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ACCA Paper F2

Management

Accounting

Class Notes

June 2011

FREE ACCA KAPLAN EXAM KIT 2017-2018 Click for Download


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© The Accountancy College Ltd January 2011

All rights reserved. No part of this publication may be reproduced, stored in a

retrieval system, or transmitted, in any form or by any means, electronic,

mechanical, photocopying, recording or otherwise, without the prior written

permission of The Accountancy College Ltd.



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Contents PAGE

INTRODUCTION TO THE PAPER 5

FORMULAE PROVIDED IN THE EXAMINATION PAPER 9

CHAPTER 1: INTRODUCTION TO COST ACCOUNTING 11

CHAPTER 2: COST CLASSIFICATION AND BEHAVIOUR 19

CHAPTER 3: BUSINESS MATHS 29

CHAPTER 4: MATERIALS, LABOUR, STOCK CONTROL 39

CHAPTER 5: OVERHEADS AND ABSORPTION COSTING 53

CHAPTER 6: COST BOOKKEEPING 65

CHAPTER 7: MARGINAL COSTING AND CONTRIBUTION THEORY 71

CHAPTER 8: COSTING FOR JOBS, BATCHES, AND SERVICES 79

CHAPTER 9: PROCESS COSTING, JOINT AND BY-PRODUCTS 91

CHAPTER 10: BUDGETS 113

CHAPTER 11: STANDARD COSTING AND VARIANCE ANALYSIS 123

CHAPTER 12: CVP ANALYSIS 139

CHAPTER 13: LIMITING FACTORS, LINEAR PROGRAMMING, RELEVANT COSTS 149

SOLUTIONS TO EXERCISES 161



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Introduction to the

paper



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INTRODUCTION TO THE PAPER


AIM OF THE PAPER

The aim of the paper is to develop knowledge and understanding of how to prepare

and process basic cost and quantitative information to support management in

planning and decision-making in a variety of business contexts.

MAIN CAPABILITIES

On successful completion of this paper candidates should be able to:

A Explain the nature and purpose of cost and management accounting

B Describe costs by classification, behaviour and purpose

C Apply essential business mathematics and use computer spreadsheets

D Explain and apply cost accounting techniques

E Prepare and coordinate budgets and standard costing for planning, feedback

and control

F Use management accounting techniques to make and support decision-

making.

Within these main capabilities, ACCA provides a more detailed guidance on the

syllabus. This can be found on pages 3 – 8 of your textbook.

RELATIONAL DIAGRAM OF MAIN CAPABILITIES

The nature and purpose of cost and management accounting (A)

Cost classification, behaviour and purpose

(B)

Cost accounting techniques

(D)

Budgeting and standard costing

(E)

Short-term decision- making techniques

(F)

Business Mathematics and computer spreadsheets

(C)



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EXAMINER

The paper F2 examiner is David Forster, who previously examined paper 1.2.

David also wrote the F2 pilot paper, which gives us a good indication of how the

syllabus areas will be examined under F2.

David has made notable changes to the paper, both in format and syllabus content.

FORMAT OF THE EXAM PAPER

Paper F2 can be sat as a written or a computer based paper.

2 hour paper.

Both computational and non-computational questions.

90 marks in total.

40 two mark questions and 10 one mark questions.

Mix of MCQ and true or false. In the CBE equivalent, other question forms may be

used, such as multiple response, multiple-response matching, or number entry.

ARTICLES

Five steps to multiple-choice success

17 May 2007

Steve Widberg describes a five-step approach to answering multiple-choice

questions.

Building knowledge

03 Nov 2006

Bob Souster, David Forster and Nicola Ventress guide students through the new

ACCA Qualification Knowledge Module papers / RELEVANT TO NEW ACCA

QUALIFICATION PAPERS F1, F2, AND F3.

ALL QUESTIONS ARE COMPULSORY



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Formulae provided in

the examination paper

Regression analysis

n

xb

n

ya

∑−

∑=

( )∑ ∑−

∑ ∑ ∑−=

22 xxn

yxxynb

( )( ) ( )( )[ ]∑ ∑−∑ ∑−

∑ ∑ ∑−=

2222 yynxxn

yxxynr

Economic order quantity

h

0

C

DC2=

Economic batch quantity

−

=

R

D1C

DC2

h

0



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FORMULAE PROVIDED IN THE EXAMINATION PAPER




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Chapter 1

Introduction to cost accounting

CHAPTER COVERAGE

1. What are the main differences between financial accounting and management

accounting?

2. What is the difference between data and information?

3. What are the different levels of management within and organisation?



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CHAPTER 1 – INTRODUCTION TO COST ACCOUNTING


CHAPTER CONTENTS

INTRODUCTION ---------------------------------------------------------- 13

DATA AND INFORMATION ---------------------------------------------- 14

MANAGEMENT ACTIVITIES --------------------------------------------- 15

LEVELS OF MANAGEMENT ----------------------------------------------- 16

ORGANISATIONS -------------------------------------------------------- 17



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INTRODUCTION

Accounting is divided into two main areas – financial accounting and management

accounting. Whereas financial accounting looks at the performance of the

organisation (in the past), management accounting looks at past performance as

well as providing information which is used for decision making within the

organisation (for the future).

Financial Accounting Management Accounting

● External use ● Internal use

● Strict rules for content and

format

● Content and format adopted to

company needs

● Primarily financial information ● Both financial and non-financial

information

● Prepared annually ● Prepared as often as necessary



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DATA AND INFORMATION

Many people assume that data and information are the same. They are not.

Data is raw, unprocessed information.

Information is processed data. It must be processed in a way that makes it

meaningful to the user.

Examples:

For data to be meaningful it must have certain characteristics or attributes. These

are many but can be summarised by the acronym – ACCURATE. Can you identify

what you think would be an attribute for each of the letters of accurate?

A

C

C

U

R

A

T

E

What do we use information for?



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MANAGEMENT ACTIVITIES

In organisations information is used for management activities such as planning,

decision making and control. Each of these three uses will be highlighted

throughout this subject. Before that, how would you describe each of these

techniques?

Planning:

Decision making:

Control:



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LEVELS OF MANAGEMENT

Management may be on either an operational, tactical or strategic level within the

organisation. How can we differentiate between these?

Strategic

Tactical

Operational

0

0

0

Long-term

Medium-term

Short-term



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ORGANISATIONS

No organisation will operate as a single entity. Each organisation would be divided

up into various departments. Some of these departments would be dealing with

producing our products while others would be providing a service, both to our

customers and to our production departments. These will be highlighted later in

the course.

Cost centre – is defined as a production or service location, a function, an activity

or an item of equipment for which costs can be ascertained.

Revenue centre – a centre devoted to raising revenue only.

Profit centre – a centre accountable for costs and revenues.

Investment centre – a centre which has its performance evaluated by its return

on capital employed.

Cost unit – a unit of product or services for which costs can be ascertained. These

are usually classed in relation to the unit the product is sold in.

Examples:

Petrol - per litre

Paint - per tin

Bread - per loaf

Using these cost units assist us being able to cost the products made. We also

need to identify service units. These will be discussed in the session on service

costing.



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Chapter 2

Cost classification and behaviour

CHAPTER COVERAGE

1. What are different classifications of costs within an organisation?

2. Which costs are involved directly in the production of goods and services?

3. What are the different cost behaviours?

4. What methods are used to separate fixed and variable costs and use this

information for forecasting?



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CHAPTER 2 – COST CLASSIFICATION AND BEHAVIOUR


CHAPTER CONTENTS

COST CLASSIFICATIONS ------------------------------------------------ 21

DIRECT AND INDIRECT COSTS 21

PRODUCTION AND NON-PRODUCTION COSTS 21

COST BEHAVIOUR ------------------------------------------------------- 22

FIXED COSTS 22

VARIABLE COSTS 22

STEP COSTS 23

SEMI-VARIABLE COSTS 23

HIGH-LOW METHOD ----------------------------------------------------- 25



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COST CLASSIFICATIONS

Costs in any organisation come in many forms and relate to many different things.

In order to properly control the costs of a business, management must understand

the nature of the costs that it faces and how they behave.

We can divide or classify these costs into 3 main areas:

● Materials

● Labour

● Other expenses

Materials and labour costs speak for themselves, however other expenses cover

many different expenses within the business – rent, administration, heating and

lighting, motoring – the list is endless.

Direct and indirect costs

● Direct costs are those which are directly involved with the making of a product

or service. The sum of the direct costs is equal to the Prime Cost

● Indirect costs are those which are incurred for other reasons. For instance,

the wages of a production worker is said to be a direct cost whilst the wages

(salary) of a supervisor would be considered as an indirect cost. The sum of

the indirect costs is equal to the Overheads

We will deal with these classifications in more detail in future sessions.

Production and non-production costs

Production costs relate to costs that are incurred in the manufacture of goods or the

delivery of a service.

They are incurred as a result of manufacture and therefore should be included in

the cost of sales in the income statement and should also be included as part of the

inventory valuation.

Non-production costs are incurred by the business in order to operate as a

successful entity (other than production costs). The main categories of non-

production costs are:

Distribution costs

Selling costs

Finance costs

Administrative costs.



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COST BEHAVIOUR

As well as dividing the costs into the above classifications each cost can be further

classified into fixed, variable, stepped and semi-variable. This classification

depends upon the behaviour of the cost.

Cost behaviour looks at whether or not a cost will change when the company’s level

of activity changes.

Level of activity = number of units produced and sold

Fixed costs

A fixed cost is a cost which remains constant in total terms when level of activity

changes.

An example of a fixed cost would be the rent of a building. A fixed sum we pay

each period.

A fixed cost can be represented in a graph as:

These costs, although fixed in total, do reduce on a per unit basis as the level of

activity rises.

For example is company has fixed costs of $5,000 and plans to produce and sell

1,000 units, then the fixed cost per unit can be calculated as:

$5,000 / 1,000 = $5 /unit

If the company increased the level of activity to 2,500 units then the fixed cost per

unit would be $5,000 / 2,500 = $2 /unit

Variable costs

Variable costs vary in proportion to the level of activity. For example if it costs £5

to make 1 unit we assume that it costs £10 to make 2, £50 to make 10 and so on.

A variable cost can be represented in a graph as:

Level of activity

Total cost



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As activity increases, total variable cost will increase. Variable cost per unit usually

remains constant.

Step costs

Stepped costs are fixed costs over a wider activity range. Some fixed costs will

increase once the level of activity goes above a certain threshold. An example of

this might be a supervisor in a factory on a salary. Each supervisor is in charge of

20 workers. As soon as we employ more than 20 workers we need to employ

another supervisor.

A stepped cost may be represented in a graph as:

Semi-variable costs

A semi-variable cost contains a fixed and a variable element. An example of this

would be an electricity bill where we pay a fixed charge per period plus a variable

charge for each unit of electricity consumed.

A semi-variable cost can be represented in a graph as:

Level of activity

Total cost

Level of activity

Total cost

Level of activity

Total cost



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We assume that all these relationships are linear, ie, the act is a straight line.

Unfortunately in practice this does not happen due to economies of scale (discounts

for quantity purchases or sales).

For the purposes of our studies we will assume that costs react to each other in a

linear (straight line) relationship.



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HIGH-LOW METHOD

If we have a semi variable cost we need to calculate the fixed and variable

elements of the cost.

The method we use is called the HIGH-LOW method. It is based upon the equation

of a straight line:

y = a + bx

This can also be represented as:

Total cost = fixed cost + (variable cost x no of units)

Once the fixed and variable cost elements have been calculated, this information

can be used to forecast what Total Costs will be at different levels of activity.

Exercise 1

The following cost information is available.

Output 65,000 units 105,000 units

Cost £133,000 £210,000

Required

Using the above data, calculate the fixed and variable costs for the business and

the total cost for 165,000 units.

Solution:

Variable cost per unit = £

Total fixed cost = £

Total cost for 165.000 units = £ + (£ x 165,000 units) = £

It is essential to master this technique as it is a common examination question and

you will be required to use this technique many times during your management

accounting studies.

When there are more than two pairs of data given we will always use the highest

and lowest for this technique.



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Class exercises

1. A manufacturing company has four types of cost (identified as T1, T2, T3 and

T4). The total cost for each type at two different production levels is:

Cost type Total cost for 125 units Total cost for 180 units £ £

T1 1,000 1,260 T2 1,750 2,520 T3 2,475 2,826 T4 3,225 4,644

Required:

Which two cost types would be classified as being semi-variable?

A T1 and T3.

B T1 and T4.

C T2 and T3.

D T2 and T4.

2. The following diagram represents the behaviour of one element of cost:

Required:

Which of the following descriptions is consistent with the above diagram?

A Annual total cost of factory power where the supplier sets a tariff based

on a fixed charge plus a constant unit cost for consumption which is

subject to a maximum annual charge.

B Total annual direct material cost where the supplier charges a constant

amount per unit which then reduces to a lower amount per unit after a

certain level of purchases.

C Total annual direct material cost where the supplier charges a constant

amount per unit but when purchases exceed a certain level a lower

amount per unit applies to all purchases in the year.

Volume of activity

Total cost



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D Annual total cost of telephone services where the supplier makes a fixed

charge and then a constant unit rate for calls up to a certain level. This

rate then reduces for all calls above this level.

3. An organisation has the following total costs at two activity levels:

Activity level (units) 17,000 22,000 Total costs (£) 140,000 170,000

Variable cost per unit is constant in this range of activity and there is a step

up of £5,000 in the total fixed costs when activity exceeds 18,000 units.

Required:

What is the total cost at an activity level of 20,000 units?

A £155,000

B £158,000

C £160,000

D £163,000

Before answering this question, think carefully about the information given

relating to the step cost. How should we use it?

4. An organisation has the following total costs at two activity levels:

Activity level (units) 8,000 13,000 Total costs (£) 22,000 31,000

Fixed costs are constant in this range of activity and variable cost per unit

decreases by £1.5 per unit when activity exceeds 12,000 units

Required:

What is the total cost at an activity level of 16,000 units?



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Chapter 3

Business maths

CHAPTER COVERAGE

1. How to draw a scatter-graph and use regression analysis for forecasting.

2. Understanding and calculating the correlation coefficient

3. The co-efficient of determination

4. What are expected values and why do management accountants use them?

5. Business spreadsheets



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CHAPTER 3 – BUSINESS MATHS


CHAPTER CONTENTS

SCATTER GRAPHS ------------------------------------------------------- 31

REGRESSION ANALYSIS 31

CORRELATION ----------------------------------------------------------- 33

INTERPOLATION AND EXTRAPOLATION ------------------------------ 34

THE COEFFICIENT OF DETERMINATION------------------------------- 35

EXPECTED VALUES------------------------------------------------------- 36

BUSINESS SPREADSHEETS --------------------------------------------- 37



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SCATTER GRAPHS

A scatter-graph is a graph on which pairs of data, which have no direct relationship,

are plotted.

In order to estimate future costs for a given activity level, we must draw a line

through these points. It is impossible to draw a straight line which will connect all

points and so we draw what is known as a LINE OF BEST FIT.

From this line we can estimate future costs. This line is very subjective. Everyone

will draw it in a slightly different place and so our forecasts will also differ. To make

a more accurate prediction of future costs we will use regression analysis.

Regression analysis

This is also known as the least squares method.

The formulae we will use is:

bxay +=

( )∑ ∑−

∑ ∑ ∑−=

22 xxn

yxxynb

We will also need to calculate the average of x and y. This is done by dividing the

total of x (and y) by n as in the second equation.

bxya −= or n

xb

n

ya

∑−

∑=

where n = number of items.

In this method we are required to calculate totals of columns of figures. A total is

represented by the sign Σ. This is pronounced sigma.

The first column of figures x represents the units. The second column y represents

the costs. Σx is the total of the column of x.

We also need to calculate Σxy, Σx2.

Exercise 1

Month Units Cost (£) January 400 1,050 February 600 1,700 March 550 1,600 April 800 2,100 May 750 2,000 June 900 2,300

Required:

Using the following methods, calculate the fixed and variable cost elements and

forecast the cost for an output of 850 units.

1. High-low method

2. Regression analysis



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Solution:

1. High-low method

2. Regression

Month Units (x) Costs (y) Xy X2 Y2 January 400 1,050 February 600 1,700 March 550 1,600 April 800 2,100 May 750 2,000 June 900 2,300



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CORRELATION

Regression analysis assumes a linear relationship. However, this does not measure

the degree of correlation between the variables as it is unlikely that the true

relationship is a straight line. To do this we need to calculate the correlation co-

efficient, r. (This is known as Pearson’s correlation coefficient.)

( )( ) ( )( )[ ]∑ ∑−∑ ∑−

∑ ∑ ∑−=

2222 yynxxn

yxxynr

r varies between +1 and –1.

+1 means perfect linear correlation

0 means no correlation

-1 means perfect negative linear correlation

Required:

Using the information above in Exercise 1, calculate the correlation coefficient.

What does this answer signify?



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INTERPOLATION AND EXTRAPOLATION

This is simply identifying values of x and y from the regression line plotted.

Interpolation is where we interrogate the line within the known range.

Extrapolation is where we interrogate the line outside of the known range where

the accuracy/relationship is assumed to be still valid. In reality this is not always

so.



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THE COEFFICIENT OF DETERMINATION

The coefficient of determination is represented by r2 – the square of r.

This signifies how much of the variation in the dependent variable is because of the

variation in the independent variable. The remaining variation is then assumed to

be because of random fluctuations.

To explain this in simple terms, it means that if r = 1 then r2 would also = 1 or

100%. This would assume that units and costs would be in perfect proportion, ie if

units were doubled then costs would also double. If r2 is below 100%, part of the

increase in costs would be for other reasons. It may be that a discount was

obtained in the cost of material or that the labour cost was lower/higher because of

different productivity/efficiency.

Required:

What is the coefficient of determination from Exercise 1?



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EXPECTED VALUES

Expected values are based on weighted averages. What is a weighted average as

opposed to a simple average?

In order to calculate an expected value we multiply the probability of something

happening (p) by the value of the outcome (x). The expected value is therefore px.

To calculate the expected value of a series of things happening we simply add up

the total of all the expected values. So the total expected value is equal to:

�px

Expected values are also used in decision making situations. A series of expected

value calculations can be made and the one with the best overall expected value

would be chosen.

Exercise 2

A company has a choice of three alternative investments. If successful investment

A gives a profit of £100,000, of which there is a 40% chance or probability,

however if not it will yield loss of (£40,000). Investment B, if successful (60%),

will yield a profit of £50,000; but if not, a loss of (£20,000). Investment C, if it is

successful (80% chance), will yield profit of £40,000; however if not it will deliver

loss of (£10,000).

Required:

Which investment should be considered?

