MANAGERIAL ACCOUNTING

Definitions and meaning:

Accounting has been defined differently by different accounting professional bodies. The
American Accounting Association defines accounting as the process of identifying,
measuring and communicating economic information to permit informed judgments and
decisions by users of the information.
The association of certified corporate accountants define management accounting as ;
The application of accounting and statistical techniques to the specific purposes of
production and interpretation of information designed to assist management in its
function of promoting maximum efficiency and in investigating ,formulating and
coordinating future plans and subsequently in measuring their execution.
Managerial accounting is the field of accounting that provides economic and financial
information for managers and other internal users.
Management accounting is a term used to describe the accounting methods systems and
techniques which coupled with special knowledge and ability, assists management in the
task of maximizing profit or minimizing losses.

Management accounting is also defined as the process of identification, measurement,

accumulation, analysis; preparation interpretation and communication of financial
information used by management to plan evaluate and control activities within an
organization and to assure appropriate use of and accountability for its resources.
Meaning of key terms in the definition above:
Identification - To recognize and evaluate various business transactions and other
economic events for appropriate accounting action.
Measurement - The estimation of the money value of transactions or economic events
that have occurred or may occur.
Accumulation - It involves recording and classifying appropriate business transactions.
Analysis- It is the determination of resources for and the relationship between the
reported activity and other economic events and circumstances.
Preparation and interpretation - Meaningful coordination of accounting and /or
planning data to identify a need of information, presented in a logical format, and if
appropriate, including conclusions drawn from those data.

Communication - Reporting of pertinent information to management and others for

internal and external uses.

Difference between financial accounting and management accounting and cost

accounting:
Financial accounting is concerned with the historical aspect of external reporting i.e.
providing financial information to outside parties such as investors, creditors and
government. Financial information is guided by generally accepted accounting principles.
Management accounting is concerned primarily with providing information to internal
users e.g. managers who are charged with the functions of planning and controlling the
operations of the firm and making a variety of management decisions. Management
accounting is not subject to the accounting principals.
Cost accounting is a formal system of accounting for costs by means of which costs of a
product or service are ascertained and controlled. It is the application of accounting and
costing principles, methods and techniques in ascertaining costs and analysis of savings
and / or excesses as compared with standards. Cost accounting is a branch of accounting
that has been developed due to limitations of financial accounting. Cost accounting is part
of management accounting. Management accounting is a generic term, which embraces
all branches of accounting. It uses techniques of financial accounting, cost accounting
and statistics to collect and analyze data to make it suitable for taking managerial
decisions in a most scientific manner so that maximum efficiency may be achieved in the
business.
A summary of differences between financial accounting and management
accounting:
Basis
Users/Audience

Frequency of the
preparation of reports
Purpose of reports

Emphasis of reports

Financial accounting
Provides data for external
users i.e. shareholders,
creditors etc.
Most financial accounting
reports are prepared
annually
Provides general purpose
information to users
Lay emphasis on historical
or past information. Its

Management accounting
Provides data for internal
users i.e. managers,
supervisors, workers etc.
Most management
accounting reports are
prepared as need arise.
Provides special purpose
information for a particular
user for a specific decision.
Lays emphasis on the future
and present

Regulation and restrictions/

legal requirements

Measurements of
information/ kind of
information
Scope

Source of the subject

matter.

Nature of the subject

Reliability /accuracy of
information.

historical in nature
Statements prepared to
fulfill statutory
requirements and are
subject to generally
accepted accounting
principles
Contains information
measured in money terms
only
Highly aggregate, i.e.
reports on the entire
business as a whole.
Primarily stands on its own
i.e. Subject matter not
borrowed from any
discipline
It is an end in itself.
Contains objective,
auditable, reliable,
consistent, and precise
information

Not subject to any accepted

principles or laws. System
and information determined
by management to meet
strategic and operational
needs. Entirely optional.
Contains both monetary and
non-monetary information.
Disaggregate i.e. reports on
sections of the business and
also on the entire business
Draws heavily from other
disciplines such as Finance
Economics, Statistics and
Operations research.
It is a means to an end
Contains subjective and
judgmental information.

Differences between cost accounting and management accounting:

Cost accounting involves working through set routines, budgets and standards, comparing
the actual with the standards, measuring the performance of, and reporting to the
management for correction of mistakes so as to improve the efficiency. Management
accounting besides these activities, will concentrate on matters relating to finance,
profitability and productivity. Management accounting involves constant monitoring of
standards set by cost accounting and giving instructions for their revision and
improvement.
Cost accounting works out the years operating statements while management accounting
proceeds further to plan and work out future operating statements of the organization.
Functions of management accounting:
The functions of management accounting are related to the management and control of a
firms resources. These functions may also be discussed from the point of view of duties
carried out by a management accountant. They include; providing information to
formulate accounting and costing policies; preparing financial reports; directing of
internal audit; budgeting; inventory control; tax administration etc.
Colin Drury (2004) outlines the functions of management accounting as:

1.
2.
3.

allocate costs between cost of goods sold and inventories for internal and
external reporting;
provide relevant information to help managers make better decisions;
provide information for planning, control and performance measurement.

The functions of Management accounting have also been broadly categorized by other
scholars as;
1. General functions
2. Specific/key functions
General functions:
These are functions carried out by a management accountant in his capacity as a manager
and can also be carried out by any other manager. The general functions of a manager
include:
1. Planning
2. Coordinating.
3. Controlling.
4. Decision making.
Planning:
The decision -making process starts with planning. Planning is a blueprint of what should
be done, how it should be done and when it should be done. Planning establishes the
enterprise objectives and determines the future course of action for accomplishing those
objectives. It provides a guideline for decision making. The task of planning involves the
identification of relevant variables both controllable and uncontrollable. Controllable
variables are subject to the influence of management and can be controlled and
manipulated to the best of advantage of the enterprise. Controllable variables include
quality and number of workers, source of capital, production techniques, cost and pricing,
sales, research and development etc. Examples of uncontrollable variables are population
changes, competition, customer attitudes, and economic conditions.
Planning as a function would therefore involve the selection of long-term and short-term
objectives and drawing up of strategic plans to achieve those objectives.
Coordinating:
In performing the coordination function, management decides how best to put together
the firms resources in order to carry out established plans.
Controlling:
This involves the implementation of a decision method and the use of feed back so that
the firms goals and specific strategic plans are optimally obtained. Control follows
planning. It is the process of ensuring that the plans are being attained. It is a feed back
system. It tells how efficient and effective objectives, goals and plans are accomplished,
what went wrong and what can be done to assure adherence to planned activities in

future. Control implies measure and evaluation of performance. The principal steps
involved in the control functions are:
1. Comparison of actual performance against predetermined budgets and standards;
2. An analysis of the variance from budgets and standards in order to determine the
underlying causes;
3. Initiation of an action that may correct the deficiencies indicated;
4. Follow up to appraise the effectiveness of the corrective action; and
5. The feedback of the information to the planning process to improve future planning
and control activities.
Decision making:
This is a purposeful selection from among a set of alternatives in light of a given
objective. This is another function of managers in general.
The decision making, planning and control process
1. Identify objectives

