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ACCT 219
COST ACCOUNTING
FREDRICK M.MUTEA
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Published by Kenya Methodist University
P.O. BOX 267 60200, MERU
Email: info@kemu.ac.ke
TEL: 254 064 30301, 31146/0736752262
Cost Accounting
ACCT 219
Fredrick Mutea 2014
All rights reserved.
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TABLE OF CONTENTS
LECTURE ONE....................................................................................................12
1.0 INTRODUCTION TO COST
ACCOUNTING......................................................12
1.1 Lecture overview..12
1.2 Objective...12
1.3 Definition and scope of costing accounting..12
1.4 Relationship of cost and other disciplines13
1.5 Distinction between financial accounting and cost accounting ...15
1.6 Purpose of cost accounting...17
1.7 Summary...20
1.8 Self-Assessment questions....21
LECTURE TWO22
2.0 COST CLASSIFICATION....22
2.1 Lecture overview..22
2.2 Objective.......22
2.3 Classification of cost....24
2.4 Cost statement..30
2.5Work in progress32
2.6 Summary...34
2.7 Self-Assessment questions...36
LECTURE
THREE.................................................................................................................39
3.0 COST
ESTIMATION.......................................................................................................39
3.1 Lecture overview..39
3.2 Objective...39
3.3 Cost estimation.... 39
3.4 High-low method.... 40
3.5 Regression analysis .... 44
3.6 Visual fit.. 47
3.7 Engineering method...47
3.8 Account analysis...48
3.9 Learning curve theory...48
3.10 Summary.48
3.11Self-Assessment questions..49
LECTURE
FOUR....................................................................................................................51
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4.0 MATERIAL
COSTING...................................................................................................51
4.1 Lecture overview.51
4.2 Objective.....51
4.3 Purchasing procedure and issue of materials. 51
4.4 Store keeping and stock control. 54
4.5 Material Coding . 56
4.6 Stock Recording and Inventory Control.. 56
4.7 Methods of valuing material issues59
4.8 Stock levels...66
4.9 Summary..69
4.10 Self-Assessment questions..70
LECTURE FIVE...................................................................................................73
5.0 LABOR COSTING..73
5.1 Lecture overview..73
5.2 Objective...73
5.3 Remuneration Methods... 73
5.4 Incentive Schemes in Practice..75
5.5 Procedure for preparing a payroll.....77
5.6 Allocating of labour costs...79
5.7 Summary...80
5.8 Self-Assessment questions...80
LECTURE SIX.82
6.0 OVERHEAD COSTING... 82
6.1 Lecture overview.....82
6.2 Objective..82.
6.3 Overhead .82
6.4 Bases of Absorption83
6.5 Service Departmental Costs87
6.6 Absorption of Overhead.94
6.8 Summary.100
6.9 Self-Assessment questions.100
LECTURE SEVEN103
7.0 COSTING Systems103
7.1 Lecture overview103
7.2 Objective.103
7.3 Specific order costing 103
7.4 Accounting for Job Order Costing..104
7.5 Job cost account.....105
7.6 Batch costing..107
7.7 Summary....108
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7.8 Self-Assessment questions....109
LECTURE EIGHT.110
8.0 CONTRACT COSTING...110
8.1 Lecture overview110
8.2 Objective.....110
8.3 Contract account.110
8.4 Features of contract accounting..111
8.5 Proforma contract account....113
8.6 Summary....117
8.7 Self-Assessment questions....117
LECTURE NINE...119
9.0 PROCESS COSTING...119
9.1 Lecture overview.......119
9.2 Objective...119
9.3 Nature of process costing..119
9.4 Valuation of work in progress120
9.5 Process losses.123
9.6 Allocation of joint cost...128
9.7 Summary....131
9.8 Self-Assessment questions.131
LECTURE TEN....133
10.0 VARIANCE ANALYSIS... 133
10.1 Lecture overview...133
10.2 Objective133
10.3 Purpose of variance analysis.133
10.4 Material variance analysis.
137
10.5 Labour variance analysis..140
10.6 Overhead variance analysis..142
10.7 Summary..149
10.8 Self-Assessment questions..150
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COURSE OVERVIEW
I welcome you to the study of Cost Accounting. In this course we shall study important concepts
and techniques needed by managers in planning, control, management and decision making in
business organization. The course has 11(eleven) lectures and each lecture takes one or more weeks
depending on the topics depth.inn addition, each has its own objectives that you should achieve. At
the end of every lecture, you will find a series of SAQs that are meant to help you to evaluate your
understanding of the concepts presented. You should attempt all the questions and activities once
you have finished studying the relevant work. A summary of each lecture is also provided at the
end with a list of further resources that you are expected to read and make notes from.
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COURSE PURPOSE
This course is intended to equip you with knowledge; skills and attitudes that will enable
understand important concepts and techniques needed by managers in planning, control, management
and decision making in business organization.
Course Content
The course will cover: Introduction to cost accounting, cost estimation, material costing, labour
costing, overhead costing, costing techniques and variance analysis.
Teaching Methods
a) Tutorials
b) Class presentations
c) Discussions
Teaching Materials
a) Chalkboard
b) Instructional Materials
c) Research papers, projects etc.
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Assessment
a) Continuous Assessment Test(s) 40%
b) End of trimester examination 60%
Other support materials: Various applicable manuals and journals; variety of electronic information
resources as prescribed by the lecturer
You will be expected to take responsibility of the learning process. The instructor will provide you
with the necessary support and facilitation in order to achieve the course objectives. You may be
expected to do assignments which will constitute 40% of the total marks. The final examination will
constitute 60% of the marks.
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SYMBOLS
Objectives
Activity
Key note
Summary
Further Reading
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COURSE OUTLINE
11
Week Topics Content
10 9.0 Process costing 9.1 Job costing and process costing
9.2 Costing procedures
9.3 Flow of cost in process costing
9.4 Normal loss and abnormal loss
9.5 Abnormal gain
11 10.0 Variance analysis 10.1Definition of variance analysis
10.2The purpose of variance analysis
10.3Material cost variances
10.4Variable overhead variances
10.5Fixed overhead variances
14 END OF TRIMESTER
EXAMS
LECTURE ONE
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courses that you will always need in all aspect of your life and profession. That why cost accounting
is taught to all students irrespective of their profession and areas of specialization. It is therefore
important that as cost accounting students you understand the important concepts in this class. This
lecture will introduce you to what we mean by cost accounting.
1.2 Objectives
Cost accounting identities, defines, measures, reports and analyses the various elements of direct
and indirect costs associated with producing and marketing goods and services. Cost accounting
also measures performance, product quality and productivity
Cost accounting systematic process of collecting, summarizing and recording data regarding the
various resources and activities in a firm so as to calculate the basis of production costs used in
financial accounting or making other relevant decisions in a firm
Cost accounting is broad and extends beyond calculating production costs for inventory valuation,
which government-reporting requirements largely dictate. However accountants do not allow
external reporting requirements to determine how they measure and control internal organizations
activities. Cost accounting focus is shifting from inventory valuation for financial reporting to
costing for decision making.
The main objective of cost accounting is communicating financial information to management for
planning, evaluating and controlling performance, and also to assist management to make more
informed decisions. Its data is used by managers to guide their decisions.
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1.4 The relationship of cost accounting and other accounting disciplines
Accounting can be described as a specialized information system that is used for purposes of
decision making by the management of the organization and other users such as tax authorities,
investors, creditors and the general public. Accounting is broadly divided into two:
i. Financial Accounting
ii. Management Accounting
1.4.1 Financial Accounting:
This is the analysis, classification, and recording of financial transactions and the ascertainment of
how such information will be reported to the various users. It involves the development of general-
purpose financial statements largely for external reporting. These statements are developed in
accordance with standards imposed by the public (through the professional accounting bodies such
as the Institute of Certified Public Accountants of Kenya ICPAK and the International Accounting
Standards Board IASB) as well as the requirements of the Companies Act Chapter 486.
Examples of information provided by a typical costing system and how it is used are given in the
following table and the following paragraphs.
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Information provided by costing system Possible uses by management
Cost per unit of production or service or for As a factor in pricing decisions, production
a process planning and cost control
Cost behaviour with varying levels of Profit planning, make or buy decisions, cost
activity
Examples of costing information and uses
Activity 1.1
As you will realize as you go through this course, the characteristics of a good cost
accounting system should be simple,economical and practical. Identify what may be hindering good
costing systems in your organisation
An important part of the management task is to ensure that operations, departments, processes and
costs are under control and that the organization and its constituent parts are working efficiently
towards agreed objectives. Although there are numerous other control systems within an
organization, for examples production control, quality control, inventory control, the costing system
is the key financial control system and monitors and the results of all activities and all other control
systems. The detailed analysis and location of all expenditures, the calculation of job and product
costs, the analysis of losses and scrap, the monitoring of labour and departmental efficiency and
outputs of the costing system provide a sound basis of information for financial control. Cost
accounting and financial accounting Financial accounting can e defined as: The classification and
recording of the monetary transactions of an activity in accordance with established concepts,
principles, accounting standards and legal requirements and their presentation, by means of profit
and loss account, balance sheets and cash flow statements, during and at the end of accounting
period Financial accounting originated to fulfill the stewardship function of businesses and this is
still an important feature. Most of the external financial aspects of the organization, e.g., dealing
with accounts payable and receivables, preparation of final accounts etc., are dealt with by the
financial accounting system. Of course internal information is also prepared, but in general it can be
said that financial accounting presents a broader, more overall view of the organization with
primary emphasis upon classification according to type of transaction rather than the cost and
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management accounting emphasis on the function, activities, products and processes and on internal
planning and control information.
Need. Financial accounting is an outcome of statute. For example, in India under the companies Act
to prepare balance sheet and profit and loss account for submission to shareholders and others. The
financial statements are generally required to be prepared in the formats prescribed by the law.
Management accounting is the result of the managements needs of information for making
decisions. It is, therefore, optional. Management accounting functions would differ from firm to
firm. A firm may have a sophisticated elaborate and comprehensive system while another may have
a partial system only.
Timing.Financial accounting adopts twelve months (one year) period for reporting financial
performance to shareholders and other investors. In contrast, management accounting reports are for
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shorter durations. Some companies in India prepare daily budgets. Monthly and quarterly reports
are quite common. Management accounting expenditure plans, for example, cover a longer
duration.
Coverage.While reporting the state of affairs of a company, financial accounting covers entire
organization. Financial statement show revenue, expenses, assets and equities of the firm as a
whole. For management accounting purpose, however, organization is divided into smaller units, or
centres. These centres may be headed by responsible persons. Cost data and other informations are
collected and reported by the centres. Thus, the data requirements of management accounting are
more specific.
Reporting. Financial statement-balance sheet and profit and loss account are subject to the
verification of statutory audit. Therefore, financial accounting stresses accuracy and precision of
accounting data. Management accounting requires information promptly for decision-making.
Continuous and speedy flow of approximate information is more useful than the precise, but
delayed information.
Management accounting uses both financial and cost information to advise management in planning
and controlling the organization. The objectives of the various facets of accounting have been given
above and differences. And the differences discussed. However, it must be realized that all form
part of the financial information system of an organization and in many organizations the various
facets are totally integrated with no artificial divisions between them.
This is the part of accounting that provides special-purpose statements and reports to management
and other persons inside the organization. The information generated by management accounting is
therefore for internal uses and is not guided by any standards or legal requirements. Management
Accounting, unlike financial accounting, is proactive i.e. it is future-oriented. It is required in
making decisions that affect the organization.
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In a nutshell, cost accounting enables a business to not only find out what various jobs or processes
have cost, but also what they should have cost. It indicates where losses are occurring before the
work is finished and therefore corrective action can be undertaken.
From the foregoing discussion, it is then clear that cost accounting is very closely related to other
accounting subjects especially management accounting. In fact, most people make no distinction
between management accounting and cost accounting, as the dividing line between the two is
slimmer than thin!
1.5.2Relationship between cost accounting and management accounting
Referring to CIMAs definition of cost accounting, we can see that cost accounting is a part of
management accounting.
CIMA defines management accounting as provision of information required by the management
for such purposes as formulation of policies, planning and controlling the activities of the
enterprise, decision taking on the alternative courses of action, disclosure to those external to the
entity (shareholders and others), disclosure to employees and safeguarding assets. Cost accounting
and management accounting have basically the same functions.
Cost ascertainment
Costs relating to materials, labour and overhead costs must be ascertained accurately. They should
be kept at minimum level possible.
Disclosure of wastes
The costs incurred for the production of any commodity can be determined in advance in view of
the past experience. If the actual costs are higher than the expected or standard costs, then this
excessive cost can be analyzed e.g. it may be from wastage of raw materials, idle labour, time
wastage etc.
Decision making
Cost accounting provides necessary information to the management for decision making e.g. what
goods to produce and in what quantities.
Cost control
Materials costs, labour costs and overheads must be maintained at desirable levels. Cost accounting
principles are used to eliminate unnecessary costs.
. Planning
The cost data and past experience are used to prepare and implement future plans e.g. expansion of
business.
Measurement of efficiency
Departmental performance can be measured using the costs data. More efficient departments will be
given greater incentives and appropriate steps taken to improve the performance of less efficient
departments.
1.6.1 Settling selling prices
A business concern must ascertain its cost and then add its profit into cost of sales to avoid charging
high or low prices which can bring negative effects.
Evaluation of profitability
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Profitability can be measured in a number of ways e.g. profit as a percentage of sales, profit
percentage to capital employed, profit per unit of output etc.
The profitability information serves as a guide to the management to make some strategic decisions
regarding the introduction of new products and increasing or decreasing the volume of production
a) Accounting for costs
This may be seen as a record keeping or score keeping role. Information must be gathered
and analyzed in a manner which will help in planning, control and decision making
b) Planning and Budgeting
This involves the quantification of plans for the future operations of the enterprise; such
plans may for the long or short term, for the enterprise as a whole or for the individual
aspects of the enterprise.
c) The control of the operations of the enterprise
Control may be assisted by the comparison of actual cost information with that included in
the plan. Any differences between planned and actual events can be investigated and
corrective action implemented as appropriate
d) Decision Making
Cost accounting information assists in the making of decisions about the future operations
of the enterprise; such decisions making may be assisted by the information from cost
techniques and cost-volume profit analysis.
e) Resource allocation decisions
For example product pricing in determining whether to accept or reject jobs: This is based
on cost and revenue implications of the relevant decisions
f) Performance evaluation
Cost accounting information is used to measure and evaluate actual performance so as to
make a decision of the degree of optimality or efficiency of resource utilization.
