Management Accounting. Paper F2 Integrated Course Notes ACF2CN07(D)

Transcription

1 Management Accounting Paper F2 Integrated Course Notes ACF2CN07(D)

2

3 F2 Management Accounting (Computer Based Exam) Study Programme Page Introduction to the paper and the course... (ii) 1 Information for management Cost classification Cost behaviour Expected values and correlation and regression End of Day 1 refer to Course Companion for Home Study 5 Spreadsheets Materials costs Labour costs Overheads and absorption costing End of Day 2 refer to Course Companion for Home Study 9 Absorption costing and marginal costing Process costing Process costing, joint products and by-products End of Day 3 refer to Course Companion for Home Study 12 Job and service costing Budgeting Standard costing End of Day 4 refer to Course Companion for Home Study 15 Basic variances Further variances CVP analysis End of Day 5 refer to Course Companion for Home Study 18 Relevant costs Linear programming End of Day 6 refer to Course Companion for Home Study 20 Answers to Lecture Examples Appendix A: Pilot Paper questions Appendix B: Formulae given in the exam Don t forget to plan your revision phase! Revision of syllabus Testing of knowledge Question practice Exam technique practice BPP provides revision courses, question days, mock days and specific material to assist you in this important phase of your studies. (i)

4 INTRODUCTION Introduction to Paper F2 Management Accounting Overall aim of the syllabus The overall aim of the paper is to develop knowledge and understanding of the application of management accounting techniques to support the management process of planning, control and decision making. The syllabus The broad syllabus headings are: A B C D E F The nature and purpose of cost and management accounting Cost classification, behaviour and purpose Business mathematics and computer spreadsheets Cost accounting techniques Budgeting and standard costing Short-term decision making techniques Main capabilities On successful completion of this paper, candidates should be able to: Explain the nature and purpose of Cost and Management Accounting Describe costs by classification, behaviour and purpose Apply essential business mathematics and use computer spreadsheets Explain and co-ordinate budgets and standard costing for planning feedback and control Use Management Accounting techniques to make and support decision-making Links with other papers APM (P5) Advanced Performance Management PM (F5) Performance Management FM (F9) Financial Management AB (F1) Accountants in Business MA (F2) Management Accounting This diagram shows where direct (solid line arrows) and indirect (dashed line arrows) links exist between this paper and other papers that may follow it. The Management Accounting syllabus assumes knowledge acquired in paper F1 Accountants in Business, and develops and applies this further and in greater depth. Paper F5 Performance Management assumes knowledge acquired at this level. (ii)

5 INTRODUCTION Assessment methods and format of the exam Examiner: David Forster Students have the option to take either a paper-based or a computer-based exam. Both exams contain 100% compulsory questions worth either 1 or 2 marks, making up a total of 90 marks to be completed in two hours as follows: 40 two-mark questions 10 one-mark questions Questions will assess all parts of the syllabus and will include both computational and non-computational elements. (iii)

6 INTRODUCTION Course Aims Achieving ACCA's Study Guide Outcomes A The nature and purpose of cost and management accounting A1 Accounting for management Chapter 1 A2 Cost and management accounting versus financial accounting Chapter 1 B Cost classification, behaviour and purpose B1 Production and non-production costs Chapter 2 B2 Direct and indirect costs Chapter 2 B3 Fixed and variable costs Chapter 3 C Business mathematics and computer spreadsheets C1 Dealing with uncertainty Chapter 4 C2 Statistics for business Chapter 4 C3 Use of computer spreadsheets Chapter 5 D Cost accounting techniques D1 Accounting for materials Chapter 6 D2 Accounting for labour Chapter 7 D3 Accounting for overheads Chapter 8 D4 Marginal and absorption costing Chapter 9 D5 Job and batch costing Chapter 12 D6 Process costing Chapters 10, 11 D7 Service/operation costing Chapter 12 E Budgeting and standard costing E1 Nature and purpose of budgeting Chapter 13 E2 Functional budgets Chapter 13 E3 Flexible budgets and standard costing Chapters 13, 14 E4 Basic variance analysis under absorption and marginal costing Chapter 15 E5 Reconciliation of budgeted profit to actual profit Chapter 16 (iv)

7 INTRODUCTION F Short-term decision making techniques F1 Cost-volume-profit analysis Chapter 17 F2 Relevant costing Chapter 18 F3 Limiting factors Chapter 19 (v)

8 INTRODUCTION Classroom tuition and Home study Your studies for BPP consist of two elements, classroom tuition and home study. Classroom tuition In class we aim to cover the key areas of the syllabus. To ensure examination success you will need to spend private study time reinforcing your classroom course with question practice and reviewing areas of the Course Notes and Study Text. Home study To support you with your private study BPP provides you with a Course Companion which helps you to work at home and aims to ensure your private study time is effectively used. The Course Companion includes a Home Study section which breaks down your home study by days, one to be covered at the end of each day of the course. You will find clear guidance as to the time to spend on various activities and their importance. You are also provided with progress tests and two course exams which should be submitted for marking as they become due. These may include questions on topics covered in class and home study. BPP Learn Online Come and visit the BPP Learn Online free at for exam tips, FAQs and syllabus health check. ACCA Forum We have thriving ACCA bulletin boards at Register and discuss your studies with tutors and students. Helpline If you have any queries during your private study simply contact your class tutor on the telephone number or address that they will supply. Alternatively, call +44 (0) (or your local training centre if outside the London area) and ask for a tutor for this paper to speak to you or to call you back within 24 hours. Feedback The success of BPP s courses has been built on what you, the students tell us. At the end of the course for each subject, you will be given a feedback form to complete and return. If you have any issues or ideas before you are given the form to complete, please raise them with the course tutor or relevant head of centre. If this is not possible, please ACCAcoursesfeedback@bpp.com. (vi)

9 INTRODUCTION Key to icons Question practice from the Study Text This is a question we recommend you attempt for home study. Real world examples These can be found in the Course Companion. Section reference in the Study Text Further reading is needed on this area to consolidate your knowledge. Formula to learn Formula given in exam (vii)

10 INTRODUCTION (viii)

11 Information for management Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: Distinguish between data and information. Identify and explain the attributes of good information. Outline the managerial processes of planning, decision making and control. Explain the difference between strategic, tactical and operational planning. Describe the purpose and role of cost and management accounting within an organisation's management information system. Compare and contrast financial accounting with cost and management accounting. Exam Context The contents of this chapter are mainly to serve as an introduction to the ACCA's Management Accounting paper. Although this chapter is an introductory chapter it is still highly examinable. You should expect questions on every chapter including this one. Qualification Context Chapter 1 provides an introduction to the management accounting environment and provides a context for the rest of this syllabus. This is examined again at paper F9 (Financial Management) where the relationship between financial management and management accounts is discussed. 1.1

12 1: INFORMATION FOR MANAGEMENT Overview Information for management Role of management accounting function Data and information Information for planning Information for control Qualities Comparison with financial accounting Information for decision making 1.2

13 1: INFORMATION FOR MANAGEMENT 1 Management accounting Purpose 1.1 The purpose of management accounting is to assist management in running their business to achieve an overall objective. 1.2 What could a business have as its objective? 1.3 The assumption that will usually be made in your studies is that companies wish to maximise the wealth of their shareholders. Usually this will be achieved by maximising profit. 2 Data and information 2.1 Data is the raw material for data processing. 2.2 Information is data that has been processed in some way to make it meaningful to the person who receives it. Lecture example 1 Preparation question What are the general qualities of good information? Solution 3 Planning, control and decision making 3.1 Information for management accounting is likely to be used for planning, control and decision making. 3.2 Planning establishing objectives selecting appropriate strategies to achieve those objectives 1.3

14 1: INFORMATION FOR MANAGEMENT Lecture example 2 Preparation question The objectives of a firm may be: Profit making firm Non profit making firm 3.3 Long-term strategic planning (corporate plan) involves determining an organisation's longterm goals and then selecting appropriate strategies to attain those objectives. 3.4 Shorter term planning involves developing tactical and operational plans in order to achieve the goals of the corporate plan. 3.5 Control There are two key mechanisms within the control process. (1) Actual performance is compared with planned performance of the organisation as set out in the detailed operational plan and adjusted in response. (2) The corporate plan is reviewed to reflect significant new information. 3.6 Decision Making Managers at all levels within an organisation make decisions. It is the role of management accountants to provide information so that management at whatever level can reach an informed decision. 4 Role of management accountant Main areas Management accounting can be broken down into five main areas. 4.1 Costing What is the cost of goods or services? We need to know this to calculate the profit that a unit will generate, to help set prices and to value inventory in the balance sheet. 1.4

15 1: INFORMATION FOR MANAGEMENT 4.2 Decision-making There are many decisions managers may have to make such as: What should we produce? How should we finance the business? Is a project worthwhile? 4.3 Planning Define objectives; assessing future costs and revenues to set up a budget. Planning is essential in assessing the purchasing/production requirements of the business. 4.4 Control Once plans have been made, they must be reviewed to ensure the company is following them and any identified inefficiencies must be addressed. 4.5 Performance evaluation The performance of divisions and employees can be assessed by comparing their performance against budgets or divisional or individual targets. Lecture example 3 Preparation question What information may the managers of a business need? Solution External Information Internal Information 1.5

16 1: INFORMATION FOR MANAGEMENT 5 Management accounting and financial accounting Lecture example 4 Preparation question Complete the following table to compare financial and management accounting: Legal requirement Users Level of precision Rules Reporting Scope Frequency Format Financial accounting Management accounting 5.1 Thus it is useful to think of the two as Financial Accounting: recording and reporting historical data Management Accounting: deciding where the company wants to go and ensuring it gets there 5.2 It is important to remember that as management accounting is forward looking, it relies heavily on guesses and approximations, to deal with future uncertainties. We therefore have to use reasonable approximations in all our calculations. 6 Chapter summary Data is raw material for data processing. 6.2 Information is data that has been processed in such a way as to be meaningful to the person who receives it. 6.3 Good information should be relevant, complete, accurate, clear, timely, appropriately communicated and the cost of it should be less than the benefit. 6.4 Information is used in a business for planning, control and decision making. 6.5 Financial accounting systems ensure that the assets and liabilities of a business are properly accounted for. Management accounting systems provide information specifically for managers. 1.6

17 Chapter 1: Questions 1.7

18 1: QUESTIONS 1.1 Information is data that has been manipulated into a report for a specific purpose. True False (1 mark) 1.2 Management accountants may provide information for management on which of the following: (i) Cost of goods and services (ii) Actual costs compared to expected costs (iii) Expected profits and production plans A (i) only B (i) and (iii) only C All of the above (1 marks) 1.3 Management accounts must be reported monthly. True False (2 marks) 1.4 (1) Management accounting will report information on the past period in order to compare it to the original budget. (2) Financial accounting will plan for the future periods. A One true one false B Both true C Both false (1 mark) 1.8

19 Chapter 1: Answers 1.9

20 1: ANSWERS 1.1 True 1.2 C 1.3 False 1.4 A END OF CHAPTER 1.10

21 Cost classification Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: Distinguish between cost, profit, investment and revenue centres. Describe the differing needs for information of cost, profit, investment and revenue centre managers. Explain and illustrate production and non-production costs. Describe the different elements of production cost materials, labour and overheads. Describe the different elements of non-production cost administrative, selling, distribution and finance. Explain the importance of the distinction between production and non-production costs when valuing output and inventories. Distinguish between direct and indirect costs in manufacturing and non-manufacturing organisations. Identify examples of direct and indirect costs in manufacturing and non-manufacturing organisations. Explain and illustrate the concepts of cost objects, cost units and cost centres. Exam Context Cost classification is one of the key areas of the syllabus and as well as providing you with key terminology for many of the following chapters, is also very examinable. Qualification Context This chapter includes terminology that will be used throughout the Fundamentals level of the ACCA qualification and on to the Professional level of your studies. Business Context Grouping costs together is essential for a business to be able to analyse costs, budget and plan effectively. 2.1

22 2: COST CLASSIFICATION Overview Cost classification Cost object Cost unit Cost centre Classification by function Production costs Non production costs Materials Materials Labour Further classification by nature Labour Overheads Overheads Direct cost Indirect cost 2.2

23 2: COST CLASSIFICATION 1 Introduction to cost classification 1.1 Cost classification is the arrangement of cost items into logical groups for example by their function (administration, production etc) or by their nature (materials, wages etc). The eventual aim of costing is to determine the cost of producing a product/service. 2 Production and non production costs Classification by function 2.1 A company may first arrange cost items into groups by function. At the highest level there could be groups of production costs and groups of non production costs. Pool of total costs Lecture example 1 Production costs Costs associated with the production of goods and services, from the supply of raw materials to the warehousing of finished goods Non production costs All other costs incurred in the business Preparation question Give some examples of production and non production costs. Solution Production costs Non production costs 2.3

24 2: COST CLASSIFICATION 2.2 Production costs can then the broken down further by their nature. Production costs Materials Labour Overheads Cost of materials that Cost of the workforce Cost of any are used in making the used in making overheads required to product or service the product support the production process 2.3 Non production costs can also be broken down further by their nature to aid analysis. Non production costs Administration Selling Distribution Finance All other costs All costs incurred All costs incurred All costs incurred incurred in in promoting and in making the to finance the managing the retaining packed product business organisation customers ready for despatch and delivery to the customer Lecture example 2 Preparation question Give examples of non-production costs under each of the four headings above. Solution Administration Selling Distribution Finance 2.4

25 2: COST CLASSIFICATION Distinction between production and non production costs. 2.4 Remember the eventual aim of costing is to determine the cost of producing a product or service. This information is important to management for many reasons, the three most important being: (1) Profitability analysis (2) Selling price determination (3) Inventory valuation purposes. For the purpose of the syllabus we will focus on the group of production costs identified in the previous section. 3 Direct and indirect costs 3.1 Production costs can be split into direct costs and indirect costs of production. Definition 3.2 A direct cost is a cost that can be traced in full to the product, service or department that is being costed. Total direct costs = Prime costs. Definition 3.3 Indirect production costs are those costs which are incurred in the course of making a product/service but which cannot be identified with a particular cost unit. Indirect production costs are often referred to as production overheads. Lecture example 3 Preparation question Identify and group the costs involved in the production of a CD. Solution Total production costs 2.5

26 2: COST CLASSIFICATION Lecture example 4 Preparation question Identify any direct or indirect non manufacturing costs associated with the production and sale of a CD. Solution Direct Indirect 3.4 In summary the cost of producing a CD could be broken down as follows: Production costs Direct production costs Prime cost Indirect production costs (production overheads) Non production cost Administration cost Selling and distribution cost Total product cost Cost Card X X X X X X X Materials Labour Expense Materials Labour Expense 4 Cost objects, cost units and cost centres 4.1 A cost object is anything for which cost data is desired eg. products, product lines, jobs, customers or departments and divisions of a company. 4.2 A cost unit is a unit of product or service in relation to which costs may be ascertained. The cost unit should be appropriate to the type of business. For example: 2.6

27 2: COST CLASSIFICATION Business Car manufacturer Ball bearing manufacturer Builder Management consultant Appropriate cost unit Car Batch of ball bearings Job / Contract Project 4.3 A cost centre is a location, function or item of equipment in respect of which costs may be ascertained and related to cost units for control purposes. Each cost centre acts as a 'collecting place' for certain costs before they are analysed further. Note: (a) Cost centres may be set up in any way the business thinks appropriate. (b) Usually, only manufacturing costs are considered and hence we will focus on factory cost centres. We need to distinguish between factory cost centres that are: (a) production cost centres, through which cost units actually flow; (b) service cost centres, which support/service the production cost centres. Lecture example 5 Preparation question Suggest three examples of production cost centres and service cost centres within a clothes manufacturing factory. Solution 4.4 Profit centres are similar to cost centres but are accountable for costs and revenues. 4.5 Revenue centres are similar to cost centres and profit centres but are accountable for revenues only. 4.6 An investment centre is a profit centre with additional responsibilities for capital investment. 2.7

28 2: COST CLASSIFICATION 5 Chapter summary A management accountant will be interested in calculating the cost of one unit of production. 5.2 Costs can be split by their function into production and non production costs. 5.3 Production costs can be split further by their nature into material, labour and overhead costs. 5.4 Direct costs are costs that can be directly traced to a unit. 5.5 Indirect costs are costs incurred in production but cannot be directly linked to a unit. 5.6 A cost card can be built up for an individual cost unit. 2.8

29 Chapter 2: Questions 2.9

30 2: QUESTIONS 2.1 Which of the following is a definition of a cost centre? A Functions or locations for which costs are ascertained and related to cost units for control purposes B Amounts of expenditure attributable to various activities C A section of an organisation for which budgets are prepared and control exercised (1 mark) 2.2 Which of the following are indirect expenses? (i) The depreciation of a machine on an assembly line (ii) The hire cost of maintenance tools or equipment for a factory (iii) The salary of a supervisor for the assembly line (iv) Primary packing materials (eg. cartons and boxes) A (i) only B (i) and (ii) C (i), (ii) and (iii) D (i), (ii), (iii) and (iv) (2 marks) 2.3 Which of the following items might be a suitable cost unit within the sales department of a manufacturing company? Item: 1. Sales commission; Item 2. Order obtained Item 3. Unit of product sold. A Items 2 and 3 B Item 1 only C Item 2 only D Item 3 only (2 marks) 2.4 A cost centre is A a unit of product or service in relation to which costs are ascertained B an amount of expenditure attributable to an activity C a production or service location, function, activity or item of equipment for which costs are accumulated (1 mark) 2.5 Which of the following items would not be suitable as a cost centre within the management accounting system of a university? A A student B A department C A college building (1 mark) 2.6 Is a canteen a production or service cost centre? A Production B Service (1 mark) 2.10

31 Chapter 2: Answers 2.11

32 2: ANSWERS 2.1 A This is a definition of a cost centre. 2.2 B These are both indirect expenses, because these costs can not be traced directly to the products made using them. (iii) Would be an indirect labour cost. 2.3 A Either calculating the cost of each order obtained or the cost of per unit of each product sold would be suitable cost units within the sales department, whereas sales commission is an item of expenditure. 2.4 C Definition of a cost centre. 2.5 A A student may be an appropriate cost unit, but not a cost centre. 2.6 B A canteen is a service cost centre as the units do not physically have to flow through it before being sold. END OF CHAPTER 2.12

33 Cost behaviour Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: Describe and illustrate graphically different types of cost behaviour. Explain and provide examples of costs that fall into the categories of fixed, stepped fixed and variable costs. Explain the structure of linear functions and equations. Use high/low analysis to separate the fixed and variable elements of total costs including situations involving stepped fixed costs and changes in the variable cost per unit. Exam Context As per Chapter 2 (Cost Classification) cost behaviour is a key area of the Management Accounting syllabus and you should expect it to be examined independently and as part of later chapters. Qualification Context Again this chapter provides terminology that will be used throughout the foundation level and on to the professional level of your studies. Specifically the high/low method as described here and which re appears in Chapter 13 of this paper will be used again within the budgeting chapter of paper F5 Performance Management to prepare flexible and flexed budgets. 3.1

34 3: COST BEHAVIOUR Overview Cost behaviour Variable cost (VC) Fixed cost (FC) Stepped fixed cost Mixed cost Cost estimation High/low method 3.2

35 3: COST BEHAVIOUR 1 Cost behaviour and output 1.1 A business needs to know how costs behave as production volumes either increase or decrease so that predictions of costs can be made. 1.2 It is expected that costs will increase as production increases but, the exact way costs behave as output changes will depend on the nature of the cost. 1.3 There is another different way of analysing and classifying costs to that discussed in chapter 2; that is by classifying them according to how they behave as output changes. Lecture example 1 Preparation question Types of cost behaviour (a) Fixed cost (FC) A fixed cost is a cost which tends to be unaffected by increases or decreases in the volume of output. It would be represented graphically as follows: Total cost $ Examples include: Output (units) (b) Stepped fixed cost A stepped fixed cost is a cost which is fixed in nature but only within certain levels of activity. It would be represented graphically as follows: Total cost $ Output (units) Examples include: 3.3

36 3: COST BEHAVIOUR (c) Variable cost (VC) A variable cost is a cost which tends to vary directly with the volume of output. The variable cost per unit is the same amount for each unit produced. It would be represented graphically as follows: Total cost $ Examples include: Output (units) (d) Mixed cost (semi-variable cost) A mixed cost is a cost which contains both fixed and variable components and so is partly affected by a change in the level of activity. It would be represented graphically as follows: Total cost $ Examples include: Output (units) 1.4 The total costs of a business are likely to have a variable cost and a fixed cost element. y Total cost TC VC FC TC FC x Output 3.4

37 3: COST BEHAVIOUR Equation of a line 1.5 If there is a linear relationship between output and total cost then the relationship can be within this form: y = a + bx Where y is the dependent variable (eg. total cost) x is the independent variable (eg. output a is the intercept on the y axis (eg. fixed cost) b is the gradient on the line (eg. variable costs per unit). Therefore TC = FC + VC/unit x output 2 Cost estimation 2.1 To help with analysis and planning for the future it is necessary to determine the fixed and variable elements of the total costs. A method known as 'high/low' can be used to estimate the fixed and variable elements of a given cost. The high/low method is a four-step method. Lecture example 2 Preparation question The total costs of a business for differing levels of output are as follows: Output Total costs (units) ($ 000) , Required (a) What are the fixed and variable elements of the total cost using the High/Low method? A Y = $30,000 + $100x C Y = $30,000 + $110x B Y = $10,000 + $110x D Y = $10,000 + $100x Workings Step 1 Review the cost records from previous periods. Select highest and lowest activity level and associated cost. 3.5

38 3: COST BEHAVIOUR Step 2 Find the change in cost resulting from the change in output. Step 3 Calculate the VC/unit. Step 4 Substitute back into formula of line. 2.2 TC y x x 500 1,000 x 2.3 What we have done Plotted a line between the highest and lowest points. Calculated formula of that line We can now use that formula for planning. 3.6

39 3: COST BEHAVIOUR Lecture example 3 Preparation question Using the information calculated in Lecture example 1: If production next year is expected to be 780 units what would the total cost be? $ Workings Assumptions about cost behaviour 2.4 The assumptions that have been made include the following: Within the normal range of output costs are assumed to be either fixed, variable or semi variable. Variable costs per unit are constant. Lecture example 4 Preparation question The following data has been collected from a business: Units produced 5,000 7,500 10,000 Total costs 54,500 76,500 90,000 Total costs are made up of two elements, a stepped fixed cost that changes when the units exceed 7,000 and some variable costs, which remain constant. Required What are the total fixed cost at production levels below and above 7,000 units? $ below 7,000 units and $ above 7,000 units. What is the variable cost per unit? $ 3.7

40 3: COST BEHAVIOUR Workings 2.5 The same methodology could be applied if fixed costs were constant and variable costs changed above a certain level of output. 3 Chapter summary Cost behaviour is the way in which costs are affected by changes in volume of output. A fixed cost will be unaffected by an increase or decrease in volume of output. A step cost is a cost which is fixed in nature within certain volumes of output. A variable cost is a cost that will vary with output. The variable cost per unit is the same amount for each unit produced. The fixed and variable element of a mixed cost can be determined by the high/low method. 4 Formula summary Total costs = Fixed costs + Variable cost/unit x Output High/low method: (1) Find higher and lowest output and cost (2) Find the difference (3) Calculate the VC/unit (4) Substitute to find the FC. 3.8

41 Chapter 3: Questions 3.9

42 3: QUESTIONS Chapter A company has the following information about its total production costs: Output Total costs $ 2,000 10,000 4,000 15,000 6,000 20,500 8,000 28,000 What are the company's fixed costs? A $2,000 B $4,000 C $10,000 D $18,000 (2 marks) 3.2 The following data relates to the overhead expenditure of a control cleaner at two activity levels: when 12,750m 2 is cleaned, the overheads incurred were $73,950 and when 15,100m 2 is cleaned, the overheads incurred were $83,585. What is the best estimate of the overheads if 16,200m 2 are to be cleaned? A $88,095 B $89,674 C $93,960 D $98,095 (2 marks) 3.3 A business has collected data about a cost, at four different levels of production: when production was 100 units, the cost totalled $1,000; when production was 150 units, the cost totalled $1,500; when production was 200 units, the cost totalled $1,500 and when production was 250 units, the cost totalled $2,000. Which of the following best describes the behaviour of this cost? A A step cost B A fixed cost C A variable cost D A semi-variable (or mixed cost) (1 mark) 3.4 A business has collected data relating to a particular costs incurred at four different activity levels: when the output was 5 units the cost totalled $20; when the output was 10 units the cost totalled $35; when the output was 50 units the cost totalled $155 and when the output was 75 units the cost totalled $230. Which of the following best describes the behaviour of this cost? A A semi-variable cost B A fixed cost C A production cost D A variable cost (1 mark) 3.10

43 3: QUESTIONS 3.5 The relationship between quantity demanded and the price of a product is known to be linear and in the form: P = X + YQ (Q is stated in thousand units) From previous experience, quantity sold is 34,000 when price is $28, and quantity sold is 28,000 at a selling price of $40 per unit. The values of X and Y are: A X = _ 16, Y = 2 B X = 96, Y = _ 2 (1 mark) 3.6 If an assembly line supervisor is paid a salary of $100 each week, and an extra 10p for every unit of production made in the week, this wage cost could be described as: A a semi-variable (mixed) cost B a fixed cost C a step cost (1 mark) 3.7 A company's weekly costs ($C) were plotted against production level (P) for the last eight weeks and a regression line calculated to be C = P. Which statement about the breakdown of weekly costs is true? A Fixed costs are $2000. Variable costs per units are $10 B Fixed costs are $500. Variable costs per unit are $8 C Fixed costs are $500. Variable costs per unit are $2000 D Fixed costs are $2000. Variable costs per unit are $500 (2 marks) 3.8 The following is a graph of cost against volume of output. Cost A B C D Volume of output Electricity bills made up of a standing charge and a variable charge Bonus payments to employees when production reaches a certain level Salesman s commissions payable per unit up to a maximum amount of commission Bulk discounts on purchases, when purchases reach a certain level. The discount being given on all units purchased. (2 marks) 3.9 A company makes one delivery per week to all its customers. The cost of these deliveries is: A a production overhead B a fixed selling and distribution cost C a variable selling and distribution cost (1 mark) 3.11

44 3: QUESTIONS 3.10 ABC Limited has recorded the following data in the two most recent periods: during period 1, costs totalling $13,500 were incurred in making 700 units and during period 2, costs totalling $18,300 were incurred in making 1,100 units. The best estimate of ABC Limited's fixed costs per period is: A $5,100 B $4,800 C $13,500 D $15,900 (2 marks) 3.12

45 Chapter 3: Answers 3.13

46 3: ANSWERS 3.1 B High/low method Output $ High 8,000 28,000 Low 2,000 10,000 6,000 18,000 18,000 Variable cost per unit = = $3 per unit 6,000 TC = FC + VC/unit x output Substitute at the highest (or lowest) output. 28,000 = FC + $3 x 8,000 28,000 24,000 = FC $4,000 = FC 3.2 A You should have calculated this solution using the High/low method to calculate the fixed costs ($21,675) and variable cost per m 2 ($4.10/m 2 ) then have used these to calculate the total overhead cost of cleaning 16,200m A This is a step cost, because the cost remains fixed within a certain range of activity, and then 'steps up' to a higher cost when the activity level increases beyond this range. 3.4 A A semi-variable cost is a cost which contains both a fixed and a variable element. It can be shown that this is a semi-variable cost either by calculating the equation of the line using the High-low method using simultaneous equation or by plotting a scattergraph of the cost against output. 3.5 B 28 = x + 34y 40 = x + 28y 12 = 6y y = 2 x = 28 (34 x 2) = 96 This can also be calculated using the high/low method. 3.6 A As the salary contains both a fixed elements (the basic wage) and a variable element (the 10p paid per unit) the wage expense is a semi-variable (or mixed) cost. 3.7 D 3.8 D A Standard charge (fixed cost) would be reflected by intercept a y-axis at a point above zero B Costs would increase more steeply rather than flatten off C Costs would rise with output up to the maximum and then become flat D Costs increase evenly with price until the discount point. The reduced price then relates to all purchases so total costs fall. Since the price (given by the gradient) is reduced the gradient is flatter. 3.9 B The deliveries will only occur when a sale has been made, it is therefore a selling and distribution cost Presuming the number of customers remains fairly constant the costs will be constant over the year and will accrue over time therefore the cost is fixed A You should have calculated this using the High/low method (or simultaneous equations). END OF CHAPTER 3.14

47 Correlation and regression; expected values Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: Calculate a correlation coefficient and coefficient of determination. Explain the concepts of a correlation coefficient and interpret the coefficients calculated. Establish a linear function using regression analysis and interpret the results. Explain and calculate an expected value. Demonstrate the use of expected values in simple decision making situations. Explain the limitations of the expected value technique. Exam Context This important topic forms part of the cost behaviour section of the syllabus and it is vital that you are able to establish linear equations using regression analysis. Expected values are a basic mathematical technique used by business in situations of uncertainty and can easily be tested early in short questions. Qualification Context These are basic mathematical tools that will be used later in the Fundamentals stage of your studies, specifically in paper F5 (Performance Management) where you will deal with risk and uncertainty within decision-making and apply expected values and sensitivity to problems. Business Context A business may use mathematical techniques to help them predict revenues or costs for future periods. 4.1

48 4: CORRELATION AND REGRESSION; EXPECTED VALUES Overview Correlation and regression; expected values Cost prediction Expected values (EV) High low method Scattergraphs Decision making Limitations Linear regression Limitations Correlation coefficient Correlation of determination Limitations 4.2

49 4: CORRELATION AND REGRESSION; EXPECTED VALUES 1 Introduction Cost prediction 1.1 In order for a business to be able to plan and make decisions, it needs to be able to accurately predict costs at differing output levels. If we can identify the relationship between the output level and the cost at that level from observation then it is possible to construct a model to predict costs at all future output levels. 1.2 If this relationship exists there is said to be a correlation between output levels and total costs. Other examples of variables that may be correlated are: a person's height and weight the distance of a journey and the time it takes to make it. 2 Scattergraph Graphical presentation 2.1 Plotting a scattergraph is the best way of ascertaining a correlation between two variables, (nowadays computer packages make this easy even for large amounts of data). For example total costs at different levels of output could be plotted as: Total costs Output 2.2 Output in this case would be the 'dependent variable' and is plotted on the x axis. Total cost is the 'independent variable' and is plotted on the y axis. 2.3 The scattergraph seems to show a linear relationship, ie. a correlation between the two variables. We can estimate the line of best fit for this data, and use this information to help predict the total cost at future levels of output. 2.4 Two main techniques for estimating this information are (a) High-low as seen in Chapter 3. This method forms a linear relationships between the highest and lowest point plotted. (b) Linear regression. This method finds the line of best fit mathematically. 4.3

