CIMA BA2 Fundamentals of Management Accounting Coursebook (BPP Learning Media)

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2
Introduction to the course
Inhalt
Welcome to BA2 Fundamentals of Management Accounting 4

Exam Technique Overview 9
Syllabus Content
Introduction to management accounting
1 Introduction to management accounting 13
Costing and cost behaviour
2 Costing 29
3 Cost behaviour 47
Costing methods
4 Absorption costing 67
5 Marginal costing and pricing decisions 99
Breakeven and limiting factor analysis
6 Breakeven analysis 119
7 Limiting factor analysis 139
Standard costing and budgeting
8 Standard costing 155
9 Flexible budgeting 167
10 Budget preparation 179
Variance analysis
11 Variance analysis 205
Job, batch and service costing
12 Job and batch costing 229
13 Performance measures and service costing 241
Cost bookkeeping
14 Cost bookkeeping 261
Decision making
15 Risk and probability 289
16 Averages and the normal distribution 313
Investment appraisal
17 Investment appraisal 341
Test your learning answers 373
Appendix A: Maths tables 391
Bibliography 395
Index 397
3
Welcome to BA2 Fundamentals of Management
Accounting
Description of the paper
This subject deals with the fundamental knowledge and techniques that underpin
management accounting. It identifies the position of the management accountant
with organisations and the role of CIMA. The subject portrays the role of
management accounting in the contexts of commercial and public sector bodies and
its wider role in society.
The identification and classification of costs and their behavior provides the basis
for understanding and applying the tools and techniques needed to plan, control
and make decisions. Budgetary control requires the setting of targets and standards
which then allow the performance of organisations to be reported and analysed by
the calculation of variances. Investment appraisal, break-even analysis and profit
maximisation are used to inform both long- and short-term decision making.
Syllabus Areas and their weighting
Weight Syllabus topic
10% A. The Context of Management Accounting
25% B. Costing
30% C. Planning and Control
35% D. Decision Making
The Objective Test exam

Format Computer Based Assessment
Duration 2 hours
Number of Questions 60
Marking No partial marking – each question marked correct or
incorrect
All questions carry the same weighting (ie same marks)
Weighting As per Syllabus Areas
All component learning outcomes will be covered
Question Types Multiple Choice
Multiple Response
Number Entry
Drag and Drop
Hot spot
Item Sets
4
Booking availability On demand

Results Immediate
Verb Hierarchy
LEVEL LEARNING OBJECTIVE VERBS USED DEFINITION

3
APPLICATION Apply Put to practical use
How you are expected Calculate Ascertain or reckon mathematically
to apply your knowledge
Demonstrate Exhibit by practical means
Prepare Make or get ready for use
Reconcile Make or prove consistent/compatible
Solve Find an answer to/prove with certainty
Tabulate Arrange in a table

2
COMPREHENSION Describe Communicate the key features of
What you are expected Distinguish Highlight the differences between
to understand
Explain Make clear or intelligible/state the meaning or purpose of
Identify Recognise, establish or select after consideration
Illustrate Use an example to describe or explain something

1
KNOWLEDGE List Make a list of
What you are expected State Express, fully or clearly, the details/facts of
to know
Define Give the exact meaning of
5
Learning Outcomes
A. The Context of Management Accounting (10%)
On completion of their studies, students should be able to:
Lead Component Level
1. Explain the purpose of (a) Explain the need for management 2

management accounting accounting
and the role of the
Management Accountant.
(b) Explain the characteristics of financial 2

information for operational, managerial
and strategic levels within organisations
(c) Explain the role of the management 2

accountant
(d) Explain the relationships between the 2

management accountant and the
organisation’s managers
2. Explain the role of CIMA as (a) Explain the role of CIMA in developing 2
a professional body for the practice of management accounting
Management Accountants.
B. Costing (25%)
1. Demonstrate cost (a) Explain the classification of costs in 2

identification and relation to output
classification.
(b) Explain the classification of costs in 2
relation to activity level
(c) Calculate appropriate costs having 3

identified cost behaviour
(d) Explain the classification of costs in 2

relation to decisions
2. Apply absorption costing (a) Prepare overhead cost statements 3

and marginal costing.
(b) Calculate the full cost of products, 3
services and activities
6
(c) Calculate the marginal cost of products, 3

services and activities
(d) Reconcile the differences between profits 3

calculated using absorption costing and
those calculated using marginal costing
(e) Apply cost information in pricing 3

decisions
C. Planning and Control (30%)

1. Prepare budgets for (a) Explain why organisations prepare 2

planning and control. forecasts and plans
(b) Prepare functional budgets 3
(c) Explain budget statements 2
(d) Identify the impact of budgeted cash 2

surpluses and shortfalls on business
operations
(e) Prepare a flexible budget 3
(f) Calculate budget variances 3
2. Apply variance analysis to (a) Explain why planned standard costs, 2

reconcile budgeted and prices and volumes are useful
actual profits in a marginal
(b) Calculate variances for materials, labour, 3
format.
variable overheads, sales prices and
sales volumes
(c) Prepare a statement that reconciles 3

budgeted profit with actual profit
calculated using marginal costing
(d) Explain why variances could have arisen 2

and the inter-relationships between
variances
3. Calculate appropriate (a) Explain the need for appropriate 2

financial and non-financial performance measures
performance measures.
(b) Calculate appropriate financial and non- 3
financial performance measures in a
variety of contexts
7
4. Prepare accounts and (a) Explain the integration of the cost 2

reports for managers. accounts with the financial accounting
system
(b) Prepare a set of integrated accounts, 3

showing standard cost variances
(c) Prepare appropriate accounts for job 3

and batch costing
(d) Prepare reports in a range of 3

organisations
D. Decision Making (35%)

1. Demonstrate the impact of (a) Explain the concepts of risk and 2

risk. uncertainty
(b) Demonstrate the use of expected values 3

and joint probabilities in decision
making
(c) Calculate summary measures of central 3

tendency and dispersion for both
grouped and ungrouped data
(d) Demonstrate the use of the normal 3

distribution
2. Demonstrate the use of (a) Apply breakeven analysis 3

appropriate techniques for
(b) Demonstrate make or buy decisions 3
short-term decision making.
(c) Calculate the profit maximising sales mix 3
after using limiting factor analysis
3. Demonstrate the use of (a) Explain the time value of money 2

appropriate techniques for
(b) Apply financial mathematics 3
long-term decision making.
(c) Calculate the net present value, internal 3
rate of return and payback for an
investment or project
8
Exam Technique Overview

1 The Best Approach to the CBA
You’re not likely to have a great deal of ‘spare time’ during the CBA itself so
you must make sure you don’t waste a single minute.
You should:
1. Work through the whole exam, answering any questions you think you
can answer correctly in a reasonably short time. If you find on occasion
that you are not very confident with your answer, click the “Flag for
Review” button before moving on.
2. Click “Next” for any that have long scenarios or are very complex and
return to these later.
th
3. When you reach the 60 question, use the Review Screen to return to any
questions you skipped past or any you flagged for review
Here’s how the tools in the exam will help you to do this in a
controlled and efficient way:
The ‘Next’ button
What does it do? This will move you on to the next question whether or not
you have completed the one you are on.
When should I use it? Use this to move through the exam on your first pass
through if you encounter a question that you suspect is going to take you a
long time to answer. The Review Screen (see below) will help you to return to
these questions later in the exam.
The ‘Flag for Review’ button
What does it do? This button will turn the icon yellow and when you reach the
end of the exam questions you will be told that you have flagged specific
questions for review. If the exam time runs out before you have reviewed any
flagged questions then they will be submitted as they are.
When should I use it? Use this when you’ve answered a question but you’re
not completely comfortable with your answer. If there is time left at the end
then you can quickly come back via the Review Screen (see below) but if time
runs out at least it will submit your current answer. Do not use the Flag for
Review button too often or you will end up with too long a list to review at the
end. Important Note – scientific studies have shown that you are usually best to
stick with your first instincts(!)
The Review Screen
What does it do? This screen appears after you click ‘Next’ on the 60 question.
th
It shows you any Incomplete Questions and any you have Flagged for Review. It
allows you to jump back to specific questions OR work through all your
Incomplete Questions OR work through all your Flagged for Review Questions.
When should I use it? As soon as you’ve completed your first run through the
th
exam and reached the 60 question. The very first thing to do is to work through
9
all your Incomplete Questions as they will all be marked as incorrect if you don’t
submit an answer for these in the remaining time. Importantly, this will also help
to pick up any questions you thought you’d completed but didn’t answer
properly (eg you only picked two answer options in a multi-response question
that required three answers to be selected). After you’ve submitted answers for
all your Incomplete Questions you should use the Review Screen to work through
all the questions you Flagged for Review.
2 The different Objective Test Question Types
Passing your CBA is all about demonstrating your understanding of the
technical syllabus content. You will find this easier to do if you are comfortable
with the different types of Objective Test Questions that you will encounter in
the CBA, especially if you have a practised approach to each one.
You will find yourself continuously practising these styles of questions
throughout your Objective Test programme. This way you will check and
reinforce your technical knowledge at the same time as becoming more and
more comfortable with your approach to each style of question.
Multiple choice
Standard multiple choice items provide four options. 1 option is correct and
the other 3 are incorrect. Incorrect options will be plausible, so you should
expect to have to use detailed, syllabus-specific knowledge to identify the
correct answer rather than relying on common sense.
Multiple response
A multiple response item is the same as a multiple choice question, except
more than one response is required. You will be told how many options you
need to select.
Number entry
Number entry (or 'fill in the blank') questions require you to type a short
numerical response. You should carefully follow the instructions in the question
in terms of how to type your answer – eg the correct number of decimal places
Drag and drop
Drag and drop questions require you to drag a “token” onto a pre-defined
area. These tokens can be images or text. This type of question is effective at
testing the order of events, labelling a diagram or linking events to outcomes.
Hot spot
These questions require you to identify an area or location on an image by
clicking on it. This is commonly used to identify a specific point on a graph or
diagram.
Item set
2-4 questions all relating to the same short scenario. Each question will be
'standalone', such that your ability to answer subsequent questions in the set
does not rely on getting the first one correct.
10
Key to icons
A key definition which is important to be

Key term
aware of for the assessment
A formula you will need to learn as it will not

Formula to learn
be provided in the assessment
A formula which is provided within the

Formula provided assessment and generally available as a pop-
up on screen
An example which allows you to apply your

knowledge to the technique covered in the
Activity
Course Book. The solution is provided at the
end of the chapter
A worked example which can be used to

Illustration review and see how an assessment question
could be answered
Assessment focus point A high priority point for the assessment
11
12
Introduction to
management
accounting
Learning outcomes
Having studied this chapter you will be able to:

• Explain the need for management accounting
• Explain the role of the management accountant
• Explain the characteristics of financial information for operational, managerial and strategic
levels within organisations
• Explain the relationships between the management accountant and the organisation's managers
• Explain the difference between placing management accounting within the finance function and
a business partnering role within an organisation
• Explain the role of CIMA in developing the practice of management accounting
Chapter context
This chapter introduces the paper by looking at what management accounting is and the role of
management accountants within organisations as well as the role of CIMA itself. There are a couple
of relatively lengthy definitions in the middle of the chapter but the key thing at this stage is to be
comfortable with the main areas of management accountancy in Section 1.
13
Chapter overview
Management accounting
Position in Definitions The role of CIMA

organisation
Main areas
Performance
Costing
evaluation
Planning Control Decision making
14
1: Introduction to management accounting
1 The need for management accounting

It is useful to start by looking at a definition:
1.1 CIMA's definition of management accounting
CIMA defines management accounting as 'the application of the principles

Key term of accounting and financial management to create, protect, preserve and
increase value for the stakeholders of for-profit and not-for-profit enterprises in the
public and private sectors. Management accounting is an integral part of
management. It requires the identification, generation, presentation,
interpretation and use of relevant information'.
(CIMA Official Terminology, 2005)
1.2 The main areas of management accounting

Following on from the above definition we could break down management
accounting into five main areas:
(a) Costing
What is the cost of goods produced or services provided?
We need to know this to assess the profitability of products or services, to help
set prices and to value inventory in the statement of financial position.
(b) Planning
Planning involves defining objectives and assessing future costs and revenues
to set up a budget.
Planning is essential to help assess purchasing and production requirements of
the business. It forces management to think ahead.
(c) Control
Once plans have been made, the company must ensure they are being
followed and assess any inefficiencies in the business.
(d) Decision making
There are many decisions managers may have to make such as:
 What should we produce?
 How should we finance the business?
 Is a project worthwhile?
The finance function is often involved in assessing and modelling the
expenditure and cash flow implications of proposed decisions.
15
(e) Performance evaluation
Employees and divisions can be assessed by comparing their performance
against targets or budgets. Sometimes performance evaluation is classed as
part of control; see (c) above.
1.3 The Global Management Accounting Principles
Global Management Accounting Principles

Key term
CIMA, in a joint project with the AICPA, has developed four principles of
management accounting to support organisations in benchmarking and improving
their management accounting systems.
The principles help the public and private sectors make better decisions, respond
appropriately to the risks they face and protect the value they generate. The four
principles are:
(1) 'Communication provides insight which is influential'
Objective. 'To drive better decisions about strategy and its execution at all
levels.'
 Communication on strategy should involve all employees
 Communication should be adapted to suit the user's needs (eg no jargon)
 Good communication helps decision making
(2) 'Information is relevant'
Objective. 'To help organisations plan for and source the information needed
for creating strategy and tactics for execution.'
 Information is accurate, timely and collected from the best sources
 It is financial and non-financial
 It is quantitative (capable of being expressed in numbers) and qualitative
(non-numeric)
(3) 'Impact on value is analysed'
Objective. 'To simulate different scenarios that demonstrate the cause-and-
effect relationships between inputs and outcomes.'
 Models should be used to estimate outcomes and measure impact of
decisions
 Models can lead to improved prioritisation of undertakings (eg
prioritising by value rather than by cost)
(4) 'Stewardship builds trust'
Objective. 'To actively manage relationships and resources so that the
financial and non-financial assets, reputation and value of the organisation are
protected.'
16
 Competent people applying best practice

 Behaving with integrity, objectivity and accountability
 Considering economic, environmental and social risks
2 The role of the management accountant

2.1 Introduction
The management accountant assists in the management of an organisation by
providing relevant information to help it achieve its objectives. The management
accountant also helps to improve the systems that produce that information.
Although it is important to appreciate that businesses will have many objectives in
order to satisfy various different groups (eg employees, customers, suppliers, the
Government), the assumption that will usually be made in your studies is that
companies wish to maximise the wealth of their shareholders. Usually this will be
achieved by maximising profit.
Management accountants undertake a wide variety of tasks and activities and their
role isn't solely restricted to producing information in monetary terms.
For a more detailed description of the role of a management accountant it is
worthwhile referring to some definitions:
2.2 CIMA's definition of the role of the management

accountant
'Chartered Management Accountants help organisations establish viable
strategies and convert them into profit (in a commercial context) or into
value for money (in a not-for-profit context). To achieve this they work as an
integral part of multi-skilled management teams in carrying out the:
 Formulation of policy and setting of corporate objectives;
 Formulation of strategic plans derived from corporate objectives;
 Formulation of shorter-term operational plans;
 Acquisition and use of finance;
 Design of systems, recording of events and transactions and
management of information systems;
 Generation, communication and interpretation of financial and
operating information for management and other stakeholders;
 Provision of specific information and analysis on which decisions are
based;
 Monitoring of outcomes against plans and benchmarks, financial and
non-financial, quantitative and qualitative, for monitoring and control; and
 Improvement of business systems and processes through risk
management and internal audit review.
17
Through these forward-looking roles and by application of their expert skills
management accountants help organisations improve their performance, security,
growth and competitiveness in an ever more demanding environment.'
CIMA's website says:
'Chartered management accountants:
 Advise managers about the financial implications of projects.
 Explain the financial consequences of business decisions.
 Formulate business strategy.
 Monitor spending and financial control.
 Conduct internal business audits.
 Explain the impact of the competitive landscape.
 Bring a high level of professionalism and integrity to business.'
(CIMA, 2016)
2.3 IFAC definition of the role and domain of the

professional accountant in business
The International Federation of Accountants (IFAC) recognises that the roles of
professional accountants who work in business are extraordinarily varied in terms of
work, experience and responsibilities. IFAC (2005) describes a professional
accountant in business as:
'Someone that first meets the standards of a professional, defined as:
 Having skills, knowledge and expertise tested by examination and
continuously developed in a structured and monitored context
 Committed to the values of accuracy, honesty, integrity, objectivity,
transparency and reliability
 Subject to oversight by a body with disciplinary powers
This is similar to other professionals that achieve accreditation through exam, and
maintain expertise via a commitment to on going continuing education.
Second, is recognized as being an accountant, defined as:
 Belonging to a recognised accountancy body upholding professional
standards and approaches in the discipline of recording, analysing,
measuring, reporting, forecasting and giving advice in support of financial,
management and strategic decisions.
And third, is in business, defined as:
 Working in an organisational entity of any size and ownership structure, or
alone, whether or not operating for profit, other than engaged in external
audit
 An integral member of, or support to, the management team striving to create
and sustain value for stakeholders'
18
IFAC (2005) has defined the domain of the professional accountant in business as:
 'The generation or creation of value through the effective use of
resources (financial and otherwise) through the understanding of the drivers of
stakeholder value (which may include shareholders, customers, employees,
suppliers, communities, and government) and organisational innovation
 The provision, analysis and interpretation of information to
management for formulation of strategy, planning, decision making and
control
 Performance measurement and communication to stakeholders,
including the financial recording of transactions and subsequent reporting to
stakeholders typically under national or international Generally Accepted
Accounting Principles (GAAP)
 Cost determination and financial control, through the use of cost
accounting techniques, budgeting and forecasting
 The reduction of waste in resources used in business processes through
the use of process analysis and cost management
 Risk management and business assurance
IFAC also states that 'The roles that Professional Accountants in Business perform
include implementing and maintaining operational and fiduciary controls, providing
analytical support for strategic planning and decision making, ensuring that
effective risk management processes are in place, and assisting management in
setting the tone for ethical practices'.
2.4 Comparison to financial accounting

The management accounting and financial accounting systems in a business both
record the same basic data for income and expenditure, but each set of records
may analyse the data in a different way. This is because each system has a
different purpose.
(a) Management accounts are prepared for internal managers of an
organisation.
(b) Financial accounts are prepared for individuals external to an
organisation eg shareholders, customers, suppliers, tax authorities and
employees.
The data used to prepare management accounts and financial accounts is the same.
The differences between the management accounts and the financial accounts arise
because the data is analysed differently.
19
3 The management accountant's position
The management accounting function may sit in various positions depending on the
structure of the business. For example, the management accounting function may be
included as part of the finance function or as a separate business partner function,
or it could even be a function which is outsourced.
3.1 Management accountant as business partner

As we have mentioned already, management accounting covers costing, planning,
control, and decision making. However, traditionally management accountants
focused on producing cost information only. They were able to use the same basic
data as financial accountants and it therefore made sense for them to be based in
the finance function.
Over time their role has widened to encompass the production of both financial and
non-financial information. This, coupled with the fact that much of the basic
information production can now be automated, has led to the argument that the
management accountant should be based outside the finance function, acting as a
business partner and adviser and working in cross-functional teams.
3.2 Shared service centre

Alternatively the entire finance function may be placed in a shared service centre.
This is a single location that provides all the accounting support for the whole
organisation.
3.3 Business process outsourcing centre

A third option is for an organisation to outsource all or part of the finance function
to an external supplier.
Activity 1: Structure of management accounting function

Info Co is currently considering how to structure its management accounting
function.
Required
State one advantage and one disadvantage for each of the three approaches listed
below.
Solution
Management accountant as business partner
20
Shared service centre
Business process outsourcing centre
3.4 Decision-making levels

However the finance function is structured it is important that management
accountants recognise that the management information needs of each
manager will vary depending on their level within the organisation.
Management information – the information supplied to managers for the

Key term purpose of planning, control and decision making.
Decision making operates at three levels:
Level Nature of tasks Nature of information
Strategic
Key term
Developing long-term Used by senior managers,
organisational goals and unstructured, forward looking and
objectives externally focused, qualitative and
quantitative, relevant to long term,
highly summarised, derived from
internal and external sources
Management Implementing the strategy set Used by middle management, routine

efficiently and effectively reports, for example, showing budget
v actual, relevant to short and
medium term, summarised at a lower
level, primarily generated internally
Operational Ensuring that specific tasks Used by front line managers,

are being carried out in an detailed, structured, numerical and
efficient and effective way internally focused, relevant to
immediate term, derived almost
entirely from internal sources
Management information should be good information. It should be relevant,

complete, accurate, clear, of manageable volume, appropriately communicated and
timely. Its cost should also be less than the benefits it provides.
21
Activity 2: Decision categories
Required
Categorise the following decisions as either strategic, management or operational:
Solution
Strategic Management Operational
Whether to take out

loans or issue shares
to raise finance
Which products to
continue/discontinue
How many
production staff to
employ
Which geographic
markets to operate
in
Which suppliers to
use
4 CIMA and its role in management accounting

CIMA is a global accounting body based in the UK. It is the world's largest
professional body of management accountants. It has over 229,000 members and
students in 176 countries.
4.1 The history of CIMA

(a) CIMA was founded in 1919 as the Institute of Cost and Works Accountants
(ICWA). It specialised in the development of accounting techniques for use in
the internal control of manufacturing, service and public sector operations.
(b) It changed its name from ICWA to the Institute of Cost and Management
Accountants (ICMA) in 1972.
(c) It changed its name again in 1986 to the Chartered Institute of Management
Accountants (CIMA) after the granting of a Royal Charter in 1975.
22
4.2 CIMA and the profession of management accounting

(a) CIMA is committed to upholding the ethical and professional standards and to
maintain public confidence in management accounting.
(b) CIMA regulates the activities of its members by a code of practice, a discipline
committee and a continuing education scheme.
(c) It is the responsibility of each student and member to ensure they comply with
both CIMA's regulations and any specific regulations and legislation as
required by their country of residence.
(d) Members and students must uphold the Code of Ethics and refrain from any
conduct which might discredit the profession. This code is based on five
fundamental principles:
 Integrity
 Objectivity
 Professional competence and due care
 Confidentiality
 Professional behaviour
(CIMA code of ethics, 2015)
23
Chapter summary
 In general terms, management accounting is for internal reporting whereas

financial accounting is for external reporting.
 The management accountant plays a critical role in providing information to
management to assist in planning, decision making and control.
 Management accounting is now increasingly seen as a support for
management by providing information for planning, control and decision making
rather than part of the finance function.
 The purpose of management information is to help managers to manage
resources efficiently and effectively, by planning and controlling operations and by
allowing informed decision-making.
 The four Global Management Accounting Principles are:
1 Communication provides insight which is influential
2 Information is relevant
3 Impact on value is analysed
4 Stewardship builds trust
 The global organisation for the accountancy profession is IFAC, the International
Federation of Accountants.
 CIMA is a global accounting body which regulates its members in order to
comply with best practice and to protect the public.
24
Keywords
 Global Management Accounting Principles: 'Four principles of management
accounting to support organisations in benchmarking and improving their
management accounting systems'
 Management accounting: 'The application of the principles of accounting and
financial management to create, protect, preserve and increase value for the
stakeholders of for-profit and not-for-profit enterprises in the public and private
sectors'
 Management information: Information supplied to managers for the purpose of
planning, control and decision making
 Managerial decisions: Implementing the strategy set, efficiently and effectively
 Operational decisions: Ensuring that specific tasks are being carried out in an
efficient and effective way
 Strategic decisions: Developing long-term organisational goals and objectives
25
Activity answers
Activity 1: Structure of management accounting

function
Management accountant as business partner
Advantages – By working in the operational environment, the management
accountant develops a better knowledge of the business, and stronger relationships
with the managers they work with. Information produced by the management
accountant can then be tailored to the needs of individual managers.
Disadvantages – Duplication of activities (where the same reports may be prepared
by several different accountants); focus is on individual departments rather than the
whole organisation; accountants can become isolated from their finance colleagues.
Shared service centre
Advantages – Centralising the function gives lower overall cost than the 'business
partner' approach, consistent reporting as the same reports are prepared for each
department, and therefore higher quality information
Disadvantages – Unresponsive to local requirements, remote from and lacking
knowledge of the operating units
Business process outsourcing centre
Advantages – Lower cost, access to the skills and knowledge of a specialist provider
Disadvantages – Loss of control, potential loss of confidentiality, inflexible once the
contract has been signed
(Only one advantage and one disadvantage for each was required)
Activity 2: Decision categories

Strategic Management Operational
Whether to take out X

loans or issue shares
to raise finance
Which products to X
continue/discontinue
How many production X

staff to employ
Which geographic X
markets to operate in
Which suppliers to X
use
26
Test your learning

1 In general terms, financial accounting is for internal reporting whereas management
accounting is for external reporting.
True
False
2 Which one of the following is not usually considered to be one of the purposes of
management information?
A Implementing
B Planning
C Control
D Decision making
3 Fill in the gaps.
Management accounting is increasingly being viewed as supporting ………………
rather than being part of the ………….. function.
4 Management information is used for planning, control and .
5 Non-financial information is relevant to management accounting.
True
False
27
28
Costing
Learning outcomes

• Explain the classification of costs in relation to output (direct and indirect costs)
• Explain the classification of costs in relation to decisions
• Explain the need for appropriate performance measures (responsibility accounting)
Chapter context
This chapter introduces some important concepts and terms that are fundamental for this paper,
including the benefit of splitting total costs into different categories to help us run the organisation
effectively.
29
Chapter overview
Costing
Costing Performance
Responsibility
accounting
Definitions Classifications
 Cost centre
 Profit centre
 Cost object
 Investment centre
 Cost unit
 Cost centre
Direct v indirect Production v Performance

non-production evaluation
 Prevention
 Appraisal
 Internal failure
 External failure
30
2: Costing
1 Costing definitions
1.1 Cost object
Cost object – anything for which cost data is desired eg products, product lines,
Key term jobs, customers or departments and divisions of a company.
1.2 Cost unit
Cost unit – a unit of product or service in relation to which costs may be

Key term ascertained.
The cost unit should be appropriate to the type of business. For example, an audit
firm could be trying to cost a complete audit, or one chargeable hour.
Activity 1: Cost units

Give appropriate cost units for the following:
Business Appropriate cost unit
Car manufacturer
Ball bearing manufacturer
Builder
Management consultant
1.3 Cost centre
Cost centre – a function or location for which costs are ascertained (and related to
Key term cost units for control purposes).
Production Service
cost centre cost centre
(Eg assembly, (Eg canteen,

processing, finishing) maintenance, stores)
31
Production cost centres – those which are actively involved in the production
Key term process.
Service cost centres – provide a service or back-up to the production
departments.
2 Introduction to cost classification

Cost classification is the arrangement of cost items into logical groups. For example:
 Classification by nature (eg materials, wages)
 Classification by function (eg administration, production)
 Classification by behaviour (see Chapter 3) or responsibility (see Section 5)
One of the eventual aims is to determine the cost of making a product or providing
a service.
2.1 Classification by function

Direct
$ Prod'n cost
Production costs X
Indirect
Prod'n cost
Non-production costs
Administration costs X
Selling and distribution costs X
Total cost X
The management accounting techniques in this paper are mostly concerned with
production costs.
2.2 Direct production costs
Direct costs – those costs which can be specifically identified with and allocated
Key term to a particular cost object. Usually the cost object will be a cost unit and therefore
direct costs can be attributed in full to a particular unit of production.
Prime cost – the total of all direct production costs.
Note that direct materials include all material becoming part of the product
(unless used in negligible amounts and/or having negligible cost) – this includes
packing materials. Direct labour is all basic hours or overtime expended on work on
the product itself, including altering the condition, conformation or composition of
the product, or inspecting, analysing or testing the product if this is specifically
required for such production. Direct expenses are any expenses which are incurred
on a specific product other than direct material cost and direct wages.
32
2: Costing
2.3 Indirect production costs (production overheads)
Indirect production costs – those costs which are incurred in the course of
Key term making a product/service but which cannot be identified with a particular cost
object (which is usually a cost unit).
It is usually easy to identify the amount of a direct expense that is spent on one unit,
but it is more difficult to do so with indirect costs as they are not spent directly on
one unit. They are usually spent in relation to a number of units.
Here are some examples:
Direct Materials that are incorporated into the finished product

materials (eg wood used in the construction of a table).
Indirect Materials that are used in the production process but not
materials incorporated into the product (eg machine lubricants and spare
parts). Insignificant costs that are attributable to each unit are
sometimes included in indirect materials for convenience (eg nails
and glue).
Direct labour Wages paid to those workers who make products in a

manufacturing business (eg machine operators) or perform the
service in a service business (eg hairdressers in a hair salon).
Indirect Wages and salaries of the other staff, such as supervisors,

labour storekeepers and maintenance workers.
Direct Expenses that are identifiable with each unit of production, such as
expenses patent royalties payable to the inventor of a new product or process.
Indirect Expenses that are not spent on individual units of production (eg rent
expenses and rates, electricity and telephone).
Activity 2: Direct and indirect costs

Jai starts a takeaway pizza business selling different types of pizzas (stone-baked
and ordinary pizzas). He rents premises, hires a special oven for the stone-baked
variety of pizza, employs an assistant to make the pizzas and a cleaner to clean the
premises. Give some examples of direct and indirect production costs associated
with the business:
33
TOTAL PRODUCTION COST = PRIME COST + PRODUCTION OVERHEADS
Labour costs
The basic distinction for classification of labour costs is that labour costs of
production workers are direct costs, and of other staff are indirect costs. However,
there are two specific scenarios where the costs of production workers should be
treated as indirect:
(1) Overtime premiums for general production (not a specific job)
(2) Idle time, where workers are being paid but no production is taking place
Activity 3: Direct or indirect?

Classify the following labour costs as either direct or indirect.
(a) The basic pay of direct workers (cash paid, tax and other deductions) is a
cost.
(b) The basic pay of indirect workers is a cost.

(c) Overtime premium, ie the premium above basic pay, for working overtime is a
cost.
(d) Bonus payments under a group bonus scheme is a cost.
(e) Social security (eg Employer's National Insurance) contributions is a

cost.
(f) Idle time of direct workers, paid while waiting for work is a cost.
Illustration of cost classification
Example
Direct materials Component parts
Direct Direct labour Workers altering product
Cost Direct other Tool hire for specific job
Indirect Production overhead Indirect materials Material used in negligible amounts

(incurred in factory from receipt Indirect labour Non-productive personnel
of order until completion) Indirect other Factory insurance
Administration overhead Indirect materials Administration stationery

(incurred in direction, control Indirect labour Accountants' salaries
and admin of an undertaking) Indirect other Office building depreciation
Selling overhead Indirect materials Price list printing/stationery

(incurred in promoting sales Indirect labour Salespeople salaries
and retaining customers) Indirect other Advertising
Distribution overhead Indirect materials Cost of packing cases

(incurred in making packed Indirect labour Despatch clerk wages
product, ready for despatch Indirect other Warehouse depreciation
and delivery)
2.4 Non-production costs

As you know, total production cost = prime cost + production overheads. All other
costs required to run the business are non-production costs.
34
2: Costing
Activity 4: Non-production costs

Give some examples of non-production costs:
TOTAL COSTS = PRODUCTION COSTS + NON-PRODUCTION COSTS
3 Historical cost v economic value of an asset

3.1 Historic cost
In practice most organisations record assets at historical cost.
Historical cost of an asset – the original cost to the organisation.

Key term
3.2 Economic value

However, assets can also be measured at their economic value.
Economic value of an asset – the most someone is willing to give up in order to

Key term obtain the asset.
How much a person is willing to pay for the asset tells us the economic value.
4 Environmental costing
4.1 Introduction
Increasingly, businesses need to be aware of the environmental costs associated
with business activities. In the past, environmental costs such as energy costs were
treated as production overheads and effectively hidden from management
scrutiny.
4.2 Classification of environmental costs
In order to manage environmental costs it can be useful to classify them into four
Key term categories.
● Environmental prevention costs – costs incurred to prevent the production of
waste that could cause damage to the environment.
● Environmental appraisal costs – costs incurred to assess whether a firm's
activities comply with environmental laws and standards.
● Environmental internal failure costs – costs incurred after waste has been
produced but not discharged into the environment.
35
● Environmental external failure costs – costs incurred after waste has been
produced and discharged into the environment. Some of these costs may be
paid by society as a whole.
Illustration 1: Case study

On 20 April 2010, multinational oil company BP's Deepwater Horizon rig
exploded off the coast of the US state of Louisiana, killing 11 workers. BP chairman
Carl-Henric Svanberg was invited to meet US President Barack Obama amid
concerns that the company did not have enough cash to pay for the clean-up
operation and compensation for those affected – and agreed to set up a claims fund
of $20 billion. The reputation of the global BP brand was seriously damaged.
This is clearly an example of an external failure cost.
Activity 5: Environmental costs

MBash Co produces catalytic converters that are purchased by a wide range of
motor manufacturers.
Required
Identify possible environmental costs that MBash may incur in each of the four
categories.
Solution
5 Relevant future income and costs for short-term

decision making
5.1 What costs are relevant?
When providing management information for decision making, you must work out
which costs and revenues are relevant to the decision.
36
2: Costing
In the context of short-term decision making, the relevant cost is contribution (the
difference between selling price and variable costs – see Chapter 5). The fixed costs
do not affect the decision made and are irrelevant costs.
Relevant cost (sometimes known as an avoidable cost) – a future, incremental

Key term cash flow arising as a direct consequence of a decision.
(a) Future costs. A decision is about the future and it cannot alter what has
already been done. Costs that have been incurred in the past are totally
irrelevant to any decision that is being made 'now'. Such costs are past
costs or sunk costs.
Costs that have been incurred include not only costs that have already been
paid, but also costs that have been committed.
Committed cost – a future cash flow that will be incurred anyway, regardless of
Key term the decision taken now.
(b) Cash flows. Only cash flow information is required. This means that costs or
charges that do not reflect additional cash spending (such as depreciation
and notional costs) should be ignored for the purpose of decision making.
(c) Incremental (sometimes called differential). By this we mean the
increase (only) in costs and revenues that occur as a result of the decision.
For example, if an employee is expected to have no other work to do during
the next week, but will be paid their basic wage (of, say, £100 per week) for
attending work and doing nothing, their manager might decide to give them a
job that earns the organisation £40. The net gain is £40 and the £100 is
irrelevant to the decision because although it is a future cash flow, it will be
incurred anyway whether or not the employee is given work. The £100 is not
an extra cost.
Opportunity cost – the benefit which would have been earned but which has
Key term been given up, by choosing one option instead of another.
37
5.2 Examples of non-relevant items
Here are some examples of non-relevant items that you may come across in the
assessment:
Examples Explanation
Non cash flow Eg depreciation, apportioned overheads

expenses
Sunk costs Eg market research
Historic cost of If materials are used by a project then they will either:
material (a) Need to be replaced, so the replacement cost is the cash
flow; or
(b) They won't, so the cost is zero (or lost revenue if they could
have been sold as scrap).
Cost of labour If labour used by a project is idle, then the cost of using that
labour is zero
Activity 6: Relevant costs

GA Co is considering whether to accept an order from a potential customer. The
trainee accountant's estimate of the profit from the project is shown below:
$
Revenue 27,000
Materials (Note 1) (18,000)
Labour (Note 2) (12,000)
Overheads (Note 3) (10,000)
Profit/(loss) (13,000)
Notes
1 The materials include $10,000 of surplus inventory that GA Co has in its
warehouse. It is not needed for any other production. This inventory has a
scrap value of $2,000.
2 Labour includes 10% of the $50,000 salary of the production manager. The
manager is an existing member of staff and has the time available to work on
this order in addition to their other duties.
3 This is an apportionment of general overheads.
Required
Using relevant cash flows assess whether GA Co should accept this order.
38
2: Costing
Solution
6 Performance measures: Responsibility accounting

and responsibility centres
Responsibility accounting – a system of accounting that segregates revenue
Key term and costs into areas of personal responsibility in order to monitor and assess the
performance of each part of an organisation.
Responsibility centre – a department or function whose performance is the
direct responsibility of a specific manager.
6.1 Responsibility accounting

Responsibility accounting attempts to associate costs, revenues, assets and liabilities
with the managers most capable of controlling them. As a system of accounting, it
therefore distinguishes between controllable and uncontrollable costs.
Controllable cost – a cost which can be influenced by management decisions

Key term and actions.
Uncontrollable cost – a cost which cannot be affected by management within a
given time span.
6.2 Responsibility centres

A responsibility centre will either be a cost centre, a profit centre, a revenue
centre or an investment centre.
39
Cost centre – managers generally only have responsibility for controlling costs (ie
Key term they make decisions about expenditure only).
Profit centre – any section of an organisation to which both revenues and costs
are assigned, so that the profitability of the section may be measured.
Revenue centre – any section of an organisation to which revenues are assigned,
before they are analysed further.
The manager of the profit centre has some influence over both
revenues and costs; that is, a say in both sales and production policies.
Investment centres – profit centres with additional responsibility for capital

Key term investment and possibly for financing.
Several profit centres might share the same capital items, for example the same
buildings, stores or transport fleet, and so investment centres are likely to include
several profit centres, and provide a basis for control at a very senior management
level.
The financial performance measures used will differ between the different types of
responsibility centre, and whether costs and/or revenues are controllable by a
particular centre manager. This will be explored further later in this Course Book.
40
2: Costing
Chapter summary
 If the users of accounting information want to know the cost of something, that
something is called a cost object.
 Cost centres are collecting places for costs before they are further analysed.
 Cost units are the basic control units for costing purposes.
 In practice most cost accounting transactions are recorded at historic cost, but
costs can be measured in terms of economic cost.
 Economic value is the amount someone is willing to pay.
 Before the cost accountant can plan, control or make decisions, all costs (whether
labour, material or overheads) must be accurately classified and their destination
in the costing system determined (cost units because they are direct costs or cost
centres because they are indirect costs).
 Classification can be by nature (subjective), by purpose (objective) or by
responsibility.
 A direct cost is a cost that can be traced in full to the product, service or
department that is being costed.
 Prime cost = direct material cost + direct labour cost + direct expenses.
 An indirect cost (or overhead) is a cost that is incurred in the course of making
a product, providing a service or running a department, but which cannot be traced
directly and in full to the product, service or department.
 Classification by function involves classifying costs as
production/manufacturing costs, administration costs or marketing/selling and
distribution costs.
 Environmental costs are important to businesses for a number of reasons.
1 Identifying environmental costs associated with individual products and
services can assist with pricing decisions.
2 Ensuring compliance with regulatory standards.
3 Potential for cost savings.
 Classification by responsibility requires costs to be divided into those that are
controllable and those that are uncontrollable. A system of responsibility
accounting is therefore required.
 Decision making requires classifying costs in a different way, according to whether
they are relevant to the decision being made. To be relevant, a cost has to be a
future, incremental cash flow.
 Performance measurement aims to establish how well something or somebody
is doing in relation to a planned activity.
41
Keywords
 Appraisal costs: Costs incurred to assess whether a firm's activities comply with
environmental laws and standards
 Avoidable cost: Another name for a relevant cost
 Committed costs: Future cash flows that will be incurred anyway, regardless of
the decision taken now
 Controllable costs: A cost which can be influenced by management decisions
and actions
 Cost centre: A function or location for which costs are ascertained (and related to
cost units for control purposes)
 Cost object: Anything for which cost data is desired, eg products, product lines,
jobs, customers or departments and divisions of a company
 Cost unit: A unit of product or service in relation to which costs may be
ascertained
 Direct costs: Costs which can be specifically identified with and allocated to a
particular cost object
 Economic value: The most someone is willing to give up in order to obtain an
asset
 External failure: Costs incurred after waste has been produced and discharged
into the environment
 Historical cost: The original cost of an asset to the organisation
 Indirect costs: Costs which are incurred in the course of making a
product/service but which cannot be identified with a particular cost object
 Internal failure: Costs incurred after waste has been produced but not
discharged into the environment
 Investment centre: Profit centres with additional responsibility for capital
investment and possibly for financing
 Opportunity cost: The benefit which would have been earned but which has
been given up, by choosing one option instead of another
 Overheads: Another name for indirect costs
 Prevention costs: Costs incurred to prevent the production of waste that could
cause damage to the environment
 Prime cost: The total direct costs of a cost object
 Production cost centre: A cost centre which is actively involved in the
production process
 Profit centre: Any section of an organisation to which both revenues and costs
are assigned, so that the profitability of the section may be measured
42
2: Costing
 Relevant costs: A future, incremental cash flow arising as a direct consequence

of a decision
 Responsibility accounting: A system of accounting that segregates revenue and
costs into areas of personal responsibility in order to monitor and assess the
performance of each part of an organisation
 Responsibility centre: A department or function whose performance is the direct
responsibility of a specific manager
 Revenue centre: Any section of an organisation to which revenues are assigned,
before they are analysed further
 Service cost centre: A cost centre which provides a service or back-up to the
production departments
 Uncontrollable costs: A cost which cannot be affected by management within a
given time span
43
Activity answers
Activity 1: Cost units

Business Appropriate cost unit
Car manufacturer A single car
Ball bearing manufacturer A box of ball bearings
Builder A job
Management consultant A project
Activity 2: Direct and indirect costs

Direct production costs
 Direct material – pizza dough and other ingredients
 Direct labour – wages paid to assistant making the pizzas
 Direct expenses – cost of hiring the pizza oven
Indirect production cost
 Indirect material – cleaning materials
 Indirect labour – cleaner's wages
 Indirect expenses – rent of premises
Activity 3: Direct or indirect?

