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Title: MANAGERIAL ACCOUNTING I
Description: these notes involve the purpose and scope of management accounting, decision making, cost estimation and forecasting, absorption cost and marginal cost, budgeting, short term planning and revision questions
Description: these notes involve the purpose and scope of management accounting, decision making, cost estimation and forecasting, absorption cost and marginal cost, budgeting, short term planning and revision questions
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MANAGERIAL ACCOUNTING NOTES
BBM 221: MANAGEMENT ACCOUNTING I
Contact Hours: 42
Pre-requisites: BBM 114, BBM 125 and BBM 221
Purpose: To provide the student with the knowledge of important concepts and techniques needed by
managers in planning, control, management and decision making in business organization
Expected Learning Outcomes of the Course:
By the end of the course unit the learners should be able to:Explain the importance of management accounting in the management of organizations
Apply management accounting techniques to solve various management dilemmas
Explain the importance of budgeting and responsibility accounting in management of
organizations
Course Content:
Nature, Purpose and scope of Management Accounting; Decision Making environments and
techniques; Cost Behavior; Cost Estimation; Relevant costing; Cost-Volume- Profit Analysis;
Variable and absorption costing; Master Budget and Responsibility Accounting
Course Outline
WEEK 1
Chapter: Nature, Purpose and Scope of Management Accounting
Sub Topics:
Definitions- Managerial Accounting, Cost Accounting, Financial Accounting
Evolution of Management Accounting
Objectives of Management Accounting
Difference between Management and Financial Accounting
Management Accounting System
The Management Accounting Guidelines
Role of management accounting in management process
Week 2 & 3
Chapter: DECISION MAKING
Sub Topics:
Decision Making Process
Decision Making Conditions
Decision Making Techniques- Decision trees analysis; Maximin, Maximax, Laplace
and Minimax regret criteria; Probability distributions, Expected values, standard
deviation, coefficient of variation; Portfolio analysis, Grid Analysis
Week 4 & 5
Chapter: COST ESTIMATION AND FORECASTING
Cost Concept
Cost Classifications- Stock valuation and profit measurement; Planning control and
decision making- Cost behavior, According to the degree of traceability to the final
product, Relevance
Managerial ability to avoid, According to functions of department,
ii
Cost Estimation Methods- Accounts analysis (Accounts inspection method), The two
point method (High-Low Method), Regression analysis (least-square method),
Graphical method, Conference method, Engineering methods
Week 6 & 7
Chapter: SHORT TERM PLANNING
Sub Topics:
Cost Volume Profit Analysis
Assumption of CVP analysis
The Break- Even Point
B
...
P in Graphical Form
B
...
P in Mathematical Formula
Margin of safety
C V P in Multi-product Environment
Criticisms of CVP analysis
Week 8 & 9
Chapter: RELEVANT COSTS FOR NON ROUTINE DECISION
Sub Topics:
The concept of cost relevance to decision making
Assumptions of Relevant Costing
Quantitative and qualitative factors in decision making
Limiting factors in decision making
Special pricing decisions
Make or buy decisions
Discontinuation decisions
Equipment replacement decisions
Week 10 & 11
Chapter: ABSORPTION COSTING AND MARGINAL COSTING
Sub Topics:
Absorption Costing
Overhead Cost Allocation
Overhead Cost Apportionment- Direct method, The step (elimination) method,
Continuous (repeated distributed) method, Algebraic method
Overhead Absorption
Application of Overhead to Product
Marginal / Variable Costing Vs Absorption Costing
A comparison of the impact of variable costing and absorption costing on profit
Activity Based Costing (ABC)
Week: 12 & 13
Chapter: BUDGETING
Sub Topics:
Budgetary Control
iii
The role and rationale of budgeting- Functions of budgets, Advantages of budgets and
budgetary control systems
Types of budgets
Mechanics of budgeting
Stages in the budgeting process
Steps in developing a master budget
Human aspects of budgeting
Alternative Budgeting Procedures- Zero-Based Budgeting (ZBB), Activity-Based
Budgeting, Incremental budgeting
Course Assessment
Examination - 70%; Continuous Assessment Test (CATS) - 20%; Assignments - 10%; Total - 100%
Recommended Text Books:
th
Horngren C
...
T Sundrem G L and Stratton W
...
1
Evolution of Management Accounting…………………………………………………8
Objectives of Management Accounting………………………………………………
...
11
Role of management accounting in management process…………………………
...
12
Chapter Two: Decision Making…………………………………………………13
Decision Making Process………………………………………………………………
...
16
2
...
1 Decision trees analysis
...
3
...
18
2
...
3 Probability distributions Expected values, standard deviation and
coefficient of variation………………………………………………………………………
...
3
...
3
...
27
Cost Concept……………………………………………………………………………
...
29
Cost Estimation Methods…………………………………………………………
...
3
...
3
...
34
3
...
3 Regression analysis (least-square method)………………………………………
...
3
...
41
3
...
5 Conference method……………………………………………………………………42
3
...
6 Engineering methods ………………………………………………………………
...
3
...
44
Review Questions………………………………………………………………………
...
51
Cost Volume Profit Analysis……………………………………………………………51
Assumption of CVP analysis……………………………………………………………51
The Break- Even Point…………………………………………………………………
...
E
...
52
B
...
P in Mathematical Formula……………………………………………………
...
57
C V P in Multi-product Environment…………………………………………………59
Criticisms of CVP analysis……………………………………………………………
...
62
Chapter Five: Relevant Costs for Non Routine Decision
The concept of cost relevance to decision making…………………………………63
Assumptions of Relevant Costing……………………………………………………
...
64
Limiting factors in decision making…………………………………………………65
Special pricing decisions……………………………………………………………
...
68
Equipment replacement decisions……………………………………………………69
Review Questions………………………………………………………………………72
Chapter Six: Absorption Costing and Marginal Costing……………………73
Absorption Costing……………………………………………………………………
...
74
Overhead Cost Apportionment………………………………………………………
...
78
Application of Overhead to Product…………………………………………………82
Marginal / Variable Costing Vs Absorption Costing……………………………
...
94
Review Questions………………………………………………………………………97
Chapter Seven: Budgeting……………………………………………………
...
99
The role and rationale of budgeting………………………………………………
...
101
Steps in developing a master budget………………………………………………
...
114
7
...
115
Review
Questions……………………………………………………………………
...
121
vi
1
...
It measures and reports financial and non-financial information that helps
managers make decision to fulfill the goals of an organization
...
It is concerned with the provision of information to people within the organization so as
to help them make decision and improve efficiency and effectiveness of existing
operations
...
Disclosure to those external to the entity
Disclosure to employees
Safeguarding assets
The above involves participative management to ensure that there is effective:Formulation of long tern plans to meet objectives
Formulation of short term operation plans
Recording of actual transactions
1
Corrective actions required to bring future actual transactions into line
...
It provides information both managerial accounting and financial accounting
...
It measures and records business transactions
and provides financial statements that are based on generally accepted accounting
principles
...
Note: - All the above three branches of the accounting should be integrated into the
company’s reporting system where:
Financial accounting maintains records of each transaction and helps control the firm’s
assets and liabilities e
...
plant, equipment, stock, debtors and creditors
...
Cost accounting analyses the financial data into more detail and provides a lot of other
information used for control
It also provides key data such as stock valuation and cost of sale which are fed back into
the financial accounting system so that accounts can be finalized
...
2
1
...
The annual financial statements which comprised of a balance sheet and profit and loss
account are still prepared and presented to management by the financial accountant
...
Management accounting compared to financial accounting is a young discipline and so
management accounting concept and tools are still evolving as new ways are found to
provide information that assists management
...
Several changes that are especially pertinent
to management accounting are:Globalization, deregulation, emergency of new industries, just in time inventory
management, continuous improvement, computer integrated manufacturing, product
quality etc
...
3 Objectives of Management Accounting
1
...
Management accounting uses past data to predict the future
2
...
The
use of management by exception reports enables control to be exercised where it is most
useful
...
Organization
There is a direct relationship between the organizational structure and the management
accounting system
...
4
...
Plans are outlined to managers so that they are fully aware of
3
what is required of them and the management accountant tells them whether or not the
desired results are achieved
...
1
...
Legal requirements
It is a legal requirement for a public limited company to produce annual financial
accounts regardless of whether or not management regards this information as useful
...
2
...
These requirements are
essential to ensure consistency and formality that is needed for external financial
statement
...
3
...
Management
requires details of expected future cost and revenues
...
Reporting frequency
Financial accounting is published annually while management accounting requires
information frequently so as to make decisions
...
Focus on individual parts or segments of the business
Financial accounting report focuses on all parts of the business whereas management
accounting focuses on a small part of the business
...
Type of information
Management accounting includes non monetary and monetary information while
financial accounting includes monetary information only
...
Financial accounting records this information in
monetary terms only
...
5 Management Accounting System
Accounting system is the system of procedures, personnel and computers used to
accumulate and store financial data in the organization
...
A system consists of a set of inputs, process and outputs
...
The design of management accounting system should be guided by the
challenges facing managers
...
What information is required?
What data is required to produce the information?
What are the sources of this data?
How should it be converted?
How often should it be converted?
Who requires it?
How often is it required?
The following factors should also be considered
What data is required to produce the information?
What are the sources of this data?
How should it be converted?
How often should it be converted?
The organizational structure, cost and accuracy should be taken into account
...
The organizational manual should be drafted which gives communication line within
the organization
...
Setting up of the cost centre, profit centre, investment centre etc
Introduction of budget and budgetary control
...
The system should be introduced gradually
5
The staff should be recruited and trained on the system
There should effective internal control system
Monitoring and evaluation after implementation
...
However, some of the guidelines
include:1
...
They should weigh the cost and the benefits expected from any
spending
...
2
...
Responsibility accounting principles
...
Responsibility accounting is a system that measures the plans and actions of each
responsibility centers
...
6
Profit centre where manager is accountable for profit only
...
Management by exceptional principle
This is a principle where management gives more attention to critical areas unusual or
exceptional out of line of the planned program
...
Role of management accounting in management process
To allocate and accumulate data and provide reliable results for internal and external
profit reporting
To provide relevant information to help managers make better decisions
To provide information for planning,
To provide information for control and
To provide information for performance measurement
Review Questions
What is the basic difference between financial and managerial accounting?
What are the key attributes of a good management accounting system?
Discuss the role of management accounting in the management process?
Explain the objectives of management accounting
Suggested References for Further Reading
Horngren et
...
, 2009, Introduction to Management Accounting, 14
th
Ed, Dorling
Kindersley, New Delhi Pg 2- 43
...
H
...
W
...
0 CHAPTER TWO: DECISION MAKING
Learning Objectives
By the end of this chapter the learner should be able to:
Describe the decision making process
Identify the decision making conditions
Illustrate various decision making techniques
Decision Making Process
Information generated by management accounting is judged based on its ultimate effect
on the outcome of decisions, an understanding of the decision making process is therefore
imperative precedent to understanding management accounting
...
Respond to divergencies from plan
8
The figure above represents a decision making process
...
The final two
stages represents the control process which s a process of measuring and correcting actual
performance to ensure that the alternatives that are chosen and the plans for
implementing them are carried out
...
Identifying objectives
Objectives provide a direction aim or guide and are therefore a prerequisite to any
decision before any good decision can be made
...
