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TABLE OF CONTENTS
Chapter 1 Introduction to cost and management accounting
Chapter 2 Accounting for Materials
Chapter 3 Accounting for Labour
Chapter 4 Accounting for Overheads
Chapter 5 Marginal and Absorption costing
Chapter 6 Breakeven analysis or CVP Analysis
Chapter 7 Accounting for Decision Making
Chapter 8 Activity Based Costing (ABC)
Chapter 9 Budgetary Planning and Control Systems
Chapter 10 Standard costing
Chapter 11 Variance analysis
Chapter 12 Processes Costing
Chapter 13 Joint and By-products

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CHAPTER ONE
INTRODUCTION TO COST AND MANAGEMENT ACCOUNTING
What is Accounting?
 Is a process of identifying, measuring, analyzing and reporting economic or financial
information to users to permit them makes informed decision. Accounting can be
divided into the following branches:
a) Financial Accounting
b) Taxation
c) Auditing
d) Management Accounting
There are many definitions of accounting. The Chartered Institute of Management
Accountants (CIMA) in its Official Terminology describes accounting as:
 The classification and recording of actual transactions in monetary terms, and
 The presentation and interpretation of these transactions in order to assess
performance over a period and the financial position at a given date.
Users of accounting information
Different people have different needs for accounting information.
 Managers need information that will assist them to plan and control the activities of
their organizations. They need to make decisions of say the selling price for their
products, they need to understand the demand for their product, their position on
the market, is their business making a profit, which of their products are more
profitable etc.
 Shareholders, other investors, require information on the value of their
investments and the income that is yielded by their investments.
 Prospective investors require information that will help them in making decisions of
where and how to invest.
 Lenders of capital such as banks would like to assess the reliability of a prospective
borrower regarding the ability to pay back sums borrowed and to pay interest on
sums borrowed.

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 Employees are concerned with the security of their jobs, they need to have
information that will enable them make better bargains regarding their wages and
other employment benefits etc.
 Government requires information for computing various economic statistics that
help in policy formulation; it also requires information for levying tax etc.
The list of users can go on and on. The users are not only business organizations, but also
individuals, church organizations, clubs and societies, various charities etc. The objective of
accounting is to provide sufficient information to meet the needs of the various users at the
lowest possible cost. It is important that the benefit derived from using information should
exceed the cost of obtaining that information.
A close look at the various users of accounting information will show that there are two
categories of users:
1. Internal parties within the organization such as managers.
2. External parties such as shareholders, lenders of capital, prospective investors,
creditors etc.
Management accounting is concerned with providing information to people within the
organization to help them make better decisions and improve the efficiency and
effectiveness of existing operations. Management accounting therefore provides
information required by managers for purposes such as:
1. Formulation of policy.
2. Planning and controlling the activities of the organization.
3. Making decisions on which course of action to take, where a number of alternatives
exist.
4. Safeguarding the assets of the organization.
Such information will aid management in:
1. Long-term planning, that is making plans that are aimed at achieving the objectives
of the organization.
2. Making short-term operation plans.
3. Comparing plans with actual results to assess performance.
4. Taking corrective actions to bring future actual transactions in line with plans.
5. Obtaining and controlling finance.

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6. Reviewing and reporting on systems and operations.
Financial accounting is concerned with providing information mainly to external parties to
satisfy their various needs according to their interests in the reporting organization.
It is referred to as “that part of accounting which covers the classification and recording of
actual transactions of an entity in monetary terms in accordance with established concepts,
principles, accounting standards and legal requirements and presents as accurate a view as
possible of the effect of those transactions over a period of time and at the end of that
time.”
Management Accounting
 Management accounting is a branch of accounting that measures and report
financial and non-financial information to managers to help them in carrying out
their managerial functions of planning, controlling and decision-making.
 Therefore the purpose of management accounting is to generate and provided
management information to various managerial levels.
Management Information
 Management information is information that managers need to effectively carry out
their managerial functions i.e. planning, controlling, organising and decision-making.
 In an organisation management information is generated and is provided in the
following three levels;
a) Strategic information
b) Tactical information
c) Operational information
Qualities of good information
i. Relevance
ii. Understandability
iii. Timeliness
iv. Comparability
v. Objectivity
vi. Reliability
vii. Completeness
viii. Cost/benefit criterion

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Comparisons between management and financial Accounting
 Both management and financial accounting follow the same accounting principles
and almost uses the same information and sources. But they differ in their roles and
presentation. The following table illustrates their differences:
Management and cost
Accounting
Financial Accounting
Information
mainly produced
for
Internal use e.g. managers and
employees
External use e.g. shareholders,
creditors, lenders, banks ,
government
Purpose of
information
To aid planning, controlling and
decision making
To record the financial
performance in a period and
the financial position at the
end of that period
Legal
requirements
None Regulated by companies Act
and others laws
Format Management decide on the
information they require and the
most useful way of presenting it
Format and content of financial
accounts intending to give true
and fair view should follow
accounting standards (IASs)
and company law
Nature of
information
Both financial and non-financial Mostly financial
Time period Historical and forward looking Mainly an historical record
 Generally management accounting is part of management information system (MIS)
designed to assist in the efficient management of business. It provides information
for internal use as opposed to financial accounting. Since management accounting
and financial accounting systems have different proposes, they are often kept
separate in two sets of accounts i.e. interlocking system. However it is possible to

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have integrated sets of accounts containing both cost and financial accounting
information i.e. integrated system.
Cost Accounting
 Cost accounting is a specialized form of management accounting which measures,
analyzes, and reports financial and non-financial information relating to the cost of
acquiring or using resources in an organization.
Purposes of Cost and management accounting
i. To calculate cost per unit of the products produced or services provided.
ii. To develop cost standards
iii. To highlight all forms of waste and analyse variations from expected performance.
iv. To provide for periodic profit and loss accounts and balance sheet by segment.
v. To reveal sources of economies in production.
vi. To provide actual versus estimate cost comparisons, guideline for future quotations
and assistance in price fixing.
vii. To ensure standards are kept up to date.
viii. To present comparative cost data for different levels of output.
ix. To provide actual information for assessment of performance of individual units,
managers, machines etc.
What is costing?
 Is the process of calculating a cost of a unit of a product or a service.
Cost classification in a cost accounting system.
 The total cost of making a product or providing a service consists of the following:
i. Material cost
ii. Labour cost (wages and salaries)
iii. Other expenses ( rent and rates, electricity, gas bills, depreciation e.t.c)
 Costs can be classified in different ways and these includes:
a. Classification by traceability (by nature)
b. Classification by function
c. Classification by behavior
d. Classification by responsibility
a. Classification by traceability
 This involves classifying costs as direct and indirect cost.

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What are direct costs?
 Is a cost that can be traced in full to the product, service or department that is being
costed.
 Examples include; raw materials costs, wages costs, wages of a foreman supervising a
single product, overtime at the request of a customer.
What is an indirect cost?
 Is a cost that cannot be traced in full to the product, service or department that is
being costed.
 Examples includes; production overheads, administration overheads, selling
overheads, wages of a foreman supervising a variety of products, overtime as a
company or management policy.
NB: indirect costs are also called overheads.
 The sum of direct costs (direct materials plus direct labour plus direct expenses) is
called prime cost.
 The sum of prime cost plus production overhead is called factory cost or full cost
of production.
 The sum of production costs plus other costs outside and or after production (non-
production overheads) e.g. marketing costs, selling costs, e.t.c is called cost of sales
or cost of goods sold.
 Cost of sales plus a profit margin or profit mark up is called selling price.
A unit cost card will appear as follows:
Direct costs: K K
Direct materials XX
Direct labour XX
Direct expenses XX
Prime Cost XX
Production overheads:
Indirect materials XX
Indirect labour XX
Indirect expenses XX XX
Production or Factory Cost XX
Non-production overheads
Admin, marketing, office rates etc. XX
Total Cost XX
Add profit margin or mark up XX

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Selling price XX
RECAP: All direct costs are variable costs but variable costs are not direct costs e.g.
commission is a variable cost but not a direct cost.
b. Classification by function
 it involves classifying costs as production or manufacturing costs, administration
costs, marketing or selling or administration costs.
 Costs which do not fall under production, administration, marketing, distribution are
called general overheads or other costs.
Other definition of terms:
Production (factory) overheads:
 It includes all indirect materials, indirect labour and other indirect expenses incurred
in the factory.
Administration overheads:
 Are all indirect material cost, indirect wages and indirect expenses incurred in the
direction, control and administration of an undertaking. E.g. depreciation, office
salaries, etc.
Selling overheads:
 Are all indirect material cost, indirect wages and indirect expenses nincurred in
promoting sales and retaining customers e.g. advertising, sales promotion, market
research, salesman salaries and commission.
Distribution overheads:
 Are all indirect material costs, wages and indirect expenses incurred in making the
packed products ready for dispatch and delivering to the customer.
c. Classification by behavior
 This involves classifying costs according to the way they are affected by changes in
the levels of activity and these includes:
1. Variable costs: these are costs which changes with the levels of activity e.g.
material and labour costs.

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2. Fixed costs: these are costs that do not change with the volume of activity
e.g. rent of factory and salaries.
3. Mixed costs or semi-variable costs or semi-fixed costs: these are costs
which are partly fixed and partly changes with the volume of activity e.g. water
bills, gas bills, electricity bills.
4. Step fixed costs: these are costs which changes at different levels of activity
e.g. rent as accommodation and loyalty bonus.
d. Classification by responsibility
 It involves classification of costs as controllable and uncontrollable costs.
What are controllable costs?
 Are costs that can be influenced by a decision of a particular or specific manager.
What are uncontrollable costs?
 Are costs that cannot be influenced or affected by a decision of a specific manager.
Other cost terminologies
Product costs: are costs identified with goods produced or purchased for resale. Such costs
are initially identified as part of the value of inventory. They becomes expenses (in the form
of cost of goods sold) only when the inventory is sold.
Period costs: are costs that are deducted as expenses during the current period without
ever being included in the value of inventory held, that are all non-manufacturing costs.
Normal costs: are those which are expected.
Abnormal costs: are those which are unusual either by nature or size and those to which
management attention should be drawn respectively.
Relevant cost: are future cash flows arising as a direct consequence of a decision made or
under review.
Irrelevant costs: are costs that are not affected by management's decision.
Notional costs: are costs which does not involve the outflow of cash either now or in future
e.g. notional rent, depreciation, notional interest.
Real costs: are costs that will result into outflow of cash.