(a) The basic pay of direct workers (cash paid, tax and other deductions) is a
direct cost.
(b) The basic pay of indirect workers is an indirect cost.
(c) Overtime premium, ie the premium above basic pay, for working overtime is
an indirect cost.
(d) Bonus payments under a group bonus scheme is an indirect cost.
(e) Social security (eg Employer's National Insurance) contributions is a direct
cost.
(f) Idle time of direct workers, paid while waiting for work is an indirect cost.
Activity 4: Non-production costs

 Advertising and marketing costs
 Administrative costs
 Selling and distribution costs
 Financing costs
44
2: Costing
Activity 5: Environmental costs

 Prevention – Costs incurred in designing the production process to reduce
pollution and training employees in operating the process correctly
 Appraisal – Inspection of the catalytic convertors and the production process
to ensure they comply with environmental legislation
 Internal failure – The cost of disposing of toxic materials and disposing of
scrap
 External failure – The cost of clearing up toxic materials that have been
discharged into rivers or into the atmosphere
Activity 6: Relevant costs

$ Comment
Revenue 27,000
Materials (10,000) The surplus inventory should be included at its scrap value.
Labour (7,000) The production manager's salary is not incremental.
Overheads – The overheads will be incurred whether or not the project is
accepted.
Profit/(loss) 10,000
The project generates a positive relevant cash flow of $10,000 (ie it will increase
GA Co's bank balance by this amount) and therefore it should be accepted.
45
Test your learning
1 (a) A ………………… is a unit of product or service to which costs can be related.
It is the basic control unit for costing purposes.
(b) A ………………… acts as a collecting place for certain costs before they are
analysed further.
(c) A ………………… is anything that users of accounting information want to
know the cost of.
2 Choose the correct words from those highlighted.
In practice, most cost accounting systems use historical cost/economic
cost/economic value/cost value as a measurement basis.
3 Classification of expenditure into material, labour and expenses is an example of:
A Classification by nature
B Classification by function
C Classification by responsibility
D Classification by behaviour
4 There are a number of different ways in which costs can be classified.
(a) ……………… and ……………… (or overhead) costs
(b) ……………… costs (production costs, distribution and selling costs,
administration costs and financing costs)
5 Which of the following would be classified as indirect labour?
A Assembly workers in a company manufacturing televisions
B A stores assistant in a factory store
C Plasterers in a construction company
D An audit clerk in a firm of auditors
6 What is the main aim of performance measurement?
A To obtain evidence in order to dismiss someone
B To establish how well something or somebody is doing in relation to a planned
activity
C To collect information on costs
D To award bonuses
7 A company has to pay a $1 per unit royalty to the designer of a product which it
manufactures and sells.
The royalty charge would be classified in the company's accounts as a (tick the
correct answer):
Direct expense
Production overhead
Administrative overhead
Selling overhead
46
Cost behaviour
Learning outcomes

• Explain the classification of costs in relation to activity level
• Distinguish between fixed, variable and semi-variable costs
• Explain stepped costs and the importance of timescales in their treatment as fixed or variable
• Calculate appropriate costs having identified cost behaviour
Chapter context
This chapter starts by covering an important way of classifying costs based on what happens when
we increase or decrease output. We can split costs between those that stay the same as output
increases (fixed costs) and those that change (variable costs). We then move on to look at how we
can calculate the fixed and variable elements of an organisation's total costs.
47
Chapter overview
Cost behaviour
Fixed Variable
$ Cost $ Cost
Volume of output Volume of output
Stepped Mixed
$ Cost
$ Cost
Volume of output
Volume of output
Line of best fit

High-low method
method
 Used to split fixed and  Provides more

variable elements accurate cost
 Find highest and lowest estimation than
activity levels high-low method
 Subtract low from high  Drawn by
 Use remainder to calculate VC estimation or
 Substitute VC back into high calculated by
or low total cost formula to linear regression
calculate FC technique
48
3: Cost behaviour
1 Cost behaviour and output

Cost behaviour – the way in which a cost changes as activity level (volume of
Key term output) changes.
A business needs to know how costs behave with output so that predictions of costs
can be made.
It is expected that costs will increase as the level of activity increases, but the exact
way costs behave with output may vary.
The level of activity refers to the amount of work done, or the number of events that
have occurred. Depending on circumstances, the level of activity may refer to
measures such as the following:
 The volume of production in a period
 The number of items sold
 The number of invoices issued
 The number of units of electricity consumed
For our purposes in this chapter, the level of activity will generally be taken to be the
volume of production/output.
1.1 Types of cost behaviour

(a) Fixed cost
Graph of fixed cost
$
Cost
Fixed cost
Volume of output (level of activity)
Fixed cost – a 'cost incurred for an accounting period, that, within certain output
Key term or turnover limits, tends to be unaffected by fluctuations in the levels of activity
(output or turnover)'. (CIMA Official Terminology, 2005)
49
(b) Stepped cost
Graph of stepped cost
Stepped cost – a cost which is fixed in nature but only within certain levels of
Key term activity. Depending on the time frame being considered, it may appear as fixed or
variable.
(c) Variable cost

Graph of variable cost
$
Cost
Volume of output
Variable cost – a cost which tends to vary directly with the volume of output. The
Key term variable cost per unit is the same amount for each unit produced whereas total
variable cost increases as volume of output increases.
(d) Mixed cost (semi-variable)

Graph of semi-variable cost
$
Cost
Variable part
Fixed part
Volume of output
50
3: Cost behaviour
A semi-variable, semi-fixed or mixed cost – a cost which is part-fixed and

Key term part-variable and is therefore partly affected by a change in the level of activity. It is
a cost that has both fixed and variable components.
Activity 1: Cost behaviour examples

Required
Give two examples of each of the different types of cost for a typical manufacturing
business.
Type of cost Examples
Fixed
Stepped
Variable
Semi-variable
1.2 Non-linear variable costs

Although variable costs are usually assumed to be linear, there are situations where
variable costs are curvilinear. Have a look at the following graphs.
Volume of output Volume of output
Graph (a) becomes steeper as levels of activity increase. Each additional unit of
activity is adding more to total variable cost than the previous unit (for example, raw
materials may become scarce and therefore more expensive at higher levels of
output). Graph (b) becomes less steep as levels of activity increase. Each additional
unit is adding less to total variable cost than the previous unit (an example of this
may be bulk buying discounts reducing the cost of materials).
The relevant range refers to the activity levels which an organisation has had
Key term experience of operating at in the past and for which cost information is available.
51
Within the relevant range, costs are often assumed to be either fixed, variable or
semi-variable. This 'linear assumption' is key to many of the costing techniques
you will see in this paper.
Linear assumption – states that total fixed costs remain constant, and variable
Key term costs are a constant amount per unit.
1.3 The importance of timescale

Whether a cost is classified as fixed or variable will depend on the timescale being
considered. The longer the timescale, the greater the proportion of costs that can be
considered as variable. For example, rent is fixed in the short run, but can be
considered a stepped cost in the medium term, and even a variable cost in the long
run.
2 Determining the fixed and variable elements of

semi-variable costs
Total
cost ($)
Variable cost (VC)
Fixed cost (FC)

Output
Total cost = Fixed cost + (VC/unit  Output)
2.1 Estimation methods

How can we estimate fixed and variable costs if we only know total cost?
 High-low method
 Line of best fit method
 Linear regression (method of least squares)
Each method only gives an estimate, and can therefore give differing results from
the other methods.
3 High-low method
High-low method – involves extrapolating (extending) a line drawn between the
Key term highest and lowest data items (activity levels).
This is a four-step method:

(1) Find highest and lowest activity levels
(2) Subtract low from high
52
3: Cost behaviour
(3) Use remainder to calculate VC (increase in costs/increase in activity)

(4) Substitute VC back into high or low total cost formula to calculate FC
Illustration 1: High-low method

The costs of operating the maintenance department of a computer manufacturer,
Bread and Butter company, for the last four months have been as follows:
Production
Month Cost volume
$ Units
1 110,000 7,000
2 115,000 8,000
3 111,000 7,700
4 97,000 6,000
Required
(a) Calculate the costs that should be expected in month 5 when output is
expected to be 7,500 units. Ignore inflation.
(b) What is the equation for estimating the total cost for a given level of output?
Solution
(a) Units $
High output 8,000 total cost 115,000
Low output 6,000 total cost 97,000
Variable cost of 2,000 18,000
Variable cost per unit $18,000/2,000 = $9
Substituting in either the high or low volume cost:

High Low
$ $
Total cost 115,000 97,000
Variable costs (8,000 × $9) 72,000 (6,000 × $9) 54,000
Fixed costs 43,000 43,000
Estimated maintenance costs when output is 7,500 units:

$
Fixed costs 43,000
Variable costs (7,500 × $9) 67,500
Total costs 110,500
(b) The equation is:

y = $43,000 + 9x
where x is the number of units and
y is the total cost.
53
Activity 2: High-low method
The total costs of a business for differing levels of output are as follows:
Month Output Total costs
Units $'000
January 500 70
February 200 30
March 800 90
April 1,000 110
Required
(a) What are the fixed and variable elements of the total cost using the high-low
method?
A Y = $30,000 + $100x B Y = $10,000 + $110x
C Y = $30,000 + $110x D Y = $10,000 + $100x
(b) What is the total cost if output is 400 units?
Solution
4 Line of best fit (Scattergraph) method

Scattergraph method: An alternative way of estimating cost behaviour, by
Key term plotting observed data on a graph and using judgement to estimate a line of best fit
through all the points on this graph
A scattergraph with total cost on the vertical axis and output on the horizontal
axis is prepared.
54
3: Cost behaviour
A line of best fit, which is a line of judgement, is drawn to pass through the
middle of the points.
A scattergraph of the cost and output in Activity 2 is shown below.
Total costs
x
($'000) 100
x
80
x
60
40
x
20
Output (Units)
200 400 600 800 1,000 1,200
The point where the line cuts the vertical axis (approximately $10,000) is the fixed
cost.
If we take the value of one of the plotted points which lies close to the line and
deduct the fixed cost from the total cost, we can calculate variable cost per unit.
Example: Total cost for 1,000 units = $110,000
Variable cost for 1,000 units = $110,000 – $10,000 = $100,000
Variable cost per unit = $100,000/1,000 = $100 per unit
Note. As BA2 is examined by CBA you will not be required to draw a
scattergraph; however, you could be required to answer objective test questions
about how the technique works.
5 Regression analysis method

Linear regression analysis (the least squares method) – finds the line of
Key term best fit using mathematical formulae and calculates the best estimates for a and b in
the linear equation below.
Using all of the pairs of data available this method minimises the deviations
between the line of best fit and each data point. This is also known as the 'method
of least squares'.
The method can be used to find the relationship between any pairs of data, not just
output and cost.
55
The basic linear relationship is defined mathematically as:
y = a + bx
eg Total cost = fixed cost + (variable cost per unit × output)
where
y is the dependent variable (eg costs)
x is the independent variable (eg output)
a is the intercept on the vertical axis (eg fixed costs)
b is the slope (gradient) of the line (eg variable cost per unit)
Formula to learn
Formulae used are:
n xy   x  y
b =
n x 2   x 2
a = y  bx
n = number of pairs of data in the sample

∑
y is the average (mean) of the y values =
∑
x is the average (mean) of the x values =
Illustration 2: Least squares method

Suppose we have the following pairs of data about output and costs.
Production
Month Cost volume
$'000 '000 units
1 82 20
2 70 16
3 90 24
4 85 22
5 73 18
Required
Calculate an equation to determine the expected level of costs, for
any given volume of output, using the least squares method.
Solution
Y = 28 + 2.6X
56
3: Cost behaviour
Workings
X Y XY X 2
Y 2
20 82 1,640 400 6,724
16 70 1,120 256 4,900
24 90 2,160 576 8,100
22 85 1,870 484 7,225
18 73 1,314 324 5,329
X = 100 Y = 400 XY = 8,104 X = 2,040

2
Y = 32,278
2
n = 5 (There are five pairs of data for x and y values)

n  XY   X  Y (5  8,104)  (100  400)
b = =
n  X   X 
2 2
(5  2, 040)  1002
40, 520  40, 000 520

= = = 2.6
10, 200  10, 000 200
a = Y – b X = 400 – 2.6   100  = 28

5  5 
 
Y = 28 + 2.6X
Where Y = total cost, in thousands
X = output, in thousands of units
Activity 3: Regression analysis

X y xy x 2
y 2
Units $'000
280 46.5
350 49.1
200 36.7
160 32.0
240 44.5
Required
(a) Calculate the regression line.
(b) Use the line to estimate costs for output of 240 units and 700 units.
57
Solution
58
3: Cost behaviour
Chapter summary
 Cost behaviour is the way in which a cost changes as activity level changes.
 Costs which are not affected by the level of activity are fixed costs.
 Total variable costs increase or decrease with the level of activity.
 A stepped cost is a cost which is fixed in nature but only within certain levels of
activity. Depending on the time frame being considered, it may appear as fixed or
variable.
 Semi-variable, semi-fixed or mixed costs are costs which are part-fixed and
part-variable and are therefore partly affected by a change in the level of activity.
 The fixed and variable elements of semi-variable costs can be determined by the high-
low method, the 'line of best fit' (scattergraph) method, or linear
regression.
59
Keywords
 Cost behaviour: The way in which a cost changes as activity level (volume of
output) changes
 Fixed costs: A cost incurred for an accounting period that, within certain output or
turnover limits, tends to be unaffected by fluctuations in the levels of activity
 High-low method: A way of estimating the fixed and variable parts of a mixed
cost, by comparing the total costs associated with two different levels of output
 Linear assumption: Costs can be assumed to behave in a linear way (ie be
fixed, variable or semi-variable)
 Linear regression: Finding the line of best fit by minimising the squares of the
vertical differences from each item of data to this line
 Relevant range: Broadly represents the activity levels at which an organisation
has had experience of operating at in the past and for which cost information is
available
 Scattergraph method: An alternative way of estimating cost behaviour, by
plotting observed data on a graph and using judgement to estimate a line of best fit
through all the points on this graph
 Semi-variable costs: Costs which are part-fixed and part-variable and are
therefore partly affected by a change in the level of activity
 Stepped costs: A cost which is fixed in nature but only within certain levels of
activity
 Variable costs: A cost which tends to vary directly with the volume of output
60
3: Cost behaviour
Activity answers
Activity 1: Cost behaviour examples

Type of cost Examples
Fixed Rent (in the short term), straight line depreciation, insurance, salary
of MD
Stepped Rent (longer term where additional premises required), labour costs
of salaried employees
Variable Raw materials, direct labour, sales commissions
Semi-variable Utility bills (standing charge plus charge for consumption)

Sales staff salary (if paid a salary plus commission per item sold)
Activity 2: High-low method

(a) D y = $10,000 + $100x
Costs
Units $
Highest (April) 1,000 110,000
Lowest (February) 200 30,000
800 80,000
 Variable cost per unit = $80,000  $100

800
Fixed cost element:
Take highest output (1,000 units)
$
Total cost 110,000
Less variable cost (1,000  100) 100,000
 Fixed cost element 10,000
Note. Alternatively, fixed cost element can be found by taking the lowest
output (200 units).
$
Total cost 30,000
Less variable cost (200  100) 20,000
 Fixed cost element 10,000
Answer: TOTAL COSTS, Y = $10,000 + $100  (answer D)

Answers A, B and C – confuse both fixed costs (as costs at lowest output) and
unit cost (as costs at highest output divided by volume).
61
(b) If x = 400
Using TC = FC + VC
TC = 10,000 + (100 × 400) = 50,000
Activity 3: Regression analysis

(a)
2 2
x y xy x Y
Units $'000
280 46.5 13,020 78,400 2,162.25
350 49.1 17,185 122,500 2,410.81
200 36.7 7,340 40,000 1,346.89
160 32.0 5,120 25,600 1,024.00
240 44.5 10,680 57,600 1,980.25
1,230 208.8 53,345 324,100 8,924.20
(5  53, 345)  (1, 230  208.8)

b 
(5  324,100)  (1, 230)2
9, 901
  0.092
107, 600
208.8 1, 230
a  0.092 
5 5
 19.128
so y = 19.128 + 0.092x (y in $'000, x in units)
y = $19,128 + $92x
(b) Interpolation, when output is 240 units
Cost predicted = $19,128 + $92  240 = $41,208
Extrapolation, when output is 700 units
Cost predicted = $19,128 + $92  700 = $83,528
62
3: Cost behaviour
Test your learning

1 The basic principle of cost behaviour is that as the level of activity rises, costs will
usually fall.
True
False
2 Fill in the gaps for each of the graph titles below.
(a)
$ Graph of a ……………….. cost
Cost
Example:
Activity
(b) Graph of a ……………….. cost

$
Cost
Example:
Activity
(c)
$
Graph of a ……………….. cost
Cost
Example:
Activity
(d)
Graph of a ……………….. cost
$
Cost
Example:
Activity
3 Costs are assumed to be either fixed, variable or semi-variable within the normal or
relevant range of output.
True
False
63
4 The costs of operating the canteen at 'Eat a lot Company' for the past three months
are as follows:
Month Cost Employees
$
1 72,500 1,250
2 75,000 1,300
3 68,750 1,175
Variable cost (per employee per month) =
Fixed cost per month =
5 Pen Co produced the following units at the following costs during October,
November and December.
Month Number Total cost
of units $
October 4,700 252,800
November 5,500 264,000
December 9,500 320,000
The costs could be subdivided into variable costs of $14 per unit and fixed costs of
$........................................ per month.
6 The management accountant at G Co is analysing some costs which have been
entered into the computer as 'miscellaneous staff expenses'.
No of staff Cost per member
of staff
20 $5
100 $5
150 $5
250 $5
What type of cost is the miscellaneous staff expense?
A Fixed
B Variable
C Semi-variable
D Non-linear
64
3: Cost behaviour
$ Sales revenue
Total cost
Variable cost
Units
In the above graph, what does the arrow represent?
A Fixed cost
B Contribution
C Profit
D Breakeven quantity in units
8 A cost which is unaffected in total by increases and decreases in the volume of
output is called:
A Stepped-fixed
B Variable
C Constant
D Fixed
9 Which one of the following is an example of a mixed cost?
A Factory rent
B Salaries
C Telephone bill
D Straight line depreciation
10 A particular cost is classified as being semi-variable.
What is the effect on the cost per unit if activity increases by 10%?
A Decrease by 10%
B Decrease by less than 10%
C Increase by less than 10%
D Remain constant
65
66
Absorption costing
Learning outcomes

• Prepare cost statements for allocation and apportionment of overheads, including reciprocal
service departments
• Calculate the full cost of products, services and activities using overhead absorption rates to
trace indirect costs to cost units
Chapter context
In this chapter we start to look at one of the key questions that management accountants have to
answer: 'How much does it cost to produce each item of our product?' Absorption costing is one
method used to answer this question, and we will look at another approach in the following chapter.
Absorption costing takes all of the production costs (both fixed and variable) and attributes them to
individual units of production. By definition overheads are going to be the most difficult costs to deal
with because they can't objectively be traced to an individual cost unit.
67
Chapter overview
Proforma
Absorption costing statement of
profit or loss
 Aim? Find cost of making one unit AC focus = split between

 Why? Pricing production and non-
Inventory valuation production costs
Profitability analysis Will contain an
adjustment to cost of
sales for any under- or
over-absorbed fixed
Steps
production overheads
(1) Allocate direct (4) Absorb overheads

costs to units into cost units
(2) Allocate and (3) Reapportion

apportion overheads service cost centre
to cost centres overheads
From service to production

 Allocate = whole cost cost centres
items charged to cost
centre
Overhead
• Apportion = cost items absorption rates
divided between cost
centres
Budgeted overhead
OAR =
Budgeted activity
Service Production
cost cost
centres centres
Prime cost Production

AC cost card
overhead
68
4: Absorption costing
1 Overview
Businesses need to put a cost on goods/services they produce (ie cost units) for
many reasons.
AIM To find the cost of making one unit
Pricing
WHY? Inventory valuation
Profitability analysis
Absorption costing (this chapter)

HOW? or
Marginal costing (Chapter 5)
1.1 Absorption costing
Absorption costing – a product costing/inventory valuation method which

Key term includes all production costs in the valuation and is required by IAS 2
Inventories for external reporting purposes.
A cost card shows us the cost to make one unit.

$/unit
Direct materials X
Direct labour X
Prime cost X
Production overheads X
Product cost X
1.2 Prime cost (direct cost)

The direct costs of a cost unit are usually straightforward to ascertain since by
definition they are identified with a cost unit.
Direct materials: x kg of material at $y per kg
Direct labour: a hrs of labour at $b per hour
This is Step (1) in the method for absorption costing below.
1.3 Production overheads

Since these are not identified with specific cost units, some method must be used to
charge a share of the total production overhead to each cost unit.
Steps (2) to (4) in the method below represent the traditional absorption costing
method by which we achieve this.
69
2 Absorption costing steps
2.1 Method
Total Production Costs
Direct Costs Indirect Costs

(overheads) 2. Allocate &
Apportion
COST CENTRES
1. Allocate Production 1 Production 2 Service
Production 1 Production 2 3. Reapportion
4. Absorb
COST UNITS
To get the full absorbed production cost there are four steps:
(1) Allocate direct costs to cost units
(2) Allocate and apportion production overheads to cost centres
(3) Reapportion overheads in service cost centres to production cost
centres
(4) Absorb overheads into cost units
3 Allocation and apportionment of production

overheads to cost centres – Step (2) of the method
The first stage in valuing the overhead cost of a cost unit is to allocate and
apportion overheads between cost centres.
3.1 Cost centres

A cost centre is a location, function or item of equipment in respect of which costs
may be ascertained and related to cost units for control purposes.
Each cost centre acts as a 'collecting place' for certain costs before they are
analysed further.
70
Notes
1 Cost centres may be set up in any way the business thinks appropriate.
2 Usually, only manufacturing costs are considered and hence we will focus on
factory cost centres.
3.2 Service and production cost centres
Production cost centres – factory cost centres through which cost units actually
Key term flow.
Service cost centres – support/service the production cost centres.
Activity 1: Production or service

Split the following between two types of cost centres.
assembly, canteen, maintenance, packing, stores, finishing
Solution
(a) Production cost centres (b) Service cost centres
71
3.3 Terminology
Allocation – when whole cost items are charged to a cost centre.

Key term
Apportionment – when cost items are divided between several cost centres.
Illustration 1: Overhead allocation

Consider the following costs of a company:
$
Wages of the supervisor of department A 200
Wages of the supervisor of department B 150
Indirect materials consumed in department A 50
Rent of the premises shared by departments A and B 300
The cost accounting system might include three cost centres.

Cost centre: 101 Department A
102 Department B
201 Rent
Overhead costs would be allocated directly to each cost centre, ie $200 + $50 to
cost centre 101, $150 to cost centre 102 and $300 to cost centre 201. The rent of
the factory will be subsequently shared between the two production departments
but, for the purpose of day to day cost recording in this particular system, the rent
will first of all be charged in full to a separate cost centre.
Apportioning general overheads

Overhead apportionment follows on from overhead allocation. The first stage of
overhead apportionment is to identify all overhead costs as production department,
production service department, administration, or selling and distribution overhead.
This means that the costs for heat and light, rent and rates, the canteen and so on
(that is, costs which have been allocated to general overhead cost centres) must be
shared out between the other cost centres.
Bases of apportionment
Overhead costs should be shared out on a fair basis. You will appreciate that
because of the complexity of items of cost it is rarely possible to use only one
method of apportioning costs to the various departments of an organisation. The
bases of apportionment for the most usual cases are given below.
72
Overhead to which the basis applies Basis
Rent, rates, heating and light, repairs and Floor area occupied by each cost
depreciation of buildings centre
Depreciation, insurance of equipment Cost or book value of equipment
Personnel office, canteen, welfare, wages Number of employees, or labour

and cost offices, first aid hours worked in each cost centre
Heating, lighting (see above) Volume of space occupied by each

cost centre
Illustration 2: Overhead apportionment

Continuing the previous Illustration, rent for the period was $300. The following
data has been identified about departments A and B:
Department A B
Number of staff 50 30
2 2
Floor space occupied 1,000 m 250 m
The most appropriate basis for apportioning rent is floor space. Therefore after
apportioning on this basis, Department A will be allocated (1,000/1,250  $300)
= $240 of the rent cost, and Department B will be allocated the remaining $60
(250/1,250  $300).
Activity 2: Overhead allocation and apportionment

Step 2 of method
Mars Co has the following overheads in the year ended 31 December 20X5:
Overhead: $
Rent and rates 90,000
Insurance of machinery and equipment 40,000
Stores costs (wages and salaries) 75,000
Heating costs 57,000
262,000
Required
Allocate and apportion overhead costs to mixing dept, stirring dept, stores and
canteen using the following information:
Mixing Stirring Stores Canteen Total
Floor space (square ft) 9,000 3,000 1,000 2,000 15,000
NBV of machinery and 2,000 1,000 600 400 4,000
equipment
73
Solution
4 Reapportionment of service cost centre overheads

– Step 3 of the method
Reapportionment – the process of transferring all service cost centre overheads
Key term to the production cost centres.
4.1 Why is reapportionment necessary?

All service cost centre overheads must be transferred to the production centres so
that all production overheads for the period are shared between the production cost
centres alone – as it is through these cost centres that cost units flow.
4.2 Reciprocal servicing

The reapportionment becomes a little more complicated where:
 There is more than one service cost centre; and
 The service centres do work for one another (reciprocal servicing).
74
4.3 Method
To reapportion service cost centre overheads to production cost centres and to
recognise all inter-service department work, an approach known as the repeated
distribution method can be used. This method involves starting with the service
cost centre with the largest allocated overheads, apportioning those between all the
other cost centres (including the other service cost centres); repeating this process
with the other service cost centre (again, spreading its overheads across all other
cost centres) and repeating until the numbers are very small, at which point the
distribution is rounded. No overheads may be left in any service cost centre.
Illustration 3: Repeated distribution method

A company has two production and two service departments (stores and
maintenance). The following information about activity in the recent costing period
is available.
Production departments Stores Maintenance

A B department department
Overhead costs $10,030 $8,970 $10,000 $8,000
Cost of material
requisitions $30,000 $50,000 – $20,000
Maintenance
hours needed 8,000 1,000 1,000 –
Recognition is made of the fact that the stores and maintenance department do work
for each other. Service department costs are apportioned as follows.
Dept A Dept B Stores Maintenance

Stores (100%) 30% 50% – 20%
Maintenance (100%) 80% 10% 10% –
The reapportionment of service department costs in this situation can be done using
the repeated distribution method of apportionment.
75
Production Production
dept A dept B Stores Maintenance
$ $ $ $
Overhead costs 10,030 8,970 10,000 8,000
First stores
apportionment
(see Note 1) 3,000 5,000 (10,000) 2,000
0 10,000
First maintenance 8,000 1,000 1,000 (10,000)

apportionment
1,000 0
Second stores 300 500 (1,000) 200

apportionment
Second maintenance 160 20 20 (200)

apportionment
Third stores 6 10 (20) 4

apportionment
Third maintenance 4 – – (4)

apportionment
(see Note 2) 21,500 15,500 0 0
Notes
1 The first apportionment is done from the service department with the higher
costs (in this case, stores).
2 When the repeated distributions bring service department costs down to small
numbers (here $4) the final apportionment to production departments is an
approximate rounding.
4.4 Algebraic method

An alternative to repeated distribution is to use the algebraic method, which uses
simultaneous equations to solve the problem. This will be illustrated in the example
below.
76
Activity 3: Service cost reapportionment (repeated

distribution)
Step 3 of the method
Production depts Service centres
Mixing Stirring Stores Canteen
$ $ $ $
Allocated and apportioned
overheads
From Activity 2 108,200 39,400 90,800 23,600
Estimated work done by the

service centres for other
departments
Stores 50% 30% – 20%
Canteen 45% 40% 15% –
Required
Using the repeated distribution method, after the apportionment of the service
departments to the production departments, what will the total overhead costs for the
production departments be?
Mixing Stirring
Overheads $ $
Solution
77
Illustration 4: Algebraic method
Using the figures in Activity 3, and the algebraic method, the total
overhead costs for the production departments would be found as follows:
Mixing Stirring
Overheads $ $
Whenever you are using equations you must define each variable.
Let C = total overheads for the canteen
S = total overheads for the stores department
Remember that total overheads for the canteen consist of general overheads
apportioned, allocated overheads and the share of stores overheads (20%).
Similarly, total overheads for stores will be the total of general overheads
apportioned, allocated overheads and the 15% share of canteen overheads.
C = 0.2S + $23,600 (1)
S = 0.15C + $90,800 (2)
We now solve the equations.
5C = S + $118,000 (3), which can be rearranged as
S = 5C – $118,000 (4)
Subtract (2) from (4):
0 = 4.85C – $208,800
Rearrange to find C:
C = $208,800/4.85 = $43,052
Substitute to find S:
S = (0.15  $43,052) + $90,800 = $97,258
These overheads can now be apportioned to the production departments using the
proportions above.
Production depts. Service centres
$ $ $ $
Allocated and apportioned
overheads
From Activity 2 108,200 39,400 90,800 23,600
Apportion stores (50:30:20) 48,629 29,177 (97,258) 19,452
Apportion canteen (45:40:15) 19,373 17,221 6,458 (43,052)
Apportioned overheads 176,202 85,798 0 0
You will notice that the total overheads for the mixing and stirring production
departments are the same regardless of the method used (any difference is due to
rounding).
78
Activity 4: Reapportionment practice

ABC Co has a production department in Block H of the building and another in
Block F. There are also two service departments, namely the canteen and the
maintenance department. Fixed overheads are incurred as follows:
Department Overheads
$'000
H Block 400
F Block 700
Canteen 550
Maintenance 800
The canteen provides food for H Block (40%), F Block (40%) and the maintenance
department (20%). Maintenance does work for H Block and F Block in the ratio 2:3.
What would be the total fixed overhead of H Block if all service department
overheads are allocated to production departments?
A $546,000
B $364,000
C $984,000
D $1,466,000
Solution
5 Absorption of overheads into production (cost

units) – Step (4) of the method
5.1 Bases
All of the production overhead costs have now been apportioned to the production
cost centres. We now need to charge these to the cost units passing through the
production cost centres. This is termed absorption. We are going to absorb an
element of total production overhead into each cost unit.
OAR (overhead absorption rate) = Production overhead

Key term Activity level
79
5.2 Choosing bases for the activity level
Ideally, the basis chosen should be the one which most accurately reflects the way
in which the overheads are in fact being incurred, and realistically reflects the
characteristics of a given cost centre.
For example:
Basis
(a) Per unit (appropriate if all units of production are identical or very similar)
(b) Per labour hour (appropriate for labour-intensive cost centres)
(c) Per machine hour (where production is controlled or dictated by machines)
(d) % of direct labour cost (where labour of differing grades is being utilised in
production)
(e) % of direct materials cost (if materials are a significant proportion of total
costs)
(f) % of prime cost
5.3 Blanket absorption rates and departmental absorption

rates
The use of separate departmental absorption rates instead of blanket (or
single factory) absorption rates will produce more realistic product costs.
Blanket or single factory overhead absorption rate – an absorption rate

Key term used throughout a factory and for all jobs and units of output irrespective of
the department in which they were produced.
Such a rate is not appropriate, however, if there are a number of departments and
units of output do not spend an equal amount of time in each department.
It is argued that if a single factory overhead absorption rate is used, some products
will receive a higher overhead charge than they ought 'fairly' to bear, whereas
other products will be under-charged. By using a separate absorption rate for each
department, charging of overheads will be equitable and the full cost of production
of items will be more representative of the cost of the efforts and resources put into
making them.
Activity 5: Calculating absorption rates

Mars Co has now reapportioned the service centre costs to its two production
departments resulting in total overheads of $176,203 and $85,797 for the mixing
and stirring departments respectively (as calculated in Activity 3).
The mixing department is labour-intensive and the stirring department is machine-
intensive.
80
During the year the following data has been collected on the work done to produce
the company's range of products.
Mixing Stirring
Direct labour hours 20,000 5,000
Direct machine hours 2,000 60,000
Number of units 10,000 10,000
Required
(a) The overhead absorption rate for the mixing department was
$ per
(b) The overhead absorption rate for the stirring department was
$ per
Solution
(a)
(b)
Cost units
(c) Mars Co has one particular product, the 'Venus', for which you obtain the
following information.
Direct materials per unit $15
Direct labour hours
– Mixing 2 hours
– Stirring 0.5 hours
Direct machine hours
– Mixing 0.2 hours
– Stirring 6 hours
Labour is paid $10 per hour.
Required
What is the total cost of this product?
A $40
B $58.30
C $66.20
D $77.33
81
Solution
(c) $
Direct materials per unit
Direct labour per unit (total labour hours  £10 per hour)
Mixing overhead (mixing labour hours  OAR per hour)
Stirring overhead (stirring machine hours  OAR per hour)
Total production cost
6 Predetermined overhead absorption rates

Businesses need to cost their production throughout the year, not at the end of an
accounting period. Therefore, they predetermine or estimate their absorption rates
for the year.
Formula to learn
Budgeted overhead
Predetermined OAR =
Budgeted activity level
Note. Activity level refers to production activity not sales.
6.1 Budget (or normal) activity level

IAS 2 (paragraph 13) states that the activity level used for absorption of overheads
should always be the budgeted (normal) activity, ie the expected long-term average.
This is to stop fluctuations in OARs due to fluctuations in activity.
6.2 Absorption into production

Businesses will record overheads regularly during the year.
Formula to learn
Overhead Absorbed = Actual Activity × Predetermined OAR
At the end of the year actual overheads will be known.
Formula to learn
Under-/(over)-absorption = Actual Overhead less Overhead Absorbed
Under-absorption – if overheads absorbed are less than actual overheads.

Key term
Over-absorption – if overheads absorbed are greater than actual overheads.
82
Overheads absorbed may differ from actual overhead costs incurred for either or
both of the following two reasons:
(a) Actual expenditure was more or less than budget.
(b) Actual units produced (ie volume) were more or less than budget.
Assessment focus point

You can always work out whether overheads are under- or over-absorbed by using
the following rule.
 If Actual overhead incurred – Absorbed overhead = NEGATIVE (N), then
overheads are over-absorbed (O) (NO).
 If Actual overhead incurred – Absorbed overhead = POSITIVE (P), then
overheads are under-absorbed (U) (PU).
So, remember the NOPU rule when you go into your assessment and you won't
have any trouble in deciding whether overheads are under- or over-absorbed!
Activity 6: Predetermined overhead absorption rates

Gurney Halleck Co had the following budgeted and actual figures for units of
production and overheads.
Budget Actual
Units of production 20,000 24,000
Overheads $100,000 $117,000
Required
Complete the following calculations.
=
Predetermined absorption rate
Overhead absorbed for period =
Under-/over-absorption =
83
7 Proforma absorption costing statement
7.1 Statement of profit or loss
$ $
Sales X
Less: Cost of sales
Opening inventory (@ full cost) X
Production costs:
Variable costs – materials X
– labour X
– variable overheads X
Fixed overhead absorbed X
X
Less: Closing inventory (@ full cost) (X)
Production cost of sales X
Adjustment for over-/under-
absorbed overhead X
Total cost of sales (X)

Gross profit X
Less sales and distribution costs (X)
Net profit X
Notes
1 Inventory is valued at full production cost.
2 The method of costing by which 'actual production costs' include a figure
based on a predetermined estimate is called normal costing.
84
Activity 7: Absorption costing practice

Selling price $25.
Cost card per unit:
$
Direct materials 7
Direct wages 8
Variable production overheads 5
Fixed production overheads 0.90
20.90
There is a variable selling cost per unit of $0.50.
Year 1 Year 2
Units Units
Normal/Budgeted production 12,000 12,000
Actual production 14,000 11,500
Actual sales 13,000 12,500
Actual fixed production overheads $11,000 $11,000
Actual fixed selling costs $5,000 $5,000
There is no opening inventory. All variable costs were as budgeted, for the two
years.
Required
(a) The total budgeted fixed production overhead was
(b) The overheads absorbed in Year 1 were
(c) The net profit in Year 1 was

(Use the statement of profit and loss account below.)
(d) The overheads in Year 2 were absorbed by
(e) The net profit in Year 2 was
85
Solution
(c) Year 1 (e) Year 2
$ $ $ $
Sales
Less: Cost of sales

Opening inventory
Production costs:
Variable costs
– materials
– wages
– variable overheads
Fixed overheads absorbed
Less closing inventory
Adj. for (over-)/under-absorption
Gross profit
Less: Selling costs
Variable selling cost
Fixed selling cost

Net profit
86
8 Advantages and disadvantages of absorption

costing
Advantages Disadvantages
Inventory valuation complies with IAS 2. Unit cost includes costs which are not
relevant for marginal decision making.
Fixed costs must be covered in the long The nature of cost behaviour is
run. obscured.
Production cannot be divorced from fixed The method of absorption is to some

costs since without them production could extent arbitrary.
not occur.
Profit can be manipulated by increasing

production even if sales do not change.
8.1 Problems of using absorption costing in today's

environment
Overhead absorption rates might be 200% or 300% of unit labour costs. Unit costs
are distorted and so cost information is misleading.
Overheads are not controlled because they are hidden within unit production
costs rather than being shown as individual totals.
Products bear an arbitrary share of overheads which do not reflect the benefits
they receive.
Absorption costing assumes all products consume all resources in
proportion to their production volumes.
(a) It tends to allocate too great a proportion of overheads to high
volume products (which cause relatively little diversity and hence use fewer
support services).
(b) It tends to allocate too small a proportion of overheads to low volume
products (which cause greater diversity and therefore use more support
services).
Activity based costing (ABC) attempts to overcome these problems.
8.2 Activity based costing (ABC)

ABC is an alternative approach to absorption costing. It involves identification of the
factors which cause the costs of an organisation's major activities. These factors are
called 'cost drivers'.
87
Activity based costing (ABC) – an 'approach to the costing and monitoring of
Key term activities which involves tracing resource consumption and costing final outputs.
Resources are assigned to activities, and activities to cost objects based on
consumption estimates. The latter utilise cost drivers to attach activity costs to
outputs'. (CIMA Official Terminology, 2005)
Detailed knowledge of ABC is not in your syllabus; however, the major ideas
behind ABC are as follows.
Major ideas behind ABC
Activities cause costs. Activities include ordering and despatching.
The costs of an The cost of the ordering activity might be driven by the number of
activity are caused or orders placed; the cost of the despatching activity, by the number
driven by factors of despatches made.
known as cost
drivers.
Costs associated with If product A requires 5 orders to be placed, and product B 15

each activity are orders, ¼ (ie 5/(5 + 15)) of the ordering cost will be assigned to
collected into cost product A and ¾ (ie 15/(5 + 15)) to product B.
pools. The costs of
an activity are
assigned to products
on the basis of the
number of the
activity's cost driver
products generated.
88
Chapter summary
 The first step in absorption costing is allocation. Allocation is the process by which
whole cost items are charged direct to a cost unit or cost centre.
 The second step in absorption costing is overhead apportionment. This involves
apportioning general overheads to cost centres and then reapportioning the costs of
service cost centres to production departments.
 There are several methods of reapportioning service department overheads to
production departments.
1 Repeated distribution method (recognises inter-service department work)
2 Algebraic method (same result as repeated distribution, but solved using
simultaneous equations)
 In absorption costing, it is usual to add overheads into product costs by applying a
predetermined overhead absorption rate. The predetermined rate is set
annually, in the budget.
 The absorption rate is calculated by dividing the budgeted overhead by the
budgeted level of activity. For production overheads, the level of activity is often
budgeted direct labour hours or budgeted machine hours.
 Management should try to establish an absorption rate that provides a
reasonably 'accurate' estimate of overhead costs for jobs, products or
services.
 The use of separate departmental absorption rates instead of blanket (or
single factory) absorption rates will produce more realistic product costs.
 The rate of overhead absorption is based on estimates (of both numerator and
denominator) and it is quite likely that either one or both of the estimates will not
agree with what actually occurs. Actual overheads incurred will probably be either
greater than or less than overheads absorbed into the cost of production.
1 Over-absorption means that the overheads charged to the cost of production
are greater than the overheads actually incurred.
2 Under-absorption means that insufficient overheads have been included in the
cost of production.
 Activity based costing (ABC) is an alternative approach to absorption costing.
It involves the identification of the factors (cost drivers) which cause the costs of
an organisation's major activities.
89
Keywords
 Activity Based Costing (ABC): An alternative approach to absorption costing. It
involves the identification of the factors (cost drivers) which cause the costs of an
organisation's major activities
 Absorption costing: A product costing/inventory valuation method which
includes all production costs in the valuation
 Allocation: Whole cost items are charged to a cost centre
 Apportionment: Cost items are divided between several cost centres
 Blanket absorption rate: An absorption rate used throughout a factory and for
all jobs and units of output irrespective of the department in which they were
produced
 Over-absorption: Overheads absorbed are more than actual overheads
 Overhead absorption rate: A means of attributing overhead to a product or
service, based for example on direct labour hours, direct labour cost or machine
hours
 Production cost centre: Factory cost centres through which cost units actually
flow
 Reapportionment: The process of transferring all service cost centre overheads to
the production cost centres
 Service cost centre: Support/service the production cost centres
 Under-absorption: Overheads absorbed are less than actual overheads
90
Activity answers
Activity 1: Production or service

(a) Packing, assembly, finishing
(b) Maintenance, canteen, stores
Activity 2: Overhead allocation and apportionment

Mixing Stirring Stores Canteen Total
Stores cost – – 75,000 – 75,000
Rent & rates

(9:3:1:2) 54,000 18,000 6,000 12,000 90,000
Insurance
(2:1:0.6:0.4) 20,000 10,000 6,000 4,000 40,000
Heating
(9:3:1:2) 34,200 11,400 3,800 7,600 57,000
108,200 39,400 90,800 23,600 262,000
91
Activity 3: Service cost reapportionment (repeated
distribution)
Production depts Service centres
Overheads 108,200 39,400 90,800 23,600
Reapportion
Stores (50:30:20) 45,400 27,240 (90,800) 18,160
– 41,760
Reapportion
Canteen (45:40:15) 18,792 16,704 6,264 (41,760)
6,264 –
Reapportion
Stores (50:30:20) 3,132 1,879 (6,264) 1,253
– 1,253
Reapportion
Canteen (45:40:15) 564 501 188 (1,253)
188 –
Reapportion
Stores (50:30:20) 94 56 (188) 38
– 38
Reapportion
Canteen (45:40:15) 17 15 6 (38)
6 –
Reapportion
Stores (50:30:20) 3 2 (6) 1
– 1
Reapportion
Canteen (45:40:15) 1 – – (1)
176,203 85,797 – –
Activity 4: Reapportionment practice

C H Block F Block Canteen Maintenance
$'000 $'000 $'000 $'000
Overheads 400 700 550 800
Canteen (2:2:1) 220 220 (550) 110
620 920 – 910
Maintenance (2:3) 364 546 (910)
984 1,466 – –
92
Activity 5: Calculating absorption rates

(a) Mixing OAR = 176,203
20,000
= $8.81 per labour hour
(b) Stirring OAR = 85,797

60,000
= $1.43 per machine hour
(c) C $66.20
Cost card for a Venus
$/unit
Direct material 15
Direct labour
Mixing (2 hrs @ $10/hr) 20
Stirring (0.5 hrs @ $10/hr) 5
Prime cost 40
Overheads
Mixing (2 hrs @ $8.81) 17.62
Stirring (6 hrs @ $1.43) 8.58
Product cost 66.20
Activity 6: Predetermined overhead absorption

rates
Predetermined overhead absorption rate = $100,000 = $5/unit
20,000 units
Overheads absorbed = 24,000 (actual units produced)  $5/unit = $120,000

Under-/over-absorption = 117,000 – 120,000 = $3,000 over-absorbed
Activity 7: Absorption costing practice

(a) OAR = $0.90
Budgeted fixed production overheads
OAR =
Normal activity
Budgeted fixed production overheads

 $0.90 =
12,000
Budgeted fixed production overhead = 12,000  $0.90 = $10,800
(b) 14,000 units × $0.90 = $12,600

(c) $43,400 (see below)
(d) Under $650 ($11,000 – (11,500 units × $0.90))
93
(e) $39,350 (see below)
Workings
Year 1 Year 1 Year 2 Year 2
$ $ $ $
Sales 325,000
(13,000  25)
(12,500  25) 312,500
Less: COS:
Opening inventory – 20,900
(1,000  $20.90)
Production costs
– materials
(14,000  $7) 98,000
(11,500  $7) 80,500
– wages
(14,000  $8) 112,000
(11,500  $8) 92,000
– variable overheads
(14,000  $5) 70,000
(11,500  $5) 57,500
– fixed overheads
(absorbed)
(14,000  $0.90) 12,600
(11,500  $0.90) 10,350
292,600 261,250
(1,000  $20.90) (W2) (20,900) –
271,700 261,250
– under/(over)
absorption (W1) (1,600) (270,100) 650 (261,900)
Gross profit 54,900 50,600
Less selling costs
– variable
(13,000  $0.50) (6,500)
(12,500  $0.50) (6,250)
– fixed (5,000) (5,000)
43,400 39,350
(W1) Under-/over-absorption
Year 1:
under-/(over) absorption = Actual expenditure – overhead absorbed
under/(over-) absorption = 11,000 – 12,600 = $1,600 over-absorbed
Year 2:
under-/(over-) absorption = 11,000 – 10,350 = $650 under-absorbed
94
(W2) You may have made some mistakes with opening and closing inventory. The
question states that there was no opening inventory in Year 1. Then 14,000 units
were produced during Year 1 and only 13,000 units were sold. This means that
there were 1,000 units left unsold at the end of Year 1 and this is the closing
inventory for Year 1. The closing inventory for Year 1 becomes the opening
inventory for Year 2.
Year 1 Year 2
Units Units
+ Opening inventory 0 1,000
+ Production 14,000 11,500
– Sales 13,000 12,500
= Closing inventory 1,000 0
95
Test your learning
1 Allocation involves spreading overhead costs across cost centres.
True
False
2 Match the following overheads with the most appropriate basis of apportionment.
Overhead Basis of apportionment

(a) Depreciation of equipment (1) Direct machine hours
(b) Heat and light costs (2) Number of employees
(c) Canteen (3) Book value of equipment
(d) Insurance of equipment (4) Floor area
3 Which of the following departments are directly involved in production?
Department Involved in production ()
Finished goods warehouse
Canteen
Machining department
Offices
Assembly department
4 In relation to calculating total absorption cost, label the following descriptions in the
correct order as Steps 1–5.
Description Step
A Apportion fixed costs over departments
B Establish the overhead absorption rate
C Choose fair methods of apportionment
D Apply the overhead absorption rate to products
E Reapportion service departments costs
5 In order to recognise the work service departments do for each other, the
………………….. or …………………….. methods of reapportioning service
department overheads should be used.
6 A direct labour hour basis is most appropriate in which of the following
environments?
A Machine-intensive
B Labour-intensive
C When all units produced are identical
D None of the above
96
7 Over-absorption occurs when absorbed overheads are greater than actual

overheads.
True
False
Traditional costing systems tend to allocate too great/too small a proportion of
overheads to high volume products and too great/too small a proportion of
overheads to low volume products.
9 The following statements concern methods of absorbing fixed production overheads
into units of production. Are they true or false?
True False
It is generally accepted that a time-based method
should be used wherever possible (for example
labour rate hours or machine rate hours).
Direct materials price percentage is not usually
considered to be a suitable method because
there is no reason why a higher material cost
should lead to a cost unit incurring more
production overhead cost.
10 H Co bases its overhead absorption rate on labour hours. The following information
is available for 20X9.
Budgeted overheads $600,000
Actual overheads $660,000
Budgeted labour hours 120,000
Actual labour hours 110,000
Calculate the over- or under-absorption of overheads for 20X9.
A $60,000 over-absorbed
B $60,000 under-absorbed
C $110,000 over-absorbed
D $110,000 under-absorbed
97
98
Marginal costing and
pricing decisions
Learning outcomes