The overriding
objective of the firm is the maximization of shareholder’s value or maximization of
future cash flows (though controversy still exists)
...
2
...
To maximize future
cash flows management identifies potential opportunities and threats in its environment
and takes appropriate steps to grow the cash flows
...
The search for alternatives involves acquisition of
information concerning the future opportunities and environments
3
...
Strategic decisions that have a profound effect on the firms future
position are made based on collected data, it is therefore imperative that adequate data is
gathered about the firm’s future capabilities and the environment in which it operates
...
9
4
...
Assuming that the objective of the organization is the maximization of future cash flows,
an incremental analysis of the net cash benefits is applied to rank the alternatives, so that
the alternative with the greatest benefits is chosen, subject to consideration of other
qualitative factors
...
Implement the Decision
The selected course of action should be implemented as part of the budgetary process
...
The budgets for various decisions are expressed in terms of cash
inflows and outflows revenues and expenses and merged together into a master budget
that brings out the budgeted profit and loss statement, cash flow statement and balance
sheet
...
6
...
Performance reports consisting of a comparison of actual outcomes with
budgeted or planned outcomes are produced and presented to management (feedback)
...
Effective control
ensures that corrective action is taken so that actual outcomes conform to planed
outcomes
...
Decision Making Conditions
Decision making under certainty
When the decision maker knows with reasonable certainty about what the available
alternatives are, and what conditions are associated with each alternative; then a state of
certainty is said to exist
...
The decision is from whom to
buy
...
Each of
these companies are known for their quality products
...
Decision making under risk
In some situations, a manager is able to estimate the level of probability at which certain
variables could occur
...
When estimates are made, a
degree of risk is involved
...
The situation requires estimating the probability that one or more known
variables might influence the decision being made
...
Decision under conditions of perfect information
Making decisions under conditions perfect information is straight forward because there
exist no unknowns
...
3 Decision Making Techniques
2
...
1 Decision Trees Analysis
Decision Trees provide a highly effective structure within which one can explore options,
and investigate the possible outcomes of choosing those options
...
This makes them particularly useful for choosing between different strategies, projects or
investment opportunities, particularly when your resources are limited
...
A decision or factor is written above the
square or circle
...
Note that that the joint probability of two events occurring is product of the two events
...
New product development can either be undertaken through thorough
development at a cost of Shs
...
The
following are the expected outcomes, accompanying probabilities and the projected
revenue for of the options
...
4
0
...
2
0
...
2
revenues
1000000
50000
2000
1000000 50000
Strengthening product
Reaping product
poor
good
mod
poor
good
poor
0
...
3
0
...
3
0
...
4
2000
400000
20000
6000 20000
Should the company develop a new product or consolidate existing product?
12
2000
2
...
2 Maximin, maximax, laplace and minimax regret criteria
Maximin: A pessimistic approach that takes into account the worst possible outcome for
each decision outcome alternative
...
This
guarantees a minimum outcome
...
3)
Moderate (0
...
2)
Small Facility
$10
$10
$10
Medium Facility
7
12
12
Large Facility
(4)
2
16
13
Maximin Solution: minimum payoff for each of the decision alternatives is: $10, $7 and
$(4)
...
Maximax: An optimistic approach that takes into account the best possible outcome for
each decision outcome alternative
...
Only takes into account
the best possible payoff
...
Solution: build large ($16)
...
This approach treats the states of nature as
equally likely
...
Solution: build medium
...
33
Large Facility
14
$4
...
” This approach seeks to minimize the difference between the
payoff that is realized and the best payoff for each state of nature
...
Regrets
Decision Alternatives
Low
Moderate
High
Worst
Small Facility
0 (10-10)
$2(12-10)
$6(16-10)
$6
Medium Facility
3 (10-7)
0(12-12)
4(16-12)
4
Large Facility
14(10-(4)
10(12-2)
0(16-16)
14
Solution: build medium ($4)
Expected monetary value: This is the weighted average of each state with the
probabilities being the weights “the best weighted average” is chosen
14
Expected Monetary Values solution
Small Facility
...
50(10) +
...
00
Medium Facility
...
50(12) +
...
50
Large Facility
...
50(2) +
...
00
Solution: build medium ($10
...
Opportunity Loss Table
Regrets
Decision Alternatives
Low
Moderate
High
Small Facility
0
$2
$6
Medium Facility
3
0
4
Large Facility
14
10
0
Expected opportunity loss solution
Small Facility
...
50(2) +
...
6
Medium Facility
...
50(0) +
...
7
Large Facility
...
50(10) +
...
2
Solution: build medium ($1
...
3
...
The expected value of a
decision represents the long-run average outcome that is expected to occur f a particular
course of action is undertaken many times
...
An estimation of the possible sales demand for each product gives the
following probability distribution of the profits for each product
...
1
600
Profits of 7,000
0
...
4
3,200
Profits of 9,000
0
...
1
1,000
=1
...
05
200
Profits of 6,000
0
...
4
3,200
Profits of 10,000
0
...
2
2,400
=1
...
1
400,000
7,000
-1,000
1,000,000
0
...
4
0
9,000
1,000
1,000,000
0
...
1
400,000
Sum of sqd dev
1,200,000
0
16
σ
1095
...
05
1,200,500
6,000
-2,900
8,410,000
0
...
4
324,000
10,000
1,100
1,210,000
0
...
2
1,922,000
Sum of sqd dev
4,590,000
σ
2142
...
4/8000 = 0
...
7% and that of B is 2142
...
241 or 24
...
A is therefore more variable than
B
...
However assuming risk aversion the manager would go for product A
...
3
...
In
deciding the type of investments that a firm should invest in it is of critical importance
that the manager considers the revenue relationship between the investment and others
held by the firm
...
If the company
chose to produce soft drinks, chances are that they will not make 2M in sales because soft
drinks and are all sold during hot seasons and they might cannibalize the ice cream sales,
worse still the company might have zero sales during cold seasons and be forced to lay
people off on the hand if it decided to make overcoats or umbrellas chances of hitting the
2M sales are high and better still sales throughout the year are assured
...
Covariance is a statistical measure of the degree to which two variables (e
...
securities return) move together
...
A negative value means that on average they move in the opposite
direction and a zero covariance means that the two variables show no tendency to vary
together in either a positive or negative linear fashion
...
If the
company had an objective of stabilizing earnings would a portfolio of product A and B
achieve this objective?
(1)Profits
(1)Profits
(2) Deviation
(3) Deviation
(4) probability
(A)
(B)
from expected
from expected
*(probability
value (Ai - A )
value (Bi - B )
for B chosen)
(5) (Ai - A )
(6) (Ai - A ) ×
(Bi - B )(Pi)
(4) × (5)
490,000
6,000
4,000
-2,000
-4,900
0
...
1
2,900,000
290,000
8,000
8,000
0
900
0
...
25
1,100,000
275,000
10,000
12,000
2,000
3,100
0
...
Correlation coefficient is a standardized statistical measure of the linear relationship
between two variables
...
0 (perfect negative correlation) through 0 (no
correlation), to + 1
...
Correlation coefficient (r) of A and B (rA,B), will be given by covariance of A of B
divided by their respective standard deviations i
...
cov
r
A,B
=
A,B
σ A ×σ B
=
2,295,000
= 0
...
4 × 2,142
...
The firm should eliminate one product and replace it
with a product whose earnings are negatively correlated
...
It is particularly powerful where one have a number of good
alternatives to choose from, and many different factors to take into account
...
One then score each option/factor combination, weight
this score, and add these scores up to give an overall score for the option
...
He needs one
that not only carries a board and sails, but also that will be good for business travel
...
No car he can find is good for all three things
...
A comfortable 'family car'
...
A convertible sports car
...
Ability to carry a sail board safely
...
Comfort over long distances
...
Firstly one draws up the unweighted table shown below, and scores each option by how
well it satisfies each factor:
19
Figure 1: Example Grid Analysis showing unweighted assessment of how each type of
car satisfies each factor
Factors:
Weights:
Sports Car
SUV/4x4
Family Car
Station
Wagon
Cost
Board
Storage Comfort
Fun
Look Total
1
0
2
0
3
2
0
2
1
1
2
3
3
1
0
3
1
0
2
3
3
3
0
1
Next he decides the relative weights for each of the factors
...
This is shown in Figure 2:
Figure 2: Example Grid Analysis showing weighted assessment of how each type of car
satisfies each factor
Factors:
Weights:
Sports Car
SUV/4x4
Family Car
Station
Wagon
Cost
4
4
0
8
Board
5
0
15
10
Storage
1
0
2
1
Comfort
2
2
4
6
Fun
3
9
3
0
Look
4
12
4
0
Total
27
28
25
8
15
3
6
0
4
36
This gives an interesting result: Despite its lack of fun, a station wagon may be the best
choice
...
A market analysis has a 30% probability of
annual sales being 5000 boats, and a 40% probability of 4000 annual sales
...
10,000 per
boat and a fixed cost and sh
...
Alternatively they can go into full
production where variable cost are sh
...
5,000,000 annually, if the new boat is to be sold for shs
...
, 2008, Management and Cost Accounting, Cangage Learning, New York Pg
2-50
Horngren et
...
, 2009, Introduction to Management Accounting, 14
Kindersley, New Delhi Pg 2- 43
...
0 CHAPTER THREE: COST ESTIMATION AND FORECASTING
Learning Objectives
By the end of this chapter the learner should be able to:
Explain the concept of cost
Describe the methods of cost classifications
Illustrate the various cost estimation methods- Accounts analysis; The two point
method; Regression analysis; Graphical method; Conference method;
Engineering methods; learning curve etc
Cost Concept and Classification
Cost
Cost is defined as the resources foregone or sacrificed to a specific objective It
is therefore the monetary unit that must be given up for goods and services
...
g
...
Cost objectives can further be divided into a cost unit or a cost centre
...
It is the basic control unit for costing purposes
...
g
...
A cost centre is allocation or person or an item of or equipment or group of these for
which cost may be ascertained and used for control purposes
...
The total cost of a cost centre may be related to the cost limit which are passed through
the centre or it may be re-allocated over other cost centers e
...
production dept, service
department etc
...
e
...
22
3
...
There are two
main way of classification namely:1
...
Product costs are those costs that are identified with the goods and services purchased or
produced for sale
...
Periodic costs or overheads are the cost that are not included in the stock valuation and
therefore are treated as expenses in the year which they are incurred
...
They are mainly
incurred due to the passage of time
...
Planning control and decision making
Under this we have:
i) Cost behavior
This is classification of cost according to variability based on the level of output
...
Variable costs are the ones which vary in total in direct proportions to changes in the
related activity level or volume e
...
material costs, direct labor costs, purchases price,
sales commissions etc
...
g
...
Figure 1: Total costs
Total costs
V
...
5,000
F
...
Constant or intercept
of $5,000
Slope = V
...
e
...
$50 per kilo of
four
2,000 4000
Output
Cost behavior is best seen through a cost function
...
The
behavior depicted in figure 1 can be summarized by the following cost function;
y = $5,000 + 50x
Where y represents total costs and x the kilos of floor milled
24
Figure 2: Unit costs
Unit costs
V
...
$50 per Kilo
F
...
