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Study Text Page number

Chapter 1: Management Information 2

Chapter 2: Materials 14

Chapter 3: Managing Inventory 32

Chapter 4: Labour 46
Chapter 5: Overheads 60

Chapter 6: Absorption and Marginal Costing 81

Chapter 7: Process Costing, Joint Products and Further Processing 95

Chapter 8: Cost Classification 107

Chapter 9: Job, Batch and Service Costing 130

Chapter 10: Alternative Cost Accounting Methods 146

Chapter 11: Sampling Techniques and Expected Values 153

Chapter 12: Forecasting Costs and Revenues 160

Chapter 13: Time Series Analysis 171

Chapter 14: Index Numbers 184

Chapter 15: Spreadsheets 191

Chapter 16: Compounding and Discounting 199

Chapter 17: Investment Appraisal 214

Chapter 18: Nature and Purpose of Budgeting 235

Chapter 19: Fixed and Flexible Budgets, Budgetary Control, and Reporting 259

Chapter 20: Behavioural Aspects of Budgeting 274

Chapter 21: Presenting Information 278

Chapter 22: Summarising and Analysing Data 280

Chapter 23: Standard Costing and Variance Analysis 306

Chapter 24: Introduction to Performance Management 343

Chapter 25: Analysing Performance 352

Chapter 26: Monitoring Performance, Cost Reductions, and Value 359

Enhancement

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Chapter 1: Management Information

1.1.1 Types of Accounting
1.1 Types of Accounting

Definitions

Financial accounting − The recording, processing, and reporting of financial information to produce financial
statements.
Management accounting − The preparation of financial and non-financial information to support management
activities.
Cost accounting − Focuses on identifying costs (a monetary valuation or assessment) of resources and their
allocation to products, services, inventory or other items. It is a function of management accounting.

Example

The roles of three professionals working at Furniture Co are presented below:

Professional Description
Role

Ayasha Ayasha works as a cost accountant at the large furniture company Furniture Co.
Cost Her work involves recording the costs of products and services. These costs are a type of
accountant financial information.
Furniture Co makes four different chairs, and Ayasha is asked to record how much it costs
the company to produce each type.
To do this, she often looks at historical financial information (how much things cost in the
past).

Ajay Ajay is a management accountant at Furniture Co. He has several responsibilities:

Management  He looks at past and future costs.
accountant
 He sometimes works with non-financial information. For example, he can be asked
to investigate how many work days have been lost because of employee sickness in the
last year.
 He provides information for the company’s managers regularly (usually monthly)
and whenever necessary.
 He advises on specific aspects of the business, which sometimes involves
planning, decision making and control.

Kalib He must prepare the financial accounts for the company at the end of each accounting
period.
Financial
accountant The financial accounts he prepares show how well Furniture Co performed during the period
under review and the state of affairs at the end of the period.
Most of the information he deals with is financial data based on past information.

1.1.1 Comparing Management and Financial Accounting

Aspect Management Accounting Financial Accounting

Users of Internal management only Shareholders, banks, creditors, potential investors, tax
information authorities, government

Requirement Voluntary, no requirement to produce. It is required by law. Presentation and content governed
to produce by law and generally accepted accounting practices.

Format of It can take any form—no legal Presentation regulated by law (e.g. Companies Acts) and
information requirements. Best practices are the profession through accounting standards.
developed and used.

Content Financial and non-financial, A summary of mainly (past) historical financial

predominantly current with future information with supporting notes.
predictions (e.g. in budgets).

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Level of More detailed (e.g. costs and revenues As prescribed by legislation, etc.
detail by department, product).

Frequency As frequently as needed by Usually annually (more frequently for certain types of
of management: Quarterly, monthly, "public interest" companies).
preparation weekly, daily, or on demand

Purpose of Used to plan, control and make Stewardship and investment decisions.
information decisions.

Bases of Standard costs, relevant costs, Historical costs (as modified by the revaluation of certain
valuation marginal costs, absorption costs. fixed assets and fair values as required by financial
reporting standards).
Other bases may also apply.

Activity 1

Determine whether the statement describes management accounting or financial accounting.

Statement Management accounting or financial accounting

No legal requirement Management accounting

Accounts primarily for shareholders Financial accounting

Use of future information and forecasts Management accounting

Reporting standards determine presentation Financial accounting

Prepared as required by management Management accounting

1.2.1 Planning, Decision-Making, and Control
2.1 Planning, Decision-Making, and Control

Managers require information for three essential activities:

Planning Managers plan a course of action for the future.

 Setting objectives, such as a sales target for a product
 Selecting the best method of achieving the objectives.
 Plans can be financial, like a budget.

Control Managers use information to check how the organisation performs compared to their plans.
 Comparing actual results with planned results (variance)
 Reviewing strategic plans when circumstances change.

Decision-making Managers use information to help them make decisions about the organisation:
 Preparing information for investment decisions (such as whether to invest in new
plant and equipment)
 Making decisions on actions to take: how much of the product to make, what price
to set, how to reduce costs etc.
Management activities’ relationship with data is illustrated below:

Some examples in practice:

Marketing Manager: Costing decisions

I need to know how much the product costs, how many units we can produce and how many we can
sell to our customers. This information helps me set the right price and calculate how much profit we
can make.

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CEO: Strategy decisions

I need to know what our competitors are doing. How much do they sell their products for? Are they
launching any new products? How do people feel about our products in comparison to the
competition? This information helps me make strategic decisions about the company's future
direction.

Factory Supervisor: Control

I need to know how our manufacturing output is performing against the targets. Are there any
worrying trends and inefficiencies in the processes? Are we wasting money or resources anywhere?
This information helps me to control efficiency and performance.

Treasury Manager: Planning

I need information about the amount we will spend each month and how much income we will receive
so that I can plan our cash requirements. I can borrow money at much better interest rates if I know
our needs.

Production Manager: Investment decision-making

I need help to assess investments and understand the costs of buying a new piece of machinery.
For example, does the future income justify purchasing an expensive new machine, or should we go
for something cheaper?

Managers need the information to help them plan, control and make decisions. Different types of
organisations will have varying information needs. For example, a sole trader will know what is happening
across the whole organisation more than the owners and managers of large, multinational organisations.
Managers in large organisations must collect and summarise the information they require from many
different sources.
1.2.2 Strategic, Tactical, and Operational Planning
2.2 Strategic, Tactical, and Operational Planning

Different types of planning and decisions are taken at each different levels in the management hierarchy.
These levels have been identified by Robert Anthony as:

Management Description
Level

Strategic Senior managers carry out strategic management. It is concerned with making significant
strategic decisions for the organisation, such as setting business objectives and deciding on
corporate strategy.
Strategic management decisions often involve long-term planning.

Tactical Tactical management is carried out by middle managers and relates to business control and the
allocation of resources. It involves developing plans, often medium-term, for implementing
strategic managers' directions.
It includes tasks such as annual budgeting and other medium-term planning, implementing the
plans when approved by senior management, and monitoring actual performance against them,
ensuring that day-to-day operations lead towards achieving long-term strategic goals.

Operational Junior managers or supervisors usually carry out operational management. It is concerned with
the implementation of tactical plans and with the management of short-term, detailed day-to-day
operations.
Operational management is the lowest level of management.

Example

Below is an illustration of the task performed by the various management levels in potentially expanding the
operations of a successful farm:

Task Management level Resources involved Timeframe impact

Deciding to expand operations by buying Strategic High Long-term

more land

Deciding on how to fund the purchase of Strategic High Long-term

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Example

more land

Identifying suitable land for purchase Tactical Medium Medium-term

Arranging finance with banks and Tactical Medium Medium-term

investors

Recruitment of employees to work on land Tactical Medium Medium-term

Plan, forecast, and budget for profits and Tactical Medium Medium-term
revenues

Monitoring actual progress to plans Tactical Low Short term

Plant crops, decide daily workloads, give Operational Low Short-term

operational instructions, and manage day-
to-day operations.

Example

The table below describes how planning activities may apply to Furniture Co:

Planning level Description Example

Operational Day-to-day planning of an organisation, with all Furniture Co prepares a schedule of

Planning managers involved. weekly meetings three months in
advance to discuss production
budgets.

Tactical planning Making short-term plans that generally cover a year Furniture Co has hired more staff to
ahead. cope with a planned increase in
production over the next 12-18
The senior and middle managers are involved.
months.

Strategic planning Creating longer-term goals and deciding how they Furniture Co is deciding whether to
will be achieved. expand into new Asian markets in the
next 10 years.
This high-level planning, done by senior managers
only, focuses on the next five to 10 years.

1.3.1 Data and information

3.1 Data and information

Definitions

Data – Raw facts and figures.

Information – Data that has been processed to have meaning.

Data is information in a raw and unorganised form. It is the facts and figures that give information meaning
and context.
Information is data that has been sorted, summarised or otherwise made more useful or easy to work with.
Information can be presented in many different forms. For example, numbers can be put into a table
(tabulated) to organise them and give them meaning, or they can be presented in reports, graphs and charts.
Activity 2

Classify the statements as data or information

Statement Data or
information

Exam results for a class of mathematics students for the years 20X1 – 20X5. Data

A graph showing the exam results of a class of mathematics students for the years 20X1 – Information
20X5.

A list of purchase invoices for Furniture Co for September 20X1. Data

Management accounts for Furniture Co for the month of June 20X1. Information

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A list showing the age of members of staff in the Human Resources (HR) department of Data
Furniture Co during 20X5

A chart showing how the ages of staff in the HR department of Furniture Co in 20X5 range Information
from 28 to 49 years old
1.3.2 Classifying Data
3.2 Classifying Data

Data and information can be categorised as either primary or secondary.

3.2.1 Primary data
Primary data is data that has been collected directly from the source.
For example, Furniture Co surveys to find out what the public thinks about its furniture before launching a
new advertising campaign.
This data is known as primary data because it was collected directly from the source with the specific aim of
finding out what the public thinks about Furniture Co’s products.
The resulting survey report is primary information prepared to help managers to make decisions about the
advertising campaign.
3.2.2 Secondary data
Secondary data is collected by someone other than the primary user.
Secondary data might have a transactional cost, meaning it was purchased directly from another entity, such
as a research firm or university.
There might also be costs in verifying the reliability of the data, such as establishing sources, cross-
referencing with data of known veracity, etc.
Secondary data may need to be processed into an appropriate format and structure before it can be used;
this process may also incur costs.
Furniture Co could purchase data on current trends in furniture products from research firms or universities.
The cost of data capture is discussed further in section 4.4.

1.4.1 Internal Sources

4.1 Internal Sources

One way to classify information is whether it originates from inside the organisation (internally) or from
outside the organisation (externally).

Internal Source Description

The organisation’s accounting system collects transaction data, including sales and
purchases. The system allows the organisation to monitor its financial performance and
provide information to help managers make informed decisions.
The accounting
system and For example, managers can evaluate the sales levels of different products to determine which
records products to produce in the future. They can also look at the details of purchase orders sent to
suppliers, and goods received included in the inventory records to help monitor the
performance of different suppliers.

Employees at all levels of an organisation interact and communicate formally and informally
while performing their duties. These interactions result in insights and information that
should be captured or obtained.
Employees and
managers For example, document conversations during meetings and maintain a central copy of
significant email conversations. Gather information from staff through interviews, internal
surveys and word-of-mouth.

In a manufacturing organisation, production records include information relating to

production levels.
For example, the production records would include the usage of materials, fuel consumption,
Production machine set-up times, machine downtimes, and the required maintenance.
records
In a service business, production records include the time spent by staff on different clients
and tasks. This information helps managers establish client fees and assess the efficiency
and profitability of operations.

Organisations record information to help them carry out operations and administrative
Administration functions.
and other records For example, managers can consult employee records maintained by human resources to
determine whether current employees have relevant experience and training for a new project

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requiring a specific skill.

The wages and salary information held in the payroll system can help forecast the
organisation’s cash flow. The policies and procedures manual is another valuable internal
source of information.

Example

Below is a discussion with the financial controller for a waste management company that collects and disposes
customer waste products.
What internal information sources does your organisation use?
Our information is from the initial recording of the jobs at the earliest possible stage in each process, which is the
job worksheet as filled in by the engineer or the operator. Also useful are their timesheets, which record the hours
they have spent on each job.
What is the information useful for?
The data gathered from our job worksheets and timesheets are summarised into information and presented to
management as key performance indicators.
The management then makes decisions based on these key performance indicators to govern the direction the
company is going.
One example of how this data was used to lead decisions was that we noticed that the drivers in a particular area
were working much overtime. It became apparent that it would be better to take on an additional engineer to cut
down on the overtime that they would work. As a result, everybody was then working more efficiently.

Example

Below is a discussion with the finance director of a strategic communications consultancy specialising in media,
corporate and government relations.
What internal information sources does your organisation use?
Internal information is essential for us because we're a service business. The most critical thing we track is staff
utilisation because, effectively, we are selling staff consultancy, i.e. time, so the biggest and most vital component
of our information requirement is staff time.
So we have software focused on collecting staff time, analysing staff time, and understanding where staff spend
their time with clients and other services.
Outside of that, we track the business’s profit and loss and sales through our accounting software and report the
data monthly through our management reporting suite.
What is the information useful for?
Regarding time, which is the most critical information to the business, as a consultancy, it's crucial because each
consultant only has so many hours to sell.
So it's essential to the business that we make sure they're making the best use of their hours, and we are charging
the best price on the hours they use or serve our clients.
So, to give you a good example, we monitor each client-if a client bills us a fee, we track the hours we supply for
that fee, and we apply a value to those hours.
On that basis, we can work out profitability on a client-by-client basis.
So to give you an excellent example of where that works for us as a business, when I first joined the firm, I brought
this data analysis offering into the agency, and then we had the means, the data, and the knowledge to go out to
our clients.
Where we'd been over-servicing clients, i.e. giving them too much of our time and not being paid enough money,
we were in a position to show them exactly how and where, and what was causing that in the first place so we
could ask for more money.
That resulted in roughly $1 million in fees for the business from just one task alone.

1.4.2 External Sources

4.2 External Sources

Multiple different sources of information can be gathered from outside an organisation.

Some of this information is gathered routinely by an organisation on a formal basis:
 To ensure that the organisation complies with the rules and regulations of doing business, they
need information about tax rules and regulations.
Organisations must also be aware of financial reporting standards, environmental legislation, health and
safety regulations and employment law.

 Organisations must also collect marketing intelligence routinely (relevant market information).

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One source of marketing intelligence is marketing research undertaken by the organisation or a specialist
agency. Research can help a business better understand customer needs and improve the reliability of their
forecasts of future trends.

Information from external sources is also collected non-routinely on a less formal basis.
Sources of external information include:
 The government and government
agencies
 The media (newspapers, magazines,  Journals and other reference works
television)  Professional bodies
 Libraries and information services  Customers and suppliers
 Online resources  Bankers
 Consultancy businesses  Trade organisations.
Across all sources, much of the information gathered is now obtained in a digital format.
Technological developments, including the advancement of computer systems and the widespread
availability of information via the internet, give managers access to more information.
1.4.3 Sources of Data: Machine, Transactional, and Human
4.3 Sources of Data: Machine, Transactional, and Human

There are three primary data sources:

Data source Description Example

Machine/sensor Data gathered from a Sensors can record data such as temperature, motion, light and
data device containing a proximity.
sensor that detects data
For example, supermarket chains often record the temperature
from the physical
of their fridges in stores using sensors and then use this data to
environment.
predict when particular sets of fridges will need to be serviced.
In the agricultural industry, sensors can measure soil
temperature and relative humidity, leading to better decisions
about pesticides and watering levels.

Transactional Data relating to the Transactional data details include the date, cost or price,
data transactions of a quantities and payment methods.
business, such as data
Compared with data such as the name and address of a
recorded when products
customer (known as master data), transactional data is created
or services are bought
frequently and changes frequently.
and sold.

Human/social Data related to humans It can include the user’s location (for example, the place of the
data from social media posts, person posting on social media), language (for example, English
handwritten letters, phone or Chinese), emotions and preferences.
calls, questionnaires and
It often needs human interpretation, for example, to establish
surveys.
and understand what people think and feel.

Activity 3

Determine the source of the data.

 Machine/sensor
 Transactional
 Human/social
Data Source

A review by a customer on social media about the quality of material used in the product Human/social

The date the materials were last purchased from the supplier Transactional

The current location of the delivery van containing the new order of the materials Machine/sensor

A customer telephone query about whether the materials in the product have changed Human/social
1.4.4 Costs of Management Information

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4.4 Costs of Management Information

4.4.1 Costs of Information

The most significant costs associated with management accounting data and information can be classified
as day-to-day running costs and storage costs:
 Day-to-day running costs
Costs associated with capturing, processing, analysing, and using data. For example, the costs associated
with maintaining a system that captures customer data as customers make purchases on an e-commerce
platform.
Another example of day-to-day running costs is the costs associated with the reporting platform which
queries data from storage and organises/translates it into useable reports/charts/dashboards.
 Storage costs
Costs associated with storage of data. An example could be costs incurred to maintain an on-site storage
server or subscription to cloud storage. It also includes costs associated with database management
systems that manage stored data and information queries.
4.4.2 Direct Data Capture Costs
Direct data capture costs are the costs of getting the data into the system. Examples include:
 Use of and processing of data forms, either manually entered into a system, digitalised forms with
pre-set fields, or automated through optical character recognition (OCR).
 Use of machine-readable bar codes, QR codes, or RFID tags.
 Artificial intelligence (AI) or algorithmic processing and codifying (adding associated tags) of non-
standardised data captures, such as faces or physical items.
 Other machines, workforce, and systems for large-scale data capture, such as measuring devices
and associated systems, laboratory work, sensors on the manufacturing line, survey drones, etc.
Direct data capture costs are directly related to obtaining the required information.
4.4.3 Indirect Costs of Producing Information
Producing information can also have significant indirect costs. Such costs are indirectly related to obtaining
the required information and they can be difficult to predict and quantify.
Examples include:
 Lost productivity, for example whilst staff are being trained in a new data capture method.
 Lower productivity, for example whilst staff become familiar with using new software.
 Delays in other parts of the business, for example while data is gathered.
 Information overload resulting in, for example, time wasted by staff trying to interpret the
information, ineffective decision-making, and focusing on the wrong things.
Example

A manufacturing business which has very high staff turnover is considering various initiatives to improve the
wellbeing of production employees. Whether or not wellbeing is improved will be measured based on staff survey
results.
Once a week, production employees will be asked to take paid time out of their day to do something they enjoy.
This will be known as ‘weekly wellbeing’. Staff will be required to fill in an online questionnaire after each
session. A weekly wellbeing session, including completion of the questionnaire will take one hour. The data
captured by the online survey will be processed automatically by the software.
The estimated costs of producing this information over a 12-week period are shown below:

$ Notes

Cost of lost production time 10,000 80 employees for 12 weeks

Cost of delays caused in other parts of the 5,000 For increased customer service
business due to lost production

Online survey design and set-up costs 3,500 Fixed cost

Online survey licence costs 2,000 For use of the online survey software for up
to 100 employees
What is the indirect cost of capturing this information?
Suggested answer:
$15,000
The costs which are directly related to capturing the information from the survey are the online survey design
and set-up costs as well as the licence for the three-month use of the software. The other costs (lost production
time and delays) are indirectly related to obtaining the survey results.

1.5.1 Good information

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5.1 Good information

Management information must help managers make informed decisions or take effective action to be of use.
Information that does not influence behaviour (including confirming that current behaviour should continue)
is of no use or value.
The mnemonic ACCURATE helps to describe useful characteristics of information.

Information provided to managers should be free from significant errors.

In most circumstances, an insignificant error will not affect the information's overall adequacy,
Accurate but the accuracy level needs to be sufficient for its purpose.
For example, it may be appropriate to round up in the thousands if smaller quantities are
insignificant.

Information should include all relevant information.

Complete
Correct information which excludes something important is of little value.

The financial benefits or value of the information must outweigh the costs of obtaining that
information.
Cost-effective For example, the cost of additional staff time to produce the information.
However, establishing the value of information is not always easy: how do you accurately
calculate the value of a ‘better-informed decision’?

Information should be tailored to meet the needs of the recipient.

User-targeted
For example, some managers may require additional information on specific business areas.

Only information directly related to the decision being considered should be provided.
Relevant Managers can suffer from information overload, making it difficult to find and focus on the most
relevant information.

The source of information should be reputable and reliable.

For example, a rumour about a new product released by a competitor should be investigated
Authoritative and verified before being accepted as accurate information.
The reliability of the source must also be considered. This is even more important nowadays
with so much information freely available online.

Useful information must be received in time for it to influence a decision.

Timely
Information received too late is worthless, no matter its other qualities.

Information should be concise, presented clearly, understandable and communicated using an

appropriate communication channel.
Easy-to-use For example, relatively detailed financial information is easier to use and absorb if
communicated using a digital or paper document rather than in a spoken conversation.
Some information may be more easily understood if presented visually (i.e. in a graph).

1.6.1 Overview of Big Data

6.1 Overview of Big Data

Definition

Big data – Collections of data that increase exponentially over time, with too much volume, variety, and velocity
for traditional data-processing methods to analyse effectively.
There is more ready access to more data today than a few years ago. That’s because of changes in the
technological environment over recent years. In particular, the use of smartphones and social media and
greater data storage capabilities mean that organisations have vast volumes of data that they can use to
support their planning, control and decision-making.
If this large volume of data is analysed correctly, management accountants are provided with more good
quality information and are therefore better able to plan, control and make decisions. In addition, data that is
analysed well can provide insights and show patterns that can help management accountants in many areas,
for example, predicting customer demand.
However, the volume of data generated every minute means that the traditional methods of data analysis
cannot keep up, and new technologies, and new approaches, are required to make sense of all this data.

1.6.2 Aspects of Big Data

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6.2 Aspects of Big Data

Aspect Description

Volume The volume of data being captured from transactions, social media, customer relationship
management systems and sensors has exploded in recent years and continues to do so.

Velocity The speed or velocity at which data is being streamed into systems and organisations is also
increasing rapidly. To be useful, this data needs to be captured and analysed in an efficient and timely
manner.

Variety Variety relates to the many types and forms of data collected and generated.
Structured data refers to data held in defined file structures, for example, a transaction file.
Unstructured data includes images, audio and video files, and ‘free text’ in social media posts and
emails.

Veracity Data quality relating to accuracy and truthfulness is essential for effective decision-making.
Practical analysis to provide valuable findings can only be done if the data collected is true; this
includes considerations on the reliability of the data source.

Value The benefit of having data for the organisation must be higher than the cost of obtaining it.

Activity 4

Match the data description to the correct aspect of Big Data.

Description Aspect

Data is too large to be analysed using a spreadsheet Variety

Data can be processed in real-time Volume

Data includes text, photographs, emojis, videos Velocity

Big data selected from a population of items may be inaccurate Value

Big data is only meaningful when analysed to form insights Veracity

6.2.1 Structured and Unstructured Data

 Structured data this data is stored within defined fields (numerical, text, date etc.), often with
defined lengths, within a defined record, in a file of similar records.
Structured data requires a model of the types and format of business data that will be recorded and how the
data will be stored, processed and accessed. This is called a data model. Designing the model defines and
limits the data that can be collected and stored and the processing that can be performed.

An example of structured data is found in banking systems, which record the receipts and payments from
your current account: date, amount, receipt/payment, and short explanations such as payee or source of the
money.

Structured data is easily accessible by well-established database-structured query languages.

 Unstructured data refers to information that does not have a pre-defined data model. It comes in all
shapes and sizes, and this variety and irregularity make it challenging to store in a way that will allow it
to be analysed, searched or otherwise used.
An often-quoted statistic is that 80% of business data is unstructured, residing in word processor
documents, spreadsheets, PowerPoint files, audio, video, social media interactions and map data.

Example

Below is an example of unstructured data and its use in a retail environment:

 You enter a large store and have your mobile phone with you. That allows your movement around the
store to be tracked.
 The store may or may not know who you are (depending on whether it knows your mobile phone

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Example

number).
 The store can record what departments you visit and how long you spend in each. Security cameras in
the ceiling match up your image with the phone, so now they know what you look like and would be able to
recognise you on future visits.
 You pass near a particular product, and previous records show that you had looked at that product
before, so a text message can be sent, perhaps reminding you about it or advertising a 10% price reduction.
 The store has a marketing campaign that states that it will never be undersold, so when you pass near
products, you might be making a price comparison, and the store has to check prices on other stores’
websites and message you with a new price.
 If you buy the product, then the store might have further marketing opportunities for related products
and consumables, and this data has to be recorded.
 You pay with an affinity credit card (a card with associations with another organisation such as a
charity or an airline), so now the store has some insight into your interests.
 You buy several products, and the store will want to discover if these items are generally purchased
together.
So just walking around a store can generate a vast quantity of data which will vary in size and nature for every
individual.

1.6.3 Use of Big Data by Organisations

6.3 Use of Big Data by Organisations

Definition

Data analytics – The process of deriving meaning from data.

Data analytics is the collection and analysis of data to find patterns and draw conclusions. The more data is
available, the better the resulting analysis and findings.
Data analytics can be significantly enhanced using artificial intelligence approaches such as machine
learning. Machine learning is an approach whereby developers build a programme that creates a model
based on a set of initial data, and the model can then be used to, for example, make predictions such as
customer demand for Product X.
The programme ‘learns’ from the additional data by comparing its output to the actual results and adjusting
its model accordingly.
So, as data about real-world sales of Product X are collected and fed into the programme, the model is
improved and produces more reliable predictions. So, the more data it is given, the better a machine learning
programme gets at making forecasts.
One of the most significant benefits of big data is its impact on decision-making. Big data, combined with
advanced analytics and other technology, provides better business insights and enables better decision-
making.
6.3.1 Organisational Strategy
Data analytics can be used to simulate many different scenarios rapidly and relatively cheaply (compared to
the time and effort involved in human-developed scenarios). This method can determine the likely best
markets and approaches to meet growth and profitability ambitions for profit-focused businesses. It could
predict the impact of climate-related events and enable governments and charities to provide relief where
and when needed. It can also be used more individually, for example, to provide medical diagnoses.
6.3.2 Customer Satisfaction And Forecasting Demand
Big data analysis allows organisations to understand their stakeholders’ preferences and needs. For
example, customers can be sent shopping offers tailored to their habits and needs. Big data from sources
such as visitor website numbers, customer surveys and social media posts can be combined with data
relating to the economic climate and competition to spot trends, predict customer demand, and prevent
issues from arising.
An example of a solution relating to addressing issues early is Gnip. This is a service that collects data from
social media. As you can imagine, social media creates vast volumes of data every hour. Analysis of social
media posts often highlights what people care about, which is valuable for business decision-making. This is
sometimes called ‘social listening’ – finding out what people think about an organisation – its customer
service, product or service, or its attitude towards the natural environment and this information can be
broken down into demographics to find out what group or type of person is expressing the opinions.
Suppose there is a small but growing stream of dissatisfied messages relating to a specific product. In that
case, the business can proactively address the problem before it becomes a widespread and widely
communicated complaint that could adversely affect the company’s image.
1.6.4 Problems with big data
6.4 Problems with big data

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Some of the limitations of management information apply to big data as much as to other forms of
management information. For example, data which is incorrect and incomplete can hinder rather than help
with decision-making. However, big data also has some unique problems:
 Big data veracity: Data needs to be relevant and trustworthy, but big data can sometimes be
imprecise, inconsistent or biased. The sources of big data include social media and the internet.


There have been numerous reports about people being dishonest on social media and websites containing
‘fake news’. If this is absorbed into data sets as having equal validity as transactional data, such as invoice
data, then the resulting analysis may not be sound.

Even transactional data can be problematic. As social norms change, historical data might not be a sound
basis for decisions about current issues. For example, analysis to assist recruitment which is based on the
backgrounds of successful applicants from the past 60 years, is likely to advise hiring staff according to the
dominant gender and race in that role in past decades without taking into account the social changes that
have taken place in more recent years.

 Big data technology: The technology is constantly evolving, and it can sometimes be challenging
to implement and costly.
 Big data analysts: Businesses need suitably skilled data analysts, which are currently in short
supply.
 Security and privacy: Security and privacy laws vary across the world. Businesses must ensure
they are not violating regulations when they source and store data.
1.7.1 Limitations Of Management Information
7.1 Limitations Of Management Information

If management information lacks the characteristics of useful information, then it may cause management to
make wrong decisions. Information can, therefore, sometimes be limited in its usefulness to management.
 Time and cost affect the quality of management information.
Time and cost are important considerations. The more time spent producing information, the more the
information costs a company. To be worthwhile, the information must deliver savings and benefits greater
than this cost. However, it can be challenging to value information accurately as it is often difficult to
measure its impact precisely.

 A lot of management information is based on past events.
The business environment changes very quickly. Therefore, information from the past might not provide a
completely accurate view of the current situation in a company or be able to indicate what will happen in the
future. However, much of the information supplied to management is based on what has happened in the
past.

 Management information is often incomplete.
Often there is something relevant happening in the business world that may not be contained in the
information used by management. For example, a new competitor may be about to launch a new product.

 Computer systems reports may contain errors.
Computer systems produce a lot of the information used by managers. Computer system reports generally
look very professional, so managers might assume that all the information is accurate. However, this
depends on whether the information has been correctly input into the computer system. If the input is
incorrect, the information in the report may be misleading.

 Information can be based on incorrect assumptions.
Those who gather management information may allow assumptions, such as the general economic
environment, the behaviour of competitors and customers’ opinions, to affect the information they produce.
These incorrect assumptions can change the meaning of the information provided.

 Too much focus on financial information.
A lot of management information is financial, and sometimes, the role of other factors may be overlooked.
For example, the marketing campaign of a competitor may affect sales.


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Chapter 2: Materials
2.1.1 Purchasing Materials
1.1 Purchasing Materials

Manufacturing companies usually follow a specified purchasing process, with in-built controls, when
acquiring materials. Different departments within the business are responsible for different steps in the
process and for recording transactions in the accounting system.

Key Point

MA assumes a computerised accounting system is used to record and control the flow of information in
transaction processing.
This means that the purchasing process is initiated, recorded, communicated, authorised, and controlled within
the computerised system.

Step Process stage Department Activity/Control

1 Request for materials Stores Create and approve purchase

requisition

Purchasing process 2 Find supplier Purchasing Source suitable supplier

3 Order goods Purchasing Create and approve purchase order

4 Receive goods Warehouse Record goods received

5 Pay for goods Finance Process and pay invoice

1. The stores department would first request the materials using an authorised purchase
requisition (purchase requisitions may come from other departments directly as well).
2. The purchasing department would then source a suitable supplier for the materials, usually from a
verified list.
3. The purchasing team would then order the goods from the external supplier using an
authorised purchase order.
4. Once the warehouse has received the goods, they will record the goods received in the system.
5. Finally, the finance team would check the invoice against the purchase order and delivery note and
process the payment for the materials.
2.1.2 Accounting Entries for Materials
1.2 Accounting Entries for Materials

Movements of materials (buying materials, moving them from stores to production or back from production
to stores) are recorded in the materials control account.
Modern accounting systems use a common input data for all accounting purposes (financial and cost
accounting).
1.2.1 Materials Control Account
The materials control account records inventory movements in an organisation’s accounting records, using
double-entry, and shows the balance of inventory held by a company at a specific point in time.
Material is an asset which is debited to the materials control account. Any transactions that increase the
asset’s value are debited to the inventory account, and those that decrease the asset’s value are credited to
the materials control account.
Opening inventory is a debit balance in the materials control account.
Each time an entry is made in the materials control account, detailed information in respect of inventory
valuation is simultaneously recorded.
Recording inventory is discussed further in section 1.4.
A summary of the transactions recorded in the materials control account are:

Transaction Debit Credit

Purchases Materials control Bank or payables

Issues to production (direct) Work-in-progress Materials control

Issues to production (indirect) Production overhead Materials control

Returns from production Materials control Work-in-progress

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Returns to supplier Payables Materials control

Differentiating direct materials and indirect materials is essential because they are accounted for differently:
1.2.2 Accounting for Direct Materials

Direct materials would be directly accounted for in work-in-progress.

 Issue of direct materials to production
Dr Work-in-progress

Cr Materials control

1.2.3 Accounting for Indirect Materials

Indirect materials would be transferred into a production overheads account for subsequent absorption into
work-in-progress.
 Issue of Indirect materials to production
Dr Production overheads

Cr Materials control

1.2.4 Absorption of Production Overheads
Production overheads (which include all indirect production costs) would be absorbed into production.
 Absorption of production overheads into production
Dr Work-in-progress

Cr Production overheads

1.2.5 Transfer To Finished Goods
Completed units would be transferred from work-in-progress to finished goods.
 Transfer to finished goods
Dr Finished goods

Cr Work-in-progress

1.2.6 Sale Of Finished Goods
The value of finished goods sold would be recognised as the cost of goods sold in the statement of profit
and loss.
 Sale of finished goods
Dr Cost of goods sold

Cr Finished goods

1.2.7 Material Control (T-account)
The accounting entries for the issue and return of materials can be displayed in a T-account format.

Materials control

Dr $ Cr $
Work-in-progress control X Work-in-progress control X

(direct materials returned to stores) (direct materials issued)

Payables X Production overheads control X

(materials purchased on credit) (indirect materials issued)

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Payables X

(materials returned to suppliers)

Example

The following is an example of some materials transactions:

1. The opening balance of cotton in the materials control account is a $4,000 debit balance.
Materials control account – cotton
$ $

Opening balance 4,000

2.
3. The fabric company Cotton Co supplies cotton to Furniture Co at the cost of $48,000. This transaction
increases the company’s assets as a debit in the materials control account.
Materials control account – cotton

$ $
Opening balance 4,000
Payables (materials purchased on credit) 48,000

4.
5. A return of cotton to the suppliers because it was damaged, valued at $2,000, is posted as a credit,
which decreases the company’s assets.
Materials control account – cotton
$ $
Opening balance 4,000 Payables (returns to 2,000
supplier)

Payables (materials purchased 48,000

on credit)

6.
7. The production department requests cotton worth $38,000, which is recorded as a credit to the
materials control account.
Materials control account – cotton

$ $
Opening balance 4,000 Payables (returns to supplier) 2,000
Payables (materials purchased on 48,000 Work-in-progress control (issued to 38,000
credit) production)

8.
9. The production department returns $3,500 of cotton to stores because it was not needed, which is
recorded as a debit.
Materials control account – cotton
$ $

Opening balance 4,000 Payables (returns to supplier) 2,000

Payables (materials purchased on 48,000 Work-in-progress control (issued 38,000
credit) to production)

Work-in-progress control (returns 3,500

to stores)

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Example

10.
11. The closing balance of $15,500 at the end of the period is the balancing figure in the materials control
account and is the opening debit balance for the next period.
Materials control account – cotton
$ $
Opening balance 4,000 Payables (returns to supplier) 2,000
Payables (materials purchased on 48,000 Work-in-progress control (issued 38,000
credit) to production)
Work-in-progress control (returns 3,500 Closing balance 15,500
to stores)

55,500 55,500
Opening balance 15,500

2.1.3 Inventory Control and Costing System

1.3 Inventory Control and Costing System

Inventory control is managing the quantity of each item and knowing where it is. In addition, it involves
recording inventory received and issued and identifying any damage or obsolescence.
Modern inventory systems use electronic methods to identify items of inventory. For example, barcodes and
scanners are often used, or QR codes (a type of barcode) and smartphones.
The data from the inventory control system is usually part of the management information system, which
includes the costing system.
Modern data capture methods provide cost accountants with real-time inventory information.
Once an order is placed, the dispatch of goods sold can be immediately updated by warehouse staff using
hand-held computers. Then, it is uploaded into the accounting system, and the sale is recorded directly and
without delay.
Cost accountants can run reports to find out,
 How many units have been sold that day or hour;
 How many units of raw materials have been issued to production, and at what price;
 How many units are remaining; and
 When the following order is due to be delivered.

Example

Furniture Co uses varnish to protect its wooden furniture products.

Note that these transactions are recorded and authorised directly within the computerised accounting system.
The information shown below will be presented and authorised digitally.
1. Requisitioning purchase of materials.
When Furniture Co’s stores department needs to buy new varnish, it must first complete a purchase
requisition and send it to the purchasing department.

When the purchasing department receives the purchase requisition, it will authorise it and order the
materials.

2. Ordering materials
The purchasing department sends an authorised purchase order to the varnish suppliers.

3. Receiving Materials
When the varnish is received into stores, the stores department will record the goods received into the
stores system and cross-check with the purchase order to check that the delivery matches the order.

4. Processing Payment
The purchasing department will compare the invoice from the supplier to the goods received records and
purchase order to verify its authenticity and authorise it for payment. When payment is due, the accounts

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Example

department will make the payment.

5. Issuing Materials
The workshop may now request for the varnish to be issued by stores to the workshop by initiating a
materials requisition.

There are two other types of records relating to the movement of materials.
 A materials return – unused materials returned to the stores department are recorded.
 A materials transfer – records of transfers of materials between different departments.
Activity 1

Determine if the statement is true or false.

Statement True or false

A materials requisition informs the company’s suppliers False

that it wishes to buy some materials from them A company sends a purchase order to buy from
suppliers.

Before a company pays its suppliers, the accounts False

department matches the goods received with the The accounts department matches the goods
materials requisition and the supplier's invoice. received with the purchase order and invoice
received before payment.

A purchase requisition is created by the production False

department when it requires more materials. A materials requisition is sent from the production
department to the stores department when it
requires more materials.
2.1.4 Recording Inventory
1.4 Recording Inventory

When materials are received in a company’s warehouse, they will be stored until the production department
needs them.
The inventory for each material will be recorded in the relevant materials control account within the
computerised accounting system.
Each time an entry is made in the materials control account, detailed information in respect of inventory
valuation is simultaneously recorded. In most accounting systems this information can be accessed by
‘drilling down’ from the figures in the materials control account.
An example of this detailed inventory valuation information (also called a stores ledger account) for wood
units at Furniture Co for June is shown below.

The inventory is valued using the cumulative weighted average method, which is discussed later in this
chapter.
2.1.5 Inventory Control
1.5 Inventory Control

Inventory is one of the highest costs for many organisations. Any organisation with inventory will undertake
checks to ensure that the items they think are in their stores are there. It also allows staff to check if there
has been any damage to the inventory.

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Stocktaking is one way in which organisations check inventory. It involves physically counting the materials
held and checking the figures against records detailing the quantity of materials the organisation should
have.

Example: Continuous Stocktaking

Note that an error still occurred and was discovered later in the day.

There are two methods of stocktaking:

 Periodic: Materials in the inventory are counted once a year.
 Continuous: Materials are checked regularly throughout the year (this method can be less
disruptive for organisations and more accurate).
2.1.6 Inventory Discrepancies
1.6 Inventory Discrepancies

Any difference between the inventory records and monitoring inventory (a physical stocktake) should be
investigated.
A company must ensure that it has adequate controls in place to minimise differences between physical
inventory counts and inventory records. These differences are known as discrepancies.
Inventory checks may reveal discrepancies between how much of an item is in inventory and the amount
shown in the inventory records.
There are many reasons for a discrepancy, and there are also ways to counteract the causes.

Reason for discrepancy Control

The quantity of goods delivered differs from what is shown All inventory should be counted as it is received
on the delivery note. and signed off.

The actual quantity of inventory issued to production Inventory issued to production should be carefully
differs from that shown in the records. counted and signed off.

Production returned excess inventory without any record All movements of inventory should be recorded.
being made in the system.

Theft of inventory by employees. Security mechanisms and regular inventory checks

will prevent this.

Inventory is damaged or obsolete and thrown away Damaged or obsolete items should be recorded.
without any record being made in the system.

1.6.1 Storing Goods

A sound warehousing system for keeping inventory accessible and secure should consider the following:
 Frequency of use and location in the warehouse
 Dangerous items and chemicals
 Special needs such as light, temperature, clean air, or hygiene requirements
 Security for valuable or high-risk items

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Activity 2

Match the discrepancy to the appropriate control.

Discrepancy Control

The quantity of goods delivered differs from what is shown in Inventory issued to production should be carefully
the record of goods received. counted and approved.(2)

The actual quantity of inventory issued to production differs All inventory should be counted as it is received
from that shown in the records. and approved.(1)

The production department returned unused inventory without Warehouse security and frequent stocktaking.(4)
any record being made in the system.
All movements of inventory should be recorded.
Theft of inventory by employees. Material returns might be used.(3)

Inventory is damaged or obsolete (out-of-date) and thrown Any items of inventory that are damaged or out-of-
away without any record being made in the system. date should be recorded.(5)

2.2.1 Inventory Valuation Methods

2.1 Inventory Valuation Methods

Organisations may frequently buy the same item but pay varying prices at different times.
For example, a furniture manufacturer will buy a lot of cotton cloth at different times and pay varying prices;
it may be challenging to keep track of the value of fabric used in production and the remainder in its
warehouse.
So how much is the cloth in their warehouse worth?
There are several different methods of calculating inventory value:
 First-in, first-out (FIFO)
 Last-in, first-out (LIFO)
 Cumulative weighted average pricing (CWA)
 Periodic weighted average pricing (PWA)
2.2.2 FIFO and LIFO
2.2 FIFO and LIFO

FIFO assumes that the inventory purchased first is sold first. So, the materials in stock at the end of a period
are valued using the most recent prices paid to suppliers.
LIFO assumes that the inventory purchased last is sold. So, the materials in stock at the end of a period are
valued using the oldest unit prices paid to suppliers.

FIFO LIFO

Goods sold Oldest first Newest first

Closing inventory valued at Latest prices Oldest prices

2.2.3 FIFO Calculation
2.3 FIFO Calculation

Example: FIFO Calculation

The following material movements have been recorded:

Quantity Value ($) Balance (Units) Balance ($)

1 Raw materials opening balance 20 20 100

May

12 Receipt of raw materials 30 180 50 280

May

13 Issue of raw materials (25) 25

May

20 Receipt of raw materials 20 160 45

May

26 Issue of raw materials (35) 10

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Example: FIFO Calculation

May

Closing balance 10
Compute the value of issues and closing inventory for May using FIFO.
Answer:

Value of purchase/issue Closing inventory balance

Date transaction Quantity $ per Value Balance $ per Balance
unit ($) (Units) unit ($)

1 Raw materials 20 20 5 100

May opening
balance

12 Receipt of raw 30 6 180 20 5 100

May materials
30 6 180

13 Issue of raw (20) 5 100 NIL 5 NIL

May materials
(25 units)

(5) 6 30 25 6 150
(25) 130
20 Receipt of raw 20 8 160 25 6 150
May materials

20 8 160
26 Issue of raw (25) 6 150 NIL 6 NIL
May materials
(35 units)

(10) 8 80 10 8 80
(35) 230

Closing balance 10 8 80
Observations:
 Purchases are reflected separately from existing inventory, as their purchase prices may differ.
 Issues are always subtracted from the earliest inventory and valued at the earlier price.
 When earlier inventory is exhausted, the issue is from the preceding earliest inventory.
 Closing inventory is valued at the latest prices.
2.2.5 Weighted Average Methods (CWA and PWA)
2.5 Weighted Average Methods (CWA and PWA)

The cumulative weighted average approach calculates the average cost per unit every time a new material
receipt occurs by dividing the total cost of held inventory by the total number of units in stock. This price is
used to value all issues to production until another delivery is received. The closing inventory is valued
using the most recently calculated weighted average price.
The periodic weighted average calculates a single weighted average cost per unit at the end of each
accounting period (rather than whenever inventory is purchased). This single weighted average price is used
to value all the issues to production and the closing inventory for the period.

(COST OF ALL RECEIPTS FOR THE PERIOD + COST OF OPENING INVENTORY)

÷ (UNITS RECEIVED FOR THE PERIOD + UNITS OF OPENING INVENTORY)
= PERIODIC WEIGHTED AVERAGE PRICE

CWA PWA

Frequency of price Every time upon receipt of new At the end of the period.
calculation material

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Price of issued material At the latest calculated weighted At the average price for the period.
average price
2.2.6 CWA Calculation
2.6 CWA Calculation

Example: CWA Calculation

The following material movements have been recorded:

Quantity Value Balance Balance

($) (Units) ($)

1 Raw materials 20 20 100

May opening balance

12 Receipt of raw 30 180 50 280

May materials

13 Issue of raw (25) 25

May materials

20 Receipt of raw 20 160 45

May materials

26 Issue of raw (35) 10

May materials

Closing balance 10
Compute the value of issues and closing inventory for May using CWA.
Answer:

Value of purchase/issue Closing inventory

balance
Date transaction Quantity $ per Value Balance $ per Balance
unit ($) (Units) unit ($)
1 Raw 20 20 5.00 100.00
May materials
opening
balance
12 Receipt of 30 6.00 180.00 50 5.60 280.00
May raw
materials

13 Issue of 25 5.60 140.00 25 5.60 140.00

May raw
materials
(25 units)

20 Receipt of 20 8.00 160.00 45 6.67 300.00

May raw
materials
26 Issue of 35 6.67 233.45 10 6.67 66.55
May raw
materials
(35 units)

Closing balance 10 6.67 66.55

Observations:
 Purchases are aggregated with existing inventory, and a new weighted average price is computed.
 Issues are always valued at the latest weighted average price.
 Closing inventory is valued at the latest weighted average.
2.2.7 PWA Calculation
2.7 PWA Calculation

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Example: PWA Calculation

The following material movements have been recorded:

Quantity Value Balance Balance

($) (Units) ($)

1 Raw materials 20 20 100

May opening balance

12 Receipt of raw 30 180 50 280

May materials

13 Issue of raw (25) 25

May materials

20 Receipt of raw 20 160 45

May materials

26 Issue of raw (35) 10

May materials

Closing balance 10
Compute the value of issues and closing inventory for May using PWA.
Answer:

Quantity Value ($)

1 May Raw materials opening balance 20 100

12 May Receipt of raw materials 30 180

20 May Receipt of raw materials 20 160

Total 70 440
PWA price per unit = $440 ÷ 70
PWA price per unit = $6.29
Value of closing inventory = $6.29 × 10
Value of closing inventory = $62.86
Value of issues:

Quantity $ per unit $

13 May Issue of raw materials (25) 6.29 157.14

26 May Issue of raw materials (35) 6.29 220.15

Observations:
 Purchases are aggregated with opening inventory, and a periodic weighted average (PWA) price is
computed for the period.
 Issues are valued at the PWA price
 Closing inventory is valued at the PWA price.
2.2.8 Practice
2.8 Practice

Activity 3

Furniture Co has had three deliveries of cotton in the last month:

Units $ per unit

1 January 50 70

15 January 20 85

30 January 35 80

On 2 January, 30 units were issued (from Furniture Co's storage warehouse) to production.

On 16 January, 30 units were issued to production.

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On 31 January, there were 45 units left in inventory.

Calculate the value of the 45 units in closing inventory using the following methods:

. FIFO
. LIFO
. Cumulative weighted average
. Periodic weighted average
*Please use the notes feature in the toolbar to help formulate your answer.

. FIFO

Value of purchase/issue Closing inventory

balance
Date transaction Quantity $ per Value Balance $ per Balance
unit ($) (Units) unit ($)

1 Receipt of 50 70 3,500 50 70 3,500

January raw
materials
2 Issue of (30) 70 2,100 20 70 1,400
January raw
materials
(30 units)
15 Receipt of 20 85 1,700 20 70 1,400
January raw
materials

20 85 1,700
16 Issue of (20) 70 1,400 NIL 70 NIL
January raw
materials
(30 units)
(10) 85 850 10 85 850
(30) 2,250
30 Receipt of
January raw 35 80 2,800 10 85 850
materials

35 80 2,800
31 Closing
45 3,650
January balance

.
. LIFO

Value of purchase/issue Closing inventory

balance

Date transaction Quantity $ per Value Balance $ per Balance

unit ($) (Units) unit ($)

1 Receipt of 50 70 3,500 50 70 3,500

January raw
materials
2 Issue of (30) 70 2,100 20 70 1,400
January raw
materials
(30 units)

15 Receipt of 20 85 1,700 20 70 1,400

January raw
materials

20 85 1,700

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16 Issue of (10) 70 700 10 70 700

January raw
materials
(30 units)

(20) 85 1,700 NIL 85 NIL

(30) 2,400
30 Receipt of
January raw 35 80 2,800 10 70 700
materials
35 80 2,800

31 Closing
45 3,500
January balance

.
. Cumulative average

Value of purchase/issue Closing inventory

balance
Date transaction Quantity $ per Value Balance $ per Balance
unit ($) (Units) unit ($)
1 Receipt of 50 70 3,500 50 70 3,500
January raw
materials

2 Issue of (30) 70 2,100 20 70.00 1,400

January raw
materials
(30 units)

15 Receipt of 20 85 1,700 40 77.50 3,100

January raw
materials
16 Issue of (30) 77.5 2325 10 77.50 775
January raw
materials
(30 units)

30 Receipt of
January raw 35 80 2,800 45 79.44 3,575
materials
31 Closing
45 3,575
January balance

.
. Periodic average

Issue cost per unit

.
= (3,500 + 1,700 + 2,800) / (50 + 20 + 35)

.
= $8,000 / 105

.
= 76.19 per unit

.
Value of closing balance

.
= $76.19 × 45 units

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.
=$3428.55

.
Activity 4

Furniture Co inventory details for June 20X1

Quantity Unit cost

(Units) $

Opening inventory 1 June 20 50.00

Purchases 5 June 40 55.00

Issues 7 June 45

Purchases 10 June 50 45.00

Issues 12 June 35

Issues 17 June 15

Purchases 25 June 50 50.00

Closing inventory 30 June 65

Calculate the value of the 65 units in closing inventory at the end of June 20X1 using the following methods:

. FIFO
. LIFO
. Cumulative weighted average
. Periodic weighted average
*Please use the notes feature in the toolbar to help formulate your answer.

. FIFO

The value of the 65 units of closing inventory is $3,175:

.
50 units at $50 per unit (the cost of the most recently purchased units in inventory)

.
15 units at $45 per unit (the cost of the second most recently purchased units in inventory)

.
. LIFO

The value of the 65 units of closing inventory is $3,250:

.
65 units at $50 per unit (the cost of the remaining oldest units in inventory and the latest purchase)

.
. Cumulative weighted average

Value of purchase/issue Closing inventory

balance

Date transaction Quantity $ per Value Balance $ per Balance

unit ($) (Units) unit ($)

1 Opening 20 50.00 1,000

June Inventory

5 Purchases 40 55.00 2,200 60 53.33 3,200

June

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7 Issues (45) 53.33 2,400 15 53.33 800

June
10 Purchases 50 45.00 2,250 65 46.92 3,050
June

12 Issues (35) 46.92 1,642 30 46.92 1,408

June

17 Issues (15) 46.92 704 15 49.92 704

June

25 Purchases 50 50.00 2,500 65 49.29 3,204

June

30 Closing 65 3,204
June balance

.
. Periodic weighted average

Issue cost per unit

.
= (1,000 + 2,200 + 2,250 + 2,500) / (20 + 40 + 50 + 50)

.
= $7,950 / 160

.
= 49.69 per unit

.
Value of closing balance

.
= $49.69 × 65 units

.
=$3,229.85

.
Activity 5

Furniture Co has had three metal deliveries during May and two issues to the sofa production department.

Date Units received Units issued

1 May 25 at $100 each

2 May 10

15 May 10 at $105 each

16 May 20

30 May 10 at $120 each

Calculate the value of the material issues and closing inventory using the following:

1. FIFO
2. LIFO
3. Periodic weighted average
4. Cumulative weighted average
*Please use the notes feature in the toolbar to help formulate your answer.

1. FIFO

On 1 May, 25 units were received at a value of $100 each

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2.
On 2 May

3.
10 units were issued to production at $100 per unit

4.
15 units remained in inventory

5.
Total value of issue = 10 × $100 = $1,000

6.
On 15 May, 10 units were received at a value of $105 each

7.
On 16 May

8.
20 units were issued to production

9.
15 of these units were valued at $100 per unit (the cost of the oldest units in inventory, from the 1 May
purchase) = $1,500

10.
5 of these units (from the 15 May purchase) were valued at $105 per unit (the cost of the most recent units in
inventory from the 15 May purchase) = $525

11.
Total value of issue = $1,500 + $525 = $2,025

12.
On 30 May, 10 units were received at a value of $120 each

13.
Value of the 15 units of closing inventory

14.
5 units at $105 per unit (the cost of the units purchased on 15 May purchase) = $525

15.
10 units at $120 per unit (the cost of the most recent units in inventory from the 30 May purchase) = $1,200

16.
Total value of closing inventory = $(525 + 1,200) = $1,725

17.
Check this as follows:

18.
Total receipts:

19.
1 May = 25 × $100 = $2,500

20.
15 May = 10 × $105 = $1,050

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21.
30 May = 10 × $120) = $1,200

22.
Total receipts = $(2,500 + 1,050 + 1,200) = $4,750

23.
Total value of issues: 2 May = $1,000 and 16 May = $2,025 = $3,025

24.
Value of inventory at 30 May = total value of receipts − total value of issues

25.
= $(4,750 − 3,025) = $1,725

26.
27. LIFO

On 1 May, 25 units were received at a value of $100 each

28.
On 2 May

29.
10 units were issued to production at $100 per unit

30.
Total value of issue = 10 × $100 = $1,000

31.
15 units remained in inventory

32.
On 15 May, 10 units were received at a value of $105 each

33.
On 16 May

34.
20 units were issued to production

35.
10 of these units were valued at $105 per unit (the cost of the newest units in inventory from the 15 May
purchase) = $1,050

36.
10 of these units (from the 1 May purchase) were valued at $100 per unit (the cost of the second oldest units
in inventory, from the 1 May purchase) = $1,000

37.
Total value of issue = $1,050 + $1,000 = $2,050

38.
On 30 May, 10 units were received at a value of $120 each

39.
Value of the 15 units of closing inventory

40.
5 units at $100 per unit (the cost of the oldest units in inventory from the 1 May purchase) = $500

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41.
10 units at $120 per unit (the cost of the most recent units in inventory from the 30 May purchase) = $1,200

42.
Total value of closing inventory = $(500 + 1,200) = $1,700

43.
Check this as follows:

44.
Total receipts:

45.
1 May = 25 × $100 = $2,500

46.
15 May = 10 × $105 = $1,050

47.
30 May = 10 × $120) = $1,020

48.
Total receipts = $(2,500 + 1,050 + 1,020) = $4,750

49.
Total value of issues: (2 May = $1,000) and (16 May = $2,050) = $3,050

50.
Value of inventory at 30 May = total value of receipts − total value of issues

51.
= $(4,750 − 3,050) = $1,700

52.
53. Periodic weighted average

This method involves totalling the value of the units received and dividing this by the total number of units
received.

54.
Total value of units received = (25 × $100) + (10 × $105) + (10 × $120) = $(2,500 + 1,050 + 1,200) = $4,750

55.
Total number of units received = 25 + 10 + 10 = 45

56.
Average issue price = $4,750/45 = $105.56 per unit

57.
The value of the 15 units of closing inventory is 15 × $105.56 = $1,583.33

58.
59. Cumulative weighted average
Date Metal units Metal units Balance of metal units Total inventory Average cost
received issued in inventory value ($) per unit ($)

1 May 25 25 2,500 100

2 May 10 (1,000) 100

15 1,500 100

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15 May 10 1,050 105

25 2,550 102

16 May 20 (2,040) 102

5 510 102

30 May 10 1,200 120

Closing 15 1,710 114

inventory

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Chapter 3: Managing Inventory

3.1.1 Inventory Costs
1.1 Inventory Costs

Companies hold stock to ensure sufficient supply to meet customer demand and prevent production delays.
They will need to manage the costs of inventory.

Inventory Description
cost

Purchase The price paid for inventory.

cost
Includes the price paid and any applicable taxes and charges.

Total purchase cost for the period = Units purchased in the period × Unit purchase price

Ordering Costs incurred for ordering inventory

cost
Includes transport and administration costs.

Ordering cost for the period = Number of orders in period ×Cost per order

Holding cost Costs incurred for holding inventory.

Includes storage, finance costs, security, insurance, obsolescence, deterioration, spoilage,
theft, etc

Holding cost for the period = Average inventory held for the period × holding cost per unit
for the period

Stockout Costs are incurred if inventory is unavailable.

cost
Includes price premiums for emergency supplies, lost sales revenue, and incentives to retain
dissatisfied customers.

1.1.1 Obsolescence

Definition

Obsolescence – Reduction in inventory value due to it becoming irrelevant to the organisation’s needs.
Reduction in the value of inventory due to it becoming irrelevant to the organisation’s needs.
For example, it is not advisable to hold stocks of tech products for extended periods, as they are eventually
surpassed by new tech and become less valuable.
1.1.2 Deterioration

Definition

Deterioration – Reduction in inventory value due to degradation in its qualities.

Reduction in the value of inventory due to degradation in its qualities.
For example, fresh produce degrades rapidly after harvesting and would be unusable after a few days unless
kept fresh with refrigeration or further processing.
Obsolete and deteriorating inventory would eventually be discarded and written off.

Example

Computer Co uses 20,000 units of computer parts each year, and each unit costs $20.
It orders 5,000 units every time it places an order, and it costs $1,400 to place an order.

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Example

Computer Co holds an average level of inventory of 2,500 units.

The holding cost is 10% of the value of the average inventory held.
Calculate Computer Co’s costs of total inventory cost for the year, including purchase, holding, and ordering
costs.
Answer:
 Purchase costs for the year
Total purchase cost = total units purchased × Purchase price

Total purchase cost = 20,000 × $20

Total purchase cost = $400,000

 Holding cost
Holding cost = 10% × value of the average inventory held

Average inventory held = 2,500

Value of average inventory held = 2,500 × $20 = $50,000

Holding cost = 10% × $50,000 = $5,000

It costs Computer Co $5,000 to hold the stock of computer parts for a year.

 Ordering cost
Number of orders in a year = Demand / Order quantity

Number of orders in a year = 20,000 / 5,000 = 4 orders in a year

Computer Co will place 4 orders in a year, and each order will cost $1,400 per order.

Total ordering costs for the year = 4 × $1,400 = $5,600

 Total inventory costs for the year
Total purchase costs for the year = $400,000

Total ordering costs for the year = $5,600

Total holding costs for the year = $5,000

Total inventory costs for the year = $(5,600 +5,000 + 400,000) = $410,600

1.1.3 Buffer inventory
Buffer inventory is the minimum amount of inventory an organisation should hold in stock to deal with an
unexpected rise in the demand for its products. Hence, it is sometimes called safety stock or safety
inventory.
1.1.4 Just-in-Time
Holding inventory incurs expenses. It must be stored, financed, secured, and kept in good condition.
Ordering 'just-in-time' (only when production is ready to use the materials) minimises inventory holding
costs.
 Production should only make as many units as can be sold.
 There will be no inventory of raw materials or finished goods.
 Smaller, more frequent deliveries are required at short notice.
 A few dedicated suppliers deliver defect-free components just in time when the parts are demanded
on the production line.
However, this increases the risk of “stock-out”, where no inventory is available for production or sales.
To mitigate this risk, companies build robust, integrated relationships with their suppliers or diversify their
sources of supply.

3.2.1 Managing Inventory Costs

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2.1 Managing Inventory Costs

Managing the different inventory costs is a balancing act, as they depend on each other.
2.1.1 Order Size
For example, it is often cheaper for organisations to buy materials in bulk (suppliers may offer a discount on
large orders). However, this can make holding costs more expensive, as there are more goods to store, and
they could become damaged or obsolete over time.

2.1.2 Stockout Costs

Another problem is the potential cost of running out of materials. If an organisation holds too much
inventory, it will have higher holding costs than it needs to. On the other hand, if it maintains too little
inventory, there is a risk of running out, known as a stockout.
Stockout costs include:
 Loss of sales during the stockout period
 Loss of reputation
 Customers switching to competitor products and continuing to buy from competitors in the future
 Cost of production stoppages (machinery and workers are idle)
 Extra ordering costs for urgent orders.
2.1.3 Balancing Inventory Costs
Balancing inventory costs is part of inventory control, which involves:
 Holding the right amount of inventory
 Valuing inventory issued and remaining
 Ordering goods
 Receiving and storing goods.
3.2.2 Inventory Control: Reorder Level
2.2 Inventory Control: Reorder Level

Organisations must pick an optimum amount of inventory to hold that minimises their overall cost.
Maintaining an optimum inventory level minimises costs. Achieving this level requires knowing the following:
 When to order? Organisations need to consider the lead time for an order − this is the time between
placing and receiving an order for materials
 How much to order? As noted, organisations must avoid holding too much or too little inventory.
Key Term

Lead time– The waiting time to receive goods after placing an order.

2.2.1 Reorder Level

Key Term

Reorder level – The inventory level held at which the company should place an order to minimise
inventory holding costs and stockout risk.
When the reorder level is reached, it signals that it is time for a company to place a new order with its
suppliers.
When an order is placed, there will be a gap between when the order is placed and when it is delivered; this
time gap is known as the lead time.

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If a company miscalculates the reorder level, it might be left without any products in stock (this is a
stockout), and the company would not be able to fulfil its customers’ orders.
The reorder level formula is

reorder level = maximum usage × maximum lead time

Must be memorised; not provided in the MA exam

Example

The following data relate to Material P, which is held in the stores of LBR Co.
 Minimum daily usage 450 units
 Maximum daily usage 800 units
 Minimum lead time 5 days
 Maximum lead time 10 days.
Daily demand for Material P is constant.
Calculate the reorder level for Material P.
Answer:
Reorder level = maximum usage × maximum lead time
Reorder level = 800 × 10 = 8,000 units

3.2.3 Inventory Control: Other Control Levels

2.3 Inventory Control: Other Control Levels

The reorder level may be used to calculate some other control levels for inventory.
2.3.1 Maximum Inventory level
Inventory held above this level is incurring excessive holding costs.

Maximum inventory level = reorder level + reorder quantity − (minimum usage × minimum lead time)

2.3.2 Average inventory level

The level of inventory is somewhere between the maximum and minimum inventory levels.

Average inventory level = buffer inventory + (order quantity / 2)

2.3.3 Minimum inventory level

There is a severe risk of stockout if the amount of inventory held is below this level.

Minimum inventory level = reorder level − (average usage × average lead time)

Example: Inventory Control Levels

The following information is available for a decorative component used in a cabinet design at Furniture Co:

Average usage 1,000 per day

Minimum usage 800 per day

Maximum usage 1,300 per day

Lead time for replenishment 5 to 15 days

Reorder quantity 20,000 units

Reorder Level
The level of inventory at which more should be ordered. This is to ensure there is enough inventory to supply
maximum production.

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Example: Inventory Control Levels

Reorder level
= Maximum usage × Maximum lead time

For T-shirt Co,

Reorder level
= 1,300 × 15
= 19,500
Minimum Level
The inventory level indicates a high risk of stockout. Often used as the buffer inventory level.

Minimum Level
= Reorder level − (average usage × average lead time)

For Furniture Co,

Minimum level
= 19,500 − (1,000 × 10)
= 9,500
Maximum Level
The maximum level warns that inventory holding is too high and more expensive than necessary.

Maximum level
= Reorder level + Reorder quantity − (Minimum usage × Minimum lead time)

For T-Shirt Co,

Maximum level
= 19,500 + 20,000 − (800 × 5)
= 35,500
Average Level
The inventory level is midway between minimum and maximum levels.

Average level
= Minimum level + (reorder quantity / 2)

For T-Shirt Co,

Average level
= 9.500 + (20,000 / 2)
= 9,500 + 10,000
= 19,500

Activity 1

Match the inventory level with its formula.

Inventory level Formula

Average inventory level Reorder level − (average usage × average lead time)

Minimum inventory level Reorder level + reorder quantity − (minimum usage × minimum lead time)

Reorder level Buffer inventory + (order quantity/2)

Maximum inventory Maximum usage × maximum lead time

*Please use the notes feature in the toolbar to help formulate your answer.

Inventory level Formula

Average inventory level Buffer inventory + (order quantity/2)

Minimum inventory level Reorder level − (average usage × average lead time)

Reorder level Maximum usage × maximum lead time

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Maximum inventory Reorder level + reorder quantity − (minimum usage × minimum lead time)

Activity 2

The following information is available for raw materials:

Average usage 200 per day

Minimum usage 150 per day

Maximum usage 280 per day

Lead time for replenishment 8–10 days

Reorder quantity 3,000 units

Calculate the inventory control levels:

. Reorder level
. Minimum inventory level
. Maximum inventory level
. Average inventory level
*Please use the notes feature in the toolbar to help formulate your answer.

. Reorder level

= Maximum usage × Maximum lead time

.
= 280 × 10

.
= 2,800

.
. Minimum Level

= Reorder level − (average usage × average lead time)

.
= 2,800 − (200 × 9)

.
= 1,000

.
. Maximum level

= Reorder level + Reorder quantity − (Minimum usage × Minimum lead time)

.
= 2,800 + 3,000 − (150 × 8)

.
= 4,600

.
. Average level

= Minimum level + (reorder quantity / 2)

.
= 1,000 + (3,000 / 2)

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= 1,000 + 1,500

.
= 2,500

.
3.3.1 Economic Order Quantity (EOQ)
3.1 Economic Order Quantity (EOQ)

There is a balance between the costs and benefits of ordering large amounts of inventory and holding
inventory:
 Inventory holding costs rise as the level of inventory rises, so ordering smaller amounts from
suppliers each time will reduce holding costs
 Ordering costs rise as the number of orders rises, so placing fewer but larger orders would reduce
order costs.

Economic order theory finds the optimal balance between ordering costs (which increase with more orders)
and holding costs (which increase when more inventory is held due to large order sizes).
The Economic Order Quantity (EOQ) is the level of stock that minimises the total inventory holding costs and
ordering costs.
The EOQ can be estimated using a graph that shows the holding costs, ordering costs and total costs at
different activity levels. The estimated EOQ is the point at which the holding and ordering costs are equal.
There are a few assumptions that apply to this theory:
 The holding cost per unit is constant
 Average inventory is held = minimum or buffer inventory + (Order quantity / 2)
3.1.1 EOQ Formula
EOQ is calculated using the following formula:

Variable Description

CH cost of holding one unit of inventory for one time period

Co cost of ordering a consignment from a supplier

D Demand during period

Example: EOQ

A department store sells 10,000 blouses a year. The cost of placing one order is $5. The cost of holding a blouse
in inventory for one year is $10.
What is the EOQ?
Solution:

​ ​
= 100 units

Activity 3

The following information relates to Glass Co.

Demand for glass is 10,000 square metres (m2) a year. The cost of placing an order of any amount for glass
is $50. The cost of holding one m2 of glass is $100 a year.

What is the EOQ of glass?

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*Please use the notes feature in the toolbar to help formulate your answer.

Co = Cost of ordering = $50

D = Number of units demanded each year = 10,000

Ch = Cost of holding one unit of product for one year = 100

EOQ = 100
Activity 4

. A car manufacturer sells 75,000 cars a year. Each vehicle needs five tyres. The cost of placing one
order for tyres is $10. The cost of holding a tyre in inventory for one year is $25.
What is the EOQ?

.
.
A manufacturing company has an EOQ of 1,000 for Component A. It uses 15,000 of these components a year.
The minimum inventory level is 4,000. The cost of holding one component in inventory for a year is $0.60.

.
What is the total cost of holding inventory for the component for a year?

.
. A company uses 65,000 units of raw material each year. It places orders in batches of 1,500, which
is its EOQ. The minimum inventory level is 2,000. The cost of holding one unit in inventory for a year is
$0.25.
What is the total cost of holding inventory for the component for a year?

.
*Please use the notes feature in the toolbar to help formulate your answer.

B)The total cost of holding inventory for the component for a year is:

The cost of holding one component for a year x the average inventory level.

.
Average inventory level

.
= minimum inventory level + EOQ/2

.
= 4,000 + 1,000 / 2

.
= 4,500

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The total cost of holding inventory for a year

.
= 4,500 × $0.60

.
=$2,700

.
. The total cost of holding inventory for the component for a year is:

The cost of holding one component for a year x the average inventory level.

.
The average inventory level

.
= minimum inventory level + EOQ / 2

.
= 2,000 + 1,500 / 2

.
= 2,750

.
The total cost of holding inventory for a year

.
= 2,750 × $0.25

.
=$687.50

.
Key Point

It’s crucial to ensure the period is [Link] the holding cost is expressed for a year, then demand should
also be for a year.

3.1.2 Applying EOQ

 The number of orders = Demand/EOQ
 The average inventory held = equal to half of the EOQ = EOQ/2 + buffer inventory
This is because as the order arrives, 100% of the stock is available, and at the end, there will not be any
stock remaining (0%), so on average, there will be 50% available (plus whatever buffer stock is kept).

 Total ordering costs = Demand/EOQ × Co (cost per order)
 Total holding costs = Average inventory × Ch (cost of holding a unit for a year)
 The total cost of ordering and holding costs = (Demand/EOQ × Co) + (Average inventory × Ch)
 Total inventory cost = total holding cost + total ordering cost + total purchase cost
3.3.2 Economic Order Quantity with Discounts
3.2 Economic Order Quantity with Discounts

Sometimes a supplier may offer an organisation discounts on the materials it buys based on the quantity it
orders.
Accepting a supplier’s discount will affect the purchase price of material and the ordering and holding costs.
 The unit cost of purchasing materials from suppliers will fall
 The total cost of placing orders will also fall, assuming the size of each order increases
 The cost of holding materials will rise as the average inventory levels rise.
3.2.1 Approach
Compare the total costs for the year without the discount with the total costs with the discount.

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1. Calculate total inventory costs using EOQ

1. The total cost of purchasing the quantity of product needed for the year
2. The total ordering costs for the year
3. The total holding costs for the year
2. Calculate total inventory costs using discounted order quantity

1. The total cost of purchasing the quantity of product needed for the year
2. The total ordering costs for the year
3. The total holding costs for the year
3. Compare total inventory costs of EOQ and discounted order quantity
If EOQ costs > discounted order quantity costs, it is cost-effective to accept the discount offered by the
supplier.
If EOQ costs < discounted order quantity costs, it is cost-effective to order using EOQ.

Example

Glass Co uses sand in its production process at a rate of 200,000 units per year. Its supplier, Sand Co, has
offered a discount of 5% if the company buys their sand in batches of 500 units at a time. The company has
accepted the discount. Each unit of sand costs $40 before the discount.
It costs $5 to hold one unit of sand for a year and $200 to place an order for sand.
Calculate the total inventory cost for the year of taking up the discount.
Answer:
 Total purchase costs
200,000 × 0.95 × $40 = $7,600,000 per year

The 0.95 value calculates the purchase costs with a 5% discount (100% − 5% = 95% = 0.95).

 Total holding costs
Average inventory level = 500/2 = 250 units.

Total holding costs = 250 × $5 = $1,250 per year

 Total ordering costs
Number of orders = 200,000/500 = 400 a year

total cost of orders = 400 × $200 = $80,000 per year

 Total inventory costs
The total inventory cost for the year is $(7,600,000 + $1,250 + $80,000) = $7,681,250

Activity 5

Coombe Co has an annual expected demand for a raw material it uses in its production process of 120,000
units. Each unit has a purchase price of $40. It holds no buffer stock.

It calculates that each order costs $500 to administer and $2 to hold a unit of inventory per month.

The supplier is offering a 2% discount on the purchase price if each order made by Coombe Co is a minimum
of 10,000 units.

The number of orders is rounded to two decimal places.

1. Calculate the total inventory cost using EOQ.

2. Calculate the total inventory cost if Coombe Co takes up the discount.
3. Determine whether ordering using EOQ or the discounted order quantity is more worthwhile.
*Please use the notes feature in the toolbar to help formulate your answer.

1. Total inventory cost (EOQ)

EOQ = √((2 × 500 × 120,000) / (2 × 12))

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EOQ = 2,236 units

Average inventory = order quantity / 2

Average inventory = 2,236 units / 2

Average inventory = 1,118 units

Total holding cost = average inventory × holding cost per year

Total holding cost = 1,118 units × (2 × 12)

Total holding cost = $26,832

Number of orders = demand / order quantity

Number of orders = 120,000 / 2,236

Number of orders = 53.67

Total ordering costs = number of orders × cost per order

Total ordering costs = 53.67 × 500

Total ordering costs = $26,835

Total inventory cost = total purchase cost + total ordering costs + total holding costs

Total inventory cost = (120,000 × 40) + 26,835 + 26,832

Total inventory cost = $4,853,667

Theoretically, the total ordering and holding cost using EOQ should be equal.

2. Total inventory cost (discounted order quantity)

Average inventory = 10,000 units / 2

Average inventory = 5,000 units

Total holding cost = 5,000 units × (2 × 12)

Total holding cost = $120,000

Number of orders = 120,000 / 10,000

Number of orders = 12

Total ordering costs = 12 × 500

Total ordering costs = $6,000

Total inventory cost = total purchase cost + total ordering costs + total holding costs

Total inventory cost = (120,000 × 40 × 0.98) + 6,000 + 120,000

Total inventory cost = $4,830,000

3. Most worthwhile order quantity

As the total inventory cost using EOQ ($4,853,667) is higher than if discounted order quantity ($4,830,000)
was accepted, it is more worthwhile for Coombe Co to take up the discount.
Activity 6

Annual demand = 800,000 units

Fixed cost of placing an order = $1,200

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Holding costs = 10% of the price paid

Price (before discounts) = $100

The supplier is offering discounts based on order quantities. The discounts are as follows:

0–4,999 units 0%
5,000–24,999 units 2%
25,000 units and above 3%

Required:

Determine the optimal order quantity.

*Please use the notes feature in the toolbar to help formulate your answer.

Step 1 Calculate EOQ as normal, ignoring discounts:

​ ​ = $100 × 10% = $10 per unit

EOQ = ​ ​ = 13,856 units

Step 2 If EOQ falls within a discount band, recalculate with the adjusted value of ​ ​ :

​ ​ = $100 × 98% × 10% = $9.80

EOQ = ​ ​ = 13,997 units

Step 3 Calculate total annual inventory costs at EOQ and of subsequent discount bands:
Purchase costs Holding costs Order costs Total costs

(D × discounted price) ​ ​ ​ ​

At EOQ $78,400,000 $68,585 $68,580 $78,537,165

(13,997) (800,000 × $98) (6,998.50 × $9.80) ($1,200 × 57.15)
At 25,000 $77,600,000 (800,000 × $97) $121,250 (12,500 × $9.70) $38,400 ($1,200 × 32) $77,759,650

Conclusion:

Optimal order quantity = 25,000 units

3.3.3 Economic Batch Quantity

3.3 Economic Batch Quantity

Batch costing involves producing a specific quantity of a product at a time (batches). Companies that use
batch costing will use Economic Batch Quantity (or EBQ) calculations to decide how many items should be
produced in each batch.
When a batch is produced, it usually requires a machine to be set up for that production batch. This is called
a machine set-up cost. Therefore, the more batches produced, the higher the machine set-up costs.
The number of items in a batch will also affect holding costs.
 Larger batch sizes will produce more items that must be held in stores. Holding costs will therefore
be higher with larger batch sizes.
 Smaller batch sizes will produce fewer items that require storage space before being sold. This
results in lower average stock levels and lower holding costs.
The EBQ model can be shown graphically. The EBQ model is very similar to the economic order quantity
model, but with a slight variation as the fact that inventory is being used as it is simultaneously being
produced is factored in. This means that the highest inventory level is slightly lower than the actual size of
the batch made.

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3.3.1 Economic Batch Quantity formula

Just as there is a formula for the EOQ, there is also one for the EBQ. It is similar, but the equation’s
denominator (bottom line) is slightly different.

Q = Size of batch
Co = Cost of setting up a batch production run
D = Number of units to be produced for the period
Ch = Cost of holding one unit of product for the period
R = Production rate for the period

Example

Glass Co produces glass in batches.

Production is at a rate of 1,000 units each week, and the factory is open for 50 weeks a year.
The weekly demand for glass is 800 units.
Setting up the machine for a production run costs $4,500 for each batch.
The cost of holding one unit of glass in stock for one year is $15.
Calculate the economic batch quantity for Glass Co.
Answer:
Co = $4,500
D = Annual demand rate = weekly demand rate × number of weeks
D= 800 × 50 = 40,000
D = 40,000
Ch is the cost of holding one unit of glass for one year, which is $15 (this is the same as in the EOQ model)
Ch = $15
R = Annual production rate = weekly production rate × number of weeks
= 1,000 × 50 = 50,000
R = 50,000
Applying the EBQ formula;
= ((2 ×4,500 ×40,000)/(15×(1−(40,000/50,000)))0.5
EBQ = 10,954

Key Point

It’s crucial to ensure the period is [Link] the holding cost is expressed for a year, then the demand and
production rates should also be for a year.

3.3.4 EOQ and EBQ compared

3.4 EOQ and EBQ compared

With the EOQ, there is an immediate re-stocking of inventory. However, with the EBQ, inventory is re-stocked
gradually each time a batch is produced.
The main things to note about the EBQ equation are:

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 Co is the cost of setting up a machine for a batch run (compare this to the cost of placing an order
in the EOQ formula)
 A figure for ‘R’ must be calculated if it is not given. ‘R’ is the annual production rate and is not in
the EOQ equation.

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Chapter 4: Labour
4.1.1 Direct and Indirect Labour
1.1 Direct and Indirect Labour

For accounting purposes, labour costs are divided into direct and indirect costs.

Definitions

Direct labour – Labour whose work is directly attributable to producing a product or service.
Indirect labour – Labour not directly attributable to the production of a product or service.

1.1.1 Direct labour costs

Direct labour costs are the costs of labour that can be specifically attributable to a product or service
provision.
Examples of direct labour costs:
 The wages and salaries of workers making a particular product in a factory that manufactures
several products.
 The wages and salaries of workers directly involved in production on a building site where new
houses are being constructed, such as a plumber.
1.1.2 Indirect labour costs
Indirect labour costs are labour costs that cannot be specifically attributable to a product or service
provision.
For example, the wages and salaries of the project managers overseeing the construction of new houses on
a building site are indirect labour costs. This is because they are not directly involved in the building
process.
Activity 1

Determine if the work described is direct or indirect labour

Labour work Classification (direct or indirect)

Plumber fitting bathrooms into new houses direct

Project manager overseeing the building projects indirect

Bricklayers who build the houses direct

Marketing manager − advertising new house for sale indirect

Carpenter making doors in new houses direct

Electrician fixing electrical cables in new houses direct

The architect who visits the site to check that plans are followed indirect

Project manager’s secretary indirect

Activity 2

Classify the labour as either direct or indirect.

Labour Classification (direct or indirect)

Sewing machinist at a clothes manufacturer direct

Factory manager indirect

A hairdresser that cuts hair at a salon direct

Office receptionist indirect

A mechanic who fixes cars at a car workshop direct

A mechanic who fixes trucks at a logistics firm indirect

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The difference between direct and indirect labour depends on the organisation. It is not always the case that
a type of labour will always be either direct or indirect across all organisations.
However, there are some other points to be aware of. When direct labour (production) workers
receive holiday pay and sick pay, this is treated as an indirect labour cost because it is not a cost (in this
case, ‘time’) directly involved in producing products.
Another indirect labour cost is idle time. This is when employees are unable to work when it is not their fault,
but they are still paid. An example of when idle time might occur is when a machine breaks down, and work
cannot start until it is fixed.
Generally, the basic pay of direct workers is a direct cost, and all other costs of direct workers are indirect
costs. All costs of indirect workers are indirect costs.

Key Point

Only hours spent directly producing a product/service are considered direct labour costs.
All other costs are indirect, even if paid to direct workers.
A bonus paid to direct workers is an example of an indirect cost paid to direct workers.

Here are some direct worker costs that require further classification:

Labour cost Description Classified as

Idle time Time in which direct workers are paid, but no work is being done. Indirect cost

General The premium above the basic rate paid to workers for hours beyond their Indirect cost
overtime regular (agreed) hours.
premium
It is usually calculated as a multiple of the basic rate.
For example, if the basic rate is $10 per hour and the overtime rate is $15
per hour, the overtime premium is $5 per hour.

Overtime Overtime spent by workers to fulfil a customer’s specific request (for Direct cost
worked for example, to complete a job earlier)
customer
In this case, the overtime rate includes the basic rate and overtime
request
premium.

Activity 3

Classify the following labour costs of Furniture Co as either direct or indirect.

Cost element Classification direct or indirect

Holiday pay to direct workers indirect

Pay for hours spent delivering orders to customers indirect

Pay for hours spent producing furniture to direct workers direct

Overtime premium paid due to holiday cover to direct workers indirect

Pay to direct workers for additional work carried out after regular direct
production hours to produce an order of customised furniture for a
customer at short notice.
1.1.3 Overtime
It is usual for staff to be paid an additional amount of money when they work extra hours. This additional
payment is known as an overtime premium. It is often, but not always, above their normal rate of pay.
Overtime premiums are indirect labour costs.

Example

Sarah earns $15 per hour for each hour she works in a café. Her standard shift is for 7 hours.
Sometimes Sarah’s boss needs extra help and asks Sarah to work longer than her shift, paying her an additional
50% per hour for this.
Today, Sarah worked 9 hours.
Calculate her total pay, and classify it as direct and indirect costs.
Answer:
$ Classification
Basic pay 9 hours × $15 135 direct
overtime premium 2 hours × $15 × 50% 15 indirect

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Example

Total pay 150

 Normal (standard) pay
A seven-hour shift’s standard direct labour cost will be $15 × 7 = $105. This is her normal pay.

 Overtime
Sarah earns $22.50 for each hour of overtime that she works. This consists of the standard $15 per hour,
plus the overtime premium of $7.5 per hour (15 ×50%).

 Basic pay
Basic pay is the total hours worked multiplied by the basic rate.

Sarah’s basic pay is 9 hours multiplied by $15, which is $135.

This would be classified as direct labour cost to the café.

 Overtime premium
The extra $7.50 on overtime hours Sarah earns is called the overtime premium. In this case, the overtime
premium of $ 15 that Sarah made is an indirect labour cost to the café.

 Total labour costs
Sarah works nine hours one day. For the nine hours worked, the direct labour cost = 9 × $15 = $135 and the
indirect labour cost = 2 × $7.50 = $15

The main thing to remember when deciding if labour costs are direct or indirect is whether the work done
was directly involved in producing the product or service.
The exception to this rule is overtime, which is split between direct costs (basic pay) and an indirect cost
(overtime premium) unless stated otherwise.
If the company’s overall workload causes the need for overtime, the overtime premium is classified as an
indirect labour cost.
If overtime is requested specifically by a customer (to rush product delivery, etc.), then the basic rate and
overtime premium of those overtime hours is classified as direct labour cost for that job.

Example: Direct Workers

The following information is available regarding direct workers of a company:

Hours Hourly rate

worked ($)

Basic hours (including 50 hours of 900 7.50

idle time)

Overtime 150 10.50

Calculate the amount to be classified as direct and indirect labour costs.
Answer:
Direct labour cost Indirect labour cost
$ per hour $ $ per hour $
900 basic hours:
850 active hours 7.50 6,375
50 idle time hours 7.50 375
150 overtime hours:
150 active hours 7.50 1,125
150 hours of overtime premium 3.00 450
Total 7,500 825
Observations:
 The active basic hours of direct workers are direct costs.
 Idle time of direct workers is an indirect cost.
 Basic pay earned from overtime hours is a direct cost.
 Overtime premium of direct workers is an indirect cost.