• Calculate the marginal cost of products, services and activities
• Reconcile the differences between profits calculated using absorption costing and those
calculated using marginal costing
• Apply cost information in pricing decisions
Chapter context
This first part of the chapter covers marginal costing which is a more straightforward alternative to
absorption costing. The aim is the same, to find the cost of one unit of production, but marginal
costing doesn't try to include any fixed costs within the unit cost; instead these are simply treated as a
cost in the period in which they are incurred (a period cost).
Whether we use marginal or absorption costing, one of the benefits of knowing the cost of our
products is that it can help in setting selling prices. The remainder of the chapter therefore looks at
how prices can be set based on cost.
99
Chapter overview
Proforma statement
Marginal costing = variable costs
of profit or loss
MC focus = split between

variable and fixed costs
MC Cost card Contribution Absorption v marginal

costing
Direct materials X …towards fixed

Direct labour X costs and profit
Direct expenses X Contribution = SP
-- less all variable
Marginal cost per unit X costs
Reconciliation of absorption Pricing decisions

and marginal costing profit
 If inventory moves then AC  Full cost plus v marginal

and MC will report different cost plus
profits • Cost mark-up v sales
• Caused by different valuations margin
of inventory (AC includes
absorbed fixed production
overheads)
100
5: Marginal costing and pricing decisions
1 Definition: marginal costing

Marginal costing – the variable cost of a product or a service. It is the cost which
Key term would be avoided if the unit was not produced or provided.
Marginal costing is an alternative method of costing to absorption costing. In

marginal costing, only variable costs are charged as a cost of sale and a
contribution is calculated. Closing inventories of work in progress or finished
goods are valued at marginal (variable) production cost. Fixed costs are treated as
a period cost, and are charged in full against profit in the accounting period in
which they are incurred.
2 Cost card
Look at the difference between the marginal cost card and the absorption cost card.
$/unit
Direct materials X
Direct labour X Used to value
Variable overhead X inventory under
Marginal cost X marginal costing
$/unit
Direct materials X
Direct labour X
Variable overhead X Used to value
Fixed overhead X inventory under
Absorption cost X absorption
costing
3 Contribution
Contribution – selling price less all variable costs.
Key term
$ $
Selling price X
Less: Variable production costs X
Variable non-production costs X
(X)
Contribution X
Any fixed costs are deducted in total from contribution to give net profit.
The term 'contribution' is really short for 'contribution towards covering fixed
overheads and making a profit'.
101
Illustration 1: Marginal costing
Water Co makes a product, the Splash, which has a variable production cost of $6
per unit and a sales price of $10 per unit. At the beginning of September 20X0
there were no opening inventories. Production during the month was 20,000 units.
Fixed costs for the month were $45,000 (production, administration, sales and
distribution). There were no variable marketing costs.
Required
Calculate, at each of the following sales levels, the total contribution and total profit
for September 20X0 and the contribution per unit and the profit/loss per unit, using
marginal costing principles.
(a) 10,000 Splashes
(b) 15,000 Splashes
(c) 20,000 Splashes
Solution
The first stage in the profit calculation must be to identify the variable costs, and
then the contribution. Fixed costs are deducted from the total contribution to derive
the profit. All closing inventories are valued at marginal production cost ($6 per
unit).
10,000 Splashes 15,000 Splashes 20,000 Splashes
$ $ $ $ $ $
Sales (at $10) 100,000 150,000 200,000
Opening 0 0 0
inventory
Variable 120,000 120,000 120,000
production cost
120,000 120,000 120,000
Less value of
closing
inventory (at –
marginal cost) 60,000 30,000
Variable cost of 90,000 120,000
sales 60,000
Contribution 40,000 60,000 80,000
Less fixed costs 45,000 45,000 45,000
Profit/(loss) (5,000) 15,000 35,000
Profit/(loss) per $(0.50) $1 $1.75
unit
Contribution per $4 $4 $4
unit
102
4 Proforma marginal costing statement of profit or

loss
$ $
Sales X
Less: Cost of sales
Opening inventory (@ marginal cost) X
Production costs:
Variable cost – Materials X
– Labour X
– Variable overheads X
X
Less closing inventory (@ marginal cost) (X)
(X)
Less variable selling, distribution and (X)
administration costs
Contribution X
Less fixed costs (production, selling, (X)
administration)
Profit X
Note. Inventory is valued at marginal production cost only.
Activity 1: Marginal costing statement of profit or loss

(Used for absorption costing earlier)
Selling price $25.
Cost card per unit:
$
Direct materials 7
Direct wages 8
Variable production overheads 5
20
There is a variable selling cost/unit at $0.50.
Year 1 Year 2
Units Units
Normal/budgeted production 12,000 12,000
Actual production 14,000 11,500
Actual sales 13,000 12,500
Actual fixed production overheads $11,000 $11,000
Actual fixed selling costs $5,000 $5,000
There is no opening inventory. All variable costs were as budgeted for the two
years.
Required
Complete the statement of profit or loss below using marginal costing principles.
103
Solution
Year 1 Year 2
$ $ $ $
Sales
Less: Cost of sales

Opening inventory
Production costs (all variable):
Less variable non-production costs
Contribution
Less: Fixed costs

Fixed production costs
Fixed selling costs
Net profit
5 Reconciliation of absorption and marginal costing

profits
Here are the profits we calculated for the activity above and the absorption costing
activity in the earlier chapter.
Year 1 Year 2 Total
$ $ $
Profit under absorption costing 43,400 39,350 82,750
Profit under marginal costing 42,500 40,250 82,750
Differences 900 (900) –
(a) The difference arises from different inventory valuations (absorption costing
inventory valued at $20.90 per unit and marginal costing inventory valued at
$20 per unit).
104
(b) If inventory levels increase, absorption costing will report a higher profit than
marginal costing.
Opening inventory at the start of Year 1 was 0 units. At the end of Year 1, it
was 1,000 units. Inventory therefore increased during the year. Absorption
costing therefore shows a higher profit for Year 1 than marginal costing.
(c) If inventory levels decrease, absorption costing will report the lower profit.
Opening inventory at the start of Year 2 was 1,000 units. At the end of Year
2, it was 0 units. Inventory therefore decreased during the year. Absorption
costing therefore shows a lower profit for Year 2 than marginal costing.
(d) The difference in reported profit is equal to the change in inventory volume
multiplied by the fixed production overhead rate per unit.
Year 1 difference: 1,000 units × $0.90 = $900
Year 2 difference: (1,000) units × $0.90 = ($900)
(e) In the long run, the total reported profit will be the same whether marginal or
absorption costing is used.
Activity 2: Absorption v marginal costing

Suppose that a company makes and sells a single product. At the beginning of
period 1, there are no opening inventories of the product, for which the variable
production cost is $4 and the sales price is $6 per unit. Fixed costs are $2,000 per
period, of which $1,500 are fixed production costs.
Period 1 Period 2
Sales 1,200 units 1,800 units
Production 1,500 units 1,500 units
(a) Assuming normal output is 1,500 units per period, the absorption costing
profit in each period and in total would be:
(i) Period 1 $
(ii) Period 2 $
(iii) Total $
(b) The marginal costing profit in each period and in total would be:
(i) Period 1 $
(ii) Period 2 $
(iii) Total $
105
An assessment question may, for example, give you a marginal costing profit figure
and ask you to use inventory figures and the overhead absorption rate to calculate
the absorption costing profit. Remember, if inventory levels increase, absorption
costing will report a higher profit than marginal costing. If inventory levels decrease,
absorption costing will report the lower profit.
Activity 3: Marginal to absorption profit

The following information is available for H Co.
20X9
Opening inventory 900 units
Closing inventory 300 units
Marginal costing profit $100,000
Using an overhead absorption rate of $20 per unit, calculate what the profit would
be if absorption costing were used.
6 Advantages and disadvantages of marginal

costing
Advantages Disadvantages
 Appropriate for decision making (any  Does not comply with IAS 2 (revised).
activity that generates a positive
contribution should be viewed
favourably, at least in the short run).
 Fixed costs are treated in accordance  Costs must be analysed into fixed and
with their nature. variable parts.
 Profit depends on sales, not production  Fixed costs cannot be ignored in the
activity levels. long run.
7 Pricing decisions
There are two considerations when deciding on a selling price for a product or
service:
(a) Should the price be based on the full cost or just the marginal cost?
(b) Should the price be determined by a 'mark-up' on cost or a 'margin' on the
selling price?
106
7.1 Full cost or marginal cost?

7.1.1 Full cost plus pricing
In full cost plus pricing, the full cost may be a fully absorbed production cost only, or
it may include some absorbed non-production costs like administration or selling
and distribution.
An amount will be added to this full cost base to represent the profit per unit a
company wants to receive.
Advantages of full cost plus Disadvantages of full cost plus
 Should ensure that fixed costs are  Does not take into account market and
covered (if working at normal capacity) demand conditions (ie lower prices
offered by rival firms)
7.1.2 Marginal cost plus pricing

In marginal cost plus pricing, an amount for profit is added to the marginal cost
only.
Advantages of marginal cost plus Disadvantages of marginal cost

plus
 Simple and easy method to use  Pricing decisions cannot ignore fixed
costs altogether – they must be covered
in the long run to generate sustainable
profits
 Draws management attention to  Still does not fully take into account
contribution, and creates a better market and demand conditions
awareness of concepts such as
breakeven analysis
7.2 Mark-up on cost or margin on sales?

The amount to be included in the selling price to represent profit per unit can be
determined in one of two ways. It is very important to understand the mathematical
difference between them. A good way to ensure you take the correct approach is to
think in terms of percentages.
7.2.1 Mark-up on cost
Mark-up – a percentage of cost, added to the cost to reach the selling price of a
Key term product or service. It is also known as a return on costs.
This method is traditionally used by retail companies, which will buy in products
from wholesalers and then add on a 'retail mark-up', say 40%, to the wholesale
price to determine a selling price in their store.
107
The mathematical approach for this is as follows:
1 Consider the cost base to represent 100%
2 Add to this the profit mark-up of 40% of the cost
3 Calculate the selling price – ie 140% of the cost base
So, if the cost of a product is $100, a selling price of $140 will represent a mark-up
of 40%.
7.2.2 Margin on sales
Margin – profit expressed as a percentage of the selling price of a product. It is

Key term also known as a return on sales.
With this approach, the profit element is calculated with reference to the selling
price, not the cost. Note the critical difference in the mathematical approach to
calculate a selling price with a sales margin of 40%:
1 Consider the selling price to represent 100%
2 Realise that this will consist of the cost base (60%) and the profit margin (40%)
3 Calculate the profit margin given the percentages in (2)
4 Add this to the cost base to determine the selling price
So, if the cost of a product is $100, and this represents 60% of the selling price, the
sales margin will be ($100/60  40) = $66.67. The selling price will therefore be
$166.67.
Activity 4: Margins and mark-ups (1)

A company uses marginal cost plus pricing for its two products, Y and Z. The
marginal cost of product Y is $30/unit, and product Z is $48/unit.
Required
Calculate the selling price for each in the following circumstances:
(i) To earn a return on costs (mark-up) of 25%
(ii) To earn a return on sales (margin) of 40%
Solution
108

A selling price is determined by including a profit margin of 20% on sales.
Required
Calculate the percentage mark-up on costs needed to generate the same amount of
profit.
Solution
109
Chapter summary
 Whereas fully absorbed product costs include fixed overhead, the marginal cost
of a product usually consists of variable costs only.
 Contribution is an important measure in marginal costing, and it is calculated as
the difference between sales value and marginal or variable cost.
 Marginal costing is an alternative method of costing to absorption costing. In
marginal costing, only variable costs are charged as a cost of sale and a
contribution is calculated. Closing inventories of work in progress or finished goods
are valued at marginal (variable) production cost. Fixed costs are treated as a
period cost, and are charged in full against profit in the accounting period in which
they are incurred.
 If there are changes in inventories during a period, marginal costing and absorption
costing systems will report different profit figures.
1 If inventory levels increase, absorption costing will report a higher profit than
marginal costing.
2 If inventory levels decrease, absorption costing will report the lower profit.
3 If the opening and closing inventory volumes and values are the same, marginal
costing and absorption costing will report the same profit figure.
4 In the long run, the total reported profit will be the same whether marginal or
absorption costing is used.
5 The difference in reported profit is equal to the change in inventory volume
multiplied by the fixed production overhead rate per unit.
 A price determined using full cost plus pricing is based on full cost plus a
percentage mark-up for profit.
 Marginal cost plus prices are based on the marginal cost of production or the
marginal cost of sales, plus a profit margin.
110
Keywords
 Contribution: The difference between sales value and marginal or variable cost
 Margin: Profit expressed as a percentage of the selling price of a product
 Marginal cost: The variable cost of a product or a service
 Mark-up: A percentage of cost, added to the cost to reach the selling price of a
product or service
111
Activity answers
Activity 1: Marginal costing statement of profit or

loss
Statement of profit or loss
Year 1 Year 1 Year 2 Year 2
$ $ $ $
Sales 325,000
(13,000  25)
(12,500  25) 312,500
Less: COS
Opening inventory
(1,000  $20) – 20,000
Production costs
– variable
(14,000  $20) 280,000
(11,500  $20) 230,000
280,000 250,000
(1,000  $20) (20,000) –
(260,000) (250,000)
65,000 62,500
Less variable selling costs (6,500) (6,250)
(13,000  $0.50)
(12,500  $0.50)
Contribution 58,500 56,250
Less: Fixed costs

– Production 11,000 11,000
– Selling 5,000 5,000
(16,000) (16,000)
Net profit 42,500 40,250
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Activity 2: Absorption v marginal costing

(a) (i) Period 1 $ 700
(ii) Period 2 $ 1,300
(iii) Total $ 2,000

Workings
The absorption rate for fixed production overhead is:
$1,500 = $1 per unit
1,500 units
Period 1 Period 2 Total
$ $ $ $ $ $
Sales 7,200 10,800 18,000
Production costs
Variable 6,000 6,000 12,000
Fixed 1,500 1,500 3,000
7,500 7,500 15,000
Add opening inventory
b/f – 1,500
7,500 9,000 15,000
c/f (1,500) – –
Production cost of sales 6,000 9,000 15,000
(Under-)/over-
absorbed
overhead – – –
Total production costs 6,000 9,000 15,000
Gross profit 1,200 1,800 3,000
Other fixed costs 500 500 1,000
Net profit 700 1,300 2,000
(b) (i) Period 1 $ 400
(ii) Period 2 $ 1,600
(iii) Total $ 2,000
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Workings
Period 1 Period 2 Total
$ $ $ $ $ $
Sales 7,200 10,800 18,000
Variable
production cost 6,000 6,000 12,000
Add opening
inventory b/f – 1,200 –
6,000 7,200 12,000
Less closing
inventory c/f (1,200) – –
Variable
production cost
of sales 4,800 7,200 12,000
Contribution 2,400 3,600 6,000
Fixed costs 2,000 2,000 4,000
Profit 400 1,600 2,000
Alternative method
In period 1, inventory increased from 0 units to 300 units. This means that
absorption profit will report a higher profit than marginal costing profit. The
difference is 300 units × OAR of $1 = $300.
Profit under absorption costing = $700.
So profit under marginal costing = $700 – $300 = $400.
In period 2, inventory decreased from 300 units to 0 units. This means that
absorption profit will report a lower profit than marginal costing profit. The
difference is 300 units × OAR of $1 = $300.
Profit under absorption costing = $1,300.
So profit under marginal costing = $1,300 + $300 = $1,600.
Activity 3: Marginal to absorption profit

Units
Opening inventory 900
Closing inventory 300
Decrease 600  $20 = $12,000 lower
Marginal profit $100,000
$12,000
Absorption profit $88,000
114

(i) X Y (ii) X Y
Cost 100% $30 $48 Cost 60% $30 $48
Profit 25% $7.50 $12 Profit 40% $20 $32
Price 125% $37.50 $60 Price 100% $50 $80

The cost structure under the sales margin of 20% is:
Cost 80%
Profit 20%
Price 100%
To translate this to a cost mark-up, need to relate profit to cost, ie 20/80 = 25%.
115
Test your learning
1 Sales value – marginal cost of sales = …………………………………………………
2 Identify which of the following relate to either:
A = Absorption costing
M = Marginal costing
A or M
(a) Closing inventories valued at marginal production cost
(b) Closing inventories valued at full production cost
(c) Cost of sales include some fixed overhead incurred in
previous period in opening inventory values
(d) Fixed costs are charged in full against profit for the period
3 Which of the following are arguments in favour of marginal costing?

(a) It is simple to operate.
(b) There is no under- or over-absorption of overheads.
(c) Fixed costs are the same regardless of activity levels.
(d) The information from this costing method may be used for decision making.
4 ABC Co plans to sell 1,200 units of product B. A 12% return is required on the
$1,000,000 annual investment in product B. A selling price of $500 per unit has
been set.
The full cost of product B is $ .
5 XYZ Co produces a component W. The standard cost card for component W is as
follows:
$
Production costs Fixed 255.70
Variable 483.50
Selling costs Fixed 124.80
Variable 75.60
Profit 60.40
Selling price 1,000.00
(a) Under an absorption costing system, what would be the value per unit of
inventory?
 $255.70  $739.20  $483.20  $227.80
(b) Under a variable costing system, what would be the value per unit of
inventory?
 $483.50  $75.60  $136.00  $124.80
116
6 When comparing the profits reported under absorption costing and marginal
costing during a period when the level of inventory increased:
A Absorption costing profits will be higher and closing inventory valuations lower
than those under marginal costing
B Absorption costing profits will be higher and closing inventory valuations
higher than those under marginal costing
C Marginal costing profits will be higher and closing inventory valuations lower
than those under absorption costing
D Marginal costing profits will be higher and closing inventory valuations higher
than those under absorption costing
7 What is a period cost in marginal costing?
8 Marginal costing and absorption costing are different techniques for assessing profit
in a period. If there are changes in inventory during a period, marginal costing and
absorption costing will report different profits.
Which of the following statements are true?
I If inventory levels increase, marginal costing will report the higher profit.
II If inventory levels decrease, marginal costing will report the lower profit.
III If inventory levels decrease, marginal costing will report the higher profit.
IV If the opening and closing inventory volumes are the same, marginal costing
and absorption costing will report the same profit figure.
A All of the above
B I, II and IV
C I and IV
D III and IV
9 A product has the following costs:
$/unit
Variable production costs 4.80
Total production costs 7.50
Total variable costs 5.90
Total costs 10.00
11,400 units of the product were manufactured in a period during which 11,200
units were sold.
What is the profit difference using absorption costing rather than marginal costing?
A The profit for the period is $540 lower.
B The profit for the period is $540 higher.
C The profit for the period is $820 lower.
D The profit for the period is $820 higher.
117
10 A company currently uses absorption costing. The following information relates to
Product X for Month 1:
Opening inventory Nil
Production 900 units
Sales 800 units
If the company had used marginal costing, which of the following combinations
would be true?
Profit Inventory valuation
A would be higher would be higher
B would be higher would be lower
C would be lower would be higher
D would be lower would be lower
118
Breakeven analysis
Learning outcomes

• Apply breakeven analysis
• Calculate the breakeven point, target profit, margin of safety and profit/volume ratio for a
single product or service
• Interpret breakeven charts and profit/volume graphs for a single product or service
Chapter context
This chapter helps answer some important questions that any business will have:
 How much to we need to sell to break even?
 How much do we need to sell to earn a certain level of profit?
119
Chapter overview
Breakeven analysis
 Breakeven point = sales

volume where profit is $0
Breakeven analysis Breakeven analysis

calculations graphs
Breakeven chart Profit volume charts

TR $
$ Profit
TC Contribution Profit
FC Contribution
VC Volume
BEP Budget
FC MoS
Volume
BEP Budget
MoS
Breakeven Required profit

point (BEB) calculations
Fixed costs Sales volume to reach required profit

BEP =
Contribution per unit Fixed cost + required profit
(volume of units) Contribution/unit
 May need high/low
method Margin of safety
C/S ratio (1) In units = budgeted sales volume –

breakeven sales volume (SV)
Fixed cost (2) As a % =
Breakeven revenue =
C/S ratio Budgeted SV – breakeven SV
×100
Contribution Budgeted SV
C/S ratio =
Verkauf
Limitations
 Split costs into VC + FC
 FC, VC/unit SP/unit = constant
 Production = sales
 Only for single product or single product mixes
120
6: Breakeven analysis
1 Breakeven point
1.1 Definition
The breakeven point for a company is the sales volume which will give the
Key term company a profit of $nil.
If sales exceed the breakeven point (BEP) the company will make a profit.
Breakeven analysis (calculations to determine the breakeven point) is often

Key term referred to as cost-volume-profit (CVP) analysis. It analyses the relationships
between activity levels, costs and profits.
1.2 Assumption
We will assume that selling price per unit and variable cost per unit and total fixed
costs are all constant, that is, they do not change with varying output. This is a
reasonable assumption for short-term decisions, although of course in the long term
or for very high levels of output, this might not apply.
1.3 Contribution
Remember that contribution per unit = selling price less all variable costs per unit.
We will need this definition to set up the breakeven formula.
$
Sales 15,000
Less VCs (5,000)
Contribution 10,000 Must be
Fixed costs (10,000) equal
Profit 0
2 Breakeven level of activity (units)

2.1 Breakeven point formula
So we will break even when…
Total contribution = Fixed costs
ie Contribution per unit  number of units = Fixed costs
Formula to learn
Breakeven level of activity (units) = Fixed costs

Cont'n /unit
When calculating the BEP, always round the number of units up to the next whole
unit.
121
Illustration 1: Breakeven point
Reardon Enterprises sells a single product with a selling price of $10 per unit. The
variable costs of producing the product are $6 per unit and the fixed costs of the
business are $200,000.
What is the breakeven point in units?
$200, 000
Breakeven point   50, 000 units
$10  6
We can prove that this is the point where no profit or loss is made.
$
Sales (50,000 × $10) 500,000
Variable costs (50,000 × $6) 300,000
Contribution 200,000
Fixed costs (200,000)
Profit –
Therefore the management of Reardon Enterprises will know that they must ensure
that sales volumes exceed 50,000 units per year in order for the business to cover
its total costs and make any profit.
Activity 1: Breakeven units

A business has a single product that it sells for $28. The variable costs of producing
the product are $19 per unit and the fixed costs of the business are $360,000.
Required
What is the breakeven point in units?
Activity 2: Breakeven point and breakeven revenue

A company has different output levels, and incurs different total production costs at
each level, as follows.
Output Total costs
Units $
6,000 44,700
8,000 57,700
Required
(a) If the selling price is $8/unit at all levels, what is the breakeven point?
(b) What is the breakeven revenue?
122
Solution
3 The C/S ratio (contribution/sales revenue)

An alternative method of finding the breakeven revenue is to use the C/S ratio.
The C/S ratio, calculated as contribution divided by sales, gives the amount of
Key term contribution earned per dollar of sales.
It is also known as the profit-volume (P/V) ratio.
4 Breakeven revenue
Formula to learn
Fixed costs
Breakeven revenue ($) =
C/ S ratio
Activity 3: C/S ratio

Using details from the breakeven revenue Activity 2 above, find the C/S ratio and
breakeven revenue.
C/S ratio =
Breakeven revenue = $
Solution
123
5 Margin of safety
As well as being interested in the BEP, management may be interested in the
amount by which actual sales can fall below anticipated sales without a loss being
made.
Margin of safety – the measure of the amount by which sales must fall before we
Key term start making a loss.
A loss is made if sales volume is less than the BEP.
Formula to learn
Margin of safety (in units) = Budgeted sales volume – breakeven sales volume
or
Budgeted sales volume – breakeven sales volume
Margin of safety (as %) = × 100
Budgeted sales volume
Activity 4: Margin of safety

Details are the same as the previous activity and with budgeted sales of 5,000
units.
Required
Margin of safety = units
Margin of safety = %
Solution
6 Breakeven and profit-volume charts

6.1 Breakeven charts
A breakeven chart shows the profit or loss at different levels of sales.
It shows, in diagrammatic form, the relationship between sales volume or value,
total revenue, and total costs. Breakeven occurs when total costs are equal to total
revenue.
The horizontal axis is used for sales volume or value and the vertical axis for money
(costs and revenue).
124
Three lines are plotted on the graph:

 Firstly the sales revenue line (which will pass through the origin, since when
sales volume is nil, revenue is nil)
 Then the fixed costs line (which will be parallel to the horizontal axis)
 And finally the total costs line
Illustration 2: Breakeven chart

The following information relates to Reardon Enterprises.
Selling price per unit $10
Variable cost per unit $6
Contribution per unit $4
Fixed costs $200,000
Breakeven point 50,000 units or $500,000
Budgeted sales 70,000 units
Breakeven chart
Cost/ 1,000
revenue Sales revenue
($'000)
900
Total cost
800
700
Variable
cost
600
500
400
300
200
Margin of
100 safety
Output (units)
25,000 50,000 70,000 100,000

Breakeven Budgeted
point sales
This chart shows variable costs, fixed costs, total costs and sales revenue at various
different activity levels.
6.2 How to interpret the breakeven chart

 The fixed cost line is a horizontal line at $200,000.
 Variable costs start at the origin – if there are no sales then there are no variable
costs. You can see, for example, variable costs at 100,000 units are $600,000.
125
 The total cost line is parallel to the variable cost line but starts at $200,000,
the level of the fixed costs.
 Sales revenue again starts at the origin. You can see that the revenue is
$1,000,000 if sales are 100,000 units.
6.3 What does the breakeven chart show?

 The BEP is the point where the sales revenue line crosses the total costs line.
 The margin of safety is the horizontal distance between budgeted sales of
70,000 units and breakeven sales of 50,000 units.
 The amount of profit or loss at each activity level is the vertical distance
between the sales revenue line and the total cost line.
6.4 Profit-volume (P/V) chart
Illustration 3: Profit-volume chart
Profit 200
$'000
150
100 Breakeven
point
50
0
25,000 50,000 75,000 100,000
50 Output
100
150
Loss 200
The P/V chart simply shows the level of profit or loss at any given level of activity.
6.5 How to interpret a P/V chart

 The loss when there are zero sales is equal to the fixed costs, $200,000.
 The profit at the 100,000 units activity level is $200,000.
126
6.6 What does the P/V chart show?

 The profit or loss at any level of activity can be read off the chart.
 The BEP is where the profit line crosses the horizontal axis – where profit is
zero.
 The horizontal axis could alternatively have shown sales revenue rather than
activity level.
Activity 5: Breakeven chart

Match the following labels to (a), (b), (c) and (d) marked on the breakeven chart
below.
Fixed costs Margin of Budgeted Budgeted variable
safety profit costs
s
le
b
Sa
sts c
al co
Tot
Fixed costs
d
a
Units
Budgeted sales
Activity 6: Profit-volume chart

G Co manufactures and sells a single product. The profit statement for May is as
follows.
$
Sales value (at $8 per unit) 80,000
Variable cost of sales (at $4.80 per unit) 48,000
Contribution 32,000
Fixed costs 15,000
Profit 17,000
127
The management accountant has used the data for May to draw the following
profit-volume graph.
$'000
A
D
$'000
C 80 Sales revenue
(a) The monetary values indicated on the graph as A, B and C are:

A $
B $
C $
(b) The term used to describe the distance D on the graph is the
.
(c) For the whole of the current year, G Co budgets to achieve a sales value of
$900,000. Assuming that the unit variable costs and selling price achieved
will be the same as that achieved during May, and that fixed costs for the year
will be $180,000, the profit for the whole year will be $ .
(d) The annual margin of safety for G Co's product is % of budgeted

sales.
Activity 7: Impact of changes

Required
Using the data from Activity 6:
(a) Describe how the line would differ if the fixed costs increased to $20,000.
(b) Describe the impact on the breakeven point if the selling price increased to $9
per unit (with variable costs remaining constant and fixed costs staying at
$15,000).
128
Solution
(a)
(b)
7 Required profit level

The approach used to find an expression for the breakeven sales volumes can be
extended to find the volume needed to attain a required profit level (or target
profit).
Formula to learn
Fixed costs + required profit
Sales volume to reach required profit level =
Contribution per unit
The required profit is like an additional fixed cost which must be covered before the
company 'breaks even'.
Activity 8: Required profit level

Using the data from Activity 2:
Fixed costs = $5,700
Contribution per unit = $1.50/unit
Required
If we need to make a profit of $10,000 the sales units volume required is
units.
129
Solution
Activity 9: Manipulating the breakeven formula

BE units 25,000
Fixed costs $75,000
Selling price $11/unit
Required
Calculate the variable cost per unit.
Solution
8 Limitations of breakeven analysis

8.1 The assumptions
(a) All costs can be split into fixed and variable elements.
(b) Fixed costs are constant.
(c) Variable cost per unit is constant.
(d) Selling price is constant.
(e) Inventory levels are constant (sales volume = production volume).
130
Chapter summary
 The breakeven point in units is found by dividing the fixed costs by the contribution
per unit.
 If a target profit is required the unit sales to achieve this can be found by dividing
the fixed costs plus target profit by the contribution per unit.
 The difference between budgeted or actual sales and the breakeven point is the
margin of safety, which can be expressed as a percentage of budgeted or actual
sales.
 The contribution/sales ratio can be used to find the breakeven point in terms of
sales revenue.
 Sales revenue, costs, contribution, profit and breakeven point can be illustrated by a
breakeven chart or a profit-volume chart.
131
Keywords
 Breakeven analysis: Calculations to determine the breakeven point
 Breakeven point: Level of sales whereby sales revenue is equal to total costs
 Contribution: Sales revenue or selling price per unit less variable costs
 Cost-volume-profit analysis: Analysis of the relationships between activity
levels, costs and profits
 Margin of safety: Excess of budgeted or actual sales over the breakeven point
sales
 Profit-volume (P/V) ratio: Ratio of contribution to sales, also known as the
contribution to sales (C/S) ratio
132
Activity answers
Activity 1: Breakeven units

Breakeven units
Breakeven point = $360,000 = 40,000 units

$28  $19
Activity 2: Breakeven point and breakeven revenue

(a) Estimate cost behaviour via high-low technique
Output Costs
$
High 8,000 57,700
Low 6,000 44,700
2,000 13,000
$13,000
 VC/unit = = $6.50
2,000
 Substituting in Low
$44,700 = FC + (6,000  $6.50)
FC = $5,700
Total costs = 5,700 + ($6.50  no of units)
5,700
BEP = Fixed costs = = 3,800 units
Cont' n/unit 8 – 6.50
(b) Breakeven revenue = 3,800  $8 = $30,400
Activity 3: C/S ratio

Contribution/unit $1.50
(a) C/S ratio = = = 0.1875
Sales price $8
$5,700
(b) Breakeven revenue = = $30,400
0.1875
Activity 4: Margin of safety

Margin of safety = 5,000 – 3,800 = 1,200 units
1,200
or  100 = 24%
5,000
The sales volume must fall by 24% from budgeted level before a loss is made.
133
Activity 5: Breakeven chart
Margin of safety (a)
Budgeted profit (b)
Budgeted variable costs (c)
Fixed costs (d)
Activity 6: Profit volume chart

(a) A $17,000
B (–$15,000)
C $37,500
Workings
A: profit achieved from $80,000 sales revenue = $17,000
B: loss at zero sales revenue = fixed costs = ($15,000)
C: breakeven point = $37,500 sales revenue (see below)
C/S ratio = 32/80 = 40%
$15,000
Breakeven point = Fixed costs = = $37,500 sales revenue
C/S ratio 0.4
(b) The term used to describe the distance D on the graph is the
margin of safety .
This is the difference between the sales revenue budgeted or achieved, and the
revenue required to break even.
(c) The profit for the whole year will be $a 180,000 .
Workings
Contribution achieved = sales revenue  C/S ratio
= $900,000  0.4
= $360,000
Fixed costs $180,000
 Profit for whole year $180,000
(d) The annual margin of safety for G Co's product is 50 % of budgeted

sales.
Workings
$180,000
Annual breakeven point = Fixed costs = = $450,000 sales
C/S ratio 0.4
revenue
Margin of safety = $900,000 – $450,000 = $450,000 sales revenue
= 50% of budgeted sales
134
Activity 7: Impact of changes

(a) The line would start at –$20,000 and cross the x axis at $50,000 using BER =
FC 20,000
= $ = $50,000
C/S ratio 0.4
(b) If selling price is $9 per unit, contribution will become ($9 – $4.80) = $4.20
per unit.
The breakeven point (in units) will therefore be $15,000 = 3,572 units
$4.20
15,000
The breakeven revenue will be $ = $32,148 (3,572  $9)*
0.467
* Note that this figure is rounded; the breakeven point must always be
rounded up to the next whole unit.
Activity 8: Required profit level

Fixed costs + required profit
Sales volume =
Unit contribution
$5,700 + $10,000
=
$1.50
= 10,467 units
Activity 9: Manipulating the breakeven formula

The variable cost is $8.
Workings
Fixed cost $75,000

BEP = = $25,000 =
Contribution per unit $11– VC
So variable cost = $8
135
Test your learning
1 Use the following to make up four formulae which can be used to calculate the
breakeven point.

Fixed costs
Fixed costs
Contribution required to break even
C/S ratio
C/S ratio
(a) Breakeven point (sales units) =
oder
(b) Breakeven point (sales revenue) =
oder
2 The P/V ratio is a measure of how much profit is earned from each $1 of sales.
True
False
3 Profits are maximised at the breakeven point.
True
False
4 At the breakeven point, total contribution = …………………………………. .
5 The total contribution required for a target profit = ……………………………….. .
136
6 Breakeven charts show approximate levels of profit or loss at different sales volume
levels within a limited range. Which of the following are true?
I The sales line starts at the origin.
II The fixed costs line runs parallel to the vertical axis.
III Breakeven charts have a horizontal axis showing the sales/output (in value or
units).
IV Breakeven charts have a vertical axis showing $ for revenues and costs.
V The breakeven point is the intersection of the sales line and the fixed cost line.
A I and II
B I and III
C I, III and IV
D I, III, IV and V
7 On a breakeven chart, the distance between the breakeven point and the expected
(or budgeted) sales, in units, indicates the ………………………………. .
8 Thornbury produces a single product X and has a contribution to sales ratio of 35%.
The annual fixed costs are $157,500. In order to break even, how many units of X
will Thornbury need to make and sell?
A 196,000
B 450,000
C 60,000
D Cannot say without more information
9 The following information is available for product H.
Breakeven point 70,000 units
Contribution per unit $4.50
Margin of safety 30%
Calculate the budgeted profit.
A $100,000 C $315,000
B $135,000 D $765,000
10 Give five limitations of CVP analysis.
 ………………………………………………………………………………………
 ………………………………………………………………………………………
 ………………………………………………………………………………………
 ………………………………………………………………………………………
 ………………………………………………………………………………………
137
138
Limiting factor
analysis
Learning outcomes

• Calculate the profit maximising product sales mix using limiting factor analysis
• Demonstrate make or buy decisions
Chapter context
This chapter helps answer some important questions that any business will have:
• If we can't produce everything our customers want, which products should we give priority to?
• Should we make our products (and all their components) ourselves, or outsource the
production?
139
Chapter overview
Limiting factor
analysis
Single limiting Make or buy

factors decisions
 Confirm that the limiting

factor is something other
than sales demand
 Calculate contribution Simple make Make or buy
earned by each product or buy with limiting
 Calculate contribution per factors
unit of limiting factor  Compare cost of
purchasing to the  Rank products by
 Rank the products relevant production comparing the
 Determine the optimal costs additional VC of
production plan purchasing per
unit of scarce
resource saved
140
7: Limiting factor analysis
1 Limiting factor analysis

1.1 Introduction
One of the more common problems faced by management is a situation where there
are not enough resources to meet the potential sales demand, and so a decision has
to be made about what mix of products to produce, using what resources there are
as effectively as possible.
The production and sales plans of a business may be limited by a limiting
factor/scarce resource.
Limiting factor – anything which limits the activity of an entity.

Key term Scarce resource – any limiting factor other than sales demand.
There are a number of potential limiting factors.

Machine hours Demand
Possible
limiting
factors
Labour Materials
The plans of the business must be built around the limiting factor.
1.2 Optimal production plan

If the business makes more than one product, it will want to find the product mix
which will maximise profit given the limiting factor.
Optimal production plan – the production budget that maximises contribution

Key term from the limiting factor.
The limiting factor decision therefore involves the determination of the

contribution earned by each different product from each unit of the
limiting factor or scarce resource.
141
Illustration 1: Optimal production plan
AB Co makes two products, the Ay and the Be. Unit variable costs are as follows.
Ay Be
$ $
Direct materials 1 3
Direct labour ($3 per hour) 6 3
Variable overhead 1 1
8 7
The sales price per unit is $14 per Ay and $11 per Be. During July 20X2 the
available direct labour is limited to 8,000 hours. Sales demand in July is expected
to be 3,000 units for Ays and 5,000 units for Bes.
Required
Determine the profit-maximising production mix, assuming that monthly fixed costs
are $20,000, and that opening inventories of finished goods and work in progress
are nil.
Solution
Step 1 Confirm that the limiting factor is something other than sales demand.
Ays Bes Total
Labour hours per unit 2 hrs 1 hr
Sales demand 3,000 units 5,000 units
Labour hours needed 6,000 hrs 5,000 hrs 11,000 hrs
Labour hours available 8,000 hrs
Shortfall 3,000 hrs
Labour is the limiting factor on production.
Step 2 Identify the contribution earned by each product per unit of limiting
factor, that is, per labour hour worked.
Ays Bes
$ $
Sales price 14 11
Variable cost 8 7
Unit contribution 6 4
Labour hours per unit 2 hrs 1 hr
Contribution per labour hour (= unit of limiting factor) $3 $4
Although Ays have a higher unit contribution than Bes, two Bes can be
made in the time it takes to make one Ay. Because labour is in short
supply it is more profitable to make Bes than Ays.
142
Step 3 Determine the optimal production plan. Sufficient Bes will be made
to meet the full sales demand, and the remaining labour hours available
will then be used to make Ays.
(a) Hours Hours Priority of

Product Demand required available manufacture
Bes 5,000 5,000 5,000 1st
Ays 3,000 6,000 3,000 (bal) 2nd
11,000 8,000
(b) Hours Contribution

Product Units needed per unit Total
$ $
Bes 5,000 5,000 4 20,000
Ays 1,500 3,000 3 9,000
8,000 29,000
Less fixed costs 20,000
Profit 9,000
Conclusion
(a) Unit contribution is not the correct way to decide priorities.
(b) Labour hours are the scarce resource, and therefore contribution per labour
hour is the correct way to decide priorities.
(c) The Be earns $4 contribution per labour hour, and the Ay earns $3
contribution per labour hour. Bes therefore make more profitable use of the
scarce resource, and should be manufactured first.
Activity 1: Limiting factors

Machine time available is 300 hours.
Labour time available is 200 hours.
A B C
$ $ $
Selling price 150 120 100
Variable costs 100 80 70
Fixed costs 20 20 20
30 20 10
Machine time 5 hrs 2 hrs 1 hr
Labour time 2 hrs 1 hr 0.5 hrs
Demand 50 50 50
143
Required
(a) What is the limiting factor?
(b) The contribution per limiting factor for

A is
B is
C is
(c) The optimum number of units to be produced of
A is units
B is units
C is units
Solution
Workings
144
2 Make or buy decisions

2.1 Introduction
We looked at relevant costing principles in Chapter 2. One particular decision
where relevant costing principles need to be applied is whether a company should
make a product itself or buy it in from an outside supplier. The approach taken will
depend on whether the company has spare capacity available to manufacture all of
its required production internally, or whether there are limiting factors.
2.2 The company has spare capacity

The relevant cost of making the product will include all variable costs and any
directly attributable fixed costs (that would be avoided if production were to cease).
This is compared to the cost of purchasing the product externally.
Activity 2: Simple make or buy decisions

One of the items that GA Co currently manufactures is component MRB which is
then used in the production of a variety of its products. The machine on which MRB
is produced has sufficient capacity to meet all of GA Co's requirements.
The cost card for component MRB is:
$
Direct materials 6.50
Direct wages 2.75
Variable production overheads 3.00
Fixed production overheads 5.25
17.50
The fixed production overheads represent the rent and rates on the factory and as
such would not be avoided if the component was not manufactured.
Required
(a) What is the relevant cost of making component MRB? (We covered relevant
costing in an earlier chapter.)
(b) Should GA Co accept a quote of $14.75 from an external supplier for
component MRB?
Solution
145
2.3 Combining internal and external production
An organisation might want to do more things than it has the resources
for, and so its alternatives would be as follows.
(a) Make the best use of the available resources and ignore the opportunities to
buy help in from outside by subcontracting some of the work
(b) Combine internal resources with buying externally so as to produce (and sell)
more and so increase profitability
We can maximise profit by minimising costs. Total costs will be minimised if those
units bought have the lowest extra variable cost per unit of scarce resource saved by
buying. Extra variable cost is the difference between the variable cost of in-house
production and the cost of buying from the subcontractor.
Illustration 2: Make or buy decisions with scarce resources

MM manufactures three components, S, A and T, using the same machines for each.
The budget for the next year calls for the production and assembly of 4,000 of each
component. The variable production cost per unit of the final product is as follows.
Machine hours Variable cost
$
1 unit of S 3 20
1 unit of A 2 36
1 unit of T 4 24
Assembly 20
100
Only 24,000 hours of machine time will be available during the year, and a
subcontractor has quoted the following unit prices for supplying components: S $29;
A $40; T $34.
Required
Advise MM which products should be manufactured internally, and which
subcontracted.
Solution
The organisation's budget calls for 36,000 hours of machine time, if all the
components are to be produced in-house. Only 24,000 hours are available, and so
there is a shortfall of 12,000 hours of machine time, which is therefore a limiting
factor. The shortage can be overcome by subcontracting the equivalent of 12,000
machine hours of output to the subcontractor.
The assembly costs are not relevant costs because they are unaffected by the
decision.
The decision rule is to minimise the extra variable costs of subcontracting
per unit of scarce resource saved (that is, per machine hour saved).
146
S A T
$ $ $
Variable cost of making 20 36 24
Variable cost of buying 29 40 34
Extra variable cost of buying 9 4 10
Machine hours saved by buying 3 hrs 2 hrs 4 hrs
Extra variable cost of buying per
hour saved $3 $2 $2.50
This analysis shows that it is cheaper to buy A than to buy T and it is most
expensive to buy S. The priority for making the components in-house will be
in the reverse order: S, then T, then A. There are enough machine hours to make
all 4,000 units of S (12,000 hours) and to produce 3,000 units of T (another
12,000 hours). 12,000 hours' production of T and A must be subcontracted.
The cost-minimising and so profit-maximising make and buy schedule is as follows.
Total
Machine hours Number of Unit variable variable
Component used/saved units cost cost
$ $
Make: S 12,000 4,000 20 80,000
T 12,000 3,000 24 72,000
24,000 152,000
Buy: T 4,000 1,000 34 34,000

A 8,000 4,000 40 160,000
12,000 346,000
Total variable cost of components, excluding assembly costs = $346,000
Activity 3: Make or buy with scarce resources

TW manufactures two products, the D and the E, using the same material for each.
Annual demand for the D is 9,000 units, while demand for the E is 12,000 units.
The variable production cost per unit of the D is $10, that of the E $15. The D
requires 3.5 kg of raw material per unit; the E requires 8 kg of raw material per
unit. Supply of raw material will be limited to 87,500 kg during the year.
A subcontractor has quoted prices of $17 per unit for the D and $25 per unit for the
E to supply the product. How many of each product should TW manufacture in
order to maximise profits?
147
Required
Fill in the blanks in the sentence below.
TW should manufacture ........... units of D and .............. units of E to maximise
profits.
Workings
148
Chapter summary
 In a limiting factor situation, contribution will be maximised by earning the

biggest possible contribution per unit of limiting factor.
 Products are ranked in order of their contribution per unit of the scarce resource,
and production plans are drawn up accordingly.
 In a make or buy situation without limiting factors, the cost of purchasing from an
external supplier is compared to the relevant cost of production (all variable costs,
plus directly attributable fixed costs).
 An organisation may have the opportunity to purchase any extra units it cannot
make due to a limiting factor. When deciding which product lines to buy rather than
make, the products are ranked according to the additional variable cost of
purchasing per unit of scarce resource 'saved'.
 The products with the lowest additional cost of purchasing per unit of scarce
resource are purchased rather than made in-house.
149
Keywords
 Limiting factor: Anything which limits the activity of an entity
 Optimal production plan: The production budget that maximises contribution
from the limiting factor
 Scarce resource: A limiting factor other than sales demand
150
Activity answers
Activity 1: Limiting factors

(a) Machine hours
Labour time required = (50  2 hrs) + (50  1 hr) + (50  0.5 hrs)
= 175 hrs
Labour time available = 200 hrs
Machine time required = (50  5 hrs) + (50  2 hrs) – (50  1 hr)
= 400 hrs
Machine time available = 300 hrs
(b) A is $10
B is $20
C is $30
(c) A is 30 units
B is 50 units
C is 50 units
Workings
A B C
Contribution/unit $50 $40 $30
÷ limiting resource ÷ 5 hrs ÷ 2 hrs ÷ 1 hr
Contribution/machine $10 $20 $30
hour
Rank 3rd 2nd 1st
Production schedule Hrs used
(1) Produce maximum 50 of C 50

(2) Produce maximum 50 of B 100
(3) Produce A with remaining hours
150
= 30 units
5 150
300
151
Activity 2: Simple make or buy decisions
(a) The relevant cost of making component MRB is:
$
Direct materials 6.50
Direct wages 2.75
Variable production overheads 3.00
Fixed production overheads –
12.25
(b) The relevant cost of buying component MRB is $14.75.