50 4: CORRELATION AND REGRESSION; EXPECTED VALUES Example 2.5 Observed costs at different production levels were as follows: Output Total Costs (units) $ , , , , ,500 These costs could be plotted on a scattergraph as follows: Costs $ 50,000 X 40,000 30,000 X X X X Output (units) The costs appear to follow an approximately linear pattern. Lecture example 1 Preparation question Racap high/low method Using the figures from the example in Paragraph 2.5 calculate the fixed cost and variable cost per unit. Fixed costs are $ Variable costs are $ per unit. 4.4

51 4: CORRELATION AND REGRESSION; EXPECTED VALUES Workings 2.6 Limitations of the high low method Only considers two values from a range of data. It ignores possible valuable data. These values are extreme and most likely to be affected by discounts etc. So may not represent costs under a normal operating range. 3 Linear regression Introduction 3.1 y X X X X X Y = a + bx a X X b X 4.5

52 4: CORRELATION AND REGRESSION; EXPECTED VALUES 3.2 The formula for a basic linear relationship as seen in Chapter 3 is: y = a + bx where y is the dependent variable (e.g. costs) x is the independent variable (e.g. output) a is the intercept on the vertical axis (y axis) (e.g. fixed costs) b is the slope (gradient) of the line (e.g. variable cost per unit). Using the information calculated from the high/low method the formula of our line would be: y = a + bx TC = $17,600 + $90 x output. 3.3 Linear regression finds mathematically the line of best fit, by minimising the squares of the vertical differences. 3.4 Formulae: b = n xy x y 2 n 2 x ( x) a = y bx = y b n n Note: This technique can be applied to any pairs of data not just cost and output. Lecture example 2 Preparation question Using the same data used in Lecture example 1. x y xy x 2 y 2 (units) ($ 000) ($ 000) ($ 000) Output Total costs Required (a) Calculate the regression line. (b) Use the line to estimate costs for output of 240 units and 700 units. 4.6

53 4: CORRELATION AND REGRESSION; EXPECTED VALUES Solution 4 Reliability of regression line 4.1 The formula applied will find a value for a and b and hence a formula for the line. The usefulness of this formula for predicting results in the future depends on how strong the correlation between the two variables is. 4.2 Correlation coefficient (r): indicates the strength of the linear relationship between x and y. 4.7

54 4: CORRELATION AND REGRESSION; EXPECTED VALUES Examples of correlation coefficients 4.3 No correlation r = 0 No correlation r = 0 Perfect negative Perfect positive correlation r = 1 correlation r = Formula r = 2 n x ( n xy )- ( x y) 2 ( x) n y ( y) where r = correlation coefficient. - 1 r Lecture example 3 Exam standard question worth 2 marks What is the correlation coefficient for the data in Lecture example 2? r = Workings 4.8

55 4: CORRELATION AND REGRESSION; EXPECTED VALUES 5 Coefficient of determination, r 2 : 5.1 r 2 indicates the proportion of change in y which would be explained by change in x. It does not prove cause and effect relationship. It merely suggests a possible link. The value must be between 0 and 1; Lecture example 4 Exam standard question worth 2 marks What is the coefficient of determination for the data in Lecture example 2? r 2 = Workings 6 Limitations of linear regression analysis Assumes linearity between x and y The observations used may be atypical Historic data is used and patterns may change in future Each observation should be independent from the others Forecasting usually involves extrapolation outside the given range of observations, where working conditions and therefore cost patterns may change. 7 Expected values 7.1 An expected value (EV) is a weighted average values, based on probabilities. 7.2 Formula Expected Value (EV) = Σnp Where Σ = sum of n = outcome/results p = probability of outcome occurring 4.9

56 4: CORRELATION AND REGRESSION; EXPECTED VALUES 7.3 Expected value can be used in situations where there are a number of possible outcomes from a single event and it is not known with certainty what will actually happen. Each outcome is assigned a probability. Lecture example 5 Exam standard question worth 2 marks A gambler has placed a bet on a horse. From past form, the probability distribution relating to its chances in the race is as follows: Place Winnings Probability 1st $100 5% 2nd $50 15% 3rd $25 10% No place Nil 70% Required What is the expected value of the gambler's winnings? Workings $ Decision making 7.4 The expected values for single events can offer a helpful guide for management decisions. A project with a positive EV should be accepted. A project with a negative EV should be rejected. 4.10

57 4: CORRELATION AND REGRESSION; EXPECTED VALUES Lecture example 6 Exam standard question worth 1 mark The following are two projects that could be carried out by a company. The company can only carry out one project. Project A Project B Probability Profit Probability Profit 0.3 $10, $5, $7, $12, $3, ($7,000) Required Which project should the company should choose to carry out? A Project A B Project B Workings 8 Limitations of expected values (a) (b) (c) EV is a long run average result therefore it is inappropriate for one-off decisions. It is heavily dependent on probability distribution. EV ignores risk where risk is the spread or variability of outcomes. 9 Chapter summary Two variables are correlated if a change in the value of one variable is accompanied by a change in the value of another variable. The degree of correlation is measured by the correlation coefficient r. The coefficient of determination, r 2, measures the proportion of the total variation in the value of one variable that can be explained by variations in the value of the other variable. The expected value is a weighted average value based on probabilities. Probability and expectation should be seen as an aid to decision making. 4.11

58 4: CORRELATION AND REGRESSION; EXPECTED VALUES 10 Formula summary Total cost = fixed costs + variable cost/unit x output y = a + bx b = nσσx ΣxΣy nσσ (ΣΣx 2 a = y - bx = Σy n b Σyx n r = [(nσx (nσnσx ( ΣxΣy) 2 2 ( Σx) (nσy) 2 ( Σy) 2 ] Expected value (EV) = Σ np n = outcome/results p = probability 4.12

59 Chapter 4: Questions 4.13

60 4: QUESTIONS Chapter A company s management accountant is analysing the reject rates achieved by 100 factory operatives working in identical conditions. Reject rates, Y%, are to be related to months of experience, X, by this regression equation: Y = X. (The correlation coefficient was r = 0.9.) Using the equation, the predicted reject rate for an operative with 12 months experience is closest to A 17% B 19% C 20% D 23% (2 marks) 4.2 In the general equation for a straight line y = a + bx the letter a represents A the gradient B the intercept on the x axis C the intercept on the y axis (1 mark) 4.3 An accountant obtained the costs associated with the manufacture of five batches of identical items. These were as follows Batch Batch size Total cost $800 $1,500 $2,500 $3,500 $4,400 Using linear regression, what is the gradient of the sample line depicting the relationship between batch size and total cost? (2 marks) 4.4 A company has weekly fixed costs of $5,000 and variable costs per unit of production of $10. The equation of the straight line relating production (P) to costs (C) is therefore A C = 5,000P + 10 B P = 5, C C C = 5, /P D C = 5, P (2 marks) 4.5 The value of the correlation coefficient between X and Y is 0.9. Which of the following is correct? A There is a weak relationship between X and Y B If the values of X and Y were plotted on a graph, the line relating them would have a slope of 0.9 C There is a very strong relationship between X and Y (1 mark) 4.6 If Σx = 440, Σy = 330, Σx 2 = 17,986, Σy 2 = 10,366, Σxy = 13,467 and n= 11, then the value of r, the coefficient of correlation, to two decimal places is: A 0.98 B 0.63 C 0.96 D 0.59 (2 marks) 4.14

61 4.15 4: QUESTIONS

62 Chapter 4: Answers 4.15

63 4: ANSWERS 4.1 A Y = X X = 12 Y = (12) = 17% 4.2 C y y = a + bx The gradient is b The intercept on the y axis is a a 0 x 4.3 In the table below, x is in 100 s of units and y is in $ 00 s. X y x 2 xy i.e. Σx = 15, Σy = 127, Σx 2 = 55, Σxy = 473, n = 5 The sample equation is y = a + bx, where b is the gradient (required in question). n xy x y 5 x x 127 b = = n x 2 ( x) (15) = 2, , = 460 = D 4.5 C The correlation coefficient of 0.9 is very close to 1 and so there is a very strong relationship between X and Y. 4.6 B r = = n xy x y (n x 2 ( x) 2 )(n y 2 ( y) 2 ) (11 13,467) ( ) ((11 17,986) (440) 2 ((11 10,366) (330 2 )) 2937 (4,246 5,126) = 0.63 END OF CHAPTER 4.16

64 Spreadsheets Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: Explain the role and feature of a spreadsheet system. Demonstrate a basic understanding of the use of spreadsheets. Identify applications for spreadsheets in cost and management accounting. Exam Context Spreadsheets may be used by the majority of students in practice and it is important to have a good working knowledge of spreadsheets for the exam. Make sure you have worked through the chapter and are aware of what is examinable. Qualification Context Paper F5 Performance Management again picks up on the benefits and dangers inherent in using spreadsheets in budgeting. Business Context Spreadsheets and computer packages are now an integral part of most businesses. They aid historic analysis, management of day to day activities and planning. 5.1

65 5: SPREADSHEETS Overview Spreadsheets What is a spreadsheet? Features and functions Formulae How are spreadsheets used in business? Other aspects Presentation of data - graphs Advantages Disadvantages 5.2

66 5: SPREADSHEETS Chapter 5 1 Introduction 1.1 The use of spreadsheets has been commonplace for over twenty years and is the basic tool of accountants to record and manipulate management information. This chapter is intended only as a summary, we recommend that you walk through Chapter 5 of the Study Text with the aid of a PC to ensure you are familiar with the basic functions of a spreadsheet. Definition 1.2 A spreadsheet is an electronic piece of paper divided into rows and columns. The intersection of a row and a column is known as a cell. Cells can be used to hold numerical data. Data can be processed by defining a relationship between cells, to derive output. 1.3 Some common applications of spreadsheets by management accountants are: (a) (b) (c) (d) (e) (f) Preparation of management accounts Cash flow analysis, budgeting and forecasting Account reconciliation Revenue and cost analysis Comparison and variance analysis Sorting, filtering, categorising large volumes of data. 2 Features and functions 2.1 Cell contents can include: (a) (b) (c) Text words, abbreviations, descriptions, references, key words, decision summary Values A number which can be used as part of a calculation Formulae A definition of a mathematical relationship between cells. For example, if we multiply the contents of two cells A1 and B1 the formula required is A1 * B The formula bar allows you to see and edit contents of the active cells. It also shows the cell address, which is the location of the current highlighted cell Formulae 2.3 Always remember in an exam to write the formula as you would actually see it in Excel. Do not forget the equals sign at the beginning. 5.3

67 5: SPREADSHEETS Lecture example 1 Preparation question Provide the required formulae for the following spreadsheet computations given the following: A B C 1 Sales Value 2 January February March Total 6 VAT 7 Gross Sales (a) In cell B5 calculate total sales value ( ). Formula (b) In cell B6 calculate the VAT payable at a rate of 17.5% on the sum calculated in B5. Formula (c) Calculate the gross sales value to invoice in Cell B7. Formula 2.4 When copying a formula we sometimes want one of the cell references to remain the same. By using $ (absolute cell referencing) we can do this. The following VAT calculation uses absolute cell referencing. A $ sign either side of the column letter anchors the formula to this cell. The formula can now be copied. A B C D 1 2 VAT Price (excl VAT) VAT Price (incl VAT) 5 12 = B5+C = B6+C = B7+C7 Lecture example 2 Exam standard question worth 2 marks What formula will be typed into C5 to calculate the VAT (using absolute cell referencing)? 5.4

68 5: SPREADSHEETS Rounding 2.5 Simple rounding uses the following formula: =ROUND(cell ref, decimal places required) e.g. =ROUND(c4:f6,2) This will round everything in cells C4 to F6 to 2 decimal places Formulae with conditions 2.6 Where statements are used in conditional formulae and follow the following structure: =IF (logical_test, value_if_true, value_if_false) For example: = IF (A5>500, HURRAY, MORE SALES PLEASE ) Note the following symbols which can be used in formulae with conditions < less than <= less than or equal to = equal to > greater than >= greater than or equal to <> not equal to Lecture example 3 Exam standard question worth 2 marks Given cell C4 contains the monthly sales revenue, devise the conditional formula to prompt the payment of a bonus. Bonuses are paid if monthly revenues are equal to or exceed $200, Presentation of data 3.1 The data in a spreadsheet could be used to generate a single linear graph as shown below. 5.5

69 5: SPREADSHEETS A B 1 2 Data for y=2x+10 3 X Values Y Values Single Linear Graph x values y=2x+10 The chart wizard provides a tool to simplify the process of chart construction. In chart wizard having selected the information you want to chart in the spreadsheet, you can choose the type of chart you want. 3.2 Both charts have been created using the line graph option. The data series have been clearly labelled and a suitable title added to the chart. A B C 1 Multiple equations 3 X Values y=10+2x y=x Multiple Linear Equations x values y=2x+10 y=x

70 5: SPREADSHEETS 3.3 Chart wizard can also create many kinds of bar or pie charts. 4 Other aspects of spreadsheets 4.1 Excel can work as a multi spreadsheet tool, linking spreadsheets together, these are sometimes referred as three dimensional spreadsheets. For example producing a profit forecast for two regions each could be done on a separate spreadsheet and the two could be consolidated together on a final page. 4.2 A macro is an automated process that may be written by recording key strokes and mouse clicks. They can be useful when a particular process needs to be carried out numerous times. Macros can be very complex, however, there some basic macros that are useful, often with a keyboard shortcut being allocated to the particular function. 5.7

71 5: SPREADSHEETS 5 Advantages and disadvantages of spreadsheets Advantages Excel is easy to learn Excel is easy to use Spreadsheets enable fast and easy calculation and manipulation of large volumes of data Enables the analysis, reporting and sharing of financial information in prescribed formats Enables What-If or sensitivity analysis to be performed very quickly Electronic data can be downloaded directly into a spreadsheet Disadvantages Garbage In = Garbage Out. Spreadsheet usefulness is limited to flaws in the original design Formulae/information in cells can be hidden and therefore it can be difficult to follow complex calculations Spreadsheet format can provide credence to presented data even if it is flawed Research has demonstrated that a high proportion of large models contain material flaws A database may be more useful for large volumes of data Spreadsheets can easily be corrupted and it is difficult to find errors in large models 6 Chapter summary Use of spreadsheets is an essential part of the day-to-day work of a management accountant. A spreadsheet is an electronic piece of paper divided into rows and columns. The intersection of a row and a column is known as a cell. Essential skills include being able to move around a spreadsheet, enter and edit data, fill in cells, insert and delete columns and rows and improve the basic layout and appearance of a spreadsheet. A wide range of formulae and functions are available within Excel. The chart wizard provides a tool to simplify the process of chart construction. Spreadsheet packages permit the user to work within multiple sheets that refer to each other. 5.8

72 Chapter 5: Questions 5.9

73 5: QUESTIONS The following information relates to questions 5.1 to 5.2 A B C D 1 Unit selling price $50 Unit variable cost $ Sales volumes 4 Quarter 1 1,000 5 Quarter 2 1,500 6 Quarter 3 2,000 7 Quarter 4 2,100 8 Sales revenue Variable costs Contribution 9 Sales budgets 10 Quarter 1 11 Quarter 2 12 Quarter 3 13 Quarter The cell B10 shows the sales revenue in $ for quarter 1. Which of the following would be a suitable formula for this cell that could then be copied through to cells B11 B13?? A = B1*B4 B = $B$4*B1 C = $B$1/*B4 D = $B$1*$B4 (2 marks) 5.2 The cell C10 shows the total variable costs for quarter 1. Which of the following would be a suitable formula for this cell that could then be copied down through to cells C11 13? A = $B4*D1 B = $D$1*$B4 C = D1* B4 D = D1*$B$4 (2 marks) 5.3 The cell D10 shows the contribution in Quarter 1. Which of the following would be a suitable formula for this cell that could then be copied down through to cells D11 13? A = B10 C10 B = $B$10 - $C$10 C = $B10 - $C10 D = B$10 C10 (2 marks) 5.4 The formula bar displays A the formula in the active cell and no other information B the location of the active cell and the formula in the active cell C the formula in the active cell and the result of the formula (1 mark) 5.10

74 5: QUESTIONS 5.5 If a cell contains ####, this means A there is not enough room to display the required number in the cell B there is not enough room to display either the required number or text in the cell C the result of the formula cannot be displayed as the formula is nonsensical (1 mark) 5.11

75 5: QUESTIONS 5.12

76 Chapter 5: Answers 5.13

77 5: ANSWERS 5.1 B 5.2 B 5.3 A 5.4 B The formula bar displays the location of the active cell and the formula in the active cell. 5.5 A B is incorrect as if there is too much text for the size of the cell, it will split into adjacent cells if they are empty, or will be hidden by the contents of the adjacent cell. If a nonsensical formula is entered into a cell, differing responses are given. For example, if your formula results in a value being divided by 0, ~DIV/0! will appear. END OF CHAPTER 5.14

78 Materials costs Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: Describe the different procedures and documents necessary for the ordering, receiving and issuing of materials from inventory. Describe the control procedures used to monitor physical and 'book' inventory and to minimise discrepancies and losses. Interpret the entries and balances in the material inventory account. Identify and explain the costs of ordering and holding inventory. Calculate and interpret optimal reorder quantities. Calculate and interpret optimal reorder quantities when discounts apply. Produce calculations to minimise inventory costs when stock is gradually replenished. Describe and apply appropriate methods for establishing reorder levels where demand in the lead time is constant. Exam Context Materials cost is a key cost within a manufacturing environment. This is an important part of the syllabus and you need to be happy with all relevant calculations. Qualification Context This paper (F2) gives you a basic grounding in the inventory control process and introduces some theoretical techniques to help with inventory ordering. Paper F9 Financial Management requires evaluation of relevant techniques in managing inventory and again uses the EOQ introduced at in this chapter. 6.1

79 6: MATERIALS COSTS Overview Material costs Ordering, receipt and issue of raw material Monitoring of inventory levels Inventory controls level Recording purchases in accounts Reorder levels Minimum level Maximum level EBQ EOQ Discounts 6.2

80 6: MATERIALS COSTS 1 Introduction 1.1 Inventory control includes the processes of (1) Ordering (2) Purchasing (3) Receiving goods into store (4) Storing (5) Issuing inventory (6) Controlling levels of inventory. We will deal with points 1-5 to start with then we will think about why and how we control levels of inventory. Section 2 2 Ordering, receipt and issue of raw material 2.1 Every movement of material should be documented in order that a proper physical record is kept and the correct entries can be entered in the 'books' of the company. 2.2 Inventory control process: Purchase requisition When the stores department need more materials they issue a purchase requisition Purchase requisition Job Number Supplier Date Requested by Quantity Code Description Cost Sent to purchasing dept Authorised: Purchase order (PO) The purchasing department raise a PO which is sent to: supplier accounts departments stores Purchase order To Order ref Address Date No Quantity Code Description Cost Subtotal 17.5% Total 6.3

81 6: MATERIALS COSTS When the goods arrive at stores: Delivery note/goods received note (GRN) Received with the goods into the stores department Signed off to confirm quantity and quality Sent to: - purchasing department - accounts department Date Time Out order no. Supplier no. Goods received note No Quantity No./Code Description Received in good condition 2.3 The accounts department should match the purchase order to the GRN and the invoice when it arrives from the supplier. 2.4 Materials purchased will be recorded in the accounting books of a company as follows. (1) When a purchase is made or an invoice received Dr Materials account Dr Materials account Cr Cash account Cr Creditors account (2) When an issue is made to a production process Dr Production process Cr Materials inventory Materials inventory (1) Materials (2) Issues to purchased X production X C/d closing inventory X B/d closing inventory X X 3 Monitoring of inventory levels X 3.1 One of the objectives of storekeeping is to maintain accurate records of inventory levels. 3.2 This involves accurately monitoring inventory movements in order that the physical inventory is reflected in the company's books. A company will carry out inventory counts to check that the physical inventory matches that shown in the inventory records. This count can be carried out on a periodic or continuing basis. 6.4

82 6: MATERIALS COSTS 4 Inventory control levels Lecture example 1 Preparation question Complete the following table: Reasons for holding inventory Cost of holding inventory / Cost of ordering inventory 4.1 The objectives of inventory control are to make sure that the total of the following costs are minimised: Holding costs Ordering costs Stockout costs 4.2 Three control levels can be calculated from historical records: Re-order level = max usage per day max number of days delivery time This is set so that in theory it is not possible to run out of inventory. Once stocks fall to this level a new order is placed. 4.3 Minimum level = re-order level (ave usage ave no. of per day days delivery) This is the level below which inventory should not normally fall as the risk of stock out becomes unacceptable. 4.4 Maximum level = re-order + reorder (min usage min no. of level quantity per day days delivery) This is the level above which inventory should not normally rise as it is uneconomical to hold more. 6.5

83 6: MATERIALS COSTS Additional terminology: 4.5 Average inventory = minimum inventory + ½ reorder quantity The average inventory formula assumes that inventory levels fluctuate evenly between the minimum (or safety) inventory level and the highest possible inventory level (the amount of inventory immediately after an order is received). 4.6 Reorder quantity The quantity of inventory which is to be ordered when inventory reaches the reorder level. Can be calculated as the Economic Order Quantity (EOQ) (see later). 5 Costs involved with inventory Costs 5.1 (a) Purchase: unaffected by stock policy unless bulk discounts are available. Purchase costs = purchase price annual demand = P D 5.2 (b) Ordering: if a fixed amount per order is charged this will be affected by inventory policy. If an amount per unit is charged, the cost will be fixed per annum since it only depends on sales level (assumed constant). Ordering costs = cost per order number of orders pa = C o Q D (where Q = order quantity per order) 5.3 (c) Holding: will consist of some costs which are fixed per annum (i.e. warehouse rental) and therefore irrelevant to inventory policy and those which vary with the number of units held in inventory and are thus relevant to any decision (i.e., per unit insurance costs). Holding costs = cost of holding the unit for one year average inventory throughout the year = C H 2 Q A particular holding cost to look out for is the cost of capital tied up in inventory For example: If the purchase price of a unit is $10, the delivery cost per unit is $2 and the cost of capital is 15% p.a. The total cost of putting one unit into inventory is $12. If unit is held in inventory for 1 year, the holding cost = 15% 12 = $

84 6: MATERIALS COSTS 6 The economic order quantity model Introduction 6.1 Economic order quantity (EOQ) is a mathematical tool to calculate the amount of inventory to order in each order and minimise the holding costs, ordering costs and purchase costs. Terms P = purchase price D = annual demand in units Co = fixed cost per order CH = cost of holding one unit for one year Q = number of units ordered Assumptions (a) Demand is constant (b) Delivery is instantaneous or lead time is constant (c) Purchase costs are constant (no discounts) The assumptions must be known. EOQ formulae 6.2 Annual inventory costs Total inventory costs = ordering costs + purchase costs + holding costs.. CoD C Q. total costs (TC) = + PD + H (from Paragraph 5.1) Q 2 The total cost is minimised when Q = EOQ = 2CoD C H 6.7

85 6: MATERIALS COSTS Lecture example 2 Preparation question Demand 150 units per month Cost per unit $25 Order cost $32 Holding cost 18% pa. of inventory value. Required (a) What is the economic order quantity (in units)? (b) What is the total cost associated with this order quantity? $ (c) What are the holding and order costs for order quantities of 200, 600 and 1,000 units? Quantity Holding costs Order costs 200 $ $ 600 $ $ 1,000 $ $ Workings 7 Discounts Introduction 7.1 Discounts may be available if the order quantity is above a certain size. This needs to be considered in determining the best order quantity. The economic order quantity will give us the optimal order quantity to minimise holding, ordering and purchase costs but it does not take into account bulk discounts available. We therefore need to calculate total costs at discount levels to find the lowest total cost. 6.8

86 6: MATERIALS COSTS Steps 7.2 (a) Calculate EOQ in normal way. (b) (c) (d) (e) Recalculate EOQ if it falls within a discount band; H will have changed as it is a % of purchase price. Calculate the total annual costs using the formula at the EOQ. Calculate annual costs at the lower boundary of each discount band above the EOQ. Select order quantity that minimises costs. Lecture example 3 Exam standard question worth 2 marks Using the same information as used in Lecture example 2 and following the steps in Paragraph 7.2, calculate the minimum total cost assuming the following discounts apply: Discount of 1% given on orders of 150 and over Discount of 2% given on orders of 300 and over Discount of 4% given on orders of 800 and over The minimum total costs are: $ Workings 6.9

87 6: MATERIALS COSTS 8 Economic batch quantity (EBQ) Introduction 8.1 The EBQ is a modification of the EOQ and is used when inventory is replenished gradually to match production rates, rather than instantaneously. This approach is used in order to minimise administration, reduce inventory holding costs and to guarantee future inventory supplies where a company is manufacturing inventory for its own use rather than ordering from an external supplier. Alternatively EBQ is used if the external supplier is willing to deliver gradually. 8.2 For example, a company may wish to order a batch of 500,000 (Q) components to secure supply whilst receiving delivery to match the weekly production demand for the components of 50,000 (R) due to the limited availability of warehouse space. Variables 8.3 Q = the amount ordered per batch D = demand in the time period CO = set up cost of one batch/cost of making one order CH = holding cost per unit per time period R = production rate/delivery rate per time period The EOQ formula is amended to reflect that Q units are never all held in inventory.... EBQ = 2CoD D C 1 H R Total holding costs = Q 1 2 D R C H Lecture example 4 Preparation question Turbot Ltd has capacity to manufacture 6,000 Whelks in a week. The Whelks are in demand at a rate of 4,000 per week. Set up costs for each production run are $750 and the holding cost of each unit is 2 cents per week. Required (a) What is the EBQ (in units)? (b) What are the total weekly holding and set up costs associated with inventory if the firm aims to minimise costs? $ and $ 6.10

88 6: MATERIALS COSTS Workings 9 Chapter summary Inventory control includes the functions of inventory ordering and purchasing, receiving goods into store, storing and issuing inventory and controlling the level of inventories. Inventory should be counted on a periodic or perpetual basis in order to match physical and book qualities. Inventory costs include purchase costs, holding costs, ordering costs and stockout costs. Inventory control levels can be calculated in order to maintain inventories at the optimum level. The three critical control levels are: recorder level minimum level maximum level The economic order quantity (EOQ) is the order quantity that minimises inventory costs. The economic batch quantity (EBQ) is a modification of the EOQ and is used when re-supply is gradual instead of instantaneous. 6.11

89 6: MATERIALS COSTS 10 Formula summary Re-order level = Max usage x max number of per day days delivery time Minimum level = re-order level - (average usage x average no per day of days delivery) Maximum level = re-order + reorder - (min usage x min no level quantity per day of days delivery) 2CoD EOQ = C H CoD C Total costs = + PD + H Q 2Q EBQ = 2CoD C (1- D) H R Total holding costs = 2 Q D 1 C R H 6.12

90 Chapter 6: Questions 6.13

91 6: QUESTIONS Chapter Which of the following statements is correct? A Lead time is the time between placing an order and receiving inventory B A stockout occurs when inventories are run down to zero just as new inventories arrive C Reorder level is the size of a fresh order placed when stock are running low (1 mark) The following information relates to questions 6.2, 6.3 and 6.4 Data for a component part with stock number B1422 is as follows: Minimum usage 1,000 units Maximum usage 2,250 units Lead time (delivery time) 8-16 days Reorder Quantity 14,500 units 6.2 What is the reorder level? A 8,000 units B 36,000 units C 18,000 units D 27,000 units (2 marks) 6.3 The Minimum inventory holding below which inventory should not fall (in units) is (2 marks) 6.4 What is the maximum inventory holding above which inventory should not rise? A 32,500 units B 34,500 units C 42,500 units D 58,500 units (2 marks) 6.5 What is the Economic Order Quantity (EOQ) where monthly demand is 2,000 units, order costs are $45 per order, inventory costs $2,160 per unit and the company's cost of capital is 10%. A 70 units B 80 units C 90 units D 100 units (2 marks) 6.6 A company has a cost of capital of 10%. It purchases inventory at $25 per unit. There is a fixed cost of $30 for each order placed and monthly demand is 1,000 units. What is the optimal order quantity (to the nearest unit)? (2 marks) 6.14

92 Chapter 6: Answers 6.15

93 6: ANSWERS 6.1 A 6.2 B Reorder level = max usage per day max number of days' delivery time. (2,250*16) = 36,000 units 6.3 Minimum level = Re-order level (Ave. usage * Ave lead time) 36,000 ( (2, ,000)/2 *(8 + 16)/2) = 16,500 units 6.4 C Maximum level = Re-order level + Re-order quantity (Min usage * Min lead time) 36, ,500 (1,000 * 8) = 42,500 units 6.5 D EOQ = 2CoD = CH 2 x 45 x 24,000 = 100 units EOQ = 2CoD C H C = $30 D = 1,000 x 12 = 12,000 h = 10% x $25 = 2.50 EOQ = 2 x 30 x 12, = 537 units END OF CHAPTER 6.16

94 Labour costs Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: Calculate direct and indirect costs of labour. Explain the methods used to relate input labour costs to work done. Prepare the journal and ledger entries to record labour cost inputs and outputs. Describe different remuneration methods: time-based systems, piecework systems and individual and group incentive schemes. Calculate the level, and analyse the costs and causes of labour turnover. Explain and calculate labour efficiency, capacity and production volume ratios. Interpret the entries in the labour account. Exam Context As with materials costs in Chapter 6, the labour cost within a manufacturing or a service environment is a key area of the syllabus. You can expect to see questions on this topic in your exam. Qualification Context This is an introductory chapter and includes basic control mechanisms that a company can use. 7.1

95 7: LABOUR COSTS Overview Labour costs Methods of remuneration Labour turnover Measuring labour activity Accounting for labour costs 7.2

96 7: LABOUR COSTS 1 Introduction 1.1 The principle of recording and controlling costs incurred by a business, already demonstrated in respect of materials, may also be applied to labour costs. Businesses will normally require a system capable of analysing both labour times and costs. Method of remuneration 1.2 (a) Time-based systems (b) (c) Wages are determined by the number of hours worked. If an employee works more than their basic hours, then an overtime payment might be made. Piecework systems In this case wages are calculated on the number of units/items produced. It is usual for pieceworkers to be guaranteed a minimum wage. Bonus/incentive schemes Eg. benefits-in-kind, profit sharing schemes and bonuses. These schemes were introduced to compensate workers paid under a time-based system, who unlike pieceworkers, could not increase their pay by being more efficient. The main aim of all these schemes is to increase productivity. Bonuses could be paid if an individual target is exceeded or if the output of a group exceeds a target. Lecture example 1 Exam standard question worth 2 marks Normal working day 8 hours Basic rate of pay $6 Standard time allowed to produce 1 unit 2 minutes Premium bonuses 75% of time saved at basic rate Required What is the cost of producing 340 units in one day? $ Working 7.3