Exercise 3

A company needs to decide between two projects – Project X and Project Y. The

profits that may be generated from each project are as follows:

Project X Project Y Probability Profit Probability Profit

0.4 £3,000 0.35 £10,000 0.6 £1,500 0.65 £0

Required:

Which project should be chosen?

What is the expected value of the profit?



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BUSINESS SPREADSHEETS

A spreadsheet is a computerized tool for mathematical analysis and presentation of

numerical data. It enables mathematical analysis and calculations to be performed

quickly and efficiently.

Spreadsheets are used in many areas of management accounting including:

● Budgeting

● Variance analysis

● Forecasting & decision making. Spreadsheets could be set up to analyse

different possible outcomes of a project.



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Chapter 4

Materials, labour, stock control

CHAPTER COVERAGE

1. What are various procedures and documents required for ordering, receiving

and issuing stocks of materials?

2. Why do the companies hold additional inventories?

3. What different types of mechanics are used to calculate and interpret optimal

re-order levels, re-order quantities and minimum and maximum levels of

stock to be held.

4. How to minimise the total cost of holding and ordering stocks.

5. What are different methods of remuneration for work done.

6. What are direct and indirect labour costs.

7. How do we account for overtime payments in an accounting system.

8. How to measure labour turnover, efficiency and productivity.



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CHAPTER 4 – MATERIALS, LABOUR, STOCK CONTROL


CHAPTER CONTENTS

MATERIALS --------------------------------------------------------------- 41

STOCK HOLDING COSTS AND ECONOMIC ORDERING QUANTITY -- 42

STOCK HOLDING COSTS 42

STOCK ORDERING COSTS 42

ECONOMIC ORDER QUANTITY 42

BULK DISCOUNTS 44

RE-ORDER LEVELS ------------------------------------------------------- 45

FREE STOCK -------------------------------------------------------------- 46

LABOUR COSTS ---------------------------------------------------------- 47

BONUS SCHEMES 49

DIRECT AND INDIRECT LABOUR COSTS 50

LABOUR RATIOS 51



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MATERIALS

Materials required for stock and later issue to production are subject to a set

procedure:

a. A purchase requisition is raised and sent to the purchasing dept.

b. A purchase order is sent to the supplier.

c. A delivery note is received together with the goods (advice note). This is

checked to the purchase order to ensure it is the same.

d. A GRN (goods received note) records the details for entering into stock.

e. A purchase invoice is sent to the company from the supplier to request

payment.



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STOCK HOLDING COSTS AND ECONOMIC ORDERING

QUANTITY

A company needs to consider two things in relation to stock management:

● How many units of stock to purchase each time an order is placed with the supplier

● How much stock the company should hold to ensure there are no shortages.

Stock holding costs

The company needs to hold a certain amount of stock to ensure it can meet

customer demand. This has a charge to it:

● Warehouse space

● Operatives

● Insurance

● Capital costs

● Deterioration costs.

These costs vary according to the amount of stock held at any one time. The

company must try to minimise these costs by holding as little stock as is possible.

The annual cost of holding stock is calculated as:

hC2

Q×

Where Q = order quantity

Ch = cost of holding one item for a year.

Stock ordering costs

It costs money to order stock. This may be in the form of:

● Administrative costs

● Delivery charges.

The greater the number of orders, the greater the charge incurred. This means

that we need to have as few orders as possible to minimise the ordering costs.

The annual cost of ordering stock is calculated as:

0CQ

D×

Where C0 = cost of placing each order

D = annual demand

Economic order quantity

By looking at these two costs we can see that larger orders cost more to hold and

less to order. Smaller orders cost less to hold and more to order. What we need to

do is find a point where we are able to minimise the total cost of ordering and

holding stock.



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There are two ways of calculating this point. The first is by means of a tabular

format whereby we calculate the cost of orders using various order quantities and

the cost of holding those quantities to find the total cost.

Example:

The following information is available for a company:

Ch = £1.5

Co = £10

Demand = 10,000 units

Calculate the annual holding costs and annual ordering costs at the following

different order quantities

Order Quantity Annual cost of

holding

Annual cost of

ordering

Total annual stock

cost

10

100

1000

Plotting this information on a graph:

The point where total annual costs are minimised is the economic order quantity.

EOQ = h

0

C

DC2

Exercise 1

Calculate the economic order quantity (EOQ) for the following item of inventory:

● Quantity required per year 32,000 items;

● Order costs are $15 per order;

● Inventory holding costs are estimated at 3% of inventory value per year;

● Each unit currently costs $40.

Order Quantity

Annual Cost



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Bulk discounts

Sometimes suppliers will give a discount for orders of large quantities.

This quantity may not be the EOQ, but the discount given may make the higher

order quantity worthwhile.

So far we have ignored the purchase costs of the materials, because they were

common to all order quantities. When bulk discounts are present we must calculate

the total cost including the purchase price.

Exercise 2

BF manufactures a range of domestic appliances. Due to past delays in suppliers

providing goods, BF has had to hold an inventory of raw materials, in order that the

production could continue to operate smoothly.

Due to recent improvements in supplier reliability, BF is re-examining its inventory

holding policies and recalculating economic order quantities (EOQ).

● Item “Z” costs BF £1000 per unit

● Expected annual production usage is 65,000 units

● Procurement costs (cost of placing and processing one order) are £2500

● The cost of holding one unit for one year has been calculated as £300

The supplier of item “Z” has informed BF that if the order was 2,000 units or more

at one time, a 2% discount would be given on the price of the goods.

Required:

Calculate the EOQ for item “Z” before the quantity discount.

Advise BF if it should increase the order size of item “Z” so as to qualify for the 2%

discount.



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RE-ORDER LEVELS

It is essential we know when to re-order goods so that we do not run out of stock.

This must take account of LEAD times – the time between placing the order and the

goods arriving in the warehouse for use.

Re-order level = maximum demand x maximum lead time

Minimum stock level = re-order level – (average demand x average lead time)

Maximum stock level = re-order level + re-order quantity – (minimum demand x

minimum lead time)

Exercise 3

Calculate the re-order level, minimum stock level and maximum stock level from

the following data:

Minimum lead time 4 days Average lead time 5 days Maximum lead time 7 days Maximum usage 500 per day Minimum usage 300 per day Re-order quantity 5,400



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FREE STOCK

Free stock is that amount of stock which is left over after all commitments have

been met.

It can be calculated as:

Physical stock + Stock on order – Stock for customers’ orders already committed.



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LABOUR COSTS

Employees may be paid a fixed salary per week/month or a wage based on the

amount of hours worked or work done in a period.

Basic rate is usually paid for each hour worked. Overtime premium is paid on top

of basic rate for each hour worked over and above the normal working hours.

Eg. An employee is paid £10 per hour for a 38 hour week and an overtime

premium of 25% (time and a quarter). In a week in which he works 42 hours he is

paid –

42 hours x £10 = £420 4 hours x £2.50 = £ 10 Total wage = £430

His normal wage would be £380

PLEASE NOTE –` for the purposes of accounting we show the TOTAL hours

worked x basic rate and the OVERTIME hours worked x premium only. This is

because the premium part is treated differently in the accounts.

Employees may be paid a wage based on the work done by the employee

(piecerate).

Eg. An employee is paid £2.50 for each unit produced up to 150 units. The rate

increases to £2.75 for each unit produced in excess of 150 units. If the employee

produces 230 units in a week they will be paid:

150 units x £2.50 = £375

80 units x £2.75 = £220

Total £595



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Method Description Graph

Hourly paid

Workers are paid for time

spent at work and not

output, possibly receiving

an enhanced rate as the

result of overtime

Piecework In this case workers are

paid by output rather than

time spent. A rate per unit

is used to calculate wages

In addition to being paid a

single piecework rate they

may be paid on a

differential piecework

scheme. This will mean

that they are paid a lower

rate for the first number of

units produced and this will

increase for further units.

Guaranteed minimum

wage

In order to give wage

stability, many workers will

be guaranteed a minimum

wage. Once output or

attendance time reaches a

threshold level, workers

will revert to a variable

rate of pay.

hrs

£ wages

units

£ wages

units

£ wages



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Exercise 4

A company employs 3 workers who are paid on a piece-work basis. The rate of pay

is £2.25 for each unit produced in a week, up to 100 units, and a rate of £3 for

each unit in excess of 100 units. There is a guaranteed minimum weekly wage of

£180 for each employee.

During one week, the output produced by each employee was:

Employee Units produced A 96 B 122 C 76

Required:

What was their total pay for the week?

Bonus schemes

In addition, both individuals and groups may be awarded bonus payments based

upon their efficiency in getting the work done.

Bonuses are usually calculated by comparing the standard hours of actual

production to the actual time taken. This then gives us the amount of time saved.

The time saved is multiplied by the given percentage and the rate to find the

amount of bonus awarded.

The standard hours of actual production is equal to:

Standard labour hours per unit x actual units produced

Exercise 5

A jobbing company operates a premium bonus scheme for its employees of 75% of

the time saved compared with the standard time allowed for a job, at the normal

hourly rate. The data relating to job 1206 completed by an employee is as follows:

Allowed time for job 1206 4 hours Time taken to complete Job 1206 3 hours Normal hourly rate of pay £8

What is the total pay of the employee for Job 1206?

A £24

B £30

C £32

D £38



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Direct and indirect labour costs

Direct Labour costs:

● Basic Rate of pay on productive hours

● Overtime premiums on work outside normal hours specifically requested by

the customer.

Indirect Labour costs:

● Overtime premiums to production staff except if specifically requested by the

customer

● Idle time of production staff at basic rate of pay

● Bonus and incentive payments to staff

● Wages paid to non production staff.

IDLE TIME is time spent doing nothing. It may be due to breaks, machine

breakdowns, lack of orders etc. This time cannot be charged directly to jobs but

must be costed and incorporated into indirect overheads.

Exercise 6

Johnson is paid by the hour. She gets paid £7.50 an hour basic plus an overtime

premium of £2.50 for any hours over 40 in a week.

Johnson assembles seed propagators. Each propagator should take 30 minutes to

complete. Johnson is paid a bonus of 50% of time saved based on her standard

hourly rate. Idle time is not included in the calculation of actual time taken.

Last week Johnson was at work for 54 hours, though 4 of these were lost due to a

machine breakdown. She assembled 124 propagators that week.

Johnson's total wages are: £

How much of Johnson’s wages should be treated as a direct cost and how much as

an indirect cost?



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Labour ratios

Labour ratios are used to:

● Measure turnover

● Measure efficiency

● Measure capacity

Labour turnover –

%100employees ofnumber Average

treplacemen needing and leaving staff ofNumber ×

This is the rate at which the employees leave an organisation and it should be kept

as low as possible due to the costs involved and also to avoid harm to the

organisation’s reputation.

Turnover costs include the time spent finding a replacement and providing training

to new members of staff.

Labour efficiency –

%100hours Actual

hours standard in output Actual×

The labour efficiency ratio measures whether it has taken production line workers

more or less time than expected to produce the output units.

100% is average. Above that is good. Below 100% and our workforce is not

working up to the required standard.

Labour capacity –

%100hours Budgeted

worked hours Actual×

The labour capacity ratio measures whether more or less hours than planned were

worked.

Production Volume –

Capacity ratio x Efficiency ratio = Production Volume ratio

The production volume ratio measures whether more or less units have been

produced than planned.



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Exercise 7

A company has the following information for a period:

Budgeted labour hours 10,000 Actual labour hours 9,000 Standard hours of actual production 9,800

There were 52 employees at the start of the period and 71 employees at the end of

the period. 5 employees left and were replaced.

Required:

Calculate the labour turnover, efficiency, capacity ratios and production volume

ratios.



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Chapter 5

Overheads and absorption costing

CHAPTER COVERAGE

1. What are overheads?

2. What are the different types of overheads?

3. What is a systematic approach in charging overheads to products and

services?

4. What is allocation and apportionment and how to apportion overheads to

production and service cost centres using an appropriate basis?

5. How to re-apportion service centre costs to production cost centres using:

● Elimination method

● Repeated distribution

● Algebraic method (simultaneous equations).

6. What is an Overhead Absorption Rate and how to calculate the appropriate

overhead absorption rates for each cost centre.

7. How to calculate and account for over or under absorbed overheads.



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CHAPTER 5 – OVERHEADS AND ABSORPTION COSTING


CHAPTER CONTENTS

OVERHEADS -------------------------------------------------------------- 55

OVERHEAD ALLOCATION ----------------------------------------------- 56

OVERHEAD APPORTIONMENT ------------------------------------------ 57

SECONDARY APPORTIONMENT ---------------------------------------- 58

1. ELIMINATION 58

2. REPEATED DISTRIBUTION 59

3. ALGEBRAIC 59

OVERHEAD ABSORPTION ----------------------------------------------- 60

OVER/UNDER ABSORPTION OF OVERHEADS ------------------------- 63



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OVERHEADS

Overheads are defined as expenditure on labour, materials or services that cannot

be directly identified with a saleable cost unit.

Overheads are divided into two main areas:

● Production and

● Non-production.

Production overheads are indirect costs that are directly related to the production.

These include items such as:

● Power

● Maintenance of machinery.

Non-production overheads are necessary expenses of the business, which are not

directly related to production. These can be classified into:

● Administration overheads

● Selling and distribution overheads

● Finance overheads.

Absorption costing is used to calculate the production overhead cost per unit



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OVERHEAD ALLOCATION

Some costs can be easily identified with a unit or units of production such as labour

and material costs. These are said to be ‘allocated to the product’. Often they are

allocated to the cost centre or department before being shared among the units of

production.



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OVERHEAD APPORTIONMENT

Some costs relate to the business as a whole. These costs then have to be shared

between the various departments or cost centres. This is done by ‘apportioning the

costs’.

“The division of costs amongst two or more cost centres in proportion to the

estimated benefit received, by using a proxy. Eg, area, headcount, capital value

etc.

These overheads then have to be included into the cost of the products which are

produced in that department. It would be easy to just divide the cost by the

number of units made. This would be fine if only one product was made or if all

products took exactly the same time to be made. As this is not the case we have to

find a way of sharing the overhead costs between the products.

Exercise 1

ABC is preparing its departmental budgets and product cost estimates for the year

ended 31 December 19X5. The company has three manufacturing departments –

Machining, Assembly, and Finishing – together with a production maintenance

department.

The following costs and related data have been estimated for the year to 31

December 19X5:

Machining Assembly Finishing Maint Total Costs: £’000 £’000 £’000 £’000 £’000 Indirect wages 10 6 8 30 54 Indirect materials 15 4 8 20 47 Power 102 Light and heat 10 Depreciation 7 Rent and rates 25 Personnel 63 Other data: Direct labour hours 12,000 8,000 16,000 6,000 42,000 Machine hours 40,000 5,000 6,000 - 51,000 Employees 6 4 8 3 21 Floor area (m2) 1,000 400 300 300 2,000 Net book value of fixed assets

20,000 8,000 3,000 4,000 35,000

The maintenance department is expected to spend 60% of its time working for the

machining department with the remainder of its time being shared equally between

assembly and finishing.

Required:

Prepare an overhead analysis sheet for ABC Ltd for its year ended 31 December

19X5.



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SECONDARY APPORTIONMENT

Not all departments are production based. Some act as a service to the production

departments. Eg, canteen, stores, maintenance. The costs of these have to be

included into the total overheads of the production departments. Secondary

apportionment is a means of apportioning overheads from service cost centres to

production cost centres by means of relevant usage factors.

● A canteen – on basis of number of employees

● A stores – on the number of stores issues.

Sometimes both service cost centres provide services to each other (reciprocal

servicing). This has to be taken into account before the final apportionments are

made.

There are three ways of secondary apportionment:

1. Elimination

2. Repeated distribution

3. Algebraic.

1. Elimination

This method is used where one service centre does not use the services of another.

For instance it is unlikely that the stores would provide a service to the canteen

while the canteen would provide a service to the stores. In this case the canteen

costs would be apportioned first followed by the stores.

Exercise 2 Elimination Method

The ABC washing machine Co. produces a standard washing machine in three

production departments (Machining, Assembly, and Finishing) and two service

departments (Materials handling and Production control).

Costs for last year, when 2,000 machines were produced were as follows:

Production departments Service

Dept: Machining Assembly Finishing Materials Handling

Production Control

Indirect materials £4,000

Indirect wage £8,000 £11,200

Other indirect costs £41,920 £12,960 £7,920 £8,000 £2,400

% use of Materials handling

60% 30% 10%

% use of Production Control

40% 30% 20% 10%

Required:

Prepare a statement showing the overhead allocated and apportioned to each of the

production departments.



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2. Repeated distribution

The costs are repeatedly shared on an equitable basis until they are all accounted

for.

3. Algebraic

By means of using simultaneous equations to arrive at the notional total used in the

continuous allotment method.

Exercise 3 Repeated distribution and algebraic methods

Production departments Service Dept: A B C P Q Costs £3,000 £4,000 £2,000 £2,500 £2,700 % of P used 20% 30% 25% - 25% % of Q used 25% 25% 30% 20% -

Required:

Reapportion the service centre costs to the production centres using:

(a) Repeated distribution method.

(b) Algebraic method.



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OVERHEAD ABSORPTION

An absorption rate can be thought of as a charge out rate for overheads.

Absorption rates can be calculated in a number of ways but the most common ways

for exam questions are:

● A rate per unit

● A rate per labour hour

● A rate per machine hour.

It is worth remembering that absorption rates are always calculated using

BUDGETED figures. Rates have to be available at the start of a period so it is

possible to cost output as the period progresses. Actual figures are only available

at the end of a period.

Absorption rates are calculated as:

Budgeted overheads / budgeted activity = OAR

A single absorption rate can be calculated for a company as a whole, known as a

blanket rate. Equally, separate absorption rates can be calculated for individual

departments, known as departmental rates.

Exercise 4 Blanket rates

Tulip Ltd makes a single product, the Bulb. Each Bulb has a prime cost of £20.00,

takes 2 labour hours and 3 machine hours. The following budgeted information is

available for the factory.

Budgeted Overhead £100,000 Budgeted Output 20,000 units Budgeted Labour Hours 50,000 hours Budgeted Machine Hours 100,000 hours

£

What is the absorption rate per unit?

What is the absorption rate per labour hour?

What is the absorption rate per machine hour?

What is the total production cost using the unit based absorption rate?

What is the total production cost using the labour hour absorption rate?

What is the total production cost using the machine hour absorption

rate?



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Exercise 5 Departmental rates

It may be more accurate to calculate separate absorption rates for different

departments. Would it be fair or meaningful to use labour hours, for instance, to

charge out overheads in a machine intensive department?

A company has the following information available:

Cutting Finishing

Budgeted Overheads £100,000 £50,000 Machine Hours 50,000 3,000 Labour Hours 20,000 12,500 Actual Overheads £132,000 £38,000 Machine Hours 40,000 4,200 Labour Hours 28,000 12,000

The following information is also available about one of the company's products:

Cutting hrs Finishing hrs Machine Hours 6 1 Labour Hours 2 4

£

What is an appropriate absorption rate for the Cutting Department?