Therefore GA Co should continue to make component MRB.
Activity 3: Make or buy with scarce resources

The correct answer is: TW should manufacture 9,000 units of D and 7,000 units of E.
D E
$ per unit $ per unit
Variable cost of making 10 15
Variable cost of buying 17 25
Extra variable cost of buying 7 10
Raw material saved by buying 3.5 kg 8 kg
Extra variable cost of buying per kg saved $2 $1.25
Priority for internal manufacture 1st 2nd
Production plan Material

used
kg
 Make D (9,000  3.5 kg) 31,500
E (7,000  8 kg) 56,000
Total materials consumed (maximum available) 87,500
The remaining 5,000 units of E should be purchased from the subcontractor.
152
Test your learning

1 When determining the optimum production plan using limiting factor analysis, what
three steps are involved?
Step 1………………………………………………………………………………………
Step 2………………………………………………………………………………………
Step 3………………………………………………………………………………………
2 Choose the correct word from those highlighted.
When there is just one limiting factor, the product with the biggest/smallest
contribution earning ability per unit of limiting factor should be produced first.
3 Which of the following is not an example of a limiting factor?
A Sales demand
B Materials
C Machine time
D Profit
4 A milkshake bar has three different products; the Chocolate Extreme, the Toffee
Deluxe and the Strawberry Sensation. Along with flavourings (which are not
restricted), they each require the following resources:
CE TD SS
Ice cream 100 g 150 g 200 g
Milk 500 ml 400 ml 250 ml
Staff time 10 minutes 15 minutes 20 minutes
Daily demand 100 200 75
Due to shortages, only 60 kg of ice cream,140 litres of milk and 100 hours of staff
time are available.
What is the limiting factor?
A Ice cream
B Milk
C Staff time
D Demand
5 If a Chocolate Extreme generates contribution of $10 per unit, a Toffee Deluxe $9
and a Strawberry Sensation $6, what is the optimal production plan?
A 100 CE, 200 TD and 40 SS
B 100 CE, 200 TD and 75 SS
C 82 CE, 200 TD and 75 SS
D 100 CE, 178 TD and 75 SS
153
154
Standard costing
Learning outcomes

• Explain why planned standard costs, prices and volumes are useful.
• Calculate standard costs for the material, labour and variable overhead elements of the cost of a
product or service.
Chapter context
This brief chapter introduces the concept of standard costing: estimating the cost of a unit of what we
produce in advance. This is useful for planning the resources an organisation requires, setting
targets, and also evaluating actual performance. This role in evaluating performance will be
investigated in detail in the following chapter.
155
Chapter overview
Standard costing
Standard setting
Bases of Advantages and

standards disadvantages
 Ideal Advantages
 Expected
• Enables budgetary control
 Current
• More accurate budgeting
 Basic
• Assists performance measurement
• Assists in target-setting for staff
• Assists in price-setting
• Simplifies bookkeeping
Disadvantages
• Difficult to forecast accurately
• Time consuming
• Regular revision required
• Demotivating if wrong
156
8: Standard costing
1 Standard cost
1.1 Definition
A standard cost – an estimated unit cost, prepared in advance and calculated

Key term from management expectations of:
(a) Efficiency levels in the use of materials and labour;
(b) The expected price of materials, labour and expenses; and
(c) Budgeted overhead costs and activity levels.
1.2 Uses
It can be used in budgetary control (ie variance analysis – see Chapter 11) or as a
means of valuing inventories and the cost of production.
Standard costing enables the principle of management by exception to be
practised.
Management by exception is the 'Practice of concentrating on activities that

Key term require attention and ignoring those which appear to be conforming to
expectations. Typically standard cost variances or variances from budget are used
to identify those activities that require attention'.
1.3 Standard costing

Standard costing may be used in a system of absorption costing or marginal
costing. A standard cost card will usually be prepared for each product
manufactured by the business.
157
Illustration 1: Standard cost card
STANDARD COST CARD – PRODUCT 1234
$ $
Direct materials
Material X: 3 kg at $4 per kg 12
Material Y: 9 litres at $2 per litre 18
30
Direct labour
Grade A: 6 hours at $7 per hour 42
Grade B: 8 hours at $8 per hour 64
106
Standard direct cost 136
Variable production overhead: 14 hours at $0.50 per hour 7
Standard variable cost of production 143
Fixed production overhead: 14 hours at $4.50 per hour 63
Standard full production cost 206
Administration and marketing overhead 15
Standard cost of sale 221
Standard profit 20
Standard sales price 241
Activity 1: Standard cost card preparation

B Company makes one product, the J. Two types of labour are involved in the
preparation of a J, skilled and semi-skilled. Skilled labour is paid $10 per hour and
semi-skilled $5 per hour. Twice as many skilled labour hours as semi-skilled labour
hours are needed to produce a J, four semi-skilled labour hours being needed.
A J is made up of three different direct materials. Seven kilograms of direct material
A, four litres of direct material B and three metres of direct material C are needed.
Direct material A costs $1 per kilogram, direct material B $2 per litre and direct
material C $3 per metre.
Variable production overheads are incurred at B Company at the rate of $2.50 per
direct labour (skilled) hour.
A system of absorption costing is in operation at B Company. The basis of
absorption is direct labour (skilled) hours. For the forthcoming accounting period,
budgeted fixed production overheads are $250,000 and budgeted production of
the J is 5,000 units.
Administration, selling and distribution overheads are added to products at the rate
of $10 per unit.
A mark-up of 25% is made on the J.
158
8: Standard costing
Required
Using the above information complete the standard cost card below for the J.
STANDARD COST CARD – PRODUCT J
$ $
Direct materials
7
Direct labour
7
Variable production overhead

7
Fixed production overhead

7
Administration, selling and distribution overhead 7
Standard profit 7
2 Standard setting
2.1 Introduction
Standard setting can be challenging for management. Accurate information is
required from various departments (for example, the purchasing department will
provide information on current and expected material prices; human resources will
confirm current rates of pay and pay rises agreed with trade unions). Inflation will
also need to be considered and factored into the standard cost card. Management
also need to decide how challenging the standard should be. There are four
different types of performance standard that an organisation could aim for:
159
Expected/attainable Ideal standards
Key term standards  Perfect operating
 Based on efficient, not conditions
perfect, operating  No wastage, breakdowns
conditions or idle time
 Should be practically  Difficult to achieve
possible
 Demotivating for staff
 Can motivate employees
to improve level of
performance
Bases
Current standards Basic standards

 Based on current  Unaltered over long
performance levels periods of time
 Include current  Become outdated quickly
inefficiencies  Least useful to evaluate
 Can lead to stagnation strengths or weaknesses in
and underperformance production performance
2.2 Advantages and disadvantages

Advantages of setting standards Disadvantages of setting standards
(a) Facilitates budgetary control (a) Difficult to forecast accurately
(b) Leads to more accurate budgeting (b) Time consuming
(c) Assists performance measurement (c) Regular revision required
(d) Assists in target setting for staff (d) Demotivating if wrong
(e) Assists in price setting (e) Not suitable if output is not homogenous
(f) Simplifies bookkeeping (f) Not focused on continuous improvement
2.3 The standard hour
The standard hour can be used to overcome the problem of how to measure
Key term output when a number of dissimilar products are manufactured.
160
8: Standard costing
Illustration 2: Standard hour

S Co manufactures plates, mugs and eggcups. Production during the first two
quarters of 20X5 was as follows.
Quarter 1 Quarter 2
Plates 1,000 800
Mugs 1,200 1,500
Eggcups 800 900
The fact that 3,000 products were produced in quarter 1 and 3,200 in quarter 2
does not tell us anything about S Co's performance over the two periods because
plates, mugs and eggcups are so different. The fact that the production mix has
changed is not revealed by considering the total number of units produced. This is
where the concept of the standard hour is useful.
The standard hour (or standard minute) is the amount of work achievable, at
standard efficiency levels, in an hour or minute.
(a) The standard time allowed to produce one unit of each of S Co's products is as
follows.
Standard
time
1
Plate /2 hour
1
Mug /3 hour
1
Eggcup /4 hour
(b) By measuring the standard hours of output in each quarter, a more useful output
measure is obtained.
Quarter 1 Quarter 2
Standard hours Standard Standard
Product per unit Production hours Production hours
1
Plate /2 1,000 500 800 400
1
Mug /3 1,200 400 1,500 500
1
Eggcup /4 800 200 900 225
1,100 1,125
The output level in the two quarters was therefore very similar.
2.4 Taking account of wastage and losses

If, during processing, the quantity of material input to the process is likely to reduce
(due to wastage or evaporation), the quantity input must be greater than the quantity
in the finished product and a material standard must take account of this.
Suppose that the fresh raspberry juice content of a litre of Purple Pop is 100 ml and
that there is a 10% loss of raspberry juice during process due to evaporation. The
standard material usage of raspberry juice per litre of Purple Pop will be:
100% 100%
100 ml  = 100 ml  = 111.11 ml
(100  10)% 90%
161
3 Standard labour costs
3.1 Remuneration methods
(a) Time-based systems. These are based on the principle of paying an
employee for the hours attended, regardless of the amount of work achieved
(wages = hours worked  rate of pay per hour).
(i) Overtime premium = extra rate per hour for hours over and above the
basic hours.
(ii) Quality of output is more important than quantity of output.
(iii) There is no incentive for improvements in employee performance.
(b) Piecework systems.
Piecework system – a scheme where an employee is paid per unit of output.

Key term
Pay is calculated according to the output achieved (wages = units produced 
rate of pay per unit).
(c) Incentive/bonus schemes. There are a variety of these schemes, all of
which are designed to encourage workers to be more productive.
Activity 2: Remuneration systems

Match the descriptions of remuneration schemes to the graphs below.
Total Total Total
wages wages wages
$ $ $
Activity Activity Activity

Graph A Graph B Graph C
Descriptions
(a) A basic hourly rate is paid for hours worked, with an overtime premium
payable for hours worked in excess of 35 per week.
(b) A straight piecework scheme is operated.
(c) A straight piecework scheme is operated, with a minimum guaranteed weekly
wage.
162
8: Standard costing
Chapter summary
 Standard costing is the preparation of standard costs to value inventories/cost

products and/or to use in variance analysis; it is a key management control tool.
 Standards for each cost element are made up of a monetary component and a
resources requirement component.
 Performance standards are used to set efficiency targets. There are four types:
ideal, attainable, current and basic.
 There are a number of advantages and disadvantages of standard costing.
 The standard hour can be used to overcome the problem of how to measure
output when a number of dissimilar products are manufactured.
 Bonus/incentive schemes often incorporate labour standards as targets.
163
Keywords
 Basic standard: Standards which are kept unaltered over a long period of time,
and may be out of date
 Current standard: Standards based on current working conditions (current
wastage, current inefficiencies)
 Expected/Attainable standard: Standards based on efficient (but not perfect)
operating conditions. Some allowance is made for wastage, inefficiencies, machine
breakdowns and fatigue
 Ideal standard: Standards based on the most favourable operating conditions,
with no wastage, no inefficiencies, no idle time and no breakdowns
 Management by exception: The practice of concentrating on activities that
require attention and ignoring those which appear to be conforming to expectations
 Piecework: A scheme where an employee is paid per unit of output
 Standard cost: A planned cost of a product, component or service
 Standard hour: The amount of work achievable, at standard efficiency levels, in
an hour
164
8: Standard costing
Activity answers
Activity 1: Standard cost card preparation

STANDARD COST CARD – PRODUCT J
$ $
Direct materials
A 7 kg  $1 7
B 4 litres  $2 8
C 3 m  $3 9
24
Direct labour
Skilled: 8  $10 80
Semi-skilled: 4  $5 20
100

Variable production overhead
20
8  $2.50

Fixed production overhead
50
8  $6.25 (W)
Administration, selling and distribution overhead 10
Standard profit 25%  204 51
Working
$250,000
Overhead absorption rate = = $6.25 per skilled labour hour
5,000  8
Activity 2: Remuneration systems

(a) Graph B
(b) Graph C
(c) Graph A
165
Test your learning
A standard cost is a planned/historical unit/total cost.
2 The only use of standard costing is to value inventory.
True
False
3 A control technique which compares standard costs and revenues with actual results
to obtain variances which are used to stimulate improved performance is known as:
A Standard costing
B Variance analysis
C Budgetary control
D Budgeting
4 Standard costs may only be used in absorption costing.
True
False
5 Four types of performance standard are:
(a) ………………………….. (c) …………………………..
(b) ………………………….. (d) …………………………..
6 The formula for standard material cost per unit = ………………………….
7 List three problems in setting standards.
(a) …………………………………………….
(b) …………………………………………….
(c) …………………………………………….
8 Which three of the following are advantages of standard costing?
A Standards are an aid to more accurate budgeting.
B Cost consciousness is stimulated.
C Inflation can be dealt with easily.
D The principle of management by exception can be operated.
166
Flexible budgeting
Learning outcomes

• Prepare a flexible budget.
• Calculate budget variances.
• Distinguish between fixed and flexible budgets.
Chapter context
The chapter looks at the role of budgeting in planning and control. At the planning stage it can be
useful to produce several budgets based on different levels of activity so that managers can
understand the impact on the business of producing and selling more or less than the main target. In
using budgets to control an organisation it makes sense to make the comparison with the actual
results as meaningful as possible by adjusting the budget to reflect the actual level of output.
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Chapter overview
Budgetary control
Flexible/flexed
Fixed budget Actual results
budget
Set before start of  Flexible = designed to change Actuals = 'Did'

period based on as level of output changes (used
in 'what if' analysis). Compared with
estimated/budgeted flexed budget in
production volumes  Flexed = adjust at the end of the
terms of standard
period to reflect actual
production volumes. variance analysis
Flexed = 'Should' in terms of
standard variance analysis
Volume Expenditure
variance variance
Measures the difference Measures the difference

between the fixed and the between the flexed budget
flexed budget – ie through and the actuals – ie standard
adjusting from budgeted to variances such as:
actual volumes  Materials price
 Materials usage
 Labour rate etc
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9: Flexible budgeting
1 Budgetary control
1.1 Different budget types
Budgetary control is obtained by comparing actual results against budget. In order
for that comparison to be meaningful, the budget needs to be amended or 'flexed'
in line with the actual activity level.
Fixed budget – the original budget set up for budgeted sales and production.
Key term
Flexible budget – a budget which is designed to change as volume of activity
changes.
Flexed budget – uses the original budget figures but for actual sales and
production.
1.2 Advantages of flexible budgets

A flexible budget has two advantages.
(a) At the planning stage, it may be helpful to know what the effects would be if
the actual outcome differs from the prediction. For example, a company may
budget to sell 10,000 units of its product, but may prepare flexible budgets
based on sales of, say, 8,000 and 12,000 units. This would enable
contingency plans to be drawn up if necessary.
(b) At the end of each month or year, actual results may be compared with the
relevant activity level in the flexible budget as a control procedure.
1.3 Preparation of flexible budgets

Step 1 The first step in the preparation of a flexible budget is the determination
of cost behaviour patterns, which means deciding whether costs are
fixed, variable or semi-variable.
 Fixed costs are easy to spot. They remain constant as activity levels
change.
 For non-fixed costs, divide each cost figure by the related activity
level. If the cost is a variable cost, the cost per unit will remain
constant. If the cost is a semi-variable cost, the unit rate will reduce
as activity levels increase.
Step 2 The second step in the preparation of a flexible budget is to calculate the
budget cost allowance for each cost item.
Budget cost allowance – the budgeted costs in the flexed budget for each cost
Key term item.
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Budget cost allowance = budgeted fixed cost* +
(number of units  variable cost per unit)**
* nil for variable cost
** nil for fixed cost
Semi-variable costs therefore need splitting into their fixed and variable components
so that the budget cost allowance can be calculated.
Illustration 1: Preparing a flexible budget

Prepare a budget for 20X6 for the direct labour costs and overhead expenses of a
production department flexed at the activity levels of 80%, 90% and 100%, using
the information listed below.
(i) The direct labour hourly rate is expected to be $3.75.
(ii) 100% activity represents 60,000 direct labour hours.
(iii) Variable costs
Indirect labour $0.75 per direct labour hour
Consumable supplies $0.375 per direct labour hour
Canteen and other welfare services 6% of direct and indirect labour costs
(iv) Semi-variable costs are expected to relate to the direct labour hours in the
same manner as for the last five years.
Direct labour Semi-variable
Year hours costs
$
20X1 64,000 20,800
20X2 59,000 19,800
20X3 53,000 18,600
20X4 49,000 17,800
20X5 40,000 (estimate) 16,000 (estimate)
(v) Fixed costs

$
Depreciation 18,000
Maintenance 10,000
Insurance 4,000
Rates 15,000
Management salaries 25,000
(vi) Inflation is to be ignored.
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Solution
80% 90% 100%

level level level
48,000 54,000 60,000
hrs hrs hrs
$'000 $'000 $'000
Direct labour 180.00 202.50 225.0
Other variable costs
Indirect labour 36.00 40.50 45.0
Consumable supplies 18.00 20.25 22.5
Canteen etc 12.96 14.58 16.2
Total variable costs ($5.145 per 246.96 277.83 308.7
hour)
Semi-variable costs (W) 17.60 18.80 20.0
Fixed costs
Depreciation 18.00 18.00 18.0
Maintenance 10.00 10.00 10.0
Insurance 4.00 4.00 4.0
Rates 15.00 15.00 15.0
Management salaries 25.00 25.00 25.0
Budgeted costs 336.56 368.63 400.7
Working
Using the high/low method:
$
Total cost of 64,000 hours 20,800
Variable cost of 24,000 hours 4,800
Variable cost per hour ($4,800/24,000) $0.20
$
Variable cost of 64,000 hours ( $0.20) 12,800
Fixed costs 8,000
Semi-variable costs are calculated as follows.

$
60,000 hours (60,000  $0.20) + $8,000 20,000
54,000 hours (54,000  $0.20) + $8,000 18,800
48,000 hours (48,000  $0.20) + $8,000 17,600
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Activity 1: Flexing a budget
Cosmic Co manufactures and sells a single product, X.
Cosmic's management uses a flexible budgeting system to control costs.
Output and sales (units) 2,000 2,750
Budget costs: $ $
Direct material 4,000 5,500
Direct labour 10,000 12,250
Fixed production overheads 5,500 5,500
Selling and distribution overheads 1,000 1,375
Total expenditure 20,500 24,625
Production and sales of X amounted to 2,550 during 20Y7.

There are no opening or closing inventories for 20Y7. The total budgeted costs in
the flexed budget for 20Y7 (known as the budget cost allowance) will be:
(a) Direct material $
(b) Direct labour (semi-variable cost) $
(c) Fixed production overheads $
(d) Selling and distribution overheads $

Solution
Workings
172
2 Budget variances
Control involves comparing a flexible budget (based on the actual activity level) with
Key term actual results. The differences between the flexible budget figures and the actual
results are budget variances.
The total variance between the original fixed budget and the actual results can be
broken down into:
Volume variance – fixed budget v flexed budget. This quantifies the difference in
Key term costs/profits that is due to changes in the volume of output.
Expenditure variance – flexed budget v actual results. This variance is
meaningful for cost control. It is a measure of what managers should have achieved,
given the production that took place, compared to what was actually achieved.
Favourable variance (F) – a variance where results were better than expected.
Adverse variance (A) – results are worse than expected.
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Activity 2: Budget variances
Dot Co issued its production budget based on a budget output of 2,000 units.
The actual output for the period was 1,500 units.
Budget Actual
Output (units) 2,000 1,500
$ $
Prime cost 50,000 31,000
Fixed overheads 130,000 132,000
Total cost 180,000 163,000
Required
(a) What was the expenditure variance?
(i) $17,000 favourable
(ii) $18,000 adverse
(iii) $4,500 favourable
(iv) $4,500 adverse
(b) What was the volume variance?
(i) $12,500 favourable
(ii) $17,000 favourable
(iii) $4,500 favourable
(iv) $12,000 adverse
Solution
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Chapter summary
 A fixed budget is a budget which is set for a single activity level.

 A flexible budget is a budget which recognises different cost behaviour patterns
and is designed to change as volume of activity changes.
 Control involves comparing a flexed budget (based on the actual activity
level) with actual results. The differences between the flexed budget figures
and the actual results are budget variances.
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Keywords
 Adverse variance (A): Results are worse than expected
 Budget cost allowance: Budgeted costs in the flexed budget for each cost item
 Budget variances: The differences between the flexed budget figures and the
actual results
 Expenditure variance: A measure of what managers should have achieved,
given the production that took place, compared to what was actually achieved
 Favourable variance (F): A variance where results were better than expected
 Fixed budget: The original budget set up for budgeted sales and production at
the start of the reporting period. It is not subsequently changed in response to
changes in activity, costs or revenue
 Flexed budget: Uses the original budget figures (for fixed costs) but flexes the
variable costs/revenues to the allowances permitted for actual sales and production
 Flexible budget: A budget which recognises different cost behaviour patterns
and is designed to change as volume of activity changes
 Volume variance: The difference in costs/profits that is due to changes in the
volume of output
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Activity answers
Activity 1: Flexing a budget

(a) Direct material is a variable cost of 4,000/2,000 = $2 per X.
Budget for 2,550 is = 2,550  $2 = $5,100.
(b) Direct labour is a semi-variable cost, therefore use the high-low method.
Units of X $
High 2,750 12,250
Low 2,000 10,000
Difference 750 2,250
Variable cost per unit = 2,250/750 = $3

Fixed cost: 12,250 = FC + (3)(2,750)
FC = $4,000
Flexed budget for 2,550 units = $4,000 + ($3  2,550) = $11,650
(c) Fixed cost = 5,500
(d) Selling and distribution is a variable cost of 1,000/2,000 = $0.50 per unit
Flexed budget for 2,550 units = 2,550  $0.50 = $1,275.
Activity 2: Budget variances

(a)
Actual results 163,000
Flexible budgets
Prime cost  50,000 1,500 units 
 2,000  37,500
 
Fixed overheads 130,000
167,500
4,500 F
(b)
Fixed budget 180,000
Flexible budget 167,500
12,500 F
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Test your learning
1 Fill in the blanks with the word 'fixed' or the word 'flexible'.
(a) At the planning stage, a ……………………. budget can show what the effects
would be if the actual outcome differs from the prediction.
(b) At the end of each period, actual results may be compared with the relevant
activity level in the ……………………. budget as a control procedure.
(c) Master budgets are ……………………. budgets.
2 Flexible budgets are normally prepared on a marginal costing basis.
True
False
3 Fill in the gaps.
Budget cost allowance = …………. + (……………….  ……………….)
4 What are the disadvantages of using a fixed budget for budgetary control?
5 Distinguish between a fixed budget and a flexible budget.
6 What are the two main reasons for differences between a fixed budget profit and
actual profit?
7 Fill in the gaps.
A flexible budget is a budget which, by recognising ………………….., is designed
to ……………….. as the level of activity changes.
8 A flexible budget is:
A budget which by recognising different cost behaviour patterns is designed to
change as the volume of activity changes
A budget for a defined period of time which includes planned revenues,
expenses, assets, liabilities and cash flow
A budget which is prepared for a period of one year which is reviewed
monthly, whereby each time actual results are reported, a further forecast
period is added and the intermediate period forecasts are updated
A budget of semi-variable production costs only
9 Which one of the following statements about a fixed budget is/are correct? A fixed
budget is:
A budget which ignores inflation
A budget for fixed assets
A budget which is most generally used for planning purposes
A budget for a single level of activity
A budget for fixed costs
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Budget preparation
Learning outcomes

• Explain why organisations prepare forecasts and plans, typically for a financial year.
• Prepare functional budgets.
• Explain budget statements; prepare a master budget based on functional budgets.
• Identify the impact of budgeted cash surpluses and shortfalls on business operations.
Chapter context
Budgeting is a key tool in many organisations and is a term that you will no doubt have come across
before. This chapter covers what a budget actually is, what it is used for, how the various types of
budget are produced and how they fit together.
179
Chapter overview
Budget preparation
Purposes Master Principal Approaches

budget budget factor
P Planning  If limiting factor  Incremental v

ZBB
R Responsibility exists then its
I Integration budget must be  Periodic v
rolling
M Motivation prepared first
E Evaluation  Participative v
imposed
Functional Financial
budgets budgets
Sales Budget
(units, $s)
Cash Capital
Overheads
Budget
Production
Budget
Labour
Budget
budgets expenditure
(units, $s) (units) (hrs, $s) budgets
Focus on 'cash effect'

Material  Cash receipts ($s) Short-, medium-
Usage and long-term
Budget  Cash payments ($s)
investment plans
(kg, litres)
 'One-offs'
Materials
Purchases
Budget
(kg, litres, $s)
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10: Budget preparation
1 What are budgets?

Competent management should manage by objectives and this generalised aim is
supported by a plan of action in the form of a formalised budget.
1.1 Definition of a budget

A financial and/or quantitative statement, prepared and approved prior
to a defined period of time, of the policy to be pursued during that period
for the purpose of attaining a given objective.
In essence it is a commitment to a financial plan of action.
1.2 Purpose of a budget

P – Planning (to achieve targets, identify problems)
R – Responsibility (managers made responsible for achieving targets)
I – Integration and co-ordination (of departments within the business)
M – Motivation (of employees to improve performance)
E – Evaluation and control (of performance by comparison of budget to actual
results)
In summary, budgets help to ensure the smooth and efficient running of a business.
1.3 Preparation of the budget

This is normally co-ordinated by the budget committee, including representatives
from every part of the organisation. The preparation of each functional budget
(sales budget, production budget, direct labour budget and so on) should be the
responsibility of the manager who will be carrying out that budget. Guidelines and
information to aid budget preparation are contained in the budget manual. This
will typically include the responsibilities of persons and the procedures, forms and
records relating to the preparation and use of budgetary data.
A budget committee – the co-ordinating body in the preparation and

Key term administration of budgets.
A budget manual – a detailed set of guidelines and information about the
budget process.
A functional budget – a budget of income and/or expenditure applicable to a
particular function of an organisation.
2 Principal budget factor (PBF)

The first task in the budgetary process is to identify the principal budget factor
(PBF). This is also known as the key budget factor or limiting budget
factor.
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Principal budget factor – the factor which limits the activities of an organisation
Key term (seen in Chapter 7).
Budgets should be constructed around the PBF:

 Identify the PBF eg raw materials availability (in kg). For most organisations
this will be sales demand.
 Calculate the budget for the PBF.
 Work all the other budgets around it.
3 Hierarchy of budgets
Master budget – Budgeted statement of profit or loss, budgeted statement of
Key term financial position and a cash budget.
MASTER BUDGET
Functional Financial
budgets budgets
(Statement of profit or loss) (Statement of financial position)
Sales budget Capital expenditure budget

Production budget Cash budgets
Direct material usage
Direct material purchases
Direct labour budget
Factory overhead budget
Selling and distribution budget
Admin expenditure budget
You might be asked to prepare any of these budgets.
182
4 Functional budgets
4.1 Overview
Sales Budget
(units, $s)
+ Closing inventory of finished goods (FGs)

– Opening inventory of FGs
Overheads Production Labour

Budget Budget Budget
(units, $s) (units) (hrs, $s)
Material Usage
Budget
(kg, litres)
+ Closing inventory of raw materials (RM)
– Opening inventory of RM
Materials Purchases
Budget
(kg, litres, $s)
4.2 Items to include and considerations

(1) Sales budget – units and value
(2) Production budget – units
 Sales quantities
 Adjust by changes in finished goods inventory
(3) Resource requirements budgets
 Materials usage (scrap, waste)
 Labour hours (idle time)
 Machine hours (idle time)
 Other
 Apply costs to resources
(4) Overheads – fixed and variable
 Absorption costing, calculate fixed overhead absorption rate and full cost
of units
(5) Materials purchases budgets ($)
 Materials usage quantities
 Adjust by changes in raw materials inventory
 Apply costs (any discounts?)
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(6) Budgeted statement of profit or loss can be prepared from combining all the
above
4.3 Suggested layout

The following is a suggested layout which ensures that all of the crucial elements of
the budget are included.
(1) Sales budget
A B Total
Quantities (units) X X
Unit selling price $Y $Y
Revenue $Z $Z $Z
(2) Production budget
A B
Units Units
Sales X X
Closing inventory X X
X X
Opening inventory (X) (X)
Production X X
(3) Material usage
Material P Material Q
kg kg
A (@ Y kg*/unit) X X
B (@ Z kg*/unit) X X
Total usage X X
* Consider wastage
(4) Material purchases
Material P Material Q Total
kg kg
Usage X X
Closing inventory of raw X X
materials
X X
Opening inventory of raw (X) (X)
materials
Purchases X X
Price/kg $Y $Y
Total cost $Z $Z $Z
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(5) Labour utilisation

Skilled Semi-skilled Total
Hrs Hrs
A (@ Y hrs*/unit) X X
B (@ Z hrs*/unit) X X
X X
Rate/hr $Y $Y
Total cost $Z $Z $Z
* Consider idle time
(6) Statement of profit or loss
A B Total
$ $ $
Revenue (from (1)) X X X
Less cost of sales (X) (X) (X)
(sales unit  cost/unit*)
Less selling and
administrative costs (X) (X) (X)
X X X
* Assuming absorption costing

You may get an assessment question which asks you to work out one budgeted
figure from another. For example, you may be given the sales budget and asked to
work out the production budget. Make sure that you learn this formula.
Units made = units sold + units in closing inventory – units in opening inventory.
The business must produce enough to cover its sales volume and to leave enough in
closing inventory, but it gets a 'head start' from opening inventory. This is why
opening inventory is deducted.
You can apply this principle to other areas of budgeting. For example:
Materials purchases = materials usage + closing inventory material – opening
inventory material.
Activity 1: Material purchases budget

Suppose a company currently holds 100 units of inventory but it wishes to increase
its inventory holding to 150 units during the next month. Sales are expected to be
850 units. Each unit requires 5 kg of material. Of units produced, 10% have to be
discarded because they are defective. No inventories of raw materials are held.
185
Required
The material purchases for next month should be kg
Solution
Activity 2: Functional budgets

Bun plc makes two types of cake. When producing the budget for 20X7 the
company realises that its principal budget factor is sales and forecasts the following
sales.
Product name: Sponge cake Cream cake

Sales (number of batches) 2,400 1,200
Selling price per batch $150 $200
Sponge cake Cream cake
Materials
Flour (@ 50c/kg) 5 kg 7 kg
Milk (@ 70c/pint) 4 pints 6 pints
Labour
Mixers (@ $20/hr) ½ hr ¾ hr
Cooks (@ $30/hr) ½ hr ½ hr
The company has inventory levels of completed batches of cakes as follows: 480
Sponges and 240 Creams and raw materials inventory of 1,000 kg of flour and
500 pints of milk. Management feel that 20X7's sales figures could well be
repeated in 20X8 and wish to have sufficient inventory of finished batches to cope
with 10% of this demand and raw materials to cope with 20% of the demand for
the finished product.
186
Required
Complete the following sentences.
(a) The volume of sales budgeted for 20X8 for Sponge is , and
for Cream is and total sales revenue will be
(b) To meet this sales demand and its closing inventory requirements, Bun will
have to produce Sponges and Creams.
(c) Bun's purchasing department will need to buy kg of flour at

a total cost of and pints of milk at a
total cost of .
(d) The total cost of labour will be .
Solution
Workings
187
188
5 Cash budgets
5.1 Overview
The level of cash held by a business is important. A cash budget shows how the
balance will change over several months.
5.2 Presentation
XYZ Co: CASH BUDGET FOR THE THREE MONTHS ENDED 31 MARCH
2007
Jan Feb Mar
Cash receipts
Sales receipts X X X
Loans, asset sales _ X X
X X X
Cash payments
Purchase payments X X X
Wages X X X
Overheads X X X
Loan repayments X
Non-current assets X _ _
X X X
Net cash flow X (X) X

Opening balance X X (X)
Closing balance X (X) X
5.3 Approach
Fill in the easy figures first.
(a) Sundry receipts and payments: for example the purchase of non-current assets.
(b) Wages and salaries: usually paid when due.
(c) Sales receipts: total sales are given, you just have to check the payment
pattern.
(d) Payments to payables: these require more care.
(e) The closing balance for one month becomes the opening balance for the next
month.
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5.4 Points to note
Cash budgets consider the cash element of business transactions, whereas the
statement of profit or loss records all transactions on an accruals basis regardless of
when cash is received or paid. Therefore:
Transaction Cash budget effect SOPL effect
Purchase of non-current Cash paid Depreciation charged

asset
Sell a non-current asset Cash received Profit or loss on sale
Sales made for cash and Cash received Accruals basis

credit
Expenses paid Cash paid Accruals basis
Activity 3: Cash budget items

Tick the boxes to show which of the following should be included in a cash budget.
Include Do not
include
Funds from the receipt of a bank loan
Revaluation of a non-current asset
Receipt of dividends from outside the business
Depreciation of distribution vehicles
Bad debts written off
Share dividend paid
Illustration 1: Cash budget

Peter Blair has worked for some years as a sales representative, but has recently
been made redundant. He intends to start up in business on his own account, using
$15,000 which he currently has invested with a savings account. Peter also
maintains a bank account showing a small credit balance, and he plans to
approach his bank for the necessary additional finance. Peter asks you for advice
and provides the following additional information.
(a) Arrangements have been made to purchase non-current assets costing $8,000.
These will be paid for at the end of September and are expected to have a five-
year life, at the end of which they will possess a nil residual value.
190
(b) Inventories costing $5,000 will be acquired on 28 September and subsequent

monthly purchases will be at a level sufficient to replace forecast sales for the
month.
(c) Forecast monthly sales are $3,000 for October, $6,000 for November and
December, and $10,500 from January 20X4 onwards.
(d) Selling price is fixed at the cost of inventory plus 50%.
(e) Two months' credit will be allowed to customers but only one month's credit will
be received from suppliers of inventory.
(f) Running expenses, including rent but excluding depreciation of non-current
assets, are estimated at $1,600 per month.
(g) Blair intends to make monthly cash drawings of $1,000.
Required
Prepare a cash budget for the six months to 31 March 20X4.
Solution
The opening cash balance at 1 October will consist of Peter's initial $15,000 less
the $8,000 expended on non-current assets purchased in September. In other
words, the opening balance is $7,000. Cash receipts from credit customers arise
two months after the relevant sales.
Payments to suppliers are a little more tricky. We are told that cost of sales is 100/150
 sales. Thus for October cost of sales is 100/150  $3,000 = $2,000. These goods
will be purchased in October but not paid for until November. Similar calculations can
be made for later months. The initial inventory of $5,000 is purchased in September
and consequently paid for in October.
Depreciation is not a cash flow and so is not included in a cash
budget.
The cash budget can now be constructed.
CASH BUDGET FOR THE SIX MONTHS ENDING 31 MARCH 20X4
Oct Nov Dec Jan Feb Mar
$ $ $ $ $ $
Payments
Suppliers 5,000 2,000 4,000 4,000 7,000 7,000
Running expenses 1,600 1,600 1,600 1,600 1,600 1,600
Drawings 1,000 1,000 1,000 1,000 1,000 1,000
7,600 4,600 6,600 6,600 9,600 9,600
Receipts
Receivables – – 3,000 6,000 6,000 10,500
Surplus/(shortfall) (7,600) (4,600) (3,600) (600) (3,600) 900
Opening balance 7,000 (600) (5,200) (8,800) (9,400) (13,000)
Closing balance (600) (5,200) (8,800) (9,400) (13,000) (12,100)
191
Activity 4: Customer receipts
Carol has forecast sales as follows: December $10,000; January $10,000;
February $12,000; March $15,000.
Sales are partly for cash and partly on credit, as follows.
 40% for cash (no discount)
 60% on credit
The cash sales receipts are received in the month of sale. A 5% discount is given to
credit customers for payment within the current month and 25% of credit customers
take up this option. All other cash is received in the month after the month of sale.
Required
Complete the following.
January February March
$ $ $
Sales 10,000 12,000 15,000
Cash sales
Credit sales
Pay in same
month
Pay in next month
Cash receipts
5.5 Potential cash surpluses or shortages

Cash budgets can give management an indication of any cash surpluses or
shortages expected.
Management can then make decisions on financing any expected cash shortage or
investing any cash surpluses. This will depend on whether the surplus or shortage is
long term or short term.
192
Activity 5: Dealing with cash surplus or shortfall

Required
Complete the following statements.
(a) Cash surpluses can be used to:
(b) Cash shortfalls can be financed by:
6 Capital expenditure budgets

6.1 Importance
Because the monetary amounts involved in capital expenditure are often large, the
capital expenditure budget is one of the principal statement of financial position
subsidiary budgets.
6.2 Term
A capital expenditure budget should be prepared for the short-term budget period
(eg 12 months) and the medium-term and long-term based on the organisation's
requirements for land, buildings, plant, machinery, vehicles, fixtures and fittings and
any other non-current assets.
6.3 Depreciation
Any depreciation on budgeted capital expenditure will need to be incorporated into
the budgeted statement of profit or loss.
7 Approaches to budgeting
7.1 Introduction
There are a number of approaches to producing budgets that organisations can
adopt. These approaches address a number of issues that are discussed below.
193
7.2 The starting point for next year's budget
Incremental budgeting – an approach where the budget is based on the current

Key term year's budget (or results) adjusted for estimated growth, inflation, or expected cost
savings.
Zero-based budgeting (ZBB) – an alternative to incremental budgeting. It starts
from the basic premise that next year's budget is zero; every process or item of
expenditure, or intended activity, must be justified in its entirety before it can be
included in the budget.
7.3 How often a budget will be prepared
Periodic budgets – prepared only once for each full budget period (usually one
Key term year) and used throughout that period.
Rolling budgets – also called continuous budgets. Instead of preparing a
periodic budget, budgets would be prepared, say, every 1, 2 or 3 months (4, 6, or
even 12 budgets each year).
Each rolling budget would plan for the next twelve months so that the current budget
is extended by an extra period as the current period ends. Cash budgets are usually
prepared on a rolling basis.
7.4 Who will be involved in preparing the budget
Participative budgeting – participative (or bottom up) budgeting gives all

Key term budget holders the opportunity to participate in setting their own budgets.
Imposed budgeting – imposed (or top down) budgeting involves budgets being
set by senior managers without the involvement of the budget holders.
Activity 6: Budget approach comparison

Budge-it Removals Co is considering the approach that it should take to budgeting.
Required
To assist in its decision list the advantages of each approach to budgeting when
compared to its alternative:
(a) Incremental budgeting v ZBB
(b) Periodic v rolling budgets
(c) Participative v imposed budgeting
194
Solution
195
Chapter summary
 Budgeting is a multi-purpose activity.
 A budget might be a forecast, a means of allocating resources, a

yardstick or a target.
 The budget committee is the co-ordinating body in the preparation and
administration of budgets.
 The manager responsible for preparing each budget should ideally be the manager
responsible for carrying out the budget.
 The budget manual is a collection of instructions governing the responsibilities of
persons and the procedures, forms and records relating to the preparation and use
of budgetary data.
 The first task in the budgetary process is to identify the principal budget factor.
This is also known as the key budget factor or limiting budget factor. The
principal budget factor is the factor which limits the activities of an organisation.
 Functional/departmental budgets include budgets for sales, production,
purchases and labour.
 A cash budget is a statement in which estimated future cash receipts and
payments are tabulated in such a way as to show the forecast cash balance of a
business at defined intervals.
 The usefulness of cash budgets is that they enable management to make any
forward planning decisions that may be needed, such as advising their bank
of estimated overdraft requirements or strengthening their credit control procedures
to ensure that customers pay more quickly.
 The master budget provides a consolidation of all the subsidiary budgets and
normally consists of a budgeted statement of profit or loss, budgeted statement of
financial position and a cash budget.
 Because of the monetary amounts involved in capital expenditure, the capital
expenditure budget is one of the principal subsidiary budgets.
 There are several different approaches to budgeting. These include incremental
budgeting, zero-based budgeting, rolling budgeting and participative
budgeting.
196
Keywords
 Budget committee: The co-ordinating body in the preparation and administration
of budgets
 Budget manual: A detailed set of guidelines and information about the budget
process
 Functional budgets: A budget of income and/or expenditure applicable to a
particular function of an organisation
 Imposed: Budgets are set by senior managers without the involvement of the
budget holders
 Incremental: The current year's budget (or results) adjusted for estimated growth,
inflation, or expected cost savings
 Master budget: Budgeted statement of profit or loss, budgeted statement of
financial position and a cash budget
 Participative: A budgeting system in which all budget holders are given the
opportunity to participate in setting their own budgets
 Periodic: A budget which is prepared only once per reporting period
 Principal budget factor: The factor which limits the activities of an organisation
 Rolling: A budget which is continuously updated by adding a further accounting
period when the earlier accounting period has expired
 Zero-based: Every process or item of expenditure, or intended activity, must be
justified in its entirety before it can be included in the budget
197
Activity answers
Activity 1: Material purchases budget

5,000 kg
Workings
Good
Units
Sales 850
Closing inventory requirement 150
Less opening inventory (100)
Production 900
To make 900 good units, need to produce 1,000 units.