2,000
4,000
Output
6,000
Unit fixed reduce as output increases as illustrated below:
Units produced
1
10
100
1,000
5,000
Fixed cost per unit
5,000
500
50
5
1
NB: 1
...
in practice fixed costs are not constant over the full range of activity, they may
increase in steps as shown below:
Total Costs
Output
25
Mixed costs or semivariable cost contain both variable and fixed components and
therefore are partly affected by production in the level of activities e
...
consumption or
elasticity
...
A direct cost is that cost which can be traced in total to the product of services that is
being costed
...
g
...
Individual costs are cost that cannot be traced directly and in full to the product or service
or department e
...
indirect materials, labor, expenses etc
...
Total cost is therefore prime costs plus overheads
...
e
...
Irrelevant
costs are not affected by the decision
...
Sunk costs are historical costs without future benefits
...
It is a cost that has been created by a decision made in the
past and cannot be changed by any decision that would be made in the future
...
The incremental costs of increasing output from
100,000 to 110,000 per week are the costs of producing an extra 10,000
...
Note that the incremental
cost per unit is referred to as marginal cost but he account is more interested in
incremental costs and the economist is more interested in the marginal cost
...
Such costs are therefore relevant in decision making
...
According to functions of department
It can be manufacturing costs, selling and marketing distance cost, administration cost,
research and development cost etc
...
Administration costs are the costs of managing an organization i
...
planning and
controlling its activities
...
27
Distribution costs are the costs of the segment of operation beginning with the receipts of
finished goods from the production department, making them ready for dispatch and
ending with reconditioning for re-use of returned empty containers which containers are
returnable
...
3
...
Accounts analysis (Accounts inspection method)
The two point method (High-Low Method)
Regression analysis (least-square method)
Graphical method
Conference method
Engineering methods
3
...
1 Accounts analysis or inspection of accounts
This requires that departmental managers and accountants to inspect each item of
expenditure within the accounts and then classifying each of these items as wholly fixed,
wholly variable or mixed variable
...
Mixed costs are decomposed into their fixed and variable components and the
departmental manager and the accountant agree on a cost function that best describes the
cost behavior
...
Item
Ksh
Direct materials
100,000
Direct labor
140,000
Indirect Labor
30,000
Depreciation
15,000
Repairs and maintenance
10,000
295,000
28
An analysis of each of the accounts reveals the following as the variable and non-variable
elements of the accounts
Item
Unit Variable
Total non-
cost
variable cost
Direct materials
10
...
00
Indirect Labor
30,000
Depreciation
15,000
Repairs and maintenance
0
...
50
50,000
The cost function is therefore y = 50,000 + Ksh 24
...
Exercise: Estimate the total cost of producing 10,000 units
3
...
2 The two point method (High-Low) Or Range Method
This consists of selecting the periods of highest and lowest activity levels and comparing
the change in the cost that results from the two levels i
...
the period with the highest level
of output and the period with the lowest level of output
...
Illustration:
Assume that the product manager of ABC Ltd is concerned about the apparent
fluctuations in efficiency and therefore work done by employees which are related to the
volume
...
68
$1,190
2
...
62
1,004
4
...
60
770
29
6
...
78
1,180
8
...
82
1,316
10
...
68
752
12
...
92
To compute the constant, we solve for “a” in the equation y = a +bx using any of the
values of x and y i
...
y = a +bx, a = y – bx
...
92×96) = $23
...
68 + ($14
...
68 + ($14
...
48
If, y = $1,000
$1000 = $23
...
92x)
30
$14
...
68
=976
...
92
65
...
If the relationship has one dependants and one independent variable it is referred to as
simple regression given by the function y = a + bx
...
88
1,211
7,744
106,568
3
...
72
917
5,184
66,024
5
...
96
1,456
9,216
139,776
7
...
46
710
2,116
32,660
9
...
94
1,032
8,836
97,008
11
...
48
963
2,304
46,224
Σ x=862
Σy=12,501
Σ x = 64,900
Week
1
...
(1)
31
2
2
Σxy=928,716
∑ xy = a∑ x + b∑ x2
...
2900232 i
...
64,900/862, this gives;
941,200
...
4803 + 64,900b…………
...
(2)
Subtract equation (2) form equation (1), and then solve for “a” this gives;
12,484
...
58/41
...
98
Insert this figure in either equation (1) or (2) to solve for b
...
98) +862b
12,501 = 3,611
...
6 = 862b
b = 8889
...
31
The cost function is therefore y = $300
...
31×Machine hours)
If x = 80 then, y = $300
...
31× 80) = $1125
...
3124
a = 12,501 − 10
...
75 − 740
...
976
32
Exercise: A hospital records show that the cost of carrying health checks in the last five
accounting periods has been as follows;
Period
No of patients seen
Total cost
1
...
940
17,800
3
...
990
17,980
5
...
940
17,800
883,600
16,732,000
3
...
990
17,980
980,100
17,800,200
5
...
Σ x=4990
Σy=89,915
Σ x = 5,196,300
Regression analysis method
An alternative formula of solving for “a” and “b” is:
n xy −
x
∑ ∑
b= ∑
y
2
2
n∑ x − (∑ x)
∑
a=
y b∑ x
n −
n
b = 5 × 90,276,450 − 4,490 × 89,915
2
5 × 5,196,300 − 4990
b = 451,382,250 − 448,675,850
25,981,500 − 24,900,100
b = 2
...
5×
4990 5 5
a = 17983 − 2,495
= 15,488
The cost function is therefore;
y = $15,488 + ($2
...
5× 850)
=$17,613
High - low method
x
y
Highest
1,260
18,650
Lowest
650
17,125
610
1525
= ∆y /∆x
1525/610
2
...
17,125 = a + 2
...
5 × number of patients seen)
The cost of carrying out health checks for 850 patients is
y = 15,500 + 2
...
It measures how well the
predicted values of y based on the cost driver x, match actual costs, y
...
The coefficient of determination is expressed as:
r =1−
Un exp lained var iation
= 1 − ∑( y a − ye )
2
2
∑( ya − y )2
Total var iation
2
Example: calculate the r of the data on hospital checks and comment on the goodness of
fit
...
650
17,125
ye =$15,488 + ($2
...
940
17,800
17,838
3
...
990
17,980
17,963
5
...
999
1,356,680
r of 0
...
9% of the variation in Y(indirect labor cost) is explained by
2
X(cost driver)
...
1% variation in Y is unexplained by variation in the cost
2
driver
...
30 or higher passes the goodness of fit test
...
68
$1,190
1002,06
2
...
26
3
...
72
917
5
...
96
1,456
7
...
46
710
9
...
94
1,032
11
...
48
963
Σ x=862
Σy=12,501
Week
2
2
ye = $300
...
31x)
795
...
06) + (1211 – 1208
...
+ (963 – 795
...
75
2
2
2
Σ (y - y ) = (1190 – 1041
...
75) +…
...
75) = 607,699
2
r =1−
∑( y a − ye )
∑( ya − y)
=
290,824
= 0
...
52 means that 52% of the variation in Y(indirect labor cost) is explained by X(cost
2
2
driver)
...
30 or higher passes the goodness of fit test
...
3
...
A
straight line is fitted to the scatter of plotted points by visual approximation
...
The unit variable cost “b” is obtained by
calculating the gradient of the straight line i
...
change in y/change in x
36
Example: Consider data from the previous illustration on ABC ltd, plot the scatter graph
and fit the line of best fit by visual approximation and estimate the cost 50 machine hours
$1,600
$1,400
$1,200
Indirectlabour costs
$1,000
$800
$600
$400
$200
$0
0
20
40
60
80
100
120
Machine hours(cost driver)
Y-intercept (constant) and thus “a” is approx 300 while, “b” is given by ∆y /∆x i
...
b=
1,000 − 800 200
= 15
...
39 × machine hours used)
If x = 50,
y = 300+ (15
...
1069
...
It however suffers from the disadvantage of the
determination of exactly where the straight line should lie, which is subjective with
different people drawing different lines with different slopes therefore giving different
cost estimated
...
3
...
5 Conference method
37
The conference method estimates cost functions on the basis of analysis and opinion
about costs and their drivers gathered from various departments of an organization
(purchasing, process engineering, manufacturing, etc) the conference method encourages
interdepartmental cooperation
...
Because the method does not require detailed analysis of data, cost
functions and cost estimates can be developed quickly
...
The cooperative
bank of UK estimates the cost functions for its retail banking products through a
consensus of estimates from personnel of the relevant departments
...
3
...
g
...
The
procedures for such analysis are to make an analysis based on direct observations of:
The physical quantity required for an activity and then convert the final results into
the cost estimate; Analyzing or breaking task into its constituent motion elements
or operations
Determining time for each motion element or operation and several observations are
made on different persons performing the task; the average of this gives the
normal or base time required for each elements
...
Motion study is the study of movement of work and machines in performing the
operations
...
This method is useful in the estimating the cost of repetitive process where input and
output relationship are clearly defined
...
The most efficient
methods of production, equipment and operating conditions are the standardized this is
followed by time measurements to determine the standard hours required by an average
38
worker to complete the job
...
The disadvantage is that the methods may be very
expensive to apply in practice
...
3
...
If the
relationship is not linear the learning curve may be used to estimate the cost functions
...
This phenomenon is called learning curve effect
...
This rate is refereed to as learning curving improvement rate given by r
...
Required:
Compute the number of hours required to produce the first 32 units
Compute the number of hours required to produce 32
nd
unit
...
100 per hour, compute the Labor cost of
producing the last 16 units
Mathematical method
39
The learning curve effect is given by the expression:
b
Yx = aX
Where;
Yx = is the cumulative average time taken to produce x
units a = is the time taken to produce the first unit
b = the natural log learning curve improvement rate divided by natural log of doubling,
tripping etc i
...
ln(learning rate)
ln 2
a) The cumulative average time required to produce first 32 units
r = 80% or 0
...
8
= −0
...
3219
655
...
42 hrs × 32
20,973
...
3219
662
...
16 × 31
20,526
...
42 × 32 - 662
...
44 – 20,526
...
48hrs
Assume that the wage rate is Kshs
...
44
40
Cumulative total hours for the first 16 units = (2000 x 16
-0
...
22
...
44 – 13,108
...
22 The
total labor cost for producing the last 16 units = 7,865
...
2
13,107
...
2
32
655
...
52
7,864
...
2
655
...
The amount of time needed to produce the first product is 100 hours
...
3219
) × (7) × (20+30)
(100 × 0
...
17
For an additional 8 products the cumulative production will be 15
b
Y15 = (a X ) × (15) × (direct mfg labor cost per hr + related overheads per hr)
(100 × 15
-0
...
4182) × (15) × (50)
31,367
...
e
...
33
18,708
...
16
(a) The direct manufacturing cost of producing the first 10 products will be:
b
Y10 = (a X ) × (10) × (direct mfg labor cost per hr)
(100 × 10
-0
...
5345) × (10) × (25)
11,913
...
8 × 11,913
...
81
The total cost of manufacturing the first 10 products is 11,913
...
81=21,444
...
3219
) × (32) × (25)
(100 × 0
...
95
The overheads are: 0
...
95 = 20,973
...
95+ 20,973
...
51
The difference between the cumulative production of 32 products and 10 products will
give the incremental cost of producing the extra 22 products i
...
47,190
...
33
25,746
...
Identify or select the dependent variable or the response variable
...