What is an appropriate absorption rate for the Finishing Department?

What is the total overhead cost per unit of product?



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Exercise 6

A company manufactures two products P1 and P2 in a factory divided into two cost

centres, X and Y. The following budgeted data are available:

Cost Centre

X Y

Allocated and apportioned fixed overhead costs $88,000 $96,000 Direct labour hours per unit: Product P1 3.0 1.0 Product P2 2.5 2.0

Budgeted output is 8,000 units of each product. Fixed overhead costs are absorbed

on a direct labour hour bases.

What is the budgeted fixed overhead cost per unit for Product P2?

A $10

B $11

C $12

D $13



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OVER/UNDER ABSORPTION OF OVERHEADS

Calculation of the overhead absorption rate (OAR) is done by using budgeted

figures. We cannot use actual figures because we do not know these until after the

event. This means that for every item we make we absorb a certain amount of

overheads into the unit. The total amount absorbed will depend upon the number

of units made.

It is highly unlikely that the budgeted production will agree exactly with the actual

or that the budgeted overhead will agree with the actual spend.

Because of this we need to calculate how much overhead has been absorbed into

our production, compare this with the actual amount and make an adjustment to

our P&L account.

If we have absorbed too much (over absorption) we will have to add back the

difference into our P&L. This will increase the reported profit.

If we have not absorbed enough (under absorption) we will have to take more out

of our P&L. This will decrease the reported profit.

Under or over absorbed overhead is calculated using:

£

Absorbed overhead (actual activity x OAR)

Actual Overhead

Under/over absorption:

Exercise 7 Under/Over absorption

Aurricula Ltd use absorption costing. The following information for its one

production department is as follows:

Shredding

Budgeted Overhead £200,000 Machine Hours 100,000 Labour Hours 30,000 Actual Overheads £208,000 Machine Hours 80,000 Labour Hours 41,000

Required:

Complete the following statement.

Overheads were

by

£



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Chapter 6

Cost bookkeeping

CHAPTER COVERAGE

1. Interpret the entries and balances in the material inventory account

2. Interpret the entries in the labour account

3. Interpret the entries in the production overhead account

4. Adjust the production overhead and income statement accounts for

under/over absorption of overheads



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CHAPTER 6 – COST BOOKKEEPING


CHAPTER CONTENTS

COST ACCOUNTS --------------------------------------------------------- 67

STOCK CONTROL ACCOUNT 67

LABOUR CONTROL ACCOUNT 67

WORK IN PROGRESS ACCOUNT 67

PRODUCTION OVERHEAD CONTROL ACCOUNT 68



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COST ACCOUNTS

A control account is a summary account. For F2, students need to understand the

stock control, labour control, work in progress and overhead control accounts and

how costs build up in these accounts.

A flow into the account is shown on the debit side and a flow out of the account is

shown on the credit side of the T account. The credit and debit sides of the T

account must balance at the end of the period.

Stock control account

Debit Entries

The debit side shows the flow of materials into the company. This will include

direct and indirect materials purchases.

Opening stock balance will also be shown as a debit.

Credit Entries

As materials are used in production, they will be shown as a credit entry in the

stock control account. Direct materials are allocated to the WIP account. Indirect

materials are allocated to the production overhead account.

Closing stock value will be the balancing figure on the credit side of the T account.

Labour control account

There is not opening or closing stock of labour. Instead, the labour control account

shows the wages paid out to staff for the period.

Debit Entries

The debit entries reflect the wages paid out to staff.

Credit Entries

The credit side of the labour control account will split the wages paid out between

direct and indirect costs to the company

Work in progress account

The work in progress account is also called the cost unit account.

Debit Entries

The costs associated with producing units of output are built up on the debit side.

This will include direct materials, direct labour and production overhead absorbed

Credit Entries

The total costs built up on the debit side is the value of the units produced. This is

shown on the credit side as an output to finished goods.



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Production overhead control account

The production overhead control account is used to build up the indirect costs

incurred by each production cost centre.

Debit Entries

Overhead costs are built up on the debit side as they are incurred during the

period.

Credit Entries

Overheads will be absorbed from the production overhead account to the WIP

account based on the overhead absorption rate. The absorbed overhead is shown

on the credit side as an allocation out of the production overhead account and into

the WIP account.

As we have seen in Chapter 3, there may be an under or over absorption of

production overheads. This will be calculated at the end of the period.

Under absorption is shown as a balancing figure on the credit side of the production

overhead account.

Over absorption is shown as a balancing figure on the debit side of the production

overhead account.

The other side of the under/over absorption adjustment is in the Income Statement

account.

Exercise 1

A company had the following budgeting information:

Production overheads £90,000

Labour hours 4,500

Actual costs for the period were as follows:

Direct materials £40,000


Direct materials issued to production £25,000

Indirect materials issued to production £20,000

Indirect wages £15,000

Direct wages for 3,900 hours £30,000

Other indirect expenses £45,000

Opening inventory value was £5,000.

Write up the T accounts for the period



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WIP

Labour Control

Stock Control



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Exercise 2

A company had the following budgeting information:

Production overheads £50,000

Labour hours 10,000

Actual costs for the period were as follows:

Direct materials £15,000


Direct materials issued to production £11,000

Indirect materials issued to production £4,300

Direct materials returned to supplier £2,000

Indirect wages £22,000

Direct wages for 10,500 hours £32,000

Other indirect expenses £21,000

Opening inventory value was £1,500

Write up the T accounts for the period.

Income Statement expense

Production Overhead Control



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Chapter 7

Marginal costing and contribution theory

CHAPTER COVERAGE

1. What is the concept of contribution and how it is calculated?

2. What are differences between Absorption and Marginal costing?

3. What is the impact of the difference on stock valuations of absorption and

marginal costing?

4. What is the impact on profit and loss accounts using absorption and marginal

costing?

5. Reconcile the profits achieved under each method.



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CHAPTER 7 – MARGINAL COSTING AND CONTRIBUTION THEORY


CHAPTER CONTENTS

ABSORPTION versus MARGINAL COSTING EXPLAINED ------------- 73

ABSORPTION COSTING 73

MARGINAL COSTING 73

PROFIT CALCULATIONS ------------------------------------------------- 74

ABSORPTION COSTING 74

MARGINAL COSTING 75

PROFIT RECONCILIATIONS -------------------------------------------- 77



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ABSORPTION versus MARGINAL COSTING EXPLAINED

There are two main methods of costing:

1. Absorption costing – where the fixed production overhead costs are absorbed

into the product cost by means of an overhead absorption rate (OAR).

2. Marginal costing – where the total fixed costs are written off in full in the

period in which they occur.

In order to correctly assess the full cost of production we need to have a portion of

these overheads included in the cost of the item.

Absorption costing

Sales – production costs = gross profit

Gross profit – non-production costs = net profit

Marginal costing

Sales – variable costs = contribution

Contribution – fixed overheads = profit



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PROFIT CALCULATIONS

Absorption costing

Absorption Costing profit is calculated using the following pro forma

Sales revenue X

Production Costs

Opening inventory X

Direct materials X

Direct labour X

Production overheads

absorbed

X

Under/over absorption X/(X)

Closing inventory (X)

Total Production Costs (X)

Gross Profit X

Non Production Costs (X)

Net Profit X

In an absorption costing system, inventory is valued at the production cost per unit.

Under absorption increases costs and should be added to production costs.

Over absorption decreases costs and should be subtracted from production costs.



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Marginal costing

Marginal Costing profit is calculated using the following pro forma

Sales revenue X

Variable Costs

Opening inventory X

Direct materials X

Direct labour X

Variable overheads X

Closing inventory (X)

Total Variable Costs (X)

Contribution X

Fixed Costs (X)

Profit X

In a marginal costing system, inventory is valued at the variable cost per unit

Exercise 1

A company makes and sells a single product. Details of this product are as follows:

Per unit Selling price £20 Direct materials £6 Direct labour £3 Variable production overheads

£4

Fixed production overheads

£20,000 per month

The fixed overhead is absorbed on the basis of expected production of 20,000 units

per month.

Required:

If actual production and sales are 20,000 units in a month, calculate

(a) The contribution per unit, the total contribution for the month and the total

profit for the month, using marginal costing.

(b) The profit for the month using absorption costing.



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Exercise 2

A company produces a single product with the following budget:

Selling price £10 Direct materials £3 per unit Direct wages £2 per unit Variable production overheads

£1 per unit

Fixed production overheads

£10,000 per month

Budgeted production 5,000 units per month

Required:

Show the operating statement for the month when 4,800 units were produced and

sold using:

(a) Absorption costing

(b) Marginal costing

Assume that all costs were as budget.

You will notice that in this question you will need to account for over or under

absorption.



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PROFIT RECONCILIATIONS

In the two exercises just done the profits achieved under both methods are exactly

the same. This is because opening inventory = closing inventory.

If there is a movement in inventory, the profits will differ. We need to be able to

reconcile these profits. This is a simple matter and very easy to do. It is also a

common exam question.

Exercise 3

Using the above budget in Exercise 2, recalculate the operating statements

assuming that production had been 6,000 units and sales 4,800 units.

Reconcile the profits.

From the figures you have calculated you will see that there is a closing stock

balance of 1,200 units. The value of these balances differ because of the amount of

fixed overhead contained within the absorption costing stock.

From this we can deduce that the difference in the profit figures is because of the

change in the number of units of stock x fixed production overhead cost per unit.

Try it:



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IMPORTANT EXAM POINT

Please remember:

● If closing inventory > opening inventory, then absorption costing profit will be

greater than marginal costing profit. This is because some of the fixed

overhead for the period is contained in the closing stock.

● If closing inventory < opening inventory, then absorption costing profit will be

less than marginal costing profit. This is because some of the overhead from

a prior period has been written off in the current period from the stock taken

from the opening stock.

● If closing inventory = opening inventory then absorption costing profit will be

equal to marginal costing profit

● Difference in profit = movement in inventory x fixed production overhead cost

per unit

Exercise 4

A company has a profit of £75,000 using a marginal costing system. Budgeted

fixed costs were £30,000 and budgeted activity was 10,000 units. The following

information is also available:

Opening inventory 500 units Production 10,500 units Sales 10,750 units

What would the profit be using absorption costing?

A £72,750

B £74,250

C £75,750

D £77,250

Exercise 5

Z Ltd produces a single product. The management currently uses marginal costing,

but is considering using absorption costing in the future. The budgeted fixed

production overheads for the period are £250,000. The budgeted output for the

period is 1,000 units. There were 400 units of opening stock for the period and 250

units of closing stock.

Required:

If absorption costing principles were applied, by how much would the profit for the

period compared to marginal costing differ?



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Chapter 8

Costing for jobs, batches, and services

CHAPTER COVERAGE

1. What are the various characteristics of specific order costing?

2. In which situations would job, batch or service costing be appropriate?

3. What are the treatments of direct and indirect costs?

4. What are various cost records and accounts involved in job order costing?

5. What is the difference between profit mark-up and profit margin?

6. How profit mark-up and margin are used to establish selling prices.

7. Analyse service costs.

8. Identify suitable cost unit measures that may be used in a variety of different

operations and services.



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CHAPTER 8 – COSTING FOR JOBS, BATCHES, AND SERVICES


CHAPTER CONTENTS

INTRODUCTION TO JOB COSTING ------------------------------------- 81

COST ACCUMULATION FOR JOBS 81

COST ACCOUNTS 84

BATCH COSTING 86

PRICING 87

SERVICE COSTING ------------------------------------------------------- 88

CHARACTERISTICS 88

IDENTIFICATION OF COST UNITS 89



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INTRODUCTION TO JOB COSTING

Jobbing production involves producing items to the specific order of a customer. As

such, mass production of items does not occur and each job will have its own

characteristics and hence costs. It is important, therefore, that costs due to an

individual job are collected separately, and remain identifiable within the accounts.

Job costs are normally collected on a job card that records specific costs incurred as

part of the job. Once a job is completed overheads are added to work out the total

cost of the job.

Cost accumulation for jobs

In cost bookkeeping, a separate job account is maintained for each job. These are

then consolidated into single work in progress account.

Exercise 1

A company makes three products, details of which are given below:

A local jobbing company has just completed a one-off job which involved making a

specialist iron frame. The item was given the job number 666.

Materials issued were as follows:

Steel grade A: 400 metres at a cost of £5.00 per metre Steel grade B: 800 metres at £6.00 per metre

Note 60 metres of grade B steel were unused and were returned to store.

The iron frame involved two production departments:

Welding: 220 normal hours, 100 overtime hours Finishing: 100 normal hours, 100 overtime hours

Hourly rate

Welding: £4.00 per normal hour, £1.00 overtime premium Finishing: £5.00 per normal hour, £1.50 overtime premium

Production overheads are absorbed at the rate of £3.00 per direct labour hour in

each department.

Note the company uses cost plus pricing of work and adds 40% to the cost of a job

to determine price. The company is very busy and would not normally work

overtime on a job of this nature

Required:

You have been asked to complete the following cost summary:



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Job 666

£ £

Materials

Grade A Steel

Grade B Steel

Wages

Wages Welding

Wages Finishing

Total Direct Cost

Overheads

Total Cost

Profit

Selling Price



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Exercise 2

A company operates a job costing system to enable them to identify the costs

incurred in carrying out works to customer specifications. Wherever possible, this

system allocates costs directly to a job.

Production overhead costs are absorbed into the cost of a job at the end of each

month at an actual rate per direct labour hour for each of the two production

departments.

The following information has been collected relating specifically to one job which

was carried out in the month just ended:

● 400 kgs of Material Y were issued from stores to Department A. Material Y is

currently valued at £0.51 per kg.

● 76 direct labour hours were worked in Department A at a basic wage of £4.50

per hour. 6 of these hours were classed as overtime at a premium of 50%.

● 300 kgs of Material Z were issued from stores to Department B. Department

B returned 35 kgs of Material Z to the storeroom as it was excess to

requirements for the job. Material Z is currently valued at £1.45 per kg.

● 110 direct labour hours were worked in Department B at a basic wage of

£4.00 per hour. 30 of these hours were classified as overtime at a premium

of 50%. All overtime worked in Department B in the month is as a result of

the request of a customer for early completion of another job that had

originally been scheduled for completion in the month following.

Overhead costs incurred during the month on all jobs in the two production

departments were as follows:

Dept A Dept B £ £ Indirect labour, at basic wage rate 2,510 2,960 Overtime premium 450 Lubricants and cleaning compounds 520 680 Maintenance 720 510 Other costs 1,200 2,150 Total labour hours worked during the month 2,000 2,800

Prepare a list of the costs that should be assigned to the job.



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Cost accounts

Exercise 3

The following information concerns Sunflower Ltd.

At the end of last month, one job was uncompleted, and the costs to date were:

JOB 6832 £ Direct Materials 630 Direct Labour (120 hrs) 960 Factory Overhead (£2 per hr) 240 Factory cost to date 1,830

At the start of the month two new jobs were started: JOB 6833, JOB 6834.

By the end of the month jobs 6832, 6833 were competed.

The following cost information is available:

Direct Materials

Issued to: £ Job 6832 2,390 Job 6833 1,680 Job 6834 3,950

Materials Transfers: £ Job 6834 to Job 6833 250 Job 6832 to Job 6833 620

Materials Returned to Store £ From Job 6832 870

Direct Labour Hours Recorded

Job 6832 430 hrs Job 6833 650 hrs Job 6834 280 hrs

Labour is charged at £8.00 per hour.

Production overheads are absorbed at the rate of £2.00 per labour hour. The actual

overheads incurred during the month were £3,800.

Required:

Complete the following job accounts:



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Job 6832

Job 6833

Job 6834



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Batch costing

Batch costing is similar to job costing in that each batch is separately identifiable.

In batch costing, the cost per unit is calculated as:

Total cost of the batch / Number of units in the batch

Exercise 4

A company operates a batch costing system. For a particular order, 5 units are

produced in a batch.

The following costs were incurred producing the batch:

Direct materials £230 Direct labour £180 Direct labour is paid at £7.50 per hour.

Production overheads are absorbed at a rate of £12 per direct labour hour and non-

production overheads are absorbed at a rate of 30% of total production cost.

What is the total cost per unit in this batch?

A £82

B £139.60

C £181.48

D £235.92



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Pricing

When determining a price, a company may use mark up or margin.

● Mark up - profit expressed as a percentage of cost

● Margin - profit expressed as percentage of price

Equally, a company may decide to use variable (marginal) cost of a unit or full cost

when calculating a price. It is important to check questions that ask for prices

carefully. Which cost is being used and is the question using mark up or margin?

Exercise 5

A company has the following cost card:

£ Direct Labour 10

Direct Materials 12

Prime cost 22

Variable Production Overhead

5

Fixed Production overhead 4

Production cost 31

Variable non-production cost 6

Fixed non-production cost 3

Total 40

Required:

£

Using a mark-up on marginal cost of sales of 80%, what is the

price?

What is the resulting profit?

Using a margin of 80% on total production cost what is the price?

What is the resulting profit?



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SERVICE COSTING

Characteristics

Definition:

“Cost accounting for services or functions, eg canteens, maintenance, personnel.

These may be referred to as service centres, departments or functions. Service

costing is also known as Operations Costing.”

Service organisations do not make or sell tangible goods. Most, however, still seek

to make a profit and in doing so are required to build up costs of their services for

charging out.

Examples:

● Transport

● Accountants

● Hotels

● Hospitals

● Schools/colleges

● Banks etc.

Recording costs for the organisations is very similar to other methods of costing, ie

direct and indirect costs.

● they tend to have a very low level of direct material costs

● it is difficult to cost one unit of output as it is often intangible

● as no two service industries are similar, costing methods will differ

considerably.

Services have certain specific characteristics which have to be taken into account:

Intangibility –

The performance of the service depends upon other factors rather than just the

service. A bus service depends upon timing, reliability, comfort, cleanliness etc.

Simultaneity –

The production and consumption of the service are done at the same time. The

product cannot be inspected beforehand. The bus journey is provided and taken at

the same time. It cannot be assessed before the journey takes place but

comments can be made afterwards.

Perishability –

The service is perishable. It cannot be provided in advance and stored.

Heterogeneity –

The exact service provided will vary each time. The bus journey will vary as to the

exact time it takes; the comfort of the passengers depends upon the number and

type of people travelling at that particular time.



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Identification of cost units

Some service units can be easily costed using an apt basis. For others there may

be a choice of bases to be used.

Eg: Hotel – cost per guest day

Transport service – cost per passenger mile

Each service organisation will therefore have to decide upon a basis to be used that

is relevant to them.