97 7: LABOUR COSTS Lecture example 2 Exam standard question worth 2 marks A company pays its employees using a piecework scheme. The rates are as follows: units per week $4 per unit units per week $4.50 per unit units per week $5 per unit units per week $5.50 per unit Required If an employee produces 163 units in week 48, what would their pay be for that week? $ Working 2 Measuring labour activity 2.1 Production is the quantity of volume of output produced. 2.2 Productivity is a measure of the efficiency with which output has been produced. An increase in productivity is likely to reduce unit costs. 2.3 A standard hour of production is the pre-determined output from one worker for one hour. In other words a standard hour is a 'quantity or work' not a period of time. Standard labour hours = actual units output x standard time per unit. Lecture example 3 Exam standard question worth 2 marks An employee makes 200 units of product A, 350 units of product B and 300 units of product C. The standard time allowed per unit was: A 4 minutes B 2 minutes C 3 minutes Required What are the standard hours produced by the employee (in hours)? 7.4

98 7: LABOUR COSTS Working Efficiency, capacity and production volume 2.4 Other measures of labour activity include the following: Efficiency x Capacity = Production volume Ratio ratio ratio Standard hours to make actual output Actualhours taken Usually expressed as a %. x Actualhours worked Budgetedhours = Standard hours to make actual output Budgetedhours Lecture example 4 Preparation question Barnes Ltd budgeted to make 13,000 standard units of output during a budgeted period of 26,000 hours (each unit should take two hours). During the period, the company actually made 14,000 units which took 35,000 hours. Required (a) What is the efficiency ratio? (b) What is the capacity ratio? (c) What is the production volume ratio? Give your answers to one dp. 7.5

99 7: LABOUR COSTS 3 Accounting for labour costs Direct vs indirect costs 3.1 We had a look at direct and indirect labour costs in Chapter 3. The table below shows in more detail how the costs will break down. Direct Workers Indirect Workers Normal Basic Pay Direct Cost Indirect Cost General Production: Overtime Basic pay element General Production: Overtime O/T Premium General Non Production: Overtime Basic pay element General Non Production: Overtime O/T Premium Specific Overtime Basic pay element Specific Overtime O/T Premium Ledger accounting Direct Cost Indirect Cost Indirect Cost Indirect Cost Direct Cost Direct Cost 3.2 (1) When gross wages are paid to employees they are accounted for as: Dr: Cr: Wages control account Bank/PAYE control account/nic control account N/A N/A Indirect Cost Indirect Cost Direct Cost Direct Cost (2) When labour is used within a particular production process, the direct labour costs are transferred from the wages control account using: Dr: Work in progress account Cr: Wages control account (3) Indirect labour costs are transferred from the wages control account to be grouped with other indirect costs using: Dr: Production overhead account Cr: Wages control account 7.6

100 7: LABOUR COSTS Wages Control Account (1) Bank etc (2) WIP (actual wages) X (direct labour) X (3) Production overheads X (indirect labour) Income Statement β X X X 3.3 More information regarding the work in progress account and the production overhead account can be found in Chapter 8 Absorption Costing. Lecture example 5 Preparation question Company X employs two types of labour: skilled workers, considered to be direct workers, and semi-skilled workers considered to be indirect workers. Skilled workers are paid $10 per hour and semi-skilled $7.50 per hour. All employees work a standard 35 hour week. There are seven skilled workers and four semi-skilled workers. The skilled workers have worked 50 hours of overtime this week, 20 hours on a specific order and 30 hours on general production. The semi-skilled workers have worked 20 hours of overtime, 10 hours on a specific order at a customer's request and the remaining 10 hours to meet general production requirements. All overtime is paid at time and a half. Required (a) What are the total direct labour costs for the week? $ (b) What are the total indirect labour cost for the week? $ (c) Complete the following account assuming the wages paid were cash of $3,580 after deductions of $895. Wages control account 7.7

101 7: LABOUR COSTS Workings 4 Labour turnover 4.1 Labour turnover is the rate at which employees leave a company and should be kept as low as possible. 4.2 Reasons for labour turnover include: Controllable causes Demotivated staff Work not interesting / challenging Staff not appropriately rewarded Staff leave to work for a competitor Uncontrollable causes Down turn in the economy resulting in staff redundancies Company recruit staff as trainees, therefore once qualified they have more options open to them 4.3 Labour turnover can be calculated as follows: Replacements Labour turnover rate = Average number of employees in period Lecture example 6 x 100% Exam standard question worth 2 marks A company has 1,000 staff at the start of 20X3 and at the end this had reduced to 920 due to redundancies being made. 100 staff took voluntary redundancy which was 20 more than the company had anticipated and these 20 employees were replaced. Required What is the labour turnover rate per year (in employees)? 7.8

102 7: LABOUR COSTS Workings 4.4 Costs associated with labour turnover can be split into two categories Replacement costs Cost of selection and placement Inefficiency of new labour Training Timing problems Preventative costs Costs to maintain good relationships Costs of welfare eg. sports facilities canteens social events Cost of pensions 5 Chapter summary Method of remuneration for production staff include Time based systems Piecework systems Bonus/incentive systems Labour productivity is a measure of the efficiency with which output has been produced. Companies will monitor productivity as part of their cost control procedures. You need to be able to calculate Efficiency ratios Capacity ratios Production volume ratios Labour costs will be split between direct and indirect costs and double entry will be used to record these costs. High labour turnover will cause increased cost to a business. 7.9

103 7: LABOUR COSTS 6 Formula summary Standard labour hours = Actual units of output x standard time per unit Labour efficiency ratio = Labour capacity ratio = Production volume ratio = Standardhours to make actual output Actual hours taken Actual hours worked x 100% Budgetedhours Standardhours to make actual output Budgetedhours x 100% x 100% Labour turnover rate = Replacements x 100% Average number of employees in period 7.10

104 Chapter 7: Questions 7.11

105 7: QUESTIONS Chapter Mary assembles 227 mobile phones in a production period. Wages are calculated on a piecework basis at the following rates. What is Mary s wage for the period? $5 per unit $6 per unit $7 per unit $8 per unit A 1,366 B 1,435 C 1,476 D 1,816 (2 marks) 7.2 1,000 hours of direct labour is incurred in the production period. If labour is paid at a standard rate of $7.5 per hour how is the cost of labour taken into production in the accounting records? A Dr Direct labour $7,500; Cr Wages control account $7,500 B Dr WIP $7,500; Cr Direct labour $7,500 C Dr Wages control account $7,500; Cr WIP $$7,500 D Impossible to calculate (2 marks) 7.3 Paul, a direct worker is paid at $5 per hour and a rate of time plus one half for overtime. Paul completes 30 hours of overtime in the period, 10 hours resulting from a specific contract and the remaining 20 hours on general overtime. What is the double entry to record the overtime? A Dr Direct labour cost $225; Cr Wages control account $225 B Dr Direct labour cost $50, Dr Overheads $175; Cr Wages control account $225 C Dr Direct labour cost $175, Dr Overheads $50; Cr Wages control account $225 D Dr Wages control account $225; Cr Direct labour cost $175, Cr Overheads $50 (2 marks) 7.4 Heritage Limited had 46 people at the start of the year and 40 people at the end of the year. During the period 14 people left the company. What is the staff turnover rate expressed as a percentage? A 11.6% B 32.6% C 37.2% D 18.6% (2 marks) 7.12

106 7: QUESTIONS The following information relates to questions 7.5, 7.6 and 7.7 A company budgeted to produce 10,000 items at a rate of 5 hours per unit for January. It actually made 11,000 items in January consuming 52,500 labour hours. 7.5 What is the labour efficiency ratio (expressed to the nearest whole percentage)? A 105% B 110% C 95% D 91% (2 marks) 7.6 What is the labour capacity ratio (expressed to the nearest whole percentage)? % (2 marks) 7.7 What is the labour production volume ratio (expressed to the nearest whole percentage)? A 105% B 110% C 95% D 91% (2 marks) 7.13

107 7: QUESTIONS 7.14

108 Chapter 7: Answers 7.15

109 7: ANSWERS 7.1 A $5 per unit 100 x $5 = $ $6 per unit 50 x $6 = $ $7 per unit 50 x $7 = $ $8 per unit 27 x $8 = $216 Total $1, B Here costs are being transferred from direct labour (Cr) into Work-in-Process (Cr) i.e. Production. 7.3 C Here costs are being allocated between direct and indirect costs and so are being transferred from the wages control account (Cr) into Direct Labour and Overheads (Dr). General overtime: Basic 20 $5 = $100 Direct cost; Overtime premium $2.5 = $50 Indirect cost Specific overtime: Basic 10 $5 = $50 Direct cost; Overtime premium $2.5 = $25 Direct cost Hence the double entry is Dr Direct labour cost $175, Dr Overheads $50; Cr Wages control account $ D Staff turnover rate = Replacements Ave no.of employees in period x 100% Average employees (46+40)/2 = 43. Replacements 14 people left the company during the year however staff numbers fell by only 6. This implies that 8 people were recruited (replaced) during the period. 8/43 x 100% = 18.6% 7.5 A Labour efficiency ratio = Standard hours of production Actual hours of production Actual activity is 11,000 units at a standard rate of 5 hrs per unit Standard hrs are 55,000 hrs Efficiency ratio = 55,000/52,500 x 100% = 105% 7.6 Labour capacity ratio = Actual hours of production Budget hours of production Budget hrs are 10,000 units at 5 hrs per unit Budget hrs are 50,000 hrs. Capacity ratio = 52,500/50,000 x 100% = 105% 7.7 B Production volume ratio = Standard hours of production = Efficiency ratio x Capacity ratio Budget hours of production Actual activity is 11,000 units at a standard rate of 5 hrs per unit Standard hrs are 55,000 hrs Budget hrs are 10,000 units at 5 hrs per unit Budget hrs are 50,000 hrs. Production volume ratio = 55,000/50,000 x 100% = 110% END OF CHAPTER 7.16

110 Overheads and absorption costing Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: Explain the different treatment of direct and indirect expenses. Describe the procedures involved in determining production overhead absorption rates. Allocate and apportion production overheads to cost centres using an appropriate basis. Reapportion service cost centre costs to production cost centres (using the reciprocal method where service cost centres work for each other). Select, apply and discuss appropriate bases for absorption rates. Prepare journal and ledger entries for manufacturing overheads incurred and absorbed. Calculate and explain the under and over absorption of overheads. Apply method of relating non-production overheads to cost units. Exam Context Overhead apportionment and absorption is one of the most important topics in your Management Accounting studies and is almost certain to appear in the exam you will be facing. Qualification Context Overhead treatment is assumed knowledge at paper Fundamentals level F5 Performance Management. Specific comparisons of absorption costing with activity based costing scenarios are a likely exam question at the higher level. 8.1

111 8: OVERHEADS AND ABSORPTION COSTING Overview Overheads and absorption costing Types of overhead Predetermined OAR Allocating overheads to units to find the full production cost Calculating a profit or loss under absorption costing 3-step approach to absorption costing Allocating non production overheads to a product (1) Allocate & apportion (2) Reapportion (3) Absorb 8.2

112 8: OVERHEADS AND ABSORPTION COSTING 1 Overview Businesses need to be able to ascertain the cost of making their product or service as discussed in Chapter 2 for three main reasons. (1) Profitability analysis (2) Selling price determination (3) Inventory valuation purposes. Cost card 1.1 To achieve this a cost card can be built up for an individual unit. For example: Cost/unit Direct materials $2/kg $8 Direct labour 3 $7/hr $21 Direct expenses $4 Prime cost $44 Indirect costs (overheads) $10 Total cost $43 Production overheads 1.2 An overhead is a cost incurred in the course of production that can't be traced directly to the product or service. Lecture example 1 Preparation question As we saw in Chapter 3 overheads can be broken down into: Indirect materials Indirect labour Indirect expenses For example It is usually straightforward to ascertain the direct costs of a cost unit to get the prime cost. However, since overheads are not identified with specific cost units some method must be used to charge a share of the total production overhead to each cost unit. 2 Absorption costing (AC) The objective of AC is to include in the total cost of a product an appropriate share of the organisations overhead. 8.3

113 8: OVERHEADS AND ABSORPTION COSTING 2.1 Absorption costing steps Total Production Costs Direct Costs Indirect Costs (overheads) Should be easy to link directly to unit and put in cost card More difficult to link to unit so we need a methodology Absorption Costing Step 1 Cost Centres Production 1 Production 2 Service Step 2 Production 1 Production 2 Step 3 COST UNIT Direct materials Direct labour Prime cost Indirect costs Full production cost/unit X X X X X Terminology 2.2 Allocate whole cost items are charged to a cost centre. Apportion cost items are divided between several cost centres. Step 1 Allocate AND APPORTION production overheads to cost centres Step 2 Reapportion overheads in service cost centres to production cost centres Step 3 Absorb overheads into cost units 8.4

114 8: OVERHEADS AND ABSORPTION COSTING 3 Step 1 - Allocation and apportionment of production overheads to cost centres 3.1 The first stage in valuing the overhead cost of a cost unit is to allocate and apportion overheads between the cost centres. 3.2 Recap: Service and production cost centres We need to distinguish between factory cost centres that are: Production cost centres, through which cost units actually flow; and Service cost centres, which support/service the production cost centres. Lecture example 2 Preparation question Overhead allocation and apportionment Mars Ltd has the following overheads in the year ended 31 December 20X5: Overhead: $ Rent and rates 90,000 Insurance of machinery and equipment 40,000 Stores costs (wages and salaries) 75,000 Heating costs 57, ,000 Additional information includes: Mixing Stirring Stores Canteen Total Floor space (square ft) 9,000 3,000 1,000 2,000 15,000 NBV of machinery and equipment 2,000 1, ,000 Required After allocating and apportioning overhead costs, calculate the total cost in the mixing dept, stirring dept, stores and canteen: Mixing department $ Stirring department Store department Canteen department $ $ $ Workings 8.5

115 8: OVERHEADS AND ABSORPTION COSTING 3.3 So apportioned costs are apportioned to cost centre on 'some fair basis'. You will need to identify relevant information from the question and think about why the cost is being generated. 4 Step 2 - Reapportionment of service cost centre overheads 4.1 As we have said, factory cost centres can be broken down into two types: (a) Production cost centres these make the cost units. (b) Service cost centres these do work for the production cost centres and one another. Unit Mixing Stirring Stores Canteen Finished goods store 4.2 We therefore need to transfer all service cost centre overheads to the production centres so that all production overheads for the period are shared between the production cost centres alone as it is through these cost centres that cost units flow. 4.3 The reapportionment becomes a little more complicated where there is: more than one service cost-centre, and 8.6

116 8: OVERHEADS AND ABSORPTION COSTING the service centres do work for one another (inter-service department work), for example the canteen feeds employees in stores and stores holds materials for canteen. 4.4 To reapportion service cost centre overheads to production cost centre there are two methods. Direct method Reciprocal method (a) (b) Inter-service department work is ignored or there is no interservice work All inter-service department work is recognised (sometimes called the repeated distribution method) The direct method All the inter-service department work is ignored and service centre overheads are reapportioned directly to production cost centres. Mainly used when there is only one service centre or the service centres do not work for each other. A simple but inaccurate method. The reciprocal method (repeated distribution) This method recognises all inter-service department work and is therefore more accurate. The reciprocal method can be carried out in two ways: (i) Repeated distribution/continuous apportionment or (ii) Algebraic method. Lecture example 3 Preparation question Service cost re-apportionment Production Depts. Service Centres Mixing Stirring Stores Canteen $ $ $ $ Allocated and apportioned overheads From Lecture example 1 108,200 39,400 90,800 23,600 Estimated work done by the service centres for other departments: Stores 50% 30% - 20% Canteen 45% 40% 15% - Required (a) After the apportionment of the service departments to the production department, the total overhead costs for the production departments using the different methods will be: 8.7

117 8: OVERHEADS AND ABSORPTION COSTING Direct Repeated distribution Mixing $ $ Stirring $ $ Algebraic Workings $ $ 8.8

118 8: OVERHEADS AND ABSORPTION COSTING (b) the most appropriate method to use would be the method This is because 8.9

119 8: OVERHEADS AND ABSORPTION COSTING 5 Step 3 - Absorption of overheads into production (cost units) 5.1 All of the production overhead costs have now been apportioned to the production cost centres. We now need to charge these to the cost units passing through the production cost centres. This is termed absorption. We are going to absorb an element of total production overhead into each cost unit. Production overhead OAR (overhead absorption rate) = Activity level Choosing the activity 5.2 Ideally, the basis chosen for the activity should be the one which most accurately reflects the way in which the overheads are in fact being incurred: For example: (a) Per unit (b) Per labour hour Main methods used in exam (c) Per machine hour (d) % of direct labour cost (e) % of direct materials cost (f) % of prime cost Process of absorption into cost units 5.3 Where the OAR has been calculated using an activity other than units some extra calculation will be required to get the cost for the cost card. (a) (b) Calculate the overhead absorption rate using an appropriate activity level (e.g. machine hours). Production overhead OAR = Activity Level (e.g.machine hours) Find the activity level per unit (e.g. machine hours per unit) and then apply the OAR calculated to the specific unit. OAR per unit = OAR per machine hour x machine hours per unit (c) Repeat for all production cost centres. Remember each production cost centre may absorb overhead on a different basis. These steps complete the process described in the diagram. 8.10

120 8: OVERHEADS AND ABSORPTION COSTING Lecture example 4 Preparation question Practise calculating OAR Calculating absorption rates Mars Ltd has decided to use the step method to re-apportion service centre costs to its two production departments, mixing and stirring. As calculated in Lecture example 2, this resulted in allocated overheads of $175,708 and $86,292 to the mixing and stirring departments respectively. During the year the following data has been collected: Mixing Stirring Direct labour hours 12,500 4,000 Direct machine hours 2,000 10,000 Number of batches of Mars bars 2,500 2,500 (each batch consists of 1,000 bars) Direct materials cost $75,000 $30,000 Direct labour cost $62,500 $20,000 Required (a) Calculate the overhead absorption rate in the mixing department if overhead is absorbed on (i) a per unit basis; (ii) a per machine hour basis. (b) Calculate the overhead absorption rate in the stirring department if overhead is absorbed (i) on a labour hours basis; (ii) on a direct materials cost basis. (c) Decide which basis you think is most appropriate for each department and why. (d) Calculate the overhead absorption rate per unit (i) in the mixing department. (ii) in the stirring department. Working 8.11

121 8: OVERHEADS AND ABSORPTION COSTING Lecture example 5 Preparation question Mars Ltd (cont) Suppose the Mars Bars are divided up as follows: Batches Normal size 1,500 Fun size 1,000 2,500 The following data is also available: Normal size Fun size Direct materials/unit Mixing $40 $15 Stirring $15 $7.5 Direct labour hours/unit Mixing 6hr 3.5hr Stirring 1.8hr 1.3hr Machine hours/unit Mixing 1hr 0.5hr Stirring 5hr 2.5hr The labour cost in both departments is $5/labour hour. 8.12

122 8: OVERHEADS AND ABSORPTION COSTING Required Using suitable bases set up a cost card for each type of Mars Bar. Solution 6 Pre-determined overhead absorption rates 6.1 Businesses need to cost their production throughout the year, not at the end of an accounting period. Therefore they predetermine or estimate their absorption rates for the year. Budgeted overhead Pre-determined OAR = Budgeted activity level Note: activity level refers to production activity not sales 6.2 Budget (or normal) activity level IAS 2 states that the activity level used for absorption of overheads should always be the budgeted (normal) activity, i.e. the expected long term average. This is to stop fluctuations in OAR s due to fluctuations in activity. 8.13

123 8: OVERHEADS AND ABSORPTION COSTING Absorption into production 6.3 Business wants to record overheads regularly during the year. Overhead = Actual Activity x Predetermined Absorbed (eg labour hrs) OAR At the end of the year actual overheads will be known and it is likely that Overhead Actual Absorbed Overhead Overheads absorbed may differ from actual overhead costs incurred for either or both of the following two reasons: (a) Actual expenditure was more or less than budget (expenditure variance). (b) Actual units produced (ie. volume) were more or less than budget (volume variance). 6.4 The difference between the overhead absorbed and the actual overhead is known as the over or under absorption. It is shown in the I/S so that in total the actual overhead is charged. The actual overhead is the amount absorbed plus an under absorption or minus an over absorption. Actual overhead Overhead absorbed Under/(over) absorption X (X) X/(X) 6.5 Under / (over) absorption can be split down further into an: (a) Expenditure variance Actual expenditure on fixed overheads Budgeted expenditure on fixed overheads Expenditure variance (b) Volume variance Actual volume of production Budgeted volume of production Difference Valued at OAR / unit $ X (X) X Units X (X) X X Lecture example 6 Preparation question Pre-determined overhead absorption rates. (a) Gurney Halleck limited had the following budgeted and actual figures for units of production and overheads. Budget Actual Units of production 20,000 24,000 Overheads $100,000 $117,

124 8: OVERHEADS AND ABSORPTION COSTING Required Complete the following calculations: Pre-determined absorption rate = Overhead absorbed for period = Under/over absorption = (b) The amount of under or over absorbed overhead would be the balancing figure in the production overhead account and would be transferred to the profit and loss account. Required Complete the following T account. Production overhead account (c) Remember that the double entry for the overhead accounts are: Dr: actual cost Cr: actual activity level pre-determined OAR Required Complete the following calculation clearly showing adverse and favourable variances. $ Expenditure variance Volume variance Over/under absorption 8.15

125 8: OVERHEADS AND ABSORPTION COSTING 7 Non-production overheads 7.1 Non-production (or non-manufacturing) overheads (as seen in Chapter 2) may also be allocated by calculating an OAR which closely matches the non-production overhead. 7.2 For external reporting non-production overheads are treated as a period cost and not allocated to units. For internal reporting the total cost of a unit can be found by including non-production costs in the cost card. 7.3 Absorbing non-production overheads One approach may be to absorb non-production costs on the basis of the products total production cost Non - production overhead OAR = Production overhead x 100 ie. non-production is allocated as a % of production cost. Other bases for absorbing overheads areas follows. Type of overhead Selling and marketing Research and development Distribution Administration Possible absorption base Sales value Consumer cost (= production cost minus cost of direct materials) or added value (= sales value of product minus cost of bought in materials and services) Sales values Consumer cost or added value 8.16

126 8: OVERHEADS AND ABSORPTION COSTING 8 Chapter summary Overheads are costs incurred in the course of making a product that can't be directly linked to a unit. The objective of absorption costing is to include a share of the overheads in the total cost of the product. The three stages of absorption costing are: (1) Allocate and apportion (2) Reapportion (3) Absorption. Under or over absorption of overheads occurs due to the difference between the estimates used in calculating the OAR and the actual overhead cost. Non manufacturing overheads can also be allocated to a product. 9 Formula summary Pre determined OAR = Budgeted(normal) overhead Budgeted activity Overhead absorbed = actual activity x pre determined OAR Actual overheads Overhead absorbed Under/(over) absorption X (X) X/(X) 8.17

127 8: OVERHEADS AND ABSORPTION COSTING 8.18

128 Chapter 8: Questions 8.19

129 8: QUESTIONS Chapter A company has two production departments and two service departments with the fixed overheads shown in the table. Production Service Production W X Y Z Overheads ($'000) Service department Y divides its times between the other departments in the ratio 3:2:1 (for W, X and Z respectively). Department Z spends 40% of its time servicing department W and 60% servicing department X. If all service departments' overheads are allocated to production departments, the total fixed overhead cost of department W is A $1,200,000 B $1,100,000 C $660,000 D $1,160,000 (2 marks) 8.2 Which of the following statements about overhead absorption rates are true? (i) They are predetermined in advance for each period (ii) They are used to charge overheads to products (iii) They are based on actual data for each period (iv) They are used to control overhead costs A (i) and (ii) only B (i), (ii) and (iv) only C (ii), (iii) and (iv) only D (iii) and (iv) only (2 marks) The following information relates to questions 8.3 and 8.4. A Ltd's budgeted and actual data for the year ended 31 December 20X1 is shown on the table. Budget Actual Production (units) 5,000 4,600 Variable costs per unit $6 $4 Fixed production overheads $10,000 $9,500 Sales (units) 4,000 4,000 Sales price per unit $10 $10 Absorption basis for fixed overheads: per unit 8.3 The reason for the under or over absorption was A the company sold fewer units than it produced B the company sold fewer units than it produced and spent less than expected on fixed overheads C the company produced fewer units than expected D the company produced fewer units than expected and spent less on fixed overheads (1 mark) 8.20

130 8: QUESTIONS 8.4 The fixed overhead absorbed during 20X1 will be: A $8,000 B $9,200 C $9,500 D $10,000 (2 marks) 8.5 Budgeted overheads for a period were $340,000. Actual labour hours and overheads were 21,050 hours and $343,825 respectively. If there was over absorption of $14,025, how many labour hours were budgeted? A 20,000 hours B 20,225 hours C 20,816 hours D 21,050 hours (2 marks) 8.6 A company absorbs overheads on machine hours, which were budgeted at 11,250 with budgeted overheads of $258,750. Actual results were 10,980 hours with overheads of $254,692. Overheads were A under-absorbed by $2,152 B over-absorbed by $4,058 C under-absorbed by $4,058 D over-absorbed by $2,152 (2 marks) 8.7 Limited makes two products in its factory, details of which are: Product X Product Y Budgeted production 1,000 units 800 units Labour hours per unit 2 3 Budgeted fixed overhead for the factory $15,400 Which one of the following absorption rates is correct? A $3.50 per unit of X B $3.50 per labour hour C $6.16 per unit of X D $15.40 per unit of Y (2 marks) 8.8 Budget Actual Overheads $10,000 $11,500 Units 5,000 6,200 Given the above situation which of the following combinations in respect of over/under absorption of overheads is correct? Total ($) Expenditure ($) Volume ($) A 900 (over) 1,500 (under) 2,400 (over) B 3,300 (over) 900 (over) 2,400 (over) C 2,400 (over) 1,500 (over) 900 (over) D 2,400 (under) 1,500 (under) 900 (under) (2 marks) 8.21

131 8: QUESTIONS 8.9 A business calculated its overhead absorption rate to be $32 per machine hour, based on an estimate that the production overheads of the business would be $216,000 in the coming year. How many machine hours did the business anticipate working? A 6,750 hours B 216,000 hours C 32 hours D Don't know, would need more information (2 marks) 8.10 Iddon Ltd makes two products, Pye and Tan, in a factory divided into two production departments, Machining and Assembly. In order to find a fixed overhead cost per unit, the following budgeted data is relevant: Machining Assembly Allocated and apportioned fixed costs $120,000 $72,000 Labour hours per unit - Pye 0.5 hours 0.20 hours Tan 1.0 hours 0.25 hours Budgeted production is 4,000 units of each product (8,000 units in all) and fixed overheads are to be absorbed by reference to labour hours. What is the budgeted fixed overhead cost of a unit of Pye? $ (2 marks) 8.11 Which of the following entries will record an under-absorption of production overheads in the overhead account? A Dr Work in progress Cr Profit and loss B Dr Overhead Cr Profit and loss C Dr Profit and loss Cr Work in progress D Dr Profit and loss Cr Overhead 8.12 The following extract of information is available concerning the four cost centres of EG Limited. Service cost Production cost centres centre Machinery Finishing Packing Canteen Number of direct employees Number of indirect employees Overhead allocated and apportioned $28,500 $18,300 $8,960 $8,400 The overhead cost of the canteen is to be re-apportioned to the production cost centres on the basis of the number of employees in each production cost centre. After the re-apportionment, the total overhead cost of the packing department, to the nearest $, will be A $1,200 B $9,968 C $10,080 D $10,160 (2 marks) 8.22

132 8: QUESTIONS 8.13 Actual overheads $496,980 Actual machine hours 16,566 Budgeted overheads $475,200 Based on the data above, and assuming that the budgeted overhead absorption rate was $32 per hour, the number of machine hours (to the nearest hour) budgeted to be worked were hours. (2 marks) 8.14 A company absorbs overheads on a labour hours basis. Budgeted labour hours were 28,800 and budgeted overheads were $633,600. Actual results were 28,000 hours and overheads of $676,800. Overheads were under/over absorbed by $ (2 marks) 8.15 ABC Limited has recorded the following data in the two most recent periods: during period 1, costs totalling $13,500 were incurred in making 700 units and during period 2, costs totalling $18,300 were incurred in making 1,100 units. The best estimate of ABC Limited's fixed costs per period is A $5,100 B $4,800 C $13,500 D $15,900 (2 marks) The following question has been included specifically to aid your understanding of Absorption costing as a full technique. It is not in the format of an exam question The AB Company has two departments, A and B, engaged in manufacturing operations and they are serviced by a stores, a maintenance department and a tool room. The following has been budgeted for the next financial period: Total Tool Overheads A B Stores Maint. room $ 000 $ 000 $$ 000 $ 000 $ 000 $ 000 Indirect labour 1, Supervision 140 Power 160 Rent 280 Rates 112 Plant insurance 40 Plant depreciation 20 2,

133 8: QUESTIONS Additional information available includes: A B Stores Maint. Tool room Floor area (square metres) 1,000 2,500 1, Number of employees Power (kilowatt hours) 60,000 30,000 3,000 15,000 12,000 Number of material requisitions 5,000 6,000-2,000 3,000 Maintenance hours 8,000 9, ,000 Plant valuation ( ) 50,000 40,000-5,000 5,000 Tool room hours estimated 7,000 10, Machine hours estimated 55,200 99, Required Using the information provided apportion the overhead costs to the various cost centres (Step 1 of AC). Once that is done practice reapportioning from the service to the production cost centres (Step 2 of AC). Practice calculating the overhead absorption rate for departments A and B using machine hours as the activity. 8.24

134 Chapter 8: Answers 8.27

135 8: ANSWERS 8.1 D W X Y Z Y (3:2:1) (600) Z (40:60) (900) 1,160 1, A Overhead absorption rates are determined in advance for each period, usually based on budgeted data. Therefore statement (i) is correct and (iii) is incorrect. OARs are used to absorb overheads into product costs therefore (ii) is correct. (iv) is incorrect as overheads are controlled by budgets and other management information. 8.3 D Under-absorption will be because of both these factors. 8.4 B OAR = $2/unit ($10,000/5,000). Absorbed overhead = $9,200 (4,600 $2). 8.5 A $ Actual overheads 343,825 Over absorbed overheads 14,025 Overhead recovery for 21,050 hrs 357,850 Therefore overhead absorption rate 357,850/21,050 = $17 per hour. Budgeted labour hours = Budgeted overheads/overhead absorption rate = $340,000/$17 = 20,000 hrs 8.6 A Overhead absorption rate = Budgeted overheads/ Budgeted machine hours = $258,750 / 11,250 machine hour = $23 per machine hour Actual hour = 10,980 hours 10,980 $23 = $252,540 absorbed This is $254,692 $252,540 = $2,152 under-absorbed 8.7 B Total labour hours for production: X = 1,000 units 2 = 2,000 hr Y = 800 units 3 = 2,400 hr 4,400 hr Budget rate/hr 15,400 = 4, /hr 8.28