Identify the independent variables also referred to as cost drivers, explanatory
variables or predictor variables
...
g
...
Gathers data on both dependent and independent variables
...
This
should be adjusted to reflect any change of circumstances e
...
inflation or change
in the type of equipment being used
...
The graph will indicate the
general relationship between dependent and independent variable and will give
visual indication as whether there is a relationship or not
...
Either of the different methods learnt such as
regression, high-low etc may be use
Evaluation of the cost function this may be done through goodness of ft methods
such as the coefficient of determination
...
Galgallo, CEO of a granite tiles manufacturing firm in Kenya is troubled by
fluctuations in productivity and wants to compute how manufacturing support
costs are related to the various sizes of batches of output
...
al
...
Garisson R
...
, and Noreen E
...
, 1997 Managerial Accounting, 8th Ed,
MacGrraw-Hill, New York, Pg 238-276
45
4
...
V
...
V
...
V
...
4
...
A relevant
range is the expected band of activity or volume in which a specified form of
budgeted sales and cost relationship will be valid e
...
$1,600
$1,400
$1,200
Costs and revenue
$1,000
$800
$600
$400
Relevant range
$200
$0 0
20
40
60
Units sold)
80
100
120
The behavior of the total cost and total revenue functions have been reliable
determined and is linear within the relevant range
...
Total fixed cost remains constant over the relevant range e
...
46
Unit selling prices are constant
...
There is no change in the level of inventory
Efficiency and productivity remains constant
...
No limiting factors exist, no constraints
...
3 The Break – Even Point
It is a form of CVP analysis
...
It establishes the relationship between
revenues and costs with respect to volume
...
The equilibrium point is known as the break even point where total revenue equal to total
costs i
...
no profit or loss
...
4
...
E
...
The sales line
Plot the sales volume on the horizontal axis
...
2
...
3
...
47
Illustration:
A tour company has fixed cost estimates costs of Ksh 60,000 a variable cost of Ksh 10
for each ticket sold and a proposed ticket sale price of Ksh 20
...
C
...
E
...
160
Loss area
V
...
120
80
40
F
...
0
1
2
3
4
5
6
7
8
9
Sales volume
48
10
11
12
13
14
15
Contribution Chart
Sales volume
280
Profit area
240
B
...
P
...
C
...
C
...
E
...
Loss area
20,000
0
-20,000
1
2
3
4
5
6
7
8
9
10
-40,000
-60,000
Sales volume
4
...
49
Units sold will cover variable costs and leave a remainder known as contribution margin
Selling price per unit – variable cost per unit = contribution per unit
Unit contribution × units sold = total contribution
B E P in units is given by:
Fixed Costs
Fixed Costs
=
Selling Pr ice per unit −Variable Cost perunit Contribution
B
...
P
...
E
...
(shs) = B
...
P
...
E
...
(Shs) = Contribution m arg in ratio , where contribution margin ratio is:
C
...
R
...
9 per unit
...
5 per unit and the T F C is sh
...
Assume that the company intends to make a profit before tax of 20% of sales,
determine the number of units that must be sold
...
Compute the number of units that must be sold to earn this target
profit
...
Solution
F
...
= Sh
...
P
...
00; V
...
= 5
...
E
...
(units) =
2,000 2,000
=
= 500 units
9−5
4
E
...
(shs) = B
...
P
...
E
...
(Shs) = Contribution m arg in ratio
=
Fixed cost
2,000 2,000
2,000
= 4,500
=
=
=
4
0
...
2 of sales, then target PBT = 0
...
9q
0
...
9q = 9q – (2000 + 5q)
1
...
8q
2000 = 2
...
2
909
...
1 Units
Alternatively, let target before tax profit be Y and X be the number of units required to
earn the target before tax profit
...
C
...
P
...
C
Sales = S P × Units sold
= 9 × X = 9X
Since Profit = 20% of 9X =
1
...
8X / 9 - 5
= 2000 + 1
...
8X
4X – 1
...
2X = 2000
X = 2000/2
...
1 units
PAT = 1640,
51
PBT (1-Tax rate)
PBT × 0
...
7
PBT = 1640/0
...
75
Alternatively assume the target after tax profit is Z, the number of units to earn the target
after tax profit is given by:
Z
F
...
+ 1−T
X = S
...
−V
...
e
...
3 = 0
...
7) / 9 – 5
2000 + 2343/4
1085
...
It measures the
risk that the company might make a loss if it fails to achieve the target
...
Margin
of safety is given by:
M arg in of safety = Expected sales − B
...
P
...
E
...
units
×100 Expected sales(units)
600 − 500
=
×100 =
16
...
P (shs)
Q (shs)
Selling price per unit
10
12
Variable cost per unit
2
8
Fixed cost
50,000
34,000
Required:Calculate the B
...
P
...
Calculate the margin of safety if budgeted sales are 10,000 units each
Compute the profit of each product if sales in units are 20% above the B
...
P
...
C
...
P
...
C
P
Q
50,000/10-2
34,000/12-8
= 50,000/8
34,000/4
= 6,250 units
8,500 units
B E P (Shs) = B E P (units) × S P
P
Q
6250 × 10
8500 ×12
= Shs
...
102,000
Expected sales − B
...
P
...
5%
M arg in of safety =
10,000 − 8,500
×100
10,000
= 15%
Profit of each product if sales units are 20% above B
...
P
...
of units required
X=
F
...
+ Y
S
...
−V
...
4X
8X-2X = 50,000
4X – 2
...
6X = 34,000
X = 8,333
...
33 × 10
Sales = 21,250 × 12
Profit = Sales- TC
profit = Sales- TC
83,333
...
33)]
255,000 – [34,000 + (8 × 21,250)]
16,666
...
7 C V P in Multi-product Environment
The single product CVP analysis can be extended to handle more realistic question where
the firm produce more that one product
...
Total B E P (Units) = Total fixed cost / Average contribution
margin B E P (shs) = B E P (units) × S P
Example
Assume that a company has the following budget for product A and product B
...
5 & 10
600,000
400,000
54
Total
160,000
1,000,000
Variable cost @sh
...
1 & 7
120,000
280,000
400,000
Total fixed cost
300,000
Profit
100,000
Required:
Compute the B E P in shillings in and units for the total product and also for product
A and B
...
Solution:
Sales mix
A
B
Total
1
...
75
40,000/16,000 = 0
...
In shs
...
6
40,000/1,000,000 = 0
...
75 × 1) + (0
...
5
120,000 units
B E P (Units) A = Sales mix × Total B E P (Units)
0
...
25 ×120,000
= 30,000 units
B E P (shs) = B E P (Units) × Unit S P
B E P (shs) A = 90,000 × 5 = 450,000
B E P (shs) B = 30,000 × 10 = 300,000
Total B E P (shs) = 750,000
ii)
Product
Sales units
A
80,000
55
B
80,000
Total
160,000
Sales @sh
...
4 & 3
320,000
240,000
560,000
Contribution @ sh
...
5
80,000/160,000 = 0
...
5 × 1 + 0
...
5 × 75,000 = 37,500units
B E P (units) B = 0
...
8 Criticisms of CVP analysis
Most criticisms of CVP relate to its basic underlying assumptions this are:
CVP ignores the curvilinear nature of total revenue and total cost schedules in
effect it assumes that changes in volume have no effect on elasticity of demand
or on the efficiency of production factors
CVP analysis is typically restricted to one time period in each case
It does not measure the impact of decision on wealth
It does not incorporate the effect of asset structure changes required by the decision
It does not acknowledge the risk created by the decision
56
Review Questions
“Any future cost is a relevant cost” Do you agree? Explain
“Avoidable costs are variable costs” Do you agree? Explain
Mash Auto charges $4 to wash a car
...
Fixed costs total $1,700 a month
...
The product sells
for $60 per unit and has a CM ratio of 40%
...
What are the variable expenses per unit?
Using the equation method:
What is the B
...
P
...
What is the company’s new B
...
P
...
al
...
Garisson R
...
, and Noreen E
...
, 1997 Managerial Accounting, 8th Ed, MacGrrawHill, New York, Pg 276-323
57
5
...
A relevant cost is appropriate to a specific management decisions and therefore are
affected by the decision at hand
...
A cost
incurred in the past is totally irrelevant to any decisions being made now
...
2
...
e
...
The costs which do not reflect
additional cash to the company are regarded to be irrelevant and therefore cannot be used
for the purpose of decision making e
...
depreciation, amortization of rent or interest,
absorbed overheads etc
...
Increment
A relevant cost occurs as a direct consequence of making a decision
...
e
...
g
...
58
Assumptions of Relevant Costing
The cost behavior pattern are known e
...
fixed, variable etc
...
The objective of decision making is to maximize short term profits
...
Quantitative and qualitative factors in decision making
Quantitative factors are outcomes that can be measured in numerical terms
...
It should be noted however that qualitative factors that can not be easily
measured in financial terms are very important and managers should give more weight to
this factors
Examples of quantitative factors
Profitability
Effect on cash flow
Sales volume
Market share
Time value of money
Efficiency
Time taken to make a decision
Examples of qualitative factors
Competitors
Customers
Government
Legal
Risk
Staff morale
Suppliers
59
Environment
Availability of information
Limiting factors in decision making
In the short term, sales demand may be in excess of current productive capacity
...
These
scarce resources are known as limiting factors
When limiting factors are present, profit is maximized when the greatest possible
contribution to profit is obtained each time a scarce resource or limiting factor is used
...
At its Kenyan plant it assembles power saw engines and lawnmower engines
...
5%
40%
60
60
60
(Ksh 24/80; 50/125 & 37
...
The limiting factor is machine
hours
...
Required:
Advise on the product mix that Kawasaki should produce during the period
Solution:
60
Engine type
Power saw
Motor bike
engines
engines
engines
Ksh 24,000
Ksh 37,500
Ksh 50,000
2
5
5
Ksh 12,000
Ksh 7,500
Ksh 10,000
1
Contribution per unit
Lawnmower
3
2
Machine hrs required to produce 1 engine
Contribution per machine hr
(Ksh24/2; 37
...
e
...
5 Special pricing decisions
Special pricing decisions typically involve one time only orders or orders at a price below
the prevailing market price
...
Differential costing examines all revenue and cost differences between
alternatives so as to determine most appropriate decisions
...
The current volume is 100,000 units per annum with the following cost
structures
...
2 each
Less: Marginal cost - Direct Labor
-Direct materials
Contribution
200,000
80,000
50,000 (130,000)
70,000
Less: Fixed cost
(30,000)
Operating profit
40,000
An opportunity has arisen to supply an additional 30,000 units per annum at sh
...
80
...
Required:
Should the order be accepted?
Solution
New order
Direct Labor cost (per unit)
= 80,000/100,000
= 0
...
8 × 1
...
96cts per unit
= 0
...
5cts × 30,000 = 15,000
Present
Projected
Difference
(without order)
(with order)
Ksh 1
...
6 Make or buy decisions
A make or buy problems involves a decision by the organization about whether it should
make of product or carry out an activity its all intend resources or whether it should pay
another organization make the product or carry out the activity
...
Whether a company should do some work with its own employees or it should
sub contract the work
...
