Chapter 1

A revision of Management Accounting

(MA) topics

Outcome

By the end of this session you should be able to

 describe and use absorption, marginal and standard costing techniques

 perform basic variance analysis

and answer questions relating to these areas.

The underpinning detail for this chapter in your Integrated Workbook can
be found in Chapter 1 of your Study Text

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Chapter 1

Overview

Traditional Marginal
Absorption
costing costing Costing
methods

A revision of
Management
Accounting topics

Standard Flexible
Standard costing
Costs budgeting

Controllability
Definition principle

Performance
Uses management

Types of
standards

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 A revision of Management Accounting (MA) topics

What is the purpose of costing?

We need to know the cost per unit for a product in order to:

 value inventory – the cost per unit can be used to value inventory, in the
statement of financial position.

 record costs – the costs associated with the product need to be recorded in
the income statement.

 price products – the business will use the cost per unit to assist in pricing the
product. For example, if the cost per unit is $0.30, the business may decide to
price the product at $0.50 per unit in order to make the required profit of $0.20
per unit.

 make decisions – the business will use the cost information to make important
decisions regarding which products should be made, and in what quantities.

How can we calculate the cost per unit? There are a number of costing methods
available, most of them based on standard costing.

A standard cost for a product or service is a pre-determined unit

cost set under specified working conditions.

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Chapter 1

1.1 The uses of standard costs

The main purposes of standard costs are:

 control – the standard cost can be compared to the actual costs and any
differences investigated

 planning – standard costing can help with budgeting

 performance measurement – any differences between the standard and the

actual cost can be used as a basis for assessing the performance of cost centre
managers

 inventory valuation – an alternative to methods such as LIFO and FIFO

 accounting simplification – there is only one cost, the standard.

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 A revision of Management Accounting (MA) topics

Standard costing is most suited to organisations with:

Mass production
Repetitive
of homogenous
assembly work
products

 The large scale repetition of production allows the average usage of resources
to be determined.

 Standard costing is less suited to organisations that produce non-homogenous

products or where the level of human intervention is high.

Illustrations and further practice

Now try TYU 1.

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Chapter 1

1.2 Preparing standard costs

A standard cost is based on the expected price and usage of material, labour and
overheads.
Cost Requirement $
Direct materials
Material A $2.00 per kg 6 kgs p.u. 12.00
Material B $3.00 per kg 2 kgs p.u 6.00
Material C $4.00 per litre 1 litre 4.00
22.00
Direct labour
Grade I labour $4.00 3 hours p.u 12.00
Grade II labour $5.40 5 hours p.u 27.00
PRIME COST 61.00

Variable production overhead $1.00 8 hours 8.00

Fixed production overhead $3.00 8 hours 24.00

Standard full production cost 93.00

Illustrations and further practice

Now try TYU 2.

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 A revision of Management Accounting (MA) topics

1.3 Types of standard

A standard cost is based on the expected price and usage of material, labour and
overheads. There are four main types of standard:

Attainable standards Basic standards

 based upon efficient (but not  long-term standards which remain

perfect) operating conditions unchanged over a period of years

 include allowances for normal  sole use is to show trends over time
material losses, realistic allowances for such items as material prices,
for fatigue, machine breakdowns, labour rates and efficiency and the
etc. effect of changing methods

 may motivate employees to work  standards may demotivate

harder since they provide a realistic employees if, over time, they
but challenging target become too easy to achieve and, as
a result, employees may feel bored
 most frequently encountered type of and unchallenged
standard

Current standards Ideal standards

 based on current working conditions  Based upon perfect operating

conditions
 useful when current conditions are
abnormal and any other standard  there is no wastage or scrap, no
would provide meaningless breakdowns, no stoppages or idle
information time

 do not attempt to motivate  may have an adverse motivational

employees to improve upon current impact since employees may feel
working conditions and, as a result, that the standard is impossible to
employees may feel unchallenged achieve

Illustrations and further practice

Now try TYU 3 in Chapter 1.

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Chapter 1

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 A revision of Management Accounting (MA) topics

1.4 Fixed, flexible and flexed budgets

1 Fixed budgets
 A fixed budget is prepared before the beginning
of a budget period for a single level of activity.

Fixed, flexible and

flexed budgets

2 Flexible budgets 3 Flexed budget

 A flexible budget is also  A flexed budget is prepared at
prepared before the beginning the end of the budget period.
of a budget period.
 It provides a more meaningful
 It is also prepared for a number estimate of costs and revenues
of levels of activity. and is based on the actual
 It requires the analysis of costs level of output.
between fixed and variable  As a result, the diversity and
elements. complexity of products has
increased.
 Not all production overheads
are driven by level of activity.