The cost per service unit is then calculated as:

Total costs for the period / Number of service units provided in the period

Exercise 6

An accountant is setting up his own business. He will be working a 40 hour work

for 48 weeks of the year.

Expenses are expected to be £35,000 and a mark-up of 30% will be applied to cost

to establish the charge per hour.

95% of his time will be chargeable to customers and the remainder will be spent

reviewing changes to statutory requirements.

What should he charge per hour for the accountancy services provided (to the

nearest penny)?



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Exercise 7

Little Larson Ltd operates a small fleet of delivery vehicles. Standard costs have

been established 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 10p per kilometre Repairs 5p per kilometre Depreciation £80 per week per vehicle Supervision £120 per week Other general expenses (fixed) £200 per week

There are two drivers and two vehicles in the fleet.

During a quiet week, only six journeys were made.

Journey Tonnes carried One-way distance (one way) of journey (km)

1 5 100 2 8 20 3 2 60 4 4 50 5 6 200 6 5 300

Required:

Calculate:

(a) The total variable cost for the week.

(b) The total fixed cost for the week.

(c) The expected average full cost per tonne/kilometre for the week.



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Chapter 9

Process costing, joint and by-products

CHAPTER COVERAGE

1. What is Process Costing and in which environment it is used for?

2. What are normal and abnormal losses/gains in process costing?

3. How to calculate the cost per unit of output.

4. What are various accounts involved in process costing?

5. What are equivalent units and how are they calculated?

6. Account for opening and closing work-in-progress using FIFO and weighted

average methods.

7. What are joint and by-products?

8. Value joint and by-products at the point of separation using physical units and

sales value methods.



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CHAPTER 9 – PROCESS COSTING, JOINT AND BY-PRODUCTS


CHAPTER CONTENTS

INTRODUCTION ---------------------------------------------------------- 93

LOSSES AND GAINS ----------------------------------------------------- 95

NORMAL LOSS 95

ABNORMAL LOSS 96

COST PER UNIT ---------------------------------------------------------- 98

ABNORMAL GAIN 99

COST ACCOUNTS -------------------------------------------------------- 103

WORK-IN-PROGRESS AND EQUIVALENT UNITS 103

OPENING WORK IN PROGRESS 105

AVCO VALUATION ------------------------------------------------------ 106

FIFO VALUATION ------------------------------------------------------- 107

JOINT AND BY-PRODUCTS --------------------------------------------- 109

INTRODUCTION 109

TREATMENT OF BY-PRODUCTS AND JOINT COSTS 110



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INTRODUCTION

In a significant number of manufacturing processes it is not possible to identify

individual cost units because of the continuous nature of production, eg oil refining,

paint production, chemical manufacture.

Using process costing it becomes possible to derive a cost for both output and

closing stocks.

Process costing has a number of features that distinguish it from job, batch and

service costing:

● Under continuous production there is almost always work in progress to be

valued.

● Wastage during a continuous production process is common and has to be

taken into account (see later).

Students often find process costing a difficult topic to understand. However, it is

straightforward if the following points are kept in mind:

1. Process accounts are simple control accounts that have debit and credit

entries and are nothing more than work in progress accounts.

2. Ledger accounts contain quantity columns that should be balanced off.

3. A set of rules applies to each procedure - once learnt they always apply.

Exercise 1

Manufacturing a product involves two processes, cutting and forming.

Units of material input Value £ Cutting 1,000,000 500,000 Forming 500,000 300,000 Direct Labour Costs Production Overhead £ £ Cutting 200,000 200,000 Forming 150,000 150,000

Required:

Given that output from Cutting is fed into Forming, write up the process accounts.

Debit PROCESS 1 (CUTTING) Credit



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Debit PROCESS 2 (FORMING) Credit

Note that direct labour and production overheads are sometimes lumped together

and termed conversion cost.



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LOSSES AND GAINS

Most processes are not 100% efficient and involve some form of loss in weight or

volume. This has to be accounted for. In process costing, an important division is

made between NORMAL LOSS and ABNORMAL LOSS.

Normal loss

These are losses that are expected as part of the production process. The cost of a

normal loss is spread across the remaining good units.

Any scrap revenue from a normal loss is used to reduce the cost of the main

process.

The cost per unit of good output is calculated as:

units output Expected

loss normal of value-costs Total

Where Expected output = Input units – Normal loss units.

The heart of getting the correct answer in questions involving abnormal losses and

gains is to calculate the unit cost of output correctly.



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Exercise 2

A process has a normal loss of 5%, which can be sold for £5 per tonne. In a

period, materials used were 160 tonnes at £23 per tonne and labour and overheads

amounted to £3,200. All losses were normal.

Required:

What were the costs per tonne of good output?

Abnormal loss

Abnormal losses are unexpected losses. Unless told otherwise it is assumed that

losses occur at the end of the process and are costed at the same rate as good

units.

An abnormal loss occurs when actual output is less than expected output. If there

are abnormal loss units, these may also be sold for scrap.

Accounting for abnormal losses:

1. Credit the process account with good output and normal loss. Value the good

output at the cost per unit value.

2. Calculate the difference between actual good output and expected output and

record the difference as abnormal loss on the credit side of the process

account.

3. Abnormal loss is valued at the cost per unit value in the process account.

4. Record the abnormal loss as a debit in the abnormal losses/gains account.

5. Increase the scrap sales by the abnormal loss.

Normal loss a/c (scrap sales)

Process a/c



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6. The difference between the cost per unit value of abnormal loss and the scrap

value is reported as a loss in the profit and loss account. This is calculated

as:

Abnormal loss units x Cost per unit – Scrap value of abnormal loss units



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COST PER UNIT

Exercise 3

Using the above information (Exercise 2), prepare the process accounts assuming

that output was 150 tonnes.

Abnormal loss/gain a/c


Process a/c



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Abnormal gain

Abnormal gains occur when actual good output is greater than expected output.

Abnormal gains represent extra good units so are costed at the same rate as other,

expected, good units.

By making more good units than expected a company will have lost out on scrap

revenue. This is accounted for in the abnormal loss/gain account.

Accounting for abnormal gains:

1. Credit the process account with good output and normal loss. Value the good

output at the cost per unit value

2. Calculate the difference between actual good output and expected output and

record the difference as abnormal gain on the debit side of the process

account

3. Abnormal gain is valued at the cost per unit value in the process account

4. Record the abnormal gain as a credit in the abnormal losses/gains account

5. Decrease the scrap sales by the abnormal gain

6. The difference between the cost per unit value of abnormal gain and the scrap

value is reported as a gain in the profit and loss account. This is calculated as:

Abnormal gain units x Cost per unit – Scrap value of abnormal gain units.



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Exercise 4

Using the above information (Exercise 2), prepare the process accounts assuming

that output was 156 tonnes.



Process a/c



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Exercise 5

In a local factory normal loss is 10% and each scrapped unit makes £0.50 from

process 1 and £3.00 from process 2.

Required:

Using the following information, prepare:

(a) Process 1 Account;

(b) Process 2 Account;

(c) Abnormal Loss/Gain Account;

(d) Scrap Account.

Process 1 Process 2 Direct materials added 2,000 units 1,250 units Direct materials cost £8,100 £1,900 Direct labour £4,000 £10,000 Production oh 150% direct labour 120% direct labour Output to process 2 1,750 Output to finished goods 2,800

Process 2 a/c

Process 1 a/c



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COST ACCOUNTS

Work-in-progress and equivalent units

At the end of the period there is likely to be some partly completed work (work-in-

progress) and some of the costs of the period have to be attributed to it. The

number of EQUIVALENT UNITS is calculated in order to spread the costs incurred

over fully and partly completed units.

If 2,000 units had been introduced into a process and only 1,500 had been

completed it would be unfair to apportion costs in the ratio 3:1 between finished

output and closing stock as the part-finished goods would not have 'received' their

complete amount of labour and materials.

This problem is overcome by converting part completed work into EQUIVALENT

UNITS of finished output. For example, if 200 units were 70% completed, they

would be charged with the cost of 140 completed units.

Getting the right answer to a question involving closing work in progress is a three-

stage process.

1. Convert physical outputs to equivalent units by constructing a

statement of equivalent units.

2. Calculate the cost per equivalent unit. This is equal to:

Total Costs / Total Equivalent Units

3. Calculate the value of each output by multiplying the number of

equivalent units by unit cost in a statement of valuation.

Exercise 6

In a period 1,000 fully completed and 200 partly completed units were produced.

The partly completed units were 50% complete. Total costs for the period were

£5,500.

Required:

Calculate the cost per equivalent unit.



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Exercise 7

The following information is available for Stinkwort Ltd.

Units £ Direct materials 5,000 16,560 Direct Labour 7,360 Production overhead 5,520 29,440

Of the 5,000 units, 4,000 were completed and 1,000 were 60% complete.

£

The value of finished units is

The value of closing WIP is

Required:

Complete the process account below for Stinkwort Ltd.

In this example it was assumed that unfinished work was completed to the same

extent for labour and materials. In reality, however, it may be the case that all

materials have been added but only a portion of the labour (or any variation on this

theme). The next exercise illustrates how this might be accounted for.

Process a/c



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Exercise 8

In a given period the production data and costs for a process were:

Production 2100 fully complete 700 partly complete

Degree of completion of the partly complete units was:

Materials 80% Labour 60% Overheads 50%

The costs for the period were:

Materials £24,800 Labour £16,750 Overheads £36,200

Calculate the total equivalent production, the cost per complete unit and the value

of the WIP.

Opening work in progress

We have been able to calculate the value of the closing work-in-progress using the

degree of completion. As this is at the end of the period, we can assume that it is

therefore the opening work-in-progress at the beginning of the next period.

There are two methods for doing this – weighted average and FIFO.



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AVCO VALUATION

Weighted average method takes the total for each element of cost and this is

divided by the equivalent units to find the cost per equivalent unit as previously

calculated.

Statement of equivalent units

Units of output x 100%

+ closing work-in-progress x % completion

= total equivalent units

Cost per equivalent unit

When calculating the cost per equivalent unit, it is important to include the total

cost of the work done.

Total cost of work done = Current period costs + Opening value of OWIP

Using the average method, all the work done on OWIP is included when calculating

the equivalent units. It is important therefore to also include all the costs

associated with OWIP when calculating the cost per equivalent unit.

Valuation

Value each component – Output and CWIP. The value will be equal to:

Number of equivalent units x Cost per equivalent unit

Exercise 9

A company operates a process costing system using the AVCO method of valuation.

The following data relate to last month:

Opening work in progress:

Units: 3,000

100% complete for materials at a cost of £12,600

30% complete for conversion costs at a cost of £970

Closing work in progress:

Units: 2,000

100% complete for materials

60% conversion costs

Inputs for the period:

Materials: 7,000units at a cost of £28,000. Conversion costs for the period were

£17,430

Required:

What is the cost per equivalent unit for materials and conversion costs?

What was the total value of the units completed last month?



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FIFO VALUATION

FIFO method assumes that we complete the opening work-in-progress prior to

starting on any new production. This method is preferred by the examiner.

For FIFO method we require that the degree of completion (%) for each element of

cost in opening work-in-progress is given.

For FIFO, we only look at the work done in the current period and associated costs.

Statement of equivalent units

+ opening work-in-progress x % left to complete in period

+ goods started started and finished in period x 100%

= equivalent units completed in period

+ closing work-in-progress x %

= total equivalent units

Cost per equivalent unit

Under the FIFO method, only the work done in the current period is included in the

statement of equivalent units calculation

Therefore, only the current period costs should be included when calculating the

cost per equivalent unit.

Valuation

Value each component as follows:

OWIP: Opening value of OWIP + Number of equivalent units x cost per equivalent

unit

Goods started and finished in the period: Number of equivalent units x cost per

equivalent unit

CWIP: Number of equivalent units x cost per equivalent unit



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Exercise 10

A company operates a process costing system using the first in first out (FIFO)

method of valuation. No losses occur in the process.

The following data relate to last month:

Units Degree of completion Value Opening work in progress 100 60% £680 Completed during the month 900 Closing work in progress 150 48%

Costs incurred in the period were £10,944

What was the value of the closing work in progress?

A £816

B £864

C £936

D £1,800

What was the total value of the units completed last month?

A £10,080

B £10,320

C £10,760

D £11,000

Exercise 11

Imagine the following information is available

Opening WIP 500 units (60% complete) £2,325

Added units 1,000 units £10,500 Closing WIP 300 units (50% complete) Finished units 1,200 units

Required:

Using the information above, write up the process account for the period using:

AVCO

FIFO



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JOINT AND BY-PRODUCTS

Introduction

Quite often when materials are input into a process, more than one product

emerges. These are then known as ‘joint products’.

“Two or more products separated in processing, each having a sufficiently high

saleable value to merit recognition as a main product.”

Sometimes a product is made by accident or we discover we sell the wastage as a

product. This is then known as a ’by-product’.

“A product that is produced from a process, together with other

products, that is either of insignificant quantity or insignificant sales

value.”

To distinguish between joint products and by-products:

● A joint product is an important saleable item. Production is geared to

producing it.

● A by-product is something produced which is a bonus to the company. It

would not be produced as a main product.

Sometimes we are in a situation where we can sell our output from a process or we

can process it further and sell other products a later stage.

joint costs Process 1 Process 2

Product B

Product D

Product C

Product A is sold after Process 1

joint costs Process 1

Product A

Product B



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Treatment of by-products and joint costs

Up to the ‘split-off’ point all costs are classed as common or joint. They have to be

shared between all joint products. After this point the additional costs have to be

allocated to the various products.

The main problem is of the need to split the joint or common costs between the

joint products to enable us to cost them efficiently. There are two main methods

used to spit these costs:

1. Physical quantities – the costs are apportioned in proportion to their

physical weight or volume of production.

2. Sales value – the costs are apportioned in proportion to the sales value of

production or the final sales value after further processing costs have been

removed.

Accounting for by-products is similar to accounting for normal losses; credit any

income received to the process account and deduct this value form the total cost

before apportioning the costs over the good production.

Exercise 12

A process produces the following products:

Product Quantity (Kg) Selling price / kg X 100,000 £1 Y 20,000 £10 Z 80,000 £2.25 The costs incurred in the process prior to the separation point were £240,000.

Required:

Apportion the joint costs to each product using:

(a) Physical units basis

(b) Sales value basis.

Exercise 13

Three joint products (A,B,C) and 1 by-product (D) arise from a process. Total joint

costs are £16,500 and outputs and selling prices are as follows:

A 200 kgs @ £20 B 300 kgs @ £14 C 500 kgs @ £18 D 100 kgs @ £5

Required:

Apportion the joint costs using:

(a) The physical units basis

(b) The sales value basis.

When further processing has to be taken into account it is sometimes helpful to

draw a small diagram and annotate the costs on to it.



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Exercise 14

PCC Ltd produces two joint products from a single process. Joint processing costs

of £150,000 are incurred up to the split-off point, when 100,000 units of A and

50,000 units of C are produced. The selling prices at spilt-off point are £1.25 per

unit for A and £2 per unit for C.

The units of A could be processed further to produce 60,000 units of a new

chemical Aplus, but at an extra fixed cost of £20,000 and variable cost of 30p per

unit of input. The selling price of Aplus would be £3.25 per unit.

Required:

Ascertain whether the company should sell A or Aplus.

Exercise 15

At the end of manufacturing in Process 1, Product K can be sold for £10 per litre.

Alternatively product K could be further processed into product KK in Process 2 at

an additional cost of £1 per litre input into this process. Process 2 is an existing

process with spare capacity in which a loss of 10% of the input volume occurs. At

the end of the further processing, product KK could be sold for £12 per litre.

Which of the following statements is correct in respect of 9,000 litres of product K?

A Further processing into product KK would increase profits by £9,000.

B Further processing into product KK would increase profits by £8,100.

C Further processing into product KK would decrease profits by £900.

D Further processing into product KK would decrease profits by £1,800.



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Chapter 10

Budgets

CHAPTER COVERAGE

1. What is a budget?

2. What are objectives of budget preparation?

3. What are different types of budgets and how are they prepared?

4. What is the key or limiting factor for budgets?

5. What is difference between fixed and flexible budgets?

6. Prepare flexible budgets and identify variances between budget and actual

costs and revenues.



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CHAPTER 10 – BUDGETS


CHAPTER CONTENTS

INTRODUCTION --------------------------------------------------------- 115

BUDGET PREPARATION ------------------------------------------------ 116

SALES BUDGETS -------------------------------------------------------- 117

PRODUCTION BUDGETS ------------------------------------------------ 118

MATERIAL USAGE AND PURCHASE BUDGETS ------------------------ 119

OTHER FUNCTIONAL BUDGETS ---------------------------------------- 120

FLEXIBLE BUDGETS ---------------------------------------------------- 122



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INTRODUCTION

A budget is defined as 'a quantitative statement, for a defined period of time, which

may include planned revenues, expenses, assets, liabilities and cash flows for a

forthcoming accounting period’.

Budgets are prepared for a number of reasons:

1. To set and communicate targets.

2. To establish a standard against which actual performance can be compared.

3. To co-ordinate inter and intra functional activities.

Both functional budgets and a master budget can be prepared.

Typical functional budgets include:

● Sales Budget

● Sales Overhead Budget

● Production Budget

● Materials Usage Budget

● Materials Purchase Budget

● Labour Budget.

The master budget has three elements:

1. Budgeted income statement

2. Cash budget

3. Budgeted balance sheet

Budget construction is commonly overseen by a BUDGET COMMITTEE who often

produce a BUDGET MANUAL.

This commonly contains information on the following:

1. The objectives behind the budgeting process.

2. A list of organisational structures, including the major budgets (and their

interrelationships), together with those responsible for controlling them.

3. Procedural and administrative information on budget preparation.



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BUDGET PREPARATION

Before the Master Budget can be prepared functional budgets have to be

completed. Given that functional budgets are inter-related, changes in one budget

can engender changes in several others. The process is iterative and can be very

time consuming.

The budgeting process begins with identifying the PRINCIPAL BUDGET factor ie, the

factor limiting the activities of a company. The budget containing this limiting

factor is the one to be constructed first as it controls all others.

In most cases the principal budget factor is sales demand ie, levels of production

/service provision are controlled by levels of demand. Equally, however, availability

of cash, labour, machine time, and raw materials can all become the principal

budget factor.



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SALES BUDGETS

Sales budgets are relatively straightforward to construct.

Exercise 1 Creating a sales budget

Dahlia Limited makes three products Collerette, Pompom, and Cacti.

Budgeted Sales

Collerette 2,000 @ £100 Pompom 4,000 @ £130 Cacti 3,000 @ £150

Required:

Using the information above, complete the sales budget template:

Collerette Pompom Cacti Total

Sales Volume

Unit price

Total Value



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PRODUCTION BUDGETS

Production Budgets can only be constructed once sales budgets have been

completed and decisions made over planned stocks of finished goods.