1,000 units produced, 90% good = 900 good units
 1,000  5 kg = 5,000 kg of materials are needed
No inventories of raw materials are held
 5,000 kg need to be purchased
Activity 2: Functional budgets

(a) Sponge 2,400 units
Cream 1,200 units
Sales revenue $600,000
(b) Sponge 2,160 units
Cream 1,080 units
(c) Flour 21,440 kg cost $10,720
Milk 17,980 pints cost $12,586
(d) $86,400
Workings
(a) SALES BUDGET
Sponge Cream Total
Sales (number of batches) 2,400 1,200 3,600
Selling price per batch $150 $200
Revenue $360,000 $240,000 $600,000
198
(b) PRODUCTION BUDGET

Sponge Cream
Sales 2,400 1,200
Closing inventory (10% X8 Sales) 240 120
2,640 1,320
Opening inventory (480) (240)
Production 2,160 1,080
(c) MATERIALS USAGE

Sponge Cream Total
Flour – (prod'n  5, 7 kg) 10,800 7,560 18,360
Milk – (prod'n  4, 6 pints) 8,640 6,480 15,120
MATERIALS PURCHASES
Flour Milk Total
Kg Pints
Usage 18,360 15,120
Closing inventory (W1) 4,080 (W2) 3,360
22,440 18,480
Opening inventory (1,000) (500)
Purchases 21,440 17,980
Cost per kg, pint $0.50 $0.70
Purchases $10,720 $12,586 $23,306
(d) LABOUR UTILISATION BUDGET

Mixers Cooks Total
Hours Hours Hours
Sponge (2,160 units  0.5, 0.5 hrs/unit) 1,080 1,080 2,160
Cream (1,080 units  0.75, 0.5 hrs/unit) 810 540 1,350
1,890 1,620 3,510
Hourly rate $20 $30
Total cost $37,800 $48,600 $86,400
(W1) Closing inventory of flour = sufficient for 20% of 20X8's demand

= [(2,400  5 kg) + (1,200  7 kg)]  20%
= 4,080 kg
(W2) Closing inventory of milk = sufficient for 20% of 20X8's demand
= [(2,400  4 pints) + (1,200  6 pints)]  20%
= 3,360 pints
199
Activity 3: Cash budget items
Any item that is a cash flow will be included. Non-cash items are excluded from a
cash budget.
Include Do not
include
Funds from the receipt of a bank loan 
Revaluation of a non-current asset 
Receipt of dividends from outside the business 
Depreciation of distribution vehicles 
Bad debts written off 
Share dividend paid 
No cash has been paid or received for the revaluation of the asset, depreciation of
vehicles or the writing off of bad debts.
Activity 4: Customer receipts

January February March
$ $ $
Sales 10,000 12,000 15,000
Cash sales
(Sales × 40%) 4,000 4,800 6,000
Credit sales
Pay in same 1,425 1,710 2,138
month
(Sales × 60% × 25% ×
95%)
4,500 4,500 5,400
Pay in next
month*
Cash receipts 9,925 11,010 13,538
* Previous month's sales × 60% × 75%
Activity 5: Dealing with cash surplus or shortfall

(a) Pay suppliers early to obtain discount
Attempt to increase sales by increasing receivables and inventory
Make short- or long-term investments
200
(b) Increasing accounts payable

Reducing receivables
Arranging an overdraft or short-term loan for short-term shortages
Arranging long-term loans or issue shares to finance long-term shortages
Activity 6: Budget approach comparison

Advantages of:
Incremental budgeting
 Easy, quick and cheap
Zero-based budgeting
 Necessitates close examination of organisation's operations
 Can identify and remove inefficient or obsolete operations
 Results in a more efficient allocation of resources
Periodic budgets
 Easy, quick and cheap
 Managers have a clear target for the year
Rolling budgets
 Forces managers to regularly reassess the budget
 Planning and control will be based on a more recent plan
 The budget always extends for some time into the future
Participative budgeting
 Budgets are based on more accurate information
 Budget holder's motivation is likely to be higher
Imposed budgeting
 Quicker
 Senior managers have a better overall view of organisational resources
 Senior managers may be more skilled in producing budgets
 Budget holders will not be able to submit budgets that are easy to achieve
(we refer to this as introducing 'budgetary slack')
201
Test your learning
1 Budgets have a number of purposes. Fill in the key words which are missing from
the statements below.
(a) To ……………… the activities of different departments towards a single plan
(b) To ……………… targets to managers responsible for achieving them
(c) To establish a system of …………………….... by comparing budgeted and
actual results
(d) To compel ………………….
2 Which of the following is unlikely to be contained within a budget manual?
A Organisational structures
B Objectives of the budgetary process
C Selling overhead budget
D Administrative details of budget preparation
3 The factor which limits the activities of an organisation is known as:
I The key budget factor
II The limiting budget factor
III The principal budget factor
IV The main budget factor
A I, II and IV
B I and III
C II and III
D I, II and III
4 If the principal budget factor is sales demand, in which order would the following
budgets be prepared?
Materials Materials Production Sales Cash

usage purchase
1st
2nd
3rd
4th
5th
5 Match the following cash positions with the appropriate management action.
Short-term surplus Increase payables
Long-term surplus Replace/update non-current assets
Short-term shortfall ? Issue share capital
Long-term shortfall Increase receivables and inventory
202
6 Depreciation has an effect on net profit and is therefore included in a cash budget.
True
False
7 Which of the following are included in the master budget?
I Budgeted statement of profit or loss
II Budgeted statement of financial position
III Budgeted cash flow
IV Functional budgets
A I, II and III
B II and III
C II, III and IV
D IV only
8 The following information is available for Biscuit Co.
Jan Feb
$ $
Budgeted sales 60,000 80,000
Gross profit as a percentage of sales 40% 40%
Closing trade payables as a percentage of
cost of sales 50% 50%
Opening inventory nil nil
Closing inventory nil nil
Note that all cost of sales are paid for on credit.
How much money should be budgeted for supplier payments in February?
A $10,500 C $24,500
B $14,000 D $42,000
9 Jay Co produces a product called the Bee. There has been a surge in Bee sales as a
result of an advertising campaign and so Jay Co is paying its staff overtime to build
up the inventory levels.
Labour hours per unit 3
Basic wage rate per hour $20
Overtime premium 25%
Normal number of labour hours per month 340,000 hours
Jay Co expects sales of 100,000 units in September and wants to have closing
inventory at the end of September of 20,000 units. There will be no opening
inventory on 1 September.
Calculate the budgeted labour cost. $
10 Fill in the blanks.
When preparing a production budget, the quantity to be produced is equal to sales
………… opening inventory ………. closing inventory.
203
204
Variance analysis
Learning outcomes

• Calculate variances for materials, labour, variable overhead, sales prices and sales volumes.
• Prepare a statement that reconciles budgeted contribution with actual contribution.
• Explain why variances could have arisen and the inter-relationships between variances
Chapter context
This chapter looks at a system that organisations can use to analyse the reasons for differences
between what they planned to happen (using budgets and standards) and what actually happened.
This is important, because as management accountants we will be expected to be able to answer the
question 'why didn't we make the return that we were expecting?'. In BA2 we will be focusing on
contribution and will therefore not need to consider fixed costs.
205
Chapter overview
Variance analysis
Traditional variance
analysis
Original budget Flexed budget Actual results

(covered in detail in
Chapter 9)
 Set before start of  Adjust for actual

period production/sales
 Based on volumes
estimated/budgeted  Enables 'like for like'
production and sales comparison with actuals
volumes  More meaningful
variance analysis
Variances
Basic variance Interpretation Backward

calculations of variances variances
'Should' v 'did'  Causes

 Sales  Interdependencies
 Materials
 Labour
 Variable
overheads
206
11: Variance analysis
1 Traditional variance analysis

Variances – measure the difference between actual results and expected results.
Key term The process by which the total difference between standard and actual results is
analysed is known as variance analysis.
Overview
Original Flexed
budget budget Actual results
Sales volume X X X
$ $ $
Sales revenue X X Sales variance X
Cost of sales:
Materials X X Material variance X
Labour X X Labour variance X
Overheads X X O'head variance X
Profit X X X
Budgeted units Actual units × Actual units ×
× standard standard cost actual cost or
cost or selling or selling selling price
price per unit price per unit per unit
Variances can be either favourable (F) ie better than expected or adverse (A)
Key term ie worse.
2 Basic variances
2.1 Sales
Formula to learn
Price: based on actual units sold – what revenue was achieved? What revenue
should have been achieved?
$
'Should' Actual sales should sell for (Act units  std $ per unit) X
'Did' Actual sales did sell for (X)
X
207
Volume: difference between budgeted and actual sales volume. Value at standard
contribution per unit.
Units
'Should' Budgeted sales X
'Did' Actual sales (X)
X
Difference valued at standard contribution $X
2.2 Materials
Formula to learn
Total: based on actual production – what did it cost? What should it have cost?
$
'Should' Actual units should cost (Act units  std kg per unit  std $ per kg) X
'Did' Actual material used did cost (X)
X
Price: based on actual purchases – what did they cost? What should they have
cost?
$
'Should' Actual purchases should cost (Act kg  std $ per kg) X
'Did' Actual purchases did cost (X)
X
Usage: based on actual production – what did it use? What should it have
used? Difference valued at standard cost.
Kg
'Should' Actual production should use (Act units  std kg per unit) X
'Did' Actual production did use (X)
X
Difference valued at standard cost $X
2.3 Labour
Formula to learn
$
'Should' Actual units should cost (Act units  std hrs per unit  X
std $ per hour)
'Did' Actual labour used did cost (X)
X
208
Rate: based on hours paid – What did they cost? What should they have cost?
$
'Should' Actual hours paid should cost (Act hrs paid  std $ per hour) X
'Did' Actual hours paid did cost (X)
X
Idle time: difference between hours paid and worked. Value at std rate per hour.
Hrs
'Should' Hours paid for X
'Did' Hours worked (X)
X
Difference valued at standard rate per hour $X
Efficiency: based on actual production – how long did it take? How long should
it have taken*? Difference valued at standard rate per hour.
Hrs
'Should' Actual production should take (Act units  std hrs per unit) X
'Did' Actual production did take (hours worked) (X)
X
Difference valued at standard rate per hour $X
* The standard time allowed for the actual production is sometimes referred to as
standard hours.
2.4 Variable overheads
Formula to learn
$
'Should' Actual units should cost X
'Did' Actual variable overheads did cost (X)
X
Expenditure: based on actual hours worked – what did they cost? What should
they have cost?
$
'Should' Actual hours paid should cost (Act hrs paid  std OAR X
$ per hour)
'Did' Actual hours paid did cost (X)
X
209
Efficiency: based on actual production – how long did it take? How long should
it have taken? Difference valued at standard rate per hour.
Hrs
'Should' Actual production should take X
'Did' Actual production did take (X)
X
Difference valued at standard variable overhead rate per hour $X
Price or rate variance – the difference between the actual and expected price
Key term paid for a unit of materials (price) or labour (rate).
Usage or efficiency variance – the difference between the actual and expected
resources used in production.
Volume variance – the difference between actual and expected sales levels.
Illustration 1: Variance calculations

Sydney Co manufactures one product, and the entire product is sold as soon as it is
produced. There are no opening or closing inventories and work in progress is
negligible. The company operates a standard costing system and analysis of
variances is made every month. The standard cost card for a product is as follows.
STANDARD COST CARD
$
Direct materials 0.5 kilos at $4 per kilo 2.00
Direct wages 2 hours at $8.00 per hour 16.00
Variable overheads 2 hours at $0.30 per hour 0.60
Standard variable cost 18.60
Standard contribution 13.40
Standing selling price 32.00
Budgeted output for the month of June 20X7 was 5,100 units. Actual results for June
20X7 were as follows.
Production of 4,850 units was sold for $150,350.
Materials consumed in production amounted to 2,300 kg at a total cost of $9,800.
Labour hours paid for amounted to 8,500 hours at a cost of $67,800.
Actual operating hours amounted to 8,000 hours.
Variable overheads amounted to $2,600.
Required
Calculate all variances.
210
Solution
(a) $
2,300 kg of material should cost ( $4) 9,200
but did cost 9,800
Material price variance 600 (A)
(b) 4,850 units should use ( 0.5 kg) 2,425 kg

but did use 2,300 kg
Material usage variance in kg 125 kg (F)
 standard price per kg × $4
Material usage variance in $ $500 (F)
(c) $
8,500 hours of labour should cost ( $8) 68,000
but did cost 67,800
Labour rate variance 200 (F)
(d) 4,850 units should take ( 2 hrs) 9,700 hrs

but did take (active hours) 8,000 hrs
Labour efficiency variance in hours 1,700 hrs (F)
 standard rate per hour × $8
Labour efficiency variance in $ $13,600 (F)
(e) Idle time variance 500 hours (A)  $8 $4,000 (A)
(f) $
8,000 hours incurring variable o/hd expenditure should 2,400
cost ( $0.30)
but did cost 2,600
Variable overhead expenditure variance 200 (A)
(g) Variable overhead efficiency variance in hours is the same

as the labour efficiency variance:
1,700 hours (F)  $0.30 per hour $510 (F)
(h) $
Revenue from 4,850 units should be ( $32) 155,200
but was 150,350
Sales price variance 4,850 (A)
(i)
Budgeted sales volume 5,100 units
Actual sales volume 4,850 units
Sales volume contribution variance in units 250 units (A)
 standard contribution per unit  $13.40
Sales volume contribution variance $3,350 (A)
211
Activity 1: Variance calculations
BUDGET Unit Total
$ $
Sales (8,000 units) 75 600,000
Production (8,700 units)
Materials 4 kg @ $4.50 per kg 18 156,600
Labour 5 hrs @ $5 per hr 25 217,500
Variable overheads 5 hrs @ $2 per hr 10 87,000
53 461,100
Closing inventory (700 units) (37,100)
424,000
Budgeted 176,000
contribution
ACTUAL $
Sales (8,400 units) 613,200
Production (8,900 units)
Materials 34,928 kg (purchased and used) 160,985
Labour 45,400 hours (worked and paid) 224,515
Variable overheads 87,348
472,848
Closing inventory (500 units) (26,500)
446,348
Actual contribution 166,852
212
Required
(a) What is the materials total variance?
(b) What is the materials price variance?
(c) What is the materials usage variance?
(d) What is the labour total variance?
(e) What is the labour rate variance?
(f) What is the labour efficiency variance?
213
(g) What is the variable overhead total variance?
(h) What is the variable overhead expenditure variance?
(i) What is the variable overhead efficiency variance?
(j) What is the sales price variance?
(k) What is the sales volume contribution variance?
214
2.5 Operating statements
Operating statements – show how the combination of variances reconcile

Key term budgeted contribution and actual contribution.
So far, we have considered how variances are calculated without considering how
they combine to reconcile the difference between budgeted contribution and actual
contribution during a period. This reconciliation is usually presented as a report to
senior management at the end of each control period. The report is called an
operating statement or statement of variances.
(a) Budgeted contribution is adjusted by the sales volume variance to
give the budgeted contribution from actual sales.
(b) The sales price variance is then included to give a figure representing the
actual sales revenue minus the standard variable cost of sales.
(c) Cost variances are then taken into account to produce a figure for actual
contribution.
Illustration 2: Operating statement

The operating statement using the data in Illustration 1 would be as follows:
SYDNEY CO – OPERATING STATEMENT JUNE 20X7
$
Budgeted contribution ($13.40  5,100) 68,340
Sales volume variance 3,350 (A)
Budgeted contribution 64,990
from actual sales
Sales price variance 4,850 (A)
Actual sales minus the standard 60,140
variable cost of sales
Cost variances (F) (A)
$ $
Material price 600
Material usage 500
Labour rate 200
Labour efficiency 13,600
Labour idle time 4,000
Variable overhead expenditure 200
Variable overhead efficiency 510
14,810 4,800 10,010 (F)
215
Check $ $
Sales 150,350
Materials 9,800
Labour 67,800
Variable overhead 2,600
80,200
Activity 2: Operating statement

Using the data from Activity 1, complete the following reconciliation.
Budgeted contribution
Sales volume variance
Sales price variance
Cost variances F A
Materials Price
Usage
Labour Rate
Efficiency
Var O/H Expenditure
Efficiency
Actual contribution
3 Interpretation of variances
Care must be taken when interpreting variances, especially when they are being
used to assess the performance of employees.
3.1 Causes of variances

(a) Excessive controllable expenditure, eg incorrect buying decisions
216
(b) Excessive uncontrollable expenditure, eg market price rise of raw materials,

unexpected overtime working
(c) Inaccurate standard due to:
 Poor planning
 Unrealistic standard due to basis used (ideal standard) or incompetence
(d) Inaccurate measurement
The cause of the variance must be determined before appropriate action can be
taken. Employees should only be judged on the factors which they have under their
control.
Variance Favourable Adverse
(a) Material price Unforeseen discounts received Price increase

More care taken in purchasing Careless purchasing
Change in material standard Change in material
standard
(b) Material Material used of higher quality Defective material

usage than standard Excessive waste
More effective use made of Theft
material
Stricter quality control
Errors in allocating material to jobs
Errors in allocating material
to jobs
(c) Labour rate Use of apprentices or other Wage rate increase

workers at a rate of pay lower Use of higher grade labour
than standard
(d) Idle time If idle time is less than budgeted Machine breakdown
idle time Non-availability of material
Illness or injury to worker
(e) Labour Output produced more quickly Lost time in excess of

efficiency than expected because of work standard allowed
motivation, better quality of Output lower than standard
equipment or materials, or better set because of deliberate
methods restriction, lack of training,
Errors in allocating time to jobs or substandard material
used
Errors in allocating time to
jobs
(f) Variable Change in types of overhead or Change in types of

overhead their cost overhead or their cost
expenditure
217
Variance Favourable Adverse
(g) Variable As for labour efficiency (if based As for labour efficiency (if
overhead on labour hours) based on labour hours)
efficiency
3.2 Interdependence of variances

Variances may affect each other
eg
Cheaper materials Favourable price variance
Inferior quality Adverse usage variance

(and labour efficiency?)
In order to interpret variances effectively any interdependence between variances
must be identified. It is not always possible to look at individual variances in
isolation.
When two variances are interdependent one will usually be adverse and the other
favourable.
It is therefore important in analysing an unfavourable variance that the overall
consequence should be considered in order to follow the appropriate control action.
Here are some common examples of interdependent variances:
 Materials price and usage (as above)
 Labour rate and efficiency (higher rates for experience and skill should result in
favourable efficiency variances)
 Sales price and sales volume (reducing the price (adverse sales price variance)
causes higher numbers of units to be sold (favourable sales volume variance))
Activity 3: Interdependence of variances

Hey Co has been let down by its supplier and has had to buy from an alternative
source. The alternative materials are of better quality but are more expensive than
the original supplier's. What effect is this change in supplier likely to have on the
variances at the month end?
(a) Materials price variance Favourable Adverse
(b) Materials usage variance Favourable Adverse
218
4 Backwards variances
Variances can be manipulated so as to derive actual data from standard cost
details, or standard costs from actual results.
Illustration 3: Deriving actual data

The standard marginal cost card for the TR, one of the products made by P Co, is as
follows.
$
Direct material 16 kg  $6 per kg 96
Direct labour 6 hours  $12 per hour 72
168
P Co reported the following variances in control period 13 in relation to the TR.

Direct material price: $18,840 favourable
Direct material usage: $480 adverse
Direct labour rate: $10,598 adverse
Direct labour efficiency: $8,478 favourable
Actual direct wages cost $171,320. P Co paid $5.50 for each kg of direct
material. There were no opening or closing inventories of the material.
Required
Calculate the following.
(a) Actual output
(b) Actual hours worked
(c) Average actual wage rate per hour
(d) Actual number of kilograms purchased and used
Solution
(a) $
Total direct wages cost 171,320
Adjust for variances:
labour rate (10,598)
labour efficiency 8,478
Standard direct wages cost 169,200
 Actual output = Total standard cost  unit standard cost

= $169,200  $72
= 2,350 units
219
(b) $
Total direct wages cost 171,320.0
Less rate variance (10,598.0)
Standard rate for actual hours 160,722.0
 standard rate per hour ÷ $12.0
Actual hours worked 13,393.5 hrs
(c) Average actual wage rate per hour = actual wages/actual hours =
$171,320/13,393.5 = $12.79 per hour.
(d) Number of kg purchased and used = x
$
x kg should have cost ( $6) 6.0x
but did cost ( $5.50) 5.5x
Direct material price variance 0.5x
 $0.5x = $18,840
 x = 37,680 kg
Activity 4: Backwards variance

Purchases of 6,850 kg of materials cost $21,920.
The materials price variance is $1,370(F).
Required
What is the standard price per kg?
Solution
220
Chapter summary
 Variances measure the difference between actual results and expected results. The
process by which the total difference between standard and actual results is
analysed is known as variance analysis.
 The direct material total variance (the difference between what the output
actually cost and what it should have cost, in terms of material) can be divided into
the direct material price variance and the direct material usage
variance.
 The direct labour total variance (the difference between what the output should
have cost and what it did cost, in terms of labour) can be divided into the direct
labour rate variance and the direct labour efficiency variance.
 If idle time arises, it is usual to calculate a separate idle time variance, and to
base the calculation of the efficiency variance on active hours (when labour
actually worked) only.
 The variable overhead total variance can be subdivided into the variable
overhead expenditure variance and the variable overhead efficiency
variance (based on active hours).
 There are a wide range of reasons for the occurrence of adverse and favourable
cost variances.
 The sales price variance is a measure of the effect on expected contribution of a
different selling price to standard selling price. It is calculated as the difference
between what the sales revenue should have been for the actual quantity sold, and
what it was.
 The sales volume variance in units is the difference between the actual units
sold and the budgeted quantity. This variance in units is usually valued at the
standard contribution per unit.
 Operating statements show how the combination of variances reconcile
budgeted contribution and actual contribution.
 Variances can be manipulated so as to derive actual data from standard cost
details.
 When two variances are interdependent (interrelated) one will usually be
adverse and the other favourable.
221
Keywords
 Adverse: The variance has led to lower contribution than expected
 Favourable: The variance has led to better contribution than expected
 Idle time: Labour hours paid but not worked
 Operating statement: The reconciliation of actual to budgeted contribution
 Price or rate variances: A difference between the actual and expected price
paid for a unit of materials (price) or labour (rate)
 Usage or efficiency variances: A difference between the actual and expected
resources used in production
 Variance: The difference between a planned, budgeted, or standard cost and the
actual cost incurred. The same comparisons may be made for revenues
 Variance analysis: Evaluation of performance by means of variances
 Volume variance: A difference between actual and expected sales levels
222
Activity answers
Activity 1: Variance calculations

(a) (i) $785 A
(ii) $3,809 A
(iii) $3,024 F
(iv) $2,015 A
(v) $2,485 F
(vi) $4,500 A
(vii) $1,652 F
(viii) $3,452 F
(ix) $1,800 A
(x) $16,800 A
(xi) $8,800 F
Materials
(a) Total variance: based on production
$
8,900 units should cost (@ $18 per unit) 160,200
8,900 units did cost 160,985
785 A
(b) Price variance: based on purchases
$
34,928 kg should cost (@ 4.50 per kg) 157,176
34,928 kg did cost 160,985
3,809 A
(c) Usage variance: based on quantity used
8,900 units should use (@ 4 kg) 35,600 kg

8,900 units did use 34,928 kg
672 kg F
Value at standard cost per kg ($4.50) $3,024 F
223
Labour
(d) Total variance: based on actual production
$
8,900 units should cost (@ $25) 222,500
2,015 A
(e) Rate variance: based on hours paid

$
45,400 hours should cost (@ $5) 227,000
45,400 hours did cost 224,515
2,485 F
(f) Efficiency variance: based on actual production and hours worked
8,900 units should take (@ 5 hours) 44,500 hrs

8,900 units did take 45,400 hrs
900 hrs A
Valued at standard cost per hour ($5) $4,500 A
Variable overheads
(g) Total variance: based on actual production
$
8,900 units should cost (@ $10) 89,000
1,652 F
(h) Expenditure variance: based on actual labour hours
$
45,400 hours should cost (@ $2) 90,800
45,400 hours did cost 87,348
3,452 F
(i) Efficiency variance:
8,900 units should take (@ 5 hours) 44,500 hrs

8,900 units did take 45,400 hrs
900 hrs A
Valued at standard rate per hour ($2) $1,800 A
224
Sales
(j) Price variance: based on actual units sold
$
8,400 units should sell for (@ $75) 630,000
8,400 units did sell for 613,200
16,800 A
(k) Volume variance:
Units
Budgeted sales 8,000
Actual sales 8,400
400 F
Valued at standard contribution per unit ($75–$53) $$8,800 F
Activity 2: Operating statement

Operating statement for period (marginal costing)
$
Budgeted contribution 176,000
Sales volume variance 8,800
Sales price variance (16,800)
168,000
Cost variances F A
Materials Price 3,809
Usage 3,024
Labour Rate 2,485
Efficiency 4,500
Var O/H Expenditure 3,452
Efficiency 1,800
8,961 10,109 (1,148)

Activity 3: Interdependence of variances

Adverse, Favourable
The materials are more expensive which will lead to an adverse price variance.
However, they are better quality, which means that the material usage variance
should be favourable.
225
Activity 4: Backwards variance
$3.40/kg
Workings
If variance is 1,370 F
and actual cost is $21,920
Insert into format:
$
6,850 kg should cost ?
6,850 kg did cost 21,920
1,370 F
 6,850 should cost 21,920 + 1,370 = $23,290
$23,290
= $3.40/kg
6,850
226
Test your learning

1 Subdivide the following variances.
(a) Direct materials cost variance
(b) Direct labour cost variance
(c) Variable production overhead variance

2 Adverse material usage variances might occur for the following reasons.
I Defective material
II Excessive waste
III Theft
IV Unforeseen discounts received
A I
B I and II
C I, II and III
D I, II, III and IV
3 Hat Co makes a product, Kap, which requires material budgeted at 50c per kg.
During June, 6,200 kg were purchased for $3,224 and 6,000 kg were used. There
was no opening inventory at the start of June. Inventory is valued at standard cost.
(a) Calculate the material price variance for June.
A $224 C $244
B $124 D $144
(b) Is the variance favourable or adverse?
Favourable Adverse
4 A regular report for management of actual cost and revenue, usually comparing
actual with budget (and showing variances), is known as:
A Bank statement
B Variance statement
C Budget statement
D Operating statement
5 A favourable sales price variance can result from a combination of a lower than
budgeted sales volume and a higher than standard selling price.
True
False
6 If two variances are interdependent, both must be either favourable or adverse.
True
False
227
7 The sales volume variance considers the difference between ………………… sales
volume and ………………… sales volume.
Fill in the gaps using two of the following words.
 total  budgeted  actual  future
 incremental  estimated  past  confirmed
8 HF Co budgeted to produce 3,000 units of product K in June. The budgeted
materials for product K were 1,500 kg at a cost of $3 per kg. The actual number of
units produced was 2,200 and the material variances were as follows:
Direct material price variance $825(A)
Direct material efficiency variance $1,650(A)
Calculate the actual direct material kg used.
A 550 kg
B 1,100 kg
C 1,650 kg
D 4,950 kg
9 Using the information in question 8, calculate the actual direct material cost for
June.
A $825
B $4,125
C $4,950
D $5,775
228
Job and
batch costing
Learning outcomes

• Explain job and batch costing.
• Prepare appropriate accounts for job and batch costing systems.
Chapter context
Job and batch costing are used where the work done by an organisation consists of separately
identifiable items or groups of items (ie batches). As each cost unit is clearly identifiable, finding the
cost per unit is relatively straightforward.
229
Chapter overview
Job and batch costing
 Job costing – single order contract

 Batch costing – group of units made to order
Valuation of job or batch
Pricing of job or batch
 Mark-up (on costs)

 Margin (of sales price)
230
12: Job and batch costing
1 Job and batch costing

1.1 Job costing
Job – a cost unit which consists of a single order or contract.

Key term
1.2 Features of a job

(a) Work is undertaken according to customer specifications.
(b) Each order is of short duration.
(c) Each order is separately identifiable from all others, ie non-homogenous.
1.3 Specific order costing

Job costing is an example of specific order costing. A customer will approach the
supplier and agree the exact specifications of the work to be done. The estimating
department can then use this information to prepare an estimate of the costs of the
job, onto which a profit margin will be added to produce a quotation. Once this is
agreed, the work will be carried out at an appropriate time.
2 Valuation of job
2.1 Incomplete at year-end date
If the job is incomplete at the year-end date, it is valued at factory cost (if using
absorption costing). Actual costs incurred are recorded on a job cost card (or job
account in computerised systems).
Job cost card – a record of the actual costs incurred on a job (job account if
Key term computerised).
2.2 Complete
After completion the job is charged with administration, selling and distribution
overheads so that the total cost of the job can be ascertained. When delivery is
made to the customer, the costs become a cost of sale.
2.3 Rectification/unexpected costs

Rectification costs are costs incurred to correct substandard work.
(a) If these are unusual occurrences, charge directly to the job
(b) If these are a frequent occurrence, treat as part of production overhead and
absorb across all jobs
A similar principle applies to overtime premiums (ie the extra amount paid per
hour over the standard hourly rate of pay); if they are incurred at the specific
request of the customer (for example to complete a job quickly), they are charged to
that job, otherwise they become part of production overhead.
231
3 Pricing of job
3.1 How is the price calculated?
A desired profit is added to costs to determine a price. This may be calculated by
using a mark-up percentage or a predetermined margin on sales.
Although this is a commonly used form of pricing, it is directly affected by the
method used to determine cost. As you have seen, there are several methods of
obtaining a cost per unit.
Illustration 1: Job costing

Twist and Tern Co is a company that carries out jobbing work. One of the jobs
carried out in February was job 1357, to which the following information relates.
Direct material Y: 400 kilos were issued from stores at a cost of $5 per kilo.
Direct material Z: 800 kilos were issued from stores at a cost of $6 per kilo.
60 kilos were returned.
Department P: 320 labour hours were worked, of which 100 hours were
done in overtime.
Department Q: 200 labour hours were worked, of which 100 hours were
done in overtime.
Overtime work is not normal in Department P, where basic pay is $8 per hour plus
an overtime premium of $2 per hour. Overtime work was done in Department Q in
February because of a request by the customer of another job to complete their job
quickly. Basic pay in Department Q is $10 per hour and overtime premium is $3
per hour.
Overhead is absorbed at the rate of $3 per direct labour hour in both departments.
(a) The direct materials cost of job 1357 is $ .
(b) The direct labour cost of job 1357 is $ .
(c) The full production cost of job 1357 is $ .
Solution
(a) The direct materials cost is $ 6,440

Workings
$
Direct material Y (400 kilos  $5) 2,000
Direct material Z (800 – 60 kilos  $6) 4,440
Total direct material cost 6,440
232
(b) The direct labour cost is $ 4,560

Workings
$
Department P (320 hours  $8) 2,560
Department Q (200 hours  $10) 2,000
Total direct labour cost 4,560
In Department P, overtime premium will be charged to overhead. In
Department Q, overtime premium will be charged to the job of the customer
who asked for overtime to be worked.
(c) The full production cost is $ 12,560

Workings
$
Direct material cost 6,440
Direct labour cost 4,560
Production overhead (520 hours  $3) 1,560
12,560
Activity 1: Job costing

SB Co has been asked to quote for a job. The company aims to make a net profit of
30% on sales. The estimated cost for the job is as follows.
Direct materials 12 kg @ $10 per kg
Direct labour 7 hours @ $7 per hour
Variable production overheads are recovered at the rate of $4 per labour hour.
Fixed production overheads for the company are budgeted to be $106,000 each
year and are recovered on the basis of labour hours. There are 10,600 budgeted
labour hours each year.
Other costs in relation to selling, distribution and administration are recovered at the
rate of $90 per job.
Required
To the nearest $, the company quote for the job should be $
Solution
233
4 Batch costing
Batch – a cost unit which consists of a separate group of units.
Key term
Batch costing – similar to job costing in that each batch of similar articles is
separately identifiable.
The cost per unit manufactured in a batch is the total batch cost divided by the
number of units in the batch. Pricing and valuation principles are similar to those for
job costing.
Activity 2: Batch costing

A printing firm is proposing offering a leaflet advertising service to local traders.
The following costs have been estimated for a batch of 10,000 leaflets.
Setting up machine 6 hours at $10 per hour
Artwork $20 per batch
Paper $1.80 per 100 sheets
Other variable printing materials $15
Direct labour cost 4 hours at $6 per hour
Fixed overheads allocated to this side of the business are $1,000 per annum incurred
at an even rate throughout the year. Overheads are recovered on the basis of orders
received, which are expected to be 2 per week for 50 weeks in the year.
The management requires 25% profit on selling price.
(a) The selling price, to the nearest cent, per thousand leaflets, for quantities of:
(i) 5,000 leaflets is $

(ii) 10,000 leaflets is $
(b) During the latest week, the firm sold 2 batches of 10,000 leaflets and one
batch of 5,000 leaflets. All costs and selling prices were as estimated.
The profit for the week was $
Workings
234
5 Job costing for internal services

Job costing systems may be used to control the costs of internal service
departments, such as the maintenance department. A job costing system enables
the cost of a specific job to be charged to a user department. Therefore instead of
apportioning the total costs of service departments, each job done is charged to the
individual user department.
Internal job costing – where the cost of a specific internal job is charged to a
Key term user department.
An internal job costing system for service departments will have the following
advantages.
(a) Realistic apportionment. The service department costs are borne by those
who incurred them.
(b) Increased responsibility and awareness. User departments appreciate
the true cost of the facilities that they are using and can take decisions
accordingly.
(c) Control of service department costs. It will be possible to measure the
efficiency or inefficiency of the service department by recording the difference
between the standard charges and the actual expenditure.
(d) Budget information. The purpose and cost of service department
expenditure can be separately identified.
235
Chapter summary
 Job costing is the costing method used where work is undertaken to customers'
special requirements and each order is of comparatively short duration.
 The usual method of fixing prices within a jobbing concern is cost plus pricing.
 An internal job costing system can be used for costing the work of service
departments.
 Batch costing is similar to job costing in that each batch of similar articles is
separately identifiable. The cost per unit manufactured in a batch is the total
batch cost divided by the number of units in the batch.
236
Keywords
 Batch: A cost unit which consists of a separate, identifiable group of units
 Batch costing: The costing of a batch, which follows similar principles to job
costing
 Internal job costing: The cost of a specific internal job is charged to a user
department
 Job: A single order or contract, where each order is of a short duration
 Job cost card: A record of the actual costs incurred on a job (job account if
computerised)
237
Activity answers
Activity 1: Job costing

$
Direct materials (12 kg @ $10 per kg) 120
Direct labour (7 hours @ $7 per hour) 49
Variable overheads (7 hours @ $4 per hour) 28
Fixed overheads (7 hours @ $10 per hour (W1) 70
267
Selling, distribution and administration costs 90
Total costs 357 70%
Profit 153 30%
Sales price 510 100%
(W1) OAR per hour = $106,000/10,600 hours = $10/hr
Activity 2: Batch costing

(a) (i) The selling price is $ 266.00
(ii) The selling price is $ 412.00
Workings
Expected orders per annum = 2 orders  50 weeks = 100 orders
$1,000
 Fixed overhead per order = = $10
100
Calculation of price
Batch size: (leaflets) 5,000 10,000
$ $
Setting up machine 60.00 60.00
Artwork 20.00 20.00
Paper 90.00 180.00
Other printing materials 7.50 15.00
Direct labour cost 12.00 24.00
Fixed overhead 10.00 10.00
Total cost 199.50 309.00
Profit 66.50 103.00
Selling price 266.00 412.00
The profit is 25% on selling price ie cost (75) + profit (25) =

selling price (100), and thus profit = 1/3 cost.
238
(b) The profit for the week was $ 282.50

Workings
$ $
Batch profit $66.50  1 66.50
$103.00  2 206.00
272.50
Plus over-absorbed overhead:
Overhead absorbed 3 batches  $10 30.00
Overhead incurred $1,000/50 weeks 20.00
10.00
Profit for the week 282.50
239
Test your learning
1 Which of the following are characteristics of job costing?
I Customer driven production
II Complete production possible within a single accounting period
III Homogeneous products
A I and II only
B I and III only
C II and III only
D III only
2 The cost of a job is $100,000.
(a) If profit is 25% of the job cost, the price of the job = $
(b) If there is a 25% margin, the price of the job = $
3 Job costing would be most appropriate for which of the following businesses?
A A pizza manufacturer
B An architect designing a new school
C A manufacturer of sugar
D A manufacturer of screws
4 What is a batch?
5 How would you calculate the cost per unit of a completed batch?
6 A job cost estimate includes 630 productive labour hours. In addition, it is
anticipated that idle time will be 10% of the total hours paid for the job. The wage
rate is $12 per hour.
What is the total estimated labour cost for the job?
A $6,804
B $7,560
C $8,316
D $8,400
7 A technical writer is to set up her own business. She anticipates working a 40-hour
week and taking four weeks' holiday per year. General expenses of the business
are expected to be $10,000 per year, and she has set herself a target of $40,000
a year salary.
Assuming that only 90% of her time worked will be chargeable to customers, her
charge for each hour of writing (to the nearest cent) should be $ .
240
Performance
measures and
service costing
Learning outcomes

• Explain the need for appropriate performance measures
• Calculate appropriate financial and non-financial performance measures in a variety of contexts
 Prepare reports in a range of organisations
Chapter context
Most of what we have covered so far has been based on manufacturing organisations. This chapter
explores performance measures for these organisations, and then addresses what additional costing
issues there are for organisations whose main activity isn't the provision of tangible goods, and
appropriate performance measures for them.
241
Chapter overview
Performance measures and

service costing
Performance Service
measures organisations
 Relatively low direct materials

 Output difficult to define
Financial Value for

measures money
 Gross profit margin  Economy

 Net profit margin  Efficiency
 ROCE  Effectiveness
 Asset turnover
Cost per unit
Total costs
Cost per unit 
Number of service cost units in the period
Composite cost units
Used by service organisations

(eg cost per kg per km for
excess baggage)
242
13: Performance measures and service costing
1 Performance measurement
One of the main roles of the management accountant is the evaluation of
performance. To assist in this a number of financial performance measures can be
calculated.
Performance measures for profit centres include:
1.1 Gross profit margin

The gross profit margin is calculated as
(gross profit  sales)  100%.
This measure calculates how efficiently a business is using its materials, labour and
production overhead in the production process.
1.2 Net profit margin

The net profit margin is calculated as
(net profit  sales)  100%.
This measure indicates how well an organisation controls all its costs in the
generation of income.
When looking at the performance of investment centres, which have control over the
resources invested as well as income and expense decisions, the following measures
can be used:
1.3 Return on capital employed (ROCE)

Return on capital employed (ROCE) (also called return on investment (ROI)) is
calculated as
(net profit/capital employed)  100%.
This shows how much profit has been generated in relation to the amount of
resources invested.
In an assessment you may not be given the capital employed figure.
Capital employed = non-current assets + investments + currents assets – current
liabilities
1.4 Asset turnover

Asset turnover is calculated as
sales ÷ capital employed.
This measures how efficiently assets are being used to generate income.
Note that ROCE = Net profit margin  Asset turnover
243
Illustration 1: ROCE, asset turnover and net profit margin
A company has the following figures:
$
Sales revenue 540,000
Net profit 50,000
Capital employed 300,000
$50,000
Return on capital employed = × 100 = 16.67%
$300,000
$540,000
Asset turnover = = 1.8
$300,000
$50,000
Net profit margin = × 100 = 9.26%
$540,000
Return on capital employed = Asset turnover × Net profit margin
16.67% = 1.8 × 9.26%
This is an important relationship as it means that any changes in return on capital
employed can be accounted for by changes in the profitability measured by net
profit margin and in the efficiency of the use of the net assets measured by asset
turnover.
Activity 1: Ratio calculations

MPRUV plc's summarised results for the last two years are shown below.
20X1 20X2
$'000 $'000
Sales 40,000 50,000
Gross profit 11,000 15,000
Net profit 6,000 8,000
Capital employed 30,000 40,000
Required
Calculate the ratios shown in Section 1.1–1.4 for both 20X1 and 20X2.
244
Solution
1.5 Residual income

An alternative to the ROCE is residual income. This is calculated as net profit less
a notional interest charge for invested capital.
Activity 2: Residual income

A division with capital employed of $400,000 currently earns a ROCE of 22%. It
can make an additional investment of $50,000 for a five-year life with nil residual
value. The average net profit from this investment would be $12,000. A notional
interest charge amounting to 14% of the amount invested is to be charged to the
division each year.
The residual income of the division after the investment will be:
A $5,000
B $32,000
C $37,000
D $39,000
Solution
245
2 Service industry costing
2.1 Service organisations
Service
organisations
Profit seeking Non profit making

organisations
eg accountancy firms, law firms, eg hospitals, schools and libraries
management consultancies,
transport companies, banks
and hotels
Service organisations do not make or sell tangible goods.

Service costing differs from product costing methods for a number of reasons.
(a) With many services, the cost of direct materials consumed will be
relatively small compared to the labour, direct expenses and overheads
cost. In product costing the direct materials are often a greater proportion
of the total cost.
(b) The output of most service organisations is difficult to define and hence a
unit cost is difficult to calculate.
(c) The service industry includes such a wide range of organisations which
provide such different services and have such different cost structures that
costing will vary considerably from one to another.
2.2 Characteristics of services
Specific characteristics of services

Key term
 Intangibility – a service usually has no physical substance
 Simultaneity – a service is consumed at the same time as it is produced
 Perishability – something that cannot be stored or worked on over time
 Heterogeneity – services generally vary between customers more than goods

Make sure you learn the four specific characteristics of services. This will help you
identify organisations that might use service costing.
246
Illustration 2: Characteristics of services

Consider the service of providing a haircut.
(a) A haircut is intangible in itself, and the performance of the service comprises
many other intangible factors, like the music in the salon, the personality of the
hairdresser, the quality of the coffee.
(b) The production and consumption of a haircut are simultaneous, and therefore
it cannot be inspected for quality in advance, nor can it be returned if it is not
what was required.
(c) Haircuts are perishable; that is, they cannot be stored. You cannot buy them
in bulk, and the hairdresser cannot do them in advance and keep them stocked
away in case of heavy demand. The incidence of work in progress in service
organisations is less frequent than in other types of organisation.
(d) A haircut is heterogeneous and so the exact service received will vary each
time: not only will two hairdressers cut hair differently, but a hairdresser will not
consistently deliver the same standard of haircut.
3 Charging customers for services

3.1 Price determination
The procedure for charging customers for services is similar to that which applies in
job costing (see previous chapter). A mark-up will be added to the cost per unit to
give a selling price which will provide the required level of profit.
3.2 Determining the cost unit

The choice of the cost unit by the organisation is important to ensure that an
equitable charge is made to the users of the service.
4 Cost per unit

Total costs for a period
Cost per unit =
Number of service cost units in the period
But what is a
Service companies often
service cost unit?
use composite cost units
247
5 Composite cost units
Composite cost unit – a cost unit that is used when a 'single' cost unit would not
Key term be appropriate (as more than one factor influences cost).
Organisations in the service industry often use composite cost units to analyse
and monitor their costs, particularly when a 'single' cost unit would not
be appropriate. As an example, an airline may base a charge for paying for
excess baggage on:
(a) How far in km the baggage will be transported
(b) The weight of the baggage
Both of these will have an impact on the airline's fuel cost so it would
be inappropriate to base the charge on km or weight alone.
An appropriate composite cost unit would therefore be $X per kg per km.
Activity 3: Composite cost units

Required
Suggest composite cost units that could be used by companies operating in the
following service industries.
Service Cost unit
Road, rail and air transport services
Hotels
Bildung
Hospitals
Activity 4: Using composite cost units

Carry Co operates a small fleet of delivery vehicles. Expected costs are as follows.
Loading 1 hour per tonne loaded
Loading costs:
Labour (casual) $2 per hour
Equipment depreciation $80 per week
Supervision $80 per week
Drivers' wages (fixed) $100 per man per week
Petrol 10c per kilometre
Repairs 5c per kilometre
Depreciation $80 per week per vehicle
Supervision $120 per week
Other general expenses (fixed) $200 per week
248
There are two drivers and two vehicles in the fleet.