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Chapter 1

Example 1
A business has prepared the following standard cost card based on producing
and selling 10,000 units per month:
$
Selling price 10
Variable production cost 3
Fixed production cost 1
–––
Profit per unit 6
Actual production and sales for month 1 were 12,000 units and this resulted in
the following:
$000
Sales 125
Variable production costs 40
Fixed production costs 9
–––
Total profit 76
Using a flexible budgeting approach, prepare a table (next page)
showing the original fixed budget, the flexed budget, the actual results
and the total meaningful variance.

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 A revision of Management Accounting (MA) topics

Meaningful
Original Flexed Actual variance
fixed budget budget results = flexed
– actual (in $)
Based on
production/ 10,000 units 12,000 units 12,000 units –
sales of
10,000 units 12,000 units
Sales × $10 per unit × $10 per unit $125,000 $5,000 Fav
= $100,000 = $120,000
Variable 10,000 units 12,000 units
production × $3 per unit × $3 per unit $40,000 $4,000 Adv
cost = $30,000 = $36,000
As per
Fixed 10,000 units
original
production × $1 per unit $9,000 $1,000 Fav
budget =
cost = $10,000
$10,000
Profit $60,000 $74,000 $76,000 $2,000 Fav

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Chapter 1

1.5 Controllability and performance management

A cost is controllable if a manager is responsible for it being incurred or is able to

authorise the expenditure.

A manager should only be evaluated on the costs over which they have control.

It is worth emphasising that this concept of controllability is an important idea for PM,
and will be revisited many times throughout the syllabus.

Illustrations and further practice

Now try TYU 5 and TYU 6 in Chapter 1.

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 A revision of Management Accounting (MA) topics

Traditional costing methods

2.1 Absorption costing

The aim of traditional absorption costing is to determine the

full production cost per unit.

TOTAL COST

Production Non-production
costs costs

Direct (prime) costs Indirect costs Non-production costs

(production
 Materials overheads)  Selling and
distribution costs
 Labour  Factory rent (advertising,
delivery)
 Supervisor’s salary
 Administrative costs
 Electricity (cleaners, postage)
 Depreciation

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Chapter 1

The assumption underlying this method of absorption is that

overhead expenditure is connected to the volume produced.

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 A revision of Management Accounting (MA) topics

Example 2
A company manufactures two products, product ‘Tablet’ and product ‘Phone’.

Information about these two products reads as follows:

Units Direct labour hours Direct machine hours
Tablet 50,000 1 4
Phone 50,000 4 1

Overhead: Cost
Indirect labour costs $10,000 Driven by the number of
labour hours
Machine maintenance $90,000 Driven by the number of
costs machine hours
Total $100,000
Calculate the product overhead costs using a traditional absorption
costing approach, with overhead absorption rates calculated on the
basis of direct labour hours.
Using a traditional absorption costing approach, the OAR may be calculated
for each production cost centre as total overheads divided by total labour
hours:
$100,000
OAR =
{ 1 × 50,000 + 4 × 50,000 }
OAR = $0.40 per labour hour.
Under traditional absorption costing, overheads would be absorbed into the
two products as follows:
Overheads absorbed into product ‘Tablet’: 1 hour × $0.40 = $0.40
Overheads absorbed into product ‘Phone’: 4 hours × $0.40 = $1.60

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Chapter 1

2.2 Marginal costing

The marginal cost is the extra cost arising as a result of making

and selling one more unit of a product or service, or is the saving in
cost as a result of making and selling one unit.

Contribution is the difference between sales value and the variable

cost of sales. It may be expressed per unit or in total.

 With marginal costing, contribution varies in direct proportion to the volume of

the units sold.

 Profits will increase as sales volume rises, by the amount of extra contribution
earned.

 Since fixed cost expenditure does not alter, marginal costing gives an accurate
picture of how a firm's cash flows and profits are affected by changes in sales
volumes.

Marginal costing Absorption costing

Period Product
cost cost

Illustrations and further practice

Now try Illustration 1 ‘Saturn’ in Chapter 1.

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 A revision of Management Accounting (MA) topics

Example 3
A company manufactures only one product called XY. The following
information relates to the product:

Selling price per unit $20

Direct material cost per unit $(6)

Direct labour cost per unit $(2)

Variable overhead cost per unit $(4)

Contribution per unit $8

Fixed costs for the period are $25,000.