Exercise 2 Planning production

In addition to the sales figures given in Exercise 1, Dahlia Ltd intends to have the

following stocks of finished goods.

Finished Stock Budget

Collerette Pompom Cacti Opening Stock Units 500 800 700 Closing Stock Units 600 1,000 800

Required:

Using this information, complete the production budget for Dahlia Ltd.

Collerette Pompom Cacti

Sales Units

Closing stock

Less

Opening Stock

Production Units



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MATERIAL USAGE AND PURCHASE BUDGETS

As this series of exercises based on Dahlia Ltd illustrates, functional budgets are

interrelated to each other, and materials usage and purchase budgets are no

different.

A materials purchase budget can only be completed once a usage budget has been

finalised, together with decisions regarding stocks of raw materials. In turn raw

material usage cannot be completed until production figures are known.

Exercise 3 How much material do we need?

In Exercise 2 you should have found that the company intends to manufacture the

following number of each product.

Collerette Pompom Cacti Production Units 2,100 4,200 3,100

The following information on materials is available:

Raw Material Usage

M1 M2 M3 kg/unit Collerette 5 2 - Pompom 3 2 2 Cacti 2 1 3

Cost per kg £5 £3 £4

Raw Materials Stock

M1 M2 M3 kg kg kg Opening stock 21,000 10,000 16,000 Closing 18,000 9,000 12,000

kgs

Usage of M1

Usage of M2

Usage of M3

kgs Value (£)

Purchases of M1

Purchases of M2

Purchases of M3



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OTHER FUNCTIONAL BUDGETS

In addition to the functional budgets produced here it is possible to produce other

functional budgets, including those for labour and overheads. As with other

functional budgets there is a strong degree of inter-linkage.

Exercise 4 Labour budget

Production figures for Dahlia Ltd's three products were as follows:

Collerette Pompom Cacti Production Units 2,100 4,200 3,100

The following information on labour usage is also available:

Collerette Pompom Cacti Hours per unit 4 6 8 Hourly rate £8.50 £8.50 £8.50

hrs Value (£)

Labour usage for the Collerette

Labour usage for the Pompom

Labour usage for the Cacti

Exercise 5

Johnson Ltd manufactures two products, A and B, and is preparing its budget for

200X. Both products are made by the same grade of labour, grade Q. The

company currently holds 800 units of A and 1,200 units of B in stock, but 250 of

these units of B have just been discovered to have deteriorated in quality and must

therefore be scrapped. Budgeted sales of A are 3,000 units and of B 4,000 units

provided that the company maintains finished goods stocks at a level equal to 3

months’ sales.

Grade Q labour was originally expected to produce one unit of A in two hours and

one unit of B in three hours, at an hourly rate of £7.50 per hour. In discussions

with trade union negotiators, however, it has been agreed that the hourly wage

rate should be raised by 50p per hour provided that the times to produce A and B

are reduced by 20%.

Produce the production budget and direct labour budget for 19X9.

Sometimes we have to take account of inefficiencies in production. We may lose

some material or have a workforce which does not work at the required rate.



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Exercise 6

Truro Ltd manufactures a single product Q, with a single grade of labour. Its sales

budget and finished goods stock budget for period 3 of 2010 are as follows:

Sales 700 units Opening stocks, finished goods 50 units Closing stocks, finished goods 70 units

The goods are inspected only when production work is completed and it is budgeted

that 10% of finished work will be scrapped.

The standard direct labour hour content of product Q is 3 hours. The budgeted

productivity ratio for direct labour is only 80% (which means that labour is only

working at 80% efficiency).

The company employs 18 direct operatives who are expected to average 144

working hours each in period 3.

Required:

(a) Prepare a production budget.

(b) Prepare a direct labour budget.

(c) Comment on the problem that your direct labour budget reveals, and suggest

how this problem may be overcome.



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FLEXIBLE BUDGETS

To this point the notes have examined the production of fixed budgets, ie no

account is taken of possible variation in budgeted levels of activity.

Flexible budgets take into account possible variation in levels of activity and costs.

They are defined as ‘a budget which, by recognising different cost behaviour

patterns, is designed to change as volume of activity changes’.

Flexible budgets are relatively straightforward to produce as they use the principles

of marginal costing. Calculating fixed costs and fully variable costs is

straightforward. However, care must be taken when dealing with semi-variable

costs, ie costs that have a fixed and a variable element.

Remember that semi-variable costs can be broken down into their fixed and

variable elements by using the High-Low method.

Exercise 7 Flexing a budget

The following information for Artichoke Ltd is available. The company's directors

are concerned by the large difference between budgeted and actual activity. They

have asked you to produce a flexible budget and to present meaningful variances.

Budget Flexed Actual

3,000 units 4,000 units 4,000 units

£ £

Sales 90,000 110,000 Less Direct Materials 30,000 45,000

Direct Labour 15,000 20,000 Fixed Production overheads

2,500 2,300

Gross Profit 42,500 42,700

Less Variable Selling cost 3,000 4,000 Fixed selling cost 1,500 2,000

Profit 38,000 36,700



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Chapter 11

Standard costing and variance analysis

CHAPTER COVERAGE

1. What is meant by a standard?

2. What are the different types of standards?

3. How to calculate the standard cost per unit of a product.

4. What is a variance?

5. How to calculate variances.

6. How to reconcile the standard profits with the actual profits through the

variances.



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CHAPTER 11 – STANDARD COSTING AND VARIANCE ANALYSIS


CHAPTER CONTENTS

INTRODUCTION --------------------------------------------------------- 125

TYPES OF STANDARD -------------------------------------------------- 126

IDEAL STANDARD 126

ATTAINABLE STANDARD 126

CURRENT STANDARD 126

BASIC OR HISTORIC STANDARD 126

VARIANCES AND VARIANCE ANALYSIS ------------------------------ 128

MATERIAL VARIANCES 129

LABOUR VARIANCES 131

VARIABLE OVERHEAD VARIANCES 132

FIXED OVERHEAD VARIANCES 132

SALES VARIANCES 134

OPERATING STATEMENTS --------------------------------------------- 136

ABSORPTION COSTING OPERATING STATEMENT 136

MARGINAL COSTING OPERATING STATEMENT 137

CAUSES OF VARIANCES 138



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INTRODUCTION

A standard cost is a carefully predetermined unit cost that is calculated in advance

of production taking place.

As such it includes standard amounts of labour at standard cost, standard amounts

of materials at standard cost, together with budgeted overheads absorbed at pre-

determined rates using budgeted levels of activity.

Standard costing is often used to establish expected costs against which actual

costs can be compared ie, a standard cost can be used to establish control over

costs.

Differences between standard and actual costs are known as variances.

The process of analysing differences between actual and standard costs is known as

variance analysis.

A typical standard cost card might be as follows: £ £ Direct Material

X (2 units) 7 Y (3 units) 8 Z (2 units) 9 24 Direct Labour

Grade 1 (6 hrs) 80 Grade 2 (5 hrs) 20 100 Standard Direct Cost 124 Standard Variable Cost of Production 100 Standard Fixed Cost 50 Standard Factory Cost 274 Standard Administration and Selling Overhead 120 Standard Cost of Sale 394 Standard Profit (50%) 197 Standard Sales Price 591



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TYPES OF STANDARD

Standard can be set on a number of bases.

Ideal standard

This is the 'perfect' standard ie, what should be achieved if there is no wastage or

loss and the whole production process functions perfectly. This type of standard

can act as long-term aspirational target.

Attainable standard

These are standards in advance of what is currently being achieved. However, the

degree of improvement required to attain the standard is a practical proposition.

This form of standard can be very motivational for staff.

Current standard

This is the standard an organisation is currently achieving. It does not provide

inspiration for improvement but it does provide a benchmark against which to

measure day-to-day activity.

Basic or historic standard

This is a standard that was set some time ago and has not been updated. It allows

a company to measure its progress over time.



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Exercise 1 Standard cost card

Using information in the paragraph below produce a standard cost card for product

Callestemon.

Each Callestemon uses 2kg of material Q at a standard cost of £30 per kg, 6 hours

of labour at £10 per hour. Variable overheads have a standard cost of £15 per

hour. The company has fixed production overheads of £20,000 and is budgeting to

produce 500 units. A standard profit of £100 is added to cost to determine

standard price.

£

Materials

Labour

Overheads

Fixed Overheads

Standard Cost

Standard Profit

Standard Price



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VARIANCES AND VARIANCE ANALYSIS

Variances can be defined as the 'Difference between a planned, budgeted or

standard cost and the actual cost incurred. The same comparisons can be made for

revenues’.

Analysis of the difference between standard and actual costs is known as VARIANCE

ANALYSIS.

FAVOURABLE VARIANCES occur when actual results are better than expected,

producing higher than expected profits.

ADVERSE VARIANCES occur when actual results are worse than expected,

producing lower than expected profits.

Variances are calculated in total (as the variance in flexible budgets). They are

then broken down into their constituent parts as per the diagram below.

Material

Labour

Variable overheads

Fixed overheads

Sales

Price

Usage

Rate

Efficiency

Expenditure

Efficiency

Expenditure

Volume

Price

Volume profit

Efficiency

Capacity



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Example 1 Owen

Owen Ltd uses a standard costing system. The standard cost card for one product

is shown below:

£ Direct Material 4 kg at £5 per kg 20 Direct Labour 2 hours at £8 per hour 16 Variable Overhead 2 hours at £3.5 per hour 7 Total Variable Cost 43 Fixed Overhead 2 hours at £7 per hour 14 Total Product Cost 57 Standard Selling Price 70 Standard Profit Margin 13

The budgeted output and sales was 1,000 units. Actual output for the period was

1,300 units and actual sales for the period was 1,250 units.

Actual cost and revenue were as follows:

£ Direct Material 5,000 kg, costing 22,700 Direct Labour 2,850 hours, costing 21,500 Variable Overhead 7,800 Fixed Overhead 14,600 Sales Revenue 1,250 units at £68 per unit 85,000

Required:

Calculate all possible variances.

Material variances

Standard Cost

Direct Material 4 kg at £5 per kg

Actual Results

Actual output 1,300 units Materials Purchased and used 5,000 Kg, costing £22,700

Key pro forma

SQ x SP

Usage

AQ x SP

Price

AQ x AP



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Possible reasons

Price Variance

1. Wrong budgeting

2. Lower/higher quality material

3. Good/poor purchasing

4. External factors (inflation, exchange

rates etc)

Usage Variance

1. Wrong budgeting

2. Lower/higher quality of material

3. Lower/higher quality of labour

4. Theft



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Labour variances

Standard Cost

Direct Labour 2 hours at £8 per hour

Actual Results

Actual output 1,300 units Hours paid and worked 2,850 Labour Cost £21,500

Key pro forma

SH x SR

Efficiency

AH x SR

Rate

AH x AR

Possible reasons

Rate Variance

1. Wrong budgeting

2. Wage inflation

3. Lower/higher skilled employees

4. Unplanned overtime or bonuses

Efficiency Variance

1. Wrong budgeting

2. Lower/higher morale

3. Lower/higher skilled employees

4. Lower/higher quality of material



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Variable overhead variances

Standard Cost

Variable overhead 2 hours at £3.5 per hour

Actual Results

Actual output 1,300 units Hours worked (from above) 2,850 Variable overhead cost £7,800

Key pro forma

SH x SR

Efficiency

AH x SR

Expenditure

AH x AR

Possible reasons

Efficiency Variance

As per labour efficiency.

Expenditure (rate) Variance

Variable overheads are made up of many different overhead cost elements; to

identify reasons for the variance we would need to analyse all elements separately.

Fixed overhead variances

Fixed costs are a constant in total terms, hence total cost is our starting point. The

analysis of variances will be dependent on the costing methodology. Do we use

absorption costing or marginal costing? Either is potentially applicable.

Absorption costing principles

Using absorption costing the fixed cost is charged or absorbed to the cost unit or

product. The total fixed overhead variance will be similar to the under/ over

absorption of overhead.

The total variance may be sub-analysed into two:

1. Volume variance – if the company produces more or less units and hence

absorb more or less overhead than budgeted.



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2. Expenditure variance – if the company spends more or less fixed overhead

than budgeted.

Question extract

Standard and Budgeted Cost

The fixed cost is (£7/hour for 2 hours) £14 per unit The budgeted number of units is 1,000 Budgeted fixed overheads is therefore £14,000

Actual Results

Actual output 1,300 units Hours worked (from above) 2,850 Fixed overhead Cost £14,600

Key pro forma

Std fixed o/h cost (of actual output)

Volume variance

Budgeted fixed o/h cost

Expenditure variance

Actual fixed o/h cost

Further analysis of fixed overheads

It is also possible to further analyse fixed overheads by considering actual hours in

relation to the actual and budgeted units produced. To be comparable the output

measures must be measures in terms of standard hours.



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Key pro forma

SH x SR

Efficiency

AH x SR

Capacity

BH x SR

Expenditure

AH x AR

Sales variances

Standards and

budget

Total Product Cost

57 Standard Selling Price 70 Standard Profit Margin 13 Budgeted sales 1,000

Actual Results

Sales (units) 1,250 Selling Price £68 Production units 1,300

Key formulae

Volume variance

(AS - BS) x SPM

Price variance

(AP - SP) x AS



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Changes to variances when using marginal costing

Variances that remain the same

Variances that change

All variable cost variances

Sales price variance Sales volume variance now valued at standard contribution margin

Fixed overhead expenditure Fixed overhead volume (and hence capacity and efficiency) disappear



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OPERATING STATEMENTS

Though individual variances provide useful information for management, they can

be combined to produce an operating statement that can be used to reconcile

budgeted and actual profit.

Since an adverse variance brings down profit it is subtracted from budgeted profit

in an operating statement. Conversely, each favourable variance puts up profit and

should be added to budgeted profit.

Absorption costing operating statement

Example 2 Owen

Using information on variances, calculated in exercises above, complete the

operating statement for Owen Ltd under absorption costing.

£

Budgeted Profit

Sales Volume Variance

Standard profit for actual sales volume

Sales Price Variance

Cost Variances

F A

Materials Price

Materials Usage

Labour Rate

Labour Efficiency

Variable Overhead Expenditure

Variable Overhead Efficiency

Fixed Overhead Expenditure

Fixed Overhead Capacity

Fixed Overhead Volume

Total

Actual profit



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Marginal costing operating statement

When reconciling using marginal costing principles it is normal to reconcile from

budgeted contribution.

Example 3 Owen

Using information on variances, calculated in exercises above, complete the

operating statement for Owen Ltd under absorption costing.

Budgeted Contribution

Sales Volume Variance

Standard contribution for actual sales volume

Sales Price Variance

Sub-total

Variable Cost Variances

F A

Materials Price

Materials Usage

Labour Rate

Labour Efficiency



Sub-total

Actual contribution

Less budgeted fixed cost

Variance

Sub-total

Actual profit



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Causes of variances

Variances can arise for a number of reasons. Example reasons are given in the

table below.

Fill in the shaded boxes with further reasons.

Variance Materials Price Purchase of better quality materials

Material Usage Use of different quality materials

Labour Rate Workers claiming overtime

Labour Efficiency Inexperienced workers used to complete work



Fixed Overhead

Sales Price Sales Promotion

Sales Volume Competition

Variances can be inter-related. Buying high quality materials will lead to an

adverse materials price variance. However, better quality material will improve

labour efficiency, leading to a favourable labour efficiency variance.



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Chapter 12

CVP analysis

CHAPTER COVERAGE

1. How to calculate the contribution per unit of a good or service.

2. How to calculate the contribution to sales ratio (C/S).

3. What is a break even point?

4. How to draw a break-even chart and profit/volume chart.

5. How to identify the break-even point by using:

● Break-even chart

● Profit/volume chart

● Mathematical technique.

6. What is the margin of safety and how it is calculated?



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CHAPTER 12 – CVP ANALYSIS


CHAPTER CONTENTS

BREAK-EVEN ANALYSIS (CVP ANALYSIS) --------------------------- 141

BREAK-EVEN POINT 141

TARGET PROFITS 141

MARGIN OF SAFETY 142

CONTRIBUTION / SALES RATIO -------------------------------------- 144

BREAK-EVEN CHART 146

PROFIT/VOLUME CHART 146

LIMITATIONS OF BREAK-EVEN ANALYSIS 147



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BREAK-EVEN ANALYSIS (CVP ANALYSIS)

CVP analysis is a technique which uses cost behaviour to identify the level of

activity at which we have no profit or loss (break-even point).

It can also be used to predict the profits or losses to be earned at varying activity

levels (using the assumed linearity of costs and revenues).

CVP analysis assumes that selling prices and variable costs are constant per unit

regardless of the level of activity and that fixed costs are just that – fixed.

In order to calculate these levels we need to consider the contribution provided by

each unit of production. Contribution is the term given to the difference between

the selling price and the variable costs which contributes first towards paying the

fixed costs and then towards providing profit.

The price of each unit we sell consists of three (3) parts.

1. the variable element which is incurred for each unit of production.

2. the fixed element which varies according to the number of units made.

If the units increase, the amount of fixed costs per unit required will

decrease.

3. the profit element.

Break-even point

If we are to calculate the break-even point let us first imagine that the fixed costs

are a large hole in the ground. What we need to find out is how many contributions

it takes to fill that hole.

Unit contribution = Selling price per unit – Variable cost per unit

Total contribution = Unit contribution x volume

At the break-even point, profit is 0:

Total Contribution = Fixed Costs + 0

Break-even point (units) = oncontributi Unit

costs Fixed

Exercise 1 Break-even point

A company has a budgeted level of activity of 10,000 units with a budgeted total

contribution of £90,000. Fixed costs are £45,000. Each unit is sold for £15.

What is the breakeven point in units?

What is the breakeven sales revenue?

Target profits

Similarly the profit we require is the pile on top of the hole. How many

contributions does it take to reach the required height?

Contribution target = Fixed costs + Target profit

Volume target (units) = oncontributi Unit

target onContributi



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Exercise 2 Breaking even and reaching a target profit

A company makes the Daisy. Each Daisy has a variable cost of £4 and a selling

price of £9. Fixed costs for the company are £35,000. Given that company wishes

to make a profit of £15,000, how many units does it have to:

Units

Sell to breakeven?

Sell to reach its target profit?

Margin of safety

The margin of safety is the area between the break-even point and the maximum

sales. This is the area that the company can operate in and be certain of making a

profit. It is usually classed as the amount of sales that a company can afford to

lose before it gets into a loss making situation.

Knowing that a product breaks even at a certain sales volume is helpful but it can

be misleading in certain circumstances.

A company makes two products, the breakeven volumes for which are shown

below:

Product A 500 units Product B 200 units

All other things being equal, which product is most likely to make a profit?