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c) Systems design
Cost accountants are becoming more involved in designing computer integrated
manufacturing (CIM) systems and databases corresponding to cost accounting needs. The
idea is for cost accountants, engineers and system designers to develop a flexible production
process responding swiftly to market needs
d) Treasury
The treasurer uses budgets and related accounting reports developed by cost accountants to
forecast cash and working capital requirements. Detailed cash reports indicate where there
are excess funds to invest or where cash deficits exist and need to be financed.
e) Financial accounting
Cost accountants work closely with financial accountants who use cost information in
valuing inventory for external reporting and income determination purposes.
f) Marketing
Marketing involves the cost accountant during the product innovation stage, the
manufacturing planning stage and the sales process. The marketing department develops
sales forecast to facilitate preparing a products manufacturing schedule. Cost estimates,
competition, supply, demand, environmental influences and the state of technology
determines the sales price that the product will be offered and will command in the market.
g) Personnel
Personnel department administers the wage rate and pay methods used in calculating each
employees pay. This department maintains adequate labour records for legal and cost
analysis purposes.
At this point, it cannot be over-emphasized that cost accounting is simply an information
system designed to produce information to assist the management of an organization in
planning and controlling the organisations activities. It also assists the management to make
informed decisions so as to enable the organization to operate at maximum effectiveness and
efficiently.
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purposes. An example of this information is with regard to the amount and location of work in
progress: (work in progress refers to partly completed units of products where a product passes
through a number of operations and processes before being passed into finished goods store or to
the customer). Work in progress information may be used by:
Activity 1.1
Review ways in which you can use cost accounting in your home and organization i.e units
departments, products and process.
1.7 Summary
(i) Cost accounting is concerned with the ascertainment and control of costs
(ii) The purpose of cost accounting is to provide detailed information for control, planning and
decision making.
(iii) To be of use, costing information must be appropriate, relevant, timely, well presented and
sufficiently accurate for the purpose intended.
(iv) Cost accounting and management accounting are closely related.
(v) The emphasis of financial accounting is upon classification by type of transaction and type and
type of expenditure rather than the functional analysis of cost accounting.
(vi) Cost, financial and management accounting all contribute to the financial information system of
an organization and increasingly in practice are totally integrated.
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1.8 Self-Assessment Questions
rd
1Paresh, S. (2010) Cost Accounting 3 Edition, Tata McGraw-Hill, New Delhi.
LECTURE TWO
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2.1Lecture overview
To this point am sure you have learnt what cost is and you are able to check the bills you pay to
indentify some of these cost. Now is high time to take you through various methods of cost
classification and the reason behind these classifications.
2.2 Lecture Objectives
(i) Define the term cost classification and the explain the rational
(ii) Describe the various cost classifications
2.1Terminologies
a) Cost
This may be defined as: A cost is the value of economic resources used as a result of production of
any commodity or performing any service or The amount of expenditure (actual or notional)
incurred on, or attributable to, a specified thing or activity. At the simplest level, cost includes two
components, quantity used and price, ie, Cost = quantity used x price Cost units The cost unit to be
used in any given situation is that which is most relevant to the purpose of the cost ascertainment
exercise. This means that in any one organization numerous cost units may be used for particular
parts of the organization or for differing purposes.
b)Cost units
It is the quantitative unit of the product or service in relation to which costs are ascertained.
The cost unit will be determined by the nature of the business enterprise. It may be
- An individual job, batch or contract
- A unit of production expressed as a relevant quantity
- A service is provided to the customer
Refers to a unit of quantity of produce, service or time in relation to which costs may be ascertained
or expressed. E.g. a kg of sugar, a meter of cloth, a liter of milk, a passenger seat, a patient bed; one
labour hour; a consulting hour etc.
Mostly, costs are ascertained in terms of cost units e.g. cost of production per meter of cloth or cost
of providing service per patient bed in the hospital etc.
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c)Cost centre
Refers to any particular part of enterprise e.g. a particular department; a function or items of
equipment in respect of which costs may be ascertained and related to cost units for control purpose.
Cost per department is ascertained hence each department in an enterprise becomes a cost centre.
POWER
MAINTENANCE
FINISHED
GOODS
Cost of sales
!
Note
There are three manufacturing centres (Making, Finishing and Packing). These are supported
by five support departments, namely Maintenance, Power, Administration, Selling and
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Distribution. All the various costs incurred in those departments produce the cost of sale of the
finished product that is offered for sale in the market. It is possible that some departments
reciprocally support each other, for example, in the above diagram, the power department
provides power to the maintenance department; in return, the maintenance department maintains
the power department.
The departments can be viewed as cost centres as we can identify and accumulate costs in
regard to them. Also, the finished products could be viewed as cost centres under the same
logic.
These different bases of cost classification are summarized in the diagram below:
Manufacturing/ Non-manufacturing
Fixed/Variable incremental/sunk
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Direct/indirect historic/opportunity
Cost Behaviour
Functional Classification
Avoidable/unavoidable
Controllable/
Uncontrollable
Standard/actual
A) Functional classification
A business has to perform a number of functions e.g. manufacture, administration, selling,
distribution and research. On this basis costs are classified into the following;
Cost behavior refers to the change in costs (increase or decrease) as the output level changes, i.e. as
we increase output, are the costs rising, dropping or remaining the same.
Cost Behaviour can be used to produce various classifications of costs such as:
a) Variable Costs Vs. Fixed Costs
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1) Variable costs:
Are costs that increase or decrease proportionately with the level of activity , i.e. that portion
of the cost of an activity that changes with the level of output.
Costs
Variable Costs
0 Activity Level
Note that with variable costs, the cost level is zero when production is zero. The cost
increases in proportion to the increase in the activity level, thus the variable cost function is
represented by a straight line from the origin. The gradient of the function indicates the
variable cost per unit.
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Costs
Variable cost
Fixed
Cost
Activity Level
3) Fixed Costs
Are costs that do not change with of the level of output. It is also called autonomous cost, as
it remains the same irrespective of the activity level as shown below.
Costs
Fixed Cost
Activity Level
The classification of cost into fixed and variable costs would only hold within a relevant range
beyond which all costs are variable. The relevant range is the activity limits within which the
cost behaviour can be predicted.
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Costs
Variable component
Semi
Variable cost
Fixed component
Activity Level
b) Indirect costs are costs which can not be conveniently identified with a particularly cost unit
process or department. They are general cost incurred for the benefit of a number of cost
unit or cost centres such as salary paid to a factory foreman.
Indirect costs are costs that will not be directly attributable to a specific product. They are regarded
as overheads. Identification of overheads to specific products is done through cost allocation and
apportionment. They include supervisors salaries, rent, electricity, depreciation of building etc.
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b) Uncontrollable costs are costs that cannot be influenced by the action of a specified member of
the enterprise e.g. fixed cost like rent are generally uncontrollable.
F. Special cost for managerial decision making
a) Relevant costs are costs which changes from one decision to the next and as such relevant cost
will be affected by the decision being made under different alternatives. In decision making
management will be concerned with those costs that differ from one decision to another.
b) Sunk or irrelevant cost These are cost which have been already been incurred in the past and
cannot be changed. They are relevant in decision making.
c) Incremental cost / differential costs This is an increase or decrease in cost as a result of an
alternative course of an action.
d) Marginal or variable cost It is the cost of producing an extra unit of a commodity.
e) Replacement cost This market value of replacing an existing asset.
f) Opportunity cost It is the sacrifice involved in accepting the alternative under consideration.
G. Classification according to time
a) Historical costs are costs ascertained after they have been incurred. They are the actual costs
which are only available after completion of the manufacturing process.
b) Predetermined costs They are future costs that are ascertained in advance of production on the
bases of all specified factors affecting cost.
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a) Historical costs are costs ascertained after they have been incurred. They are the actual costs which
are only available after completion of the manufacturing process.
b) Predetermined costs They are future costs that are ascertained in advance of production on the bases
of all specified factors affecting cost.
Concepts of Cost accounting Cost per unit this may be unit of a product service all time in relation to
which cost may be ascertained all expressed. There are the things that the business is set up to provide
which cost to ascertained. E.g. kilowatt in case of power consumption meals in case of a hotel passages
in case of transport. Profit centre `this may be defined as subdivision within an organization operating
on a self contained bases. Usually it will be a cost and an income earning subdivision hence producing
profit measurable as a return on capital employed.
Activity 2.1
Now that you have known the different type of cost classification, can you indentify the different
cost in an organization and group them in each of the classification learnt above
FORMAT Shs
Material cost x
Labour cost x
Direct expenses (if any) x
Prime cost Xx
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Depreciation x x
Cost of goods manufactured xx
Administration overheads x
Selling and distribution overheads x
Total cost of sales x
Profit x
Sales xx
EXAMPLE I
Prepare a cost statement from the following information.
Shs
Raw materials 600,000
Direct labour 160,000
Factory rent 30,000
Power 10,000
Supervisors salaries 40,000
Administration expenses 80,000
Selling and distribution expenses 30,000
Solution
Cost statement
Shs
Raw materials 600,000
Direct labour 160,000
Prime cost 760,000
EXAMPLE 2
From the following information, prepare a cost statement.
Shs
Raw materials 1,600,000
Direct labour 700,000
Factory rent 100,000
Power 60,000
Indirect wages 40,000
Administration expenses 80,000
Selling & distribution expenses 60,000
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Profit 25% of cost.
Solution
COST STATEMENT
Shs
Material cost 1600,000
Labour cost 700,000
Prime cost 1300,000
Kemu ltd manufacturing company provides to you the following information for the month of
October 2014.
STOCKS ON 1ST OCTOBER 2014
Shs
Raw materials 800,000
Work in progress 240,000
Finished goods 400,000
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Factory rent 200,000
Power 100,000
Sundry factory expenses 300,000
Office salaries 260,000
Sundry office expenses 140,000
Salesmens salaries 360,000
Sundry selling expenses 120,000
Sales 10,000,000
REQUIRED
1. Prepare a production cost statement
2. Prepare a profit statement.
Solution
PRODUCTION COST STATEMENT
DIRECT MATERIALS
Opening stock 800,000
Purchases of raw materials 5,000,000
5800,000
Less: closing stock (700,000)
Cost of material used 5100,000
Direct wages 1,600,000
Prime cost 6,700,000
WORK IN PROGRESS
Opening 240,000
Closing (340,000) (100,000)
Production for factory cost 7,800,000
PROFIT STATEMENT
SHS (SHS)
Sales 10,000,000
Less: cost of goods sold:
Opening stock 400,000
Add: production cost 7800,000
8200,000
Less closing stock (460,000) 7,740,000
Gross profit 2,260,000
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LESS: EXPENSES
Shs
Administration overheads 260,000
Sundry office expenses 140,000 400,000
SELLING & DISTRIBUTION
Salesmens salaries 360,000
Sundry selling expenses 120,000 480,000 880,000
Net profit 1,380,000
2.6 Summary
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2. Production or factory costs. These include all prime costs plus overheads (production or
factory).
3. Total cost of sales. These include production cost plus the other overheads e.g. administration
and selling and distribution.
These are explained as under:-
Direct materials consists of the raw materials used in a product and some component which are
incorporated into the finished product.
Cost of direct materials = opening stock + purchases closing stock
NB: 1. Transport charges on material purchased are added.
2. Returns of material purchased are deducted.
Direct wages are remuneration paid to factory workers for converting the raw materials into
finished goods. They also include remuneration of construction workers, machine operation etc.
Direct expenses Include any expenditure other than direct materials and direct wages incurred on
the production of some specific product. E.g. hire charges of equipment for the production of a
specific product, costs of designs or drawings etc.
Prime cost = Direct material cost + direct labour costs + direct expenses (if any)
Over heads These are costs which cannot be identified to the production of any specific product.
They are also called indirect expenses and include:-
1. Production or factory overheads.
2. Administration overheads.
3. Selling and distribution overheads.
Administration overheads.
These are expenses incurred in providing control, direction and management of the enterprise. They
include expenses related to secretarial, accounting and legal services. Others include:-
Rent, rates, insurance, water and electricity for the office.
Salaries of office staff e.g. accountants, clerks etc.
Depreciation of office furniture, office equipment and office buildings.
Office stationery and maintenance cost of office equipment.
Legal expenses e.g. fees of advocates.
Financial expenses e.g. interest on loans bank charges etc.
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Selling and distribution expenses
Selling overheads are the expenses incurred to secure orders and to increase sales of the enterprise.
They also include:-
Advertisement expenses.
Salaries of salesmen and commission of sales agents.
Sales correspondence expenses and cost of preparing catalogue and price lists.
Rent of salesrooms and offices, water and electricity expenses of salesrooms.
Distribution overheads are those expenses which are incurred on the movement of finished goods
from factory to warehouse and then in delivering these goods to the customers. These include:-
Transport charges (carriage outwards).
Cost of maintaining delivery vans e.g. fuel insurance and repair charges.
Salaries of delivery van drivers, mechanics and delivery clerks.
Rent, rates, insurance, water and electricity charges of warehouse.
NB: total cost + profit (or minus loss) gives the selling price.
QUESTION ONE
What is meant by the tem classification of costs? Explain various types of cost classifications. 2.
Write short notes on
a) Cost unit
b) Cost centre
c) Profit centre
d) Cost behavior
37
sake of it? Explain
QUESTION TWO
Discuss the behavioural classification of costs, explaining all the terms
used therein.
QUESTION THREE
Discuss in detail what constitutes manufacturing costs as production costs, administration
costs as well asselling and administration costs.
QUESTION FOUR
The functional classification of costs classifies costs as production costs,
administration costs as well as selling and administration costs.
Explain what constitutes these costs in detail.
QUESTION FIVE
Papermaking Ltd. Makes paper which is cut and packed before being transferred into the finished
goods store. The paper is moved from department to department by a fork lift truck. Each pack of
finished product contains one ream of paper. The paper is loaded onto wooden pallets before
delivering to customers. The following cost information related to papermaking Ltd. For period
ended 31st March 2014
Sh.
Pulp 100,000.000
Clay 40,000.000
Wrapping paper (used in packing dept.) 3,500.000
Spare knives for cutting machines 800.000
Cleaning rags for machines 500.000
Royalty payments 10,000.000
Making dept. wages to packages 38,000.000
Cutting dept. wages for machine crew 26,000.000
Packing dept. wages to packages 20,000.000
Fork lift truck driver wages 8,000.000
Factory managers salary 11,000.000
Wooden pallets 3,600.000
Dispatch dept. wages 17,000.000
Delivery vehicle driver wages 9,600.000
Sales managers salary 17,500.000
Advertising cost 16,500.000
Sales office wages 18,500.000
General Managers salary 30,000.000
38
Production managers salary 21,500.000
Maintenance fitter wages 25,000.000
Maintenance workshop costs 17,000.000
Maintenance engineers salary 18,000.000
Administration salaries 45,000.000
Electricity costs (See note 1) 18,000.000
Administration office machine rental 1,000.000
Note 1
Electricity is charged to each function area as follows; production 75%, administration 5%, selling
5%, distribution 15%.