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Differential cost: is the difference in cost of alternative choices
Incremental cost: is the difference in cost between making the unit and not making it.
Opportunity cost: is the benefit forgone by selecting one alternative in preference to the
most profitable or best alternatives.
Sunk costs or past costs or committed costs: are past costs or expenditures which is not
directly relevant in decision making.
 They might have been charged already as a cost of sale in previous accounting
periods or will be charged in future accounting period though has already been
committed.
Avoidable costs: is a specific cost of an activity or sector of a business that would be
avoided if the activity or sector did not exist.
Allocation of costs to cost centres
Cost unit
 Is a unit of a product or service to which cost can be related or ascertained.
 A cost unit is a basic control unit for costing purposes.
Examples of cost units:
Industry or area Cost unit
Hospital  Patient per night, number of
operations, outpatient visit, etc
Brewery industry  Barrel
Hotel  Rooms, guest per night, beds
occupied per night, meals supplied
Road haulage business  Tone per mile, mile
Road passenger business  Passenger per mile
Canteen  Meals supplied
Car production  Cost per car
Garment production  Cost per garment
Doctor or Lawyer  Cost per client
Cost centres

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 These are collecting places for costs before they are further analysed. Or
 Is a location, function, activity, or item of equipment in respect of which costs may be
related or ascertained. Examples includes a machine, a department, group of
achiness, a project, overhead costs (rent, rates, electricity
Types of cost centres
There are two main types of cost centres and these are;
a. Service cost centres: these are centres that provide services to other cost centres
which has no output to the external market but provides support internally.
Examples are stores, maintenance, canteen, personnel department among others.
b. Production cost centres: these are centers that has output to the external market.
They are involved in production of goods and not provision of services. Examples
are milling, moulding, engineering, packing and assembly department among
others.
Cost objects: is any activity for which a separate measurement of cost is desired.
 If users of management information wish to know the cost of something, that
something is called a cost object. Examples are cost of a product, cost of a
service, and cost of operating a department.
Profit centres:
 Are collecting places for both costs and revenues before they are further
analysed.
Revenue centres:
 Are collecting places for revenues before they are further analysed.
Investment centres:
 Is a profit centre with an additional responsibility for capital investment and
possibly financing and whose performance is measured by its return on
investment.
Responsibility centres:
 Is a department or organizational function whose performance is a direct
responsibility of a specific manager.
NOTE: cost, revenue, profit and investment centres are all known as responsibility
centres.

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Cost behaviour
 This refers to the way in which cost are affected by changes in the levels of activity or
output.
Why is cost behavior essential?
It is useful for:
i. Budgeting and planning
ii. Decision making
iii. Control accounting
Levels of activity (volume of output) may refer to either of the following:
i. Number of units produced
ii. Value of items sold
iii. Number of items sold
iv. Labour or machine hours
v. Number of invoices issued
vi. Number of units of electricity consumed, e.t.c
Cost behavior principles
 The basic principle is that as the levels of activity rises the costs will usually
rise and vice versa.
NB the commonly used levels of activity are volume of output and labour or machine hours
Cost behavior patterns:
Fixed costs: are costs that do not change with the levels of activity. E.g. rent, salaries,
straight line depreciation e.t.c
They are also known as period costs because they relate to a span of time.
Sketch graph
Total fixed cost
Costs (K)

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Output
Variable costs: are costs which changes with levels of activity e.g. raw material costs, direct
labour cost, sales commission, bonus payment.
Sketch graph
Variable cost
Cost (K)
Output
Step fixed costs: is a cost which is fixed in nature but only within certain levels of activity
e.g. rent as accommodation, loyalty bonus.
Sketch graph
Step costs
Costs (K)
Relevant range
Output
Relevant range: is a period within which fixed costs remain unchanged.
Mixed costs or semi-fixed cost or semi-variable cost: Are costs which are partly fixed
and partly changes with the levels of activity e.g. electricity and gas bills, sales man salaries,
cost of running a car.
Sketch graph

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Total costs
Costs (K) variable cost part
Fixed cost part
Output
Assumptions about cost behavior
 Within the normal or relevant range of output, costs are often assumed to be either
fixed, variable, or mixed.
 Departmental costs within an organization are assumed to be mixed costs
 Departmental costs are assumed to rise in a straight line as the volume of activity
increases. I.e. costs are said to be linear.
Determining fixed and variable elements from mixed costs
There are several ways of estimating fixed and variable costs from mixed costs and these
are:
1) Scatter graph
This involves preparing a scatter graph of costs in the previous periods (with costs on the y-
axis and volume on the x-axis) and then drawing a line of best fit through the points as
follows:
Sketch graph
Total costs
Y-axis Estimated line of best fit (ELOBF) ₒ ₒͦ ͦ ͦ ͦ
ₒ ͦ ₒ ͦ ͦ
Costs (K) ͦ ͦ ͦ Variable part
ₒ ͦ ͦͦₒ ₒ
Fixed part
Output X-axis

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Fixed cost line is determined where line of best fit cuts the y- axis.
2) Statistical analysis or least square regression analysis
It involves calculating a line of best fit from historic records of cost and output data and
then measuring the degree of confidence in these estimates by means of correlation
coefficient.
It involves formulating an equation of Y=a + bx where; Y= total cost, a= fixed cost, b=
variable cost per unit and x= output or quantity.
3) High-low method or technique
This is the common method used in costing and budgetary control and involves the
following steps:
Step 1: Review records of costs and output in previous periods
Select the period with highest and lowest activity levels
Determine the total cost at the highest and lowest activity levels selected above
Step 2: Calculate the variable cost per unit by calculating;
Total cost at highest levels less total cost at lowest levels / total units at highest levels less
total units at lowest levels = variable cost per unit.
Step 3: Then determination of fixed costs
Total costs at highest levels less (total units at highest levels *variable cost per unit) = fixed
costs. Or
Total costs at lowest levels less (total units at lowest levels *variable cost per unit) = fixed
costs.
Example on high- low method or technique
Example
1. Ignoring Inflation
The costs of operating the maintenance department of a computer manufacturer, Silick and
Chips Ltd, for the last four months have been as follows.

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Month Cost Production volume
K standard hours
1 110,000 7,000
2 115,000 8,000
3 111,000 7,700
4 97,000 6,000
What costs should be expected in month five when output is expected to be 7,500 standard
hours? Ignore inflation
Solution
Volume Total Cost
(Hours) K
High output 8,000 115,000
Low output 6,000 97,000
Range 2,000 18,000
Variable cost per standard hour = K18 000
2,000
= K9.00
Subtracting in either the high or low volume:
High Low
K K
Total cost 115,000 97,000
Variable costs (8000 x K9) 72,000 (6000 x K9) 54,000
Fixed Costs 43,000 43,000
Estimating costs of 9000 standard hours of output
K
Fixed costs 43,000
Variable costs (9000 x K9) 81,000
Total Costs 124,000

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2. With Inflation
R&F Ltd has recorded the following total costs during the last five years.
Average
Year Output price level
volume Total cost index %
units K
2000 65,000 145,000 100
2001 80,000 179,200 112
2002 90,000 209,100 123
2003 60,000 201,600 144
2004 75,000 248,000 160
Requirements
Calculate the total cost that should be expected in 2007 if output is 85,000 units and the
average price level index is 180?
Solution
Adjusting price levels to a common basis
Output Total cost Adjusted Total cost
units K K
High level 90,000209,100 x 100 170,000
123
Low level 60,000201,600 x 100 140,000
144
Range 30,000 30,000
Variable cost per unit = K30, 000
30,000 = K1.00 per unit
Substituting into high level K
Total cost 170,000
Variable costs (90000 x K1) 90,000
Fixed cost 80,000
Costs in 2005 for 85,000 units will be as follows:

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K
Variable cost (85000 x K1) 85,000
Fixed costs 80,000
Total costs 165,000
At index 180 = 165,000 x 180
100
= K270, 000
CHAPTER TWO
ACCOUNTING FOR MATERIALS
Accounting for materials is vital for management to implement an effective inventory
control system, and to be aware of major costing problems relating to pricing of material
issues and inventory valuations at the end of each accounting period. Normally inventory in
an organisation are classified under the following:

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i. Raw materials are elements or substances which are used in the
manufacturing of a particular unit.
ii. Work in progress (WIP)
iii. Spare parts/Consumables (e.g. cleaning materials)
iv. Finished goods.
The main stages of material control involved in inventory system cover the following;
a) Ordering of inventory.
b) Purchasing of inventory.
c) The receipts of inventory into stores.
d) Storage.
e) Issue of inventory into production departments.
f) Accounting.
Inventory control
Is the systematic regulation of inventory levels. This is necessary in keeping the
manufacturing operations of the business to go on continuously without sudden
interruptions if raw materials are lacking, or a great deal of expenses can be incurred on
inventory with a short shelf life.
Inventory Controls
There are three main objective of inventory control:
 To be able to supply to production process the required level of inventory of an
appropriate quality as and when required;
 To have efficient and effective procedures for the ordering and storage of materials
 To have appropriate inventory recording procedures.
The main stages of material control
Ordering and Receiving Materials
a) An order is initiated by a particular department or cost centre requisitioning the
stores for some materials. This is made on a Material requisition.
b) A purchase requisition is made by the stores department and sent to purchasing
department, authorizing order for further inventory.
c) Purchasing department place an order with a supplier through a Local Purchase
order (L.P.O), copies of the purchase orders are sent to accounts department and
stores.
d) The supplier delivers the consignment of materials, and the storekeeper

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signs a delivery note for the carrier.
e) On receipt of goods the store keeper confirm the goods and prepares a Goods
receivable note (GRN) and copy will be send to accounts department to marched
with an invoice before making payment.
f) All the goods are kept by storekeeper and recorded on a Bin card which will contain
details of goods received and issued to production i.e. records physical movement
of inventory. Inventory record card contains more information, such as order placed,
and free inventory balance. Free Inventory balance represents what is really
available for future use calculated by material in inventory plus materials on order
form suppliers minus materials requisitioned, not yet issued. Stores ledger include
details about the price paid for each batch of goods received and their total value.
Any transfers of goods from stores department have to be authorized and the Bin
card and stores ledgers have to be up dated.
Issue of Materials
Materials can only be issued against a materials requisition or stores issue note.
Where materials, having been issued to one job or cost centre, are later transferred to a
different job or centre, a material transfer note should be raised.
Material returns must also be documented, on materials returned note. This is a reverse of a
requisition note.
Storage of Raw Materials
Storekeeping involves storing materials. Materials may be kept in either a central (main)
store; this is a centralized storekeeping or a departmental (sub) store. Sub-stores may be
necessary for the storage of high value items, inflammable and corrosive materials, part-
finished goods, raw materials or tools and fixtures.
Centralised storekeeping system
Advantages
 There will be less duplication of physical resources, such as land, buildings, and
equipment.
 Fewer personnel will need to be employed.
 Greater supervision of staff is possible.
 Clerical and recording costs can be reduced.
 Inventory count is easier to arrange and to operate.
Disadvantages;