It is tempting to state B as it has the lower breakeven point. You should reconsider

this in the light of the budgeted sales figures below:

Product A 2,000 units Product B 300 units

Breakeven sales are a smaller percentage of budgeted sales for Product A than they

are for Product B and as such Product A is much more likely to make a profit.

Margin of safety measures the difference between budgeted and breakeven sales

and expresses it as a percentage of budgeted sales. It represents how far below

budgeted sales actual sales can fall before a loss will be made.

Margin of safety = (budgeted sales – breakeven sales / budgeted sales) x 100

Product A (2,000 – 500 / 2,000 x 100 = 75%

Product B (300 – 200) / 300 x 100% = 33%

Exercise 3 Margin of Safety

A company is budgeting to sell 150,000 units at £7. Each unit has a variable cost

of £4 and the company’s fixed costs are £342,000. What is the margin of safety?



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Quick exercises

1. Selling price £3 per unit Variable costs £1 per unit Fixed costs £500

Calculate the break-even point.

2. If the fixed costs increase by 10% and the company aims to make £200

profit, what output is required?

3. Assuming the maximum output is 250 units, what selling price would achieve

the required profit target of £200 assuming the increased fixed costs?

4. Budgeted sales 80,000 units Selling price £8 Variable costs £4 per unit Fixed costs £200,000

What would be the break-even point and the margin of safety?



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CONTRIBUTION / SALES RATIO

The above calculations are useful in calculating the break-even point of one unit of

production. If a company makes more than one product it may be better to

calculate the C/S ratio.

C/S ratio = sales Unit

oncontributi Unit or

sales Total

oncontributi Total

A product having a sales price of £10 and unit contribution of £4 would have a C/S

ratio of:

10£

4£= 0.4

This means that forty pence of every pound of sales revenue is contribution.

Breakeven sales revenue can then be calculated as:

ratio C/S

Costs Fixed

Exercise 4 C/S Ratio

Penstemon Ltd make a product, the Sepal. Each Sepal sells for £15 and has a

variable cost of £6. Total fixed costs are £198,000. The company is budgeting to

sell 66,000 units.

Unit contribution is: £

C/S Ratio is:

Breakeven revenue is: £

Margin of safety is: £



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Exercise 5

The following details relate to a shop which currently sells 25,000 pairs of shoes

annually.

Selling price per pair £40 Purchase cost per pair £25

Total annual fixed costs: Salaries £100,000 Advertising £40,000 Other fixed expenses £100,000

Required:

Answer each part independently of data contained in other parts of the

requirement.

(a) Calculate the break-even point and margin of safety in number of pairs of

shoes sold.

(b) Assuming that 20,000 pairs of shoes were sold in a year, estimate the shop’s

net income or loss.

(c) If a selling commission of £2 per pair of shoes sold was introduced, how many

pairs of shoes would need to be sold in a year in order to earn a net income of

£10,000?

(d) Assume that for next year an additional advertising campaign costing £20,000

is proposed, whilst at the same time selling prices are to be increased by

12%, what would be the break-even point in number of pairs of shoes?



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Break-even chart

Profit/volume chart

A break-even chart shows the costs and revenues at a number of activity levels. It

does not however, show the amount of profit or loss at these levels. This is shown

on the profit/volume chart.

Fixed costs (total loss)

Break-even point

Total profit Profit

Loss

Sales activity

Break-even point

Sales activity

Costs and revenues

Margin of safety

Fixed costs

Total costs

Sales revenue

Profit

Budgeted activity



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From this chart we can read off the amount of profit or loss for any level of activity.

1. The x axis represents sales (units or values)

2. The y axis shows profits above the x axis and losses below.

3. When sales = zero, the net loss is equal to the fixed costs.

4. If variable cost per unit and total fixed costs are constant throughout the

relevant range, the profit/volume chart is shown as a straight line.

5. If there are\changes in either of these costs at various levels of activity, it will

be necessary to calculate the profit or loss at each point where the cost

structure alters before plotting the points onto the chart.

Limitations of break-even analysis

Once costs and revenues have been determined, it is usually assumed that they will

have a linear relationship, ie

● Fixed costs will be constant over the relevant range

● Variable costs will vary in direct proportion to volume

● Selling price will remain unchanged

● The efficiency and productivity of the workforce remain constant.

The analysis covers either a single product or a mix of products at which it is

assumed that the proportion of each product will remain the same as volume

increases or decreases.

In constructing a break-even chart, the sales and costs are likely to be valid only in

a particular range of activity. This is referred to as THE RELEVANT RANGE. Outside

this range the same cost and revenue relationships are unlikely to exist. Eg, an

alteration in volume could affect the level of fixed costs (stepped) or the rate of

variable costs or selling prices (economies of scale).



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Chapter 13

Limiting factors, linear programming,

relevant costs

CHAPTER COVERAGE

1. What is a limiting factor?

2. How to find out any limitation in the production process.

3. How to rank the products and work out the optimum production plan by using

the limiting factor/resource.

4. Why do management accountants have to use Linear programming technique

in limiting factor analysis?

5. What is relevant cost?

6. Why is relevant cost study important in short term decision making?



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CHAPTER 13 – LIMITING FACTORS, LINEAR PROGRAMMING, RELEVANT COSTS


CHAPTER CONTENTS

LIMITING FACTORS (SCARCE RESOURCES) ------------------------- 151

METHOD OF WORKING 152

LINEAR PROGRAMMING ----------------------------------------------- 155

RELEVANT COSTS AND REVENUES ------------------------------------ 157

RELEVANT CASH FLOWS ARE FUTURE CASH FLOWS 158

RELEVANT CASH FLOWS ARE INCREMENTAL CASH FLOWS 158

COMMITTED COSTS ARE NOT RELEVANT 158

RELEVANT COSTS CAN BE OPPORTUNITY COSTS 158



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LIMITING FACTORS (SCARCE RESOURCES)

Within most business organisations there are not enough resources available to

fulfil all the plans of the organisation. The factor which is in short supply is known

as the ‘limiting factor’.

When an organisation is short of a resource it has to make decisions regarding its

production scheduling so as to make the best use of that resource.

Typically the limiting factor is the forecast level of sales. In some circumstances,

limited supply of labour or machine time could govern the level of output.

Questions at this level, assume that a company wishes to maximise its return on

the resources it has available.

Limiting factor analysis is the technique used to calculate the mix of products that

should be made to maximise return on a single limiting factor.

Take the two products below. Which one should the company make to maximise its

return on scarce machine hours?

Red Herring

£ £ Unit Sales Price 40 80 Unit Variable Cost 10 20 Contribution 30 60 Unit Fixed cost 20 20 Unit Profit 10 40

It is tempting to state the Herring due to its higher unit profit.

However, this could be the wrong suggestion for two reasons:

1. Profit should not be used as its calculation includes fixed costs that do not

change as the result of the decision.

2. The apportioning of fixed cost between products could be quite arbitrary.

Contribution should be used.

Even if contribution is used the wrong decision can still be made.

Contribution per unit of product does not take into account the amount of scarce

resource used to generate that contribution. Decisions on production priorities

should be made using the contribution generated per unit of scarce resource used –

in this case contribution per machine hour.

Imagine if 1,000 machine hours are available and each Red takes 1 hour and each

Herring 3 hours.

Red Herring

£ £

Unit Sales Price 40 80 Unit Variable Cost 10 20 Contribution 30 60 Machine hrs 1 3 Contribution per hour 30 20 Total hours available 1,000 1,000 Total contribution £30,000 £20,000



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Method of working

1. If not stated, calculate the limiting factor

2. Find the contribution per unit of each product by deducting variable cost from

selling price.

3. Calculate the contribution per unit of limiting factor by dividing the

contribution per unit by the units of limiting factor required to make each

product.

4. Rank these in order of priority.

5. Prepare a production schedule showing how many units of each product you

are going to make taking account of priorities and prior contracts etc.

6. Calculate the total contribution earned by this production.

7. If required, deduct fixed costs to find the profit achieved in the period.

Exercise 1

A company makes three products, details of which are given below:

Speedwell Nettle Liatris Demand 1,000 units 1,000 units 1,000 units £ £ £ Unit price 50 70 50 Variable cost 10 50 25 Labour hours 4 1 2

Total fixed costs for the company are £7,500. There are 1,800 hours available.

Required:

How much of each product should be made to maximise profit for the company?

Units of Speedwell

Units of Nettle

Units of Liatris



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Exercise 2

X Ltd makes three products, A, B and C, of which unit costs, machine hours and

selling prices are as follows:

A B C

Machine hours 10 12 14

£ £ £

Direct materials @ 50p/kg 7 6 5

Direct wages @ 75p/hr 9 6 3

Variable overheads 3 3 3

Marginal cost 19 15 11

Selling price 25 20 15

Contribution per unit 6 5 4

Sales demand for the period is: 4,000 6,000 6,000

As a matter of company policy it is decided to produce a minimum of 1,000 units of

Product A. The supply of materials in the period is unlimited but machine hours are

limited to 200,000 and direct labour hours to 50,000.

Required:

Indicate the production levels that should be adopted for the three products in

order to maximise profitability, and state the maximum contribution that would be

achieved.

Note: In this question we have a prior commitment that has to be honoured before

we can proceed with our production scheduling.



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Exercise 3

X Ltd manufactures 4 liquids – A, B, C and D. The selling price and unit cost details

for these products are as follows:

A B C D

£/litre £/litre £/litre £/litre

Selling price 100 110 120 120

Direct materials 24 30 16 21

Direct labour (£6/hr) 18 15 24 27

Direct expenses - - 3 -

Variable overhead 12 10 16 18

Fixed overhead 24 20 32 36

Profit 22 35 29 18

Fixed overhead is absorbed on the basis of labour hours, based on a budget of

1,600 hours per quarter.

During the next 3 months the number of direct labour hours is expected to be

limited to 1,345. The same labour is used for all products.

The marketing director has identified the maximum demand for each of the 4

products during the next 3 months as follows:

A 200 litres B 150 litres C 100 litres D 120 litres

These maximum demand levels include the effects of a contract already made

between X Ltd and one of its customers, Y Ltd, to supply 20 litres each of A, B, C,

and D during the next 3 months.

Required:

(a) Determine the number of litres of products A, B, C, and D to be produced/sold

in the next 3 months in order to maximise profits.

(b) Calculate the profit that this would yield.



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LINEAR PROGRAMMING

Linear programming is a graphical technique used to identify the profit maximising

production levels when there is more than one limiting factor (constraint).

In order to be able to use this technique there must be a linear relationship

between the variables.

The best way of describing this technique is by means of an example.

Exercise 4

A company makes and sells two products X and Y. It has a shortage of labour

which is limited to 20,000 hours per annum. This is insufficient to satisfy the full

demand for both products. The unit costs, contributions and labour hours are as

follows:

Product X Product Y

Labour hours per unit of output 5 10

£ £

Selling price 80 100

Variable cost 50 50

Contribution 30 50

The company can sell any number of product Y but expects the maximum annual

demand of X to be 3,000 units.

Method:

1. Define the unknowns – the variables which must be considered.

Let x = number of units of X produced and sold

Let y = number of units of Y produced and sold

2. Formulate the constraints – the limitations to be placed on the variables.

This means expressing them as a mathematical equation.

Labour hours 5x + 10y ≤ 20,000

Maximum sales x ≤ 3,000

Non-negativity x, y ≥ 0

3. Formulate the objective function (what we want to maximise). This is

usually to maximise contribution.

Maximise 30x + 50y

4. Graph the constraints and objective function.

We need to transfer these figures onto the graph by means of drawing

straight lines which relate to the constraints already determined.

5. Identify the “feasible region”. This is the area where production is a

feasible option.



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6. Establish the optimum point using the graph or simultaneous

equations. To find the optimum point, place a clear ruler along the objective

function. Slide the ruler outwards from the origin, staying parallel to the

objective function. The last point in the feasible region to cross the leading

edge of the ruler is the optimum point.

Exercise 5

JWW Ltd manufactures two products, X and Y, and any quantities produced can be

sold for £60 per unit and £25 per unit respectively. Variable costs of the two

products are:

X Y £ per unit £ per unit Materials (at £5 per kg) 15 5 Labour (at £6 per hour) 24 3 Other variable costs 6 5 Total 45 13

Next month only 4,200 kg of material and 3,000 labour hours will be available.

The company holds no stocks and aims to maximise total contribution each month.

Required:

Write down the objective function.

Write down the constraints of the problem.

Graph these constraints and shade the feasible region.

Determine the numbers of each product to be produced to achieve the objective of

maximising contribution.

0

500

1000

1500

2000

2500

0 1000 2000 3000 4000 5000

Units of Y

Units of X



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RELEVANT COSTS AND REVENUES

Relevant costing decisions are based on an analysis of what changes as the result

of a decision – not total cost or total revenue but change in total cost and revenue.

Exercise 6

A company makes moulds and estimates that its standard product costs £1,500 to

make. At present there is spare capacity in the factory and the owners are

searching for additional business. A small local company has offered to buy 10

moulds for £900 each.

Required:

Should the company accept the offer?

On the face of it the answer is clear. If each pump costs £1,500 and they can only

sell them for £900, there is little point in their manufacture.

However, using relevant costing the problem would be approached from a different

angle.

1. How does total cost change if one more pump is built?

2. How does total revenue change if one more pump is sold?

Imagine the following breakdown of mould cost is available.

£ Materials 500 Labour 300 Fixed Production Overheads 700 Total 1,500

Making one more mould will incur an additional £500 of materials and £300 of

labour. However, factory overheads will not change, as they are all fixed costs.

The relevant (extra) cost of making one more mould is therefore £800.

If the mould is sold, the company will receive £900.

£ Relevant revenue 900 Less: Materials (500) Labour (300) Contribution 100

Since sale of the mould makes a positive contribution the company should go ahead

with the contract. This £100, although not profit, will contribute towards paying the

company’s fixed costs.

So what are relevant costs/revenues?

Relevant costs and revenues are simply cash flows that arise as the result of a

decision. If a cash flow if unaffected by a decision then it is not relevant.



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Relevant cash flows are future cash flows

In the example of the mould, development costs for the product are not taken into

account. They are sunk (historical costs) that will not be changed as a result of a

decision.

Relevant cash flows are incremental cash flows

The quarterly bill for materials used to make moulds could be £50,000. Increasing

the number of moulds produced by one unit increases the bill to £50,500. The

relevant cost of the extra mould is neither £50,000 nor £50,500. It is the change

in total material costs triggered by the decision to make one more mould – £500.

Committed costs are not relevant

Before the new contract for additional moulds arose the company was due to pay a

labour bill of £7,000 at the end of the month. This is not a relevant cost as it will

have to be paid regardless of the company’s decision regarding the extra moulds ie,

the company is committed to paying the wages irrespective of the decision being

made.

Relevant costs can be opportunity costs

A company has a limited supply of materials. If it uses them to make moulds it

cannot also make plastics. For every mould made the company loses contribution

on plastics worth £200. This is a relevant cost ie, it is a cash inflow that does not

arise as the result of a decision to manufacture moulds.

Exercise 7

A company has 600kgs of material in stock that cost £50/kg three years ago. To

replace the material would cost the company £60/kg.

Relevant Cost

£

At present the company does not have a use for the materials.

If it receives a one-off order that can use the material, what is

the relevant cost per kg?


However, it can sell the materials at £5/kg to a local scrap

merchant.



The company currently uses the materials in all of its products.

It can sell the materials for £5 per kg to a local scrap merchant.

If the company uses a kg of the materials in a product, what is

the relevant cost?



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Exercise 8

A company has just secured a new contract which requires 700 hours of labour.

There are 200 hours of spare labour capacity. The remaining hours could be

worked as overtime at time and a half or labour could be diverted from the

production of Product P. Product P currently earns a contribution of $8 per labour

hour and direct labour is currently paid at a rate of $9 per normal hour.

What is the relevant cost of labour for the contract?

Exercise 9

A company has a machine it was planning to sell for proceeds of £15,000 as the

machine is no longer in use by the company. The machine cost £70,000 5 years

ago.

A customer has requested a specific contract which the machine would be required

for. The duration of the contract would be 1 year. At the end of the contract, the

machine would have no sales value. The cost of disposing the machine would be

£5,000.

What is the relevant cost of the machine for this contract?

A £70,000

B £20,000

C £15,000

D £5,000



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Solutions to exercises

CHAPTER CONTENTS

CHAPTER 2 -------------------------------------------------------------- 162

CHAPTER 3 -------------------------------------------------------------- 164

CHAPTER 4 -------------------------------------------------------------- 166

CHAPTER 5 -------------------------------------------------------------- 170

CHAPTER 6 -------------------------------------------------------------- 175

CHAPTER 7 -------------------------------------------------------------- 178

CHAPTER 8 -------------------------------------------------------------- 180

CHAPTER 9 -------------------------------------------------------------- 185

CHAPTER 10 ------------------------------------------------------------- 196

CHAPTER 11 ------------------------------------------------------------- 199

CHAPTER 12 ------------------------------------------------------------- 200

CHAPTER 13 ------------------------------------------------------------- 203



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SOLUTIONS TO EXERCISES


CHAPTER 2

Exercise 1

Units Cost High 105,000 £210,000 Low 65,000 £133,000 40,000 £77,000

Variable cost = £77,000/40,000 = £1.925 per unit

Fixed cost = £210,000 – (105,000 x £1.925) = £7,875

Forecast for 165,000 units = £7,7875 + (165,000 x £1.925) = £325,500

Class Exercises

1. A

A simple way to identify these would be to assess which are totally variable.

T1 = 1,000/125 x 180 = 1,440 Ans = Semi variable T2 = 1,750/125 x 180 = 2,520 Ans = Variable T3 = 2,475/125 x 180 = 3,564 Ans = Semi variable T4 = 3,225/125 x 180 = 4,644 Ans = Variable

2. D

This diagram shows a variable above a fixed cost. The variable cost

decreases after a certain level of activity (slope is less steep).

3. C

From the information give we cannot use the high-low method in its normal

form as the fixed cost increases by £5,000. We need to remove this stepped

increase first and add it back in any forecasts we make above the limit of

18,000 units.

Units Cost High 22,000 £165,000 Low 17,000 £140,000 5,000 £5,000

Variable cost = £25,000/5,000 = £5 per unit

Fixed cost = £140,000 – (17,000 x £5) = £55,000

Forecast for 20,000 units = £55,000 + (20,000 x £5) + 5,000 = £160,000

4. £32,800

We need to remove the change in variable cost per unit before the high low

method can be applied.