62
Example
The total cost of component Y is as follows:
Per unit (Ksh)
Units (20,000)
Direct Labor
8
160,000
Direct Materials
1
20,000
Variable overhead
4
80,000
Fixed overheads applied
5
100,000
Total manufacturing cost
18
360,000
The same component can be bought @sh
...
Required:
Should the company buy or make the components if the fixed overhead is assumed to be
consumed whether company buys or makes the components
...
7 Discontinuation decisions
Organizations are periodically confronted with the decisions of ether discontinuing or
adding operations in various branches or business segments
...
Relevant costs can be applied to discontinuation
decisions as illustrated in the following example
...
The budgeted results for the next
quarter are as follows:
Kampala
Arusha
Kigali
Total
(Ksh000)
(Ksh000)
(Ksh000)
(Ksh000)
Cost of goods sold
800
850
1,000
2,650
Sales staff salaries
160
200
240
600
Sales office rent
60
90
120
270
Depreciation of sales office equipment
20
30
40
90
Apportionment of Thika warehouse rent
24
24
24
72
Depreciation of Thika warehouse equipment
20
16
22
58
-Cause and effect allocations
120
152
186
458
-Arbitrary apportionment
360
400
340
1,100
1,564
1,762
1,972
5,298
236
238
(272)
202
1,800
2,000
1,700
5,500
Regional and Headquarters costs:
Total costs assigned to each location
Reported profit (loss)
Sales
Assuming that the above results are likely to be typical of future performance, should the
Kigali territory be discontinued?
Solution:
Since cost of goods sold, sales staff salaries, office rent and cause and effect
allocations
are
specific
to
the
regional
offices
and
therefore
differential/incremental costs they are consequently relevant
Depreciation of regional sales offices and Thika warehouse equipment are past or
sunk costs and therefore irrelevant
Thika warehouse rent and costs apportioned arbitrarily will remain irrespective of
the decision and therefore are not a differential or incremental cost and
consequently they are irrelevant
...
154, 000 to profits and fixed costs
5
...
However one aspect of equipment
replacement decisions that can be addressed by relevant cost and revenue analysis is that
of book value of old equipment i
...
original cost minus accumulated depreciation
...
Consider the following
example
Example:
East African Cables Ltd is considering replacing its metal smelting machine a newer
more efficient model but with an overall shorter life
...
1
...
Old Machine
New Machine
1,000,000
600,000
Useful life
5 yrs
2 yrs
Current age
3 yrs
0 yrs
Remaining useful life
2 yrs
2 yrs
Accumulated depreciation
600,000
Not acquired yet
Book value
400,000
Not acquired yet
Current disposal price
40,000
Not acquired yet
Original cost
65
Terminal disposal price in 2 years
0
Annual operating costs (repairs coolants etc)
0
800,000
460,000
To focus on the main concept of relevance we ignore time value of money and income
taxes
...
A C
...
However its disposal price of Ksh 40,000 is differential/incremental
revenue and thus relevant
Annual operating costs are differential/incremental costs and thus relevant
Since revenue from cables are unaffected by the decision they are irrelevant, further
disposal price for the two machines after two years is zero, not differential/
incremental and consequently irrelevant
Keep
Replace
Differential costs & revenues
New machine cost
-
600,000
(600,000)
Current disposal of old machine
-
(40,000)
40,000
Operating costs (for 2 yrs)
1,600,000
920,000
680,000
Total relevant costs
1,600,000
1,480,000
120,000
Review Questions
What is a relevant cost?
Define the following terms: incremental cost, opportunity cost, sunk cost, and
avoidable cost
XYC Co
...
It currently produces this part internally, but is considering outsourcing
this activity
...
The production manager has prepared the following information concerning
the internal manufacture 60,000 units of the part
...
50 per unit allocation for salary paid to a
supervisor to oversee production of the part
...
Assume if XYZ outsources, its
purchase price from the outsourcer is $12 per unit
...
ABC will pay XYZ $23 per unit but will take the parts only if they are
manufactured by XYZ
...
Because of the rapid
changes in technology, copy cat expect the replacement equipment to have a 3year useful
life only
...
al
...
H
...
W
...
0 CHAPTER SIX: ABSORPTION COSTING AND MARGINAL COSTING
Learning Objectives
By the end of this chapter the learner should be able to:
Differentiate absorption costing and marginal / variable Costing
Explain overhead cost allocation
Illustrate various methods of overhead cost apportionment
Describe the methods of overhead absorption
Explain the application of overhead to product
compare the impact of variable costing and absorption costing on profit
Describe activity based costing (ABC)
There are two methods of costing namely:Absorption costing
Marginal costing
Absorption Costing
Cost accumulation means building up cost of something usually the cost of the end
product such as a unit of production, a job a service
...
Traditionally absorption costing or full costing has been used to measure the cost of
production is a period
...
Absorption costing is establishing the cost of work done by a downing indirect cost or
overheads to the direct cost of material and Labor incurred in producing the work
...
The principle justifying use of absorption costing is the matching or the accrual concept
of accounting whereby revenues are to be matched with associated expenses both directly
and indirectly
...
Direct cost can easily be traced to the financial product, job or service
...
This can be done through
the process of
68
Overheads cost allocation
Overhead cost apportionment
Overhead cost absorption or recovery
6
...
Cost allocation is that part of cost attribution which charges a specific cost to a cost unit
or a cost centre
...
Examples of costs centers include, production department,
administrative department, selling and distribution department, service cost centers e
...
maintenance, tool room etc
...
3 Overhead Cost Apportionment
This is that part of cost attribution which shares costs among two or more costs centers or
units in proportion to the estimated benefits received
...
When overheads have
been allocated they can then be apportioned
...
This
means that the shared overheads must be divided between other cost centers
...
g
...
69
In order to add production overheads to the unit cost it is necessary to have all overheads
charged to the production department
...
This can be done through various methods, namely:
Direct method
The step (elimination) method
Continuous (repeated distributed) method
Algebraic method
The Direct Method
This method apportions the cost of each service cost centre in turn to the production
department only i
...
there is no inter service usage
...
Example
A B Ltd has two production, and two service departments the following information is
provided registration apportion the total overhead costs between production account and
balance
...
Service Dept
...
10,000
8,000
1,000
1,000
-
Solution
Workings
Usage
Stores
Maintenance
Total
Production department
A
B
100,000 30,000/100,000 50,000/100,000
× 100
× 100
= 30%
= 50%
10,000 8,000/10,000
1,000/10,000
× 1,000
× 100
= 80%
= 10%
Note:
70
Service department
Stores
Maintenance
20,000/100,000
× 100
= 20%
1,000/10,000
× 100
= 10%
A
Apportion of stores cost 10,000
B
= 30/80 ×10,000 =3,750
Apportion of maintenance cost 8,000 =
80/90 × 8,000 = 7111
...
9
Apportionment
Production department
Service department
Total
A
B
Stores
Maintenance
Overhead allocation
37,000
10,030
8,970
10,000
8,000
Apportionment of
10,000
30/80 × 10,000
50/80 × 10,000
(10,000)
= 3,750
= 6,250
80/90 × 8000 =
10/90 × 8,060 =
7,111
889
20,891
16,109
store cost
Apportionment of
8,000
maintenance cost
Total
37,000
(8,000)
0
0
The Step (Elimination) Method
The service department providing the highest service to the other service department is
identified
...
e
...
The next department providing the highest service is identified and the re-apportionment
is done to the remaining department and first department will not share it, as it has
already been closed down
...
M
...
Production Department
Service Department
Total
A
B
Stores
Maintenance
Overhead
37,000
10,030
8,970
10,000
8,000
Stores
100%
30%
50%
Maintenance
100%
80%
10%
10%
Overhead
37,000
10,030
8,970
10,000
71
20%
8,000
Apportion Store overhead
3,000
5,000
(10,000)
2,000
Apportion maintenance
8,889
1,111
0
(10,000)
21,919
15,081
0
0
Working
Stores
Maintenance
A
30/100 × 10,000 = 3,000
80/90 × 10,000 = 8,889
B
50/100 × 10,000 = 5,000
10/90 × 10,000 = 1,111
* Stores to maintenance
=
20/100 × 10,000 = 2,000
Continuous or repeated distributed method
This apportions the cost of each service cost centre to the production department and also
to the other service costs centers that makes use of its service
...
Refer to the above example
Production Department
Total
Overhead
A
37,000
B
Service Department
Stores
Maintenance
10,030
8,970
10,000
8,000
Apportion Stores
3,000
5,000
(10,000)
2,000
Apportion maintenance
8,000
1,000
1,000
(10,000)
Apportion Stores overhead
300
500
(1,000)
200
Apportion maintenance
160
20
20
(200)
6
10
(20)
4
0
4
Apportion Stores
Apportion maintenance
3
...
4
0
...
2
15,500
...
4
0
21,499
...
4 = 36,999
...
1M
S = 10,000 + 10%
ii)
M = 8,000 + 20%
M = 8,000 + 0
...
1 (8,000 + 0
...
02S = 10,800
0
...
98S
= 10,800
S = 11,020
M = 8,000 + 0
...
2
1,020
...
4
(10,204)
21,499
...
4
0
0
6
...
The process of charging overhead to cost unit of product is known as overhead
absorption
...
It is a means of
attributing overhead to a product or service based for example on:direct labor hours
direct labor cost
machine hours etc
There are two methods in absorption of overhead namely:Computation of overhead absorption rate
Computation of rates to cost units
...
If an unsatisfactory absorption rate is
selected it will lead to misleading result or cause overhead to be over or under stated
73
for product costing purposes
...
e
...
e
...
e
...
Generally
overhead absorption rate is computed as:
O
...
R
...
This method includes:
Unit of output
This is used adhere products produced in the department are similar
...
A
...
= Total budgeted overhead / Units of output produced
...
It recognizes the
time spent on production and unlike direct Labor cost it is not affected by bonuses and
overtime
...
R
...
It recognizes price spent on work
...
R
...
This method
is used where raw material prices are stable
...
R
...
A
...
= Total budgeted overheads / Direct labor cost ×100
Prime cost % Rate
Prime cost includes direct material and direct labor cost
...
O
...
R
...
1, 2, and 3
...
Job
1
2
3
Direct material
70,000
130,000
250,000
Direct wages
90,000
140,000
150,000
Direct expenses
14,000
14,000
6,000
Overheads are absorbed as follows:
Production overhead is 100% on direct wages
Administration overheads is 25% on prime cost
Selling and distribution is 5% on factory cost
Required:
Show the total cost chargeable to each job
Solution
Job
1
2
3
Direct material
70,000
130,000
250,000
Direct wages
90,000
140,000
150,000
Direct expenses
14,000
14,000
6,000
Prime Cost
174,000
284,000
150,000
Production overhead cost (100% of Direct wages)
90,000
140,000
150,000
Factory cost
264,000
424,000
556,000
Administration (25% of prime cost)
43,500
71,000
101,500
Selling and distribution(5% of factory cost)
13,200
21,200
27,800
75
Total cost charged to job
320,000
516,200
685,300
Example 2:
The cost department of A B C ltd made the following estimates for the coming year 2004
Factory overheads
£425,000
Material cost
£850,000
Production is
20,800 units
Labor cost
£250,000
Labor hours
£106,250
Machine hours
850,000
Required;
Compute the factory overhead rate based on:
Labor cost
Labor hours
Material cost
Prime cost
Machine hours
Units produced
...
