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e-learning content Director Dcel: elearning@cuck.ac.ke

COURSE:BACHELOR OF COMMERCE

Unit code: HBC 2203

Unit title : COST ACCOUNTING

Author : Cpa, Jacob 0. Indika

Department of Accounting & Finance ,Faculty of commerce ,

The Cooperative University College of Kenya (Cuck)

Date:8th December, 2014

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CONTENTS

LESSON ONE : INTRODUCTION TO COST ACCOUNTING

LESSON TWO : OVERHEADS

LESSON THREE: MARGINAL AND ABSORPTION COSTING

LESSON FOUR : RELEVANT COSTING

LESSON FIVE: COST ACCOUNTS

LESSON SIX : CONTRACT COSTING

LESSON SEVEN : COST-VOLUME-PROFIT (C-V-P) ANALYSIS

LESSON EIGHT: BUDGETING AND BUDGETARY CONTROL

LESSON NINE: PROCESS COSTING

LESSON TEN: STANDARD COSTING AND VARIANCE ANALYSIS

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LESSON ONE: INTRODUCTION TO COST ACCOUNTING

Lesson Objectives:

After studying this lesson, the learner is expected to:

Define and explain the purposes and scope of Cost accounting.

Explain the differences between Cost accounting, Management accounting and Financial

accounting.

Identify elements of costs and classify costs.

Understand need for cost control systems, their effects and problems

Apply costing principles and prepare cost statements.

1.1 Definitions of cost accounting

Cost accounting may be defined as ‘The establishment of budgets, standards costs and

actual costs of operations, processes , activities or products and the analysis of variances, or

the social use of funds’ .Terminology.

Cost accounting has been defined as ‘The application of accounting and costing principles,

methods and techniques in the ascertainment of costs and the analysis of savings and /or

excesses as compared with previous experience or with standards’. C.I.M.A.

It is clear from the above definitions that cost accounting or costing is important for provision

of accounting information that is useful for planning , decision making and cost control in

both commercial and non-profit making organisations. The first step in costing is to ascertain

or establish costs incurred or to be incurred in making a product or providing a service .For

instance, the costs incurred in manufacture of a product are direct materials, direct labour

and production overheads (eg fuel, electricity, water, lubricants).Costs incurred in training

would include hire of lecture hall, facilitators fees, computers, laptops, projectors, stationery,

meals and transport etc.

1.2 Purposes of cost accounting

The following can be described as the main purposes of costing:

Ascertainment of costs-establishment of cost incurred historically by cost centres, by

predetermined standards and variance analysis or by use of marginal methods.

Decision making-such as choice of product mix, make or buy and special order

decisions

Cost control-comparison of budgeted and actual results and variance analysis

Planning-expansion of business, acquisition of new plant and machinery ,increasing

production capacity

Measurement of efficiency-better utilisation of resources and improving performance

Setting of selling prices-cost plus profit mark-up used to get sales price

Evaluation of profitability- determination of performance via net income achieved.

Budgeting-preparation of operational and financial budgets such as material, labour,

production cost budgets and profit or loss budgets.

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1.3 cost control and cost reduction

It is necessary to distinguish between cost control and cost reduction. Cost control

aims at conformity with some set standards, norms or benchmarks which are taken to be

targets for measuring efficiency. Standards are taken as the minimum costs for

production or providing a service or running a department. Therefore cost control can

only be effective when certain standards are set and communicated to managers

responsible for achieving them.

Cost reduction is an achievement of real and permanent reductions I costs and even

continuously challenges standards for improvement. It is embraces a dynamic approach

and corrective function as compared to cost control. It may be said that cost control is

only an attempt to cost reduction.

1.4 Cost Accounting and management accounting

Management accounting may be defined as ‘ An integral part of management concerned

with identifying , presenting and interpreting information used for Formulating strategy,

Planning and controlling activities ,Decision making; Optimising the use of resources

,Disclosure to shareholders and others external to the entity, Disclosure to employees,

Safeguarding assets. Thus the management accountant is part of senior management and

his task is to ensure that there is effective formulation of plans to meet company both long-

term and short- term company objectives ,sourcing and utilisation of funds, recording of

transactions , communicating of financial and operating information ,analysing costs and

revenues and reporting on variances and making regular reviews on systems and operations

and recommend corrective action as necessary .It can be said that cost accounting is part of

management accounting with greater emphasis on the costs of functions ,activities,

processes and products. Essentially, there is a thin line between cost accounting and

management accounting.

1.5 Cost accounting and financial accounting

Financial accounting can be defined as ‘ The classification and recording of monetary

transactions of an entity in accordance with established concepts, principles, accounting

standards and legal requirements and presentation of a view of those transactions during

and at the end of an accounting period’. Financial accounting deals mainly with the

preparation of financial statements (Final accounts) for external reporting .Final accounts

detail the performance of an organisation over a defined period and show the state of affairs

at the end of that period in form of profit or Loss and Balance Sheet statements. In Kenya, it

is mandatory for limited liability companies to prepare annual accounts in accordance with

the requirements of the Companies Act and International Accounting Standards. Financial

accounting relies heavily on historical financial information of monetary nature. On the other

hand, cost accounting emphasises on internal reporting. However, financial accounting

heavily relies on costing information for financial data. Because of the significance of these

two types of accounting, most organisations have set up costing and financial accounting

departments to address the aforementioned functions .The basic differences between cost

accounting and financial accounting can also be summarised in next paragraph.

1.6 Typical issues that may confront the Cost Accountant

The following are the typical problems that may confront the cost accountant:

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1. How a company can attempt to produce and sell more products within the existing

capacity or limited resources.

2. Effect of dropping a certain product/ department on the company’s net profit.

3. Effect on net profit on acceptance of a special order.

4. The make or buy decision

5. Whether selling prices should be increased as a result of a wage increase award.

6. Decreases in net profit despite substantial increase in output.

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1.7 Elements of cost

A cost may be defined as ‘The amount of expenditure (actual or notional) incurred

on, or attributable to, a specific thing or activity’.

The total cost of making a product or providing a service consists of cost of materials

, cost of wages and salaries(labour costs ) and cost of other expenses (egg Rent and

rates, Electricity, water , fuel and lubricants, depreciation etc.).

Costs may be classified as under:

1) Fixed and Variable costs

Total cost is the sum of fixed cost and variable costs, although some

A fixed cost is a cost which is incurred for a particular period of time and which,

within certain activity levels is unaffected by changes in the level of activity.

A variable cost is a cost which tends to vary with the level of activity. Activity is

measured by output or volume of sales (quantity).

Examples of fixed costs are rent and rates, insurance, salaries, interest charges,

cost of stationery, advertising and sales promotion expenses.

Variable costs include the cost of direct materials, direct wages, and sales

commission.

2) Direct and indirect cost

A direct cost is a cost that can be fully traced to the product, service, or

department that utilises that cost.

An indirect cost is a cost which cannot be directly traced to a particular

product, service or department that incurred the cost.

Material, labour and other expenses can be classified as either direct costs or

indirect costs.

Direct materials, direct labour and direct expenses are direct costs .They are

often referred to as prime cost.

Direct materials include raw materials, component parts, work in progress and

key packaging materials.

Direct labour includes direct wages for workers engaged in factory, product

inspectors, analysts and testers specifically required for such production,

foremen and shop clerks etc.

Direct expenses ( also called chargeable expenses) include expenses for hire of

specialised tools or equipment for a particular job, maintenance costs of tools ,

fixtures etc.

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Indirect costs are costs for indirect material, indirect wages and indirect

expenses. Indirect materials are materials which cannot be traced in the finished

product eg consumable stores (nuts, bolts, nails, lubricating oil ).

Indirect wages include wages for non-productive personnel in the production

department eg factory supervisors or foremen wages, storemen’s wages, wages

for maintenance, cleaners and repairers.

Indirect expenses include Rent, rates and insurance of factory, depreciation, fuel

, water, power, electricity charges ,maintenance of plant, machinery and

factory buildings.

3) Functional costs

This is the tradition costing system of classifying costs .It involves classifying

costs as either production/manufacturing costs, administrative costs , selling

costs or distribution costs.

Production costs are costs related to factory or manufacture and consist of costs

of raw material, labour and production overheads (factory rent, insurance,

depreciation , electricity and water etc ).

Administration overheads are costs related to general office work and support

departments ( Accounting, personnel, stores, purchasing, office maintenance )

and include office rent ,salaries ,depreciation ,stationery, finance costs,

directors emoluments, research and development, training etc.

Selling costs or marketing costs are the costs associated with promoting

products and securing customers orders. These include advertisement expenses,

salesmen salaries and commission, depreciation on delivery vans etc.

Distribution costs are the costs of the consequence of operations and are

incurred to ensure the finished product from warehouse is finally delivered to

customers. These costs include transport costs from factory to warehouse and

customers premises, costs of maintaining delivery vans( fuel, insurance ,repair

charges), salaries of delivery van drivers, mechanics, clerks, rent, rates,

insurance, water and electricity charges for the warehouse.

Research and development costs are cost for searching for new or improved

products ,enhancement of knowledge and innovations.

4) Other cost classifications :

Other cost classifications which may be of interest to a costing student are as

follows:

Product and period costs

Avoidable and unavoidable costs

Controllable and uncontrollable costs

Committed fixed costs and discretionary fixed costs

1.8 Cost control systems

The purposes of cost accounting can only be achieved if an effective costing

system is established and installed in the organisation .A costing system is

designed based on the requirements of the business entity .The system should

be designed so to be simple, economical and practicable.

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1Essential elements of an effective cost control system

The following are prerequisites for the success of a cost control system:

a) Cooperation and support from staff at all levels.

b) Budgets or standards should be mutually agreed upon where

appropriate.

c) Involvement of staff in the design and operation of system .

d) A well developed and adequate accounting system.

e) Staff training and development for better job performance and

competence.

f) Support and involvement of top management in the budgeting process.

2General possible problems with cost control systems

Possible problems of cost control systems include:

Resistance of introduction of new system due to job insecurity.

Setting standards and budgets is sometimes difficulty and time

consuming.

Set standards may be inaccurate if done in haste.

In order to mitigate the typical problems, before installing a cost control

system , a variety of factors such as the size and nature of organisation

business, methods of manufacturing processes, availability of equipment’s

,staff capability and capacity and other cost factors should be considered so

to come up with a well-designed system.

It is important to note that costing systems may be automated in order to

enhance efficiency or throughput e.g adoption of boilers to fasten

manufacturing processes in a factory .Other possible cost effects of such

automation include reduction of direct labour cost per unit, variable costs

and cost per unit. However, automation has often been resented by workers

through their labour unions due to fear of massive lay-offs of employees.

1.9 Cost Statements

Cost information may be presented in the form of statements under appropriate

headings depending on whether the organisation is in service, trading or

manufacturing industry. The two common forms of cost statements are:

production cost and profit statements. These statements may be prepared to

show:

Production cost or factory cost ( cost of goods manufactured )

Total cost of sales.

Total cost of sales, profit and sales (income statement).

The following cost relationship may be helpful in preparing cost

statements:

Direct material + Direct labour + Direct expenses = prime cost

Prime cost + production overheads = Full factory cost

Full factory cost + selling +administration + distribution overheads= Full

cost of Sales.

It is important to note the following when preparing cost statements:

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(i) Work in progress (WIP) :opening WIP is added to and closing WIP is

deducted from factory cost to obtain net factory cost as

necessary.

(ii) Profit Mark-up and Margin: There is a relationship between cost,

profit and sales ie COST PRICE + PROFIT =SALES PRICE or COST

OF SALES + PROFIT = SALES.

Profit mark-up =profit/cost price

Profit margin = profit/sales price

(iii) Contribution: It is defined as the difference of sales and

variable (marginal) costs .

Example 1

The cost accountant of Florida Ltd, which manufactures a product called”

Flora”, has provided the following information for a period:

Shs Direct material cost 300,000

Direct wages 80,000

Direct expenses 20,000

Fixed factory overheads 20,000

Distribution cost (fixed) 23,300

Additional information

Variable production overheads are absorbed at 12½% of the prime cost.

Administrative expenses (20% variable ) are 5% of factory cost.

Selling costs (50% variable) are 50% of the total administrative and

distribution costs.

The company’s profit margin is estimated to be 25%.

7,203 units of the product were sold during the period ; there were no

opening and closing stocks.

Required

a) Compute the selling price and sales ( to the nearest hundred) for the period.

b) Compute the contribution and contribution margin per unit.

Solution

a) Flora Ltd

Shs

Direct materials 300,000

Direct labour 80,000

Direct expenses 20,000

Variable production overheads 50,000

Variable administration overheads 4,700

Variable selling overheads 11,700

Variable cost of sales 466,400

Fixed production overheads 20,000

‘’ administration overheads 18,800

‘’ selling overheads 11,700

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‘’ distribution overheads 23,300

Total cost of sales 540,200

Add: profit mark-up 1/3 180,067

SALES 720,300

Selling price She 720,300÷7,203 = shs 100

b) Contribution = sales-variable cost of sales.

= shs 720,300-466,400 = shs 253,900

Contribution per unit = shs 253,900 ÷ 7,203 = shs 35

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LESSON ONE: QUIZZES

1 Which of the following is a characteristic of cost control?

A It’s main objective is to have continuous economy of costs.

B It is not contented only with performance as per predetermined standards.

C It is an achievement of predetermined costs or goals.

D It regards standards as benchmarks which can be improved upon.

Correct answer C

2 Which of the following is true of direct costs?

A They are production overheads

B They are prime costs .

C They are direct expenses

D They are not incurred in providing services

Correct answer B

3The costs involved in manufacture of a unit of product were : direct materials sh 4,000,

direct labour sh 3,000 ;production overheads were half of prime cost and direct expenses

were 25% of production overheads. The factory cost was:

A sh 12,000

B sh 8,000

C sh 7,000

D sh 11,000

Correct answer A

Factory cost=direct materials +direct labour+direct exps+producton ohd

= sh 4,000 +3,000+1,000+4,000=sh 12,000.

4 Match the following costs with the appropriate cost classification

Cost cost classification

a Salary of finance manager’s secretary (1) production costs

b Trade discounts given to customers (2) Administration overheads

c overtime pay for machine operators (3) selling costs

d Freight-in on materials used (4) Research& Development

e cost of chemicals used in the laboratory (5) Distribution costs

Answer

a(2), b(3), c(1), d(5), e (4)

5 State five factors to be considered when installing a costing system.

6 Identify six typical problems of installing a costing system.

7 Give two examples each for committed fixed and discretionary fixed costs.

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8 Explain any five advantages of having a costing department in an organisation.

9 Suggest any five limitations of cost accounting ( 10 marks)

Answers to quizzes 5-9

5Factors to be considered when installing a costing system:

The size and organisation of the business.

The methods of manufacture

The type of product

The availability of staff

Amount of data processing , equipment availability etc

6 Typical problems when installing a cost control system :

Definition of responsibilities

Definition of cost centres

Compilation of comprehensive coding systems

Accurate recording systems for materials, labour, machine usage etc

Definition of direct and indirect costs, fixed and variable costs,period and

product costs etc

Development of appropriate methods for overhead apportionment and

absorption

Development of appropriate material issues and valuation methods

7)i Committed fixed costs are those costs arising from the possession of fixed and

intangible assets such as plant and machinery, Motor vehicles , computers , goodwill

.These assets give rise to depreciation and amortization expenses.

ii Discretionary fixed costs are controllable costs which result from management’s

decisions and are easily altered and incurred depending on prevailing circumstances.

They include training expenses, research and development and some personal

emoluments.

8 Advantages of cost accounting

Communicating financial information for :

iplanning – product design, standardisation. Pricing, budgeting

iicost control- variance analysis and investigations

iii Decision making-Make or Buy ,special order, product mix , shut down decisions etc

iv performance measurement and evaluation -responsibility accounting

v Formulating overall strategies and long term plans

9 Limitations of cost accounting

I It entails a lot of costs to instal and operate a costing system

ii Complexity of systems and bereucracy in running them

iiiCosting systems may not be easily implemented or appropriate to the entity

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ivThere may resistance from workers’ union against introduction of new system.

LESSON ONE:QUESTIONS

1 Copa sacco Ltd owns a printing press. The costs involved in printing and selling a batch

of 100 books are as follows:

shs

Direct materials 87,500

Direct labour 12,500

Direct expenses 3,000 Indirect factory overheads 17,000 Administration overheads 15,000 Distribution overheads 5,000 Selling overheads 4,000 Profit margin 20%

Required: Prepare cost statements to show Prime cost, Production cost, Total cost , Sales and selling price ( 10 marks).

Answer

Copa sacco Ltd

Cost statement

shs

Direct material 87,500 Direct labour 12,500 Direct expenses 3,000 PRIME COST 103,000 Indirect factory overheads 17,000 PRODUCTION COST 120,000 Administrative overheads 15,000 Distribution overheads 5,000 Selling overheads 4,000 TOTAL COST 144,000 Add : Profit (¼×144,000) 36,000 SALES 180,000 Selling price per book sh 1,800 (10 marks)

2 A firm manufactures a product whose sales are very volatile. It engages salesmen and a manager

who are paid on commission basis. Sales commission is 5% of sales. Managers commission is 10% of

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profits before his commission. It is the firm’s policy to charge sales commission before other

expenses. In year 2012, the Net profit was shs 9,000 (sh’000) and factory expenses, excluding the

commissions , were shs 6,500 (sh’000).

Required:

a) Formulate an equation to show the relationship between sales, factory expenses and profit ( 6

marks).

b) Determine the sales commission and manager’s commission ( 4marks)

c) Prepare profit statement for the period ( 6 marks)

d) Suppose the sales were shs 20,000 ( sh’000) and factory expenses were shs 7,000 ( sh’000),

calculate the managers commission and Net profit for the period ( 4 marks)

Answer

a) Let S= sales e= sales commission C= manager’s sales commission E= factory expenses excluding commissions. P= Net Profit, Then S-e-C-E=P and C=1/10 ( 0.95S-E), e= 0.05 S Solving for P, P=0.855S-0.9E or S= I/0.855 ( P+ 0.95 E). b) If P=9,000 and E= 6,500 Sales (S)= 1/0.855 ( 9000+ 0.90×6,500)=17,368 (sh’000) Sales commission (e)=5% × 17,368= 868 (sh’000) Manager’s commission=1/10 ( 0.95 ×17,368- 6.500)= 1,000 (sh’000) c Profit statement for year 2012 sh’000 sales 17,368 Less:sales commission 868 16,500 Less :Expenses 6,500 Profit before manager’s commission 10,000 Less: Manager’s commission 1,000 Net Profit 9,000

d Profit, P= 0.855(20,000)-0.90 (7,000 )= 10,800 (sh’000) Manager’s commission, C= 1/10 ( 0.95×20,000-7000 )=1,200 (sh’000) 3 Morris Ochoka,the financial controller of Sabatia enterprises Ltd, accidentally tossed the company’s cost records into a wastebasket which had been light .On realising that mistake, he rushed to the roaring blaze and managed to retrieve only a few of the records.From the salvaged records, he managed to determine the following facts about the current year 2014:

(i) Sales totalled sh 1000,000 during 2014. (ii) The beginning inventories for the year were : work in progress sh 120,000; Finished

goods sh 60,000. (iii) There were no closing inventories of raw materials. (iv) Direct labour is equal to 25% of conversion cost; direct labour is also equal to 40%

of prime cost. (v) The work in progress inventory decreased by sh 20,000 during the year. (vi) Gross margin during the year was 55% of sales. (vii) Manufacturing overheads amounted to sh 240,000 in the year.

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(iv)Administrative expenses for 2014 were twice as great as net income but only 25% of selling expenses.

The company’s Board of directors requires cost statements from Mr. Ochoka for an urgent board meeting. Required :Prepare cost statements for cost of goods manufactured, cost of goods sold and profit for the year (clearly show workings for direct material and direct labour cost for the year) ( 20 marks ) Answer Let M=direct materials , L= direct labour, A=Administration expenses, S= Selling expenses and N= net profit/income. L= 25% ( L+ 240,000 ) , 4L= L+ 240,000, L=80,000 Also L=40% ( M+80,000) ie 80,000= .40 ( M+80,000) , M=120,000 Then A=2N and A= 25% ×S ie S=8N Gross profit (GP)= 55% ×1000,OOO = 550,000; then cost of sales =450,000 GP-A-S=N ie 550,000-2N-8N=N, Solving for N, N=50,000 A=2×50,000=100,000 and S= 4×100,000=400,000. Sabatia enterprises a Statement of cost of goods manufactured for year 2014 Sh Direct materials 120,000 Direct labour 80,000 Manufacturing overheads 240,000 440,000 Add: Beginning WIP 120,000 Less: Ending WIP (100,000) Cost of goods manufactured 460,000 b Cost of goods sold (sales) Sh Beginning finished goods inventory 60,000 Add:Cost of goods manufactured 460,000 520,000 Less: Ending finished goods inventory 70,000 Cost of sales 450,000

c Profit statement for year 2014 shs Sh Sales 1,000,000 Less: Cost of sales 450,000 Gross profit 550,000 Less: Operating expenses Administration expenses 100,000 Selling expenses 400,000 500,000 Net profit 50,000

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LESSON TWO: OVERHEADS Lesson objectives At the end of this lesson, the learner should be able to:

a) Explain the different treatment of direct and indirect expenses. b) Allocate and apportion production overheads to cost centres using an appropriate basis.

c) Describe the steps involved in calculating overhead absorption rates d) Calculate and explain under and over absorbed overheads. 1.1 Overheads and absorption costing

Overhead is the cost incurred in the course of making a product, providing a service or running a department , but which cannot be traced directly and in full to the product, service or department .Overheads comprise indirect materials , indirect labour and indirect expenses. Overheads can be classified as production, administration, selling and distribution . Absorption costing method is generally used in dealing with overheads.The objective of absorption costing is to include in the total cost of a product an appropriate share of the organisation’s total overhead Unlike marginal costing , absorption costing recognises both fixed and variable production overheads as important elements of production.The theoretical justification for using absorption costing is that all production overheads are incurred in the production of the organisation’s output and so each unit of the product receives some benefit from these costs. Each unit of output should therefore be charged with some of the overhead costs. The main reasons for using absorption costing are inventory valuations , pricing decisions and establishing the profitability of different products. The three main stages in absorption costing (sometimes referred to as allotment ) are allocation, apportionment and absorption.

1.2 Procedures for dealing with production (factory )overhead costs The following are the guiding steps in dealing with manufacturing or factory overheads:

a. The factory is divided into cost centres: those departments concerned with actually making the product to be sold ( production cost centres) and those departments which to not actually make the products but contribute to the efficient working of the production cost centres ( service cost centres).

b. Wherever possible, a direct charge or allocation is made to the cost centres. c. Each cost incurred jointly by a number of cost centres is apportioned to them on some

equitable or fair basis. d. The service costs are transferred to the production cost centres. e. All products made in a particular cost centre are charged with a fair share of the

overhead costs 1.3 Overhead allocation

Allocation is the allotment of whole items of costs to cost centres and this method should be used whenever possible .It is the process by which the whole cost items are charged to a cost unit or as a cost centre eg salary of a service department manager. A Cost centre may be a production department,a production area service department, an administrative department, a selling or a distribution department, or an overhead cost centre.For instance, direct labour would be charged to a production cost centre whereas costs such as canteens are charged direct to the various overhead cost centres.When allocating overheads one must ensure that a cost centre necessitated the overhead to be incurred and the exact amount of overhead is known.

1.4 Overhead apportionment Apportionment refers to the division or sharing of costs among two or more cost centres in proportion to the estimated benefit received or derived ,using a fair basis or proxy. This occurs where the total value of an overhead item is shared among cost centres that used the overhead through

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primary apportionment or distribution. Service centre costs may further be reapportioned (via secondary distribution) to production cost centres by using various methods such as direct method , reciprocal method etc. Bases of apportionment The following bases may be used to equitably apportion overhead costs to cost centres : Overhead to which the basis applies Basis of apportionment Rent, rates, heating and lighting, repairs and Floor area occupied by each cost centre Depreciation of buildings Floor area Depreciation and insurance of equipment cost or book value of equipment Managers salary, canteen costs, supervision Number of employees, wages paid, output Medical expenses ,, ,, ,, Heating and lighting (factory boilers) Volume of space occupied by each cost centre Maintenance of building Floor area Maintenance costs of plant, fire and machine plant values Insurance of machinery plant values Stores Store requisitions Fire and machine insurance plant values Note that some overheads may be apportioned on the basis of the unit of measure of service consumed eg electricity and water- meter reading( k/ watts and litres), maintenance ( number of workers or hours spend in each cost centre, Horse power(H.P) Hours etc. Where it is not practicable, apportion the overheads on the basis of a factor which approximates to the amount of service consumed.

Example 1 The following total expenses are to be apportioned to the departments X,Y and Z in the month : shs Electric power 10,500 Rates 1,500 Maintenance& repairs of machinery 21,000 Supervision 45,000 Insurance of premises 1,500 79,500 You are also given the following information: Department X Y Z Floor Area ( sq. m) 5000 7500 2500 Total H.P of machinery 15 10 5 Value of machinery (sh) 30,000 20,000 100,000 Number of personnel 30 100 20

Answer Overhead apportionment summary Department X Y Z Total Overhead base sh sh sh sh Electric power HP of machinery 5,250 3,500 1,750 10,500 Rates Floor area 500 750 250 1,500 Maintenance Value of machinery 4,200 2,800 14,000 21,000 Supervision No. of personnel 9,000 30,000 6,000 45,000 Insurance (premises) Floor area 500 750 250 1,500 Total 19,450 37,800 22,250 79,500 Apportionment of service cost centre costs to production departments

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Service department costs are charged to production departments by an allocation process. Only production department produce the goods that will finally be sold to the consumer at a predetermined price. It is therefore prudent to transfer all costs, direct and indirect to the production department for absorption of total cost to production units. Hence, indirect costs of service departments such as stores, maintenance, purchasing and personnel, should eventually be transferred to production cost centres using an appropriate method .Service (support ) departments may also provide services to each other. Services provided between service departments are known as interdepartmental or reciprocal services. There may arise a rare situation in which a production department also provides services to service departments. In such a case, the related production depatment’s service cost should be removed and apportioned first before the normal apportionment progresses. A technical assessment of services given to another department or to each other is usually provided in the form of ratios. The following are the commonly used methods to apportion service department costs to production departments :

a. Direct method –ignores the costs of services between departments and allocates all service department costs directly to production departments using the ratios of services provided. It is the simplest method of dealing with reciprocal services.

b. Step-down or elimination method- provides for allocation of a department’s costs to other service as well as to production departments in a sequence manner. Preferably start the allocation with the service department that provide more services to other service departments .The previous services department whose costs have been apportioned is dropped or eliminated from subsequent apportionments. The direct method and step-down methods are much simpler but less accurate and therefore rarely examined.

c. Repeated distribution or reciprocal method- service department costs are allocated to both the production departments and service departments that use the services. The service department costs are then gradually and repeatedly apportioned to the production department until the amounts allotted to and from the service departments diminish. It is also known as the continuous allotment method. This method is used where there are inter departmental or reciprocal services and is the most accurate apportionment method. However, this method is cumbersome and tedious especially when more than three service departments or production departments are involved.

d. Algebraic or simultaneous equations method-This is an alternative to the reciprocal method. Two simultaneous equations for the total overhead costs for the service cost centres are derived and solved. The resultant service costs are then apportioned to production departments in using the technical assessment service ratios However, where there are more than two service cost centres, this method becomes complex and as such, the reciprocal method should be used. For example, in case of two service cost centres, A and B with total overheads of shy 10000 and shy 7800 respectively. A provides 20% of its services to B , while B provides 10% of its services to A, then the total overhead equations ( X and Y for A and B respectively ) would be as here below : X= 10000 + 10% Y and Y= 7800 + 20% X.