Example: Indirect Workers

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Example: Indirect Workers

The following information is available regarding the workers of a company:

Hours Hourly rate

worked ($)

Basic hours, direct workers (including 900 7.50

50 hours of idle time)

Overtime, direct workers 150 10.50

Basic hours, indirect workers 350 6.00

Overtime, indirect workers 50 8.50

Calculate the amount to be classified as direct and indirect labour costs.
Answer:
Direct labour cost Indirect labour cost
$ per hour $ $ per hour $
900 direct worker basic hours:
850 active hours 7.50 6,375
50 idle time hours 7.50 375
150 direct worker overtime hours:
150 active hours 7.50 1,125
150 hours of overtime premium 3.00 450
350 indirect worker basic hours
350 hours 6.00 2,100
50 indirect worker overtime hours
50 hours 8.50 425
Total 7,500 3,350
Observations:
 The cost of indirect workers is indirect.

Activity 4

Remont employs 15 workers in a factory at an hourly rate of $3.60. A working day is 9 hours, and usually 20
working days in a month. The firm budgets 6 hours per unit.

During October, there were only 14 working days because of a hurricane. To compensate for lost production,
each worker worked 45 hours over weekends for an overtime premium of 50%. Actual production for October
was 430 units, 20 units fewer than budgeted.

Calculate the direct labour cost for October.

*Please use the notes feature in the toolbar to help formulate your answer.

Direct Labour Costs $

15 workers × 14 days × 9 hours × $3.60 6,804

15 workers × 45 hours × $3.60 2,430

Total direct labour costs 9,234

As the overtime premium ($1,215) is incurred in the making up for time lost due to "natural causes", it most
likely will be recognised as a separate, indirect cost. Again, however, variations are possible.

Normal hours per month are 2,700 for 450 units (i.e. 6 hours per unit).

If 315 units were produced in 1,890 hours of normal working (15 × 14 × 9), then 115 units were produced in
675 hours of overtime (i.e. less than 6 hours per unit).
Activity 5

A summary of Perky's factory payroll for October showed the following:

Basic hours 7,000

Hours of overtime 1,000

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Hours of idle time 500

The idle time, which arose due to a power cut, increased the hours of overtime worked due to general work
pressures.

Basic pay is $15 per hour, and overtime is paid at a premium of ​ ​ .

Calculate the indirect labour cost for October.

*Please use the notes feature in the toolbar to help formulate your answer.

The overtime premium and the cost of idle time are indirect labour costs.

Indirect labour costs $

Overtime premium (1,000 × 33 1/3% × $15) 5,000

Idle time (500 × $15) 7,500

Total indirect labour costs 12,500

4.2.1 Recording Labour Costs
2.1 Recording Labour Costs

Organisations record all labour costs associated with work done by employees. Time spent working will
often be charged to a job or a client.
2.1.1 Recording Work Done

Key Point

MA assumes the use of a computerised accounting system for the recording, processing, and reporting of
labour costs.
There are two reasons for recording time spent working:
 Employees can be paid for the hours that they have worked
 Time can be charged to specific jobs or clients (especially if work is done on several of these
simultaneously).
Hours worked can be recorded by attendance records and timesheets. These are usually linked to the
computerised accounting system, which verifies the employee and automatically calculates the hours
worked.
Sometimes it might be necessary to break down the time that an employee has been working into different
jobs. This is so that time can be charged to specific jobs or clients. In such cases, it will be necessary to use
time records that specify the activities worked on during a period.
Examples include:
 Timesheets − these are commonly used in many service industries. Solicitors and accountants
often use them because they charge for their work based on how long they have spent on a client’s
project.
 Job sheets − these are often known as task-related timesheets and are used to list the time spent
on one particular job by several employees. The total time spent on a job can be determined and
accounted for at the end of the job.
When a worker is paid, that worker’s total pay, including any overtime premium, will be administered by the
payroll system. Therefore, the payroll system will need to work out the total cost and be able to apportion
this back to the job the worker is doing.

4.2.2 Recording Labour Costs in Accounts

2.2 Recording Labour Costs in Accounts

The first step in accounting for labour costs is to record the gross pay, net pay and any deductions in the
wages control account.
2.2.1 Paying Wages
 Payment of net pay to employees
Dr Wages control

Cr Bank / Cash (net pay)

 Payment of employee deductions and employer contributions to external entities
Dr Wages control

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
Cr Payables (tax / national insurance)

Pay-as-you-earn (PAYE) is the tax deduction system in the UK. Each time an employee is paid, tax is
deducted from their gross pay and remitted to the tax authority.

The term “PAYE” is applicable to the UK. Other jurisdictions may label mandatory tax deductions with other
terms.

2.2.2 Accounting for Labour Costs in Wages Control
 Accounting for costs of labour (including employer contributions)
Dr Work-in-progress / production overheads / employer contributions

Cr Wages control

Labour costs are then accounted for using the same principles applied to direct and indirect materials costs.
 Direct labour costs are debited to the work-in-progress account
 Indirect labour costs are debited to the production overhead control account
 Both direct and indirect labour costs are credited to the wages control account.
2.2.3 Accounting for Direct Labour Costs

Direct labour costs would be directly accounted for in work-in-progress.

 Direct labour costs associated with production
Dr Work-in-progress

Cr Wages control

2.2.4 Accounting for Indirect Labour Costs

Indirect labour costs would be transferred into a Production overheads account for subsequent absorption into
work-in-progress.
 Transfer of indirect labour costs to production overheads
Dr Production overheads

Cr Wages control

2.2.5 Absorption of Production Overheads
Production overheads (which include all indirect production costs) would be absorbed into production.
 Absorption of production overheads into production
Dr Work-in-progress

Cr Production overheads

2.2.6 The Wages (Labour) Control Account
Wages Control Account
$ $
Bank X Work-in-progress X
(Payment of net wages) (Direct labour costs)
Payables X Production overheads X
(Mandatory deductions and contributions e.g. tax, (Indirect labour costs)
national insurance etc)
Statement of profit or loss X
(Other labour costs e.g. employer
contributions, etc.)

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National insurance is a mandatory contribution by employees to a regulated fund that disburses certain
employee protections, such as statutory redundancy payments and medical care provisions for injuries
sustained at the workplace, etc.
The term “National insurance” applies to the UK. Other jurisdictions may use other terms for mandatory
insurance contributions.

Example

The following illustrates entries into the wages control account:

1. Post $100,000 of wages and salaries paid for the period as a credit to the Bank account and a debit to
the labour account (where they are an expense).
Wages Control Account
$ $
Bank 100,000 To production (WIP)
To production overhead

1. After analysing the $100,000 into direct labour costs of $80,000 and indirect labour costs of $20,000, the
labour account for the period can be completed.
2. Post the direct labour costs of $80,000 to the production department by crediting the labour account and
debiting the WIP account (where the production costs are held).
Wages Control Account
$ $
Bank 100,000 To production (WIP) 80,000
To production overhead

Production (WIP) Account

$ $
Wages Control 80,000

1. Indirect labour costs of $20,000 are not a direct cost of production; they are production overheads
credited to the labour account and debited to production overheads account
Wages Control Account
$ $
Bank 100,000 To production (WIP) 80,000
To production overhead 20,000

Production Overheads Account

$ $
Bank 20,000

Indirect labour costs include overtime premium, sick pay, holiday pay and idle time.

1. Ensure labour account balances. The labour costs will flow through the cost accounts and eventually be
reflected in the statement of profit and loss as expenses.
Wages Control Account
$ $
Bank 100,000 To production (WIP) 80,000
To production overhead 20,000
100,000 100,000

4.3.1 Remuneration methods

3.1 Remuneration methods

Key Point

For the MA exam, assume labour costs are variable unless

specified otherwise.
Remuneration methods are the different ways an organisation can pay its employees for their work. For
example, an employee can be paid a constant salary for a fixed period (per week, month or year).
Alternatively, remuneration can be one of the following systems:
3.1.1 Time-Based System

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Payment is based on the hours an employee works.

If they work overtime, they are usually paid a higher rate.
There are some distinctions to make when it comes to how employees are paid:
 Salary: Organisations pay salaried employees an agreed amount per month
 Wages: Waged employees are paid based on an agreed hourly rate, depending on how many hours
they work
 Overtime premiums are paid to persuade workers to work longer hours than normal. An overtime
premium will be in addition to the standard pay rate.
Salary, wages and overtime are time-based remuneration systems: payment is based on the time employees
work.

Advantages Disadvantages

 Time-based payment systems  In time-based systems, there is no incentive for employees

are simple to administer to be efficient
 One standard rate applies to all  Everyone is paid the same regardless of performance
employees in the same role (which  More supervision is needed because employees are not as
seems fairer to employees) highly motivated as they are when working under an incentive
scheme

3.1.2 Piecework System

Payment is based on the number of products that an employee produces.
Piecework systems are straight or differential:
 Straight piecework - employees are paid a set amount for each unit of product they produce.
 Differential piecework - employees are paid different rates per unit depending on how many units
they have produced. They may be rewarded with higher rates as their production level increases above
agreed targets.
Within a piecework system, employees may receive a guaranteed minimum wage despite the number of units
produced. This is known as piecework with a guaranteed minimum wage.

Example

Furniture Co pays its employees using a differential piecework scheme that includes a guaranteed wage.
Details of the scheme are:
 $5 per unit for up to 20 units per day
 $5.20 per unit for each unit between 21 and 25 per day
 $5.50 per unit for units 26 and each further unit per day
There is a guaranteed wage of $90 per day.
Calculate three different employees' wages based on producing the following in a day using the above
information:
Rohan produced 17 units
Divya produced 22 units
Solomon produced 27 units.
Answer:

1. Rohan (17 units)

$
17 units at $5 85.00
85.00
However, as Rohan has earned less than the guaranteed minimum daily wage, he will earn $90.

1. Divya (22 units)

$
20 units at $5 100.00
2 units at $5.20 10.40
110.40

2.
Divya has earned more than the guaranteed daily minimum wage, so he will make $110.40.

1. Solomon (27 units)

$
20 units at $5 100.00
5 units at $5.20 26.00

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Example

2 units at $5.50 11.00

137.00
2.
Solomon has earned more than the guaranteed daily minimum wage, so he will make $137.00

Activity 6

Sarah Kowalski carves wooden animals for a small company supplying the tourist market. In week 26, her
production was as follows:

Product Standard time allowed/unit Units produced

Deer 2 hours 6

Mink 1.5 hours 5

Owls 1 hour 12

Eagles 2 hours 6

She is paid $6 per standard hour of production (irrespective of actual time worked).

Calculate Sarah's earnings for week 26.

*Please use the notes feature in the toolbar to help formulate your answer.

Sarah's week 26 earnings are as follows:

Deer 72 6 × 2 × $6

Mink 45 5 × 1.5 × $6

Owls 72 12 × 1 × $6

Eagles 72 6 × 2 × $6

Sarah’s earnings for week 26 261

3.1.3 Incentive-based systems
Employees may be paid a bonus if they have reached targets set by their employers. These can be either
individual or group-based schemes.
Employees may be given incentives to produce output more quickly than expected. They are usually
rewarded with extra pay (a bonus). These are also known as bonus schemes and may be for individuals or
teams (groups).
Incentive schemes can be either output- or performance-based remuneration schemes. They are designed to
encourage employees to work harder or more efficiently.

Incentive type Description

Piecework payment is a fixed amount for each item (each piece of work) completed, regardless of how
long it takes.
This means that more efficient workers get paid more than inefficient workers.
This method can guarantee the cost per unit for organisations, which helps planning accuracy.

Bonuses a monetary incentive based on the performance of an individual, group, or whole organisation.
Employees could receive a bonus based on their performance, or all employees might receive
a share of a group bonus.

Commission Commissions are paid based on a successful outcome.

They are often used in sales as a percentage of the sales amount.

Profit-sharing Employees are given a share of the profit made by the organisation in the year.
schemes

Advantages Disadvantages

 Help to increase production while controlling costs per  Incentive schemes are more

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unit, which helps the accuracy of planning expensive to administer

 More efficient employees are paid more than inefficient  Quality control is needed to ensure
or less hardworking employees output meets standards.
 May attract more skilled workers

Example: Types of Remuneration

Some examples of how specific roles at Furniture Co are compensated are as follows:

Role Remuneration scheme

Factory Worker Hourly wage

Operates cloth printing  Paid based on hours worked.
machine in the factory.
 Shift is 7 hours.
 Hours worked more than 7 hours are paid overtime at a “time and a half” of
the standard hourly rate.

Pieceworker Piecework
Embroiders furniture  Paid for each piece of work completed to standard.
covers in the factory.

IT project worker Job-based

Works on a project for  Paid a fixed amount for the entire project.
the company.
 Timing of payment depends on project deliverables achieved.

Junior worker Fixed salary

Purchasing for head  Paid a fixed monthly salary.
office.
 May work additional hours without additional compensation.

Sales manager Fixed salary and commission

Makes sales.  Paid a fixed monthly salary
 Also earns a commission based on a percentage (%) of sales

Senior Manager Fixed salary and profit-sharing scheme

Manages entire division.  Paid a fixed monthly salary.
 May work additional hours without additional compensation
 Will receive a share of profit at the end of the year as an incentive.

4.4.1 Labour Turnover

4.1 Labour Turnover

Labour turnover is the rate at which employees leave an organisation.

Employees may look for new jobs for various reasons:
 Offered a higher salary elsewhere
 Non-conducive work environment or inflexible working hours.
 Seeking a better social environment.
 looking for a new challenge or career advancement.
 Seeking a more secure position during a challenging economic period.
 Retirement or extended leave.
Example

Some reasons why employees leave their organisations are discussed below:

Character Description

Desmond Gaining a qualification

I’ve been working as a waiter while studying for a marketing qualification outside work. I’ve now
finished my studies and want to use this qualification, so I’m currently looking for a marketing and
Public Relations (PR) job.

Karishma A new work atmosphere

I’ve been with my company for a couple of years now, but I don’t feel like my colleagues, and I
work as well together as we’d like. So I want to find a team which suits the way I work.

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Example

Hanna Career change

I’ve been a financial consultant for over ten years, but I’d like to try something different. I’m
considering starting my own business or working in a new industry.

4.4.2 The Costs of Labour Turnover

4.2 The Costs of Labour Turnover

Labour turnover creates costs for an organisation. The costs of labour turnover can be analysed as follows:
 Preventative costs: the costs involved in preventing employees from leaving an organisation
 Giving them more attractive benefits, such as improved bonus schemes or perks like
insurance
 Offering flexible working hours and structures
 Employee development programmes, such as training, to help with their career
progression
 Increasing salaries
 Improving the working environment; this could be anything from redecorating and hiring
additional staff who fit the company and team ethos to buying new computers.
 Replacement costs: the costs involved in replacing those employees who have left an organisation.
Preventative costs Replacement costs

 Cost of benefits and  Loss of output due to the time gap between an old employee leaving
incentive schemes and a new employee starting
 Cost of development  Cost of recruitment (advertising, recruitment agency fees)
training to encourage  Costs of training (training courses and existing staff providing
employees to progress in instruction)
their careers at the
organisation
 Lower production volumes while new employee learns how to do
the job

Activity 7

Classify the measures as preventive or replacement costs.

Measure Preventive or Replacement

Pay competitive salaries and research to work out what figures are competitive Preventive

Cost of training new staff Replacement

Provide employee benefits, for example, gym membership, staff discounts Preventive

Offer employees training and development programmes Preventive

Cost of advertising for new staff Replacement

Cost of recruiting temporary staff to cover work when a position becomes vacant Replacement
and before new staff is appointed.

Cost of working hours lost while interviewing job applicants Replacement

Offer bonuses for increased productivity Preventive

4.4.3 Labour Turnover Rate
4.3 Labour Turnover Rate

Organisations measure labour turnover and compare it to a base rate. This is so that the company can
understand if its turnover rate is unusual or in line with expected rates.
The labour turnover rate measures the number of employees leaving in a period and expresses this as a
percentage of the total labour force.
The formula is:

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The average number of employees = (Opening employees + Closing employees) ÷ 2

Replacements in this formula refer to employees leaving and being replaced.
For example, if 250 employees resigned in a year and the decision was made to hire another 200, the number
of replacements would be 200.

Example

Magazine Co made a series of redundancies after a decrease in its business’ profits. It had 25,000 employees at
the beginning of 20X4 and 19,000 employees at the end of 20X4. As well as the redundancies, 2,000 employees
resigned in the year and were replaced by new employees.
What is the labour turnover rate in 20X4 to the nearest whole per cent?
Answer:
Average number of employees = (25,000 + 19,000)/2 = 22,000
Number of replacements = 2,000
Using the formula:

​ ​

= 2,000/22,000 × 100% = 9% (to the nearest whole per cent)

Activity 8

. Furniture Co had 300 employees at the beginning of 20X0. At the end of 20X0, there were 500
employees.
45 employees resigned in the year and were immediately replaced. An additional 200 employees were
recruited for new jobs during the year.

.
What is the labour turnover rate?

.
. Oogie Co had 15,000 employees at the beginning of 20X0 and 11,000 employees at the end of 20X0,
following a downturn in its business. In addition to the redundancies, 1,500 employees resigned in the
year and were replaced immediately by new employees.
What is the labour turnover rate?

.
Answer in % to the nearest two decimal places

*Please use the notes feature in the toolbar to help formulate your answer.

. 45 / ([300 + 500] / 2) = 11.25%

. 1,500 / ([15,000 + 11,000] / 2) = 11.54%
4.5.1 Labour ratios
5.1 Labour ratios

There are several ratios that organisations use to measure the performance of their employees.

Exam advice

These formulae must be memorised as they will not be provided in the MA exam.

5.1.1 Efficiency Ratio

The efficiency ratio measures whether the production output took more or less direct labour time than
expected.
Effeciency Ratio =Expected hours to make actual output/Actual hours*100%
A ratio of > 100% indicates greater labour efficiency than budgeted.
A ratio of < 100% indicates poorer labour efficiency than budgeted.
5.1.2 Capacity Utilisation Ratio
The capacity utilisation ratio measures whether the total direct labour hours worked were greater or less
than budgeted.
Capacity utilization Ratio =Actual hours worked/ Budgeted hours*100%

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A ratio > 100% indicates more labour hours were worked than budgeted.
A ratio of < 100% indicates fewer labour hours were worked than budgeted.
5.1.3 Production Volume Ratio
The production volume ratio measures how the actual production output for a period (in direct labour hours)
compares with the budgeted output.
Production Ratio =Expected hours to make actual output/Budgeted hours*100%
A ratio > 100% indicates higher than budgeted performance.
A ratio of < 100% indicates a lower-than-budgeted performance.
5.1.4 Relationship Between Labour Ratios
The relationship between the ratios is:

Efficiency ratio × capacity utilisation ratio = production volume ratio

Key Point

The labour ratios are based on direct labour hours.

Example

A company has 2,000 hours available (budgeted) to make 20,000 units of a product in March.
The company produced 18,000 units which took the workforce 1,750 hours.
Calculate the efficiency, capacity, and production volume ratios for March.
Answer:
Hours available = hours budgeted = 2,000
Each unit is expected to take 2,000/20,000 = 0.1 hours
Actual output = 18,000
Actual output is expected to take 18,000 × 0.1 = 1,800 hours
Actual hours taken to make actual output = 1,750

1. Efficiency ratio
Each unit is expected to take 2,000/20,000 = 0.1 hours
Actual output = 18,000
Actual output is expected to take 18,000 × 0.1 = 1,800 hours
Actual hours taken to make actual output = 1,750
Efficiency ratio = 1,800/1,750 × 100% = 102.86% (to 2 decimal places)
2. Capacity ratio
Hours available = hours budgeted = 2,000
Actual hours taken to make actual output = 1,750
Capacity ratio = 1,750/2,000 × 100% = 87.50%(to 2 decimal places)
3. Production volume ratio
Each unit is expected to take 2,000/20,000 = 0.1 hours
Actual output = 18,000
Actual output is expected to take 18,000 × 0.1 = 1,800 hours
Hours available = hours budgeted = 2,000
Production volume ratio = 1,800/2,000 × 100% = 90%

Activity 9

Brownie Co budgeted to make 100 units of output in June. Each unit was expected to take 3 hours of direct
labour.

The actual production volume in June was 110 units, which took 350 hours of direct labour.

For June,

. What is the labour efficiency ratio for Brownie Co?

. What is the capacity utilisation ratio for Brownie Co?
. What is the production volume ratio for Brownie Co?
. Show the relationship between the ratios.
*Please use the notes feature in the toolbar to help formulate your answer.

. Efficiency ratio = ((110 × 3) / 350) × 100% = 94.29%

. Capacity utilisation ratio = (350 / 300) × 100% = 116.67%
. Production volume ratio = (110 × 3) / 300 × 100% = 110%

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. Efficiency ratio × Capacity utilisation ratio = Production volume ratio

94.29% × 116.67% = 110.00%
Activity 10

A company budgeted to make 800 units of output in December. Each unit was expected to take 1 hour and 30
minutes of direct labour.

The actual production volume in December was 760 units, which took 950 hours of direct labour.

For December,

. What is the labour efficiency ratio?

. What is the capacity utilisation ratio?
. What is the production volume ratio?
. Show the relationship between the above ratios.
*Please use the notes feature in the toolbar to help formulate your answer.

. Efficiency ratio = (760 × 1.5) / 950 × 100% = 120%

. Capacity utilisation ratio = 950 / (800 × 1.5) × 100% = 79.17%
. Production volume ratio = (760 × 1.5) / (800 × 1.5) × 100% = 95%
. Efficiency ratio × Capacity utilisation ratio = Production volume ratio
= 120% × 79.17% = 95%

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Chapter 5: Overheads
5.1.1 Expenses
1.1 Expenses

Definition

Expense – Decreases in economic benefits during the accounting period in the form of outflows, depletions of
assets, or incurrences of liabilities.
IASB

Expenses result in either:

 The decrease in an asset such as cash in the bank account when items are paid for immediately, or
 The increase in a liability – such as an account payable or creditor when items are paid for on
credit.
Material and labour costs are types of expenses. Other expenses are not materials or labour costs – for
example, the rent paid for an organisation's factory and offices, insurance and electricity.
Other expenses are referred to as ‘expenses' in this chapter.
5.1.2 Classifying Expenses by Function
1.2 Classifying Expenses by Function

A method of classifying expenses is grouping them by the departments (function) they are associated with,
such as production, finance, human resources and sales.
Some examples are below:

Function Expenses

Buildings  Rent
management
 Utility bills (gas, electricity, water)
 Telecommunications (phones, internet)
 Taxes on property.

Production  Repairs
department
 Maintenance
 Lease (hire) costs.

Selling and  Advertising

distribution
 Customer service
 Delivery.

Finance and legal  Interest charges on loans

 Legal fees (for example, on agreeing to a contract)
 External audit
 Insurance.
5.1.3 Direct and Indirect Expenses
1.3 Direct and Indirect Expenses

Expenses may be classified as direct and indirect in the same way as materials and labour costs.
 Direct expenses are directly attributable to a specific product or service and are part of its direct
cost.
 Indirect expenses cannot be attributed to a specific product and are also known as overheads.
Activity 1

Identify the expense as direct or indirect.

Expense direct or indirect

Costs of electricity needed to power equipment and machinery used in the production direct
process for a single product.

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Costs for cleaning and maintaining the factory. indirect

Rent costs for the factory where production processes are carried out. indirect

The warehouse manager’s monthly salary. indirect

Hire costs for the machinery used in the production process to produce several different indirect
products.

Insurance costs for the warehouse where inventory of several products is held. indirect

Costs for custom tooling needed to make a specific product. direct

*Please use the notes feature in the toolbar to help formulate your answer.

Expense direct or indirect

Costs of electricity needed to power equipment and machinery used in the production
process for a single product.

Costs for cleaning and maintaining the factory.

Rent costs for the factory where production processes are carried out.

The warehouse manager’s monthly salary.

Hire costs for the machinery used in the production process to produce several different
products.

Insurance costs for the warehouse where inventory of several products is held.

Costs for custom tooling needed to make a specific product.

Activity 2

Classify the expenses as direct or indirect.

Expense Classification
(direct or indirect)

Fuel for a concrete mixer used by a construction company to build a new factory

Lease costs for a specialist embroidery machine used for a particular batch of products

Purchase of customised design software needed to design a skyscraper for a customer

project

Employer's pension contributions for direct labour

Insurance costs for the warehouse where inventory is held

Rent costs for the factory where production processes are carried out

The warehouse manager’s monthly salary

Costs for cleaning and maintaining the factory for a T-shirt manufacturer

*Please use the notes feature in the toolbar to help formulate your answer.

Expense Classification
(Direct or Indirect)

Fuel for a concrete mixer used by a construction company to build a new factory direct

Lease costs for a specialist embroidery machine used for a particular batch of products direct

Purchase of customised design software needed to design a skyscraper for a customer direct
project

Employer's pension contributions for direct labour indirect

Insurance costs for the warehouse where inventory is held indirect

Rent costs for the factory where production processes are carried out indirect

The warehouse manager’s monthly salary indirect

Costs for cleaning and maintaining the factory for a T-shirt manufacturer indirect

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5.1.4 Treatment Of Direct And Indirect Expenses

1.4 Treatment Of Direct And Indirect Expenses

Direct expenses are called this because they directly relate to the production of a single product. They are,
therefore, added to the direct material costs and direct labour costs to form the prime cost of a product.
Direct materials + direct labour + direct expenses = prime cost of a product
Indirect expenses do not relate directly to the production of a single product, so they must be shared
between the various products that create the expenses.
Prime cost of a product + share of overheads = total cost of a product
5.2.1 Absorption Costing Process
2.1 Absorption Costing Process

Absorption costing is a process that involves sharing overheads between different products. Its purpose is
to ensure that the total cost of production also reflects the indirect costs.
There are three steps in the absorption costing process:

1. Overhead allocation
A production overhead cost is allocated or charged to a cost centre if the whole amount of the cost can be
specifically related to a single cost centre.
2.
1. Overhead apportionment and reapportionment
If it is impossible to allocate the whole cost of the production overhead item to a single cost centre, then the
cost must be shared out, or apportioned, to all the cost centres that contribute to its cost fairly.
2.
The overheads of service cost centres cannot be specifically identified with any one cost centre. So they
must be apportioned (or shared out) between the production cost centres fairly.
3.
1. Overhead absorption
The final step in the absorption costing process is to calculate a production overhead absorption
rate (OAR)– this is the rate at which overheads are absorbed into the cost of each unit.
2.
Exam advice

In the MA exam, the costs that need to be allocated to individual departments or cost units should be
[Link] and reapportion production overheads based on the available information.

5.2.2 Why Calculate Overhead Absorption?

2.2 Why Calculate Overhead Absorption?

Include overhead costs in the total cost per unit of a product or service to ensure that the total cost per unit
is accurate. This is necessary for two reasons:
 To calculate a reasonable selling price and determine whether a product is profitable.
 To calculate inventory value accurately.
2.2.1 Selling Price and Profitability
For a company that makes a single product, determining profitability is comparing total costs and revenues:
if revenue is higher than cost, then the company is profitable.
For companies that make multiple products, the products might differ in profitability. Therefore, their specific
total costs need to be calculated to understand which products are profitable. This would include overheads.
2.2.2 Inventory Valuation
Inventory consists of raw materials, bought-in components, work in progress (partially completed
products/goods) and finished products/goods. Including overheads in the cost per unit results in a more
accurate unit cost, resulting in a more accurate inventory valuation. An accurate inventory value is needed
for the following:
 Including an accurate inventory figure in the financial statements

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 Correctly calculate the cost of sales figure, which is used to calculate gross profit or loss in the
statement of profit or loss.
Key Point

Cost of sales = Opening inventory + Cost of production – Closing inventory

5.2.3 Production and Non-Production Activities
2.3 Production and Non-Production Activities

The activities and departments of a manufacturing organisation can be categorised into production and non-
production activities/departments.
For example, the factory in which the organisation makes its products and the warehouse in which it stores
its materials and goods relate to the production of goods. The organisation’s production site might have
several cost centres.
Non-production departments include sales, distribution and delivery, finance (the accountants!), and human
resources. These departments are not directly involved in making or storing the organisation’s products and
could be in a different location to the factory and warehouse.

5.2.4 Cost Centres

2.4 Cost Centres

A cost centre is a department or division that incurs costs. The organisation can decide what cost centres to
use. A cost centre could be a team or department, a single person or even a machine.
2.4.1 Production Cost Centre
A production cost centre is a department or activity directly producing the cost unit.
Production cost centres in a manufacturer are likely to include activities such as:
 Assembly
 Mixing
 Painting
 Packaging
 Ageing (holding products to mature)
 Moulding (shaping flexible raw material using a rigid frame)
2.4.2 Service Cost Centre
A service cost centre is a department or activity that provides ancillary services to support production cost
centres.
In a manufacturer, these may include the following:
 Logistics and warehouse services
 Security
 Staff canteen and other human resource services
 Maintenance
 Cleaning
5.2.5 Whole Costs and Common Costs
2.5 Whole Costs and Common Costs

2.5.1 Whole Costs

Whole cost items are overheads (indirect costs) attributable to a single cost centre. Therefore, they are
allocated to a single cost centre.
For example, at T-Shirt Co, the salary of the warehouse manager is a whole cost item as it relates only to the
warehouse cost centre.
Activity 3

Furniture Co has identified four of its cost centres:

 Assembly
 Design
 Purchasing
 Maintenance
Allocate the cost elements below to the appropriate cost centre.

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Cost Cost centre allocated to.

(Assembly, Design, Purchasing, or Maintenance)

Sewing machine depreciation Assembly

Computer-aided-design (CAD) software Design

Purchasing Assistant salary Purchasing

Engineer's salary Maintenance

Assembly supervisor’s salary Assembly

Designer’s salary Design

Sewing machine operator training Assembly

Travel to suppliers Purchasing

Quality control checks Assembly

2.5.2 Common Costs
Common costs need to be shared among different cost centres.
For example, the cost of electricity to power the whole factory site is a common cost because it relates to all
the cost centres – including the warehouse, assembly centre, cleaning department, purchasing offices, etc.
An apportionment base must be selected to determine how much of a typical cost is to be charged to a cost
centre. For example, kilowatt-hours might be the basis for apportioning electricity costs among cost centres.

5.2.6 Apportionment Principles

2.6 Apportionment Principles

Apportionment, the second stage in absorption costing, is sharing common overheads between cost centres.
Examples of common costs:
 Building lighting (shared by all cost centres in the building)
 All the cost centres also share rent, insurance, and utilities (water and electricity) in the building.
There are two parts to the apportionment stage:
1. apportion all common costs across each production and production service cost centre;
2. reapportion all service costs between the production cost centres. (so all overheads are fully charged to
production cost centres).
The aim is to eventually establish the total overhead costs for each production cost centre.
5.2.7 Bases of Apportionment
2.7 Bases of Apportionment

An apportionment base must be identified to apportion common costs among cost centres.
An apportionment base measures how much the cost centre should be charged for the common cost. It
should be fair and measurable.
Examples of bases for apportioning shared overhead costs to different cost centres might include:
 Depreciation of machinery: use the carrying amount of the machinery held by each cost centre to
apportion the cost of machinery depreciation.
 Rent and rates: ¬ to apportion rent and rates overheads fairly, use the floor area of individual cost
centres.
 Heat and light: ¬ again, use the floor area of individual cost centres to apportion rent and rates
overheads.
 Power: Typically, the cost of power is apportioned based on the kilowatt hours used by different
cost centres.
 Insurance of machinery:¬ use the carrying amount of the machinery held by each cost centre to
apportion the cost of insurance of machinery.
2.7.1 Fairness of Apportionment Base
Fairness reflects the reality of the situation: what is the underlying reason for the cost?
For example, should rent be apportioned based on the number of workers in each department or the floor
space used?
The number of workers is easy to determine; this might be the most reasonable basis in an office. However,
because machinery and other equipment in a factory might take up more space in some departments than in
others, floor space might be a fairer basis.

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There are many different bases on which to apportion costs. Therefore, an accountant must judge each cost
item’s fairest basis for apportionment.

Exam advice

In the exam, read the question carefully to select the most appropriate base.

2.7.2 Changing Apportionment Base

As processes and methods of manufacturing change, the most appropriate apportionment base may also
change.
For example, a business has a car park that all staff use: the costs might be shared by apportioning them
based on the staff in each department.
If the business were to sell part of the car park and the remaining few parking spaces were reserved for
visitors, then the basis for apportionment would need to change from staff per department to visitors per
department.

5.2.8 Calculating Apportionment

2.8 Calculating Apportionment

The steps are:

1. Identify cost centres, whole costs, and common costs.
2. Allocate whole costs to cost centres.
3. Select an appropriate base for common costs
4. Apportion common costs on the proportion of the apportionment base used by the cost centre.

Example

An organisation has two production cost centres: A and B. It also has two service cost centres: maintenance and
warehouse.
Indirect expenses that need to be apportioned are as follows:

Indirect expenses $

Rent and rates 100,000

Power 40,000
Details relating to the floor area and power usage of the four cost centres are shown below.

Base Total Production Production Maintenance Warehouse

Cost Cost
Centre A Centre B

Floor 2,000 1,000 600 200 200

area
(sq m)

Power 100% 60% 20% 10% 10%

usage
(%)
Apportion the indirect expenses to the cost centres using the appropriate basis.
Answer:

1. Apportionment of rent and rates

First, Decide how to apportion rent and rates overheads. The floor area of each cost centre seems the most
appropriate way to do this because, in the long term, the bigger a department grows to be, the more space it will
occupy, and therefore, cause (or drive) rent and rates. Thus, the floor area will be the basis for apportionment.

Total Production Production Maintenance Warehouse

Cost Cost
Centre A Centre B

Floor area 2,000 1,000 600 200 200

(square m)

Apportioned 100,000 50,000 30,000 10,000 (W3) 10,000

cost (W1) (W2) (W4)

Workings:

(W1)Production cost centre A = $100,000 × 1,000/2,000 = $50,000

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Example

(W2)Production cost centre B = $100,000 × 600/2,000 = $30,000

(W3)Maintenance = $100,000 × 200/2,000 = $10,000

(W4)Warehouse = $100,000 × 200/2,000 = $10,000

1. Apportionment of power
The cost of power should be apportioned based on the percentage of power used by each cost centre.

Total Production Production Maintenance Warehouse

Cost Cost
Centre A Centre B

Power 100% 60% 20% 10% 10%

usage (%)

Apportioned 40,000 24,000 8,000 (W6) 4,000 (W7) 4,000 (W8)

cost (W5)

Workings:

(W5)Production cost centre A = $40,000 × 60% = 24,000

(W6)Production cost centre B = $40,000 × 20% = 8,000

(W7)Maintenance = $40,000 × 10% = 4,000

(W8)Warehouse = $40,000 × 10% = 4,000

Activity 4

A company has the following overhead costs totalling $10,000:

Cost item $

Rent 5,000

Heating 3,000

Lighting 1,000

Water 1,000

The following information about the cost centres of the company is available:

Production Service cost centres Total

cost centres

Mixing Bottling Cleaning Canteen

Floor 120 100 10 20 250

space
(m2)

Calculate the overhead amounts to be apportioned to each cost centre.

*Please use the notes feature in the toolbar to help formulate your answer.

Basis of Total overhead Cost apportioned to cost centres

Item of costapportionment cost Mixing Bottling Cleaning Canteen
$ $ $ $ $
Rent Floor space 5,000 2,400 2,000 200 400
Heating Floor space 3,000 1,440 1,200 120 240
Lighting Floor space 1,000 480 400 40 80
Water Floor space 1,000 480 400 40 80
Total 10,000 4,800 4,000 400 800

Activity 5

Budget for May: $

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Canteen costs 4,100

Machine depreciation 1,700

Machine repairs 500

Factory rent and rates 6,300

Production manager's salary 7,200

Heat and light 3,200

Materials storage 2,000

25,000

The Assembly department occupies approximately three-quarters of the area of the factory.

The production manager, on average, spends twice as long supervising the 30 workers in the Assembly
department as she does the 70 workers in the Trimming department.

The carrying value of the equipment in the Assembly department and the Trimming department is $104,500
and $115,500, respectively.

Materials storage costs should be apportioned two-fifths to Assembly and three-fifths to Trimming.

Using appropriate bases, apportion total overheads between the two cost centres.

*Please use the notes feature in the toolbar to help formulate your answer.

Basis Assembly to Trimming Ratio Assembly $ Trimming

Canteen Number of staff 3:7 1,230 2,870

Machine Carrying value * 807.50 892.50

depreciation

Machine repairs Carrying value ** 237.50 262.50

Rent and rates Area 3:1 4,725 1,575

Production Time spent 2:1 4,800 2,400

manager's salary

Heat and light Area 3:1 2,400 800

Materials storage Allocation 2:3 800 1,200

15,000 10,000

*[$104,500 / ($104,500 + $115,500)] × $1,700 = $807.50

**[$104,500 / ($104,500 + $115,500)] × $500 = $237.50

5.2.9 Reapportionment
2.9 Reapportionment

If the overhead costs of the service departments are not shared, then the cost of running these departments
will not be added to the production departments. Service departments, like canteens and maintenance, do
not directly produce goods.

For this reason, it is necessary to reapportion the overheads incurred by the service departments.

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2.9.1 Service departments

Service departments are not directly involved in making products. Instead, their primary purpose is to
provide a service to the production departments and their employees.
Examples of service departments include:
 Canteen – to provide meals and refreshments for workers
 Maintenance – to repair and maintain production machinery
 Payroll – to calculate salaries and wages of employees and to pay them
 Warehouse – to store finished products and raw materials.
Service departments will therefore have costs that are indirectly related to the production of goods. These
costs should be apportioned to the production cost centres, where they can be absorbed into the costs of
products. When service centre costs are shared between production cost centres, this is called service cost
centre cost reapportionment.

5.2.10 Reapportionment Of Service Cost Centre Costs

2.10 Reapportionment Of Service Cost Centre Costs

Service cost centre cost reapportionment aims to ensure that all of an organisation’s overheads are
allocated and apportioned to production cost centres. This is because units of production only use the
production cost centres.
Reapportionment calculations are the same as apportionment calculations, but there will be a need to decide
the fairest basis for apportionment.
MA requires the understanding of three methods:
 Direct
 Step-down
 Reciprocal
5.2.11 Direct Reapportionment Method
2.11 Direct Reapportionment Method

The direct reapportionment method is when service cost centre overheads are only apportioned to
production cost centres. Services provided to other service cost centres are ignored.

Example

The processes of overhead allocation and apportionment have taken place, and the results are as follows:

Cost centre Production Production Cost Service Cost Service Cost Centre Total ($)
Cost Centre Centre B ($) Centre Warehouse ($)
A ($) Maintenance ($)

Allocated and 100,000 50,000 20,000 30,000 200,000

apportioned
overheads
Usage of the service cost centres by the production cost centres is as follows:

Production Cost Centre Production Cost

A Centre B

Number of maintenance call-outs 40 120

The proportion of warehouse space occupied by the 70% 30%

cost centre’s products
Reapportion the service cost centre costs to the production cost centres.
Answer:

1. Reapportionment of maintenance overheads

Maintenance overheads will be reapportioned based on the number of call-outs made by each production cost
centre.
2.
This can be calculated by multiplying the total cost of the maintenance department ($20,000) by the proportion of
call-outs made by the individual production cost centres.
3.
For example, 40/160 for Production Cost Centre A and 120/160 for Production Cost Centre B. The working is
shown below.
4.
Production Cost Centre A ($20,000 × 40/160) = $5,000
5.

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Example

Production Cost Centre B ($20,000 × 120/160) = $15,000

6.
1. Reapportionment of warehouse overheads
Warehouse overheads will be apportioned based on the proportion of warehouse space occupied by each
production cost centre’s products.
2.
Production Cost Centre A ($30,000 × 70%) = 21,000
3.
Production Cost Centre B ($30,000 × 30%) = 9,000
4.
The reapportionment of service cost centre overheads can be summarised as follows.

Production Production Service Cost Service Total

Cost Cost Centre Cost ($)
Centre A Centre B Maintenance Centre
($) ($) ($) Warehouse
($)

Allocated and 100,000 50,000 20,000 30,000 200,000

apportioned
overheads

Maintenance 5,000 15,000 (20,000) -

department
reapportionment

Warehouse 21,000 9,000 (30,000) -

department
reapportionment

Total 126,000 74,000 - - 200,000

Note that the service cost centres no longer have any overheads. They have all been reapportioned to the
production cost centres that they support.

Activity 6

The overhead costs of a manufacturing firm have been allocated and apportioned as follows:

Production cost centres Service cost centres

Assembly Finishing Maintenance Purchasing
$ $ $ $
Allocated overheads 1,800,000 760,000 147,500 80,500
Apportioned overheads 145,500 60,500 25,350 14,750
Total overheads 1,945,500 820,500 172,850 95,250

The maintenance department spent the following time on the other cost centres:

Assembly 600 hours

Finishing 200 hours

Purchasing 50 hours

The purchasing department completed the following number of purchase orders for the other cost centres:

Assembly 110 orders

Finishing 75 orders

Maintenance 25 orders

Calculate the total overhead costs charged to the production cost centres after using the direct
reapportionment method to reapportion service cost centre overheads.

*Please use the notes feature in the toolbar to help formulate your answer.

The direct method ignores services provided to other service cost centres.

Reapportionment of maintenance department overheads by maintenance hours:

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Production cost Assembly Finishing Total

centre

Maintenance 600 200 800

hours

Reapportionment $129,638 $43,212 $172,850

(600 / 800 × $172,850) (200 / 800 ×$172,850)

Reapportionment of purchasing department overheads by the number of orders:

Production cost Assembly Finishing Total

centre

Orders 110 75 185

Reapportionment $56,635 $38,615 $95,250

(110 / 185 × $95,250) (75 / 185 × $95,250)

The completed overhead charge to production cost centres is as follows:

Service cost centre Basis of apportionment Total cost Assembly Finishing
$ $ $
Maintenance Maintenance hours 172,850 129,638 43,212
Purchasing Number of orders 95,250 56,635 38,615
268,100 186,273 81,827
Previously allocated and apportioned costs 2,766,000 1,945,500 820,500
Total overhead 3,034,100 2,131,773 902,327
5.2.12 Step-Down Reapportionment Method
2.12 Step-Down Reapportionment Method

In the step-down method, the costs of one service centre (CS1) are reapportioned to the production cost
centres and the other service centre (CS2).
The costs of the other service centre (CS2) are then reapportioned to the production cost centres.
The cost centre with the highest total costs, or that carries out the most work for the other service centre, is
reapportioned first.

Exam advice

Read the exam question carefully if it requires step-down reapportionment.

 The service cost centre that does not provide services to other service cost centres is
reapportioned last.
 If the above does not apply, and the question does not specify the order of reapportionment,
reapportion the service cost centre with the highest cost first.

Example: Step-Down Reapportionment

The overhead costs of a manufacturing firm have been allocated and apportioned as follows:
Production cost centres Service cost centres
Assembly Finishing Maintenance Purchasing
$ $ $ $
Allocated overheads 1,800,000 760,000 147,500 80,500
Apportioned overheads 145,500 60,500 25,350 14,750
Total overheads 1,945,500 820,500 172,850 95,250
The maintenance department spent the following time on the other cost centres:

Assembly 600 hours

Finishing 200 hours

Purchasing 50 hours
The purchasing department completed the following number of purchase orders for the other cost centres:

Assembly 110 orders

Finishing 75 orders

Maintenance 25 orders

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Example: Step-Down Reapportionment

Calculate the total overhead costs charged to the production cost centres after using the step-down
reapportionment method to reapportion service cost centre overheads.
Using the step-down method, service cost centre overheads are reapportioned to other cost centres first, then
reapportioned to production cost centres.
Maintenance is reapportioned first as it has higher overheads
Reapportionment of maintenance department overheads by maintenance hours:

Production cost Assembly Finishing Purchasing Total

centre

Maintenance 600 200 50 850

hours

Reapportionment $122,012 $40,670 $10,168 $172,850

(600 / 850 × $172,850) (200 / 850 × $172,850) (50 / 850 × $172,850)

The total purchasing department costs to be reapportioned are now $105,418 ($95,250 + $10,168). Overheads are
apportioned to production cost centres only.
Reapportionment of purchasing department overheads by the number of orders:

Production cost centre Assembly Finishing Total

Orders 110 75 185

Reapportionment $62,681 $42,737 $105,418

(110 / 185 × $105,418) (75 / 185 × $105,418)

All service cost centre costs have been fully charged to production cost centres.
The completed overhead charge to production cost centres is as follows:
Assembly Finishing Maintenance Purchasing
$ $ $ $
Previously allocated and apportioned costs 1,945,500 820,500 172,850 95,250
Service cost centre Basis of apportionment
Maintenance Maintenance hours 122,012 40,670 (172,850) $10,168
Purchasing Number of orders 62,681 42,737 NIL (105,418)
Total overhead 2,130,193 903,907 NIL NIL

5.2.13 Reapportionment Practice

2.13 Reapportionment Practice

Activity 7

The overhead costs of a manufacturing firm for the week have been allocated and apportioned as follows:

Production cost centres Service cost centres

Mixing Bottling Cleaning Canteen
$ $ $ $
Allocated overheads 10,000 15,000 1,500 700
Apportioned overheads 4,800 4,000 400 800
Total overheads 14,800 19,000 1,900 1,500

The cleaning department spent the following time on the other cost centres:

Mixing 200 hours

Bottling 150 hours

Canteen 50 hours

The canteen served the following number of meals to each department:

Mixing 50 meals

Bottling 35 meals

Cleaning 10 meals

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1. Calculate the total overhead costs charged to the production cost centres after using the direct
reapportionment method to reapportion service cost centre overheads.
2. Calculate the total overhead costs charged to the production cost centres after using the step-
down reapportionment method to reapportion service cost centre overheads (Reapportion cleaning
costs first).
*Please use the notes feature in the toolbar to help formulate your answer.

Reapportionment of cleaning department overheads by cleaning hours:

Production cost Mixing Bottling Total

centre

Cleaning hours 200 150 350

Reapportionment $1,086 $814 $1,900

(200 / 350 × $1,900) (150 / 350 × $1,900)

Reapportionment of canteen department overheads by the number of meals:

Production cost Mixing Bottling Total

centre

Meals served 50 35 85

Reapportionment $882 $618 $1,500

(50 / 85 × $1,500) (35 / 85 × $1,500)

The completed overhead charge to production cost centres is as follows:

Mixing Bottling Cleaning Canteen
$ $ $ $
Previously allocated and apportioned costs 14,800 19,000 1,900 1,500
Service cost centre Basis of apportionment
Cleaning Cleaning hours 1,086 814 (1,900) NIL
Canteen Meals served 882 618 NIL (1,500)
Total overhead 16,768 20,432 NIL NIL

2.

Reapportionment of cleaning department overheads by cleaning hours:

Production cost Mixing Bottling Canteen Total

centre

Cleaning hours 200 150 50 400

Reapportionment $950 $713 $237 $1,900

(200 / 400 × $1,900) (150 / 400 × $1,900) (50 / 400 × $1,900)

Canteen overheads to be apportioned is $1,737

Reapportionment of canteen department overheads by meals served:

Production cost Mixing Bottling Total

centre

Meals served 50 35 85

Reapportionment $1,022 $715 $1737

(50 / 85 × $1,737) (35 / 85 × $1,737)

Note: the meals served by the canteen to the cleaning department are ignored when apportioning canteen
costs to avoid reciprocal reapportionment.

The completed overhead charge to production cost centres is as follows:

Mixing Bottling Cleaning Canteen
$ $ $ $
Previously allocated and apportioned costs 14,800 19,000 1,900 1,500
Service cost centre Basis of apportionment
Cleaning Cleaning hours 950 713 (1,900) 237
Canteen Meals served 1,022 715 NIL (1,737)

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Total overhead 16,772 20,428 NIL NIL

5.2.14 Reciprocal Method Of Service Cost Centre Reapportionment

2.14 Reciprocal Method Of Service Cost Centre Reapportionment

Sometimes service cost centres might work for each other (unlike in the previous activity when service cost
centres only did work for the production cost centres). When this happens, overheads must be
reapportioned using the reciprocal method of reapportionment.
There are two methods to solve reciprocal service cost centre costs:
 Repeated distribution method
 Algebraic method
2.14.1 Repeated Distribution Method
The reciprocal method is also known as the repeated distribution method because it requires repeated
reapportionments until there are no overheads left in the service cost centres.

Example

The processes of overhead allocation and apportionment have taken place, and the proportion of work done by
the service centres for the other cost centres is as follows:

Cost centre Production Production Service Cost Service Total

Cost Cost Centre Cost ($)
Centre A Centre B Maintenance Centre
($) ($) ($) Warehouse
($)

Allocated 100,000 50,000 20,000 30,000 200,000

and
apportioned
overheads

Proportion 35% 40% 25%

maintenance

Proportion 50% 30% 20%

stores
The reciprocal method of service cost centre reapportionment works as follows, using repeated distribution. :

Total Production cost centre A Production Service cost centre Service cost
($) ($) cost centre maintenance ($) centre warehouse
B ($) ($)

Allocated and 200,000 100,000 50,000 20,000 30,000

apportioned
overheads

Reapportion 7,000 8,000 (20,000) 5,000

Maintenance

200,000 107,000 58,000 - 35,000

Reapportion 17,500 10,500 7,000 (35,000)

Warehouse

200,000 124,500 68,500 7,000 -

Reapportion 2,450 2,800 (7,000) 1,750

Maintenance

200,000 126,950 71,300 - 1,750

2.14.2 Algebraic Method

The algebraic method uses simultaneous equations to solve for the reapportionment of reciprocal services.

Example

A company’s overheads have been allocated and apportioned to its five cost centres, as shown below.

Production cost Production cost Service cost Service cost Service cost
centre A centre B centre C centre D centre E

Apportioned and 80,000 100,000 10,000 20,000 4,000

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Example

Allocated overhead
($)
The usage of service cost centres is as follows:

Cost centre A B C D E

Use of C's services 40% 50% nil 10% nil

Use of D's services 75% 20% 5% nil nil

Use of E's services 30% 70% nil nil ni

Reapportion the service cost centre costs to the production cost centres.
Answer:
Algebraic approach
Firstly, set up the overhead re-apportionment process as a set of equations.
Let:
A = the total overhead $ apportioned to department A
B = the total overhead $ apportioned to department B, etc
Then:
A = 80,000 + 0.40 C + 0.75 D + 0.30 E
B = 100,000 + 0.50 C + 0.20 D + 0.70 E
C = 10,000 + 0.05 D
D = 20,000 + 0.10 C
E = 4,000
Note that the equations for C and D are simultaneous – i.e. C is a function of D, and D is a function of C. Therefore,
these two equations must be solved first.
Various approaches are possible to solve simultaneous equations, but substitution is the quickest.
Substituting the D equation into the C equation:
C = 10,000 + 0.05 (20,000 + 0.10 C)
Multiplying out the bracket:
C = 10,000 + 1000 + 0.005 C
Collecting terms:
0.995 C = 11,000
C = 11,055.3
Substituting into the D equation:
D = 20,000 + 0.10 × 11,055.3
D = 21,105.5
Finally, plugging these values into the equations for A and B, the total overhead apportioned to each of the
production cost centres is:
A = 80,000 + 0.40 × 11,055.3 + 0.75 × 21,105.5 + 0.3 × 4,000
A = 101,451.2
B = 100,000 + 0.50 × 11,055.3 + 0.20 × 21,105.5 + 0.7 × 4,000
B = 112, 548.8

Exam advice

The FMA/MA exam will practically focus on the algebraic approach, as the repeated distribution would
be too time-consuming.
5.2.15 Bases of Absorption and Overhead Absorption Rates
2.15 Bases of Absorption and Overhead Absorption Rates

Remember that the main aim of absorption costing is to absorb the production overheads into a production
unit.
The process of absorbing overheads begins with the allocation and apportionment of indirect costs to cost
centres. This is followed by the reapportionment of service cost centre costs into the production cost
centres.

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The next step in absorption costing is to establish the overhead absorption rate.
2.15.1 Bases of absorption – a quick review
When all the overheads have been allocated, apportioned and reapportioned into the production department
cost centres, a suitable absorption basis needs to be established.
To establish a suitable basis of absorption, it is likely that:
 Labour-intensive production cost centres would use absorption rates based on the number of
labour hours.
 Machine-intensive production cost centres would use absorption rates based on machine hours.
5.2.16 Calculation Of Overhead Absorption Rates
2.16 Calculation Of Overhead Absorption Rates

The overhead absorption rate is the rate at which overheads are absorbed into the cost of a unit of product.
Once an appropriate basis for the overhead absorption rate has been established, the absorption rate can be
calculated.
The overhead Absorption Rate (OAR) is typically calculated as follows:
OAR = Total overheads of production cost centre / total absorption base

Example

Overheads have been allocated, apportioned and reapportioned to give the following total overheads for
Production Cost Centres A and B.
Each unit of Product X made requires 2 labour hours in Production Cost Centre A and 4 machine hours in
Production Cost Centre B.

Production Cost Production Cost Maintenance Warehouse Total

Centre A Centre B

Total overheads $126,000 $74,000 - - $200,00

0

Number of labour hours 20,000 5,000 25,000

worked

Number of machine 10,000 40,000 50,000

hours used

. Calculate the overhead absorption rates for each production cost centre.
. Calculate the overheads absorbed for Product X.
Answer:
a)

1. Overhead absorption rate for Production Cost Centre A

Production Cost Centre A absorbs overheads based on direct labour hours. There were 20,000 labour hours
worked in the Production Cost Centre A.
2.
Overhead apportioned = $126,000
3.
Total hours worked = 20,000
4.
Production Cost Centre A overhead absorption rate = Total overheads/Total hours worked
5.
= $126,000 / 20,000 hours = $6.30 per direct labour hour
6.
1. Overhead absorption rate for Production Cost Centre B
Most of the work in Production Cost Centre B is automated. Cost centre B, therefore, absorbs overheads based
on machine hours. There were 40,000 machine hours used in Production Cost Centre B.
2.
Overhead apportioned = $74,000
3.
Machine hours used = 40,000
4.
Production Cost Centre B overhead absorption rate = Total overheads/Total machine hours
5.
$74,000 / 40,000 hours = $1.85 per machine hour

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Example

6.
b)
Production cost centre Hours Overhead absorption rate $
A 2 labour hours $6.30 per labour hour 12.60
B 4 machine hours $1.85 per machine hour 7.40
Overheads absorbed 20.00
Each unit of Product X absorbs $20.00 of indirect production costs.

Activity 8

The production overheads of a manufacturer for the period have been allocated and apportioned as follows:

Assembly Finishing Maintenance Purchasing

$ $ $ $
Previously allocated and apportioned costs 1,945,500 820,500 172,850 95,250
Service cost centre Basis of apportionment
Maintenance Maintenance hours 122,012 40,670 (172,850) $10,168
Purchasing Number of orders 62,681 42,737 NIL (105,418)
Total overhead 2,130,193 903,907 NIL NIL

The total overhead costs of Assembly and Finishing are $2,130,193 and $903,907, respectively.

Assembly activities are machine-intensive while Finishing activities are labour-intensive.

There are 100,000 machine hours to be worked in Assembly while Finishing budgets to work 20,000 labour
hours.

A unit of Product X requires 1 hour in Assembly and 2 hours in Finishing.

1. Calculate the OAR for Assembly and Finishing.

2. Calculate the overheads absorbed per unit of Product X.
*Please use the notes feature in the toolbar to help formulate your answer.

1. Calculate the OAR for Assembly and Finishing.

Assembly Finishing

Total Overheads 2,130,193 903,907

($)

Total basis:

Machine hours 100,000

Labour hours 20,000

OAR $21.30 per machine $45.20 per labour hour

hour ($903,907 / 20,000)
($2,130,193 / 100,000)

1. Calculate the overheads absorbed per unit of Product X.

Product X: OAR ($ / hour) Hours $
Assembly 21.30 1 21.30
Finishing 45.20 2 90.40
OAR per unit 111.70

Activity 9

A company has two production departments – A and B. The company makes three products – Product 1,
Product 2 and Product 3. The following information is available relating to Product 1:

Department A B

Overhead $100,000 $60,000

Labour hours 10,000 15,000

Machine hours 40,000 5,000

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Product 1: labour hours per unit 1.5 hours 3 hours

Product 1: machine hours per unit 6 hours 1 hour

Overheads in department A are to be absorbed based on machine hours.

Overheads in department B are to be absorbed based on labour hours.

How much overhead would be included in the cost of a unit of Product 1?

*Please use the notes feature in the toolbar to help formulate your answer.

Department A B

Total Overheads 100,000 60,000

($)

Total basis:

Machine hours 40,000

Labour hours 15,000

OAR $2.50 per machine $4.00 per labour

hour hour
($100,000/ 40,000) ($60,000 / 15,000)
Product 1: OAR ($ / hour) Hours $
Department A 2.50 6 machine hours 15.00
Department B 4.00 3 labour hours 12.00
OAR per unit 27.00

Activity 10

A company has two production departments (Mixing and Bottling), making one product. The following
information is available relating to the product:

Department Mixing Bottling

Overhead $25,000 $40,000

Labour hours 750 500

Machine hours 2,000 1,000

labour hours per unit 45 minutes 40 minutes

Machine hours per unit 5 hours 15 minutes

Overheads in Mixing are to be absorbed based on machine hours.

Overheads in Bottling are to be absorbed based on labour hours.

How much overhead would be included in the cost of a unit of the product?

*Please use the notes feature in the toolbar to help formulate your answer.

Department Mixing Bottling

Total Overheads 25,000 40,000

($)

Total basis:

Machine hours 2,000 1,000

Labour hours 750 500

OAR $12.50 per machine $80.00 per labour

hour hour
($25,000/ 2,000) ($40,000 / 500)
OAR ($ / hour) Hours $
Mixing 12.50 5 machine hours 62.50
Bottling 80.00 40/60 labour hours 53.33

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OAR per unit 115.83

5.2.17 Predetermined Overhead Absorption Rates

2.17 Predetermined Overhead Absorption Rates

It is common for an overhead absorption rate to be calculated at the beginning of a year. When this happens,
a predetermined overhead absorption rate is calculated based on budgeted production overheads and
activity levels (such as labour and machine hours).

Predetermined overhead absorption rate = Budgeted production overhead/ Budgeted activity levels

5.2.18 Under and Over-Absorption

2.18 Under and Over-Absorption

 Over absorption means that more production overheads were recovered than required. It occurs
when more production overheads are charged to production units than were incurred.
If absorbed overheads > actual overheads over absorption (over recovery) of overheads

 Under absorption means that insufficient production overheads were recovered. It occurs when
lower production overheads are charged to production units than were incurred.
If actual overheads > absorbed overheads under absorption (under-recovery) of overheads

2.18.1 Determining Over or Under-Absorption
1. Determine the overhead absorption rate
Determine the predetermined overhead absorption rate by dividing the budgeted overhead by the
budgeted activity.
2. Calculate the overhead absorbed
Calculate the overheads absorbed by multiplying the absorption rate by the actual activity achieved.
3. Compare with actual figures
Compare the figure for overhead absorbed with the actual overhead cost incurred.
$
Overheads absorbed X
Actual overheads (X)
Over-/under-absorption X / (X)
Example

The following table shows the budgeted and actual overheads and activity levels for an organisation:

Budgeted overhead ($) 100,000 Actual overhead ($) 116,000

Budgeted machine 40,000 Actual machine 42,000

hours hours

Calculate the amount of overhead over or under-absorbed.

1. Determine the overhead absorption rate
Budgeted overhead absorption rate = budgeted overheads/budgeted machine hours = $100,000/40,000
machine hours = $2.50 per machine hour
2. Calculate the overhead absorbed
Overhead absorbed = actual machine hours × budgeted overhead absorption rate = 42,000 × $2.50 = $105,000
3. Compare absorbed overhead with actual overhead
Actual overhead = $116,000
Absorbed overhead = $105,000
Therefore under absorbed overhead = $116,000 − $105,000 = $11,000
Under-absorption means that insufficient production overheads were recovered.

Activity 11

Consider the following information:

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 Actual overheads were $690,000

 Budgeted overhead absorption rate was $50 per machine hour
 Actual machine hours were 14,000.
Were overheads over-absorbed or under-absorbed?

*Please use the notes feature in the toolbar to help formulate your answer.
$
Overheads absorbed 700,000 $50 × 14,000
Actual overheads (690,000)
Over-/under-absorption 10,000 Over-absorbed
5.2.19 Accounting for Production Overheads
2.19 Accounting for Production Overheads

The journal entries for manufacturing (production) overheads when they are both incurred and absorbed
occur in the following ledger accounts:
 Production overheads account
 Under/over absorption of production overheads account.
Example

Discussion of the journal entries for over and under-absorption of overheads is as follows:
Under-absorption

1.
Indirect costs associated with production are debited to the production overheads account. These are indirect
materials, indirect labour, and indirect expenses.
2.
The total of these is the actual production overhead for a period. In this case, the total actual overheads is $60,000
3.
The credit to work-in-progress represents the amount of overhead absorbed.
4.
Production Overheads
$ $
Indirect materials 20,000 Work-in-progress 55,000
Indirect labour 30,000
Indirect expenses 10,000
60,000 60,000
5.
As total actual production overheads ($60,000) > absorbed overheads ($55,000), overheads are under-absorbed.
6.
The under-absorption is reflected on the credit side as a balancing figure.
7.
Production Overheads
$ $
Indirect materials 20,000 Work-in-progress 55,000
Under-absorption of overheads
(balancing figure)
Indirect labour 30,000 5,000
Indirect expenses 10,000
60,000 60,000
The under-absorbed overhead is debited to the under or over-absorption of overheads account, and then it is
transferred to the statement of profit and loss as an expense.
Over-absorption
Production Overheads
$ $
Indirect materials 20,000 Work-in-progress 68,000
Indirect labour 30,000
Indirect expenses 10,000

The total actual production overheads ($60,000) < absorbed overheads ($68,000), so overheads have been over-

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Example

absorbed.
The over-absorbed overhead is debited to the production overhead account as a balancing figure.
Production Overheads
$ $
Indirect materials 20,000 Work-in-progress 68,000
Indirect labour 30,000
Indirect expenses 10,000
Over-absorption of overheads
(balancing figure)
8,000
68,000 68,000
The over-absorbed overhead is credited to the under or over-absorption of overheads account, then transferred to
the statement of profit and loss, where it reduces production costs.

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Chapter 6: Absorption and Marginal Costing

6.1.1 Definitions
1.1 Definitions

Definitions

Direct costs – Costs that can be measured reliably and directly traced to a specific cost unit. All other costs are
indirect costs (overheads).
Prime costs – The total sum of direct costs, also known as the total direct cost.
Indirect costs – Costs that are not directly traceable to a cost unit; also known as overheads.
Production costs – Costs associated with making the product.
Non-production costs – Costs which are not associated with making the product.
Variable costs – Costs which change in direct relation to a change in production level.
Fixed costs – Costs which remain the same irrespective of production level.

Cost classification is explained in detail in chapter 8, section 3. You should read this section prior to
studying this chapter 6.
6.2.1 Concept of Contribution
2.1 Concept of Contribution

Definition

Contribution − The difference between a product or service’s selling price and marginal cost.
Contribution is the amount that contributes towards the recovery of the overheads of an organisation.
If contribution in total is greater than fixed overheads, the company will profit.
2.1.1 Contribution formula

Contribution = Selling price − Marginal cost (also known as total variable cost)

For example, if Product P sells for $30 per unit and its marginal cost is $17 per unit, the contribution earned
per unit sold is $13 ($30 - $17)
2.1.2 Total contribution
Contribution per unit is the same for all levels of sales and production. This means it is straightforward to
calculate total contribution and profit.

Total contribution = contribution per unit × number of units sold

2.1.3 Period costs (Fixed overheads)

Fixed overheads are treated as period costs when marginal costing is used. Period cost means that the
expense is incurred over a period and is unrelated to production levels.
Marginal costing collects the fixed production overheads in the production overheads account and debits
them to the statement of profit or loss (as an expense) at the end of an accounting period.
2.1.4 Contribution Graph

Profit /
Point Contribution v. Fixed cost Loss Note

A Contribution < Fixed cost Loss Losses incurred as contribution was insufficient to cover

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fixed costs.

B Contribution = Fixed cost Break-even Contribution is equal to fixed costs, resulting in neither
profit nor loss.

Contribution > Fixed cost Profit Contribution exceeds fixed costs, resulting in profit
C earned.
6.2.2 Marginal Costing
2.2 Marginal Costing

Marginal costing is a costing method used for short-term decision-making. It facilitates this by recognising
costs according to their behaviour.
This means that fixed and variable costs are treated differently, especially in inventory valuation.
2.2.1 Fixed Costs
Marginal costing expenses fixed costs against profit for the period, not retaining any fixed costs in the
inventory valuation. This is because fixed costs do not change in the short-term and are irrelevant to short-
term decision-making (they would be incurred regardless of the decision).
Compare this to absorption costing, where fixed costs are allocated, apportioned, and absorbed into
inventory. Any unsold inventory would carry a portion of these fixed costs into the next period.
2.2.2 Variable Costs
Under marginal costing, only variable (marginal) costs are included in inventory valuation.
This is because the marginal cost of a product is the increase in expenses required to produce an additional
unit, which is usually its variable cost.
For example, if it costs $60,000 to make 10,000 units and $60,003 to produce 10,001 units, the marginal cost
of the additional unit is $3.

Key Point

Under marginal costing, inventory is valued at only marginal (variable) production costs.
Under absorption costing, inventory is valued at total production costs (including a portion of fixed production
overheads).

The marginal cost of a product usually consists of the following:

 Prime costs:
 Direct materials
 Direct labour
 Direct expenses
 Variable production overheads
Activity 1

Classify the statements as relating to either marginal costing or absorption costing.

Classification
(Marginal costing or
Absorption costing)
Statement

Fixed costs are written off in total in the period they relate to Marginal costing

Costing is based on the cost of producing one more unit Marginal costing

Fixed costs relating to the previous period could be carried forward in the cost Absorption costing
of the opening inventory

Fixed costs are included in the cost of inventory Absorption costing

Costing is based on the variable costs of production Marginal costing

If there is closing inventory, a portion of the fixed costs are carried forward into Absorption costing
the next period
6.3.1 Absorption and Marginal Costing Inventory Valuation
3.1 Absorption and Marginal Costing Inventory Valuation

Absorption and marginal costing are two different methods of dealing with production overheads. As a result,
they may produce profit figures for an accounting period that differ from each other.

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Absorption Costing Marginal Costing

All production costs Variable production costs only.

Valuation of production
(finished goods) (including production overheads) Fixed production overheads are not included.

Absorbed into cost units Expensed off for the period as a cost (period
Treatment of fixed cost).
(included in the value of finished
production overheads
goods)

Relationship with the Selling price – absorption cost = Selling price – marginal cost = contribution.
selling price profit

The total cost of production; helps The marginal cost of production is the cost
set a selling price that covers all of making one additional unit.
Description
production costs.
Useful for decision-making.

Marginal costing values inventory at marginal cost (variable production costs only).
Absorption costing values inventory at the full absorption cost (including overheads absorbed). The full
absorption cost is sometimes called the full production cost.
3.1.1 Absorption costing cost card

$ per unit
Direct materials [x]
Direct labour [x]
Direct expenses [x]
Variable production overheads [x]
Fixed production overheads [x]

Unit cost under absorption costing [x]

3.1.2 Marginal costing cost card

$ per unit
Direct materials [x]
Direct labour [x]
Direct expenses [x]
Variable production overheads [x]

Unit cost under marginal costing [x]

Note that the total unit cost on the marginal cost card is also the total variable production cost.

Key Point

The total cost (value) of a unit of finished goods under absorption costing will always be higher than marginal
costing.
This is due to the fixed production overheads absorbed into the cost unit under absorption costing.

Example

A company makes Product P, which sells for $30 per unit. Product P’s cost card is as below:

$ per unit

Direct materials 5

Direct labour 10

Direct expenses 1

Variable production overheads 1

Fixed production overheads 3

What are Product P’s absorption and marginal cost and profit per unit?
 Absorption cost card

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Example

$ per unit
Direct materials 5
Direct labour 10
Direct expenses 1
Variable production overheads 1
Fixed production overheads 3
Unit cost of Product P under absorption costing 20
Selling price 30
Absorption profit per unit 10
 Marginal cost card
$ per unit
Direct materials 5
Direct labour 10
Direct expenses 1
Variable production overheads 1
Unit cost of Product P under marginal costing 17
Selling price 30
Marginal profit per unit 13
 Fixed production overheads have been removed when using marginal costing.
This is because the marginal cost of a unit = total of direct costs (also known as ‘prime cost’) + variable
overheads. No fixed production overheads are included, in contrast to absorption costing.

 Profit of Product P if it sells for $30 per unit and total production cost (full absorption cost) is $20
When absorption costing is used, Profit = Selling price − total production cost

Therefore profit = $30 - $20 = $10

 The difference between the profit and contribution of Product P is $3 ($13 − $10). This represents the
amount of the fixed production overheads that were absorbed into Product P under absorption costing.

Activity 2

BKU Co is in the process of valuing one of its products, Product XB. Product XB has a marginal cost of $15
per unit and an absorption cost of $18 per unit. At the end of September, there were 2,500 units left in
inventory.

. What is the value of this inventory at the end of September if BKU Co uses marginal costing to
value its products?
. If BKU Co uses absorption costing instead to value its products, what would the value of BKU Co’s
inventory of Product XB be at the end of September?
. Why is the valuation of inventory under absorption costing higher than under marginal costing?
*Please use the notes feature in the toolbar to help formulate your answer.

. Value of inventory under marginal costing = marginal cost per unit × number of units left in
inventory

= $15 × 2,500 = $37,500

.
. Value of inventory under absorption costing = absorption cost per unit × number of units left in
inventory

= $18 × 2,500 = $45,000

Marginal costing does not include a share of fixed production overheads in the cost of a unit, but absorption
costing does. This means that the value of inventory under absorption costing will always be higher than its
value under marginal costing.

.
Activity 3

Production data for one grommet:

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Materials: 2.4 kg @ $3 per kg

Direct labour: 1.5 hours @ $5 per hour

The variable overhead rate is $4 per direct labour hour. The fixed overhead absorption rate is $7 per direct
labour hour. The budgeted production is 5,000 grommets.

Budgeted fixed overheads:

Units × no of hours per unit × hourly rate = 5,000 × 1.5 hours × $7 = $52,500

Determine the cost of a grommet for inventory valuation purposes on:

(a) a marginal costing basis; and

(b) an absorption costing basis.

*Please use the notes feature in the toolbar to help formulate your answer.

. Marginal cost (MC)

$

Materials 7.20 2.4 kg @ $3 per kg

Direct labour 7.50 1.5 hours @ $5 per hour

Variable overheads 6.00 1.5 hours @ $4 per hour

Marginal cost per unit 20.70

.
. Absorption cost (AC)
$

Marginal cost (as above) 20.70

Plus: Fixed overheads 10.50 (1.5 hours @ $7 per hour)

Absorption cost per unit 31.20

.
Activity 4

The information in the table relates to Product YT for June.

$ per unit

Direct materials 8

Direct labour 12

Direct expenses 3

Variable production overheads 2

Fixed production overheads 5

Fixed selling costs 1

At the end of June, 1,750 units of Product YT were left in inventory.

. What is the full absorption cost of one unit of Product YT?

. If Product YT sells for $38 per unit, how much contribution is earned for each unit sold?
. If Product YT sells for $38 per unit, how much is the profit per unit under absorption costing?
. How much was the value of inventory at the end of June under absorption costing?
. How much was the value of inventory at the end of June under marginal costing?
*Please use the notes feature in the toolbar to help formulate your answer.

. Full absorption cost per unit of Product YT = $(8+12+3+2+5) = $30

. Contribution = Selling price − marginal cost.

Marginal cost per unit of Product YT = $(8+12+3+2) = $25

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.
Contribution = $38 - $25 = $13 per unit

.
. Full absorption cost per unit of Product YT = $(8+12+3+2+5) = $30

Absorption profit = $38 − $30 − $1 = $7 per unit

.
. Full absorption cost per unit = $(8+12+3+2+5) = $30

Inventory valuation = $30 × 1,750 = $52,500

.
. Marginal cost per unit = $(8+12+3+2) = $25

Inventory valuation = $25 × 1,750 = $43,750

.
6.3.2 Absorption and Marginal Costing Profit Differences
3.2 Absorption and Marginal Costing Profit Differences

Because units of inventory are valued differently under absorption and marginal costing, this will affect the
following:
 The value of opening inventory at the beginning of an accounting period
 The value of closing inventory at the end of an accounting period.
3.2.1 Absorption costing: statement of profit or loss format
$ $
Sales revenue X
Cost of sales
Opening inventory X
Production costs X
Closing inventory (X)
Production cost of sales (X)
Gross profit X
Non-production overheads (X)
Absorption profit X

3.2.2 Marginal Costing: Statement Of Profit Or Loss Format

$ $
Sales revenue X
Cost of sales
Opening inventory X
Variable production costs X
Closing inventory (X)
Variable production cost of sales (X)
Variable non-production costs (X)
Contribution X
Fixed production overheads (X)
Fixed non-production overheads (X)
Marginal profit X
Example

The following information relating to Product Z for January 20X4 is available: Sales in January were 8,500 units of
Product Z at $30 per unit = $255,000
 The full absorption cost per unit of Product Z is $10 per unit. This comprises a marginal cost of $8 per
unit and absorbed production fixed overhead of $2 per unit.
 1 January inventory of 2,000 units of Product Z was held. This inventory was valued at 2,000 × $10 per
unit = $20,000
 9,000 units of Product Z were produced in January at a total production cost of 9,000 × $10 = $90,000
 On 31 January, inventory of 2,500 units of Product Z was held. This inventory was valued at 2,500 × $10

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Example

= $25,000.
Prepare statements of profit or loss for Product Z for Jan 20X4, using:
a) Absorption costing
b) Marginal costing
Answer:

. Absorption costing statement of profit and loss

$ $
Sales revenue 255,000
Cost of sales:
Opening inventory 20,000
Production costs 90,000
Closing inventory (25,000)
Production cost of sales (85,000)
Absorption profit 170,000

.
. Marginal costing statement of profit and loss
$ $
Sales revenue 255,000
Cost of sales:
Opening inventory 16,000
Production costs 72,000
Closing inventory (20,000)
Marginal cost of sales (68,000)
Contribution 187,000
Fixed production overhead (18,000)
Marginal profit 169,000
.
Notes:
 Opening inventory
Opening inventory is valued at marginal cost ($8) per unit in the marginal costing statement and full
absorption cost ($10) in the absorption costing statement. The difference is due to fixed overheads absorbed
in inventory ($2 per unit)when absorption costing is used.
The difference is that absorption costing opening inventory is valued at $4,000 more than marginal costing.

 Production cost
The difference in the production cost is also due to the difference in the cost of a unit under marginal and
absorption costing.
Production of 9,000 units costs $18,000 more ($90,000 -$72,000) because the 9,000 units are valued at $2 more
under absorption costing and 9,000 × $2 = $18,000.


Closing inventory
Closing inventory is valued at marginal cost ($8) per unit in the marginal costing statement and full absorption
cost ($10) in the absorption costing statement. The difference is due to fixed overheads absorbed in inventory ($2
per unit)when absorption costing is used.
The difference is that absorption costing closing inventory is valued at $5,000 more than marginal costing.

 Contribution
Contribution only appears in the marginal costing statement of profit or loss and is the difference between
the sales revenue and the variable cost of sales (or total marginal cost).
Sales − marginal cost = contribution
$255,000 − $68,000 = $187,000
 Fixed production overheads (period costs)
Fixed production overheads only appear as fixed production overheads in the marginal costing statement of
profit or loss. They are taken away from the total contribution to calculate the profit for the period.
Fixed production overheads are included in the opening inventory, production costs and closing inventory in
the absorption costing statement of profit or loss.

Activity 5

Furniture Co has a product with the following budgeted price and costs for a month:

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 Direct labour cost per unit of $7.00

 Direct material cost per unit of $3.00
 Variable production overhead cost per unit of $5.00
 Each unit requires one hour of direct labour
 The sales price is $40.00
 There are no opening inventories
 Budgeted production in the month is 500 units
 Fixed production costs are $2,000
. Calculate Furniture Co’s monthly marginal profit if 400 units were sold.
. Calculate Furniture Co’s monthly absorption profit if 400 units were sold.
*Please use the notes feature in the toolbar to help formulate your answer.

.
$ $ Note
Sales 16,000 400 × 40
Opening inventory NIL
Production 7,500 500 × (3 + 5 + 7)
Less: Closing inventory (1,500) (500 − 400) × (3 + 5 + 7)
Cost of sales (6,000)
Contribution 10,000
Fixed Overheads (2,000)
Marginal Profit 8,000

.
.
$ $ Note
Sales 16,000 400 × 40
Opening inventory NIL
Production 9,500 500 × (3 + 7 + 5 + 4*)
Less: Closing inventory (1,900) (500 − 400) × (3 + 7 + 5 + 4*)
Cost of sales (7,600)
Absorption Profit 8,400
.
*Fixed OAR working:

.
OAR

.
= (2000 / 500)

.
= $4 per unit

.
Activity 6

Baller Co produces 1,000 units of product X per month.

On February 1, there were 80 units in the opening inventory.

Each Product X requires 2 hours of labour and 2 square metres of material. Labour costs are $10 per hour,
while material costs $5 per square metre.

Fixed production overheads are $2,000 per month.

Each Product X sells for $50.

February sales were 1,000 units. In March, sales were 900 units.

. Calculate absorption and marginal costing profit for February and March.
Absorption Costing Profit Statement Template

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February March
Absorption Costing Profit Statement $ $ $ $
Sales
Opening inventory
Production
Less: Closing inventory
Cost of sales
Absorption costing profit

Use an absorption costing cost card to calculate the value of a unit Product X.

Marginal Costing Profit Statement Template

February March
Marginal Costing Profit Statement $ $ $ $
Sales
Opening inventory
Production
Less: Closing inventory
Cost of sales
Contribution
Fixed Overheads
Marginal Costing Profit

Use a marginal costing cost card to calculate the value of a unit of Product X.

*Please use the notes feature in the toolbar to help formulate your answer.

. Absorption costing profit

Absorption costing cost card:

$
Direct materials
(2 ×$5) 10
Direct labour
(2 ×$10) 20
Total direct cost 30
Fixed production overheads absorbed
($2,000 ÷ 1,000) 2
Absorption cost per unit 32

Absorption costing profit statement:

February March
Absorption costing profit statement $ $ $ $
Sales
February (1,000 × $50) 50,000
March (900 × $50) 45,000
Opening inventory
February (80 × $32) 2,560
March (from February closing inventory) 2,560
Production
(1,000 × $32) 32,000 32,000
Less: Closing inventory
February ((1,000 + 80 − 1,000) ×$32) (2,560)
March ((1,000 + 80 − 900) ×$32) (5,760)
Cost of sales (32,000) (28,800)
Absorption costing profit 18,000 16,200
. Marginal costing profit

Marginal costing cost card:

$
Direct materials 10

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(2 ×$5)
Direct labour
(2 ×$10) 20
Total marginal cost 30

Marginal costing profit statement:

February March
Marginal costing profit statement $ $ $ $
Sales
February (1,000 × $50) 50,000
March (900 × $50) 45,000
Opening inventory
February (80 × $30) 2,400
March (from February closing inventory) 2,400
Production
(1,000 × $30) 30,000 30,000
Less: Closing inventory
February ((1,000 + 80 – 1,000) ×$30) (2,400)
March ((1,000 + 80 − 900) ×$30) (5,400)
Cost of sales (30,000) (27,000)
Contribution 20,000 18,000
Less: Fixed production Overheads (2,000) (2,000)
Marginal costing profit 18,000 16,000
6.3.3 Reconciling Absorption and Marginal Costing Profit
3.3 Reconciling Absorption and Marginal Costing Profit

Absorption and marginal costing will report different profits if there is a change in the number of units of
opening and closing inventory.
The difference between absorption and marginal profit may be expressed as:
$
Marginal profit X
+([closing inv. − opening inv.] × overhead absorption rate) X / (X)
Absorption profit X
This means the difference between absorption and marginal costing profit is the overheads absorbed into
inventory multiplied by the change in inventory.
Absorption and marginal profit are the same if there is no change in inventory levels.

Example

The answers from the previous example of Product Z for January 20X4 are summarised as follows:
Opening inventory on 1 January 20 X 4 = 2,000 units of Product Z
Closing inventory on 30 January 20 X 4 = 2,500 units of Product Z
Full production cost = $10 per unit
Marginal cost = $8 per unit
Absorption costing profit = $170,000
Marginal costing profit = $169,000
Reconcile Product Z’s absorption and marginal profit for January 20X4.
Answer:
The profit from the two methods is reconciled as follows:
$
Marginal profit 169,000
+([closing inv. − opening inv.] × overhead absorption rate)
+([2,500 − 2,000] × $2)
1,000
Absorption profit 170,000

3.3.1 Determining whether absorption or marginal cost profit will be higher

Opening vs Closing Inventory Absorption costing (AC) profit vs Marginal costing (MC) profit

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Opening = Closing AC profit = MC profit

Opening > Closing AC profit < MC profit

Opening < Closing AC profit > MC profit

The difference in profits can be calculated as follows:
Change in inventory × fixed production overhead cost per unit
Activity 7

Baller has supplied the following information for February and March:

February March
Absorption costing profit ($) 18,000 16,200
Marginal costing profit ($) 18,000 16,000

Opening inventory (units) 80 80

Closing inventory (units) 80 180

The fixed production overhead absorbed per unit is calculated as $2.

. Reconcile Baller Co’s absorption and marginal costing profit for February and March.
Absorption and Marginal costing profit reconciliation template

February March
$ $
Marginal profit
+([closing inv. − opening inv.] × overhead absorption rate)
Absorption profit

*Please use the notes feature in the toolbar to help formulate your answer.

February March

$ $

Marginal costing profit 18,000 16,000

+ ([Closing inventory − Opening inventory]× overheads absorbed per unit)

February ((80−80) × $2) NIL

March ((180−80) × $2) 200

Absorption costing profit 18,000 16,200

Activity 8

1. Opening inventory is 1,000 units, and closing inventory is 500 units. Absorption costing profit is
$27,000, and the fixed production overheads are absorbed at $2.50 per unit.
What is the marginal costing profit?

2.
3. Opening inventory is 8,000 units, and closing is 9,500 units. Marginal costing profit is $842,000, and
the fixed production overheads are absorbed at $17 per unit.
What is the absorption costing profit?

4.
5. Opening inventory is 12,000 units, and closing is 12,000 units. Absorption costing profit is $98,000,
and the fixed production overheads are absorbed at $4.50 per unit.
What is the marginal costing profit?