136 8: ANSWERS 10, A Overhead absorption rate = = 2/unit 5,000 Overhead actually absorbed = 6,200 $2/unit = $12,400 Overhead actually incurred = $11,500 Over-absorption = $ 900 Expenditure variance = $11,500 actual - $10,000 budgeted = $1,500 Under Volume variance = (6,200 actual - 5,000 units budgeted) $2/unit = $2,400 Over Equalling total variance of $ 900 Over 8.9 A The budgeted machine hours equals the total overheads divided by the OAR Machining hours 1.5 4,000 = 6,000 hours Assembly hours ,000 = 1,800 hours $120,000 Machining rate = = $20 6,000 $72,000 Assembly rate = = $40 1, Pye = (0.5 $20) + (0.20 $40) = $ D Example Overhead Account $ $ Actual 190,000 Absorbed costs 180, P&L (under absorption) 10, , , D Number of employees in packing department = 2 direct + 1 indirect = 3 Number of employees in all production departments = 15 direct + 6 indirect = 21 Packing department overhead $8,400 Canteen cost apportioned to packing department = 3 21 = $1,200 Original overhead allocated and apportioned = $8,960 Total overhead after apportionment of canteen costs = $10, The number of machine hours (to the nearest hour) budgeted to be worked were 14,850 hours. Budgeted hours = = Budgeted overheads Budgeted overhead absorptionrate $475,200 $32 = 14,850 hours 8.29

137 8: ANSWERS 8.14 Overheads were under absorbed by $ 60,800 OAR = Budgeted overheads Budgeted labour hours $633,600 = 28,800 $22 per labour hour $ Overhead absorbed = $22 28, ,000 Overhead incurred = 676,800 Under absorbed by 60, A Using High/Low method Units Costs ($) High 1,100 18,300 Low ,500 Difference 400 4,800 Variable cost per unit = = $12 per unit $4, units 18,300 = Fixed cost + ($12 1,100) 18,300 = FC + 13,200 FC = $5, The AB Company Item of Basis of Tool cost apportionment Total A B Stores Maintenance room $ 000 $ 000 $ 000 $ 000 $ 000 $$ 000 Allocation and apportionment Indirect labour Allocation 1, Supervision No of employees Power Kilowatt hours Rent Floor area Rates Floor area Plant insurance Plant valuation Plant depreciation Plant valuation , , Reapportionment Stores* No of material (240) requisitions Maintenance Maintenance hours (230) 60 Tool room Tool room hours (289) Total overhead 1,104 1,485 Absorption Machine hours 55,200 99,000 Machine hour absorption rate $20 $15 *The stores costs were apportioned before the maintenance and tool room costs because the latter two departments made use of stores services and therefore had to receive a charge from the stores before they were in turn re-apportioned. Similarly, the maintenance cost centre was re-apportioned next, to ensure that the tool room received the appropriate charge before it too was closed and re-apportioned. END OF CHAPTER 8.30

138 Marginal and absorption costing Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: Explain the importance of and apply the concept of contribution. Demonstrate and discuss the effect of absorption and marginal costing on inventory valuation and profit determination. Calculate profit or loss under absorption and marginal costing. Reconcile the profits or losses calculated under absorption and marginal costing. Describe the advantages and disadvantages of absorption and marginal costing. Exam Context Look out for questions in your examination which require you to calculate profit or losses using absorption and marginal costing and then reconcile the profits calculated under the two methods. Qualification Context As with Chapter 8, within the 'skills' Fundamentals level papers particularly F5 Performance Management, costing techniques within the modern business environment will be studied. These are often compared with the more traditional techniques of absorption costing and marginal costing. 9.1

139 9: MARGINAL AND ABSORPTION COSTING Overview Marginal an absorption costing Cost card under AC Cost card under MC CONTRIBUTION Profit/Loss under AC Profit/Loss under MC Reconciliations Advantages/disadvantages of AC and MC 9.2

140 9: MARGINAL AND ABSORPTION COSTING 1 Overview 1.1 Some businesses only want to know the variable costs of the units they make, regarding fixed costs as period costs. Marginal costing (MC) includes only the variable cost of a product or a service. That is a cost which would be avoided if the unit was not produced or provided. Cost card marginal costing $/unit Direct materials X Direct labour X Used to value Variable overhead X inventory under MC Marginal cost X Used to value Fixed overheads X inventory under AC Full profit cost X Recap 2 Contribution 2.1 Contribution is a fundamental concept in marginal costing. Contribution is an abbreviation of "contribution towards fixed costs and profit". It is the difference between selling price and all variable costs (including nonproduction variable costs), usually expressed on a per unit basis. $ $ Selling price X Less: Variable production costs X Variable non-production costs X (X) Contribution X 2.2 Note: Contribution takes account of all variable costs. Marginal cost takes account of variable production costs only and inventory is valued at marginal cost. 9.3

141 9: MARGINAL AND ABSORPTION COSTING 3 Calculating a profit or loss under marginal costing 3.1 Sales Less: variable cost of sales: Opening inventory X Production costs: Variable X X Less: closing inventory Less: Variable selling, distribution and administration costs CONTRIBUTION Less fixed costs: Production Selling and distribution Administration NET PROFIT Note: Inventories are valued at variable production costs only. Lecture example 1 $ $ X (X) X X X (X) X (X) X (X) X Preparation question Selling price $25. Cost card per unit: $ Direct materials 7 Direct wages 8 Variable production overheads 5 20 There is a variable selling cost per unit of $0.50. Year 1 Year 2 units units Normal/budgeted production 12,000 12,000 Actual production 14,000 11,500 Actual sales 13,000 12,500 Actual fixed production overheads $11,000 $11,000 Actual fixed selling costs $5,000 $5,000 There is no opening inventory. All variable costs were as per budget for the two years. Required Set out a profit and loss account under marginal costing for both years 1 and

142 9: MARGINAL AND ABSORPTION COSTING Solution Year 1 Year 2 $ $ $ $ Sales Less: variable cost of sales Opening inventory Production costs variable Less: closing inventory Less: variable selling costs Contribution Less: fixed costs Production Net profit Workings Selling 9.5

143 9: MARGINAL AND ABSORPTION COSTING 4 Calculating a profit or loss under absorption costing 4.1 Sales Less: cost of sales: Opening inventory Production costs: Variable costs Fixed overhead absorbed Less: closing inventory Fixed overhead under/(over) absorbed GROSS PROFIT Less: Selling, administration etc costs (non production) NET PROFIT Note: Inventory is valued at full production cost. Lecture example 2 $ $ X X X X X (X) X X/(X) (X) X (X) X Preparation question (Information as per Lecture example 1) Selling price $25. Cost card per unit: $ Direct materials 7 Direct wages 8 Variable production overheads 5 Fixed production overheads There is also a variable selling cost per unit of $0.50 Year 1 Year 2 units units Normal/budgeted production 12,000 12,000 Actual production 14,000 11,500 Actual sales 13,000 12,500 Actual fixed production overheads $11,000 $11,000 Actual fixed selling costs $5,000 $5,000 There is no opening inventory. All variable costs were as per budget for the two years. Required $ (a) What are the total budgeted fixed production overhead? (b) Set out a profit and loss account under absorption costing for years 1 and 2 using the proforma given. 9.6

144 9: MARGINAL AND ABSORPTION COSTING Solution Sales Year 1 Year 2 $ $ $ $ Less: cost of sales Opening inventory Production costs Variable Fixed overhead absorbed Less: closing inventory Fixed overhead under/(over) absorbed Gross profit Less: selling costs Net profit Working 9.7

145 9: MARGINAL AND ABSORPTION COSTING 5 Reconciliation of absorption and marginal costing profits 5.1 Year 1 Year 2 Year 3 $ $ $ Absorption costing 43,400 39,350 82,750 Marginal costing 42,500 40,250 82, (900) - Overall the same profit is recognised The difference arises from different inventory valuations. (Absorption costing inventory valued at $20.90 per unit and marginal costing inventory valued at $20 per unit.) Lecture example 3 Reconcile the profit figure using the following proforma. Solution Preparation question Absorption costing profit Add: fixed overheads b/f in opening inventory Year 1 Year 2 $ $ Less: fixed overheads b/f in closing inventory Marginal costing profit 5.2 Profits generated using AC and MC can also be reconciled as follows: Difference in the profit = Change in stock in units x OAR per unit To work out which profit figure is higher compare: Production vs Sales Closing inventory vs Opening inventory AC profit vs MC profit This is useful for multiple choice questions. 9.8

146 9: MARGINAL AND ABSORPTION COSTING 6 Absorption costing vs marginal costing Absorption costing Marginal costing Recognises that selling price Highlights contribution so must cover all costs. appropriate for decision making. Complies with IAS 2. Fixed costs treated in accordance with their nature. Profits can be manipulated by Profit depends on sales and changing production levels. efficiency not production levels. Based on the assumption that Danger that contribution fails to overheads are volume related. cover fixed costs. Does not comply with IAS 2 Necessitates analysis of mixed costs between fixed and variable 7 Chapter summary The marginal cost is the variable cost of one unit. Contribution is the amount that a unit when sold contributes towards fixed costs. In marginal costing fixed costs are treated as period costs. In absorption costing fixed costs are absorbed into the units and carried forward with closing inventory. 8 Formula summary Contribution = SP ALL VC. Difference in profit = Change in inventory x OAR Under AC and MC in units per unit 9.9

147 9: MARGINAL AND ABSORPTION COSTING 9.10

148 Chapter 9: Questions 9.11

149 9: QUESTIONS 9.1 If a company increases its inventory during the period which of the following statements is true? A B C Absorption costing will produce lower profits than marginal costing Absorption costing will produce higher profits than marginal costing Absorption costing profits will be the same as marginal costing profits D There is not enough information to know which method has the highest profits (1 mark) 9.2 When opening inventories were 8,500 litres and closing inventories 6,750 litres, a firm had a profit of $62,100 using marginal costing. Assuming that the fixed overhead absorption rate was $3 per litre, what would be the profit using absorption costing? A $41,850 B $56,850 C $67,350 D $82,250 (2 marks) 9.3 The cost structure for a product is as follows: Product Per unit $ Selling price 30 Variable production costs 9 Fixed production costs 6 Total production costs 15 Non-production overheads: Variable 2 Fixed 3 Total cost 20 What is the contribution per unit? A $10 B $15 C $19 D $21 (2 marks) 9.12

150 9: QUESTIONS 9.4 A firm has started to produce a single product with a unit selling price of $25. In the first year of production standard capacity was 100,000 units, production was 110,000 units and sales were 90,000 units. The actual costs incurred were: Fixed Variable Materials and labour $10 per unit Factory overhead $300,000 $5 per unit Selling and admin expenses $100,000 $2 per unit What would be the values of net income, calculated using the different bases of marginal costing and absorption costing? Using marginal costing Using absorption costing $ $ A 20,000 (40,000) loss B 20,000 80,000 C 320, ,000 D 320, ,000 (2 marks) 9.5 A company produces a single product for which cost and selling price details are as follows. $ per unit $ per unit Selling price 28 Direct material 10 Direct labour 4 Variable overhead 2 Fixed overhead 5 21 Profit per unit 7 Last period, 8,000 units were produced and 8,500 units were sold. The opening inventory was 3,000 units. Actual fixed overhead costs for the period were $42,000. The profits reported using an absorption costing system would be $ (2 marks) 9.6 In a period, opening inventories were 12,600 units and closing inventories 14,100 units. The profit, based on marginal costing, was $50,400 and profit using absorption costing was $60,150. The fixed overhead absorption rate per unit is A $4.00 B $4.27 C $4.77 D $6.50 (2 marks) 9.7 In a period, opening inventories were 10,000 units and closing inventories 11,000 units. Profits, based on marginal costing, were $100,000 and profit under absorption costing was $105,000. The fixed overhead absorption rate per unit is A $0.50 B $5.00 C $4.50 D $5,000 (2 marks) 9.13

151 9: QUESTIONS Data for questions 9.8 and 9.9 Last year, a firm started to produce a single product with a unit selling price of $14. In the first year of operation standard capacity was 50,000 units, production was 50,000 units, and sales were 40,000 units. The actual costs incurred were: Fixed Variable Raw materials $3.00 per unit produced Direct labour $2.00 per unit produced Factory overhead $200,000 $1.00 per unit produced Selling and administrative expenses $80,000 $1.00 per unit sold 9.8 Using absorption costing, what was the unit cost of closing inventory? A $5.00 B $6.00 C $10.00 D $13.00 (2 marks) 9.9 What would be the value of net income using absorption costing? Using absorption costing $ A 40,000 profit B 64,000 profit C 40,000 loss D 64,000 loss (2 marks) 9.14

152 9: QUESTIONS The following question has been included specifically to aid your understanding of Absorption costing as a full technique. It is not in the format of an exam question Product Omega Preparatory question A firm manufactures and sells a single product Product Omega Product Omega per unit Selling price $30 Direct costs $8 Details for the months of September and October are as follows: September October Production of Omega 750 units 1,000 units Sales of Omega 600 units 1,150 units Fixed production overheads $4,500 $4,500 There was no opening stock at the beginning of September. The normal level of activity for both sales and production is 900 units per month. Fixed production overheads are budgeted for $4,500 per month and are absorbed on a unit basis. Required Try preparing for September and October profit statements showing stock valuations, based on the principles of: (i) (ii) absorption costing; marginal costing. See if you can reconcile the different profits calculated for absorption and marginal costing. 9.15

153 9: QUESTIONS 9.16

154 Chapter 9: Answers 9.17

155 9: ANSWERS Chapter B If inventories are rising, closing inventory is greater than opening inventory. Using absorption costing fixed overheads will be included in the closing inventory valuation closing inventory value is higher using absorption costing cost of sales is lower using absorption costing profits are higher using absorption costing 9.2 B $ Opening inventory (8,500) Closing inventory 6,750 Change in inventory (1,750) x overhead absorption rate $3 Amount of overhead absorbed, thus reducing profit by this amount $5,250 Profit = 62,100 5,250 $56, C $ Selling price 30 Variable production costs (9) Variable non-production costs (9) Contribution per unit D Marginal costing: Contribution 9.5 = selling price variable costs = = 8 $ Total contribution ($8 x 90,000) 720,000 Less: fixed production costs (300,000) fixed selling & admin expenses (100,000) Net profit 320,000 Absorption costing is higher by: 20,000 units of inventory x OAR per unit 300,000 = 20,000 x 100,000 = $60,000 Absorption costing profit = 320, ,000 = $380,000 $ $ Sales (8,500 $28) 238,000 Cost of sales: Opening inventory (3,000 $21) 63,000 Production costs (8,000 $21) 168,000 Closing inventory (2,500 $21) (52,500) Under-absorption of fixed overheads [(8,000 5) 42,000] 2,000 (180,500) Profit 57,

156 9: ANSWERS 9.6 D Units Opening inventory 12,600 Closing inventory 14,100 Increase in inventory level 1,500 $ Absorption costing profit 60,150 Marginal costing profit 50,400 Difference in profit 9,750 Therefore overhead rate = $9,750/1,500 = $6.50 per unit 9.7 B The difference in profits is due to fixed overheads in opening/closing inventory. 1,000 extra units of inventory led to a $5,000 difference in profits. Therefore each unit of inventory has $5 of fixed overheads. 9.8 C 9.9 A $ Materials 3 Labour 2 Factory - variable 1 Factory - fixed ,000 / 50, $ $ Sales (40,000 x $14) 560,000 Variable production costs [50,000 x ($3 + $2 + $1)] 300,000 Fixed production costs 200,000 Less: closing inventory 10,000 x $10 (100,000) (400,000) Gross profit 160,000 Less: variable selling expenses 40,000 x $1 (40,000) Less: fixed selling expenses (80,000) Net profit 40,

157 9: ANSWERS $4, (i) Fixed production overhead absorption rate = = $5 per unit 900 Profit Statements Using Absorption Costing September October $ $ $ $ $ $ $ Sales revenue (W1) 18,000 34,500 Cost of goods sold: Opening stock 1,950 Direct cost (W2) 6,000 8,000 Fixed production overhead absorbed (W3) 3,750 5,000 9,750 14,950 Less closing stock (W5) (1,950) 7,800 14,950 Under/(over) absorbed production o/h (W4) 750 (8,550) (500) (14,450) Profit 9,450 20,050 (W1) Sales: September = 600 $30 October = 1,150 $30 (W2) Direct costs: September = 750 $8 October = 1,000 $8 (ii) (W3) Fixed production overhead: September = 750 $5 October = 1,000 $5 (W4) Under/(over) absorption: September = $4,500 $3,750 October = $4,500 $5,000 (W5) Closing stock: September = 150 units $(8 + 5) Profit Statements Using Marginal Costing September October $ $ $ $ Sales revenue 18,000 34,500 Variable cost of goods sold: Opening stock 1,200 Direct costs 6,000 8,000 6,000 9,200 Less closing stock (150 $8) (1,200) (4,800) (9,200) Contribution 13,200 25,300 Fixed production overhead 4,500 4,500 Profit 8,700 20,800 September October $ $ Absorption costing profit 9,450 20,050 Less: fixed overhead c/f in closing stock (150 $5) (750) Add: fixed overhead b/f in opening stock (150 $5) 750 Marginal costing profit 8,700 20,800 END OF CHAPTER 9.20

158 Process costing Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: Describe the characteristics of process costing. Describe the situations where the use of process costing would be appropriate. Explain the concepts of normal and abnormal losses and abnormal gains. Calculate the cost per units of process outputs. Prepare process accounts involving normal and abnormal losses and abnormal gains. Calculate and explain the concept of equivalent units. Apportion process costs between work remaining in process and transfers out of a process using the weighted average and FIFO methods. Prepare process accounts in situations where work remains incomplete. Prepare process accounts where losses and gains are identified at different stages of the process. Note: Situations involving WIP and losses in the same process are excluded. Exam Context Process costing has historically been a common examination question. You might be required to do calculations for completion of a process account. Make sure that you can deal with losses, gains, scrap and WIP. Qualification Context Modern costing techniques, such as backflush accounting, are tested within the F5 Performance Management syllabus and are often compared to traditional process costing techniques. 10.1

159 10: PROCESS COSTING Overview Process costing General principles of process costing with no losses Abnormal loss or gain Work in progress Normal losses Closing WIP Opening WIP Without scrap value With scrap value Subsequent/previous processes 10.2

160 10: PROCESS COSTING 1 General principles Introduction 1.1 Process costing is a costing system used in situations where goods or services are produced in a series of processes. The essence of process costing involves the averaging of the total costs of each process over the total output of that process. It is not an alternative to absorption costing or marginal costing. 1.2 Examples of processes where process costing may be used are: Oil refining Paper Food and drink Chemicals Inputs Process 1 Good output Cost per unit = Input costs Units Process costing no losses Lecture example 1 Preparation question Input to Process I during a period was 1,000 units of raw materials, cost $40,000. Other costs were: labour $50,000, overheads $20,000. All output was transferred to Process II. Required Complete the process account. Solution Unit calculation: Input units = Good output 10.3

161 10: PROCESS COSTING PROCESS I Units $ Units $ Workings 2 Normal loss with no scrap value Definition 2.1 Normal loss is the loss that is expected from a businesses experience of the process eg. wastage or evaporation. Good output Inputs Process 1 Normal loss - expected Lecture example 2 Preparation question Input and costs same as in Lecture example 1. Losses normally account for 10% of input. Output was 900 units. Required Prepare the Process I ledger account 10.4

162 10: PROCESS COSTING Solution Unit calculation: Input units = Good output + Normal loss Process I Units $ Units $ 3 Normal loss with a scrap value 3.1 Any proceeds we receive for the normal loss can be used to reduce the processing costs. Input cost - scrap value of normal loss Cost per unit = Input units - normal loss units 3.2 Normal loss can be calculated in several ways, depending on the normal expectation of the process: (a) % of input (most common) this means materials input only not opening WIP; (b) % of throughput = opening WIP + materials input closing WIP; (c) % of good output (d) % of total output = good output + losses. 10.5

163 10: PROCESS COSTING Lecture example 3 Preparation question Required Prepare the Process and Scrap ledger accounts for the following situations using data as in Lecture example 1. Solution (a) All scrapped units have a scrap value of $20 each. Note: The unit calculation will be as per Lecture example 2. Process I Units $ Units $ Scrap Account Units $ Units $ (b) Suppose that the scrap merchant does not pay $20 per unit as anticipated, but only $19. Then the losses a/c will look like: Scrap Account Units $ Units $ 10.6

164 10: PROCESS COSTING 4 Abnormal loss or gain 4.1 An abnormal loss or gain occurs when the actual loss is different to expected loss. Good output (hopefully!) Inputs Process 1 Normal loss Expected Abnormal loss Or NOT Abnormal gain expected Abnormal loss 4.2 This is the excess of actual spoilage over normal spoilage. The abnormal loss should be valued at the same cost per unit as a good unit and any losses or gains taken to the income statement for the period. Lecture example 4 Preparation question As before, but output to Process II is 880 units not 900 units as expected. Required Prepare appropriate ledger accounts. 10.7

165 10: PROCESS COSTING Solution Unit calculation: Input units = Good output + Normal loss + /- Abnormal loss/(gain). Process I Units $ Units $ Scrap Account Units $ Units $ Abnormal Losses/Gains Account Units $ Units $ Abnormal gains 4.3 This is the shortfall of actual spoilage from normal spoilage. It is treated in the same way as the abnormal loss. (Actual loss is less than the normal loss expected.) 10.8

166 10: PROCESS COSTING Lecture example 5 Preparation question As before but output to process II is 920 units, not 900 units as expected. Required Prepare appropriate ledger accounts. Solution Unit calculation Process I Units $ Units $ Scrap Account Units $ Units $ Abnormal Losses Account Units $ Units $ 10.9

167 10: PROCESS COSTING 5 Subsequent processes 5.1 Costs in each process include the full cost of material inputs from previous processes. Good output Process 2 Inputs Process 1 Normal loss (to scrap a/c) Abnormal loss/gain (to abnormals a/c) 5.2 Labour and overhead costs together are called conversion costs. Lecture example 6 Preparation question The output from process I (from Lecture example 5 (920 units with a value of $110,400) is input to process II. Normal loss in process II is 10% of good output and has no scrap value. Output from process II is 900 units. Other inputs to process II are: Added materials $20,600 Conversion $35,000 Required Prepare appropriate ledger accounts given the above information. Solution Unit calculation Process II Units $ Units $ 10.10

168 10: PROCESS COSTING Scrap Account Units $ Units $ Abnormal Losses Account Units $ Units $ 6 Work in progress 6.1 At the end of the accounting period we may have two types of output from the process: (a) Fully completed good output. (b) Output that we have not had time to finish. This partially completed output is known as work in progress (WIP). Valuing WIP 6.2 If we compare the value of one unit of WIP with the value of one unit of good output the value of the unit of WIP will be less than the value of one unit of good output. This is because WIP is only partially completed. To make comparison easier we restate partially completed units in terms of equivalent whole units

169 10: PROCESS COSTING Lecture example 7 Preparation question Finished goods 200 units Input costs $250 Input units 300 PROCESS Required WIP 50% complete 100 units (a) (i) Using the usual cost per unit calculation, what would the cost per unit be? $ (ii) What would the value of WIP be? $ (iii) What would the value of finished goods be? $ (b) (i) Using equivalent units, what would the cost per equivalent be? (ii) What would the value of WIP be? $ (iii) What would the value of finished goods be? $ $ Working 10.12

170 10: PROCESS COSTING 7 Closing WIP (no opening WIP) Lecture example 8 Preparation question The following are introduced into Process I. Raw materials 1,500 units $12,975 Labour $9,576 Overheads $3,156 Normal loss is 10% of input with a scrap value of $1/unit. Closing WIP: 50 units completed as below Raw materials Labour Overheads The output was as expected. Required 100% complete 60% complete 30% complete Prepare appropriate ledger accounts given the information above. (a) Unit calculation: Input units = Good output + Normal + /- Abnormal + Closing Loss Loss / (gain) WIP Raw materials Labour Overheads Process I Units $ Units $ Output to Process II Normal loss (b) Complete the statement of equivalent units Total Materials Labour Overheads Finished output Normal loss Closing WIP 10.13

171 10: PROCESS COSTING (c) What is the cost per equivalent unit for the following? Materials Labour Overheads Workings Valuations (d) The value of finished goods is The value of closing WIP is Workings 10.14

172 10: PROCESS COSTING 8 Opening and closing WIP 8.1 The closing WIP from one accounting period will become the opening WIP in the next. There are two methods that we can use when there is opening WIP. 8.2 (a) FIFO (b) Assumes that opening WIP is completed first; Spreads costs incurred in the period over work done in that period; ie. (i) FG/output (started and finished) (ii) Opening WIP (finished) (iii) Closing WIP (started) and then add on the opening WIP costs to the sum of (i) and (ii) to give the total costs of finished output. Weighted average all items are equally likely to be completed; spread all costs (including those b/fwd in opening WIP) over all units. Lecture example 9 Preparation question Same process as Lecture example 8 but for the following period: Raw materials 2,050 units $22,140 Labour $16,497 Overheads $9,240 Normal loss 10% of input. Scrap value $1 each. Opening WIP: 50 units Output from Process I : 1,815 units Closing WIP: 80 units complete as below Raw materials 100% complete Labour 60% complete Overheads 60% complete Required Prepare a Process I ledger account using (a) FIFO and (b) weighted average methods. (a) FIFO Unit calculation: Opening + Input = Good output + Normal + / - Abnormal + Closing WIP WIP Units loss loss/(gain) Note: Exam questions will not contain both WIP and abnormal gains or losses 10.15

173 10: PROCESS COSTING Opening WIP b/f Raw Materials Labour Overheads Process I Units $ Output to Process II Normal loss Closing WIP c/f Units $ Statement of equivalent units Total Materials Labour Overheads Opening WIP Goods started and finished Good output Normal loss Closing WIP Costs per equivalent unit Materials Labour Overheads Workings Valuations Good output Closing WIP 10.16

174 10: PROCESS COSTING Workings (b) Weighted average Note: Everything will be the same up until doing the statement of equivalent units. Process I Units $ Units $ Opening WIP b/d Normal loss Raw materials 2,050 22,140 To Process II 1,815 Labour 16,497 Closing WIP c/d 80 Overheads 9,240 Abnormal gain 2,100 2,100 Statement of equivalent units Total Materials Labour Overheads Good output Normal loss Closing WIP Costs per equivalent unit Materials Labour Overheads Workings 10.17

175 10: PROCESS COSTING Valuations Good output Closing WIP Workings 9 Previous processes 9.1 The output from one process may undergo further processing in a subsequent process. Say we have Process I and Process II. The output from Process I becomes an input into Process II. So in Process II we may have: opening WIP, materials from Process I, added materials, and conversion costs. All WIP in Process II must by definition be 100% complete in terms of Process I inputs (the Process I material). 10 Further points FIFO or weighted average? 10.1 Questions will not always state which method to use. You can make this choice by looking at how the opening WIP is quoted

176 10: PROCESS COSTING Information about opening WIP includes: (1) % complete materials % complete conversion Total cost brought forward (2) No % complete information Total cost brought forward broken down into: $ materials $ conversion FIFO Method Weighted Average Method 11 Chapter summary Process costing can be used in a situation where it is not possible to identify separate units of production. Expected losses are called normal losses. During the process abnormal gains or losses may occur, when the actual loss differs to the expected loss. Opening and closing WIP can be accounted for using either the FIFO or weighted average method. Question approach: (1) Determine output/losses and WIP units. (2) Set up account and fill out easy parts. ie. units and value of normal loss (3) Calculate the cost per equivalent unit. (4) Complete accounts. 12 Formula summary Unit calculation: Opening WIP + Input units = Good + Normal +/- Abnormal + Closing WIP output loss loss/(gain) Cost per unit (used when no WIP) Input cost - scrap value of normal loss CPU = Input units - normal loss units 10.19

177 10: PROCESS COSTING 10.20

178 Chapter 10: Questions 10.21

179 10: QUESTIONS 10.1 An abnormal loss would arise when (i) total losses are less than expected (ii) total losses are greater than expected (iii) total output is less than expected (iv) total output is greater than expected Which one of the following is correct? A (i) only B (i) and (ii) C (ii) and (iii) D (iii) and (iv) (2 marks) 10.2 The correct accounting treatment for a normal loss would be A normal loss would be valued in the same way as good output and debited from the process account B any scrap value associated with normal loss would be entered as a credit in the process account (1 mark) 10.3 How would an abnormal gain be accounted for in the process account? A An abnormal gain would be valued at scrap value and debited from the process account B An abnormal gain would be valued in the same way as good output and debited to the process account C An abnormal gain would be valued in the same way as good output and credited to the process account (1 mark) The following information relates to questions 10.4 and 10.5 Scaramanger Ltd is a manufacturer specialising in metallic paint finishes. During the previous month, 15,000 units of raw materials costing $18,000 had been introduced to the process and labour and overhead costs of $8,220 had been incurred. There was no opening WIP at the start of the month, but 4,000 units were only 70% complete at the end of the period The cost per equivalent unit for this process, assuming no losses were expected or incurred is $ (2 marks) 10.5 How many equivalent units of closing WIP were there in the period, assuming no losses were expected or incurred? A 1,200 B 2,800 C 4,000 D 10,500 (2 marks) 10.22

180 10: QUESTIONS The following information relates to questions 10.6 to 10.8 Bell Ltd makes one product and uses process costing to account for costs. During January, 10,000 units of material were input to the process at a cost of $20,000 and conversion costs of $10,000 were incurred. At the end of the period 8,500 units were transferred to finished goods, but the remaining units were only 60% complete. There was no opening work in progress for January and no losses were expected or experienced The value of closing WIP shown in the account (to the nearest $) is (2 marks) A $2,871 B $4,785 C $4,500 D $2, What was the cost per equivalent unit (to the nearest penny) for the period? A $2.13 B $3.00 C $3.19 D $ How many equivalent units of closing WIP were there? A 600 B 900 C 1,500 D 5,100 (2 marks) (2 marks) 10.9 A company which produces high-class perfumes, has a production schedule for April showing that 5,000kg of materials were input to the process. These cost an average of 50 cents per kg. Other costs for the month amounted to $1,500. It is generally expected that 20% of materials input will be lost due to spillage and that the waste can be sold for 20 cents per kg. Output from this process was 3,800kg for April. What is the total abnormal loss in kg for April? A 1,200kg B 4,000kg C 1,000kg D 200kg (2 marks) 10.23

