertaken by government establishments.
(iii) The costs and benefits of each programme are determined, so that budget allocations can
be made on the basis of the cost-benefit of the programme.
(iii) Analyses the alternatives to find the most effective means of reaching basic programme
objectives.
(iv) This analytical procedure will be established as to systematically form part of budgetary
control.
5 Continuous Budget/Rolling Budget
Continuous budget which is known as rolling budget is a system of budgeting that involves
continuously updating budgets by reviewing the actual results of a specific period in the
budget and determining a budget for the corresponding time period. It has been described as
an attempt to prepare targets and plans which are more realistic and certain by shortening the
period of budget preparations. Under this method, instead of preparing a budget annually,
there would be budget every three or six months so that as the current period ends, the budget
is extended by an extra period; for example, if a continuous budget is prepared every three
months, the first three months would be planned in great details and the nine months in lesser
details, because of the greater uncertainty above the longer term future.
Advantages
i. Management is made to be continuously aware of the budgetary process since the figures
for the next 12 months are always available.
ii. It allows for more frequent assessment and revision of the budgets in the light of current
trends particularly during the period of inflation, thus, the budget does not become quickly
obsolete or outdated.
Disadvantages
i. Higher costs and efforts are required for continuous budgeting.
ii. It is time consuming in that, in each period, the whole procedures of preparing budgets
have to be undertaken.
FORECAST
"The technique of business forecasting has been developed to give a logical and
comprehensive means of providing management with information to determine the most
advantageous plans which can be made within the anticipated resources of the business."
(MA).Despite the uncertainty that exists about the future, business plans are prepared to
resolve some of this uncertainty.
DISTINCTION BETWEEN FORECAST AND BUDGETS
A forecast states the events which are likely to occur in the future. A budget states the plans
which the managers will endeavour to turn into actual events. It is a statutory executive order.
FORECASTING PROCEDURES
a) Assessments by staff of sales department: Estimates should be made by the individual

salesmen and passed upwards to the sales manager. The advantage of this method is that
individual salesmen can give consideration to the particular factors which are relevant in their
areas.
(b) Mathematical analysis of past sales: Such analyses should indicate trends and seasonal
variations. This information can be adjusted for known factors, such as increase advertising,
to give a forecast of future sales.
(c) Senior management judgement: The senior management team, including production
manager, administrative manager etc., will meet to discuss sales prospects. The approach
brings a variety of skills and experience to the forecasting exercise.
BUDGETARY CONTROL
Budgetary control is also defined as 'the establishment of budgets relating the responsibilities
of executive to the requirements of a policy, and the continuous comparison of actual with
budgeted results either to secure by individual action the objective of that policy or to provide
a basis for its revision.
Certain fundamental principles can be outlined from the above definitions of budgetary
control:
(a) Establish a plan or target of performance which co-ordinates all the activities of the
business; (b) Record the actual performance;
(c) Compare the actual performance with that planned;
(d) Calculate the differences or variances, and analyse the reasons for them
(e) Act immediately, if necessary, to remedy the situation.
THE OBJECTIVES OF BUDGETARY CONTROL
(a) To combine the ideas of all levels of management in the preparation of the budget;
(b) To co-ordinate all activities of the business;
(c) To centralize control;
(d) To decentralize responsibility of each of the manager involved;
(e) To act as a guide for management decisions, when unforeseeable conditions affect the
budget
(f) To plan and control income and expenditure so that maximum profitability is achieved
(g) To direct capital expenditure in the most profitable direction
(h) To ensure that sufficient working capital is available for the efficient operation of the
business
(i) To provide a yardstick against which actual results can be compared;
(h) To show management which action is needed to remedy a situation.
THE ORGANISATION FOR BUDGETARY CONTROL
These include:
(a) The Preparation of an Organization Chart: This defines the functional responsibilities of
each member of management and ensures that he knows his position in the company and his
relationship to other members.
(b) The Budget Period is the time to which the plan of action relates. Period budgets cover a
fixed period of time, most commonly one year. They will be divided into shorter time
periods, known as: control periods, for purposes of reporting control.
c) Budget manual-The organization for budgeting [and budgetary control] should be