2. search for alternative courses of

action

3. Gather data about alternatives

4. select alternative courses of action

5. implement the decisions

6. compare actual and planned

outcomes

7. respond to divergences from plan

Source: Colin Drury (2004), pg9
Principal functions of a management accountant:
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The management accountant also known as the controller is in charge of the accounting
department. His authority is basically staff authority in that he/she gives advice and
services to other departments. At the same time, the management accountant has line
authority over members of his/her own department such as the internal auditor,
bookkeepers, budget analysts etc. The principal functions on the management accountant
include:
1. Planning and control of operations.
2. Reporting and interpretation of the firms performance.
3. Tax administration.
4. Reporting to government.
5. Protection of assets.
6. Economic appraisal.
7. Product and customer costing.
Planning and control- This function requires the management accountant to establish,
coordinate and administer as part of management, a plan for the control of operations.
This plan would work for profit planning, programs of capital investment and financing
of the business.
Reporting and interpretation of the firms performance- The management accountant is
required by this function to compare actual performance with operating plans and
standards and to interpret the results of operations to all levels of management and to
owners of the business.
Tax administration- The management accountant has the function and duty of
administering taxes. He helps to formulate and administer the tax policies and procedures
of the organization.
Reporting to the government- This function requires the management accountant to
supervise or coordinate the preparation of reports to the government and its agencies.
Protection of assets- The management accountant is required to protect the organizations
assets through internal controls, internal audit and arranging for insurance cover.
Economic appraisal- This function involves appraising economic and social forces that
affects the business and to interpret their effect on the business.

Basic cost concepts:

Management accounting, like any discipline has its own specialized terms. Learning
these terms is essential to understand the concepts and procedures discussed in the
subject.
Cost is the cash or cash equivalent value sacrificed for goods and services that are
expected to bring a current or future benefit to the organization. Costs are incurred to
produce future benefits. In a profit making firm future benefits usually mean revenues.
As costs are used up in the production of revenue, they are said to expire. Expired costs
are called expenses. In each period, expenses are deducted from revenues in the income
statement to determine the periods profit. A loss is a cost that expires without producing
any revenue benefit. Many costs do not expire in a given period. These unexpired costs
are classified as assets and appear on the balance sheet.
The cost concepts used in management accounting includes;
Opportunity cost: - This is the benefit given up or sacrificed when an alternative is
chosen over another. For example, choosing to attend school instead of working has an
opportunity cost equal to the wages foregone. Opportunity costs affect decision in that
they tell us how much is lost by failing to exploit an opportunity. It is the net income
foregone by rejecting an alternative.
Relevant cost: - This is the cost that will influence the decision made. It is the expected
future cost that will differ between alternatives.
Product costs: - These are inventorable costs, identified as part of inventory on hand.
They are therefore assets until they are sold. Once they are sold they become expenses.
All manufacturing costs are product costs.
Period cost: - These are costs not inventorable and are charged against revenue in the
period in which the revenue is earned. Selling, general expenses and administrative
expenses are period costs.
Standard costs: - This is a production or operating cost that is carefully predetermined.
It is a target cost that should be achieved. The standard cost is compared with the actual
cost in order to measure the performance of a given costing department.
Incremental cost: - This is the difference in cost between two or more alternative course
of actions.
Sunk cost: - This is the cost of resources that have already been incurred and cannot be
changed or affected by any decision made at present or in future. They represent past and
historical cost.

Classification of costs:
In management and cost accounting we try to organize costs in terms of the special
purpose, or functions they serve .Below a summary of cost classification;
Summary of classifications;
Basis
Behavior

Classification
-Fixed cost
-Variable cost
-Semi variable

Function

-Manufacturing cost
-Non manufacturing cost

Function / tracebility to the

product being produced.

-Direct cost

-Indirect cost

How costs are charged

-Product cost

-Period cost

Management Influence

Examples
Rent, Insurance
Direct wages, labour
and material.
Supervisors salary,
inspection cost, service
department cost, fringe
benefits and rental of
delivery tracks etc.
Cost of raw material and
direct labour etc.
Salaries for managers,
rent paid for premises
etc.
Cost or raw materials
and labour needed to
convert the raw
materials into finished
goods etc.
Depreciation on plant
and equipment,
maintenance,
supervision, property
taxes etc.
Direct material, direct
labour and direct
overheads etc.
selling and distribution
costs , advertising ,sales
commission ,legal fees
etc.

-controllable cost

Maintenance cost , cost

of inputs etc.

- Non controllable cost

Rent and factory

overheads etc..

Cost classification terms:

Variable costs - These are costs that vary in direct proportion to changes in the level of
activity.
Fixed costs - These are costs which do not change with changes in the level of activity.
Semi-Variable - These are costs that contain both a fixed and a variable component.

Direct costs are those costs that are directly traceable to the product that is being
produced or manufactured.
Controllable costs are those costs heavily influenced by the manager.
Non controllable costs are those cost which the manager has no influence over. All costs
are controllable at some level.

Manufacturing costs are those costs associated with the production function in the plant
and the factory.
Non manufacturing costs are those costs associated with the function of selling and
administration. Manufacturing costs can be further subdivided into direct and indirect
manufacturing cost.