6%
Machine hours = 425,000 / 850,000
76
£ 0
...
4 per unit
Application of Overhead to Product
Note: Once overhead absorption rates are computed overhead should be applied to
product or jobs overhead per unit is given by:
Overhead per unit = OAR × Unit of a base in product
Example:
Kahawa Ltd absorbs its production overhead by using predetermined rates i
...
a
percentage of direct labor cost for department P and machine hour rate for department Q
...
Job no
...
5hrs
Machine hours
20hrs
260hrs
Following the end of financial year it was ascertained that actual production overhead
incurred by department P was £555,000 and Q was £900,000
Required:
To calculate the overhead absorption rate for each of the department P & Q
77
To determine the total production overhead cost to be charged to job no
...
Show the over or under absorbed for each of the department and for the
st
company as a whole for the year ended 31 October assuming that actual
direct labor cost and machine hours worked as originally estimated
...
9%
= £5
...
186 Cost statement
P
Q
Total
Direct material
200
800
1000
Direct labor cost
360
190
550
Production overhead 114
...
60
1326
1,739
...
60
2316
3,289
...
If the predetermined
OAR is different from actual rates of overhead, the amount to be charged to production
(absorbed) will not be equal to actual overhead
...
Over absorption arises where absorbed overheads is more than the amount of overheads
actually incurred
...
Under absorption is when the amount of overhead absorbed is less than the amount of
overheads incurred
...
P
78
Q
Actual overhead (incurred)
555,000
900,000
Less estimated
517,000
922,500
Overheads absorbed
38,000
(22,500)
6
...
It has a special value in decision making
...
In marginal costing however, fixed manufacturing overheads are not absorbed in the cost
unit such that stocks are valued at variable cost only
...
In marginal costing fixed costs are excluded from the inventorable costs
...
Marginal costing is also referred to as contribution approach or direct
costing or variable costing
...
Profit and Loss Account
Marginal Costing
Ksh
Sales
Ksh
xxx
Opening stock
xxx
Production cost - Direct material
xxx
- Direct labor
xxx
- Variable production overhead
xxx
Less closing stock
xxx
Cost of sales
xxx
Contribution
xxx
Less non production overheads
xxx
Net contribution
79
Less fixed cost
xxx
Net profit
xxx
Absorption Costing
Ksh
Sales
Ksh
xxx
Opening stock
xxx
Production cost- Direct material
xxx
- Direct labor
xxx
- Variable production overhead
xxx
- Fixed production overhead
xxx
Less closing stock
xxx
Cost of sales
xxx
Adjustments for under/(over) recovery of overhead
xxx
Gross profit
xxx
Less non production overheads e
...
marketing
xxx
Net profit
xxx
Example:
The following information is available for XYZ Company
Period
1
2
3
4
5
6
Units sold (000)
150
120
180
150
140
160
Units produced (000)
150
150
150
150
170
140
Budgeted activity is expected to average 150,000 units per period and there is no opening
stock for period 1
...
Required:
Prepare a profit and loss statement based on variable and absorption costing
Solution:
Variable costing
Period
1
80
2
3
4
5
6
Opening stock
-
-
180
-
-
180
Production cost (units produced × 6)
900
900
900
900
1020
840
Closing stock
----
(180)*
----
----
(180)
(60)
Cost of sales
900
720
1,080
900
840
960
Fixed costs
300
300
300
300
300
300
Total costs
1,200
1,020
1,380
1,200
1,140
1,260
Sales
1,500
1,200
1,800
1,500
1,400
1,600
Gross profit
300
180
420
300
260
340
Less non mfg costs
100
100
100
100
100
100
Net profit
200
80
320
200
160
240
Note:* For period 150,000 units were produced but only 120,000 units were sold, the
difference 30,000 i
...
(150,000 - 120,000) needs to be subtracted from the production
cost to get the cost of sales and consequently becomes the opening stock for the next
period
...
e
...
This is
the unit fixed cost that should be added to the unit variable cost to get the unit production
cost
Period
1
2
3
4
5
6
-
-
240
-
-
240
1,200
1,200
1,200
1,200
1,360
1,120
Closing stock
----
(240)*
----
----
(240)
(80)
Cost of sales
1,200
960
1,440
1,200
1,120
1,280
---
---
---
---
(40)
20
Total costs
1,200
960
1,440
1,200
1,080
1,300
Sales
1,500
1,200
1,800
1,500
1,400
1,600
Gross profit
300
240
360
300
320
300
Less non mfg costs
100
100
100
100
100
100
Net profit
200
140
260
200
220
200
Opening stock
Production cost [units produced × (6 + 2)]
Adjustment for u/(o) recovery of overhead
A comparison of the impact of variable costing and absorption costing on profit
81
When production equals sales
Whenever production equals sales profits will be the same under marginal and absorption
costing because inventories will neither increase nor decrease (as in period 1 and 4) and
consequently if opening inventories exist, the same amount of fixed overhead will be
carried forward as an expense to be included in the current period opening inventory
valuation as will be deducted in the closing inventory valuation from the production cost
figure
When production exceeds sales
Whenever production exceeds sales profits will be the higher under absorption than under
marginal costing because inventories are increasing (as in period 2 and 5) and as a result
a greater amount of fixed costs in the closing inventory is being deducted from the
expenses of the period than is being brought forward in the opening inventory for the
period the previous period
...
The effect is a 60,000 increase in profit over marginal costing
When sales exceeds production
Whenever sales exceeds production profits will be the higher under marginal than under
absorption costing because inventories are reducing (as in period 3 and 6) and as a result
a lesser amount of fixed costs in the closing inventory is being deducted from the
expenses of the period than is being brought forward in the opening inventory for the
period the previous period
...
Consequently
Ksh 360,000 of fixed costs is allocated to the period instead of Ksh 300,000 the effect is
Ksh 60,000 increase in profit over absorption costing
...
For instance in
period 1, the difference between profits is 60,000 i
...
[(150,000 – 120,000) × 2]
...
Where: UFC = Unit Fixed Cost
Qp= quantity produced
Therefore OPBTAC is given as OPBTVC plus the difference in profits between variable
and absorption costing i
...
OPBTAC = OPBTVC + (Qp – Qs) × UFC
= Qs (UCM) – FC + [UFC (Qp – Qs)]
It can therefore be concluded that:
Under variable costing profit is driven by unit level of sales
Under absorption costing profit is driven by (a) unit level of sales (b) unit level of
production and(c) the chosen fixed overhead absorption rate
Consider period 2 in the above example for instance:
OPBTVC =120(10 - 6) – 300 = 180
OPBTAC =120(10 - 6) – 300 + [2(150 - 120)] = 240
Arguments in support of variable costing
Variable costing provides more information for decision making
83
The advantage of variable costing is that variable and fixed costs are highlighted this
provides relevant information for short term decision making
...
Whereas for absorption costing profit is a function of sales,
production and the unit fixed cost thus when stock fluctuate profits may be distorted
...
A further argument in favor of variable costing for internal performance measurement is
that if absorption costing was used managers could deliberately influence the results by
unnecessarily increasing stocks in successive periods in the short term
Variable costing avoids fixed overheads being capitalized in unsaleable stocks
With surplus socks that can not be sold, absorption costing will have allocated a portion
of fixed over heads for the period to the unsaleable stocks with only a proportion
remaining for be allocated to the be allocated to the sellable stocks
...
With an absorption costing
system however, fixed costs will be deferred by including it in the closing inventory and
only recorded as an expense when sales are made
...
Since
managerial reward is often liked to external financial measures there is a strong case to
ensure tat internal accounting system does not conflict with external financial reporting
requirements
Absorption costing does not understate the importance of fixed costs
Some people argue that decisions based on a variable costing system may concentrate
sales revenue only and forget that that fixed costs must be met in the long run
...
this is also incorrect because absorption costing
will not ensure tat fixed costs are covered if sales volume is less than the estimate used t
calculate the fixed overhead rate
...
The costs and
revenues were as follows:
Ksh
Sales
100,000
Direct materials
20,000
Direct labor
15,000
Fixed
15,000
Administration & selling
20,000
Required:
Prepare profit and loss statement under marginal and absorption costing
...
M
...
L
...
M
20,000
- D
...
15,000
-Fixed cost
15,000
Cost of sales
50,000
Gross profit
50,000
Less administration & selling
25,000
Net profit
25,000
Exercise 2
A Company produces a single product
...
10
Direct material cost per unit Ksh
...
2
Variable overhead per unit Ksh
...
10,000 per month
Production volume 5,000 units per months
Actual
Production 6,000 units
Sales 4,800 units
Assume that all costs were as budgeted
86
Required;
Prepare a profit statement using:
Absorption costing
Marginal costing
Prepare a reconciliation statement to reconcile the two reported profit figures under
absorption and marginal costing
Solution
Use units budgeted to absorb fixed overhead to product units
O A R = Fixed overheads / No of units
10,000 / 5000 units
Ksh
...
ii)
Marginal costing
Ksh
Ksh
Sales (4,800 × 10)
48,000
Marginal cost
Opening stock
0
Add production cost (6 × 6,000)
36,000
Less closing stock (6000 - 4,800) × 6
7,200
Cost of sales
28,800
Gross profit
19,200
Less fixed overheads
10,000
Net profit
9,200
Reconciliation statement under marginal and absorption costing
Profit under absorption costing
= 11,600
Difference in opening stock (0 - 0)
0
Less: difference in closing stock (9,600-7,200)
= (2,400)
Profit under marginal costing
= 9, 200
Alternative method
Profit Statement
Marginal cost
Ksh
Sales (4 800× 10)
Ksh
Absorption costing
Ksh
48,000
48,000
Less: Variable cost of sales
Direct material (6 000× 3)
18,000
18,000
Direct labor (6 000× 2)
12,000
12,000
Variable overhead (6000×1)
6,000
6,000
Fixed production (6000× 2)
Nil
12,000
Total cost
36,000
48,000
Less closing stock
7,200
9,600
88
Ksh
Cost of sales
28,800
38,400
Contribution to gross profit
19,200
9,600
Less fixed cost
12,000
Nil
Unadjusted profit
7,200
9,600
Nil
2000
9200
11,600
Add over recovery of o/h
Net profit
6
...
An activity is an event, task or unit of work with a specified
purpose e
...
designing product, setting up machines operating machines and distributing
products
...
ABC Seeks to attribute overhead costs to product on a more realistic basis rather than
production volume and also attempts to show the relationship between the overhead cost
and the activities that caused them
...
g
...
Identifying the factors which determine the cost of an activity called cost drivers
...
Mainly expressed as a percentage of the chosen driver
...
Long term variable overhead – which is fixed in the short term but varies in the
long term
Fixed overheads – which do not vary
89
a) Short term variable overhead
Are the costs that vary with production volume e
...
indirect labor, indirect material, cost
of power e
...
c
...
Such as direct labor hours, machine hours, direct material costs, number of
units etc
b) Long term variables
Are an overheads cost which do not vary with production volume but varies with other
measuring activities e
...
cost of support services like stock handling cost, production
scheduling, and machine set up etc
...
ABC requires that these overhead be traced to the product by transaction
based cost drivers
...
makes 4 products 1, 2, 3 & 4
...
Products
1
2
3
4
Output
25
25
250
250
No
...
7 per unit
Overheads
Ksh
...