documented in a budget manual, which has been described as a "procedure or rule book
which 'sets out standing instructions governing the responsibilities of persons, and the
procedures, forms and records relating to the preparation and use of budgets". (CIMA)
UNIT 6 STANDARD COSTING
A STANDARD COST
Standard cost is defined as the planned unit cost of the products, components or services
produced in a period. The standard cost may be determined on a number of bases. The main
uses of standard costs are in performance measurement control, stock valuation and in the
establishment of selling prices.
STANDARD COSTING
This is a useful control technique based on the feedback control concept which ensures the
determination of standard costs of products or services and compares them with the actual
results and costs with the difference being referred to as a variance. This difference can be
further explained by a process called variance analysis. The standard costing technique can be
of use in a number of circumstances such as: where there is repetition of jobs and large
production activities (process); service industries (hospital, merchandising) etc.
REASONS FOR ADOPTING A STANDARD COSTING

TECHNIQUE
Some of the basic reasons for adopting a standard costing technique are:
a) To encourage management and employees, since it ensures that they have to plan ahead;
(b) To serve as the basis for quoting for jobs or fixing prices;
(c) To ensure that performance improvement measures are adequately guided;
(d) To provide the basis for setting budgets;
(e) To ensure that standards are put in place and variances properly analysed in order to
control costs;
(f) To provide the basis for allocating duties in order to check inefficiencies or take advantage
of opportunities;
DRAWBACKS/DISADVANTAGES OF THE TECHNIQUE
The following are the disadvantages of standard costing;
(a) Lack of understanding of its application could bring about resistance from the employees.
(b) Confidence of the users may be eroded, especially where they become outdated.
(c) The technique may be very expensive to operate especially where technicalities are
involved and set-up time is elongated.
(d) It may not be appropriate for business use, if standard costs are not properly determined.
SETTING OF STANDARDS
The Types of Standards
Performance standards setting are a function of four basic standards:
(a) Ideal Standards: These are based on perfect operating conditions whereby there are no
wastages, inefficiencies, idle-time, breakdown of machines etc.
(b) Basic Standards: These are standards which remained unaltered over a long span of time
and they may become outdated as a result of changes in technology, laws, norms etc. They
can only be used to express changes in the level of efficiency or performance over a period of
time as well as the trend of prices from period to period.
(c) Current Standards: They are based on current conditions of service or production, for
example, current losses, inadequacies etc. However, they do not seem to bring about a higher
current level of performance.
(d) Attainable/Expected Standards: They are a function of normal operating circumstances,