181 10: QUESTIONS The following information relates to questions and A factory makes moulded plastic pet toys. During August, work commenced on 20,000 Christmas novelty toys. At the start of the month there were no partly finished toys but at the end of the month there were 2,000 units which were only 40% complete. Costs in the month were $3,722, How many equivalent units of closing WIP were there in the month? A 20,000 B 2,000 C 18,000 D 800 (2 marks) What is the total value of fully completed output which would show in the process account? A $3,960,000 B $3,564,000 C $3,722,400 D $3,350,160 (2 marks) With regard to normal losses, which of the following statements is true? A Normal losses always occur in a production process B The normal loss is the number of rejected outputs from a process C Normal loss units are valued at their scrap value in the process account (1 mark) During a particular period inputs to process I were as follows: Materials 1,000 units $9,000 Labour $8,750 Overhead $4,375 There was no opening WIP at the start of the period. Normal loss is expected to be 10% of input materials and 930 units were output to process II. Closing work in progress was 50 units completed as follows: Materials 100% Labour 50% Overhead 50% There are no scrap proceeds from losses. What is the value of closing WIP at the end of the period? A $900 B $915 C $875 D $1,010 (2 marks) 10.24

182 10: QUESTIONS The following question has been included specifically to aid your understanding of Process costing as a full technique. It is not in the format of an exam question The following data relates to the current period for a single manufacturing process of Harty Fisherlin Gredients Ltd. Opening work-in-progress of 1,000 units, valued at 1,595 and complete as follows: Materials input from previous process 100% Materials added 75% Labour 40% Overhead 20% Costs during the period were: Material input from previous process 8,000 units at 90c per unit Material added $3,870 Direct labour $2,640 Overhead $1,980 Closing work-in-progress: complete as follows: 2,000 units Material input from previous process 100% Material added 50% Labour 40% Overhead 30% Required Prepare the process account for the period

183 10: QUESTIONS 10.26

184 Chapter 10: Answers 10.27

185 10: ANSWERS Chapter C (ii) If more losses have been incurred than expected the loss is abnormally high. (iii) If output is less than expected, losses must be higher than expected B Normal loss would be entered as a credit in the process account at scrap value B An abnormal gain would be valued in the same way as good output and would be entered as a debit in the process account Total number of equivalent units = 1,000 fully completed + 4,000 70% completed = 11, ,800 = 13,800. Cost per equivalent unit = ($18,000 + $8,220)/13,800 = $ B Total number of closing WIP equivalent units = 4,000 70% completed = 2, A Total equivalent units = 8,500 finished goods + 60% 1,500 closing WIP = 8, = 9,400. Total cost = $20,000 + $10,000 = $30,000. Cost per equivalent unit = $30,000/9,400 = $ = $2, C Total equivalent units = 8,500 finished goods + 60% 1,500 closing WIP = 8, = 9,400. Total cost = $20,000 + $10,000 = $30,000. Cost per equivalent unit = $30,000/9,400 = $ B Total number of incomplete units = input output = 10,000 8,500 = 1,500. These were only 60% complete, therefore equivalent units of closing WIP 1, % = D Normal loss in the period = 5,000kg x 20% = 1,000kg. Expected good output = Inputs Normal loss = 5,000kg 1,000kg = 4,000kg. Abnormal loss = Expected output Actual output = 4,000kg 3,800kg = 200kg D Equivalent units of Closing WIP 40% of 2, B Total finished output = total inputs WIP = 20,000 2,000 = 18,000; Total equivalent units = 18, % + 2,000 40% = 18, = 18,800; Total cost = $3,722,400 thus cost/eu = $3,722,400/18,800 = $198; Valuation of completed output = 18,000 units $198 = $3,564, C Revenue from the sale of normal loss units is used to reduce the total costs of production, and thus normal loss units are included in the process account at their scrap value C Equivalent units table Total Materials Labour Overhead Good output to process II Closing WIP Normal loss Abnormal gain (80) (80) (80) (80) 1, Costs $9,000 $8,750 $4,375 Cost per unit $10 $10 $5 Valuation of closing WIP $ Material 50 x $ Labour 25 x $ Overhead 25 x $

186 10: ANSWERS Harty Fisherlin Gredients (W1) Statement of equivalent units Previous process Added Total materials materials Labour Overheads Opening WIP 1, (to complete) (0%) (25%) (60%) (80%) Started & finished 6,000 6,000 6,000 6,000 6,000 (W) Output 7,000 Closing WIP 2,000 2,000 1, (to start) (100%) (50%) (40%) (30%) (W2) (W3) 9,000 8,000 7,250 7,400 7,400 Cost per EU Previous process Added Labour Overheads materials materials $ $ $ $ Costs 7,200 3,870 2,640 1,980 Cost per EU $0.9 $0.53 $0.36 $0.27 Total cost per EU $2.06 Statement of valuation $ $ $ Good output opening WIP cost b/f 1,595 to complete materials added (250 $0.53) 133 labour (600 $0.36) 216 overheads (800 $0.27) started and finished units (6,000 $2.06) 12,360 14,520 Closing WIP $ Materials from previous process (2,000 $0.9) 1,800 Added materials (1,000 $0.53) 530 Labour (800 $0.36) 288 Overheads (600 $0.27) 162 2,780 Process Account Units $ Units $ Opening WIP b/f 1,000 1,595 Material input 8,000 7,200 Finished production Material added 3,870 transferred (W3) 7,000 14,520 Direct labour 2,640 Closing WIP c/f (W3) 2,000 2,780 Overheads 1,980 Rounding (15) Work-in-progress b/f 2,000 2,780 9,000 17,285 9,000 17,

187 10: ANSWERS END OF CHAPTER 10.30

188 Process costing, joint products and by-products Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: Distinguish between by-products and joint products. Value by-products and joint products at the point of separation. Prepare process accounts in situations where by-products and/or joint products occur. Exam Context This chapter is part of the topic process costing. The majority of questions relating to process costing may be from Chapter 10 but be prepared for some shorter questions in this area. Qualification Context Chapter 11 introduces the terminology of joint and by products that will be referred to within modern costing techniques at paper F

189 11: PROCESS COSTING, JOINT PRODUCTS AND BY-PRODUCTS Overview Processing costing, joint and by-products Joint products By products Accounting treatments Method of allocating costs Physical units Relative sales value 11.2

190 11: PROCESS COSTING, JOINT PRODUCTS AND BY-PRODUCTS 1 Introduction Joint and by-products Joint products Forestry Byproduct Joint products 1.1 Joint products are two or more products which are output from the same processing operation, but which are indistinguishable from each other up to their point of separation. They each have a substantial sales value either immediately or after further processing. By-product 1.2 These are products produced at the same time and in the same process as the joint products but are recognised by a relatively low sales value compared to the main product or joint products and are produced in much smaller volumes. They are secondary to the main products / processes. Lecture example 1 Preparation question State three examples of joint products and by-products. Solution 11.3

191 11: PROCESS COSTING, JOINT PRODUCTS AND BY-PRODUCTS 2 Treatment By-products 2.1 (a) Do not allocate joint costs to them. (b) (c) Joint products If usual occurrence then calculate net proceeds of by-products and reduce process costs by this amount. If one-off then calculate net proceeds and treat as miscellaneous income. 2.2 Cannot identify until split-off point. Therefore common costs incurred up to split-off point need to be apportioned on some basis to the joint products. Method of apportionment: (a) physical units (b) relative sales value 3 Physical units 3.1 Apportioning common costs on the basis of the proportion that the output of each product be as by weight or volume of output. Lecture example 2 Preparation question Process: P1 600 kg P2 1,200 kg By-product 200 kg for which we expect to realise $500. Required Allocate the joint costs on a physical units basis. 11.4

192 11: PROCESS COSTING, JOINT PRODUCTS AND BY-PRODUCTS Solution Process A/C Units $ Units $ Materials 2,000 2,000 Labour 2,000 Overheads 1, Physical units basis useful where: (a) the joint products are in the same form e.g. both solids or both liquids (b) the joint products are components in another product and therefore have no relevant sales value. 4 Relative sales value 4.1 The relative sales value method is the most commonly used method of apportioning joint costs. Lecture example 3 Preparation question From Lecture example 2 now suppose both products can be sold immediately. P1 sells at $2/kg P2 sells at $5/kg Required What is the profit on each under: (a) physical measurement apportionment? P1 $ P2 $ (b) relative sales value apportionment? P1 $ P2 $ 11.5

193 11: PROCESS COSTING, JOINT PRODUCTS AND BY-PRODUCTS Workings 4.2 Relative sales value basis is useful where: (a) products are to be sold immediately with no further costs being incurred (such as selling costs); (b) joint products are not in the same form of output. 5 Chapter summary Joint products are two or more products separated after a process, each of which has a significant value. A by-product is an incidental product from a process which has an insignificant value compared to the main product. The main methods of apportioning joint costs are: physical measurement relative sales value 11.6

194 Chapter 11: Questions 11.7

195 11: QUESTIONS 11.1 In a process account if by products normally occur they would be treated in the same way as a normal loss True False (2 marks) 11.2 If finished output from a process can be split into two joint products, one of which is a liquid and one a solid the best method for apportioning costs would be on a A volume basis B relative sales price basis (1 mark) 11.3 Costs allocated in total to two joint products are $100,000. Product 1 sells at $1.50 Product 2 sells at $1.60 The costs allocated to product 1 if a Sales Value method is used would be $ (2 marks) 11.8

196 Chapter 11: Answers 11.9

197 11: ANSWERS Chapter True 11.2 B If one is a liquid and one a solid it would not be possible to allocate costs on a volume basis Product 1 SP = = $100,000 = $48,000 END OF CHAPTER 11.10

198 Job and service costing Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: Describe the characteristics of job and batch costing. Describe the situations where the use of job or batch costing would be apportioned. Prepare cost records and accounts in job and batch costing situations. Establish job costs from given information. Identify situations where the use of service operation costing is appropriate. Illustrate suitable unit cost measures that may be used in different service/operation situations. Carry out service cost analysis in simple service industry situations. Exam Context Although a small part of the syllabus this is a popular topic for questions. Make sure that you are able to deal with basic calculations. Qualification Context This chapter introduces many tools that will be used throughout your studies including with the later strategic papers, such as mark-ups and margins and costing particular jobs. Business Context Many businesses will use these techniques when calculating charges to clients for work performed. 12.1

199 12: JOB AND SERVICE COSTING Overview Job and service costing Job and batch costing Service industry Cost card Composite cost units Service department costing Mark up Margin 12.2

200 12: JOB AND SERVICE COSTING 1 Job and batch costing Job and batch 1.1 A job is a cost unit that consists of a single order or contract. Each job is separately identifiable and costs can be attributed to each job i.e. construction of a rail link. A batch is a cost unit that consists of a separate, readily identifiable group of units, ie. production of 10,000 disposable razors. Here the cost of a single unit is too small to be measured in $ s. Lecture example 1 Preparation question Suggest three examples of businesses that use job costing. 1 Solution 2 3 Cost cards 1.2 A cost card can be drawn up for each job or batch using absorption costing or marginal costing techniques in the same way as for individual products. 1.3 A job cost card would look like: Direct materials Direct labour (hrs x $/hr) Prime cost Variable overheads (hrs x $/hr) Fixed overheads Total cost Profit Selling price of job Job XYZ $ X X X X X X X X The organisation may also absorb non-production overheads and include these in the estimate of the total jobs cost. 1.4 The profit on the job may be calculated in one of two ways. 12.3

201 12: JOB AND SERVICE COSTING Mark-up 1.5 A profit mark-up is calculated as a percentage of the total costs of the job. Margin For example a 20% mark up on a job with total costs of $20,000 would be calculated as follows: % $ Selling price ,000 Total cost (100) (20,000) Profit 20 4, A profit margin is calculated as a percentage of the selling price of the job. For example a 20% margin on a job with total costs of $20,000 would be calculated as follows: % $ Selling price ,000 Total costs (80) (20,000) Profit 20 5,000 Lecture example 2 Exam standard question each worth 2 marks A company is preparing for job X112. The job requires materials worth $1,350 and 150 hours of labour. Labour is paid at $6 per hour, variable overheads are absorbed at a rate of $2 per labour hour and fixed overheads at a rate of $3 per labour hour. Required (a) What is the selling price of job X112 if the company wants to earn a margin of 25%? $ (b) What is the selling price of job X112 if the company wants to earn of mark-up of 25%? $ Workings 12.4

202 12: JOB AND SERVICE COSTING Rectification costs 1.7 If the finished output is found to be substandard, it may be possible to rectify the fault. Rectification costs can be split into two categories: Rectification work that is not a frequent occurrence is charged as a direct cost to the job Rectification work that it a frequent occurrence is treated as a production overhead 2 Service industry costing Lecture example 3 Preparation question (a) How do service organisations differ to manufacturing organisations? Service Manufacturing Product Types of cost Cost unit Heterogenous/ homogenous (b) Examples of service organisations include: Lecture example 4 Preparation question Suggested cost units that might be used by the service industry companies listed below. Solution Service Road, rail and air transport services Cost unit Hotels Education Hospitals Catering establishments 12.5

203 12: JOB AND SERVICE COSTING 2.1 Cost per unit Total costs for period = Number of service units in the period 3 Charging customers for services 3.1 The procedure for charging customers for services is similar to that which applies in job costing. A mark up will be added to the cost per unit to give a selling price which will provide the required level of profit. 3.2 The choice of the cost unit by the organisation is important to ensure that an equitable charge is made to the users of the service. Composite cost units 3.3 These are used when a single measure would not be appropriate. For example, the charge for excess baggage on an airline might be based on. (a) how far in km baggage has to be transported. (b) how heavy the baggage is. Both of these will impact on the airline's fuel cost so it would be inappropriate to base the charge on either distance or weight alone. Clearly taking 10kg 100 km will cost less than taking 10kg 10,000 km. To take account of this, a composite cost unit is derived i.e. cost per kg per km. This will provide a method of comparing costs for any weight travelling any journey. Lecture example 5 In the last year the following information was collected: Total kg of excess baggage carried 100,000 kg Total miles excess baggage carried 30,000 miles Total cost incurred (eg extra fuel) $5m Required What is the cost of carrying an extra 3kg an extra 7,500 miles? Workings Exam standard question worth 2 marks $ 12.6

204 12: JOB AND SERVICE COSTING 4 Service department costing 4.1 Service department costing is used to establish a specific cost for an 'internal service' that is a service provided by one department for another, rather than one sold externally to customers. Service departments therefore include canteens and data processing departments. 4.2 Service department costing has two basic purposes: (a) (b) To control the costs and efficiency in the service department. To control the costs of the user departments, and prevent the unnecessary use of services. The bases for charging service costs to user departments 4.3 The cost of support services charged to user departments could be based on any of the following. (a) No charge at all (b) Total actual cost (c) Standard absorption cost (d) Variable cost (e) Opportunity cost (f) Cost plus a margin for profit 5 Chapter summary Job costing is a costing method applied where work is undertaken to customers' special requirements and each order is of comparatively short duration. The usual method of fixing prices when job costing is used is cost plus pricing. Batch costing is similar to job costing, however the cost of a batch is calculated rather than the cost of an individual unit. Service costing is used by companies operating is a service industry. The main difficulty is defining a realistic cost unit. 6 Formula summary Mark up Selling price 120% - set total costs Total costs 100% to 100% 20% Margin Selling price 100% - set selling price Total costs 80% to 100% Profit 20% Cost per unit Total costs for period = Number of service units in the period 12.7

205 12: JOB AND SERVICE COSTING 12.8

206 Chapter 12: Questions 12.9

207 12: QUESTIONS 12.1 For which of the following businesses is process costing more appropriate than job costing? A A manufacturer of newsprint B A civil engineering contractor C A publisher of text-books D An advertising agency (1 mark) 12.2 For which one of the following is it most appropriate to use job order costing? A A petroleum refinery B A manufacturer of personal computers C A firm of solicitors (1 mark) 12.3 A graphic designer uses Job Costing and recovers overheads based on direct labour hours. Three projects were worked on during a period, the details of which were: Project 1 $ Project 2 $ Project 3 $ Opening WIP 4, ,000 Material in period 8,575 14, Labour for period 6,250 11,500 2,250 The overheads for the period were exactly as budgeted $70,000. Project 3 was completed during the period and consisted of 250 identical designs. The firm adds 70% to total production costs to arrive at a selling price. What is the selling price of a design? A It cannot be calculated without more information. B $ C $ D $ (2 marks) 12.10

208 Chapter 12: Answers 12.11

209 12: ANSWERS 12.1 A B and D are examples of job costing C is an example of batch costing C Job costing is appropriate where each unit of work is tailored to individual customer requirements B Project 3 $ Opening WIP 23,000 Materials - Labour 2,250 Overheads $3.50 (W1) x 2,250 7,875 33,125 (W1) 70,000 6, , ,250 =$3.50 Selling price 170% 56, Costs 100% 33,125 Profit 70% Selling price per unit = 56, = $ END OF CHAPTER 12.12

210 Budgeting Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: Explain why organisations use budgeting. Explain the administrative procedures used in budgeting process. Describe the stages in the budgeting process. Explain the term 'principal budget factor'. Prepare budgets for sales, production, materials (usage and purchases), labour and overheads. Explain and prepare fixed, flexible and flexed budgets. Exam Context Budgeting is one of the key roles that a management accountant may perform and essential for planning and control within a business. You should make sure that you are happy with using the information from a cost card to prepare operating budgets. Qualification Context The fundamental aspects of budgeting learnt in this paper give the ground work for paper F5 Performance Management. At the higher level budgetary control, types of budgets, behavioural aspects of budgeting are looked at and flexed budgets are prepared as within the F2 Management Accounting syllabus Business Context A core part of any business is to determine its objectives and come up with a plan of how they will achieve these objectives (strategy). Budgeting provides detail of how the business should operate in order to achieve its objectives. 13.1

211 13: BUDGETING Overview Budgeting Planning and control Preparing budgets Principal budget factor (PBF) Operating budget Fixed and flexible budgets 13.2

212 13: BUDGETING 1 Introduction 1.1 A budget is a financial and/or quantitative plan of operations for a forthcoming period. 2 Planning and control 2.1 Budgeting is part of the overall process of planning and control. A budget is a plan which will assist in achieving objectives. 2.2 The cycle of planning and control: Determine objectives Compare actual with budget Set budget Budgetary planning Operate in line with objectives 2.3 Planning takes place at different levels within an organisation Time frame Type of planning Long-term Strategic Strategic planning affects future direction Medium-term Tactical Implementing strategy Short-term Operational Day-to-day running of the business Budgetary control 2.4 A system must be controlled to keep it steady or enable it to change safely. Control is required because unpredictable disturbances arise and enter the system, so that actual results/(outputs) deviate from expected results. Examples of disturbances from the environment which would impact on a business system would be as follows: Rise in the cost of raw materials Changes in demand levels Price war 13.3

213 13: BUDGETING A control system must ensure that the business is capable of surviving the disturbances. The components of a controlled system include: A meaningful target A method of gathering information from a system A method of comparing information to the target The means to initiate control action 2.5 Objectives of a budgetary planning and control system are as follows: To ensure achievement of objectives To compel planning To communicate ideas and plans To co-ordinate activities To provide a framework for responsibility accounting To establish a system of control To motivate employees to improve their performance. 3 Preparation of budgets 3.1 The budget period is commonly the accounting year and is usually split up into 12 or 13 control periods. 3.2 The budget manual is a collection of instructions governing the budgetary process. It is likely to contain: an explanation of the objectives of the budget organisational structures principal budgets administrative detail procedural matters 3.3 The Budget Committee is the co-ordinating body in the preparation and administration of budgets. 13.4

214 13: BUDGETING 4 Hierarchy of budgets MASTER BUDGET Operating budgets (Income statement) Financial budgets (Balance sheet) *Sales budget *Production budget *Direct material usage *Direct material purchases *Direct labour budget *Factory overhead budget Selling and distribution budget * You might be asked to prepare any of these budgets. Capital expenditure budget Working capital budget Cash budgets 5 Principal budget factor (or limiting budget factor) 5.1 This is the factor which prevents an organisation from expanding at present beyond a certain point. For example: The principal budget factor is usually sales demand. Other factors may include: Availability of raw material Availability of labour supply Machine capacity Availability of cash Distribution and selling resources Setting up a budget 5.2 Step 1 is to identify the principal budget factor. Step 2 is to work the budgets around it. 13.5

215 13: BUDGETING 6 Operating budget preparation LABOUR BUDGET hours/value SALES BUDGET units/value (1) Consider op/cl inventory FG Sales X Op.inventory (X) Cl. inventory X Production required X (2) Losses incurred/damaged goods PRODUCTION BUDGET units OVERHEADS BUDGET value Units produced x kg per unit from CC Material USAGE Budget Kg/litres etc Material PURCHASE Budget Kg/litres/value (1) Consider op/cl inventory RM Production usage X Op inventory (X) Cl inventory X Materials required X (2) Losses incurred Think about discounts Lecture example 1 Exam standard question worth 2 marks Suppose a company currently holds 100 units of inventory but it wishes to increase its inventory holding to 150 units during the next month. Sales are expected to be 850 units. Each unit requires 5 kg of material. Of the units produced, 10% have to be discarded because they are defective. No inventories of raw materials are held. Required How many kg of materials should be purchased next month? 13.6

216 13: BUDGETING Workings Lecture example 2 Preparation question Operating budgets Bun plc makes a range of cakes. When producing the budget for 20X1 the company realises that its principal budget factor is sales, and forecasts the following sales: Product Name: Sponge Jam Cream Sales (number of batches) 2,400 4,800 1,200 Selling price per batch $150 $175 $200 The unit direct costs of producing a batch of each type of cake are: Sponge Jam Cream Materials Flour (@ 50c/kg) 5 kg 6 kg 7 kg Milk (@ 70c/litre) 4 litres 5 litres 6 litres Labour Mixers (@ $2/hr) ½ hr ¾hr 1 hr Cooks (@ $3/hr) ½ hr ½hr 1 hr The company has inventory levels of completed batches of cakes as follows: 480 Sponges, 480 Jams and 240 Creams and raw materials inventory of 1,000 kg of flour and 500 litres of milk. Management feel that 20X1 s sales figures could well be repeated in 20X2 and wishes to have sufficient inventory of finished batches to cope with 10% of this demand and raw materials to cope with 20% of the demand for the finished product. 13.7

217 13: BUDGETING Required Complete the following sentences. (a) The volume of sales budgeted for Sponge is for Jam is and for Cream is and total sales revenue will be (b) To meet this sales demand Bun will have to produce Sponges Creams and Jams. (c) Bun's purchasing department will need to buy of flour at a total cost of and litres of milk at a total cost of (d) The total cost of labour will be Workings 13.8

218 13: BUDGETING 7 Fixed and flexible budgets 7.1 The fixed budget is the master budget prepared before the beginning of the budget period. It is based on budgeted volumes, costs and revenues. 7.2 The flexible budget is a budget which is designed to change as volume of activity changes. This can be done by recognising the behaviour of different costs (fixed or variable). Flexible budgets have two uses: (a) At the planning stage preparing budgets at differing levels of activity. This is an example of 'what if?' analysis. (b) Retrospectively, at the end of a control period to aid with budgetary control, to compare actual results with what should have been achieved based on budgeted costs/revenues at the actual volumes. 7.3 When used within this context of budgetary control the flexible budget is referred to as the flexed budget. A flexed budget is a budget that has been prepared based on actual volumes for budgetary control purposes. Purpose of flexible budgets 7.4 (a) Designed to cope with different activity levels to keep the budget meaningful and hence preserve the relevance of variances for effective control. (b) (c) Useful at planning stage to show different results from possible activity levels. Necessary as control device because we can meaningfully compare actual results with relevant flexible budget, ie budgetary control. Differences between the flexible budget figures and actual results are called variances. Lecture example 3 Exam standard question worth 2 marks Chateau Larnaque has a bottling plant for its wine and has prepared flexible budgets: Flexible Budgets Bottles: 10,000 12,000 14,000 Production costs: $ $ $ Materials 30,000 36,000 42,000 Labour 27,000 31,000 35,000 Overhead 20,000 20,000 20,000 77,000 87,000 97,

219 13: BUDGETING Required If actual production was 12,350 what is the flexed budget production cost? $ Workings 8 Chapter summary A budget is a quantified plan that will help a company reach its objectives. The budget committee co-ordinates the preparation and administration of budgets. The principal budgets factor should be identified at the start of the process. Fixed budgets are based on budgeted volumes and remain unchanged. Flexible budgets enable a company to do 'what if?' analysis changing these volumes

220 Chapter 13: Questions 13.11

221 13: QUESTIONS 13.1 Bryant Ltd has budgeted to sell 14,000 units of XP2 in the year. Opening inventories of XP2 are 3,000 units and the company plans to reduce inventory levels by 20%. How many units should be produced in the year? units. (2 marks) 13.2 Each unit of product Zon uses 6kg of material Zen. Budgeted details for September are as follows: Opening inventory Closing inventory Finished units of Zon 1,000 units 1,200 units Paw materials (Zen) 1,000 kg 1,200 kg It is anticipated that sales of Zon in September will be 7,500 units. How much Zen needs to be purchased in September? Kgs (2 marks) 13.3 The following statements relate to a flexible budget. Statement (1) A flexible budget is updated halfway through the year to incorporate the actual results for the first half of the year. Statement (2) A budget which shows sales revenues and costs at different potential levels of activity. Which of the following is true? A Only statement (1) is correct B Only statement (2) is correct C Both statements are correct (1 mark) 13.4 Which two of the following statements are correct? (1) A budget manual contains a timetable for budget preparation. (2) A master budget contains the raw materials purchases budget. (3) One objective of budgeting is to ensure that a company's resources can be allocated efficiently. (4) Sales demand will always be the principal budgetary factor. A Statements 1 and 3 B Statements 2 and 3 C Statements 4 and 2 (1 mark) 13.5 The principal budget factor is the overestimation of revenue budgets and underestimation of cost budgets, which operates as a safety factor against risk. A True B False (1 mark) 13.12

222 13: QUESTIONS The following information relates to questions 13.6 and A company is preparing budgets for the forthcoming year. The estimated sales for the first four months of the forthcoming year are as follows: Month 1 Month 2 Month 3 Month 4 12,000 units 14,000 units 11,000 units 12,000 units 40% of each month's sales units are to be produced in the month of sale and the balance will be produced in the previous month. 50% of the direct materials required for each month's production will be purchased in the previous month and the balance in the month of production. The direct material cost per unit is: $9/unit $3/kg) The production budget in units for month 1 will be A 12,000 units B 7,200 units C 8,400 units D 13,200 units (2 marks) 13.7 The materials cost budget for month 2 will be $ (2 marks) 13.13

223 13: QUESTIONS 13.14

224 Chapter 13: Answers 13.15

225 13: ANSWERS 13.1 Opening inventory 3,000 Sales (14,000) Production β 13,400 Closing inventory (reduction of 20% = 80% of opening) 2, Production budget Opening inventory (FG) 1,000 Production β 7,700 Sales (7,500) Closing inventory (FG) 1,200 Material requirement for 7,700 units = 7,700 6kg = 46,200 kg Materials purchases budget Opening inventory (RM) 1,000 kg Materials purchases β 46,400 kg Material requirement (46,200) kg Closing inventory (RM) 1,200 kg 13.3 B 13.4 A A raw materials purchases budget is an operating budget. Other factors such as material available or labour hours available will drive production levels False 13.6 D Month 1 Month 2 Month 3 Sales units 12,000 14,000 11,000 Opening stock (7,200) (8,400) (6,600) Closing stock (60%) 8,400 6,600 7,200 Production 13,200 12,200 11, Following on from 13.6 Month 1 Month 2 Month 3 3kg materials usage 39,600 kg 36,600 kg 34,800 kg Opening stock (19,800) (18,300) Closing stock (50%) 18,300 17,400 Purchases 38,100 kg 35,700 kg $3/kg $107,100 END OF CHAPTER 13.16

226 Standard costing Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: Explain the purpose and principles of standard costing. Establish the standard cost per unit under absorption and marginal costing. Exam Context Standard costing is a popular part of the syllabus and has been regularly examined. This chapter gives you an understanding of key terminology to be used in Chapter 15 on basic variance analysis. Qualification Context The technical knowledge from this chapter is used again in paper F5 Performance Management where written questions can examine the use of standard costs and methods of deriving standard costs. 14.1

227 14: STANDARD COSTING Overview Standard costing Definition Setting standards Use in cost card Uses in business Advantages/disadvantages 14.2

228 14: STANDARD COSTING 1 Standards 1.1 A standard is prepared by management in advance, and details their expectations of the future. 1.2 Standards are not just for items of production in manufacturing businesses. They exist in many different spheres. Standard times for repairing cars, standard punctualities for train companies and standard response times for ambulances are just some of the many examples encountered. 1.3 A standard cost is a predetermined estimated unit cost and is calculated using management expectations of: (a) efficiency levels in the use of materials and labour; (b) the expected price of materials, labour and expenses; (c) budgeted overhead costs and activity levels. 1.4 A standard cost card will usually be prepared for each product manufactured by the business. For example: Direct materials $3/kg $12.00 Direct labour 3 $10/hr $30.00 Standard direct cost $42.00 Under Variable production o/h $1.50/hr $4.50 MC Standard variable cost of production $46.50 Fixed production cost $4.50/hr $13.50 Under Standard cost $60.00 AC 2 Standard setting Lecture example 1 Preparation question There are four types of performance standard, explain what each standard would be based on: (a) Ideal standards (b) Current standards 14.3

229 14: STANDARD COSTING (c) Basic standards (d) Expected standards Standard setting involves a compromise between exerting control and aiding motivation, which may often conflict. 3 Uses of standard costs 3.1 Standard costing has two principal uses: (a) (b) to value inventory and cost production as seen within marginal and absorption costing. to act as a control device highlighting activities that are not conforming to plan for further investigation. Standard costing as a control technique 3.2 Predetermined standard costs are compared with actual costs. The process by which the total difference between standard and actual results is analysed is known as variance analysis. 4 Advantages and disadvantages of setting standards Advantages (a) Facilitates budgetary control (b) Leads to more accurate budgeting (c) Assists performance measurement (d) Assists in target setting for staff (e) Assists in price setting (f) Simplifies bookkeeping Disadvantages (a) Difficult to forecast accurately (b) Time consuming (c) Regular revision required (d) Demotivating if wrong 14.4

230 14: STANDARD COSTING 5 Chapter summary A standard cost is a predetermined estimated unit cost used for inventory valuation and control. A standard cost card shows full details of the standard cost of each product. Differences between actual and standard costs are called variances. 14.5

231 14: STANDARD COSTING 14.6

232 Chapter 14: Question 14.7

233 14: QUESTION 14.1 What is the name given to a standard that can be achieved, allowing for normal shrinkage, wastage and machine breakdowns, if a standard unit of work is performed efficiently, a machine is properly operated or materials are properly used? A Expected standard B Basic standard C Current standard D Ideal standard (2 marks) 14.8