Marginal costing Vs absorption costing; (Income determination)

Income statements prepared using the functional classification of costs is referred to as

absorption or full costing statements.
This classification is required in the preparation of financial statements for external
reporting.
Under the absorption costing approach, expenses are segregated according to function
and then deducted from revenues to arrive at income before taxes.
Absorption costing assigns all manufacturing costs to the product. Direct materials, direct
labour, variable overheads and fixed overheads define the cost of a product. Thus under
absorption costing, fixed overheads are assigned to the product through the use of a
predetermined fixed overhead rate and does not expire until the product is sold. In other
words fixed overhead is an inventorable cost.

Marginal costing on the other hand is a method compatible with the behavioral approach
to income determination. This approach is based on the behavior of costs with respect to
change in the level of activity.
Marginal costing may also be referred to as variable costing. It assigns only variable
manufacturing costs to the product. These costs include; direct material, direct labour and
variable overheads. Fixed overheads are excluded from the from the product cost. Under
variable costing, fixed overheads are seen as expiring in the given period. Fixed
overheads are therefore charged in total against the revenue of the period. They are
treated as period cost.
A Summary of the difference between absorption costing and marginal costing:
Marginal costing

Absorption costing

Only variable costs are considered for

product costing and inventory valuation

Both fixed cost and variable cost are

considered for product costing and
inventory valuation

Fixed overheads are considered period

costs and profitability of different
products is judged by P/V ratio.

Fixed cost is charged to cost of

production. Each product is to bear a
reasonable share of fixed costs and
profitability of product is thus influenced
by subjective apportionment of fixed
overheads.

Presentation of data is oriented to

highlight the total contribution and
contribution from each product

The presentation of cost data is on

conventional pattern. Net profit of each
product is determined after deducting
fixed overheads

The difference in the magnitude of

opening and closing stock does not affect
the unit cost of production.

The difference in the magnitude of

opening stock and closing stock affects
the unit cost of production due to the
impact of related fixed overheads.

Effect of opening and closing stock on profit:

The following will be noted when the income statements under absorption costing and
marginal costing are compared:

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1. When sales and production coincides i.e. their is neither opening stock nor closing
stock, the results under both methods will be the same.
2. More than profits under marginal costing. This is because under absorption costing, a
portion of fixed overheads is charged to the closing stock and carried over to the next
year instead of being charged to the current period.
3. When closing stock is less than the opening stock, the profit shown under absorption
costing will be lower than the profit shown under marginal costing. This is because ,
under absorption costing a portion of fixed cost relating to the previous year is
charged to current period.
Illustration one:
Ufundi Furniture mart uses an absorption costing system of record and cost analysis. The
following data relating to the year ended 30th June 20x5 is provided:
Unit cost data:
`
Selling price
Direct material
Direct labour
Sales commission

Sh.
200
55
40
10

Fixed Costs:
Production overheads
Sales promotion costs
Administration costs

560,000
150,000
215,000

Additional information:
(i) Production overheads are all fixed, and the predetermined absorption rate applied to
production as based on the budgeted amount of Sh 20 per unit of production.
(ii) Total production during the year amounted to 28,000 units. Opening stock of finished
goods were 5,000 units, but this level had fallen by 2,000 units at the end of the year.
The same unit costs persisted throughout 20x3 / 20x4 and 20x4 / 20x5.

Required:
Prepare a profit and loss statement under absorption costing and marginal costing for the
year ended 30th June 20x5.
Illustration two:
Shalom bakery produces and sells bread. There oven fresh bread is popular in the city. In
the year just ended 31st December 20x5, the company produced 115,000 units of bread.
The accountant produced the profit and loss account shown below:

11

Sh
Sales (125,000 units)
Less cost of sales:
Opening stock
Production costs
Less closing stock
Gross profit
Less Selling and administrative expenses
Net profit

Sh
3,000,000

180,000
1,035,000
1,215,000
(90,000)

1,125,000
1,875,000
670,000
1,205,000

Additional information:
1. The closing and opening stock units are valued as follows;
Variable cost Sh 5
Fixed cost Sh 4
2. Of the selling and administrative expenses Sh 280,000 is variable cost of selling.
3. Sh 810,000 of the production costs represent fixed cost of production.
4. Stock as on 31st December 20x5 was 10,000 units.
Required:
(i) Using the marginal costing approach prepare a profit and loss statement
(ii) Reconcile the difference in profits as revealed by the accountants statement and the
statement prepared in (i) above.
Illustration three:
The following data have been extracted from the budgets and standard costs of ABC Ltd,
a company which manufacturers and sells a single product.
Per unit (Sh)
Selling price
45
Direct Material cost
10
Direct Wages cost
4
Variable overhead cost
2.50
Fixed production overhead costs are budgeted at Sh 400,000 per annum. Normal
production levels are thought to be 320,000 units per annum.
Budgeted selling and distribution costs are as follows:
Variable
Fixed

Sh 1.50 per unit sold

Sh 80,000 per annum

Budgeted administration costs are Sh 120,000 per annum.

The following pattern of sales and production is expected during the first six months of
the year:

12

Sales (units)
Production (units)

January-March
60,000
70,000

April-June
90,000
100,000

There is to be no stock on 1st January.

You are required
(a)

(b)

To prepare profit statements for each of the two quarters, in columnar

format, using
(i)
Marginal costing
(ii)
Absorption costing
To reconcile the profits reported for the quarter January- March in your
answer above.

Illustration four:
Riat Ltd is considering its plans for the year ending 31st December 2001. It makes and
sells a single product, which has budgeted costs and selling price as follows:
Sh per unit
Selling price
45
Direct materials
11
Direct labour
8
Production overhead:
Variable
4
Fixed
3
Selling overhead:
Variable
5
Fixed
2
Administration overhead:
Fixed
3
Fixed overhead cost per unit is based on a normal annual activity level of 96,000 units.
These costs are expected to be incurred at a constant rate throughout the year.
Activity levels during January and February 2001 are expected to be:
January
February
Units
Units
Sales
7,000
8,750
Production
8,500
7,750
Assume that there will be no stocks held on 1st January 2001.
Required:
Prepare, in columnar format, profit statements for each of the two months of January and
February 2001 using:
(i)
Absorption costing
(ii)
Marginal costing