Note 2
Maintenance costs should be totaled before a cost summary is prepared and charges to each function
making use of the maintenance service as follows; production 80%, administration 3%, selling 3%,
distribution 14%.
Required
Prepare a cost summary for the period ended 31 March 19x4 analyzing costs into
prime costs, production costs and total cost.
(Give all subtotals of classified costs).
rd
1Paresh, S. (2010) Cost Accounting 3 Edition, Tata McGraw-Hill, New Delhi.
39
LECTURE THREE
3.0Cost Estimation and Forecasting
3.1Lecture Overview
After you have learnt what cost is, and the different classification it is vital to have knowledge on the
various techniques which can be used to separate mixed costs and to formulate linear prediction
equation the equation is to be used to estimate and forecast future cost.
3.2 Lecture Objectives
3.3.1 The methods that can be used for this purpose are:-
a) Accounts classification (separating mixed costs) entails the examination of accounts and regards and
classifying each item of expenditure into fixed, variable and semi variable. Although the method is
quick and inexpensive and it is considerably subjective and inaccurate.
40
b) Industrial engineering (cost estimation and forecasting) this is considered is the most scientific
method of establishing a cost standard. Work study techniques are applied to determine levels of input
needed to satisfy given levels of outputs. Those, inputs are then turned into standards in order to
estimate product cost in the future.
Advantages
1. It enables an organization to determine the most effective way to apply resources.
2. Standard can be set using efficient usage.
3. There is control of operation by comparing actual results with the expected results
Disadvantages
1. It is costly to use as it involves experts.
2. It is not effective for controlling many types of overhead costs.
3. It is not easy to apply in non-manufacturing activities since relationship between cost and output
cannot be determined.
41
vi) Formulate linear prediction equation
Total Variable Cost = Cost at high activity level Cost at low activity level
Therefore,
Unit Variable cost = Variable cost = Cost at high level activity cost at low level activity
Output Units Units at high activity level units at low activity level
The variable cost per unit so calculated forms the bof the straight line equation mentioned earlier. By
substituting b into the equation, we can obtain a, the fixed cost.
Illustration 1
Based on performance, you have been provided with the following information regarding ABC Ltd for
the year ended 31 December 2004 :
Labour hours Service cost (Shs)
Required
Develop a total cost function based on the above data using the high-low method.
Solution
Unit Variable cost = Variable cost = Cost at high level activity cost at low level activity
Output Units Units at high activity level units at low activity level
= Shs.50,000 = shs.100/hr
500 hrs
Therefore b = 100
To get the fixed cost a, substitute b into the straight line equation as follows:
When labour hours (x) = 800, service cost (total cost, y) = shs.200,000
Therefore from the Straight Line equation, y = a + b x
200,000 = a + (100) 800
200,000 = a + 80,000
a = 200,000 80,000
42
a = 120,000
Therefore fixed costs = shs.120,000
NB: Even if we used the 2nd set of labour hours and service costs, were would still get he same answer i.e.
When labour hours (x) = 300, service cost (total cost, y) = Shs.150,000.
Therefore 150,000 = a + 100(300)
a =150,000 30,000 = Shs.120,000
Therefore the cost equation is:
y = 120,000 + 100x
This equation can be used to estimate or predict the total costs : for example, when the activity level is say at
1000 labour hours, then the total cost would be
Y= 120,000 + 1000(100)
=120,000 + 100,000
= Shs.220,000.
ILLUSTRATION 2
The production manager of Kemu ltd Company, is concerned abut the apparent fluctuation in efficiency and
wants to determine how labour costs (in Sh.) are related to volume. The following data presents results of
the 12 most recent weeks.
Required:
Estimate the cost function using:
The high low method
Regression analysis
43
Estimate the labour cost to be incurred.
SOLUTION
We will first use the high-low method to establish the cost function.
Highest point X Y
416
Lowest point 21 180
Difference 28 236
Y= a + bx
We can Substitute the lowest points (21,180)
180 = a + 8.43(21)
i. if X=45 units
Y = 3 + 8.43*45
= Sh.382.35
ii. 34 Y = 3 + 8.43(34)
= Sh.289.62
Note:
The main problems of the high low method are:
Reliability is low
It Ignores all the other points except the highest and lowest which in most cases are outliners.
Disadvantages
1. It is not logical to use two points to represent all the points.
44
2. The estimated cost function poorly describes the actual cost relationship.
3. Costs are not properly matched with the independent variable.
= a + bx
When the equation includes 2 or more independent variables, it is referred to as multiple regression and is of
the form:
SIMPLE REGRESSION
Regression analysis determines mathematically the regression line of best fit. It is based on the principle that
the sums of squares of the vertical deviation from the line established is the least possible
I.e. (Y Y ) 2
is minimised
The equation can be solved by the use of normal equations and these are:
1. y = na + b (x)
xy = a (x) + b (x2)
a= Y - bx
n n
Looking at illustration 2.1, then we first compute the sum of X, Y, XY, X2 and Y2
45
1 34 340 11560 1156 115600
2 44 346 15224 1936 119716
3 24 287 8897 961 82369
4 36 262 9432 1296 68644
5 30 220 6600 900 48400
6 49 416 20384 2401 173056
7 39 337 13143 1521 113569
8 21 180 3780 441 32400
9 41 376 15416 1681 141376
10 47 295 13865 2209 87026
11 34 215 7310 1156 46225
12 24 275 6600 576 75625
430 3549 132,211 16234 1104005
b. i. If X = 45 units, then
ILLUSTRATION
Assume that the company (in illustration 2.1) intends to spend Sh.400 on labour cost next period. Compute
the number of units that the company may produce.
SOLUTION
Note:
= a + bx is a regression of Y on X i.e. Y = f(x)
We require a regression of X on Y. i.e. X = g(Y) to answer the above question. The general format of the
equation is:
X = a1 + b1 Y
46
b = n xy x y
nY 2 (Y)2
a = X - bY
n n
= 0.0926
a1 = 430 - 0.0926(3549)
12 12
a1 = 8.3286
Thus if the Company intends to spend Sh.400 on labour, the number of units to be produced will be:
X = 8.33 + 0.093(400)
= 45.56 units
Approximately 46 units
Illustration:
Assume a firm has total costs of 8m, 4m and 1m respectively when the output units are 400,000, 200,000 and
respectively. Estimate its cost equation using the visual fit method.
47
10
9
Dependant 8 X
Variable 7 X X X
(Total Cost) 6 X X X
5 X X X X X
4 X
3 X X X X X
2 X X
1m X
X2 X3
0 200,000 400,000
Independent Variable
(Output Level)
Fixed Cost X
0 1m
Note : Change in Y
Gradient Y3 - Y2 Variable Cost Per Unit
Change in X X3 X2
48
3.8 Account Analysis (Inspection of Accounts)
Using account analysis, the accountant examines and classifies each ledger account as variable, fixed or
mixed. Mixed accounts are broken down into their variable and fixed components. They base these
classifications on experience, inspection of cost behaviour for several past periods or intuitive feelings of
the manager.
Activity 3.1
Using the knowledge acquired early in the unit think of a particular department in your
organization and classify cost into variable and fixed cost and predict the cost to be incurred in
the next month.
This is also referred to as improvement curve theory. It occurs when new production methods are introduced,
new product s (either goods or services) are made or when new employees are hired. It is based on the
proposition that as workers gain experience in a task, they need less time to complete the job and productivity
increases.
The learning curve theory affects not only direct labour costs but also impacts direct labour related costs such as
supervision, and direct material costs due to reduced spoilage and waste as experience is gained.
3.10 Summary
Cost estimation is a procedure used to measure costs of various items used in the process of production.
While cost forecasting is the process of accurately determining in advance the cost that will be incurred
in the process of manufacturing a particular product over a given future period
There are various methods that can be applied by cost accounting in cost estimation and forecasting
a) High Low Activity method
b) Account Analysis
c) Engineering Analysis
49
d) Visual Fit (Scatter graph) method
e) Simple linear regression analysis
h)Learning curve Theory
QUESTION ONE
CB plc produces a wide range of electronic components including its best selling item, the Laser Switch.
The company is preparing the budgets for Year 5 and knows that the key element in the Master Budget is the
contribution expected from the Laser Switch. The records for this component for the past four years are
summarised below:
Year 1 Year 2 Year 3 Year 4
Sale (unit) 150,000 180,000 200,000 230,000
Required:
As a starting point for forecasting Year 5 contribution, to project the trend, using linear regression;
To calculate the 95% confidence interval of the individual forecast for Year 5 if the standard error of the
forecast
is 14,500 and the appropriate t value is 4,303, and to interpret the value calculated;
To comment on the advantages of using linear regression for forecasting and limitations of the technique.
QUESTION TWO
The theory of the experience curve is that an organisation may increase its profitability through obtaining
greater familiarity with supplying its products or services to customers. This reflects the view that
profitability is solely a function of market share.
Required:
Discuss the extent to which the application of experience curve theory can help an organisation to prolong
the life cycle of its products or services.
50
3.12 Further Reading
rd
1Paresh, S. (2010) Cost Accounting 3 Edition, Tata McGraw-Hill, New Delhi.
51
LECTURE FOUR
4.0 Material costing
4.1Lecture Overview
The lecture is to introduce you to various methods of accounting for material issue from the stores and
valuation of closing stock .
4.2 Objectives
52
4.3.2 Purchasing procedure (STEPS)
This involves acquisition of goods/services done by the purchasing department. Its importance
depends on the nature of business e.g. in a manufacturing business, the department is very important
than in service industry. Purchases control is exercised to ensure that goods are purchased at right
time of right quality and in right quantity. Over purchasing, under purchasing or purchase of inferior
quality goods have negative effects to the business.
53
Once the supplier receives the purchase order, he makes arrangements to deliver the goods. The
selling organization prepares and delivers the goods. The buying organization prepares and issues
goods received note and also signs the delivery note. Other documents involved in the receipt of
goods include advice note and a package sheet. Goods are mostly received by the stores
department.
If goods received are of inferior quality or not according to the description given in the purchase
order, then the receiving dept can refuse to accept them.
A rejection Note or goods returned note are issued.
Invoice this is a claim of money by the supplier from the purchases for the goods supplied. Its
send by the supplier to the buying firm.
Payment After receiving the invoice, the buyer checks the amounts due to the supplier and once
satisfied he makes arrangements to remit money e.g. through a cheque. On receipt of the cheque or
cash, the supplier issues a receipt as a proof that transactions have been completed.
Recording stock- Goods purchased are recorded in the accounting books of any organization. The
entries in the cost are made from goods received notes while the financial entries are made from
invoices. Both entries should be reconciled.
54
Its a document used to return some materials to the stores department incase they were in excess. It
contains:-
Details of materials returned.
Reason for as return.
The job number to which it was originally charged.
Signatures of the person who returns from the department and the receiver in the stores
department.
Material transfer note
Its a document used to transfer materials from one job to another job or from one department to
another department.
It is used by the stores and costing depts to charge the value of materials to the correct jobs.
55
o Decentralized stores
o Imprest stores
Centralized Stores
Centralized system In this case the duty and responsibility of purchasing is done by one purchaser is
purchasing department.
b)
Decentralized Stores
These are stores where materials are held and issued by sub-stores in each department or branch.
The advantages are the disadvantages of centralized and vice versa.
. Decentralized system the duty and responsibility of purchasing is placed with individual branch department
or geographical department. Advantages of centralized system
i) Less expensive since few activities are concentrated in one department.
ii) There is better control because of effective and efficient monetary.
iii) There is more accountability.
iv) There is bulk buying hence economies of scale are enjoyed.
v) Fewer staffs are employed.
vi) There is expertise in buying due to specialization.
56
Visit your organization purchasing department and indentify which method of store system it has
adopted.
4.5 Material Coding
A code is defined as a system of symbols designed to be applied to a classified set of items to give
a brief accurate reference facilitating entry, collation and analysis.
Materials are coded for immediate identification. The coding may be in terms of sizes or models.
Purposes of Coding
To avoid ambiguity in description
To minimize length in description.
Principle of Coding
a) Certainty
b) Elasticity flexibility
c) Brevity brief
d) Memorization easy and possible to remember and understand the code numbers.
e) Uniformity equal length and same structure codes.
f) Exclusive each item should have only one code and this code should not be used for
any other item.
57
STORES LEDGER
Date Receipts Issues Balances
G.R Qty Price Value M..K Qty Price Value Units Value
note note No
NO
FORMAT
BIN CARD
DATE RECEIPTS ISSUES BALANCE REMARKS
G.R NO Qty M.R NO QTY QUANTITY
Stock Taking
58
Stock taking means to check physically the stock items in order to ensure that stock quantities
shown on stock records and actual quantities are the same.
59
c) An emphasis on perfect quality i.e. zero defects
d) Short set-ups
e) A move towards batch size of one
f) 100% on time deliveries
g) A constant drive for improvement
h) Demand- pull manufacture
Production only takes place when there is actual customer demand for the product so JIT works on a
pull-through basis which means that products are not made to go into stock. Benefits from JIT
(i) Lower investment required in all forms of inventory
(ii) Space savings from the reduction in inventory and improved layouts.
(iii) Greater customer satisfaction resulting from higher quality better deliveries and greater product
variety
(iv) The buffers provided by traditional inventories masked other areas of waste and inefficiency,
supplier unreliability and so on. Elimination of these problems improves performance dramatically.
(v) The flexibility of JIT and ability to supply small batches enables companies to respond more quickly
to market changes and to be able to satisfy market niches
Perpetual inventory involves recording all receipts, issues and running balances on bin card
To determine the material cost of different jobs or products, materials issued must be valued.
Valuation methods include.
a) First In, First Out (FIFO)
b) Last In, First Out (LIFO)
c) Weighted average
we will only consider FIFO, LIFOand Average Weight Cost methods.
To show the recording in the stores ledger cards under each case, the following example is used.
Example
May 2 received 500 units at Ksh20 each
8 received 300 units at ksh 22 each
10 issued 400 units
15 issued 200 units
20 received 600units at Ksh25
25 issued 300units
27 received 200units at Ksh26
60
a) First In First Out (FIFO).
The method assumes that the goods issued are those which have been longest on hand and that those
remaining in stock represent the latest purchases or production.
The stocks whose cost is to be carried forward were acquired or produced most recently.
NB: materials are issued at the cost price of that consignment which was received first. When this
consignment is finished, then cost price of next consignment is finished, then cost price of next
consignment is charged to value the materials issued.
This method is based on the assumption that stock purchased first is issued first. Prices of stock
purchased first are used to determine the cost or value of inventory issued. Closing stocks are
carried at the latest costs.