234 Chapter 14: Answer 14.9

235 14: ANSWER 14.1 A An expected standard represents future performance and objectives that are reasonably attainable. It will be more 'demanding' than a current standard (which is a short-term standard reflecting current conditions, possibly developed from a longer-term basic standard). It will be less demanding that an 'ideal' standard, which makes no allowance for spoilage, wastage and machine breakdowns, and assumes ideal operating conditions. END OF CHAPTER 14.10

236 Basic variance analysis Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: Calculate the following variances: Materials total, price and usage Labour total, rate and efficiency Variable o/h total, expenditure and efficiency Fixed o/h total, expenditure and where appropriate volume, capacity and efficiency Interpret all of the variances above. Explain possible causes of all of the variances above. Describe the interrelationships between the variances above. Exam Context Variance calculation is a very important part of your Management Accounting studies and it is vital that you are able to calculate all of the different types of variance included in the syllabus. Qualification Context All variances examined at F2 are examinable in the F5 Performance Management paper. This is taken a step further by including a few further calculations and the interpretation and behavioural aspects of variances. Business Context Actual costs and revenues are compared, against forecasts within a business on a frequent basis. This is part of the budgetary control process and help to identify problems within the production process. 15.1

237 15: BASIC VARIANCE ANALYSIS Overview Basic variance analysis Variable cost variances Fixed cost variances Calculation Materials - price - usage Labour - rate - efficiency - idle time Variable o/h - expenditure - efficiency Calculation Fixed o/h - expenditure - Volume efficiency capacity Interpretation/ interdependence 15.2

238 15: BASIC VARIANCE ANALYSIS 1 Variances 1.1 Variances explain the difference between actual results and expected results (ie. standard costs and revenues) and provide information for performance evaluation and control purposes. 1.2 Variances can be divided into three main groups Variable cost variances Fixed overhead variances Sales variances (in Chapter 16). Traditional variance analysis 1.3 Original Flexed Actual budget budget budget Sales volume X X X $ $ $ Sales revenue X X Sales price X variance Cost of sales: Materials X X Material variance X Labour X X Labour variance X Overheads X X Overhead variance X Profit X Sales volume variance X X The flexed budget uses the actual level of activity multiplied by the unit budgeted data (i.e. standard cost or selling price). Variances can be either favourable (F) i.e. better than expected or adverse (A) i.e. worse than expected. 2 Cost variances 2.1 Materials (a) Price: based on actual purchases what should they have cost? what did they cost? (b) Usage: based on actual production what should it have used? what did it use? Difference valued at standard cost. 15.3

239 15: BASIC VARIANCE ANALYSIS 2.2 Labour (a) Rate: based on hours paid what should they have cost? what did they cost? (b) Idle time: difference between hours paid and hours worked. Value at standard rate per hour. (c) Efficiency based on actual production how long should it have taken? how long did it take? Difference valued at standard rate per hour. 2.3 Variable overheads (a) Expenditure: based on actual hours worked what should they have cost? what did they cost? (b) Efficiency: based on actual production how long should it have taken? how long did it take? Difference valued at standard rate per hour. Note. This assumes variable overheads are incurred per labour hour 15.4

240 15: BASIC VARIANCE ANALYSIS 3 Fixed overheads 3.1 In Chapter 8 (Absorption Costing) we calculated the over / (under) absorption in a period as: Overheads absorbed (OAR x actual activity) x Actual overheads (x) Over / (under) absorption x/(x) 3.2 The over / (under) absorption of fixed overheads can be split further as follows: Fixed overhead volume variance Budgeted production volume X Actual production volume X X Value at OAR / Unit $X Fixed overhead expenditure variance Budgeted expenditure $X Actual expenditure $X $X 3.3 When overheads are absorbed on a labour hour or machine hour basis the volume variance can be split further into: Volume efficiency variance Based on actual production How long did it take? How long should it have taken? Value at standard OAR/hour Volume capacity variance Budgeted hours of work Actual hours of work Value at standard OAR / hour 15.5

241 15: BASIC VARIANCE ANALYSIS Lecture example 1 Preparation question BUDGET Unit Total $ $ Sales (8,000 units) ,000 Production (8,700 units) Materials 4 $ ,600 Labour $ ,500 Variable overheads 5 $ , ,100 Closing inventory (700 $53/unit)) (37,100) 424,000 Budgeted contribution 176,000 Budgeted fixed overheads 130,500 ACTUAL $ Sales (8,400 units) 613,200 Production (8,900 units) Materials purchased 35,464 kgs for $163,455 (used 34,928 kgs) 161,043 Labour (45,400 hours) 224,515 Variable overheads 87, ,906 Closing inventory (500 $53/unit) (26,500) 446,406 Actual contribution 166,794 Actual fixed overheads 134,074 Required (a) What is the materials price variance? (b) What is the materials usage variance? (c) What is the labour rate variance? 15.6

242 15: BASIC VARIANCE ANALYSIS (d) What is the labour efficiency variance? (e) What is the variable overhead expenditure variance? (f) What is the variable overhead efficiency variance? (g) What is the fixed overhead expenditure variance? Workings 15.7

243 15: BASIC VARIANCE ANALYSIS Lecture example 2 Preparation question Additional information for Lecture example 1. If the company had been using absorption costing: Standard Cost Card $ Materials $4.50/kg 18 Labour $5/hr 25 Variable o/h $2/hr 10 Fixed o/h $3/hr Required (a) What is the fixed overhead volume variance? (b) Break the fixed overhead volume variance down into: A volume efficiency variance A volume capacity variance 15.8

244 15: BASIC VARIANCE ANALYSIS 4 Interpretation of variances 4.1 Care must be taken when interpreting variances, especially when they are being used to assess the performance of employees. Remember to use the scenario in the question to give you ideas. 4.2 The following table may help you to think about some of the operational causes of variances. Variance Favourable Adverse Material price Material usage Labour rate Idle time Labour efficiency Fixed overhead expenditure Unforeseen discounts received Greater care in purchasing Change in material standard Material used of higher quality than standard More efficient use of material Errors in allocating material to jobs Use of workers at a rate of pay lower than standard The idle time variance is always adverse Output produced more quickly than expected because of worker motivation, better quality materials etc Errors in allocating time to jobs Lower grade of labour than originally planned Savings in costs incurred Price increase Careless purchasing Change in material standard Defective material Excessive waste or theft Stricter quality control Errors in allocating material to jobs Wage rate increase Machine breakdown Illness or injury to worker Lost time in excess of standard Output lower than standard set because of lack of training, substandard materials etc Errors in allocating time to jobs Increase in cost of services used Overhead expenditure variances ought to be traced to the individual cost centres where the variances occurred. Fixed overhead volume Interdependence of variances Production or level of activity greater than budgeted Production or level of activity less than budgeted 4.3 In order to interpret variances effectively any interdependence between variances must be identified, i.e. it is not always possible to look at individual variances in isolation. 15.9

245 15: BASIC VARIANCE ANALYSIS When two variances are interdependent one will usually be adverse and the other favourable. E.g. (a) Cheaper materials Favourable price variance Inferior quality Adverse usage variance and perhaps adverse efficiency variance (labour and overheads) (b) Higher rate for labour Adverse price (rate) variances Higher efficiency Favourable efficiency variances. Favourable usage variances (materials) 4.4 It is therefore important in analysing any variance that the overall consequence should be considered. An unfavourable variance may give concern by itself, but a favourable variance may have unfavourable interdependent variances. 5 Chapter summary A variance is the difference between the standard cost and the actual cost incurred. There are three groups of variances Variable cost variances Fixed overhead variances Sales variances (Chapter 16) Causes of variances should be investigated. In an exam context use the scenario given to identify causes. Variances are often interdependent

246 Chapter 15: Questions 15.11

247 15: QUESTIONS The following information relates to questions 15.1 and 15.2 Rooney Nose Ltd, which manufactures product Z, uses a standard costing system and values its inventories at standard cost. The standard cost of raw materials in product Z is 3 kilos of material R at $5 per kilo = $15 per unit of Z. During April, Rooney Nose Ltd purchased 28,300 kilos of material R at a cost of $148,575, or $525 per kilo. It manufactured 8,500 units of product Z, using 26,200 kilos of R What was the raw material price variance for material R in April? A $3,500 (A) B $6,550 (A) C $7,075 (A) D $3,676 (A) (2 marks) 15.2 What was the raw material usage variance for material R in April? A $3,500 (A) B $3,675 (A) C $10,500 (A) D $7,075 (A) (2 marks) 15.3 Which one of the following would NOT help to explain a favourable direct materials usage variance? A Achieving a lower output volume than budgeted B A reduction in materials wastage rates (1 mark) 15.4 Eastlake Production Ltd manufactures Product W. It employs a standard costing system, and the standard direct labour cost for product W is 2 hours per unit at $3.60 per hour = $7.0. In July, 5,000 units of W were manufactured. The direct labour costs totalled $36,400, and of the 9,700 direct labour hours worked in July, 200 hours were in overtime. What were the direct labour rate variance and the direct labour efficiency variance in July? A Rate variance $400 (A), Efficiency variance $1,080 (F) B Rate variance $400 (A), Efficiency variance $1,800 (F) C Rate variance $1,480 (A), Efficiency variance $1,080 (F) D Rate variance $1480 (A), Efficiency variance $1,800 (F) (2 marks) 15.5 Which one of the following would NOT explain an adverse direct labour efficiency variance? A Poor scheduling of direct labour workers B Setting standard efficiency at a level that is too low C Unusually lengthy machine breakdowns (1 mark) 15.6 The budgeted raw material cost for producing 100 units of a product is 2,000kg at $4.50/kg. The actual results for completing 100 units were 2,200 kg purchased and used at a total cost of $10,780. What is the raw material price variance? A $880 favourable B $800 favourable C $800 unfavourable D $880 unfavourable (2 marks) 15.12

248 15: QUESTIONS 15.7 Cuba Limited manufactures a product Q and uses a standard costing system. During May, results were recorded as shown below. Number of units of Q produced 2,200 units Direct labour hours worked and paid 4,840 hours Direct labour cost $14,520 Direct labour rate variance $968 (A) Direct labour efficiency variance $1,232 (F) What is standard direct labour cost for product Q? A 2 hours at $2.80 per hour B 2.1 hours at $3.20 per hour C 3.24 hours at $3.00 per hour D 2.4 hours at $2.80 per hour (2 marks) 15.8 A company's standard labour rate for its factory workers is set at $5 per hour. The standard time allowed to produce one unit of product is 20 minutes. During the period 4,800 units were produced and the factory workers were paid $5.25 per hour. The actual hours paid were 1,560. What is the labour rate variance? A $390 unfavourable B $190 unfavourable C $190 favourable D $390 favourable (2 marks) 15.9 The standard direct labour cost of producing one unit of Splink is $20 and the standard wage rate of the operatives employed in manufacturing the product is $5 per hour. Budget production of Splink is 250 units. Annual results are: Production of Splink 300 units Direct labour hours producing Splinks 1,120 hours Wages paid for hours producing Splinks $5,580 What is the labour efficiency variance? (A = adverse, F = favourable) A $420 F B $400 F C $600 A D $630 A (2 marks) A product requires raw material costing 50c per kg at standard cost. In February, 2,500kg of raw materials were purchased at a cost of $1,500; 2,300kg of raw materials were used. If raw material inventory is valued at standard cost and there was no opening inventory of raw material, what was the materials price variance for February? A $250 adverse B $230 adverse C $230 favourable D $250 favourable (2 marks) 15.13

249 15: QUESTIONS A company is obliged to buy sub-standard materials at lower than standard price because nothing else is available. As an indirect result of this purchase, are the materials usage variance and labour efficiency likely to be favourable or adverse? Materials usage Labour efficiency variance variance A favourable favourable B adverse favourable C favourable adverse D adverse adverse (2 marks) The following information relates to questions and The standard material cost of one unit of Alpha is $40 (8 $5/kg) During a period 1,970 kgs of material were used to produce 250 units of Alpha. The cost of this material was $10,000. There were no changes in raw material inventory during the period Calculate the materials price variance. $ (2 marks) Calculate the material usage variance. $ (2 marks) The following information relates to questions 15.14, and The standard labour cost of making one unit of XYZ is $15.50 (2 $7.75). During July 1,200 units were produced in 2,300 labour hours. The actual cost of labour during the period was $21,000 for 2,500 hours Calculate the labour rate variance. $ Calculate the labour efficiency variance. $ (2 marks) (2 marks) Calculate the labour idle time variance variance. $ (2 marks) 15.14

250 Chapter 15: Answers 15.15

251 15: ANSWERS 15.1 C Closing inventories are valued at standard cost, and so the materials price variance is calculated on the quantities purchased in the month, and not on the quantities used. Per kilo Total $ $ 28,300 kilos should cost ,500 did cost ,575 7,075 (A) 15.2 A Kilos of R 8,500 units of product Z should use ( 3 kilos) 25,500 did use 26,200 Usage variance in kilos 700 (A) Standard cost per kilo $5 Usage variance in $ $3,500 (A) 15.3 B Variations in output volume should not affect usage of materials per unit produced. A high quality of material might reduce wastage or scrap levels that would in turn improve the materials usage rate. With lower quality control standards there should be fewer rejection items, a higher proportion of successfully-completed items, and so an improvement in materials usage C $ 9,700 hours worked should cost ( $3.6) 34,920 did cost 36,400 Rate variance 1,480 (A) 5,000 units of W should take ( 2 hrs) 10,000 hrs did take 9,700 hrs Efficiency variance in hours 300 hrs (F) Standard rate per hour $3.6 Efficiency variance in $ 1,080 (F) 15.5 B If the standard efficiency level is too low, efficiency variances will be favourable. Poor work scheduling, and machine breakdowns create abnormal amounts of idle time. Idle time is a form of inefficiency variance. Less training will often make staff less efficient in doing their work D 15.7 D $ 2,200 kg Should cost $4.50 9,900 did cost 17, adverse $ 4,840 hours did cost 14,520 Rate variance 968 (A) 4,840 hours should cost 13,552 Standard rate per hour $2.80 Efficiency variance in $s $1,232 (F) Standard rate per hour $2.80 Efficiency variance in hours 440 (F) 2,200 units did take 4,840 hours 2,200 units should take 5,280 hours Standard hours per unit 2.4 hours 15.16

252 15: ANSWERS 15.8 A Actual hours paid and worked should cost 1,560 $5 = $7,800. Actual hours paid and worked did cost 1,560 $5.25 = $8,190. The labour rate variance = $7,800 $8,190 = $390 unfavourable B A Hrs 300 units should take 4 hours 1,200 did take 1, F 5 (std cost) $400 F $ 2,500 kg should cost 1,250 did cost 1, A D Substandard More wastage More time needed to produce units Adverse usage Adverse labour efficiency variance Materials price variance: 1,970 kg should have $5/kg $9,850 1,970 kg did cost $(10,000) Adverse $ Materials usage variance 250 units should have 8 kg per unit 2,000 kg 250 units did use 1,970 kg x $5pkg 30 kg Favourable $ Labour rate variance = 2,500 hrs should have $7.75/hr $19,375 2,500 did cost $21,000 Adverse $1, Labour efficiency variance = 1,200 units should have 2 hrs per unit 2,400 hrs 1,200 units did take 2,300 hrs 100 hrs Value $7.75 phr Favourable $

253 15: ANSWERS Labour idle time variance Total hours paid 2,500 Total hours worked 2,300 Idle hours 200 $7.75 Adverse $1,550 END OF CHAPTER 15.18

254 Further variance analysis Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: Calculate, interpret and explain sales price and volume variance. Reconcile budgeted profit with actual profit under standard absorption costing. Reconcile budgeted profit or contribution with actual profit or contribution under standard marginal costing. Calculate actual or standard figures given a variance (backward variances). Exam Context Variance analysis is traditionally a very popular exam topic. Make sure that you are able to prepare operating statements and explain why calculated variances have occurred. Qualification Context It is the operating statements that are examinable at the later papers with the actual variance calculations being assumed knowledge. Business Context This chapter continues the discussion of variance analysis and its importance to businesses begun in Chapter

255 16: FURTHER VARIANCE ANALYSIS Overview Further variance analysis Sales variance Operating statements Calculate Sales - price variance - sales volume variance AC MC Interpretation Backward variances 16.2

256 16: FURTHER VARIANCE ANALYSIS 1 Sales variances 1.1 Sales variances measure the effect on expected profit of a different selling price to the standard and a different volume of sales to the original budget. The total variances can be split as follows: 1.2 (a) Price: based on actual units sold (b) what revenue was achieved? what revenue should have been achieved? Volume: difference between budgeted and actual sales volume. Value at standard contribution (marginal costing). Lecture example 1 Preparation question Same information as Lecture example 1 in Chapter 15. BUDGET Unit Total $ $ Sales (8,000 units) ,000 Production (8,700 units) Materials 4 $ ,600 Labour $ ,500 Variable overheads 5 $ , ,100 Closing inventory (700 $53/unit) (37,100) 424,000 Budgeted contributions 176,000 Budgeted fixed overheads 130,500 ACTUAL $ Sales (8,400 units) 613,200 Production (8,900 units) Materials purchased 35,464 kgs for $163,455 (used 34,928 kgs) 161,043 Labour (45,400 hours) 224,515 Variable overheads 87, ,906 Closing inventory (500 $53/unit)) (26,500) 446,406 Actual contribution 166,794 Actual fixed overheads 134,

257 16: FURTHER VARIANCE ANALYSIS Required (a) What is the sales price variance? (b) Workings What is the sales volume variance? 2 Operating statements 2.1 An operating statement shows how the combination of variances reconcile budgeted contribution and actual profit. Lecture example 2 Preparation question Using the variances calculated in Lecture example 1 in Chapter 15 and Lecture example 1 in Chapter 16, complete the operating statement below. 16.4

258 16: FURTHER VARIANCE ANALYSIS Solution Operating statement for period ended 31/12/XX (under marginal costing) Budgeted contribution Sales volume variance Sales price variance Cost variances: $F $A Materials Price Usage Labour Rate Idle Efficiency Variable overheads Expenditure Efficiency Actual contribution $ Fixed overheads Budgeted fixed overhead Expenditure variance Actual profit Workings 16.5

259 16: FURTHER VARIANCE ANALYSIS 3 Absorption costing 3.1 There are two main differences between the variances calculated in an marginal costing systems and the variances calculated in a absorption costing system. (a) (b) In a marginal costing system the only fixed overhead variance is an expenditure variance. In absorption costing we can also calculate the fixed overhead volume variance as seen in Lecture example 2 in Chapter 15. The sales volume variance is valued at standard profit not at standard contribution. 3.2 In addition, when you are preparing an operating statement under absorption costing you reconcile budgeted profit to flexed budgeted profit to actual profit. Lecture example 3 Preparation question Using the same data used in Lecture example 2, produce an operating statement that reconciles budgeted contribution to actual profit under marginal costing principles. Solution Operating statement for period ended 31/12/XX (under absorption costing) Budgeted profit Sales volume variance Sales price variance $F $A Cost variances (as before) Materials Price Usage Labour Rate Idle Efficiency Variable overheads Expenditure Efficiency Fixed overheads: Expenditure variance Capacity variance Efficiency variance $ Actual profit 16.6

260 16: FURTHER VARIANCE ANALYSIS Workings 4 Backwards variances 4.1 Sometimes an exam question may be set which requires you to work from a set of variances back to actual or budgeted data. Lecture example 4 Exam standard question worth 2 marks The direct labour cost data relating to last month was as follows: Actual hours worked 28,000 Total direct labour cost $117,600 Direct labour rate variance $ 8,400 (adverse) Direct labour efficiency variance $ 3,900 (adverse) Required To the nearest thousand (in hours), what are the total standard labour hours last month? Workings 16.7

261 16: FURTHER VARIANCE ANALYSIS 5 Chapter summary Sales price variance and sales volume variance measure the effect on profit of different selling prices and volumes to the standard. Cost variances measure the effect on profit or different actual costs to the flexed budget. Operating statements show how the combination of variances reconcile budgeted profit and actual profit. Be prepared to produce part of the operating statement only, for example budgeted materials cost to actual materials cost. The differences in variance calculations between using absorption and marginal costing include: Under marginal costing only the fixed overhead expenditure variance needed sales volume variance calculated based on standard contribution operating statement reconciles budgeted contribution to actual contribution 16.8

262 Chapter 16: Questions 16.9

263 16: QUESTIONS The following data relates to questions 16.1 and 16.2 The following data is available with regard to a product Period Period Actual Budget Sales (Units) 10,100 10,000 $ $ Sales Value 52,520 51,000 Manufacturing costs at standard 43,430 43,000 Manufacturing profit 9,090 8, What was the sales price variance? A $1,010 adverse B $510 favourable C $520 favourable D $1,010 favourable (2 marks) 16.2 What is the sales volume variance? A $80 favourable B $90 favourable C $510 favourable D $520 favourable (2 marks) 16.3 The budgeted selling price was $10 per unit. The actual selling price was $9 per unit. The actual sales volume was 5,000 units. What is the selling price variance? A $5,000 (F) B $5,000 (A) C $45,000 (F) D $45,000 (A) (2 marks) 16.4 The budgeted sales volume was 5,000 units. The actual sales volume was 5,200 units. The standard contribution per unit is $6. What is the sales volume variance using marginal costing? A $200 (A) B $200 (F) C $1,200 (A) D $1,200 (F) (2 marks) 16.10

264 16: QUESTIONS The following question has been included specifically to aid your understanding of Variances as a full technique. It is not in the format of an exam question Newstyle Furniture Limited manufactures a lounge chair by subjecting plasticised metal to a moulding process thereby producing the chair in one piece. Standard Budget/data: Unit variable costs: Direct material 6kg at 50c per kg Direct labour 2 hours at 80c per hour Variable overhead 60c per direct labour hour Budgeted fixed overhead for the year (240 working days) $30,000 Budgeted production/sales for the year 60,000 chairs Standard selling price per chair $10 Actual data for period 1: Required Number of working days 20 Production/sales 5,200 chairs Direct material received and used: Delivery number 1 12,000 kg cost $5,880 Delivery number 2 14,000 kg cost $6,790 Delivery number 3 6,000 kg cost $3,060 Direct labour hours worked 10,080, cost $8,770 Variable overhead $ 6,150 Fixed overhead $ 2,550 Sales income $51,300 Analyse the cost and sales variances from the information provided above and prepare an operating statement incorporating the result of your analysis

265 16: QUESTIONS 16.12

266 Chapter 16: Answers 16.13

267 16: ANSWERS 16.1 D 16.2 A $ 10,100 units should sell for ( $5.10) 51,510 did sell 52,520 $1,010 F Actual volume 10,100 units Budget 10, F at standard profit $0.80 [$8,000/10,000 units] $80 F 16.3 B Sales revenue from 5,000 units should have been ( $10) = $50,000 but was ( $9) = $45,000. Variance = $(50,000 45,000) = $5,000 (A) D The actual variance is $1,200 (F). Variance = (actual sales budgeted sales) contribution per unit = (5,200 5,000) $6 = $1,200 (F) Operating statement for Period 1 $ Standard profit on budgeted sales $ 3.70) 18,500 Add sales volume margin variance $3.70) 740 F Standard profit on actual sales 19,240 Less sales price variance (5,200 x $10 $51,300) 700 A 18,540 Manufacturing variances Adverse Favourable $$ $ $ Material (W1) Price 270 Usage 400 Labour (W2) Rate 706 Efficiency 256 Variable overhead (W3) Expenditure 102 Efficiency 192 Fixed overhead (W4) Expenditure 50 Volume 100 1, A Actual profit (W5) 18,100 (W1) Materials $ Price: 32,000 kg Should cost 16,000 Did cost 15, F 16.14

268 16: ANSWERS Usage: 5,200 chairs Should use 31,200 kg Did use 32,000 kg 800 $0.50 $400 A (W2) Labour $ Rate: 10,080 hrs Should cost 8,064 Did cost 8, A Efficiency: 5,200 chairs Should take 10,400 hr Did take 10,080 hr 320 $0.80 $256 F (W3) Variable Overheads $ Expenditure: 10,080 hrs Should cost 6,048 Did cost 6, A Efficiency: 5,200 chairs Should take 10,400 hr Did take 10,080 hr 320 $0.60 $192 F (W4) Fixed Overheads $ Expenditure: Actual 2,550 Budgeted ($30,000 / 12) 2, A Volume c / unit $100 F (W5) Standard unit cost $ Actual profit $ $ Direct material 3.00 Sales 51,30 0 Direct labour 1.60 Direct material 15,730 Variable overhead 1.20 Direct labour 8,770 Fixed overhead 0.50 Variable overhead 6, Fixed overhead ,20 0 Profit 3.70 Profit 18,10 0 Selling price

269 16: ANSWERS END OF CHAPTER 16.16

270 Cost-volume-profit (CVP) analysis (Break- even analysis) Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: Calculate and interpret a break-even point and a margin of safety. Understand and use the concepts of a target profit or revenue and a contribution to sales ratio. Identify the elements in traditional and contribution break-even charts and profit/volume charts. Apply CVP analysis to single and multiple product situations. Note: Multi-product break-even charts and profit/volume charts are excluded. Exam Context CVP analysis is an important tool that management accountants can use in decision making. Most examination questions will require that you can recall the formulae included in this chapter make sure you learn them so that you can apply them when you need to. Qualification Context CVP analysis as learnt here is a basic tool that a company can use particularly for short term decision-making. It is therefore a tool that can be useful at all levels of your studies. Business Context When using a marginal costing system, there is more risk that fixed costs will not be covered. Using CVP, the business can plan to ensure fixed costs are covered and target profit figures can also be calculated. 17.1

271 17: COST-VOLUME-PROFIT (CVP) ANALYSIS Overview CVP analysis Break-even analysis calculations Break-even analysis graphs Break-even chart Profit volume charts Break-even point C/S ratio Required profit calculations Margin of safety Limitations 17.2

272 17: COST-VOLUME-PROFIT (CVP) ANALYSIS 1 Introduction 1.1 The break-even point for a company is the sales volume which will give the company a profit of $nil. If sales exceed the break-even point the company will make a profit. Break-even analysis is often referred to as cost-volume-profit analysis. 1.2 We will assume that the selling price per unit, variable cost per unit and fixed costs are all constant. Sales revenue and total costs will therefore both be linear. 1.3 Remember that contribution per unit = selling price less all variable costs per unit. We will need this definition to set up the break-even formula. $ Sales 15,000 Less: VCs (5,000) Contribution 10,000 Must be Fixed costs (10,000) EQUAL Profit 0 2 Break-even point calculations 2.1 So we will break-even when: Contribution = fixed costs Contribution/unit x Q = fixed costs. Break-even point (BEP) = Fixed Costs Contribution / unit Lecture example 1 Exam standard question each worth 2 marks A company has different output levels, and incurs different total production costs at each level, as follows: Output Total costs (units) $ 6,000 44,700 8,000 57,700 Required (a) If the selling price is $8/unit at all levels, what is the BEP (in units)? (b) What is the break-even revenue? $ 17.3

273 17: COST-VOLUME-PROFIT (CVP) ANALYSIS Workings 3 The Contribution to Sales ratio (C/S Ratio) 3.1 The ratio of contribution to sales is an alternative method of finding the break-even point. It gives the amount of contribution earned per pound of sales. It can be measured as a fraction or a percentage. It is also known as the profit-volume (P/V) ratio and can be used to determine break-even revenue. Fixed costs Break-even revenue = C/S ratio 17.4

274 17: COST-VOLUME-PROFIT (CVP) ANALYSIS Lecture example 2 Preparation question Using details as per Lecture example 1: (a) What is the C/S ratio? (b) What is the break-even revenue? Workings $ 4 Margin of safety 4.1 This is a measure of the amount by which sales must fall before we start making a loss. A loss is made if sales volume is less than the BEP. Margin of safety (in units) = Budgeted sales volume break-even sales volume or, margin of safety (as %) = Budgeted sales volume - Break - even sales volume 100 % Budgeted sales volume 17.5

275 17: COST-VOLUME-PROFIT (CVP) ANALYSIS Lecture example 3 Preparation question Using details as per Lecture example 1 and with budgeted sales being 5,000 units: What is the margin of safety (in units)? What is the margin of safety (as a %)? Workings 5 Required profit level 5.1 The approach used to find an expression for the break-even sales volumes can be extended to find the volume needed to attain a required profit level. Fixed costs + required profit Sales volume to reach required profit level = Unit contribution The required profit is like an additional fixed cost which must be covered before the company breaks even. Lecture example 4 Exam standard question worth 2 marks Using the data from the previous lecture example Fixed costs = $5,700 Contribution per unit = $1.50/unit Required What is the sales volume (in units) required to make a profit of $10,000? Workings 17.6

276 17: COST-VOLUME-PROFIT (CVP) ANALYSIS 6 Break-even chart 6.1 The break-even point can also be determined graphically using a break-even chart as a contribution breakeven chart. This diagrammatically shows the relationship between: Revenue, costs and sales volume. Lecture example 5 Preparation question Sketch the break-even chart for Lecture example 1. $ Output 7 Profit-volume chart 7.1 The profit volume chart is a variation of the break-even chart which illustrates the relationship of costs and profit to sales and the margin of safety. 17.7

277 17: COST-VOLUME-PROFIT (CVP) ANALYSIS Lecture example 6 Preparation question Sketch the profit-volume chart for Lecture example 1. $ Output Lecture example 7 Preparation question (a) How would the line differ if the fixed costs increased to $6,500? (b) Describe the impact on the break-even point if the selling point increased to $10. Solution 17.8

278 17: COST-VOLUME-PROFIT (CVP) ANALYSIS Lecture example 8 Preparation question BE units 25,000 Fixed costs $75,000 Selling price $11 Required What is the variable cost per unit? $ Workings 8 Limitations of breakeven analysis 8.1 Break-even analysis is a useful technique for managers as it can provide simple and quick estimates. It does however have a number of limitations. (a) All costs can be split into fixed and variable elements. (b) Fixed costs are constant. (c) Variable cost per unit is constant. (d) Selling price is constant. (e) Constant inventory levels (Sales = Production) are assumed (f) Analysis only possible for single products or for single product mixes. 9 Chapter summary A company can use BEP calculations to help with short term decision making. The breakeven point is the sales volume where the company makes no profit or loss. Break-even charts can be used as a visual aid for management decision making. 17.9

279 17: COST-VOLUME-PROFIT (CVP) ANALYSIS 10 Formulae summary Contribution per unit = Unit selling price unit variable costs Profit = (Sales volume x contribution per unit) Fixed costs Break-even sales volume = Break-even sales revenue = Where c/s ratio = Margin of safety (%) = Fixed costs Contribution per Fixed cost c/s ratio Contribution Sales unit Budgeted sales - Breakeven sales Budgeted sales Margin of safety (units) = Budgeted sales Breakeven sales Fixed cost + Target profit Sales volume to achieve a target profit = Contribution per unit x