13

Illustration five:
The following information was obtained from the records of ABC Ltd which
manufactures one standard product:
Sales and expense budget for the year ended 31st may 2001
Total
Sh
Sh 000
Sales (120,000 units)
6,000
Production cost of sales:
Variable costs
3,900
Fixed costs
1,200
5,100
900
Administration and distribution cost (fixed)
600
Net Profit
300

Sh

Unit
Sh
50

32.50
10.00 42.50
7.50
5.00
2.50

On 31st may 2001, the following information was extracted from the records regarding
the actual production and sales:
6 months to
6months to
Nov 2000
May 2001
Production (units)
55,000
40,000
Sales (units)
48,000
42,000
Stocks:
Opening (units)
----7,000
Closing (units)
7,000
5,000
Required:
Prepare in columnar form, the semi- annual trading and profit and loss accounts for ABC
Ltd under each of the following methods:
(i)
Absorption costing
(ii)
Marginal Costing
Illustration six:
The following budgeted profit statement has been prepared using absorption costing
principles:

Sales
Opening stock
Production costs:
Direct materials
Direct Labour
Overhead

January to June
Sh000
Sh000
540
100

July to December
Sh000
Sh000
360
160

108
162
90
460

36
54
30
280

14

Closing stock

160

Gross profit
Production overhead:
(Over) Under absorption (12)
Selling costs
50
Distribution costs
45
Administration costs
80

80
300
240

200
160
12
50
40
80

Net profit/ (Loss)

163
77

182
(22)

Sales Units

15,000

10,000

Production units

18,000

6,000

The members of the management team are concerned by the significant change in
profitability between the two six month periods. As management accountant, you have
analyzed the data upon which the above budget statement has been produced, with the
following results:
1. The production overhead cost comprises both a fixed and a variable element; the
latter appears to be dependent on the number of units produced. The fixed element
of the cost is expected to be incurred at a constant rate throughout the year.
2. The selling costs are fixed.
3. The distribution cost comprises both fixed and variable elements; the latter
appears to be dependent on the number of units sold. The fixed element of the
cost is expected to be incurred at a constant rate throughout the year.
4. The administration costs are fixed.

Required:
(a) Present the above budgeted profit statement in marginal costing format
(20 marks)
(b) Reconcile each of the six monthly profit/loss values reported respectively under
marginal and absorption costing
(5 marks)
Process costing:
Question one:
Kenlub is an industrial lubricant produced in two successive chemical processes.
The output of process one is passed to process two for further processing.
You are given the following information with regard to the month of October
2000:

15

Process one:
Materials 3,000kg at 25cents per kg
Labour Sh 120
Process plant time 12 hours at Sh 20 per hour
Process two:
Materials 2,000kg at 40 cents per kg
Labour Sh 84
Process plant time 20hours at Sh 13.50 per hour
General overhead amounted to Sh 357 and is absorbed into process costs on
labour basis.
The normal output of process one is 80% of input and of process two 90% of
input.
Waste matter from process one is sold at 20cents per Kg and that from process
two for 30 cents per Kg.
The output for October was as follows:
Process one 2,300 Kg
Process two 4,000 Kg
There was no stock or work in progress at either the beginning or the end of the
month. In addition all the available waste has been sold.

Required:
Prepare accounts for the following:
(a)
Process one
(b)
Process two

(8 marks)
(7 marks)

Contract costing:
This is a method of costing adopted by business concerns which carry out building or
construction contracts. In principle, it is similar to job costing and is usually adopted for
work which is site-based, of a relatively long duration and undertaken to the customers
special requirements. Because of the self contained nature of most site operations more
costs than normal can be identified as direct and thus charged to the contract, e.g.
telephone on site, design and planning salaries, site vehicle cost. This method of costing
is mostly used by builders, civil engineering contractors, constructional and mechanical
engineering firms etc.
Each contract is considered as a separate unit of cost and is allotted a distinguishing
number. A separate account is kept for such individual contract; usually a greater part of
work is carried out at the contract site, so the whole of the expenditure can be charged
direct to the contract. However, the overhead relating to the office, central stores requires
apportionment among the various contracts on some arbitrary basis such as percentage of
wages materials or prime cost.

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A particular feature associated with contracts is the provision for progress payment to be
made by the clients which are necessary because of the length and value of some
contract. The basis for these interim payments is an architects certificate of work
satisfactorily complete. The amount paid is usually the certified value less a percentage
retention which is released by the client when the contract is fully completed. Because
the contract often extends over more than one financial year it is necessary to estimate the
profit on uncompleted contracts so as to avoid undue fluctuation in company results. The
profit taken is conservatively estimated to allow for any unforeseen difficulties and costs.
Anticipated losses should be allowed for, in full, as early as possible.
Illustration one
The following information relates to contract No. C.74 being undertaken by AB
Construction Company for the year ended 30. September 1991.
Ksh. (000)
Materials on hand at site 1 October 1990
900
Payment for direct wages
4,800
Accrued wages not yet paid 30 September 1991
400
Materials on hand at site 30 September 1991
2,600
Payment for direct expenses
6,400
Depreciation expenses on equipment at site
800
Cost of materials purchased
37,650
Machinery installation and service cost
2,400
Accrued expenses not yet paid 30 September 1991
600
Defective materials returned to stores
350
Value of Work Certified
40,000
Cash received from contractee
38,000
Cost of Work not yet Certified
24,000
Estimated total contract cost
125,000
Contract price
180,000

The contract has been in progress since 1 October 1990.It is estimated that the contract
will be completed within 9 months from 30 September 1991.
Required:
a) Prepare the contract account for the year ended 30 September 1991as it would
appear in the records of AB Construction Company. (Contract profit, if any, is to
be credited in the ratio of work certified to work not certified.)
b) Compute the value of work in-progress as at 30 September 1991.
Illustration two:
Majengo builders have been engaged to construct a building to serve as the head office
for Mwalimu cooperative society. Construction work commenced on 1st June 2000 and

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the following information was extracted from Majengo builders accounting records on
30th November 2000.
Sh
Contract price
500,000
Payment for direct wages
240,000
Accrued wages
10,000
Materials issued
275,000
Materials returned to store
2,500
st
Plant and equipment at cost on 1 June
150,000
Installation cost
125,000
Payment for direct expenses
75,000
Direct expenses accrued, 30th November
5,000
th
Value of plant and equipment 30 November
100,000
Material on site, 30th November
27,500
Value of work certified
800,000
Cost of work not yet certified
50,000
Cash received from Mwalimu coop society
750,000
Required:
(a)
Prepare the contract account for the building for the six months to 30th
November 2000, as it would appear in the records of Majengo Builders.
(b)
Determine the amount to be shown as work in progress in the records of
majengo builders at 30th November 2000.