thus ensuring that some allowances are available for losses, wastages, inadequacies, etc. They
make for a challenging situation for employees in as much as psychological awareness is
created.
Capacity Levels
(a) Full Capacity: It is the "production volume expressed in standard hours that could be
achieved if sales order, supplier and workforce were available for all installed work places"
(CIMA). Under this circumstance, full capacity can be related to ideal standards with the
assumption that labour shortages, shortfall in supplies, equipment breakdown will not affect
the smooth running of the production processes.
(b) Practical Capacity: This is "full capacity less an allowance for known unavoidable volume
losses" (CIMA). Some examples of unavoidable losses are: repair time for equipment and
plants, job resetting times, machine breakdown etc.
(c) Budgeted Capacity: It is the "standard hours planned for the period, taking into account
budgeted sales, suppliers and workforce availability " (CIMA). In effect, it is the labour hours
and machine hours required to have the budgeted units and can be a function of current
standards that are not peculiar to normal practical capacity over an extended period of time.
d) Idle Capacity: This is the difference between the practical capacity and the budgeted
capacity based on standard hours of output. This is the unutilized capacity that is not
required, in that, the budgeted volume is less than the practical volume that could be
achieved.
SHORTCOMINGS OF SETTING STANDARD COSTS
The shortcomings that can be associated with the setting of standard costs may include:
(a) The significant influence of quantity discounts and cyclical price changes that may make
it difficult to determine the prices of materials.
(b) If it is desired to have a mix of the constituents parts of materials, it may be difficult to
determine the proportion of the mix of the constituent parts of the materials.
(c) It may not be easy to come up with the appropriate wage efficiency standard.
(d) The manner of introducing the issue of inflation into predetermined unit costs is also a
matter of concern.
(e) Even though good materials may be expensive to obtain, the issue is how to determine the
quality to be utilized per time may not be easy especially when there is the need to reduce
material losses and spoilage
VARIANCE ANALYSIS
1 Basic Variances
The basic variances can be categorised under four main headings:
(a) Sales volume variance.
(b) Sales price variance.
(c) Variable cost variances, that is, direct materials; direct labour and variable overheads
(which can also be sub-divided into spending and efficiency variances).
(d) Fixed overhead cost variances, that is, expenditure and volume variances (which can be
further categorised into efficiency and capacity variances (which can also be sub-divided into
capacity usage and fixed overhead idle-time variance).
COMPUTATION OF VARIANCES
Variances may be computed as follows:
(a) Material cost variances
The material cost variance shows the difference between the actual costs incurred and the
standard costs. It is calculated as Standard cost less actual cost, that is, (SC - AC).
(i) Material price variance
This is derived by multiplying the difference between the standard price and actual price by
the actual quantity of materials purchased. It is calculated as: Actual Quantity (Standard Price
– Actual Price).This variance may occur because of:
 Material price changes.

 Reduction in supply of materials
 Ineffective purchasing policy.
 Non-availability of storage space.
 Insufficient funds.
 Purchasing mistakes.
 Reversal of specification standards.
(ii) Material usage variance
This is determined by multiplying the difference between the standard quantity and the actual
quantity by the standard price of quantity used. The standard quantity is expressed as a
function of the actual quantity produced at the standard specifications. It is calculated as SP
(Standard Quantity – Actual Quantity)
The material usage variance can be sub-divided into mix and yield variances:
 Material Mix Variance — This can be computed by multiplying the difference