6.
*Please use the notes feature in the toolbar to help formulate your answer.

1. Fall in inventory = 1,000 − 500 = 500 units.

The difference in inventory valuation = change in inventory × fixed production overhead per unit

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2.
= 500 × $2.50

3.
= $1,250

4.
The difference in profit is $1,250

5.
When inventory levels fall, marginal costing gives a higher profit figure than absorption costing.

6.
Marginal costing profit

7.
= $27,000 + $1,250

8.
= $28,250

9.
10. Rise in inventory

= 9,500 − 8,000

11.
= 1,500 units

12.
The difference in inventory valuation = change in inventory × fixed production overhead per unit

13.
= 1,500 × $17

14.
= $1,250

15.
The difference in profit is $25,500

16.
When inventory levels rise, absorption costing gives a higher profit figure than marginal costing.

17.
Absorption costing profit

18.
= $842,000 + $25,500

19.
= $867,500

20.
21. When there is no change in inventory levels and opening inventory = closing inventory, marginal
costing profits are the same as absorption costing profits.

Therefore, the marginal costing profit = $98,000

22.
6.3.4 Advantages and Disadvantages of Absorption and Marginal Costing

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3.4 Advantages and Disadvantages of Absorption and Marginal Costing

Organisations will decide which method to use based on these differences and the particular circumstances
within the organisation.
 Organisations will probably use marginal costing for short-term decision-making.
This is because knowing the contribution that each unit of a product earns is valuable information to have in
the decision-making process.

 If an organisation is more interested in knowing what profits it has earned in a period, it is more
likely to use absorption costing.
3.4.1 Advantages and Disadvantages of Marginal Costing

Advantages Disadvantages

Marginal costing is easy to use. It requires profits to be reconciled with

absorption costing profits.

It is useful to management accountants because it can be Inventory at the end of an accounting period is
used for short-term decision-making. not valued in line with relevant international
accounting standards (IAS 2).

It does not involve any complicated under or over- The production costs do not include all the costs
absorption costing calculations. involved in producing the products, as they
exclude fixed production overheads.

At different sales levels, the contribution earned per unit is

constant, so it is easy to calculate the total contribution
earned for a period.

Marginal costing does not involve absorbing overheads into

product units because the fixed production overheads are
treated as period costs.

3.4.2 Advantages and Disadvantages of Absorption Costing

Advantages Disadvantages

Absorption costing complies with the relevant accounting standard The process of absorbing fixed
(IAS 2), which requires that some fixed production overheads be production overheads into units of
included in inventory valuations at the end of an accounting period. production is complicated. It involves
calculating overhead absorption rates at
the beginning of an accounting period
and under/over-absorbed overhead at the
end.

It helps to control costs. Under and over-absorption is analysed to Absorption costing has limited use in the
understand why it has occurred in an accounting period. decision-making process.
This analysis encourages organisations to look at their spending
and control costs.

Absorption costing is more complete concerning the valuation of

inventory. It considers all costs, so it provides a better
understanding of the costs involved in making products and
providing services.
Therefore, it is beneficial when estimating the costs and profits of an
organisation.

Activity 9

Determine if the statement applies to absorption costing or marginal costing.

Statement Absorption costing or

Marginal costing

This method is useful when making short-term decisions. Marginal costing

Closing inventory is not valued in line with relevant international accounting standards Marginal costing

All the costs are considered, which provides a better idea of all the costs of making Absorption costing
products and providing services.

This method encourages organisations to consider all spending and to control costs. Absorption costing

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This method does not usually help the short-term decision-making process Absorption costing

Fixed costs are charged against the profit of the period in which they are incurred. Marginal costing

Closing inventory value includes a share of fixed production costs. Absorption costing

Produces an inventory valuation suitable for use in the external financial accounts Absorption costing

Results in the higher inventory valuation of the two methods Absorption costing

Results in a higher profit figure for the period when inventory volumes decrease Marginal costing

Focuses on the importance of contribution to fixed overhead and profit Marginal costing

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Chapter 7: Process Costing, Joint Products and

Further Processing
7.1.1 Process Costing
1.1 Process Costing

Definition

Process costing– a method of costing used when identical (homogeneous) units are mass-produced
through a continuous process.
Some organisations produce homogeneous output through a continuous process− for example, oil refining
or chemical manufacturing. In this case, it is not practical to track the cost of each output unit separately.
Examples of situations where process costing is used are:
 Soft drinks industry
 Cake and bread-making industries
 Paint and chemical production
 Oil production (crude oil is processed to produce a variety of products)
 Sweets and chocolate manufacturing.
Under process costing, the unit cost of production is calculated by dividing the total cost of the process by
the number of units output from the process.

Sometimes, the output from one process forms the material input for subsequent processes. For example,
crude oil goes through several refining processes before becoming petroleum.

Materials that have entered the production process but have yet to be output are part of the work in progress.
7.1.2 Loss of Material
1.2 Loss of Material

A loss occurs when the volume of output is lower than the input. There is usually some level of loss during a
process. Some of it is expected and unavoidable, while other losses are avoidable and result from
environmental changes or management actions.

Example: Types of Losses

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Example: Types of Losses

Three types of volume changes should be accounted for:

Type of Description Valued at

Change

Normal loss The expected unavoidable wastage from a process. Nil, or scrap value of
applicable.
Reasons why normal loss occurs include:
 Evaporation of liquids
 Spillage of liquids
 Wastage of materials.

Abnormal The difference when the actual loss is higher than normal loss. Cost of expected output.
loss

Abnormal The difference when the actual loss is less than normal loss. Cost of expected output.
gain
When there are losses in the process, the formula to calculate the expected output is as follows:

INPUT UNITS – UNITS OF NORMAL LOSS = EXPECTED UNITS OUTPUT FROM PROCESS

1.2.1 Calculation of Normal Loss, Abnormal Loss, and Abnormal Gain

Units
Input X
Less: normal loss (X)
Expected output X
Actual ouput (X)
Abnormal loss/gain (X) / X

Activity 1

TRY Co has input 5,000 kg of materials into Process 1. The normal loss is expected to be 5%.

The actual output from the process was 4,843kg.

Determine whether there was an abnormal gain or loss from Process 1.

*Please use the notes feature in the toolbar to help formulate your answer.

Kg Notes
Input 5,000
Normal loss (250) 5% of input
Expected output 4,750
Actual ouput (4,843)
Abnormal gain 93

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TRY Co’s Process 1 experienced an abnormal gain of 93 kg.

Activity 2

Process 1 has an input of 4,000 units of materials.

It is expected to lose 5% of the materials put into the process.

Calculate the expected output from Process 1.

*Please use the notes feature in the toolbar to help formulate your answer.

Expected output units = input units − normal loss units

Expected output units = 4,000 − (4,000 × 5%)

Expected output units = 3,800

Activity 3

The following information relates to Process 1:

Total input units of Process 1 = 10,000

a. Calculate the expected output in units for Process 1 when there is a normal loss of 20% of units put
into the process.
b. If the normal loss is 20% of the input units and the actual output is 7,000, calculate the abnormal
loss or gain units.
c. If the normal loss is 20% of the input units and the actual output is 8,500, calculate the abnormal
loss or gain in units.
*Please use the notes feature in the toolbar to help formulate your answer.

a. Expected output = 10,000 − (10,000 × 20%)= 8,000 units

b. Actual output = 7,000 units; therefore, the process has lost 1,000 units MORE than expected.

Abnormal loss = expected output − actual output = 8,000 − 7,000 = 1,000

c.
Expected output = 10,000 − (10,000 × 20%)= 8,000 units

d.
e. Actual output = 8,500 units; therefore, the process has lost 500 units less than expected.

Abnormal gain = actual output − expected output = 8,500 − 8,000 = 500

f.
There is an abnormal gain of 500 units.

g.
Activity 4

a. Process Y has an input of 20,000 units of materials and is expected to lose 5% of the materials put
into the process.
The actual output transferred to process Z was 19,500 units.

b.
Outputs from Process Y are transferred to Process Z.

c.
Calculate the normal loss in units and any abnormal gain/loss units from Process Y.

d.
e. Process K has had an input of 7,500 units of materials and is expected to lose 20% of the materials
put into the process.
The actual output transferred to Process L was 5,400 units.

f.
Calculate the expected output of Process K and any abnormal gain/loss experienced.

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g.
*Please use the notes feature in the toolbar to help formulate your answer.

a.
Process Y Units
Input 20,000
Normal loss (5%) (1,000)
Expected output 19,000
Actual ouput 19,500
Abnormal gain 500
b.
Process Y’s normal loss is expected to be 1,000 units and has experienced an abnormal gain of 500 units.

c.
d.
Process K Units
Input 7,500
Normal loss (20%) (1,500)
Expected output 6,000
Actual ouput 5,400
Abnormal 600
e.
Process Y’s expected output was 6,000 units, and it experienced an abnormal loss of 600 units.

f.
1.2.2 Valuing Losses
Losses are not always lost entirely from the process; sometimes, they can be sold for scrap − this is called
scrap value, and its information is recorded in the scrap account.
Any income generated from scrap is used to reduce the input costs of a process. This causes the process
costs to be reduced.

7.2.1 Multiple Products

2.1 Multiple Products

Multiple products produced from a process are known as joint products or by-products.

Term Item Description

Common Process 1 Joint products and by-products are two or more products that come from a
process common process.
In this diagram, the common process is Process 1.

Split-off point End of Process Joint and by-products are created after a split-off point, or separation point, in
1 (branches) the processing.
(separation
point) At the end of a common process, several different products are formed.
For example, gasoline and kerosene are joint products from a (common) oil
refining process after the split-off point.
Getting one product without getting the other is impossible, and the products
are often produced in a fixed ratio.
Costs incurred before the split-off point are common costs.

Common Input The costs input into a process that produces multiple products is known as

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costs common costs.

(pre- Common costs must be apportioned between joint products.
separation
costs)

Joint Products A Products that are produced at the same time from the same process.
products and C
Almost all of the process output’s sales value is from its joint products.
In this diagram, assume that Products A and C are joint products.

By-product Product B A product that is produced at the same time as joint products, but has a
significantly lower sale value, is a by-product.
Its value is so low that it is not worthwhile to undertake the process. This sales
value is usually subtracted from common costs.
In this diagram, assume product B is a by-product.

Further Process 2 The output of a process may be further processed into another product.
processing
The organisation must decide whether further processing of a product is
profitable.
This diagram shows that Product C can be added to Process 2 to create Product
D.

7.2.2 Common Cost Apportionment

2.2 Common Cost Apportionment

A process’s common costs may be apportioned to joint products using the following methods:
 By physical measurement (quantity, weight, or volume)
 By market value
 By net realisable value
2.2.1 Apportionment by Physical Measurement

Common costs are apportioned among joint products by their proportion of physical output.
Joint product unit cost = Common costs $ / (total joint product units)

Joint product cost = joint product unit cost × joint product units

In the example shown in the diagram here:

Joint product unit cost
= total common costs / total quantity produced
= (100 + 50) / (7 + 8)
= 150 / 15
= $10 per unit
Costs for Product 1
= $10 × 7
= $70
Costs for Product 2
= $10 × 8
= $80

Key Point

All joint products with common costs apportioned by physical measurement will have an equal unit cost at the
separation point.

Activity 5

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A process’s common costs are $40,000; 120,000 kg of Product A and 80,000 kg of Product B are produced.

Calculate the joint costs of Products A and B apportioned by physical units produced.

*Please use the notes feature in the toolbar to help formulate your answer.

Product A joint costs = 120,000 ÷ (120,000 + 80,000) × $40,000 = $24,000

Product B joint costs = 80,000 ÷ (120,000 + 80,000) × $40,000 = $16,000

2.2.2 Apportionment by Market Value

Common costs are apportioned among joint products by their proportion of sales value.
Joint product unit cost = Common costs $ / (total joint product sales value)

Joint product cost = joint product unit cost × joint product sales value

This method apportions costs according to the market value of each product produced.
When market value is the basis of apportionment, all joint products will have the same gross profit
percentage margin at the split-off point.
This method is used on the assumption that price is directly related to the cost of a product.
In the example shown in the diagram here:
Joint product unit cost
= Common costs $ / (total joint product sales value)
= $150 / (($2.90 × 7) + ($2.15 × 8))
= $4 per $ of sales value.
Costs for Product 1
= $4 × ($2.90 × 7)
= $81.20
Costs for Product 2
= $4 × ($2.15 × 8)
= $68.80

Key Point

All joint products with common costs apportioned by sales value will have the same gross margin % at the
separation point.

Activity 6

120,000 kg of Product A and 80,000 kg of Product B are produced from a joint process.

The common process costs are $40,000

Product A is sold for $2 per kg

Product B is sold for $1 per kg.

a) Apportion the joint costs to Products A and B by market value.

b) Calculate the profit margin earned by Products A and B.

*Please use the notes feature in the toolbar to help formulate your answer.

a. The joint costs will be apportioned as follows:

Product A sales value = 120,000 kg × $2 = $240,000

b.
Product B sales value = 80,000 kg × $1 = $80,000

c.
Total sales value of Products A and B = $(240,000 + 80,000) = $320,000

d.

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Product A joint costs = 240,000 ÷ 320,000 × $40,000 = $30,000

e.
Product B joint costs = 80,000 ÷ 320,000 × $40,000 = $10,000

f.
g. Product A profit margin = profit ÷ sales revenue = (240,000 − 30,000) ÷ 240,000 × 100% = 87.5%

Product B profit margin = profit ÷ sales revenue = (80,000 − 10,000) ÷ 80,000 × 100% = 87.5%

h.
Activity 7 Joint Product Costing

Dot, a chemical company, produces three joint products in one of its processes. After separation, each joint
product undergoes further processing. Senior management is eager to establish the profitability of each
product and requests that you prepare a report for the monthly management meeting.

The following information is available from its costing department for May.

(1) Joint product costs for the month total $19,000.

(2) Product data is as follows:

Product

D O T
Sales price per kg $2.50 $5.00 $10.00
Estimated sales value per kg at the separation point $0.50 $2.75 $4.00
Output in kgs 5,000 2,000 3,000
Further process cost $10,000 $5,000 $15,000

Prepare a statement showing the estimated profit or loss for each product and in total, using the following
methods of allocating joint costs:

(a) Physical quantity (Weight of output)

(b) Sales value at the split-off point

Note: Process loss can be ignored.

*Please use the notes feature in the toolbar to help formulate your answer.

(a) Physical quantity (Weight of output) method:

Total weight of output = 10,000 kg

Joint costs per kg = ​ ​ = $1.90

D O T Total
$ $ $ $
Sales (Price/kg × kgs) 12,500 10,000 30,000 52,500

Post-separation costs 10,000 5,000 15,000 30,000

Joint costs (output in kgs × $1.90) 9,500 3,800 5,700 19,000
19,500 8,800 20,700 49,000
Profit/(loss) (7,000) 1,200 9,300 3,500
(b) Sales value at split-off point:
$

5,000 × 0.50 = 2,500

2,000 × 2.75 = 5,500
3,000 × 4.00 = 12,000
20,000

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Joint costs must be apportioned in above ratio.

D O T Total
$ $ $ $
Sales 12,500 10,000 30,000 52,500
Post-separation costs 10,000 5,000 15,000 30,000
Joint costs 2,375 5,225 11,400 19,000
12,375 10,225 26,400 49,000

Profit/(loss) 125 (225) 3,600 3,500

2.2.3 Apportionment by Net Realisable Value (NRV)
Sometimes a joint product is not saleable at the separation point and can only be sold after further
processing.
If no sales value is available for a joint product at the separation point, apportion common costs based on
net realisable value (NRV): this is the sales value minus further processing costs.
Joint product net realisable value = Joint product sales value after further processing − further processing
costs.

Joint product cost per $ of sales = total pre-separation costs / total net realisable value

In the example shown in the diagram here, Product 2 cannot be sold at the separation point. It costs $9.30 to
further process Product 2 into Product 2b, which can be sold for $8 per kg.
Cost per $ of sales
= $150 / (($2.90 × 7) + ($8 × 8 − $9.30))
= $2 per $ of net realisable value
Costs for Product 1
= $2 × ($2.90 × 7)
= $40.60
Costs for Product 2
= $2 × ($8 × 8 − 9.30)
= $109.40

7.2.3 Practice
2.3 Practice

Activity 8: Common Cost Apportionment

1. Apportion the common costs between Product A and Product B by physical measurement.
2. Apportion the costs between Product A and Product B by sales value and calculate their gross
margin %.
*Please use the notes feature in the toolbar to help formulate your answer.

1. Cost per unit of measurement = total pre-separation costs / total quantity produced

Total common costs

2.
= 500,000 + 200,000

3.
= 700,000

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4.
Total physical measurement

5.
= 20,000 + 15,000

6.
= 35,000

7.
Cost per kg

8.
= 700,000 / 35,000

9.
= $20/kg

10.
Costs for Product A

11.
= $20 × 15,000

12.
= $300,000

13.
Costs for Product B

14.
= $20 × 20,000

15.
= $400,000

16.
17. Cost per $ of sales = total pre-separation costs / total sales value

Total pre-separation (common) costs = 700,000

18.
Total sales (market) value = (20,000 × 40) + (15,000 × 25) = 800,000 + 375,000 = 1,175,000

19.
Costs for Product A = $700,000 × 375,000 / 1,175,000 = $223,404

20.
Costs for Product B = $700,000 × 800,000 / 1,175,000 = $476,596

21.
[Gross profit margin = (revenue − cost of sales) / revenue]

22.
Product A = (375,000 − 223,404) / 375,000 = 40%

23.
Product B = (800,000 − 476,596) / 800,000 = 40%

24.

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Activity 9: Net Realisable Value

 Product A may be sold after process 1, or it may be turned into Product AA with further processing
 Product B cannot be sold at the split-off point: it must be further processed into Product BB to be
saleable.
Calculate the common costs apportioned by net realisable value to Products A and B and their profit
margin %.

*Please use the notes feature in the toolbar to help formulate your answer.

First, apportion the costs between Product A and Product B by net realisable value. To do this, calculate the
net realisable value of Product A and Product B.

1) Total common costs (material costs + conversion costs) = $700,000

Net realisable value of Product B = (18,000 kg × $60) − $80,000 processing costs = $1,000,000

Net realisable value of Product A = (15,000 kg × $25) = $375,000

2) Cost per dollar of sales = total pre−separation costs / total sales value

Total market value (net realisable value) = 1,000,000 + 375,000 = $1,375,000

Costs for Product A = $700,000 × 375,000 / 1,375,000 = $190,909

Costs for Product B = $700,000 × 1,000,000 / 1,375,000 = $509,091

Gross profit margin = (net realisable value − cost of sales) / net realisable value

Product A = (375,000 − 190,909) / 375,000 = 49%

Product B = (1,000,000 − 509,091) / 1,000,000 = 49%

7.2.4 Accounting for By-Products
2.4 Accounting for By-Products

By-products are produced as a side-effect of making something else. By-products have a less significant
sales value than joint products, but they do have a value and are not waste products.
By-products may incur further costs if they must be separated from main products or treated before the sale.
2.4.1 Examples of By-Products
 Molasses from sugar refining: molasses can be sold to consumers for cooking and baking and can
also be used by manufacturers of drinks and animal feed.
 Sawdust from wood processing: sawdust can create certain building materials.
 Straw from harvesting grains: straw can also be used for animal bedding and feed, to make hats, or
to create biofuels.
2.4.2 Accounting for By-Products
The net realisable value of by-products is subtracted from common costs before apportionment to joint
products.
The output measure of joint products should not include by-products.
$
Process costs X
NRV of by-products (X)
Common costs to be apportioned to joint products X

2.4.3 Net Realisable Value (NRV) of By-Products

The NRV of a by-product is its final sales value minus any costs that will be incurred in separating the by-
product from the main products or treating it in preparation for sale.

NRV of by-product = final sales value − further processing costs

For example, if sawdust can be sold for $0.50 per kilogram, but packaging it for sale costs $0.10 per kilogram,
its net realisable value is $0.40 per kilogram ($0.50 − $0.10).
If total production costs were $120,000, and the process produced 100 kilograms of sawdust:
$

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Process costs 120,000

NRV of by-products (40) $0.40 × 100
Common costs to be apportioned to joint products 119,960
Alternatively, by-product receipts can be transferred to income as incidental other income. However, this is
generally only done when the value is minimal.
Activity 10

TZV Co manufactures two joint products and one by-product from Process 1. The following information
relates to May 20X5:

Materials input to process: $595,000

Conversion costs: $105,000

Output Sales revenue per unit

Units $

Joint product A 22,500 25

Joint product B 9,375 20

By-product C 5,000 4

The policy of TZV Co is to reduce process costs with the sales revenue of By-product C and to apportion the
joint costs of Products A and B based on sales value.

How are the common process costs of Process 1 apportioned in May 20X5?

*Please use the notes feature in the toolbar to help formulate your answer.

Calculate total process costs before considering by-products.

Total process costs = materials input to process + conversion costs = $(595,000 + 105,000) = $700,000

Calculate revenue from by-product C

Revenue from by-product C = 5,000 × $4 = $20,000

Calculate net process costs

Net process costs = total process costs − sales revenue from by-product C

= $700,000 − $20,000 = $680,000

Calculate the total sales value of joint products

Total sales value of joint products = units of production × sales value per unit

Units of production ($) Total sales revenue ($)

Joint product A 22,500 25 562,500

Joint product B 9,375 20 187,500

750,000

Apportion net process costs

Net process costs are apportioned based on sales value of joint products.

Total sales revenue ($) Calculation Apportioned cost $

Joint product A 562,500 562,500/750,000 × $680,000 510,000

Joint product B 187,500 187,500/750,000 × $680,000 170,000

750,000 680,000

So, the calculations for TZV Co’s process of apportioning net process costs are as follows:

Total sales revenue ($) Calculation Apportioned cost $

Joint product A 562,500 562,500/750,000 × $680,000 510,000

Joint product B 187,500 187,500/750,000 × $680,000 170,000

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750,000 680,000
7.3.1 Evaluating Further Processing Viability
3.1 Evaluating Further Processing Viability

Organisations must determine if it is profitable to process joint products further.

This is done by comparing the incremental revenues and costs of further processing.
For further processing of a joint product to be worthwhile, the incremental revenues must exceed the
additional processing costs.
$
Incremental revenues X (Further processed sales value − separation point sales value)
Further processing costs (X)
Incremental profit/loss X/(X) If positive, further processing is worthwhile

From the above diagram, is it worthwhile to further process Product A into AA?
$
Incremental revenues from Product AA 165,000 ($45 × 12,000) − ($25 × 15,000)
Further processing costs (125,000)
Incremental profit/loss 40,000 Worthwhile to further process
Key Point

Common costs are not relevant to the further processing decision.

Activity 11: Further Processing

Joint products A and B are outputs of a single manufacturing process. Each product could be sold at the
split-off point or processed further. The following information about the two products is available:

Product A B

$ per unit $ per unit

Share of common costs 50.00 50.00

Selling price at the split-off point 46.00 68.00

Cost of further processing 12.50 24.00

Selling price after further processing 64.00 82.00

Determine whether it is worthwhile to process Products A and B further.

*Please use the notes feature in the toolbar to help formulate your answer.

Product A B
$ per unit $ per unit
Selling price after further processing 64.00 82.00
Less selling price at the split-off point (46.00) (68.00)
Incremental revenue 18.00 14.00
Further processing costs (12.50) (24.00)
Incremental profit/loss 5.50 (10.00)

3. Product A has an incremental profit, so it is worth undertaking the further processing

4. Product B has an incremental loss, so it should be sold at the split-off point.

Joint product common costs are not relevant to the further processing decision.

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Chapter 8: Cost Classification

8.1.1 Cost Units
1.1 Cost Units

Definition

Cost unit – A unit of product or service with which costs are associated.
In cost accounting, a cost unit is a unit of a product or service with which costs are associated.
Different organisations use different cost units. The following are some possible cost units for organisations:

Organisation Possible Cost Unit

Microchip manufacturer A unit of microchip

Train operator Kilometre travelled

University Full-time student

Restaurant Meal served

Bakery A loaf of bread

A cost unit is not always a single item. It might also be calculated in batches.
For example, a single cost unit might be a batch of 1,000 bricks for an organisation that manufactures bricks.
A cost unit is linked to the product or service delivered to the customer. Therefore, there is a link between
how a production unit is costed and eventually priced.

Key Point

An organisation may have to use different cost units to associate costs. But, again, it depends on
what management wants to examine.

1.1.1 Cost Unit Information

Managers need to know the cost and resources required to produce cost units to make well-informed
decisions. This information can be used in several different ways.
 To determine a selling price
Managers need to know the cost of a cost unit produced to determine the selling price required to profit.

 To decide what to produce
Managers need to know how much profit each cost unit is expected to make to determine what to make.

 To help with cost control
Over time, an organisation will know each cost unit's costs and production times. If they vary from
expectations (for instance, significantly higher), this will trigger an investigation and action to bring things
back on track.

 To plan and budget
Managers need the information to help calculate a realistic budget. They need to know how much the
intended output of cost units will cost, what resources they will need and whether the organisation can
afford it.

8.1.2 Cost Object
1.2 Cost Object

A cost object is something for which costs can be collected. Examples of cost objects are:
 A product such as nails
 A service such as haircutting
 A machine that manufactures products or provides support services.
 A department in a manufacturing organisation, such as the production department.
Eventually, all cost object costs are allocated to cost units.

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8.1.3 Responsibility Accounting

1.3 Responsibility Accounting

Definitions

Responsibility accounting – Accounting method for costs according to the manager responsible for those costs.
Responsibility centre – An activity or area of responsibility in an organisation a manager is responsible for and
has control over.
Controllable cost – A cost that is within the control of a manager.
Uncontrollable cost – A cost that is beyond the control of a manager.

Each manager’s responsibility centre needs to be identified to evaluate the manager’s performance.
When evaluating the performance of a responsibility centre and the person (or people) responsible for it
(such as a manager), a distinction should be made between controllable and uncontrollable costs.
The principle of responsibility accounting is that managers should only be judged or held accountable for
costs they can influence or control.
For example, rental costs for the whole factory may be shared across multiple responsibility centres (such
as production or logistics) and are outside the control of the managers of those responsibility centres.
Therefore, it should not be considered when judging the performance of those managers.
Information provided to the responsibility centre manager and those judging his performance should
distinguish between controllable and uncontrollable costs.
8.1.4 Cost Centres
1.4 Cost Centres

Definition

Cost centre – An activity or area of responsibility in an organisation that generates costs but is not responsible
for generating revenue or producing direct profit.
A cost centre only incurs costs, which must be collected and analysed.
Examples of cost centres:

Item Description

Function Many organisations treat functions (or departments) as cost centres –production, information
technology, human resources and finance.

Activity An activity within an organisation can be treated as a cost centre – for example, the
storekeeping activity.

Project Projects may also be cost centres – for example, developing a new product.

Person A person might be a cost centre – for example, a finance director. Costs might include the
director's salary or the running costs of their company car.

Process A process can be treated as a cost centre – for example, the finishing process in a bespoke
furniture manufacturer.

Production or Production or service locations may also be treated as cost centres – for example, the mixing
service location department in the factory of a food manufacturer (production location) or head office (service
location).

Equipment or A specific item or group of equipment or machinery can be treated as a cost centre – for
machinery example, the paint spraying machine in the factory of a car manufacturer.

Activity 1

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Indicate whether the following elements of Furniture Co are cost centres or not.

Mark “Yes” if the element is a cost centre; Mark “No” if it is not.

Cost centre?
Element
Yes or No

The sewing department Yes

The sewing department is a cost centre at Furniture Co. The baking department
incurs costs but is not responsible for revenue. Although the sewing department
produces the products that will be sold, selling Furniture Co products is not their
responsibility.

The sales function, No

including the Furniture Co At Furniture Co, the sales function is responsible for maximising sales of Furniture
boutique Co products and, therefore, is responsible for generating revenue. It is not a cost
centre.

The delivery department Yes

If Furniture Co provides a free delivery service, there is no revenue associated with
the delivery department, so it is a cost centre. However, if Furniture Co charges a
fee for delivery and revenue is earned this way, then Furniture Co’s delivery service
is not a cost centre.

Finance and Yes

administration The finance and administration function is a cost centre. The finance and
administration function incurs costs but is not responsible for revenue.
Performance measures are those related to productivity and efficiency, such as cost per unit, production
volume, and efficiency ratios.
1.4.1 Impact of Cost Centres
Cost centres accumulate costs but have no income or revenue attributed to them. This can result in cost
centres being:
 Perceived negatively and viewed as hurting profit while failing to contribute to the value of an
organisation
 Targeted for cutbacks and redundancies when an organisation is under pressure to reduce costs.
Cost centre managers often find it difficult to justify expansion – for example, the need to invest in additional
employees, training or equipment. The emphasis on costs makes it difficult to demonstrate the positive
impact these investments may bring.
Despite these difficulties, cost centres can positively impact an organisation. Although cost centres do not
earn income, they help the organisation earn income.
For example, there would be no products to sell without the production function, and without the human
resources function, employees would not be as well equipped to perform well.

8.1.5 Revenue Centres

1.5 Revenue Centres

Definition

Revenue centres – Department or division where the revenues are collected.

They are similar to cost centres, but the manager of a specific revenue centre will be responsible for the
revenue of their revenue centre and not the costs.
Revenue centre managers will need to have information about the revenue generated from the products or
services sold by their revenue centre.
8.1.6 Profit Centres
1.6 Profit Centres

Definition

Profit centre – An activity or area of responsibility in an organisation to which costs and revenue can be
attributed.
Identifying profit centres allows profitability to be measured as a product of costs and revenues, which is
impossible for a cost centre.
Examples of profit centres might include an individual health club in a chain of clubs owned by a company, a
salesperson, or a restaurant in a large hotel.

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Like cost centre managers, profit centre managers are accountable for the costs under their control.
However, they are also responsible for the sales revenue earned by their centre and thus for the profits of
the areas they manage.
The profit centre manager should have control (or, at the very least, influence) over the centre’s revenue and
costs.
Performance measures are related to profit, such as gross and net profit margin; and cost centre measures.
Some key features of profit centres are:

In the hierarchy of an organisation, profit centres generally sit higher than cost centres, and
there are often several cost centres within a profit centre.
Organisational
hierarchy Some profit centres also consist of individual members of staff – for example, a sales
representative whose generated income can be traced.

Profit centres tend to cover a significant area of operations.

The seniority of For example, a profit centre might cover an entire division of an organisation.
profit centre
managers Profit centre managers are expected to generate income and control or minimise the costs
incurred. The role is broad and demanding and attracts a high level of seniority.

Profit centres can generate revenue externally or internally (by selling to other parts of the
organisation).
External and
internal revenue It is not essential where the source of revenue originates as long as it is recorded and the
profit is measurable and controllable.

It is possible for a cost centre to become a profit centre – for example, if a delivery driver
becomes a general courier service used by other organisations or if an internal service
From cost centre to function starts charging for the services it provides.
profit centre
For instance, if the information technology function generates internal revenue by charging
other functions for the work carried out, it would become a profit centre.

Activity 2

Classify the elements as either a cost centre or a profit centre.

Element Cost centre or profit centre

The research and development function Cost centre

A hand car wash service Profit centre

A ‘factory shop’ attached to the factory selling directly Profit centre

to the public.

A local branch of a cell phone retail organisation Profit centre

The finance function Cost centre

8.1.7 Investment Centres
1.7 Investment Centres

Definition

Investment centre – An activity or area of responsibility in an organisation to which costs and

revenue can be attributed and capital deployment.
The distinguishing feature of an investment centre is that its manager is also responsible for making
investment decisions regarding the assets available for use (asset investment), such as the purchase and
sale of non-current (long-term) assets.
Therefore, an investment centre is a business unit controlling costs, revenue, and asset investment.
Investment centre performance measures relate to asset expenditure, such as Return on investment (ROI),
Asset turnover, or Residual income (RI), and the criteria that apply to responsibility centres lower in the
management hierarchy.

Definition

Business unit – A particular activity or area of responsibility in an organisation that has a degree of
autonomy in deciding plans and processes for generating profits.

Cost centre Revenue centre Profit centre Investment centre

Generates costs ☑ ☑ ☑

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Generates revenue ☑ ☑ ☑

Non-current asset ☑
procurement
A business unit might be an internal function in an organisation or a subsidiary with a separate legal identity
and ownership structure.
8.1.8 Responsibility Centre Structure
1.8 Responsibility Centre Structure

Activity 3

Classify each statement to the responsibility centre it most applies to.

Statements may apply to more than one responsibility centre.

Statement Cost centre, profit centre, or investment centre

The manager has responsibility for both costs and sales. Profit centre
Investment centre

The manager has the authority to make asset expenditure Investment centre
decisions.

The manager is not responsible for revenue. Cost centre

The responsibility centre does not generate any revenue. Cost centre

The responsibility centre provides a basis for control at a very Investment centre
senior level.

The responsibility centre generally the lowest within the Cost centre
organisational hierarchy.
8.1.9 Asset Expenditure
1.9 Asset Expenditure

Asset expenditure occurs when a new non-current asset is bought, or existing non-current assets are
improved.
It also relates to replacing a non-current asset that has come to the end of its useful life.
An example of asset expenditure is a company buying a new truck or modifying an existing truck to carry
heavier loads.
Asset expenditure is shown on the Statement of Financial Position as an asset.
1.9.1 Accounting Entry
Generally, the accounting entry would be:
Dr Asset (Statement of Financial Position)
Cr Cash / Bank / Payables (Statement of Financial Position)

8.1.10 Expenses
1.10 Expenses

Expenses occur when paying for the ongoing costs of running the organisation. It is expensed in the period
revenue is generated from it (matching concept).
Examples include buying raw materials, paying for labour and paying rent.
For example, maintenance of a truck – for instance, repairing it after an accident – is an expense because the
truck (the asset) will maintain the previous capacity to do things that it already had – repairing the truck does
not enhance its usefulness from before the accident.
Expenses are shown on the Statement of Profit or Loss.
1.10.1 Accounting Entry
Generally, the accounting entry would be:

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Dr Expense (Statement of Profit or Loss)

Cr Cash / Bank / Payables (Statement of Financial Position)

8.1.11 Classifying Expenditure as Asset Expenditure or Expenses

1.11 Classifying Expenditure as Asset Expenditure or Expenses

Expenses are reflected in the Statement of Profit or Loss immediately, reducing profit. Asset expenditure
does not affect the calculation of profit.
1.11.1 Impact of Misclassification
Suppose an expense is incorrectly shown as asset expenditure. In that case, expenses will be understated
(shown as being lower than they should be), meaning that profit will be overstated (shown as being higher
than it should be).
If asset expenditure is incorrectly classified as an expense, expenses will be overstated. This means that
profit will be understated.
Activity 4

Identify whether the calculated profit is correct, understated, or overstated for the given expense
classifications.

Calculated Profit
(Correct, Overstated, or Understated)
Expense

Furniture Co has purchased five new computers for $3,000 each. The
computers will be used for three years before being replaced. The
entire cost has been posted to expenses.

Furniture Co has purchased $25,000 of cotton for use in production.

Since it is a large volume, the cost has been capitalised.

Furniture Co purchased a used lorry for $5,000 to make deliveries.

Since the lorry is not new, the cost has been charged to other
expenses.

Furniture Co has hired an industrial sewing machine. The rental

costs for the year have been charged to expenses.

*Please use the notes feature in the toolbar to help formulate your answer.

Calculated Profit Feedback

(Correct, Overstated, or
Expense Understated)

Furniture Co has purchased five new computers Understated Expenses have been overstated
for $3,000 each. The computers will be used for by writing off the entire cost,
three years before being replaced. The entire meaning that profit is
cost has been posted to expenses. understated.

Furniture Co has purchased $25,000 of cotton Overstated Raw materials consumed are a
consumed in production. Since it is a large revenue item; capitalising them
volume, the cost has been capitalised. has understated expenditure, so
profit is overstated.

Furniture Co purchased a used lorry for $5,000 Understated Expenditure has been overstated,
to make deliveries. Since the lorry is not new, as the lorry is still a non-current
the cost has been charged to other expenses. asset, even if it is not new.

Furniture Co has hired an industrial sewing Correct As Furniture Co is hiring the

machine. The rental costs for the year have been machine and not buying it, these
charged to expenses. costs are being treated correctly.
8.2.1 Codes and Coding Systems
2.1 Codes and Coding Systems

Definitions

Code – A unique set of characters used to identify an item, consisting of numbers, letters, or other symbols.
Coding system – System by which codes are created, managed and used.

A code is a unique set of characters (numbers, letters or symbols) used to identify an item, such as a
customer or a type of material.

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Barcodes and QR codes are typical coding systems commonly used to identify products. These combine
code with a graphic pattern that a machine can read to provide convenient data entry.
Below is an example of a barcode and a barcode reader.

Using codes in accounting is to identify transactions in an accounting system and direct them to the correct
place in the accounts.
Using full descriptions of items, even in manual systems, is impractical because codes are far shorter and
quicker to enter.
Effective coding systems will facilitate fast and accurate processing and improve the organisation’s
efficiency.
Characteristics of an effective coding system are:

Logical Based on an easy-to-understand structure to facilitate learning and application.

Concise Codes should be just long enough to hold the necessary detail.

The coding structure should be consistently applied across the organisation. Haphazard code
applications must be avoided.
Consistent
For example, two identical products should have codes that illustrate their similarity.

Unique Each code should be unique and applicable only to a specific item.

The coding system should have sufficient room for expansion and additional detail. Codes
Expandable
created should have adequate characters to contain the necessary information.
8.2.2 Types of Coding Systems
2.2 Types of Coding Systems

Definition

Chart of accounts – A document that contains comprehensive details on the classes of codes and the accounts
and items they identify.
The coding system used by an organisation is often determined by the computerised accounting software
package, which may come with a ready-made chart of accounts and suggested codes.
Five different coding systems are examined:

2.2.1 Sequential
Sequential (or progressive) coding systems allocate a standard numeric code to each item in a sequence.
Example of sequential chart of accounts:

Code Description

001 Bread roll, small, white

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002 Bread roll, small, wholegrain

003 Bread roll, large, white

004 Bread roll, large, wholegrain

005 Bread loaf, small, white

A disadvantage is that there might be no apparent connection between an item and its code.
This code structure can accommodate 999 individual items, and each item added to the product range will be
allocated the following available code in the sequence.
2.2.2 Block
Block (or group classification) coding systems group similar items together in a block. This system is often
applied to the chart of accounts in an accounting system.
Example of block chart of accounts:

Code block Description

1000 Non-current assets

2000 Current assets

3000 Non-current liabilities

4000 Current liabilities

5000 Equity

6000 Revenue

7000 Expenses
This code structure can accommodate 999 items within each category. For example, the account code for a
bakery oven might be 1001, and for a computer might be 1002.
A potential disadvantage is that the number of items in each block is limited.
2.2.3 Faceted
A faceted code is broken down into facets (or groups), each representing a different characteristic. For
example, consider a furniture manufacturer using a three-faceted coding system:

Facet 1 2 3
Code XX - XX - XXXX
Description  Two digits long  two characters long  Four digits long
 Represents the  Represents different  Represents the
department, function or cost types of cost. cost item.
centre.
A possible chart of accounts for the above code is as follows:

Facet 1: Function Facet 2: Cost type Facet 3: Cost item

01 Preparation DM Direct materials 0001 - 0100 Direct material descriptions

02 Production DL Direct labour 0101 - 0150 Direct labour activities

03 Inspection DE Direct expenses 0151 - 0500 Production overhead cost items

04 Despatch IC Indirect costs

Given this information, a possible code for adding the leather to the arms of a sofa (cost item 0070) during
production is 02 DM 0070:

Facet 1 2 3

Code 02 - DM - 0070
Description Production Direct Materials Leather (Direct Materials)

2.2.4 Hierarchical
A hierarchical coding system is like a faceted system because each code is broken down into facets; the
difference is that each facet is a sub-category that represents a subset of the previous category. The code
grows in length as more detail is provided.
The following chart of accounts shows a four-digit code with up to 4 hierarchies:

Hierarchy Digit Digit Digit digit Description

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1 3 X X X Bread roll

2 3 1 X X Small bread rolls

3 3 1 1 X Small wholegrain bread roll

3 3 1 2 X Small white bread roll

2 3 2 X X Large bread roll

1 4 X X X Bread loaf
If the code number for an item begins with 3, it will be some bread roll. Subsequent digits provide further
detail in the code: the second digit indicates the size of the bread roll (1 for small and 2 for large), the third
digit indicates the type of flour from which the roll is made (1 for wholegrain and 2 for white) and so on.
2.2.5 Mnemonic
A mnemonic coding system uses an abbreviation or other memory trigger to help identify the meaning of the
code. An example is the three-letter system used to identify airports in the travel industry:

Code Airport Name

BNE Brisbane

LHE Lahore

LAX Los Angeles

LHR London Heathrow

SIN Singapore

2.2.6 Mixed Code

A coding system will not always be structured using only one of the above categories. In reality, most coding
systems are a combination of different system types. These are known as mixed codes.
A typical example of mixed codes is the flight numbers used by airlines. For example, Flight SA237
represents a South African Airlines flight from London Heathrow (LHR) to Johannesburg (JNB). The flight
number (or code) includes aspects of a mnemonic code (SA) and a number representing the route.
Activity 5

QWB Co has four production departments and four non-production departments. The non-production
departments are the Finance department, the Marketing department, the Administration department and the
Human Resources department. These departments are treated as individual cost centres where costs are
collected.

Here are some of the codes that QWB Co’s accounts department uses:

 Finance department = FIN

 Marketing department = MAR
 Administration department = ADM
 Human Resources department = HRD
 Salaries (labour) code = 004
 Printing and paper code = 005
 Computer repairs code = 006
 Rent code = 007
 Rates code = 008
 Electricity costs code = 009
To code expenses, QWB Co first allocates costs to a non-production cost centre. These costs are then given
a code that reflects the type of expenditure (for example, computer repairs, rent and salaries).

Code the costs correctly:

Cost Code

Finance department rent cost FIN007

Marketing department printing and paper cost MAR005

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Administration department electricity cost ADM009

Human Resources department salaries cost HRD004

Finance department salaries FIN004

Human Resources department electricity cost HRD009

Marketing department computer repairs MAR006

Administration department rates ADM008

8.2.3 Using Codes
2.3 Using Codes

Accounting systems capture transactions and other information, process them according to programmed
rules and produce outputs such as financial statements, management accounting information, and reports.
This process relies on transactions being classified correctly and directed to the correct location in the
accounting system. Again, coding helps to facilitate this process.
Items classified using codes include:

Item Description

Customers Account codes represent customers in the sales order process and the receivables ledger.

Suppliers Account codes represent suppliers in the purchasing process and the payables ledger.

The general ledger chart of accounts uses codes to identify the different accounts within
General ledger
the ledger. The account code allocated to each entry directs the entry to the correct double-
accounts
entry account.

Products are allocated codes to facilitate invoicing and costing. Product codes are entered
Products
on customer orders and invoices issued to customers.

Cost centre codes may be added to transactions to help aggregate costs for each cost
Cost centres
centre.

Employee numbers represent individual employees in payroll and human resources

Employees
systems.

Job codes are used to allocate costs and revenue to jobs.

Jobs For example, each job undertaken by an accounting practice has a unique code to charge
for the time spent working.

Codes are allocated to items of raw materials to identify and track them from when they are
Materials
received from suppliers to when they are issued to production.
8.3.1 Cost Classification
3.1 Cost Classification

Cost classification is the process of organising costs according to their common characteristics and in a
way that will be useful to the managers of an organisation.
This definition will become more apparent as the idea of classifying costs is discussed in more detail.

Classification Description
type

Element This is the most basic classification of a cost and involves putting an item of expenditure into
one of the following categories or classes:
 Materials – for example, flour, eggs, butter and sugar to make a cake.
 Labour – for example, creaming, beating and folding when making a cake.
 Expenses – the cost of heating the oven to the right temperature to bake a cake.

Nature Each element of cost (materials, labour and expenses) can be further classified according to its
nature.
The categories of nature are:
 Direct
 Indirect.
There are direct and indirect materials, direct and indirect labour and direct and indirect
expenses.

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Function Costs can also be classified according to their function.

Categorising by function means according to the sort of work that is being done.
The most general classification by function is as follows:
 Production costs
 Non-production costs.
Production costs are costs involved in manufacturing a product. These include:
 Direct materials
 Direct labour
 Direct expenses
 Overheads.
Non-production costs are not involved in the production process and can be further subdivided
into:
 Administration
Expenses for general operations management, such as manager’s salary, head office rent, etc.

 Selling
Expenses for making sales, such as wages of sales staff, retail premises, etc.

 Distribution
Expenses for delivering goods to customers, such as driver salaries, vehicle fleet maintenance,
fuel, etc.

 Finance
Costs of financing, including loan interest, etc.

Behaviour As production levels increase, costs do not automatically increase at the same rate as
production levels - it will all depend on how individual costs behave.
The behaviour of costs can be classified as follows:
 Variable
 Semi-variable
 Fixed
 Stepped fixed
Semi-variable and stepped fixed costs are also known as mixed costs.

Example:

Winston’s Football Factory makes footballs from a particular type of plastic called Plastic F.
How would Winston classify the costs of plastic F used to make the footballs?
 Element: Plastic F is a material cost.
 Nature: Plastic F is a direct cost (directly attributable to the product).
 Function: Plastic F is a production cost.
 Behaviour: Plastic F is a variable cost.
8.3.2 Direct and Indirect Costs
3.2 Direct and Indirect Costs

Definitions

Direct costs – Costs that can be measured reliably and directly traced to a specific cost unit.
All other costs are indirect costs.
Prime costs – The total sum of direct costs, also known as the total direct cost.
Indirect costs – Costs that are not directly traceable to a cost unit; also known as overheads.

Term Description

Cost unit A cost unit – a product (such as a t-shirt) or unit of product or service (such as a litre of paint or
transporting a passenger on a train for one mile) – has direct and indirect costs.

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Direct Direct costs can be traced to a single cost unit. In the Furniture Co example, the costs of the cotton
costs fabric used to make the t-shirt (materials), the wages of the machinist who sews the sofa cover(labour)
and the cost of royalty payments for a specific chair design (expenses) are all direct costs.

Indirect The organisation incurs indirect costs to produce goods or services; they cannot be directly attributed
costs to a single cost unit. In the Furniture Co example, the factory manager's salary, the materials used to
clean the factory and the petrol for the delivery vans to take the furniture from the factory to the
warehouse are all indirect costs.

Activity 6

Classify the costs as either direct or indirect.

Cost Direct or Indirect

Machine operator Direct

Product packaging Direct

Wages for factory supervisor Indirect

Rent for factory Indirect

Raw materials Direct

Components bought from other suppliers (such as studs to decorate a sofa) Direct

Electricity used to light a factory Indirect

Manager’s salary Indirect

8.3.3 Production And Non-Production Costs
3.3 Production And Non-Production Costs

When valuing output and inventories, it is essential to distinguish between production and non-production
costs. This is because the value of a unit of inventory or a completed unit of product (output) should only
include production costs (the costs associated with making the product).
The value of inventory and output affect the gross profit reported for an accounting period, and inventory at
the end of an accounting period is stated as an asset in an organisation’s statement of financial position.
Non-production costs, on the other hand, are written off in an accounting period.
8.3.4 Cost Card
3.4 Cost Card

Definition

Cost card – A record of the costs associated with producing and selling a single product or service.

Example: Producing a Cost Card.

1. Allocate direct costs to cost unit

Sofa cover unit cost card (extract)
$ $
Direct materials:
Cotton X
Thread X
Ink X
X
Direct labour:
Machine operators' wages X
Embroidery staff wages X
X
Direct expenses:
Royalty payments X
X
Total direct (prime) cost X
2. Including indirect production and non-production costs
Organisations divide costs between responsibility centres to help manage and control all the costs involved

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Example: Producing a Cost Card.

in producing the organisation's products and running the organisation.

Indirect costs (overheads) are typically allocated to the appropriate responsibility centre; for example, the
production department(s) (there might be several different production centres) and non-production centres
such as the human resources department, finance department or sales department.
The cost card usually shows the overheads for the production responsibility centres as one line and the
overheads for all the non-production responsibility centres as a separate line.
3. Calculate overhead cost per unit
Find out how many cost units will be produced in the relevant period. First, divide the production overheads
by the number of units. Then, divide the other (non-production) overheads by the number of units. Finally,
enter these figures onto separate lines on the cost card.
Sofa cover unit cost card (extract; continued)
$ $
Total direct (prime) cost X
Production overheads X
Total production cost X
Other overheads X
(administration, distribution and selling)
Total cost X
4. Calculate the total cost per unit
Add the overhead costs per unit to the direct costs to calculate the total cost per cost unit.
Sofa cover unit cost card
$ $
Direct materials:
Cotton X
Thread X
Ink X
X
Direct labour:
Machine operators' wages X
Embroidery staff wages X
X
Direct expenses:
Royalty payments X
X
Total direct (prime) cost X
Production overheads X
Total production cost X
Other overheads
(administration, distribution and selling) X
Total cost X

8.3.5 Cost Behaviour

3.5 Cost Behaviour

Cost behaviour is the way that costs behave as activity levels change.
Cost behaviour classifies costs as:
 Variable costs
 Fixed costs
 Semi-variable costs
 Stepped fixed costs.
8.3.6 Variable costs
3.6 Variable costs

Variable costs are costs that change or vary directly to a change in the activity level.
On a total cost over output graph, the cost behaviour is shown as a straight line starting from the origin (zero)
that increases as output increases.

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In the illustration below, variable cost increases proportionally with output by $40 per unit. This would be the
gradient of the cost line.

Example

Winston rents a factory where the footballs are made. Each football has the following estimated costs:
$
Direct materials 5.00
Direct labour 2.00
Direct expenses 1.00
Total direct costs (prime cost) 8.00
In four weeks, the factory made the following number of footballs:

Number of Total cost of Workings (Number of footballs ×

footballs making footballs($) Direct cost = Total cost of making footballs)

Week1 250 2,000 250 × $8 = $2,000

Week2 200 1,600 200 × $8 = $1,600

Week3 225 1,800 225 × $8 = $1,800

Week4 0 0 0 × $8 = $0
Graphical representation of the variable costs:

Pinpoint Description

[A] This is the total cost when 200 footballs are made at $8 each (200×$8).

[B] This is the total cost when 225 footballs are made at $8 each (225×$8).

[C] This is the total cost when 250 footballs are made at $8 each (250×$8).

[D] This line on the variable cost graph increases at a constant rate and is shown as a straight line. The
cost per unit is constant at $8 per football produced.

[E] Variable costs are zero when production levels are nil, and no footballs are produced.

8.3.7 Fixed costs

3.7 Fixed costs

A cost that remains the same irrespective of the output level.

On a total cost over output graph, the cost behaviour is shown as a horizontal straight line regardless of
output.
In the illustration below, the building insurance cost of $5,000 is constant regardless of the output level.

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Example

Winston rents his factory for $200 per week from his friend Kane.
The activity level for the next four weeks is as below:

Wee Footballs produced Description

k

1 250 In Week 1, when 250 footballs are made, Winston will have to pay $200 rent.

2 200 In Week 2, when 200 footballs are made, Winston will have to pay $200 rent.

3 225 In Week 3, when 225 footballs are made, Winston will have to pay $200 rent.

4 0 In Week 4, when no footballs are made, Winston will have to pay $200 in rent.

Winston has to pay $200 per week rent to Kane regardless of whether the factory makes 0, 200, 225 or 250
footballs.
Because this cost does not change as the number of footballs produced changes, the rent is a fixed cost.

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Example

Fixed costs are sometimes called period costs because what causes (or 'drives') them is the passage of time,
regardless of how much work is done in that period.

8.3.8 Total Fixed Cost Per Unit

3.8 Total Fixed Cost Per Unit

If the total fixed cost of $200 per week remains constant, as per the above graph, the fixed cost per unit falls
as the activity level rises.
The fixed cost per unit for Winston’s Football Factory is calculated as follows:

Total fixed cost (rent) Number of Fixed cost per Workings

per week $ footballs unit $

Week 200 250 0.80 $200/250 = $0.80

1

Week 200 200 1.00 $200/200 = $1.00

2

Week 200 225 0.89 $200/225 = $0.89

3
The following graph shows how the fixed cost per unit falls as more footballs are produced:

8.3.9 Semi-Variable Costs

3.9 Semi-Variable Costs

Semi-variable costs are costs which are partly fixed and partly variable.
For example, A common way electricity and mobile service providers charge customers for usage is to bill
for a fixed and variable component:
 A fixed part, such as a standing charge, for providing a telephone line or an electricity supply
connection.
 A variable part which changes according to the number of telephone calls made or the electricity
used.
On a total cost over output graph, the cost behaviour is shown as a straight line that starts from the level of
fixed costs and increases proportionally with output.
In the illustration below, the fixed utility of $150 is payable regardless of consumption. The total cost
increases by $2 per unit consumed.
The variable cost per unit is also the gradient of the cost line.

Example

Winston’s Football Factory must pay its electricity bill. The company that supplies the power to the factory
charge $50 per week plus $1.50 per unit of electricity used. The following table shows how the electricity costs
increase as more electricity is used at the factory.
Number of electricity Fixed cost Variable cost Total cost Total cost per unit
units used $ $ $ $

0 50.00 0.00 50.00 -

20 50.00 30.00 80.00 4.00

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Example

40 50.00 60.00 110.00 2.75

60 50.00 90.00 140.00 2.33

80 50.00 120.00 170.00 2.12

The graph of the factory’s electricity costs is shown below.

The total cost of electricity increases as more units of electricity are used.

8.3.10 Stepped fixed costs

3.10 Stepped fixed costs

A stepped-fixed cost is fixed within a range of output (activity) and increases to a higher fixed constant when
that range is exceeded.
On a total cost over output graph, the cost behaviour is shown as a horizontal straight line for a range of
activity and increases (steps up) when that range is exceeded to a higher horizontal straight line for a higher
range of activity.
In the illustration below, the warehouse cost of $20,000 is constant for up to 10,000 units and steps up to
$40,000 when that range is exceeded due to the need to acquire additional warehouse space.

Example

It is the year of the Football World Cup, and suddenly, everyone has gone football crazy! Winston’s company has
doubled its average demand of 200 footballs a week to 400 a week. So he asks Kane if he can rent another one of
his factories.
Demand then increases again to 600 footballs a week, so Winston has to rent a third factory!
Winston now has to pay rent to Kane for three factories, each costing $200 per week. So he now pays a total rent
of $600 per week, and the World Cup is only four weeks away.

This graph shows how the total cost of rent increases in steps as the production of footballs increases and
Winston has to rent more factories.
When the demand for footballs is about 200 per week, Winston only needs to rent one factory for $200 per week.
When the demand for footballs has doubled to approximately 400 per week, Winston has to rent another factory.
The rental costs increase in a step from $200 to $400 per week.
As football demand increases again, the two factories cannot cope and need more space to produce footballs.
This is when Winston rents a third factory, and the rental costs step up again from $400 to $600 per week as the
number of factories increases from two to three.
Winston has three factories, but if the excitement over the World Cup continues and demand for footballs grows

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Example

again, Winston will need a fourth factory! Four factories will cost him $800 in rent per week, and the total cost will
increase from $600 to $800.

3.10.1 Ranges Of Activity

Cost behaviour is only relevant within a particular activity range.
This was observed regarding Winston’s factory rental costs.
 The fixed cost of $200 per week only applies when one factory is being rented
 Once another factory is rented, the fixed cost rises to $400 per week to cope with the higher
production levels and the need for more factory space.
Once an activity range’s upper limit is reached, a higher fixed cost is incurred.
Activity 7

Describe the cost behaviour illustrated by the graph:

 Variable
 Fixed
 Fixed cost per unit
 Semi-variable
 Stepped fixed
Graph Cost behaviour

Fixed

Semi-variable

Fixed cost per unit

Variable

Stepped-fixed

Activity 8

Determine the most likely behaviour of the costs of Furniture Co in response to changes in production
quantity at its factory.

Behaviour
(Variable, Fixed, Stepped,
Cost or Mixed) Note

Thread Variable Thread is an example of a variable cost. For each new sofa cover

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made, more thread is needed to sew it with.

If no sofa covers are made in a month, no thread is needed.

Factory Fixed Rent is an example of a fixed cost. Terms on the rental space and fee
rent are agreed upon in advance.
If 100 items are made using that factory space, the rent would be the
same as making no items.
Fixed costs are also called ‘period costs’ because they are driven by
the passage of time rather than the volume of activity.

Factory Stepped This is an example of a stepped cost.

supervis Imagine that a factory must have one supervisor per 10 workers. A
or’s factory supervisor for 10 workers might be paid $20,000 a year, but
salary another supervisor at $20,000 per year would be required for 11
workers, resulting in a total supervisor cost of $40,000. However, if
there were 12 workers, only two supervisors would be needed.
8.3.11 Summary of Cost Behaviour
3.11 Summary of Cost Behaviour

For an increase in activity:

Cost
Behaviour Fixed Variable Mixed Stepped fixed

Cost per Decreases Remains Decreases Decreases within range of activity.

unit constant
Increase if activity range is exceeded, then decreases
again.

Total cost Remains Increases Increases Remains constant within a range of activity.
constant
Increases to a higher constant if activity range is
exceeded.

8.4.1 High-Low Method

4.1 High-Low Method

The high-low method is a technique for identifying the fixed and variable elements of a semi-variable cost so
that more accurate predictions of costs can be made.
It requires a range of data collected over a period, corresponding to costs with different activity levels.
It assumes a linear relationship between total cost and output that the equation of a straight line can express:
y = a + bx
Where:
 "b" is the slope or gradient (i.e. variable cost per unit); and
 "a" is the intercept on the y-axis (i.e. total fixed cost).
The gradient is the amount by which y increases when x increases by 1:
A gradient would be a negative number if the line slopes from the top left to the bottom right (y decreasing
as x increases).
Semi-variable costs are made up of a fixed cost and a total variable cost.
Total semi-variable cost = Fixed cost + (Variable cost per unit × number of units)
This will be easier to see using some shorthand symbols:

Total cost (TC) = Fixed cost (FC) + (Quantity (Q) × Unit variable costs (VC)

Suppose cost information relating to different activity levels is available. In that case, semi-variable costs
can be separated into the fixed cost and variable cost components using the equation above – this is the
foundation of the high/low method.

Example

Furniture Co had the following total costs for one department over the last six years:

Year Output volume Total cost

(units)

20X1 25 750

20X2 40 900

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Example

20X3 55 1,050

20X4 30 800

20X5 45 950

20X6 50 1,000
What will be the total cost in 20X7 if the output is 58 units?
Solution:
Step 1: Select the highest and lowest activity levels
Identify the year in which the highest number of units was produced and the year in which the lowest number of
units was made.
In the example, 20X1 had the lowest activity level. Conversely, 20X3 had the highest activity level.
Step 2: Identify the total activity and costs
Next, identify the number of units produced and their total cost for:
 The year with the highest activity level
 The year with the lowest activity level.
Output volume Total cost
Year (units) ($)

20X1 25 750

20X3 55 1,050
Step 3: Calculate the variable cost per unit
Calculate the variable cost per unit using the following formula:
Variable cost per unit

= (Total costhighest activity – Total costlowest activity) ÷ (Total unitshighest activity – Total unitslowest activity)

For this example:

Variable cost per unit
= ($1,050 – $750) ÷ (55 – 25)
= $10 per unit
Step 4: Calculate the fixed cost per unit
Calculate the fixed cost per unit by re-arranging the total cost formula:
Fixed cost

= Total cost – (variable cost per unit × output)

For this example, using the output of 25 units:

Fixed cost
= $750 – ($10 × 25 units)
= $500
Step 5: Calculate the total costs at the target level of activity.
For this example, the target output is 58 units:
Total cost
= fixed cost + variable cost
= $500 + ($10 × 58 units)
=$500 + $580
=$1080

Activity 9

The following information shows how much it costs per year to have different numbers of machines serviced
by a specialist football machine maintenance company.

Number of machines serviced Total cost $

2 110

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4 140

6 170

8 200

10 230

12 260

Using the high-low method, estimate how much it will cost to service 16 machines annually.

*Please use the notes feature in the toolbar to help formulate your answer.

Identify the total activity and costs

Number of machines serviced Total cost $

2 110

10 230

12 260

Calculate the variable cost per unit

Calculate the variable cost per unit using the following formula:

Variable cost per unit

= (Total costhighest activity – Total costlowest activity) ÷ (Total unitshighest activity – Total unitslowest activity)

For this example:

Variable cost per unit

= ($260 – $110) ÷ (12 – 2)

= $15 per unit

Calculate the fixed cost per unit

Fixed cost

= Total cost – (variable cost per unit × output)

Fixed cost

= $260 – ($15 × 12 units)

= $260 – $180

= $80

Calculate the total costs at the target level of activity.

Total cost

= fixed cost + variable cost

= $80 + ($15 × 16 units)

= $80 + $240

= $320
Activity 10

A business had the following phone bills over the past six months.

Total call duration Cost

(hours) ($)
Year

Jan 450 34,250

Feb 900 68,000

Mar 1,200 90,500

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Apr 1,100 83,000

May 1,050 79,250

June 875 66,125

What will the call cost in July be if calls totalling 950 hours are made?

*Please use the notes feature in the toolbar to help formulate your answer.

Step 1: Select the highest and lowest activity levels

January had the lowest activity level. March had the highest activity level.

Step 2: Identify the total activity and costs

Output volume Total cost

Month (hours) ($)

Jan 450 34,250

Mar 1,200 90,500

Step 3: Calculate the variable cost per unit

Variable cost per hour

= ($90,500 – $34,250) ÷ (1,200 – 450)

= $75 per hour

Step 4: Calculate the fixed cost per unit

Fixed cost for the activity level of 450 hours:

= $34,250 – ($75 × 450 hours)

= $500

Step 5: Calculate the total costs at the target level of activity.

For the target usage of 950 hours:

Total cost

= $500 + ($75 × 950 hours)

= $500 + $71,250

= $71,750
8.4.2 High/Low Method: Stepped Fixed Costs
4.2 High/Low Method: Stepped Fixed Costs

The high/low method can also estimate the total cost when stepped fixed costs are involved. The process is
the same as for semi-variable costs above, but make sure to use the highest and lowest activity information
for activity levels where the fixed costs are the same.

Example

An organisation wants to estimate the total cost of producing 4,000 units using the following information:

Number of units Total cost ($)

1000 9,800

2000 14,800

3000 20,760
Fixed costs increase by 20% when the number of units produced is more than 2,000.
Fixed costs are, therefore, the same at activity levels of 1,000 and 2,000.
Variable cost per unit = $(14,800 – 9,800)/(2,000 – 1,000) = 5,000/1,000 = $5
Fixed cost = $14,800 – (2,000 × $5) = $4,800
When more than 2,000 units are produced, fixed costs rise by 20%.

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Example

20% of $4,800 = $960

Therefore fixed costs will rise to $(4,800 + 960) = $5,760.
The estimated cost of producing 4,000 units is, therefore:
Total cost of 4,000 units = $5,760 + (4,000 × $5) = $25,760

8.4.3 High/Low Method: Changing Variable Cost Per Unit

4.3 High/Low Method: Changing Variable Cost Per Unit

So far, the equation has been applied assuming that the variable cost per unit remains the same at all activity
levels. This is why the graph of total variable cost is a straight line.
The high/low method can also be used to estimate the total costs even with changes in the variable cost per
unit.

The process is the same as for semi-variable costs earlier, but, as with stepped fixed costs, make sure to use
the highest and lowest activity information within the activity range where the variable costs are the same.
However, one point that must be made of the high/low method is that it will only be an estimate of costs. The
graph of the high/low method shows that there is always the assumption that costs increase in a straight line;
this is rarely the case, as the actual behaviour of costs depends upon several factors, particularly in
instances of stepped costs or non-uniform variable costs.
The high/low method connects two points – high and low – on the assumed straight line.

Example

An organisation wishes to estimate the total cost of producing 800 units using the following information:

Number of units Total cost $

400 12,000

500 13,000

600 13,400
The variable cost per unit decreases by 10% when the number of units produced exceeds 550.
Variable costs are, therefore, the same at activity levels of 400 and 500.
Variable cost per unit = $(13,000 – 12,000)/(500 – 400) = 1,000/100 = $10
Fixed cost = $13,000 – (500 × $10) = $8,000
When more than 550 units are produced, variable costs fall by 10%.
10% of $10 = $1
Therefore variable costs will fall to $(10 – 1) = $9
The estimated cost of producing 800 units is, therefore:
Total cost of 800 units = $8,000 + (800 × $9) = $15,200

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Chapter 9: Job, Batch and Service Costing

9.1.1 Job Costing Principles
1.1 Job Costing Principles

Job costing is the process of calculating the costs of a specific job.

A job is a cost unit that consists of a single order or contract. Compared to continuous production, it is
usually limited in scope and period.
Examples of jobs include:
 Construction of a new shopping centre
 Development of a website for an organisation
 Redecoration of office buildings
 A wedding cake made to exact specifications.
For example, a building company may contract to construct an office building for a client. The office building
will be a unique product specific to that customer. As a result, because of the particular materials, labour
and other expenses involved in creating the product, it will have a unique cost.
The critical difference between a job and continuous production is that the output of each job is uniquely
identifiable, compared to the homogeneous result of continuous production, where every cost unit is
identical.
A job may be a single physical product, several products or a service – for example, a decorating job carried
out by a decorator for a customer. It may also include a combination of products and services.
Job costing is an appropriate system for deriving the cost of unique or specific customer orders. It is helpful
in industries where each job is different (and incurs different costs). For example, a company that
manufactures bespoke ships will likely allocate costs for each vessel produced.

Example

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Example

9.1.2 Job Costing Process

1.2 Job Costing Process

Stage Description

Customer specifies requirements The customer describes desired requirements and specifications to
the supplier.

Specification and delivery date Customer and supplier agree on requirements, specifications and
agreed timeframe of delivery.

Supplier estimates pricing The supplier calculates the price and negotiates with the customer.
Various methods may be used to calculate the price, including
markup, where a profit is added to the total cost to arrive at the
selling price.

Pricing agreed Supplier and customer agree on a price.

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Job is scheduled for production The job is scheduled for production by the supplier.
Supplier sets up unique job cost codes and accounts.

9.1.3 Job Records

1.3 Job Records

Once a job has been agreed upon, the company carrying out the job carries out the following steps:

1. Each job is given a unique code

2. All direct costs associated with the job are coded directly to the job code
3. A share of the overheads is calculated and charged to the job
4. The job cost is calculated, usually on a job cost card.
5. The difference between the actual costs and the agreed selling price is the profit.
Key Point

Job cost cards are usually created and held electronically in the computerised accounting system.
9.1.4 Job Costing
1.4 Job Costing

Job costing is collecting all the cost information relating to that job.
When a job is planned, a cost card will be prepared with the expected costs:
Job cost card $
Direct materials X
Direct labour X
Direct expenses X
Total direct costs X
Production overhead X
Total production costs X
Administration overhead X
Selling overhead X
Total job cost X
The cost card will be used to create a budget for the job. The actual costs will be recorded in the accounting
system.
Example of a job account:
Job account
$ $
Direct materials X Cost of sales X
Direct labour X
Direct expenses X
Production overhead at budgeted rate X
Other overheads X
X X
Example

Step 1: Job cost card

When planning a job, the expected material, labour costs, and other estimated direct expenses and overheads are
collected on a job cost card.
Job cost card $ $
Direct materials 800
Direct labour 500
Direct expenses 1,800
Total direct (prime) cost 3,100
Production overhead 1,000
Total production cost 4,100
Administration overhead 600
Selling and distribution overhead 300
Cost of sales 5,000

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Example

Step 2: Budget
The job cost card is used to inform a budget for the job.
The budget in this example would be $5,000
Step 3: Job Account
The actual costs for the job are recorded in a job account.
Job account
$ $
Direct materials 900 Cost of sales 5,250
Direct labour 600
Direct expenses 1,900
Production overhead at budgeted rate 1,100
Administration overhead 500
Selling and distribution overhead 250
5,250 5,250
Note that the actual job costs are different from the budget.
Step 4: Comparison with Budget
The figures from the job account are compared to the budget so that the manager can identify any variances and
see if the job was completed on budget.
Budget Actual Variance
$ $ $
Total direct (prime) cost 3,100 3,400 (300)
Production overhead 1,000 1,100 (100)
Total production cost 4,100 4,500 (400)
Administration overhead 600 500 100
Selling and distribution overhead 300 250 50
Cost of sales 5,000 5,250 (250)
Note that the actual cost has exceeded the budget in some categories and was less than the budget in others.
This leads to variances.

 If a job is completed over budget, the profit will be less than expected
 If a job is completed under budget, the profit will be more than expected.
Activity 1

Kelvin is a decorator and prices his jobs by adding a 20% profit to the total estimated costs of a job. Thandi
has asked Kelvin to estimate how much it would cost to redecorate her kitchen. Kelvin has estimated the
following costs:

 Direct materials − paint: 10 litres at $15 per litre

 Direct labour − preparation and painting time: 35 hours at $12 per hour
 Direct expenses: $25
 Variable overheads: $2 per labour hour
 Additional fixed overheads (to cover, for example, phone calls, petrol and so on): $35 per job.
Complete the job cost card for painting Thandi’s kitchen.

*Please use the notes feature in the toolbar to help formulate your answer.

Job Cost Card − Thandi’s Kitchen

$ $

Direct materials 150

Direct labour 420

Direct expenses 25

Total direct (prime cost) 595

Variable overheads 70

Other overheads 35

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Total job cost 700

Profit 140

Estimated job price for Thandi 840

[1] 150 10 litres at $15 per litre = $150

[2] 420 35 hours at $12 per hour = $420

[3] 25 $25 is stated as being the direct expenses in the question.

[4] 595 Total direct (prime) cost = direct materials + direct labour + direct expenses = $(150 + 420 + 25) = $595

[5] 70 35 hours at $2 per hour = $70

[6] 35 $35 is stated as being the other overheads in the question.

[7] 700 Total job cost = $(150 + 420 + 25 + 70 + 35)= $700

[8] 140 Profit = 20% ×$700 = $140. This is known as ‘cost plus’ pricing.

[9] 840 Estimated job price for customer = Total job cost + profit = $(700 + 140) = $840
Activity 2

Chipboard collects cost data in a job order cost system. The following data relates to Job 139:

Direct Material Issues $ Direct Labour Hours Rate $

14 October 2,200

17 October 950 17 October 180 13.00

22 October 450 24 October 140 14.50

Overheads are charged at $9 per direct labour hour.

Calculate the cost of Job 139.

*Please use the notes feature in the toolbar to help formulate your answer.

Costs: $ $
Direct material ($2,200 + 950 + 450) 3,600
Direct labour
180 hours × $13.00 2,340
140 hours × $14.50 2,030 4,370
Factory overhead applied:
320 hours × $9 2,880
Cost of Job 139 10,850
9.1.5 Cost-Plus Pricing
1.5 Cost-Plus Pricing

The cost-plus pricing method adds the required profit to the total cost of the product or job.
The required profit may be expressed as:
 Mark-up %
A percentage of the cost.

 Margin %
A percentage of the selling price.

Example

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Example

T-Shirt Co has a job, Job A, with a total cost of $5,000.

Calculate Job A’s profit and selling price, with a profit markup of 20% on the total cost.
Solution:
The organisation has a target profit of a 20% mark-up on the total cost:
Mark-up ($)
= Mark-up % × Cost
= 20% × $5,000
= $1,000
The selling price of Job A is calculated as follows:
Selling price $
= Total cost + Mark-up $
=$5,000 + $1,000
= $6,000

The selling price can be expressed as 120% of the total cost:

Example

T-Shirt Co has a job, Job A, with a total cost of $5,000.

Calculate Job A’s profit and selling price, with a profit margin of 20%.
Solution:
Note that margin is always calculated based on the selling price, which would be 100%.
Since the profit margin is 20%, this would mean that the total cost as a percentage of the selling price would be
80%:
Total cost % of the selling price
= 100% − Margin %
=100% − 20%
= 80%
The selling price of Job A is calculated as follows:
Selling price $ = Total cost $ / Total cost %
= $5,000 / 80%
= $6,250

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Example

The profit margin of Job A is calculated as follows:

Profit $
= Selling price $ − Total cost $
= $6,250 − $5,000
= $1,250

Alternatively, the profit can be calculated using the percentages below:

Profit $
= Total cost $ × (Margin % / Total cost %)
=$5,000 × (20% / 80%)
=$1,250

Key Point

Note that although markup is usually calculated as a percentage of the total cost, it may have other bases (such
as a percentage of total direct costs).
Margin is always expressed as a percentage of the selling price (which is 100%).

Activity 3

a) The total cost of a job is $45,000. The markup is 30%.

What is the selling price for this job?​ ​ ​ ​ ​ ​

b) The total cost of a job is $500,000. The markup is 15%.

What is the selling price for this job?

c) The total cost of a job is $45,000. The profit margin is 30%.

What is the selling price for this job?

d) The total cost of a job is $500,000. The profit margin is 15%.

What is the selling price for this job?

*Please use the notes feature in the toolbar to help formulate your answer.

. Selling price

= Total cost $ × (100% + mark-up %)

.
= $45,000 × (100% + 30%)

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.
=$45,000 × 130%

.
=$58,500

.
. Selling price

= Total cost $ × (100% + mark-up %)

.
= $500,000 × (100% + 15%)

.
=$500,000 × 115%

.
=$575,000

.
. Selling price

= Total cost $ / (100% − margin %))

.
= $45,000 / (100% − 30%)

.
=$45,000 / 70%

.
=$64,286

.
. Selling price

= Total cost $ / (100% − margin %))

.
= $500,000 / (100% − 15%)

.
=$500,000 / 85%

.
=$588,235

.
9.1.6 Batch Costing Principles
1.6 Batch Costing Principles

Batch costing is like job costing; the only difference is that the batch’s output is several units (a batch)
rather than a single unit. In addition, the units within a batch are homogeneous (identical to each other).
Like job costing, each batch will be uniquely identified by a batch code.
Batch costing is often used in manufacturing, especially where liquids or large numbers of a standard item
are made.
Examples of batches include:
 Computer chips – different memory sizes will be made in different batches
 Inks and dyes – different colours will be made in different batches
 T-shirts at T-Shirt Co – different t-shirts will be made in different batches.

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The costs involved in producing a single batch (for example, 100 plain white t-shirts) are estimated and
collected to calculate the total batch cost. The cost per unit within the batch can then be calculated using the
following formula:

Cost per unit = total batch cost / number of units in a batch

Example

A company manufactures buttons. Production of 500 green buttons, produced in Batch G24, had the following
costs:

Direct materials $800

20 hours of heating at $20 per hour

Direct labour
30 hours shaping at $15 per hour

The cost of hiring special safety equipment was $100.

Production overheads were absorbed at $9.60 per direct labour hour.
Selling and distribution overheads were $300.
What was the cost per unit (per button) for Batch G24?
Solution:
Total cost for Batch G24:
$ $

Direct material 800

Direct labour

Heating 400 20 hours × $20

Shaping 30 hours × $15
450
850

Direct expense
100
Prime cost 1,750

Production overheads
480 $9.60 × 50 hours
Production cost
2,230
Selling and administrative costs
300
Total cost
2,530
Cost per unit for Batch G24
= $2,530 ÷ 500 units
= $5.06 per unit.

Activity 4

A printing shop can print business cards in batches of 400 or 800. The raw card to make 400 cards costs $20,
while the ink to print 400 cards costs $5.

The machine must be set up for each batch, costing $24 per setup.

It takes a technician 2 hours to print 400 cards. The technician is paid $9 per hour.

Production overheads are absorbed at $5.50 per 200 cards.

Administration overheads are allocated at $0.50 per 100 cards.

The print shop prices its cards to earn a 20% profit margin.

Calculate the cost, profit, and selling price per card for 400 and 800-card batches.

*Please use the notes feature in the toolbar to help formulate your answer.

Batch size

400 800

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$ $

Card 20 40

Ink 5 10

Machine set-up cost 24 24

Printers’ hourly wages 18 36

Total direct (prime) cost 67 110

Production overhead 11 22

Total production cost 78 132

Administration overhead 2 4

Total batch cost 80 136

Profit margin 20 34

Selling price 100 170

Selling price per card 0.25 0.2125

Selling price = Total batch cost/0.8

= $80/0.8 = $100 for 400 business cards and

= $136/0.8 = $170 for 800 business cards.

Selling price per card

For 400 cards = $100/400 = $0.25

For 800 cards = $170/800 = $0.2125.

Activity 5

Carrie uses a batch costing system in her cuckoo clock manufacturing business. Last month the following
were used in manufacturing a batch of 120 clocks:

 Direct materials of $17,800

 500 labour hours in the clockworks department (Department A)
 750 labour hours in the assembly and finishing department (Department B)
 Direct labour costs $10 an hour in Department A and $8 an hour in Department B.
 Production overheads are absorbed at 120% of labour cost.
Prepare a batch cost card showing the total cost of the batch and the unit cost of a clock.

*Please use the notes feature in the toolbar to help formulate your answer.

Costs: $ $
Materials 17,800
Labour:
Department A (500 hours × $10) 5,000
Department B (750 hours × $8 6,000
11,000
Production overheads:
Department A ($5,000 × 120%) 6,000
Department B ($6,000 × 120%) 7,200
13,200
Total factory costs 42,000

Cost of a clock = $42,000/120 = $350

9.1.7 Set-Up Costs

1.7 Set-Up Costs

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The equipment used for batches often needs to be cleaned and set up for the next batch to be processed.
This is because the next batch might require different production inputs and settings.
For example, a large-scale manufacturer might produce a batch of detergent and then clean and reconfigure
the same machinery to produce bleach.
Set-up costs can be high, so they are included in the batch cost as a direct expense.

Example 6: Set-Up Costs

A company manufactures memory chips for phones. A customer has ordered 300 chips.
A standard batch of 100 chips has the following costs:

Direct materials $25

Direct labour $10

Machine set up $100

The production overheads are $100 per labour hour. Labour is paid $20 per hour.
What is the cost of this customer order?
Solution:
$ Calculation Explanation
Direct material 75 $25 × 3 Each batch is 100 chips, so three batches are needed to make 300 chips.
Direct labour 30 $10 × 3 The labour cost is taken from the costs per batch.
Direct expense 300 $100 × 3 Three batches would require set-up to be performed three times.
Prime cost 405
Production 150 0.5 × 3 × $100 Labour is paid at $20 an hour, and the cost per batch is $10, so each
overheads batch requires ½ an hour, and three batches are needed for this order.

Total cost 555

The total cost for 300 chips is $555.
Cost per chip
= $555 ÷ 300
= $1.85 per unit

9.2.1 Characteristics of Services - SHIP

2.1 Characteristics of Services - SHIP

Services usually demonstrate four essential characteristics, as illustrated below with an example of a lawyer:

Characteristic Description Lawyer example

Simultaneity The service provider cannot be separated from the The lawyer cannot be separated from the
service. This characteristic is also known as services they are providing.

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‘inseparability’.

Heterogeneity Each instance of the service is unique. This Every case and client is different, so each
characteristic is also known as ‘inconsistency’ or time the lawyer is in court, they will use a
‘variability’. unique approach to represent their client.

Intangibility Services are not tangible. The lawyer’s arguments in court are not a
tangible item.

Perishability Services cannot be stored for future use. A lawyer’s arguments in court cannot be
saved and stored for later use. They are
only relevant at this moment for this
audience.
Services usually also have the following characteristics, again as illustrated with the example of a lawyer:

Characteristic Description Lawyer example

Involvement The customer is involved in the service The client is vital to the legal case – it wouldn’t
delivery. exist without them.

No transfer of The service is not owned and cannot be The lawyer’s services for executing a legal case
ownership sold to a third party. cannot be sold to a third party.
Providers of services generally offer customers expertise or the use of facilities. There is usually no physical
product to take home (although the service provider might furnish something to show that the service has
been received, such as a report, statement, receipt or bill).
Some examples of service providers are:
 Accountancy firms: providing audit services
 Banks: providing financial services such as bank accounts, loans and credit
 Dentists: providing tooth cleaning services
 Universities: providing an education
 Lawyers: providing legal expertise and advice.
Activity 6

Classify the items below as either a good or service.

Classification
(Good or Service)
Item

Shampoo Good

Pillow Good

Haircut Service

Stay at hotel Service

Childcare Service

Bicycle Good

Theatre performance Service

Bus journey Service

Textbook Good

Language class Service

9.2.2 Service Organisations and Internal Services
2.2 Service Organisations and Internal Services

Service organisations are companies and not-for-profit organisations which sell or provide services to
customers.
However, services are also provided within service organisations and those selling goods. These are service
departments or cost centres, for example:
 Maintenance: repairs and upkeep of property and machines
 Libraries: organisations may have knowledge resources available to staff
 Canteens: factories and many government organisations provide subsidised meals for workers.
These are internal services.
2.3 Proliferation of Service Organisations

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As economies develop, there is a trend towards higher numbers of service organisations rather than
manufacturing organisations. Therefore, knowledge and understanding of service costing will be critical to a
management accountant’s work.
9.2.4 Problems in Service Costing
2.4 Problems in Service Costing

Costing for services may be challenging due to their nature.

Challenge Lawyer example

Difficult to identify a cost unit to which  A court case often involves multiple activities: client
costs are allocated. interaction, paperwork, court appearances, etc., and may be
performed by various staff.
 It is not easy to meaningfully allocate costs and price the
service.

Indirect costs are often a more  A lawyer’s office space will probably be expensive (especially
significant percentage of a service’s in a prime location.
cost than a physical product. This
makes a meaningful and fair allocation
 Lawyers might incur extensive entertainment and
administrative support expenses.
of shared costs necessary.
 These costs need to be allocated to each legal case on a fair
basis.

The number of inputs for each cost  Each legal case handled by the lawyer will take a different
unit may be unique. amount of time and require different resources and support from
the firm
9.2.5 Service Cost Units
2.5 Service Cost Units

Cost Unit Description Example

Simple cost Service is homogeneous and  Haircut per customer

unit provided to one customer at a
time.
 Gigabytes of mobile data
 Car wash session
 Subscription fee

Composite Service is a function of two  Hotel Room-night

cost unit variables.
 Hospital bed-night
 Charge-out rates for different staff levels (e.g.
associate hour or partner hour)

Complex Service is unique, personalised,  Cost to argue a legal case in court

services and complex, with many cost
elements.
 Contractor services for construction/refurbishment
(by job or of buildings.
engagement) It may include both simple and  Other complex service provisions (e.g. maintenance
composite cost units. contracts etc)

Activity 7

Select the most appropriate cost unit for the organisation.

Options:

 Bed-day
 Student-semester
 Passenger-kilometre
Organisation Composite cost unit

School

Hospital

Bus service

*Please use the notes feature in the toolbar to help formulate your answer.