Illustration Three:
The data given below refers to contract FOD101 for the construction of a road to link
Limuru and lodwar.
The contract was commenced on 1st April at an agreed price of Sh 400,000,000. The
contract was expected to take four years to complete. Retention money was agreed at
10% of work certified.
Details of the contract during the first year are as follows:
Sh. 000
Direct Materials:
Received on site
Returned from site
Lost from site, but insured
On site at 31st March
Direct Wages:
Paid
Accrued at 31st March

51,200
500
600
7,100
26,400
600

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Direct expenses:
Paid
Accrued at 31tst March
Plant :
In use on site at cost
Valuation at 31st March
Site overhead
Allocated head office charges
Cash received in respect of work certified
Cost of Work completed but not yet certified

4,800
200
40,000
30,000
7,400
3,600
90,000
14,000

Required:
(a)
Prepare a contract account.
(b)
Evaluate the work in progress as at 31st March

COST ESTIMATION:
Cost estimation is the process of estimating the relation between costs and the cost
drivers that cause them. Some costs are directly related to an activity and can be
estimated based on the activity. Other costs are indirectly related to an activity and are
not as easy to predict because they are indirect. This is one of the challenges that cost
managers must address in estimating costs. Another challenge exists because costs and
expenditures do not always occur at the same time. The main purposes of cost estimation
are to manage costs, make decisions, and to plan and set standards.
A cost is what occurs when resources are acquired for production or other activity in an
organization. Expenditures are the payments for the activities in an organization.
Expenditures do not always occur at the same time as the cost. When there are big time
differences between the cost activity and the expenditure for cost activity, cost managers

19

need to distinguish between them. In most cases, managers assume that costs and
expenditures match reasonably well. This simplifies the cost estimation process.
The understanding that "costs do not just happen" is tied to an understanding between
costs and activities. Managers must identify activities that cause costs in order to estimate
costs. They must then manage the activities in order to manage costs.

The Goal of Cost Estimation

The ultimate goal of cost estimation is to determine the amount of fixed and variable
costs so that a cost equation can be used to predict future costs. You should remember the
concept of functions from your business calculus class. The function that represents the
equation of a line will appear in the format of:
y=mx+b
Where y = total cost
m = the slope of the line, i.e., the unit variable cost
x = the number of units of activity
b = the y-intercept, i.e., the total fixed costs
Determining a linear function is useful in predicting cost amounts at different levels of
activity. Why do managers need to be able to predict costs? They want to plan for future
operations often through what-if analysis and budgets. A key concept you must
remember is that before you employ any of the estimation methods, you must have
already determined the cost is mixed. There is no need to analyze a cost to break it down
into fixed and variable portions if you already know whether it is variable or fixed. Your
goal is to determine the variable cost per unit and total fixed costs to plug into the cost
equation.
Reasons for cost estimation:
There are three reasons why organizations find it necessary to estimate costs. Cost
estimation is used to
(1) Manage costs,
(2) Make decisions, and
(3) Plan and set standards.

Cost management is best accomplished by determining which activities drive costs and
then managing these activities.

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Decision making in a business setting is based on cost and profit information. Since
resources are limited, organizations are always confronted with choosing among
alternatives. Given two cost-causing alternatives, managers must use estimated costs
before deciding which alternative to choose. Cost estimation requires that managers
understand the underlying behaviour of costs being estimated.
A simple cost behaviour pattern is one in which costs are some combinations of fixed and
variable. Total variable costs change in proportion with total activity. In the simplest
case, there is only one activity driving variable costs. Fixed costs are those costs that do
not vary with activity. This simple cost pattern can be expressed mathematically. It is,
y = m x + b,
Where; y = Total costs,
b= Fixed costs,
m = the cost driver rate,
x = the number of cost driver units.
This simple mathematical expression is just the equation for a line, suggesting that the
cost pattern shows a linear relationship between costs and activity.
Real-world applications of cost estimation can be depicted as a simple linear expression.
However, a more realistic expression considers multiple cost drivers and complex cost
behaviours. As always, managers must weigh the costs and benefits of using a more
complex estimation method.
Another cost pattern commonly encountered is one with step costs, also known as semifixed costs. Step costs change with activity of the cost driver but not in direct proportion.
These costs increase in chunks. For instance, rent on a store is a fixed cost. However, if
the store is not large enough to accommodate rapidly increased sales activity, then a
larger, more expensive store may be rented, increasing this seemingly fixed cost based on
increased activity (units sold).
When trying to determine the pattern of costs, one must take into consideration the
relevant range of activity. The relevant range is the range over which an organization
expects to operate and over which assumed cost patterns are reasonably accurate. As long
as the relevant range falls below the point where the next higher level of a step cost will
be expended, one can assume the simpler cost estimation y = m x + b model is useful for
cost estimation.
Another cost pattern that might be encountered is a semi-variable cost. Semi-variable
costs have elements of fixed costs and variable costs. Utility costs are a simple example.

21

If, in a given month an organization shut down, it would still have some amount of
electricity costs. When that same organization is open and operating, electricity costs will
rise because the use of electricity has risen. There are many semi-variable costs that occur
in a business setting.
Some cost patterns are even more complex than the three just described. The simple cost
line, semi-fixed, and semi-variable cost patterns are all linear in nature. Some cost
patterns are curved, and trying to predict such costs is more difficult than costs that are
linear. One type of non-linear cost is called a learning curve. When there is a relationship
between the amount of experience in performing a task and the amount of time it takes to
perform it, a learning phenomenon occurs. The more experienced a person becomes with
a new task, the more quickly they can complete the task, until they are completely
familiar with it.
The cost pattern associated with this learning phenomenon can be expressed
mathematically, based on the amount of experience in performing a task and the time
required to perform it. Mathematically, the learning phenomenon is expressed as
Y = aXb, where
Y = Average number of labor-hours required for X units of cost driver volume,
a = Number of labor-hours required for the first cost driver unit,
X = Cumulative number of cost driver units,
b = Index of learning equal to the log of the learning rate divided by the log of 2.
For instance, a learning rate of 80%, commonly used in practice, would result in a value
for "b" of -.322.
The idea behind the learning phenomenon is that the greater the cost driver volume, the
greater the experience.
The learning phenomenon and the learning curve can be applied to new products or
processes and is helpful to managers trying to estimate costs of a complex process. A
process that appears to be very costly and time consuming might be rejected if managers
do not factor learning into estimated time to complete the process.