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 Transport costs may be increased.
 Departments that are some distance from a Centralised store may find that delays
and errors occur hence there may be stoppages to production.
 There is a greater risk of inventory losses if all inventories are located centrally owing
to such factors as fire and theft.
 There may be a loss of local knowledge and expertise.
Inventory coding
 To ensure that inventory control system runs smoothly, each item held in stores
must be unambiguously identified. Materials are therefore coded and classified.
Some of the advantages of coding are that ambiguity is avoided; its time saving as
descriptions can be length and time consuming and make computerized processing
easier.
Inventory count
 Involves counting the physical inventory at a certain date and then check against the
balance in the clerical records. There are two methods of inventory count:
Periodic inventory count:
 This is usually carried out annually and the objective is to count all items of
inventory on a specific date.
Continuous inventory count:
 Involves a specialist team counting and checking a number of inventory items each
day, so that each item is checked at least once a year.
Inventory discrepancies
 This will occur when inventory checks disclose difference between the physical
amount of an item in inventory and the amount in the inventory records. The cause
should be investigated and appropriate action taken to ensure that it does not
happen again.
If it is due to clerical error, then the records should be rectified immediately. If it is because
units of inventory appear to be missing, the lost inventory must be written off. The
accounting transaction will be recorded by a store credit note if items of inventory have
been lost, or a stores debit note if there is more actual inventory than the amount recorded.
Then a stock adjustment account will be debited or credited depending on the situation.
The balance of this account is written off directly to profit and loss account at appropriate
times.
Perpetual Inventory

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 Perpetual inventory involves the recording of every receipt and issue of inventory as
it occurs on bin cards and store ledger accounts.
 This means that there is a continuous clerical record of the balance of each item of
inventory. The balance on the inventory ledger account therefore represents the
inventory on hand and this balance is used in calculation of closing inventory in
monthly and annual accounts.
In practice, physical inventory may not agree with recorded inventory and therefore
continuous inventory count is necessary to ensure that the perpetual inventory system is
functioning correctly and that minor inventory discrepancies are corrected.
Inventory Levels and Statistical techniques
The overall objective of inventory Control is to maintain the inventory levels that minimize
the combined cost made up of the following;
 Holding cost (i.e. cost of storage and stores operations, interest charges, insurance
costs, risk of obsolescence, deterioration and theft),
 Ordering costs (i.e. clerical and administrative costs associated with purchasing,
accounting for and receiving goods, transport costs and production run costs) and
 Inventory out costs (lost contribution from lost sales, loss of future sales due to
disgruntled customers, loss of goodwill, cost of production stoppages, labour
frustration over stoppages and extra costs of urgent, small quantity, replenishment
orders)
 This is to ensure that there is no inventory out: Insufficient inventory to meet
production demand- which lead to loss of customers goodwill, reduced profits and
on other hand no surplus inventory are carried which result in increased storage
costs, which leads to reduced profits. Hence inventory must be at an optimal level.
Inventory Control Terminologies
 Lead time/procurement time: The time period between ordering and
replenishment.
 Demand: Amount required by sales or production (usually expressed as a rate of
demand per week, year etc).
 Physical inventory: number of physical items in inventory at a given time.
 Buffer inventory /minimum inventory/safety inventory: inventory allowance to
cover errors in forecasting the lead time or demand during the lead time.
 Maximum inventory: inventory level selected as a maximum desirable which is
used as an indicator to show when inventory have risen too high.
 Free inventory: physical inventory plus outstanding replenishment order minus
unfulfilled requirement.
Free inventory = material in inventory + Ordered inventory form suppliers - inventory
requisitioned, not yet issued

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Inventory Levels
Inventory control levels can be calculated in order to maintain inventories at the optimal
levels as follows,
Reorder Level
This is the level where inventory have to be replenished; the level is determined by the
maximum rate of consumption and lead time, which is the time between placing an order
with supplier and the inventory becoming available for use.
Reorder level= maximum usage x maximum lead time
Reorder Quantity
This is Quantity of inventory to be ordered when the inventory reaches reorder level. The
quantity is set so that the combined cost of ordering and holding are minimized.
RQ= Maximum Inventory level-(Reorder level-minimum usage x minimum lead time)
Minimum Level
It is a warning level to draw management attention to the fact that inventory are
approaching a dangerous low level. It is determined by Reorder level average rate of
consumption and average lead time.
Minimum Level= Reorder level-(average usage x average lead time)
Maximum Level
A warning to the management that inventory have reached a wasteful level, inventory level
must not exceed this up most limits, it is set by considering the following factors; reorder
level, quantity ordered, minimum rate of consumption and minimum lead time.
Max. L=Reorder level + Reorder Quantity-(minimum usage x minimum lead time)
Average Inventory
AS= Minimum Inventory + ½ Reorder Quantity
ECONOMIC ORDER QUANTITY/ ECONOMIC BATCH QUANTITY
Is a reorder quantity where holding and ordering cost are at a minimum. This theory
assume that cost tend to increase with the level of cost and so could be reduced by
ordering smaller amounts from suppliers each time.

25. 24
EOQ=√2cd/h Where: c- Cost of order
h- Holding cost/ carrying cost
d- Annual demand
Example
The following data relate to an item of raw material used by M. The cost of raw material is
K20, usage per week is 250 units, cost of ordering material is K400 and the annual cost of
holding inventory as a percentage of cost is 10%. Year consist of 48 weeks and 5 days by
week. Calculate the EOQ.
Solution
EOQ =√2cd/h = √ 2 x 400 x (250 x 48) =√4,800,000 = 2,191 units
10% x K20
Example
Assume the company decides to make widgets in its own factory. Machinery has been
purchased with a capacity of 250,000 widgets per annum, but the company uses 50,000
widgets. The cost of inventory is K10, ordering and handling cost K150 per order and
carrying costs are 15% per annum. Determine EOQ.
Solution
EOQ =√ 2 x 150 x 50,000
1.5 (1 - 50,000/250,000) = 3,536
Example
A company uses components at the rate of 500 units per month, which are bought in at a
cost of K1.20 each from the supplier. It costs K20 each time to place an order, regardless of
the quantity ordered.
The supplier offers a 5% discount on the purchase price for order quantities of 2000 items
of more. The current EOQ is 1000 units. The total holding cost is 20% per annum of the
value of inventory held.
Required
Should the discount be accepted?
Solution
Order quantity 1000 2000

26. 25
K K
Order cost (6000/1000xK20) 120 (6000/2000xK20) 60
Holding cost [20%xK1.20x (1000/2)] 120 [K0.24x0.95x (2000/2)] 228
Purchase cost (6000xK1.20) 7200 (6000xK1.20x0.95) 6840
Total annual costs 7440 7128
The discount should be accepted because it saves the company K312 (K7440-K7128).
Example
The following details are extracted from the accounts of EJ Investments at the end of the
year;
Opening inventory K2 000
Purchases K26 000
Closing inventory K5 000
Calculate the inventory turnover.
Solution
Inventory turnover rate = 3000 + 26000 – 5000
(3000 + 5000)/2
= 6 times per annum
On average inventory is held for two months. But note that this is an average figure. High
turnover indicates efficiency in manufacturing.
Alternative method uses the maximum inventory level and minimum inventory level and
turnover will be calculated as follows;
Cost of materials consumed during the period
½(maximum inventory level + minimum inventory level)
Suppose the maximum level is K3000 and the minimum level is K1000 and what has been
issued during the period is K10000, the turnover will be calculated as follows;
= 10000
½(3000 + 1000) = 5 times
A more refined method uses the re-order quantity as follows;

27. 26
Cost of materials consumed during the period
Minimum inventory level +½ Re-order quantity
Suppose the maximum inventory level is 1500 units and the minimum is 600 units. The re-
order quantity is 800 units and issues during the period were 6000 units, the turnover will
be;
= 6000
600 + ½(800)
= 6 times
Assumptions of EOQ
 Meaningful order costs and inventory holding costs can both be calculated.
 Order costs and inventory holding costs are constant.
 Rate of demand are known
 Known constant price per unit
 Orders are not received in batches.
 Replenishment is made instantaneously
It is clear from the assumptions that the main problem that arises from the use of the EOQ
is difficulty in calculating the order and the inventory holding costs. Nevertheless, the EOQ
should be used only as a guide and should not be adhered rigidly without regard of the
stores manager's personal experience and knowledge of what actually happens in practice.
Instantaneous replenishment
Gradual replenishment
This is where inventory is replenished over a period of time.
EOQ with gradual replenishment
= √ 2 x Ordering cost x Demand
Carrying cost (1- Demand/production rate per annum)
There are a number of important formulae related to EOQ that you should note;
Average inventory held is equal to ½ of the EOQ (= EOQ/2).
The number of orders in a year = Expected annual demand/EOQ
Total annual holding cost = Average inventory (EOQ/2) x holding cost per unit of inventory.
Total annual ordering cost = Number of orders x cost of placing an order.