Example 2 A company has three production departments and two service departments . The overheads for these departments for a period are as follows: shs

Production dept: P 25,000 Q 20,000 R 15,000 Service dept: A 10,000

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B 7,800 Total overhead 77,800 The overheads of service centres are charged as under: Department P Q R A B Service dept : A 30% 30% 20% ------ 20% B 40% 30% 20% 10% ----

Required : Show the overheads chargeable to the three production departments using direct method, step-down method, repeated distribution and Simultaneous equations or algebraic method Solution a Direct method P Q R Total Sh sh sh sh Overheads (given ) 25,000 20,000 15,000 60,000 Service Dept A 3,750 3,750 2,500 10,000 Dept B 3,467 2,600 1,733 7,800 Total 32,217 26,350 19,233 77,800 b Step-down method P Q R A B Total Sh sh sh sh sh sh Overhead ( as given) 25,000 20,000 15,000 10,000 7,800 77,800 Apportion A’s service costs 3,000 3000 2000 (10000) 2000 28,000 23,000 17,000 0 9,800 Apportion B’s service costs 4356 3267 2177 0 (9,800) 77,800 Total 32, 356 26,267 19,177 0 0 77,800 c Repeated distribution method P Q R A B Total Sh sh sh sh sh sh Overheads ( as given) 25,000 20,000 15,000 10,000 7,800 77,800 Apportion ‘A’s service costs 3,000 3,000 2,000 (10,000) 2,000 Total 28,000 23,000 17,000 9,800

Apportion ‘ B’s service costs 3,920 2,940 1,960 980 (9,800) Total 31,920 25,940 18,960 980 Apportion ‘A’s service costs 294 294 196 (980) 196 Total 32,214 26,234 19,156 196 Apportion ‘ B’s service costs 78 59 39 20 (196) Total 32292 26,293 19,195 20

Apportion ‘A’s service costs 8 8 4 (20) Total 32,300 26,301 19,199 77,800 dSimultaneous equations method Let x=Total overhead of dept ‘A’ y= Total overhead of dept ‘B’ Then x= 10,000 + 0.1y and y= 7,800 + 0.2x,two simultaneous equations derived. Solving for x and y we get x=11,000 and y=10,000 The service costs for dept A only are 80%×11,000= shs 8,800 The service costs for dept B only are 90%× 10,000 =shs 9,000

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The next step is to apportion the service department costs to the production departments Only in the ratios of services provided to them. Apportionment of service costs to production departments- Simultaneous Equations method Production departments P Q R Total (shs) Overheads allocated (shs) 25,000 20,000 15,000 60,000 Apportion A service costs 3,300 3,300 2,200 8,800 Apportion B service costs 4,000 3,000 2,000 9,000 Total 32,300 26,300 19,200 77,800 1.5 Overhead absorption

This refers to the sharing out of overheads to the various cost centres that used the overheads .It is used when the overheads cannot be allocated or attributed to a specified cost centre .The aim is to establish the overhead absorption rate eg overhead cost per unit. Having allocated and or apportioned overhead costs, the next step should be to absorb them into the cost of production. As mentioned on absorption costing, the reasons for absorbing overheads are:

The control of overhead expenditure.

Charging of overhead to cost units.

Valuation of work in progress.

Valuation of abnormal losses.

Profit measurement

Decision making The two stages of absorbing overheads in cost units are namely; computation of predetermined overhead absorption rate (OAR) and application of this rate to cost units.

1 Choosing the appropriate overhead base The predetermined overhead absorption rate is calculated using budgeted figures. It is therefore necessary that an appropriate absorption method be selected depending on the prevailing circumstances of the organisation. Some organisations may be labour-intensive, while others may be capital-intensive or produce all identical units . Hence the choice of an absorption method may be based on the following factors: units of output, direct labour hours, machine hours, direct material cost, direct labour cost and prime cost. The choice of an absorption rate requires personal judgement and common sense, depending on the characteristics and real circumstances of a particular cost centre/ department. However, most factories use direct labour hours or machine hours. 2General procedure in overhead absorption The basic steps in absorbing overheads to cost units are as follows:

a) Estimate the overhead likely to be incurred during the coming period. b) Estimate the activity level for the period e g direct hours, machine hours. c) Divide the estimated overhead by the budgeted activity to determine the

OAR. d) Absorb the overhead into the cost unit by applying the calculated absorption

rate. 3Over and under absorption of overheads Over and under absorption of overheads occurs because the predetermined overhead Absorption rates are based on budgeted/ estimated figures. Hence, the overheads Absorbed by the process may not agree with the actual overheads incurred for the period

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Over absorption occurs if the overhead absorbed exceed the actual overheads while Under absorption occurs if the overhead absorbed are less than the actual overheads.

Example 3 Department S has provided the following data for a period: Budgeted overheads shs 200,000 Actual overheads shs 200,500 Budgeted direct labour Hours (DLH) 40,000 Actual direct labour hours 42000

Required: a) overhead absorption rate (OAR) b) overhead absorbed c) over or under absorbed overheads

solution a) OAR = Budgeted overheads = shs 200,000 = shs 5 per DLH

Budgeted direct labour hours 40,000 hrs b) Overheads absorbed = Actual direct labour Hrs × OAR =42,000×shs5 = shs 210,000 c) Over absorbed overheads =Overhead absorbed- Actual overhead incurred

=She 210,000-200,500 = shs 9,500. 1.6 Overheads and Activity-based costing (ABC)

Absorption costing has been criticised because all overheads are absorbed into production volume (measured by labour or machine hours), even though many support overheads vary, not with production volume, but with the range and complexity of production. Nowadays, support overheads form a major component of total cost as direct costs continue to diminish. Thus, support overheads relating to technical engineering and design services, planning, tooling, data processing are becoming increasingly significant proportion of total costs in modern factories due to advanced technological developments. ABC was developed to address the problem inherent in conventional approaches such as absorption costing so as to ensure that support overheads are traced to the product costs more practically. ABC is a method of charging overheads to cost units on the basis of benefits derived from a particular indirect activity e.g ordering, planning ,setting etc and thus attempts to show the relationship between overhead costs and the activities that cause them (cost drivers ). We have already with classification of costs under the traditional systems in lesson one.

1 Cost classifications using Activity Based Costing Using the ABC , Kaplan and Cooper have proposed classification of overheads in the following manner : a Short-term variable costs: These are costs that vary with production volume. These costs should ideally be traced to products using production volume influencers as appropriate. Examples include direct labour hours, machine hours , direct material cost, direct labour cost, prime cost and units of production .ABC recognises that there could be several cost drivers whenever production volume influencers are used in varying proportions to cost products. c Long-term variable costs-These are overhead costs which do not vary with production volume but do vary with other measures of activity but not immediately. These are costs for support activities such as stock handling, production scheduling, set-ups etc. which tend to be fixed in the short term but vary in the longer term depending on the varieties and complexity of products manufactured. These costs which were traditionally considered as fixed should be traced to products using transaction based cost drivers. c Fixed costs-These costs to not vary with production activity in the short term. These costs include manager’s salary; Rent, rates etc. tend to relatively small. 2 Outline of ABC system

The main steps involved in ABC are as follows:

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i) Identify the main activities in the organisation .These activities include material handling, purchasing, reception, despatch, machining, assembly etc.

ii) Identify the factors which determine the costs of an activity or cost drivers such as number of purchase orders, number of orders delivered, number of set-ups etc.

iii) Collect the cost of each activity or cost pools or cost centres. iv) Charge support overheads to products on the basis of their usage of the activity,

expressed in terms of the chosen cost driver(s).

2 Transaction- based cost drivers ABC focuses mainly on factors that cause or driver costs otherwise called the cost drivers. Cost drivers can be defined as ‘ Activities or transactions which are significant determinants of cost ‘. Choosing ideal cost drivers is a difficult task. According to Cooper, ‘There are no simple rules that pertain to the selection of cost drivers .The best approach is to identify the resources that constitute a significant proportion of the product costs and determine their cost behaviour .If several are long term variable costs, a transaction –based cost system should be considered ‘.A well designed ABC system enables an organisation to determine value or cost addition of its departments and what causes the activity for which the department is responsible.

Examples of transactional –based cost drivers are given below : Support Department costs ( i.e cost pools ) Possible cost driver Production scheduling Number of production runs Set-up costs Number of production runs Material handling Number of production runs Finished goods stock handling Number of orders delivered Despatch costs Number of orders delivered Purchasing costs Number of purchase orders Raw material stock handling Number of orders received Quality control Number of inspections Machinery (power, depreciation etc ) Number of machine hours Example 4

Two products X and Y are made using similar equipment and methods. The data for the last period are: X Y Units produced 6000 8000 Labour hours per unit 1 2 Machine hours per unit 4 2 Set-ups in a period 15 45 Orders handled in the period 12 60 Overheads for the period shs Relating to production set-ups 179,000 Relating to order handling 30,000 Relating to machine activity 55,000 264,000 Required: Calculate the overheads to be absorbed per unit of each product based on a) Conventional absorption costing using labour hour rate. b) An ABC approach using suitable cost drivers.

Answer a) Using conventional absorption costing

Labour hours

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Product X = 6000 units @ 1 = 6000 Product Y = 8000 units @ 2 = 16000 Total labour hours 22000

Absorption overhead rate (OAR), based on labour hrs= Shs . 264000=Shs 12 per hour 22000 Overheads absorbed : Product X shs 1 × 12 =sh12,Total overheads=6000× sh12=shs72000 Product Y shs 2×12 =sh24,Total overheads =8000× shs24=shs192000 Total overheads = shs 264000

b) Using ABC Machine hours per period : Product X: 6000×4= 24000 Product Y =8000×2 =16000 40000 Cost driver rates Production set-ups = shs 179000 =shs 2983 per set-up 60 Order handling = shs 30000 =shs 417 per order

72 Machine costs = shs 55000 = shs 1.375 per hour. 40000 Overheads using ABC costs Product X product Y Total Shs shs shs Set-ups 15× shs 2983 = 44745 45× shs2983 = 134235 Orders 12× shs 417 = 5000 60×shs 417 = 25020 Machines 24000× shs 1.375 = 33000 16000×shs 1.375=22000 82745 181255 264000

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LESSON TWO QUIZZES

1State the objective of overhead absorption. 2Give five examples of absorption. 3Give three methods used in the allotment of reciprocal service costs.

Answers to quizzes 1-3 1 The objective of overhead absorption (absorption costing) is to include in the total cost of a

Product an appropriate share of the organisation s total overhead .An appropriate share is generally taken to mean an amount which reflects the amount of time and effort that has gone into producing a unit or completion of a job in terms of indirect costs other than materials and labour.

2 Absorption bases include direct labour hours, machine hours, units of output. 3 Methods of apportioning service department costs to production cost centres- step-down, Reciprocal and Simultaneous equations methods.

4Match the following overheads with the most suitable basis of apportionment.

Overhead Basis of apportionment a) Cost accounting (1) Number of employees b) Cafeteria (2)Labour hours c) Fire & machine insurance (3)Floor area d) Heating& Lighting (4)Plant value

Answer a(2), b(1), c(4),d(3).

5 The following data relates to a cost centre in one year: Budgeted labour hours 25,000 Actual labour hours 24,000 Budgeted overheads sh 350,000 Actual overheads shs 356,000 The over or under absorbed overhead based on labour hours for the period was A sh 6,000 B sh 14,000 C sh 20,000 D sh 8,000 Correct answer C. OAR=sh350,000/25,000 hrs=sh14, overhead absorbed=24,000 hrs@sh14=sh 336,000 Overhead under-absorbed=Actual ohs-absorbed ohs=sh 356,000-336,000=sh20,000. 6Which of the following are two basics of absorption costing? A calculate the direct labour rate and rate per machine hour B Estimate the budgeted overhead and budgeted activity for the period C Ascertain the budgeted overhead and actual activity for the period D Estimate the budgeted overhead and budgeted machine hours for the period Correct answer B

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LESSON TWO QUESTIONS

1 A company has three production departments and two service departments and for a period, the departmental overheads distribution summary has the following totals: Shs Production Dept : A 80000 B 70000 C 50000 Service Dept : 1 23400 2 30000 253400 The expenses of the service departments are charged out on a percentage basis as follows : A B C 1 2 Service department : 1 20% 40% 30% - 10% 2 40% 20% 20% 20% -

Required: Show the apportionment of the overheads to the production departments using: a) Simultaneous Equations method b) Repeated distribution method

Answer A simultaneous equations method Let x= Total overhead for Dept 1 Y= Total overhead for Dept 2 Then x= 23,400 +0.20y and y= 30,000 + 0.10 x. Solving for x and y , x=300,00 and y=330,000 Apportionment using simultaneous equations method Total A B C

shs shs shs shs Overheads (given) 200,000 80,000 70,000 50,000 Service Dept: 1 : 27,000 6,000 12,000 9,000 2 : 26,400 13,200 6,600 6,600 253,400 99,200 88,600 656,000

a Repeated distribution method A B C 1 2 Total Sh sh sh sh sh sh

Overheads (as given ) 80,000 70,000 50,000 23,400 30,000 253,400 Apportion Dept 1 service costs 4,680 9,360 7,020 (23,400) 2,340 Sub-total 84,680 79,360 57,020 32,340

Apportion Dept 2 service costs 12,936 6,468 6,468 6,468 ( 32,340) Sub-total 97,616 85,828 63,488 6,468 Apportion Dept 1 service costs 1,294 2,587 1,940 (6,468) 647 Sub-total 98,910 88,415 65,428 647 Apportion Dept 2 service costs 260 129 129 129 (647) Sub-total 99,170 88,544 65,557 129 Apportion Dept 1 service costs 26 52 39 (129) 12 Sub-total 99,196 88,596 65,596 12

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Apportion Dept 2 service costs 6 3 3 (12) Total 99,202 88,599 65,599 253,400

2 X Ltd has four departments, A,B,C and D . The actual costs for a period are as follows: Shs shs Rent 10,000 supervision 15,000 Repairs to plant 6,000 fire insurance 5,000 Depreciation to plant 4,500 power 9,000 Light 1,000 Employer’s Liability Insurance 1,500 The following information is also available in respect to the four departments: Department A B C D Area sq. m 1,500 1,100 900 500 Number of employees 20 15 10 5 Total wages (shs) 60,000 40,000 30,000 20,000 Value of plant (shs) 240,000 180,000 120,000 60,000 Value of stock (shs) 150,000 90,000 60,000 - Required : Apportion the costs to the various departments on fair basis. Answer Apportionment to departments A B C D Total Overhead item Base shs shs shs shs shs Rent Area sq.m 3,750 2,750 2,250 1,250 10,000 Repairs to Plant Value of plant 2,400 1,800 1,200 600 6,000 Depreciation to plant value of plant 1,800 1,350 900 450 4,500 Light Area sq.m 375 275 225 125 1,000 Supervision No. of employees 6,000 4,500 3,000 1,500 15,000 Fire insurance Value of plant 2,000 1,500 1,000 500 5,000 Power Area sq.m 3,375 2,475 2,025 1,125 9,000 Liability insurance Total wages 600 400 300 200 1,500 Totals 20,300 15,050 10,900 5,750 52,000

3 Comp ware Ltd is a company based in the industrial area that manufactures computer accessories. The company uses predetermined overhead rates in applying overhead s to production orders .It uses cost of labour in applying overhead incurred in department A , while in department B, it uses Machine hours. The company made the following projections at the commencement of year 2013:

Department A B Shs Shs Direct material 1,800,000 400,000 Direct labour 1,200,000 250,000 Production overheads 960,000 220,000 3,960,000 870,000 Machine hours 96,000 22,000 Direct labour hours 80,000 25,000 During the year, Job L10 consumed the following inputs : A B Material issued (shs ) 11,000 2,500 Direct labour cost (shs) 9,600 2,000

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Machine hours 768 176 Direct labour hours 640 200 Required: a Overhead absorption rates for department A and B b Total cost of production for Job L10 c At the end of the year 2013, the actual factory overhead cost incurred amounted to Sh 944,000 for Dept A and Sh 231,000 for Dept B. Actual direct labour cost was shs 1,100,000 in Dept A and a total of 24,000 machine hours were used in Dept B. Calculate the over or under absorption of overheads for the two departments and the company as a whole. Answer a Calculation of overhead absorption rates(OAR) OAR= Total budgeted overhead Budgeted activity Dept A : OAR = sh 960,000÷sh1,200,000=0.80 per direct labour cost Dept B : OAR = sh 220,000÷ 22,000 = sh 10 per machine hour. b Total cost of production for Job L10 A B Total Sh sh sh Direct material 11,000 2,500 Direct labour 9,600 2,000 Production overheads 7,680 1,760 Production cost 28,280 6,260 34,540 c Over and under absorption of overheads in 2013 A B Total (for company) sh sh sh Actual overheads incurred 944,000 231,000 Overheads absorbed 880,000 240,000 Over / (under) absorption ( 64,000) 11,000 53,000

4 Chakula safi Ltd makes four products namely: Bora, Sawa , Afya and Mpya.Details of the four products and relevant information are given below for one period :

Product output Number of Direct Machine Material Material Units production labour hours hours cost components Runs in a period per unit per unit per unit per unit Bora 50 6 2 2 sh 30 4 Sawa 75 8 4 4 sh 75 5 Afya 250 10 2 2 sh 30 4 Mpya 250 10 4 4 sh 75 3

Direct labour cost is sh 7 per hour. Overhead costs are as follows : Cost cost driver Sh Short run variable costs Machine hours 18,250 Scheduling costs No. of production runs 17,680 Set-up costs No. of production runs 13,600 Material handling No. of components 16,970 Total 66,500

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Required: a) Calculate the total cost for each product if all overhead costs are absorbed on a machine hour

basis b) Calculate the total costs for each product, using activity based costing.

Answer a Conventional or traditional product costing based on machine hours Overhead absorption rate (OAR) (based on machine hour)= Total overhead cost/machine hours = sh 66,500 ÷1,900 = sh 35 per machine hour. Product Cost per unit No of units Total cost(sh)

Bora 2 machine hrs@ sh 35 sh70 50 3,500 Sawa 4 ,, @ sh 35 sh 140 75 10,500 Afya 2 ,, @ sh 35 sh 70 250 17,500 Mpya 4 ,, @ sh 35 sh 140 250 35,000 66,500 Machine hours=2 ×50+ 4×75 +2×250 + 4×250=100+300+500+1,000=1,900 hours Machine hours: Bora (100 ), Sawa (300), Afya (500) and Mpya( 1,000) b Activity bases costing (based on cost drivers) Activity Short run scheduling setup material Total (sh) Variable cost costs costs handling costs Cost of activity (sh) 18,250 17,680 13,600 16,970 66,500 Consumption ( cost driver) 1900 34 34 23 25 Machine hrs production production material Runs Runs components Cost per unit Of consumption sh 9.61 sh520 sh400 sh7.30 Allocation of cost Total cost unit cost To products sh sh sh sh sh sh Bora 961 3,120 2,400 1460 7,941 159 Sawa 2,883 4,160 3,200 2,738 12,981 173 Afya 4,805 5,200 4,000 7,300 21,305 85 Mpya 9,610 5,200 4,,000 5,463 24,275 97 Total 18,259 17,680 13,600 16961 66,500 514 7 Western emporium Ltd has two production departments ( P and Q) and two service department Stores (S) and Maintenance ( M). It incurred the following overhead costs : P Q S M Shs Shs shs shs Allocated costs 60,000 40,000 10,000 20,000 Apportioned costs 20,000 10,000 10,000 5,000 Total costs 80,000 50,000 20,000 25,000 Production department P made 120 requisitions of materials while Department Q made 80 requisitions of materials in the same period. Department M provided 500 hours of work for department P and 750 hours for Department Q. Required : Determine the total production overhead costs of department P and Q

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Solution

Allocation of overhead costs to production departments (using direct method) P Q S M Total Sh sh sh sh sh Overheads allocated 80,000 50,000 20,000 25,000 Apportion S’s costs to P & Q 12,000 8,000 (20,000) Subtotal 92,000 58,000 Apportions M’s costs to P&Q 10,000 15,000 ( 25,000) 102,000 73,000 175,000

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LESSON THREE: MARGINAL AND ABSORPTION COSTING

Lesson objectives

At the end of this lesson, the learner should be to:

a) Identify marginal costs and full costs

b) Distinguish between Marginal and Absorption costing and state their

advantages and limitations.

c) Prepare operating statements using Marginal and Absorption costing

Principles

d) Reconcile profits/ losses obtained using marginal and absorption costing

principles.

2.1 Marginal and Full costs

In lesson one , we attempted to distinguish between Fixed costs and variable costs.

Variable costs are sometimes referred to as marginal costs. These are the costs that

vary with levels of activity i e volume or output. As output changes ( increases or

decreases ), marginal costs change as well. Marginal cost is the cost of a unit of a

product or service which would be avoided if that unit were not produced or

provided. It is for this reason that these costs are considered by managers as

important for decision making and even stock valuation. Examples of marginal cost

of sales are prime costs, variable production overheads, salesmen commissions and

other commissions based on profits or sales or production levels. Marginal

production cost are prime costs plus variable production overheads.

Full cost ( or absorbed costs ) of sales are all costs, fixed and variable , that are

associated with production and sale of the product.In other words, full costs

comprise prime cost, production overheads , administration, selling and distribution

oveheads or expenses.Full costs of production would comprise marginal costs of

production plus variable and fixed production overheads.

2.2 Marginal costing

Marginal costing is an alternative method of costing to absorption costing.

This costing technique is invariably referred to as variable or direct costing or

contribution approach. Under this technique, only direct costs are charged to cost of

product or cost of sale and contribution is calculated. Fixed costs attributable to a

relevant period are written off in full against the contribution of the period. Thus,

fixed costs are treated as period costs and charged in full to the profit or loss

account of the accounting period in which they are incurred.They are considered as

irrelevant for managerial decisions involving alternative products.

Contribution is the difference between sales and marginal cost of sales.

Contribution = Sales- Marginal cost of sales.

Contribution- Fixed costs = Profit.

The concept of contribution is vital in marginal costing and is often used to mean ‘

contribution towards covering fixed overheads and making a profit ‘.

In marginal costing, the closing stocks of Raw materials, work in progress and

finished goods are valued at marginal or variable cost of production.

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2.3 Absorption costing

Under this method, all costs are absorbed into production and thus operating

statements do not distinguish between fixed and variable costs. It is also referred

full costing or indirect costing .Consequently, the valuation of stocks and work

progress contains both fixed and variable elements. Absorption costing is the basis of

financial accounting.

2.4 Marginal costing versus absorption costing

The following are the arguments in favour of marginal costing:

a)Simple to operate especially where variable and fixed costs are

separable.

b) The method avoids apportionment of fixed costs to products which

may be difficult and arbitrary.

c) When sales are constant but production fluctuates marginal costing

shows steady net profit whereas absorption costing shows amounts of

fluctuating net profits.

d) Under or over absorption of overheads is almost entirely avoided in

case fixed overheads are excluded in the calculation of absorption rates.

e) Fixed costs are incurred on a timely basis and do not relate to activity

and it is only logical to write them off in the period they are incurred using

marginal costing.

f) Marginal costing operating statements nearly approach cash flow

statements and can be used ascertain actual cash position .

The following arguments are in support of absorption costing:

a)It is ’fair’ to share fixed production costs between units of production as

such costs are incurred in order to make output and should not be ignored.

b) Closing stocks are valued in accordance with International

Financial Reporting Standards.

c) It is easier to determine the profitability of several products by charging a

share of fixed overheads to them rather than basically using contribution.

d) Fixed costs should be included in stock valuations in order to prevent a

series of losses especially in industries have large amounts of such costs.

2.5 Operating (profit ) statements using Marginal and absorption costing principles

Differences arise in the profit or loss obtained when using marginal and absorption costing.In

marginal costing: closing stocks are valued at marginal production cost, fixed costs are

treated as period costs and cost of sales does not include a share of fixed overheads.Thus, in

marginal costing, it is necessary to identify variable costs, contribution and fixed costs.

On the other hand, when using absorption costing, closing stocks are valued at full

production cost, fixed costs are absorbed into unit costs and cost of sales does include a

share of fixed overheads. If there are any opening stocks, they should be valued at full

production cost, unless they are already valued. In absorption costing, it is not necessary to

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distinguish variable costs from fixed costs. Under both methods, the initial step is therefore

to evaluate cost of production per unit as a basis of valuing stocks.

The differences in profits reported under the two costing systems is due to the different stock

valuation methods used and hence it is necessary to prepare a reconcilliation statement.

Example 1

The following data was provided by the cost accountant of KK Ltd for a certain period:

Selling price sh 600 per unit

Sales 1,000 units

Production 800 units

Opening stock 400 units

Closing stock 200 units

Direct material cost shs 80,000

Direct labour cost shs 16000

Variable factory overheads shs 24,000

Fixed factory overheads shs 40,000

Required: prepare operating statements for the period using:

a)Marginal costing

b)Absorption costing

c)Reconcile the profits in (a) and (b) above.

Solution

Evaluation of cost of production per unit

a) Marginal costing b) absorption costing

Qty value (shs) Qty value (shs)

Direct materials 800 80,000 800 80,000

Direct labour 16,000 16,000

Variable factory OHDS 24,000 24,000

Fixed factory OHDS --------- 40,000

Cost of production 800 120,000 800 160,000

Cost of production per unit = shs 150 cost of production per unit = shs 200

Value of closing stocks=200 units × shs 150 value of closing stocks=200 units×shs 200

= shs 30,000 =shs 40,000

Operating statements

a) Marginal costing b) Absorption costing

Sh sh

Sales 1,000 units @ shs 600 600,000 Sales 600,000

Less: Cost of sales Less: cost of sales

Opening stock 400@shs 150 60,000 Opening stock 400@shs 200 80,000

Cost of production 800 @ shs150 120,000 cost of production 800@shs 200 160,000

Closing stock 200 @ shs 150 (30,000) closing stock 200 @ shs 200 (40,000)

150,000 200,000

Contribution 450,000 Gross profit 400,000

Less: Fixed factory overheads 40,000 Fixed factory overheads ---------

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PROFIT 410,000 400,000

c) Reconcilliation statement

Marginal costing (shs) Absorption costing(shs) Difference (shs)

Opening stocks 600,000 80,000 (20,000)

Closing stocks 30,000 40,000 (10,000)

30,000 40,000 (10,000)

Profit 410,000 400,000 10,000

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LESSON THREE QUIZZES 1 Which of the following statements is TRUE about marginal costing? A Period costs are ignored when preparing operating statements B Only variable costs are considered when preparing operating statements C It may lead to the firm setting prices which are lower than total costs

D It is recommended for valuation of stocks and work in progress in financial accounts. Correct answer C 2 A firm makes and sells a product whose variable production cost is sh 6 per unit and selling price sh 10. In a period, production was 20,000 units but only 18,000 units sold. Total fixed costs were sh 45,000. A sales commission of 5% is offered. There were no opening inventories in the period. The profit for the period using marginal costing was A Sh 18,000 B sh 60,000 C sh 14,000 D sh 15,000

Correct answer A Profit=sales –variable production cost-sales commission-fixed costs =sh 180,000-108,000-9,000-45,000= sh18,000, closing stock=2,000@sh6=sh12,000 Variable cost of production=20,000@sh6-12,000=sh 108,000. 3Match the following descriptions with the correct costing term

Description costing term a) Sales minus product and period costs 1 marginal cost b) Sales minus variable costs 2 Absorption cost c) Fixed plus variable costs 3 contribution d) Total costs minus fixed costs 4 net profit

Answer a(4), b(3), c(2), d(1)

LESSON THREE: QUESTIONS

1 The following information has been extracted from the books of Langata Ltd for 2013:

Cost element Amount (sh) Direct material 7,200,000 Direct labour 1,800,000 Variable production overheads 1,500,000 Fixed production overheads 2,700,000 Sales Salaries 450,000 Sales commission 300,000 Advertisement expenses 480,000 Sundry fixed expenses 720,000 Addition information:

Production was 30,000 and sales 24,000 units.