Adjusted total costs at the high level of activity =

£31,000 + £1.5 x 1,000 = £32,500



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Variable cost = (32,500 – 22,000)/(13,000 – 8,000) = £2.1

For the first 12,000 units produced, the variable cost per unit will be £2.1. For

any additional units produced the variable cost per unit will be

£2.1 - £1.5 = £0.6

Fixed costs = £22,000 - £2.1 x 8,000 = £5,200

Total cost for 16,000 units =

£5,200 + £2.1 x 12,000 + £0.6 x 4,000 = £32,800



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CHAPTER 3

Exercise 1

1 High-low method

500

250,1

400900

050,1300,2=

−

−

Variable cost = £2.50

Fixed cost = 2300 – (900 x £2.50) = £50

Forecast for 850 units = 50 + (850 x £2.50) = £2175

2 Regression

Month x y xy x2 y2

January 400 1,050 420,000 160,000 1,102,500

February 600 1,700 1,020,000 360,000 2,890,000

March 550 1,600 880,000 302,500 2,560,000

April 800 2,100 1,680,000 640,000 4,410,000

May 750 2,000 1,500,000 562,500 4,000,000

June 900 2,300 2,070,000 810,000 5,290,000 4,000 10,750 7,570,000 2,835,000 20,252,500

( ) ( )

( ) 2000,4000,835,2*6

750,10*000,4000,570,77*6

−

−=b

000,000,16000,010,17

000,000,43000,420,45

−

−=b 396.2£=b

33.194396.2*6

000,4

6

750,10=

−=a

For forecasting, our equation is y = 194.33 + 2.396x

850 units = 194.33 + (2.396 x 850) = £2,230.93

3 Correlation

( ) ( )

( )( )[ ]22 750,10500,252,20*6000,4000,835,2*6

750,10*000,4000,570,77*6r

−−

−=

98697.0500,952,5*000,010,1

000,420,2==r

4 Coefficient of determination = r2 = 0.974 = 97%



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Exercise 2

A = (100,000 * 40%) + ( (40,000) * 60%) = £16,000

B = (50,000 * 60%) + ( (20,000) * 40%) = £22,000

C = (40,000 * 80%) + ( (10,000) * 20%) = £28,000

C is the best option.

Exercise 3

Project X:

Expected value = 0.4 x £3,000 + 0.6 x £1,500 = £2,100

Project Y:

Expected value = 0.35 x £10,000 + 0.65 x £0 = £3,500

Project Y is the best option



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CHAPTER 4

Exercise 1

894%3*40

000,32*15*2EOQ == (to nearest whole number)

Exercise 2

041,1300

000,65*2500*2==EOQ = 1,000 (nearest whole number)

Number of orders per year = 65,000/1,000 = 65 * £2,500 = £162,500

Cost of holding = 1,000/2 * £300 = £150,000

Total cost = £312,500

If we purchase 2,000 units per order

Ordering cost = 32.5 * £2,500 = £81,250 Holding cost = 2,000/2 * £300 = £300,000 Total cost = £381,250

BUT we save 65,000 * £1,000 * 2% = £1.3 m

Answer = Yes.

Exercise 3

ROL = 500 * 7 = 3,500

Minimum level = 3,500 – (5 * 400) = 1,500

Maximum level = 3,500 + 5,400 – (4 * 300) = 7,700.

Exercise 4

Employee Produced Rate Earned Received A 96 2.25 216.00 216.00

B 100 2.25 225.00

22 3.00 66.00

122 291.00 291.00

C 76 2.25 171.00 180.00

Total 687.00



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Exercise 5

Expected hours to complete job: 4 hours

Actual hours to complete job: 3 hours

Time saved: 1 hour

Bonus: 1 hr x £8 x 75% = £6

Total wage for job: £8 x 3 + £6 = £30



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Exercise 6

Hours Rate Total

Basic rate 54 7.50 405.00 Overtime premium 14 2.50 35.00

Bonus 45.00

Total pay 485.00

Bonus calculation:

Should take 124 units * 0.5 hrs 62.00

Did take 50.00

Time saved 12.00

Bonus = 12 hrs * 50% * £7.50 = £45.00

Direct cost

Indirect cost

Worked hours @ basic rate 50 7.50 375.00

Idle time 4 7.50 30.00 Overtime premium 14 2.50 35.00

Bonus 45.00 375.00 110.00



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Exercise 7

Turnover Ratio = 5/61.5 x 100% = 8.13%

Average staff = (52 + 71)/2 = 61.5

Efficiency Ratio = 9,800/9,000 x 100% = 108.89%

Capacity Ratio = 9,000/10,000 x 100% = 90%

Production Volume = 108.89% x 90% = 98%



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CHAPTER 5

Exercise 1

Solution – method of working (a):

From the question we can see that the costs for indirect wages and materials have

been allocated directly to the cost centres. This is because we can identify these

costs directly to the cost centres concerned.

The remainder of the costs must be shared over the cost centres in relation to the

amount of usage of the cost. This can be established by looking at the additional

information and deciding which piece of information relates to which cost. For

example the power costs would be determined by the number of hours the

machines had been working and the light and heat by the overall area of the

building.

To apportion costs we need to take the total of the overhead cost and divide it by

the total of the basis used. The resulting figure can then be multiplied by the

individual usage of the cost.

Power (for machining dept) 000,40hours m/c 000,51

000,102£×

This process can then be repeated for each cost and cost centre. The figures can

then be inserted into the table above and the columns totalled.

Costs Basis Machining Assembly Finishing Maint Total

Indirect wages allocated 10.000 6.000 8.000 30.000 54.000 Indirect materials allocated 15.000 4.000 8.000 20.000 47.000

Power machine hours 80.000 10.000 12.000 102.000

Light & Heat floor area 5.000 2.000 1.500 1.500 10.000

Depreciation NBV 4.000 1.600 0.600 0.800 7.000

Rent & Rates floor area 12.500 5.000 3.750 3.750 25.000

Personnel employees 18.000 12.000 24.000 9.000 63.000

144.500 40.600 57.850 65.050 308.000



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Exercise 2

Machine Assembly Finishing Handling Prod control

Total

Indirect materials 4000.00

Indirect wages 8000.00 11200.00

Indirect expenses 41920.00 12960.00 7920.00 8000.00 2400.00

41920.00 12960.00 7920.00 20000.00 13600.00 96400.00

Prod cont 5440.00 4080.00 2720.00 1360.00 -

13600.00 0.00

Handling 12816.00 6408.00 2136.00 -

21360.00 0.00

60176.00 23448.00 12776.00 0.00 0.00 96400.00

Exercise 3

(repeated distribution method)

A B C P Q

Total costs 3000.00 4000.00 2000.00 2500.00 2700.00

P costs * % 500.00 750.00 625.00 -

2500.00 625.00

0.00 3325.00

Q costs * % 831.25 831.25 997.50 665.00 -3325.00

P costs * % 133.00 199.50 166.25 -665.00 166.25

Q costs * % 41.56 41.56 49.88 33.25 -166.25

P costs * % 6.65 9.98 8.31 -33.25 8.31

Q costs * % 2.08 2.08 2.49 1.66 -8.31

P costs * % 0.5 0.66 0.5 -1.66 4515.04 5835.03 3849.93 0.00 0.00

(algebraic method)

P = 2500 + 20%Q Q = 2700 + 25%P Substituting Q into the first equation: P = 2500 + 20%(2700 + 25%P) P = 2500 + 540 + 5%P 0.95P = 3040 P = 3200 Q = 2700 + 25%(3200) Q = 3500

A B C P Q

Total costs 3000.00 4000.00 2000.00 2500.00 2700.00

P costs * % 640.00 960.00 800.00 -

3200.00 800.00

Q costs * % 875.00 875.00 1050.00 700.00 -

3500.00

4515.00 5835.00 3850.00 0.00 0.00



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Exercise 4

Absorption rate per unit = £100,000/20,000 = £5 per unit

Production cost = £20 + £5 = £25

Absorption rate per labour hour = £100,000/50,000 hours = £2 per lab hr

Production cost = £20 + (2 x £2) = £24

Absorption rate per machine hour = £100,000/100,000 hours = £1 per mc hr

Production cost = £20 + (3 x £1) = £23

Exercise 5

This question has two pitfalls. Firstly, the actual data for the cost centres are

irrelevant as absorption rates are always calculated using budgeted data.

Secondly, the question does not give guidance over whether labour or machine

hours should be used to calculate rates. This is straightforward to solve. For each

department use the higher of labour or machine hours.

Cutting: Use machine hours as budgeted machine hours higher than budgeted

labour hours

Finishing: Use labour hours as budgeted labour hours higher than budgeted

machine hours.


Budgeted Overhead / Budgeted Activity

Cutting: £100,000 / 50,000 = £2 per machine hour

Finishing: £50,000 / 12,500 = £4 per labour hour

Cutting Finishing Total

Product Costing 6 x £2 = £12 4 x £4 = £16 £28



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Exercise 6

The total budgeted fixed overhead cost for P2 will be the sum of:

Fixed overhead cost per unit in Dept X + Fixed overhead cost per unit in Dept Y

To calculate this, we first need to calculate the overhead absorption rate in each

department

The OAR for each department will be equal to:

Budgeted overhead/budgeted activity

Department X:

Budgeted labour hours:

Product Labour hours

per unit

Number of units Total labour hours

P1 3 8,000 24,000

P2 2.5 8,000 20,000

44,000

OAR for Department X = $88,000 / 44,000 = $2/labour hour

Department Y:

Budgeted labour hours:

Product Labour hours

per unit

Number of units Total labour hours

P1 1 8,000 8,000

P2 2 8,000 16,000

24,000

OAR for Department X = $96,000 / 24,000 = $4/labour hour

Total budgeted overhead for product P2 =

2.5 hrs x $2 + 2 hrs x $4 = $13/unit



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Exercise 7

Overhead absorption rates are calculated using budgeted figures. Further, machine

hours should be used as this is the higher of the two measures of activity.


Budgeted Overhead / Budgeted Activity

£200,000 / 100,000 = £2 per unit

£

Absorbed overhead (actual activity x OAR) (80,000 x £2) 160,000

Actual Overhead 208,000

Under absorption: 48,000



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CHAPTER 6

Exercise 1

WIP

Direct materials £25,000 Direct wages £30,000 Production o/h £78,000 £133,000

Finished Goods £133,000 £133,000

Labour Control

Wages paid £45,000 £45,000

WIP £30,000 Production o/h £15,000 £45,000

Stock Control

Balance b/d £5,000 Purchases £40,000 Purchases £20,000 £65,000

WIP £25,000 Production o/h £20,000 Balance c/f £20,000 £65,000



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Exercise 2

Labour Control

Wages paid £54,000 £54,000

WIP £32,000 Production o/h £22,000 £54,000

Stock Control

Balance b/d £1,500 Purchases £15,000 Purchases £7,500 £24,000

WIP £11,000 Production o/h £4,300 Purchase returns £2,000 Balance c/f £6,700 £24,000

Income Statement Expense

Under absorption Production o/h £2,000


Indirect materials £20,000 Indirect wages £15,000 Other expenses £45,000 £80,000

WIP £78,000 Under absorption £2,000 £80,000



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Income Statement Expense

Over absorption Production o/h £5,200 £5,200


Indirect materials £4,300 Indirect wages £22,000 Indirect expenses £21,000 Over absorption £5,200 £52,500

WIP £52,500 £52,500

WIP

Direct materials £11,000 Direct wages £32,000 Production o/h £52,500 £95,500

Finished Goods £95,500 £95,500



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CHAPTER 7

Exercise 1

The contribution per unit = Selling price – variable cost.

20 – (6 + 3 + 4) = 7

Total contribution = 7 x 20,000 units = £140,000

Total profit = total contribution – total fixed costs

£140,000 - £20,000 = £120,000

To calculate the profit using absorption costing, we first need to calculate the OAR.

This is equal to £20,000 / 20,000 units = £1 per unit

This means that the full production cost per unit is

variable cost + fixed cost = 13 + 1 = 14

Total sales = 20,000 x £20 = £400,000 Total production cost = 20,000 x £14 = £280,000 Total profit = £120,000

Exercise 2

Absorption costing:

£ £

Sales (4,800 x £10) 48,000

Production cost (4,800 x £8) 38,400

9,600

Under absorption 400

9,200

OAR = £10,000/5,000 = £2 per unit

Total production cost = 3 + 2 + 1+ 2 = £8

Absorbed = 4,800 x £2 9,600

Actual overhead cost 10,000 Under absorption 400

Marginal costing:

£ £

Sales (4,800 x £10) 48,000


19,200

Less fixed costs 10,000 9,200



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Exercise 3

Absorption costing:

£ £

Sales (4,800 x £10) 48,000


Closing stock (1,200 x £8) 9,600

38,400

9,600

Over absorption 2,000

11,600

Absorbed = 6,000 x £2 12,000

Actual overhead cost 10,000 Over absorption 2,000

Marginal costing:

£ £

Sales (4,800 x £10) 48,000


Closing stock (1,200 x £6) 7,200

28,800

19,200

Fixed costs 10,000 9,200

Reconciliation:

Difference in profits = £2,400

Change in stocks x OAR = 1,200 x £2 = £2,400.

Exercise 4

Closing inventory = 500 + 10,500 – 10,750 = 250

Inventory has decreased by 500 – 250 = 250units. As inventory has decreased,

absorption costing profit will be less than marginal costing profit.

Fixed cost per unit = £30,000 / 10,000 = £3

Absorption costing profit = £75,000 – 250 x £3 = £74,250

Exercise 5

OAR = £250,000/1,000 = £250 per unit

Stock decreased by 150 units

Profit for absorption costing will be lower by 150 x £250 = £37,500.



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CHAPTER 8

Exercise 1

Job 666

£ £

Materials *1

Grade A Steel 2,000

Grade B Steel 4,440

Wages *2

Wages Welding 1,280

Wages Finishing 1,000

Total Direct Cost 8,720

Overheads *3 1,560

Total Cost 10,280

Profit 4,112

Selling Price 14,392

*1 Direct Material Costs

£ Steel Grade A (400m x £5.00) 2,000 Steel Grade B (740m x £6.00) 4,440

Note materials returned to store are not included in the cost of the job.

*2 Direct Labour Cost

£ Welding Department (320hrs x £4.00) 1,280 Finishing Department (200hrs x £5.00) 1,000 2,280

The question implies overtime is worked because the factory is generally

busy. The overtime premium should not be charged to the customer and

should, therefore, be charged to production overheads.



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*3 Absorbed overheads

£ Absorbed overhead (520 x £3.00) 1,560

Price

£10,280 x 1.40 = £14,392.

Exercise 2

Job 123

£ £

Materials*1

Material Y 204

Material Z 384.25

Wages*2

Dept A 342

Dept B 440

Total Direct Cost 1,368.25

Overheads*3 452.70

Total Cost 1820.95

*1 Direct Material Costs

£ Material Y (400kg x £0.51) 204 Material Z (265kg x £1.45) 384.25

Note materials returned to store are not included in the cost of the job.

*2 Direct Labour Cost

£ Dept A (76hrs x £4.50) 342 Dept B (110hrs x £4.00) 440

The question implies overtime in Dept A is worked because the factory is generally

busy. The overtime premium should not be charged to the customer and should,

therefore, be charged to production overheads.

In Dept B the overtime is worked at the request of a customer but not this one, so

it will be charged to the other job. This overtime premium is not a production

overhead.

*3 Absorbed overheads

Dept A Dept B £ £

Total overheads for the period 5,400 6,300 (ex premium) Total hours 2,000 2,800 OAR £2.70 /hr £2.25 /hr



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Exercise 3

Job 6832

£ £ Opening Balance 1,830 Material returns 870 Materials Control 2,390 Job 6833 620 Labour (£8 x 430) 3,440 Finished Goods (bal) 7,030 Overhead (£2 x 430) 860 8,520 8,520

Job 6833

£ £ Materials Control 1,680 Finished Goods 9,050 Labour (£8 x 650) 5,200 Overhead (£2 x 650) 1,300 Job 6834 250 Job 6832 620 9,050 9,050

Job 6834

£ £ Materials control 3,950 Job 6833 250 Labour (£8 x 280) 2,240 Closing WIP 6,500 Overheads (£2 X 280) 560

6,750 6,750

Exercise 4

Total cost for the batch:

Direct materials £230

Direct labour £180

Production o/h £288

Total production cost £698

Non Production cost £209.4

Total cost £907.4

Cost per unit = 907.4 / 5 = £181.48

Production o/h:

Labour hours for the batch = £180/£7.50 = 24 hours

Production o/h cost = 24 hours x £12 = £288



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Exercise 5

£

Using a mark up on marginal cost of sales of 80%, what is the

price? 59.40

Marginal cost = £22 +£5 + £6 = £33 Mark up £33 x 1.8 = £59.40

What is the resulting profit? 19.40

(£59.40 - £40 = £19.40)

Using a margin of 80% on total production cost what is the price? 155

Total production cost = £31 Price: £31 / 20 x 100

What is the resulting profit? 115

(£155 - £40)

Exercise 6

Service cost unit = Client hour

Total service units provided in the period = 40 hours x 48 weeks x 95% = 1824

Cost per service unit = £35,000/1824 = £19.19

Charge per hour = £19.19 + 30% x £19.19 = £24.95



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Exercise 7

Variable Fixed

£ £

Loading costs Labour (30 x 1 x 2) 1 60

Depreciation 80

Supervision 80

Other costs Wages (£100 x 2) 200

Petrol (10p x 730 x 2) 2 146

Repairs (5p x 730 x 2) 73

Depreciation (£80 x 2) 160

Supervision 120

General expenses 200

279 840

1 Total number of tonnes loaded = 30

2 Please note we have to make a trip back as well

Tonnes Kms Total

5 100 500

8 20 160

2 60 120

4 50 200

6 200 1200

5 300 1500

3,680

Cost per tonne km = 1,119

£ 3680 = 0.30



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CHAPTER 9

Exercise 1

PROCESS 1 (CUTTING)

Units £ Units £ Direct Materials 1,000,000 500,000 Output to P2: 1,000,000 900,000 Direct Labour 200,000 Production overheads 200,000 1,000,000 900,000 1,000,000 900,000

PROCESS 2 (FORMING)

Units £ Units £ Materials from P1 1,000,000 900,000 Output to 1,500,000 1,500,000 Added materials 500,000 300,000 Finished Direct Labour 150,000 Goods Production overheads 150,000 1,500,000 1,500,000 1,500,000 1,500,000

Exercise 2

Process a/c

Units £ Units £

Materials 160 3,680 N. loss 8 40

Lab & ohds 3,200 Output 152 6,840

160 6,880 160 6,880

Cost per tonne of good output = 45£8160

40880,6=

−

−

Value of output = 152 x £45 = £6,840


Units £ Units £

Process a/c 8 40 Bank/cash 8 40

40 40



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Exercise 3

Process a/c

Units £ Units £


Lab & ohds 3,200 Output 150 6,750

Ab loss 2 90

160 6,880 160 6,880


Units £ Units £


Ab loss a/c 2 10

50 50


Units £ Units £

Process a/c 2 90 Scrap sales 2 10

P&L a/c 80

90 90

Exercise 4

Process a/c

Units £ Units £


Lab & ohds 3,200 Output 156 7,020

Ab gain 4 180

164 7,060 164 7,060


Units £ Units £


Ab gain 4 20

40 40



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Units £ Units £

Scrap sales 4 20 Process

a/c 4 180

P&L a/c 160

180 180



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Exercise 5

Process 1 a/c

Units £ Units £

Materials 2,000 8,100 N. loss 200 100

Labour 4,000 Process 2 1,750 17,500

P Ohds 6,000 Ab loss 50 500

2,000 18,100 2,000 18,100

Cost of good output = (8,100 – 100) / (,000 – 200) = £10

Process 2 a/c

Units £ Units £

Process 1 1,750 17,500 N. loss 300 900

Materials 1,250 1,900 Output 2,800 42,000

Labour 10,000

P Ohds 12,000

Ab gain 100 1,500

3,100 42,900 3,100 42,900

Cost of good output = (41,400 – 900) / (3,000 – 300) = £15.