28. 27
There is also a formula that allows us to calculate the total annual cost (TAC) i.e. the total of
holding costs and ordering costs.
TAC = C x D/Q + H x Q/2
Where: C - ordering cost
D - Annual demand
Q - Reorder quantity (EOQ)
H - Holding cost
Bulk Discount
 It is worthwhile taking a discount and ordering larger quantities if doing so
minimises the total of material costs, ordering cost, inventory holding cost.
The total cost will be minimized at one of the following:
At the pre-discount EOQ level, so that a discount is not worthwhile.
At the minimum order size necessary to earn the discount.
To establish whether the discount should be accepted or not, the following calculations
should be carried out;
i. Calculate total actual cost with discount. And
ii. Compare this with the annual costs without the discount (at the EOQ point).
Inventory turnover
It is important to compare turnover of different grades and kinds of inventory as a means of
detecting inventory which does not move regularly.
Inventory turnover is measured in terms of the ratio of cost of materials consumed to the
average inventory held during the period.
Cost of materials consumed during the period
Average inventory of material during the period
Example
The following details are extracted from the accounts of EJ Investments at the end of the
year;
Opening inventory K2 000
Purchases K26 000

29. 28
Closing inventory K5 000
Calculate the inventory turnover.
Solution
Inventory turnover rate = 3000 + 26000 - 5000
(3000 + 5000)/2 = 6 times per annum
On average inventory is held for two months. But note that this is an average figure. High
turnover indicates efficiency in manufacturing.
Alternative method uses the maximum inventory level and minimum inventory level and
turnover will be calculated as follows;
Cost of materials consumed during the period
½(maximum inventory level + minimum inventory level)
Suppose the maximum level is K3000 and the minimum level is K1000 and what has been
issued during the period is K10000, the turnover will be calculated as follows;
= 10000
½(3000 + 1000)
= 5 times
A more refined method uses the re-order quantity as follows;
Cost of materials consumed during the period
Minimum inventory level +½ Re-order quantities
Suppose the maximum inventory level is 1500 units and the minimum is 600 units. The re-
order quantity is 800 units and issues during the period were 6000 units, the turnover will
be;
= 6000___
600 + ½(800) = 6 times
Example
Component X is one of thousands of items kept in a store of a manufacture. Maximum
inventory level set at 17000 units. Expected consumption per month for maximum is 3000

30. 29
units, for minimum 1600 units and estimated delivery period maximum 4 months and
minimum 2 months.
Required to calculate
1. Reorder level,
2. Reorder quantity,
3. Minimum level,
4. Average inventory held.
Solution
1. Reorder level = Maximum usage x maximum delivery period
= 3,000 units x 4 months
= 12,000 units
2. Reorder quantity = maximum inventory - (reorder level - minimum usage in
minimum delivery period)
= 17,000 units - (12,000 units - (1,600 units x 2 months))
= 8,200 units
3. Minimum level= reorder level - (average usage x average delivery period)
= 12,000 units - (2,300 units x 3 months)
= 5,100 units
4. Average inventory held = minimum inventory + ½ reorder quantity
= 5,100 units + 4,100 units
= 9,200 units
Types of inventory revealed by inventory turnover are;
Slow moving inventory: Inventory with low turnover, they take a long time to be used up.
These should be maintained at lowest level consistent with forecast demand and supply.

31. 30
Obsolete inventory: Items of inventory which have become out of date and are no longer
required. These should be scrapped off if they have some scrap value, otherwise they are
discarded.
Dormant inventory: Inventory that presently has no demand, but there is a possibility that
in future they may be required. Consultations should be made between purchasing
manager, stores controller, production controller and cost accountant to make decision
whether to retain them due to anticipated demand or scrap them to reduce storage costs.
Inventory valuation
Correct pricing of issues and the valuation of inventory are important as they have a direct
effect on the calculation of profit.
Methods stock valuation
a) First in First out (FIFO)
b) Last in First out (LIFO)
c) Cumulative weighted average cost (AVCO)
d) Periodic simple average (PSA)
e) Periodic weighed average (PWA)
f) Replacement cost
g) Standard cost
Inventory valuation and profitability
Ledger entry related to materials
The cost of materials issued is recorded on a stores ledger account for raw materials and
finished goods. The cost of work in progress completed is recorded in a system of
production costing records. The stores ledger account also shows the value of materials or
finished goods received into store, the value of materials returned, credit notes and debit
notes.
Example
At 1 July 2007, the total value of items held in store was K50 000. During July the following
transactions occurred.
K
Materials purchased from suppliers, on credit 120,000
Materials returned to suppliers, because they were of unsatisfactory quality 3,000
Materials purchased for cash 8,000
Direct materials issued to the production department 110,000
Indirect materials issued as production overhead costs 25,000
Value of materials written off after a discrepancy was found in a inventory check 1,000
Direct materials returned to store from production 4,000

32. 31
Required
Draw up a materials account and inventory adjustment account for July 2007.
Solution
Materials Account_________________________________
K K
Opening inventory b/f 50,000 Returns to supplier 3,000
Purchases (payables a/c) 120,000 Work in progress-issues 110,000
Purchases (cash a/c) 8,000 Production o/h a/c-issues 25,000
Returns from WIP 4,000 Loss of inventory-adj a/c 1,000
Closing inventory C/F 43,000
182,000 182,000
Inventory Adjustment account________________________
K K
Stores account 1,000 Profit and loss account 1,000
Example
S Limited had the following transactions relating to production material AB1 for the month
of April 2007:
Date Description Units Price per unit (K)
April 1 Opening inventory 45 10
April 6 Purchases 70 12
April 10 Issues to production30
April 13 Purchases 15 15
April 17 Issue to production 40
April 20 Purchases 100 14
April 22 Issue to production 90
April 24 Issue to production 40
April 27 Purchases 80 17
Required:
1. Using the following methods of pricing the issue of materials to production, calculate
the value of the closing inventory of AB1 as at 30 April 2007:
a) first in, first out (FIFO);
b) last-in, first-out (LIFO)
c) cumulative weighted average (CWA)
d) periodic simple average (PSA)
e) periodic weighted average (PWA)

33. 32
f) standard cost (assume that standard cost per unit is K20)
2. Assuming that the total sales revenue for completed units of AB1 for April 2007 was
K4000 and the other production costs involved totaled K500, calculate S's gross profit
using each of the above inventory pricing methods.
Solution
(a) First In First Out (FIFO)
_____________________________________________________________________________
Date Receipts Issues Inventory
April Quantity Price Value Quantity Price Value Quantity Value
K K K K K____
1 45 450
6 70 12 840 115 1290
10 30 10 300 85 990
13 15 15 225 100 1215
17 40 15 @ K10 450 60 765
25 @ K12
20 100 14 1400 160 2165
22 90 45 @ K12 1185 70 980
15 @ K15
30 @ K14
24 40 14 560 30 420
27 80 17 1360 ____ 110 1780
3825 2395
(b) Last In First Out (LIFO)
____________________________________________________________________________
Date Receipts Issues Inventory
April Quantity Price Value Quantity Price Value Quantity Value
K K K K K____
1 45 450
6 70 12 840 115 1290
10 30 12 360 85 930
13 15 15 225 100 1155
17 40 15 @ K15 525 60 630

34. 33
25 @ K12
20 100 14 1400 160 2030
22 90 14 1260 70 770
24 40 10 @ K14 470 30 300
15 @ K12
15 @ K10
27 80 17 1360 ____ 110 1660
3825 2615
(b) Cumulative Weighted Average (CWA) or Weighted Average Cost(AVCO)
_____________________________________________________________________________
Date Receipts Issues Inventory
April Quantity Price Value Quantity Price Value Quantity Value
K K K K K____
1 45 450
6 70 12 840 115 1290
10 30 K1290/115 337 85 953
= K11.22
13 15 15 225 100 1178
17 40 K1178/100 471 60 707
= K11.78
20 100 14 1400 160 2107
22 90 K2107/160 1185 70 922
= K13.17
24 40 13.17 527 30 395
27 80 17 1360 ____ 110 1755
3825 2520
(d) Periodic simple average
Purchases K
1) April 1 10
2) April 6 12
3) April 13 15
4) April 20 14
5) April 27 17
68
K68/5 =13.60

35. 34
Issues to production 200 (30 + 40 + 90 + 40) x K13.60 = K2720
(Opening inventory + purchases) - Issues to production = closing inventory value
= (K450 + 3825) - 2720
= K1555
(e) Periodic weighted average
Opening inventory + purchases during April
Opening inventory units + units purchased during April
= K450 + 840 + 225 + 1400 + 1360 = 4275 = K13.79
45 + 70 + 15 + 100 + 80 310
Issues to production = 200 x K13.79 = K2758
Closing inventory value = (opening inventory + purchases) - issues to production
= (K450 + 3825) - 2758
= K1517
(f) Standard costing method
Opening + purchases less issues to production x standard cost per unit
45+70+15+100+80 – (30+40+90+40) =110 x 20
Value of closing stock is K220.00
2. Calculation of gross profit
FIFO LIFO CWA PSA PWA
K K K K K
Sales revenue 4000 4000 4000 4000 4000
Direct materials (2495) (2615) (2520) (2720) (2758)
Other costs (500) (500) (500) (500) (500)
(2995) (3115) (3020) (3220) (3258)

36. 35
Gross profit 1005 885 980 780 742
Just-in time (JIT) control system
Just-in-time systems (JIT)
The just-in-time approach to manufacturing first appeared from the Japanese (called
kanban in Japanese). The success of Japanese firms in international markets in the 1980s
generated interest among many Western companies as to how this success was achieved.
The implementation of the just-in-time methods was considered to be one of the major
factors contributing to this success.
Colin Drury defines a JIT approach as a philosophy of management dedicated to the
elimination of non-value added activities. A non-value added activity is defined as an
activity where there is an opportunity for cost reduction without reducing the customer’s
perceived usefulness of a product or service. In contrast, a value-added activity is an activity
that customers perceive as adding usefulness to the product or service they purchase.
The CIMA Terminology defines JIT as:
‘A technique for the organization of work flows, to allow rapid, high quality, flexible
production whilst minimizing manufacturing waste and stock levels.’
JIT production is defined as:
‘A system which is driven by the demand for finished products whereby each component
on a production line is produced only when needed for the next stage.’
JIT purchasing is defined as:
‘Matching the receipt of the material closely with usage so that raw material inventory is
reduced to near zero levels.’
The various definitions give JIT the appearance of being merely an alternative production
management system, with similar characteristics and objectives to techniques such as MRP.
However, as properly defined by Colin Drury, JIT is a philosophy of management, as it
encompasses a commitment to continuous improvement and the pursuit of excellence in
the design and operation of the production management system.
The JIT approach is results driven, with the aim being the elimination of all non-value added
costs. It is surprising how little of what traditionally happens in manufacturing system
actually adds value to the product. The lead times to produce and sell a good consists not
only of processing it, but also inspecting it for quality, moving it from machine to machine,
having it queue at each machine as it waits for further processing, and finally storing it as a
finished good prior to sale. It will be apparent that value is only added to the product
during the actual processing stages. These have been estimated to represent as little as