During a slack week, only six journeys were made.
Tonnes carried (one
Journey way) One-way distance of journey
Kilometres
1 5 100
2 8 20
3 2 60
4 4 50
5 6 200
6 5 300
The expected average full cost per tonne-kilometre for the week is $ .
6 Value for money

Many organisations are run on a not-for-profit basis. In this case the performance
measures in the previous section are less valid. It is more important to assess
whether the organisation is getting good value for money by measuring
economy, efficiency, and effectiveness.
Value for money – Getting the best possible combination of services from the
Key term least resources
Economy – purchase of inputs of appropriate quality at minimum cost.
Efficiency – use of these inputs to maximise output.
Effectiveness – use of these inputs to achieve organisation's goals (quality, speed
of response).
These are sometimes known as the 3Es.
Activity 5: Value for money measures

Birmington University is a public sector (state owned) higher education institution
with 27,000 students, 500 staff and an annual budget of $243m.
Required
Identify possible performance measures for Birmington University that would give an
indication of its economy, efficiency and effectiveness.
Solution
249
7 Non-financial performance indicators (NFPIs)
7.1 Definition
NFPIs – measures of performance based on non-financial information which

Key term operating departments use to monitor and control their activities.
7.2 Examples
Examples of non-financial performance indicators (NFPIs) are summarised in the
table below.
Area assessed Performance measures
Service quality Number of complaints

Proportion of repeat bookings
On-time deliveries
Customer waiting time
Personnel Staff turnover

Days lost through absenteeism
Days lost through accidents/sickness
Training time per employee
Different industries will place a different weighting on each area depending on

those most critical to their success.
7.3 Value of NFPIs

(a) Information can be provided quickly for managers (eg per shift, daily or
hourly) unlike traditional financial performance reports.
(b) Anything can be measured/compared if it is meaningful to do so.
(c) They are easy to calculate and easier for non-financial managers to
understand and use effectively.
(d) They are less likely to be manipulated than traditional profit-related
measures.
(e) They can be quantitative or qualitative.
(f) They provide information about key areas such as quality and customer
satisfaction.
(g) They are a better indicator of future prospects than financial indicators
which focus on the short term.
250
7.4 Problems with NFPIs

(a) Too many measures can lead to information overload for managers,
providing information which is not truly useful.
(b) They may lead managers to pursue detailed operational goals at the
expense of overall corporate strategy.
(c) They need to be linked with financial measures.
(d) They need to be developed and refined over time to ensure they remain
relevant.
8 The balanced scorecard

8.1 Introduction
A popular approach in current management thinking to performance measurement
(for service and non-service organisations) is the use of what is called a 'balanced
scorecard', consisting of a variety of indicators both financial and non-financial.
8.2 Balanced scorecard perspectives and measures

The balanced scorecard focuses on four different perspectives and aims to establish
goals for each, together with measures which can be used to evaluate whether these
goals have been achieved.
251
How do we create value for our shareholders?
Financial
perspective
Goals Measures
How do What
customers must we
see us? excel at?
Customer Internal business

perspective perspective
Goals Measures Goals Measures
Innovation and
learning
perspective
Goals Measures
Can we continue to
improve and create value?
8.3 Features
(a) Traditional measures are mainly inward looking and narrow in focus, with
overemphasis on financial measures and short-term goals.
(b) The balanced scorecard focuses on both internal and external factors and links
performance measures to key elements of a company's strategy.
(c) It requires a balanced consideration of both financial and non-financial
measures and goals to prevent improvements being made in one area at the
expense of another.
252
(d) It attempts to identify the needs and concerns of customers in order to identify
new products and markets and focuses on comparison with competitors to
establish best practice.
Financial perspective – performance measures determining whether the business

Key term has achieved value for shareholders.
Innovation and learning perspective – measures to evaluate the business's
capacity to maintain its competitive position through the acquisition of new skills
and the development of new products.
Internal business perspective – aims to improve internal processes and
decision making.
Customer perspective – performance measures that matter to customers.
Activity 6: Balanced scorecard measures

The following statements have been made about the use of the balanced scorecard:
(1) % of customers ordering a dessert could be used as a measure of customer
satisfaction for a restaurant
(2) % of revenue from meals sold from the specials board could be used as a
measure of innovation for a restaurant
Which of the above statements is/are true?
A (1) only
B (2) only
C Neither (1) nor (2)
D Both (1) and (2)
Solution
253
Chapter summary
 Ratios and percentages are useful financial performance measurement

techniques.
 The profit margin (profit to sales ratio) is calculated as (profit  sales)  100%.
 The gross profit margin is calculated as gross profit  sales  100%.
 Return on capital employed (ROCE) or return on investment (ROI)
shows how much profit has been made in relation to the amount of resources
invested.
 Residual income (RI) is an alternative way of measuring the performance of an
investment centre. It is a measure of the centre's profits after deducing a notional or
imputed interest cost.
 Asset turnover measures how efficiently the assets of the business are being
used.
 Service organisations do not make or sell tangible goods.
 Specific characteristics of services
– Intangibility
– Simultaneity
– Perishability
– Heterogeneity
 One main problem with service costing is being able to define a realistic cost
unit that represents a suitable measure of the service provided. If the service is a
function of two activity variables, a composite cost unit may be more
appropriate.
Total costs incurred in the period
 Average cost per unit of service =
Number of service units supplied in the period
 The success of not-for-profit organisations cannot be judged in terms of

profitability, nor against competition.
 Value for money is getting the best possible combination of services from the
least resources.
 Many businesses will use a mixture of financial and non-financial performance
measures (NFPIs) to analyse the performance of the business.
 The balanced scorecard is an approach that measures performance from four
perspectives: financial, innovation and learning, internal business, and
customer.
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Keywords
 Composite cost unit: A cost unit that is used when a 'single' cost unit would not
be appropriate (as more than one factor influences cost)
 Customer perspective: Performance measures that matter to customers
 Economy: Attaining the appropriate quantity and quality of inputs at the lowest
cost to achieve a certain level of output
 Effectiveness: The extent to which declared objectives/goals are met
 Efficiency: The relationship between inputs and outputs
 Financial perspective: Performance measures determining whether the business
has achieved value for shareholders
 Heterogeneity: Services generally vary between customers more than goods
 Innovation and learning perspective: Measures to evaluate the business's
capacity to maintain its competitive position through the acquisition of new skills
and the development of new products
 Intangibility: A service usually has no physical substance
 Internal business perspective: Aims to improve internal processes and
decision making
 Non-financial performance indicators (NFPIs): Measures of performance
based on non-financial information which operating departments use to monitor and
control their activities
 Perishability: Something that cannot be stored or worked on over time
 Simultaneity: A service is consumed at the same time as it is produced
 Value for money: Getting the best possible combination of services from the
least resources
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Activity answers
Activity 1: Ratio calculations

20X1 20X2
Gross profit margin 11,000/40,000 = 27.5% 15,000/50,000 = 30.0%
Net profit margin 6,000/40,000 = 15.0% 8,000/50,000 = 16.0%
ROCE 6,000/30,000 = 20.0% 8,000/40,000 = 20.0%
Asset turnover 40,000/30,000 = 1.33 50,000/40,000 = 1.25
Activity 2: Residual income

C $
Divisional profit after investment ((400,000  22%) + 12,000)) 100,000
Notional interest (450,000  0.14) (63,000)
Residual income 37,000
Activity 3: Composite cost units

Service Cost unit
Road, rail and air transport Passenger/mile or tonne
Hotel Per person per night
Education Per student per college day
(to allow for different course lengths)
Hospitals Patient/day
Activity 4: Using composite cost units

The expected average full cost per tonne-kilometre for the week is $ 0.304 .
Workings
Variable costs
Journey 1 2 3 4 5 6
$ $ $ $ $ $
Loading labour 10 16 4 8 12 10
Petrol (both ways) 20 4 12 10 40 60
Repairs (both ways) 10 2 6 5 20 30
40 22 22 23 72 100
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Total costs
$
Variable costs (total for journeys 1 to 6) 279
Loading equipment depreciation 80
Loading supervision 80
Drivers' wages 200
Vehicles depreciation 160
Drivers' supervision 120
Other costs 200
1,119
Journey One-way distance
Tonnes Kilometres Tonne-kilometres
1 5 100 500
2 8 20 160
3 2 60 120
4 4 50 200
5 6 200 1,200
6 5 300 1,500
3,680
Activity 5: Value for money measures

Economy – The average salary for a lecturer, the cost of running the building per
2
m per month
Efficiency – Students per lecturer, students per class
Effectiveness – Pass rates, drop-out rates, percentage of graduates employed
within six months of graduation
Activity 6: Balanced scorecard measures

D Both of these measures would be suitable for a restaurant and it should be
possible to get the required information.
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Test your learning
1 What is the main aim of performance measurement?
A To obtain evidence in order to dismiss someone
B To establish how well something or somebody is doing in relation to a planned
activity
C To collect information on costs
D To award bonuses
2 Place the correct letters in the boxes.
ROCE =  100% Profit margin =  100%
A Profit
B Capital employed
C Sales
3 Which one of the following is the correct formula for asset turnover?
A Sales  capital employed
B Net profit  sales
C Capital employed  sales
D Sales  net profit
4 With many services the cost of direct materials will be relatively high.
True
False
5 Match up the following services with their typical cost units.
Service Cost unit
Hotels Patient/day
Education Meal served
?
Hospitals Full-time student
Catering organisations Occupied bed-night
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6 What are the specific characteristics of services?

I Intangibility
II Heterogeneity
III Perishability
IV Consistency
V Regularity
VI Simultaneity
A I, III, V and VI
B II, III, IV and V
C I, II, III and VI
D II, IV, V and VI
...........................
7 Average cost per unit of service =
...........................
8 Which two of the following might be characteristics of a hospital?
Use of composite cost units
High materials costs
High levels of indirect costs as a proportion of total cost
Calculation of profit per patient
9 Which of the following are characteristics of service costing?
High levels of indirect costs as a proportion of total cost
Cost units are often intangible
Use of composite cost units
Use of equivalent units
10 Which of the following would be suitable cost units for a hospital?
Patient/day
Operating theatre hour
Ward
X-ray department
Outpatient visit
259
260
Cost bookkeeping
Learning outcomes

• Explain the integration of the cost accounts with the financial accounting system.
• Prepare a set of integrated accounts, showing standard cost variances.
Chapter context
In earlier chapters we looked at how the cost of what we produce is calculated and the calculation of
variances by comparing these costs with standards. This chapter looks at how these figures are
actually entered into a costing system. This involves using double entry bookkeeping that is covered
more extensively in Paper BA3, but if you haven't studied for this subject yet there is a basic
approach that is sufficient for BA2.
261
Chapter overview
Cost bookkeeping
Integrated system
One set of accounts for cost and

financial accounting purposes
Preparing cost accounts

using absorption costing
Track costs of production from

procurement of resources through
to sale of finished goods
X X
As production
progresses, costs
flow through the
t-accounts…
262
14: Cost bookkeeping
1 Recording costs
Whatever costing system is used, costs must be recorded for use in financial and
management accounting.
Manufacturing businesses need details about inventories of raw materials, work in
progress (WIP) and finished goods on an ongoing basis.
2 Integrated system
An integrated system has one set of accounts in which all transactions are
Key term recorded. The same system provides financial accounting and costing information.
This compares with an interlocking system where one system is used for the
financial accounting function and a completely separate system is used for
cost/management accounting.
2.1 Integrated v non-integrated systems

Advantages of integrated systems:
(a) Saves administrative effort and expense
(b) Less confusing
Disadvantages of integrated systems:
(a) One set of books fulfils two purposes (may conflict eg inventory valuations)
(b) More detailed analysis of costs required
3 Cost bookkeeping – general approach

Bookkeeping – the process of entering transactions in the books of the business,
Key term by creating equal debit and credit entries in separate ledger accounts.
A standard manufacturing process will begin with the procurement of raw materials.
Labour will be employed and paid for and production overheads will be incurred in
turning the raw materials into finished goods. The finished goods will be stored in a
warehouse before being sold.
For each individual stage of this process, entries will be made into a cost
bookkeeping system. The nature of the accounting entry will often mirror the
physical 'transactions' that take place in the production environment.
3.1 The principal accounts in a system of integrated

accounts
(a) The resources accounts
(i) Materials control account or stores control account
(ii) Wages (and salaries) control account
(iii) Production overhead control account
(iv) Administration overhead control account
(v) Selling and distribution overhead control account
263
(b) Accounts which record the cost of production items from the start
of production work through to cost of sales
(i) Work in progress control account
(ii) Finished goods control account
(iii) Cost of sales control account
(c) Sales account
(d) Statement of profit or loss
In general, to correctly identify each double entry, two stages are required:
(1) Identify the two t-accounts that will be affected by the transaction
(2) Establish the debit (DR) entry and the credit (CR) entry
Note. If you are not yet familiar with debits and credits, a rule of thumb you may
find useful is 'out on the right, in on the left', as this approach will be correct for all
of the 'cost transactions'.
Activity 1: Double entry example

Raw materials valued at $1,500 are transferred from the material stores to the
factory.
Required
Show the t-accounts and double entry required to account for this transaction.
Solution
4 Accounting for materials

Although a company can choose to structure its internal cost accounts in any way it
chooses, there are several types of transactions that will always be accounted for in
the same way.
4.1 Raw materials procurement

Raw materials need to be procured. This will be done either on credit or by paying
cash. The double entry to record this would be as follows:
On credit: DR Raw materials CR Trade payables
Pay cash: DR Raw materials CR Cash
264
Either way, as the materials are procured, they are shown in the raw materials
account on the left-hand side (ie as they 'come into the stores').
4.2 Raw materials issued

When they are needed, the materials will be transferred out of the stores. How this
is treated in the cost accounts depends on whether the materials are direct or
indirect. Direct material costs will form part of the direct cost per unit. Indirect
materials will form part of the overall production overheads (ie to be absorbed
separately in an absorption costing system).
Direct: DR WIP/Production CR Raw materials
Indirect: DR Production overheads CR Raw materials
Note that either way, as the materials are used, they are shown in the raw materials
account on the right-hand side (ie as they 'go out of the stores').
Activity 2: Raw materials issued

Raw materials worth $6,500 are purchased on credit in a period. In the same
period, $5,000 of raw materials are issued to production, and $1,500 are issued
to the maintenance department.
Required
Show the t-accounts and double entries required to account for these transactions in
a cost bookkeeping system.
Solution
5 Accounting for labour

Cost bookkeeping for labour follows exactly the same principles as accounting for
material (since it is just another resource used to make finished products). However,
it is complicated by the different elements that make up an employee's wages (eg
NI (social security) and income tax deductions), and the different types of labour
cost that can be incurred (eg overtime and bonuses).
265
5.1 Paying for labour
The cost bookkeeping entries relating to the payment of wages need to account for
the various deductions associated with an employee's net pay.
The gross wage will include the following items, and there will be a double entry for
each:
Net pay DR Wages control CR Cash
PAYE (Pay As You Earn DR Wages control CR PAYE control
income tax)
National Insurance DR Wages control CR NI control
(Employee's)
It is important to realise that the end result of this is that the gross cost of wages has
been debited to the wages control account.
Wages control account – a 'collecting place' for net wages paid and
Key term deductions made from gross pay.
Note. There is an additional labour cost to the company – Employer's NI

contributions. This is paid by the company directly to the tax authorities.
Illustration 1: The wages control account

The following details were extracted from a weekly payroll for 750 employees at a
factory.
Direct Indirect
workers workers Total
Analysis of gross pay: $ $ $
Ordinary time 36,000 22,000 58,000
Overtime: basic wage 8,700 5,430 14,130
premium 4,350 2,715 7,065
Shift allowance 3,465 1,830 5,295
Sick pay 950 500 1,450
Idle time 3,200 – 3,200
56,665 32,475 89,140
Net wages paid to employees 45,605 24,220 69,825
Required
Prepare the wages control account for the week.
Solution
(a) The wages control account acts as a sort of 'collecting place' for net wages
paid and deductions made from gross pay. The gross pay is then analysed
between direct and indirect wages.
266
(b) The first step is to determine which wage costs are direct and which are
indirect. The direct wages will be debited to the WIP account and the indirect
wages will be debited to the production overhead account.
(c) There are in fact only two items of direct wages cost in this example – the
ordinary time ($36,000) and the basic overtime wage ($8,700) paid to direct
workers. All other payments (including the overtime premium) are indirect
wages.
(d) The net wages paid are debited to the control account, and the balance then
represents the deductions which have been made for income tax, national
insurance, and so on.
WAGES CONTROL ACCOUNT
$ $
Bank: net wages paid 69,825 Work in progress – direct 44,700
labour
Deductions control accounts* Production overhead control:
($89,140 – $69,825) 19,315 Indirect labour 27,430
Overtime premium 7,065
Shift allowance 5,295
Sick pay 1,450
Idle time 3,200
89,140 89,140
* In practice there would be a separate deductions control account for each type of
deduction made (such as income tax, National Insurance).
Activity 3: Wages control account

In April, the total gross pay to the manufacturing workforce was $55,000. PAYE
deductions were $20,000 and employees' NI contributions were $5,000.
Required
Calculate the net pay in the period and show the t-accounts required to account for
these transactions in a cost bookkeeping system.
Solution
267
5.2 Incurring labour costs in production
At the end of each period, the gross wages incurred need to be related to the work
done by the employees. This will depend on whether their work should be treated as
direct or indirect labour. Total gross wages will be split into two and transferred to
one of two accounts – WIP account for the direct labour element and production
overheads account for indirect labour. (This is the same principle as for direct and
indirect materials.)
There are some general rules as to how split labour costs:
Direct workers Indirect workers

Normal basic pay Direct cost Indirect cost
General production: Direct cost Indirect cost
Overtime – Basic pay
element
General production: Indirect cost Indirect cost
Overtime – O/T premium
General non-production: Indirect cost Indirect cost
Overtime – Basic pay
element
General non-production: Indirect cost Indirect cost
Overtime – O/T premium
Idle time Indirect cost Indirect cost
5.3 Special rule

In certain circumstances, production may be carried out at the specific request of
a customer. If this results in overtime premiums being paid, or bonuses being
paid, then these 'extra' labour costs should be treated as direct costs because they
can be identified with specific production units.
5.4 Bookkeeping entries

When the nature of the labour cost has been identified the cost bookkeeping entries
will be as follows:
Direct labour: DR WIP/Production CR Wages
Indirect labour: DR Production overheads CR Wages
Activity 4: Clearing the wages control account

(Continued from Activity 3 – ie total gross wage $55,000)
An analysis of the work done in April showed the following:
268
Direct workers Indirect workers

Basic pay – ordinary hours $35,000 $5,000
General overtime – basic element $4,500 $2,000
– overtime premium $2,250 $1,000
Bonus for completion of rush order (at $4,000

request of customer)
Idle time $1,250
Required
Show the double entries required to account for these transactions in a cost
accounting system.
Solution
Wages control account
Cash 30,000
PAYE 20,000
NI 5,000
55,000
WIP
Production overhead
6 Accounting for other indirect costs

In addition to indirect materials and indirect labour, a manufacturing company will
incur many other indirect production costs, such as rent, rates and insurance.
The entries for these will be:
DR Production overhead CR Rent/Rates/Other control account
6.1 Depreciation
Depreciation of machinery used in production is worthy of special attention. Note
that this is treated as an indirect cost related to production, with the depreciation
amount in a period accounted for as follows:
DR Production overhead CR Provision for depreciation
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7 Absorbing production overheads
When all of the indirect costs have been 'collected' in the production overhead
account, they will be absorbed into production, according to the absorption
basis used by the company. The double entry for this transaction is:
DR WIP/Production CR Production overhead
The WIP/Production account will now be charged with all the costs relating to
production in the period (ie all the direct costs and all the absorbed indirect costs).
Note. In a marginal costing company, the total overheads will just be transferred
directly to the statement of profit or loss and treated as a period cost.
7.1 Under-/over-absorption
The production overheads account will now have been debited with all the indirect
costs incurred, and credited with the amount absorbed into production.
Any remaining balance on this account will represent under- or over-
absorption.
This balance should be transferred from the production overheads account to the
statement of profit or loss, to ensure the actual profit shown is corrected for any
under-/over-absorption of costs into production.
The double entry will depend on whether the company under- or over-absorbed:
Under-absorbed:
DR Statement of profit or loss CR Production overhead
Over-absorbed:
DR Production overhead CR Statement of profit or loss
Activity 5: Overhead absorption

Production overheads incurred in a period total $95,000.
Required
Show the t-accounts and double entries required in an absorption costing
environment if profit is to be adjusted for any under-/over-absorption and the
overheads absorbed into production are $88,000:
Solution
270
8 From WIP to the statement of profit or loss (SOPL)

8.1 WIP to finished goods
[DR Finished goods CR WIP/Production]
At the end of the period, the cost of any finished goods will be transferred from the
WIP account to the finished goods account (to reflect finished goods being
transferred from the factory to the warehouse). Any unfinished WIP will remain in
the WIP account as a balance carried forward to the next period.
8.2 Finished goods to cost of sales

[DR Cost of sales CR Finished goods]
Any finished goods sold during the period will have their costs transferred to the
cost of sales account. Again, the cost of any closing inventory will remain in the
finished goods account as a balance carried forward.
8.3 Cost of sales to SOPL [DR SOPL CR Cost of sales]

The 'cost of goods sold' will be transferred from the cost of sales account to the
statement of profit or loss (SOPL) at the end of the reporting period. At this stage it
will be joined by the revenue received from selling the finished goods and any
adjustments for under-/over-absorption.
Any non-production expenses like sales and administration will be charged to
the SOPL at this time.
The resulting balance on the SOPL will represent profit (or loss) in the period.
9 Summary of main t-accounts in cost bookkeeping

9.1 Paying for resources
Materials Production overhead

Cash Cash
Buy materials
Pay overheads
Labour
Cash
Pay salaries
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9.2 Using resources in production
Materials
Cash Direct mats
used/issued
Labour WIP/Production
Cash Direct lab used Direct mats FGs
Indirect labour Direct lab
O/h
absorb'd
Production overhead
Cash (rent) Overhead
Indirect labour absorbed
Depreciation
Difference = Over-/under-absorption (goes to SOPL)
9.3 Finished goods are sold

Finished goods Sales
WIP/prod'n FG sold Sales Actual
(via cost of in SOPL sales
sales to SOPL)
SOPL
9.4 Summary
Finished Cost of goods Sales revenue to
Expenses WIP
goods sold to SOPL SOPL
Activity 6: Bookkeeping practice

This Activity illustrates all the common 'transactions' in cost bookkeeping, and shows
how the costs flow through the t-accounts, from the procurement of resources to the
calculation of profit in the statement of profit or loss.
The following balances were extracted from a company's books at 30 September
2016:
$
Raw materials inventory 9,000
WIP 8,250
Finished goods inventory 10,800
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During the next three months the following transactions took place (all purchases
and sales were on credit):
$
Materials purchased 24,700
Materials issued to WIP 27,150
Materials issued to maintenance 1,000
Direct wages paid and worked (3,500 hours) 51,900
Indirect wages paid and worked 18,300
Depreciation of factory equipment 800
Other production overheads paid 13,950
Sales and distribution costs paid 7,800
Cost of sales 105,000
Sales 135,000
The closing inventory of WIP at 31 December 2016 was valued at $25,770.
Overheads are absorbed on the basis of direct labour hours at a predetermined
rate of $10/hour.
Required
Complete the following ledger accounts as they would appear in an integrated
system of accounting.
Solution
Raw material Labour
Production overhead Provision for depreciation
WIP/Production Finished goods inventory
273
Sales Statement of profit or loss
Sales and distribution costs Cost of sales
10 Accounting for variances

10.1 How cost variances arise
The final issue that needs to be considered is how variances are accounted for. The
initial payments for material, labour and overheads are entered at their actual cost
but then everything is valued at standard cost each time a transaction between cost
ledger accounts is recorded.
eg raw materials, labour, fixed overhead  WIP
completed production from WIP  finished goods
274
eg
Raw materials control a/c Direct wages control a/c
$ $ $ $
Actual X WIP (@ std) X Actual X WIP X
cost cost
Price variance (A) X (hrs paid @ std)
bal c/f (@ std) X Rate variance (A) X
X X X X
Work in progress control a/c

$ $
Raw mat's (@ std) X Finished goods (@ std) X
Direct wages (@ std) X Mat's usage var (A) X
Labour eff'cy var (F) X
X X
10.2 The variance account

The result, as can be seen above, is that the price and rate variances are the
balancing figures in their respective control accounts, and the usage and efficiency
variances likewise in the WIP control account.
The double entry for each variance is made to a variance account, the balance on
which goes to the SOPL.
Variance account
$ $
Mat's price (A) X Labour efficiency (F) X
Labour rate (A) X
Mat's usage (A) X SOPL X
X X
Activity 7: Accounting for variances

A company uses raw material J in production. The standard price for material J is
$3 per metre. During the month 6,000 metres were purchased for $18,600, of
which 5,000 metres were issued to production.
Required
Show the t-accounts to record the above transactions.
Solution
275
Activity 8: Double entry for variances
A firm uses standard costing and an integrated accounting system. The double entry
for an adverse material usage variance is:
A DR Stores control account CR Work in progress control account
B DR Material usage variance account CR Stores control account
C DR Work in progress control account CR Material usage variance account
D DR Material usage variance account CR Work in progress control account
11 Job and batch accounts

A separate work in progress account is maintained for each individual job or batch.
DR Job a/c CR
$ $
Raw material X Material transferred X
Labour X Material returned to stores X
Overhead X COS (or bal c/f if incomplete) X
X X
12 Quick reference table

Transaction DR entry CR entry With
Procurement of materials
Purchase raw DR Materials CR Cash or Cost of materials

materials Payables purchased
Materials used
Issue materials to DR CR Materials Cost of materials

factory WIP/Production issued
Issue indirect DR Production CR Materials Cost of materials

materials overhead issued
276
Payment of wages
Pay wages DR Wages control Gross pay
CR Cash Net pay
CR PAYE control PAYE element
CR NI control Employee's NI
contributions
Labour used
Direct labour worked DR CR Wages control Cost of direct labour

WIP/Production
Indirect labour DR Production CR Wages control Cost of indirect labour

worked overhead
Other indirect costs
Pay fixed overhead DR Production CR Cash or Rent Cost of rent in period

(rent) overhead control
Depreciation DR Production CR Provision for Depreciation in period

overhead dep'n
Absorb overheads
Absorb prod'n DR CR Production Total absorbed on

overheads WIP/Production overhead given basis
Under-absorption DR Statement of CR Production Amount under-

profit or loss overhead absorbed
Over-absorption DR Production CR Statement of Amount over-absorbed

overhead profit or loss
WIP to finished goods
Complete finished DR Finished CR Cost of finished goods

goods goods WIP/Production
Finished goods to CoS
Sell finished goods DR Cost of sales CR Finished Cost of goods sold

goods
Pay non-prod'n costs DR Non-prod'n CR Cash Cost of admin in the

(admin) period
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Complete statement DR Statement of CR Cost of sales Final cost of sales

of profit or loss profit or loss amount
DR Sales CR Statement of Revenue in the period

profit or loss
DR Statement of CR Non-prod'n Non-production costs

profit or loss control in period
278
Chapter summary
 Cost bookkeeping is based on the principles of double entry, the golden

rule of which is that for every entry made in one account, there must be
a corresponding balancing entry in another account.
 Integrated systems combine both financial and cost accounts in one system of
ledger accounts.
 The basic entries in an integrated system are as follows:
Expenditure on materials, wages and overheads
DR Resources account
CR Cash or accounts payable
Work in progress
DR WIP (for overhead, this is overhead absorbed)
CR Resources accounts (for overhead, this is overhead absorbed)
Finished goods
DR Finished goods
CR WIP
Cost of sales
DR Cost of sales
CR Finished goods
 In a standard cost bookkeeping system, the variances are recorded as
follows:
1 The material price variance is recorded in the stores control account.
2 The labour rate variance is recorded in the wages control account.
3 The following variances are recorded in the work in progress account.
Material usage variance
Idle time variance
Labour efficiency variance
Variable overhead efficiency variance
4 The production overhead expenditure variance will be recorded in the production
overhead control account.
5 The production overhead volume variance may be recorded in the
fixed production overhead account. (Note. Alternatively, you may find
the volume variance recorded in the work in progress account.)
6 The balance of variances in the variance accounts at the end of a period may be
written off to the statement of profit or loss.
279
 The general principle in standard cost bookkeeping is that cost variances should be
recorded as early as possible. They are recorded in the relevant account in
which they arise and the appropriate double entry is taken to a variance
account.
 Adverse variances are debited to the relevant variance account; favourable
variances are credited in the relevant variance account.
280
Keywords
 Bookkeeping: The process of entering transactions in the books of the business,
by creating equal debit and credit entries in separate ledger accounts
 Integrated system: A set of accounting records that integrates both financial and
cost accounts using a common input of data for all accounting purposes
 Interlocking system: Separate financial and management accounting systems
 Wages control account: A 'collecting place' for net wages paid and deductions
made from gross pay
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Activity answers
Activity 1: Double entry example

Raw materials WIP/Production
WIP 1,500 Materials 1,500
DR WIP/Production $1,500 CR Raw materials $1,500
Activity 2: Raw materials issued

Raw materials WIP/Production
Payables 6,500 WIP 5,000 Direct materials
5,000
Prod o'head
1,500
Payables Production overhead

Raw materials Indirect materials
6,500 1,500
Purchases: DR Raw materials CR Payables
Issue Direct Mats: DR WIP CR Raw materials
Issue Indirect Mats: DR Prod overhead CR Raw materials
Activity 3: Wages control account

Cash PAYE control a/c
Wages 30,000 Wages 20,000
Wages control a/c NI control a/c

Cash 30,000 Wages 5,000
PAYE 20,000
NI 5,000
55,000
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Gross pay = Net pay + PAYE + Employees' NI

$55,000 = Net pay + $20,000 + $5,000
Net pay = $55,000 – ($20,000 + $5,000)
Net pay = $30,000
Net pay: DR Wages control CR Cash
PAYE: DR Wages control CR PAYE control
NI: DR Wages control CR NI control
Activity 4: Clearing the wages control account

Wages WIP
Cash 30,000 WIP 43,500 Direct labour
43,500
PAYE 20,000 Prod o'head
11,500
NI 5,000
55,000 55,000
Production overhead
Indirect labour
11,500
Analysis of labour costs:

Direct labour = $35,000 + $4,500 + $4,000 = $43,500
Indirect labour = $2,250 + $1,250 + $8,000 = $11,500
Direct labour: DR WIP CR Wages
Indirect labour: DR Prod o'head CR Wages
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Activity 5: Overhead absorption
Production overhead WIP/Production
Incurred 95,000 Absorbed – WIP Prod overhead
88,000 88,000
St of profit or loss
7,000β
95,000 95,000

Under-abs 7,000
Absorption: DR WIP CR Prod overhead

Adjustment: DR Statement of profit or loss CR Prod overhead
Activity 6: Bookkeeping practice

Raw material Labour
B/d 9,000 WIP 27,150 Cash 70,200 WIP 51,900
Creditors 24,700 Prod overheads Overheads 18,300
1,000
c/d 5,550 70,200 70,200
33,700 33,700
B/d 5,550
Production overhead Provision for depreciation

Materials 1,000 WIP 35,000 Prod o'head 800
Indirect (3,500 hrs C/d 800
labour 18,300  $10/hr) 800 800
Depreciation 800 B/d 800
Cash (other
production
overhead) 13,950
SOPL (over-
absorption) 950
35,000 35,000
WIP/Production Finished goods inventory

B/d 8,250 Finished 96,530 B/d 10,800 Cost of 105,000
Materials 27,150 goods WIP 96,530 sales
Labour 51,900
Overhead 35,000 c/d 25,770 C/d 2,330
122,300 122,300 107,330 107,330
B/d 25,770 B/d 2,330
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Sales Statement of profit or loss

I/S 135,000 Debtors 135,000 Cost of sales Sales 135,000
105,000
Sales and
distribution
costs 7,800 Over-
Profit 23,150 absorption
950
135,950 135,950
Sales and distribution costs Cost of sales

Cash 7,800 I/S 7,800 Finished
goods 105,000 I/S 105,000
Activity 7: Accounting for variances

Raw material
Cash/payables (actual) 18,600 WIP (5,000  $3) 15,000
Raw material variance 600
($3.10 – $3)  6,000
Balance c/d (1,000  $3) 3,000
WIP
Raw materials 15,000
Raw material variance

Raw materials 600
Activity 8: Double entry for variances

The correct answer is D.
The usage variance arises during production therefore the correct account to be
credited is work in progress. Option D is correct.
An adverse variance is debited to the relevant variance account. Therefore we can
eliminate the incorrect options A and C.
Option B has the correct debit entry for the adverse variance but the credit entry is
incorrect.
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Test your learning
1 What is the double entry for the following in an integrated accounts system?
(a) Production overhead absorbed in the cost of production
(b) Completed work transferred from the production process to inventory
2 GF Co bought $100,000 worth of materials and issued $75,000 to production. An
entry was made to trade payables for the purchase; which three of the following
entries completes the correct bookkeeping treatment?
I DR Raw materials $75,000
II DR Raw materials $100,000
III CR Work in progress $75,000
IV CR Raw materials $75,000
V CR Raw materials $100,000
VI DR Work in progress $75,000
VII DR Work in progress $100,000
3 The wages control account for X Co for October looks like this.
WAGES CONTROL ACCOUNT
$'000 $'000
Bank 110 Work in progress 101
Production overhead 7
Balance c/d 2
110 110
Indicate whether the following statements are true or false.

True False
I Total wages incurred during October was $110,000
II Indirect wages incurred during October was $7,000
III Wages accrued at the end of October were $2,000
4 The material usage variance is recorded in the raw materials control account.
True
False
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5 Indicate whether the following statements are true or false.

True False
I Integrated systems conform to statutory requirements
II Integrated systems are preferable to two systems because
they conform to statutory requirements
III Integrated systems reduce the number of account
reconciliations
IV Systems with separate cost and financial accounting
systems can aid provision of internal management
information
6 Which three of the following variances are recorded in the work in progress
control account in a standard cost bookkeeping system?
Material price variance
Material usage variance
Labour rate variance
Variable overhead efficiency variance
Sales variance
Idle time variance
7 A company operates an integrated accounting system. The accounting entries for
the issue to production of indirect materials from inventory would be:
Debit Credit
A Work in progress account Stores control account
B Stores control account Overhead control account
C Overhead control account Stores control account
D Cost of sales account Stores control account
8 Which of the following descriptions correctly describes a control account?
A An account for pooling costs before they are recharged
B Contra to cash
C An account which records total cost as opposed to individual costs
D A type of suspense account
9 In a cost bookkeeping system what would be the entry for the absorption of
production overhead?
Debit Credit
A Cost ledger control account Production overhead account
B Production overhead account Work in progress account
C Work in progress account Cost ledger control account
D Work in progress account Production overhead account
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288
Risk and probability
Learning outcomes

• Explain the concepts of risk and uncertainty
• Demonstrate the use of expected values and joint probabilities in decision making
Chapter context
In this chapter we start to look at a key function of management; that of making decisions. All
decisions carry some element of risk or uncertainty. We distinguish between these, and then look at
ways of dealing with risk by looking at the concept of probability, linking probability to expected
values, and finally how decisions can be made based on expected values.
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Chapter overview
Probability Outcomes Complement P (success) = 1-P

(failure)
Mutually Independent
exclusive P[X and Y] = P[X] x P[Y]
P[X or Y] = P[X] + P[Y] OR AND
Addition Multiplication
Non-mutually Dependent
exclusive P[X and Y] = P[X] x
P[X or Y] = P[X] + P[Y] P[Y/X]
– P[X and Y]
Expected values
 EV =  PX
 Weighted average
based on probabilities
Payoff tables Joint probability

tables
 Profit/loss for each  Two or more risky variables

combination of variables  Three-step approach:
 Make decision based on – Construct two-way data table
highest EV – Calculate joint attributes
– Multiply to get EVs
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15: Risk and probability
1 Introduction
Decision making involves making decisions now which will affect future outcomes
and it is unlikely that future cash flows will be known with certainty.
1.1 Risk
Risk – exists where a decision maker has knowledge that several possible future
Key term outcomes are possible, usually due to past experience.
This past experience enables a decision maker to estimate the probability of the
likely occurrence of each potential future outcome. Risk can be quantified.
1.2 Uncertainty
Uncertainty – exists when the future is unknown and the decision maker has no
Key term past experience on which to base predictions.
Uncertainty cannot be quantified but techniques can be adopted to reduce

uncertainty.
These might include:
 Market research
 Focus groups
2 The concept of probability

Probability – the likelihood of a particular outcome from a given event.
Key term
2.1 Notation
Formula to learn
P[x] = The probability of outcome x occurring.
The number of ways in which x can occur
P[x] =
The total number of possible outcomes
2.2 Examples
(a) Consider a ten-horse race where each horse has an equal chance of winning
and there can only be one winner. The probability or likelihood of selecting
the winner is one in ten (1/10).
(b) Consider a six-sided dice showing the numbers 1 to 6. Assuming each side
has an equal chance of being thrown, the probability of throwing a six is one
in six (1/6).
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(c) Consider a standard pack of playing cards. The probability of selecting a red
card at random is 26 possibilities from 52 cards (possible outcomes) (26/52).
So, given that a red card has been picked from a packet of 52 cards, what is the
probability of it being a 10?
There are 26 red cards in the pack and of these, two will be 10s:
Solution:
2 1
P(10) =   0.077  7.7%
26 13
2.3 Expressing probabilities
Probability can be expressed as a proportion or a percentage.
If an event has a probability of 1 it is said to be certain.
Certainty Impossibility
Decimal 1 0
Percentage 100% 0%
Fraction 1 0
2.4 Sum of all probabilities

p = 1 always (note the  (sigma) symbol means 'the sum of')
For example, toss a coin once
p(head) = ½, p(tail) = ½
p (all outcomes) = p(head) + p(tail) = 1
Terminology
Key term
(a) Mutually exclusive outcomes (OR):
Definition – The outcome of one event cannot happen at the same time as
the outcome of another.
Eg a student can only have one country of birth.
(single event)
(b) Non-mutually exclusive outcomes (OR):
Definition – Both outcomes can occur at the same time.
Eg a student can be studying for an accountancy qualification and their
country of birth is the UK.
(c) Independent events (AND):
Definition – One outcome has nothing to do with another.
Eg asking two unrelated students where they were born.
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(d) Dependent events (AND):

Definition – One outcome depends upon something else taking place either
with a proviso regarding the first event or given it has happened.
Eg asking twins where they were born.
(successive events)
3 Probability laws
3.1 Multiplication laws (AND)
Here we consider the outcomes of successive events.
3.2 Independent events

Here we acknowledge that the outcome of one event has no impact on the outcome
of another event.
Formula provided
The probabilities of two events are multiplied as follows:
P[X and Y] = P[X]  P[Y]
P[X∩Y] = P[X]  P[Y] (note the ∩ (intersect) symbol means objects that 'belong' in
both set X and set Y)
Activity 1: Independent events

Required
What is the probability of getting two heads in two throws of a coin?
Solution
3.3 Dependent events

Here the probability of one event is dependent on the outcome of a previous
event.
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Formula provided
P[X and Y] = P[X]  P[Y|X]
where P[Y|X] is the probability of Y occurring given that X has already occurred.
Note the vertical line means 'given'.
Activity 2: Dependent events

Required
A class contains 16 male students and 14 female. What is the probability of the first
two to arrive in the morning being male?
Solution
3.4 Addition laws (OR)

Consider all the possible outcomes of a single event. The addition laws are relevant
when we are interested in considering a specific group of potential outcomes
against all the possible outcomes.
(a) Mutually exclusive outcomes – The outcome of one event cannot happen
at the same time as the outcome of another. Here we add the probabilities of
the outcomes.
Formula provided
P[X or Y] = P[X] + P[Y]
This can be illustrated in the form of a Venn diagram.
P(X) P(Y)
Activity 3: Mutually exclusive events

Required
What is the probability that a person's birthday falls in June or July?
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Solution
(b) Non-mutually exclusive outcomes – Both outcomes can occur at the

same time.
Formula provided
P[X or Y] = P[X] + P[Y] – P[X and Y]
This can be illustrated in the form of a Venn diagram.
P(X) P(Y)
P(X and Y)
Activity 4: Non-mutually exclusive events

Required
What is the probability of a person's birthday falling in May or having been born
on a Sunday?
Solution
3.5 Complementary probabilities

Using complementary probabilities is a possible shortcut when an event is repeated
a number of times, such that calculating the probability of the combination of
successive events becomes unwieldy.
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It may be possible to split the event ultimately between two outcomes, success and
failure. As we must have either success or failure then p(success) + p(failure) =
certainty = 1
Formula to learn
Rearranging the equation
P (success) = 1 – P (failure)
Examples
(a) P[at least one success in n attempts] = 1 – P[failure in all attempts]
(b) P[at least one six in 10 throws of a dice] = 1 – P[no sixes in 10 throws of dice]
Activity 5: Complementary probabilities

A coin is tossed four times.
Required
What is the probability of getting at least one head?
Solution
4 Conditional probability
Conditional probability relates to the chance of an event occurring given other
events have already taken place.
A contingency table is helpful in calculating these probabilities.
Illustration 1: Conditional probability

A cosmetics company has developed a new anti-dandruff shampoo which is being
tested on volunteers. Seventy per cent of the volunteers have used the shampoo
whereas others have used a normal shampoo, believing it to be the new anti-
dandruff shampoo. Two-sevenths of those using the new shampoo showed no
improvement whereas one-third of those using the normal shampoo had less
dandruff.
Required
A volunteer shows no improvement. What is the probability that he/she used the
normal shampoo?
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Solution
The problem is solved by drawing a contingency table, showing 'improvement' and
'no improvement', volunteers using normal shampoo and volunteers using the new
shampoo.
Let us suppose that there were 1,000 volunteers (we could use any number). We
could depict the results of the test on the 1,000 volunteers as follows.
New Normal Total

shampoo shampoo
Improvement ***500 ****100 600
No improvement **200 *** 200 400
*700 300 1,000
2
* 70%  1,000 **  700
7
1
*** Balancing figure ****  300
3
We can now calculate P (shows no improvement)
400
P(shows no improvement) =
1, 000
200 1
P(used normal shampoo | shows no improvement) = =
400 2
Other probabilities are just as easy to calculate.
500 5
P (shows improvement | used new shampoo) = =
700 7
500 5
P (used new shampoo | shows improvement) = =
600 6
Activity 6: Conditional probability

A sample of 100 university students have been analysed by the subjects they are
studying and whether they pay their tuition fees promptly. The sample has been
cross-tabulated into arts students/science students against fast payers/slow payers.
60 of the students sampled were classified as arts students, of which 40 are slow
payers. In total, 30 of the students are fast payers.
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Required
Calculate the probability that a student chosen at random is a fast-paying science
student.
Solution
298
5 Expected values
5.1 Introduction
When the final outcome is unknown and a range of possible future outcomes has
been quantified (for example, best, worst and most likely) probabilities can be
assigned to these outcomes and a weighted average (expected value) of those
outcomes calculated.
EV = px
where p is the probability of the outcome occurring and x is the value of the
outcome (profit or cost).
Expected value (EV) – a weighted average, based on probabilities.

Key term
5.2 Use of expected values

Expected value can be used in situations where there are a number of possible
outcomes from a single event and it is not known with certainty what will actually
happen. Each outcome is assigned a probability.
Activity 7: Expected value calculation

A gambler has placed a bet on a horse. From past form, the probability distribution
relating to its chances in the race is as follows.
Place Winnings Probability
1st $100 5%
2nd $50 15%
3rd $25 10%
No place Nil 70%
Required
What is the expected value of the gambler's winnings?
Solution
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6 Payoff tables
6.1 Uses
Expected value concepts can be used to make decisions under conditions of
uncertainty. We must consider the outcome of each choice against an
uncontrollable event.
6.2 Method
(a) Set up payoff table – profit/loss for each combination of variables.
Questions usually involve two variables:
(i) The variable subject to uncertainty (probability distribution given in
question)
(ii) The decision variable (for example, which order quantity)
Decision variable – the different options a manager has to choose between.