between the standard specification of the material input and the actual mix used by the
standard price. That is, SP (SM — AM).
 Material Yield Variance — This can be expressed as the difference between the
standard yield and the actual yield from the materials used in production. That is, SC
(AQSM - SQSM) or SP (SY-AY)
(b) Wage Cost Varian
Wage cost variance is the difference between the standard wage cost of actual output and the
labour cost paid for. It is commonly separated into wage rate variance, an idle time variance
and efficiency variance.
Wage Usage Variance - This is as a result of the difference between standard labour hours of
actual output and the labour hours actually paid for multiplied by the standard rate per hour,
that is, SR (SH - AH). The wage usage variance can be sub-divided into an idle time and
efficiency variance.
Idle Time Variance — This is the difference resulting from hours lost through unexpected
situations, such as machine breakdown, lack of materials or tools, etc. (unexpected idle time
multiplied by standard hour).
Efficiency Variance – This is the variance resulting from the difference between the standard
labour hours of actual output and the useful labour hours actually worked. This is represented
by Standard Labour Cost of Actual output and standard cost of useful hours worked
multiplied by the standard rate of pay; that is, SR (SH – AUH).
(c) Variable Overhead Variance
Variable overhead can be absorbed into production on the basis of units of output produced
or standard hours used in production. Where standard hours are adopted as the strength for
determining the level of activity, the variable overhead absorption rate can be computed as:
The variable overhead variance can be sub-divided into expenditure variance and efficiency
variance.
Expenditure Variance: This is as a result of the difference between actual cost and standard
cost for the actual level of activity. It is to be taken that where the determination of level of
activity is a function of the actual activity labour hours, the actual activity is the number of
labour hours for which the work was performed. It is calculated as the difference between
standard rate and actual rate multiplied by the actual hour.
Efficiency Variance: This is as a result of the difference in the labour hours worked and the
standard hours equivalent of actual production, multiplied by the standard cost or rate. It is
expected that the activity level will be measured in labour hours for the purpose of
determining the variable overhead absorption rate. Its formula is SR (SH - AH).
(d) Fixed Overhead Variance
Fixed Overhead cost is a cost that will not change within a giver level of activity, but
overhead absorption rate per unit will be charged to products, Nonetheless, it is normal to
compute a budgeted fixed overhead absorption rate whenever product cost and valuation of
stock are required.
(i) Fixed Overhead Expenditure Variance - This is the difference between the actual and
predetermined cost of overhead. The degree of spending on the fixed overhead is not affected
by the volume of activity.
(ii) Fixed Overhead Volume Variance — This is the difference between the standard fixed
overhead elements of actual output and the standard fixed overhead in the budget. Its
formulae is given as SR (BR - SH).
(e) Sales Variance
A sales variance is used to give effect to the difference between budgeted sales and actual
sales and can be further sub-divided into a sales price variance and sales volume variance.
These variances may be related to sales profit or sales contribution, with the assertion that
those related to profit or contribution ensure the provision of effective information.
(i) Sales Price Variance - This variance is used to determine the effect of selling output above
or below the predetermined selling price. Its formulae is: AQ (SSP - ASP).
(ii) Sales Volume Variances - This variance is used to determine the effect on profit or
contribution on selling more or less than the predetermined quantity. Its formulae is SP (BQ -
A QS), where, BQ = budgeted quantity and AQS = actual quantity sold.
Q. Explain the following:
i. The Balanced Scorecard and describe the four perspectives
The balanced scorecard is a performance measurement and reporting system that strikes a
balance between financial and operating measures, links performance to rewards, and gives
explicit recognition to the diversity of organizational goals. Balance scorecard is a set of
measurement that gives top managers a fast but comprehensive view of the business. The
balance scorecard includes both financial and operational measures that tell us how an
organization has performed. Companies use the balanced scorecard to focus management‘s
attention on items subject to action periodically.
In using the balanced scorecard, the managers will have to view performance from four
different perspectives.
 Financial Perspective – how does the company look to the shareholders?

 Customer Perspective – how is the company seen by customers?
 Internal Perspective – how well does the company manage its internal processes?
 Innovative and learning Perspective – how can the company continue improving and
creating value?
1 Financial Perspective
This shows how the company creates value for its owners. The owners being the shareholders
will be concerned with several aspects of financial performance which include:
 Market share
 Cash flow
 Revenue growth
 Share price
 Profit ratio
 Profit growth
2 Customer Perspective
This looks at what customers value the most. Thus, the company can focus its performance
targets on satisfying the customers more effectively. In order to meet the financial perspective
targets, the customers should be satisfied so as to drive more sales. This aspect will look at
things like:
 Customers service
 Responsiveness
 New products
 Customer Loyalty
 New markets
 Reliability
3 Internal Perspective
In order to achieve it‘s financial and customers objectives, what processes must the company
perform with excellence? So the company should focus on activities that are essential to
satisfying the shareholders and customers. So the company will be focusing on things like:
 Improve core competence

 Quality performance
 Improvement in technology
 Inventory management
 Streamline processes
 Motivated workforce
 Manufacturing
4 Innovation and Learning Perspective
This is concerned on how the company can continue to improve and create value. The
company will be focusing on how to improve the value already created while satisfying the
shareholders and customers (financial and customers objectives). This will thus, help to
sustain the customers too. So the company will be focusing on things like:
 New product development