Selling price per unit sh 550

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Required: a)Prepare operating statements using: iMarginal costing method iiAbsorption costing method

b )Reconcile the profit figures (if any ) arising from the above statements. Solution Langata Ltd Operating statements Marginal costing Absorption costing sh sh sh sh

Sales (24,000 @550) 13,200,000 13,200,000 Less: cost of production Variable cost of production 10,500,000 10,500,000 Fixed cost of production - 2,700,000 Cost of production 10,500,000 13,200,000 Less :Closing finished goods 2,100,000 8,400,000 2,640,000 10,560,000 4,800,000 2,640,000 Less: Sales commission 300,000 Contribution 4,500,000 Less: Fixed costs: Less:Operating expoenses Fixed production cost 2,700,000 sales commission 300,000 Sales salaries 450,000 sales salaries 450,000 Advertising expenses 480,000 Advertising 480,000 Sundry fixed expenses 720,000 4,350,000 sundry fixed exps720,000 1,950,000 Profit 150,000 690,000

2 Jo Enterprises Ltd has an annual production capacity of 300,000 units and normal capacity is reclaimed at 90%. Standard variable production cost were shs 18 per unit and fixed production cost amounted to shs 540,000 per annum. Variable selling cost were shs 4.50 per unit while fixed selling cost were shs 405,000. The unit selling price was shs 30. For the year ended 30th June 2014, the units sold were 225,000.

Required :

a Income statement under absorption costing.

b Income statement under marginal costing.

c Reconcile the two profits (loss) above and explain the reasons for the difference.

Answer

Jo enterprises Ltd Income statements for year ended 30th June , 2014

Marginal costing Absorption costing

Sh sh sh sh Sales(300,000×90%@ sh 30) 6,750,000 6,750,000 Less:Cost of production Variable cost (270,000@18) 4,860,000 4,860,000

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Fixed cost - 540,000 5400,0000 Less:closing stock (45,000@18)( 810,000 ) 4,050,000 (900,000) 4,500,000 Gross contribution 2,700,000 2,250,000 Less: Variable selling costs 1,012,000 1,012,000 Contribution 1,687,500 Less: Fixed costs Production costs 540,000 Selling costs 405,000 945,000 405,000 1,417,500 Net profit 742,500 832,500

3 The following budgeted information relates to Mamba Ltd which sells a single product ,for the

month of June 2014:

Sh per unit Selling price 16 Prime cost 8 Fixed production cost 3 Additional information:

Variable production cost are 25% of prime cost

Units sold were 18,000 but there were 7,000 units of closing stock.

There were no opening stock. Required: Prepare operating statements for the month on the basis of Marginal and absorption costing.

SOLUTION Mamba Ltd Marginal costing Absorption costing Shs sh

Sales (18,000@ sh16) 288,000 sales 288,000 Less: Marginal cost of production 250,000 Full cost of production 325,000 Less: Closing stock(7,000 @10) ( 70,000) ( 91,000) Net cost of production 180,000 234,000 Contribution 108,000 Gross profit 54,000 Less :Fixed production cost 75,000 - Net profit 33,000 54,000

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LESSON FOUR: RELEVANT COSTING AND DECISION MAKING

Lesson objectives

After studying the lesson, the learner should be able to: a) Explain the concept of relevant costing b) Identify the relevant costs of materials , labour and overheads c) Calculate contribution and contribution per unit of the limiting factor. d) Determine the optimal production plan where a single binding constraint exists e) Ascertain whether a company should make or buy a product or consider a special order.

3.1 Decision making Decision making is one of the major responsibilities of a manager .The manager is constantly faced with problems of deciding what products to sell, what production methods to use , whether to make or buy component parts , what prices to charge , what channels of distribution to use , whether to accept special orders at special prices , and so forth. At best, decision making is a difficult and complex task .Decision making is concerned with the future and involves a choice between alternatives. Financial information is critical when making choices. For instance, one may to consider whether to join university next year or forego employment as a clerical officer in the County at a salary of She 20,000 per month. Other than quantitative factors, qualitative factors need to be considered as well. In the above case, the person should consider the possibility of getting employment after university and salary expected. It is therefore important to obtain relevant information on cost and revenues before making an appropriate decision. A relevant cost is a future cash flow arising as a direct consequence of a decision. Stated in another way, the relevant costs of a decision are those costs (and revenues) that can are differential as between the alternative being considered. Decision making should therefore be based on relevant costs. . Information may be said to be relevant when it is about: (i) future costs and revenues (ii) future cash flows and (iii) incremental costs and revenues. Other terms that are sometimes used to describe relevant costs are avoidable costs, differential costs, opportunity cost and attributable costs. Any cost that is avoidable is relevant for decision making purposes. An avoidable cost can be defined as accost that can be eliminated as a result of choosing one alternative over another in ma decision –making situation. All costs are considered to be avoidable , except sunk costs and future costs that do not differ between the alternatives at hand. Marginal costs can be considered as relevant in decision making. Fixed costs remain constant over

the activity range and are therefore irrelevant in decision making unless they are directly attributable

to the activity

3.2 Short run tactical decisions and marginal costing

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The concept of marginal costing and contribution comes in the fore again when discussing relevant costing. In making tactical or short run decisions, which seek to make the best use of existing facilities, marginal cost, revenue and contribution of each alternative is relevant. The alternative which maximises the contribution per unit of the key factor should be chosen in order of ranking. The key factor or limiting factor or principal budget factor is a factor which is a binding constraint to the organisation in terms of availability of resources and capacity. However, the maximisation of the contribution per unit of the limiting factor(cpu) decision rule can only be useful in case of a single binding constraint and where the constraint is continuously divisible. Examples of limiting factors are sales demand, labour, materials ,capacity and financial constraints. Typical short run decisions where marginal costing principles may be applied are acceptance of a new

order, make or buy decisions, shut down decisions and choice of product where a limiting factor

exists. The following steps are important in analysing the problems and making appropriate

decisions : ( a) Separate fixed and variable costs b) Identify directly attributable fixed and general

fixed costs (c) calculate the contribution ( revenue less marginal cost) of each alternative.(d)

identify the limiting factor and calculate the contribution per unit of the limiting factor (cpu) .e)

Finally, choose the alternative which maximises the contribution per unit of the limiting factor and

rank them based on the highest cpu.

3.3 Choice of product ( product mix) decisions Sometimes there may be limited resources to meet a potential demand. A choice has therefore to be made about which products to make and in what unit quantities using the available resources in the most efficient and effective way. This is possible where there is a single binding constraint or limiting factor. The objective of management is to maximise profits and the profits will be maximised when contribution is maximised. The product that yields the highest contribution per unit of the limiting factor should be chosen in that order. The possible quantities of production within the binding constraints are then used to calculate sales, variable costs and contribution .Fixed costs are deducted from the contribution and prepare to derive overall profit and hence company’s profit statement. Example 1

The following details are available regarding two products, A and B produced by a company : A B Per unit shs shs Direct materials 5 4 Direct labour 3 3 Variable production overheads 2 1 10 8 Selling price 15 8 Direct labour hours per unit 4 2 Sales demand (units) 500 500 Fixed costs for the period amounted to shs 2,000. Direct labour hours available for the period are limited to 1,500 hours. Required : Determine the optimum production plan and profit for the period. Solution Product A (shs) B(shs) Contribution per unit 5 (15-10) 4 (12-8) Contribution per unit of Limiting factor (labour hours ) 1.5 (5÷4) 2 (4÷2)

Ranking of products : B.A, production of Product B should be given priority using the available labour hours.

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Direct labour hours required: Product B, 500 units@ 2hrs =1,000 hrs Product A , 500 units @ 4 hrs=2,000 hrs Total 3,000 hrs Production plan Direct labour hrs units product Sales demand(units) Required Available produced

B 500 1,000 1,000 500 A 500 2,000 500 125 1000 3,000 ,1500 625 Thus, optimum production would be : product B, 500 units and product A, 125 units.

Profit statement shs Contribution : product B 500 units @shs4 = shs 2,000 Product A 125 units @ shs 5 = shs 625 2,625 Less : Fixed cost 2,000 PROFIT 625 3.4 Make or Buy decisions The manufacture of a product involves many steps .These steps involves acquisition of raw materials, processing these raw materials to remove impurities to obtain desirable usable ones , fabrication, actual manufacture of finished product and finally, distribution of the final product to the ultimate consumer. When a company is involved in more than one of these steps, it is said to be vertically integrated. Some firms may choose to become fully vertically integrated but others may integrate partially and choose to produce only certain fabricated parts or components that go into their final products. Any decision relating to vertical integration may be considered is a make or buy decision. A make or buy decision involves a company’s decision as to whether it should make a product / carry out an activity with its own internal resources or pay another company to make the product / carry out an activity .It is a question of internal or external sourcing .Examples of make or buy decisions are : a A decision to produce a fabricated part or component internally, rather than to the part externally from a supplier b A decision by a construction company to undertake work entirely with its own labour force or subcontract some jobs to other companies The relevant costs will be the differential costs between making and buying .In general, the marginal (variable) cost of manufacture of the product /component should be compared with the buying price. Where the marginal cost of manufacture is less than the buying price, the firm should make the product rather than buy and vice versa. However, when manufacturing the component displaces existing production, the lost contribution must be added to the marginal cost of the component before comparison with the buying price. Additionally ,in a situation where a company must subcontract work to make up a shortfall in its own production capability, its total costs are minimised if those components or products subcontracted are those with the lowest extra variable cost of buying per unit of limiting factor saved by buying. Apart from the relevant costs, other qualitative factors that may be considered in make or buy decisions include

i) Profitable use of spare capacity left in contracting company and resistance of its labour force for fear of losing work to an outside subcontractor

ii)Reliability of subcontractor with delivery times and quality of outside components iii)Flexibility and need to maintain better control over operations by company making everything itself. iv)Reliability of estimates of fixed costs .

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Example 2

Kazuri Ltd makes three components, X,Y and Z. The following costs have been recorded: X Y Z Unit cost shs shs shs Variable cost 30 70 60 Fixed cost 20 80 40 Total cost 50 150 100 A subcontractor has offered to supply the components to the company at the following prices : components Xshs 45, Y shs 60 and Z shs 65 per unit. Required: Determine which components should the company buy. Solution Component X Y Z Shs shs shs Variable cost of making 30 70 60 Variable cost of buying 45 60 65 Savings from buying (15) 10 (5)

The variable cost of making component Y is greater than the variable cost of buying it.BB Ltd should consider buying in component Y only and manufacture X and Z internally.

3.5 Special order decisions This decision can also be thought of as ‘ one-off contract’ decision .It is a decision which will concern a contract which would utilise a company’s spare capacity but which would have to be accepted at a price lower than that normally required by the organisation. In general, a contract would be accepted if it increases contribution and profits. Otherwise the contract would be rejected if it lowers profits. Fixed costs are irrelevant in such a decision in case they change as result of the order, then they should be considered. However, it would be prudent to consider a number of factors before a final decision is made such as: I whether acceptance of one order at a lower price will lead to other customers in demanding lower prices or favourable price discounts as well. Ii Whether the special order is the most profitable way of using the spare capacity. Iii Whether the special order could tie up capacity which could be used for future full price business Iv whether fixed costs will change or not as a result of the order. V Likely future sales demand for the product. Vi future state of the economy Example 3 X Ltd makes a single product which sells for shs 20.I t has a full cost of shs15, which is made up as follows: Shs Direct materials 4 Direct labour (2 hours) 6 Variable overhead 2 General fixed overhead 3 15

The labour force is currently working at 90% of capacity and so there is a spare capacity of 2,000 units. A customer has approached the company with a request for the manufacture of a special order of 2,000 units for which he is willing to pay shs25,000.Fixed costs are expected to increase by shs 200. Required: Assess whether the special order should be accepted. Solution Shs Value of special order (price) 25,000

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Less: cost of sales Direct materials ( 2,000 units@ sh2) 4,000 Direct labour ( 2,000 units @ sh 6 ) 12,000 Variable Overheads (2,000 units @ sh2) 4,000 Attributable fixed costs 200 Relevant cost of order 24,200 Profit from order acceptance 800 The special order should be accepted since it increases profits by shs 800.

3.6 Shut down or discontinuing decisions

These decisions involve the following: a) Dropping a product which is unprofitable b) Closure of a factory, department or branch due to persistent losses or excessive running expenses c) If the decision is to shut down, whether the closure should be permanent or temporary. In such cases, the total contribution of the profitable product(s) should be determined and total general fixed costs (including for unprofitable ones) deducted therefrom to arrive at the new profit. However, any fixed costs that are attributable to the dropped product and which would be saved if its production ceased should be deducted from total general fixed costs. The previous total profit should then be compared with the new profit to determine whether to shut down or not. If the result is an increase in profit, then the product should be dropped. Other factors that need to be considered are whether more profitable products would replace the dropped ones, new markets are available and if general fixed costs will remain same alter. Example 4 Rongai Ltd produces three X, Y and Z. The current net profits from the three products is as follows: X Y Z Total shs shs shs shs Sales 500,000 400,000 600,000 1,500,000 Variable costs 300,000 250,000 350,000 900,000 Contribution 200,000 150,000 250,000 600,000 Fixed costs 170,000 180,000 200,000 550,000 Profit (Loss) 30,000 (30,000) 50,000 50,000 The Managing director of the company is disturbed with the persistent losses incurred in making product Y and and has asked you as a cost accountant for advice as to whether the product should be dropped or not. Sh 50,000 of the fixed costs of Y would be saved if its production ceased. All other fixed costs would remain the unchanged. There are no anticipated changes in selling prices.

a) Assess whether product Y should be dropped or not. b) The company is also considering to utilise the resources realised from dropping production of

Y to production of a new product ,N. Product would sell for shs 500,000 and incur variable costs of shs300,000 and extra direct fixed costs of shs60,000. Advise whether product Y would be dropped. Solution a)Contribution : product X shs 200,000 Product Z shs 250,000 Total contribution shs 450,000 Less: Fixed costs remaining shs 500,000 Loss ( 50,000) The dropping of product Y results in decrease of company profits from shs 50,000 to a loss of shs 50,000. It is recommended that product Y be dropped. b) Comparison of profits expected from old(Y) and new product(N):

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Y N Increment Shs shs sh Sales 400,000 500,000 100,000 Less : variable costs 250,000 300,000 50,000

Contribution 150,000 200,000 50,000 Less : Direct Fixed costs 50,000 60,000 10,000 Profit 100,000 140,000 40,000

It would be more profitable to drop production of Y and utilise resources to making N as profits will increase by sh40,000.

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LESSON FOUR: QUIZZES 1) Which of the following statements is NOT TRUE about relevant costs?

A They are future costs, cash flows and incremental costs B They are avoidable, differential and opportunity costs C They are attributable fixed and and controllable costs D They are committed fixed costs and uncontrollable costs Correct answer D 2A firm produces three products X,Y and Z whose unit sales prices are sh 50,sh 60 and sh 80 respectively. Their unit variable costs are sh 20,sh36 and sh40;and the labour hours (limited ) required to produce each unit are 3 hours,2hours and 5 hours respectively .The ranking of the products in priority of production would be: A X,Y,Z B Z,Y,X C Y,X,Z D Z,X,Y Correct answer C Contribution per unit: X sh30,Y sh24 ,Zsh40, Labour hrs per unit: X 3hrs,Y 2 hrs and Z 5hrs. Contribution per unit of labour hr=Xsh10,Y sh 12 ,Z sh 8 Ranking based on contribution per labour hour(from highest): Y ,X,Y

3Which of the following statements best describes a key factor ?

A It is limited direct material, direct labour and machine hour. B It is limited demand for sales, materials and lack of space. C It is a constraint which prevents indefinite expansion or unlimited profits. D It is factor which limits expansion and profits. Correct answer C

LESSON FOUR QUESTIONS 1JJ co Ltd makes two products , the K and the L. K sells for shs 50 per unit and L sells for shs 70 per unit. Their variable costs per unit are shs 35 and shs 40 respectively. Each unit of K uses 2kg of raw material and L uses 3kg of material. In the forthcoming period, the availability of raw material would be limited to 2,250 kgs. The company is contracted to supply 500 units of K to a supermarket. Maximum demand for L is 250 units while the demand for K is unlimited. Fixed costs are shs 5,750 per annum. Required : Determine the profit-maximising product mix and profit results. solution Product K L Selling price per unit (sh) 50 70 Variable cost per unit (sh) 35 40 Contribution per unit (sh) 15 30 Material usage per unit (kg) 2 3 Contribution per unit of limiting factor sh/kg) 7.5 10 As material is limiting factor, produce L followed by K. However, since the demand for K is unlimited, any remaining materials would be utilised to produce K. Material Product Requirements Available production Kg kg units L 750 750 250

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K 1,000 1,500 750 Total 1,750 2,250 1,000 Profit statement : sh Contribution : product K (750@sh 15) 11,250 Product L ( 250@ sh 30) 7,500 18,750 Less : Fixed costs 5,750 Net profit 13,000 2 Masai Lane Ltd manufactures two components, the A and the B, using the same machines for each. The budget for the next year calls for the production of 4,000 units of each component. The variable production cost per unit of the final product, G , is as follows: Machine hours variable cost (shs} 1 unit of A 3 20 1 unit of B 2 36 56 Machine hours are limited to 18,000 hours. A subcontractor has quoted the following unit prices for supplying the components: A shs 29 and B shs 40. Advise Green Lane Ltd. Solution Production mix Product Machine hours production Units Required Available units A 4,000 12,000 12,000 4,000 B 4,000 8,000 6,000 3,000 8,000 20,000 18,000 7,000 Comparison of variable costs of making and buying A B Sh sh Variable cost of making 20 36 Variable cost of buying 29 40 Extra variable cost of buying 9 4 Machine hours saved by buying 3hrs 2hrs Extra variable cost of buying sh 3 sh 2 ( per hour saved) Recommendation: Priority would be to make 4,000 units of A (12,000 machine hrs) and 3,000 units B(6,000 machine hrs), using 18,000 machine hours. Then subcontract 1,000 units of B ( 2,000 machine hrs). Total variable production costs of the component: sh For making: A 4,000 units@ sh 20 80,000 B 3,,000 units @ sh 36 108,000 188,000 For buying B 1,000 units@ sh 40 40,000 228,000

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3 KK Ltd makes four components, K, L ,M and N. for which costs in the forthcoming year are expected to be as follows : K L M N Production ( units ) 1,000 2,000 4,000 3,000 Unit marginal costs : Shs shs shs shs Direct materials 40 50 30 40 Direct labour 80 90 40 60 Variable production overheads 30 40 10 30 150 180 80 130 Specific fixed costs of manufacture 10,000 70,000 80,000 80,000 Other committed fixed costs per annum are sh 300,000. An outsider has offered to supply units of K, L, M and N for sh 130, shs220, shs 110 and shs150 per unit respectively. Required: Assess whether the company should make or buy the components. Solution Analysis of variable costs between making and buying would give some cost savings ie differencial costs which are relevant costs. Specific or directly attributable fixed costs would also be saved when buying. Product K L M N Sh sh sh sh Unit variable cost of making 150 180 80 130 Unit variable cost of buying 130 220 110 150 Extra cost of buying (per unit) (20) 40 30 20 Production ( in units) 1,000 2,000 4,000 3,000 Extra variable cost of buying (per annum) (20000) 80,000 120,000 60,000 Attributable fixed costs saved by buying 10,000 70,000 80,000 80,000 Extra total cost of buying (10,000) 10,000 40,000 (20,000) Conclusion: The company should buy components K and N and make savings of sh 10,000 and sh 20,000 .Purchase cost of K are less than the variable production cost of making it .On the other hand, there is a saving in fixed cost of sh 80,000 when product N is bought rather than internally manufactured .Products Land M should be made internally. Note that the relevant costs are variable cost of making and buying as well as the savings in directly attributable fixed costs of making. Other fixed committed costs are irrelevant costs because they will not change whether the components are bought or not. 4 During a month when 1,000 units were made, costs and sales per unit were as follows :

Shs Sales 480 Less: Prime cost 220 Fixed cost 140 360 Profit 120 A proposal has been made to reduce the selling price to shs 450 per unit at which price ,sales would be 1,300 units. This volume would necessitate paying overtime to the labour which

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would result in an increase of shs 10 in the labour costs and engaging a wages clerk at a salary of sh 10,000 per month.

Determine whether the new proposal is worthwhile or not Solution Profit statement:

Current proposed Sales (units) 1,000 1,300

Sh sh Contribution per unit 260 (480-220) 220 (450-230) Contribution 260,000 286,000 Fixed cost 140,000 150,000 Net profit 120,000 136,000

5 Usafi Ltd produces a detergent called ZE . The following budget has been prepared for next year.

Raw material 25,000 Litres shs 100,000 Direct wages 30,,000 Hours 75,000 Variable overhead 30,000 Fixed costs 125,000 Total cost 330,000 Profit 70,000 Sales shs 400,000

The company has special bulk order of the detergent but is hesitant to accept it. The order would use 5,000 litres and 4,000 hours of labour. Calculate the minimum price at which the company could accept the order, assuming a) Raw material supplies are the limiting factor. b) Direct labour is the limiting factor.

Solution sh Direct material 5,000 litres@sh 4 20,000 Direct labour 4,000 hours@ sh 2.5 10,000 Variable overheads 4,000 hours@sh1 4,000 Variable cost 34,000

a) If material supply is limited

Contribution per unit of material (litres)= contribution/litres ordered=Sh 195,000÷25,000 = sh 7.80 per litre Variable cost sh 34,000 Contribution: 5,000litres @ sh 7.8 39,000 Contract price sh 73,000

b) If labour is limited Contribution per unit of labour hour= sh 195,000÷30,000 hrs= sh 6.50 per hr Variable cost sh 34,000 Contribution : 4,000hrs @ sh 6.5 26,000 Contract price sh 60,000

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CHAPTER FIVE: Cost Accounts

Lesson objectives After studying this lesson , the learner should be able to:

a) Explain how an interlocking system operates b) Distinguish between interlocking and integral costing systems c) Prepare cost ledgers and Trial balance from given financial information. d) Identify the causes of differences of profit in financial and cost accounts

e) Reconcile the profits in financial and cost accounts 1.0 Interlocking Accounts

Interlocking accounting system is also called non-integral cost accounting. It is a system of cost accounting where cost and financial transactions are kept separately .The cost accounts have no double entry connection with the financial accounts but use the same basic data. The cost ledger and financial ledger are maintained separately. The responsibilities of recording the ledgers can shared as follows: cost accountant (cost ledgers) and the financial accountant (financial ledgers). The principal financial ledgers are General ledger, Debtors ledger and Creditors ledger .On the other hand, the principal cost ledgers are:

i Cost ledger- contains nominal accounts and some real accounts (principal ledger). ii Stores ledger- Contains stores such as Raw materials, WIP, Receipts and Issues (Subsidiary ledger). iii Work-in-progress (Subsidiary ledger). iv Finished Goods Ledger (Subsidiary ledger).

There are three types of accounts maintained in the financial ledger, namely: i) Personal accounts eg debtors and creditors, ii)Real accounts eg cash, fixed assets, stocks etc and iii)Nominal accounts eg wages, heat and lighting, rent and rates, discounts, carriage etc. On the other hand, cost Ledger contains only impersonal accounts. Transactions affecting the nominal accounts are recorded separately in both ledgers. Cost profit and financial profit do not agree due to items may appear in financial ledgers only while some in cost ledgers only. These items need to be reconciled at the end of the year.

1.1 Advantages of maintaining cost ledger The cost ledger is the principal ledger in the cost accounting book-keeping system and several advantages can be derived from it, including the following:

a) It facilitates prompt preparation of costing profit and loss account, Balance sheet . b) It is the basis for analysis and control of costs , preparation of accounts for each cost

centre, for cost ascertainment and control purposes c) It assists management in formulating policies as the ledger summarises the detailed

information regarding cost available in subsidiary records. d) It helps to check all transactions, records in the financial accounts and therefore

Provides internal check through the use of various control accounts e) It helps to determine value of closing stock and Work-in-progress (WIP) promptly. f) It provides detailed information for planning, control and decision making through

the generation of internal reports. 1.2 Control accounts These are the total accounts in the cost ledger which summarises totals of individual accounts-entries are made once at the end of each accounting period based on the periodical totals of transactions in related subsidiary ledgers and books eg purchases of individual items of stores appearing in individual accounts in the stores ledger are totalled and posted in Stores Ledger control account in the Cost ledger in total purchases. Thus the Stores ledger control account is stores ledger in summary

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form. Similarly, a control account is also maintained for each of the subsidiary ledgers. The objective of opening a control account for cost ledger is to complete the double entry . 1.3 Main advantages of control accounts

1 Provides management detailed information for policy formulation. 2 Enables preparation of final accounts- profit and loss account and Balance sheet

3 Provides internal check leading to greater accuracy of the accounts and proper bookkeeping.

1.4Principal accounts in the Cost ledger The main control accounts maintained in the cost ledger are : General ledger adjustment account, Stores ledger control account, Wages control account, purchases overhead account, Administration overhead account ,Selling and Distribution account, Work in Progress , Finished Goods, Cost of Sales, Costing Profit and Loss accounts. These accounts and their respective accounting entries are discussed as herebelow :

1) General ledger adjustment control Account (GLA)

This account is also known as the’ Cost ledger control account’, or ‘Cost ledger contra account ‘or ‘Financial ledger account’. The account takes care of personal accounts and real accounts since in the cost ledger only impersonal accounts are maintained. This account is needed to maintain the double entry principle within the cost ledger and contains postings which affect accounts outside the costing system eg Debtors, Creditors, Cash. The main entries which are made in this account are as follows :

a. When materials are purchased: DR Stores ledger adjustment account CR General ledger adjustment account

b. When wages are paid : DR Wages control account CR General ledger adjustment account

c. When overheads are paid : DR Overhead account (eg selling, distribution expense) CR General ledger adjustment account

d. When sales are made : DR General ledger adjustment account CR Costing Profit and loss account

e. Sales returns: DR Costing profit & loss account CR General ledger adjustment account

f. When recording costing profit : DR Costing profit and loss account CR General ledger adjustment account. Example 1 X Ltd made purchases of raw materials worth shs 40,000 and paid wages amounting shs 10,000.Prepare entries in the cost books. 1 purchase of raw materials: Dr Stores ledger control account 40,000 Cr General ledger adjustment account 40,000 2 wages paid : Dr Wages control account 10,000 Cr General ledger adjustment account 10,000 Notes

All items of income and expenditure taken from financial accounts and all transfers from cost books to financial books for transactions (eg Returns for materials from stores, transfers to capital expenditure performed by factory, transfer of costing profit and loss etc are recorded in the account .