37. 36
10% of the total manufacturing lead time in many companies, and thus up to 90% of
production time adds costs but no value.
The aim of JIT is to see the manufacturing lead time equal to the processing time. Although
this objective is unlikely ever to be achieved in practice, it nevertheless creates the correct
climate for the commitment to continuous improvement and excellence.
JIT is a customer led production system, also known as a ‘pull’ system. The main aim is to
produce products as they are required by the customer rather than build up inventory to
cater for demand.
JIT system incorporates:
JIT purchasing, requires raw material to be purchased, in such a way that receipt and usage
of materials coincides.
The following are the assumptions of JIT purchasing;
 suppliers will deliver on time
 suppliers will deliver materials of 100% quality (i.e. there will be no rejects returns
and production delays)
 JIT production, components or work in progress is only produced when needed in
the next stage of production. The system is driven by need for finished products. The
result is minimal (or in some cases non-existent) inventories of work in progress and
finished goods.
Characteristics of JIT
 A move towards zero inventory
 Elimination of non-value added activities
 An emphasis on perfect quality (i.e. zero defects)
 It’s a demand-pull manufacturing
Aims or advantages of JIT
 Minimizing warehousing and storage cost in the case of raw materials, to ensure
those costs are borne by the supplier.
 Eliminating the waste by maintaining control over quality of inventory to be input to
production process.
 Reducing the raw material and work in progress inventory carried as working capital
through more efficient production planning thus saving the financial costs.
 Reducing the finishing goods inventory held as working capital.
JIT has been successfully implemented in Japan and UK; however its success is hampered
for the following reasons:

38. 37
It is costly to administer.
It depends on very close relationship with supplier in terms of production scheduling and
quality control.
Commitment to quality and close relationship with suppliers runs counter to a business
culture where price rather than quality is basis for choosing suppliers.
CHAPTER THREE
ACCOUNTING FOR LABOUR
Labour comprise wages and salaries paid to employees of the organisation. As any other
costs it has a system of controlling the labour cost.
Techniques used to control labour cost includes:
1. Production planning- this is the preparation of planning schedule in advance of
production runs, with supporting schedule of man-hour requirements. This is so to
reduce or avoid bottlenecks due to shortage of labour and idle time payment due to
stoppage in production.
2. A labour budget and use of labour standards- a standard of expected performance is
required to measure productivity by comparing the actual time taken against the
expected time and in making of production planning schedules and labour budgets.
3. The labour performance reports. These should be prepared periodically, to signal
whether control action is needed.
4. Wage incentive scheme. Usually employees are productive and more efficient if
motivated. If the scheme is applied correctly it will reward both the company and
employees by raising productivity.

39. 38
5. Accounting for direct labour cost. The system should identify direct labour cost
associated with product, process or jobs.
Production and Productivity
Production is the quantity or volume of output produced.
Productivity is a measure of efficiency with which output has been produced.
Production levels can be planned and controlled by manipulating overtime, number of staff
or by managing productivity. Productivity if improved enables the company to achieve its
production targets in fewer hours of work, and therefore at a lower cost.
Measurements of labour activities
Capacity ratio (C) = Actual hours worked (A)
Budgeted hours (B)
 If the ratio is above 100% then its favourable (F) and if below 100% then its adverse
(A).
 It is a substitute of fixed overhead capacity variance.
OR
Capacity ratio =efficiency ratio x volume ratio
Efficiency ratio (E) =Standard hours (Expected hour to make an output)(S)
Actual hours taken (A)
 Efficiency ratio is also called productivity ratio
 If the ratio is below 100% then its adverse (A) and if it is above 100% its favourable
(F)
OR
Efficiency ratio = capacity ratio / volume ratio
Volume ratio (V) =Standard hours (Output measured in expected hours)(S)
Budgeted hours (B)
 Volume ratio is also called production or activity ratio
 This compares actual output with budgeted output
 It is similar to production volume variance
 If the ratio is above 100% then its favourable (F) and if below 100% then its adverse
(A).

40. 39
OR
Volume ratio = capacity ratio / efficiency ratio
Standard hours = actual output * standard hours per unit (budgeted hours per unit)
NOTE: A mnemonic CABESAVSB is used to recall the above formulae.
Example
R & F Ltd budgets to make 25,000 standard units of output (in four hours each) during a
budget period of 100,000 hours.
Actual output during the period was 27,000 units which took 120,000 hours to make.
Calculate the efficiency, capacity and production volume ratios.
Solution
a) Efficiency ratio
(27,000 x 4) hours x 100% = 90%
120,000
b) Capacity ratio
120,000 hours x 100% = 120%
100,000 hours
c) Production volume ratio
(27,000 x 4) hours x 100% = 108%
100,000
The production volume ratio of 108% (more output than budgeted) is explained by the
120% capacity working, offset to a certain extent by the poor efficiency (90% x 120% =
108%).
Recording Labour Cost
Several departments and management groups are involved in the control and measuring of
labour cost, these will include;
1. Personnel department
This department is responsible for engaging employees, their discharge, transfer,
classification and method of remuneration, besides issuing reports to management on
normal and overtime hours worked absenteeism and sickness, lateness, labour turnover
and disciplinary action.

41. 40
When a person is employed a personnel record card should be prepared showing full
personal particulars, previous employment, medical category and wage rate among
others.
2. Production planning department
This department schedules work, issues job orders to production departments and
chases up jobs in the factory when they run late. Materials requisitions and job time
tickets are issued with job orders.
3. Timekeeping department
Timekeeping department is responsible for accurately recording the time spent in the
factory by each worker and time spent by each worker on each job or operation-
attendance tine and job time respectively.
Following are records to be kept:
a) Daily and weekly time sheets- show how a worker spent his time during the day. The
objective is to reconcile all the time recorded in attendance within different jobs or
operations.
b) Clock cards- record the total number of hours a worker is present in a day including
overtime hours.
c) Job cards- relate to a single job and contain entries relating to numerous employees.
d) Route cards- similar to job cards except that they follow the product through the
works and carry details of all operations to be carried out.
Wages are calculated on the basis of the hours noted on the attendance card, whereas
production costs are obtained from the time sheets. It is most important that any idle
(waiting) time is booked by employees to enable total time spent to be reconciled with
total time attended.
4. Wages department
This department is responsible for preparation of the payroll and payment of wages.
Besides it will also do the following;
a) Maintaining a record of job classification, department and wage rate of each
employee and calculating and recording each employee's earnings
b) Summarising the wages costs and hours worked in each cost centre, to enable
payment and average cost centre pay rates determined for control and budget
purposes.
c) Summarising deductions from pay, overtime premium, bonus payments and the
employees' payments in respect of taxation and pension etc.
d) Providing an internal check on preparation and payout of wages.

42. 41
Attendance cards are the basis for payroll preparation. After calculation of net pay, a pay
slip is prepared showing all details of earnings and deductions.
The following are safeguards relating to the preparation of payroll and payment
of wages;
a) Install some time recording mechanism.
b) A person made responsible for timekeeping.
c) Wages sheets checked by personal officer.
d) Separate payroll and payout clerks.
e) Deductions prepared by another clerk.
f) Control accounts maintained.
g) Wage rate schedules maintained by personnel.
h) Identify employees on receipts of wages packet.
i) Unclaimed wages register maintained and wages locked up.
5. Cost accounting department
Cost accounting department is responsible for the accumulation and classification of all
cost data of which labour costs are part. The information is the passed to management
in the form of accounting reports to enable them determine what control measures are
required.
Data will be obtained from the following documents;
a) Clock cards, job cards, idle time cards, A reconciliation is required on total
attendance time with time booked on job cards plus time booked as idle.
b) Wages calculation sheet, rate of pay schedule, deduction charts and schedules.
Required for payroll calculation.
c) Payroll. All analyses and abstracts of labour cost can be obtained from the payroll.
d) Wages analysis. An analysis of the payroll to respective cost units or cost centre. At
the end of week or month, the totals for all jobs are added and the grand total
should agree with total wages paid.
An idle time report should be prepared analyzing the non-productive time and the
causes.
Idle time has a cost because employees will still be paid their basic wage or salary for
these unproductive hours and so there should be a record of idle time.
Idle time ratio= Idle hours x 100%
Total hours

43. 42
The ratio is useful because it shows the proportion of available hours which were lost as
a result of idle time.
Labour Turnover
Labour turnover is a measure of number of employees leaving/ being recruited in a period
of time (say one year) expressed as a percentage of the total labour force.
Labour Turnover = Replacements x 100
Average no. of employees in period
The labour turnover can be caused by both unavoidable factors like retirement, death,
illness, accident, marriage, pregnancy e.t.c and controllable factors which include low wages,
unsafe or stressful conditions, lack of career advancement opportunity, poor relationship
between management and staff etc.
Example 1
Time Rate
A factory operate a 40 hour week and direct worker works for 45 hours and is paid at K40
per hour with overtime at time rate plus half. PAYE is deducted at K450 and pension
contribution of K200. Employer's contribution to pension scheme is K240.
Requirements
Prepare a payroll for direct worker.
Solution
Payroll
Basic pay (40 x 40) 1,600
Overtime (5 x 60*) 300
Gross Pay 1,900
Deduction
PAYE 450
Pension contribution 200
Net pay 1,250
*K40 + K20 (½ of K40) = K60
Cost to employer
Gross pay 1,900
Pension contribution 240
2,140
Example 2

44. 43
Ten employees work as a group. A bonus is paid to each man in the group for excess
production when production exceeds the standard of 200 pieces per hour and the bonus is
in addition to a man's wages at hourly rate. The bonus paid is one half of the percentage of
production in excess of the standard quantity. Each man is paid as a bonus this percentage
of a wage rate of K52.00 per hour.
The following is one weeks' record
Day Hours worked Production
Sunday 90 24,500
Monday 88 20,600
Tuesday 90 24,200
Wednesday 84 20,100
Thursday 88 20,400
Friday 40 10,200
480 120,000
Requirements
1. Compute the rate and amount of bonus of the week
2. Calculate total pay of Chrissie who worked 42 hours and was paid K30.00 per hour basis,
and Charity, who worked 44 hours and was paid K37.50 per hour basic
Solution
1. Standard production for the week (480 hours x 200) = 96,000 pieces
Actual production for the week = 120,000 pieces
Excess production = 24,000 pieces
Bonus rate = 24,000 x 50% x 52.00
96,000
= K6.50 per hour
= 480 hours x K6.50
= K3 120
2. Chrissie Charity
K K
Basic pay 42 x 30.00 1,260 44 x 37.50 1,650
Bonus pay 42 x 6.50 273 44 x 6.50 286
1,533 1,936
Example 3