 Continuous improvement
 Technological leadership
 HR development
 Product diversification
ii. SMART Performance Pyramid
The Strategic Measurement and Reporting Technique (SMART) performance pyramid builds
on four levels that show the link between corporate strategy, strategic business units and
operation. The first level defines the overall corporate vision which is translated into
individual business unit objectives. Second level shows the short-term targets of cash flow
and profitability and long term goals of growth and market position. The third level is
business operating systems which consist of customer satisfaction, flexibility and
productivity. The last level, which is the fourth level is the business unit and consists of four
key performance measures (quality, delivery, cycle time and waste). The SMART
performance pyramid is a balanced model which measures stakeholder satisfaction such as
customer satisfaction, quality and delivery. It also measures the operation activity for
example, productivity and lead time. The main strength of the SMART performance pyramid
is that it provides a link between corporate objectives with operational performance indicators
iii. Building Blocks
This model is mostly suitable for service industries. The building blocks are grouped into
three:
 Dimensions
 Standard
 Reward
Dimensions
These are areas of the business that have to be monitored and controlled if business goals are
to be achieved. These dimensions can be further subdivided into two:
 Determinants
 Results
IMPORTANCE AND SHORTCOMINGS OF PLANNING AND

OPERATIONAL VARIANCES
(a) Ensures an orderly manner of reviewing standards as well as the associated basis for
setting them up.
(b) Prompts the realistic nature of standard costing and variance analysis, especially where
circumstances change and are drastic.
(c) Ensures the usage of updated information, especially in the operational variances adopted
for determining present levels of efficiency.
(d) Since standard costing as a technique is realistic and informative, its acceptability will be
on the high side and encourage motivation.
(e) Since the planning efforts are enhanced, problem areas can be easily identified and actions
takes as at when due.
THE SHORTCOMINGS OF THE VARIANCES
(a) The responsibility centres may experience some form of pressure especially where
interpretation are involved in terms of controllable and uncontrollable activities or internal or
external factors affecting planning and operating duties.
(b) The determination and updating of additional variances entail many clerical and
managerial efforts on a continuous basis.
(c) The determination of the ex-post element may be subjective, hence resulting in the
allotment of the planning and operational causal factors being political in nature.
CONTROL RATIOS
A standard hour is a measure of the work content in an hour and not that of time involved or
taken to produce. For example, if 500 units of a product should be produced in one hour, then
output of 2000 units is equivalent to 4 standard hours. Therefore, the relationship between
standard hours and actual production can be expressed as control rations. These are used to
show the degree of efficient or inefficient utilization of resources at the disposal of
management.
The following ratios can be computed:
(a) Activity Ratio
This ratio compares the actual level of production with the planned level of production. It can
be expressed as:
(b) The Efficiency Ratio
The ratio measures the efficiency with which production has been achieved. Actual time
taken to achieve the actual production is compared with the time such production should have
taken. The efficiency ratio can be expressed as:
(c) The Capacity Ratio
This ratio assesses the utilization of the available capacity by comparing actual hours worked
with budgeted hours.
CALCULATION OF PLANNING AND OPERATIONAL

VARIANCES
In calculating planning and operational variances, we have to understand the following terms:
(a) Ex-Ante: this is the first target set.
(b) Ex-Post: this is the later situation during the year or immediately which were not foreseen
during the first target (Budget);
(c) Actual Result: this is actual result at the end of the period.
Planning Variances = Ex-Ante – Ex-Post
Operational Variances = Ex-Post – Actual Result
Planning variances are those variances which are not within the control of management
(Uncontrollable).
Operational variances are variances which are controllable by the management. Planning
variances may be due to the following:
(a) New government policy on importation
(b) New government policy on taxation
(c) Inflation
DEFINITION OF MARGINAL COSTING
CIMA defines marginal costing "as a decision making technique used to determine the effect
of cost on changes in the volume of time and output in a multi-product firm especially in the
short run". Thus, it is a technique which emphasizes the variable cost of a product, that is, the
direct material, direct labour, direct expenses and other variable overheads. It demands that
fixed costs of the relevant periods are written off in full against the contribution. The
contribution is the difference between the sales value and the variable or marginal cost of a
product in a given period of time.
MARGINAL COSTING STATEMENT FORMAT
MERITS OF MARGINAL COSTING
Marginal costing is a technique which is of utmost importance to management decision