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All transactions in the cost ledger must be recorded through control account.

The balance in this account will always be equal to the sum of all the balances of the impersonal accounts.

If a transaction is of an internal nature affecting cost accounts only ( transfers from stores ledger to Work in progress(WIP) , WIP to Finished Goods (FIGS), then no entry is required in GLA ,as a double entry is possible without recourse to this balancing account.

2) Stores ledger control account (SLA) This account shows a record of material receipts and issues to production. In case of any material returns, their value will be credited to this account. The balance in this account represents material in hand at the end of the period. The necessary entries to this account are as here below: a) Material purchased or received: DR Stores ledger control account CR General ledger

adjustment account b) Material Rejected and Returned to Suppliers: DR General ledger adjustment

account CR Stores ledger control account c) Material issued to production : DR Work in progress CR Stores ledger control

account d) Material Rejected/Returned from production: DR Stores ledger control account CR

Work in progress

3) Work in progress control account This account records direct materials, direct labour, direct expenses, production overheads incurred and cost of sales or finished goods. The balance on this account represents the value of WIP at the end of the year .The necessary entries to this account are as follows : a Prime costs incurred : DR Work in progress account CR Individual prime/direct costs b Production overheads incurred :DR Work in progress account CR Production overheads c Special material purchases : DR WIP account CR Special purchases d Value of Finished goods : DR WIP account CR Finished Goods account 4)Finished Goods Ledger control account This account shows the cost of completed jobs and the cost of finished goods sold.The balance on this account shows the value of finished goods on hand at year end.The necessary double entry is as below : a Cost of finished goods transferred from WIP : DR FIGS account CR Cost of finished goods transferred from WIP

b Cost of goods sold : DR Cost of goods sold CR FIGS account 5)Wages control account This account shows the total wages paid to the employees. It is not really a control account as it does not control a subsidiary ledger. However, the account does not have any closing balance. The necessary double entries are as below : a Gross Wages incurred : DR Wages control account CR General ledger adjustment account b Direct wages : DR WIP account CR Wages control account

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c Indirect wages : DR Production, adm,selling or distribution Overhead individual accounts CR Wages control account. 6)Production overhead account DR Indirect materials , indirect labour, indirect expenses incurred CR Overheads absorbed/recovered. The balance is transferred to Overhead Adjustment account (OAA) or Costing Profit& Loss Account (CP&L ) 7)Administration overhead account DR Administration Expenses CR Overheads absorbed by Finished goods. The balance of under or over absorbed overheads is transferred to OAA or CP&L. 8) Selling and Administration Overhead account DR Selling & Administration expenses CR Overheads recovered from cost of goods sold. The balance of under or over absorbed overheads is transferred to OAA. 9) Cost of sales account DR Cost of Sales CR Selling& Administration expenses. This is eventually transferred to Costing Profit/ Loss account by the entry below : DR Costing Profit/ Loss account CR Cost of sales 10)Overhead adjustment account (OAA ) This account may be maintained. All under or over absorbed overheads are transferred to the account and the balance shows the overall figure of under or over recovered overheads. The overall figure is eventually transferred to the Costing Profit& Loss account or Suspense account. DR Under absorbed overheads for production, administration, selling & distribution overheads CR OAA DR OAA CR Over absorbed from respective Overhead control accounts. 11)Costing Profit and Loss account (CP&L ) DR Cost of sales, abnormal losses, under recovery of overheads CR CP&L. DR CP&L CR Sales, Abnormal gains, over absorbed overheads , Value of goods sold etc. The balance on this account represents Costing Profit or Loss which is to be transferred to General Ledger adjustment account . This profit is reconciled with the Financial Profit or Loss .To facilitate correct recording or posting of the above transactions, it may be helpful to open T-accounts. 12)Other accounts requiring special treatment: a) Carriage inwards : DR Production overhead account CR General ledger adjustment account b)Capital orders completed : DR Capital orders account CR WIP.

The asset , when capitalised , is transferred to the financial ledger by : DR General ledger Adjustment account CR Capital order account.

c)special repair orders completed : DR Special repair orders account CR WIP The cost of repair is then charged to user department by: DR Production, administration, selling, distribution overhead account CR Special repairs order account.

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Example 1 The following transactions took place during the month of March 2000 in West end manufacturers Ltd:

1) Shs Materials purchased: a) Cash purchases 20,000 b) Credit purchases 60,000 c) Credit purchases (special job) 16,000

2) Returns to suppliers 10,000 3) Direct materials issued to production 40,000 4) Indirect materials issued to production 18,,000 5) Materials returned from production

To store 6,000 6) Materials transferred from Job no.11

To Job no.15 2,000 Required: Enter the transactions in the cost books. Solution 1 a) DR(shs) CR (shs) Stores ledger control account 20,000 General ledger adjustment account 20,000 b) Stores ledger control account 60,000

General ledger adjustment account 60,000 C ) WIP ledger control account 16,000

General ledger adjustment account 16,000 2 General ledger adjustment account 10,000 Stores ledger control account 10,000 3 WIP ledger control account 40,000 Stores ledger control account 40,000 4 Production Overhead account 18,000 Stores ledger control account 18,000 5 Stores ledger control account 6,000 WIP ledger control account 6,000 6 Job No. 15 account 2,000 Job No.11 account 2.000 1.5 Reconcilliation of Cost and Financial accounts

When interlocking accounting system is used, differences arise between the profit shown by the cost accounts and the financial accounts and hence a reconciliation becomes necessary. The reconciliation between the cost accounts and financial accounts may be done through preparation of either a ‘’Reconciliation statement ‘’ or ‘’Memorandum Reconcilliation account’’. However, if intergral accounts are prepared, there is no need for such reconciliation.

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Reasons for Reconcilliation

a) To find out the causes for the differences and to ensure that no item of expenditure or income has been omitted and that there is no over or under recovery of overheads.

b) Cost ascertainment and cost control depend on accuracy of cost analysis, distribution and allocation. Hence reconciliation ensures accuracy.

c) Helps to check the arithmetic accuracy of both sets of accounts and hence facilitates internal control by testing the reliability of cost accounts through highlighting differences that cause increase or decrease in profits.

d) Helps in the standardization of accounting policies such as inventory valuation, overhead absorption and depreciation provisions.

e)Promotes coordination and cooperation among the costing and financial accounting departments in generating correct and reliable accounting information that satisfy both Statutory requirements and managerial decision making.

Causes for the differences of profits in cost accounts and financial accounts These differences can arise due to the following items : 1 Items included only in financial accounts (they do not relate to manufacturing

activities. a) Purely financial charges , reducing profit:

These items include fines and penalties; interest on bank loans/ mortgages; discount on shares, debentures and bonds; loss on investment or on its sale; loss on sale of fixed assets, scrapping of machinery, uninsured destruction of assets; stamp duty ,discount and other expenses, transfer of stock, shares, bonds, debentures; remuneration paid to the proprietor in excess of a fair reward for services rendered.

b) Purely financial income , increasing profit: Items here include rental income; fees received on issue, transfer of shares; profit on sale of fixed assets, investments; interest received on bank deposits and other investments; dividends received on investment in shares; share premium.

c) Appropriation of profit : Donations and charities, income tax, goodwill, preliminary expenses, debenture discount, dividends paid, transfer to General reserve, appropriation to sinking funds, additional provisions for depreciation etc

2) Items included only in the cost accounts : Notional rent on premises owned ; notional interest on capital employed in

Production, salary for the proprietor where he works but does not charge salary. 3) Under or over absorption of overheads In financial accounts the actual overheads incurred is taken into account. In cost Accounts, overheads are applied to costs units at predetermined rates and Amount recovered may vary from actual overheads .If over and under recovery are not charged to Costing profit and loss account, the profits on the two sets of books will not tally. 4)Use of different methods of stock valuation

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In financial accounts stock is valued at cost or market value ,whichever is lower. In costs accounts, stock valuation methods used include LIFO, LIFO, Weighted Average cost .

5)Use of different rates of depreciation In financial accounts the rates are given by Companies Act and Income Tax Act. .In cost accounts, Machinery Hour Rate (MHR), production unit method. The formats of reconciliation statement and memorandum reconciliation statements are shown as below:

AProforma Reconcilliation Statement

Shs shs

Profit as per cost accounts xxx

Add: 1) Financial incomes not recorded in cost accounts xx 2) Overvaluation of OPENING stocks , xx 3) Under valuation of CLOSING stocks, xx 4) Over absorption of overheads xx 5) Items charged in cost accounts only xx Less: 1) Financial charges not considered in cost accounts xx 2) Undervaluation of OPENING stocks , xx 3) Overvaluation of CLOSING stocks , xx 4) Under absorption of overheads xx Profit as per Financial accounts xxx

B Proforma Memorandum Reconciliation Account Sh sh Under absorption of overheads xxx Profit as per cost accounts xxx In cost accounts over-absorption of OHDs in cost

Overvaluation of Closing Stocks xxx accounts xxx

Undervaluation of opening stocks xxx undervaluation of closing stocks, xxx Purely financial charges xxx overvaluation of opening stocks, xxx Net profit as per Financial accounts Items charged only in cost accounts xxx (Balancing figure) xxx financial incomes not recovered

In cost accounts xxx

XXXX XXXX

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1.6 Integral Accounts

The reconciliation of profits in financial and cost accounts can be avoided by designing an ‘ integrated’ or ‘ integral ‘ system of accounting .Basically, the integral accounts system is similar to the separate accounting and costing systems, except that of course it eliminates the duplication of entries , and the maintenance of unnecessary accounts .The integral system is a single set of accounts which provides both financial and cost accounting information. Unlike the interlocking system, both personal and impersonal accounts are maintained in the ledger. In effect, there are accounts for stock, production, administration, selling and distribution overheads followed by such final accounts as cost of sales, profit and loss .The basic principles in the design of an integral accounting system are as below: a) Under the double entry method, cost ledger includes the creditors control account, cash

account; debtors control account and provision for depreciation account, replacing the General ledger cost control account.

b) Under the Third entry method which is similar to the double entry method, except that a third entry is made in respect of elements of cost. All items of cost eg purchases, are debited in total in a Cost ledger control account, and credited to a Creditor’s account. The cost is then analysed into Third-entry accounts (which are not part of a double-entry system) in respect of materials, factory overheads, administration, selling and distribution overheads. The totals of these accounts are then transferred to Finished Goods account, Profit and Loss account etc. However, it is felt that the ordinary double- entry principles are sufficient, because the analysis work described in the third-entry method would be obtainable from the job cards, standing order cards, etc.

Benefits of integrated accounts a) Avoids the need for reconciliation. b) Enables more reliance to be placed on cost information as subject to formal control

procedures. c) The development of integrated system becomes easier eg Stock control, payroll, which

incorporates accounting records.

Example 2

The costing profit of Gataka Ltd for the year ending 31st December 2006 was shs 92,000, whereas the

financial profit for shs 120,000. The following information is given:

1)The cost accounting records show :

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iThe opening stock as January 1, was shs 230,000 and closing stock on 31st

December was valued at shs 308,000 .

iiProduction overhead recovered was shs 136,,000

iiiAdministration overhead was absorbed at 5% of sales

ivSelling and distribution overhead was recovered at 7½% of sales

vNotional rent and interest on capital were shs 16,000 and shs 12,000.

2)The company’s financial Trading and Profit and Loss account the year ending 31st December, 2006 was as under:

shs opening stock 280,,000 material purchase 1,120,000

shs

1,400,000 Less: closing stock 320,000 Direct materials consumed 1,080,000 Direct wages 480,000 Prime cost 1,560,000 Production overheads 140, 000 Factory cost 1,700,000 Gross profit 300,000

2, 000,000 2,000,000 Discount allowed 16,000 Gross profit 300,000 Administration expenses 110,000 Discounts received 30,000 Debenture interest 10,000 Dividends received 36,000 Selling& distribution expenses 134, 000 Interest received 24,000 Net profit 120, 000

390,000 390,000 Required: Prepare a memorandum or proforma reconciliation statement. Answer Memorandum Reconcilliation Statement

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Sh sh sh Profit as per cost accounts 92,000 Add: Items not credited in cost accounts: Discount received 30,000 Dividends received 36,000 Interest received 24,000 90,000 Add: Difference in closing stocks 12,000 Add: Selling &distribution ohds over-recovered 16,000 118,000 210,000 Less: Items not debited in cost accounts: Discounts allowed 16,000 Debenture interest 10,000 26,000 Add: Difference in opening stock 50,000 Add: Overheads under-recovered in cost accounts: Production ohds 4,000 Administration ohds 10,000 14,000 90,000 Financial profit 120,000 LESSON FIVE QUIZZES

1 Which of the following are the control accounts of the cost ledger? A General ledger, stores ledger, work- in- progress ledger and finished goods ledger. B Cost ledger contra, stores ledger, work –in- progress ledger, finished goods Ledger. C General ledger , stores ledger, finished goods ledger and wages control. D General ledger, cost ledger contra, stores ledger, work in progress ledger Correct answer B

2Match the following transactions with their credit cost journal entries:

Transaction journal a) purchases 1 Work in progress

b) materials allocated 2 Finished goods c) Jobs delivered 3 Stores control d ) completed jobs 4 Cost ledger contra Correct answer a(4), b(3),c(2), d(1)

3The financial profit and loss account of kkm Ltd showed a gross profit of sh 500,000 before charging the following expenses: office salaries sh 96,680, office expenses sh64,280, sales manager’s salary sh 20,000,Sales men’s salaries 85,120, sales expenses sh 68,380, packing costs sh 17,500, distribution expenses sh 24,920. Only the office salaries and office expenses had been charged in the cost accounts. The costing profit would be:

A Sh 123,120 B sh 215,920 C Sh 339,040 D sh 284,080 Correct answer C Financial profit=gross profit-expenses= sh 500,000-376,880=123,120 Cost profit=financial profit +expenses(excluding office salaries and office expenses) =sh123,120+20,000+85,120+68,380+17,500+24,920=sh339,040.

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LESSON FIVE QUESTIONS

1 The cost accounts of Neema Ltd revealed profit for the year as shs 48,390. The company’s financial accounts disclosed the following position :

Manufacturing Account

Shs shs Shs Raw material:

_opening stock 1,900 Transfers to finished stock 111,400 Purchases less returns 54,900 56,800 Less: Closing Stock 1,800 55,000 Direct labour 35,500 Factory overhead 21,400 111,900 WIP- - opening 8,400 -closing (8,900) Factory cost of production 111,400 111,400 Finished Goods account

Opening stock 11,600

Transfer from

manufacturing account

111,400

123,000

Cost of sales transferred to

trading a/c

110,700

Closing stock 12,300

123,000

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Trading account

Factory cost of sales

transferred from

stock a/c 110, 700

Gross profit c/d

73,800

184,500

Sales184,500

184.500

Profit and Loss Account

Sh

Administrative expenses 15,600

Distribution expenses 10,182

Discount allowed 1,511

Debenture interest 850

Fines 500

Leases(non -trading) 350

Net profit 46,950

Shs

Gross profit b/d 73,800

Discount received 1,806

Interest received 37

Dividends received 300

75,943 75,943

Stock valuations in the cost accounts were as follows : Opening balance closing balance

Shs shs Raw materials 1,969 1,850 Work in progress 8,280 8,730 Finished stock 11,396 12,810

Depreciation amounting to sh 6,146 was charged in the cost accounts whereas Factory overhead in the Financial accounts included Sh 5,873 for this expense. The profit shown in the cost accounts has been arrived at before charging Notional rent shs 1,500. Required: Prepare a reconciliation of the two profit figures.

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Sh sh sh

Profit as per cost accounts 48,390 Add: Items not credited in cost accounts Stock valuations: Raw materials 19 Work in progress 50 Depreciation 273 342 Less: Items not debited to cost accounts Finished goods 714 (372)

48,018

Per Financial accounts shs 73,800? Less: Administration 15,600 Distribution 10,182 25,782 48,018 Note : All other items in the Profit and Loss Account would not appear in the cost accounts.

2The balances shown in the cost accounts of Mcosti Ltd as at September 30th are as follows : :

shs shs Cost ledger control account 69,600 Stores ledger control a/c 3,696 WIP Control a/c 6,390 Wages control a/c (accrued wages ) 622 Factory overhead control a/c ( under absorbed overhead) 336 Finished Goods Stock a/c 24,000 Cost of sales a/c 364,000 Administration overhead control a/c 55,600 Marketing overhead control a/c 37,000 Sales 560,000 560,622 560,622

The following transactions occurred in the month of October : Shs Total invoices for material stocks 30,244 Gross wages payable (including employer’s contributions Shs 900) : Factory direct wages 12,000 Factory indirect wages 5,800 17,800 Accrued wages October 31st 846 P.A.Y.E (Income tax deductions) 3,200 Other deductions 1,000 Net wages cheque drawn 12,700 Materials issued to production 28,370 Wages allocated: Factory direct wages shs 12,000 Factory indirect wages shs 6,024

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Indirect materials issued to factory 1,740 Invoices for factory overhead expenses 4,248 Stores stock October 31st 3,830 Work in progress October 31st 8,760 Finished Goods stock October 31st 28,000 Administration overheads incurred 6,200 Marketing overhead incurred 4,100 Sales 64,000 Interim dividend paid 16,000 Required: a) Prepare entries to record the transactions in cost books.

a) Extract the Trial Balance from the cost accounts as at 31 st October. Solutions

a) Journal entries

DR (shs) CR (shs)

1) Stores ledger control 30,244 Cost ledger control a/c 30,244 Invoices for materials

2) Wages control 17,800 Cost ledger control 17,800 Gross wages

3) Work in progress 28,370 Stores ledger control 28,370

Materials issued 4) Work in progress 12,000

Factory overhead control 6,024 Wages control 18,024

Allocated wages 5) Factory overhead control 1,740

Stores ledger control 1,740 Indirect materials issued

6) Factory overhead control 4,248 Cost ledger control 4,248

Overhead invoices 7) Finished stock 38,000

Work in progress 38,000 Prime cost of goods completed

8) Finished stock 12,000 Factory overhead 12,000

9) Cost of sales 46,000 Finished stock 46,000

10) Administration overhead 6,200 Marketing overhead 4,100 Cost ledger control 10,300 Overhead incurred

11) Cost ledger control 64,000 Sales 64000

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b)Mcosti Ltd Trial Balance as at 31st October Dr Cr Shs shs Cost ledger control a/c 71,008 Stores ledger control 3,830 Work in progress 8,760 Wages control 846 Factory overhead control 348 Finished goods stock 28,000 Cost of sales 410,000 Administration overhead control 61,800 Marketing overhead control 41,100 Sales 624,000 624,846 624,846

3 The profit shown in the financial accounts of Copa Ltd is shs 92,960 and for the same period the cost accounts showed a profit of shs 102, 480 .Analysis of the two sets of accounts disclosed the following information: Stock valuation cost accounts Financial accounts Raw materials: shs shs

Opening stock 34,105 36,295 Closing stock 27,415 25,640

Finished Goods : Opening stock 66,455 64,525 Closing stock 57,150 55,655 Dividends and interest received of shs2,760 and a loss of shs8,750 on the sale of an old computer equipment were not entered in the cost accounts. Required : Reconcile the profit figures.

Answer

Memorandum reconciliation statement

Sh sh sh

Profit as per cost accounts 102,480

Add: Items not credited in cost accounts: Dividends& interest received 2,760 Add : Difference in opening stock (FIGS) 1,930 4,690 107,170 Less: Difference in closing stock(FIGS)) 1,495 Difference in opening stock (RMI) 2,190 Difference in closing stock(RMI)) 1,775 Loss on sale of computer 8,750 14,210 Profit as per financial accounts 92,960

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4The following information is provided by the cost accountant of Kk Ltd: shs ( 1)a) Cost of services obtained 240,000 b) Petty cash spend for various expenses 10,000 Analysis of services reveals : Production overheads 100,000 Administration overheads 60,000 Selling& distribution overheads 80,000 Analysis of petty cash reveals : Production overheads 6,000 Administration overheads 800 Selling& distribution overheads 3,200 (2 )Overhead absorbed is as under :

a) Production overhead 96,000 b) Administration overhead 64,000 c) Selling & distribution overhead 80,000

Required : Record the above transactions in the cost books.

Cost books: Dr (sh) Cr (sh) (1 )a) Production overhead a/c 240,000 Sundry creditors a/c 240,000

b) Production overhead a/c 6,000 Administration overhead a/c 800

Selling& distribution a/c 3,200 General ledger adjustment a/c 10,000 (2) a) Work in progress a/c 96,000

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Production overhead a/c 96,000 b) Finished goods ledger a/c 64,000 Administration overhead a/c 64,000 c) Cost of sales 80,000 Selling& distribution 80,000 The under and over-absorbed overhead are transferred to Costing Profit and Loss a/c via overhead adjustment a/c as follows: (3) a) Administration overhead a/c (0ver -absorbed) 3,200 Overhead adjustment a/c 10,000 Production overheads (under-absorbed) 10,000 Selling& distribution overhead ( ,, ) 3,200 b ) Costing Profit& Loss a/c 10,000 Overhead adjustment a/c 10,000

LESSON SIX : CONTRACT ACCOUNTS

Lesson objectives After studying this lesson, the learner should be able to:

a) Identify key characteristics of contract costing. b) Distinguish the various types of contracts and methods of contract accounting. c) Identify cost elements of a contract and calculate notional profit and interim profits for

incomplete contracts. d) Calculate work in progress and extract contract Balance Sheet items e) Prepare Contract and contractee accounts.

1.0 Definitions of a contract and contract types Contract costing is a form of specific order costing which also includes job and batch costing.Contract costing is a term derived from a contract ,which is a cost unit or cost centre which accumulates direct costs of production and apportioned head office overhead expenses. Thus, contract costing is a form of specific order costing that is applied to relatively large cost units which take a long duration to complete due to enormous work involved. Most contracts are of constructional nature where work undertaken includes construction of buildings, bridges, roads, dams, ship-building , specialised equipment and oil exploration .Although the contract itself can be regarded as a cost unit, subunits will often be used for cost analysis. For example, in a building contract, the subunits may include foundations, steelwork, walls, roof, electrical installations, plumbing, floors, painting and decorating etc. Contract or terminal costing is similar to job costing except for the distinct characteristics highlighted below. Builders, civil-engineering contractors, constructional and mechanical-engineering and similar firms make use of this type of costing method. Construction contracts may be of three types, namely: 1) Fixed price contracts : Where the contractor (builder/ supplier) agrees with the Contractee (client /customer)to a fixed contract price or charge for service rendered.

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2)Fixed price contracts subject to escalation clause: The contract and contractee agree on a fixed price subject to escalation clause which provides for variation in contract price due to price changes in prime costs and other overheads , if any. The contractor can only be reimbursed the excess expenditure provided he has sufficient proof such as genuine purchase invoices and receipts. 3) Cost plus contracts :The contractor is reimbursed the actual cost incurred on contract plus a percentage markup to cover for profit on contract. Furthermore, IAS 11 ‘ Accounting for construction contracts’ recommends two methods of accounting for contracts: Percentage of completion method and Completed contract method. This particular standard is largely dealt with in financial accounting and reporting and therefore we will not duel on it here.

1.1 Characteristics of construction contracts a) A formal contract/Agreement is usually made between the contractor and client for

reference in case of disputes. b) Work is undertaken to suit clients’ special requirements or specifications. c) Work usually takes a long duration, more than one year. d) Work is done on site, with own cashier and timekeeper, away from the contractor’s own

premises or office .Perhaps some initial assemblies such as pre-cast concrete frames ,window and door frames, may be prepared at contractors premises.

e) Work is mostly constructional or civil works. f) Except for general administrative overheads, most of the items of cost are directly

chargeable to the contract. General administration overhead is apportioned over a number of contracts.

g) Substantial part of a contract is generally subcontracted or ‘sublet’ to specialists. h) A separate account is opened for each contract to ascertain its profit or loss. i) Payments by the customer are made at different stages of the contract based on

surveyor’s or architect’s certificate on value of work completed. A retention money ( a specified percentage of work certified) is withheld by the client until a specific period of time, agreed in the original contract, has elapsed.

j) Penalties may be imposed on the contractor for failing to complete the work within the agreed time.

k) Contracts may either be fixed price contracts or fixed price with escalation clause or cost plus contracts.

However, there are some problems associated with contract costing. These include identifying direct costs, low indirect costs, difficulties of cost control and dividing the profit between two or more accounting periods. 2.0 Contract costs

The main costs of construction contracts are: a) Direct materials-These may be obtained from contractors’ stores or purchased

locally and delivered to site. Material delivery notes should be used to correctly record materials delivered and received by the site supervisor or engineer. Excess or defective materials should be returned to store with material return note. Any unused materials at the end of the accounting period are carried forward to the next period. Material costs form a large component of direct costs of a contract.

b) Direct labour-Cost of direct labour ( including supervision) incurred on a particular contract should be recorded using work or time sheets and charged to the contract as a direct cost.

c) Direct expenses –In addition to direct materials and direct labour, there are high direct expenses incurred on contracts. These direct expenses include costs of hiring/leasing plant and machinery, site office expenses, establishment charges,

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costs of power, water, stationery, telephones, repairs etc .However, all other overheads( general head office expenses) incurred for the company as a whole should be assessed , apportioned on a fair basis and charged to specific contract.

d) Cost of plant- If Plant is owned by the company and used on contract , three accounting methods may be used. These methods include charging depreciation on straight-line or declining balance basis to the contract, charging the contract with current book value of plant or opening a separate plant account for recording depreciation costs and running costs ( ie repairs, fuels etc) of related to the used equipment. In the later case, a notional charge is then made to user contracts at a predetermined rate. Most contractors use the second method of charging the contract with the current book value of plant. Plants used on contracts include cranes, trucks, mixers, lorries, bulldozers etc and their costs are charged as direct costs of contract using any of the methods mentioned above. However, cost plant of plant transferred to another contract should be removed and charged to user contract.

e) Subcontractors fees-Much work on large contracts is often given to subcontractors ,who are specialists, so as to accomplish the contract in time. Such subcontractors may include ventilation engineers, lift manufacturers, flooring specialists, electricians, plumbers etc. The invoiced amounts of the subcontractors works will be charged as direct costs to the contract. Small amounts of subcontractors’ fees may be conveniently charged as direct materials or direct expenses or overheads to the contract account. Note that the subunits are the ones mostly subcontracted.

f) Architect’s or Survey fees- Usually an architect or surveyor would be called upon by the Client to inspect the contract work done periodically and certify the amount of work completed. The architect’s certificate is used by the contractor to make claims for payments by client. Architect’s fees is charged as direct cost of the contract.