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Organisation Composite cost unit

School Student-semester

Hospital Bed-day

Bus service Passenger-kilometre

2.5.1 Examples of Composite Cost Units
 Long-distance delivery vans carry heavy items, so there are two units to consider: distance
travelled and weight of the items transported. Therefore, a suitable composite cost unit would be a
tonne-kilometre or a tonne-mile (depending on the units of distance used).
 Airline companies fly passengers all over the world over various distances. A suitable composite
cost unit is a passenger-kilometre or a passenger-mile. Rail and bus companies can use the same unit.
 Hotels might wish to know how many of their rooms were occupied and by how many guests. A
suitable composite cost unit for hotels might be an occupied bed-night.
 It is useful for hospitals to know the number of patients treated and how many days each patient
was in the hospital. Therefore, a suitable composite cost unit for a hospital might be a patient-day.
 A suitable composite cost unit for a school might be a student-hour. This would cover the number
of students and how many days they are taught in a given period.
9.2.6 Service cost card
2.6 Service cost card

A service cost card would be like a job cost card, with each cost element separately identified.
2.6.1 Cost Card Example
The following cost card is an example of a patient’s hospital stay.
$ $ Note
Direct materials
(medicine) 500
Direct labour
(nurses and doctors) 1200
Direct expenses 0
Total direct (prime) 1700 It is estimated by dividing the total budgeted costs for the year by the number
cost of hospital beds to get the cost per bed and then by 365 to get the cost per
bed per day.
Service overhead 200 Indirect costs (overheads) relating to the service may be calculated using
(hospital rent, absorption costing to show the total service costs.
cleaning)
Total service cost 1900
Administration
overhead 100
Cost of service 2000
9.2.7 Calculating Total Cost per Service Unit
2.7 Calculating Total Cost per Service Unit

The following formula is used to calculate the cost per service unit:

Labour cost in services is usually higher than materials, and indirect costs are likely to make up more of the
total cost of services than for physical products.
The following is an example of how to approach calculating the total cost of a night’s stay at a hotel. The
composite cost unit of occupied room-night is used.

Cost
element Examples Description Charge to cost unit

Direct costs  Toiletries Only incurred if a Directly charged to cost

room is occupied. unit.
 In-room beverages
 Air-conditioning
 Newspaper
 Breakfast
 Room turnover (cleaning)

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 Laundry

Other  Facilities (pool, gym, restaurant, Usually fixed in They are charged to cost
service etc.) nature, they need to units on a reasonable
costs be apportioned basis.
 Shared services (cleaning,
reasonably.
maintenance, room amenities, concierge, Cost / total estimated
baggage handling) room-nights

Overheads  Administrative (management Usually fixed in They are charged to cost

salaries) nature, it needs to be units on a reasonable
apportioned basis.
 Property costs (leases, licenses,
reasonably.
etc.) Cost / total estimated
room-nights

If a hotel has ten rooms with a 70% yearly occupancy rate, the number of room-nights would be:
= 10 × 365 × 70%
= 2,555 room-nights per year.
If fixed hotel costs are $63,875 per year, the cost per room-night would be:
= 63,875 ÷ 2,555
= $25 per room-night
Activity 8

1. A hospital has 100 beds. In one week, the average bed occupancy was 67%. The cost of running the hospital
for the week was $90,000. There 7 days in a week.
What was the cost per patient per night for the week?

2. A school has 250 students. In one year, the cost of running the school is $880,750.
What was the cost per student per year?
3. A local government is responsible for 40,000 kilometres of roads. The maintenance costs for the year were
$350,000.

What was the maintenance cost per kilometre per year?

*Please use the notes feature in the toolbar to help formulate your answer.

1. Number of occupied bed-nights = 100 × 7 × 67% = 469

Cost per occupied bed-night = $90,000 / 469 = $191.90 per bed-night

2.
3. Cost per student-year = $880,750 / 250 = $3,523 per student-year
4. Cost per kilometre-year = $350,000 / 40,000 = $8.75 per kilometre-year
Activity 9

Thandi’s Hair Salon – September expenses

Hair products 480

Salaries 1,540

Rent 575

Rates 220

Electricity 275

Repairs and renewals 550

Other costs 536

During September, the salon provided 288 haircuts to its customers.

Calculate the cost per haircut at Thandi’s Hair Salon for September.

*Please use the notes feature in the toolbar to help formulate your answer.

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The total costs for September = $(480 + 1,540 + 575 + 220 + 275 + 550 + 536) = $4,176

Cost per haircut = Total cost of providing service in a given period/Number of cost units of the service
supplied in a given period.

Cost per haircut = Total hair salon expenses for September/Number of haircuts in September

Cost per haircut = $4,176/288 = $14.50

Activity 10

An organic compost manufacturer manages its deliveries using a van. This van delivers bags of compost
(weighed in kg) to garden centres.

The following information relates to the deliveries in the first week of May.

Day of Garden Weight of compost delivered Distance covered (kilometres)

delivery Centre (kilograms)

Monday A 500 120

Tuesday B 750 170

Wednesday C 800 80

Thursday D 450 90

Friday E 1,000 70

Total 3,500 530

The cost of running the van for the first week of May was $3,620.

Calculate how much it costs for his van to transport 1 kg of compost a distance of 1 km.

*Please use the notes feature in the toolbar to help formulate your answer.

The appropriate composite cost unit is kg-km

Day of delivery Garden Centre Weight of compost delivered (kg) Distance covered (km) Kg-km

Monday A 500 120 60,000

Tuesday B 750 170 127,500

Wednesday C 800 80 64,000

Thursday D 450 90 40,500

Friday E 1,000 70 70,000

Total 3,500 530 362,000

The cost per kg-km for the week

= $3,620 ÷ 362,000 kg-km

= $0.01 per kg-km

9.2.8 Service Cost Analysis
2.8 Service Cost Analysis

Organisations in the same service industry sectors might want to compare how they are doing against their
competitors. Therefore, it makes sense for these organisations to use the same service cost units to assess
their businesses against the industry average.
For example, organisations in the airline industry might compare the cost of their services using the same
composite cost unit.

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Chapter 10: Alternative Cost Accounting

Methods
0.1.1 Activity-Based Costing
1.1 Activity-Based Costing

Activity-based costing (ABC) is a form of absorption costing where overheads are absorbed into products
based on a wide range of activities involved in producing a product or service.
The main principle of activity-based costing is that activities cause (or “drive”) costs.
Under ABC, costs are first traced to activities and then to products. First, activities causing overheads (cost
drivers) are identified, and later these activities are used as a base for allocating overhead costs.
Remember that all costs are variable long-term because an organisation can change what it does. So if an
organisation can avoid some activity that causes fixed costs, it will be able to reduce its fixed cost base in
the longer term, becoming more competitive.
ABC is effective when overheads form a large proportion of the cost base.
There are three steps to perform ABC:
1. Identify cost pools.
This is the collection of costs associated with activities.

2. Identify cost drivers.

These are the specific, measurable activities that cause costs to be incurred.

3. Calculate cost per cost driver.

This measures the cost incurred for each cost driver.

Exam advice

The MA exam does not require calculations for alternative costing methods.
Any calculations shown are for illustration purposes only.

Example

One of Winston’s friends, Shivani, runs a hotel. The hotel is in a town that has a significant conference and
tourist trade. Shivani pays a fixed rent for the building yearly.
At Shivani's boutique hotel, most guests stay for just one night. A small proportion of guests stay for five
nights. Checking people in and out is expensive because Shivani feels that guests staying in her hotel are
unwilling to wait long to check in or out.
Almost everybody checks in at around 3pm and checks out at about 9am, so there are lots of reception staff to
cope with this peak demand.
Shivani also has an agreement with a nearby restaurant. She pays the restaurant an annual fee, and the
restaurant gives her guests dinner free for the first night of their stay.
Each room in the hotel is identical. When people stay longer than one night, the rooms are only refreshed and
not thoroughly cleaned. When somebody checks out, there is a deep cleaning of each room, which requires
detailed cleaning and new laundry throughout the room and bathroom.
Laundry costs are fixed because Shivani has an annual contract with a local laundry to clean all the towels and
bedding, regardless of volume.
The hotel has 40 rooms, with 70 percent average occupancy. There are, therefore, 10,220 customer-nights in the
hotel throughout the year. The average occupancy of the room is 1.5 guests.
She has estimated the direct costs of a customer stay to be only the cost of the expensive chocolates and drink
she provides to each guest daily. These cost $10 per day.
Shivani has used traditional absorption costing to work out the full cost of a customer-day in a hotel room,
using a customer-day as the absorption base.
She believes she should charge a standard markup of 40% on the full cost. This is represented in the standard
cost card.
Shivani wonders if she should give a discount per day for people who stay five nights because they create less
work than one-night short-stay guests.
She knows that in the long term, if she only had guests who stayed for five nights, she could employ fewer
reception staff and fewer cleaners and pay less for the annual fees to the restaurant. In the longer term, she

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Example

could reduce her fixed cost base, including laundry costs.

She has observed that there are typically 5,000 guest check-ins each year.
She wishes to determine costs and prices separately for one-night and five-night stays. She decides to do her
absorption costing calculations more accurately, using activity-based costing.
1. Identify cost pools.
 Rent
 Check-in/out
 Restaurant
 Refresh cleaning
 Deep cleaning
 Laundry
2. Identify cost drivers.
 Check-in: Number of visits
 Restaurant: Number of customer-visits
The restaurant would need to provide dinner for the first night for the number of guests per visit. So the
driver would be the number of guest-visits.


 Refresh cleaning: Number of room-nights – Number of visits
The number of visits is excluded as those nights require deep cleaning.


 Deep cleaning: Number of visits
The room would need to be deep-cleaned before each check-in.


 Rent and Laundry: Number of room-nights
There is no driver for these costs, so they are apportioned by room-night.


3. Calculate cost per cost driver.
This measures the cost incurred for each cost driver. The cost amounts are given.

Cost pool $ Cost driver No. driver $ /

driver

Check-in/out 180,000 Number of visits 5,000 36

Restaurant 50,000 Number of guest- 7,500 6.67

visits
(5,000 ×
1.5)

Refresh 50,000 Number of room- 5,220 9.58

cleaning nights less number
(10,220 −
of visits
5,000)

Deep 100,000 Number of visits 5,000 20

cleaning

Other 380,000 Number of room- 10,220 37.18

nights
(rent and
laundry)

Cost drivers are the activities that, in the long term, cause the fixed production overhead to be incurred in the
first place.
In the longer term, if the number of cost drivers can be reduced, her total fixed overhead can be reduced.
Shivani is now ready to produce separate standard cost cards for one-night and five-night stays.
Shivani's traditional absorption costing is probably producing a price per night that is unattractive to longer
stays of five nights, even though these longer-stay customers are more profitable.
In Shivani's case, fixed overheads are almost all her total costs because the additional variable costs of having
a customer stay one more night are small.

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Example

Almost all her costs are incurred at the same rate if the hotel is full or empty.

Note that the process is different to the traditional absorption costing approach. The conventional approach
assumes various costs can be lumped together and an overhead absorption rate calculated. Under ABC,
different overhead absorption rates are calculated for multiple activities. This gives rise to a more accurate
allocation of overhead costs.
In many cases, where fixed costs are a relatively small proportion of overall costs or where a company
doesn't produce significantly different sales to different customers, the cost of analysing the components of
fixed costs and working out the appropriate cost drivers might not be cost-effective.
For service industries with high fixed costs as a proportion of total costs, the activity-based method of
absorption costing is likely to add significantly to the quality of decisions made, especially regarding pricing
and product profitability.

Example

Stationers Co manufactures pens and pencils. Three departments are involved in the activity-based costing
process: the stores department, the pens department and the pencils department.
The stores department receives raw materials (wood, plastic, lead and ink). The indirect costs associated with
receiving raw materials are $75,000, and the total number of goods received notes processed by this department
is 10,000.
The stores department issues these raw materials to the pen and pencil production departments as they are
required. The indirect costs associated with issuing raw materials are $90,000, and the number of materials
requisition notes (MR) processed by this department is 15,000.
The pen department generates 8,500 MRs, and the pencil department generates 6,500 MRs in 20X5.
What are the main activities of Stationers Co’s stores department?
There are two main activities in the stores department:

1. Receiving raw materials from suppliers

2. Issuing raw materials to the production departments.
Identify the cost pools in the stores department of Stationers Co.
There are two cost pools in the stores department of Stationers Co:

1. Receiving raw materials from suppliers - $75,000

2. Issuing raw materials to production departments - $90,000
Identify the cost drivers of the stores department of Stationers Co.

1. The cost driver in the cost pool ‘Receiving raw materials from suppliers’ is the number of goods
received notes (GRN).
2. The cost driver in the cost pool ‘Issuing raw materials to the production departments’ is the number of
materials requisition notes (MR).
Calculate the cost driver rate for each activity in the stores department.
Indirect cost per goods received note (GRN) = $75,000/10,000 = $7.50 per GRN
Indirect cost per materials requisition note (MR) $90,000/15,000 = $6 per MR
Calculate how much is allocated to the pen department for the MRs generated in 20X5.
The pen department generates 8,500 MRs.
Each MR is charged at $6
Allocation to pen department = 8,500 × $6 = $51,000.

10.1.2 Target costing

1.2 Target costing

Target costing is, in simple terms, a way of working out the maximum cost of a product that a company can
incur and still expect to make the required profit. It works back from the price the company believes
customers will be willing to pay and determines the product’s maximum cost.
There are various points to consider when working out the target cost. First, it is essential to decide on a
selling price that will attract the most customers and therefore ensure a high level of sales.
In a market where a company has competitors making similar products, there will be a maximum price that
customers are willing to pay. This optimum selling price will be the target selling price of the product.
Once the target selling price has been agreed upon, then the target cost of the product can also be worked
out.
With target costing, apply the same techniques as ‘cost plus' pricing but work back from the price to
determine the maximum possible costs.

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10.1.3 Calculating the Target Cost

1.3 Calculating the Target Cost

The steps to apply target costing are as follows:

1. Determine the selling price
A selling price that meets the needs of the entity’s strategy and market environment is determined.
This may be supported in many ways, such as evaluating competitor prices, customer surveys,
analysis of demand, etc.

2. Determine the desired margin

An acceptable profit margin is deducted from the selling price.

3. Determine target cost

The target cost is the cost after deducting the profit margin from the selling price.

4. Determine the budgeted cost

The budgeted (or actual, if the product is already being produced) cost is compared to the target cost.

5. Close the cost gap

If the target cost is lower than the budgeted cost, cost reduction measures may be taken to reduce the
gap between the budgeted and target cost.

Example

The following information relates to FBG Co.

1. Determine the selling price
The target selling price of a new product, Product Z, was estimated to be $180. This was agreed upon after
FBG Co conducted a survey asking potential customers how much they were prepared to pay for Product
Z.

2. Determine the desired margin

FBG desires a profit margin of 40%, which would be $72 per unit.

3. Determine target cost

Product Z’s target cost would be $108 ($180 − $72)

The company aims to produce Product Z for a cost of no greater than $108 per unit.

4. Determine the budgeted cost

FBG will need to examine its budgeted cost to produce Product Z.

5. Close the cost gap

If the budgeted cost of Product Z is higher than $108, FBG will need to find ways to reduce that gap through
cost-reduction measures.

Reducing production costs may involve removing product features which customers do not value and are
unwilling to pay for.

Target costing can only be used if the markets and customers are well understood. To use it effectively, the
target selling price of each product must be reliably determined, with a clear idea or policy about how much
profit to earn from each unit of product sold.
Producing products at a cost that is less than or equal to the target cost of each product is crucial in target
costing. To do this, a company might need to find ways of reducing the costs involved in making a product
so that it can produce the product at its target cost.

10.1.4 Lifecycle Costing

1.4 Lifecycle Costing

Lifecycle costing takes into account all of the costs that are incurred during the life cycle of a product.
To investigate lifecycle costing, start by looking at the product life cycle. Manufactured products have a
limited period during which companies can sell them successfully because customers will eventually lose
interest in the product or the product becomes outdated. This is known as the product life cycle.
The product life cycle is the equivalent process for any good, invention or other product the business
creates.
1.4.1 Product life cycle

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The life cycle of a product is shown on the following graph.

Lifecycle stage Description

Development The product is designed and developed during this stage. Prototypes may be produced.
Manufacturing processes will also be created, including any special machinery required to make
the product. Cash flow will be negative at this stage, as no revenue exists.

Introduction The introduction stage happens when the product is launched and becomes available to the
public. During this period, marketing expenses might be high; sales volume is often low but
growing.

Growth Assuming customers are interested in the product, demand for it will start to grow faster during
the growth stage of its life cycle. This causes sales and profits to increase as the new product
becomes popular with the public. As a result, the company now benefits from economies of
scale.

Maturity During the maturity stage of the product’s life cycle, demand levels out, and growth slows down.
However, it still makes a profit at this stage, and in many cases, it is the most profitable stage of
a product’s life.
The product might have to be frequently updated to maintain its attractiveness to the public.

Decline Decline is the final stage in the life of a product. It is when fewer people wish to buy the product,
and profits decline and eventually turn into losses. It is the end of the product’s life.
The main aim of organisations that use lifecycle costing is to ensure the product is profitable over its life.
Therefore, the total income earned from the product should be more than the costs incurred during its life.
The types of costs that lifecycle costing will take into account when costing a product will include:
 Design and development costs
 Advertising costs
 Production costs, for example, materials, labour and overhead costs
 Training costs
 Selling and distribution costs
 Depreciation of machinery
 End-of-life costs, such as disposal costs of machinery that are no longer required when production
finishes.

Cost type Description

Design and Design and development costs will be incurred before a product is made and before the
development introduction stage of the product’s life cycle (although it is common also to see some
costs redesign cost at different stages of the life cycle).

Advertising Advertising costs will be incurred throughout the life cycle of a product. It is common to
costs spend more money on advertising a product when it is first launched, for example, in the
introduction stage of the product’s life cycle.

Production costs Production costs are incurred during all four stages of a product’s life cycle. As production

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volumes increase, the cost per unit will fall and begin to rise again when volumes start to
decline.

Sales and Sales and distribution costs are incurred at four stages of a product’s life cycle.
distribution
costs

End-of-life costs End-of-life costs are incurred when a product is no longer manufactured. An example of a life
cost is the cost incurred in restoring a leased factory or shop to its previous state when
handed back to the landlord.

Example

Winston’s Football Factory is planning to manufacture a new product, a football calendar showing the top 12
football teams in the world. Initial results from a market research survey show that 40,000 units at $18 per unit
should sell over the product’s life. It is also estimated that the following costs will be incurred over the lifetime of
the calendar production:
Design and development costs of $40,000
Production costs $10 per unit
End-of-life costs of $18,000.
The total lifecycle cost of calendar production is calculated as follows:
Cost type Total ($) Calculation
Design and development costs 40,000
Production costs 400,000 40,000 × 10
End-of-life costs 18,000
Lifecycle cost 458,000
For the football calendars to be profitable, Winston will want to ensure that it earns more than $458,000 from
sales income over its life.
The lifecycle cost per unit of calendars = Total lifecycle costs/Number of units
The calculation for this is $458,000/40,000
This results in a lifecycle cost per unit of $11.45.

The lifecycle cost per unit is important as it helps businesses determine their pricing. If, for example, an
attempt is made to make a profit on the product in the early stages, when production costs are high, and
volumes are low, it would require charging a price that nobody would be willing to pay, which may result in
the product never getting to the much more profitable maturity phase.
1.4.2 Committed Costs
During the planning and design phase, many of the decisions made about the product's design will
determine the costs which will be incurred in the future. These are committed costs. Although not incurred
during the design phase, the company is committed to incurring future expenditures (mainly during the
manufacturing stage).
Tools such as target costing (see previous) may be used to reduce such committed costs if they exceed
what is acceptable.
The pattern of expenditure will vary from industry to industry. However, it is common for committed costs
during the planning and design phase to reach 80% of the total costs over the product's life.

1.4.3 Cost Behaviour in the Product Lifecycle

The actual costs incurred during the product lifecycle typically include the following:

Stage Fixed Costs Variable Costs

Planning and  Product design
design
 Building prototypes
 Market research

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Manufacturing  Marketing and advertising  Materials and components

and sales
 Fixed production and sales overheads  Direct labour
 Design updating  Variable production and non-
production overheads
 Sales commissions

Service and  Decommissioning factories  Servicing (may be outsourced)

abandonment
 Disposal of products

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Chapter 11: Sampling Techniques and

Expected Values
11.1.1 Population
1.1 Population

Definition

Population – The set of items from which a sample is drawn to form conclusions.
A population is the entire group of interest.
The whole population may be examined to draw conclusions if it is manageable.
However, often it is impracticable to examine the entire group. For example, for a company, the population
might be all the customers who buy a particular product. This could be millions of people.

11.1.2 Sample
1.2 Sample

Definition

Sample – A subset of items selected from a population which is analysed to form conclusions about the
population.
A sample is a group of things selected from a population. The aim of studying a sample is to draw valid
conclusions about the population without studying every item.
Sampling risk, the risk that conclusions drawn from the sample will not apply to the population as a whole,
should be minimised.
For example, a company that is considering altering its product in some way might put together a focus
group of 20 different customers and ask them what they think of the proposed change.
A population is often too large to study in its entirety. Studying every item would cost a lot in terms of money
and time. Analysing a sample is cheaper and less time-consuming, but it must have the same characteristics
as the whole population.
It is vital that the sample is representative of the population and is not biased. The better the sample
represents the population, the higher the confidence that the decisions made after looking at a sample are
the same as if the entire population had been examined.

11.1.3 Random Sampling

1.3 Random Sampling

Definition

Random sampling – The selection of a sample from a population where every item has an equal chance of
being selected.

Example

Random samples of 5 were drawn from a population of 20 individuals.

Example

Winston would like to survey his customers to find out what they think about the quality of the service they

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Example

have received from his company. Winston has 1,000 customers now.
Winston has decided to sample 1% of the 1,000 customers.
1. The sample should consist of 10 customers at random (1% of the 1000 customers = 10).
2. 10 customers would be randomly selected from a numbered list of 1,000 customers.
3. The selection can be made by generating ten random numbers from 1-1,000 and then selecting the
corresponding customer in the numbered list to form part of the sample.
The numbered list of the population of customers is known as a sampling frame because it lists the whole
population of Winston’s customers.

11.1.4 Systematic Sampling

1.4 Systematic Sampling

Systematic sampling is a technique that involves selecting every nth item after the first item, which is
selected randomly.

Example

Winston would like to survey his customers to find out what they think about the quality of the service they have
received from his company. Winston has 1,000 customers now.
Winston has decided to select a sample of 1% of the 1,000 customers using systematic sampling.
The first customer is chosen by randomly selecting one of the customers numbered 1-100 in the sampling frame
of customers listed 1-1,000. Next, customer number 40 is randomly selected from the list –using a random
number generator function.
The second customer selected will be the customer who is 140th on the list of customers. The reason for this is
to choose 10 items out of a thousand, so there will be a gap of 100 between each item selected (1,000/10 = 100).
This gap is known as the sampling interval.
The third customer selected will be the customer who is 240th on the list of customers.
The list of ten customers in the sample would be the following from the list of customers:
1st = customer number 40 on the list
2nd = customer number 140 on the list
3rd = customer number 240 on the list
4th = customer number 340 on the list
5th = customer number 440 on the list
6th = customer number 540 on the list
7th = customer number 640 on the list
8th = customer number 740 on the list
9th = customer number 840 on the list
10th = customer number 940 on the list

Example

Systematic samples of 5 were drawn from a population of 20 individuals.

Note that the first person (darkened square) is selected randomly, and the interval between individuals is
constant.

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Example

11.1.4 Systematic Sampling

1.4 Systematic Sampling

Systematic sampling is a technique that involves selecting every nth item after the first item, which is
selected randomly.

Example

Winston would like to survey his customers to find out what they think about the quality of the service they have
received from his company. Winston has 1,000 customers now.
Winston has decided to select a sample of 1% of the 1,000 customers using systematic sampling.
The first customer is chosen by randomly selecting one of the customers numbered 1-100 in the sampling frame
of customers listed 1-1,000. Next, customer number 40 is randomly selected from the list –using a random
number generator function.
The second customer selected will be the customer who is 140th on the list of customers. The reason for this is
to choose 10 items out of a thousand, so there will be a gap of 100 between each item selected (1,000/10 = 100).
This gap is known as the sampling interval.
The third customer selected will be the customer who is 240th on the list of customers.
The list of ten customers in the sample would be the following from the list of customers:
1st = customer number 40 on the list
2nd = customer number 140 on the list
3rd = customer number 240 on the list
4th = customer number 340 on the list
5th = customer number 440 on the list
6th = customer number 540 on the list
7th = customer number 640 on the list
8th = customer number 740 on the list
9th = customer number 840 on the list
10th = customer number 940 on the list

Example

Systematic samples of 5 were drawn from a population of 20 individuals.

Note that the first person (darkened square) is selected randomly, and the interval between individuals is
constant.

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11.1.5 Stratified sampling

1.5 Stratified sampling

Stratified sampling is used when the population is divided into different strata or groups. A random sample
is then taken from each group. It is a good technique when there are apparent groups within a population.
Using a stratified sample reduces the chance of accidentally putting together a sample that is not
representative of the population as a whole.

Example

Winston uses regional distributors to deliver the footballs to different areas and knows that his footballs are more
popular in some regions than others.
The following information relates to the customers of Winston’s footballs.

Area of country Number of customers

North 200

South 400

East 300

West 100

Total 1,000
To apply stratified sampling:
1. Divide the list of customers into areas
Divide the list of Winston’s customers into four separate areas: North, South, East and West. This gives us
four groups with 200, 400, 300 and 100 customers respectively.

2. Identify proportions for each group

The second step of stratified sampling is identifying the proportion or percentage of customers in each
stratum. This is done as follows:

Area of country Number of customers Proportion Workings

North 200 0.2 200/1,000=0.2

South 400 0.4 400/1,000=0.4

East 300 0.3 300/1,000=0.3

West 100 0.1 100/1,000=0.1

Total 1,000 1.0

3. Calculate the sample required from each group
The total sample size is 10 customers. The number of customers to be selected from each area of the
country is calculated as follows:

Area of country Proportion Working Number of customers in sample

North 0.2 0.2 × 10 2

South 0.4 0.4 × 10 4

East 0.3 0.3 × 10 3

West 0.1 0.1 × 10 1

Total 1.0 10
4. Select a random sample from each group
The technique’s final stage is to select a random sample from each group.

Here, two customers will be randomly selected from the North, 4 from the South, 3 from the East and 1 from the
West. This sample selection method involves selecting a sample that is in proportion to the number of customers
in each group, so the results should be more representative than a normal random sample.

11.1.6 Multistage Sampling

1.6 Multistage Sampling

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Sometimes a population may be too large to be sampled using the methods discussed so far because it will
not be possible to draw up a sampling frame of all the items in the population.
Multistage sampling is a sampling technique that involves dividing a large population (such as a country)
into different areas. First, a set of regions is selected randomly, and each chosen location is divided into
further sub-areas. A random sample of these is then selected.
This process is continued until a random population sample in one of the smallest sub-areas is chosen to be
interviewed.
The main difference between multistage and stratified sampling is that all stages are randomised in
multistage sampling. In stratified sampling, obvious groups within a population are identified and selected –
only then are they further randomised.

Example

As the Football World Cup is fast approaching, a local football club has decided to survey the country’s entire
population to see who they think will win the World Cup.
As it is impossible to list the whole population to obtain a sampling frame, the survey company have decided to
divide the country into ten areas and select five towns in each area.
A sample of 250 people in each town is then selected, and each person is asked who they think is likely to win
the World Cup.

11.1.7 Cluster sampling

1.7 Cluster sampling

Cluster sampling is a technique that involves dividing the total population into small groups (or clusters) and
then randomly selecting one cluster and interviewing the entire population of the chosen cluster.
In the example above, a cluster would be one of the towns in one of the areas, and all of the randomly-
selected towns’ populations would be interviewed in cluster sampling.
11.1.8 Quota sampling
1.8 Quota sampling

Quota sampling is a technique that involves dividing the population into different groups with interviewers
and then questioning a particular proportion or quota of people in each group. It is common for the
interviewers to decide how to select the sample from each group.
Activity 1

Determine the sampling technique described.

 Random sampling
 Cluster sampling
 Systematic sampling
 Quota sampling
Statement Sampling method

Every 15th child in a school is selected for an interview after the first child is chosen Systematic sampling
randomly.

1,000 people are each given a number 1 – 1,000, and then raffle tickets are drawn Random sampling
from a box to select prize winners.

Every patient in a hospital is questioned about the treatment they received in a Cluster sampling
hospital that was selected randomly.

An interviewer is asked to question the following: ‘5 men in Supermarket A’, 10 Quota sampling
Women in Supermarket B’, 5 Women in Supermarket C’ and ’10 men in Supermarket
D’.
11.2.1 Probability
2.1 Probability

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Definition

Probability – The likelihood of an event, quantified between 0 (certainty event will not happen) and 1 (certainty
event will happen).
A probability of 0 means there is no chance of the event occurring, i.e. it is impossible.
A probability of 1 means the event will occur with certainty.
A probability of 0.5 means a 50% chance of an event occurring. For example, two possible events may occur
when a coin is tossed. The coin may land heads up, or it may land tails up. The probability of heads up is 1
out of 2, or ½ or 50%.
2.1.1 Assigning Probabilities To Events
Probabilities are often estimated by analysing experience or by doing research. In simple situations, the
probability (p) of an event occurring is:
P = Number of events / Number of possible outcomes

Example

A box of coloured pens containing 3 red pens, 2 blue pens and 1 yellow pen.
If a pen is picked randomly, what is the probability that it will be a blue pen?
P(blue pen) = Number of blue pens / Number of pens
= 2/6
= 1/3 or 0.33 (to two decimal places)
The probability of picking a red pen = 3/6 = 1/2
The probability of picking a yellow pen is 1/6.
Note that the sum of the probabilities adds up to 1. (1/3 + ½ + 1/6 = 1).

Key Point

The sum of the probabilities of an event must equal 1.

Activity 2

The following information is provided relating to a set of three possible sales demand scenarios:

Scenario Probability

Poor demand 0.2

Medium demand ???

High demand 0.1

What is the probability of a medium demand scenario (to one decimal place)?

*Please use the notes feature in the toolbar to help formulate your answer.

The total of the probabilities must add up to 1. Therefore, the missing probability = 1 − 0.2 − 0.1 = 0.7

11.2.2 Expected Values

2.2 Expected Values

Modern businesses operate in situations of uncertainty, with much data being estimated based on various
conditions. Data such as future sales demand and costs cannot be accurately predicted. Sometimes it is
possible to assign probabilities to the likelihood of events. Once this has been done, an expected value can
be calculated.

Definition

Expected value – Weighted arithmetic mean of possible outcomes.

The expected value is calculated by multiplying each outcome by the probability of that outcome and adding
up the total.
Generally, the decision rule would be to choose the outcome with the highest EV.

E(X) = Expected value of event

P = probability
X = value of the outcome

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E(X) = P1x1 + P2x2 + P3x3…+ Pnxn.

E(X) = Σ (xi p(xi))

Example

Research has estimated the following weekly sales volumes and their associated probabilities:

Sales volume (units) Probability

1,000 0.2

5,000 0.5

7,000 0.3
What is the expected value of sales volume for the week?
Answer:

Sales volume (units) Probability Sales volume x probability

1,000 0.2 200

5,000 0.5 2,500

7,000 0.3 2,100

Expected value 4,800

The expected sales volume is 4,800 units. Management can use this information to make decisions. For example,
if the cost card showed that this product would only make a profit if a minimum of 5,000 units were sold,
producing and selling this product would not be financially worthwhile.

Activity 3

A business is deciding whether or not to buy a new machine. The additional profits provided by the machine
per year and their associated probabilities are as follows:

Additional profit Probability

$2,000 0.35

$5,000 0.55

$6,000 0.10

What is the expected additional profit per year?

*Please use the notes feature in the toolbar to help formulate your answer.

The expected additional profit = ($2,000 × 0.35) + ($5,000 × 0.55) + ($6,000 × 0.10) = $4,050

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Chapter 12: Forecasting Costs and Revenues

12.1.1 Correlation
1.1 Correlation

This is the data table used to discuss the high-low method to identify the variable and fixed costs of the
maintenance contract at Winston’s Football Factory.
The number of football-making machines serviced and the total cost are variables.

Number of machines serviced Total cost ($)

2 110

4 140

6 170

8 200

10 230

12 260
The contract comprises a fixed call-out fee ($80) and a variable cost for each machine serviced.
The data can be plotted on a scatter diagram.

The graph shows that total cost increases as the number of machines serviced increases.
This means that there is a relationship between these two variables –there is a correlation between them.
1.1.1 Correlation

Definition

Correlation – The measure of how strongly related two variables are. If they are related, a change in one
variable will cause a change in the other variable.
In the case of Winston’s maintenance contract costs, a perfectly straight line can be drawn through the
plotted points, which shows a high level of correlation.
Sometimes, however, drawing a line through all the plotted points is impossible, so a line of best fit needs to
be drawn.
1.1.2 Lines Of Best Fit
A line of best fit is a graph line showing the general direction that the plotted points seem to be heading.
The line of best fit will show whether there is a linear relationship between two variables. The line of best fit
can help determine the level of correlation.
1.1.3 Degrees Of Correlation
If the line of best fit exactly hits all the points on the scatter diagram, it indicates a very strong correlation, as
shown in the maintenance contract cost graph for Winston’s Football Factory.
If data points are scattered around the line, it may suggest no relationship between those two things. This
would be a low degree of correlation.
The strength of the relationship between two variables will vary and can be classified as follows:
 Perfect positive correlation
The line of best fit joins up the data points with a straight line sloping upwards., which means that as the
value of one variable increases, the value of the other variable increases as well.

This graph shows that there is an exact linear relationship between the points plotted and have a perfect
positive correlation.


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
 Perfect negative correlation
The line of best fit joins up the data points with a straight line sloping downwards., which means that as the
value of one variable increases, the value of the other variable decreases.

This graph shows that there is an exact linear relationship between the points plotted and have a perfect
negative correlation.



 Partial positive correlation
There isn't an exact relationship between the data points plotted on this graph, and they cannot be joined up
to make a straight line.

However, a line of best fit may be drawn, estimating the general direction of the data.

This line is an upward-sloping line, which means that as the value of one variable increases, the value of the
other variable also tends to increase.

This graph shows a vague linear relationship between the plotted points and therefore has a partial positive
correlation.



 Partial negative correlation
There isn't an exact relationship between the data points plotted on this graph, and they cannot be joined up
to make a straight line.

However, a line of best fit may be drawn, estimating the general direction of the data.

This line is a downward-sloping line, which means that as the value of one variable increases, the value of
the other variable tends to decrease.

This graph shows a vague linear relationship between the plotted points and therefore has a partial negative
correlation.



 No correlation
A scatter diagram shows more varied data plotted on it. There is no possible relationship between the
plotted points and no correlation.

A line of best fit cannot be drawn for this scatter diagram, indicating no correlation.


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
12.1.2 Correlation Coefficient
1.2 Correlation Coefficient

The degree of correlation between two variables can be determined by calculating a correlation coefficient, r.
The formula for calculating the correlation coefficient, r, is:

Exam guidance

The correlation coefficient formula is provided in the exam.

Example

Here is the information relating to Winston’s maintenance contract.

Number of machines serviced Total cost ($)

2 110

4 140

6 170

8 200

10 230

12 260
For correlation coefficient calculations, add more columns to the data table for Winston’s maintenance contract
for ‘xy’, ‘x2’ and ‘y2’.
x = Number of machines serviced
y = Total cost
xy = x multiplied by y for each set of data
x2 = x multiplied by x
y2 = y multiplied by y

Number of machines serviced x Total cost $ y xy x2 y2

2 110 220 4 12,100

4 140 560 16 19,600

6 170 1,020 36 28,900

8 200 1,600 64 40,000

10 230 2,300 100 52,900

12 260 3,120 144 67,600

Solving for r:

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Example

Activity 1

Calculate for Coastway Café the correlation coefficient between the number of ice creams sold (y) and the
average daily temperature (x).

Average daily temperature Number of ice-creams

(x) (y)
xy x2 y2
14 59 826 196 3.481
27 102 2,754 729 10,404
20 84 1,680 400 7,056
22 85 1,870 484 7,225
17 75 1,275 289 5,625
∑ 100 405 8,405 2,098 33,791

*Please use the notes feature in the toolbar to help formulate your answer.

n=5
(∑x)2 = 1002 = 10,000
(∑y)2 = 4052 = 164,025

There is, therefore, a high positive correlation between the average daily temperature and the number of ice
creams sold.
Activity 2

Cutters uses a machine which runs at different speeds. The higher the speed (x), the shorter the
component’s life (y).

x y xy x2 y2
17 19.2 326.4 289 368.64
20 18.5 370.0 400 342.25
20 17.0 340.0 400 289.00
25 15.8 395.0 625 249.64
26 14.1 366.6 676 198.81
28 11.4 319.2 784 129.96
31 12.4 384.4 961 153.76
32 10.6 339.2 1,024 112.36

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36 11.2 403.2 1,296 125.44

40 8.8 352.0 1,600 77.44
275 139.0 3,596.0 8,055 2,047.30

Calculate the correlation coefficient between the machine speed (x) and the component’s life (y).

*Please use the notes feature in the toolbar to help formulate your answer.

Applying the correlation coefficient formula, r = -0.9509

12.1.3 Interpreting The Correlation Coefficient

1.3 Interpreting The Correlation Coefficient

r value Description

1 Perfect positive correlation

0 No correlation

-1 Perfect negative correlation

Between 0 and 1 partial positive correlation

Between 0 and -1 partial negative correlation

The closer the r value is to either 1 or −1, the stronger is the correlation between the variables.
1.3.1 Correlation and Causation
Establishing a correlation between two variables does not prove that one thing causes the other (‘causation’).
For example, there is a positive correlation between sun protection cream usage and the number of people
requiring lifeguard assistance while swimming. However, this does not mean that sun protection cream
causes swimmers to get into difficulty.

12.1.4 Coefficient Of Determination

1.4 Coefficient Of Determination

The coefficient of determination is a variation of the correlation coefficient.

The main difference is that it does not consider whether the relationship is positive or negative. Instead, it
just looks at an absolute value, which measures how much the linear variation in one variable can be
explained by the variation in another variable.
The coefficient of determination is calculated by squaring the correlation coefficient (r2 = r × r).

Example

The coefficient of determination of the data relating to Winston’s service contract is as follows:
Correlation coefficient = r = 1
Coefficient of determination = r2
= 12
=1×1
=1
This means variations in the number of machines services can explain 100% of the variations in the total cost.
What if the correlation coefficient (r) of the data relating to Winston’s service contract had been − 0.9?
−0.92 = −0.9 × −0.9 = 0.81
In this case, variations in the number of machines serviced explains 81% of the variations in the total cost; 19%
of the variations are due to other factors.
What if the correlation coefficient (r) had been +0.8?
0.82 = 0.8 × 0.8 = 0.64
This indicates an even weaker relationship between the two variables. In this instance, 64% of the variations in
the total cost can be explained by the number of machines serviced, leaving 36% of the variations to be explained
by other factors.

Activity 3

1. If the correlation coefficient for a data set is calculated to be 0.85, what is the coefficient of determination?

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a. 0.02
b. 0.15
c. 0.72
d. 0.85
2. If the coefficient of determination was calculated for two variables - total cost (the dependent variable) and
level of activity (the independent variable) and was found to be 0.64 - which of the following statements is
true?

a. Total costs can explain 64% of the variations in the activity level.
b. Total costs can explain 8% of the variations in the activity level.
c. 64% of the variations in total costs can be explained by activity level.
d. 8% of the variations in total costs can be explained by activity level.
3. If the correlation coefficient for a data set was measured to be −0.25, which of the following statements is
true?

a. There is a perfect positive correlation

b. There is a perfect negative correlation
c. There is a partial positive correlation
d. There is a partial negative correlation
*Please use the notes feature in the toolbar to help formulate your answer.

1. 0.72

The coefficient of determination is the value of r2 = 0.852= 0.72

2.
3. 64% of the variations in total costs can be explained by activity level.

The coefficient of determination measures the degree of variability of a dependent variable that can be
explained by the degree of variability of the independent variable. Therefore 64% of the variation in total
costs can be explained by the variation in the activity level.

4.
5. There is a partial negative correlation

If the value of the correlation coefficient is between 0 and -1, this indicates a partial negative correlation
between the two variables.

6.
12.1.5 High/low Method
1.5 High/low Method

Using the formula below, the high/low method separates semi-variable costs into fixed and variable elements.
Total semi-variable cost = Fixed cost + (Variable cost per unit × number of units)
This can also be expressed using the linear function (equation) y = a + bx.

Example

Number of machines serviced Total cost ($)

2 110

4 140

6 170

8 200

10 230

12 260
Winston’s cost data for machine maintenance provided above may be expressed as a linear equation on a
graph.

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Example

Term Name Description

x the independent It is not dependent on another variable but determines the value of the dependent
variable. variable.
On the graph of Winston’s maintenance contract costs, it is the ‘Number of
machines serviced’.

y the dependent As its name suggests, it is dependent on the independent variable. In other words,
variable. the value of y is determined by the value of x.
On the graph of Winston’s maintenance contract costs, it is the ‘Total cost’.

b the gradient the gradient of the straight line is the amount by which the total changes when one
more machine (x) is serviced.
The gradient is the rate of change of the total, so the variable cost per unit.

a the y-intercept This is the point at which the line cuts the y-axis, and in this case, it is the value of
the fixed cost. It means that at zero production level, total costs are still 80.

12.1.6 Linear Functions

1.6 Linear Functions

The linear function y = a + bx can be used to calculate the line of best fit rather than draw it on a scatter
diagram. This is done by inserting the results from the high/low method into the linear function.
The example of Winston’s maintenance contract and the cost of servicing the football-making machines (a
semi-variable cost) can be examined to demonstrate how this works.
Write the total semi-variable cost equation below as a linear function, y = a + bx.
Total semi-variable cost = Fixed cost + (Variable cost per unit × number of units)
For Winston’s maintenance contract:
 The fixed cost (a) is 80. This is where the y- axis is intercepted in the graph of Winston’s
maintenance contract costs
 The variable cost per machine (b) is $15. This is the gradient of the straight line on the graph.
As the number of machines serviced (x) is known, calculate the total semi-variable cost (y) using the linear
function: y = 80 + 15x. Therefore, this function can forecast the total semi-variable cost for servicing any
number of machines.
Activity 4

1. A linear cost function is stated as y = a + bx. What does the value of ‘a’ represent?

a. Fixed cost
b. Variable cost
c. Independent variable
d. Dependent variable
2. A linear function is stated as y = a + bx. What does the value of ‘b’ represent?

a. Fixed cost
b. Variable cost
c. Independent variable
d. Dependent variable
3. A linear function is stated as y = a + bx. What does the value of ‘x’ represent?

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a. Fixed cost
b. Variable cost
c. Independent variable
d. Dependent variable
4. A linear function is stated as y = a + bx. What does the value of ‘y’ represent?

a. Fixed cost
b. Variable cost
c. Independent variable
d. Dependent variable
*Please use the notes feature in the toolbar to help formulate your answer.

1. Fixed cost

‘a’ is the point at which the line of the equation y = a + bx cuts the y-axis and represents the fixed cost.

2.
3. Variable cost

‘b’ is the gradient of the line of the equation y = a + bx and represents the amount by which y increases when
there is an increase of one unit of x. b represents the variable cost.

4.
5. Independent variable

x represents the independent variable in the linear cost equation.

6.
7. Dependent variable

y represents the dependent variable in the linear cost equation.

8.
1.6.1 Advantages And Disadvantages Of The High/Low Method

Advantages Disadvantages

 It is easy to understand.  If only two activity levels are available, the estimated
 It is easy to use and can determine the fixed and variable costs may not be very accurate.
fixed and variable elements of semi-variable  It assumes that costs are only affected by the activity
costs even if data is available for only two level, but this may not be the case in practice.
activity levels.
12.1.7 Linear Regression Analysis
1.7 Linear Regression Analysis

Linear regression analysis analyses past cost data to calculate the values of ‘a’ and ‘b’ in a linear function of
a line of best fit.
The values of ‘a’ and ‘b’ are known as linear regression coefficients.
The regression analysis formulae that are provided in the MA exam are as follows:

Exam guidance

The linear regression formulae are provided in the exam.

Example

The following data table is Winston’s machine maintenance costs:

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Example

Number of machines Total cost xy x2

serviced $
x y

2 110 220 4

4 140 560 16

6 170 1,020 36

8 200 1,600 64

10 230 2,300 100

12 260 3,120 144

Σx = 42 Σy = 1,110 Σxy = Σx2 =

8,820 364
Inserting these values to calculate a and b:

a = 185 − 105 = 80
Therefore, the equation for Winston’s maintenance contract, calculated using linear regression, is y = 80 + 15x.

Activity 5

Using linear regression, calculate for Coastway Café the linear function of the line of best fit between the
number of ice creams sold (y) and average daily temperature (x).

Average daily temperature Number of ice-creams

(x) (y)
xy x2 y2
14 59 826 196 3.481
27 102 2,754 729 10,404
20 84 1,680 400 7,056
22 85 1,870 484 7,225
17 75 1,275 289 5,625
∑ 100 405 8,405 2,098 33,791

*Please use the notes feature in the toolbar to help formulate your answer.

n=5

∑x = 100

∑y = 405

∑xy = 8,405

∑x2 = 2,098

(∑x)2 = 10,000

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a = 405/5 − (3.1 × 100/5) = 19

So y = 19 + 3.1x
Activity 6

Cutters uses a machine which runs at different speeds. The higher the speed (x), the shorter the
component’s life (y).

x y xy x2 y2
17 19.2 326.4 289 368.64
20 18.5 370.0 400 342.25
20 17.0 340.0 400 289.00
25 15.8 395.0 625 249.64
26 14.1 366.6 676 198.81
28 11.4 319.2 784 129.96
31 12.4 384.4 961 153.76
32 10.6 339.2 1,024 112.36
36 11.2 403.2 1,296 125.44
40 8.8 352.0 1,600 77.44
275 139.0 3,596.0 8,055 2,047.30

Calculate the linear function of the line of best fit between the speed of the machine (x) and the component’s
life (y).

*Please use the notes feature in the toolbar to help formulate your answer.

n = 10

b = ​ ​

a = ​ ​

y = 26.55 − 0.46x
12.1.8 Forecasting Costs And Revenues Using Regression Coefficients
1.8 Forecasting Costs And Revenues Using Regression Coefficients

Regression coefficients are ‘a’ and ‘b’ in the equation of a straight line, y = a + bx.
Organisations can use linear functions to predict the future costs and revenues of something. For example,
the equation y = 80 + 15x may predict the cost of servicing 16 football-making machines at Winston’s
Football Factory.
In this case, use x = 16 in the cost equation to know how much it will cost to service 16 machines and x
represents the number of machines serviced.
y = 80 + 15 x where x = 16
y = 80 + (15 × 16) = 320
Therefore, the cost of servicing 16 machines would be $320.
12.1.9 Difficulties When Forecasting Costs And Revenues
1.9 Difficulties When Forecasting Costs And Revenues

Using equations can help forecast costs and revenues, but this approach assumes past trends will continue
and the future will look similar to the past.
In reality, it isn’t easy to forecast future events accurately for the following reasons.
Political, Economic, Social and Technological changes, sometimes referred to as PEST factors, are difficult
to predict. For example:
 Political: A change in government or government policy, for example, a different attitude towards
trade barriers.

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 Economic: Changes in inflation, interest rates and exchange rates.

 Social: Changes in attitudes and taste
 Technological: New technologies, new production techniques.
Other factors that make forecasting difficult:
 Trends and seasonal variations that occurred in the past may not continue. Therefore, it is
unrealistic to assume trends will continue (to ‘extrapolate’ based on current trends).
 Uncertainty increases with time. The further into the future a forecast is for, the more unreliable it is
likely to be.
 Uncertainty increases if data is scarce, for example, data obtained from a very small sample.
Activity 7

1. If y = 1,500 + 14x, what is the total cost forecast for 800 units?

2. If y = 2,500 + 20x, what is the total cost forecast for 500 units?

3. If y = 2,800 + 125x, what is the total cost forecast for 76 units?

4. If y = 1,750 + 50x, what is the total cost forecast for 221 units?

*Please use the notes feature in the toolbar to help formulate your answer.

1. y = 1,500 + (14 × 800) = 12,700

2. y = 2,500 + (20 × 500) = 12,500

3. y = 2,800 + (125 × 76) = 12,300

4. y = 1,750 + (50 × 221) = 12,800

12.1.10 Advantages And Disadvantages Of Linear Regression Analysis
1.10 Advantages And Disadvantages Of Linear Regression Analysis

Advantages Disadvantages

 It is easy to use.  It assumes that a linear relationship exists

 It can be used to forecast costs and between two variables, but this may not be true. For
revenues. example, variable costs per unit might decrease at
higher output levels.
 It only needs a few data sets to establish the
linear relationship between two variables.  It only uses two variables to calculate a linear
function, but in practice, there may be more than one
 If the relationship between two variables is
independent variable affecting the dependent
strong, forecast costs and revenues should be
variable.
reliable.
 It assumes that the way costs and revenues
 It uses all available data and provides a
behave in the past is the way that they will behave in
definitive line of best fit. (Unlike the high/low
the future, but this is not always the case in practice.
method, which only uses two observations at
extremes and is likely to be non-typical.)  If the relationship between two variables is not
strong, forecast costs and revenues may not be
reliable.

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Chapter 13: Time Series Analysis

13.1.1 Principles of Time Series Analysis
1.1 Principles of Time Series Analysis

There are usually four components in time series analysis:

Component Description

Trend The underlying long−term movement in values over time.

Seasonal variation short−term fluctuations in value, resulting from differing circumstances affecting
results at different times of the day, week, month, year, etc.

Cyclical variation medium−term changes in values resulting from factors that repeat in cycles. Cyclical
variations are longer−term than seasonal variations.

Random variation Fluctuations that are not part of a pattern and are difficult to predict

1.1.1 Identifying Variations from a Graph

 The data line is the plotted time series data on a graph.

Time series data can be plotted onto a graph to identify patterns.

 The trend is the data line's general direction, showing the data values' long−term movement. In this
graph, the trend appears to be increasing.
 Seasonal variations are short−term fluctuations around the trend line. They are the gaps between
the trend and the data line on a graph that regularly recur.
Example

Franklyn's Football Factory is a sizeable football−manufacturing company. The following table shows the sales
figures over twelve years:

Year Actual sales

$000s

Year 1 21.00

Year 2 52.00

Year 3 24.00

Year 4 27.00

Year 5 29.00

Year 6 54.00

Year 7 30.00

Year 8 31.00

Year 9 33.00

Year 10 58.00

Year 11 36.00

Year 12 39.00
This table is an example of a time series. The data in the table can also be shown on a time series graph, as
shown here.

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Example

13.1.2 Predicting Future Values

1.2 Predicting Future Values

Time series analysis can be expressed as either an additive or multiplicative model:

Y = T + S + C+ R

Or

Y=T×S×C×R

Y = Data point

T = Trend

S = Seasonal variation

C = Cyclical variation

R = Random variation

For short−term forecasting, cyclical and random variations are ignored as they are difficult to predict. The
model may be simplified to:
Y=T+S

Or

Y=T×S

Example

Point Label Description

A Seasonal There was a significant increase in sales in Year 2 – this seasonal variation occurred
Variation – Year 2 when the World Cup took place (once every four years).

B Trend Line – Draw the line of best fit on the graph to show a relationship between actual sales
Relevant Range and time.
[Solid line only]
On a time series graph, a line of best fit is called a trend line as it shows the trend of
the results over the 12 years.
Sales are moving in an upward direction as they increase over time. Linear
regression analysis can also be used to establish the linear function of this trend
line.

C Seasonal There was a significant increase in sales in Year 6 – this seasonal variation occurred
Variation – Year 6 during the World Cup.

D Seasonal There was a significant increase in sales in Year 10 – this seasonal variation
Variation – Year occurred during the World Cup.
10

E Forecast Sales – Forecast the trend in Year 14 by reading the value from the graph. The forecast trend
Year 14 for Year 14 is approximately $45,000.
However, the World Cup is scheduled to take place in Year 14, so the forecast trend
needs to be adjusted by the seasonal variation to make a reliable sales forecast for
Year 14.

F Extrapolated One of the things to do in time series analysis is to predict future trends. This is

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Example

Trend Line [Dotted done by extending (extrapolating) the trend line outside the relevant range to
line only] forecast the trend in the coming years.
 Relevant range
The trend line’s relevant range is between Years 1 and 12 because this is where the observed actual sales figures
have been plotted.

To see what the trend line would look like outside this range, it needs to be extrapolated (extended into the
future). This would mean that, after Year 12, any extrapolated trend line would be outside the relevant range and
may not be a reliable estimate of the trend in the future.

 Extrapolation
Extrapolation, in the context of the time series graph, means extending into the future, that is, beyond Year 12.

13.1.3 Time Series Analysis Approach
1.3 Time Series Analysis Approach

Time series analysis is a technique that makes budget forecasts using trend and seasonal variations.
1. Identify the trend of a time series (either by moving averages or linear regression analysis).
2. Forecast the times series’ trend into the future
3. Identify seasonal variations (which will cause the trend to alter from its linear function).
4. Adjust the trend (by the estimated seasonal variations to prepare budget forecasts).
13.2.1 The Trend
2.1 The Trend

The trend is the smoothed−out time series line. In other words, the trend line indicates the general direction
of the data line with minimal fluctuations.
The trend of historical data can be established in the following ways:
 By establishing the equation of the line of best fit using linear regression analysis.
 By drawing the line of best fit.
 By using a method called moving averages.
13.2.2 Moving Averages
2.2 Moving Averages

The moving average method calculates the average of a set of consecutive periods. Averaging the time
series data removes any seasonal variations to estimate the trend.
If the set of periods is odd, the moving average will coincide with the middle data point.
If the set of periods used is an even number, the moving average must be calculated twice to ensure the
mid−point trend figure coincides with a data point.

Example: Moving Average (Odd−Numbered Set & Even−Numbered Set)

The following revenue data is available:

Year Revenue

$’000

20X1 50

20X2 54

20X3 55

20X4 59

20X5 60

20X6 64

20X7 68

20X8 72

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Example: Moving Average (Odd−Numbered Set & Even−Numbered Set)

1. Calculate a three−point moving average from the data and plot it on a graph.
2. Calculate a two−point moving average from the data.
Solution:

1.

2.

3.

4.
For the sake of presentation, the axis does not start from the origin (zero).
5.
6.
Year Revenue Sum of two Moving Moving average
years average
(mid−point)

$000 $000 $000 $000

20X1 50

104 52.00
(50 + 54) (104 / 2)

20X2 54 53.25
((52 + 54.5) / 2)

109 54.50
(54 + 55) (109 / 2)

20X3 55 55.75
((54.5 + 57) / 2)

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Example: Moving Average (Odd−Numbered Set & Even−Numbered Set)

114 57.00
(55 + 59) (114 / 2)

20X4 59 58.25
((57 + 59.5) / 2)

119 59.50
(59 + 60) (119 / 2)

20X5 60 60.75
((59.5 + 62) / 2)

124 62.00
(60 + 64) (124 / 2)

20X6 64 64.00
((62 + 66) / 2)

132 66.00
(64 + 68) (132 / 2)

20X7 68 68.00
((66 + 70) / 2)

140 70.00
(68 + 72) (140 / 2)

20X8 72

7.
The observed trend is increasing.
8.
Activity 1: Moving Average Method

The following revenue data is available:

Quarter Revenue ($)

1 24,000

2 33,000

3 48,000

4 15,000

1. Calculate a three−point moving average from the data.

2. Calculate a two−point moving average from the data.
*Please use the notes feature in the toolbar to help formulate your answer.

1.
Quarter Revenue Sum of three Moving Average
($) quarters ($)

1 24,000

2 33,000 105,000 35,000

3 48,000 96,000 32,000

4 15,000

2.
3.

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Quarter Revenue Sum of two Moving Moving average

($) quarters average ($; mid−point)
($)

1 24,000

57,000 28,500

2 33,000 34,500

81,000 40,500

3 48,000 36,000

63,000 31,500

4 15,000

4.
Activity 2

Year Actual sales

$000s

Year 1 21.00

Year 2 52.00

Year 3 24.00

Year 4 27.00

Year 5 29.00

Year 6 54.00

Year 7 30.00

Year 8 31.00

Year 9 33.00

Year 10 58.00

Year 11 36.00

Year 12 39.00

Using the above data, calculate a 4−year moving average for Franklyn’s Football Factory.

*Please use the notes feature in the toolbar to help formulate your answer.

Year Actual 4−year Moving Trend Workings

sales moving average
total

$000s $000s $000s $000s $000s

(A) (B) (C) (D)

Year 21
1

Year 52
2

124 31

Year 24 32 (31 + 33) ÷ 2 = 32

3

132 33

Year 27 33.25 (33 + 33.5) ÷ 2 = 33.25

4

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134 33.5

Year 29 34.25 (33.5 + 35) ÷ 2 = 34.25

5

140 35

Year 54 35.5 (35 + 36) ÷ 2 = 35.5

6

144 36

Year 30 36.5 (36 + 37) ÷ 2 = 36.5

7

148 37

Year 31 37.5 (37 + 38) ÷ 2 = 37.5

8

152 38

Year 33 38.75 (38 + 39.5) ÷ 2 = 38.75

9

158 39.5

Year 58 40.5 (39.5 + 41.5) ÷ 2 = 40.5

10

166 41.5

Year 36
11

Year 39
12

The trend expressed on a graph would be as follows:

13.2.3 Average Periodic Increase

2.3 Average Periodic Increase

The average period increase of the trend can be calculated by taking the difference between the earliest and
latest values and dividing them by the number of periods.
This assumes the trend is consistent.
The formula is:

Average periodic increase = (Trendlatest value − Trendearliest value) / Number of periods

Example: Average Periodic Increase

This is the 3-point moving average calculated from Example 4:

Year Revenue Sum of three years Moving average

$000 $000 $000

20X1 50

20X2 54 159 53.00

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Example: Average Periodic Increase

20X3 55 168 56.00

20X4 59 174 58.00

20X5 60 183 61.00

20X6 64 192 64.00

20X7 68 204 68.00

20X8 72
Calculate the average periodic increase for the given trend and forecast the trend’s expected value for 20X9 and
20Y0.
Solution:
Average periodic increase = (Trendlatest value – Trendearliest value) / Number of periods
Average periodic increase = (68 − 53) / 5 [20X2 to 20X7 is 5 periods]
Average periodic increase = 15 / 5
Average periodic increase = 3
The average yearly increase in trend is $3,000.
The expected values for 20X9 and 20Y0 are:

Last trend
Expected
point Periods after Trend increase
value
(20X7) the last trend
$000
point (20X7) $000
$000
Year

20X9 68 2 6 74
(3 × 2)

20Y0 68 3 9 77
(3 × 3)

13.2.4 Using Regression Coefficients To Calculate The Trend

2.4 Using Regression Coefficients To Calculate The Trend

When the linear function of a trend line has been derived (worked out) by linear regression analysis, it can be
used to forecast future costs and revenues.

Example

Sales (in $000s) over 24 months have a trend which follows the following linear function: y = 30 + 2x where y =
sales value and x = sequential number of months.
What is the sales trend forecast for Month 28?
Answer:
The trend in Month 28 = 30 + (2 × 28) = 30 + 56 = 86
The sales trend in Month 28 is therefore forecast to be $86,000.

13.3.1 Seasonal Variation

3.1 Seasonal Variation

Seasonal variations are regularly recurring fluctuations on the trend line for a time series. They are caused
by the pattern of demand for a product or service and can occur annually, monthly, weekly or daily.
The seasonal variation in a time series can be calculated and used in conjunction with the trend to predict
future cash flows.
As a reminder, the formula for calculating a time series is:
Y = T + S (Additive model)

Or

Y = T × S (Multiplicative model)

The seasonal variation may be determined as follows:

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S = Y − T (Additive model)

Or

S = Y / T (Multiplicative model)

The steps to calculate the seasonal variation are as follows:

1. Calculate the trend.
2. Calculate the variation for each season.
3. Average the variation for each season, and normalise (this step is to ensure any trend effects are removed)
 To normalise seasonal variation in the additive model, ensure the sum of the average variations is
zero.
 To normalise seasonal variation in the multiplicative model, ensure the sum of the average
variations equals the number of seasons.
(i.e. if each season is a quarter in the year, the sum of average variations should be four since there are four
quarters in a year).

Example

Here are the actual sales results for Franklyn's Football Factory, looked at earlier, and the trend values.
A value for the seasonal variation is calculated by subtracting the trend from the actual sales for Years 1−12.
The seasonal variations in Years 6 and 10 are positive and very high due to the World Cup being in these years.

Example Calculating Seasonal Variation (Additive Model)

The following data is available for sales:

Year Quarter Revenue ($000)

Q1 60

Q2 55
20X1
Q3 25

Q4 70

Q1 61

Q2 57
20X2
Q3 27

Q4 74

Q1 63

Q2 56
20X3
Q3 29

Q4 77
There is a clear indication of seasonality for each quarter.

1. Using the additive model, calculate the quarterly seasonal variation. (use a three−point moving average
for calculating the trend)
2. Using the additive model, forecast the quarterly sales for 20X4.
Solution:
1. Calculate the trend (moving average method):
Revenue Sum of three Moving
Year Quarter ($000, Y) quarters average

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Example Calculating Seasonal Variation (Additive Model)

($000; T)

20X1 Q1 60

Q2 55 140 46.67

Q3 25 150 50.00

Q4 70 156 52.00

20X2 Q1 61 188 62.67

Q2 57 145 48.33

Q3 27 158 52.67

Q4 74 164 54.67

20X3 Q1 63 193 64.33

Q2 56 148 49.33

Q3 29 162 54.00

Q4 77
Average periodic increase = (54.00 − 46.67) ÷ 9 periods = 0.81
Calculate the variation for each season (quarter):

Revenue Moving average Seasonal variation

Year Quarter ($000; Y) ($000; T) (Y − T)

20X1 Q1 60

Q2 55 46.67 8.33

Q3 25 50.00 (25.00)

Q4 70 52.00 18.00

20X2 Q1 61 62.67 (1.67)

Q2 57 48.33 8.67

Q3 27 52.67 (25.67)

Q4 74 54.67 19.33

20X3 Q1 63 64.33 (1.33)

Q2 56 49.33 6.67

Q3 29 54.00 (25.00)

Q4 77
Average the variation for each season (quarter), and normalise to zero (this step is to ensure any trend effects are
removed)
Quarter Q1 Q2 Q3 Q4 Total
20X1 8.33 (25.00) 18.00
20X2 (1.67) 8.67 (25.67) 19.33
20X3 (1.33) 6.67 (25.00)
Total (3.00) 23.67 (75.67) 37.33
÷ Number of periods (quarters) 2 3 3 2
Average seasonal variation (1.5) 7.89 (25.22) 18.67 (0.16)
Normalisation adjustment 0.04 0.04 0.04 0.04 0.16
Seasonal variation ($000; S) (1.46) 7.93 (25.18) 18.71 NIL
Minor rounding errors are ignored.
2. Forecast the future data value by using the time series formula Y = T + S:

=
Trend
+ Expected
($000; T)
Seasonal revenue
Year Quarter (see variation ($000, S) ($000, Y)

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Example Calculating Seasonal Variation (Additive Model)

Workings)

20X4 Q1 55.62 (1.46) 54.16

Q2 56.43 7.93 64.36

Q3 57.24 (25.18) 32.06

Q4 58.05 18.71 76.76

Workings: Trend ($000; T)
Q1 20X4 = Q3 20X3 + (2 x average periodic increase) = 54.00 + (2 x 0.81) = 55.62
Q2 20X4 = Q1 20X4 + average periodic increase = 55.62 + 0.81 = 56.43
Q3 20X4 = Q2 20X4 + average periodic increase = 56.43 + 0.81 = 57.24
Q4 20X4 = Q3 20X4 + average periodic increase = 57.24 + 0.81 = 58.05

Example: Calculating Seasonal Variation (Multiplicative Model)

Using the data from the earlier example,

1. Using the multiplicative model, calculate the quarterly seasonal variation. (use a three−point moving average
for calculating the trend)
2. Using the multiplicative model, forecast the quarterly sales for 20X4.
Solution:
1. Calculate the trend (moving average method, from the earlier example):

Revenue Moving average

Year Quarter ($000, Y) ($000; T)

20X1 Q1 60

Q2 55 46.67

Q3 25 50.00

Q4 70 52.00

20X2 Q1 61 62.67

Q2 57 48.33

Q3 27 52.67

Q4 74 54.67

20X3 Q1 63 64.33

Q2 56 49.33

Q3 29 54.00

Q4 77
Average periodic increase = (54.00 − 46.67) / 9 periods = 0.81
Calculate the variation for each season (quarter):

Revenue Moving average Seasonal variation

Year Quarter ($000; Y) ($000; T) (Y / T)

20X1 Q1 60

Q2 55 46.67 1.18

Q3 25 50.00 0.50

Q4 70 52.00 1.35

20X2 Q1 61 62.67 0.97

Q2 57 48.33 1.18

Q3 27 52.67 0.51

Q4 74 54.67 1.35

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Example: Calculating Seasonal Variation (Multiplicative Model)

20X3 Q1 63 64.33 0.98

Q2 56 49.33 1.14

Q3 29 54.00 0.54

Q4 77
Average the variation for each season (quarter), and normalise their sum to 4(this step is to ensure any trend
effects are removed)
Quarter Q1 Q2 Q3 Q4 Total
20X1 1.18 0.50 1.35
20X2 0.97 1.18 0.51 1.35
20X3 0.98 1.14 0.54
Total 1.95 3.50 1.55 2.70
÷ Number of periods (quarters) 2 3 3 2
Average seasonal variation 0.98 1.17 0.52 1.35 4.02
Normalisation adjustment (0.005) (0.005) (0.005) (0.005) (0.02)
Seasonal variation (S) 0.975 1.165 0.515 1.345 4.00
The normalisation error of 0.02 is insignificant and may be ignored. However, normalisation is done here to
illustrate the calculation.
2. Forecast the future data value by using the time series formula Y = T × S:

Trend
($000; T) × =
Seasonal Expected
(see
variation revenue
Workings)
Year Quarter (S) ($000, Y)

20X4 Q1 55.62 0.975 54.23

Q2 56.43 1.165 65.74

Q3 57.24 0.515 29.48

Q4 58.05 1.345 78.08

Workings: Trend ($000; T)
Q1 20X4 = Q3 20X3 + (2 x average periodic increase) = 54.00 + (2 x 0.81) = 55.62
Q2 20X4 = Q1 20X4 + average periodic increase = 55.62 + 0.81 = 56.43
Q3 20X4 = Q2 20X4 + average periodic increase = 56.43 + 0.81 = 57.24
Q4 20X4 = Q3 20X4 + average periodic increase = 57.24 + 0.81 = 58.05

Activity 3

1. The sales trend in Month 28 is forecast to be $86,000, and the seasonal variation in Month 28 is
forecast to be +15,000.
Calculate the sales budget forecast for Month 28 using the additive model.

2.
3. The sales trend in Month 28 is forecast to be $86,000, and the seasonal variation in Month 28 is
indicated to be 0.82 times the trend.
Calculate the sales budget forecast for Month 28 using the multiplicative model.

4.
*Please use the notes feature in the toolbar to help formulate your answer.

1. Sales budget forecast for Month 28 = Trend + 15,000 = 86,000 + 15,000 = 101,000
2. Sales budget forecast for Month 28 = $86,000 × 0.82 = $70,520.
13.3.2 Budget Forecasts
3.2 Budget Forecasts

Information about the trend and seasonal variations can be used to make budget forecasts:
 Use regression coefficients to forecast the trend for a future period.

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 Adjust forecast trend values by the seasonal variation to forecast budgets for future periods.
13.3.3 Advantages And Disadvantages Of Time Series Analysis
3.3 Advantages And Disadvantages Of Time Series Analysis

Advantages Disadvantages

 It can be used to make forecasts if  It assumes that the trend is a linear function (straight line),
a straight-line trend is assumed to exist but this may not always be the case in practice.
and information about seasonal  It assumes that what has happened in the past is likely to
variations is available. occur in future, but this is not always the case in practice.
 If the relationship between two  It assumes that seasonal variations occur with constant
variables is strong, forecast costs and regularity, though this is not always the case in practice.
revenues should be reliable.

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Chapter 14: Index Numbers

14.1.1 Single Item Index Numbers
1.1 Single Item Index Numbers

Definition

Index– A measure to compare values over time.

The purpose of index numbers is to compare values of things over time, for example, prices and quantities
of products. They are also used to adjust historical data and make forecasts.
1.1.1 Simple price index
A simple price index measures the changes in prices of a single item over time. The formula used to
calculate the price index of an item is as follows:
Price index = P1/P0 × 100

P0 = Price at Time 0 (the base year)

P1= Price at Time 1

Under the fixed base method, the base year is allocated an index of 100, and subsequent years are measured
against this base.
Under the chain base method, the base year is always the year immediately before the year under
consideration.

Key Point

Most indexes are base-100, meaning that the base year is given a value of 100. This makes it easier to see
changes.
For example, a year with a 120 index is 20% more than the base year (100).

The fixed base method shows changes relative to the base year. The chain base method shows the change
from year to year.

Example

The oil price is $270 a barrel in 20X1, $300 in 20X2, $340 in 20X3 and $380 in 20X4.
Calculate a chain base index and a fixed base index that uses 20X1 as the base year.
Answer:
Chain base index
20X1: 100
20X2: 111 (300/270 × 100)
20X3: 113 (340/300 × 100)
20X4: 112 (380/340 × 100)
Fixed base index
20X1: 100
20X2: 111 (300/270 × 100)
20X3: 126 (340/270 × 100)
20X4: 141 (380/270 × 100)

Example: Using a Price Index

The following index is available for Furniture Co:

Year Revenue ($000) Index

20X1 10,000 100

20X2 ? 110

20X3 ? 115

1. Which year has been selected as the base year?

2. What is Furniture Co’s revenue in the years 20X2 and 20X3?

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Example: Using a Price Index

Solution:

1. As 20X1 has been assigned the index value of 100, it is the base year.
2.
Current year index = (Price1/Price0) × 1000
3.
Re-arranged:
4.
Price1 = Price0 × (Current year index/1000)
5.
Revenue20x2 = 10,000 × (110/100)
6.
Revenue20x2 = 10,000 × 1.1
7.
Revenue20x2 = 11,000
8.
Furniture co’s revenue in 20X2 is $11m
9.
Revenue20x3 = 10,000 × (115/100)
10.
Revenue20x3 = 10,000 × 1.15
11.
Revenue20x3 = 11,500
12.
Furniture co’s revenue in 20X3 is $11.5m
13.
Activity 1: Using a Price Index

The following index is available for Furniture Co:

Year Revenue ($000) Index

20X1 50.00 100

20X2 ? 110

20X3 ? 115

20X4 ? 100

20X5 ? 120

20X6 57.50 ?

1. What is Furniture Co’s expected revenue for 20X2 to 20X5?

2. What is the index for the year 20X6?
*Please use the notes feature in the toolbar to help formulate your answer.

1.
Year Revenue ($000) Index

20X1 50.00 100

20X2 55.00 110

20X3 57.50 115

20X4 50.00 100

20X5 60.00 120

2.
3.
Current year index = (Pricecurrent year/Pricebase year) × 100base year

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4.
20X6 index = (57.50/50.00) × 100

5.
20X6 index = 1.15 × 100

6.
20X6 index = 115

7.
Activity 2: One Variable

The price of a chocolate bar for the years 20X2 through 20X5 has been as follows:

Year Price ($)

20X2 0.51
20X3 0.56
20X4 0.59
20X5 0.62

Calculate the price index for a chocolate bar each year, with Year 20X2 as the base.

*Please use the notes feature in the toolbar to help formulate your answer.

Year Calculation Index

20X2 100

20X3 (0.56/0.51) × 100 109.8

20X4 (0.59/0.51) × 100 115.7

20X5 (0.62/0.51) × 100 121.6

1.1.2 Quantity Index
Quantity index = Q1/Q0 × 100
Q0 = Quantity at Time 0 (the base year)
Q1= Quantity at Time 1

Example

The following data relates to Product K:

Year Sales (Units)

20X1 6,800

20X8 8,500
A simple quantity index is calculated by using 20X1 as the base year, Q0 and 20X8 as Q1 (quantity at Time 1):
Quantity index = Q1/Q0 × 100 = 8,500/6,800 × 100 = 125
The quantity index calculated shows that the number of units of Product K sold in 20X8 has increased by 25%
compared to the quantity sold in 20X1.

Index numbers can also be interpreted as percentages. For example, the quantity index of 125 calculated in
the example can also be thought of as 125%, which is equivalent to an increase of 25%, while a price index of
130 would indicate a price rise of 30%.
Activity 3

The following data relates to Product R:

20X5 is the base year, P0 and 20X8 is P1 (price at time 1)

Year Sales (units) Price ($)

20X5 3,500 28.00

20X8 4,795 43.12

Calculate the price and quantity index for 20X8.

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*Please use the notes feature in the toolbar to help formulate your answer.

Price index = P1/P0 × 100

P0 = Price at Time 0 (the base year) = 20X5 = 43.12

P1 = Price at Time 1 = 20X8 = 28

Price index= (43.12 )/28.00 × 100 = 154

Quantity index = Q1/Q0 × 100

Q0 = Quantity at Time 0 (the base year) = 20X5 = 4,795

Q1 = Quantity at Time 1 = 20X8 = 3,500

Quantity index= 4,795/3,500 × 100 = 137

14.1.2 Weighted index
1.2 Weighted index

A weighted index must be calculated when multiple items (or variables) are considered.
For example, a country’s inflation rate is commonly measured by calculating a weighted index based on
several products. The products that are selected are those that represent the items that might appear in the
shopping basket of an average household. These indices are often given names, for example (in the UK) the
Retail Price Index (RPI). Movement of this index is used to compare with movement in other areas, for
example, when considering what is ‘reasonable’ when considering wage and salary increases.

Example

A company manufactures three products: Product AA, Product BB and Product CC. Information relating to these
products is shown in the following table.

Product type Sales price ($) 20X5 Sales price ($) 20X6

Product AA 10 12

Product BB 16 20

Product CC 20 22
The management accountant of the company wishes to calculate a weighted price index and uses the following
weightings, which are based on the number of units of each product sold.

Product type Sales volume (units)

Product AA 8,000

Product BB 4,000

Product CC 2,000
Calculate the price index weighted on units sold.
Answer:
1. Calculate the simple price index for each product.

Price index – Product AA = P1 / P0 × 100% = 12 / 10 × 100 = 120

Price index – Product BB = P1 / P0 × 100% = 20 / 16× 100 = 125

Price index – Product CC = P1 / P0 × 100% = 22 / 20× 100 = 110

2. Weight the price indices using the number of units sold

Product Price Weighting (sales Price index ×

type index units) weighting

Product 120 8,000 960,000

AA

Product 125 4,000 500,000

BB

Product 110 2,000 220,000

CC

Total 14,000 1,680,000

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Example

3. Calculate the weighted price index

Weighted price index = (Price index × weighting) /Weighting
= 1,680,000/14,000
= 120

Indices enable meaningful comparisons between figures from different years, removing the impact of price
movements (inflation or deflation).
Activity 4 Weighted Price Index

A weighted price index is based on the consumption of three products: bread, cheese and eggs. The
following information has been provided as at 31 December:

20X2 20X5

Commodity Quantity Unit P× Unit P×

(annual) price Q Price Q

$ $ $ $

Bread 100 loaves 0.51 0.62

Cheese 25 kilos 1.60 2.00

Eggs 50 half-dozen 0.80 0.90

Calculate the price index at 31 December 20X5, taking 31 December 20X2 as the base.

*Please use the notes feature in the toolbar to help formulate your answer.

Price index for 31 Dec 20X5 = 157 / 131 × 100 = 119.8

Example

Sanjay’s annual salary over the past three years is shown below, alongside the corresponding Retail Price Index
(RPI).

Year Annual salary ($) RPI

20X2 35,000 160

20X3 35,800 163

20X4 36,400 167

Has Sanjay’s salary increased or decreased in real terms (so after allowing for inflation) on the previous year, in
20X3 and 20X4?
Answer:
20X3
Sanjay’s 20X2 salary at 20X3 prices would be: (35,000 / 160) x 163 = $35,656. So Sanjay’s 20X3 salary of $35,800
has increased in real terms on his 20X2 salary.
20X4
Sanjay’s 20X3 salary at 20X4 prices would be: (35,800 / 163) x 167 = $36,679. So Sanjay’s 20X4 salary of $36,400
has decreased in real terms to his 20X3 salary.

14.1.3 Laspeyre and Paasche indices

1.3 Laspeyre and Paasche indices

Laspeyre and Paasche indices are types of weighted aggregate indices.

1.3.1 Laspeyre index
A Laspeyre price index uses quantities from the base period as weights..

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Example

A rose seller recorded the number of batches of different colour roses they purchased in 20X3 and 20X4 and
the average price paid per batch. The information is shown below.

Year 20X3 20X4

Batches Price per batch Batches Price per batch

Red 150 28.00 85 21.00

White 68 22.60 65 18.80

Yellow 96 19.80 100 17.70

Calculate:
A Laspeyre quantity index and Paasche quantity index for 20X4, with 20X3 as the base year.
Answer:
P0Q0 = (150 × 28) + (68 × 22.6) + (96 × 19.8) = 7,637.6
P0Q1 = (85 × 28) + (65 × 22.6) + (100 × 19.8) = 5,829
Laspeyre quantity index: (5,829.00 / 7,637.60) × 100 = 76.3
P1Q0 = (150 × 21) + (68 × 18.8) + (96 × 17.7) = 6,127.6
P1Q1 = (85 × 21) + (65 × 18.8) + (100 × 17.7) = 4,777
Paasche quantity index:(4,777.00 / 6,127.60) × 100 = 78.0

Activity 5 Laspeyre and Paasche

Fisher, a small manufacturing company, uses three components (A, B and C) in production. Management
wants to know the effect of price changes on these three materials.

The following information is available at 31 December:

Component Price Price Quantity Quantity

20X2 20X5 20X2 20X5
A $1.2 $2.5 4,000 2,000
B $5.3 $5.8 1,000 800
C $2.3 $2.7 2,000 4,000
Calculate both the Laspeyre and Paasche price indices as at 31 December 20X5. (Assume 31 December 20X2
is the base date.)

*Please use the notes feature in the toolbar to help formulate your answer.

Component Price Quantity Price Quantity PoQ0 PnQo PoQn PnQn

Po Qo Pn Qn $ $ $ $
A $1.20 4,000 $2.50 2,000 4,800 10,000 2,400 5,000
B $5.30 1,000 $5.80 800 5,300 5,800 4,240 4,640
C $2.30 2,000 $2.70 4,000 4,600 5,400 9,200 10,800
14,700 21,200 15,840 20,440

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Price indices for 31 December 20X5 (31 December 20X2 as the base):

Laspeyre = ​ ​ × 100 = 144.2

Paasche = ​ ​ × 100 = 129.0

Index numbers can be used to forecast price movements in the future.
Historical data can be used to calculate a trend line or a line of best fit. However, it should be adjusted for
inflation using price indices before calculating a trend line or a linear function using linear regression
analysis. This is the best way to obtain the most accurate results.
Similarly, when the trend line is extrapolated (extended) into future periods, forecasts should be adjusted for
inflation by using estimated future price indices.
Activity 6

Price indices for Products XX, YY and ZZ were: 1.45, 1.08 and 1.35, respectively.

Sales (in units) for Products XX, YY and ZZ were: 2,100, 4,300 and 2,900, respectively.

Calculated the weighted average using the table below as a template:

Price index Weighting Weighted price index

Product XX 1.45 2,100

Product YY 1.08 4,300

Product ZZ 1.35 2,900

Total NA 9,300

*Please use the notes feature in the toolbar to help formulate your answer.

Price index Weighting Weighted price index

Product XX 1.45 2,100 3,045

Product YY 1.08 4,300 4,644

Product ZZ 1.35 2,900 3,915

Total NA 9,300 11,604

Weighted price index = price index × weighting

Product XX = 1.45 × 2,100 = 3,045

Product YY = 1.08 × 4,300 = 4,644

Product ZZ = 1.35 × 2,900 = 3,915

The weighted index = 125

Weighted index = 11,604 / 9,300 × 100 = 125

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Chapter 15: Spreadsheets

15.1.1 The Role of Spreadsheets
1.1 The Role of Spreadsheets

Definition

Spreadsheet – An electronic document divided into rows and columns used for storing, organising and
manipulating data.
Spreadsheets are useful tools because they can perform calculations quickly and easily. They can also
analyse and represent (in the form of charts, graphs and tables) large volumes of numerical data.
15.1.2 Features of spreadsheets
1.2 Features of spreadsheets

A spreadsheet worksheet is made up of rows and columns.

 Rows go across the page and are labelled with numbers
 Columns go down the page and are labelled with letters
 The intersection of a column and a row in a spreadsheet is referred to as a cell
 Every cell has its address or reference label, composed of the column and row it is positioned in.
A spreadsheet document is called a workbook.
Here are some of the features of a blank workbook:

Feature Name Description

Number

1 Quick access The Quick Access Toolbar provides quick and easy access to features frequently
toolbar used in the spreadsheet.

2 Ribbon The ribbon is the line of buttons and icons directly above the work area. Clicking
on one of the main menu options on the ribbon (for example, 'File', 'Home', 'Insert')
will reveal the options relevant to that feature. For instance, the options to save,
open, print, etc., are presented by clicking' File'.

3 Filename The file name is displayed at the top of the screen. In this example, the file name is
‘Features’.

4 Name box The name box displays the active cell's cell reference (usually a letter/number
combination). A cell is the intersection of a row and a column; the active cell is the
(cell reference)
currently selected cell. If a name has been defined for a cell or range of cells, that
name will appear in the name box rather than the cell reference.

5 Formula bar The formula bar displays the content of the active cell. This can be used to enter
content and create formulae.

6 A range A range is a group of cells. In this example, the cells shaded in yellow represent
the ranges from cells D7 to F8 (or D7:F8).

7 Worksheet tabs Every workbook can contain multiple worksheets. These worksheets can be
accessed using the worksheet tabs displayed at the bottom of the screen.
This workbook has three worksheets, and the active worksheet is Sheet 1.

8 Status bar The status bar shows the current status. By default (cell mode), it displays
four options:

Ready to indicate a general state.


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
Enter to indicate content entry mode. It is displayed when you select a cell and
start typing or press F2 twice.


Edit to indicate in-cell editing mode. It is displayed when you double-click a cell or
when you press F2 so that you can enter or edit data in a cell.


Point to indicate formula cell selection mode. It is displayed when you start a
formula and click the cells you want to include.

15.1.3 Cell Content
1.3 Cell Content

Type of Description Example

content

Text A text cell usually contains words or other  Mix of alphabets and numbers.
characters that cannot be used in
mathematical calculations.
 Alpha-numeric codes.
 Dates in text form
If the content is to be used in formulae, it
must be converted into values.  Other forms of text.