Advantages
1. It is a realistic system: oldest items are usually issued first out.
2. Unrealized profits or losses do not arise
3. It is easy to calculate if prices of materials dont fluctuate
4. Closing stocks values reflect the latest costs thus tend to reflect the current market values.
5. It is acceptable to many tax authorities and is also consistent with accounting practices e.g.
IAS/IFRS.
Disadvantages
1. It involves tedious calculations if the price of materials fluctuate from time to time
2. Product costs, based on the oldest material prices, lag behind current conditions especially in
inflationary markets.
3. Comparison of one job with another may be difficult if materials are issued at different prices.
61
G.R QTY Price Value M.R QUANTITY Price Value Qty Value
NO NO
500 units purchased on May 2, were first in and these must go first. These were issued as 400 units
on May 10 and 100unstis on May 15. These should be valued at Ksh20 per unit. 300 units
purchased on May 8, were issued as 100units on May 15 and 200 units or May 25.
These must be valued at Ksh22 each unit. From 600 units purchased on May 20, 100units were
issued on May 25 and 100 units on May 30. These were valued at Ksh25 each. Now 600 units in
stock are valued as under:-
400 units from May 20 purchases = 400x25 = 10,000
200 units purchased on May 27 = 200 x 26 = 5,200
15,200
62
Advantages
1. Product costs tend to be based on current market prices and is therefore realistic.
2. A charge to production is as closely related to current price levels as possible
Disadvantages
1. Stocks are valued at the oldest prices.
2. It involves tedious calculations if the price of materials fluctuate from time to time.
3. Comparison of one job with another may be unfair and difficult
Example
STORES LEDGER CARD
Date Receipts Issues Balance
G.R Qty Price Value M.R Qty Price Value Quantity Value
No NO
Shs Shs Shs Shs Shs
May 2 500 20 10,000 500 10,000
8 300 22 6,600 800 16,000
10 400
300 22 6,600 500 10,000
100 20 2,000 400 8,000
15 200 20 4,000 200 4,000
20 600 25 15,000 800 19,000
25 300 25 7,500 500 11,500
27 200 26 5,200 700 16,700
30 100 26 2,600 600 14,100
500 units were purchased on May 2 and 300 units on May 8. 400 units issued on May 10 must be
300 units from May 8, purchases and 100 units from May 2 purchases.
300 units are valued at Ksh22 each and 100 units at Ksh20 each. 200 units issued on May 15 will be
from first consignment because second consignment of May 8 is already finished. These must be
charged at Ksh20 each.
300 units issued on May 25 must be from last consignment of May 20 and these are charged at
Ksh25 each. 100 units issued on May 30 must be from last consignment of May 27 and these are
charged at Ksh26 each. Now 600 units in stock are valued as under:-
Ksh
100 units from May 27, purchases = 100x26 = 2,600
63
300 units from May 20 purchases = 300x25 = 7,500
200 units from May 2 purchases = 200 x20 = 4,000
_____
14,100
C ) Average Weighted Cost Average
i. This method is a perpetual weighted average system where the issue price is recalculated after each
receipt of stocks taking into account both quantities and money vale of the stocks received.
In this case stock used or unused is based on the average price per unit where the average price per unit
is calculated as follows:
= Total value of stocks = Average Price Per Unit
No. of units of stock
This means weighted average price under this method, the total value of goods in stock is divided
by the number of units of stock. The resultant figure is weighted average price.
NB:
The method is simple and logical but it is not close to current value of goods.
Profit and loss may arise on the materials issued.
STORE LEDGER CARD
DATE RECEIPTS ISSUES BALANCE
G.R Qty Price Value M.R Qty Price Value Quantity Value
No NO
Shs Shs
May 2 500 20 10,000 500 10,000
8 300 22 6,600 800 16,600
10 400 20.75 8,300 400 8,300
15 200 20.75 4,150 200 4,150
20 600 25 15,000 800 19,150
25 300 23.94 7,181 500 11,969
27 200 26 5,200 700 17,169
30 100 24.53 2,453 600 14,716
64
No. of units
There for weighted average price is calculated as:
Stock Control
This means making sure that the business has the right quantity of goods, in the right place and at
the right time. Stock level must be maintained at a reasonable level.
- Insurance and security cost - Refrigeration and conditioning - Ware housing changes. - Maintenance of
machinery
iii) Ordering cost is the cost of bringing stock items into the store. They include loading and off loading
charges cost of purchasing department, transport etc.
65
iv) Stock out cost or shortage cost is the cost incurred as a result of not having inventory items in stock.
E.g. production disruption which may lead to lower production, lost discounts cost of speeding up orders
and deliveries, lost customer good will.
Economic Order Quality (EOQ) This refers to the optimum number of units should be ordered every
time an order is made so as to minimize total stock cost. Assumptions / limitation of EOQ
1. Replenishment is instantaneous (Q). There is no lead time. Lead time is the time taken between
ordering and delivery.
2. No safety stock.
3. Demand is known in advance and it is constant.
4. Purchasing cost and cost per order are constant i.e. there are affected by factors like discount.
5. Stock is replaced in equal batches.
6. Cost per order is constant irrespective of quality.
7. Stock holding / carrying cost is a function of average inventory.
8. No stock out cost.
66
P = Cost price per item
I = stock holding cost per annum (expressed as a fraction of stock value)
EXAMPLE
A company has an annual demand for material p of 25,000 tons per annum. The cost price per ton
is Ksh2, 000 and stock holding is 25% per annum of the stock value. Delivery cost per batch is
Ksh400.
Calculate the E.O.Q
E.O.Q = 2(400) (25,000)
25% of Ksh2000
= 2(400) (25,000)
500
= 40,000 = 200units
This means that 200units must be purchased at one time. If the batch size is more than or less than
200 units then stock holding and ordering costs will be higher
On the other hand, having too little of the stock may have the following problems
i) Lost customer goodwill.
ii) Costly in terms of speeding up orders.
iii) Low production which may lead to losses.
Too low stock level or too high stock levels are not beneficial to an organization. Too low stock
level means production demands are not met resulting to loss of customers and profits reduction.
67
High stock levels results in high storage costs, greater risk of deterioration of the stock hence
reduction in the enterprises profits.
Factors Affecting Stock Levels.
1. Availability
2. Lead time refers to the period between the date of order and date of delivery. If lead time is
more then stock must be maintained at high level and vice versa.
3. Stock holding cost high stockholding cost calls for low stock level and vice versa.
4. Consumption
5. Trade discount, - if the benefits of trade discount (due to bulk purchases) is greater than
stockholding cost, then stock level must be maintained at high level.
6. Durability.
68
d) Re-Order quantity
This is the quantity of stock ordered once the re-order point is reached. The quantity is such as to
minimize stock costs taking into consideration the cost of holding stocks and making an order. This is
also regarded as the Economic Order Quantity (EOQ). It is computed as follows:
Where D is the annual demand (knits)
Co is the cost of making one order
Ch is the holding cost per unit per annum
EOQ 2DCO
Ch
Where:
Max C = Maximum consumption
Min C = Minimum consumption
NC = Normal consumption i.e. average of max: C and Min C.
Max: RP Maximum re-order period or lead period
Min: RP Minimum re-order period
NRP Normal re-order period
RQ Re order quantity
Min: SL Minimum stock level
Max: SL Maximum stock level
EXAMPLE 1
69
Illustration
The following information was extracted from the books of Danex Holdings regarding its
stocks:
i. Reorder quantity 1,800
ii. Reorder period 4 weeks
iii. Maximum consumption 450 units/week
iv. Normal consumption 300 units/week
v. Minimum consumption 150 units/week
Vi Maximum reorder period 5 weeks
Vii Minimum reorder period 3 weeks
Required
Determine the following stock levels for Danex Holdings:
i. Re-order level
ii. Maximum stock level
iii. Minimum stock level
Solution
i) Re-order level = Maximum consumption X maximum reorder period
= 450 units X 5 weeks = 2,250 units
ii) Maximum stock level = reorder level + reorder quantity-
70
From the costing perspective, the essentials of material purchase and control prior to actual use in
production can be summarized as follows:
i. Materials of appropriate quality and specification should be purchased only when required and
appropriately authorized.
ii. The suppliers chosen should represent an appropriate balance between quality, price and delivery.
iii. Materials should be properly received and inspected.
iv. Appropriate storage facilities should be provided and stock levels physically checked on a
regular basis.
v. Direct material used in production should be charged to production on an appropriate and
consistent pricing basis.
vi. Indirect material used in production and non production departments should be appropriately
charged to correct cost centre and included in the overheads of the cost centre.
vii. The documentation, accounting system and controls at each stage should be well designed and
effective
viii. Stock taking must be well organized to ensure that stock quantities on hand are available when
required.
QUESTION ONE
Assume the following purchases were made in Liz Ltd
Date of purchase Units purchased Price/unit
1st January 500 100
2nd January 600 200
3rd January 800 400
Units used on 4th January are 900. Determine the value/cost of units used by using FIFO, LIFO and weighted
average.
Required:
Determine the cost of units used and the value of the closing stocks using FIFO, LIFO and Weighted
Average.
QUESTION TWO
71
LATEX Ltd. are retailers who sell ceramic tiles. During the months of Jan to March 2012, there were
price fluctuations. Due to the above problem the company had to adjust its selling prices.
The following transactions took place during the period.
3 JAN Opening stock was 5,000 tiles valued at Sh 825,000.
10 JAN Orders placed with the company increased, so extra tiles had to be
obtained from Mombasa. Therefore 22,000 tiles were purchased at a cost Sh 140
each but in addition, there was a freight and insurance charge of Sh 5 per tile.
31 JAN During the month 20,0000 tiles were sold at a price of Sh 220 each.
4 FEB A new batch of 14,000 tiles was purchased at a cost of Sh 175 per tile.
28 FEB The sales for the month of August were 14,000 tiles at a selling price of Sh 230
each.
1 MARCH A further 24,000 tiles were purchased at a cost of Sh 195 each.
30 MARCH 27,000 tiles were sold during September at price of Sh 240 each.
The cost accountant of LATEX Ltd decided he would apply first-in-first-out basis and weighted average
methods of material pricing for purposes of comparison.
Required:
(i) A stores ledger account using the two methods and showing stock values at 30 MARCH 2012.
(14 marks)
(ii) The trading accounts using each of the above methods.
QUESTION THREE
The following information is provided for material PQ 251. Maximum consumption = 12000 units
per week.
Minimum consumption = 8000 units per week
Reorder period or Lead time 4 - 6 wks
Re-order quantity 60,000 units
Required
1. Re order level
2. Minimum stock level
3. Maximum stock level
4. Average stock level
4.11 Further Reading
72
rd
1.Paresh, S. (2010) Cost Accounting 3 Edition, Tata McGraw-Hill, New Delhi.
73
LECTURE FIVE
5.1Lecture Overview
Labour is the physical and mental energy applied by human beings in the process of manufacture of a
product or service. It is important to understand how the cost of labour is accounted for in this process.
This lesson introduces the learner to various method of labour costing.
5.2 Objectives
74
contractors. In effect firms will be operating Just in Time system for labor. The new developments are
not without disadvantages as it may result into social oppressions, low and irregular earnings, and biased
dismissals in the pretext of no work or poor performance.
Within these two categories there are innumerable variations some of which have general applicability
whilst others are of a local and specialized nature. Remuneration systems are frequently complex and
administratively cumbersome, but because the system is the result of negotiations, disputes and
disagreements over the years, attempts to rationalize and simplify are frequently met with hostility and
suspicion.
The newer forms of production organization, such as Just In Time systems mean more and more workers
will be paid time rates and will not have their pay dependent on individual output levels. There are two
reasons for this: first, parts are only produced as and when required. This means that the repetitive
production of components that move into stock is avoided as one of the key objectives of JIT. Secondly,
what counts in JIT is the output of the group (known as a production cell) as a whole. As a consequence
workers have to be flexible and adaptable so that they can move from task to task according the demand.
In such circumstances individual incentive schemes are of little or no value.
In addition more and more wages and salaries, traditionally classified as overheads, are now being
traced to product lines and classed as direct. Support functions are also grouped around specific product
lines so that identification of costs is more direct. This has led to the development and use of activity
based cost system (ABC System)
Disadvantages
i. it has no real incentive to increase output
ii. all employees in the same grade are paid the same rate regardless of performance
iii. constant supervision may be necessary
75
ii. Work where incentive schemes would be difficult or impossible to install e.g. direct labor, stores
assistants, clerical work etc.
iii. Work where output is not under the employees control e.g. power station workers, teachers, etc.
Disadvantages
i. May cause other employers to raise their rates to attract better workers thus nullifying the original
effect.
ii. Problems occur when the original target production figures are not met
76
Harsey Scheme
Bonus = (time saved x wage rate)
Halsey Weir
Bonus = 1/3 (time saved x wage rate)
Rowan: bonus = time taken x time saved x wage rates
Time allowed
Example 1
Total output of Mwangi for one week was 480 units. He was allowed 8 minutes per unit. He
completed these units in 52 hrs. His wage rate per hour is Ksh18.
Calculate his total wage according to:-
i. Halsey scheme
ii. Halsey weir scheme
iii. Rowan scheme
Answer
Units completed = 480 units
Time allowed per unit = 8 minutes
Time allowed for 480 units = (8/60 x 480) hrs = 64hrs
Time taken = 52 hours
Time saved = (64-52) hrs = 12 hrs
Basic wage rate = Shs (52x18)
= Shs936
i) Halsey scheme:
Bonus = x T.S x wage rate
= x 12 x Shs18
= shs108
Total wage = basic wage + bonus
= shs936 + 108 = shs1044
Ii) Halsey weir scheme
Bonus = 1/3 x T.S x wage rate
1/3 x 12 x 18
77
= shs72
Total wage = basic + bonus
= 936 + 72
= Shs1008
Iii.)Rowan scheme
Bonus = T.T x T.S x wage rate
T.A
= 52 x 12 x18
64
= shs175.50
Total wage = basic + bonus
= 936 + 175.50
=Shs1, 111.50
78
MU5 Joseph 200 320 per Hr 1600
MU6 Elizabeth 170 260 per Hr 10,000
Additional Information
1. Normal working hours per month are 180. Overtime payable for extra hours at the rate of
50% above normal pay rate.