45. 44
ST Co. manufactures a single product. Its workforce consists of 10 employees, who work a
36-hour week exclusive of lunch and tea breaks. The standard time required to make one
unit of the product is two hours, but the current efficiency (or productivity) ratio being
achieved is 80%. No overtime is worked, and the workforce is paid K4 per attendance hour.
Because of agreements with the workforce about procedures, there is some unavoidable
idle time due to bottlenecks in production, and about four hours per week per person are
lost in this way.
The company can sell all the output it manufactures, and makes a cash profit of K20 per
unit sold, deducting currently achievable costs of production but before deducting labour
costs.
An incentive scheme is proposed whereby the workforce would be paid K5 per hour in
exchange for agreeing to new work procedures that would reduce idle time per employee
per week to two hours and also raise the efficiency ratio to 90%.
Required
Evaluate the incentive scheme from the point of view of profitability.
Solution
The current situation
Hours in attendance 10 x 36 360
Hours spent working 10 x 32 320
Units produced, 80% efficiency 320∕2 x 80∕100 = 128 units
Cash profit before deducting labour cost (128 x K20) 2 560
Less: Labour costs (K4 x 360 hours) 1 440
Net profit 1 120
Incentive scheme
Hours spent working 10 x 34 340
Units produced, at 90% efficiency 340 ∕ 2 x 90 ∕ 100 = 153 units
Cash profits before deducting labour costs (153 x K20) 3 060
Less: Labour costs (K4 x 360) 1 800
Net profit 1 260

46. 45
In spite of a 25% increase in labour costs, profits would rise by K140 per week. The
company and the workforce would both benefit provided, of course, that management can
hold the workforce to their promise of work reorganization and improved productivity.
The cost of labour turnover
1. Preventive costs: cost incurred in trying to keep employees, e.g. pension scheme
providing security cost of personal administration in maintaining good relationships,
medical services etc.
2. Replacement costs: costs incurred as a result of hiring new employees e.g. costs of
selection and placement, training, inefficiency of new labour etc.
Replacement costs are associated with high labour turnover, whereas high preventive costs
may lead to low labour turnover.
Labour turnover can be reduced by:
1. Paying satisfactory wages
2. Offering satisfactory hours and conditions of work.
3. Creating a good informal relationship between fellow workers and between supervisors
and subordinates.
4. Offering good training schemes and a well-understood career or promotion ladder
5. Improving the content of jobs to create job satisfaction
6. Proper planning so as to avoid redundancies.
Direct and Indirect Labour
Labour cost constitute of the following:
1. Basic pay of direct workers i.e. cash paid, tax and other deductions which is a direct
cost to the unit, job or process.
2. Basic pay of indirect workers is an indirect cost unless the worker's time is dedicated
to an order specifically asked by a customer.
3. Overtime premium paid to both direct and indirect works is an indirect cost except
where the overtime is specifically requested by a customer or it is worked regularly in
the normal course of operations by direct workers.
4. Bonus payments are generally an indirect cost.
5. Employer’s insurance and pension contributions are normally treated as indirect
labour cost.
6. Idle time is an overhead costs.
7. The cost of work on capital equipment is incorporated into the capital cost of the
equipment.
Accounting for labour costs

47. 46
The labour cost will be recorded in the wages control account.
Example
The following details were extracted from a weekly payroll for 750 employees at a factory.
Analysis of gross pay
Direct Indirect
Workers workers Total
K K K
Ordinary time 36,000 22,000 58,000
Overtime: basic wage 8,700 5,430 14,130
Premium 4,350 2,715 7,065
Shift allowance 3,465 1,830 5,295
Sick pay 950 500 1,450
Idle time 3,200 - 3,200
56,665 32,475 89,140
Net wages paid to employees K45 665 K24 220 K69 825
Required
Prepare the wages control account for the week.
Solution
Wages Control Account_______________________
K K
Bank: Net wages paid 69,825 Work in progress-direct labour 44,700
Deductions Production overhead:
(PAYE & Superannuation)19,315 indirect labour 27,430
Overtime Premium 7,065
Shift allowances 5,295
Sick pay 1,450
Idle time 3,200
89,140 89,140

48. 47
CHAPTER FOUR
ACCOUNTING FOR OVERHEADS
Absorption costing
 Is a principle whereby fixed and variable costs are allotted to cost units and total
overheads are absorbed according to activity levels.
 The distinguishing feature of absorption costing is that the cost of an item is
calculated by adding (absorbing) a share of fixed overheads costs.
 In marginal costing also known as variable costing or direct costing only variable
overheads are absorbed.
Procedure for building up accost of a unit
a) Ascertain and charge the items of prime costs i.e. direct costs.
b) Charge the appropriate amount of factory or production overheads.
c) The sum of (a) and (b) is the factory cost or full cost of production.
d) Charge the appropriate amount of selling and distribution overheads.
e) Charge the appropriate amount of administration overheads.
f) The sum of (c, (d) and (e) will be the total cost of sales.
Note: Absorption only goes as far as point (c) i.e. applies to production only.
Reasons for using absorption costing
a) Closing stock valuation which must be included in the balance sheet and to calculate
cost of stocks used or sold in the period. i.e
Closing stocks = opening units plus production units or purchases less sales units
b) Pricing decisions i.e. companies attempt to fix the selling prices by calculating the
cost of production or sales and then adding a profit margin to get the selling prices.
c) Establishing profitability of individual products where different products are
produced or manufactured.
Stages in absorption costing (costing procedure)
There are three stages of calculating the cost of overheads to be charged to manufactured
output and these includes;

49. 48
I. Cost allocation or overhead allocation
 It means charging of discrete identifiable items of cost to cost centres or cost
units. Or
 Is the process by which whole cost items are charged direct to a cost centre or
cost unit.
Example
The cost of a certain cottage company includes the following:
Wages of a foreman of department A K200, 000.00
Wages of a foreman of department B K150, 000.00
Indirect materials consumed in department A K50, 000.00
Rent of the factory premises shared by department A and B K300, 000.00
Requirements
Allocate the overhead costs.
II. Cost apportionment or overhead apportionment
 Is the process by which cost items or cost centre costs are divided between
several cost centres in a fair proportion. Or
 Is the division of cost amongst two or more cost centres in proportion to the
estimated benefits received using an appropriate basis.
III. Overhead absorption
 Is the process whereby cost centre costs are added to unit, job, or process costs.
 It is a means of attributing overheads to a product or service based on for
example on direct labour hours, direct labour cost, or machine hours.
NB: Overhead absorption is of great importance when dissimilar products are made
using common facilities, because overhead should reflect the load that each product
places upon the production facilities.
Cost apportionment and reapportionment
 In order to apportion cost amongst different departments several bases are used
.the table below illustrate some of the bases of apportionment and re
apportionment.
Basis of apportioning overhead costs

50. 49
Overheads to which the basis relates Basis of apportionment
Rent, rates, heating and light, repairs and
depreciation of buildings
 Floor area occupied by each
department
Depreciation of equipment and insurance
of equipment
 Cost of equipment
 Book value of equipment
 Depreciation rates on cost of
equipment
Personnel office cost, canteen, welfare
costs, wages and office costs, first aid.
 Number of employees
 Labour hours
Heating, lighting  Volume of space occupied by
each department
Carriage inwards  Value of material issues to each
department
Lighting  Floor area occupied by each
department
Heating  Volume occupied by each
department
Basis of reapportionment of service cost to other departments
Service departments Possible basis of apportionment
Stores department  Number of material usage or
requisitions
 Value of material usage or
requisition
General service department  Machine or labour hours
Maintenance department  Hours of maintenance and repair
work done for each department
Production planning  Direct labour hours worked for
each production department
Selling and marketing  Sale value
Research and development  Consumer cost i.e. production
cost minus cost of direct
material
 Added value i.e. sales value
minus cost of bought in
materials
Distribution  Sales value
Administration  Consumer cost and added value

51. 50
Example
Bravo limited incurred the following overhead costs:
K’ 000
Depreciation of factory 1,000
Factory repairs and maintenance 600
Factory office costs 1,500
Depreciation of equipment 800
Insurance of equipment 200
Heating 390
Lighting 100
Canteen 900
TOTAL 5,490
Additional information relating to the service and production departments in the factory is
as follows;
Production department service departments
A B stores canteen
Allocated overheads K10, 000.00 K15, 000.00 K17, 000.00 K21, 000.00
Floor area (sq. metres) 1200 1600 800 400
Volume (cubic metres) 3000 6000 2400 1600

52. 51
Number of employees 30 30 15 15
Book value of equipment K30, 000.00 K20, 000.00 K10, 000.00 K20, 000.00
Requirements
Apportion the overheads costs to the four departments
Reapportionment
 Is the apportionment of the allocated and apportioned overheads from service cost
centres to production cost centres.
Why is it important to reapportion service cost centre costs to production cost
centres?
 It is essential so as to incorporate or add service cost into production cost.
 If absorption costing is used failure to do so will lead to under absorption of
overheads and under valuation of finished goods stock.
Methods of reapportionment
a. Direct method or ignoring reciprocity or two step methods
a. It involves apportioning service cost to production department only on the
assumption that service cost centres do not offer services to each other but
rather they offer services to production departments only.
Reciprocity
 This refers to a situation where service cost centres share costs amongst other
service cost centres.
Service departments e.g. stores service departments e.g. canteen
b. Specific order of closing or step down method
 It involves apportioning allocated overheads not only to production
departments but also to other service departments.
 Start apportioning the department that offers services to both production and
other service departments and finishing with a service department that offers
services to production cost centres only.
How does it work alternatively?
 Start apportioning service departments which ranks first either horizontally or
vertically depending on the format of a question. Or

53. 52
 Start apportioning a service department with the highest overheads. Or
 Start apportioning a service department which shares most to other service
department and finish with the least sharing service department.
c. Repeated distribution or continuous allotment or reciprocal method
 This is where service cost centre costs are re apportioned repeatedly using given
bases or percentages or ratios until they become insignificant and immaterial.
d. Algebraic method or simultaneous equations method
 This involves formulation of simultaneous equations and can be difficult where
there are more than two unknowns.
NOTE: if no method is given in an exam, the method adopted depends on the kind of
a question but in most cases where there is reciprocity use algebraic or continuous
allotment method and the least immaterial apportioned figure should be allocated to
the production department bearing a greater ratio or percentage of reapportionment.
If no method is given, and you are stuck on which method to use here is a hint “start
with algebraic ,if it doesn’t work, try continuous allotment, if it doesn’t work, try
specific order of closing and lastly, if it doesn’t work, try direct method.( try and
adopt one method that suits the question first).
Example
Hover and hover limited has two production and two service departments (stores and
maintenance). The following information about the recent costing period is available:
Production department Service department
A B stores maint
Overhead costs: K10, 030.00 K8, 970.00 K10, 000.00 K8,
000.00
Cost of material requisition K30, 000.00 K50, 000.00 - K20, 000.00
Maintenance hours needed 8,000 hrs 1,000 hrs 1,000hrs -
The following additional information has been identified to show the appropriate shares of
overhead costs:
Production departments Service departments
A B stores maint
Sores 30% 50% - 20%

54. 53
Maintenance 80% 10% 10% -
Requirements
Reapportion the overhead costs using the following methods
a) Direct method
b) Specific order of closing
c) Reciprocal method
d) Simultaneous method
Overhead absorption
 Overheads refers to all indirect costs
 Overheads are also called on-cost or burden cost
 Overhead absorption is the process whereby overheads are added to unit, job, or
process costs.
 Overhead absorption is also called overhead recovery.
Overheads are usually added to unit cost using a predetermined overhead absorption rate
which is calculated from budgeted figures.
Overhead absorption rate= budgeted overheads /budgeted levels of activity.
Where:
Budgeted levels of activity can be any possible basis of absorption.
Overhead absorption rate (OAR) is also called overhead recovery rate (ORR).
Chosing the appropriate absorption basis or rate.
Different bases of absorption rates include:
a) A percentage of direct labour cost
b) A percentage of direct material cost
c) A percentage of prime cost
d) A rate per machine hour
e) A rate per labour hour
f) A rate per unit
g) A percentage of factory cost (for administration overhead).
h) A percentage of sales or factory cost (for selling and administration overheads).