Key term
(b) Apply probabilities to calculate expected value (EV).
EV = np(x)
where:
n = various profits under an option
p(x) = chance of each profit occurring
Be prepared to interpret your findings. Decision rules are as follows:
 A project with a positive EV should be accepted.
 A project with a negative EV should be rejected.
 When faced with a number of alternative decisions, the one with the highest
EV should be chosen.
Illustration 2: Payoff tables

A sandwich shopkeeper will determine how many sandwiches to make each day
(decision variable). Sales of those sandwiches will be determined by customer
demand (variable subject to uncertainty) which lies in a range between 40 and 70
sandwiches. Sandwiches cost $1 to make and sell at $2.
What is the optimum level of sandwiches to make? Clearly this will be the order
which generates the highest daily profit.
Set up a grid of 'Decision variable' v 'Variable subject to uncertainty' and calculate
the daily profit in each case (revenue less cost).
An expected value can then be determined for each decision variable using the
expected value formula.
300
The order level with the highest expected profit will be selected.
Demand Make 40 Make 50 Make 60 Make 70
40 (20% $40 $30 $20 $10
probability)
50 (30% $40 $50 $40 $30
probability)
60 (30% $40 $50 $60 $50
probability)
70 (20% $40 $50 $60 $70
probability)
Expected value $40 $46 $46 $40
The shopkeeper will be indifferent between an order of 50 or 60 sandwiches.
Activity 8: Payoff tables

In an internal audit of 400 invoices, the following numbers of errors were
discovered:
Number of errors: 0 1 2 3 4 5 6 or
more
Number of invoices: 180 38 80 40 40 20 2
Required
(a) Calculate the percentage of invoices with errors.
(b) Calculate the expected value of the number of errors per invoice (to 3 decimal
places). (Hint: probability calculation = number of invoices ÷ total number of
invoices)
Solution
301
6.3 Limitations of expected values (EVs)
(a) EV is a long-term average, so the EV will not be reached in the short term
and is therefore not suitable for one-off decisions.
(b) The results are dependent on the accuracy of the probability distribution. In
particular, it uses discrete variables rather than continuous variables (ie
variables are point estimates rather than a continuous range). This may not
accurately model the real situation.
(c) EV takes no account of the risk associated with a decision.
(d) The EV itself may not represent a single possible outcome.
7 Joint probability tables

Joint probability table – records the range of possible outcomes where there
Key term are two variables that are uncertain or risky.
If there are two variables that are uncertain or risky it may be helpful to record the
range of possible outcomes in a joint probability table.
Analysis could take the form of EVs or the data table could be used to give
management an overview of the decision it is facing.
Activity 9: Joint probability table

Brown Co has developed a new product.
The company is confident that demand for the product will be 30,000 units at a
selling price of $25, but both the variable cost per unit and the specific fixed costs
associated with this product are uncertain.
Brown Co believes that the following circumstances could occur.
VC per unit Probability FC Probability
$ $
12 0.2 100,000 0.4
13 0.35 110,000 0.5
14 0.45 120,000 0.1
Required
(a) Construct a two-way data table for profit generated.
Fixed costs
$100,000 $110,000 $120,000
$12
VC
$13
$14
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(b) Using the joint probabilities for each combination of fixed cost
and variable cost, calculate the expected value of Brown Co's
profit.
Joint probability table (enter just the probabilities)
Fixed costs
$100,000 $110,000 $120,000
Prob 0.4 0.5 0.1
$12 0.2
VC
$13 0.35
$14 0.45
Expected value of profit
Fixed costs
$100,000 $110,000 $120,000
$12
VC
$13
$14
Workings
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Chapter summary
 When there is a strong element of risk or uncertainty in a decision, the decision that
is taken may be affected by the extent of the risk or uncertainty.
 'Risk' and 'uncertainty' are often used to mean the same thing. However, to be more
exact, 'risk' in decision making exists when the future outcome cannot be predicted
for certain, but probabilities can be estimated for each possible outcome.
Uncertainty, in contrast, is when there is insufficient information to make a reliable
prediction about what will happen and there are no probability estimates of
different possible outcomes.
 Probability is a measure of likelihood and can be stated as a percentage, a ratio, or
more usually as a number from 0 to 1.
 The simple addition law for two mutually exclusive events, A and B, is as
follows.
P(A or B) = P(A) + P(B)
 Mutually exclusive outcomes are outcomes where the occurrence of one of the
outcomes excludes the possibility of any of the others happening.
 The simple multiplication law for two independent events, A and B, is as
follows.
P(A and B) = P(A) P(B)
 Independent events are events where the outcome of one event in no way
affects the outcome of the other events.
 The general rule of addition for two events, A and B, which are not mutually
exclusive, is as follows.
P(A or B) = P(A) + P(B) – P(A and B)
 The general rule of multiplication for two dependent events, A and B, is as
follows.
P(A and B) = P(A)  P(B|A)
= P(B)  P(A|B)
 Dependent or conditional events are events where the outcome of one event
depends on the outcome of the others.
 Contingency tables can be useful for dealing with conditional probability.
 An expected value is a weighted average value of the different possible outcomes
from a decision, where weightings are based on the probability of each possible
outcome. The expected value for a single event can offer a helpful guide for
management decisions: a project with a positive EV should be accepted
and a project with a negative EV should be rejected.
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 Probability and expectation should be seen as an aid to decision

making, as it is used to help calculate risk.
 A payoff table is simply a table with rows for circumstances and columns for
actions (or vice versa), and the payoffs in the cells of the table.
 Expected values indicate what an outcome is likely to be in the long term, if the
decision can be repeated many times over. Fortunately, many business transactions
do occur over and over again.
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Keywords
 Decision variable: The different options a manager has to choose between
 Dependent: One outcome depends upon something else taking place either with
a proviso regarding the first event or given it has happened
 Expected value: The weighted average, based on probabilities, of a range of
possible outcomes
 Independent: One outcome has nothing to do with another
 Joint probability table: A method of recording the range of possible outcomes
where there are two variables that are uncertain or risky
 Mutually exclusive: The outcome of one event cannot happen at the same time
as the outcome of another
 Non-mutually exclusive: Both outcomes can occur at the same time
 Probability: The likelihood of a particular outcome from a given event
 Risk: A decision maker has knowledge that several future outcomes are possible,
usually due to past experience
 Uncertainty: When the future is unknown and the decision maker has no past
experience on which to base predictions
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Activity answers
Activity 1: Independent events

P[H and H] = ½  ½ = ¼
Activity 2: Dependent events

16 15 8
P[Male and Male] =  
30 29 29
Activity 3: Mutually exclusive events

1 1 1
P[June or July] =  
12 12 6
Activity 4: Non-mutually exclusive events

Assume four Sundays per month
1 1 1 1
P[May or Sunday] =   
12 7 12 7
3
=
14
Activity 5: Complementary probabilities

P[No heads]
1
= P[T, T, T and T] = ½  ½  ½  ½ =
16
1 15
 P[G 1 head] = 1 – 
16 16
Activity 6: Conditional probability

Arts Science Total
Fast payer 20 10 30
Slow payer 40 30 70
60 40 100
10
Probability = = 0.1
100
Activity 7: Expected value calculation

Winnings Probability EV
$
100  0.05 = 5
50  0.15 = 7.5
25  0.10 = 2.50
Nil  0.70 = Nil
15
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Activity 8: Payoff tables
(a) Percentage of invoices with errors:
Total number of invoices = 400
Number without errors = 180
Number with errors = 400 – 180
220
Percentage with errors = × 100 = 55%
400
(b)
Number of errors: 0 1 2 3 4 5 6 or more
Number of invoices: 180 38 80 40 40 20 2
Probability: 0.45 0.095 0.2 0.1 0.1 0.05 0.005
No of invoices
(Probability calculation = )
Total no of invoices
Expected value of number of errors per invoice
= (0 × 0.45) + (1 × 0.095) + (2 × 0.2) + (3 × 0.1) + (4 × 0.1) + (5 × 0.05) +
(6 × 0.005)
= 0 + 0.095 + 0.4 + 0.3 + 0.4 + 0.25 + 0.03
= 1.475 errors.
Activity 9: Joint probability table

(a) Profit generated ($'000)
Fixed costs
$100,000 $110,000 $120,000
$12 290 280 270
VC
$13 260 250 240
$14 230 220 210
(b) Joint probability
Fixed costs
$100,000 $110,000 $120,000
Prob 0.4 0.5 0.1
$12 0.2 0.08 0.1 0.02
VC
$13 0.35 0.14 0.175 0.035
$14 0.45 0.18 0.225 0.045
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Expected value of profit

Fixed costs
$100,000 $110,000 $120,000
$12 23,200 28,000 5,400
VC
$13 36,400 43,750 8,400
$14 41,400 49,500 9,450
$
EV profit = px 245,500
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Test your learning
1 An analysis of 480 working days in a factory shows that on 360 days there were
no machine breakdowns. Assuming that this pattern will continue, what is the
probability that there will be a machine breakdown on a particular day?
A 0%
B 25%
C 35%
D 75%
2 A production director is responsible for overseeing the operations of three factories
– North, South and West. He visits one factory per week. He visits the West factory
as often as he visits the North factory, but he visits the South factory twice as often
as he visits the West factory.
What is the probability that in any one week he will visit the North factory?
A 0.17
B 0.20
C 0.25
D 0.33
3 A project may result in profits of $15,000 or $20,000, or in a loss of $5,000. The
probabilities of each profit are 0.2, 0.5 and 0.3 respectively.
What is the expected profit?
4 ABC Co is considering launching a new product. The new product will have a
selling price of $6 per unit. Fixed costs are expected to be $2,500. Expected sales
volumes and variable costs are as follows.
Sales units Probability Variable cost per unit Probability
1,500 0.8 $2.30 0.65
2,500 0.2 $2.50 0.35
What is the expected profit?
5 How is expected value calculated?
A px
B px
C epx
D xp
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6 Tick the correct boxes to indicate the usefulness of expected values as a guide to
decision making in the following decisions.
Most Not as
useful useful
(a) Whether to change the logo painted on the

window of 700 retail outlets
(b) Whether to purchase machine X or machine Y
(c) Whether to launch product A
(d) Deciding on the optimum daily purchases of a

perishable item
311
312
Averages and the
normal distribution
Learning outcomes

• Calculate summary measures of central tendency and dispersion for both grouped and
ungrouped data (including mean, median, mode, range, variance, standard deviation, and
coefficient of variation)
• Demonstrate the use of the normal distribution
Chapter context
It is vital for management to be able to summarise raw data into useful information. This chapter
contains mathematical methods of summarising data.
We use sampling in the business world to make assumptions about populations. Rather than carrying
out a full census, we gather data that is representative of the whole population. Using normal
distribution we can start to attach probabilities and percentages to the likelihood of events and
attributes, for decision making.
313
Chapter overview
Survey Averages Dispersed Standard

results data deviation
 (x x)2
=
n
Typical Or
attributes
 fx2 2
-x
f
Mean Median Mode

 Ungrouped  Ungrouped/  Occurring
 Grouped Grouped most
fx  Odd/Even frequently
x= Distribution
f
Normal Standard deviation Mean

distribution  
Z-scores
Z = x 

Tables Percentages
314
16: Averages and the normal distribution
1 Terminology
Grouped data – where the frequency is shown in terms of a range. Known as
Key term continuous data.
Ungrouped data – discrete data, where the frequency is shown in terms of a
specific measure/value.
2 Averages
2.1 Introduction
The example below will be used throughout the chapter in order to calculate the
three averages; the mean, median and mode.
In the small town of Brum Brum, a survey of 1,600 out of 100,000 car owners was
performed to find out about annual mileage travelled. The results were as follows:
Mid-point No
mileage cars
x f fx
< 2,000 1,000 * 10
2,000 – < 4,000 3,000 14
4,000 – < 6,000 5,000 154
6,000 – < 8,000 7,000 292
8,000 – < 10,000 9,000 493
10,000 – < 12,000 11,000 404
12,000 – < 14,000 13,000 164
14,000 – < 16,000 15,000 48
 16,000 17,000 * 21
1,600
* assume same size as adjacent intervals
2.2 Mean
Arithmetic mean – the best known type of average and is widely understood. It
Key term is used for further statistical analysis.
Formula provided
Ungrouped data:
Sum of values of items
Mean =
number of items
315
Illustration 1: The arithmetic mean for ungrouped data
The demand for a product on each of 20 days was as follows (in units).
3 12 7 17 3 14 9 6 11 10 1 4 19 7 15 6 9 12 12 8
The arithmetic mean of daily demand is x .

Sum of demand 185
x= = 20 = 9.25 units
Number of days
In this example, demand on any one day is never actually 9.25 units. The arithmetic
mean is merely an average representation of demand on each of the 20 days.
Grouped data:
x
 fx or x=
fx
(frequency distribution)
n f
where x = value
f = frequency
To calculate the arithmetic mean of grouped data we need to decide on a value
which best represents all of the values in a particular class interval.
This value is known as the mid-point.
Activity 1: Calculating the mean

Required
Using the information in 2.1, calculate the mean annual mileage for these 1,600
cars.
Solution
316
2.3 Mode
Mode – the most frequently occurring item.

Key term
Ungrouped data: the most frequently occurring item in the list.
Grouped data: we cannot say what the most frequently occurring item is;
however, we can estimate the mode using the following method.
To find the mode using a histogram:
(1) Draw the frequency histogram and identify the highest frequency class
(2) Draw a diagonal line from the top of the block either side of the highest class
(3) The intercept is the estimated modal value, read from the x axis
Illustration 2: Finding the mode using a histogram

Using the data from the previous example
No. of cars
500
Estimated modal value
read from the x axis.
400
300
200
100
0
1,000 3,000 5,000 7,000 9,000 11,000 13,000 15,000 17,000
Mileage
Reading from the histogram the mode is approximately 9,250 miles.
You cannot draw a histogram in a computer based assessment so questions may
ask you to interpret a diagram.
317
2.4 Median
Median – the value of the middle item.

Key term
Ungrouped data (odd number)
(1) Arrange data in order
(2) Calculate middle (median) rank –

n 1  nth item in the list
2
(3) Median value = the entry corresponding to the median rank
Ungrouped data (even number)
(1) Arrange the data in order
(2) Calculate the mean of the two median ranks
n n
The mean of th and  1 th
2 2
Activity 2: Calculate the median (ungrouped data)

The following scores are observed for the times taken to complete a task, in minutes.
12, 34, 14, 15, 21, 24, 9, 17, 11, 8
What is the median score?
A 14.00
B 14.10
C 14.50
D 14.60
Workings
Grouped data
(a) Arrange data in order
(b) Calculate middle (median) rank (note whether even or odd)
(c) Estimate median using ogive (cumulative frequency distribution graph)
Finding the median from an ogive (using data from Activity 1)
1,600
Median rank = = 800th
2
We can now look up the 800th item on our ogive.
318
Cumulative no.
of cars
1,600
1,500
1,400
1,300
1,200
1,100
1,000
th
800 item
900
800
700
600
500
400
300
Reading from the graph the median is

200 approximately 9,000 miles.
100
1,000 3,000 5,000 7,000 9,000 11,000 13,000 15,000 17,000

Mileage
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3 Advantages and disadvantages
3.1 Mean ( x )
Advantages
(a) Used most frequently
(b) Most commonly understood
(c) Uses all data
Disadvantages
(a) May not be a value in the distribution
(b) Distorted by extreme high/low values
(c) Ignores dispersion
3.2 Mode
Advantages
(a) Most popular item
(b) Not distorted by high/low values
(c) Corresponds to an actual value in the distribution
Disadvantages
(a) Ignores dispersion
(b) Does not take into account all data
3.3 Median
Advantages
(a) Not distorted by high/low values
(b) Corresponds to an actual value in the distribution
Disadvantages
(a) Ignores dispersion
(b) Limited use
3.4 Limitations
The averages we have calculated do not explain very much about the distribution
itself. We cannot determine whether the data lies close to the central point (the
mean) or is scattered around the entire range of possible values. This is called
dispersion.
Graphical methods enable us to see what is happening within the distribution, but
there is a need for a more statistical measure. This is known as the standard
deviation and it measures dispersion.
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4 Dispersion
Averages are a method of determining the 'location' or central point of a
distribution, but they give no information about the dispersion of values in the
distribution.
Measures of dispersion give some idea of the spread of a variable about its
average (mean).
4.1 Standard deviation
Standard deviation – one of the most important measures of dispersion. The

Key term standard deviation measures the spread of data around the mean.
In general, the larger the standard deviation value in relation to the mean, the more
dispersed the data.
Formula provided
(x x)2
=
n
For a frequency distribution the formula becomes
fx 2 2
= -x
f
where  = standard deviation
x = value
x = mean
f = frequency
n = f
Note that  is the Greek letter sigma (in lower case).

Advantages
(a) Uses all data
(b) Gives 'weight' to values that lie far away from mean
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Illustration 3: Standard deviation
The hours of overtime worked in a particular quarter by the 60 employees of ABC
Co are as follows.
Hours Frequency
More than Not more than
0 10 3
10 20 6
20 30 11
30 40 15
40 50 12
50 60 7
60 70 6
60
Using the formula provided in the assessment, the standard deviation calculation is
as follows.
Mid-point
x f fx x² fx²
5 3 15 25 75
15 6 90 225 1,350
25 11 275 625 6,875
35 15 525 1,225 18,375
45 12 540 2,025 24,300
55 7 385 3,025 21,175
65 6 390 4,225 25,350
f = 60 fx = 2,220 fx = 97,500
2
 fx 2,220
Mean = = = 37
f 60
2
fx 2  fx  97,500
Variance = the square of the standard deviation:  = – (37)2
f  f  60
 
= 256 hours
Standard deviation = 256 = 16 hours
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Activity 3: Standard deviation calculation

Required
Complete the following table and calculate .
Mid-point No
mileage of cars
2 2
x f fx x fx
('000)
<2 1 10
2 – < 4 3 14
4 – < 6 5 154
6 – < 8 7 292
8 – < 10 9 493
10 – < 12 11 404
12 – < 14 13 164
14 – < 16 15 48
 16 17 21
1,600
x = 9,347.5 miles
Solution
323
4.2 Coefficient of variation
This measures the standard deviation as a percentage of the mean. It is particularly
useful when comparing the dispersion of two distributions.
The higher the percentage, the higher the dispersion.
Formula to learn
σ
Coefficient of variation =
x
For example, suppose that two sets of data, A and B, have the following means and
standard deviations.
A B
Mean 120 125
Standard deviation 50 51
Coefficient of variation (50/120) 0.417 (51/125) 0.408
Although B has a higher standard deviation in absolute terms (51 compared to 50),
its relative spread is less than A's since the coefficient of variation is smaller.
Activity 4: Coefficient of variation

Required
Calculate the coefficient of variation for Activity 3.
Solution
The standard deviation's main properties are as follows.

(a) It is based on all the values in the distribution and so is more
comprehensive than dispersion measures based on quartiles, such as the
quartile deviation (see Section 5.3).
(b) It is suitable for further statistical analysis.
(c) It is more difficult to understand than some other measures of dispersion.
The importance of the standard deviation lies in its suitability for further
statistical analysis. (We shall consider this further when we study the normal
distribution.)
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5 Variance, range, quartiles and deciles

5.1 Variance
Variance – defined as the square of the standard deviation (2).

Key term
Watch out for questions where you are given a variance but need a standard
deviation for your calculation.
Formula to learn
Variance =  2
Standard deviation σ variance
5.2 Range
Range – a measure of spread; the difference between the highest and lowest
Key term possible values or, where data is grouped, it will be the difference between the
upper interval limit and the lowest interval limit.
5.3 Quartiles
Quartiles divide a distribution into quarters. In other words, the quartiles and the
Key term median divide the population into four groups of equal size.
(a) Lower quartile (Q1) – defined as the value below which 25% of the
observations fall.
(b) Median (Q2) – lies at the mid-point (50%) between the upper and lower
quartiles and is defined as the value below which 50% of the observations fall.
(c) Upper quartile (Q3) – defined as the value above which 25% of the
observations fall.
(d) Inter-quartile range – the difference between the upper and lower
Key term quartiles (Q3–Q1).
(e) Quartile deviation (or semi-interquartile range) is calculated as:

1
(upper quartile – lower quartile)
2
Activity 5: Quartile deviation

Required
The lower and upper quartiles of a distribution are given as 44 and 62. Calculate
the quartile deviation.
325
Solution
5.4 Deciles
Deciles divide a distribution into tenths (1/10ths).
6 Normal distribution
6.1 Introduction
Normal distribution (or probability distribution) – a frequency distribution which

Key term is important because it arises frequently in 'real life'. It is any distribution that is
symmetrical around the mean.
It has been found that many probability distributions are close enough to
a normal distribution to be treated as one without any significant loss of
accuracy. This means that the normal distribution can be used as a tool in business
decision making involving probabilities.
For example, if we take the population of the UK and look at the distribution of the
height of all adults it would almost certainly follow a normal distribution. In fact,
most data distributions follow a normal distribution where the majority of items lie
near to the average.
6.2 Shape
The normal distribution is often described as a 'bell-shaped' curve. The normal
curve for the height of adults might look like this.
 = 4"
50% 50%
 = 5ft 8"
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When using the normal distribution we will use the  (pronounced mew) to define
the mean and  to define standard deviation.
Here  = 5ft 8" and standard deviation,  = 4"
6.3 Reason for shape

As the majority of people's heights lie on or near to the average height (the mean),
there is a higher concentration of occurrences the closer we get to the mean.
As you get further away from the mean, the number of people with these heights
gets smaller and smaller, hence the curve gets lower and lower.
6.4 Symmetry
When attempting questions, it is important to note the normal distribution is always
symmetrical around the mean. Consequently, the area either side of the mean
represents 50%.
6.5 Properties of normal distribution

(a) The curve is symmetrical centred on  (mean).
In our example, 50% of people are taller than 5ft 8" and 50% are shorter than
5ft 8".
Standard =  = 4"
deviation
50% 50%
 = 5ft 8"
(b) The total area under the curve = 1 or 100% of the population.
(c) The width of the curve is measured in terms of the standard deviation ().
(d) For practical purposes the range of the normal distribution is six standard
deviations
ie heights of adults range between
 – 3 = 5ft 8" – (3  4") = 4ft 8"
and  + 3 = 5ft 8" + (3  4") = 6ft 8"
There will be occasional exceptions but on the whole heights will be in this
range.
(e) The most useful feature of the normal curve is that, at a point a certain number
of standard deviations from the mean, the area under the curve will always
represent the same % of the population (no matter what normal curve is being
considered).
327
Illustration 4: Normal distribution examples
(a)
Standard =  = 4"
deviation
50% 47.5%
1.96 
In the height example this would mean that 2.5% of the population are
taller than 5ft 8" + 1.96  4" = 6ft 3.84".
(b)
50% 34.13%
1
Here we are measuring a range one standard deviation from the mean ie
5ft 8" + 1  4" = 6ft.
This would mean that 84.13% of the population are shorter than 6ft and
15.87% of the population are taller than 6ft.
(c)
50% 47.72%
2
Here we are measuring a range two standard deviations from the mean ie
5ft 8" + (2  4") = 6ft 4".
This would mean that 97.72% of the population are shorter than 6ft 4"
and 2.28% of the population are taller than 6ft 4".
328
We need a method to translate distances from the mean into probabilities ie

areas under the curve. We do this with a combination of z-scores and normal
distribution tables.
6.6 Z-scores
Distances from the mean in the normal distribution are always measured by the
Key term number of standard deviations they represent. This is known as a z-score.
Formula provided
z = x  (formula on normal distribution table)


6.7 Normal distribution tables

These are tables which give the relationship between % of population and z-score
for any z-score. You will be provided with these in the formulae sheet given in the
assessment.
Illustration 5: Calculating z
Calculate the following z-scores and identify the corresponding proportions using
normal distribution tables.
(a) x = 100,  = 200,  = 50
(b) x = 1,000,  = 1,200,  = 200
Solution
(a) z = x _μ
σ
100 200
=
50
= 2
A z-score of 2 corresponds to a proportion of 0.4772 or 47.72%.
(b) z = x _μ
σ
1,0001,200
=
200
= 1
A z-score of 1 corresponds to a proportion of 0.3413 or 34.13%.
329
Activity 6: Using the normal distribution
The average number of litres of water consumed in three months by accountancy
students is 251. The standard deviation is 15 litres.
Assume a normal distribution.
Required
What is the likelihood that a student will drink:
(a) More than 285 litres?
(b) Less than 200 litres?
(c) Between 220 and 255 litres?
Solution

It is important to recognise that you may need to manipulate the z-score calculation
to answer questions. For example, you may need to work backwards from a % of
population to calculate the z-score and then the x value.
330
Illustration 6: Calculating x
A normal distribution has a mean of 120 and a standard deviation of 15. 75% of
the population is therefore below what value?
Solution
50% of the population is below 120.
25% of the population is below x.
From the normal distribution table, a value of 0.25 equates to a z value of 0.67.
x μ
z=
σ
x 120
0.67 =
15
0.67 × 15 = x – 120
10.05 = x – 120
x = 10.05 + 120
= 130.05
75% of the population is below 130.05.
Activity 7: Manipulating the z-score

Required
A normal distribution has a mean of 150 and a standard deviation of 20.
80% of the population is therefore below what value?
Solution
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Chapter summary
 The arithmetic mean is the best known type of average and is widely
understood. It is used for further statistical analysis.
 The arithmetic mean of ungrouped data = sum of items  number of items.
 fx  fx
 The arithmetic mean of grouped data, x = n
or where n is the
f
number of values recorded, or the number of items measured.
 The mode or modal value is an average which means 'the most frequently
occurring value'.
 The mode of a grouped frequency distribution can be calculated from a
histogram.
 The median is the value of the middle member of an array. The middle item of an
n  1
th
odd number of items is calculated as the item.

2
 The median of a grouped frequency distribution can be established from
an ogive.
 The range is the difference between the highest and lowest observations.
 The quartiles and the median divide the population into four groups of equal
size.
 The semi-interquartile range is half the difference between the upper and
lower quartiles.
 The inter-quartile range is the difference between the upper and lower quartiles
(Q3–Q1) and hence shows the range of values of the middle half of the population.
 The variance, 2, is the average of the squared mean deviation for each value in a
distribution.
 The standard deviation, which is the square root of the variance, is the most
important measure of spread used in statistics. Make sure you understand how to
calculate the standard deviation of a set of data.
 The spreads of two distributions can be compared using the coefficient of
variation.
 The normal distribution is a probability distribution which usually applies to
continuous variables, such as distance and time.
 Properties of the normal distribution are as follows.
1 It is symmetrical and bell shaped.
2 It has a mean, µ (pronounced mew).
3 The area under the curve totals exactly 1.
4 The area to the left of µ = area to right of µ.
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 The normal distribution can be used to calculate probabilities. Sketching a graph of

a normal distribution curve often helps in normal distribution problems.
z = x

Where z = the number of standard deviations above or below the mean
x = the value of the variable under consideration
µ = the mean
 = the standard deviation
 If you are given the variance of a distribution, remember to first calculate the
standard deviation by taking its square root.
333
Keywords
 Arithmetic mean: The best known type of average and is widely understood. It is
used for further statistical analysis. It is calculated as the sum of the values of all
items in a data set, divided by the number of items
 Grouped: Where the frequency is shown in terms of a range. Known as
continuous data
 Inter-quartile range: The difference between the upper and lower quartile; it
shows the range of values of the middle half of the population
 Mean: The best known type of average; calculated as the sum of the values of all
the items, divided by the number of items
 Median: The value of the middle item in a set of data
 Mode: The most frequently occurring item in a set of data
 Normal distribution: A distribution that is symmetrical around the mean
 Quartile: The values that divide a distribution into quarters
 Range: The difference between the highest and lowest possible values
 Standard deviation: A measure of the spread of data round the mean
 Ungrouped: Discrete data, where the frequency is shown in terms of a specific
measure/value
 Z-score: The number of standard deviations away from the mean of a particular
value
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Activity answers
Activity 1: Calculating the mean

Mid-point No of cars Mileage
xf f fx
< 2,000 1,000 10 10,000
2,000 < 4,000 3,000 14 42,000
4,000 < 6,000 5,000 154 770,000
6,000 < 8,000 7,000 292 2,044,000
8,000 < 10,000 9,000 493 4,437,000
10,000 < 12,000 11,000 404 4,444,000
12,000 < 14,000 13,000 164 2,132,000
14,000 < 16,000 15,000 48 720,000
 16,000 17,000 21 357,000
1,600 14,956,000
 fx
Mean =
f
14,956,000
=
1,600
= 9,347.5
The mean annual mileage of these car owners is 9,347.5 miles.
Activity 2: Calculate the median (ungrouped data)

The first thing to do is to arrange the scores in order of magnitude.
8, 9, 11, 12, 14, 15, 17, 21, 24, 34
There are ten items, and so median is the arithmetic mean of the fifth and sixth
items.
14+15 29
= = = 14.50
2 2
The correct answer is therefore C.
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Activity 3: Standard deviation calculation
Mid-point No of cars
2 2
Mileage x f fx x fx
('000) ('000)
<2 1 10 10 1 10
2–<4 3 14 42 9 126
4–<6 5 154 770 25 3,850
6–<8 7 292 2,044 49 14,308
8 – < 10 9 493 4,437 81 39,933
10 – < 12 11 404 4,444 121 48,884
12 – < 14 13 164 2,132 169 27,716
14 – < 16 15 48 720 225 10,800
 16 17 21 357 289 6,069
1,600 14,956 151,696
fx 2
σ   x2
f
151,696
  9.34752 NB. Calculations using '000s of miles.
1,600
= 2.72658........ (measured in '000s)
ie standard deviation = 2,727 miles (nearest mile)
Activity 4: Coefficient of variation

σ
Coefficient of variation =
x
2,727
=
9,347.5
= 0.292 (3 dp)
ie 29.2%
Activity 5: Quartile deviation

Q3  Q1  62 44  18  9
The quartile deviation =
2 2 2
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Activity 6: Using the normal distribution

x = 25
 = 15
(a)
x 2.27
Z(285) = 285  251  2.27  (0.5 – 0.4884)

15  0.0116
 probability of a student drinking more than 285 litres is 0.0116 or 1.16%.
(b)
–3.4 x
200  251  (0.5 – 0.49966)
Z(200) =  3.4
15  0.00035
 probability of a student drinking less than 200 litres in 3 months is 0.00034
(0.034%) ie negligible.
337
(c)
–2.07 0.27
x
220  251
 2.07  0.4808
Z(220) = 15
225  251
 0.27  0.1064
Z(255) = 15
 probability that a student will drink between 220 and 255 litres in 3 months
= 0.4808 + 0.1064 = 0.5872 or 58.72%.
Activity 7: Manipulating the z-score

50% are below 150
Need to find 30% (30% from the tables gives a z of 0.85)
x  150
 0.85  x = 167
20
80% of the population is under 167.
338
Test your learning

1 Insert the formulae in the box below into the correct position.
(a) The arithmetic mean of ungrouped data =
(b) The arithmetic mean of grouped data = or
x
 n
 fx
 n
 fx

f
2 What is the name given to the average which means 'the most frequently occurring
value'?
Arithmetic mean
Median
Mode
3 The mean weight of a group of components has been calculated as 133.5. The
individual weights of the components were 143, 96, x, 153.5, 92.5, y, 47. When
y = 4x;
What is the value of x?
4 Calculate the mid-points for both discrete and continuous variables in the table
below.
Class interval Mid-point Mid-point
(Discrete data) (Continuous data)
25 < 30
30 < 35
35 < 40
40 < 45
45 < 50
50 < 55
55 < 60
60 < 65
5 (a) The mode of a grouped frequency distribution can be found from a(n)
histogram/ogive.
(b) The median of a grouped frequency distribution can be found from a(n)
histogram/ogive.
6 A group of children have the following ages in years: 10, 8, 6, 9, 13, 12, 7, 11.
What is the median age?
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7 Fill in the blanks in the statements below using the words in the box.
(a) quartile = Q1 = value which 25% of the

population fall.
(b) quartile = Q3 = value which 25% of the
population fall.
Upper Above Below Lower
8 (a) The formula for the semi-interquartile range is
(b) The semi-interquartile range is also known as the

9 The area under the curve of a normal distribution = which represents
% of all probabilities.
10 A normal distribution has a mean of 80 and a variance of 16. What is the upper
quartile of this distribution?
340
Investment
appraisal
Learning outcomes

• Explain the time value of money
• Apply financial mathematics
• Calculate the net present value, internal rate of return and payback for an investment or project
Chapter context
One of the key roles of the management accountant is providing information to help make better
decisions. This chapter looks at long-term decision making. It starts by addressing the time value of
money and methods to factor the time value of money into calculations. It then covers several
techniques that can be used to help make a particularly difficult decision: which long-term projects
should be invested in to increase the wealth of the owners of the business?
341
Chapter overview
Decision making and

investment appraisal
Time value Investment

of money appraisal
Discounting or
compounding
Payback NPV IRR
Time taken to The total of all The annual %

Annuities and
repay investment relevant cash flows return from project
perpetuities
Ignores: discounted at cost The discount rate
of capital at which NPV = 0
 The time value
of money Positive NPV – Accept project if
accept project IRR > cost of
 Cash flows after
payback Negative NPV – capital
reject project
NPV is superior to IRR
342
17: Investment appraisal
Introduction
The time value of money
For long-term decision making an important factor is the time value of money. This is
the idea that money today is worth more than the same amount of money in the
future.
Illustration 1: Time value of money

Required
(a) Given a choice between receiving $600 now, or $200 per year for 3 years
starting in one year’s time, which would you choose? Why?
(b) Would your answer change if you were offered only $500 now? How much
of a drop would be required for you to decide to accept the future payments
instead of the immediate payment?
Solution
(a) It is common sense to prefer the immediate payment of $600. Three annual
payments of $200 are not as attractive as $600 received today. This is the
meaning of the term 'time value of money'. The logic behind rejecting the
future cash flows is that you would be better off if you took the $600 now and
put it into a bank account and invested it. Future cash flows are also uncertain
(more risky) and their purchasing power is lower in periods of inflation.
(b) It is more difficult to judge when the immediate cash flow is of a lower nominal
value. We cannot make this decision objectively without some form of analysis
to take into account the time value of money. The standard approach to
dealing with situations like this is to use 'discounting' techniques and we will
look at these later.
1 Interest
1.1 Definition
Interest is the amount of money which an investment earns over time.
1.2 Example
How much will an investor have after 5 years if they invest $1,000 at 10% simple
interest per annum?
Final sum = $1,000 + (5 × 0.1 × $1,000) = $1,500
1.3 Formula
Formula to learn (simple interest)

S = X + rXn
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Where S = final sum
X = amount invested
r = interest rate as a decimal
n = number of periods investment is held for
Activity 1: Simple interest

$500 is invested in a savings account earning simple interest of 0.1% per month.
Required
Calculate the final value in the account after two years.
Solution
2 Compounding
Interest is normally calculated by means of compounding.
Key term Compound interest is where interest is calculated and paid on capital plus any
interest paid or payable earned up to that point.
This means that, as interest is earned, it is added to the original investment and
starts to earn interest itself.
2.1 Formula
Formula provided (compound interest)

S = X (1 + r)n
Where S = final sum
X = amount invested
r = interest rate as a decimal
n = number of periods investment is held for
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Illustration 2: Compound interest

T0 T1 T2 T3 T4
$100
Interest $10 $11 $12 $13
ie S1 = $100 (1 + 0.1) = $110
S2 = S1 +0.1S1 = S1 (1 + 0.1) = 100 (1 + 0.1) (1 + 0.1)
= 100 (1 + 0.1)2
= $121
Activity 2: Compound interest

Required
(a) $500 is invested in a savings account earning compound interest of 10% p.a.
How much will the investment have grown to in five years' time?
(b) $1,750 is invested for 20 years at 6% compound interest. What is the final
value of the investment?
(c) A house is purchased for $200,000. If house price growth is 1.2% per annum
for 8 years, how much will the house be worth in 8 years' time? (To the
nearest whole number)
Solution
345
2.2 Equivalent rates – non-annual compounding
In the previous activities, interest has been calculated annually, but this isn't
always the case. Interest may be compounded daily, weekly, monthly or
quarterly.
For example, $10,000 invested for 5 years at an interest rate (called a nominal
rate) of 2% per month will have a final value of $10,000  (1 + 0.02)60 =
$32,810. Notice that n relates to the number of periods (5 years  12 months) that
r is compounded.
Activity 3: Non-annual compounding

$1,000 initial investment, 6% six-monthly interest rate.
Required
What is the value of the investment after one year and how much interest is earned?
Solution
2.3 Equivalent rates – effective annual interest rate (EAR)
Formula to learn
The non-annual compounding interest rate can be converted into an annual
equivalent using the following formula. (This formula is not given in the assessment.)
(1+R) = (1+r)n
where R = effective annual rate
r = period rate
n = number of periods in a year
The EAR is also called the annual percentage rate (APR) by banks, building societies
and credit companies.
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Activity 4: EAR
Required
If the quarterly rate of interest is 3.9%, what is the annual percentage rate?
Solution
3 Discounting
3.1 Introduction
Discounting – the opposite of compounding. Here we are evaluating an

Key term equivalent value of money at an earlier point in time. We are, in effect, taking
account of the 'time value of money'.
The basic principle of discounting is that if we wish to have $S in n years' time, we

need to invest a certain sum now (year 0) at an interest rate of r% in order to obtain
the required sum of money in the future.
3.2 Formula
Earlier we saw, for compounding, the future value of an amount is given by the
formula:
S = X (1 + r)n
S
Rearranging the formula for X,, the present value, we have X
1 r n
Activity 5: Discounting a single cash flow

We need $1,610 at the end of 5 years from now.
Required
Assuming we could earn 10% p.a., how much should be invested now?
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Solution
3.3 Present value
Present value – the value, in today's prices, of a future cash flow.

Key term
$1,000 is the present value (PV) of $1,610 @ 10% in 5 years.
In purely monetary terms we would be indifferent between receiving $1,000 now or
$1,610 in 5 years. In order to maintain the same purchasing power, we would
require $1,610 in 5 years' time to purchase goods costing $1,000 now.
3.4 Discount factor
Formula provided
1
is known as a discount factor – DFn
1  r 
n
Therefore present value = Sn  DFn

We can take any future cash flow and discount it back to what it is equivalently
worth today.
3.5 Tables
Some discount factors are available in tables. The tables range from discount
(interest) rates of between 1% and 20% and between 1 and 20 periods. Should
interest rates or periods fall outside these ranges then use the formula to derive the
answer.
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Activity 6: Discounting a single cash flow using tables

We need $5,000 at the end of 3 years.
Required
Assuming we could earn interest at 8% p.a., how much should we invest now?
Solution
Activity 7: Discounting with changing interest rates

Required
If the interest rate is currently 10% but in 2 years' time will change to 15%, what is
the 5-year discount factor?
Solution
349
4 Annuities
Annuity – a constant sum of money paid or received each and every period for a
Key term given number of periods.
4.1 Present value

The PV of an annuity is the discounted value of each annuity payment over the
period of the investment. A practical example of this would be someone about to
retire, who wants to 'buy' a pension of $X per year for Y years. The cost of this
pension is the PV of the annuity.
4.2 Present value of an annuity (discounting)

The present value of an annuity represents that amount you would be prepared to
receive now to make you indifferent between future receipts from the annuity and a
cash lump sum at T0 (ie now).
Activity 8: Present value of annuity (timeline)

An investment is made of $100 now and at the end of each of the next 3 years with
a discount rate of 10% per annum.
Required
What is the present value of this investment?
Solution
4.3 Cumulative discount factors

To make the calculations easier we can use cumulative discount factors (CDFs) to
calculate the PV of an annuity.
$100  (1 + DF1 + DF2 + DF3)
The CDF is a sum of the annual discount factors for the period concerned.
CDF1-3 = DF1 + ...... + DF3
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A selection of these are given in the tables. The following formula must be used for
an annuity > 20 periods.
Formula provided
1 1 
CDF1 n  1 
r  (1  r)n 
Formula to learn
Timing
(a) Present value of an annuity starting at time 1 = a  CDFn
(b) Present value of an annuity starting at time 0 (ie now) = a  (1+ CDFn)
Activity 9: Present value of annuity (tables and formula)

Required
(a) What is the present value of an annuity that pays $12,000 at the end of each
year for 10 years, assuming an interest rate of 6%?
(b) What is the present value of an annuity that pays $10,000 at the end of each
year for 25 years, assuming an interest rate of 7.5%?
(c) What is the present value of $1,500 invested now and at the end of each of
the next 4 years at an interest rate of 6%?
Solution
351
4.4 Timing of cash flows (delayed annuities)
If the annuity payment does not start until a future period, we need to take this into
account when calculating the present value of an annuity.
We do this by taking the CDF for years 1 – n (where n is the last payment or receipt
made) and deduct the CDF for the years prior to the start of the annuity.
Activity 10: Delayed annuity

Required
Calculate the present value of an annuity of $3,000 per annum, using a discount
rate of 6% per annum.
The annuity starts at the end of the third year and finishes at the end of the tenth
year.
Solution
4.5 Perpetuities
Perpetuity – an annuity, commencing at T1 which continues to be paid/received at

Key term regular intervals forever.
A perpetuity therefore has no end. For example, you might receive an entry to a
competition offering you $1,000 per year for the remainder of your life.
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Formula provided
PV of $1 per annum in perpetuity = 1

r
For the formula to work, the timing of the first cash flow must be in one year's time
(ie at T1).
Activity 11: Perpetuity calculations

Required
(a) If the interest rate is 10%, what would you pay for a perpetuity of $1,000
starting in 1 year's time?
(b) What would you pay if the same perpetuity starts now?
(c) What would you pay if the same perpetuity starts in 4 years' time?
Solution
5 Investment appraisal
5.1 Importance
To be successful organisations need to make long-term investments. These
investments may be, for example, in new machinery, new products, new production
facilities, or refurbishing retail outlets.
Proper appraisal of projects involving capital expenditure is
important for the following reasons.
(a) A relatively significant amount of the resources of the business will be involved.
(b) A capital investment decision may be difficult to reverse, and on any reversal
considerable costs may have been incurred for little benefit.
(c) Investment decisions need to be considered in the light of strategic and tactical
decisions of the company. The decision made should be consistent with the
company's long-term objective, which will usually be the maximisation of the
wealth of shareholders.
(d) Future benefits need detailed evaluation since they are often difficult to predict.
Consequently, there may be a high degree of risk and uncertainty.
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5.2 Techniques
Businesses need techniques to help them decide which investments are worth
making. The assumption made is that the key criteria in making the decision is
whether the investment will increase the wealth of the owners of the business.
There are three investment appraisal techniques that you need to be able to use in
BA2.
All three techniques are based on relevant cash flows.
6 Payback period
6.1 Definition
Payback period – a measure of how many years it takes for the cash flows
Key term affected by the decision to invest to repay the cost of the original investment.
A long payback period is considered risky because it relies on cash flows that are
in the distant future.
Activity 12: Payback period

GA Co is considering purchasing a new machine for $250,000. Cash flow
projections from the project (which can be assumed to accrue evenly) are shown
below.
Year Net cash flows
$
1 60,000
2 60,000
3 80,000
4 100,000
5 100,000
After 5 years the machine will be scrapped. The scrap value of the machine is
included in the year 5 cash flow shown above.
Required
Calculate the payback period for the project, in years, to 1 decimal place.
Solution
354
6.2 Decision rule

The decision rule is to accept all projects with a payback period within the
company's target payback period.
6.3 Advantages of payback

(a) A simple way of screening out projects that look too risky
(b) Useful when a company has cash flow problems
6.4 Disadvantages of payback

(a) Ignores the timing of the cash flows within the payback period
(b) Ignores the cash flows outside the payback period
(c) Ignores the time value of money
7 Discounted cash flow techniques: net present

value (NPV)
7.1 NPV
We need a technique that allows us to take into account the timing of cash flows
when deciding whether to accept a project.
Net present value technique – a comparison of the discounted value of the future
Key term cash flows with the cost of setting up a project today.
Many projects involve investing money now and receiving returns on the
investment in the future; so the timing of a project's cash flows need to be analysed
to see if they offer a better return than the return an investor could get if they
invested their money in other ways.
The process of adjusting a project's cash flows to reflect the return that investors
could get elsewhere uses the discounting principles we saw earlier in this chapter.
The cash flows of the project are discounted to present value and compared to
the cash outlay taking place.
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Illustration 3 – NPV
Dog Co is considering whether to spend $5,000 on an item of equipment. The
'cash profits', the excess of income over cash expenditure, from the project would
be $3,000 in the first year and $4,000 in the second year. The company will not
invest in any project unless it offers a return in excess of 15% per annum.
Required
Assess whether the investment is worthwhile, or 'viable'.
In this example, an outlay of $5,000 now promises a return of $3,000 during the
first year and $4,000 during the second year. It is a convention in discounted
cash flow, however, that cash flows spread over a year are assumed to occur at
the end of the year, so that the cash flows of the project are as follows.
$
Year 0 (now) (5,000)
Year 1 (at the end of the year) 3,000
Year 2 (at the end of the year) 4,000
A net present value (NPV) statement could be drawn up as follows.
Year Cash flow Discount factor Present value
$ 15% $
0 (5,000) 1.000 (5,000)
1 3,000 0.870 2,610
2 4,000 0.756 3,024
Net present value +634
The project has a positive NPV, so it is acceptable.
Activity 13: Net present value (1)

Required
If a project involved the outlay of $1,000 today and provided a definite return of
$1,001 in 1 year's time, would you accept it if you could get a return of 5% on
investments of similar risk?
356
Solution
7.2 Decision rule

If the discounted value of the future cash flows are higher than the cost of setting up
a project today, then the project has a positive NPV and should be accepted.

Required
(a) If a project involved the outlay of $1,000 today and provided a definite return
of $1,000 per year for 2 years starting in 1 year's time, would you accept
it if you could get a return of 5% on investments of similar risk?
(b) If a project involved the outlay of $1,000 today and provided a definite return
of $1,000 per year, for the foreseeable future starting in 1 year's time,
would you accept it? (Again assume that you could get a return of 5% on
investments of similar risk.)
Solution
357
Annuity – a series of equal cash flows. Use the annuity table or discount
Key term
each cash flow separately, whichever you prefer (the annuity table is quicker).
Cost of capital – the return required by the company's investors (5% in
the activity. If required this will always be provided in the assessment).
Activity 15: NPV – GA Co

We earlier calculated the payback for GA's proposed investment, the details of
which are reproduced below.
GA Co is considering purchasing a new machine for $250,000. Cash flow
projections from the project are shown below.
Year Net cash flows
$
1 60,000
2 60,000
3 80,000
4 100,000
5 100,000
After 5 years the machine will be scrapped. The scrap value of the machine is
included in the year 5 cash flow shown above. GA's cost of capital is 10%.
Required
Calculate the NPV for the project.
Solution
358
Advantages of NPV Disadvantages of NPV
Shareholder wealth is maximised. It can be difficult to identify an

appropriate discount rate.
It takes into account the time value of For simplicity, cash flows are sometimes all
money. assumed to occur at year ends: this
assumption may be unrealistic.
It is based on cash flows which are less Some managers are unfamiliar with the
subjective than profit. concept of NPV.
Shareholders will benefit if a project with

a positive NPV is accepted.
8 Discounted cash flow techniques: Internal rate of

return (IRR)
8.1 Introduction
Internal rate of return – a discounted cash flow technique that calculates the
Key term annual percentage return given by a project.
8.2 Decision rules

If the internal rate of return (IRR) is greater than the cost of capital then the project
should be accepted. If it earns a lower rate of return, it is not worthwhile (and
its NPV would be negative).
8.3 Interaction with NPV

IRR is also the discount rate where the NPV of the project = 0.
Graphical representation of IRR
NPV
IRR
r%
For most investments the NPV of a project will decrease as the discount rate (the
required rate of return) increases as demonstrated by the illustration above.
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8.4 The three-step approach to calculating the IRR
Step 1
Calculate the NPV of the project at the first rate (usually the cost of
capital given in the question)
Step 2
Calculate the NPV of the project at a second rate
If the first NPV is positive then use a higher rate whereas if the first NPV is negative
then use a lower rate.
Step 3
Calculate the IRR using the formula
Note. You will need to learn the formula for the assessment.
The formula will work whether you have two positive NPVs, two negative NPVs, or
a positive and a negative NPV.
Formula to learn
NPVa
IRR = a + (b–a)
NPVa – NPVb
Where a is the lower discount rate giving NPVa
b is the second discount rate giving NPVb
Activity 16: IRR – GA Co

Required
Calculate the internal rate of return (to 1 decimal place) for GA's project shown in
the previous activity.
Solution
Step 1 is complete – we already know from Activity 15 that the NPV
at 10% is + $44,580.
360
9 NPV or IRR?
Both NPV and IRR are superior methods for appraising investments compared to
payback because:
(a) They account for the time value of money
(b) They look at the cash flows over the whole life of the project
9.1 Advantage of IRR

IRR gives the annual percentage return of a project. This concept is easy for
non-financial managers to understand and for financial managers to calculate
because it does not require the calculation of a cost of capital.
9.2 Disadvantage of IRR

IRR can result in dysfunctional behaviour. This is best illustrated by looking at
an example.
Activity 17: Dysfunctional behaviour

You are given the opportunity to invest in one of two mutually exclusive projects (ie
you can invest in either project A or project B but not both).
Project Initial Project return

investment ($) %
A 10 50
B 1,000 1
Required
Which project should you invest in if your objective is to maximise your wealth?
361
Solution
Disadvantages Explanation
Mutually exclusive projects A smaller project might be chosen over a larger

project because it has a higher IRR. NPV would
choose the larger project because it deals in $,
not %.
A change in direction of the If there is another year of negative cash flows,

cash flows there may be more than 1 IRR. This means that IRR
becomes confusing.
Conclusion – NPV is a better technique.
9.3 The role of IRR

NPV does not have any of the problems of IRR. The role of IRR is to act as a tool for
explaining the benefits of an investment to non-financial managers. It should not be
used as the financial analysis used to justify the investment decision.
This is not to say that NPV is perfect. Like any financial technique, there is the
danger that the non-financial benefits of an investment are ignored.
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Chapter summary
 The time value of money is based on the concept that money received now is
worth more than the same sum received in one year's time or at another time in the
future.
 Simple interest is interest which is earned in equal amounts every year (or month)
and which is a given proportion of the original investment (the principal). The simple
interest formula is S = X + nrX.
 Compounding means that, as interest is earned, it is added to the original
investment and starts to earn interest itself. The basic formula for compound interest
is S = X(1 + r)n.
 An effective annual rate of interest is the corresponding annual rate when
interest is compounded at intervals shorter than a year.
 A nominal rate of interest is an interest rate expressed as a per annum figure
although the interest is compounded over a period of less than one year. The
corresponding effective rate of interest shortened to one decimal place is the
annual percentage rate (APR).
 Annuities are an annual cash payment or receipt which is the same amount every
year for a number of years.
 The present value of an annuity of $1 per annum receivable or payable for n
years commencing in one year, discounted at r% per annum, can be calculated
using the following formula.
 