2. P.A.Y.E to be deducted at the rate of 20% of gross wage.
3. N.S.S.F to be deducted Ksh200 for each employee.
4. N.H.I.F to be deducted Ksh400 for each employee.
PAYROLL MAY 2014
S.No Name Total Rate Gross Deductions Net Advance Bal
hrs wage wage
worked
P.A.Y.E NSSF NHIF Total
deductions
Shs Shs Shs Shs Shs Shs Shs Shs Shs
5011 Alex 190 12 2,340 234 80 20 334 2,006 600 1,406
5012 Robert 180 10 1,800 180 80 20 280 1,520 500 1,020
5013 Wachira 200 16 3,360 336 80 20 436 2,924 800 2,124
5014 Paul 170 13 2,210 221 80 20 321 1,889 500 1,389
5015 Josphat 210 10 2,250 225 80 20 325 1,925 800 1,125
5016 Mwangi 200 14 2,940 294 80 20 394 2,545 700 1,846
79
4. Paul = 170hrs x Shs13 2,210
5. Josphat = 180hrs x shs10 1,800
30hrs x shs15 450 2,250
6. Mwangi = 180hrs xshs14 2,520
20hrs x shs21 420 2,940
NB: I. For overtime, payment is to be made at normal rate plus 50% of normal rate.
(ii) P.A.Y.E is taken 10% of gross pay.
Activity 2.6
Finally, we have come up with a pay roll; do you see any linkages or relationships between the pay
roll and the payslip. Look at your pay slip and compare.
80
A B C
160 120 80
OR 4: 3: 4
Therefore labour cost is apportioned as per these proportions.
Job A = shs72000x4/9 = shs800
B = shs72000x3/9 = shs600
C = shs72000x2/9 = shs400
5.7 Summary
In summary, the lecture aimed at explaining method of labour costing The two main categories of
remuneration are:
i. Time based
ii. Remuneration related to output or performance
Illustration 1
Under a premium bonus scheme, workers received a guaranteed basic hourly minimum rate of pay plus a
bonus of 50% of the time saved. No payment is paid beyond the time allowed but the bonus which is paid at
the basic hourly rate is applicable to the accepted output only. No penalty is imposed on rejected output. The
following details are available for the month of January 2003
Worker A B C
Time allowed per unit (hrs) 1/6
Units produced 474 684 175
Units rejected 54 84 25
Time taken (hrs) 78 72 80
Basic Pay per hour (Kshs) 6 6 3
81
Required
From the above information calculate for each employee
a) Bonus hours and amount of bonus paid
b) Gross wages earned
c) Labour cost for each good unit sold
Illustration 2
Based on the data below you are required to calculate the remuneration of each employee as determined by
each of the following methods
i. Hourly rate
ii. Basic piece rate
iii. Individual bonus scheme where the employee receives the bonus in proportion of the time saved
to time allowed
82
LECTURE SIX
6.3 OVERHEADS
Overheads refer to the total cost of indirect materials, indirect labour and indirect expenses.
Indirect costs are those costs which cannot be identified to the production of some specific goods.
Overheads May Be Classified As:-
Production Overheads include indirect materials, indirect wages, factory rent and rates,
depreciation of factory plant and other indirect expenses.
Administration overheads e.g. office salaries, office rent depreciation of office equipments and
other office expenses.
Selling and distribution overheads e.g. advertisement, salaries of salesmen, rent of sales
warehouse, delivery van expenses, depreciation of delivery van and other sundry selling and
distribution expenses.
Over heads may also be classified as fixed overheads, sums fixed over heads or variable overheads.
Overhead Allotment
This means the charging of overheads to cost units or cost centers. This is done so as to ascertain the
total cost of a job as a product.
83
Stages of Overhead Allotment
Collection of overheads
Overheads analysis
Overhead absorption
Collection of Overheads
This involves accumulation of overheads in a specified period under separate heading.
These are collected from costing and financial accounting records e.g. indirect wages are obtained
from wages analysis book, indirect materials from stores requisitions etc.
Overhead Analysis
This is an analysis that charges overheads to cost centers. A cost centre is a location, person or item
of equipment. (Or group of these) in respect of which cost may be ascertained and related to cost
units e.g. production department A is a cost centre. There are two ways of charging overheads to
cost centers via
Allocation of overheads.
Apportionment of overheads.
Allocation of overheads means to change those overheads to a cost centre which results solely from
the existence of that cost centre. E.g. salaries of supervisors of department A are expenses of this
department and must be charged to this cost centre only. This is possible only if:-
1. The cost centre has caused the overhead to be incurred and
2. The exact amount of the overhead is known.
Apportionment of overheads means to charge a cost centre a fair share of an overhead.
The overheads which are incurred for the organization as a whole must be charged to various cost
centers of the organization e.g. monthly rent shared among the departments in an organization in a
specified proportion.
Absorption of Overheads
This refers to the charging of overheads to cost units. The overheads of a particular cost centre are
absorbed into cost units produced during a specified period.
6.4 Bases of Apportionments.
84
The following bases are applied for apportionment of overheads to cost centers.
NB: Appropriate basis of apportionment should be chosen. The basis should be equitable,
practicable, economical, reasonable and accurate.
85
6. Other columns depending on the No of departments or cost centre.
Example
The following information relates to a factory which has four departments.
A) Overhead shs
Rent 160,000
Repairs to plant 100,000
Depreciation of plant 80,000
Light & heat 40,000
Supervision 120,000
Repairs to buildings 60,000
Departments
mixing boiling heating packing
Area in Sq meters 3000 2400 1600 1000
No of employees 70 50 50 30
Value of plant (shs) 1000,000 600,000 400,000
X2
Required: prepare an overhead analysis sheet showing clearly the basis of apportionment.
per m2
Repair to Value of 50,000 Shs1,000,000 Shs 0.05 25,000 15,000 10,000 -
plant plant per shs
Depreciation Value of 40,000 Shs1,000,000 Shs0.04 20,000 12,000 8,000 -
86
of plant plant per shs
Light & heat Area 20,000 4000m2 Shs per 7,500 6,000 4,000 2,500
5/m2
Supervision No of 60,000 100 Shs 600 21,000 15,000 15,000 9,000
employees employees per
employee
Repairs to Area 30,000 4000m2 Shs7.5 11,250 9,000 6,000 3,750
buildings per m2
280,000 114,750 81,000 59,000 25,250
WORKINGS
4000
8. Supervision per employee = shs 60,000 = shs600
100
87
12. Apportionment of depreciation of plant e.g. dep C = 200,000x shs0.04
= shs8,000
13.
14. Apportionment of light & heat e.g. dep D = 500 x shs5= shs 2,500
Example
A company operates a factory whose overheads for the year ending 31st Dec 2014 are as follows:-
Indirect Wages
Shop No 1 84,000
2 116,000
3 108,000
Tool room 74,000
88
Stores 30,000
Clerical services 44,000 456,000
89
Required: prepare an overhead analysis sheet for the departments of the factory for the year ending
31st Dec 2014 showing clearly the basis of apportionment.
90
Overheads Basis Amount Units Rate Shop No Shop No Shop No Tool Stores Clerical
(shs) per 1 2 3 room services
unit
Shs Shs Shs Shs Shs Shs
Indirect Allocation 154,000 - 40,000 60,000 20,000 12,000 16,000 6,000
material
Indirect wages 228,000 42,000 58,000 54,000 37,000 15,000 22,000
Rent & rates Area 100,000 500m2 20 20,000 15,000 30,000 10,000 15,000 10,000
Insurance 20,000 2,000,000 0.01 5000 9000 2000 3000 500 500
Book
value
Depreciation 300,000 2,000,000 0.15 75,000 135,000 30,000 45,000 7,500 7500
Power H.P 90,000 900 45,000 36,000 - 9,000 - -
100
Light & heat Area 40,000 8 8,000 6,000 12,000 4,000 6,000 4,000
5000m2
235,000 319,000 148,000 120,000 60,000 50,000
Service Dept
overheads
apportioned
over
production
depts. Ratios
Tool room Technical 30:50:20 36,000 60,000 24,000 (120,000)
(60,000)
Stores Estimate 50:30:20 30,000 18,000 12,000
Clerical 30:40:30 15,000 20,000 15,000 (50,000)
servicies
932,000 316,000 417,000 199,000 - - -
91
Service Departments Providing Service to Other Service Departments
When some service departments provide services to production departments as well to other
service departments then a part of the overhead cost of one service department should be charged
to other service department. E.g. assume the maintenance department provides some services to
the stores department and similarly, the stores department provides some services to the
maintenance department. In this case, the over head cost of the maintenance department should
be charged partly to the stores department and the over head cost of store department should be
charged partly to the maintenance department. Ultimately, the overheads of these service
departments must be charged to the production department only.
The methods of transferring the overheads of service departments to the production department in
respect of service departments providing services to other service departments include;
1) Repeated distribution or continued allotment method
2) Simultaneous equation
EXAMPLE 1
A manufacturing company has three production department and two service department.
Overheads of these departments for a period one as follows
A technical assessment for the apportionment of the costs of the service department shows.
92
DEPARTMENTS
A B C X Y
X 40% 20% 30% - 10%
Y 50% 20% 20% 10% -
You are required to show the total overhead chargeable to the three production department by
using the method known as continued allotment of apportioning service department costs
between the two service departments.
DEPARTMENTS
A B C X Y
Overhead 150,000 270,000 190,000 30,000 50,000
O.H of X apportioned 12,000 6,000 9,000 (30,000) 3,000
O.H of Y apportioned 26,500 10,600 10,600 5,300 (53,000)
O.H of X apportioned 2120 1060 1590 (5300) 530
O.H of Y apportioned 265 106 106 53 (530)
O.H of X apportioned 21 11 16 (53) 5
O.H of Y apportioned 3 1 1 - (5)
190909 287778 211313 0 0
NB. I. The appropriate portion of the overhead of one service department is charged to the
other service department. E.g. 10% of the O.H of X department is charged to Y
department and so on. The process is continued until all the amounts are transferred to
production department.
II. The final overheads of the production department are equal to the total of O.H of all
departments i.e. 190,109 + 287,778 + 211,311 = 690,000
EXAMPLE 2.
A company has three production departments and two service departments. Overheads of these
departments for a specific period are as follows:-
93
Production departments (shs)
P 25,000
Q 20,000
R 15,000
Service departments
A 10,000
B 7,800
77,800
The overheads of service center are charged out as under
DEPARTMENTS
P Q R A B
Service Dep: A 30% 30% 20% - 20%
Service Dep: B 40% 30% 20% 10% -
Required: show the total overhead chargeable to the three production departments by using
simultaneous equation methods.
Answer:
Let x = Total overhead of Dep A
Y = Total overhead of Dep B
Then X = 10,000 + 0.1y ------------ (i)
Y = 7,800 + 0.2x ------------- (ii)
Eliminate decimals by multiplying both equations by 10.
10x = 10, 0000 + y
10y = 78,000 + 2x
Re- arranging the equations:
10x y = 10,000 -------------- (iii)
-2x + 10y = 78,000 ------------- (iv)
Multiply equation (iv) by 5 and add the result to equation (iii)
10x y = 100,000
94
-10x + 50y = 390,000
49y = 490,000
Y = 490,000 = 10,000
49
Substitute the value of y = 10,000 in equation (iii)
10x 10,000 = 100,000
10x = 110,000
X = 11,000
Now, Let see apportion the value of x = 11,000 and y = 10,000 to the production
departments on the basis of agreed percentages.
PRODUCTION DEPARTMENTS
P Q R TOTAL
shs shs shs shs
Original O.H 25,000 20,000 15,000 60,000
Service Dep A 3,300 3,300 2,200 8,800
Service Dep B 4000. 3,000 2,000 9,000
Total 32,300 26,300 19,200 77,800
95
In order to charge overheads to cost units, overhead absorption rate (O.A.R) is calculated.
The O.A.R is that rate at which overheads are charged to each cost unit.
96
1. Units of output appropriate when all the units produced are identical and involve
identical time and production process.
2. Direct labour hour appropriate in those departments which are labour intensive.
3. Direct machine hour appropriate in those cost centers where machines are used to great
extend in order to complete the production process.
4. Direct wages percentage appropriate where wages paid are related to time.
5. Direct material percentage suitable for those organizations when material cost represents
a large portion of total costs and where the material cost is significant factor.
6. Prime cost percentage: - most appropriate where each jobs material and labour cost
proportions vary to great extent. Standard hours applicable in organizations where
standard costing technique is applied. Overheads are absorbed according to standard
hours.
Example
The following information is available from a manufacturing company:-
Total overhead shs600, 000
Total direct wages shs480, 000
Total direct material cost shs500, 000
Direct labour hours 75,000
Direct machine hours 50,000
Units of output shs750, 000
Calculate six overhead absorption rates.
97
Direct machine hours machine hr
50,000
Percentage of material cost Overhead x 100 Shs600,000 x 100 = 120% of
Material cost 500,000 material
cost
Percentage of direct wages Overhead x 100 Shs600,000 x100 = 125% of
Direct wages direct
480,000 wages
Percentage of prime cost Overhead x 100 Shs600,000 x 100 = 61.2% of
Prime cost prime
980,000 cost
On job number 1234 produced in the department during the period the relevant data was:-
Direct wages shs5,000
Direct materials shs12,000
Labour hours shs900
Machine hours shs250
Calculate the total cost of job No 1234 by five different methods of overhead absorption.
98
Answer
Method Absorption rates
Direct labour hours shs150,000 = shs7.5 per machine hour
20,000
Direct machine hours shs 150,000 = shs30 per machine hour
5,000
Direct material percentage shs150,000 x100 = 75% of material cost
200,000
Direct wages percentage shs150, 000 x100 = 150% of direct wages
Shs100, 000
Prime cost percentage shs150,000 x 100 = 50% of prime cost
300,000
99
Overhead (250xshs30) 7,500
(I.e. machine hours of this job x
Machine hour rate) Total cost 24,500
100
The actual overheads may be different than the estimated overheads. This results to under or over
absorption. If absorbed overheads are less than the actual overheads, this is known as under
absorption.
On the other hand, if the absorbed overheads are greater than actual overheads, this is known as
over absorption.
NB: The amount of under absorbed overheads should be added to total costs before the profit is
calculated. Over absorbed overheads are subtracted.
6.8 Summary
There should be a direct cause-effect relationship between consumption of overheads and the
chosen cost driver. This relationship is not necessarily a short term one. Costs such as salaries
make up a significant portion of total overheads but are not easily adjusted in the short run. The
number and type of cost drivers chosen will depend on several factors such as:
i. the required accuracy of product costing
ii. The extend that a given cost driver captures the actual consumption of an activity by a
product.
iii. The extend to which a cost driver can be related to many activities or cost pools. The cost
pool should be homogenous (fairly represented by one cost driver). Where this is not
possible the pool may need to be subdivided and numerous cost drivers used. (of
course this will complicate the system).
iv. The extend that one cost can be fairly applied to diverse products. For example if the cost
driver, number of inspections were used to trace inspection costs to products,
distortions will occur if inspections take varying amounts of time for different
products.
101
Example.
a) Equator garments Ltd manufactures custom-made suits tailored to the requirements of each
customer. They use predetermined overhead absorption rates in allocating overheads to each job.