3.0 Contract account A contract or job account ( or work in progress account) is usually opened for each Contract and debited with the cost of direct materials, direct labour, direct expenses and overhead charges on the contract. The cost of plant or depreciation charge is debited contract account depending on the method used. Value of Work certified and cost of work done is credited to the account. Any unused and returned materials and material transfers are credited to the contract. Material and plant on site at the end of the accounting period are similarly credited to the contract account and forward to the next period. Any proceeds on sale of materials and plant are credited to this account. On an uncompleted contract, where no profits are taken mid-way through the contract, the cost of work in progress (WIP) is carried forward as a closing stock balance. The purpose of the contract account is to ascertain the profit or loss on a contract.

The contractor may also prepare a debtors or contractee account to show the amount owed by the client. The contractee account will be debited with the value of work Certified and credited with the cash received and retention monies, if any.

4.0 Profit on incomplete contracts

There are no accounting difficulties if a contract is constructed and completed within the

same accounting period. In that case, the entire profit or loss can be transferred to the Profit

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and Loss account (P&L A/C).However, there arises a problem whenever a contract takes longer

than one year to complete, as is common in most construction contracts. The issue here is how

to determine how much of the profit is to be transferred to P& Loss A/C and how much to carry

forward in the next period. Obviously, this will depend on the completion stage of the contract.

4.1 Procedure for determining the profit to be taken to the Profit and Loss account

i. When the contract is completed less than 25% only, no profit should be credited to the P&L A/C.

ii. When the contract is completed or work certified is 25% or more but less than 50% of total value of contract, Profit taken=1/3 ×Notional Profit × Cash received/ work certified.

iii. When the contract is completed or work certified 50% or more but less than 75% of the total value of contract, Profit taken=2/3× Notional profit ×Cash received/work certified.

iv. Where the contract is more than 75% complete, total profit of the contract should be estimated after considering the cost already incurred plus the additional or estimated expenditure or cost to be incurred in order to complete the contract. In such a case, profit should be credited to P&L A/C, being computed as: Profit taken=Estimated Profit ×Work certified/Contract price.

v. For loss on contract, however, the entire amount of loss should be transferred to the P& Loss account by debiting P&LA/C and crediting the Contract A/C. Notes

Notional profit =Value of work completed-Cost incurred to date.

Estimated profit=Contract price-Cost incurred to date-estimated costs of completion.

Work in progress=Cost incurred to date + Profit taken-Cash received.

4.2 Necessary Journal Entries to record contract transactions

a) When materials are issued to a contract: DR Contract A/c CR Materials a/c.

b) When wages are paid or outstanding: DR Contract a/c Cr Wages or Outstanding

wages a/c.

c) When direct expenses are paid or outstanding :DR Contract a/c CR Direct expenses

or Outstanding direct expenses a/c.

d) When plant and Machinery are installed : DR Contract a/c CR Plant& Machinery

a/c.

e) When materials are transferred from one contract to another (say, from contract

A to Contract B): DR Contract B a/c CR Contract A a/c.

f) When materials remain at the site at year end : DR Materials in hand a/c CR

Contract a/c.

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g) When materials are returned to store at the year end: DR Material Returns a/c CR

Contract a/c.

h) When Plant and Machinery remained at site at year end at Written –Down Value :

DR Plant& Machinery a/c CR Contract a/c.

i) When works are certified : DR Work certified a/c CR Contract a/c.

j) When works are uncertified : DR Works uncertified a/c CR Contract a/c.

k) When materials or Plants are sold: DR Bank a/c CR Contract a/c (at cost) CR P& L

a/c (with profit on sale).(In case of loss on sale, P&L a/c should be debited ).

l) When materials are lost or stolen and covered by the insurance company in part:

DR Bank a/c (with amount received from the Insurance company) CR P&L

a/c(actual loss) CR Contract a/c

m) When scrap is sold: DR Bank a/c CR Contract a/c.

n) When cheque or cash is received from Contractee (Client): DR Bank/Cash CR

Contractee a/c.

o) When profit is made on contract: DR Contract a/c CR P& L a/c CR Reserve/

Provision a/c

p) When a loss is made : DR P&L a/c CR Contract a/c.

Example 1 The following sums have been spent on a contract, still incomplete on the day the books of accounts of KK Contractors Ltd are being closed for the year ending 30th June, 2009:

Shs Materials 1,600,000 Wages 1,400,000 Direct charges 1,000,000

The contractor has received from the client shs 4,000,000, being 80% of the work certified. The value of work not certified at that date was She 200,000.

Required: Determine amount of profit to be credited to the Profit and Loss Account. Solution KK Contractor’s Ltd Contract Account for the year ending 30th June,2009 Dr shs shs Cr

To: Materials Wages Direct charges Profit & Loss a/c(note 1) Balance c/d Next yr: : WIP: Certified

sh 1,600,000 1,400,000 1,000,000 640,000 560,000 5,200,000 5,000,000

WIP : certified uncertified

sh 5,000,000 200,000 5,200,000

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uncertified Less: Balance b/d

200,000 5,200,000 560,000 4,640,000

4,640,000

Note 1 : Profit to P& L a/c: 2/3 × shs 1,200,000 × 80% = shs 640,000 Notional profit= Work certified +work uncertified- costs incurred to date= Sh

= shs 5,200,000- 1,600,000-1,400,000-1,000,000= shs 1,200,000.

Example 2

The following is the summary of the entries in a contract ledger account on 31st December 2005 in respect of Contract No. 12 undertaken by Mijengo contractors Ltd :

Shs Materials 3,500,000 Wages 1,800,000 Establishment charges 800,000 Materials from stores 700,000 Plant 3,420, 000 Scrap sold 182,000 Direct expenses 700, 000 Additional information :

Accruals as at 31st December, 2005 : Wages shs 90,000, direct expenses shs 120,000.

The cost of work not certified included in materials shs 260,000; Wages shs 100.000 and direct expenses shs 150,000.

Sh 200,000 worth of plant and shs 300,000 worth of materials were destroyed by fire.

Sh 400,000 worth of plant was sold for shs 300,000 and materials costing shs 500,000 were sold for shs 600,000.

Depreciation till 31st December 2005 on plant was shs 1000000.

Materials at site shs 500000.

Cash received from contractee shs 6,000,000, being 80% of works certified.

Contract price shs 10,000,000. Required : a) Prepare Contract account and Contractee account.

b) Compute the value of Work in progress. c) Show Balance Sheet ( Extract).

Solution Mijengo contractors Ltd a)i Contract account No. 12 to 31st December, 2005

Dr Cr

To: Materials Materials

She

Sh 3,500,000

P &Loss a/c : Plant a/c

Shs 200,000

Shs

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from stores Wages paid ,, Accrued Direct expenses ,, Accrued Establishment charges Plant a/c P & Loss a/c: Profit on material sold( 600000-500000) Notional profit c/d

1,800,000 90,000 700,000 120,000

700,000 1,890,000 820,000 800,000 3,420,000 100,000 782,,000 12,012,000

Material a/c(destroyed) Bank:Sale of scrap Sale of materials Sale of plant P& Loss a/c : Loss on sale of Plant (400,000-300,000) Work in progress a/c: Material on site Work certified Work uncertified: Materials Wages Expenses Plant

300,000 500,000 7,500,000 260,000 100,000 150,000 1,820,000

500,000 182,000 600,000 300,000 100,000 10,330,000 12,012,000

To: P&Loss a/c Profit provision c/d

417,100 364,,900

Notional profit b/d 782,000

782,000 782,000

(a)ii Dr Contractee account Cr

shs Work certified 7,500,,000 7,500,000

Shs Bank 6,000,000 Balance c/d 1,500,000 7,500,000

b)Work in progress (WIP)=cost incurred to date +profit taken-cash received = shs 722,8000+417,100- 600000= shs 164,5100. Or WIP= Contractee’s a/c balance+ Cost of work not certified-Profit provision = shs 1,500,000+510,000-364,900= shs 1,645,100. c) Balance Sheet (Extract) as at 31st Dec 2005

Liabilities : shs Accrued wages 90,000

Assets : shs Materials 500,000

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,, direct expenses 120,000 Plant 1,820,000 WIP 1,645,100

LESSON SIX QUIZZES

1 A construction contractor has recorded the following details in a year: contract price sh 4,000,000, work certified sh 3,000,000, work not certified sh76,000 ,costs incurred to date sh 2,100,000 and cash received from client sh 2,520,,000.The profit to be taken in the year’s final accounts would be: A sh 546,560 B sh 976,000 C sh 924,000 D sh 429,440 Correct answer A

2 Which of the following are NOT characteristics of contract costing? I Customer driven production. 11 complete production extends to multiple periods. 111 Method of costing not similar to job costing. A 1 and 11 only B 1 and 111 only C 11 and 111 only D 111 only Correct answer D

3 Match the following contract cost with their classification in contract accounts. Cost classification a Depreciation of plant 1 indirect cost

b Normal rectification costs 2 direct cost c Head office expenses apportioned 3 direct expense d Sub-contractor’s fee 4 production overhead answer a(2),b(4),c(1),d(3) LESSON SIX: QUESTIONS

1 Mr.Kibisu, a contractor, started work on 1st January 2010 , for the construction of an office block for Mumias Farmers Society Ltd .The agreed contract price was Sh 5,000,000.On 31st March 2010 when he prepared his final accounts, the following information relating to the contract was extracted from his books of accounts : Shs Materials issued from stores to site 1,600,000 Wages paid 1,012,000 Wages outstanding on 31st march 2010 375,200 New machines sent to site on 1st January 1,480,000

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Direct charges paid 75,000 Direct charges outstanding on 31st march 6,000 Establishment charges apportioned to contract 64,000 On 31st march 2010: unused materials on site were shs 216,200. Machines were depreciated at 20% p.a. Value of certified work shs 3,500,000; Cost of work done but not yet certified to date shs 180,000. On the basis of the architect’s certificate, Mr.Kibisu had received a total sum of shs 2,800,000 from the client till 31st march 2010. Required: a) Prepare Contract account and Contractee’s account in Mr Kibisu’s ledger.

b) Calculate the work in progress (WIP).

c)Show the relevant portion of the contractor’s Balance Sheet as at 31st march 2010. solution

a) Mr Kibisu i) Contract account for year ended 31st March, 2010 Dr Cr

Material from store Wages paid Wages accrued New machines installed Direct charges paid Direct charges accrued Establishment costs Notional profit c/d Profit taken(w1) Profit provision c/d

Sh 1,600,000 1,012,000 375,200 1,480,000 75,000 6,000 64,000 4,612,200 690,000 5,302,200 368,000 322,000 690,000

Materials on hand Machines on site Work certified Work uncertified

Notional profit/d

Sh 216,200 1,406,000 3,500,000 180,000 5,302,200 690,000 690,000

W1 Calculation of profit taken( work less than 75% complete) Profit taken=2/3×notional profit× cash received Work certified = 2/3 ×690,000×2,800,000 3,500,000 = sh 368,000 Profit provision=sh 690,000-368,000=sh 322,000. ii) Dr Contractee’s account Cr

Sh Work certified 3,500,000 3,500,000

sh cash 2,800,000 Bal c/d 700,000 3,500,000

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b) W2 work in progress(wip)

WIP=Cost to date+profit provision-cash received= sh2,990,000+368,000-2,800,000 = sh 558,000 Or WIP=work certified +work uncertified less profit provision-cash received = sh 3,500,000+180,000-322,000-2,800,000=sh 558,000. Or WIP= Contractee’s a/c balance+cost of work uncertified-profit provision = Sh700,000+180,000-322,000=sh 558,000. c) Mr.Kibisu Balance sheet (extracts) as at 31st march, 2010

ASSETS Material onsite Machines on site WIP(w2)

Sh 216,200 1,406,000 558,000

LIABILITIES Wages accrued Direct charges accrued Capital account(profit)

Sh 375,200 6,000 368,000

2Rongai Builders Ltd was awarded a contract to build a library complex at Copa Training Institute and work commenced at the site on 1st May, 2009.During the period to 28thFebruary,2010,the expenditure on the contract was as follows: Shs Materials issues from store 941,100 Materials purchased 2,807,000 Wages 1,849,300 Direct expenses 614,900 Administrative expenses allocated 214,600 Plant purchased for use at site 1,218,000 The contractor had received on account the sum of shs 6, 417,000 , representing the amount of certificate no.1 issued by the architect in respect of work completed to 28th February 2010, after deducting 10% retention money. The following relevant information is also available:

(i) The plant and machinery had an effective life of 5 years with no residual value and (ii) The company only takes credit for 2/3 of the profit on work certified.

Required:(a) Prepare Contract account for the period to 28th February 2010. (b)Show your calculation of profit to be credited to Profit & Loss account. c) calculate value of work in progress. solution a)Rongai Builders Ltd Contract account for the year ended 28th February,2010 Dr Cr

Sh Sh

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Material issued from store Material purchased Wages Direct expenses Adm expenses Plant sent to site Notional profit c/d Profit taken(w1) Profit provision

941,100 2,807,000 1,849,300 614,900 214,600 1,218,000 7,644,900 500,100 8,145,000 300,060 200,040 500,100

Plant on site Work certified Notional profit b/d

1,015,000 7,130,000 8,145,000 500,100 500,100

b) W1calculation of profit on contract Profit taken=2/3×notional profit× cash received Work certified =2/3×500,100×6417,00×6,417,000 7,130,000 =sh 300,060 Profit provision= sh 500,100-300,060=sh 200,040. W2 plant on site = cost less depreciation= sh 1,218,000-203,000=sh1,015,000 Depreciation on plant=20%×1,218,000×10/12 ( for 10 months) = sh 203,000. c) work in progress(WIP) WIP=work certified-profit provision-cash received= sh 7130,000-200,040-6,417,000=sh 512,960

3 Isinya construction Ltd comment work on a contract for shs 10,000,000 on 1st July 2005 . The following details about the contract obtained at the end of the year:

Shs shs Materials purchased 2,000,000 wages paid 900,000 General expenses 200,000 Plant purchased 1,000,000 Materials on hand (30.6.2006) 500,000 wages accrued 100,000 Works certified 4,000,000 cash received 3,000,000 Works uncertified 300,000 Depreciation on plant 100,000 An escalation clause in the contract read as follows :’’ in the event of process materials and rates of wages increase by more than 5% , the contract price would be increased accordingly by 25% of the rise in the cost of materials and wages beyond 5% in each case’’. Since the date of

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signing the agreement, prices of materials and wage rates increased by 25%. The above clause is not considered for purposes of work certification. Required : Prepare the Contract account. Solution

Isinya construction Ltd Contract account Dr Cr

Materials Wages Wages accrued General expenses Plant Profit taken(w1) Profit provision(w2)

Sh 2,000,000 900,000 100,000 200,000 1,000,000 400,000 1,200,000

Materials on hand Plant on site Escalation costs(w3) Work certified Work uncertified

Sh 500,000 900,000 100,000 4,000,000 300,,000

5,800,000 5,800,000

W1 Calculation of profit on contract( less than 50% complete) Notional profit= value of work done-costs incurred to date =sh 4,000,000+300,000-2,700,000=sh 1,600,000 Profit to be taken=1/3×notional profit ×cash received Work certified = 1/3×1,600,000×3,000,000 4,000,000 =sh 400,000 W2Profit provision Profit provision= Notional profit-profit taken =sh 1,600,000-400,000=sh 1,200,000 Plant on site=cost less depreciation= sh 1,000,000-100,000 =sh 900,000 W3Calculation of escalation costs Based on increase of 25% Estimated cost of material at the date of contract= sh 1,500,000÷1.25=sh 1,200,000 Cost of wages at the date of contract= sh 1,000,000÷1.25= sh 800,000. Total cost of materials and wages =sh 2,000,000 Escalation cost =5%×sh 2,000,000=sh 100,000 4 Ujenzi Bora Ltd commenced a contract on 1.7.2004. The total contract price was shs 5,000,000 but the company accepted the same for shs 4,500,000. It was decided to estimate the total profit and to take to the credit of Profit &Loss a/c that portion of estimated profit on cash basis which the work completed bore to the total contract. Actual expenditure till 31.12.2004 and estimated expenditure in 2005 are given as below:

Actuals till 31.12.2004 Estimate for 2005 Shs shs Materials 750,000 1,300,000 Labour 550,000 600,000 Plant purchased (original cost) 400,000 ------

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Miscellaneous expenses 200,000 355,000 Plant returned to store (31.12.2004) (original cost ) 100,000 250,000( as at 30.9.2005) Materials at site 50,000 ------- Work certified 2,000,000 Full Works uncertified 75,000 ------ Cash received 1,800,000 Full Plant is subject to annual depreciation at 20% of original cost. It is the company’s policy to charge depreciation on time basis. The contract is likely to be completed on 30.9.2005.

Required : Contract account for the year ended 31.12.2004. solution

Ujenzi Bora Ltd Contract account for the year ended 31st December, 2004 Dr Cr

Materials Labour Plant Misc. expenses P&Loss a/c(w1) Provision

Sh 700,000 550,000 400,000 200,000 264,000 321,000 2,485,000

WIP: Materials Plant(w2) Plant returned to store Work certified Work not certified

Sh 50,000 270,000 90,000 2,000,000 75,000 2,485,000

W1 Estimated total profit Sh sh Estimated incomes: Plant returned to stores 90,000 (100,000-10,000) Plant ,2005 187,500 277,500 Plant on site (50,000-12,500) 37,500 Contract price 4,500,000 4,815,000

Less:Estimated expenditure Materials (75000+130,000) 2,050,000 Labour ( 55,000+60,000) 1,150,000 Plant 400,000 Misc. expenses 555,000 4,155,000 Estimated profit 660,000

Profit to be credited to P&L a/c=Estimated profit× cash received Total contract price = sh 660,000×1,800,000 =sh 264,000. 4,500,000 Profit provision= sh 660,000-264,000= W2 Plant on site as at 31.12.2004 = cost-plant returned-depreciation =Sh 400,000-100,000-30,000=sh 270,000.

5 Ongata Construction Ltd obtained a contract for the construction of a bridge. The value of the

contract is shs 2,400,000 and the work commenced on 1st October 2008.The following details are

shown in the books for the year ended 30th September, 2009:

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Shs shs Plant purchased 120,000 wages paid 680,000 Materials issued to site 672,000 direct expenses 16,000 General overheads apportioned 64,000 wages accrued 5,600 Materials on site 8,000 direct expenses accrued 2,400 Work not yet certified at cost 28,000 Cash received from the contractor was shs 1,200,000, being 80% of the value of work certified. Life of plant purchased is 5 years and scrap value is nil.

Required : a) Prepare the Contract Account for the year ended 30th September, 2009. b) Show the amount of profit which you consider might be fairly taken on the

contract and how you have calculated it.

a Ongata construction Contract account for year ended 30th September,2009 Dr Cr

Plant purchased Material General ohds Wages paid Wages accrued Direct expenses ,, accrued Profit taken(w1) Profit provision

Sh 120,000 672,000 64,000 680,000 5,600 16,000 2,400 38,400 33,600

Material on site Plant on site** Work certified Work uncertified

Sh 8,000 96,000 1,500,000 28,000

1,632,000 1,632,000

b) calculation of profit to be taken Notional profit =value of work-costs incurred to date =sh 1,500,000 +28,000-1,456,000=sh 72,000. Profit taken=2/3 × notional profit×cash received

Work certified =2/3×72,000 ×1,200,000 1,500,000 = 48,000×80%= sh 38,400 **Profit provision =sh 72,000-38,400=sh33,600. plant on site= sh120,000 less annual depreciation (20% =120,000-24,000=sh 96,000

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LESSON SEVEN: COST-VOLUME-PROFIT (C-V-P) ANALYSIS

Learning objectives After studying this lesson, the learner should be able to: a) State the uses and assumptions of C-V-P Analysis. b) Calculate and interpret breakeven point (BEP) and margin of safety. c) Understand and use the concepts of a target profit and contribution to sales

ratio. d) Apply CVP Analysis to single product firms e) Explain the effects of changes in the Sales mix on contribution margin and

on the BEP. f) Identify the limitations of CVP Analysis.

1.0 CVP or Break even Analysis: Definition and Uses Cost-Volume -Profit (CVP) Analysis or model involves the study of the interrelationships between costs, volume and profit at various levels of activity. In its simplest form , it means sales minus costs equals profit. It is sometimes referred to as ‘ break even analysis’, although the later term is narrower and may be misleading. CVP Analysis comes into play when the management of an organisation wishes to know the profit likely to be made in a period for expected production and sales levels. The management may also be interested to known the firm’s breakeven point and margin of safety. Needless to say, Cvp analysis is one of the most important tools the manager can use to unearth an organisation’s untapped resources and profit potential. The break even point (BEP) is the activity level (volume) at which there is neither profit nor loss ( ie profit equals zero).The margin of safety (MOS) is the excess of actual or budgeted sales over break even sales. Henceforth,we shall use BEU and BES to represent break even point in Units and sales value respectively. CVP Analysis uses the principles of marginal costing and is an important tool for short term planning and decision making. The key concept of marginal costing is that costs should be separated into variable and fixed costs. Since fixed costs remain constant over the activity range, they are considered as irrelevant in decision making. In marginal costing, only variable costs are deemed relevant for decision making. Thus, CVP Analysis seeks the most profitable combination of variable costs, fixed costs, selling price and sales volume. Typical short-run or tactical decisions where CVP Analysis or marginal costing can be applied include : Choice of product mix, special order decisions, Make or buy decisions , shut-down or discontinuing decisions. Pricing of products, marketing strategy and utilisation of productive facilities.

1.2 Limiting assumptions behind CVP or Break Even Analysis Several limiting assumptions must be made in CVP Analysis. The key assumptions are:

a) All costs are classified as either fixed or variable. b) Variable costs are proportional to sales volume c) Fixed costs are constant within the relevant range. d) The selling price per unit will remain constant. e) All functions- that is sales, variable costs and fixed costs- are linear. f) The analysis is for either one product or a single mix that remain constant. g) The beginning and ending inventory levels are not significantly different.

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h) The only factor affecting costs is sales volume. 2.0 CVP Analysis using equations The Breakeven point can be determined using a a formula (equation ) or graph.We shall derive important CVP Analysis formulae using equation method, since this is the method commonly preferred by examiners. Let S= Sales value, C= Total cost, V= variable costs ,F= Fixed cost and P= Profit or Net income. The Cvp relationship can be given as: Sales= Total costs + profit or Sales- Total cost= Profit before tax, which can be expressed further as : Sales- variable costs- Fixed costs= PROFIT or S-V-F=P. At Break even point, profit is zero (P=0) and therefore S-V-F=0 or S= V+F. Suppose we know the selling price (s), variable cost per unit(v) and quantity(q),then : s×q-v×q-F=P. It follows that: s×q-v×q-F= P, then q(s-v)=F+P ie q= F+P /(s-v). For a targeted level of profit, the quantity to be produced and sold would be: Quantity sold= (Fixed cost + Target Profit)÷(selling price-variable cost per unit) At breakeven point : BEU= F/(s-v) ie Quantity= Fixed cost ÷(selling price-variable cost per unit) Note: i) Contribution (cm) =sales – variable cost or contribution per unit (cu) = selling price-variable cost per unit. ii) Contribution to sales, contribution margin ratio or profit/ volume ratio (C/S or PV Ratio) = s-v/s or S-V/S, which can also be expressed as a percentage. iii) Variable cost ratio (VCR) = v/s or V/S

iv)BES=F/cm×s or BES= F÷PV ratio v) BEU ( for target profit after Tax =( F + P/ (1- t))/ (s-v),where t= corporation tax rate. vi) BES (for multi-product firm ) = F/cm ×S.

2.0 Sales mix The concept of sales mix applies to multi-product firms.Sales mix is the relative combination of products represented in total sales.For firms that produce many products,they must consider sales mix in their breakeven analysis or Cvp Analysis.In such a case , the contribution margins for each product cannot be used in isolation. Instead, they must be weighted by the number of each unit expected to be sold (or sales ratio) and a weighted contribution margin per mix(wcmpm) ratio derived. This ratio is then used in the same manner as the contribution margin per unit or Pv ratio in single product situations. The Cwmpm is calculated as follows: Firstly, multiply each product’s contribution margin by its unit sales to arrive at it contribution margin per mix. Secondly, sum the individual contribution per mix.

Example 1 A company sells its single product for shs250 per unit.The variable costs per unit is shs150 and fixed cost total shs35,000 per annum. Required : a) Breakeven point in units and value. b) Contribution margin ratio and Variable cost ratio. c) Quantity to be sold to earn a net profit of shs10,000 and margin of safety. d) Profit earned when 400 units are sold . e) Re compute (c) and (d) if the company is in the 25% tax bracket.

Solution a) BEU = F/s-v = Shs 35000/ (350-250)= 350 units or BES =shs 87500 ( 350 ×

shs 250 ). b) PV ratio= s-v/(s) ×100% =( 350-250)/ 350 × 100%= 100/350 ×100%=28.6%,

Variable cost ratio =VCR = v/s ×100%= 250/350 ×100%= 71.4%

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c) Quantity (q) = F+P/s-v= (35000+10000)/350-250 =45000÷100=450 units .Margin of safety=Actual sales-BEU=450-350 = 100 units or shs 35,000

d) Profit when q=400, s×q-v×q-F=P =shs 350×400-250×400-35000=140000-100000-35000=shs 5000.

e) I) Q=F +(P/(1-t)/(s-v)= {35000 +10000(1-0.25)}/350-250=35000 +

(10000/.75 ) /100=(35000+13333)/100= 48333/100=483 units. Ii) Q=400, then 400={35000+( P/.75)}÷100, solving for P, Profit =shs3750.

Example 2 Singer Ltd sells product ‘P’ for shs 50 per unit. Fixed costs are shs 210,000 p.a and the current variable cost ratio is 60% . Its profit margin has remained consistently at 10%.Required: aBreakeven point (in units and value) and contribution margin ratio.

bSales (in units and shs ) and margin of safety. cIn an effort to improve its profitability, the company is considering a new strategy :introducing a 10% sales commission and reducing advertisement costs by shs 60,000 .Calculate the new breakeven point and sales volume and assess whether this new strategy is worthwhile. solution

a) BEP (Units)= 210,000÷(50-30) =210,000/20 =10500 units or shs 525,000.Contribution margin or C/s ratio =50-30/50 =0.4 or 40% , note variable cost per unit=60% × selling price =0.6×shs50=shs30.

b) s×q- v×q-210000= 10%(s×q)=50q-30q-210,000=0.1×50q=20q-210,000=5q, solving for q, q=14,000 units or shs 700,000. Margin of safety= 14,000-10,500=3,500 units or shs 175,000.

c) Reducing advertisement cost , reduces fixed costs to shs 150000 (shs210000-60000) , variable cost increases by 10% of Shs50 ie by shs 5 to shs 35. New BEP= 150000 ÷ (50-35)=150,000÷15=10,000 units or shs500,000. New sales volume:50q-35q-150,000=10%× 50q ,solving for q, q=15,000 units or shs750,000. Current profit=10% ×sh50×14000 =shs 70,000, profit with new strategy= 10%× shs50× 15,000= shs 75,000. The new strategy increases profit by shs 7,500 and is worthwhile on purely financial perspective.