Cost Estimation Methods

Mixed costs have a fixed portion and a variable portion. There are a handful of methods
used by managers to break these costs into the two manageable components--fixed costs

22

and variable costs. The process of breaking mixed costs into fixed and variable portions
allow us to predict the costs and plan for the future since we now have a good insight on
how these costs behave at various activity levels. We often call the process of separating
mixed costs into fixed and variable components, cost estimation.
Cost estimation methods are broadly categorized into three methods namely:
(1)

Statistical methods, especially simple regression (scatter graph and high-low) and
multiple regression analysis,

(2)

Account analysis, and

(3)

Engineering estimates.

The above commonly used methods are outlined and discussed separately below:
1.
2.
3.
4.

Account analysis/ Inspection of accounts method

Engineering method
Scatter graphs
High-low method

Account Analysis
This is one of the methods of estimating fixed and variable costs that require considerable
subjective judgment. This is the approach taken to identify cost behavior in the study of
managerial accounting by looking at a cost and guessing its most likely type of cost
behavior. It is most often used by accountants or managers who are familiar with the
costs within the accounts. Account analysis is the only method you can use to estimate
costs when only one data point is known. The account analysis approach requires four
steps:
Step 1: Look through the costs that are included in a particular account and classify each
amount as variable or fixed based on judgment.
Step 2: Total the variable costs. Determine variable costs per unit by dividing the total of
all the variable costs you identified by the number of units produced (or sold). This will
give you the cost per unit.
Total Variable Costs
= Variable cost per unit
# of Units Produced
Step 3: Total the fixed costs.
Step 4: Plug your answers to steps 2 and 3 into the cost formula by replacing the slope
(m) with variable cost per unit and the y-intercept (b) with total fixed costs in the
following format:

23

y=mx+b

Scatter Graph Approach

"A scatter graph or scatter diagram is a type of display that contains one or more scatter
plots each of which use Cartesian coordinates to display values for two variables for a set
of data. The data is displayed as a collection of points, each having the value of one
variable determining the position on the horizontal axis and the value of the other
variable determining the position on the vertical axis.
A scatter plot only specifies a dependent or independent variable when a variable exists
that is under the control of the experimenter. If a parameter exists that is systematically
incremented and/or decremented by the experimenter, it is called the control parameter or
independent variable and is customarily plotted along the horizontal axis. The measured
or dependent variable is customarily plotted along the vertical axis. If no dependent
variable exists, either type of variable can be plotted on either axis and a scatter plot will
illustrate only the degree of correlation (not causation) between two variables.
A scatter plot can suggest various kinds of correlations between variables with a certain
confidence level. Correlations may be positive (rising), negative (falling), or null
(uncorrelated). If the pattern of dots slopes from lower left to upper right, it suggests a
positive correlation between the variables being studied. If the pattern of dots slopes from
upper left to lower right, it suggests a negative correlation. A line of best fit can be drawn
in order to study the correlation between the variables. An equation for the correlation
between the variables can be determined by established best-fit procedures. For a linear
correlation, the best-fit procedure is known as linear regression and is guaranteed to
generate a correct solution in a finite time. Unfortunately, no universal best-fit procedure
is guaranteed to generate a correct solution for arbitrary relationships.
One of the most powerful aspects of a scatter plot, however, is its ability to show
nonlinear relationships between variables. Furthermore, if the data is represented by a
mixture model of simple relationships, these relationships will be visually evident as
superimposed patterns.
This approach requires multiple data points and requires five steps:
Step 1: Draw a graph with the total cost on the y-axis and the activity (units) on the xaxis. Plot the total cost points for each activity points.
Step 2: Visualize and draw a straight line through the points.
Step 3: Determine variable costs per unit by identifying the slope thorough a measure of
rise over run.

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Rise
Run

= Variable cost per unit

Alternatively;
Difference in cost
Difference in activity

variable cost per unit.

Step 4: Identify where the line crosses the y-axis. This is the total fixed cost.
Step 5: Plug your answers to steps 3 and 4 into the cost formula by replacing the slope
(m) with variable cost per unit and the y-intercept (b) with total fixed costs in the
following format:
y=mx+b

Illustration

Refer Colin drury pg 1039 and 1040 & 1041

High-Low Method
The high-low method uses the highest and lowest activity levels over a period of time to
estimate the portion of a mixed cost that is variable and the portion that is fixed. Like the
account analysis and scatter graph method, the amounts determined for fixed and variable
costs are only estimates. Because it uses only the high and low activity levels to calculate
the variable & fixed costs, it may be misleading if the high and low activity levels are not
representative of the normal activity. For example, if most data points lie in the range of
60 to 90 percent for a particular accounting test, and one student scored a 20, the use of
the low point might distort the actual expectation of costs in the future.
The high-low method is most accurate when the high and low levels of activity are
representation of the majority of the other points. The steps below guide you through the
high-low method:
Step 1: Determine which set of data represents the total cost and which represents the
activity. Find the lowest and highest activity points.
Step 2: Determine variable costs per unit by using the mathematical formula for a slope
where you take divide the change in cost by the change in activity:
y2 -y1
= Variable cost per unit
x2 - x1
Where x2 is the high activity level
x1 is the low activity level
y2 is the total cost at the high activity level selected
y1 is the total cost at the low activity level selected

25

Step 3: Plug your answer to steps 2 along with either the high or the low point into the
cost formula by replacing the slope (m) with variable cost per unit, the high activity total
cost for the y variable, and the high activity for the x variable. Then solve for fixed costs
(b).
Step 4: Plug your answers to steps 2 and 3 into the cost formula by replacing the slope
(m) with variable cost per unit and the y-intercept (b) with total fixed costs in the
following format:
y=mx+b

High Low Example:

The Information concerning units sold and total costs for Bridges, Inc. for five months of
2009 is given below:
Units
January
1,200
February
1,150
March
1,190
April
1,300
May
1,310
Use the high-low method to answer the following:
A. How much are variable costs per unit?
B. How much are total fixed costs?
C. Write the cost equation in proper form

Costs?
$74,150
71,000
72,400
80,600
79,040

Solution:
Step 1: Select the high and low data activity points. Because the Units column represents
activity, select the high point: May, and the low point: February.
Step 2: Use the slope formula by subtracting the smallest from the largest activity on the
denominator. Use the corresponding total costs for May and February and subtract the
smallest from the largest cost on the numerator:
y2 - y1
x2 - x1

$79,040 - $71,000
1,310 - 1,150

$50.25 per unit

Alternatively;
Difference in cost
Difference in activity

variable cost per unit.