1 1 
PV = 1
r  1+r n 
   
Note that it is the PV of an annuity of $1 and so you need to multiply it by the actual
value of the annuity.
 The present value of an annuity can also be calculated by using annuity factors
found in annuity tables.
Present value of an annuity
Annuity =
Annuity factor
 A perpetuity is an annuity which lasts forever, instead of stopping after n years.

The present value of a perpetuity is PV = a/r where r is the cost of capital, as
a proportion.
 The concept of present value can be thought of in two ways.
1 It is the value today of an amount to be received some time in the future.
2 It is the amount which would have to be invested today to produce a given
amount at some future date.
363
 Discounting is the reverse of compounding. The discounting formula is X = S 
1/(1 + r)n which is a rearrangement of the compounding formula.
The key methods of project appraisal are:
1 The payback period
2 Net present value
3 Internal rate of return (IRR)
 The payback period is the time taken for the initial investment to be recovered in
the cash inflows from the project. The payback method is particularly relevant if
there are liquidity problems, or if distant forecasts are very uncertain.
 Discounted cash flow approaches take account of the time value of money –
the fact that $1 received now is worth more because it could be invested to become
a greater sum at the end of a year, and even more after the end of two years, and
so on. As with payback, discounted cash flow approaches use cash figures before
depreciation in the calculations.
 The net present value method calculates the present value of all cash flows,
and sums them to give the net present value. If this is positive, then the project is
acceptable.
 The internal rate of return technique uses a trial and error method to discover
the discount rate which produces the NPV of zero. This discount rate will be the
return forecast for the project.
364
Keywords
 Annuity: An annual cash payment or receipt which is the same amount every year
for a number of years
 Compounding: Interest is calculated and paid on capital plus any interest paid or
payable earned up to that point. The process of compounding converts a present
value to a future value by adding interest
 Discounting: Evaluating an equivalent value of money at an earlier point in time.
Discounting converts a future value to a present value
 Internal rate of return: The annual percentage return given by a project
 Net present value: A comparison of the discounted value of the future cash flows
with the cost of setting up a project today
 Payback period: How many years it takes for the cash flows affected by the
decision to invest to repay the cost of the original investment
 Perpetuity: An annuity which lasts forever
 Present value: The value, in today's prices, of a future cash flow
365
Activity answers
Activity 1: Simple interest

Final value = 500 + (0.001 × 500 × 24)
= $512
Activity 2: Compound interest

(a) 500(1 + 0.1)5 = $805.26
(b) 1,750 × (1 + 0.06)20 = $5,612.49
8
(c) 200,000 × (1 + 0.012) = $220,026
Activity 3: Non-annual compounding

0 6 months 1
$60 $63.6
$1,000 $1,060 $1,123.6
Alternative
S2 = $1,000(1.06)2
= $1,123.6
Activity 4: EAR
1+R = (1 + 0.039)4
1+R = 1.165
R = 16.5%
Activity 5: Discounting a single cash flow

$1,610
S1 =  $1,000
(1.1)5
Activity 6: Discounting a single cash flow using

tables
DF3 = 0.794
 PV = $5,000  0.794 = $3,970
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Activity 7: Discounting with changing interest rates

1
DF5 =  0.543
(1.1)2 (1.15)3
Activity 8: Present value of annuity (timeline)

100 100 100
PV = 100 +  
(1 0.1) (1 0.1)2 (1 0.1)3
= $348.69
Activity 9: Present value of annuity (tables and

formula)
(a) Using tables, annuity factor is 7.360. Make sure you can find this figure in the
annuity discount tables. You need to look up 6% for period 10.
PV = 12,000 × 7.36 = $88,320
Using formula:
1  1 
PV  12,000  1 
0.06  1 0.0610 
 
= $88,321
Always use the discount tables if you can.
1  1 
(b) PV  10,000  1 
0.075  1 0.075 25 
= $10,000 × 11.147
= $111,470
(c) Using tables:
PV = 1,500 × (1 + 3.465)
= 6,697.50
Using formula:
 
1  1 
PV  1,500  1,500  1
0.06  1 0.06 4 
 
PV = 1,500 + 5,197.66 = $6,697.66
Activity 10: Delayed annuity

PV of annuity for 3–10 years
CDF = (CDF 1 to 10) minus (CDF 1 to 2)
Using tables: @ 6% = 7.360 – 1.833
3,000 × (7.360 – 1.833) = $16,581
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Activity 11: Perpetuity calculations
1,000
(a)  $10,000
0.1
(b) PV = a × (1 + 1/r)
PV = 1,000 × (1+ 1/10%)
PV = $11,000
(c) CDF = 1/r – CDF1-3
CDF = 1/10% – 2.487
CDF = 7.513
PV = a × CDF
PV = 1,000 × 7.513
PV = $7,513
Activity 12: Payback period

Time Net cash flows Cumulative cash flow
$ $
0 (250,000) (250,000)
1 60,000 (190,000)
2 60,000 (130,000)
3 80,000 (50,000)
4 100,000 50,000
Assuming that the cash flows occur evenly during year 4, payback will be 3 +
50,000/100,000 = 3.5 years.

Discount Present
Time Cash flow factor (5%) value
0 (1,000) 1.000 (1,000)
1 1,001 0.952 953
NPV (47)
A negative NPV means that the investment does not give a 5% return and therefore
should be rejected.

(a)
Time Cash flow Discount factor (5%) Present value
0 (1,000) 1.000 (1,000)
1 1,000 0.952 952
2 1,000 0.907 907
NPV 859
oder
368

0 (1,000) 1.000 (1,000)
1–2 1,000 1.859 1,859
NPV 859
A positive NPV means that the investment gives more than a 5% return and
therefore should be accepted.
(b)
0 (1,000) 1.000 (1,000)
1+ 1,000 20.000* 20,000
NPV 19,000
A positive NPV means that the investment gives more than a 5% return and
therefore should be accepted.
* The discount factor for a cash flow that occurs every year (a perpetuity)
starting in one year's time is 1/r =1/0.05 = 20.
Activity 15: NPV – GA Co

0 (250,000) 1.000 (250,000)
1 60,000 0.909 54,540
2 60,000 0.826 49,560
3 80,000 0.751 60,080
4 100,000 0.683 68,300
5 100,000 0.621 62,100
NPV 44,580
Activity 16: IRR – GA Co

Step 1 is complete – we already know from Activity 15 that the NPV at 10% is +
$44,580.
Step 2
As the NPV is positive at 10% the IRR must be higher than this, therefore try 15%
(but any rate higher than 10% could have been used).
0 (250,000) 1.000 (250,000)
1 60,000 0.870 52,200
2 60,000 0.756 45,360
3 80,000 0.658 52,640
4 100,000 0.572 57,200
5 100,000 0.497 49,700
NPV 7,100
369
Step 3
NPVa
IRR = a + (b – a)
NPVa  NPVb
a =10, NPVa = 44,580
b = 15, NPVb = 7,100
44,580
IRR = 10 + (15 – 10) = 15.9%
44,580  7,100
Activity 17: Dysfunctional behaviour

Project Initial investment Project return Project return
$ $
A 10 50% 5.00
B 1000 1% 10.00
Even though it produces a lower percentage return, it is investment B that increases
your wealth more in absolute terms (ie $s) and therefore it is this investment that
should be accepted.
370
Test your learning

1 An investor has been offered two deals:
Option 1 1.1% compounded every 3 months
Option 2 3.2% compounded every 6 months
Which option offers the best APR?
2 A machine will cost $25,000 to replace in 25 years' time. The rate of interest is
8.5% per annum.
What is the present value of the replacement cost of the machine? (To the nearest $)
3 A project requiring an investment of $120,000 is expected to generate returns of

$40,000 in years 1 and 2 and $35,000 in years 3 and 4. If the NPV is $22,000
at 9% and –$4,000 at 10%, what is the IRR for the project? (To 2 decimal places)
4 What is the present value of an annuity of $5,000 per annum discounted at 7% if it

starts at the end of the third year and finishes at the end of the tenth year?
5 What is the yardstick for acceptance of projects when using the net present value
method?
A Accept if a profit is made
B Accept if the present value of future cash flows is positive
C Accept if payback occurs within an reasonable time frame
D Accept if the discount rate that achieves a breakeven return is greater than the
company's cost of capital
6 Tick the correct box to indicate whether or not the following items are included in
the cash flows when determining the net present value of a project.
Included Not included
(a) The disposal value of equipment at the end of its life
(b) Depreciation charges for the equipment
(c) Research costs incurred prior to the appraisal
(d) Interest payments on the loan to finance the investment
371
372
Test your learning – answers
Chapter 1: Introduction to management accounting

1 False. Management accounting is mainly concerned with the preparation of
management accounts for internal managers of an organisation. Financial
accounts are prepared for individuals external to an organisation eg
shareholders and customers.
2 A Implementing. The purpose of management information is to help
managers to manage resources efficiently and effectively by planning
and controlling operations and by allowing informed decision making.
3 Management accounting is increasingly being viewed as supporting
management rather than being part of the finance function.
4 Decision making
5  True
The management accountant may frequently have to take into account non-
financial information.
Chapter 2: Costing
1 (a) Cost unit
(b) Cost centre
(c) Cost object
2 Historical cost
3 A
4 (a) Direct, indirect (overhead) costs
(b) Functional
5 B The others are direct labour.
6 B Note that the question said 'the main aim'. Performance measurement
may well be used to decide on bonus levels but this is not the main aim.
7  Direct expense
The royalty cost can be traced in full to the company's product, therefore it is a
direct expense.
Chapter 3: Cost behaviour

1 False. They will rise.
2 (a) Stepped cost. Example: rent, supervisors' salaries
(b) Variable cost. Example: raw materials, direct labour
(c) Semi-variable cost. Example: electricity and telephone
(d) Fixed. Example: rent, depreciation (straight line)
373
3 True
4 Variable cost = $50 per employee per month
Fixed costs = $10,000 per month
Activity Cost
$
High 1,300 75,000
Low 1,175 68,750
125 6,250
Variable cost per employee = $6,250/125 = $50
For 1,175 employees, total cost = $68,750
Total cost = variable cost + fixed cost
$68,750 = (1,175  $50) + fixed cost
Fixed cost = $68,750 – $58,750
= $10,000
5 $187,000
Using the high-low method we have:
Units Cost
$
Highest 9,500 320,000
Lowest 4,700 252,800
Difference 4,800 67,200
Variable costs = 67,200/4,800 = $14/unit

Fixed costs = Total cost – variable cost
At 9,500 units, fixed cost = $320,000 – (9,500 × $14) = $187,000
6 B Variable. Make sure you read the question carefully. Note that the $5 is
per staff member so 100 staff would mean $500 in expenditure.
7 A The difference between variable cost and total cost = fixed cost.
8 D The name given to cost unaffected by increases and decreases in the
volume of output is fixed costs.
9 C Telephone bills usually have a fixed element (the line rental) and a
variable element (the charge per call made). Options A, B and D are all
usually fixed costs.
10 B Only part of the cost is variable so a 10% increase in activity will lead to
a less than 10% increase in the overall cost. Cost per unit will therefore
decrease by less than 10%.
374
Chapter 4: Absorption costing

1 False. It is the process whereby whole cost items are charged direct to a cost
unit or cost centre.
2 (a) (3)
(b) (4)
(c) (2)
(d) (3)
3 Department Involved in production ()
Finished goods warehouse
Canteen
Machining department 
Offices
Assembly department 
4 A = 2
B = 4
C = 1
D = 5
E = 3
5 Repeated distribution method or algebraic method
6 B
7 True
8 Traditional costing systems tend to allocate too great a proportion of
overheads to high volume products and too small a proportion of overheads
to low volume products.
9 True. It is generally the case that overheads increase with time therefore a time-
based approach is considered most sensible.
True. This method is not particularly logical.
Budgeted overheads $600,000
10 D OAR = = = $5 per labour hour
Budgeted labour hours 120,000
Overheads absorbed = 110,000 hours  $5
= $550,000
Overheads absorbed – actual overheads = $550,000 – $660,000
= $110,000
 overheads were under-absorbed by $110,000.
375
Chapter 5: Marginal costing and pricing decisions
1 Contribution
2 A or M
(a) Closing inventories valued at marginal production cost M
(b) Closing inventories valued at full production cost A
(c) Cost of sales include some fixed overhead incurred in A
previous period in opening inventory values
(d) Fixed costs are charged in full against profit for the period M
3 All are arguments in favour of marginal costing.

4 Required return = 12%  $1,000,000 = $120,000
Expected revenue = 1,200  $500 = $600,000
Expected cost = expected revenue – required return
 Expected cost = $(600,000 – 120,000) = $480,000
 Full cost per unit = $480,000/1,200 = $400
5 (a) $255.70 + $483.50 = $739.20
Selling costs are never included in inventory valuations. The valuation
under absorption costing is the full production cost so it is the sum of the
fixed production cost and the variable production cost.
(b) $483.50
Selling costs are never included in inventory valuations. The valuation
under a variable costing system is the variable production cost.
6 B Closing inventory valuation under absorption costing will always be
higher than under marginal costing because of the absorption of fixed
overheads into closing inventory values.
The profit under absorption costing will be greater because the fixed
overhead being carried forward in closing inventory is greater than the
fixed overhead being written off in opening inventory.
7 A fixed cost.
8 D If inventory levels decrease, marginal costing will report the higher profit.
If inventory levels increase, absorption costing will report the higher
profit. The profit figures will be the same where inventory levels are
unchanged.
9 B 200 units  ($7.50 – $4.80)/unit
10 D Under marginal costing, closing inventory will be valued lower than
under absorption costing. If production is greater than sales the inventory
level has increased during the month. Absorption costing would therefore
produce a higher profit than marginal costing.
376
Chapter 6: Breakeven analysis

Fixed costs
1 (a) Breakeven point (sales units) =
Contributi on per unit

oder
Fixed costs
(b) Breakeven point (sales revenue) =
C/S ratio
or
C/S ratio
2 False. The P/V ratio is a measure of how much contribution is earned from
each $1 of sales.
3 False. At the breakeven point there is no profit.
4 At the breakeven point, total contribution = fixed costs.
5 The total contribution required for a target profit = fixed costs + required profit.
6 C The fixed cost line runs parallel to the horizontal axis and the breakeven
point is the intersection of the sales line and the total costs line.
7 Margin of safety
8 D The sales revenue can be calculated as $157,500/0.35 = $450,000.
The number of units cannot be calculated with the information supplied.
9 B $135,000
Fixed costs
Breakeven point =
Contribution/unit
Fixed costs
 70,000 units =
$4.50
 Fixed costs = 70,000 units  $4.50
= $315,000
Budgeted sales units  Breakeven sales units
Margin of safety =
Budgeted sales units
Budgeted sales units  70,000
 0.3 =
Budgeted sales units
Let x = budgeted sales units
x  70,000
0.3 =
x
 0.3x = x – 70,000
 70,000 = x – 0.3x
377
 70,000 = 0.7x
 x = 100,000 = budgeted sales units
Total profit = Contribution – fixed costs
= (100,000 units  $4.50) – $315,000
= $135,000
10
 It assumes fixed costs are constant at all levels of output.
 It assumes that variable costs are the same per unit at all levels of output.
 It assumes that sales prices are constant at all levels of output.
 It assumes production and sales are the same (inventory levels are
ignored).
 It ignores the uncertainty in the estimates of fixed costs and variable
cost per unit.
You may also have thought:
 A breakeven chart may be time consuming to prepare.
Chapter 7: Limiting factor analysis

1 Step 1 Confirm that the limiting factor is something other than sales
Step 2 Calculate contribution per unit of limiting factor for each product
Step 3 Make products in rank order until scarce resource is used up
(optimal production plan)
2 Biggest
3 D Limiting factors are resources or demand.
4 D Milk (0.5 × 100 + 0.4 × 200 + 0.25 × 75) = 148.75 litres, but only
140 are available
5 C (contribution per litre for CE = $20, for TD is $22.50 and for SS is $24)
Note. Always round down the last unit unless divisible.
Chapter 8: Standard costing

1 A standard cost is a planned unit cost.
2 False. It has a number of uses including:
(a) To value inventory and cost production for cost accounting purposes
(b) To act as a control device by establishing standards and highlighting
activities that are not conforming to plan and bringing these to the
attention of management
378
3 A
4 False. They can be used in marginal costing too.
5 (a) Ideal
(b) Attainable
(c) Current
(d) Basic
6 Standard material cost per unit = standard material usage  standard material
price
7 Three of:
(a) Deciding how to incorporate inflation into planned unit costs
(b) Agreeing on a performance standard (attainable or ideal)
(c) Deciding on the quality of materials to be used (a better quality of
material will cost more, but perhaps reduce material wastage)
(d) Estimating materials prices where seasonal price variations or bulk
purchase discounts may be significant
(e) Finding sufficient time to construct accurate standards as standard
setting can be a time-consuming process
(f) Incurring the cost of setting up and maintaining a system for
establishing standards
(g) Dealing with possible behavioural problems, managers responsible
for the achievement of standards possibly resisting the use of a standard
costing control system for fear of being blamed for any adverse
variances
8 A, B and D
If standards are planned carefully they can be an aid to more accurate
budgeting. Cost consciousness can be stimulated when a target of efficiency is
set for employees. Variances enable the principle of management by exception
to be operated by setting tolerance limits.
Chapter 9: Flexible budgeting

1 (a) At the planning stage, a flexible budget can show what the effects
would be if the actual outcome differs from the prediction.
(b) At the end of each period, actual results may be compared with the
relevant activity level in the flexible budget as a control procedure.
(c) Master budgets are fixed budgets.
2 True
3 Budget cost allowance = budgeted fixed cost + (number of units  variable
cost per unit)
379
4 Using a fixed budget at the planning stage means that only one activity level
scenario is planned for. Management is not forced to think of contingency
plans for different activity levels.
When actual results are compared against a fixed budget the variances that
are due to different activity levels can produce a misleading impression of
performance.
5 A fixed budget is a budget which is designed to remain unchanged
regardless of the volume of output or sales achieved.
A flexible budget is a budget which, by recognising different cost
behaviour patterns, is designed to change if volumes of output change.
6 A fixed budget profit might differ from an actual profit because costs were
higher or lower than expected given the actual output and/or sales volumes
were different to the level expected.
7 cost behaviour patterns
flex/change
8  A budget which by recognising different cost behaviour patterns is
designed to change as the volume of activity changes.
A flexible budget shows the budgeted costs and revenues at different
levels of activity. The budgeted variable costs and revenues are
increased or decreased in line with changes in activity, and
the budgeted fixed cost remains unaltered.
9  A budget which is most generally used for planning purposes
 A budget for a single level of activity

Fixed budgets are prepared for a single level of activity and do not
include any provision for the event that actual volumes may differ from
the budget. They are generally used for planning purposes because they
use a single level of activity for co-ordination and resource allocation.
Chapter 10: Budget preparation

1 (a) Co-ordinate
(b) Communicate
(c) Control
(d) Planning
2 C
3 D
4 1st Sales
2nd Production
3rd Material usage
380
4th Material purchase

5th Cash
5 Short-term surplus Increase payables
Long-term surplus Replace/update non-current assets
Short-term shortfall Issue share capital
Long-term shortfall Increase receivables and inventory
6 False. Only cash flow items are included in cash budgets. Depreciation is not
a cash flow and so is not included in a cash budget.
7 A
8 D Jan Feb
$ $
Sales 60,000 80,000
Gross profit (@ 40%) 24,000 32,000
Cost of sales (sales – GP) 36,000 48,000
Closing trade payables (@ 50%) 18,000 24,000
$
Feb opening payables 18,000
Increase in amounts owing (COS) 48,000
Feb closing payables (24,000)
Amount paid in Feb 42,000
9 $7,300,000
Jay Co needs to produce 100,000 + 20,000 = 120,000 units in September.
Labour hours required = 120,000 units  3 hours
= 360,000 hours
Only 340,000 hours are usually worked so there will need to be overtime of
360,000 – 340,000 = 20,000 hours.
$
360,000 hours at basic rate ( $20) 7,200,000
20,000 hours at premium ( $20  25%) 100,000
Budgeted labour cost 7,300,000
10 When preparing a production budget, the quantity to be produced is equal to

sales minus opening inventory plus closing inventory.
381
Chapter 11: Variance analysis
1 (a) Price
Usage
Rate
(b)
Efficiency
Expenditure
(c)
Efficiency
2 C Unforeseen discounts received would lead to a favourable price
variance.
3 B $124 Adverse
$
6,200 kg should have cost (× 50c) 3,100
But did cost 3,224
124 (A)
4 D
5 True. The variance is favourable if the actual price is higher than standard.
6 False. Favourable material price and adverse material usage variances might
be interdependent, for example.
7 The correct words are budgeted and actual.
8 C First we write out the way we would normally calculate the material
efficiency variance and fill in the figures that we know.
2,200 units should have used (× 3,000/1,500 kg) 1,100 kg
But did use (Q)
Material efficiency variance in kg (P)
 standard cost per kg x $3
$1,650 (A)
Working backwards we can see that the efficiency variance in kg (box

(P))
= 1,650 ÷ $3
= 550 kg
Now that we know the efficiency variance in kg, we can work out the
number of kg that were actually used (box (Q)).
= 550 kg + 1,100 kg
= 1,650 kg
382
9 D $5,775
1,650 kg should have cost (× $3) 4,950
But did cost
Materials price variance 825 (A)
Working backwards we can see that the actual cost must have been 825
+ 4,950 = $5,775.
Chapter 12: Job and batch costing

1 A Homogeneous means 'all the same'. Jobs are usually on customer request
and therefore are all different.
2 (a) $100,000 + (25%  $100,000) = $100,000 + $25,000 = $125,000
(b) Profit is 25% of the selling price, therefore selling price should be written
as 100%:
%
Selling price 100
Profit 25
Cost 75
 Price = $100,000  100/75 = $133,333.

3 B A pizza manufacturer would probably use batch costing. Sugar and
screws are both homogenous items so do not need job costing.
4 A group of similar articles which maintains its identity during one or more
stages of production and is treated as a cost unit.
5 Total batch cost

Number of units in the batch
6 D (630 ÷ 0·9 hours)  $12/hour) = $8,400.

Closing work in progress value = 61,894 + 3,190
= $65,084
7 Charge for each hour of writing (to the nearest cent) should be $ 28.94
Weeks worked per year = 52 – 4 = 48
Hours worked per year = 48  40 hrs
= 1,920
Hours chargeable to clients = 1,920  90% = 1,728
Total expenses = $10,000 + $40,000 = $50,000
$50,000
Hourly rate = = $28.94 per hour
1,728
383
Chapter 13: Service costing and performance
measures
1 B Note that the question said 'the main aim'. Performance measurement
may well be used to decide on bonus levels but this is not the main aim.
2 ROCE = A  100% Profit margin = A  100%
B C
3 A Asset turnover = sales  capital employed. Net profit margin = net profit
 sales revenue
4 False. Labour, direct expenses and overheads will be a greater proportion of
total cost.
5 Service Cost unit
Hotels Patient/day
Education Meal served
Hospitals Full-time student
Catering organisations Occupied bed-night
6 C
7 Average cost per unit of service =
Total costs incurred in the period
Number of service units supplied in the period
8 Service costing characteristics include composite cost units and high levels of
indirect costs as a proportion of total cost. Not-for-profit organisations such as
hospitals would not measure performance on profit so profit per patient would
be inappropriate.
9  High levels of indirect costs as a proportion of total cost
 Cost units are often intangible
 Use of composite cost units

In service costing it is difficult to identify many attributable direct costs. Many
costs must be treated as indirect costs and shared over several cost
units, therefore the first characteristic does apply. Many services are
intangible; for example, a haircut or a cleaning service provide no physical,
tangible product. Therefore the second characteristic does apply. Composite
cost units such as passenger-mile or bed-night are often used in service
costing, therefore the third characteristic does apply. The fourth characteristic
does not apply because equivalent units are more often used in costing for
tangible products.
10  Patient/day
 Operating theatre hour
 Outpatient visit
384
All of the above would be measurable and would be useful for control
purposes. A ward and an x-ray department are more likely to be used as
cost centres for the purpose of cost collection and analysis.
Chapter 14: Cost bookkeeping

1 (a) DR Work in progress control account
CR Production overhead account
(b) DR Finished goods control account
CR Work in progress control account
2 II
IV
VI
Costs incurred are debited to the materials account, and those issued as direct
materials to production are credited to the materials account and subsequently
debited to the work in progress account.
3 I False. Total wages paid was $110,000.
II True. Indirect wages of $7,000 were charged to production overhead.
III False. Wages were prepaid at the end of October.
4 False. Material usage variances are recorded in the WIP account.
5 I True.
II False. This is one of the disadvantages of an integrated system. It must
conform to statutory requirements but this is not necessarily useful for
management purposes.
III True. Having one set of accounts instead of two eliminates the need to
reconcile the two systems.
IV True. As mentioned above, the integrated system must conform to
statutory requirements. Internal management information does not need
to conform to statutory requirement and in some cases it is more useful if
it doesn't.
6 Material usage variance, variable overhead efficiency variance and idle time
variance. The material price variance is recorded in the stores control account.
The labour rate variance is recorded in the wages control account. The sales
variances do not appear in the books of account.
7 C The cost of indirect materials issued is credited to the stores
account and 'collected' in the overhead control account pending its
absorption into work in progress. Therefore the correct answer is
C.
8 C An account which records total cost as opposed to individual costs
9 D Debit Work in progress account Credit Production overhead account
385
Chapter 15: Risk and probability
1 B The data tells us that there was a machine breakdown on 120 days (480
– 360) out of a total of 480.
P(machine breakdown) = 120/480  100%
= 25%
You should have been able to eliminate option A immediately since a
probability of 0% = impossibility.
If you selected option C, you calculated the probability of a machine
breakdown as 120 out of a possible 365 days instead of 480 days.
If you selected option D, you incorrectly calculated the probability that
there was not a machine breakdown on any particular day.
2 C Factory Ratio of visits
North 1
South 2
West 1
4
P(visiting North factory) = 1/4 = 0.25
If you didn't select the correct option, make sure that you are clear about
how the correct answer has been arrived at. Remember to look at the
ratio of visits since no actual numbers of visits are given.
3 11,500
EV = (15,000 × 0.2) + (20,000 × 0.5) + (–5,000 × 0.3)

= 3,000 + 10,000 – 1,500
= 11,500
4 Expected sales volume = (1,500 × 0.8) + (2,500 × 0.2) = 1,700
 Expected sales revenue = 1,700 × $6 = $10,200
Expected unit cost = ($2.30 × 0.65) + ($2.50 × 0.35) = $2.37
 Expected total variable costs = $2.37 × 1,700 = $4,029
Profit = sales – variable costs – fixed costs = $10,200 – $4,029 – $2,500 =
$3,671
5 A An expected value is the sum of the different possible outcomes (x)
multiplied by their associated probability of occurrence (p).
6 Expected values would be useful for decisions (a) and (d) because they are
repeated several times.
386
Chapter 16: Averages and the normal distribution

x
1 (a) n
 fx  fx
(b) n or
f
2 Mode
3 80.5
Total
Mean =
7
So Total = 7 × 133.5
= 934.5
934.5 = 143 + 96 + x + 153.5 + 92.5 + y + 47
934.5 = 532 + x + y
y = 4x
So 934.5 = 532 + x + 4x
5x = 934.5 – 532
5x = 402.5
x = 80.5
4 Class interval Mid-point Mid-point
(Discrete data) (Continuous data)
25 < 30 27 27.5
30 < 35 32 32.5
35 < 40 37 37.5
40 < 45 42 42.5
45 < 50 47 47.5
50 < 55 52 52.5
55 < 60 57 57.5
60 < 65 62 62.5
5 (a) Histogram
(b) Ogive
6 9½ 6, 7, 8, 9, 10, 11, 12, 13
Median is 9½
7 (a) Lower quartile = Q1 = value below which 25% of the population fall
(b) Upper quartile = Q3 = value above which 25% of the population fall
Q3  Q1
8 (a)
2
(b) Quartile deviation
387
9 1, 100%
10 The upper quartile is at the point where 25% of the area under the curve is
above this point.
25%
80 Upper quartile
From the normal distribution table, the nearest value to 0.25 is 0.2486 which
corresponds to a z value of 0.67.
If z = 0.67
 = 80
 = 16 = 4
x μ
z=
σ
x  80
0.67 =
4
x – 80 = 4  0.67
x = 2.68 + 80
= 82.68
Chapter 17: Investment appraisal

4
1 2 APR of Option 1 = (1+ 0.011) – 1
= 0.0447
= 4.47%
2
APR of Option 2 = (1 + 0.032) – 1
= 0.065
= 6.50%
Option 2 therefore offers the best APR.
25,000
2 3,252 (1.085) 25
 NPVa 
 (b  a)
3 9.85 IRR = a +  NPV a  NPV b  %
 22,000 
= 9% +   1 %
(22,000  4,000) 
388
= 9% + 0.85%
= 9.85%
4 26,08 PV of annuity from year 3–10 = PV from year 1–10 – PV from

year 1–2
= $5,000 × (7.024 – 1.808)
= $26,080
5 B Accept the project if the net present value is positive
6 (a) Included
(b) Not included (non-cash)
(c) Not included (past cost)
(d) Not included (included in the discount rate)
389
390
Appendix
Appendix
Area under the normal curve

This table gives the area under the normal curve between the mean and the point Z
standard deviations above the mean. The corresponding area for deviations below
the mean can be found by symmetry.
(x  )
Z
 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0.0 .0000 .0040 .0080 .0120 .0160 .0199 .0239 .0279 .0319 .0359
0.1 .0398 .0438 .0478 .0517 .0557 .0596 .0636 .0675 .0714 .0753
0.2 .0793 .0832 .0871 .0910 .0948 .0987 .1026 .1064 .1103 .1141
0.3 .1179 .1217 .1255 .1293 .1331 .1368 .1406 .1443 .1480 .1517
0.4 .1554 .1591 .1628 .1664 .1700 .1736 .1772 .1808 .1844 .1879
0.5 .1915 .1950 .1985 .2019 .2054 .2088 .2123 .2157 .2190 .2224
0.6 .2257 .2291 .2324 .2357 .2389 .2422 .2454 .2486 .2517 .2549
0.7 .2580 .2611 .2642 .2673 .2704 .2734 .2764 .2794 .2823 .2852
0.8 .2881 .2910 .2939 .2967 .2995 .3023 .3051 .3078 .3106 .3133
0.9 .3159 .3186 .3212 .3238 .3264 .3289 .3315 .3340 .3365 .3389
1.0 .3413 .3438 .3461 .3485 .3508 .3531 .3554 .3577 .3599 .3621
1.1 .3643 .3665 .3686 .3708 .3729 .3749 .3770 .3790 .3810 .3830
1.2 .3849 .3869 .3888 .3907 .3925 .3944 .3962 .3980 .3997 .4015
1.3 .4032 .4049 .4066 .4082 .4099 .4115 .4131 .4147 .4162 .4177
1.4 .4192 .4207 .4222 .4236 .4251 .4265 .4279 .4292 .4306 .4319
1.5 .4332 .4345 .4357 .4370 .4382 .4394 .4406 .4418 .4429 .4441
1.6 .4452 .4463 .4474 .4484 .4495 .4505 .4515 .4525 .4535 .4545
1.7 .4554 .4564 .4573 .4582 .4591 .4599 .4608 .4616 .4625 .4633
1.8 .4641 .4649 .4656 .4664 .4671 .4678 .4686 .4693 .4699 .4706
1.9 .4713 .4719 .4726 .4732 .4738 .4744 .4750 .4756 .4761 .4767
2.0 .4772 .4778 .4783 .4788 .4793 .4798 .4803 .4808 .4812 .4817
2.1 .4821 .4826 .4830 .4834 .4838 .4842 .4846 .4850 .4854 .4857
2.2 .4861 .4864 .4868 .4871 .4875 .4878 .4881 .4884 .4887 .4890
2.3 .4893 .4896 .4898 .4901 .4904 .4906 .4909 .4911 .4913 .4916
2.4 .4918 .4920 .4922 .4925 .4927 .4929 .4931 .4932 .4934 .4936
2.5 .4938 .4940 .4941 .4943 .4945 .4946 .4948 .4949 .4951 .4952
2.6 .4953 .4955 .4956 .4957 .4959 .4960 .4961 .4962 .4963 .4964
2.7 .4965 .4966 .4967 .4968 .4969 .4970 .4971 .4972 .4973 .4974
2.8 .4974 .4975 .4976 .4977 .4977 .4978 .4979 .4979 .4980 .4981
2.9 .4981 .4982 .4982 .4983 .4984 .4984 .4985 .4985 .4986 .4986
3.0 .49865 .4987 .4987 .4988 .4988 .4989 .4989 .4989 .4990 .4990
3.1 .49903 .4991 .4991 .4991 .4992 .4992 .4992 .4992 .4993 .4993
3.2 .49931 .4993 .4994 .4994 .4994 .4994 .4994 .4995 .4995 .4995
3.3 .49952 .4995 .4995 .4996 .4996 .4996 .4996 .4996 .4996 .4997
3.4 .49966 .4997 .4997 .4997 .4997 .4997 .4997 .4997 .4997 .4998
3.5 .49977
391
PRESENT VALUE TABLE
-n
Present value of £1 ie (1 + r) where r = interest rate, n = number of periods until payment or receipt.
Periods Interest rates (r)

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239
16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218
17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198
18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180
19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164
20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065
16 0.188 0.163 0.141 0.125 0.107 0.093 0.081 0.071 0.062 0.054
17 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045
18 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038
19 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031
20 0.124 0.104 0.087 0.073 0.061 0.051 0.041 0.037 0.031 0.026
392
Test your learning answers
CUMULATIVE PRESENT VALUE TABLE

This table shows the present value of £1 per annum, receivable or payable at the end of each year
n
1  (1  r)
for n years .
r

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824
17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201
19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365
20 18.046 16.351 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514
393
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675
16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730
17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775
18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812
19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843
20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870
394
Bibliography
Bibliography
Chartered Institute of Management Accountants (2015) CIMA Code of Ethics.

London, CIMA
CIMA (2005) CIMA Official Terminology. Oxford, CIMA Publishing.
CIMA (2016) About us. [Online] Available from: www.cimaglobal.com/About-us/

[Accessed 30 June 2016].
CIMA (2016) Why CIMA? [Online] Available from: www.cimaglobal.com/About-

us/Why-CIMA-is-different/ [Accessed 13 June 2016].
IFAC (2005) The Roles and Domain of the Professional Accountant in Business.
[Online] Available from: www.ifac.org/system/files/publications/files/the-roles-
and-domain-of-the.pdf [Accessed 30 June 2016].
International Accounting Standards Board (2012) IAS 2 Inventories. [Online]

Available from: www.ifrs.org/IFRSs/Pages/IFRS.aspx [Accessed 30 June 2016].
395
396
Index
Index
Composite cost unit, 248
A Compounding, 344
Absorb, 70
equivalent rates, 346
Absorption, 79
non-annual, 346
Absorption base, 80
Compound interest, 344
Absorption costing, 69
Conditional probability, 296
Activity based costing (ABC), 87, 88
Contribution, 101, 132
Addition laws, 294
Contribution/sales (C/S) ratio, 123
Algebraic method, 76, 78
Control, 15
Allocate, 70
Controllable cost, 39
Allocation, 72
Cost behaviour, 49, 59
Annuity, 352, 358
Cost card, 69, 101
present value, 350
Cost centre, 31, 40, 70
Apportion, 70
production cost centre, 32, 71
Apportionment, 72
service cost centre, 32, 71, 74
Apportionment bases, 72
Cost classification, 32
Appraisal cost, 35
Cost object, 31
Arithmetic mean, 315
Cost of capital, 358
Asset turnover, 243
Cost unit, 31
Averages, 315
Costing, 15
Avoidable cost, 37
Cost-volume-profit (CVP) analysis,
121, 132
B Cumulative discount, 350
Balanced scorecard, 251 Current standards, 160
Bases of apportionment, 72 Customer perspective, 253
Basic standards, 160
Batch, 234 D
Batch costing, 234
Deciles, 326
Blanket absorption rate, 80
Decision making, 15
Bookkeeping, 263
Decision variable, 300
Breakeven analysis, 121, 132
Departmental absorption rates, 80
Breakeven chart, 124
Dependent events, 293
Breakeven point, 121, 132
Direct costs, 32
Breakeven units, 122
Direct expenses, 32
Budget, 181
Direct labour, 32
Budget committee, 181
Direct materials, 32
Budget cost allowance, 169
Discount factor, 348
Budget manual, 181
Discounted cash flow techniques, 355
Budget variances, 173
Discounting, 347
single cash flow, 347
C Dispersion, 321
Capital expenditure budget, 193 Dysfunctional behaviour, 361
Cash budget, 189
CIMA, 22
CIMA definition of management accounting,
E
Economic policy, 125, 126, 127
15
Economic value, 35
Coefficient of variation, 324
Economy, 249
Committed cost, 37
Effective annual interest rate (EAR), 346
Complementary probabilities, 295
Effectiveness, 249
397
Efficiency, 249
Expected value, 299
Expected/attainable standards, 160
J
Job, 231
Expenditure variance, 173
Job account, 231
External failure cost, 36
Job cost card, 231
Job costing for internal services, 235
F Joint probability table, 302
Financial accounting, 19
Financial perspective, 253
Fixed budget, 169
K
Fixed cost, 49 Key budget factor, 181
Flexed budget, 169
Flexible budget, 169 L
Full cost plus pricing, 107 Labour efficiency variance, 209
Function, 32 Labour rate variance, 209
Functional budget, 181 Labour utilisation budget, 185
Least squares method, 55
G Limiting budget factor, 181
Global Management Accounting Limiting factor, 141
Principles, 16 Line of best fit, 55
Gross profit margin, 243 Linear assumption, 52
Grouped data, 315 Linear regression, 55
Lower quartile, 325
H
Heterogeneity, 246 M
High-low method, 52 Make or buy, 145
Historic cost, 35 Management accounting, 15
Management by exception, 157
Management decision, 21
I Management information, 21
Ideal standards, 160 Margin, 108
Idle time variance, 209 Margin of safety, 124, 132
Imposed budgeting, 194 Marginal costing, 101
Incremental budgeting, 194 Marginal cost plus pricing, 107
Independent, 292 Mark-up, 107
Independent events, 292 Master budget, 182
Indirect production costs, 33 Material price variance, 208
Innovation and learning perspective, Material purchases budget, 184
253 Material usage budget, 184
Intangibility, 246 Material usage variance, 208
Integrated system, 263
Mean, 315
Interdependence of variances, 218
Measures of dispersion, 321
Interest, 343
Median, 318
Interlocking system, 263
Mode, 317
Internal business perspective, 253
Mutually exclusive outcomes, 294
Internal failure cost, 35
Mutually exclusive, 292
Internal job costing, 235
Internal rate of return, 359
Inter-quartile range, 325 N
Investment appraisal, 353 Net present value, 355
Investment centre, 40 Net profit margin, 243
Irrelevant costs, 37
398
Index
Non-financial performance indicators Regression analysis method, 55

(NFPIs), 250 Relevant cost, 37, 145
Non-mutually exclusive, 292 Relevant range, 51
Normal distribution, 326 Remuneration methods, 162
Normal distribution tables, 329 Repeated distribution method, 75
Residual income, 245
Responsibility accounting, 39
O Responsibility centre, 39
Operating statements, 215 Return on capital employed (ROCE), 243
Operational decision, 21
Return on costs, 107
Opportunity cost, 37
Return on investment (ROI), 243
Optimal production plan, 141
Return on sales, 108
Over-absorption, 82
Revenue centre, 40
Overhead, 73
Risk, 291
Overhead absorption rate (OAR), 79
Role of the management accountant, 17
Overhead allocation, 72
Rolling budgets, 194
Overhead apportionment, 72
Overtime premium, 162
S
P Sales budget, 181
Sales price variance, 207
Participative budgeting, 194
Sales volume variance, 208
Payback period, 354
Scarce resource, 141
Payoff tables, 300
Scattergraph, 54
Performance evaluation, 16
Scattergraph method, 54
Periodic budgets, 194
Semi-fixed, 51
Perishability, 246
Semi-variable, 51
Perpetuity, 352
Service cost centre, 32, 71
Piecework system, 162
Service industry costing, 246
Planning, 15
Service organisations, 246
Present value, 348, 350
Simple interest, 343
Prevention cost, 35
Simultaneity, 246
Price or rate variance, 210
Single factory overhead absorption
Pricing decisions, 106
rate, 80
Prime cost, 32
Sinking fund, 352
Principal budget factor, 181, 182
Standard cost, 157
Probability, 291
Standard deviation, 321
Production budget, 181
Standard hour, 160
Production cost centre, 32, 71
Standard setting, 159
Professional accountant, 18
Stepped cost, 50
Profit centre, 40
Stewardship, 16
Profit-volume (P/V) ratio, 123, 132
Strategic decision, 21
Profit-volume chart, 126
Sunk costs, 37
Q T
Quartiles, 325
Target profit, 129
Time-based systems, 162
R Time value of money, 343
Range, 325
Reapportion, 70
Reapportionment, 74
Reciprocal servicing, 74
U
Uncertainty, 291
399
Uncontrollable cost, 39 Variances, 207, 325
Under-absorption, 82 Volume variance, 173, 210
Ungrouped data, 315
Upper quartile, 325
Usage or efficiency variance, 210
W
Wages control account, 266
V Z
Value for money, 17, 249
Zero-based budgeting (ZBB), 194
Variable cost, 50
Z-score, 329
Variable overhead efficiency variance, 210
Variable overhead expenditure variance, 209
400
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CIMA BA2

CIMA Certificate Course Book

Fundamentals of Management Accounting

CMCEB2E(CB)AUG16 (RICOH).indd 1-3 26/07/2016 16:20

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ISBN 9781 5097 0632 7 A note about copyright

Welcome to BA2 Fundamentals of Management Accounting 4

Weight Syllabus topic

10% A. The Context of Management Accounting

30% C. Planning and Control

35% D. Decision Making

The Objective Test exam

Booking availability On demand

LEVEL LEARNING OBJECTIVE VERBS USED DEFINITION

LEVEL LEARNING OBJECTIVE VERBS USED DEFINITION

LEVEL LEARNING OBJECTIVE VERBS USED DEFINITION

Lead Component Level

1. Explain the purpose of (a) Explain the need for management 2

(b) Explain the characteristics of financial 2

(c) Explain the role of the management 2

(d) Explain the relationships between the 2

Lead Component Level

1. Demonstrate cost (a) Explain the classification of costs in 2

(c) Calculate appropriate costs having 3

(d) Explain the classification of costs in 2

2. Apply absorption costing (a) Prepare overhead cost statements 3

Lead Component Level

(c) Calculate the marginal cost of products, 3

(d) Reconcile the differences between profits 3

(e) Apply cost information in pricing 3

C. Planning and Control (30%)

Lead Component Level

1. Prepare budgets for (a) Explain why organisations prepare 2

(b) Prepare functional budgets 3

(c) Explain budget statements 2

(d) Identify the impact of budgeted cash 2

(e) Prepare a flexible budget 3

(f) Calculate budget variances 3

2. Apply variance analysis to (a) Explain why planned standard costs, 2

(c) Prepare a statement that reconciles 3

(d) Explain why variances could have arisen 2

3. Calculate appropriate (a) Explain the need for appropriate 2

4. Prepare accounts and (a) Explain the integration of the cost 2

(b) Prepare a set of integrated accounts, 3

(c) Prepare appropriate accounts for job 3

(d) Prepare reports in a range of 3

D. Decision Making (35%)

Lead Component Level

1. Demonstrate the impact of (a) Explain the concepts of risk and 2

(b) Demonstrate the use of expected values 3

(c) Calculate summary measures of central 3

(d) Demonstrate the use of the normal 3

2. Demonstrate the use of (a) Apply breakeven analysis 3

3. Demonstrate the use of (a) Explain the time value of money 2

Exam Technique Overview

A key definition which is important to be

A formula you will need to learn as it will not

A formula which is provided within the

An example which allows you to apply your

A worked example which can be used to

Assessment focus point A high priority point for the assessment

Having studied this chapter you will be able to:

Position in Definitions The role of CIMA