55. 54
NOTE: there is no best way of choosing an overhead absorption rate or basis but its
subject to judgment and common sense, but what matters is choosing a basis which
reflects the characteristics of a department and prevents undue anomalies.
For example:
a) A department with more machine hours than labour hours is machine intensive
hence uses machine hours as a basis.
b) A department with more labour hours than machine hours is labour intensive hence
uses labour hours as a basis.
c) A rate per unit is appropriate in departments where all units produced are identical
and use identical production processes.
Why are hourly bases commonly used?
 Because they are likely to reflect the load on a cost centre or department hence
the incidence of overheads.
 Non hourly rates are seldom used because there is no relationship between them
and the ways in which the overheads are incurred.
Example on overhead absorption rates
The budgeted production overheads and other budgeted data of a certain cottage
company in Salima are as follows:
Production departments
A B
Overheads costs K36, 000.00 K5,
000.00
Direct material cost K32, 000.00 -
Direct labour cost K40, 000.00 -
Machine hours 10,000 hours -
Direct labour hours 18,000 hours -
Units of production - 1,000 units
Requirements

56. 55
Calculate the overhead absorption rates using various bases of absorption.
Blanket vs departmental absorption rates
 Blanked overhead absorption rate is a rate used throughout a factory and for all
jobs and units of output irrespective of the departments in which they were
produced.
Circumstances where blanket overhead absorption rate is not appropriate
 Where there is more than one department or where jobs spent unequal amount
of time in each department.
Why not blanket overhead absorption rates?
 Some products may receive a higher charge of overheads than they could fairly
bear, while others may be undercharged.
Why are departmental overhead absorption rates commonly used?
 It is fair and full cost of production will represent the real amount of effort and
resources put into making them
Example on departmental vs. blanket absorption rates
Old age grammar school has two production departments for which the following
budgeted information is available:
Departments A B TOTAL
Budgeted overheads K360, 000.00 K200, 000.00 K560, 000.00
Budgeted direct labour hours 200,000 hrs. 40,000 hrs. 240,000 hrs.
Requirements
a) Calculate the following rates:
i. Single factory or blanket overhead absorption rate
ii. Separate or departmental overhead absorption rates
b) Job X has a prime cost of K100,000.00 and takes 300 hours in department A and
does not involve any work in department B. job Y has a prime cost of K100,000.00
and takes 280 hours in department A and 20 hours in department B.
Requirements
Calculate the cost of each job using the rates calculated in a (i) and (ii).

57. 56
Over or under absorption of overheads
 Over or under absorption of overheads occurs because the predetermined rates
are based on estimates.
What is over absorption?
 This occurs where actual overheads incurred are less than overhead absorbed.
What is under absorption?
 This occurs where actual overheads incurred are more than overheads absorbed.
NOTE: Absorbed overhead = actual activity x overhead absorption rate
How to calculate under or over absorption
Dept. A Dept. B
K’000 K’000
Actual overheads (overhead incurred) XXX XXX
Less: absorbed overheads XXX XXX
Under or (over) absorbed overheads XXX (XXX)
Note: here is a simple rule to work out whether overheads are over or under
absorbed.
Actual overheads incurred – absorbed overheads = negative (N), then overheads are over
absorbed (O) i.e N.O. (Negative means Over).
Actual overheads incurred – absorbed overheads = positive (P), then overheads are under
absorbed (U) i.e P.U. (Positive means Under).
This then follows that N.O.P.U. rule should be used to identify under or over
absorption of overheads
Reasons for under or over absorbed overheads
 Actual overheads are different from budgeted overheads.
 Actual activity levels are different from the budgeted activity levels.
 Both actual overheads and actual activity levels are different from budgeted
overheads and budgeted activity levels.
Example on under or over absorbed overheads

58. 57
Franco and company has a budgeted production overheads of K50,000.00 and a budgeted
activity of 25,000 direct labour hours.
Requirements
Calculate the under or over absorption of over heads and state the reasons for the under or
over absorption in the following circumstances:
a. Actual overheads cost K47, 000.00 and 25,000 direct labour hours are worked.
b. Actual overheads cost K50, 000.00 and 21,500 direct labour hours are worked.
c. Actual overheads cost K47, 000.00 and 21,500 direct labour hours are worked.
Show the reasons for under or over absorption by causes or causation (show the reasons in
figures) and prepare a reconciliation statement.
Ledger entries relating to overheads
Marritto motorcycles absorb production overheads at the rate of K0.50 per operating
hour and administration overheads at 20% of the production cost of sales. Actual data for
one month was as follows:
Administration overheads K32, 000.00
Production overheads K46, 000.00
Operating hours 90,000 hours
Production cost of sales K180, 000.00
Requirements Prepare the ledger accounts relating to overheads.
How is over or under absorption of overheads accounted for?
 Over absorbed overheads is credited to the income statement or profit and loss
account.
 Under absorbed overheads is debited to the income statement or profit and loss
account.
Template showing under or over absorption by causes or causation
This method explains the for under or over absorption
Dept. A Dept. B
Expenditures K’000 K’000
Budgeted overhead XXX XXX
Actual overhead XXX XXX
Under (over) XXX (XXX)

59. 58
Volume Units or Hours Units or Hours
Budgeted hours XXX XXX
Actual hours XXX XXX
Under or over in hours XXX XXX
X Overhead absorption rate OAR OAR
Under or (over) (XXX) XXX
Reconciliation statement
K’000 K’000
Volume under or over (XXX) XXX
Less: Expenditures under or over XXX (XXX)
Under or (over) absorption XXX (XXX)
Exam style questions
Mbayifwa rice milling company has two production departments Milling and Packing and
two service departments Maintenance and stores. The company’s weekly overheads cost is
as follows:
Milling K90, 000.00 and Packing K75, 000.00
Direct labour hours are budgeted at 5000 hours and machine hours at 3000 hours. Costs for
the service departments are allocated as follows:
Maintenance 60% to milling
30% to packing
10% to stores
Stores 30% to milling
50% to packing
20% to maintenance
At the end of one week, actual results were tabulated as follows:
Milling K65, 000.00
Packing K45, 000.00

60. 59
Maintenance K25, 000.00
Stores K20, 000.00
The milling department actually worked 2900 machine hours and the packing department
worked 5200 direct labour hours.
Requirements
a. Compute the overhead to be charged o the milling and packing department for the
week using the reciprocal method and simultaneous equations method.
b. Calculate the under or over absorption of overheads in the two production
departments.
c. State the factors that that have caused the under or over absorption of overheads.
d. Make a reconciliation of the under or over absorption in relation to the production
department with reference to the causation.
e. Prepare departmental overhead accounts to show the entries of overheads
f. Show the over or under absorption in the over or under absorption overhead
account.
g. State the accounting treatment for over or under absorbed overhead.
ABC ltd has two production departments, a Machine shop and an Assembly shop, and
three service departments, Stores, Engineering and General services. The Engineering
service department serves the Machine shop only.
The following data has been provided:
Department : book area effective prod. Direct capacity
Value (sqm) horse labour machine
(K) Power (%) hours hours
Production:
Machine shop 210, 000 11,00085 350,000 90000
Assembly shop 30, 000 8,000 5 300,000 -
Service:
Stores 12, 000 2,000 -
Engineering 36, 000 2,500 10
General 12, 000 1,500 -
TOTAL 300, 000 25,000 100
The annual budgeted overhead costs for the year are:

61. 60
Indirect wages consumable supplies
Machine shop 88, 580.00 30, 800.00
Assembly shop 16, 220.00 4, 200.00
Stores 8, 200.00 2,800.00
Engineering 5, 340.00 4, 000.00
General 7,340.00 3, 000.00
TOTAL 125, 680.00 45, 200.00
Depreciation of machinery K44, 000.00
Insurance of machinery K8, 000.00
Insurance of buildings K3, 600.00 (note 1)
Power K7, 200.00
Light and heat K6, 000.00
Rent and rates K14, 100 (note 2)
Notes:
1. Because of certain fire risks, the machine shop is responsible for a special loading of
insurance on the building. This results in a total building insurance cost for the
machine shop of 50% of the annual premium.
2. The general services department is located in building owned by the company. This
building is valued at K80, 000.00 and is charged into costs at a notional rental value
of 6% per annum. This cost is additional to the rent and rates shown above.
3. The values of issues of material to the production departments are in the same
proportions as shown above for consumable supplies.
Requirements
a. Prepare and compete an overhead analysis sheet showing the bases of any
apportionments.
b. Calculate suitable overhead absorption rates for the production departments. No
services department costs are to be apportioned amongst other service department.
c. The following information relates to job 149 undertaken by ABC ltd on behalf of a
customer:
Direct materials K50, 000.00
Direct labour K20, 000.00
Other direct expenses K127, 000.00
Direct labour hours:
Machine shop 100 machine hours, 80 labour hours
Assembly shop 120 labour hours