making efforts. The following reasons are pertinent to this assertion:
(a) Profit volume ratio helps management to decide which products are most profitable
(b) Contribution margin helps to decide whether:
(i) To accept or reject a special order;
(ii) To close down a line of product or business;
(iii) To determine product profitability;
(iv) To determine product mix using linear programming technique;
(v) To make or buy or lease decisions on an item of plant and equipment; and
(vi) To decide further processing decision particularly in relation to joint product cost.
(c) It assists in the pricing decision making process.
(d) Contribution approach can be used to forecast the units to be produced and sold.
(e) It facilitates the stock valuation for final accounts purposes.
DEMERITS OF MARGINAL COSTING
The difficulties associated with marginal costing are as follows:
(a) The analysis of costs into fixed and variable costs may be subjective for the purpose of
costs classification.
(b) It places emphasis on the short run effects of costs, whereas, fixed costs will vary in the
medium and long term.
(c) It is impossible to determine strategic or long term decision in that, giving a product total
cost data, it needs to be noted that in the final analysis (long run) fixed costs must be
recovered.
(d) It focuses attention on the contribution level and the tendency to exclude fixed costs by
the management may be disastrous.
ABSORPTION COSTING
Absorption costing is a method of costing stocks in which all production costs such as
variable and fixed are included as part of the cost of items'. (Statement of Accounting
Standard, No. 4). Absorption costing, therefore, is a technique in which all costs are absorbed
into production cost, hence operating statements, prepared using this approach, does not
distinguish between fixed and variable cost. It is an approach which allocates all production
costs into individual products. Fixed production overhead are absorbed into products by
establishing overhead absorption rate. This may result to over or under absorbed overhead,
which is less or more than recovery of fixed overheads at planned or predetermined activity
level.
ADVANTAGES OF ABSORPTION COSTING
(a) It does not undermine the importance of fixed cost.
(b) It avoids fictitious losses being reported by representing product cost at full factory cost to
bring the product to a point that its ready for use.
(c) It assists in arriving at total cost of production which is a basis for selling price decision
process.
(d) It matches costs with revenues since fixed production cost are considered in the product
cost.
(e) It represents current market trends and, therefore, it is widely accepted especially for tax
purposes.
DISADVANTAGES OF ABSORPTION COSTING
(a) It does not help in decision-making.
(b) Production may be very difficult since there is element of fixed cost in the product cost.
(c) Calculation of under or over absorbed overhead may be problematic.
(d) It overbears the product cost with management administrative inefficiency which may
partly be represented in fixed cost.
(e) It does not conform with the matching principle which stipulates that all costs (fixed and
variable) must be matched against revenue in the period concerned for determination of
profit.
MARGINAL AND ABSORPTION COSTING COMPARED
Marginal Costing
Marginal Costing is a useful technique for studying the effects of changes in volume and type
of output in a multi-product business. It is an accounting technique which determines the
marginal cost by distinguishing between fixed and variable costs. The primary purpose of
marginal costing is to provide information to management on the effects on costs and
revenues of changes in the volume and type of output in the short run.
Absorption costing
Absorption costing is the approach used in all published accounts, and all financial
accounting statements. It emphasizes a functional classification of costs, for example
manufacturing, selling and distribution and financial costs. In contrast, marginal costing, or
the contribution approach, highlights the behaviour of costs and classifies them accordingly,
by identifying variable costs and fixed costs.
Further distinctions between the two techniques are presented in tabular form below:
MARGINAL COSTING AND DECISION MAKING
Decision making is defined as making choices between future and uncertain alternatives. It
must be emphasized that all decision making relates to the future and that a decision is a
choice between alternatives in pursuit of an objective. Where no alternatives exist, no
decision can be made and nothing can be done now that will alter the past.
THE DECISION PROCESS
The overall decision process can be subdivided into stages:
(a) determination of objective(s)
(b) consideration of alternatives
(c) evaluation of alternatives in the light of the objective(s)
(d) selection of the course of action
THE TYPES OF DECISIONS
(a) Routine planning decisions - These relate to budgeting decisions whereby fixed and
variable costs are analysed together with revenues over a period.
(b) Short-run problem decisions - These refer to unforeseen decisions of a nonrecurring