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Step 3: Pick one point. They will both result in the same final answer. Substitute the total
cost of one of the points for y in the equation: y = mx + b. Using the low point of
February, total costs are $71,000 total cost at 1,150 units. Substitute the variable cost
from step 2 into the formula for m. Substitute the number of activity units for the low
data point for x You should now have the following equation:
71,000 = $50.25*1,150 + b
Solve for total fixed costs which is the b variable, which gives you $13,212.50.
Step 4: Determine the cost formula to use in estimating the mixed costs at various levels
in the following format by plugging in the variable cost per unit and total fixed cost by
plugging the variable cost per unit and the total fixed costs into the cost equation as
follows:
y = $50.25x + $13,213
The standard format is to express variable cost per unit using two decimal places and
total fixed costs with no decimal places.
Engineering method:
This is a cost estimation method in use by some organizations. Engineering estimates are
cost estimates based on measurement and pricing of the work involved in the activities
that go into a product. The engineering method differs from regression and account
analysis in one important way. It uses cost and activity projections instead of historical
costs. Cost analysts prepare detailed step-by-step analysis of each activity required to
make a product, together with the costs involved.
The engineering method has several advantages. The detailed cost information it provides
allows managers to predict future costs with more accuracy than account analysis or
regression. The detailed information provides a benchmark to be used to evaluate future
activities. Since it does not rely on historical information, it can be used to estimate costs
for totally new activities. The engineering method also helps managers to identify nonvalue-added activities.
The engineering method has some drawbacks too. One obvious one is that it is expensive
and time-consuming. Another is that it is based on estimates and may not be properly
adjusted for conditions that are non-optimal.

UNIT 2

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Cost-volume-profit analysis:
Cost volume profit analysis is the systematic examination of the relationships among
costs, volume, prices and profit. Cost volume profit analysis is widely used for planning
activities including the determination of the break even point of a firm.
The cost-profit-volume relationship helps management to provide answers to questions
like;
i) What sales volume is required to break even?
ii) What sales volume is necessary in order to earn a desired profit?
iii) What profit can be expected on a given sales volume?
iv) How would change in selling price ,variable cost ,fixed costs, and out put affect
profits?
v) How would a change in the mix of products sold affect the break even point, target
income and profit potential?
The break even analysis is of immense utility to management as it provides an insight
into the effect and inter- relationship of factors which influence profits of the firm.
Cost volume profit analysis requires the understanding of classification of cost according
to behavior. Semi variable costs are separated into their variable and fixed components.
In order to understand the CVP and break-even analysis one should understand the
following concept;
(i) Contribution Margin (CM) :- This is the excess of sales (S) over the variable costs
(VC) of the product. It is the amount of money available to cover fixed costs (FC)
and to generate profits.
(ii) Unit contribution Margin: - This is the excess of the unit selling price (P) over the
unit variable cost (v). It is expressed as ; Unit CM = p - v
(iii) Contribution margin ratio:- It is the contribution margin as a percentage of sales.
This is expressed in the formulae ; CM ratio = CM/S or S-VC/S or 1-VC/S. The
contribution margin ratio can also be computed using per unit data as below;
CM ratio = Unit CM/p or p-v/p or 1-v/p

Break-even analysis:

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Break even analysis is a specific way of presenting and studying the inter-relationship
between costs, volume and profits.
It establishes a relationship between revenues and costs with respect to volume. It
indicates the level of sales at which cost and revenue are in equilibrium. The equilibrium
is commonly known as the break even point.
The break even point is the activity level at which total cost equals total revenue. This is
the point of no- profit , no-loss.
The break even point may be determined using the following approaches;
(i) The equation approach.
(ii) Contribution margin approach.
(iii) Graphical approach.
The equation approach:
The equation approach is based on the cost-volume equation, which shows the
relationship
among sales, variable , fixed costs, and net income:
The equation is expressed as;
Sales = Variable cost + Fixed cost + Profit
Sales - Variable cost = CM -Fixed cost = Profit.
S - VC - FC = Profit;
Or
(Unit selling price No. of units) - ( Unit variable cost
Profit.

No. of units)- Fixed costs =

Suppose;
Unit selling price is p , Number of units sold x ,and variable cost is v , then the above
expression would be expressed as below;
px - vx = CM - FC = Profit, or;
At break even point , where profit is equal to zero, px = vx + FC
To find the break even point in units one would solve the equation using variables given
to get x.

The contribution approach:

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The contribution margin approach is another technique for computing the break-even
point. It is based on solving the cost- volume equation . Solving the equation px = vx +
FC for x yields the following formulae;
X = FC/ p-v
Where p-v is the unit contribution margin(CM) by definition , and X is the break-even
point in units . In other words, B.E.P in units = Fixed cost/ unit contribution margin.
The graphical approach:
The graphical approach is based on the break-even chart. Sales revenue , variable cost,
and
fixed cost are plotted on the vertical axis, while the volume is plotted on the horizontal
axis. The
break even point is the point where the total sales revenue line intersects the total cost
line. The
chart can also effectively report profit potentials over a wide range of activity.
Assumptions underlying the break even /cost-volume-profit analysis:
1.
2.
3.
4.
5.
6.
7.
8.
9.