Values A value is a number that can be used in a  Numbers

calculation
 Dates in value form
 Other useable values

Formulae Instructions for performing calculations.  Mathematical operators

Indicated by an equal (=) sign at the start
of the formula.
 Links to cell references
 Spreadsheet formulae (SUM, PRODUCT,
COUNT, etc.)
15.1.4 Mathematical Operators
1.4 Mathematical Operators

Step Description Example

1 Cells A1 and A2 contain values.

The objective is to calculate the sum of cells A1
and A2 in cell B1.

2 Input equal sign in cell B1

3 Select cell A1

4 Input the addition operator

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5 Select cell A2

6 Press Tab or Enter to calculate the sum.

 For subtraction, use a subtraction operator (−)

 For multiplication, use a multiplication operator (×)
 For division, use a division operator (/)
Key Point

The mathematical order of operations applies when using mathematical operators in a spreadsheet.
For example, the spreadsheet will perform multiplication and division operations before addition and subtraction,
and operations in parentheses will be completed first.

Example

To calculate the average monthly gross profit based on Quarter 1. use the gross profit value for Quarter 1 ($4,250)
and divide it by 3 (the number of months).

To calculate the predicted annual gross profit based on the current rate, the average monthly gross profit is to be
multiplied by 12 months.

15.1.5 SUM Function

1.5 SUM Function

The sum function can rapidly calculate the sum of multiple cells.

Step Description Example

1 Cell range A1 to A5 contains values.

The objective is to calculate the sum of cell range A1 to A5
in cell B1 using the SUM function.

2 Input an equal sign in cell B1, and the SUM function, with an
opening parenthesis.

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3 Select cell range A1 to A5 by clicking and dragging to select

the cell range.
Alternatively, the cell range could be typed in as A1:A5.

4 Type in closing parenthesis to close off the function.

5 Press Tab or Enter to calculate the sum.

Activity 1

Write the correct formula (using cell references) and destination cell to calculate the requirement.

Requirement Formula Destination cell

Use the addition (+) operator to calculate the sum of cells B3, C3, and D3, in =B3+C3+D3 E3
cell E3.

Use the SUM function to calculate the sum of cell range A4 to A7 in cell B4 =SUM(A4:A7) B4

Use the multiplication (×) operator to multiply cell E3 by 4 in cell A1. =E3×4 A1

Use the division (/) operator to calculate the quotient of cell A2 (dividend) =A2/A3 B4
and cell A3 (divisor) in cell B4

Calculate the product of the sum of cells A1 and A2, with A3, in A4 =(A1+A2)×A3 A4

Calculate the quotient of cell E3, with the divisor being the difference =E3/(F1−F2) A8
between cell F1 (minuend) and F2 (subtrahend), in cell A8
15.1.6 AVERAGE Function
1.6 AVERAGE Function

The AVERAGE function calculates the average of the selected range of values.

Step Description Example

1 Cell range A1 to A5 contains values.

The objective is to calculate the average of cell range A1 to
A5 in cell B1 using the AVERAGE function.

2 Input an equal sign in cell B1, and the AVERAGE function,

with an opening parenthesis.

3 Select cell range A1 to A5 by clicking and dragging to select

the cell range.
Alternatively, the cell range could be typed in as A1:A5.

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4 Type in closing parenthesis to close off the function.

5 Press Tab or Enter to calculate the average.

15.1.7 ROUND Function

1.7 ROUND Function

The round function changes the value of a cell by rounding the number to a specified number of digits.
The ROUND function changes the underlying value rather than just changing how a value is displayed
(which is the case when formatting numbers).

Step Description Example

1 The objective is to round the value of cell A1 using the ROUND function, to
zero decimal places, in cell B1

2 Input an equal sign in cell B1, and the ROUND function, with an opening
parenthesis.

3 Select A1 and add a comma after the cell reference.

4 Type 0 to round to zero decimal places, then close parenthesis to close off
the function.

5 Press Tab or Enter to round the figure.

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PS The digit placed after the comma in the ROUND function determines the
place the number is round to:

Formula cell Formula Result

B2 =ROUND(A2,2) 1234.56

B3 =ROUND(A3,1) 1234.6

B4 =ROUND(A4,−1) 1230

B5 =ROUND(A5,−2) 1200

15.1.8 IF Function
1.8 IF Function

The IF function applies a logical test and returns different values depending on whether the logical test has
been met.

Ste Description Example

p

1 The objective is to evaluate if the value in cell A1 is less than 10

and return the value 1 if the logical test is met and 0 if the logical
test fails in cell B1.

2 Input an equal sign in cell B1 and the IF function with an opening

parenthesis.

3 Input the logical test with the cell reference A1, then add a comma.
=IF(A1<10,

4 Type 1 after the first comma (returns a value of 1 if the logical test
succeeds), then add a comma.
=IF(A1<10,1,

5 Type 0 after the second comma to return a value of 0 if the logical

test fails, and then a closing parenthesis to close the formula.
=IF(A1<10,1,0)

6 Press Tab or Enter to run the IF function.

The value of 1 is returned, as 9 is less than 10.

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PS Copying the formula to the other cells in the column yields the
following results:

Formula cell Formula Result

B2 =IF(A2<10,1,0) 0

B3 =IF(A3<10,1,0) 1

B4 =IF(A4<10,1,0) 0

B5 =IF(A5<10,1,0) 1

Activity 2

The following spreadsheet includes the monthly sales figures for an organisation. If a salesperson achieves
monthly sales above $10,000, they are paid a bonus of $1,000.

Using the IF function, determine the formula to determine whether each salesperson would receive a bonus
based on the condition given above and the predicted returned value.

If the person meets the conditions to receive the bonus, the value of 1000 should be returned to the formula
cell.

If the person does not meet the conditions to receive the bonus, the value of 0 should be returned to the
formula cell.

Salesperson Formula cell Formula Returned value

Heng C2

Chew C3

Bennet C4

Tanya C5

*Please use the notes feature in the toolbar to help formulate your answer.

Salesperson Formula Formula Returned

cell Value

Heng C2 =IF(B2>10000,1000,0) 0

Chew C3 =IF(B3>10000,1000,0) 1000

Bennet C4 =IF(B4>10000,1000,0) 1000

Tanya C5 =IF(B5>10000,1000,0) 0
15.1.9 Uses of spreadsheets in cost and management accounting
1.9 Uses of spreadsheets in cost and management accounting

Spreadsheets are used to perform a wide range of functions. Their flexibility means they can be designed
and adapted to fit various tasks.
 Preparation of budgets
 Inventory valuation
 Preparation of monthly management accounts
 Calculation of variances
 Forecasting costs and revenues
 ‘What if’ analysis

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 Ad-hoc analysis of revenue and cost items

 Creation of charts to display management accounting information visually
15.1.10 Advantages and limitations of spreadsheets
1.10 Advantages and limitations of spreadsheets

1.10.1. Advantages of spreadsheets

 Spreadsheets are relatively easy to use.
 The use of formulae should reduce calculation error compared with a manual system.
 Calculations can be performed more quickly, and data can be processed faster in a spreadsheet
compared with a manual system.
 Once a spreadsheet has been set-up, including all the necessary formulae, it can easily be copied,
e.g. for use again in the next period.
 Data may be linked from one cell to another, speeding up processing and the production of reports.
 Data may be imported from other systems and spreadsheets may be directly linked to them.
 Spreadsheet output can be formatted and presented professionally, including charts.
1.10.2. Limitations of spreadsheets
 Spreadsheets cannot detect data input errors.
 Errors in formulae may not be obvious and can be difficult to find.
 Spreadsheets are at risk of cyber-attack and system failure.
 Spreadsheets lack the formal structure and controls of other systems e.g. they are easily amended
without a visible audit trail.
 Database software is more stable and secure than spreadsheets and is therefore more suitable for
data management, queries, protection, and storage of large amounts of data.

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Chapter 16: Compounding and Discounting

16.1.1 Simple Interest
1.1 Simple Interest

Interest is the cost of borrowing money or the amount earned from investing money.
A bank usually pays interest on deposits (principal).
A bank will charge interest on money borrowed (loans) from it.
The deposit or loan amount is known as the principal.
If the yearly interest amount is the same, it is simple interest.
1.1.1 Calculation
The formula for simple interest is

s=P×r×n
s = interest $
p = principal amount $
r = nominal interest rate % per year
n = number of periods (years)

The formula for the future value (principal + interest) of an investment, using simple interest, would be:
The formula for simple interest is

FV = P × (1 + (r × n))

Key Point

The beginning of the first year is usually known as year 0.

For the end of the first year, n = 1

Example: Simple Interest

Sam puts $55,000 into the bank at a rate of 5% simple interest per year.
How much will Sam have at the end of 4 years?
Solution:
Simple interest table:

Year Opening balance Interest charge Closing balance

$ $ (5%) $

1 55,000 2,750 57,750

(principal)

2 57,750 2,750 60,500

3 60,500 2,750 63,250

4 63,250 2,750 66,000

Future value formula:
P = 55,000
r = 0.05
n=4
FV = P × (1 + (r × n))
FV = 55,000 × (1 + (0.05 × 4))
FV = 55,000 × (1 + 0.2)
FV = 55,000 × 1.2
FV = 66,000
Sam will have $66,000 after four years.

Example 2: Simple Interest

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Example 2: Simple Interest

Sam puts $55,000 into the bank at a rate of 5% simple interest per year.
How much will Sam have to withdraw after six months?
Solution:
Simple interest table:

Year Opening balance Interest charge Closing balance

$ $ (5%) $

0.5 55,000 1,375 56,375

(principal)

Future value formula:

P = 55,000
r = 0.05
n = 0.5
FV = P × (1 + (r × n))
FV = 55,000 × (1 + (0.05 × 0.5))
FV = 55,000 × (1 + 0.025)
FV = 55,000 × 1.025
FV = 56,375
Sam will have $56,375 after six months (0.5 years).

16.1.2 Compound Interest

1.2 Compound Interest

With compound interest, the interest is calculated based on the principal plus the interest earned every year.
The interest stays in the account and is reinvested, so additional interest is earned on interest. (therefore, a
bank account paying compound interest will grow deposits faster than one paying simple interest)
The formula to calculate the future value of an investment earning compound interest is:

FV = P × (1 + i)n
FV = Future value $
P = Principal $
i = nominal interest rate % per period
n = number of compounding periods

Example 3: Compound Interest

Sam puts $55,000 into the bank at a rate of 5% interest per year, compounded yearly.
How much will Sam have at the end of 4 years?
Solution:
Simple interest table:

Year Opening balance Interest charge Closing balance

$ $ (5%) $

1 55,000.00 2,750.00 57,750.00

(principal)

2 57,750.00 2887.50 60637.50

3 60,637.50 3031.88 63669.38

4 63,669.38 3183.47 66852.84

Future value formula:
P = 55,000
r = 0.05
n=4
FV = P × (1 + r)n

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Example 3: Compound Interest

FV = 55,000 × (1 + 0.05)4
FV = 55,000 × 1.2155
FV = 66,852.84
Sam will have $66,852.84 after four years.

Activity 1: Simple and Compound Interest

Jo is deciding between three investment options:

1. Invest $10,000 at a 4% compound interest rate per year for four years.
2. Invest $9,000 at a rate of 6% simple interest for five years
3. Invest $11,000 at a 5% compound interest rate for three years.
Calculate the future value of each investment at the end of their terms (to the nearest whole number).

*Please use the notes feature in the toolbar to help formulate your answer.

1. P = 10,000

r = 0.04

2.
n=4

3.
FV = P × (1 + r)n

4.
FV = 10,000 × (1 + 0.04)4

5.
FV = 10,000 × 1.1699

6.
FV = 11,699

7.
1. P = 9,000

r = 0.06

2.
n=5

3.
FV = P × (1 + (r × n))

4.
FV = 9,000 × (1 + (0.06 × 5))

5.
FV = 9,000 × (1 + 0.30)

6.
FV = 9,000 × 1.30

7.
FV = 11,700

8.
1. P = 11,000

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r = 0.05

2.
n=3

3.
FV = P × (1 + r)n

4.
FV = 11,000 × (1 + 0.05)3

5.
FV = 11,000 × 1.1576

6.
FV = 12,734

7.
Investment 3 has the highest future value.
Activity 2

David puts $75,000 into the bank at an 8% annual interest.

a. How much simple interest has David earned at the end of three years?
b. How much simple interest has David earned at the end of four years?
c. How much compound interest has David earned at the end of two years?
d. How much compound interest has David earned at the end of five years?
*Please use the notes feature in the toolbar to help formulate your answer.

. P = principal (the amount invested originally) = $75,000

r = interest rate = 8% = 0.08

.
n = number of years = 3

.
Simple interest earned = $75,000 × 0.08 × 3 = $18,000

.
. P = principal (the amount invested originally) = $75,000

r = interest rate = 8% = 0.08

.
n = number of years = 4

.
Simple interest earned = $75,000 × 0.08 × 4 = $24,000

.
. S = $75,000 × (1 + 0.08)2

= $87,480

.
If the future value of David’s investment is $87,480, then he has earned interest of $(87,480 − 75,000) =
$12,480

.
. S = $75,000 × (1 + 0.08)5

= $110,199.61

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.
If the future value of David’s investment is $110,199.61 then he has earned interest of $(110,199.61 − 75,000)
= $35,199.61

.
The result of investing $75,000 at 8% for five years was as follows:

.
 Final value of investment = $110,199.61
 Total interest earned over five years = $35,199.61

The following table shows the amount of compound interest earned each year and that at the end of Year 5,
the total interest earned was $35,199

Year Balance at the beginning of the year Interest at Balance at the end of the year
8%

($) ($) ($)

1 75,000.00 6,000.00 81,000.00

2 81,000.00 6,480.00 87,480.00

3 87,480.00 6,998.40 94,478.40

4 94,478.40 7,558.27 102,036.64

5 102,036.67 8,162.93 110,199.60

Total 35,199.60
16.2.1 Nominal and Effective Annual Rates
2.1 Nominal and Effective Annual Rates

2.1.1 Nominal Interest Rate

The nominal interest rate is the stated interest rate without compounding.
For example, an investment may quote an interest rate of 10% per annum, compounded daily. The nominal
interest rate is 10% per year.
Here are some more examples:

Quote Nominal interest rate

5% per year, compounded daily 5% per year

12% per year, compounded monthly 12% per year

8% per year, compounded quarterly 8% per year

2.1.2 Effective Annual Rate (EAR)

Compound interest can be compounded yearly or more regularly (quarterly, monthly, weekly, daily).
The more frequent the compounding period, the higher the actual annual interest earned.
The effective annual rate (EAR) changes the nominal interest rate at its compounding frequency into an
equivalent yearly rate that can calculate the interest received in the year.
This allows for easier comparison between quotes of interest rates with different compounding periods.
The formula for EAR is:

e = (1 + i)n − 1
i = (r / n)
i = nominal interest rate per compounding period %
e = Effective annual rate %
r = nominal annual rate %
n = number of compounding periods in a year

Reminder: the future value of a loan or investment with compounding interest would be:

FV = P × (1 + i)n
P = principal $

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i = nominal interest rate per compounding period %

n = number of compounding periods

Example: Effective Annual Rate

Jess borrowed $1,000 from a bank. The interest rate was quoted as 12% per year, compounded monthly.
Calculate the effective annual rate (EAR) of Jess’s loan.
Solution:
i = 12% / 12 months
i = 0.01 (1% per month)
Using the FV of the compounding interest formula with i:
P = 1,000
i = 0.01
n = 12 (12 compounding months in a year)
FV = P × (1 + i)n
FV = 1,000 × (1 + 0.01)12
FV = 1,000 × 1.1268
FV = 1,126.83
The EAR may be derived by comparing the present value and future value of Jess’s loan:
FV = P × (1 + e)
1,126.83 = 1,000 × (1 + e)
e = (1,126.83 / 1,000) − 1
e = 12.68%
The EAR of Jess’s loan is 12.68%
The EAR formula can be used to find EAR faster:
e = (1 + i)n − 1
e = (1 + 0.01)12 − 1
e = 1.1268 − 1
e = 0.1268 (12.68%)

Activity 3

David puts $75,000 into the bank at a 2% monthly interest rate.

. What is the nominal rate of annual interest?

. What is the effective rate of annual interest?
*Please use the notes feature in the toolbar to help formulate your answer.

. Nominal rate of interest

= 2% per month or 24% per year (2% × 12 months)

.
. The effective interest rate is the nominal interest rate with compounding so that it is expressed in
terms of how much David will receive in a year.

Formula: E = (1 + r)n − 1

.
Where:

.
E = effective interest rate

.
r = nominal rate of interest = 2% per month

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n = the number of periods in a year

.
E = (1 + 0.02)12 − 1

.
E = 1.268 − 1

.
E = 0.268

.
0.268 expressed as a percentage is 26.8% per year
Activity 4

1. David puts $100,000 into the bank at a rate of 3% interest every six months. What is the nominal
interest rate per year to the nearest whole percent?
2. David puts $100,000 into the bank at a rate of 3% interest every six months. What is the effective
rate of interest (to 2 decimal places)?
3. Ella puts $50,000 into the bank at a quarterly rate of 2.5% interest. What is the nominal rate of
interest per year?
4. Ella puts $50,000 into the bank at a quarterly rate of 2.5% interest. What is the effective interest rate
per year (to 2 decimal places)?
*Please use the notes feature in the toolbar to help formulate your answer.

1. The nominal rate of interest = 6% per year.

The nominal interest rate is the rate of interest stated without compounding, 3% every six months or 6% per
year (2 × 3%).

2.
1. The effective rate of interest = 6.09% per year.

The effective interest rate is the rate of interest including compounding:

2.
E = (1 + 0.03)2 – 1 = 0.609 = 6.09%

3.
1. The nominal rate of interest = 10% per year.

The nominal interest rate is the rate of interest stated without compounding, that is, 2.5% each quarter =
2.5% × 4 = 10% per year.

2.
1. The effective interest rate = 10.38% per year (to 2 decimal places).

The effective interest rate is the nominal interest rate with compounding at the stated intervals, which is 2.5%
with compounding.

2.
Use the formula: E = (1 + r)n − 1 to calculate the effective rate of interest where:

3.
E = effective interest rate

4.
r = nominal rate of interest = 2.5% every three months (quarterly)

5.
n = the number of periods in a year = 4

6.

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E = (1 + 0.025)4 − 1

7.
E = 1.1038 − 1

8.
E = 0.1038

9.
0.1038 expressed as a percentage is 10.38% per year

10.
Activity 5: Effective Annual Rate

Hal wants to buy a car that costs $5,000. He has two financing choices:

1. Taking out a loan, which has a simple interest rate of 5% a year

2. Paying with his credit card will incur an interest rate of 2% per quarter.

Hal will be able to repay the loan or credit card in two years.

Which option gives him a better interest rate?

*Please use the notes feature in the toolbar to help formulate your answer.

The EAR of the credit card is:

i = 0.02 (2% per quarter)

n = 4 (4 quarters in a year)

e = (1 + i)n − 1

e = (1 + 0.02)4 − 1

e = 1.0824 − 1

e = 0.0824 (8.24%)

The EAR of the credit card is higher than the loan’s simple annual interest rate. Hal should finance his car
with the loan.
Activity 6: Future Value of Loan

Ana needs a short-term loan and sees a rate of 3% per week advertised in the paper. Therefore, she needs to
borrow $150 for seven weeks.

How much would she have to repay at the end of seven weeks?

*Please use the notes feature in the toolbar to help formulate your answer.

To find the future value of the loan:

P = 150

i = 0.03 (3% per week)

n = 7 (7 weeks)

FV = P × (1 + i)n

FV = 150 × (1 + 0.03)7

FV = 150 × 1.2299

FV = 184.49

Ana would need to repay $184.49 after seven weeks.

16.3.1 Future Value of Investments (Compounding)
3.1 Future Value of Investments (Compounding)

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Calculating the future value of investments is the same as calculating the future value of bank deposits.
A fundamental assumption is that cash flows from the investment are reinvested at the same rate as the
investment.
For example, if a baker invests in a machine to make cakes for three years, any cash earned from selling
cakes in the first year will be used to continue using the device to make cakes in the future.
The future value formula is:

FV = P × (1 + i)n
P = principal $ (initial investment)
i = nominal interest rate per compounding period %
n = number of compounding periods

Activity 7: Future Value of Investment

What is the value of $40,000 invested for six years at an interest rate of 10%?

*Please use the notes feature in the toolbar to help formulate your answer.

P = 40,000

i = 0.10

n=6

FV = P × (1 + i)n

FV = 40,000 × (1 + 0.10)6

FV = 40,000 × 1.7716

FV = 70,862.44

The future value of the investment is $70,862.44

16.3.2 Present Value of Investments (Discounting)
3.2 Present Value of Investments (Discounting)

Discounting is the opposite of compounding. Instead of finding the future value of the investment in the
future, the principal (present value) needed to invest now is calculated.
3.2.1 Time Value of Money
Cash inflow available immediately is more valuable than cash inflow in the future. This is due to several
reasons:
1. Availability of cash to make investments
2. Avoidance of the uncertainty of future cash flows
3. Avoidance of deterioration in the value of money (inflation)
This phenomenon of valuing immediate cashflows higher than future cash flows is known as the time value
of money.
Because of this, the future cash inflows of any investment must be compared to the current value of money.
If the value of the future cash flows is less than the cash inflow now, it is not worth investing in.
Discounting is used to estimate the present value of future cash flows.
For example, which would be preferable: a $1,000 cash inflow now or a $2,000 cash inflow in 2 years?
The answer to this question depends on the time value of money and the factors that affect it.
3.2.2 Present Value Formula
The present value formula is a re-arrangement of the future value formula:
PV = FV / (1 + i)n
PV = present value of investment $
FV = future value of investment $
i = nominal interest rate % per compounding period
n = number of compounding periods
It can also be expressed as:

PV = FV × (1 / (1 + i)n)

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(1 / (1 + i)n) is the formula to calculate a discount factor.

Example: Discounting

What is the present value of $70,000 received at the end of year six if interest rates are 10%?
Solution:
FV = 70,000
i = 0.1 (10% per year)
n = 6 (6 years)
PV = FV × (1 / (1 + i)n)
PV = 70,000 × (1 / (1 + 0.1)6)
PV = 70,000 × 0.5645
PV = 39,513.18

16.3.3 Discount Rate and Discount Factors

3.3 Discount Rate and Discount Factors

3.3.1 Discount Rate

A discount rate is the interest rate used to convert the future value of investments to their present values.
3.3.2 Discount Factors
Discount factors convert the future value of an investment to its present value for a fixed number of periods
at a specific discount rate.
The formula to calculate present and future values can be simplified to:
PV = FV × DF
DF is the discount factor (from the present value table)
In Example 5, the discount factor of 0.5645 was used to find the present value of an investment from its value
six years in the future, discounted at 10%.
Discount factors can be quickly determined from discount factor tables.
Math tables (annuity and discount factors)

Example: Discounting

A company will earn $20,000 in 5 years. The cost of capital is 5%. What is the present value of future earnings?
The 5% discount rate, rounded to 3 decimal places, is 0.784.
Solution:
FV = 20,000
PV = FV × (1 / (1 + i)n)
PV = 20,000 × 0.784
PV = 15,680
The present value of future earnings is $15,680

Activity 8

1. If $40,000 is invested at an interest rate of 10%, calculate how much it will be worth (to the nearest $)
in six years using a present value table.
2. $7,500 will be received at the end of eight years. If the interest rate is 5%, calculate how much
money should be invested now to the nearest $, using present value tables.
*Please use the notes feature in the toolbar to help formulate your answer.

1. FV = PV / DF

Discount factor from present value tables = 0.564

2.
FV = $40,000/0.564 = $70,922 (to the nearest $)

3.
Note that there is a slight difference in the answers calculated using the formula and the discount factor from
tables because the present value factor is rounded to three decimal places.

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4.
1. $5, 078 (to the nearest $)

Calculate the present value of $7,500 using the following:

2.
PV = FV × DF

3.
Discount factor from present value tables = 0.677

4.
PV = $7,500 × 0.677 = $5,078 (to the nearest $)

5.
16.4.1 Perpetuity
4.1 Perpetuity

A perpetuity is a consistent cash flow every period till infinity

An example of a perpetuity could be receiving $100 every year forever.
4.1.1 Discounting a Perpetuity
The discount factor of a perpetuity starting in year 1 is:

Discount factor (perpetuity) = 1 / i

i = discount rate %

So the present value of a perpetuity is:

PV = annual cash flow × (1 / i)

Example 7: Perpetuity

A company will receive $70,000 a year forever. Interest rates are 10%.
What is the present value of the total receipts?
Solution:
annual cash flow = 70,000
i = 0.1
PV = annual cash flow × (1 / i)
PV = 70,000 × (1 / 0.1)
PV = 70,000 / 0.1
PV = 700,000
The present value of the perpetuity is $700,000

Activity 9

Fred receives $70,000 a year in perpetuity. The applicable discount rate is 10%, and the first payment is in
one year.

What is the present value of the money Fred receives?

*Please use the notes feature in the toolbar to help formulate your answer.

Present value of Fred’s perpetuity = $70,000/0.1 = $700,000

Present value of a perpetuity=(Annual cash flow)/(Discount rate (i))

Perpetuity = $70,000

Interest rate = 10% = 0.1 (as a proportion)

Present value of Fred’s perpetuity = $70,000/0.1 = $700,000

16.4.2 Annuity
4.2 Annuity

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An annuity is a consistent cash flow every period for several periods.

An example of an annuity could be to receive $100 every year for ten years.
The discount factor of an annuity is called an annuity factor and is calculated as follows:

Annuity Factor (AF) = (1 − (1 + i) − n) / i

i = discount rate %
n = number of annuity periods

Annuity factors may be quickly looked up on the annuity tables provided in the MA exam.
The present value of an annuity that starts one year after the initial investment is calculated as follows:
PV = annual cash flow × AF

Example: Annuity

A company will receive $70,000 a year for six years. Interest rates are 10%.
What is the present value of the total receipts?
Refer to the tables for applicable discount and annuity factors.
Solution:
Table solution:

Year Cash flow $ Discount factor Present value $

1 70,000 0.909 63,630

2 70,000 0.826 57,820

3 70,000 0.751 52,570

4 70,000 0.683 47,810

5 70,000 0.621 43,470

6 70,000 0.564 39,480

Total 304,780
Formula solution:
annual cash flow = 70,000
i = 0.1
PV = FV × AF
PV = 70,000 × 4.355
PV = 304,850
The present value of the annuity is $304,850.
The slight difference with the table solution is due to rounding.

Activity 10

Fred receives $80,000 a year for six years. The applicable discount rate is 10%, and the first payment is in
one year.

What is the present value of the money Fred receives?

*Please use the notes feature in the toolbar to help formulate your answer.

Present value of an annuity (starting in year 1)= annuity × AF

Annuity = $80,000 and AF (annuity factor) = 4.355

Present value of Fred’s annuity = $80,000 × 4.355 = $348,400

16.4.3 Calculating PV of Annuity or Perpetuity not starting on Year 1

4.3 Calculating PV of Annuity or Perpetuity not starting on Year 1

4.3.1 PV of Perpetuity or Annuity Starting Immediately (year 0)

The formula to calculate the PV of an annuity or perpetuity starting immediately is:

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PVperpetuity = (annual cash inflow / i) + annual cash inflow

PVannuity = annual cash inflow × (AF n − 1 + 1)
n − 1 means the annuity period – 1 year. So 6-year annuity starting immediately will use an annuity factor for
years 1 to 5.

Example

Fred receives $70,000 a year for six years. Interest rates are 10%, and the first payment starts immediately.
What is the present value of the money Fred receives?
Answer:

Annual cash inflow: $70,000

PVannuity = annual cash inflow × (AF n − 1 + 1)
PVannuity = $70,000 × (AF6 − 1 + 1)
PVannuity = $70,000 × (AFyear 1 to 5 + 1)
PVannuity = $70,000 × (3.791 + 1)
PVannuity = $70,000 × 4.791
PVannuity = $335,370

4.3.2 PV of Perpetuity or Annuity Starting After Year 1

To calculate the PV of a perpetuity or annuity that begins after year 1:

PVperpetuity = annual cash flow × ([1 / i] − AFyears no cash flow)

Or
PVperpetuity = (annual cash flow / i) × DFyears no cash flow
PVannuity = annual cash flow × (AF year 1 to year annuity end − AFyear 1 to year before annuity start)
Or
PVannuity = (annual cash flow × AF years of annuity) × DFyear 1 to year before annuity start

Example: Perpetuity starting after Year 1

A company will receive $70,000 a year in perpetuity. The first payment will be at the end of year 4. Interest rates
are 10%.
What is the present value of the total receipts?
Refer to the tables for applicable discount and annuity factors.
Solution:
Annual cash flow = 70,000
i = 0.1
PVperpetuity = annual cash flow × ([1 / i] − AFyears no cash flow)
PVperpetuity = 70,000 × ([1 / 0.1] − AFyears 1 to 3)
PVperpetuity = 70,000 × (10 − 2.487)
PVperpetuity = 70,000 × 7.513
PVperpetuity = 525,910
The present value of the perpetuity is $525,910.
It can also be calculated as follows:
PVperpetuity = (annual cash flow / i) × DFyears no cash flow
PVperpetuity = (70,000 / 0.1) × DFyears 1 to 3
PVperpetuity = (70,000 / 0.1) × 0.751

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Example: Perpetuity starting after Year 1

PVperpetuity = 700,000 × 0.751

PVperpetuity = 525,700
Difference due to rounding.

Example

Fred receives $70,000 a year for six years. Interest rates are 10%, and the first payment starts in 2 years.
What is the present value of the money Fred receives?
Solution:

Annual cash flow = 70,000

PVannuity = annual cash flow × (AF year 1 to year annuity end − AFyear 1 to year before annuity start)
PVannuity = annual cash flow × (AF year 1 to 7 − AFyear 1)
PVannuity = 70,000 × (AFyear 1 to 7 − AFyear 1)
PVannuity = 70,000 × (4.868 − 0.909)
PVannuity = 70,000 × 3.959
PVannuity = 277,130
It can also be calculated as follows:
PVannuity = (annual cash flow × AF years of annuity ) × DFyear 1 to year before annuity start
PVannuity = (annual cash flow × AF year 1 to 6 ) × DFyear 1
PVannuity = (70,000 × 4.355) × 0.909
PVannuity = 304,850 × 0.909
PVannuity = 277,109
Difference due to rounding.

Activity 11

A company will receive $70,000 a year for six years. The first payment will be at the end of year 4. Interest
rates are 10%.

What is the present value of the total receipts?

Refer to the tables for applicable discount and annuity factors.

*Please use the notes feature in the toolbar to help formulate your answer.

Table solution:

Year (n) Cash flow $ Discount factor Present value $

4 70,000 0.683 47,810

5 70,000 0.621 43,470

6 70,000 0.564 39,480

7 70,000 0.513 35,910

8 70,000 0.467 32,690

9 70,000 0.424 29,680

Total 229,040

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Formula solution:

Annual cash flow = 70,000

i = 0.1

PV = annual cash flow × (AFyear 1 to year annuity end − AFyear 1 to year before annuity start)

PV = annual cash flow × (AFyear 1 to year 9 − AFyear 1 to year 3)

PV = 70,000 × (5.759 − 2.487)

PV = 70,000 × 3.272

PV = 229,040

The present value of the annuity is $229,040.

3.272 is the annuity factor for years 4 to 9.

Annuity and discount factors may be looked up from tables.
Math tables (annuity and discount factors)
Activity 12

1. A perpetuity of $3,000 is due to start with the first payment to be made immediately. The interest
rate is 8%. What is the present value of the perpetuity?
2. A perpetuity of $3,000 is due to start in three years. The interest rate is 8%. What is the present
value of the perpetuity?
*Please use the notes feature in the toolbar to help formulate your answer.

1. PV perpetuity = $3,000/0.08 = $37,500

If the perpetuity starts now, the PV will be calculated as follows:

2.
PV = $3,000 + $37,500 = $40,500

3.
Calculate the PV by adding 1 to the annuity factor.

4.
Annuity factor = 1/0.08 = 12.50

5.
Annuity factor when first payment is now = 1 + 12.50 = 13.5

6.
Therefore PV = 13.5 × $3,000 = $40,500

7.
1. Calculate the PV of the perpetuity in the usual way:

PV of perpetuity = $3,000/0.08 = $37,500

2.
If the first payment is in three years (two years later), discount the perpetuity back using the DF for two years
at 8%, which is 0.857

3.
PV of perpetuity (with the first payment in three years) = $37,500 × 0.857 = $32,137.50

4.

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Chapter 17: Investment Appraisal

17.1.1 Investment Appraisal
1.1 Investment Appraisal

Asset expenditure is the cost of purchasing or improving non-current assets such as:
 Vehicles
 Land
 Buildings
 Machinery.
Asset expenditure usually involves investing large sums of money in something expected to provide a return
on the amount invested. The return on investment is stated in the following ways:
 Rate of return
 Cost of capital
 Target return.
An organisation must make a return on its investments to earn the money to pay its investors (shareholders).
An organisation determines if something is worth investing in by looking at the amount of money the
investment is likely to generate in the future and comparing this to the amount it will cost over its life. This is
investment appraisal.
1.1.1 Considerations of Investment Appraisal

Aspect Description

Initial An organisation will first want to know how much a new machine will cost– this is often called the
investment initial investment.

Running An organisation will also want to know how much it costs to run the machine each year. Running
costs costs will include the cost of the fuel needed for the machine to work, the cost of servicing the
machine so that it is working efficiently, and the cost of insuring the machine.

Income An organisation will also want to know how much income the machine will generate and for how
generation many years. This is information useful in the appraisal of a new item of machinery.

Cost savings An organisation will also be interested to know whether the machine will cost less than the
currently used machine. Any reduction in operating costs would be a cost-saving, and the
organisation would be interested to know about this when appraising the new machine.

Useful life The length of time that a machine will be in operation is known as its useful life.
The longer the useful life of a machine, the better it is in terms of its appraisal because while it is
useful, it will generate an income.

Scrap When a machine is no longer useful to an organisation, it might be able to be sold for scrap. Any
proceeds sale proceeds at the end of the useful life of an asset are known as its residual value or scrap
value.

17.1.2 Cash Flow and Accounting Profit

1.2 Cash Flow and Accounting Profit

Generally, it is the cash flows (both inflows and outflows) associated with buying a new machine that is of
interest to an organisation when it is considering investing in something or not, rather than the accounting
profits.
1.2.1 Difference between Cash Flow and Accounting Profit
Profit (or loss) is shown on an organisation’s statement of profit or loss for a period. Most organisations also
prepare cash budgets to see how much money will be coming in and going out of their bank account in a
future period.
This distinction applies to several transactions:

Transaction Accounting profit basis Cash flow basis

Sales revenue Statements of profit or loss show the income earned in a Cash inflow is measured when
period, including sales made on credit that hasn’t been paid funds are received.
yet.

Expenditure Statements of profit or loss show expenditures incurred Cash outflow is measured when
during a period. payment is made.

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Non-cash Non-cash expenses such as depreciation and credit Not a cash flow.
items purchases reduce profits. They appear in an organisation’s
statement of profit or loss.

Purchase of The purchase of non-current assets is written off in the Cash outflow is measured when
non-current statement of profit or loss via a depreciation charge over payment is made.
assets the useful life of an asset.

Sale of non- When an asset reaches the end of its useful life and is Cash inflow is measured when
current assets disposed of, there will probably be proceeds from the sale payment is received.
and an accounting profit or loss on disposal, which is the
difference between the carrying amount and sales
proceeds. Profit or loss on disposal = Cash proceeds –
carrying amount
17.1.3 Relevant Cash Flows
1.3 Relevant Cash Flows

Investment appraisal is concerned with relevant cash flows rather than accounting profits.
Relevant cash flows are cash flows that occur directly from the decision to invest in something, for example,
a new machine.
Cash flows that arise directly from a particular decision are often called incremental cash flows.
If a specific decision can avoid a cash flow, it is a relevant cash flow.
Examples of relevant cash flows include:
 The initial cost of the investment
 Running costs of the investment
 The amount of cash flow (for example, contribution) that the investment will generate
 Any cost savings that may arise as a result of going ahead with the investment
 Any sale proceeds arising at the end of the investment’s useful life (scrap value).
 Any conversion of cash into working capital at the start of the project and conversion back into
cash at the end.
17.1.4 Time Value of Money
1.4 Time Value of Money

Investors prefer to receive $1 today rather than $1 in one year.

This concept is referred to as the "time value of money" (or "time preference for money").
There are several possible reasons for this:
 Liquidity preference – if money is received today, it can either be spent or reinvested to earn more.
Hence, investors have a preference for having cash/liquidity today.
 Risk – cash received today is safe; future cash receipts may be uncertain.
 Inflation – cash today can be spent at today's prices, but the value of future cash flows may be
eroded by inflation.
Discounted cash flow (DCF) techniques involve looking at the relevant cash flows of an asset expenditure
(for example, a new machine, project or building) and discounting them to bring them back to their present
value (what they are worth now). Again, notice the word ‘cash’ rather than ‘profit’ and note that they must be
‘relevant’ cash flows.
DCF techniques take into account the time value of money.

17.1.5 Discounted Cash Flow Techniques

1.5 Discounted Cash Flow Techniques

Discounted cash flow (DCF) techniques involve looking at the relevant cash flows of capital investment (for
example, a new machine, project or building) and discounting them to bring them back to their present value
(what they are worth now).
This is done to account for the time value of money.
MA discusses three methods of investment appraisal:
 Net present value (NPV) method
 Internal rate of return (IRR) method
 Discounted payback method.
17.1.6 Tabulating Cash Flows
1.6 Tabulating Cash Flows

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It is important that the timing of cashflows is properly tabulated, as this would affect the calculation of their
present value.

Example

Year Net cash flow Discount factor at 8% Present value

$ $

0 (90,000) 1 (90,000)

1 15,000 0.926 13,890

2 15,000 0.857 12,855

3 27,000 0.794 21,438

4 31,000 0.735 22,785

5 41,000 0.681 27,921

6 11,000 0.630 6,930

Net present value 15,819

The cash flows are the same in Years 1 and 2 ($15,000).
The net cash flows in Years 1 and 2 could be shown as a two-year annuity of $15,000.

Year Net cash flow Discount factor at 8% Present value

$ $

0 (90,000) 1 (90,000)

1-2 15,000 1.783 26,745

3 27,000 0.794 21,438

4 31,000 0.735 22,785

5 41,000 0.681 27,921

6 11,000 0.630 6,930

Net present value 15,819

17.2.1 Time Value of Money

2.1 Time Value of Money

As a reminder, the value of immediate cash inflow is more valuable than cash inflows in the future.
A simple question that illustrates the time value of money is, “Is it better to have $10,000 now or $12,000 after
two years?”
The answer to the above question depends on many factors, such as inflation, risks, and the investor’s
expected return.
This means that future cash flows (future value) must be discounted to an equivalent immediate cash flow
(present value). The discount rate reflects the various factors that affect the valuation of future cash flows
(such as risk, inflation, and cost of capital).
Managers use discounting techniques to analyse the value of cash inflows that will happen in the future due
to investment and compare the viability of different potential investments.

Example: Valuing and Comparing Investments

Jo has $10,000 to invest. She has two options available to her:

1. Invest the money in a fixed deposit that pays 7% compounding interest per year; or
2. Invest in her friend’s business and receive $12,000 after two years.
Which investment increases Jo’s wealth more?
Solution:
Jo will earn 7% annually if she invests in the fixed deposit. For her to choose Option 2, it would need to generate
more returns than the fixed deposit.
Calculating the FV of Option 1
Assume the fixed deposit is maintained for two years to make it comparable to Option 2.

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Example: Valuing and Comparing Investments

PV = 10,000
i = 0.07
n = 2 (2 years, to make it comparable to Option 2)
FV = PV × (1 + i)n
FV = 10,000 × (1 + 0.07)2
FV = 10,000 × 1.1449
FV = 11,449
The future value earned from the fixed deposit is $11,449. This is lower than the $12,000 return offered by Option
2.
Calculating the PV of Option 2
Let’s assume 7% is Jo’s minimum required rate of return (since she can invest in the fixed deposit for little risk)
FV = 12,000
i = 0.07
n=2
PV = FV × (1 + i) − n
PV = 12,000 × (1 + 0.07) − 2
PV = 12,000 × 0.8734
PV = 10,481
The PV of Option 2 is $10,481, which is higher than Jo’s initial investment of $10,000. This means that Option 2
increases Jo’s wealth more than Option 1.
The net present value ($10,000 − $10,481) of Option 2 is $481.
If the net present value of Option 2 were negative, it would be more worthwhile to invest in the fixed deposit.

17.3.1 Net Present Value

3.1 Net Present Value

The NPV is the sum of the present values of an investment’s relevant cash flows.
NPV considers:
 Cash outflows (payments out of the organisation)
 Cash inflows (payments received into the organisation)
 The time value of money.
As a reminder, the formula to calculate the present value (PV) of a cash flow is:

PV = FV × DF
FV = future cash flow
DF = Discount factor (for a specific period, at a specific discount rate)
DF = (1 + i)−n
i = discount rate (usually the required rate of return)
n = number of years from present.

Discount and annuity factors may be looked up from tables:

Math tables (annuity and discount factors)

Example: Using NPV

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Example: Using NPV

3.1.1 Calculating NPV

To calculate NPV, the following is required:
 The value of the cash outflows and inflows resulting from the investment.
 The timing of the cash outflows and inflows (to consider the time value of money).
 The required or target rate of return (discount rate) to ascertain the discount factors used.
The discount factor (also known as cost of capital or required rate of return) used will reflect the entity’s cost
of funds and its required rate of return.
With this information, the investment’s net present value can be calculated. The decision rule to apply NPV is:

NPV Impact of investment Decision

=0 Breaks even; investment does not increase nor Investors would be indifferent to the decision.
decrease investor’s wealth (financial impact of choice does not matter.)

>0 Increases investor’s wealth Investment should be accepted.

<0 Decreases investor’s wealth Investment should be rejected.

If an organisation chooses between two or more projects, it will accept the project with the highest NPV.
Only relevant costs are included in NPV calculations. These are future, incremental cash flows that result
from the decision being made.
3.1.2 Assumptions
 All cash flows occur at the year’s start or end.
 The initial investment happens at Year 0 (today).
Year 0 means the point of the first cash outflow.

 All the other cash flows take place in Year 1 or later.
3.1.3 Templates
Two templates may be used to calculate NPV:

Year Net cash flow Discount factor NPV

0 (XXX) XXX XXX

X XXX XXX XXX
Total XXX
The above template is helpful for simple NPV calculations; it discounts yearly net cash flows.

Year 0 1 2 3
$ $ $ $
Cash flow item (XXX)
Cash flow item XXX XXX XXX
Cash flow item (XXX) (XXX) (XXX)

Net cash flow (XXX) XXX (XXX) XXX

Discount factor 1.000 XXX XXX XXX
Present value (XXX) XXX (XXX) XXX
NPV XXX
The above template is suitable for investments with multiple cash flow items. More rows may be added to
include additional cash flows.

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17.3.2 Calculation
3.2 Calculation

Example: Furniture Co

Furniture Co is considering investing in a new piece of machinery. The investment would start immediately and
last for six years. The following information about the investment is available:
 The machine will cost $320,000 and will be disposed of for $80,000 at the end of year 6. Depreciation is
calculated using the straight-line method.
 Annual costs relating to the investment will be $125,000. The company uses a discount rate of 10%.
 Sales resulting from the investment are:
Year Sales units Sales price ($)

1 20,000 12

2 20,000 12

3 18,000 14

4 18,000 14

5 16,000 16

6 16,000 16

 All sales are on a cash basis.
 Assume cash flows occur at the end of the year.
Calculate the NPV of Furniture Co’s potential investment (to the nearest $000).
The discount factors for a 10% discount rate are:
Year Discount factor
0 1.000
1 0.909
2 0.826
3 0.751
4 0.683
5 0.621
6 0.564
Solution:
 Depreciation is ignored as it is a non-cash item.
Year 0 1 2 3 4 5 6
$000 $000 $000 $000 $000 $000 $000
Machine (320) 80
purchase and
disposal
Annual costs (125) (125) (125) (125) (125) (125)

Sales W1 240 240 252 252 256 256

Net cash flow (320) 115 115 127 127 131 211
Discount factor 1.000 0.909 0.826 0.751 0.683 0.621 0.564
Present value (320) 105 95 95 87 81 119
NPV 262
The NPV of the project is $262,000 (rounded to $000). As the NPV is positive, T-shirt Co should accept the
investment.
W1: Sales

Year Sales units × Sales price ($) = Total sales ($000)

1 20,000 12 240

2 20,000 12 240

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Example: Furniture Co

3 18,000 14 252

4 18,000 14 252

5 16,000 16 256

6 16,000 16 256

Activity 1

Elgar has $10,000 to invest for five years. He could deposit it in a bank, earning 8% per year compound
interest.

He has been offered an alternative: investment in a low-risk project expected to produce net cash inflows of
$3,000 for each of the first three years, $5,000 in the fourth and $1,000 in the fifth year.

Calculate the project’s net present value and state whether it is worthwhile.

*Please use the notes feature in the toolbar to help formulate your answer.

Time Description Cash flow 8% DF PV

$ $

0 Investment (10,000) 1 (10,000)

1 Net inflow 3,000 0.926 2,778

2 Net inflow 3,000 0.857 2,571

3 Net inflow 3,000 0.794 2,382

4 Net inflow 5,000 0.735 3,675

5 Net inflow 1,000 0.681 681

NPV = 2,087

NPV is positive, so project is worthwhile.

17.3.3 Target Rate of Return (Cost of Capital)
3.3 Target Rate of Return (Cost of Capital)

When applying NPV analysis to appraise investments, a discount rate must be specified.
This discount rate includes several factors, particularly the cost of capital (the cost of the organisation’s
funds).
For example, if a business borrows funds from a bank (loan) at an interest rate of 10% per year, then its cost
of capital would be 10%. Therefore, any investment in undertakes must generate a return exceeding 10% to
be worthwhile.
Similarly, shareholders that provide funds to a business may demand a target rate of return on their
investment. If the firm does not offer this rate of return, the shareholders will invest their funds elsewhere.
Therefore, the cost of capital is usually the discount rate used in NPV analysis to appraise potential
investments.
Activity 2: NPV

A company is appraising a project that will require the purchase of machinery costing $780,000, which will
have no resale value at the end of the project.

Annual costs relating to the investment will be $240,000, increasing by 15% each year. The company uses a
discount rate of 7%.

Sales resulting from the investment are:

Year Sales units Sales price ($)

1 10,000 50

2 12,000 55

3 15,000 60

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Calculate the NPV of the project (to the nearest $000).

The discount factors for a 7% discount rate are:

Year Discount factor

0 1.000
1 0.935
2 0.873
3 0.816

*Please use the notes feature in the toolbar to help formulate your answer.

Year 0 1 2 3
$000 $000 $000 $000
Machine purchase (780)
Annual costs (240) (276) (317)
Sales W1 500 660 900
Net cash flow (780) 260 384 583
Discount factor at 7% 1.000 0.935 0.873 0.816
Present value (780) 243 335 475
NPV 273

The NPV of the project is $273,000 (rounded to $000). As the NPV is positive, the company should accept the
investment.

W1: Sales

Year Sales units × Sales price ($) = Total sales ($000)

1 10,000 50 500

2 12,000 55 660

3 15,000 60 900
17.3.4 Effect of Cash Flow Timings on NPV
3.4 Effect of Cash Flow Timings on NPV

Example

The cash flows and NPV of an investment have been identified as follows:

The above calculation assumes all cash flows (except for the initial investment) occur at the end of the year.
The calculation below assumes supplier payments for material purchases have to be made at the beginning of
the year rather than at the end. All other cash flows are assumed to occur at the end of the year.

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Example

Note that the NPV of the project is now negative, and the recommendation would be to reject the investment.
It is important to carefully identify the timing of cash flows and understand how it affects NPV.

17.3.5 Practice
3.5 Practice

Activity 3: NPV

A company is considering starting a new project. The project would begin immediately and last for three
years. The following information is about the project:

The start-up cost is $100,000 and includes machinery with no resale value. It will cost $20,000 to dispose of
the machinery. Initial research costing $2,500 has provided information about the expected costs and
revenue of the project: annual cash sales will be $60,000, and yearly costs will be 30% of the sales revenue.
The company has a cost of capital of 6%.

Calculate the NPV of the project

The discount factors for a 6% discount rate are:

Year Discount factor

0 1.000
1 0.943
2 0.890
3 0.840

*Please use the notes feature in the toolbar to help formulate your answer.

 Initial research is ignored as it is a sunk cost.

 Disposal cost is included as it will be incurred in the future due to the project.
Year 0 1 2 3
$ $ $ $
Start-up (100,000)
Disposal (20,000)
Sales 60,000 60,000 60,000
Costs (18,000) (18,000) (18,000)
Net cash flow (100,000) 42,000 42,000 22,000
Discount factor at 6% 1.000 0.943 0.890 0.840
Present value (100,000) 39,606 37,380 18,480
NPV (4,534)

The NPV of the project is -$4,534. As the NPV is negative, the company should reject the project.
Activity 4: NPV

A company has a cost of capital of 12% per annum. It is considering investing $50,000 now to receive eight
annual sums of $10,000 (commencing in one year). The annuity factor for 12% over eight years is 4.968.

What is the net present value of this investment?

*Please use the notes feature in the toolbar to help formulate your answer.

Year Net cash flow Discount factor @ 12% NPV ($)

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0 (50,000) 1.000 (50,000)

1 to 8 10,000 4.968 49,680
Total (320)

The NPV of the investment is -$320.

Activity 5

Winston’s Football Factory has been thinking about manufacturing football shirts for a few years as the
frenzy of the World Cup has gripped the country! A new machine to manufacture t-shirts has just been
launched, with the following information:

The machine will cost $520,000 and have a resale value of $80,000 at the end of six years. Depreciation is
calculated using the straight-line method.

The annual running costs of the machine will be $125,000. Winston’s Football Factory uses a discount factor
of 10%.

The sales income is forecast to be $240,000 in Years 1 and 2, $252,000 in Year 3, and $256,000 in Years 4, 5
and 6.

Calculate the NPV of investing in the machine.

*Please use the notes feature in the toolbar to help formulate your answer.

Sales Purchase of Annual running Net cash Discount factor at Present

Year revenue machine costs flow 10% value
$ $ $ $ $
0 (520,000) (520,000) 1.000 (520,000)
1 240,000 (125,000) 115,000 0.909 104,535
2 240,000 (125,000) 115,000 0.826 94,990
3 252,000 (125,000) 127,000 0.751 95,377
4 256,000 (125,000) 131,000 0.683 89,473
5 256,000 (125,000) 131,000 0.621 81,351
6 256,000 80,000 (125,000) 211,000 0.564 119,004
Net present value 64,730
Example: Discussing investment viability

17.3.6 Advantages and Disadvantages

3.6 Advantages and Disadvantages

3.6.1 Advantages
 The NPV method considers the time value of money.
 NPV is an absolute measure of return, presented in monetary terms and not as a percentage.
 The NPV method uses cash flows (which are real) rather than profit (which is more subjective as it
can be manipulated).
 The NPV method considers the whole life of the investment or project.
3.6.2 Disadvantages
 The NPV method is complicated for non-financial managers to understand.

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 NPV relies on judgment regarding the discount rate used.

Activity 6

Determine if the statements are the correct application of NPV.

Statement Correct or Incorrect

If the NPV of Investment A = $348,000, the investment should be Incorrect

rejected. NPV is positive, so investment should be
accepted.

If the NPV of Investment B = $(125,000), the investment should be Correct

rejected. NPV is negative, so investment should be
rejected.

An organisation is considering two mutually exclusive investments: Incorrect

Investment C with an NPV of $42,999 and Investment D with an NPV NPV of Investment C is higher than
of $(53,000). Investment D should be accepted. Investment D. Investment C should be
accepted.

An organisation is considering two mutually exclusive investments: Incorrect

Investment E with an NPV of $74,580 and Investment F with an NPV NPV of Investment F is higher than
of $83,920. Therefore, investment F should be rejected. Investment E. Investment F should be
accepted.
17.4.1 Internal Rate of Return (IRR)
4.1 Internal Rate of Return (IRR)

The internal rate of return (IRR) is the discount rate at which the NPV of an investment is zero.
It is the internal rate of return generated from an investment.
4.1.1 Decision Rule
The IRR is compared to the cost of capital.
 If IRR > cost of capital, the project returns higher than the cost of capital and should be accepted.
 If IRR < cost of capital, the project returns lower than the cost of capital and should be rejected.
4.1.2 Estimating IRR with a Graph
If a graph is plotted with its NPV value and the discount rate as its axes, the discount rate at which NPV is
zero is its IRR.

Key Point

Usually, the lower the discount rate, the higher the NPV.
This method is not practical for the MA exam, as the NPV across a range of discount factors would need to
be calculated.
4.1.3 Estimating IRR with the Interpolation Method
The NPV of two discount rates, one higher and one lower, is calculated, and the IRR is estimated between
them.
Ideally, a positive and negative NPV should be calculated, and they should not be too distant from zero.

Exam advice

The suggested discount rates for IRR calculations will be provided in the MA exam.
In most cases, the NPV for two different rates will be provided.

The formula to calculate IRR using interpolation is:

IRR =
​ ​

ra = lower discount rate chosen

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rb = higher discount rate chosen

Na = NPV at ra

Nb = NPV at rb

Graphically, the method looks like this:

The graph above plots the NPV of discount rates ra and rb.
The interpolation method estimates the IRR based on a straight line between the points. However, there
might be some error, as the NPV curve is usually not straight.

Example 4: IRR

A company is appraising a project that will require the purchase of machinery costing $780,000, which will have
no resale value at the end of the project.
Annual costs relating to the investment will be $240,000, increasing by 15% each year. The company uses a
discount rate of 7%.
Sales resulting from the investment are:

Year Sales units Sales price ($)

1 10,000 50

2 12,000 55

3 15,000 60
What is its IRR?
Solution:
The cash flows of the project are as follows:
Year 0 1 2 3
$000 $000 $000 $000
Machine purchase (780)
Annual costs (240) (276) (317)
Sales W1 500 660 900
Net cash flow (780) 260 384 583
A high and low discount rate is selected to estimate IRR.
NPV @ 22%
Year 0 1 2 3
$000 $000 $000 $000
Net cash flow (780) 260 384 583
Discount factor 1.000 0.820 0.672 0.551
Present value (780) 213 258 321
NPV 12
NPV @ 23%

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Example 4: IRR

Year 0 1 2 3
$000 $000 $000 $000
Net cash flow (780) 260 384 583
Discount factor 1.000 0.813 0.661 0.537
Present value (780) 211 254 313
NPV (2)
Applying the IRR formula:
ra = 22%
rb = 23%
NPVa = 12
NPVb = −2
IRR = ra + (NPVa / (NPVa − NPVb))(rb − ra)
IRR = 22% + (12 / (12 − (−2)) (23% − 22%)
IRR = 22% + (12 / 14) (1%)
IRR = 22% + (0.857) (1%)
IRR = 22.857%
There will be some differences with the true IRR due to rounding errors and the nature of IRR estimation using
interpolation.

Activity 7: IRR

Furniture Co is considering investing in a new piece of machinery. The investment would start immediately
and last for six years.

The following information about the investment is available:

Year Net cash flow ($)

0 (520,000)

1 115,000

2 115,000

3 127,000

4 127,000

5 131,000

6 211,000

What is the IRR of the potential investment?

Recommended to use 12% and 15% cost of capital rates.

*Please use the notes feature in the toolbar to help formulate your answer.

A high and low discount rate is selected to estimate IRR.

NPV @ 15%
Year 0 1 2 3 4 5 6
$ $ $ $ $ $ $
Net cash flow (520,000) 115,000 115,000 127,000 127,000 131,000 211,000
Discount factor 1.000 0.870 0.756 0.658 0.572 0.497 0.432
Present value (520,000) 100,050 86,940 83,566 72,644 65,107 91,152
NPV (20,541)

NPV @ 12%
Year 0 1 2 3 4 5 6
$ $ $ $ $ $ $
Net cash flow (520,000) 115,000 115,000 127,000 127,000 131,000 211,000
Discount factor 1.000 0.893 0.797 0.712 0.636 0.567 0.507

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Present value (520,000) 102,695 91,655 90,424 80,772 74,277 106,977

NPV 26,800

Applying the IRR formula:

ra = 12%

rb = 15%

NPVa = 26,800

NPVb = −20,541

IRR = ra + (NPVa / (NPVa − NPVb))(rb − ra)

IRR = 12% + (26,800 / (26,800 − (−20,541)) (15% − 12%)

IRR = 12% + (26,800 / 47,341) (3%)

IRR = 12% + (0.566) (3%)

IRR = 12% + 1.70%

IRR = 13.70%

There will be some differences with the true IRR due to rounding errors and the nature of IRR estimation
using interpolation.
Activity 8: IRR

A company is considering starting a new project. The project would begin immediately and last for three
years.

The following information about the cash flows of the project is available:

Year Net cash flow

0 (150,000)

1 40,000

2 60,000

3 80,000

What is the IRR of the project? (use the discount rates of 8% and 10%)

*Please use the notes feature in the toolbar to help formulate your answer.

A high and low discount rate is selected to estimate IRR.

NPV @ 8%
Year 0 1 2 3
$ $ $ $
Net cash flow (150,000) 40,000 60,000 80,000
Discount factor 1.000 0.926 0.857 0.794
Present value (150,000) 37,040 51,420 63,520
NPV 1,980

NPV @ 10%
Year 0 1 2 3
$ $ $ $
Net cash flow (150,000) 40,000 60,000 80,000
Discount factor 1.000 0.909 0.826 0.751
Present value (150,000) 36,360 49,560 60,080
NPV (4,000)

Applying the IRR formula:

ra = 8%

rb = 10%

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NPVa = 1,980

NPVb = --4,000

IRR = ra + (NPVa / (NPVa − NPVb))(rb − ra)

IRR = 8% + (1,980 / (1,980 − (--4,000)) (10% − 8%)

IRR = 8% + (1,980 / 5,980) (2%)

IRR = 8% + (0.331) (2%)

IRR = 8% + 0.66%

IRR = 8.66%
Activity 9

The data below concerns Winston’s Football Factory’s proposed investment in the t-shirt manufacturing
machine. Winston’s Football Factory has a target rate of return of 12.5% on all investments.

Year Net cash flow

0 (520,000)

1 115,000

2 115,000

3 127,000

4 131,000

5 131,000

6 211,000

Calculate the IRR of the new machine to determine if it will be a good investment, using a 10% and 15% rate
of return.

*Please use the notes feature in the toolbar to help formulate your answer.

NPV at 10%

Year Net cash flow Discount factor at 10% Present value

$ $

0 (520,000) 1.000 (520,000)

1 115,000 0.909 104,535

2 115,000 0.826 94,990

3 127,000 0.751 95,377

4 131,000 0.683 89,473

5 131,000 0.621 81,351

6 211,000 0.564 119,004

Net present value 64,730

NPV at 15%

Year Net cash flow Discount factor at 15% Present value

$ $

0 (520,000) 1.000 (520,000)

1 115,000 0.870 100,050

2 115,000 0.756 86,940

3 127,000 0.658 83,566

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4 131,000 0.572 74,932

5 131,000 0.497 65,107

6 211,000 0.432 91,152

Net present value (18,253)

Applying the IRR formula:

IRR = A + ( a/(a − b) ×(B − A))

Where:

A = lower discount rate (the one giving a positive NPV) = 10%

B = higher discount rate (the one giving a negative NPV) = 15%

a = NPV at discount rate A = $64,730

b = NPV at discount rate B = $(18,253)

IRR = 10% + ( 64,730/(64,730 − ( − 18,253) ) ×(15 − 10))%

IRR = 10% + ( 64,730/82,983 × 5)% = 10% + 3.9% = 13.9% (to one decimal place)

The IRR for the new machine was calculated to be 13.9%. The investment in the machine should go ahead
because it is above Winston’s Football Factory’s target rate of return of 12.5%.
4.1.4 IRR Of An Annuity
Calculate the IRR of an annuity by first using the following formula to find out the annuity factor:

Initial investment ÷ annuity = annuity factor

the value of 'n' in the annuity table is how long the annuity will be paid for.
After calculating a value for the annuity factor, look in the annuity tables to find the rate, 'r', closest to it.
4.1.5 IRR Of A Perpetuity
The IRR of a perpetuity can be calculated using the following formula:

Annual cash flow÷initial investment ×100%

17.4.2 Advantages and Disadvantages of IRR

4.2 Advantages and Disadvantages of IRR

4.2.1 Advantages
 The IRR method considers the time value of money
 IRR uses cash flows (which are real) rather than profit (which can be manipulated)
 The IRR method is easy for non-financial managers to compare against a target %
4.2.2 Disadvantages
 IRR ignores the size of projects when appraising investments (if two projects have the same IRR,
the larger project will increase investor wealth more).
 An investment decision based on IRR may conflict with NPV. In this case, it is always NPV that is
the superior appraisal method.
 For non-conventional investments (where multiple investments are needed throughout the
project’s life), There may be more than one solution for IRR.

The graph above shows two possible IRRs for a project.

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17.5.1 Simple (Non-Discounted) Payback

5.1 Simple (Non-Discounted) Payback

Simple payback is a method of investment appraisal that measures the time it will take for cash inflows to
equal initial cash outflows.
5.1.1 Decision Rule
An organisation may limit how long an investment project should take to break even.
If the payback period for a project is shorter than the set limit, the project will be selected.
If two or more projects are being considered, the project with the shortest payback period may be selected.
There is a risk that the decision recommended by payback differs from NPV; the most lucrative investment
may be rejected by payback for not generating returns fast enough.
5.1.2 Calculation
The calculation of payback requires knowing the following:
 The value of the cash flows
 The timing of the cash flows.
It is usually assumed that cash flows accrue evenly over the year.
The template to calculate simple payback is:

Year Cash flow ($) Cumulative cash flow ($)

0 (XXX) (XXX)

1 XXX (XXX)

2 XXX (XXX) [B]

3 XXX [A] XXX

4 XX XXX
The payback period is the time for cumulative cash flow to turn positive (which occurs in Year 3).
To find the specific period within the year of payback, the cumulative positive cash flow is divided by the
cash flow for the year.
In the above template, the simple payback period would be 2 + (|B / A|) years.

Example 5: Simple Payback

A project has an initial investment of $250,000 and cash inflows of $30,000 per year.
What is the payback period?
Solution:
Table solution:

Year Cash flow ($000) Cumulative cash flow ($000)

0 (250) (250)

1 30 (220)

2 30 (190)

3 30 (160)

4 30 (130)

5 30 (100)

6 30 (70)

7 30 (40)

8 30 (10)

9 30 20
The simple payback period is 8 + (|10 / 30|) = 8.33 years ≈ 8 years 4 months
Formula solution:
As the yearly cash flows from this investment are consistent, the payback period may be found with a formula:
Payback period
= initial investment / annual cash flow

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Example 5: Simple Payback

= 250,000 / 30,000
= 8.33 years ≈ 8 years 4 months

Activity 10: Simple Payback

A project has the following cash flows.

Year Net Cash flow

0 (250,000)

1 160,000

2 180,000

3 140,000

What is the payback period?

*Please use the notes feature in the toolbar to help formulate your answer.

Year Cash flow ($000) Cumulative cash flow ($000)

0 (250) (250)

1 160 (90)

2 180 90

3 140 230

The payback period is 1 + (|90 / 180|) = 1.5 years ≈ 1 year 6 months

Activity 11

The following cash flow table is available for an investment in a machine.

Year Net cash flow

0 (520,000)

1 115,000

2 115,000

3 127,000

4 131,000

5 131,000

6 211,000

Calculate the simple payback period of this investment.

*Please use the notes feature in the toolbar to help formulate your answer.

Year Net cash flow Cumulative cash flow

$ $

0 (520,000) (520,000)

1 115,000 (405,000)

2 115,000 (290,000)

3 127,000 (163,000)

4 131,000 (32,000)

5 131,000 99,000

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6 211,000 310,000

At the end of Year 4, the cumulative cash flow was $(32,000); at the end of Year 5, the cumulative cash flow
was $99,000. Therefore, payback occurs in year 5.

4 + (|32,000 / 131,000|) = 4.24 years ≈ 4 years 3 months

17.5.2 Discounted Payback

5.2 Discounted Payback

Simple payback does not consider the time value of money, which means its payback period is understated.
Discounted payback considers the time value of money and adjusts cash flows to their present value. The
calculated payback period is the time taken for cumulative PV to break even (equals zero).
5.2.1 Calculation

Example 6: Discounted Payback

A project requires an initial investment of $50,000 and has the following annual cash flows:

Year Cash flow ($)

1 21,810

2 23,753

3 38,860

4 42,373
The organisation has a required rate of return of 9%.
What is the discounted payback period?
The applicable 9% discount factors are:

Year Discount factor

1 0.917

2 0.842

3 0.772

4 0.708
Solution:

Year Cash flow Discount factor PV ($) Cumulative PV ($)

0 (50,000) 1.000 (50,000) (50,000)

1 21,810 0.917 20,000 (30,000)

2 23,753 0.842 20,000 (10,000)

3 38,860 0.772 30,000 20,000

4 42,373 0.708 30,000 50,000

The discounted payback period is 2 + (10,000 / 30,000) = 2.33 years ≈ 2 years 4 months

Activity 12

The following cash flow table is available for an investment in a machine.

Year Net cash flow

0 (520,000)

1 115,000

2 115,000

3 127,000

4 131,000

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5 131,000

6 211,000

Calculate the discounted payback period of this investment at a 10% rate of return.

*Please use the notes feature in the toolbar to help formulate your answer.

Year Net cash Discount factor at 10% Discounted Cumulative cash flow
flow cash flow

$ $ $

0 (520,000) 1 (520,000) (520,000)

1 115,000 0.909 104,535 (415,465)

2 115,000 0.826 94,990 (320,475)

3 127,000 0.751 95,377 (225,098)

4 131,000 0.683 89,473 (135,625)

5 131,000 0.621 81,351 (54,274)

6 211,000 0.564 119,004 64,730

At the end of Year 5, the cumulative discounted cash flow was $(54,274), and at the end of Year 6, the
cumulative cash flow was $64,730. The payback period is between years 5 and 6.

54,274/119,004 × 12 months = 5.47 = 5.6 months (round up to the nearest month)

The non-discounted payback period is 5.46 years, or about 5 years and 6 months.
Activity 13

Project Beta has the following net cash flows:

Year Net Cash flow $

0 (250,000)

1 160,000

2 180,000

3 140,000

Calculate the simple payback period for Project Beta.

Calculate the discounted payback period for Project Beta at a 15% rate of return.

*Please use the notes feature in the toolbar to help formulate your answer.

Year Net cash flow Cumulative net cash flow

$ $

0 (250,000) (250,000)

1 160,000 (90,000)

2 180,000 90,000

3 140,000 230,000

At the end of Year 1, the cumulative cash flow was $(90,000), and at the end of Year 2, the cumulative cash
flow was $90,[Link], the payback period is between years 1 and 2.

90,000/180,000 × 12 months = 6 months (to the nearest month)

The non-discounted payback period is 1.5 years, or about 1 year and 6 months.

Year Net cash flow Discount factor @ 15% Present value Cumulative present value

$ $ $

0 (250,000) 1 (250,000) (250,000)

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1 160,000 0.870 139,200 (110,800)

2 180,000 0.756 136,080 25,280

3 140,000 0.658 92,120 117,400

At the end of Year 1, the cumulative discounted cash flow was $(110,900), and at the end of Year 2, the
cumulative cash flow was $25,[Link], the payback period is between years 1 and 2.

110,800/136,080 × 12 months = 9.77 = 10 months (round up to the nearest month)

The discounted payback period is 1.81 years, or about 1 year and 10 months.

Exam advice

Some questions may request that the payback period be expressed in years and months.
17.5.3 Advantages and Disadvantages
5.3 Advantages and Disadvantages

5.3.1 Advantages
 The payback method is simple to calculate
 outcome is easy to understand for non-financial managers
 helps organisations with cash flow problems identify which projects will return the investment
early
5.3.2 Disadvantages
 Simple payback does not consider the time value of money
 Payback does not consider the cash flows that take place after the payback period; it may
underestimate the value of the project
 The payback method does not work well if there are costs later in the project.
 The payback method encourages decisions to be made on short-term factors rather than the long-
term benefit to the organisation

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Chapter 18: Nature and Purpose of Budgeting

18.1.1 Introduction
1.1 Introduction

Definition

Budget – A financial plan.

A budget is a quantitative (measurable) expression of a plan of action for a future period.
Budgets set out a detailed plan of expected revenues and expenditures for a specified future period, for
example, a year.
A budget period is how long the budget is for —for example, one month, one quarter (three months) or one
year.
Budgets let us:
 Communicate the activities of the organisation
 Coordinate the plans of the organisation
 Control the performance of the organisation.
Budgets are often set as targets for what the organisation wants and a detailed plan of how the business
intends to make that happen. To understand where budgets fit into an organisation’s planning process, an
example of a strategic plan for Furniture Co is shown:

Term Description Furniture Co Example

An organisation's vision statement sets out what it would like

to achieve. A clear vision helps managers make decisions
and take action to help the organisation achieve its vision. To be the best Furniture Company
Vision
in the world.
These are long-term aspirations – some organisations have
the same vision for their whole existence.

Goals are general statements of what the organisation wants

To have a world-leading furniture
Goal to do to achieve its vision. These are medium to long-term
design team by 20X8.
aspirations.

Objectives are SMART statements of the goals. SMART

stands for: specific, measurable, achievable, realistic and By 20X5, 100% of the design team
Objectives time-bounded. will be trained to Level 7 in 3D
Computer-Aided Design (CAD).
These are short to medium-term aspirations.

Action plans are detailed plans to achieve objectives and the Send 50 design team members to
Action plan
resources required. They usually are one year in duration. Level 3 CAD courses this year.

Budgets are financial plans. They are based on action plans.

They are often set as targets for what the organisation wants
to happen. The action plan is expressed in
Budget
financial terms.
These follow the same time frame as the action plans –
typically one year.

18.1.2 Types of Budgets

1.2 Types of Budgets

Types of budgets include:

Budget type Description

Sales Sales budgets provide information about the expected volumes of sales and selling prices for
budgets future periods.

Functional Functional budgets include the budgets for an organisation’s departments (or functions):
budgets
 Production budgets
 Raw materials usage budgets

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 Raw materials purchases budgets

 Labour budgets
 Variable overhead budgets
 Fixed overhead budgets.

Cash This budget is prepared by working out all of the expected cash receipts (mainly from sales) and
budgets the expected payments (mainly for purchases) and summarising them in a series of cash flows.

Master Individual budgets are summarised into the master budget, which is made up of the following:
budget
 Budgeted statement of profit or loss
 Budgeted statement of financial position
 Cash budget.
18.1.3 The Principal Budget Factor
1.3 The Principal Budget Factor

Definition

Principal budget factor – The primary factor that limits an organisation’s activities
The principal budget factor is the factor or budget that limits the activities of an organisation. Therefore, the
budget relating to the principal budget factor should always be prepared first.
The principal budget factor of most organisations is sales. This is because there will be a limit to the demand
for an organisation’s products. For example, there is no point in an organisation producing 500,000 units of a
product in a year if demand is never likely to be more than 1,000 units in a year.
However, the principal budget factor can be something other than sales. Sometimes there may be other
factors that limit the level of activity of an organisation.
For example, if not enough skilled workers are not available to make as much of a product as the customers
want to buy, this can directly affect the volume of production. If this is the case, the labour budget must be
prepared first. The number of labour hours available will determine the number of units of a product that can
be produced.

Example

Imagine that demand for Winston’s footballs is 50,000 footballs per year. If there are 40 skilled workers at
Winston’s Football Factory, and each person works 40 hours per week for 46 weeks a year, the availability of
skilled labour (in hours per year) is as follows:
 Availability of skilled labour = 40 workers × 40 hours × 46 weeks = 73,600 hours
 If each football requires 2 hours of skilled labour: maximum football production = 73,600/2 = 36,800
footballs.
The production budget (assuming no opening or closing inventory) will be based on 36,800 footballs per year.
It is currently impossible to meet maximum demand, so the limiting factor is labour time.
This means that, unusually, the sales budget would be done after the labour budget.

18.1.4 Use of Budgeting

1.4 Use of Budgeting

Organisations will want to plan how much money they will earn in a future period (sales revenue) and how
they will spend it. This is one of the main reasons that organisations prepare budgets.

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18.1.5 The Planning And Control Cycle

1.5 The Planning And Control Cycle

Definitions

Planning – Developing objectives and selecting a plan that will achieve these objectives.
Control – The steps taken by management to ensure that the objectives are achieved.

The planning and control cycle’s planning stage ends with preparing an organisation’s budgets. This is
followed by the control stage, where an organisation compares its actual results with its planned results
(budgets) prepared before the budget period.
The differences between these two results are known as variances.

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18.1.6 The Budgeting Process

1.6 The Budgeting Process

The planning stage of the planning and control cycle is completed when the aims and objectives of an
organisation have been established, and the organisation’s budgets have been prepared (that is, at the end
of the planning stage of the planning and control cycle).
At this point, the budget process starts and ends at the end of the control stage.
In the following planning and control cycle diagram, the budgeting process begins at stage 4 and ends at
stage 8.

Budgeting stage Description

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Budget Committee Once the planning stage has been completed and a strategy for achieving an
organisation’s aims has been agreed upon, the budget committee can be
formed. The primary responsibilities of the budget committee are:
 To co-ordinate the budget preparation process
 To prepare the budget manual
 To communicate details of the budgeting process to the budget
holders.
The budget committee is headed up by the chairman (often the managing
director of the organisation) and includes a budget officer and the functional
budget holders.

Budget Manual The budget manual sets out the procedures that should be followed during
the budgeting process. It also includes forms that should be used and
instructions on preparing individual budgets.
It is usually prepared by a finance team member who is also a member of the
budget committee.
Note that the budget manual does not contain any budgets; it is simply a
reference for preparing budgets.

Limiting factor identified The limiting factor must be identified before any budgets are prepared. This
is because the limiting factor (also known as the principal budget factor) will
be the budget factor that will limit the amount of product that an organisation
can make.
Once the principal budget factor has been identified, the relevant budget is
prepared. So, for example, if sales is the limiting factor, then the sales
budget is prepared first.

Functional budgets prepared (first Once the principal budget factor has been identified and the relevant budget
draft) prepared, all of the other functional budgets can be prepared by the budget
holders and their team members.
These budgets will be the first drafts and will be subject to review until the
budget committee agrees to the final budgets.

Review of first draft budgets Once the first drafts have been reviewed, they need to be adjusted.
This stage of the budget process can involve several reviews until a final
budget is agreed upon by the budget holders and accepted by the budget
committee.

Master budget The master budget is prepared once the budget committee has agreed to the
final drafts of the functional budgets. First, the functional budgets are used
to prepare the budgeted statement of profit or loss. Then the cash budget
(and other information) is used to prepare the budgeted statement of
financial position.
These budgets are then summarised in the master budget.
 Budgeted statement of profit or loss – functional budgets
 Budgeted statement of financial position – cash budget:

Budget review process The budgets are compared with the actual results in the budget process.
Any significant variances are investigated. In addition, the budgets are
monitored continuously by comparing them with the actual results achieved.

18.1.7 Forecasts
1.7 Forecasts

Definition

Forecast – An estimate of future performance, usually created referring to actual results for the period.
Whereas a budget is a financial plan, a forecast predicts the future. It is the expected financial results for a
future period.
Forecasting techniques include
 Using index numbers to forecast future prices and quantities.

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 Regular contracts with customers and clients can be used to forecast sales.
 Market research methods can indicate the likely level of sales demand for a product, especially if
there are plans to launch a new product in the future.
 Linear regression analysis can forecast future sales demand by estimating a linear function.
 Time series analysis estimates the trend of something from historical data taken over time.
1.7.1 Making Forecasts

Period Activity Description

October Prepare budget Imagine the financial year runs from January to December 20X1. The
20X0 budget will be prepared mid or late 20X0 – perhaps October 20X0.
The board of directors might approve the budget in November 20X0,
and in January 20X1, the execution of plans begins.

November Budget approval After consideration, senior management approves the budget.
20X0

January Beginning of the financial year The organisation begins activities based on the budget for 20X1.
20X1 – start delivering budget plans

March 20X1 Prepare forecast for 20X1 In March, prepare a forecast for 20X1. The actual results for January
and February 20X1 are available. This helps in two ways:
 First, the forecast only has to predict ten months rather
than 12 months –the January and February results are included
in the full-year 20X1 forecast.
 Second, some of the assumptions made are more certain –
the selling price will have been fixed, and there is a better idea of
the labour and materials costs.

1.7.2 Problems with forecasting

The further a prediction is into the future, the more difficult it is to get it right. For example, accurately
predicting how much a chocolate bar will cost tomorrow accurately is easy. However, the price of the
chocolate bar 12 months into the future is more uncertain.

18.1.8 Economic Environment Impact on Budgeting

1.8 Economic Environment Impact on Budgeting

The general economic environment will affect organisations at a local (or national) level and a global (or
international) level.
When the economy is strong, it can be described as a boom time. In a boom time, the economy is growing,
and confidence in the future is high.
At these times:
 Businesses can increase the prices of their products, and so revenues increase
 Suppliers may increase their prices, so costs may increase
 There are lots of jobs for people
 Investments perform well.
When the economy is weak, it can be described as a bust time – the economy is no longer growing, and
people will be less confident about the future. During these times:
 Businesses will struggle and may even become bankrupt
 There will be less money in the economy
 Unemployment will increase
 Investor confidence will weaken.

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Political and other factors will also have a bearing on the confidence of consumers and people in companies
who make investment decisions.
There is a range of economic factors that can influence a business’ costs and revenues.

Economic Description
Factor

Inflation This is the rate at which prices rise. In times of high inflation, people’s spending patterns are
affected. This can affect business decisions. Rising input prices also affect business decisions,
including investment decisions.

Interest rates High interest rates discourage investment by individuals (for example, on purchases of homes,
cars and household goods). This reduces demand for companies’ products. It also makes it more
expensive for companies to invest.

Tax rates When tax rates are low, people will have more money at the end of a month or week and tend to
spend more. When tax rates are high, the opposite will happen, and there will be a less confident
economy as people worry about the future. In addition, in a high-tax economy, businesses are
less likely to set up new businesses or invest in existing ones.

Local Rents, jobs, housing markets and local industries will all vary from place to place (for example,
economic from town to town, region to region or country to country).
factors

Exchange Exchange rates affect the prices and levels of imports and exports. They also affect inflation.
Rates

Government Government policies affect the economy due to government spending, taxation, and policies
Policies specifically designed to manage the economy.

Central bank The roles of central banks include supervising banking activities and controlling inflation, which
operations involves setting interest rates.
18.1.9 Sustainability in Budgeting
1.9 Sustainability in Budgeting

Traditionally, budgets have been focussed on monetary amounts, on financial aspects only. In recent years,
the expectation for business organisations to behave ethically and sustainably has increased. This has led
to a need for performance measurement and budget setting to cover wider issues including sustainability.
Sustainability refers to the idea that organisations should operate in ways that do not use resources that
cannot be replaced and that do not damage the environment.
1.9.1 Application of Sustainability in Budgeting
The inclusion of aspects of sustainability in budgeting encourages greater transparency and accountability
in how organisations impact the environment.
The aim is to have clearer information and goals on how budgeting decisions affect sustainability and
societal well-being measures, such as the impact on climate and local community, pollution and CO2
emissions.
Performance information related to the budget can reflect additional measures, such as those pertaining to
the United Nation’s Sustainable Development Goals (UN SDGs), in addition to traditional financial indicators.
Budgets that should incorporate these measures range from asset expenditure budgets to planning and
operational budgets.
In most organisations, existing budgetary processes are not well-equipped to capture and report non-
financial information. Therefore, investment may be needed to develop and implement appropriate
information systems.
Budget setters need to identify the right set of sustainability measures relevant to their activities. Metrics
need to be measurable and trackable over time.
For example, how can carbon emissions be measured and tracked? How can the environmental impact of
different investment opportunities be measured?
There is no denying the increasing regulatory and investor demand for meaningful reporting of an
organisation's environmental impact and other ethical and sustainability issues. This makes investment in
systems and processes to implement sustainable budgeting increasingly attractive.
18.2.1 Sales Budgets
2.1 Sales Budgets

Definition

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Definition

Budget – A financial plan.

The main aspects to consider are:
 Expected demand
 Expected selling price
Example

Winston’s Football Factory is preparing the budgets for the coming year, 20X5. It has forecasted expected
demand using time series analysis.
The expected demand in 20X5 is the only factor limiting the number of footballs the factory will produce, so the
principal budget factor is sales.

Year 20X5

Budgeted Sales 4,800 footballs

Budgeted Selling Price $35 per football

Sales budget = 4,800 × $35 = $168,000

18.2.2 Production Budget

2.2 Production Budget

The main aspects to consider are:

 Expected demand
 Opening inventory
Opening inventory at the beginning of a period will reduce the required production amount.

 Desired level of closing inventory.
Increasing closing inventory at the end of a period will increase the amount required to be produced in a
period.


Example

Year 20X5

Budgeted Sales 4,800 footballs

Budgeted Selling Price $35 per football

At the beginning of the budget period, Winston’s Football Factory has 350 footballs in the warehouse.
The number of footballs required to be in closing inventory at the end of the budget period is 550.
Given the above data, prepare the 20X5 production budget for Winston’s Football Factory.
Answer:
Number of footballs
Sales budget 4,800
+ Closing inventory 550
− Opening inventory (350)
Production budget 5,000

Activity 1

Forecast year 20X8

Budgeted Sales 72,000 units

Budgeted Selling Price $6.50 per unit

Opening inventory 5,500 units

Closing inventory 7,200 units

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Given the above data, produce the sales budget ($) and production budget (units).

*Please use the notes feature in the toolbar to help formulate your answer.

Sales budget ($) 72,000 × $6.50 $468,000

Production budget (units) 72,000 − 5,500 + 7,200 73,700 units

Activity 2

The standard cost card below applies to producing a unit of Hoodie Y:

T-shirt unit cost card

$ $
Direct materials:
Cotton 4
Thread 1
Ink 1
6
Direct labour:
Machine operators' wages 3
Embroidery staff wages 10
13
Direct expenses:
Royalty payments 1
1
Total direct (prime) cost 20
Production overheads 5
Total production cost 25
Other overheads (administration, distribution and selling) 10
Total cost 35

Develop a production budget based on the production and sales of 1,000 units of Hoodie Y for 20X1 using
the given template.

Production (units) 1,000

$
Direct materials
Direct labour
Direct expenses
Direct cost
Production overheads
Other overheads
TOTAL COST

*Please use the notes feature in the toolbar to help formulate your answer.