In the cutting department the rate is based on direct labour hours and in the stitching department
the rate is based on machine hours. The management of equator garments ltd wants to set
overhead absorption rates to help in determining prices in the next financial year. The cost
accountant has provided the following budgeted data for the financial year:-
Cutting Stitching
Direct labour cost shs1, 200,000 shs750, 000
Factory overhead shs1, 500,000 shs1, 620,000
Direct labour hours shs60, 000 shs30, 000
Machine hours - shs40, 000
Required: calculate the overhead absorption rates for each department.
102
Factory overhead cost incurred 1,600,000 760,000
Required: calculate the amount of under or over absorption of overhead for each department.
rd
1Paresh, S. (2010) Cost Accounting 3 Edition, Tata McGraw-Hill, New Delhi.
103
LECTURE SEVEN
a) Job costing
b) Batch costing
c) Contract costing
104
b) Procedures of Job Costing
The application of job costing method begins when a customers order is received. After accepting an
order, an individual work/job order number is assigned to each job for or separate order identification..
Production order is then made giving authority for the job to start. A job cost account for each job is then
opened. In this account, all costs relating to that particular job are recorded and this account closed only
when the job is complete. After completion of the job, an invoice is prepared and served to the customer.
Materials for each job are made using material requisition forms
Labour is charged on the basis of the amount of time used to complete that particular job as
recorded in time-keeping records.
Overheads are charged on the basis of an predetermined overhead absorption rate.
Applied Overhead absorption rate = Budgeted Overheads Denominator value
The Denominator value where the denominator value refers to units of some specified overhead
absorption base e.g. machine hours, direct labour hours.
105
Indirect Wages
Dr Factory overheads control A/c
Cr Wages Control A/c
1. Production Overheads
(i) (not yet paid) Dr Factory overhead control A/c
Cr Expenses/Creditor control A/c
(ii) (When paid) Dr Expense/creditors A/c
Cr Cash A/c
Note
Overheads entries apply when there is an interlocking accounting system.
5. Finished goods transferred to the store:
Dr Finished goods stock control A/c
Cr W.I.P Control A/c
6. Sale delivery of finished goods to customers:
(i) On Credit: Dr Debtors control A/c Cr Sales A/c
(ii) In Cash: Dr Bank/Cash A/c Cr(Sales A/c
7. Cost of goods sold to customers:
Dr Cost of sales A/c
Cr Finished goods control A/c
8. (i) When there is over absorption of production overheads:
Dr Factory overheads control A/c
Cr P & L A/c
(ii) When there is under absorption of production overheads:
Dr P& L A/c
Cr Factory overheads control A/c
9. When there are non-manufacturing overheads:
Dr P & L A/c
Cr Non-manufacturing overheads control A/c or non-manufacturing
overheads/expenses are regarded as period costs & are therefore not changed To
W.I.P control A/c.
106
Dr Cr
Direct materials issued from stock X Materials returned to the store X
Materials transferred to other jobs
Direct wages X X
Cost of completed jobs transferred to
Production overheads absorbed X finished goods A/c X
Materials transferred from other jobs X Balance c/d (Total cost of that job) X
XX XX
Illustrations:
The following transactions were made by Z limited in the month of December.
Direct Materials
8,000/= was bought on credit, out of these, materials worth 5,000/= were returned to the suppliers.
50,000/= was issued from the store
Indirect materials issued amounted to 5,000/=
Direct wages allocated to production amounted to 20,000/=
Goods worth 200,000/= were sold
Finished goods worth 100,000/= were transferred to the store.
The cost of goods sold was 140,000/=
Unpaid indirect expenses were 32,000/=
Indirect wages allocated amounted to 15,000/=
Non-manufacturing overheads incurred amounted to 20,000/=
Overhead expenses charged to the jobs 60,000/=
Required
a) Prepare the stores ledger control A/c
b) Factory overhead control A/c
c) W.I.P. control A/c
d) Costing P & L A/c
107
60,000 60,000
a) Procedures:
Allocation of batch number
Production order is made
Creation of batch costs account
Completion of the work and closure of the batch cost account
Allocation of costs to individual units in the batch
Determination of selling price/batch and unit.
Illustrations
The budgeted variable overheads of Githurai Ltd for the year 2001 are given as below:
Additional Information
Selling and administering overheads are changed at 10% of total production costs while the profit
mark up is 25 of total costs:
108
An order for 2,000 units was received from a customer. The batch number of this order is 510.
The following additional information in respect of this batch is provided below:
Direct materials 87,000/=
Direct Labor Dept A (150 direct labor hrs) 12shs. Direct labor hour.
Required
a) Calculated the total cost of the batch
b) Cost/Unit
c) Selling Price of the batch
d) Selling Price unit
Solution
Githurai Limited
Batch 510
Particulars Shs.
D Materials 87,000
D Labour: Dept A (150 x 12) 1,800
Dept B (40 x 50) 6000
Dept C (60 x 20) 1,200
Dept D (100 x 10) 1,000 4,600
Prime Cost 91,600
7.7 Summary
109
Job costing is also known as job order costing, it is that form of specific order costing which
applies where the work is undertaken as per customers specific requirements and each order is of
comparatively short duration.
In job costing every job can be identified clearly and have their own costs. Work in progress
depends upon the number of job in hand at the end of the period. each job is a separate
accounting unit, and separate job number or production numbers are allotted to each job.
1.What do you understand by job order costing? Under what condition, is it suitable
2.Explain the procedure involved in job order costing
.
110
LECTURE EIGHT
8.0 CONTRACT COSTING
8.1 Lecture Overview
This is a form of specific order costing that is applied to relatively large cost units, which normally take a
considerable length of time to complete e.g. building or construction works. Contract jobs are undertaken
in accordance with specific requirements of contractee/Customer. Contracts may be distinguished from
job orders by the following features:
The money value of a contract is much larger than that of a job order.
To second the progress of contract works, a special account known as a contract account is maintained.
8.2 Objectives
This is a form of specific order costing that is applied to relatively large cost units, which normally take a
considerable length of time to complete e.g. building or construction works. Contract jobs are undertaken
in accordance with specific requirements of contractee/Customer. Contracts may be distinguished from
job orders by the following features:
The money value of a contract is much larger than that of a job order.
111
A contract consumes significantly larger amounts of resources than a job order.
For a contract, special progress reports are usually made while in job costing, reports are made
after the completion of the job.
For a contract, indirect costs are relatively smaller in relation to direct costs but the vice versa is
time for job order.
To second the progress of contract works, a special account known as a contract account is maintained.
3. Contract plant
The amount of plant used in a contract work is a key feature.
112
This includes :cranes, trucks, mixers, lorries etc. if plant is on lease basis, then the leasing charges
are directly charged to the contract, on the other hand, if plant is purchased then this plant is
charged to that contract for which it was purchased.
At the end of the year or on completion of the contract, the contract account is credited with the
value of plant at that time. Thus the depreciation of plant is charged to the respective contract.
If the plant is moved frequently from one contract to another contract, then each contract is
charged the depreciation of the plant at a specific rate.
4. Subcontracts:
If the contractor assigns some work to sub-contractors e.g. electrical or plumbing work, the
amount paid to subcontractors is charged to the respective contract.
5. The contract price
This is the price agreed upon by the contractor and the contractee after the tendering process.
6. Architects certificate.
The architect inspects the work done periodically and certifies the amount of work completed.
The contractor can claim the amount of work of work certified from the contractee. The architect
is appointed by the contractee.
7. Retention
A specific percentage of work certified is withheld by the contractee or client. This amount
withheld is known as retention money. The amount is paid to the contractor on the completion of
the contract.
The main purpose of this retention money is to ensure that the contract has been completed
according to the satisfaction of the client and all defects in the work have been rectified by the
contractor. If the contractor does not remove such defects, then the retention money is not
released by the contractee.
The retention money is shown as debtors in the books of the contractor.
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When a contract extends over a number of years, it may be necessary to take profit each year in
order to avoid wide fluctuations in annual profits.
The following rules are applied:
a) Take no profits on the very early stage of contract.
b) When the contract is in its maturity, then:
Amount of profit taken = 2/3 x notional profit x cash received
Value of work certified
c) When the contract is nearing its completion, then:
Amount of profit taken = notional profit x value of work certified
Contract price
NB: Notional profit = value of work completed - cost incurred to date.
8.5 Proforma contract account
This is a separate account that is opened and maintained for each contract undertaken for the purpose of
accumulating cots. Each contract is given a number and all costs relating to that particular contract are
recorded in this account. A typical contract account is as shown below:
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This formula of calculating the part of national profit taken in the year is used when substantial
costs have been incurred on the contract but the contract is not near completion. But when the
contract is near completion the profit taken is calculated as:
Profit taken = Estimated profit x cash received/contract price.
Where Estimated profit = Contract price Estimated total cost and
Estimated total cost = Costs incurred to date and estimated future costs.
b) Profit not taken = refers to the part of the national profit that is not recognized in the current
period. It is profit carried forward to be recognized in the years that follow.
c) Retention Money
This is a portion of the value of work certified that is retained by the contractor to protect himself
from faulty work that might be evident at the time of progress payments or at the completion of
the contract. This amount is released after satisfactory performance under the contract.
Example.
Ideal construction company ltd won the contract for the construction of a multi story building at a
cost of sh.200 million. The data relating to the contract for the year ended 31st December 1998
were as under:
Sh (000)
Materials issued to the site 80,000
Materials purchased locally 15,700
Direct wages: paid 5,800
Accrued 350
Plant purchased and installed 48,800
Direct expenditure:
Paid 1,780
Accrued 70
Established charges 180
Materials returned to store 850
Work certified 150,000
Cost of work not certified 3,800
Materials on site on December 31 5,330
Value of plant on Dec 31 41,500
The company had received from the client, payments amounting to sh. 126 million
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Required:
a) Prepare the contract account;
b) Prepare the contractee account;
c) Show how the various items will appear in the balance sheet as at dec 31 1998.
Answer.
CONTRACT ACCOUNT
Sh (000) shs(000)
Direct materials
Issued from store 80,000 Materials returned from store 850
Purchased locally 15,700 materials on site c/d 5,330
Plant installed 48,800 plant on site c/d 41,500
Cost to date c/d 105,000
Direct wages: (shs)
Paid 5,800
Accrued c/d 350 6,150
Direct expenses
Paid 1,780
Accrued c/d 701,850
Established charges 180
152,680 152,680
Cost to date b/d 105,000 contractee A/c
Work certified 150,000
cost of work not yet
Notional profit c/d 48,800 certified c/d 3,800
153,800 153,800
Profit & loss A/c (w1) 27,328 notional profit b/d 48,800
Profit provision c/d 21,472 _______
48,800 48,800
Stock on site b/d 5,330 direct wages accrued b/d 350
Plant on site b/d 41,500 direct expenses accrued b/d 70
Cost of work not yet
Certified b/d 3,800 profit provision b/d 21,472
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CONTRACTEES ACCOUNT shs.(000)shs.(000)
Workings
(w1) calculation of profit:
Amount of profit taken = notional profit x 2/3 x cash received
Work certified
= 48,800 x 2/3 x 126,000
150,000
= shs. 27,328
Profit provision c/d = 48,800- 27,328
= sh. 21,472.
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132,328
Less: cash received 126,000
W.I.P. 6,328
Method 2 shs.(000)
Contractees A/c balance c/d 24,000
Add: cost of work not
yet certified 3,800
27,800
Less: profit provision 21,472
W.I.P. 6,328
8.6 Summary
Contract costing, which is otherwise called terminal costing, is adopted by those business undertakings which
undertake long-term contracts, eg builders and contractors,civil engineering firms, ship building companies etc
In case of contract costing,the cost of each contract is ascertained by charging the expenses attributable to each
contract.Most of the expenses are of direct type and only the general and administrative overheads have to be
apportioned.
The profits of contract costing are generally recognized on an annual basis as the work progresses.A contact
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The following figures have been extracted from the records of China youn Ltd., for they year
ended 31 Dec. 2013 in respect of an office block commissioned by the Outer City Grabbers Ltd:
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LECTURE NINE
9.0Process costing
9.1 Lecture Overview
This lecture is to introduce you to costing used by those concerns which manufacture articles of
uniform standards. These firms manufacture articles on a continuous flow basis.
9.2 Objectives
Process 1
Shs Shs
Direct Material: 1,000 Transferred to
Direct Labour 500 Process 2: 3,000
Overheads 1,500 3,000
3,000 3,000
Process 2
Shs Shs
Transfer from Transfer to
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Process 1: 3,000 Finished Goods: 6,000
Direct material 1,500
Direct labour 1,000
Overheads 500 ____
6,000 6,000
Illustration 1
Suppose there are 4,000 units of a product in ending inventory out of which 60% are fully complete
whereas the remaining are 70% complete. What are the equivalent units of the product?
Illustration 2
Material A is added at the beginning of a production process. Labor and overheads are added continuously
during the production process. At the end of the process, 10,000 units were complete and 2,000 units were
60% complete as per labor and overheads. The cost of raw materials used during the period amounted to
shs.220,000, labour shs.150,000 and overheads shs.74,000. There was no opening inventory.
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Required
Determine the cost per unit of both the completed units, and the units in the ending inventory.
Solution:
Conversion (direct
Physical Units Materials Labour and
overheads
Completed 10,000 10,000 10,000
Ending Inventory 2,000 2,000 1, 200
12,000 ______ _______
Equivalent Units 12,000 11,200
Cost for the Period 220,000 224,000
Cost per Equivalent Unit: Shs.18.33 220,000/1,200=sh18.33 224,000/11,200=sh20
Total Cost/Equivalent Unit =18.33+sh.38.33
In the above illustrations, there is no opening work in process. When it exists, we need to adopt a method
of valuing it and incorporating it into the process accounts. The two main methods used for purposes of
valuing the opening work in progress:
a) Weighted Average
When this method is used, all costs of production are considered in assigning costs to inventory. The
method puts together opening work in process inventory costs and cost of production. It mixes the
costs of previous period with those of current period in determining costs per unit.
Under weighted average approach, we do not distinguish the units started and completed in the current
period from the `units completed and transferred ` and the `Ending working period`
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X % of completion
Cost/Equivalent Unit = Current Costs
Equivalent Units
Carefully Note that FIFO distinguishes the units started and completed in the current period from
the units completed and transferred. This is done by subtracting the beginning W.I.P. from the
units completed and transferred and the ending work in process.
Illustration
The following work in progress account relates to the blending department of ABC Limited, a soft-
drinks company for the month of January 2013. Raw materials were introduced at the start of the
work while labour and overheads were incurred through-out the blending process.
Blending Department: W.I.P A/C
Particulars Shs Particulars Sh
Bal b/f = 5,000L (4/5) = 65,000 Completed and transferred out: 29,000L -
Raw materials added (30,000L) 125,000 Ending W.I.P (2/3) 6,000L -
Direct Labour 145,000
Factor Overheads 201,000
Additional Information
1. Beginning W.I.P. consists of the following:
- Raw materials shs.15,000
- Direct Labor shs.20,000
- Factory Overheads shs.30,000.