280 Chapter 17: Questions 17.11

281 17: QUESTIONS The following information relates to questions 17.1 to 17.3 $ Materials 12 Labour 30 Variable production overhead 13 Distribution cost 5 Total variable cost 60 Selling price 100 Contribution per unit 40 $ Factory cost 100,000 Administration costs 50,000 Total fixed costs 150, What is the break-even point (BEP) in terms of units? A 1,500 B 2,500 C 3,750 D None of the answers. (2 marks) 17.2 What is the sales revenue that would yield a net profit of $30,000? A $75,000 B $180,000 C $375,000 D $450,000 (2 marks) 17.3 If budgeted sales are 5,000 units, the margin of safety is % (2 marks) 17.4 A company manufactures and sells a single product which has a standard variable cost per unit of $40 and a standard selling price per unit of $100. At the budgeted output level of 1,000 units per month, the standard fixed cost per unit is $10. What is the breakeven point in sales revenue per month (to the nearest thousand)? A $10,000 B $16,700 C $20,000 D $25,000 (2 marks) 17.5 F Scuttle Ltd has fixed costs of $50,000 per annum. The company sells a single product for $25 per unit. The contribution to sales ratio is 40%. What is the breakeven point in revenue? A $5,000 B $50,000 C $125,000 D $83,333 (2 marks) 17.12

282 17: QUESTIONS The following information relates to The accountant of Eastlake plc has calculated the company s break-even point from the following data: $ Selling price per unit 6 Variable production cost per unit 1.20 Variable selling cost per unit 0.40 Fixed costs per unit, based on a budgeted 10,000 units p.a The company s break-even point is: A 8,333 units B 9,091 units C 10,000 units D 100,000 units (2 marks) 17.7 How many units must be sold if Lee wants to make a profit of $12,000? Units (2 marks) 17.8 It is now expected that variable production cost per unit and selling price per unit will each increase by 10%. These changes will cause the break-even point to fall by A 0.8% B 1.6% C 9.1% D 9.8% (2 marks) 17.9 Dot Ltd has fixed costs of $55,000. Each unit is sold for $61 per unit and variable costs are $17 per unit. If Dot Ltd wish to make a profit of $22,000, how many units must the company sell? Units (2 marks) Tartan Ltd plans to produce and sell 7,000 kilts. Fixed costs absorbed are $10 per kilt. Contribution per kilt is $12. What is Tartan's margin of safety? A 7,000 kilts B 1,167 kilts C 3,200 kilts D 5,833 kilts (2 marks) The following information relates to questions Stratosphere Ltd sells one product for which data is given below: $ per unit Selling price 20 Variable cost 12 Fixed cost 4 The fixed costs are based on a budgeted activity level of 10,000 units for the period

283 17: QUESTIONS How many units must be sold if Stratosphere wishes to earn a profit of $4,000 for one period? A 5,500 B 5,000 C 44,000 D 42,000 (2 marks) What is Stratosphere's margin of safety for the budget period if fixed costs prove to be 15% higher than budgeted? A 82.1% B 23.6% C 42.5% D 50.4% (2 marks) If the selling price and variable cost increase by 20% and 12% respectively, by how much must sales volume change compared with the original budgeted level in order to achieve the original budgeted profit for the period (assuming the original fixed costs)? A 24.24% decrease B 24.24% increase C 36.72% decrease D 36.72% increase (2 marks) $ Sales X Total costs Y Variable costs Z N A Output (units) In the above break-even chart, the contribution at level of output A can be read as: A Distance N B Distance X C Distance Y D Distance Z (2 marks) 17.14

284 Chapter 17: Answers 17.15

285 17: ANSWERS 17.1 C Break-even point = fixed cost/contribution per unit = $150,000/$40 = 3, D Required contribution = fixed costs + required profit = $(150, ,000) = $180,000. Required sales volume = required contribution/contribution per unit = $180,000/$40 = 4,500 units. Sales revenue = 4,500 $100 = $450, Margin of safety = 100% (budgeted volume breakeven volume)/budgeted volume = 100% (5,000 3,750)/5,000 = 25% B Units required to break even = fixed costs/contribution per unit = (1,000 x $10)/$(100 40) = 167 to nearest unit. Breakeven sales revenue = (167 $100) = $16, C Break-even points in units = fixed costs/contribution per unit = $50,000/($25 0.4) = 5,000. Break-even sales revenue = 5,000 $25 = $125,000 or using c/s ratio $50,000/0.4 = $125, B B/E = = Fixed costs Contribution/unit 10,000 4 ( ) = 9,091 units 17.7 Profit = $12,000, B/E = = FC + Pr ofit Contribution/unit 40, , = 11,818 units 17.8 D New B/E point = 40,000 ( ) = 8,197 % fall = 9,091 8,197 9,091 = 9.8% 17.9 Fixed costs + required profit Contribution per unit 55, ,000 (61 17) = 1,750 units 17.16

286 17: ANSWERS B Break-even sales = 7,000 x 10 $12 = 5,833 kilts Margin of safety = 7,000 5,833 = 1,167 kilts A Fixed cost + target cost Contribution per unit = (10,000 x 4) + 4, = 5, C Budgeted sales = 10,000 Break-even sales: 5,750 Fixed cost Contributionper unit = 40,000 x = 5,750 Margin of safety = 10,000-5,750 10,000 = 42.5% A Original budgeted profit: $ Contribution (10,000 x 8) 80,000 Fixed costs (40,000) Profit 40,000 $ per unit New sales prices ($20 x 1.20) New variable cost ($12 x 1.12) New contribution Contribution required (as above) $80,000 Sales volume now needed ( 10.56) 7,576 Units Distance Z This is 2,424 units or 24.24% less than original budgeted sales of 10,000 units. Contribution = sales variable costs

287 17: ANSWERS END OF CHAPTER 17.18

288 Relevant costs and decision making Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: Explain the concept of relevant costing. Calculate the relevant costs for materials, labour and overheads. Calculate the relevant costs associated with non-current assets. Explain and apply the concept of opportunity cost. Exam Context Relevant costing is one of the key syllabus topics for paper F2. Make sure that you can calculate relevant costs for materials, and labour and the deprival value of an asset. Qualification Context This chapter provides the knowledge and understanding of how to calculate the relevant cost. This becomes important within the F9 Financial Management syllabus within project appraisal methods such as NPV. 18.1

289 18: RELEVANT COSTS AND DECISION MAKING Overview Relevant costs and decision making Relevant costs Limiting factor decisions Materials Overheads Labour Non current assets 18.2

290 18: RELEVANT COSTS AND DECISION MAKING 1 Relevant costs 1.1 A relevant cost is a future cashflow arising as a direct consequence of a decision. ie. a relevant cost is a: 1.2 Future Incremental Cashflow Costs that have been incurred in the past are totally irrelevant to any decision being made 'now' SUNK COSTS Only extra costs incurred/saved as a result of the decision will be relevant Other terms used in the context of relevant costing include: Only cashflow information is required eg. ignore depreciation Avoidable costs 1.3 Definition Those costs which can be identified with an activity/decision and which would be avoided if the activity did not exist. For example, equipment costs for a project of $7,000 will be avoided if the project does not go ahead. Opportunity cost 1.4 Definition The benefit foregone by selecting one course of action in preference to the most profitable alternative. For example, X plc can undertake one of two projects. Project A would results in profits of $20,000 and Project B $14,000. X plc would decide to go ahead with Project A in order to maximise its profits as a result of this it would lose out on the $14,000 from Project B. Therefore the opportunity cost of going ahead with Project A is $14,000. This would be a relevant cost when deciding which project to undertake. 2 Relevant costs of inputs for decision making 2.1 We need to be able to calculate the relevant costs of all inputs into a particular project in order to make a decision to go ahead or not. This will include the relevant costs of: materials labour overheads non current assets and any opportunity cost associated with the project. 18.3

291 18: RELEVANT COSTS AND DECISION MAKING Relevant cost materials 2.2 In inventory Not in inventory In continual No other Scarce Just have use use to buy it If taken from inventory will have to replace Take from inventory Relevant cost Relevant cost Relevant cost Relevant = current market = zero = opportunity cost of cost price or Sales value not using for alternative = current market forgone opportunities price Lecture example 1 Exam standard question each worth 2 marks A contract requires 400 kg of X and 200 kg of Y. The following data is available Current In inventory Historic purchase Scrap cost price value X 300 kg $2/kg $3/kg $2.20 Y 300 kg 50p/kg $2/kg $1.50 X is no longer used by the company; Y is regularly used for other products/purposes within the business. Required What is the relevant cost of material X and material Y to be included in the contract cost? Material X $ Material Y $ 18.4

292 18: RELEVANT COSTS AND DECISION MAKING Workings Relevant cost labour 2.3 Labour Full capacity, Spare capacity Full capacity but could hire and can't hire more more Relevant cost = Relevant cost = Relevant cost = Current market price Zero Opportunity cost of not using labour or alternative opportunities 18.5

293 18: RELEVANT COSTS AND DECISION MAKING Lecture example 2 Exam standard question each worth 2 marks A plc is deciding whether to undertake a new contract. 15 hours of labour are required for the contract. Labour is currently at full capacity producing X. Cost card for X $/unit Direct materials (10 $2) 20 Direct labour (5 $6) 30 Variable overheads (60% of direct labour) 18 Prime cost 68 Selling price 90 Contribution 22 Required What would the cost of using 15 hours of labour for the contract be? Workings $ Relevant cost - Overheads 2.4 In general variable costs will be relevant costs and fixed costs will be irrelevant to a decision. There may be occasions when fixed costs are a relevant cost. For example it may be necessary to employ an extra supervisor if a particular order is accepted, this would be an attributable fixed cost. General fixed overheads would not be a relevant cost as they are often an apportioned share of fixed costs of items which would be completely unaffected by decisions. Relevant cost - Deprival value 2.5 If the business was deprived of an asset how much money would it have to receive to be no worse off? The deprival value can be calculated as the: 18.6

294 18: RELEVANT COSTS AND DECISION MAKING Lower of Replacement cost Higher of NRV Economic value in business Lecture example 3 Exam standard question worth 2 marks A machine cost $14,000 ten years ago. In the business it is expected to generate future revenues of $10,000. It could be scrapped for $8,000. An equivalent machine in the same condition would cost $9,000 to buy now. Required What is the deprival value of the machine? $ Workings 18.7

295 18: RELEVANT COSTS AND DECISION MAKING Lecture example 4 Exam standard question worth 2 marks As above but replacement cost $11,000. Recalculate the deprival value: $ Workings 3 Limiting factor decisions 3.1 The production and sales plans of a business may be constrained by limiting factors/scarce resources. For example: Sales demand Machine hours Labour hours Raw materials The plans of the business must be built around these factors. Optimal production plan 3.2 If the business makes more than one product, it will want to find the product mix which will make best use of the limiting factors in order to achieve its objectives. e.g. If the company s objective is to maximise profit it will want to arrange its production plan so as to generate the maximum profit. 3.3 Where a business has a single limiting factor and is aiming to maximise contribution, it should rank its products in terms of which gives the most contribution per unit of scarce resource. The optimal production plan can then be determined. 18.8

296 18: RELEVANT COSTS AND DECISION MAKING Lecture example 5 Exam standard question each worth 2 marks Machine time available is 300 hours. A B C $ $ $ Selling price Variable costs Fixed costs Machine time 5hr 2hr 1hr Demand Required What is the optimal production plan? Solution 4 General factors to consider in decision-making 4.1 (a) Are the cash flows known with certainty? (b) What are the objectives of the company? (c) Are there any alternative courses of action that have not been considered? (d) What will be the impact of the decision on the following? (i) The workforce (ii) Customers (iii) Competitors 18.9

297 18: RELEVANT COSTS AND DECISION MAKING 5 Chapter summary Relevant costs are future incremental cashflows. Relevant costs also include deprival costs and opportunity costs. In general variable costs will be relevant costs and fixed costs will be irrelevant to a decision. In a make or buy decision with no limiting factors, the relevant costs for the decision are the differential costs between the two options. The decision to accept or reject a contract should be made on the basis of whether or not the contract increases contribution and profit

298 Chapter 18: Questions 18.11

299 18: QUESTIONS 18.1 Cox L'espair Ltd is a specialised component manufacturer working below full capacity. Its chief executive, Rowan Attstroke, would like to fill up capacity by taking on extra work at low prices. A potential customer has offered to buy 1,000 units of component FGH. Each unit of FGH requires 2 units of Material M111 and 5 units of Material M222. Units in inventory Original purchase price per unit Current replacement price per unit Disposal value per unit Material $ $ $ M111 1, M222 4, Notes: 1 Materials M111 is in continuous use by the company. 2 Material M222 is no longer used by the company, and existing inventories are now surplus to requirements. For Rowan Attstroke to calculate a minimum price for the customer's order, what would be the relevant cost of the materials? A $15,700 B $16,700 C $17,500 D $19,500 (2 marks) 18.2 Scorsatz Okker has a machine which it purchased two years ago for 15,000 and which now has a net book value of $5,000. Perry Striker, the company's chief executive, is wondering whether to use the machine for a one-year project. If not used, it would have no other use, and although it could be sold, there would be a loss on disposal of $2,000. If used for the project, the machine would have a one-year life, after which it would have no resale value, but would cost $1,500 to dispose of. The variable operating costs of the machine would be $6,000 for the year. In deciding whether to go ahead with the one year project, and ignoring interest costs, the relevant costs of the machine would be $ (2 marks) 18.3 Jamie is considering starting a new business and he has already spent $7,500 on market research and intends to spend a further $2,500. In the assessment of the relevant costs of the decision to set up the business, market research costs are: A a sunk cost of $10,000 B a sunk cost of $7,500 and an incremental cost of $2,500 C a sunk cost of $2,500 and an incremental cost of $7,500 (1 mark) 18.12

300 18: QUESTIONS 18.4 Antigua Limited produces a single product with a standard cost card as shown. $ Direct materials (0.25 kg at $1.20/kg) 0.30 Direct materials (1.5 hours at $5/hr) 7.50 Overheads Only 20,000 labour hours can be obtained and 3,500kg of material will be available to purchase in the next month. The sales manager believes that maximum demand will be 13,000 units and the production manager intends to reduce finished goods inventories by 600 units. What will be the limiting factor? A Materials only B Labour only C Materials and labour D Sales demand (2 marks) 18.5 A contract requires 100 hours of labour. The company pays their staff $6/hour. There is no spare capacity and if the company wishes to undertake the contract they will have to take staff away from their current production making vases. Each vase takes 4 hours to make and earns a contributions of $30 per unit. What is the relevant cost of labour for the contract? A $600 B $750 C $1,350 D $3,600 (2 marks) 18.6 Equipment is required for a new contract offered to XYZ plc. The equipment is currently expected to generate revenues for the company of $125,000. It could be sold for $112,000. To buy an equivalent machine would cost $107,000. What is the relevant cost of the equipment? A $107,000 B $112,000 C $125,000 D $232,000 (2 marks) 18.7 Stuart Ltd has to incorporate 100 kgs of material X into a special order for a customer. Data for material X is as follows: Quantity in inventories 75 kgs Original purchase price $2/kg Current replacement price $3/kg If not used on the special order all existing inventories of X must be disposed of at a cost to F Ltd of $0.50/kg. What is the relevant cost to material X for the special order? A $37.50 cost B $37.50 saving C $75.00 cost D $ cost (2 marks) 18.13

301 18: QUESTIONS 18.14

302 Chapter 18: Answers 18.15

303 18: ANSWERS 18.1 B Relevant costs can never be costs already incurred. Original purchase prices for M111 and M222 are irrelevant. Relevant costs: $ M111 in continuous use, so quantities used will be replaced: (1,000 x 2 $3.50) 7,000 M222 5,000 units of which 4,000 units are in inventory (which can be sold if not used) $1.80 7,200 M222 Further 1,000 units to be purchased $2.50 2,500 16, The company would lose the opportunity to sell the machine now, and would instead incur disposals cost in one year. These are both relevant costs. $ Variable operating costs 6,000 Current proceeds from disposal of machine (opportunity cost) 3,000 (5,000 2,000) Disposal cost in one years time 1,500 10, B $7,500 has been spent on market research already and is therefore a sunk cost and irrelevant to the decision. The further $2,500 will only be spent if Jamie continues with the project, therefore it is an incremental (relevant) cost of the decision to go ahead D Units Sales 13,000 Decrease in stock (600) Production 12,400 Hours Labour: Available 20,000 Required (12, ) 18,600 Therefore not limiting. Kg Materials: Available 3,500 Required (12, ) 3,100 Therefore not limiting. Therefore sales demand is the limiting factor 18.5 C 100 hrs Using the 100 hours on the contract means 4 hrs per unit = 25 vases can't be made $ Lost contribution (25 x $30) 750 Add back: labour not saved (100 x $6) 600 Relevant cost 1,

304 18: ANSWERS 18.6 A Relevant cost Lower of ($107,000) Replacement cost Higher of ($107,000) ($125,000) 18.7 A Net realisable Value in Value use ($112,000) ($125,000) $ Extra costs 25kg $3 (75) Saved cash on disposal of stock 37.5 (37.5) 18.17

305 18: ANSWERS END OF CHAPTER 18.18

306 Linear programming Syllabus Guide Detailed Outcomes Having studied this chapter you will be able to: Identify a single limiting factor. Determine the optimal production plan where an organisation is restricted by a single limiting factor. Formulate a linear programming problem involving two variables. Determine the optimal solution to a linear programming problem using a graphical approach. Use simultaneous equations, where appropriate, in the solution of a linear programming problem. Exam Context Linear programming has been examined consistently under the old syllabus. Make sure that you can follow the methodical approach to answering questions. Qualification Context The tools learnt in this chapter are again used in paper F5 Performance Management where multi-limiting factor analysis and shadow pricing are examined. 19.1

307 19: LINEAR PROGRAMMING Overview Linear programming Single limiting factor Multiple limiting factors (Chapter 18) Linear programming model Assumptions 19.2

308 19: LINEAR PROGRAMMING 1 Limiting factors 1.1 As seen in Chapter 18 a limiting factor is a constraint on the organisation's production. The production plan must aim to maximise the contribution per unit of limiting factor. Chapter 18 dealt with simple production planning given a single limiting factor. In this chapter we look at the approach to this problem using linear programming. 2 Linear programming Introduction 2.1 Linear programming describes the problem of profit maximisation or cost minimisation in terms of a mathematical model, which can then be solved. Formulating the linear programming model 2.2 The approach to linear programming model is as follows: (1) Define variables (including units to be used) (2) Identify constraints as linear inequalities (3) Construct objective function (4) Graph constraint (5) Establish feasible region (6) Add profit/contribution line (7) Determine optional solution. Lecture example 1 Preparation question Suzie makes two types of garden ornament, Gnomes and Statues. The data relating to each is: Gnomes Statues Materials 2kg 4kg Labour hours 5 hours 6 hours Contribution $6 $9 There is a maximum of 80kg of material available per week and 180 labour hours per week. Demand for Gnomes seems to be unlimited but maximum weekly demand for statues is

309 19: LINEAR PROGRAMMING Required If Suzie wants to maximise contribution, formulate the linear programme. (a) Find the optimal production plan and the maximum contribution that this will generate. Solution (a) (1) Definition of variables (2) Identification of constraints as linear equalities (3) Construct objective function (4) Graph constraints (5) Establish feasible region (6) Add profit/contribution line 19.4

310 19: LINEAR PROGRAMMING (7) Determine optimal solution (b) If the maximum demand for statues fell to four per week, how would the situation change? Solution Minimisation problems 2.3 The objective could be to minimise something e.g. costs. The procedure for solving the problem graphically is the same (plot the constraint, identify feasible region) BUT the optimal point will be the point closest to the origin, still in the feasible region. Assumptions of linear programming 2.4 (a) Linear relationship between variables and objective function (e.g. units made and contribution contribution/units is constant). (b) Linear relationship between variables and constraints (e.g. units made and materials used materials usage/unit is constant). (c) Solution may be non-integer (eg can we make 0.2 of a unit?). (d) Company has only one objective. (e) All values known with certainty. (f) Only two variables: problems involving more than two variables cannot be solved graphically. 19.5

311 19: LINEAR PROGRAMMING 3 Chapter summary A limiting factor limits the organisation's production. The production plan must aim to maximise the contribution per unit of limiting factor. Linear programming is a technique for solving the limiting factor problem mathematically. Linear programming at this fairly simple level, is a technique that can be carried out in a fairly 'handle-turning' manner once you have got the basic idea. The steps to follow are: (1) Define variable (2) Establish constraints (3) Construct objective function (4) Graph constraints (5) Establish feasible region (6) Add profit/contribution line (7) Determine optimal solution. 19.6

312 Chapter 19: Question 19.7

313 19: QUESTION 19.1 Fleet Ltd produces two types of rolling pin, the basic and the de-luxe. Both types require turning and finishing. Turning hours are limited to 640 per month and basic and de-luxe pins can be turned at the rate of 4 and 2 per hour, respectively. A basic pin requires 0.5 hours of finishing, while a de-luxe requires finishing hours are available each month. If x = monthly production of basic pins y = monthly production of de-luxe pins then the constraints on the values of x and y are x 0, y 0, and A 4x + 2y 640; 0.5x y 480 B 0.25x + 0.5y 640; 0.5x y 480 C 4x + 2y 640; 2x + 0.8y 480 D 0.25x + 0.5y 640; 2x + 0.8y 480 (2 marks) 19.8

314 Chapter 19: Answer 19.9

315 19: ANSWER 19.1 B Turning hours: Basic pins 4 per hour 15 mins each De-luxe 2 per hour 30 mins each 0.255x + 0.5y 640 Finishing 0.5x y 480 END OF CHAPTER 19.10

316 Answers to Lecture Examples 20.1

317 20: ANSWERS TO LECTURE EXAMPLES Chapter 1 Answer to Lecture Example 1 Accuracy in accordance with user s needs Timeliness not out of date/relevant to use Relevant to user Appropriately communicated suitable format and suitable audience Cost effective cost less than benefit Appropriate volume correct level of detail, stick to objectives. Answer to Lecture Example 2 Profit making firm Non profit making firm Maximise profits/shareholder wealth Provide goods/services Minimise costs Minimise costs Maximise revenue Use resources efficiently Increase market share Satisfaction of donor Answer to Lecture Example 3 Providing best quality External information Competitors services offered prices charged Customers other services they might use satisfaction jobs to tender for Suppliers continuation of trade Possibility of opening new office/dept eg tax Internal information Management accounts performance against budget debtor reports Budgets (eg. cash, production, sales) Staff availability and schedules 20.2

318 20: ANSWERS TO LECTURE EXAMPLES Answer to Lecture Example 4 Financial accounting Management accounting Legal requirement X Users External and internal Internal Precision True and fair As accurate as possible for the users needs Rules Generally accepted accounting principles No rules govern them but some established techniques used Reporting Past data Past and present data to make decisions about future Scope Whole organisation Segments/divisions or whatever is needed by the business Frequency Annual As required Format Governed by Companies Act No set format Chapter 2 Answer to Lecture Example 1 Production costs Non production costs Raw materials Sales staff Production staff Distribution staff Depreciation on assets Admin department Factory rent Finance department 20.3

319 20: ANSWERS TO LECTURE EXAMPLES Answer to Lecture Example 2 Non Production Costs Administration Selling Distribution Finance Depreciation of office equipment Office salaries directors etc Sales staff Packing Finance director Cars for sales staff Drivers Staff Stationery Insurance Software Advertising Answer to Lecture Example 3 Total production costs Direct Indirect Materials Labour Expenses Material Labour Expenses CD Factory Royalties Oil/grease Supervisor Rent Box staff for machine Rates Insurance Answer to Lecture Example 4 Direct Indirect Selling cost per CD ie. Advertising Admin department Distribution cost per CD ie. Post & Finance department packaging Head office Answer to Lecture Example 5 Production cost centres Machining Finishing Mixing Stirring Pressing Packing Clothes manufacturing Food production CD production Service cost centre Canteen Maintenance Stores 20.4

320 20: ANSWERS TO LECTURE EXAMPLES Chapter 3 Answer to Lecture Example 1 Types of cost behaviour (a) Fixed cost (b) Stepped fixed cost Total cost $ Total cost $ eg. rent, rates, insurance O O eg. rent if further production space is required (c) Variable cost (d) Mixed cost $ $ Total cost Total cost O O eg. material, labour eg. telephone bill, labour on minimum wage or total cost Answer to Lecture Example 2 Units Costs $ Highest 1, ,000 Lowest , ,000 $80,000 variable cost per unit = = $ Fixed cost element: TC = FC + VC/unit x output Substitute at the highest level: $110,000 = FC + $100 x 1,000 FC = $10,000 D y = $10,000 + $100x Answer to Lecture Example 3 y = 10, x y = 10, x 780 TC = $88,

321 20: ANSWERS TO LECTURE EXAMPLES Answer to Lecture Example 4 High/low method above volume of 7,000 units. Output Total cost $ Lowest 7,500 76,500 Highest 10,000 90,000 2,500 13,500 VC/unit = $13,500 = $5.40/unit 2,500 NB. This is constant at all volumes of output TC = FC + VC/unit x output Substitute at lowest (or highest) level: $76,500 = FC + $5.40 x 7,500 FC = $36,000 above output of 7,000 units. So at 5,000 units TC = FC + VC/unit x output $54,500 = FC + $5.40 x 5,000 FC = $27,500 below output of 7,000 units. Chapter 4 Answer to Lecture Example 1 Units Cost $ High (units) ,100 Low (units) ,000 Difference ,100 Any change in costs is entirely due to variable elements $17,100 variable cost per unit = = $90 / unit 190 Substitute this into the high activity level then: Total costs = Fixed costs + variable costs/unit x output ie. $49,100 = Fixed costs $90 Fixed costs = $17,600 Answer to Lecture Example 2 (a) x y xy x 2 Y 2 (units) ($000) ($000) ($000) ,020 78,400 2, , ,500 2, ,340 40,000 1, ,120 25,600 1, ,680 57,600 1, , , ,100 8,

322 20: ANSWERS TO LECTURE EXAMPLES b = ( 5 53,345) ( 1, ) ( 5 324,100) ( 1,230) 2 = 9, ,600 = (in 000' s) Remember b represents the gradient of the line ie. $92.02 per unit a = , = (in 0000' s) Remember a represents the fixed costs ie. $19,128 in total (b) ie. y = x y = $19,128 + $92x Interpolation, when output is 240 units Cost predicted = $19,128 + $ = $41,208 Extrapolation, when output is 700 units Cost predicted = $19,128 + $ = $83,528 Answer to Lecture Example 3 r= ( 107,600 ) ( 5 8,924.2 ) ( ) 9,901 2 = 9, ,600 1, =0.94 Answer to Lecture Example 4 r 2 = Answer to Lecture Example 5 Winnings Probability EV $ $ = = = 2.50 Nil 0.70 = Nil 15 Answer to Lecture Example 6 Expected profit from Project A Probability x Profit $ 0.3 x 10,000 = 3, x 7,000 = 4,900 7,

323 20: ANSWERS TO LECTURE EXAMPLES Expected profit from Project B Probability x Profit $ $ 0.2 x 5,000 = 1, x 12,000 = 6, x 3,000 = x (7,000) = (1,400) 5,900 The company should choose Project A. Chapter 5 Answer to Lecture Example 1 (a) = B2 + B3 + B4 or = SUM(B2 : B4) (b) = B5* (c) = B5 + B6 or = B5* Answer to Lecture Example 2 Absolute cell referencing: = B5*$C$2 Answer to Lecture Example 3 = IF (C4>=200000, BONUS, NO BONUS ) Chapter 6 Answer to Lecture Example 1 Reasons for holding inventory Costs of holding inventory Costs of ordering inventory Ensure goods are available to meet demand Cost of storage ie. no stockout Provide a buffer between processes Interest charges Meet future shortages Insurance Take advantage of bulk discount Risk of obsolescence Absorb seasonable fluctuations in usage and Deterioration demand Investment if expecting shortages/inflation Cost of ordering - Clerical and administration - Transport 20.8

324 20: ANSWERS TO LECTURE EXAMPLES Answer to Lecture Example (a) EOQ = = 160 units (b) Total cost = = C D + PD Q O + CHQ 2 ( 32)(150 12) ( )(160) + (25)(150 12) = , = $45,720 (c) Q C H 2 C O Q D Order quantities Holding costs Order costs units $ $ (150 x 18% x 25 = = ) , ,000 2, Answer to Lecture Example 3 Steps: 2CoD 2 x 32 x 150 x 12 (a) EOQ = = CH 25 x 18% = 160 units per order (b) Recalculate = 2 x 32 x 150 x x 99% x 18% = units/order ie. 161 units CoD CH (c) Total cost = + PD + Q 2Q = + (25 x 0.99) (150 12) = , = 45, CoD CH (d) Total cost = + PD + Q 2Q 32 x 150 x 12 = + ( ) (150 12) = , = 44,953.5 ( ) ( )

325 20: ANSWERS TO LECTURE EXAMPLES (e) Total cost = = CoD CH + PD + Q 2Q ( ) ( ) (150 12) = , ,728 = 45,000 Order over 300 units at a time Answer to Lecture Example 4 (a) EBQ = ,000 4, ,000 = 30,000 units Set up costs = 4,000 30,000 $750 = $100 Holding costs = 30,000 4, = $ ,000 Chapter 7 Answer to Lecture Example 1 Standard time mins 680 mins Actual time 8 hrs 60 mins 480 mins Time saved 200 mins Bonus 75% (200 mins/60) $6/hr $15 Basic 8 hr $6 $48 $63 Answer to Lecture Example 2 $ 1 st 100 units (100 $4) 400 Next 50 units (50 $4.50) 225 Remaining 13 units (13 $5) 65 Week 48 pay 690 Answer to Lecture Example 3 Standard hours produced: A 200 x 4 = 800 B 350 x 2 = 700 C 300 x 3 = 900 2,400 mins 60 = 40 hours 20.10

326 20: ANSWERS TO LECTURE EXAMPLES Answer to Lecture Example 4 (a) Efficiency ratio = 14,000 x 2 35,000 x 100 = 80% 35,000 (b) Idle capacity ratio = x 100 = 134.6% 26,000 (c) Production volume ratio = 14,000 x 2 26,000 x 100 = 107.7% Answer to Lecture Example 5 Direct cost Indirect cost $ $ Skilled workers: Basic pay for normal hours worked (7 35 $10) 2,450 Basic pay for general overtime (30 $10) 300 Specific overtime (20 $10 1.5) 300 Overtime premium for general overtime (30 $10 0.5) 150 Semi-skilled workers: Basic pay for normal hours (4 35 $7.50) 1,050 Specific overtime (10 $ ) General overtime (10 $ ) , , Wages control account $ $ Bank net pay 3, Work in progress account Deductions PAYE/NIC direct labour 3, Production overheads indirect labour 1, , , Answer to Lecture Example 6 Labour turnover = 20 x 100 = 2.08% (1, )