Multiply the costs by the production volume and put the information into a table.
Budget 20X1
Production (units) 1,000

$ Calculation
Direct materials 6,000 6 × 1,000
Direct labour 13,000 13 × 1,000
Direct expenses 1,000 1 × 1,000
Direct cost 20,000
Production overheads 5,000 5 × 1,000
Other overheads 10,000 10 × 1,000
TOTAL COST 35,000
18.2.3 Standard Cost
2.3 Standard Cost

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Definition

Standard cost – A predetermined cost of a unit of a product

A product’s standard cost is what the company budgets to make the product. It is a standard that applies to
all units of the product produced. These costs are shown on the product’s standard cost card.
For example, if a production unit requires 1kg of material as standard, then 100 units would require 100kg of
materials.
Cost budgets are produced based on a product’s standard cost.

Example

The standard cost of producing one football at Winston’s Football Factory is shown on the following cost card:

Cost item Units Cost Cost per football ($)

Direct materials – Plastic F 1 kg $3/kg 3.00

Direct labour 2 hours $6/hour 12.00

Variable overheads 2 hours $1/hour 2.00

Fixed overheads 2 hours $2/hour 4.00

Total cost per football 21.00

18.2.4 Raw Materials Budgets

2.4 Raw Materials Budgets

There are two types of raw materials budgets:

 Raw materials usage budget
 Raw materials purchases budget.
The raw materials usage budget is calculated first to inform the purchase budget.
2.4.1 Raw Materials Usage Budget

Example

The budgeted production is 5,000 footballs.

The standard cost information in the earlier example shows that 1 kg of Plastic F is required for each football
produced.
The materials usage budget is calculated as follows:
Materials usage budget (Plastic F) = Budgeted production × Number of kg per football
Materials usage budget (Plastic F) = 5,000 × 1 kg = 5,000 kg

2.4.2 Materials Purchases Budget

The raw materials purchases budget must account for any opening or closing inventory of raw materials and
production usage.

Example

The budgeted production is 5,000 footballs.

The standard cost information in the earlier example shows that 1 kg of Plastic F is required for each football
produced.
Each kg of Plastic F costs $3 per kg.
Winston’s Football Factory has 400 kg of Plastic F in opening inventory and expects to have 1,000 kg of it in
closing inventory.
The materials usage budget is calculated as follows:
Plastic F (kg)
Materials usage budget 5,000
+ Closing inventory 1,000
− Opening inventory (400)
Materials purchases budget 5,600
Materials purchases budget (in $) = Materials purchases budget (in kg) × Cost per kg
Materials purchases budget (in $) = 5,600 kg × $3 = $16,800

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2.4.3 Planned Inventory Levels

Information about planned inventory levels of raw materials and finished goods may be provided.
For example, a question may state that the closing inventory of finished goods is planned to be 20% of
budgeted sales.
Activity 3

XYZ Co has budgeted to produce 25,000 units of Product S next year. Each unit of Product S requires 25 kg
of Material T. Material T costs $2.50 per kg. At the beginning of next year, XYZ Co expects to have 3,000 kg of
Material T held in inventory.

At the end of the period, closing inventory is planned to be 25% higher than opening inventory.

1. What is the budgeted materials usage of Material T?

2. What is the opening inventory level (in kg) of Material T?

3. What is the closing inventory level (in kg) of Material T?

4. What is the materials purchases budget (in kg) of Material T?

5. What is the materials purchases budget (in $) of Material T?

*Please use the notes feature in the toolbar to help formulate your answer.

1. Budgeted materials usage = 25,000 units × 25 kg per unit = 625,000 kg

2. 3,000kg, which is the number of kg of Material T that XYZ Co expects to have at the beginning of
next year.
3. Closing inventory = 125% of 3,000 = 3,750 kg
4.
Material T (kg)
Materials usage budget 625,000
+ Closing inventory 3,750
− Opening inventory (3,000)
Materials purchases budget 625,750

5.
5. Materials purchases budget (in $) = 625,750 × $2.50 = $1,564,375

Key Point

The usage budget must be determined before calculating the purchase budget.
18.2.5 Labour Budgets
2.5 Labour Budgets

The labour budget is calculated similarly to the materials usage budget.

Example

The standard cost of producing one football at Winston’s Football Factory is the following cost card:

Cost item Units Cost Cost per football ($)

Direct materials – Plastic F 1 kg $3/kg 3.00

Direct labour 2 hours $6/hour 12.00

Variable overheads 2 hours $1/hour 2.00

Fixed overheads 2 hours $2/hour 4.00

Total cost per football 21.00

What is the labour budget for the 5,000 footballs to be produced in 20X5?
Labour budget (in hours)
Labour budget (in hours) = Budgeted production × Number of labour hours per football
Labour budget (in hours) = 5,000 footballs × 2 labour hours per football
Labour budget (in hours) = 10,000
Labour budget (in $)

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Example

Labour budget (in $) = Labour budget (in hours) × Standard labour cost per labour hour
Labour budget (in $) = 10,000 hours × $6 per hour = $60,000

2.5.1 Skilled And Unskilled Labour

Sometimes an organisation will need different types of labour to manufacture its products, such as skilled
and unskilled labour.
A separate labour budget is calculated for each type of labour.
Activity 4

LBR Co has budgeted to produce 10,250 units of Product AA in 20X0. Each unit of Product AA requires 3
hours of skilled labour and 5 hours of unskilled labour. Skilled labour costs $4 per hour, and unskilled labour
costs $2 per hour.

1. What is the skilled labour budget for 20X0?

2. What is the unskilled labour budget for 20X0?

3. What is the total labour hours budget for 20X0 in hours?

4. What is the total labour hours budget for 20X0 in $?

*Please use the notes feature in the toolbar to help formulate your answer.

1. To produce 10,250 units of Product AA, the required skilled labour hours = 10,250 × 3 = 30,750
2. To produce 10,250 units of Product AA, the required unskilled labour hours = 10,250 × 5 = 51,250
3. The total labour hours budget for 20X0 is the sum of the required skilled and unskilled labour hours
= 30,750 + 51,250 = 82,000 hours.
4. The total labour hours budget for 20X0 in $ is the sum of the total costs of skilled and unskilled
labour hours = (30,750 × $4) + (51,250 × $2) = $123,000 + $102,500 = $225,500.
2.5.2 Unproductive Labour Time
Sometimes workers are paid for hours they have not been able to work, for example, if a machine breaks
down. This is known as idle time.
Workers are usually paid for idle time because it has not been their fault that they have not been able to work.
Therefore, idle hours will need to be accounted for in labour budgets.

Example

A company estimates that it will take 1,900 labour hours to carry out a job and that 5% of workers’ paid hours are
lost through idle time. The labour rate per hour is $4.
The workers are therefore paid for 1,900/0.95 = 2,000 hours
The labour budget in hours is 2,000 hours.
The labour budget in $ = 2,000 × $4 = $8,000

18.2.6 Overhead Budgets

2.6 Overhead Budgets

Overhead budgets can be separated into production overhead budgets and non-production overhead
budgets.

Example

Standard cost per football

Units Cost per unit ($) Cost per unit ($)

Direct materials – Plastic F 1 kg $3 3.00

Direct labour 2 hours $6 12.00

Variable production overheads 2 hours $1 2.00

Fixed production overheads 2 hours $2 4.00

Total cost per football 21.00

Production overhead budget
Production overheads can be separated into variable and fixed production overheads, both based on labour

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Example

hours worked at Winston’s Football Factory.

The number of budgeted labour hours at the factory is 10,000 hours.
Budgeted production overheads (variable and fixed)
The budgeted variable production overheads = 10,000 labour hours × $1 per labour hour = $10,000
The budgeted fixed production overheads = 10,000 labour hours × $2 per labour hour = $20,000
Non-production overhead budgets
Winston’s Football Factory also has overheads of $36,600 that are not directly related to the football-making
process. They include administration and selling, and distribution costs.

Activity 5

A company manufactures two products: Product XX and Product YY. Data relating to the coming year is
shown in the table:

Product XX Product YY

Budgeted production (units) 3,000 2,000

Machine hours per unit 5 8

Variable production overheads per machine hour are $2 and fixed production overheads per machine hour
are $3.

Determine if the statements are correct or incorrect.

Statement Correct or Incorrect

Budgeted machine hours for Product XX Correct

= 15,000 machine hours Budgeted machine hours = 3,000 × 5 hours per machine for Product
XX = 15,000 machine hours

Budgeted machine hours for Product YY Correct

= 16,000 machine hours Budgeted machine hours = 2,000 × 8 hours per machine for Product
YY = 16,000 machine hours

Total budgeted machine hours = 62,000 Incorrect

Total budgeted machine hours = 15,000 + 16,000 = 31,000

Variable production overheads budget = Correct

$62,000 Variable production overheads budget = 31,000 machine hours × $2 =
$62,000

Fixed production overheads budget = Incorrect

$62,000 Fixed production overheads budget = 31,000 machine hours × $3 =
$93,000
18.3.1 Cash Budget
3.1 Cash Budget

A cash budget details an organisation’s estimated cash inflows and outflows for a future period. It includes
the opening and closing cash balances of an organisation.
3.1.1 Non-cash items
Cash inflows include the cash received by an organisation, and cash outflows include the cash payments
made by an organisation.
Some items in the statement of profit or loss are not cash items and are excluded from the cash budget.
Examples of this are the depreciation of a non-current asset and profit on the sale of a non-current asset.
Activity 6

Determine if the item is a cash inflow, outflow, or not a cashflow.

Item Cash inflow Cash outflow No cash flow

Cash released on taking out a new loan [YES]

Purchase of non-current assets [YES]

Credit sales [YES]

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Payments to suppliers [YES]

Cash sales [YES]

Profit or loss on sale of non-current assets [YES]

Labour costs – wages and salary payments [YES]

Sale of non-current assets [YES]

Depreciation [YES]

Payments for production and non-production overheads [YES]

Repayment of a loan [YES]

Receipts from receivables [YES]

18.3.2 Timing Of Cash Flows
3.2 Timing Of Cash Flows

Cash receipts and payments do not always occur immediately after a transaction happens.

Example

The following are typical cash flow timings that might be provided in the exam.
 Cash receipts for credit sales – cash sales are paid in the month of sale, but receipts for credit sales can
be in the month of the sale, one month later or two months later.
 Payments to suppliers – these payments are often paid some period after the goods are received,
perhaps a month after the purchase.
 Payments for wages and salaries to employees for the work they have done – these are usually paid in
the month they are due.
Payments for production and non-production overheads – these are usually paid in the month they are incurred.

Activity 7

Sales of footballs at Winston’s Football Factory are spread evenly throughout the year.

Total sales = $168,000, therefore monthly sales = $168,000/12 = $14,000 per month.

40% of the sales of footballs at Winston’s Football Factory are cash sales, and 60% of sales are on credit,
with the cash expected to be received the month after the sale.

Quarter 1 20X5

January February March

$ $ $

Cash receipts – December 20X4 credit sales 8,400

Cash receipts – January cash sales 5,600

Cash receipts – January credit sales 8,400

Cash receipts – February cash sales 5,600

Cash receipts – February credit sales 8,400

Cash receipts – March cash sales 5,600

Total 14,000 14,000 14,000

Produce Winston’s Football Factory’s budgeted cash receipts for the months of Quarter 1 20X5

3.2.1 Irrecoverable debts

Cash receipts must be adjusted for information about irrecoverable debts (money the organisation will never
receive for sales made).

18.3.3 Cash Budget - Quarterly Cash Budgets

3.3 Cash Budget - Quarterly Cash Budgets

It is common to prepare a quarterly cash budget to show how the cash payments and receipts are spread
over the year.

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Activity 8

Use the following information to prepare the cash budget for Winston’s Football Factory for 20X5.

 Sales budget and expected pattern of cash receipts: $42,000 per quarter
 Materials purchases budget: $16,800 = $4,200 per quarter
 Labour cost budget: $60,000 = $15,000 per quarter
 Variable production overheads budget: $10,000 = $2,500 per quarter
 Fixed production overheads: $20,000 = $5,000 per quarter
 Non-production overheads: $36,600 = $9,150 per quarter
 Repayment of loan on 14.02.X5 = $15,000 in Quarter 1
 Purchase of non-current asset on 13.06.X5 = $40,000 in Quarter 2.
 The cash balance on 01.01.X5 was $72,000.
*Please use the notes feature in the toolbar to help formulate your answer.

Quarter 1 Jan- Quarter 2 April - Quarter 3 July- Quarter 4 Oct- Total

March June Sept Dec
$ $ $ $ $
Receipts (A) 42,000 42,000 42,000 42,000 168,000
Payments
Materials 4,200 4,200 4,200 4,200 16,800
Labour 15,000 15,000 15,000 15,000 60,000
Variable production
overheads 2,500 2,500 2,500 2,500 10,000
Fixed production
overheads 5,000 5,000 5,000 5,000 20,000
Non-production
overheads 9,150 9,150 9,150 9,150 36,600
Loan repayment 15,000 15,000
Purchase of equipment 40,000 40,000
Total payments (B) 50,850 75,850 35,850 35,850 198,400
Net cash flow (A) – (B) (8,850) (33,850) 6,150 6,150 (30,400)
Cash balance brought
forward 72,000 63,150 29,300 35,450
Cash balance carried
forward 63,150 29,300 35,450 41,600

Activity 9 Cash Budgets

Omega Electronics has the following budgeted statement of profit or loss:

January February March April

$000 $000 $000 $000
Sales 40 45 50 55
Cost of sales (20) (22.5) (25) (27.5)
Gross profit 20 22.5 25 27.5
Salaries and wages (10) (10) (10) (10)
Other administrative costs (5) (5) (5) (5)
Depreciation (7.5) (7.5) (7.5) (7.5)
Profit (2.5) 0 2.5 5

Cash on 31 December was $5,000. The following assumptions have been made relating to cash flows:

1. Half of the customers will pay in the month following the sale, and the other half will pay two
months after the sale. In November and December, the monthly sales revenue was $70,000.
2. At the start of each month, there must be sufficient inventory to meet 50% of that month's cost of
sales. At the end of April, the closing inventory will be $15,000.
3. Purchases will be paid for one month after they are made. Purchases in December were $27,500.
4. All salaries, wages, and other administrative costs are paid in cash in the month they arise.
5. There will be no investments during the period.
Prepare the cash budget for the months of January to April.

*Please use the notes feature in the toolbar to help formulate your answer.

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January February March April

$000 $000 $000 $000
Receipts from customers (W1) 70 55 42.5 47.5
Payments to suppliers (W2) (27.5) (21.25) (23.75) (26.25)
Salaries and wages (10) (10) (10) (10)
Other administrative costs (5) (5) (5) (5)
Net cash flow for the month 27.5 18.75 3.75 6.25
Cash at the start of the month 5 32.5 51.25 55
Cash at the end of the month 32.5 51.25 55 61.25

Workings
(1) Receipts from credit customers
Sales 40 45 50 55
Receipts from customers:
50% in the following month 35 20 22.5 25
50% two months later 35 35 20 22.5
Receipts 70 55 42.5 47.5
(2) Payments to suppliers
Cost of sales 20 22.5 25 27.5
Less: Opening inventory (10) (11.25) (12.5) (13.75)
Add: Closing inventory 11.25 12.5 13.75 15
Credit purchases 21.25 23.75 26.25 28.75
Payments to suppliers (one month later) 27.5 21.25 23.75 26.25
18.3.4 Budgeted statement of profit or loss
3.4 Budgeted statement of profit or loss

The budgeted statement of profit or loss estimates how profitable an organisation is forecast to be in a
future budget period.

Example

The following information for Winston’s Football Factory is available to prepare the budgeted statement of profit or
loss for next year, 20X5.

Standard cost of one football (see 2.3 Standard Cost) $21

Budgeted selling price per football (see 2.1 Sales Budget) $35

Sales budget (see 2.1 Sales Budget) $168,000

Opening inventory of finished goods (see 2.2 Production Budget) 350 footballs

Closing inventory of finished goods (see 2.2 Production Budget) 550 footballs

Production Budget (see 2.2 Production Budget) 5,000 footballs

Non-production overheads (see 2.6 Overhead Budgets) $36,600

Complete the budgeted statement of profit or loss.

$ $ Note

Sales revenue 168,000 [1]

Cost of sales

Opening inventory 7,350 [2]

Production costs 105,000 [3]

Closing inventory (11,550) [4]

Production cost of sales (100,800) [5]

Gross profit 67,200 [6]

Non-production overheads (36,600) [7]

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Example

Net profit 30,600 [8]

Note Item Description

[1] Sales revenue Budgeted sales revenue of $168,000 from a budgeted sales volume of 4,800 gives a
figure budgeted selling price per football of $35 ($168,000 / 4,800).

[2] Opening The opening inventory value of $7,350 comprises the opening inventory of finished
inventory value goods.
The opening inventory of finished footballs is calculated by multiplying the number of
footballs in opening inventory, which equals 350, by the standard cost of producing one
football, which equals $21.
Therefore, the value of opening inventory of finished goods is $7,350 (350 × $21).

[3] Production The production costs for the period are calculated by multiplying the number of footballs
costs for the to be produced in the period, based on the production budget, by the standard cost per
period football.
5,000 × $21 = $105,000

[4] Closing The closing inventory value of $11,550 comprises the closing inventory of finished
inventory value goods.
The closing inventory of finished footballs is calculated by multiplying the number of
footballs in closing inventory, which equals 550, by the standard cost of producing one
football, which equals $21.
Therefore, the value of closing inventory of finished goods is $11,550 (550 × $21).

[5] Production cost Production cost of sales = opening inventory + production costs − closing inventory =
of sales $(7,350 + 105,000 − 11,550) = $100,800

[6] Gross profit Gross profit = Sales revenue − production cost of sales = $(168,000 − 100,800) = $67,200

[7] Non-production Non-production overheads are stated as being $36,600 in the information available.
overheads

[8] Net profit Net profit = gross profit − non-production overheads = $(67,200 − 36,600) = $30,600

Activity 10

Use the following information to practise preparing the budgeted statement of profit or loss for the coming
year for a company that makes a single product, Product ABC, using the given template.

Note: You are required to calculate the budgeted production.

Standard cost of one unit of Product ABC $8

Budgeted sales 23,000 units sold

Budgeted selling price $12.50

Non-production overhead budget $49,000

Opening inventory of finished goods of Product ABC 2,500 units

Closing inventory of finished goods of Product ABC 2,000 units

Budgeted statement of profit or loss

$ $

Sales revenue

Cost of sales

Opening inventory

Production costs

Closing inventory

Production cost of sales

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Gross profit

Non-production overheads

Net profit

*Please use the notes feature in the toolbar to help formulate your answer.

Budgeted statement of profit or loss

$ $ Note
Sales revenue 287,500 1
Cost of sales
Opening inventory 20,000 2
Production costs 180,000 3
Closing inventory (16,000) 4
Production cost of sales (184,000) 5
Gross profit 103,500 6
Non-production overheads (49,000) 7
Net profit 54,500 8

Notes

[1] Budgeted sales volume × Budgeted sales price = 23,000 × $12.50 = $287,500

[2] Opening inventory of finished goods = 2,500 units × Standard cost per unit of Product ABC = 2,500 × $8 =
$20,000

[3] Production cost of finished goods = Budgeted production x Standard cost per unit of Product ABC =
22,500 units × $8 = $180,000

Budgeted Production Units

Sales budget 23,000

+ Closing inventory 2,000
− Opening inventory (2,500)
Production budget 22,500

[4] Closing inventory of finished goods = 2,000 units × Standard cost per unit of Product ABC = 2,000 × $8 =
$16,000

[5] Production cost of sales = Opening inventory + Production costs − Closing inventory = $(20,000 + 180,000
− 16,000) = 184,000

[6] Gross profit = Sales revenue − Production cost of sales = $(287,500 − 184,000) = $103,500

[7] Non-production overheads are stated as being $49,000

[8] Net profit = Gross profit − Non-production overheads = $(103,500 − 49,000) = $54,500
Activity 11 Budget Preparation

Annie manufactures exclusive office equipment and is attempting to prepare a budget for March.

The following information is relevant:

Opening inventory in units Budgeted sales in units March Selling price

Chairs 63 290 120

Desks 36 120 208

Stools 90 230 51

Annie requires that her closing inventory be 30% of that month's sales.

All three products are made using wood, plastic, unskilled labour, skilled labour and other overheads. The
quantities per unit of equipment are as follows:

Wood Plastic Unskilled Skilled labour

labour

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m3 m3 Hour Hour

Chairs 4 2 3 2

Desks 5 3 5 8

Stools 2 1 2 –

Cost per m / per hour $12

3
$7 $4 $6

Annie's opening inventory of raw materials is 142 cubic metres of wood and 81 cubic metres of plastic. She
intends to increase this during March, however, so that she always has sufficient raw materials to produce
50 units of each item of equipment.

Overheads are recovered at $1 per labour hour (unskilled and skilled).

(a) Prepare functional budgets for March for:

(i) Sales

(ii) Production

(iii) Materials usage

(iv) Labour usage

(v) Materials purchases

(b) (i) Calculate the standard cost per unit for each item of equipment.

(ii) Prepare a budgeted statement of profit or loss and calculate gross profit for the month ending 31 March.

*Please use the notes feature in the toolbar to help formulate your answer.

. Functional budgets

(i) Sales budget

.
Chairs Desks Stools Total$

Quantity 290 120 230

Price $120 $208 $51

Value $34,800 $24,960 $11,730 $71,490

.
(ii) Production budget in units

.
Chairs Desks Stools

Sales 290 120 230

Add: Closing inventory (30% of Sales) 87 36 69

Less: Opening inventory (63) (36) (90)

Production 314 120 209

.
(iii) Materials usage in units (m3)

.
Material Wood (m3) Plastic (m3)

Chairs (314 × 4) 1,256 (314 × 2) 628

Desks (120 × 5) 600 (120 × 3) 360

Stools (209 × 2) 418 (209 × 1) 209

2,274 1,197

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(iv) Labour usage

.
Unskilled Hours Skilled Hours

Chairs (314 × 3) 942 (314 × 2) 628

Desks (120 × 5) 600 (120 × 8) 960

Stools (209 × 2) 418 NA

1,960 1,588

Cost per hour ($) 4 6

Total Cost ($) 7,840 9,528

.
(v) Materials purchases budget

.
Material Wood (m3) Plastic (m3)

Usage 2,274 1,197

Add: Closing inventory

50 × (4 + 5 + 2) 550

50 × (2 + 3 + 1) 300

2,824 1,497

Less: Opening inventory (142) (81)

Quantity purchased 2,682 1,416

Cost per m 3
12 7

Total Purchases ($) 32,184 9,912

.
. (i) Standard cost per unit
Chairs Desks Stools
$ $ $

Wood ($12 × 4) 48 ($12 × 5) 60 ($12 × 2) 24

Plastic ($7 × 2) 14 ($7 × 3) 21 ($7 × 1) 7
Unskilled labour ($4 × 3) 12 ($4 × 5) 20 ($4 × 2) 8
Skilled labour ($6 × 2) 12 ($6 × 8) 48 NA N/A
Overhead ($1 × 5) 5 ($1 × 13) 13 ($1 × 2) 2
Cost per unit 91 162 41

.
(ii) Budgeted statement of profit or loss for the month ending 31 March

.
$ $ Note
Sales 71,490 [1]
Less cost of sales:
Opening inventory of finished goods 15,255 [2]
Production cost of finished goods 56,583 [3]
71,838
Closing inventory of finished goods (16,578) [4]
Production cost of sales (55,260) [5]
Gross profit 16,230 [6]
.

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Workings:

.
Note Item Description

[1] Sales revenue figure From sales budget in (a)(i).

[2] Opening and closing Opening and closing inventory units are from production budget in (a)(ii).
and inventories of finished Standard cost per unit from (b)(i).
[4] goods Chairs Desks Stools Total $
Opening inventory (units) 63 36 90
(x standard cost) $91 $162 $41
= Opening inventory ($) 5,733 5,832 3,690 15,255
Closing inventory (units) 87 36 69
(x standard cost) $91 $162 $41
= Closing inventory ($) 7,917 5,832 2,829 16,578

[3] Production cost of Budgeted production (a)(ii) x standard cost per unit (b)(i)
finished goods (314 × $91) + (120 × $162) + (209 × $41)
= $28,574 + $19,440 + $8,569 = $56,583

[5] Production cost of sales Opening inventory + production cost − closing inventory
= $15,255 + $56,583 − $16,578 = $55,260

[6] Gross profit Sales − cost of sales

= $71,490 − $55,260 = $16,230

.
18.3.5 Budgeted Statement Of Financial Position
3.5 Budgeted Statement Of Financial Position

The budgeted statement of financial position shows the assets and the liabilities (what the business owns
and owes) at the end of the budget period.
The following example shows Winston Football Factory’s budgeted statement of financial position at
01.01.X5 (the beginning of the budget period) and at 31.12.X5 (the end of the budget period). The budgeted
statement of financial position at 31.12.X5 reflects the budgeted change in cash over the year (from the cash
budget) and the budgeted profit or loss for the year (from the budgeted statement of profit or loss).

Example

The budgeted statement of financial position for Winston’s Football Factory at the beginning of the budget
period at 01.01.X5 is as follows:

Statement of financial position at 01.01.X5

Note $ $

Non-current assets [1] 220,000

Current assets

Inventory [2] 8,550

Trade receivables [3] 8,400

Cash [4] 72,000

[A] [5] 88,950

Current liabilities [6]

Trade payables [6] 1,400

Other short-term liabilities [7] 15,000

[B] [8] 16,400

Net current assets (A) − (B) [9] 72,550

Net assets [10] 292,550

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Example

Note Item Description (at 01.01.X5)

[1] Non-current Non-current assets is another name for fixed assets. The figure of $220,000 is brought
assets forward from 31.12.X4.

[2] Inventory in Inventory in the warehouse at the beginning of the budget period. It comprises the
the warehouse finished football inventory (350 units valued at $21 each [equalling $7,350] and the
value of the raw materials held in inventory = 400 kg × $3 = $1,200.
Total inventory value at 01.01.X5 = $(7,350 + 1,200) = $8,550.
(see 3.4 Budgeted Statement of Profit or Loss – Example; and 2.4.2 Materials
Purchases Budget − Example)

[3] Trade Trade receivables are the amount due from customers at the beginning of the budget
receivables period and are represented by 60% of the sales in December 20X4, which are expected
to be paid in January 20X5.
60% × $14,000 = $8,400
(see 3.2 Timing of Cash Flows – Activity 7)

[4] Cash (opening Cash of $72,000 is given as the opening balance in the cash budget.
balance)
(see 3.3 Cash Budget – Activity 8)

[5] Total of the The figure at [A] is the total of the current assets.
current assets
In the example, it is the inventory plus trade receivables plus cash, which equals
$88,950.
$8,550 + $8,400 + $72,000 = $88,950

[6] Trade payables Assuming the standard one-month credit period for materials purchases, trade
payables represent the value of the outstanding credit purchases of materials at the
end of December 20X4, that is, one month’s purchases of $1,400.
$16,800 ÷ 12 = $1,400
(see 2.4.2 Materials Purchases Budget – Example)

[7] Other short- Other short-term liabilities include the bank loan of $15,000, which will be repaid in
term liabilities month 2 of the budget period on 14.02.X5.
(see 3.3 Cash Budget – Activity 8)

[8] Total of The current liabilities are totalled at this point.

current
$1,400 + $15,000 = $16,400
liabilities

[9] Net current The net current assets are the difference between the current assets and the current
assets liabilities, in this case, $72,550.

[10] Net assets The net assets are the total of the non-current and net current assets, which in this
situation equals $292,550.

The budgeted statement of financial position for Winston’s Football Factory at the end of the budget
period at 31.12.X5 is as follows:

Statement of financial position Statement of financial position

at 01.01.X5 at 31.12.X5

Note $ $ $ $

Non-current assets [1] 220,000 260,000

Current assets

Inventory [2] 8,550 14,550

Trade receivables [3] 8,400 8,400

Cash [4] 72,000 41,600

[A] [5] 88,950 64,550

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Current liabilities

Trade payables [6] 1,400 1,400

Other short-term [7] 15,000 0

liabilities

[B] [8] 16,400 1,400

Net current assets [9] 72,550 63,150

(A) – (B)

Net assets [10] 292,550 323,150

Note Item Description (at 31.12.X5)

[1] Non-current The figure is increased by $40,000 which is the non-current asset purchased on 13.06.X5.
assets
$220,000 + $40,000 = £260,000
(see 3.3 Cash Budget – Activity 8)

[2] Inventory in Inventory in the warehouse at the end of the budget period. It comprises the finished
the warehouse football inventory (550 units valued at $21 each [equalling $11,550] and the value of the
raw materials held in inventory = 1,000 kg × $3 = $3,000.
Total inventory value at 31.12.X5 = $(11,550 + 3,000) = $14,550.
(see 3.4 Budgeted Statement of Profit or Loss – Example; and 2.4.2 Materials Purchases
Budget – Example)

[3] Trade Trade receivables are the amount due from customers at the end of the budget period
receivables and are represented by 60% of the sales in December 20X5, which are expected to be
paid in January 20X6.
60% × $14,000 = $8,400
(see 3.2 Timing of Cash Flows – Activity 7)

[4] Cash (closing $

balance)
Opening cash balance 72,000
Purchase of non-current asset (40,000)
Repayment of loan (15,000)
Change in inventory ($8,550 − $14,550) (6,000)
Profit (see 3.4 Budgeted Statement of Profit or Loss) 30,600
Closing cash balance 41,600
The net cash outflow for the year is $30,400
= ($72,000 − $41,600)
(see 3.3 Cash Budget – Activity 8 Solution)

[5] Total of the The figure at [A] is the total of the current assets.
current assets
In the example, it is the inventory plus trade receivables plus cash, which equals $64,550.
$14,550 + $8,400 + $41,600 = $64,550

[6] Trade Assuming the standard one-month credit period for materials purchases, trade payables
payables represent the value of the outstanding credit purchases of materials at the end of
December 20X5, that is, one month’s purchases of $1,400.
$16,800 ÷ 12 = $1,400
(see 2.4.2 Materials Purchases Budget – Example)

[7] Other short- Other short-term liabilities are nil at 31.12.X5 because the bank loan of $15,000 was
term liabilities repaid in month 2 of the budget period on 14.02.X5.
(see 3.3 Cash Budget – Activity 8)

[8] Total of The current liabilities are totalled at this point.

current
$1,400 + $15,000 = $16,400
liabilities

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[9] Net current The net current assets are the difference between the current assets and the current
assets liabilities, in this case, $63,150.

[10] Net assets The net assets are the total of the non-current and net current assets, which in this
situation equals $323,150.
18.4.1 Asset Expenditure
4.1 Asset Expenditure

Asset expenditure is when an organisation spends a large amount of money buying non-current assets.
 It involves investing large sums of money in a future project
 The aim is to generate future revenues
 investment appraisal is an essential stage of the capital budgeting proce
18.4.2 Asset Expenditure Planning And Control
4.2 Asset Expenditure Planning And Control

Large sums of money are involved in most investment projects. However, once long-term investments have
started, they cannot be reversed without losing some of the capital invested. Therefore, organisations must
select the capital investments that will be the most profitable in the long run.
Investment planning takes place at the beginning of the asset expenditure budgeting process. Organisations
consider the investments that may be required in the medium- to long-term at the strategic planning stage.
There are several steps in the asset expenditure budgeting process.

Stage Description

Plan Investment projects are usually planned during the strategic planning process when
expenditure organisations create medium-long-term goals and decide how they will be achieved. Senior
managers typically plan this and focus on investment in the next five to 10 years.

Identify An organisation identifies all possible projects that may be suitable to achieve the long-term
possible goals of the organisation and their associated costs and revenues.
projects

Appraise Investment appraisal is the next investment planning and control stage and involves appraising
possible individual projects. During the appraisal process, organisations often estimate future relevant
projects costs and revenues and discount them to work out their net present value.

Select the best Once the investment appraisal process has been completed, the most suitable project is
project selected based on the company’s requirements.
For example, a company may have a required rate of return for new projects, or a minimum
discounted payback period.
The project selected must be approved by the asset expenditure committee.

Start project Once the most suitable project has been selected and approved, the initial investment in the
project can start, for example, buying the new machine or building under consideration.

Control project This stage of the investment process is where the costs and revenues are monitored by
comparing actual project revenues and expenditures with the budget.
Any significant variations in revenues and expenditures are investigated. The project is also
reviewed over its lifetime so that information can be gathered and used to aid future capital
investment projects.

18.4.3 Relevant Cash Flows

4.3 Relevant Cash Flows

Investment appraisal is concerned with the relevant cash flows arising rather than accounting profits.
Relevant cash flows are cash flows that arise directly from the decision to invest in something, for example,
a new machine. Cash flows that occur as a direct consequence of a particular decision are often called
incremental cash flows.
Examples of relevant cash flows include:
 Initial cost of the investment
 Running costs of the investment
 The amount of income that the investment will generate
 Any cost savings that may arise as a result of going ahead with the investment
 Any sale proceeds that may arise at the end of the investment’s useful life (residual value).

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Activity 12

Determine if the item of expenditure is a relevant or irrelevant cash flow.

Relevant or
Item of expenditure
Irrelevant

The purchase cost of a non-current asset

Cost of the market research survey paid before

the investment decision is made.

Annual depreciation charge of a non-current

asset

Training costs to teach employees how to

operate the new machine (non-current asset)

*Please use the notes feature in the toolbar to help formulate your answer.

Item of expenditure Relevant or Irrelevant

The purchase cost of a non- Relevant

current asset The purchase of the non-current asset is relevant. This is because if the
project goes ahead, there will be cash outflow to acquire the non-current
asset.

Cost of the market research Irrelevant

survey paid before the investment The market research costs are not relevant to the decision. This is because
decision is made. they are not future cash flows from the decision to purchase the asset. They
have already been paid and cannot be influenced by the decision.

Annual depreciation charge of a Irrelevant

non-current asset Depreciation is a non-cash item. Therefore, it does not generate a cash flow
and is not a relevant cost.

Training costs to teach employees Relevant

how to operate the new machine Training costs are future cash flows that will arise as a direct result of
(non-current asset) deciding to buy the asset. Training costs are, therefore, a relevant cost.

Chapter 19: Fixed and Flexible Budgets,

Budgetary Control, and Reporting
19.1.1 Fixed Budget
1.1 Fixed Budget

A fixed budget is a budget that is produced for a single level of activity. It is prepared before the beginning of
a budget period at the planning stage of the planning and control cycle.

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Example

Winston’s Football Factory produced a series of functional budgets based on the sale of 4,800 footballs and the
production of 5,000 footballs. The fixed budget for 4,800 footballs is summarised below:

Winston’s Football Factory – Fixed Budget For 20X5 – 4,800 Footballs

$ Note

Sales revenue 168,000 [1]

Materials cost 14,400 [2]

Labour cost 57,600 [3]

Variable production overheads 9,600 [4]

Fixed production overheads 19,200 [5]

Non-production overheads 36,600 [6]

Budgeted profit 30,600 [7]

Note Description

[1] The sales revenue budget is based on sales of 4,800 footballs at a budgeted selling price of $35 per
football. Sales revenue = 4,800 × $35 = $168,000.

[2] The materials cost budget is the cost of producing 4,800 footballs at a standard materials cost of $3 per
football. Materials cost budget = 4,800 × $3 = $14,400.

[3] The labour cost budget is the cost associated with producing 4,800 footballs at a standard labour cost of
$12 per football = 4,800 × $12 = $57,600.
Alternatively, the budgeted labour hours associated with producing 4,800 footballs is 2 hours per
football. Therefore, the budgeted labour hours are 9,600 at this production level, and the cost per labour
hour is $6. This means the labour cost budget = 9,600 × $6 = $57,600.

[4] The variable production overhead budget is the production overhead cost associated with producing
4,800 footballs at a standard variable overhead cost of $2 per unit = 4,800 × $2 = $9,600 (Alternatively,
9,600 labour hours × $1 per hour = $9,600).

[5] The fixed production overhead budget is $19,200.

[6] The non-production overheads are fixed at $36,600.

[7] The budgeted profit of $30,600 is the difference between the budgeted sales revenue of $168,000 and all
the budgeted costs listed in the table above.

19.1.2 Flexible budgets

1.2 Flexible budgets

Flexible budgets are sometimes prepared simultaneously with the original (fixed) budgets, allowing an
organisation to see how much profit can be earned at different sales levels.
A flexible budget shows what costs and revenues are expected to be at different activity levels. For example,
material is a variable cost. Using the information in Activity 1 below, at a production level of 4,800 footballs,
material cost per unit is $14,400/4,800 = $3. Therefore, at a production level of 5,000 footballs, material cost
would be expected to be $3 x 5,000 = $15,000. Fixed costs, however, remain fixed.
Activity 1

Winston’s Football Factory wants to prepare a flexible budget for varying activity levels. Therefore, the
following template has been prepared.

WINSTON’S FOOTBALL FACTORY – FLEXIBLE BUDGET FOR 20X5

Number of footballs 4,800 5,000 5,200

$ $ $

Sales revenue 168,000

Materials cost 14,400 15,000

Labour cost 57,600

Variable production overheads 9,600

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Fixed production overheads 19,200 19,200

Non-production overheads 36,600 36,600

Budgeted profit 30,600

Complete the flexible budget using the above template.

*Please use the notes feature in the toolbar to help formulate your answer.

Number of footballs 4,800 5,000 5,200

$ $ $

Sales revenue 168,000 [1]175,000 [8]182,000

Materials cost 14,400 [2]15,000 [9]15,600

Labour cost 57,600 [3]60,000 [10]62,400

Variable production overheads 9,600 [4]10,000 [11]10,400

Fixed production overheads 19,200 [5]19,200 [12]19,200

Non-production overheads 36,600 [6]36,600 [13]36,600

Budgeted profit 30,600 [7]34,200 [14]37,800

Workings:

[1] 5,000/4,800 × $168,000 = $175,000

[2] 5,000/4,800 × $14,400 = $15,000

[3] 5,000/4,800 × $57,600 = $60,000

[4] 5,000/4,800 × $9,600 = $10,000

[5] Fixed production overheads are the same at all levels of sales and so will be $19,200.

[6] Non-production overheads are the same at all levels of sales and so will be $36,600.

[7] Budgeted profit = $(175,000 − 15,000 − 60,000 − 10,000 − 19,200 − 36,600) = $34,200

[8] 5,200/4,800 × $168,000 = $182,000

[9] 5,200/4,800 × $14,400 = $15,600

[10] 5,200/4,800 × $57,600 = $62,400

[11] 5,200/4,800 × $9,600 = $10,400

[12] Fixed production overheads are the same at all levels of sales and so will be $19,200.

[13] Non-production overheads are the same at all levels of sales and so will be $36,600.

[14] Budgeted profit = $(182,000 − 15,600 − 62,400 − 10,400 − 19,200 − 36,600) = $37,800
Activity 2

Jerry’s Toys, which makes a single product, the Moogie, wants to produce a flexible budget for the year.

It sells Moogies for $36 each.

Moogie standard cost card:

Cost element $ per unit

Materials 3

Labour 12

Variable production overhead 2

Complete Jerry Toys’s flexible budget for the activity levels of 5,000 and 5,200 Moogies produced and sold,
calculating budgeted profit.

Flexible Budget Number of Moogies

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Units produced and sold 4,800 5,000 5,200

$ $ $

Sales revenue 172,800

Materials cost 14,400

Labour cost 57,600

Variable production overheads 9,600

Fixed production overheads 19,200

Non-production overheads 36,600

Budgeted profit 35,400

*Please use the notes feature in the toolbar to help formulate your answer.

Flexible budget Number of Moogies

Units produced and sold 4,800 5,000 5,200

$ $ $

Sales revenue 172,800 [1]180,000 [8]187,200

Materials cost 14,400 [2]15,000 [9]15,600

Labour cost 57,600 [3]60,000 [10]62,400

Variable production overheads 9,600 [4]10,000 [11]10,400

Fixed production overheads 19,200 [5]19,200 [12]19,200

Non-production overheads 36,600 [6]36,600 [13]36,600

Budgeted profit 35,400 [7]39,200 [14]43,000

Workings:

[1] 5,000 × $36 = $180,000

[2] 5,000/4,800 × $14,400 = $15,000

[3] 5,000/4,800 × $57,600 = $60,000

[4] 5,000/4,800 × $9,600 = $10,000

[5] Fixed production overheads are the same at all levels of sales and so will be $19,200.

[6] Non-production overheads are the same at all levels of sales and so will be $36,600.

[7] Budgeted profit = $(180,000 − 15,000 − 60,000 − 10,000 − 19,200 − 36,600) = $39,200

[8] 5,200 × $36 = $187,200

[9] 5,200/4,800 × $14,400 = $15,600

[10] 5,200/4,800 × $57,600 = $62,400

[11] 5,200/4,800 × $9,600 = $10,400

[12] Fixed production overheads are the same at all levels of sales and so will be $19,200.

[13] Non-production overheads are the same at all levels of sales and so will be $36,600.

[14] Budgeted profit = $(187,200 − 15,600 − 62,400 − 10,400 − 19,200 − 36,600) = $43,000
19.1.3 Flexed Budget
1.3 Flexed Budget

Fixed budgets, based on the assumption that a fixed volume of sales will occur in the period, are not very
useful because it is not possible to make any meaningful comparisons if the actual results for sales are
different than stated. This is the main disadvantage of using fixed budgets in the control process –not
comparing like with like.
The solution is to flex the budget to the actual activity levels.

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A flexed budget is a budget that is prepared by adjusting the original budget to show expected costs and
revenues for the actual activity level.
For example, if sales volume is higher than expected, the costs contained within the budget that would be
expected to vary with sales volume would be updated.
Actual revenue and costs are then compared with the flexed budget and variances are calculated.

Example

Following on from Activity 1, the actual sales of Winston’s Football Factory were 5,100 footballs. Therefore, to
compare actual results to the budget, the budget has been flexed to the actual sales:

Fixed budget Flexed budget

Number of footballs 4,800 5,100

$ $

Sales revenue 168,000 178,500

Materials cost 14,400 15,300

Labour cost 57,600 61,200

Variable production overheads 9,600 10,200

Fixed production overheads 19,200 19,200

Non-production overheads 36,600 36,600

Budgeted profit 30,600 36,000

Activity 3 Flexed Budgets

KK has prepared an original budget as follows:

$000
Sales (50,000 items @ $100) 5,000

Production costs (55,000 units)

Materials (55,000 × $40) 2,200
Labour (55,000 × $3) 165
Variable overheads (55,000 × $9) 495
Fixed overheads (55,000 × $15) 825
Budgeted cost of production 3,685

Actual sales were 53,000 units, and production was 56,000 units.

Prepare a flexed budget for the actual level of activity.

*Please use the notes feature in the toolbar to help formulate your answer.

$000 Notes
Sales (53,000 × $100) 5,300 1
Production costs 1
Materials (56,000 × $40) 2,240
Labour (56,000 × $3) 168
Variable overheads (56,000 × $9) 504
Fixed overheads (825) 2
Flexed budgeted cost of production 3,737

Notes:

1. Only the activity levels (for sales and production) are changed. Unit selling prices and unit costs
are unchanged.
2. Fixed costs do not change with activity levels, so the ‘flexed’ budget is simply the total original
budgeted fixed cost. The total original budgeted fixed cost was $825,000.
19.1.4 Simple variances
1.4 Simple variances

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Calculate simple variances by subtracting the actual results from the flexed budget figures. Generally, the
variance is favourable if the results are better than expected.
Favourable variances (F) occur, for example, when:
 Sales revenue is higher than expected
 Costs are lower than expected.
Favourable variances have a positive effect on profit.
Adverse variances (A) occur, for example, when:
 Sales revenue is lower than expected
 Costs are higher than expected.
Adverse variances have a negative effect on profit.

Example

Flexed Actual Variance Note

budget results

Number of 5,100 5,100

footballs

$ $ $

Sales revenue 178,500 168,300 10,200 A This is the difference between the expected sales revenue (as
shown in the flexed budget) and the actual results for the period
= $(178,500 − 168,300) = $10,200.
Sales revenue is lower than expected, so this variance is
adverse.

Materials cost 15,300 14,175 1,125 F This is the difference between the expected materials cost (as
shown in the flexed budget) and the actual results for the period
= $(15,300 − 14,175) = $1,125.
Materials costs are lower than expected, so this variance is
favourable.

Labour cost 61,200 52,000 9,200 F This is the difference between the expected labour cost (as
shown in the flexed budget) and the actual results for the period
= $(61,200 − 52,000) = $9,200.
Labour costs are lower than expected, so this variance is
favourable.

Variable 10,200 12,480 2,280 A This is the difference between the expected variable production
production overheads (as shown in the flexed budget) and the actual
overheads results for the period = $(10,200 − 12,480) = −$2,280.
Variable production overheads are higher than expected, so this
variance is adverse.

Fixed 19,200 19,760 560 A This is the difference between the expected fixed production
production overheads (as shown in the flexed budget) and the actual
overheads results for the period = $(19,200 − 19,760) = $560.
Fixed production overheads costs are higher than expected, so
this variance is adverse.

Non- 36,600 34,500 2,100 F This is the difference between the expected non-production
production overheads (as shown in the flexed budget) and the actual
overheads results for the period = $(36,600 − 34,500) = $2,100.
Non-production overheads costs are lower than expected, so
this variance is favourable.

Budgeted 36,000 35,385 615 A This variance can be calculated in two different ways:
profit
 The sum of all of the individual variances = $(−10,200 +
1,125 + 9,200 − 2,280 − 560 + 2,100) = −$615
 The difference between the budgeted profit and the
actual profit = $(35,385 − 36,000) = −$615
It is adverse because the profit was lower than expected.

Activity 4

Determine the variance for each cost item in the operating statement below.

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“F” is Favourable, “A” is Adverse

Budget 20X1 Actual 20X1 Variance

($) ($) ($)

Production (units) 1,000 1,000

Direct materials 6,000 6,300

Direct labour 13,000 13,000
Direct expenses 1,000 1,010
Direct cost 20,000 20,310
Production overheads 5,000 4,900
Other overheads 10,000 10,000
TOTAL COST 35,000 35,210

*Please use the notes feature in the toolbar to help formulate your answer.

Budget Actual
20X1 20X1 Variance
($) ($) ($) Notes
Production (units) 1,000 1,000
Direct materials ended up costing $300 more than
Direct materials
6,000 6,300 300 A expected.
Direct labour 13,000 13,000 0
Direct expenses were also $10 more than the
Direct expenses
1,000 1,010 10 A original budget predicted.
Direct cost 20,000 20,310 310 A
Production
overheads 5,000 4,900 100 F Production overheads were $100 less than expected.
Other overheads 10,000 10,000 0
TOTAL COST 35,000 35,210 210 A

Activity 5: Variances

Fill in the appropriate figures in the spaces given to complete the variance statement.

“F” is Favourable, “A” is Adverse

Budget 20X1 Actual 20X1 Variance

($) ($) ($)

Production (units) 1,000 1,000

Direct materials 6,000 6,100

Direct labour 13,000 200 A
Direct expenses 1,000 1,030
Direct cost 20,000 20,330
Production overheads 4,900 200 F
Other overheads 10,000 10,000
TOTAL COST 35,100

*Please use the notes feature in the toolbar to help formulate your answer.

Budget 20X1 Actual 20X1 Variance

($) ($) ($)
Production (units) 1,000 1,000

Direct materials 6,000 6,100 100 A

Direct labour 13,000 13,200 200 A
Direct expenses 1,000 1,030 30 A
Direct cost 20,000 20,330
Production overheads 5,100 4,900 200 F
Other overheads 10,000 10,000 0
TOTAL COST 35,100 35,230 130 A

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Activity 6

The following standard cost card for a product is available.

Unit cost card $

Direct materials 6
Direct labour 13
Direct expenses 1
Total direct (prime) cost 20

Budgeted production overheads are $5,000, and other overheads are expected to be $10,000.

The company has the following actual results for 20X1.

Actual 20X1
($)

Production (units) 1,200

Direct materials 6,600

Direct labour 16,800
Direct expenses 1,080
Direct cost 24,480
Production overheads 5,100
Other overheads 11,000
TOTAL COST 40,580

Calculate a flexed budget for the actual activity level of 1,200 units and simple variances compared with the
actual results.

*Please use the notes feature in the toolbar to help formulate your answer.

Flexed Budget 20X1 Actual 20X1 Variance

($) ($) ($)
Production (units) 1,200 1,200

Direct materials 7,200 6,600 600 F

Direct labour 15,600 16,800 1,200 A
Direct expenses 1,200 1,080 120 F
Direct cost 24,000 24,480 480 A
Production overheads 5,000 5,100 100 A
Other overheads 10,000 11,000 1,000 A
TOTAL COST 39,000 40,580 1,580 A
19.1.5 Semi-variable costs
1.5 Semi-variable costs

Sometimes the cost behaviour in a flexible budget may be determined using the high-low linear regression
method.
Activity 7

QPTM Co prepared the following flexible budget for the coming year.

400 units 500 units 600 units

$ $ $

Materials cost 2,000 2,500 3,000

Labour cost 1,200 1,500 1,800

Production overheads 900 1,000 1,100

Non-production overheads 400 400 400

Actual results were 550 units, and the following costs were incurred :

 Materials cost = $2,650

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 Labour cost = $1,700

 Production overheads = $1,140
 Non-production overheads = $440.
Complete the operating statement below:

Flexed Actual Variance Favourable

budget results (F)/Adverse (A)
550 550
units units

$ $ $

Materials cost

Labour cost

Production
overheads

Non-
production
overheads

*Please use the notes feature in the toolbar to help formulate your answer.

Flexed Actual Variance Favourable Feedback

budget results (F)/Adverse
550 550 (A)
units units

$ $ $

Materials 2,750 2,650 100 [F] 1

cost

Labour 1,650 1,700 50 [A ] 2

cost

Production 1,050 1,140 90 [A ] 3

overheads

Non- 400 440 40 [A ] 4

production
overheads

Feedback

1. Materials cost per unit when 400 units produced = $2,000/400 = $5

Materials cost per unit when 500 units produced = $2,500/500 = $5

2.
Materials cost per unit = $5, which is a variable cost. The materials cost when 550 units produced = 550 × $5
= $2,750

3.
Materials variance = $2,750 − $2,650 = $100 F – the variance is favourable because materials cost was lower
than expected.

4.
5. Labour cost per unit when 400 units produced = $1,200/400 = $3

Labour cost per unit when 500 units produced = $1,500/500 = $3

6.
Labour cost per unit = $3, which is a variable cost. The labour cost when 550 units produced = 550 × $3 =
$1,650

7.

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Labour cost variance = $1,650 − $1,700 = $50 A – is adverse because labour costs were higher than expected.

8.
9. Production overheads cost per unit when 400 units are produced = $900/400 = $2.25

Production overheads cost per unit when 500 units are produced = $1,000/500 = $2

10.
The production overheads are not variable costs but follow the semi-variable cost behaviour pattern. The
high/low method can establish the fixed and variable elements of the production overheads cost.

11.
Variable cost per unit = $(cost at highest level − cost at lowest level)/(units at highest activity level − units at
lowest activity level)

12.
Variable cost per unit = $(1,000 − 900)/(500−400) = $100/100 = $1

13.
Fixed cost element = Total semi-variable cost at highest activity level − (variable cost per unit × number of
units at highest activity level)

14.
Fixed cost element = $1,000 − ($1 × 500) = $1,000 − $500 = $500

15.
Therefore, the flexed overhead budget for 550 units = $500 + (550 × $1) = $1,050

16.
Production overheads variance = $1,050 − $1,140 = $90 A. The variance is adverse because the production
overhead costs were higher than expected.

17.
18. The non-production overheads cost variance = $400 − $440 = $40 A – the variance is adverse
because the non-production overhead costs were higher than expected.
19.1.6 ‘What if’ analysis
1.6 ‘What if’ analysis

Spreadsheets can carry out calculations quickly and accurately. ‘What if’ analysis is one of the most
valuable applications of spreadsheets and allows the consequences of a change of one item of data to be
calculated quickly and accurately.
This is a technique which helps managers of an organisation to see the results that could be obtained from a
variety of different situations, for example, in:
 The preparation of cash budgets
 The preparation of flexible budgets.
Another use of ‘what if’ analysis or scenario planning is preparing flexible budgets, flexed budgets and
variance calculations. Knowing how the costs in a pre-prepared fixed budget behave, a spreadsheet can
prepare flexible budgets for various given activity levels quickly and accurately using relevant formulae.

Example

The cash budget shown below is based on an expected pattern of cash receipts and expenditures (payments) for
Winston’s Football Factory in 20X5:

Quarter 1 Jan-March Quarter 2 April - Quarter 3 July- Quarter 4 Oct- Total Note
June Sept Dec

$ $ $ $ $

Receipts (A) 42,000 42,000 42,000 42,000 168,000 1

Payments

Materials 4,200 4,200 4,200 4,200 16,800 2

Labour 15,000 15,000 15,000 15,000 60,000 3

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Example

Variable 2,500 2,500 2,500 2,500 10,000 4

production
overheads

Fixed 5,000 5,000 5,000 5,000 20,000 5

production
overheads

Non- 9,150 9,150 9,150 9,150 36,600 6

production
overheads

Loan 15,000 15,000 7

repayment

Purchase of 40,000 40,000 8

equipment

Total 50,850 35,850 75,850 35,850

payments
(B)

Net cash (8,850) 6,150 (33,850) 6,150

flow
(A) – (B)

Cash 72,000 63,150 69,300 35,450

balance
brought
forward

Cash 63,150 69,300 35,450 41,600

balance
carried
forward
Notes
[1] Sales budget and expected cash receipts: $42,000 per quarter
[2] Materials purchases budget: $16,800 = $4,200 per quarter
[3] Labour cost budget: $60,000 = $15,000 per quarter
[4] Variable production overheads budget: $10,000 = $2,500 per quarter
[5] Fixed production overheads: $20,000 = $5,000 per quarter
[6] Non-production overheads: $36,600 = $9,150 per quarter
[7] Repayment of loan on 14.02.X5 = $15,000 in Quarter 1
[8] Purchase of non-current asset on 13.06.X5 = $40,000 in Quarter 2
what-if scenario
If the purchase of non-current asset were moved from Q2 to Q3, the cash budget would change accordingly:

If the purchase of non-current asset were moved from Q2 to Q4, the cash budget would change accordingly:

The changes are quickly calculated using a spreadsheet.

Example: What-If Analysis

On average, Alison currently makes and sells 125 designer-label teddies a month. Each teddy costs $10 to make
and sells for $25. Her fixed costs are $15,000 per annum. Therefore her current profit is:

Sales (12 × 125 units @ $25) 37,500

Less: Variable costs (1,500 × $10) 15,000

Contribution 22,500

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Example: What-If Analysis

Less: Fixed costs (15,000)

Profit 7,500

1. "What if" she must reduce the selling price to $20 to compete with mass-produced teddies?
Revenue will be reduced by $7,500 (1,500 × $5). Costs are unchanged, so this also affects contribution (and
profit). This results in no profit.
2.
3. "What if" she reduces her output to 100 teddies a month to make them more exclusive and maintain the
current selling price?
Assuming that fixed costs remain fixed, reducing output by 300 units will reduce contribution by $4,500 (300 ×
($25 − 10)). The revised profit will be $3,000, which appears to be a preferable strategy to (1).
4.
19.2.1 The Planning and Control Cycle
2.1 The Planning and Control Cycle

Organisations set goals and objectives and then create budgets to help them plan how to achieve them. By
comparing the budget and actual data, managers can check performance and adjust processes to improve
or correct performance. Future budgets can be adjusted to predict future results better. This planning and
control cycle enables managers to undertake control processes systematically.

Control step Description

Set goals The organisation’s goals should be linked to its vision – what it wants to achieve long term.
The goals should be reviewed regularly against actual performance to ensure they are
achievable but stretching.

Set objectives This is when the detailed plans are made for the upcoming year. This will include sales targets,
and action production plans and capital investment requirements.
plans

Budget Budgets are financial plans for the implementation of detailed action plans. Depending on what
management wants, these may be ambitious, realistic or easy.
The budgets will be based on assumptions, including customer demand, labour rates, raw
materials, etc.

Implement When the action plans are implemented, the products are made and sold, or services are
provided to customers.

Monitor Actual performance is compared to budget and any other relevant comparators.
Variances are analysed to understand the reasons for the variances. Then, if possible and
necessary, actions are taken to bring results back in line.

Review and When the plan is implemented, any mistaken assumptions made in the budget creation can be
forecast adjusted, and the manager can produce a more realistic projection of the results.
19.2.2 Budgetary Control Reports
2.2 Budgetary Control Reports

Variances are summarised in a budgetary control report and presented to management with findings,
conclusions and recommendations.
Since it would be very time-consuming to investigate every single variance in a budget period, it is usual
to investigate only significant variances before reporting them to management.

19.2.3 Exception Reporting

2.3 Exception Reporting

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Exception reporting ensures that managers only get the information they need to act on by reporting the
significant variances.
The organisation will determine when a variance is “significant”. For a charity, which must report back to
donors, $5 might be significant. For a large multinational company, $10,000 might be the threshold. A
percentage is often used, so variances over a certain percentage are reported to the managers.
For example, any variances over 5% of the flexed budget should be investigated further to determine why
they occurred.

Example

Budgetary Control Statement

Flexed budget Actual Variance Variance as a percentage of

results the flexed budget

Number of footballs 5,100 5,100 %

(Variance / flexed budget)

$ $ $

Sales revenue 178,500 168,300 10,200 A 5.71

Materials cost 15,300 14,175 1,125 F 7.35

Labour cost 61,200 52,000 9,200 F 15.03

Variable production 10,200 12,480 2,280 A 22.35

overheads

Fixed production overheads 19,200 19,760 560 A 2.92

Non-production overheads 36,600 34,500 2,100 F 5.74

Budgeted profit 36,000 35,385 615 A 1.71

Winston’s Football Factory states that any variances over 5% of the flexed budget should be investigated further
to determine why they occurred. The following variances should therefore be investigated:
 Sales variance
 Materials cost variance
 Labour cost variance
 Non-production overheads budget
 Variable production overheads.

Activity 8

QPTM Co’s policy is to investigate all variances which are 5% or more of the flexed budget for a budget
period.

Calculate the variance of each item as a percentage of the flexed budget and indicate whether the variance
should be investigated.

Budgetary Control Statement

Flexed Actual results Variance Variance as a percentage of Investigate variance? Y

budget 550 550 units the flexed budget = Yes N = No
units

$ $ $ %

Materials 2,750 2,650

cost

Labour cost 1,650 1,700

Production 1,050 1,140

overheads

Non- 400 420

production
overheads

QPTM Co should investigate the variances that are 5% or more of flexed budget = Production overheads
variance (8.57%) and non-production overheads variance (5%).

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*Please use the notes feature in the toolbar to help formulate your answer.

Flexed Actual Variance Variance Investigate

budget results as a variance?
550 550 percentage Y = Yes N
units units of the = No
flexed
budget

$ $ $ %

Materials 2,750 2,650 100 [F] 3.64 N

cost

Labour 1,650 1,700 50 [A ] 3.03 N

cost

Production 1,050 1,140 90 [A ] 8.57 Y

overheads

Non- 400 420 20 [A ] 5.00 Y

production
overheads

QPTM Co should investigate the variances that are 5% or more of flexed budget = Production overheads
variance (8.57%) and non-production overheads variance (5%).

19.2.4 Controllable and Non-Controllable Variances

2.4 Controllable and Non-Controllable Variances

It is essential to consider whether a variance is controllable or non-controllable. The manager can correct
controllable variances, but factors beyond the manager’s control cause non-controllable variances.
Managers may have to explain non-controllable variances and adjust their plans accordingly.
For example, an increase in the price of cotton due to a bad harvest is not controllable by the manager.
However, an increase due to purchasing a higher grade than planned is controllable.

Example

The rental cost that an organisation pays to run its business will probably be controlled by the budget holder for
the property or facilities cost centre. The cost of rent is mostly fairly dealt with by sharing the expense across
the different departments based on the area of space each department occupies.
However, the department manager to which rent is apportioned may not have any influence over the rental cost,
so they cannot be responsible for it.
Rent may be part of the overall responsibility of the property manager, to whom it is a controllable cost.

19.2.5 Investigating Variances

2.5 Investigating Variances

When should variances be investigated?

 When the variance is significant (exceeds the threshold %)
 When the variance is controllable
 When the variance investigation is cost-beneficial – in other words, it would not cost more to
investigate than the cost implications of the variance.
Activity 9: Investigating Variances

Match the scenarios of Furniture Co with its effect on cost variance (favourable or adverse)

Effect on cost variance

(Favourable or adverse)

Effect on cost variance

Scenario (Favourable or adverse)

Furniture Co was given an unexpected discount on a batch of cotton for their

loyalty to a supplier.

Furniture Co ordered cheaper dye than it usually uses to save on material

costs. However, the more inexpensive dye was less effective at colouring the
cloth than the regular dye, so much more dye than usual had to be used.

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A market-rate increase meant Furniture Co had to increase wages for their

staff.

Furniture Co decided to change suppliers and use better quality fabric in

production. Labour efficiency increased as the new material was easier to work
with.

*Please use the notes feature in the toolbar to help formulate your answer.

Effect on cost variance

Scenario (Favourable or adverse)

Furniture Co was given an unexpected discount on a batch of cotton for their Favourable
loyalty to a supplier.

Furniture Co ordered cheaper dye than it usually uses to save on material Adverse
costs. However, the more inexpensive dye was less effective at colouring the
cloth than the regular dye, so much more dye than usual had to be used.

A market-rate increase meant Furniture Co had to increase wages for their staff. Adverse

Furniture Co decided to change suppliers and use better quality fabric in

production. Labour efficiency increased as the new material was easier to work
with.
19.2.6 Taking Action On Variances
2.6 Taking Action On Variances

Once a variance has been investigated, the business should know more about why the deviation from the
budget happened.
Management should take action to prevent adverse variances from worsening.
For example, the company may look for alternative suppliers if there is an adverse materials price variance.
In the previous activity, QPTM Co’s significant adverse variable overhead might indicate that machines use
more electricity than expected and should be inspected and overhauled to reduce power consumption.

19.2.7 Responsibility Accounting

2.7 Responsibility Accounting

A responsibility centre is a department or cost centre under the direct responsibility of a manager or a group
of managers.
Responsibility accounting involves an organisation having departments or cost centres where the
responsibility for particular costs and revenues comes under the control of one manager or group of
managers. These managers are usually known as budget holders.
By giving people responsibility for agreed targets, the day-to-day management of the business is spread
among more people. Staff often find that they feel more motivated when they are given responsibility.
Managers who work closely with a particular business area may also know more about it than senior
managers, so they may produce better budgets that are more realistic and motivating.
It is easier to control costs and analyse the results for a budget period when these costs are grouped and
are the responsibility of a specific person or group.
The primary responsibility centres are:
 Cost centre
 Revenue centre
 Profit centre
 Investment centre.
Managers of responsibility centres should only be responsible for the costs they can influence – these are
known as controllable costs. It is, therefore, essential to determine whether costs are controllable or
uncontrollable within a specific responsibility centre.
If employees feel that their performance is being assessed based on factors they cannot control, this will
likely decrease their motivation because the budget and control system would seem unfair.
Managers of responsibility centres must have a clear idea of their areas of responsibility so that there is
never any area of an organisation for which no one takes responsibility.
A company’s organisation chart should show who is responsible for the different cost centres and
departments.
Activity 10

Determine which items each responsibility manager is responsible for by checking the box in the appropriate
column.

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Costs Revenues Asset expenditure

Cost centre manager

Revenue centre manager

Profit centre manager

Investment centre manager

*Please use the notes feature in the toolbar to help formulate your answer.

Costs Revenues Asset expenditure Note

Cost centre manager [KEY] 1

Revenue centre manager [KEY] 2

Profit centre manager [KEY] [KEY] 3

Investment centre manager [KEY] [KEY] [KEY] 4

Notes:

[1] Cost centres are where the costs of a department or organisation are collected. The manager of a specific
cost centre will be responsible for the costs of their cost centre.

[2] Revenue centres are where the revenues of a department or organisation are collected. They are similar
to cost centres, but the manager of a specific revenue centre will be responsible for the revenue of their
revenue centre, not the costs.

[3] Profit centres are where costs and revenues are collected. The costs and revenues of a particular profit
centre will be under the direct responsibility of the profit centre manager.

[4] Investment centre managers are responsible for costs, revenues and asset expenditure.

Chapter 20: Behavioural Aspects of Budgeting

20.1.1 Motivation
1.1 Motivation

Motivation involves factors that help make people interested in what they are doing, for example, being
committed to a job or a hobby. It pushes people to want to achieve either a personal goal or a goal that has
been set for them by someone else.
Motivation is essential within business organisations as employees need to be motivated so that the
company can achieve its objectives. The objectives of an organisation are its long-term goals - that is, where
an organisation would like to see itself in the future.

20.1.2 Goal Congruence

1.2 Goal Congruence

The planning and control systems need to drive all employees (the senior managers, general managers and
factory workers) in the same direction and promote the same desire to achieve the company’s goal. This is
known as goal congruence.

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It is important that all employees, regardless of level, are motivated to achieve the organisation’s aims and
that they are all working toward the same goals.
20.1.3 Effect of Budgets on Motivation
1.3 Effect of Budgets on Motivation

Three main things affect the motivation of employees within the planning and control system:
 Budgets (targets) set by the organisation
 Incentive or reward schemes
 How involved employees are in the budget-setting process.
Budgets are the performance targets set by an organisation in the budget-setting process ahead of a future
budget period.
Budgets can affect the behaviour of the employees of an organisation.

Research has shown that:

 Targets can be used to motivate employees;
 If individuals have higher levels of intended achievement, their actual achievement rises.
But if targets are too easy to achieve (e.g. basic standards), individuals will not be motivated to improve
performance. On the other hand, targets which are too difficult (e.g. ideal standards) can be demotivating.
Research suggests that targets just out of reach are optimal for motivation (e.g. just above the current
standard). However, this is only a general rule. The optimal target may be different from individual to
individual.
An adverse variance may result even though performance has been maximised. Care must be taken to
ensure that the budget holder does not react adversely to this. A solution to the adverse variance might be to
use a lower standard for performance evaluation.

20.1.4 Budgets And Performance Measurement

1.4 Budgets And Performance Measurement

There is a close link between budgets and motivation, and both can directly affect performance.
Hopwood identified three ways of using budgetary information to assess performance at the end of a budget
period.

Budgeting Description
approach

Budget- The performance of employees is judged on their ability to meet short-term budget targets – this
constrained is the most critical aspect of their overall work performance.
style
For example, if the budget is exceeded due to spending on repairing a piece of equipment, even if
it is vital to the work, and the budget is exceeded, this action will be criticised.

Profit In this case, employees are judged on their ability to make their department function more
conscious effectively by, for example, changing a process to make it faster and more efficient. Of course,
style budgets are still important, but they are used more as guidelines. Therefore, more than budgetary
information is used to evaluate performance.

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Non- Budgetary information is not considered to be important when evaluating performance. Although
accounting all organisations must control how they spend money, there are situations in which other factors
style are more significant. For example, this could happen if the safety department at a train company
exceeds its budget and spends extra money on health and safety checks to meet standard
requirements.

20.1.5 Managerial Incentive Schemes

1.5 Managerial Incentive Schemes

Budgets will only motivate employees up to a certain point.

Two other factors can increase the motivation of employees in an organisation and encourage them to reach
the goals set in a budget period.
 Financial motivation - rewards in the form of incentive schemes
 Non-financial motivation - promotion and increased responsibility.
People are generally motivated by the possibility of earning more money, so organisations will often have
financial incentives in place.
20.1.6 Budgetary Control
1.6 Budgetary Control

Budgetary control involves looking at the actual results for a responsibility centre and seeing how these
results compare to the targets set in the budget-setting process.
At the end of the budget period, responsibility centre managers will be judged on their department’s results.
They and their subordinates should receive a reward or bonus if they have achieved the targets set ahead of
the budget period.
If these managers and their employees are given financial incentives to achieve the targets set for their
responsibility centres, there is a greater chance that these targets will be met.
1.6.1 Qualities Of Good Incentive Schemes

Quality Description

Fair The scheme in operation should give employees a fair reward or bonus that recognises their efforts
to achieve the organisation’s aims.

Motivate The scheme in operation should motivate all of the employees of an organisation to work together
towards achieving the aims of the organisation.

Clear The scheme in operation should be clearly stated so that the rewards that employees receive for
achieving the targets are apparent to each employee.

Easily It should be possible to quickly and reliably measure the scheme in operation so that there is no
measured misunderstanding over what each staff member receives when they reach the targets set during a
budget period.
20.1.7 Types Of Incentive Scheme
1.7 Types Of Incentive Scheme

There are several types of incentive schemes that an organisation can use.

Profit-sharing scheme Employees are paid a percentage of the organisation’s profits based on

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their met targets.

Share-option scheme Employees may be offered shares in the organisation they work for at a
discounted price as a reward for their efforts in achieving the
organisation’s targets for a given period.

Individual bonus schemes Individual employees are paid a bonus based on their efforts in achieving
the targets set.

Group bonus schemes Individual employees are paid a bonus based on the efforts of the
department or team they work in when they have achieved the targets set.

20.1.8 Approaches to Budgeting

1.8 Approaches to Budgeting

Two different ways that budgets can be set depending on how involved employees are in the budget-setting
process:

1.8.1 Imposed Budgeting

The top-down approach to budgeting is also known as imposed budgeting. This is because the budgets for a
future period are set by senior managers and imposed on employees without any involvement of the budget
holders, such as junior managers.
This means that the managers and employees responsible for achieving the targets set by the budgets do
not have any say in the budget itself. This can have a demotivating effect on the junior managers and
employees who are expected to reach the targets set by the senior managers.
1.8.2 Participative Approach To Budgeting
The bottom-up approach is also known as the participative approach to budgeting. As part of this approach
to budgeting, budget holders, for example, junior managers, are involved in the budget-setting process.
If employees at any level are involved in the budget process, they are more likely to accept the budgets set
and work towards the targets for the budget period ahead.
When employees are involved in the budget-setting process, the motivation of the employees of an
organisation is usually increased.

Situations where top-down budgeting may be suitable Situations where bottom-up budgeting may be suitable

Small organisations where departments are closely Large organisations where departments are independent of
involved with other departments. each other.

New organisations. Well-established organisations.

When the economy is struggling. When the economy is booming.

Where non-finance staff do not have the training to Where non-finance staff have suitable training in producing
produce budgets. budgets themselves.
20.1.9 Advantages and Disadvantages of Bottom-Up Budgeting
1.9 Advantages and Disadvantages of Bottom-Up Budgeting

1.9.1 Advantages

Advantage Description

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Motivating It will likely increase the motivation of the employees for whom the budgets
are set.

Achievable Participative budgets are likely to be more achievable because those

employees involved in setting the budgets are the same employees trying to
reach the targets set.

Combines experiences The experience of junior and senior managers is combined in the budget-
setting process.

Realistic Participative budgets are more realistic because of the involvement of lower-
level managers.

Co-ordinates employee and The employee’s personal goals of the employees are coordinated with the
organisational goals organisation’s long-term goals.

Considers employee goals The personal goals of employees will be considered during the budget-setting
process.

1.9.2 Disadvantages
Junior managers may add in budgetary slack to make budgets easier to achieve.
Budgetary slack, also known as budgetary bias or padding, is where costs may be over-estimated in a cost
budget or sales revenue under-estimated in a sales budget to make the budget easy to achieve.
The budget-setting process may need to begin several months before the budget period so that the views of
all of the employees involved in the process can be considered.
If senior managers make changes, the junior managers may view these changes adversely. As a result, there
may be a division between the different levels of management.

Chapter 21: Presenting Information

21.1.1 Emails
1.1 Emails

Emails are widely used in business as they are fast, cost-effective, verifiable (the sender is known), and able
to disseminate information quickly and effectively.
 CC and BCC
In addition to the recipient, emails may be distributed via CC (carbon copy) and BCC (blind carbon copy).

To CC someone is the send a copy of the email to that person, who is not the intended recipient, but should
be kept in the know. The intended recipient also knows that the email has been CC’d by someone else.

To BCC someone is the send a copy of the email to that person, who is not the intended recipient, but should
be kept in the know, without the knowledge of the intended and CC’d recipients.

BCC recipients know to whom the email has been sent and CC’d; the intended and CC’d recipients will not
be aware the email has been sent to BCC recipients.

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
 Signature
Emails are often sent with a formalised signature detailing the sender’s role and other official corporate
information and communication channels.

They also include disclaimers regarding the company’s liability over the contents of the email and data
security guidelines.

21.1.2 Reports
1.2 Reports

Organisations produce different reports for different purposes:

 Standard reports are produced regularly, for example, monthly reports on performance against
budget
 Ad hoc reports are produced to respond to a single situation or problem, for example, a report on
the impact of a new product that a competitor has launched.
The format of a report contains some crucial elements.

Report element Description

Distribution list This should show whom the report was written by, sent to, and its date.
and date

Introduction The introduction should describe the purpose and reason behind the report and explain any
terms used if necessary. It should also outline any limitations in the information within the
message.

Sections The report should be organised logically and divided into sub-headings. Each paragraph needs a
clear point.

Summary Pinpoint description: Reports should include a summary and recommendations where
appropriate.
Reports may include charts, graphs and tables. When writing a report, consider if any information can be
presented in these ways to help non-financial managers understand the information more easily.
These elements help the user process the available information when reading a report.
 Reading the summary and conclusion provides a quick overview of what the report is trying to
communicate.
 The introduction would provide some context to the reason and purpose of the report.

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 Headings allow the user to drill down quickly to the relevant section in the report they need to
understand.
21.1.3 The Report Writing Process
1.3 The Report Writing Process

There are three main stages in the report writing process.

Stage Description

Plan It is a good idea to plan before starting. Here are some points to think about:
 The type of report to write.
 Who the report is for.
 The purpose of the report.
 What needs to be stated.
Also, consider whether there should be visualisations or analyses in the report:
 Tables
 Charts
 Graphs
 Analyses
 Ideas and opinions.

Write Make sure to write the report so its contents and meaning are clear to the reader.
This will include paying attention to the following:
 Spelling
 Punctuation
 Grammar
 Use of English - keep sentences short and to the point
 Choice of words and phrases – do not use overly-complex words
 Calculations – they must be accurate.
Remember that when writing a report for management, it should communicate professionally.

Review Once the first draft of the report is completed, it should be reviewed before sending it off.
The review process includes the following:
 Checking that all areas of the report that are required are covered.
 Reading through everything written and checking spelling and grammar
 Making sure that the report is clear and easy to understand.
21.2.1 Tables
2.1 Tables

Tables should be set up to fit on one page or a single display. This makes them much more user-friendly so
that all the information can be simultaneously seen.
If data or information used to prepare a table has been taken from a specific source, this should be noted
somewhere on the table.
Guidelines to produce tables:
 Has a suitable title.
 Each column has a heading
 Each row has a heading
 Totals are shown in bold
Cost and revenues of different sales levels at Winston’s Football
Factory

Level of 4,800 4,900 5,000 5,100 5,200 5,300

sales
(number of
footballs)

$ $ $ $ $ $

Sales 168,000 171,500 175,000 178,500 182,000 185,500

revenue

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Materials 14,400 14,700 15,000 15,300 15,600 15,900

cost

Labour 7,500 58,800 60,000 61,200 62,400 63,600

cost

Variable 9,600 9,800 10,000 10,200 10,400 10,600

production
overhead

Fixed 19,200 19,600 20,000 20,400 20,400 21,200

production
overhead

Non- 36,600 36,600 36,600 36,600 36,600 36,600

production
overhead

Budgeted 30,600 32,000 33,400 34,800 36,200 37,600

profit
21.2.2 Data Visualisation (Charts)
2.2 Data Visualisation (Charts)

Once the data has been analysed and cleaned (errors, mistakes, and irrelevant data removed; arranged
meaningfully), it can be presented and communicated to the person(s) who will be using it in a way that they
will find easy to understand.
2.2.1 Advantages and Disadvantages
Data visualisation convert raw data into a visual format that enables humans to hold interest and understand
the message the data is meant to portray.
A good visualisation tells a story, and allows easy identification of trends and outliers.
The disadvantage is that the story being portrayed by the visualisation may be biased or inaccurate, and may
be an attempt to manipulate the understand of the user. Also, it may indicate causation when none exists.
2.2.2 Types Of Data Visualisation
Charts (graphs) and tables are helpful ways of quickly highlighting relationships and trends within data.

Format Example Description

Name

Line Line charts are useful for showing trends over time, such as sales revenue
chart growth.

Bar Bar charts help show comparisons. For example, a company might wish to
chart compare budget expectations against actual results.

Pie chart Pie charts can show a relative comparison to a whole, such as sales in
different regions.

Scatter Scatter graphs show results over two axes, which helps identify correlations
diagram and trends.

Table Tables help show precise numerical data, such as financial statements.

There are also dashboards which might be a combination of several visualisations and charts to give users a
quick glance of the information they need.

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Definitions

The following elements are crucial for effective charts:

Chart Title – Name of the chart, describing its contents and purpose.
Axis Title – Defines the axes of the chart.
Legend (key) – provides context data points displayed on the chart.
Gridlines – Lines on the chart to assist the user in comparing data points to axes.

Activity 1: Charts

Select the best format to present the information given in each scenario. (Line chart, bar chart, pie chart,
scatter chart, or table)

Information Best format

(Line chart, bar chart, pie chart,
scatter chart, or table)

A company wants to understand how production costs respond to

changes in activity.

An organisation has just received the final figures for its actual material
price costs last year and wants to compare them to the budget’s original
estimates.

A company wants to know which product segment contributes the most

revenue relative to total revenue for the period.

A company wants to display the results of a detailed survey of inventory

costs for different products, showing the current month, prior month,
prior year and % changes.

A company wants to compare recorded employee time spent on

producing a product unit and its final quality score to determine if there
is any link.

*Please use the notes feature in the toolbar to help formulate your answer.

Best format
(Line chart, bar chart, pie chart,
Information scatter diagram or table)

A company wants to understand how production costs respond to changes in Line chart
activity.

An organisation has just received the final figures for its actual material price Bar chart
costs last year and wants to compare them to the budget’s original estimates.

A company wants to know which product segment contributes the most Pie chart
revenue relative to total revenue for the period.

A company wants to display the results of a detailed survey of inventory costs Table
for different products, showing the current month, prior month, prior year
and % changes.

A company wants to compare recorded employee time spent on producing a Scatter diagram
product unit and its final quality score to determine if there is any link.
21.2.3 Presenting and Interpreting Data (Bar Charts)
2.3 Presenting and Interpreting Data (Bar Charts)

Bar charts are drawn with two axes: the independent variable on the x-axis and the dependent variable on
the y-axis.
Bar charts must be drawn from the origin (where the x- and y-axes are both zero) to reduce misinterpretation.
Bar charts are best used for comparison between two data series. However, for observing a trend, a line
chart may be superior.
Data presented in a bar chart could cover the following:
2.3.1 A Single Data Series Over Several Periods (Simple Bar Chart)

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This example shows total sales over five years. An increasing trend may be observed. The wider the vertical
gap of a bar compared to another bar, the more significant the change.
The gridlines help to clarify the differences in the bars.
The data series may also be presented horizontally, with the axes reversed.

Example

Franklyn's Football Factory Competitor 1 Competitor 2

Year Sales $000s Sales $000s Sales $000s

1 21.00 28.00 21.00

2 52.00 39.00 39.00

3 24.00 43.20 28.80

The above information is presented as a simple bar chart below:

2.3.2 Multiple Data Series In A Single Period (Simple Bar Chart)

This example shows the sales of each division for the year 20X3. It can be observed that:
 West has significantly fewer sales than the other divisions (shortest bar, much lower than others)
 South had the most sales (tallest bar)
 North, South, and East generate most of the sales. (higher proportion of bars compared to West).
2.3.3 Multiple Data Series Over Multiple Periods (Compound/Clustered Bar Chart)

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This example shows two data series: Total sales and Total costs. The legend (key) is essential in
differentiating the data series. Total sales is blue, and Total costs is red.
Some observations are:
 Sales have exceeded costs every year, indicating profit (the blue bar is higher than the red bar)
 Both sales and costs are increasing over the years.
 Costs have increased faster than sales (the gap between red and blue bars has narrowed over the
years).
 Sales in 20X3 have exceeded $600,000 (blue bar exceeds $600,000 gridline)
 There was a significant increase in sales and costs from 20W9 to 20X0 (wide gaps between the bars
of 20W9 compared to 20X0).

This compound bar chart shows the sales of four divisions over time.
It allows for comparisons between divisions in a year and observing trends relating to the divisions over
time. However, it does not display total sales.
Some observations are:
 South has overtaken North as having the highest sales in 20X3 (the blue bar is the tallest for all
years except 20X3).
 West has been experiencing declining sales (the purple bar getting shorter over time).
 Sales in the North have been consistent (not much change in the blue bar over time).
Compound bar charts do not show the proportion of a data series to the total. There is also a risk of
overloading the chart with data, diluting the meaning it’s supposed to convey.

Example

Franklyn's Football Competitor Competitor Total

Factory 1 2

Year Sales $000s Sales $000s Sales $000s Sales

$000s

1 21.00 28.00 21.00 70.00

2 52.00 39.00 39.00 130.00

3 24.00 43.20 28.80 96.00

The cumulative total sales of all three entities for each year are presented as a compound bar chart below:

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Example

2.3.4 Stacked Bar Chart

A stacked bar chart shows a data series’ proportions to a total figure better than a compound bar chart. In
this example, total sales and their upward trend are easily identified.
It is also reasonably clear that the South (red) and East (green) are experiencing sales growth as a
proportion of total sales. However, the exact proportions of each division are difficult to determine without
additional labels, and comparing divisions to each other is challenging.

Example

Franklyn's Football Competitor Competitor Total

Factory 1 2

Year Sales $000s Sales $000s Sales $000s Sales

$000s

1 21.00 28.00 21.00 70.00

2 52.00 39.00 39.00 130.00

3 24.00 43.20 28.80 96.00

The cumulative total sales of all three entities for each year are presented as a stacked bar chart below:

2.3.5 100% Stacked (Component) Bar Chart

All the bars of a 100% stacked bar chart are the same height, and the purpose is to show proportions (similar
to a pie chart).
However, the trend in proportions is easiest to see for the North (blue)division. Without labels, it is more
challenging to observe the trends in ratios for the other divisions.
As with a pie chart, a 100% stacked bar chart does not show the change in absolute figures.

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Example

Franklyn's Football Competitor Competitor Total

Factory 1 2

Year Sales $000s Sales $000s Sales $000s Sales

$000s

1 21.00 28.00 21.00 70.00

2 52.00 39.00 39.00 130.00

3 24.00 43.20 28.80 96.00

The cumulative total sales of all three entities for each year are presented as a percentage stacked bar chart
below:

In this example, the stacks are displayed horizontally.