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LESSON SEVEN:QUIZZES 1 Which of the following is one of the assumptions that underly CVP analysis: A The actual selling price per unit must change in proportion to units sold in the period B For variable costs, the actual cost per unit of output must remain constant. C For fixed costs, the actual costs per unit of output must remain constant D The sales mix must change with production level. Correct answer C

2 In a given period the company’s sales were sh 600,000 , variable cost sh 480,000 and fixed cost sh 60,000.Determine BEP and sales volume required to earn a profit of sh 20,000. Answer PV ratio= contribution/ sales = 120,000/600,000= 0.20 BEP(shs)= Fixed cost/PVratio=60,000/0.20=sh 300,000. Sales (sh)= (Fixed cost + target profit)/Pv ratio = (60,000+20,000)/0.20=sh 400,000.

3 Kware Ltd manufactures and sells two products, Alpha an Beta in the ratio of 5:3 respectively. The fixed costs are sh 70,250 and the contribution margin per composite unit is sh 85. Determine the number of Betas that will be sold to break even. Answer BEP=Fixed cost/ contribution margin per composite unit = sh 70,250/sh 85= 850 mixers Number of Betas required at breakeven point =850@ 3= 2,550 units.

4 Match the following terms with their equivalent meanings. Term meaning

a) Contribution 1 contribution to sales b) Margin of safety 2 Fixed cost plus target profit c) PV ratio 3 Actual sales-Total cost d) Break even point 4 Total cost

Answer a(2),b(3),c(1),d(4)

5Galleria Ltd makes a product which sells for shs40 and has a variable cost of shs 30 per unit .Budgeted fixed costs are shs70,000 and budgeted sales are 8,000 units. calculate

i) BEP in units and value ii) Margin of safety and budgeted profit. iii) Budgeted sales at a targeted profit of shs 20,000. LESSON SEVEN:QUESTIONS

1 Mamba Ltd produces a single product. The Selling price per unit is shs 200,Variable cost per unit shs 150 and Fixed costs shs 180,000.A sales commission of 10% is offered to its salesmen. Required:

i) Contribution margin ratio and BEP.

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ii) Sales volume required to earn a profit margin of 10%. Solution I Pv ratio= unit contribution /selling price =30/200=0.15 or 15% ,unit variable cost= sh150 +10% of sh 200=sh 170, unit contribution=sh 200-170=sh30. BEP (units)= 180,000 /(200-170)=180,000/30=6,000 units. 2Sales required to earn a profit of 10% on sales Let q=sales volume or units 200q-170q-180,000=10%(200q) 30q=180,000+20q 10q=180,000 Solve for q to get q=18,000 units or sh3,600,000.

2Wellma Ltd sells a product at a price of shs20 per unit. Its variable cost per unit is shs12 and fixed costs are shs 360,000 p.a. In the next financial year, the company wishes to earn before tax target income of shs 480,000.To achieve this target, the company intends to offer its sales manager an incentive of shs2 per unit in excess of breakeven sales. Determine

a) BEP units before the incentive offer. b) How many units must be sold to earn the targeted income. c) New BEP after the incentive offer is introduced.

1 BEP units=Fixed cost/unit contribution margin=360,000/8=45,000 units. 2 Let q= units to be sold to achieve targeted profit;

Sales-variable cost-fixed cost=profit (selling price remains same) Then, 20q-{(12q +2 (q-45,000)} -360,000=480,000 20q-12q-2q+90,000-360,000=480,000 6q=360,000+480,000-90,000=750,000, q=125,000 Units to be sold 125,000 units.

3 New Variable costs =12 (125,000)+2 (125,000-45,000)=1,500,000 +160,000 =sh 1,660,000 New variable cost per unit=sh1,660,000/125,000=sh13.28 per unit. BEP=360,000/(20-13.28)=360,000/6.72=53,571 units.

i) 3 The super eagle Ltd is the sole distributor for a new product in West Kenya.The product sells for shs 60 per unit and has a contribution margin ratio of 40%.The company’s fixed expenses are shs 360,000 per year.

Required: a) Variable cost per unit. b) i) BEP in units and shs.

ii)Sales ( in units and shs) required to earn an annual profit of shs 50,000. iii)Assume that through negotiation with the manufacturer, the company is able to reduce its variable cost by shs 3 per unit.Calculate the company’s new BEP in units and shs. Solution 1Pv ratio = unit contribution/selling price, let v=variable cost per unit ( 60-v )/60=40%=0.40; solving for v=36 Unit contribution=selling price-variable cost per unit=60-36=sh24. 2BEP (units)=fixed cost/unit contribution=360,000/24=15,000 units or sh 900,000 New BEP= 360,000/(60-33)=360,000/27=13,333 units. 3Sales for a targeted profit of sh 50,000

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S=( F+P)/PV ratio= (360,000+50,000)/0.40= sh 1,025,000 or 17,083 units. 4Bela bela Ltd provides the following information for a year: Fixed cost per annum sh 432,000 Break even sales sh 1,440,000 Units sold 20,000 units Annual profit sh 240,000 Required: a) Annual sales,selling price and variable cost per unit. b) If the new variable cost ratio is 60%,determine the new BEP. c) If sales volume are increased by 5%, without change in other factors, what would

be the new annual profit? Solution

1BEP sh= fixed cost /pv ratio Then, 1,440,000=432,000/pvratio Pv ratio=432,000/1,440,000=0.30 or 30% Variable cost ratio=0.70 or 70% Sales for a profit of sh 240,000, q=20,000 Sales (S)=( Fixed cost+profit)/pv ratio=(432,000 +240,000)/0.30=sh 2,240,000

Selling price per unit =S/q=sh 2.240,000/20,000= sh 112. Variable cost per unit=70%×sh 112=sh78.40. 2 New pv ratio=40%=0.40 New BEP= 432,000/0.40=sh 1,080,000 or 9,643 units. 3 New sales ,q=21,000 units

Then profit (P) =q(s-v)-F, P=21,000(112-78.40)-432,000= =sh 705,600-432,000 =sh 273,600

5 Close Bridge Ltd makes a product which has a variable production cost of shs 80 per unit and a variable sales cost of shs 20 per unit. Fixed costs are shs 600,000 per annum , the Selling price is shs 150 and the current volume of sales is 20,000 units. The company is considering whether to have an improved machine for production .Annual Hire costs for the machine would be sh 106,000 and it is expected that the variable Production cost would fall to shs60 per unit. Required: a) Determine the sales volume needed to achieve the same profit as is currently earned if the machine is hired. b) Assess if it is worthwhile to hire the machine if sales volume remains the same. Solution 1 Current profit, P=q(s-v)-F=20,000(150-80-20)-600,000=1,000,000-600,000=sh 400,000. Unit Variable cost=sh 80+20=sh100. With hire of new machine, New unit variable cost=sh 60+20=sh 80 New fixed costs=600,000+106,000 =sh 706,000 ( raised due to machine hire cost) Sales units required to achieve profit of sh400,000 : q(s-v)-F=P, profit=q(150-80)-706,000=400,000, solving for q we get q=15,800 units.

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Sales volume 15,800 units 2Profit with mew machine when sales are 20,000 units P=q(s-v)-

F=20,000(150-80)-706,000= sh 694,000The new machine increases profits by sh 294,000 (sh

694,000-400,000) and is therefore worthwhile.

LESSON EIGHT: BUDGETING Lesson objectives After studying this lesson, the learner should be able to:

a) Define a budget and explain the objectives of budgeting. b) Demonstrate an understanding of budgetary planning and budgetary control c) Distinguish between Fixed and Flexible Budgets and prepare Flexible Budgets. d) Prepare Income Statement Budgets and Balance sheet Budgets e) Known the salient features of Zero-based Budgeting and Activity-based budgeting. f) Identify the problems associated with budgeting

1.0 Definitions of a budget and objectives of budgeting A budget is ‘ quantitative statement for a defined period of time , which may include planned revenues, expenses, assets, liabilities and cash flows .A budget facilitates planning. (CIMA official Terminology).From the above statement, we can deduce that a budget is a quantified plan of action for a future accounting period which can aid an organisation to achieve its set targets. Once you assign a monetary value on a plan, it becomes a budget .Most organisations including Governments prepare budgets well in advance before the beginning of every financial year or other defined periods of time. Budgets enables them translate their overall objectives into comprehensive plans of actions .The importance of planning need not be overemphasised. Thus, even in our daily lives, we plan for household purchases, children’s fees, travelling expenses, Christmas parties’ , Weddings and Construction of houses and other projects etc. The aim is to know how much you are likely to spend against your revenue and avoid unnecessary or unachievable expenditure. The process of preparing a budget is known as budgeting. This will form the basis of our discussion in the rest of this lesson. 1.2 The objectives of budgeting

Budgets help us to achieve the following objectives e) Coordination of activities of different departments or divisions towards a single plan. f) Communication of targets to the line managers responsible for achieving them. g) Controlling the operating results by comparing the budgeted and actual results and

reporting variances for investigation and recommending remedial action. h) Planning the activities or requirements of the organisation by managers. i) Evaluating the performance of manager based on set targets. j) Motivating managers who achieve departmental set targets and assessing how well

individual objectives compare favourably with overall organisation goals (goal congruence)

k) Clarification of authority and responsibility. 1.2 Conditions necessary for successful budgeting

As a perquisite, budgeting is likely to succeed if the following conditions are met: a) Top management is involved and supports the process. b) The organisation sets out clear and realistic or achievable goals and objectives c) Managers are properly assigned and are aware of their responsibilities or duties and

enjoy delegated authority. d) The organisation has a well -developed structure in terms of responsibility, profit or

investment centres under the control of its managers. e) An adequate accounting system exists f) There is full participation and involvement of line managers in the budgeting process

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g) Effective communication at all staff levels to create awareness of organisational objectives, targets which form the basis of budgeting.

h) Budget education to enhance knowledge and budgeting skills among staff i) There is Flexibility as budgets are subject to changes due to the dynamic business

environment 1.3 Budgetary planning and Control Planning and control do not mean the same thing. Planning involves the development of future objectives and the preparation of various budgets to achieve those objectives, while control involves the steps taken by management to ensure that the set objectives are realised and that the various units or departments functions are consistent with overall organisational policies and practices. An effective organisation must built objectives against which control can be directed .In essence, it must have both plans and controls. The important aspects of budgetary planning and control comprises the budgeting process and organisation of budget control.

1.3.1 The budgeting process The budgeting process essentially involves the following steps:

a) Communicating organisational and unit set objectives and targets to the budgeters with the use of a budget manual.

b) Determining the key or limiting factor which could be machine hours, labour hours, material, finance, operating capacity etc

c) Preparation of the Sales budget, which is the starting point for preparing the Master budget.

d) Initial preparation of other budgets like production budget, direct materials budget, direct labour budget, manufacturing overhead budget etc.

e) Lobbying for support of budgets from senior managers. f) Coordination, review of the various budgets and draft Master

budget by budget committee. g) Submission and approval of final budget by Board of directors,

University Council, Trustees. h) Budget implementation. i) Monitoring of budgets.

1.3.2 Organisation of budget control Budget control means the establishment of budgets relating the responsibilities of executives to the requirements of a policy and analysing variances between budgeted and actual results for corrective action. Policies may not be static due to changing environment factors and are therefore subject to revision. The following are the key elements to achieving budget control:

a) The creation of budgets centres b) The introduction of adequate accounting system. c) The preparation of organisational charts d) The establishment of a budget committee.

Below is a brief look at each of the above four elements. Budget centre:A section of an organisation defined for the purposes of budgetary Control. It is sometimes referred to as a responsibility centre. It is a department or Organisational function whose performance is the direct responsibility of a specific manager.Ideally, costs should be charged to budget centres before they are apportioned to other centres for purposes of responsibility.

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Accounting system: Asystem of recording transactions related to material purchases and issues, labour costs and factory overheads incurred.This is the basis of cost accumulation. Organisation charts: This is the layout of assigned responsibilities,authorities and reporting levels for every manager in the organisation. Budget committee:It is the coordinating authority in the preparation and administration of budgets It helps to resolve difficulties and disputes which may arise between functional managers and take decision.It is usually chaired by the Managing director and assisted by a budget officer (an accountant). However, critical policy decisions must be referred to the Board of directors. The budget committee, which comprises functional managers, is often guided by a budget manual in carrying out its functions.

1.4 Budgeting systems

Different organisations have developed different budgeting systems and methods to suit their legislative or regulatory or policy requirements .Budgets may be majorly classified as continuous (rolling), static or flexible. One common method used in developing budget estimates for static and flexible budgets is zero-based budgeting. We will discuss flexible budgets and Master budgets( major component of static budgets ) in subsequent sections.

1.5 Flexible Budgets Unlike fixed budgets which are set for a single level of activity, flexible budgets may be altered to accommodate different levels of activities. A flexible budget may be defined as that budget which by different cost behaviour patterns is designed to change as volume of activity changes. Flexible (or flexed) budgets are used at the planning stage to ascertain the effects of differing actual results and budgeted production. These budgets are also used for controlling. Thus, at the end of each month or year, actual results may be compared with the relevant activity level in the flexible budget, and the resulting differences analysed for investigation and remedial action as deemed necessary. It is important to note that flexible budgeting uses the principles of marginal or direct costing; past cost behaviour patterns are analysed by separating costs into fixed and variable elements. Costs which are semi-variable (mixed ) may pose some problem. In such a case, the High-Low method is recommended in estimating the level of future costs. This is a method of separating a mixed cost into fixed and variable elements in analysing the change in the activity and cost between the high and low points in a group of observed data. Steps in preparing flexible budgets

a) Identify the relevant activity level (eg units, machine hours, labour hours) b) Identify the fixed and variable cost elements in costs being considered for

budgeting c) Calculate the variable cost per unit in each cost element (if any ) d) Prepare the flexible budget (or estimate cost ) for each activity level by

multiplying the variable cost per unit by the activity level and then add the respective fixed cost.

Example 1 The production overheads for KK Manufacturers have been recorded in the past four years and are given as below: Year Output (units) production overhead (shs) 2010 15,800 774,000 2011 15,400 762,000 2012 19,600 888,000 2013 18,200 850,000 Budgeted production for year 2014 is 20,000 units.

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Required: Estimate the production overhead for the year using the High-Low method. Solution Units shs 2012(Highest point) 19,600 888,000 2011(Lowest point) 15,400 762,000 Difference 4,200(q) 126,000(c) Variable cost per unit (v)= change in cost/change in units=c÷q = shs 126,000÷4200 = shs 30 per unit. Total cost (Tc) = Variable cost (V) + Fixed cost (F). = v× x + F If we take 2012: shs 888,000= shs30×19,600 +F =588,000 +F. Solving for F, F=30,000.Therefore Fixed costs are shs 30,000. For 2014, quantity (q) =20,000, Total cost (Tc) = shs30 ×20,000 +30,000 =shs 600,000 +30,000 = shs 630,000. Example 2 New innovations Ltd uses flexible budgets that are based on the following data: Sales commission: 10% of sales. Advertising expense: 18% of sales. Miscellaneous selling expenses: shs 28,000 p.m. plus 4% of sales. Office salaries expense: shs 180,000 p.m. Office supplies expense: 3% of sales. Miscellaneous administration expenses: shs 220,000 plus 2% of sales. Required: Prepare a FLEXIBLE Selling and administration expenses budget for January for sales volume of shs 1000,000, shs 1,250,000 and shs 1,500,000. Solution New Innovations: Flexible Selling and administration expenses Budget shs shs shs Sales volume 1,000,000 1,250,000 1,500,000 Variable costs: Sales commission (10%) 100,000 125,000 150,000 Advertising expenses(18%) 180,000 225,000 270,000 Miscellaneous selling exps (4%) 40,000 50,000 60,000 Office supplies expenses (3%) 30,000 37,5000 45,000 Miscellaneous admin expenses(2%) 20,000 25,000 30,000 Total variable costs 370,000 462,500 555,000 Fixed costs: Miscellaneous selling expenses 28,000 28,000 28,000 Miscellaneous salary expenses 180,000 180,000 180,000 Miscellaneous admin expenses 22,000 22,000 22,000 Total fixed costs 230,000 230,000 230,000 Total costs 600,000 692,500 785,000

1.6 Master Budgets In a manufacturing business, it is common to find the following functional budgets: Operating Budgets: Budget type preparer Sales budget sales manager Production budget production manager Direct materials purchases budget Chief Buyer

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Direct Labour cost budget Human Resources manager Factory production overheads budget Production manager Cost of Goods sold budget Finance manager Selling& Administration expenses budget Finance manager Marketing manager Financing budget: Cash Budget Finance manager Investing budget: Capital Expenditure budget Managing Director Research & Development budget ** Research Director

The following points should be noted :

I) The budgeted Income Statement integrates the sales budget, cost of goods sold budget and selling and administration budget..

II) The budgeted balance sheet budget integrates the cash budget and capital expenditure budget .

III) The Master Budget integrates the operating, financing and investing budget(capital expenditure budget)

IV) **The research & development budget is a discretionary expenditure budget.

1.6.1 Preparation of the Operating budgets 1. Sales budget: It is the most important budget and should be

prepared prior to other operating budgets ( production, labour cost budgets etc) .It is usually difficult to prepare due to uncertainties in demand, selling prices, competition, new lines and trade conditions and Government policy etc. The sales budget helps production managers to plan their requirements in a realistic manner as it acts a target to be achieved .Sales equal to selling prices per unit multiplied by the respective quantities.

2. Production budget: Initially, a production forecast in quantity only will be developed from the sales budget after allowing for policy decisions in respect of finished inventories and thereafter translated into budget requirements for the major productive resources. In manufacturing business, the production budget will be derived as below: Expected units to be sold xx Add: Desired units in Ending Finished Inventory xx

Less: Estimated units in Beginning Finished Inventory (xx) Total units to be produced xx

3 Direct material purchases budget: In a manufacturing concern, the material units to be purchased will be determined as follows: Materials (usage) required for production xx Add: Desired Ending material Inventory xx Less: Estimated Beginning material Inventory (xx) Direct materials to be purchased (units) xx The estimated quantities of direct materials to be purchased are aimed at Supporting budgeted production and desired inventory level.

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Sometimes a separate material usage budget is prepared before the material purchases budget.

However, in a merchandise firm which buys finished goods for resale, stock (in units)to be purchased to meet customer demand will be arrived at as here below:

Budgeted sales xx Add: Desired Ending inventory xx Less : Beginning inventory (xx) Finished inventory to be purchased xx 4 Direct labour cost budget : This estimates the direct Labour hours and relate Cost needed to support budgeted production. Direct labour cost equals Labour hours required times hourly wage rate. 5 Factory production overhead budget: This is made up of expenses related to sh Factory: Indirect factory overhead xx Supervisor’s salaries xx Power and lighting xx Depreciation on plant& equipment xx Indirect materials xx Maintenance of plant& equipment xx Insurance, Rent, Rates ,Taxes xx Total factory overhead costs shs xx

3 Cost of goods sold Budget :This budget integrates the direct materials purchases Budget, direct labour cost budget, factory overhead cost budget and estimated and desired inventories for direct materials, work in progress and finished goods. Cost of goods sold will then be determined as under: sh Beginning Finished Goods Inventory xx Add: Cost of goods manufactured xx Less : Ending finished goods inventory (xx) Cost of goods sold xx

4 Selling and administration expenses budget This consists of selling or marketing costs, administration costs including distribution expenses. They are additional expenses incurred to ensure that goods manufactured eventually reach the customer or consumer. The expense emanates from service departments such as accounting, purchasing, marketing, finance, stores/warehousing and transport etc. The related costs may be summarised as under: sh Selling expenses: Sales salaries& expenses xx Advertising xx Salesmen commissions’ xx Travel allowances xx Xx Administration expenses: Office salaries expenses xx Office rent, rates & insurance xx Office supplies xx Office power, water, telephones xx

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Miscellaneous admin expenses xx Xx Total selling& Admin expenses xx

1.7Balance sheet budget

1.6.2 Cash Budget A cash budget is the most common balance sheet budget prepared by many business entities. Most cash budgets are prepared on monthly, quarterly or semi- annually , to guide management on the liquidity position of the firm. It is an analysis of expected cash receipts and cash payments in a period. Difference between cash receipts and cash payments would be surplus or deficit. The analysis begins with opening cash or overdraft, then all cash receipts are added and cash payments deducted for the relevant period. Any surplus (excess cash) or deficit ( cash shortages) for the period are carried forward to the next period and so on. The main sources of cash receipts and cash payments are as follows: 1 Cash Receipts

a. Cash receipts from cash sales. b. Cash collections from debtors based on credit terms ( a

schedule of cash collections to be prepared). c. Cash receipts from interest, dividends, rent, rates .fines and

penalties. d. Loans, grants and donations compensations. e. Miscellaneous receipts from sale of fixed assets, issue of shares

and debentures, calls, sale of scrap. 2 Cash payments

a) Cash payments for cash purchases b) Cash payments to creditors (suppliers) based on credit terms ( a

schedule of cash payments should be prepared). c) Cash payments for administration, selling and distribution overheads

such as office salaries, rent, insurance, electricity, water, telephones, taxes, rates,

d) Cash payments towards loans and interests, dividends, financial charges commissions and fees), law suits, fines and penalties.

e) Purchase of fixed assets, shares and debentures, calls. Note that overdraft balance may be offset by borrowing while surplus cash may be used to invest in short term securities. The terms of loans, repayments of interest and payments on the securities should be studied and complied with.

1.7 Zero-based budgeting( ZBB) ZBB is ‘’ A method of budgeting whereby all activities are re-evaluated each time a budget is formulated. Each functional budget starts with the assumption that the function does not exist and is at zero cost. Increments of cost are compared with increments of benefit, culminating in the planning maximum benefit for a given budgeted cost ‘’ ( CIMA ,Terminology). ZBB was first developed in North America as an alternative method to incremental budgeting. The ZBB is based on Cost/Benefit analysis in an attempt to ensure value for

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money. It questions the long-standing assumptions and serves as a tool for systematically examining unproductive projects. For instance, it interrogates questions such as: should the function be performed at all and in what way? What should be quantity level and are we doing too much or too little? What should be the cost of the project? In this way, a questioning attitude is developed whereby each cost item and its level has to be justified in relation to the way it helps to meet objectives and how the expenditure benefits the organisation. ZBB can be applied in both profit-making and Non-profit making and Non –governmental organisations (NGOs). According to Stonish (1976), ZBB involves the following three stages:

a) A description of each organisational activity in a decision package. Decision packages of a county government might include care of the elderly, childcare, care for the deaf and blind, bursary schemes, rural road projects, medical facilities etc.

b) The decision packages are then evaluated and ranked. c) The resources are then allocated accordingly.

The benefits that may be derived from ZBB include:

Leads to efficient allocation of resources by need and benefit.

Develops a questioning attitude on long-standing assumptions and systematically examines and identifies inefficient and valueless operations.

Focuses on outputs in relation to value for money.

Enhances staff participation in decision making and leads to improved motivation and performance.

1.8 Activity-based budgeting(ABB)

ABB is a planning and control system which seeks to support the objective of continuous improvement and is based on activity analysis techniques. It uses the principles of Activity-based costing (ABC) by identifying the major organisational activities, factors that influence the cost of a particular activity (cost drivers) and creates a cost centre(cost pool) for each activity. According to Brimson and Fraser, the outline of ABB will be as follows:

A linkage between strategy , planning guidelines and operational plans

The use of activity analysis techniques to relate costs to activities

Identification of improved options, budget proposals and priority lists

Implement activity-based budgets or plans through participatory approach and control for sustainable continuous improvement. Example 3

A firm has the following plans for the next few months: Month sales material purchases wages &salaries Shs shs shs September 600,000 200,000 120,000 October 600,000 400,000 150,000 November 700,000 400,000 170,000 December 900,000 300,000 130,000 Additional information:

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I. All sales are made on credit. Half of the debtors are expected to pay within the month of sale and to claim a 2% cash discount. The remainder are expected to pay in the following month.

II. The firm plans to pay its creditors in full in the month following that of the purchase.

III. All employees are paid in full in the month in which the wage or salary is earned.

IV. Rent of shs 100,000 each quarter is payable on the normal quarter days.

V. Other cash overheads of shs20,000 per month are payable. VI. Some new plant due for delivery in September will be paid in

November at a cost of shs 250,000. VII. On 1st October, the firm plans to have shs 100,000 in the bank.

Required: A cash budget for the months of October to December ( inclusive ). Solution Cash budget (October -December) October November December shs shs shs Cash receipts (Inflows): Debtors: current month 294,000 343,000 441,000 Previous month 300,000 300,000 350,000 Total cash inflows (A) 594,000 643,000 791,000 Cash payments (outflows): Creditors 200,000 400,000 400,000 Wages &salaries 150,000 170,000 130,000 Rent - - 100,000 Overheads 20,000 20,000 20,000 Plant acquired - 250,000 - Total cash outflows (B) 370,000 840,000 650,000 Cash surplus (deficit) (A-B) 224,000 (197,000) 141,000 Opening Bank balance 100,000 324,000 127,000 Cumulative cash balance 324,000 127,000 268,000 Example 4 Mavuno Ltd manufactures two products, namely Q and P. Two types of material X and Y are used in manufacture of these products. The following information is provided by the company for the year 2009:

i) Budgeted sales : Product Quantity(Units) Price (shs) Q 18,000 65 P 20,000 80

ii) Materials used: Material X Y Unit cost per kg shs 6 shs 3 Quantity used ( kgs per unit) Q 3 6 P 5 4 The following were the stock levels of the finished product: Product opening closing

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Q 3,000 1,500 P 2,000 2,500 Material (kgs) X 5,000 6,000 Y 4,000 3,000 Required: Prepare the following budgets:

a) Sales budget. b) Production budget. c) Material usage quantities budget. d) Material purchases budget (in quantities and shs).

Solution a) Sales budget

Product Quantity unit price Total (shs) Q 18,000 shs65 1,170,000 P 20,000 shs 80 1,600,000 2,770,000

b) Production budget(in units) Q P Sales (units) 18,000 20,000

Add: Closing stock units 1,500 2,500 Total requirements 19,500 22,500

Less: stocks at Beginning 3,000 2,000 Production in units 16,500 20,500

c) Material usage budget (in quantities) Product X Y Total Q 49,500 99,000 P 102,500 82,000 Total (kgs) 152,000 181,000 333,000

d) Material purchases budget (in kgs and shs) X Y Material usage 152,000 181.000 Closing stock 6,000 3,000 Total requirements 158,000 184,000

Less: Opening stock 5,000 4,000 Material purchases 153,000 180,000 Cost per unit shs6 shs 3 Material purchases cost (shs) 918,000 540,000

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LESSON EIGHT: QUIZZES

1 Which of the following make up the master budget? A Sales budget, operating budgets, financial budget B Sales budget, capital expenditure budget, financial budget C Operating budgets, financial budget and capital expenditure budget. D Operating budgets, sales budget,budgeted income statement. Correct answer C

2 Which of the following comprise a Cost of Goods Sold budget? A Production budget, material purchases budget, labour cost budget B Material purchases budget, labour cost budget, factory overhead cost budget C Sales budget, production budget, material cost budget D Material purchases budget, labour cost budget, selling expenses budget Correct answer B 3 Tea cups Ltd manufactures cups. Budgeted sales are 64,000 cups for next year. The estimated beginning inventory is 2,500 cups and the expected ending inventory is 3,500 cups. Determine the production budget (in units) for next year. Answer Production=budgeted sales plus desired closing inventory minus estimated beginning inventory =64,000+3,000-2,500= 65,000 units 4 Usenge Ltd has budgeted to produce 59,000 units and sale 50,000 units in July,2016.Each unit of the product requires 8kg of material .Beginning inventory of material is 27,000 kg and the desired ending material inventory is 25,000 kg. Material costs sh 0.50 per kg. Determine the material purchases budget for July, 2016.