Required
Calculate cost/equivalent units using:
a) Weighted average
b) FIFO
Weighted Average
Total Physical Materials Conversion
Units
Completed Transferred Out: 29,000 29,000 29,999
Ending W.I.P 6,000 6,000 4,000
______ ______ (2/3 X 6,000)
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35,000 35,000 33,000
FIFO
Total Physical Units Materials Conversion
Beginning W.I.P 5,000 1,000 = (1/5 X 500)
Units started and completed
during
The current period
= (2,900 5,000) 24,000 24,000 24,000
Ending W.I.P 6,000 6,000 4,000 = (2/3 x 6,000)
35,000
* Equivalent Units of 5,000 x (1 4/5) = 1,000 units was the work done in the period to complete the
beginning W.I.P.
Note that the previous period costs in the beginning W.I.P (Materials. shs.15,000 and converting
shs.50,000) have been excluded in *
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Scrap: Material held after a productive process, which are irrecoverable or have no recoverable
value.
Rework: These are finished goods that do not meet quality standards but which with some
additional work can be sold.
Loss: Refers to finished or partially finished units, which cannot be reworked or used for their
intended purpose. They may be discarded or sold for minimal value. There are two types of
spoilage;
- Normal Loss: is loss expected and unavoidable even under the most efficient systems of
production. Normal spoilage cost is normally included in product cost.
- Abnormal Spoilage: This is loss that is avoidable with efficient operating conditions. The cost is
regarded as controllable and can be eradicated if due diligence and supervision are exercised. The
cost is normally treated as a loss and charged to profit and loss account.
(ii) Recognition and Re-Assignment Approach In this approach, the normal spoilage is
included in the equivalent units computation; further, the normally spoilt units will be
assigned costs just like any other unit. The spoilage costs will then be reallocated to these
good units that have passed the inspection point. The steps to follow under this method are:
(a) Compute equivalent units including normal spoilage.
(b) Assign costs to all units including normal spoilage.
(c) Reassign normal spoilage costs to good output.
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Beginning W.I.P. (25% complete as to conversion): 10,000 units
Costs for beginning W.I.P:
Transferred in Shs.82,900
Conversion costs Shs.42,000
Units started in the current period. 70,000 units
Current costs: Transferred in Shs.645,100
Conversion Shs.612,500
Additional Materials*
Units completed and transferred: 50,000 units
Units in ending W.I.P (95% complete as to conversion) 20,000 units
Spoilt Units 10,000 units
Additional Information
1. Normal spoilage is 10% of all good units that pass inspection
2. Inspection occurs when production is 80% complete.
3. Conversion costs are incurred evenly through-out the process.
Required
Prepare a process cost report using
(a) Weighted Average
(b) FIFO
Apply both the recognition re-assignment approach in dealing with the spoilage.
Solution
Mombasa Limited.
Process Cost Report (Dept 2)
Weighted Average Approach
Physical Units Physical Transferred In Additional Conversion
Units Materials
Beginning W.I.P. 10,000
Units started in Current 70,000
Period
Units to Account for 80,000
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Equivalent Units:
Finished Goods: 50,000 50,000 50,000 50,000
Ending W.I.P 20,000 20,000 20,000 19,000
Normal Spoilage @ 10%
(50,000 + 20,000): 7,000 7,000 - 5,600 - (80%x70)
Abnormal Spoilage:
(10,000 3,000) 3,000 3,000 - 2,400 - (80%x30)
Equivalent Units 80,000 80,000 70,000 77,000
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Additional Material = 20,000 x 9.3 = 186,000
Conversion Costs = 19,000 x 8.5 = 161,500
Normal Spoilage costs = 20,000 x 111,300 = 31,800
70,000
561,300
Abnormal Spoilage:
Transferred in costs = 3,000 x 9.10 = 27,300
Additional Material = = -
Conversion Costs = 2,400 x 8.5 = 20,400
47,700
Costs Accounted for 2,033,50
0
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Cost Assignment:
Finished Goods: 50,000x28.44 1,422,000
Ending W.I.P: Transferred in: 20,000 x 9.97 = 199,460
Materials: 20,000 x 9.30 = 186,000
Conversion: 19,000 x 9.167 = 174,173 559,663
Allocation of joint costs involves assigning the costs of the joint process to the products emerging at the
split off point. Any costs beyond the split off point are referred to as separable costs.
(i) Calculate the overall rate of gross margin for al the products
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(ii) Multiply the computed overall rate by the sales of every product to obtain the gross
margin of the product.
(iii) Deduct the gross margin from the sales value of the product to determine the total costs
for each product.
(iv) Deduct separable costs from the total costs to obtain joint costs allocated.
Illustration
A company produces three products, Y1, Y2, and Y3 in the same process. The data below reflects
average monthly results:
Y1 Y2 Y3
Monthly output (kg) 40,000 20,000 20,000
Sales Value at split off (shs.) 0 30,000 105,000
Sales Value after Split off 45,000 100,000 155,000
Costs of further processing 20,000 40,000 65,000
Solution
(i) Physical/Measurement/Unit Method
Y1 Y2 Y3 TOTAL
Physical Output: (Kg) 40,000 20,000 20,000 80,000
Proportion 50% 25% 25%
Joint costs allocated 50,000 25,000 25,000
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Total Sales Value after slit-off: Y1 = 45,000
Y2 = 100,000
Y3 = 155,000
300,000
Less: Total Costs:
Joint Costs: 100,000
Further Processing Costs: Y1 20,000
Y2 40,000
Y3 65,000 (225,000)
75,000
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9.7 Summary
Process costing is used to determine the cost of a product at each operation, process, or stage of
manufacture. This method of costing is used in industries engaged in the manufacture of paints,
simple chemicals, textiles, steel etc
Manufacturing operation or process is continuous when the arrangement of plant and machinery
is such that the production of an item of standard nature continues for a long period of time
without any stoppages
9.8 Self-Assessment Questions
QUESTION ONE
A company produces three products, A1, A2, and A3 in the same process. The data below reflects
average monthly results:
A1 A2 A3
Monthly output (kg) 80,000 40,000 40,000
Sales Value at split off (shs.) 0 60,000 210,000
Sales Value after Split off 90,000 200,000 210,000
Costs of further processing 40,000 80,000 130,000
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Recommended Text Books:
rd
1Paresh, S. (2010) Cost Accounting 3 Edition, Tata McGraw-Hill, New Delhi.
133
LECTURE TEN
10.0VARIANCE ANALYSIS
10.2 objectives
In a typical organization, the planning process starts with a budget followed by actual performance. The
budget will usually be based on standard costs of the desired output units. But how does a budget actual
performance relate?
Performance leads to preparation of a performance report, which compares the budgeted performance
and the actual performance, and therefore determines whether there is a favourable (F) or
unfavourable (U) variance. These variances are exceptions, thus the performance report (Variance
report) is an exceptions report.
Variance signals those areas that require managerial attention and these are usually areas with
problems. These variances lead to investigation in those problems areas and the appropriate corrective
action is determined, recommended and later on implemented.
!
Variance reporting concentrates on both favourable and unfavourable variances. Usually,
unfavourable variances are punished on the responsible persons while favourable variances are
rewarded. However, this is a rule of thumb but not always the case. Remember that an
unfavourable variance might arise due to factors beyond the employees or managers control, in
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which case you cant punish that person: rather, you need to explain the unfavourable variance in
terms of the uncontrollable factor of alternatively adjust the standard to incorporate the changed
circumstances. The same case can be argued for favourable variances.
A simple standard costing system that is easily well understood by everyone in the organization.
Fast and timely reporting of variances at the point of incidence so as to attach responsibility for
favourable or unfavourable variance.
Rapid management action to correct adverse (unfavourable) variances and encourage favourable
variances.
Utmost commitment to the process of setting standards and performance evaluation by all
managers and employees.
However, not all variances are identified and acted upon. Only those types of variances, which fulfill
the cost control needs of the organization and meet performance evaluation purposes of the entity are
identified, calculated and acted upon. Thus, the only criterion for the calculation of a variance is its
usefulness to the organization: if it is not useful for management purposed, then it should not be
calculated!
For example, the material cost variance can be analyzed into usage variance and price variance. The
usage variance is the responsibility of the foreman or production manager using those materials, while
the price variance is the responsibility of the purchasing manger.
The above example illustrates how variance analysis is utilized to attach responsibility for cost
variances to individuals. Such individuals cannot claim that they are not responsible for the variances
arising. However, to be able to attach such responsibility, the costs must be controllable by the
concerned individuals!
Due to tendency of budgetary control and standard costing variance analysis responsibilities to
individuals, it is usually referred to as responsibility accounting. But where departments are
135
interdependent, then responsibility accounting may not be straight forward due to inefficiencies or
efficiencies brought in from other departments.
Variance analysis subdivides the total difference between the budgeted profit and actual profit for the
period into the detailed difference. This is illustrated in the figure below. Each of the managers
responsible for each of the detailed variances can then he held responsible. But remember that only
those variances useful for management controls are calculate.
At this point it is critical to understand that every variance has two aspects, a price aspect and a quantity
aspect: these two aspects combine to produce a cost variance. This is illustrated below:
Etc.
Note that the operating profit variance, it follows, is then the sum of all the cost (labour, material, variable
overheads, fixed overheads) variances and sales variances. Remember that the operating profit variance is
simply the difference between the budgeted and actual profit. You then need to note that budgeted figures
do not form part of the double entry system, and thus the budgeted profit variance does not enter the
ledger accounts. The other reason why the operating profit variance is not entered in the ledgers is that it
is a resultant figure i.e. a sum of all the other variances.
But all the other variances are entered into the ledger system and form part of double entry. We will see
later how these variances are treated in the accounts
136
Variance Chart:
Operating profit
Variance
137
!
Carefully note that when prices are being charged to production, this can be done at the actual or
standard price. For purposes of making variances analysis useful, instant and easily understood, we will
assume that the process of production changes the costs to production units at the standard costs. When
units are changed with standard costs, it is now very easily to compare the standard cost with the actual
costs and compute the variance immediately: consequently, the responsibility for the variances can also be
assigned immediately and corrective measures implemented.
For purposes of our calculations, we will assume the following basic data for company ABC limited:
The standard cost for the production of a radio cassette model called stereo F262 is as follows:
During the month, 6,500 kg of raw materials were purchased at shs.3.80 per kilo and all of it was used to
produce 2000 units of finished products. Also, 4,500 hours of direct labour time were used at a total cost
of shs.64,350.
i. The Direct Material Price Variance Refers to the difference between the standard price and the
actual purchase price for the actual quantity of materials. It can be calculated at the time of
purchase or time of usage. The latter is specific to the quantity of material utilized in production.
But generally, in the calculation of direct material price variance, the quantity purchased is used as
the basis of the variance.
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Diagrammatically, the direct material price variance can be illustrated as follows:
Direct material = (Actual Quantity x Actual Price) (Actual Quantity x Standard Price)
Price Variance
= (AQ.AP) (AQ.SP)
From the above equation, it is clear that the direct material price variance is as a consequence of the actual
purchase price of direct materials being different from the standard p rice of the direct materials.
ii. Direct Material Usage (Efficiency) Variance: Refers to the difference between the actual quantity
used and the standard quantity specified for the actual production, all valued at the standard purchase
price.
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Actual Quantity x Standard Price Standard Quantity x Standard Price
Factoring out the standard price (SP) from the above equation gives us the following equation:
It is again clear that the direct material usage variance arises due to the production department using more
materials than expected (the standard).
Recap: The above two direct material price variances can now be summarized as follows:
From our basic data first before the beginning of the discussion on variances, we can calculate:
The variance is favourable since we used less costs than the standard cost.
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= (6,500 X 3.80) (6,000 X 4)
= 24,700 24,000
= 700 Unfavourable
Note that the above equation (total materials variance) agrees with the following:
Tutorial Note Please make sure you follow the basics of the calculation of the direct material variances
calculations so that you can effectively follow the following variances sections.
Direct Labour Rate Variance: This is the difference between the actual direct labour rate and the
standard direct labour rate for the total hours worked.
Using an equation, this can be shown as follows;
It is clear from the above equation that the direct labour rate variance arises due to the actual rate paid for
the actual labour hours worked differing from the standard rate that was expected to be paid for those
labour hours.
Direct Labour Efficiency Variances This is the difference between the standard hours allowed for the
actual production achieved and the hours actually worked, all valued at THE standard labour rate. Using
an equation, this can be shown as follows:
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Direct Labour efficiency variance = SR (AHrs SHrs).
Thus, the direct labour efficiency variance arises due to the actual hours used in production varying from
the standard hours expected to have been used.
NB: The direct labour efficiency variance is also called the direct labour usage variance.
Recap:
Actual Labour Hours x Actual Rate Rate Variance Total Direct
Less: Labour variance
Actual Labour Hours x Standard Rate
Actual Labour Hours x Standard Rate Efficiency Variance
Standard Labour hours x Standard Rate
From our basic data, we can calculate the labour variances as follows:
i. Labour Rate Variance = (AH x AR) (AH x SR)
= AH (AR SR)
NB: AH x AR = Shs.64,350
Labour Rate Variance = 64,350 (4,500 x 14)
= Shs.1,350 Unfavourable.
The variance is favourable because we spent less than the expected cots.
The above paragraph leads to an important question. What typically causes variances of direct labour and
direct materials? This question is answered in the sections that follow.
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Typical Causes of Material Variances
Price Variances
a) Paying higher or lower prices than planned.
b) Losing or gaining quantity discounts by buying in smaller or larger quantities than planned.
c) Buying lower or higher quality than planned.
d) Buying substitute material due to unavailability of planned material.
10.6OVERHEAD VARIANCES
Introduction
This section will describe how the variable overhead total variance and the fixed overhead total variances
calculated. You can recall the overheads refer to production costs that cannot be categorized as direct
since they cannot be directly traced to an individual unit of production.
It is necessary to recall that overheads are absorbed into costs by means of Predetermined Overhead
Absorption Rates (OAR). The overhead absorption rate is predetermined as follows:
The activity level so budgeted could be expressed as units, weight, sales etc: but the most useful concept
of the activity level is the standard hour. Thus, the total overhead absorbed = OAR x Standard hours of
production.
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Where the standard costing system uses Total absorption costing principles (where both fixed and variable
overheads are absorbed into production costs), the total overheads absorbed can be sub-divided into Fixed
Overhead Absorption Rates (FOAR) and Variable Overhead Absorption Rates (VOAR).
Thus,
Fixed Overhead Absorbed = FOAR x Standard hours of production
Variable Overhead Absorbed = VOAR x Standard hours of production.