Some observations are:
 There is an increase in the cost proportion of raw materials (blue).
 There is a decrease in the cost proportion of non-production O/H (purple) over time.
It is challenging to conclude the proportions of direct labour (red) and production O/H (green) without labels.
Note that the chart does not show absolute figures.
21.2.4 Presenting and Interpreting Data (Line Charts)
2.4 Presenting and Interpreting Data (Line Charts)

Line charts are drawn with two axes, usually with the independent variable on the x-axis and the dependent
variable on the y-axis.
Care must be taken during the production and interpretation of the chart if the axes of a line chart are not
drawn from the origin.
A line chart is best suited to observe trends over time.
2.4.1 Simple Line Chart

This example shows a gentle increase in the sales trend over five years. Note that it is drawn from the origin.

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By contrast, the same data in this chart shows a more significant rate of change in total sales.
This is because the chart is not drawn from the origin, resulting in a different scale.
2.4.2 Line chart with Multiple Data Series

This example shows Total sales (blue) and Total costs (red) using the same data as the compound bar chart
shown earlier. Similarly, the legend is essential to help differentiate the data series.
Note that the y-axis is not from the origin. The smaller scale means that the rate of change in the lines
appears more significant.
The gap between the lines is profit. So the narrowing gap in 20X2 and 20X3 means that profit is shrinking.
It is easy to see the sales and costs trend and how they compare.
21.2.5 Presenting and Interpreting Data (Pie Charts)
2.5 Presenting and Interpreting Data (Pie Charts)

Pie charts are excellent for showing the proportions of multiple data series at a single period or point.
The entire pie is deemed 100%, with each data series representing a proportion. So, for example, 25% would
be a quarter of the pie.

In this example, it is clear that the North (blue) division has the most significant proportion of sales.

In this example, it is observed that the sales proportions of North (blue) and West (purple) have reduced
compared to 20W9, whereas the proportions of East (green) and South (red) have increased.
It is essential to remember that the pie chart does not show absolute figures well. For example, sales of the
North and West divisions may have been growing, but this is not observable from the pie chart.

Example

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Example

Franklyn's Football Competitor Competitor Total

Factory 1 2

Year Sales $000s Sales $000s Sales $000s Sales

$000s

3 24.00 43.20 28.80 96.00

The cumulative total sales of all three entities for Year 3 are presented as a pie bar chart below:

21.2.6 Presenting and Interpreting Data (Scatter Diagram)

2.6 Presenting and Interpreting Data (Scatter Diagram)

Scatter diagrams plot data points on a chart with two variables for each axis. A line of best fit may be drawn
to ascertain the trend.

Month Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Output (units) 100 110 90 100 100 130 110 90 120 130 140 100

Total costs ($) 2,500 2,600 2,200 2,600 2,550 3,000 2,650 2,300 2,800 2,900 2,950 2,400
The above information can be displayed as a scatter diagram.

There is a positive correlation between output units and total costs (more output, higher cost). However,
note that some cost variation occurs at some output levels.
A line of best fit can be drawn.

The line of best fit is helpful in forecasting outcomes. From this example:
 If the output is between 100 to 120 units, the expected total cost would be between $2,600 and
$2,800.
A forecast made within the range of a data set is an interpolation.

 If output exceeds 140 units, the expected cost would be above $3,000.
A forecast made outside the range of a data set is extrapolation.

21.2.7 Inappropriate Data Visualisation
2.7 Inappropriate Data Visualisation

It’s essential to use the proper visualisation to convey the appropriate meaning to the user. For example, the
wrong chart type will be misleading and may lead to dysfunctional decision-making.

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There are a couple of errors in this example:

 The use of a line to connect the data points suggests change over time. However, this is not the
case, as the x-axis contains names, not periods.
 The title and legend of the chart are meaningless.
 The numbers on the y-axis are meaningless.
 It is not clear what the words on the x-axis represent.

The conclusion drawn from this graph is that the average costs of each material are relatively stable.
Comparing the lines to each other is not helpful, as the nature of the product may dictate the price.
The graph does not show the proportion of cost or total cost, as the y-axis title is the average cost $ per kg
of material.

The above example is an improved graph that shows fluctuations in the average cost per kg of Material A
over time.
These changes make the graph more meaningful:
 The scale has been changed to a non-zero scale and is more granular (smaller increments) to
illustrate the price change better.
 Only material A is shown, allowing users to focus on what’s happening to the prices of this material.

The stacked bar chart above combines sales and costs into a single bar.

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This chart is meaningless, as no useful information can be obtained in presenting costs and sales this way.
21.2.8 Presenting Management Information
2.8 Presenting Management Information

Managers should not need to sift through the information they receive to find the areas that require their
attention.
Management accountants can add value by providing and presenting information in a format that highlights
areas requiring management attention. However, if vital information is buried within a lengthy report, there is
a real danger that it will be missed (information overload).
One way of ensuring management receive information that focuses their attention where it is most needed is
to use a management dashboard.
A dashboard report or screen layout measures and presents selected information and indicators relating to
critical areas of the business. The dashboard report or screen presents vital information in a clear format
(like a car dashboard), so management can respond quickly with appropriate decisions.

Dashboards often include charts and tables, presenting information in a way that makes it easy to interpret
and digest. Management accountants should be instrumental in designing dashboards to ensure the
information included covers the most critical areas and is easily understood.

Chapter 22: Summarising and Analysing Data

22.1.1 Structured and Unstructured Data
1.1 Structured and Unstructured Data

1.1.1 Structured Data

Structured data appears in a standardised format, such as relational databases and spreadsheets, making it
easy to analyse data. For example, accounting systems record transaction data in a form that makes data
processing and analysis easy.
1.1.2 Semi-Structured Data

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Semi-structured data does not have a fully standardised format, but some elements make it easier to analyse
than unstructured data. It is a mixture of structured and unstructured data.
For example, a digital photograph taken on a smartphone would contain an image (unstructured data) as well
as the date and time (structured data). The photograph could also be given a name (known as a tag) to aid
analysis.
1.1.3 Unstructured Data
Unstructured data appears in various formats and is challenging to analyse and manage. Examples include
images, video and audio, and data from machines or traffic or weather sensors.
22.1.2 Categorical versus Numerical Data
1.2 Categorical versus Numerical Data

1.2.1 Categorical Data

Categorical data is descriptive rather than numerical and is often divided into groups or categories.
Examples of categorical data include race, sex, age group, marital status and location, and satisfaction or
quality levels. Categorical data can be nominal or ordinal data.

Nominal data Nominal data is categorical data that cannot be ordered.

The industry of a business can be categorised, but there is no way of ordering the industries
from lowest to highest.

Ordinal data Ordinal data is categorical data with a set order from lowest to highest.
For example, businesses often ask customers to rate their product or service on a scale of 1
to 10. Note that the numbers on a scale of 1 to 10 are being used to represent descriptions
such as ‘very satisfied’ or ‘unsatisfied’, and they are not numbers in the mathematical sense.
These scales are, therefore, categorical data rather than numerical data.

1.2.2 Numerical Data

Numerical data is data that is measurable and therefore described using numbers. Examples include height,
weight, inventory count and number of staff. Numerical data can be continuous or discrete data.

Continuous Continuous data is numerical data that can have any value. Continuous data is measured rather than
data. counted, such as height, weight, length and temperature.

Discrete Discrete data is countable and cannot be made more precise. For example, the number of children,
data. cars, and sales volume. It usually involves whole numbers; for example, having 2.6 cars is
impossible.

22.1.3 Data Analytics

1.3 Data Analytics

Data analytics is the collection and analysis of data to find patterns and draw conclusions. There are
different data analysis types, including descriptive and inferential.
Descriptive analysis explains or summarises what the data shows. This helps to interpret the data and
identify patterns, but it doesn’t allow for conclusions to be drawn. Examples of descriptive analysis include
calculating the mean, median, mode and spread.
Inferential analysis uses a sample to produce theories or conclusions about a population. An example of
inferential analysis is regression analysis.
Activity 1

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Determine if the statement is true or false.

Statement True or false

All data can be classified as either nominal or ordinal

Continuous data is measured rather than counted

*Please use the notes feature in the toolbar to help formulate your answer.

Statement True or false

All data can be classified as False

either nominal or ordinal This is incorrect because nominal and ordinal data are descriptive, categorical
data classifications. Data can also be numerical.

Continuous data is measured True

rather than counted That’s right because continuous data can take on any value.
22.2.1 Averages
2.1 Averages

There are three main measures of centrality (or averages):

 Mean (or arithmetic mean)
 Median
 Mode.
The most commonly used average is the arithmetic mean, or the mean, so let’s start by looking at how to
calculate this first.
2.1.1 Mean
The mean is calculated as follows:

Mean = Sum of items /Number of items

The formula may be written using symbols:

Mean = ∑n /n where n = number of items

Example

Footie Boots Co is an independent football boot manufacturer. The sale of football boots over seven days is as
follows:
4,2,1,4,4,3,3
The total number of boots sold = 4 + 2 + 1 + 4 + 4 + 3 + 3 = 21
Number of items = 7
Mean = ∑n /n = 21/7 = 3
The arithmetic mean of the number of pairs of football boots sold per day is, therefore, 3.

Activity 2 Mean of Ungrouped Data

In a series of 20 “spot checks”, the following passengers were counted at a particular bus stop.

37 36 35 36

35 35 37 38

36 37 36 36

38 37 36 37

36 36 38 35

Calculate the mean number of passengers.

*Please use the notes feature in the toolbar to help formulate your answer.

f = frequency

No. of passengers (x) f fx

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35 4 140

36 8 288

37 5 185

38 3 114

Total 20 727

∑f = 20

∑fx = 727

Therefore, mean = 727/20 = 36.35 passengers

2.1.2 Frequency distribution tables
Sometimes it is easier to present data in a frequency distribution table. This shows how often an item occurs
in the data set.

Example

Footie Boots Co is an independent football boot manufacturer. The sale of football boots over seven days is as
follows:
4,2,1,4,4,3,3
The data given above may be tabulated into a frequency distribution table as follows:
Number

sold (pairs of football Number of Number sold x number

boots) days of days

x f (frequency) fx

1 1 1

2 1 2

3 2 6

4 3 12

∑f = 7 ∑fx = 21
Calculate the arithmetic mean using the following formula:
Mean = ∑fx /∑f = 21/7 = 3

The mean is sometimes shown using the symbol x̅ (known as ‘x bar’).

Activity 3 Average weekly wage

As part of the preparation for a wage negotiation, the human resources manager of a company has collated
the following data from a sample of weekly payslips:

Data Frequency f

180 – < 185 41

185 – < 190 57

190 – < 195 27

195 – < 200 23

200 – < 205 15

205 – < 210 7

Calculate the average weekly wage.

*Please use the notes feature in the toolbar to help formulate your answer.

Data Mid-point Frequency

x f fx

180 – < 185 182.5 41 7,482.5

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185 – < 190 187.5 57 10,687.5

190 – < 195 192.5 27 5,197.5

195 – < 200 197.5 23 4,542.5

200 – < 205 202.5 15 3,037.5

205 – < 210 207.5 7 1,452.5

∑f = 170 ∑fx = 32,400

2.1.3 Mode
The mode is an average that indicates the most frequently-occurring value in a data set.
Let’s have another look at the number of boots sold by Footie Boots Co in seven days:

Example

Footie Boots Co is an independent football boot manufacturer. The sale of football boots over seven days is as
follows:
4,2,1,4,4,3,3
The most frequently-occurring value is 4, which occurs three times (more than any other value).
This is also seen in the frequency distribution table above, which shows that four pairs of football boots were sold
on three of the seven days.
The mode is, therefore, 4.

2.1.4 Median
The median is the average that represents the middle item in a set of data that is arranged in increasing
(ascending) order.

Example

Footie Boots Co is an independent football boot manufacturer. The sale of football boots over seven days is as
follows:
4,2,1,4,4,3,3
The data given may be arranged in ascending order as follows:
Number of pairs of football boots sold: 1,2,3,3,4,4,4
The middle item in this data set is the fourth item, 3.
Note that the mean and mode all have the same value in the example, but this is not always the case. For example,
a data set might have very different values for each of these averages.

Activity 4

Determine if the statement describes the mean, mode, or median.

Statement Mean, mode, or median

The average that represents the most frequently-occurring value in a set of data mode

The average that represents the middle item in a set of data that is arranged in Median
ascending order.

The average that is most commonly used and can be calculated using the formula mean
∑fx /∑f
22.2.2 The Mean Of Grouped Data
2.2 The Mean Of Grouped Data

Sometimes data is collected and recorded in ‘class intervals’ or ‘groups’. For example, the class interval ‘> 0
≤ 5’ includes the values 1, 2, 3, 4 and 5. When data is grouped in this way, find the mid-point of each class
interval or group to calculate the arithmetic mean.
The mid-point of the class interval ‘> 0 ≤ 5’ is 3.
The mid-point is the value most representative of all the values in a specific group of data (or ‘class interval’).

Example

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Example

Umbrella Co has analysed data on demand for umbrellas at its market stall over 15 days. The results are shown in
the following grouped frequency distribution table:

Demand for umbrellas (number Frequency (number of

sold) days)

>0≤5 10

> 5 ≤ 10 1

> 10 ≤ 15 4
To calculate the arithmetic mean for this data, start by finding the mid-point of each group of data, as follows:

Demand for umbrellas Mid- Frequency (number of

(number sold) point x days) f

>0≤5 3 10

> 5 ≤ 10 8 1

> 10 ≤ 15 13 4
Having found the mid-points, the frequency distribution table may be completed as follows:

Demand for Mid- Frequency Number sold x

umbrellas (number point x (number of days) number of days
sold) f fx

>0≤5 3 10 30

> 5 ≤ 10 8 1 8

> 10 ≤ 15 13 4 52

∑f = 15 ∑fx = 90
The completed frequency distribution table, as shown above, enables the calculation of the arithmetic mean using
the formula:
Mean = ∑fx /∑f = 90 /15 = 6
The conclusion is that the average number of umbrellas sold per day is 6.

22.3.1 Measures Of Dispersion

3.1 Measures Of Dispersion

Averages give an idea of the central point of a set of data values, but they don’t indicate how dispersed or
spread out the values are.
Important measures of dispersion include:
 Range
 Variance
22.3.2 Range
3.2 Range

The range is the difference between the highest and lowest values in a set of data values.

Example

The number of pairs of football boots sold each day of the week is: 4, 2, 5, 3, 4, 4, 5
The range is the difference between the highest value (5) and the lowest value (2). The range of this set of data
values is, therefore 5 − 2 = 3.
For grouped data, such as the class interval ‘> 0 ≤ 5’, which includes the values 1, 2, 3, 4 and 5, the range would be
the difference between the highest value (5) and the lowest value (1). The range of this set of data values is,
therefore 5 − 1 = 4.

22.3.3 Variance
3.3 Variance

Another critical measure of dispersion is the variance.

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The variance measures the spread of data values in a data set. It measures how far each value in the set is
from the arithmetic mean.
The variance is known as ‘sigma squared’ and is denoted by the symbol, σ2
∑ is the capital letter for the Greek character ‘sigma’, and σ is the lowercase letter for ‘sigma’.
The formula used to calculate the variance of ungrouped data is as follows:
Variance (for ungrouped data) = ∑(x − x̅ )2 /n

1. Calculate the difference between each value in the data set and the mean: (x − x̅ )
2. Square the difference between each value in the data set and the mean: (x − x̅ )2
3. Add together the values calculated in Step 2 to calculate ∑(x − x̅ )2
4. Calculate the average of the result obtained in Step 3 by dividing ∑(x − x̅ )2 by the number of values in the data
set, n, to establish the variance:
Variance (for ungrouped data) = ∑(x − x̅ )2 /n

Example

The sales of football boots over seven days were recorded as follows:
4,2,1,4,4,3,3
This data may be tabulated as follows:

Day Number sold (pairs of football boots)

1 4

2 2

3 1

4 4

5 4

6 3

7 3
The arithmetic mean x̅ is 3 (Mean = ∑n /n = 21 /7 = 3).
1. Calculate the difference between each value in the data set and the mean: (x − x̅ )

Day Number sold (pairs of football boots) x (x − x̅ )

1 4 1

2 2 -1

3 1 -2

4 4 1

5 4 1

6 3 0

7 3 0
2. Square the difference between each value in the data set and the mean: (x − x̅ )2

Day Number sold (pairs of football boots) x (x − x̅ ) (x − x̅ )2

1 4 1 1

2 2 -1 1

3 1 -2 4

4 4 1 1

5 4 1 1

6 3 0 0

7 3 0 0

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Example

3. Add together the values calculated in Step 2 to calculate ∑(x − x̅ )2

∑(x − x̅ )2 = 1 + 1 + 4 + 1 + 1 + 0 + 0 = 8
4. Calculate the average of the result obtained in Step 3 by dividing ∑(x − x̅ )2 by the number of values in the data
set, n, to establish the variance:
Variance (for ungrouped data) = ∑(x − x̅ )2 /n
Variance = 8/7 = 1.14 (to 2 decimal places)

Example

Umbrella Co has grouped the demand for its umbrella as follows:

Demand for umbrellas Mid- Frequency (number fx

(number sold) point x of days)
f

>0≤5 3 10 30

> 5 ≤ 10 8 1 8

> 10 ≤ 15 13 4 52

∑f = 15 ∑fx =
90
Mean = ∑fx /∑f = 90/15 = 6
Calculate the variance for Umbrella Co’s umbrella sales using the information given in the table above:

Demand for Mid- Frequency(number fx (x (x f(x

umbrellas(number point of days) f − − −
sold) x x̅ x̅ x̅ )2
) )2

>0≤5 3 10 30 −3 9 90

> 5 ≤ 10 8 1 8 2 4 4

> 10 ≤ 15 13 4 52 7 49 196

∑f = 15 ∑fx
=
90
Add together the values calculated in Step 3 to calculate ∑f(x − x̅ )2 = 90 + 4 + 196 = 290
Calculate the average of the result obtained in Step 4 by dividing ∑f(x − x̅ )2 by ∑f to establish the variance:
Variance (for grouped data) = ∑f(x − x̅ )2 /∑f
Variance = 290/15 = 19.33

3.3.1 Summary
 The range is the difference between the highest and lowest values in a set of data values.
 The mean deviation is the mean of the absolute deviations of a data set about the data's mean. The
formula for calculating the mean deviation is:
 Mean deviation = ∑f│x − x̅ │ /∑f
 The variance (sigma squared, σ2) measures the spread of data values in a data set. It measures
how far each value in the set is from the arithmetic mean.
 The formula for calculating the variance of ungrouped data = ∑(x − x̅ )2 /n
 The formula for calculating the variance of grouped data = ∑f(x − x̅ )2 /∑f
22.3.4 Measures Of Dispersion: Standard Deviation And Coefficient Of Variation
3.4 Measures Of Dispersion: Standard Deviation And Coefficient Of Variation

The standard deviation measures the spread of data around the arithmetic mean. It is the square root of the
variance and can be calculated using the following formula, depending on whether the data concerned is
grouped or ungrouped.
Standard deviation (grouped and ungrouped data) = √Variance
The higher the standard deviation value compared to the arithmetic mean, the more dispersed the data.

Example

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Example

A variance of 19.33 for Umbrella Co was calculated.

standard deviation = √variance
The standard deviation for Umbrella Co = √ 19.33 = 4.40 (to 2 decimal places)

3.4.1 The standard deviation of ungrouped data

The above formula is provided in the exam.

Example

Quarterly levels of sales of Product A at Pink Co were recorded as follows:

Quarter Sales ($000s)

1 4

2 3

3 8

4 5
The mean =x̅ = (4 + 3 + 8 + 5)/4 =20/4 = 5
Standard deviation = √ ∑(x − x̅ )2 /n
= √ 14/4
= √ 3.5
= 1.87 (to 2 decimal places)

Activity 5

The following information relates to a set of four items of data:

Item number │x − x̅ │

1 4

2 2

3 3

4 5

Item number │x − x̅ │ (x − x̅ )2

1 4 16

2 2 4

3 3 9

4 5 25

∑(x − x̅ )2 = 54

What is the standard deviation (to 2 decimal places)?

*Please use the notes feature in the toolbar to help formulate your answer.

Standard deviation (for ungrouped data) = √ ∑(x-x̅ )2 /n

= √ 54/4

= √ 13.5

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= 3.67
3.4.2 The standard deviation of grouped data
The standard deviation of grouped data can be calculated using the following formula:

Example

Monthly sales of Product B at Green Co were recorded as follows:

Sales ($000s) Number of months (f) Midpoint ($000s) (x) fx

0-2 2 1 2

3-5 5 4 20

6-8 4 7 28

9-11 1 10 10

∑f=12 ∑fx=60
Finding the elements of the equation:

Sales Number of Midpoint fx (x − (x − f(x −

($000s) months (f) ($000s) (x) x̅ ) x̅ )2 x̅ )2

0-2 2 1 2 −4 16 32

3-5 5 4 20 −1 1 5

6-8 4 7 28 2 4 16

9-11 1 10 10 5 25 25

∑f=12 ∑fx=60
∑f(x − x̅ )2 = 32 + 5 + 16 + 25 = 78
Standard deviation = √ 78/12 = √ 6.5 = 2.55 (to 2 decimal places)

22.3.5 The Coefficient Of Variation

3.5 The Coefficient Of Variation

The coefficient of variation is a measure of dispersion that compares the spreads of two or more data sets.
The coefficient of variation is also known as the coefficient of relative spread and is calculated as follows:

Coefficient of variation = standard deviation/mean

The higher the value of the coefficient of variation, the wider the data spread. Therefore, when comparing
two or more sets of data, the data set with the highest coefficient of variation is the one that has the greatest
dispersion or spread of data.

Example

The following information applies to Umbrella Co:

Arithmetic mean 6

Variance 19.33

Standard deviation 4.40

Coefficient of variation = standard deviation/mean
Therefore, Umbrella Co’s coefficient of variation = 4.40/6 = 0.73 (to 2 decimal places)

22.3.6 Using The Coefficient Of Variation To Compare Different Populations

3.6 Using The Coefficient Of Variation To Compare Different Populations

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The standard deviation measures the spread of data around the arithmetic mean. To compare the relative
spreads of two or more sets of data or populations, the coefficient of variation must be calculated.

Example

Umbrella Co sells umbrellas worldwide, including Country A and Country B.

Country A has an annual rainfall of 8,500 mm, and Country B has a yearly rainfall of 2,400 mm.
Data relating to monthly sales of umbrellas in Country A and Country B are as follows:

Country A: Number of umbrellas sold per Country B: Number of umbrellas

month (000s) sold per month (000s)

Arithmetic mean 100 25

Standard deviation 8 8
In this example, the standard deviation is not useful to measure how much monthly umbrella sales vary between
the two countries.
This is because the mean number of umbrellas sold per month is very different in the two countries.
Monthly umbrella sales in Country A (which has a very high annual rainfall) is 100,000, whereas monthly sales in
Country B (which has a much lower yearly rainfall) is 25,000 umbrellas.
In this situation, the coefficient of variation is a much more useful comparative measure of the variability of
umbrella sales in Countries A and B.
Coefficient of variation: Country A = 8/100 = 0.08 or 8%
Coefficient of variation: Country B = 8/25 = 0.32 or 32%
These results show us that umbrella sales in the country where annual rainfall is very high (Country A) do not
vary from month to month as much as the umbrella sales in Country B (which has a much lower annual rainfall),
where monthly umbrella sales can vary by as much as 32% of the arithmetic mean.

Activity 6 Coefficient of variation

Government statistics on the basic daily wages of workers in two countries show (all figures converted to
$ equivalent):

Mean standard deviation

Country A: x̅ = $120 s = $55

Country B: x̅ = $90 s = $50

Determine which country has the wider spread of daily wages.

*Please use the notes feature in the toolbar to help formulate your answer.

Country A has a higher standard deviation and a higher mean. Comparing the coefficients of variation:

Country A: $55 ÷ $120 ´ 100 = 45.8%

Country B: $50 ÷ $90 ´ 100 = 55.6%

Country B has the widest relative spread of data.

Activity 7

Determine whether the statements are true or false.

Statement True or false

The standard deviation is a measure of dispersion False

that compares the spreads of two different sets of That’s right. The coefficient of variation is the measure of
data. dispersion that compares the spreads of two different
sets of data.

The standard deviation of grouped data is the same True

as the square root of the variance of the same data That’s right. The standard deviation of both grouped and
set. ungrouped data is calculated by taking the square root of
the variance.

If Data Set A has a coefficient of variation of 0.45 False

and Data Set B has a coefficient of variation of 0.48, That’s right. The higher the value of the coefficient of
this means that Data Set A has a wider spread of variation, the wider the data spread. As 0.48 is a higher
data than Data Set B. value than 0.45, Data Set B has a wider spread of data
than Data Set A.

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22.4.1 The Normal Distribution

4.1 The Normal Distribution

Data can be distributed (spread out) in different ways. For example, the heights of students in a particular
school year could be shown as a bar chart as follows:

The bar chart shows relatively few short people, many of average height and few who are incredibly tall.
A line on the chart would be roughly bell-shaped and look like this:

A normal distribution is a frequency distribution with the following properties:

 It is symmetrical about the mean (and the mean is symbolised by the Greek letter μ)
 The area under the curve is equal to 1
 The graphical shape of the normal distribution is a bell-shaped curve

Note that because the normal distribution is symmetrical, the area under the curve on the left-hand side of µ
is 0.5, and the area under the curve on the right-hand side of µ is 0.5.
The normal distribution is interesting because it approximates many areas of real life. For example, the
number of different peoples’ heights occurring in the population could be shown by a bell-shaped curve like
the one above, where x = the height and y = the frequency of people. The probability of someone having an
average height is high. The likelihood of someone being extremely short or tall is small. There are so many
real-life situations that follow a normal distribution that it can be used in business to make decisions
involving probability.
The results of manufacturing processes tend towards the normal distribution. For example, where products
are manufactured in bottles of, say, one litre in volume, the mean will be approximately one litre. Still, some
bottles may contain more than one litre, and others may have slightly less. In cases where manufacturing
processes don’t follow a normal distribution, this may indicate that the production process is not operating
efficiently.
4.1.1 Interpretation
With a normal distribution, the spread about the mean is measured using the standard deviation σ.
Regardless of the value of the mean and standard deviation, provided the same number of standard
deviations from the mean is measured, it will always divide the areas under the curve into the same
proportions. For example, one standard deviation from the mean contains 34.13% of the data frequencies.
Two standard deviations from the mean include 47.72% of the data frequencies.

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Activity 8

If an item is chosen randomly, what is the probability that it will lie in the shaded region shown on the normal
distribution curve below (to the nearest whole percent)?

*Please use the notes feature in the toolbar to help formulate your answer.

34% of frequencies have a value within one standard deviation of the mean. The curve is symmetrical, so one
standard deviation on either side of the mean = 34% + 34% = 68%.
22.4.2 Normal Distribution Tables
4.2 Normal Distribution Tables

A table may be used (a normal distribution table) to calculate probabilities.

The table given in the exam shows the area under the normal curve between the mean and the point Z
standard deviations above the mean. The corresponding area for deviations below the mean can be found by
symmetry.

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The table also gives the formula:

​ ​
Where Z = the number of standard deviations above or below the mean (known as the Z score)
x = the data value
μ = the mean (also known as x̅ )
α = the standard deviation
Note that when Z is a negative number, it indicates the number of standard deviations below the mean. On
the other hand, when Z is a positive number, it shows the number of standard deviations above the mean.
But since the normal distribution curve is symmetrical, the proportion is the same, for example, 1 standard
deviation above the mean or 1 standard deviation below the mean.

Example

A drinks manufacturer aims to sell its drinks in cartons containing 200ml of juice.
The packaging machine is set to average at 200ml with a 3ml standard deviation.
What percentage of cartons will have less than 198ml?

1. Draw the Diagram

Required area = < 198m

2. Calculate Z-score
Z = (198 − 200)/3 = 0.67
0.67 = the number of standard deviations below the mean

3. Find the value of the Z-score in the tables and label it on the diagram (so it’s clear).

Remember that the table shows the area under the normal curve between the mean and the point Z standard deviations above th
The corresponding area for deviations below the mean (as in the case here) can be found by symmetry.

4. Calculate the required area using the drawing, remembering that the total area under the curve is 1 and the area under each half
curve is 0.5.
Percentage of cartons containing less than 198ml = 0.5 − 0.2486 = 0.2514 = 25.14%

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Activity 9

A normal distribution has a mean of 50 and a standard deviation of 5.

What percentage of frequencies lie in the range 50 – 55 (to two decimal places)?

What percentage of frequencies lie above 45 (to two decimal places)?

What percentage of frequencies lie below 40 (to two decimal places)?

What percentage of frequencies lie in the range 40 - 63 (to two decimal places)?

*Please use the notes feature in the toolbar to help formulate your answer.

1. 34.13%

2.
The area required is the shaded area above. (The sketch is not to scale.) The tables provide the value for the
area between 55 and the mean.

3.
Z-score = (55 − 50) /5 = 1. From the tables is 0.3413 or 34.13%

4.
A normal distribution has a mean of 50 and a standard deviation of 5.

5.
6. 84.13%

7.
The area required is the shaded area above. (The sketch is not to scale.) However, the tables will only
provide the value for the area between 45 and the mean. Therefore, 0.5 (i.e. the right-hand side of the curve)
must be added to the area given by the table.

8.
Z-score = (45 − 50) /5 = 1. From the tables is 0.3413 or 34.13%

9.
Therefore, the percentages of frequencies that lie above 45 = 34.13% + 50% = 84.13%

10.
A normal distribution has a mean of 50 and a standard deviation of 5.

11.
12. 2.28%

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13.
The area required is the shaded area above. (The sketch is not to scale.) However, the tables will only
provide the value for the area between 40 and the mean. Therefore, subtract the value from the table away
from the total area of the left-hand side of the curve.

14.
Z-score = (40 − 50) /5 = 2. From the tables is 0.4772 or 47.72%

15.
Therefore, the percentages of frequencies that lie below 40 = 50% − 47.72% = 2.28%

16.
A normal distribution has a mean of 50 and a standard deviation of 5.

17.
18. 97.25%

19.
The area required is the shaded area above. (The sketch is not to scale.) However, the tables will only
provide the value for the area between 40 and the mean or 63 and the mean. Both of these values must be
calculated and then added together.

20.
Z-score = (40 − 50) /5 = 2. From the tables is 0.4772 or 47.72%

21.
Z-score = (63 − 50) /5 = 2.6. From the tables is 0.4953 or 49.53%

22.
Therefore, the percentage of frequencies that lie between 40 and 63 = 47.72% + 49.53% = 97.25%

23.
Activity 10 Normal distribution

The average time and standard deviations of two job types are as follows:

Job A Job B

Minutes Minutes

Average time 75 100

Standard deviation 15 10

(a) Calculate the proportion of time that a Job A will take longer than the average time for a Job B.

(b) Calculate the proportion of time that a Job B will take less than the average time for a Job A.

*Please use the notes feature in the toolbar to help formulate your answer.

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(a) Proportion of time that Job A will take longer than 100 minutes

The requirement is to calculate the probability that a Job A will take longer than 100 minutes. To be able to
use the normal distribution tables to obtain percentage figures (i.e. the probability of an outcome occurring),
we need to convert the normal distribution into a z-score. We do this using the formula, using the value
being considered of 100 minutes, a mean of 75 minutes, and a standard deviation of 15 minutes, as shown
below.

​ ​ = 1.67

The the answer shows the z-score of 1.67.

Next, the value of the z-score is found using the normal distribution table. The value required is that shown
at the intersection of row 1.6 and column 0.07, which is 0.4525. This means that the proportion under the
normal curve between the mean and the z-value is 0.4525. We know that the total area under the standard
distribution curve equals 1, and as the curve is symmetrical, that the area under each half of the curve is 0.5.
Therefore, the probability that a Job A will take longer than 100 minutes is (0.5 - 0.4525) = 0.0475 or 4.75%.

(b) Calculate the proportion of time that a Job B will take less than the average time for a Job A.

​ ​ = −2.5

The proportion under the normal curve is 0.4938 (per table). Therefore the proportion of time that a Job B will
take less than 75 minutes is 0.0062 (i.e. 0.62%).

Chapter 23: Standard Costing and Variance

Analysis

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23.1.1 Standard Costing

1.1 Standard Costing

The standard cost of a product or service is a planned or predetermined cost which indicates how much a
unit of a product or service should cost.
Standard costing is a method of costing that involves determining the standard costs of a unit of product or
service (based on estimates of future costs).
Standard costing is a control technique because it involves comparing standard (expected) costs with actual
costs and calculating their differences.
These differences or variances are reported to management to highlight areas where the organisation is not
aligned with its plan for the budget period under review.
Standard costing is also a method of valuing inventory and costs of production.
Standard costs are commonly used in budgeting and variance analysis for planning and setting targets.

Example

The following is the standard cost card of a football at Winston’s Football Factory:

Standard (expected) Units Cost per Cost per Notes

cost per football kg/hour($) unit ($)

Direct materials – 1 kg $3 3.00 1

Plastic F

Direct labour 2 $6 12.00 2

Hours

Variable production 2 $1 2.00 3

overheads Hours

Fixed production 2 $2 4.00 4

overheads Hours

Total cost per 21.00 5

football
Notes:

1. This is based on the standard usage of 1 kg of Plastic F at a standard cost of $3 per kg of Plastic F.
Standard direct materials cost per football = 1 kg × $3 = $3
2.
3. This is based on the standard labour time to make one football (2 hours) and the standard cost per
labour hour ($6).
Standard direct labour cost per football = 2 Hours × $6 = $12
4.
5. This is based on the standard labour hours per football (2 hours) and the standard variable production
overhead cost per labour hour ($1).
Standard variable production cost per football = 2 Hours × $1 = $2
6.
7. This is based on the standard labour hours per football (2 hours) and the standard fixed production
overhead cost per labour hour ($2).
Standard fixed production cost per football = 2 Hours × $2 = $4
8.
9. The total cost per football = direct materials + direct labour + variable production overheads + fixed
production overheads = $(3 + 12 + 2 + 4) = $21

1.1.1 Deriving Standard Costs

Below is an example of how Winston’s Football Factory may have derived the standards to produce a
football.

Standard Derivation

Standard weight of Plastic F Based on the standard product specification for one football which would
have been prepared by experts when the factory first started to manufacture
footballs.

Standard cost of 1 kg of Plastic F Based on information from the purchasing department relating to the
expected price of Plastic F and whether any discounts are available.

Standard labour hours – one Based on the expected time taken to make one football from the standard

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football operation sheet, which will have been set by experts when Winston’s Football
Factory first started manufacturing footballs.

Standard rate labour force paid Information available from the Human Resources department.
per hour

Standard variable overhead – one This will be a predetermined rate based on expected production volumes and
football variable production overhead costs.

Standard fixed production A predetermined rate based on expected production volumes and fixed
overhead absorbed production overhead costs.
23.1.2 Standard Costs and Quantities
1.2 Standard Costs and Quantities

1.2.1 Types of standards

The different standards set by an organisation can affect how motivated employees are.
There are four different types of standards used to estimate standard costs:

Standard Description
type

Basic Basic standards, probably set some years ago, stay the same over time and are often out-of-date.
standard
These standards are used to show trends over time so that changes in material prices and labour
rates, for example, can be tracked.
Since these standards do not change over time, they are not useful for motivating employees
because these targets are too easy to achieve.

Ideal Ideal standards are based on perfect manufacturing conditions:

standard
 No wastage of materials
 No machine breakdowns
 No idle time
 100% labour efficiency.
Since perfect manufacturing conditions do not exist, ideal standards are likely to demotivate
workers because they will feel that the targets set are impossible to achieve. Time may be wasted
investigating many adverse variances with little commercial value.

Attainable Attainable targets are achievable with a certain amount of hard work and are the most motivating
standard standard an organisation can set.
Attainable standards are the most useful because they are based on the most efficient
manufacturing conditions.
Unlike ideal standards, they make allowances for waste materials, machine breakdowns and idle
time.

Current Current standards are based on the organisation’s current efficiency levels–material waste,
standard machine breakdowns, and idle hours.
Such standards do not motivate employees to try to improve on these current standards because
there is no incentive for the employees to improve the efficiency with which they work.

23.1.3 Standard cost per unit

1.3 Standard cost per unit

A standard cost card shows the standard cost elements of a product unit. The name “cost card” came from
the early days of management accounting, when each product would have a separate card in a file that listed
the standard cost of that product.
Standard cost calculations will almost certainly be presented using spreadsheets, but the term “standard
cost card” has survived into the modern era.
An organisation’s standard cost card will be different depending on whether the organisation uses
absorption costing or marginal costing.
Activity 1

Below are the standard costs for a football made at Winston’s Football Factory, which is sold for a budgeted
selling price of $35:

Standard cost per football Cost per unit ($)

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Direct materials – Plastic F 3.00

Direct labour 12.00

Variable production overheads 2.00

Fixed production overheads 4.00

Produce the standard cost card for a football using marginal and absorption costing using the templates
provided.

Marginal standard cost card $

Direct materials – Plastic F 3.00

Direct labour 12.00

Standard prime cost 15.00

Variable production overheads 2.00

Standard variable (marginal) production cost 17.00

Standard contribution per football 18.00

Sales price 35.00

Absorption standard cost card $

Direct materials – Plastic F 3.00

Direct labour 12.00

Standard prime cost 15.00

Variable overheads 2.00

Standard variable production cost 17.00

Fixed production overheads 4.00

Standard full (absorption) production cost 21.00

Standard profit per football 14.00

Sales price 35.00

23.1.4 Application in Budgeting Process
1.4 Application in Budgeting Process

The standard will be used to plan budgets and be the basis for comparison of actual performance.
The process is illustrated below:

23.2.1 Applying Variances

2.1 Applying Variances

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The standard approach to variances results in the majority of the volume variances being combined into the
"sales volume" variance, expressed in terms of standard profit margin or contribution.
All variances affect contribution or profit. When the sales volume is flexed, it is not just the sales revenue
that changes – but also all the associated sales costs. The "net" impact on budgeted profit is reflected by the
margin – profit margin (absorption costing) or contribution (marginal costing).
23.2.2 Sales Price Variance
2.2 Sales Price Variance

The total sales variance is the difference between budgeted and actual revenue and can be divided into price
and quantity variances.

Example

The following is a simple sales variance comparing the actual results for selling 5,100 footballs with the original
budget for selling 4,800 footballs:
Original budget Actual results Variance

Number of footballs produced and sold 4,800 5,100

$ $ $

Sales revenue 168,000 168,300 300 F

The total sales variance is $300 favourable.

2.2.1 Sales Price Variance

The sales price variance compares the actual product selling price to what they should have been sold for
(budget).

Sales price variance $

Sales revenue should be X Actual quantity × Budgeted price

Sales revenue was X Actual quantity × Actual price

Sales price variance X/(X)

Example

The information below regarding the total sales variance is available:

Original Actual Variance

budget results

Number of footballs 4,800 5,100

produced and sold

$ $ $

Sales revenue 168,000 168,300 300 F

The budgeted selling price per football is $35.
Calculate the sales price variance.
Answer:

Sales price variance $

Sales revenue should be 178,500 5,100 × $35

Actual quantity × Budgeted price

Sales revenue was 168,300

Sales price variance 10,200 A

Note: the actual selling price is $33 (168,300 / 5,100)
The sales price variance is $10,200 adverse as the actual selling price is lower than budgeted.

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Activity 2

An organisation’s budgeted sales for last month were 5,500 units with a standard selling price of $25 per unit
and a standard contribution of $12 per unit.

Last month’s actual sales were 5,620 units at an average selling price of $23 per unit.

Calculate the sales price variance.

*Please use the notes feature in the toolbar to help formulate your answer.

Sales price variance $

Sales revenue should be 140,500 5,620 × $25

Actual quantity × Budgeted price

Sales revenue was 129,260 5,620 × $23

Actual quantity × Actual price

Sales price variance 11,240 A

The sales price variance is $11,240 adverse as the actual selling price is lower than budgeted.
23.2.3 Causes of sales price variances
2.3 Causes of sales price variances

Sales price variances occur because there has been a change from the budgeted selling price. As a result,
the selling price is either higher or lower than expected.
There could be several reasons the company would sell at a lower selling price:
 To boost sales volume in poor economic conditions.
 To match competitor pricing.
 To clear stocks to prepare for the launch of a new model.
 To increase market share.
23.2.4 Sales Volume Variance
2.4 Sales Volume Variance

As its name suggests, The sales volume variance arises when the fixed budget and actual sales volumes for
a period differ. How the sales volume variance is calculated depends on the costing system that an
organisation uses:
 Organisations that use marginal costing will value the difference in budgeted and actual sales
volumes at the standard contribution per unit
 Organisations that use absorption costing will value the difference in budgeted and actual sales
volumes at the standard profit per unit.
Sales volume variance

Sales volume should be (budgeted) X

Sales volume was (actual) X

Sales volume variance (units) X/(X)

Standard profit or contribution per unit ($ per unit) X

Sales volume variance ($) X/(X)

Example

The information below regarding the total sales variance is available:

Original Actual Variance

budget results

Number of footballs 4,800 5,100

produced and sold

$ $ $

Sales revenue 168,000 168,300 300 F

The budgeted selling price per football is $35.

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The standard marginal cost of producing a football is $17, and the fixed production overhead absorption rate per
football is $4.
Calculate the marginal and absorption costing sales volume variance.
Answer:

Absorption costing sales volume variance

Sales volume should be (budgeted) 4,800

Sales volume was (actual) 5,100

Sales volume variance (units) 300 F

Standard profit per unit ($ per unit) 14

Sales volume variance ($) $4,200 F

The standard profit per unit is $14 (35 – 17 – 4).

Marginal costing sales volume variance

Sales volume should be (budgeted) 4,800

Sales volume was (actual) 5,100

Sales volume variance (units) 300 F

Standard contribution per unit ($ per unit) 18

Sales volume variance ($) $5,400 F

The standard contribution per unit is $18 (35 – 17).
The sales volume variance is favourable as the actual sales volume is higher than budgeted.

Activity 3

An organisation’s budgeted sales for last month were 5,500 units with a standard selling price of $25 per unit
and a standard contribution of $12 per unit.

Last month’s actual sales were 5,620 units at an average selling price of $23 per unit.

Calculate the marginal costing sales volume variance using the template below.

*Please use the notes feature in the toolbar to help formulate your answer.

Marginal costing sales volume variance

Sales volume should be (budgeted) 5,500

Sales volume was (actual) 5,620

Sales volume variance (units) 120 F

Standard contribution per unit ($ per unit) 12

Sales volume variance ($) $1,440 F

The sales volume variance is favourable as the actual sales volume is higher than budgeted.

23.2.5 Causes Of Sales Volume Variances

2.5 Causes Of Sales Volume Variances

Sales volume variances are caused by factors leading to the sales volume being higher or lower than
expected (as shown in the flexed budget).
The key factors include:
 Increased demand for a product, for example, if the product’s price is reduced or marketing
expenditure is increased.
 Lower demand for a product than expected, perhaps because of a downturn in the economy or if
the product price is too high.
 Lower production levels than budgeted due to machine breakdown or worker strikes.
23.3.1 Materials Total Variance
3.1 Materials Total Variance

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The materials total variance is the difference between the following costs:
 The amount that actual production should cost – this is the flexed materials budget
 The amount that actual production did cost – this is the actual cost of materials.
Example

The standard cost card for a football from Winston’s Football Company is as follows:

STANDARD COST CARD – FOOTBALL $

Direct materials (Plastic F; 1 kg at $3 per kg) 3.00

Direct labour (2 hours at $6 per hour) 12.00

Standard prime cost 15.00

Variable production overheads (2 hours at $1 per hour) 2.00

Fixed production overheads (2 hours at $2 per hour) 4.00

Standard cost per football (full absorption production cost) 21.00

Standard gross profit (profit per football) 14.00

Standing selling price (sales price) 35.00

5,100 footballs were produced in 20X5, and 5,250 kg of Plastic F was used, costing $14175.
Calculate the materials total variance for 20X5.

Materials total variance $ Workings [1]

5,100 footballs should cost 15,300 5,100 × $3 [2]

5,100 footballs did cost 14,175 Actual cost (given) [3]

Materials total variance 1,125 F $(15,300 − 14,175) [4]

Notes:

1. The materials total variance is calculated by comparing what 5,100 footballs should have cost (valued
at $3 standard material cost per football) with the actual materials cost of making 5,100 footballs.
2. The expected materials cost for 5,100 footballs is $15,300. This is 5,100 footballs multiplied by the
standard material cost per football of $3.
3. The actual materials cost for 5,100 footballs is $14,175, which is the actual cost of materials in 20X5.
4. The difference between what the materials cost of 5,100 footballs should be and what the materials cost
of 5,100 was is the materials total variance.
The materials total variance of $1,125 is favourable (F) because the actual cost of materials for producing 5,100
footballs was less than expected.

23.3.2 Analysis Of The Materials Total Variance

3.2 Analysis Of The Materials Total Variance

The materials total variance calculated above can be further analysed into the following variances:
 Materials price variance
 Materials usage variance.

Activity 4

An organisation has a budgeted material cost of $360,000 for 80,000 units per month. Each unit is budgeted
to use 3 kg of materials. The standard cost of material is $1.50 per kg. Actual materials in the month cost
$364,095 for 81,000 units, and 234,900 kg were purchased and used.

Calculate the materials total variance using the template provided.

Materials Total Variance $ Workings

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81,000 units should cost 364,500 81,000 × 3 × $1.50

81,000 units did cost 364,095 Actual cost (given)

Materials total variance 405 F $(364,500 − 364,095)

23.3.3 Materials Price Variance
3.3 Materials Price Variance

An adverse materials total variance indicates that more has been spent on materials than expected. However,
the organisation needs to find out whether the cause was that more material was used than expected or
whether the material used was more expensive than expected (or both). The organisation needs additional
detail to understand the cause(s) and take corrective action.
The materials price variance arises when the amount paid for materials differs from the amount budgeted to
be paid for materials in a budget period.
The materials price variance is the difference between the following costs:
 The amount that actual direct materials should have cost – this is the flexed materials budget
 The amount that actual materials did cost – this is the actual cost of materials.
Materials price variance $

Materials should have cost (budgeted) X Actual usage × Budgeted price

Materials did cost X Actual usage × Actual price

Materials price variance X/(X)

Example

The following standard cost card excerpt is applicable:

STANDARD COST CARD – FOOTBALL $

Direct materials (Plastic F; 1 kg at $3 per kg) 3.00

5,100 footballs were produced in 20X5, and 5,250 kg of Plastic F was used, costing $14175.
Calculate the materials price variance for 20X5

Materials price variance $

5,250 kg of Plastic F should have cost (budgeted) 15,750 5,250 × $3

Actual quantity × Budgeted price

5,250 kg of Plastic F did cost 14,175

Materials price variance 1,575 F

The materials price variance is favourable (F) because the actual cost of 5,250 kg of Plastic F was less than
expected.

Activity 5

An organisation has a budgeted material cost of $360,000 for 80,000 units per month. Each unit is budgeted
to use 3 kg of materials. The standard cost of material is $1.50 per kg. Actual materials in the month cost
$364,095 for 81,000 units, and 234,900 kg were purchased and used.

Calculate the materials price variance using the template provided.

Materials price variance $

234,900 kg should cost (budgeted)

234,900 kg did cost

Materials price variance

*Please use the notes feature in the toolbar to help formulate your answer.

Materials price variance $ Workings

234,900 kg should cost (budgeted) 352,350 234,900 × $1.50

Actual quantity × Budgeted price

234,900 kg did cost 364,095

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Materials price variance 11,745 A $(352,350 − 364,095)

The materials price variance is adverse (A) because the actual cost of 234,900 kg was more than expected.

23.3.4 Working Backwards

3.4 Working Backwards

The MA/FMA Study Guide requires calculating actual or standard figures where the variances are given.
Therefore, this question type will need a strong understanding of calculating variances.

Example

An organisation uses standard costing. The following information is available for Material M, which is required to
make Product P.
4,500 kg of Material M were purchased.
The standard cost of Material M is $2.20 per kg.
The adverse materials price variance for Material M is $225
Calculate the actual cost per kg of Material M.

Materials price variance $ Workings

4,500 kg should cost (budgeted) ??? 4,500 × $2,20

Actual quantity × Budgeted price

4,500 kg did cost ??? 4,500 × Actual price

Actual production × Actual price

Materials price variance 225 A

4,500 Kg of Material M should cost: 4,500 × $2.20 = $9,900

Let x = the actual cost of 4,500 kg of Material M
X = $(9,900 + 225) = $10,125
Actual cost per kg of Material M = Actual cost/4,500 kg
= $10,125/4,500 kg = $2.25

Materials price variances may be based on the quantity of material purchased or the amount used.

Exam advice

The MA exam may require the calculation of material variances based on purchases or production.
It is usually assumed that production is equal to sales.
If part of an operating statement, calculate materials variances based on production.

Activity 6

Big Manufacturing Co (BMC) uses a standard price for component X of $10.00 per unit. During the year, BMC
buys 30,000 units of component X for $12.50 each.

25,000 units of component X are used in production during the year.

i. Calculate the materials price variance based on materials purchased.

ii. Calculate the materials price variance based on materials used in production.
*Please use the notes feature in the toolbar to help formulate your answer.

This can be worked out in the following ways:

i. Based on purchases

($12.50 − $10.00) × 30,000 = $75,000 A

i. Based on usage

($12.50 − $10.00) × 25,000 = $62,500 A

23.3.5 Causes Of Materials Price Variances

3.5 Causes Of Materials Price Variances

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Materials price variances are caused by:

 General increases in the cost of materials (for example, when there is a worldwide shortage)
 When different suppliers are used
 When there is an increase or decrease in the bulk quantity discounts available
 When higher or lower quality materials are used, which will affect the prices paid: higher quality
materials cost more, and lower quality materials cost less.
23.3.6 Materials Usage Variance
3.6 Materials Usage Variance

The materials usage variance arises when the amount of material used in a budget period differs from the
amount budgeted to be used.
The materials usage variance is the difference between the following costs:
The amount of material that should have been used – this is the flexed materials budget quantity
The amount of material that was used – this is the actual quantity of materials used.

Materials usage variance

Actual production should have used (budgeted; kg) X Actual production × Budgeted quantity

Actual production did use (actual; kg) X Actual quantity

Material usage variance (kg) X/(X)

Standard cost per kg ($ per kg) X

Materials usage variance ($) X/(X)

Example

The following standard cost card excerpt is applicable:

STANDARD COST CARD – FOOTBALL $

Direct materials (Plastic F; 1 kg at $3 per kg) 3.00

5,100 footballs were produced in 20X5, and 5,250 kg of Plastic F was used, costing $14175.
Calculate the materials usage variance for 20X5

Materials Usage Variance Workings [1]

5,100 footballs should use 5,100 kg 5,100 footballs × 1 kg [2]

5,100 footballs did use 5,250 kg Actual usage (given) [3]

Materials usage variance 150 (A) kg $(5,100 − 5,250) [4]

x standard cost per kg $3

Materials usage variance (in $) $450 A 150 × $3 [5]

Notes:

1. The materials usage variance is calculated by comparing the expected usage of Plastic F for 5,100
footballs with the actual use of Plastic F for 5,100 footballs.
2. The expected materials usage for 5,100 footballs is 5,100 multiplied by the standard usage of 1 kg of
Plastic F per football. 5,100 footballs should therefore use 5,100 kg of Plastic F.
3. The actual materials usage for 5,100 footballs is 5,250 kg. This is the actual usage of Plastic F in 20X5.
4. The difference between the amount of Plastic F that 5,100 footballs should use and the amount of
Plastic F that 5,100 footballs did use is the materials usage variance in kg.
5. Multiply the difference of 150 kg by the standard cost of $3 per kg of Plastic F to calculate the materials
usage variance in $, which is $450. Remember that the standard cost is a predetermined estimated cost per
unit rather than the actual cost per unit.
The materials usage variance is adverse (A) because the actual volume of Plastic F required to make 5,100
footballs was more than expected.

Activity 7

An organisation has a budgeted material cost of $360,000 for 80,000 units per month. Each unit is budgeted
to use 3 kg of materials. The standard cost of material is $1.50 per kg. Actual materials in the month cost
$364,095 for 81,000 units, and 234,900 kg were purchased and used.

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Calculate the materials usage variance using the template provided.

Materials usage variance Workings

81,000 units should use 243,000 81,000 × 3 kg

81,000 units did use 234,900 Actual usage (given)

Materials usage variance (in kg) 8,100 F 243,000 − 234,900

x standard cost per kg $1.50

Materials usage variance (in $) $12,150 F 8,100 × $1.50

The materials usage variance is favourable because fewer materials were used than expected.

23.3.7 Reconciling With Material Total Variance

3.7 Reconciling With Material Total Variance

Material total variance = material price variance + material usage variance.

Example

An organisation has a budgeted material cost of $360,000 for 80,000 units per month. Each unit is budgeted to
use 3 kg of materials. The standard cost of material is $1.50 per kg. Actual materials in the month cost $364,095
for 81,000 units, and 234,900 kg were purchased and used.
The materials total variance is $405 F ([$1.50 × 3 × 81,000] − 364,095)

$ Workings

Materials price 11,745 A

variance

Materials usage 12,150 F

variance

Materials total 405 F Materials total variance = Materials price variance + Materials usage
variance variance =(11,745) + 12,150 = 405

23.3.8 Causes Of Materials Usage Variances

3.8 Causes Of Materials Usage Variances

 There is a range of factors that cause materials usage variances:

 Higher than expected levels of materials wastage
 Lower than expected levels of materials wastage
 A change in the standard quantity of material required for one unit of a product due to a product
specification change
 An incorrect standard
 Higher quality material may be used, which could result in lower levels of wastage than normal
 Lower quality material may be used, which could result in higher levels of wastage than normal.
23.4.1 Labour Total Variance
4.1 Labour Total Variance

Key Point

The variable production overheads variance is calculated in the same way as the labour variances.
The calculation of labour variances is highly similar to material variances. The labour total variance is the
difference between the following costs:
 The amount that labour should have cost for the actual production level in a period – this is the
flexed labour budget
 The amount that labour did cost in the budget period – this is the actual cost of labour.
Example

The standard cost card for a football from Winston’s Football Company is as follows:

STANDARD COST CARD – FOOTBALL $

Direct materials (Plastic F; 1 kg at $3 per kg) 3.00

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Example

Direct labour (2 hours at $6 per hour) 12.00

Standard prime cost 15.00

Variable production overheads (2 hours at $1 per hour) 2.00

Fixed production overheads (2 hours at $2 per hour) 4.00

Standard cost per football (full absorption production cost) 21.00

Standard gross profit (profit per football) 14.00

Standing selling price (sales price) 35.00

5,100 footballs were produced in 20X5, and 10,400 direct labour hours were used, costing $52,000.
Calculate the labour total variance for 20X5.

Labour total variance $ Workings

5,100 footballs should cost 61,200 5,100 × $12

5,100 footballs did cost 52,000 Actual cost (given)

Labour total variance 9,200 F

The actual labour cost in 20X5 was less than was budgeted to produce 5,100 footballs, and so the labour total
variance for this period is favourable.

23.4.2 Analysis Of The Labour Total Variance

4.2 Analysis Of The Labour Total Variance

The labour total variance calculated above can be further analysed into the following variances:
 Labour rate variance
 Labour efficiency variance.

They are calculated the same way as material price and usage variances.
It is normal to talk about a labour rate rather than a labour “price” and labour efficiency rather than the rather
harsh-sounding labour “usage”, but if the concepts of material price and usage are well understood, the
similar labour variances are reasonably straightforward.
Activity 8

The employees of an organisation worked 14,800 direct labour hours last month at an actual cost of $140,600
and manufactured 5,800 units. Each unit of product is budgeted to take 2.5 direct labour hours.

The standard direct labour cost per hour was $9.

Calculate the labour total variance

*Please use the notes feature in the toolbar to help formulate your answer.

Labour Total Variance $ Workings

5,800 units should have cost 130,500 5,800 × 2.5 × $9

5,800 units did cost 140,600 Actual cost (given)

Labour total variance 10,100 A $(130,500 − 140,600)

The labour total variance is adverse because the actual labour cost incurred in producing 5,800 units was
more than in the flexed budget.

23.4.3 Labour Rate Variance

4.3 Labour Rate Variance

If an organisation calculates the labour total variance and is adverse, it knows that too much more has been
spent on labour than expected.
The organisation might have paid too much per hour, paid for too many hours or allowed staff to waste time
while still being paid their hourly rate.

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To understand the cause(s) and take the necessary corrective action, the organisation requires more
information and looks into the sub-variances.
The labour rate variance arises when the amount paid per labour hour differs from the amount budgeted to
be paid per labour hour in a budget period.
The labour rate variance is the difference between the following costs:
 The amount that labour should have cost for the actual number of hours worked
 The amount that labour did cost for the actual number of hours worked.
Labour rate variance $

Labour should have cost (budgeted) X Actual hours × Budgeted rate

Labour did cost (actual) X Actual hours × Actual rate

Labour rate variance X/(X)

Example

The following standard cost card excerpt is applicable:

STANDARD COST CARD – FOOTBALL $

Direct labour (2 hours at $6 per hour) 12.00

5,100 footballs were produced in 20X5, and 10,400 direct labour hours were used, costing $52,000.
Calculate the labour rate variance for 20X5

labour rate variance $

10,400 direct labour hours should have cost (budgeted) 62,400 10,400 × $6
Actual quantity × Budgeted rate

10,400 direct labour hours did cost $52,000

labour rate variance 10,400 F

The labour rate variance is favourable (F) because the actual cost of 10,400 direct labour hours was less than
expected.

Activity 9

The employees of an organisation worked 14,800 direct labour hours last month at an actual cost of $140,600
and manufactured 5,800 units. Each unit of product is budgeted to take 2.5 direct labour hours.

The standard direct labour cost per hour was $9.

Calculate the labour rate variance.

*Please use the notes feature in the toolbar to help formulate your answer.

Labour rate variance $ Workings

14,800 hours should cost 133,200 14,800 × $9

14,800 hours did cost 140,600 Actual cost (given)

Labour rate variance 7,400 A $(133,200 − 140,600)

The labour rate variance is adverse (A) because the actual cost of 14,800 direct labour hours was more than
expected.
23.4.4 Causes Of Labour Rate Variances
4.4 Causes Of Labour Rate Variances

A variety of factors affect labour rate variances.

Activity 10

Determine if the statement would give rise to an adverse or favourable labour rate variance.

Statement Labour rate variance

Favourable or Adverse

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If more highly-skilled labour than expected is used in a budget period, this may Adverse
cost more per hour.

If lower-skilled labour than expected is used in a budget period, this may cost Favourable
less per hour.

More overtime hours were worked in a budget period than planned. Adverse

Bonus payments made in the budget period were higher than planned. Adverse
23.4.5 Labour Efficiency Variance
4.5 Labour Efficiency Variance

The labour efficiency variance arises when the actual amount of time taken to produce the actual production
volume differs from the amount of time expected. It is calculated the same way as the materials usage
variance.
The labour efficiency variance is the difference between the following:
The number of hours that it should take to produce the actual production volume – this is the flexed labour
hours budget.
The number of hours that it did take to make the actual production volume – this is the actual hours worked.

Labour efficiency variance

Actual production should have used (budgeted; hours) X Actual production × Budgeted hours

Actual production did use (actual; hours) X Actual hours

Labour efficiency variance (hours) X/(X)

Standard hourly rate($ per hour) X

Labour efficiency variance ($) X/(X)

Example

The following standard cost card excerpt is applicable:

STANDARD COST CARD – FOOTBALL $

Direct labour (2 hours at $6 per hour) 12.00

5,100 footballs were produced in 20X5, and 10,400 direct labour hours were used, costing $52,000.
Calculate the labour efficiency variance for 20X5

Labour efficiency variance Workings [1]

5,100 footballs should take 10,200 hours 2 hours per football [2]

5,100 footballs did take 10,400 hours Actual hours (given) [3]

Labour efficiency variance (in hours) 200 A 10,200 − 10,400 [4]

x standard cost per labour hour $6

Labour efficiency variance (in $) $1,200 A 200 × $6 [5]

Notes

1. The labour efficiency variance is calculated by comparing the number of hours that it should take to
produce 5,100 footballs with the actual number of labour hours that it did take to make 5,100 footballs.
2. Each football takes 2 hours to make; so, 5,100 footballs should take 5,100 multiplied by 2 hours which
equals 10,200 labour hours.
3. But it actually took 10,400 labour hours to make 5,100 footballs.
4. The difference between the expected hours to make 5,100 footballs and the actual hours it took to make
5,100 footballs is 200 hours. This is our labour efficiency variance in hours.
5. To calculate our labour efficiency variance in $, multiply the 200 hours by the standard labour hour cost,
which is $6. The labour efficiency in $ is, therefore, $1,200.
The labour efficiency variance is adverse (A) because the number of hours it took to produce 5,100 footballs was
more than expected.

Activity 11

The employees of an organisation worked 14,800 direct labour hours last month at an actual cost of $140,600
and manufactured 5,800 units. Each unit of product is budgeted to take 2.5 direct labour hours.

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The standard direct labour cost per hour was $9.

Calculate the labour efficiency variance

*Please use the notes feature in the toolbar to help formulate your answer.

Labour efficiency variance Workings

5,800 units should take 14,500 hours 5,800 × 2.5 hours

5,800 units did take 14,800 hours Actual hours (given)

Labour efficiency variance (in hours) 300 A 14,500 − 14,800

x standard cost per labour hour $9

Labour efficiency variance $2,700 A 300 × $9

The labour efficiency variance is adverse because more hours were worked than expected to produce 5,800
units last month.

23.4.6 Working Backwards

4.6 Working Backwards

Activity 12

An organisation uses standard costing. The following information is available for last month:

 2,800 hours were worked.

 The standard allowance for the actual number of units produced is 2,850 hours.
 The standard rate per labour hour is $4.80.
 The adverse labour rate variance is $840.
What was the actual rate paid per labour hour worked last month?

A. $4.50
B. $4.80
C. $5.10
D. $5.40
*Please use the notes feature in the toolbar to help formulate your answer.

C) $5.10

2,800 hours should cost 13,440 2,800 × $4.80

2,800 hours did cost x

Labour rate variance 840 A

Let x = the actual cost of the actual hours worked

The actual cost of 2,800 hours = x

13,440 − x = −840

Therefore x = 13,440 + 840 = 14,280

The actual cost of the 2,800 hours worked last month = $14,280

Therefore the actual rate paid per labour hour worked last month = $14,280/2,800 hours = $5.10
Activity 13 Actual Labour Rate

Steamer operates a standard marginal costing system. The standard cost card for one of its products shows
that it requires five hours of labour at an hourly rate of $12. Last month, 11,500 units were produced, and the
following variances arose:

Labour rate variance $45,000 adverse

Labour efficiency variance $30,000 adverse

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Calculate the actual rate paid per hour.

*Please use the notes feature in the toolbar to help formulate your answer.

The actual rate per hour is the total actual cost divided by actual hours – neither of which is given in this
case. Therefore it is necessary to use the efficiency variance to calculate actual hours and the rate variance
to calculate actual labour cost.

11,500 units should take (x 5 hrs) 57,500 hours

Actual number of units did take ? hours

Labour efficiency variance in hours (?)

× standard cost per labour hour × $12

Labour efficiency variance $30,000 Adverse

Therefore, the labour efficiency variance in hours = $30,000 / $12 = 2,500 hours.

Therefore, the actual number of hours taken was 57,500 + 2,500 = 60,000. (Actual hours should have been
57,500, but the variance is adverse, meaning that the actual number of hours taken was more than 57,500.)

60,000 hours should cost (x $12) 720,000

60,000 hours did cost ?

Labour rate variance 45,000 Adverse

60,000 hours should have cost $720,000, but an adverse labour rate variance means 23.4.7 Reconciling
with Labour Total Variance
4.7 Reconciling with Labour Total Variance

Example

The employees of an organisation worked 14,800 direct labour hours last month at an actual cost of $140,600 and
manufactured 5,800 units. Each unit of product is budgeted to take 2.5 direct labour hours.
The standard direct labour cost per hour was $9.

$ Workings

Labour rate variance 7,400 A

Labour efficiency variance 2,700 A

Labour total variance 10,100 A Labour total variance = Labour rate variance + Labour
efficiency variance = (7,400) + (2,700) = (10,100)

they cost more: $720,000 + $45,000 = $765,000

Therefore actual (average) hourly rate paid = $765,000 ÷ 60,000 hours = $12.75 per hour

23.4.7 Reconciling with Labour Total Variance

4.7 Reconciling with Labour Total Variance

Example

The employees of an organisation worked 14,800 direct labour hours last month at an actual cost of $140,600 and
manufactured 5,800 units. Each unit of product is budgeted to take 2.5 direct labour hours.
The standard direct labour cost per hour was $9.

$ Workings

Labour rate variance 7,400 A

Labour efficiency variance 2,700 A

Labour total variance 10,100 A Labour total variance = Labour rate variance + Labour
efficiency variance = (7,400) + (2,700) = (10,100)

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23.4.8 Causes Of Labour Efficiency Variances

4.8 Causes Of Labour Efficiency Variances

Various factors affect labour efficiency variances:

4.8.1 Causes Of A Favourable Variance
 More highly-skilled labour
If more highly-skilled labour than expected is used in a budget period, this may cause output to be produced
more quickly than expected. This will give rise to a favourable labour efficiency variance.

 Increased supervision
If there is increased supervision due to more supervisors being employed, this may cause employees to
work more efficiently.

 Staff training increased
If staff training is increased, employees can do their jobs more efficiently.

 New incentives introduced
If new incentives are introduced during the budget period (for example, a new bonus scheme), workers may
be motivated to work more quickly. This would lead to increased efficiency levels.

4.8.2 Causes Of An Adverse Variance
 Lower skilled labour
If lower-skilled labour than expected is used in a budget period, this may cause output to be produced more
slowly than expected. This will give rise to an adverse labour efficiency variance.

 New employees
New employees will work less efficiently than experienced employees because they will not benefit from the
learning curve effect.

 Demotivated staff
If staff are demotivated or in dispute with management, this is likely to result in each unit taking longer to
produce than was expected, resulting in an adverse efficiency variance.

23.5.1 Fixed Production Overhead Variances
5.1 Fixed Production Overhead Variances

5.1.1 Impact of Production Levels on Fixed Production Overheads

The higher the production level, the more beneficial it is to a company regarding its fixed production
overheads.
Higher production levels mean more production units absorb the fixed production overhead.

Example

A car manufacturer launches a new car and expects to produce and sell 100,000 units in the launch year.
The car has proved very popular, and the company manufactures and sells 200,000 units in the launch year.
The company set the car’s selling price based on the need to absorb (recover) their fixed production costs over
100,000 units.
In producing and selling 200,000 units, the company have incurred the same fixed costs.
The contribution per unit will be the same as the selling price per unit, and the variable costs per unit will be the
same with 200,000 units sold as with 100,000 units sold.
The profit per unit will increase because of the over-absorption of fixed production overhead.
So, higher production levels are beneficial when considering fixed production overheads.

Two ways to absorb (recover) a different amount of fixed production overhead from the amount of fixed
production overhead actually incurred are:
 Spend more or less on fixed production overhead than was expected (an expenditure variance)
 Make more or fewer units than was expected (a volume variance)
These two things make up the under or over-absorption of fixed production overhead for the period.
5.1.2 Marginal Costing – Fixed Production Overhead Variances

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In a marginal costing system, there is only one fixed production overhead variance: the fixed production
overhead expenditure variance. The fixed production overhead total variance in a marginal costing system is,
therefore, equal to the fixed production overhead expenditure variance.
This is because fixed production overheads are not absorbed into the cost of a unit of product as they are
with absorption costing - they are treated as a period cost and written off in the statement of profit or loss for
the budget period.
5.1.3 Absorption Costing – Fixed Production Overhead Variances
Organisations that use absorption costing systems absorb the fixed production overheads into the product
units produced in a budget period.
The amount of fixed production overhead absorbed is based on a fixed production overhead rate decided
before the budget period. This means there may be under-or over-absorption of fixed production overheads
in a budget period.
In an absorption costing system, the fixed production overhead total variance is equivalent to any under- or
over-absorption which might have occurred in a budget period. This fixed production overhead total
variance can be separated into the following:
 Fixed production overhead expenditure variance
 Fixed production overhead volume variance.

Key Point

In absorption costing, the fixed production overhead total variance is the amount of under or over-absorbed
fixed (production) overhead in the budget period.
In marginal costing, the only fixed production overhead variance is the fixed production overhead expenditure
variance (the difference between the actual fixed production overhead and the budgeted fixed production
overhead).
The fixed production overhead expenditure variance is calculated in the same way for both absorption and
marginal costing.

23.5.2 Fixed Production Overhead Total Variance

5.2 Fixed Production Overhead Total Variance

The fixed production overhead total variance is the difference between the fixed production overheads
absorbed and actual fixed production overheads incurred. Therefore, it will be the amount of over or under-
absorption.

Fixed production overhead total $

variance

Total fixed production overheads X Actual production units × standard absorption base per unit ×
absorbed overhead absorption rate

Total fixed production overheads X

incurred

Fixed production overhead total X/(X)

variance

Example

The standard cost card for a football from Winston’s Football Company is as follows:

STANDARD COST CARD – FOOTBALL $

Direct material (Plastic F; 1 kg at $3 per kg) 3.00

Direct labour (2 hours at $6 per hour) 12.00

Standard prime cost 15.00

Variable production overheads (2 hours at $1 per hour) 2.00

Fixed production overheads (2 hours at $2 per hour) 4.00

Standard cost per football (full absorption production cost) 21.00

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Example

Standard gross profit (profit per football) 14.00

Standing selling price (sales price) 35.00

5,100 footballs were produced in 20X5, and 10,400 direct labour hours were used. Actual fixed production
overheads incurred in 20X5 were $19,760.
The expected number of footballs to be produced in 20X5 was 4,800.
Calculate the fixed production overhead total variance for 20X5.

Fixed production overhead total $

variance

Total fixed production overheads 20,400 5,100 × 2 direct labour hours × $2 per direct labour hour
absorbed
Actual production units × standard absorption base per unit ×
overhead absorption rate

Total fixed production overheads 19,760

incurred

Fixed production overhead total 640 F 20,400 − 19,760

variance
The profit per unit will increase because of the over-absorption of fixed production overhead.
This variance is favourable because more overheads were absorbed than expected.

23.5.3 Fixed Production Overhead Expenditure Variance

5.3 Fixed Production Overhead Expenditure Variance

The fixed production overhead total variance is explained by either:

 The fixed production overhead expenditure variance (the difference between the budgeted fixed
production overhead expenditure and the actual fixed production overhead expenditure); and
 The fixed production overhead volume variance (the actual production volume differing from the
expected production volume)
Breaking the total fixed production overhead variance into these two variances will help an organisation
understand how and why under or over-absorption occurred.
5.3.1 Fixed Overhead Expenditure Variance

Fixed production overhead $

expenditure variance

Budgeted fixed production X Budgeted production units × standard absorption base per unit
overheads absorbed × overhead absorption rate

Total fixed production overheads X

incurred

Fixed production overhead X/(X)

expenditure variance

Example

The standard cost card for a football from Winston’s Football Company is as follows:

STANDARD COST CARD – FOOTBALL $

Fixed production overheads (2 hours at $2 per hour) 4.00

5,100 footballs were produced in 20X5, and 10,400 direct labour hours were used. Actual fixed production
overheads incurred in 20X5 were $19,760.
The expected number of footballs to be produced in 20X5 was 4,800.
Calculate the fixed production overhead expenditure variance for 20X5.

Fixed production overhead $

expenditure variance

Budgeted fixed production 19,200 4,800 × 2 direct labour hours × $2 per direct labour hour
overheads absorbed
Budgeted production units × standard absorption base per unit
× overhead absorption rate

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Example

Total fixed production overheads 19,760

incurred

Fixed production overhead 560 A

expenditure variance
The variance is adverse because actual fixed production overheads were more than expected.

23.5.4 Possible Causes Of Fixed Production Overhead Variances

5.4 Possible Causes Of Fixed Production Overhead Variances

When fixed production costs (such as factory rent, canteen running costs and so on) are higher or lower
than expected, then differences between budgeted and actual fixed production costs will arise. This will
therefore cause variances to occur in the budget period.

Example

At Winston’s Football Factory, in 20X4, when the World Cup was on, Winston had to rent additional factory
space to cope with the increased demand for footballs. At the beginning of 20X4, when the budgets had been
prepared, this additional factory rent had not been predicted; it is, therefore, likely that the factory rental cost
(and therefore the fixed production overheads) in this budget period were higher than expected.
This would have given rise to an adverse fixed production overhead variance.

Activity 14

1. The fixed production overhead expenditure variance only occurs when an organisation uses
absorption costing.
Is the above statement true or false?

2.
1. Organisations that use marginal costing will only calculate one fixed production overhead variance:
the fixed production overhead volume variance.
Is the above statement true or false?

2.
1. The following information relates to the fixed budget and actual results of an organisation for a
budget period.
Standard fixed production overhead absorbed per unit (2.5 hours @$2 per hour) $5

Actual direct labour hours to make 87,000 units 215,400 hours

Actual fixed production overheads in the budget period $460,000

Fixed budget production volume 85,000

Fixed budget direct labour hours (85,000 units at 2.5 hours each) 212,500 hours

2.
Fixed production overheads are absorbed based on labour hours, and the actual volume produced in the
budget period was 87,000 units.

3.
What is the fixed production overhead expenditure variance for the budget period?

4.
. $14,500 adverse
. $14,500 favourable
. $35,000 adverse
. $35,000 favourable
*Please use the notes feature in the toolbar to help formulate your answer.

1. False

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The fixed production overhead variance occurs in organisations that use absorption costing and marginal
costing. Marginal costing still considers fixed production overheads and budgets for them but does not
attempt to work out a fixed production overhead per unit.

2.
1. False

The only fixed production overhead variance that is calculated under marginal costing systems is the fixed
production overhead expenditure variance.

2.
1. C. $35,000 adverse
Fixed production overhead expenditure variance $

Budgeted fixed production overheads – 85,000 units (85,000 × $5) 425,000

Actual fixed production overheads 460,000

Fixed production overhead expenditure variance 35,000 A

2.
5.4.1 Summary
 The only fixed production overhead variance under a marginal costing system is the fixed
production overhead expenditure variance.
 The fixed production overhead expenditure variance under marginal and absorption costing is
calculated similarly.
 The fixed production overhead total variance in an absorption costing system is the amount of
under or over-absorbed overhead in a budget period.
 The amount of under- or over-absorption in a period comprises the fixed production overhead
expenditure variance and the fixed production overhead volume variance.
 If a business uses absorption costing and produces more than expected, this will create a
FAVOURABLE fixed production overhead volume variance. The more produced, the greater the chance
to over-absorb fixed production overheads, increasing profit.
23.5.5 Fixed Production Overhead Volume Variance (Absorption Costing)
5.5 Fixed Production Overhead Volume Variance (Absorption Costing)

The fixed production overhead volume variance identifies how much of the fixed production overhead total
variance occurs due to the difference between actual and expected production volume.

Fixed production overhead volume $

variance

Budgeted fixed production X Budgeted production units × standard absorption base per unit
overheads absorbed × overhead absorption rate

Total fixed production overheads X Actual production units × standard absorption base per unit ×
absorbed overhead absorption rate

Fixed production overhead volume X/(X)

variance

Example

The standard cost card for a football from Winston’s Football Company is as follows:

STANDARD COST CARD – FOOTBALL $

Fixed production overheads (2 hours at $2 per hour) 4.00

5,100 footballs were produced in 20X5, and 10,400 direct labour hours were used. Actual fixed production
overheads incurred in 20X5 were $19,760.
The expected number of footballs to be produced in 20X5 was 4,800.
Calculate the fixed production overhead volume variance for 20X5.

Fixed production $ Workings

overhead volume
variance

Budgeted fixed 19,200 4,800 × 2 direct labour hours × $2 per direct labour hour
production overheads
Budgeted production units × standard absorption base per unit × overhead
absorbed
absorption rate

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Example

Total fixed production 20,400 5,100 × 2 direct labour hours × $2 per direct labour hour
overheads absorbed
Actual production units × standard absorption base per unit × overhead
absorption rate

Fixed production 1,200 $(20,400 − 19,200)

overhead volume F
variance
More fixed production overheads were actually absorbed than were budgeted to be absorbed – giving rise to a
favourable variance.

Activity 15

This information relates to the fixed budget and actual results of an organisation for a budget period. Fixed
production overheads are absorbed based on labour hours, and the actual volume produced in the budget
period was 87,000 units.

Standard fixed production overhead absorbed per unit (2.5 hours @$2 per hour) $5

Actual direct labour hours to make 87,000 units 215,400 hours

Actual fixed production overheads in the budget period $460,000

Fixed budget production volume 85,000

Fixed budget direct labour hours (85,000 units at 2.5 hours each) 212,500 hours

Calculate the fixed production overhead volume variance using the template provided.

Fixed production overhead $ Workings

volume variance

Budgeted fixed production 425,000 85,000 × 2.5 direct labour hours × $2 per direct labour hour
overheads absorbed Budgeted production units × standard absorption base per unit
× overhead absorption rate

Total fixed production 435,000 87,000 × 2.5 direct labour hours × $2 per direct labour hour
overheads absorbed Actual production units × standard absorption base per unit ×
overhead absorption rate

Fixed production overhead 10,000 F 435,000 − 425,000

volume variance
23.5.6 Causes Of Fixed Production Volume Variances
5.6 Causes Of Fixed Production Volume Variances

A fixed production volume variance will occur when budgeted production volumes differ from the actual
production volumes for a budget period. This can happen for an almost infinite number of reasons, including:
 Production volumes are lower than expected because of strike action by workers
 Production volumes are lower than expected because of the increased number of machine
breakdowns
 Production volumes are lower than expected because of a fall in demand for a product
 Production volumes are lower than expected because of a shortage of labour
 Production volumes are higher than expected due to an increase in the demand for a product
23.5.7 Reconciling with Fixed Production Overheads Total Variance
5.7 Reconciling with Fixed Production Overheads Total Variance

The fixed production overhead total variance comprises the fixed production overhead expenditure variance
and the fixed production overhead volume variance.

Example

The fixed production overheads variances for Winston’s Football Factory are as follows:

$ Workings

Fixed production overhead 560 A

expenditure variance

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Example

Fixed production overhead 1,200 F

volume variance

Fixed production overhead 640 F Fixed production overhead volume variance + Fixed production
total variance overhead expenditure variance = Fixed production overhead total
variance
Note that the fact that the actual level of production is higher than the expected level of production has resulted
in the over-absorption of fixed production overheads and increased profit for the period.
The total of the expenditure and volume variances here is 640 Favourable. This is the figure calculated earlier on
when for the total over-absorption.

23.5.8 Working Backwards

5.8 Working Backwards

The exam may require calculating actual or standard figures where the variances are given.

Example

An organisation has budgeted to produce and sell 6,000 units of its single product. It uses standard costing, and
the fixed production overhead per unit is $6.50
During the period, the following variances occurred.
Fixed production overhead expenditure variance: $5,000 A
Fixed production overhead volume variance: $7,800 F
Calculate the actual fixed overheads in the period and the actual production volume in the period.

$ Workings

Actual fixed overheads x

Budgeted fixed overheads 39,000 $6.50 × 6,000

Fixed production overhead expenditure variance 5,000 A

The fact that the fixed overhead expenditure variance is adverse means that the actual fixed overheads were
$5,000 more than budgeted.
Actual fixed overheads = budgeted fixed overheads + fixed overhead expenditure variance
= $39,000 + $5,000
= $44,000
Calculating the actual production volume
The fixed production overhead volume variance (in units) = Fixed overhead volume variance
Standard fixed overhead rate per unit
= $7,800 ÷ $6.50
= 1,200 units (Favourable)
The fact that the variance is favourable means that 1,200 more units were produced than budgeted:
6,000 + 1,200 = 7,200 units.
Alternative method:

$ Workings

Actual units × standard fixed overhead rate per unit x x × $6.50

Budgeted expenditure 39,000 $6.50 × 6,000

Fixed production overhead volume variance 7,800 F

Actual units × standard fixed overhead rate per unit = $39,000 + $7,800
= $46,800
Actual units = $46,800 ÷ standard fixed overhead rate per unit $6.50
= 7,200 units

23.5.9 Subdivision Of The Fixed Production Overhead Volume Variance

5.9 Subdivision Of The Fixed Production Overhead Volume Variance

The fixed production overhead volume variance can be further subdivided into:

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 Fixed production overhead capacity variance

 Fixed production overhead efficiency variance

These sub-variances are calculated to explain the cause of variances and what corrective action is required.
Sub-variances relating to capacity variance will provide information about the amount of activity.

Key Point

Fixed overhead volume variance and its sub-variances only apply to absorption costing.
23.5.10 Fixed Production Overhead Capacity Variance
5.10 Fixed Production Overhead Capacity Variance

The fixed production overhead capacity variance is the difference between planned hours of work and actual
hours worked, multiplied by the standard absorption rate per hour.
If actual hours worked are more than budgeted, the variance is favourable, is more fixed overheads can be
absorbed.
When calculating the fixed production overhead capacity variance, calculate the difference between the work
hours in the fixed budget and the actual budget.

Fixed production overhead capacity variance Workings

Budgeted absorption basis Budgeted production units × standard

X
absorption base per unit

Actual absorption basis X

Capacity variance X/(X)

×Standard overhead absorption rate per basis ($ per

X
basis)

Fixed production overhead capacity variance ($) X/(X)

Example

The standard cost card for a football from Winston’s Football Company is as follows:

STANDARD COST CARD – FOOTBALL $

Fixed production overheads (2 hours at $2 per hour) 4.00

5,100 footballs were produced in 20X5, and 10,400 direct labour hours were used. Actual fixed production
overheads incurred in 20X5 were $19,760.
The expected number of footballs to be produced in 20X5 was 4,800.
Calculate the fixed production overhead capacity variance for 20X5.

Fixed production overhead capacity variance Workings

Budgeted absorption basis 9,600 4,800 × 2 direct labour hours

Budgeted production units × standard absorption
base per unit

Actual absorption basis 10,400 Direct labour hours

Capacity variance 800 F 10,400 − 9,600

×Standard overhead absorption rate per basis 2

($ per basis)

Fixed production overhead capacity variance ($) 1,600

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Example

F
More fixed production overheads were actually absorbed than were budgeted to be absorbed – which is a
favourable situation, and therefore, this gives rise to a favourable variance.
Since more hours were worked than were budgeted, the variance is favourable.

Activity 16

This information relates to the fixed budget and actual results of an organisation for a budget period. Fixed
production overheads are absorbed based on labour hours, and the actual volume produced in the budget
period was 87,000 units.

Standard fixed production overhead absorbed per unit (2.5 hours @$2 per hour) $5

Actual direct labour hours to make 87,000 units 215,400 hours

Actual fixed production overheads in the budget period $460,000

Fixed budget production volume 85,000

Fixed budget direct labour hours (85,000 units at 2.5 hours each) 212,500 hours

Calculate the fixed production overhead capacity variance using the template provided.