Answer Units of material purchases=production plus desired ending material inventory minus estimated beginning inventory. =59,000+25,000-27,000=470,000 units Material purchase cost=470,000@ sh 0.50=sh 235,000. LESSON EIGHT:QUESTIONS 1 Victoria furnishers Ltd manufactures office cabinets from steel. The following information has been provided by its production department: Steel per cabinet 50 kg

Direct labour per cabinet 18 Minutes Variable factory overheads 20% of direct labour cost Supervisor’s salaries shs 320,000 per month Depreciation shs 50,000 per month Direct labour rate shs 46 per hour Steel cost shs 3.70 per kg Required: Prepare a Flexible budget for 15,000 bulbs for the month of January 2015, assuming that inventories are not significant.

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Solution Victoria furnishers Ltd

Flexible budget for Jan ,2015 (15,000 units) sh Variable costs: Direct material 2,775,000 Direct labour 207,000 Factory overheads 41,400 Fixed costs: QSupervisor salaries 320,000 Depreciation 50,000 Total cost 3,393,400

2 ABC Ltd makes two products, X and Y, using two types of raw materials ( A and B).The following

information is given for a budget period: i Budget sales Product Quantity (units) selling price (sh) X 10,000 40 Y 8,000 30 ii Material usage A B Unit cost (per kg) shs 5 shs8 Quantities used (kg per unit) A B Product X 5 3 Y 4 2 iii Finished Goods Budget (units) X Y Beginning inventory 500 1500 Ending inventory 1,000 500 iv Raw material Budget (units) A B Beginning inventory 1,500 2,500 Ending inventory 1,000 3,000 Required: a) Sales Budget ( in shs) b) Production Budget (in units) c) Material usage Budget (in kg) d) Material purchases Budget (in kg and shs) Solution a) Sales Budget

Product units to be sold price per unit shs X 10,000 40 400,000 Y 8,000 30 240,000 640,000

b) Production Budget ( in units) X Y Units to be sold 10,000 8,000

Add: Desired Ending Finished inventory 1,000 500

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Total needs 11,000 8,500 Less: Desired Beginning Finished inventory 500 1,500 Units to be produced 10,500 7,000

c) Material usage Budget (in kg)(Based on units to be produced) Product units A B X 10,500 52,500 31,500 Y 7,000 28,000 14,000 Material usage 80,500 45,500

d) Material purchases Budget (in kg ) ( Based on material usage) A B Total

Material usage 80,500 45,500 Add: Desired Ending material inventory 1,000 3,000 Total material requirements 81,500 48,500 Less: Desired Beginning material inventory 1,500 2,500 Required material purchases 80,000 46,000 Cost per kg shs 5 shs 8 Budgeted material purchases 400,000 368,000 768,000

3 Fryz inn Ltd makes pizzas for sale .It has determined from its production budget the following

production estimated volumes for small and large frozen pizzas for June 2015: Budgeted production volume: small pizza 5,200 units Large pizza 9,400 units There are three direct material units used in producing the two types of pizza. The quantities of direct materials expected to be used for each pizza are as follows : Direct materials small pizza large pizza Dough 0.90 kg per unit 1.50 kg per unit Tomato 0.60 kg per unit 1.0 kg per unit Cheese 0.75 kg per unit 1.25 kg per unit In addition, Fryz has determined the following information about each material: Dough Tomato Cheese Estimated inventory Jan, 1 580 kg 210 kg 325 kg Desired inventory June, 30 640 kg 200 kg 355 kg Price per kg shs 11 shs 26 shs 28 Required: Prepare the company’s Direct materials purchases budget for the month of June. Solution Fyz inn Ltd Material purchases budget Dough Tomato Cheese

Kg kg kg Total(shs) Material for production (kgs) 18,780 12,520 15,650 Add:desired ending inventory 640 200 355 19,420 12,720 16,005 Less:Estimated beginning inventory 580 210 325 Units of material purchases(kgs) 18,840 12,510 15,680 Unit purchase cost sh 11 sh 26 sh 28

Material purchases budget 207,240 325,260 439,040 971,540

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CHAPTER NINE: PROCESS COSTING

Lesson objectives After studying this lesson, the learner should be able to: a) Define process costing and explain the basis of all process costing systems. b) Distinguish between normal and abnormal losses and prepare process, normal

loss, abnormal loss/gain , scrap accounts. c) Explain the concept of equivalent units and the valuation of finished goods and

work in progress. d) Distinguish between joint products and by-products. e) Demonstrate an understanding of the methods of accounting for joint products

and joint products in process accounts. f) Explain the methods of accounting for by-products.

1.0 Definition and basis of process costing

Process costing is a form of operation costing where it is not easy to identify separate units of production or jobs due to the nature of the production processes involved. Unlike in job or batch costing, a product passes through distinct processes or stages of manufacture before the final product or output is realised. Process costing is common in industries in which the material handled is liquid or semi-solid. Industries with continuous process production include oil refining, paper, foods, chocolates and drinks, chemicals, paint, cement, textile and detergents etc. Characteristics of Process costing

iControl accounts are established for each process or departments which act as process cost centres used to record and accumulate all process costs (direct material, labour and overheads). ii As production moves from one process stage to another, costs are transferred to it and the chargeable cost of the output of one process becomes the raw material input of the next process and so on. iii There is usually closing work in progress (WIP) which must be valued .Process costs for a period is apportioned between completed output and work in progress using FIFO or Average cost methods. iv There is often a loss in the process due to spoilage, waste, evaporation ,defects or other cause, which should be accounted for using average cost per unit of good output or scrapped value. vApart from final process output, there may be a by-product(s) and or joint product (s) ,which need to be accounted for separately.

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Elements of process costs As stated earlier, the final output of a process comes after undergoing several processes .Control accounts are established for each process and direct costs and production overheads are allocated to each process. Direct costs are charged and allocated in the same manner as in job costing. However, the detailed work of allocating costs as in job costing is not necessary in this case. A process account is opened for each process and debited with all direct costs and production oveheads and credited with costs of output, abnormal loss and scrap value of normal loss.The main elements of process costs are : 1 Direct materials: Raw material is introduced as input into a production process and transferred into subsequent processes as necessary. Some more materials may be added to the original material at each stage 2 Direct labour Cost of direct labour or wages is debited to the each process account. However, due to automation in many process industries, the cost of direct labour is insignificant. 3 Direct expenses: These include cost of packaging, hire of specialised tools and equipment. These are also debited to each process account, albeit being insignificant. 4 Production or factory (manufacturing) overheads The proportion of production overheads is relatively high due to automated plant and machinery. Each process is charged with a reasonable share of the production overheads on fair basis. The total cost of direct labour, direct expenses and production overhead is often referred to as conversion cost.

1.1 Basic Procedures used in process costing There are four key steps in process costing depending on whether there are normal losses, scrap, opening and closing work in progress. These are :

a) Determining Output and Losses: calculate the expected output ,normal and abnormal loss or gain. In case there is opening or closing WIP, equivalent units are calculated.

b) Calculate the cost per unit of output or equivalent unit.Cost per unit is based on ‘good’ output.

c) Calculate the total cost of output, losses and WIP. In case there is WIP, a statement of equivalent production and statement of evaluation will be prepared. Cost per unit is used to calculate cost of output (completed production ( and abnormal loss or gain. Normal loss is not given a cost.

d) Prepare process, Normal loss and abnormal losses accounts as necessary. 1.2 Losses in process costing

In the course of manufacture, there may arise process losses: Normal and abnormal loss and abnormal gain ( on rare occasions). A normal loss is the loss which is expected under normal circumstances like evaporation; it is unavoidable and therefore absorbed into good production. It is not given a cost. However, proceeds realised from sale of normal loss units are credited to the process account. An abnormal loss is the loss which is not expected and occurs under abnormal

circumstances which may include machinery breakdown, defective materials industrial accidents or labour inefficiency. The opposite of abnormal loss is abnormal gain. Abnormal loss and gain units are costed at the same cost per unit as the good production as they do not affect good output. Their costs are analysed separately

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and posted to their respective accounts. The abnormal loss is credited to process account while the abnormal gain is debited .

The following guidelines may be useful in calculating normal and abnormal loss units: a) Actual loss = Input-Actual production (output). b) Expected production= Input-Normal loss. c) Abnormal loss= Expected production-Actual production

= Actual loss- Normal loss. d) Normal loss= Actual loss-Abnormal loss. e) Actual loss = Normal loss + Abnormal loss.

1.3 Accounting for scrap Losses which arise from the process may be sold at scrap value ( minimal price).The sales proceeds (revenue) realised from scrap are used to reduce the process costs.The following procedures may be used to account for scrap in process accounts : a) Scrap value of normal loss units: DR Scrap value account CR Process account (with

the value of sale proceeds) b) Scrap value of abnormal loss : DR Scrap value account CR Abnormal loss account

(with the sale proceeds from abnormal loss units) c) Scrap value of abnormal gain : DR Abnormal gain account CR Scrap value account (

with the sale proceeds from abnormal gain ) d) Cash received from scrap sales : DR Cash or Bank CR Scrap value account . e) Scrap sold on credit : DR Debtors account CR Scrap value account.

There may arise disposal costs on normal and abnormal losses. In such a case, the disposal costs of normal loss units should be debited to the process costs or reduced from scrap value of normal loss units. On the other hand, include the disposal costs of abnormal loss units in the abnormal loss account and then transfer the cost of abnormal loss to the Profit and Loss account.

Sometimes a process may also have waste, which is material arising from the production process that has no value.

1.4 Process costing with and without process losses a) Without process losses: All materials and conversion costs are debited to the

Process account and the accumulated costs are transferred to the next process. Columns will be opened on both sides of the process account to shown input units (for memorandum only). This is uncommon.

b) With process losses : In case there are normal and abnormal losses, all material and conversion costs are debited to process account and credited with normal losses ( Scrap value ), abnormal losses , Output.

1.5 Valuation of Work in progress(WIP) The concept of equivalent units is used when there are opening and closing work in progress. Equivalent units (EU)are defined as ‘ a notional quantity of completed units substituted for an actual quantity of in completed physical units in process , where the aggregate work content of the incomplete units is deemed to be equivalent to that of the substituted quantity of completed units ‘. When opening WIP is involved, the value of completed units transferred to substituted is computed by either F.I.F.O (First-in First-out) or Average or Weighted Average Method. These methods are considered here below:

a) F.I.F.O Method : It is a method of accounting for cost flows in a process costing system in which effective or equivalent units of production and unit costs relate to only work done and completed during the current period. WIP moves on a First-in First-out basis. Incomplete units in opening WIP is first completed before taking up work on any new units. Opening WIP units are separated with

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the closing WIP. This is shown separately in a Statement of equivalent units production costs. Inventory brought forward from the previous year is not added to the current costs. The objective of the FIFO method is to value closing WIP at current costs. This is the commonest method of stock valuation. It is appropriate when the degree of completion of each element in opening stock is given but not the value of each cost element. This method is considered to be more superior than the average cost for purposes of cost control; current performance should be measured in relation to costs of the current period only rather than on current plus previous costs.

b) AVERAGE cost Method: It is a method of accounting for cost flows in a process costing system in which units in the opening work in progress inventory are presumed to have been started and completed during the current period. The method is used when the degree of completion of each element in opening WIP is not given but the value of each cost element is provided. Opening WIP Units are not shown separately in the equivalent production statement, but are included in the total units completed and transferred to the subsequent process and finished stock. The method is simple to simpler to apply than the FIFO method but has less usefulness in cost control. The value of opening WIP is added to the costs incurred during the current accounting period and total cost divided by the total equivalents to get the average cost of equivalent units. It is necessary to breakdown the elements of cost into materials, labour and overheads.

c) WEIGHTED Average Method: This method is used when dissimilar products are produced in the same process .A close study of production and costs of each variety of products is essential. The relative importance of one product as compared to other should also be indicated in terms of points. These points are used as a common denominator. To find cost of production in weighted average, statements of weighted average production in terms of points and cost for each variety of products should be prepared .When weights or points are considered, the calculation of weighted average process cost becomes easier.

1.1 Joint and by-product costing During a production process, there may arise joint products and or by-products. Joint products are two or more products which simultaneously emerge from a production process but each of which has a significant relative sales value .These products are indistinguishable from each other up to the point of sale. Examples of joint products can be found in oil refining where diesel fuel, petrol, paraffin and lubricants emerge from the same production process. Since a joint product is regarded as having a significant value, it should be costed separately and its profitability determined. By-products are products which arise from the simultaneous production process incidentally and have a minor or low sales value when compared to joint products. They are supplementary or secondary products. By-products may arise in timber industry eg saw dust, small offcuts and park .In sugar processing, molasses may arise as a by-product. Unlike joint products, by-products are not separately costs due to their insignificant value.

1.2 Accounting for joint products The main problem for joint products is the apportionment of joint costs prior to the point of separation (split-off point) on a fair basis. Joint costs are not separately identifiable until the split-off point is reached in production process. A decision needs to

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be made regarding the basis of apportionment and also whether the joint product can be sold profitably at one stage of processing or subsequently after further processing. Of course post-separation costs (materials, labour, and overheads) will be incurred on further processing. However, subsequent costs after the split off point may not pose accounting problems since they can easily be traced directly to the product. The methods of accounting for joint products are :

a) Physical unit or measurement basis b) Average unit cost method c) Weighted average (or survey) method d) i) Market value method (at the point of separation)

ii) Market value method ( after further processing) iii) Net value method

iv)Standard cost method v)Contribution method 1 Physical units or measurement method In this method, the joint costs are apportioned on the basis of weight, volume or unit of output of the joint products. However, this method is not appropriate where the products separate during the processes into different states and where one product generates more income than the other relative to its physical measurement. 2 Average unit cost method The pre-separation joint cost is divided by the total units of production of the joint products to arrive at the average unit cost .This unit cost is then multiplied by the weight of each product to get its apportioned joint cost. 3 Weighted average or survey method Weights or points are assigned to each individual joint product. The individual product units are then multiplied with the respective weights to get equivalent or weighted units. Then total units of the products are divided by the sum of the Equivalent units to arrive at the weighted average cost. The weighted average cost is multiplied by the products equivalent units to get its apportioned cost. 4 Market value or Sales value basis Under this method, the joint costs are apportioned in proportion to the relative sales value of the product. Sales value is taken as market value at the point of separation. This method is suitable where joint products have different economic values. Where the post separation costs are too high, the alternative method is to apportion joint costs using sales value less far processing or post separation costs. This method is also called notional sales value method. It may be important to say that the choice of a method of apportioning joint products depends on the circumstances and personal judgement of the cost accountant provided the apportionment is made on a fair basis.

Example1 Product Z is produced after two processes. The following information is available:

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Process

1 2 Item Total cost (sh) shs shs Direct material 360,000 280,000 80,000 Direct labour 70,000 30,000 40,000 Direct expenses 100,000 100,000 - Production overhead incurred is Sh 120,000 and is on 200% of direct labour. Production during the period was 2,000 kgs and there were no opening or closing stocks or process losses. Required: Prepare process 1 and 2 accounts. Dr Process 1 account Cr

Units shs Material 2000 280,000 Labour 30,000 Expenses 100,000 Overheads 60,000 2,000 470,000

Units shs To process2 2,000 470,000

----------------------------

- 2,000 470,000

DR Process 2 account Cr

Units shs From process1 2,000 470,000 Materials 80,000 Labour 40,000 Expenses - Overhead 80,000 2,000 670,000

Units shs Finished stock 2,000 670,000

2,000 670,000

Example 2

A production process produces three joint products A,B and C. The pre-separation costs amounted to shs 400,000. The output from the three products was : A 10,000 kg, B 2,000 kg and C 8,000 kg. Required : a) Apportion the joint products using i) physical unit basis ii) Average cost method. b)Assume the joint products have been assigned weight factors of 6, 8 and 4 for A,B and C respectively, apportion the joint costs using the Weighted average or survey method.

Solution a i) Physical unit basis Apportionment of joint costs : Product A : 10÷20 × shs400,000 = shs 200,000

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Product B : 2÷20 × shs 400,000 = shs 40,000 Product C :8÷20 × shs 400,000 = shs 160,000

ii) Average cost method Average cost per kg = sh 400,000 ÷20,000kgs = shs 20 per kg. Apportionment of joint costs : Product A 10,000 kgs × shs 20 = shs 200,000 Product B 2,000 Kgs × shs 20 = shs 40,000 Product C 8,000kgs × shs 20 = shs 160,000

c) Weighted average cost method Product units weight weighted weighted Apportioned

(kgs) Units (kgs) average cost A 10,000 6 60,000 3.7037 222,220

B 2,000 8 16,000 3.7037 59,250 C 8,000 4 32,000 3.7037 118,530

Example 3

Process 2 receives units from process 1, processes them and transfers the units to the next process 3.The following information is given for a period:

Opening WIP : 400 units ( 25% complete) valued at sh 50,000 1,600 units were received from process1 valued at sh 86,000 1,640 units were transferred to process 3

Closing WIP : 320 units (50% complete) The process costs for the period were sh 331,600. No units were scrapped. Required: a) calculate the effective units of production.

b)Prepare process 2 accounts using: i FIFO method of valuation ii AVERAGE COST method of valuation Solution a)FIFO method Effective units=Completed units+ Equivalent units in closing WIP-Equivalent units in Opening WIP= 1,680 + 50%× 320 -25%× 400=1,680+ 160-100= 1,740 Total cost for the period=previous costs+transfers in =sh 331,600+ 86,000 =sh 417,600 Cost per unit=Total costs / effective units=(417,600/870=sh 240 Value of closing WIP= 320 units× 50%@sh 24= sh 38,400

Process 2 account(using FIFO method)

Units Sh Units Sh

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Opening WIP From process1 Process costs

400

1,600

50,000 86,000 331,600

Transferers to Process3 Closing WIP

1,680 320

429,200 38,400

2,000

467,600

2,000

467,600

b) Average cost method Effective units=1,680 + 320×50%=1,680+160=1,840 units. Total costs=Costs of opening WIP+valuation of units transferred in +process 2 costs =sh 50,000+ 86,000+ 331,600=sh 467,600 Cost per unit =sh 467,600/ 1,840=sh 254.13. Value of transfers to process 3= 1,680 units@ sh 254.13= sh 426,939 Valuation of closing WIP= 320 units @ 50%@sh254.13= sh40,661. Process 2 account (using average cost method)

Opening WIP From process 1 Process costs

Units Sh Transfers to process 3 Closing WIP

Units Sh

400 1,600 2,000

50,000 86,000 331,600 467,600

1,680 320 2,000

426,939 40,661 467,600

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LESSON NINE: QUIZZES

1 Which of the following statements is NOT TRUE about process costing? A It is a form of operating costing. B Wok in progress is a distinguishable homogeneous mass. C Normal loss is usually valued at the cost per unit of good output. D Poses a problem on how to value closing work in progress and completed units. Correct answer C 2 Mafuta Ltd input to a process 2,000 units. Process costs were sh 90,000 and normal loss was 10% .Actual output was 1,750 units and normal loss units were sold for at sh 9.00 each. There were no opening or closing work in progress. Determine normal and abnormal losses, cost per unit and cost of output. Solution Normal loss= 10%× 2,000 =200 units Abnormal loss= Actual loss- normal loss=(2,000-1,750)-200= 250-200=50 units. Expected output=input-normal loss=2,000-200=1,800 units. Scrap value of normal loss= 200 units@ sh 9 =sh 1,800 Cost per unit= Process costs- scrap value of normal loss =sh 90,000-1,800= sh 49. Expected or’ good’ output 1,800

Cost of output= 1,750 units@ sh 49=sh 85,750. 3Match the following cost terms with their appropriate basic process costing

Cost term meaning A normal loss 1.It is given a cost B Abnormal loss 2.It is not given a cost C Expected output 3 It is deducted from material cost D Scrap 4 It is used to calculate unit cost Correct answer a(2),b(1),c(4),d(3)

LESSON NINE: QUESTIONS 1The Production department of Chuma Ltd has given the following data:

Opening work in progress-2,300 kg( 70% complete). Completed production:46,500 kg . Closing work in progress-1,800 kg (25% complete) Materials are added at the beginning of the process. Determine the total equivalent units for direct materials and conversion costs

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Answer Calculation of Effective or Equivalent units of production(EU) Equivalent units=completed units + Equivalent closing WIP units- Equivalent Opening WIP units a Materials: Equivalent units =46,500+1,800-2,300=46,000 units. bConversion costs: Equivalent units= 46,500 +1,800×25% -2,300×70% =46,500+450-1,610=45,340 units

2 The process manager of Koitobos Ltd has given the following information for July,2013: Opening work in progress-4,000 (30% complete). Completed units: 58,000 litres . Closing work in progress :3,000 litres (60% complete). cost of materials transferred in the process :sh 22,800 ; conversion cost for the period sh 8,790. Assume that materials are added at the beginning of the process. Required: a)Total equivalent units for direct materials and conversion costs. b) Direct material cost per equivalent unit and conversion cost per equivalent unit. Solution a)Effective units of production=completed units+Equivalent units in Closing WIP-Equivalent units in Opening WIP For Materials: effective units=58,000+3000-4,000=57,000 units ( 100% completed) For conversion costs : effective units=58,000 + 3,000@60%-4,000@30% =58,000 +1,800-1,200=58,600 units. b) Direct material cost per equivalent unit=material cost/material effective units=sh22,800/57,00=sh 0.40 per litre. Conversion cost per equivalent unit= conversion cost/conversion cost effective units =sh 8,790/58,600=sh0.15 per litre.

Cost element

Completed + Equivalent- Equivalent = Total effective Units units in units in units Closing WIP Opening WIP

Costs Shs

Cost per (sh) unit

Material Conversion cost

58,000 + 3000 - 4,000 = 57,000 58,000 + 1,800 -1,200 = 58,600

22,800 8,790

0.40 0.15 0.55

3 Simiti Ltd manufactures a product which undergoes through two processes. During the year ending 31st December, 2013, the following data was recorded in the first process: Opening work in progress: 10,000 units (materials 100% complete, conversion 70% complete) Units started into production :150,000 units Units completed and transferred to next process:140,000 units Closing work in progress:20,000 units (materials 60% complete, conversion 25% complete)

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Required: Determine the equivalent units of production using a) FIFO method b) Average cost method

a FIFO Effective or equivalent units of production Materials: Equivalent units=complete units+ equiv units in Closing WIP+ equiv units in Opening WIP =140,000+20,000@60%-10,000@100%=140,000+12,000-10,000=142,000 units Conversion: Equivalent units=140,000 +20,000@25%-10,000@70%=140,000+5,000-7,000=138,000 b Average cost method Materials : Equivalent units=completed units+ equivalent units in closing WIP. = 140,000 +20,000@60%=140,000+12,000=152,000 units. Conversion :Equivalent units=140,000+20,000@25%=140,000+5,000=145,000 units. 4 Pamoja products Ltd produces three joint products but each of which can be processed further

before sale. The following information is given for one month:

Product A B C Selling price per unit(at split-off point) sh12 sh 16 sh18 Selling price per unit(post processing) sh 20 sh 40 sh 60 Post-separation point costs sh 40,000 sh 20,000 sh50,000 Units of output 3,500 2,500 2,000 The joint costs before split-off were sh 80,000.The management is also considering to stop further processing of loss- making products in future. Required: Prepare a profit statement for each product using the physical measurement method and determine the maximum amount to be spend on post-separation cost of product A Solution Product A B C Sh sh sh Sales 70,000 100,000 120,000 Costs: Joint product costs(@sh 10 per unit) 35,000 25,000 20,000 Post separation costs 40,000 20,000 50,000 Total costs 75,000 45,000 70,000 Profit (loss) ( 5,000) 55,000 50,000 Joint costs are apportion on the basis of output: ie sh 80,000/8,000 units=sh 10 per unit Product A has a loss of sh 5,000.The maximum post –separation cost should be at break even point. Therefore maximum post separation costs are sh 35,000 ( sh 40,000-5,000) 5 The following information is given for a milling process for June:

Material input:3,000 litres Output :2,000 litres Material costs sh 234,000 Conversion cost sh 126,000 Normal loss is 10%.Loss units are sold at sh 20 each. Required:

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aDetermine output and losses b calculate the cost per unit,total cost of output and losses c prepare the milling process account and abnormal loss or gain account. Solution Output and losses Normal loss= 3,000@10%=300 units; scrap value of normal loss=300@sh 20=sh 6,000. Actual loss= input-output=3,000-2,000=1,000 units. Abnormal loss= Actual loss-normal loss= 1,000-300=700 units. Expected output=input-normal loss=3,000-300=2700. bCost perunit, total cost of output and losses Cost per unit=process costs-scrap value of normal loss Expected output = (sh 234,000+126,000-6,000)/2,700 = sh131.10 Output: 2,000 units@sh 131= sh 262,200 Abnormal loss: 700 units@sh 131=sh 91,800 Normal loss : 300 units@ sh 20= sh 6,000* Total cost 360,000 *scrap value of normal loss is credited to Process account. Milling Process Account c Dr Cr

Material Conversion costs

Units Sh Normal loss Output Abnormal loss

Units Sh

3,000 3,000

234,000 126,000 360,000

300 2,000 700 3,000

6,000* 262,200 91,800 360,000

Abnormal loss account Dr Cr

Process account

Sh Scrap account Profit& Loss a/c

Sh

91,800 91,800

14,000** 77,800 91,800

** Scrap value of abnormal loss=700 units@sh 20=sh14,000 (credited to abnormal loss a/c)

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LESSON TEN: STANDARD COSTING AND BASIC VARIANCE ANALYSIS Lesson objectives After studying this lesson, the learner should be able to:

a) Explain the objectives of standard costing and define a standard cost. b) Distinguish between standard costing and budgetary control. c) Explain the various types of performance standards and prepare a standard cost. d) Define variance analysis and explain its components. e) Calculate material, labour, fixed overhead and variable cost variances. f) Identify the causes of material, labour and overhead variances.

1.0 Objectives of standard costing The term standard costing is derived from ‘ standard cost’. A standard cost is a planned or predetermined unit cost of production. The total standard cost of a product is the total planned cost per unit of materials, labour, variable and fixed overheads.It is determined from estimates of expected prices or rates for materials ,labour and overheads. Standard costing is a control technique which establishes predetermined estimates of the costs of products or services, collects actual costs and output data and compares the actual results with the predetermined estimates. It measures control by way of variance analysis, whereby standard costs are compared with actual costs and differences arising therein are investigated.