16
...
94
65
...
95
65
...
46 × overheads)
b) A
...
C
...
A
...
Short term variable = 8,250/1650hrs
Ksh
...
320 per product run
Set up cost = 3,650/24hrs
Ksh
...
2 per material component
Cost Schedule
Product
1
2
3
4
Direct material
30
75
30
75
(2×5) = 10
(4×5) = 20
(2×5) = 10
(4×5) = 20
8
...
8
Short term variable
(Scheduling cost × no
...
of units
Set up cost × no
...
of units
(320×3)/25 = 38
...
2
(150×3)/25 = 18
24
42
6
(2 × 8) = 16
10
16
12
Material handling cost × material components
Note: ABC is costly and undervalues the profits, absorption costing over values the
profits and is cheaper
...
The expected volume of production
was 14,000 units so the fixed overhead rate was $98,000÷14,000=$7 per unit
Budgeted sales price was $75 per unit
...
Assume that there
were absolutely no variances from standard and variable costs or budgetd selling prices
or budgeted fixed costs in 20X4
...
For 20X4, prepare income statements based on standar4d variable (direct) costing
and standard absorption costing
Consider the following actual data for 20X5:
Direct materials
$285,000
Direct labor
174,200
Variable factory overhead
36,000
Fixed factory overhead
95,000
Selling and administrative costs
Variable
118,000
Fixed
80,000
Sales
1,068,000
For 20X4, prepare income statements based on standar4d variable (direct)
costing and standard absorption costing
Explain why operating income differs between variable costing and
absorption costing
...
Horngren et
...
, 2009, Introduction to Management Accounting, 14
th
Ed, Dorling
Kindersley, New Delhi Pg 588- 635
...
H
...
W
...
0 CHAPTER SEVEN: BUDGETING
Learning Objectives
By the end of this chapter the learner should be able to:
Explain the meaning of budgetary control
Describe the role and rationale of budgeting- functions of budgets, advantages of
budgets and budgetary control systems
Identify the different types of budgets
Illustrate the mechanics of budgeting
Identify the stages in the budgeting process and the Steps in developing a master
budget
Discuss the human aspects of budgeting
Describe alternative budgeting procedures- Zero-Based Budgeting (ZBB), ActivityBased Budgeting, Incremental budgeting
The CIMA definition of a budget is: “A plan quantified in monetary terms, prepared and
approved prior to a defined period of time, usually showing planned income to e
generated and/or expenditure to be incurred during that period ad the capital to be
employed to attain the given objective”
A budget is therefore an agreed plan which evaluates in financial terms the various
targets set by a company’s management
...
1 Budgetary Control
The CIMA definition of a budget control is: “the establishment of budgets relating the
responsibilities of executives to the requirements of a policy and the continuous
comparison of actual with budgeted results, either to secure by individual action the
objective of that policy or to provide a basis for revision”
Budgetary control allows management to review variances in order to identify aspects of
the business that are performing better or worse than expected
...
Corrective action s then taken to reduce the impact of
adverse trends
94
7
...
These targets are
set in conjunction with each manager with each manager in this way managers are
committed to achieving their budgets
...
Identifying problems in advance allows the firm
to take the necessary corrective action to alleviate difficulty
Scope for improvement is identified
Budges will identify all the areas that can be improved thereby increasing efficiency and
profitability
Improved coordination
All the managers’ plans are combined and evaluated so that a total budget for the
company can be prepared
...
All variances will be monitored
and positive action taken in order to correct those areas of the business that are failing to
perform
95
Raising finance
Any provider of finance will want to satisfy itself that the company is being managed
correctly and that funds advanced will be repaid and interest commitments honored
...
7
...
The master budget is
analyzed into subsidiary budgets which detail responsibility for generating sales and
controlling costs
Capital budgets
These budgets detail all the projects on which capital expenditure will be incurred during
the following year and when expenditure is likely to be incurred
...
Capital
budgets enable the fixed asset section of the balance sheet to be completed and provide
information for the cash flow budget
Cash flow budgets
This budget analyses the cash flow implications of each of the above budgets
...
The
cash flow budget will also include the receipt of finance from loans and other sources
together with forecast repayments
...
4 Mechanics of budgeting
Stages in the budgeting process
96
Communication of the details of a budget policy and guidelines to those
people responsible for the preparation of budgets
It is essential that all managers be made aware of the policy of top management for
implementing the long term plan in the current year’s budget so that common guidelines
can be established
...
In
many organizations the factor is sales demand, but it is also possible for production
capacity to restrict performance if sales demand is in excess of production capacity
...
It is therefore the most important
budget since other budgets are based on it and most difficult to prepare because it is
based on the action of customers, the state of the economy and competitors
Initial preparation of various budgets
Managers responsible for meeting the budgeted performance should prepare the budgets
for those areas fro which they are responsible
...
The managers at this level should submit their budgets
to their superiors for approval who in turn submit the budgets to their superiors for
approval and so on
Coordination and review of budgets
As the individual budgets move up in the organizational hierarchy in the negotiation
process, they must be examined in relation to each other
...
This enables management to identify those items not proceeding according to
plan, reasons investigated and if the reasons are within managements control corrective
action is taken
Steps in developing a master budget
Prepare a sales/revenue budget
Prepare the production budget (in units)
Prepare the direct material usage budget
Prepare the direct material purchase budget
Prepare the direct manufacturing labor budget
Prepare the direct manufacturing/factory overhead budget
Prepare ending inventories budget
Prepare the cost of goods sold budget
Prepare non-manufacturing/selling and administration budget
Prepare the cash budget
Prepare the budgeted income statement
Prepare the budgeted balance sheet
Prepare the departmental budgets*
Example: The following illustration is adapted from (Drury 2004: 601)
XTC Company manufactures two products; alpha and beta which are produced by
department 1 and 2 respectively
...
20 per unit
Material Y
Ksh 16
...
00 per hour
ii) Overhead is recovered on a direct labor hour basis
iii) The standard material and labor usage for each product are as follows:
alpha
beta
Material X
10 units
8 units
Material Y
5 units
9 units
Direct labor
10 hrs
15 hrs
iv) Finished products:
alpha
beta
Forecast sales (units)
8,500
1,600
Selling price per unit (Ksh)
400
560
Required ending inventory(units)
1,870
90
Beginning inventory(units)
170
85
v) Direct material:
Material X
Material Y
Beginning inventory
8,500
8,000
Required ending inventory
10,200
1,700
vi) Budgeted variable overhead rates per direct labor hour:
Dept 1(Ksh)
Indirect materials
1
...
80
Indirect labor
1
...
20
Power (variable portion)
0
...
40
Maintenance(variable portion)
0
...
40
Dept 1(Ksh)
Dept 2(Ksh)
Depreciation
100,000
80,000
Supervision
100,000
40,000
Power (variable portion)
40,000
2,000
Maintenance(variable portion)
vii)
Dept 2(Ksh)
45,600
3,196
Budgeted fixed overheads:
Estimated non-manufacturing overheads:
99
(Ksh)
Administration – stationary etc
4,000
Salaries: -Sales
74,000
-Office
28,000
Commissions
60,000
Vehicle expenses(sales)
22,000
Advertising
80,000
Miscellaneous (office)
8,000
Total
276,000
Budgeted cash flows:
Quarter 1
Quarter 2
Quarter 2
Quarter 2
(Ksh)
(Ksh)
(Ksh)
(Ksh)
1,000,000
1,200,000
1,120,000
985,000
400,000
480,000
440,000
547,984
Payments for wages
400,000
440,000
480,000
646,188
Other costs & expenses
120,000
100,000
72,016
13,642
Receipts from customers
Payments: Materials
The balance sheet for the previous year end 200X was as follows:
Ksh
Fixed assets: Land
Ksh
Ksh
170,000
Buildings and equipment
Less depreciation
1,292,000
255,000
Current asset: Stocks -Finished goods
-Raw materials
1,037,000
1,207,000
99,076
189,200
Debtors
289,000
Cash
34,000
611,276
Less current liabilities: Creditors
248,800
362,476
Net assets
1,569,476
Represented by Shareholder’s Funds:
1,200,000 ordinary shares f Ksh 1 each
Reserves
1,200,000
369,467
1,569,476
Required:
Prepare a master budget for the year 200X and the following budgets
100
Sales budget
Production budget
Direct material usage budget
Direct material purchase budget
Direct labor budget
Factory overhead budget
Selling and administration budget
Cash budget
Solution:
Sales/revenue budget
It shows the quantities of each product the company plans to sell and the intended selling
price
...
Sales budget for the year 200X
Product
(1) Units sold
(2) Selling price
(3)Total revenue= (1)×(2)
Alpha
8,500*
400*
3,400,000
Beta
1,600*
560*
896,000
4,296,000
*See information item (iv) - finished products
In practice total sales budget for the year is broken down into subsidiary monthly sales
budgets
Production budget
This budget is expressed in units only and the responsibility of the production manager
...
20
102,000*
734,400
12,840***
92,448
114,840
Material Y
16
...
Te objective is to
purchase the materials at the right time and at the planned purchase price taking into
consideration the planned inventory levels
Annual direct material purchase budget
Material X
Material Y
Quantity necessary to meet production
(as per material usage budget – column 6)
102
65,445
10,200
Required closing inventory*
114,840
1,700
125,040
67,145
Less beginning inventory*
8,500
8,000
Total units to be purchased
116,540
59,145
× 7
...
Annual direct labor budget
Dept 1
Dept 2
Budgeted production (units)*
10,200
1,605
Production hours per unit**
×10
×15
102,000
24,075
126,075
×12
×12
×12
1,224,000
288,900
1,512,900
Total budgeted hours
Budgeted wage rate per hour (Ksh)***
Total wages(Ksh)
Total
See annual production budget
See information item (iii) - direct labor usage
See information item (ii) - direct labor cost
Factory overhead budget
This is the responsibility of the respective production department managers
...
The overheads are analyzed according
to whether they are variable or fixed
Annual overhead budget: anticipate activity – 102,000 direct labor hrs for dept 1 and
24,075 direct labor hrs for dept 2
Variable overhead
Rate per hour
103
Overheads
Total
Dept 1
Dept 2
Dept 1
Dept 2
(102,000)
(24,075)
Variable overheads
Indirect material
1
...
80
122,400
19,260
Indirect labor
1
...
20
122,400
28,890
Power (variable portion)
0
...
40
61,200
9,630
Maintenance (variable portion)
0
...
40
20,400
9,630
326,400
67,410
Depreciation
100,000
80,000
Supervision
100,000
80,000
Power (variable portion)
40,000
2,000
Maintenance (variable portion)
45,600
3,196
285,600
125,196
410,796
612,000
192,606
804,606
6
...
00
393,810
Fixed overheads
Total overhead (variable + fixed o/h)
Budgeted departmental overhead rate (Total overhead ÷
budgeted hrs for each dept)
vii)
Prepare ending inventories budget
Direct materials
Material X
Material Y
Required closing inventory
10,200
1,700
Planned unit purchase price (Ksh)
× 7
...
6
620,840
45,144
Total value of each finished product
Total planned closing inventory
Total
100,640
665,984
766,624
*Finished goods cost is calculated as follows:
Alpha
Cost Units used
Direct materials
104
Beta
Ksh
Units used
Ksh
X
7
...
00
8
57
...