Units £ Units £

Process 1 200 100 Bank/cash 4 725

Process 2 300 900 Ab gain 100 300

Ab loss 50 25

550 1,025 104 1,025


Units £ Units £

Process 1 50 500 Scrap sales 50 25

Scrap sales 100 300 Process 2 100 1,500

P&L a/c 725

150 1,525 150 1,525



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Exercise 6

Units % completion Equivalent units

1,000 100% 1,000

200 50% 100 1,100

Cost per equivalent unit = £5,500 / 1,100 = £5.

Exercise 7

Getting the right answer here is a three-stage process:

1. Calculating the number of equivalent units.

2. Calculating the cost the cost per equivalent unit.

3. Combining the above to value each output from the process.

1. Statement of Equivalent units

Output Physical Units Equivalent units Finished goods 4,000 4,000 (100% complete) Closing WIP 1,000 600 (60% complete)

2. Statement of Unit Cost

ie, 9,440/4,600 = £6.40.

3. Statement of Evaluation:

Finished goods: 4,000 equivalent units x £6.40 =£25,600 Closing WIP: 600 equivalent units x £6.40 = £3,840

Process a/c

Units £ Units £

Materials 5,000 16,560 Output 4,000 25,600

Labour 7,360 Closing WIP 1,000 3,840

P Ohds 5,520

5,000 29,440 5,000 29,440



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Exercise 8

Process a/c

Units £ Units £

Materials 2,800 24,800 Output (1) 2,100 64,575

Labour 16,750 Closing WIP (2) 700 13,185

P Ohds 36,200

(rounding error) -10 2,800 77,750 2,800 77,750

Statement of Equivalent units

Units % Materials Labour Overheads

Output 2100 100% 2100 2100 2100

WIP 700 80% 560

700 60% 420

700 50% 350

2660 2520 2450

Cost £24,800 £16,750 £36,200 Cost/Eq unit £9.32 £6.65 £14.78

Statement of Valuation

1. Output = 2100 x (9.32 + 6.65 + 14.78) = £64,575

2. WIP = (560 x 9.32) + (420 x 6.65) + (350 x 14.78) = £13,185.



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Exercise 9


Units % Materials

Conversion

Costs

Output 8000 100% 8000 8000

WIP 2000 100% 2000

60% 1200

10,000 9,200

Cost £40,600 £18,400 Cost/Eq unit £4.06 £2.00

Value of units completed: 8,000 x £4.06 + 8,000 x £2.00 = £48,480



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Exercise 10


Units %

Equivalent

Units

OWIP 100 40% 40 Goods Started & finished 800 100% 800

CWIP 150 48% 72

912

Cost £10,944

Cost/Eq unit £12

CWIP valuation: 72 x £12 = £864

Units completed:

Goods started & finished: 800 x £12 £9,600

OWIP completed: 40 x £12 £480

OWIP value from prior period: £680

Total value of goods completed: £10,760



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Exercise 11

Process a/c W Ave FIFO

Units £ Units £ £

Op WIP 500 3,000 Closing WIP 300 1,500 1,500

Added units 1,000 10,500 Finished units 1,200 12,000 12,000

1,500 13,500 1,500 13,500 13,500

Statement of Equivalent units (W Average)

Units % Costs

Output 1,200 100% 1,200

WIP 300 50% 150

1,350

Cost 10,500

3,000 £13,500

Cost/Eq unit £10.00

Valuation:

WIP = 150 x £10 = £1,500 Finished units = 1,200 x £10 = £12,000.

Statement of Equivalent units (FIFO)

Units % Costs

Output 1,200 100% 1,200

- Op WIP 500 60% 300

900

+ WIP 300 50% 150

1,050

Cost £10,500

Cost/Eq unit £10.00

Valuation:

WIP = 150 x £10 = £1,500 Finished units = 900 x £10 = £9,000 + Op WIP b/f £3,000 Total £12,000



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Exercise 12

Product Quantity S Price Sales Value

X 100,000 £1 £100,000

Y 20,000 £10 £200,000

Z 80,000 £2 £180,000 200,000 £480,000

Physical units method – 000,200

000,240£ x 100,000 = £120,000

20,000 = £24,000 80,000 = £96,000

Sales value method – 000,480

000,240£ x 100,000 = £50,000

200,000 = £100,000 180,000 = £90,000

Exercise 13

The sales value of the by-product is deducted from joint costs. The remaining joint

cost balance is then apportioned across the joint products.

Joint costs = £16,500 – 100 x £5 = £16,000

Product Quantity S Price Sales Value

A 200 £20 £4,000

B 300 £14 £4,200

C 500 £18 £9,000

1,000 £17,200

Physical units method – 000,1

000,16£ x 200 = £3,200

300 = £4,800 500 = £8,000

Sales value method – 200,17

000,16£ x 4,000 = £3,721

4,200 = £3,907 9,000 = £8,372



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Exercise 14

Option 1 – sell 100,000 units of A @ £1.25 = £125,000

Option 2 – sell 60,000 units of A+ @ £3.25 = £195,000.

Increase in revenue of £70,000.

Extra costs are (100,000 x £0.30) + £20,000 = £50,000.

Therefore net gain of £70,000 - £50,000 = £20,000.

Exercise 15

Option 1 – sell 9,000 litres of K @ £10 = £90,000

Option 2 – sell (9,000 x 90%) litres of KK @ £12 = £97,200.

Increase of £7,200.

Extra costs are 9,000 x £1 = £9,000.

Therefore loss of revenue (and therefore profits) of £1,800.



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CHAPTER 10

Exercise 1

Collerette Pompom Cacti Total

Sales Volume 2,000 4,000 3,000 Unit price £100 £130 £150 Total Value £200,000 £520,000 £450,000 £1,170,000

Exercise 2

Production budgets can only be completed once sales budgets are known. Note

too, how opening and closing stocks of finished goods have to be taken into

account. Opening stocks are a subtraction from the production total and closing

stocks an addition.


Sales Units 2,000 4,000 3,000 Closing stock 600 1,000 800

Less 2,600 5,000 3,800 Opening Stock (500) (800) (700)

Production Units 2,100 4,200 3,100

Exercise 3

Production Units M1 (kg) M2 (kg) M3 (kg)

Collerette 2,100 10,500 4,200 - Pompom 4,200 12,600 8,400 8,400 Cacti 3,100 6,200 3,100 9,300 Usage (kgs) 29,300 15,700 17,700

When constructing the materials purchase budget, opening and closing stocks of

material should be taken into account.

Materials Purchase Budget

M1 M2 M3

kg kg kg

Budgeted usage 29,300 15,700 17,700 Closing stocks 18,000 9,000 12,000 47,300 24,700 29,700 Opening stocks 21,000 10,000 16,000 Budgeted purchases

26,300 14,700 13,700

Unit cost £5 £3 £4 Total £131,500 £44,100 £54,800



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Exercise 4

Labour budgets are relatively straightforward to construct. Multiply production

figures by unit hours to get total hours consumed for each product. This can then

be multiplied by hourly rates to get cost.


Production Units 2,100 4,200 3,100 Hours per unit 4 6 8 Total hours 8,400 hrs 25,200 24,800 Hourly rate £8.50 £8.50 £8.50 Cost £71,400 £214,200 £210,800

Exercise 5

A B

Budgeted sales 3,000 4,000

Closing stock (1) 750 1,000

3,750 5,000

- Opening stock 800 950

Production units 2,950 4,050

Labour hours (2) 1.6 2.4

Total hours 4,720 9,720

Rate per hour £8 £8

Labour cost £37,760 £77,760

(1) – closing stock = (sales / 12) x 3

(2) – Labour hours = original time x 80%

Exercise 6

Q

Budgeted sales 700

Closing stock 70

770

- Opening stock 50

Required units 720 = 90%

Scrap 80 = 10%

Production units 800 = 100%

Labour hours 3.0

Total hours 2,400 = 80%

Paid hours 3,000 = 100%



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Exercise 7

Sales and variable costs are scaled up according to the difference in activity level.

Examples:

Sales: 4,000 / 3,000 x £90,000 = £120,000

Direct materials: 4,000 / 3,000 x £30,000 = £40,000

Fixed costs are simply copied across the budget as these items are not related to

activity.

Original

Budget

Flexed

Budget

Actual Variances

3,000 units 4,000 units 4,000 units

£ £ £ £

Sales 90,000 120,000 110,000 10,000 (A) Less Direct Materials 30,000 40,000 45,000 5,000 (A)

Direct Labour 15,000 20,000 20,000 0 Fixed Production overheads

2,500 2,500 2,300 200 (F)

Gross Profit 42,500 57,500 42,700

Less Variable Selling cost 3,000 4,000 4,000 0 Fixed selling cost 1,500 1,500 2,000 500 (A)

Profit 38,000 52,000 36,700 15,300 (A)



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CHAPTER 11

Exercise 1 Standard cost card

£

Materials 2kg x £30/kg 60

Labour 6hrs x £10/hr 60

Overheads 6hrs x £15/hr 90

Fixed Overheads £20,000/500 40

Standard Cost 250

Standard Profit 100

Standard Price 350



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CHAPTER 12

Exercise 1

The first step is to calculate unit contribution:

Contribution per unit: £90,000 / 10,000 = £9

Breakeven sales volume can be calculated as: onContributi Unit

Costs Fixed

= £45,000 / £9 = 5000 units

Breakeven sales revenue = Breakeven units x Selling Price

= 5000units x £15 = £75,000

Exercise 2

The first step is to calculate unit contribution:

ie £9 - £4 = £5.

Breakeven sales volume can be calculated as: onContributi Unit

Costs Fixed

ie units 000,75£

000,35£= .

Target sales volume can be calculated as: onContributi Unit

Profit TargetCosts Fixed +

ie units 000,104£9£

000,15£000,35£=

−

+.

Units

Sell to breakeven? 7,000

Sell to reach its target profit? 10,000



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Exercise 3

Step 1: Calculate unit contribution:

Unit sales price – unit variable cost: £7 - £4 = £3

Step 2: Calculate breakeven sales:

Fixed cost / unit contribution = breakeven sales volume

£342,000 / £3.00 = 114,000 units

Step 3: Calculate margin of safety:

(Budgeted sales – breakeven sales / budgeted sales) x 100)

150,000 – (114,000 / 150,000) x 100% = 24%

The margin of safety is 14.3%. This means that sales can fall 14.3% below budget

before a loss is made.

Quick exercises

1. 500 / (3 – 1) = 250

2. (550 + 200) / 2 = 375

3. 250 = 750 / cont/unit cont/unit = 3

therefore s. price = 3 + 1 = 4

4. BEP = 200,000 / (8 – 4) = 50,000

Margin of safety = (80,000 – 50,000) / 80,000 = 37.5%

Exercise 4

Unit contribution is (unit sales price – unit variable cost): £15 - £6 = £9

C/S Ratio (unit contribution / unit sales): £9 / £15 = 0.6 or 60%

Breakeven revenue: Fixed costs / C/S Ratio = £192,000 / 0.6 = £320,000

Margin of safety:

(Budgeted sales – breakeven sales / budgeted sales) x 100)

Budgeted sales: 62,000 x £15 = £930,000

(£930,000 - £320,000 / £930,000) x 100 = 65.6%



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Exercise 5

(a) Unit contribution = £40 - £25 = £15

Breakeven point: Fixed costs / Contribution = £240,000 / 15 = 16,000

Margin of safety = Budgeted sales – breakeven sales =

25,000 – 16,000 = 9,000 pairs

(b) 20,000 x £15 = £300,000 - £240,000 = £60,000

(c) Unit contribution = £40 – (£25 + 2) = £13

Required = (£240,000 + £10,000) / 13 = 19,231

(d) Unit contribution = (£40 + £4.80) – £25 = £19.8

Breakeven point: = (£240,000 + £20,000)/ 19.8 = 13,132



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CHAPTER 13

Exercise 1

Speedwell Nettle Liatris

Demand 1,000 units 1,000 units 1,000 units £ £ £ Unit price 50 70 50 Variable cost 10 50 25 Unit contribution 40 20 25 Labour hours 4 1 2 Contribution per hr £10 £20 £12.50 Priority 3rd 1st 2nd

Number of products made 0 1,000 400

Hours used 0 (1,000 x 1hr) 1,000 hours

(400 x 2) 800 hours

Production Schedule

Product Units Hrs/unit Total hrs Balance

1,800

Nettle 1,000 1 1,000 800

Liatris *400 2 800 -

* Balancing figure



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Exercise 2

Machine hours required

Demand Hrs/unit Total hours Product A 4,000 10 40,000

B 6,000 12 72,000

C 6,000 14 84,000

196,000

Labour hours required

Demand Hrs/unit(1) Total hours Product A 4,000 12 48,000

B 6,000 8 48,000

C 6,000 4 24,000

120,000

As we have 200,000 machine hours available we have spare capacity. Labour

hours are limited to 50,000 – which means we are short by 70,000 hours.

Labour hours is our limiting factor.

(1) Product A = £9 paid at £0.75 / hr = 12 hours.

A B C

£ £ £

S Price 25 20 15

Variable cost 19 15 11

Cont / unit 6 5 4

Labour hours(1) 12 8 4

Cont / lab hr £0.50 0.625 £1

Ranking 3 2 1

Production Schedule


50,000

A 1,000 12 12,000 38,000

C 6,000 4 24,000 14,000

B *1,750 8 14,000 -

* Balancing figure

Contribution Schedule

Product Units Cont / unit Total cont

A 1,000 6 6,000

C 6,000 4 24,000

B 1,750 5 8,750

38,750



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Exercise 3

A B C D

£ £ £ £

S Price 100 110 120 120

Variable cost 54 55 59 66

Cont / unit 46 55 61 54

Labour hours(1) 3 2.5 4 4.5

Cont / lab hr £15.33 £22.00 £15.25 £12.00

Ranking 2 1 3 4

(1) Product A = £18 paid at £6 / hr = 3 hours.


1,345

A, B, C, D 20 14 280 1,065

B 130 2.5 325 740

A 180 3 540 200

C *50 4 200 -

* Balancing figure

Profit statement:

Product Units Cont / unit Total cont

A 200 46 9,200

B 150 55 8,250

C 70 61 4,270

D 20 54 1,080

22,800

Less Fixed cost (2) 12,800

Profit 10,000

(2) Fixed overhead absorbed on basis of labour hours. Product A fixed overhead = £24, labour hours = 3, OAR = £8/lab hr. Budgeted fixed overheads = 1,600 hours x £8 = £12,800.



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Exercise 5

Let the number of product X = x and the number of product Y = y.

Contribution per unit of X: £60 - £15 - £24 - £6 = £15

Contribution per unit of Y: £25 - £5 - £3 - £5 = £12

The objective is to maximise total contribution:

Maximise 15x + 12y

Constraint 1: Only 4,200kg of material is available

X Y

Material usage (per unit) 3kg 1kg

Therefore, 3x + 1y ≤ 4,200

Constraint 2: Only 3,000 labour hours are available:

X Y

Labour usage (per unit) 4hrs 0.5hrs

Therefore, 4x + 0.5y ≤ 3,000

Represented graphically:

The optimal production plan will be at one of the corner of the feasible region

(points A, B and C):

Point A is where the line 3x + y = 4,200 crosses the Y axis and so x = 0.

If x = 0, then 3(0) + y = 4,200, so y = 4,200units

Total contribution at point A: 15(0) + 12(4,200) = £50,400

Point B is there the lines 3x + y = 4,200 and 4x + 0.5y = 3,000 intersect. This

point can be calculated using simultaneous equations:

3x + y = 4,200, so y = 4,200 – 3x

4x + 0.5y = 3,000

A

B

0

1000

2000

3000

4000

5000

6000

7000

0 500 1000 1500

No of Units of Y

Number of Units of X

Feasible

region

Feasible

region

Feasible

region

Feasible

region

C



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Substituting the first equation for y gives:

4x + 0.5(4,200 – 3x) = 3,000

4x + 2,100 – 1.5x = 3,000

2.5x = 900

X = 360 units

So y = 4,200 – 3(360) = 3,120 units

Total contribution at point B: 15(360) + 12(3,120) = £42,840

Point C is there the line 4x + 0.5y = 3000 meets the X axis, so y = 0.

If y = 0, then 4x + 0.5(0) = 3,000, so x = 750units

Total contribution at point C: 15(750) + 12(0) = £11,250



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Exercise 7

A company has 600kgs of material in stock that cost £50/kg three years ago. To

replace the material would cost the company £60/kg.

Relevant Cost

£




Reasoning. The company has no use for the material and the

price paid for the material in stock is a sunk cost.

Nil


However, it can sell the materials at £5/kg to a local scrap

merchant.



Reasoning. The company has no use for the material.

However, it could sell the material for scrap. This is the

opportunity cost of accepting the one-off order.

£5

The company currently uses the materials in all of its products.

It can sell the materials for £5 per kg to a local scrap merchant.

If the company uses a kg of the materials in a product, what is

the relevant cost?

Reasoning. The company uses the materials in all products.

Any materials used would have to be replaced so replacement

cost is the relevant cost.

£60

Exercise 8

Option 1: the hours could be worked as overtime

Relevant cost = 500 x $9 x 1.5 = $6,750

Option 2: labour hours could be diverted from Product P

Relevant cost = 500 x $9 + 500 x $8 = $8,500

The relevant cost is the lower of the 2 options, so $6,750.

Exercise 9

The £70,000 is a sunk cost.

The £15,000 current sales value is relevant as it is an opportunity cost.

The £5,000 is a relevant cost as it is a cost the company will incur in the future as a

result of using the machine for the project.

Total relevant cost = £5,000 + £15,000 = £20,000.



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