Fixed production overhead capacity variance

Budgeted absorption basis

Actual absorption basis

Capacity variance

×Standard overhead absorption rate per basis ($ per basis)

Fixed production overhead capacity variance ($)

*Please use the notes feature in the toolbar to help formulate your answer.

Fixed production overhead capacity variance Workings

Budgeted absorption basis 212,500 85,000 × 2.5 direct labour hours

Budgeted production units × standard absorption
base per unit

Actual absorption basis 215,400 Direct labour hours

Capacity variance 2,900 F 215,400 − 212, 500

×Standard overhead absorption rate per basis 2

($ per basis)

Fixed production overhead capacity variance 5,800 F

($)

The fixed production overhead capacity variance is favourable because the actual hours worked were more
than the originally budgeted hours.

23.5.11 Fixed Production Overhead Efficiency Variance

5.11 Fixed Production Overhead Efficiency Variance

The other way to increase productivity and remain cost-effective is to work smarter rather than harder.
The fixed production overhead efficiency variance measures how ‘smart’ or efficient an organisation is, while
the fixed production overhead capacity variance measures how hard an organisation works.

Fixed production overhead efficiency variance Workings

Actual production should take (basis) Actual production units × standard absorption
base per unit

Actual production actually took (basis) Actual absorption base

Efficiency variance (basis)

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×Standard overhead absorption rate per basis

($ per basis)

Fixed production overhead efficiency variance

($)
If an organisation works smart and hard, it should be rewarded ¬in the form of over-absorption and a long-
term reduction in the fixed cost per unit.

Example

The standard cost card for a football from Winston’s Football Company is as follows:

STANDARD COST CARD – FOOTBALL $

Fixed production overheads (2 hours at $2 per hour) 4.00

5,100 footballs were produced in 20X5, and 10,400 direct labour hours were used. Actual fixed production
overheads incurred in 20X5 were $19,760.
The expected number of footballs to be produced in 20X5 was 4,800.
Calculate the fixed production overhead efficiency variance for 20X5.

Fixed production overhead efficiency variance Workings

5,100 footballs should take 10,200 5,100 × 2 direct labour hours

Actual production units × standard absorption
base per unit

5,100 footballs actually took 10,400 Actual absorption base

Capacity variance 200 A 10,400 − 10,200

×Standard overhead absorption rate per basis 2

($ per basis)

Fixed production overhead efficiency variance ($) 400 A

The fixed production overhead efficiency variance is adverse because the number of hours it took to produce
5,100 footballs was more than expected.

5.11.1 Check
The fixed production overhead volume variance comprises the fixed production overhead capacity variance
and the fixed production overhead efficiency variance.

Example

The fixed production overhead volume variances for Winston’s Football Factory may be reconciled as follows:

$ Workings

Fixed production overhead 1,600

capacity variance F

Fixed production overhead 400 A

efficiency variance

Fixed production overhead 1,200 Fixed production overhead capacity variance + Fixed production
volume variance F overhead efficiency variance = Fixed production overhead volume
variance
The results for the fixed production overhead capacity variance and fixed production overhead efficiency
variance show that the workers at Winston’s factory appear to have worked harder (longer hours) but at lower
efficiency (less smart). It is possible that the employees at Winston’s factory were tired because of working long
hours, so they were less efficient.

Activity 17

This information relates to the fixed budget and actual results of an organisation for a budget period. Fixed
production overheads are absorbed based on labour hours, and the actual volume produced in the budget
period was 87,000 units.

Standard fixed production overhead absorbed per unit (2.5 hours @$2 per hour) $5

Actual direct labour hours to make 87,000 units 215,400 hours

Actual fixed production overheads in the budget period $460,000

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Fixed budget production volume 85,000

Fixed budget direct labour hours (85,000 units at 2.5 hours each) 212,500 hours

Calculate the fixed production overhead efficiency variance using the template provided.

Fixed production overhead efficiency variance

87,000 units should take

87,000 units actually took

Capacity variance

×Standard overhead absorption rate per basis ($ per basis)

Fixed production overhead efficiency variance ($)

*Please use the notes feature in the toolbar to help formulate your answer.

Fixed production overhead efficiency variance Workings

87,000 units should take 217,500 87,000 × 2.5 direct labour hours
Actual production units × standard absorption
base per unit

87,000 units actually took 215,400 Actual absorption base

Capacity variance 2,100 F 215,400 − 217,500

×Standard overhead absorption rate per basis 2

($ per basis)

Fixed production overhead efficiency variance 4,200 F

($)

The fixed production overhead efficiency variance is favourable because producing 87,000 units took fewer
hours to make than expected, meaning the employees worked more efficiently than expected.

23.6.1 Reconciliations Under Standard Absorption Costing

6.1 Reconciliations Under Standard Absorption Costing

Key Point

Only the sales volume variance adjusts the fixed budget contribution or profit. The other variances reconcile
the standard contribution or profit on actual sales (flexed budget) to the actual contribution or profit.
An operating statement is a statement or schedule that summarises all of the variances for a budget period
and reconciles, or compares, the budgeted profit with the actual profit for that period.
The statement presents management with a concise summary of variances and some commentary or
explanation. It enables management to identify the areas that are not proceeding as planned and require
their attention.
6.1.1 Standard absorption costing operating statements
Absorption costing operating statements have three main features.
 Starts with budgeted profit
Absorption costing operating statements start with the budgeted profit for the budget period.

 Standard profit on actual sales
The standard profit on actual sales for a budget period is calculated by adding the favourable sales volume
variance to the budgeted profit or subtracting the adverse sales volume variance from the budgeted profit.

 Actual profit for the budget period
The actual profit for a budget period is calculated by adding favourable variances and subtracting adverse
variances from the standard profit on actual sales.

Example

The 20X5 results for Winston’s Football Factory are as follows:

The sales budget for 20X5 was set at 4,800 units selling at $35 each.
The standard absorption cost per football was $21, and the standard contribution per football was $18.

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Example

The actual results for 20X5 were as follows:

5,100 footballs were sold for $168,300, and non-production overheads were $34,500.
The variances calculated were as follows:

Favourable Adverse

$ $

Sales volume variance 4,200

Sales volume contribution variance 5,400

Sales price variance 10,200

Materials price variance 1,575

Materials price variance 450

Labour rate variance 10,400

Labour efficiency variance 1,200

Variable production overhead expenditure variance 2,080

Variable production overhead efficiency variance 200

Fixed production overhead expenditure variance 560

Fixed production overhead volume variance 1,200

Prepare the absorption costing operating statement.

Favourable variances Adverse variances Notes

$ $ $

Budgeted gross profit 67,200 1

Sales volume variance 4,200 4,200

Standard profit on actual sales 71,400 2

Sales price variance 10,200 (10,200)

Materials price 1,575 1,575

Materials usage 450 (450)

Labour rate 10,400 10,400

Labour efficiency 1,200 (1,200)

Variable production overhead rate 2,080 (2,080)

Variable production overhead efficiency 200 (200)

Fixed production overhead expenditure 560 (560)

Fixed production overhead volume variance 1,200 1,200

Actual gross profit 69,885 3

Non-production overheads (34,500) 4

Actual net profit 35,385 5

Notes:
[1] The standard profit per football = standard selling price − standard total absorption cost = $35 − 21 = $14
The budgeted profit = 4,800 footballs × $14 per football = $67,200
[2] Standard profit on actual sales = budgeted profit + favourable sales volume variance = $(67,200 + 4,200) =
$71,400
[3] Actual gross profit = Standard profit on actual sales + favourable variances − adverse variances = $(71,400 +
1,575 + 10,400 + 1,600 − 10,200 − 450 − 1,200 − 2,080 − 200 − 560 − 400) = $69,885
[4] Non-production overheads – this is the actual result for 20X5
[5] Actual net profit = actual gross profit – non-production overheads = $(69,885 − 34,500) = $35,385

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Activity 18

The following variances for a company have been calculated.

Sales price variance $2,300 favourable

Sales volume variance $500 adverse

Materials price variance $600 favourable

Materials usage variance $2,400 favourable

Labour rate variance $400 favourable

Labour efficiency variance $1,200 adverse

Fixed production overhead expenditure variance $2,000 adverse

Fixed production overhead volume variance $4,500 favourable

The fixed budget profit for the budget period was $45,000.

Produce the absorption costing operating statement

+/− $

Fixed budget profit N/A 45,000

Sales volume variance − 500

Sales price variance + 2,300

Materials price variance + 600

Materials usage variance + 2,400

Labour rate variance + 400

Labour efficiency variance − 1,200

Fixed production overhead expenditure variance − 2,000

Fixed production overhead volume variance + 4,500

Actual profit 51,500

6.1.2 Summary
 Add favourable variances to the budgeted profit
 Subtract adverse variances from the budgeted profit.
23.6.2 Marginal Costing Operating Statements
6.2 Marginal Costing Operating Statements

Marginal costing operating statements have three main features.

 Start with the budgeted contribution
Marginal costing operating statements start with the budgeted contribution for the budget period.

 Standard contribution on actual sales
The standard contribution on actual sales for a budget period is calculated by adding the favourable sales
volume variance to the budgeted contribution or subtracting the adverse sales volume variance from the
budgeted contribution.

 Actual profit for a budget period
The actual profit for a budget period is calculated by adding favourable variances and subtracting adverse
variances to the standard contribution on actual sales.

Some companies prefer to produce operating statements that reconcile budgeted contribution to actual
contribution and ignore fixed costs altogether.

Example

The 20X5 results for Winston’s Football Factory are as follows:

The sales budget for 20X5 was set at 4,800 units selling at $35 each.

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Example

The standard absorption cost per football was $21, and the standard contribution per football was $18.
The actual results for 20X5 were as follows:
5,100 footballs were sold for $168,300, and non-production overheads were $34,500.
The variances calculated were as follows:

Favourable Adverse

$ $

Sales volume variance 4,200

Sales volume contribution variance 5,400

Sales price variance 10,200

Materials price variance 1,575

Materials price variance 450

Labour rate variance 10,400

Labour efficiency variance 1,200

Variable production overhead expenditure variance 2,080

Variable production overhead efficiency variance 200

Fixed production overhead expenditure variance 560

Fixed production overhead volume variance 1,200

Prepare the marginal costing operating statement.

Favourable Adverse Notes

$ $ $

Budgeted contribution 86,400 1

Sales volume contribution variance 5,400 +5,400

Standard contribution on actual sales (flexed budget contribution) 91,800 2

Sales price variance 10,200 −10,200

Materials price 1,575 +1,575

Materials usage 450 −450

Labour rate 10,400 +10,400

Labour efficiency 1,200 −1,200

Variable overhead rate 2,080 −2,080

Variable overhead efficiency 200 −200

Actual contribution 89,645 3

Actual fixed production overheads (19,760) 4

Actual non-production overheads (34,500) 5

Profit for the period 35,385 6

Notes:
[1] The standard contribution per football = standard selling price − standard marginal cost = $35 − 17 = $18
The budgeted contribution = 4,800 footballs × $18 per football = $86,400
[2] Standard contribution on actual sales = budgeted contribution + favourable sales volume variance = $(86,400 +
5,400) = $91,800
[3] Actual gross profit = Standard contribution on actual sales + favourable variances − adverse variances =
$(91,800 − 10,200 + 1,575 − 450 + 10,400 − 1,200 − 2,080 − 200) = $89,645
[4] Actual fixed production overheads:

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Example

Budgeted fixed overhead per unit = fixed overhead volume variance ÷ (Actual sales units − budgeted sales units)
= 1,200 ÷ (5,100 − 4,800) = $4 per unit.
Total budgeted fixed overheads = $4 × 4,800 units = $19,200
Actual fixed production overheads = budgeted fixed overheads + expenditure variance
= $19,200 + $560 = $19,760
[5] Non-production overheads – this is the actual result for 20X5
[6] The actual profit for the period = actual gross profit – fixed production overheads – non-production overheads
= $(89,645 − 19,760 − 34,500) = $35,385.

23.6.3 Proof of net profit figure

6.3 Proof of net profit figure

Example

The sales revenue was $168,300, and the costs for producing and selling 5,100 footballs are shown in the
following table.

Actual results

5,100 footballs

($)

Materials cost for 5,250 kg 14,175

Labour cost for 10,400 hours 52,000

Variable production overheads 12,480

Fixed production overheads 19,760

Non-production overheads 34,500

Total costs 132,915

Therefore, the net profit for 20X5 is expected to be:
Net profit = sales revenue − total costs
Net profit = $168,300 − $132,915 = $35,385
As seen in the operating statements, the net profit for 20X5 was $35,385, as expected.

Activity 19
An organisation uses marginal costing. In a period, the actual net profit was $82,000, and the variances were
as follows:

Materials variance 200 adverse

Labour variance 4,000 favourable

Overheads variance 1,500 favourable

Sales price variance 800 adverse

Sales volume contribution variance 920 favourable

What was the budgeted net profit for the period?

A. $76,580
B. $76,700
C. $81,880
D. $87,420

*Please use the notes feature in the toolbar to help formulate your answer.

A) $76,580

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Let budgeted net profit = x

x − 200 + 4,000 + 1,500 − 800 + 920 = 82,000

Alternatively, this can be worked out by going backwards As follows:

x = 82,000 + 200 − 4,000 − 1,500 + 800 − 920 = 76,580

Budgeted net profit 76,580

Materials variance −200

Labour variance +4,000

Overheads variance +1,500

Sales price variance −800

Sales volume contribution variance +920

Actual net profit 82,000

6.3.1. Summary
Don’t forget to:
 Add favourable variances to the budgeted profit
 Subtract adverse variances from the budgeted profit.
Key Point

Only the sales volume variance adjusts the fixed budget contribution or profit. The other variances reconcile the
standard contribution or profit on actual sales (flexed budget) to the actual contribution or profit.
23.7.1 Investigation of Variances
7.1 Investigation of Variances

Key Point

Only the sales volume variance adjusts the fixed budget contribution or profit. The other variances reconcile the
standard contribution or profit on actual sales (flexed budget) to the actual contribution or profit.
Four main aspects must be considered before investigating variances.
 Significance
An organisation will usually state that it will investigate significant variances, for example, when the variance
is more than a certain percentage of the flexed or fixed budget.

Significance refers to how large a variance is and that companies set guidance on when a variance should
be investigated.

 Control
When variances are controllable, it is possible to reduce the effects of the variance in the budget period.
However, if variances cannot be controlled, it might be necessary to revise the original budget.

 Elimination
The chance that a variance could be eliminated.

For example, control action could have been taken if the adverse labour efficiency variance at Winston’s
Football Factory of $1,200 had been identified during the budget period.

If the labour efficiency variance had been identified as $300 after the first quarter, control action might have
been taken to increase efficiency by $100 for each of the next three quarters. This would have eliminated the
variance.

 Cost
Cost of investigating the variance. The cost of the investigation should be less than its benefits.

Activity 20

Winston’s Football Factory states that any significant variance over 5% of the flexed budget should be
investigated further to determine why it occurred.

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Flexed budget

5,100 footballs

Sales revenue 178,500

Materials cost 15,300

Labour cost 61,200

Variable production overheads 10,200

Fixed production overheads 19,200

Non-production overheads 36,600

Budgeted profit 36,000

Use the flexed budget information above to determine which variances are significant and should be
investigated further by indicating yes or no.

Favourable Adverse Investigate?Yes or no

$ $

Sales volume variance 4,200

Sales price variance 10,200

Materials price variance 1,575

Materials usage variance 450

Labour rate variance 10,400

Labour efficiency 1,200

variance

Variable production 2,080

overhead expenditure
variance

Variable production 200

overhead efficiency
variance

Fixed production 560

overhead expenditure
variance

Fixed production 1,600

overhead capacity
variance

Fixed production 400

overhead efficiency
variance

*Please use the notes feature in the toolbar to help formulate your answer.

Favourable Adverse Investigate? Note

$ $

Sales volume variance 4,200 NO [1]

Sales price variance 10,200 YES [2]

Materials price variance 1,575 YES [3]

Materials usage variance 450 NO [4]

Labour rate variance 10,400 YES [5]

Labour efficiency variance 1,200 NO [6]

Variable production overhead expenditure variance 2,080 YES [7]

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Variable production overhead efficiency variance 200 NO [8]

Fixed production overhead expenditure variance 560 NO [9]

Fixed production overhead capacity variance 1,600 YES [10]

Fixed production overhead efficiency variance 400 NO [11]

[1] This variance is not significant because it is less than 5% of the flexed budget.

4,200/178,500 × 100% = 2.35%

[2] This variance is significant because it is more than 5% of the flexed budget.

10,200/178,500 × 100% = 5.71%

[3] This variance is significant because it is more than 5% of the flexed budget.

1,575/15,300 × 100% = 10.29%

[4] This variance is not significant because it is less than 5% of the flexed budget.

450/15,300 × 100% = 2.94%

[5] This variance is significant because it is more than 5% of the flexed budget.

10,400/61,200 × 100% = 16.99%

[6] This variance is not significant because it is less than 5% of the flexed budget.

1,200/61,200 × 100% = 1.96%

[7] This variance IS significant because it is more than 5% of the flexed budget.

2,080/10,200 × 100% = 20.39%

[8] This variance is not significant because it is less than 5% of the flexed budget.

200/10,200 × 100% = 1.96%

[9] This variance is not significant because it is less than 5% of the flexed budget.

560/19,200 × 100% = 2.92%

[10] This variance is significant because it is more than 5% of the flexed budget.

1,600/19,200 × 100% = 8.33%

[11] This variance is not significant because it is less than 5% of the flexed budget.

400/19,200 × 100% = 2.08%

23.7.2 The Planning And Control Cycle

7.2 The Planning And Control Cycle

 Measure actual results

Once the planning stage is completed, the budget will have been prepared for the coming period. The control
process begins when the actual results are measured at some stage during the budget period to compare
them with the budget or plan for the same period.

 Calculate variances
Variances for the budget period are calculated and summarised on the variance report.

 Investigate significant variances
Significant variances are variances which are large enough to require investigation. This significance level
highlights the variances that should be investigated and reported to management, most usefully explaining

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why they have occurred. The variance analysis report at the end of this unit shows how variances can be
reported to management.

 Act on variances
If the budgets set in advance are very different to the actual results, the budgets may need to be revised. On
the other hand, in some situations, the best possible strategy to achieve the organisation’s objectives may
need to be changed to something more realistic.

23.7.3 Variance Analysis Reports
7.3 Variance Analysis Reports

A variance analysis report is a report that can be used to replace or support an operating statement. It
provides a more narrative explanation of the variances that have occurred in a period for management and
summarises the reasons why the most significant variances have occurred.
Finally, the variance analysis report investigates the significant variances, highlights potential issues and
consequences, and recommends how to prevent these variances from re-occurring in future budget periods.
Variances will be summarised in a control report and presented to management along with findings,
conclusions and recommendations.

Example

Variance analysis report – Winston’s Football Factory 20X5

Introduction
This report has been prepared by Lola Lucaro, Management Accountant of Winston’s Football Factory, for the
budget period 20X5. In this report, the actual results for the budget period have been compared with the flexed
budget for the same period, and the resulting variances have been analysed.
Budgeted profit variance
The budgeted profit variance was $516 adverse, representing 1.63% of the flexed budget. However, behind this
overall result are several significant variances for this budget period which have been investigated. These results
are shown below.
Sales price variance $10,200 adverse – 5.71%
The adverse sales price variance of $10,200 arose because the selling price was reduced from $35 to $33 per
football in this budget period. However, this price reduction led to an increase in the sales volume, hence the
$4,200 favourable sales volume variance.
Materials price variance $1,575 favourable - 10.29%
The favourable materials price variance of $1,575 represents 10.29% of the flexed budget and is a significant
variance which has been investigated. The reason for its occurrence is because lower quality materials (Plastic F)
were used than usual, which was cheaper to buy, resulting in a favourable materials price variance.
Labour rate variance $10,400 favourable – 16.99%
The favourable labour rate variance of $10,400 occurred because cheaper labour was employed during the budget
period than usual, which led to a cost saving over the year.
A higher number of students than usual were used during the year, and the students were paid a lower wage than
the regular factory workers, resulting in a favourable labour rate variance.
Variable production overhead expenditure variance $2,080 adverse – 20.39%
The adverse variable production overhead expenditure variance of $2,080 occurred because the original fixed
budget for variable production overheads was too low. The actual variable overheads incurred in the period were
more than budgeted.
Fixed production overhead capacity variance $1,600 favourable – 8.33%
Similarly, the fixed production overhead capacity variance is favourable because the actual hours worked (10,400)
exceeded the budgeted number of hours (9,600). This is because additional students were employed over the year
to cope with the increased demand brought about by the price reduction. As a result, the number of labour hours
worked increased, resulting in a favourable capacity variance.
Conclusions
During 20X5, $615 less profit was earned than expected for the budget period. While this might appear to be an
insignificant deviation from the plan for 20X5, this adverse variance was the sum of 11 individual variances, five of
which are considered significant. Therefore, it is crucial that the individual variances, in addition to the overall
difference between expected and actual profit, are assessed during the control process.
Recommendations
It is not recommended that any further investigations are carried out into the significant variances that have
arisen, as there are valid explanations for their occurrence. However, it is recommended that comparisons are
made quarterly rather than on an annual basis. This is so necessary control action can be taken earlier in the
control process. A controllable variance should be brought under control as soon as possible.
Suppose a variance occurs and is thought to be uncontrollable. In that case, it will be possible to make

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Example

amendments and revise the budget for the remaining period to consider these factors.
Appendix
Winston’s Football Factory – Variance Report 20X5

Variances Favourabl Adverse % of

e flexed
budget

$ $

Sales volume variance 4,200 2.35

Sales price variance 10,200 5.17

Materials price variance 1,575 10.29

Materials usage variance 450 2.94

Labour rate variance 10,400 16.99

Labour efficiency variance 1,200 1.96

Variable production overhead expenditure variance 2,080 20.39

Variable production overhead efficiency variance 200 1.96

Fixed production overhead expenditure variance 560 2.92

Fixed production overhead capacity variance 1,600 8.33

Fixed production overhead efficiency variance 400 2.08

23.7.4 Interrelationships Between The Variances

7.4 Interrelationships Between The Variances

It is common for variances to show a clear relationship with each other. For example, a favourable variance
may be directly related to an adverse variance.

Example

The following are relationships between variances of Winston’s Football Company:

 Sales price variance $10,200 – 5.71%
The favourable sales volume variance of $4,200 is directly related to the adverse sales price variance of $10,200.
This is because, during the budget period of 20X5, the standard selling price of $35 was reduced to $33 to attract
more sales, which is precisely what happened. Therefore, the sales volume was greater than expected (favourable
sales volume variance), and the sales price was lower than expected (adverse sales price variance). Generally,
when a product’s price is reduced, it will cause an increase in the sales volume because customers will be able to
buy the company’s products because of their lower prices.

 Materials price variance $1,575 favourable - 10.29%
The favourable materials price variance of $1,575 is directly related to the adverse materials usage variance of
$450. This is because a cheaper type of Plastic F was purchased for manufacturing footballs in 20X5.

This cheaper material resulted in more wastage and an adverse materials usage variance.

 Labour rate variance $10,400 favourable – 16.99%
The favourable labour rate variance of $10,400 represents 16.99% of the flexed labour budget and is directly
related to the adverse labour efficiency variance. This is because students were employed during 20X5 at a lower
rate than the usual factory workers. This led to a favourable rate variance because the students were paid less
than $6 per hour (the standard labour rate per hour). On the other hand, due to the student workforce being on a
learning curve (and therefore less experienced than the usual factory workers), there was an adverse labour
efficiency variance of $1,200 because the workforce, on the whole, was slower than the standard time of two
labour hours per football.

Key Point

Only the sales volume variance adjusts the fixed budget contribution or profit. The other variances reconcile the
standard contribution or profit on actual sales (flexed budget) to the actual contribution or profit.
23.7.5 Examples of Causes for Variances
7.5 Examples of Causes for Variances

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Variance Favourable Adverse Can Be Either

Favourable or Adverse

Materials Bulk discounts Market price increase Bad Different supplier

price purchasing Delivery costs
Good purchasing Different material
Change in quality

Materials Better quality More Defective material Different batch sizes

usage efficient
Theft Change in mix
Excessive waste or spoilage

Labour rate Lower skilled labour Wage rise Different skill mix
Overtime working
Bonus payments

Labour Motivation Strikes

efficiency
Higher pay Lower pay
Better equipment Poor equipment
Learning effect Slow working
Better material Poor material
Higher grade Lower grade
Lack of material
Breakdowns Injury/Illness
Lack of orders

Overhead Cost savings/cutbacks Cost increases Incorrect split of semi-variable costs

expenditure
Excessive service usage

Overhead (see labour efficiency)

efficiency

Overhead Increase in productive Excessive idle time

capacity hours
Shortage of plant capacity

Sales price Market shortage Price reduction to achieve Change in quality

volume increase
Response to competitors
Pass on cost changes

Sales volume Rise in market share Fall in market share

Rise in market size Fall in market size
Price decrease Price increase

Chapter 24: Introduction to Performance

Management
24.1.1 Operational, tactical, and strategic objectives
1.1 Operational, tactical, and strategic objectives

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1.1.1 Planning

Each type of planning sets out different aims or objectives for an organisation, depending on whether they
are relevant in the short-term, medium-term or long-term.
In general, the overall aim of a profit-making organisation is to make the maximum amount of profit possible
for its shareholders. Non-profit making organisations, on the other hand, will be more likely to set the overall
objective of providing value for money to their users.
24.1.2 Role Of Operational, Tactical and Strategic Objectives In Performance Measurement
1.2 Role Of Operational, Tactical and Strategic Objectives In Performance Measurement

An organisation will typically set its strategic objectives first and then develop tactical and operational plans
to achieve its goals.
It is vital that suitable performance measures are set for each organisation’s objectives – this will allow the
organisation to assess whether they are being achieved. It will also enable control action to be taken if
necessary.

Objective Description Example

type
(Winston’s Football Factory)

Operational Will involve achieving short-term aims, for Producing a target number of footballs per day
example, day-to-day targets such as: Achieving or week.
a given level of sales or answering the phone
within a given time.

Tactical Involves achieving medium-term aims, for Calculating whether the number of footballs
example, monthly/quarterly or annual targets manufactured in a period has increased due to
that can be measured. For example, an the more regular maintenance of the football-
organisation might calculate variances by manufacturing machines.
comparing the actual costs for a period with
the budgeted costs.

Strategic Concerns the organisation as a whole. How profitable the company is during a period
or Winston’s market share.
24.1.3 Mission Statements
1.3 Mission Statements

Before any top-level planning can take place at the strategic level, an organisation must prepare its mission
statement. These are used as a guide to help organisations in several areas, such as planning, motivating
staff and developing marketing and PR campaigns.
A mission statement is a written statement that describes an organisation’s aims: what it is trying to achieve
and how it hopes to achieve it. Mission statements are usually written by the strategic managers of an
organisation and have four main elements:

Mission Description Example

statement

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element (Winston’s Football Factory)

Purpose The purpose of the The primary purpose of Winston’s Football Factory is to create high-
organisation’s existence. quality footballs which are affordable to all, from established nations
to emerging markets. In doing this well, the company should be able
to provide a fair return to investors.

Strategy The products or services Winston’s Football Factory produces footballs of high quality. It is
the organisation offers and also looking to expand into other football-related markets where
how it provides them. viable projects may exist, for example, the manufacture of football
shirts.

Policies The standards of behaviour Winston’s Football Factory's workforce must follow the staff
the organisation expects handbook's guidance. Winston’s Football Factory also prides itself
from its staff while they are on a high standard of customer care – customers are the
working for the company. organisation’s number one priority. Consequently, they expect their
staff to provide the highest service possible. As a result, employees
are expected to report unethical practices, such as bribery, to their
supervisors.

Values The fundamental values Winston’s Football Factory believes that the organisation will be
and beliefs of the more productive if its workforce is happy. Workforce happiness will
organisation. increase levels of efficiency because the staff will enjoy their work,
the people they are working with and the environment in which they
are working.
24.1.4 Critical Success Factors And Key Performance Indicators
1.4 Critical Success Factors And Key Performance Indicators

Critical success factors are the specific areas of business that must be successful for an organisation to
achieve its objectives. Critical success factors are commonly abbreviated to CSFs.
Key performance indicators use financial or non-financial information to measure how well an organisation
is doing in terms of its critical success factors. Key performance indicators are commonly abbreviated as
KPIs.
Critical success factors are an essential part of the control system of an organisation. All employees in an
organisation should know the CSFs for their company and work towards the same goals.
Critical success factors can be measured by KPIs based on financial or non-financial information.

Example

The aims of Winston’s Football Factory may be translated into

critical success factors (CSF) as follows:

The CSFs listed above are what Winston’s Football Factory must
achieve to succeed, and they must be measurable in terms of KPIs.

CSFs should be identified and written so they can be translated into KPIs that can measure performance in a
timely, reliable and cost-effective manner.

Example

Winston’s Football Factory’s CSFs may be measured by the following KPIs:

CSF KPI

Financial return Winston’s Football Factory management wants to ensure that its shareholders receive high
for shareholders returns from the money they invest in its organisation.
(maximise profits)
One way this could be measured is to monitor how much gross profit the company earns
for every $ the shareholders have invested. This is a financial KPI.
A further financial KPI to monitor profitability is to measure operating profit as a
percentage of sales revenue. A high return is a good indicator that shareholders will
receive a high financial return on their investment.
Profitability measures are discussed in detail in chapter 25, section 1.

Quality of One way to measure the quality of the footballs manufactured by an organisation is to
footballs record the number of rejected footballs during the quality assurance process.
This process should ensure that all defective footballs are identified before being sold to
customers. Alternatively, measuring the number of faulty footballs returned to the factory
in a period would be a useful way of measuring the quality of the manufactured footballs.

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Example

This is a non-financial KPI.

A further example of a KPI is to compare against other footballs on the market, for
example, how close to professional standard the ball is.

Customer care There are several ways that customer care or customer satisfaction can be measured. One
such way is to obtain data about when an order is placed and when the goods are sent to
the customer.
Another way of measuring customer satisfaction is to review records of customer
complaints. This is a non-financial KPI.
Other KPIs for customer service include:
 Footfall – the number of customers visiting the office in a given period
 External visits to customers by staff

Happy staff who Staff happiness may be indicated by some of the following measures: number of staff
work efficiently complaints, staff turnover rates and absenteeism rates.
Staff who work efficiently will take fewer hours than expected to complete a job.
Similarly, if they are working inefficiently, they will probably take longer to complete a job
than expected. Therefore, one way to measure how efficiently staff work is to compare the
actual hours worked with the expected hours to complete a job. This would is a non-
financial KPI.
Further examples of KPIs are:
 How much overtime staff have needed to complete a job
 A positive score (e.g. at least 3 out of 5) on customer feedback forms.

24.1.5 External Factors and Performance Measurement

1.5 External Factors and Performance Measurement

Organisations may have difficulty in achieving the objectives that have been set out in their mission
statements due to influences out of their control, for example:
 Economic and market conditions – the economy goes through boom and bust cycles affecting
local and broader global economies.
Such external factors may affect the key performance indicators of an organisation during these periods.

 Competitors’ actions – sometimes, if an organisation’s main competitor launches a new product
which causes the organisation to lose a large percentage of its market share, it is likely to hurt its
performance.
 Government regulation – rules and regulations issued by local and national governments can affect
the performance of organisations.
For example, employment regulations may prevent employees from working above a certain number of
hours. This may impact the production capacity of an organisation, especially if the skills key employees
possess are in short supply.

Many countries have a national minimum wage, which some organisations may feel hinders their financial
performance. Other areas include regulations around safety standards and labelling requirements, for
example, on food products. Laws such as these affect how organisations act, impacting their performance.

24.1.6 Impact of Sustainability on Performance Measurement
1.6 Impact of Sustainability on Performance Measurement

Sustainability is increasingly at the forefront of stakeholder concerns when evaluating company

performance.
Because of this, the company must design and implement performance measures that indicate how
sustainable the organisation is and what it is doing to improve its sustainability.
1.6.1 Defining Sustainability
Sustainability is defined as the ability to meet the current generation’s needs without compromising future
generations’ ability to meet their own needs.
It usually encompasses three main areas:
 Environmental: Care and stewardship for the environment. Company activities should be
ecologically sustainable and minimise damage to the natural environment.

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 Social: The company should care for the local communities and stakeholders and ensure human
rights and quality of life are upheld.
 Governance: The company should be accountable to its stakeholders and focus on sustainable
long-term value generation.
1.6.2 Incorporating Sustainability in Performance Measurement
To successfully incorporate sustainability, it needs to be given a sufficient level of priority in setting CSFs
and KPIs, and adequate reporting systems and accountability must be enforced.

Example

Consider the following additional CSFs and their corresponding KPIs to Winston’s Football Factory:

Mission CSF KPI

aspect

Purpose To be at the forefront of  Ranking among sustainable organisations in the

sustainable organisations in the sector.
sector.
 Recognition by independent sustainability certification
bodies.
 Measurement of public perception regarding
sustainability.

Strategy To ensure that activities are  Compliance with sustainable reporting standards.
known to be sustainable,
meeting international
 Implementation of sustainability reporting and
measurement processes in critical activities.
standards.

Policy To minimise damage to the  Measurement of pollutants produced by company

environment and uplift activities.
communities.
 Analysis of the supply chain for pollutants and human
impact.

Value To be a force for sustainability.  Measurement of contribution to overall societal

sustainability development goals (such as the United
Nation’s Sustainable Development Goals)

24.2.1 The Balanced scorecard

2.1 The Balanced scorecard

The balanced scorecard is a strategic planning and management system that links business activities to the
overall aims of an organisation.

The fundamental concept of the balanced scorecard is that the performance of an organisation should be
measured using financial and non-financial performance measures to give a more balanced view of how an
organisation is performing.
Historically, an organisation’s performance was only measured in terms of how well it was doing from a
financial point of view.
A balanced scorecard will take different things into account for various organisations. For example, the idea
of a 'customer' may be different for public and private sector organisations. A public sector organisation
may see customers as a group of residents. A private sector organisation might refer to customers as
individuals who purchase their products.

24.2.2 Importance Of Non-Financial Information

2.2 Importance Of Non-Financial Information

Using non-financial and financial performance measures together is essential when investigating an
organisation’s performance.

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Non-financial indicators can provide management accountants with useful 'early warnings'. For example, a
downturn in sales of a particular product, such as a car, will affect car manufacturers and businesses that
contribute materials to the vehicle manufacturing industry.
2.2.1 Benefits of Both Financial and Non-Financial Performance Indicators
 Hidden results: It is easier to disguise financial results if responsibility centre managers wish to
make the results of their department look better than they are if there are incentive schemes in place.
Poor performance is harder to hide if an organisation also uses non-financial performance measures.
 Inability to locate problems: Non-financial performance indicators can sometimes bring attention to
the fact that there is a problem within an organisation before a financial performance measure can. For
example, if the quality of a product has fallen to such a level that it is affecting sales, a non-financial
performance indicator (number of rejects in a period, for example) will indicate that there is a problem
before a financial indicator will show that sales revenue has fallen (due to customer dissatisfaction with
quality). This means that taking action on a non-financial performance indicator can fix a developing
problem before it develops into a situation that adversely affects the business’s financial performance.
 Ease of understanding: Non-financial performance indicators may be more easily understood than
financial performance indicators by non-financial members of staff.
 Lack of balance: Using a mix of financial and non-financial performance measurements gives a
more ‘balanced’ view of how an organisation is performing (and hence the development of the balanced
scorecard).
24.2.3 Balance Scorecard Perspectives
2.3 Balance Scorecard Perspectives

The balanced scorecard (developed by Drs. Robert Kaplan and David Norton) identifies four angles
(commonly called perspectives) from which an organisation should be viewed.

Example

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Example

24.2.4 Measures Of Financial Success

2.4 Measures Of Financial Success

An organisation's CSF ‘financial success’ often follows from customer satisfaction, process efficiency and
growth. For example:
 Increased customer satisfaction will lead to an increase in sales revenue
 Increased process efficiency will lead to a reduction in costs
 Increased growth will lead to new products and more sales revenue.
Overall, an increase in sales revenue and a reduction in costs will lead to a rise in profit, which indicates an
organisation's financial success.
24.2.5 Advantages and Disadvantages of the Balanced Scorecard Method
2.5 Advantages and Disadvantages of the Balanced Scorecard Method

There are several advantages and disadvantages to using the balanced scorecard method.
2.5.1 Advantages

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 Balanced view: The balanced scorecard looks at four different perspectives and gives a balanced
view of an organisation.
Traditional performance measures focus on how well an organisation is doing in terms of profit and
shareholder wealth. In contrast, the balanced scorecard gives a complete idea of how well an organisation
achieves its objectives.

Traditionally, managers have often been assessed on profit only, but this is a flawed measure. Those
managers could easily cut back on innovation as research and development take time to affect profits.

 Short-term to long-term: The balanced scorecard looks at an organisation’s medium and long-term
objectives as well as short-term ones.
The balanced scorecard will, therefore, give an idea of what an organisation should expect from a financial
and non-financial point of view across different timescales.

 Goal congruence: Goal congruence is encouraged through the balanced scorecard because staff
from all areas of an organisation are working towards common goals.
As these goals change, it is common for the corresponding critical success factors and KPIs to change. This
means that a business has to analyse itself to ensure it understands what its CSFs genuinely are – for
example, customer needs change over time, so any CSFs relating to customer opinion and actions must be
reassessed.

If a business measures only its financial performance in the current accounting period, managers may
prioritise this one measure too highly and cut back unwisely on investments that are an expense in this year
but which will bring benefits in the longer term.

2.5.2 Disadvantages
 Time-consuming: It takes much time to develop a balanced scorecard for an organisation.
Management must consider the goals it would like to achieve in each of the four areas.
Once the goals have been established, the objectives need to be decided upon and broken down into critical
success factors and their key performance indicators.

 Subjective: The selection of individual performance measures is subjective and must be agreed
upon by respective management teams.
 Conflicting: There may be conflicting performance measures on a balanced scorecard. For example,
if an organisation aims to reduce costs across the business, it will be challenging to research new
projects because this will affect costs.
These conflicts are often a natural part of life and business, but a good manager will resolve this by
prioritising the more critical demand.

 Difficult to interpret: Balanced scorecards may not be very easy to interpret as the non-financial
performance measures may use arbitrary (or random) KPIs.
For example, non-financial KPIs, such as measuring sick days, vary in significance depending on the type of
business; sick days in a high-street shop may correlate to a lack of motivation from staff, but in a hospital,
staff are always likely to have a higher number of sick days because of greater exposure to infection. The
KPI ‘sick days’ may be a factor in the balanced scorecard in both instances, but the same conclusions
cannot be drawn.

24.2.6 The Relationship Between Short-Term and Long-Term Performance
2.6 The Relationship Between Short-Term and Long-Term Performance

If responsibility managers are offered a reward in the form of a bonus if their department (or responsibility
centre) does well, then such a system can affect the decisions that they might make. However, these
decisions often introduce new issues to consider.

Example

The following flowchart illustrates how offering a bonus may influence managers to think more short-term:

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Short-termism is a term used to describe how a division’s short-term performance can be considered more
important than the long run because it often forms the basis of a manager’s reward system

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Chapter 25: Analysing Performance

25.1.1 Profitability Measures
1.1 Profitability Measures

Profitability ratios show how well an organisation can generate profits. Shareholders receive the return that
they have earned from an organisation’s profits, and profit is also reinvested in the organisation for future
activities.
Profit-making organisations aim to make the maximum profit possible for their shareholders.
Profit maximisation can be measured by one of the following ratios:
 Return on capital employed
 Return on sales (operating profit margin as a percentage of sales)
 Gross margin (gross profit margin as a percentage of sales).
1.1.1 Capital employed
The term capital employed can relate to several entries in an organisation’s statement of financial position.
However, the term in management accounting is used less precisely than in financial accounting: it means
any source of long-term funds rather than just owner’s equity.
 Net assets
 Total assets − current liabilities
 Total equity + non-current liabilities.
The second and third bullets are similar: they mean equity plus long-term debt.
Capital employed = total equity + non-current liabilities

Operating profit = net profit

Capital employed = Total assets − current liabilities

Measure Description

Return on capital employed = Return on capital employed is also known as Return on investment. It is a
Operating profit/capital employed × measure of the return (profit) that is being made on the capital that is
100% invested in the organisation.
Or Investors will be looking for an organisation with a high ROCE value,
indicating a good investment return.
Return on capital employed =
Operating profit/(net assets) × 100% ROCE can be compared with other companies in the same industry sector
or the company’s capital cost.
Or
Comparing companies in other sectors is inappropriate as their operating
Return on capital employed =
environment is different. Service industries, for example, require less
Operating profit/(total equity + non-
capital than manufacturing industries and will show a greater return on
current liabilities) × 100%
capital employed for each dollar of profit.

Return on sales = (Operating This ratio is also known as the operating margin and shows operating
profit/Revenue) × 100% profit as a percentage of sales.
Generally, the higher the return on sales value, the better because a low
value will indicate that prices are too low or costs are too high. This is
referred to as the profit margin.

Gross margin = (Gross profit/Revenue) This ratio shows how well the organisation is performing in terms of its
× 100% gross profit as a percentage of sales revenue.
The higher the gross margin value, the better, indicating that prices and
costs are at the correct level. Comparing gross and net margins is also
useful to see if operating expenses are getting out of control.

Activity 1

Winston's Football Factory − budgeted statement of profit or loss 31.12.X5

$ $

Sales revenue 168,000

Cost of sales

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Opening inventory 8,550

Production costs 106,800

Closing inventory (14,550)

Production cost of sales (100,800)

Gross profit 67,200

Non-production overheads (36,600)

Net profit 30,600

Budgeted statement of financial position − 31.12.X5

$ $

Non-current assets 260,000

Current assets:

Inventory 14,550

Trade receivables 8,400

Cash 41,600

(A) 64,550

Current liabilities

Trade payables 1,400

Other short-term liabilities -

(B) 1,400

Net current assets (A) − (B) 63,150

Net assets (292,550 + 30,600) 323,150

Calculate the following profitability ratios of Winston’s Football Factory:

1. Return on capital employed

2. Return on sales (operating margin)

3. Gross margin

*Please use the notes feature in the toolbar to help formulate your answer.

1. Return on capital employed 9.5%

Return on capital employed = Operating profit/(net current assets) × 100%

2.
= 30,600/323,150 × 100% = 9.5%

3.
4. Return on sales 18.2%

Return on sales = (Operating profit/Revenue) × 100%

5.
= 30,600/168,000 × 100% = 18.2%

6.
7. Gross margin 40.0%

Gross margin = (Gross profit/Revenue) × 100%

8.

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= 67,200/168,000 × 100% = 40.0%

9.
Exam advice

Return on capital employed should not be calculated by any profit figure divided by any asset figure.
Its formal definition is operating profit divided by ordinary shareholder’s funds plus non-current liabilities. ROCE
is a critical ratio in performance measurement, and candidates must know its meaning if they want to pass.

25.2.1 Activity Measures

2.1 Activity Measures

Activity ratios measure how easily an organisation can convert the items in its statement of financial
position into cash or sales. They indicate how efficiently an organisation manages its assets.
The activity of an organisation may be measured using the following indicators:
 Asset turnover
 Inventory holding period
 Receivables collection period
 Payables payment period
Activity Description
measure

Asset turnover Asset turnover = Revenue/Capital employed

Asset turnover shows how well an organisation generates sales from its capital employed.
In general, organisations should have a high asset turnover value.

Receivables Receivables collection period = (Receivables/Credit sales) × 365 days

collection
This ratio measures how long, on average, the credit customers of an organisation take to pay
period
for the goods they have purchased.
If trade receivables take longer than expected (per the terms of their credit agreement), the
organisation loses out on interest that could have been earned by investing that money in the
bank.
High receivables collection period ratios may also indicate that an organisation is not managing
its debts as well as it should be.

Payables Payables payment period = (Payables/Purchases) × 365 days

payment period
Or
Payables payment period = (Payables/Cost of sales) × 365 days
The payables payment period indicates how long it takes an organisation to pay its suppliers for
the goods and services it purchases.
If the number of payables payment period increases or decreases over a period, then this can
indicate that an organisation is finding it easier or harder to pay its debts.

Inventory Inventory holding period = (Inventory/Cost of sales) × 365 days

holding period
The inventory turnover period measures the average time an organisation holds its products in
stores before they are sold.
A high inventory turnover period could mean that an organisation produces more products than
are being demanded.

Activity 2

Winston's Football Factory − budgeted statement of profit or loss 31.12.X5

$ $

Sales revenue 168,000

Cost of sales

Opening inventory 8,550

Production costs 106,800

Closing inventory (14,550)

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Production cost of sales (100,800)

Gross profit 67,200

Non-production overheads (36,600)

Net profit 30,600

Budgeted statement of financial position − 31.12.X5

$ $

Non-current assets 260,000

Current assets:

Inventory 14,550

Trade receivables 8,400

Cash 41,600

(A) 64,550

Current liabilities

Trade payables 1,400

Other short-term liabilities -

(B) 1,400

Net current assets (A) − (B) 63,150

Net assets (292,550 + 30,600) 323,150

Cash sales represent 20% of the total sales revenue during the year.

Calculate the following activity measures of Winston’s Football Factory:

1. Asset turnover =Asset turnover = Revenue/Capital employed = Revenue/net assets = 168,000/323,150

= 0.52

2. Receivables collection period =Receivables collection period = (Receivables/Credit sales) × 365 days
= 8,400/(168,000 × 80%) × 365 = 22.8 days

3. Payables payment period =Payables payment period = (Payables/Cost of sales) × 365 days =
1,400/100,800 × 365 days = 5.1 days
4. Inventory holding period =Inventory holding period = (Inventory/Cost of sales) × 365 days =
14,550/100,800 × 365 days = 52.7 days

25.2.2 The Relationship Between ROCE, Return on Sales and Asset Turnover
2.2 The Relationship Between ROCE, Return on Sales and Asset Turnover

There are many different approaches to generating a return from the capital employed by a business.
At one end of the scale, assets produce high volumes of products intended for the mass market. As a result,
products are mass-produced and sold relatively cheaply, with a low profit margin. For example, a ready-
made, cheap clothing manufacturer will likely follow this approach.
At the other end of the scale, the premium or niche approach generates income from a relatively low
production level. A relatively small number of items are produced and sold, but each product and each
transaction has a high profit margin. A manufacturer of high-quality, premium branded watches will likely
follow this approach.
Neither approach is ‘better’ - the key is adopting the strategy that best meets demand in the market and fits
the organisation’s capabilities.
The relationship between ROCE, return on sales and asset turnover can be expressed as a formula as
follows:

ROCE = Return on Sales × Asset turnover

25.3.1 Liquidity Measures

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3.1 Liquidity Measures

Liquidity measures how easily an organisation can convert its assets into cash. The term ‘asset rich, cash
poor’ means that the wealth of an individual or an organisation is tied up in its non-current assets, which
may not be converted into cash immediately.
Liquidity shows how well an organisation manages its cash on a day-to-day basis.
3.1.1 Profits versus cash flow
Profitability does not mean liquidity. Many organisations may be profitable, but that does not mean they will
not develop cash flow problems if they do not adequately manage their cash inflows and outflows.
3.1.2 Liquidity measures
The following ratios measure the liquidity of an organisation:
 Current ratio
 Acid test (quick) ratio.
Liquidity Description
measure

Current Current ratio = Current assets/Current liabilities

ratio
This ratio measures whether an organisation will likely have enough cash over the next 12 months
to meet its short-term financial obligations (such as trade payables and bank overdrafts).
Although generally, a current ratio being 1 is considered acceptable, many successful companies
have lower current ratios than 1 because they have very effective working capital management and
can keep their payables waiting.
On the other hand, the smaller and less powerful the business, the more dangerous it is to have a
CA ratio below 1.
Running out of money − poor liquidity − is the biggest cause of business failure, so it makes sense
for a smaller or less powerful organisation to keep a reasonably high liquidity ratio.

Acid test Acid test (quick) ratio = (Current assets − inventory)/Current liabilities
(quick)
This ratio is a similar ratio calculation to the current ratio, but the current assets are reduced by the
ratio
value of inventory.
This is because an organisation’s inventory may not be able to be converted into cash in the short
term. This means that the quick ratio gives a measure of the very short-term liquidity of a business.
The quick ratio provides a better indication of the organisation’s ability to pay its bills in the short
term than the current ratio. The quick ratio can also help businesses determine their ability to meet
any sudden, unexpected demands for money − for example, because of a legal case.

Activity 3

A company has current assets of $1m, including inventory of $0·7m, and current liabilities of $0.4m. What
would be the effect on the value of the current and acid test ratios if the company bought more raw material
inventory on three months’ credit?

Indicate whether the raw material purchase on credit would increase or decrease the liquidity ratios.

Ratio Increase or Decrease

Current ratio

Acid test ratio

*Please use the notes feature in the toolbar to help formulate your answer.

Ratio Increase or Decrease

Current Decrease
ratio For example, assuming $0.5m inventory is purchased on credit, the current assets would increase by
$0.5, and so would the current liabilities.
The opening current ratio = current assets /current liabilities = 1.0m/0.4m = 2.5
If inventory of $0.5m is purchased, then current assets will be $1.0m + $0.5m = $1.5m and current
liabilities would be $0.4 + $0.5 = $0.9, and so: Current ratio is now = current assets/current liabilities
= 1.5/0.9 = 1.67
The current ratio has decreased.

Acid test Decrease

ratio The opening acid test ratio = (current assets − inventory)/current liabilities = (1.0 − 0.7)/0.4 = 0.75
If inventory of $0.5m is purchased, then current assets will be $1.0m + $0.5m = $1.5m and current

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liabilities would be $0.4 + $0.5 = $0.9, and so: Acid test ratio is now = current assets −
inventory/current liabilities = 1.5 − (0.7 + 0.5)/0.9 = 0.33
The acid test ratio has also decreased.
25.3.2 Gearing Measures
3.2 Gearing Measures

Gearing is a term used to indicate how well-placed an organisation is to meet its long-term debts (non-
current liabilities). It reflects an organisation’s choice regarding its mix of funding, for example, its mix of
equity capital and debt capital. Different companies make different choices regarding the financing of their
organisation based on their willingness to take on financial risk. The long-term debt incurs interest charges
which must be paid whatever the level of profit achieved.

Exam advice

Gearing may be measured in several ways. The required method will be stated in the exam question.
The level of gearing for an organisation is commonly measured using the following ratios:
 Capital gearing (sometimes referred to as leverage)
 Interest cover.
Gearing Description
measure

Capital Capital gearing ratio = non-current liabilities/ordinary shareholders’ funds × 100%

gearing
or
Capital gearing ratio = non-current liabilities/(ordinary shareholders’ funds + non-current liabilities)
× 100%
or
Capital gearing ratio = debt/equity × 100%
This is sometimes called the debt-to-equity ratio and compares the shareholders’ funds with other
sources of long-term finance. The higher the gearing ratio, the higher the financial risk to the
organisation.

Interest Interest cover = Operating profit/Finance costs

cover
This is sometimes called income gearing, and it indicates how an organisation can pay interest that
may be due on its debts.

25.4.1 Resource Utilisation Measures

4.1 Resource Utilisation Measures

The three measures that indicate how efficiently, or how productively, an organisation is operating are the
following:
 Production volume ratio (also known as activity ratio), which breaks down into
 Efficiency ratio
 Capacity utilisation ratio
These ratios are not concerned with the financial performance of an organisation but more with how it is
utilising (using) its resources (labour, machine hours and so on). This is referred to as resource utilisation.
These ratios are linked as shown below;

Activity (or production volume) ratio = Efficiency ratio × Capacity ratio

The formula above shows that to increase output (production volume ratio), the company must either work
longer (capacity ratio) or work ‘smarter’ (efficiency ratio).

Resource Description
utilisation
measure

Efficiency
ratio

The efficiency ratio measures how efficiently the workforce works by comparing the expected
number of labour hours (to produce a given output) with the actual hours worked.
The labour hours that are compared to calculate this ratio are similar to those in labour and
overhead efficiency variances.

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Capacity
ratio

The capacity ratio compares the actual labour hours with the budgeted labour hours and
measures whether the workforce has worked more or fewer hours than budgeted.
The labour hours that are compared to calculate this ratio are similar to those in the fixed
overhead capacity variance.

Production
volume ratio
(Activity
ratio)
The activity ratio compares the expected number of labour hours worked (to produce a given
level of output) with the budgeted number of labour hours worked.

The relationship between the ratios is:

Efficiency ratio × capacity utilization ratio = production volume ratio

 Budgeted hours: the number of hours in the initial (fixed) budget.

 Expected hours: means the number of hours actual volume produced is expected to take. It is
based on the flexed budget and is the expected number of hours for the actual production level.
 Actual hours: The actual number of hours worked in the period. The difference between the actual
and expected hours is the labour efficiency variance (in hours).
The efficiency ratio measures much the same thing but in a ratio format. If there is an efficiency ratio of more
than one ( > 1), there is a favourable efficiency variance.
If there is a capacity ratio of more than one, it means there is a favourable capacity variance.
4.1.1 Standard Hours
Standard hours are the hours an operation is expected to take.
Activity 4

The following information relates to Winston’s Football Factory in 20X5:

In 20X5, 5,100 footballs were sold and produced. The initial budgeted production volume was 4,800 footballs.

9,600 labour hours were budgeted, and 10,400 labour hours were actually worked.

The standard labour hours per football = 2 hours.

Budgeted labour hours 9,600

Actual labour hours 10,400

Standard (expected) labour hours 10,200

Calculate the efficiency, capacity, and activity ratios of Winston’s football Factory in 20X5.

*Please use the notes feature in the toolbar to help formulate your answer.

Efficiency ratio = 98%

Expected labour hours = 5,100 footballs × 2 labour hours = 10,200

Efficiency ratio = Expected number of labour hours/Actual labour hours × 100%

Efficiency ratio = 10,200/10,400 × 100% = 98%

Capacity ratio = 108%

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Capacity ratio = Actual labour hours/Budgeted labour hours

Capacity ratio = 10,400/9,600 × 100% = 108%

Activity ratio = 106%

Activity ratio = Expected labour hours/Budgeted labour hours

Activity ratio = 10,200/9,600 × 100% = 106% (Note also, the interrelationship with the other two formulae:
106% = 108% × 98%)
Activity 5

Furniture Co budgeted to make 100 units of output in June. Each unit was expected to take 3 hours of direct
labour.

The actual production volume in June was 110 units, which took 350 hours of direct labour.

For June,

a) What is the efficiency ratio for Furniture co?

b) What is the capacity utilisation ratio for Furniture co?

c) What is the production volume ratio for Furniture co?

d) Show the relationship between the ratios.

*Please use the notes feature in the toolbar to help formulate your answer.

a) Efficiency ratio = ((110 × 3) / 350) × 100% = 94.29%

b) Capacity utilisation ratio = (350 / 300) × 100% = 116.67%

c) Production volume ratio = (110 × 3) / 300 × 100% = 110%

d) Efficiency ratio × Capacity utilisation ratio = Production volume ratio

94.29% × 116.67% = 110.00%

Activity 6

A company budgeted to make 800 units of output in December. Each unit was expected to take 1 hour and 30
minutes of direct labour.

The actual production volume in December was 760 units, which took 950 hours of direct labour to make.

For December,

a) What is the efficiency ratio?

b) What is the capacity utilisation ratio?

c) What is the production volume ratio?

d) Show the relationship between the above ratios.

*Please use the notes feature in the toolbar to help formulate your answer.

a) Efficiency ratio = (760 × 1.5) / 950 × 100% = 120%

b) Capacity utilisation ratio = 950 / (800 × 1.5) × 100% = 79.17%

c) Production volume ratio = (760 × 1.5) / (800 × 1.5) × 100% = 95%

d) Efficiency ratio × Capacity utilisation ratio = Production volume ratio

= 120% × 79.17% = 95%

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Chapter 26: Monitoring Performance, Cost

Reductions, and Value Enhancement
26.1.1 Performance Measures in Manufacturing Organisations
1.1 Performance Measures in Manufacturing Organisations

 Profitability, activity, liquidity and gearing

These will be the main financial key performance indicators that the organisation will be interested in, and
they look at the overall performance of an organisation.

 Resource utilisation
This can be measured by calculating non-financial indicators such as activity, efficiency and capacity ratios.

 Variance analysis
Variances are an essential measure of performance.

 Quality
Quality is how well a product or service meets the customer’s needs. It involves applying various standards
and measurement and monitoring of quality costs.

 Customer satisfaction
 Customer satisfaction is essential for the long-term growth and profitability of companies.
There are several ways that it can be measured. For example, customer survey results and the number of
new customers recommended by current customers are measurement methods.

26.1.2 Measuring Performance in Service Industries
1.2 Measuring Performance in Service Industries

Service industry organisations provide services and do not produce physical products as manufacturing
industries do. Examples of places where services are provided are hairdressers, restaurants, hospitals,
hotels and accountancy firms.
Services have several characteristics that make them different from products. For example, services are
intangible, perishable, inconsistent and simultaneous.
These characteristics make measuring performance in service industry organisations more complicated than
in other industries.
There would be a focus on non-financial performance measures specifically related to delivering the service.

Example

Some examples of performance measures for service industries include:

Example company Service performance measure

Airline Arrival on time %

Seat capacity utilisation %
Cost per passenger-kilometre
Revenue per passenger kilometre
Aircraft availability rates
Route market share %
Emissions per passenger-kilometre
Baggage loss rate %

Electricity utility Cost per megawatt-hour supplied

Uninterrupted supply %
Revenue per megawatt hour supplied
Sustainable generation %
Generation efficiency %

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Example

Emissions per megawatt-hour generated %

Building management Complaint resolution period

Complaint resolution date
Cost per square foot
Service availability period %
Number of security incidents

26.1.3 Measuring Performance in Non-Profit And Public Sector Organisations

1.3 Measuring Performance in Non-Profit And Public Sector Organisations

Non-profit seeking organisations include charities, government bodies, educational establishments and
public sector organisations. Let’s look at these in a bit more detail:
 Charities and other voluntary organisations do not look to make a profit. Instead, donations from
donors fund these organisations.
 Public sector organisations, for example, hospitals and schools. These organisations are
controlled and funded by the government (which receives the money in taxes paid by the taxpayers).
Taxpayers who fund public sector organisations are interested in value for money: they want low taxes but
high public service levels from what they have paid.
Donors who make charitable donations will want to ensure the maximum amount of their contributions will
be spent on its intended purpose (the charity’s beneficiaries) rather than on administration charges. The
donors will therefore want to see that their donations are being put to good use.
Most public sector organisations aim to provide value for money or the best possible service for a limited
budget. Therefore, in most cases, financial performance measures will not suit public sector organisations.

Example: Stakeholders' Conflicting Objectives

Stakeholders in a state-funded university:

 The university's management board is accountable to multiple principals.

 However, the requirements of the principals may conflict:
 Students may desire small class sizes, an extensive library, etc.
 Government wants to minimise the costs per student.
 Designing a performance measurement system with multiple and conflicting objectives is tricky.
 Management must try to rank its principals/stakeholders and prioritise objectives.
One of the difficulties in measuring performance in such organisations is how to value their outputs because
the outputs are not usually in financial terms. This problem has led to the development of the VFM or Value
for Money concept.

26.1.4 Value for Money (VFM) concept

1.4 Value for Money (VFM) concept

The Value for Money concept revolves around the 3E approach – the three Es are:
1.4.1 Economy – Inputs
This is a measure of inputs-related costs (the aim is to minimise costs for a set quality or a set amount of
inputs). Inputs are the resources input, for example, time, money, materials and labour.
1.4.2 Efficiency – Process
This is a measure of how the inputs and outputs are related, with the aim being to achieve the maximum
output from the actual input (resources) used in a process.
1.4.3 Effectiveness – Outputs.
This relates the outputs of a process to the objectives of an organisation.

Example

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Example

A government wants to measure the performance of the state schools in its country and is looking at both
financial and non-financial performance indicators.
The government wishes to assess the average class sizes of state schools. Which of the three Es would be the
best description of the measure of class sizes?
A school will generally consist of many students taught by several teachers.
The teachers can be thought of as the ‘input’; they are the resources that cost money to employ (in the form of
wages), and the students can be considered as the ‘output’ – an educated pupil is the result of a state-run
school education.
Efficiency is a measure of how the inputs and outputs are related, with the aim being to achieve the maximum
output from the actual input (resources) used in a process. The efficiency = outputs/inputs = pupils/teachers,
the result of which is the average class size in a school.
The government wishes to assess the pass rates of the state schools. Which of the three Es would be the best
description of the measure of pass rates?
A school will generally consist of many students taught by several teachers.
Schools will aim to prepare students to the required standard so that they will be able to pass their exams.
The students can be thought of as the ‘output’ – an educated pupil is the result of a state-run school education,
and ‘pass rates’ are one of the school’s objectives. The VFM measure that links output to objectives is
effectiveness – how well does the school’s output relate to its purpose (pass rate) – the answer is
‘effectiveness’.
The government wishes to assess the average cost of employing one full-time teacher in each state school.
Which of the three Es would be the best description of the measure of hiring one full-time teacher?
The teachers can be considered the ‘input’; they are the resources that cost money to employ (in the form of
wages). Therefore, the teachers’ wages are the cost (the amount spent on the inputs).
The measure of employing one full-time teacher can therefore be described as ‘economy’ because this is the
measure that relates cost to input.

Example University Objectives – Conflicting 3Es

High effectiveness is likely to conflict with economy and efficiency.

Multiple and conflicting objectives also may exist due to the various stakeholders involved.

26.2.1 Assessment Of Managerial Performance and Problems Involved

2.1 Assessment Of Managerial Performance and Problems Involved

It is not easy to monitor the individual performance of a division or department manager within an
organisation. This is because sometimes there are factors that may affect a division but are not under the
direct control of the manager of that division. Therefore, it would be unfair to assess the division manager
based only on a single performance measure of his division.
As well as ensuring the measures represent a fair reflection of the manager’s responsibilities and area of
influence, it is also essential to ensure the criteria used are aligned with the organisation’s strategy and
long-term goals. This is not easy to achieve.
For example, if client or customer satisfaction and long-term customer retention are vital to the
organisation’s long-term success, it would not be appropriate to judge management performance based only
on short-term profitability. A focus on profitability may lead to managers taking a commercially aggressive
stance when dealing with customers and reducing resources dedicated to customer service, which in the
long term may lead to customers switching to competitors.
Specific targets can be set for managers. For example, a manager could be assigned an increase in sales
target for a period. It would also be fair to assess a divisional manager based on costs and revenues within
their control.
Therefore,
 It would be fair to assess cost centre managers on controllable costs

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 It would be fair to assess revenue centre managers on controllable revenues

 It would be fair to assess profit centre managers on controllable costs and revenues
 It would be fair to assess investment centre managers on controllable costs, revenues and
investments.
Controllable costs and revenues result in a controllable profit, and this is commonly used in the calculation
of two performance measures that can be used to assess managerial performance in divisions that are
investment centres:
 Return on investment ratio (ROI)
 Residual income ratio (RI).
26.2.2 Imputed Interest
2.2 Imputed Interest

The imputed interest (which is sometimes known as the notional interest rate) is calculated as follows:

Imputed interest = Capital employed (or net assets) × imputed interest rate or cost of capital

An exam question might give information relating to imputed/notional interest rates.

26.2.3 Return on investment (ROI)
2.3 Return on investment (ROI)

Return on Investment = Controllable profit/controllable capital employed

or
Return on Investment = Operating profit/Net assets

The return on investment is a similar ratio to the ROCE. It is commonly used when assessing the managerial
performance of an individual department or responsibility centre when profit and capital employed (net
assets) can be controlled by the manager in charge.
ROI is a relative measure (expressed in %)

26.2.4 Residual income (RI)

2.4 Residual income (RI)

Residual Income = Controllable profit − Imputed interest on capital employed

or
Residual income = operating profit − (net assets × imputed interest rate)

A manager has exceeded the profit level required to satisfy the investors if residual income is positive.
Residual income is an absolute measure (expressed in $).
26.2.5 Application of RI and ROI
2.5 Application of RI and ROI

Example

A division currently earns an ROI of 25%.

It is considering investing in a project with a RI of $2,000 at an imputed interest charge of 25%.
What is the project’s effect on the division’s ROI if undertaken?
Substitution - ROI
Start by substituting some simple numbers into the information given. For example, if the division currently
earns an ROI (operating profit over net assets) of 25%, this could be represented by an operating profit of
$25,000 and net assets of $100,000.
ROI = 25,000/100,000 × 100% = 25%
Substitution - RI
A residual income of $2,000 could be represented by an operating profit of $14,000 less an imputed interest
charge of $48,000 × 25%.
Residual income is calculated as follows:
RI = operating profit − (net assets × imputed interest charge)
RI = $14,000 − ($48,000 × 25%) = $(14,000 − 12,000) = $2,000

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Example

New ROI
Calculate the new ROI using the following:
 existing net asset and operating profit information; and
 the new net asset and operating profit information.
Existing operating profit = $25,000
Existing net assets = $100,000
New operating profit = (existing operating profit + project operating profit = $25,000 + $14,000 = $39,000
New net assets = existing net assets + project net assets = $100,000 + $48,000 = $148,000
New ROI = 39,000/148,000 × 100% = 26.4% = an increase in ROI (up from 25%).

Activity RI Versus ROI

The following information is available on a company’s two departments:

Department 1 Department 2

$000 $000

Capital employed 1,000 100

Profits Year 1 200 20

Year 2 220 40

Target ROI = 20%

Determine which department is performing better using the following:

(a) Residual income; and

(b) Return on investment.

*Please use the notes feature in the toolbar to help formulate your answer.

(a) Residual income

Department 1 Department 2
$000 $000
Year 1
Profit 200 20
Less capital charge 200 (20% × 1,000) 20 (20% × 100)
Residual income 0 0

Year 2
Profit 220 40
Less capital charge 200 (20% × 1,000) 20 (20% × 100)
Residual income 20 20

(b) Return on Investment

Department 1 Department 2

$000 $000

Year 1 20% 200/1,000 20% 20/100

Year 2 22% 220/1,000 40% 40/100

It is easier for the larger division to generate an additional $20,000 residual income, so using RI to compare
departments/managers controlling different asset base sizes is misleading.

Therefore, ROI is the better performance indicator in this situation.

Activity 2: ROI and Decision-Making

The following information is available on a division and its possible investment in a project:

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Division Project

$000 $000

Capital employed 1,000 100

Controllable profit 300 25

Target ROI 20%

Required

(a) Calculate ROI and RI for the division:

(i) Pre-project; and

(ii) Post-project.

(b) Explain whether or not the divisional manager would accept the project if they were paid a bonus based
on the following:

(i) ROI; and

(ii) RI.

*Please use the notes feature in the toolbar to help formulate your answer.

a)

ROI % RI ($000)

(i) Pre-project 30% 100

300/1,000 300 − (20% × 1,000)

(ii) Post-project 29.5% 105

325/1,100 325 − (20% × 1,100)

(b)

(i) ROI

Although the project ROI is acceptable to the company (as it is greater than 20%), the manager would
not be motivated to accept the project as it lowers divisional ROI.

(ii) RI

The manager would be motivated to accept the project. This decision would be congruent with the
goals of the company.

26.2.6 Advantages And Disadvantages Of ROI

2.6 Advantages and Disadvantages of ROI

2.6.1 Advantages
 It is similar to the ROCE ratio, so it is widely known.
 It uses operating profit/controllable profit and capital employed/net assets to calculate the ratio –
this information can be easily obtained from accounting information.
 The ROI is a relative measure (percentage) and will provide meaningful comparisons between
different-sized divisions.
 ROI is a commonly used ratio, and so it can be used to make comparisons between different
organisations as well as different divisions within an organisation.
2.6.2 Disadvantages
 Identifying the controllable costs and revenues (which impact profit) in ROI calculations can be
challenging.
 The single results of ROI calculations are unlikely to be the 'full story' of how well divisional
managers have performed.
 ROI may lead to managers making decisions that will be best for their performance measure rather
than for the organisation as a whole. For example, managers may reject projects that have a positive RI
if they lower the manager's ROI.
 ROI values may give a false impression of being high when old non-current assets are valued at
their net book value.

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26.2.7 Advantages And Disadvantages Of RI

2.7 Advantages And Disadvantages Of RI

2.7.1 Advantages
It uses operating profit/controllable profit and capital employed/net assets to calculate the ratio – this
information can be easily obtained from accounting information.
The RI is stated as an absolute value and can be useful when information about an actual value rather than a
relative value (such as ROI) is needed.
2.7.2 Disadvantages
 Identifying the controllable costs and revenues (which impact profit) in RI calculations can be
challenging.
 The single results of RI calculations are unlikely to be the 'full story' of how well divisional
managers have performed.
 The RI calculation requires an imputed interest charge which must be estimated.
26.3.1 Benchmarking
3.1 Benchmarking

Benchmarking compares an organisation’s performance measures to the best in the organisation’s industry
(or to internal departments or divisions) or the best practices from other companies in a different sector.
Comparisons can help improve performance, and this is important for benchmarking as the information
indicates an organisation’s strengths and weaknesses against its competition.
The process of external benchmarking involves an organisation identifying the best companies in their
industry or in another industry where similar processes exist. The organisation then compares its results
with those of other organisations. The benefit of this process is that the organisation carrying out the
benchmarking process learns how well the other organisations are performing and what they are doing that
makes them successful.
There are four main types of benchmarking.

Internal With internal benchmarking, an organisation compares the performance of its different
benchmarking divisions or departments.
This is more commonly used in larger organisations which have similar divisions or
departments operating within them.
For example, a large multi-national organisation with offices in many countries might compare
how its accounts receivable departments operate worldwide to help share best practices and
promote efficiency.

Competitive With competitive benchmarking, organisations look to their industry's most successful
benchmarking organisations to see how they compare with their competitors' performances and make
changes where improvement can be achieved.
For example, an organisation may wish to improve the performance of its accounts receivable
department by comparing its processes to those of the organisation in its industry with the
best-run accounts receivable department.

Functional With functional benchmarking, an organisation will compare its processes’ performance with a
benchmarking top-performing organisation in another industry which performs a similar function.
For example, a credit card company would be a good industry for an organisation to look to
when it is aiming to improve the performance of its accounts receivables department. This is
because credit card companies collect monies that are owed to them on a large scale, the same
function performed by an organisation’s accounts receivable department.

Strategic Strategic benchmarking compares performance measures like an organisation's market share
benchmarking in its industry and its profitability ratios with other organisations to improve its strategic or
long-term plans.
Benchmarking enables organisations to learn more about how best-performing divisions within themselves
or the organisations within their industry operate. An organisation can improve its performance with this
information (where it is available).
Benchmarking exercises are carried out by following the benchmarking process.
1. Select the activity to be benchmarked
Where the organisation appears to be underperforming in a particular activity, it may select this activity
as an area to be benchmarked. An organisation identifies areas of poor performance by comparing its
performance measures with those of the following:

 Other departments or divisions within its organisation

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 Other organisations within its industry

 Other organisations in different industries.
2. Carry out the benchmarking process.
Obtain detailed information by looking at the following:

 Publically available information

 Observation
 By arranging with other organisations to interview their employees.
3. Identify improvements
The organisation may look to see how improvements can be made, which may include:

 Identifying whether new processes could be developed to improve performance

 Reviewing methods used by other organisations to see whether methods employed by them could
lead to improvements.
4. Act on improving performance
Once organisations have decided which activities they would like to improve upon and how to bring
about this improvement, they must make plans to bring about these improvements and then act on
them.

5. Monitor performance progress

Once a programme to improve performance has been set up, it should be monitored and reviewed to
identify how it is doing. If necessary, this process should be repeated if the results planned have not
been achieved.

26.4.1 Total Quality Management (TQM)

4.1 Total Quality Management (TQM)

4.1.1 What is Total Quality Management?

Quality can be defined as the standard of something as measured against other things of a similar kind.
Total quality management (TQM) is a management process that focuses on two main things:
 Getting it right the first time
 Continual improvement of products or services.
TQM’s elements are:
 Total – every part of the organisation is involved in the TQM process: employees, customers and
suppliers.
 Quality – products and services must be provided at the standard expected by the customer to
meet their needs. Quality does not mean perfection. It means meeting the customer’s expectations and
delivering a product or service that is fit for purpose.
 Management – prevent faulty products from being produced or bad service from being provided.
This is achieved by managing the quality of an organisation’s products and services.
26.4.2 TQM: Costs of Quality
4.2 TQM: Costs of Quality

Specific costs will be involved in producing products and services that meet quality standards. These costs
are known as the costs of quality.
There are four main groups of costs of quality:
 Internal failure costs - these are the costs that are incurred when faulty products or poor services
are discovered while they are still in the organisation. They are usually found by the quality assurance
team.
 Cost of correcting faulty products or improving poor quality services
 Cost of scrapping poor-quality materials
 Production delays.
For example, at Winston’s Football Factory, footballs made that don’t meet production standards must be
scrapped or reworked, costing the company money.
 External failure costs - these are the costs that are incurred when faulty products or poor services
are discovered after they have left the organisation. They are usually found by the customer.
 Cost of repairing defective products
 Cost of replacing defective products and poor services
 Loss of customer goodwill.
For example, at Winston’s Football Factory, dissatisfied customers may return poor-quality footballs or claim
a warranty repair. As a result, there might also be a sales decline due to a reputation for poor quality.

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 Prevention costs - these are the costs that arise because an organisation is trying to prevent
producing faulty products and providing poor services.
Examples of prevention costs

 Product design improvements
 Maintenance of quality control equipment
 Wages of quality control staff
 Training of quality control staff
For example, at Winston’s Football Factory, a quality assurance process in monitoring materials and the
manufacturing process is implemented. This costs money and time, as machines need to be calibrated,
employees need to be trained, materials need to be sourced and inspected, etc.
 Appraisal costs - these are the costs that arise because an organisation is appraising or assessing
the quality of its goods or services.
 Inspection costs of materials received from suppliers
 Inspection costs of finished goods
 Costs of appraising the services provided to customers.
For example, at Winston’s Football Factory, footballs are subjected to a series of quality tests and may only
be sold to the customer after passing.
4.2.1 Expenses of using TQM
In organisations using TQM, the prevention and appraisal costs will be higher than in organisations not
using TQM. This is because these types of cost increase as more money is spent on preventing faults and
assessing the quality of goods and services.
In organisations using TQM, the internal and external failure costs will be lower than those not using TQM.
This is because organisations using TQM will provide fewer faulty goods and better quality services.
If using a TQM cost management system is to be beneficial, the costs of quality (prevention and appraisal
costs) should be less than the costs of failure (internal failure and external failure costs).

26.4.3 Application of TQM

4.3 Application of TQM

 Change of work culture from the pursuit of the minimum cost to that of satisfying customers.
 Understanding that poor quality costs money.
 Total involvement of all employees in the pursuit of quality.
 Pursuing continuous improvement and accepting that it is a never-ending process.
 Use benchmarking and other quality tools to understand the true costs of activities and the value
they generate.
26.5.1 Cost Reduction
5.1 Cost Reduction

Cost control identifies areas where costs are higher than expected (for example, higher than budget) and
aims to bring them back in line with expectations.
Cost reduction aims to reduce the unit cost of a product to one that is below the standard cost by looking at
ways in which individual cost elements of a product can be reduced.
Cost reduction should be carried out through a planned cost reduction programme. Cost reduction
programmes should be ongoing processes that continually look for areas where there may be opportunities
to reduce costs.
Ideally, costs would be minimised and ‘designed out’ of a product or process at the product or process
design stage, and unnecessary costs would be avoided.
In reality, inefficiencies and higher-than-necessary costs can become established within organisations.
Eventually, a cost reduction programme may be introduced. But, unfortunately, some cost reduction
programmes are rushed and relatively unplanned, mainly when there is pressure to cut costs straightaway.
Such arbitrary programmes can result in an immediate reduction in costs, although the steps taken may not
be in the organisation’s long-term interests. For example, the programme may lead to employee
redundancies, resulting in the inability to meet orders due to insufficient staff.
The main differences between cost reduction and cost control are summarised in the table below.

Cost reduction Cost control

Broad focus: aims to reduce the unit cost of Narrower focus: focuses on costs that are higher than
producing and delivering a product or service expected

Rather than accepting standards and budgets, Uses standards and budgets as a way of planning and
cost reduction programmes challenge them controlling costs

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Attempts to achieve genuine savings in the cost Involves a comparison of actual costs with the standard or
of production, distributing, selling and budget, and an investigation of variances
administration
Cost reduction may involve work study techniques, which consist of observing and analysing current
working methods and looking for efficiency improvements. How the people and departments are organised
may also be reviewed to establish whether a more efficient way of working is possible.
26.5.2 Areas for Cost Reduction
5.2 Areas for Cost Reduction

5.2.1 Materials
The cost of materials could be reduced by:
 Reducing wastage levels (one way of achieving this is to buy higher quality materials which are
easier to work with)
 Seeking to purchase materials from different suppliers whose prices are lower
 Purchasing materials in bulk to take advantage of quantity discounts which may be available
 Investigating the use of substitute materials that are cheaper to buy that will do the same job (and
are of the same quality).
5.2.2 Labour
If the employees work more productively, they will produce more output for the same wages, reducing the
labour cost per product unit.
Labour productivity can be increased by:
 Introducing incentive schemes to encourage workers to work more efficiently and to produce more
output
 Regular maintenance of machinery to reduce idle (non-productive) hours that employees are paid
for whether they can work or not.
5.2.3 Machinery
If machinery works more efficiently, it will enable the organisation to produce more output during the same
operating hours, reducing the overheads per unit associated with running the machinery.
Regular maintenance can improve machinery efficiency to ensure it runs at its most efficient level.
5.2.4 Production Overheads
Variable and fixed production overheads are often based on labour hours or machine hours. Therefore,
improving labour and machine efficiency will affect the overheads charged to a product unit.
5.2.5 Non-Production Overheads
Non-production overheads include administration and finance costs, for example. One way an organisation
can look to reduce finance costs is to make sure that it is paying the lowest interest rate for any finance
(bank loan or overdraft) that it might have.
Activity 3

The following table shows the resources involved in making one football at Winston’s Football Factory:

Standard cost per football Units Cost per kg ($) Cost per unit ($)

Direct materials – Plastic F 1 kg $3 3.00

Direct labour 2 Hours $6 12.00

Variable overheads 2 Hours $1 2.00

Fixed overheads 2 Hours $2 4.00

Total cost per football 21.00

Winston’s Football Factory is planning a cost reduction programme to look into possible areas where costs
might be reduced without any reduction in the quality of each football.

The following options have been identified:

 A replacement material to Plastic F called Plastic L, which has identical properties but only costs
$2.50 per kg
The material composition of Plastic L is slightly different to that of Plastic F. Even though it is of the same
quality, the difference in its composition means there is less wastage, so the standard usage of Plastic L
would be 0.9 kg per football.


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Plastic L is slightly easier to work with, saving five minutes in labour time for each football manufactured.

 Plans are being made to introduce a bonus scheme, and results have shown that productivity will
increase, resulting in a saving of ten minutes per football produced.
The quality of the footballs will be unchanged, and the standard selling price will remain at $35 per football.

Calculate the revised cost card and standard profit per football if the suggested options are implemented
(using the absorption costing template below)

Standard cost per football $ per unit Note

Direct materials – Plastic L 2.25 1

Direct labour 10.50 2

Variable overheads 1.75 3

Fixed overheads 3.50 4

Total cost per football 18.00

Selling price 35.00

Revised standard profit 17.00 5

Notes:

[1] Plastic L = 0.9 kg × $2.50 = $2.25

[2] Direct labour = 1.75 Hours × $6 = $10.50

[3] Variable overheads = 1.75 Hours × $1 = $1.75

[4] Fixed overheads = 1.75 Hours × $2 = $3.50

[5] The revised standard profit per football (using absorption costing) is now $17
The cost reductions identified in the above activity have resulted in an increase in profitability for Winston’s
Football Factory. For example, if sales were 5,100 footballs during a period, this could save $15,300 (5,100 ×
$3) in production costs and a corresponding increase in profitability.
In the case of this example for Winston’s Football Factory, it is assumed that following the cost reduction
programme, the selling price remained constant at $35.
Another option would be to reduce the selling price to sell more footballs - for example, by encouraging
customers who previously favoured cheaper, lower quality footballs to purchase a Winston’s Football
Factory football.
For example, if the selling price were lowered to $33, the profit per football would still increase (from the
previous $14 per ball to $15). Therefore, It may be possible to sell more footballs and increase the profit
margin. This demonstrates the power of what may seem relatively small cost reductions.
26.5.3 Value Analysis
5.3 Value Analysis

Value analysis is a cost reduction method that looks at a product’s or service’s components and considers
how each one affects its unit cost. Value analysis also looks at how the design of a product or service can be
changed without affecting its value.
The main aims of value analysis are:
 To produce a product or cost at a given standard for the most economical cost
 To look closely at each product or service feature and ask how necessary each feature is.
5.3.1 Types of Value
Four types of value are used when considering how necessary the features of a product or service are.

Value type Description

Utility value The value of the product or service from the point of view of its use. The utility value is also known
as the use value.

Esteem The value of a product or service from the point of view of what it means to the customer (its
value prestige).

Cost value The value of a product or service from the point of view of how much it costs to produce and sell.

Exchange The value of a product or service from the point of view of its market value.

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value
26.5.4 Value Analysis Method Of Cost Reduction
5.4 Value Analysis Method Of Cost Reduction

Two assumptions are associated with the value analysis method of cost reduction:
 Consumers will have a standard of quality that they require for each product or service, and
organisations will work towards this required standard
 The organisation tries to achieve the desired objective for a product or service for the lowest
possible cost.
There are six main steps involved in carrying out a value analysis.
1. Select an item for value analysis
It is common for the product or service that incurs the highest costs (which therefore represents the
greatest possibility of saving costs) to be selected for value analysis.

2. Record information relating to the selected item

When recording the information that relates to the item chosen for value analysis, consider the
following questions:

 Does the product or service carry out its intended function?

 What are the costs associated with producing this product or service?
 Are there any alternative methods of making the product or service, and what are the associated
costs?
3. Analyse product/service information
Analysis of the product/service includes:

 How essential are all of the elements of the product/service?

 Can each individual cost element be purchased or manufactured at a lower cost?
 Are all of the features of the product/service necessary?
 Is it possible to substitute one of the items of cost for a cheaper alternative (of the same quality and
functionality)?
4. Consider alternatives
This stage considers the alternative ways of producing a product/delivering services that are available
to an organisation. It is a good idea to gather information about each alternative’s cost at this stage.

5. Select the option that costs the least

Evaluate each of the alternatives available and consider their associated costs. Then select the best
option from those available.

6. Recommend the best option

Recommend the best option and begin planning the cost reduction programme.

26.5.5 Value Analysis and Activity-Based Costing

5.5 Value Analysis and Activity-Based Costing

Value analysis reflects aspects of activity-based costing (ABC).

ABC measures activities’ cost and performance level, including how activities contribute to the
organisation’s success. ABC and value analysis aims to ensure that the things the organisation does are
necessary, are done well, and ‘add value’.

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