The main purposes or objectives of standard costing may be summarised as follows: a. To assist in setting budgets and evaluating managerial performance. b. To act assist in cost control by highlighting variances in cost of material,

labour and overheads.. Managers are then able to know those adverse situations that require remedial action.

c. To provide a prediction of future costs that can be used for decision making d. To provide a basis for inventory valuation, thus avoiding tedious methods

like FIFO, LIFO and Weighted average cost. e. To provide targets that managers are expected to achieve .Those who

achieve the set targets become motivated. 1.1Standard cost and budgetary control

It may be important to note that most students confuse standard costing and budgetary control. The following include some of the differences between standard costing and budgetary control: 1) Standard costing is applied mainly in manufacturing activities whereas budgetary

control is universal. 2) Standard costing emphasises set cost standards maintained while budgetary control

emphasises profit planning

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3) Standard costing uses standard cost per unit of product or service as benchmark whereas budgetary control is a total concept for departmental organisation in an entire period.

4) Standard cost is established after considering a variety of factors like production volume, methods employed and efficiency determinants whereas budgetary control is based on previous performance and makes adjustments for any expected changes

5) Standard costing is the basis of variance analysis which is normally revealed through accounting; in budgetary control variances are revealed through statistical measure

6) standard costing lays the basis for investigation of variances ; budgetary control gives more emphasis on budget over expenditures

7) Standard costing is useful in decision making pertaining to cost management; budgetary control puts more emphasis on general administrative and policy decisions.

8) Standard costing is more useful for cost accounts whereas budgetary control mirrors financial accounts.

1.2 Performance standards and standard standard costs

The quantity of materials and labour time required will depend on the level of performance required by management. You may note remember that material and labour costs are prime costs and therefore are a major determinant of a standard cost. Standards imply an acceptable level of production efficiency and one of the major objectives of setting standard is to motivate employees to achieve efficiency in operations

Types of performance standards a. Basic or constant cost standards: These are constant standards that remain

unchanged over long periods of time. They provide a basis for comparison with actual costs. However, they are seldom used because they disregard changes in production, material prices and labour rates.

b. Ideal or theoretical standards: These are standards which can only be achieved under perfect operating conditions. They represent perfect performance .Such standards assume no idle time, no machine breakdowns and no material shortages and labour strikes. They tend to be unrealistic and unattainable; they are unlikely to be attained and used in practice due to their adverse impact on employee motivation.

c. Attainable or expected standards: These represent costs that should be incurred under normal or efficient operating conditions .They are standards that are difficult but not impossible to achieve .They cater for normal material spoilage, machine breakdowns and lost time etc.

d. Current standards: These are set for a relatively short period to reflect current conditions .They are normally used in during inflationary times but are same as attainable standards when the conditions stabilise .They are set for short periods but quickly adjusted when circumstances change. 1.4Problems of standard costs Using standard costs for performance evaluation has been criticised on the following grounds:

1) Standards discourage operating improvements beyond the standards set. 2) Standards may not be preserved for long especially in a rapidly changing,

dynamic production environment. 3) Standard narrow employees focus to efficiency improvements and makes

them ignore overall organisational objectives.

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4) Standards may cause employees to unduly focus attention on their own divisional, departmental or branch operations to the detriment of other operations that require them.

1.5Components of a standard cost Setting a standard cost is the essence of standard costing .A standard cost is accumulated for each product, comprising the standard cost of materials and labour (wages) used together with a predetermined share of budgeted variable and fixed production overheads. For standard cost of materials, material prices, quantity issued and consumed and actual output units have to be ascertained.In case of labour costs, labour efficiency ( time worked and time paid) and estimated wage rates and actual rates are required. variable overheads are absorbed into production on the basis of labour hours. It is therefore necessary to estimate the variable overhead for the year and budgeted activity (output) units or hours.These are used to calculate the variable overhead absorption rate (VOAR) per unit. Fixed overheads can be budgeted in total before production starts but the amount to be included in a standard product cost depends on budgeted output. A fixed overhead absorption overhead rate (FOAR) is the determined. The total standard production costs per unit are summarised into a standard cost card or sheet specification.

Example 1 The standard cost for production of one unit of product ‘Z’ is given as below: Material: 1 kg at shs 4 per kg Labour : 1 hour at shs 2 per hour Variable overheads shs 2 per unit Fixed overheads shs 5 per unit Required: a) Prepare a standard cost card and determine the standard cost for production of 2,000 units. b) calculate the unit selling price if the profit margin is estimated to be 20%. Solution

a) Standard cost card Cost shs per unit Materials : 1kg @ shs 4 4 Labour : 1 Hr @ shs 2 2 Variable overhead rate (VOAR) 2 Fixed overhead rate (FOAR) 5 Standard cost per unit 13 Standard cost for production of 2,000 units = 2,000× shs 13 =shs 26,000 .

b) Selling price per unit = shs 13 + 25% ×shs 13 = shs 13 +3.25=shs16.25 If profit margin is 20%(⅟5) , the profit mark up is 25% ( ¼) ( Note the relationship :cost price + profit= selling price)

Example 2 The following information is given for manufacture of a product: Budgeted output for the year 9,800 units Standard details for one unit: Direct labour : 40 sq. metres at shs 53 per sq.metre Direct wages: Bonding dept : 48 hours at shs 25 per hour Finishing dept : 30 hours at shs 19 per hour

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Budgeted costs and hours per annum Variable overheads : Shs Hours Bonding dept 3,750,000 500,000 Finishing dept 1,500,000 300,000 Fixed overheads : Shs Production 3,920,000 Selling & Distribution 1,960,000 Administration 980,000

Required:a) Prepare a standard cost card for one unit to show Prime cost, Variable production cost, Total production cost and Total cost. b) Calculate the selling price if profit margin is 15%. Solution a) Standard cost per unit ( Budget)

Shs shs Material : 40 sq.m @ shs53 2,120 Labour : Bonding :48 Hrs @ shs 25 1,200 Finishing:30 Hrs @ shs 19 570 1,770 PRIME COST 3,890

Variable overhead Bonding ( shs 7.50×48 hours) * 360 Finishing ( shs 5.00× 30 hours)* 150 510 Variable cost of production 4,400 Fixed overheads 400** Total production (factory) cost 4,800 Selling & distribution overheads (shs 960,000÷9,800 units) 200 Administration overheads (shs 980,000÷9,800 units) 100 300 Total cost 5,100 Add : Profit mark up (3/17 × shs 5,100 ) 900 Selling price per unit 6,000

*Variable overhead absorption rates (VOAR): Bonding dept : shs 3,750,000 /500,000 Hrs= sh 7.50 per Hour. Finishing dept : shs 1,500,000/300,000 Hrs = shs 5.00 per Hour. **Fixed overhead absorption rate(FOAR): (shs 3,920,000÷9,800 units)= shs 400. 2.0 VARIANCE ANALYSIS

A variance simply means a deviation or difference from the expected. Actual costs are compared with the budgeted or standard costs to obtain a variance. Variance analysis refers to critical analysis of each element of production cost (material, labour, variable and fixed overheads) in an attempt to reveal adverse or favourable variances which need to be investigated if they are ‘out of control’. Price or rate variance measures the difference between actual prices (AP) or rate (AR) paid and the standard price (SP) or rate (SR) that should have been paid for materials or labour. Quantity or efficiency variance measure the difference between the actual quantity (AQ) or hours (AH) for direct material or labour used and the standard quantity(SQ) or hours (SH) that should have been used. Standard quantities or hours are based on actual units produced (output achieved). The standard hour is the quantity of output or amount of work which should be performed in one year.

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Variance analysis relies to a great extent on standard costing. For instance, Standard prices and quantities and actual prices and quantities must be known in order to calculate variances. Variance analysis is used as a control and evaluation tool. The following is the breakdown of basic variances:

1) Material cost variance =Price variance + Usage variance. 2) Labour cost variance= Rate variance + Efficiency variance 3) Variable overhead cost variance= Expenditure variance +Efficiency variance 4) Fixed overhead cost variance= Expenditure variance+ Volume variance;

Fixed overhead volume variance=Volume efficiency variance+ Volume capacity variance. 2.1 Material cost variances

The direct material cost variance can be subdivided into material PRICE variance and USAGE variance. The direct material cost variance is the difference between what the output actually cost and what it ought to have cost, in terms of material. The material price variance is the difference between the standard cost and the actual cost for the actual quantity of material used or purchased. The material usage or quantity variance is the difference between the standard quantity of materials that should have been used for the number of units actually produced and the actual quantity of materials used, valued at the standard cost per unit of material. PRICE variance= Actual quantity (Actual price-standard price)=AQ(AP-SP) USAGE variance =Standard price (Actual quantity-standard quantity)=SP (AQ-SQ) Note that the price variance may be segregated at the time of purchase ( when the material is taken into stock) or at the time of issue from the stock(when the material is put into production ).Both methods have their advantages and disadvantages .However, where a full standard costing system is operation, as is usually the case, price variance should be calculated on purchases for the period .If actual price or actual quantity exceed the standard price or standard quantity respectively, the material cost variances would be adverse or vice versa.

Reasons for material cost variances Material price variance

a. Price changes as a result of wage awards, increases in customs duties etc

b. Differences in standard and actual order quantities due to gains or losses in quantity discounts

c. Obtaining materials from a different supplier other than the listed one

d. Differences between standard and actual carriage costs ( freight, insurance, storage etc)

e. Differences between the standard and actual quality of materials

2.2 Labour cost variances Direct labour cost variance can be subdivided into labour rate variance and efficiency (quantity) variance. Labour cost variance is the difference between what the output should have cost and what it actually cost in terms of labour. The labour rate variance is the difference between the standard cost and the actual cost for the actual number of hours paid for. The labour efficiency variance is the difference between the hours that should have been worked for the number of units actually produced and the actual number of hours

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worked valued at the standard rate per hour .The variances may either be adverse or favourable. If actual rate or actual hours exceed the standard rate or standard hours respectively, the labour cost variance would be adverse or vice versa. The calculation of labour cost variances are similar to those of material cost variances. The actual price and standard price are replaced with actual rate and standard rate respectively in labour cost variances. Similarly, the actual quantity and standard quantity are replaced with actual hours and standard hours respectively in labour cost variances. RATE variance= Actual Hours paid ( Actual rate- standard rate)=AHP(AR-SR) EFFICIENCY variance= Standard rate (Actual hours-standard hours)=SR (AH-SH) However, note that when there is idle time, actual hours worked are used to calculate the efficiency variance. In this case, idle time is the difference between actual time worked (AH) and actual time or hours paid (AHP). Idle time variance= Standard rate (Actual hours paid-Actual hours)=SR (AHP-AH).Idle time variance is always adverse. Reasons for labour cost variances Labour rate variance

a) Use of different grades of labour other than planned b) Payment of unplanned overtime or bonuses c) Material prices variance causes Labour efficiency variance

a) Idle time due to machine breakdowns and material shortages

b) Errors in allocating time to jobs c) Poor supervision and disorganisation in the factory

workshop 2.3 OVERHEAD COST VARIANCES The overhead cost variance is the difference between the standard overhead cost specified for the production achieved, i.e. the flexible budget and the actual overhead cost incurred. The standard overhead cost usually comprises the variable and fixed overheads. It is necessary therefore to break the overhead cost variance into variable overhead and fixed overhead cost variances.

1VARIABLE OVERHEAD COST VARIANCES The variable overhead cost variance can be subdivided into variable overhead expenditure variance and variable overhead efficiency variance. Variable overhead cost variance is the difference between the actual variable overheads incurred and the variable overheads absorbed, which may be over or under absorbed overheads. Variable overhead expenditure variance is the difference between the actual variable overheads incurred and the allowable variable overheads based on the actual hours worked. Variable overhead efficiency variance is the difference between the allowed variable overheads and the absorbed variable overhead. Variable overhead efficiency variance is uses the same hours as in labour efficiency variance but priced at the variance overhead rate per hour. Variable overhead expenditure variance=Actual variable overhead-(VOAR ×Actual labour Hours )

VOAR= Variable overhead absorption rate. Variable overhead efficiency variance= VOAR (Actual Hours- Standard Hours).

2 FIXED OVERHEAD COST VARIANCE Fixed overhead cost variance is the difference between the standard cost of fixed overhead absorbed in the production achieved ,whether completed or not, and the fixed

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overhead attributed and charged to that period. The fixed overhead cost variance can be subdivided into fixed overhead expenditure and fixed overhead volume variances. Fixed overhead expenditure variance is the difference between the budget cost allowance for production for a specified control period and the actual fixed expenditure attributed and charged to that period. Fixed overhead volume variance is the difference between the standard cost absorbed in the production achieved, whether completed or not, and the budget cost allowance for a specified control period. The fixed overhead volume variance can further be subdivided into fixed overhead efficiency variance and fixed overhead capacity variance. The fixed overhead efficiency variance is the difference between the standard cost absorbed in the production achieved, whether completed or not, and the actual direct labour hours worked, valued at the standard hourly absorption rate. Fixed overhead capacity variance is the difference between budgeted (planned) hours of work and the actual hours worked, multiplied by the standard absorption rate per hour. Fixed overhead expenditure=Actual Fixed overhead expenditure-Budgeted Fixed overhead expenditure. Fixed overhead volume variance=Standard cost unit rate (Actual production-Budgeted production) Fixed overhead efficiency variance=FOAR (Actual Hours in input-Standard Hours in output)

Where FOAR= Fixed overhead absorption rate. Fixed overhead capacity variance=FOAR (Actual Hours in input-Budgeted Hours) Or =Standard cost per unit (Budgeted production-Standard Production) Example 2 The standard direct material specification for product ‘Z’ is to use 5 kg of raw material X at sh 60 per kg. Last month, 30 units of product Z were produced from 160 kg of the raw material, which cost shs 9,400 in total. Required: Calculate the material PRICE and USAGE variance. Solution Material price variance = AQ (AP-SP) =160kg (shs 58.75-60.00) =shs 200 F , usage variance =SP (AQ-SQ) = shs 60 (160-150) =shs 600 A Material cost total variance= shs 200 F + shs 600 A=shs 400A. Standard quantity (SQ) = Standard usage rate per unit× Actual units produced=5kg×30 units= 150kg. Example 3 The standard direct cost of a unit of a product is given below: Materials : 2kg at shs 12.50 per kg Wages: 10 Minutes at sh 24 per hour. In a certain period, 420 units were produced, 860 kg of material were used at a cost of shs 10,300 and 72 hours of labour were worked .Actual labour hours paid were 80 hours at a cost of shs2,000. Required: Calculate the Material and labour cost variances. Solution

a)material cost variances Price variance= AQ(AP-SP)=860 kg(11.979-12.50)=shs 10,300-10750=shs450 F Usage variance= SP(AQ-SQ)=shs12.5(860-840)= shs 250A Material cost variance= shs 450F +250A=shs 200F. Standard quantity (SQ)= 2kg ×420 units=840 kg.

Check:material cost variance=(AP×AQ)-(SP×SQ)=shs 10,300-(12.50×840)-shs 10,300-10,500=shs200F

b)Labour cost variances

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Rate variance=AHP(AR-SR)=80 hrs (sh25-24)= shs 80A Efficiency variance =SR( AH-SH)=shs24 (72-70)=shs 48A Idle time variance=SR (AHP-AH)=shs24 (80-72)=shs 192 A Labour cost variance=shs 80A+48A +192A= shs 320A. Standard hours =10/60 ×420 =70 hours. Check: Labour cost variance=(AR×AHP)- (SR×SH)=Sh(80×25)-(24×70)= sh 2000-1680=sh320A. Example 4 The variable production overhead cost of one unit of a product were:2 hours for sh 15 per Hour. During a certain period, 400 units of the product were made. The actual labour hours were 760 hours at a total cost of shs 12,300. Required: Calculate the variable overhead cost variances. Solution Variable overhead expenditure variance=Actual variable overheads- (VOAR× Actual labour hrs) =shs 12,300-(sh15×760)=shs 12,300-11,400=shs900A. Variable overhead efficiency variance=VOAR (Actual Hours-Standard Hours)=shs 15 ( 760-800)=sh600F. Variable overhead cost variance=shs 900A+600F= shs 300A. Variable overhead absorption rate (VOAR) = sh 15 per hour. Standard hours= 2hours× 400 units= 800 hours. Example 4 The following information is given for product : The standard fixed overhead cost per unit: 5 hours at sh shs 80 per hour. Budgeted fixed overheads shs 400,000.Budgeted production 1,000 units. Actual fixed overhead expenditure shs 409,000.Actual labour hours were 5,400 hours for output of 1,100 units. Required: Calculate the fixed overhead cost variances. Fixed overhead expenditure variance=Actual fixed overheads- Budgeted fixed overhead expenditure. = shs 409,000-400,000 =shs 9,000 A Fixed overhead volume variance=Standard cost unit rate ( Actual production-Standard production) = shs 400 (1,100-1,000)= shs 40,000 F. Fixed overhead volume efficiency variance=FOAR ( Actual hours-Standard hours)=shs 80( 5,400-5,500)= shs 8,000 F. Or =standard cost unit rate (Actual quantity-Standard production). Fixed overhead volume capacity variance=FOAR (Actual hours-budgeted hours) =shs80 (5,400-5,000)= sh 32,000 F Or Capacity variance= Standard cost unit rate ( Budgeted production-Standard production).Note that standard production quantity is not given .

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LESSON TEN: QUIZZES 1 Which of the following is NOT TRUE about standard costing? A It makes possible the use of management by exception. B It facilitates cash planning and inventory planning. CIt provides comparison of actual and budgeted performance at given activity levels DIt represents realistic yardsticks, more useful for cost reduction. Correct answer C 2 Machine tools Ltd has set the following labour standard for one unit of its product : Direct labour time per unit: 15 minutes Direct labour rate per hour : sh 5.50 Actual results for a period were: Actual hours worked ,7,700 hours for a total cost of sh 40,810. Output: 30,000 units. Calculate the labour rate and efficiency variance. Solution Labour rate variance=AH(AR-SR)=7,700 ( 5.30-5.50)=sh1,540 F Labour efficiency variance=SR (AH-SH)= 5.50( 7,700-7,500)= sh 1,100A. Total labour cost variance= sh 1,540F+ sh 1,100A=sh 440F. Standard hours(SH)=15/60× 30,000 units=7,500 hours. 3 Which of the following reasons might cause adverse material quantity variances 1 Change in material standard II Defective material III Stricter quality control IV Lower rate of scrap then expected A I B 1 and II C 1,II and III D I,II,III and IV Correct answerD . LESSON TEN: QUESTIONS 1) New Bomas Ltd uses variance analysis as a method of cost control. The following information is available for the year ended 30th September, 2011 Budget: Production for the year 12,000 units Standard cost per unit: Shs Direct material (3kg at sh 10 per kg 30

Direct labour (4 hours at sh 6 per hour) 24

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Overheads ( 4 hours at sh 2 per hour) 8 Standard cost 62 Actual results : Actual production for year: 11,500 units Materials:37,250 kg at a total cost of shs 345,000 Labour: 45.350 Hours at a total cost of shs 300,000 Required : Material and labour cost variances. Solution Material cost variances: Price variance =AQ (AP-SP)=37,250 kg(9.26-10)=345,00-372,500= sh 27,500F Usage variance =SR(AQ-SQ)=sh 10 ( 37,250-34,500)=sh27,500A. Labour cost variances: Rate variance= AH( AR-SR)=45,350 Hrs ( 6.61-6)=shs 300,000-272,100=sh27,900 A Efficiency variance= SR ( AH-SH)= sh 6( 45,350-46,000) =sh 3,900 F.

2 Jumba manufacturers Ltd produces single product for sale in the local market. The company uses standard costing to control its operations. The standard cost per unit of the product is as follows: shs Direct materials ( 4 litres @ sh12 ) 48 Direct labour ( 3hours @ sh10) 30 Variable factory overheads (3hours @sh 6) 18 96 During the month of June, 2010, 12,000 units were produced and the following costs incurred: Material purchases : 55,000 Litres @ sh 11 per litre Direct labour (36,800 hours ) : total cost shs 360,000 Variable factory overheads: shs 202,000 Raw material stocks were : Beginning 6,000 litres and ending 12,200 litres. Required : a) material price and usage variance. b) Labour rate and usage variance c) Total variable factory overhead variance d) Explain the possible causes of each of the above variances. Solution

amaterial cost variances: Price variance= AQ (AP-SP)= 55,000 ( sh 11-12 ) =sh 5,500 F Usage variance = SP (AQ-SQ)= sh 12 ( 48,800-48,000)=sh 9,600A

b Labour cost variances Rate variance= AH (AR-SR)= 36,800 ( sh 9.78-10)= sh 360,000-368,000)=sh 8,000F Efficiency variance= SR( AH-SH )= sh 10( 36,800-36,000)=sh 8,000A. C Total variable overhead variance= Actual variable overheads charged-( VOAR× Actual output) = sh 202,000-18×12,000= sh 202,000-216,000= sh 14,000 F

d) Causes of material and labour cost variances (refer text) Causes of variable overhead variances:

Savings in costs incurred

More economical use of services

Efficiency in labour force work

Overtime

Machine breakdowns, strikes, labour shortages

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3The production manager of Viwandani Ltd has given a weekly budget the machining section as follows: Day work ( 40 hours) Four skilled operatives 160 Ten semi-skilled operatives 400 560 Production: Product X 330 units at 1 hour each Product Y 460 units at ½ hour each Wage rates are sh 50 and sh 36 for skilled and semi-skilled workers respectively. The actual results for a week were as follows: Five skilled and nine semi-skilled workers were paid shs 23,600 for a 40-hour week. .Production was 300 of product X and 440 of product Y. There was a power blackout for 2 hours which disrupted production. Required : Calculate the direct labour variances for the week. Solution Labour rate variance=Actual cost-Actual hrs× standard rate= sh23,600-560×40=23600-22400= sh 1,200A. Labour efficiency variance= Standard rate( Actual hrs worked-standard hours)=Sh 40( 560-520)=sh 1,600 A. Budgeted wages= 160×shs 50 + 400×sh 36= sh 22,400. Budgeted standard hours= 330 × 1hr + 460×½ hr= 560 hours. Standard rate= sh 22,400÷560 hrs= sh 40 per hr. Standard hours=300×1 hr + 440×½ hr= 520 hours. Idle time variance= idle time × standard rate= 14 ×2hrs× sh 40= sh 1,120. 4 A manufacturing company engages 200 artisans at the rate of sh 60 per hour in its production department. A 42-hour working week is in operation an there are 4 weeks in January .The standard performance is set at 60 units per hour. During February, 182 artisans were paid at a standard rate of sh 60 per hour, but 10 artisans were paid sh 62.50 per hour, while 8 artisans were paid at sh 57.50 per hour. The factory production was disrupted for2 hours due to a power failure. Actual output was 10,100 units in the month. Required: Labour cost variances. Solution Direct wages rate variance= AH (AR-SR)= 1,680( 62.5-60) + 1344(57.5-60)= sh 4,200 A + 3,360F=sh 840A Direct wages efficiency variance =SR (AH-SH)= sh 60 ( 33,200-33,667 )= sh 28,000 F. Idle time variance= idle time × standard rate=200×2 hours× sh 60 –sh 24,000A. Actual hours worked= 200 artisans × 166(168-2) hours = 33,200 hours. Rate variance occurs when actual rate differs from standard ie 10 artisans ×42 hrs×4 weeks=1680 hours and 8 employees ×42 hours× 4 weeks=1,344 hours. Actual quantity=10,100 units. Standard hours= Number of men× Quantity produced= Standard quantity per hour = (200×10,100)/60= 33,667 hours. Actual hours worked per artisan= 42 hours × 4 weeks= 168 hours less 2hours stoppage=166 hours 5 The standard cost for a unit of product of an item is given as follows: Material: 1 kg @ sh 4 per kg Labour: 1 hour @ sh 8 per hour Variable overheads: sh 48,000 for budget period. Fixed overheads: sh 24,000 for budget period.

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Output: 24,000 units. Actual results: Actual production: 2,000 units Materials:3,000 kg @ sh 3.50 per kg Labour : 2,400 hours @ sh 8.50 per hour Variable overheads: sh 5,000 Fixed overheads: sh 4,000. Time worked : 2,300 hours. Required: aPrepare a standard cost card for 2,000 units. bCalculate I material cost variances ii Labour cost variances iii Total variable cost variance iv Total fixed cost variance solution a Standard cost card (based on 2,000 units): sh Material : 1kg @ shs 4 sh 4@2000 units 8,000 Labour :1hr @ sh8 sh 8@2,000 units 16,000 Variable overheads (sh 48,000/24,000 ) sh 2 @2,000 units 4,000 Fixed overheads ( sh 24,000/24,000) sh 1 @2,000 units 2,000 Standard cost sh 15 @ 2,000 units 30,000 b Material cost variances: Price variance= AQ (AP-SP) =3000 (sh3.5-4.0) =sh 3,000 F Usage variance = SP (AQ-SQ) = sh 4 (3,000-2,000)= sh 4,000 A Material cost variance= sh 3,000 F+4,000 A = sh 1,000 A c Labour cost variances: Rate variance= AH ( AR- SR)= 2,400 ( sh 8.5-8.0)= sh 1,200A Efficiency variance = SR (AHW-SH)=sh 8.50 ( 2,300-2,000)=sh 2,550 A Idle time variance= SR (AH-AHW)= sh 8.50 ( 2,400-2,300)= sh 850 A Total Labour cost variance= sh 1,200A + 2,550 A +850 A= sh 4,600 A. AHW= Actual hours worked. AH=Actual hours paid. d Total variable overhead variance= Actual variable ohds- VOAR@ Actual output = sh 5,000- sh2 @ 2000=sh5,000-4,000 =sh 1,000 A e Total fixed overhead variance= Actual fixed ohds- FOAR @Actual output = sh 4,000- sh 1 @ 2000 = sh 4,000-2,000= sh 2,000 A

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Reference books

1T.Lucey,(1995) costing, 4e, DP Publications Ltd, ISBN 1 858050 52 9 2 Ray H.Garrison(1985) , Managerial Accounting: Concepts for planning, Control, Decision Making,4e,Business Publications Inc ISBN 0-256-03261-0 3 J.Wald (1984), Bigg’s cost Accounts, 11e, Pitman Publishing Ltd 4L.W.J Owler and J.L Brown, Wheldon’s cost accounting and costing methods 5Harrold Bierman Jr, Thomas R. Dyckman, Managerial cost Accounting 6Edward J blocher,Kung H.Chen, Gary Cokins, Thomas w.Lin (2005) Cost management: A strategic emphasis 3rd Edition, Mc Graw-Hill 7Ray H. Garrison, Eric W. Noreen, G Richard Chesley, Raymond F Carrol , Managerial accounting: Concepts for Planning, control and Decision making,Times Tower Professional Publishing , Irwin. 8Collin Drury (1990) management and cost accounting, 2rd Edition, Chapman and Hall 9S.N Chakrabarti (2004) Advanced cost and management Accountancy: Analysis and control,New Central Book Agency (P) Ltd, India. 10S.K Chakravarty Cost and Management Accounting 11 J.Reeve, C.Warren,J.Duchac (2012), Principles of Accounting, 24th Edition,South-western,Cengage Learning, ISBN: 13: 978-0-538-47894-6