2,500 5,000 7,500 10,000
Level of activity
units units units units
Revenue 50,000 100,000 150,000 200,000
Variable costs 30,000 60,000 90,000 120,000
Total contribution 20,000 40,000 60,000 80,000
Fixed costs 25,000 25,000 25,000 25,000
Total profit/loss (5,000) 15,000 35,000 55,000
Contribution per unit $8 $8 $8 $8
Profit/(loss) per unit $(2) $3 $4.67 $5.50

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Chapter 1

Advantages/disadvantages of
AC and MC

Absorption costing

 Includes elements of fixed overheads in inventory values, in

accordance with IAS 2.

 Analysing under/over absorption of overheads is a useful

exercise in controlling costs of an organisation.

 In small organisations, absorbing overheads into the cost of

products is the best way of estimating job costs and profits on
jobs.

The main disadvantage of AC is that it is more complex to operate

than marginal costing, and it does not provide any useful
information for decision making, like marginal costing does.

Marginal costing

 Contribution per unit is constant, unlike profit per unit which

varies with changes in sales volumes. It is simple to operate.

 Fixed costs are a period cost and are charged in full to the
period under consideration.

 Marginal costing is useful in the decision-making process.

The main disadvantage of MC is that closing inventory is not valued

in accordance with IAS 2 principles, and that fixed production
overheads are not shared out between units of production, but
written off in full instead.

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A revision of Management Accounting (MA) topics

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Chapter 1

You should now be able to answer TYU questions 1, 2, 3 and 4 from Chapter 1
of the Study Text.

You will be able to partly answer questions 36, 37 and 40 from the Exam Kit.

For further reading, visit Chapter 1 from the Study Text and review the PM
article on ‘activity based costing’ at www.accaglobal.com.

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 A revision of Management Accounting (MA) topics

Answers

Example 1
A business has prepared the following standard cost card based on producing
and selling 10,000 units per month:
$
Selling price 10
Variable production cost 3
Fixed production cost 1
–––
Profit per unit 6
Actual production and sales for month 1 were 12,000 units and this resulted in
the following:
$000
Sales 125
Variable production costs 40
Fixed production costs 9
–––
Total profit 76
Using a flexible budgeting approach, prepare a table (next page)
showing the original fixed budget, the flexed budget, the actual results
and the total meaningful variance.

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Chapter 1

Meaningful
Original Flexed Actual variance
fixed budget budget results = flexed
– actual (in $)
Based on
production/ 10,000 units 12,000 units 12,000 units –
sales of
10,000 units 12,000 units
Sales × $10 per unit × $10 per unit $125,000 $5,000 Fav
= $100,000 = $120,000
Variable 10,000 units 12,000 units
production × $3 per unit × $3 per unit $40,000 $4,000 Adv
cost = $30,000 = $36,000
As per
Fixed 10,000 units
original
production × $1 per unit $9,000 $1,000 Fav
budget =
cost = $10,000
$10,000
Profit $60,000 $74,000 $76,000 $2,000 Fav

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 A revision of Management Accounting (MA) topics

Example 2
A company manufactures two products, product ‘Tablet’ and product ‘Phone’.

Information about these two products reads as follows:

Units Direct labour hours Direct machine hours
Tablet 50,000 1 4
Phone 50,000 4 1

Overhead: Cost
Indirect labour costs $10,000 Driven by the number of
labour hours
Machine maintenance $90,000 Driven by the number of
costs machine hours
Total $100,000
Calculate the product overhead costs using a traditional absorption
costing approach, with overhead absorption rates calculated on the
basis of direct labour hours.
Using a traditional absorption costing approach, the OAR may be calculated
for each production cost centre as total overheads divided by total labour
hours:
$100,000
OAR =
{ 1 × 50,000 + 4 × 50,000 }
OAR = $0.40 per labour hour.
Under traditional absorption costing, overheads would be absorbed into the
two products as follows:
Overheads absorbed into product ‘Tablet’: 1 hour × $0.40 = $0.40
Overheads absorbed into product ‘Phone’: 4 hours × $0.40 = $1.60

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Chapter 1

Example 3
A company manufactures only one product called XY. The following
information relates to the product:

Selling price per unit $20

Direct material cost per unit $(6)

Direct labour cost per unit $(2)

Variable overhead cost per unit $(4)

Contribution per unit $8

Fixed costs for the period are $25,000.

2,500 5,000 7,500 10,000
Level of activity
units units units units
Revenue 50,000 100,000 150,000 200,000
Variable costs 30,000 60,000 90,000 120,000
Total contribution 20,000 40,000 60,000 80,000
Fixed costs 25,000 25,000 25,000 25,000
Total profit/loss (5,000) 15,000 35,000 55,000
Contribution per unit $8 $8 $8 $8
Profit/(loss) per unit $(2) $3 $4.67 $5.50

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