327 20: ANSWERS TO LECTURE EXAMPLES Chapter 8 Answer to Lecture Example 1 Indirect material Indirect labour Indirect expenses Answer to Lecture Example 2 Mixing eg. oil, grease, paper towel eg. supervisor salary eg. rent, rates, insurance, depreciation Stirring Stores Canteen Total $ $ $ $ $ Stores cost 75,000 75,000 Rent & Rates (9:3:1:2) 54,000 18,000 6,000 12,000 90,000 Insurance (2:1:0.6:0.4) 20,000 10,000 6,000 4,000 40,000 Heat and light (9:3:1:2) 34,200 11,400 3,800 7,600 57, ,200 39,400 90,800 23, ,000 Answer to Lecture Example 3 (a) Direct method Prod depts. Service centres Mix $ Stir $ Stores $ Canteen $ Overheads 108,200 39,400 90,800 23,600 Reapportion Stores (50:30) 56,750 34,050 (90,800) Reapportion Canteen (45:40) 12,494 11,106 (23,000) 177,444 84,

328 20: ANSWERS TO LECTURE EXAMPLES Reciprocal method Prod depts. Service centres Mix Stir Stores Canteen $ $ $ $ Overheads 108,200 39,400 90,800 23,600 Reapportion Stores (50:30:20)) 45,400 27,240 (90,800) 18,160 41,760 Reapportion Canteen (45:40:15) 18,792 16,704 6,264 (41,760) 6,264 Reapportion Stores (50:30:20) 3,132 1,879 (6,264) 1,253 1,253 Reapportion Canteen (45:40:15) (1,253) 188 Reapportion Stores (50:30:20) (188) Reapportion Canteen (45:40:15) (38) 6 Reapportion Stores (50:30:20) 3 2 (6) 1 1 Reapportion Canteen (45:40:15) 1 (1) 176,203 85, Algebraic method Let S be total amount reapportioned out of stores C be total amount reapportioned out of maintenance S = 90, C C = 23, S Solve for S and M S = 90, (23, S) S = 90, , S 0.97S = 94,340 S = 97,258 Substitute 97,258 = 90, C C = 43,

329 20: ANSWERS TO LECTURE EXAMPLES (b) Production depts. Service centres M $ S $ S $ C $ Overheads 108,200 39,400 90,800 23,600 Stores (50:30:20) 48,629 29,177 (97,258) 19,452 Canteen (45:40:15) 19,374 17,221 6,458 (43,053) 176,203 85, Reciprocal method because there is more than one service department and they both do work for each other. Answer to Lecture Example 4 (a) (i) Mixing OAR = (ii) Mixing OAR = (b) (i) Stirring OAR = $175,708 2,500 units = $70.28 per batch of mars bars $175,708 2,000 machine hours = $87.85 per machine hour $86,292 4,000 labour hours = $21.57 per labour hour (c) (d) (ii) Stirring OAR = $86,292 $30,000 direct material = $2.88 per $1 of direct material cost The most appropriate activity for the mixing department is labour hours as it is a labour intensive department. The most appropriate activity for the stirring department is machine hours as it is a machine intensive department. Mars bars Mixing $175,708 12,500 = ,500 2,500 Stirring $86,292 10,000 = ,000 2,500 = $70.30 = $34.52 Total overheads = $ per batch of mars bars

330 20: ANSWERS TO LECTURE EXAMPLES Answer to Lecture Example 5 Mars Ltd (cont) Cost card Normal size Fun size $ $ Direct materials Mixing Stirring Direct labour Mixing $ Stirring $ Overheads Mixing $ Stirring $ Answer to Lecture Example 6 (a) Pre-determined overhead absorption rate = 100,000 20,000 units = $5/unit (b) Overheads absorbed = 24,000 (actual units produced) $5/unit = $120,000 Actual overhead = $117,000 Under/(over) absorption = $(3,000) Production overhead account $ $ Actual production overhead 117,000 WIP absorbed 120,000 P & L over absorption 3,000 (24,000 5) 120, ,000 (c) $ Expenditure variance 17,000 (A) Volume variance 20,000 (F) Over absorption 3,000 (F) Workings Expenditure variance Actual expenditure = $117,000 Budget expenditure = $100,000 $ 17,000 (A) Volume variance Actual production = 24,000 units Budget production = 20,000 units 4,000 units (F) Value at FOAR $5 = $20,000 (F) 20.15

331 20: ANSWERS TO LECTURE EXAMPLES Chapter 9 Answer to Lecture Example 1 Year 1 Year 1 Year 2 Year 2 $ $ $ $ $25 325, ,500 Less: COS Opening inventory (1,000 $20) 20,000 Production costs variable (14,000 $20) 280,000 (11,500 $20) 230, , ,000 Less: Closing inventory (1,000 $20) (20,000) (260,000) (250,000) 65,000 62,500 Less: variable selling costs (13,000 $0.50) (6,500) (12,500 $0.50) (6,250) Contribution 58,500 56,250 Less: fixed costs Production 11,000 11,000 Selling 5,000 5,000 (16,000) (16,000) Net profit 42,500 40,250 Answer to Lecture Example 2 (a) FOAR = $0.90 FOAR = Budgeted fixed production Normal activity overheads $0.90 = Budgeted fixed production 12,000 overheads Budgeted fixed production overhead = 12,000 $0.90 = $10,

332 20: ANSWERS TO LECTURE EXAMPLES (b) Absorption profit and loss Year 1 Year 1 Year 2 Year 2 $ $ $ $ $25 325, ,500 Less: CoS: Opening inventory 20,900 (1,000 $20.9) Production costs variable (14,000 $20) 280,000 (11,500 $20) 230,000 fixed (absorbed) (14,000 $0.9) 12,600 (11,500 $0.9) 10, , ,250 Less: closing inventory (1,000 $20.9) (20,900) 271, ,250 (Over)/under absorption (1,600) 650 (270,100) (261,900) Gross profit 54,900 50,600 Less: selling costs variable (13,000 $0.50) (6,500) (12,500 $0.50) (6,250) fixed (5,000) 43,400 (5,000) 39,350 Answer to Lecture Example 3 Reconciliation of absorption and marginal costing profits Profit Reconciliation Statement Year 1 Year 2 $ $ Absorption costing profit 43,400 39,350 Add: Fixed overheads b/f in opening inventory 900 Less: Fixed overheads c/f in closing inventory (900) Marginal costing profit 42,500 40,

333 20: ANSWERS TO LECTURE EXAMPLES Chapter 10 Answer to Lecture Example 1 Unit calculation Input units = Good output 1,000 = 1,000 Process I Units $ Units $ Raw materials 1,000 40,000 To Process II 1, ,000 Labour 50,000 Overheads 20,000 1, ,000 1, ,000 Cost/unit = Costs Output = 110,000 1,000 = 110/unit Answer to Lecture Example 2 Unit calculation Input units = Good output + Normal loss 1,000 = Process I Units $ Units $ Raw materials 1,000 40,000 Normal loss 100 Labour 50,000 To Process II ,000 Overheads 20,000 1, ,000 1, ,000 Cost/unit = Costs Normal Output = 110, Answer to Lecture Example 3 (a) = /unit Process I Units $ Units $ Raw materials 1,000 40,000 Normal loss 100 2,000 Labour 50,000 To Process II ,000 Overheads 20,000 1, ,000 1, ,000 Cost/unit = cost - scrap value of normal loss 110,000 2,000 = = 120/unit input units - normal loss units Scrap Account Units $ Units $ Normal loss 100 2,000 Cash 100 2,

334 20: ANSWERS TO LECTURE EXAMPLES (b) Scrap Account Units $ Units $ Normal loss 100 2,000 Cash 100 1,900 P&L a/c , ,000 Answer to Lecture Example 4 Unit calculation Input units = Good output + Normal loss +/ Abnormal loss/(gain) 1,000 = Abnormal gain Process I Units $ Units $ Raw materials 1,000 40,000 Normal loss 100 2,000 Labour 50,000 To Process II ,600 Overheads 20,000 Abnormal loss 20 2,400 1, ,000 1, ,000 Cost/unit = = Input costs - scrap value of normal loss input units - normal loss units 110,000 2,000 1, = $120/unit Scrap Account Units $ Units $ Normal loss 100 2,000 Cash 120 2,400 Abnormal loss , ,400 Abnormal Losses Account Units $ Units $ Abnormal loss 20 2,400 Scrap P&L a/c 2, , ,400 Answer to Lecture Example 5 Input units = Good output + Normal loss +/ Abnormal loss/(gain) 1,000 = Abnormal gain Process 1 Units $ Units $ Raw materials 1,000 40,000 Normal loss 100 2,000 Labour 50,000 To Process II ,400 Overheads 20,000 Abnormal gain 20 2,400 1, ,400 1, ,

335 20: ANSWERS TO LECTURE EXAMPLES Scrap Account Units $ Units $ Normal loss 100 2,000 Abnormal gain Cash 80 1, , ,000 Abnormal Gains Account Units $ Units $ Scrap Abnormal gain 20 2,400 P&L account 2, , ,400 Cost/unit = = Input costs - scrap value of normal loss Input units - normal loss units 110,000 2,000 1, = $120/unit Answer to Lecture Example 6 Input units = Good output + Normal loss +/ Abnormal loss/(gain) 920 = Abnormal gain Process II Units $ Units $ Input from process ,400 Output to finished Added materials 20,600 goods ,000 Conversion 35,000 Normal loss 90 Abnormal gains β 70 14, , ,000 Scrap Account Units $ Units $ Normal loss 90 Abnormal gain 70 Scrap Abnormal Gains Account Units $ Units $ Scrap 70 Abnormal gain 70 14,000 P&L a/c 14, , ,000 Cost/unit = Input costs - scrap value of normal loss Input units normal loss units 166,000 = = $200/unit 20.20

336 20: ANSWERS TO LECTURE EXAMPLES Answer to Lecture Example 7 (a) Cost per unit = (b) Total cost Total units 250 = = $0.83 per unit 300 units Hence valuations: Finished goods 200 $0.83 each = $166 WIP 100 $0.83 each = $83 WIP 100 units 50% complete = 50 equivalent units 250 cost per equivalent unit: 250 units = $1 per equivalent unit Hence valuations: Finished goods 200 equivalent $1 each = $200 WIP 50 equivalent $1 each = $50 Answer to Lecture Example 8 (a) Input units = Good output + Normal loss +/ Abnormal loss/(gain) + Cl WIP 1,500 = 1, Process I Units $ Units $ Raw materials 1,500 12,975 Normal loss Labour 9,576 To Process II 1,300 24,830 Overheads 3,156 Closing WIP c/d (b) (c) (d) 1,500 25,707 1,500 25,707 Statement of equivalent units Total Materials Labour Overheads Finished output 1,300 1,300 1,300 1,300 Closing WIP Normal loss 150 1,500 1,350 1,330 1,315 Cost per equivalent unit Materials Labour Overheads $ $ $ Costs 12,975 9,576 3,156 Scrap proceeds (150) ,825 9,576 3,156 Cost/EU $9.50 $7.20 $2.40 Total cost/eu $19.10 Valuations Finished goods (1,300 $19.10) $24,830 $ Closing WIP Materials (50 $9.50) 475 Labour (30 $7.20) 216 Overheads (15 $2.40)

337 20: ANSWERS TO LECTURE EXAMPLES Answer to Lecture Example 9 (a) FIFO Op WIP + Input units = Good output + Normal loss +/ Ab loss/gain + Cl WIP ,050 = 1, Process I Units $ Units $ Opening WIP Normal loss Raw materials 2,050 22,140 To Process II 1,815 46,778 Labour 16,497 Overheads 9,240 Closing WIP 80 1,623 Rounding 4 2,100 48,606 2,100 48,606 Statement of equivalent units Total Materials Labour Overheads Opening WIP (completed) Started & finished 1,765 1,765 1,765 1,765 Output 1,815 1,765 1,785 1,800 Closing WIP (started) Normal loss 205 2,100 1,845 1,833 1,848 Costs per equivalent unit Materials Labour Overheads $ $ $ Costs 22,140 16,497 9,240 Scrap proceeds (205) ,935 16,497 9,240 Cost/EU $11.89 $9 $5 Total cost/eu $25.89 Valuations $ Good output Costs b/f in opening WIP 727 Materials (1,765 $11.89) 20,986 Labour (1,785 $9) 16,065 Overheads (1,800 $5) 9,000 46,778 (b) $ Closing WIP Materials (80 $11.89) 951 Labour (48 $9) 432 Overheads (48 $5) 240 1,623 Weighted average Process I Units $ Units $ Opening WIP Normal loss Raw materials 2,050 22,140 To Process II 1,815 46,791 Labour 16,497 Closing WIP 80 1,616 Overheads 9,240 Rounding (86) 2,100 48,604 2,100 48,

338 20: ANSWERS TO LECTURE EXAMPLES Statement of equivalent units Total Materials Labour Overhead Good output 1,815 1,815 1,815 1,815 Closing WIP Normal loss 205 2,100 1,895 1,863 1,863 Chapter 11 Cost per equivalent unit Materials Labour Overhead $ $ $ Costs b/f incurred 22,140 16,497 9,240 normal loss proceeds (205) 22,410 16,713 9,276 Cost/EU $11.83 $8.97 $4.98 Total Cost/EU $25.78 Valuations $ Good output (1,815 $25.78) 46,791 $ Closing WIP materials (80 $11.83) 946 labour (48 $8.97) 431 overheads (48 $4.98) 239 1,616 Answer to Lecture Example 1 Joint products Oil refinery (diesel, petrol, paraffin) Chicken farm (legs, wings) Saw mill (timber vs sawdust) By-product Saw mill (sawdust) Answer to Lecture Example P1 : (5, ) = $1,500 1,800 1,200 P2 : (5,00 500) = $3,000 1,800 Process Account Units $ Units $ Material 2,000 2,000 Output P ,500 Labour 2,000 P2 1,200 3,000 Overheads 1,000 By-product ,000 5,000 2,000 5,

339 20: ANSWERS TO LECTURE EXAMPLES Answer to Lecture Example 3 (a) (b) Chapter 12 Sales Costs Profit $ $ $ P1 1,200 1,500 (300) P2 6,000 3,000 3,000 7,200 4,500 2,700 Sales Costs Profit $ $ $ Margin P1 1, ½% P2 6,000 3,750 2,250 37½% 7,200 4,500 2,700 Answer to Lecture Example 1 Job costing may be used by: Plumbers Builders Engineering company Answer to Lecture Example 2 (a) Job X112 $ Direct materials 1,350 Direct labour (150 x $6) 900 Variable overheads (150 x $2) 300 Prime cost 2,550 Fixed overheads (150 x $3) 450 Total cost 3,000 (b) SP 100% 4,000 C (75%) (3,000) P 25% 1,000 Job X112 $ SP 125% 3,750 C (100%) (3,000) P 25%

340 20: ANSWERS TO LECTURE EXAMPLES Answer to Lecture Example 3 (a) Service Manufacturing Product Intangible Tangible Types of cost Cost unit Heterogenous/ homogenous High proportion Indirect Difficult to identify Can't be stored Composite Heterogenous High proportion Direct Easy to identify Can build up stock (not always - perishable Homogenous (b) Accountancy firm Advertising agency Law firm Government agency Charity Answer to Lecture Example 4 Service Road, rail and air transport Hotel Education Hospital Catering establishment Cost unit Passenger/mile or tonne Occupied bed nights Full time students/tutor Patient/day Meals served Answer to Lecture Example 5 Kg carried miles taken 100,000 kg 30,000 = 3,000,000,000kg/miles $5,000,000 = $ /kg/mile 3,000,000,000 To carry 3kg 7,500 miles Cost = $

341 20: ANSWERS TO LECTURE EXAMPLES Chapter 13 Answer to Lecture Example 1 5,000 kg Workings Good Units Sales 850 less: opening inventory (100) Closing inventory requirement 150 Production good units required, but 10% of production defective. need to produce i.e. 900 good and 100 defective = 1,000 units 90 materials required = 1,000 5kg = 5,000kg No inventories of raw materials are held 5,000 kg needs to be purchased Answer to Lecture Example 2 (a) Sponge 2,400 units Jam 4,800 units Cream 1,200 units Sales revenue $1,440,000 (b) Sponge 2,160 units Jam 4,800 units Cream 1,080 units (c) Flour 56,000 kg cost $28,000 Milk 46,780 pints cost $32,746 (d) $25,

342 20: ANSWERS TO LECTURE EXAMPLES Workings (a) SALES BUDGET Sponge Jam Cream Total Sales (number of batches) 2,400 4,800 1,200 8,400 Selling price per batch $150 $175 $200 Revenue $360,000 $840,000 $240,000 $1,440,000 (b) (c) (d) PRODUCTION BUDGET Sponge Jam Cream Sales 2,400 4,800 1,200 Closing stock ,640 5,280 1,320 Opening stock (480) (480) (240) Production 2,160 4,800 1,080 MATERIALS USAGE Sponge Jam Cream Total Flour (kg) 10,800 28,800 7,560 47,160 Milk (litres) 8,640 24,000 6,480 39,120 MATERIALS PURCHASES Flour Milk Total Kg $ Litres $ $ Usage 47,160 23,580 39,120 27,384 50,964 Closing stock 9,840 4,920 8,160 5,712 10,632 57,000 28,500 47,280 33,096 61,596 Opening stock (1,000) (500) (500) (350) (850) Purchases 56,000 $28,000 46,780 32,746 60,746 LABOUR UTILISATION BUDGET Mixers Cooks Total (Hours) (hours) (hours) Sponge (2,160 units) 1,080 1,080 2,160 Jam (4,800 units) 3,600 2,400 6,000 Cream (1,080 units) 1,080 1,080 2,160 5,760 4,560 10,320 Hourly rate $2 $3 Total cost $11,520 $13,680 $25,

343 20: ANSWERS TO LECTURE EXAMPLES Answer to Lecture Example 3 Output 10,000 12,000 14,000 Material cost/unit Labour cost/unit Overhead fixed at all activity levels Materials Variable cost of $3/unit $3 x 12,350 = $37,050 Labour Mixed cost Output High/low method Cost $ 14,000 35,000 10,000 27,000 4,000 8,000 8,000 VC/unit = = $2/unit 4,000 TC = FC + VC/unit x Output 27,000 = FC + 2 x 10,000 FC = 7,000 $ VC $2 x 12,350 = 24,700 FC 7,000 31,700 Overheads fixed cost 20,000 88,750 Chapter 14 Answer to Lecture Example 1 Types of standard (a) Ideal standards These are based on perfect operating conditions i.e. no wastage, no idle time, therefore, representing very difficult targets to achieve in practice. Their effect is to demotivate staff because staff are never able to reach the targets which have been established. (b) Current standards These are based on current performance levels therefore including current inefficiencies etc. No attempt is made to aim for improved future performance thereby leading to stagnation and under performance. (c) Basic standards These standards are left unaltered over long periods of time and are likely to become out dated quickly. These are used to measure long-term performance and are least useful as a means of indicating strengths and weaknesses in production performance

344 20: ANSWERS TO LECTURE EXAMPLES (d) Expected standards These are based on hope for improved operating performance but not perfect performance i.e. what should be practically possible. If they are well set, these types of standard should motivate employees to improved levels of performance because they know the standards can be achieved. Chapter 15 Answer to Lecture Example 1 Workings Materials (a) Price variance : based on actual purchases $ 35,464 kg should $4.50/kg 159,588 35,464 kg did cost 163,455 3,867 A (b) Usage variance : based on actual production Kg 8,900 bidgets should 4kg 35,600 8,900 bidgets did use 34, kg F Value at $4.50/kg 3,024 F Total materials variance 843 A Labour (c) Rate variance : based on actual hours paid $ 45,400 hours should $5/hr 227,000 45,400 hours did cost 224,515 2,485 F (d) Efficiency variance: based on actual production hrs 8,900 bidgets should 5hrs 44,500 8,900 bidgets did take 45, hrs (A) Valued at $5/hr Total labour variance Variable overheads (e) Expenditure variance $4,500 A 2,015 A $ 45,400 hours should $2 90,800 45,400 hours did cost 87,348 3,452 F 20.29

345 20: ANSWERS TO LECTURE EXAMPLES (f) Efficiency variance: based on actual production Hrs 8,900 bidgets should 5hrs 44,500 8,900 bidgets did take 45, hrs A Valued at $2 Total variable overhead variance Fixed overheads (g) Expenditure variance: $1,800 A $1,652 F $ Actual expenditure 134,074 Budgeted expenditure 130,500 3,574 A Answer to Lecture Example 2 Volume variance: Units Actual production 8,900 Budgeted production 8, units F Value at O.A.R/unit ($15) Efficiency variance: $3,000 F hrs 8,900 bidgets should take 44,500 8,900 bidgets did take 44, hrs F Value at O.A.R/hr ($3) Capacity variance: $1,200 F hrs Total budgeted hours 43,500 Actual hours worked 44, hrs F Value at O.A.R/hr ($3) Total fixed overhead variance: $1,800 F 574 A 20.30

346 20: ANSWERS TO LECTURE EXAMPLES Chapter 16 Answer to Lecture Example 1 Sales (a) Price variance: based on actual units sold $ 8,400 bidgets should sell $75 630,000 8,400 bidgets did sell for 613,200 16,800 A Volume variance: Units Budgeted sales 8,000 Actual sales 8, units F Value at standard contribution $22 $8,800 F Answer to Lecture Example 2 Operating Statement under marginal costing $ Budgeted contribution (8,000 units at $22/unit) 176,000 Sales volume variance 8, ,800 Sales price variance (16,800) 168,000 Cost variances: F A Materials price usage 3,024 3,867 Labour wage rate 2,485 idle 6,500 efficiency 2,000 Var. O/head expenditure 852 efficiency 800 9,161 10,367 (1,206) Actual contribution 166,794 Less: Fixed costs: Budgeted 130,500 Expenditure variance 3,574 (A) (134,074) Actual profit 32,

347 20: ANSWERS TO LECTURE EXAMPLES Answer to Lecture Example 3 Operating statement under absorption costing $ Budgeted profit 56,000 Sales volume variance 2,800 58,800 Sales price variance (16,800) 42,000 $(F) $(A) Cost variances: Materials price 3,867 usage 3,024 Labour rate 2,485 idle 6,500 efficiency 2,000 Variable overheads expenditure 852 efficiency 800 Fixed overheads expenditure 3,574 efficiency 1,200 capacity 1,800 12,161 13,941 (1,780) Actual profit 40,220 Workings Sales volume variance Units Budgeted sales 8,000 Actual sales 8, units F Valued at standard profit/unit $7 $2,800 Answer to Lecture Example 4 (1) Labour rate variance $ Actual hours should cost β 109,200 28,000 x standard cost Actual hours did cost 117,600 $8,400 A Standard cost = 109,200 = $3.90/hour 28,000 (2i) Labour efficiency variance Hours Actual units should take β 27,000 Actual units did take 28,000 1,000 hours (A) standard cost $3.90 3,900 (A) 20.32

348 20: ANSWERS TO LECTURE EXAMPLES Chapter 17 Answer to Lecture Example 1 Estimate cost behaviour via High/Low technique Output Costs $ High 8,000 57,700 Low 6,000 44,700 2,000 13,000 13,000 VC/unit = = ,000 Substituting in High $57,700 = FC + 8,000 $6.50 FC = $5,700 (Total costs = 5,700 + $6.50 no. of units) Fixed costs 5,700 BEP = = = 3,800 units Contribution/unit Break-even revenue = 3,800 $8 = $30,400 Answer to Lecture Example 2 Contribution/unit 1.5 C/S ratio = = = Sales price 8 5,700 Break-even revenue = = $30, Answer to Lecture Example 3 Margin of safety = 5,000 3,800 = 1,200 units 1,200 or 100 = 24% 5,000 The sales volume must fall by 24% from budgeted level before a loss is made

349 20: ANSWERS TO LECTURE EXAMPLES Answer to Lecture Example 4 10, ,700 Sales volume = = 10, units Answer to Lecture Example 5 TOTAL COSTS AT BEP = 5,700 + ($6.50 3,800) = $30,400 TOTAL REVENUE AT BEP = 3,800 $8 = $30,400 $ 40,000 38,200 Sales & Costs 30,400 TR TC 5,000 $8 = $40,000 (5, ) + 5,700 = $38,200 5,700 $ 3,800 5,000 Sales volume 40,000 Sales revenue Total costs Profit Contribution 30,400 Fixed costs Variable cost Fixed costs MoS 3,800 5,

350 20: ANSWERS TO LECTURE EXAMPLES Answer to Lecture Example 6 Change in profit PROFIT Gradient of line = = contribution per unit = 1.50 Change in volume 1,800 fixed cost 5,700 BEP 3,800 Volume 5,000 (Unit) margin of safety Answer to Lecture Example 7 (a) The line would start at 6,500 and cross the x axis at units. The gradient would not change. FC using BEP = unit cost (b) If selling price is $10 = 6, The contribution will become $ = $3.50 So break-even point will be 5, = 1,629 units Answer to Lecture Example 8 Workings Fixed cost BEP = = $25,000 = Contribution per unit $25,00 ($11 VC) = $75,000 $275,000 - $25,000 VC = $75,000 $200,000 = $25,000 VC VC = $8 So Variable cost = $8 = 4,333 units 75, VC 20.35

351 20: ANSWERS TO LECTURE EXAMPLES Chapter 18 Answer to Lecture Example 1 Historic cost can be ignored as it is a sunk cost. irrelevant. X Since X is no longer used by the company, the inventory of X will be used rather than buying in new supplies of X. (Note: the next best alternative to using the inventory is to scrap it for $2.20/kg) So relevant cost X $ 300kg inventory: lost scrap value (300 $2.20) kg buy in (100 $3) Y If the inventory of Y is used it will have to be replaced when it is needed elsewhere in the business. So relevant cost Y $ 200kg at current purchase price (200 $2) 400 Answer to Lecture Example 2 Labour is currently working at full capacity if 15 hours are used in the contract 15 hrs 5 hrs = 3 units of X will not be made Cash flows under each option Undertake contract Make 3X $ $ Direct labour Contribution lost (15 $6) (90) (3 $22) 66 Variable overheads (60% 90) (54) (144) relevant cost of using labour = $(144) $66 = $(210) Alternative approach $ Lost contribution (3 $22) 66 Add: costs not saved labour (3 $30) 90 variable overheads (3 $18)

352 20: ANSWERS TO LECTURE EXAMPLES Answer to Lecture Example 3 With the current machine, the company will use it and generate $10,000 revenues. Deprival value lower of = $9,000 Replacement cost higher of = $10,000 = $9,000 NRV Economic value = $8,000 = $10,000 If the company was given $9,000, it would replace the machine and generate $10,000 from it. Answer to Lecture Example 4 Deprival Value lower of = $10,000 Replacement cost higher of = $10,000 = $11,000 NRV Economic value = $8,000 = $10,000 If deprived of the machine, the company would not replace it, since replacement cost > money the machine would generate. as long as the company is given $10,000 it has not lost out. Answer to Lecture Example 5 A B C Contribution per unit $50 $40 $30 Machine hours per unit 5hr 2hr 1hr Contribution per machine hr $10 $20 $30 Rank (3) (2) (1) Production plan: Product Units Machine hour Total hours Contribution $ C ,500 B ,000 A , , hours = 30 units 5hrs/unit 20.37

353 20: ANSWERS TO LECTURE EXAMPLES Chapter 19 Answer to Lecture Example 1 (a) (1) Definition of variables Let g = No. of gnomes produced per week s = No. of statues produced per week (2) Identification of constraints as linear equalities Materials : 2g +4s 80 Labour : 5g + 6s 180 Demand statues : s 10 Non-negativity : g,s 0 (3) Construct the objective function Maximise contribution 6g + 9s (4) Plot constraints on graph 2g + 4s = 80 (g = 0, s = 20) (g = 40, s = 0) 5g + 6s = 180 (g = 0, s = 30) (g = 36, s = 0) s = 10 Linear Programme for Suzie s Production Problem 30 Labour 20 Materials 10 A B C Demand statues D g (5) Establish feasible region ie. would be defined by boundary origin, A, B, C, D 20.38

354 20: ANSWERS TO LECTURE EXAMPLES (6) Plot the objective function on the graph as C = 6g + 9s C could be any number we are trying to solve to get the maximum value for C. Pick any value for C. Let C = 6 9 (makes it easy to plot) 6 9 = 6g + 9s (g = 0, s = 6) (g = 9, s = 0) See graph. (7) Determine optimal solution We want to maximise contribution C, so we want the line furthest from the origin and still within the feasible region. slide objective function (using ruler) until this point is found. Point C on the graph. Point C is the intersection of the materials and labour constraints. Solve simultaneously Materials : 2g + 4s = 80 ( 3) 6g + 12s = 240 Labour : 5g + 6s = 180 ( 2) 10g + 12s = 360 4g = 120 g = 30 Substitute into materials s = 80 s = 5 The optimal production plan is 30 gnomes and 5 statues The maximum contribution 6g + 9s is: $ $5 9 = $225 If it is unclear from your graph whether the optimal point is B or C you can check the contribution at each B: Intersection S = 10 and materials 2g + 4s = 80 g = 20 contribution = $ $9 10 = $210 Lower than contribution at C C is optimal 20.39

355 20: ANSWERS TO LECTURE EXAMPLES (b) If the maximum demand for statutes is 4, the new graph would be S 30 Labour 20 Materials 10 Demand for statues N g the new optimal point would be at N, the intersection of new max statues and labour i.e. s = 4 and 5g + 6s = 180 i.e. g = 31.2 units END OF ANSWERS TO LECTURE EXAMPLES 20.40

356 Appendix A: Pilot Paper Questions 21.1

357 21: APPENDIX A: PILOT PAPER QUESTIONS 21.2

358 : APPENDIX A: PILOT PAPER QUESTIONS

359 21: APPENDIX A: PILOT PAPER QUESTIONS 21.4

360 : APPENDIX A: PILOT PAPER QUESTIONS

361 21: APPENDIX A: PILOT PAPER QUESTIONS 21.6

362 : APPENDIX A: PILOT PAPER QUESTIONS

363 21: APPENDIX A: PILOT PAPER QUESTIONS 21.8

364 : APPENDIX A: PILOT PAPER QUESTIONS

365 21: APPENDIX A: PILOT PAPER QUESTIONS 21.10

366 : APPENDIX A: PILOT PAPER QUESTIONS

367 21: APPENDIX A: PILOT PAPER QUESTIONS 21.12

368 : APPENDIX A: PILOT PAPER QUESTIONS

369 21: APPENDIX A: PILOT PAPER QUESTIONS 21.14

370 : APPENDIX A: PILOT PAPER QUESTIONS

371 21: APPENDIX A: PILOT PAPER QUESTIONS 21.16

372 : APPENDIX A: PILOT PAPER QUESTIONS

373 21: APPENDIX A: PILOT PAPER QUESTIONS END OF APPENDIX A 21.18

374 Appendix B: Formulae given in the exam 22.1