nature, so that revenue and costs are obtained within a relatively short time.
(c) Investment or disinvestments decisions - These refer to decision of long-term

consequences. It allows for the concept of time value of money and the appreciation of
discounted cash flow techniques.
(d) Long-range decisions - These relate to an infrequently reviewed decisions. They are
decisions made once, meant to provide a continuing solution to a recurring problem, for
example, deciding, or reviewing the channel of distribution of the company's products.
(e) Control decisions - That is, these are cautious decisions with a view to evaluate the
benefits expected such that they exceed the costs of investigation. It is more like "think
before you act" circumstances.
RELEVANT COST
Any cost that is useful for decision making is often referred to as a relevant cost. A cost is s
aid to be relevant provided there is a future cash flow arising from a direct consequence of a
decision. A relevant cost is one which arises as a direct consequence of a decision.
DIFFERENTIAL COSTING
This is a term used in the preparation of adhoc information when all the cost and income
differences between the various options being considered are highlighted so that clear
comparisons can be made of all the financial consequences. In one sense, differential costing
is a wider concept than marginal costing because all cost changes are considered, both fixed
and variable, whereas the presumption when marginal cost is used is that only variable cost
changes.
KEY BUDGET FACTOR / LIMITING FACTOR
Key budget factor sometimes known as a limiting factor or principal budget factor is a factor
which is a binding constraint upon the organization, that is, the factor which restricts
indefinite expansion or unlimited profits. It may be sales, availability of finance, skilled
labour, supplies of material or lack of space. Where a single binding constraint can be
identified, then the general objective of maximizing contribution can be achieved by selecting
the alternative which maximizes the contribution per unit of key factor. It will be apparent
that from time to time, the key factor in an organization will change. For example, a firm may
have a shortage of orders. It overcomes this by appointing salesmen and then finds that there
is a shortage of machinery capacity. The expansion of the productive capacity may introduce
a problem of lack of space and so on.
COST-VOLUME-PROFIT (CVP) ANALYSIS
Cost-Volume-Profit Analysis otherwise known as Break-Even Analysis refers to a technique

that assists in decision making by employing the marginal costing concept and is used to
measure the effect on profit as a result of changes in volume of activities, cost and prices. It
also facilitates planning in the sense that CVP analysis could assist to predict future cost
levels and sales as related to a range of level of activity. It demonstrates how the profit will
be affected as a result of changes in any of the variables that make up the profit function. Its
use requires the separation of the total cost function into their, variable and fixed portion, as
required in the application of marginal costing principles.
Basic Assumptions of CVP-Analysis
The basic assumptions associated with CV P technique are:
(a) All costs could be categorized as either variable cost or fixed cost.
(b) Semi-Variable cost can be segregated into both the variable and its fixed component.
(c) Selling price per unit is constant. (d) Variable cost per unit is constant.
(e) Total fixed cost remains unchanged regardless of output.
(f) Parity of production and sales.
Limitations of the Basic Assumptions
The basic assumptions of C-V-P have the following deficiencies:
a) It might be difficult to separate some costs into their fixed and variable cost portions.
(b) The selling price per unit is assumed to be constant. This is not realistic because of
possibility of discounts.
(c) The variable cost per unit is assumed to be constant. This is not realistic because quantity
discount could result in decrease in material cost and labour cost per unit could fall whenever
the learning curve theory becomes applicable.
(d) Fixed cost is assumed to remain unchanged. This is not true because in reality, fixed cost
moves in a step-like manner. Also in the long run all costs are variable.
(e) It is assumed that production is equal to sale, hence no closing stock. This assumption
looks unrealistic because a business is a going concern and invariably stocks are carried from
one period to the other.
(f) The assumption of one product or constant mix of product is not realistic because most
organizations produce variety of products and invariably actual mix turn out to be radically
different from the expected level of activity.
Q. What are the formulae for: break-even point (units); break-even point (sales value)
Q. Explain the term ―Opportunity Cost‖
Opportunity cost is the value of benefit sacrificed in favour of an alternative course of action.
It is the maximum amount that could be obtained at any given point in time if a resource was
sold or put to the most valuable alternative use that would be practicable. Opportunity cost of
goods or services is measured in terms of revenue which could have been earned by
employing that goods or services in some other alternative uses. Opportunity cost of goods or
services is measured in terms of revenue which could have been earned by employing that
goods or services in some other alternative uses. Relevant cost may also be expressed as
opportunity costs. An opportunity cost is the benefit of the next best alternative that is
forgone.