The analyses presumes that costs can be reliably divided into fixed and variable
category. Mixed costs are ignored.
Fixed costs will remain constant and will not change with the change in the level
of output
Variable costs will fluctuate in the same proportion in which the volume of
output varies.
Selling price will remain constant even though there may be competition or
change in volume of production.
The number of units produced and sold will be the same so that there is no
opening stock and closing stock.
There will be no change in the operating efficiency .
There is only one product or in case of many products , the product mix remains
the same.
Prices of factors of production remain constant. In other words, prices of variable
cost factors e.g. wages, raw material etc. will remain the same.
Sales and expenses relations are varied only within a band of activity referred to
as the relevant range.

Uses of the break even /cost-volume-profit analysis:

The C-V-P/Break even analysis used in ;
1. Predicting profit over a wide range of activity
2. Pricing of products ,especially in a lean business season. During this season ,it would
became necessary to bring down prices of products in order to boost sales. The
management should understand the impact of reducing prices on the profitability of
the firm.

30

3. Decision making ,for example , in situations where the management has to decide
whether it should add to its capacity or not.
4. Evaluating profit performance.
5. Profit planning.
Limitations of the break even /cost-volume-profit analysis:
The analyses is based on certain assumptions which limit the utility and general
applicability of the break-even analysis. The analysis suffers from the following
assumptions:
1. It is difficult to separate costs into fixed and variable components.
2. It is not correct to assume that total fixed cost would remain unchanged over the
entire range of activity.
3. The assumption of constant selling price and unit variable cost is not valid.
4. It is difficult to use the break even analysis for a multi-product firm.
5. The break-even analysis is a short term concept and has limited use in long-term
planning.
6. The break even analysis is a static tool.
Margin of safety :
Margin of safety is the difference between the actual sales and the sales at break even
point . It is the excess production over the break even points output .
Sales or out put beyond break even point is known as margin of safety because it gives
some profit after meeting fixed costs .
Margin of safety indicates the extent to which sales may fall before the firm suffers a
loss . The larger the margin of safety , the safer is the business .
Margin of safety at break even point is zero because actual sales volume is just equal to
the break even sales.
Margin of safety can be increased by ;
1. Increasing the level of production .
2. Increasing the selling price.
3. Reducing the fixed or variable costs or both.
4. Substituting the existing products by more profitable products.

Illustration one:

31

Using the data provided below compute the break even point of the firm in units and
shillings using the following methods;
(a) Equation approach.
(b) Contribution approach.
(c) Graphical approach.

Estimated sales 100,000 units@Sh.20

Variable costs:
Direct materials
Direct labor
Factory overheads
Contribution
Fixed costs:
Factory overhead
Administrative and selling overhead
Net profit

Sh.
2,000,000
300,000
500,000
200,000 (1,200,000)
800,000

200,000
200,000

(400,000)
400,000

Illustration Two:
Dawa pharmaceuticals is planning to start manufacturing a new drug. The firm is
expected to incur annually a fixed production overhead of Sh 2,000,000 and a variable
cost of Sh 600 per unit of drug. The company is expected to sell the drug for Sh 1,000
per unit.
Required:
Compute the break-even sales and units of the company using;
(i) Equation approach.
(ii) Contribution approach.
(iii) Graphical approach.
Illustration three:
The budget of a medium size manufacturing company shows that in the next twelve
months ,40,000 units of product B12 will be produced and sold at Sh 200 per unit. The
budgeted production costs are;
Sh.
Direct material cost
3,000,000
Direct labour
2,000,000
Variable overhead cost
1,000,000
Fixed overhead costs
1,500,000

Required:
Compute the following;
(i) B.E.P in sales and units.

32

(ii) Likely Net profit if sales volume is increase by 10%.

Illustration four:
A company manufacturing two products (product A and B) had the following budget:

Sales (units)
Sales @ Sh.5 for A and Sh.10 for B
Variable cost Sh.4 for A and Sh.3 for B
Contribution margin Sh.1 and Sh.7
respectively
Less fixed costs
Operating income (profit)

A
B
120,000
40,000
Sh.
Sh.
600,000 400,000
480,000 120,000
120,000 280,000

Total
160,000
Sh.
1,000,000
600,000
400,000
(300,000)
100,000

Required:
Using the data provided above, compute the break even point for the company in sales
and units
Illustration four:
ABC Limited manufactures product Y13.The company has experienced a steady growth
over the last five years. However, increased competition has led the managing directors
to believe that an aggressive campaign is needed next year to maintain the companys
present growth. The companys accountant has presented the managing directors with
the following data for the current year, 20x5, for use in preparing for next years
advertising campaign.
Budgeted costs for the years 20x5 -20x6
Sh.
Variable costs per unit:
Direct labour
Direct materials
Variable overheads
Fixed costs:
Manufacturing
Selling
Administrative
Total fixed costs

640
320
240
1,200
2,000,000
3,200,000
5,600,000
10,800,000

Selling price per unit

2,000
Expected sales,20x5 (220,000units)
Sh 40,000,000
The managing director has set the sales target for the year 20x6 at a level of Sh
44,000,000 (20,000 units)
Required :

33

(a) What is the projected operating income for 20x5

(b) Calculate the break even point in units and shillings for 20x5.
(c) The MD believe that to attain the sales target in the year 20x5 requires
Selection of a suitable product mix:
When a firm manufactures more than one product , The management of the firm will be
faced by the problem of selecting a product mix that maximizes profit. The best product
mix is that which gives a maximum contribution . Products which gives a maximum
contribution are to be retained and their production increased. Products which give
comparatively less contribution should be reduced or closed all together. The effect of
product mix can be seen by comparing the p/v ratio and the break even point. A product
mix will be favorable if it increases the p/v ratio and reduces the break eve point.
Illustration:
The following information is about a firm that manufactures more than one product.
Using the data provided , advise the management on the most suitable product mix that
gives the highest profits.
Product
Direct materials
,,
,,
Direct wages
,,
,,
Fixed expenses Sh. 80,000
( variable expenses are allocated to products as
100% of direct wages).
Selling price
,,
,,

A
B
A
B

Per unit
Sh.
1,000
900
300
200

A
B

2,000
1,500

The product/ sales mix proposed is;

(a) 100 units of product A and 200 units of product B
(b) 150 units of product A and 150 units of product B
(c) 200 units of product A and 100 units of product B

34