62. 61
Requirements
If ABC ltd calculates its selling price by adding a profit margin is 40%, Calculate the price of
job 149.
DC Limited is an engineering company which uses job costing to attribute costs to
individual products and services provided to its customers. It has commenced the
Preparation of its fixed production overhead cost budget for 2001 and has identified the
following costs:
K’000
Machining 600
Assembly 250
Finishing 150
Stores 100
Maintenance 80
TOTAL 1 180
The stores and maintenance departments are service departments.
An analysis of the services they provide indicates that their costs should be
apportioned accordingly:
Machining Assembly Finishing Stores Maintenance
Stores 40% 30% 20% — 10%
Maintenance 55% 20% 20% 5% —
The number of machine and labour hours budgeted for 2001 is:
Machining Assembly Finishing
Machine hours 50 000 4 000 5 000
Labour hours 10 000 30 000 20 000
Requirements:
(a) Calculate appropriate overhead absorption rates for each production department for
2001.
(b) Prepare a quotation for job number XX34, which is to be commenced early in
2001, assuming that it has:
Direct materials costing K2400
Direct labour costing K1500
And requires: Machine hours Labour hours
Machining department 45 10
Assembly department 5 15

63. 62
Finishing department 4 12
And that profit is 20% of selling price.
(c) Assume that in 2001 the actual fixed overhead cost of the assembly department totals
K300 000 and that the actual machine hours were 4200 and actual labour hours were 30
700.
Requirements
Prepare the fixed production overhead control account for the assembly
department, showing clearly the causes of any over/under-absorption.
(d) Explain how activity based costing would be used in organizations like DC
Limited.
Sven Ltd has two production departments, Machining and Assembly, and two service
departments, Tooling and Maintenance. The budgeted activity levels for April 2004 were
thus:
Machining 400 hours K16,000
Assembly 2,400 hours K9,600
The service departments are apportioned thus:
Tooling 70% to Machining
20% to Assembly
10% to Maintenance
Maintenance 50% to Machining
30% to Assembly
20% to Tooling
During April 2004 the actual results were:
Machining 420 hours K12,000
Assembly 2,300 hours K8,000
Tooling K5,000
Maintenance k3,000
Required:
a) Calculate the budgeted overhead absorption rate per hour for each of the
production departments.
b) Calculate the amount of overhead to be charged to each of the production
departments.

64. 63
c) Calculate the amount of under or over absorption of overhead for each of the
production departments.
d) ‘The under or over utilisation of capacity can have an effect on the fixed cost of an
organisation.’ Briefly describe two ways, other than the under/over absorption
calculated above, by which this effect can be measured.

65. 64
CHAPTER FIVE
MARGINAL AND ABSORPTION COSTING
What is a marginal cost?
 Is the variable cost of one unit of a product which can be avoided if such a
product or service is not produced or provided.
What is marginal costing?
 Is a principle whereby variable costs are charged to cost units and fixed cost
attributed to the relevant period is written off in full against the contribution for
that period.
Marginal costing
 This is an alternative method to absorption costing where only variable costs are
charged as cost of sales and a contribution is calculated.
 In marginal costing closing stock, work in progress or finished goods are valued
at marginal (variable) production cost.
 In marginal costing fixed costs are treated as period costs hence charged in full
to the profit and loss of the accounting period in which they relate or incurred.
Elements of marginal cost of production of an item
 Direct material
 Direct labour
 Variable production overheads
Marginal cost of sales (variable cost of sales)
 It includes variable (marginal) cost of production i.e. direct material cost, direct
labour cost, and variable production cost (overheads), plus variable cost of
administration, selling and distribution.
Contribution
 Is the difference between sales value and marginal or variable cost of sales.
 It means contribution towards covering fixed overheads and making a profit.
Uses of marginal costing
 For planning
 For decision making

66. 65
Cases or situations where marginal costing principles are used as a decision
making aid.
These include:
 Make or buy decisions
 Accepting or rejecting special orders (contracts)
 Shut down decisions (closing or continuation decisions)
 Limiting factor decision making (determining the most efficient use of scarce
resources).
Uses of absorption costing.
 Used for routine reporting.
 Used for financial accounting purposes.
Principles of marginal costing
a. Period fixed costs are the same for any volume of sales and production if the levels
of activity is within the relevant range hence:
 Revenue will increase by the same values of the items sold.
 Cost will increase by variable cost per unit.
 Profits will increase by the amount of contribution earned from an extra
item.
b. If the volume of sales fall by one item profit also fall by the amount of contribution
earned from that one item.
c. Profit measurement is based on analysis of contribution.
d. When a unit of a product is made, the extra costs incurred in its manufacture are the
variable costs and fixed costs are unaffected.
Application of marginal costing principles
Example1
Rain until September Company makes a product, the splash which has a variable
production cost of K16 per unit and a sales price per unit K20. At the beginning of
September 2013, there were no opening inventories and production during the month was
20, 000 units. Fixed costs for the month were K45, 000.00 (production, administration, sales
and distribution). There were no variable marketing costs.
Requirements

67. 66
Calculate the contribution and profit for September 2013, using marginal costing principles
if sales were:
a. 10, 000 splashes
b. 15, 000 splashes
c. 20, 000 splashes
Example 2
Tom and jerry ltd makes two products, the Tom and Jerry. Information relating to each of
these products for April 2011 is as follows:
Toms Jerry’s
Opening inventory nil nil
Production units 15, 000 6, 000
Sales units 10,000 5, 000
Sales price per unit K20 K30
Cost per unit: K K
Direct materials 8 14
Direct labour 4 2
Variable production overheads 2 1
Variable sales overheads 2 3
Fixed cost for the month: K
Production cost 40, 000.00
Administration cost 15, 000.00
Sales and distribution costs 25, 000.00
Requirements
a) Calculate the profit in 2011 in April using marginal costing principles
b) Calculate the profit if sales had been 15000 units of Toms and 6000 units of Jerry’s.
c) What is the contribution to sales ratio for both (a) and (b) above for Toms and Jerry.
NOTE: when using marginal costing or its principles the contribution to sales ratio is
the same even if sales change.

68. 67
But it does mean that contribution to sales ratio is the same when variable costs
change.
Variable sales costs vary with sales units and not production units.
Variable production costs vary with production units and not sales units.
Marginal and absorption costing compared
Marginal costing Absorption costing
Closing inventories are valued at variable
costs only.
Closing inventories are valued at full
production cost i.e. fixed + variable costs.
Fixed costs are period costs Fixed costs are absorbed into unit costs.
Costs of sales does not include a share of
fixed costs (overheads)
Costs of sales does include a share of fixed
production costs (overheads)
Marginal vs. absorption costing
Example 1
Ross ltd budgeted to commence production of product X in month one. The standard
variable production cost per unit of product X is:
K
Material 70
Labour 40
Production overhead 30
Budgeted monthly fixed production overhead is K72, 000.00
Production is budgeted a 6000 units per month which will be used to calculate a
predetermined fixed overhead absorption rate if absorption costing is used.
The budgeted selling price of X is K180 per unit.
The actual production and sales for the first three months were:
Month 1 Month 2 Month 3
Production 5500 units 6200 units 5900 units

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Sales 5000 units 6300 units 6200 units
Requirements
a) Calculate both the standard contribution and profit for one unit.
b) Prepare profit statements for month 2 and month 3 only using
i. Marginal costing
ii. Absorption costing
c) Prepare a statement to reconcile the profits obtained using both methods for month
2 and month 3.
d) Mention two advantages and disadvantages of using marginal costing.
Example 2
Rowland Company makes and sells one product, the standard cost of which is as follows
for one unit:
K
Direct material 28
Direct labour 18
Production overhead: variable 3
Fixed 20
Standard production cost 69
Normal output is 16000 units per annum and this figure is used for the fixed production
overhead calculation. Costs relating to selling, distribution and administration are:
Variable 20% of sales value
Fixed K180, 000.00 per annum
The only variance is a fixed production overhead volume variance. There are no units in
finished stock at 1 October, 2013. The fixed overhead expenditure is spread evenly
throughout the year. The selling price per unit is K140.
For the six monthly period detailed below, the number of units to be produced and sold are
budgeted as:
October to March 2013 April to September 2013

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Production units 8500 7000
Sales units 7000 8000
Requirements
a) Prepare to management statements showing sales, costs and profits using:
i. Marginal costing
ii. Absorption costing
b) Reconcile the profits reported under both methods for each period.
Reconciliation procedure
K’000
Profit as per marginal costing statement XXX
Adjustments on fixed OAR XXX
Add: closing stock * fixed OAR XXX
Less: opening stock * fixed OAR (XXX)
Profit as per absorption costing statement XXX
What causes the difference in profits under the two methods.
 Stocks are valued on total production cost in absorption costing whilst in
marginal costing are valued on variable production costs only.
 If stock levels increases between the beginning and end of period absorption
costing reports higher profits because some of the fixed production overheads
incurred during the period will be carried forward in closing stocks to be set
against sales revenues in the following period instead of being set off in full
against the profits in the concerned period.
 If stock levels decreases between the beginning and end of period absorption
costing reports lower profits because both fixed production overheads incurred
during the period and which had been carried forward in opening stock is
released and included in cost of sales.
Advantages of marginal costing
 It is simple to understand and apply.
 It concentrates on the controllable aspects of the business by separating fixed
from variable costs.

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 It is a useful short term survival technique in a competitive environment or where
recession is experienced.
Disadvantages of marginal costing
 It uses historical data whilst management decisions relate to the future
 It is difficult to classify fixed and variable costs from mixed costs
 It is not suitable for pricing decisions in the long run as it ignores fixed costs
Arguments in favour of absorption costing
 It sounds realistic to charge all output with a share of fixed production costs which
are incurred in order to make output.
 It is in line with SAAP 9 for closing stock valuation.
 It does not distort profits through stock valuation where stock building is necessary
or activity is seasonal.
 Profitability of various products can be established since fixed costs are already
charged to each product.
Reasons for marginal costing
 Under or over absorption of overheads is avoided.
 It is simple to operate
 No arbitrary apportionment of fixed costs
 It sounds realistic to value stock at variable production cost since it is directly
attributable.
 For management better information about expected profits is obtained from the use
of variable cost and contribution.

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CHAPTER SIX
BREAKEVEN ANALYSIS OR COST VOLUME PROFIT ANLYSIS(CVP ANALYSIS)
Break even analysis or CVP analysis
 Is the study of the interrelationships between costs, volume, and profit at various
levels of activity.
What is breakeven point (break even sales)?
 Is a point where no profits nor losses occur
 Is the amount by which actual sales can fall below anticipated sales without a loss
being incurred.
Formula for breakeven sales (point)
Breakeven point in units = total fixed cost/ contribution per unit OR
Breakeven point in revenue = total fixed cost/contribution to sales ratio (C/S ratio)
Example 1 on breakeven point
Nugget Company has provided with you the following information:
Expected sales 10000 units at K8 per unit = K80, 000.00
Variable cost K5 per unit
Fixed cost K21, 000.00