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WINSMART ACADEMY

MOTTO: PERSONALISED TUTORING FOR LEADERS OF TOMORROW

ACC313 MANAGEMENT ACCOUNTING SUMMARY

UNIT 1: GENERAL PRINCIPLES OF COSTING

IMPORTANCE AND BASIC PRINCIPLES OF COSTING

ESSENTIALS OF A GOOD COSTING SYSTEM

C. Costing system should be simple to operate and understand. Unnecessary complications

Classification of costs can be made according to the following basis:

A. Classification according to elements:- Costs can be classified according to the elements.

They are mentioned below.

C. Classification according to behaviour:- Costs can also be classified according to their

COSTING METHODS AND TECHNIQUES

Methods of Costing:- The following are the methods of costing.

The following are the techniques of costing.

UNIT 2 COST ACCOUNTING SYSTEMS

WHAT IS COST ACCOUNTING SYSTEM?

Types of Cost Accounting include the following:

1. Standard cost accounting

COMPARISON BETWEEN COST ACCOUNTING AND FINANCIAL

4. In financial accounting, cost classification is based on type of transactions, for example,

DISTINCTION BETWEEN COST ACCOUNTING AND

3. Techniques Employed: Various techniques used by cost accounting include standard

4. Evolution: Evolution of cost accounting is mainly due to the limitations of financial

PARTS OF A COST ACCOUNTING SYSTEM

A cost accounting system requires five parts that include:

1. An input measurement basis

We shall look at them one after the other.

Input Measurement Bases

The inventory valuation methods encompass the following:

i) Throughput Method: The throughput method was developed to complement a concept

Cost Accumulation Method

 Scientific identification (e.g., by job)

Recording Interval Capability

Inventory records can be maintained on a perpetual or periodic basis. Consequently, the

NECESSITY FOR COST ACCOUNTING SYSTEM

1. The analysis of profitability of individual products, services or jobs.

2. The analysis of the different departments or operations.

6. The effects on profits of increase or decrease in output or shutdown of a product line or

UNIT 3: DETERMINATION OF COST BEHAVIOUR

COST BEHAVIOUR CONCEPT

REASONS FOR STUDYING COST BEHAVIOUR

1. For the prediction of cost to facilitate budgetary and corporate planning

CONCEPT OF RELEVANT RANGE

BASIC PRINCIPLES OF COST BEHAVIOUR

Fixed, varied, stepped or mixed

Examples of fixed costs are:

1. The salary per month of a supervisor

Other examples of step cost area:

1. Rent — where accommodation requirements increase, as output levels get higher.

UNIT 4: ELEMENT OF COST AND COST ESTIMATION TECHNIQUES

The Nature and Types of Cost Classification

Costs can be classified in a number of different ways:

 By their behavior. Do they increase as an organisation gets busier or do they tend to

UNIT 5 BUDGETS AND BUDGETARY CONTROL

The purpose of a budget is to:

(i) Communicate ideas and plans to everyone affected by them.

(ii) Coordinate the activities of different departments or sub-units of the organization.

(iv) Motivate employees to improve their performances.

THE TYPES OF BUDGET