00
15
80
...
00
12
10
120
...
00
Dept 1
6
10
60
...
00
Direct labor
Factory overheads:
332
...
60
Prepare the cost of goods sold budget
Ksh
Opening inventories:
Finished products (170 × 332
...
60)
99,076
Direct materials (8,500×7
...
00)
189,200
Direct material purchases *
1,785,408
Direct labor*
1,512,900
Factory overheads*
804,606
Less closing inventories*
(766,624)
Cost of goods sold
3,624,566
See respective budgets
Prepare non-manufacturing/selling and administration budget
Ksh
Selling: Salaries
Ksh
74,000
Commissions
60,000
Car expenses
22,000
Advertising
80,000
Administration: Stationary
4,000
Salaries
28,000
Miscellaneous
8,000
236,000
40,000
276,000
Prepare the cash budget
The objective of the cash budget is to ensure that sufficient cash is available at all times
to meet the level of operations outlined in the various budgets
...
e
...
e
...
e
...
20 per unit
734,400
51,000 units of material Y at Ksh 16 per unit
816,000
Variable overheads (see factory overheads budget):
107
1,550,400
Actual(Ksh)
Indirect material
122,400
Indirect labor
122,400
Power (variable portion)
61,200
Maintenance (variable portion)
20,400
326,400
Fixed overheads (see factory overheads budget):
Depreciation
100,000
Supervision
100,000
Power (variable portion)
40,000
Maintenance (variable portion)
45,600
285,600
3,386,400
Exercise:
ABC Limited wishes to prepare an operating budget for the forthcoming period
...
Opening stocks of material X was 300kg and for material Y were 1,000liters
...
Required:
Prepare the following budgets;
Production in units
Material usage (kg and litres)
Materials purchase (kg, litres and Ksh)
108
Labor (hours and Ksh)
State and discuss the usefulness of budgets
Human aspects of budgeting
Reaction of mangers to budget levels
If the objective is to achieve success rather than avoid failure, then budgets which are set
difficult or too easy at as demotivators whereas those of moderate difficulty provide the
highest levels of motivation
If the objective id to avoid failure rather than achieve success, then even moderate
difficulty targets will not be attempted only those of easy level of difficulty will be
attempted
...
Commitment may be enhanced by demonstrating to each employee the benefit
that they can derive from the process, using the process for future promotions,
recognizing and appreciating the efforts of implementers, identifiers of reasons for
variances and suggestions of corrective actions etc
Problem of separate budget centers in relation to staff motivation
In big organizations it is very difficult to relate one budget center to the budget of the
remaining centers and although each center will know its results, it may not appreciate
how its results have contributed to the total business performance
...
7 Alternative Budgeting Procedures
Zero – Based Budgeting (ZBB)
ZBB starts from the assumption previous budgets are meaningless in the context of those
currently being set and so all budgeting starts at a nil basis from which all expenditure is
identified
...
Each functional budget starts with the assumption that the
function does not exist and is at zero cost
...
An American fostered concept, this definition shows that the benefit to be derived
exceeding its costs is a central factor, No activity can automatically assume that funds
will continue to be received, it is necessary to prove that any funds that are allocated will
achieve a positive benefit for the organization
...
In relation to the provision of health care for instance this might include
breaking it down into the distinct units of maternity care, psychiatric treatment and so on
...
Decision Units
Once the organization has been broken down into logical units the next step is to analyse
it into decision units which are basically any activity for which a decision needs to be
made about the resources to be allocated to it
...
Decision packages
Each decision unit has a budget prepared for it by the function concerned which details
the resources it requires and the benefits which should accrue
...
Each package will be made up of a “base” package, which details the minimum
requirements for the decision unit concerned, and “incremental packages which are the
provision of greater levels of service that the manager concerned considers desirable
...
Each package will have its own budget and analysis of expected benefits
...
This
may be done by senior management, who are responsible for the overall allocation of
resources within the organization, or by the managers themselves, because, as you can
imagine, there is the potential for there to be a vast number of packages under
consideration
...
Each base package should be ranked as the highest priority for that particular decision
unit with each of the incremental packages ranked in descending order of importance
...
It is possible therefore, that one decision unit may have all its
decision packages ranked high enough to be accepted; another unit may receive only a
portion because its expected benefits in terms of cost are ranked lower overall
...
The traditional problem of slack being built into incremental budgeting exercises
should be eradicated because each request for funds starts from a “zero base”
and has to justify itself
...
Past inefficiencies that have been built into the budget are excluded
...
Difficulties encountered
There is a large volume of extra work associated with starting the budgeting
process from scratch in each new period
...
There is the difficulty of deciding on benefits derived under cost-Benefit Analysis
...
Thus, packages
which were originally accepted might be rejected if the analysis were to be
undertaken again and vice versa
...
This can be overcome by making sure that a
package is used as a “base” and therefore obtains a higher priority
...
112
ZBB despite its many advantages is much less widespread in the UK that it is in the
United States possibly because of the large amount of extra work involved and the much
more “tradition” outlook of British companies
...
It also forms a link between planning and budgeting
The process begins with the breaking down of the strategic plan into plans or objectives
for individual business units and by the use of activity analysis, into plans for the
individual activities themselves
...
Critical success factors are also an important
element in the process and once these are known, performance indicators can be set for
them to determine how the company is performing in comparison to its activity-based
budget
...
The advantages claimed for the process are similar to those for activity based costing:
Identification of inefficient processes and unprofitable products is made easier
Elimination of non-value added activities
Enhanced performance measurements and control
There is better control over the causes of cost of identifying them with the activities
they result from
It provides the ability to view the organization from a different perspective that cuts
across traditional departmentalization
Incremental budgeting
113
This is the traditional method of budgetary control which uses the previous year’s budget
as the basis for the current year’s budget, usually with an allowance for change due to
inflationary activity or efficiency
...
The disadvantages of such an approach, particularly when
compared to the previous two budgeting methods are as follows:
There is no focus on the efficient use of resources by identifying the activities
they emanate from
...
The link with the strategic plan is often non-existent
A further result of its arbitrary nature is that commitment on the part of those
responsible for budget achievement may be low
...
Review Questions
What are the major benefits of budgeting?
Describe the mechanics of budgeting
Explain the steps in developing a master budget
Describe the advantages and limitations of various budgeting approaches
KPLC plans inventory levels (at cost) at the end of each month as follows: May,
$275,000; June, $220,000; July, $270,000 and August, 240,000
...
Cost of goods
sold is 60% of sales
...
Payments
for each month’s purchases are made as follows: 10% during that month; 80% the
next month and the final 10% the next month
...
al
...
Garisson R
...
, and Noreen E
...
, 1997 Managerial Accounting, 8th Ed,
MacGrraw-Hill, New York, Pg 324-357
115
Sample Papers
DEPARTMENT OF ACCOUNTING AND FINANCE
BBM221: MANAGEMENT ACCOUNTING 1
Time: 2 Hrs
Instructions to Candidates: Answer question 1 (Compulsory) and any other TWO
questions
...
Sales are expected to
be June, $440,000: July, $350,000; August, $420,000
...
Purchases in April were $250,000; May $180,000
...
Prepare budget schedules for June, July and August for
purchases and for disbursement for purchases
...
The following is the budget for the product
Budget
Selling price Ksh
...
3
Direct wages per unit Ksh
...
1
Fixed production overhead Ksh
...
A market analysis has a 30% probability of annual sales
being 5000 boats, and a 40% probability of 4000 annual sales
...
10,000 per boat and a fixed cost and
sh
...
Alternatively they can go into full production where variable cost
are sh
...
5,000,000 annually, if the new boat is to be
sold for shs
...
The result of this in most 12 weeks research carried out is as shown below;
Week
13
...
15
...
17
...
19
...
21
...
23
...
Machine hours(cost driver)
68
88
62
72
60
96
78
46
82
94
68
48
Indirect labor costs
$1,190
1,211
1,004
917
770
1,456
1,180
710
1,316
1,032
752
963
Find the indirect labor costs associated with 90 machine hours and (b) the machine hours
that $1,000 of indirect labor cost would produce
...
9 per
unit
...
5 per unit and the T F C is sh
...
Assume that the company intends to make a profit before tax of 20% of sales,
determine the number of units that must be sold
...
Compute the number of units that must be sold to earn this target
profit
...
10mks
Question 5
Kawasaki Company Ltd manufactures a broad range of engines for commercial products
...
Information on these products is as follows:
117
Engine type
Selling price
Variable cost per unit
Contribution per unit
Contribution margin percentage
(Ksh 24/80; 50/125 & 37
...
5%
60
Motor bike
engines
Ksh 125,000
Ksh 75,000
Ksh 50,000
40%
60
Assume that only 600 machine hours are available daily for assembling engines,
additional capacity can not be obtained in the short run
...
It takes 2, 5 and 5 machine hours produce one power saw, one lawnmower and one
motor bike engine respectively
...
Question 1
Discuss the role of management accounting in the management process? 5mks
Describe the decision making process 5mks
The following information is available for XYZ Company
Units sold (000)
Units produced (000)
1
150
150
2
120
150
Period
3
4
180 150
150 150
5
140
170
6
160
140
Budgeted activity is expected to average 150,000 units per period and there is no opening
stock for period 1
...
Required:
Prepare a profit and loss statement based on variable and absorption costing 10mks
KPLC plans inventory levels (at cost) at the end of each month as follows: May,
$275,000; June, $220,000; July, $270,000 and August, 240,000
...
Cost of goods sold is 60% of
sales
...
Payments for each month’s
purchases are made as follows: 10% during that month; 80% the next month and the
final 10% the next month
...
New product development can either be undertaken through thorough
development at a cost of Shs
...
The
following are the expected outcomes, accompanying probabilities and the projected
revenue for of the options
...
4
0
...
2
1000000 50000 2000
Rapid development
good
mod
poor
0
...
2
0
...
3
0
...
3
0
...
4
400000 20000 6000 20000 2000
Should the company develop a new product or consolidate existing product? 20mks
Question 3
Assume that the product manager of ABC Ltd is concerned about the apparent
fluctuations in efficiency and therefore work done by employees which are related to the
volume
...
26
...
28
...
30
...
32
...
34
...
36
...
Use the regression method 20mks
Question 4 (20mks)
Auto Robot Ltd which manufactures two products P & Q has provided the following
information
...
E
...
of each product in units and in shs
...
E
...
Question 5
Consider the following data concerning Copy Cat Photocopying Limited
Old equipment
Useful life in years
Current age in years
Original cost
Accumulated depreciation
5
2
$25,000
10,000
120
Proposed replacement
equipment
3
0
$15,000
0
Book Value
15,000
Not acquired yet
Disposal value(in cash ) now
7,000
Not acquired yet
Disposal value in 3 years
0
0
Annual cash operating costs for
power, maintenance, toner etc
14,000
8,000
Copy cat is trying to decide whether to replace the old equipment
...
Ignore the effects of taxes 20mks
121
Title: MANAGERIAL ACCOUNTING I
Description: these notes involve the purpose and scope of management accounting, decision making, cost estimation and forecasting, absorption cost and marginal cost, budgeting, short term planning and revision questions
Description: these notes involve the purpose and scope of management accounting, decision making, cost estimation and forecasting, absorption cost and marginal cost, budgeting, short term planning and revision questions