Total Overheads Absorbed = (FOAR + VOAR) x Standard hours of production
But where the standard marginal costing principles are utilized by the standard costing system, only
variable overheads are absorbed into production costs and thus only variances relating to variable
overheads arise. This makes overhead variance analysis a bit easier in this case.
Again for purposes of our illustrations in overhead variance analysis, we will assume the following basic
data for company ABC Ltd in the production of a radio cassette model Stereo F262:
Note
Based on our budget above, the predetermined overhead absorption rates can be computed as follows:
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It is also notable from our budget that the budgeted labour hours and the budgeted standard hours of
production are the same: this is the normal planning basis, which assumes that the actual labour hours will
be the same as the standard hours actually produced. This would imply that efficiency is as initially
planned so that no efficiency variances would arise. However, this is rarely the case in practice and
therefore the efficiency variances in overhead variances analysis.
Start Note:
The total overhead variance can be broken down into its two constituent parts, namely:
i. The variable overhead variance, and
ii. The fixed overhead variance
The variable overhead expenditure variable is the difference between the actual variable overheads
incurred and the allowed variable overheads based on the actual hours worked. This is calculated as
follows:
The variable overhead efficiency variance is the difference between the allowed variable overheads and
the absorbed variable overheads and the absorbed variable overheads. This is calculated as follows:
Shs.1,010 (U)
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This is defined as the difference between the standard cost of fixed overheads absorbed in the
production achieved (whether completed or not), and the fixed overheads attributed and charged to
that period.
This is in fact the over or under absorbed overheads for the period under consideration.
The fixed overhead volume variance has two main components namely:
The fixed overhead expenditure variance is the difference between the budget cost allowance for
production for a specified control period and the actual fixed expenditure attributed to and charged to
the period. It is therefore the difference between the actual and budgeted fixed overheads.
The fixed overhead volume variance is the difference between the standard cost absorbed in the
production achieved and the budget cost allowed for the period. It arises due to the actual production
volume differing from the planned: this is in turn caused by volume differing form the planned: This
is in turn caused labour efficiency variance and or capacity variance (hours of working being less or
The fixed overhead efficiency variance is the portion of the fixed overhead volume variance which is
the difference between the standard cost absorbed in the production achieved whether completed or
not, and the actual labour hours worked. (valued at the standard hourly absorption rate).
Recap:
146
The above discussion can be summarized as follows:
Actual expenditure on
Production
Referring to our basic data, we can calculate the fixed overhead variances as follows:
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Fixed Overhead Efficiency Variance:
= Shs.795 (Unfavourable).
The approach described so far is the most commonly used especially for examination. Another
purpose that the student should be confident enough with so far for further insights, the student could
QUESTION THREE
Beauty Products Ltd. Are manufactures of a body lotion that is sold to retailers in packages of 24 one-
quarter litre bottles. In the month of July, 750 packages were produced and sold. Details regarding
production costs are given below:
Shs
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Sales (750 packages @ Sh.360 each) 270,000
Production costs:
Direct materials:
Material A 15,000 litres @ Sh.1.60 per litre 24,000
Material B 16,500 litres @ Sh.2.90 per litre 47,850
Labour 3,200 hours @ Sh.15 per hour 48,000
Overheads 70,000
189,850
80,150
Gross profit
Operating expenses
Packaging costs 750 packages @ sh.20 15,000
Administrative costs 55,000
NET PROFIT 10,150
Beauty Products had budgeted to produce and sell 1000 packages for the month of July. At this production
level they anticipated a net profit of sh.90,500 as shown below:
Shs
Sales (1000 packages @ Sh.365 each) 365,000
Production costs:
Direct materials:
Material A 15,000 litres @ Sh.1.50 per litre 22,500
Material B 16,500 litres @ Sh.3.00 per litre 54,000
Labour 4,000 hours @ Sh.13.80 per hour 55,200
Overheads: based on 150% labour costs 82,800
214,500
150,000
Gross profit
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Operating expenses:
Packaging costs 1000 packages @ sh.15 15,000
Administrative costs (all fixed) 45,000
NET PROFIT (budgeted) 90,500
Required
a) Prepare a flexible budget profit and loss statement for the production level achieved for Beauty
Products Ltd. For the month of July
b) Determine the effect (favourable or unfavourable) that the failure to achieve the target sales of 1000
units in July had no budgeted profit for each of the following items show your calculations)
i. Sales
ii. Materials
iii. Material A and Material B
iv. Labour
v. Overheads
vi. Packaging material
vii. Administrative costs
c) Explain briefly TWO other major factors (apart from the failure to achieve target sales) which are
causes of the difference between budgeted and actual profit. (Calculations are not necessary)
10.7 Summary
Using our basic data, we can then calculate the variable overheads variances as follows:
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= Shs.13,930 (3,150 x 4)
= Shs.13,930 Shs.12,600
= Shs.1,330 Unfavourable
The variance is favourable because we spent less than the standard cost.
Note
The total variable overheads variances
= Variable Overhead Expenditure Variance + Variable Overhead Efficiency Variance
This can also be directly obtained by calculating the difference between the actual variable overheads cots
incurred and the production cost absorbed in variance overheads;
QUESTION FOUR
For a product the following data was given:
Standards per unit of product:
Direct material 4 kilogrammes at Sh.0.75 pr kilogramme
Direct labour 2 hours at sh.1.60 per hour
Actual details for a given financial period:
Output produced in units 38,000
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Direct materials: Shs
Purchased 180,000 kilogrammes for 126,000
Issued to production 154,000 kilogrammes
Direct labour 78,000 hours worked for 136,500
QUESTION FIVE
Maridadi People Ltd., an exclusive cosmetic business, manufactures a popular perfume, known as Jasho,
which it sells in bottles, thorough its retail shops for Sh.2,000. During the latest quarter ending 30
September 20X1, the company budgeted to make a profit of Sh.875,000 before deducting fixed overheads
amounting to Sh.400,000. The standard cost per bottle is shown below:
Shs
Materials - 10 Kg @ Sh.50 per Kg 500
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Labour - 10 hours @ Sh.60 per hour 600
Variable factory overheads 200
Marginal cost per bottle 1,300
Fixed factory overheads 320
Total cost per bottle 1,620
Factory overhead costs (variable and fixed) are absorbed into products on the basis of direct labour hours.
Actual results for the quarter as follows:-
Shs
Sales - 1,100 bottles 2,365,000
Raw Materials (14,000 Kg) 784,000
Labour (15,000 work hours) 997,500
Variable factory overhead incurred 320,800
Fixed factory overheads incurred 441,700
Production in the quarter amounted to 1300 units. Out of the total raw materials purchased, 2000 Kg. Are
still in stock. There were no operating balances of raw materials or finished goods stocks. It is the policy
of the company to value all stocks at standard cost.
Required
a) Calculate the following variances; indicting clearly whether they are favaourable (F) or unfavourable
(U): -
i. Material price and usage.
ii. Labour rate and efficiency
iii. Variable factory overhead over or under absorbed
iv. Sales price and sales margin quantity.
b) Independently calculate the operating profit variance; and explain its significance.
c) Why should management investigate favourable significant variances?
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LECTURE ELEVEN
11.2 Objectives
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The general objective of a budget is to set some target to be achieved in a specific period, mainly
the advantages include:
(i) It provides clear guidance for managers and supervisors and is the major way in which
organizational objectives are translated into specific tasks and objectives related to
individual managers.
(ii) It helps to improve communication and co-ordination among the management and
employees.
(iii)These are used to determine and evaluate the performance of the business enterprise.
(iv)It helps to clarify the authority and responsibilities of the departmental manager and other
staff members.
(v) Because of the exception principal which is at the heart of budgetary control,
management time can be saved and attention directed to areas of most corners.
(vi)Its a tool for planning.
(vii) Involving lower & middle management with the preparation of budgets & the
establishment of clear target against which performance can be judged is a form of
Motivating factor.
Budgetary Control.
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Budgetary control is a management technique which is adopted to control the business more
effectively.
As defined by the institute of costal management Accountant (I.C.M.A), budgetary control refers
to:-
The establishment of departmental budgets relating the responsibilities of executives to the
requirements of a policy and the continuous comparison of actual with budgeted results either to
secure by individual action the objectives of that policy or to provide a firm basis for its revision
Budget differs from budget control in that, a budgetary control in that, a budget is a standard with
which to measure the actual achievement of people, departments, firms e.t.c. whereas. Budgetary
control is the planning in advance of the various functions of a business so that the business as a
whole can be controlled.
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This is a rule book which lays down the budgeting procedures, organizational structure,
designations of responsibilities and budget time table
The Budget Period
The budget is prepared for a specific period e.g.
i) Period Budgets
ii) Continuous budgets
Period budget cover a fixed period of time e.g. 6 month, 1 year, 5years e.t.c. if the period is
long, then the period is divided into shorter period often called control periods.
Conditions budget is a process whereby budgets for a year are continuously extended by
another period i.e. one quarter or half year. The quarter or half year just ended is dropped and
next quarter or half year is included. This process is also called rolling budgeting.
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6. Produce financial budgets.
7. Produce master budget.
8. Submission of budget to chief executive or board of directors for approval or
amendments.
9. Publish agreed budgets for ensuring period.
10. Recording of actual results.
11. Actual/ budget comparison and identification of variances.
12. Reporting to budget holders and senior management.
13. Variance investigation variance and their causes provide the link between budgetary
control and budgetary planning.
14. Developing solutions to problems revealed by budgetary control.
Master Budget.
This is a summary of al other budget and includes also a budgeted profit and loss account and a
balance sheet; it shows the overall picture of the budgeted targets for the next period.
It contains various subsidiary or functional budgets.
A functional budget is one which relates to any of the functions of an enterprise. This may
include:-
a) Sales budget.
b) Production budget.
c) Purchase budget.
d) Production cost budget.
e) Selling and distribution cost budget.
f) Cash budget
g) Budgeted profit and loss account and balance sheet.
Cash Budgeting.
This is prepared to show the expected cash receipts and cash payments in next few months or one
year period.
Functions Of A Cash Budget.
(i) To ensure that cash is available for revenue expenditure.
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(ii) Indicate when, where and how much cash will be needed and whether this is
permanent or temporary.
(iii) Preserve liquidity throughout the year.
(iv) Reveal surplus cash for investments or expansion of facilities.
(v) Guide management on financial capital expenditure internally or externally.
The cash budget is affected by the:-
(i) Expansion or contraction of the investment in fixed assets.
(ii) Increase or decrease in stocks and debtors.
(iii) Rate of inflation anticipated.
(iv) Policy decision like credit control, dividends and taxation.
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Regression analysis Least squares method.
Time series analysis.
Exponential smoothing approach.
These are covered in statistics and Quantitative Techniques.
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culminating in the planning maximum benefit for a given budgeted cost CIMA its thus, a cost
benefit approach.
Activity Based Budgeting (ABB)
Also called activity cost management, is a planning and control system which seeks to support
the objective of continuous improvement.
The method recognizes that it is activities which causes cost and is a more focused method of
budgeting.
Examples;
1. Oshal Ltd manufactures two types of products for the printing industry. Budgeted sales of the
products, known as P and Q for 2014are.
Product Quantity Price (Shs)
P 3,000 80
Q 7,000 70
Stocks of these products were as under:-
Product Opening Stock Closing Stock
P 2,000 units 1,500 units
Q 1,800 units 2,500 units
Required:
(i) Prepare sales budget.
(ii) Prepare production budget.
i. Sales Budget.
Product Quantity Sale Price per unit (Shs) Sales Value
P 3,000 80 240,000
Q 7,000 70 490,000
730,000
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P Q
Sales (Units) 3,000 7,000
Increase (Decrease) in stock (500) 700
Units to be produced 2,500 7,700
Example 2
The following information was extracted from the books of Box Ltd, a company which started
trading one year ago.
2014.
Month Sales (Shs) Purchases (Shs)
April 150,000 100,000
May 160,000 110,000
June 160,000 90,000
July 170,000 90,000
August 200,000 80,000
September 200,000 130,000
October 180,000 140,000
November 180,000 60,000
December 200,000 60,000
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6. The share holders at their last Extraordinary general Meeting increased the share capital by
Shs. 70,000 and the first call of Shs. 40,000 will be received in October, 2014.
7. In October, 2014, the company is due to receive Shs. 20,000 as compensation for a civil suit.
8. The monthly administration expenses amounting to Shs. 33,000 include factory depreciation
charge of Shs. 4,000 and preliminary expenses of Shs. 3,000.
9. Office equipment worth Shs. 13,000 will be paid for in November, 2014.
Required:
Prepare a cash budget for the period 1st June to 31st December, 2014.
CASH BUDGET
June July August Sept Oct Nov Dec
Receipts: Shs. Shs. Shs. Shs. Shs. Shs. Shs.
Balance b/f 180,000 153,000 203,000 274,000 345,000 437,000 440,000
Receipts from sales (w2) 159,000 166,000 187,000 197,000 188,000 182,000 192,000
Share Capital - - - - 40,000 - -
Compensation received - - - - 20,000 - -
Total Receipts 339,000 319,000 390,000 471,000 593,000 619,000 632,000
Less:
Payments:
Payments to creditors (w1) 110,000 90,000 90,000 80,000 130,000 140,000 60,000
Administration expenses 26,000 26,000 26,000 26,000 26,000 26,000 26,000
Corporation tax - - - 20,000 - - -
Retention money 50,000 - - - - - -
Office equipment - - - - - 13,0000 -
186,000 116,000 116,000 126,000 156,000 179,000 86,000
Balance c/f 153,000 203,000 274,000 345,000 437,000 440,000 546,000
Workings:
1) Supplies are paid one month after the delivery of goods e.g may purchases will be paid on
June, June on July and so on.
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2) Receipts from sales
a) June Shs b) July shs.
60% of June Sale = 96,000 60% of July sales = 102,000
30% of May sale = 48,000 30% of Sept sales = 48,000
10% of April Sale = 15,000 10% of May sale = 16,000
159,000 166,000
3. The monthly administration expenses are shs. 33,000 which include factory depreciation
charge of shs. 4,000 and preliminary expenses of shs. 3,000. these two charges (i.e shs. 7,000
= 3,000 + 4,000) do not include cash payments so cash paid every month is shs. 26,000 i.e
(shs. 33,000 7,000)
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11.7 Summary
Budget can be explained as a financial and/or quantitative statement, prepared and approved prior to a
defined period of time, of the policy to be pursued during that period for the purpose of attaining a
given objective.
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January 74,000 55,200 9,000 30,000
February 82,000 61,200 9,000 30,000
March 20,000 80,000 60,000 9,500 30,000
April 22,000 90,000 69,000 9,500 32,000
May 25,000 100,000 75,000 10,000 32,000
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